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75362_1993.txt

75362_1993

1993

75362

ITEM 1. BUSINESS (a) General Development of Business PACCAR Inc (the Company), incorporated under the laws of Delaware in 1971, is the successor to Pacific Car and Foundry Company which was incorporated in Washington in 1924. The Company traces its predecessors to Seattle Car Manufacturing Company formed in 1905. In the U.S., the Company's manufacturing operations are conducted through unincorporated manufacturing divisions and a wholly owned subsidiary. Each of the divisions and the subsidiary are responsible for at least one of the Company's products. That responsibility includes new product development, applications engineering, manufacturing and marketing. Outside the U.S., the Company manufactures and sells through wholly owned subsidiary companies in Canada and Australia, through a United Kingdom branch of a wholly owned U.S. subsidiary, and through an affiliate in Mexico. In January 1994, the Company increased its ownership in the Mexican affiliate from 49% to 55%. An export sales division generally is responsible for export sales. Product financing and leasing is offered through U.S. and foreign finance subsidiaries. A U.S. subsidiary is responsible for retail automotive parts sales. (b) Financial Information About Industry Segments and Geographic Areas Information about the Company's industry segments and geographic areas in response to Items 101(b), (c)(1)(i), and (d) of Regulation S-K appears on page 39 of the Annual Report to Stockholders for the year ended December 31, 1993 and is incorporated herein by reference. (c) Narrative Description of Business The Company has three principal industry segments, (1) manufacture of heavy-duty trucks and related parts, (2) automotive parts sales and related services, and (3) finance and leasing services provided to customers and dealers. Manufactured products also include industrial winches and oilfield equipment. The Company competes in the truck parts aftermarket primarily through its dealer network. It sells general automotive parts and accessories through retail outlets. The Company's finance and leasing activities are principally related to Company products and associated equipment. TRUCKS The Company designs and manufactures trucks which are marketed under the Peterbilt, Kenworth, and Foden nameplates in the Class 8 diesel category (having a minimum gross vehicle weight of 33,000 pounds). These vehicles, which are built in five plants in the U.S. and one each in Australia, Canada, the United Kingdom and Mexico, are used worldwide for over-the-road and off-highway heavy-duty hauling of freight, petroleum, wood products, construction and other materials. Heavy-duty trucks and related service parts are the largest segment of the Company's business, accounting for 88% of total 1993 revenues. The Company competes in the North American Class 6/7 markets with its Mid-Ranger cab-over-engine vehicles. These medium-duty trucks are assembled at PACCAR's factory in Quebec, Canada. This line of business represents a small percentage of the Company's sales to date. Trucks are sold to independent dealers for resale. The Company's U.S. independent dealer network consists of 310 outlets. Trucks manufactured in the U.S. for export are marketed by PACCAR International, a U.S. division. Those sales are made through a worldwide network of 34 dealers. Trucks manufactured in the United Kingdom, Australia, Canada, and Mexico are marketed domestically through independent dealers and factory branches; trucks manufactured in these countries for export are also marketed by PACCAR International. The Company's trucks are essentially custom products and have a reputation for high quality. Major components, such as engines, transmissions and axles, as well as a substantial percentage of other components, are purchased from component manufacturers pursuant to customer specifications. Raw materials and other components used in the manufacture of trucks are purchased from a number of suppliers. The Company is not limited to any single source for any major component. No significant shortage of materials or components was experienced in 1993 and none is expected in 1994. Manufacturing inventory levels are based upon production schedules and orders are placed with suppliers accordingly. Replacement truck parts are sold and delivered to the Company's independent dealers through the PACCAR Parts Division. Parts consist of proprietary parts manufactured by PACCAR and finished parts purchased from various suppliers. Replacement parts inventory levels are determined largely by anticipated customer demand and the need for timely delivery. There were six principal competitors in the U.S. Class 8 truck market in 1993. PACCAR's share of that market was approximately 22% of registrations in 1993. The market is highly competitive in price, quality and service, and PACCAR is not dependent on any single customer for its sales. There are no significant seasonal variations. The Kenworth, Peterbilt and Foden trademarks and trade names are recognized internationally and play an important role in the marketing of the Company's truck products. The Company engages in a continuous program of trademark and trade name protection in all marketing areas of the world. Although the Company's truck products are subject to environmental noise and emission controls, competing manufacturers are subject to the same controls. The Company believes the cost of complying with noise and emission controls will not be detrimental to its business. The Company's truck sales backlog at year-end 1993 was estimated at $1,268,000,000. This compares with $776,000,000 at year-end 1992. Production of the year-end 1993 backlog is expected to be completed during 1994. The number of persons employed by the Company in its truck business at December 31, 1993 was approximately 8,000. OTHER MANUFACTURED PRODUCTS Other products manufactured by the Company account for 2% of total 1993 revenues. This group includes industrial winches and oilfield extraction pumps and service equipment. Winches are manufactured in two U.S. plants and are marketed under the Braden, Carco, and Gearmatic nameplates. Oilfield extraction pumps and service equipment are manufactured in three U.S. plants and marketed under the Trico and Kobe nameplates. The markets for all of these products are highly competitive and the Company competes with a number of well established firms. The Braden, Carco, Gearmatic, Trico, and Kobe trademarks and trade names are recognized internationally and play an important role in the marketing of those products. The Company has an ongoing program of trademark and trade name protection in all relevant marketing areas. AUTOMOTIVE PARTS The Company purchases and sells general automotive parts and accessories, which account for 5% of total 1993 revenues, through 120 retail locations under the names of Grand Auto and Al's Auto Supply. These locations are supplied from the Company's distribution warehouses. FINANCE COMPANIES The Company has five wholly owned finance companies which provide financing principally for trucks manufactured by the Company in the U.S., Canada, the United Kingdom, and Australia. These companies provide lease financing for independent dealers selling PACCAR products and retail and inventory financing for new and used Class 6, 7 and 8 trucks regardless of make or model. Installment contracts are secured by the products financed. LEASING COMPANIES PACCAR Leasing Corporation (PLC), a wholly owned subsidiary, franchises selected PACCAR truck dealers to engage in full service truck leasing under the PacLease trade name. PLC also leases equipment to and provides managerial and sales support for its franchisees. Similar leasing operations are conducted in Canada through a division of PACCAR of Canada Ltd. and in the United Kingdom through a wholly owned subsidiary, PacLease Limited. RAILEASE Inc, a wholly owned subsidiary, leases railcars to a railroad. GENERAL INFORMATION PATENTS The Company owns numerous patents which relate to all product lines. Although these patents are considered important to the overall conduct of the Company's business, no patent or group of patents is considered essential to a material part of the Company's business. RESEARCH AND DEVELOPMENT The Company maintains a technical center where product testing and research and development activities are conducted. Additional product development activities are conducted within each separate manufacturing division. Amounts spent on research and development were approximately $22 million in 1993, $21 million in 1992 and $22 million in 1991. REGULATION As a manufacturer of highway trucks, the Company is subject to the National Traffic and Motor Vehicle Safety Act and Federal Motor Vehicle Safety Standards promulgated by the National Highway Traffic Safety Administration. The Company believes it is in compliance with the Act and applicable safety standards. Information regarding the effects that compliance with federal, state and local provisions regulating the environment have on the Company's capital and operating expenditures and the Company's involvement in environmental cleanup activities is included in Management's Discussion and Analysis of Financial Condition and Results of Operations and the Company's Consolidated Financial Statements incorporated by reference in Items 7 and 8, respectively. EMPLOYEES On December 31, 1993, the Company employed a total of 11,800 persons, excluding employees of its Mexican affiliate. ITEM 2. ITEM 2. PROPERTIES The Company and its subsidiaries and affiliate own and operate manufacturing plants in seven U.S. states, Canada, Australia, Mexico and the United Kingdom including a new truck manufacturing facility in Renton, Washington which was completed in 1993. Several parts distribution centers, sales and service facilities and finance and administrative offices are also operated in owned or leased premises in these five countries. A facility for product testing and research and development is located in Skagit County, Washington. Retail auto parts sales locations are primarily in leased premises in five western states. The Company's corporate headquarters is located in owned premises in Bellevue, Washington. The Company considers substantially all of the properties used by its businesses to be suitable for their intended purposes. Due to improved business conditions in 1993 in the markets served by the Company's business segments, many of the Company's manufacturing facilities operated at or near their productive capacities. Geographical locations of manufacturing plants within indicated industry segments are as follows: Properties located in Torrance, Signal Hill and Pomona, California; Bartlesville, Oklahoma; Kansas City, Missouri; and Seattle, Washington are being held for sale. These properties were originally obtained principally as a result of business acquisitions in 1987 and 1988. ITEM 3. ITEM 3. LEGAL PROCEEDINGS The Company and its subsidiaries are parties to various lawsuits incidental to the ordinary course of business. Management believes that the disposition of such lawsuits will not materially affect 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. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS Common stock of the Company is traded over the counter on the NASDAQ National Market System under the symbol PCAR. The table below reflects the range of trading prices as reported by NASDAQ and cash dividends declared. The cash dividends declared and stock prices have been restated to give effect to the 15% stock dividend declared December 14, 1993. There were 3,292 record holders of the common stock at December 31, 1993. The Company expects to continue paying regular cash dividends, although there is no assurance as to future dividends because they are dependent upon future earnings, capital requirements and financial conditions. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA Selected Financial Data on page 41 of the Annual Report to Stockholders for the year ended December 31, 1993 are 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 21 through 24 of the Annual Report to Stockholders 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 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 Income -- Years Ended December 31, 1993, 1992 and 1991 Consolidated Statements of Stockholders' 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, 1992 and 1991 Quarterly Results (Unaudited) on page 41 of the Annual Report to Stockholders for the year ended December 31, 1993 are incorporated herein by reference. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE The registrant has not had any disagreements with its independent auditors on accounting or financial disclosure matters. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Item 401(a), (d), (e) and Item 405 of Regulation S-K: Identification of directors, family relationships, business experience and compliance with Section 16(a) of the Exchange Act on pages 3 and 4 of the proxy statement for the annual stockholders meeting of April 26, 1994 is incorporated herein by reference. Item 401(b) of Regulation S-K: Executive Officers of the registrant as of February 1, 1994: Officers are elected annually but may be appointed or removed on interim dates. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION Compensation of Directors and Executive Officers and Related Matters on pages 5 through 11 of the proxy statement for the annual stockholders meeting of April 26, 1994 is incorporated herein by reference. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Stock ownership information on pages 1 and 2 of the proxy statement for the annual stockholders meeting of April 26, 1994 is incorporated herein by reference. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Information on page 4 of the proxy statement for the annual stockholders meeting of April 26, 1994 is incorporated herein by reference. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) (1) and (2) - The response to this portion of Item 14 is submitted as a separate section of this report. (3) Listing of Exhibits (in order of assigned index numbers) (3) Articles of incorporation and bylaws (a) PACCAR Inc Certificate of Incorporation, as amended to April 27, 1990 (incorporated by reference to the Quarterly Report on Form 10-Q for the quarter ended March 31, 1990). (b) PACCAR Inc Bylaws, as amended to April 28, 1987 (incorporated by reference to the Quarterly Report on Form 10-Q for the quarter ended March 31, 1987). (4) Instruments defining the rights of security holders, including indentures (a) Rights agreement dated as of December 21, 1989 between PACCAR Inc and First Chicago Trust Company of New York setting forth the terms of the Series A Junior Participating Preferred Stock, no par value per share (incorporated by reference to Exhibit 1 of the Current Report on Form 8-K of PACCAR Inc dated December 27, 1989). (b) Indenture for Senior Debt Securities dated as of December 1, 1983 between PACCAR Financial Corp. and Citibank, N.A., Trustee (incorporated by reference to Exhibit 4.1 of the Annual Report on Form 10-K of PACCAR Financial Corp. for the year ended December 31, 1983). (c) First Supplemental Indenture dated as of June 19, 1989 between PACCAR Financial Corp. and Citibank, N.A., Trustee (incorporated by reference to Exhibit 4.2 to PACCAR Financial Corp.'s registration statement on Form S-3, Registration No. 33-29434). (d) Forms of Medium-Term Note, Series E (incorporated by reference to Exhibits 4.3A, 4.3B and 4.3C to PACCAR Financial Corp.'s Registration Statement on Form S-3 dated June 23, 1989, Registration Number 33-29434, and Forms of Medium-Term Note, Series E, incorporated by reference to Exhibit 4.3B.1 to PACCAR Financial Corp.'s Current Report on Form 8-K, dated December 19, 1991, under Commission File Number 0-12553). Letter of Representation among PACCAR Financial Corp., Citibank, N.A. and the Depository Trust Company, Series E, dated July 6, 1989 (incorporated by reference to Exhibit 4.3 of PACCAR Financial Corp.'s Annual Report on Form 10-K, dated March 29, 1990. File Number 0-12553). (e) Forms of Medium-Term Note, Series F (incorporated by reference to Exhibits 4.3A, 4.3B and 4.3C to PACCAR Financial Corp.'s Registration Statement on Form S-3 dated May 26, 1992, Registration Number 33-48118). Form of Letter of Representation among PACCAR Financial Corp., Citibank, N.A. and the Depository Trust Company, Series F (incorporated by reference to Exhibit 4.4 to PACCAR Financial Corp.'s Registration Statement on Form S-3 dated May 26, 1992, Registration Number 33-48118). (f) Forms of Medium-Term Note, Series G (incorporated by reference to Exhibits 4.3A and 4.3B to PACCAR Financial Corp.'s Registration Statement on Form S-3 dated December 8, 1993, Registration Number 33- 51335). Form of Letter of Representation among PACCAR Financial Corp., Citibank, N.A. and the Depository Trust Company, Series G (incorporated by reference to Exhibit 4.4 to PACCAR Financial Corp.'s Registration Statement on Form S-3 dated December 8, 1993, Registration Number 33-51335). (10) Material contracts (a) PACCAR Inc Incentive Compensation Plan (incorporated by reference to Exhibit (10)(a) of the Annual Report on Form 10-K for the year ended December 31, 1980). (b) PACCAR Inc Deferred Compensation Plan for Directors (incorporated by reference to Exhibit (10)(b) of the Annual Report on Form 10-K for the year ended December 31, 1980). (c) Supplemental Retirement Plan (incorporated by reference to Exhibit (10)(c) of the Annual Report on Form 10-K for the year ended December 31, 1980). (d) 1981 Long Term Incentive Plan (incorporated by reference to Exhibit A of the 1982 Proxy Statement, dated March 25, 1982). (e) Amendment to 1981 Long Term Incentive Plan (incorporated by reference to Exhibit (10)(a) of the Quarterly Report on Form 10-Q for the quarter ended March 31, 1991). (f) PACCAR Inc 1991 Long-Term Incentive Plan (incorporated by reference to Exhibit (10)(h) of the Quarterly Report on Form 10-Q for the quarter ended June 30, 1992). (g) Amended and Restated Deferred Incentive Compensation Plan. (13) Annual report to security holders Portions of the 1993 Annual Report to Shareholders have been incorporated by reference and are filed herewith. (21) Subsidiaries of the registrant (23) Consent of independent auditors (24) Power of attorney Powers of attorney of certain directors (b) No reports on Form 8-K were filed for the three months ended December 31, 1993. (c) Exhibits (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. PACCAR Inc ----------------------------------- Registrant /s/ C. M. Pigott 3-24-94 ----------------------------------- C. M. Pigott, Director, 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 dates indicated. * Pursuant to power of attorney ANNUAL REPORT ON FORM 10-K ITEM 14(a)(1) AND (2), (c) AND (d) LIST OF FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES CERTAIN EXHIBITS FINANCIAL STATEMENT SCHEDULES YEAR ENDED DECEMBER 31, 1993 PACCAR INC AND SUBSIDIARIES BELLEVUE, WASHINGTON FORM 10-K -- ITEM 14(A)(1) AND (2) PACCAR INC AND SUBSIDIARIES LIST OF FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES The following consolidated financial statements of PACCAR Inc and subsidiaries, included in the Annual Report to Stockholders 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 Stockholders' 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, 1992 and 1991 The following consolidated financial statement schedules of PACCAR Inc and consolidated subsidiaries are included in Item 14(d): Schedule VIII -- Allowances for Losses 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. PACCAR INC AND SUBSIDIARIES SCHEDULE VIII - ALLOWANCES FOR LOSSES (MILLIONS OF DOLLARS) (A) Allowance for losses deducted from trade receivables. (B) Allowance for losses deducted from notes, contracts, and other receivables. (1) Uncollectible trade receivables, notes, contracts and other receivables written off, net of recoveries. PACCAR INC AND SUBSIDIARIES SCHEDULE IX -- SHORT-TERM BORROWINGS (MILLIONS OF DOLLARS) (A) Short-term borrowings are comprised primarily of amounts owed by the finance and leasing subsidiaries and represent commercial paper and short-term notes with maturities of less than one year and bank lines of credit which have no termination date but are reviewed annually for renewal. (B) The average amount outstanding during the period was computed by dividing the total average monthly outstanding principal balances by twelve. (C) The weighted average interest rate during the period was computed by dividing the actual interest expense by the average short-term borrowings outstanding.

714655_1993.txt

714655_1993

1993

714655

Item 1. Business Biogen, Inc. ("Biogen" or the "Company") is a biopharmaceutical company principally engaged in the business of developing and manufacturing drugs for human health care through genetic engineering. Biogen currently derives revenues from five products sold by licensees around the world. During 1993, Biogen's licensees generated total sales of approximately $1.5 billion from these products. In the future, Biogen expects to derive additional revenues from sales of proprietary products which Biogen will market. One of Biogen's two leading product candidates, its Hirulog(TM) thrombin inhibitor, is in Phase III clinical trials for two indications and in Phase II trials for certain other indications. Hirulog(TM) is a rationally designed antithrombotic being tested for use in the treatment of a number of arterial cardiovascular conditions. Biogen's other leading product candidate, recombinant beta interferon, is in Phase III clinical trials for one indication and in Phase II clinical trials for certain other indications. Recombinant beta interferon is a protein being tested for use as a therapy for multiple sclerosis and certain viruses and cancers. Biogen focuses its research and development efforts on areas where it has particular scientific and competitive strengths: cardiovascular disease, inflammatory diseases, AIDS and certain cancers and viruses. Biogen is conducting preclinical tests on three anti-inflammatory product candidates from its T-cell activation, T-cell/B-cell interaction and cell adhesion programs. These product candidates are being tested for therapeutic uses in a broad range of acute and chronic inflammatory and autoimmune diseases. Biogen is also conducting preclinical tests on an antimucolytic agent for treatment in cystic fibrosis and several other pulmonary diseases. In addition, Biogen has earlier-stage research programs directed toward new immune system modulators, antithrombotic agents, virus inhibitors and drug delivery agents. Biogen Proprietary Products and Major Research Programs Biogen's research is focused on biological systems and processes where its scientific expertise in molecular biology, cell biology, immunology and protein chemistry can lead to a greater understanding of disease processes and, as a result, to the creation of new pharmaceuticals. Biogen selects product candidates from its research programs to test in clinical trials, focusing its efforts on those agents with the greatest potential competitive advantages and large commercial markets. Described below are Biogen's proprietary products in clinical trials and its major research programs. Products in Clinical Trials Hirulog(TM) Thrombin Inhibitor Hirulog(TM) is a rationally designed antithrombotic which directly inhibits thrombin, a central component in the cascade that leads to clot formation in arteries and veins. Biogen believes that Hirulog(TM) may have broad therapeutic applications and is focusing its initial clinical efforts on the use of Hirulog(TM) during coronary balloon angioplasty, for the treatment of unstable angina and as an adjunctive with thrombolytic agents for treating myocardial infarction (heart attack). Each of these indications often requires expensive and invasive surgical procedures, and Biogen believes there is a significant need for better treatments which is not met by currently available medications. To date, Hirulog(TM) has been administered to more than 2,500 patients in Phase I, Phase II and Phase III clinical trials conducted in North America and Europe. The results of Phase I and Phase II clinical trials to date have shown that Hirulog(TM) is well tolerated and has a dose-related antithrombotic effect in humans. A clinical trial of Hirulog(TM) in the treatment of unstable angina conducted by the Thrombolysis in Myocardial Infarction (TIMI) group at the Brigham and Women's Hospital has been completed. A second, larger Phase III clinical trial of Hirulog(TM) in unstable angina recently began. A Phase III clinical trial of Hirulog(TM) in angioplasty and additional Phase II trials are ongoing. Biogen presently expects the Phase III trials of Hirulog(TM)in angioplasty to be completed in 1994. Because of the mechanism of action and results of in vitro, in vivo and clinical testing of Hirulog(TM), Biogen believes Hirulog(TM) has the potential for use in many situations where an anticoagulant is needed. Hirulog(TM) is the product of Biogen research which began on hirudin, the anticoagulant protein found in the saliva of the medicinal leech. Based on their knowledge of the structure and function of hirudin and thrombin, Biogen's scientists designed a smaller molecule which may have different therapeutic effects from those of hirudin. Hirulog(TM) is a chemically synthesized, twenty amino acid peptide. Biogen has contracted with a major chemical company to provide Biogen with the quantities of Hirulog(TM) necessary to meet its anticipated needs for clinical trials and commercial sale. Biogen is developing Hirulog(TM) as a proprietary therapeutic product which it intends to market itself, assuming the successful completion of clinical studies and receipt of applicable regulatory approvals. In 1991, Biogen licensed to Commonwealth Serum Laboratories Limited, Australia's largest domestic pharmaceutical company, the rights to market Hirulog(TM) as a therapeutic in Australia and New Zealand. Recombinant Beta Interferon Natural beta interferon is a protein produced by fibroblast cells in response to viral infection. Biogen is investigating recombinant beta interferon for use as an antiviral and anticancer agent and for the treatment of multiple sclerosis. Dosing in a Phase III clinical trial in the United States of recombinant beta interferon for the treatment of multiple sclerosis, sponsored by the National Institutes of Health, ended in February 1994. The Company is currently collecting and analyzing data and information from the trial. Biogen is also conducting and sponsoring clinical investigations for the use of recombinant beta interferon in treating hepatitis B, hepatitis C, and other diseases. Phase II clinical trials of beta interferon are ongoing in Europe and the United States for several indications. Compared to natural beta interferon, beta interferon produced through recombinant technology is believed to be a purer and more consistent product, and can be produced in recombinant form in large quantities. Biogen's recombinant beta interferon is produced in mammalian cells. Biogen believes that recombinant beta interferon has greater activity in vivo than natural beta interferon. In addition, Biogen believes that recombinant beta interferon can be administered by routes, such as subcutaneous and intramuscular, which are limited for natural beta interferon. Biogen is developing recombinant beta interferon as a proprietary product and, assuming the successful completion of clinical studies and receipt of applicable regulatory approvals, intends to market the drug in North America and Europe. In 1993, Bioferon Biochemische Substanzen GmbH & Co. ("Bioferon"), a pharmaceutical company owned jointly by Biogen and Dr. Rentschler Arzneimittal GmbH & Co. ("Rentschler"), was liquidated and its assets sold to Rentschler. As a result, Biogen's agreements with Bioferon and Asta Pharma AG relating to beta interferon and the participation of Bioferon and Asta in the development of Biogen's recombinant beta interferon have terminated. Major Research Programs Inflammation Program Biogen scientists have been working to understand the activities of white blood cells involved in the inflammation process. Biogen has focused on two events central to inflammation: (1) the activation of T-cells, specialized white blood cells which initiate and control the immune response; and (2) the adhesion of white blood cells to the endothelium (blood vessel walls) and their migration through the endothelium into surrounding tissues where they cause inflammation. Activation and adhesion of white blood cells depend upon the binding of pairs of receptor molecules which appear on the surface of white blood cells and endothelial cells. When these pairs of receptors bind together their interactions create cellular "pathways" for activation and adhesion events. Biogen has investigated several of these cellular pathways and identified new receptors in certain of these pathways. Based on its research, Biogen has selected three cellular pathways as the best points of therapeutic intervention to prevent inflammation: (1) the LFA-3/CD2 pathway, which activates T-cells, (2) the VCAM-1/VLA-4 pathway, which is necessary for the adhesion of several types of white blood cells to endothelial cells, and (3) the TBAM/CD40 pathway which activates B-cells which produce antibodies. Biogen believes that products which interrupt these pathways will block the inflammation process at an early stage, thus preventing tissue damage more effectively than currently available therapies. Moreover, such products should result in selective inhibition of the immune system, rather than the broad suppression associated with most therapies currently available or under development. In in vitro and in vivo experiments the product candidates from the inflammation program have shown promising inhibitory effects. The Company has delayed commencing Phase I clinical trials of product candidates from the inflammation program while resources are devoted to development of Hirulog* and beta interferon. Gelsolin Thick viscid secretions in the airways of cystic fibrosis ("CF") patients are believed to cause progressive pulmonary destruction. A major contributor to the viscosity of CF mucus is the release of a large amount of filamentous actin by degenerating inflammatory cells which migrate in large numbers to the airways of CF patients. Biogen and its collaborators believe that severing actin filaments contaminating the CF airway mucus may lead to clinical improvement in CF patients. Biogen is developing a recombinant form of an actin severing agent, human r-P gelsolin, for reducing airway obstruction in CF and several other pulmonary diseases. The Company is presently conducting preclinical studies of gelsolin product candidates. Other Research Programs As part of its further research efforts, Biogen is investigating a number of different approaches for intervening in thrombotic processes, targeting new approaches to the treatment of certain persistent viral diseases, such as human papillomavirus infections, and developing methods for delivering drug products directly to the inside of cells. Additional efforts are being directed towards new strategies for intervening in diseases where the normal pattern of growth regulation has been disturbed. Abnormal growth is implicated in diseases as diverse as cancer, which is characterized by the uncontrolled growth of abnormal cells, and restenosis, in which the reclosure of blood vessels may be associated with the growth of scar tissue. Biogen is also exploring various avenues of therapeutic intervention in AIDS. One of these avenues is a therapy that blocks entry of HIV into cells via CD4. Biogen has identified a monoclonal antibody, known as 5A8, directed against CD4, which has the potential to block HIV infection and HIV- induced cell fusion or HIV/CD4 cell fusion. Research Costs During 1993, 1992 and 1991, Biogen's research and development costs were approximately $79.3 million, $60.4 million and $44.3 million, respectively. There can be no assurance that any of the products described above or resulting from Biogen's research programs will be successfully developed, prove to be safe and efficacious at each stage of clinical trials, meet applicable regulatory standards, be capable of being produced in commercial quantities at reasonable costs or be successfully marketed. Products Being Marketed or Developed by Biogen Licensees Intron(R) A Alpha Interferon Alpha interferon is a naturally occurring protein produced by normal white blood cells. Biogen has been granted patents in the United States and in Europe covering the production of alpha interferons through recombinant DNA techniques and has applications pending in numerous other countries. See "Patents and Other Proprietary Rights." Biogen's worldwide licensee for recombinant alpha interferon, Schering-Plough Corporation ("Schering-Plough"), first began commercial sales of its Intron(R) A brand of alpha interferon in the United States in 1986 for hairy-cell leukemia. Schering-Plough now sells Intron(R) A in more than 60 countries for more than 16 indications, including hepatitis B, hepatitis C, genital warts and Kaposi's sarcoma. Sales of Intron(R) A by Schering-Plough were $572 million in 1993, the majority of which were generated outside the United States. Currently the largest market for Intron(R) A is in Japan for the treatment of hepatitis C. The United States Food and Drug Administration ("FDA") has approved Intron(R) A for the treatment of hepatitis B and hepatitis C in the United States. Schering-Plough has undertaken studies using Intron(R) A for a number of additional indications. These studies include Phase III trials of Intron(R) A for the treatment of chronic myelogenous leukemia, bladder cancer, non- Hodgkin's lymphoma, malignant melanoma, renal cell carcinoma, multiple myeloma and head and neck cancer, and earlier phase trials for Crohn's disease and, in combination with AZT or ddI, as a treatment for AIDS. Royalties from Schering-Plough accounted for approximately 57% of Biogen's revenues (excluding interest) in 1993. Hepatitis B Vaccines and Diagnostics Hepatitis B is a blood-borne disease which causes a serious infection of the liver and substantially increases the risk of liver cancer. More than 250 million people worldwide have chronic hepatitis B virus infections. Biogen holds several important patents related to hepatitis B antigens produced by genetic engineering techniques. See "Patents and Other Proprietary Rights." These antigens are used in recombinant hepatitis B vaccines and in diagnostic test kits used to detect hepatitis B infection. In total, sales of hepatitis B vaccines and diagnostic products by Biogen licensees exceeded $900 million in 1993. Hepatitis B Vaccines The American Academy of Pediatrics and the United States Centers for Disease Control and Prevention ("CDCP") have recommended that all infants born in the United States receive inoculation against hepatitis B as part of a universal vaccination program. At least 20 countries around the world already recommend vaccination for all infants. CDCP and the American Academy of Pediatrics have also recommended universal immunization of ten-year-old children and at-risk adolescents. In addition, the United States Occupational Safety and Health Administration ("OSHA") has recommended that all persons with an occupational exposure to blood and other infectious material receive the hepatitis B vaccine. In 1992, OSHA instituted a program requiring certain employers to offer the vaccine at no cost to all employees at risk. SmithKline Beecham Biologicals s.a. ("SmithKline") and Merck & Co., Inc. ("Merck") are the two major worldwide marketers of hepatitis B vaccines. Biogen has licensed to SmithKline exclusive rights under Biogen's hepatitis B patents to market hepatitis B vaccines in the major countries of the world, excluding Japan. SmithKline's vaccine is approved in the United States and in over 60 other countries. In 1990, SmithKline and Biogen entered into a sublicense arrangement with Merck under which Biogen currently receives royalties. Royalties from SmithKline and Merck together accounted for approximately 34% of Biogen's revenues (excluding interest) in 1993. Biogen has also licensed rights under its hepatitis B patents to Merck and The Green Cross Corporation non-exclusively in Japan. In 1993, SmithKline initiated arbitration in the United States regarding the rate of royalties payable on sales of hepatitis B vaccines by SmithKline in the United States. In the fourth quarter of 1992, SmithKline received a favorable decision against Biogen in a foreign arbitration regarding similar royalty provisions in a separate agreement governing international sales of hepatitis B vaccines by SmithKline. Biogen has received leave to appeal the foreign arbitration decision from the English Chancery Court. The Company believes that a decision in the United States similar to the foreign arbitration decision is not probable. Hepatitis B Diagnostics Biogen has licensed its proprietary hepatitis B rights non-exclusively, on an antigen-by-antigen basis, to diagnostic kit manufacturers. Biogen currently has hepatitis B license or supply agreements for diagnostic use with more than a dozen companies, including Abbott Laboratories, the major worldwide marketer of hepatitis B diagnostic kits, Ortho Diagnostic Systems, Inc., Roche Diagnostic Systems, Inc. and Organon Teknika B.V. Other Products Gamma Interferon Gamma interferon is a protein produced by cells of the immune system. Biogen has developed a recombinant gamma interferon for Biogen Medical Products Limited Partnership ("BMPLP"). In 1993, BMPLP terminated its agreements with Bioferon under which Bioferon developed gamma interferon and, under a distribution agreement with Rentschler, marketed gamma interferon in Germany for the treatment of rheumatoid arthritis as a second line therapy for patients who no longer benefit from nonsteroidal anti-inflammatory drugs. See "Patents and Other Proprietary Rights." In Japan, Biogen's licensee, Shionogi & Co., Ltd. ("Shionogi"), markets recombinant gamma interferon under the trademark Imunomax(R)-Gamma for renal cell carcinoma. Biogen supplies Shionogi with its clinical and commercial needs for recombinant gamma interferon. In general, gamma interferon has experienced disappointing results in clinical trials for tested indications. Porcine Somatotropin Porcine somatotropin ("PST") is a protein normally produced in young pigs which promotes their growth and development into adult animals. Biogen believes that PST significantly increases feed conversion efficiency and daily weight gain and improves the quality of the meat product in pigs by reducing fat content. Biogen has been granted a patent in the European Patent Office and has applications pending in certain other countries, including the United States, covering the production of PST through recombinant DNA techniques. Until 1993, recombinant PST was being developed by Pitman-Moore, Inc., a subsidiary of the IMCERA Group, under an agreement with Biogen. In 1993, Pitman-Moore terminated its development agreement with Biogen and the license to recombinant PST patent rights, citing changing market conditions. Patents and Other Proprietary Rights Biogen has filed numerous patent applications in the United States and various other countries seeking protection of a number of its processes and products, and patents have issued on a number of these applications. Issues remain as to the ultimate degree of protection that will be afforded to Biogen by such patents. There is no certainty that these patents or others, if obtained, will be of substantial protection or commercial benefit to Biogen. Furthermore, it is not known to what extent Biogen's other pending patent applications will ultimately be granted as patents or whether those patents that have been issued will prevail if they are challenged in litigation. Trade secrets and confidential know-how are important to Biogen's scientific and commercial success. Although Biogen seeks to protect its proprietary information, there can be no assurance that others will not either develop independently the same or similar information or obtain access to Biogen's proprietary information. Recombinant Alpha Interferon Biogen has more than 30 patents in countries around the world, including the United States and countries of the European Patent Office, covering the production of recombinant alpha interferons. Biogen continues to seek related patents in the United States and other countries. Three infringement suits have been filed in Biogen's name to enforce its European alpha interferon patent. The first suit was filed in Vienna, Austria against Boehringer Ingelheim Zentrale GmbH ("BI") and two of its subsidiaries. The Austrian Court has stayed Biogen's infringement case pending a decision by the Austrian Patent Office on BI's petition to revoke Biogen's European (Austrian) patent on grounds peculiar to Austrian law. The second suit was filed in Dusseldorf, Germany against Dr. Karl Thomae GmbH and two other BI companies. The German trial and appeal courts ruled in favor of Biogen and have enjoined Thomae from the further manufacture, use or sale of recombinant alpha-2(c) interferon. The third suit was filed in Warsaw, Poland against Boehringer Ingelheim Pharma GmbH ("BI Pharma"). The Polish court preliminarily enjoined BI Pharma from further infringement of Biogen's patent. The court then stayed the injunction pending a decision on BI Pharma's appeal. Recombinant Hepatitis B Antigens Biogen has more than 50 granted patents in countries around the world, including three in the United States and two in countries of the European Patent Office, and several patent applications, covering the recombinant production of hepatitis B surface, core and "e" antigens. Biogen continues to seek related patents in the United States and other countries. Biogen's first European hepatitis B patent was opposed by five companies. The Opposition Division of the European Patent Office maintained the patent over those oppositions. Two of the opponents appealed the Opposition Division's decision to the Technical Board of Appeal which is the final arbiter. Biogen expects an oral hearing on this appeal in June 1994. Biogen's second European hepatitis B patent was opposed by four companies. In 1992, the Opposition Division decided to revoke Biogen's second European hepatitis B patent alleging that it lacked inventive step. Biogen has appealed this decision to the European Patent Office Technical Board of Appeal. The patent will remain in force during the appeal process. Although such matters can never be free from doubt, Biogen believes that the decision of the Opposition Division will be reversed on appeal. Biogen has filed three infringement suits to enforce its hepatitis B patents, in England against Medeva plc ("Medeva"), in Israel against Bio-Technology General (Israel) Ltd. ("BTG"), and in Singapore against Scitech Medical Products Pte Ltd. and Scitech Genetics Pte Ltd. The action against Medeva seeks to enjoin Medeva's planned production and distribution of hepatitis B vaccine. In November 1993, the United Kingdom High Court of Justice ruled in favor of Biogen and enjoined Medeva from further infringement of one of Biogen's European (UK) patents. The Court then stayed the injunction pending decision on Medeva's appeal. The appeal is expected to be heard in mid-1994. In 1992, BTG brought an action against Biogen seeking a compulsory license under Biogen's Israeli hepatitis B patent and Biogen filed an infringement suit against BTG, seeking to enjoin BTG's production, sale and distribution of hepatitis B vaccine. Both cases are continuing in Israel. In 1993, Biogen sued Scitech Products and Scitech Genetics in Singapore. The case is continuing in Singapore. Recombinant Beta Interferon The European Patent Office and certain countries have granted patents to Biogen covering the recombinant production of beta interferon. In other countries, including the United States, Biogen has filed patent applications and continues to seek patents covering the recombinant production of beta interferon and related technology. Biogen's European patent was opposed by one company. In December 1993, the European Patent Office's Opposition Division dismissed the opposition and maintained Biogen's patent. Biogen expects the opponent to appeal this decision. In the United States, Biogen's claims to key intermediates in the recombinant production of beta interferon were involved in an interference to determine who was the first to invent those intermediates in the United States. Priority of invention was awarded to another party in the interference. Biogen's pending United States claims to the production of recombinant beta interferon were not part of that interference. Other parties have also filed patent applications in various countries covering the recombinant production of beta interferon, and, in particular, key intermediates in that production, as well as beta interferon itself. One such party has been granted several patents in the European Patent Office and in certain countries on the key intermediates. The same party was awarded priority to those intermediates in the United States interference. Biogen has obtained non-exclusive rights to manufacture, use and sell recombinant beta interferon under these patents in various countries of the world, including the United States, Japan and most European countries. Another party has been granted various patents in the United States and in other countries on beta interferon itself. Biogen has obtained worldwide, non-exclusive rights under these patents to make, use and sell recombinant beta interferon. Hirulog(TM) Thrombin Inhibitor In 1993, the United States Patent Office issued to Biogen a patent covering Biogen's Hirulog(TM) thrombin inhibitor. Biogen has several patent applications pending on Hirulog(TM) and continues to seek patents covering Hirulog(TM) in the United States and other countries. Recombinant Gamma Interferon In 1988 and 1990, Genentech, Inc. ("Genentech") was granted several patents in the United States and Europe claiming recombinant gamma interferon and intermediates and methods for the production of recombinant gamma interferon. In January 1990, Genentech and Biogen and BMPLP entered into a cross-license agreement under which Genentech and Biogen/BMPLP each licensed to the other its United States patent rights relating to certain gamma interferons and their intermediates and processes of production for certain fields of use. At the same time, Biogen granted Genentech a non-exclusive worldwide sublicense for certain proteins under certain of its licensed process patents relating to the secretion of proteins. Biogen opposed the Genentech European gamma interferon patent in the European Patent Office. The European Patent Office has maintained the Genentech patent in a decision that cannot be appealed. If Genentech's European gamma interferon patents continue in force in Europe with their present scope and Biogen does not obtain a license under such patents, Biogen will likely be prevented from selling recombinant gamma interferon in Europe. Other Patents In January 1994, Biogen filed suit in the District Court in Osaka, Japan, against Sumitomo Pharmaceutical Co., Ltd. ("Sumitomo"). The suit seeks to enjoin Sumitomo from importing and selling its recombinant human growth hormone products in Japan. Biogen believes that these products are made by a process that infringes certain of its licensed patents relating to the secretion of proteins. In January 1994, Biogen granted Eli Lilly and Company ("Lilly") a non-exclusive license under certain of Biogen's patents for gene expression. Lilly uses the patented vectors and methods in several products that are on the market or in development. Third Party Patents Biogen is aware that others, including various universities and companies working in biotechnology, have also filed patent applications and have been granted patents in the United States and in other countries claiming subject matter potentially useful or necessary to Biogen's business. Some of those patents and applications claim only specific products or methods of making such products, while others claim more general processes or techniques useful or now used in the biotechnology industry. Genentech has been granted patents and is prosecuting other patent applications in the United States and certain other countries which it may allege are currently used by Biogen and the rest of the biotechnology industry to produce recombinant proteins in microbial hosts. Genentech has offered to Biogen and others in the industry non-exclusive licenses under those patents and patent applications for various proteins and in various fields of use, but not for others. Schering-Plough, Biogen's exclusive licensee for recombinant alpha interferon, is licensed under certain of these patents for the manufacture, use and sale of recombinant alpha interferon. The ultimate scope and validity of Genentech's patents, of other existing patents, or of patents which may be granted to third parties in the future, the extent to which Biogen may wish or be required to acquire rights under such patents, and the availability and cost of acquiring such rights currently cannot be determined by Biogen. There has been, and Biogen expects that there may continue to be, significant litigation in the industry regarding patents and other intellectual property rights. Such litigation could create uncertainty and consume substantial resources. Competition and Marketing Competition in the biotechnology and pharmaceutical industries is intense and comes from many and varied sources. Biogen does not believe that it or any of the other industry leaders can be considered dominant in view of the rapid technological change in the industry. Biogen experiences significant competition from specialized biotechnology firms in the United States, Europe and elsewhere and from many large pharmaceutical, chemical and other companies. Certain of these companies have substantially greater financial, marketing and human resources than Biogen. The pharmaceutical companies have considerable experience in undertaking clinical trials and in obtaining regulatory approval to market pharmaceutical products. In addition, certain of Biogen's products may be subject to competition from products developed using alternatives to biotechnology techniques. Much competition is directed towards establishing proprietary positions through research and development. A key aspect of such competition is recruiting and retaining qualified scientists and technicians. Biogen believes that it has been successful in attracting skilled and experienced scientific personnel. Biogen believes that leadership in the industry will be based on managerial and technological superiority and may be influenced significantly by patents and other forms of protection of proprietary information. The achievement of such a position depends upon Biogen's ability to attract and retain skilled and experienced personnel, its ability to identify and exploit commercially the products resulting from biotechnology and the availability of adequate financial resources to fund facilities, equipment, personnel, clinical testing, manufacturing and marketing. Many of Biogen's competitors are working to develop products similar to those under development and testing by Biogen. The timing of the entry of a new pharmaceutical product into the market can be an important factor in determining the product's eventual success and profitability. Early entry may have important advantages in gaining product acceptance and market share. Moreover, for certain diseases with limited patient populations, the FDA is prevented under the Orphan Drug Act, for a period of seven years, from approving more than one application for the "same" product for a single orphan drug designation, unless a later product is considered clinically superior. Accordingly, the relative speed with which Biogen can develop products, complete the testing and approval process and supply commercial quantities of the product to the market is expected to have an important impact on Biogen's competitive position. In addition, competition among products approved for sale may be based, among other things, on patent position, product efficacy, safety, reliability, availability and price. Regulation Biogen's current and contemplated activities and the products and processes that will result from such activities are and will be subject to substantial government regulation. Before pharmaceutical products may be sold in the United States and other countries, clinical trials of the products must be conducted and the results submitted to appropriate regulatory agencies for approval. These clinical trial programs generally involve a three-phase process. Typically, in Phase I, trials are conducted in volunteers or patients to determine the early side effect profile and, perhaps, the pattern of drug distribution and metabolism. In Phase II, trials are conducted in groups of patients with a specific disease in order to determine appropriate dosages, expand evidence of the safety profile and, perhaps, determine preliminary efficacy. In Phase III, large scale, comparative trials are conducted on patients with a target disease in order to generate enough data to provide the statistical proof of efficacy and safety required by national regulatory agencies. The receipt of regulatory approvals often takes a number of years, involving the expenditure of substantial resources and depends on a number of factors, including the severity of the disease in question, the availability of alternative treatments and the risks and benefits demonstrated in clinical trials. On occasion, regulatory authorities may require larger or additional studies, leading to unanticipated delay or expense. In connection with the commercialization of products resulting from Biogen's projects, it is necessary, in a number of countries, to comply with certain regulations relating to the manufacturing and marketing of such products and to the products themselves. For example, the commercial manufacturing, marketing and exporting of pharmaceutical products require the approval of the FDA in the United States and of comparable agencies in other countries. The FDA has established mandatory procedures and safety standards which apply to the manufacture, clinical testing and marketing of pharmaceutical products in the United States. The process of seeking and obtaining FDA approval for a new product and the facilities in which it can be produced is likely to take a number of years and involve the expenditure of substantial resources. The commercial manufacture and marketing of pharmaceutical products for animal use require approval of either the FDA or the USDA and of comparable agencies in other countries. In addition, the regulatory approval processes for products in the United States, Canada and Europe are undergoing or may undergo changes. Biogen cannot determine what effect any changes in regulatory approval processes may have on its business. In the United States, the federal government is currently undertaking a complete review and reformation of health care coverage and costs. Resulting legislation or regulatory actions may have a significant effect on the Company's business. Biogen's ability to commercialize successfully human pharmaceutical products also may depend in part on the extent to which reimbursement for the costs of such products and related treatments will be available from government health administration authorities, private health insurers and other organizations. Currently, substantial uncertainty exists as to the reimbursement status of newly approved health care products by third-party payors. Biogen's policy is to conduct relevant research in compliance with the current United States National Institutes of Health Guidelines for Research Involving Recombinant DNA Molecules (the "NIH Guidelines") and all other federal and state regulations. By local ordinance, Biogen is required, among other things, to comply with the NIH Guidelines in relation to its facilities in Cambridge, Massachusetts, and is required to operate pursuant to certain permits. Various laws, regulations and recommendations relating to safe working conditions, laboratory practices, the experimental use of animals and the purchase, storage, movement, import and export and use and disposal of hazardous or potentially hazardous substances, including radioactive compounds and infectious disease agents, used in connection with Biogen's research work are or may be applicable to its activities. These include, among others, the United States Atomic Energy Act, the Clean Air Act, the Clean Water Act, the Occupational Safety and Health Act, the National Environmental Policy Act, the Toxic Substances Control Act and the Resource Conservation and Recovery Act, national restrictions on technology transfer and import, export and customs regulations. The extent of government regulation which might result from future legislation or administrative action cannot accurately be predicted. Certain agreements entered into by Biogen involving exclusive license rights may be subject to national or supranational antitrust regulatory control, the effect of which also cannot be predicted. Employees At January 1, 1994, Biogen employed 380 full-time employees, of whom 55 held Ph.D. and/or M.D. degrees. Of the 380 employees, 167 were engaged in, or directly supported, research and process development and 111 were involved in, or directly supported, manufacturing, quality assurance/quality control, regulatory, medical operations and preclinical and clinical development. Biogen maintains consulting arrangements with a number of scientists at various universities and other research institutions in Europe and the United States, including the six outside members of its Scientific Board. Item 2. Item 2. Properties Substantially all of Biogen's facilities are located in Cambridge, Massachusetts, where the Company leases all or part of five buildings containing a total of approximately 220,000 square feet of office and research and development space. Most of the Company's operations are contained in a 67,000 square foot building housing a pilot production plant, laboratories and office space, in a building with a combined 64,000 square feet of space containing laboratories, purification and aseptic bottling facilities and office space, in a multitenant building where the Company occupies approximately 54,000 square feet of office space and in a 17,000 square foot building designed for specialized research laboratories. The leases for these sites terminate in 1998 (with the right to renew), 2004, 1998 (with the right to renew) and 2004, respectively. In 1993, the Company began construction of a 150,000 square foot building in Cambridge, Massachusetts which will house laboratories and office space. The anticipated cost of construction, including the land, is approximately $40 million. Upon completion of the building, the Company has the option, subject to certain conditions, to obtain a secured term loan with a bank for up to $25 million for a period of up to ten years. The building is scheduled for completion in 1995. The Company believes that its pilot production plant in Cambridge, Massachusetts and existing outside sources will allow it to meet its production needs for clinical trials and its initial commercial production needs for its Hirulog(TM) thrombin inhibitor and beta interferon product. Biogen believes that the facilities are in compliance with appropriate regulatory standards. The Company expects that additional facilities and outside sources will be required to meet the Company's future research and production needs. Item 3. Item 3. Legal Proceedings For a description of legal proceedings relating to patent rights, see Item 1, "Business-Patents and Other Proprietary Rights." Item 4. Item 4. Submission of Matters to a Vote of Security Holders None Executive Officers The following is a list of the executive officers of the Company and their principal positions with the Company. Each individual officer serves at the pleasure of the Board of Directors. Name Age Positions James L. Vincent . 54 Chairman of the Board of Directors, Chief Executive Officer James R. Tobin . . 49 President and Chief Operating Officer Michael J. Astrue. 37 Vice President - General Counsel, Secretary and Clerk Kenneth M. Bate. . 43 Vice President - Marketing and Sales Frank A. Burke, Jr. 50 Vice President - Human Resources Lawrence S. Daniels 51 Vice President - Strategic Planning Joseph M. Davie. . 54 Vice President - Research Irving H. Fox. . . 50 Vice President - Medical Affairs Timothy M. Kish . 42 Vice President - Finance, Chief Financial Officer and Treasurer James C. Mullen. . 35 Vice President - Operations Michael R. Slater. 47 Vice President - Regulatory Affairs Irvin D. Smith.... 61 Vice President - QA/QC and Drug Development The background of these officers is as follows: James L. Vincent joined the Company as its Chief Executive Officer in October 1985. He also served as Chief Operating Officer and President from April 1988 until February 1994. He is also Chairman of the Board of Directors of the Company. Before joining Biogen, Mr. Vincent served as Group Vice President, Allied Corporation and as President, Allied Health & Scientific Products Company, a subsidiary of Allied Corporation. Before joining Allied Corporation, Mr. Vincent was with Abbott Laboratories, Inc. where he served in various capacities, including Executive Vice President, Chief Operating Officer and Director of the parent corporation. Mr. Vincent is, in addition, Chairman of the Executive Board of Wharton Graduate School of the University of Pennsylvania and is a member of the Board of Directors of Continental Bank, Continental Corporation and Millipore Corporation. James R. Tobin joined the Company as its President and Chief Operating Officer in February 1994. Prior to joining the Company, Mr. Tobin served in various capacities at Baxter International, including Executive Vice President from 1988 until 1992 and President and Chief Operating Officer from 1992 until 1993. Michael J. Astrue was appointed Vice President - General Counsel, Secretary and Clerk of the Company in June 1993. Prior to joining the Company, Mr. Astrue was a partner in the Boston law firm of Mintz, Levin, Cohn, Ferris, Glovsky and Popeo, P.C. and a managing director of its wholly-owned consulting firm, ML Strategies, from November 1992 to June 1993. From June 1989 through November 1992, Mr. Astrue served as General Counsel of the United States Department of Health and Human Services. From April 1988 through June 1989, Mr. Astrue served as Associate Counsel to the President of the United States. Kenneth M. Bate was appointed Vice President - Marketing and Sales in August 1993 after serving as Vice President - Finance and Chief Financial Officer since August 1990 and as Treasurer of the Company since December 1991. From 1978 until 1990, Mr. Bate was employed by Peter Kiewit & Sons, Inc. and its subsidiaries in various financial capacities, most recently as Vice President - Treasurer. Frank A. Burke, Jr., was appointed Vice President - Human Resources in May 1986 after serving for 12 years in various human resource management positions at Allied-Signal, Inc., most recently as Director of Compensation and Employee Benefits of the Engineered Materials Sector. Lawrence S. Daniels was appointed Vice President - Strategic Planning of the Company in August 1993 after serving as Vice President - Marketing and Business Development since November 1991. Prior to joining the Company, Mr. Daniels served for nine years in planning and administrative functions for Allied-Signal, Inc., most recently as Vice President, Corporate Strategy Development. Joseph M. Davie, Ph.D. was appointed Vice President - Research of the Company in April 1993. Prior to joining the Company, Dr. Davie was employed by Searle Corporation where he served as Senior Vice President - Science and Technology from January 1993 to April 1993, President - Research and Development from July 1987 to January 1993 and Senior Vice President - Discovery Research from January 1987 to July 1987. Irving H. Fox, M.D. was appointed Vice President - Medical Affairs in February 1990. Dr. Fox joined Biogen following a 14-year career at the University of Michigan, where he held professorships in internal medicine and biological chemistry, and from 1978 to 1990, was program director of the Clinical Research Center at the University of Michigan Hospital. Timothy M. Kish was appointed Vice President - Finance, Treasurer and Chief Financial Officer of the Company in August 1993 after serving as Corporate Controller of the Company since 1986. Prior to joining Biogen, Mr. Kish was Director of Finance for Allied Health & Scientific Products Company, a subsidiary of Allied Corporation. Before joining Allied, Mr. Kish served in various capacities at Bendix Corp., most recently as Executive Assistant to the President. James C. Mullen became Biogen's Vice President - Operations in December 1991 after serving as Senior Director - Operations since February 1991. Mr. Mullen joined the Company in 1989 as Director - Facilities and Engineering and then served as Acting Director - Manufacturing and Engineering. Before coming to Biogen, Mr. Mullen held various positions of responsibility from 1984 through 1988 at SmithKline-Beckman Corporation, most recently as Director, Engineering - - SmithKline and French Laboratories, Worldwide. Michael R. Slater was appointed Vice President - Regulatory Affairs in 1991. Mr. Slater has been with Biogen since 1983, serving first as Head of Regulatory Affairs and then as Director of Regulatory Affairs of Biogen, S.A., the Company's former Swiss subsidiary. From 1985 to 1988, Mr. Slater served as Director of Corporate Regulatory Affairs of Biogen Research Corp. From 1988 to 1991, Mr. Slater served as Vice President - Quality Assurance and Regulatory Affairs of the Company. Irvin D. Smith, Ph.D. was appointed Vice President - Quality Assurance/Quality Control and Drug Development in August 1993 after serving as General Manager of Bioferon, Biogen's former joint venture in Germany, since July 1991. Dr. Smith was a private consultant from March 1990 to July 1991 and President and Chief Executive Officer of Applied BioSystems from October 1987 to March 1990. PART II Item 5. Item 5. Market for Registrant's Common Equity and Related Stockholder Matters The section entitled "Market for Securities" in the Company's 1993 Annual Report to Shareholders is hereby incorporated by reference. Item 6. Item 6. Selected Financial Data The section entitled "Selected Financial Data" in the Company's 1993 Annual Report to Shareholders is hereby incorporated by reference. Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations The section entitled "Management's Discussion and Analysis of Financial Condition and Results of Operations" in the Company's 1993 Annual Report to Shareholders is hereby incorporated by reference. Item 8. Item 8. Financial Statements and Supplementary Data The sections entitled "Consolidated Balance Sheets," "Consolidated Statements of Income," "Consolidated Statements of Cash Flows," "Consolidated Statements of Shareholders' Equity," "Notes to Consolidated Financial Statements" and "Report of Independent Accountants" in the Company's 1993 Annual Report to Shareholders are hereby incorporated 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, Promoters and Control Persons Directors The sections entitled "Election of Directors" and "Other Matters" in the Company's definitive proxy statement for its 1994 Annual Meeting of Stockholders, which the Company intends to file with the Commission no later than April 30, 1994, are hereby incorporated by reference. Executive Officers Information concerning the Company's Executive Officers is set forth in Part I of this Annual Report on Form 10-K. Item 11. Item 11. Executive Compensation The sections entitled "Executive Compensation", "Board of Directors and Committees", "Employment Arrangements", "Statement of Compensation Philosophy" and "Performance Graph" in the Company's definitive proxy statement for its 1994 Annual Meeting of Stockholders, which the Company intends to file with the Commission no later than April 30, 1994, are hereby incorporated by reference. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management The section entitled "Share Ownership" in the Company's definitive proxy statement for its 1994 Annual Meeting of Stockholders, which the Company intends to file with the Commission no later than April 30, 1994, is hereby incorporated by reference. Item 13. Item 13. Certain Relationships and Related Transactions The section entitled "Certain Transactions" in the Company's definitive proxy statement for its 1994 Annual Meeting of Stockholders, which the Company intends to file with the Commission no later than April 30, 1994, is hereby incorporated by reference. PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K. (a) Financial Statements and Financial Statement Schedules. The following documents are filed as a part of this report: 1. Financial Statements, as required by Item 8 of this Form, incorporated by reference herein from the 1993 Annual Report to Shareholders attached hereto as Exhibit 13: Item Location Consolidated Balance Sheets Annual Report under the caption "Biogen, Inc. and Subsidiaries Consolidated Balance Sheets." Consolidated Statements of Income Annual Report under the caption "Biogen, Inc. and Subsidiaries Consolidated Statements of Income." Consolidated Statements of Cash Flows Annual Report under the caption "Biogen, Inc. and Subsidiaries Consolidated Statements of Cash Flows." Consolidated Statements of Shareholders' Equity Annual Report under the caption "Biogen, Inc. and Subsidiaries Consolidated Statements of Shareholders' Equity." Notes to Consolidated Financial Statements Annual Report under the caption "Biogen, Inc. and Subsidiaries Notes to Consolidated Financial Statements." Reports of Independent Accountants Page 25 of this Report; Annual Report under the caption "Report of Independent Accountants." With the exception of the portions of the 1993 Annual Report to Shareholders specifically incorporated herein by reference, such report shall not be deemed filed as part of this Annual Report on Form 10-K. (2) Financial Statement Schedules: Item Location Report of Independent Accountants Page 25 of this Report Consent of Independent Accountants Page 26 of this Report Schedule I, Marketable Securities Page 27 of this Report Schedule X, Supplementary Income Page 28 of this Report Statement Information Schedules not included herein are omitted because they are not applicable or the required information appears in the Consolidated Financial Statements or Notes thereto. (3) Exhibits Exhibit No. Description (3.1) Articles of Organization, as amended (k) (3.2) By-Laws, as amended (o) (4.1) Form of Common Stock Share Certificate (q) (4.2) Form of Warrant Certificate (f) (4.3) Certificate of Designation of Series A Junior Participating Preferred Stock (j) (4.4) Rights Agreement dated as of May 8, 1989 between Registrant and The First National Bank of Boston, as Rights Agent (j) (10.1) Independent Consulting and Project Agreement dated as of June 29, 1979 between Registrant and Kenneth Murray (a)** (10.2) Letter Agreement dated March 12, 1993 with Dr. Kenneth Murray relating to renewal of Independent Consulting Agreement (o)** (10.3) Minute of Agreement dated February 5, 1981 among Registrant, The University Court of the University of Edinburgh and Kenneth Murray (a)** (10.4) Independent Consulting Agreement dated as of June 29, 1979 between Registrant and Phillip A. Sharp (a)** (10.5) Letter Agreement dated December 10, 1992 with Phillip Sharp relating to chairmanship of Scientific Board and renewal of Independent Consulting Agreement (o)** (10.6) Project Agreement dated as of December 14, 1979 between Registrant and Phillip A. Sharp (a)** (10.7) Share Restriction and Repurchase Agreement dated as of December 15, 1979 between Registrant and Phillip A. Sharp (a)** (10.8) Consulting Agreement dated as of April 1, 1991, as amended, between Registrant and Alexander G. Bearn (m)** (10.9) Form of Amendment dated July 1, 1988 to Independent Consulting Agreement between Registrant and Scientific Board Members (h)** (10.10) Form of Extension of Independent Consulting Agreement between Registrant and Scientific Board Members (k)** (10.11) Form of Share Purchase Agreement between Registrant and Scientific Board Members (a)** (10.12) Form of Stock Option Agreement between Registrant and each of Alan Belzer, Harold W. Buirkle, James W. Stevens and Roger H. Morley (d)** (10.13) Letter regarding employment of James L. Vincent dated September 23, 1985 (c)** (10.14) Form of Stock Option Agreement with James L. Vincent under 1985 Non-Qualified Stock Option Plan (o)** (10.15) Letter dated December 13, 1989 regarding employment of Dr. Irving H. Fox (l)** (10.16) Letter dated August 13, 1990 regarding employment of Mr. Kenneth M. Bate (m)** (10.17) Letter dated October 23, 1991 regarding employment of Mr. Lawrence S. Daniels (o)** (10.18) Letter dated April 7, 1993 regarding employment of Dr. Joseph M. Davie (p)** (10.19) Letter dated January 12, 1994 regarding employment of James R. Tobin *,** (10.20) Letter dated August 30, 1993 regarding employment of Irvin D. Smith, Ph.D.*,** (10.21) Form of Indemnification Agreement between Registrant and each Director and Executive Officer (h)** (10.22) Second Amended and Restated Agreement and Certificate of Limited Partnership dated as of May 15, 1984 among Biogen Medical Products, Inc. as General Partner and certain limited partners (k) (10.23) First Amendment dated December 22, 1986 to Agreement and Certificate of Limited Partnership (d) (10.24) Technology License Agreement dated May 15, 1984 between Biogen B.V. and Biogen Medical Products Limited Partnership (k) (10.25) Development Contract dated May 15, 1984 between Biogen B.V. and Biogen Medical Products Limited Partnership (k) (10.26) Amendment dated December 22, 1986 to Development Contract (d) (10.27) Amendment dated January 1, 1987 to Development Contract (g) (10.28) Extension Agreement dated October 10, 1989 relating to Development Contract (k) (10.29) Extension Agreement dated December 31, 1993 relating to Development Contract * (10.30) Joint Venture Option Agreement dated May 15, 1984 between Biogen Inc. and Biogen Medical Products Limited Partnership (k) (10.31) Purchase Option Agreement dated May 15, 1984 between Biogen B.V. and the limited partners of Biogen Medical Products Limited Partnership (k) (10.32) Guaranty dated May 15, 1984 to Biogen Medical Products Limited Partnership by Registrant guaranteeing certain obligations of Biogen Medical Products, Inc., Biogen B.V. and Biogen Inc. to the Partnership (k) (10.33) Demand Loan Agreement dated October 1, 1989 between Biogen Medical Products Limited Partnership and Biogen Medical Products, Inc. (k) (10.34) Standard Form Commercial Lease dated January 29, 1981 between Ira C. Foss and Ira C. Foss, Jr., as Trustees of Eastern Realty Trust, and B. Leasing, Inc. (k) (10.35) Letter of May 24, 1989 exercising option under Standard Form Commercial Lease dated January 29, 1981 (k) (10.36) Lease Extension Agreement dated February 20, 1990 between Eastern Realty Trust and Registrant (k) (10.37) Standard Form Commercial Lease dated June 1, 1989 between Eastern Realty Trust and Registrant (k) (10.38) Cambridge Center Lease dated October 4, 1982 between Mortimer Zuckerman, Edward H. Linde and David Barrett, as Trustees of Fourteen Cambridge Center Trust, and B. Leasing, Inc. (a) (10.39) First Amendment to Lease dated January 19, 1989 amending Cambridge Center Lease dated October 4, 1982 (o) (10.40) Second Amendment to Lease dated March 8, 1990 amending Cambridge Center Lease dated October 4, 1982 (o) (10.41) Third Amendment to Lease dated September 25, 1991 amending Cambridge Center Lease dated October 4, 1982 (o) (10.42) Lease dated October 6, 1993 between North Parcel Limited Partnership and Biogen Realty Limited Partnership*. (10.43) 1983 Employee Stock Purchase Plan as amended through April 3, 1992 and restated (n)** (10.44) 1982 Incentive Stock Option Plan as amended through March 25, 1993 and restated with form of Option Agreement (p)** (10.45) 1985 Non-Qualified Stock Option Plan as amended through March 25, 1993 and restated with form of Option Agreement (p)** (10.46) 1987 Scientific Board Stock Option Plan as amended through April 3, 1992 and restated with form of Option Agreement (n)** (10.47) Exclusive License and Development Agreement dated December 8, 1979 between Registrant and Schering Corporation (a) (10.48) Amendatory Agreement dated May 14, 1985 to Exclusive License and Development Agreement dated December 8, 1979 (c) (10.49) Amendment and Settlement Agreement dated September 29, 1988 to Exclusive License and Development Agreement dated December 8, 1979 (o) (10.50) Amendment dated March 20, 1989 to Exclusive License and Development Agreement dated December 8, 1979 (o ) (10.51) License Agreement (United States) dated March 28, 1988 between Registrant and SmithKline Beecham Biologicals, s.a. (as successor to Smith Kline-R.I.T, s.a.) (o) (10.52) License Agreement (International) dated March 28, 1988 between Registrant and SmithKline Beecham Biologicals, s.a. (as successor to Smith Kline-R.I.T., s.a.) (o) (10.53) Sublicense Agreement dated as of February 15, 1990 among Registrant, SmithKline Beecham Biologicals, s.a (as successor to SmithKline Biologicals, s.a.) and Merck and Co., Inc. (o) (11) Computation of Earnings per Share * (12) None (13) Incorporated portions from Biogen, Inc. 1993 Annual Report to Shareholders * (22) Subsidiaries of the Registrant * (24.1) Consent of Price Waterhouse (Included in Part IV hereof) (29) None (a) Previously filed with the Commission as an exhibit to Registration Statement on Form S-1, File No. 2-81689 and incorporated herein by reference. (b) Previously filed with the Commission as an exhibit to Registration Statement on Form S-8, File No. 2-87550 and incorporated herein by reference. (c) Previously filed with the Commission as an exhibit to Registrant's Annual Report on Form 10-K for the year ended December 31, 1985, as amended, File No. 0-12042 and incorporated herein by reference. (d) Previously filed with the Commission as an exhibit to Registrant's Annual Report on Form 10-K for the year ended December 31, 1986, as amended, File No. 0-12042 and incorporated herein by reference. (e) Previously filed with the Commission as an exhibit to Report on Form 8-K, File No. 0-12042, dated September 30, 1988 and incorporated herein by reference. (f) Previously filed with the Commission as an exhibit to Registration Statement on Form 8-B, File No. 0-12042, dated December 12, 1988 and incorporated herein by reference. (g) Previously filed with the Commission as an exhibit to Registrant's Annual Report on Form 10-K for the year ended December 31, 1987, File No. 0-12042 and incorporated herein by reference. (h) Previously filed with the Commission as an exhibit to Registrant's Annual Report on Form 10-K for the year ended December 31, 1988, File No. 0-12042 and incorporated herein by reference. (i) Previously filed with the Commission as an exhibit to Registration Statement on Form S-3, File No. 33-28612 and incorporated herein by reference. (j) Previously filed with the Commission as an exhibit to Registration Statement on Form 8-A, File No. 0-12042, filed May 26, 1989 and incorporated herein by reference. (k) Previously filed with the Commission as an exhibit to Registrant's Annual Report on Form 10-K for the year ended December 31, 1989, File No. 0-12042, and incorporated herein by reference. (l) Previously filed with the Commission as an exhibit to Registrant's Annual Report on Form 10-K for the year ended December 31, 1990, File No. 0-12042, and incorporated herein by reference. (m) Previously filed with the Commission as an exhibit to Registrant's Annual Report on Form 10-K for the year ended December 31, 1991, File No. 0-12042, and incorporated herein by reference. (n) Previously filed with the Commission as an exhibit to Registrant's Quarterly Report on Form 10-Q for the quarter ended June 30, 1992, File No. 0-12042, and incorporated herein by reference. (o) Previously filed with the Commission as an exhibit to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1993, File No. 0-12042, and incorporated herein by reference. (p) Previously filed with the Commission as an exhibit to the Registrant's Quarterly Report on Form 10-Q for the quarter ended June 30, 1993, File No. 0-12042, and incorporated herein by reference. (q) Previously filed with the Commission as an exhibit to Registration Statement on Form S-3, File No. 33-51639, and incorporated herein by reference. * Filed herewith ** Management contract or compensatory plan or arrangement (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. BIOGEN, INC. By:/s/ James L. Vincent James L. Vincent, Chairman of the Board and Chief Executive Officer Dated 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. Signatures Title Date /s/ James L. Vincent Chairman, Board of DirectorsMarch 18, 1994 James L. Vincent (principal executive officer) /s/ Timothy M. Kish Vice President - Finance March 18, 1994 (principal Timothy M. Kish financial and accounting officer) /s/ Alexander Bearn Director March 18, 1994 Alexander Bearn /s/ Harold W. Buirkle Director March 18, 1994 Harold W. Buirkle /s/ Alan Belzer Director March 18, 1994 Alan Belzer /s/ Roger H. Morley Director March 18, 1994 Roger H. Morley /s/ Kenneth Murray Director March 18, 1994 Kenneth Murray /s/ Phillip A. Sharp Director March 18, 1994 Phillip A. Sharp /s/ James W. Stevens Director March 18, 1994 James W. Stevens Report of Independent Accountants on Financial Statement Schedules To the Board of Directors of Biogen, Inc. Our audits of the consolidated financial statements referred to in our report dated January 20, 1994 appearing on page 32 of the 1993 Annual Report to Shareholders of Biogen, Inc. and its subsidiaries (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. Price Waterhouse Boston, Massachusetts January 20, 1994 Consent of Independent Accountants We hereby consent to the incorporation by reference in the Prospectus constituting part of its Registration Statements on Form S-8, as amended (Nos. 2-87550, 2-96157, 33-9827, 33-14742, 33-37312, 33-22378, 33-41077 and as filed on September 21, 1993) and on Form S-3, as amended (Nos. 33-14741, 33-14743, 33-20183, and 33-51639) of Biogen, Inc. and its subsidiaries of our report dated January 20, 1994 appearing on page 32 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 in this Form 10-K. Price Waterhouse Boston, Massachusetts March 28, 1994 SCHEDULE I BIOGEN, INC. AND SUBSIDIARIES MARKETABLE SECURITIES AT DECEMBER 31, 1993 (in thousands) PRINCIPAL MARKET VALUE BALANCE NAME OF ISSUER AND AMOUNTS OF AT BALANCE SHEET TITLE OF EACH ISSUE BONDS & NOTES COST SHEET DATE AMOUNT Corporate Bonds and Notes: Aluminum Co America $ 300 $ 300 $ 296 $ 300 American Brands Inc. 2,000 2,029 2,017 2,023 Associates Corp of NA 2,840 2,855 2,927 2,852 Bank America Corp 1,300 1,373 1,369 1,359 Bankers TR NY Corp 2,675 2,668 2,670 2,669 Beneficial Corp 1,500 1,696 1,686 1,668 BNY Master CR Card TR 2,500 2,555 2,560 2,543 Boeing Co 300 301 301 301 Chase Manhattan CR Corp 1,250 1,277 1,275 1,272 Commercial CR Group Inc 300 296 297 296 Discover Card TR 6,583 6,876 6,862 6,865 Discover Card TR 625 635 631 632 First Chicago Master TR 2,833 2,890 2,906 2,879 Fleet MTG Secs Inc. 2,000 2,040 2,046 2,036 Ford Motor CR CO 6,500 6,915 6,875 6,772 Ford Motor CR CO 554 579 575 577 General Motors Accep Corp 3,964 3,989 4,013 3,980 Gillette Co 300 300 298 300 Golden West Finl Corp DEl 900 1,029 998 1,021 Household Fin Corp 2,752 2,935 2,921 2,914 Korea Dev BK 2,000 2,184 2,134 2,168 MMCA Auto Grantor TR 1,862 1,859 1,849 1,859 Nissan Auto Receivables 799 798 804 798 Norwest Corp 1,925 1,908 1,916 1,915 Premier Auto TR 4,190 4,179 4,187 4,179 Reebok INTL LTD 1,082 1,196 1,161 1,183 Republic NATL BK New York 2,000 2,000 2,050 2,000 Ryland MTG Secs Corp 5,516 5,517 5,566 5,517 Saxon MTG Secs Corp 1,890 1,952 1,952 1,951 Security Pac Corp 1,000 1,051 1,092 1,040 Shawmut Natl Remic TR 241 248 246 248 Smith Barney Shearson HLDGS IN 1,000 1,000 1,009 1,000 Standard CR Card Master TR 1 1,250 1,266 1,275 1,260 Structured Asset Secs Corp 926 924 945 924 Syntex USA Inc. 1,000 995 996 996 Tennessee Valley Auth 300 296 299 296 TMS Home Equity LN TR 1,529 1,572 1,548 1,572 WMX Technologies 2,000 2,010 2,002 2,009 Computer Industry Bonds 530 528 552 528 Retail Industry Bonds 2,600 2,602 2,600 2,602 Utility Industry Bonds 5,605 5,920 5,912 5,843 U.S. Government Securities 115,548 112,633 113,886 112,658 TOTAL MARKETABLE SECURITIES $ 195,805 SCHEDULE X BIOGEN, INC. AND SUBSIDIARIES SUPPLEMENTARY INCOME STATEMENT INFORMATION (in thousands) The amounts shown below are included in costs and expenses in the consolidated statements of income. 1993 1992 1991 Maintenance and repairs. . . . . . . . . . 1,883 1,4531,410 Patent amortization. . . . . . . . . . . . 2,258 3,6601,689 Royalties. . . . . . . . . . . . . . . . . 11,588 9,3843,768 There were no material charges for advertising and taxes, other than payroll and income taxes, for the periods noted above. EXHIBIT INDEX Exhibit No. Description (10.19) Letter dated January 12, 1994 regarding employment of James R. Tobin (10.20) Letter dated August 30, 1993 regarding employment of Irvin D. Smith, Ph.D. (10.29) Extension Agreement dated December 31, 1993 relating to Development Contract. (10.42) Lease dated October 6, 1993 between North Parcel Limited Partnership and Biogen Realty Limited Partnership. (11) Computation of Earnings per Share (13) Incorporated portions from Biogen, Inc. 1993 Annual Report to Shareholders. (22) Subsidiaries of the Registrant. (24.1) Consent of Price Waterhouse (included in Part IV hereof).

107844_1993.txt

107844_1993

1993

107844

Item 1. Business. General Wisconsin Bell, Inc. (the Company), is incorporated under the laws of the State of Wisconsin and has its principal office at 722 North Broadway, Milwaukee, Wisconsin 53202 (telephone number 414-549-7102). 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, Michigan Bell Telephone Company and The Ohio Bell Telephone Company (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 Wisconsin 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 in now used to identify all the Ameritech companies, the Company is sometimes regionally identified as Ameritech Wisconsin. The Company is engaged in the business of furnishing a wide variety of advanced telecommunications services in Wisconsin, including local exchange and toll service and network access services in Wisconsin. In accordance with the Consent Decree and resulting Plan of Reorganization (Plan) described below, the Company provides two basic types of telecommunications services within speci-fied geograph-ical 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 telecommunica-tions 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 67 percent of the population and 14 percent of the area of Wisconsin is served by the Company. The remainder of the state is served by other local telecommunications companies. La Crosse, Wisconsin, is the only city of over 50,000 population in the State in which local service is furnished by a non- affiliated company. 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 . . . . . . . . . 1,898 1,834 1,784 1,738 1,684 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. API pays license fees to the Company under 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 91% 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 75% of the revenues from communication services were attributable to intrastate operations. 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 $2,571,000,000 at December 31, 1988, to about $2,724,000,000 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 .............. $174,000,000 1992 .............. $174,000,000 1990 .............. $155,000,000 1993 .............. $147,000,000 1991 .............. $164,000,000 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 6,000,000 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 Federal Communications Commission (FCC) seeking approval of the program. The filing reflects capital expenditures of approximately $53.0 over the next three years. The Company may also, depending on market demand make additional capital expenditures under the digital video network upgrade program. The Company anticipates that its capital expenditures for the program will be funded without increasing its recent historical level of capital expenditures. Capital expenditures are expected to be about $156.0 in 1994. This amount excludes any capital expenditures that may occur in 1994 related to the above described video network upgrade program. 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 the "Modification of Final Judgment" (Consent Decree), which arose out of antitrust litigation brought by the Department of Justice (DOJ), and which required 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 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, its ownership of the exchange telecommunications, exchange access and printed directory advertising portions of the Ameritech Bell 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 telecommunica-tions services or information services, manufacture or provide telecommun-ications products or provide any product or service, except exchange telecom- munications 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 premises 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 provides 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. Intrastate Rates and Regulation The Company, in providing communications services, is subject to regulation by the Public Service Commission of Wisconsin (PSCW) with respect to intrastate rates and services, depreciation rates (for intrastate services), issuance of securities and other matters. Unless otherwise indicated, the amounts of the changes in revenues resulting from changes in intrastate rates referred to below are stated on an annual basis and are estimates without adjustment for subsequent changes in volumes of business. The principal changes in intrastate rates authorized since January 1, 1989, were: On June 29, 1989, the PSCW approved an order which extended competition to some intraLATA toll services by authorizing interexchange carriers to provide certain services in competition with the Company and other local carriers. As a result, effective July 6, 1989, the PSCW approved the Company's proposals to reprice the intraLATA toll services that would be affected by the new competitive environment. These services include WATS and 800 Services and Value Calling Plans. This repricing order caused long distance revenue to decrease by about $5,800,000 annually. On July 1, 1989, the PSCW ordered a 14% return on equity which resulted in credits on customer bills. This would have caused an annual decrease of $34,700,000 in local service and access revenues, however, this amount was reduced by $3,500,000 due to a temporary injunction granted by the Milwaukee County Circuit Court on August 9, 1989. The injunction was a result of an appeal filed by the Company relating to the inside wire installation and maintenance portion of the PSCW order. On December 27, 1989, the PSCW issued an interim and amended order which decreased the ongoing rate credit by $5,200,000 per quarter year starting January 1, 1990. This adjustment was in consideration of the shortfall Wisconsin Bell was expected to incur due to the implementation of access rates for intrastate long distance service and the mirroring of interstate access rates. Additionally, the PSCW established this adjustment on a subject-to-refund with interest provision basis, pending final determination of the Company's shortfall at a later date. On June 15, 1990, the PSCW ordered a refund of $23,500,000 to residential and business customers as well as interexchange carriers, related to the level of earnings experienced during the moratorium period covering August 1987 through July 1989. At the same time, the PSCW also ordered the Company to refund approximately $2,000,000 to customers in order to pass back savings resulting from a gross receipts tax rate reduction effective January 1, 1989. The order resulted in credits on customer bills and refunds to interexchange carriers during the month of July 1990. The Company made sufficient provisions in the financial statements throughout the 1987-89 period in anticipation of the PSCW findings. The PSCW also ruled that an additional $9,300,000 was subject to refund pending the outcome of the appeal associated with inside wire. On September 5, 1990, the PSCW approved two alternate plans for intrastate regulation - the Base Case Plan and the Three-Year Plan. The Company chose to participate in the Three-Year Plan. The terms and conditions of the plan were effective October 1, 1990, and resulted in an annual decrease of $3,943,000 in local service revenues. Under the Three--Year Plan, the rate of return on equity was set at 13.75 percent and the Company's revenues were not subject-- to-refund on a going forward basis. This trial, which was to remain in effect until December 31, 1993, has been extended while the PSCW reviews a new price regulation plan. In February 1994, bills were introduced in the Wisconsin legislature that, if passed, would replace rate-of-return regulation with price regulation for companies choosing it. On February 21, 1991, the PSCW authorized the elimination of the subject-- to-refund with interest provision pertaining to the Company's expected quarterly shortfall of $5,200,000 due to the change from independent company settlements to access charges. The PSCW also determined that no refund is necessary for this item during the January 1, 1990, through September 30, 1990, subject-to--refund period. On May 1, 1991, the Company repriced its Value Calling Plans reducing long distance revenue by approximately $900,000 annually. Effective June 1991 and in accordance with provisions of the Three-Year Plan, the Company implemented a volume discount rate structure that replaced the previous residential local service calling plans. The new rate structure reduces local service revenue by nearly $23,000,000 annually. On September 1, 1992, the Company eliminated Business Touchtone charges reducing local service revenue by $4,800,000 annually. On October 5, 1992, the Company repriced its Value Calling Plans reducing long distance revenue by approximately $600,000 annually. On March 30, 1993, the PSCW reached a final decision concerning inside wire and moratorium refund issues. In April 1993, the Company commenced refunding $22,500,000 to residential and business customers and interexchange carriers. The $21,300,000 credit/rate reduction consisted of three elements: $17,300,000 for settlement of inside wire appeals; $3,900,000 for an addi- tional refund from the 1987-89 moratorium review; and $158,000 for additional gross receipts tax rate reductions that must be passed back to customers. Additionally during 1993, the Company repriced other specific services which resulted in the following approximate rate reductions: Effective Date Revenue Category/Service Annual Impact January 1, 1993 Access Revenue $ (500,000) Carrier Directory Assistance Long Distance Revenue (145,000) Special Toll Billing February 1, 1993 Local Svc./Long Dist. Revenue (2,330,000) Optinet Bell Channel March 1, 1993 Access Revenue (560,000) Optinet DS1 May 15, 1993 Access Revenue (6,130,000) Switched Access CCL and TS August 1, 1993 Local Service Revenue (1,400,000) Business Volume Discount Plan FCC Regulatory Jurisdiction The Company is 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 nonregulated 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 appli-cable 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 units 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 reductions of 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 Charges 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. 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 state regulatory commissions. The Ameritech landline telephone companies currently provide access services to interexchange carriers authorized by the state regulatory commissions to provide service between local serving areas pursuant to tariffs which generally parallel the terms of the interstate access tariffs. In the event interexchange carriers are authorized by the state regulatory commissions to provide service within their local serving areas, the Ameritech landline telephone companies intend to provide access service under the same tariffs applicable to intrastate services provided by such carriers between the Ameritech landline telephone companies' local serving areas. Separate arrangements govern compensation between Ameritech landline telephone companies and independent telephone companies for jointly provided communications within the five Ameritech companies' local serving areas and associated independent telephone company exchanges. These arrangements are subject to the jurisdiction of the FCC and the state regulatory commissions. Competition Regulatory, legislative and judicial decisions, 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 telephone company central offices, wire centers, tandem switches and certain remote nodes. Ameritech filed a tariff in November 1993 to effect that change which was effective in February 1994. Ameritech is seeking opportunities to compete on an equal footing. Although the Company is barred from providing interLATA and nationwide 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 service 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. 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 environ- ment 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 the state regulatory commissions in its region to support implementation of the plan. Ameritech 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 6,000,000 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 to approximately 1,000,000 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. Cable/Telco Cross Ownership Ban In November 1993, Ameritech filed motions 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 in Washington D.C. 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 5,137 persons, a decrease from 5,659 at December 31, 1992. During 1993, approximately 270 employees left the payroll as a result of voluntary and involuntary workforce programs, and 156 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 600 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 the workforce results from technological improvements, consolidations and initiatives identified by management to balance its cost structure with emerging competition. Approximately 3,875 employees are represented by the Communications Workers of America (CWA), a union affiliated with the AFL-CIO. In July and August 1993, the Ameritech landline telephone companies and Ameritech Services reached agreement with the union on a workforce transition plan for assigning union-represented employees to the newly established business units. The agreement with the CWA extends 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. During 1992, 171 of the Company's management employees left the Company through a voluntary early retirement program and involuntary terminations. Through 1995, the Company expects to eliminate additional positions through job consolidations and force reduction initiatives resulting from technological efficiencies. 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 36% of the Company's investment in telecommunica- tions plant in service; land and buildings (occupied principally by central offices) represented 12%; telecommunications instruments and related wiring and equipment, including private branch exchanges, substantially all of which are on the premises of customers, represented 10%; 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 42%. 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, administrative offices, business offices and some installations of central office equipment are in rented quarters. 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 of all of the foregoing actions would not be material in amount to the financial position of the Company. PART II WISCONSIN BELL, INC. Item 6. Item 6. SELECTED FINANCIAL AND OPERATING DATA (Dollars in Millions) 1993 1992 1991 1990 1989 Revenues Local service. . . . . . . . $ 488 $ 475 $ 471 $ 476 $ 433 Interstate network access. . 239 225 221 219 212 Intrastate network access. . 88 93 85 73 72 Long distance. . . . . . . . 207 200 198 193 137 Other. . . . . . . . . . . . 100 94 98 99 106 Total. . . . . . . . . . . . . 1,122 1,087 1,073 1,060 960 Operating expenses . . . . . . 867 866 865 848 764 Operating income . . . . . . . 255 221 208 212 196 Interest expense . . . . . . . 32 42 44 41 43 Other (income) expense, net . 11 6 (2) 1 2 Income taxes . . . . . . . . . 74 56 57 56 41 Income before cumulative effect of change in accounting principles. . . . 138 117 109 114 110 Cumulative effect of change in accounting principles . . - (152) - - - Net income (loss) . . . . . . $ 138 $ ( 35) $ 109 $ 114 $ 110 Total assets . . . . . . . . . $2,038 $2,043 $2,048 $2,056 $2,011 Property, plant and equipment, net . . . . . . . $1,658 $1,700 $1,711 $1,723 $1,746 Capital Expenditures . . . . . $ 147 $ 174 $ 164 $ 155 $ 174 Long-term debt . . . . . . . . $ 307 $ 379 $ 476 $ 507 $ 509 PART II WISCONSIN BELL, INC. Item 6. SELECTED FINANCIAL AND OPERATING DATA (Dollars in Millions) (Continued) 1993 1992 1991 1990 1989 Debt ratio . . . . . . . . . . 44.6% 44.9% 40.0% 39.2% 39.8% Pretax interest coverage . . . 7.4 5.4 5.3 5.4 4.9 Return to average equity . . . 20.9% (5.2)% 13.2% 14.1% 13.6% Return on average total capital. . . . . . . . . . . 13.8% .4% 10.5% 11.0% 10.6% Customer lines - at end of year (000's) . . . . . . . . 1,898 1,834 1,784 1,738 1,684 % Customer lines served by digital electronic offices . 64.3% 49.0% 32.6% 28.3% 26.9% % Customer lines served by analog electronic offices. . 35.7% 51.0% 67.4% 71.7% 73.1% Customer lines per employee. . 369 324 292 260 244 Employees - at end of year . . 5,137 5,659 6,106 6,690 6,908 Item 7. Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS (Dollars in Millions) The Year 1993 Compared to the Year 1992 Following is a discussion and analysis of the results of operations of the Company for the years ended December 31, 1993 and 1992, based on the Statements of Income and Rein-vested Earnings. Other pertinent data are also given in the Selected Financial and Operating Data. Revenues Total operating revenues were $1,122.3 for 1993 and $1,087.4 for 1992. The increase of $34.9 or 3.2%, consisted of the following: Increase Percent 1993 1992 (Decrease) Change Local service $487.7 $474.9 $12.8 2.7% Local service revenues increased $12.8 which resulted from an $18.9 increase in business and residence revenue volumes. Customer lines increased 3.5% from 1,833,722 at December 31, 1992, to 1,898,159 at December 31, 1993. In addition, public telephone revenues increased $1.0 and Directory revenues increased $0.5. These increases were partially offset by a $3.0 decrease due to the business touchtone rate elimination effective September 1992, and a $2.6 reduction related to a refund for inside wire that was charged against local message revenues effective April 1, 1993. In addition, private line revenues decreased $2.0. Increase Percent 1993 1992 (Decrease) Change Network access Interstate access $239.1 $224.6 $ 14.5 6.5% Intrastate access $ 88.6 $ 93.3 $ (4.7) (5.0%) Interstate access charge revenues increased $14.4 due in part to a $6.4 decrease in National Exchange Carriers Association (NECA) transitional support funding and a $5.9 demand and rate increase in end user revenues. In addition, payments to American Telephone and Telegraph (AT&T) for 800 settlements decreased $3.6. A demand increase of $5.7 in traffic sensitive access revenues also contributed to the increase. Interstate switched minutes of use increased 5.3%. This increase was partially offset by a $7.3 decrease in traffic sensitive access revenues caused by rate reductions. Intrastate access revenues decreased $4.7 primarily from a $11.4 decrease in switched access revenues caused by rate reductions. This decrease was partially offset by a $6.0 increase in switched access volumes. Intrastate switched minutes of use increased 8.3%. Increase Percent 1993 1992 (Decrease) Change Long distance $206.8 $200.4 $6.4 3.2% Long distance revenues increased $6.4 primarily due to a $5.2 increase associated with increased message toll volumes, a $2.1 increase in independent company toll revenue and a $1.8 increase related to the finalization of independent company cost studies. These increases were partially offset by $2.7 in volume decreases in private line, wide area telephone service (WATS) and coin revenues. Increase Percent 1993 1992 (Decrease) Change Miscellaneous - net $100.1 $94.2 $5.9 6.3% Miscellaneous revenues increased $5.9 due to a $2.8 increase in revenues from inside wire due to the price restructuring of inside wire maintenance plans and increased time and material rates. In addition, affiliated company cost recovery billings increased $1.1, and uncollectible expense decreased $1.6. Operating Expenses Operating expenses were $867.3 in 1993 and $865.9 in 1992. The increase of $1.4 or 0.1% consisted of the following: Increase Percent 1993 1992 (Decrease) Change Depreciation $186.1 $186.4 $(0.3) (.1%) Depreciation decreased $0.3 as a result of completing the amortization of a reserve deficiency authorized by the Public Service Commission of Wisconsin (PSCW) of $24.3. This decrease was partially offset by increased rates due to the PSCW represcription, and the amortization of an additional reserve deficiency authorized by the PSCW effective July 1, 1993. Increase Percent 1993 1992 (Decrease) Change Employee related expenses $255.8 $260.7 $(4.9) (1.9%) Employee related expenses decreased $4.9. Force reductions reduced employee related expenses by $15.3. At December 31, 1993, the Company had 5,137 employees compared to 5,659 at December 31, 1992, a decrease of 522 employees. This decrease due to force reductions was partially offset by wage and salary increases of $7.4 and overtime increases of $2.5. Increase Percent 1993 1992 (Decrease) Change Taxes other than income taxes $62.8 $61.7 $1.1 1.8% The increase in taxes other than income taxes resulted from an increase in remainder assessment fees and a sales/use tax assessment. Increase Percent 1993 1992 (Decrease) Change Other operating expenses $362.6 $357.1 $5.5 1.5% The increase in other operating expenses resulted primarily from affiliated billing increases of $10.7 for the Company's allocation of common Ameritech costs. These increases were partially offset by a $2.0 decrease in contract services, a $2.0 decrease in materials and supplies and a $1.2 decrease in miscellaneous other expenses. Other Income and Expenses Increase Percent 1993 1992 (Decrease) Change Interest Expense $32.0 $42.0 ($10.0) (23.8%) The decrease in interest expense is due to the retirements in 1993 of $300.0 in long-term debt, bearing interest ranging from 8% to 8-3/4%. This debt was refinanced with short-term debt with Ameritech, which bears lower interest rates, and $150.0 of long-term debt bearing interest at 6-3/4%. Increase Percent 1993 1992 (Decrease) Change Other (Income)/Expense $10.7 $6.2 $4.5 72.6% The increase in other expense is due primarily to $5.8 in interest income from Internal Revenue Service refunds that occurred during 1992. In addition, the Company expensed $9.0 in debt refinancing costs in 1993 and $8.0 of such costs in 1992. Increase Percent 1993 1992 (Decrease) Change Income Tax Expense $74.3 $56.0 $18.3 32.7% The increase in income tax expense reflects the increase in the federal tax rate from 34% to 35% and a $39.0 or 22.5% increase in income before income taxes and cumulative change in accounting principles. Other Matters 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 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 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. 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, competitive access providers have requested regulatory authority to provide full local exchange service in Wisconsin. 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 the 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 Federal Communications Commission (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 proposed 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. Status of 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 business 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 Corporation (Ameritech), the parent of the Company, 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 6,000,000 Ameritech customers. The Company has filed an application with the FCC seeking approval of the program. The application reflects capital expenditures of approximately $53.0 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 to its recent historical level of capital expenditures. 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 method the Company had been following and, accordingly, did not have a material 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 $151.8, net of a deferred income tax benefit of $93.8. 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 600 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 $53.0 or $31.7 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 $14.2. 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 $30.0 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. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Shareholder of Wisconsin Bell, Inc.: We have audited the accompanying balance sheets of Wisconsin Bell, Inc., (a Wisconsin corporation) as of December 31, 1993 and 1992, and the related statements of income and reinvested earnings and cash flows for each of 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 Wisconsin Bell, Inc. 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. Milwaukee, Wisconsin January 28, 1994  WISCONSIN BELL, INC. STATEMENTS OF INCOME AND REINVESTED EARNINGS (Dollars in Millions) Year Ended December 31, 1993 1992 1991 Revenues . . . . . . . . . . . . . . . . . . . $1,122.3 $1,087.4 $1,072.8 Operating expenses Depreciation and amortization . . . . . . . 186.1 186.4 181.6 Employee related expenses . . . . . . . . . 255.8 260.7 285.3 Taxes other than income taxes. . . . . . . . 62.8 61.7 59.6 Other operating expenses . . . . . . . . . . 362.6 357.1 338.7 867.3 865.9 865.2 Operating income . . . . . . . . . . . . . . 255.0 221.5 207.6 Interest expense . . . . . . . . . . . . . . 32.0 42.0 43.6 Other expense (income), net. . . . . . . . . . 10.7 6.2 (1.6) Income before income taxes and cumulative effect of change in accounting principles. . 212.3 173.3 165.6 Income taxes . . . . . . . . . . . . . . . . . 74.3 56.0 56.8 Income before cumulative effect of change in accounting principles. . . . . . . 138.0 117.3 108.8 Cumulative effect of change in accounting principles, net of related tax benefits ($93.8) . . . . . . . . . . . . - (151.8) - Net income (loss) . . . . . . . . . . . . . . 138.0 (34.5) 108.8 Reinvested earnings, beginning of year . . . . . . . . . . . . . . . . . . 11.9 171.6 166.8 Less: dividends . . . . . . . . . . . . . . . 125.0 125.2 104.0 Reinvested earnings, end of year . . . . . . . $ 24.9 $ 11.9 $ 171.6 _______ _______ _______ The accompanying notes are an integral part of the financial statements. WISCONSIN BELL, INC. BALANCE SHEETS (Dollars in Millions) December 31, December 31, 1993 1992 ASSETS Current Assets: Cash . . . . . . . . . . . . . . . . . $ - $ 3.1 Receivables Customers (less allowance for uncollectibles of $9.2 and $9.3 respectively) 179.0 177.2 Ameritech and affiliates. . . . . . . 31.2 6.6 Other . . . . . . . . . . . . . . . . 12.6 16.4 Material and supplies . . . . . . . . . 6.4 7.8 Prepaid directories . . . . . . . . . . 10.8 10.9 Prepaid and other . . . . . . . . . . . 21.0 9.0 261.0 231.0 Property, plant and equipment . . . . . . 2,724.4 2,704.1 Less, accumulated depreciation. . . . . . 1,066.2 1,003.9 1,658.2 1,700.2 Investments, principally in affiliates. . 27.5 22.6 Other assets and deferred charges . . . . 91.6 89.6 Total assets. . . . . . . . . . . . . . . $2,038.3 $2,043.4 ________ ________ LIABILITIES AND SHAREOWNER'S EQUITY Current Liabilities: Debt maturing within one year - Ameritech . . . . . . . . . . . . . . $ 237.8 $ 61.3 Other . . . . . . . . . . . . . . . . .9 100.4 Accounts payable - Ameritech and affiliates. . . . . . . 27.4 32.7 Other . . . . . . . . . . . . . . . . 109.0 85.6 Other current liabilities . . . . . . . 76.9 111.6 452.0 391.6 Long-term debt. . . . . . . . . . . . . . 306.5 379.0 Deferred Credits and Other Long-Term Liabilities: Accumulated deferred income taxes . . . 201.6 155.2 Unamortized investment tax credits. . . 42.9 52.2 Postretirement benefits other than pensions . . . . . . . . . . . . 225.8 231.3 Long-term payable to affiliate (ASI) for SFAS 106 adoption . . . . . . . . 8.8 9.9 Other . . . . . . . . . . . . . . . . . 124.2 160.7 603.3 609.3 WISCONSIN BELL, INC. BALANCE SHEETS (Continued) (Dollars in Millions) December 31, December 31, 1993 1992 Shareowner's Equity: Common shares, $20 par value per share, 31,995,000 shares authorized, 31,960,395 shares issued and outstanding . . . . . . . . . . . . . . 639.2 639.2 Proceeds in excess of par value . . . . 12.4 12.4 Reinvested earnings . . . . . . . . . . 24.9 11.9 676.5 663.5 Total liabilities and shareowner's equity . . . . . . . . . . . $2,038.3 $2,043.4 ________ ________ The accompanying notes are an integral part of the financial statements. WISCONSIN BELL, INC. STATEMENTS OF CASH FLOWS (Dollars in Millions) Year Ended December 31, 1993 1992 1991 Cash flows from operating activities: Net income (loss). . . . . . . . . . . . . $138.0 $(34.5) $108.8 Adjustments to net income (loss): Cumulative effect of change in accounting principles. . . . . . . - 151.8 - Depreciation and amortization. . . . . 186.1 186.4 181.6 Deferred income taxes, net . . . . . . 10.7 (18.3) (16.8) Investment tax credits, net. . . . . . (9.3) (6.9) (9.0) Interest during construction . . . . . (.4) (.4) (.3) Provision for uncollectibles . . . . . 10.4 12.0 9.5 Change in accounts receivable. . . . . (33.0) (16.5) 18.9 Change in materials and supplies . . . 1.4 (0.6) (4.9) Change in prepaid expenses and certain other current assets . . . . (24.6) (1.0) (49.7) Change in accounts payable . . . . . . 18.1 18.1 18.6 Change in accrued taxes. . . . . . . . (2.4) (4.5) 2.1 Change in certain other current liabilities. . . . . . . . . . . . . .7 11.0 (14.1) Net change in certain noncurrent . . . assets and liabilities. . . . . . . . (27.8) 20.0 3.7 Other. . . . . . . . . . . . . . . . . 12.6 - (.2) Net cash from operating activities . . . . . 280.5 316.6 248.2 Cash flows used for investing activities: Capital expenditures, net. . . . . . . . . (147.4) (174.4) (164.3) Proceeds (net of removal costs) from disposal of property, plant and equipment. . . . . . . . . . . 2.3 1.2 (.2) Additional equity investments in ASI (affiliates) . . . . . . . . . . . . (3.0) (4.0) - Net cash used for investing activities (148.1) (177.2) (164.5) WISCONSIN BELL, INC. STATEMENTS OF CASH FLOWS (Continued) (Dollars in Millions) Year Ended December 31, 1993 1992 1991 Cash flows used for financing activities: Net change in short-term debt. . . . . . . - (42.0) 23.3 Intercompany financing, net. . . . . . . . 176.5 61.3 - Issuance of long-term debt, net of discount . . . . . . . . . . . . 145.6 - - Retirements of long-term debt. . . . . . . (320.0) (30.7) (2.7) Cost of refinancing long term debt . . . . (12.6) - - Dividend payments. . . . . . . . . . . . . (125.0) (125.2) (104.0) Net cash used for financing activities (135.5) (136.6) (83.4) Net increase (decrease) in cash. . . . . . . (3.1) 2.8 .3 Cash, beginning of period. . . . . . . . . . 3.1 .3 - Cash, end of period . . . . . . . . . . . . $ - $ 3.1 $ .3 ______ ______ ______ The accompanying notes are an integral part of the financial statements. WISCONSIN BELL, INC. NOTES TO FINANCIAL STATEMENTS (Dollars in Millions) Wisconsin Bell, Inc. ("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 (SFAS No. 71), "Accounting for the Effects of Certain Types of Regulation" the Company gives accounting recognition to 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 10% ownership interest in ASI, an Ameritech controlled affiliate, that provides consolidated planning, development, management and support services to all of the Ameritech Bell companies. The Company also provides certain services, such as loaned employees, to ASI. 1993 1992 1991 . Purchases of materials and $174.4 $178.1 $161.4 charges for services from ASI . Recovery of cost for services $ 15.0 $ 14.1 $ 11.3 provided to ASI 2. Ameritech (the Company's parent) - Ameritech provides various administrative, planning, financial and other services to the Company. These services are billed to the Company at cost. 1993 1992 1991 . Charges incurred for services $ 11.4 $12.8 $12.9 3. Ameritech Publishing, Inc. (API) - The Company has an agreement under which payments are made to the Company by API for license fees and billing and collection services 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 $40.6 $40.9 $40.8 . Purchases by the Company from API $ 9.1 $ 8.3 $ 7.9 4. Ameritech Information Systems, Inc. (AIS) - The Company has an agreement under which the Company reimburses AIS for costs incurred by AIS in connection with the sale of network services by AIS employees. 1993 1992 1991 . Charges incurred for services $5.6 $4.5 $4.6 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 $12.6 $15.2 $14.6 Property, Plant and Equipment - Property, plant and equipment is stated at original cost. The original cost of property, plant and equipment acquired from ASI includes a return on investment to ASI. The provision for depreciation is based principally on the straight-line remaining life and the straight-line equal life group methods of depreciation applied to individual categories of property, plant and equipment with similar characteristics. The provision for intrastate deprecia-tion is prescribed by the Public Service Commission of Wisconsin (PSCW) and differs from the Federal Communications Commission (FCC) prescribed methods. The PSCW permits only the use of the straight-line remaining life method. Generally, when depreciable plant is retired, the amount at which such plant has been carried in property, plant and equipment in service is charged to accumulated depreciation. The cost of maintenance and repairs of plant is charged to expense. Investments - The Company's investment in ASI (10% ownership or $26.7 for 1993 and 10% or $22.0 for 1992, respectively) is reflected in the financial statements using the equity method of accounting. All other investments are carried at cost. Material and Supplies - Inventories of new and reusable material and supplies are stated at the lower of cost or market with cost determined generally on an average cost 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 consoli-dated federal income tax return filed by Ameritech and its subsidiaries. Consolidated income tax currently payable has been allocated to the Company based on the Company's contribution to consolidated taxable income and tax credits. 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 Company and accordingly, did not have a significant impact on the Company's financial statements upon adoption. 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 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 revenue to be recovered in telephone rates when the related taxes become payable in future years. 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 for the provision of short-term financing. This arrangement became effective for the Company June 1, 1992. 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 Note D and H. (B) INCOME TAXES - The components of income tax expense before accounting changes were as follows: Year Ended December 31, 1993 1992 1991 Federal Current . . . . . . . . . . . $ 60.1 $65.8 $68.5 Deferred - net. . . . . . . . 2.4 (22.3) (20.3) Investment tax credits - net. (9.3) (6.9) (9.0) Total. . . . . . . . . . 53.2 36.6 39.2 State and Local Current . . . . . . . . . . . 12.8 15.4 14.1 Deferred - net. . . . . . . . 8.3 4.0 3.5 Total. . . . . . . . . . 21.1 19.4 17.6 Total income tax expense . . . . . $ 74.3 $56.0 $56.8 Deferred income tax expense (credits) results principally from temporary differences caused by the change in the book and tax bases of property, plant and equipment due to the use of different depreciation methods and lives for financial reporting and income tax purposes. Total income taxes paid were $74.5, $89.0 and $77.1 in 1993, 1992 and 1991, respectively. The following is a reconciliation between the statutory federal income tax rate for each of the last three years and the Company's effective tax rate: Year Ended December 31, 1993 1992 1991 Statutory tax rate. . . . . . . . . . . 35.0% 34.0% 34.0% State income taxes, net of federal benefit . . . . . . . . . . . . . . . . 6.5 7.4 7.0 Reduction in tax expense due to amortization of investment tax credits . . . . . . . . . . . . . . . . (4.3) (4.1) (5.4) Benefit of tax rate differential applied to reversing temporary differences . . . . . . . . . . . . . . (2.4) (3.3) (3.5) Other - net . . . . . . . . . . . . . . 0.2 (1.7) 2.2 Effective tax rate. . . . . . . . . . . 35.0% 32.3% 34.3% _____ _____ _____ The Revenue Reconciliation Act of 1993, enacted in August of 1993, 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 accounted prescribed by SFAS No. 71 (see Note A). The result was a reduction in deferred income tax expense of $2.3, primarily from increasing the deferred tax assets associated SFAS Nos. 106 and 112 (see Note C). As of December 31, 1993, the Company had a regulatory asset of $41.7 (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 $72.2 (reflected in Other Deferred Credits) related to the reduction of deferred taxes resulting from the change in the federal statutory income tax rate of 35 percent 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. As of December 31, 1993 and 1992, the components of long-term accumulated deferred income taxes were as follows: 1993 1992 Deferred tax assets: Postretirement benefits $ 87.0 $ 90.2 Postemployment benefits 3.5 3.5 SFAS No. 71 accounting 25.6 71.8 Other, net 13.3 11.1 129.4 176.6 Deferred tax liabilities: Accelerated depreciation 323.3 331.4 Other 7.7 .4 331.0 331.8 Net deferred tax liability $201.6 $155.2 Deferred income taxes in current assets and liabilities are not shown as they are not significant. (C) EMPLOYEE BENEFIT PLANS Pension Plans - Ameritech maintains noncontributory defined pension and death benefit plans covering substantially all of the Company's management and nonmanagement 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 nonmanagement plan. Pension (credit) cost is allocated to subsidiaries based upon the percentage of compensation for the management plan and per employee for the nonmanagement 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) cost for the Ameritech plans: Year Ended December 31, 1993 1992 1991 Pension credit . . . . . . . . . . . . . . $(9.8) $(10.6) $(7.3) ______ _______ ______ Current year credit as a percentage of salaries and wages. . . . . . . . . . . (4.7%) (4.8%) (3.0%) _______ ________ _______ Pension credit was 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 costs 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 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 as expense over the period in which the employee renders service and becomes eligible to receive benefits. The cost of health care costs and post-retirement 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 unrecognized obligation was $230.2 less deferred income taxes of $90.3 or $139.9, net. To this amount, is added the Company's 10 percent share of ASI's transition benefit obligation of $6.2 for a total charge of $146.1. 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 ratemaking 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 costs on 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 projected benefit obligation exceeded the fair value of plant 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 December 31, 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 healthcare cost trend rate in 1993 was 9.6% and 10% in 1992, and is assumed to decrease gradually to 4% in 2007 and remain at that level. The assumed increase in healthcare cost is 9.2% for 1994. The healthcare cost trend rates have a significant effect on the amounts reported for costs each year. Specifically, increasing the assumed healthcare cost trend rates by one percentage point in each year would have increased the transition obligation and annual expense by 18%. Postretirement benefit cost under SFAS No. 106 for 1993 and 1992 was $23.7 and $21.9, respectively. During 1991, the cost of postretirement health care benefits for retirees was $20.3. As of December 31, 1993, the company had approximately 4,359 retirees eligible to receive health care and group life insurance benefits. 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 $5.5, net of deferred taxes of $3.5. To this amount is added the Company's 10% share of ASI's one-time charge of $.2 for a total charge of $5.7. Previously the Company used the cash method to account for such costs. Future expense levels are dependent upon actual claim experience, but are not expected to be materially different than prior charges to income. Workforce Reductions - During 1993, 270 employees left the Company through a voluntary early retirement program and involuntary terminations. The net cost of this effort including termination benefits, settlement and curtailment gains from the pension plan, was a credit to expense of $2.8. The involuntary termination plan remains in effect until December 31, 1994. During 1992, 172 employees left the Company through a voluntary early retirement program and involuntary terminations. The net cost of this effort including termination benefits, settlement and curtailment gains from the pension plan, was a credit to expense of $0.1. During 1991, the Company offered most of its management employees an early retirement program. The net cost of this program, including termination benefits and a settlement gain from the pension plan, was $0.9. (D) DEBT MATURING WITHIN ONE YEAR - Debt maturing within one year is included as debt in the computation of debt ratios and consists of the following at December 31: Weighted Average Amounts Interest Rates 1993 1992 1991 1993 1992 1991 Notes Payable - Commercial Paper . . $ - $ - $42.1 - % - % 4.7% Parent (Ameritech) . 237.8 61.3 - 3.1% 3.3% - Long-term debt maturing within one year. . . .9 100.4 30.7 Total. . . . . $238.7 $161.7 $72.8 ______ ______ _____ Average notes payable outstanding during the year . . . . . . . $115.7 $ 43.5 $13.6 3.1%* 3.5%* 5.5%* ______ ______ _____ ___ ___ ___ Maximum notes payable at any month-end during the year. . . . $237.8 $ 65.2 $42.1 ______ ______ _____ * Computed by dividing the average daily face amount of advances and 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 arrangements. (E) LONG-TERM DEBT - Long-term debt consists principally of mortgage bonds and debentures issued by the Company. The following table sets forth interest rates and other information on long-term debt outstanding at December 31. Interest Maturities 1993 1992 4.88% 1995 $ - $ 20.0 4.38% 2002 20.0 20.0 6.25% 2004 50.0 50.0 7.25% 2007 90.0 90.0 8.00% 2014 - 100.0 8.25% 2016 - 100.0 6.75% 2024 150.0 - 310.0 380.0 Capital lease obligation . . . .9 .6 Other . . . . . . . . . . . . (.9) (.3) Unamortized discount, net . . (3.5) (1.3) Total . . . . . . . . . . . . $306.5 $379.0 _______ _______ On December 30, 1992, the Company announced a plan to call its 8-3/4% $100.0 bonds effective February 1, 1993. The premium paid to call the bonds, ($5.1) along with the unamortized discount and debt issuance costs related to the bonds ($2.9) have been expensed as of December 31, 1992 and are included in other expense (income). The bond call was financed with short-term borrowings from Ameritech. On August 11, 1993, the Company issued $150.0 of 6-3/4% debentures due August 15, 2024. The proceeds from the sale, along with short-term borrowings, were used to retire $100.0 of 8-1/4% debentures due November 15, 2016 and $100.0 of 8% debentures due January 1, 2014. The Company has filed a registration statement with the Securities and Exchange Commission for the issuance of up to $200.0 in unsecured debt securities for general corporate purposes. Early extinguishment of debt costs (including call premiums and write-offs of unamortized deferred costs) were $9.0, $8.0 and $0.0 in 1993, 1992 and 1991, respectively, and were included in other expense (income) on the statements of income. (F) LEASE COMMITMENTS - The Company leases certain facilities and equipment used in its operations under both operating and capital leases. Rental expense under operating leases was $14.1, $14.7 and $19.3 for 1993, 1992 and 1991, respectively. At December 31, 1993 the aggregate minimum rental commitments under noncancelable leases were approximately as follows: Years Operating Capital 1994 . . . . . . . . . . . . . . . . . . . . . $2.3 $1.0 1995 . . . . . . . . . . . . . . . . . . . . . 1.9 .8 1996 . . . . . . . . . . . . . . . . . . . . . 1.2 .2 1997 . . . . . . . . . . . . . . . . . . . . . .7 - 1998 . . . . . . . . . . . . . . . . . . . . . .3 - Thereafter . . . . . . . . . . . . . . . . . . .2 - Total minimum rental commitments . . . . . . . $6.6 2.0 ____ Less: amount representing executory costs . . .1 amount representing interest costs . . .1 Present value of minimum lease payments . $1.8 ____ (G) FINANCIAL INSTRUMENTS - The following table presents the estimated fair value of the Company's financial instruments as of December 31, 1993: Carrying Fair Value Value Cash and temporary cash investments. . . . . . $ - $ - Debt . . . . . . . . . . . . . . . . . . . . . 551.7 549.5 Long-term payable to ASI (for postretirement benefits). . . . . . . . . . . . . . . . . 8.8 8.8 Other assets . . . . . . . . . . . . . . . . . 3.1 3.1 Other liabilities. . . . . . . . . . . . . . . 6.8 6.8 Carrying Fair Value Value Cash and temporary cash investments. . . . . . $ 3.1 $ 3.1 Debt . . . . . . . . . . . . . . . . . . . . . 555.6 541.8 Long-term payable to ASI (for postretirement benefits). . . . . . . . . . . . . . . . . 9.9 9.9 Other assets . . . . . . . . . . . . . . . . . 7.3 7.3 Other liabilities. . . . . . . . . . . . . . . 23.1 23.1 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 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 estimated based on the year-end quoted market price for the same or similar issues. Other Assets and Liabilities - These financial instruments consist primarily of other investments, other accrued liabilities and customer deposits. The fair values of these items was based on expected cash flows or, if available, quoted market prices. Long-Term Payable to ASI (For Postretirement Benefits) - This item represents the long-term payable to ASI for the Company's proportional share of ASI's transition benefit obligation related to the adoption of SFAS No. 106. (H) ADDITIONAL FINANCIAL INFORMATION Balance Sheet December 31, Other current liabilities: 1993 1992 Accrued payroll . . . . . . . . . . . $ 6.1 $ 12.6 Compensated absences. . . . . . . . . 17.7 17.9 Accrued taxes . . . . . . . . . . . . 4.3 6.7 Income taxes deferred one year . . . - 8.8 Advance billings and customers' deposits . . . . . . . . . . . . . 32.4 32.0 Accrued interest . . . . . . . . . . 9.5 11.2 Other . . . . . . . . . . . . . . . . 6.9 22.4 Total . . . . . . . . . . . . . . . $ 76.9 $111.6 _______ _______ Statements of Income Year Ended December 31, 1993 1992 1991 Interest Expense: Interest on long-term debt . . . . . $ 29.3 $ 37.5 $ 38.2 Interest on notes payable - Ameritech 4.0 .9 - Interest on notes payable - Other . . - .6 .8 Other . . . . . . . . . . . . . . . . (1.3) 3.0 4.6 Total . . . . . . . . . . . . . . . $ 32.0 $ 42.0 $ 43.6 _______ _______ _______ Interest paid, net of amounts capitalized was $29.7, $40.9 and $39.7 in 1993, 1992 and 1991, respectively. Taxes other than income taxes Gross receipts. . . . . . . . . . . . $ 59.7 $ 59.8 $ 57.7 Other . . . . . . . . . . . . . . . . 3.1 1.9 1.9 Total . . . . . . . . . . . . . . . $ 62.8 $ 61.7 $ 59.6 _______ _______ _______ Maintenance and repair expense $158.0 $160.1 $158.3 _______ _______ _______ Advertising $ 12.7 $ 9.4 $ 9.7 _______ _______ _______ Depreciation - Percentage of average depreciable property, plant and equipment . . . . . . . . . 7.0% 7.1% 7.1% _______ _______ _______ Revenues from AT&T, consisting principally of interstate network access and billing and collection service revenues, comprised approximately 14% of total operating revenues in 1993, 1992 and 1991. No other customer accounted for more than 10% of total revenues. (I) QUARTERLY FINANCIAL INFORMATION (UNAUDITED) Net Calendar Operating Income Quarter Revenues Income (Loss) 1st . . . . . . . . . . . $ 272.8 $ 67.0 $ 37.6 2nd . . . . . . . . . . . 281.4 62.1 35.7 3rd . . . . . . . . . . . 282.7 59.3 30.2 4th . . . . . . . . . . . 285.4 66.6 34.5 Total . . . . . . . . $1,122.3 $255.0 $138.0 ________ ______ _______ 1st . . . . . . . . . . . $ 264.8 $ 54.2 $(120.4) 2nd . . . . . . . . . . . 269.6 55.2 28.0 3rd . . . . . . . . . . . 276.7 61.7 30.4 4th . . . . . . . . . . . 276.3 50.4 27.5 Total . . . . . . . . $1,087.4 $221.5 $ (34.5) ________ ______ ________ 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 and charges for the early retirement of debt. In the 1992 quarter, the Company recognized higher costs and charges resulting from its market realignment efforts, the early retirement of debt, and increased advertising. 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 postretirement and postemployment benefits, as discussed previously in Note C. The charges totaled $151.8. All adjustments necessary for a fair statement of results for each period have been included. (J) CALCULATION OF RATIO OF EARNINGS TO FIXED CHARGES The ratio of earnings to fixed charges of the Company for the years ended December 31, 1993, 1992, 1991, 1990 and 1989 were 6.78, 4.70, 4.31, 4.57 and 4.00, 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 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. (K) 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 $31.7. The charge will be recorded in the first quarter of 1994. The details of this plan are discussed on page 22 in MD&A. Item 9. Item 9. Changes in and Disagreements 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 the annual report. 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: Page Selected Financial and Operating Data................ 15 Report of Independent Public Accountants............. 23 Statements of Income and Reinvested Earnings......... 24 Balance Sheets....................................... 25 Statements of Cash Flows............................. 27 Notes to Financial Statements........................ 29 (2) Financial Statement Schedules: V - Telecommunications Plant...................... 46 VI - Accumulated Depreciation...................... 50 VIII - Allowance for Uncollectibles.................. 54 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 Securities and Exchange Commission ("SEC"), are incorporated herein by reference as exhibits hereto. Exhibit Number (3)a Articles of Association of the registrant as amended March 27, 1990. (Exhibit 3a to Form 10-K for 1989, File No. 1-6589.) (3)b By-Laws of the registrant as amended March 27, 1990. (Exhibit 3b to Form 10-K for 1989, File No. 1-6589.) (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. (10)a 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.) (10)b 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 1983 for American Information Technologies Corporation, File No. 1-8612.) (12) Computation of ratio of earnings to fixed charges. (24) Consent of independent public accountants. (28) Authorization of deputization. (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. 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. Wisconsin Bell, Inc. By Paul J. LaRosa (Paul J. LaRosa, Treasurer) 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: Bronson J. Haase President Principal Financial Officer: Richard H. Witte Vice President and By Paul J. LaRosa Comptroller (Paul J. LaRosa, Treasurer and by written authorization) December 16, 1993) Ameritech Corporation By Richard H. Brown (Richard H. Brown, Vice Chairman) the sole shareholder of the registrant, which is a statutory close corporation managed by the shareholder rather than by a board of directors. March 30, 1994 ______________________________________________________________________________ ______________________________________________________________________________ COL. A COL. B COL. C COL. D COL. E COL. F ______________________________________________________________________________ Balance at Additions Retire- Other Balance Beginning at Cost ments Changes at End Classification of Period -Note(a) -Note(b) -Note(c) of Period ______________________________________________________________________________ Year 1993 Land.................... $ 16.5 $ 0.8 $ 0.3 $ - $ 17.0 Buildings............... 315.2 9.4 2.9 - 321.7 Computers and Other Office Equipment....... 153.9 7.3 13.8 - 147.4 Vehicles and Other Work Equipment......... 26.7 2.3 1.6 - 27.4 Central Office Equipment.............. 968.7 98.2 97.2 - 969.7 Information Origination/ Termination Equipment.. 26.6 2.1 1.9 - 26.8 Cable and Wire Facilities............. 1,144.9 40.8 8.8 - 1,176.9 Capitalized Lease Assets................. 4.4 1.5 0.7 - 5.2 Miscellaneous Other Property............... 6.2 0.9 (0.2) - 7.3 Total Telecommunications Plant in Service....... 2,663.1 163.3 127.0 - 2,699.4 Telecommunications Plant Under Construction..... 41.0 (16.0) - - 25.0 Total Telecommunications Plant.................. $2,704.1 $147.3 $127.0 $ - $2,724.4 ________ _______ ______ _______ ________ The notes on page 50 are an integral part of this Schedule. ______________________________________________________________________________ ______________________________________________________________________________ COL. A COL. B COL. C COL. D COL. E COL. F ______________________________________________________________________________ Balance at Additions Retire- Other Balance Beginning at Cost ments Changes at End Classification of Period -Note(a) -Note(b) -Note(c) of Period ______________________________________________________________________________ Year 1993 Land.................... $ 16.0 $ 0.7 $ 0.2 $ - $ 16.5 Buildings............... 306.4 12.2 3.4 - 315.2 Computers and Other Office Equipment....... 156.2 7.1 9.4 - 153.9 Vehicles and Other Work Equipment......... 27.4 2.1 2.8 - 26.7 Central Office Equipment.............. 971.1 86.9 89.3 - 968.7 Information Origination/ Termination Equipment.. 25.3 3.1 1.8 - 26.6 Cable and Wire Facilities............. 1,109.6 45.6 10.3 - 1,144.9 Capitalized Lease Assets................. 4.6 0.2 0.4 - 4.4 Miscellaneous Other Property............... 7.4 (1.2) - - 6.2 Total Telecommunications Plant in Service....... 2,624.0 156.7 117.6 - 2,663.1 Telecommunications Plant Under Construction..... 23.3 17.7 - - 41.0 Total Telecommunications Plant.................. $2,647.3 $174.4 $117.6 $ - $2,704.1 ________ _______ ______ _______ ________ The notes on page 50 are an integral part of this Schedule. ______________________________________________________________________________ ______________________________________________________________________________ COL. A COL. B COL. C COL. D COL. E COL. F ______________________________________________________________________________ Balance at Additions Retire- Other Balance Beginning at Cost ments Changes at End Classification of Period -Note(a) -Note(b) -Note(c) of Period ______________________________________________________________________________ Year 1993 Land.................... $ 14.8 $ 1.7 $ 0.5 $ - $ 16.0 Buildings............... 294.6 14.0 2.2 - 306.4 Computers and Other Office Equipment....... 165.0 14.5 23.3 - 156.2 Vehicles and Other Work Equipment......... 27.1 3.2 2.9 - 27.4 Central Office Equipment.............. 942.3 80.0 51.2 - 971.1 Information Origination/ Termination Equipment.. 25.2 2.8 2.7 - 25.3 Cable and Wire Facilities............. 1,072.3 51.0 13.7 - 1,109.6 Capitalized Lease Assets................. 5.2 0.1 0.7 - 4.6 Miscellaneous Other Property............... 8.5 (1.1) - - 7.4 Total Telecommunications Plant in Service....... 2,555.0 166.2 97.2 - 2,624.0 Telecommunications Plant Under Construction..... 19.6 3.7 - - 23.3 Total Telecommunications Plant.................. $2,574.6 $169.9 $97.2 $ - $2,647.3 ________ _______ _____ _______ ________ The notes on page 50 are an integral part of this Schedule. FOOTNOTES TO SCHEDULE V (Millions of Dollars) _______________ (a) Additions, other than to buildings, include material purchased from Ameritech Services Inc., a centralized procurement subsidiary in which the Company has a 10 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) Comprised principally of reclassifications between plant categories. ______________________________________________________________________________ ______________________________________________________________________________ COL. A COL. B COL. C COL. D COL. E COL. F ______________________________________________________________________________ Balance at Additions Retire- Other Balance Beginning at Cost ments Changes at End Classification of Period -Note(a) -Note(b) -Note(c) of Period ______________________________________________________________________________ Year 1993 Buildings............... $ 64.1 $ 7.7 $ 4.4 $(0.2) $ 67.2 Computers and Other Office Equipment....... 98.3 14.1 13.4 - 99.0 Vehicles and Other Work Equipment......... 9.0 1.6 1.9 - 8.7 Central Office Equipment.............. 376.2 95.9 92.9 - 379.2 Information Origination/ Termination Equipment.. 13.9 2.8 2.0 - 14.7 Cable and Wire Facilities............. 438.6 63.2 10.6 - 491.2 Capitalized Lease Assets................. 3.5 0.4 0.7 - 3.2 Miscellaneous Other Property............... 0.3 0.4 (2.1) 0.2 3.0 Total Telecommunications Plant in Service....... 1,003.9 186.1 123.8 - 1,066.2 Telecommunications Plant Under Construction..... - - - - - Total Telecommunications Plant.................. $1,003.9 $186.1 $123.8 $ - $1,066.2 ________ ______ ______ _______ ________ The notes on page 54 are an integral part of this Schedule. ______________________________________________________________________________ ______________________________________________________________________________ COL. A COL. B COL. C COL. D COL. E COL. F ______________________________________________________________________________ Balance at Additions Retire- Other Balance Beginning at Cost ments Changes at End Classification of Period -Note(a) -Note(b) -Note(c) of Period ______________________________________________________________________________ Year 1993 Buildings............... $ 61.4 $ 7.7 $ 5.0 $ - $ 64.1 Computers and Other Office Equipment....... 88.3 19.3 9.3 - 98.3 Vehicles and Other Work Equipment......... 9.6 1.8 2.4 - 9.0 Central Office Equipment.............. 362.9 99.7 86.4 - 376.2 Information Origination/ Termination Equipment.. 13.6 2.2 1.9 - 13.9 Cable and Wire Facilities............. 396.5 54.1 12.0 - 438.6 Capitalized Lease Assets................. 3.4 0.5 0.4 - 3.5 Miscellaneous Other Property............... .7 1.1 1.5 - 0.3 Total Telecommunications Plant in Service....... 936.4 186.4 118.9 - 1,003.9 Telecommunications Plant Under Construction..... - - - - - Total Telecommunications Plant.................. $936.4 $186.4 $118.9 $ - $1,003.9 ______ ______ ______ _______ ________ The notes on page 54 are an integral part of this Schedule. ______________________________________________________________________________ ______________________________________________________________________________ COL. A COL. B COL. C COL. D COL. E COL. F ______________________________________________________________________________ Balance at Additions Retire- Other Balance Beginning at Cost ments Changes at End Classification of Period -Note(a) -Note(b) -Note(c) of Period ______________________________________________________________________________ Year 1993 Buildings............... $ 57.8 $ 7.4 $ 3.8 $ - $ 61.4 Computers and Other Office Equipment....... 90.4 20.7 7 22.8 - 88.3 Vehicles and Other Work Equipment......... 10.2 1.9 2.5 - 9.6 Central Office Equipment.............. 317.3 96.4 50.8 - 362.9 Information Origination/ Termination Equipment.. 14.4 2.0 2.8 - 13.6 Cable and Wire Facilities............. 357.5 53.9 14.9 - 396.5 Capitalized Lease Assets................. 3.4 0.6 0.6 - 3.4 Miscellaneous Other Property............... 1.0 (1.3) (1.0) - 0.7 Total Telecommunications Plant in Service....... 852.0 181.6 97.2 - 936.4 Telecommunications Plant Under Construction..... - - - - - Total Telecommunications Plant.................. $852.0 $181.6 $97.2 $ - $936.4 ______ ______ _____ _______ ______ The notes on page 54 are an integral part of this Schedule. FOOTNOTES TO SCHEDULE VI (Millions of Dollars) _______________ (a) Comprised of depreciation related to short-term interest during construction charged initially to deferred charges and reclassifications between plant categories. ______________________________________________________________________________ ______________________________________________________________________________ COL. A COL. B COL. C COL. D COL. E ______________________________________________________________________________ Charged to Balance at Other Balance Beginning Charged to Accounts Deductions at End Classification of Period Expenses -Note(a) -Note(b) of Period ________________________________________________________________________________ Year 1993 .......... $9.3 $10.4 $19.1 $29.6 $9.2 Year 1992 .......... $6.3 $12.0 $19.6 $28.6 $9.3 Year 1991 .......... $4.8 $9.5 $11.9 $19.9 $6.3 __________________________ (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 billed by the Company. (b) Amounts written off as uncollectible. EXHIBIT INDEX Exhibit Number Page (3)a Articles of Incorporation of the registrant, as amended March 27, 1990. (Exhibit 3a to Form 10-K for 1989, File No. 1-6589.) (3)b By-laws of the registrant, as amended March 27, 1990. (Exhibit 3b to Form 10-K for 1989, File No. 1-6589.) 4 No instrument which defines the rights of holders of long-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. (10)a 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.) (10)b 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 1983 for American Information Technologies Corporation, File No. 1-8612.) (12) Computation of ratio of earnings to fixed 56 charges. (24) Consent of independent public accountants. 57 (28) Authorization of deputization. 58 WISCONSIN BELL, INC. COMPUTATION OF RATIO OF EARNINGS TO FIXED CHARGES (Dollars in Millions) Year Ended December 31, 1993 1992 1991 1990 1989 EARNINGS (a) Income before interest deductions and cumulative effect of change in accounting principles . . . $ 170.0 $ 159.3 $ 152.4 $ 155.6 $ 153.8 (b) Federal and state income taxes . . . . . . . . . . . 74.3 56.0 56.8 55.9 41.2 (c) Portion of rental expense representative of interest factor . . . . . . . . . . 4.7 4.9 6.4 6.0 7.2 $ 249.0 $ 220.2 $ 215.6 $ 217.5 $ 202.2 FIXED CHARGES (a) Total interest deductions including capital lease obligations . . . . . . . . $ 32.0 $ 42.0 $ 43.6 $ 41.6 $ 43.3 (b) Portion of rental expense representative of the interest factor . . . . . . 4.7 4.9 6.4 6.0 7.2 $ 36.7 $ 46.9 $ 50.0 $ 47.6 $ 50.5 Ratio . . . . . . . . . . . . . 6.78 4.70 4.31 4.57 4.00 _______ _______ _______ _______ _______ CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS As independent public accountants, we hereby consent to the incorporation by reference of our report dated January 28, 1994, included as an Exhibit to this Form 10-K, into Wisconsin Bell, Inc.'s previously filed Registration Statement File No. 33-53510. Arthur Andersen & Co. Milwaukee, Wisconsin March 30, 1994 Ameritech Exhibit 28 AUTHORIZATION OF DEPUTIZATION AUTHORIZATION Date 12 / 16 / 93 I, (Principal Name) Richard H. Witte hereby appoint (Deputy Name) Paul J. LaRosa (Title) Treasurer (Location) 722 N. Broadway, Milwaukee to sign on my behalf. X All papers requiring my signature. Only those papers listed below (specify). __________________________________________________________________ __________________________________________________________________ Principal's Approval Status Indicator(s): 4 Capital Expenditures 4 General Expenditures Length of deputization (maximum one year): From Date 12 / 16 / 93 To Date 12 / 16 / 94 Signature of Deputy /s/ Paul J. LaRosa Title Treasurer Vice President and Signature of Principal /s/ Richard H. Witte Title Comptroller CANCELLATION Effective Date / / Signature of Principal ____________________________________________________ or Signature of Deputy ________________________________________________________ DISTRIBUTION Forward original to the appropriate voucher unit. Forward copies to others on a need-to-know basis.

36204_1993.txt

36204_1993

1993

36204

Item 1 Description of Business General First Commerce Corporation (FCC) is a multi-bank holding company with five wholly-owned bank subsidiaries in Louisiana: First National Bank of Commerce (FNBC) in New Orleans, City National Bank of Baton Rouge (CNB), Rapides Bank & Trust Company in Alexandria (RB&T), The First National Bank of Lafayette (FNBL) and The First National Bank of Lake Charles (FNBLC). Effective January 1, 1994, First Acadiana National Bancshares, Inc. (FANB), the parent company of First Acadiana National Bank was acquired by FCC for 1,290,145 shares of common stock. First Acadiana National Bank was merged with FNBL. The acquisition was accounted for as a pooling-of-interests. The five banks accounted for 99.3% of the assets of FCC at December 31, 1993 and substantially all of the net income for 1993. The banks offer customary services of banks of similar size and similar markets, including numerous types of interest- bearing and noninterest-bearing deposit accounts, commercial and installment loans, trust services, correspondent banking services and safe deposit facilities. For further discussion of FCC's operations, see the Financial Review section of FCC's 1993 Annual Report, which is incorporated by reference into Item 7 of this Annual Report on Form 10-K. During 1993, FCC or its bank subsidiaries owned seven bank- related subsidiaries: First Commerce Investment Services, Inc. (FCIS), Baronne Street Properties, Inc. (BSP), KNW, Ltd. (KNW), DLC, Ltd. (DLC), First Commerce Community Development Corporation (FCCDC), First Commerce Service Corporation (FCSC) and New Orleans Bancshares, Inc. (NOBS). FCIS is a discount brokerage subsidiary, which was organized under the rules of the Securities and Exchange Commission in 1985 and is a member of the National Association of Securities Dealers, Inc. (NASD). BSP is a 1% general partner and FNBC is a 99% limited partner in DLC and KNW, Louisiana Partnerships in Commendam, created to manage and sell foreclosed property. FCIS and BSP are both subsidiaries of FNBC. In 1992, FCCDC was organized as a Louisiana non-profit organization under the policy guidelines established by the OCC for community development corporations. First Commerce developed this corporation to assist low-to-moderate income individuals to buy homes. Each of the five subsidiary banks of FCC owns 20% of FCCDC's outstanding common stock. FCSC performs services such as audit, credit review, data processing, accounting, financial reporting and other services for all other subsidiaries of FCC. NOBS is an inactive company, organized in 1983 to hold the name "New Orleans Bancshares." Regulation Like other bank holding companies in Louisiana, FCC is subject to regulation by the Louisiana Commissioner of Financial Institutions and the Federal Reserve Board. Under the terms of the Bank Holding Company Act of 1956 (the "Act"), as amended, FCC is restricted to only banking or bank-related activities specifically allowed by the Act or the Federal Reserve Board. The Act requires FCC to file required reports with the Federal Reserve Board. Each of FCC's subsidiary banks is a member of the Federal Reserve System and is subject to regulation by the Federal Reserve Board and the FDIC. The four national bank subsidiaries are also subject to regulation and supervision by the Comptroller of the Currency, while the state-chartered bank subsidiary is subject to regulation and supervision by the Louisiana Commissioner of Financial Institutions. Payment of Dividends The primary source of funds for the dividends paid by FCC to its stockholders and debt service obligations is the dividends it receives from the bank subsidiaries. The payment of dividends by FCC's national banks is regulated by the Comptroller of the Currency. The payment of dividends by FCC's state bank is regulated by the Louisiana Commissioner of Financial Institutions and the Federal Reserve Board. Prior approval must be obtained from the appropriate regulatory authorities before dividends can be paid if the amount of defined capital, surplus and retained earnings is below defined regulatory limits. Additionally, the bank subsidiaries may not pay dividends in excess of their retained net profits (net income less dividends for the current and prior two years) without prior regulatory approval. Under certain circumstances, regulatory authorities may prohibit the payment of dividends by a bank or its parent holding company. See Note 16 of Notes to Consolidated Financial Statements, which is incorporated by reference into Item 8 of this Annual Report on Form 10-K. Borrowings by the Company Federal law prohibits FCC from borrowing from its bank subsidiaries, unless the borrowings are secured by specified amounts and types of collateral. Additionally, such secured loans are generally limited to 10% of each subsidiary bank's capital and surplus and, in the aggregate with respect to FCC and all of its subsidiaries, to 20% of each subsidiary bank's capital and surplus. Further, a bank holding company and its subsidiaries are prohibited from engaging in certain tie-in arrangements in connection with any extension of credit, lease or sale of property or furnishing of services. Company Support of Bank Subsidiaries The Financial Institutions Reform, Recovery and Enforcement Act of 1989 ("FIRREA") contains a "cross-guarantee" provision which could result in any insured depository institution owned by FCC (i.e., any bank subsidiary) being assessed for losses incurred by the FDIC in connection with assistance provided to, or the failure of, any other depository institution owned by FCC. In addition, under Federal Reserve Board policy, FCC is expected to act as a source of financial strength to each of its bank subsidiaries and to commit resources to support each such bank in circumstances in which such bank might need such outside support. The Federal Deposit Insurance Corporation Improvement Act of 1991 (the "1991 Act") provides, among other things, that undercapitalized institutions, as defined by regulatory authorities, must submit recapitalization plans, and a parent company of such an institution must either (i) guarantee the institution's compliance with the capital plan, up to an amount equal to the lesser of five percent of the institution's assets at the time it becomes undercapitalized or the amount of the capital deficiency when the institution fails to comply with the plan, or (ii) suffer certain adverse consequences such as a prohibition of dividends by the parent company to its shareholders. Annual Insurance Assessment FCC's bank subsidiaries are subject to deposit insurance assessment by the FDIC. These assessments have been rising in recent years and could increase still further in the future. Prompt Corrective Action The 1991 Act and implementing regulations classify banks into five categories generally relating to their regulatory capital ratios and institutes a system of supervisory actions indexed to particular classification. Generally, banks that are classified as "well capitalized" or "adequately capitalized" are not subject to the supervisory actions specified in the 1991 Act for prompt corrective action, but may be restricted from taking certain actions that would lower their classification. Banks classified as "undercapitalized", "significantly undercapitalized" or "critically undercapitalized" are subject to restrictions and supervisory actions of increasing stringency based on the level of classification. Under the present regulation, all five of FCC's Banks are "well-capitalized". While such a classification would exclude the Banks from the restrictions and actions envisioned by the prompt corrective action provisions of the 1991 Act, the regulatory agencies have broad powers under other provisions of federal law that would permit them to place restrictions on the Banks or take other supervisory action regardless of such classification. Other Provisions of 1991 Act In general, the 1991 Act subjected banks and bank holding companies to significantly increased regulation and supervision. Other significant provisions of the 1991 Act require the federal regulators to draft non-capital regulatory measures to assure bank safety, including underwriting standards and minimum earnings levels. The legislation further requires regulators to perform annual on-site bank examinations, places limits on real estate lending and tightens audit requirements. The 1991 Act and implementing regulations also impose disclosure requirements relating to fees charged and interest paid on checking and deposit accounts. Miscellaneous Federal and Louisiana law provide for the enforcement of any pro rata assessment of stockholders of a bank to cover impairment of capital stock by sale, to the extent necessary, of the stock of any assessed stockholder failing to pay the assessment. FCC, as the stockholder of its bank subsidiaries, is subject to these provisions. FCIS is registered as a broker-dealer under the Securities Exchange Act of 1934, as amended, and is subject to regulation by the Securities and Exchange Commission and the Louisiana Commissioner of Securities. FCIS is a member of the NASD and, as such, is required to belong to the Securities Investor Protection Corporation, to which FCIS must pay an annual assessment. Item 2 Item 2 Properties FCC's executive offices are located in leased facilities in the Central Business District of New Orleans. Through its subsidiaries, FCC also owns or leases its principal banking facilities and offices in New Orleans, Baton Rouge, Alexandria, Lafayette and Lake Charles. Of the 108 banking offices open at the end of 1993, 65 are owned and 43 are leased. FCSC performs data processing services for FCC and each of its subsidiaries in a facility in the Metropolitan New Orleans area, which is owned by FCSC. Management considers all properties owned or leased to be suitable and adequate for their intended purposes and considers the leases to be fair and reasonable. For additional information concerning premises and information concerning FCC's obligations under long-term leases, see Note 9 of Notes to Consolidated Financial Statements, which is incorporated by reference into Item 8 of this Annual Report on Form 10-K. Item 3 Item 3 Legal Proceedings FCC and its subsidiaries have been named as defendants in various legal actions arising from normal business activities in which damages of various amounts are claimed. The amount, if any, of ultimate liability with respect to such matters cannot be determined. However, after consulting with legal counsel, management believes any such liability will not have a material effect on FCC's consolidated financial condition. Item 10. Executive Officers of the Registrant Ian Arnof, 54--President, Chief Executive Officer and Director of FCC since 1983. Amos T. Beason, 53--Executive Vice President and Chief Investment Officer of FCC since 1988. R. Jeffrey Brooks, 45--Executive Vice President and Director of Strategic Support of FCC since 1993; President and Chief Operating Officer of FNBL from 1992 to 1993; Senior Vice President and Bankcard Group Manager of FNBC from 1986 to 1992. Thomas L. Callicutt, Jr., 46--Senior Vice President, Controller and Principal Accounting Officer of FCC since 1987. Michael A. Flick, 45--Executive Vice President of FCC since 1985; Chief Credit Policy Officer of FCC since 1985; Chief Financial Officer from 1988 to 1992; Secretary to the Board of Directors since 1987. Howard C. Gaines, 53--Chairman and Chief Executive Officer of FNBC since 1988. Thomas C. Jaeger, 43--Senior Vice President and Chief Internal Auditor of FCC since 1989. Mr. Jaeger served as Senior Vice President and Chief Financial Officer of FNBC from 1987 to 1989. David B. Kelso, 41--Executive Vice President and Chief Financial Officer of FCC since 1992. Prior to joining FCC, Mr. Kelso was a consultant with the MAC Group in Washington, D.C. for more than five years. Ashton J. Ryan, Jr., 46--President and Chief Operating Officer of FNBC since 1991. Senior Executive Vice President of FCC since 1993. From 1981 to 1991, Mr. Ryan was a partner with Arthur Andersen & Co., CPAs, New Orleans, Louisiana. Joseph V. Wilson III, 44--Senior Executive Vice President of FCC since 1993; Executive Vice President of FCC from 1989 to 1992; Executive Vice President--Retail Group of FNBC from 1984 to 1989. Item 14. (a) 3. Exhibits 3.1 Amended and Restated Articles of Incorporation of First Commerce Corporation. 3.2 Amended By-laws of First Commerce Corporation. 4.1 Indenture between First Commerce Corporation and Republic Bank Dallas, N.A., Trustee, including the form of 12 3/4% Convertible Debenture due 2000, Series A included as Exhibit 4.1 to First Commerce Corporation's Annual Report on Form 10-K for the year ended December 31, 1985 and incorporated herein by reference. 4.2 Indenture between First Commerce Corporation and Republic Bank Dallas, N.A., Trustee, including the form of 12 3/4% Convertible Debenture due 2000, Series B included as Exhibit 4.2 to First Commerce Corporation's Annual Report on Form 10-K for the year ended December 31, 1986 and incorporated herein by reference. 10.1 Amendments numbered 8 and 9 to First Commerce Corporation 1985 Stock Option Plan and Form of Nonqualified Stock Option Ageerement, included as Exhibit 4-C and 4-D to First Commerce Corporation's Registration Statement (Registration No. 2-97152) on Form S-8, and incorporated herein by reference. 10.2 Amended First Commerce Corporation 1992 Stock Incentive Plan, Form of Nonqualified Stock Option Agreement and Form of Restricted Stock Agreement. 10.3 Amended First Commerce Corporation Supplemental Tax-Deferred Savings Plan. 10.4 First Commerce Corporation's Sharemax Corporate Incentive Plan. 10.5 First Commerce Corporation's Chief Executive Officer Sharemax Plan. 11 Statement Re: Computation of Earnings Per Share. 13 First Commerce Corporation's 1993 Annual Report to Stockholders. 21 Subsidiaries of First Commerce Corporation. 23 Consent of Arthur Andersen & Co. 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 Commerce Corporation (Registrant) By /s/ Thomas L. Callicutt, Jr. Thomas L. Callicutt, Jr. Senior Vice President, Controller and 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 and in the capacities on the dates indicated. Item 10. Executive Officers of the Registrant Ian Arnof, 54--President, Chief Executive Officer and Director of FCC since 1983. Amos T. Beason, 53--Executive Vice President and Chief Investment Officer of FCC since 1988. R. Jeffrey Brooks, 45--Executive Vice President and Director of Strategic Support of FCC since 1993; President and Chief Operating Officer of FNBL from 1992 to 1993; Senior Vice President and Bankcard Group Manager of FNBC from 1986 to 1992. Thomas L. Callicutt, Jr., 46--Senior Vice President, Controller and Principal Accounting Officer of FCC since 1987. Michael A. Flick, 45--Executive Vice President of FCC since 1985; Chief Credit Policy Officer of FCC since 1985; Chief Financial Officer from 1988 to 1992; Secretary to the Board of Directors since 1987. Howard C. Gaines, 53--Chairman and Chief Executive Officer of FNBC since 1988. Thomas C. Jaeger, 43--Senior Vice President and Chief Internal Auditor of FCC since 1989. Mr. Jaeger served as Senior Vice President and Chief Financial Officer of FNBC from 1987 to 1989. David B. Kelso, 41--Executive Vice President and Chief Financial Officer of FCC since 1992. Prior to joining FCC, Mr. Kelso was a consultant with the MAC Group in Washington, D.C. for more than five years. Ashton J. Ryan, Jr., 46--President and Chief Operating Officer of FNBC since 1991. Senior Executive Vice President of FCC since 1993. From 1981 to 1991, Mr. Ryan was a partner with Arthur Andersen & Co., CPAs, New Orleans, Louisiana. Joseph V. Wilson III, 44--Senior Executive Vice President of FCC since 1993; Executive Vice President of FCC from 1989 to 1992; Executive Vice President--Retail Group of FNBC from 1984 to 1989. Item 14. Item 14. (a) 3. Exhibits 3.1 Amended and Restated Articles of Incorporation of First Commerce Corporation. 3.2 Amended By-laws of First Commerce Corporation. 4.1 Indenture between First Commerce Corporation and Republic Bank Dallas, N.A., Trustee, including the form of 12 3/4% Convertible Debenture due 2000, Series A included as Exhibit 4.1 to First Commerce Corporation's Annual Report on Form 10-K for the year ended December 31, 1985 and incorporated herein by reference. 4.2 Indenture between First Commerce Corporation and Republic Bank Dallas, N.A., Trustee, including the form of 12 3/4% Convertible Debenture due 2000, Series B included as Exhibit 4.2 to First Commerce Corporation's Annual Report on Form 10-K for the year ended December 31, 1986 and incorporated herein by reference. 10.1 Amendments numbered 8 and 9 to First Commerce Corporation 1985 Stock Option Plan and Form of Nonqualified Stock Option Ageerement, included as Exhibit 4-C and 4-D to First Commerce Corporation's Registration Statement (Registration No. 2-97152) on Form S-8, and incorporated herein by reference. 10.2 Amended First Commerce Corporation 1992 Stock Incentive Plan, Form of Nonqualified Stock Option Agreement and Form of Restricted Stock Agreement. 10.3 Amended First Commerce Corporation Supplemental Tax-Deferred Savings Plan. 10.4 First Commerce Corporation's Sharemax Corporate Incentive Plan. 10.5 First Commerce Corporation's Chief Executive Officer Sharemax Plan. 11 Statement Re: Computation of Earnings Per Share. 13 First Commerce Corporation's 1993 Annual Report to Stockholders. 21 Subsidiaries of First Commerce Corporation. 23 Consent of Arthur Andersen & Co. 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 Commerce Corporation (Registrant) By /s/ Thomas L. Callicutt, Jr. Thomas L. Callicutt, Jr. Senior Vice President, Controller and 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 and in the capacities on the dates indicated.

858339_1993.txt

858339_1993

1993

858339

ITEM 3. LEGAL PROCEEDINGS. Bass Public Limited Company, Bass International Holdings N.V., Bass (U.S.A.) Incorporated, Holiday Corporation and Holiday Inns, Inc. (collectively "Bass") v. The Promus Companies Incorporated ("Promus"). A complaint was filed in the United States District Court for the Southern District of New York against Promus on February 6, 1992, under Civil Action No. 92 Civ. 0969(SWK). The complaint alleges violation of Rule 10b-5 of the federal securities laws, intentional and negligent misrepresentation, breach of express warranties, breach of contract, and express and equitable indemnification. The complaint generally alleges breaches of representations and warranties under the Merger Agreement with respect to the 1990 spin-off of Promus and acquisition of the Holiday Inn hotel business by Bass, violation of the federal securities laws due to such alleged breaches, and breaches of the Tax Sharing Agreement between Bass and Promus entered into at the closing of the Merger Agreement. The complaint seeks an unspecified amount of damages, unspecified punitive or exemplary damages, and declaratory relief. The Company believes that it has complied with all applicable laws and agreements with Bass in connection with the Merger and is defending its position vigorously. Promus has filed (a) an answer denying, and asserting affirmative defenses to, the substantive allegations of the complaint and (b) counterclaims alleging that Bass has breached the Tax Sharing Agreement and agreements ancillary to the Merger Agreement. The counterclaims request unspecified compensatory damages, injunctive and declaratory relief and Promus' costs, including reasonable attorneys fees and expenses. On April 17, 1992, Bass filed a motion seeking to disqualify the Company's outside counsel in the litigation, Latham & Watkins, on various grounds. That motion was denied by the trial court on January 7, 1994. Discovery has begun, but no trial date has been set. Certain tax matters. In connection with the Spin-off, Promus is liable, with certain exceptions, for taxes of Holiday and its subsidiaries for all pre-merger tax periods. Bass is obligated under the terms of the Tax Sharing Agreement to pay Promus the amount of any tax benefits realized from pre-merger tax periods of Holiday and its subsidiaries. All federal income taxes and interest assessed by the Internal Revenue Service ("IRS") for the 1978 through 1984 tax years were paid during 1992. The federal income taxes and interest thereon associated with the agreed issues from the IRS audit of the 1985 and 1986 tax years were paid in 1991. Negotiations with the IRS to resolve disputed issues for the 1985 and 1986 tax years were concluded and settlement reached during fourth quarter 1993. Final payment of the federal income taxes and related interest due under the settlement is expected to be made during second quarter 1994. The IRS has completed its examination of Holiday's federal income tax returns for 1987 through the Spin-off date and has issued its proposed adjustments to those returns. Federal income taxes and related interest assessed on agreed issues were paid subsequent to year-end. The total liability of approximately $23.7 million for the federal income tax and interest payments to be made, as discussed above, was included in current liabilities on December 31, 1993. A protest of all unagreed issues for the 1987 through Spin-off periods was filed with the IRS during the third quarter of 1993 and negotiations to resolve disputed issues are currently expected to begin during the second quarter of 1994. Final resolution of the disputed issues is not expected to have a materially adverse effect on Promus' consolidated 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 POSITIONS AND OFFICES HELD AND PRINCIPAL OCCUPATIONS OR EMPLOYMENT DURING PAST 5 NAME AND AGE YEARS - ----------------------------------- ------------------------------------------ Michael D. Rose (52)............... Chairman of the Board and Chief Executive Officer of Promus since November 1989. President of Promus (1989-1991). Chief Executive Officer (1981-1990), Chairman of the Board (1984-1990) and President (1988-1990) of Holiday. Effective April 29, 1994, Mr. Philip G. Satre will become Chief Executive Officer of Promus. Mr. Rose will continue as Chairman of the Board. Mr. Rose also is a director of Ashland Oil, Inc., First Tennessee National Corporation and General Mills, Inc. Philip G. Satre (44)............... Director, President and Chief Operating Officer of Promus since April 1991. Director and Senior Vice President of Promus (1989-1991). President (since 1984) and Chief Executive Officer (1984-1991) of Harrah's and Senior Vice President (1987-1990) and a Director (1988-1990) of Holiday. Effective April 29, 1994, Mr. Satre will become Chief Executive Officer of Promus in addition to his position as President. He also is a director of Goody's Family Clothing, Inc. John M. Boushy (39)................ Senior Vice President, Information Technology and Corporate Marketing of Promus since June 1993. Vice President, Strategic Marketing of Harrah's April 1989 to June 1993. Charles A. Ledsinger, Jr. (44)..... Senior Vice President and Chief Financial Officer of Promus since August 1990. Treasurer of Promus from November 1989 to February 1991. Vice President of Promus from November 1989 to August 1990. Vice President, Project Finance (1986-1990) of Holiday. He also is a director of Perkins Management Company, Inc., a privately-held general partner of Perkins Family Restaurants, L.P., a publicly-traded limited partnership. Ben C. Peternell (48).............. Senior Vice President, Corporate Human Resources and Communications of Promus since November 1989. Senior Vice President, Corporate Human Resources (1985-1990) of Holiday. Colin V. Reed (46)................. Senior Vice President, Corporate Development of Promus since May 1992. Vice President, Corporate Development of Promus from November 1989 to May 1992. Vice President (1988-1990) of Holiday. He also is a director of Sodak Gaming, Inc. E. O. Robinson, Jr. (54)........... Senior Vice President and General Counsel of Promus since April 1993 and Secretary of Promus since November 1989. Vice President and Associate General Counsel of Promus from November 1989 to April 1993. Vice President (1988-1990) of Holiday. PART II ITEM 5. ITEM 5. MARKET FOR THE COMPANY'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS. Information as to the principal markets in which the Company's Common Stock is traded and the high and low prices of such stock for the last two years is set forth on the inside back cover of Book Two of the Annual Report, which information is incorporated herein by reference. On February 26, 1993, the Company's Board of Directors authorized a two-for-one stock split (the "First Stock Split"), in the form of a stock dividend, which was effected by the distribution on March 29, 1993 of one additional share of Common Stock for each share of Common Stock owned by stockholders of record on March 8, 1993. On October 29, 1993, the Company's Board of Directors authorized a three-for-two stock split (the "Second Stock Split"), in the form of a stock dividend, which was effected by the distribution on November 29, 1993 of one additional share Common Stock for each two shares of Common Stock owned by stockholders of record on November 8, 1993. All references herein to dividends paid, numbers of common shares, per share prices and earnings per share amounts have been restated to give retroactive effect to the First Stock Split and the Second Stock Split. The approximate number of holders of record of the Company's Common Stock as of March 4, 1994, is as follows: The Company paid a special, one-time $10 (retroactively adjusted for the First Stock Split and the Second Stock Split) per share dividend to its common stockholders on February 22, 1990. The Company does not presently intend to declare any other cash dividends. The terms of the Company's Bank Facility substantially limit the Company's ability to pay cash dividends on Common Stock and limitations are also contained in agreements covering other debt of the Company. See "Management's Discussion and Analysis--Intercompany Dividend Restriction" on page 9 of Book Two of the Annual Report and Note 6 to the financial statements on pages 16 and 17 of Book Two of the Annual Report, which pages are incorporated herein by reference. When permitted under the terms of the Bank Facility and the other debt, the declaration and payment of dividends is at the discretion of the Board of Directors of the Company. The Board of Directors of the Company intends to reevaluate its dividend policy in the future in light of the Company's results of operations, financial condition, cash requirements, future prospects and other factors deemed relevant by the Board of Directors. There can be no assurance that any cash dividends on Common Stock will be paid in the future. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA. See the information for the years 1989 through 1993 set forth under "Selected Financial Data" in Book Two of the Annual Report on page 24, which page is incorporated herein by reference. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. See the information set forth in Book Two of the Annual Report on pages 2 through 9, which pages are incorporated herein by reference. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. See the information set forth in Book Two of the Annual Report on pages 10 through 24, which pages 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. DIRECTORS See the information regarding the names, ages, positions and prior business experience of the directors of the Company set forth on pages 4 through 6 of the Proxy Statement, which pages are incorporated herein by reference. EXECUTIVE OFFICERS See "Executive Officers of the Registrant" on page 31 in Part I hereof. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION. See the information set forth in the Proxy Statement on pages 6 and 7 thereof entitled "Compensation of Directors" and the information on pages 13 through 23 thereof. The information on pages 6 and 7 of the Proxy Statement entitled "Compensation of Directors" and the information on pages 18 through 23 of the Proxy Statement entitled "Summary Compensation Table," "Option Grants in the Last Fiscal Year," "Aggregated Option Exercises in 1993 and December 31, 1993, Option Values," and "Certain Employment Arrangements" are incorporated herein by reference. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. See the information set forth in the Proxy Statement on page 3 thereof entitled "Share Ownership of Directors and Executive Officers" and on pages 24 and 25 thereof entitled "Certain Stockholders," which information on said pages is incorporated herein by reference. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. See the information set forth in the Proxy Statement entitled "Certain Transactions" on pages 23 and 24 thereof, which information 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 (including related notes to consolidated financial statements)* filed as part of this report are listed below: Report of Independent Public Accountants Consolidated Balance Sheets as of December 31, 1993 and December 31, 1992. Consolidated Statements of Income for the Fiscal Years Ended December 31, 1993, December 31, 1992, and January 3, 1992. Consolidated Statements of Stockholders' Equity for the Fiscal Years Ended December 31, 1993, December 31, 1992, and January 3, 1992. Consolidated Statements of Cash Flows for the Fiscal Years Ended December 31, 1993, December 31, 1992, and January 3, 1992. - --------------- * Incorporated by reference from pages 10 through 23 of Book Two of the Annual Report. 2. Schedules for the fiscal years ended December 31, 1993, December 31, 1992, and January 3, 1992, are as follows: NO. - ----- II -Consolidated amounts receivable from related parties and underwriters, promoters, and employees other than related parties III -Condensed financial information of registrant V -Consolidated property and equipment VI -Consolidated accumulated depreciation and amortization of property and equipment VIII -Consolidated valuation and qualifying accounts X -Consolidated supplementary income statement information Schedules I, IV, VII, IX, XI, XII, XIII and XIV are not applicable and have therefore been omitted. 3. Exhibits (footnotes appear on pages 38 and 39): NO. - ------- 3(1) -Certificate of Incorporation of The Promus Companies Incorporated. (1) 3(2) -Bylaws of The Promus Companies Incorporated, as amended. (16) 4(1) -Rights Agreement dated as of February 7, 1990, between The Promus Companies Incorporated and The Bank of New York as Rights Agent. (12) 4(2) -Offering Circular dated February 9, 1988, for $200,000,000 Holiday Inns, Inc. 8 5/8% Notes due 1993 and $200,000,000 9% Notes due 1995; Indenture dated as of February 15, 1988, among Holiday Inns, Inc., Holiday Corporation and Sumitomo Bank of New York Trust Company, Trustee; Irrevocable Letter of Credit dated February 25, 1988, by The Sumitomo Bank, Limited, New York Branch. (3) 4(3) -Indenture Supplement No. 1 dated as of February 7, 1990, under Indenture dated as of February 15, 1988, among Holiday Inns, Inc., Holiday Corporation and Sumitomo Bank of New York Trust Company, Trustee; Amendment No. 1 dated February 7, 1990, to Irrevocable Letter of Credit dated February 25, 1988, by The Sumitomo Bank, Limited, New York Branch. (12) 4(4) -Indenture dated as of March 30, 1987, between Holiday Inns, Inc., Issuer, Holiday Corporation, Guarantor, and Commerce Union Bank (now Sovran Bank/Central South), Trustee; Prospectus dated March 5, 1987, for $900,000,000 Holiday Inns, Inc. 10 1/2% Senior Notes due 1994. (4) 4(5) -First Supplemental Indenture dated as of January 12, 1990, with respect to the 10 1/2% Senior Notes due 1994, among Sovran Bank/Central South, as trustee, Holiday Corporation, as guarantor, The Promus Companies Incorporated and Holiday Inns, Inc., as issuer; Second Supplemental Indenture dated as of February 7, 1990, with respect to the 10 1/2% Senior Notes due 1994, among Holiday Inns, Inc., Holiday Corporation, Embassy Suites, Inc., The Promus Companies Incorporated and Sovran Bank/Central South; Form of Note for 10 1/2% Senior Notes due 1994. (12) 4(6) -Indenture dated as of March 30, 1987, between Holiday Inns, Inc., Issuer, Holiday Corporation, Guarantor, and LaSalle National Bank, Trustee; Prospectus dated March 5, 1987, for $500,000,000 Holiday Inns, Inc. 11% Subordinated Debentures due 1999. (5) 4(7) -First Supplemental Indenture dated as of January 8, 1988, under Indenture dated as of March 30, 1987, among Holiday Inns, Inc., Holiday Corporation and LaSalle National Bank. (3) 4(8) -Second Supplemental Indenture dated as of February 23, 1988, under Indenture dated as of March 30, 1987, among Holiday Inns, Inc., Holiday Corporation, Guarantor, and LaSalle National Bank. (3) NO. - ------- 4(9) -Third Supplemental Indenture dated as of January 17, 1990, with respect to the 11% Subordinated Debentures due 1999, among LaSalle National Bank, as trustee, Holiday Corporation, as guarantor, The Promus Companies Incorporated and Holiday Inns, Inc., as issuer; Fourth Supplemental Indenture dated as of February 7, 1990, with respect to the 11% Subordinated Debentures due 1999, among Holiday Inns, Inc., Holiday Corporation, Embassy Suites, Inc., The Promus Companies Incorporated and LaSalle National Bank; Form of Debenture for 11% Subordinated Debentures due 1999. (12) 4(10) -Letter to Bank of New York dated March 18, 1993 constituting Certificate under Section 12 of the Rights Agreement dated as of February 7, 1990. (11) 4(11) -Interest Swap Agreement between Bank of America National Trust and Savings Association and Embassy Suites, Inc. dated May 14, 1993. (6) 4(12) -Interest Swap Agreement between NationsBank of North Carolina, N.A. and Embassy Suites, Inc. dated May 18, 1993. (6) 4(13) -First Supplemental Indenture dated as of July 15, 1987, among Irving Trust Company, as resigning trustee with respect to the 1999 Notes, Indiana National Bank as successor trustee with respect to the 1999 Notes and Holiday Inns, Inc.; Second Supplemental Indenture dated as of January 8, 1988, under Indenture dated as of January 15, 1984, between Holiday Inns, Inc., and Irving Trust Company, as trustee with respect to 8 3/8% Notes due 1996; Third Supplemental Indenture dated as of January 8, 1988, under Indenture dated as of January 15, 1984, among Holiday Inns, Inc., Irving Trust Company, as resigning trustee with respect to the 8 3/8% Notes due 1996, and LaSalle National Bank as successor trustee with respect to the 8 3/8% Notes due 1996; Fourth Supplemental Indenture dated as of February 23, 1988, under Indenture dated as of January 15, 1984, between Holiday Inns, Inc. and LaSalle National Bank, as trustee with respect to the 8 3/8% Notes due 1996. (3) 4(14) -Fifth Supplemental Indenture dated as of January 23, 1990, with respect to the 8 3/8% Notes due 1996, among LaSalle National Bank, as trustee, The Promus Companies Incorporated and Holiday Inns, Inc., as issuer; Sixth Supplemental Indenture dated as of February 7, 1990, with respect to the 8 3/8% Notes due 1996, among Holiday Inns, Inc., Embassy Suites, Inc., The Promus Companies Incorporated and LaSalle National Bank; Form of Note for 8 3/8% Notes due 1996. (12) 4(15) -Indenture dated as of April 1, 1992, with respect to the 10 7/8% Senior Subordinated Notes due 2002, among The Bank of New York, as trustee, The Promus Companies Incorporated, as guarantor, and Embassy Suites, Inc., as issuer; Form of Note for 10 7/8% Senior Subordinated Notes due 2002. (18) 4(16) -Indenture dated as of August 1, 1993, with respect to the 8 3/4% Senior Subordinated Notes due 2000, among The Bank of New York, as trustee, The Promus Companies Incorporated, as guarantor, and Embassy Suites, Inc., as issuer; Form of Note for 8 3/4% Senior Subordinated Notes due 2000. (6) 4(17) -Interest Swap Agreement between The Sumitomo Bank, Limited and Embassy Suites, Inc. dated October 22, 1992; Interest Swap Agreement between The Bank of Nova Scotia and Embassy Suites, Inc. dated October 22, 1992; Interest Swap Agreement between The Nippon Credit Bank and Embassy Suites, Inc. dated October 22, 1992; (18) 10(1) -Amended and Restated Agreement and Plan of Merger among Holiday Corporation, Holiday Inns, Inc., The Promus Companies Incorporated, Bass plc, Bass (U.S.A.) Hotels, Incorporated (a Delaware corporation) and Bass (U.S.A.) Hotels, Incorporated (a Tennessee corporation), dated as of August 24, 1989. (1) 10(2) -First Amendment to the Amended and Restated Agreement and Plan of Merger among Holiday Corporation, Holiday Inns, Inc., The Promus Companies Incorporated, Bass plc and Bass (U.S.A.) Hotels, Incorporated, dated as of February 7, 1990. (2) 10(3) -Tax Sharing Agreement dated as of February 7, 1990, among Holiday Corporation, Holiday Inns, Inc., The Promus Companies Incorporated, Bass plc, Bass European Holdings, N.V., Bass (U.S.A.), Inc. and Bass (U.S.A.) Hotels, Incorporated. (12) +10(4) -Form of Indemnification Agreement entered into by The Promus Companies Incorporated and each of its directors and executive officers. (1) +10(5) -The Promus Companies Incorporated 1990 Stock Option Plan. (12) - --------------- + Management contract or compensatory plan or arrangement required to be filed as an exhibit to this form pursuant to Item 14(a)(3) of Form 10-K. NO. - ------- +10(6) -The Promus Companies Incorporated 1990 Restricted Stock Plan. (12) +10(7) -The Promus Companies Incorporated Savings and Retirement Plan Trust Agreement. (12) +10(8) -Amendment to The Promus Companies Incorporated Savings and Retirement Plan dated May 1, 1991. (15) +10(9) -Financial Counseling Plan of The Promus Companies Incorporated as amended February 25, 1993. (11) +10(10) -Form of Severance Agreement dated July 30, 1993, entered into with E. O. Robinson, Jr. and John M. Boushy. (22) 10(11) -Credit Agreement, dated as of July 22, 1993, among Embassy Suites, Inc., The Promus Companies Incorporated, the Banks parties thereto, Marina Associates and Bankers Trust Company, as Administrative Agent. (19) 10(12) -Amended and Restated Reimbursement Agreement, dated as of July 22, 1993, among Embassy Suites, Inc., The Promus Companies Incorporated, Marina Associates and The Sumitomo Bank, Limited, New York Branch. (19) 10(13) -Master Collateral Agreement, dated as of July 22, 1993, among The Promus Companies Incorporated, Embassy Suites, Inc., the other Collateral Grantors parties thereto, Bankers Trust Company, as Administrative Agent, and Bankers Trust Company as Collateral Agent. (19) 10(14) -Security Agreement dated as of July 22, 1993, among Embassy Suites, Inc., the Collateral Grantors parties thereto and Bankers Trust Company, as Collateral Agent. (19) 10(15) -Deed of Trust, Leasehold Deed of Trust, Assignment, Assignment of Leases and Rents, Security Agreement and Financing Statement, dated as of July 22, 1993, from Embassy Suites, Inc., Harrah's Laughlin, Inc., and Harrah's Reno Holding Company, Inc., the Grantors, to First American Title Company of Nevada, as Trustee, for the benefit of Bankers Trust Company, as Beneficiary. (19) 10(16) -Mortgage, Leasehold Mortgage, Assignment, Assignment of Leases and Rents and Security Agreement, dated as of July 22, 1993, from Marina Associates and Embassy Suites, Inc., the Mortgagors, to Bankers Trust Company, as Collateral Agent and the Mortgagee. (19) 10(17) -Pledge Agreement, dated as of July 22, 1993, between The Promus Companies Incorporated and Bankers Trust Company, as Collateral Agent. (19) 10(18) -Pledge Agreement, dated as of July 22, 1993, among Embassy Suites, Inc., ESI Equity Development Corporation, Harrah's, Harrah's Club, Casino Holding Company, and Bankers Trust Company, as the General Collateral Agent, and Bank of America Nevada as the Nevada Collateral Agent. (19) 10(19) -Form of License Agreement for Hampton Inns. (7) 10(20) -Form of License Agreement for Hampton Inns revised 1988. (8) 10(21) -Form of License Agreement for Hampton Inns revised 1991. (15) 10(22) -Form of License Agreement for Hampton Inns revised 1992. (18) 10(23) -Form of License Agreement for Embassy Suites. (9) 10(24) -Form of License Agreement for Embassy Suites revised 1989. (12) 10(25) -Form of License Agreement for Embassy Suites revised 1990. (13) 10(26) -Form of License Agreement for Embassy Suites revised 1991. (15) 10(27) -Form of License Agreement for Embassy Suites revised 1992. (18) 10(28) -Form of Short-Term License Agreement for Embassy Suites. (12) 10(29) -Form of Short-Term License Agreement for Embassy Suites revised 1990. (13) 10(30) -Form of Short-Term License Agreement for Embassy Suites revised 1991. (15) 10(31) -Form of Short-Term License Agreement for Embassy Suites revised 1992. (18) 10(32) -Form of License Agreement for Homewood Suites. (3) 10(33) -Form of License Agreement for Homewood Suites revised 1992. (18) - --------------- + Management contract or compensatory plan or arrangement required to be filed as an exhibit to this form pursuant to Item 14(a)(3) of Form 10-K. NO. - ------- **10(34) -Form of License Agreement for Homewood Suites revised 1993. **10(35) -Form of License Agreement for Embassy Suites revised 1993. **10(36) -Form of Short-Term License Agreement for Embassy Suites revised 1993. **10(37) -Form of License Agreement for Hampton Inns revised 1993. **10(38) -Form of License Agreement for Hampton Inn & Suites. 10(39) -Management Agreement dated as of December 17, 1986, between Hampton Inns, Inc. and Hampton/GHI Associates No. 1. (10) 10(40) -Form of Management Agreement between Embassy Suites, Inc. and affiliates of General Electric Pension Trust. (10) +10(41) -Employment Agreement dated August 1, 1987 between Holiday Corporation and Michael D. Rose; Amendment to Employment Agreement dated as of January 31, 1990 between The Promus Companies Incorporated and Michael D. Rose. (12) +10(42) -Amended and Restated Severance Agreement dated as of May 1, 1992 between The Promus Companies Incorporated and Michael D. Rose. (18) +10(43) -Summary Plan Description of Executive Term Life Insurance Plan. (18) +10(44) -Forms of Stock Option (1990 Stock Option Plan). (12) +10(45) -Revised Forms of Stock Option (1990 Stock Option Plan). (18) +10(46) -Form of The Promus Companies Incorporated's Annual Bonus Plan, as amended, for Managers and Executives. (13) +10(47) -Forms of Restricted Stock Award (1990 Restricted Stock Plan). (12) +10(48) -Deferred Compensation Plan dated October 16, 1991. (15) +10(49) -Form of Deferred Compensation Agreement. (12) +10(50) -Form of Deferred Compensation Agreement revised November 1991. (15) +10(51) -Executive Deferred Compensation Plan. (12) +10(52) -First Amendment to Executive Deferred Compensation Plan, dated as of October 25, 1990. (13) +10(53) -Second Amendment to Executive Deferred Compensation Plan, dated as of October 25, 1991. (15) +10(54) -Third Amendment to Executive Deferred Compensation Plan, dated as of October 29, 1992. (18) +10(55) -Forms of Restricted Stock Award (1990 Restricted Stock Plan). (18) +10(56) -First Amendment to Escrow Agreement dated January 31, 1990 among Holiday Corporation, certain subsidiaries thereof and Sovran Bank, as escrow agent. (12) +10(57) -Escrow Agreement dated February 6, 1990 between The Promus Companies Incorporated, certain subsidiaries thereof, and Sovran Bank, as escrow agent. (12) +10(58) -Form of Amended and Restated Severance Agreement dated November 5, 1992, entered into with Charles A. Ledsinger, Jr., Ben C. Peternell, Philip G. Satre and Colin V. Reed. (18) +10(59) -Form of memorandum agreement dated July 2, 1991, eliminating stock appreciation rights under stock options held by Charles A. Ledsinger, Jr., Ben C. Peternell and Philip G. Satre. (14) +10(60) -The Promus Companies Incorporated Amended and Restated Savings and Retirement Plan dated as of February 6, 1990. (18) +10(61) -Administrative Regulations, Long Term Compensation Plan (Restricted Stock Plan and Stock Option Plan), dated as of January 1, 1992. (17) +10(62) -Amendment dated October 29, 1992 to The Promus Companies Incorporated Savings and Retirement Plan Trust Agreement; Amendment dated September 21, 1992 to The Promus Companies Incorporated Savings and Retirement Plan Trust Agreement (18) +10(63) -Revised Form of Stock Option. (21) +10(64) -The Promus Companies Incorporated 1990 Stock Option Plan (as amended as of April 30, 1993). (20) - --------------- ** Filed herewith + Management contract or compensatory plan or arrangement required to be filed as an exhibit to this form pursuant to Item 14(a)(3) of Form 10-K. NO. - ------- **10(65)-Limited Partnership Agreement of Des Plaines Limited Partnership between Harrah's Illinois Corporation and John Q. Hammons, dated February 28, 1992; First Amendment to Limited Partnership Agreement of Des Plaines Limited Partnership dated as of October 5, 1992. +**10(66)-Amendment to Escrow Agreement dated as of October 29, 1993 among The Promus Companies Incorporated, certain subsidiaries thereof, and NationsBank, formerly Sovran Bank. **10(67)-Amended and Restated Partnership Agreement of Harrah's Jazz Company, dated as of March 15, 1994, among Harrah's New Orleans Investment Company, New Orleans/Louisiana Development Corporation and Grand Palais Casino, Inc.; First Amendment to the Amended and Restated Partnership Agreement of Harrah's Jazz Company, effective as of March 15, 1994. 10(68) -Form of Rivergate Ground Lease by and among Harrah's Jazz Company, Rivergate Development Corporation and the City of New Orleans. (23) 10(69) -Form of General Development Agreement among Harrah's Jazz Company, Rivergate Development Corporation and the City of New Orleans. (23) 10(70) -Form of Temporary Casino Lease by and among Harrah's Jazz Company, Rivergate Development Corporation and the City of New Orleans. (23) 10(71) -Form of Casino Management Agreement between Harrah's Jazz Company and Harrah's New Orleans Management Company. (23) **11 -Computations of per share earnings. **12 -Computations of ratios. **13 -Portions of Annual Report to Stockholders for the fiscal year ended December 31, 1993. (24) **21 -List of subsidiaries of The Promus Companies Incorporated. 99(1) -Proxy Statement--Information Statement--Prospectus dated December 13, 1989 of Holiday Corporation, The Promus Companies Incorporated and Bass Public Limited Company. (12) - --------------- ** Filed herewith + Management contract or compensatory plan or arrangement required to be filed as an exhibit to this form pursuant to Item 14(a)(3) of Form 10-K. FOOTNOTES (1) Incorporated by reference from the Company's Registration Statement on Form 10, File No. 1-10410, filed on December 13, 1989. (2) Incorporated by reference from the Company's Current Report on Form 8-K dated February 16, 1990, File No. 1-10410. (3) Incorporated by reference from Holiday Corporation's Annual Report on Form 10-K for the fiscal year ended January 1, 1988, filed March 31, 1988, File No. 1-8900. (4) Incorporated by reference from Holiday Inns, Inc.'s Registration Statement on Form S-3, File No. 33-11770, filed February 24, 1987. (5) Incorporated by reference from Holiday Inns, Inc's Registration Statement on Form S-3, File No. 33-11163, filed December 31, 1986. (6) Incorporated by reference from the Company's and Embassy Suites, Inc.'s Amendment No. 2 to Form S-4 Registration Statement, File No. 33-49509-01, filed July 16, 1993. (7) Incorporated by reference from Holiday Inns, Inc.'s Annual Report on Form 10-K for the fiscal year ended December 30, 1983, filed March 21, 1984, File No. 1-4804. (8) Incorporated by reference from Holiday Corporation's Annual Report on Form 10-K for the fiscal year ended December 30, 1988, filed March 30, 1989, File No. 1-8900. (9) Incorporated by reference from Holiday Corporation's Annual Report on Form 10-K for the fiscal year ended January 3, 1986, filed March 28, 1986, File No. 1-8900. (10) Incorporated by reference from Holiday Corporation's Annual Report on Form 10-K for the fiscal year ended January 2, 1987, filed March 27, 1987, File No. 1-8900. (11) Incorporated by reference from the Company's Quarterly Report on Form 10-Q for the quarter ended March 31, 1993, filed May 13, 1993, File No. 1-10410. (12) Incorporated by reference from the Company's Annual Report on Form 10-K for the fiscal year ended December 29, 1989, filed March 28, 1990, File No. 1-10410. (13) Incorporated by reference from the Company's Annual Report on Form 10-K for the fiscal year ended December 28, 1990, filed March 21, 1991, File No. 1-10410. (14) Incorporated by reference from the Company's Quarterly Report on Form 10-Q for the quarter ended September 27, 1991, filed November 8, 1991, File No. 1-10410. (15) Incorporated by reference from Amendment No. 2 to the Company's and Embassy's Registration Statement on Form S-1, file No. 33-43748, filed March 18, 1992. (16) Incorporated by reference from the Company's Annual Report on Form 10-K for the fiscal year ended January 3, 1992, filed March 26, 1992, File No. 1-10410. (17) Incorporated by reference from the Company's Quarterly Report on Form 10-Q for the quarter ended March 31, 1992, filed May 13, 1992, File No. 1-10410. (18) Incorporated by reference from the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1992, filed March 12, 1993, File No. 1-10410. (19) Incorporated by reference from the Company's Current Report on Form 8-K filed August 6, 1993, File No. 1-10410. (20) Incorporated by reference from Post-Effective Amendment No. 1 to the Company's Form S-8 Registration Statement, File No. 33-32864-01, filed July 22, 1993. (21) Incorporated by reference from the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1993, filed August 12, 1993, File No. 1-10410. (22) Incorporated by reference from the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1993, filed November 12, 1993, File No. 1-10410. (23) Incorporated by reference from Amendment No. 1 to Form S-1 Registration Statement of Harrah's Jazz Company and Harrah's Jazz Finance Corp., File No. 33-73370, filed February 22, 1994. (24) Filed herewith to the extent provisions of such report are specifically incorporated herein by reference. (b) The following Reports on Form 8-K were filed during the fourth quarter of 1993 and thereafter through March 24, 1994: NONE 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. THE PROMUS COMPANIES INCORPORATED Dated: March 28, 1994 By: MICHAEL D. ROSE .................................. (Michael D. Rose, 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 IN THE CAPACITIES AND ON THE DATES INDICATED. Signature Title Date - ------------------------------------- ------------------------ -------------- JAMES L. BARKSDALE Director March 28, 1994 ..................................... (James L. Barksdale) JAMES B. FARLEY Director March 28, 1994 ..................................... (James B. Farley) JOE M. HENSON Director March 28, 1994 ..................................... (Joe M. Henson) MICHAEL D. ROSE Director and Chief March 28, 1994 ..................................... Executive Officer (Michael D. Rose) WALTER J. SALMON Director March 28, 1994 ..................................... (Walter J. Salmon) PHILIP G. SATRE Director, President and March 28, 1994 ..................................... Chief Operating (Philip G. Satre) Officer BOAKE A. SELLS Director March 28, 1994 ..................................... (Boake A. Sells) RONALD TERRY Director March 28, 1994 ..................................... (Ronald Terry) EDDIE N. WILLIAMS Director March 28, 1994 ..................................... (Eddie N. Williams) SHIRLEY YOUNG Director March 28, 1994 ..................................... (Shirley Young) CHARLES A. LEDSINGER, JR. Chief Financial Officer March 28, 1994 ..................................... (Charles A. Ledsinger, Jr.) MICHAEL N. REGAN Controller and Principal March 28, 1994 ..................................... Accounting Officer (Michael N. Regan) REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To The Promus Companies Incorporated: We have audited in accordance with generally accepted auditing standards, the financial statements included in The Promus Companies Incorporated 1993 annual report to stockholders, incorporated by reference in this Form 10-K, and have issued our report thereon dated February 8, 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 on page 34 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. Memphis, Tennessee, February 8, 1994. SCHEDULE II THE PROMUS COMPANIES INCORPORATED CONSOLIDATED AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS, AND EMPLOYEES OTHER THAN RELATED PARTIES S-1 SCHEDULE III THE PROMUS COMPANIES INCORPORATED CONDENSED FINANCIAL INFORMATION OF REGISTRANT BALANCE SHEETS (IN THOUSANDS) The accompanying Notes to Financial Statements are an integral part of these balance sheets. S-2 SCHEDULE III (CONTINUED) THE PROMUS COMPANIES INCORPORATED CONDENSED FINANCIAL INFORMATION OF REGISTRANT STATEMENTS OF INCOME (IN THOUSANDS) The accompanying Notes to Financial Statements are an integral part of these statements. S-3 SCHEDULE III (CONTINUED) THE PROMUS COMPANIES INCORPORATED CONDENSED FINANCIAL INFORMATION OF REGISTRANT STATEMENTS OF CASH FLOWS (IN THOUSANDS) The accompanying Notes to Financial Statements are an integral part of these statements. S-4 SCHEDULE III (CONTINUED) THE PROMUS COMPANIES INCORPORATED CONDENSED FINANCIAL INFORMATION OF REGISTRANT NOTES TO FINANCIAL STATEMENTS DECEMBER 31, 1993 NOTE 1--BASIS OF ORGANIZATION The Promus Companies Incorporated (Promus), a Delaware corporation, is a holding company, the principal assets of which are the capital stock of two subsidiaries, Embassy Suites, Inc. (Embassy) and Aster Insurance Ltd. (Aster). These condensed financial statements should be read in conjunction with the consolidated financial statements of Promus and subsidiaries. NOTE 2--FISCAL YEAR As of the beginning of fiscal 1992, Promus changed from a fiscal year to a calendar year for financial reporting purposes. The impact of this change on Promus' financial statements was immaterial. NOTE 3--ORGANIZATIONAL COSTS Organizational costs are being amortized on a straight-line basis over a five year period. NOTE 4--OWNERSHIP OF ASTER The value of Promus' investment in Aster has been reduced below zero. Promus' negative investment in Aster at December 31, 1993 and 1992 was $12.8 million and $10.9 million, respectively, and is included in investments in and advances to subsidiaries on the accompanying balance sheets. In addition, Promus has guaranteed the future payment by Aster of certain insurance-related liabilities. NOTE 5--LONG-TERM DEBT Promus has no long-term debt obligations. Promus has guaranteed certain long-term debt obligations of Embassy. NOTE 6--STOCKHOLDERS' EQUITY On October 29, 1993, Promus' Board of Directors approved a three-for-two stock split (the October split), in the form of a stock dividend, effected by a distribution on November 29, 1993, of one additional share for each two shares owned by stockholders of record on November 8, 1993. The October split followed a two-for-one split, also effected as a stock dividend, approved by the Board on February 26, 1993, and distributed on March 29, 1993. The $1.50 par value per share of Promus' common stock was unchanged by these splits. The par value of the additional shares issued as a result of these splits was capitalized into common stock on the accompanying balance sheets by means of a transfer from capital surplus. All references in these financial statements to numbers of common shares and earnings per share have been restated to give retroactive effect to both stock splits. During the second quarter of 1993, Sodak Gaming, Inc. (Sodak), in which a subsidiary of Embassy owns an equity investment, completed an initial public offering of its common stock. As required by equity accounting rules, Embassy's subsidiary increased the carrying value of its investment in Sodak by an amount equal to its pro rata share of the proceeds of Sodak's offering, approximately $6.4 million. A corresponding increase was recorded in the combination of the subsidary's capital surplus and S-5 SCHEDULE III (CONTINUED) THE PROMUS COMPANIES INCORPORATED CONDENSED FINANCIAL INFORMATION OF REGISTRANT NOTES TO FINANCIAL STATEMENTS DECEMBER 31, 1993 NOTE 6--STOCKHOLDERS' EQUITY (CONTINUED) deferred income tax liability accounts. As a result of this activity, Promus increased its investment in Embassy and its capital surplus by approximately $3.8 million. In addition to its common stock, Promus has the following classes of stock authorized but unissued: Preferred stock, $100 par value, 150,000 shares authorized Special stock, 5,000,000 shares authorized- Series B, $1.125 par value NOTE 7--INCOME TAXES Promus files a consolidated tax return with its subsidiaries. During 1992, Promus and its subsidiaries adopted Statement of Financial Accounting Standards No. 109, Accounting for Income Taxes. The provisions of the statement were applied retroactively to the Spin-off date (February 7, 1990), and the cumulative effect of this change in accounting for income taxes of approximately $9.5 million was charged against stockholders' equity. There were no changes in the amounts of previously reported income from continuing operations or net income resulting from the application of this statement. NOTE 8--EXTRAORDINARY ITEMS Promus' equity in Embassy's net extraordinary items for fiscal 1993 and 1992 was as follows: S-6 SCHEDULE V THE PROMUS COMPANIES INCORPORATED CONSOLIDATED PROPERTY AND EQUIPMENT - --------------- (A) Principally construction of new casino facilities and refurbishment of existing casino and hotel properties, including transfers from construction-in-progress. (B) Land held for future development or disposition is included in property held for future use and amounted to $42.1 million, net of an $11.0 million reserve for property dispositions. S-7 SCHEDULE V (CONTINUED) THE PROMUS COMPANIES INCORPORATED CONSOLIDATED PROPERTY AND EQUIPMENT - --------------- (A) Principally refurbishment and expansion of casino and hotel properties, including transfers from construction-in-progress. (B) Land held for future development or disposition is included in property held for future use and amounted to $41.4 million, which is net of an $11.0 million reserve for property dispositions. S-8 SCHEDULE V (CONTINUED) THE PROMUS COMPANIES INCORPORATED CONSOLIDATED PROPERTY AND EQUIPMENT - --------------- (A) Principally refurbishment and expansion of casino and hotel properties, including transfers from construction-in-progress. (B) Principally transfers from deferred charges of $7.8 million, partially offset by the transfer to investments in nonconsolidated affiliates of $1.0 million in assets contributed to a joint venture. (C) Land held for future development or disposition is included in property held for future use and amounted to $41.4 million, which is net of an $11.0 million reserve for property dispositions. S-9 SCHEDULE VI THE PROMUS COMPANIES INCORPORATED CONSOLIDATED ACCUMULATED DEPRECIATION AND AMORTIZATION OF PROPERTY AND EQUIPMENT S-10 SCHEDULE VIII THE PROMUS COMPANIES INCORPORATED CONSOLIDATED VALUATION AND QUALIFYING ACCOUNTS - --------------- (A) Uncollectible accounts written off, net of amounts recovered. (B) Amortization of reserve balance. (C) Write-off at time of property dispositions. S-11 SCHEDULE X THE PROMUS COMPANIES INCORPORATED CONSOLIDATED SUPPLEMENTARY INCOME STATEMENT INFORMATION S-12 CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS As independent public accountants, we hereby consent to the incorporation of our reports dated February 8, 1994, included in or incorporated by reference in this Form 10-K for the year ended December 31, 1993, into the Company's previously filed Registration Statements File Nos. 33-32863, 33-32864 and 33-32865. ARTHUR ANDERSEN & CO. Memphis, Tennessee, March 28, 1994. EXHIBIT INDEX NO. - ------- 3(1) -Certificate of Incorporation of The Promus Companies Incorporated. (1) 3(2) -Bylaws of The Promus Companies Incorporated, as amended. (16) 4(1) -Rights Agreement dated as of February 7, 1990, between The Promus Companies Incorporated and The Bank of New York as Rights Agent. (12) 4(2) -Offering Circular dated February 9, 1988, for $200,000,000 Holiday Inns, Inc. 8 5/8% Notes due 1993 and $200,000,000 9% Notes due 1995; Indenture dated as of February 15, 1988, among Holiday Inns, Inc., Holiday Corporation and Sumitomo Bank of New York Trust Company, Trustee; Irrevocable Letter of Credit dated February 25, 1988, by The Sumitomo Bank, Limited, New York Branch. (3) 4(3) -Indenture Supplement No. 1 dated as of February 7, 1990, under Indenture dated as of February 15, 1988, among Holiday Inns, Inc., Holiday Corporation and Sumitomo Bank of New York Trust Company, Trustee; Amendment No. 1 dated February 7, 1990, to Irrevocable Letter of Credit dated February 25, 1988, by The Sumitomo Bank, Limited, New York Branch. (12) 4(4) -Indenture dated as of March 30, 1987, between Holiday Inns, Inc., Issuer, Holiday Corporation, Guarantor, and Commerce Union Bank (now Sovran Bank/Central South), Trustee; Prospectus dated March 5, 1987, for $900,000,000 Holiday Inns, Inc. 10 1/2% Senior Notes due 1994. (4) 4(5) -First Supplemental Indenture dated as of January 12, 1990, with respect to the 10 1/2% Senior Notes due 1994, among Sovran Bank/Central South, as trustee, Holiday Corporation, as guarantor, The Promus Companies Incorporated and Holiday Inns, Inc., as issuer; Second Supplemental Indenture dated as of February 7, 1990, with respect to the 10 1/2% Senior Notes due 1994, among Holiday Inns, Inc., Holiday Corporation, Embassy Suites, Inc., The Promus Companies Incorporated and Sovran Bank/Central South; Form of Note for 10 1/2% Senior Notes due 1994. (12) 4(6) -Indenture dated as of March 30, 1987, between Holiday Inns, Inc., Issuer, Holiday Corporation, Guarantor, and LaSalle National Bank, Trustee; Prospectus dated March 5, 1987, for $500,000,000 Holiday Inns, Inc. 11% Subordinated Debentures due 1999. (5) 4(7) -First Supplemental Indenture dated as of January 8, 1988, under Indenture dated as of March 30, 1987, among Holiday Inns, Inc., Holiday Corporation and LaSalle National Bank. (3) 4(8) -Second Supplemental Indenture dated as of February 23, 1988, under Indenture dated as of March 30, 1987, among Holiday Inns, Inc., Holiday Corporation, Guarantor, and LaSalle National Bank. (3) 4(9) -Third Supplemental Indenture dated as of January 17, 1990, with respect to the 11% Subordinated Debentures due 1999, among LaSalle National Bank, as trustee, Holiday Corporation, as guarantor, The Promus Companies Incorporated and Holiday Inns, Inc., as issuer; Fourth Supplemental Indenture dated as of February 7, 1990, with respect to the 11% Subordinated Debentures due 1999, among Holiday Inns, Inc., Holiday Corporation, Embassy Suites, Inc., The Promus Companies Incorporated and LaSalle National Bank; Form of Debenture for 11% Subordinated Debentures due 1999. (12) 4(10) -Letter to Bank of New York dated March 18, 1993 constituting Certificate under Section 12 of the Rights Agreement dated as of February 7, 1990. (11) 4(11) -Interest Swap Agreement between Bank of America National Trust and Savings Association and Embassy Suites, Inc. dated May 14, 1993. (6) 4(12) -Interest Swap Agreement between NationsBank of North Carolina, N.A. and Embassy Suites, Inc. dated May 18, 1993. (6) NO. - ------- 4(13) -First Supplemental Indenture dated as of July 15, 1987, among Irving Trust Company, as resigning trustee with respect to the 1999 Notes, Indiana National Bank as successor trustee with respect to the 1999 Notes and Holiday Inns, Inc.; Second Supplemental Indenture dated as of January 8, 1988, under Indenture dated as of January 15, 1984, between Holiday Inns, Inc., and Irving Trust Company, as trustee with respect to 8 3/8% Notes due 1996; Third Supplemental Indenture dated as of January 8, 1988, under Indenture dated as of January 15, 1984, among Holiday Inns, Inc., Irving Trust Company, as resigning trustee with respect to the 8 3/8% Notes due 1996, and LaSalle National Bank as successor trustee with respect to the 8 3/8% Notes due 1996; Fourth Supplemental Indenture dated as of February 23, 1988, under Indenture dated as of January 15, 1984, between Holiday Inns, Inc. and LaSalle National Bank, as trustee with respect to the 8 3/8% Notes due 1996. (3) 4(14) -Fifth Supplemental Indenture dated as of January 23, 1990, with respect to the 8 3/8% Notes due 1996, among LaSalle National Bank, as trustee, The Promus Companies Incorporated and Holiday Inns, Inc., as issuer; Sixth Supplemental Indenture dated as of February 7, 1990, with respect to the 8 3/8% Notes due 1996, among Holiday Inns, Inc., Embassy Suites, Inc., The Promus Companies Incorporated and LaSalle National Bank; Form of Note for 8 3/8% Notes due 1996. (12) 4(15) -Indenture dated as of April 1, 1992, with respect to the 10 7/8% Senior Subordinated Notes due 2002, among The Bank of New York, as trustee, The Promus Companies Incorporated, as guarantor, and Embassy Suites, Inc., as issuer; Form of Note for 10 7/8% Senior Subordinated Notes due 2002. (18) 4(16) -Indenture dated as of August 1, 1993, with respect to the 8 3/4% Senior Subordinated Notes due 2000, among The Bank of New York, as trustee, The Promus Companies Incorporated, as guarantor, and Embassy Suites, Inc., as issuer; Form of Note for 8 3/4% Senior Subordinated Notes due 2000. (6) 4(17) -Interest Swap Agreement between The Sumitomo Bank, Limited and Embassy Suites, Inc. dated October 22, 1992; Interest Swap Agreement between The Bank of Nova Scotia and Embassy Suites, Inc. dated October 22, 1992; Interest Swap Agreement between The Nippon Credit Bank and Embassy Suites, Inc. dated October 22, 1992; (18) 10(1) -Amended and Restated Agreement and Plan of Merger among Holiday Corporation, Holiday Inns, Inc., The Promus Companies Incorporated, Bass plc, Bass (U.S.A.) Hotels, Incorporated (a Delaware corporation) and Bass (U.S.A.) Hotels, Incorporated (a Tennessee corporation), dated as of August 24, 1989. (1) 10(2) -First Amendment to the Amended and Restated Agreement and Plan of Merger among Holiday Corporation, Holiday Inns, Inc., The Promus Companies Incorporated, Bass plc and Bass (U.S.A.) Hotels, Incorporated, dated as of February 7, 1990. (2) 10(3) -Tax Sharing Agreement dated as of February 7, 1990, among Holiday Corporation, Holiday Inns, Inc., The Promus Companies Incorporated, Bass plc, Bass European Holdings, N.V., Bass (U.S.A.), Inc. and Bass (U.S.A.) Hotels, Incorporated. (12) 10(4) -Form of Indemnification Agreement entered into by The Promus Companies Incorporated and each of its directors and executive officers. (1) 10(5) -The Promus Companies Incorporated 1990 Stock Option Plan. (12) 10(6) -The Promus Companies Incorporated 1990 Restricted Stock Plan. (12) 10(7) -The Promus Companies Incorporated Savings and Retirement Plan Trust Agreement. (12) 10(8) -Amendment to The Promus Companies Incorporated Savings and Retirement Plan dated May 1, 1991. (15) NO. - ------- +10(9) -Financial Counseling Plan of The Promus Companies Incorporated as amended February 25, 1993. (11) +10(10) -Form of Severance Agreement dated July 30, 1993, entered into with E. O. Robinson, Jr. and John M. Boushy. (22) 10(11) -Credit Agreement, dated as of July 22, 1993, among Embassy Suites, Inc., The Promus Companies Incorporated, the Banks parties thereto, Marina Associates and Bankers Trust Company, as Administrative Agent. (19) 10(12) -Amended and Restated Reimbursement Agreement, dated as of July 22, 1993, among Embassy Suites, Inc., The Promus Companies Incorporated, Marina Associates and The Sumitomo Bank, Limited, New York Branch. (19) 10(13) -Master Collateral Agreement, dated as of July 22, 1993, among The Promus Companies Incorporated, Embassy Suites, Inc., the other Collateral Grantors parties thereto, Bankers Trust Company, as Administrative Agent, and Bankers Trust Company as Collateral Agent. (19) 10(14) -Security Agreement dated as of July 22, 1993, among Embassy Suites, Inc., the Collateral Grantors parties thereto and Bankers Trust Company, as Collateral Agent. (19) 10(15) -Deed of Trust, Leasehold Deed of Trust, Assignment, Assignment of Leases and Rents, Security Agreement and Financing Statement, dated as of July 22, 1993, from Embassy Suites, Inc., Harrah's Laughlin, Inc., and Harrah's Reno Holding Company, Inc., the Grantors, to First American Title Company of Nevada, as Trustee, for the benefit of Bankers Trust Company, as Beneficiary. (19) 10(16) -Mortgage, Leasehold Mortgage, Assignment, Assignment of Leases and Rents and Security Agreement, dated as of July 22, 1993, from Marina Associates and Embassy Suites, Inc., the Mortgagors, to Bankers Trust Company, as Collateral Agent and the Mortgagee. (19) 10(17) -Pledge Agreement, dated as of July 22, 1993, between The Promus Companies Incorporated and Bankers Trust Company, as Collateral Agent. (19) 10(18) -Pledge Agreement, dated as of July 22, 1993, among Embassy Suites, Inc., ESI Equity Development Corporation, Harrah's, Harrah's Club, Casino Holding Company, and Bankers Trust Company, as the General Collateral Agent, and Bank of America Nevada as the Nevada Collateral Agent. (19) 10(19) -Form of License Agreement for Hampton Inns. (7) 10(20) -Form of License Agreement for Hampton Inns revised 1988. (8) 10(21) -Form of License Agreement for Hampton Inns revised 1991. (15) 10(22) -Form of License Agreement for Hampton Inns revised 1992. (18) 10(23) -Form of License Agreement for Embassy Suites. (9) 10(24) -Form of License Agreement for Embassy Suites revised 1989. (12) 10(25) -Form of License Agreement for Embassy Suites revised 1990. (13) 10(26) -Form of License Agreement for Embassy Suites revised 1991. (15) 10(27) -Form of License Agreement for Embassy Suites revised 1992. (18) 10(28) -Form of Short-Term License Agreement for Embassy Suites. (12) 10(29) -Form of Short-Term License Agreement for Embassy Suites revised 1990. (13) 10(30) -Form of Short-Term License Agreement for Embassy Suites revised 1991. (15) 10(31) -Form of Short-Term License Agreement for Embassy Suites revised 1992. (18) 10(32) -Form of License Agreement for Homewood Suites. (3) 10(33) -Form of License Agreement for Homewood Suites revised 1992. (18) - --------------- + Management contract or compensatory plan or arrangement required to be filed as an exhibit to this form pursuant to Item 14(a)(3) of Form 10-K. NO. - ------- **10(34) -Form of License Agreement for Homewood Suites revised 1993. **10(35) -Form of License Agreement for Embassy Suites revised 1993. **10(36) -Form of Short-Term License Agreement for Embassy Suites revised 1993. **10(37) -Form of License Agreement for Hampton Inns revised 1993. **10(38) -Form of License Agreement for Hampton Inn & Suites. 10(39) -Management Agreement dated as of December 17, 1986, between Hampton Inns, Inc. and Hampton/GHI Associates No. 1. (10) 10(40) -Form of Management Agreement between Embassy Suites, Inc. and affiliates of General Electric Pension Trust. (10) +10(41) -Employment Agreement dated August 1, 1987 between Holiday Corporation and Michael D. Rose; Amendment to Employment Agreement dated as of January 31, 1990 between The Promus Companies Incorporated and Michael D. Rose. (12) +10(42) -Amended and Restated Severance Agreement dated as of May 1, 1992 between The Promus Companies Incorporated and Michael D. Rose. (18) +10(43) -Summary Plan Description of Executive Term Life Insurance Plan. (18) +10(44) -Forms of Stock Option (1990 Stock Option Plan). (12) +10(45) -Revised Forms of Stock Option (1990 Stock Option Plan). (18) +10(46) -Form of The Promus Companies Incorporated's Annual Bonus Plan, as amended, for Managers and Executives. (13) +10(47) -Forms of Restricted Stock Award (1990 Restricted Stock Plan). (12) +10(48) -Deferred Compensation Plan dated October 16, 1991. (15) +10(49) -Form of Deferred Compensation Agreement. (12) +10(50) -Form of Deferred Compensation Agreement revised November 1991. (15) +10(51) -Executive Deferred Compensation Plan. (12) +10(52) -First Amendment to Executive Deferred Compensation Plan, dated as of October 25, 1990. (13) +10(53) -Second Amendment to Executive Deferred Compensation Plan, dated as of October 25, 1991. (15) +10(54) -Third Amendment to Executive Deferred Compensation Plan, dated as of October 29, 1992. (18) +10(55) -Forms of Restricted Stock Award (1990 Restricted Stock Plan). (18) +10(56) -First Amendment to Escrow Agreement dated January 31, 1990 among Holiday Corporation, certain subsidiaries thereof and Sovran Bank, as escrow agent. (12) +10(57) -Escrow Agreement dated February 6, 1990 between The Promus Companies Incorporated, certain subsidiaries thereof, and Sovran Bank, as escrow agent. (12) +10(58) -Form of Amended and Restated Severance Agreement dated November 5, 1992, entered into with Charles A. Ledsinger, Jr., Ben C. Peternell, Philip G. Satre and Colin V. Reed. (18) +10(59) -Form of memorandum agreement dated July 2, 1991, eliminating stock appreciation rights under stock options held by Charles A. Ledsinger, Jr., Ben C. Peternell and Philip G. Satre. (14) +10(60) -The Promus Companies Incorporated Amended and Restated Savings and Retirement Plan dated as of February 6, 1990. (18) +10(61) -Administrative Regulations, Long Term Compensation Plan (Restricted Stock Plan and Stock Option Plan), dated as of January 1, 1992. (17) +10(62) -Amendment dated October 29, 1992 to The Promus Companies Incorporated Savings and Retirement Plan Trust Agreement; Amendment dated September 21, 1992 to The Promus Companies Incorporated Savings and Retirement Plan Trust Agreement (18) +10(63) -Revised Form of Stock Option. (21) +10(64) -The Promus Companies Incorporated 1990 Stock Option Plan (as amended as of April 30, 1993). (20) - --------------- ** Filed herewith + Management contract or compensatory plan or arrangement required to be filed as an exhibit to this form pursuant to Item 14(a)(3) of Form 10-K. NO. - ------- **10(65)-Limited Partnership Agreement of Des Plaines Limited Partnership between Harrah's Illinois Corporation and John Q. Hammons, dated February 28, 1992; First Amendment to Limited Partnership Agreement of Des Plaines Limited Partnership dated as of October 5, 1992. +**10(66)-Amendment to Escrow Agreement dated as of October 29, 1993 among The Promus Companies Incorporated, certain subsidiaries thereof, and NationsBank, formerly Sovran Bank. **10(67)-Amended and Restated Partnership Agreement of Harrah's Jazz Company, dated as of March 15, 1994, among Harrah's New Orleans Investment Company, New Orleans/Louisiana Development Corporation and Grand Palais Casino, Inc.; First Amendment to the Amended and Restated Partnership Agreement of Harrah's Jazz Company, effective as of March 15, 1994. 10(68) -Form of Ground Lease by and among Harrah's Jazz Company, Rivergate Development Corporation and the City of New Orleans. (23) 10(69) -Form of General Development Agreement among Harrah's Jazz Company, Rivergate Development Corporation and the City of New Orleans. (23) 10(70) -Form of Temporary Casino Lease by and among Harrah's Jazz Company, Rivergate Development Corporation and the City of New Orleans. (23) 10(71) -Form of Casino Management Agreement between Harrah's Jazz Company and Harrah's New Orleans Management Company. (23) **11 -Computations of per share earnings. **12 -Computations of ratios. **13 -Portions of Annual Report to Stockholders for the fiscal year ended December 31, 1993. (24) **21 -List of subsidiaries of The Promus Companies Incorporated. 99(1) -Proxy Statement--Information Statement--Prospectus dated December 13, 1989 of Holiday Corporation, The Promus Companies Incorporated and Bass Public Limited Company. (12) - --------------- ** Filed herewith + Management contract or compensatory plan or arrangement required to be filed as an exhibit to this form pursuant to Item 14(a)(3) of Form 10-K. FOOTNOTES (1) Incorporated by reference from the Company's Registration Statement on Form 10, File No. 1-10410, filed on December 13, 1989. (2) Incorporated by reference from the Company's Current Report on Form 8-K dated February 16, 1990, File No. 1-10410. (3) Incorporated by reference from Holiday Corporation's Annual Report on Form 10-K for the fiscal year ended January 1, 1988, filed March 31, 1988, File No. 1-8900. (4) Incorporated by reference from Holiday Inns, Inc.'s Registration Statement on Form S-3, File No. 33-11770, filed February 24, 1987. (5) Incorporated by reference from Holiday Inns, Inc's Registration Statement on Form S-3, File No. 33-11163, filed December 31, 1986. (6) Incorporated by reference from the Company's and Embassy Suites, Inc.'s Amendment No. 2 to Form S-4 Registration Statement, File No. 33-49509-01, filed July 16, 1993. (7) Incorporated by reference from Holiday Inns, Inc.'s Annual Report on Form 10-K for the fiscal year ended December 30, 1983, filed March 21, 1984, File No. 1-4804. (8) Incorporated by reference from Holiday Corporation's Annual Report on Form 10-K for the fiscal year ended December 30, 1988, filed March 30, 1989, File No. 1-8900. (9) Incorporated by reference from Holiday Corporation's Annual Report on Form 10-K for the fiscal year ended January 3, 1986, filed March 28, 1986, File No. 1-8900. (10) Incorporated by reference from Holiday Corporation's Annual Report on Form 10-K for the fiscal year ended January 2, 1987, filed March 27, 1987, File No. 1-8900. (11) Incorporated by reference from the Company's Quarterly Report on Form 10-Q for the quarter ended March 31, 1993, filed May 13, 1993, File No. 1-10410. (12) Incorporated by reference from the Company's Annual Report on Form 10-K for the fiscal year ended December 29, 1989, filed March 28, 1990, File No. 1-10410. (13) Incorporated by reference from the Company's Annual Report on Form 10-K for the fiscal year ended December 28, 1990, filed March 21, 1991, File No. 1-10410. (14) Incorporated by reference from the Company's Quarterly Report on Form 10-Q for the quarter ended September 27, 1991, filed November 8, 1991, File No. 1-10410. (15) Incorporated by reference from Amendment No. 2 to the Company's and Embassy's Registration Statement on Form S-1, file No. 33-43748, filed March 18, 1992. (16) Incorporated by reference from the Company's Annual Report on Form 10-K for the fiscal year ended January 3, 1992, filed March 26, 1992, File No. 1-10410. (17) Incorporated by reference from the Company's Quarterly Report on Form 10-Q for the quarter ended March 31, 1992, filed May 13, 1992, File No. 1-10410. (18) Incorporated by reference from the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1992, filed March 12, 1993, File No. 1-10410. (19) Incorporated by reference from the Company's Current Report on Form 8-K filed August 6, 1993, File No. 1-10410. (20) Incorporated by reference from Post-Effective Amendment No. 1 to Form S-8 Registration Statement, File No. 33-32864-01, filed July 22, 1993. (21) Incorporated by reference from the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1993, filed August 12, 1993, File No. 1-10410. (22) Incorporated by reference from the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1993, filed November 12, 1993, File No. 1-10410. (23) Incorporated by reference from Amendment No. 1 to Form S-1 Registration Statement, File No. 33-73370, filed February 22, 1994. (24) Filed herewith to the extent provisions of such report are specifically incorporated herein by reference.

78814_1993.txt

78814_1993

1993

78814

Item 1. Business Pitney Bowes Inc. and its subsidiaries (the "company") operates in three industry segments: business equipment, business supplies and services, and financial services. The company's operations are in the following geographic areas: the United States, Europe, and Canada and other countries. Financial information concerning revenue, operating profit and identifiable assets by industry segment and geographic area appears on page 21 of the Pitney Bowes Inc. 1993 Annual Report to Stockholders and is incorporated herein by reference. Business Equipment. Business equipment consists of three product classes: mailing systems, copying systems and voice processing systems. These products are sold, rented or leased (see "Financial Services") by the company and through dealers. Revenue for each product class is included in the financial information incorporated herein by reference. Mailing systems include postage meters, parcel registers, mailing machines, manifest systems, letter and parcel scales, mail openers, mailroom furniture, folders, paper handling and shipping equipment, and facsimile machines. Copying systems include a wide range of copying systems and supplies. Voice processing systems include small work group and central dictation and voice processing systems, communications recorders and portable and desktop dictation units of the company's Dictaphone subsidiary. Business Supplies and Services. Business supplies and services includes equipment and supplies used to encode and track price, content, item identification and other merchandise information manufactured and marketed by the company's Monarch Marking Systems, Inc. ("Monarch") subsidiary. In addition, this segment includes facilities management services for a variety of business support functions, including correspondence mail and reprographics management, high volume automated mail center management and related activities such as facsimile, supplies distribution and records management provided by the company's Pitney Bowes Management Services subsidiary. In October 1993, the company acquired all outstanding shares of Ameriscribe Corporation ("Ameriscribe"). Ameriscribe is a nationwide provider of on-site reprographics, mailroom and other office services to industrial corporations and professional service firms on a contract basis. The company consolidated this unit with its facilities management business operated through its wholly-owned subsidiary, Pitney Bowes Management Services, Inc. In 1992, the company sold its Wheeler Group Inc. ("Wheeler") subsidiary, a direct mail marketer of office supplies. Wheeler has been classified in the Consolidated Statement of Income as a discontinued operation. (See Note 11, "Acquisitions and discontinued operations", of the Notes to Consolidated Financial Statements in the Pitney Bowes Inc. 1993 Annual Report to Stockholders which information is incorporated herein by reference). Financial Services. The financial services segment includes the company's worldwide financing operations. The company provides lease financing for its products as well as other financial services for the commercial and industrial markets. Lease financing transactions and other financial services are executed through the company's wholly-owned subsidiaries: Pitney Bowes Credit Corporation, including Colonial Pacific Leasing Corporation, Pitney Bowes Real Estate Financing Corporation and Atlantic Mortgage & Investment Corporation in the United States; Pitney Bowes Finance PLC in the U.K.; Adrema Leasing in Germany; Pitney Bowes Finance S.A. in France and Pitney Bowes Credit Australia Ltd. The company's subsidiary, Pitney Bowes of Canada Ltd., also has a financing division through which leasing arrangements are made available to its customers. The finance operations financed 34 percent, 33 percent and 32 percent of consolidated sales in 1993, 1992 and 1991, respectively. Since the first quarter of 1993, the company has continued to phase out the business of financing non-Pitney Bowes equipment outside the United States. The company is also continuing an inquiry and evaluation of the conduct by former management personnel of its German leasing business. The company expects to complete its inquiry by the end of the second quarter of 1994. (See Management's Discussion and Analysis in the Pitney Bowes Inc. 1993 Annual Report to Stockholders which information is incorporated herein by reference). In the United States the company continues to lease a broad range of other commercial and industrial products. Products financed include both commercial and non-commercial aircraft, over-the-road trucks and trailers, rail cars, and high- technology equipment such as data processing and communications equipment as well as commercial real estate properties. The finance operations have also participated, on a select basis, in certain other types of financing activities including syndication of certain lease transactions which do not satisfy financial services' investment criteria, senior secured loans in connection with acquisition, leveraged buyout and recapitalization financing and certain project financings as well as mortgage servicing. Financial services' 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 financial services segment 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. While the company's funding strategy 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. Nonrecurring Charges. In December 1989, the company announced a series of transition initiatives designed to improve the company's competitiveness, enhance business focus and allow for the transition to a new generation of advanced systems products. In support of these initiatives, the company recorded a one-time, pretax charge of $110 million against fourth-quarter 1989 earnings. The three-year transition program included a reduction in the company's worldwide workforce approximating 1,500 positions, a change of employee skill mix, a reduction in the number of product distribution centers and a streamlining of administrative systems and equipment service organizations. The company also established a dedicated United States Copier Division responsible for sourcing, selling, marketing, servicing and supporting the company's copier products. In September 1990, the company 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 copiers consistent with its marketing strategy directed at serving large corporations and multi-unit installations. Due to this change in strategy and the resultant discontinuance of the equipment remanufacturing process, the company adjusted the estimated useful life of copiers from five years to three years and established a reserve for the disposal of copiers which previously would have been remanufactured, employee severance payments and facility closing costs. The aggregate one-time, pretax charge against 1990 third-quarter earnings was $86.5 million. Support Services. The company maintains extensive field service organizations in the United States and certain other countries to provide support services to customers who have rented, leased or purchased equipment. Such support services, provided primarily on the basis of annual maintenance contracts, accounted for 15 percent of revenue in each of the last three years. Marketing. The company's products and services are marketed through an extensive network of offices in the United States, and through a number of subsidiaries and independent distributors and dealers in many countries throughout the world as well as through direct marketing and outbound telemarketing. The company sells to a variety of business, governmental, institutional and other organizations. It has a broad base of customers, and is not dependent upon any one customer or type of customer for a significant part of its business. The company does not have significant backlog or seasonality relating to its businesses. Operations Outside the United States. The company's manufacturing operations outside the United States are in Australia, Canada, Hong Kong, Mexico, Switzerland, Singapore and the United Kingdom. Competition. The company has historically been a leading supplier of certain products and services in its business segments, particularly postage meters and mailing machines, price marking supplies and equipment, and voice processing systems. However, in all three segments it has strong competition from a number of companies. In particular, it is facing competition in many countries for new placements from several postage meter and mailing machine suppliers, and its mailing systems products face some competition from products and services offered as alternative means of message communications. Also, the facilities management business, a market leader in providing mail and related support services to the corporate, financial services, and professional services markets, competes against national, regional and local firms specializing in facilities management. The company believes that its long experience and reputation for product quality, and its sales and support service organizations are important factors in influencing customer choices with respect to its products and services. The financing 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 the finance operations do 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 the finance operations' competitive position in these markets. Research and Development/Patents. The company has research and development programs that are directed towards developing new products and improving the economy and efficiency of its operations, including its production and service methods. Expenditures on research and development totaled $99.0 million, $101.6 million and $114.0 million in 1993, 1992 and 1991, respectively. As a result of its research and development efforts, the company has been awarded a number of patents with respect to several of its existing and planned products. However, the company believes its businesses are not materially dependent on any one patent or any group of related patents. The company also believes its businesses are not materially dependent on any one license or any group of related licenses. Material Supplies and Environmental Protection. The company believes it has adequate sources for most parts and materials for the products it manufactures. However, products manufactured by the company rely to an increasing extent on microelectronic components, and temporary shortages of these components have occurred from time to time due to the demands by many users of such components. The company purchases copying, facsimile, scales, desktop dictating and transcribing machines, and portable dictating machines primarily from Japanese suppliers. The company believes that it has adequate sources available to it for the foreseeable future for such products. The company is subject to extensive and changing federal, state, local and other countries environmental laws and regulations, including those relating to the operations or ownership of real property and to the use, handling, storage, discharge and disposal of hazardous substances. Expenditures relating to environmental laws and regulations do not have, and are not expected to have, a material adverse effect on capital expenditures, or on the company's financial position or results of operations. Employee Relations. At December 31, 1993, 32,539 persons were employed by the company, 26,523 in the United States and 6,016 outside the United States. Employee relations are considered to be very satisfactory. The great majority of employees are not represented by any labor union. Management follows the policy of keeping employees informed of its decisions, and encourages and implements employee suggestions whenever practicable. Item 2. Item 2. Properties The company's World Headquarters and certain other office and manufacturing facilities are located in Stamford, Connecticut. The company maintains research and development operations in Stratford, Connecticut as well as near Dayton, Ohio and a corporate engineering and technology center in Shelton, Connecticut. A sales and service training center is located near Atlanta, Georgia. The company is building a new facility to house its Shipping and Weighing Systems Division in Shelton, Connecticut, which is expected to be completed in 1995. The company believes that its current and planned manufacturing, administrative and sales office properties are adequate for the needs of all three of its business segments. Business Equipment. Business equipment products are manufactured in a number of plants principally in Connecticut, as well as in: Melbourne, Florida; Harlow, England; Pickering, Ontario, Canada; and Killwangen, Switzerland. Most of these facilities are owned by the company. Sales and support services offices, substantially all of which are leased, are located throughout the United States and in a number of other countries. Business Supplies and Services. The company's Monarch subsidiary has executive offices and production facilities near Dayton, Ohio and facilities in: Pickering, Ontario, Canada; Mexico City, Mexico; Sydney, Australia; Singapore and Hong Kong. Production facilities of the Pitney Bowes Marking Systems Ltd. subsidiary are located in a leased office and manufacturing building in Harlow, England. A number of Monarch sales and support services offices, substantially all of which are leased, are located throughout the United States and in a number of other countries. The company's Pitney Bowes Management Services subsidiary is headquartered in Stamford, Connecticut and leases facilities in 25 cities located throughout the United States as well as one leased facility in Toronto, Ontario, Canada. Financial Services. Pitney Bowes Credit Corporation leases executive and administrative offices in Norwalk, Connecticut; Jacksonville, Florida; and Tualatin, Oregon. Executive and administrative offices of the financing operations outside the United States are maintained in London, England; Heppenheim, Germany; Paris, France; Mississauga, Ontario, Canada; and Chatswood, Australia. A number of leased regional and district sales offices are located throughout the United States, Canada and Germany. Item 3. Item 3. Legal Proceedings The company is a defendant in a number of lawsuits, none of which will, in the opinion of management and legal counsel, have a material adverse effect on the company's financial position or results of operations. Item 4. Item 4. Submission of Matters to a Vote of Security Holders None. Executive Officers of the Registrant Executive Officer Name Age Title Since George B. Harvey 62 Chairman, President and 1967 Chief Executive Officer Carmine F. Adimando 49 Vice President - Finance 1982 and Administration, and Treasurer Marc C. Breslawsky 51 President, Pitney Bowes 1985 Office Systems, a division Michael J. Critelli 45 President - Pitney Bowes 1988 Financial Services, a division Steven J. Green 42 Vice President - Controller 1988 Hiro R. Hiranandani 56 President - Pitney Bowes 1981 Mailing Systems, a division Paul Reece 57 Vice President - Operations 1987 and Technology Douglas A. Riggs 49 Vice President - Communications, 1988 Planning, Secretary and General Counsel Carole F. St. Mark 51 President - Pitney Bowes 1985 Logistics Systems and Business Services, a division Johnna G. Torsone 43 Vice President - Personnel 1993 There is no family relationship among the above officers, all of whom have served in various corporate, division or subsidiary positions with the company for at least the past five years except for Johnna G. Torsone. Prior to joining the company in October 1990, Ms. Torsone was a partner with the New York law firm of Parker, Chapin, Flattau & Klimpl where she practiced employment and labor law for 14 years. PART II Item 5. Item 5. Market for the Registrant's Common Stock and Related Stockholders' Matters The sections entitled "Stock Information" and "Stock Exchanges" on the inside back cover of the Pitney Bowes Inc. 1993 Annual Report to Stockholders are incorporated herein by reference. At December 31, 1993, the company had 31,189 common stockholders of record. Item 6. Item 6. Selected Financial Data The section entitled "Summary of Selected Financial Data" on page 26 of the Pitney Bowes Inc. 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 section entitled "Management's Discussion and Analysis" on pages 21 to 25 of the Pitney Bowes Inc. 1993 Annual Report to Stockholders is incorporated herein by reference, except for the section on page 25 relating to "Dividend Policy." Item 8. Item 8. Financial Statements and Supplementary Data The financial statements, together with the report thereon of Price Waterhouse dated February 1, 1994, appearing on pages 27 to 39 of the Pitney Bowes Inc. 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 None. PART III Item 10. Item 10. Directors and Executive Officers of the Registrant Except for the information regarding the company's executive officers (see "Executive Officers of the Registrant" on page 7), the information called for by this Item is incorporated herein by reference to the sections entitled "Election of Directors" and "Security Ownership of Directors and Executive Officers" on pages 2 to 6 of the Pitney Bowes Inc. Notice of the 1994 Annual Meeting and Proxy Statement. Item 11. Item 11. Executive Compensation The sections entitled "Directors' Compensation", "Executive Officer Compensation", "Severance and Change of Control Arrangements" and "Pension Benefits" on pages 7 to 13, and 17 to 19 of the Pitney Bowes Inc. Notice of the 1994 Annual Meeting and Proxy Statement are incorporated herein by reference. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management The section entitled "Security Ownership of Directors and Executive Officers" on pages 6 and 7 of the Pitney Bowes Inc. Notice of the 1994 Annual Meeting and 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 - see Item 8 on page 8 and "Index to Financial Statements and Schedules" on page 16. 2. Financial statement schedules - see "Index to Financial Statements and Schedules" on page 16. 3. Exhibits (numbered in accordance with Item 601 of Regulation S-K). Reg. S-K Status or Incorporation Exhibits Description by Reference (3)(a) Restated Certificate of Incorporated by reference to Incorporation, as amended Exhibit (3a) to Form 10-K as filed with the Commission on March 30, 1993. (Commission file number 1-3579) (b) By-laws Incorporated by reference to Exhibit (1) to Form 8-K as filed with the Commission on March 13, 1993. (Commission file number 1-3579) (4)(a) Form of Indenture dated as Incorporated by reference to of November 15, 1987 Exhibit (4a) to Form 10-K as between the company and filed with the Commission on Chemical Bank, as trustee March 24, 1988. (Commission file number 1-3579) (b) Form of Debt Securities Incorporated by reference to Exhibit (4b) to Form 10-K as filed with the Commission on March 24, 1988. (Commission file number 1-3579) (c) Form of First Supplemental Incorporated by reference to Indenture dated as of Exhibit (1) to Form 8-K as June 1, 1989 between the filed with the Commission on company and Chemical Bank, June 16, 1989. (Commission as Trustee file number 1-3579) (d) Form of Indenture dated as Incorporated by reference to of April 15, 1990 between Exhibit (4.1) to Registration the company and Chemical Statement on Form S-3 Bank, as successor to (No. 33-33948) as filed with Manufacturers Hanover the Commission on March 28, Trust Company, as Trustee 1990. (e) Forms of Debt Securities Incorporated by reference to Exhibit (4) to Form 10-Q as filed with the Commission on May 14, 1990. (Commission file number 1-3579) (f) Form of Indenture dated as Incorporated by reference to of May 1, 1985 between Exhibit (4a) to Registration Pitney Bowes Credit Statement on Form S-3 Corporation and Bankers (No. 2-97411) as filed with the Trust Company, as Trustee Commission on May 1, 1985. (g) Letter Agreement between Incorporated by reference to Pitney Bowes Inc. and Exhibit (4b) to Registration Bankers Trust Company, as Statement on Form S-3 Trustee (No. 2-97411) as filed with the Commission on May 1, 1985. (h) Form of First Supplemental Incorporated by reference to Indenture dated as of Exhibit (4b) to Registration December 1, 1986 between Statement on Form S-3 Pitney Bowes Credit (No. 33-10766) as filed with the Corporation and Bankers Commission on December 12, 1986. Trust Company, as Trustee (i) Form of Second Incorporated by reference to Supplemental Indenture Exhibit (4c) to Registration dated as of February 15, Statement on Form S-3 1989 between Pitney Bowes (No. 33-27244) as filed with the Credit Corporation and Commission on February 24, 1989. Bankers Trust Company, as Trustee (j) Form of Third Supplemental Incorporated by reference to Indenture dated as of Exhibit (1) to Form 8-K as May 1, 1989 between Pitney filed with the Commission on Bowes Credit Corporation May 16, 1989. (Commission and Bankers Trust Company, file number 1-3579) as Trustee The company has outstanding certain other long-term indebtedness. Such long-term indebtedness does not exceed 10% of the total assets of the company; therefore, copies of instruments defining the rights of holders of such indebtedness are not included as exhibits. The company agrees to furnish copies of such instruments to the Securities and Exchange Commission upon request. Executive Compensation Plans: (10)(a) Retirement Plan for Incorporated by reference to Directors of Pitney Exhibit (10a) to Form 10-K as Bowes Inc. filed with the Commission on March 30, 1993. (Commission file number 1-3579) (b) Deferred Compensation Incorporated by reference to Plan for Directors Exhibit (10b) to Form 10-K as filed with the Commission on March 30, 1993. (Commission file number 1-3579) (c) Pitney Bowes Inc. Incorporated by reference to Directors' Stock Plan Exhibit (10a) to Form 10-K as filed with the Commission on March 25, 1992. (Commission file number 1-3579) (d) Pitney Bowes 1991 Stock Incorporated by reference to Plan Exhibit (10b) to Form 10-K as filed with the Commission on March 25, 1992. (Commission file number 1-3579) (e) Pitney Bowes Inc. Key Incorporated by reference to Employees' Incentive Plan Exhibit (10c) to Form 10-K as (as amended and restated) filed with the Commission on March 25, 1992. (Commission file number 1-3579) (f) 1979 Pitney Bowes Stock Incorporated by reference to Option Plan (as amended Exhibit (10d) to Form 10-K as and restated) filed with the Commission on March 25, 1992. (Commission file number 1-3579) (g) Pitney Bowes Severance Incorporated by reference to Plan, as amended, dated Exhibit (10) to Form 10-K as December 12, 1988 filed with the Commission on March 23, 1989. (Commission file number 1-3579) (11) Statement re computation Exhibit (i) of per share earnings (12) Computation of ratio of Exhibit (ii) earnings to fixed charges (13) Portions of annual report Exhibit (iii) to security holders (21) Subsidiaries of the Exhibit (iv) registrant (23) Consent of experts and Exhibit (v) counsel (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 Inc. By /s/ George B. Harvey (George B. Harvey) Chairman, President and Chief Executive Officer Date March 30, 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. Signature Title Date /s/ George B. Harvey Chairman, President March 30, 1994 George B. Harvey and Chief Executive Officer - Director /s/ Carmine F. Adimando Vice President-Finance March 30, 1994 Carmine F. Adimando and Administration, and Treasurer (principal financial officer) /s/ Steven J. Green Vice President-Controller March 30, 1994 Steven J. Green (principal accounting officer) /s/ Linda G. Alvarado Director March 30, 1994 Linda G. Alvarado /s/ William E. Butler Director March 30, 1994 William E. Butler /s/ Colin G. Campbell Director March 30, 1994 Colin G. Campbell /s/ John C. Emery, Jr. Director March 30, 1994 John C. Emery, Jr. /s/ Charles E. Hugel Director March 30, 1994 Charles E. Hugel /s/ David T. Kimball Director March 30, 1994 David T. Kimball Signature Title Date Director March 30, 1994 Leroy D. Nunery /s/ Phyllis S. Sewell Director March 30, 1994 Phyllis S. Sewell /s/ Arthur R. Taylor Director March 30, 1994 Arthur R. Taylor INDEX TO FINANCIAL STATEMENTS AND SCHEDULES The additional financial data should be read in conjunction with the financial statements in the Pitney Bowes Inc. 1993 Annual Report to Stockholders. 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. Also, separate financial statements of less than 100 percent owned companies, which are accounted for by the equity method, have been omitted because they do not constitute significant subsidiaries. ADDITIONAL FINANCIAL DATA Page Pitney Bowes Inc.: Report of independent accountants on financial statement schedules 17 Financial statement schedules for the years 1991 - 1993: Valuation and qualifying accounts and reserves (Schedule VIII) 18 Short-term borrowings (Schedule IX) 19 Supplementary income statement information (Schedule X) 20 REPORT OF INDEPENDENT ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULES To the Board of Directors of Pitney Bowes Inc. Our audits of the consolidated financial statements referred to in our report dated February 1, 1994 appearing on page 39 of the Pitney Bowes Inc. 1993 Annual Report to Stockholders (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 by reference in Item 14(a)2 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 Stamford, Connecticut February 1, 1994 PITNEY BOWES INC. SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEARS ENDED DECEMBER 31, 1991 TO 1993 PITNEY BOWES INC. SCHEDULE IX - SHORT-TERM BORROWINGS FOR THE YEARS ENDED DECEMBER 31, 1991 TO 1993 PITNEY BOWES INC. SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION FOR THE YEARS ENDED DECEMBER 31, 1991 TO 1993 (Dollars in thousands) Charged to costs and expenses Item 1993 1992 1991 Maintenance (1) $53,279 $47,387 $41,736 (1) Excludes costs associated with equipment maintenance agreements sold to customers.

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ITEM 3. LEGAL PROCEEDINGS. Montrose Chemical Corporation of California ("Montrose"), whose stock is 50% owned by Chris-Craft and 50% by a subsidiary of ICI Americas, Inc. ("ICI"), discontinued its manufacturing operations in 1983 and has since been defending claims for costs and damages relating to environmental matters. Chris-Craft has been named as a defendant in certain of these actions by plaintiffs seeking to hold Chris-Craft liable for Montrose activities. In April 1983, the United States of America and the State of California instituted an action in the Federal District Court for the Central District of California, United States of America et al. v. J.B. Stringfellow, et al., Case No. 83-2501 (JMI) (Mcx), against Montrose and approximately 30 other defendants relating to alleged environmental impairment at the Stringfellow Hazardous Waste Disposal Site in California. The complaint alleges that Montrose generated toxic wastes containing DDT which were deposited at the Stringfellow Site between 1969 and 1972, allegedly constituting approximately 19% by volume of all toxic wastes deposited at the site. During this period, the Stringfellow Site was licensed as a hazardous waste disposal facility by the State of California. The action seeks an injunction against numerous generators of waste materials which were deposited at the Stringfellow Site, including Montrose, the owners of the Stringfellow Site and others to abate the release of substances from the site and to remedy allegedly hazardous conditions. The action seeks to impose joint and several liability against all defendants for all costs of removal and remedial action incurred by the federal and state governments at the site. On September 30, 1990, the United States Environmental Protection Agency ("EPA") issued a Record of Decision for the site which selected some of the interim remedial measures preferred by the EPA and the State, the estimated present value of the capital costs of which was estimated by them to be $169,000,000, although the estimate purports to be subject to potential variations of up to 50%. Plaintiffs also seek recovery for remedial expenditures. The action also seeks unspecified damages for alleged harm to natural resources. Private parties have intervened in the action. On June 22, 1992, Montrose and other defendants signed a consent decree with the United States regarding certain remedial work at and near the Stringfellow Site, which decree was entered by the District Court in October 1992. On November 30, 1993 Special Master Harry V. Peetris entered a recommended ruling allocating liability at the site under both the Comprehensive Environmental Response, Compensation and Liability Act of 1980 ("CERCLA") and state law. The CERCLA allocation was 65% to the State of California, 10% to the owners of the site and 25% to the generator defendants (including Montrose). The state law allocation was 100% to the State and 0% to the Stringfellow entities. The Special Master's recommended ruling will be reviewed by the District Court before it enters a final allocation decision. The State is expected to appeal when the final order is entered by the District Court. In addition, the United States Department of Justice has sought and received information regarding the relationship between Montrose and its two 50% shareholders. The Department's inquiry is directed to the issue whether Chris-Craft, as a shareholder of Montrose, shall be added as a party to the action. In February 1993 Montrose and Chris-Craft were among a group of defendants which settled a case entitled Newman, et al. v. J.B. Stringfellow, et al., Case No. 165944 MF, in Riverside County (California) Superior Court. In Newman more than 4,000 plaintiffs sought unspecified monetary damages from more than 20 defendants for personal injury and property damage purportedly caused by substances allegedly released from the Stringfellow site. Montrose contributed approximately $7.5 million to the Newman settlement, over 80% of which was covered by insurance. Chris-Craft made no contribution to the settlement. The State of California is appealing the August 1993 order of the Newman court finding the settlement was in good faith. In 1992 Chris-Craft was named a defendant in a personal injury action entitled Teresa Howell v. J.B. Stringfellow, Jr., et al., Case No. 216798 in Riverside County (California) Superior Court, involving claims brought by an individual plaintiff seeking to recover unspecified damages from approximately 15 defendants (including Montrose) for alleged injuries purportedly resulting from exposure to substances disposed of at the Stringfellow Hazardous Waste Disposal Site in California. On January 25, 1994, the court in the Howell case ordered the suit to be dismissed as time-barred by applicable statutes of limitations. In June 1990, the United States of America and the State of California commenced an action in the United States District Court for the Central District of California, entitled United States of America, et al. v. Montrose Chemical Corporation of California, et al., Civil Action No. 90-3122 AAH (JRX), against, among others, Montrose and Chris-Craft. Certain United States subsidiaries of ICI (the "ICI Subsidiaries"), as well as Westinghouse Electric Corporation, Potlatch Corporation and Simpson Paper Company, which have no connection with Chris-Craft, were also named as defendants. Brought under CERCLA, the complaint alleges that Montrose released hazardous substances, including DDT, into the environment in and around Los Angeles, California, including the waters surrounding the Palos Verdes Peninsula, the Los Angeles-Long Beach Harbor, and the Channel Islands. The complaint alleges that other defendants released PCBs into the same waters. The complaint seeks a declaration that defendants are jointly and severally liable for damages (in amounts not specified), including loss of use and cost of restoration, resulting from injury to natural resources caused by the alleged releases, plaintiffs' response costs incurred in connection with such damage, and plaintiffs' costs in assessing such damages. On April 26, 1993, the court approved a settlement between the plaintiffs, the Los Angeles County Sanitation District ("LACSD") and numerous municipalities and local government entities which had been sued by Montrose, Chris-Craft and other defendants as third-party defendants. The settlement would resolve all liability between the plaintiffs and the LACSD and the third-party entities for approximately $42 million in cash and in-kind services, and purports to immunize the settling defendants from the cross- claims and third party claims of Montrose and Chris-Craft. Montrose, Chris-Craft and other defendants have appealed the District court's approval of the settlement to the Ninth Circuit Court of Appeals. Plaintiffs also seek to hold Montrose, Chris-Craft, and the ICI Subsidiaries jointly and severally liable for all costs incurred in connection with the alleged hazardous substance contamination at the Montrose plant site in Torrance, California. Montrose terminated most of its operations, including all DDT manufacturing, prior to 1983. Since 1984 Montrose has been complying with a Consent Order entered into with the Nevada Department of Conservation and Natural Resources Division of Environmental Protection ("DEP") requiring operation of a ground water intercept treatment system near a production facility used by Montrose until 1985 in Henderson, Nevada. The EPA and DEP are currently reconsidering whether the complex that includes the Henderson facility should be included on the National Priority List. In April 1991, Montrose entered into a second consent order with DEP and other parties requiring investigation of environmental conditions at the Henderson facility. Montrose is a defendant in an action styled Levin Metals Corporation, et al. v. Parr-Richmond Terminal Company, et al., Case Numbers C-84-6273 BAC, C-84-6234 BAC and C-85-4776 BAC in the United States District Court for the Northern District of California, in which it is alleged that Montrose contributed to the contamination of certain real property in Richmond, California, and in which damages sought exceed $15 million. In December 1992 two parties to the Parr-Richmond action filed pleadings naming Chris-Craft as a defendant alleging, among other things, that Chris-Craft is secondarily liable under corporate liability theories for Montrose's liabilities, if any. Chris-Craft filed an answer denying liability on June 11, 1993, asserting numerous affirmative defenses and filing counterclaims. The court in the Levin case has ordered discovery efforts to proceed in advance of a mediation conference scheduled for early June 1994. In January 1990, Montrose and Chris-Craft were each notified by the United States National Oceanic and Atmospheric Administration that the United States intends to name each of them as a defendant in an action seeking recovery for alleged damage to natural resources emanating from the Richmond site. In March 1990, the EPA added the site to the National Priority List. In August 1991 and March 1992, the EPA invited potentially responsible parties, including Chris-Craft, to undertake investigation and remedial actions at the site. Chris-Craft has not taken any such actions. In August 1992, Montrose was named one of approximately 18 defendants in Alderman, et al. v. Cadillac Fairview/California, Inc., et al., Case No. BC062039 in Los Angeles County (California) Superior Court, where approximately 100 individual plaintiffs seek to recover unspecified amounts for alleged personal injuries and property damage purportedly caused by contamination at two neighboring properties in California, one of which formerly was used by Montrose for manufacturing operations. Chris-Craft was added as a defendant in December 1992. After the complaint against Chris-Craft was served, the United States of America, a third- party defendant, removed the Alderman action to the United States District Court for the Central District of California, where it is currently pending (Case No. 92-7535 ER). Plaintiffs have moved to remand the Alderman action to state court; their motion to remand is pending. In January 1993, Chris-Craft filed an answer denying the allegations against it and denying any and all liability. No substantial discovery has yet occurred in the Alderman action, although much is scheduled for 1994. A statement of damages filed by the plaintiffs alleges general damages of $7 million. In October 1992, Montrose was named one of approximately 20 defendants in T H Agriculture and Nutrition Company, Inc. v. Aceto Chemical Co., Inc., Case No. C92-4152-MHP in the Federal District Court for the Northern District of California, where it is alleged Montrose contributed to contamination at a former pesticide formulation site in Fresno, California and where damages sought exceed $21 million. During 1993 Montrose rejected a settlement demand by the plaintiffs of $12.69 million. Chris-Craft was added as a defendant in January 1994. In October 1992, Montrose was named one of approximately 28 third party defendants by a County Sanitation District of Los Angeles County in Acosta, et al. v. County Sanitation Districts of Los Angeles County, et al., Case No. BC057637 in Los Angeles County (California) Superior Court, where it is alleged Montrose is partially liable for an unspecified decrease in the values of properties owned by approximately 530 individual plaintiffs living near a Sanitation District sewage treatment facility. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. Not applicable. EXECUTIVE OFFICERS OF THE REGISTRANT The executive officers of Chris-Craft, as of February 28, 1994, are as follows: Schedule II CHRIS-CRAFT INDUSTRIES, INC. AND SUBSIDIARIES AMOUNTS RECEIVABLE FROM RELATED PARTIES, UNDERWRITERS, PROMOTERS AND EMPLOYEES OTHER THAN RELATED PARTIES FOR THE THREE YEARS ENDED DECEMBER 31, 1993 (In Thousands) The loan was made for the purpose of assisting Mr. Lindsey in relocating his home in connection with the relocation of UTV's executive offices from Minneapolis to Los Angeles. The loan was represented by a non-interest bearing five-year note, with no payment due before maturity. In December 1988, the note was revised and extended. Under the Revision and Extension Agreement, 10% of the original balance is due and payable December 31 of each year through December 31, 1997. Such installments will be forgiven on each such December 31 if the borrower is still employed by UTV on each such forgiveness date. The note is secured by a deed of trust on the borrower's home and provides that at the option of the holder the loan will become due and payable upon sale or further encumbrance of the borrower's home without the consent of the holder or upon the borrower's voluntary termination of employment with UTV. Schedule X CHRIS-CRAFT INDUSTRIES, INC. AND SUBSIDIARIES SUPPLEMENTARY INCOME STATEMENT INFORMATION (In Thousands) EXHIBIT INDEX

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Item 1 - Business CoreStates Financial Corp ("CoreStates") is a bank holding company registered under the Federal Bank Holding Company Act of 1956, as amended (the "Act") and incorporated under the laws of Pennsylvania with executive offices at Philadelphia National Bank Building, Broad & Chestnut Streets, Philadelphia, Pennsylvania 19107 (telephone number 215-973-3827). At December 31, 1993, CoreStates had total consolidated assets of approximately $23.7 billion and shareholders' equity of approximately $1.96 billion and, based on December 31, 1993 rankings of bank holding companies, was believed to be the 32nd largest bank holding company in the United States at such date. Banking Subsidiaries The lead banking subsidiary of CoreStates is CoreStates Bank, N.A. ("CoreStates Bank"), a national banking association with executive offices located in Philadelphia, Pennsylvania. Divisions of CoreStates Bank are marketed as Philadelphia National Bank Division, the wholesale banking unit, CoreStates First Pennsylvania Bank Division, the retail banking unit, and since its merger into CoreStates Bank in August 1993, CoreStates Hamilton Bank, the unit serving central Pennsylvania. Other principal banking subsidiaries of CoreStates are New Jersey National Bank ("NJNB"), a national banking association with its executive offices located in Pennington, New Jersey and CoreStates Bank of Delaware N.A. ("CBD"), a national banking association with its sole office located in New Castle County, Delaware. CoreStates Bank, NJNB and CBD are sometimes referred to herein as the "Banking Subsidiaries". Through CoreStates Bank, NJNB and CBD, CoreStates has been engaging in the business of providing wholesale banking services, consumer financial services which includes retail banking, trust & investment management services and electronic payment services which are provided through CoreStates' Electronic Payment Services, Inc. affiliate. Other Direct and Indirect Subsidiaries and Affiliates Congress Financial Corporation, ("Congress") a majority-owned subsidiary of ------------------------------ CoreStates, and its subsidiaries are engaged in commercial financing and factoring with headquarters in New York City and offices in Atlanta, Boston, Chicago, Columbia, Dallas, Los Angeles, Miami, Milwaukee, Portland and San Juan. As of December 31, 1993, factored receivables of Congress and its subsidiaries totalled $555.2 million while outstanding commercial finance obligations and other receivables totalled $1,426.4 million. CoreStates Capital Corp ("Capital") is CoreStates' designated financing ----------------------- entity to obtain both short-term and long-term financing for CoreStates and its other subsidiaries. At December 31, 1993, Capital had outstanding commercial paper in the aggregate principal amount of $468.8 million and debt securities in the aggregate outstanding principal amount of $1,433 million, with maturities ranging from 1 month to 11 years. Electronic Payment Services, Inc. ("EPS") is a joint venture formed in late --------------------------------- 1992 that combined the separate consumer electronic transaction processing business of CoreStates, Banc One Corporation, PNC Financial Corp. and Society Corporation into the nation's leading provider of automated teller machine and point of sale processing services to individuals, financial institutions and retail stores. CoreStates former electronic payment services business is now conducted by EPS. EPS has announced the signing of a definitive agreement providing for two additional banking companies to enter the joint venture. The transactions are expected to be completed in 1994. CoreStates also has several other direct and indirect subsidiaries including companies engaged in discount brokerage services, investment advisory services, lease financing activities, holding real property facilities used by CoreStates' Banking Subsidiaries and companies created solely to facilitate the business of other subsidiaries. For analytical purposes, management has focused CoreStates into four core businesses: Wholesale Banking, Consumer Financial Services, Trust & Investment Management and Electronic Payment Services conducted by EPS. Further information regarding CoreStates' four core businesses is presented in Management's Discussion and Analysis of Financial Condition and Results of Operations at pages 21 through 23 of the CoreStates Annual Report to Shareholders for the fiscal year ended December 31, 1993 (Exhibit 13 pages 7 through 10) which pages of the Annual Report are incorporated herein by reference. A brief discussion of the four core businesses is presented below. There is considerable inter-relationship among these businesses. Wholesale Banking Wholesale banking services are provided through the ----------------- Banking Subsidiaries and Congress by the following groups: corporate and institutional banking; investment banking; cash management; international banking; corporate middle market; and specialized finance. Domestic financing services include commercial, industrial and real estate loans, the financing of receivables, inventory, equipment and other requirements of business customers and the provision of financial services for correspondent banks. Foreign and international finance services include the making of loans and acceptances, the issuance and confirmation of letters of credit and related financial services. Also provided are transaction processing services, including cash management, lock box, funds transfer and collection and disbursement management on both a domestic and international basis. International activities are conducted directly by CoreStates Bank through its head office in Philadelphia and 23 foreign offices. In addition, banking and financing activities are conducted through two wholly-owned Edge Act subsidiaries. Advisory services are also provided which relate to loan syndications, private placements, mergers and acquisitions, company valuations and other similar matters. This business also deals in and underwrites obligations of the United States Government, federal agencies and general obligations of States and municipal sub-divisions and assists individual corporate customers as well as other institutions with the purchase and sale of all types of marketable securities. Consumer Financial Services This core business is provided by the Banking --------------------------- Subsidiaries and includes community banking and specialty products. Specialty products includes credit card, student lending and residential mortgage. Community banking services are offered through the branch network of the Banking Subsidiaries in Pennsylvania and New Jersey. This branch banking network provides a full range of products including deposit, loan and related financial products, primarily on a full relationship basis. The specialty products and consumer finance line of business is provided primarily by CBD which is the issuer of credit cards and also engages in a direct consumer loan business. Trust & Investment Management This core business provides products through ----------------------------- four business lines: institutional trust, personal trust, private banking and investment management. These products are offered through the Banking Subsidiaries and include fiduciary administration and transaction processing services, corporate trust services and through CoreStates Investment Advisors, Inc., investment management services. Electronic Payment Services This core business includes the MAC automated --------------------------- teller machine network ("MAC") and point of sale processing ("POS"). Customers for these businesses include individuals, financial institutions and retail stores. The MAC and POS business lines were contributed to EPS on December 4, 1992. Strategic Actions A discussion of strategic actions taken by CoreStates in 1993 is presented in Management's Discussion and Analysis of Financial Condition and Results of Operations at pages 19 through 21 of the CoreStates Annual Report to Shareholders for the fiscal year ended December 31, 1993 (Exhibit 13 pages 4 through 7) which pages of the Annual Report are incorporated herein by reference. Government Supervision and Regulation CoreStates is a registered bank holding company subject to the supervision of, and to regular inspection by, the Board of Governors of the Federal Reserve System ("Federal Reserve"). All three Banking Subsidiaries are organized as national banking associations, which are subject to regulation by the Comptroller of the Currency ("OCC"). The Banking Subsidiaries are also subject to regulation by other federal bank regulatory bodies. In addition to banking laws, regulations and regulatory agencies, CoreStates and its subsidiaries and affiliates are subject to various other laws, regulations and regulatory agencies, all of which directly or indirectly affect CoreStates' operations, management and ability to make distributions. The following discussion summarizes certain aspects of those laws and regulations that affect CoreStates. Proposals to change the laws and regulations governing the banking industry are frequently raised in Congress, in the state legislatures and before the various bank regulatory agencies. The likelihood and timing of any changes and the impact such changes might have on CoreStates and its Banking Subsidiaries are difficult to determine. An important function of the Federal Reserve System is to regulate the national supply of bank credit. Among the instruments of monetary policy used by the Federal Reserve System to implement its objectives are: open market operations in U.S. Government securities; changes in the discount rate on bank borrowings; and changes in reserve requirements on bank deposits. Under the Act, CoreStates' activities, and those of companies which it controls or in which it holds more than 5% of the voting stock, are limited to banking or managing or controlling banks or furnishing services to or performing services for its subsidiaries, or any other activity which the Federal Reserve determines to be so closely related to banking or managing or controlling banks as to be a proper incident thereto. In making such determinations, the Federal Reserve is required to consider whether the performance of such activities by a bank holding company or its subsidiaries 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. Bank holding companies, such as CoreStates, are required to obtain prior approval of the Federal Reserve to engage in any new activity or to acquire more than 5% of any class of voting stock of any company. The Act also requires bank holding companies to obtain the prior approval of the Federal Reserve before acquiring more than 5% of any class of voting shares of any bank which is not already majority-owned. Provisions of federal banking laws restrict the amount of distributions that can be paid to CoreStates by the Banking Subsidiaries. Under applicable federal laws, no dividends may be paid in an amount greater than net profits then on hand, reduced by certain loan losses (as defined in the applicable statutes). In addition, for each of CoreStates' Banking Subsidiaries, prior approval of federal banking authorities is required if dividends declared by a Banking Subsidiary in any calendar year will exceed its net profits (as defined) for that year, combined with its retained net profits for the preceding two calendar years. Based on these regulations, CoreStates' Banking Subsidiaries, without regulatory approval, could declare dividends at December 31, 1993 of $171 million. The OCC, in the cases of the Banking Subsidiaries, also has authority to prohibit payment of a dividend if such payment constitutes what, in the OCC's opinion, is an unsafe or unsound practice. In addition, the ability of CoreStates and its national Banking Subsidiaries to pay dividends may be affected by the various minimum capital requirements and the capital and non- capital standards to be established under the Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA"), as described below. The rights of CoreStates, its shareholders and its creditors to participate in any distribution of the assets or earnings of its Banking Subsidiaries is further subject to the prior claims of creditors of the respective Banking Subsidiaries. According to Federal Reserve policy, CoreStates is expected to act as a source of financial strength to each Banking Subsidiary and to commit resources to support each Banking Subsidiary in circumstances in which it might not do so absent such policy. In addition, any capital loans by Corestates to any Banking Subsidiary would be subordinated in right of payment to deposits and certain other indebtedness of each Banking Subsidiary. In addition, CoreStates' Banking Subsidiaries are subject to certain restrictions imposed by Federal law on any extension of credit to, and certain other transactions with CoreStates, Capital and certain other non-bank subsidiaries, on investments in stock or other securities thereof and on the taking of such securities as collateral for loans. Among other things, the aggregate of such loans made by each Banking Subsidiary to CoreStates or to any single non-bank subsidiary generally may not exceed 10% of the sum of such Banking Subsidiaries' capital and surplus, as defined, and all loans by each Banking Subsidiary to CoreStates and its non-bank subsidiaries are limited to 20% of such Banking Subsidiaries' capital and surplus. Such loans must be secured by collateral with a value between 100% and 130% of the loan amount, depending on the type of collateral. The Banking Subsidiaries may extend credit to CoreStates and its non-bank subsidiaries without regard to these restrictions to the extent such extensions of credit are secured by specific kinds of collateral such as obligations of or guaranteed by the U.S. Government or its agencies and certain bank deposits. FDICIA modifies certain provisions of the Federal Deposit Insurance Act and makes revisions to several other banking statutes. In general, FDICIA subjects banks to significantly increased regulation and supervision, and requires the federal banking agencies to take "prompt corrective action" with respect to banks which do not meet minimum capital requirements. Among other things, FDICIA requires a bank which does not meet any one of its capital requirements set by its regulators to submit a capital restoration plan for improving its capital. A holding company of a bank must guarantee that the bank will meet its capital plan, subject to certain limitations. If such a guarantee were deemed to be a commitment to maintain capital under the U.S. federal Bankruptcy Code, a claim under such guarantee in a bankruptcy proceeding involving the holding company would be entitled to a priority over third party creditors of the holding company. In addition, FDICIA prohibits a bank from making a capital distribution to its holding company or otherwise if it fails to meet any capital requirements. Furthermore, under certain circumstances, a holding company of a bank which fails to meet certain of its capital requirements may be prohibited from making any capital distributions to its shareholders or otherwise. Critically undercapitalized banks (which are defined to include banks which still have a positive net worth) are generally subject to the mandatory appointment of a receiver. All of CoreStates' Banking Subsidiaries meet current regulatory capital requirements and are "well capitalized" as defined by regulatory authorities. Pursuant to FDICIA, in 1993 the FDIC issued a regulation entitled "Annual Independent Audits and Reporting Requirements" for banks which requires, among other things, a management assessment on the effectiveness of the internal controls over financial reporting as of the end of fiscal year 1993. CoreStates and the Banking Subsidiaries have complied with this regulation for 1993. The Financial Institution Reform, Recovery, and Enforcement Act ("FIRREA") enacted in August 1989 provides among other things for cross-guarantees of the liabilities of insured depository institutions pursuant to which any bank or savings association subsidiary of a holding company may be required to reimburse the FDIC for any loss or anticipated loss to the FDIC that arises from a default of any of such holding company's other subsidiary banks or savings associations or assistance provided to such an institution in danger of default. The Banking Subsidiaries of CoreStates are subject to such cross-guarantee. The deposits of each of the Banking Subsidiaries are insured up to applicable limits by the FDIC. Accordingly, the Banking Subsidiaries are subject to deposit insurance assessments to maintain the Bank Insurance Fund (the "BIF") of the FDIC. Pursuant to FDICIA, the FDIC has established a risk- based insurance assessment system. This approach is designed to ensure that a banking institution's insurance assessment is based on three factors: the probability that the applicable insurance fund will incur a loss from the institution; the likely amount of the loss; and the revenue needs of the insurance fund. Effective January 1, 1993, the FDIC established a risk related premium assessment system, with assessment rates ranging from .23% of domestic deposits (the same rate as under the previous flat-rate assessment system) for those banks deemed to pose the least risk to the insurance fund, to .31% for those banks deemed to pose the greatest risk (with intermediate rates of .26%, .29% and .30%). All Corestates' Banking Subsidiaries have been notified by the FDIC that, for the semiannual assessment period beginning January 1, 1993, each will be subject to an assessment rate of .23%. CAPITAL GUIDELINES A discussion of capital guidelines and capital strengths is included in Management's Discussion and Analysis of Financial Condition and Results of Operations on pages 23 and 24 of the CoreStates Annual Report to Shareholders for the fiscal year ended December 31, 1993 (Exhibit 13 pages 11 and 12) which pages of the Annual Report are incorporated herein by reference. COMPETITION The activities in which CoreStates and the Banking Subsidiaries engage are highly competitive. Generally, the lines of activity and markets served involve competition with other banks and non-bank financial institutions, as well as other entities which offer financial services, located both within and without the United States. The methods of competition center around various factors, such as customer services, interest rates on loans and deposits, lending limits and location of offices. The four core business segments in the markets served by the Banking Subsidiaries and EPS are highly competitive and the Banking Subsidiaries and EPS compete with other commercial banks, savings and loan associations and other businesses which provide services similar to those offered by the Banking Subsidiaries and EPS. The Banking Subsidiaries actively compete in wholesale banking with local, regional and international banks and non-bank financial organizations, some of which are significantly larger than certain of the Banking Subsidiaries. In providing consumer financial services, the Banking Subsidiaries' competitors include other banks, savings and loan associations, credit unions, regulated small loan companies and other non-bank organizations offering financial services. In providing trust and investment management services, the Banking Subsidiaries compete with other banks, investment counselors and insurance companies in national markets for institutional funds and corporate pension and profit sharing accounts. The Banking Subsidiaries also compete with other banks, insurance agents, financial counselors and other fiduciaries for personal trust business. The Banking Subsidiaries also actively compete for funding. A primary source of funds is deposits, and competition for deposits includes other deposit taking organizations, such as commercial banks, savings and loan associations and credit unions, and so- called "money market" mutual funds. The Banking Subsidiaries also actively compete for funds with U.S. Government securities and in the open money market. Employees As of February 28, 1994, CoreStates and its subsidiaries employed 11,180 persons on a full time basis and 2,855 persons on a part-time basis. CoreStates provides a variety of employment benefits and considers its relations with its employees to be satisfactory. Selected Statistical Information Tables and selected statistical information concerning CoreStates and its subsidiaries as described below and set forth on pages of the CoreStates 1993 Annual Report to Shareholders (and Exhibit 13 page numbers) set forth below are incorporated herein by reference: Information illustrating the interest sensitivity of CoreStates interest earning assets and interest bearing liabilities is contained on page 74 of the Annual Report to Shareholders (Exhibit 13 page 84) and on page 11 of this Form 10-K. Corestates Financial Corp And Subsidiaries Interest Sensitivity Analysis at December 31, 1993 (In Millions) Notes to interest sensitivity analysis: (a) Non-performing loans are included in 1-90 days. (b) Deposit volume exclude time deposits not at interest. (c) Represents the portion of total interest earning assets which are funded by non-interest bearing funding sources including demand deposits and shareholders' equity. EXECUTIVE OFFICERS OF THE REGISTRANT The following table shows the name and age of the current executive officers of CoreStates Financial Corp ("Corporation") and their present and previous positions held by them for at least the past five years. Item 2 Item 2 - Properties The principal offices of CoreStates and CoreStates Bank are located in a 25-story building known as the Philadelphia National Bank Building ("PNB Building"), located at Broad and Chestnut Streets, Philadelphia, Pennsylvania, owned by Clymer Realty Corporation, a real estate subsidiary of CoreStates Bank, and in leased space located at Centre Square West, 16th and Market Streets, Philadelphia, Pennsylvania. CoreStates and its subsidiaries and affiliates occupy approximately 260,000 square feet of the PNB Building's approximately 400,000 square feet of office space and 547,600 square feet of the office space in the Centre Square complex. Approximately 194,100 square feet of office space in the Widener Building adjacent to the PNB Building is leased for use by CoreStates Bank. In addition, office space is leased for use by CoreStates and CoreStates Bank in the following Philadelphia locations: approximately 393,000 square feet in the Penn Mutual Buildings, 510, 520 and 530 Walnut Street, approximately 111,600 square feet in the Curtis Center, 6th and Walnut Streets, and approximately 62,100 square feet in the Graham Building, One Penn Square West. Fifth and Market Corporation, a real estate subsidiary of CoreStates Bank, owns the 11 story building located at Fifth and Market Streets, Philadelphia, Pennsylvania. The building, containing approximately 587,000 square feet, is comprised of almost 493,000 square feet of office space, a branch banking office and an underground garage, in addition to the public access and service areas. CoreStates Bank's operations center and its loss prevention and security, human resources and loan accounting units presently occupy all of the office space in this building. CoreStates Bank also owns a service and warehouse building at 1306 Spring Garden Street in Philadelphia and a six story building at 3020 Market Street in Philadelphia which is used for storage. An administrative center at 1097 Commercial Avenue, Lancaster, Pennsylvania and the executive offices of its CoreStates Hamilton Bank division at 100 North Queen Street, Lancaster, Pennsylvania are also owned by CoreStates Bank. Of 183 CoreStates Bank domestic banking offices at December 31, 1993, 70 were in CoreStates Bank owned premises and 113 were in leased premises. The lease provisions for rented properties generally provide for initial terms of at least 10 to 15 years with varying options for renewal. On May 13, 1977, CoreStates (then National Central Financial Corporation) borrowed $25 million from two institutional lenders at an interest rate of 8 5/8% per annum. The loan is payable over 25 years, with level monthly installments which are set to fully amortize the loan by maturity. The loan is secured by a first lien mortgage on 30 CoreStates Bank owned properties previously owned by Hamilton Bank and occupied by the CoreStates Hamilton Bank division of CoreStates Bank. As of December 31, 1993, NJNB maintained 103 bank and bank-related properties. Of the total, 55 were owned in fee and 48 were leased, of which 13 were owned partially in fee and partially under lease. Of the leased properties most of the leases range from five to 27 years. All real estate and buildings owned by NJNB are free from mortgages. Of the buildings owned by NJNB, four include space leased to others, and of the buildings leased by NJNB, one includes space leased to others. CBD leases space in three office buildings located at 1523 Concord Pike, New Castle County, Delaware. The buildings contain 131,593 square feet of rental space, all of which is occupied by CBD. The leases expire in 1995 and contain three five-year renewal options in favor of CBD. The offices of CoreStates' other direct and indirect subsidiaries and the foreign branch and representative offices of CoreStates Bank are in leased premises. Rental expense, reduced by sublease income, for CoreStates and its subsidiaries in 1993 was $56.6 million. Item 3 Item 3 - Legal Proceedings In the normal course of business, CoreStates and its subsidiaries are subject to numerous pending and threatened legal actions and proceedings, some for which the relief or damages sought are substantial. Management does not believe the outcome of these actions and proceedings will have a materially adverse effect on the consolidated financial position of CoreStates. Item 4 Item 4 - Submission of Matters to a Vote of Security Holders Not applicable. PART II Item 5 Item 5 - Market for the Registrant's Common Stock and Related Stockholder Matters CoreStates Common Shares are traded on the New York Stock Exchange under the symbol "CFL". Until December 29, 1993, CoreStates Common Shares were traded in the over-the-counter market and the price quotations were reported on the NASDAQ National Market System. The table below sets forth, for the periods indicated, the high and low prices for CoreStates Common shares as reported on the New York Stock Exchange or as quoted on the NASDAQ National Market System, as applicable, and cash dividends declared per share. Over-the-counter market quotations reflect inter-dealer prices, without retail mark-up, mark-down or commission and may not necessarily represent actual transactions. The information set forth in the table has been adjusted retroactively for a stock dividend in the form of a two-for-one stock split declared on August 17, 1993 and distributed on October 15, 1993 to shareholders of record on September 15, 1993. On March 4, 1994, there were approximately 32,848 registered holders of Common Stock of CoreStates. CoreStates currently expects to continue its policy of paying regular cash dividends, although there can be no assurance as to further dividends because they are dependent upon further operating results, capital requirements and financial condition. The approval of the Comptroller of the Currency is required for national banks to pay dividends if the total of all dividends declared in any calendar year exceeds the bank's net profits for that year combined with its retained net profits for the preceding two calendar years. Under this formula CoreStates Bank, NJNB and CBD can declare dividends to CoreStates of approximately $151 million, $19 million and $1 million, respectively, plus an additional amount equal to CoreStates Bank's, NJNB's and CBD's retained net profits for 1994 up to the date of dividend declaration. Item 6 Item 6 - Selected Financial Data Pursuant to General Instructions G(2), information required by this Item is incorporated by reference from pages 66, 67 and 68 of the CoreStates Annual Report to Shareholders for the fiscal year ended December 31, 1993 (Exhibit 13 pages 75 through 77). Item 7 Item 7 - Management's Discussion and Analysis of Financial Condition and Results of Operations Pursuant to General Instructions G(2), information required by this Item is incorporated by reference from pages 18 through 40 of the CoreStates Annual Report to Shareholders for the fiscal year ended December 31, 1993 (Exhibit 13 pages 1 through 37). Item 8 Item 8 - Financial Statements and Supplementary Data Pursuant to General Instructions G(2), information required by this Item is incorporated by reference from pages 40 through 77 of the CoreStates Annual Report to Shareholders for the fiscal year ended December 31, 1993 (Exhibit 13 pages 38 through 90). 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 Pursuant to General Instruction G(3), information required by this Item is incorporated by reference from pages 1 through 7 of the CoreStates Proxy Statement dated March 17, 1994 and from Part I of this report on Form 10-K. Item 11 Item 11 - Executive Compensation Pursuant to General Instruction G(3), information required by this Item is incorporated by reference from pages 10 through 18 of the CoreStates Proxy Statement dated March 17, 1994. Such incorporation by reference shall not be deemed to specifically incorporate by reference the information referred to in Item 402(a)(8) of Regulation S-K. Item 12 Item 12 - Security Ownership of Certain Beneficial Owners and Management Pursuant to General Instruction G(3), information required by this Item is incorporated by reference from pages 2-7, 15-16, and 18 of the CoreStates Proxy Statement dated March 17, 1994. On March 25, 1994 CoreStates received a corrected Schedule 13G from Mellon Bank Corporation which indicates that Mellon Bank Corporation and its subsidiaries and affiliates own 3.06% of the outstanding Shares of Common Stock of CoreStates rather than the 5.34% as reported on the original Schedule 13G dated February 9, 1994 and reflected on page 7 of the CoreStates Proxy Statement dated March 17, 1994. Item 13 Item 13 - Certain Relationships and Related Transactions Pursuant to General Instruction G(3), information required by this Item is incorporated by reference from page 10 of the CoreStates Proxy Statement dated March 17, 1994. PART IV Item 14 Item 14 - Exhibits, Financial Statement Schedules and Reports on Form 8-K (a) 1. Financial Statements: The following consolidated statements of CoreStates Financial Corp 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: (a) 2. Financial Statement Schedules 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. (a) 3. Exhibits -------- * Management contract or compensatory plan or arrangement required to be filed as an exhibit pursuant to Item 14(c) of Form 10-K. (b) Reports on Form 8-K for the quarter ended December 31, 1993: A report on Form 8-K was filed on October 12, 1993 reporting that CoreStates Financial Corp and Constellation Bancorp had entered into a definitive agreement providing for CoreStates to acquire Constellation pursuant to an exchange of stock. In addition, the following financial statements were filed: (1) Interim condensed consolidated statements of Constellation Bancorp as of June 30, 1993 and for the six months ended June 30, 1993 and 1992. (2) Year-End consolidated financial statements of Constellation Bancorp as of and for the year ended December 31, 1992. (3) Pro Forma Financial Information for CoreStates Financial Corp and Constellation Bancorp as follows: (i) Pro Forma Condensed Combined Balance Sheet as of June 30, 1993 (ii) Pro Forma Condensed Combined Statements of Income for: Six months ended June 30, 1993 and 1992 Year ended December 31, 1992, 1991 and 1990 A Report on Form 8-K was filed on October 21, 1993 reporting earnings information contained in the news release of CoreStates Financial Corp dated October 20, 1993. A Report on Form 8-K was filed on November 19, 1993 reporting that CoreStates Financial Corp and Independence Bancorp had entered into a definitive agreement for CoreStates to acquire Independence in an exchange of stock. A Report on Form 8-K was filed on December 13, 1993 reporting that CoreStates Financial Corp and Independence Bancorp had entered into a definitive agreement for CoreStates to acquire Independence in an exchange of stock. In addition, the following financial statements of Independence Bancorp were filed: (1) Interim condensed consolidated statements of Independence Bancorp, Inc. as of September 30, 1993 and for the Nine months ended September 30, 1993 and 1992. (2) Year-end consolidated financial statements of Independence Bancorp, Inc. as of and for the year ended December 31, 1992. NOTE: CoreStates Financial Corp will furnish, at cost, any exhibit not accompanying this document upon request. Cost for each document is determined by the number of pages in the document. REPORT OF INDEPENDENT AUDITORS The Board of Directors and Shareholders CoreStates Financial Corp We have audited the accompanying consolidated balance sheets of CoreStates Financial Corp as of December 31, 1993 and 1992, and the related consolidated statements of income, changes in shareholder' 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 CoreStates Financial Corp 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. As discussed in Note 1 to the financial statements, in 1993 the Company changed its methods of accounting for certain investments in debt and equity securities and for postemployment benefits, and in 1992 the Company changed its method of accounting for income taxes and for postretirement benefits other than pensions. /s/Ernst & Young Philadelphia, Pennsylvania February 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. (Registrant) CORESTATES FINANCIAL CORP 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.

356080_1993.txt

356080_1993

1993

356080

ITEM 1. BUSINESS A. H. Belo Corporation (the "Company" or "Belo") owns and operates newspapers and network-affiliated television stations in five U.S. cities. The Company traces its roots to The Galveston Daily News, which began publishing in 1842. Incorporated in Texas in 1926, the Company was reorganized as a Delaware corporation in 1987. (References herein to "Company" or "Belo" mean A. H. Belo Corporation and its wholly-owned subsidiaries unless the context otherwise specifies.) The Company's principal newspaper is The Dallas Morning News. In addition, the Company publishes eight community newspapers for certain suburbs in the Dallas-Fort Worth metropolitan area. The Company also owns and operates network-affiliated VHF television broadcast stations in Dallas-Fort Worth and Houston, Texas; Sacramento-Stockton-Modesto, California; Norfolk-Portsmouth-Newport News-Hampton, Virginia and Tulsa, Oklahoma. Note 11 to the Consolidated Financial Statements, included on page 35 of this document, contains information about the Company's industry segments for the years ended December 31, 1993, 1992 and 1991. NEWSPAPER PUBLISHING The Company's wholly-owned subsidiary, The Dallas Morning News, Inc., publishes the Company's principal newspaper, The Dallas Morning News, each morning, including Sunday. Published continuously since 1885, The Dallas Morning News provides coverage of local, state, national and international news. The Morning News is distributed throughout the Southwest, though its circulation is concentrated primarily in the twelve counties surrounding Dallas and Fort Worth: Collin, Dallas, Denton, Ellis, Henderson, Hood, Hunt, Johnson, Kaufman, Parker, Rockwall and Tarrant counties. The Dallas Morning News strives to serve the public interest by maintaining a strong and independent voice in matters of public concern. It is the policy of the Company to allocate such resources as may be necessary to maintain excellence in news reporting and editorial comment in The Dallas Morning News. The Dallas Morning News serves a large readership in its primary market. Average paid circulation for the six months ended September 30, 1993, according to the unaudited Publisher's Statement of the Audit Bureau of Circulations, an independent agency, was 527,387 daily and 814,404 on Sunday, an increase of 2.5 percent and .6 percent, respectively, over the six months ended September 30, 1992, which were 514,342 daily and 809,188 on Sunday. In December 1991, the Company's principal competitor, the Dallas Times Herald (owned by Times Herald Printing Company), ceased operations and sold substantially all of its assets to the Company for $55.7 million. The primary daily newspaper competing with The Dallas Morning News in its marketing area is the Fort Worth Star-Telegram, owned by Capital Cities/ABC, Inc.. The Dallas Morning News also competes for advertising with television and radio stations (including a television station owned and operated by the Company), magazines, direct mail, cable television, billboards and other newspapers (including the other newspapers owned and operated by the Company). The basic material used in publishing The Dallas Morning News is newsprint. The average unit price of newsprint consumed during 1993 was higher than that of the prior year due to a market-wide increase in newsprint prices. At present, newsprint is purchased from eight suppliers. During 1993, the Company's three largest providers of newsprint provided approximately 65 percent of the annual requirements, but the Company is not dependent on any one of these suppliers. Management believes its sources of newsprint, along with alternate sources that are available, are adequate for its current needs. In January 1994, the Company restructured the operations of its wholly-owned subsidiary, Dallas-Fort Worth Suburban Newspapers, Inc.. As part of the restructuring, Dallas-Fort Worth Suburban Newspapers, Inc., was split into two wholly-owned subsidiaries, DFW Suburban Newspapers, Inc., and DFW Printing Company, Inc.. DFW Suburban Newspapers, Inc. will continue to publish its six paid circulation newspapers for suburban communities in the Dallas-Fort Worth metropolitan area. These publications are delivered one to two days a week. In addition, two free newspapers are published once a week. Each of the Company's community publications has its own sales, circulation, news and editorial personnel, and several of the publications currently maintain separate offices. All administrative functions, however, are centralized and all of the newspapers are printed at a plant in Arlington, Texas. This plant is owned and operated by DFW Printing Company, Inc., which in addition to printing the suburban newspapers, conducts the Company's commercial printing operations. TELEVISION BROADCASTING The following table lists relevant information about the Company's television broadcasting stations: _____________________________ (1) Designated Market Area ("DMA") is an exclusive geographic area consisting of all counties in which the local stations receive a preponderance of total viewing hours. DMA data, which is published by the A. C. Nielsen Company ("Nielsen"), is a significant factor in determining television advertising rates. All the information shown above is as of November 1993. (2) Applications for renewal of the licenses for certain stations are pending before the Federal Communications Commission, and the stations' licenses are by statute continued in effect pending action thereon. (3) The number of television broadcasting stations is as of November 1993 and is based on information published by Nielsen. In each of these markets, one of the VHF stations indicated is a non-commercial public broadcasting television station, except for Dallas-Fort Worth, where there are two VHF stations that are non-commercial public broadcasting stations, and Norfolk-Portsmouth-Newport News-Hampton, where there are no VHF non-commercial public broadcasting stations. In addition, there is one UHF non-commercial public broadcasting station in Norfolk- Portsmouth-Newport News-Hampton and one in Tulsa. Affiliation with a television network can have a significant influence on the revenues of a television station because the audience share drawn by a network's programming can affect the rates at which a station can sell advertising time. The Federal Communications Commission ("FCC") regulates certain provisions of television station's network affiliation contracts. The television networks compete for affiliations with licensed television stations through program commitments and local marketing support. From time to time, local television stations also solicit network affiliations on the basis of their ability to provide a network better access to a particular market. Generally, rates for national and local spot advertising sold by the Company are determined by each station, which receives all of the revenues, net of agency commissions, for that advertising. Rates are influenced both by the demand for advertising time and the popularity of the station's programming. Most advertising during network programs is sold by the networks, which pay their affiliated stations negotiated fees for broadcasting such programs and advertising. The Company's television broadcast properties compete for advertising revenues directly with other media such as newspapers (including those owned and operated by the Company), billboard advertising, magazines, direct mail advertising, radio, other television stations, cable television systems, and indirectly, with motion picture theaters and other news and entertainment media. The success of broadcast operations depends on a number of factors, including the general strength of the national and local economy, the ability to provide attractive programming, audience ratings, relative cost efficiency in reaching audiences as compared to other advertising media, technical capabilities and governmental regulations and policies. Each of the three major television networks is represented in each television market in which the Company has a television broadcast station. Each of the markets is served by at least two other commercial VHF television stations and at least two commercial UHF television stations. Competition for advertising sales and local viewers within each market is intense, particularly among the network-affiliated commercial VHF television stations. In the Dallas-Fort Worth market, the other commercial VHF stations are owned by Argyle Television Holdings, Inc., LIN Broadcasting Corporation and Gaylord Entertainment Company. In Houston, the other commercial VHF stations are owned by Capital Cities/ABC, Inc. and H & C Communications, Inc. (sale pending to The Washington Post Company). In the Sacramento-Stockton-Modesto market, Kelly Broadcasting Company and Continental Broadcasting Ltd. also own commercial VHF stations. The Norfolk-Portsmouth-Newport News- Hampton market is served by two other commercial VHF stations, one owned by LIN Broadcasting Corporation and the other by Narragansett Capital Associates, L. P.. In the Tulsa market, the two other commercial VHF stations are owned by Scripps Howard Inc. and Perpetual Corporations Communications (Allbritton Communications Company). Fox-affiliated stations also compete in each of Belo's markets for advertising sales and local viewers. The Fox-affiliated stations in Belo's broadcast markets are all commercial UHF television stations and are owned by the following companies: Fox Television Stations, Inc., in Dallas-Fort Worth; The Fox Network in Houston; Renaissance Communications in Sacramento-Stockton-Modesto; WTVZ, Inc. in Norfolk-Portsmouth-Newport News-Hampton; and Clear Channel Television in Tulsa. REGULATION OF TELEVISION BROADCASTING The Company's television broadcasting operations are subject to the jurisdiction of the FCC under the Communications Act of 1934, as amended (the "Act"). Among other things, the Act empowers the FCC to assign frequency bands; determine stations' frequencies, location and power; issue, renew, revoke and modify station licenses; regulate equipment used by stations; impose penalties for violation of the Act or of FCC regulations; impose fees for processing applications and other administrative functions; and adopt regulations to carry out the Act's provisions. The Act also prohibits the assignment of a broadcast license or the transfer of control of a broadcast licensee without prior FCC approval. Under the Act, the FCC also regulates certain aspects of the operation of cable television systems and other electronic media that compete with broadcast stations. The Act would prohibit the Company's subsidiaries from continuing as broadcast licensees if record ownership or power to vote more than one-fourth of the Company's stock were to be held by aliens or foreign governments or their representatives, or if an officer or more than one-fourth of the Company's directors were aliens. Under the Act, television broadcast licenses may be granted for maximum periods of five years and are renewable upon proper application for additional five-year terms. Renewal applications are granted without hearing if there are no competing applications or issues raised by petitioners to deny such applications that would cause the FCC to order a hearing. A full comparative hearing is required if competing applications are filed. A federal court of appeals has affirmed an FCC decision that recognizes an incumbent licensee's "renewal expectancy" based on substantial service to its community. The precise parameters of licensees' renewal expectancies in comparative proceedings are ambiguous at the present time. This ambiguity may lead to new FCC rules or policies as the result of pending FCC rulemaking proceedings, or Congressional legislation reforming the comparative renewal process. Applications for renewal of broadcast licenses for three of the Company's stations are pending before the FCC. The stations' licenses are by statute continued pending action thereon. The current license expiration dates for each of the Company's television broadcast stations are set forth in the table under "Business-Television Broadcasting." FCC rules limit the total number of television broadcast stations that may be under common ownership, operation and control, or in which a single person or entity may hold office or have more than a specified percentage of voting power. FCC rules also place certain limits on common ownership, operation and control of, or cognizable interests or voting power in, (a) broadcast stations serving the same area, (b) broadcast stations and daily newspapers serving the same area and (c) television broadcast stations and cable systems serving the same area. The Company's ownership of The Dallas Morning News and WFAA-TV, which are both located in the Dallas-Fort Worth area and serve the same market area, predate the adoption of the FCC's rules regarding cross-ownership, and the Company's ownership of The Dallas Morning News and WFAA has been "grandfathered" by the FCC. These FCC rules affect the number, type and location of newspaper, broadcast and cable television properties that the Company might acquire in the future. For example, under current rules, the Company could not acquire any daily newspaper, broadcast or cable television properties in a market in which it now owns or has an interest deemed attributable under Commission rules in a television station, except that the Commission's rules provide that waivers of their restrictions could be granted to permit the Company's acquisition of radio stations in the Dallas, Houston and Sacramento markets. Under current FCC regulations, and in light of the Company's current investments, the Company could acquire outright two more television stations (not including "satellite" television stations which rebroadcast all or most of a parent station's programming) in other markets without disposing of any stations (provided the number of television households in the sum of all Company-owned stations' Area of Dominant Influence ("ADI") did not exceed 25 percent of the total television households in the nation, counting only 50 percent of ADI households for UHF stations). The FCC has instituted rulemaking proceedings looking toward possible relaxation of certain of these rules regulating television station ownership. The Company recently announced that it has reached an agreement in principle to purchase WWL-TV in New Orleans, Louisiana. See Note 12 of Notes to Consolidated Financial Statements on page 36. If the purchase is consummated, the Company could acquire outright one more television station under the parameters described above. The FCC has significantly reduced its past regulation of broadcast stations, including elimination of formal ascertainment requirements and guidelines concerning amounts of certain types of programming and commercial matter that may be broadcast. There are, however, FCC rules and policies, and rules and policies of other federal agencies, that regulate matters such as network-affiliate relations, cable systems' carriage of syndicated and network television programming on distant stations, political advertising practices, obscene and indecent programming, equal employment opportunity, application procedures and other areas affecting the business or operations of broadcast stations. The FCC has modified its rules which restrict network participation in program production and syndication, an action which is the subject of pending review proceedings. The Supreme Court has refused to review a lower court decision that upheld FCC action invalidating most aspects of the Fairness Doctrine, which had required broadcasters to present contrasting views on controversial issues of public importance. The FCC may, however, continue to regulate other aspects of fairness obligations in connection with certain types of broadcasts. The FCC has adopted rules to implement the Children's Television Act of 1990, which, among other provisions, limits the permissible amount of commercial matter in children's television programs and requires each television station to present educational and informational children's programming. The FCC has adopted various regulations to implement certain provisions of the Cable Television Consumer Protection and Competition Act of 1992 ("1992 Cable Act") which, among other matters, includes provisions respecting the carriage of television stations' signals by cable television systems and requiring mid-license term review of television stations' equal employment opportunity practices. Certain provisions of the 1992 Cable Act, including the provisions respecting cable systems' carriage of local television stations, are the subject of pending judicial review proceedings. The FCC has also modified its rules to enable local telephone companies to provide a "video dialtone" service that would be similar to the ordinary telephone dialtone and would provide access for consumers to a wide variety of services including video programming. This decision is the subject of pending judicial review proceedings. Proposals for additional or revised regulations and requirements are pending before and are being considered by Congress and federal regulatory agencies from time to time. The FCC is at present considering modification or elimination of rules respecting territorial exclusivity in non-network program arrangements; rules relating to telephone company ownership of cable television systems; and policies with respect to high definition television. The Company cannot predict the effect of existing and proposed federal regulations and policies on its broadcast business. The foregoing does not purport to be a complete summary of all the provisions of the Act or the regulations and policies of the FCC thereunder. Also, various of the foregoing matters are now, or may become, the subject of court litigation, and the Company cannot predict the outcome of any such litigation or the impact on its broadcast business. EMPLOYEE RELATIONS As of December 31, 1993, the Company had 2,863 full-time employees. There are 37 full-time and 17 part-time composing room employees of The Dallas Morning News represented by a union. The union contract covering these employees expires on June 19, 1994. There are 28 full-time and one part-time television broadcasting employees of WFAA-TV represented by a union under a contract that expires on September 11, 1994. ITEM 2. ITEM 2. PROPERTIES The Company's corporate offices and certain departments of The Dallas Morning News are located in downtown Dallas in a portion of a 17-story office building owned by the Company. The Company owns and operates a newspaper printing facility in Plano, Texas (the "North Plant"), in which eight high-speed offset presses are housed to print The Dallas Morning News. Expansion of these facilities to accommodate increased circulation and provide greater publishing flexibility was completed during 1993. The remainder of The Dallas Morning News' operations are housed in a Company-owned five-story building in downtown Dallas. This facility is equipped with computerized input and photocomposition facilities and other equipment that is used in the production of both news and advertising copy. DFW Suburban Newspapers, Inc. and DFW Printing Company, Inc. operations are located at a Company-owned plant in Arlington, Texas. This facility is pledged as security for certain industrial revenue bonds issued in 1985. The studios and offices of WFAA-TV occupy Company-owned facilities in downtown Dallas. The Company also owns 50 percent of the outstanding capital stock of Hill Tower, Inc. ("Hill Tower"), owner of a 1,500-foot transmitting tower and antennas located in Cedar Hill, Texas. The remaining 50 percent of Hill Tower is owned by the CBS television affiliate in Dallas, a subsidiary of Argyle Television Holdings, Inc.. This equipment is used by both WFAA and the CBS television affiliate. KHOU-TV operates from Company-owned facilities located in Houston. The station's transmitter is located near DeWalt, Texas and includes a 2,000-foot tower. The facility is wholly-owned by the Company. KXTV operates from Company-owned facilities located in Sacramento, California. The station's 2,000-foot tower and transmitter system are located in Sacramento County, California. The tower and transmitter building are owned by a joint venture between the Company and a subsidiary of Anchor Media, Ltd., which owns and operates the ABC television affiliate in Stockton. KXTV leases the transmitter site from the joint venture. WVEC-TV operates from Company-owned facilities in Hampton and Norfolk, Virginia. The Company-owned transmitting facilities include a 980-foot tower and antenna in Driver, Virginia. WVEC also leases additional building space adjacent to the Company-owned facilities, which houses the marketing and business departments. KOTV operates from Company-owned facilities located in Tulsa, Oklahoma. The station's transmitting system is located near Tulsa. The transmitter site and 1,839-foot tower are owned by a joint venture between the Company and Scripps Howard Inc., owner and operator of the NBC television affiliate in Tulsa. The balance of KOTV's transmitting equipment is owned by the station. All of the foregoing subsidiaries have additional leasehold interests that are used in their respective operations. The Company also owns certain land and a building located near downtown Dallas that were acquired from the Dallas Times Herald in December 1991. Sale of this property is expected to be completed in 1994. The Company believes its properties are in good condition and well maintained, and that such properties are adequate for present operations. ITEM 3. ITEM 3. LEGAL PROCEEDINGS There are legal proceedings pending against the Company, including a number of actions for alleged libel. In the opinion of management, liabilities, if any, arising from these actions are either covered by insurance or would not have a material adverse effect on the operations or financial position of the Company. 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 fourth quarter of the fiscal year covered by this Form 10-K. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The Company's authorized common equity consists of 150 million shares of Common Stock, par value $1.67 per share. Currently, 50 million shares are designated as Series A Common Stock and 15 million shares are designated as Series B Common Stock. The Series A and Series B shares are identical in all respects except that Series B shares are entitled to ten votes per share on all matters submitted to a vote of shareholders, while the Series A shares are entitled to one vote per share; transferability of the Series B shares is limited to family members and affiliated entities of the holder; and Series B shares are convertible at any time on a one-for-one basis into Series A shares. Shares of the Company's Series A Common Stock are traded on the New York Stock Exchange (NYSE symbol: BLC). The following table lists the high and low closing prices and last sale prices for Series A Common Stock as reported by the New York Stock Exchange for the last two years. On February 28, 1994, the closing price for the Company's Series A Common Stock, as reported on the New York Stock Exchange, was $52 1/4 and the approximate number of shareholders of record of the Series A Common Stock at the close of business on such date was 720. There is no established public trading market for shares of Series B Common Stock, and such shares are subject to significant restrictions on transfer. Series B shares, however, are convertible at any time into Series A shares on a one-for-one basis. On February 28, 1994, there were approximately 589 holders of record of shares of Series B Common Stock. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA (A) Net earnings for 1993 includes an increase of $6,599,000 (33 cents per share) representing the cumulative effect of adopting Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes", effective January 1, 1993. (B) In December 1991, the Company purchased substantially all of the operating assets of the Dallas Times Herald newspaper for $55,673,000. Also see accompanying Management's Discussion and Analysis of Financial Condition and Results of Operations and Notes to Consolidated Financial Statements. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS LIQUIDITY AND CAPITAL RESOURCES During 1993, net cash provided by operations was $84,818,000, compared to $78,336,000 in 1992. Cash from operations continues to be Belo's primary source of liquidity. The $6,482,000 increase in net cash provided by operations from 1992 to 1993 resulted primarily from increased earnings and lower payments for taxes. In 1993, cash provided by operations was sufficient to fund capital expenditures and dividends on common stock and to make unscheduled repayments of long-term debt. An additional $17,242,000 was generated through the exercise of stock options in 1993, which was also used to pay down debt. At December 31, 1993, Belo had access to a $450,000,000 variable rate revolving credit agreement on which borrowings at that time were $250,000,000. Belo also uses short-term unsecured notes from time to time as a source of financing temporary cash requirements, when rates are favorable. At December 31, 1993, Belo had $21,000,000 of such short-term notes outstanding. On January 15, 1993, Belo retired its 9.45% Notes due in 1993 in the amount of $100,000,000 by borrowing under its revolving credit agreement and in December 1993, another $100,000,000 in 8 5/8% debt was redeemed, also with proceeds from the revolving credit agreement. During 1993, Belo entered into agreements that cap at 6 percent the interest on $75,000,000 of variable rate borrowings. These agreements expire in 1996. Capital expenditures in 1993 were $60,169,000 (excluding $1,961,000 of capitalized interest) compared to $26,750,000 (excluding $395,000 of capitalized interest) in 1992. Nearly 45 percent of these expenditures were for the expansion of The Dallas Morning News' North Plant production facility. The expansion project was substantially completed in the third quarter of 1993 and provides increased press capacity and greater publishing flexibility. Other significant capital additions for 1993 include the replacement of the news department computer system of The Dallas Morning News, expansion and renovation of certain Belo broadcast station facilities and completion of a new transmitter at the Virginia station. In addition, Belo purchased the building in which its corporate offices and several departments of The Dallas Morning News are located. The Company expects to finance future capital expenditures using net cash generated from operations and, when necessary, bank borrowings. Required future payments for capital expenditures in 1994 are $9,992,000 and total capital expenditures in 1994 are expected to be approximately $50,000,000. Dividends of $11,128,000 were paid in 1993 compared to $10,381,000 in 1992. These 1993 dividends represent a total of 56 cents per share of outstanding Series A and Series B Common Stock. Dividends of 54 cents per share were paid in 1992. On December 31, 1993, Belo's ratio of long-term debt to total capitalization was 44.5 percent, compared to 51.8 percent at the end of 1992. The improvement in 1993 is primarily due to earnings in excess of dividend payments, funds generated through the exercise of stock options, and a $25,000,000 reduction in long-term debt. In December 1993, the Board of Directors authorized purchases of up to 1,000,000 shares of the Company's Series A Common Stock from time to time. The Company has the authority to purchase approximately 357,000 shares remaining from a previous Board authorization. In addition, the Company has in place a repurchase program authorizing the purchase of up to $2,500,000 of Company stock annually. Belo believes that its present financial condition and credit relationships will enable it to adequately meet its current obligations and provide for future growth. RESULTS OF OPERATIONS Belo recorded 1993 net earnings of $51,077,000 or $2.53 per share, compared to $37,170,000 ($1.90 per share) in 1992 and $12,392,000 (65 cents per share) in 1991. Earnings in 1993 were affected by certain nonrecurring items, including a $6,599,000 increase (33 cents per share) representing the cumulative effect of adopting Statement of Financial Accounting Standards ("SFAS") No. 109 in January 1993. This increase was partially offset in the third quarter when Belo recorded a $2,249,000 (11 cents per share) adjustment to deferred taxes following an increase in the federal income tax rate from 34 percent to 35 percent. Also included in 1993 earnings is a fourth quarter restructuring charge of $5,822,000 (19 cents per share), related primarily to the write-off of goodwill and a reduction in the carrying value of production assets associated with the newspaper operations of Dallas-Fort Worth Suburban Newspapers, Inc. ("DFWSN"), a wholly-owned subsidiary of Belo. The production assets adjusted include building and improvements and publishing equipment. The restructuring decision was made in an effort to streamline operations and reduce costs of DFWSN's newspaper publishing and commercial printing operations. The restructuring was substantially completed in January 1994. In the fourth quarter, Belo reversed certain music license fee accruals totaling $3,349,000 (10 cents per share). This action was in response to an agreement between the All Industry Television Music License Committee and the American Society of Composers, Authors and Publishers, defining the formula used to compute licensing fees for the use of certain music in television broadcasts from 1984 to 1994. The formula was approved by a New York Federal District Court Magistrate in the fourth quarter. Net earnings for 1993 excluding the above special items were $2.40 per share. In 1992, net earnings of $37,170,000 or $1.90 cents per share, included a $4,019,000 (16 cents per share) increase in earnings before taxes from a property damage settlement with the United States Navy. Excluding this one-time gain, 1992 earnings were $1.74 per share. Net earnings in 1991 were hampered by an overall weak economy, especially in Texas, where Belo's three largest subsidiaries operate. Earnings for 1991 were also affected by several items, including a favorable Internal Revenue Service ("IRS") settlement which increased net earnings by $6,787,000. Offsetting this amount, however, were a number of unusual one-time charges, including a $4,000,000 unfavorable judgment in a lawsuit against one of Belo's broadcast subsidiaries; a $4,000,000 reserve for a note receivable related to a previous asset sale; a $1,500,000 settlement of an antitrust lawsuit; a $1,384,000 provision for post-retirement benefits; a $1,259,000 write-down of certain broadcast film contract rights; and $1,241,000 in early retirement charges. The net effect on 1991 earnings of these unusual items was a decrease of 7 cents per share. Excluding these items, earnings for 1991 were 72 cents per share. Interest expense in 1993 was 37.8 percent less than 1992 interest expense. The most significant contributing factor to the current year savings was lower interest rates. In January 1993, Belo replaced $100,000,000 of 9.45 percent notes with proceeds from the revolving credit agreement, which had an average interest rate of 3.7 percent during 1993. A similar financing of debt took place in December 1993, when $100,000,000 of 8 5/8 percent notes were redeemed using proceeds from the revolving credit agreement. Also contributing to the decrease in 1993 interest expense was Belo's lower average debt outstanding and the capitalization of $1,961,000 of interest in 1993 versus 1992 capitalized interest of $395,000. Interest expense in 1992 was relatively unchanged when compared to 1991 interest expense. Other income and expense in 1993 includes a $986,000 gain on the sale of two parcels of non-operating real estate and several smaller, individually insignificant items. As noted earlier, 1992's other income and expense included a gain of $4,019,000 before taxes, related to a property damage settlement with the United States Navy. Other income and expense for 1991 included the $4,000,000 reserve for a note receivable and $1,500,000 for the settlement of an antitrust lawsuit. The Company's effective tax rate in 1993 was 41.1 percent, which compares to 39.6 percent in 1992 and 33.4 percent in 1991. The effective rate in 1993 was affected by an increase in the federal income tax rate, which resulted in an increase in current tax expense and a $2,249,000 increase in deferred tax expense to adjust deferred taxes to the 35 percent rate. The 1993 rate was favorably impacted by the reversal of certain tax accruals as a result of new tax legislation regarding amortization of intangibles. The effective rate in 1991 was favorably impacted by reversals of tax accruals related to IRS settlements. NEWSPAPER PUBLISHING In 1993, newspaper publishing revenues represented 61.6 percent of consolidated revenues, compared to 61 percent in 1992 and 57.9 percent in 1991. The composition of revenues in each of these three years was essentially the same, with advertising accounting for approximately 87 percent, circulation 11 percent and other publishing revenues, primarily commercial printing, 2 percent. Newspaper advertising volume for The Dallas Morning News, Belo's principal newspaper, is measured in column inches. Volume for the last three years was comprised as follows: Total publishing revenues in 1993 were $335,642,000, up 6.7 percent from revenues of $314,701,000 earned in 1992. Classified advertising revenues were nearly 11 percent better than last year due to both linage and rate increases. The increase in linage was primarily attributable to automotive and employment advertising. Retail and general advertising revenues also improved in 1993 relative to 1992, primarily due to increased rates. Circulation revenues increased 5.9 percent in 1993 primarily from a January 1, 1993 increase in the price of a Sunday single-copy and the weekend subscription rate. Revenues in 1992 of $314,701,000 improved 26 percent over 1991 revenues of $249,737,000. Higher advertising volumes, combined with rate increases, generated the 1992 advertising revenue improvement. Average circulation increased by approximately 25 percent daily and 30 percent Sunday after the December 1991 closure of the Dallas Times Herald. Based primarily on this increased circulation, the Company announced a 15 percent rate increase across substantially all advertising categories, effective on January 15, 1992. Additional rate increases ranging from 6.5 percent to 11.5 percent were announced in the third quarter of 1992. The Company also experienced volume gains in all advertising categories, with the most significant increases in general and classified advertising. The Company believes that its advertising rates continue to compare favorably with competing media and have not negatively affected advertising volumes. Future demand for advertising in the Dallas-Fort Worth area will continue to depend on general economic conditions of the Southwest region and the United States as a whole. Management further believes that increased circulation from the conversion of former Dallas Times Herald readers was substantially realized in 1992. Thus, the ability of the Company to generate continued growth in circulation and advertising revenues will likely depend on the ability of its newspapers to compete successfully in the highly competitive Dallas-Fort Worth media market, where numerous news and advertising alternatives are available. In addition, various market and demographic factors, such as circulation and readership trends, retail sales activity, inflation and population growth will also affect future revenues. Earnings from newspaper publishing operations in 1993 were $44,293,000 after a $5,822,000 restructuring charge related to DFWSN. Excluding the restructuring charge, earnings were $50,115,000, an increase of 16.6 percent from 1992. While total publishing revenues increased 6.7 percent, operating expenses (excluding the charge) increased only 5.1 percent, resulting in an operating margin of 14.9 percent versus 13.7 percent in 1992. Salaries, wages and employee benefits rose primarily as a result of merit increases and an increase in the number of full-time employees. Newsprint expense was up due to both increased consumption associated with the linage increase and a higher average cost per ton. Contributing to the increase in linage was the publishing of special sports sections in connection with the Dallas Cowboys' appearance in the Super Bowl. The volume variance accounted for approximately 60 percent of the overall increase in newsprint expense. In addition, expansion of delivery routes resulted in increased distribution expenses. Depreciation expense was higher in 1993 than in 1992 following the completion of The Dallas Morning News North Plant expansion project. Partially offsetting these increases were savings in outside services, bad debt expense and property taxes. Earnings from publishing operations increased to $42,974,000 in 1992 from $21,417,000 in 1991, resulting in operating margins of 13.7 percent and 8.6 percent, respectively. Revenue increases outpaced higher operating costs, resulting in operating margin improvement. The 1992 increase in salaries, wages and employee benefits was from merit increases, more employees, higher benefit costs and incentive bonuses. Newsprint consumed, and consequently newsprint costs, were higher in 1992 compared to 1991 due to the increase in circulation mentioned before. However, a significant decline in the average price of newsprint in 1992 helped to mitigate the volume variance. Amortization of intangibles was included in 1992 earnings from newspaper publishing operations for the first time following the December 1991 purchase of an intangible asset from the Dallas Times Herald. BROADCASTING Belo's five television broadcast subsidiaries contributed 38.4 percent of total 1993 revenues compared to 39 percent in 1992 and 42.1 percent in 1991. Broadcast revenues for 1993 of $209,193,000 increased 4 percent over 1992 revenues of $201,241,000. In 1992, revenues improved 10.7 percent from the $181,848,000 of the previous year. Broadcast revenues for the last three years were derived as follows: The broadcast revenue mix has been relatively stable over the last three years, with a slight variation in 1992 other revenue due to higher political advertising. Local and national advertising revenues in 1993 increased 6.2 percent and 6.6 percent, respectively, compared to 1992 revenues. Stations in Houston, Virginia and Tulsa combined for an overall revenue gain of $9,266,000 while Dallas station revenues were relatively flat and the California station experienced a slight revenue decline. In 1993, all of Belo's broadcast stations with the exception of the Dallas station experienced an increase in local advertising revenues. National advertising revenues increased at all but Belo's California station. Contributing factors to the 1993 improvements include strong ratings performances, healthier local economies and competitive pricing strategies. The industry categories contributing the most to advertising revenues were restaurants, automobiles, department stores and health care. Partially offsetting these revenue gains, however, were a significant decrease in political advertising compared to 1992, a weaker California economy and the effect of competitive forces. The favorable revenue performance in 1992 compared to 1991 was due to improved demand for both local and national advertising, combined with a higher than expected volume of political advertising for national, state and local elections. Political revenues in 1992 were $4,780,000 higher than in 1991, accounting for 25 percent of the overall year-to-year increase. National and local advertising increased by 9.8 percent and 9 percent, respectively, in 1992 from 1991. National advertising revenues were higher in 1992, due, in part, to broadcast of the Super Bowl and Winter Olympics by Belo's three CBS-affiliated stations. Broadcast earnings from operations for 1993 were $63,240,000, including a $3,349,000 increase related to the reversal of certain music license fee accruals. Excluding the music license fee adjustment, earnings from broadcast operations were $59,891,000 compared to $56,461,000 in 1992, an increase of 6.1 percent. In addition to the overall 4 percent increase in revenues, operating costs increased only 3.3 percent, excluding the music license fee adjustment. Contributing to the increase in 1993 expenses were higher salaries, wages and employee benefits due to merit increases, higher benefit costs and an increase in the number of employees in the broadcast division. Communications and travel expenses were higher in 1993 than in 1992 due to coverage of significant news stories, including the Dallas Cowboys' trip to the 1993 Super Bowl, the Presidential Inauguration, and the Branch Davidian story in Waco, Texas. These increases were partially offset by savings in 1993 programming expense. Earnings from broadcast operations were $56,461,000 in 1992, compared with $41,553,000 in 1991. The 1991 broadcast earnings were reduced by several one-time charges, including a $4,000,000 charge for an unfavorable judgment in an employment-related lawsuit, a $1,259,000 write-down of certain broadcast film contract rights and a $788,000 charge for early retirement costs. Excluding these items, comparable earnings increased by $8,861,000 in 1992 from 1991. The increase in broadcast earnings resulted from the $19,393,000 increase in revenues, partially offset by increases in salary and benefit costs due to merit increases, health care expenses and incentive compensation. In recent years, the television broadcast industry has been affected by increased competition for viewing audiences. Belo continues to compete aggressively for advertisers and viewing audiences in markets that offer many alternative media outlets. Future earnings growth will likely depend on the ability to offer competitive audience delivery to advertisers and on general economic conditions. OTHER MATTERS On February 23, 1994, Belo announced an agreement in principle to purchase the assets of WWL-TV, the CBS affiliate in New Orleans, Louisiana for $110,000,000. Belo intends to borrow funds from its revolving credit agreement to complete the transaction. The transaction, which is subject to the signing of a definitive agreement, as well as customary closing conditions, including approval by appropriate government agencies, will be accounted for as a purchase. The Company expects that a definitive agreement will be entered into by early spring and that the transaction will be completed during the third quarter of 1994. At the end of 1993, Belo adjusted the discount rate used in computing the accumulated pension benefit obligation from 9 percent to 7.5 percent and changed the expected rate of return on plan assets from 11 percent to 10.25 percent. The effect of these changes is expected to increase 1994 pension costs by approximately $2,000,000. In 1993, the Financial Accounting Standards Board released SFAS No. 112, "Employers' Accounting for Postemployment Benefits." The requirements of the standard, which relate primarily to workers' compensation, disability, severance pay and other benefits provided after employment but before retirement, do not differ significantly from existing accounting practices employed by the Company. Therefore, planned adoption of the standard in January 1994 is not expected to significantly affect the Company's net earnings. In the Cable Television Consumer Protection and Competition Act of 1992, Congress gave commercial broadcast stations new rights with respect to cable television systems located in the television markets they serve. Under this new law, each commercial broadcast station has the right, at its election, either to demand that their signal be carried on local cable television systems or, alternatively, to require these cable systems to obtain the station's consent in order to retransmit the broadcast station's signal. The Company's broadcast stations have elected the retransmission consent right with respect to most local cable systems. The Company's broadcast stations have completed agreements granting retransmission consent in exchange for various forms of consideration with substantially all of the cable systems in the television markets in which such stations are located. While some of these agreements are short-term, expiring within the next few months, the Company anticipates that it will be able to replace these with longer-term agreements before their expiration. The net effect of inflation on Belo's operations and net income has not been material in the last few years because of a relatively low rate of inflation during this period and because of efforts to lessen the effect of rising costs through a strategy of improved productivity, cost control and, when warranted, increased prices. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The consolidated financial statements, together with the report of independent auditors and financial statement schedules, are included on pages 21 through 42 of this document. Financial statement schedules other than those included have been omitted because the required information is contained in the consolidated financial statements or related notes, or such information is not applicable. 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 set forth under the headings "Outstanding Capital Stock and Stock Ownership of Directors and Principal Shareholders," "Executive Officers of the Company" and "Election of Directors" contained in the definitive Proxy Statement for the Company's Annual Meeting of Shareholders to be held on May 4, 1994, is incorporated herein by reference. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The information set forth under the heading "Executive Compensation and Other Matters" and "Election of Directors" contained in the definitive Proxy Statement for the Company's Annual Meeting of Shareholders to be held on May 4, 1994, is incorporated herein by reference. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information set forth under the heading "Outstanding Capital Stock and Stock Ownership of Directors and Principal Shareholders" in the definitive Proxy Statement for the Company's Annual Meeting of Shareholders to be held on May 4, 1994, is incorporated herein by reference. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information set forth under the headings "Executive Compensation and Other Matters" and "Election of Directors" contained in the definitive Proxy Statement for the Company's Annual Meeting of Shareholders to be held on May 4, 1994, is incorporated herein by reference. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) (1) The financial statements listed in the Index to Financial Statements and Schedules included in the Table of Contents are filed as part of this report. (2) The schedules listed in the Index to Financial Statements and Schedules included in the Table of Contents are filed as part of this report. (3) Exhibits Certain of the exhibits to this report are hereby incorporated by reference, as specified: EXHIBIT NUMBER DESCRIPTION - ------- ----------- 3.1 Certificate of Incorporation of the Company (incorporated by reference to Exhibit 3.1 to the Company's Annual Report on Form 10-K dated March 19, 1992 (the "1991 Form 10-K")) 3.2 Certificate of Correction to Certificate of Incorporation dated May 13, 1987 (incorporated by reference to Exhibit 3.2 to the Company's Annual Report on Form 10-K dated March 18, 1993 (the "1992 Form 10-K")) 3.3 Certificate of Designation of Series A Junior Participating Preferred Stock of the Company dated April 16, 1987 (incorporated by reference to Exhibit 3.3 to the 1991 Form 10-K) 3.4 Certificate of Amendment of Certificate of Incorporation of the Company dated May 4, 1988 (incorporated by reference to Exhibit 3.4 to the 1992 Form 10-K) 3.5 Amended Certificate of Designation of Series A Junior Participating Preferred Stock of the Company dated May 4, 1988 (incorporated by reference to Exhibit 3.5 to the 1992 Form 10-K) 3.6 Certificate of Designation of Series B Common Stock of the Company dated May 4, 1988 (incorporated by reference to Exhibit 3.6 to the 1992 Form 10-K) 3.7 Bylaws of the Company, effective December 16, 1992 (incorporated by reference to Exhibit 3.7 to the 1992 Form 10-K) 4.1 Certain rights of the holders of the Company's Common Stock are set forth in Exhibits 3.1-3.6 above 4.2 Specimen Form of Certificate representing shares of the Company's Series A Common Stock (incorporated by reference to Exhibit 4.2 to the 1992 Form 10-K) 4.3 Specimen Form of Certificate representing shares of the Company's Series B Common Stock (incorporated by reference to Exhibit 4.3 to the Company's Annual Report on Form 10-K dated March 20, 1989) 4.4 Form of Rights Agreement, dated March 10, 1986 between the Company and RepublicBank Dallas, National Association as Rights Agent, which includes as Exhibit B thereto the Form of Right Certificate (incorporated by reference to Exhibit 4.8 to the 1991 Form 10-K) 4.5 Supplement No. 1 to Rights Agreement (incorporated by reference to Exhibit 4.9 to the 1991 Form 10-K) 4.6 Supplement No. 2 to Rights Agreement (incorporated by reference to Exhibit 4.9 to the 1992 Form 10-K) 4.7 Supplement No. 3 to Rights Agreement (incorporated by reference to Exhibit 4.10 to the 1992 Form 10-K) 4.8 Supplement No. 4 to Rights Agreement dated December 12, 1988 substituting Manufacturers Hanover Trust Company as Rights Agent 4.9 Supplement No. 5 to Rights Agreement (incorporated by reference to Exhibit 4.1 to the Company's Quarterly Report on Form 10-Q for the quarterly period ended June 30, 1993) 10.1 Contracts relating to television broadcasting: (1) Contract for Affiliation between KOTV in Tulsa, Oklahoma and CBS, with Network Affiliation Consent (incorporated by reference to Exhibit 10.1(1) to the 1991 Form 10-K) (2) Contract for Affiliation between KHOU-TV in Houston, Texas and CBS, with Network Affiliation Consent (incorporated by reference to Exhibit 10.1(2) to the 1991 Form 10-K) EXHIBIT NUMBER DESCRIPTION ------- ----------- (3) Letter Amendment, dated June 11, 1993, to Contract for Affiliation between KHOU-TV in Houston, Texas and CBS (4) Contract for Affiliation between KXTV in Sacramento, California and CBS (incorporated by reference to Exhibit 10.3 to the Company's Quarterly Report on Form 10-Q for the quarterly period ended March 31, 1993 (the "First Quarter 1993 Form 10-Q")) (5) Contract for Affiliation between WFAA-TV in Dallas, Texas and ABC, with Network Affiliation Consent (incorporated by reference to Exhibit 10.1(4) to the Company's Annual Report on Form 10-K dated March 28, 1991 (the "1990 Form 10-K")) (6) Rider One to Contract for Affiliation between WFAA-TV in Dallas, Texas and ABC (incorporated by reference to Exhibit 10.1 to the First Quarter 1993 Form 10-Q) (7) Contract for Affiliation between WVEC-TV in Hampton-Norfolk, Virginia and ABC, with Network Affiliation Consent (incorporated by reference to Exhibit 10.1(5) to the 1991 Form 10-K) 10.2 Contracts relating to newspaper publication: (1) Founding agreement dated July 28, 1987 between the Company and Newsprint South, Inc. for newsprint supply (incorporated by reference to Exhibit 10.2(2) to the 1990 Form 10-K) (2) Amendment to the founding agreement dated June 30, 1990 between the Company and Newsprint South, Inc. for newsprint supply (incorporated by reference to Exhibit 10.2(3) to the 1990 Form 10-K) 10.3 (1) Management Security Plan (incorporated by reference to Exhibit 10.4(1) to the 1991 Form 10-K) (2) Stock Option Plan (incorporated by reference to Exhibit 10.4(2) to the 1991 Form 10-K) (3) Amendment to Stock Option Plan by the Compensation Committee of the Board of Directors (incorporated by reference to Exhibit 10.4(3) to the 1991 Form 10-K) (4) Amendments to Stock Option Plan (incorporated by reference to Exhibit 10.4(4) to the 1991 Form 10-K) (5) Amendment to Stock Option Plan dated December 19, 1986 (incorporated by reference to Exhibit 10.4(5) to the 1991 Form 10-K) (6) Amendment to Stock Option Plan dated February 22, 1989 (7) 1986 Long-Term Incentive Plan (incorporated by reference to Exhibit 10.4(7) to the 1991 Form 10-K) (8) Amendment No. 1 to 1986 Long-Term Incentive Plan dated October 22, 1986 (incorporated by reference to Exhibit 10.4(8) to the 1991 Form 10-K) (9) Amendment No. 2 to 1986 Long-Term Incentive Plan effective January 1, 1987 (incorporated by reference to Exhibit 10.3(9) to the 1992 Form 10-K) (10) Amendment No. 3 to 1986 Long-Term Incentive Plan dated May 4, 1988 EXHIBIT NUMBER DESCRIPTION ------- ----------- (11) Amendment No. 4 to 1986 Long-Term Incentive Plan dated May 13, 1988 (12) Amendment No. 5 to 1986 Long-Term Incentive Plan dated February 22, 1989 (13) Amendment No. 6 to 1986 Long-Term Incentive Plan dated May 6, 1992 (incorporated by reference to Exhibit 10.3(13) to the 1992 Form 10-K) (14) The A. H. Belo Corporation Employee Savings and Investment Plan (incorporated by reference to Exhibit 10.4(13) to the Company's Annual Report on Form 10-K dated March 27, 1990 (the "1989 Form 10-K")) (15) First Amendment to the A. H. Belo Corporation Employee Savings and Investment Plan, dated January 29, 1992 (incorporated by reference to Exhibit 10.3(15) to the 1992 Form 10-K) (16) Second Amendment to the A. H. Belo Corporation Employee Savings and Investment Plan, dated October 22, 1992 (incorporated by reference to Exhibit 10.3(16) to the 1992 Form 10-K) (17) Third Amendment to the A. H. Belo Corporation Employee Savings and Investment Plan (incorporated by reference to Exhibit 10.2 to the First Quarter 1993 Form 10-Q) (18) Fourth Amendment to the A. H. Belo Corporation Employee Savings and Investment Plan (incorporated by reference to Exhibit 4.14 to Post-Effective Amendment No. 1 to Form S-8 (Registration No. 33-30994)) (19) Fifth Amendment to the A. H. Belo Corporation Employee Savings and Investment Plan (20) The G. B. Dealey Retirement Pension Plan (as amended and restated effective January 1, 1988) (21) First Amendment to the G. B. Dealey Retirement Pension Plan (22) Second Amendment to the G. B. Dealey Retirement Pension Plan (23) Third Amendment to the G. B. Dealey Retirement Pension Plan (24) Fourth Amendment to the G. B. Dealey Retirement Pension Plan (25) Fifth Amendment to the G. B. Dealey Retirement Pension Plan (26) Master Trust Agreement, effective as of July 1, 1992, between A. H. Belo Corporation and Mellon Bank, N. A. (27) A. H. Belo Corporation Supplemental Executive Retirement Plan (28) Trust Agreement dated February 28, 1994, between the Company and Mellon Bank, N. A. (29) Summary of A. H. Belo Corporation Executive Compensation Program (incorporated by reference to Exhibit 10.3(18) to the 1992 Form 10-K) (30) Employment and Consultation Agreement between A. H. Belo Corporation and James P. Sheehan (incorporated by reference to Exhibit 10.1 to the Company's Quarterly Report on Form 10-Q for the quarterly period ended September 30, 1993) 10.4 (1) Credit Agreement dated October 27, 1988, between the Company and The First National Bank of Chicago as Managing Agent (incorporated by reference to Exhibit 10.4(1) to the 1992 Form 10-K) EXHIBIT NUMBER DESCRIPTION ------- ----------- (2) Amendment No. 1 to 1988 Credit Agreement between the Company and The First National Bank of Chicago as Managing Agent dated November 8, 1989 (incorporated by reference to Exhibit 10.5(4) to the 1990 Form 10-K) (3) Amendment No. 2 to 1988 Credit Agreement between the Company and The First National Bank of Chicago as Managing Agent dated April 24, 1991 (incorporated by reference to Exhibit 10.5(5) to the 1991 Form 10-K) (4) Amendment Agreement dated May 14, 1992, between the Company and The First National Bank of Chicago as Managing Agent (incorporated by reference to Exhibit 10.4(4) to the 1992 Form 10-K) (5) Amendment Agreement dated November 6, 1992, between the Company and The First National Bank of Chicago as Managing Agent (incorporated by reference to Exhibit 10.4(5) to the 1992 Form 10-K) (6) Loan Agreement dated October 1, 1985, between City of Arlington Industrial Development Corporation and Dallas-Fort Worth Suburban Newspapers, Inc. (incorporated by reference to Exhibit 10.5(2) to the 1991 Form 10-K) (7) Letter of Credit and Reimbursement Agreement dated as of June 2, 1987, between Dallas-Fort Worth Suburban Newspapers, Inc. and The Sanwa Bank, Limited, Dallas Agency covering $6,400,000 City of Arlington Industrial Development Corporation Industrial Development Revenue Bonds (incorporated by reference to Exhibit 10.5(3) to the 1991 Form 10-K) (8) Amendment and Waiver Agreement dated as of December 30, 1992, by and between the Company and The Sanwa Bank, Limited, Dallas Agency (incorporated by reference to Exhibit 10.4(8) to the 1992 Form 10-K) 10.5 Joint Venture Agreement dated August 1, 1989, between the Company and Universal Press Syndicate (incorporated by reference to Exhibit 10.6 to the 1989 Form 10-K) 21 Subsidiaries of the Company 23 Consent of Ernst & Young Executive Compensation Plans and Arrangements: Management Security Plan--1991 Form 10-K, Exhibit 10.4(1) Stock Option Plan--1991 Form 10-K, Exhibit 10.4(2) Amendment to Stock Option Plan by the Compensation Committee of the Board of Directors--1991 Form 10-K, Exhibit 10.4(3) Amendments to Stock Option Plan--1991 Form 10-K, Exhibit 10.4(4) Amendment to Stock Option Plan dated December 19, 1986--1991 Form 10-K, Exhibit 10.4(5) Amendment to Stock Option Plan dated February 22, 1989--filed herewith as Exhibit 10.3(6) 1986 Long-Term Incentive Plan--1991 Form 10-K, Exhibit 10.4(7) Amendment No. 1 to 1986 Long-Term Incentive Plan dated October 22, 1986-- 1991 Form 10-K, Exhibit 10.4(8) Amendment No. 2 to 1986 Long-Term Incentive Plan effective January 1, 1987-- 1992 Form 10-K, Exhibit 10.3(9) Amendment No. 3 to 1986 Long-Term Incentive Plan dated May 4, 1988--filed herewith as Exhibit 10.3(10) Amendment No. 4 to 1986 Long-Term Incentive Plan dated May 13, 1988--filed herewith as Exhibit 10.3(11) Amendment No. 5 to 1986 Long-Term Incentive Plan dated February 22, 1989 --filed herewith as Exhibit 10.3(12) Amendment No. 6 to 1986 Long-Term Incentive Plan dated May 6, 1992--1992 Form 10-K Exhibit 10.3(13) The A. H. Belo Corporation Employee Savings and Investment Plan--1989 Form 10-K, Exhibit 10.4(13) First Amendment to the A. H. Belo Corporation Employee Savings and Investment Plan, dated January 29, 1992--1992 Form 10-K, Exhibit 10.3(15) Second Amendment to the A. H. Belo Corporation Employee Savings and Investment Plan, dated October 22, 1992--1992 Form 10-K, Exhibit 10.3(16) Third Amendment to the A. H. Belo Corporation Employee Savings and Investment Plan--First Quarter 1993 Form 10-Q, Exhibit 10.2 Fourth Amendment to the A. H. Belo Corporation Employee Savings and Investment Plan--Post-Effective Amendment No. 1 to Form S-8, Exhibit 4.14 Fifth Amendment to the A. H. Belo Corporation Employee Savings and Investment Plan--filed herewith as Exhibit 10.3(19) The G. B. Dealey Retirement Pension Plan (as amended and restated effective January 1, 1988)--filed herewith as Exhibit 10.3(20) First Amendment to the G. B. Dealey Retirement Pension Plan--filed herewith as Exhibit 10.3(21) Second Amendment to the G. B. Dealey Retirement Pension Plan--filed herewith as Exhibit 10.3(22) Third Amendment to the G. B. Dealey Retirement Pension Plan--filed herewith as Exhibit 10.3(23) Fourth Amendment to the G. B. Dealey Retirement Pension Plan--filed herewith as Exhibit 10.3(24) Fifth Amendment to the G. B. Dealey Retirement Pension Plan--filed herewith as Exhibit 10.3(25) A. H. Belo Corporation Supplemental Executive Retirement Plan--filed herewith as Exhibit 10.3(27) Summary of A. H. Belo Corporation Executive Compensation Program--1992 Form 10-K, Exhibit 10.3(18) Employment and Consultation Agreement between A. H. Belo Corporation and James P. Sheehan--Quarterly Report on Form 10-Q for the quarterly period ended September 30, 1993, Exhibit 10.1 (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 Sections 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. A. H. BELO CORPORATION By: /s/ Robert W. Decherd Robert W. Decherd Chairman of the Board, President & Chief Executive Officer Dated: 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 Company and in the capacities and on the dates indicated: REPORT OF INDEPENDENT AUDITORS The Board of Directors and Shareholders A. H. Belo Corporation We have audited the accompanying consolidated balance sheets of A. H. Belo Corporation and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of earnings, shareholders' equity, 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 financial statements referred to above present fairly, in all material respects, the consolidated financial position of A. H. Belo Corporation and subsidiaries at December 31, 1993 and 1992, and the consolidated 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. 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 5 to the consolidated financial statements, effective January 1, 1993, the Company changed its method of accounting for income taxes. /s/ERNST & YOUNG Dallas, Texas January 26, 1994, except for Note 12, as to which the date is February 23, 1994. CONSOLIDATED STATEMENTS OF EARNINGS A. H. Belo Corporation and Subsidiaries See accompanying Notes to Consolidated Financial Statements. CONSOLIDATED BALANCE SHEETS A. H. Belo Corporation and Subsidiaries CONSOLIDATED BALANCE SHEETS (CONTINUED) A. H. Belo Corporation and Subsidiaries See accompanying Notes to Consolidated Financial Statements. CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY A. H. Belo Corporation and Subsidiaries See accompanying Notes to Consolidated Financial Statements. CONSOLIDATED STATEMENTS OF CASH FLOWS A. H. Belo Corporation and Subsidiaries See accompanying Notes to Consolidated Financial Statements. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS A. H. Belo Corporation and Subsidiaries NOTE 1: SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES A) PRINCIPLES OF CONSOLIDATION The consolidated financial statements include the accounts of A. H. Belo Corporation (the "Company" or "Belo") and its wholly-owned subsidiaries after the elimination of all significant intercompany accounts and transactions. Certain amounts for the prior years have been reclassified to conform to the current year presentation. B) STATEMENT OF CASH FLOWS For the purpose of the Consolidated Statements of Cash Flows, the Company considers all highly liquid debt instruments purchased with a remaining maturity of three months or less to be temporary cash investments. Such temporary cash investments are carried at cost which approximates fair value. C) INVENTORIES Inventories, consisting primarily of newsprint, ink and other supplies used in printing newspapers, are stated at the lower of average cost or market value. D) PROPERTY, PLANT AND EQUIPMENT Depreciation of property, plant and equipment is provided principally on a straight-line basis over the estimated useful lives of the assets as follows: E) INTANGIBLE ASSETS, NET Intangible assets, net includes primarily the excess cost applicable to subsidiaries acquired since 1984 which is being amortized on a straight-line basis over 40 years. The carrying value of intangible assets is periodically reviewed to determine if impairment exists. In 1993, the Company determined that excess cost associated with its suburban newspaper operations was not recoverable (see Note 2). Also included in Intangible assets, net is the intangible asset acquired in 1991 (see Note 3) which is being amortized on a straight- line basis over its currently estimated useful life of 18 years. Accumulated amortization of intangible assets was $112,775,000 and $100,392,000 at December 31, 1993 and 1992, respectively. F) EARNINGS PER COMMON AND COMMON EQUIVALENT SHARE Earnings per common and common equivalent share are based on the weighted average number of shares outstanding during the period, including common equivalent shares representing dilutive stock options. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS A. H. Belo Corporation and Subsidiaries NOTE 2: RESTRUCTURING CHARGE The Consolidated Statement of Earnings for 1993 includes a $5,822,000 charge related to Dallas-Fort Worth Suburban Newspapers, Inc. ("DFWSN"), that consists primarily of the write-off of goodwill and a reduction in the carrying value of production assets to their fair value. The production assets adjusted include building and improvements and publishing equipment. The charge was recognized in conjunction with the decision to restructure DFWSN upon the determination that the carrying value of these assets was not recoverable. Fair value of production assets was determined principally by market value. The restructuring was substantially completed in January 1994. NOTE 3: ACQUISITION In December 1991, the Company acquired substantially all of the operating assets of the Dallas Times Herald newspaper for $55,673,000, after the newspaper's owner, Times Herald Printing Company, ceased publication of the newspaper. The majority of the assets acquired consisted of newspaper presses and other operating equipment, land, buildings and intangible assets. Following the Company's purchase price allocation, $28,717,000 was included in property, plant and equipment and $23,135,000 was included in intangible assets, net. NOTE 4: LONG-TERM DEBT Long-term debt consists of the following: At the end of 1993, the Company had access to $450,000,000 in revolving credit on which the borrowings were $250,000,000 and $30,000,000 at December 31, 1993 and 1992, respectively. Average interest rates were 3.7 percent and 4.2 percent in 1993 and 1992, respectively. Loans under the revolving credit agreement bear interest at a rate based, at the option of the Company, on the participating bank's prime rate, certificate of deposit rate or LIBOR. The agreement also provides for commitment fees ranging from 1/8 to 1/4 percent per annum depending on the amount of unused commitment. Each January 1 and July 1, until expiration of the commitment on July 1, 1998, the commitment is reduced. Available credit as of January 1, 1994 is $418,750,000. No mandatory repayment of amounts outstanding at December 31, 1993, including short-term borrowings classified as long-term, would be required to be made until January 1, 1996. The revolving credit agreement contains certain covenants, including the maintenance of cash flow in relation to both the Company's leverage and its fixed charges, and a limitation on repurchases of the Company's stock. The Company is in compliance with these covenants at December 31, 1993. During 1993, the Company continued to use various short-term unsecured notes as an additional source of financing. At both December 31, 1993 and 1992, the average interest rate on this debt was 3.7 percent. Due to the Company's intent to renew the short-term notes and its continued ability to refinance this debt on a long-term basis through its revolving credit agreement, $21,000,000 and $66,000,000 of short-term notes outstanding at December 31, 1993 and 1992, respectively, have been classified as long-term. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS A. H. Belo Corporation and Subsidiaries The 9.45% Unsecured Notes matured on January 15, 1993 and were redeemed using proceeds from the revolving credit agreement. On December 16, 1993, the Company exercised an option to redeem its 8 5/8% Unsecured Notes due in 1996 at par plus accrued interest, also using proceeds from the revolving credit agreement. In 1993, 1992 and 1991, the Company incurred interest costs of $16,976,000, $24,554,000 and $24,254,000, respectively, of which $1,961,000, $395,000 and $372,000, respectively, were capitalized as components of construction cost. At December 31, 1993, the Company had outstanding letters of credit of $7,509,000 issued in the ordinary course of business. During 1993, the Company entered into agreements that cap at 6 percent the interest on $75,000,000 of variable rate borrowings. These agreements expire in 1996. Because substantially all of the Company's debt is due under the variable rate revolving credit agreement, no significant differences exist between the carrying value and fair value. NOTE 5: INCOME TAXES Effective January 1, 1993, the Company adopted the provisions of Statement of Financial Accounting Standards (SFAS) No. 109, "Accounting for Income Taxes" changing to the liability method of accounting for 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 and laws that will be in effect when the differences are expected to reverse. As permitted by SFAS No. 109, prior years' financial statements have not been restated to reflect the change. The cumulative effect of adopting SFAS No. 109 as of January 1, 1993 is to increase net earnings by $6,599,000 or 33 cents per share. Subsequent to the adoption of SFAS No. 109, the federal income tax rate was increased from 34 percent to 35 percent, retroactive to January 1, 1993. The Company's deferred taxes were adjusted to reflect the new tax rate, resulting in an increase in deferred tax expense of $2,249,000. Deferred tax expense also reflects a decrease of $1,000,000 for the reversal of certain tax accruals as a result of new tax legislation regarding the amortization of intangibles. Income tax expense (benefit) consists of the following: NOTES TO CONSOLIDATED FINANCIAL STATEMENTS A. H. Belo Corporation and Subsidiaries Income tax provisions for the years ended December 31, 1993, 1992 and 1991 differ from amounts computed by applying the applicable U.S. federal income tax rate as follows: During 1992, the Company and one of its equity affiliates settled a claim against the United States Navy which resulted in an increase in equity in earnings of an equity affiliate of $1,901,000, on which no taxes were provided by the Company because such undistributed earnings are expected to remain invested in that affiliate. During December 1991, the Company reached a settlement with the Internal Revenue Service ("IRS") resolving all pending audit issues in connection with an IRS examination of the Company's tax returns for 1984 through 1988. The principal issue in the examination was the deductibility of the amortization of value of network affiliation agreements and FCC licenses of four of the Company's television stations acquired in 1984. The settlement resulted in a $6,787,000 increase in net earnings from the reversal of excess income taxes and interest accruals in connection with the IRS examination. Significant components of the Company's deferred tax liabilities and assets as of December 31, 1993, are as follows: NOTES TO CONSOLIDATED FINANCIAL STATEMENTS A. H. Belo Corporation and Subsidiaries The sources of deferred income taxes and the tax effect of each for years prior to the adoption of SFAS No. 109 are as follows: NOTE 6: EMPLOYEE RETIREMENT PLANS The Company sponsors a noncontributory defined benefit pension plan covering substantially all employees. The benefits are based on years of service and the average of the employee's five years of highest annual compensation earned during the most recently completed ten years of employment. The funding policy is to contribute annually to the plan an amount at least equal to the minimum required contribution for a qualified retirement plan, but not in excess of the maximum tax deductible contribution. The following table sets forth the plan's funded status and prepaid pension costs (included in other assets on the Consolidated Balance Sheets) at December 31, 1993 and 1992: The increase in unrecognized net loss is the result of the change in the discount rate from 9 percent to 7.5 percent. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS A. H. Belo Corporation and Subsidiaries The net periodic pension cost (benefit) includes the following components: Assumptions used in the accounting for the defined benefit plan are: The Company sponsors a defined contribution plan that covers substantially all of its employees. Subject to certain dollar limits, employees may contribute a percentage of their salaries to this plan, and the Company will match a portion of the employee's contributions. The Company's contributions totaled $1,895,000, $1,135,000 and $799,000 in 1993, 1992 and 1991, respectively. Contributions were higher in 1993 following a change in the Company's matching percentage from 35 percent to 50 percent. The Company also sponsors unfunded non-qualified retirement and death benefit plans for key employees. The Company had recorded a liability for these plans of $3,994,000 and $2,174,000 at December 31, 1993 and 1992, respectively, most of which is classified as long-term in other liabilities on the Consolidated Balance Sheets. Expense recognized in 1993, 1992 and 1991 was $1,412,000, $908,000 and $405,000, respectively. NOTE 7: LONG-TERM INCENTIVE PLAN The Company's current long-term incentive plan has been in place since 1986. There are, however, stock options awarded under a prior plan, which will remain outstanding until they are exercised, canceled or expire. The following table presents the status of the stock options awarded under the prior plan. At December 31, 1993, all of these options were exercisable. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS A. H. Belo Corporation and Subsidiaries Awards under the 1986 long-term incentive plan may be granted to employees in the form of incentive stock options, non-qualified stock options, restricted shares or performance units, the values of which are based on the long-term performance of the Company. In addition, options may be accompanied by stock appreciation rights and limited stock appreciation rights. Rights and limited rights may also be issued without accompanying options. The plan was amended in 1988 to provide for a one-time grant of non-qualified options to purchase 2,500 shares of Series A Common Stock to non-employee directors and to eliminate the previous limit on the number of restricted shares that may be issued. The plan was also amended in 1992 to provide for automatic annual grants through 1997 of non-qualified options to non-employee directors serving after the 1992 Annual Meeting of Shareholders and an additional one-time grant of options to purchase 10,000 shares of Series A Common Stock to those directors subsequently elected. The amendment also increased the number of shares for which awards could be made under the plan. The maximum aggregate number of shares of common stock that may be granted in relation to options, restricted shares and rights, and limited rights issued without accompanying options is 3,600,000 less the number of performance units granted under the plan. The maximum number of performance units that may be granted under the plan is 3,600,000 less the number of options, restricted shares and rights, and limited rights issued without accompanying options granted. Grants made under the 1986 long-term incentive plan during 1993, 1992 and 1991 are summarized below: 1986 LONG-TERM INCENTIVE PLAN The non-qualified options granted under the Company's long-term incentive plan become exercisable in cumulative installments over a period of three years. On December 31, 1993, of the 1,423,192 options outstanding, 821,659 were exercisable. Performance units and shares of Series A Common Stock reserved for grants under the plan were 613,874 and 896,746 at December 31, 1993 and 1992, respectively. A provision for the restricted shares is made ratably over the restriction period. Expense recognized under the plan for restricted shares was $3,598,000, $2,723,000 and $1,889,000 in 1993, 1992 and 1991, respectively. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS A. H. Belo Corporation and Subsidiaries NOTE 8: COMMITMENTS AND CONTINGENT LIABILITIES The Company is involved in certain claims and litigation related to its operations. In the opinion of Management, liabilities, if any, arising from these claims and litigation are either covered by insurance or would not have a material adverse effect on the consolidated financial statements of the Company. In 1991, the Company recorded a $4,000,000 accrual for a judgment resulting from an unfavorable verdict in an employment-related lawsuit. Commitments for the purchase of first-run broadcast film contract rights totaled approximately $60,635,000 at December 31, 1993. Advance payments on plant and equipment expenditures at December 31, 1993 primarily relate to renovations of existing facilities owned by certain Belo broadcasting stations. Required future payments for capital expenditures are $9,992,000 and $882,000 in 1994 and 1995, respectively. In December 1993, the Company purchased the building in which it had been leasing office space. The building had been constructed by a partnership in which the Company was a limited partner prior to 1992. Lease expense for the building in 1991 was $2,807,000. Total lease expense for property and equipment, including the office space through November 1993, was $5,447,000, $6,130,000 and $5,780,000 in 1993, 1992 and 1991, respectively. Future minimum rental payments for operating lease agreements are as follows: NOTE 9: COMMON AND PREFERRED STOCK The Company has two series of common stock authorized, issued and outstanding, Series A and Series B. The shares are identical except that Series B shares are entitled to ten votes per share on all matters submitted to a vote of shareholders, while the Series A shares are entitled to one vote per share. Transferability of the Series B shares is limited to family members and affiliated entities of the holder. Series B shares are convertible at any time on a one-for-one basis into Series A shares. Each outstanding share of common stock is accompanied by one preferred share purchase right which entitles shareholders to purchase 1/100th of a share of Series A Junior Participating Preferred Stock. The rights will not be exercisable until a party either acquires beneficial ownership of 30 percent of the Company's common stock or makes a tender offer for at least 30 percent of its common stock. The rights expire in 1996. If the Company is acquired in a merger or business combination, each right has an initial exercise price of $175 (subject to adjustment) and can be used to purchase the common stock of the surviving company having a market value of twice the exercise price of each right. The number of shares of Series A Junior Participating Preferred Stock reserved for possible conversion of these rights is equivalent to one one-hundredth of the number of shares of common stock issued and outstanding plus the number of shares reserved for grant under the 1986 Long-Term Incentive Plan and Stock Option Plan. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS A. H. Belo Corporation and Subsidiaries NOTE 10: SUPPLEMENTAL CASH FLOW INFORMATION Net cash provided by operations reflects cash payments for interest and income taxes as follows: NOTE 11: INDUSTRY SEGMENT INFORMATION The Company operates in two industries: newspaper publishing and television broadcasting. Operations in the newspaper publishing industry involve the sale of advertising space in published issues, the sale of newspapers to distributors and individual subscribers and commercial printing. Operations in the broadcast industry involve the sale of air time for advertising and the broadcast of entertainment, news and other programming for both local markets and syndication. Net operating revenues by industry segment include sales to unaffiliated customers and intersegment revenues, which before their elimination, are accounted for on the same basis as revenues from unaffiliated customers. Selected segment data is as follows: (A) Included in Newspaper publishing earnings from operations in 1993 is a $5,822,000 restructuring charge consisting primarily of the write-off of goodwill and a reduction in the carrying value of production assets related to the restructuring of DFWSN (see Note 2). (B) Included in Broadcasting earnings from operations in 1993 is a $3,349,000 reversal of certain music license fee accruals. (C) Included in Broadcasting earnings from operations in 1991 is a $788,000 provision for early retirement costs, a $1,259,000 write-down of certain broadcast film contract rights and a $4,000,000 accrual for an adverse judgement in an employment-related lawsuit. (D) Included in corporate expenses in 1991 is a $1,500,000 settlement of an antitrust lawsuit as part of the agreement to acquire the Dallas Times Herald assets (see Note 3). NOTES TO CONSOLIDATED FINANCIAL STATEMENTS A. H. Belo Corporation and Subsidiaries NOTE 12: SUBSEQUENT EVENT On February 23, 1994, the Company announced an agreement in principle to purchase the assets of a television broadcast station in New Orleans, Louisiana for $110,000,000. The Company anticipates that the acquisition will be financed using borrowings from its revolving credit agreement. The transaction, which is subject to the signing of a definitive agreement, as well as customary closing conditions, including approval by appropriate government agencies, will be accounted for as a purchase. The Company expects that a definitive agreement will be entered into by early spring and that the transaction will be completed during the third quarter of 1994. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS A. H. Belo Corporation and Subsidiaries NOTE 13: QUARTERLY RESULTS OF OPERATIONS (UNAUDITED) Following is a summary of the Unaudited Quarterly Results of Operations for 1993 and 1992: (A) Amount represents the cumulative effect of adopting SFAS No. 109, "Accounting for Income Taxes" (see Note 5). (B) A settlement of a claim against the United States Navy was reached in which the Company and one of its equity affiliates were among the plaintiffs. The Company's portion of the settlement and its equity in earnings of the affiliate increased earnings before income taxes by $4,019,000 and net earnings by $3,235,000 or 16 cents per share. The $4,019,000 gain is included in Other, net on the Consolidated Statements of Earnings. The equity in earnings amounted to $1,901,000, on which no taxes are provided by the Company because such undistributed earnings are expected to remain invested in that affiliate. (C) Belo's income tax provision in the third quarter reflects a $2,249,000 charge representing an adjustment to deferred taxes following an increase in the federal income tax rate from 34 percent to 35 percent (see Note 5). (D) Included in Newspaper publishing earnings from operations for the fourth quarter of 1993 is a $5,822,000 restructuring charge consisting primarily of the write-off of goodwill and a reduction in the carrying value of production assets related to the restructuring of DFWSN (see Note 2). (E) Included in Broadcasting earnings from operations for the fourth quarter of 1993 is a $3,349,000 reversal of certain music license fee accruals. (F) Belo's income tax provision in the fourth quarter of 1992 reflects a $1,101,000 benefit resulting from the favorable resolution of a franchise tax issue. MANAGEMENT'S RESPONSIBILITY FOR FINANCIAL STATEMENTS The Management of A. H. Belo Corporation is responsible for the preparation of the Company's consolidated financial statements, as well as for their integrity and objectivity. Those statements are prepared using generally accepted accounting principles, they include amounts that are based on our best estimates and judgments, and we believe they are not misstated due to material fraud or error. Management has also prepared the other information in the Annual Report and is responsible for its accuracy and its consistency with the financial statements. Management maintains a system of internal control that is designed to provide reasonable assurance of the integrity and reliability of the financial statements, the protection of assets from unauthorized use or disposition, and the prevention and detection of fraudulent financial reporting. That system of internal control provides for appropriate division of responsibility, and is documented in written policies and procedures. These policies and procedures are updated as necessary and communicated to those employees having a significant role in the financial reporting process. Management continually monitors the system of internal control for compliance. Management believes that, as of December 31, 1993, the Company's system of internal control is adequate to accomplish the objectives described above. Management recognizes, however, that no system of internal control can ensure the elimination of all errors and irregularities, and it recognizes that the cost of the internal controls should not exceed the value of the benefits derived. Finally, Management recognizes its responsibility for fostering a strong ethical climate within the Company according to the highest standards of personal and professional conduct, and this responsibility is delineated in the Company's written statement of business conduct. That statement of business conduct addresses, among other things, the necessity for due diligence and integrity, avoidance of potential conflicts of interest, compliance with all applicable laws and regulations, and the confidentiality of proprietary information. /S/ Robert W. Decherd Robert W. Decherd Chairman of the Board, President & Chief Executive Officer /S/ Michael D. Perry Michael D. Perry Senior Vice President & Chief Financial Officer SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT A. H. Belo Corporation and Subsidiaries (1) Amounts represent allocation of purchase price for assets acquired from the Dallas Times Herald in December 1991. (2) In 1993, retirements and other adjustments includes the reclassification of advance payments related to completion of the expansion of The Dallas Morning News' North Plant production facility, and the reduction of the carrying value of certain assets of DFWSN. SCHEDULE VI - ACCUMULATED DEPRECIATION OF PROPERTY, PLANT AND EQUIPMENT A. H. Belo Corporation and Subsidiaries (1) In 1993, retirements and other adjustments includes the reduction of the carrying value of certain assets of DFWSN. SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS A. H. Belo Corporation and Subsidiaries (1) Uncollectible accounts written off, net of recoveries and other miscellaneous adjustments. SCHEDULE X - SUPPLEMENTARY EARNINGS STATEMENT INFORMATION A. H. Belo Corporation and Subsidiaries E-1 E-2 E-3 E-4 E-5 E-6

882244_1993.txt

882244_1993

1993

882244

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

83394_1993.txt

83394_1993

1993

83394

ITEM 1. BUSINESS ________________ (a) General Development of Business _______________________________ Resorts International, Inc. ("RII") is a holding company which, through its subsidiaries, is principally engaged in the ownership and operation of Merv Griffin's Resorts Casino Hotel ("Resorts Casino Hotel") in Atlantic City, New Jersey, and the Paradise Island Resort & Casino, the Ocean Club Golf & Tennis Resort and the Paradise Paradise Beach Resort, all located on Paradise Island, The Bahamas. RII was incorporated in Delaware in 1958. The term "Company" as used herein includes RII and/or one or more of its subsidiaries as the context may require. In Atlantic City, the Company owns and operates the Resorts Casino Hotel, which has approximately 670 guest rooms, a 60,000 square foot casino, an 8,000 square foot racetrack simulcast betting and poker area and related facilities, located on the Boardwalk. Pursuant to a major capital improvements program that began in 1989, virtually all guest rooms and public areas at the Resorts Casino Hotel have been refurbished. See "(c) Narrative Description of Business - Atlantic City - Capital Improvements" below, and "ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS." Approximately 10 acres of Boardwalk property owned by the Company is leased to Atlantic City Showboat, Inc. ("ACS") under a 99-year net lease (the "Showboat Lease"). All lease payments due under the Showboat Lease directly service the Company's interest obligations under the Showboat Notes described under "(c) Narrative Description of Business - Atlantic City - Showboat Lease" below. The leased acreage is the site of the Showboat Casino Hotel (the "Showboat") which is operated by ACS. The Company also owns other real estate in the Atlantic City area, most of which consists of vacant land. Casino operations in Atlantic City are conducted under a casino license which is subject to periodic review and renewal by action of the New Jersey Casino Control Commission (the "Casino Control Commission"). The Company's current license was renewed in February 1994 through January 31, 1996 and is subject to certain financial reporting and other conditions. See "Regulation and Gaming Taxes and Fees - New Jersey" under "(c) Narrative Description of Business" below. On Paradise Island, the Company operates a 30,000 square foot casino and owns and operates resort and hotel facilities that include a total of 1,357 guest rooms and related amenities. The Company owns substantial undeveloped real estate in The Bahamas in addition to its operating properties. See "Restructuring of Series Notes" below for a description of a proposed restructuring (the "Restructuring") which includes the disposition of the Company's Paradise Island operations and properties. Casino operations in The Bahamas are conducted under a casino license which is subject to periodic review and renewal by the Gaming Board of the Commonwealth of The Bahamas. The Company's current license is subject to various conditions. See "Regulation and Gaming Taxes and Fees - The Bahamas" under "(c) Narrative Description of Business" below. - 3 - Restructuring of Series Notes _____________________________ Background __________ The outstanding principal amount of RII's Senior Secured Redeemable Notes due April 15, 1994 (the "Series Notes") is $481,907,000. Including the interest due on the maturity date of approximately $36,000,000, RII's total obligation at maturity will amount to approximately $518,000,000. The Company's ability to pay the principal balance due on the Series Notes at maturity was premised on certain assumptions included in RII's 1990 plan of reorganization (the "Old Plan"), the most significant of which was the Company's ability to sell its Paradise Island assets by December 31, 1991 at a price ranging from $250,000,000 to $300,000,000. Other assumptions included the Company's ability to generate substantial excess cash flow from its operations and the Company's ability to sell its non-operating real estate holdings in Atlantic City at acceptable prices. However, the recession in the United States, and more specifically in the northeast sector, the acute competition in Atlantic City and The Bahamas, the unexpected increase in competition from other jurisdictions, the unforeseen difficulty in selling the Paradise Island assets at the projected price, and the adverse impact of the conflict in the Persian Gulf in early 1991 on transportation and tourism, all adversely affected the Company's ability to realize the assumptions in the Old Plan. Although the Company did not discontinue its efforts to sell the Paradise Island assets, it experienced a very limited amount of interest by prospective purchasers. The only offer the Company received for its Paradise Island assets prior to the Restructuring described below was made in August 1991. That offer would have netted the Company approximately $150,000,000 if the transaction had been consummated. This amount was inadequate to retire sufficient Series Notes at par so as to permit the Company's then remaining Atlantic City operations to service the debt that would have remained outstanding. Subsequent discussions with the prospective purchaser did not lead to a definitive agreement, and the discussions terminated in early 1992. As the possibilities of a sale of the Paradise Island assets at other than a depressed price diminished and the Company was unable to generate substantial excess cash flow from its operations, the principal amount of the Series Notes (originally $325,000,000) increased due to a payment-in-kind ("PIK") interest feature of the Series Notes, which allowed the Company to satisfy interest obligations on its Series Notes by the issuance of additional Series Notes in lieu of making cash interest payments. Thus, it became evident that in order for the Company to reduce its debt to a level that could be supported by the cash flow reasonably anticipated on a continuing basis, it had to develop financial alternatives other than, or in conjunction with, a sale of its Paradise Island assets. The Company has been working with its financial advisers on developing and analyzing financial alternatives, as well as developing a long-term financial plan, since late 1991. In this connection, management of the Company, with the assistance of its legal and financial advisers, commenced discussions with representatives of major holders of Series - 4 - Notes in the summer of 1992 in an effort to reach an agreement as to the terms of a possible restructuring of the Series Notes. This process resulted in the Restructuring described below. Restructuring _____________ On October 25, 1993 RII and three of its subsidiaries, Resorts International Hotel, Inc. ("RIH"), Resorts International Hotel Financing, Inc. ("RIHF") and P.I. Resorts Limited ("PIRL"), filed a Form S-4 Registration Statement (No. 33-50733) with the Securities and Exchange Commission. This Registration Statement describes in detail the Restructuring which RII and GGRI, Inc. ("GGRI"), RII's subsidiary which guaranteed the Series Notes, propose to accomplish through a joint plan of reorganization (the "Plan") which was proposed and for which acceptances were solicited before commencing cases under chapter 11 of title 11 of the United States Code (the "Bankruptcy Code"). This process is known as a "prepackaged bankruptcy." On February 1, 1994, after certain amendments, the Registration Statement was declared effective. On February 5, 1994 the solicitation of acceptances of the Plan commenced with the mailing of the Information Statement/Prospectus for Solicitation of Votes on Prepackaged Plan of Reorganization, ballots and other materials to holders of Series Notes, RII's common stock (the "RII Common Stock") and stock options (the "1990 Stock Options") issued pursuant to the RII Senior Management Stock Option Plan (the "1990 Stock Option Plan"). Holders of Series Notes, RII Common Stock and 1990 Stock Options as of January 10, 1994 (the "Voting Record Date") were entitled to vote on the Plan. The solicitation period ended on March 15, 1994. The Plan is the result of extensive negotiations among RII, Fidelity Management & Research Company ("Fidelity") and TCW Special Credits ("TCW"). Fidelity and TCW separately advise and manage various funds and accounts that as of the Voting Record Date held in the aggregate approximately 64% of the outstanding principal amount of Series Notes. In addition, RII, Fidelity and TCW held discussions with Sun International Investments Limited ("SIIL"), an unaffiliated company, regarding the purchase of a 60% interest in the Company's Paradise Island assets (the "SIHL Sale") through a subsidiary of SIIL, Sun International Hotels Limited ("SIHL"), formed for that purpose. The Restructuring contemplates, among other things, the exchange of the Series Notes for: (i) $125,000,000 principal amount of 11% Mortgage Notes due 2003 (the "RIHF Mortgage Notes") to be issued by RIHF and guaranteed by RIH, RII's subsidiary that owns and operates the Resorts Casino Hotel; (ii) $35,000,000 principal amount of 11.375% Junior Mortgage Notes due 2004 (the "RIHF Junior Mortgage Notes") to be issued by RIHF and guaranteed by RIH; (iii) 40% of the RII Common Stock on a fully diluted basis (excluding 1990 Stock Options and options to be issued under a newly proposed stock option plan (the "1994 Stock Option Plan")); (iv) either (a) $65,000,000 in cash, plus interest at an annual rate of 7.5% from January 1, 1994 through the closing date of the SIHL Sale, plus 40% of the capital stock of SIHL, representing the consideration received from the proposed SIHL Sale, or, if the SIHL Sale is not consummated, (b) 100% of the equity of PIRL, which was recently formed to be a holding company in the event of the spin-off (the "PIRL Spin-Off") of 100% of the equity of RII's Bahamian subsidiaries and, through subsidiaries, the assets of RII and certain of its domestic subsidiaries which support the Company's Bahamian operations, and related liabilities; (v) the Company's Excess - 5 - Cash, as defined in the Plan, which is estimated to be at least $30,000,000 and (vi) rights to receive distributions estimated to be approximately $2,500,000 in respect of units of beneficial interest (the "Litigation Trust Units") owned by RII in a litigation trust (the "Litigation Trust") established pursuant to the Old Plan to pursue certain claims against Donald Trump and certain of his affiliates. Each $1,000 principal amount of RIHF Junior Mortgage Notes is to be issued as part of a unit with one share of RII Class B Common Stock (the "RII Class B Stock") and may not be transferred separately from such share of RII Class B Stock. Holders of the RII Class B Stock are to have certain voting rights only with respect to the election of directors and are not to participate in any dividends which may be declared by RII's Board of Directors. Holders of RII Class B Stock will be entitled to elect one-third of RII's Board of Directors unless on more than six occasions RIHF either makes PIK interest payments or fails to make interest payments on the RIHF Junior Mortgage Notes (the "Class B Triggering Event"). Upon the occurrence of the Class B Triggering Event, holders of RII Class B Stock will be entitled to elect the majority of RII's Board of Directors. RIHF may only make PIK interest payments under certain circumstances provided for in the indenture for the RIHF Junior Mortgage Notes. The Restructuring also provides for certain funds or accounts managed by Fidelity to enter into a senior credit facility with RIHF (the "RIHF Senior Facility") which will allow RIHF to borrow up to $20,000,000 through the issuance of notes. The RIHF Senior Facility is to be available for a single borrowing during the one-year period from the date the Plan becomes effective (the "Effective Date"). Notes issued pursuant to the RIHF Senior Facility will bear interest at 11% per year and mature in 2002. The following transactions, among others, are also to be effected in connection with the Restructuring: (i) the initial post-Restructuring directors of RII will be named to the RII Board of Directors (see "ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT"); (ii) RII will issue warrants to purchase 10% of RII Common Stock on a fully diluted basis (the "Griffin Warrants"), to The Griffin Group, Inc. (the "Griffin Group"), a company controlled by Merv Griffin, the Chairman of the Board of RII (see "Transactions with Management and Others - Griffin Services Agreement" under "ITEM 11. EXECUTIVE COMPENSATION - Compensation Committee Interlocks and Insider Participation") and (iii) the 1990 Stock Option Plan will be terminated, though existing holders of 1990 Stock Options will retain their options, and the 1994 Stock Option Plan, which will allow for the granting of options to purchase up to 5% of the outstanding RII Common Stock, will be implemented. Consummation of the Plan is subject to a number of conditions including, but not limited to, confirmation by the Bankruptcy Court and receipt of required regulatory approvals of the Casino Control Commission and the Government of The Bahamas. For the Plan to be confirmed by the Bankruptcy Court, the Plan must comply with various requirements of the Bankruptcy Code. Also, to confirm the Plan on a consensual basis, acceptances must be received from (i) holders of Series Notes constituting at least 66 2/3% in principal amount and more than 50% in number of those voting - 6 - and (ii) at least 66 2/3% each of RII Common Stock and 1990 Stock Options voted. In addition to the vote required by the Bankruptcy Code, a condition to confirmation of the Plan is the entry of an order declaring that certain security documents (the "Security Documents") under which the liens on the property securing the Series Notes were granted or created shall be deemed released and terminated. To effectuate such termination and release consensually, the record holders of at least 66 2/3% in aggregate principal amount of the outstanding Series Notes and the record holders of at least a majority in aggregate principal amount of each series of the Series Notes must consent to the termination of the Security Documents. There are several other conditions to confirmation of the Plan which, subject to the approval of Fidelity and TCW (in certain circumstances), may be waived by RII and GGRI. The solicitation agent has advised the Company that it has received the requisite acceptances for confirmation of the Plan and sufficient consents to release the Security Documents. The Company intends to proceed with the filing of its prepackaged bankruptcy cases; however, there can be no assurance as to whether or when the Restructuring will be effected, or that any restructuring that may ultimately be consummated will be on terms similar to those of the Restructuring. Event of Default ________________ As of September 30, 1993 RII was not in compliance with its covenant contained in the indenture for the Series Notes (the "Series Note Indenture") to maintain a Tangible Net Worth, as defined in the Series Note Indenture, of at least $50,000,000. Since that date RII's Tangible Net Worth has continued to decline. On February 2, 1994, 30 days after receiving notice of such default from the trustee for the Series Notes (the "Series Note Trustee"), this default became an Event of Default. Upon the occurrence of an Event of Default, the Series Note Trustee may accelerate the maturity of the Series Notes by declaring all unpaid principal of and accrued interest on the Series Notes due and payable or may foreclose upon the collateral securing the Series Notes. In addition, the holders of 40% in principal amount of the Series Notes then outstanding may require the Series Note Trustee to accelerate the maturity of the Series Notes. If the Series Note Trustee accelerates the maturity of the Series Notes or forecloses upon the collateral securing the Series Notes, RII and GGRI, as guarantor of the Series Notes, and certain of their subsidiaries whose assets are pledged to secure the Series Notes (including RIH and Resorts International (Bahamas) 1984 Limited ("RIB"), RII's indirect subsidiary, which together with its subsidiaries owns and operates the Company's Bahamian properties) would be forced to seek immediate protection under the Bankruptcy Code. If such events occur, there can be no assurance that the Restructuring would be implemented, that a reorganization of RII and GGRI rather than a liquidation would occur or that any reorganization that might occur would be on terms as favorable to the holders of Series Notes and holders of RII Common Stock as the terms of the Plan. (b) Financial Information about Industry Segments _____________________________________________ The information called for by this item is incorporated by reference to the tables entitled "Revenues," "Contribution to - 7 - Consolidated Loss Before Income Taxes" and "Identifiable Assets, Depreciation and Capital Additions" in "ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS." (c) Narrative Description of Business _________________________________ Atlantic City _____________ Gaming Facilities _________________ The Resorts Casino Hotel has a 60,000 square foot casino and a racetrack simulcast betting and poker area of approximately 8,000 square feet. At December 31, 1993, these gaming areas contained 50 blackjack tables, 25 poker tables, 13 dice tables, 10 roulette tables, 2 baccarat tables, 2 mini-baccarat tables, 2 pai gow poker tables, 1 big six wheel, 1 sic bo table, 1,916 slot machines and nine betting windows and customer-operated terminals for race book. As described below under "Capital Improvements," the casino and hotel facilities at the Resorts Casino Hotel have undergone extensive renovation and remodeling pursuant to a major capital improvements program. During 1993, the Company had total gaming revenues from its Atlantic City casino of $244,116,000. This compares to total gross win of $233,780,000 for 1992 and $218,881,000 for 1991. For 1993 this amount includes simulcast commissions and poker revenue totaling $5,745,000; the Company has offered simulcast betting and poker since June 28, 1993. Casino gaming in Atlantic City is highly competitive and is strictly regulated under the New Jersey Casino Control Act and regulations promulgated thereunder ("Casino Control Act"), which affect virtually all aspects of the Company's Atlantic City casino operations. See "Competition" and "Regulation and Gaming Taxes and Fees - New Jersey" below. Resort and Hotel Facilities ___________________________ The Resorts Casino Hotel commenced operations in May 1978 and was the first casino/hotel opened in Atlantic City. This was accomplished by the conversion of the former Haddon Hall Hotel, a classic hotel structure originally built in the early 1900's, into a casino/hotel. It is situated on approximately seven acres of land with approximately 310 feet of Boardwalk frontage overlooking the Atlantic Ocean. The Resorts Casino Hotel consists of two hotel towers, the 15-story East Tower and the nine-story North Tower. In addition to the casino facilities described above, the casino/hotel complex includes approximately 670 guest rooms and suites, the 1,400-seat Superstar Theatre, eight restaurants, two cocktail and entertainment lounges, a new VIP slot and table player lounge, an indoor swimming pool and health club, and retail stores. The complex also has approximately 50,000 square feet of convention facilities, including eight large meeting rooms and a 16,000 square foot ballroom. The Company owns a garage that is connected to the Resorts Casino Hotel by a covered walkway. This garage is used for patrons' self parking and accommodates approximately 700 vehicles. The Company also offers valet parking at nearby, uncovered leased lots that provide - 8 - space for approximately 600 cars and has an additional leased lot which provides self-parking for approximately 200 cars. Consistent with industry practice, the Company reserves a portion of its hotel rooms and suites as complimentary accommodations for high-level casino wagerers. For 1993, 1992 and 1991 the average occupancy rates, including complimentary rooms which were primarily provided to casino patrons, were 92%, 93% and 90%, respectively. The average occupancy rate and weighted average daily room rental, excluding complimentary rooms, were 47% and $62, respectively, for 1993. This compares with 57% and $61, respectively, for 1992, and 51% and $67, respectively, for 1991. Capital Improvements ____________________ The Company has pursued a major capital improvements program since 1989 in order to compete more effectively in the Atlantic City market. During these five years capital additions at Resorts Casino Hotel exceeded $100,000,000. In 1993 the Company converted certain back-of-the-house space into a simulcast facility, which houses nine betting windows and customer-operated terminals and approximately 80 seats for simulcast betting operations, as well as 25 poker tables, various other table games and a bar with food service. Also, certain casino renovations were completed, 280 slot machines were purchased, most of which replaced older models, and the new VIP slot and table player lounge, "Club Griffin," opened. In addition, guest room refurbishments continued and a new centralized mobile communications system was installed. During the years 1989 through 1992 improvements included refurbishment of rooms in both the East Tower and the North Tower, casino renovations, purchase of new slot machines and gaming equipment, conversion of the parking garage from valet to self-parking, restaurant remodeling and upgrading, renovation of public areas, installation of new computer equipment and management information systems, as well as improvements to the infrastructure such as elevators, air conditioning, and exterior renovations and painting. With the completion of the capital improvements program in 1993, management expects capital expenditures in 1994 to decline to approximately $12,000,000 which will be primarily for maintenance of existing facilities. Marketing _________ The Company continues to take advantage of the celebrity status of Merv Griffin, who is actively engaged in the marketing of the Resorts Casino Hotel. Mr. Griffin, who is Chairman of the Board of RII, is featured in television commercials and in print advertisements. Mr. Griffin also produced live at the Resorts Casino Hotel "Merv Griffin's New Year's Eve Special 1993" which was broadcast nationwide. Mr. Griffin is to continue to participate in the operations and marketing of the Resorts Casino Hotel through the term of a License and Services Agreement described in "Transactions with Management and Others - Griffin Services Agreement" under "ITEM 11. EXECUTIVE COMPENSATION - Compensation Committee Interlocks and Insider Participation." The Company's marketing strategy is designed to enhance the appeal of the Resorts Casino Hotel to the mid and premium-level slot and table game players. For slot players, in 1993 the Company (i) introduced a new "cash-back" program which rewards players with cash refunds or complimentaries based on their volume of play; (ii) expanded - 9 - and upgraded "Hollywood Hills," its high-limit slot area; and (iii) opened a VIP slot and table player lounge, "Club Griffin." Also, in an effort to attract mid and premium table game players, the Company has established customer development teams to increase opportunities in this market area. The entertainment product has also been modified to attract the mid and premium players through increased booking of star headliners and, in 1993, changing the revue show more frequently than in prior years. New Convention Center _____________________ In January 1992, the State of New Jersey enacted legislation that authorized a financing plan for the construction of a new convention center to be located on a 30-acre site next to the Atlantic City train station at the base of the Atlantic City Expressway. The Company understands that the new convention center will have 500,000 square feet of exhibit space and an additional 104,200 square feet of meeting rooms. Construction of the new convention center began in early 1993 and it is scheduled to be completed in the fall of 1996. The convention center is part of a broader plan that includes an additional expansion of the Atlantic City International Airport and other improvements in Atlantic City. Officials have commented upon the need for improved commercial air service into Atlantic City as a factor in the success of the proposed convention center. See further discussion under "Transportation Facilities" below. Also, in order to spur construction of new hotel rooms and renovation of substandard hotel rooms into deluxe accommodations to support the new convention center, certain funds have been set aside by the Casino Reinvestment Development Authority (the "CRDA"), a public authority created under the Casino Control Act, to aid in financing such projects. Ten casino/hotels have filed proposals to obtain financing for such projects; however, plans for these projects are considered preliminary. Although these developments are viewed as positive and favorable to the future prospects of the Atlantic City gaming industry, the Company, at this point, can make no representations as to whether, or to what extent, its operations may be improved by the completion of the new convention center, the proposed airport expansion projects and the proposed increase in number of hotel rooms in the area. Transportation Facilities _________________________ The lack of an adequate transportation infrastructure in the Atlantic City area continues to negatively affect the industry's ability to attract patrons from outside a core geographic area. In 1989 the terminal at the Atlantic City International Airport (located approximately 12 miles from Atlantic City) was expanded to handle additional air carriers and large passenger jets, but scheduled service to that airport from major cities by national air carriers remains extremely limited. Also, in 1989 Amtrak express rail service to Atlantic City commenced from Philadelphia, New York, Washington and other major cities in the northeast. This was expected to improve access to Atlantic City and expand the geographic size of the Atlantic City casino industry's marketing base. However, there has been no significant change in the industry's marketing base or in the principal means of transportation to Atlantic City, which continues to be automobile and bus. The resulting geographic limitations and traffic congestion have restricted Atlantic City's growth as a major - 10 - destination resort. However, the Company understands that the South Jersey Transportation Authority has begun work on a comprehensive master plan for the future development of the airport which plan is expected to be completed in 1994. Plans for expansion that would approximately double the size of the existing passenger terminal have already been announced. The Company understands that construction of this project is to commence in the spring of 1994 and its completion is scheduled for late in the summer of 1995. The Company continues to utilize day-trip bus programs. A non-exclusive easement enables the Resorts Casino Hotel to utilize a bus tunnel under the adjacent Trump Taj Mahal Casino-Resort (the "Taj Mahal"), which connects Pennsylvania and Virginia Avenues, and a service road exit from the bus tunnel. This reduces congestion around the Pennsylvania Avenue bus entrance to the Resorts Casino Hotel. To comfortably accommodate its bus patrons, the Company has a waiting facility which is located indoors, adjacent to the casino, and offers various amenities. Competition ___________ Competition in the Atlantic City casino/hotel industry is intense. Casino/hotels compete primarily on the basis of promotional allowances, entertainment, advertising, services provided to patrons, caliber of personnel, attractiveness of the hotel and casino areas and related amenities, and parking facilities. The Resorts Casino Hotel competes directly with 11 casino/hotels in Atlantic City which, in the aggregate, contain approximately 786,000 square feet of gaming area, including simulcast betting and poker rooms, and 8,700 hotel rooms. The total amount of gaming area of these competing properties is expected to increase as the Showboat has announced plans for a sizable addition to its casino gaming floor and certain other casino/hotels are expected to add simulcasting rooms which are permitted to house other authorized table games. Unlike casino gaming floor area, which is regulated based on the number of guest rooms at a particular property, the size of simulcasting rooms is not limited. The Resorts Casino Hotel is located at the eastern end of the Boardwalk adjacent to the Taj Mahal, which is next to the Showboat. These three properties have a total of more than 2,400 hotel rooms and approximately 278,000 square feet of gaming space in close proximity to each other. A 28-foot wide enclosed pedestrian bridge between the Resorts Casino Hotel and the Taj Mahal allows patrons of both hotels and guests for events being held at the Resorts Casino Hotel and at the Taj Mahal to move between the facilities without exposure to the weather. A similar enclosed pedestrian bridge connects the Showboat to the Taj Mahal, allowing patrons to walk under cover among all three casino/hotels. The remaining nine Atlantic City casino/hotels are located approximately one-half mile to one and one-half miles to the west on the Boardwalk or in the Marina area of Atlantic City. All Atlantic City casino/hotels compete for customers with casino/hotels located in Nevada, and in certain foreign resort areas, including The Bahamas, particularly with respect to destination-oriented business, including conventions. The Las Vegas casino/hotel industry benefits from a favorable climate and nearby airport facilities that serve most major domestic carriers. - 11 - Atlantic City casino/hotels also compete with casinos located in other U.S. jurisdictions, particularly those close to New Jersey. Colorado, Illinois, Iowa, Louisiana, Mississippi, Missouri and South Dakota have legalized, and several other states, including Pennsylvania, and the District of Columbia are currently considering legalizing limited land-based and riverboat casino gaming. Additionally, certain gaming operations are conducted or have been proposed on Federal Indian reservations in a number of states. In January 1993, a casino on an Indian reservation located in Connecticut was authorized to operate slot machines and in September 1993 this facility was expanded to house more than 3,000 slot machines. Previously, this casino, which opened in early 1991, was only authorized to conduct table gaming operations. In July 1993 the Oneida Indians opened a casino near Syracuse, New York. In October 1993 approval was granted for the construction of a high stakes gambling casino on the St. Regis Mohawk reservation in New York State near the Canadian border, 50 miles southwest of Montreal. Under New York state law, poker and slot machines currently are not permitted. This rapid expansion of casino gaming, particularly that which has been or may be introduced into jurisdictions in close proximity to Atlantic City, may adversely affect the Company's operations as well as the Atlantic City gaming industry. Gaming Credit Policy ____________________ Credit is extended to selected gaming customers primarily in order to compete with other casino/hotels in Atlantic City which also extend credit to customers. Credit play represented 24% of table game volume at the Resorts Casino Hotel in 1993, 23% in 1992 and 24% in 1991. Gaming receivables, net of allowance for uncollectible amounts, were $3,618,000, $4,503,000 and $5,586,000 as of December 31, 1993, 1992 and 1991, respectively. The collectibility of gaming receivables has an effect on results of operations, and management believes that overall collections have been satisfactory. Atlantic City gaming debts are enforceable under the laws of New Jersey and certain other states, although it is not clear whether other states will honor this policy or enforce judgments rendered by the courts of New Jersey with respect to such debts. Showboat Lease ______________ The Showboat has approximately 515 guest rooms, a 60-lane bowling center, a 65,000 square foot casino and a 15,000 square foot simulcast betting and poker room. The Showboat is situated on approximately 10 acres which are owned by the Company and leased to ACS pursuant to the Showboat Lease, a 99-year net lease dated October 26, 1983, as amended. The Showboat Lease provided for an initial annual rental, which commenced in March 1987, of $6,340,000, subject to future annual adjustment based upon changes in the consumer price index. The annual rental was $8,118,000 for the 1993 lease year and is expected to approximate $8,300,000 for the 1994 lease year. The Company's First Mortgage Non-Recourse Pass-Through Notes due June 30, 2000 (the "Showboat Notes") are secured and serviced by the Showboat Lease, and all lease payments are made to the Indenture Trustee for the Showboat Notes to meet the Company's interest obligations under those notes. See Note 11 of Notes to Consolidated Financial Statements. - 12 - The Showboat Lease provides that if, under New Jersey law, the Company is prohibited from acting as lessor, including any finding by the Casino Control Commission that the Company is unsuitable, the Company must appoint a trustee, acceptable to the Casino Control Commission, to act for the Company and collect all lease payments on the Company's behalf. In that event, the trustee also must proceed to sell the Company's interest in the Showboat Lease and the leased property to a buyer qualified to act as lessor. The net proceeds of any such sale, together with any unremitted rentals, would be paid to the Company. Also, if the Company is no longer able to act as a lessor, as aforesaid, ACS would have an option to acquire ownership of the 10 acres leased from the Company. The option would be exercisable during a period of not more than three months. The purchase price would be an amount equal to the greater of $66,000,000 or the fair market value of the leased acreage, as defined, but in no event may the purchase price be more than 11 times the rent being paid by ACS in the year in which the option may become effective. If the fair market value is not ascertained within the time required by the Casino Control Commission, then the purchase price would be the lesser of $66,000,000 or 11 times the rent being paid by ACS in the year the option may become effective. In the event of any sale of the leased property under the circumstances described above, the disposition of the proceeds of such sale would be governed by the indenture for the Showboat Notes. Under the Casino Control Act, both the Company and ACS, because of their lessor-lessee relationship, are jointly and severally liable for the acts of the other with respect to any violations of the Casino Control Act by the other. In order to limit the potential liability that could result from this provision, ACS, its parent, Ocean Showboat, Inc., and the Company have entered into an indemnity agreement pursuant to which they agree to indemnify each other from all liabilities and losses which may arise as a result of acts of the other party that violate the Casino Control Act. The Casino Control Commission could determine, however, that the party seeking indemnification is not entitled to, or is barred from, such indemnification. Other Properties ________________ The Company owns in the aggregate approximately 90 acres of land in Atlantic City at various sites which could be developed and are available for sale. This acreage primarily consists of vacant land in Great Island, Rum Point, the marina area and waterfront parcels in the inlet section. See "ITEM 2. ITEM 2. PROPERTIES ___________________ The Company's casino, resort hotel and related properties in Atlantic City and The Bahamas, together with certain other properties, described above under "ITEM 1. BUSINESS," are owned in fee, except for approximately 1.2 acres of the Resorts Casino Hotel site which are leased pursuant to ground leases expiring from 2056 through 2067. RII's office in North Miami, Florida, is located in a three-story building owned by RII. The Restructuring contemplates the dispositon of this office building through either the SIHL Sale or the PIRL Spin-Off. The Company's principal properties, including the Resorts Casino Hotel, the Paradise Island Resort & Casino, the Ocean Club Golf & Tennis Resort and the Paradise Paradise Beach Resort (but not the land underlying the Showboat or the Showboat Lease), and, in each case, any additions or improvements to those properties, together with all related furniture, fixtures, machinery and equipment, directly or indirectly comprise the collateral securing the Series Notes. The Showboat Lease, including the land subject to the lease, secures the payment of the Showboat Notes. Atlantic City - Other Properties ________________________________ The Company owns various non-operating sites in Atlantic City that could be developed and are available for sale. These sites consist primarily of vacant land in Great Island, Brigantine Island and the marina area, and waterfront parcels in the inlet section. In view of the generally depressed state of the commercial real estate market in Atlantic City and the condition of the economy generally, the Company does not anticipate any significant real estate activity in the foreseeable future. RII is the owner of real property located at Brigantine Boulevard on Brigantine Island that consists of approximately 40 acres ("Rum Point"), of which only approximately 17 acres can potentially be developed because the remaining portions constitute wetlands areas and consequently are not available for development. Additional environmental and coastal restrictions apply to the development of Rum Point, though the Company currently is attempting to have the restrictions modified to permit development. RII owns in fee an approximately 552 acre parcel located in Atlantic City on Blackhorse Pike (the "Great Island Property"), of which approximately 500 acres are considered to be wetlands. The Company owns in fee an eight acre parcel located in the marina area of Atlantic City immediately adjacent to the Harrah's Casino Hotel. The Company also owns in fee various individual parcels of property located in the area of Atlantic City known as the South Inlet which in the aggregate constitute approximately 10 acres and a parcel of land in Atlantic City consisting of approximately seven acres and a warehouse thereon. The Company is the owner of various additional properties at scattered sites in Atlantic City. Principal among these is the so-called "Trans Expo" site, a 2.3 acre parcel located near the site of the new convention center. The Bahamas - Other Properties ______________________________ The Company, through RIB, owns 562 acres on Paradise Island. RIB has prepared a land use master plan for the island. See "The Bahamas - 24 - - - Land and Other Assets" under "ITEM 1. BUSINESS - (c) Narrative Description of Business" for a description of the acreage available for development and the preparation of a master plan for Paradise Island. The Company does not anticipate any significant real estate sales on Paradise Island while it is seeking to implement the Restructuring. The Company, through a subsidiary of RIB, also owns approximately 1,555 acres of undeveloped and 120 acres of partially developed land located on Little Hawksbill Creek, several miles from Freeport, Grand Bahama Island. As previously indicated, approval by the Bahamian Government is required for foreign ownership of real property in The Bahamas. In addition, any foreign investment in The Bahamas requires exchange control approval by the Central Bank of The Bahamas. No sale of any property located in The Bahamas to non-Bahamian nationals may be completed until such governmental approvals are obtained. ITEM 3. ITEM 3. LEGAL PROCEEDINGS __________________________ New York Supreme Court - Friedman Derivative Action ___________________________________________________ RII has been named as the nominal defendant in an action (Arthur M. Friedman suing derivatively on behalf of RII v. Merv Griffin et al. and RII, Nominal Defendant) brought derivatively on its behalf by a shareholder, Arthur Friedman. The complaint was filed in the Supreme Court of the State of New York, New York County on January 27, 1994 and was amended in February 1994. The defendants in the action, as amended, are Merv Griffin, Griffin Group, David P. Hanlon, who was President, Chief Executive Officer and a director of RII through October 31, 1993, and all of the other current directors of RII. The complaint seeks to recover for the Company an unspecified sum of money as compensatory damages for allegedly wrongful acts by the defendants. The allegations include that the defendants improperly (i) permitted defendant Griffin not to repay money he allegedly owed to the Company and (ii) paid defendant Hanlon excessive compensation. The defendants have until April 1, 1994 to respond to the complaint. The Company anticipates that it will file its chapter 11 prepackaged bankruptcy cases before that time and that the litigation will be stayed by the Bankruptcy Court. U.S. District Court Action - RII v. Lowenschuss _______________________________________________ As previously reported, in October 1989 RII filed an action in the U.S. District Court for the Eastern District of Pennsylvania to recover certain sums paid to the defendant, as trustee for two Individual Retirement Accounts, for RII stock in the 1988 merger, in which RII was acquired by Merv Griffin. This action was transferred to the Bankruptcy Court for the District of New Jersey. After the transfer, the Bankruptcy Court granted RII's motion to amend its complaint to allege two new claims for fraudulent conveyance against the defendant. In the Bankruptcy Court, RII filed a motion for summary judgment and the defendant filed a motion to dismiss. The Bankruptcy Court issued an opinion in February 1992 denying both parties' motions. In August 1992, the defendant filed a petition in the Bankruptcy Court - 25 - for the District of Nevada, thus staying RII's action in New Jersey. The Bankruptcy Court confirmed Lowenschuss' plan of reorganization in October 1993. RII is currently appealing the confirmation order and other orders of the Bankruptcy Court in the District of Nevada. New Jersey Superior Court Action - Atlantic City Board of Education - _____________________________________________________________________ Great Island ____________ In July 1984, the Atlantic City Board of Education enacted a resolution which identified Great Island as the only suitable site for a new high school and, consequently, called for its condemnation by those agencies which have the power of eminent domain. In 1987, a stringent environmental policy was adopted by the State of New Jersey which significantly limited the development of Great Island. After the adoption of this environmental program, and after receiving the power of eminent domain, the Board formally condemned Great Island. A condemnation commission determined that the value of the property was $15,900,000 in 1984 and $10,360,000 in 1987. Both the Board of Education and RII appealed the commission's decision to the Superior Court of New Jersey, which held that a 1987 date of valuation was appropriate, rather than, as claimed by RII, a 1984 date of valuation. In December 1990, after a de novo inquiry into the value of the property, a jury decided that the value of the property was approximately $7,537,000. Of this amount, $5,720,000 had previously been paid. The difference between the initial consideration offered and the jury's valuation, plus interest thereon, was released to the Company in November 1992. The Company appealed to the Appellate Division the New Jersey Superior Court's determination of the valuation date of the condemned property. In July 1993 the Appellate Division affirmed the trial court's determination of the valuation date. In August 1993 the Company filed a notice of petition for certification with the Supreme Court of the State of New Jersey. The certification was denied by the Supreme Court in October 1993. The Company does not intend to pursue this case any further. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS ____________________________________________________________ Not applicable - 26 - PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED _____________________________________________________________ STOCKHOLDER MATTERS ___________________ The principal market for RII Common Stock is the American Stock Exchange. The high and low quarterly sales prices on the American Stock Exchange of RII Common Stock in 1993 and 1992 were as follows: 1993 1992 _______________ ______________ Quarter High Low High Low _______________________________________________________________________ First 1 1/8 13/16 2 3/4 1 1/4 Second 3 7/8 13/16 2 3/8 1 Third 2 3/4 1 9/16 1 1/4 3/4 Fourth 2 1/8 1 3/8 1 1/4 11/16 _______________________________________________________________________ No dividends were paid on RII Common Stock during the last two fiscal years. The Series Notes contain certain restrictions on the payment of cash dividends. The number of holders of record of RII Common Stock on February 28, 1994 was 1,984. - 27 - - 28 - Notes to Selected Financial Data Note A: During 1989, RII and certain of its subsidiaries filed ______ consents to involuntary petitions or filed voluntary petitions for relief under the Bankruptcy Code. The effects of the bankruptcy proceedings reflected in the selected financial data for periods during which the Company operated subject to the jurisdiction of the Bankruptcy Court are (i) the Company stopped accruing interest on its previously outstanding public debt issues in November and December 1989, (ii) the Company stopped amortizing debt issuance costs on the dates the respective interest accruals ceased, and (iii) the Company included in long-term debt at December 31, 1989 sinking funds due in 1990 and accrued interest on public debt stayed in bankruptcy proceedings. In 1990 the Company emerged from bankruptcy proceedings pursuant to the Old Plan. The reorganization was accounted for using "fresh start" accounting. Accordingly, all assets and liabilities were restated to reflect their estimated fair values and the accumulated deficit was eliminated. The Company recorded the effects of the reorganization as of August 31, 1990. The 1990 operating information is presented separately for the periods "Through August 31" and "From September 1" due to the new basis of accounting which resulted from the application of fresh start accounting. Changes in operations during the past five years include the following: Amphibious airline operation was sold in December 1990. Security consulting service operations were sold in 1990 and 1991. Note B: Operating revenues for 1993 include the sale of a ______ residential lot in The Bahamas for net proceeds of $445,000. Earnings from operations for 1993 include a net gain of $224,000 on that sale. Operating revenues for 1992 include the sale of a residential lot in The Bahamas for net proceeds of $213,000. Earnings from operations for 1992 include a net loss of $17,000 on that sale. Operating revenues for 1990 include the sales of various parcels of vacant land in The Bahamas for net proceeds of $3,933,000. Earnings from operations for 1990 include gains of $247,000 on those sales. Operating revenues for 1989 include the sales of various parcels of vacant land in Atlantic City and The Bahamas for net proceeds of $5,053,000. Earnings from operations for 1989 include a net loss of $317,000 on those sales. Note C: See Note 1 of Notes to Consolidated Financial Statements ______ for a discussion of this item in 1993 and 1992. Note D: The 1989 net gain from purchases of subordinated debentures ______ resulted from the Company's purchases of $13,528,000 of its subordinated debentures to satisfy sinking fund requirements. Note E: This item includes interest income, interest expense and ______ amortization of debt discount and issuance costs. - 29 - Note F: For the years 1989 through 1992 the Company accounted for ______ income taxes in accordance with Statement of Accounting Standards No. 96 "Accounting for Income Taxes". No tax provision was recorded for the two periods of 1990 due to the generation of net operating losses for federal and state income tax purposes. The gain on exchange of debt which is reflected in the extraordinary item in 1990 was not taxable. A deferred tax benefit resulted from the elimination of basis differences on the previously outstanding public debt, and is included in the extraordinary item. For the year 1989 the Company had net operating losses for purposes of federal and state income taxes. To the extent the carryforward of these net operating losses reduced the existing deferred tax liability, it resulted in a tax benefit for the year. The write-off of goodwill in 1989 was a non-deductible item for income tax purposes. See Note 13 of Notes to Consolidated Financial Statements for discussion of income taxes for 1993, 1992 and 1991. Note G: The exchange of securities in connection with the ______ reorganization in 1990 resulted in a gain of $421,611,000 which, together with the related deferred income tax benefit of $8,198,000, was reported as an extraordinary item. Note H: See Note 2 of Notes to Consolidated Financial Statements ______ for discussion of net loss per share of common stock. For 1989 and the period through August 31, 1990 there was a sole shareholder of RII. Accordingly, no per share data is disclosed for those periods. Note I: These items are presented net of unamortized discounts. ______ Note J: RII has not paid any dividends on its capital stock during ______ the five years presented. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION ____________________________________________________________________ AND RESULTS OF OPERATIONS _________________________ FINANCIAL CONDITION ___________________ Liquidity _________ At December 31, 1993, the Company's current liabilities exceeded its current assets by $435,081,000 because the Series Notes, which are due April 15, 1994 are classified as current liabilities (due within one year). The Company's working capital at December 31, 1993 included unrestricted cash and equivalents of $62,546,000. A substantial amount of the unrestricted cash and equivalents is required for day-to-day operations, including approximately $15,000,000 of currency and coin on hand which amount varies by days of the week, holidays and seasons, as well as approximately $15,000,000 of additional cash balances necessary to meet current working capital needs. The principal amount of the Series Notes outstanding is $481,907,000. Including the interest due on the maturity date of approximately $36,000,000, the total obligation due on April 15, 1994 - 30 - will approximate $518,000,000. See "ITEM 1. BUSINESS - (a) General Development of Business - Restructuring of Series Notes" for a description of the proposed Restructuring of the Series Notes. There can be no assurance as to whether or when the Restructuring will be effected, or that any restructuring that may ultimately be consummated will be on terms similar to those of the Restructuring. If the Restructuring is accomplished, management believes that, although the Restructuring includes the disposition of the Paradise Island properties and operations, the Restructuring will improve the Company's long-term liquidity and enhance its ability to meet its financial obligations as they become due. If the Restructuring had occurred on December 31, 1993, the Company's working capital deficit would have been reduced to a nominal amount, the net book value of the Company's property and equipment would have been reduced to approximately $275,000,000, the total outstanding principal amount of the Company's public debt would have been reduced from $587,240,000 to approximately $266,000,000, and the Company's shareholders' deficit would have been reduced to a nominal amount. Although the Restructuring will result in a significant reduction in the Company's unrestricted cash and equivalents due to the distribution of Excess Cash to holders of the Series Notes, the Company will retain $20,000,000 of unrestricted cash and equivalents and will have the $20,000,000 RIHF Senior Facility available for one year from the Effective Date of the Restructuring should the Company have unforeseen cash needs. The Company believes that the RIHF Senior Facility will serve as a safeguard if an emergency arises from current operations, or serve as a source of funds for a profitable investment opportunity. If the Restructuring is accomplished, there can be no assurance that the Company will generate sufficient cash from operations to repay, when due, the principal amount of the RIHF Mortgage Notes due in 2003, the principal amount of the RIHF Junior Mortgage Notes due in 2004 or the principal amount of the Showboat Notes maturing in 2000. As a result, the Company may be required to refinance such amounts as they become due and payable. While the Company believes that it will be able to refinance such amounts, there can be no assurance that any such refinancing would be consummated or, if consummated, would be in an amount sufficient to repay such obligations, particularly in light of the Company's high level of debt that will continue after the Restructuring. Since the Company currently does not have the means to repay the Series Notes, management is unable to predict the future liquidity of the Company if the Restructuring is not accomplished. See Note 1 of Notes to Consolidated Financial Statements for a description of an Event of Default with respect to the Series Notes and the possible impact on the Company and the Restructuring should the Series Note Trustee accelerate the maturity of the Series Notes or foreclose upon the collateral securing the Series Notes. Capital Expenditures and Other Uses of Funds ____________________________________________ In recent years, capital expenditures have consistently been a significant use of financial resources. See capital additions by - 31 - geographic and business segment in the table entitled "Identifiable Assets, Depreciation and Capital Additions" below. Pursuant to a capital expenditure program developed by the Company in 1989, virtually all guest rooms and public areas at Resorts Casino Hotel were refurbished by the end of 1993. Also pursuant to this program, virtually all guest rooms in the Company's Paradise Island facilities were refurbished by 1991. Capital additions for Resorts Casino Hotel in 1991 amounted to $22,734,000 as approximately 200 guest rooms in the East Tower were refurbished and certain information systems were upgraded. In 1992, capital additions amounted to $15,548,000 and included the conversion of the parking garage from valet to self-parking, the construction of a covered walkway from the garage to the Resorts Casino Hotel, the continued renovation of guest rooms, the purchase of additional slot machines and improvements to the building's infrastructure. Capital additions in 1993 amounted to $21,618,000, as the Company converted certain back-of-the-house space into an 8,000 square foot simulcast facility which houses nine betting windows and customer-operated terminals and approximately 80 seats for simulcast betting operations, as well as 25 poker tables, various other table games and a full service bar. Also, certain casino renovations were completed, 280 slot machines were purchased, most of which replaced older models, and the new VIP slot and table player lounge, "Club Griffin," opened. In addition, guest room refurbishment continued and a new centralized mobile communications system was installed. With the completion of the capital expenditure program in 1993, recurring capital expenditures to keep existing facilities competitive can be expected to approximate $12,000,000 per year for the Resorts Casino Hotel. Capital additions in 1991 for Paradise Island properties amounted to $3,726,000 as new carpeting was installed in the casino, a new casino management system was implemented and certain kitchen areas and guest rooms were renovated. Capital additions for 1992 totalled $4,317,000, and included the installation of 37 new slot machines, expansion of the Paradise Island Airport parking lot, upgrading existing computer equipment and restaurant renovations. In 1993 the Company expended $3,747,000 which included the purchase of 110 new slot machines as replacements for older models as well as various maintenance projects. The expenditures for 1991, 1992 and 1993 were somewhat curtailed from those originally planned, in response to the operating performance of the Company's facilities on Paradise Island. The Company's capital expenditures on Paradise Island in 1994 are expected to be limited to maintenance projects. The Company continually monitors its capital expenditure plan and considers both the timing and the scope of certain projects to be flexible. Thus, economic developments and other factors may cause the Company to deviate from its present capital expenditure plans. Another significant use of funds in recent years has been recapitalization costs. Payments of legal, financial and other advisory fees and costs amounted to $8,095,000 and $2,460,000 in 1993 and 1992, respectively, in contemplation of a restructuring of the Series Notes and payments of $237,000, $2,954,000 and $5,883,000 in 1993, 1992 and 1991, respectively, for costs associated with the Old Plan. - 32 - Capital Resources and Other Sources of Funds ____________________________________________ Since 1991, operations have been the most significant source of funds to the Company. In 1993 Merv Griffin, the Chairman of the Board of RII, made a partial payment of $3,477,000 of principal on his note payable to RII (the "Griffin Note"). As described in Note 10 of Notes to Consolidated Financial Statements, the Griffin Note was then cancelled and a new note (the "Group Note") from Griffin Group was substituted therefor. Griffin Group now owes the Company $5,318,000 under the Group Note. Pursuant to the Restructuring, the next payment the Company is required to make to Griffin Group under its License and Services Agreement (the "New Griffin Services Agreement," also described in Note 10), $2,310,000, is to be applied to reduce the balance due under the Group Note. The then remaining balance of the Group Note is to be collected by RII and distributed to holders of Series Notes as part of Excess Cash. As part of the Restructuring, the Company will have the $20,000,000 RIHF Senior Facility available for one year from the Effective Date for the Company's working capital and general corporate purposes. The Company believes that the RIHF Senior Facility will serve as a safeguard if an emergency arises from current operations, or serve as a source of funds for a profitable investment opportunity. RESULTS OF OPERATIONS _____________________ General _______ The following discussion addresses certain operations the disposition of which is contemplated in the Restructuring. They include the Paradise Island portion of the casino/hotel segment, the Paradise Island portion of the real estate related segment and the airline segment. - 33 - Revenues ________ For the Year Ended December 31, __________________________________ (In Thousands of Dollars) 1993 1992 1991 _______________________________________________________________________ Casino/hotel: Atlantic City, New Jersey: Casino $244,116 $233,780 $218,881 Rooms 6,974 8,766 8,074 Food and beverage 15,926 16,056 16,406 Other casino/hotel 4,463 4,138 4,113 ________ ________ ________ 271,479 262,740 247,474 ________ ________ ________ Paradise Island, The Bahamas: Casino 62,943 66,120 61,003 Rooms 28,734 30,235 33,173 Food and beverage 30,917 32,851 36,053 Other casino/hotel 18,867 17,890 17,563 ________ ________ ________ 141,461 147,096 147,792 ________ ________ ________ Total casino/hotel 412,940 409,836 395,266 ________ ________ ________ Real estate related: Atlantic City, New Jersey 8,057 7,813 7,542 Paradise Island, The Bahamas 445 213 ________ ________ ________ 8,502 8,026 7,542 ________ ________ ________ Airline 21,802 22,483 18,234 Other segments 115 162 97 Intersegment eliminations (3,795) (3,573) (2,896) ________ ________ ________ Revenues from operations $439,564 $436,934 $418,243 ________ ________ ________ _______________________________________________________________________ Casino/hotel - Atlantic City, New Jersey ________________________________________ Casino revenues from the Company's Atlantic City casino/hotel increased by $10,336,000 in 1993 and $14,899,000 in 1992. Disregarding casino revenues derived from poker and simulcasting, which activities commenced on June 28, 1993, the increase in table and slot win was $4,591,000, or a 2% increase over 1992. The Atlantic City casino industry had a net increase in table and slot win of 2% over 1992, while the average increase over the previous four years was 4.2%. The Company believes that the increased competition from other newly opened or expanded jurisdictions which permit gaming has slowed the growth of gaming revenue in Atlantic City and, for the Company in 1993, has significantly increased the cost of obtaining additional revenue. For both years the Company's increased casino revenues resulted primarily from increased slot revenues. The improvement in slot revenues resulted from the effect of increases in amounts wagered by patrons, while the hold percentage (ratio of casino win to total amount wagered for slots or total amount of chips purchased for table games) declined. This reflects management's decision to decrease the slot hold percentage in order to attract more slot players and to encourage increased slot wagering per player, as well as marketing programs which targeted slot players. In 1993 and 1992 the Company's table game revenues declined, as did the entire Atlantic City casino industry's. In 1993 the Company's decline of 3.3%, as compared to the industry's decline of 3.1%, was - 34 - due to a lower hold percentage, while the amounts wagered on table games did not fluctuate significantly from the prior year. In 1992, the Company's decline of 6.5%, as compared to the industry's decline of 3.3%, was due to a decrease in amounts wagered and, to a lesser extent, a decrease in the table game hold percentage. Although total occupancy was relatively flat in 1993 compared to 1992, the number of complimentary rooms provided to casino patrons increased. The reduced occupancy from rooms sold resulted in lower room revenues during 1993 and contributed to the decrease in food and beverage revenues. Casino/hotel - Paradise Island, The Bahamas ___________________________________________ Revenues from the Company's Paradise Island casino/hotel operations decreased by $5,635,000 in 1993 and by $696,000 in 1992. In 1993 casino revenues decreased $3,177,000 primarily due to the effect of a decrease in table game hold percentage from 16.5% in 1992 to 14.4% in 1993. The Company's average table game hold percentage over the four years ended 1992 was 17.2%. The effect of this decrease was partially offset by the effect of an increase in table game drop and improved slot win. Room revenues and food and beverage revenues also were lower in 1993 due to lower occupancy, net of complimentary rooms. Although total air arrivals to the Paradise Island - New Providence Island area increased by 5% in 1993, the Company lost market share as it did not continue to reduce room rates in response to significant rate reductions by competitors. In 1992 increased casino revenue was more than offset by decreased room revenue and food and beverage revenue. Casino revenue was up due to increases in both slot win and table game win. The increase in table game revenue reflected an increase in drop (amount of chips purchased), the favorable effect of which more than offset the impact of a decline in the table game hold percentage. The decrease in room revenue was due to reduced room rates and occupancy, net of complimentary rooms. The reduction in occupancy also had an adverse effect on food and beverage revenue. Total air arrivals to the Paradise Island - New Providence Island area were down in 1992 by 10%, which management of the Company attributed to the continuing economic recession and reduced air service available. In addition, the Company's competitors reduced room rates in 1992 and the Company, in an effort to maintain occupancy, did the same. The Restructuring contemplates the disposition of the Paradise Island assets and operations. Real Estate Related ___________________ Atlantic City real estate related revenues in 1993, 1992 and 1991 represent rent from ACS pursuant to the Showboat Lease. Such rent receipts are restricted for the payment of interest on the Showboat Notes. See Note 7 of Notes to Consolidated Financial Statements. The Paradise Island real estate related revenues in 1993 and 1992 resulted from the sale of residential lots on Paradise Island. - 35 - Airline _______ Airline revenues decreased by $681,000 in 1993 due primarily to a decrease in passenger revenues during the fourth quarter of the year, as competition from the south Florida-Nassau routes increased. In addition to the new Jet Shuttle service that began operations earlier in the year, during the fourth quarter of 1993 Trinity Air, a Bahamian carrier, commenced operations offering jet service at lower fares than those offered by the Company on its south Florida-Paradise Island routes and by other carriers on their south Florida-Nassau routes. Also, from mid-November 1993 through early January 1994, Bahamasair changed the aircraft used for its south Florida-Nassau flights to jets with a larger seating capacity. Also affecting airline revenues in 1993 was a decrease in revenues from contract training, flight and maintenance work for non-affiliated parties. Airline revenues increased by $4,249,000 in 1992 due primarily to an increase in number of passengers flown as other airlines ceased their flights or reduced the frequency of their flights to The Bahamas and the Company expanded its flight schedule. Also, 1992 includes revenues from contracted training, flight and maintenance work for non-affiliated parties. The Restructuring contemplates the disposition of the airline operations. Contribution to Consolidated Loss _________________________________ Before Income Taxes ___________________ For the Year Ended December 31, ___________________________________ (In Thousands of Dollars) 1993 1992 1991 _______________________________________________________________________ Casino/hotel: Atlantic City, New Jersey $ 12,069 $ 21,051 $ 14,817 Paradise Island, The Bahamas* (9,979) (5,592) (5,707) _________ ________ ________ 2,090 15,459 9,110 _________ ________ ________ Real estate related: Atlantic City, New Jersey 6,654 6,425 5,911 Paradise Island, The Bahamas 224 (17) _________ ________ ________ 6,878 6,408 5,911 _________ ________ ________ Airline* (14) 77 83 Other segments (122) (70) (148) Unallocated corporate expense 4,066 (372) 1,080 _________ ________ ________ Earnings from operations 12,898 21,502 16,036 Other income (deductions): Interest income 3,174 4,969 4,824 Interest expense (57,244) (40,856) (31,157) Amortization of debt discount (51,203) (37,569) (32,105) Recapitalization costs (8,789) (2,848) _________ ________ ________ Loss before income taxes $(101,164) $(54,802) $(42,402) _________ ________ ________ * The Paradise Island casino/hotel segment subsidized the operation of PIA in the amount of $3,329,000 and $760,000 for the years 1993 and 1991, respectively. _______________________________________________________________________ - 36 - Casino/hotel - Atlantic City, New Jersey ________________________________________ Casino, hotel and related operating results decreased by $8,982,000 for 1993 as increased revenues described above were offset by a net increase in operating expenses. The most significant increases in operating expenses were casino promotional costs ($7,700,000), payroll and related costs ($6,000,000), other casino operating expenses ($2,600,000), depreciation ($2,300,000), fees to Griffin Group for services rendered under the New Griffin Services Agreement described in Note 10 of Notes to Consolidated Financial Statements ($2,200,000) and entertainers fees and accomodations ($1,000,000). The increase in casino promotional costs was due primarily to a new program in 1993 which rewards slot players by giving cash back to patrons based on their level of play. Since the introduction of the "cash-back" program the Company has reduced cash giveaways to bus patrons and through other promotional mailings. The majority of the increase in payroll and related costs was due to merit and union increases in salary and wage rates. The remaining increase in payroll and related costs and a significant portion of the casino operating costs increase were associated with the new simulcast and poker facility. The increase in entertainment costs resulted from a return to offering more headliner shows in 1993. The most significant cost reductions in 1993 were in the performance and incentive bonus ($3,300,000) and in food and beverage costs ($1,400,000). Casino, hotel and related operating results improved by $6,234,000 for 1992 as increased revenues discussed above were partially offset by a net increase in operating expenses. The most significant increases in operating expenses were payroll and related costs ($3,500,000), depreciation ($2,300,000), casino win tax ($1,400,000) and performance incentive bonuses ($1,200,000). The increase in payroll and related costs was due to increases in wages, payroll taxes and union benefits. For 1992 the most significant decrease in net operating expenses was the provision for doubtful receivables ($2,100,000). For a discussion of competition in the Atlantic City casino/hotel industry see "Atlantic City - Competition" under "ITEM 1. BUSINESS - (c) Narrative Description of Business." Casino/hotel - Paradise Island, The Bahamas ___________________________________________ Casino, hotel and related operating results declined by $4,387,000 for 1993 as decreased revenues discussed above were partially offset by a net decrease in operating expenses. These operations suffered, generally, as management's attention was diverted by the impending disposition of the Paradise Island operations contemplated in the Restructuring and the Company experienced the loss of certain key management personnel. The most significant reductions in operating expenses for 1993 were in sales and marketing ($1,000,000), food and beverage and other direct costs ($900,000) and gaming taxes and fees ($700,000). The reduction in sales and marketing costs resulted primarily from reductions in advertising during 1993. Gaming taxes and fees declined relative to the decrease in casino revenue. A reduction in occupancy resulted in decreased food, beverage and other direct costs as well as reduced staffing levels and overall operating costs throughout the - 37 - facility. The most significant increase in operating expenses was the subsidy of PIA ($3,329,000), RII's subsidiary which provides air service between south Florida and the Company's Paradise Island Airport, which increased as PIA's operating results declined. See "Airline" below. Casino, hotel and related operating results improved by $115,000 for 1992 as decreased revenues discussed above were more than offset by net decreased operating expenses. The most significant reductions in operating expenses were food, beverage and other direct costs ($1,000,000), depreciation ($800,000), payroll and related costs ($800,000) and the subsidy of PIA ($760,000). The reduced occupancy level and the reduction in number of visitors to the area contributed to an overall reduction in operating costs throughout the facility. The subsidy of PIA decreased as PIA's operating results improved. See "Airline" below. For 1992 the most significant increases in operating expenses were marketing and promotional costs ($1,400,000) and gaming taxes and fees ($1,000,000). The Company increased its marketing and promotional efforts over the prior year in an effort to attract a greater number of patrons to its facilities. For a discussion of competition in The Bahamas, see "The Bahamas - - Competition" under "ITEM 1. BUSINESS - (c) Narrative Description of Business." Real Estate Related ___________________ The comparison of earnings from Atlantic City real estate related activities is affected by increases in rental income under the Showboat Lease described above. The Paradise Island real estate related earnings represent the net gain in 1993 and net loss in 1992 on the sales of residential lots on Paradise Island mentioned above. Airline _______ Airline operating results before the subsidy from the Paradise Island casino/hotel segment decreased by $3,420,000 in 1993 and increased by $754,000 in 1992. For 1993 the decrease resulted primarily from an increase in maintenance costs and, to a lesser extent, the decrease in passenger revenues discussed above. For 1992 the increase resulted primarily from the contract work for non-affiliated parties noted above. Unallocated Corporate Expense _____________________________ Unallocated corporate expense decreased by $4,438,000 in 1993 and increased by $1,452,000 in 1992. These variances resulted primarily from charges recorded in 1992 of approximately $2,900,000 in connection with the start-up, management and subsequent termination of an agreement to manage a casino located in Black Hawk, Colorado. Also affecting corporate expense for 1993 is a reduction in corporate payroll and related costs ($800,000). Also affecting corporate expense for 1992 was a reduction in certain corporate insurance costs ($600,000) and an increase in the amount of overhead expense allocated from corporate to certain operations ($600,000). - 38 - The Environmental Protection Agency ("EPA") has named a predecessor to RII as a potentially responsible party in the Bay Drums hazardous waste site (the "Site") in Tampa, Florida which the EPA has listed on the National Priorities List. No formal action has commenced against RII and RII intends to dispute any claims of this nature, if asserted. Although it may ultimately be determined that RII is one of several hundred parties that are jointly and severally liable for the costs of Site remediation and for damages to natural resources at the Site caused by hazardous wastes, the extent of any such liability, if any, cannot be determined at this time. Other Income (Deductions) _________________________ The increase in interest expense in 1993 and 1992 was due to a combination of (i) an increase in the stated interest rates of the Series Notes; (ii) increased principal amounts of debt outstanding due to PIK interest on the Series Notes; and (iii) changes in the market value of the Series Notes as, through October 15, 1993, the Company recorded interest at the estimated market value of additional Series Notes to be issued in satisfaction of its interest obligations. Subsequent to October 15, 1993 the Company's option to PIK interest on the Series Notes is no longer available. Thus, effective October 16, 1993 the Company began recording interest expense on the Series Notes at the stated rate in lieu of a discounted rate to reflect market value. Amortization of debt discount increased in 1993 and 1992 primarily due to the additional discounts associated with Series Notes issued in satisfaction of interest obligations. If the Restructuring is accomplished, the Company's interest expense and amortization of debt discount are expected to be significantly less after the Restructuring. Recapitalization costs in 1993 and 1992 include costs of financial advisers retained to assist in the development and analysis of financial alternatives which would enable the Company to reduce its future debt service requirements and other legal and advisory fees incurred in connection with the currently proposed Restructuring. Income Taxes ____________ See Note 13 of Notes to Consolidated Financial Statements for an explanation of changes in the Company's effective income tax rate during the years 1991 through 1993. - 39 - - 40 - - 41 - ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA ____________________________________________________ The Company's consolidated financial statements and supplementary data are presented on the following pages: Page Financial Statements References ____________________ __________ Report of Independent Auditors 43 Consolidated Balance Sheets at December 31, 1993 and 1992 45 Consolidated Statements of Operations for the years ended December 31, 1993, 1992 and 1991 47 Consolidated Statements of Cash Flows for the years ended December 31, 1993, 1992 and 1991 48 Consolidated Statements of Changes in Shareholders' Equity (Deficit) for the years ended December 31, 1993, 1992 and 1991 49 Notes to Consolidated Financial Statements 50 Financial Statement Schedules: Schedule II: Amounts Receivable from Related Parties for the years ended December 31, 1993, 1992 and 1991 69 Schedule V: Property and Equipment for the years ended December 31, 1993, 1992 and 1991 70 Schedule VI: Accumulated Depreciation of Property and Equipment for the years ended December 31, 1993, 1992 and 1991 72 Schedule VIII: Valuation Accounts for the years ended December 31, 1993, 1992 and 1991 73 Schedule X: Supplementary Statements of Operations Information for the years ended December 31, 1993, 1992 and 1991 74 Supplementary Data __________________ Selected Quarterly Financial Data (Unaudited) 75 - 42 - REPORT OF INDEPENDENT AUDITORS ______________________________ The Board of Directors and Shareholders Resorts International, Inc. We have audited the accompanying consolidated balance sheets of Resorts International, Inc. as of December 31, 1993 and 1992, and the related consolidated statements of operations, changes in shareholders' equity (deficit), 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 consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Resorts International, 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, 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 explained in Notes 1 and 7, the Series Notes become due and payable in April 1994. It presently appears unlikely the Company has the ability to redeem the Series Notes at maturity. In addition, the Company is not in compliance with a covenant contained in the indenture for the Series Notes and therefore an event of default has occurred. As a result of such default the trustee may accelerate the maturity of the Series Notes or may allow foreclosure upon the collateral securing the Series Notes. The Company proposes to restructure the Series Notes and anticipates filing a prepackaged bankruptcy plan of reorganization as part of such restructuring. Consummation of the plan of reorganization would be subject to a number of conditions including regulatory and governmental approvals and confirmation by the bankruptcy court. There can be no assurance as to whether or when the restructuring will be effected. These conditions and events raise substantial doubt about the Company's - 43 - ability to continue as a going concern. The financial statements and schedules do not include any adjustments to reflect the possible future effects on the recoverability and classification of assets or the amounts and classification of liabilities that may result from the outcome of this uncertainty. ERNST & YOUNG Philadelphia, Pennsylvania February 18, 1994 except for paragraph 8 of Note 1, as to which the date is March 17, 1994 - 44 - Resorts International, Inc. CONSOLIDATED BALANCE SHEETS (In Thousands of Dollars) December 31, _____________________ Assets 1993 1992 _____________________________________________________________________ Current assets: Cash (including cash equivalents of $41,273 and $36,344) $ 62,546 $ 56,818 Restricted cash equivalents 14,248 10,069 Receivables, net 19,297 25,457 Inventories 8,664 8,531 Prepaid expenses 10,664 7,062 ________ ________ Total current assets 115,419 107,937 ________ ________ Property and equipment: Land and land rights, including land held for investment, development and resale 243,336 243,900 Land improvements and utilities 22,891 22,519 Hotels and other buildings 182,011 170,250 Furniture, machinery and equipment 80,424 67,693 Construction in progress 1,277 1,215 ________ ________ 529,939 505,577 Less accumulated depreciation (82,099) (54,761) ________ ________ Net property and equipment 447,840 450,816 Deferred charges and other assets 12,526 10,197 ________ ________ $575,785 $568,950 ________ ________ _____________________________________________________________________ See Notes to Consolidated Financial Statements. - 45 - Resorts International, Inc. CONSOLIDATED BALANCE SHEETS (In Thousands of Dollars, except par value) December 31, ______________________ Liabilities and Shareholders' Deficit 1993 1992 ______________________________________________________________________ Current liabilities: Current maturities of long-term debt, net of unamortized discount $ 466,336 $ 828 Accounts payable and accrued liabilities 84,164 71,672 _________ _________ Total current liabilities 550,500 72,500 _________ _________ Long-term debt, net of unamortized discount 85,029 460,712 _________ _________ Deferred income taxes 54,000 53,000 _________ _________ Commitments and contingencies (Note 15) Shareholders' deficit: Common stock - 20,157,234 shares outstanding - $.01 par value 202 202 Capital in excess of par 102,092 102,092 Accumulated deficit (210,720) (108,556) _________ _________ (108,426) (6,262) Note receivable from related party (5,318) (11,000) _________ _________ Total shareholders' deficit (113,744) (17,262) _________ _________ $ 575,785 $ 568,950 _________ _________ ______________________________________________________________________ See Notes to Consolidated Financial Statements. - 46 - Resorts International, Inc. CONSOLIDATED STATEMENTS OF OPERATIONS (In Thousands, except per share data) For the Year Ended December 31, _____________________________________ 1993 1992 1991 _______________________________________________________________________ Revenues: Casino $ 307,059 $299,900 $279,884 Rooms 35,708 39,001 41,247 Food and beverage 46,843 48,907 52,459 Other casino/hotel revenues 23,330 22,028 21,676 Other operating revenues 18,122 19,072 15,435 Real estate related 8,502 8,026 7,542 _________ ________ ________ 439,564 436,934 418,243 _________ ________ ________ Expenses: Casino 189,304 176,119 166,133 Rooms 10,906 11,799 12,112 Food and beverage 41,859 42,819 45,508 Other casino/hotel operating expenses 69,918 64,654 64,054 Other operating expenses 14,697 15,549 12,055 Selling, general and administrative 71,700 73,262 71,732 Provision for doubtful receivables 2,889 4,047 6,373 Depreciation 27,924 25,322 23,814 Real estate related 1,605 1,599 1,612 Unallocated corporate expense (4,136) 262 (1,186) _________ ________ ________ 426,666 415,432 402,207 _________ ________ ________ Earnings from operations 12,898 21,502 16,036 Other income (deductions): Interest income 3,174 4,969 4,824 Interest expense (57,244) (40,856) (31,157) Amortization of debt discount (51,203) (37,569) (32,105) Recapitalization costs (8,789) (2,848) _________ ________ ________ Loss before income taxes (101,164) (54,802) (42,402) Income tax benefit (expense) (1,000) 1,348 831 _________ ________ ________ Net loss $(102,164) $(53,454) $(41,571) _________ ________ ________ Net loss per share of common stock $ (5.07) $ (2.65) $ (2.07) _________ ________ ________ Weighted average number of shares outstanding 20,157 20,146 20,092 _________ ________ ________ _______________________________________________________________________ See Notes to Consolidated Financial Statements. - 47 - Resorts International, Inc. CONSOLIDATED STATEMENTS OF CASH FLOWS (In Thousands of Dollars) For the Year Ended December 31, ________________________________ 1993 1992 1991 ______________________________________________________________________ Cash flows from operating activities: Cash received from customers $ 441,354 $ 432,212 $ 411,456 Cash paid to suppliers and employees (393,013) (390,012) (378,312) _________ _________ _________ Cash flow from operations before interest and income taxes 48,341 42,200 33,144 Interest received 3,809 5,211 4,014 Interest paid (8,440) (8,463) (9,228) Income taxes refunded, net of payments 306 1,484 729 _________ _________ _________ Net cash provided by operating activities 44,016 40,432 28,659 _________ _________ _________ Cash flows from investing activities: Payments for property and equipment (25,308) (19,832) (25,587) Proceeds from sales of property and equipment 445 213 147 Proceeds from prior year sales of property and equipment 2,484 1,676 CRDA deposits and bond purchases (3,025) (2,871) (2,689) Proceeds from sales of short-term money market securities with maturities greater than three months 1,377 2,083 Purchases of short-term money market securities with maturities greater than three months (492) (1,768) _________ _________ _________ Net cash used in investing activities (27,003) (19,691) (26,453) _________ _________ _________ Cash flows from financing activities: Collection on note receivable from shareholder 3,477 Payments of recapitalization costs (8,332) (5,414) (5,883) Repayments of non-public debt (2,251) (1,619) (2,064) _________ _________ _________ Net cash used in financing activities (7,106) (7,033) (7,947) _________ _________ _________ Net increase (decrease) in cash and cash equivalents 9,907 13,708 (5,741) Cash and cash equivalents at beginning of period 66,887 53,179 58,920 _________ _________ _________ Cash and cash equivalents at end of period $ 76,794 $ 66,887 $ 53,179 _________ _________ _________ ______________________________________________________________________ See Notes to Consolidated Financial Statements. - 48 - Resorts International, Inc. CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY (DEFICIT) (In Thousands of Dollars) Capital in Common excess of Accumulated Note stock par deficit receivable __________________________________________________________________________ Balance at December 31, 1990 $ 200 $101,372 $ (13,531) $(11,000) Settlement of Other Class 3C Claims 1 594 Stock awards 34 Net loss for year 1991 (41,571) ______ ________ _________ ________ Balance at December 31, 1991 201 102,000 (55,102) (11,000) Settlement of Other Class 3C Claims 1 92 Net loss for year 1992 (53,454) ______ ________ _________ ________ Balance at December 31, 1992 202 102,092 (108,556) (11,000) Collection on note receivable from shareholder 3,477 Cancellation of note receivable from shareholder 7,523 Issuance of note receivable from Griffin Group (7,523) Reduction of note receivable from Griffin Group applied to prepaid services 2,205 Net loss for year 1993 (102,164) ______ ________ _________ ________ Balance at December 31, 1993 $ 202 $102,092 $(210,720) $ (5,318) ______ ________ _________ ________ __________________________________________________________________________ See Notes to Consolidated Financial Statements. - 49 - Resorts International, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1 - RESTRUCTURING OF SERIES NOTES ______________________________________ The term "Company" as used herein includes Resorts International, Inc. ("RII") and/or one or more of its subsidiaries, as the context may require. The outstanding principal amount of RII's Senior Secured Redeemable Notes due April 15, 1994 (the "Series Notes") is $481,907,000. Including the interest due on the maturity date of approximately $36,000,000, RII's total obligation at maturity will amount to approximately $518,000,000. Sources of repayment or refinancing at maturity have been uncertain for some time; the Company has been working with its financial advisers on developing and analyzing financial alternatives, as well as developing a long-term financial plan, since late 1991. In this connection, management of the Company, with the assistance of its legal and financial advisers, engaged in discussions with representatives ("Fidelity" and "TCW") of major holders of Series Notes in an effort to reach an agreement as to the terms of a possible restructuring of the Series Notes. Further negotiations were conducted among the Company, Fidelity, TCW and an unrelated party ("SIIL") regarding SIIL's acquisition of a 60% interest in the Company's Paradise Island assets (the "SIHL Sale") through a subsidiary of SIIL ("SIHL") formed for that purpose. This process resulted in the filing by RII and certain of its subsidiaries on October 25, 1993 of a Form S-4 Registration Statement with the Securities and Exchange Commission. This Registration Statement describes in detail the restructuring (the "Restructuring") which RII and GGRI, Inc. ("GGRI"), RII's subsidiary which guaranteed the Series Notes, propose to accomplish through a prepackaged bankruptcy joint plan of reorganization (the "Plan"). On February 1, 1994, after certain amendments, the Registration Statement was declared effective. On February 5, 1994 the solicitation of acceptances of the Plan commenced with the mailing of the Information Statement/Prospectus for Solicitation of Votes on Prepackaged Plan of Reorganization, ballots and other materials to holders of Series Notes and equity interests in RII. The Restructuring contemplates, among other things, the exchange of the Series Notes for: (i) $125,000,000 principal amount of 11% Mortgage Notes due 2003 (the "RIHF Mortgage Notes") to be issued by Resorts International Hotel Financing, Inc. ("RIHF"), a newly formed subsidiary of RII, and guaranteed by Resorts International Hotel, Inc. ("RIH"), RII's subsidiary that owns and operates Merv Griffin's Resorts Casino Hotel in Atlantic City (the "Resorts Casino Hotel"); (ii) $35,000,000 principal amount of 11.375% Junior Mortgage Notes due 2004 (the "RIHF Junior Mortgage Notes") to be issued by RIHF and guaranteed by RIH; (iii) 40% of RII's common stock on a fully diluted basis (excluding certain stock options); (iv) either (a) $65,000,000 in cash, plus interest at an annual rate of 7.5% from January 1, 1994 through the closing date of the SIHL Sale, plus 40% of the capital stock of SIHL, representing the consideration received from the proposed SIHL Sale, or, if the SIHL Sale is not consummated, (b) 100% of the equity of P.I. Resorts Limited ("PIRL"), a subsidiary of RII - 50 - which was recently formed to be a holding company in the event of the spin-off (the "PIRL Spin-Off") of 100% of the equity of RII's Bahamian subsidiaries and, through subsidiaries, the assets of RII and certain of its domestic subsidiaries which support the Company's Bahamian operations, and related liabilities; (v) the Company's Excess Cash, as defined in the Plan, which is estimated to be at least $30,000,000 and (vi) rights to receive distributions in respect of units of beneficial interest owned by RII in a litigation trust (the "Litigation Trust") established pursuant to RII's 1990 plan of reorganization. The Restructuring also provides for certain funds or accounts managed by Fidelity to enter into a senior credit facility with RIHF (the "RIHF Senior Facility") which will allow RIHF to borrow up to $20,000,000 through the issuance of notes. The RIHF Senior Facility is to be available for a single borrowing during the one-year period from the date the Plan becomes effective. Notes issued pursuant to the RIHF Senior Facility will bear interest at 11% per year and mature in 2002. Consummation of the Plan is subject to a number of conditions including, but not limited to, confirmation by the Bankruptcy Court and receipt of required regulatory approvals of the New Jersey Casino Control Commission (the "Casino Control Commission") and the Government of The Bahamas. For the Plan to be confirmed by the Bankruptcy Court, the Plan must comply with various requirements of the Bankruptcy Code. Also, to confirm the Plan on a consensual basis, acceptances must be received from (i) holders of Series Notes constituting at least 66 2/3% in principal amount and more than 50% in number of those voting and (ii) at least 66 2/3% each of RII's common stock and outstanding stock options voted. In addition to the vote required by the Bankruptcy Code, a condition to confirmation of the Plan is the entry of an order declaring that certain security documents (the "Security Documents") under which the liens on the property securing the Series Notes were granted or created shall be deemed released and terminated. To effectuate such termination and release consensually, the record holders of at least 66 2/3% in aggregate principal amount of the outstanding Series Notes and the record holders of at least a majority in aggregate principal amount of each series of the Series Notes must consent to the termination of the Security Documents. There are several other conditions to confirmation of the Plan which, subject to the approval of Fidelity and TCW (in certain circumstances), may be waived by RII and GGRI. The solicitation period ended on March 15, 1994. The solicitation agent has advised the Company that it has received the requisite acceptances for confirmation of the Plan and sufficient consents to release the Security Documents. The Company intends to proceed with the filing of its prepackaged bankruptcy cases; however, there can be no assurance as to whether or when the Restructuring will be effected, or that any restructuring that may ultimately be consummated will be on terms similar to those of the Restructuring. For information as to revenues and contribution to consolidated loss before income taxes of the operations to be disposed of pursuant to the Restructuring (through either the SIHL Sale or the PIRL Spin-Off) see the segment tables included in "ITEM 7. MANAGEMENT'S - 51 - DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS." Operations to be disposed of include the Paradise Islandportion of the casino/hotel segment, the Paradise Island portion of the real estate related segment and the airline segment. Recapitalization costs in 1993 and 1992 include costs of financial advisers retained to assist in the development and analysis of financial alternatives which would enable the Company to reduce its future debt service requirements and other legal and advisory fees incurred in connection with the currently proposed Restructuring. Event of Default ________________ As of September 30, 1993, RII was not in compliance with its covenant contained in the indenture for the Series Notes (the "Series Note Indenture") to maintain a Tangible Net Worth, as defined in the Series Note Indenture, of at least $50,000,000. Since that date RII's Tangible Net Worth has continued to decline. On February 2, 1994, 30 days after receiving notice of such default from the trustee for the Series Notes (the "Series Note Trustee"), this default became an Event of Default. Upon the occurrence of an Event of Default, the Series Note Trustee may accelerate the maturity of the Series Notes by declaring all unpaid principal of and accrued interest on the Series Notes due and payable or may foreclose upon the collateral securing the Series Notes (the "Collateral"). (See Note 7 for a description of the Collateral.) In addition, the holders of 40% in principal amount of the Series Notes then outstanding may require the Series Note Trustee to accelerate the maturity of the Series Notes. If the Series Note Trustee accelerates the maturity of the Series Notes or forecloses upon the Collateral, RII and GGRI, as guarantor of the Series Notes, and certain of their subsidiaries whose assets are pledged to secure the Series Notes (including RIH and Resorts International (Bahamas) 1984 Limited ("RIB"), RII's indirect subsidiary, which together with its subsidiaries owns and operates the Company's Bahamian properties) would be forced to seek immediate protection under chapter 11 of title 11 of the United States Code (the "Bankruptcy Code"). If such events occur, there can be no assurance that the Restructuring would be implemented, that a reorganization of RII and GGRI rather than a liquidation would occur or that any reorganization that might occur would be on terms as favorable to the holders of Series Notes and holders of RII's common stock as the terms of the Plan. NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES ___________________________________________________ Principles of Consolidation ___________________________ The consolidated financial statements include the accounts of RII and all significant subsidiaries. All significant intercompany transactions and balances have been eliminated in consolidation. The accounts of foreign subsidiaries are maintained in U.S. dollars. Revenue Recognition ___________________ The Company records as revenue the win from casino gaming activities which represents the difference between amounts wagered and amounts won by patrons. Revenues from hotel and related services and from theatre ticket sales are recognized at the time the related service is performed. - 52 - Complimentary Services ______________________ The Consolidated Statements of Operations reflect each category of operating revenues excluding the retail value of complimentary services provided to casino patrons without charge. The rooms, food and beverage, and other casino/hotel operations departments allocate a percentage of their total operating expenses to the casino department for complimentary services provided to casino patrons. These allocations do not necessarily represent the incremental cost of providing such complimentary services to casino patrons. Amounts allocated to the casino department from the other operating departments were as follows: (In Thousands of Dollars) 1993 1992 1991 ______________________________________________________________________ Rooms $ 4,470 $ 3,738 $ 3,563 Food and beverage 20,353 20,805 19,254 Other casino/hotel operations 7,412 6,408 5,839 _______ _______ _______ Total allocated to casino $32,235 $30,951 $28,656 _______ _______ _______ ______________________________________________________________________ Cash Equivalents ________________ The Company considers all of its short-term money market securities purchased with maturities of three months or less to be cash equivalents. The carrying value of cash equivalents approximates fair value due to the short maturity of these instruments. Inventories ___________ Inventories of provisions, supplies and spare parts are carried at the lower of cost (first-in, first-out) or market. Property and Equipment ______________________ Property and equipment are depreciated over their estimated useful lives using the straight-line method for financial reporting purposes. Casino Reinvestment Development Authority ("CRDA") Obligations ______________________________________________________________ Under the New Jersey Casino Control Act ("Casino Control Act"), the Company is obligated to purchase CRDA bonds, which will bear a below-market interest rate, or make an alternative qualifying investment. The Company charges to expense an estimated discount related to CRDA investment obligations as of the date the obligation arises based on fair market interest rates of similar quality bonds in existence as of that date. On the date the Company actually purchases the CRDA bond, the estimated discount previously recorded is adjusted to reflect the actual terms of the bonds issued and the then existing fair market interest rate for similar quality bonds. The discount on CRDA bonds purchased is amortized to interest income over the life of the bonds using the effective interest rate method. Payment-In-Kind ("PIK") Interest Accrual ________________________________________ When the Company elects to satisfy its interest obligations - 53 - through PIK instead of cash interest payments, for financial statement purposes, such interest is accrued at the estimated market value of the notes to be issued. The discount resulting from the difference between face value and estimated market value of the additional notes decreases interest expense of the current period and is amortized to expense over the remaining life of the issue. Income Taxes ____________ RII and all of its domestic subsidiaries file consolidated U.S. federal income tax returns. For the years 1991 and 1992, the Company accounted for income taxes under the liability method prescribed by Statement of Financial Accounting Standards No. 96 ("SFAS 96"), "Accounting for Income Taxes." Under this method, the deferred tax liability is determined based on the difference between the financial reporting and tax bases of assets and liabilities and enacted tax rates which will be in effect for the years in which the differences are expected to reverse. The deferred tax liability is reduced by cumulative tax credits and losses being carried forward for tax purposes, subject to applicable limitations. Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 109 ("SFAS 109"), "Accounting for Income Taxes." SFAS 109 supersedes SFAS 96 but retains the liability method of accounting for income taxes. Among other changes, SFAS 109 changed the recognition and measurement criteria for deferred tax assets included in SFAS 96. There are no income taxes in The Bahamas and the income of RII's subsidiaries in The Bahamas is generally not subject to U.S. federal income taxation until it is distributed to a U.S. parent. Deferred federal income taxes are provided on the undistributed earnings of Bahamian subsidiaries. Per Share Data ______________ Per share data was computed using the weighted average number of shares of common stock outstanding. NOTE 3 - CASH EQUIVALENTS _________________________ Cash equivalents and restricted cash equivalents at December 31, 1993 included reverse repurchase agreements (federal government securities purchased under agreements to resell those securities) with the institutions listed in the following table under which the Company had not taken delivery of the underlying securities. These agreements matured January 3, 1994 except for $596,000 with City National Bank of Florida which matured January 31, 1994. - 54 - (In Thousands of Dollars) _______________________________________________________________________ City National Bank of Florida $14,634 National Westminster Bank NJ $ 5,945 First Fidelity Bank N.A., South Jersey $ 4,780 Summit Trust Company $ 4,278 _______________________________________________________________________ The Company's cash equivalents at December 31, 1993 also included U.S. Treasury Bills and bank time deposits. NOTE 4 - RESTRICTED CASH EQUIVALENTS ____________________________________ Components of restricted cash equivalents at December 31 were as follows: (In Thousands of Dollars) 1993 1992 _______________________________________________________________________ Amount, including interest earned, on deposit with trustee for Litigation Trust $ 4,278 $ 4,969 Escrow for the SIHL Sale 4,000 Showboat Lease payments and interest earned thereon held by trustee (see Note 11) 3,405 3,303 Collateral account for Series Notes 1,220 1,183 Cash equivalents securing letters of credit and other guarantees 1,345 614 _______ _______ $14,248 $10,069 _______ _______ _______________________________________________________________________ If the agreement for the SIHL Sale is terminated, under certain circumstances RII may be required to reimburse certain of SIHL's expenses. Escrow for the SIHL Sale represents funds set aside for that purpose pursuant to a related escrow agreement. - 55 - NOTE 5 - RECEIVABLES ____________________ Components of receivables at December 31 were as follows: (In Thousands of Dollars) 1993 1992 _______________________________________________________________________ Gaming $15,566 $19,476 Less allowance for doubtful accounts (6,598) (6,952) _______ _______ 8,968 12,524 _______ _______ Non-gaming: Hotel and related 6,131 5,850 Other trade 2,560 2,970 Interest on note receivable from related party 271 927 Contracts and notes 212 211 Bahamian duty refunds receivable 48 719 Refundable state income taxes 36 499 Other 2,347 2,969 _______ _______ 11,605 14,145 Less allowance for doubtful accounts (1,276) (1,212) _______ _______ 10,329 12,933 _______ _______ $19,297 $25,457 _______ _______ _______________________________________________________________________ NOTE 6 - ACCOUNTS PAYABLE AND ACCRUED LIABILITIES _________________________________________________ Components of accounts payable and accrued liabilities at December 31 were as follows: (In Thousands of Dollars) 1993 1992 _______________________________________________________________________ Accrued interest $18,464 $ 9,928 Accrued payroll and related taxes and benefits 16,277 16,178 Customer deposits and unearned revenues 9,768 7,976 Trade payables 8,524 6,701 Accrued gaming taxes, fees and related assessments 7,719 8,166 Litigation Trust and related expenses 3,513 4,327 Accrued costs of recapitalization 3,510 2,372 Other accrued liabilities 16,389 16,024 _______ _______ $84,164 $71,672 _______ _______ _______________________________________________________________________ NOTE 7 - LONG-TERM DEBT _______________________ Pursuant to the Company's 1990 plan of reorganization, RII issued the Series Notes, consisting of the Series A Notes and the Series B Notes, and the First Mortgage Non-Recourse Pass-Through Notes due June 30, 2000 (the "Showboat Notes"). - 56 - The carrying value and fair value by component of long-term debt at December 31 were as follows: 1993 1992 ____________________ ____________________ Carrying Fair Carrying Fair (In Thousands of Dollars) Value Value Value Value _______________________________________________________________________ Series A Notes $ 262,531 $ 176,552 $230,410 $131,334 Less unamortized discount (8,331) (24,636) _________ ________ 254,200 205,774 _________ ________ Series B Notes 219,376 147,530 190,182 107,453 Less unamortized discount (7,447) (19,265) _________ ________ 211,929 170,917 _________ ________ Showboat Notes 105,333 94,800 105,333 88,480 Less unamortized discount (20,452) (22,485) _________ ________ 84,881 82,848 Capitalized leases 355 355 2,001 2,001 _________ _________ ________ ________ 551,365 419,237 461,540 329,268 Less due within one year (466,336) (324,289) (828) (828) _________ _________ ________ ________ $ 85,029 $ 94,948 $460,712 $328,440 _________ _________ ________ ________ _______________________________________________________________________ The fair value presented above for the Company's long-term debt is based on December 31 closing market prices for publicly traded debt and carrying value for capitalized leases, because capitalized leases are not considered material to the total. The Series Notes are guaranteed as to payment of principal and interest by GGRI, the subsidiary of RII which, through its Bahamian subsidiaries, owns and operates the Company's Bahamian properties, and are secured by the Collateral described below. The Series A Notes and the Series B Notes will rank pari passu with respect to amounts realized upon any sale or other disposition of the Collateral. The Collateral consists of: (i) RII's fee and leasehold interests in substantially all of its real properties other than the 99-year net lease of a 10 acre site underlying the Showboat Casino Hotel in Atlantic City (the "Showboat Lease") and the real property that is subject to the Showboat Lease; (ii) the fee and leasehold interests in the real and personal property of Resorts Casino Hotel and the contiguous parking garage which interests are owned by RIH, (iii) all of the outstanding capital stock of RIH and GGRI and all of RII's other direct and indirect domestic subsidiaries; (iv) promissory notes made by RIH in the aggregate principal amount of $325,000,000; (v) 66% of the outstanding voting stock and 100% of the non-voting stock of RIB, the Bahamian subsidiary of GGRI which together with its subsidiaries owns and operates the Company's Bahamian properties; and - 57 - (vi) a $50,000,000 promissory note made by RIB and guarantees thereof by certain of RIB's subsidiaries. The Collateral described above consists of substantially all of the assets of the Company other than the Showboat Lease and the real property that is subject to the Showboat Lease. The Series Notes bear interest as follows: Series A Series B _______________________________________________________________________ April 11, 1990 through April 15, 1991 6% May 8, 1990 through April 15, 1991 11% Year ended April 15, 1992 9% 15% Year ended April 15, 1993 12% 15% Year ending April 15, 1994 15% 15% _______________________________________________________________________ Interest on the Series Notes is payable semi-annually on April 15 and October 15 in each year. The Series Note Indenture allowed RII to satisfy all or any portion of interest accruing on the Series Notes to date by making PIK payments. On each interest payment date through October 15, 1993, the Company elected to make PIK payments. The cumulative principal amounts of Series A and Series B Notes issued to satisfy such interest obligations were $75,031,000 and $80,626,000, respectively. In accordance with the Company's 1990 plan of reorganization, $1,250,000 principal amount of Series B Notes were issued through December 31, 1993 in settlement of certain claims ("Other Class 3C Claims") against RII and certain of its subsidiaries which were outstanding as of the date the Company filed for relief under the Bankruptcy Code. Additional Series B Notes may be issued in the future in settlement of Other Class 3C Claims. The Series Note Indenture contains certain restrictive covenants on the part of RII, including restrictions on (i) the payment of cash dividends or redemptions of capital stock by RII; (ii) the repurchase of any Series Notes other than at par, unless certain conditions are met; (iii) the incurrence of additional indebtedness, with certain exceptions; (iv) mergers and consolidations with entities other than affiliates of RII; and (v) the ability of RII and its subsidiaries to sell their assets. As discussed in Note 1, an Event of Default has occurred with respect to the Series Notes. Also as discussed in Note 1, the Company intends to restructure the Series Notes as proposed in the Restructuring; however, there can be no assurance as to whether or when such Restructuring will be effected. The Showboat Notes are non-recourse notes, secured by a mortgage encumbering the real property which is subject to the Showboat Lease, by a collateral assignment of the Showboat Lease, and by a pledge of any proceeds of the sale of such mortgage and collateral assignment. - 58 - Interest on the Showboat Notes consists of a pass-through (subject to certain adjustments) of the lease payments received under the Showboat Lease. See Note 11 for a description of the Showboat Lease. Interest is payable semi-annually on January 15 and July 15. The weighted average effective interest rates on RII's publicly held debt at December 31, 1993 were as follows: Series A Notes - 27.7%; Series B Notes - 28.7%; and Showboat Notes - 11.1%. Minimum principal payments of long-term debt outstanding as of December 31, 1993, for the five years thereafter are as follows: 1994 - - $482,114,000; 1995 - $140,000; 1996 - $8,000; 1997 - None; 1998 - None. NOTE 8 - SHAREHOLDERS' DEFICIT ______________________________ RII is authorized to issue 50,000,000 shares of common stock. Of the 20,157,234 outstanding at December 31, 1993, 20,000,000 were issued in 1990 as the Company emerged from bankruptcy proceedings, 20,000 were awarded to certain members of RII's Board of Directors in 1991, and 137,234 were issued in settlement of Other Class 3C Claims. Additional shares of RII's common stock may be issued in the future in settlement of Other Class 3C Claims. See Note 10 for a description of notes receivable from related parties. NOTE 9 - STOCK OPTION PLAN __________________________ The Resorts International, Inc. Senior Management Stock Option Plan (the "1990 Stock Option Plan") authorizes the grant of stock options to members of the Company's management. The number of shares which may be granted under the 1990 Stock Option Plan may not exceed 10% of the shares of Common Stock Outstanding, as defined in the 1990 Stock Option Plan, subject to adjustment. Pursuant to the 1990 Stock Option Plan, options to purchase up to 5% of the shares of Common Stock Outstanding could be granted to David P. Hanlon, who was the President and Chief Executive Officer of RII until October 31, 1993; the remaining options could be granted to other eligible employees at the discretion of a committee appointed by the Board of Directors of RII. In 1991 the Company granted an option to Mr. Hanlon to purchase 5% of the Common Stock Outstanding at an exercise price of $1.875 per share, the fair market value on the date of grant. Although Mr. Hanlon's employment with the Company terminated effective October 31, 1993, pursuant to an agreement dated September 27, 1993 between RII and Mr. Hanlon, Mr. Hanlon is to retain his option until its expiration on October 31, 1997. This option was fully exercisable at December 31, 1993. - 59 - In addition to Mr. Hanlon's option, options to purchase the following shares of RII's common stock were outstanding at December 31, 1993: Exercise Options Options Price Outstanding Exercisable _______________________________________________________________________ $1.875 634,000 627,000 $1.75 30,000 10,000 _______ _______ 664,000 637,000 _______ _______ _______________________________________________________________________ No shares were issued in connection with the exercise of stock options during 1991, 1992 or 1993. NOTE 10 - RELATED PARTY TRANSACTIONS ____________________________________ License and Services Agreements _______________________________ Pursuant to the Company's 1990 plan of reorganization, Merv Griffin, Chairman of RII's Board of Directors, The Griffin Group, Inc. (the "Griffin Group"), a corporation owned by Mr. Griffin, and RII entered into a License and Services Agreement. Pursuant to this agreement, for the two years ended September 16, 1992, RII was granted a non-exclusive license to use Mr. Griffin's name and likeness to promote its facilities and operations and Mr. Griffin agreed to act as Chairman of the Board of RII and to provide certain other services without compensation, subject to certain conditions relating principally to the continuation of his control of the Company. In April 1993, RII, RIH and Griffin Group entered into a License and Services Agreement (the "New Griffin Services Agreement") effective as of September 17, 1992. Pursuant to this agreement, Griffin Group granted RII and RIH a non-exclusive license to use the name and likeness of Merv Griffin to advertise and promote the Company's facilities and operations. Also pursuant to the New Griffin Services Agreement, Mr. Griffin is to provide certain services to the Company, including serving as Chairman of the Board of RII and as a host, producer and featured performer in various shows to be presented in Resorts Casino Hotel, and furnishing marketing and consulting services. The New Griffin Services Agreement is to continue until the later of September 17, 1996 or the fourth anniversary of the consummation of a Reorganization (as defined, which would include a restructuring such as that discussed in Note 1) of RII; but in no event shall the term extend beyond September 17, 1997. If a Reorganization has not been consummated by September 17, 1996, the New Griffin Services Agreement shall terminate on that date. The New Griffin Services Agreement provides for earlier termination under certain circumstances including, among others, a change of control (as defined) of the Company and Mr. Griffin ceasing to serve as Chairman of the Board of RII. The Restructuring described in Note 1 contemplates that the New Griffin Services Agreement will remain in place. The New Griffin Services Agreement provides for compensation to Griffin Group in the amount of $2,000,000 for the year ended September 16, 1993, and in specified amounts for each of the following years, which increase at approximately 5% per year. In accordance with the - 60 - New Griffin Services Agreement, upon signing, the Company paid Griffin Group $4,100,000, representing compensation for the first two years. Thereafter, the New Griffin Services Agreement calls for annual payments on September 17, each representing a prepayment for the year ending two years hence. In lieu of paying in cash, at the Company's option, it may satisfy its obligation to make any of the payments required under the New Griffin Services Agreement by reducing the amount of the Group Note described below. In September 1993 the Company notified Griffin Group that it would satisfy its obligation to make the $2,205,000 payment for the year ending September 16, 1995 by reducing the Group Note by that amount. In the event of an early termination of the New Griffin Services Agreement, and depending on the circumstances of such early termination, all or a portion of the compensation paid to Griffin Group in respect of the period subsequent to the date of termination may be required to be repaid to the Company. The New Griffin Services Agreement also provides for the issuance to Griffin Group, on the effective date of a Reorganization of RII, of warrants (the "Griffin Warrants") to purchase 10% of the common stock of the reorganized entity on a fully diluted basis. In connection with the events described in Note 1, RII's Board of Directors subsequently approved certain revisions to the exercise price of the Griffin Warrants. The Griffin Warrants are to be exercisable at the lesser of (i) the average market price of RII's common stock for the 20 trading days following the effective date of a Reorganization and (ii) $1.875. The Company agreed to indemnify, defend and hold harmless Griffin Group and Mr. Griffin against certain claims, losses and costs, and to maintain certain insurance coverage with Mr. Griffin and Griffin Group as named insureds. Notes Receivable from Related Parties _____________________________________ Pursuant to the Company's 1990 plan of reorganization, in September 1990 RII received $12,345,000 in cash and an $11,000,000 promissory note (the "Griffin Note") from Merv Griffin for certain shares of RII common stock purchased by him. In April 1993, in accordance with the New Griffin Services Agreement, Mr. Griffin made a partial payment of $4,100,000 on this note comprised of $3,477,000 principal and $623,000 accrued interest. The Griffin Note, which then had a remaining balance of $7,523,000, was cancelled and a new note from Griffin Group (the "Group Note") in the amount of $7,523,000 was substituted therefor. As noted above, in September 1993 the balance of the Group Note was reduced by $2,205,000. The Group Note, which is unconditionally guaranteed as to principal and interest by Mr. Griffin, due on demand and bears interest at the rate of 3% per annum, comprises the note receivable from related party reflected on the accompanying Consolidated Balance Sheet as of December 31, 1993. Other _____ The Company reimbursed Griffin Group $181,000, $396,000, and $358,000 for charter air services related to Company business rendered in 1993, 1992 and 1991, respectively. In 1993 and 1992 the Company agreed to pay $100,000 and provided certain facilities, labor and accommodations to subsidiaries of January Enterprises, Inc. ("January Enterprises"), of which Merv - 61 - Griffin is Chief Executive Officer, in connection with the production of the live television broadcast of "Merv Griffin's New Year's Eve Special" from Resorts Casino Hotel. In 1991 "Merv Griffin's New Year's Eve Special" was broadcast from Resorts Casino Hotel by another subsidiary of January Enterprises. The Company provided facilities, labor and accommodations relative to that production as well. Also, in 1991 the Company paid $235,000 and provided certain facilities and personnel to a subsidiary of January Enterprises for the production of the "Ruckus Game Show" in the Company's facilities. The Company received certain promotional considerations in connection with the television broadcast of these shows. Antonio C. Alvarez II, a shareholder of Alvarez & Marsal, Inc., has been a member of the Board of Directors of RII since September 1990. The Company paid Alvarez & Marsal, Inc. $300,000 and $241,000 for financial advisory services rendered in 1992 and 1991, respectively. Warren Cowan, who was Chairman of Rogers & Cowan, Inc. until July 1992, has been a member of the Board of Directors of RII since September 1990. The Company paid Rogers & Cowan, Inc. $128,000 and $147,000 for public relations services rendered for the Company's Atlantic City and Paradise Island properties in 1992 and 1991, respectively. NOTE 11 - SHOWBOAT LEASE ________________________ The Company leases to a subsidiary ("ACS") of Showboat, Inc., a resort and casino operator, approximately 10 acres of land adjacent to the Boardwalk in Atlantic City. Under the 99-year net lease, lease payments are payable in equal monthly installments on the first day of each month. The annual lease payment for the lease year ending March 31, 1994, is $8,118,000. The lease payment is to be adjusted annually, as of April 1, for changes in the consumer price index. Pursuant to the lease agreement, the Company is unable to transfer its interest in the lease, other than to an affiliate, without giving ACS the opportunity to purchase such interest at terms no less favorable than agreed to by any other party. As described in Note 7, the Showboat Notes are secured by a mortgage encumbering the real property which is subject to the Showboat Lease, by a collateral assignment of the Showboat Lease, and by a pledge of any proceeds of the sale of such mortgage and collateral assignment. Lease payments under the Showboat Lease are required to be passed-through to holders of the Showboat Notes. NOTE 12 - RETIREMENT PLANS __________________________ RII and certain of its subsidiaries participate in a defined contribution plan covering substantially all of their non-union, full-time employees. The Company makes contributions to this plan based on a percentage of eligible employee contributions. Total pension expense for this plan was $804,000, $767,000 and $740,000 in 1993, 1992 and 1991, respectively. In 1991 the Company recorded a gain of $344,000 resulting from the settlement of a defined benefit plan which was terminated in 1989. Net periodic pension income for this plan for 1991 amounted to $121,000. - 62 - In addition to the plans described above, union and certain other employees of several subsidiary companies are covered by multi-employer defined benefit pension plans to which subsidiaries make contributions. Such contributions totalled $1,392,000, $1,403,000 and $2,404,000 in 1993, 1992 and 1991, respectively. NOTE 13 - INCOME TAXES ______________________ As discussed in Note 2, the Company adopted SFAS 109 effective January 1, 1993. There was no effect on the accompanying Consolidated Statements of Operations nor was there a cumulative effect of adopting SFAS 109. 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 liabilities and assets as of December 31, 1993 were as follows: (In Thousands of Dollars) _______________________________________________________________________ Deferred tax liabilities: Basis differences on property and equipment $ (85,200) Other (3,100) _________ Total deferred tax liabilities (88,300) _________ Deferred tax assets: Net operating loss carryforwards 259,900 Basis differences on debt 15,100 Book reserves not yet deductible for tax 17,100 Tax credit carryforwards 2,900 Other 5,300 _________ Total deferred tax assets 300,300 Valuation allowance for deferred tax assets (266,000) _________ Deferred tax assets, net of valuation allowance 34,300 _________ Net deferred tax liabilities $ (54,000) _________ _______________________________________________________________________ In August 1993 tax law changes were enacted which resulted in an increase in the Company's federal income tax rate. The increase resulted in a $1,000,000 increase in the Company's deferred income tax liability and a deferred income tax provision of the same amount. During 1992 the Company received federal income tax refunds of $1,348,000 when the audit of the Company's 1981 and 1982 tax returns was completed. Such amount was recorded as a federal income tax benefit in 1992. During 1991 the Company received a federal income tax refund of $831,000. The refund related to the carryback of certain 1983 credits to 1980 and was issued when the examination of the Company's 1983 tax return was waived. Such amount was recorded as a federal income tax benefit in 1991. Net operating losses were generated for federal tax purposes in 1993, 1992 and 1991, so no current federal tax provision was recorded in those years. No state tax provision was recorded in those years due to the utilization of state net operating loss carryforwards in states where the Company generated taxable income. - 63 - The effective income tax rate on the loss before income taxes varies from the statutory federal income tax rate as a result of the following factors: 1993 1992 1991 _______________________________________________________________________ Statutory federal income tax rate (35.0%) (34.0%) (34.0%) Net operating losses for which no tax benefit was recognized 34.7% 33.6% 33.4% Income taxes refunded (2.5%) (2.0%) Other, including impact of increase in tax rate in 1993 1.3% .4% .6% _______ _______ _______ Effective tax expense (benefit) rate 1.0% (2.5%) (2.0%) _______ _______ _______ _______________________________________________________________________ The Company provides deferred taxes on the unremitted earnings of its Bahamian subsidiaries by allowing for the sale of the Bahamian assets in the SFAS 109/SFAS 96 computations as it is the intention of the Company to sell its Bahamian assets. The Company anticipates that taxes on any such sale will be offset by net operating loss carryforwards under the provisions of the Internal Revenue Code for gains existing as of the date of change in ownership. For federal tax purposes the Company had net operating loss carryforwards of approximately $742,000,000 at December 31, 1993. Of this amount, approximately $260,000,000 is not limited as to use and expires from 2005 through 2008. Due to a change of ownership of RII in 1990, the balance of the tax loss carryforward which expires from 1999 through 2005 is limited in its availability to offset future taxable income of the Company. Though otherwise limited, such loss carryforwards would be available to offset gains on sales of assets owned at the date of change in ownership of the Company which are sold within five years of that date. At December 31, 1993 RII and its subsidiaries had significant net operating loss carryforwards in New Jersey, which expire from 1994 through 1999, and in Florida, which expire from 1994 through 2008. Also, for federal tax purposes, the Company had tax credit carryforwards of $2,900,000 at December 31, 1993 which expire from 1998 through 2008. The source of loss before income taxes was as follows: (In Thousands of Dollars) 1993 1992 1991 _______________________________________________________________________ U.S. source loss $ (81,542) $(41,526) $(30,095) Foreign source loss (19,622) (13,276) (12,307) _________ ________ ________ Loss before income taxes $(101,164) $(54,802) $(42,402) _________ ________ ________ _______________________________________________________________________ - 64 - NOTE 14 - STATEMENTS OF CASH FLOWS __________________________________ Supplemental disclosures required by Statement of Financial Accounting Standards No. 95 "Statement of Cash Flows" are presented below. (In Thousands of Dollars) 1993 1992 1991 _______________________________________________________________________ Reconciliation of net loss to net cash provided by operating activities: Net loss $(102,164) $(53,454) $(41,571) Adjustments to reconcile net loss to net cash provided by operating activities: Depreciation 27,924 25,322 23,814 Amortization (principally debt discount) 51,251 37,565 32,415 Interest expense settled by issuance of long-term debt 40,268 31,165 19,584 Provision for doubtful receivables 2,889 4,047 6,373 Provision for discount on CRDA obligations 1,541 1,451 1,574 Deferred tax provision 1,000 Recapitalization costs 8,789 2,848 Stock awards 34 Net loss on sales of property and equipment 220 113 533 Net (increase) decrease in accounts receivable 2,236 2,744 (9,719) Net (increase) decrease in inventories and prepaids (849) 429 (433) Net (increase) decrease in deferred charges and other assets (416) (1,499) 296 Net increase (decrease) in accounts payable and accrued liabilities 11,327 (10,299) (4,241) _________ ________ ________ Net cash provided by operating activities $ 44,016 $ 40,432 $ 28,659 _________ ________ ________ Non-cash investing and financing transactions: Exchange of note receivable from shareholder for note receivable from Griffin Group $ 7,523 Reduction in note receivable from Griffin Group applied to prepaid services $ 2,205 Increase in liabilities for additions to property and equipment and other assets $ 632 $ 112 $ 1,180 Reclassifications to other assets from receivables and property and equipment $ 450 $ 337 $ 674 Other Class 3C Claims settled for common stock and Series B Notes $ 227 $ 1,448 ______________________________________________________________________ - 65 - NOTE 15 - COMMITMENTS AND CONTINGENCIES _______________________________________ CRDA ____ The Casino Control Act, as originally adopted, required a licensee to make investments equal to 2% of the licensee's gross revenue (as defined under the Casino Control Act) (the "investment obligation") for each calendar year, commencing in 1979, in which such gross revenue exceeded its "cumulative investments" (as defined in the Casino Control Act). A licensee had five years from the end of each calendar year to satisfy this investment obligation or become liable for an "alternative tax" in the same amount. In 1984 the New Jersey legislature amended the Casino Control Act so that these provisions now apply only to investment obligations for the years 1979 through 1983. Effective for 1984 and subsequent years, the amended Casino Control Act requires a licensee to satisfy its investment obligation by purchasing bonds to be issued by the CRDA, or by making other investments authorized by the CRDA, in an amount equal to 1.25% of a licensee's gross revenue. If the investment obligation is not satisfied, then the licensee will be subject to an investment alternative tax of 2.5% of gross revenue. Since 1985, a licensee has been required to make quarterly deposits with the CRDA against its current year investment obligation. An analysis of RIH's investment obligations under the Casino Control Act and RIH's means of settlement since 1979 follows: (In Thousand of Dollars) 1979-1983 1984-1993 Total _______________________________________________________________________ Investment obligations $(21,637) $(29,172) $(50,809) Means of settlement: Housing related investments under audit 13,104 13,104 Housing related investments previously approved 1,000 1,000 CRDA deposits/bond purchases 7,533 28,479 36,012 ________ ________ ________ Remaining investment obligation at December 31, 1993, which was deposited in January 1994 $ -0- $ (693) $ (693) ________ ________ ________ _______________________________________________________________________ With regard to the housing related investments under audit, in January 1988 the CRDA notified the Company of its interpretation as to the periods of time during which expenditures could be made to satisfy investment obligations. CRDA's interpretation differs from RIH's and if found to be correct would decrease the amount of RIH's qualifying expenditures by approximately $5,000,000 to $6,000,000. RIH believes that its interpretation is correct and intends to contest this issue. - 66 - RIH also received a letter dated November 9, 1989, from the State of New Jersey Department of the Treasury (the "Treasury") stating that the housing related investments made by RIH were not sufficient to meet its investment obligation for the years 1979 through 1983. The letter also stated that alternative tax in the amount of $21,637,000 was due for those years, in addition to penalties and interest thereon which amounted to $12,514,000 as of the date of the letter. As set forth in the table above, the Company believes that $8,533,000 of such obligations have been settled; $7,533,000 in cash and $1,000,000 by previously approved housing related investments. Also, the Company has received audit reports issued by an agency acting on behalf of the Treasury identifying $10,165,000 of project development costs available for investment credit towards the investment obligation. This leaves a total of $2,939,000 of housing related investments under audit in question. The Company has notified the Treasury that it takes exception to the Treasury's computation of amounts due. Further, the Company believes that the $2,939,000 of housing related investments in question will be found, under further audit, to have been satisfied. Although these matters have been dormant for some time, the Company was recently verbally contacted by the Treasury and expects further communication regarding the Treasury's proposal for a resolution of these matters in the near future. If the CRDA's interpretation as to the periods of time during which qualifying expenditures can be made is found to be correct, or if the Treasury's issue is determined adversely, RIH could be required to pay the relevant amount in cash to the CRDA. In the opinion of management, based upon advice of counsel, the aggregate liability, if any, arising from these issues will not have a material adverse effect on the accompanying consolidated financial statements. As reflected in the table above, through December 31, 1993, RIH had made CRDA deposits/bond purchases totalling $36,012,000. However, in August 1989 RIH donated $12,048,000 to the CRDA in exchange for which RIH was relieved of its obligation to purchase CRDA bonds of $18,193,000. Because RIH already had the $18,193,000 for bond purchases on deposit with the CRDA, the difference between this amount and the amount of the donation, or $6,145,000, was refunded to RIH in August 1989. Thus, at December 31, 1993, RIH had a remaining balance of $4,873,000 face value of bonds issued by the CRDA and had $12,946,000 on deposit with the CRDA. These bonds and deposits, net of an estimated discount charged to expense to reflect the below-market interest rate payable on the bonds, were recorded as other assets in the Company's Consolidated Balance Sheets. RIH records charges to expense to reflect the below-market interest rate payable on the bonds it may have to purchase to fulfill its investment obligation at the date the obligation arises. The charges in 1993, 1992 and 1991 for discounts on obligations arising in those years were $1,541,000, $1,451,000 and $1,574,000, respectively. - 67 - Litigation __________ RII and certain of its subsidiaries are defendants in certain litigation. In the opinion of management, based upon advice of counsel, the aggregate liability, if any, arising from such litigation will not have a material adverse effect on the accompanying consolidated financial statements. NOTE 16 - GEOGRAPHIC AND BUSINESS SEGMENT INFORMATION _____________________________________________________ Schedules of geographic and business segment information relating to (i) revenues, (ii) contribution to consolidated loss before income taxes and (iii) identifiable assets, depreciation and capital additions are included in "ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS." - 68 - - 69 - - 70 - - 71 - - 72 - - 73 - SCHEDULE X __________ Resorts International, Inc. and Subsidiaries SUPPLEMENTARY STATEMENTS OF OPERATIONS INFORMATION (In Thousands of Dollars) For the Year Ended December 31, __________________________________ 1993 1992 1991 _____________________________________________________________________ Maintenance and repairs $23,439 $20,843 $18,845 Gaming taxes $26,704 $26,053 $24,376 Property taxes $ 9,392 $ 9,279 $ 9,193 Advertising $ 8,900 $10,086 $11,370 _____________________________________________________________________ - 74 - - 75 - 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 directors of RII are: Director Name Age Since ____ ___ ________ Merv Griffin 68 1988 Chairman of the Board of Directors Antonio C. Alvarez II 45 1990 Warren Cowan 73 1990 Thomas E. Gallagher(1) 49 1993 Joseph G. Kordsmeier 54 1991 Paul C. Sheeline 72 1990 ____________________________ (1) Mr. Gallagher was elected by remaining members of RII's Board of Directors to replace David P. Hanlon who resigned as of October 31, 1993. Pursuant to the Company's Restated Certificate of Incorporation, the total number of directors is fixed at six. The Board of Directors is divided into three equal classes, Class I, Class II, and Class III, which have staggered three year terms. Notwithstanding the foregoing, each director shall serve until his successor is elected and qualified or until his earlier death, resignation or removal. Messrs. Kordsmeier and Sheeline comprise Class I, Messrs. Alvarez and Gallagher comprise Class II, and Messrs. Griffin and Cowan comprise Class III. If the Restructuring is effected, a new classified Board of Directors of RII will be named. Pursuant to the Plan, on the Effective Date the initial post-Restructuring Board of Directors of RII will be composed of directors designated by RII. After the Restructuring, the holders of RII Common Stock, voting as a class, will be entitled to elect four directors of RII and the holders of RII Class B Stock, voting as a class, will be entitled to elect two directors of RII (the "Class B Directors"). See "Restructuring of Series Notes - Restructuring" under "ITEM 1. BUSINESS - (a) General Development of Business" for a description of the Class B Triggering Event which would entitle holders of RII Class B Stock to elect a majority of RII's Board of Directors. The initial post-Restructuring Board of Directors of RII will consist of Merv Griffin, Thomas E. Gallagher, Jay M. Green (age 46), William Fallon (age 40) and, as Class B Directors, Charles Masson (age 40) and Vincent J. Naimoli (age 56). - 76 - The Audit Committee consists of two independent directors, Messrs. Kordsmeier and Sheeline. Messrs. Griffin, Gallagher and Sheeline are members of the Executive Committee of the Board of Directors, which was formed in November 1993. The executive officers of RII are: Executive Officer Name Age Since ____ ___ _________ Merv Griffin 68 1988 Chairman of the Board of Directors Christopher D. Whitney 49 1988 Office of the President, Executive Vice President, Chief of Staff, General Counsel and Secretary Matthew B. Kearney 54 1982 Office of the President, Executive Vice President-Finance, Chief Financial Officer and Treasurer David G. Bowden 53 1979 Vice President-Controller, Chief Accounting Officer, Assistant Secretary and Assistant Treasurer _______________________ RII's officers serve at the pleasure of the Board of Directors. Pursuant to an agreement dated as of September 27, 1993 between RII and David P. Hanlon (the "Hanlon Termination Agreement"), David P. Hanlon resigned as of October 31, 1993, from his positions as President, Chief Executive Officer and a director of RII. Pending completion of its restructuring, RII will be managed by an Office of the President comprised of Messrs. Whitney and Kearney. Business Experience ___________________ The principal occupations and business experience for the last five years or more of the directors, nominees and executive officers of RII are as follows: Merv Griffin - Chairman of the Board of RII since November ____________ 1988; Chairman of Griffco Resorts Holding, Inc. ("Griffco," a Company which through September 1990 was owned by Mr. Griffin and from November 1988 through September 1990 was RII's parent) from its incorporation in May 1986 to September 1990; President of Griffco from September 1988 to September 1990; Chairman of Griffin Group since its incorporation in September 1988; Chairman of January Enterprises, Inc. ("January Enterprises"), a television production and holding company doing business as Merv Griffin Enterprises, from 1964 to May 1986, and Chief Executive - 77 - Officer since 1964; director of Hollywood Park Operating Company from 1987 to June 1991; television and radio producer since 1945. Mr. Griffin created and produced the nationally syndicated television game shows, "Wheel of Fortune" and "Jeopardy." For 21 years, through 1986, Mr. Griffin hosted "The Merv Griffin Show," a nationally syndicated talk show. In 1986, Mr. Griffin sold January Enterprises to The Coca Cola Company, but he continues to act as Chief Executive Officer of January Enterprises, presently a wholly-owned indirect subsidiary of Sony Pictures Entertainment, Inc. Antonio C. Alvarez II - Chief Executive Officer of Phar-Mor Inc., _____________________ a discount drugstore chain, since February 1993; President and Chief Operating Officer of Phar-Mor Inc. from September 1992 to February 1993; Chairman of Alvarez & Marsal, Inc. ("Alvarez & Marsal"), a financial advisory firm, since September 1983; Vice President and Controller of Norton Simon Inc. from December 1981 to September 1983; prior thereto, Partner, Coopers & Lybrand. Warren Cowan - Public relations consultant since July 1992; ____________ Chairman of Rogers & Cowan, Inc., a public relations firm, from 1986 until July 1992; President of Rogers & Cowan, Inc. from 1964 until 1986. Thomas E. Gallagher - President and Chief Executive Officer of ___________________ Griffin Group since April 1992 and a director of Players International, Inc., a riverboat gaming company, since December 1992. For the preceeding 15 years, Mr. Gallagher was a partner of the law firm of Gibson, Dunn & Crutcher. Joseph G. Kordsmeier - President and sole owner of Kordsmeier ____________________ Company, consultants to the lodging industry, since 1982; Senior Vice President of Sales and Marketing Worldwide and other positions with Hyatt Hotels from 1972 to 1982; Mr. Kordsmeier also serves on the Advisory Board to Language Line, a division of AT&T. Paul C. Sheeline - Chairman of Vale Petroleum Corporation from ________________ 1989 to 1991; Consultant to Intercontinental Hotels Corporation ("Intercontinental") from 1986 to June 1990; Chief Executive Officer of Intercontinental from 1971 to 1985. In addition, Mr. Sheeline was Of Counsel to the Washington, D.C. law firm of Verner, Liipfert, Bernhard, McPherson and Hand from 1985 through March 1993. William Fallon - Executive Vice President of R.M. Bradley & Co. ______________ Inc. ("Bradley"), a real estate brokerage and management company, since March 1994; Senior Vice President of Bradley from 1988 to March 1994; other positions with Bradley from 1979 to 1988; director of Massachusetts Certified Development Corporation, a small business development company, from 1987 to present. Jay M. Green - Executive Vice President Finance and ____________ Administration and Treasurer of Culbro Corporation, a diversified consumer and industrial products company since 1988; Chairman of the Board of The Eli Witt Company, a Culbro subsidiary, since February 1993; prior to 1988, Vice President and Controller of Columbia Pictures Entertainment, Inc. - 78 - Charles Masson - President of McCloud Partners, a private ______________ advisory firm, since June 1993; director of Salomon Brothers Inc from 1991 through May 1993; Vice President of Salomon Brothers Inc from 1983 through 1990. Vincent J. Naimoli - Chairman, President and Chief Executive __________________ Officer of Harvard Industries, Inc. since 1993; Chairman and Chief Executive Officer of Doehler-Jarvis Corporation since 1991; Chairman, President and Chief Executive Officer of Ladish Company, Inc. since 1993; Managing General Partner of the Tampa Bay Baseball Ownership Group since 1992; Chairman, President and Chief Executive Officer of Anchor Industries International, Inc., an operating and holding company, since 1989; director of Lincoln Foodservice Products, Inc. since 1991; director of Simplicity Pattern Company since 1990; Chairman, President and Chief Executive Officer of Anchor Glass Container Corporation from 1983 through 1989. Christopher D. Whitney - Office of the President of RII since ______________________ November 1993; Executive Vice President of RII since December 1989; General Counsel to and Secretary of RII since February 1989; Chief of Staff of RII since December 1988; Senior Vice President of RII from December 1988 to December 1989; Senior Vice President, Law & Government and General Counsel of Harrah's East, Inc. from November 1984 to December 1988; Vice President, General Counsel and Secretary of Harrah's, the western branch of the casino subsidiary of Holiday Corporation ("Holiday") located in Reno, Nevada, from June 1983 to November 1984; Vice President, General Counsel and Secretary of Perkins Restaurants, Inc., Holiday's restaurant group subsidiary then located in Minneapolis, Minnesota from November 1981 to June 1983; Vice President & Associate General Counsel (Litigation) of Holiday in Memphis, Tennessee from January 1979 to November 1981. Matthew B. Kearney - Office of the President of RII since __________________ November 1993; Executive Vice President - Finance of RII since September 1993; Chief Financial Officer of RII since 1982; Vice President-Finance of RII from 1982 through September 1993. David G. Bowden - Vice President-Controller and Chief Accounting _______________ Officer of RII since 1979. - 79 - - 80 - Notes to Summary Compensation Table (1) Mr. Hanlon resigned from all positions with RII and its subsidiaries as of October 31, 1993. (2) Represents performance bonus for year in which presented. (3) Includes $375,000 in each of 1992 and 1991 for special incentive bonus payments in satisfaction of a guaranteed bonus in connection with Mr. Hanlon's agreement to enter into employment with the Company. Also includes performance bonuses of $831,435 for 1992 and $950,000 for 1991. (4) Represents bonus in recognition of efforts relative to the Restructuring. (5) Includes $157,776 for legal fees and expenses incurred in connection with the preparation and negotiation of the Hanlon Employment Agreement (defined below under "Employment Contracts and Termination of Employment and Change in Control Arrangements - David P. Hanlon"). (6) The 1990 Stock Option Plan provided for the grant to Mr. Hanlon of options to purchase 5% of the shares of Common Stock Outstanding, as defined, which amount by its definition is subject to adjustment. The amount reflected here is based on Common Stock Outstanding at December 31, 1993. Due to the expiration of certain 1990 Stock Options in connection with certain employee terminations, since that date the number of shares under option to Mr. Hanlon has decreased. As of February 28, 1994, Mr. Hanlon had options to purchase 1,089,275 shares. (7) Includes $2,648,656 for Mr. Hanlon pursuant to the Hanlon Termination Agreement (see "Employment Contracts and Termination of Employment and Change in Control Arrangements - David P. Hanlon" below); the cost of group life and health insurance: Mr. Hanlon - $16,109, Mr. Whitney - $7,379, Mr. Kearney - $20,794 and Mr. Bowden - $28,603; the Company's contribution to a defined contribution group retirement plan: Mr. Hanlon - $10,000, Mr. Whitney - $6,000, Mr. Kearney - $5,625 and Mr. Bowden - $2,700; and the cost of additional disability coverage for Mr. Hanlon - $7,949. See also the description of the New Griffin Services Agreement under "Compensation Committee Interlocks and Insider Participation - Transactions with Management and Others - Griffin Services Agreement" below for a description of compensation to Griffin Group for certain services rendered by Mr. Griffin. Option Grant Table __________________ No options were granted in 1993 to the executive officers named in the Summary Compensation Table. Accordingly, no "Option Grant Table" is presented herein. Fiscal Year End Option Value Table __________________________________ The following table sets forth information as of December 31, 1993, concerning the unexercised options held by executive officers - 81 - named in the Summary Compensation Table, none of whom exercised options in 1993. No options held by those executive officers were in-the-money at December 31, 1993. Options are "in-the-money" when the fair market value of underlying common stock exceeds the exercise price of the option. All options held by the named executives have an exercise price of $1.875 per share. The closing price of RII Common Stock on December 31, 1993, was $1.625 per share. Number of Unexercised Options at December 31, 1993, all of which were Name Exercisable ____ ____________________________________ David P. Hanlon 1,094,800 (1) Christopher D. Whitney 100,000 Matthew B. Kearney 87,500 David G. Bowden 25,000 ________________________ (1) This amount was based on Common Stock Outstanding, as defined, as of December 31, 1993. See Note (6) of Notes to Summary Compensation Table above. Compensation of Directors _________________________ RII's non-employee directors are each entitled to receive $35,000 annually as compensation for serving as a director, $500 for each Board meeting attended and $500 for each Committee meeting attended when such Committee meeting is not held on the same day as a Board meeting or another Committee meeting. No compensation was paid to Mr. Griffin or Mr. Hanlon for their services as directors of RII in 1993. However, Griffin Group was compensated for certain services provided by Mr. Griffin, including Mr. Griffin's serving as Chairman of the Board of RII. See the description of the New Griffin Services Agreement under "Compensation Committee Interlocks and Insider Participation - Transactions with Management and Others - Griffin Services Agreement" below. Messrs. Alvarez, Cowan, Gallagher, Kordsmeier and Sheeline received $41,500, $ 42,000, $6,333, $43,000 and $42,500, respectively, for their services as directors during 1993. Employment Contracts and Termination of Employment and Change in ________________________________________________________________ Control Arrangements ____________________ David P. Hanlon. Pursuant to the Hanlon Termination Agreement, _______________ RII and Mr. Hanlon mutually agreed to the termination, as of October 31, 1993, of the employment agreement (the "Hanlon Employment Agreement") between RII and Mr. Hanlon dated as of September 17, 1992 pursuant to which Mr. Hanlon served as President and Chief Executive Officer of RII. - 82 - Pursuant to the Hanlon Termination Agreement, Mr. Hanlon received a $719,661 performance bonus for 1993 that was earned pursuant to the Hanlon Employment Agreement but not yet paid as of October 31, 1993. In addition, pursuant to the Hanlon Termination Agreement, Mr. Hanlon is entitled to receive the present value of future base salary pursuant to the Hanlon Employment Agreement as determined under the Hanlon Termination Agreement in the sum of $1,303,076 and $1,345,580 in respect of the performance bonuses for fiscal years ending 1994 and 1995 payable under the Hanlon Employment Agreement, half of which was paid on October 31, 1993 and half of which will be paid upon the earlier of (i) the acceptance of a reorganization or recapitalization of RII by the requisite number and amount of RII's creditors voting on such restructuring or reorganization and (ii) April 15, 1995. In addition, Mr. Hanlon will receive a bonus from RII in the amount of $325,000 in connection with the reorganization or recapitalization of RII, payable prior to any bankruptcy filing by RII. Finally, Mr. Hanlon will receive a bonus of $300,000 upon the disposition of the Paradise Island operations. Accordingly, Mr. Hanlon would receive a total of $625,000 in connection with the Restructuring. The payment to be made to Mr. Hanlon with respect to the disposition of the Paradise Island operations may be subject to the approval of the Bankruptcy Court. Mr. Hanlon is also entitled to participate in all of RII's benefit plans through and including September 16, 1995, unless Mr. Hanlon receives a comparable benefit in connection with subsequent employment. Mr. Hanlon will retain all 1990 Stock Options previously granted to him. Christopher D. Whitney and Matthew B. Kearney. The Company has _____________________________________________ employment agreements with Messrs. Whitney and Kearney, both dated as of May 3, 1991, which were extended to May 1995. The respective terms of employment will each renew automatically for another year unless either party to the agreement notifies the other that the term is not to be renewed. Mr. Whitney's agreement provides for an annual salary of $300,000 and Mr. Kearney's agreement was recently amended to provide for an annual salary of $300,000. If the Company terminates the executive's employment without cause, as defined, the executive will be entitled to receive base salary payments through the end of his term of employment. If such a termination of his employment follows a change in control, as defined, the executive will receive a lump-sum payment equal to the present value of such base salary payments. Compensation Committee Interlocks and Insider Participation ___________________________________________________________ Messrs. Alvarez, Griffin and Sheeline serve as members of the Compensation Committee of the Board of Directors of RII. Mr. Griffin also serves as an officer of RII. Transactions with Management and Others _______________________________________ Griffin Services Agreement. In April 1993 RII and RIH entered __________________________ into a License and Services Agreement with Griffin Group, the New Griffin Services Agreement, dated and effective as of September 17, 1992 to replace the previous License and Services Agreement among RII, Merv Griffin and Griffin Group upon its expiration. Pursuant to the New Griffin Services Agreement, Griffin Group granted RII and RIH a non-exclusive license to use the name and likeness of Merv Griffin, in certain advertising media and limited merchandising, for the sole - 83 - purpose of advertising and promoting the Resorts Casino Hotel and the Paradise Island operations. In connection with such license, Griffin Group will not grant any similar license to any casino/hotel located in either Atlantic City or The Bahamas during the term of the New Griffin Services Agreement, so long as RII and RIH own or operate casino and hotel facilities in such locations. It is expected that Merv Griffin will not be associated with the Paradise Island operations subsequent to the Restructuring. Pursuant to the New Griffin Services Agreement, Griffin Group agreed to provide to RII and RIH, for the term of the New Griffin Services Agreement, the non-exclusive services of Merv Griffin, subject to the performance by RII and RIH of its obligations under the New Griffin Services Agreement, (i) as Chairman of the Board of Directors of RII, (ii) as host, producer, presenter and featured performer relative to certain shows to be presented at the Resorts Casino Hotel, (iii) as consultant and marketing adviser, (iv) in certain capacities, as spokeperson for RII and RIH and (v) as participant in certain radio, television and print advertisements. The New Griffin Services Agreement is to continue in force until the later of September 17, 1996, or the fourth anniversary of the effective date of any restructuring of RII's outstanding debt or any reorganization of RII under the Bankruptcy Code. If no such restructuring or reorganization has been consummated as of September 17, 1996, the New Griffin Services Agreement shall terminate as of that date. Additionally, in no event shall the New Griffin Services Agreement extend beyond September 17, 1997. The New Griffin Services Agreement provides for earlier termination under certain circumstances including, among others, a change of control (as defined) of the Company and Mr. Griffin ceasing to serve as Chairman of the Board of RII. The Restructuring contemplates that the New Griffin Services Agreement will remain in place. Under the New Griffin Services Agreement, Griffin Group was entitled to receive from RII and RIH $4,100,000 upon execution of such agreement, as compensation for the first two years of services. Thereafter, the agreement calls for annual payments on September 17, each representing a prepayment for the year ending two years hence. These required payments are in the amounts of $2,205,000 and $2,310,000 for services during the third and fourth years, respectively, of the term of the New Griffin Services Agreement. Thereafter, should the New Griffin Services Agreement remain in force for another full year, RII and RIH will pay Griffin Group additional compensation in the amount of $2,425,000 or, if the New Griffin Services Agreement remains in force for less than a full year, a prorated portion of such amount. In lieu of paying in cash, at the Company's option, it may satisfy its obligation to make any of the payments required under the New Griffin Services Agreement by reducing the amount of the Group Note described below under "Indebtedness of Management." RIH made the $4,100,000 payment for the first two years under the New Griffin Services Agreement in April 1993. In September 1993, RII satisfied the Company's obligation to make the $2,205,000 payment for the year ending September 16, 1995 by reducing the Group Note by that amount. The Restructuring contemplates that on or prior to the Effective Date RII will satisfy the Company's $2,310,000 obligation to - 84 - Griffin Group for the fourth year of the New Griffin Services Agreement by reducing the principal amount of the Group Note in an equal amount. The New Griffin Services Agreement also provides that, as additional compensation, RII will issue to Griffin Group, on the effective date of a reorganization of RII, the Griffin Warrants to purchase 10% of the common stock of the reorganized entity. The Griffin Warrants are to be exercisable at the lesser of (i) the average market price of RII's common stock for the 20 trading days following the effective date of a reorganization and (ii) $1.875. RII and RIH also have agreed to indemnify Merv Griffin and Griffin Group for certain costs and liabilities arising in connection with the New Griffin Services Agreement or Merv Griffin's services, or the service of any employee of Griffin Group, as a director or officer of RII or any subsidiary thereof. Pursuant to the New Griffin Services Agreement, RII and RIH have agreed to maintain for at least four years comprehensive public liability, personal injury and umbrella insurance coverage in specified amounts for both Griffin Group and Merv Griffin, individually. RII and RIH also have agreed to reimburse Griffin Group for certain expenses incurred by Griffin Group and Merv Griffin in connection with the license and services agreed to under the New Griffin Services Agreement. If Griffin Group fails to perform its obligations pursuant to the New Griffin Services Agreement, all unearned advance payments to Griffin Group will be repaid to the Company. Indemnity Agreement. RII agreed to indemnify Merv Griffin ___________________ pursuant to an Indemnity Agreement (the "Indemnity Agreement"), executed on September 19, 1990, against any and all losses by reason of, arising from, in connection with, or relating to the Acquisition Claims (as defined in the Indemnity Agreement). The Acquisition Claims relate to all claims asserted against Mr. Griffin in connection with the acquisition of RII by Griffco in November 1988, and all transactions consummated in connection therewith, including the sale of the Taj Mahal to certain affiliates of Donald Trump and the issuance of certain debt securities by GGRI. RII also agreed to reimburse Mr. Griffin for any out-of-pocket expenses (including counsel fees) incurred by him in connection with the enforcement of, or preservation of any rights under, the Indemnity Agreement. Other Transactions. The Company reimbursed Griffin Group __________________ $181,000 for charter air services rendered in 1993 to Mr. Griffin as well as other directors and officers of RII for travel related to Company business. In 1993 the Company agreed to pay a subsidiary of January Enterprises, of which Merv Griffin is Chief Executive Officer, $100,000 and provided certain facilities, labor and accommodations in connection with the production of the live television broadcast of "Merv Griffin's New Year's Eve Special 1993" from Resorts Casino Hotel. The Company received certain promotional considerations in connection with the television broadcast of this show. - 85 - In early 1992, RII entered into an agreement with Alvarez & Marsal pursuant to which it was to provide financial advisory services in connection with the development and analysis of financial alternatives available to the Company, and the development of a long-term financial plan. According to an amendment to this agreement, RII paid no fees to Alvarez & Marsal during 1993; however, the agreement, as amended, provides for a fee of $250,000 and 125,000 shares of RII Common Stock upon consummation of an out-of-court restructuring or upon receipt of a number and amount of consents sufficient to confirm a prepackaged plan of reorganization. Mr. Alvarez, a shareholder of Alvarez & Marsal, has been a member of the Board of Directors of RII since September 1990. Certain Business Relationships ______________________________ The Company retained Verner, Liipfert, Bernhard, McPherson and Hand during 1993 for certain legal services. Mr. Sheeline, who was Of Counsel to this law firm through March 1993, has been a director of RII since 1990. Indebtedness of Management __________________________ In September 1990, Merv Griffin, Chairman of the Board of RII, purchased 4,400,000 shares of RII Common Stock for which RII received $12,345,000 in cash and an $11,000,000 promissory note, the Griffin Note. The Griffin Note was secured by a letter of credit issued by a bank, bore interest at 8% per year and was due upon demand. In April 1993, simultaneous with RIH's payment to Griffin Group of $4,100,000 for the first two years of service under the New Griffin Services Agreement described above under "Transactions with Management and Others - Griffin Services Agreement," Mr. Griffin made a partial payment of principal and interest in the amount of $4,100,000 on the Griffin Note, resulting in a remaining balance of $7,523,333. The Griffin Note was then cancelled and a new note from Griffin Group, the Group Note, in the amount of $7,523,333 was substituted therefor. The Group Note is payable on demand and bears interest at the rate of 3% per year. Merv Griffin has personally guaranteed payment of the Group Note. As noted above, RII satisfied the Company's September 1993 obligation of $2,205,000 under the New Griffin Services Agreement by reducing the Group Note by that amount. Also, the Restructuring contemplates that (i) on or prior to the Effective Date RII will satisfy the Company's $2,310,000 obligation to Griffin Group for the fourth year of the New Griffin Services Agreement by reducing the principal amount of the Group Note in an equal amount and (ii) thereafter, but no later than the Effective Date, Griffin Group will pay RII the then remaining balance of the Group Note plus accrued interest, which proceeds will be included in the Company's Excess Cash to be distributed to holders of the Series Notes. - 86 - ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND _____________________________________________________________ MANAGEMENT __________ Security Ownership of Certain Beneficial Owners _______________________________________________ The following table sets forth information as to the beneficial ownership of RII Common Stock as of February 28, 1994, by persons known by RII to be holders of 5% or more of such common stock. Information as to the number of shares beneficially owned has been furnished by the persons named in the table. Amount and Name and Address Nature of of Beneficial Beneficial Percent Owner Ownership of Class ________________ __________ ________ Merv Griffin 4,398,115 21.82% c/o The Griffin Group, Inc. 780 Third Avenue, Suite 1801 New York, NY 10017 David P. Hanlon 1,089,275 (1) 5.13% P.O. Box 486 Oceanville, NJ 08231 _______________________ (1) Ownership represents shares issuable upon exercise of 1990 Stock Options. Related percentage shown gives effect to the exercise of options for such shares. See Note (6) of Notes to Summary Compensation Table in "ITEM 11. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS ________________________________________________________ Messrs. Alvarez, Griffin and Sheeline serve as members of the Compensation Committee of the Board of Directors of RII. See "ITEM 11. EXECUTIVE COMPENSATION - Compensation Committee Interlocks and Insider Participation" for information regarding certain relationships and related transactions involving these directors. - 88 - 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. The financial statement index required herein is incorporated by reference to "ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA." 2. The index of financial statement schedules required herein is incorporated by reference to "ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA." Financial statement schedules not included have been omitted because they are either not applicable or the required information is shown in the consolidated financial statements or notes thereto. 3. The following exhibits are filed herewith or incorporated by reference: Exhibit Numbers Exhibit _______ _______ (2)(a) Second Amended Joint Plan of Reorganization of Resorts International, Inc., Resorts International Financing, Inc., Griffin Resorts Inc. (now GGRI), and Griffin Resorts Holding Inc., dated as of May 31, 1990. (Incorporated by reference to Exhibit 35 to registrant's Form 8 Amendment No. 1 to its Form 8-K Current Report dated August 30, 1990, in File No. 1-4748.) (2)(b) Joint Plan of Reorganization Proposed by Resorts International, Inc., GGRI, Inc., Resorts International Hotel, Inc., Resorts International Hotel Financing, Inc. and P.I. Resorts Limited. (Incorporated by reference to Appendix A of the Information Statement/Prospectus included in Amendment No. 3, dated February 1, 1994, to the Form S-4 Registration Statement in File No. 33-50733.) (3)(a) Restated Certificate of Incorporation of the registrant. (Incorporated by reference to Exhibit (3)(a) to registrant's Form 10-K Annual Report for the fiscal year ended December 31, 1990, in File No. 1-4748.) (3)(b) By-laws, as amended, of the registrant. (Incorporated by reference to Exhibit (4)(d) to registrant's Form 10-Q Quarterly Report for the quarter ended September 30, 1990, in File No. 1-4748.) (4)(a)(1) See Exhibits (3)(a) and (3)(b) as to the rights of holders of registrant's common stock. - 89 - (4)(a)(2) Indenture dated as of September 14, 1990, between the registrant and Chemical Bank (successor to Manufacturers Hanover Trust Company), as Trustee, with respect to registrant's Senior Secured Redeemable Notes due April 15, 1994, with Exhibits as executed. (Incorporated by reference to Exhibit (4)(a)(1) to registrant's Form 10-Q Quarterly Report for the quarter ended September 30, 1990, in File No. 1-4748.) (4)(a)(3) Amended and Restated RIH $200,000,000 Senior Note. (Incorporated by reference to Exhibit (4)(a)(2) to registrant's Form 10-Q Quarterly Report for the quarter ended September 30, 1990, in File No. 1-4748.) (4)(a)(4) Amended and Restated RIH $125,000,000 Senior Note. (Incorporated by reference to Exhibit (4)(a)(3) to registrant's Form 10-Q Quarterly Report for the quarter ended September 30, 1990, in File No. 1-4748.) (4)(a)(5) RII Pledge Agreement. (Incorporated by reference to Exhibit Q to registrant's Form 8-A Registration Statement dated July 19, 1990, in File No. 1-4748.) (4)(a)(6) Assignment of Leases and Rents, RII as Assignor. (Incorporated by reference to Exhibit U to registrant's Form 8-A Registration Statement dated July 19, 1990, in File No. 1-4748.) (4)(a)(7) RIB $50,000,000 Promissory Note to RIH. (Incorporated by reference to Exhibit V to registrant's Form 8-A Registration Statement dated July 19, 1990, in File No. 1-4748.) (4)(a)(8) Indenture of Mortgage from Paradise Island Limited. (Incorporated by reference to Exhibit W to registrant's Form 8-A Registration Statement dated July 19, 1990, in File No. 1-4748.) (4)(a)(9) Guaranty by Paradise Island Limited. (Incorporated by reference to Exhibit X to registrant's Form 8-A Registration Statement dated July 19, 1990, in File No. 1-4748.) (4)(a)(10) Indenture of Mortgage from Paradise Beach Inn Limited. (Incorporated by reference to Exhibit Y to registrant's Form 8-A Registration Statement dated July 19, 1990, in File No. 1-4748.) (4)(a)(11) Guaranty by Paradise Beach Inn Limited. (Incorporated by reference to Exhibit Z to registrant's Form 8-A Registration Statement dated July 19, 1990, in File No. 1-4748.) (4)(a)(12) Indenture of Mortgage from Island Hotel Company Limited. (Incorporated by reference to Exhibit AA to registrant's Form 8-A Registration Statement dated July 19, 1990, in File No. 1-4748.) - 90 - (4)(a)(13) Guaranty by Island Hotel Company Limited. (Incorporated by reference to Exhibit BB to registrant's Form 8-A Registration Statement dated July 19, 1990, in File No. 1-4748.) (4)(a)(14) RIB Collateral Assignment Agreement among RIH, GRI (now GGRI), RIB, Paradise Island Limited, Island Hotel Company Limited, Paradise Beach Inn Limited, and The Bank of New York. (Incorporated by reference to Exhibit CC to registrant's Form 8-A Registration Statement dated July 19, 1990, in File No. 1-4748.) (4)(a)(15) RII Security Agreement. (Incorporated by reference to Exhibit P to registrant's Form 8-A Registration Statement dated July 19, 1990, in File No. 1-4748.) (4)(b) Indenture dated as of September 14, 1990, between the registrant and The Bank of New York, as Trustee, with respect to registrant's First Mortgage Non-Recourse Pass-Through Notes due June 30, 2000, with Exhibits as executed. (Incorporated by reference to Exhibit (4)(b) to registrant's Form 10-Q Quarterly Report for the quarter ended September 30, 1990, in File No. 1-4748.) (4)(c)* Resorts International, Inc. Senior Management Stock Option Plan. (Incorporated by reference to Exhibit 8.5 to Exhibit 35 to registrant's Form 8 Amendment No. 1 to its Form 8-K Current Report dated August 30, 1990, in File No. 1-4748.) (10)(a)(1) Agreement, dated May 23, l978, between HCB and Paradise Enterprises Limited. (Incorporated by reference to Exhibit (10)(b)(i) to registrant's Form 10-K Annual Report for the fiscal year ended December 31, 1988, in File No. 1-4748.) (10)(a)(2) Letter, dated July 2, 1985, from HCB to the registrant amending Exhibit (10)(a)(1) hereto. (Incorporated by reference to the exhibit to registrant's Form 8-K Current Report dated July 9, 1985, in File No. 1-4748.) (10)(a)(3) Agreement, dated May 23, 1978, between HCB and Paradise Realty Limited (now RIB). (Incorporated by reference to Exhibit 10.01 to GRI's Form S-1 Registration Statement filed July 13, 1988, in File No. 33-23063.) (10)(a)(4) Letter, dated September 26, 1988, from HCB to RIB extending Exhibit (10)(a)(3) hereto. (Incorporated by reference to Exhibit (10)(b)(iv) to registrant's Form 10-K Annual Report for the fiscal year ended December 31, 1988, in File No. 1-4748.) (10)(a)(5) Supplement, dated February 21, 1990, to license granted March 30, 1978 to Paradise Enterprises Limited. (Incorporated by reference to Exhibit (10)(b)(v) to registrant's Form 10-K Annual Report for the fiscal year ended December 31, 1989, in File No. 1-4748.) ________________________ * Management contract or compensatory plan. - 91 - (10)(a)(6) Supplement, dated September 7, 1990, to license granted March 30, 1978 to Paradise Enterprises Limited. (Incorporated by reference to Exhibit (10)(b)(6) to registrant's Form 10-K Annual Report for the fiscal year ended December 31, 1990, in File No. 1-4748.) (10)(a)(7) Supplement, dated January 15, 1991, to license granted March 30, 1978 to Paradise Enterprises Limited. (Incorporated by reference to Exhibit (10)(b)(7) to registrant's Form 10-K Annual Report for the fiscal year ended December 31, 1990, in File No. 1-4748.) (10)(a)(8) Supplement, dated February 13, 1992, to license granted March 30, 1978 to Paradise Enterprises Limited. (Incorporated by reference to Exhibit (10)(a)(8) to the registrant's Form 10-K Annual Report for the fiscal year ended December 31, 1992, in File No. 1-4748.) (10)(a)(9) Supplement, dated December 30, 1992, to license granted March 30, 1978 to Paradise Enterprises Limited. (Incorporated by reference to Exhibit (10)(a)(9) to the registrant's Form 10-K Annual Report for the fiscal year ended December 31, 1992, in File 1-4748.) (10)(b)(1) Lease Agreement, dated October 26, 1983, between the registrant and Ocean Showboat, Inc. (Incorporated by reference to Exhibit (10)(c)(i) to registrant's Form 10-K Annual Report for the fiscal year ended December 31, 1986, in File No. 1-4748.) (10)(b)(2) First Amendment, dated January 15, 1985, to Lease Agreement, dated October 26, 1983, between the registrant and Atlantic City Showboat, Inc. (assignee from affiliate - Ocean Showboat, Inc.). (Incorporated by reference to Exhibit (10)(c)(ii) to registrant's Form 10-K Annual Report for the fiscal year ended December 31, 1984, in File No. 1-4748.) (10)(b)(3) Second and Third Amendments, dated July 5 and October 28, 1985, respectively, to Lease Agreement, dated October 26, 1983, between the registrant and Atlantic City Showboat, Inc. (Incorporated by reference to Exhibit (10)(c)(iii) to registrant's Form 10-K Annual Report for the fiscal year ended December 31, 1985, in File No. 1-4748.) (10)(b)(4) Restated Third Amendment, dated August 28, 1986, to Lease Agreement, dated October 26, 1983, between the registrant and Atlantic City Showboat, Inc. (Incorporated by reference to Exhibit (10)(c)(iv) to registrant's Form 10-K Annual Report for the fiscal year ended December 31, 1986, in File No. 1-4748.) (10)(b)(5) Fourth Amendment, dated December 16, 1986, to Lease Agreement, dated October 26, 1983, between the registrant and Atlantic City Showboat, Inc. (Incorporated by reference to Exhibit (10)(c)(v) to registrant's Form 10-K Annual Report for the fiscal year ended December 31, 1986, in File No. 1-4748.) - 92 - (10)(b)(6) Fifth Amendment, dated February 1987, to Lease Agreement, dated October 26, 1983, between the registrant and Atlantic City Showboat, Inc. (Incorporated by reference to Exhibit (10)(c)(vi) to registrant's Form 10-K Annual Report for the fiscal year ended December 31, 1986, in File No. 1-4748.) (10)(b)(7) Sixth Amendment, dated March 13, 1987, to Lease Agreement, dated October 26, 1983, between the registrant and Atlantic City Showboat, Inc. (Incorporated by reference to Exhibit (10)(c)(vii) to registrant's Form 10-K Annual Report for the fiscal year ended December 31, 1986, in File No. 1-4748.) (10)(b)(8) Seventh Amendment, dated October 18, 1988, to Lease Agreement, dated October 26, 1983, between the registrant and Atlantic City Showboat, Inc. (Incorporated by reference to Exhibit (10)(c)(viii) to registrant's Form 10-K Annual Report for the fiscal year ended December 31, 1988, in File No. 1-4748.) (10)(c)(1)* RII Executive Health Plan. (Incorporated by reference to Exhibit (10)(c)(1) to registrant's Form 10-K Annual Report for the fiscal year ended December 31, 1992, in File No. 1-4748.) (10)(c)(2)* Resorts Retirement Savings Plan. (Incorporated by reference to Exhibit (10)(c)(2) to registrant's Form 10-K Annual Report for the fiscal year ended December 31, 1991, in File No. 1-4748.) (10)(d)(1)* Employment Agreement, dated as of September 17, 1992, between the registrant and David P. Hanlon. (Incorporated by reference to Exhibit (10)(d)(4) to registrant's Form 10-K Annual Report for the fiscal year ended December 31, 1992, in File No. 1-4748.) (10)(d)(2)* Termination Agreement, dated as of September 27, 1993, between RII and David P. Hanlon. (Incorporated by reference to Exhibit 10.27 to registrant's Form S-4 Registration Statement dated October 25, 1993, in File No. 33-50733.) (10)(d)(3)* Employment Agreement, dated May 3, 1991, between the registrant and Christopher D. Whitney. (Incorporated by reference to Exhibit (10)(d)(2) to registrant's Form 10-K Annual Report for the fiscal year ended December 31, 1991, in File No. 1-4748.) (10)(d)(4)* Amendment to Employment Agreement, dated as of December 3, 1992, between RII and Christopher D. Whitney. (Incorporated by reference to Exhibit 10.22 to registrant's Form S-4 Registration Statement dated October 25, 1993, in File No. 33-50733.) ________________________ *Management contract or compensatory plan. - 93 - (10)(d)(5)* Employment Agreement, dated May 3, 1991, between the registrant and Matthew B. Kearney. (Incorporated by reference to Exhibit (10)(d)(3) to registrant's Form 10-K Annual Report for the fiscal year ended December 31, 1991, in File No. 1-4748.) (10)(d)(6)* Amendment to Employment Agreement, dated December 3, 1992, between RII and Matthew B. Kearney. (Incorporated by reference to Exhibit 10.24 to registrant's Form S-4 Registration Statement dated October 25, 1993, in File No. 33-50733.) (10)(d)(7)* Second Amendment to Employment Agreement, dated September 24, 1993, between RII and Matthew B. Kearney. (Incorporated by reference to Exhibit 10.25 to registrant's Form S-4 Registration Statement dated October 25, 1993, in File No. 33-50733.) (10)(e)(1)* Stock Option Agreement, dated as of May 3, 1991, between the registrant and David P. Hanlon. (Incorporated by reference to Exhibit (10)(e)(1) to registrant's Form 10-K Annual Report for the fiscal year ended December 31, 1991, in File No. 1-4748.) (10)(e)(2)* Stock Option Agreement, dated as of May 3, 1991, between the registrant and Christopher D. Whitney. (Incorporated by reference to Exhibit (10)(e)(2) to registrant's Form 10-K Annual Report for the fiscal year ended December 31, 1991, in File No. 1-4748.) (10)(e)(3)* Stock Option Agreement, dated as of May 3, 1991, between the registrant and Matthew B. Kearney. (Incorporated by reference to Exhibit (10)(e)(3) to registrant's Form 10-K Annual Report for the fiscal year ended December 31, 1991, in File No. 1-4748.) (10)(e)(4)* Stock Option Agreement, dated as of May 3, 1991, between the registrant and David G. Bowden. (Incorporated by reference to Exhibit (10)(e)(5) to registrant's Form 10-K Annual Report for the fiscal year ended December 31, 1991, in File No. 1-4748.) (10)(e)(5)* Amendment No. 1, dated as of September 17, 1992, to Exhibit (10)(e)(1). (Incorported by reference to Exhibit (10)(e)(6) of registrant's Form 10-K Annual Report for the fiscal year ended December 31, 1992, in File No. 1-4748.) (10)(f)* License and Services Agreement, dated as of September 17, 1992, among Griffin Group, RII and RIH. (Incorporated by reference to Exhibit 10.34 to registrant's Form S-4 Registration Statement dated October 25, 1993, in File No. 33-50733.) ________________________ *Management contract or compensatory plan. - 94 - (10)(g) Litigation Trust Agreement, dated as of September 17, 1990, among RII, RIFI, Griffin Resorts Holding Inc. and Griffin Resorts Inc. (now GGRI). (Incorporated by reference to Exhibit 1.46 to Exhibit 35 to the Form 8 Amendment dated November 16, 1990, to the registrant's Form 8-K Current Report dated August 30, 1990, in File No. 1-4748.) (10)(h)(1) Promissory Note, dated September 28, 1990, between Merv Griffin and the registrant. (Incorporated by reference to Exhibit 9.1A to Exhibit 35 to the Form 8 Amendment dated November 16, 1990, to the registrant's Form 8-K Current Report dated August 30, 1990, in File No. 1-4748.) (10)(h)(2) Letter of Credit, dated October 1, 1990, by Morgan Guaranty Trust Company of New York. (Incorporated by reference to Exhibit 9.1B to Exhibit 35 to the Form 8 Amendment dated November 16, 1990, to the registrant's Form 8-K Current Report dated August 30, 1990, in File No. 1-4748.) (10)(h)(3) Letters extending the termination date of Exhibit (10)(h)(2). (Incorporated by reference to Exhibit (10)(i)(2) to the registrant's Form 10-K Annual Report for the fiscal year ended December 31, 1992, in File No. 1-4748.) (10)(i)(1) Promissory Note, dated September 17, 1992, between Griffin Group and the registrant. (Incorporated by reference to Exhibit 1 to Exhibit 10.34 to registrant's Form S-4 Registration Statement dated October 25, 1993, in File No. 33-50733.) (10)(i)(2) Guaranty dated September 17, 1992 by Mervyn E. Griffin in favor of RII. (Incorporated by reference to Exhibit 2 to Exhibit 10.34 to registrant's Form S-4 Registration Statement dated October 25, 1993, in File No. 33-50733.) (10)(j) Indemnity Agreement, executed on September 19, 1990, between Merv Griffin and the registrant. (Incorporated by reference to Exhibit 9.6 to Exhibit 35 to the Form 8 Amendment dated November 16, 1990, to the registrant's Form 8-K Current Report dated August 30, 1990, in File No. 1-4748.) (10)(k) Hotel Corporation of The Bahamas Right of First Refusal. (Incorporated by reference to Exhibit (10)(n) to registrant's Form 10-K Annual Report for the fiscal year ended December 31, 1988, in File No. 1-4748.) (10)(l)(1) Consulting agreement between Alvarez & Marsal, Inc. and the registrant, effective March 1, 1992. (Incorporated by reference to Exhibit (10)(m)(l) to registrant's Form 10-K Annual Report for the fiscal year ended December 31, 1992, in File No. 1-4748.) - 95 - (10)(l)(2) Amendment, dated September 14, 1992, to the consulting agreement between Alvarez & Marsal, Inc. and the registrant. (Incorporated by reference to Exhibit (10)(m)(2) to registrant's Form 10-K Annual Report for the fiscal year ended December 31, 1992, in File No. 1-4748.) (10)(m) Letter Agreement dated July 1, 1993 between RII and Bear Stearns & Co. Inc. for retention of services. (Incorporated by reference to Exhibit 10.63 to Amendment No. 1, dated January 5, 1994, to registrant's Form S-4 Registration Statement in File No. 33-50733.) (10)(n)(l) Paradise Island Purchase Agreement dated October 11, 1993 between RII and Sun International Hotels Limited, with Exhibits and Schedules. (Incorporated by reference to Exhibit 10.55 to registrant's Form S-4 Registration Statement dated October 25, 1993, in File No. 33-50733.) (10)(n)(2) Amendment dated as of November 30, 1993 to the Paradise Island Purchase Agreement dated October 11, 1993 between RII and Sun International Hotels Limited concerning Bahamas Developers Limited. (Incorporated by reference to Exhibit 10.55(a) to Amendment No. 3, dated February 1, 1994, to registrant's Form S-4 Registration Statement in File No. 33-50733.) (10)(n)(3) Amendment dated as of November 30, 1993 to the Paradise Island Purchase Agreement dated October 11, 1993 between RII and Sun International Hotels Limited. (Incorporated by reference to Exhibit 10.55(b) to Amendment No. 3, dated February 1, 1994, to registrant's Form S-4 Registration Statement in File No. 33-50733.) (10)(o)(1) PIRL Standby Distribution Agreement dated October 15, 1993 between RII and PIRL. (Incorporated by reference to Exhibit 10.59 to registrant's Form S-4 Registration Statement dated October 25, 1993, in File No. 33-50733.) (10)(o)(2) Letter Agreement between RII and PIRL concerning airline support services. (Incorporated by reference to Exhibit 10.60 to registrant's Form S-4 Registration Statement dated October 25, 1993, in File No. 33-50733.) (10)(p) Bondholders Support Agreement dated October 11, 1993 among RII, Griffin Resorts Inc. (now GGRI), Sun International Investments Limited, Sun International Hotels Limited, TCW Special Credits and Fidelity Management and Research Company, concerning bondholders support. (Incorporated by reference to Exhibit 10.52 to registrant's Form S-4 Registration Statement dated October 25, 1993, in File No. 33-50733.) - 96 - (10)(q) Letter Agreement dated October 11, 1993 among Fidelity Management and Research Company, TCW Special Credits, RII and Sun International Hotels Limited concerning consent rights of holders of Old Series Notes. (Incorporated by reference to Exhibit 10.50 to registrant's Form S-4 Registration Statement dated October 25, 1993, in File No. 33-50733.) (10)(r)(1) Letter Agreement dated October 19, 1993 among RII, Fidelity Management, TCW Special Credits, Sun International Hotels Limited, Sun International Investments Limited and GGRI regarding GGRI, Inc. (Incorporated by reference to Exhibit 10.56 to registrant's Form S-4 Registration Statement dated October 25, 1993, in File No. 33-50733.) (10)(r)(2) Letter Agreement dated October 15, 1993, among RII, Fidelity Management, TCW Special Credits and Sun International Hotels Limited regarding P.I. Resorts Limited. (Incorporated by reference to Exhibit 10.58 to registrant's Form S-4 Registration Statement dated October 25, 1993, in File No. 33-50733.) (21) Subsidiaries of the registrant. Registrant agrees to file with the Securities and Exchange Commission, upon request, copies of any instrument defining the rights of the holders of its consolidated long-term debt. (b) Reports on Form 8-K ___________________ The Company filed a Form 8-K Current Report, dated October 25, 1993 to report that RII filed a Registration Statement on Form S-4 (Registration No. 33-50733) with the Securities and Exchange Commission covering the proposed exchange of the Series Notes for, among other consideration, shares of RII Class B Stock, $125,000,000 principal amount of RIHF Mortgage Notes, $35,000,000 principal amount of RIHF Junior Mortgage Notes and, under certain circumstances, ordinary shares of PIRL. (c) Exhibits Required by Item 601 of Regulation S-K _______________________________________________ The exhibits listed in Item 14(a)3. of this report, and not incorporated by reference to a separate file, follow "SIGNATURES." (d) Financial Statement Schedules Required by Regulation S-X ________________________________________________________ The financial statement schedules required by Regulation S-X are incorporated by reference to "ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA." - 97 - 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. RESORTS INTERNATIONAL, INC. ___________________________ (Registrant) Date: March 17, 1994 By/s/ Merv Griffin _____________________________ Merv Griffin 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. By/s/ Merv Griffin March 17, 1994 ________________________________ Merv Griffin Chairman of the Board By ________________________________ Antonio C. Alvarez II Director By ________________________________ Warren Cowan Director By _________________________________ Thomas E. Gallagher Director By ________________________________ Joseph G. Kordsmeier Director By ________________________________ Paul C. Sheeline Director By ________________________________ Christopher D. Whitney Executive Vice President (Principal Executive Officer) By ________________________________ Matthew B. Kearney Executive Vice President - Finance (Principal Executive Officer and Principal Financial Officer) By ________________________________ David G. Bowden Vice President - Controller and Assistant Secretary (Principal Accounting Officer) - 98 - 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. RESORTS INTERNATIONAL, INC. ___________________________ (Registrant) Date: March 17, 1994 By _____________________________ Merv Griffin 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. By ________________________________ Merv Griffin Chairman of the Board By/s/ Antonio C. Alvarez II March 17, 1994 ________________________________ Antonio C. Alvarez II Director By ________________________________ Warren Cowan Director By _________________________________ Thomas E. Gallagher Director By ________________________________ Joseph G. Kordsmeier Director By ________________________________ Paul C. Sheeline Director By ________________________________ Christopher D. Whitney Executive Vice President (Principal Executive Officer) By ________________________________ Matthew B. Kearney Executive Vice President - Finance (Principal Executive Officer and Principal Financial Officer) By ________________________________ David G. Bowden Vice President - Controller and Assistant Secretary (Principal Accounting Officer) - 99 - 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. RESORTS INTERNATIONAL, INC. ___________________________ (Registrant) Date: March 17, 1994 By _____________________________ Merv Griffin 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. By ________________________________ Merv Griffin Chairman of the Board By ________________________________ Antonio C. Alvarez II Director By/s/ Warren Cowan March 17, 1994 ________________________________ Warren Cowan Director By _________________________________ Thomas E. Gallagher Director By ________________________________ Joseph G. Kordsmeier Director By ________________________________ Paul C. Sheeline Director By ________________________________ Christopher D. Whitney Executive Vice President (Principal Executive Officer) By ________________________________ Matthew B. Kearney Executive Vice President - Finance (Principal Executive Officer and Principal Financial Officer) By ________________________________ David G. Bowden Vice President - Controller and Assistant Secretary (Principal Accounting Officer) - 100 - 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. RESORTS INTERNATIONAL, INC. ___________________________ (Registrant) Date: March 17, 1994 By _____________________________ Merv Griffin 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. By ________________________________ Merv Griffin Chairman of the Board By ________________________________ Antonio C. Alvarez II Director By ________________________________ Warren Cowan Director By/s/ Thomas E. Gallagher March 17, 1994 _________________________________ Thomas E. Gallagher Director By ________________________________ Joseph G. Kordsmeier Director By ________________________________ Paul C. Sheeline Director By ________________________________ Christopher D. Whitney Executive Vice President (Principal Executive Officer) By ________________________________ Matthew B. Kearney Executive Vice President - Finance (Principal Executive Officer and Principal Financial Officer) By ________________________________ David G. Bowden Vice President - Controller and Assistant Secretary (Principal Accounting Officer) - 101 - 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. RESORTS INTERNATIONAL, INC. ___________________________ (Registrant) Date: March 17, 1994 By _____________________________ Merv Griffin 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. By ________________________________ Merv Griffin Chairman of the Board By ________________________________ Antonio C. Alvarez II Director By ________________________________ Warren Cowan Director By _________________________________ Thomas E. Gallagher Director By/s/ Joseph G. Kordsmeier March 17, 1994 ________________________________ Joseph G. Kordsmeier Director By ________________________________ Paul C. Sheeline Director By ________________________________ Christopher D. Whitney Executive Vice President (Principal Executive Officer) By ________________________________ Matthew B. Kearney Executive Vice President - Finance (Principal Executive Officer and Principal Financial Officer) By ________________________________ David G. Bowden Vice President - Controller and Assistant Secretary (Principal Accounting Officer) - 102 - 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. RESORTS INTERNATIONAL, INC. ___________________________ (Registrant) Date: March 17, 1994 By _____________________________ Merv Griffin 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. By ________________________________ Merv Griffin Chairman of the Board By ________________________________ Antonio C. Alvarez II Director By ________________________________ Warren Cowan Director By _________________________________ Thomas E. Gallagher Director By ________________________________ Joseph G. Kordsmeier Director By/s/ Paul C. Sheeline March 17, 1994 ________________________________ Paul C. Sheeline Director By ________________________________ Christopher D. Whitney Executive Vice President (Principal Executive Officer) By ________________________________ Matthew B. Kearney Executive Vice President - Finance (Principal Executive Officer and Principal Financial Officer) By ________________________________ David G. Bowden Vice President - Controller and Assistant Secretary (Principal Accounting Officer) - 103 - 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. RESORTS INTERNATIONAL, INC. ___________________________ (Registrant) Date: March 17, 1994 By _____________________________ Merv Griffin 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. By ________________________________ Merv Griffin Chairman of the Board By ________________________________ Antonio C. Alvarez II Director By ________________________________ Warren Cowan Director By _________________________________ Thomas E. Gallagher Director By ________________________________ Joseph G. Kordsmeier Director By ________________________________ Paul C. Sheeline Director By/s/ Christopher D. Whitney March 17, 1994 ________________________________ Christopher D. Whitney Executive Vice President (Principal Executive Officer) By/s/ Matthew B. Kearney March 17, 1994 ________________________________ Matthew B. Kearney Executive Vice President - Finance (Principal Executive Officer and Principal Financial Officer) By/s/ David G. Bowden March 17, 1994 ________________________________ David G. Bowden Vice President - Controller and Assistant Secretary (Principal Accounting Officer) - 104 - RESORTS INTERNATIONAL, INC. ___________________________ Form 10-K for the fiscal year ended December 31, 1993 EXHIBIT INDEX _____________ Reference to previous Exhibit filing or page number Number Exhibit in Form 10-K _______ _______ _____________________ (2)(a) Second Amended Joint Incorporated by reference Plan of Reorganization to Exhibit 35 to registrant's of Resorts International, Form 8 Amendment No. 1 to Inc., Resorts International its Form 8-K Current Report Financing, Inc., Griffin dated August 30, 1990, in Resorts Inc. (now GGRI), File No. 1-4748. and Griffin Resorts Holding Inc., dated as of May 31, 1990. (2)(b) Joint Plan of Reorgan- Incorporated by reference to ization Proposed by Resorts Appendix A of the Information International, Inc., GGRI, Statement/Prospectus included Inc., Resorts International in Amendment No. 3, dated Feb- Hotel, Inc., Resorts Inter- ruary 1, 1994, to the Form S-4 national Hotel Financing, Registration Statement in File Inc. and P.I. Resorts No. 33-50733. Limited. (3)(a) Restated Certificate of Incorporated by reference to Incorporation of the Exhibit (3)(a) to regis- registrant. trant's Form 10-K Annual Report for the fiscal year ended December 31, 1990, in File No. 1-4748. (3)(b) By-laws, as amended, of Incorporated by reference the registrant. to Exhibit (4)(d) to registrant's Form l0-Q Quarterly Report for the quarter ended September 30, 1990, in File No. l-4748. (4)(a)(1) See Exhibits (3)(a) and (3)(b) as to the rights of holders of registrant's common stock. (4)(a)(2) Indenture dated as of Incorporated by reference September 14, 1990, to Exhibit (4)(a)(1) to between the registrant and registrant's Form l0-Q Chemical Bank (successor Quarterly Report for the to Manufacturers Hanover quarter ended September Trust Company), as Trustee, 30, 1990, in File No. with respect to registrant's l-4748. Senior Secured Redeemable Notes due April 15, 1994, with Exhibits as executed. - 105 - RESORTS INTERNATIONAL, INC. ___________________________ Form 10-K for the fiscal year ended December 31, 1993 EXHIBIT INDEX _____________ Reference to previous Exhibit filing or page number Number Exhibit in Form 10-K _______ _______ _____________________ (4)(a)(3) Amended and Restated RIH Incorporated by reference $200,000,000 Senior Note. to Exhibit (4)(a)(2) to registrant's Form 10-Q Quarterly Report for the quarter ended September 30, 1990, in File No. 1-4748. (4)(a)(4) Amended and Restated RIH Incorporated by reference $125,000,000 Senior Note. to Exhibit (4)(a)(3) to registrant's Form 10-Q Quarterly Report for the quarter ended September 30, 1990, in File No. 1-4748. (4)(a)(5) RII Pledge Agreement. Incorporated by reference to Exhibit Q to registrant's Form 8-A Registration Statement dated July 19, 1990, in File No. 1-4748. (4)(a)(6) Assignment of Leases and Incorporated by reference Rents, RII as Assignor. to Exhibit U to registrant's Form 8-A Registration Statement dated July 19, 1990, in File No. 1-4748. (4)(a)(7) RIB $50,000,000 Promissory Incorporated by reference Note to RIH. to Exhibit V to registrant's Form 8-A Registration Statement dated July 19, 1990, in File No. 1-4748. (4)(a)(8) Indenture of Mortgage from Incorporated by reference Paradise Island Limited. to Exhibit W to registrant's Form 8-A Registration Statement dated July 19, 1990, in File No. 1-4748. (4)(a)(9) Guaranty by Paradise Incorporated by reference Island Limited. to Exhibit X to registrant's Form 8-A Registration Statement dated July 19, 1990, in File No. 1-4748. (4)(a)(10) Indenture of Mortgage Incorporated by reference from Paradise Beach Inn to Exhibit Y to registrant's Limited. Form 8-A Registration Statement dated July 19, 1990, in File No. 1-4748. - 106 - RESORTS INTERNATIONAL, INC. ___________________________ Form 10-K for the fiscal year ended December 31, 1993 EXHIBIT INDEX _____________ Reference to previous Exhibit filing or page number Number Exhibit in Form 10-K _______ _______ _____________________ (4)(a)(11) Guaranty by Paradise Beach Incorporated by reference Inn Limited. to Exhibit Z to registrant's Form 8-A Registration Statement dated July 19, 1990, in File No. 1-4748. (4)(a)(12) Indenture of Mortgage from Incorporated by reference Island Hotel Company to Exhibit AA to registrant's Limited. Form 8-A Registration Statement dated July 19, 1990, in File No. 1-4748. (4)(a)(13) Guaranty by Island Hotel Incorporated by reference Company Limited. to Exhibit BB to registrant's Form 8-A Registration Statement dated July 19, 1990, in File No. 1-4748. (4)(a)(14) RIB Collateral Assignment Incorporated by reference Agreement among RIH, GRI to Exhibit CC to registrant's (now GGRI), RIB, Paradise Form 8-A Registration Island Limited, Island Hotel Statement dated July 19, 1990, Company Limited, Paradise in File No. 1-4748. Beach Inn Limited, and The Bank of New York. (4)(a)(15) RII Security Agreement. Incorporated by reference to Exhibit P to registrant's Form 8-A Registration Statement dated July 19, 1990, in File No. 1-4748. (4)(b) Indenture dated as of Incorporated by reference September 14, 1990, to Exhibit (4)(b) to between the registrant registrant's Form 10-Q and The Bank of New York, Quarterly Report for the as Trustee, with respect quarter ended September to registrant's First 30, 1990, in File No. Mortgage Non-Recourse 1-4748. Pass-Through Notes due June 30, 2000, with Exhibits as executed. - 107 - RESORTS INTERNATIONAL, INC. ___________________________ Form 10-K for the fiscal year ended December 31, 1993 EXHIBIT INDEX _____________ Reference to previous Exhibit filing or page number Number Exhibit in Form 10-K _______ _______ _____________________ (4)(c) Resorts International, Incorporated by reference Inc. Senior Management to Exhibit 8.5 to Exhibit Stock Option Plan. 35 to registrant's Form 8 Amendment No. 1 to its Form 8-K Current Report dated August 30, 1990, in File No. 1-4748. (10)(a)(1) Agreement, dated May 23, Incorporated by reference l978, between HCB and to Exhibit (10)(b)(i) to Paradise Enterprises registrant's Form 10-K Limited. Annual Report for the fis- cal year ended December 31, 1988, in File No. 1-4748. (10)(a)(2) Letter, dated July 2, Incorporated by reference 1985, from HCB to the to the exhibit to regis- registrant amending trant's Form 8-K Current Exhibit (10)(a)(1) hereto. Report dated July 9, 1985, in File No. 1-4748. (10)(a)(3) Agreement, dated May 23, Incorporated by reference 1978, between HCB and to Exhibit 10.01 to GRI's Paradise Realty Limited Form S-1 Registration (now RIB). Statement filed July 13, 1988, in File No. 33-23063. (10)(a)(4) Letter, dated September Incorporated by reference 26, 1988, from HCB to RIB to Exhibit (10)(b)(iv) extending Exhibit to registrant's Form 10-K (10)(a)(3) hereto. Annual Report for the fiscal year ended December 31, 1988, in File No. 1-4748. (10)(a)(5) Supplement, dated February Incorporated by reference 21, 1990, to license to Exhibit (10)(b)(v) to granted March 30, 1978 to registrant's Form 10-K Paradise Enterprises Annual Report for the fis- Limited. cal year ended December 31, 1989, in File No. 1-4748. (10)(a)(6) Supplement, dated Septem- Incorporated by reference ber 7, 1990, to license to Exhibit (10)(b)(6) to granted March 30, 1978 to registrant's Form 10-K Paradise Enterprises Annual Report for the fis- Limited. cal year ended December 31, 1990, in File No. 1-4748. - 108 - RESORTS INTERNATIONAL, INC. ___________________________ Form 10-K for the fiscal year ended December 31, 1993 EXHIBIT INDEX _____________ Reference to previous Exhibit filing or page number Number Exhibit in Form 10-K _______ _______ _____________________ (10)(a)(7) Supplement, dated January Incorporated by reference 15, 1991, to license to Exhibit (10)(b)(7) to granted March 30, 1978 to registrant's Form 10-K Paradise Enterprises Annual Report for the Limited. fiscal year ended December 31, 1990, in File No. 1-4748. (10)(a)(8) Supplement, dated February Incorporated by reference 13, 1992, to license to Exhibit (10)(a)(8) to granted March 30, 1978 to the registrant's Form 10-K Paradise Enterprises Ltd. Annual Report for the fiscal year ended December 31, 1992, in File No. 1-4748. (10)(a)(9) Supplement, dated December Incorporated by reference 30, 1992, to license granted to Exhibit (10)(a)(9) to March 30, 1978 to Paradise the registrant's Form Enterprises Limited. 10-K Annual Report for the fiscal year ended December 31, 1992, in File No. 1-4748. (10)(b)(1) Lease Agreement, dated Incorporated by reference October 26, 1983, between to Exhibit (10)(c)(i) to the registrant and Ocean registrant's Form 10-K Showboat, Inc. Annual Report for the fis- cal year ended December 31, 1986, in File No. 1-4748. (10)(b)(2) First Amendment, dated Incorporated by reference January 15, 1985, to Lease to Exhibit (10)(c)(ii) Agreement, dated October to registrant's Form 10-K 26, 1983, between the Annual Report for the registrant and Atlantic fiscal year ended December City Showboat, Inc. 31, 1984, in File No. (assignee from affiliate 1-4748. - Ocean Showboat, Inc.). (10)(b)(3) Second and Third Amend- Incorporated by reference ments, dated July 5 and to Exhibit (10)(c)(iii) October 28, 1985, to registrant's Form respectively, to Lease 10-K Annual Report for Agreement, dated October the fiscal year ended 26, 1983, between the December 31, 1985, in registrant and Atlantic File No. 1-4748. City Showboat, Inc. - 109 - RESORTS INTERNATIONAL, INC. ___________________________ Form 10-K for the fiscal year ended December 31, 1993 EXHIBIT INDEX _____________ Reference to previous Exhibit filing or page number Number Exhibit in Form 10-K _______ _______ _____________________ (10)(b)(4) Restated Third Amendment, Incorporated by reference dated August 28, 1986, to to Exhibit (10)(c)(iv) Lease Agreement, dated to registrant's Form October 26, 1983, between 10-K Annual Report for the registrant and the fiscal year ended Atlantic City Showboat, December 31, 1986, in File Inc. No. 1-4748. (10)(b)(5) Fourth Amendment, dated Incorporated by reference December 16, 1986, to to Exhibit (10)(c)(v) Lease Agreement, dated to registrant's Form October 26, 1983, between 10-K Annual Report for the registrant and the fiscal year ended Atlantic City Showboat, December 31, 1986, in File Inc. No. 1-4748. (10)(b)(6) Fifth Amendment, dated Incorporated by reference February 1987, to Lease to Exhibit (10)(c)(vi) Agreement, dated October to registrant's Form 26, 1983, between the 10-K Annual Report for registrant and Atlantic the fiscal year ended City Showboat, Inc. December 31, 1986, in File No. 1-4748. (10)(b)(7) Sixth Amendment, dated Incorporated by reference March 13, 1987, to Lease to Exhibit (10)(c)(vii) Agreement, dated October to registrant's Form 26, 1983, between the 10-K Annual Report for registrant and Atlantic the fiscal year ended City Showboat, Inc. December 31, 1986, in File No. 1-4748. (10)(b)(8) Seventh Amendment, dated Incorporated by reference October 18, 1988, to Lease to Exhibit (10)(c)(viii) Agreement, dated October to registrant's Form 26, 1983, between the 10-K Annual Report for registrant and Atlantic the fiscal year ended City Showboat, Inc. December 31, 1988, in File No. 1-4748. (10)(c)(1) RII Executive Health Plan. Incorporated by reference to Exhibit (10)(c)(1) to registrant's Form 10-K Annual Report for the fiscal year ended December 31, 1992, in File No. 1-4748. - 110 - RESORTS INTERNATIONAL, INC. ___________________________ Form 10-K for the fiscal year ended December 31, 1993 EXHIBIT INDEX _____________ Reference to previous Exhibit filing or page number Number Exhibit in Form 10-K _______ _______ _____________________ (10)(c)(2) Resorts Retirement Incorporated by reference to Savings Plan. Exhibit (10)(c)(2) to regis- trant's Form 10-K Annual Report for the fiscal year ended December 31, 1991, in File No. 1-4748. (10)(d)(1) Employment Agreement, Incorporated by reference dated as of September 17, to Exhibit (10)(d)(4) to 1992, between the regis- registrant's Form 10-K Annual trant and David P. Hanlon. Report for the fiscal year ended December 31, 1992, in File No. 1-4748. (10)(d)(2) Termination Agreement, Incorporated by reference to dated as of September Exhibit 10.27 to registrant's 27, 1993, between RII Form S-4 Registration State- and David P. Hanlon. ment dated October 25, 1993, in File No. 33-50733. (10)(d)(3) Employment Agreement, Incorporated by reference dated May 3, 1991, to Exhibit (10)(d)(2) to between the registrant registrant's Form 10-K Annual and Christopher D. Whitney. Report for the fiscal year ended December 31, 1991, in File No. 1-4748. (10)(d)(4) Amendment to Employment Incorporated by reference Agreement, dated as of to Exhibit 10.22 to regis- December 3, 1992, between trant's Form S-4 Registration RII and Christopher D. Statement dated October 25, Whitney. 1993, in File No. 33-50733. (10)(d)(5) Employment Agreement, dated Incorporated by reference May 3, 1991, between the to Exhibit (10)(d)(3) to registrant and Matthew B. registrant's Form 10-K Kearney. Annual Report for the fiscal year ended December 31, 1991, in File No. 1-4748. (10)(d)(6) Amendment to Employment Incorporated by reference Agreement, dated December to Exhibit 10.24 to regis- 3, 1992, between RII and trant's Form S-4 Registration Matthew B. Kearney. Statement dated October 25, 1993, in File No. 33-50733. - 111 - RESORTS INTERNATIONAL, INC. ___________________________ Form 10-K for the fiscal year ended December 31, 1993 EXHIBIT INDEX _____________ Reference to previous Exhibit filing or page number Number Exhibit in Form 10-K _______ _______ _____________________ (10)(d)(7) Second Amendment to Employ- Incorporated by reference ment Agreement, dated Sep- to Exhibit 10.25 to regis- tember 24, 1993, between RII trant's Form S-4 Registration and Matthew B. Kearney. Statement dated October 25, 1993, in File No. 33-50733. (10)(e)(1) Stock Option Agreement, Incorporated by reference dated as of May 3, 1991, to Exhibit (10)(e)(1) to between the registrant registrant's Form 10-K Annual and David P. Hanlon. Report for the fiscal year ended December 31, 1991, in File No. 1-4748. (10)(e)(2) Stock Option Agreement, Incorporated by reference dated as of May 3, 1991, to Exhibit (10)(e)(2) to between the registrant registrant's Form 10-K Annual and Christopher D. Whitney. Report for the fiscal year ended December 31, 1991, in File No. 1-4748. (10)(e)(3) Stock Option Agreement, Incorporated by reference dated as of May 3, 1991, to Exhibit (10)(e)(3) to between the registrant registrant's Form 10-K Annual and Matthew B. Kearney. Report for the fiscal year ended December 31, 1991, in File No. 1-4748. (10)(e)(4) Stock Option Agreement, Incorporated by reference dated as of May 3, 1991, to Exhibit (10)(e)(5) to between the registrant registrant's Form 10-K Annual and David G. Bowden. Report for the fiscal year ended December 31, 1991, in File No. 1-4748. (10)(e)(5) Amendment No. 1, dated Incorporated by reference as of September 17, 1992, to Exhibit (10)(e)(6) to to Exhibit (10)(e)(1). registrant's Form 10-K Annual Report for the fiscal year ended December 31, 1992, in File No. 1-4748. (10)(f) License and Services Incorporated by reference to Agreement, dated Exhibit 10.34 to registrant's as of September 17, 1992, Form S-4 Registration State- among Griffin Group, RII ment dated October 25, 1993, and RIH. in File No. 33-50733. - 112 - RESORTS INTERNATIONAL, INC. ___________________________ Form 10-K for the fiscal year ended December 31, 1993 EXHIBIT INDEX _____________ Reference to previous Exhibit filing or page number Number Exhibit in Form 10-K _______ _______ _____________________ (10)(g) Litigation Trust Agreement, Incorporated by reference dated as of September 17, to Exhibit 1.46 to Exhibit 1990, among RII, RIFI, 35 to the Form 8 Amendment Griffin Resorts Holding dated November 16, 1990, Inc. and Griffin Resorts to the registrant's Form Inc. (now GGRI). 8-K Current Report dated August 30, 1990, in File No. 1-4748. (10)(h)(1) Promissory Note, dated Incorporated by reference September 28, 1990, to Exhibit 9.1A to Exhibit between Merv Griffin and 35 to the Form 8 Amendment the registrant. dated November 16, 1990, to the registrant's Form 8-K Current Report dated August 30, 1990, in File No. 1-4748. (10)(h)(2) Letter of Credit, dated Incorporated by reference October 1, 1990, by Morgan to Exhibit 9.1B to Exhibit 35 Guaranty Trust Company of to the Form 8 Amendment dated New York. November 16, 1990, to the registrant's Form 8-K Current Report dated August 30, 1990, in File No. 1-4748. (10)(h)(3) Letters extending the term- Incorporated by reference to ination date of Exhibit Exhibit (10)(i)(2) to the (10)(h)(2). registrant's Form 10-K Annual Report for the fiscal year ended December 31, 1992, in File No. 1-4748. (10)(i)(1) Promissory Note, dated Incorporated by reference to September 17, 1992, between Exhibit 1 to Exhibit 10.34 to Griffin Group and the registrant's Form S-4 Regis- registrant. tration Statement dated Octo- ber 25, 1993, in File No. 33-50733. (10)(i)(2) Guaranty dated September Incorporated by reference to 17, 1992 by Mervyn E. Exhibit 2 to Exhibit 10.34 to Griffin in favor of RII. registrant's Form S-4 Regis- tration Statement dated Octo- ber 25, 1993, in File No. 33-50733. - 113 - RESORTS INTERNATIONAL, INC. ___________________________ Form 10-K for the fiscal year ended December 31, 1993 EXHIBIT INDEX _____________ Reference to previous Exhibit filing or page number Number Exhibit in Form 10-K _______ _______ _____________________ (10)(j) Indemnity Agreement, Incorporated by reference executed on September 19, to Exhibit 9.6 to Exhibit 1990, between Merv Griffin 35 to the Form 8 Amendment and the registrant. dated November 16, 1990, to the registrant's Form 8-K Current Report dated August 30, 1990, in File No. 1-4748. (10)(k) Hotel Corporation of The Incorporated by reference Bahamas Right of First to Exhibit (10)(n) to Refusal. registrant's Form 10-K Annual Report for the fiscal year ended December 31, 1988, in File No. 1-4748. (10)(l)(1) Consulting agreement Incorporated by reference to between Alvarez & Marsal, Exhibit (10)(m)(1) to regis- Inc. and the registrant, trant's Form 10-K Annual effective March 1, 1992. Report for the fiscal year ended December 31, 1992, in File No. 1-4748. (10)(1)(2) Amendment, dated September Incorporated by reference to 14, 1992, to the consulting Exhibit (10)(m)(2) to agreement between Alvarez registrant's Form 10-K Annual & Marsal, Inc. and the Report for the fiscal year registrant. ended December 31, 1992, in File No. 1-4748. (10)(m) Letter Agreement dated Incorporated by reference to July 1, 1993 between RII Exhibit 10.63 to Amendment and Bear Stearns & Co. Inc. No. 1, dated January 5, 1994, for retention of services. to registrant's Form S-4 Registration Statement in File No. 33-50733. (10)(n)(1) Paradise Island Purchase Incorporated by reference to Agreement dated October 11, Exhibit 10.55 to registrant's 1993 between RII and Sun Form S-4 Registration State- International Hotels ment dated October 25, 1993, Limited, with Exhibits and in File No. 33-50733. Schedules. - 114 - RESORTS INTERNATIONAL, INC. ___________________________ Form 10-K for the fiscal year ended December 31, 1993 EXHIBIT INDEX _____________ Reference to previous Exhibit filing or page number Number Exhibit in Form 10-K _______ _______ _____________________ (10)(n)(2) Amendment dated as of Novem- Incorporated by reference to ber 30, 1993 to the Para- Exhibit 10.55(a) to Amend- dise Island Purchase Agree- ment No. 3, dated February 1, ment dated October 11, 1994, to registrant's Form S-4 1993 between RII and Sun Registration Statement in File International Hotels No. 33-50733. Limited concerning Bahamas Developers Limited. (10)(n)(3) Amendment dated as of Incorporated by reference to November 30, 1993 to the Exhibit 10.55(b) to Amend- Paradise Island Purchase ment No. 3, dated February 1, Agreement dated October 11, 1994, to registrant's Form S-4 1993 between RII and Sun Registration Statement in File International Hotels No. 33-50733. Limited. (10)(o)(1) PIRL Standby Distribution Incorporated by reference to Agreement dated October 15, Exhibit 10.59 to registrant's 1993 between RII and PIRL. Form S-4 Registration State- ment dated October 25, 1993, in File No. 33-50733. (10)(o)(2) Letter Agreement between Incorporated by reference to RII and PIRL concerning Exhibit 10.60 to registrant's airline support services. Form S-4 Registration State- ment dated October 25, 1993, in File No. 33-50733. (10)(p) Bondholders Support Incorporated by reference to Agreement dated October 11, Exhibit 10.52 to registrant's 1993 among RII, Griffin Form S-4 Registration State- Resorts Inc. (now GGRI), ment dated October 25, 1993, Sun International Invest- in File No. 33-50733. ments Limited, Sun Inter- national Hotels Limited, TCW Special Credits and Fidelity Management and Research Company, concerning bondholders support. (10)(q) Letter Agreement dated Oct- Incorporated by reference to ober 11, 1993 among Fidelity Exhibit 10.50 to registrant's Management and Research Com- Form S-4 Registration State- pany, TCW Special Credits, ment dated October 25, 1993, RII and Sun International in File No. 33-50733. Hotels Limited concerning consent rights of holders of Old Series Notes. - 115 - RESORTS INTERNATIONAL, INC. ___________________________ Form 10-K for the fiscal year ended December 31, 1993 EXHIBIT INDEX _____________ Reference to previous Exhibit filing or page number Number Exhibit in Form 10-K _______ _______ _____________________ (10)(r)(l) Letter Agreement dated Oct- Incorporated by reference to ober 19, 1993 among RII, Exhibit 10.56 to regis- Fidelity Management, TCW trant's Form S-4 Registration Special Credits, Sun Inter- Statement dated October 25, national Hotels Limited, 1993, in File No. 33-50733. Sun International Invest- ments Limited and GGRI regarding GGRI, Inc. (10)(r)(2) Letter of Agreement dated Incorporated by reference to October 15, 1993, among RII, Exhibit 10.58 to registrant's Fidelity Management, TCW Form S-4 Registration State- Special Credits and Sun ment dated October 25, 1993, International Hotels in File No. 33-50733. Limited regarding P.I. Resorts Limited. (21) Subsidiaries of the Pages 117-118. registrant. - 116 - EXHIBIT 21 __________ Subsidiaries of the Registrant As of December 31, 1993 ______________________________ Percentage of Outstanding Place of Stock Held Name of Subsidiary Incorporation By Registrant __________________ _____________ _____________ ANTL, Inc. Florida l00% Aces Advertising Agency, Inc. New Jersey (1) Bahamas Developers Limited The Bahamas (2) Ess Zee Corporation New Jersey 100% GGRI, Inc. Delaware 100% International Suppliers, Inc. Florida 100% Island Hotel Company Limited The Bahamas (2) New Pier Operating Company, Inc. New Jersey 100% P.I. Resorts Limited The Bahamas 100% Paradise Beach Inn, Limited The Bahamas (3) Paradise Enterprises Limited The Bahamas (2) Paradise Island Airlines, Inc. Florida l00% Paradise Island Bridge Management Company Limited The Bahamas (2) Paradise Island Limited The Bahamas (2) Paradise Island Vacations, Inc. Florida 100% Paradise Security Services Limited The Bahamas (2) Resorts International (Bahamas) 1984 Limited The Bahamas (4) Resorts International Disbursement, Inc. Florida 100% Resorts International Hotel Financing, Inc. Delaware 100% Resorts International Hotel, Inc. New Jersey l00% Resorts Representation International, Inc. Florida 100% (1) 100% owned by Resorts International Hotel, Inc. (2) 100% owned by Resorts International (Bahamas) 1984 Limited (3) 100% owned by Paradise Island Limited (4) 100% owned by GGRI, Inc. - 117 - The registrant's subsidiaries generally do business in their respective corporate names or distinctive short forms thereof which are readily identifiable. Resorts International Hotel, Inc. uses the name Merv Griffin's Resorts Casino Hotel extensively. Resorts International (Bahamas) 1984 Limited, Paradise Enterprises Limited and Island Hotel Company Limited do business under the name Paradise Island Resort & Casino. Paradise Beach Inn, Limited does business under the name Paradise Paradise Beach Resort. The names of certain subsidiaries, which considered in the aggregate did not constitute a "significant subsidiary" as of December 31, l993 as defined in Rule l.02(v) of Regulation S-X, have been omitted. - 118 -

703559_1993.txt

703559_1993

1993

703559

ITEM 1. BUSINESS (a) General Development of Business. HUBCO, Inc. ("HUBCO" or "Registrant" or the "Company") is a bank holding company registered under the Bank Holding Company Act of 1956, as amended (the "Bank Holding Company Act"). HUBCO was organized under the laws of New Jersey in 1982 by Hudson United Bank for the purpose of creating a bank holding company for Hudson United Bank. HUBCO directly owns Hudson United Bank ("the Bank") and a second subsidiary, HUB Financial Services, Inc. HUBCO is also the indirect owner, through Hudson United Bank of an investment subsidiary and an inactive subsidiary. Each of HUBCO's direct and indirect subsidiaries is described below in this Item 1. Growth of Hudson United Bank Hudson United Bank was incorporated in 1890 as a state-chartered commercial bank. The bank took on its present name in a merger with United National Bank of Bergen County in 1972. In 1975, Hudson United Bank acquired an additional branch when it purchased Peoples Trust Company of Dunellen. In 1981, the bank sold one of its branches in Bloomfield, New Jersey. In 1983, the bank acquired another branch when it assumed the deposits and purchased certain assets of Pan American National Bank from the Federal Deposit Insurance Corporation ("FDIC") and began operating the former Pan American National Bank office in Union City, New Jersey as a branch of Hudson United Bank. Additional branches were opened in West New York, North Bergen, and Edgewater, New Jersey in 1986, 1988 and 1990, respectively. Since October 1990, HUBCO has engaged in a series of acquisitions, which are briefly described below. As of the filing of this Form 10-K, the Company has two substantial acquisitions pending. In May, 1993, the Company and the Bank agreed to acquire Statewide Savings Bank, S.L.A. ("Statewide"), a mutual savings and loan association, in a merger-conversion transaction. Under the agreement, the Company will sell shares of its common stock to Statewide's eligible depositors and other voting members at a discounted price (which is the lesser of $18.00 per share, or 95% of the market price of HUBCO stock for the 10 trading days prior to the closing date) in an amount equal to the appraised value of Statewide as determined by an independent appraiser. The independent appraiser has, on a preliminary basis as of December 6, 1993, determined the appraised value of Statewide to be approximately $35 million. The Company's stockholders will be offered any remaining shares at the same price as the shares are offered to Statewide's depositors. Shares not sold to Statewide's eligible depositors, other voting members and the Company stockholders are expected to be sold to the public at the then market price. As part of the transaction and simultaneously with the closing, Statewide will convert from a state savings and loan to a state mutual savings bank charter, from mutual to stock form and finally to a Commercial Bank Charter and then be merged into the Company's banking subsidiary, Hudson United Bank. As of the end of Statewide's last fiscal year on March 31, 1993, Statewide reported total assets, tangible net worth and net income of $518 million, $13.4 million and $5.1 million, respectively and had 13 branch offices serving Northern New Jersey markets. In December 1993, the Company filed a registration statement on Form S-3 for purposes of proceeding with the merger conversion and the sale of the Company's common stock. At about the same time, the Company, the Bank and Statewide filed various regulatory applications with the New Jersey Department of Banking, the Federal Deposit Insurance Corporation ("FDIC") and the Board of Governors of the Federal Reserve System ("FRB"). The New Jersey Department of Banking approved the applications that were filed by the Bank and by Statewide. However, the FDIC proposed a new policy and new interim regulations on mutual to stock conversions in January and February, 1994 and eventually, Statewide was required in March 1994 to file a new notice of conversion with the FDIC. On March 25, 1994, Statewide's notice of conversion was accepted by the FDIC for processing, but such processing may take up to 60 days. The policy of the FDIC on conversions, especially merger conversions, is still evolving and the effect of this on the approval of the Statewide transaction, is difficult to determine at this time. The transaction is subject to the approval of the FDIC and the FRB, neither of which have been received. The transaction is also subject to the approval of Statewide's depositors at a meeting to be held for that purpose. Statewide has the right to terminate the transaction if any of the approvals impose substantial conditions. The parties recently agreed to extend to the date after which either party could terminate the acquisition agreement to June 30, 1994. The acquisition of Statewide has taken longer than the Company anticipated due to a variety of factors. As a consequence, the Company has incurred and continues to incur substantial expenses for legal, accounting and printing costs in connection with the acquisition. If the acquisition were not consummated these expenses, which have been capitalized, would impact the Company's earnings , and there could be in that quarter a decline in earnings compared to the prior quarter. In November, 1993, the Company and its subsidiary bank agreed to acquire Washington Bancorp, Inc. and its subsidiary, Washington Savings Bank (together "Washington") for a combination of cash and convertible preferred stock with an aggregate consideration of approximately $40.5 million. In the transaction, approximately 51% of Washington's common stock will be converted into a new Class A Convertible preferred stock of the Company and 49% of Washington shares will be converted into cash at $16.10 per share, with Washington stockholders having the right to elect either cash or the preferred stock. Each full share of preferred stock will have a stated value of, and be redeemable for, $24.00 or be convertible into one share of Company common stock. The holders of the preferred stock will be entitled to receive an annual dividend to be set annually on the basis of the average market price of the Company's common stock during a twenty consecutive business day period ending two days prior to the date the dividend is set. The dividend will range from $1.00 per share of preferred stock if the common stock is trading at $24.00 or higher, up to $1.68 per share if the common stock is trading below $19.00. If the common stock is trading between $19.00 and $23.99, the dividend will be between $1.56 and $1.10 per share. The shares are immediately convertible whenever HUBCO shares trade at an average price of $24.00 for a ten day period. At December 31, 1993, Washington reported $282.6 million in assets and $2.8 million in earnings for the year and had eight branch offices serving Northern New Jersey markets. Consummation of the transaction contemplated by the Washington Merger Agreement is subject to a number of conditions, including, among others, obtaining all necessary regulatory approvals and the approval of Washington's shareholders, the receipt by Washington of a fairness opinion and, to the extent necessary, the approval of the Company's stockholders. The Company has made a determination that a vote of the Company's stockholders will not be required. The Company has the right to terminate the Washington Merger Agreement for a number of reasons, including if there is a material adverse change in the business, operations or financial condition of Washington. Under the material adverse change clause, but without limiting the definition of a material adverse change, the Company has the right to terminate the Washington Merger Agreement if Washington's largest non-performing loan, a loan of approximately $9.0 million, is not brought to performing status or if substantial steps are not taken to proceed with foreclosure on the loan. Although the Company anticipates that it will proceed with the acquisition of Washington, it continues to examine this loan and the circumstances surrounding the collateral. The Company's acquisition philosophy is to seek in-market or contiguous market opportunities which can be accomplished with little dilution to earnings. Since October 1990, the Company has acquired the assets and liabilities of six institutions, adding to its assets and liabilities a total of $807.2 million in assets and $805.7 million in liabilities and expanding its branch network from 15 branches to 37 branches. Over 80% of these assets and liabilities were acquired through government assisted transactions which allows the Bank to reprice deposits, review loans and purchase only those loans which meet its underwriting criteria. The balance of the assets and liabilities were acquired in traditional negotiated private transactions which the Company believes present a different level of risk than the risk presented in government assisted transactions. Summary of Acquisitions The following chart summarizes the acquisitions undertaken by the Company since October 1990: The Company's profitability and its financial condition may be significantly impacted by the continuing implementation of its acquisition strategy and by the consummation of the acquisition of Statewide and the acquisition of Washington. If the acquisition of Statewide and the acquisition of Washington are both consummated, the Company will add 21 branch offices (some of which it may close) and approximately $781 million in assets, increasing the Company's branches by more than 50% and its assets by 75%. Moreover, it is likely that an expansion of this magnitude will necessitate substantially increased staffing in the Company's operations along with the increased revenue stream. In addition to the other challenges presented by the acquisitions of Statewide and Washington, both institutions have a significant volume of non-performing assets, including non-accrual loans and real estate acquired in connection with collection actions on loans ("OREO properties"). At December 31, 1993, the Company had $11.5 million in non-performing assets, while Statewide had $12.5 million and Washington had $20.0 million. The Company does plan to utilize bulk sales of problem assets to reduce these non-performing assets. The Company intends to continue to seek acquisition opportunities that arise in its market area. There can be no assurance that the Company will be able to acquire additional financial institutions or, if additional financial institutions are acquired, that these acquisitions will be managed successfully to enhance the profitability of the Company. On November 8, 1993, the Company's Board of Directors authorized a stock repurchase plan and authorized management to repurchase up to 10% of its outstanding common stock per year beginning immediately. At that time, the Company had approximately 6.9 million shares outstanding. As of March 1, 1994, the Company had repurchased 455,081 shares at a cost of $10,131,898 , of which 12,300 shares have been reissued by the Company as awards under its restricted stock plan and the balance of the Treasury shares will be reissued in the Statewide merger conversion stock offering. The Company's management currently does not have intentions to purchase additional shares under the stock repurchase plan but intends to re-examine the issue from time to time. The Company's last repurchase of shares was on January 24, 1994. On January 14, 1994, the Company sold $25 million aggregate principal amount of subordinated debt in a private placement. The subordinated debentures bear interest at 7.75% per annum payable semi-annually. The debentures mature in 2004 (i.e., ten years after the date of original issuance) and payment of the principal of the debentures may be accelerated only upon the bankruptcy or insolvency of the Company or its major banking subsidiary. The debt was issued under an indenture intended to comply with the terms and conditions of the Trust Indenture Act of 1939 and the Company is obligated to register the subordinated debt with the SEC by July 13, 1994, for an exchange offer for registered securities or in a resale transaction. The subordinated debt has been structured to comply with the current rules of the Board of Governors of the Federal Reserve System regarding debt which will qualify as Tier 2 capital under the FRB capital adequacy rules. It may also be invested in the banking subsidiary as Tier I capital. The Company sold the debt as part of a long term strategy to raise capital and did not need the additional capital or funds raised to pay for existing acquisitions. The Company intends to use the net proceeds from the sale of the subordinated debt for general corporate purposes, including investments in and advances to the Company's subsidiaries, and for financing possible future acquisitions of deposits and banking assets. Pending such use, the Company or its subsidiaries may temporarily invest the net proceeds in investment grade securities. The Company has outgrown the space at its headquarters office and commencing in the fourth quarter of 1993 the Company actively undertook a search for additional space to expand its headquarters operations. In March of 1994, the Company contracted to purchase a 64,350 square foot building in Mahwah, New Jersey to house the executive offices of the Company and the Company's data processing subsidiary, which will service the Bank's data processing and check processing needs and will offer its services to smaller banks in the New York and New Jersey area. The net increase in the Company's total other expenses directly attributable to this purchase is anticipated to be approximately one percent. Other Subsidiaries HUBCO has a second directly-owned subsidiary called HUB Financial Services, Inc., a data processing subsidiary formed in January 1983, which has primarily serviced automobile and equipment leases for Hudson United Bank, on a fee basis. In 1988 HUB Financial Services, Inc. received approval from the Federal Reserve Board for making, acquiring, selling and servicing real estate mortgage loans, and commenced operations as a mortgage broker. In 1984, Hudson United Bank established a subsidiary corporation in Delaware to manage a portion of its investment portfolio and had contributed $20,033,509 of its investment portfolio to the corporation as of December 31, 1992. In February 1993, the assets of the Delaware Corporation were transferred up to its parent, Hudson United Bank, in the form of a dividend and the subsidiary was dissolved. In 1987, Hudson United Bank established a subsidiary corporation in New Jersey to manage a portion of its investment portfolio and to operate under state tax law as an investment company. As of December 31, 1993, $338,630,069 of the Bank's investment portfolio is being managed by the New Jersey corporation. Hudson United Bank also owns an inactive subsidiary, Lafayette Development Corp. Unionization of Hudson United Bank Hudson United Bank is administratively divided into three divisions: the Northern Division, the Southern Division and the Essex Division. The Southern Division of Hudson United Bank is unionized. Local 153 of the Office and Professional Employees International Union represents the bank's clerical staff in the Southern Division's bargaining unit. In February 1993, a three-year collective bargaining agreement was negotiated which provides for a modest increase in wages, an increase in hours of employment, contributions towards the cost of providing health care benefits and an increase in the annual pension benefit for employees with more than three years of service who were employed as of March 1, 1990. Currently, approximately 49% of the employees in the bargaining unit are members of the union. The collective-bargaining agreement expires February 28, 1996. Regulatory Matters There are a variety of statutory and regulatory restrictions governing the relations among HUBCO and its subsidiaries: Capital Adequacy Guidelines Bank holding companies must comply with the Federal Reserve Board's risk-based capital guidelines, which became effective on February 15, 1989 and were fully phased-in on December 31, 1992. Under the guidelines, risk weighted assets are calculated by assigning assets and certain off-balance sheet items to broad risk categories. The total dollar value of each category is then weighted by the level of risk associated with that category. As of December 31, 1992, minimum risk-based capital to risk based assets ratio of 8.00% must be attained. At least one half of an institution's total risk based capital must consist of Tier 1 capital, and the balance may consist of Tier 2, or supplemental, capital. Tier 1 capital consists primarily of common stockholder's equity along with preferred or convertible preferred stock, minus goodwill. Tier 2 capital consists of an institution's allowance for loan and lease losses, subject to limitation, hybrid capital instruments and certain subordinated debt. The allowance for loan and lease losses which is considered Tier 2 capital is limited to l.25% of an institution's risk-based assets. As of December 31, 1993, HUBCO's total risk-based capital ratio was 14.85% consisting of a Tier 1 ratio of 13.60% and a Tier 2 ratio of l.25%. Both ratios exceed the requirements under these regulations. In addition, the Federal Reserve Board has promulgated a leverage capital standard, with which bank holding companies must comply. Bank holding companies must maintain a minimum Tier l capital to total assets ratio of 3%. However, institutions which are not among the most highly rated by federal regulators must maintain a ratio 100-to-200 basis points above the 3% minimum. As of December 31 1993, HUBCO had a leverage capital ratio of 7.22%. The FDIC also imposes risk based and leverage capital guidelines on Hudson United Bank. These guidelines and the ratios to be met are substantially similar to those imposed by the Federal Reserve Board. If a bank does not satisfy the FDIC's capital requirements, it will be deemed to be operated in an unsafe and unsound manner and will be subject to regulatory action. As of December 31, 1993, Hudson United Bank had a risk weighted capital ratio of 13.94% and a leverage capital ratio of 6.70%. These ratios exceed the requirements under the FDIC regulations. See also "Management's Discussion and Analysis of Financial Condition and Results of Operation - Capital." Restrictions on Dividend Payments The payment of dividends by the Bank to HUBCO is regulated. Under the New Jersey Banking Act of 1948, as amended, Hudson United Bank may pay dividends only out of retained earnings, and out of surplus to the extent that surplus exceeds 50 percent of stated capital. Under the Financial Institutions Supervisory Act, the FDIC has the authority to prohibit a state-chartered bank from engaging in conduct which, in the FDIC's opinion, constitutes an unsafe or unsound banking practice. Under certain circumstances, the FDIC could claim that the payment of a dividend or other distribution by a bank to its sole shareholder constitutes an unsafe or unsound practice. Restrictions on Transactions Between HUBCO and the Bank The Banking Affiliates Act of 1982, as amended, severely restricts loans and extensions of credit by the Bank to HUBCO and HUBCO affiliates (except affiliates which are banks). In general, such loans must be secured by collateral having a market value ranging from 100% to 130% of the loan, depending upon the type of collateral. Furthermore, the aggregate of all loans from the Bank to HUBCO and its affiliates may not exceed 20% of that Bank's capital stock and surplus and, singly to HUBCO or any affiliate, may not exceed l0% of the Bank's capital stock and surplus. Similarly, the Banking Affiliates Act of 1982 also restricts the Bank in the purchase of securities issued by, the acceptance from affiliates of loan collateral consisting of securities issued by, the purchase of assets from, and the issuance of a guarantee or standby letter- of-credit on behalf of, HUBCO or any of its affiliates. Holding Company Supervision Under the Bank Holding Company Act, HUBCO may not acquire directly or indirectly more than 5 percent of the voting shares of, or substantially all of the assets of, any bank without the prior approval of the Federal Reserve Board. HUBCO cannot acquire any bank located outside New Jersey unless the law of such other state specifically permits the acquisition. In general, the Federal Reserve Board, under its regulations and the Bank Holding Company Act, regulates the activities of bank holding companies and non-bank subsidiaries of banks. The regulation of the activities of banks, including bank subsidiaries of bank holding companies, generally has been left to the authority of the supervisory government agency, which for Hudson United Bank is the New Jersey Department of Banking (the "Department"). Interstate Banking Authority New Jersey law allows New Jersey banking organizations to acquire or be acquired by banking organizations in other states on a "reciprocal" basis (i.e., provided the other state's laws permit New Jersey banking organizations to acquire or be acquired by banking organizations in that state on substantially the same terms and conditions applicable to banking acquisitions solely within the state). FIRREA The Financial Institutions Reform, Recovery and Enforcement Act of 1989 ("FIRREA") established new capital standards and enhanced regulatory oversight of the thrift industry. Many thrifts were unable to comply with the new regulations creating opportunities for mergers and acquisitions by commercial banks as well as other thrift institutions. From time to time, HUBCO investigates potential opportunities that arise as the result of this legislation and the enforcement of regulations promulgated thereunder. While FIRREA focuses primarily on the recovery and reform of the savings and loan industry, there are provisions which affect commercial banks. Such provisions include a new deposit insurance system, increased deposit insurance premiums, restrictions on acceptance of brokered deposits and increased consumer-related disclosure requirements. Recent Regulatory Enactments The Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA") was enacted in December 1991. FDICIA was primarily designed to provide additional financing for the FDIC by increasing its borrowing ability. The FDIC was given the authority to increase deposit insurance premiums to repay any such borrowing. In addition, FDICIA identifies the following capital standard categories for financial institutions: well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized. As a result of FDICIA, the various banking regulatory agencies have set certain capital and other measures for determining the categories into which financial institutions fall. FDICIA imposes progressively more restrictive constraints on operations, management and capital distributions depending on the category in which an institution is classified. Pursuant to FDICIA, undercapitalized institutions must submit recapitalization plans, and a company controlling a failing institution must guarantee such institution's compliance with its plan. FDICIA also required the various regulatory agencies to prescribe certain non-capital standards for safety and soundness relating generally to operations and management, asset quality and executive compensation, and permits regulatory action against a financial institution that does not meet such standards. The agencies have implemented some of those regulations and have proposed to implement others. The deposits of the Bank are insured up to applicable limits by the FDIC. Accordingly, the Bank is subject to deposit insurance assessments to maintain the Bank Insurance Fund (the "BIF") of the FDIC. As of January 1, 1993, the FDIC began a risk-based insurance assessment system. This approach is designed to ensure that a banking institution's insurance assessment is based on three factors: the probability that the applicable insurance fund will incur a loss from the institution; the likely amount of the loss; and the revenue needs of the insurance fund. Management believes that the provision of FDICIA and the risk-based insurance assessment will not have a material effect upon the financial position of HUBCO. Source of Strength Doctrine According to Federal Reserve Board policy, bank holding companies are expected to act as a source of financial strength to each subsidiary bank and to commit resources to support each such subsidiary. This support may be required at times when a bank holding company may not be able to provide such support. Furthermore, in the event of a loss suffered or anticipated by the FDIC - either as a result of default of a bank subsidiary of the Company or related to FDIC assistance provided to the subsidiary in danger of default - the other bank subsidiaries of the Company may be assessed for the FDIC's loss, subject to certain exceptions. (b) Industry Segments. The Registrant has one industry segment -- commercial banking. (c) Narrative Description of Business. HUBCO exists primarily to hold the stock of its subsidiaries. During 1993, HUBCO had two directly-owned subsidiaries -- Hudson United Bank and HUB Financial Services, Inc. In addition, HUBCO, through Hudson United Bank, indirectly owns two additional subsidiaries. The historical growth of, and regulatory scheme affecting, each of HUBCO's direct and indirect subsidiaries is described in Item 1(a) above, which is incorporated herein by reference. HUBCO is a legal entity separate from its subsidiaries. The stock of the Bank is HUBCO's principal asset. Dividends from Hudson United Bank are the primary source of income for HUBCO. As explained above in Item 1(a), legal and regulatory limitations are imposed on the amount of dividends that may be paid by the Bank to HUBCO. Hudson United Bank currently maintains its head office in Union City, New Jersey. The Bank operates out of 37 offices in six northern New Jersey counties. Of these offices, all but one are located in the northern New Jersey counties of Bergen, Essex, Hudson, Morris and Passaic. One other branch is located in Dunellen, Middlesex County, New Jersey. HUBCO owns a two-story building one block from Hudson United Bank's main office which HUBCO is leasing to the Bank as an operations center. In March of 1994, HUBCO contracted to purchase a 64,350 square foot building in Mahwah, New Jersey to house the executive offices of HUBCO and the Company's data processing subsidiary, which will service the Bank's data processing and check processing needs and will offer its services to smaller banks in the New York and New Jersey area. At December 31, 1993, HUBCO through its subsidiaries had deposits of $935,687,813, net loans of $518,579,459 and total assets of $1,041,824,323. HUBCO ranked 12th among New Jersey commercial banks and bank holding companies in terms of asset size as of December 31, 1993. The Bank is a full service commercial bank and offers the services generally performed by commercial banks of similar size and character, including checking, savings, and time deposit accounts, certificates of deposit, trust services, safe deposit boxes, secured and unsecured personal and commercial loans and residential and commercial real estate loans. The principal focus of the Bank is its local market place. The Bank's deposit accounts are competitive in the current environment and include money market accounts and a variety of interest- bearing transaction accounts. In the lending area, the Bank primarily engages in consumer lending, commercial lending and real estate lending activities. Hudson United Bank offers a variety of trust services. At December 31, 1993, the Trust Department had approximately $99,571,000 of assets under management or in its custodial control. There are over 100 commercial banks throughout New Jersey, many of which have offices in Northern New Jersey. In addition, large banks in New York City compete for the business of New Jersey residents and businesses located in HUBCO's primary areas of trade. A number of other depository institutions compete for the business of individuals and commercial enterprises in New Jersey including savings banks, savings and loan associations, brokerage houses, financial subsidiaries of the retail industry and credit unions. Other financial institutions, such as mutual funds, consumer finance companies, factoring companies, and insurance companies, also compete with HUBCO for both loans and deposits. Competition for depositors' funds, for creditworthy loan customers and for trust business is intense. Despite intense competition with institutions commanding greater financial resources, the Bank's supply of funds has imposed no substantial impediment to its normal lending functions. While the Bank is limited to making commercial loans to a single borrower in an amount not to exceed fifteen percent of its capital and has a "house limit" significantly below that level, it has, on occasion, arranged for participation by other banks in larger loan accommodations. The Bank has focused on becoming an integral part of the communities it serves. Officers and employees are trained to meet the needs of their customers and emphasis is placed on addressing the needs of the local communities served. HUBCO and its subsidiaries had 400 full-time employees and 87 part-time employees as of December 31, 1993, compared to 388 full-time and 68 part-time employees at the end of 1992. (d) Financial Information about foreign and domestic operations and export sales. Not Applicable (e) Executive Officers of the Registrant The following table sets forth certain information as to each executive officer of HUBCO who is not a director. NAME,AGE AND POSITION WITH OFFICER OF PRINCIPAL OCCUPATION HUBCO HUBCO SINCE DURING PAST FIVE YEARS D. Lynn Van Borkulo- 1988 1st Sr. Vice President, Hudson Nuzzo, 44 United Bank, Corporate Secretary, HUBCO; at Hudson United Bank since 1967. Last five years has progressed from V.P. and Sr. Trust Officer to V.P. Commercial Loans, to S.V.P. Corporate Affairs. Was promoted to 1st SVP in 1988. Christina L. Maier, 40 1987 Assistant Treasurer of HUBCO and Senior Vice President and Controller of the Bank; at Hudson United Bank since 1979. Last five years served as Controller; promoted to Senior Vice President in 1988. (f) Statistical Disclosure Required Pursuant to Securities Exchange Act, Industry Guide 3. The statistical disclosures for a bank holding company required pursuant to Industry Guide 3 are contained in HUBCO's 1992 Annual Report on pages 8-10 and 14-17, and on the following pages of this Report on Form 10-K: PAGES(S) OF ITEM OF GUIDE 3 THIS REPORT II. Investment Portfolio . . . . . . . . . . . . . . . . . 17 III. Loan Portfolio . . . . . . . . . . . . . . . . . . . . 18-20 IV. Summary of Loan Loss Experience. . . . . . . . . . . . 21-21a V. Deposits . . . . . . . . . . . . . . . . . . . . . . . 22 VI. Return on Equity and Assets. . . . . . . . . . . . . . 23 VII. Short-Term Borrowings. . . . . . . . . . . . . . . . . 24-25 HUBCO, Inc. and Subsidiaries S.E.C. GUIDE 3 - ITEM II INVESTMENT PORTFOLIO Book Value at End of Each Report Period December 31 1993 1992 1991 (In Thousands of Dollars) U.S. Treasury and Other U.S. Government Agencies and Corporations $391,098 $291,377 $ 89,613 State and Political Subdivisions 25,652 16,068 13,158 Other Securities 4,833 14,424 35,928 Common Stock 5,102 592 155 Preferred Stock 0 61 61 ________ ________ ________ TOTAL $426,685 $322,522 $138,915 ======== ======== ======== Weighted average yields on tax-exempt obligations have been computed on a fully tax-equivalent basis assuming a tax rate of 35 percent. HUBCO, Inc. and Subsidiaries S.E.C. GUIDE 3 - ITEM III LOAN PORTFOLIO Types of Loans At End of Each Reported Period December 31 1993 1992 1991 1990 1989 Commercial, Financial, and Agricultural $119,563 $129,550 $132,090 $118,734 $107,335 Real Estate - Construction 7,117 3,777 3,108 7,422 7,102 Real Estate - Mortgage 330,018 298,995 257,064 157,558 136,101 Installment 77,945 86,903 77,334 86,766 112,510 Lease Financing 122 1,644 6,158 14,258 26,338 Foreign -- -- -- -- -- ________ ________ ________ ________ ________ TOTAL $534,765 $520,869 $475,754 $384,738 $389,386 ======== ======== ======== ======== ======== HUBCO, Inc. and Subsidiaires S.E.C. GUIDE 3 - ITEM III LOAN PORTFOLIO The following table shows the maturity of loans (excluding residential mortgages of 1-4 family residences, installment loans and lease financing) outstanding as of December 31, 1993. Also provided are the amounts due after one year classified according to the sensitivity to changes in interest rates. Maturities and Sensitivity to Changes in Interest Rates MATURING After One After Within But Within Five One Year Five Years Years Total Commercial, Financial, and Agricultural $ 58,037 $32,990 $28,536 $119,563 Real Estate Construction 5,652 1,465 - 0 - 7,117 Real Estate - Mortgage 75,722 43,897 18,571 138,190 ________ _______ _______ ________ TOTAL $139,411 $78,352 $47,107 $264,870 ======== ======= ======= ======== INTEREST SENSITIVITY Fixed Variable Rate Rate Due After One But Within Five Years $48,815 $29,537 Due After Five Years 26,501 20,606 _______ _______ TOTAL $75,316 $50,143 ======= ======= HUBCO, Inc. and Subsidiaries S.E.C. GUIDE 3 - ITEM III LOAN PORTFOLIO Nonaccrual, Past Due and Restructured Loans December 31 1993 1992 1991 1990 1989 ____ ____ ____ ____ ____ (In Thousands of Dollars) Loans accounted for on a nonaccrual basis $5,534 $4,248 $4,160 $8,224 $3,332 Loans contractually past due 90 days or more as to interest or principal payments 1,443 1,409 1,181 894 1,778 Loans whose terms have been renegotiated to provide a reduction or deferral of interest or principal because of a deterioration in the financial position of the borrower 2,177 2,257 3,527 808 - 0 - At the end of the reporting period, there were no loans not disclosed under the preceding two sections where known information about possible credit problems of borrowers causes management of the Company to have serious doubts as to the ability of such borrowers to comply with the present loan repayment terms and which may result in disclosure of such loans in the two preceding sections in the future. At December 31, 1993 and 1992, there were no concentrations of loans exceeding 10% of total loans which are not otherwise disclosed as a category of loans pursuant to Item III.A. of Guide 3. -21a- HUBCO, Inc. and Subsidiaries S.E.C. GUIDE 3 - ITEM V DEPOSITS The following table sets forth average deposits and average rates for each of the years indicated. 1993 1992 1991 Amount Rate Amount Rate Amount Rate (In Thousands of Dollars) Domestic Bank Offices: Non-interest-bearing demand deposits $185,848 $152,397 $113,504 Interest-bearing demand deposits 112,836 2.74% 97,494 3.34% 63,348 4.84% Savings deposits 342,540 2.58 278,925 3.26 174,557 4.86 Time deposits 251,128 3.37 303,029 4.54 197,020 6.53 Foreign bank offices -- -- -- ________ ________ ________ TOTAL $892,352 $831,845 $548,429 ======== ======== ======== Maturities of time certificates of deposit and other time deposits of $100,000 or more issued by domestic offices, outstanding at December 31, 1993 are summarized as follows: Time Certificates Other Time of Deposit Deposits Total 3 months or less $12,000 $--- $12,000 Over 3 through 6 months 5,030 --- 5,030 Over 6 through 12 months 4,636 --- 4,636 Over 12 months 1,985 --- 1,985 _______ ____ _______ $23,651 $--- $23,651 ======= ==== ======= HUBCO, Inc. and Subsidiaries S.E.C. GUIDE 3 - ITEM VI RETURN ON EQUITY AND ASSETS Year Ended December 31, 1993 1992 1991 Return on Average Assets 1.44% 1.05% .82% Return on Average Equity 19.34 17.38 12.75 Dividend Payout Ratio 23.00 25.04 33.44 Average Equity to Average Assets Ratio 7.44 6.04 6.45 HUBCO, Inc. and Subsidiaries S.E.C. GUIDE 3 - ITEM VII SHORT-TERM BORROWINGS The following table shows the distribution of the Company's short-term borrowings and the weighted average interest rates thereon at the end of each of the last three years. Also provided are the maximum amount of borrowings and the average amounts of borrowings as well as weighted average interest rates for the last three years. The term for each type of borrowing disclosed is one day. Federal Funds Purchased and Securities Sold Under Agreement Other Short- to Repurchase Term Borrowings (In Thousand of Dollars) Year ended December 31: 1993 $19,629 $1,000 1992 14,133 1,000 1991 12,040 1,000 Weighted average interest rate at year end: 1993 2.50% 2.95% 1992 2.92 3.05 1991 4.02 4.22 Maximum amount outstanding at any month's end: 1993 $29,269 $1,000 1992 17,010 1,000 1991 24,574 1,000 Average amount outstanding during the year: 1993 $14,603 $ 938 1992 14,500 928 1991 13,790 929 Federal Funds Purchased and Securities Sold Under Agreement Other Short- to Repurchase Term Borrowings (In Thousand of Dollars) Weighted average interest rate during the year: 1993 2.28% 3.09% 1992 3.31 4.00 1991 4.79 6.11 ITEM 2. ITEM 2. PROPERTIES The corporate headquarters of HUBCO and the main office of Hudson United Bank are located in a four story facility in Union City, New Jersey. The property is approximately 42,400 square feet and is owned by Hudson United Bank. Hudson United Bank occupies 36 additional branch offices, of which 18 are owned and 18 are leased. All leased properties have rental payments at or below fair market value. Of the eighteen properties leased, one has an option to purchase and nine have renewal options for terms of five to sixty-four years. The remaining eight locations have expiration dates ranging from 1995- 2005. The data processing and deposit services center for the Bank is located in a two-story building in Union City, New Jersey, which is approximately 14,000 square feet. The building is owned by HUBCO and leased to Hudson United Bank. HUBCO has outgrown the space at its headquarter's office and commencing in late December 1993, HUBCO actively undertook a search for additional space to expand its headquarter's operations. In March of 1994, HUBCO purchased a 64,350 square foot building in Mahwah, New Jersey, to house the executive offices of HUBCO and the Company's data processing subsidiary. ITEM 3. ITEM 3. LEGAL PROCEEDINGS In the normal course of business, lawsuits and claims may be brought by and may arise against HUBCO and its subsidiaries. In the opinion of management, no legal proceedings which have arisen in the normal course of the Company's business and which are presently pending or threatened against HUBCO or its subsidiaries, when resolved, will have a material adverse effect on the business or financial condition of HUBCO or any of its subsidiaries. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of Shareholders of HUBCO during the fourth quarter of 1993. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. As of December 31, 1993, HUBCO had approximately 1,596 shareholders. HUBCO's common stock was listed on the American Stock Exchange during 1992. Effective March 1, 1993, HUBCO is listed on the Nasdaq National Market. The following represents the high and low sale prices from each quarter during the last two years. The numbers have been restated to reflect a 10% stock dividend paid by HUBCO on June 1, 1993. High Low 1st Quarter $24 5/8 $16 2nd Quarter 24 3/8 19 3rd Quarter 25 1/4 20 1/4 4th Quarter 24 1/4 20 High Low 1st Quarter $12 1/2 $ 8 3/8 2nd Quarter 12 5/8 10 5/8 3rd Quarter 13 11 3/8 4th Quarter 16 7/8 12 The following table shows the per share quarterly cash dividends paid upon the common stock over the last two years. 1993 1992 March 1 $.10 March 1 $.09 June 1 .11 June 1 .09 September 1 .11 September 1 .09 December 1 .12 December 1 .10 December 1 .03 (extra) December 1 .03 (extra) Dividends are generally declared within 30 days prior to the payable date, to stockholders of record l0-20 days after the declaration date. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA (In Thousands Except For Per Share Amounts) Reference should be made to pages 4-6 of this Report on Form 10-K for a discussion of recent acquisitions which affect the comparability of the information contained in this table. 1993 1992 1991 1990 1989 Net Interest Income $ 47,018 $ 41,013 $ 26,472 $ 22,991 $ 23,293 Provision for Loan 3,600 4,116 2,312 4,150 1,860 Losses Net Income 14,202 9,641 5,021 2,215 3,309 Per Share Data(1) Net Income 2.06 1.58 1.01 .45 .67 Cash Dividends .47 .40 .33 .33 .33 Declared Balance Sheet Totals: Total Assets-12/31 1,041,825 931,911 673,159 595,128 548,132 Long Term Debt-12/31 - - 763 831 899 Average Equity - 73,451 55,467 39,367 37,634 37,123 for year Average Assets - 987,894 918,116 610,297 549,704 530,556 for year (1) Per share data is adjusted retroactively to reflect a 10% stock dividend paid November 15, 1991 to stockholders of record on November 6, 1991, and a 10% stock dividend paid June 1, 1993 to stockholders of record on May 11, 1993. ITEM 7. ITEM 7. HUBCO'S 1993 Annual Report contains on pages 6 through 22, the information required by Item 7 and that information is incorporated herein by reference. That discussion is supplemented by the following information. On March 18, 1994, HUBCO entered into an interest rate exchange agreement (the "agreement") for the purpose of hedging the interest rate related to the $25,000,000 subordinated debt issued in January, 1994. The agreement is a contractual agreement between HUBCO and its counterparty to exchange fixed and floating rate interest obligations without exchange of the underlying notional amount of $25,000,000. The agreement was entered into in an effort to lower the overall cost of borrowings. such agreement involves interest rate risk. If interest rates increase, the benefit resulting from the agreement will be diminished. The notional principal amount is used to express the volume of the transaction involved in this agreement; however, this amount does not represent exposure to credit loss. HUBCO's counterparty to the agreement is the fixed rate payor on the agreement and HUBCO is the floating rate payor on the agreement. The The floating rate is reset every three months. As of the date of the agreement, the net reduction in the interest rate on the subordinated debt was 1.65%. The original term of this agreement is 3 years. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA HUBCO's 1992 Annual Report contains on pages 23 through 36, the information required by Item 8 and that information is incorporated herein by reference. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE In March 1991, the Audit Committee of the Board of Directors of the Company recommended that Arthur Andersen be engaged as the Company's independent accountants to audit the books and records of the Company for 1991. The Company did not have any disagreement with Ernst & Young on any matter of accounting principles or practice, financial statement disclosure, or auditing scope or procedure. Ernst & Young's year-end reports did not contain an adverse opinion or a disclaimer of opinion and were not qualified as to uncertainty, audit scope, or accounting principles. The Audit Committee's recommendation was approved by the Board of Directors on March 26, 1991. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT HUBCO's Proxy Statement for its 1994 Annual Meeting on pages 4 to 6, under the caption "Proposal I - Election of Directors", contains the information required by Item 10 with respect to directors of HUBCO and certain information with respect to executive officers and that information is incorporated herein by reference. Certain additional information regarding executive officers of HUBCO, who are not also directors, appears under subsection (e) of Item 1 of this Form 10-K. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION HUBCO's Proxy Statement for its 1994 Annual Meeting contains on pages 10 to 20, under the caption "Executive Compensation", and on page 22 under the caption "Compensation Committee Interlocks and Insider Participation", the information required by Item 11 and that information is incorporated herein by reference. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT HUBCO's Proxy Statement for its 1994 Annual Meeting contains on pages 7 to 9, under the caption "Stock Ownership of Management and Principal Shareholders", the information required by Item 12 and that information is incorporated herein by reference. The Company knows of no person or group which is the beneficial owner of more than five percent of any class of the Company's voting securities, except as set forth on pages 7 and 8 of HUBCO's Proxy Statement for its 1994 Annual Meeting. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS HUBCO's Proxy Statement for its 1994 Annual Meeting on page 22 under the captions "Compensation Committee Interlocks and Insider Participation" and "Certain Transactions with Management", contains the information required by Item 13 and that information is incorporated herein by reference. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) (1) & (2) List of Financial Statements and Financial Statement Schedules The below listed consolidated financial statements and report of independent public accountants of HUBCO, 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: Reports of Independent Public Accountants Consolidated Balance Sheets at December 31, 1993 and 1992 Consolidated Statements of Income for the Years Ended December 31, 1993, 1992 and 1991 Consolidated Statements of Changes in Stockholders' Equity 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 Notes to Consolidated Financial Statements Schedules to the Consolidated Financial Statements required by Article 9 of Regulation S-X are not required under the related instructions or are inapplicable, and therefore have been omitted. (a) (3) Exhibits List of Exhibits (2a) Agreement and Plan of Reorganization dated as of May 21, 1993, between HUBCO, Hudson and Statewide, together with Exhibit A, the Plan of Conversion. (Incorporated by reference from the Company's Current Report on Form 8-K dated May 21, 1993.) (2b) Agreement and Plan of Merger dated as of November 8, 1993, between HUBCO, Inc., Hudson United Bank and Washington Bancorp, Inc. and Washington Savings Bank. (Incorporated by reference from the Company's Current Report on Form 8-K dated November 8, 1993.) (3a) The Certificate of Incorporation of HUBCO, Inc. filed May 5, 1982 and amendments to the Certificate of Incorporation, dated November 22, 1983, January 30,1984 January 11, 1985, July 17, 1986, March 25, 1987, April 26, 1991, November 26, 1991, March 25, 1992 and May 17, 1993. (3b) The By-Laws of HUBCO, Inc. (4) Indenture dated as of January 14, 1994 between HUBCO, Inc. and Summit Bank as Trustee for $25,000,000 7.75% Subordinated Debentures due 2004. (10a) Employment contract with Kenneth T. Neilson. (Incorporated by reference from the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1991, Exhibit (10a). (10b) Employment contract with James E. Schierloh. (Incorporated by reference from the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1991, Exhibit (10b). (10c) Employment contract with D. Lynn Van Borkulo. (Incorporated by reference from the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1991, Exhibit (10c). (10d) Collective Bargaining Agreement with Local 153 of the Office and Professional Employees International Union, dated January 26, 1993. (Incorporated by reference from the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1992, Exhibit (10d). (10e) Purchase and Assumption Agreement dated April 14, 1993, among the Company, Hudson United Bank, Ramapo Financial Corporation and The Ramapo Bank. (Incorporated by reference from the Company's Current Report on Form 8-K dated April 14, 1993.) (13) 1993 Annual Report to Shareholders (22) List of Subsidiaries. (24) Consent of Arthur Andersen & Co. (b) Reports on Form 8-K Form 8-K dated November 8, 1993 Item 5. Other Events -- Reported on the announcement by the Company that it and its principal subsidiary, Hudson United Bank, have entered into an Agreement and Plan of Merger with Washington Bancorp, Inc. and Washington Savings Bank, pursuant to which HUBCO will acquire Washington Bancorp, Inc. for a combination of securities and cash. Item 7. Exhibits -- Included Agreement and Plan of Merger dated as of November 8, 1993, Stock Option Agreement between Washington Bancorp, Inc. and HUBCO, Inc. dated November 8, 1993 and press release dated November 8, 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. HUBCO, INC. By:s/ James E. Schierloh James E. Schierloh Chairman of the Board Dated: 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 s/James E. Schierloh Chairman of the James E. Schierloh Board and Director March 22, 1994 s/Kenneth T. Neilson President and March 22, 1994 Kenneth T. Neilson Director s/Robert J. Burke Director March 22, 1994 Robert J. Burke s/Henry G. Hugelheim Director March 22, 1994 Henry G. Hugelheim s/Harry J. Leber Director March 22, 1994 Harry J. Leber s/Charles F.X. Poggi Director March 22, 1994 Charles F. X. Poggi s/Sr. Grace Frances Strauber Director March 22, 1994 Sister Grace Frances Strauber s/Edwin Wachtel Director March 22, 1994 Edwin Wachtel s/Christina L. Maier Assistant March 22, 1994 Christina L. Maier Treasurer

790650_1993.txt

790650_1993

1993

790650

Item 1. Business GENERAL Southern New England Telecommunications Corporation (the "Corporation") was incorporated in 1986 under the laws of the State of Connecticut and has its principal executive offices at 227 Church Street, New Haven, Connecticut 06510 (telephone number (203) 771-5200). The Corporation is a holding company engaged through its subsidiaries in operations principally in the State of Connecticut: The Southern New England Telephone Company (providing for the most part regulated telecommunications services and directory publishing services); SNET America, Inc. (providing interstate and international long distance services to Connecticut customers); SNET Cellular, Inc., SNET MobileCom, Inc. and SNET Paging, Inc. (providing personal communications services); SNET Diversified Group, Inc. (primarily engaged in the leasing of communications equipment to residential and business customers; and providing other telecommunications services not subject to regulation); and SNET Real Estate, Inc. (engaging in leasing commercial real estate). The Corporation furnishes financial and strategic planning, and stockholder relation functions on its own behalf and on behalf of its subsidiaries. THE SOUTHERN NEW ENGLAND TELEPHONE COMPANY The Southern New England Telephone Company ("Telephone Company"), a local exchange carrier ("LEC"), was incorporated in 1882 under the laws of the State of Connecticut and is engaged in the provision of telecommunications services in the State of Connecticut, most of which are subject to rate regulation. These telecommunications services include (i) local and intrastate toll services, (ii) exchange access service, which links customers' premises equipment ("CPE") to the facilities of other carriers, and (iii) other services such as digital transmission of data and transmission of radio and television programs, packet switched data network and private line services. Through its directory publishing operations, the Telephone Company publishes and distributes telephone directories throughout Connecticut and certain adjacent communities. In 1993, approximately 75% of the Corporation's consolidated revenues and sales were derived from the Telephone Company's rate regulated telecommunication services. The remainder were derived principally from the Corporation's other subsidiaries, directory publishing operations, and activities associated with the provision of facilities and non-access services to interexchange carriers. About 71% of the operating revenues from rate regulated services were attributable to intrastate operations, with the remainder attributable to interstate access services. State Regulatory Matters The Telephone Company, in providing telecommunications services in the State of Connecticut, is subject to regulation by the Connecticut Department of Public Utility Control ("DPUC"), which has jurisdiction with respect to intrastate rates and services, and other matters such as the approval of accounting procedures, the issuance of securities and the setting of depreciation rates on telephone plant utilized in intrastate operations. The DPUC has adopted for intrastate ratemaking purposes accounting and cost allocation rules, similar to those adopted by the Federal Communications Commission ("FCC"), for the separation of costs of regulated from non-regulated activities. State Regulation On May 24, 1993, the DPUC issued a final decision on the capital recovery portion of the November 1992 rate request submitted by the Telephone Company ("Rate Request"). The Telephone Company was granted an increase in the composite intrastate depreciation rate from 5.7% to approximately 7.3%. This equated to an increase in Telephone Company revenue requirement of approximately $40 million annually. The new depreciation rates were implemented effective July 1, 1993. On July 7, 1993, the DPUC issued a final decision ("Final Decision-I") in its three-phase review of the current and future telecommunications requirements of Connecticut and a final decision ("Final Decision-II") in the remainder of the Rate Request docket. The Final Decision-I addressed the issues of (i) competition [see Item 1., "Competition"]; (ii) infrastructure modernization; (iii) rate design and pricing principles; and (iv) regulatory and legislative frameworks. With respect to "rate design and pricing principles," the DPUC stated that the pricing of all services must be more in line with the costs of providing these services. Historically, to provide universal service, basic residential services have been subsidized by other tariffed services, primarily message toll and business services. In regard to the regulatory and legislative framework, the DPUC endorsed the concept of incentive-based regulation as a potentially more effective and efficient regulatory system than the present rate of return regulation. The Final Decision-II authorized a rate of return on the Telephone Company's common equity ("ROE") of 11.65% and an increase in intrastate revenue of $37.5 million effective July 7, 1993. The Telephone Company was authorized previously to earn a 12.75% ROE. On August 13, 1993, the DPUC granted the Telephone Company an additional revenue requirement of $1.9 million to the $37.5 million previously awarded based on a review of certain areas requested by the Telephone Company. The total increase in intrastate revenue of $39.4 million is virtually offset by the approximate $40 million increase in capital recovery. In addition, the Final Decision-II addressed areas of infrastructure modernization and incentive regulation. Under infrastructure modernization, the Final Decision-II supported, but did not mandate, implementation of an infrastructure modernization program. On December 3, 1993, the Telephone Company sought approval from the DPUC to allow the Telephone Company to develop and provide electronic information services ("EIS"), including electronic publishing services. Since 1984, dramatic industry changes in technology, regulation and competition have eliminated any need for such a restriction. For the last three years, AT&T and the Regional Bell Operating Companies ("RBOCs") have been permitted to enter the electronic publishing and information services markets. For the same reasons that the U.S. District Court lifted the ban on information services and electronic publishing services for AT&T and the RBOCs, the Company believes that the DPUC should lift the ban on the Telephone Company offering of EIS. A hearing in this matter is expected in the first half of 1994. State legislation, signed into law effective July 1, 1993, authorized the formation of a task force to study Connecticut's telecommunications infrastructure and policies. Draft legislation, based on the recommendations the task force submitted in February 1994, provides a framework to move forward with a new regulatory model for Connecticut. This model would move telecommunications toward a fully competitive marketplace and provide alternative forms of regulation. Overall, the goals of the draft legislation are to: (i) ensure high-quality and affordable universal telecommunications service for Connecticut customers; (ii) promote effective competition and the development of an advanced infrastructure; and (iii) enhance the efficiency of government, educational, and health care facilities through telecommunications. Intrastate Rates The Final Decision-II established rates designed to achieve the increase in intrastate revenue of $39.4 million. The following major provisions were included in the Final Decision-II: (i) reductions in intrastate toll rates including several toll discount plans; (ii) an increase in basic local exchange rates for residential and business customers to be phased in over a two-year period; (iii) a reduction in the pricing ratio gap between business and residential basic local service over a two-year period: (iv) a $7.00 per month Lifeline credit for low-income residential customer; (v) an increase in local calling service areas for most customers with none being reduced: (vi) an increase in the local coin telephone rate from $.10 to $.25; (vii) an increase in the directory assistance charge from $.24 to $.40 and a decrease in the number of "free" directory assistance calls; and (viii) a late payment charge of 1% monthly effective January 1, 1994. This rate award was implemented on July 9, 1993 through a combination of increases for coin telephone calls, directory assistance calls along with an approximate 15% interim surcharge on the remaining products and services with authorized increases including local exchange. On July 22, 1993, the DPUC issued a supplemental decision reducing the interim surcharge implemented on July 9, 1993 to approximately 8%. The Telephone Company issued credits during August of 1993 to customers who were charged at the higher rate. The 8% surcharge was in effect until October 9, 1993, when the remaining new rates became effective, including an average increase in residential basic local exchange rates of $.32 a month and a slight decrease in average monthly business rates. In addition, residential basic local exchange rates will increase $.31 a month and business rates will decrease an average of $.84 a month beginning in July 1994. At December 31, 1993, the Telephone Company's intrastate ROE was below the authorized 11.65%. Federal Regulatory Matters The Telephone Company is subject to the jurisdiction of the FCC with respect to interstate rates, services, video dial tone, access charges and other matters, including the prescription of a uniform system of accounts and the setting of depreciation rates on plant utilized in interstate operations. The FCC also prescribes the principles and procedures (referred to as "separations procedures") used to separate investments, revenues, expenses, taxes and reserves between the interstate and intrastate jurisdictions. In addition, the FCC has adopted accounting and cost allocation rules for the separation of costs of regulated from non-regulated telecommunications services for interstate ratemaking purposes. ratemaking purposes. Federal Regulation On July 1, 1993, the FCC, in connection with its normal triennial review of depreciation, granted the Telephone Company new depreciation rates retroactive to January 1, 1993. The new rates increased depreciation expense by approximately $11 million in 1993. Under current price cap regulation, however, any changes in depreciation rates cannot be reflected in interstate access rates (see "Interstate Rates," below). On January 19, 1994, the Telephone Company filed suit in the U.S. District Court in New Haven claiming that the Cable Communications Policy Act of 1984 ("Cable Act") violates the Telephone Company's First and Fifth Amendment rights. The Cable Act limits the in-territory provision of cable programming by LECs such as the Telephone Company. The Cable Act currently prohibits LECs from owning more than 5% of any company that provides cable programming in their local service area. Since January 1, 1988, the Telephone Company has utilized an FCC approved, company specific Cost Allocation Manual ("CAM"), which apportions costs between regulated and non-regulated activities, and describes transactions between the Telephone Company and its affiliates. In addition, the FCC requires larger LECs, including the Telephone Company, to undergo an annual independent audit to determine whether the LEC is in compliance with its approved CAM. The Telephone Company has received audit reports for 1988 through 1992 indicating it is in compliance with its CAM, and is currently undergoing an audit for the year 1993. Interstate Rates The Telephone Company elected price cap regulation effective July 1, 1991. Under price cap regulation, which replaces traditional rate of return regulation, prices are no longer tied directly to the costs of providing service, but instead are capped by a formula that includes adjustments for inflation, assumed productivity increases, and "exogenous" factors, such as changes in accounting principles, in FCC cost separation rules, and taxes. The treatment as exogenous of various factors affecting a company's costs is subject to FCC interpretation. By electing price cap regulation, the Telephone Company is provided the opportunity to earn a higher interstate rate of return than that allowed under traditional rate of return regulation. However, price cap regulation presents additional risks since it establishes limits by which the Telephone Company is able to increase rates, even if the Telephone Company's interstate rate of return falls below the authorized rate of return. The Telephone Company is allowed to annually elect a productivity offset factor of 3.3% or 4.3%. Since price cap regulation was elected in July 1991, the Telephone Company has selected the 3.3% productivity factor and does not anticipate changing its election for the next tariff period. Choosing the 3.3% factor, the Telephone Company is allowed to earn up to a 12.25% interstate rate of return annually. Earnings between 12.25% and 16.25% would be shared equally with customers, and earnings over 16.25% would be returned to customers. Any amounts returned to customers would be in the form of prospective rate reductions. In addition, the Telephone Company's ability to achieve or exceed its interstate rate of return will depend, in part, on its ability to meet or exceed the assumed productivity increase. As of December 31, 1993, the Telephone Company's interstate rate of return was below the 12.25% threshold. The Telephone Company filed tariffs under price cap regulation on April 2, 1993 which took effect on July 2, 1993, subject to the FCC's further investigation. The Telephone Company will file its 1994 annual interstate access tariff filing on April 1, 1994 to become effective July 1, 1994. The filing will adjust interstate access rates for an experienced rate of inflation, the FCC's productivity target, and exogenous cost changes, if any. In January 1994, the FCC began its scheduled inquiry into the price cap plan for LECs, to determine whether to revise the current plan to improve its performance in meeting the FCC's objectives. Results of this inquiry are expected in late 1994 or early 1995. In an order released on January 9, 1990, which did not directly apply to the Telephone Company, the FCC established a precedent whereby a customer has a right to recover damages if they can establish that a LEC exceeded its authorized rate of return. The FCC, in a March 1993 order responding to a complaint filed by Sprint Communications Company ("Sprint") alleging overearnings in switched traffic sensitive access charges, affirmed the Telephone Company's right to offset overearnings in one access category with underearnings in another category, and held that the Telephone Company had no liability. Sprint has appealed the order to the U.S. Court of Appeals. Regulated Operations The network access lines provided by the Telephone Company to customers' premises can be interconnected with the access lines of other telephone companies in the United States and with telephone systems in most other countries. The following table sets forth, for the Telephone Company, the number of network access lines in service at the end of each year and the number of intrastate toll and intrastate WATS messages handled for each year: 1993 1992 1991 1990 1989 Network Access Lines in Service 1,964 1,937 1,922 1,904 1,875 (in thousands) Intrastate Toll and WATS Messages 524 526 516 521 523 (in millions The Telephone Company has been making, and expects to continue to make, significant capital expenditures to meet the demand for regulated telecommunications services and to further improve such services (see discussion of I-SNET in "Competition"). The total gross investment in telephone plant increased from approximately $3.4 billion at December 31, 1988 to approximately $4.0 billion at December 31, 1993, after giving effect to retirements, but before deducting accumulated depreciation at either date. Since 1989, cash expended for capital additions was as follows: Dollars in millions 1993 1992 1991 1990 1989 Cash Expended for Capital Additions $231.6 $269.1 $296.3 $370.0 $338.8 In 1993, the Telephone Company funded its cash expenditures for capital additions entirely through cash flows from operations. In 1994, capital additions are expected to be approximately $230 million. The Telephone Company expects to fund substantially all of its 1994 capital additions through cash flows from operations. The Telephone Company currently accounts for the economic effects of regulation in accordance with the provisions of SFAS No. 71, "Accounting for the Effects of Certain Types of Regulation." In the event recoverability of operating costs through rates becomes unlikely or uncertain, whether resulting from competitive effects or specific regulatory actions, SFAS No. 71 would no longer apply. The financial impact of an accounting change, should the Telephone Company no longer qualify for the provisions of SFAS No. 71, would be material. Competition The Telephone Company's regulated operations are subject to competition from companies, carriers and competitive access providers which construct and operate their own communications systems and networks for the provision of services to others. At present, regulation continues to provide for a system of subsidies which prevent the Telephone Company's prices from moving toward the cost of providing the service. The Telephone Company's ability to compete depends to some degree on the action of regulators regarding the pricing of local, toll and network access services, and on the Telephone Company's continuing ability to manage its costs effectively. In the Final Decision-I, the DPUC concluded that currently authorized intrastate competition has not adversely affected either service availability or cost, and that a broadened scope of intrastate competitive participation was prudent and warranted. Accordingly, the DPUC found that 10XXX calling and resale competition were in the public interest and should be allowed beginning July 7, 1993 in accordance with recently enacted State legislation. Using 10XXX calling, customers can use any certified carrier for interexchange calling within Connecticut by dialing 1, 0, and XXX (a three-digit carrier code). Terms and conditions associated with the provision of specialized/ancillary services, including monitoring, reporting and compensation, would no longer apply. Since the issuance of Final Decision-I, several interexchange carriers have filed applications with and received approval from the DPUC to offer 10XXX intrastate long-distance service. In addition, a number of resellers have filed for initial certificates of public convenience and necessity. The Telephone Company anticipates additional applications will be filed. The introduction of competition to intrastate long- distance service and the Telephone Company's reduction in intrastate toll rates will further erode the Telephone Company's intrastate toll revenues. Pursuant to Final Decision-I, the Telephone Company filed on October 1, 1993 its proposed implementation plan for equal access based on customer preference for dual primary interexchange carrier capability (ability to choose one carrier for interstate calling and either the same or a different carrier for intrastate long distance calling). The Telephone Company's position regarding cost recovery remains that interexchange carriers should pay for the direct costs of implementing equal access. Regarding competition for local exchange services, in January 1994, MCI announced plans to construct and operate local communication networks in large markets throughout the United States, including parts of Connecticut in which the Telephone Company operates. These networks would allow MCI to bypass the Telephone Company's facilities and provide services directly to customers. Pending DPUC approval, these services are expected to be available in Connecticut within two to three years. Also in January 1994, the Telephone Company announced that it had reached an agreement to lease part of its existing digital fiber optic ring network in the greater Hartford metropolitan area to MFS Communications, Inc ("MFS"). This agreement allows MFS to provide services to large business customers on an intraexchange basis and eliminates the need for MFS to construct their own facilities. Teleport Communications Group, another competitive access provider, recently announced plans to provide local telephone links for interstate services to businesses and long distance companies in the Hartford area. In an order adopted in September 1992, the FCC required certain LECs, including the Telephone Company, to offer expanded special access interconnection to all interested parties, permitting competitors to terminate their own transmission facilities in LEC central offices. The Telephone Company filed tariffs which were implemented in June 1993, subject to investigation, and was granted some additional pricing flexibility in light of this increased competition. In August 1993, the FCC adopted rules, which largely mirror the requirements adopted in September 1992 for special access interconnection, requiring certain LECs, including the Telephone Company, to offer expanded interstate switched access interconnection. The Telephone Company tariffs which implemented changes associated with switched access interconnection became effective in February 1994. The Telephone Company has received applications from competitive access providers for special access interconnection in selected central offices of the Telephone Company. The Telephone Company anticipates additional applications for both special and switched access interconnection will be filed. A number of LECs, including the Telephone Company, have appealed the FCC's orders to offer special and switched access interconnection. Oral arguments on the appeal of the special access order were heard in February 1994 with a decision expected later in 1994. The appeal of the switched access order has been delayed pending a decision on the special access appeal. The Telephone Company, expecting to see continued movement toward a fully competitive telecommunications marketplace, both on an interexchange and intraexchange basis, has taken several steps to effectively position itself. On January 13, 1994, the Telephone Company announced its intention to invest $4.5 billion over the next 15 years to build a statewide information superhighway ("I-SNET"). I-SNET will be an interactive multimedia network capable of delivering voice, video and a full range of information and interactive services. The Telephone Company expects I-SNET will reach approximately 500,000 residences and businesses thru 1997. In addition, the Telephone Company has reduced its intrastate toll rates beginning in July 1993 [see Item 1., "Intrastate Rates"], is committed to reducing its cost structure, remains focused on providing quality customer service and has introduced several new services as mentioned below. New Services On March 31, 1993, the Telephone Company together with Sprint announced the introduction of 800 CustomLink Service (service mark). This service allows the Telephone Company to offer it business customers an 800 service enabling them to receive calls from anywhere in the United States as well as international locations. In 1993, the Telephone Company launched the next generation of CentraLink products, CentraLink (service mark) 3100. CentraLink 3100 is a central-office based product that allows flexibility to add additional phone lines, locations and features to adapt to customers' changing telecommunications requirements. In 1993, the Corporation established SNET America, Inc. ("SNET America") under the laws of Connecticut. SNET America offers a complete range of interstate and international long distance services to Connecticut customers, including calling card and 800 service, along with volume discount plans such as Distance Plus (service mark). Distance Plus offers graduated discounts where the discount increases as the usage increases. SNET America began offering service in the third quarter of 1993. Under a proposed marketing arrangement between the Telephone Company and SNET America filed with the DPUC on January 7, 1994, the Telephone Company anticipates selling SNET America's interstate and international products, and SNET America will sell the Telephone Company's intrastate products. This arrangement will enable the Corporation to satisfy its customers complete long distance calling needs with a single point of contact. On October 21, 1993, the FCC approved the Telephone Company's application to construct, operate, own, and maintain facilities to conduct a technology and marketing trial for use in providing video dial tone service in West Hartford, Connecticut. With construction of the fiber optic and coaxial facilities completed, the trial began in early 1994. The trial, offered to approximately 500 customers, provides hundreds of choices of videos. On December 15, 1993, the Telephone Company filed a request with the FCC for an expansion of this trial. The proposal seeks to provide this service to an additional 20,000 customers in other areas of Connecticut. On December 22, 1993, the Telephone Company filed with the DPUC its application to conduct a market trial for Digital Enhancer, an Integrated Services Digital Network offering. Digital Enhancer provides customers with integrated voice and data communications capabilities on a single telephone access line. Digital Enhancer will be offered from specially equipped digital central offices and will require customer- provided terminal equipment to access and use the service. This service will enable customers to reduce their telecommunications costs by reducing wiring requirements, increase productivity through increased data transmission speed, and improve quality of service through reduced data error rates. Directory Publishing The Telephone Company's directory publishing operation remains sensitive to the Connecticut economy. The continuing decline in new business formations and the acceleration of business failures within the State will further suppress advertising growth potential in the near term. The Connecticut advertising marketplace continues to undergo major structural changes and is becoming increasingly more fragmented and competitive. Directory publishing faces potential increased competition from non-traditional services such as desktop publishing, electronic shopping services and the expansion of cable television. Furthermore, additional competition may arise from the regional BOCs' ability to now offer information services. The Telephone Company's directory publishing operation will continue to strategically widen its business focus and respond to emerging market opportunities to position itself effectively against this potential competition [see discussion of EIS in Item 1., "State Regulation"]. PERSONAL COMMUNICATIONS SERVICES The Corporation provides personal communications services, which consist of wholesale and retail cellular telephone communications and paging services, through its subsidiaries SNET Cellular, Inc. ("Cellular"), SNET MobileCom, Inc. ("MobileCom") and SNET Paging, Inc. ("Paging"). SNET Cellular, Inc. Cellular was incorporated in 1985 under the laws of the State of Connecticut. In 1990, Cellular formed the Springwich Cellular Limited Partnership ("Springwich") with NYNEX Mobile Communications Company ("NYNEX Mobile"), The Granby Telephone and Telegraph Company of Massachusetts, Inc., The Woodbury Telephone Company and a fifth partner (New York SMSA Limited Partnership, of which NYNEX Mobile is the managing partner). Springwich is authorized to provide wholesale cellular radio telecommunications services in the Hartford, New Haven, New London, and Fairfield, Connecticut New England County Metropolitan Areas ("NECMAs") and in the Springfield, Massachusetts NECMA. Springwich also is licensed to provide cellular wholesale service in three Rural Service Areas ("RSA"), Windham and Litchfield Counties in Connecticut and Franklin County in Massachusetts. The combined population of this region is approximately 4 million. Springwich is currently subject to FCC, DPUC and the Massachusetts Department of Public Utility jurisdictions. In January of 1993, Cellular incorporated SNET Springwich, Inc. ("SSI"), a wholly owned subsidiary of Cellular. Cellular transferred a 32% general partnership interest in Springwich to SSI in both 1993 and 1994 and anticipates transferring the remaining 18.5% partnership interest in Springwich to SSI in 1995. Springwich has "roamer agreements" with other cellular carriers which allow customers of Springwich access to cellular markets throughout the United States and Canada and allow customers of other carriers to use Springwich's network. On July 31, 1990, Springwich petitioned the DPUC to initiate a proceeding to address whether the conditions necessary to forebear from rate regulation of cellular mobile telephone service in Connecticut NECMAs were present, as required of the DPUC under Connecticut legislation enacted in 1985. Subsequent to the petition, the DPUC initiated a proceeding (Docket No. 90-08-03) to address this issue. In 1991, the DPUC issued a decision denying Springwich's petition for forbearance citing that the record did not indicate that forbearance would enhance or expedite the evolution of the cellular marketplace. On December 16, 1992, the DPUC reopened Docket No. 90-08-03 to reconsider its 1991 decision. The DPUC closed this docket on December 15, 1993 without a decision. Pursuant to a recent federal law, state regulation of cellular activities is pre-empted unless the FCC approves a petition by the state regulatory agency to continue its regulatory scheme. Such a filing, if one is to be made, must be done by August 10, 1994., In February 1993, Cellular announced that it had joined with other major mobile communications companies to form MobiLink (service mark) Partners. In July 1993, the MobiLink Partners set common standards for cellular service nationwide under the new brand name Mobilink (service mark). Mobilink includes a number of innovations designed to make cellular service easier to use and accessible to more cellular phone users across much of the United States and Canada. On October 22, 1993, the FCC issued a report and order allocating radio spectrum to be licensed for use in providing personal communications services ("PCS"). These bandwidths of spectrum could provide new services such as advanced voice paging, two-way acknowledgment paging, data messaging, electronic mail and facsimile transmissions. Under the order, separate bandwidths would be auctioned to potential PCS providers in each geographic area of the United States. The FCC is seeking comments on the design of the auction process, financing alternatives for special interest licenses, and the classes of licenses and permits that should be included in the competitive bidding process. The auction of these bandwidths of spectrum will allow additional competitors to enter the market place Springwich serves. In 1992, Bell Atlantic Corporation ("Bell Atlantic") completed the acquisition of Metro Mobile CTS, Inc., a non-wireline provider of cellular services that operates in Springwich markets. Bell Atlantic, which operates under the name Bell Atlantic Mobile, has substantial capital, technological and marketing resources. Cellular has made and will continue to make significant investments in network expansion and enhancements in order to effectively compete. SNET MobileCom, Inc. MobileCom was incorporated in 1985 under the laws of the State of Connecticut. MobileCom purchases wholesale cellular communications service from Springwich and resells cellular communications service to the retail market under the servicemark LINX in Springwich's serving area. MobileCom markets its services through its internal sales force and through agreements with third-party distributors. MobileCom anticipates continuing competition from local, regional and national resellers. Over the past few years, intense competition for new customers has led to increases in selling and promotional costs. MobileCom anticipates that this trend will continue into the foreseeable future. In response to this competition, MobileCom has offered a new cellular service plan called Linx Omni that provides customers with a package of cellular services plus a free cellular phone when the customer signs a 24 month service agreement. SNET Paging, Inc. Paging was incorporated in February 1990 under the laws of the State of Connecticut. Paging launched service on April 1, 1991. Paging provides its customers with tone, numeric and alphanumeric paging services through its service trademark Page 2000 (service mark). Customers have a choice of either selecting local or regional coverage. Paging also serves as a reseller of SkyTel, a nationwide paging service. Currently Paging's network is capable of providing services in Connecticut, most of Massachusetts, southern New Hampshire, Rhode Island, Metropolitan New York City, and northern New Jersey. TNI Associates, Inc. ("TNIA"), formerly SNET Paging Acquisition Corporation, a wholly owned subsidiary of Paging, also was formed in February 1990 under the laws of the State of Connecticut. In October 1993, TINA purchased the remaining 50.5% partnership interest in the net assets of TNI Associates (the "TNI Partnership") from Telecommunications Network, Inc. The TNI Partnership business purchased by TNIA operates a wide area paging network covering the seaboard area from Metropolitan New York to southern New Jersey and Philadelphia. Paging has three primary competitors in the Northeast region it serves. One is dominant in the Connecticut marketplace and is perceived as offering competitive pricing and a high quality network. The second offers multistate and regional services that focus on large metropolitan markets with less emphasis on Connecticut. The last is a large national carrier that offers the lowest price with an apparent strategy of building market share rapidly. SNET DIVERSIFIED GROUP, INC. SNET Diversified Group, Inc. ("Diversified") was incorporated in 1986 under the laws of the State of Connecticut in order to identify and develop new, non-regulated business opportunities. The majority of Diversified's activities are leasing and selling CPE to residential and small business customers. Prior to 1988, embedded CPE was leased under regulation to customers by the Telephone Company. As part of the 1993 SNET Systems, Inc. ("Systems") reorganization, Diversified established a new division, Business Communications, which continues to offer and maintain certain key products that are complementary to the Telephone Company's central-office based solutions. SNET Premium Services, which offers network related activities such as ConnNet (service mark) and Conference Calling, was transferred from the Telephone Company to Diversified effective January 1, 1993. Diversified faces significant competition from numerous department store, discount store, and business equipment retailers that carry CPE. Diversified has differentiated its product line from its competitors by offering a wide array of quality products coupled with superior customer assistance and by offering customers leasing options. SNET REAL ESTATE, INC. SNET Real Estate, Inc. ("Real Estate") was incorporated in 1983 under the laws of the State of Connecticut. Real Estate is an owner of commercial property which it leases under operating leases and is a participant in a partnership that also leases commercial property. Currently, Real Estate is managing its existing portfolio and is not actively pursuing additional real estate investments. Real Estate faces a risk that real estate markets in which its properties are located, primarily Connecticut, may further deteriorate from their current condition. This risk is minimized by the conservative nature of Real Estate's portfolio, a majority of which is leased to affiliates. SNET SYSTEMS, INC. SNET Systems, Inc. ("Systems") was incorporated in 1986 under the laws of the State of Connecticut and was subsequently dissolved in December 1993. Systems marketed a full range of sophisticated communications systems and services primarily to large business customers as well as provided consulting, installation and maintenance services related to communications systems. On January 15, 1993, the Corporation announced that it would disband Systems and reassign its functions and employees to other organizations within the Corporation. This reorganization of Systems' operations is in line with the Corporation's strategy to focus on the Telephone Company's central-office based solutions. As discussed previously, a new division of Diversified, Business Communications, was formed as a result of this reorganization and will continue to offer and maintain certain key products that are complementary to central-office based solutions. SNET CREDIT, INC. SNET Credit, Inc. ("Credit") was incorporated in 1983 under the laws of the State of Connecticut. Credit provided lease financing of telecommunications and other equipment for Systems and third parties under operating, direct-financing and leveraged leases. In September 1992, the Corporation announced its intention to withdraw from the finance business by phasing out the activities of Credit because it no longer fit into the Corporation's long-term strategic business plan. During the first and second quarters of 1993, Credit sold portions of its direct-financing lease portfolio. Certain existing leveraged leases and direct financing leases have been retained as investments. Employee Relations The Corporation and its subsidiaries employed approximately 9,820 persons at February 28, 1994, of whom approximately 68% are represented by The Connecticut Union of Telephone Workers, Inc. ("CUTW"), an unaffiliated union. In December 1993, the Corporation announced a business restructuring program designed to reduce costs and will result in approximately 2,500 employees exiting the business over the next two to three year period. Item 2. Item 2. Properties The principal properties of the Corporation and its subsidiaries do not lend themselves to a detailed description by character and location. The majority of telecommunications plant, property and equipment of the Corporation and its subsidiaries is owned by the Telephone Company. Of the Corporation's investment in telecommunications plant, property and equipment at December 31, 1993, central office equipment represented 39%; connecting lines not on customers' premises, the majority of which are on or under public roads, highways or streets and the remainder on or under private property, represented 35%; land and buildings (occupied principally by central offices) represented 12%; telephone instruments and related wiring and equipment, including private branch exchanges, substantially all of which are on the premises of customers, represented 2%; and other, principally vehicles and general office equipment, represented 12%. Substantially all of the central office equipment installations and administrative offices are located in Connecticut in buildings owned by the Telephone Company situated on land which it owns in fee. Many garages, service centers and some administrative offices are located in rented quarters. The Corporation has a significant investment in the properties, facilities and equipment necessary to conduct its business wherein the overwhelming majority of this investment relates to telephone operations. Management believes that the Corporation's facilities and equipment are suitable and adequate for the business. As discussed previously, the Telephone Company plans to invest $4.5 billion over the next 15 years to build I-SNET. The Telephone Company plans to support this investment primarily through increased productivity from the new technology deployed, ongoing cost containment initiatives and customer demand for the new services offered. The Telephone Company does not plan to request a rate increase for this investment. Item 3. Item 3. Legal Proceedings The Corporation and certain of its subsidiaries are involved in various claims and lawsuits that arise in the normal conduct of their business. In the opinion of management, upon advice of counsel, these claims will not have a material adverse effect on the Telephone Company or the Corporation. Item 4. Item 4. Submission of Matters to a Vote of Security Holders No matter was submitted to a vote of security holders in the fourth quarter of the fiscal year covered by this report. Executive Officers of the Registrant (1) (as of January 1, 1994) Executive Officer Name Age(2) Position Since Daniel J. Miglio 53 Chairman, President and Chief Executive Officer 1/86 Robert F. Neal 58 Senior Vice President- Organization Development 1/87 Ronald M. Serrano 38 Senior Vice President- Corporate Development 1/93 Donald R. Shassian 38 Senior Vice President and Chief Financial Officer 12/93 Madelyn M. DeMatteo 45 Vice President, General Counsel and Secretary 5/90 John A. Sadek 60 Vice President and Comptroller 1/86 (1) Includes executive officers subject to Section 16 of the Securities Exchange Act of 1934. (2) As of December 31, 1993. Mr. Miglio, Mr. Neal, Mr. Sadek and Ms. DeMatteo have held high level managerial positions with the Corporation or its subsidiaries for more than the past five years. Mr. Serrano was a Vice President of Mercer Management Consulting, Inc., (formerly Strategic Planning Associates) for more than five years prior to joining the Corporation. Mr. Shassian was a partner with Arthur Andersen & Co., independent accountants, for more than five years prior to joining the Corporation. PART II Item 5. Item 5. Market for the Registrant's Common Stock and Related Stockholder Matters The common stock of the Corporation is listed on the New York and Pacific stock exchanges and the number of holders of record, computed on the basis of registered accounts, were approximately 57,177 as of February 28, 1994. Information with respect to the quarterly high and low sales price for the Corporation's common stock and quarterly cash dividends declared is included in the registrant's Annual Report to Stockholders on page 48 under the caption "Market and Dividend Data" and is incorporated herein by reference pursuant to General Instruction G(2). Items 6 through 8. Information required under Items 6 through 8 is included in the registrant's Annual Report to Stockholders for the fiscal year ended December 31, 1993 on pages 18 through 47 in their entirety and 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 or disagreements with accountants on any accounting or financial disclosure occurred during the period covered by this report. PART III Items 10 through 13. Information required under Items 10 through 13 is included in the registrant's Proxy Statement dated March 28, 1994 on pages 1 (commencing under the caption "Proxy Statement") through 17. Such information is incorporated herein by reference. Information regarding executive officers of the registrant required by Item 401(b) and (e) of Regulation S-K is included in Part I of this Annual Report on Form 10-K following Item 4. PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules, and Page Reports on Form 8-K (a) Documents filed as part of the report: (1) Report on Consolidated Financial Statements * Report of Audit Committee * Report of Independent Accountants * Consolidated Financial Statements: Consolidated Statement of (Loss) Income - for the years ended December 31, 1993, 1992 and and 1991 * Consolidated Balance Sheet - as of December 31, 1993 and 1992 * Consolidated Statement of Changes in * Stockholders' Equity - for the years ended December 31, 1993, 1992, 1991 * Consolidated Statement of Cash Flows - for the years ended December 31, 1993, 1992 and 1991 * Notes to Consolidated Financial Statements * (2) Consolidated Financial Statement Schedules for the year ended December 31, 1993 Report of Independent Accountants 24 V - Telecommunications Plant, Property and 25 Equipment VI - Accumulated Depreciation 29 VIII - Valuation and Qualifying Accounts 30 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 applicable. * Incorporated herein by reference to the appropriate portions of the registrant's Annual Report to Stockholders for the fiscal year ended December 31, 1993 (see Part II). (3) Exhibits: Exhibits identified in parentheses below, on file with the SEC, are incorporated herein by reference as exhibits hereto. Exhibit Number 3a Amended and Restated Certificate of Incorporation of the registrant as filed June 14, 1990 (Exhibit) 3-A to Form SE dated 3/15/91, File No. 1-9157). 3b By-Laws of the registrant as amended and restated through October 10, 1990 (Exhibit 3 to Form 8-K dated 10/10/90, File No. 1-9157). 4a Rights Agreement dated February 11, 1987 between Southern New England Telecommunications Corporation and The State Street Bank and Trust Company, as Rights Agent (Exhibit 1 to Form SE dated 2/13/87-1, File No. 1-9157). Amendment No. 1 dated December 13, 1989 (Exhibit 4 to Form SE dated 12/28/89, File No. 1-9157). Amendment No. 2 dated October 10, 1990 (Exhibit 4 to Form SE dated 10/12/90, File No. 1-9157). 4b No instrument which defines the rights of holders of long-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. 10 (iii)(A)1 SNET Short Term Incentive Plan as amended March 1, 1993 (Exhibit 10(iii)(A)1 to 1992 Form 10-K dated 3/23/93, File No. 1-9157). 10 (iii)(A)2 SNET Long Term Incentive Plan as amended March 1, 1993 (Exhibit 10(iii)(A)2 to 1992 Form 10-K dated 3/23/93, File No. 1-9157). 10 (iii)(A)3 SNET Financial Counseling Program as amended January 1987 (Exhibit 10-D to Form SE dated 3/23/87-1, File No. 1-9157). 10 (iii)(A)4 Group Life Insurance Plan and Accidental Death and Dismemberment Benefits Plan for Outside Directors of SNET as amended July 1, 1986 (Exhibit 10-E to Form SE dated 3/23/87-1, File No. 1-9157). 10 (iii)(A)5 SNET Executive Non-Qualified Pension Plan and Excess Benefit Plan as amended November 1, 1991 (Exhibit 10-A to Form SE dated 3/20/92, File No. 1-9157). Amendments dated December 8, 1993. (3) Exhibits (continued): Exhibit Number 10 (iii)(A)6 SNET Management Pension Plan as amended November 1, 1987 (Exhibit 10-C to Form SE dated 3/21/88-1, File No. 1-9157). Amendments dated September 1, 1988 and January 1, 1989 (Exhibit 10-C to Form SE dated 3/21/89, File No. 1-9157). Amendments dated January 1, 1989 through August 6, 1989 (Exhibit 10-B to Form SE dated 3/20/90, File No. 1-9157). Amendments dated June 5, 1991 through September 25, 1991 (Exhibit 10-B to Form SE dated 3/20/92, File No. 1-9157). Amendments dated January 1, 1993 (Exhibit 10(iii)(A)6 to 1992 Form 10-K dated 3/23/93, File No. 1-9157). Amendments dated September 8, 1993 through December 8, 1993. 10 (iii)(A)7 SNET Incentive Award Deferral Plan as amended March 1, 1993 (Exhibit 10(iii)(A)7 to 1992 Form 10-K dated 3/23/93, File No. 1-9157). 10 (iii)(A)8 SNET Mid-Career Pension Plan as amended November 1, 1991 (Exhibit 10-D to Form SE dated 3/20/92, File No. 1-9157). Amendments dated December 8, 1993. 10 (iii)(A)9 SNET Deferred Compensation Plan for Non-Employee Directors as amended January 1, 1993 (Exhibit 10(iii)(A)9 to 1992 Form 10-K dated 3/23/93, File No. 1-9157). 10 (iii)(A)10 Change-in-Control Agreements (Exhibit 10-F to Form SE dated 3/15/91, File No. 1-9157). 10 (iii)(A)11 SNET 1986 Stock Option Plan as amended March 1, 1993 (Exhibit 10(iii)(A)11 to 1992 Form 10-K dated 3/23/93, File No. 1-9157). 10 (iii)(A)12 SNET Retirement and Disability Plan for Non- Employee Directors as amended April 14, 1993. 10 (iii)(A)13 SNET Non-Employee Director Stock Plan effective January 1, 1994 (Exhibit 4.4 to Registration No. 33-51055, File No. 1-9157) 10 (iii)A)14 Description of SNET Executive Retirement Savings Plan. 12 Computation of Ratio of Earnings to Fixed Charges. 13 Pages 18 through 48 of the registrant's Annual Report to Shareholders for the fiscal year ended December 31, 1993. 21 Subsidiaries of the Corporation. 23 Consent of Independent Accountants. (3)Exhibits (continued): Exhibit Number 24a Powers of Attorney. 24b Board of Directors' Resolution. 99a Annual Report on Form 11-K for the plan year ended December 31, 1993 for the SNET Management Retirement Savings Plan will be filed as an amendment prior to June 30, 1994. 99b Annual Report on Form 11-K for the plan year ended December 31, 1993 for the SNET Bargaining Unit Retirement Savings Plan will be filed as an amendment prior to June 30, 1994. The Corporation will furnish, without charge, to a stockholder upon request a copy of the Annual Report to Shareholders and Proxy Statement, portions of which are incorporated by reference, and will furnish any other exhibit at cost. (b) Reports on Form 8-K: On November 3, 1993, the Corporation and the Telephone Company filed, separately, reports on Form 8-K, dated November 3, 1993, announcing that effective December 1, 1993, Donald R. Shassian, will assume the position of Senior Vice President and Chief Financial Officer of both the Corporation and the Telephone Company. On December 8, 1993, the Corporation and the Telephone Company filed, separately, reports on Form 8-K, dated December 8, 1993, announcing charges against fourth quarter earnings totaling $4.08 per common share. These charges include a restructuring charge for workforce and reengineering reductions, a refinancing charge and a charge for discontinued operations. On January 25, 1994, the Corporation and the Telephone Company filed, separately, reports on Form 8-K, dated January 24, 1994, announcing the Corporation's 1993 financial results. 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 NEW ENGLAND TELECOMMUNICATIONS CORPORATION By /s/ J. A. Sadek J. A. Sadek, Vice President and Comptroller, 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 date indicated. PRINCIPAL EXECUTIVE OFFICER: D. J. Miglio* Chairman, President, Chief Executive Officer and Director PRINCIPAL FINANCIAL AND ACCOUNTING OFFICERS: D. R. Shassian* Senior Vice President and Chief Financial Officer J. A. Sadek By /s/ J. A. Sadek Vice President and Comptroller (J. A. Sadek, as attorney-in-fact and on his own behalf) DIRECTORS: F. G. Adams* William F. Andrews* Richard H. Ayers* Zoe Baird* Barry M. Bloom* F. J. Connor* William R. Fenoglio* March 23, 1994 Claire L. Gaudiani* J. R. Greenfield* N. L. Greenman* Worth Loomis* Burton G. Malkiel* Frank R. O'Keefe, Jr.* *by power of attorney REPORT OF INDEPENDENT ACCOUNTANTS To the Stockholders of Southern New England Telecommunications Corporation: Our report on the consolidated financial statements of Southern New England Telecommunications Corporation has been incorporated by reference in this Form 10-K from the 1993 Annual Report to Stockholders of Southern New England Telecommunications Corporation on page 29 therein. In connection with our audits of such financial statements, we have also audited the related financial statement schedules for each of the three years in the period ended December 31, 1993 listed in Item 14 (a) (2) of this Form 10-K. 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 required to be included therein. Hartford, Connecticut COOPERS & LYBRAND January 24, 1994 Schedule V - Sheet 1 SOUTHERN NEW ENGLAND TELECOMMUNICATIONS CORPORATION SCHEDULE V--TELECOMMUNICATIONS PLANT, PROPERTY and EQUIPMENT (Millions of Dollars) COL. A COL. B COL. C COL. D COL. E COL. F Balance at Additions Retirements Other Balance Year 1993 beginning at cost - Note (b) Changes at end Classification of period - Note(a) - Note (c) of period Land $ 28.4 $ .7 $ - $ - $29.1 Buildings 437.9 27.8 9.2 .7 457.2 Central Office Equipment 1,631.5 116.4 94.2 8.6 1,662.3 Station Apparatus 59.5 8.5 .6 (3.8) 63.6 Large Private Branch Exchange 9.2 - 8.4 - .8 Pole Lines 135.6 5.5 2.4 .2 138.9 Cable 1,083.6 50.8 13.6 .1 1,120.9 Underground Conduit 212.3 9.5 .7 (.9) 220.2 Public Telephone Equipment 16.9 4.3 (1.7) - 22.9 Other Communica- tions Equipment 65.8 7.2 1.9 - 71.1 Furniture and Office Equipment 300.7 44.5 24.0 (.4) 320.8 Vehicles and Other Work Equipment 108.0 8.6 9.9 - 106.7 Telecommunications Plant Property and Equipment Under Construction 84.0 2.1 - (6.6) 79.5 Other 2.0 1.4 - 1.0 4.4 TOTAL (d) $4,175.4 $287.3 $163.2 $(1.1) $4,298.4 The notes on Sheet 4 are an integral part of this Schedule. Schedule V - Sheet 2 SOUTHERN NEW ENGLAND TELECOMMUNICATIONS CORPORATION SCHEDULE V--TELECOMMUNICATIONS PLANT, PROPERTY and EQUIPMENT (Millions of Dollars) COL. A COL. B COL. C COL. D COL. E COL. F Balance at Additions Retirements Other Balance Year 1992 beginning at cost - Note (b) Changes at end Classification of period - Note(a) - Note (c) of period Land $ 27.4 $ .8 $ - $ .2 $28.4 Buildings 423.3 21.9 4.9 (2.4) 437.9 Central Office Equipment 1,578.1 136.4 84.0 1.0 1,631.5 Station Apparatus 74.4 9.8 24.8 .1 59.5 Large Private Branch Exchange 11.5 - 2.3 - 9.2 Pole Lines 131.3 5.9 1.6 - 135.6 Cable 1,029.8 69.2 15.3 (.1) 1,083.6 Underground Conduit 197.4 15.1 .2 - 212.3 Public Telephone Equipment 19.3 .5 2.9 - 16.9 Other Communica- tions Equipment 63.6 5.9 3.6 (.1) 65.8 Furniture and Office Equipment 281.5 30.7 11.0 (.5) 300.7 Vehicles and Other Work Equipment 99.6 15.5 6.8 (.3) 108.0 Telecommunications Plant Property and Equipment Under Construction 92.7 (7.9) - (.8) 84.0 Other 1.0 1.0 - - 2.0 TOTAL (d) $4,030.9 $304.8 $157.4 $(2.9) $4,175.4 The notes on Sheet 4 are an integral part of this Schedule. Schedule V - Sheet 3 SOUTHERN NEW ENGLAND TELECOMMUNICATIONS CORPORATION SCHEDULE V--TELECOMMUNICATIONS PLANT, PROPERTY and EQUIPMENT (Millions of Dollars) COL. A COL. B COL. C COL. D COL. E COL. F Balance at Additions Retirements Other Balance Year 1991 beginning at cost - Note (b) Changes at end Classification of period - Note(a) - Note (c) of period Land $ 27.3 $ .1 $ - $ - $27.4 Buildings 396.9 27.8 1.4 - 423.3 Central Office Equipment 1,545.2 135.6 91.2 (11.5) 1,578.1 Station Apparatus 80.0 4.2 9.8 - 74.4 Large Private Branch Exchange 13.0 - 1.5 - 11.5 Pole Lines 124.6 7.7 1.0 - 131.3 Cable 979.3 65.6 15.1 - 1,029.8 Underground Conduit 188.1 9.5 .2 - 197.4 Public Telephone Equipment 18.4 1.0 .1 - 19.3 Other Communica- tions Equipment 59.5 6.3 2.2 - 63.6 Furniture and Office Equipment 256.9 35.1 24.6 14.1 281.5 Vehicles and Other Work Equipment 92.3 14.8 4.9 (2.6) 99.6 Telecommunications Plant Property and Equipment Under Construction 82.9 9.8 - - 92.7 Other .1 .9 - - 1.0 TOTAL (d) $3,864.5 $318.4 $152.0 $ - $4,030.9 The notes on Sheet 4 are an integral part of this Schedule. Schedule V - Sheet 4 Notes to Schedule V (a) For regulated telephone plant, additions shown include (1) the original cost of reused material, which is concurrently credited to Material and Supplies, and (2) an Allowance for Funds Used During Construction. (b) Items of telecommunications plant, property and equipment when retired, sold or reclassified are deducted from the property accounts at original cost. (c) Represents current year transfers between classifications, and other minor adjustments. (d) For interstate telephone plant, the FCC has approved the equal life group ("ELG") depreciation method using a remaining-life formula on a phased-in basis beginning in 1982. Vintages of interstate plant in service prior to the phase-in of ELG are being depreciated using a composite vintage group method. In addition, the FCC approved the use of straight-line amortization effective January 1, 1987 to recover an interstate reserve deficiency over a five-year period ended December 31, 1993. For intrastate plant, the DPUC approved ELG for 1993 vintages and subsequent periods. Vintages of intrastate plant in service prior to 1993 are being depreciated using a composite vintage group method. For the years 1993, 1992 and 1991, depreciation expense on telecommunications plant expressed as a percentage of average depreciable plant was 7.0%, 6.2% and 6.6%, respectively. Property and equipment other than regulated telephone plant is depreciated primarily using the straight-line method over the estimated useful lives of the assets. Assets acquired under capital leases are generally amortized over the life of the lease using the straight-line method. SOUTHERN NEW ENGLAND TELECOMMUNICATIONS CORPORATION SCHEDULE VI--ACCUMULATED DEPRECIATION (Millions of Dollars) COL. A COL. B COL. C COL. D COL. E COL. F Balance at Additions Retirements Other Balance beginning charged - Note (a) Changes at end Description of period to expense of period Year 1993 $1,408.0 $286.8 $162.4 $(4.2) $1,528.2 Year 1992 1,318.7 247.6 157.1 (1.2) 1,408.0 Year 1991 1,221.5 251.5 154.7 .4 1,318.7 (a) Includes net salvage. (b) Columns B and F include accumulated depreciation on the Corporation's nonregulated telecommunications plant, property and equipment, which is shown net of such accumulated depreciation in Note 13 to the consolidated financial statements. SOUTHERN NEW ENGLAND TELECOMMUNICATIONS CORPORATION SCHEDULE VIII--VALUATION AND QUALIFYING ACCOUNTS (Millions of Dollars) COL. A COL. B COL. C COL. D COL. E COL. F Additions Balance at Additions Charged Balance beginning charged to to other Deductions at end Description of period expense accounts - Note B of -Note (a) period Allowance for Uncollectible Accounts Receivable: Year 1993 $21.8 $ 28.9 $3.6 $27.6 $ 26.7 Year 1992 16.3 33.3 3.9 31.7 21.8 Year 1991 10.3 31.7 3.6 29.3 16.3 Allowance for Uncollectible Direct-Financing Lease Notes Receivable of Discontinued Operations: Year 1993 $ 8.2 $ 15.6 $ - $12.1 $ 11.7 Year 1992 4.6 9.2 - 5.6 8.2 Year 1991 2.7 4.8 - 2.9 4.6 Restructuring Charge: Year 1993 $ - $355.0 $ - $ - $355.0 (a) Includes amounts previously written off that were credited directly to this account when recovered and miscellaneous debits and credits. (b) Includes amounts written off as uncollectible. Exhibit Index Exhibits identified in parentheses below, on file with the SEC, are incorporated herein by reference as exhibits hereto. Exhibit Number 3a Amended and Restated Certificate of Incorporation of the registrant as filed June 14, 1990 (Exhibit) 3-A to Form SE dated 3/15/91, File No. 1-9157). 3b By-Laws of the registrant as amended and restated through October 10, 1990 (Exhibit 3 to Form 8-K dated 10/10/90, File No. 1-9157). 4a Rights Agreement dated February 11, 1987 between Southern New England Telecommunications Corporation and The State Street Bank and Trust Company, as Rights Agent (Exhibit 1 to Form SE dated 2/13/87-1, File No. 1-9157). Amendment No. 1 dated December 13, 1989 (Exhibit 4 to Form SE dated 12/28/89, File No. 1-9157). Amendment No. 2 dated October 10, 1990 (Exhibit 4 to Form SE dated 10/12/90, File No. 1-9157). 4b No instrument which defines the rights of holders of long-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. 10 (iii)(A)1 SNET Short Term Incentive Plan as amended March 1, 1993 (Exhibit 10(iii)(A)1 to 1992 Form 10-K dated 3/23/93, File No. 1-9157). 10 (iii)(A)2 SNET Long Term Incentive Plan as amended March 1, 1993 (Exhibit 10(iii)(A)2 to 1992 Form 10-K dated 3/23/93, File No. 1-9157). 10 (iii)(A)3 SNET Financial Counseling Program as amended January 1987 (Exhibit 10-D to Form SE dated 3/23/87-1, File No. 1-9157). 10 (iii)(A)4 Group Life Insurance Plan and Accidental Death and Dismemberment Benefits Plan for Outside Directors of SNET as amended July 1, 1986 (Exhibit 10-E to Form SE dated 3/23/87-1, File No. 1-9157). 10 (iii)(A)5 SNET Executive Non-Qualified Pension Plan and Excess Benefit Plan as amended November 1, 1991 (Exhibit 10-A to Form SE dated 3/20/92, File No. 1-9157). Amendments dated December 8, 1993. 10 (iii)(A)6 SNET Management Pension Plan as amended November 1, 1987 (Exhibit 10-C to Form SE dated 3/21/88-1, File No. 1-9157). Amendments dated September 1, 1988 and January 1, 1989 (Exhibit 10-C to Form SE dated 3/21/89, File No. 1-9157). Amendments dated January 1, 1989 through August 6, 1989 (Exhibit 10-B to Form SE dated 3/20/90, File No. 1-9157). Amendments dated June 5, 1991 through September 25, 1991 (Exhibit 10-B to Form SE dated 3/20/92, File No. 1-9157). Amendments dated January 1, 1993 (Exhibit 10(iii)(A)6 to 1992 Form 10-K dated 3/23/93, File No. 1-9157). Amendments dated September 8, 1993 through December 8, 1993. 10 (iii)(A)7 SNET Incentive Award Deferral Plan as amended March 1, 1993 (Exhibit 10(iii)(A)7 to 1992 Form 10-K dated 3/23/93, File No. 1-9157). 10 (iii)(A)8 SNET Mid-Career Pension Plan as amended November 1, 1991 (Exhibit 10-D to Form SE dated 3/20/92, File No. 1-9157). Amendments dated December 8, 1993. 10 (iii)(A)9 SNET Deferred Compensation Plan for Non-Employee Directors as amended January 1, 1993 (Exhibit 10(iii)(A)9 to 1992 Form 10-K dated 3/23/93, File No. 1-9157). 10 (iii)(A)10 Change-in-Control Agreements (Exhibit 10-F to Form SE dated 3/15/91, File No. 1-9157). 10 (iii)(A)11 SNET 1986 Stock Option Plan as amended March 1, 1993 (Exhibit 10(iii)(A)11 to 1992 Form 10-K dated 3/23/93, File No. 1-9157). 10 (iii)(A)12 SNET Retirement and Disability Plan for Non- Employee Directors as amended April 14, 1993. 10 (iii)(A)13 SNET Non-Employee Director Stock Plan effective January 1, 1994 (Exhibit 4.4 to Registration No. 33-51055, File No. 1-9157) 10 (iii)A)14 Description of SNET Executive Retirement Savings Plan. 12 Computation of Ratio of Earnings to Fixed Charges. 13 Pages 18 through 48 of the registrant's Annual Report to Shareholders for the fiscal year ended December 31, 1993. 21 Subsidiaries of the Corporation. 23 Consent of Independent Accountants. 24a Powers of Attorney. 24b Board of Directors' Resolution. 99a Annual Report on Form 11-K for the plan year ended December 31, 1993 for the SNET Management Retirement Savings Plan will be filed as an amendment prior to June 30, 1994. 99b Annual Report on Form 11-K for the plan year ended December 31, 1993 for the SNET Bargaining Unit Retirement Savings Plan will be filed as an amendment prior to June 30, 1994.

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Item 1. Business GENERAL Bell Atlantic - Washington, D.C., Inc. (formerly The Chesapeake and Potomac Telephone Company) (the "Company") is incorporated under the laws of the State of New York and has its principal offices at 1710 H Street, N.W., Washington, D.C. 20006 (telephone number 202-392-9900). The Company is a wholly owned subsidiary of Bell Atlantic Corporation ("Bell Atlantic"), which is one of the seven regional holding companies ("RHCs") formed in connection with the court- approved divestiture (the "Divestiture"), effective January 1, 1984, of those assets of the American Telephone and Telegraph Company ("AT&T") related to exchange telecommunications, exchange access functions, printed directories and cellular mobile communications. The Company presently serves a territory consisting of a single Local Access and Transport Area ("LATA"). A LATA is generally centered on a city or based on some other identifiable common geography and, with certain limited exceptions, a LATA marks the boundary within which the Company may provide telephone service. The Company provides two basic types of telecommunications services. First, the Company transports telecommunications traffic between subscribers located within the same LATA ("intraLATA service"), including both local and toll services. Local service includes the provision of local exchange ("dial tone"), local private line and public telephone services (including dial tone service for pay telephones owned by the Company and other pay telephone providers). Among other local services provided are Centrex (telephone company central office-based switched telephone service enabling the subscriber to make both intercom and outside calls) and a variety of special and custom calling services. Toll service includes message toll service (calling service beyond the local calling area) within LATA boundaries, and intraLATA Wide Area Toll Service (WATS)/800 services (volume discount offerings for customers with highly concentrated demand). Second, the Company provides exchange access service, which links a subscriber's telephone or other equipment to the transmission facilities of interexchange carriers which, in turn, provide telecommunications service between LATAs ("interLATA service") to their customers. See "Competition - IntraLATA Toll Competition." The communications industry is currently undergoing fundamental changes driven by the accelerated pace of technological innovation, the convergence of the telecommunications, cable television, information services and entertainment businesses, and a regulatory environment in which many traditional regulatory barriers are being lowered and competition permitted or encouraged. Although no definitive prediction can be made of the market opportunities these changes will present or whether Bell Atlantic and its subsidiaries, including the Company, will be able successfully to take advantage of these opportunities, Bell Atlantic is positioning itself to be a leading communications, information services and entertainment company. BELL ATLANTIC - WASHINGTON, D.C., INC. OPERATIONS During 1993, Bell Atlantic reorganized certain functions formerly performed by each of the seven Bell System operating companies ("BOCs") transferred to it pursuant to the Divestiture, including the Company (collectively, the "Network Services Companies"), into nine lines of business ("LOBs") organized across the Network Service Companies around specific market segments. The Network Services Companies, however, remain responsible within their respective service areas for the provision of telephone services, for financial performance and for regulatory matters. The nine LOBs are: The Consumer Services LOB markets communications services to residential ----------------- customers within the service territories of the Network Services Companies, including the service territory of the Company, and plans in the future to market information services and entertainment programming. The Carrier Services LOB markets (i) switched and special access to the ---------------- Company's local exchange network, and (ii) billing and collection services, including recording, rating, bill processing and bill rendering. The principal customers of this LOB are interexchange carriers; AT&T is the largest single customer. Other customers include business customers and government agencies with their own special access network connections, wireless customers and other local exchange carriers ("LECs") which resell network connections to their own customers. The Small Business Services LOB markets communications and information ----------------------- services to small businesses (customers having up to 20 access lines or 100 Centrex lines). The Large Business Services LOB markets communications and information ----------------------- services to large businesses (customers having more than 20 access lines or more than 100 Centrex lines). These services include voice switching/processing services (e.g., dedicated private lines, custom Centrex, call management and voice messaging), end-user networking (e.g., credit and debit card transactions, and personal computer-based conferencing, including data and video), internetworking (establishing links between the geographically disparate networks of two or more companies or within the same company), network integration (integrating multiple geographically disparate networks into one system), network optimization (disaster avoidance, 911, intelligent vehicle highway systems), video services (distance learning, telemedicine, surveillance, videoconferencing) and integrated multi-media applications services. The Directory Services LOB manages the provision of (i) advertising and ------------------ marketing services to advertisers, and (ii) listing information (e.g., White Pages and Yellow Pages). These services are currently provided primarily through print media, but the Company expects that use of electronic formats will increase in the future. In addition, the Directory Services LOB manages the provision of photocomposition, database management and other related products and services to publishers. The Public and Operator Services LOB markets pay telephone and operator ---------------------------- services in the service territories of the Network Services Companies to meet consumer needs for accessing public networks, locating and identifying network subscribers, providing calling assistance and arranging billing alternatives (e.g., calling card, collect and third party calls). The Federal Systems LOB markets communications and information technology and --------------- services to departments, agencies and offices of the executive, judicial and legislative branches of the federal government. BELL ATLANTIC - WASHINGTON, D.C., INC. The Information Services LOB has been established to provide programming -------------------- services, including on-demand entertainment, transactions and interactive multimedia applications within the Territory and in selected other markets. See "FCC Regulation and Interstate Rates - Telephone Company Provision of Video Dial Tone and Video Programming". The Network LOB manages the technologies, services and systems platforms ------- required by the other eight LOBs and the Network Services Companies, including the Company, to meet the needs of their respective customers, including, without limitation, switching, feature development and on-premises installation and maintenance services. The Company has been making and expects to continue to make significant capital expenditures on its networks to meet the demand for communications services and to further improve such services. Capital expenditures were approximately $109 million in 1991, $103 million in 1992, and $106 million in 1993. The total investment in plant, property and equipment decreased from approximately $1.41 billion at December 31, 1991 to approximately $1.31 billion at December 31, 1992 and 1993, in each case after giving effect to retirements, but before deducting accumulated depreciation at such date. The Company is projecting capital expenditures for 1994 at an amount similar to 1993. However, subject to regulatory approvals, the Network Services Companies, including the Company, plan to allocate capital resources to the deployment of broadband network platforms (technologies ultimately capable of providing a switched facility for access to and transport of high-speed data services, video-on-demand, and image and interactive multimedia applications). Most of the funds for these expenditures are expected to be generated internally. Some additional external financing may be necessary or desirable. LINE OF BUSINESS RESTRICTIONS The consent decree entitled "Modification of Final Judgment" ("MFJ") approved by the United States District Court for the District of Columbia (the "D.C. District Court") which, together with the Plan of Reorganization ("Plan") approved by the D.C. District Court set forth the terms of Divestiture also established certain restrictions on the post-Divestiture activities of the RHCs, including Bell Atlantic. The MFJ's principal restrictions on post-Divestiture RHC activities included prohibitions on (i) providing interexchange telecommunications, (ii) providing information services, (iii) engaging in the manufacture of telecommunications equipment and customer premises equipment ("CPE"), and (iv) entering into any non-telecommunications businesses, in each case without the approval of the D.C. District Court. Since Divestiture, the D.C. District Court has retained jurisdiction over the construction, modification, implementation and enforcement of the MFJ. In September 1987, the D.C. District Court rendered a decision which eliminated the need for the RHCs to obtain its approval prior to entering into non-telecommunications businesses. However, the D.C. District Court refused to eliminate the restrictions relating to equipment manufacturing or providing interexchange services. With respect to information services, the Court issued a ruling in March 1988 which permitted the RHCs to engage in a number of information transport functions as well as voice storage and retrieval services, including voice messaging, electronic mail and certain information gateway services. However, the RHCs were generally prohibited from providing the content of the data they transmitted. As the result of an appeal of the D.C. District Court's September 1987 and March 1988 decisions by the RHCs and other parties, the United States Court of Appeals for the District of Columbia Circuit ordered the D.C. District Court to reconsider the RHCs' request to provide information content and determine whether removal of the restrictions thereon would be in the BELL ATLANTIC - WASHINGTON, D.C., INC. public interest. In July 1991, the D.C. District Court removed the remaining restrictions on RHC participation in information services, but imposed a stay pending appeal of that decision. In October 1991, the United States Court of Appeals for the District of Columbia Circuit vacated the stay, thereby permitting the RHCs to provide information services, and in May 1993 affirmed the D.C. District Court's July 1991 decision. The United States Supreme Court denied certiorari in November 1993. Several bills have been introduced in the current session of Congress pursuant to which the line of business restrictions established by the MFJ could be eliminated or modified. No definitive prediction can be made as to whether or when any such legislation will be enacted, the provisions thereof or their impact on the business or financial condition of the Company. FCC REGULATION AND INTERSTATE RATES The Company is subject to the jurisdiction of the Federal Communications Commission ("FCC") with respect to interstate services and certain related matters. The FCC prescribes a uniform system of accounts for telephone companies, interstate depreciation rates and the principles and standard procedures used to separate plant investment, expenses, taxes and reserves between those applicable to interstate services under the jurisdiction of the FCC and those applicable to intrastate services under the jurisdiction of the respective state regulatory authorities ("separations procedures"). The FCC also prescribes procedures for allocating costs and revenues between regulated and unregulated activities. Interstate Access Charges The Company provides intraLATA service and does not participate in the provision of interLATA service except through offerings of exchange access service. The FCC has prescribed structures for exchange access tariffs to specify the charges ("Access Charges") for use and availability of the Company's facilities for the origination and termination of interstate interLATA service. Access Charges are intended to recover the related costs of the Company which have been allocated to the interstate jurisdiction ("Interstate Costs") under the FCC's separations procedures. In general, the tariff structures prescribed by the FCC provide that Interstate Costs of the Company which do not vary based on usage ("non-traffic sensitive costs") are recovered from subscribers through flat monthly charges ("Subscriber Line Charges"), and from interexchange carriers through usage- sensitive Carrier Common Line ("CCL") charges. See "FCC Regulation and Interstate Rates - FCC Access Charge Pooling Arrangements". Traffic-sensitive Interstate Costs are recovered from carriers through variable access charges based on several factors, primarily usage. In May 1984, the FCC authorized the implementation of Access Charge tariffs for "switched access service" (access to the local exchange network) and of Subscriber Line Charges for multiple line business customers (up to $6.00 per month per line). In 1985, the FCC authorized Subscriber Line Charges for residential and single-line business customers at the rate of $1.00 per month per line, which increased in installments to $3.50 effective April 1, 1989. As a result of the phasing in of Subscriber Line Charges, a substantial portion of non-traffic sensitive Interstate Costs is now recovered directly from subscribers, thereby reducing the per-minute CCL charges to interexchange carriers. This significant reduction in CCL charges has tended to reduce the BELL ATLANTIC - WASHINGTON, D.C., INC. incentive for interexchange carriers and their high-volume customers to bypass the Company's switched network via special access lines or alternative communications systems. However, competition for this access business has increased in recent years. See "Competition - Alternative Access and Local Services". FCC Access Charge Pooling Arrangements The FCC previously required that all LECs, including the Company, pool revenues from CCL and Subscriber Line Charges that cover the non-traffic sensitive costs of the local exchange network, that is, the Interstate Costs associated with the lines from subscribers' premises to telephone company central offices. To administer such pooling arrangements, the FCC mandated the formation of the National Exchange Carrier Association, Inc. Some LECs received more revenue from the pool than they billed their interexchange carrier customers using the nationwide average CCL rate. Other companies, including the Company, received substantially less from the pool than the amount billed to their interexchange carrier customers. By an order adopted in 1987, the FCC changed its mandatory pooling requirements. These changes, which became effective April 1, 1989, permitted all of the Network Services Companies as a group to withdraw from the pool and to charge CCL rates which more closely reflect their non-traffic sensitive costs. The Network Services Companies, including the Company, are still obligated to make contributions of CCL revenues to companies who choose to continue to pool non-traffic sensitive costs so that the pooling companies can charge a CCL rate no greater than the nationwide average CCL rate. In addition to this continuing obligation, the Network Services Companies, including the Company, have a transitional support obligation to high cost companies who left the pool in 1989 and 1990. This transitional support obligation phases out over five years. These long-term and transitional support requirements will be recovered in the Network Services Companies' (including the Company's) CCL rates. Depreciation Depreciation rates provide for the recovery of the Company's investment in telephone plant and equipment, and are revised periodically to reflect more current estimates of remaining service lives and future net salvage values. In October 1993, the FCC issued an order simplifying the depreciation filing process by reducing the information required for certain categories of plant and equipment whose remaining service life, salvage estimates and depreciation rates fall within an approved range. Petitions for reconsideration of that order were filed in December 1993. In November 1993, the FCC issued a further order inviting comments on proposed ranges for an initial group of categories of plant and equipment. Price Caps In September 1990, the FCC adopted "price cap" regulation to replace the traditional rate of return regulation of LECs. LEC price cap regulation became effective on January 1, 1991. The price cap system places a cap on overall prices for interstate services and requires that the cap decrease annually, in inflation-adjusted terms, by a fixed percentage which is intended to reflect expected increases in productivity. The price cap level can also be adjusted to reflect "exogenous" changes, such as changes in FCC separations procedures or accounting rules. LECs subject to price caps have somewhat increased flexibility to change the prices of existing services within certain groupings of interstate services, known as "baskets". BELL ATLANTIC - WASHINGTON, D.C., INC. Under price cap regulation, the FCC set an authorized rate of return of 11.25% for the years 1991 and beyond. To the extent that a company is able to earn a higher rate of return through improved efficiency, the FCC's price cap rules permit them to retain the full amount of this higher return up to 100 basis points above the authorized rate of return (currently, up to a 12.25% rate of return). If a company's rate of return is between 100 and 500 basis points above the authorized rate of return (that is, currently, between 12.25% and 16.25%), the company must share 50% of the earnings above the 100-basis-point level with customers by reducing rates prospectively. All earnings above the 500-basis-point level must be returned to customers in the form of prospective rate decreases. If, on the other hand, a company's rate of return is more than 100 basis points below the authorized rate of return (that is, currently, below 10.25%), the company is permitted to increase rates prospectively to make up the deficiency. Under FCC-approved tariffs, the Network Services Companies are charging uniform rates for interstate access services (with the exception of Subscriber Line Charges) throughout their service areas and are regarded as a single unit by the FCC for rate of return measurement. On February 16, 1994, the FCC initiated a rulemaking proceeding to determine the effectiveness of LEC price cap rules and decide what changes, if any, should be made to those rules. This rulemaking is expected to be concluded by the end of 1994. In January 1993, the FCC denied the Company exogenous treatment of the increased expense for postretirement benefits required under Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions", which the Company adopted effective January 1, 1991. The Company has appealed this decision. The appeal is likely to be decided during the second half of 1994. Computer Inquiry III In August 1985, the FCC initiated Computer Inquiry III to re-examine its regulations requiring that "enhanced services" (e.g., voice messaging services, electronic mail, videotext gateway, protocol conversion) be offered only through a structurally separated subsidiary. In 1986, the FCC eliminated this requirement, permitting the Company to offer enhanced services, subject to compliance with a series of nonstructural safeguards designed to promote an effectively competitive market. These safeguards include detailed cost accounting, protection of customer information and certain reporting requirements. In June 1990, the United States Court of Appeals for the Ninth Circuit vacated and remanded the Computer Inquiry III decisions to the FCC, finding that the FCC had not fully justified those decisions. In December 1991, the FCC adopted an order which reinstated relief from the separate subsidiary requirement upon a company's compliance with the FCC's Computer III Open Network Architecture ("ONA") requirements and strengthened some of the nonstructural safeguards. In the interim, the Network Services Companies, including the Company, had filed interstate tariffs implementing the ONA requirements. Those tariffs became effective in February 1992, subject to further investigation. That investigation was completed on December 15, 1993, when an order was released making minor changes to the Network Services Companies' ONA rates. In March 1992, the Company certified to the FCC that it had complied with all initial ONA obligations and therefore should be granted structural relief for enhanced services. The FCC granted the Company structural relief in June 1992. Other parties have appealed this decision, which remains in effect pending the outcome of the appeal. A decision on the appeal is likely by the end of 1994. BELL ATLANTIC - WASHINGTON, D.C., INC. The FCC's December 1991 order has been appealed to the United States Court of Appeals for the Ninth Circuit by several parties. Pending decision on those appeals, the FCC's decision remains in effect. If a court again reverses the FCC, the Company's right to offer enhanced services could be impaired. FCC Cost Allocation and Affiliate Transaction Rules In 1987, the FCC adopted rules governing (i) the allocation of costs between the regulated and unregulated activities of a communications common carrier and (ii) transactions between the regulated and unregulated affiliates of a communications common carrier. The cost allocation rules apply to certain unregulated activities: activities that have never been regulated as communications common carrier offerings and activities that have been preemptively deregulated by the FCC. The costs of these activities are removed prior to the separations procedures process and are allocated to unregulated activities in the aggregate, not to specific services for pricing purposes. Other activities must be accounted for as regulated activities, and their costs are subject to separations procedures. These activities include (i) those which have been deregulated by the FCC without preempting state regulation, (ii) those which have been deregulated by a state but not the FCC and (iii) "incidental activities," which cannot, in the aggregate, generate more than 1% of a company's revenues. Since the Network Services Companies, including the Company, engage in these types of activities, the Network Services Companies, including the Company, pursuant to the FCC's cost allocation rules, filed a cost allocation manual, which has been approved by the FCC. The affiliate transaction rules govern the pricing of assets transferred to and services provided by affiliates. These rules generally require that assets be transferred between affiliates at "market price", if such price can be established through a tariff or a prevailing price actually charged to third parties. In the absence of a tariff or prevailing price, "market price" cannot be established, in which case (i) asset transfers from a regulated to an unregulated affiliate must be valued at the higher of cost or fair market value, and (ii) asset transfers from an unregulated to a regulated affiliate must be valued at the lower of cost or fair market value. The affiliate transaction rules require that a service provided by one affiliate to another affiliate, which service is also provided to unaffiliated entities, must be valued at tariff rates or market prices. If the affiliate does not also provide the service to unaffiliated entities, the price must be determined in accordance with the FCC's cost allocation principles. In October 1993, the FCC proposed new affiliate transaction rules which would essentially eliminate the different rules for the provision of services and apply the asset transfer rules to all affiliate transactions. The Network Services Companies, including the Company, have filed comments opposing the proposed rules. The FCC has not attempted to make its cost allocation or affiliate transaction rules preemptive. State regulatory authorities are free to use different cost allocation methods and affiliate transaction rules for intrastate ratemaking and to require carriers to keep separate allocation records. Telephone Company Provision of Video Dial Tone and Video Programming In 1987, the FCC initiated an inquiry into whether developments in the cable and telephone industries warranted changes in the rules prohibiting telephone companies such as the Company from providing video programming in their respective service territories directly or indirectly through an affiliate. BELL ATLANTIC - WASHINGTON, D.C., INC. In November 1991, the FCC released a Further Notice of Proposed Rulemaking in these proceedings. In August 1992, the FCC issued an order permitting telephone companies such as the Company to provide "video dial tone" service. Video dial tone permits telephone companies to provide video transport to multiple programmers on a non-discriminatory common carrier basis. The FCC has also ruled that neither telephone companies that provide video dial tone service, nor video programmers that use these services, are required to obtain local cable franchises. Other parties have appealed these orders, which remain in effect pending the outcome of the appeal. In December 1992, two Bell Atlantic Companies, Bell Atlantic - Virginia, Inc. and Bell Atlantic Video Services Company, filed a lawsuit against the federal government in the United States District Court for the Eastern District of Virginia seeking to overturn the prohibition in the Cable Communications Policy Act of 1984 against LECs providing video programming in their respective service areas. In a decision rendered in August 1993 and clarified in October 1993, the court struck down this prohibition as a violation of the First Amendment's freedom of speech protections and enjoined its enforcement against Bell Atlantic, the Network Services Companies, including the Company, and Bell Atlantic Video Services Company. This decision has been appealed to the United States Court of Appeals for the Fourth Circuit. In early 1993, the FCC granted Bell Atlantic authority to test a new technology known as Asynchronous Digital Subscriber Line ("ADSL") for use in delivering video entertainment and information over existing copper telephone lines. Beginning in March 1993, Bell Atlantic began a one-year technical trial of ADSL serving up to 400 Bell Atlantic employees in northern Virginia. In the Fall of 1993, Bell Atlantic petitioned the FCC for authorization to expand and convert this technical trial upon its completion into a six month market trial serving up to 2,000 customers. Bell Atlantic also requested authority to offer a commercial video dial tone service to customers served by 25 central offices in part of northern Virginia and southern Maryland upon completion of the six month market trial. These applications are pending at the FCC. Interconnection and Collocation In October 1992, the FCC issued an order allowing third parties to collocate their equipment in telephone company offices to provide special access (private line) services to the public. The FCC's stated purpose was to encourage greater competition in the provision of interstate special access services. The order permits collocating parties to pay LECs an interconnection charge that is lower than the existing tariffed rates for similar non-collocated services; it allows LECs limited additional pricing flexibility for their own special access services when collocated interconnection is operational. In February 1993, Bell Atlantic's seven telephone subsidiaries, including the Company, filed an interstate tariff to allow collocation for special access services. This tariff is currently effective. Bell Atlantic and certain other parties have appealed the FCC's special access collocation order. Bell Atlantic expects the appeal to be decided in 1994. On September 2, 1993, the FCC extended collocation to switched access services. The terms and conditions for switched access collocation are similar to those for special access collocation. On November 18, 1993, Bell Atlantic's seven telephone subsidiaries, including the Company, filed an interstate tariff to allow collocation for switched access services. This tariff became effective on February 16, 1994. Bell Atlantic and certain other parties have appealed the FCC's switched access collocation order. Appeals of this order have been stayed pending a decision on the appeals of the special access collocation order. BELL ATLANTIC - WASHINGTON, D.C., INC. Increased competition through collocation will adversely affect the revenues of the Company, although some of the lost revenues could be offset by increased demand of the Company's own special access services as a result of the slightly increased pricing flexibility that the FCC has permitted. The Company does not expect the net revenue impact of special access collocation to be material. Revenue losses from switched access collocation, however, may be larger than from special access collocation. Intelligent Networks In December 1991, the FCC issued a Notice of Inquiry into the plans of the BOCs, including the Company, to deploy new "modular" network architectures, such as Advanced Intelligent Network ("AIN") technology. The Notice of Inquiry asks what, if any, regulatory action the FCC should take to assure that such architectures are deployed in a manner that is "open, responsive, and procompetitive". On August 31, 1993, the FCC issued a Notice of Proposed Rulemaking proposing a schedule for AIN deployment. The proposals in that Notice of Proposed Rulemaking generally follow those that Bell Atlantic proposed in its response to the Notice of Inquiry. The Company cannot estimate when the FCC will conclude this proceeding. The results of this proposed rulemaking could include a requirement that the Company offer individual components of its services, such as switching and transport, to competitors who will provide the remainder of such services through their own facilities. Such increased competition could divert revenues from the Company. However, deployment of AIN technology may also enable the Company to respond more quickly and efficiently to customer requests for new services. This could result in increased revenues from new services that could at least partially offset losses resulting from increased competition. STATE REGULATION AND INTRASTATE RATES The communications services of the Company are subject to regulation by the District of Columbia Public Service Commission (the "PSC") with respect to intrastate rates and services and other matters. In January 1993, as the outcome of a process begun by a Company proposal to the PSC in 1988, the PSC adopted a regulatory reform plan for the in-territory services of the Company. Under the plan, the PSC adopted a banded rate of return on equity (based on earnings from all services) with 12.5% as the midpoint: the Company would be allowed to seek rate increases if its return on equity falls below 11.5% and would be required to share, through prospective rate cuts, 50% of any earnings in excess of a return on equity of 13.5%. The Company's rates for most residential services were frozen at the levels set in the prior rate proceeding in March 1992. The PSC granted pricing flexibility, including custom contracting and 14-day tariffing, for all Centrex services and for high capacity private line services since these services were found to be subject to competition. The PSC also established a screen for determining what other services are competitive and BELL ATLANTIC - WASHINGTON, D.C., INC. therefore should be subject to flexible pricing in the future. The plan will be in effect for three years after which the PSC will investigate the Company's performance and determine what regulatory structure is appropriate at that time. Pursuant to the PSC's January 1993 regulatory reform plan, in December 1993, the PSC re-set the Company's banded rate of return on equity to range from 10.45% to 12.45%, with a midpoint of 11.45%. However, the PSC also found that the Company was entitled to increased annual revenues of $15.8 million. The PSC increased the rates for public telephone service, increased the message unit rate for business customers and increased certain other business and residential rates to cover the increased revenue requirement. Rates for basic residential service remain frozen at the level set in March 1992. Under the plan, the Company also applied for and received pricing flexibility for several competitive services, including digital data services, paging services, speed calling, Repeat Call, Home Intercom and Home Intercom Extra. NEW PRODUCTS AND SERVICES The following were among the new products and services introduced by the Company in 1993: IntelliLinQ PRI (Integrated Service Digital Network - Primary Rate Interface --------------- (ISDN-PRI)) is an optional arrangement for local exchange access, directed at medium and large business customers with PBX service, which enables customers to increase the efficacy of their current trunking and to transmit 64Kbps circuit-switch data over the public network. Frame Relay Service allows for data connectivity between or among widely ------------------- distributed locations through the use of Frame Relay Subscriber Network Access Lines from the customer's premises to Bell Atlantic's serving wire centers. Centrex Extend permits multi-location Centrex intercom service for a closed -------------- end user group of a single Centrex customer. The Company also introduced the Centrex/Direct Inward Dialing Intercept --------------------------------------- Service, Switched Redirect, Fiber Distributed Data Interface and Individual Line - ------- ----------------- --------------------------------- ---------------- Business (ISDN) products. - -------- COMPETITION Regulatory proceedings, as well as new technology, are continuing to expand the types of available communications services and equipment and the number of competitors offering such services. An increasing amount of this competition is from large companies which have substantial capital, technological and marketing resources, many of which do not face the same regulatory constraints as the Company. Alternative Access and Local Services A substantial portion of the Company's revenues from business and government customers is derived from a relatively small number of large, multiple-line subscribers. The Company faces competition from alternative communications systems, constructed by large end users, interexchange carriers and alternative access vendors, which are capable of originating and/or terminating calls without the use of the local telephone company's plant. In Washington, D.C., BELL ATLANTIC - WASHINGTON, D.C., INC. Institutional Communications Company has deployed an optical fiber network to compete with the Company in the provision of switched and special access services and local services. The ability of such alternative access providers to compete with the Company has been enhanced by the FCC's orders requiring the Company to offer collocated interconnection for special and switched access services. Other potential sources of competition are cable television systems, shared tenant services and other non-carrier systems which are capable of bypassing the Company's local plant, either partially or completely, through substitution of special access for switched access or through concentration of telecommunications traffic on fewer of the Company's lines. Well-financed competitors are seeking authority, or are likely soon to seek authority, to offer competing local exchange services, such as dial tone and local usage, in some of the most lucrative of the Company's local telephone service areas. Southwestern Bell Corporation provides cellular service in the Washington, D.C. Metropolitan area. The two largest long-distance carriers are also positioning themselves to begin to offer services that will compete with the Company's local exchange services. In November 1992, AT&T announced its intention to acquire a controlling interest in McCaw Cellular Communications Inc. ("McCaw"), the largest cellular company in the United States, and to integrate McCaw's wireless local service network with AT&T's long distance network. In December 1993, MCI Communications Corporation ("MCI") announced its intention to invest $2 billion to begin building competing local exchange and access networks in twenty major markets in the United States, some of which are likely to be in the Company's service territory. In March 1994, MCI also announced its intention to acquire a substantial interest in Nextel Communications Inc. (formerly Fleet Call Inc.), and to integrate Nextel's wireless local service network with MCI's long distance network in at least 10 major markets, one or more of which might be in the Company's service territory. The entry of these and other local exchange service competitors will almost certainly reduce the local exchange service revenues of the Company, at least in the market segments and geographical areas in which the competitors operate. Depending on such competitors' success in marketing their services, and the conditions of interconnection established by the regulatory commissions, these reductions could be significant. These revenue reductions may be offset to some extent by revenues from interconnection charges to be paid to the Company by these competitors. The Company seeks to meet such competition by establishing and/or maintaining competitive cost-based prices for local exchange services (to the extent the FCC and state regulatory authorities permit the Company's prices to move toward costs), by keeping service quality high and by effectively implementing advances in technology. See "FCC Regulation and Interstate Rates - Interstate Access Charges" and "- FCC Access Charge Pooling Arrangements". Personal Communications Services Radio-based personal communications services ("PCS") also constitute potential sources of competition to the Company. PCS consists of wireless portable telephone services which would allow customers to make and receive telephone calls from any location using small handsets, and which could also be used for data transmission. The FCC has authorized trials of such services, using a variety of technologies, by numerous companies. BELL ATLANTIC - WASHINGTON, D.C., INC. In September 1993, the FCC issued a report and order allocating radio spectrum to be licensed for use in providing PCS. Under the order, seven separate bandwidths of spectrum, ranging in size from 10 MHz to 30 MHz, would be auctioned to potential PCS providers in each geographic area of the United States; five of the spectrum blocks would be auctioned by "basic trading area" and the remaining two would be auctioned by larger "major trading area" (as such trading areas are defined by Rand McNally). LECs and companies with LEC subsidiaries, such as Bell Atlantic, are eligible to bid for PCS licenses, except that cellular carriers, such as Bell Atlantic, are limited to obtaining only 10 MHz of PCS bandwidth in areas where they provide cellular service. Bidders other than cellular providers may obtain multiple licenses aggregating up to 40 MHz of bandwidth in any area. Bell Atlantic has stated that it intends to pursue PCS licenses in the auctions, which are expected to be held in 1994 or in early 1995. In December 1993, the FCC awarded pioneer's preference PCS licenses to, among other entities, American Personal Communications ("APC"), which is owned in part by The Washington Post Company. APC's license authorizes it to provide PCS service in competition with the local exchange services of the Network Services Companies in all or large portions of Pennsylvania, the District of Columbia, Maryland, Virginia and West Virginia. APC has announced its intention to build out an operational system by the first quarter of 1995. If implemented, PCS and other similar services would compete with services currently offered by the Company, and could result in losses of revenues. Centrex The Company offers Centrex service, which is a telephone company central office-based communications system for business, government and other institutional customers consisting of a variety of integrated software-based features located in a centralized switch or switches and extended to the customer's premises primarily via local distribution facilities. In the provision of Centrex, the Company is subject to significant competition from the providers of CPE systems, such as private branch exchanges ("PBXs"), which perform similar functions with less use of the Company's switching facilities. Users of Centrex systems generally require more subscriber lines than users of PBX systems of similar capacity. The FCC increased the maximum Subscriber Line Charge on embedded Centrex lines to $6.00 per month per line effective April 1, 1989. Increases in Subscriber Line Charges result in Centrex users incurring higher charges than users of comparable PBX systems. The PSC has approved Centrex tariff revisions designed to offset the effects of such higher Subscriber Line Charges. Directories The Company continues to face significant competition from other providers of directories as well as competition from other advertising media. In particular, the former sales representative of several of the Network Services Companies, including the Company, publishes directories in competition with those published by the Company in its service territory. BELL ATLANTIC - WASHINGTON, D.C., INC. Public Telephone Services The Company faces increasing competition in the provision of pay telephone services from other pay telephone service providers. In addition, the growth of wireless communications negatively impacts usage of public telephones. Operator Services Alternative operator services providers have entered into competition with the Company's operator services product line. CERTAIN CONTRACTS AND RELATIONSHIPS Certain planning, marketing, procurement, financial, legal, accounting, technical support and other management services are provided on behalf of the Company on a centralized basis by Bell Atlantic's wholly owned subsidiary, Bell Atlantic Network Services, Inc. ("NSI"). Bell Atlantic Network Funding Corporation provides short-term financing and cash management services to the Company. The seven RHCs each own (directly or through subsidiaries) a one-seventh interest in Bell Communications Research, Inc. ("Bellcore"). Pursuant to the Plan, Bellcore furnishes the RHCs and their BOC subsidiaries with technical assistance such as network planning, engineering and software development, as well as various other consulting services that can be provided more effectively on a centralized basis. Bellcore is the central point of contact for coordinating the efforts of the RHCs in meeting the national security and emergency preparedness requirements of the federal government. It also helps to mobilize the combined resources of the RHCs in times of natural disasters. EMPLOYEE RELATIONS As of December 31, 1993, the Company employed approximately 2,900 persons, including employees of the centralized staff at NSI. This represents approximately a 1% decrease from the number of employees at December 31, 1992. The Company's workforce is augmented by members of the centralized staff of NSI, who perform services for the Company on a contract basis. Approximately 88% of the employees of the Company are represented by the Communications Workers of America, which is affiliated with the American Federation of Labor - Congress of Industrial Organizations. Under the terms of the three-year contracts ratified in October 1992 by unions representing associate employees of the Network Services Companies, including the Company, and NSI, represented associates received a base wage increase of 3.74% in August 1993. Under the same contracts, associates received a Corporate Profit Sharing payment of $495 per person in 1994 based upon Bell Atlantic's 1993 financial performance. BELL ATLANTIC - WASHINGTON, D.C., INC. Item 2. Item 2. Properties The principal properties of the Company do not lend themselves to simple description by character and location. At December 31, 1993, the Company's investment in plant, property and equipment consisted of the following: "Connecting lines" consists primarily of aerial cable, underground cable, poles, conduit and wiring. "Central office equipment" consists of switching equipment, transmission equipment and related facilities. "Land and buildings" consists of land owned in fee and improvements thereto, principally central office buildings. "Telephone instruments and related equipment" consists primarily of public telephone terminal equipment and other terminal equipment. "Other" property consists primarily of furniture, office equipment, vehicles and other work equipment, capital leases, leasehold improvements and plant under construction. The Company's central offices are served by various types of switching equipment. At December 31, 1993 and 1992, the number of local exchanges and the percent of subscriber lines served by each type of equipment were as follows: BELL ATLANTIC - WASHINGTON, D.C., INC. Item 3. Item 3. Legal Proceedings Pre-Divestiture Contingent Liabilities and Litigation The Plan provides for the recognition and payment by AT&T and the former BOCs (including the Company) of liabilities that are attributable to pre-Divestiture events but 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 and torts (including business torts, such as alleged violations of the antitrust laws). Except to the extent that affected parties otherwise agree, contingent liabilities that are attributable to pre-Divestiture events are shared by AT&T and the BOCs in accordance with formulas prescribed by the Plan, 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. Each company's allocable share of liability under these formulas depends on several factors, including the type of contingent liability involved and each company's relative net investment as of the effective date of Divestiture. Under the formula generally applicable to most of the categories of these contingent liabilities, the Company's aggregate allocable share of liability is approximately 0.5%. AT&T and various of its subsidiaries and the BOCs (including, in some cases, the Company) have been and are parties to various types of litigation relating to pre-Divestiture events, including actions and proceedings involving environmental claims and allegations of violations of equal employment laws. Damages, if any, ultimately awarded in the remaining actions relating to pre- Divestiture events could have a financial impact on the Company whether or not the Company is a defendant since such damages will be treated as contingent liabilities and allocated in accordance with the allocation rules established by the Plan. While complete assurance cannot be given as to the outcome of any contingent liabilities or 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 of all of the remaining potential or actual pre- Divestiture claims would not be material in amount to the financial position of the Company. BELL ATLANTIC - WASHINGTON, D.C., INC. PART I Item 4. Item 4. Submission of Matters to a Vote of Security Holders (Omitted pursuant to General Instruction J(2).) PART II Item 5. Item 5. Market for Registrant's Common Equity and Related Stockholder Matters (Inapplicable.) Item 6. Item 6. Selected Financial Data (Omitted pursuant to General Instruction J(2).) BELL ATLANTIC - WASHINGTON, D.C., INC. Item 7. Item 7. Management's Discussion and Analysis of Results of Operations (Abbreviated pursuant to General Instruction J (2).) This discussion should be read in conjunction with the Financial Statements and Notes to Financial Statements included in the index set forth on page. RESULTS OF OPERATIONS Net income for 1993 decreased $8,157,000 or 23.0% from the same period last year. Results for 1993 reflect an after-tax charge of $4,221,000 for the adoption of Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits" (Statement No. 112) and a $4,494,000 extraordinary charge, net of tax, for the early extinguishment of debt. OPERATING REVENUES Operating revenues increased $9,843,000 or 1.8% in 1993. The increase in operating revenues was comprised of the following: Local service revenues are earned from the provision of local exchange, local private line and public telephone services. Local service revenues increased $3,666,000 or 1.3% in 1993. The increase was primarily due to higher demand for value-added central office services such as Custom Calling and Caller ID. Also contributing to the higher revenues was growth in private line services and directory assistance revenues due to higher demand for these services. These increases were offset in part by a decrease in rates for basic service. Access lines in service at December 31, 1993 were substantially unchanged from 1992. Network access revenues are received from interexchange carriers (IXCs) for their use of local exchange facilities in providing interstate long-distance services to IXCs' customers, and from end-user subscribers. Switched access revenues are derived from usage-based charges paid by IXCs for access to the Company's network. Special access revenues arise from access charges paid by customers who have private lines, and end-user access revenues are earned from local exchange carrier customers who pay for access to the network. Network access revenues decreased $780,000 or .6% in 1993, due to the effect of interstate rate reductions filed by the Company with the Federal Communications Commission (FCC) which became effective on July 2, 1993 and July 1, 1992, and by related estimated price cap sharing liabilities. This decrease was partly offset by a 5.8% growth in access minutes of use, and lower support payments to the National Exchange Carrier Association (NECA) interstate common line pool. Toll service revenues are earned from interexchange usage services such as Message Telecommunication Services. Toll service revenues remained substantially unchanged from 1992. Directory advertising, billing services and other revenues include revenues earned from directory advertising, billing and collection services provided to IXCs and others, premises services such as inside wire installation and maintenance services, rent of Company facilities by affiliates and non- affiliates and certain nonregulated enhanced network services. BELL ATLANTIC - WASHINGTON, D.C., INC. Directory advertising, billing services and other revenues increased $5,764,000 or 4.3% in 1993. This increase was primarily due to increased customer demand for premises services and for Answer Call, a nonregulated enhanced network service. These revenue increases were offset in part by decreased billing and collection revenue in 1993 as a result of reductions in services provided under long-term contracts with certain IXCs and decreased directory advertising revenue due to decreasing volumes attributable primarily to competition. The provision for uncollectibles, expressed as a percentage of total operating revenues was .8% in 1993 and 1.0% in 1992. The decrease in the provision reflects favorable collection experience. OPERATING EXPENSES Operating expenses increased $12,446,000 or 2.7% in 1993. The increase in operating expenses was comprised of the following: Employee costs consist of salaries, wages and other employee compensation, employee benefits, and payroll taxes paid directly by the Company. Similar costs incurred by employees of Bell Atlantic Network Services, Inc. (NSI) are allocated to the Company and are included in other operating expenses. Employee costs increased $7,817,000 or 5.2% in 1993. Higher employee costs from salary and wage increases and overtime were offset in part by savings resulting from workforce reduction programs implemented in 1992. The Company continues to evaluate ways to streamline and restructure its operations and reduce its workforce requirements in an effort to improve its cost structure. Depreciation and amortization expense decreased $2,600,000 or 2.4% in 1993, principally due to lower depreciation expense as a result of reduction in the level of depreciable plant in 1993. Taxes other than income decreased $3,138,000 or 7.3% in 1993 due to lower property assessments and a reduction in the use tax paid to the District of Columbia. Other operating expenses consist primarily of contracted services, including centralized service expenses allocated from NSI, rent, network software costs, and other general and administrative expenses. Other operating expenses increased $10,367,000 or 6.5% in 1993, primarily reflecting higher costs for contracted services as a result of higher employee costs and taxes allocated from NSI and increased network software costs associated with enhancing the Company's network. OPERATING INCOME TAXES The provision for income taxes decreased $1,337,000 or 7.3% in 1993. The Company's effective income tax rate was 31.0% in 1993 compared to 33.9% in 1992. The decrease in the effective tax rate resulted primarily from the effect of recording in 1992 an adjustment to deferred taxes associated with the retirement of certain plant investments. This decrease was offset in part by the effect of the recently enacted federal tax legislation which increased the federal corporate tax rate from 34% to 35%. A reconciliation of the statutory federal income tax rate to the effective rate for each period is provided in Note 5 of Notes to Financial Statements. BELL ATLANTIC - WASHINGTON, D.C., INC. Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" (Statement No. 109). In connection with the adoption of Statement No. 109, the Company recorded a charge to income of $381,000 in the first quarter of 1993 (see Note 5 of Notes to Financial Statements). OTHER INCOME AND EXPENSE Other income, net of expense, decreased $90,000 in 1993, principally due to the effect of interest income recognized in 1992 in connection with the settlement of various federal income tax matters relating to prior periods. This decrease was substantially offset by an increase in the allowance for funds used during construction as a result of higher telephone plant under construction in 1993. INTEREST EXPENSE Interest expense decreased $1,914,000 or 9.0% in 1993, principally due to the effects of lower short-term interest rates and long-term debt refinancings. EXTRAORDINARY ITEM The Company called $90,000,000 in 1993 of long-term debentures which were refinanced at more favorable interest rates. As a result of this early retirement, the Company incurred an after-tax charge of $4,494,000 in 1993. This debt refinancing will reduce interest costs on the refinanced debt by approximately $1,400,000 annually. CUMULATIVE EFFECT OF CHANGE IN ACCOUNTING PRINCIPLE In connection with the adoption of Statement No. 112, effective January 1, 1993, the Company recorded a one-time, cumulative effect after-tax charge of $4,221,000 in 1993 (see Note 4 of Notes to Financial Statements). The adoption of Statement No. 112 did not have a significant effect on the Company's ongoing level of expense in 1993 and is not expected to have a significant effect in future periods. COMPETITION AND REGULATORY ENVIRONMENT The telecommunications industry is currently undergoing fundamental changes which may have a significant impact on future financial performance of all telecommunications companies. These changes are driven by a number of factors, including the accelerated pace of technology change, customer requirements, a changing industry structure characterized by strategic alliances and the convergence of telecommunications and cable television, and a changing regulatory environment in which traditional regulatory barriers are being lowered and competition encouraged. The convergence of cable television, computer technology, and telecommunications can be expected to dramatically increase competition in the future. The Company is already subject to competition from numerous sources, including competitive access providers for network access services, competing cellular telephone companies and others. During 1993, a number of business alliances were announced that have the potential to significantly increase competition both within the industry and within the areas currently served by Bell Atlantic. Over the past several years, Bell Atlantic has taken a number of actions in anticipation of the increasingly competitive environment. Cost reductions have been achieved, giving greater pricing flexibility for services exposed to competition. A new lines of business organization structure was adopted. Subject to regulatory approval, the Company plans to allocate capital resources to the deployment of broadband network platforms. On the regulatory front, an alternative regulation plan has been approved on a trial basis by the District of Columbia Public Service Commission (PSC). BELL ATLANTIC - WASHINGTON, D.C., INC. The Company conducts ongoing evaluations of its accounting practices, many of which have been prescribed by regulators. These evaluations include the assessment of whether costs that have been deferred as a result of actions of regulators and the cost of the Company's telephone plant will be recoverable in the future. In the event recoverability of costs becomes unlikely due to decisions by the Company to accelerate deployment of new technology in response to specific regulatory actions or increasing levels of competition, the Company may no longer apply the provisions of Statement of Financial Accounting Standards No. 71, "Accounting for the Effects of Certain Types of Regulation" (Statement No. 71). The discontinued application of Statement No. 71 would require the Company to write off its regulatory assets and liabilities and may require the Company to adjust the carrying amount of its telephone plant should it determine that such amount is not recoverable. The Company believes that it continues to meet the criteria for continued financial reporting under Statement No. 71. A determination in the future that such criteria are no longer met may result in a significant one-time, non-cash, extraordinary charge, if the Company determines that a substantial portion of the carrying value of its telephone plant may not be recoverable. In September 1993, the FCC issued a report and order allocating radio spectrum to be licensed for use in providing personal communications services (PCS). Under the order, seven separate bandwidths of spectrum, ranging in size from 10 MHz to 30 MHz, would be auctioned to potential PCS providers in each geographic area of the United States. The geographical units by which the licenses would be allocated will be "basic trading areas" or larger "major trading areas." Five of the spectrum blocks are to be auctioned on a basic trading area basis, and the remaining two are to be auctioned by major trading area. Local exchange carriers such as the Company are eligible to bid for PCS licenses, except that cellular carriers are limited to obtaining 10 MHz of PCS bandwidth in areas where they provide cellular service. Bidders other than cellular providers may obtain multiple licenses aggregating up to 40 MHz of bandwidth in any area. Bell Atlantic has stated that it intends to pursue PCS licenses in the auctions, which are expected to be held in 1994. In August 1993, the United States District Court for the Eastern District of Virginia ruled unconstitutional the 1984 Cable Act's limitation on in-territory provision of programming by local exchange carriers such as the Company. The Cable Act currently prohibits local exchange carriers from owning more than 5% of any company that provides cable programming in their local service area. In a case originally brought by two Bell Atlantic subsidiaries, the court ruled that this prohibition violates the First Amendment's freedom of speech protections, and enjoined enforcement of the prohibition against Bell Atlantic and its telephone subsidiaries. The ruling has been appealed. STATE REGULATORY ENVIRONMENT The communications services of the Company are subject to regulation by the PSC with respect to intrastate rates and services and other matters. BELL ATLANTIC - WASHINGTON, D.C., INC. In January 1993, as the outcome of a process begun by a Company proposal to the PSC in 1988, the PSC adopted a regulatory reform plan for the in-territory services of the Company. Under the plan, the PSC adopted a banded rate of return on equity (based on earnings from all services) with 12.5% as the midpoint: the Company would be allowed to seek rate increases if its return on equity falls below 11.5% and would be required to share, through prospective rate cuts, 50% of any earnings in excess of a return on equity of 13.5%. The Company's rates for most residential services were frozen at the levels set in the prior rate proceeding in March 1992. The PSC granted pricing flexibility, including custom contracting and 14-day tariffing, for all Centrex services and for high capacity private line services since these services were found to be subject to competition. The PSC also established a screen for determining what other services are competitive and therefore should be subject to flexible pricing in the future. The plan will be in effect for three years after which the PSC will investigate the Company's performance and determine what regulatory structure is appropriate at that time. Pursuant to the PSC's January 1993 regulatory reform plan, in December 1993, the PSC re-set the Company's banded rate of return on equity to range from 10.45% to 12.45%, with a midpoint of 11.45%. However, the PSC also found that the Company was entitled to increased annual revenues of $15.8 million. The PSC increased the rates for public telephone service, increased the message unit rate for business customers and increased certain other business and residential rates to cover the increased revenue requirement. Rates for basic residential service remain frozen at the level set in March 1992. Under the plan, the Company also applied for and received pricing flexibility for several competitive services, including digital data services, paging services, speed calling, Repeat Call, Home Intercom and Home Intercom Extra. FINANCIAL CONDITION Management believes that the Company has adequate internal and external resources available to meet ongoing requirements including network expansion and modernization, and payment of dividends. Management expects that presently foreseeable capital requirements will be financed primarily through internally generated funds, although additional long-term debt may be needed to fund development activities and to maintain the Company's capital structure within management's guidelines. During 1993, as in prior years, the Company's primary source of funds continued to be cash generated from operations. Revenue growth, cost containment measures and savings on interest costs contributed to cash provided from operations of $149,902,000 for the year ended December 31, 1993. The primary use of capital resources continued to be capital expenditures. The Company invested $106,265,000 in 1993 in the network. This level of investment is expected to continue in 1994. The Company plans to allocate capital resources to the deployment of broadband network platforms, subject to regulatory approval. As of December 31, 1993, the Company's debt ratio was 46.3% compared to 45.3% at December 31, 1992. On February 1, 1993, the Company sold $90,000,000 of Thirty Year 7 3/4% Debentures through a public offering. The debentures are not redeemable prior to February 1, 2003. The net proceeds were used on February 22, 1993 to redeem $90,000,000 of Forty Year 9 3/8% Debentures. This debt refinancing will reduce annual interest costs on the refinanced debt by approximately $1,400,000. As of December 31, 1993, the Company had $60,000,000 outstanding under a shelf registration statement filed with the Securities and Exchange Commission. BELL ATLANTIC - WASHINGTON, D.C., INC. PART II Item 8. Item 8. Financial Statements and Supplementary Data The information required by this Item is set forth on pages through. 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(2).) Item 11. Item 11. Executive Compensation (Omitted pursuant to General Instruction J(2).) Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management (Omitted pursuant to General Instruction J(2).) Item 13. Item 13. Certain Relationships and Related Transactions (Omitted pursuant to General Instruction J(2).) BELL ATLANTIC - WASHINGTON, D.C., INC. 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 and Financial Statement Schedules appearing on Page. (2) Financial Statement Schedules See Index to Financial Statements and Financial Statement Schedules appearing on Page. (3) Exhibits Exhibits identified in parentheses below, on file with the SEC, are incorporated herein by reference as exhibits hereto. Exhibit Number (Referenced to Item 601 of Regulation S-K) --------------------------------------------------------- 3a Restated Certificate of Incorporation of the registrant, as amended September 14, 1990. (Exhibit 3a to the registrant's Annual Report on Form 10-K for the year ended December 31, 1990, File No. 1-7368.) 3a(i) Certificate of Amendment of the registrant's Certificate of Incorporation, dated January 12, 1994 and filed January 13, 1994. 3b By-Laws of the registrant, as amended June 18, 1992. (Exhibit 3b to the registrant's Annual Report on Form 10-K for the year ended December 31, 1992, File No. 1-7368.) 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 Agreement Concerning Contingent Liabilities, Tax Matters and Termination of Certain Agreements among AT&T, Bell Atlantic Corporation, and the Bell Atlantic Corporation telephone subsidiaries, and certain other parties, dated as of November 1, 1983. (Exhibit 10a to Bell Atlantic Corporation Annual Report on Form 10-k for the year ended December 31, 1993, File No. 1-8606.) 10b Agreement among Bell Atlantic Network Services, Inc. and the Bell Atlantic Corporation telephone subsidiaries, dated November 7, 1983. (Exhibit 10b to Bell Atlantic Corporation Annual Report on Form 10-K for the year ended December 31, 1993, File No. 1-8606.) 23 Consent of Coopers & Lybrand. 24 Powers of attorney. (b) Reports on Form 8-K There were no Current Reports on Form 8-K filed during the quarter ended December 31, 1993. BELL ATLANTIC - WASHINGTON, D.C., 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. Bell Atlantic - Washington, D.C., Inc. By /s/ Sheila D. Shears -------------------------------- Sheila D. Shears Controller March 29, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons on behalf of this registrant and in the capacities and on the date indicated. ] ] Principal Executive Officer: ] William M. Freeman President and ] Chief Executive ] Officer ] ] Principal Financial Officer: ] Sheila D. Shears Controller ] ] ] ] Directors: ] By /s/ Sheila D. Shears ] ----------------------- Joseph T. Ambrozy ] Sheila D. Shears Sherry F. Bellamy ] (individually and Samuel L. Foggie ] as attorney-in- William M. Freeman ] fact March 29, Franklyn G. Jenifer ] 1994 Eduardo Pena, Jr. ] (constituting a majority ] of the registrant's ] Board of Directors) ] ] ] BELL ATLANTIC - WASHINGTON, D.C., INC. Index to Financial Statements and Financial Statement Schedules Financial statement schedules other than those listed above have been omitted either because the required information is contained in the financial statements and the notes thereto, or because such schedules are not required or applicable. BELL ATLANTIC - WASHINGTON, D.C., INC. REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors and Shareowner of Bell Atlantic - Washington, D.C., Inc. We have audited the financial statements and financial statement schedules of Bell Atlantic - Washington, D.C., Inc. as listed in the index on 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 financial position of Bell Atlantic - Washington, D.C., Inc. 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. 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 1, 4 and 5 to financial statements, the Company changed its method of accounting for income taxes and postemployment benefits in 1993 and postretirement benefits other than pensions in 1991. /s/ COOPERS & LYBRAND 2400 Eleven Penn Center Philadelphia, Pennsylvania February 7, 1994 BELL ATLANTIC - WASHINGTON, D.C., INC. STATEMENTS OF INCOME AND REINVESTED EARNINGS For the Years Ended December 31 (Dollars in Thousands) The accompanying notes are an integral part of these financial statements. BELL ATLANTIC - WASHINGTON, D.C., INC. BALANCE SHEETS (Dollars in Thousands) The accompanying notes are an integral part of these financial statements. BELL ATLANTIC - WASHINGTON, D.C., INC. BALANCE SHEETS (Dollars in Thousands) The accompanying notes are an integral part of these financial statements. BELL ATLANTIC - WASHINGTON, D.C., INC. STATEMENTS OF CASH FLOWS For the Years Ended December 31 (Dollars in Thousands) The accompanying notes are an integral part of these financial statements. BELL ATLANTIC - WASHINGTON, D.C., INC. NOTES TO FINANCIAL STATEMENTS 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Basis of Presentation Bell Atlantic - Washington, D.C., Inc. (formerly The Chesapeake and Potomac Telephone Company) (the Company), a wholly owned subsidiary of Bell Atlantic Corporation (Bell Atlantic), maintains its accounts in accordance with the Uniform System of Accounts (USOA) prescribed by the Federal Communications Commission (FCC) and makes certain adjustments necessary to present the accompanying financial statements in accordance with generally accepted accounting principles applicable to regulated entities. Such principles differ in certain respects from those used by unregulated entities, but are required to appropriately reflect the financial and economic impacts of regulation and the ratemaking process. Significant differences resulting from the application of these principles are disclosed elsewhere in these Notes to Financial Statements where appropriate. Revenue Recognition Revenues are recognized as earned on the accrual basis, which is generally when services are rendered based on the usage of the Company's local exchange network and facilities. Cash and Cash Equivalents The Company considers all highly liquid investments with a maturity of 90 days or less when purchased to be cash equivalents. Cash equivalents are stated at cost, which approximates market value. Material and Supplies New and reusable materials are 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. Prepaid Directory Costs of directory production and advertising sales are deferred until the directory is published. Such costs are amortized to expense and the related advertising revenues are recognized over the average life of the directory, which is generally 12 months. Plant and Depreciation The Company's provision for depreciation is based principally on the remaining life method of depreciation and straight-line composite rates. The provision for depreciation is based on the following estimated remaining service lives: buildings, 25 to 35 years; central office equipment, 3 to 10 years; telephone instruments and related equipment, 3 to 6 years; poles, 19 years; cable and wiring, 5 to 17 years; conduit, 34 years; office equipment and furniture, 5 to 8 years; and vehicles and other work equipment, 3 to 8 years. This method provides for the recovery of the remaining net investment in telephone plant, less anticipated net salvage value, over the remaining service lives authorized by regulatory commissions. Depreciation expense also includes amortization of certain classes of telephone plant (and certain identified depreciation reserve deficiencies) over periods authorized by regulatory commissions. When depreciable plant is replaced or retired, the amounts at which such plant has been carried in plant, property and equipment are removed from the respective accounts and charged to accumulated depreciation, and any gains or losses on disposition are amortized over the remaining service lives of the remaining net investment in telephone plant. BELL ATLANTIC - WASHINGTON, D.C., INC. Maintenance and Repairs The cost of maintenance and repairs of plant, including the cost of replacing minor items not constituting substantial betterments, is charged to operating expenses. Allowance for Funds Used During Construction Regulatory commissions allow the Company to record an allowance for funds used during construction, which includes both interest and equity return components, as a cost of plant and, for interstate, as an item of other income. Such income is not recovered in cash currently, but will be recoverable over the service life of the plant through higher depreciation expense recognized for regulatory purposes. Employee Benefits Pension Plans Substantially all employees of the Company are covered under multi-employer noncontributory defined pension benefit plans sponsored by Bell Atlantic and its subsidiaries, including the Company. The Company uses the projected unit credit actuarial cost method for determining pension cost for financial reporting purposes. Amounts contributed to the Company's pension plans are actuarially determined, principally under the aggregate cost actuarial method, and are subject to applicable federal income tax regulations. Postretirement Benefits Other Than Pensions Substantially all employees of the Company are covered under postretirement health and life insurance benefit plans. Effective January 1, 1991, the Company adopted Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," which requires accrual accounting for all postretirement benefits other than pensions. Under the prescribed accrual method, the Company's obligation for these postretirement benefits is to be fully accrued by the date employees attain full eligibility for such benefits. A portion of the postretirement accrued benefit obligation is contributed to 501(c)(9) trusts and 401h accounts under applicable federal income tax regulations. The amounts contributed to these trusts and accounts are actuarially determined, principally under the aggregate cost actuarial method. Postemployment Benefits The Company provides employees with postemployment benefits such as disability benefits, workers' compensation, and severance pay. Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits," which requires accrual accounting for the estimated cost of benefits provided to former or inactive employees after employment but before retirement. Prior to 1993, the cost of these benefits was charged to expense as the benefits were paid. Income Taxes Bell Atlantic and its domestic subsidiaries, including the Company, file a consolidated federal income tax return. Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" (Statement No. 109), which requires the determination of deferred taxes using the liability method. Under the liability method, deferred taxes are provided on book and tax basis differences and deferred tax balances are adjusted to reflect enacted changes in income tax rates. BELL ATLANTIC - WASHINGTON, D.C., INC. The consolidated amount of current and deferred tax expense is allocated by applying the provisions of Statement No. 109 to each subsidiary as if it were a separate taxpayer. Prior to 1993, the Company accounted for income taxes based on the provisions of Accounting Principles Board Opinion No. 11, "Accounting for Income Taxes" (APB No. 11). Under APB No. 11, deferred taxes were generally provided to reflect the effect of timing differences on the recognition of revenue and expense determined for financial and income tax reporting purposes. The Tax Reform Act of 1986 repealed the investment tax credit (ITC) as of January 1, 1986, subject to certain transitional rules. ITCs were deferred and are being amortized as a reduction to income tax expense over the estimated service lives of the related assets. Reclassifications Certain reclassifications of prior years' data have been made to conform to 1993 classifications. 2. DEBT Long-Term Long-term debt consists principally of debentures issued by the Company. Interest rates and maturities of the amounts outstanding at December 31 are as follows: Long-term debt outstanding at December 31, 1993 includes $155,000,000 that is callable by the Company. The call prices range from 102.8% to 100.0% of face value, depending upon the remaining term to maturity of the issue. On February 1, 1993, the Company sold $90,000,000 of Thirty Year 7 3/4% Debentures, due February 1, 2023, through a public offering. The debentures are not redeemable by the Company prior to February 1, 2003. The net proceeds from this issue were used on February 22, 1993 to redeem $90,000,000 of Forty Year 9 3/8% Debentures due in 2026, at a call price of 107.5% of the face value of the issue. As a result of the early extinguishment of this debt, which was called on January 23, 1993, the Company recorded a charge of $7,576,000, before an income tax benefit of $3,082,000, in the first quarter of 1993. At December 31, 1993, the Company had $60,000,000 outstanding under a shelf registration statement filed with the Securities and Exchange Commission. BELL ATLANTIC - WASHINGTON, D.C., INC. The fair value of long-term debt is estimated based on the quoted market prices for the same or similar issues. At December 31, 1993 and 1992, the fair value of the Company's long-term debt, excluding unamortized discount and premium and capital lease obligations, is estimated at $251,000,000 and $241,000,000, respectively. Maturing Within One Year Debt maturing within one year consists of the following at December 31: * Amounts represent average daily face amount of the note. ** Weighted average interest rates are computed by dividing the average daily face amount of the note into the aggregate related interest expense. At December 31, 1993, the Company had an unused line of credit balance of $125,000,000 with an affiliate, Bell Atlantic Network Funding Corporation (BANFC) (Note 7). 3. LEASES The Company has entered into both capital and operating leases for facilities and equipment used in operations. Plant, property and equipment included capital leases of $15,227,000 and $11,252,000 and related accumulated amortization of $9,067,000 and $7,535,000 at December 31, 1993 and 1992, respectively. In 1993, 1992, and 1991, the Company incurred initial capital lease obligations of $4,346,000, $26,000, and $76,000, respectively. Total rent expense amounted to $11,062,000 in 1993, $11,864,000 in 1992, and $15,393,000 in 1991. Of these amounts, the Company incurred rent expense of $7,558,000, $6,876,000, and $7,416,000 in 1993, 1992, and 1991, respectively, from affiliated companies. BELL ATLANTIC - WASHINGTON, D.C., INC. At December 31, 1993, the aggregate minimum rental commitments under noncancelable leases for the periods shown are as follows: 4. EMPLOYEE BENEFITS Pension Plans Substantially all of the Company's management and associate employees are covered under multi-employer noncontributory defined benefit pension plans sponsored by Bell Atlantic and certain of its subsidiaries, including the Company. The pension benefit formula is based on a flat dollar amount per year of service according to job classification under the associate plan and a stated percentage of adjusted career average earnings under the plans for management employees. The Company's objective in funding the plans is to accumulate funds at a relatively stable level over participants' working lives so that benefits are fully funded at retirement. Plan assets consist principally of investments in domestic and foreign corporate equity securities, U.S. and foreign Government and corporate debt securities, and real estate. Aggregate pension cost for the plans is as follows: The decrease in pension cost in 1993 is due to the net effect of the elimination of one-time charges associated with special termination benefits that were recognized in the preceding years, favorable investment experience, and changes in plan demographics due to retirement and severance programs. In 1992, the Company recognized $1,838,000 of special termination benefit costs related to the early retirement of associate employees. The special termination benefit costs and the net effect of changes in plan provisions, certain actuarial assumptions, and the amortization of actuarial gains and loss related to demographic and investment experience increased pension cost in 1992. A change in the expected long-term rate of return on plan assets resulted in a $3,119,000 reduction in pension cost (which reduced operating expenses by $2,807,000 after capitalization of amounts related to the construction program) and substantially offset the 1992 cost increase. BELL ATLANTIC - WASHINGTON, D.C., INC. Statement of Financial Accounting Standards No. 87, "Employers' Accounting for Pensions" (Statement No. 87) requires a comparison of the actuarial present value of projected benefit obligations with the fair value of plan assets, the disclosure of the components of net periodic pension costs and a reconciliation of the funded status of the plans with amounts recorded on the balance sheets. The Company participates in multi-employer plans and therefore, such disclosures are not presented for the Company because the structure of the plans does not allow for the determination of this information on an individual participating company basis. Significant actuarial assumptions are as follows: The Company has in the past entered into collective bargaining agreements with unions representing certain employees and expects to do so in the future. Pension benefits have been included in these agreements and improvements in benefits have been made from time to time. Additionally, the Company has amended the benefit formula under pension plans maintained for its management employees. Expectations with respect to future amendments to the Company's pension plans have been reflected in determining the Company's pension cost under Statement No. 87. Postretirement Benefits Other Than Pensions Effective January 1, 1991, the Company adopted Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pension," (Statement No. 106). Statement No. 106 requires accrual accounting for all postretirement benefits other than pensions. Under the prescribed accrual method, the Company's obligation for these postretirement benefits is to be fully accrued by the date employees attain full eligibility for such benefits. In conjunction with the adoption of Statement No. 106, the Company elected, for financial reporting purposes, to recognize immediately the accumulated postretirement benefit obligation for current and future retirees, net of the fair value of plan assets and recognized accrued postretirement benefit cost (transition obligation), in the amount of $79,725,000, net of a deferred income tax benefit of $54,927,000. For purposes of measuring the interstate rate of return achieved by the Company, the Federal Communications Commission (FCC) permits recognition of postretirement benefit costs, including amortization of the transition obligation, in accordance with the prescribed accrual method included in Statement No. 106. In January 1993, the FCC denied adjustments to the interstate price cap formula which would have permitted tariff increases to reflect the incremental postretirement benefit cost resulting from the adoption of Statement No. 106. For intrastate ratemaking purposes, regulators issued an order on December 21, 1993, as part of a general rate preceding, which provided for the recognition of accrued postretirement benefits cost, including amortization of the transition benefit obligation over a twenty year period. Pursuant to Statement of Financial Accounting Standards No. 71, "Accounting for the Effects of Certain Types of Regulation" (Statement No. 71), a regulatory asset associated with the recognition of the transition obligation was not recorded because of uncertainties as to the timing and extent of recovery given the Company's assessment of its long-term competitive environment. BELL ATLANTIC - WASHINGTON, D.C., INC. Substantially all of the Company's management and associate employees are covered under postretirement health and life insurance benefit plans sponsored by Bell Atlantic and certain of its subsidiaries, including the Company. The determination of benefit cost for postretirement health benefit plans is based on comprehensive hospital, medical, surgical and dental benefit plan provisions. The postretirement life insurance benefit formula used in the determination of postretirement benefit cost is primarily based on annual basic pay at retirement. The Company funds the postretirement health and life insurance benefits of current and future retirees. Plan assets consist principally of investments in domestic and foreign corporate equity securities, and U.S. Government and corporate debt securities. The aggregate postretirement benefit cost for the year ended December 31, 1993, 1992, and 1991 was $13,694,000, $12,084,000, and $11,875,000, respectively. As a result of the 1992 collective bargaining agreements, Bell Atlantic amended the postretirement medical benefit plan for associate employees and certain associate retirees of the Company. The increases in the postretirement benefit cost between 1993 and 1991 were primarily due to the change in benefit levels and claims experience. Also contributing to these increases were changes in actuarial assumptions and demographic experience. Statement No. 106 requires a comparison of the actuarial present value of projected benefit obligations with the fair value of plan assets, the disclosure of the components of net periodic postretirement benefit costs, and a reconciliation of the funded status of the plan with amounts recorded on the balance sheets. The Company participates in multi-employer plans and therefore, such disclosures are not presented for the Company because the structure of the plans does not provide for the determination of this information on an individual participating company basis. The assumed discount rate used to measure the accumulated postretirement benefit obligation was 7.25% at December 31, 1993 and 7.75% at December 31, 1992. The assumed rate of future increases in compensation levels was 5.25% at December 31, 1993 and 1992. The expected long-term rate of return on plan assets was 8.25% for 1993 and 1992 and 7.5% for 1991. The medical cost trend rate in 1993 was approximately 13.0%, grading down to an ultimate rate in 2003 of approximately 5.0%. The dental cost trend rate in 1993 and thereafter is approximately 4.0%. Postretirement benefits other than pensions have been included in collective bargaining agreements and have been modified from time to time. The Company has periodically modified benefits under plans maintained for its management employees. Expectations with respect to future amendments to the Company's postretirement benefit plans have been reflected in determining the Company's postretirement benefit cost under Statement No. 106. Postemployment Benefits Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits" (Statement No. 112). Statement No. 112 requires accrual accounting for the estimated cost of benefits provided to former or inactive employees after employment but before retirement. This change principally affects the Company's accounting for disability and workers' compensation benefits, which previously were charged to expense as the benefits were paid. The cumulative effect at January 1, 1993 of adopting Statement No. 112 reduced net income by $4,221,000, net of a deferred tax benefit of $2,891,000. The adoption of Statement No. 112 did not have a significant effect on the Company's ongoing level of operating expense in 1993. BELL ATLANTIC - WASHINGTON, D.C., INC. 5. INCOME TAXES Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" (Statement No. 109). Statement No. 109 requires the determination of deferred taxes using the liability method. Under the liability method, deferred taxes are provided on book and tax basis differences and deferred tax balances are adjusted to reflect enacted changes in income tax rates. Prior to 1993, the Company accounted for income taxes based on the provisions of Accounting Principles Board Opinion No. 11. Statement No. 109 has been adopted on a prospective basis and amounts presented for prior years have not been restated. As of January 1, 1993, the Company recorded a charge to income of $381,000, representing the cumulative effect of adopting Statement No. 109, which has been reflected in Operating Income Taxes in the Statement of Income and Reinvested Earnings. Upon adoption of Statement No. 109, the effects of required adjustments to deferred tax balances were primarily deferred on the balance sheet as regulatory assets and liabilities in accordance with Statement of Financial Accounting Standards No. 71, "Accounting for the Effects of Certain Types of Regulation" (Statement No. 71). At January 1, 1993, the Company recorded income tax-related regulatory assets totaling $19,245,000 in Other Assets. These regulatory assets represent the anticipated future regulatory recognition of the Statement No. 109 adjustments to recognize (i) temporary differences for which deferred taxes had not been provided and (ii) the increase in the deferred state tax liability which resulted from increases in state income tax rates subsequent to the dates the deferred taxes were recorded. In addition, income tax-related regulatory liabilities totaling $40,199,000 were recorded in Deferred Credits and Other Liabilities - Other. These regulatory liabilities represent the anticipated future regulatory recognition of the Statement No. 109 adjustments to recognize (i) a reduced deferred tax liability resulting from decrease in federal income tax rates subsequent to the dates the deferred taxes were recorded and (ii) a deferred tax benefit required to recognize the effects of the temporary differences attributable to the Company's policy of accounting for investment tax credits using the deferred method. These deferred taxes and regulatory assets and liabilities have been increased for the tax effect of future revenue requirements. These regulatory assets and liabilities are amortized at the time the related deferred taxes are recognized in the ratemaking process. Prior to the adoption of Statement No. 109, the Company had income tax timing differences for which deferred taxes had not been provided pursuant to the ratemaking process of $18,484,000 and $24,273,000 at December 31, 1992 and 1991, respectively. These timing differences principally related to the allowance for funds used during construction and certain taxes and payroll-related construction costs capitalized for financial statement purposes, but deducted currently for income tax purposes, net of applicable depreciation. The Omnibus Budget Reconciliation Act of 1993, which was enacted in August 1993, increased the federal corporate income tax rate from 34% to 35%, effective January 1, 1993. In the third quarter of 1993, the Company recorded a net benefit to the tax provision of $131,000, which included a $919,000 charge for the nine month effect of the 1% rate increase, more than offset by a one- time net benefit of $1,050,000 related to adjustments to deferred tax assets associated with the postretirement benefit obligation of the Company. Pursuant to Statement No. 71, the effect of the income tax rate increase on deferred tax balances was primarily deferred through the establishment of regulatory assets of $722,000 and the reduction of regulatory liabilities of $4,319,000. The Company did not recognize regulatory assets and liabilities related to the postretirement benefit obligation or the associated deferred income tax asset. BELL ATLANTIC - WASHINGTON, D.C., INC. The components of income tax expense are as follows: Income tax benefits which relates to non-operating income and expense and is included in Miscellaneous-net were $665,000, $10,000, and $352,000 in 1993, 1992, and 1991, respectively. For the years ended December 31, 1992 and 1991, deferred income tax expense resulted from timing differences in the recognition of revenue and expense for financial and income tax accounting purposes. The sources of these timing differences and the tax effects of each were as follows: The provision for income taxes varies from the amount computed by applying the statutory federal income tax rate to income before provision for income taxes. The difference is attributable to the following factors: At December 31, 1993, the significant components of deferred tax assets and liabilities were as follows: BELL ATLANTIC - WASHINGTON, D.C., INC. Total deferred tax assets include approximately $58,000,000 related to postretirement benefit costs recognized in accordance with Statement No. 106. This deferred tax asset will gradually be realized over the estimated lives of current retirees and employees. 6. SUPPLEMENTAL CASH FLOW AND ADDITIONAL FINANCIAL INFORMATION For the years ended December 31, 1993, 1992, and 1991, revenues generated from services provided to AT&T, principally network access, billing and collection, and sharing of network facilities, were $42,983,000, $57,144,000 and $60,879,000 respectively. At December 31, 1993 and 1992, Accounts receivable, net, included $14,672,000 and $13,205,000 respectively, from AT&T. Financial instruments that potentially subject the Company to concentrations of credit risk consist of trade receivables with AT&T, as noted above. Credit risk with respect to other trade receivables is limited due to the large number of customers included in the Company's customer base. At December 31, 1992, $510,000 of negative cash was classified as Accounts payable. 7. TRANSACTIONS WITH AFFILIATES The Company has contractual arrangements with an affiliated company, Bell Atlantic Network Services, Inc. (NSI), for the provision of various centralized corporate, administrative, planning, financial and other services. These arrangements serve to fulfill the common needs of Bell Atlantic's telephone subsidiaries on a centralized basis. In connection with these services, the Company recognized $103,684,000, $99,153,000, and $94,619,000 in operating expenses for the years ended December 31, 1993, 1992, and 1991, respectively. Included in these expenses were $6,908,000 in 1993, $9,450,000 in 1992, and $7,673,000 in 1991 billed to NSI and allocated to the Company by Bell Communications Research, Inc., another affiliated company owned jointly by the seven regional holding companies. In 1991, these charges included $2,680,000, associated with NSI's adoption of Statement No. 106. In addition, in 1991, the Company recognized $27,124,000 representing the Company's proportionate share of NSI's accrued transition obligation under Statement No. 106. In connection with the adoption of Statement No. 112 in 1993, the cumulative effect included $555,000, net of a deferred income tax benefit of $380,000, representing the Company's proportionate share of NSI's accrued cost of postemployment benefits at January 1, 1993. BELL ATLANTIC - WASHINGTON, D.C., INC. The Company has a contractual agreement with an affiliated company, BANFC, for the provision of short-term financing and cash management services. BANFC issues commercial paper and secures bank loans to fund the working capital requirements of the telephone subsidiaries and NSI and invests funds in temporary investments on their behalf. In connection with this arrangement, the Company recognized interest expense of $124,000, $818,000, and $1,587,000 in 1993, 1992, and 1991, respectively, and $214,000, $54,000, and $2,000 in interest income in 1993, 1992, and 1991, respectively. In 1993, the Company received $59,750,000 in revenue from affiliates, principally related to rent received for the use of Company facilities and equipment, and paid $7,973,000 in other operating expense to affiliated companies. These amounts were $57,326,000 and $6,876,000, respectively, in 1992, and $56,856,000 and $7,416,000, respectively, in 1991. On February 1, 1994, the Company declared and paid a dividend in the amount of $7,672,000 to Bell Atlantic. 8. QUARTERLY FINANCIAL INFORMATION (unaudited) Net income for the first quarter of 1993 has been restated to include a charge of $4,221,000, net of a deferred income tax benefit of $2,891,000, related to the adoption of Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits" (Note 4). BELL ATLANTIC - WASHINGTON, D.C., INC. SCHEDULE V - PLANT, PROPERTY AND EQUIPMENT ------------------------------------------ For the Year Ended December 31, 1993 (Dollars in Thousands) The notes on page are an integral part of this schedule. BELL ATLANTIC - WASHINGTON, D.C., INC. SCHEDULE V - PLANT, PROPERTY AND EQUIPMENT For the Year Ended December 31, 1992 (Dollars in Thousands) The notes on page are an integral part of this schedule. BELL ATLANTIC - WASHINGTON, D.C., INC. SCHEDULE V - PLANT, PROPERTY AND EQUIPMENT For the Year Ended December 31, 1991 (Dollars in Thousands) The notes on page are an integral part of this schedule. BELL ATLANTIC - WASHINGTON, D.C., INC. NOTES TO SCHEDULE V - PLANT, PROPERTY AND EQUIPMENT - -------------- (a) These additions include (1) the original cost (estimated if not specifically determinable) of reused material, which is concurrently credited to material and supplies, and (2) allowance for funds used during construction. Transfers between Plant in Service, Plant Under Construction and Other are also included in Additions at Cost. (b) Items of plant, property and equipment are deducted from the property accounts when retired or sold at the amounts at which they are included therein, estimated if not specifically determinable. (c) The Company's provision for depreciation is principally based on the remaining life method and straight-line composite rates prescribed by regulatory authorities. The remaining life method provides for the full recovery of the remaining net investment in plant, property and equipment. In 1992, the Company implemented changes in depreciation rates approved by regulatory authorities. These changes reflect decreases in estimated service lives of the Company's plant, property and equipment in service. This ruling will allow a more rapid recovery of the Company's investment in plant, property and equipment through closer alignment with current estimates of its remaining economic useful life. For the years 1993, 1992, and 1991, depreciation expressed as a percentage of average depreciable plant was 8.4%, 8.5%, and 7.0%, respectively. (d) See Note 1 of Notes to Financial Statements for the Company's depreciation policies. BELL ATLANTIC - WASHINGTON, D.C., INC. SCHEDULE VI - ACCUMULATED DEPRECIATION For the Years Ended December 31, 1993, 1992, and 1991 (Dollars in Thousands) - ---------------------------------------- (a) Includes any gains or losses on disposition of plant, property and equipment. These gains and losses are amortized to depreciation expense over the remaining service lives of remaining net investment in plant, property and equipment. BELL ATLANTIC - WASHINGTON, D.C., INC. SCHEDULE VIII - VALUATION OF QUALIFYING ACCOUNTS For the Years Ended December 31, 1993, 1992, and 1991 (Dollars in Thousands) - ------------------------------------------- (a) (i) Amounts previously written off which were credited directly to this account when recovered; and (ii) accruals charged to accounts payable for anticipated uncollectible charges on purchases of accounts receivable from others which were billed by the Company. (b) Amounts written off as uncollectible. BELL ATLANTIC - WASHINGTON, D.C., INC. SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION For the Years Ended December 31, 1993, 1992, and 1991 (Dollars in Thousands) Advertising costs for 1993, 1992, and 1991 are not presented, as such amounts are less than 1 percent of total operating revenues. Amounts reported for 1992 and 1991 for maintenance and repairs have been revised to include certain additional costs. EXHIBITS FILED WITH ANNUAL REPORT FORM 10-K UNDER THE SECURITIES EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED DECEMBER 31, 1993 Bell Atlantic - Washington, D.C., Inc. COMMISSION FILE NUMBER 1-7368 Form 10-K for 1993 File No. 1-7368 Page 1 of 1 EXHIBIT INDEX Exhibits identified in parentheses below, on file with the Securities and Exchange Commission (SEC), are incorporated herein by reference as exhibits hereto. Exhibit Number (Referenced to Item 601 of Regulation S-K) - ---------------------------------------------------------- 3a Restated Certificate of Incorporation of the registrant, as amended September 14, 1990. (Exhibit 3a to the registrant's Annual Report on Form 10-K for the year ended December 31, 1990, File No. 1-7368.) 3a(i) Certificate of Amendment of the registrant's Certificate of Incorporation, dated January 12, 1994 and filed January 13, 1994. 3b By-Laws of the registrant, as amended June 18, 1992. (Exhibit 3b to the registrant's Annual Report on Form 10-K for the year ended December 31, 1992, File No. 1-7368.) 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 Agreement Concerning Contingent Liabilities, Tax Matters and Termination of Certain Agreements among AT&T, Bell Atlantic Corporation, and the Bell Atlantic Corporation telephone subsidiaries, and certain other parties, dated as of November 1, 1983. (Exhibit 10a to Bell Atlantic Corporation Annual Report on Form 10-K for the year ended December 31, 1993, File No. 1-8606.) 10b Agreement among Bell Atlantic Network Services, Inc. and the Bell Atlantic Corporation telephone subsidiaries, dated November 7, 1983. (Exhibit 10b to Bell Atlantic Corporation Annual Report on Form 10-K for the year ended December 31, 1993, File No. 1-8606.) 23 Consent of Coopers & Lybrand. 24 Powers of attorney.

847322_1993.txt

847322_1993

1993

847322

ITEM 1. BUSINESS Development and Description of Business - --------------------------------------- Information concerning the business of CRIIMI MAE Inc. (CRIIMI MAE) is contained in Part II, Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations, and in Notes 1, 5 and 14 of the notes to the consolidated financial statements of CRIIMI MAE contained in Part IV (filed in response to Item 8 hereof), which is incorporated herein by reference. Employees - --------- CRIIMI MAE has no employees. Services are performed for CRIIMI MAE by CRI Insured Mortgage Associates Adviser Limited Partnership (the Adviser) and agents retained by it. ITEM 2. ITEM 2. PROPERTIES CRIIMI MAE does not hold title to any real estate. CRIIMI MAE indirectly holds interests in real estate through CRI Liquidating REIT, Inc.'s (CRI Liquidating) equity investment in three Participating Mortgage Investments. These investments were comprised of two components: 85% of the original investment amount was a GNMA Mortgage-Backed Security; and 15% of the original investment amount was an uninsured equity contribution to the limited partnership (a Participation) which owns the underlying property. During 1993, CRI Liquidating sold the GNMA Mortgage-Backed Securities, but retained its Participations. The aggregate carrying value of these Participations represents less than 1% of CRIIMI MAE's total consolidated assets as of December 31, 1992 and 1993. Although CRIIMI MAE does not own the related real estate, the government insured and guaranteed mortgage investments (Government Insured Multifamily Mortgages) in which CRIIMI MAE has invested are first or second liens, or are collateralized by first or second liens, on the respective residential apartment, nursing home or townhouse complexes. PART I ITEM 3. ITEM 3. LEGAL PROCEEDINGS Reference is made to Note 15 of the notes to the consolidated financial statements on pages 134 through 135 of the 1993 Annual Report to Shareholders, which is incorporated herein by reference. 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 THE REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS (a), (b) and (c) The information required in these sections is included in Selected Consolidated Financial Data on pages 22 through 26 of the 1993 Annual Report to Shareholders, which section is incorporated herein by reference. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA Reference is made to Selected Consolidated Financial Data on pages 22 through 26 of the 1993 Annual Report to Shareholders, which section is incorporated herein by reference. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Reference is made to Management's Discussion and Analysis of Financial Condition and Results of Operations on pages 27 through 63 of the 1993 Annual Report to Shareholders, which section is incorporated herein by reference. PART II ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Reference is made to pages 64 through 74 of the 1993 Annual Report to Shareholders for the consolidated financial statements of CRIIMI MAE, which are incorporated herein by reference. See also Item 14 of this report for information concerning financial statements and financial statement schedules. 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), (b), (c) and (e) The information required by Item 10 (a), (b), (c) and (e) with regard to directors and executive officers of the registrant is incorporated herein by reference to CRIIMI MAE's 1994 Notice of Annual Meeting of Shareholders and Proxy Statement to be filed with the Securities and Exchange Commission no later than April 30, 1994. (d) There is no family relationship between any of the directors and executive officers. (f) Involvement in certain legal proceedings. None. (g) Promoters and control persons. Not applicable. PART III ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The information required by Item 11 is incorporated herein by reference to CRIIMI MAE's 1994 Notice of Annual Meeting of Shareholders and Proxy Statement to be filed with the Commission no later than April 30, 1994, and Note 3 of the notes to the consolidated financial statements included in the 1993 Annual Report to Shareholders. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information required by Item 12 is incorporated herein by reference to CRIIMI MAE's 1994 Notice of Annual Meeting of Shareholders and Proxy Statement to be filed with the Commission no later than April 30, 1994. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS (a) Transactions with management and others. Of CRIIMI MAE's five officers, two are executive officers who serve on CRIIMI MAE's Board of Directors. CRIIMI MAE's 1994 Notice of Annual Meeting of Shareholders and Proxy Statement to be filed with the Commission no later than April 30, 1994, and Note 3 of the notes to the consolidated financial statements, included in the 1993 Annual Report to Shareholders, which contain a discussion of the amounts, fees and other compensation paid or accrued by CRIIMI MAE to the directors and executive officers and their affiliates, are incorporated herein by reference. (b) Certain business relationships. CRIIMI MAE has no business relationship with entities of which the general and limited partners of the Adviser to CRIIMI MAE are officers, directors or equity owners other than as set forth in CRIIMI MAE's 1994 Notice of PART III ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS - Continued Annual Meeting of Shareholders and Proxy Statement to be filed with the Commission no later than April 30, 1994, which is incorporated herein by reference. (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) List of documents filed as part of this report: 1 and 2. Financial Statements and Financial Statement Schedules The following financial statements are incorporated herein by reference in Item 8 from the indicated pages of the 1993 Annual Report to Shareholders: The report of CRIIMI MAE's independent accountants with respect to the above listed consolidated financial statements appears on page 64 of the 1993 Annual Report to Shareholders. All other financial statements and financial statement schedules have been omitted since the required information is included in the financial statements or the notes thereto, or is not applicable or required. (a) 3. Exhibits (listed according to the number assigned in the table in Item 601 of Regulation S-K) Exhibit No. 3 - Articles of incorporation and bylaws. d. Articles of Incorporation of CRIIMI MAE Inc. (Incorporated by reference from Exhibit 3(d) to the Quarterly Report on Form 10-Q for the quarter ended June 30, 1993). e. Bylaws of CRIIMI MAE Inc. (Incorporated by reference from Exhibit 3(e) to the Quarterly Report on Form 10-Q for the quarter ended June 30, 1993). f. Agreement and Articles of Merger between CRIIMI MAE Inc. and CRI Insured Mortgage Association, Inc. as filed with the Office of the Secretary of the State of Delaware (Incorporated by reference from Exhibit 3(f) to the Quarterly Report on Form 10-Q for the quarter ended June 30, 1993). g. Agreement and Articles of Merger between CRIIMI MAE Inc. and CRI Insured Mortgage Association, Inc. as filed with the State Department of Assessment and Taxation for the State of Maryland (Incorporated by reference from Exhibit 3(g) to the Quarterly Report on Form 10-Q for the quarter ended June 30, 1993). Exhibit No. 4 - Instruments defining the rights of security holders, including indentures. a. $85,000,000 Credit Agreement, and the exhibits thereto, dated as of October 23, 1991, between CRI Insured Mortgage Association, Inc., Signet Bank/Virginia and Westpac Banking Corporation (Incorporated by reference from Exhibit 4(g) to the Annual Report on Form 10-K for 1991). b. Collateral Pledge Agreement, and the exhibits thereto, dated as of December 31, 1991, between CRI Insured Mortgage Association, Inc., Signet Bank/Virginia, Westpac Banking Corporation and Chemical Bank (Incorporated by reference from Exhibit 4(h) to the Annual Report on Form 10-K for 1991). c. Temporary Global Note, dated as of December 31, 1991, in the aggregate amount of $19,190,625 issued by the registrant (Incorporated by reference from Exhibit 4(i) to the Annual Report on Form 10-K for 1991). d. $100,000,000 Amended and Restated Credit Agreement, and the exhibits thereto, dated as of October 23, 1991 and Amended December 22, 1992, between CRI Insured Mortgage Association, Inc., Signet Bank/Virginia and Westpac Banking Corporation (Incorporated by reference from Exhibit 4(d) to the Annual Report on Form 10-K for 1992). e. Amended and Restated Collateral Pledge Agreement, and the exhibits thereto, dated as of December 31, 1991 and amended and restated as of December 29, 1992, between CRI Insured Mortgage Association, Inc. and Chemical Bank (Incorporated by reference from Exhibit 4(e) to the Annual Report on Form 10-K for 1992). f. Amended and Restated Letter of Credit and Reimbursement Agreement and the exhibits thereto, dated as of February 9, 1993 between CRI Funding Corporation, Canadian Imperial Bank of Commerce New York Agency and National Australia Bank Limited, New York Branch (Incorporated by reference from Exhibit 4(f) to the Annual Report on Form 10-K for 1992). g. Amended and Restated Guaranty, dated as of February 9, 1993 between CRI Insured Mortgage Association, Inc., Canadian Imperial Bank of Commerce New York Agency and National Australia Bank Limited, New York Branch (Incorporated by reference from Exhibit 4(g) to the Annual Report on Form 10-K for 1992). h. Amended and Restated Loan Agreement and the exhibits thereto, dated as of February 9, 1993 between CRI Insured Mortgage Association, Inc. and CRI Funding Corporation (Incorporated by reference from Exhibit 4(h) to the Annual Report on Form 10-K for 1992). i. Second Amended and Restated Security Agreement and the exhibits thereto, dated as of February 9, 1993 between CRI Insured Mortgage Association, Inc., Canadian Imperial Bank of Commerce New York Agency and Chemical Bank (Incorporated by reference from Exhibit 4(i) to the Annual Report on Form 10-K for 1992). j. Committed Master Repurchase Agreement between Nomura Securities International, Inc. and CRI Insured Mortgage Association, Inc. dated April 30, 1993 (Incorporated by reference from Exhibit 4(j) to the Quarterly Report on Form 10-Q for the quarter ended June 30, 1993). k. Committed Master Repurchase Agreement Governing Purchases and Sales of Participation Certificates between Nomura Asset Capital Corporation and CRI Insured Mortgage Association, Inc. dated April 30, 1993 (Incorporated by reference from Exhibit 4(k) to the Quarterly Report on Form 10-Q for the quarter ended June 30, 1993). l. Committed Master Repurchase Agreement between Nomura Securities International, Inc. and CRIIMI MAE Inc. dated November 30, 1993 (filed herewith). m. Committed Master Repurchase Agreement Governing Purchases and Sales of Participation Certificates between Nomura Asset Capital Corporation and CRIIMI MAE Inc. dated November 30, 1993 (filed herewith). n. Extension and Amendment Agreement between CRI Funding Corporation, CRIIMI MAE Inc., Canadian Imperial Bank of Commerce New York Agency, National Australia Bank Limited, New York Branch, and The Fuji Bank, Ltd., New York Branch dated January 25, 1994 (filed herewith). o. Settlement Agreement between Alex J. Meloy, Trustee of the Harry Meloy Family Trust and Alan J. Hunken, Trustee of the Alan J. Hunken Retirement Plan, individually and in their capacities as representatives of certain plaintiff classes in Alex J. Meloy, et ----------------- al., v. CRI Liquidating REIT, Inc., et al., and (ii) CRI ------------------------------------------- Liquidating REIT, Inc.; CRIIMI MAE Inc.; C.R.I., Inc.; William B. Dockser; Martin C. Schwartzberg, and H. William Willoughby dated September 24, 1993 (filed herewith). Exhibit No. 10 - Material contracts. a. Revised Form of Advisory Agreement. (Incorporated by reference from Exhibit No. 10.2 to the Registration Statement). Exhibit No. 13 - Annual Report to security holders, Form 10-Q or Quarterly Report to security holders. a. 1993 Annual Report to Shareholders. Exhibit No. 21 - Subsidiaries of the registrant. a. CRI Liquidating REIT, Inc., incorporated in the state of Maryland. b. CRIIMI, Inc., incorporated in the state of Maryland. (b) Reports on Form 8-K No reports on Form 8-K were filed during the fourth quarter of 1993. (c) Exhibits The list of Exhibits required by Item 601 of Regulation S-K is included in Item (a)(3) above. (d) Financial Statement Schedules See Item (a) 1 and 2 above. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized. CRIIMI MAE INC. February 15, 1994 /s/ William B. Dockser - --------------------- ------------------------------ DATE William B. Dockser Chairman of the Board and Principal 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: February 15, 1994 /s/ Elizabeth O. Flanagan - --------------------- --------------------------------- DATE Elizabeth O. Flanagan Chief Financial Officer and Principal Financial and Accounting Officer February 15, 1994 /s/ H. William Willoughby - --------------------- --------------------------------- DATE H. William Willoughby Director, President and Secretary February 15, 1994 /s/ Jay R. Cohen - --------------------- --------------------------------- DATE Jay R. Cohen Executive Vice President and Treasurer February 2, 1994 /s/ Frederick J. Burchill - --------------------- --------------------------------- DATE Frederick J. Burchill Executive Vice President February 2, 1994 /s/ Garrett G. Carlson, Sr. - --------------------- --------------------------------- DATE Garrett G. Carlson, Sr. Director February 10, 1994 /s/ G. Richard Dunnells - --------------------- --------------------------------- DATE G. Richard Dunnells Director February 15, 1994 /s/ Robert F. Tardio - --------------------- --------------------------------- DATE Robert F. Tardio Director CROSS REFERENCE SHEET The item numbers and captions in Parts I, II, III and IV hereof and the page and/or pages in the referenced materials where the corresponding information appears are as follows: CROSS REFERENCE SHEET EXHIBIT INDEX CRIIMI MAE INC. ANNUAL REPORT TO SHAREHOLDERS Selected Consolidated Financial Data CRIMIMI MAE INC. Selected Consolidated Financial Data - Continued CRIIMI MAE INC. Selected Consolidated Financial Data - Continued The selected consolidated statements of income data presented above for the years ended December 31, 1991, 1992 and 1993, and the consolidated balance sheet data as of December 31, 1992 and 1993, were derived from and are qualified by reference to CRIIMI MAE's consolidated financial statements which have been included elsewhere in this Annual Report to Shareholders. The consolidated statements of income data for the years ended December 31, 1989 and 1990 and the consolidated balance sheet data as of December 31, 1989, 1990 and 1991 were derived from audited financial statements not included in this Annual Report to Shareholders. This data should be read in conjunction with the consolidated financial statements and the notes thereto. (a) All financial information of CRIIMI MAE for the periods prior to the Merger (defined below) on November 27, 1989 has been presented in a manner similar to a pooling of interests, which effectively combines the historical results of the CRIIMI Funds (defined below). The dividends and net income per share amounts for the year ended December 31, 1989 have been restated based upon the weighted average shares outstanding as if the Merger had been consummated on January 1, 1989. (b) This amount does not include the special dividend of $2.31 per share paid to CRIIMI MAE shareholders of record on November 27, 1989. (c) Includes recognition of an extraordinary loss of approximately $6.6 million ($0.33 per share) resulting from the refinancing of certain notes payable. CRIIMI MAE INC. Selected Consolidated Financial Data - Continued (d) Includes net unrealized gain on mortgage investments of CRI Liquidating of approximately $29.0 million due to the implementation of Statement of Financial Accounting Standard No. 115. Market Data - ----------- On November 28, 1989, CRIIMI MAE was listed on the New York Stock Exchange (Symbol CMM). Prior to that date, there was no public market for CRIIMI MAE's shares. As of December 31, 1992 and 1993, there were 20,183,533 shares held by approximately 23,000 investors. The following table sets forth the high and low closing sales prices and the dividends per share for CRIIMI MAE shares during the periods indicated: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Background - ---------- CRIIMI MAE Inc. (CRIIMI MAE) (formerly CRI Insured Mortgage Association, Inc.), an infinite-life, actively managed real estate investment trust (REIT), is the largest REIT specializing in government insured and guaranteed mortgage investments secured by multifamily housing complexes (Government Insured Multifamily Mortgages) located throughout the United States. CRIIMI MAE's principal objectives are to provide stable or growing quarterly cash distributions to its shareholders while preserving and protecting its capital. CRIIMI MAE seeks to achieve these objectives by investing primarily in Government Insured Multifamily Mortgages using a combination of debt and equity financing. CRIIMI MAE and its subsidiary, CRI Liquidating REIT, Inc. (CRI Liquidating), are Maryland corporations. CRIIMI MAE and CRI Liquidating were formed in 1989 to effect the merger into CRI Liquidating (the Merger) of three federally insured mortgage funds sponsored by C.R.I., Inc. (CRI), a Delaware corporation formed in 1974: CRI Insured Mortgage Investments Limited Partnership (CRIIMI I); CRI Insured Mortgage Investments II, Inc. (CRIIMI II); and CRI Insured Mortgage Investments III Limited Partnership (CRIIMI III; and, together with CRIIMI I and CRIIMI II, the CRIIMI Funds). The Merger was effected to provide certain potential benefits to investors in the CRIIMI Funds, including the elimination of unrelated business taxable income for certain tax-exempt investors, the diversification of investments, the reduction of general overhead and administrative costs as a percentage of assets and total income and the simplification of tax reporting information. In the Merger, which was approved by investors in each of the CRIIMI Funds and subsequently consummated on November 27, 1989, investors in the CRIIMI Funds received, at their option, shares of CRI Liquidating common stock or shares of CRIIMI MAE common stock. Investors in the CRIIMI Funds that received shares of CRIIMI MAE common stock became shareholders in an infinite-life, actively managed REIT having the potential to increase the size of its portfolio and enhance the returns to its shareholders. CRIIMI MAE shareholders retained their economic interests in the assets of the CRIIMI Funds which were transferred to CRI Liquidating through the issuance of one CRI Liquidating share to CRIIMI MAE for each MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued share of CRIIMI MAE common stock issued to investors in the Merger. Upon the completion of the Merger, CRIIMI MAE held a total of 20,361,807 CRI Liquidating shares, or approximately 67% of the issued and outstanding CRI Liquidating shares. Investors in the CRIIMI Funds that received shares of CRI Liquidating common stock, as well as CRIIMI MAE, became shareholders in a finite-life, self-liquidating REIT the assets of which consist primarily of Government Insured Multifamily Mortgages and other assets formerly held by the CRIIMI Funds. CRI Liquidating intends to hold, manage and dispose of its mortgage investments in accordance with the objectives and policies of the CRIIMI Funds, including disposing of any remaining mortgage investments by 1997 through an orderly liquidation. Pursuant to a Registration Rights Agreement dated November 28, 1989 between CRIIMI MAE and CRI Liquidating, CRIIMI MAE sold 3,162,500 of its CRI Liquidating shares in an underwritten public offering which was consummated in November 1993. As a result of such sale, CRIIMI MAE holds a total of 17,199,307 CRI Liquidating shares, or approximately 57% of CRI Liquidating's issued and outstanding common stock. CRIIMI MAE used approximately $4.9 million of the approximately $26.5 million in net proceeds to terminate a 9.23% interest rate swap agreement on $25 million of CRIIMI MAE's existing indebtedness and used the remaining net proceeds to purchase Government Insured Multifamily Mortgages. CRIIMI MAE and CRI Liquidating are governed by a board of directors, a majority of whom are independent directors with extensive industry related experience. The Board of Directors of CRIIMI MAE and CRI Liquidating has engaged CRI Insured Mortgage Associates Adviser Limited Partnership (the Adviser) to act in the capacity of adviser to CRIIMI MAE and CRI Liquidating. The Adviser's general partner is CRI and its operations are conducted by CRI's employees. CRIIMI MAE's and CRI Liquidating's executive officers are senior executive officers of CRI. The Adviser manages CRIIMI MAE's portfolio of Government Insured Multifamily Mortgages and other assets with the goal of maximizing CRIIMI MAE's value, and conducts CRIIMI MAE's day-to-day operations. Under an advisory agreement between CRIIMI MAE and the Adviser, the Adviser and its affiliates receive certain fees and expense reimbursements. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued CRIIMI MAE Investments - ---------------------- CRIIMI MAE's investment policies, which are overseen by the CRIIMI MAE Board of Directors, are intended to foster its objectives of providing stable or growing quarterly cash distributions to its shareholders while preserving and protecting its capital. CRIIMI MAE seeks to achieve these objectives by investing primarily in Government Insured Multifamily Mortgages issued or sold pursuant to programs sponsored by the Federal Housing Administration (FHA) and the Government National Mortgage Association (GNMA). CRIIMI MAE's sources of capital include borrowings, principal distributions received on its CRI Liquidating shares, principal proceeds of CRIIMI MAE mortgage dispositions and proceeds from equity offerings. As of December 31, 1992 and 1993, CRIIMI MAE directly owned 60 and 126 Government Insured Multifamily Mortgages, respectively, which had a weighted average effective interest rate of approximately 10.1% and 8.52%, a weighted average remaining term of approximately 31 years and 34 years, and a tax basis of approximately $226 million and $499 million, respectively. As of December 31, 1992 and 1993, CRIIMI MAE indirectly owned through its subsidiary, CRI Liquidating, 73 and 63 Government Insured Multifamily Mortgages, respectively, which had a weighted average effective interest rate of approximately 9.91% and 10.03%, a weighted average remaining term of approximately 28 years and 27 years, and a tax basis of approximately $221 million and $173 million, respectively. Thus, on a consolidated basis, as of December 31, 1992 and 1993, CRIIMI MAE owned, directly or indirectly, 133 and 189 Government Insured Multifamily Mortgages, respectively. These consolidated mortgage investments (including Mortgages Held for Disposition) had a weighted average effective interest rate of approximately 9.98%, a weighted average remaining term of approximately 29 years and a tax basis of approximately $447 million, as of December 31, 1992. These amounts compare to a weighted average effective interest rate of approximately 8.95%, a weighted average remaining term of approximately 32 years and a tax basis of approximately $672 million, as of December 31, 1993. In addition, as of December 31, 1993, CRIIMI MAE had committed MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued approximately $41 million for investment in Government Insured Multifamily Mortgages or advances on FHA-Insured Loans (defined below) relating to the construction or rehabilitation of multifamily housing projects, including nursing homes and intermediate care facilities (Government Insured Construction Mortgages), to be funded by borrowings under the Commercial Paper Facility and the remaining funds available under the Master Repurchase Agreements, as defined below in "Liquidity-Corporate Borrowings". In connection with CRI Liquidating's business plan which calls for an orderly liquidation of approximately 25% of its December 31, 1993 portfolio balance each year through 1997, on February 10, 1994, CRI Liquidating sold twelve Government Insured Multifamily Mortgages resulting in net sales proceeds of approximately $48.7 million. As of the date of the sale, these twelve Government Insured Multifamily Mortgages had a weighted average effective interest rate of approximately 10.3%, a weighted average remaining term of approximately 28 years and a tax basis of approximately $34 million. This sale is expected to result in financial statement and tax basis gains of approximately $11.7 million and $14.7 million, respectively. As discussed below, CRIIMI MAE is permitted to make direct investments in primarily two categories of Government Insured Multifamily Mortgages at, near, or above par value (Near Par or Premium Mortgage Investments). FHA-Insured Loans--The first category of Near Par or Premium Mortgage Investments in which CRIIMI MAE is permitted to invest consists of Government Insured Multifamily Mortgages insured by FHA pursuant to provisions of the National Housing Act (FHA-Insured Loans). All of the FHA-Insured Loans in which CRIIMI MAE invests are insured by HUD for effectively 99% of their current face value. As part of its investment strategy, CRIIMI MAE also invests in Government Insured Construction Mortgages which involve a two-tier financing process in which a short-term loan covering construction costs is converted into a permanent loan. CRIIMI MAE also becomes the holder of the permanent loan upon conversion. The construction loan is funded in HUD-approved draws based upon the progress of construction. The construction loans are GNMA-guaranteed or insured by HUD. The construction loan generally MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued does not amortize during the construction period. Amortization begins upon conversion of the construction loan into a permanent loan, which generally occurs within a 24-month period from the initial endorsement by HUD. Mortgage-Backed Securities--The second category of Near Par or Premium Mortgage Investments in which CRIIMI MAE is permitted to invest consists of federally guaranteed mortgage-backed securities or other securities backed by Government Insured Multifamily Mortgages issued by entities other than GNMA (Mortgage-Backed Securities) and Mortgage-Backed Securities 100% guaranteed as to principal and interest by GNMA (GNMA Mortgage-Backed Securities). As of December 31, 1993, all of CRIIMI MAE's mortgage investments in this category were GNMA Mortgage-Backed Securities. The GNMA Mortgage-Backed Securities in which CRIIMI MAE invests are backed by Government Insured Multifamily Mortgages insured in whole by HUD, or insured by HUD and a coinsured lender under HUD mortgage insurance programs and the coinsurance provisions of the National Housing Act. The Mortgage-Backed Securities in which CRIIMI MAE is permitted to invest, although none have been acquired as of December 31, 1993, are backed by Government Insured Multifamily Mortgages which are insured in whole by HUD under HUD mortgage insurance programs. Generally, Government Insured Multifamily Mortgages which are purchased near, at or above par value will result in a loss if the mortgage investment is prepaid or assigned prior to maturity because the amortized cost of the mortgage investment, including acquisition costs, is approximately the same as or slightly higher than the insured amount of the mortgage investment. As of December 31, 1993, substantially all of the mortgage investments owned directly by CRIIMI MAE consisted of Government Insured Multifamily Mortgages that are Near Par or Premium Mortgage Investments. Based on current interest rates, the Adviser does not believe that the prepayment, assignment, or sale of any of CRIIMI MAE's Government Insured Multifamily Mortgages would result in a material financial statement or tax basis gain or loss. CRI Liquidating Mortgage Investments--CRI Liquidating's mortgage investments consist solely of the Government Insured Multifamily Mortgages it acquired from the CRIIMI Funds in the Merger. The CRIIMI Funds invested primarily in Government Insured MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued Multifamily Mortgages issued or sold pursuant to programs of GNMA and FHA. The majority of CRI Liquidating's mortgage investments were acquired by the CRIIMI Funds at a discount to face value (Discount Mortgage Investments) on the belief that based on economic, market, legal and other factors, such Discount Mortgage Investments might be sold for cash, prepaid as a result of a conversion to condominium housing or otherwise disposed of or refinanced in a manner requiring prepayment or permitting other profitable disposition three to twelve years after acquisition by the CRIIMI Funds. Based on current interest rates, the Adviser expects that (i) the disposition of most of CRI Liquidating's Government Insured Multifamily Mortgages will result in a gain on a financial statement basis, and (ii) the disposition of any of CRI Liquidating's Government Insured Multifamily Mortgages will not result in a material loss on a financial statement basis and will result in a gain on a tax basis. Other CRIIMI MAE Mortgage Investments--In addition to investing in FHA-Insured Loans and GNMA-Mortgage Backed Securities, CRIIMI MAE's investment policies also permit CRIIMI MAE to invest in Government Insured Multifamily Mortgages which are not FHA-insured or GNMA-guaranteed (Other Insured Mortgages) and in certain other mortgage investments which are not federally insured or guaranteed (Other Multifamily Mortgages). Pursuant to CRIIMI MAE's policy, at the time of their acquisition, Other Multifamily Mortgages must have an expected yield of at least 150 basis points (1.5%) greater than the yield on Government Insured Multifamily Mortgages which could be acquired in the then current market and must meet certain other strict underwriting guidelines. The CRIIMI MAE Board of Directors has adopted a policy limiting Other Multifamily Mortgages to 20% of CRIIMI MAE's total consolidated assets. As of December 31, 1993, CRIIMI MAE had not invested or committed to invest in any Other Insured Mortgages or Other Multifamily Mortgages and CRIIMI MAE does not currently intend to invest in any Other Multifamily Mortgages for at least twelve months after the filing date of this report. CRIIMI MAE is currently exploring opportunities in connection with the sponsorship of securities offerings which involve the pooling of certain Other Multifamily Mortgages to further enhance MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued potential returns to CRIIMI MAE shareholders. Such sponsorship may also include the investment by CRIIMI MAE in the non-investment grade or unrated tranches of mortgage pools having a high current yield. As of December 31, 1993, CRIIMI MAE had not participated in the sponsorship of any such securities offerings. The Adviser does not expect that investments of this nature will exceed 5% of CRIIMI MAE's total consolidated assets for at least twelve months after the filing date of this report. Investment in Insured Mortgage Funds and Advisory Partnership--On September 6, 1991, CRIIMI MAE, through its wholly owned subsidiary CRIIMI, Inc., acquired from Integrated Resources, Inc. all of the general partnership interests in four publicly held limited partnerships known as the American Insured Mortgage Investors Funds (the AIM Funds). The AIM Funds own mortgage investments which are substantially similar to those owned by CRIIMI MAE and CRI Liquidating. CRIIMI, Inc. receives the general partner's share of income, loss and distributions (which ranges among the AIM Funds from 2.9% to 4.9%) from each of the AIM Funds. In addition, CRIIMI MAE owns indirectly a limited partnership interest in the adviser to the AIM Funds in respect of which CRIIMI MAE receives a guaranteed return each year. Acquisitions - ------------ During 1993, CRIIMI MAE directly acquired 61 Government Insured Multifamily Mortgages with an aggregate purchase price of approximately $284 million at purchase prices ranging from $0.5 million to $30.8 million, with a weighted average effective interest rate of approximately 7.56% and a weighted average remaining term of approximately 33.4 years. In addition, during 1993, CRIIMI MAE funded advances of approximately $29 million on Government Insured Construction Mortgages with a weighted average effective interest rate of approximately 8.73%. As of December 31, 1993, CRIIMI MAE had committed to acquire additional Government Insured Multifamily Mortgages and to make additional advances on and/or acquire Government Insured Construction Mortgages, totalling approximately $41 million. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued During 1993, CRIIMI MAE, and, during each of 1992 and 1993, CRI Liquidating entered into transactions in which mortgage-backed and other government agency securities were purchased. These transactions provided CRIIMI MAE with above average returns compared to its other short-term investments while maintaining the high quality of its assets and assisted in maintaining CRI Liquidating's REIT status. Some of these purchases were financed with borrowings which were nonrecourse and fully secured with the purchased mortgage-backed and other government agency securities. As of December 31, 1993, CRIIMI MAE and as of December 31, 1992 and 1993, CRI Liquidating had disposed of the mortgage-backed and other government agency securities acquired in such year and repaid the related debt. Dispositions - ------------ Dispositions result from prepayments of, defaults on and sales of Government Insured Multifamily Mortgages. Decreases in market interest rates could result in the prepayment of certain mortgage investments. CRIIMI MAE believes, however, that declining interest rates result in increased prepayments of single-family mortgages to a greater extent than mortgages on multifamily properties. This is partially due to lockouts (i.e. prepayment prohibitions), prepayment penalties or difficulties in obtaining refinancing for multifamily dwellings. However, because of the current low interest rates and HUD's current strategy of encouraging mortgagors to refinance high interest rate loans, CRIIMI MAE may experience increased prepayment levels as compared to prior years. Decreases in occupancy levels, rental rates or value of any property underlying a mortgage investment may result in the mortgagor being unable or unwilling to make required payments on the mortgage and thereby defaulting. The proceeds from the assignment (following a default) or prepayment of a Discount Mortgage Investment are expected to exceed the amortized cost of the investment. The proceeds from the assignment or prepayment of a Near Par or Premium Mortgage Investment may be slightly less than, the same as, or slightly more than, the amortized cost of the investment. The proceeds from the sale of any mortgage investment, whether a Discount Mortgage Investment or a Near Par or Premium Mortgage Investment may be slightly less than, the same MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued as, or more than the amortized cost of the investment depending on interest rates at the time of sale. On an amortized cost and tax basis, substantially all of CRIIMI MAE's mortgages are Near Par or Premium Mortgage Investments. Therefore, the proceeds from a default or prepayment of any of CRIIMI MAE's mortgage investments are expected to be slightly less than, the same as, or slightly more than the amortized cost and tax basis of such mortgages. On an amortized cost basis, as of December 31, 1993, approximately 91% of CRI Liquidating's mortgages were Discount Mortgage Investments and approximately 9% were Near Par or Premium Mortgage Investments. On a tax basis, all of CRI Liquidating's mortgages were Discount Mortgage Investments. Therefore, whether by default or prepayment, the proceeds from the disposition of CRI Liquidating's mortgage investments would, for a majority of such mortgages, be expected to exceed the tax basis of such mortgages. However, on an amortized cost basis, the proceeds from a default on, or prepayment of CRI Liquidating's Near Par or Premium Mortgage Investments would be expected to be slightly less than, the same as, or slightly more than the amortized cost. While it is not expected that CRIIMI MAE will sell any of its mortgage investments, CRI Liquidating's business plan calls for an orderly liquidation of approximately 25% of its December 31, 1993 portfolio balance per year through 1997. Therefore, to the extent mortgage investments are not otherwise disposed of, CRI Liquidating intends to sell a substantial portion of its portfolio as is necessary to effect its liquidation plan. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued Historical Dispositions - ----------------------- The following table sets forth certain information concerning dispositions of Government Insured Multifamily Mortgages by CRIIMI MAE and CRI Liquidating for the past five years: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued (1) CRIIMI MAE or CRI Liquidating may elect to receive insurance benefits in the form of cash when a Government Insured Multifamily Mortgage defaults. In that event, 90% of the face value of the mortgage generally is received within approximately 90 days of assignment of the mortgage to HUD and 9% of the face value of the mortgage is received upon final processing by HUD which may not occur in the same year as assignment. If CRIIMI MAE or CRI Liquidating elects to receive insurance benefits in the form of HUD debentures, 99% of the face value of the mortgage is received upon final processing by HUD. Gains from dispositions are recognized upon receipt of funds or HUD debentures and losses generally are recognized at the time of assignment. (2) Eight of the 37 assignments were sales of Government Insured Multifamily Mortgages then in default and resulted in the CRIIMI Funds, CRI Liquidating or CRIIMI MAE receiving near or above face value. (3) In connection with the Merger, CRI Liquidating recorded its investment in mortgages at the lower of cost or fair value, which resulted in an overall net write down for tax purposes. For financial statement purposes, carryover basis of accounting was used. Therefore, since the Merger, the net gain for tax purposes was greater than the net gain recognized for financial statement purposes. As a REIT, dividends to shareholders are based on tax basis income. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued Liquidity - --------- CRIIMI MAE and CRI Liquidating closely monitor their cash flow and liquidity positions in an effort to ensure that sufficient cash is available for operations and debt service requirements and to continue to qualify as REITs. CRIIMI MAE and CRI Liquidating's cash receipts, which have been derived from scheduled payments of outstanding principal of and interest on, and proceeds from dispositions of, mortgage investments held by CRIIMI MAE and CRI Liquidating, plus cash receipts from interest on temporary investments, borrowings, cash received from CRIIMI MAE's interests in the AIM Funds and advisory partnership, and cash received from CRI Liquidating's investment in limited partnerships (Participations), were sufficient for the years 1991, 1992 and 1993 to meet operating, investing and financing cash requirements. It is anticipated that cash receipts will be sufficient in future years to meet similar cash requirements. Cash flow was also sufficient to provide for the payment of dividends to shareholders. As of December 31, 1993, there were no significant commitments for capital expenditures; however, as of such date, CRIIMI MAE had committed to fund additional Government Insured Construction Mortgages and acquire additional Government Insured Multifamily Mortgages totaling approximately $41.0 million. Dividends -- During 1993, CRIIMI MAE increased its quarterly dividend to $0.28 per share. Dividends totaled $1.12 per share for 1993. During the twelve consecutive quarters before 1993, CRIIMI MAE paid dividends of $0.27 per share. CRIIMI MAE's objective is to pay a stable quarterly dividend and to increase the tax basis income over time, and thereby increase the quarterly dividend. Although CRIIMI MAE's mortgage investments yield a fixed monthly mortgage payment once purchased, the cash dividends paid by CRIIMI MAE and by CRI Liquidating will vary during each year due to several factors. The factors which impact CRIIMI MAE's dividend include (i) the distributions which CRIIMI MAE receives on its CRI Liquidating shares, (ii) the Net Positive Spreads (as defined below) on borrowings under CRIIMI MAE's financing facilities, (iii) the fluctuating yields on short-term debt and the rate at which CRIIMI MAE's commercial paper rate based and London Interbank Offered Rate (LIBOR) based debt is priced, (iv) the fluctuating yields in the short-term money market MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued where the monthly mortgage payments received are temporarily invested prior to the payment of quarterly dividends, (v) the yield at which principal from scheduled monthly mortgage payments, mortgage dispositions and distributions from the AIM Funds and from CRI Liquidating can be reinvested, (vi) variations in the cash flow received from the AIM Funds, and (vii) changes in operating expenses. Additionally, mortgage dispositions may increase the return to the shareholders for a period, although neither the timing nor the amount can be predicted. The factors which impact CRI Liquidating's dividend include (i) yields on CRI Liquidating's mortgage investments, (ii) the reduction in the asset base and monthly mortgage payments due to monthly mortgage payments received or mortgage dispositions, (iii) the fluctuating yields in the short-term money market where the monthly mortgage payments received are temporarily invested prior to the payment of quarterly dividends, (iv) changes in operating expenses and (v) variations in the cash flow received from the Participations. Asset/Liability Management -- CRIIMI MAE seeks to enhance the return to its shareholders through the use of leverage. Nevertheless, CRIIMI MAE's use of leverage carries with it the risk that the cost of borrowings could increase relative to the return on its mortgage investments, which could result in reduced net income or a net loss and thereby reduce the return to shareholders. A key objective of asset/liability management is to reduce interest rate risk. The Adviser continuously monitors CRIIMI MAE's outstanding borrowings in an effort to ensure that CRIIMI MAE is making optimal use of its borrowing ability based on market conditions and opportunities. Over the past four years, the Adviser has reduced CRIIMI MAE's effective borrowing rate through refinancings and new financings and the Adviser continues to evaluate opportunities to further reduce CRIIMI MAE's borrowing costs. CRIIMI MAE expects to continue to use leverage only to the extent that (i) the proceeds therefrom will be used for investments such as CRIIMI MAE's current portfolio of Government Insured Multifamily Mortgages or other high quality assets including Other Multifamily Mortgages and Other Insured Mortgages; (ii) the risk of adverse changes in interest rates is reduced by MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued the use of hedging techniques such as those currently employed by CRIIMI MAE; and (iii) the Adviser believes that after investing all funds from any specific borrowing, a Net Positive Spread (the difference between the yield on a mortgage investment acquired with borrowings and all incremental borrowing and operating expenses on a tax basis associated with the acquisition of such mortgage investment) of at least 40 basis points will be achievable. It is CRIIMI MAE's policy to borrow only when the Net Positive Spread on the borrowing is at least 40 basis points at inception of the borrowing. Such policy provides that if Net Positive Spreads of at least 40 basis points are not maintained, the annual and master servicing fees payable to the Adviser, which are calculated as a percentage of invested assets, will be reduced so that such fees, in basis points, equal the Net Positive Spread, in basis points. As of December 31, 1992 and 1993, CRIIMI MAE had a Net Positive Spread of approximately 60 and 177 basis points, respectively, on its borrowings. With respect to approximately $300.0 million of new borrowings invested or committed for investment during 1993, as of December 31, 1993, CRIIMI MAE had an average Net Positive Spread of approximately 250 basis points. CRIIMI MAE's secured financings require that its debt-to-equity ratio not exceed 2.5:1. As of December 31, 1993, CRIIMI MAE's debt-to-equity ratio, excluding approximately $41 million of borrowings committed for investment in mortgages, was 2.2:1, and its debt-to-equity ratio, including such borrowings, was 2.4:1. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued Corporate Borrowings--The following table summarizes CRIIMI MAE's corporate borrowings as of December 31, 1993: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued (1) Commercial Paper Facility--The following table shows commercial paper borrowing activity as of December 31, 1992 and 1993 and for the years then ended: The base issuance rate for commercial paper issued under CRIIMI MAE's commercial paper facility (the Commercial Paper Facility) ranged from 3.20% to 4.45% during the year ended December 31, 1992 and 3.15% to 3.68% during the year ended December 31, 1993, and was 4.02% and 3.41% as of December 31, 1992 and 1993, respectively. CRIIMI MAE's Commercial Paper Facility provides for the issuance of commercial paper by CRI Funding Corporation, an unaffiliated special purpose corporation, which lends the proceeds from the issuance to CRIIMI MAE. If commercial paper is not issued, the special purpose corporation may meet its obligation to MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued provide financing to CRIIMI MAE by borrowing at a rate of LIBOR plus 0.50% under a $140.0 million revolving credit facility which was established in connection with the Commercial Paper Facility. Borrowings pursuant to the Commercial Paper Facility are collateralized by a pledge of certain of CRIIMI MAE's Government Insured Multifamily Mortgages. The loan agreements contain numerous covenants which CRIIMI MAE must satisfy, including requirements that the fair value of collateral pledged must equal at least 110% of the amounts borrowed and that interest on the collateral pledged equal at least 120% of the debt service on the amounts borrowed. In addition, 60% of the Government Insured Multifamily Mortgages pledged as collateral must be GNMA-Mortgage Backed Securities. As of December 31, 1993, Government Insured Multifamily Mortgages held directly by CRIIMI MAE with a market value and face value of approximately $145.4 million and $139.7 million, respectively, were used as collateral pursuant to the Commercial Paper Facility. In February 1993, CRIIMI MAE entered into an agreement to replace a $190.0 million letter of credit which provided the credit enhancement for the Commercial Paper Facility and related revolving credit facility, with two letters of credit in the amount of $35.0 million and $155.0 million provided by National Australia Bank, Limited and Canadian Imperial Bank of Commerce (CIBC), respectively. In April 1993, the letter of credit provided by CIBC was reduced to $105.0 million. Subsequent to December 31, 1993, the special purpose corporation replaced borrowings under the Commercial Paper Facility with revolving credit loans. These revolving credit loans were scheduled to mature on January 28, 1994; however, the maturity date has been extended until February 28, 1994. CRIIMI MAE executed a Commitment Letter and Term Sheet for a revolving credit facility, dated November 24, 1993, to replace these agreements with a 30-month non-amortizing bank loan to be issued prior to the expiration date of the letter of credit agreements by lenders including the aforementioned bank group on terms substantially similar to the April 1993 Master Repurchase Agreements (defined below). While there is no assurance, CRIIMI MAE expects to close on such new revolving credit facility on or before February 28, 1994. If CRIIMI MAE is unable to consummate the loan by such MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued date, the Adviser believes that it will be able to obtain a further extension of its existing revolving credit loans. (2) Master Repurchase Agreements--On April 30, 1993, CRIIMI MAE entered into master repurchase agreements (the Master Repurchase Agreements) with Nomura Securities International, Inc. and Nomura Asset Capital Corporation (collectively, Nomura) which provide CRIIMI MAE with $350.0 million of available financing for a three-year term. CRIIMI MAE intends to seek renewal of the Master Repurchase Agreements upon expiration. Interest on such borrowings is based on the three-month LIBOR plus 0.75% or 0.50% depending on whether FHA-Insured Loans or GNMA Mortgage-Backed Securities, respectively, are pledged as collateral. For April through December 1993, the three-month LIBOR for these borrowings ranged from 3.18% to 3.50%. The value of the collateral pledged must equal at least 105% and 110% of the amounts borrowed for GNMA Mortgage-Backed Securities and FHA-Insured Loans, respectively. No more than 60% of the collateral pledged may be FHA-Insured Loans and no less than 40% may be GNMA Mortgage-Backed Securities. As of December 31, 1993, mortgage investments directly owned by CRIIMI MAE which approximate $349.4 million at market value and $342.2 million at face value, were used as collateral pursuant to certain terms of the Master Repurchase Agreements. As of December 31, 1993, CRIIMI MAE used approximately $281.7 million of the funds available under the Master Repurchase Agreements to acquire Government Insured Multifamily Mortgages and $50.0 million to repay a portion of borrowings under the Commercial Paper Facility. In addition, approximately $18.3 million of the balance of the funds available have been committed for investment in Government Insured Multifamily Mortgages or advances on Government Insured Construction Mortgages. On November 30, 1993, CRIIMI MAE entered into additional repurchase agreements with Nomura pursuant to which Nomura will provide CRIIMI MAE with an additional $150.0 million of available financing for a three-year term. The agreements provide that the funding will be utilized to purchase FHA-Insured Loans and GNMA Mortgage-Backed Securities in the event of the successful completion of the Equity Offering (described below in "Other Events"). In that event, it is contemplated that CRIIMI MAE will borrow the full $150.0 million no earlier than the consummation of MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued the Equity Offering, but no later than July 1, 1994. The terms of the $150.0 million financing arrangements are similar to the terms of the Master Repurchase Agreements entered into in April 1993. (3) Bank Term Loan--On October 23, 1991, CRIIMI MAE entered into a credit agreement with two banks for a reducing term loan facility (the Bank Term Loan) in an aggregate amount not to exceed $85.0 million, subject to certain terms and conditions. In December 1992, the credit agreement was amended to increase the reducing term loan by $15.0 million. The Bank Term Loan had an outstanding principal balance of approximately $61.7 million and $52.0 million as of December 31, 1992 and 1993, respectively. As of December 31, 1992 and 1993, the Bank Term Loan was secured by the value of 17,784,000 and 13,874,000 CRI Liquidating shares owned by CRIIMI MAE, respectively. As a result of principal payments on the Bank Term Loan in 1993, 750,000 of the 13,874,000 CRI Liquidating shares pledged as collateral were released in January 1994. The Bank Term Loan requires a quarterly principal payment based on the greater of the return of capital portion of the dividend received by CRIIMI MAE on its CRI Liquidating shares securing the Bank Term Loan or an amount to bring the Bank Term Loan to its scheduled outstanding balance at the end of such quarter. The minimum amount of annual principal payments is approximately $15.8 million, with any remaining amounts of the original $85.0 million of principal due in April 1996 and any remaining amounts of the $15.0 million of increased principal due in December 1996. The amended Bank Term Loan provides for an interest rate of 1.10% over three-month LIBOR plus an agent fee of 0.05% per year. During 1992 and 1993, three-month LIBOR for borrowings under the Bank Term Loan ranged from 3.44% to 4.50% and 3.19% to 3.59%, respectively. Hedging -- CRIIMI MAE is subject to the risk that changes in interest rates could reduce Net Positive Spreads by increasing CRIIMI MAE's borrowing costs and/or decreasing the yield on its Government Insured Multifamily Mortgages. An increase in CRIIMI MAE borrowing costs could result from an increase in short-term interest rates. To partially limit the adverse effects of rising interest rates, CRIIMI MAE has entered into a series of interest rate hedging agreements in an aggregate notional amount MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued approximately equal to all of its outstanding borrowings and commitments. To the extent CRIIMI MAE has not fully hedged its portfolio, in periods of rising interest rates CRIIMI MAE's overall borrowing costs would increase with little or no overall increase in mortgage investment income, resulting in returns to shareholders that would be lower than those available if interest rates had remained unchanged. Borrowings by CRIIMI MAE generally are hedged by swap, cap or collar agreements. As of December 31, 1993, CRIIMI MAE had in place interest rate collars on the indices underlying borrowing rates for the Commercial Paper Facility (the CP Index) with an aggregate notional amount of $115 million, a weighted average floor of 8.55% and a weighted average cap of 10.37%. An interest rate collar limits the CP Index to a maximum interest rate and also enables CRIIMI MAE to receive the benefit of a decline in the CP Index to the floor of the collar for the period of the collar. To the extent that the CP Index increases, CRIIMI MAE's overall borrowing costs would not increase until the CP Index reaches the level of the floor of the collar. At that point, CRIIMI MAE's borrowing costs would increase as the CP Index increases but only until the CP Index reaches the maximum rate provided for by the collar. As of December 31, 1993, CRIIMI MAE had in place interest rate caps on the CP Index and LIBOR underlying borrowing rates for the Commercial Paper Facility and Master Repurchase Agreements. The caps based on the CP Index have an aggregate notional amount of $50 million and a weighted average cap of 8.73%. The caps based on LIBOR have an aggregate notional amount of $300 million with a weighted average cap of 6.23%. CRIIMI MAE also had an interest rate cap with a notional amount of approximately $63 million and a cap of 6.5% on the LIBOR underlying the Bank Term Loan. An interest rate cap effectively limits CRIIMI MAE's interest rate risk on floating rate borrowings by limiting the CP Index or LIBOR, as the case may be, to a maximum interest rate for the period of the cap. To the extent the CP Index or LIBOR decrease, CRIIMI MAE's borrowing costs would decrease under such caps. To the extent the CP Index or LIBOR increase, CRIIMI MAE's borrowing costs would increase but only until the CP Index or LIBOR reaches the maximum rate provided for by the cap. As of December 31, 1993, certain cap agreements based on the three-month MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued LIBOR with a notional amount of $300 million were between approximately 2.62% and 3.13% above the current three-month LIBOR. On December 1, 1993, CRIIMI MAE paid approximately $4.9 million to terminate an interest rate swap entered into on February 8, 1990 with a notional amount of $25 million and a fixed rate of 9.23%. The termination of this swap was effective December 1, 1993. The cost to terminate the interest rate swap was expensed in the accompanying consolidated statement of income for the year ended December 31, 1993 as the underlying debt under the Commercial Paper Facility being hedged was repaid. As of December 31, 1993, CRIIMI MAE had in place no swap agreements. Current interest rates are substantially lower than when CRIIMI MAE entered into $165 million of its existing interest rate hedging agreements. As of December 31, 1993, certain collar agreements based on the CP Index with a notional amount of $115 million carried minimum interest rates which were between approximately 5.0% and 5.4% above the current CP Index. Such hedging agreements expire in 1995. While there is no assurance that any new agreements will be made, the Adviser is actively exploring alternatives to replace these hedging agreements when they expire in order to capitalize on the current low interest rate environment. As a result of minimum interest rate levels associated with the swap agreement terminated in December, 1993 and the collar agreements which expire in 1995, CRIIMI MAE incurred additional interest expense of $4.3 million, $8.1 million and $8.6 million for the years ended December 31, 1991, 1992 and 1993, respectively, of which approximately $0.8 million, $1.3 million and $1.4 million, respectively, was attributable to the terminated swap agreement. The additional interest expense amounts also include amortization of approximately $0.1 million, $0.2 million and $0.6 million, respectively, related to up-front hedging costs. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued The following table sets forth information relating to CRIIMI MAE's hedging agreements with respect to borrowings under the Commercial Paper Facility and Master Repurchase Agreements: (a) On May 24, 1993, CRIIMI MAE and CIBC terminated the floor on this former collar. In consideration of such termination, CRIIMI MAE paid CIBC approximately $2.3 million. This amount was deferred on the accompanying consolidated balance sheet as the underlying debt being hedged is still outstanding. This amount will be amortized for the period from May 24, 1993 through May 24, 1996. CRIIMI MAE amortized approximately $0.5 million of this deferred amount in the accompanying consolidated statements of income for the year ended December 31, 1993. (b) Approximately $4.5 million of costs were incurred in 1993 in connection with the establishment of interest rate hedges. These costs are being amortized using the effective interest method over the term of the interest rate hedge agreement for financial statement purposes and in accordance with the regulations under Internal Revenue Code Section 446 with respect to notional principal contracts for tax purposes. (c) The hedges are based either on the 30-day Commercial Paper Composite Index (CP) or three-month LIBOR. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued In addition, CRIIMI MAE entered into an interest rate hedge agreement on the Bank Term Loan to cap LIBOR at 6.5% based on the expected paydown schedule and an incremental hedge of 10.5% on the difference between the required and expected paydown schedules. As of December 31, 1993, three-month LIBOR was approximately 3.13% below the 6.5% cap. Although CRIIMI MAE expects the overall average life of its mortgage investments to exceed ten years, CRIIMI MAE's hedging agreements range in maturity from 3 to 10 years principally because of the limited availability and high cost of instruments with maturities greater than 10 years. Thus, to the extent CRIIMI MAE has not completely matched the duration of its existing mortgages to that of its existing hedges, upon the expiration of these hedges CRIIMI MAE would be fully exposed to the adverse effects of rising interest rates. The Adviser continues to actively review asset/liability hedging techniques as CRIIMI MAE's existing hedges approach their expiration dates and to monitor the duration of its hedges relative to its assets. A reduction in long-term interest rates could increase the level of prepayments of CRIIMI MAE's Government Insured Multifamily Mortgages. CRIIMI MAE's yield on mortgage investments will be reduced to the extent CRIIMI MAE reinvests the proceeds from such prepayments in new mortgage investments with effective rates which are below the rates of the prepaid mortgages. In addition, the fluctuation of long-term interest rates may affect the value of CRIIMI MAE's Government Insured Multifamily Mortgages. Although decreases in long-term rates could increase the value of CRIIMI MAE's mortgage investments, increases in such long-term rates could decrease the value of CRIIMI MAE's mortgage investments and, in certain circumstances, require CRIIMI MAE to pledge additional collateral in connection with its borrowing facilities. This would reduce CRIIMI MAE's borrowing capacity and, in an extreme case, may force CRIIMI MAE to liquidate a portion of its assets at a loss in order to comply with certain covenants under its financing facilities. CRIIMI MAE is exposed to credit loss in the event of nonperformance by the other parties to the interest rate hedge agreements should interest rates exceed the caps. However, the MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued Adviser does not anticipate nonperformance by any of the counterparties, each of which has long-term debt ratings of A or above by Standard and Poor's and A2 or above by Moody's. Cash Flow--1993 versus 1992 - --------------------------- Net cash provided by operating activities increased for 1993 as compared to 1992 principally due to an increase in mortgage investment income partially offset by an increase in interest expense due primarily to mortgage acquisition activity in 1993 funded by proceeds from financings. Also contributing to the increase in cash provided by operating activities was an increase in accounts payable and accrued expenses attributable to the accrued costs incurred by CRIIMI MAE with respect to its Equity Offering of common stock, as described below in "Other Events". Partially offsetting the increase in net cash provided by operating activities for 1993 was the payment of approximately $4.9 million to terminate an interest rate swap agreement and an increase in interest expense due primarily to mortgage acquisition activity in 1993 funded by proceeds from financings. Net cash used by investing activities increased for 1993 as compared to 1992. This increase was principally due to the acquisition of Government Insured Multifamily Mortgages and advances on Government Insured Construction Mortgages of approximately $312.7 million in 1993 as compared to $31.8 million in 1992. Also contributing to the increase in cash used by investing activities was the acquisition of other short-term investments of approximately $175.3 million in 1993 as compared to approximately $66.8 million in 1992. In addition, proceeds of approximately $6.1 million were received during 1993 related to the sale of HUD debentures, as compared to the receipt of proceeds of approximately $2.3 million during the same period in 1992 related to the redemption of HUD debentures. Partially offsetting the increase in net cash used by investing activities was the receipt of approximately $167.1 million from the disposition of other short-term investments and proceeds from mortgage dispositions of approximately $93.4 million in 1993 as compared to approximately $65.5 million and $50.4 million, respectively, in 1992. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued Net cash provided by financing activities increased for 1993 compared to 1992. This increase was primarily due to the receipt of net proceeds of approximately $331.7 million from the Master Repurchase Agreements, approximately $115.6 million from the financing of other short-term investments and approximately $15.0 million from an expansion of CRIIMI MAE's Bank Term Loan, partially offset by payments on short-term and long-term debt, a paydown of borrowings of commercial paper and the payment of deferred financing costs. Cash Flow--1992 versus 1991 - --------------------------- Net cash provided by operating activities increased for 1992 as compared to 1991 principally due to an increase in interest payable and a decrease in receivables and other assets compared to 1991 partially offset by a decrease in accounts payable and accrued expenses. The increase in interest payable for 1992 compared to 1991 is due to the payment in 1991 of approximately $3.0 million in interest accrued as of December 31, 1990. The decrease in receivables and other assets was attributable to the collection of the accrued interest on a mortgage which defaulted in the second half of 1991. The decrease in accounts payable and accrued expenses was due to the payment of acquisition costs incurred and accrued with respect to the acquisition of the AIM Funds in 1991. Net cash provided by investing activities decreased for 1992 as compared to 1991. This decrease resulted principally from the disposition in 1992 by CRIIMI MAE and CRI Liquidating of five Government Insured Multifamily Mortgages and the remaining 9% of two previously disposed Government Insured Multifamily Mortgages resulting in disposition proceeds aggregating approximately $50.4 million. This compares to 33 mortgage dispositions during 1991 resulting in disposition proceeds of approximately $119.0 million. Also during 1992, cash of approximately $65.5 million and approximately $2.3 million was received from the sale of other short-term investments and the redemption of HUD debentures, respectively. However, this was offset by the purchase of other short-term investments in 1992. During 1991, CRIIMI MAE and CRIIMI, Inc. paid a total of approximately $24.4 million to acquire interests in the AIM Funds and the limited partnership that serves as their adviser. In addition, CRIIMI MAE paid MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued approximately $3.7 million during 1991 for costs associated with this acquisition. This acquisition was principally funded with the proceeds from the sale of Government Insured Multifamily Mortgages. Net cash used in financing activities decreased for 1992 as compared to 1991. This decrease was primarily due to approximately $97.6 million paid in 1991 for the early extinguishment of long-term debt and the purchase of approximately $21.6 million in U.S. Treasury Securities in connection with the defeasance of long-term debt which occurred in 1991, partially offset by $85.0 million in proceeds received in 1991 from the refinancing. This decrease was also offset by an increase in principal payments on long-term debt from approximately $13.3 million during 1991 to $23.3 million in 1992. Results of Operations - --------------------- 1993 versus 1992 - ---------------- CRIIMI MAE earned approximately $23.0 million in tax basis income for 1993, a 6.4% increase from approximately $21.6 million for 1992. On a per share basis, tax basis income for 1993 increased to approximately $1.14 per share from approximately $1.07 per share for 1992. Net income for financial statement purposes was approximately $15.8 million for 1993, a 1.8% decrease from approximately $16.0 million for 1992. On a per share basis, financial statement net income for 1993 decreased to approximately $0.78 per share from $0.79 per share for 1992. Mortgage investment income increased $4.4 million or 9.4% to $50.3 million for 1993 from $45.9 million for 1992. This increase was due principally to an increase in mortgage investments, net of dispositions, resulting from acquisitions and advances on Government Insured Construction Mortgages during 1993 which were funded principally by proceeds from the Master Repurchase Agreements. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued Other income increased $1.4 million or 30.0% to $6.2 million for 1993 from $4.8 million for 1992. This increase was attributable primarily to approximately $175 million in other short-term investments acquired by CRIIMI MAE and CRI Liquidating during 1993, all of which were disposed of by December 31, 1993 as compared to approximately $67 million in other short-term investments acquired by CRI Liquidating during 1992, all of which were disposed of by December 31, 1992. Total income increased $5.8 million or 11.3% to $56.5 million for 1993 from $50.7 million for 1992. This increase was primarily due to the growth in mortgage investment income and other income during 1993. Interest expense increased $3.6 million or 14.8% to $28.0 million for 1993 from $24.4 million for 1992. This increase was principally a result of greater amounts borrowed during 1993 under the Master Repurchase Agreements entered into in April 1993 which provided financing of $350 million, of which approximately $331.7 million was outstanding as of December 31, 1993. This increase was partially offset by a reduction in interest rates on CRIIMI MAE's borrowings for 1993 as compared to 1992. In December 1993, CRIIMI MAE paid approximately $4.9 million to CIBC to terminate an interest rate swap entered into on February 8, 1990 with a notional amount of $25 million and a fixed rate of 9.23%. The termination of this swap was effective December 1, 1993. Other operating expenses increased $1.1 million or 32.4% to $4.6 million in 1993 from $3.5 million in 1992. This increase was attributable primarily to legal fees incurred in connection with certain litigation as described below in "Other Events." Also contributing to the increase in other operating expenses was an increase in general and administrative expenses due primarily to increased mortgage acquisition and disposition activities, the increase in costs to produce CRIIMI MAE's 1992 Annual Report to Shareholders due to its increased size and mailing costs, and the recognition of costs incurred in connection with CRIIMI MAE's reincorporation as a Maryland corporation which was effective in July 1993. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued Fees to related party are comprised of annual fees and incentive fees paid to the Adviser. The Adviser receives annual fees for managing the portfolios of CRIIMI MAE and CRI Liquidating. These fees include a base component equal to a percentage of average invested assets. In addition, fees paid to the Adviser by CRI Liquidating may include a performance based component that is referred to as the deferred component. The deferred component, which is also calculated as a percentage of average invested assets, is computed each quarter but paid (and expensed) only upon meeting certain cumulative performance goals. If these goals are not met, the deferred component accumulates, and may be paid in the future if cumulative goals are met. In addition, certain incentive fees are paid by CRIIMI MAE and CRI Liquidating on a current basis if certain performance goals are met. Fees to related party increased $0.5 million or 21.3% to $2.7 million for 1993 from $2.2 million for 1992. This increase was due primarily to an increase in annual fees and incentive fees during 1993, as discussed below. Annual fees increased $0.4 million or 20.6% to $2.5 million for 1993 from $2.1 million for 1992. This increase was primarily due to increased CRIIMI MAE mortgage assets, including advances on Government Insured Construction Mortgages. Also contributing to the increase for 1993 was the payment by CRI Liquidating in 1993, of the deferred component of the annual fee due to specific performance goals being met, which included the payment of the deferred component for the second half of 1992. Partially offsetting the increase in annual fees for 1993 was a reduction in the mortgage base, which is a component used in determining the annual fees payable by CRI Liquidating. The mortgage base has been decreasing as CRI Liquidating effects its business plan to liquidate by 1997. The CRIIMI MAE incentive fee is equal to 25% of the amount by which net income from additional mortgage investments exceeds the annual target return on equity and is payable quarterly, subject to year-end adjustment. The incentive fee increased approximately $50,000 or 30.6% to $0.2 million for 1993 from $0.2 million for 1992. This increase was primarily attributable to the fact that CRIIMI MAE's net income from additional mortgage investments exceeded the annual target return on equity during both the second and third quarters of 1993; accordingly, an incentive fee was paid MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued during those quarters. This compares to 1992 when CRIIMI MAE's net income from additional mortgage investments exceeded the annual target return on equity only in the third quarter. During 1993, CRIIMI MAE recorded a provision of $1.5 million, including $0.25 million paid in cash, in connection with the settlement of the litigation described below in "Other Events." Total expenses increased $11.7 million or 38.6% to $41.8 million for 1993 from $30.1 million for 1992. This increase was principally due to costs incurred to terminate an interest rate swap, an increase in interest expense and the recognition of a provision for settlement of litigation described below in "Other Events". Net gains on mortgage dispositions increased $1.7 million or 28.3% to $7.4 million in 1993 from $5.7 million in 1992. Gains or losses on mortgage dispositions are based on the number, carrying amounts, and proceeds of mortgage investments disposed of during the period. Gains on mortgage dispositions increased $2.0 million or 32.7% to $8.1 million in 1993 from $6.1 million in 1992. This increase was primarily due to the disposition of 17 mortgages during 1993, 11 of which resulted in gains. This compares to the disposition of seven mortgages during 1992, three of which resulted in gains. Losses on mortgage dispositions increased $0.4 million or 98.4% to $0.8 million in 1993 from $0.4 million in 1992 due to the financial statement loss of $0.5 million recognized in March 1993 as a result of the prepayment of the mortgage on Owings Manor Apartments. In November 1993, CRIIMI MAE recognized a financial statement gain of approximately $3.3 million and a tax basis gain of approximately $4.9 million in connection with the sale of 3,162,500 CRI Liquidating shares held by CRIIMI MAE. 1992 versus 1991 - ---------------- CRIIMI MAE earned approximately $21.6 million in tax basis income for 1992, a 1.9% decrease from approximately $22.0 million for 1991. On a per share basis, tax basis income for 1992 decreased to approximately $1.07 per share from approximately $1.09 per share for 1991. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued Net income for financial statement purposes was approximately $16.0 million for 1992, a 78.2% increase from approximately $9.0 million for 1991. On a per share basis, financial statement net income for 1992 increased to approximately $0.79 per share from $0.45 per share for 1991. Mortgage investment income decreased $3.4 million or 6.9% to $45.9 million for 1992 from $49.3 million for 1991. This decrease was due principally to the mortgage dispositions during 1992 and 1991. Other income decreased $.2 million or 4.5% to $4.8 million for 1992 from $5.0 million for 1991. This decrease was primarily attributable to lower interest rates available for short-term investments during 1992 and the elimination on December 31, 1991, of the debt service reserve for certain notes payable, which reserve was previously invested in short-term investments. Partially offsetting this decrease was the interest earned on other short-term investments purchased by CRI Liquidating in April, July and August 1992, net of monthly option fees. In addition, this decrease in income was partially offset by an increase in income from investments in the AIM Funds and the related advisory partnership which were acquired in September 1991. Total income decreased $3.6 million or 6.7% to $50.7 million for 1992 from $54.3 million for 1991. This decrease was primarily due to a reduction in mortgage investment income and partially offset by an increase in other income during 1992. Interest expense decreased $1.4 million or 5.4% to $24.4 million for 1992 from $25.8 million for 1991. This decrease was principally a result of a reduction in both the amount of long-term debt outstanding and the interest rate thereon resulting from the refinancing on December 31, 1991 of notes payable. This decrease in interest expense on long-term debt was partially offset by an increase in interest paid or accrued on borrowings under CRIIMI MAE's Commercial Paper Facility as greater amounts were borrowed during 1992 and an increase in interest expense attributable to the seller financing of 99% of the purchase price of certain other short-term investments purchased by CRI Liquidating in July and August 1992. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued Other operating expenses decreased $.3 million or 6.6% to $3.5 million in 1992 from $3.8 million in 1991. This decrease was attributable primarily to a decrease in the amortization of deferred costs resulting from the mortgage dispositions and the related reduction in the amount of capitalized deferred costs which occurred during 1992 and 1991. Fees to related party decreased $87,000 or 3.7% to $2.2 million in 1992 from $2.3 million in 1991. This decrease was due primarily to the reduction of CRI Liquidating's portfolio as a result of mortgage dispositions. Also contributing to this decrease was a reduction in the deferred component of the Adviser's annual fee paid in 1992 as a result of certain performance goals that were met for only two quarters in 1992 compared to all quarters in 1991. Partially offsetting this decrease was an increase in the annual base component resulting from CRIIMI MAE mortgage acquisitions. Net gains on mortgage dispositions increased $1.7 million or 41.6% to $5.7 million in 1992 from $4.0 million in 1991. This increase was principally due to the disposition, in 1992, of CRI Liquidating's investment in a mortgage which resulted in the recognition of a gain in 1992 totalling approximately $5.9 million. This compares to the disposition of 13 Government Insured Multifamily Mortgages during 1991 which resulted in gains totalling approximately $5.2 million. CRI Liquidating's Government Insured Multifamily Mortgages have a different tax basis than book basis because the Merger, while a taxable event, was treated in a manner similar to a pooling of interests for financial accounting purposes. Although some of the mortgage dispositions during 1992 resulted in a loss for financial statement purposes, the combined dispositions resulted in a net tax basis gain totalling approximately $11.1 million. During 1992, two properties in which CRI Liquidating holds Participations experienced operating results insufficient to pay debt service and the annual return on such Participations. CRI Liquidating recognized a loss of approximately $0.7 million with respect to the write-off of one of these Participations. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued In addition to the items discussed above, net income for 1992 increased from 1991 due, in part, to the recognition of an extraordinary loss of approximately $6.6 million in 1991 resulting from the refinancing of certain notes payable. All other costs associated with the refinancing have been included in deferred financing fees on the balance sheet and are being amortized on the effective interest method over the term of the refinancing. However, for tax purposes these deferred financing fees as well as the extraordinary loss have been capitalized and are being amortized over the term of the refinancing. REIT Status - ----------- CRIIMI MAE and CRI Liquidating have qualified and intend to continue to qualify as REITs as defined in the Internal Revenue Code and, as such, will not be taxed on that portion of their taxable income which is distributed to shareholders provided that at least 95% of such taxable income is distributed. CRIIMI MAE and CRI Liquidating intend to distribute substantially all of their taxable income and, accordingly, no provision for income taxes has been made in the accompanying consolidated financial statements. CRIIMI MAE and CRI Liquidating, however, may be subject to tax at normal corporate rates on net income or capital gains not distributed. Other Events - ------------ On March 22, 1990, a complaint was filed, on behalf of a class comprised of certain limited partners of CRIIMI III and shareholders of CRIIMI II (the Plaintiffs), in the Circuit Court for Montgomery County, Maryland against CRIIMI MAE, CRI Liquidating, CRIIMI I and its general partner, CRIIMI II, CRIIMI III and its general partner, CRI and William B. Dockser, H. William Willoughby and Martin C. Schwartzberg (the Defendants). On November 18, 1993, the Court entered an order granting final approval of a settlement agreement between the Plaintiffs and the Defendants pursuant to which CRIIMI MAE will issue to class members, including certain former limited partners of CRIIMI I, up to 2.5 million warrants, exercisable for 18 months after issuance, to purchase shares of CRIIMI MAE common stock at an exercise price of $13.17 per share. In addition, the settlement included a payment of $1.4 million for settlement administration costs and MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued the Plaintiff's attorneys' fees and expenses. Insurance provided $1.15 million of the $1.4 million cash payment, with the balance paid by CRIIMI MAE. CRIIMI MAE accrued a total provision of $1.5 million in the accompanying consolidated statements of income for the uninsured portion of the cash settlement paid by CRIIMI MAE and for the estimated value of the warrants that are expected to be issued as part of the settlement. The number of warrants to be issued is dependent on the number of class members who submit a proof of claim within 60 days of January 14, 1994 (the date the proof of claim was mailed by CRIIMI MAE). The issuance of the warrants pursuant to the settlement agreement will have no impact on CRIIMI MAE's tax basis income. Depending upon the number of warrants issued, CRIIMI MAE will record in its financial statements a non-cash expense ranging from $0 (if no warrants are issued) to $5 million (if all 2.5 million warrants are issued). Based on the Adviser's estimate of the number of warrants to be issued, CRIIMI MAE has accrued a total provision of $1.5 million (which includes the uninsured portion of the cash settlement) in the accompanying consolidated statement of income for 1993, which provision may be increased or decreased once the actual number of warrants issued is known. The Adviser estimates that the final charge (after adjustments to the provision) to net income and the increase in the number of shares of common stock outstanding as a result of the exercise of the warrants will not have a material adverse effect on CRIIMI MAE's net income and net income per share. The exercise of the warrants will not result in a charge to CRIIMI MAE's tax basis income. Further, the Adviser believes that the exercise of the warrants will not have a material adverse effect on CRIIMI MAE's tax basis income per share or annualized cash dividends per share because CRIIMI MAE intends to invest the proceeds from any exercise of the warrants in accordance with its investment policy to purchase Government Insured Multifamily Mortgages and other authorized investments. However, in the case of a significant decline in the yield on mortgage investments and a significant decrease in the Net Positive Spread which CRIIMI MAE could achieve on its borrowings, the exercise of the warrants may have a dilutive effect on tax basis income per share and cash dividends per share. Receipt of the proceeds from the exercise of the warrants will increase CRIIMI MAE's shareholders' equity. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued On October 19, 1993, CRIIMI MAE filed a Registration Statement on Form S-3 (Commission File No. 33-50679), expected to be amended on February 16, 1994, to register for sale to the public approximately 6.0 million shares of CRIIMI MAE's common stock (or 6.9 million shares if the underwriters exercise their overallotment option) (the Equity Offering). While there is no assurance that the Equity Offering will be consummated, it is currently expected that the sale will be completed in March 1994, subject to, among other things, such Registration Statement becoming effective and market conditions at such time. The net proceeds from the sale of the shares are estimated to be approximately $64.3 million (based on an offering price of $11.50 per share, the reported last sale price on February 11, 1994, and not including the over-allotment). Although no specific investments have as yet been selected, CRIIMI MAE intends to use such proceeds primarily for the acquisition of Government Insured Multifamily Mortgages, the purchase of interest rate hedging agreements and for other general corporate purposes, including, without limitation, working capital. It is not expected that any of the proceeds will be used to repay indebtedness of CRIIMI MAE. The costs of the Equity Offering, including professional fees, filing fees, printing costs and other items, are expected to approximate $.6 million (which was incurred or accrued as of December 31, 1993). Additionally, underwriting fees in an amount which approximates 6.0% of the gross offering proceeds are expected to be incurred. Fair Value of Financial Instruments - ----------------------------------- The following estimated fair values of CRIIMI MAE's consolidated 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 CRIIMI MAE. In connection with CRIIMI MAE's and CRI Liquidating's implementation of Statement of Financial Accounting Standards No. 115 "Accounting for Certain Investments in Debt and Equity Securities" (SFAS 115) as of December 31, 1993, CRIIMI MAE's MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued Investment in Mortgages continues to be recorded at amortized cost; however, CRI Liquidating's Investment in Mortgages, and CRIIMI MAE's and CRI Liquidating's Mortgages Held for Disposition, are recorded at fair value as of December 31, 1993. The difference between the amortized cost and the fair value of CRI Liquidating's Government Insured Multifamily Mortgages represents the net unrealized gains on CRI Liquidating's Government Insured Multifamily Mortgages. CRIIMI MAE's share of the net unrealized gains on CRI Liquidating's Government Insured Multifamily Mortgages is reported as a separate component of shareholders' equity as of December 31, 1993. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued (A) CRI Liquidating's mortgage investments and all Mortgages Held for Disposition were accounted for at fair value on the accompanying consolidated balance sheet as of December 31, 1993. 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 - ----------------------- The fair value of the Government Insured Multifamily Mortgages is based on the average of the quoted market prices from three investment banking institutions which trade insured mortgage loans as part of their day-to-day activities. Commercial paper - ---------------- The carrying amount approximates fair value because of the short maturity of the debt. Long-term debt - -------------- The carrying amount approximates fair value because the current rate on the debt is reset quarterly based on market rates. Interest rate hedge agreements - ------------------------------ The fair value of interest rate hedge agreements (used to hedge CRIIMI MAE's commercial paper and long-term debt) is the estimated amount that CRIIMI MAE would pay to terminate the agreements as of December 31, 1993, taking into account current interest rates and the current creditworthiness of the counterparties. The amount was determined based on the average of two quotes received from financial institutions which enter into these types of transactions as part of their day-to-day activities. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS ---------------------------------------- To the Shareholders of CRIIMI MAE Inc. We have audited the accompanying consolidated balance sheets of CRIIMI MAE Inc. (CRIIMI MAE) and its Subsidiaries as of December 31, 1992 and 1993, and the related consolidated statements of income, changes in shareholders' equity and cash flows for the years ended December 31, 1991, 1992 and 1993. These financial statements are the responsibility of CRIIMI MAE'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 present fairly, in all material respects, the consolidated financial position of CRIIMI MAE and its Subsidiaries as of December 31, 1992 and 1993, and the consolidated results of their operations and their cash flows for the years ended December 31, 1991, 1992 and 1993, in conformity with generally accepted accounting principles. As explained in Note 2 of the notes to the consolidated financial statements, effective December 31, 1993, CRIIMI MAE and its Subsidiaries changed their method of accounting for their investment in mortgages. Washington, D.C. Arthur Andersen & Co. February 11, 1994 CRIIMI MAE INC. CONSOLIDATED BALANCE SHEETS ASSETS CRIIMI MAE INC. CONSOLIDATED BALANCE SHEETS ASSETS (Continued) The accompanying notes are an integral part of these consolidated financial statements. CRIIMI MAE INC. CONSOLIDATED BALANCE SHEETS LIABILITIES AND SHAREHOLDERS' EQUITY The accompanying notes are an integral part of these consolidated financial statements. CRIIMI MAE INC. CONSOLIDATED STATEMENTS OF INCOME CRIIMI MAE INC. CONSOLIDATED STATEMENTS OF INCOME (Continued) The accompanying notes are an integral part of these consolidated financial statements. CRIIMI MAE INC. CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY For the years ended December 31, 1991, 1992 and 1993 CRIIMI MAE INC. CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY For the years ended December 31, 1991, 1992 and 1993 The accompanying notes are an integral part of these consolidated financial statements. CRIIMI MAE INC. CONSOLIDATED STATEMENTS OF CASH FLOWS CRIIMI MAE INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued) CRIIMI MAE INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued) The accompanying notes are an integral part of these consolidated financial statements. CRIIMI MAE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. Organization and the Merger CRIIMI MAE Inc. (CRIIMI MAE) (formerly CRI Insured Mortgage Association, Inc.), is an infinite-life, actively managed real estate investment trust (REIT), which specializes in government insured and guaranteed mortgage investments secured by multifamily housing complexes (Government Insured Multifamily Mortgages) located throughout the United States. CRIIMI MAE's principal objectives are to provide stable or growing quarterly cash distributions to its shareholders while preserving and protecting its capital. CRIIMI MAE seeks to achieve these objectives by investing primarily in Government Insured Multifamily Mortgages using a combination of debt and equity financing. CRIIMI MAE and its subsidiary, CRI Liquidating REIT, Inc. (CRI Liquidating), are Maryland corporations. CRIIMI MAE and CRI Liquidating were formed in 1989 to effect the merger into CRI Liquidating (the Merger) of three federally insured mortgage funds sponsored by C.R.I., Inc. (CRI), a Delaware corporation formed in 1974: CRI Insured Mortgage Investments Limited Partnership (CRIIMI I); CRI Insured Mortgage Investments II, Inc. (CRIIMI II); and CRI Insured Mortgage Investments III Limited Partnership (CRIIMI III; and, together with CRIIMI I and CRIIMI II, the CRIIMI Funds). The Merger was effected to provide certain potential benefits to investors in the CRIIMI Funds, including the elimination of unrelated business taxable income for certain tax-exempt investors, the diversification of investments, the reduction of general overhead and administrative costs as a percentage of assets and total income and the simplification of tax reporting information. In the Merger, which was approved by investors in each of the CRIIMI Funds and subsequently consummated on November 27, 1989, investors in the CRIIMI Funds received, at their option, shares of CRI Liquidating common stock or shares of CRIIMI MAE common stock. Investors in the CRIIMI Funds that received shares of CRIIMI MAE common stock became shareholders in an infinite-life, actively managed REIT having the potential to increase the size of its portfolio and enhance the returns to its shareholders. CRIIMI MAE shareholders retained their economic interests in the assets of the CRIIMI Funds which were transferred to CRI Liquidating through CRIIMI MAE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. Organization and the Merger - Continued the issuance of one CRI Liquidating share to CRIIMI MAE for each share of CRIIMI MAE common stock issued to investors in the Merger. Upon the completion of the Merger, CRIIMI MAE held a total of 20,361,807 CRI Liquidating shares, or approximately 67% of the issued and outstanding CRI Liquidating shares. Investors in the CRIIMI Funds that received shares of CRI Liquidating common stock, as well as CRIIMI MAE, became shareholders in a finite-life, self-liquidating REIT the assets of which consist primarily of Government Insured Multifamily Mortgages and other assets formerly held by the CRIIMI Funds. CRI Liquidating intends to hold, manage and dispose of its mortgage investments in accordance with the objectives and policies of the CRIIMI Funds, including disposing of any remaining mortgage investments by 1997 through an orderly liquidation. Pursuant to a Registration Rights Agreement dated November 28, 1989 between CRIIMI MAE and CRI Liquidating, CRIIMI MAE sold 3,162,500 of its CRI Liquidating shares in an underwritten public offering which was consummated in November 1993. As a result of such sale, CRIIMI MAE holds a total of 17,199,307 CRI Liquidating shares, or approximately 57% of CRI Liquidating's issued and outstanding common stock. CRIIMI MAE used approximately $4.9 million of the approximately $26.5 million in net proceeds to terminate a 9.23% interest rate swap agreement on $25 million of CRIIMI MAE's existing indebtedness and used the remaining net proceeds to purchase Government Insured Multifamily Mortgages. CRIIMI MAE and CRI Liquidating are governed by a board of directors, a majority of whom are independent directors with extensive industry related experience. The Board of Directors of CRIIMI MAE and CRI Liquidating has engaged CRI Insured Mortgage Associates Adviser Limited Partnership (the Adviser) to act in the capacity of adviser to CRIIMI MAE and CRI Liquidating. The Adviser's general partner is CRI and its operations are conducted by CRI's employees. CRIIMI MAE's and CRI Liquidating's executive officers are senior executive officers of CRI. The Adviser manages CRIIMI MAE's portfolio of Government Insured Multifamily Mortgages and other assets with the goal of maximizing CRIIMI CRIIMI MAE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS MAE's value, and conducts CRIIMI MAE's day-to-day operations. Under an advisory agreement between CRIIMI MAE and the Adviser, the Adviser and its affiliates receive certain fees and expense reimbursements (see Note 3). On September 6, 1991, CRIIMI MAE, through its wholly owned subsidiary CRIIMI, Inc., acquired from Integrated Resources, Inc. (Integrated) all of the general partnership interests in four publicly held limited partnerships known as the American Insured Mortgage Investors Funds (the AIM Funds). The AIM Funds own mortgage investments which are substantially similar to those owned by CRIIMI MAE and CRI Liquidating. CRIIMI, Inc. receives the general partner's share of income, loss and distributions (which ranges among the AIM Funds from 2.9% to 4.9%) from each of the AIM Funds. In addition, CRIIMI MAE owns indirectly a limited partnership interest in the adviser to the AIM Funds in respect of which CRIIMI MAE receives a guaranteed return each year (see Note 14). CRIIMI MAE and CRI Liquidating have qualified and intend to continue to qualify as REITs under Sections 856-860 of the Internal Revenue Code. As REITs, CRIIMI MAE and CRI Liquidating do not pay taxes at the corporate level. Qualification for treatment as REITs require CRIIMI MAE and CRI Liquidating to meet certain criteria, including certain requirements regarding the nature of their ownership, assets, income and distributions of taxable income. On October 19, 1993, CRIIMI MAE filed a Registration Statement on Form S-3 (Commission File No. 33-50679), expected to be amended on February 16, 1994, to register for sale to the public approximately 6.0 million shares of CRIIMI MAE's common stock (or 6.9 million shares if the underwriters exercise their overallotment option) (the Equity Offering). While there is no assurance that the Equity Offering will be consummated, it is currently expected that the sale will be completed in March 1994, subject to, among other things, such Registration Statement becoming effective and market conditions at such time. The net proceeds from the sale of the shares are estimated to be CRIIMI MAE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS approximately $64.3 million (based on an offering price of $11.50 per share, the reported last sale price on February 11, 1994, and not including the over-allotment). Although no specific investments have as yet been selected, CRIIMI MAE intends to use such proceeds primarily for the acquisition of Government Insured Multifamily Mortgages, the purchase of interest rate hedging agreements and for other general corporate purposes, including, without limitation, working capital. It is not expected that any of the proceeds will be used to repay indebtedness of CRIIMI MAE. The costs of the Equity Offering, including professional fees, filing fees, printing costs and other items, are expected to approximate $.6 million (which was incurred or accrued as of December 31, 1993). Additionally, underwriting fees in an amount which approximates 6.0% of the gross offering proceeds are expected to be incurred. 2. Summary of Significant Accounting Policies Method of accounting - -------------------- The consolidated financial statements of CRIIMI MAE are prepared on the accrual basis of accounting in accordance with generally accepted accounting principles. Reclassifications - ----------------- Certain amounts in the consolidated financial statements as of December 31, 1992 and for the years ended December 31, 1991 and 1992 have been reclassified to conform with the 1993 presentation. Cash and cash equivalents - ------------------------- Cash and cash equivalents consist of money market funds, time and demand deposits and repurchase agreements with original maturities of three months or less. CRIIMI MAE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Consolidation and minority interests - ------------------------------------ The consolidated financial statements reflect the financial position, results of operations, and cash flows of CRIIMI MAE, CRI Liquidating, and CRIIMI, Inc., for all periods presented. All intercompany accounts and transactions have been eliminated in consolidation. Since CRIIMI MAE owned approximately 67%, 67% and 57% of CRI Liquidating as of December 31, 1991, 1992 and 1993, respectively, the ownership interests of the other shareholders in the equity and net income of CRI Liquidating are reflected as minority interests in the accompanying consolidated financial statements. Consolidated statements of cash flows - ------------------------------------- Since the consolidated statements of cash flows are intended to reflect only cash receipt and cash payment activity, the consolidated statements of cash flows do not reflect investing and financing activities that affect recognized assets and liabilities and do not result in cash receipts or cash payments. Such activity consisted of the following: o In July 1991, CRI Liquidating received $2,334,150 in 12 3/4% United States Department of Housing and Urban Development (HUD) debentures as proceeds from the disposition of the mortgage investment in Oak Hill Road Apartments. The proceeds from the redemption of the HUD debentures, including interest, were received in January 1992. Cash payments made for interest for the years ended December 31, 1991, 1992 and 1993 were $27,883,482, $20,826,987 and $22,448,356, respectively. CRIIMI MAE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Investment in mortgages - ----------------------- 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). This statement requires that most 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. This statement, though not required to be adopted until 1994 for CRIIMI MAE and CRI Liquidating, has been adopted for the year ended December 31, 1993. CRIIMI MAE, an infinite-life entity, has the intent and ability to hold its mortgage investments until maturity. Consequently, all mortgage investments, excluding Mortgages Held for Disposition (see Note 6), have been classified as Held to Maturity and continue to be recorded at amortized cost as of December 31, 1993. CRI Liquidating intends to dispose of its existing Government Insured Multifamily Mortgages by March 31, 1997 through an orderly liquidation. In order to achieve this objective, CRI Liquidating will sell certain of its mortgage investments in addition to mortgages assigned to HUD. Consequently, the Adviser believes that the mortgage investments held by CRI Liquidating fall into the Available for Sale category (as defined by SFAS 115). As such, as of December 31, 1993, all of CRI Liquidating's mortgage investments are recorded at fair value with CRIIMI MAE's share of the net unrealized gains on CRI Liquidating's mortgage investments reported as a separate component of shareholders' equity. Subsequent increases or decreases in the fair value of Available for Sale mortgage investments shall be included as a separate component of shareholders' equity. Realized gains and losses for mortgage investments CRIIMI MAE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS classified as Available for Sale will continue to be reported in earnings, as discussed below. Prior to December 31, 1993, CRI Liquidating accounted for its mortgage investments 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 life 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 payments received or accrued less amortization of the premium. CRIIMI MAE's consolidated investment in mortgages is comprised of Government Insured Multifamily Mortgages issued or sold pursuant to programs of the Federal Housing Administration (FHA) (FHA-Insured Loans) and mortgage-backed securities guaranteed by the Government National Mortgage Association (GNMA) (GNMA-Mortgage-Backed Securities). Payment of principal and interest on FHA-Insured Loans is insured by HUD pursuant to Title 2 of the National Housing Act. Payment of principal and interest on GNMA-Mortgage-Backed Securities is guaranteed by GNMA pursuant to Title 3 of the National Housing Act. Mortgages held for disposition - ------------------------------ At any point in time, CRI Liquidating and CRIIMI MAE may be aware of certain mortgages which have been assigned to HUD or for which the servicer has received proceeds from a prepayment. In addition, at certain times CRI Liquidating may enter into a contract to sell certain mortgages. In these cases, CRIIMI MAE and CRI Liquidating will classify these mortgages as Mortgages Held for Disposition. Mortgages Held for Disposition have been accounted for at the lower of cost or market prior to December 31, 1993, and at fair value CRIIMI MAE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS as of December 31, 1993 under the Available for Sale criteria of SFAS 115. Gains from dispositions of mortgages are recognized upon the receipt of funds 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. Investment in insured mortgage funds and advisory partnership - ------------------------------------------------------------- The acquisition of certain interests in the AIM Funds in September 1991 (see Note 14), including certain acquisition costs aggregating approximately $7.7 million, have been recorded under the purchase method of accounting, which provides that the investment be recorded at cost, including the acquisition costs. CRIIMI MAE is utilizing the equity method of accounting for its investment in the AIM Funds and advisory partnership, which provides for recording CRIIMI MAE's share of net earnings or losses in the AIM Funds and advisory partnership reduced by distributions from the limited partnerships and adjusted for purchase accounting amortization. The purchase price, including the deferred acquisition costs of approximately $7.7 million, was allocated among the general partner interests and the advisory partnership interest based on the partnerships' and advisory contracts' estimated fair values. The general partnership and advisory interests were assigned a total value of approximately $27 million and $5 million, respectively. Deferred costs - -------------- Included in deferred costs are mortgage selection fees, which are being paid to the Adviser of CRIIMI MAE (see Note 3) or were paid to the former general partners or adviser to the CRIIMI Funds. These deferred costs are being amortized using the effective interest method on a specific mortgage CRIIMI MAE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS basis from the date of the acquisition of the related mortgage to the expected dissolution date of CRI Liquidating or over the term of the mortgage for CRIIMI MAE (see Note 1). Upon disposition of a mortgage, the related unamortized fee is treated as part of the mortgage investment carrying value in order to measure the gain or loss on the disposition. Borrowing policy of CRI Liquidating - ----------------------------------- CRI Liquidating's Articles of Incorporation do not limit the amount or percentage of indebtedness which CRI Liquidating may incur. CRI Liquidating does not intend to incur any indebtedness, except in connection with the maintenance of its REIT status. During 1992 and 1993, CRI Liquidating entered into transactions in which it incurred debt in connection with the purchase of government guaranteed mortgage-backed securities and government insured certificates backed by project loans. This debt was nonrecourse and fully secured with the purchased government guaranteed mortgage-backed securities and government insured certificates backed by project loans. As of December 31, 1992 and 1993, CRI Liquidating disposed of these government guaranteed mortgage-backed securities and government insured certificates backed by project loans, and repaid the related debt. Interest expense is based on the seller financing of a portion of the purchase price of the other short-term investments in government guaranteed mortgage-backed securities and government insured certificates backed by project loans (see Note 7). Deferred financing costs - ------------------------ Costs incurred in connection with the establishment of CRIIMI MAE's commercial paper facility (the Commercial Paper Facility) and the issuance of long-term debt and commercial paper (see Notes 10 and 11) are amortized using the effective interest method over the terms of the borrowings. CRIIMI MAE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Interest rate hedge agreements - ------------------------------ Amounts to be paid or received under interest rate hedge agreements are accrued currently and are netted for financial statement presentation purposes. Shareholders' equity - -------------------- CRIIMI MAE has authorized 60,000,000 shares of $.01 par value common stock and issued 21,184,807 shares as of December 31, 1992 and 1993. All shares issued, exclusive of the shares held in treasury, are outstanding. As of December 31, 1992 and 1993, 10,266 and 7,732 shares, respectively, were held for issuance pending presentation of predecessor units and are considered outstanding. Additionally, 25,000,000 shares of $.01 par value preferred stock are authorized; however, no shares are issued or outstanding. Income taxes - ------------ CRIIMI MAE and CRI Liquidating have qualified and intend to continue to qualify as REITs as defined in the Internal Revenue Code and, as such, will not be taxed on that portion of their taxable income which is distributed to shareholders provided that at least 95% of such taxable income is distributed. CRIIMI MAE and CRI Liquidating intend to distribute substantially all of their taxable income and, accordingly, no provision for income taxes has been made in the accompanying consolidated financial statements. CRIIMI MAE and CRI Liquidating, however, may be subject to tax at normal corporate rates on net income or capital gains not distributed. CRIIMI MAE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Per share amounts - ----------------- Net income, dividends and return of capital per share amounts for 1991, 1992 and 1993 represent net income, dividends and return of capital, respectively, divided by the weighted average shares outstanding during each year. The per share amounts are based on the weighted average shares outstanding, including shares held for issuance, pending presentation of predecessor units in the CRIIMI Funds. CRIIMI MAE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 3. Transactions with Related Parties Below is a summary of the related party transactions which occurred during the years 1991, 1992 and 1993. These items are described further in the text which follows: (a) Included in the accompanying consolidated statements of income. A detailed schedule of CRI Liquidating's annual fee is reflected in the tables below. (b) These amounts are deferred on the accompanying consolidated balance sheets and amortized over the mortgage investment term. (c) Included as general and administrative expenses on the accompanying consolidated statements of income. (d) Included as income from investment in insured mortgage funds and advisory partnership, before amortization, on the accompanying consolidated statements of income. (e) Included as a reduction of investment in insured mortgage funds and advisory partnership on the accompanying consolidated balance sheets. (f) Included as a component of gains from mortgage dispositions on the accompanying consolidated statements of income. (g) As a result of reaching the carryover CRIIMI I target yield during the first and fourth quarters of 1993, CRI Liquidating paid deferred annual fees during these quarters (including $86,395 of deferred annual fees from the third and fourth quarters of 1992 which were paid during the first quarter of 1993). (h) As of June 1, 1993, pursuant to the First Amendment to the CRI Insured Mortgage Association, Inc. Advisory Agreement, CRIIMI MAE was granted the right to reduce the amounts paid to the Adviser by the difference between its guaranteed $700,000 distribution and the amount actually paid to CRIIMI MAE by CRI/AIM Investment Limited Partnership. As such, the amounts paid to the Adviser during 1993 were reduced by $101,859 which represents the difference between the guaranteed distribution for the period and the amount actually paid to CRIIMI MAE. CRIIMI MAE has entered into an agreement with the Adviser (the Advisory Agreement) under which the Adviser is obligated to present an investment program to CRIIMI MAE, to evaluate and negotiate voluntary and involuntary mortgage dispositions, provide administrative services for CRIIMI MAE and conduct CRIIMI MAE's day-to-day operations. The Advisory Agreement is for a term through November 27, 1995. The Advisory Agreement, absent a notice of termination or non-renewal, will be automatically renewed for successive three-year terms. The Advisory Agreement may be terminated solely for cause, as defined in the Advisory Agreement, by CRIIMI MAE or the Adviser. Notice of non-renewal must be given at least 180 days prior to the expiration date of the Advisory Agreement. If CRIIMI MAE terminates the Advisory Agreement other than for cause, or the Adviser terminates the Advisory Agreement for cause, in addition to compensation otherwise due, CRIIMI MAE will be required to pay the Adviser a fee equal to the Annual Fee (as described below) payable for the previous fiscal year. If the Advisory Agreement is not renewed, no termination fee will be payable. Under the Advisory Agreement, the Adviser receives compensation from CRIIMI MAE as follows: o An annual fee (the Annual Fee) for managing CRIIMI MAE's portfolio of mortgages. The Annual Fee is equal to 0.375% of average invested assets invested in Additional Mortgage Investments (defined as mortgages acquired by CRIIMI MAE after the Merger), payable quarterly. o Included in the Annual Fee shown in the preceding table is the Master Servicing Fee for overseeing the servicing of the Additional Mortgage Investments. The master servicing fee is equal to 0.025% annually of the outstanding face balance of the Additional Mortgage Investments, payable quarterly. o A mortgage selection fee for analyzing, evaluating and structuring Additional Mortgage Investments. The mortgage selection fee equals 0.75% of amounts invested in Additional Mortgage Investments. The Adviser is also entitled to receive one-half of the fees paid to CRIIMI MAE by the owner or developer of a property underlying a participating mortgage investment, provided that the interest rate on the base mortgage investment is at least equal to the prevailing market interest rate for similar base mortgage investments coupled with investments in limited partnerships. In 1991, the Adviser adopted a policy with respect to borrowings above and beyond the original $140 million Notes (see Note 11) and $140 million Commercial Paper Facility (see Note 10) which would result in a reduction in the amount of fees payable by CRIIMI MAE if Net Positive Spreads (the difference between the yield on a mortgage investment acquired with borrowings and all incremental borrowing and operating expenses on a tax basis associated with the acquisition of such mortgage investment) are not maintained: the total Annual Fee and master servicing fee of 0.40% of invested assets payable to the Adviser with respect to mortgage investments purchased with the proceeds of any particular tranche of borrowings will be reduced incrementally if CRIIMI MAE's Net Positive Spread on such tranche of borrowings falls below 0.40%, and the mortgage selection fee will be eliminated upon reinvestment of proceeds of mortgage dispositions where the mortgage investment was purchased with borrowed funds and disposed of in less than five years without providing a cumulative yield on the original mortgage investment at disposition of at least 100 basis points higher than the original yield at the date of purchase. Since the adoption of this policy, CRIIMI MAE expanded its Commercial Paper Facility (defined below) by $50 million (which expansion was paid down in 1993), increased its Bank Term Loan (defined below) by $15 million and entered into Master Repurchase Agreements (defined below) of approximately $350 million. As of December 31, 1992 and 1993, CRIIMI MAE had a Net Positive Spread of approximately 60 and 177 basis points, respectively, on its borrowings. o An incentive fee equal to 25% of the amount by which net income from Additional Mortgage Investments exceeds the annual target return on equity is payable quarterly, subject to year-end adjustment. Net income from Additional Mortgage Investments is the difference between mortgage investment income, including gains or losses on dispositions, from the mortgage investments directly invested in by CRIIMI MAE less financing costs and operating expenses, including a portion of CRIIMI MAE's general and administrative and professional expenses that the Adviser has determined to be specifically assigned to those mortgage investments. Equity for purposes of this computation is CRIIMI MAE's shareholders' equity on a tax basis. The target return on equity will be determined on a quarterly basis and will equal 1% over the average yield on Treasury Bonds maturing nearest to ten years from such quarter, as reported on a daily basis throughout such quarter, based on quotations supplied by the Federal Reserve Bank of New York, as reported by The Wall Street Journal. CRI Liquidating has also entered into an agreement with the Adviser (CRI Liquidating Advisory Agreement) under which the Adviser is obligated to evaluate and negotiate voluntary mortgage dispositions, provide administrative services for CRI Liquidating and conduct CRI Liquidating's day-to-day affairs. The terms of the CRI Liquidating Advisory Agreement are similar to CRIIMI MAE's terms. Under the CRI Liquidating Advisory Agreement, the Adviser receives compensation from CRI Liquidating as follows: o An annual fee (the CRI Liquidating Annual Fee) for managing CRI Liquidating's portfolio of mortgages. The CRI Liquidating Annual Fee is calculated separately for each of the remaining mortgage pools from the former CRIIMI Funds. With respect to CRIIMI I, the CRI Liquidating Annual Fee will equal 0.75% of average invested assets invested in mortgage investments transferred by CRIIMI I in the Merger, one-third of which will be deferred and paid on a cumulative basis only during such quarters as the carryover CRIIMI I target yield, as discussed below, is achieved on a cumulative basis. Any such deferred amounts will be paid only out of proceeds of mortgage dispositions attributable to CRIIMI I mortgage investments representing market discount. With respect to CRIIMI II, the CRI Liquidating Annual Fee will equal 0.75% of average invested assets invested in existing mortgage investments transferred by CRIIMI II in the Merger, one-fourth of which will be deferred and paid on a cumulative basis only during such quarters as the carryover CRIIMI II target yield, as discussed below, is achieved on a cumulative basis. Any such deferred amounts will be paid only out of operating income attributable to CRIIMI II mortgage investments. With respect to CRIIMI III, the CRI Liquidating Annual Fee will equal 0.25% of average invested assets invested in mortgage investments transferred by CRIIMI III in the Merger. After December 31, 1993, this fee will be reduced to 0.125% for any quarter that the carryover CRIIMI III cumulative annual fee yield, as discussed below, is not achieved. The carryover CRIIMI I target yield will be achieved during any quarter that the former CRIIMI I mortgage investments transferred in the Merger generate a cumulative yield (including gains or losses on mortgage dispositions) on amounts invested in such assets of 13.33% per annum based on financial statement income. The carryover CRIIMI II target yield will be achieved during any quarter that the former CRIIMI II mortgage investments transferred in the Merger generate a cumulative yield (including gains or losses on mortgage dispositions) on amounts invested in such assets of 11.66% per annum based on financial statement income. The carryover CRIIMI III cumulative annual fee yield will be achieved during any quarter, commencing after December 31, 1993, that the former CRIIMI III mortgage investments transferred in the Merger generate a cumulative yield (including gains or losses on mortgage dispositions) on amounts invested in such assets of 10.89% per annum based on financial statement income. Detail of the CRI Liquidating Annual Fees for the years 1991, 1992 and 1993 is as follows: For the year ended December 31, 1991 For the year ended December 31, 1992 For the year ended December 31, 1993 o The Adviser is also entitled to certain incentive fees (the Incentive Fees) in connection with the disposition of certain mortgage investments. Like the CRI Liquidating Annual Fee, the Incentive Fees are calculated separately with respect to mortgage investments transferred in the Merger by CRIIMI I and CRIIMI II. No Incentive Fees are payable with respect to mortgage investments transferred by CRIIMI III. During any quarter in which either the carryover CRIIMI I or CRIIMI II target yields have been achieved on a cumulative basis and the Adviser has been paid any deferred amounts of the CRI Liquidating Annual Fee, the Incentive Fee will equal approximately 9.08% of net disposition proceeds representing the financial statement gain on the related CRIIMI I or CRIIMI II mortgage investments disposed of. After the carryover CRIIMI I adjusted contribution or the carryover CRIIMI II adjusted share capital has been reduced to zero, the Incentive Fee will increase to approximately 9.08% of the net disposition proceeds from the disposition of CRIIMI I or CRIIMI II mortgage investments, each determined separately. The carryover CRIIMI I adjusted contribution and the carryover CRIIMI II adjusted share capital equal the aggregate adjusted contribution of CRIIMI I investors (initial investment of investors reduced by all amounts distributed to them representing distributions of principal on their original mortgage investments other than distributions of proceeds of mortgage dispositions representing market discount that have been applied to the target yield) and the aggregate share capital of CRIIMI II investors (initial investment of investors reduced by all amounts distributed to them representing distributions of principal on their original mortgage investments other than distributions of proceeds of mortgage dispositions representing market discount that have been applied to the target yield), respectively, as of November 27, 1989, the consummation date of the Merger. Subsequent to November 27, 1989, the carryover CRIIMI I adjusted contribution and the carryover CRIIMI II adjusted share capital are reduced by all amounts of principal received from their respective former mortgage investments, whether as part of regular mortgage payments or as proceeds of mortgage dispositions, except for proceeds of mortgage dispositions representing market discount that have been applied to the respective target yield. 4. Fair Value of Financial Instruments The following estimated fair values of CRIIMI MAE's consolidated 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 CRIIMI MAE. As of December 31, 1992, CRIIMI MAE and CRI Liquidating recorded their mortgage investments at amortized cost (excluding Mortgages Held for Disposition which were recorded at the lower of cost or market as discussed in Note 6). In connection with CRIIMI MAE's and CRI Liquidating's implementation of SFAS 115 as of December 31, 1993 (see Note 2), CRIIMI MAE's Investment in Mortgages continues to be recorded at amortized cost; however, CRI Liquidating's Investment in Mortgages and CRIIMI MAE's and CRI Liquidating's Mortgages Held for Disposition (see Note 6), are recorded at fair value as of December 31, 1993. The difference between the amortized cost and the fair value of CRI Liquidating's Government Insured Multifamily Mortgages represents the unrealized net gains on CRI Liquidating's Government Insured Multifamily Mortgages. CRIIMI MAE's share of the unrealized net gains on CRI Liquidating's Government Insured Multifamily Mortgages is reported as a separate component of shareholders' equity as of December 31, 1993. (a) CRI Liquidating's Mortgage Investments and all Mortgages Held for Disposition were accounted for at fair value on the accompanying consolidated balance sheet as of December 31, 1993 (see Note 2). 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 Government Insured Multifamily Mortgages and mortgages held for disposition are based on the average of the quoted market prices from three investment banking institutions which trade insured mortgage loans 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. Commercial paper - ---------------- The carrying amount approximates fair value because of the short maturity of the debt. Long-term debt - -------------- The carrying amount approximates fair value because the current rate on the debt is reset quarterly based on market rates. Interest rate hedge agreements - ------------------------------ The fair value of interest rate hedge agreements (used to hedge CRIIMI MAE's commercial paper and long-term debt) is the estimated amount that CRIIMI MAE would pay to terminate the agreements as of December 31, 1992 and 1993, taking into account current interest rates and the current creditworthiness of the counterparties. The amount was determined based on the average of two quotes received from financial institutions which enter into these types of transactions as part of their day-to-day activities. 5. Investment in Mortgages CRIIMI MAE's investment policies, which are overseen by the CRIIMI MAE Board of Directors, are intended to foster its objectives of providing stable or growing quarterly cash distributions to its shareholders while preserving and protecting its capital. CRIIMI MAE seeks to achieve these objectives by investing primarily in Government Insured Multifamily Mortgages issued or sold pursuant to programs sponsored by FHA and GNMA. CRIIMI MAE's sources of capital include borrowings, principal distributions received on its CRI Liquidating shares, principal proceeds of CRIIMI MAE mortgage dispositions and proceeds from equity offerings. As of December 31, 1992 and 1993, CRIIMI MAE directly owned 60 and 126 Government Insured Multifamily Mortgages, respectively, which had a weighted average effective interest rate of approximately 10.1% and 8.52%, a weighted average remaining term of approximately 31 years and 34 years, and a tax basis of approximately $226 million and $499 million, respectively. As of December 31, 1992 and 1993, CRIIMI MAE indirectly owned through its subsidiary, CRI Liquidating, 73 and 63 Government Insured Multifamily Mortgages, respectively, which had a weighted average effective interest rate of approximately 9.91% and 10.03%, a weighted average remaining term of approximately 28 years and 27 years, and a tax basis of approximately $221 million and $173 million, respectively. Thus, on a consolidated basis, as of December 31, 1992 and 1993, CRIIMI MAE owned, directly or indirectly, 133 and 189 Government Insured Multifamily Mortgages, respectively. These consolidated mortgage investments (including Mortgages Held for Disposition) had a weighted average effective interest rate of approximately 9.98%, a weighted average remaining term of approximately 29 years and a tax basis of approximately $447 million, as of December 31, 1992. These amounts compare to a weighted average effective interest rate of approximately 8.95%, a weighted average remaining term of approximately 32 years and a tax basis of approximately $672 million, as of December 31, 1993. In addition, as of December 31, 1993, CRIIMI MAE had committed approximately $41 million for investment in Government Insured Multifamily Mortgages or advances on FHA-Insured Loans relating to the construction or rehabilitation of multifamily housing projects, including nursing homes and intermediate care facilities (Government Insured Construction Mortgages), to be funded by borrowings under the Commercial Paper Facility and the remaining funds available under the Master Repurchase Agreements (see Notes 10 and 11). During 1993, CRIIMI MAE directly acquired 61 Government Insured Multifamily Mortgages with an aggregate purchase price of approximately $284 million at purchase prices ranging from $0.5 million to $30.8 million, with a weighted average effective interest rate of approximately 7.56% and a weighted average remaining term of approximately 33.4 years. In addition, during 1993, CRIIMI MAE funded advances of approximately $29 million on Government Insured Construction Mortgages with a weighted average effective interest rate of approximately 8.73%. As of December 31, 1993, CRIIMI MAE had committed to acquire additional Government Insured Multifamily Mortgages and to make additional advances on and/or acquire Government Insured Construction Mortgages, totalling approximately $41 million. In connection with CRI Liquidating's business plan which calls for an orderly liquidation of approximately 25% of its December 31, 1993 portfolio balance each year through 1997, on February 10, 1994, CRI Liquidating sold twelve Government Insured Multifamily Mortgages resulting in net sales proceeds of approximately $48.7 million. As of the date of the sale, these twelve Government Insured Multifamily Mortgages had a weighted average effective interest rate of approximately 10.3%, a weighted average remaining term of approximately 28 years and a tax basis of approximately $34 million. This sale is expected to result in financial statement and tax basis gains of approximately $11.7 million and $14.7 million, respectively. As discussed below, CRIIMI MAE is permitted to make direct investments in primarily two categories of Government Insured Multifamily Mortgages at, near, or above par value (Near Par or Premium Mortgage Investments). FHA-Insured Loans--The first category of Near Par or Premium Mortgage Investments in which CRIIMI MAE is permitted to invest consists of FHA-Insured Loans. All of the FHA-Insured Loans in which CRIIMI MAE invests are insured by HUD for effectively 99% of their current face value. As part of its investment strategy, CRIIMI MAE also invests in Government Insured Construction Mortgages which involve a two-tier financing process in which a short-term loan covering construction costs is converted into a permanent loan. CRIIMI MAE also becomes the holder of the permanent loan upon conversion. The construction loan is funded in HUD-approved draws based upon the progress of construction. The construction loans are GNMA-guaranteed or insured by HUD. The construction loan generally does not amortize during the construction period. Amortization begins upon conversion of the construction loan into a permanent loan, which generally occurs within a 24-month period from the initial endorsement by HUD. Mortgage-Backed Securities--The second category of Near Par or Premium Mortgage Investments in which CRIIMI MAE is permitted to invest consists of federally guaranteed mortgage-backed securities or other securities backed by Government Insured Multifamily Mortgages issued by entities other than GNMA (Mortgage-Backed Securities) and GNMA Mortgage-Backed Securities. As of December 31, 1993, all of CRIIMI MAE's mortgage investments in this category were GNMA Mortgage-Backed Securities. The GNMA Mortgage-Backed Securities in which CRIIMI MAE invests are backed by Government Insured Multifamily Mortgages insured in whole by HUD, or insured by HUD and a coinsured lender under HUD mortgage insurance programs and the coinsurance provisions of the National Housing Act. The Mortgage-Backed Securities in which CRIIMI MAE is permitted to invest, although none have been acquired as of December 31, 1993, are backed by Government Insured Multifamily Mortgages which are insured in whole by HUD under HUD mortgage insurance programs. Generally, Government Insured Multifamily Mortgages which are purchased near, at or above par value will result in a loss if the mortgage investment is prepaid or assigned prior to maturity because the amortized cost of the mortgage investment, including acquisition costs, is approximately the same as or slightly higher than the insured amount of the mortgage investment. As of December 31, 1993, substantially all of the mortgage investments owned directly by CRIIMI MAE consisted of Government Insured Multifamily Mortgages that are Near Par or Premium Mortgage Investments. Based on current interest rates, the Adviser does not believe that the prepayment, assignment, or sale of any of CRIIMI MAE's Government Insured Multifamily Mortgages would result in a material financial statement or tax basis gain or loss. CRI Liquidating Mortgage Investments--CRI Liquidating's mortgage investments consist solely of the Government Insured Multifamily Mortgages it acquired from the CRIIMI Funds in the Merger. The CRIIMI Funds invested primarily in Government Insured Multifamily Mortgages issued or sold pursuant to programs of GNMA and FHA. The majority of CRI Liquidating's mortgage investments were acquired by the CRIIMI Funds at a discount to face value (Discount Mortgage Investments) on the belief that based on economic, market, legal and other factors, such Discount Mortgage Investments might be sold for cash, prepaid as a result of a conversion to condominium housing or otherwise disposed of or refinanced in a manner requiring prepayment or permitting other profitable disposition three to twelve years after acquisition by the CRIIMI Funds. Based on current interest rates, the Adviser expects that (i) the disposition of most of CRI Liquidating's Government Insured Multifamily Mortgages will result in a gain on a financial statement basis, and (ii) the disposition of any of CRI Liquidating's Government Insured Multifamily Mortgages will not result in a material loss on a financial statement basis and will result in a gain on a tax basis. The safekeeping and servicing of the mortgage investments (excluding CRI Liquidating's investment in limited partnerships) is performed by various trustees and servicers under the terms of the Servicing Agreements. Other Investments - ----------------- In addition to investing in FHA-Insured Loans and GNMA-Mortgage Backed Securities, CRIIMI MAE's investment policies also permit CRIIMI MAE to invest in Government Insured Multifamily Mortgages which are not FHA-insured or GNMA-guaranteed (Other Insured Mortgages) and in certain other mortgage investments which are not federally insured or guaranteed (Other Multifamily Mortgages). Pursuant to CRIIMI MAE's policy, at the time of their acquisition, Other Multifamily Mortgages must have an expected yield of at least 150 basis points (1.5%) greater than the yield on Government Insured Multifamily Mortgages which could be acquired in the then current market and must meet certain other strict underwriting guidelines. The CRIIMI MAE Board of Directors has adopted a policy limiting Other Multifamily Mortgages to 20% of CRIIMI MAE's total consolidated assets. As of December 31, 1993, CRIIMI MAE had not invested or committed to invest in any Other Insured Mortgages or Other Multifamily Mortgages and CRIIMI MAE does not currently intend to invest in any Other Multifamily Mortgages for at least twelve months after the filing date of this report. CRIIMI MAE is currently exploring opportunities in connection with the sponsorship of securities offerings which involve the pooling of certain Other Multifamily Mortgages to further enhance potential returns to CRIIMI MAE shareholders. Such sponsorship may also include the investment by CRIIMI MAE in the non-investment grade or unrated tranches of mortgage pools having a high current yield. As of December 31, 1993, CRIIMI MAE had not participated in the sponsorship of any such securities offerings. The Adviser does not expect that investments of this nature will exceed 5% of CRIIMI MAE's total consolidated assets for at least twelve months after the filing date of this report. Descriptions of the mortgage investments owned, directly or indirectly by CRIIMI MAE which exceed 3% of the total carrying amount of the consolidated mortgage investments as of December 31, 1993, summarized information regarding other mortgage investments and mortgage investment income earned in 1991, 1992 and 1993, including interest earned on the disposed mortgage investments, are as follows: * As construction loans convert to permanent loans, information reported in prior periods is reclassified to the applicable permanent loan classification. ** For additional information regarding Mortgages Held for Disposition, see Note 6 of the notes to consolidated financial statements. *** Construction draws are part of a short-term financing process and are funded to cover construction costs. The construction draws are converted into a long-term permanent loan generally within a 24-month period from the initial endorsement by HUD. (A) All mortgages are collateralized by first or second liens on residential apartment, retirement home, nursing home, development land or townhouse complexes which have diverse geographic locations and are FHA-Insured Loans or GNMA Mortgage-Backed Securities. Payment of the principal and interest on FHA-Insured Loans is insured by HUD pursuant to Title 2 of the National Housing Act. Payment of the principal and interest on GNMA Mortgage-Backed Securities is guaranteed by GNMA pursuant to Title 3 of the National Housing Act. The investment in limited partnerships is not federally insured or guaranteed. (B) Principal and interest on permanent mortgages is payable at level amounts over the life of the mortgage investment. Total annual debt service payable to CRIIMI MAE and CRI Liquidating(excluding principal and interest on the mortgages classified as held for disposition) for the mortgage investments held as of December 31, 1993 is approximately $61.1 million. (C) Reconciliations of the carrying amount of CRIIMI MAE's consolidated mortgage investments for the years ended December 31, 1992 and 1993 follow: (D) Principal Amount of Loans Subject to Delinquent Principal or Interest is not presented since all required payments with respect to these FHA-Insured Loans or GNMA Mortgage-Backed Securities are current and none of these mortgages are delinquent as of December 31, 1993, except the mortgages classified as Mortgages Held for Disposition as discussed in Note 6 and the mortgages on Guinn Nursing Home and Oak Hills Nursing Home which had an aggregate face value of approximately $6.2 million as of December 31, 1993. CRIIMI MAE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 5. Investment in Mortgages - Continued Historical Dispositions - ----------------------- The following table sets forth certain information concerning dispositions of Government Insured Multifamily Mortgages by CRIIMI MAE and CRI Liquidating for the past five years: NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Investment in Mortgages - Continued 5. Investment in Mortgages - Continued (1) CRIIMI MAE or CRI Liquidating may elect to receive insurance benefits in the form of cash when a Government Insured Multifamily Mortgage defaults. In that event, 90% of the face value of the mortgage generally is received within approximately 90 days of assignment of the mortgage to HUD and 9% of the face value of the mortgage is received upon final processing by HUD which may not occur in the same year as assignment. If CRIIMI MAE or CRI Liquidating elects to receive insurance benefits in the form of HUD debentures, 99% of the face value of the mortgage is received upon final processing by HUD. Gains from dispositions are recognized upon receipt of funds or HUD debentures and losses generally are recognized at the time of assignment. (2) Eight of the 37 assignments were sales of Government Insured Multifamily Mortgages then in default and resulted in the CRIIMI Funds, CRI Liquidating or CRIIMI MAE receiving near or above face value. (3) In connection with the Merger, CRI Liquidating recorded its investment in mortgages at the lower of cost or fair value, which resulted in an overall net write down for tax purposes. For financial statement purposes, carryover basis of accounting was used. Therefore, since the Merger, the net gain for tax purposes was greater than the net gain recognized for financial statement purposes. As a REIT, dividends to shareholders are based on tax basis income. CRIIMI MAE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 6. Mortgages Held for Disposition As of December 31, 1992 and 1993, the following mortgages were classified as held for disposition: CRIIMI MAE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 6. Mortgages Held for Disposition - Continued (1) Represents a CRI Liquidating mortgage investment. In connection with CRI Liquidating's implementation of SFAS 115 (see Note 2) as of December 31, 1993, all of CRI Liquidating's mortgage investments, including Mortgages Held for Disposition, were recorded at fair value. As of December 31, 1992, all of CRI Liquidating's mortgage investments classified as Mortgages Held for Disposition were recorded at the lower of cost or market. (2) Represents a CRIIMI MAE mortgage investment. As of December 31, 1992, all of CRIIMI MAE's mortgage investments classified as Mortgages Held for Disposition were recorded at the lower of cost or market. In connection with CRIIMI MAE's implementation of SFAS 115 (see Note 2) as of December 31, 1993, all of CRIIMI MAE's mortgage investments classified as Mortgages Held for Disposition were recorded at fair value. CRIIMI MAE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 7. Other Short-Term Investments During 1993, CRIIMI MAE, and, during each of 1992 and 1993, CRI Liquidating entered into transactions in which mortgage-backed and other government agency securities were purchased. These transactions provided CRIIMI MAE with above average returns compared to its other short-term investments while maintaining the high quality of its assets and assisted in maintaining CRI Liquidating's REIT status. Some of these purchases were financed with borrowings which were nonrecourse and fully secured with the purchased mortgage-backed and other government agency securities. As of December 31, 1993, CRIIMI MAE and as of December 31, 1992 and 1993, CRI Liquidating had disposed of the mortgage-backed and other government agency securities acquired in such year and repaid the related debt. CRIIMI MAE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 8. Reconciliation of Financial Statement Net Income to Tax Basis Income Reconciliations of the financial statement net income to the tax basis income for the years ended December 31, 1991, 1992 and 1993 are as follows: CRIIMI MAE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 8. Reconciliation of Financial Statement Net Income to Tax Basis Income - Continued Differences in the financial statement net income and the tax basis income principally relate to differences in the tax bases of assets and liabilities and their related financial reporting amounts resulting from the Merger, investment in mortgages, long-term debt and deferred financing costs, investment in U.S. Treasury Securities and partnership investments. The tax basis of investment in mortgages is approximately $70.3 million less than the financial statement basis as of December 31, 1993. The tax basis of long-term debt and deferred financing costs as of December 31, 1993 was approximately $15 million and $5 million, respectively, greater than the financial statement basis. The tax basis of investments in U.S. Treasury Securities, purchased in connection with the defeasance of long-term debt (see Note 11) and netted with the defeased long-term debt for financial statement purposes, is approximately $15 million greater than the financial statement basis as of December 31, 1993. As a result of the foregoing, the nature of the dividends for income tax purposes on a per share basis is as follows: CRIIMI MAE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 9. Summary of Quarterly Results of Operations (Unaudited) The following is a summary of unaudited quarterly results of operations for the years ended December 31, 1991, 1992 and 1993: CRIIMI MAE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 9. Summary of Quarterly Results of Operations (Unaudited) - Continued 10. Commercial Paper The following table shows commercial paper borrowing activity as of December 31, 1992 and 1993 and for the years then ended: CRIIMI MAE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 10. Commercial Paper - Continued In May 1991, CRIIMI MAE entered into an agreement to amend the Commercial Paper Facility (defined below) which increased the funds available for borrowings from $140.0 million to $190.0 million. As of December 31, 1992 and 1993, CRIIMI MAE had borrowed a total of approximately $186.3 million and $95.3 million, respectively. The base issuance rate for commercial paper issued under CRIIMI MAE's commercial paper facility (the Commercial Paper Facility) ranged from 3.20% to 4.45% during the year ended December 31, 1992 and 3.15% to 3.68% during the year ended December 31, 1993, and was 4.02% and 3.41% as of December 31, 1992 and 1993, respectively. CRIIMI MAE's Commercial Paper Facility provides for the issuance of commercial paper by CRI Funding Corporation, an unaffiliated special purpose corporation, which lends the proceeds from the issuance to CRIIMI MAE. If commercial paper is not issued, the special purpose corporation may meet its obligation to provide financing to CRIIMI MAE by borrowing at a rate of LIBOR plus 0.50% under a $140.0 million revolving credit facility which was established in connection with the Commercial Paper Facility. Borrowings pursuant to the Commercial Paper Facility are collateralized by a pledge of certain of CRIIMI MAE's Government Insured Multifamily Mortgages. The loan agreements contain numerous covenants which CRIIMI MAE must satisfy, including CRIIMI MAE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 10. Commercial Paper - Continued requirements that the fair value of collateral pledged must equal at least 110% of the amounts borrowed and that interest on the collateral pledged equal at least 120% of the debt service on the amounts borrowed. In addition, 60% of the Government Insured Multifamily Mortgages pledged as collateral must be GNMA- Mortgage Backed Securities. As of December 31, 1993, Government Insured Multifamily Mortgages held directly by CRIIMI MAE with a market value and face value of approximately $145.4 million and $139.7 million, respectively, were used as collateral pursuant to the Commercial Paper Facility. In February 1993, CRIIMI MAE entered into an agreement to replace a $190.0 million letter of credit which provided the credit enhancement for the Commercial Paper Facility and related revolving credit facility, with two letters of credit in the amount of $35.0 million and $155.0 million provided by National Australia Bank, Limited and Canadian Imperial Bank of Commerce (CIBC), respectively. In April 1993, the letter of credit provided by CIBC was reduced to $105.0 million. Subsequent to December 31, 1993, the special purpose corporation replaced borrowings under the Commercial Paper Facility with revolving credit loans. These revolving credit loans were scheduled to mature on January 28, 1994; however, the maturity date has been extended until February 28, 1994. CRIIMI MAE executed a Commitment Letter and Term Sheet for a revolving credit facility, dated November 24, 1993, to replace these agreements with a 30-month non-amortizing bank loan to be issued prior to the expiration date of the letter of credit agreements by lenders including the aforementioned bank group on terms substantially similar to the April 1993 Master Repurchase Agreements (defined below). While there is no assurance, CRIIMI MAE expects to close on such new revolving credit facility on or before February 28, 1994. If CRIIMI MAE is unable to consummate the loan by such date, the Adviser believes that it will be able to obtain a further extension of its existing revolving credit loans. CRIIMI MAE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 11. Long-term debt The following table summarizes CRIIMI MAE's long-term debt as of December 31, 1992 and 1993: CRIIMI MAE's long-term debt matures over the next three years as follows: CRIIMI MAE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 11. Long-term debt - Continued Master Repurchase Agreements - ---------------------------- On April 30, 1993, CRIIMI MAE entered into master repurchase agreements (the Master Repurchase Agreements) with Nomura Securities International, Inc. and Nomura Asset Capital Corporation (collectively, Nomura) which provide CRIIMI MAE with $350.0 million of available financing for a three-year term. CRIIMI MAE intends to seek renewal of the Master Repurchase Agreements upon expiration. Interest on such borrowings is based on the three-month LIBOR plus 0.75% or 0.50% depending on whether FHA-Insured Loans or GNMA Mortgage-Backed Securities, respectively, are pledged as collateral. For April through December 1993, the three-month LIBOR for these borrowings ranged from 3.18% to 3.50%. The value of the collateral pledged must equal at least 105% and 110% of the amounts borrowed for GNMA Mortgage-Backed Securities and FHA-Insured Loans, respectively. No more than 60% of the collateral pledged may be FHA-Insured Loans and no less than 40% may be GNMA Mortgage-Backed Securities. As of December 31, 1993, mortgage investments directly owned by CRIIMI MAE which approximate $349.4 million at market value and $342.2 million at face value, were used as collateral pursuant to certain terms of the Master Repurchase Agreements. As of December 31, 1993, CRIIMI MAE's debt-to-equity ratio, excluding approximately $41.0 million of borrowings committed for investment in mortgages, was 2.2:1 and its debt-to-equity ratio, including such borrowings, was 2.4:1. As of December 31, 1993, CRIIMI MAE used approximately $281.7 million of the funds available under the Master Repurchase Agreements to acquire Government Insured Multifamily Mortgages and $50.0 million to repay a portion of borrowings under the Commercial Paper Facility. In addition, approximately $18.3 million of the balance of the funds available have been committed for investment in Government Insured Multifamily Mortgages or advances on Government Insured Construction Mortgages. On November 30, 1993, CRIIMI MAE entered into additional repurchase agreements with Nomura pursuant to which Nomura will CRIIMI MAE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 11. Long-term debt - Continued provide CRIIMI MAE with an additional $150.0 million of available financing for a three-year term. The agreements provide that the funding will be utilized to purchase FHA-Insured Loans and GNMA Mortgage-Backed Securities in the event of the successful completion of the Equity Offering (see Note 1). In that event, it is contemplated that CRIIMI MAE will borrow the full $150.0 million no earlier than the consummation of the Equity Offering, but no later than July 1, 1994. The terms of the $150.0 million financing arrangements are similar to the terms of the Master Repurchase Agreements entered into in April 1993. Bank Term Loan - -------------- On October 23, 1991, CRIIMI MAE entered into a credit agreement with two banks for a reducing term loan facility (the Bank Term Loan) in an aggregate amount not to exceed $85.0 million, subject to certain terms and conditions. In December 1992, the credit agreement was amended to increase the reducing term loan by $15.0 million. The Bank Term Loan had an outstanding principal balance of approximately $61.7 million and $52.0 million as of December 31, 1992 and 1993, respectively. As of December 31, 1992 and 1993, the Bank Term Loan was secured by the value of 17,784,000 and 13,874,000 CRI Liquidating shares owned by CRIIMI MAE, respectively. As a result of principal payments on the Bank Term Loan in 1993, 750,000 of the 13,874,000 CRI Liquidating shares pledged as collateral were released in January 1994. The Bank Term Loan requires a quarterly principal payment based on the greater of the return of capital portion of the dividend received by CRIIMI MAE on its CRI Liquidating shares securing the Bank Term Loan or an amount to bring the Bank Term Loan to its scheduled outstanding balance at the end of such quarter. The minimum amount of annual principal payments is approximately $15.8 million, with any remaining amounts of the original $85.0 million of principal due in April 1996 and any remaining amounts of the $15.0 million of increased principal due in December 1996. CRIIMI MAE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 11. Long-term debt - Continued The amended Bank Term Loan provides for an interest rate of 1.10% over three-month LIBOR plus an agent fee of 0.05% per year. During 1992 and 1993, three-month LIBOR for borrowings under the Bank Term Loan ranged from 3.44% to 4.50% and 3.19% to 3.59%, respectively. On December 31, 1991, with the $85.0 million from the Bank Term Loan and the debt service reserve account, CRIIMI MAE repurchased approximately $97.6 million and defeased the remaining $19.2 million of the outstanding notes issued pursuant to an Indenture dated November 28, 1989 (the Notes). CRIIMI MAE purchased approximately $21.6 million of U.S. Treasury Securities to fund the principal and interest due in accordance with the original payment schedule to defease the Notes which were not repurchased. As a result of this early extinguishment of debt, CRIIMI MAE recognized an extraordinary loss of approximately $6.6 million in the accompanying consolidated statements of income for the year ended December 31, 1991. All remaining costs associated with the Bank Term Loan have been included in deferred financing fees on the accompanying balance sheet and will be amortized using the effective interest method over the life of the Bank Term Loan. However, for tax purposes these deferred financing fees as well as the extraordinary loss have been capitalized and will be amortized over the term of the Bank Term Loan. 12. Interest Rate Hedge Agreements CRIIMI MAE is subject to the risk that changes in interest rates could reduce Net Positive Spreads by increasing CRIIMI MAE's borrowing costs and/or decreasing the yield on its Government Insured Multifamily Mortgages. An increase in CRIIMI MAE borrowing costs could result from an increase in short-term interest rates. To partially limit the adverse effects of rising interest rates, CRIIMI MAE has entered into a series of interest rate hedging agreements in an aggregate notional amount approximately equal to all of its outstanding borrowings and commitments. To the extent CRIIMI MAE has not fully hedged its portfolio, in periods of rising interest rates CRIIMI MAE's CRIIMI MAE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 12. Interest Rate Hedge Agreements - Continued overall borrowing costs would increase with little or no overall increase in mortgage investment income, resulting in returns to shareholders that would be lower than those available if interest rates had remained unchanged. Borrowings by CRIIMI MAE generally are hedged by swap, cap or collar agreements. As of December 31, 1993, CRIIMI MAE had in place interest rate collars on the indices underlying borrowing rates for the Commercial Paper Facility (the CP Index) with an aggregate notional amount of $115 million, a weighted average floor of 8.55% and a weighted average cap of 10.37%. An interest rate collar limits the CP Index to a maximum interest rate and also enables CRIIMI MAE to receive the benefit of a decline in the CP Index to the floor of the collar for the period of the collar. To the extent that the CP Index increases, CRIIMI MAE's overall borrowing costs would not increase until the CP Index reaches the level of the floor of the collar. At that point, CRIIMI MAE's borrowing costs would increase as the CP Index increases but only until the CP Index reaches the maximum rate provided for by the collar. As of December 31, 1993, CRIIMI MAE had in place interest rate caps on the CP Index and LIBOR underlying borrowing rates for the Commercial Paper Facility and Master Repurchase Agreements. The caps based on the CP Index have an aggregate notional amount of $50 million with a weighted average cap of 8.73%. The caps based on LIBOR have an aggregate notional amount of $300 million with a weighted average cap of 6.23%. CRIIMI MAE also had an interest rate cap with a notional amount of approximately $63 million and a cap of 6.5% on the LIBOR underlying the Bank Term Loan. An interest rate cap effectively limits CRIIMI MAE's interest rate risk on floating rate borrowings by limiting the CP Index or LIBOR, as the case may be, to a maximum interest rate for the period of the cap. To the extent the CP Index or LIBOR decrease, CRIIMI MAE's borrowing costs would decrease under such caps. To the extent the CP Index or LIBOR increase, CRIIMI MAE's borrowing costs would increase but only until the CP Index or LIBOR reaches the maximum rate provided for by the cap. As of CRIIMI MAE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 12. Interest Rate Hedge Agreements - Continued December 31, 1993, certain cap agreements based on the three-month LIBOR with a notional amount of $300 million were between approximately 2.62% and 3.13% above the current three-month LIBOR. On December 1, 1993, CRIIMI MAE paid approximately $4.9 million to terminate an interest rate swap entered into on February 8, 1990 with a notional amount of $25 million and a fixed rate of 9.23%. The termination of this swap was effective December 1, 1993. The cost to terminate the interest rate swap was expensed in the accompanying consolidated statement of income for the year ended December 31, 1993 as the underlying debt under the Commercial Paper Facility being hedged was repaid. As of December 31, 1993, CRIIMI MAE had in place no swap agreements. Current interest rates are substantially lower than when CRIIMI MAE entered into $165 million of its existing interest rate hedging agreements. As of December 31, 1993, certain collar agreements based on the CP Index with a notional amount of $115 million carried minimum interest rates which were between approximately 5.0% and 5.4% above the current CP Index. Such hedging agreements expire in 1995. While there is no assurance that any new agreements will be made, the Adviser is actively exploring alternatives to replace these hedging agreements when they expire in order to capitalize on the current low interest rate environment. As a result of minimum interest rate levels associated with the swap agreement terminated in December, 1993 and the collar agreements which expire in 1995, CRIIMI MAE incurred additional interest expense of $4.3 million, $8.1 million and $8.6 million for the years ended December 31, 1991, 1992 and 1993, respectively, of which approximately $0.8 million, $1.3 million and $1.4 million, respectively, was attributable to the terminated swap agreement. The additional interest expense amounts also include amortization of approximately $0.1 million, $0.2 million and $0.6 million, respectively, related to up-front hedging costs. CRIIMI MAE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 12. Interest Rate Hedge Agreements - Continued The following table sets forth information relating to CRIIMI MAE's hedging agreements with respect to borrowings under the Commercial Paper Facility and the Master Repurchase Agreements: CRIIMI MAE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 12. Interest Rate Hedge Agreements - Continued (a) On May 24, 1993, CRIIMI MAE and CIBC terminated the floor on this former collar. In consideration of such termination, CRIIMI MAE paid CIBC approximately $2.3 million. This amount was deferred on the accompanying consolidated balance sheet as the underlying debt being hedged is still outstanding. This amount will be amortized for the period from May 24, 1993 through May 24, 1996. CRIIMI MAE amortized approximately $0.5 million of this deferred amount in the accompanying consolidated statements of income for the year ended December 31, 1993. (b) Approximately $4.5 million of costs were incurred in 1993 in connection with the establishment of interest rate hedges. These costs are being amortized using the effective interest method over the term of the interest rate hedge agreement for financial statement purposes and in accordance with the regulations under Internal Revenue Code Section 446 with respect to notional principal contracts for tax purposes. (c) The hedges are based either on the 30-day Commercial Paper Composite Index (CP) or three-month LIBOR. CRIIMI MAE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 12. Interest Rate Hedge Agreements - Continued In addition, CRIIMI MAE entered into an interest rate hedge agreement on the Bank Term Loan to cap LIBOR at 6.5% based on the expected paydown schedule and an incremental hedge of 10.5% on the difference between the required and expected paydown schedules. As of December 31, 1993, three-month LIBOR was approximately 3.13% below the 6.5% cap. CRIIMI MAE is exposed to credit loss in the event of nonperformance by the other parties to the interest rate hedge agreements should interest rates exceed the caps. However, the Adviser does not anticipate nonperformance by any of the counterparties, each of which has long-term debt ratings of A or above by Standard and Poor's and A2 or above by Moody's. 13. Treasury Stock On January 12, 1990, CRIIMI MAE commenced a cash tender offer (the Tender Offer) to repurchase and to hold in treasury up to 1,000,000 outstanding CRIIMI MAE shares at $9.50 per share. The offer expired at midnight on February 12, 1990. Pursuant to the Tender Offer, CRIIMI MAE purchased and holds in treasury 1,001,274 CRIIMI MAE shares at $9.50 per share which are shown at cost on the accompanying consolidated balance sheets. Such shares could be reissued for such purposes as, among others, the acquisition of other businesses and the distribution of stock dividends. 14. Acquisition - AIM Funds Interest Effective March 1, 1991, CRIIMI MAE entered into a Purchase Agreement dated as of December 13, 1990 with Integrated and certain of its affiliates, and AIM Acquisition Corporation to acquire certain of the interests of Integrated and its affiliates in the AIM Funds sponsored by Integrated. On September 6, 1991, CRIIMI, Inc. acquired all of the general partnership interests in the AIM Funds for $23,342,591. In addition, CRIIMI MAE and CRI each invested $1,086,714 for an aggregate 20% limited partnership interest in a limited partnership which serves as the adviser to the AIM Funds. The remaining 80% of the adviser partnership is CRIIMI MAE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 12. Interest Rate Hedge Agreements - Continued owned by parties unrelated to CRIIMI MAE or CRI. The adviser partnership entered into subadvisory agreements with an affiliate of CRI under which such affiliate will perform certain services with respect to the mortgage portfolios of the AIM Funds. For its investment, CRIIMI, Inc. will receive the General Partner's share of income, loss and distributions (which ranges among the AIM Funds from 2.9%- 4.9%) from each fund and an affiliate of CRIIMI, Inc. will receive certain expense reimbursements. CRIIMI MAE is guaranteed an annual return on its investment in the adviser partnership, through the distributions it receives indirectly from the adviser partnership and a right of offset against amounts payable to its Adviser (see Note 3). Combined summarized financial information as of December 31, 1992 and 1993 and for the years ended December 31, 1991, 1992 and 1993 of the AIM Funds in which CRIIMI MAE's equity in the net income exceeds 10 percent of CRIIMI MAE's net income, is as follows: CRIIMI MAE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Combined Summarized Financial Information (Unaudited) CRIIMI MAE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Statements of Income CRIIMI MAE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 15. Settlement of Litigation On March 22, 1990, a complaint was filed, on behalf of a class comprised of certain limited partners of CRIIMI III and shareholders of CRIIMI II (the Plaintiffs), in the Circuit Court for Montgomery County, Maryland against CRIIMI MAE, CRI Liquidating, CRIIMI I and its general partner, CRIIMI II, CRIIMI III and its general partner, CRI and William B. Dockser, H. William Willoughby and Martin C. Schwartzberg (the Defendants). On November 18, 1993, the Court entered an order granting final approval of a settlement agreement between the Plaintiffs and the Defendants pursuant to which CRIIMI MAE will issue to class members, including certain former limited partners of CRIIMI I, up to 2.5 million warrants, exercisable for 18 months after issuance, to purchase shares of CRIIMI MAE common stock at an exercise price of $13.17 per share. In addition, the settlement included a payment of $1.4 million for settlement administration costs and the Plaintiff's attorneys' fees and expenses. Insurance provided $1.15 million of the $1.4 million cash payment, with the balance paid by CRIIMI MAE. CRIIMI MAE accrued a total provision of $1.5 million in the accompanying consolidated statements of income for the uninsured portion of the cash settlement paid by CRIIMI MAE and for the estimated value of the warrants that are expected to be issued as part of the settlement. The number of warrants to be issued is dependent on the number of class members who submit a proof of claim within 60 days of January 14, 1994 (the date the proof of claim was mailed by CRIIMI MAE). The issuance of the warrants pursuant to the settlement agreement will have no impact on CRIIMI MAE's tax basis income. Depending upon the number of warrants issued, CRIIMI MAE will record in its financial statements a non-cash expense ranging from $0 (if no warrants are issued) to $5 million (if all 2.5 million warrants are issued). Based on the Adviser's estimate of the number of warrants to be issued, CRIIMI MAE has accrued a total provision of $1.5 million (which includes the uninsured portion of the cash settlement) in the accompanying consolidated statement of income for 1993, which provision may be increased or decreased once the actual number of warrants issued is known. The Adviser CRIIMI MAE INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 15. Settlement of Litigation - Continued estimates that the final charge (after adjustments to the provision) to net income and the increase in the number of shares of common stock outstanding as a result of the exercise of the warrants will not have a material adverse effect on CRIIMI MAE's net income and net income per share. The exercise of the warrants will not result in a charge to CRIIMI MAE's tax basis income. Further, the Adviser believes that the exercise of the warrants will not have a material adverse effect on CRIIMI MAE's tax basis income per share or annualized cash dividends per share because CRIIMI MAE intends to invest the proceeds from any exercise of the warrants in accordance with its investment policy to purchase Government Insured Multifamily Mortgages and other authorized investments. However, in the case of a significant decline in the yield on mortgage investments and a significant decrease in the Net Positive Spread which CRIIMI MAE could achieve on its borrowings, the exercise of the warrants may have a dilutive effect on tax basis income per share and cash dividends per share. Receipt of the proceeds from the exercise of the warrants will increase CRIIMI MAE's shareholders' equity. Appendix CRIIMI MAE Schedule of Government Insured Multifamily Mortgages (Excluding Mortgages Held for Disposition) As of December 31, 1993 (Unaudited) Appendix CRIIMI MAE Schedule of Government Insured Multifamily Mortgages (Excluding Mortgages Held for Disposition)(Continued) As of December 31, 1993 (Unaudited) Appendix CRIIMI MAE Schedule of Government Insured Multifamily Mortgages (Excluding Mortgages Held for Disposition)(Continued) As of December 31, 1993 (Unaudited) Appendix CRIIMI MAE Schedule of Government Insured Multifamily Mortgages (Excluding Mortgages Held for Disposition)(Continued) As of December 31, 1993 (Unaudited) Appendix CRIIMI MAE Schedule of Government Insured Multifamily Mortgages (Excluding Mortgages Held for Disposition)(Continued) As of December 31, 1993 (Unaudited) Appendix CRIIMI MAE Schedule of Government Insured Multifamily Mortgages (Excluding Mortgages Held for Disposition)(Continued) As of December 31, 1993 (Unaudited) Appendix CRIIMI MAE Schedule of Government Insured Multifamily Mortgages (Excluding Mortgages Held for Disposition)(Continued) As of December 31, 1993 (Unaudited) Appendix CRIIMI MAE Schedule of Government Insured Multifamily Mortgages (Excluding Mortgages Held for Disposition)(Continued) As of December 31, 1993 (Unaudited) Appendix CRIIMI MAE Schedule of Government Insured Multifamily Mortgages (Excluding Mortgages Held for Disposition)(Continued) As of December 31, 1993 (Unaudited) (a) Includes a supplemental note in the principal balance of $268,568 with a net coupon of 9.25% and a maturity date of July 1, 1996. (b) Excludes one Mortgage Held for Disposition. Appendix CRI Liquidating Schedule of Government Insured Multifamily Mortgages (Excluding Mortgages Held for Disposition) As of December 31, 1993 (Unaudited) Appendix CRI Liquidating Schedule of Government Insured Multifamily Mortgages (Excluding Mortgages Held for Disposition) (Continued) As of December 31, 1993 (Unaudited) Appendix CRI Liquidating Schedule of Government Insured Multifamily Mortgages (Excluding Mortgages Held for Disposition) (Continued) As of December 31, 1993 (Unaudited) Appendix CRI Liquidating Schedule of Government Insured Multifamily Mortgages (Excluding Mortgages Held for Disposition) (Continued) As of December 31, 1993 (Unaudited) Appendix CRI Liquidating Schedule of Government Insured Multifamily Mortgages (Excluding Mortgages Held for Disposition) (Continued) As of December 31, 1993 (Unaudited) The following Government Insured Multifamily Mortgages were sold by CRI Liquidating on February 10, 1994: (a) Excludes two Mortgages Held for Disposition. Directors and Executive Officers The Annual Report to the Securities and Exchange Commission on Form 10-K is available to Shareholders and may be obtained by writing: Investor Services/CRIIMI MAE Inc. C.R.I., Inc. The CRI Building 11200 Rockville Pike Rockville, Maryland 20852 CRIIMI MAE Inc. shares are traded on the New York Stock Exchange under the symbol CMM.

45599_1993.txt

45599_1993

1993

45599

ITEM 1. BUSINESS GENERAL John H. Harland Company (the "Company" or the "Registrant") was founded in 1923 as a general printer and lithographer. Today, the Company is a leading printer and supplier of checks, business documents and forms to the financial industry. The Company also designs and produces optical mark reading ("OMR") and optical character recognition ("OCR") forms and equipment for use in educational and commercial markets. The Company, a Georgia corporation, is headquartered in Atlanta, Georgia and operates primarily in the printing industry. In addition, the Company operates one major subsidiary, Scantron Corporation ("Scantron"). Scantron produces and provides OMR equipment and scannable forms to the educational and commercial markets. Scantron is a Delaware corporation based in Tustin, California. In November 1991, Scantron acquired the remaining 50% of Datascan, its European partner in OMR/OCR machine development and distribution, for $3 million. In September 1993, Scantron acquired Economics Research, Inc. ("ERI"), a software company based in Costa Mesa, California. ERI provides test development, scoring, analysis and grade management products for educational markets. In February 1992, the Company acquired the net assets of Interchecks Inc. ("Interchecks"), a Seattle, Washington-based check printer for $50 million in cash. Interchecks was purchased from the United Kingdom company Bowater plc through its United States subsidiary Rexham Inc. On January 1, 1993, the Company acquired substantially all the net assets of Rocky Mountain Bank Note Company ("RMBN"), a Lakewood, Colorado-based check printer, for $37.9 million in cash. A portion of the consideration was financed through borrowings under the Company's unsecured line of credit and the balance was paid in cash. RMBN assets were purchased from ROMO Corp., the sole shareholder of RMBN. In October 1993, the Company announced the formation of a new subsidiary, The Check Store, Inc. ("The Check Store"), which will market checks and related products directly to consumers. The Check Store will become operational during the first half of 1994. On January 7, 1994, the Company acquired Marketing Profiles, Inc. ("MPI"). MPI is based in Maitland, Florida and is a database marketing and consulting company which provides software products and related marketing services to the financial industry. On March 24, 1994, the Company announced that it had signed a definitive agreement to purchase the net assets of FormAtion Technologies, Inc.("FTI"). FTI develops, markets and supports lending and platform automation software for the financial services industry. The FTI acquisition is expected to be completed by March 31, 1994. Both the MPI and FTI transactions were for cash amounts which are not considered material. During 1993, the Company developed three strategic alliances with independent companies to provide its financial industry customers with additional services and products. Through its alliance with TeleCheck Services, Inc., the nation's leading provider of check authorization and related guarantee services, the Company addresses security and fraud concerns of financial institutions. Through Cardpro Services, Inc., a nationwide provider of magnetic stripe cards, the Company provides full-service plastic card programs for financial institutions. Through its alliance with Bottomline Technologies, Inc. , a leader in desktop printing of magnetic ink character recognition ("MICR") readable documents, the Company offers point of service production capabilities of MICR readable documents. DESCRIPTION OF BUSINESS UNITS Overview In 1993, the Company operated under two business units, the Financial Services Group ("FSG") and the Data Services Group ("DSG"). Both units oper- ate primarily within the printing industry segment. FSG provides financial documents to support America's payment systems. DSG's principal operation is the production of data collection forms which are used in conjunction with form reading equipment. Approximately 95% of the Company's consolidated revenues during the three years ended December 31, 1993, 1992 and 1991, respectively, were from sales of checks and related items, business documents, and scannable forms. Approximately 5% of the Company's consolidated revenues during the periods were from sales of scanning equipment and revenues from other areas. Financial Services Group FSG includes the Company's check printing operations and specialty printing operations. FSG's principal products consist of MICR encoded checks, deposit tickets and related forms for financial institutions and their customers. The product line consists of a number of different styles of checks including scenic checks, which incorporate multi-colored backgrounds, personal and business three-to-the-page checks and carbonized payroll, voucher, window, and computer generated checks (includes continuous form checks and checks produced with laser printers). In 1993, FSG's overall prices of its checks and related products remained essentially unchanged from 1992 due to competitive conditions in the check printing industry. FSG, through its specialty print operations, also produces a number of printed or lithographed custom printed packages, forms, business products and computer-related documents for sale to financial institutions and other commercial establishments. Such custom printed items include specially designed checks and deposit tickets printed with a customer's individual design, magnetically encoded internal control documents and carbon- interleaved forms. FSG's documents are printed on stock lithographed in its 7 base stock plants and at its specialty printing plant. FSG imprints checks and related product documents at its 50 check printing facilities located in 33 states and 1 plant in Puerto Rico. All of these plants are devoted exclusively to printing checks, deposit tickets and related forms. FSG's products are marketed across the United States and in Puerto Rico through a sales force of approximately 360 personnel. FSG's sales organization is organized by customer type through three distinct sales support units, Primary, National and Business Services. The Primary sales unit, consisting of approximately 280 sales representatives, serves community based financial institutions. The National Accounts sales unit of 70 sales representatives serves the top 400 financial institutions in the country. The Business Services unit, consisting of approximately 10 representatives, serves selected retail markets such as superstores, software companies and catalog merchandisers. The primary responsibility of the sales force is to consult with customers regarding their needs and provide solutions to meet those needs. FSG also uses catalogs, brochures and similar sales aides to present solutions to customers. Data Services Group The DSG provides creative data collection and management solutions for its customers. Data collection represents diverse technologies with similar objectives -- converting information into a computer-compatible format, then providing information that can be used for a specific function. DSG concentrates on the production and distribution of OMR, OCR and imaging forms and systems within the data collection market. DSG's principal products are scanning equipment and the scannable forms used in conjunction with the equipment. DSG also offers maintenance services for the scanning machines and software products related to data collection and analysis activities. DSG forms and equipment are used as a solution for capturing, tabulating and analyzing data. DSG's primary market is the educational field for test scoring and grade reporting. Within the commercial sector, DSG equipment and forms are used to collect and analyze survey responses, inventory informa- tion, employee evaluations, order information and other forms of data collec- tion and analysis. The products are marketed primarily through 193 sales and service representatives located in 49 locations throughout the United States and 2 locations in Canada. Representatives sell and place new equipment and provide ongoing assistance, such as machine servicing and development of new forms. DSG's products are also marketed in certain foreign countries through distributorships. Other Information Relating to Business of the Company Seasonal Business There is a seasonal nature to DSG's business in the educational market, but it does not significantly affect the Company's consolidated results. Patent, Trademarks, Licenses, Franchises and Concessions On February 4, 1992, the Company received a patent on a Scannable Form and System developed by Scantron. This patent expires February 4, 2009. Also, the Company has trademarks on names of several of its products and services. The Company believes these patents and trademarks impact business, however, it does not consider any of them to be critical to its operation. Competition Financial Services Group -- At the present time, there are a number of domestic companies specializing in the production of MICR encoded checks and related items similar to those produced by the Company. The Company believes that the primary competitive factors considered by customers are printing accuracy, service capabilities, price and the availability of a complete product line. The Company compares favorably with its competitors with regard to these above mentioned factors. Although complete statistics on check production are not available, the Company believes it is among the largest printers of MICR encoded personalized checks in the United States. One other printer has substantially greater sales and financial resources than the Company. Technological advancements in electronics have created possible alternatives to the check as a medium of transferring funds. While electronic funds transfer has gained acceptance for some applications, it has had minimal acceptance by consumers as a mode of personal payment. At this time, the Company cannot determine or predict what effect this technology may eventually have on the check printing business. Data Services Group -- The data collection market is a highly fragmented industry, with many large and small competitors, and is growing at approximately 15% annually. DSG products are sold mainly in the United States with minor sales activity in Puerto Rico, Canada, Europe, the Middle East and the Far East. Scannable forms are produced by commercial and specialized forms printers throughout the United States. DSG has attempted to identify and develop specialized products for niche markets. DSG believes it is the leading provider of OMR stand-alone equipment to the educational market in the United States. In Canada, one competitor has substantially larger sales. The loss of any one customer in the FSG or DSG would not have a material adverse effect on the Company. Raw Materials The Company purchases its principal raw materials (safety paper, form paper and MICR bond) from several large domestic manufacturers. Past conditions in the paper market have resulted in temporary increases in paper prices and required advanced scheduling of paper deliveries. However, raw materials have traditionally been readily available, and the Company has never experienced a paper shortage. The Company purchases other raw materials, such as vinyl (used in the production of check book covers), inks, checkboards, packaging materials and miscellaneous paper from a number of suppliers. The components used in the assembly and manufacturing of the OMR equipment are purchased from equipment manufacturers, supply firms and others. The Company has no reason to believe that it cannot continue to obtain such materials or suitable substitutes for its operation. The Company has no long- term contracts with any of its raw material suppliers. Number of Employees As of December 31, 1993, the Company and its subsidiaries employed ap- proximately 7,300 people (includes 649 temporary employees). ITEM 2. ITEM 2. PROPERTIES As of December 31, 1993, the Company and its subsidiaries owned 49 facilities located in 30 states of which all but 2 facilities were production and service facilities. Approximate square footage of owned facilities to- taled 2,000,000 square feet. The Company leases approximately 591,000 square feet in 22 facilities for printing and/or warehouse activities. The leased facilities are located in 14 states and Puerto Rico. Printing production locations: Alburqueque, NM Miami (Sunrise), FL Atlanta (Decatur), GA (2) Milwaukee (Waukesha), WI Baltimore (Columbia), MD Minneapolis (Plymouth), MN Birmingham, AL Nashville (Antioch), TN Boise, ID New Orleans, LA Boston (Rockland), MA Newark (West Caldwell), NJ Centralia, WA (2) Oklahoma City, OK Chicago (Burr Ridge), IL Orlando, FL Cincinnati, OH Phoenix, AZ Cleveland (East Lake), OH Pittsburgh (Mars), PA Concord, CA Portland (Tualatin), OR Covington, GA Richmond, VA Dallas (Irving), TX Rochester, NY Denver (Aurora), CO Salt Lake City, UT (2) Denver (Lakewood), CO San Antonio, TX Des Moines (Urbandale), IA San Diego, CA Detroit (Plymouth), MI San Francisco (Livermore), CA El Paso, TX San Juan (Carolinas), PR Essex, MD San Juan (Gurabo), PR Fresno, CA Shreveport (Bossier City), LA Greensboro, NC St. Louis (St. Peters), MO Hartford (Enfield), CT St. Petersburg, FL Houston, TX Tucson, AZ Indianapolis, IN Tustin, CA Jackson, MS West Columbia, SC Jacksonville, FL Wilkes-Barre, PA Kansas City, MO Yorba Linda, CA Memphis (Bartlett), TN Idle production locations: Birmingham, AL (leased) Memphis, TN (sold 2/94) Cincinnati, OH (leased) Philadelphia (West Chester), PA Denver (Wheat Ridge), CO (sold 2/94) (lease terminated 3/94) Portland (Beaverton), OR (leased) Gulfport, MS (sold 1/94) Richmond, VA (leased) Warehouse locations: Chicago (Arlington Heights), IL West Columbia, SC Fresno, CA The foregoing information excludes Company held properties leased to others. The Company leases office space for sales and services activities in areas where there are no production facilities. These leases are not considered to be significant. The Company also has a facility in Villeret, Switzerland (9,000 square feet). The Company's executive offices are located in Atlanta, Georgia. ITEM 3. ITEM 3. LEGAL PROCEEDINGS Not applicable. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Not applicable. ITEM X. EXECUTIVE OFFICERS OF THE REGISTRANT The following table sets forth the names and ages of all executive officers of the Company and all positions and offices with the Company presently held by such executive officers. Name Age Office Held Robert R. Woodson 61 Chairman, President and Chief Executive Officer William M. Dollar 45 Vice President, Treasurer, and Chief Financial Officer Earl W. Rogers Jr. 45 Senior Vice President Michael S. Rupe 43 Senior Vice President Victoria P. Weyand 43 Vice President and Secretary Of the foregoing officers, Mr. Woodson is also a Director of the Registrant. Officers are elected annually by the Board of Directors. Mr. Woodson was elected Chairman of the Board in April 1992 and has been Chief Executive Officer since April 1990 and President since April 1984. Mr. Dollar was elected Vice President in April 1992 and has been Treasurer and Chief Financial Officer of the Registrant since February 1990. Prior to his employment with the Company, Mr. Dollar served as Assistant Vice President and Regional Controller of units of Sonat Inc., a Birmingham, Alabama-based energy company, from 1981 through 1989. Mr. Rogers was elected Vice President in April 1989 and Senior Vice President in April 1993 and was named manager of the Company's Financial Services Group in July 1993. Mr. Rogers joined the Company in 1976 and has served in the positions of plant manager, district operations manager and FSG operations manager. Mr. Rupe was elected Senior Vice President in 1991. In 1987, Mr. Rupe was Treasurer and Chief Financial Officer of the Company, prior to that time, Mr. Rupe had served in the positions of Assistant-Treasurer and Controller. In 1989, Mr. Rupe left the Company to assume the position of Executive Vice President with Profit Freight Systems. Mr. Rupe returned to the Company in March 1991. Ms. Weyand was elected Secretary of the Registrant in January 1994 and is Vice President-Investor Relations. Ms. Weyand's responsibilities also include investor relations, shareholder relations and strategic planning/acquisition support. Ms. Weyand was elected Vice President of the Registrant in 1980 and has served the Company in a variety of positions including Vice President-Human Resources. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS See the information with respect to the market for an number of holders of the Company's common stock, quarterly market information and dividend information which is set forth on page of this Annual Report on Form 10- K. The number of holders of record of the Company's common stock was computed by a count of record holders on December 31, 1993. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA See the information with respect to selected financial data on page of this Annual Report on Form 10-K. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS See the information under the caption Management's Discussion and Analysis of Results of Operations and Financial Condition on pages through of this Annual Report on Form 10-K. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA See the information with respect to Financial Statements and Supplementary Data on pages through and page, respectively of this Annual Report on 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 The information regarding Directors required herein is incorporated by reference to the information under the caption "Management of the Company" in the Registrant's Definitive Proxy Statement for the Annual Shareholders' Meeting dated March 17, 1994 (the "Proxy Statement"). The information regarding Executive Officers required herein is included in Part I, Item X of this report and incorporated herein by reference. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The information regarding executive compensation is incorporated by reference to the information under the caption "Executive Compensation and Other Information" in the Registrant's Proxy Statement. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information required herein is incorporated by reference to the information under the caption "Management of the Company -- Beneficial Ownership" in the Registrant's Proxy Statement. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information required herein is incorporated by reference to the information under the caption "Certain Transactions" in the Registrant's Proxy Statement. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K Page in this Annual Report on Form 10-k ------------- (a)1. Financial Statements: Management Responsibility for Financial Statements Independent Auditors' Report Consolidated Balance Sheets Consolidated Statements of Income Consolidated Statements of Cash Flows Consolidated Statements of Shareholders' Equity Notes to Consolidated Financial Statements. Quarterly Financial Information (unaudited) Page in this Annual Report on Form 10-k ------------- (a)2. Financial Statement Schedules: Schedule V. Property, plant and equipment S1 Schedule VI. Accumulated depreciation and amortization of property, plant and equipment S2 Schedule VIII. Valuation and qualifying accounts S3 Schedule IX. Short-term borrowings S4 Schedule X. Supplementary income statement information S5 (a)3. Exhibits (Asterisk indicates exhibit previously filed with the Securities and Exchange Commission and incorporated herein by reference.) 3.1 Amended and Restated Articles of Incorporation. 3.2 * By-Laws, as amended. Adopted by the Board of Directors on July 27, 1990 filed as Exhibit 3(D) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1990. 4.1 Indenture, as supplemented and amended, relating to 6.75% Convertible Subordinated Debentures due 2011 of Scantron Corporation (omitted pursuant to Item 601(b)(4)(iii) of Regulation S-K; will be filed upon request). 4.2 * Form of Rights Agreement dated as of June 9, 1989, between the Registrant and Citizens and Southern Trust Company. Filed as Exhibit 1 to Form 8-K dated June 9, 1989. 4.3 * First Amendment dated June 12, 1992 to Rights Agreement dated June 9, 1989 between the Company and NationsBank of Georgia Inc., N.A., succes- sor to Citizens and Southern Trust Company. Filed as exhibit 4.1 on Form 10-Q for the quarter ended September 30, 1992. 4.4 * Second Amendment dated July 24, 1992 to Rights Agreement dated June 9, 1989 between the Company and Trust Company Bank, successor to NationsBank of Georgia Inc., N.A., and to Citizens and Southern Trust Company. Filed as exhibit 4.2 on Form 10-Q for the quarter ended September 30, 1992. 4.5 Note Agreement dated as of December 1, 1993 between the Company and the purchasers listed on Schedule I of the agreement, for the issuance and sale of $85,000,000 aggregate principle amount of 6.60% Series A Senior Notes Due December 30, 2008. 10.1 Form of Deferred Compensation Agreement between the Registrant and the following Executive Officer and Director: Mr. Woodson and the follow- ing Retired Executive Officer and Current Director: Mr. Lang. 10.2 * Form of Monthly Benefit Amendment to Deferred Compensation Agreement between the Registrant and the following Executive Officer and Director: Mr. Woodson and the following Retired Executive Officer and Current Director: Mr. Lang. Filed as Exhibit 10(H) to the Registrant's Annual Report on Form 10-K for the year ended December 3l, 1990. 10.3 Form of Deferred Compensation Agreement between the Registrant and the following Executive Officers: Messrs. Dollar, Rogers and Rupe. 10.4 Form of Deferred Compensation Agreement between the Registrant and the following Executive Officer: Ms. Weyand. 10.5 Form of Frozen Benefit Amendment to Deferred Compensation Agreement between the Registrant and the following Executive Officer: Ms. Weyand. 10.6 Form of Amendment to Deferred Compensation Agreement between the Regis- trant and the following Executive Officer and Director: Mr. Woodson and the following Retired Executive Officer and Current Director: Mr. Lang and the following Executive Officers: Messrs. Dollar, Rogers and Rupe and Ms. Weyand. 10.7 Form of Non-Compete and Termination Agreement between the Registrant and the following Executive Officer and Director: Mr. Woodson, the following Retired Executive Officer and Current Director: Mr. Lang and the following Executive Officers: Messrs. Dollar, Rogers and Rupe. 10.8 Form of Executive Life Insurance Plan between the Registrant and the following Executive Officer and Director: Mr. Woodson, the following Retired Executive Officer and Current Director: Mr. Lang and the fol- lowing Executive Officers: Messrs. Dollar, Rogers and Rupe and Ms. Weyand. 10.9 * The John H. Harland Company Incentive Stock Option Plan filed as Exhib- it (28)(a) to the Registrant's Registration Statement on Form S-8 (no. 33-1402). 10.10 Amendment to the John H. Harland Company Incentive Stock Option Plan. 10.11 * John H. Harland Company 1981 Incentive Stock Option Plan, As Extended. Filed as Exhibit 10.1 to the Registrant's Report on Form 10-Q for the quarterly period ended June 30, 1993. 10.12 * Asset Purchase Agreement, dated as of February 7, 1992, by and among the Registrant , Rexham, Inc. ("Rexham") and Interchecks; as partially assigned to Centralia Holding Corp. ("Centralia") on February 19, 1992; and as amended on February 19, 1992 by and among the Registrant, Cen- tralia, Rexham and Interchecks. Filed as exhibit 2.1 on Form 8-K dated March 4, 1992 by Form SE dated March 4, 1992. 10.13 * Asset Purchase Agreement, dated as of November 13, 1992, by and among the Registrant, The Rocky Mountain Bank Note Company and Romo Corp.; and as amended on November 25, 1992, by and among the Registrant, The Rocky Mountain Bank Note Company and Romo Corp. Filed as exhibit 2.1 and 2.2 on Form 8-K dated January 11, 1993. 10.14 Term Loan Agreement dated as of October 25, 1993 between the Company and Trust Company Bank for a $15,000,000 Term Loan due 2003. 21.1 Subsidiaries of the Registrant. 23.1 Consent of Independent Auditors b. Report on Form 8-K 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, thereunto duly authorized. JOHN H. HARLAND COMPANY William M. Dollar ____________________ William M. Dollar Vice President, Treasurer and Chief Financial Officer 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. Robert R. Woodson 3/30/94 John J. McMahon, Jr. 3/30/94 ______________________ ________ ______________________ ________ Robert R. Woodson Date John J. McMahon, Jr. Date Chairman, President and Director Director (Principal Executive Officer) William M. Dollar 3/30/94 ______________________ ________ ______________________ ________ William M. Dollar Date G. Harold Northrop Date Vice President, Treasurer and Director Chief Financial Officer (Principal Financial and Accounting Officer) Juanita Powell Baranco 3/30/94 H.G. Pattillo 3/30/94 ______________________ ________ ______________________ ________ Juanita Powell Baranco Date H.G. Pattillo Date Director Director ______________________ ________ ______________________ ________ I. Ward Lang Date Larry L. Prince Date Director Director Lawrence L. Gellerstedt Jr. 3/30/94 John H. Weitnauer, Jr. 3/30/94 ______________________ ________ ______________________ ________ Lawrence L. Date John H. Weitnauer, Jr. Date Gellerstedt Jr. Director Director Edward J. Hawie 3/30/94 L. C. Whitney 3/30/94 ______________________ ________ ______________________ ________ Edward J. Hawie Date L. C. Whitney Date Director Director JOHN H. HARLAND COMPANY _______________________ Management Responsibility For Financial Statements Independent Auditors' Report Consolidated Financial Statements and Notes to Consolidated Financial Statements Supplemental Financial Information Management's Discussion and Analysis of Results of Operations and Financial Condition Supplemental Financial Statement Schedules For Inclusion in the Annual Report on Form 10-K to the Securities and Exchange Commission for the year ended December 31, 1993. -F1- JOHN H. HARLAND COMPANY AND SUBSIDIARIES MANAGEMENT RESPONSIBILITY FOR FINANCIAL STATEMENTS The financial statements and related financial information included in this report were prepared by the Company in conformity with generally accepted accounting principles consistently applied. Management's best estimates and judgments were used, where appropriate. Management is responsible for the integrity of the financial statements and for other financial information included in this report. The consolidated financial statements and supplementary financial schedules have been audited by the Company's independent auditors, Deloitte & Touche. As set forth in their report, their audits were conducted in accordance with generally accepted auditing standards and formed the basis for their opinion on the accompanying financial statements. They consider the Company's control structure and perform such tests and other procedures as they deem necessary to express an opinion on the fairness of the financial statements. The Company maintains a control structure which is designed to provide reasonable assurance that assets are safeguarded and that the financial records reflect the authorized transactions of the Company. As a part of this process, the Company has an internal audit function which evaluates the adequacy and effectiveness of the control structure. The Audit Committee of the Board of Directors includes directors who are neither officers nor employees of the Company. The Committee meets periodically with management, internal auditors and the independent auditors to discuss auditing, the Company's control structure and financial reporting matters. The Director of Internal Audit and the independent auditors have full and free access to meet with the Audit Committee. William M. Dollar Vice President, Treasurer and Chief Financial Officer -F2- INDEPENDENT AUDITORS' REPORT To the Board of Directors and Shareholders of John H. Harland Company: We have audited the accompanying consolidated balance sheets of John H. Harland Company and its 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. 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 John H. Harland 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. 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 8 to the consolidated financial statements, effective January 1, 1993, the Company changed its method of accounting for income taxes to conform with the provisions of Statement of Financial Accounting Standards No. 109. DELOITTE & TOUCHE Atlanta, Georgia January 28, 1994 -F3- JOHN H. HARLAND COMPANY AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (In thousands except share and per share amounts) December 31 1993 1992 - ---------------------------------------------------------------------- ASSETS CURRENT ASSETS: Cash and cash equivalents $ 26,224 $ 19,133 Short-term investments 1,900 150 Accounts receivable from customers, less allowance for doubtful accounts of $1,753 and $1,343 63,660 56,700 Inventories: Raw materials and semi-finished goods 22,389 20,692 Hardware component parts 1,478 2,547 Finished goods 2,133 3,882 Deferred income taxes 6,694 Other 10,417 7,555 ---------------------- Total current assets 134,895 110,659 ---------------------- INVESTMENTS AND OTHER ASSETS: Investments 8,103 7,705 Goodwill and other intangibles - net 54,053 37,528 Acquisition deposit and other 7,014 36,259 ---------------------- Total investments and other assets 69,170 81,492 ---------------------- PROPERTY, PLANT AND EQUIPMENT: Land 9,201 8,746 Buildings and improvements 72,212 66,394 Machinery and equipment 204,405 186,400 Furniture and fixtures 15,082 13,259 Leasehold improvements 2,134 2,050 Additions in progress 2,008 1,434 ---------------------- Total 305,042 278,283 Less accumulated depreciation and amortization 152,656 130,554 ---------------------- Property, plant and equipment - net 152,386 147,729 ---------------------- Total $ 356,451 $ 339,880 ====================== See Notes to Consolidated Financial Statements. -F4- CONSOLIDATED BALANCE SHEETS (continued) December 31 1993 1992 - ----------------------------------------------------------------------- LIABILITIES AND SHAREHOLDERS' EQUITY CURRENT LIABILITIES: Short-term debt $ 4,000 $ 22,000 Accounts payable - trade 8,690 9,639 Accrued liabilities: Salaries, wages and employee benefits 15,458 11,966 Taxes 649 4,090 Other 15,182 11,771 ---------------------- Total current liabilities 43,979 59,466 ---------------------- LONG-TERM LIABILITIES: Long-term debt 111,542 12,622 Deferred income taxes 6,393 1,987 Other 10,863 9,583 ---------------------- Total long-term liabilities 128,798 24,192 ---------------------- Total liabilities 172,777 83,658 ---------------------- SHAREHOLDERS' EQUITY Series preferred stock, authorized 500,000 shares of $1.00 par value, none issued Common stock, authorized 144,000,000 shares of $1.00 par value, 37,907,497 shares issued 37,907 37,907 Additional paid-in capital 4,225 4,326 Foreign currency translation adjustment 72 187 Retained earnings 325,323 303,249 ---------------------- Total shareholders' equity 367,527 345,669 Less 7,421,903 and 3,858,049 shares in treasury, at cost 183,853 89,447 ---------------------- Shareholders' equity - net 183,674 256,222 ---------------------- TOTAL $ 356,451 $ 339,880 ====================== See Notes to Consolidated Financial Statements. -F5- JOHN H. HARLAND COMPANY AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME (In thousands except per share amounts) Year ended December 31 1993 1992 1991 - -------------------------------------------------------------------------- NET SALES $ 519,486 $ 444,980 $ 378,659 -------------------------------- COST AND EXPENSES: Cost of sales 288,786 236,559 189,835 Selling, general and administrative expenses 125,077 111,100 94,060 Employees' profit sharing 9,614 9,118 8,105 Amortization of intangibles 8,702 4,673 Restructuring charge 12,191 -------------------------------- Total 432,179 361,450 304,191 -------------------------------- INCOME FROM OPERATIONS 87,307 83,530 74,468 INTEREST AND OTHER INCOME (EXPENSE)-NET (1,633) 4,737 5,234 -------------------------------- INCOME BEFORE INCOME TAXES AND CUMULATIVE EFFECT OF CHANGE IN ACCOUNTING PRINCIPLE 85,674 88,267 79,702 INCOME TAXES 33,152 31,629 29,882 -------------------------------- INCOME BEFORE CUMULATIVE EFFECT OF CHANGE IN ACCOUNTING PRINCIPLE 52,522 56,638 49,820 CUMULATIVE EFFECT OF CHANGE IN ACCOUNTING PRINCIPLE 2,385 -------------------------------- NET INCOME $ 52,522 $ 56,638 $ 47,435 ================================ PER COMMON SHARE: Income before cumulative effect of change in accounting principle $ 1.62 $ 1.59 $ 1.33 -------------------------------- Net Income $ 1.62 $ 1.59 $ 1.27 ================================ See Notes to Consolidated Financial Statements. -F6- JOHN H. HARLAND COMPANY AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (In thousands) Year ended December 31 1993 1992 1991 - ------------------------------------------------------------------------- OPERATING ACTIVITIES: Net Income $ 52,522 $ 56,638 $ 47,435 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 35,102 29,662 22,684 Deferred income taxes (2,288) (2,135) (5,767) Loss (gain) on sale of assets 599 (3,410) Provision for restructuring charge 12,191 Provision for postretirement benefits 768 640 4,156 Other 965 1,070 1,915 Change in assets and liabilities net of effects of businesses acquired: Accounts receivable 3,059 (3,706) 6,740 Inventories and other current assets 3,347 1,540 (1,398) Accounts payable and accrued expenses (2,969) (2,142) 5,502 Other - net (434) 229 (238) ------------------------------- Net cash provided by operating activities 90,671 78,386 93,220 ------------------------------- INVESTING ACTIVITIES: Purchases of property, plant and equipment (27,121) (18,721) (16,899) Proceeds from sale of property, plant and equipment 1,474 1,979 1,059 Change in short-term investments - net (1,750) 52,350 (32,465) Payment for acquisition of businesses - net of cash acquired (9,564) (54,826) Acquisition deposit (31,900) Proceeds from sale of Puerto Rico bonds 49,982 Other - net (2,469) (2,169) 1,989 ------------------------------- Net cash used in investing activities (39,430) (3,305) (46,316) ------------------------------- FINANCING ACTIVITIES: Proceeds from issuance of long-term debt 100,000 Short-term borrowings (18,000) 18,000 Purchases of treasury stock (99,435) (65,565) (22,806) Issuance of treasury stock 4,779 4,818 4,061 Dividends paid (30,448) (32,088) (32,196) Other - net (1,046) (36) 806 ------------------------------- Net cash used in financing activities (44,150) (74,871) (50,135) ------------------------------- Increase (decrease) in cash and cash equivalents 7,091 210 (3,231) Cash and cash equivalents at beginning of year 19,133 18,923 22,154 ------------------------------- Cash and cash equivalents at end of year $ 26,224 $ 19,133 $ 18,923 =============================== Cash paid during the year for: Interest $ 2,144 $ 998 $ 1,115 =============================== Income Taxes $ 38,785 $ 36,613 $ 31,972 =============================== See Notes to Consolidated Financial Statements. -F7- See Notes to Consolidated Financial Statements. -F8- JOHN H. HARLAND COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. SIGNIFICANT ACCOUNTING POLICIES: Consolidation - The consolidated financial statements include the financial statements of John H. Harland Company and its wholly owned subsidiaries (the "Company"). Intercompany balances and transactions have been eliminated. Cash Equivalents - The Company considers all highly liquid debt instruments purchased with a maturity of three months or less to be cash equivalents. Inventories - Inventories are stated at the lower of cost or market. Cost of inventory for checks and related forms is determined by average costing. Cost of scannable forms and hardware component parts inventories is determined by the first-in, first-out method. Cost of data entry terminals is determined by the specific identification method. Investments - Short-term investments are carried at cost plus accrued interest, which approximates market, and consist primarily of certificates of deposit and demand notes with original maturities in excess of three months. Marketable equity securities included in long-term investments are carried at the lower of cost or market. Other long-term investments are carried principally at cost. Property, Plant and Equipment - Property, plant and equipment are carried at cost. Depreciation of buildings is computed primarily by the declining balance method. Depreciation of equipment, furniture and fixtures is calculated by the straight-line or sum-of-the-years digits methods. Leasehold improvements are amortized by the straight-line method over the life of the lease or the life of the property, whichever is shorter. Accelerated methods are used for income tax purposes for all property where it is allowed. Goodwill and Other Intangibles - Amortization of goodwill is calculated by the straight-line method over a 40-year period. The Company periodically assesses the recoverability of goodwill based on its judgment as to the future profitability of its operations. Other intangible assets consist primarily of purchased customer lists and non-compete covenants. Amortization of other intangible assets is calculated by the straight-line method over the estimated useful life which is primarily a 5-year period. Net Income Per Share - Net income per common share is based on the weighted average number of shares of common stock and common share equivalents outstanding during each year which was 32,460,128 for 1993, 35,688,645 for 1992 and 37,468,637 for 1991. Common share equivalents include the number of shares issuable upon the exercise of the Company's stock options and the conversion of convertible securities. The difference between primary and fully diluted common share equivalents is not significant. Income Taxes - Effective Jan. 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" ("SFAS 109") in which deferred tax liabilities and assets are determined based on the difference between financial statements and tax bases of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse. 2. BUSINESS SEGMENTS: The Company operates principally within the printing industry. -F9- 3. ACQUISITIONS: On January 1, 1993, the Company completed the acquisition of substantially all the net assets of the Denver-based Rocky Mountain Bank Note Company ("RMBN") for cash of $37.9 million and acquisition related costs of approximately $8.9 million. The purchase was funded through short-term borrowings of $18.0 million and by internally generated funds. The acquisi- tion has been accounted for as a purchase and, accordingly, the acquired net assets and operations have been included in the consolidated financial state- ments from the date of acquisition. Assets acquired totaled $46.8 million, net of liabilities assumed of $2.0 million. Of the total acquisition cost, $25.7 million was allocated to intangible assets, of which $10.7 million represented goodwill. On February 19, 1992, the Company completed the acquisition of substantially all the net assets of Interchecks Inc. ("Interchecks"), a Seattle, Washington-based check printer for a cash purchase price of $50 million and acquisition related costs of $9.4 million. The acquisition has been accounted for as a purchase and, accordingly, the acquired net assets and operations have been included in the consolidated financial statements from the date of acquisition. Assets acquired totaled $59.4 million, net of liabilities assumed of $4.7 million. Of the total acquisition cost, $38.4 million was allocated to intangible assets, of which $13.4 million represented goodwill. The following represents the unaudited pro forma results of operations which assumes the acquisitions occurred at the beginning of the respective year in which the assets were acquired as well as the beginning of the immediately preceding year. These results include certain adjustments, primarily increased amortization of intangible assets, reduced interest income and reduced depreciation expense (in thousands of dollars, except per share amounts): 1992 1991 - ----------------------------------------------------------------------- Net sales $ 539,889 $ 453,541 Income before cumulative effect of change in accounting principle 55,968 45,938 Net income 55,968 43,553 Per common share: Income before cumulative effect of change in accounting principle 1.57 1.21 Net income 1.57 1.15 The pro forma financial information presented above does not purport to be indicative of either the results of operations that would have occurred had the acquisitions taken place at the beginning of the periods presented or of future results of operations of the combined businesses. 4. RESTRUCTURING CHARGE: During the fourth quarter of 1991, the Company recorded a provision of $12,191,000 for the restructuring and revaluation of certain subsidiaries and investments of $9,191,000 and for taxes of $3,000,000 for the repatriation of earnings from Puerto Rico. The Company's policy had been to invest such earnings long term to avoid the payment of taxes upon repatriation. 5. INVESTMENTS AND OTHER ASSETS: Long-term investments at December 31, 1993 primarily consisted of investments in limited partnerships. Other assets at December 31, 1992 included a $31,900,000 deposit related to the acquisition of RMBN. -F10- 6. SHORT-TERM DEBT: At December 31, 1993, the Company had available unsecured lines of credit under which it could borrow up to $111,000,000 in the form of short-term notes for which no compensating balances or commitment fees are required. At December 31, 1992, the Company had borrowed $18,000,000 under the lines of credit at an interest rate of 3.8%. No amounts were outstanding under the lines of credit at December 31, 1993. In addition, the Company had outstanding at December 31, 1993 and 1992 an Industrial Revenue Bond, due on demand, in the amount of $4,000,000 which bears interest at an average rate of 5.26%. 7. LONG-TERM DEBT: The Company's long-term debt consists of (in thousands): 1993 1992 - ------------------------------------------------------------------------ Series A Senior Notes $ 85,000 Term Loan 15,000 Convertible Subordinated Debentures 10,600 $ 10,579 Other 1,477 2,573 ----------------------- 112,077 13,152 Less current portion 535 530 ----------------------- Long-term Debt $ 111,542 $ 12,622 ======================= In December 1993, the Company issued $85,000,000 of Series A Senior Notes ("Senior Notes") and arranged a $15,000,000 Term Loan ("Term Loan"). The Senior Notes and the Term Loan are at fixed interest rates of 6.60% and 6.63%, respectively. The Senior Notes mature from 2004 to 2008 and the Term Loan is due 2003. Both the Term Loan and the Senior Notes contain certain covenants, the most restrictive of which limit the amount of funded indebtedness of the Company and require the Company to maintain a minimum fixed charge coverage ratio. At December 31, 1993, the Company was in compliance with the covenants associated with these agreements. The Company's 6.75% convertible subordinated debentures are convertible into common stock of the Company at any time prior to maturity, at a conversion price of $25.17 per share, subject to adjustment in certain events. At December 31, 1993, there were 328,249 shares of common stock reserved for conversion of the debentures. The debentures are entitled to an annual mandatory sinking fund, commencing June 1, 1996, calculated to retire 75% of the debentures prior to maturity in 2011. The debentures are redeemable, in whole or in part, at any time at the option of the Company at specific redemption prices plus accrued interest. The debentures are subordinated to all senior debt. Other long-term debt relates principally to capitalized lease obligations. Annual maturities of long-term debt including sinking fund requirements during the next five years are: 1994-$535,000; 1995-$519,000; 1996-$813,000; 1997-$559,000; and 1998-$550,000. 8. INCOME TAXES: Effective January 1, 1993, the Company adopted SFAS 109. Previously, the Company had computed its income tax expense in accordance with the provisions of the Accounting Principles Board Opinion No. 11. The cumulative effect of adopting SFAS 109 was not significant to the Company's consolidated financial statements. -F11- The provision for income taxes for the years ended December 31, 1993, 1992 and 1991 (including the impact of the accounting change in 1991) includes the following (in thousands): 1993 1992 1991 - ------------------------------------------------------------------------ Current: Federal $ 28,350 $ 29,709 $ 29,259 State 7,090 4,055 4,959 -------------------------------------- Total 35,440 33,764 34,218 -------------------------------------- Deferred: Federal (1,999) (1,879) (5,254) State (289) (256) (513) -------------------------------------- Total (2,288) (2,135) (5,767) -------------------------------------- Total $ 33,152 $ 31,629 $ 28,451 ====================================== The tax effects of significant items comprising the Company's net deferred tax asset and liability as of December 31, 1993 are as follows (in thousands): - ------------------------------------------------------------------------ Current deferred tax asset: Accrued vacation $ 2,634 Other accrued liabilities 4,742 Other (682) -------- Total 6,694 -------- Noncurrent deferred tax liability: Difference between book and tax basis of property (13,976) Other liabilities 5,542 Postretirement benefit obligation 2,085 Other (44) -------- Total (6,393) Valuation allowance 0 Net deferred tax asset $ 301 ======== A reconciliation between the Federal income tax statutory rate and the Company's effective income tax rate is as follows: 1993 1992 1991 - ------------------------------------------------------------------------ Statutory rate 35.0% 34.0% 34.0% State and local income taxes net of Federal income tax benefit 5.0 4.3 4.0 Income from Puerto Rico (3.7) (3.3) (2.3) Other, net 2.4 0.8 1.8 ---------------------------------- Effective income tax rate 38.7% 35.8% 37.5% ================================== -F12- 9. SHAREHOLDERS' EQUITY: Each share of common stock includes a stock purchase right which is not currently exercisable but would become exercisable upon occurrence of certain events as provided for in the Rights Agreement. The rights expire on July 5, 1999. 10. EMPLOYEE STOCK PURCHASE PLAN: The Company has an Employee Stock Purchase Plan under which employees are granted an option to purchase shares of the Company's common stock during the quarter in which the option is granted. The option price is 85% of the fair market value of the stock at the beginning or end of the quarter, whichever is lower. Options for shares were exercised at prices ranging from $18.70 to $23.06 in 1993, $17.64 to $20.24 in 1992 and $16.26 to $19.60 in 1991. At December 31, 1993, there were 672,657 shares of common stock reserved for purchase under the plan. 11. STOCK OPTION PLANS: The Company has granted incentive and non-qualified stock options to certain key employees to purchase shares of the Company's common stock at the fair market value of the common stock on the date of the grant. The options generally become exercisable one year from the date of grant. Option transactions during the three years ended December 31, 1993 are as follows: Exercise Shares Price - ------------------------------------------------------------------------ Balance, December 31, 1990 460,541 $ 9.11 - 25.13 Options Granted 68,000 22.75 Exercised (76,202) 9.11 - 21.88 Cancelled (47,100) 21.88 - 25.13 --------- Balance, December 31, 1991 405,239 9.11 - 25.13 Options Granted 92,500 23.88 - 24.75 Exercised (90,414) 9.11 - 23.50 Cancelled (47,176) 11.59 - 25.13 --------- Balance, December 31, 1992 360,149 9.11 - 24.75 Options Granted 102,157 23.88 - 26.25 Exercised (55,467) 9.11 - 23.50 Cancelled (31,151) 11.34 - 24.75 --------- Balance, December 31, 1993 375,688 9.11 - 26.25 ========= At December 31, 1993, there were options for 273,531 shares exercisable and 682,978 shares of common stock reserved for options under the plans. 12. PROFIT SHARING AND DEFERRED COMPENSATION: The Company has a non- contributory profit sharing plan to provide retirement income for most of its employees. The Company is required to contribute to the profit sharing plan's trust fund an amount equal to 7.5% of its income before income taxes and profit sharing contribution plus such additional amount as the Board of Directors may determine, up to a maximum of 15% of the aggregate compensation of participating employees (see Consolidated Statements of Income). -F13- The Company has deferred compensation agreements with certain officers. The present value of cash benefits payable under the agreements is being provided over the periods of active employment. The charge to expense for the agreements was $345,000 in 1993, $286,000 in 1992 and $463,000 in 1991. 13. POSTRETIREMENT BENEFITS: The Company sponsors two defined postretirement benefit plans that cover qualifying salaried and non-salaried employees. One plan provides health care benefits and the other provides life insurance benefits. The medical plan is contributory and contributions are adjusted annually based on actual claims experience, while the life insurance plan is noncontributory. The Company's intent is that the retiree provide approximately 50% of the actual cost of providing the medical plan. Neither plan is funded. In 1991, the Company adopted the provisions of SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" and elected immediate recognition of the transition amount of $3,816,000 ($2,385,000 after income taxes). As of December 31, 1993, the accumulated postretirement benefit obligation ("APBO") was $7,614,000. The following table reconciles the plans' status to the accrued postretirement health care and life insurance liability as reflected on the balance sheet as of December 31, (in thousands): 1993 1992 - ------------------------------------------------------------------------ APBO: Retirees $ 1,890 $ 1,834 Fully eligible participants 1,790 1,057 Other participants 3,934 2,907 -------------------- 7,614 5,798 Unrecognized net loss (1,195) (457) --------------------- Accrued postretirement benefit obligation - included in Other Liabilities $ 6,419 $ 5,341 ===================== Net postretirement costs are summarized as follows (in thousands): 1993 1992 1991 - ------------------------------------------------------------------------ Service costs $ 245 $ 184 $ 131 Interest on APBO 523 456 338 -------------------------------- Net periodic postretirement cost $ 768 $ 640 $ 469 ================================ For measurement purposes, the cost of providing medical benefits was assumed to increase by 12% in 1993, decreasing to an annual rate of 7.5% after 1998. The medical cost trend rate assumption could have a significant effect on amounts reported. An increase of 1% in the assumed rate of increase would have had the effect of increasing the APBO by $851,000 and the net periodic postretirement cost by $113,000. The weighted average discount rate used in determining the APBO was 7.5% in 1993, 8.5% in 1992 and 9% in 1991 and employee earnings were estimated to increase 4.5% annually until age 65. -F14- 14. 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: Short-term investments - The carrying amount approximates fair value because of the short maturity of those instruments. Long-term investments - The fair values of certain investments are estimated based on quoted market prices. The fair values of the Company's investments in limited partnerships are based on estimates by general partners in the absence of readily ascertainable market values. For the Company's other investments, which are not actively traded and are immaterial, fair value is based on an estimate of the net realizable value of those investments. Long-term debt - The fair values of the Company's convertible debentures are based on recent market quotes. The fair value of the other long-term debt is based on estimated rates currently available to the Company for debt with similar terms and maturities. The carrying value and estimated fair values of the Company's financial instruments at December 31, 1993 and 1992 are as follows (in thousands): Carrying Value Fair Value 1993 1992 1993 1992 - ------------------------------------------------------------------------ Assets: Short-term investments $ 1,900 $ 150 $ 1,900 $ 150 Long-term investments 8,103 7,705 9,169 8,601 Liabilities: Long-term debt 111,542 12,622 112,105 13,931 15. COMMITMENTS AND CONTINGENCIES: Total rental expense was $12,257,000 in 1993, $6,969,000 in 1992, and $3,731,000 in 1991. Minimum annual rentals under non-cancellable operating leases total $22,471,000 and range from $7,536,000 in 1994 to $1,847,000 in 1998. 16. SUBSEQUENT EVENT: On January 7, 1994, the Company acquired Marketing Profiles, Inc. ("MPI") for $18,000,000 in cash and a contingent purchase payment payable in 1997 to the former MPI shareholders. The contingent purchase payment is based upon a multiple of MPI's 1996 operating results as defined in the acquisition agreement. The acquisition price was funded with a portion of the proceeds received in the December 1993 issuance of long-term debt (See Note 7). The acquisition will be accounted for using the purchase method of accounting and, accordingly, the results of operations of MPI will be included in the Company's consolidated financial statements from the date of acquisition. MPI is based in Maitland, Florida and is a database marketing and consulting company which provides software products and related marketing services to the financial industry. -F15- JOHN H. HARLAND COMPANY AND SUBSIDIARIES - Supplemental Financial Information SELECTED QUARTERLY FINANCIAL DATA, DIVIDENDS PAID AND STOCK PRICE RANGE (unaudited) (In thousands except per share amounts) --------- Quarter ended ---------- March 31 June 30 September 30 December 31 - ----------------------------------------------------------------------- 1993: Net sales $ 133,504 $ 129,979 $ 129,922 $ 126,081 Gross profit 58,928 59,814 56,892 55,066 Net income 13,119 14,127 13,318 11,958 Per common share: Net income .39 .42 .42 .39 Dividends paid .235 .235 .235 .235 Market price: High 27 1/2 28 1/8 27 3/4 25 5/8 Low 24 1/4 25 5/8 25 1/4 20 7/8 1992: Net sales 103,629 113,766 113,975 113,610 Gross profit 49,917 53,677 52,804 52,023 Net income 14,869 14,530 13,671 13,568 Per common share: Net income .41 .40 .39 .39 Dividends paid .225 .225 .225 .225 Market price: High 25 1/4 25 24 1/4 27 1/4 Low 22 1/8 20 1/2 20 5/8 22 1/2 The Company's common stock (symbol:JH) is listed on the New York Stock Exchange. At December 31, 1993 there were 8,044 shareholders of record. SELECTED FINANCIAL DATA (In thousands except per share amounts) --------- Year ended December 31 --------- 1993 1992 1991 1990 1989 - ---------------------------------------------------------------------- Net sales $ 519,486 $ 444,980 $ 378,659 $ 366,834 $ 344,734 Net income 52,522 56,638 47,435 57,167 58,052 Total assets 356,451 339,880 351,554 347,105 321,081 Long-term debt 111,542 12,622 11,661 11,304 11,276 Per common share: Net income 1.62 1.59 1.27 1.52 1.54 Dividends paid .94 .90 .86 .78 .68 Average number of shares outstanding 32,460 35,689 37,469 37,604 37,797 Refer to Note 13 of the Notes to Consolidated Financial Statements regarding the impact of change in accounting method for postretirement benefits in 1991 and to Note 4 for impact of a restructuring charge in 1991. Refer to Note 3 regarding the impact of acquisitions in 1992 and 1993. -F16- JOHN H. HARLAND COMPANY AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITIONS RESULTS OF OPERATIONS 1993 versus 1992 1993 consolidated net sales increased $74.5 million or 16.7% over 1992 and represented the 44th consecutive year of sales increases. The Company's Financial Services Group ("FSG") had a net sales increase of $72.1 million or 18.4% which consisted of an 18.1% increase in units and a price and product mix increase of 0.3%. The FSG sales increase is attributable to the acquisition of Rocky Mountain Bank Note Company ("RMBN") in January 1993 coupled with the impact of the February 1992 acquisition of Interchecks, Inc. ("Interchecks") (see Note 3 of the Notes to Consolidated Financial Statements). Competitive pricing pressures within the check printing industry contributed to the mild change in the FSG price and product mix. Net sales by the Company's Data Services Group ("DSG") increased $2.4 million or 4.6% in 1993 primarily due to increases in hardware sales and service-related revenues while 1993 form sales were flat compared to 1992. The hardware sales and service-related revenue increases offset sales decreases by DSG's European sales subsidiary Datascan and the loss of revenues associated with American Testronics Company, the assets of which were sold in June 1992. Consolidated cost of goods sold increased $52.2 million or 22.1% and increased as a percentage of sales to 55.6% from 53.2% in 1992. FSG's cost of goods sold increased as a percentage of sales to 56.0% from 53.4% in 1992 primarily due to acquired operations, which had lower margins, and duplication of costs during integration of acquired operations. FSG achieved labor productivity improvements of 0.6% in 1993. DSG's cost of goods sold increased slightly as a percentage of sales to 51.8% in 1993 from 51.1% in 1992. DSG's gross margin improved as a result of the 1992 sale of American Testronics Company, which had lower margins, but the improvement was offset by increased machine sales and service-related revenues, which have lower margins than forms, and by increased product development costs. Consolidated selling, general and administrative expenses increased $14.0 million or 12.6% in 1993 primarily due to acquired operations, higher information systems costs and increases in employee health care costs. As a percentage of sales, consolidated selling, general and administrative expenses decreased from 25.0% in 1992 to 24.1% in 1993. The consolidation of selling and certain administrative functions of the acquired operations was a primary factor contributing to this decrease. Profit sharing costs increased $0.5 million but decreased as a percentage of sales from 2.0% in 1992 to 1.9% in 1993. Due to the February 1992 acquisition of Interchecks and the January 1993 acquisition of RMBN, amortization of intangibles increased $4.0 million over 1992 and was 1.7% as a percentage of sales in 1993 compared to 1.1% in 1992. Of the total 1993 amortization of intangibles, $8.0 million relates to intangible assets which are being amortized over 5 years. Interest and other income (expense) - net decreased $6.4 million from 1992. The primary components of the change were gains of $3.4 million realized in 1992 on the dispositions of American Testronics Company and the Puerto Rico bond investment portfolio and increased interest expense, which totaled $2.6 million in 1993 due to increased levels of debt. Another component of the interest and other income (expense) - net change was reduced interest income earned in 1993 due to lower average cash and investment balances. Income before income taxes decreased $2.6 million or 2.9% from 1992 and -F17- decreased as a percentage of sales from 19.8% in 1992 to 16.5% in 1993. The effective consolidated income tax rate for 1993 was 38.7% compared to 35.8% in 1992. The effective tax rate increased primarily as a result of the Omnibus Tax Reconciliation Act of 1993, which increased the federal corporate tax rate from 34% to 35%, and certain nonrecurring tax exempt items and higher tax exempt income in 1992. 1992 versus 1991 Consolidated 1992 sales increased $66.3 million or 17.5% over 1991. Both FSG and DSG experienced sales increases with FSG contributing $60.7 million of the increase and DSG contributing $5.6 million. FSG's sales growth was attributable to a 25.7% increase in check unit production tempered by a 7.4% reduction from price and product mix. The unit increase came principally from the new business obtained through the acquisition of Interchecks in February 1992 with a lesser portion due to an increase in FSG's core business. Lower pricing in 1992 resulted from competitive conditions in the check printing industry. DSG's sales increased 11.8% partially due to the consolidation of Datascan's results of operations after acquisition of the remaining 50% of Datascan's stock in December 1991 and to sales increases in educational markets. Consolidated gross profit margin declined in 1992 to 46.8% from 49.9% in 1991. Margins in both FSG and DSG were negatively impacted by acquired operations (Interchecks and Datascan, respectively); however, FSG realized an increase in labor efficiency of 3.6% in its core operations as a result of completion of the conversion to offset printing and computerized production systems in 1991. DSG's margin declines were moderated by the sales increase in standard forms in its educational markets which generally provide higher margins. Selling, general and administrative expenses increased $17.0 million in 1992 or 18.1% and, as a percentage of sales, increased to 25.0% from 24.8% in 1991. The primary components of this increase were employee health care costs, the costs of enhanced data processing systems, expenses of acquired operations and marketing costs associated with customer relations. Profit sharing costs increased $1.0 million but decreased as a percentage of sales from 2.1% in 1991 to 2.0% in 1992. Amortization of intangibles costs associated with the acquired operations totaled $4.7 million or 1.1% as a percentage of sales. Interest and other income decreased $0.5 million or 9.5% from 1991, which is attributable to both lower interest rates and significantly lower investment balances, a result of the use of funds for the acquisitions of Interchecks and Datascan and for the stock repurchase program. The reduced interest and other income was offset by $3.4 million of gains realized in the sale of the Puerto Rico bond investment portfolio and the sale of the assets of American Testronics Company. The Company's effective consolidated income tax rate decreased to 35.8% from 37.5% primarily due to the higher level of tax exempt income in 1992. Outlook The Company will continue its efforts to further diversify its business during 1994. On January 7, 1994, the Company acquired Marketing Profiles, Inc. ("MPI"), a database marketing and consulting company which provides software products and related marketing services to the financial industry. See Note 16 of the Notes to Consolidated Financial Statements. In October 1993, the Company announced the formation of a new subsidiary, The Check Store, Inc. ("The Check Store"), which will market checks and related products directly to consumers. The direct marketing of checks and related products to consumers is currently the fastest growing segment of the -F18- check printing market and The Check Store, which will become operational during the first half of 1994, represents the Company's entry into this distribution channel. It is anticipated that The Check Store will have lower margins than the Company's traditional check printing operations and, due to start-up costs and expenditures for marketing and product development, will negatively impact the Company's results and cash flows during 1994. The Company is unable to determine if or when The Check Store operations will contribute positively to cash flow or operating results. The Company expects that its check printing operations will continue to experience competitive pricing pressures during 1994, and as a result the price component of changes in revenue might be flat or negative. However, the Company anticipates that profit margins should experience a slight improvement in 1994 as a result of the continued integration of acquired operations along with other cost control measures. FINANCIAL CONDITION, CAPITAL RESOURCES AND LIQUIDITY Cash flows provided by operations in 1993 were $90.7 million compared to $78.4 million in 1992, an increase of 15.7%. The primary uses of funds in 1993 were for the purchase of the Company's common stock, the acquisition of the net assets of RMBN, additions to property, plant and equipment and dividends paid to the Company's shareholders. In December 1993, the Company issued $85.0 million of Series A Senior Notes ("Senior Notes") with a final maturity of December 2008, and also arranged a $15.0 Million Term Loan ("Term Loan") due December 2003. The Senior Notes and the Term Loan have a fixed annual interest rate of 6.60% and 6.63%, respectively. Proceeds from these obligations were used to repay amounts outstanding under short-term lines of credit and to fund the January 1994 purchase of MPI and will be used to fund additional purchases of Company stock and for general corporate purposes. The Company has unsecured lines of credit which provide for borrowing up to $111.0 million. At December 31, 1993, no amounts were outstanding under these lines, a decrease of $18.0 million from December 31, 1992. Excluding the borrowings under the unsecured lines of credit, which the Company replaced with long-term financing, the ratio of current assets to current liabilities increased from 2.7 at December 31, 1992 to 3.1 at December 31, 1993, and working capital increased to $90.9 million at December 31, 1993 from $69.2 million at December 31, 1992. In March 1993, the Company completed a program announced in November 1991 to repurchase 4.0 million shares of its common stock. In June 1993, the Company initiated a new program to repurchase 3.4 million additional common shares which was completed in November 1993 at an average cost of $26.24 per share. In December 1993, the Company announced another program to repurchase 1.5 million common shares but had not purchased any shares under this program as of December 31, 1993. Additions to property, plant and equipment for 1993 were $27.1 million compared to $18.7 million in 1992. The Company anticipates 1994 capital expenditures will total approximately $37 million. On December 31, 1993, the Company had $28.1 million in cash and cash equivalents and short-term investments. The Company believes that its current cash position, funds from operations and available amounts under its lines of credit will be sufficient to meet anticipated requirements for working capital, dividends, capital expenditures, the purchase of MPI, the announced stock repurchase program and other corporate needs. -F19- -S1- -S2- -S3- -S4- JOHN H. HARLAND COMPANY AND SUBSIDIARIES SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (In thousands of dollars) ___________________________________________________________________________ ITEM 1993 1992 1991 ___________________________________________________________________________ MAINTENANCE AND REPAIRS........ $ 15,790 $ 12,127 $ 9,785 ======== ======== ======= Other items required by this schedule were less than one percent of net sales or not applicable. -S5- EXHIBIT INDEX (* indicates document is incorporated by reference) Page Number Location of Documents or Exhibit Incorporation Desig- by Reference nation Description (Inclusive) ______ ___________ ___________ 3.1 * Amended and Restated Articles of Incorporation. 10 3.2 * By-laws, as amended. Adopted by the Board of Directors on July 27, 1990. 10 4.1 Indenture, as supplemented and amended, relating to 6.75% Convertible Subordinated Debentures due 2011 of Scantron Corporation (omitted pursuant to Item 601(b)(4)(iii) of Regulation S-K; will be filed upon request). 10 4.2 * Form of Rights Agreement, dated as of June 9, between the Registrant and Citizens and Trust Company. 10 4.3 * First Amendment dated June 12, 1992 to Rights Agreement dated June 9, 1989 between the Company and NationsBank of Georgia Inc., N.A., successor to Citizens and Southern Trust Company. 10 4.4 * Second Amendment dated July 24, 1992 to Rights Agreement dated June 9, 1989 between the Company and Trust Company Bank, successor to NationsBank of Georgia Inc., N.A., and to Citizens and Southern Trust Company. 10 4.5 Note Agreement dated as of December 1, 1993 between the Company and the purchasers listed on Schedule I of the agreement, for the issuance and sale of $85,000,000 aggregate principle amount of 6.60% Series A Senior Notes Due December 30, 2008. 10 10.1 Form of Deferred Compensation Agreement between the Registrant and the following Executive Officer and Director: Mr. Woodson and the following Retired Executive Officer and Current Director: Mr. Lang. 10 10.2 * Form of Monthly Benefit Amendment to Deferred Compensation Agreement between the Registrant and following Executive Officer and Director: Mr. Woodson and the following Retired Executive Officer and Current Director: Mr. Lang. 10 10.3 * Form of Deferred Compensation Agreement between the Registrant and the following executive officers: Messrs. Dollar, Rogers and Rupe. 10 10.4 Form of Deferred Compensation Agreement between the Registrant and Ms. Weyand, Executive Officer. 10 10.5 Form of Frozen Benefit Amendment to Deferred Compensation Agreement between the Registrant and Ms. Weyand, Executive Officer. 10 -X1- EXHIBIT INDEX continued Page Number Location of Documents or Exhibit Incorporation Desig- by Reference nation Description (Inclusive) ______ ___________ ___________ 10.6 Form of Amendment to Deferred Compensation Agreement between the Registrant and the following Executive Officer Director: Mr. Woodson and the following Retired Executive Officer and Current Director: Mr. Lang and the following Executive Officers: Messrs. Dollar, Rogers and Rupe and Ms. Weyand. 11 10.7 Form of Non-Compete and Termination Agreement between the Registrant and the following Executive Officer and Director: Mr. Woodson, the following Retired Executive Officer and Current Director: Mr. Lang and the following Executive Officers Messrs. Dollar, Rogers and Rupe. 11 10.8 Form of Executive Life Insurance Plan between the Registrant and the following Executive Officer and Director: Mr. Woodson, the following Retired Executive Officer and Current Director: Mr. Lang and the following Executive Officers: Messrs. Dollar, Rogers and Rupe and Ms. Weyand. 11 10.9 * The John H. Harland Company Incentive Stock Option Plan. 11 10.10 Amendment to the John H. Harland Company Incentive Stock Option Plan. 11 10.11 * John H. Harland Company 1981 Incentive Stock Option Plan, As Extended. 11 10.12 * Asset Purchase Agreement, dated as of February 7, 1992, by and among the Registrant , Rexham, Inc. ("Rexham") and Interchecks; as partially assigned to Centralia Holding Corp. ("Centralia") on February 19, 1992; and as amended on February 12, 1992 by and among the Registrant, Centralia, Rexham and Interchecks. 11 10.13 * Asset Purchase Agreement, dated as of November 13, 1992, by and among the Registrant, The Rocky Mountain Bank Note Company and Romo Corp.; and as amended on November 25, 1992, by and among the Registrant, The Rocky Mountain Bank Note Company and Romo Corp. 11 10.14 Term Loan Agreement dated as of October 25, 1993 between the Company and Trust Company Bank for a $15,000,000 Term Loan due 2003. 11 21.1 Subsidiaries of the Registrant. 11 23.1 Independent Auditors' Consent 11 -X2-

83246_1993.txt

83246_1993

1993

83246

Item 1. Business REPUBLIC NEW YORK CORPORATION Republic New York Corporation (the "Corporation"), incorporated in Maryland in 1973, is a bank holding company that commenced operations in July, 1974. At December 31, 1993, the Corporation had consolidated total assets of $39.5 billion and stockholders' equity of $2.7 billion. Its principal asset is the capital stock of Republic National Bank of New York (the "Bank"). At December 31, 1993, the Bank accounted for approximately 75% of the consolidated assets and, for the year ended December 31, 1993, accounted for approximately 75% of consolidated revenues and 85% of consolidated net income of the Corporation. The Corporation's other significant banking subsidiary, formerly known as The Manhattan Savings Bank, is Republic Bank for Savings ("RBS"). See "Republic Bank for Savings". Republic Factors Corp. ("Factors"), which commenced operations in 1977, is the other significant subsidiary of the Corporation. See "Republic Factors Corp." The executive offices of the Corporation are located at 452 Fifth Avenue, New York, New York 10018 (telephone 212-525-6100). As used herein, the term "Corporation" includes the subsidiaries of the Corporation and the terms "Bank" and "RBS" include the subsidiaries of the Bank and RBS, respectively, unless the context indicates otherwise. The Corporation acquired SafraCorp California, the owner of all the outstanding shares of SafraBank (California), on September 20, 1993 for which the Corporation paid approximately $6,500,000 to Edmond J. Safra, the owner of all the outstanding shares of SafraCorp California and the principal stockholder of the Corporation. Pursuant to the Purchase Agreement between Mr. Safra and the Corporation, such payment approximated the consolidated net book value of SafraCorp California on September 20, 1993. Such purchase price was determined by a committee of independent directors of the Corporation, which had received an opinion from investment bankers retained by it, to the effect that the consideration to be paid was fair to the Corporation from a financial point of view. Effective September 21, 1993, SafraBank (California) converted from a state-chartered bank to a national banking association and changed its name to Republic Bank California N.A. Effective December 1, 1993, SafraCorp California was merged into the Corporation. Thereafter, on January 13, 1994, substantially all of the assets of Republic International Bank of New York (California), the Bank's Edge Act subsidiary in Beverly Hills, California, were transferred to and its liabilities assumed by Republic Bank California N.A. REPUBLIC NATIONAL BANK OF NEW YORK The Bank, a national banking association organized in 1965, commenced operations in January, 1966. The Bank provides a variety of banking and financial services worldwide to corporations, financial institutions, governmental units and individuals. At December 31, 1993, the Bank had total assets of $29.7 billion, total deposits of $19.2 billion and stockholder's equity of $2.2 billion. At December 31, 1993 the Bank was the fifteenth largest commercial bank in the United States based on total deposits. The Bank's headquarters and principal banking office is located at 452 Fifth Avenue, New York, New York. The Bank has 34 domestic branch banking offices in New York City and the suburban counties of Westchester and Rockland. The Bank maintains foreign branch offices in London, Milan, Buenos Aires, Santiago, Hong Kong, Singapore, Tokyo and the Cayman Islands; wholly-owned foreign banking subsidiaries in London, England, Montreal, Canada, Nassau, The Bahamas, Singapore, Montevideo, Uruguay and the Cayman Islands; and an Edge Act subsidiary in Miami, Florida. The Bank also has foreign representative offices in Beijing, Beirut, Buenos Aires, Caracas, Jakarta, Mexico City, Montevideo, Moscow, Punta del Este, Rio de Janeiro, and Taipei. The Bank's facilities are supplemented by a network of correspondent banks throughout the world. International Banking The Bank is active in international banking where it operates principally as a wholesale bank. It has been its policy to deal primarily with foreign governments, their agencies, foreign central banks and foreign commercial banks as borrowers or guarantors. At December 31, 1993, approximately 75% of the Bank's cross-border net outstandings were to or guaranteed by such entities. The Bank's international banking services include accepting deposits, extending credit, forfait financing, buying and selling foreign exchange, buying and selling banknotes denominated in various currencies, issuing letters of credit and bankers' acceptances and handling the collection and transfer of money. The Bank increased its international banking services capabilities in 1993 with the acquisition of Citibank's World Banknote Services business and with the acquisition of Bank Leumi (Canada). The Banknote Services business ships U.S. dollars to and from financial institutions in nearly 40 countries. The acquisition of Bank Leumi (Canada) provided the Bank with entry into the Toronto market and added an additional office in Montreal. Through its International Private Banking Department, headquartered in New York City, the Bank offers a full range of financial services to individuals who are citizens or residents of countries other than the United States, including accepting deposits, buying and selling foreign exchange, banknotes denominated in various currencies, precious metals and financial instruments, issuing letters of credit and handling the collection and transfer of money. An analysis of the Corporation's international operations for each of the years in the three years ended December 31, 1993 is contained in the following sections of its 1993 Annual Report to Stockholders filed as an Exhibit to this Report which is hereby incorporated herein by reference: (a) Note 13 of the Notes to Consolidated Financial Statements on page 69 in such report for allocation of the Corporation's total assets, total operating revenue, income (loss) before income taxes and net income (loss) among geographic areas for each of the years in the three years ended December 31, 1993; and (b) "Management's Discussion and Analysis - Liability and Asset Management" on pages 35 through 44 in such report for other relevant information on international operations. For information concerning the Corporation's outstandings in certain foreign countries, see "Management's Discussion and Analysis - Liability and Asset Management - Asset Management - Cross-border Outstandings" on pages 43 and 44 and "Allowance for Possible Loan Losses" on pages 42 and 43 in the 1993 Annual Report to Stockholders. Safra Republic Holdings S.A. Safra Republic Holdings S.A. ("Safra Republic"), a Luxembourg holding company, is principally engaged, through wholly-owned banking subsidiaries in Switzerland, Luxembourg, France, Guernsey and Gibraltar, in international private banking and commercial banking, offering a range of private banking services primarily to wealthy individuals. At December 31, 1993, the Bank owned approximately 48.8%, Saban S.A., the Corporation's principal stockholder, owned approximately 20.7% and international investors owned approximately 30.5% of the outstanding shares of Safra Republic. At December 31, 1993, Safra Republic had total assets of $11.3 billion, total deposits of $7.3 billion and total shareholders' equity of approximately $1.3 billion. Safra Republic's client services include the accepting of a wide variety of deposits and the execution of transactions in foreign exchange, precious metals, securities and banknotes. Safra Republic also provides credit facilities, portfolio management and investment advisory services and safekeeping and other fiduciary services. In addition, Safra Republic offers commercial banking services to governments, government agencies, banks and corporations. Domestic Banking The Bank provides a full range of domestic banking services, including commercial, consumer installment and mortgage loans to individuals and businesses. It also accepts deposits, including time and savings deposits and regular and special checking accounts, and issues large denomination negotiable certificates of deposit of $100,000 or more. Through its Domestic Corporate Lending Department, the Bank services the financing requirements of large national companies, middle-market companies and other businesses in the New York metropolitan area and selected markets outside of New York. Information concerning the composition of the Corporation's domestic and international loan portfolio is presented in the section "Loan Portfolio" under "Operating Information" found on page 7 of this report. The Corporation also engages in factoring activities through Factors, a wholly-owned subsidiary of the Corporation. See "Republic Factors Corp." Other banking facilities usually associated with a full-service commercial bank are offered, among which are safe deposit boxes, safekeeping and custodial services, collections and remittances, letters of credit and foreign exchange. The Bank's Trust Department provides a broad range of fiduciary services to both individual and corporate accounts. The following table sets forth the percentages of the Corporation's domestic and international assets and liabilities, based upon the location of the obligor or customer, at December 31 in each of the last three years. Precious Metals, Foreign Exchange, Securities and Derivative Transactions The Bank is a dealer in gold and silver bullion and coins for sale to commercial and industrial users and investors. For this activity, the Bank receives and sells gold and silver on consignment, and the Bank maintains its own inventory. In its precious metals activities, the Bank, from time to time, takes positions in precious metals for its own account, but such positions are taken within guidelines and limits established by the Bank's Board of Directors at what are considered by management to be prudent levels. Position limits are periodically reviewed and changed as appropriate to account for changing market conditions and to minimize risks. At December 31, 1993, approximately $24.8 million of the Bank's inventory in precious metals was unhedged. Also, with respect to gold and silver bullion and gold coins, significant activities of the Bank include buying and simultaneously selling for future delivery, other arbitraging between markets when, in each case, the respective premium or differential derived provides an attractive return relative to alternative investment opportunities, and writing and purchasing options with other participants in the over-the-counter institutional and interbank market. Sales of precious metals for future delivery are generally done through futures contracts executed on major commodity exchanges in the United States. The Bank is one of the authorized purchasers to which the United States Mint sells its gold bullion coins for distribution throughout the world. Income from each of these activities is treated as income from precious metals. The Bank also derives income from acting as a licensed depository of precious metals for various commodity exchanges. On December 31, 1993, the Bank acquired Mase Westpac Limited from Westpac Banking Corporation of Australia and changed the name to Republic Mase Bank Limited ("Republic Mase"). Republic Mase is one of the five members of the London gold fixing. Republic Mase, an authorized U.K. banking institution, engages in global wholesale trading in gold, silver, platinum and palladium, including spot, forward and options dealing, and provides financial services to central banks, international financial institutions and institutional investors. Republic Mase also offers production and inventory financing to mining companies, industrial manufacturers and end-users. It has subsidiaries in Australia and Hong Kong. The New York branch of Republic Mase is in the process of being liquidated, with all its activities being transferred to the Bank. In Australia, Republic Mase Australia Limited ("RMAL") acts as a primary market-maker in the domestic and international bullion markets. RMAL provides a full range of services to Australian and Asian gold producers. Republic Mase's subsidiary in Hong Kong, Republic Mase Hong Kong Limited, operates on behalf of Republic Mase as a primary market-maker servicing the financial requirements of its Far East and Asian clients, notably in Japan, Taiwan, Hong Kong and China. In its foreign exchange trading and arbitrage activities, the Bank, from time to time, takes positions in foreign currencies for its own account, but such positions are taken only in currencies and within guidelines and limits established by the Bank's Board of Directors at what are considered by management to be prudent levels. Position limits are periodically reviewed and changed, as appropriate, to minimize the risks inherent in these activities, such as currency revaluations, exchange controls and other regulatory and political policies of foreign governments. The Bank's activities in foreign exchange also involve servicing the needs of its customers, including other banks, which do not require the Bank to assume large positions in foreign currencies. It has been the Bank's policy to hedge all significant assets and liabilities due in foreign currencies to United States dollars. Investment securities represent a significant portion of the Corporation's interest-earning assets. The Corporation attempts to manage the return on its assets while also considering the creditworthiness of borrowers and counterparties, the interest rate sensitivity of the assets and the maturity of such assets. To balance these criteria while maintaining an adequate return, the Corporation's investment securities portfolio consists primarily of debt securities issued by the United States Government and United States government agencies. In addition, the Corporation will invest in debt securities issued by U.S. states and other political subdivisions, as well as bonds, debentures and redeemable preferred stock of highly-rated corporations. Republic Forex Options Corporation ("RFOC"), an operating subsidiary of the Bank, is a foreign currency options participant on the Philadelphia Stock Exchange. RFOC is a market-maker in foreign currency options and trades for its own account. Information concerning derivative instruments is contained in the 1993 Annual Report to Stockholders in the section entitled "Management's Discussion and Analysis - Liability and Asset Management - Off-balance Sheet Financial Instruments" on pages 44 through 46 and in Note 1G and Notes 15 and 16 of the Notes to Consolidated Financial Statements on page 56 and pages 70 through 73, respectively, in such report all of which are hereby incorporated herein by reference. REPUBLIC BANK FOR SAVINGS RBS, a wholly-owned New York State chartered savings bank subsidiary of the Corporation, is engaged in the granting of mortgages on residential real property located primarily in New York State, including one to four family dwellings, units within condominium projects or units within cooperative housing projects. RBS' deposit activities include accepting savings, demand, money market, fixed-rate individual retirement, Keogh and NOW accounts. RBS also provides consumer credit and is active in the bond market. At December 31, 1993, RBS had total assets of $6.1 billion, total deposits of $4.8 billion and total stockholder's equity of $478 million. RBS' headquarters and principal banking office is located at 415 Madison Avenue, New York, New York. RBS has 24 full service branch banking offices in New York City and Nassau, Suffolk and Westchester counties and 8 additional branches in Broward and Dade counties, Florida. REPUBLIC FACTORS CORP. Factors is a wholly-owned subsidiary of the Corporation. Factors purchases, without recourse, accounts receivable from approximately 450 clients. These receivables are due on average in 60 days from over 55,000 customers primarily in the retail apparel industry throughout the United States. In addition, certain clients receive payment for these receivables prior to their maturity date. From time to time, Factors makes advances in excess of the receivables purchased. These advances are seasonal in nature and may be either secured or unsecured. Letters of credit accommodations are also provided. For these services, Factors earns commissions, interest and service fees. For the year ended December 31, 1993, Factors factored approximately $4.8 billion of sales making it the fifth largest factor in the United States based on such sales volume. Factors' headquarters and principal office is located at 452 Fifth Avenue, New York, New York. In addition, Factors has offices located in Los Angeles, California and Charlotte, North Carolina. OTHER FINANCIAL SERVICES Republic New York Securities Corporation. Republic New York Securities Corporation ("RNYSC"), a wholly-owned subsidiary of the Corporation, commenced operations on November 2, 1992 as a full- service securities brokerage whose principal activities are prime brokerage, securities borrowing and lending, margin lending, third party research and vendor services, correspondent clearing, and asset management and fiduciary services offered primarily to institutional investors and high net worth individuals. On January 10, 1994, the Board of Governors of the Federal Reserve System (the "Federal Reserve Board") granted approval to RNYSC to underwrite and deal in all forms of debt and equity securities. RNYSC is a registered broker-dealer with the Securities and Exchange Commission and is a member of the National Association of Securities Dealers, Inc. and the New York Stock Exchange, Inc. In addition, it is an associate member of the American Stock Exchange and the Philadelphia Stock Exchange. RNYSC is also a member of the commodity exchanges set forth below. In connection with the expansion of RNYSC's activities, in February 1994, Republic Clearing Corporation ("RCC",) a wholly- owned subsidiary of the Corporation, was merged into RNYSC in order to consolidate associated securities, back office, record keeping and related functions into one business unit. RNYSC is registered with the Commodity Futures Trading Commission and the National Futures Association as a futures commission merchant. RNYSC acts primarily as a commodities broker to the Bank in executing for the Bank's account futures contracts and options on futures contracts on the commodity exchanges listed below. It acts to facilitate the Bank's activities as a dealer in precious metals, financial instruments and foreign exchange. RNYSC also acts as a futures commission merchant for the general public to execute futures contracts and options on futures contracts covering gold and silver bullion and coins, various financial instruments and foreign currencies. As a result of the merger with RCC, RNYSC is now a clearing member of the Commodity Exchange Inc. and the Chicago Mercantile Exchange and is also a non-clearing member of the New York Futures Exchange and the Philadelphia Board of Trade. Republic New York Securities International Limited. On February 24, 1994, Republic New York Securities International Limited ("RNYSIL"), the Corporation's wholly-owned London based subsidiary, became a member of the Securities and Futures Authority. It is anticipated that RNYSIL will commence operations in the second quarter of 1994 and will provide a range of financial services in European markets to institutional investors and high net worth individuals, including prime brokerage, securities borrowing and lending, third party research and vendor services, and the processing of transactions related to equity, fixed income and derivative instruments. The business to be conducted by RNYSIL is intended to complement the business of RNYSC. Republic Asset Management Corporation. Republic Asset Management Corporation ("RAM"), the Corporation's wholly-owned subsidiary, commenced operations in the second quarter of 1993. RAM provides a broad range of investment, economic and financial advice to individuals, corporations and governments, among others. RAM is a registered investment adviser under the Investment Company Act of 1940 and is registered as a commodity trading adviser and commodity pool operator with the Commodity Futures Trading Commission. OPERATING INFORMATION This section provides, on a consolidated basis, certain statistical data concerning the Corporation and supplements information contained in the 1993 Annual Report to Stockholders which is incorporated hereinbelow by reference. Distribution of Assets, Liabilities and Stockholders' Equity; Interest Rates and Interest Differential Information on the Corporation's consolidated average balances of assets, liabilities and stockholders' equity, computed principally on the basis of daily averages, and the interest income earned and the interest expense paid and the average rates earned and paid for each of the years in the five years ended December 31, 1993 is found in the table entitled "Average Balances, Net Interest Differential, Average Rates Earned and Paid" on pages 84 and 85 in the Corporation's 1993 Annual Report to Stockholders which is incorporated herein by reference. Interest income on certain tax-exempt obligations included in such table has been adjusted to a fully-taxable equivalent basis using the tax rate of 44% in 1993 and 42% for all other periods. Information on the approximate effect on net interest income of changes in volume of interest-earning assets and interest-bearing liabilities and the rates earned or paid thereon for the three years ended December 31, 1993 is found on pages 29 and 30 in "Management's Discussion and Analysis - Results of Operations - Net Interest Income" in such report which is also incorporated herein by reference. Information concerning the Corporation's interest rate sensitivity gap position at December 31, 1993 is found on page 35 in "Management's Discussion and Analysis - Liability and Asset Management" in the Corporation's 1993 Annual Report to Stockholders which is hereby incorporated herein by reference. Deposits Information concerning the Corporation's deposits, classified by major categories, at December 31 in each of the last three years is contained in the 1993 Annual Report to Stockholders in the section entitled "Management's Discussion and Analysis - Liability and Asset Management - Liability Management - Deposits" on pages 35 through 37 in such report which is hereby incorporated herein by reference. Information on the interest rates paid by deposit type is contained on pages 84 and 85 of the 1993 Annual Report to Stockholders which is hereby incorporated herein by reference. Investment Portfolio For information on the Corporation's portfolio of investment securities, see "Management's Discussion and Analysis - Liability and Asset Management - Asset Management - Investment Portfolio" on pages 39 and 40 of the 1993 Annual Report to Stockholders which is hereby incorporated herein by reference. Loan Portfolio The following table sets forth the composition of the Corporation's domestic and foreign loan portfolios at December 31 in each of the past five years. Maturity Distribution and Interest Sensitivity of Loans Information presenting the maturity distribution of the Corporation's domestic and foreign loan portfolios at December 31, 1993 and an analysis of the interest sensitivity of such portfolios at such date is contained in the section entitled "Management's Discussion and Analysis - Liability and Asset Management - Asset Management - Loan Portfolio" on page 41 in the 1993 Annual Report to Stockholders which is hereby incorporated herein by reference. Risk Elements Information presenting the risk elements of the Corporation's domestic and foreign loan portfolios and foreign outstandings at December 31, 1993, 1992 and 1991, including past due, non-accrual and other nonperforming assets, is contained in the section entitled "Management's Discussion and Analysis - Liability and Asset Management - Asset Management - Cross-border Outstandings" on pages 43 and 44 and "Allowance for Possible Loan Losses" on pages 42 and 43 in the 1993 Annual Report to Stockholders which is hereby incorporated herein by reference. For information presenting off-balance sheet risk of financial instruments together with related risk concentrations, see Note 16 of the Notes to Consolidated Financial Statements accompanying the Corporation's financial statements in the 1993 Annual Report to Stockholders which is hereby incorporated herein by reference. For information relating to the effect on the Corporation's 1993 income of loans classified as non-accrual and restructured and other information on outstandings in certain debtor countries, see Note 5 of the Notes to the Consolidated Financial Statements and "Management's Discussion and Analysis - Liability and Asset Management - Asset Management - Cross-border Outstandings" on pages 43 and 44 and "Allowance for Possible Loan Losses" on pages 42 and 43 in the 1993 Annual Report to Stockholders which is hereby incorporated herein by reference. Management periodically reviews the loan portfolio, particularly non-accrual and restructured loans. The review may result in a determination that a loan should be placed on a non-accrual status for income recognition. In addition, to the extent that management identifies potential losses in the loan portfolio, it reduces the book value of such loans, through charge-offs, to their estimated collectible value. The Corporation's policy is to classify as non-accrual any loan on which payment of principal or interest is 90 days or more past due. In addition, a loan will be classified as non-accrual if, in the opinion of management, based upon a review of the borrower's or guarantor's financial condition, collateral value and other factors, payment is questionable, even though payments are not 90 days or more past due. When a loan, other than a well secured residential mortgage loan, is classified as non-accrual, any unpaid interest is reversed against current income. The loan remains in a non-accrual classification until such time as the loan is brought current, when it may be returned to accrual classification. When principal and interest on a non-accrual loan are brought current, if in management's opinion future payments are questionable, the loan would remain classified as non-accrual. Subsequent payments of either interest or principal received on a partially charged-off non-accrual or restructured loan are first applied to any remaining balance outstanding, until the loan is reduced to its net realizable value, then to recoveries and lastly to income. Interest is included in income thereafter only to the extent received in cash. The large number of consumer installment loans and the relatively small dollar amount of each makes an individual review impracticable. The Corporation charges off any consumer installment loan which is past due 90 days or more. Residential mortgage loans are placed on non-accrual status when the mortgagor is in bankruptcy, or foreclosure proceedings are instituted, at which time the loan ceases to accrue interest. Any accrued interest receivable remains in interest income as an obligation of the borrower. Credit Risk Management and Allowance for Possible Loan Losses Information presenting the Corporation's allowance for possible loan losses, amounts of domestic loans by loan category and total foreign loans charged-off and recoveries of such loans previously charged-off, loans, net of unearned income, and related ratios is contained in the section entitled "Management's Discussion and Analysis - Liability and Asset Management - Asset Management - Allowance for Possible Loan Losses" on pages 42 and 43 in the 1993 Annual Report to Stockholders which is hereby incorporated herein by reference. Credit risk and exposure to loss are inherent parts of the banking business. Management seeks to manage and minimize these risks through its loan and investment policies and loan review procedures. Senior management establishes and continually reviews lending and investment criteria and approval procedures that it believes reflect the risk averse nature of the Corporation. The loan review procedures are set to monitor adherence to the established criteria and to ensure that on a continuing basis such standards are enforced and maintained. Management's objective in establishing lending and investment standards is to minimize the risk of loss and provide for income generation through pricing policies. In the case of foreign investments and loans, management emphasizes investments and loans to, or with guarantees of, governments, government agencies or banks. In addition, the Corporation places particular emphasis on the matching of the maturity and interest rate sensitivity of assets and liabilities. By this policy, the Corporation seeks to minimize the effect of rate changes, largely externally influenced and difficult to control, on the portfolio and to limit its exposure largely to credit risks over which it has more direct control. One technique which the Corporation utilizes to achieve these goals are interest rate and currency swaps designed to protect against rate and currency fluctuations. The Corporation's loan portfolios are regularly reviewed and monitored by the Credit Review Department, which, each quarter, prepares a report containing recommendations as to the amount of loans to be charged-off. During the preparation of the report, the Credit Review Department consults with lending officers and the heads of the lending departments. The report is then submitted for consideration to certain members of Executive Management who determine the amount of loans to be charged-off. The Credit Policy Committee subsequently reviews the loans to be charged-off and ratifies Executive Management's decision. Rules and formulae relative to the adequacy of the allowance, although useful as guidelines to management, are not final determinants. In addition, any loan or portion thereof which is classified as a "loss" by regulatory examiners (examinations are generally made annually) is charged-off. Consistent with its policy of maintaining an adequate allowance for possible loan losses, management generally charges-off a loan, or a portion thereof, when a loss is probable. The allocation of the allowance for possible loan losses between the Corporation's domestic and foreign components is contained in Note 5 of the Notes to the Consolidated Financial Statements found on page 59 of the 1993 Annual Report to Stockholders which is hereby incorporated herein by reference. In anticipation of the restructuring programs of various Latin American obligors, a large provision for possible loan losses was taken in 1989. Extensive foreign charge-offs related to restructuring countries debt were taken in 1989 and 1990. In 1991 and 1992, as the value of foreign obligations stabilized, the previously provided foreign provision was reallocated to domestic obligations as the domestic economy continued to deteriorate. Domestic charge-offs exceeded foreign charge-offs in 1991, 1992 and 1993. In order to comply with certain regulatory reporting requirements, management has prepared the following allocation of the Corporation's allowance for possible loan losses among various categories of the loan portfolio for each of the years in the five- year period ended December 31, 1993. In management's opinion, such allocation has, at best, a limited utility. It is based on management's assessment as of a given point in time of the risk characteristics of each of the component parts of the total loan portfolio and is subject to changes as and when the risk factors of each such component part change. Such allocation is not indicative of either the specific amounts or the loan categories in which future charge-offs may be taken, nor should it be taken as an indicator of future loss trends. In addition, by presenting such allocation, management does not mean to imply that the allocation is exact or that the allowance has been precisely determined from such allocation. At December 31, in each of the years 1993 through 1989, the Corporation's allowance for possible loan losses represented approximately 198%, 128%, 145%, 159% and 326%, respectively, of total non-accrual and restructured loans. The coverage of the allowance for loan losses to non-accrual and restructured loans is only one subjective measure of the adequacy of the allowance for loan losses that management utilizes. The Corporation's policy is to maintain an allowance for loan losses that is adequate to absorb all inherent credit losses in the Corporation's credit portfolios, including off-balance sheet credit instruments. Inherent losses are unconfirmed losses that probably exist based upon known information regarding the credit quality and portfolio characteristics prevailing as of the date of the evaluation. Future events are expected to confirm these losses, at which time these amounts will be charged off against the allowance for loan losses. The Corporation performs a comprehensive and consistently applied analysis of the various factors that affect collectibility that is in accordance with regulatory guidance. The process is complex and includes several different analyses of the portfolio. Management analyzes its portfolio by three main components: individually significant loans, homogeneous groups or pools of loans, and other segmentations of the portfolio into pools of loans with similar risk characteristics, such as risk classification, type of loan, industry group, collateral, size and maturity and country risk characteristics. The individually significant loans represent larger more problematic loans which are individually assessed as to collectibility. For homogeneous portfolios, principally the consumer retail portfolio, the Corporation utilizes the prior year's loss experience to estimate an amount necessary to provide for the upcoming twelve months of expected losses. For the other segmentations of the portfolio, historical loss rates are calculated for loans with similar characteristics. These loss rates are updated quarterly and are based upon the loss experience incurred for more than the last five years. While the historical loss rates provide a starting point for the Corporation's analysis, historical losses are not by themselves a sufficient basis to determine the appropriate level of the allowance for loan losses. The actual rate selected for the analysis may differ from the calculated loss rate as the historical rate may be adjusted upward or downward to reflect current and anticipated business and economic conditions and other factors which are likely to cause the current portfolio to differ from historical experience. The Corporation's allowance also reflects a margin for the imprecision in the estimates of expected credit losses. The resultant allowance for loan losses is viewed by management as a single, unallocated allowance available for all credit losses and any segmentation thereof is done only for compliance with reporting requirements. Financial Ratios The following table presents average stockholders' equity as a percentage of average assets and the Corporation's returns on average stockholders' equity and average total assets (based on net income) and its dividend payout ratio (based on net income applicable to Common Stock) for each of the years in the three years ended December 31, 1993. The rate of the quarterly dividend payable on the Corporation's Common Stock, adjusted to reflect a three-for-two stock split distributed on October 21, 1991, was $.213 per share commencing with the dividend payment on April 1, 1989, was increased to $.22 per share commencing with the dividend payment on April 1, 1990, was increased to $.233 per share with the dividend payment on April 1, 1991, was increased to $.25 per share commencing with the dividend payment on January 1, 1992, was increased to $.27 per share commencing with the dividend payment on April 1, 1993 and will be increased to $.33 commencing with the dividend payable on April 1, 1994. Competition All of the Corporation's banking activities are highly competitive. The Bank and RBS compete actively with other commercial banks, savings and loan associations, financing companies, credit unions and other financial institutions located throughout the United States and, in some of their activities, with government agencies. For international business, the Bank competes with other United States banks which have foreign installations and with other major foreign banks located throughout the world. Employees As of December 31, 1993, the Corporation had approximately 5,300 full-time equivalent employees. Customers It is the opinion of management that there is no single customer or affiliated group of customers whose deposits, if withdrawn, would have a material adverse effect on the business of the Corporation. For information concerning transactions with persons related to the Corporation and its management see Item 13 in Part III of this Report and the section entitled "Transactions with Management and Related Persons" found on pages 19 and 20 under "Election of Directors" in the Corporation's definitive Proxy Statement dated March 16, 1994 for its 1994 Annual Meeting of Stockholders filed pursuant to Section 14 of the Securities Exchange Act of 1934, which is hereby incorporated herein by reference. SUPERVISION AND REGULATION General The Corporation is a bank holding company within the meaning of the United States Bank Holding Company Act of 1956, as amended (the "BHCA"), and is registered as such with the Federal Reserve Board. As a registered bank holding company, the Corporation is subject to substantial regulation and supervision by the Federal Reserve Board. The Corporation's subsidiary banks are subject to regulation and supervision by federal and state bank regulatory agencies, including the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation ("FDIC") and the New York State Banking Department. Federal banking and other laws impose a number of requirements and restrictions on the operations and activities of depository institutions. In addition, the federal banking agencies are currently implementing recently enacted legislation that might result in additional substantial restrictions on operations and activities and increased operating costs. The BHCA requires the prior approval of the Federal Reserve Board for the acquisition by a bank holding company of more than 5% of the voting stock or substantially all of the assets of any bank or bank holding company. In addition, the BHCA prohibits the Corporation from acquiring direct or indirect control of more than a 5% interest in a bank or bank holding company located in a state other than New York unless the laws of such state expressly authorize such acquisition. Also, under the BHCA, bank holding companies are prohibited, with certain exceptions, from engaging in, or from acquiring more than 5% of the voting stock of any company engaging in, activities other than banking or managing or controlling banks or furnishing services to or performing services for their subsidiaries. The BHCA also authorizes the Federal Reserve Board to permit bank holding companies to engage in, and to acquire or retain shares of companies that engage in, activities which the Federal Reserve Board determines to be so closely related to banking or managing or controlling banks as to be a proper incident thereto. The effect of the Federal Reserve Board's findings under this standard has been to expand the financially related activities in which bank holding companies may engage. The Federal Reserve Act imposes restrictions on extensions of credit by subsidiary banks of a bank holding company to the bank holding company or certain of its subsidiaries, on investments in the stock or other securities thereof, and on the taking of such stock or securities as collateral for loans to any borrower. Further, under the BHCA and the Federal Reserve Board's regulations, a bank holding company, as well as certain of its subsidiaries, is prohibited from engaging in certain tie-in arrangements in connection with any extension of credit or provision of any property or services. Under longstanding policy of the Federal Reserve Board, a bank holding company is expected to act as a source of financial strength for its subsidiary banks and to commit resources to support such banks. As a result of such policy, the Corporation may be required to commit resources to its subsidiary banks in circumstances where it might not do so absent such policy. There are also various requirements and restrictions imposed by the laws of the United States and the State of New York and by regulations of the Federal Reserve System, of which the Bank is a member, affecting the operations of the Corporation, the Bank and their subsidiaries, including the requirement to maintain reserves against deposits, restrictions relating to the nature and amount of loans that may be made by the Bank, the interest that may be charged thereon and restrictions relating to investments, branching and other activities of the Corporation, the Bank and their subsidiaries. RNYSC is subject to supervision and regulation by the Federal Reserve Board, the Securities and Exchange Commission, the New York Stock Exchange, the National Association of Securities Dealers and the Commodity Futures Trading Commission. RAM is also subject to supervision and regulation by the Federal Reserve Board, the Securities and Exchange Commission and the Commodity Futures Trading Commission. As a registered investment adviser and a commodity trading adviser, RAM is also subject to the provisions of the Investment Advisers Act of 1940 and the Commodity Exchange Act, respectively. Both RNYSC and RAM are subject to the rules and regulations applicable to broker-dealers and investment advisers, respectively, in each state in which they operate. Capital Requirements The Corporation is subject to risk-based capital requirements for bank holding companies. The requirements provide that the minimum ratio of total capital to risk-weighted assets (including certain off-balance sheet activities, such as standby letters of credit and derivative instruments) be equal to 8.0% of risk- weighted assets. Of this amount, at least half must be composed of common equity, minority interest, noncumulative perpetual preferred stock and a limited amount of cumulative perpetual preferred stock, less goodwill ("Tier 1 capital"). The remainder may consist of certain amounts of subordinated debt and cumulative preferred stock and a limited amount of the allowance for loan losses ("Tier 2 capital"). A final rule that became effective in 1993 requires the deduction of intangible assets recorded prior to February 19, 1992, purchased mortgage servicing rights and purchased credit card relationships, subject to certain minimums. In addition to the risk-based capital requirements described above, the Corporation must maintain a minimum leverage ratio of 3% (defined as Tier 1 capital divided by consolidated quarterly average total assets). Bank holding companies that are experiencing significant growth or are actively seeking acquisitions are expected to maintain a leverage ratio of 4% to 5%. The Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA"), which became law on December 19, 1991, further requires the federal bank regulatory agencies bi-annually to review risk-based capital standards to ensure that they adequately address interest rate risk, concentration of credit risk and risks from non-traditional activities. Regulations incorporating concentrations of credit risk and risk from non-traditional activities into bank capital requirements were proposed on March 29, 1993 and reproposed in modified form on February 22, 1994 and are currently being reviewed by the Corporation. The Corporation does not believe that the proposed regulations will materially affect the Corporation's level of Tier 1 capital. FDICIA also revised bank regulatory structures embodied in several other federal banking statutes, required the federal banking regulators to set five capital levels ranging from "well capitalized" to "critically undercapitalized", authorized federal banking regulators to intervene in connection with the deterioration of a bank's capital level, placed limits on real estate lending and tightened audit requirements. If a banking institution fails to meet the capital guidelines, banking regulators could require it to raise additional capital to meet such capital requirements. An "undercapitalized" bank must develop a capital restoration plan approved by the appropriate bank regulators and the bank's compliance with such plan must be guaranteed by its parent holding company. The liability of the parent holding 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 capital plan and is accorded a priority, in the event of the bankruptcy of the parent holding company, over the parent's general unsecured creditors. Legislation enacted as part of the Omnibus Budget Reconciliation Act of 1993 provides for a preference in right of payment of certain claims realized in the "liquidation or other resolution" of any depository institution insured by the FDIC. That statute requires claims to be paid in the following order of priority: (i) administrative expenses of the receiver; (ii) any deposit liability of the institution; (iii) any other general or senior liability of the institution (which is not an obligation described in clause (iv) or (v) below); (iv) any obligation subordinated to depositors or general creditors (which is not an obligation described in clause (v) below); and (v) any obligation to shareholders or members (including any depository institution holding company or any shareholder or creditor of such company). For purposes of the statute, deposit liabilities would include any deposit payable at an office of the insured depository institution located in the United States, but would not include any deposit payable at an office outside the United States or any international banking facility deposit. The banking supervisory authorities in the Group of Ten countries and Luxembourg adopted a framework for standardizing bank capital adequacy requirements in the international banking system. The framework establishes minimum levels of capital for international banks and ties the capital a bank must hold to its risk-weighted asset mix. The Corporation and certain of its banking subsidiaries are located in such countries and are subject to the framework's requirements, as implemented by the appropriate local supervisory authority. Insurance Premiums FDICIA also revised sections of the Federal Deposit Insurance Act affecting bank regulation, deposit insurance and funding of the Bank Insurance Fund ("BIF") administered by the FDIC. Among the significant revisions that could have an impact on the Corporation is the authority granted the FDIC to impose special assessments on insured depository institutions to repay FDIC borrowings from the United States Treasury or other sources and to establish semiannual assessments on BIF member banks so as to maintain the BIF at the designated reserve ratio defined in FDICIA. On September 15, 1992, the FDIC adopted final rules that revised the assessments paid by insured depository institutions for deposit insurance. The amended regulations increased the deposit insurance assessment for certain members of the BIF effective for the first semiannual period of 1993, and thereafter, and adopted a transitional risk-based deposit insurance assessment system. Under the FDIC's plan, the assessment of 23 cents per $100 of domestic deposits for all depository institutions was changed, effective January 1, 1993, to an assessment based on a depository institution's assessment risk classification depending on whether it is considered "well capitalized", "adequately capitalized" or "undercapitalized" and on certain supervisory evaluations of the institution as "healthy", cause for "supervisory concern" and cause for "substantial supervisory concern" (designated as supervisory subgroups "A", "B" and "C", respectively, for reference purposes). Under the assessment rate schedule adopted, a well capitalized bank in subgroup "A" will be assessed at the current rate of 23 cents per $100 of domestic deposits. For purposes of the FDIC's deposit insurance assessment rules, an institution will be 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 Tier 1 leverage ratio of at least 5%; "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 Tier 1 leverage ratio of at least 4%; and "undercapitalized" if it does not meet either of the foregoing standards. FDICIA generally limits the FDIC's ability to protect all deposits, including those exceeding the $100,000 insurance limit and foreign deposits. The legislation also provides that only "well capitalized banks" and "adequately capitalized banks" can use brokered deposits. "Adequately capitalized banks" can accept brokered deposits only if they first obtain waivers from the FDIC and they cannot pay above-market rates on such deposits. "Well capitalized banks" and "adequately capitalized banks" can insure accounts on a pass-through basis established under certain qualified employee benefit plans. Miscellaneous Significant provisions of FDICIA require federal banking regulators to draft standards in a number of other areas to assure bank safety and soundness, including internal controls, information systems and internal audit systems, credit underwriting, asset growth, compensation, loan documentation and interest rate exposure. FDICIA requires the regulators to establish maximum ratios of classified assets to capital, and minimum earnings sufficient to absorb losses without impairing capital. The legislation also contains provisions which tighten independent auditing requirements, restrict the activities of state-chartered banks, amend various consumer banking laws, limit the ability of "undercapitalized banks" to borrow from the Federal Reserve's discount window, and require federal banking regulators to perform annual on-site bank examinations and set standards for real estate lending. To date, the banking regulators have issued proposed regulations and in some cases adopted final regulations under FDICIA covering (i) real estate lending standards, requiring depository institutions to develop and implement internal procedures, including setting specific loan-to-value ratios for various types of real estate loans; (ii) revisions to the risk-based capital rules to account for interest rate risk, concentration of credit risk, and the risks posed by "non-traditional activities"; (iii) rules requiring depository institutions to develop and implement internal procedures to evaluate and control credit and settlement exposure to their correspondent banks; (iv) risk-based FDIC insurance premiums; (v) rules prohibiting, with certain exceptions, state banks from making equity investments of the types and amount not permissible for national banks; and (vi) rules addressing various "safety and soundness" issues, including operations and managerial standards, standards for asset quality, earnings and stock valuations, and compensation standards for the officers, directors, employees and principal shareholders of the depository institution. The Corporation cannot, at this stage, determine what impact, if any, such rules and regulations may have on its financial condition or operations. It is anticipated that such rules and regulations and other provisions of FDICIA will result in increased costs for the banking industry due to increased FDIC assessments and in more limitations on activities by all but the most well capitalized depository institutions. It should be noted that the Financial Institutions Reform, Recovery and Enforcement Act of 1989 ("FIRREA") provides for cross-guarantees of the liabilities of insured depository institutions pursuant to which any bank or savings association subsidiary of a bank holding company may be required to reimburse the FDIC for any loss or anticipated loss to the FDIC that arises from a default of any of such holding company's subsidiary banks or savings associations or for assistance provided by the FDIC to such an institution in danger of default. The domestic banking subsidiaries of the Corporation are subject to such a cross-guarantee. The federal International Lending Supervision Act of 1983 (the "Act") requires banking institutions to maintain a special reserve out of current income against certain international assets. A special reserve will be required if the relevant bank regulatory agency determines that the quality of the assets has been impaired by a protracted inability of public or private borrowers in a foreign country to make payments on their external indebtedness or that no definite prospects exist for orderly restoration of debt service. To date, the foregoing provisions of the Act have not affected the reserves maintained by the Corporation. It is not possible to predict the extent to which the provisions of the Act requiring the establishment of special reserves will affect the Corporation's earnings in the future. Dividends The Corporation's ability to pay dividends is dependent upon its receipt of dividends from its subsidiaries and on its earnings from investments. In 1990, the Comptroller of the Currency and the Federal Reserve Board, regarding state-chartered banks that are members of the Federal Reserve System, enacted amendments to the restrictions relating to the way in which national banks calculate their dividend payment capacity, aligning the treatment of loan loss reserves for dividend payment purposes with regulatory reporting standards. The current rule provides, among other things, that national banks cannot include provisions to their loan loss reserves as part of income when calculating the amount of dividends they may pay. National banks are also required to use only capital surplus that represents earnings, not paid-in capital, when calculating permissible dividends. The approval of the Comptroller of the Currency is required if the total of all dividends declared or proposed to be declared by the Bank in any calendar year exceeds the Bank's net profits, as defined, for that year combined with its retained net profits for the preceding two calendar years. The Comptroller of the Currency also has authority under the Financial Institutions Supervisory Act to prohibit a national bank from engaging in what, in his opinion, constitutes an unsafe or unsound practice in conducting its business. The payment of dividends could, depending upon the financial condition of the Bank, be deemed to constitute such an unsafe or unsound practice. Similarly, in respect of RBS, New York State banking law requires the approval of the Superintendent of Banks if the total of all dividends declared were to exceed net profits as defined. In addition, the agreement pursuant to which the Corporation acquired RBS provides that dividends may not be paid by RBS if its primary or total capital is, or as a result of any such dividend payment would be, below the minimum amounts required by applicable regulations. Based on the Bank's and RBS' financial position at December 31, 1993, under the foregoing formulae, the Bank may declare dividends in 1994 without approval of the Comptroller of the Currency, and RBS could declare aggregate dividends in 1994, without regulatory approval, of approximately $187 million and $19 million, respectively, plus an additional amount equal to their respective net profits for 1994 up to the date of any dividend declaration. There are no regulatory or contractual restrictions on Factors' ability to pay dividends to the Corporation. EFFECT OF GOVERNMENTAL POLICIES The earnings of the Corporation, the Bank and RBS are affected not only by general economic conditions, both domestic and foreign, but also by legislative and regulatory changes which, among other things, affect lending rates and costs and by the monetary and fiscal policies of the United States government, its agencies, including the Federal Reserve Board, and of foreign governments and international agencies. The policies of the various governmental authorities influence to a significant extent the growth of bank loans, investments and deposits. The nature and impact of future changes in such monetary and fiscal policies on the Corporation's, the Bank's and RBS' future business and earnings are not predictable. Item 2. Item 2. Properties The Corporation has its principal offices in its world headquarters building at 452 Fifth Avenue, New York, New York 10018, which is owned and occupied principally by the Bank, and also owns properties in Miami, Florida, Buenos Aires, Argentina, Santiago, Chile, Montevideo, Uruguay, Milan, Italy and London, England, which house the Bank's offices in those locations. The Bank and RBS also own other properties in New York City, which are principally occupied by branches. All of the remainder of the Corporation's offices and other facilities throughout the world are leased. Item 3. Item 3. Legal Proceedings The nature of its business generates a certain amount of litigation against the Corporation involving matters arising in the ordinary course of the Corporation's business. None of the legal proceedings currently pending or threatened to which the Corporation or its subsidiaries is a party or to which any of their properties are subject will have, in the opinion of management of the Corporation, a material effect on the business or financial condition of the Corporation or its subsidiaries. Item 4. Item 4. Submission of Matters to a Vote of Security Holders No meetings of security holders were held during the fourth quarter of 1993. Item 10. Directors and Executive Officers of the Corporation (a) Names, Ages and Positions The names, ages and positions of the executive officers of the Corporation are as follows: Each of the above executive officers is a member of the respective Management Executive Committees of the Corporation and the Bank, except for Peter A. Cohen who is not a member the Bank's Management Executive Committee. The term of each such officer is for a year, which runs from the annual meeting of the Board of Directors of the Corporation and the Bank, respectively, following the Annual Meeting of Stockholders of each, until the next such Annual Meeting or until removed by the respective Board of Directors. Each of the above officers' service in his current position is indicated in his biography below. Mr. Edmond J. Safra is the Honorary Chairman of the Board of Directors of the Corporation and the Bank. Mr. Safra is Chairman of the Board of Republic National Bank of New York (Suisse) S.A., the Bank's affiliate in Geneva, Switzerland. In addition, Mr. Safra is a principal stockholder of the Corporation, owning approximately 28.4% of the Corporation's outstanding Common Stock, as of March 8, 1994, through his ownership of all the outstanding shares of Saban S.A., which owns directly and indirectly 14,959,436 shares of the Corporation's Common Stock and of another corporation which owns 29,776 shares of the Corporation. The advice of Mr. Safra, as the principal stockholder, is often sought by the Corporation with respect to major policy decisions and other significant matters. (b) Biographies of Corporation's Executive Officers The biographical information for the past five years for the above executive officers of the Corporation is as follows: Walter H. Weiner has been a director and Chairman of the Board of the Corporation and the Bank and a director of RBS for over five years. Mr. Weiner also serves as a member of RBS' Compensation and Benefits, Credit Review and Executive Committees. Jeffrey C. Keil has been a director and President of the Corporation and a director and a Vice Chairman of the Board of the Bank and a director of RBS for over five years. Mr. Keil also serves as a member of RBS' Executive Committee. Peter A. Cohen has been a director and a Vice Chairman of the Corporation since November 1992. Since such time he also has been Chairman of RNYSC. From February 1990 to November 1992, Mr. Cohen was a consultant, principally with Andrew Lauren & Co. Prior to February 1990, Mr. Cohen was Chairman and Chief Executive Officer of Shearson Lehman Hutton, Inc. Cyril S. Dwek has been a director of the Corporation and the Bank and a Vice Chairman of the Corporation and a Vice Chairman of the Board of the Bank in charge of the International Department for over five years. Mr. Dwek has been a director of RBS since April 1990. Ernest Ginsberg has been a director and a Vice Chairman and General Counsel of the Corporation and a director and a Vice Chairman of the Board of the Bank for over five years. Until July 1990, he had also been General Counsel of the Bank for over five years. Mr. Ginsberg has been a director of RBS and a member of its Executive Committee for over five years. Vito S. Portera has been a director of the Corporation for over five years and a Vice Chairman of the Corporation since April 1989. He has been a director and a Vice Chairman of the Board of the Bank and RBS for over five years. Mr. Portera also has been Chairman of the Board of Republic International Bank of New York, the Miami, Florida Edge Act subsidiary of the Bank, for over five years. Dov C. Schlein has been a director and a Vice Chairman of the Corporation and a director and President of the Bank and a director of RBS for over five years. Mr. Schlein also serves as a member of RBS' Compensation and Benefits and Executive Committees. Nathan Hasson was elected a director and appointed a Vice Chairman of the Corporation in January 1993. He has been a director and a Vice Chairman of the Board of the Bank for over five years in charge of its Financial Management Group. He also serves as Treasurer of the Bank and RBS. Mr. Hasson has been a director of RBS since April 1990. PART II Item 5. Item 5. Market for the Registrant's Common Equity and Related Stockholder Matters Information on the market prices of the Corporation's Common Stock, dividend payments on the Common Stock, the number of stockholders of record and related matters may be found in the section entitled "Security Market Information" on page 49 in the Corporation's 1993 Annual Report to Stockholders which is hereby incorporated herein by reference. Item 6. Item 6. Selected Financial Data Data for each of the years in the five-year period ended December 31, 1993 on the Corporation's operating income, net income, including earnings per share data, assets, long-term debt, dividends and other relevant matters are presented in the section entitled "Selected Financial Data" on pages 82 and 83 in the Corporation's 1993 Annual Report to Stockholders which is hereby incorporated herein by reference. Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations The section entitled "Management's Discussion and Analysis" on pages 28 through 49 in the 1993 Annual Report to Stockholders is hereby incorporated herein by reference. Item 8. Item 8. Financial Statements and Supplementary Data The financial statements of the Corporation as of December 31, 1993 and 1992 and for each of the years in the three year period ended December 31, 1993 are found on pages 50 through 53 in the 1993 Annual Report to Stockholders and, together with the accompanying notes thereto found on pages 55 through 76 and the Independent Auditors' Report on Financial Statements found on page 77 in such report, are hereby incorporated herein by reference. Selected quarterly data presented on page 80 in such Annual Report in the section entitled "Selected Financial Data" are also hereby 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 See Item 10 in Part I of this Report for information on executive officers of the Corporation. Information concerning the directors of the Corporation and nominees for election as directors thereof is presented on pages 2 through 5 in the section entitled"Election of Directors" in the Corporation's definitive Proxy Statement dated March 16, 1994 for its 1994 Annual Meeting of Stockholders filed pursuant to Section 14 of the Securities Exchange Act of 1934, which is hereby incorporated herein by reference. Item 11. Item 11. Executive Compensation Information concerning compensation of executive officers of the Corporation is presented in the section "Compensation of Directors and Executive Officers - Executive Officers" found on pages 9 through 18 under "Election of Directors" in the Corporation's definitive Proxy Statement dated March 16, 1994 for its 1994 Annual Meeting of Stockholders filed pursuant to Section 14 of the Securities Exchange Act of 1934, which is hereby incorporated herein by reference. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management Information concerning the number of shares of Common Stock of the Corporation beneficially owned by certain owners and management is presented on pages 2 through 5 in the section "Election of Directors" and page 21 in the section entitled "Ownership of Voting Securities" in the Corporation's definitive Proxy Statement dated March 16, 1994 for its 1994 Annual Meeting of Stockholders filed pursuant to Section 14 of the Securities Exchange Act of 1934, which is hereby incorporated herein by reference. Item 13. Item 13. Certain Relationships and Related Transactions Information concerning transactions between the Corporation and executive officers and directors and certain related persons is presented in the section "Transactions with Management and Related Persons" found on pages 19 and 20 under "Election of Directors" in the Corporation's definitive Proxy Statement dated March 16, 1994 for its 1994 Annual Meeting of Stockholders filed pursuant to Section 14 of the Securities Exchange Act of 1934 and in Note 17 of the Notes to Consolidated Financial Statements accompanying the Corporation's financial statements in the 1993 Annual Report to Stockholders, both of which are hereby incorporated herein 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 (i) Financial Statements of Republic New York Corporation and Subsidiaries, included in the Annual Report to Stockholders for the year 1993 (on pages indicated below) and incorporated herein by reference: Page Consolidated Statements of Condition, December 31, 1993 and 1992................................................ 50 Consolidated Statements of Income, Years ended December 31, 1993, 1992 and 1991................................. 51 Consolidated Statements of Changes in Stockholders' Equity, Years ended December 31, 1993, 1992 and 1991.... 52 Consolidated Statements of Cash Flows, Years ended December 31, 1993, 1992 and 1991........................ 53 Notes to Consolidated Financial Statements.............. 55 Independent Auditors' Report on Financial Statements.... 77 (ii) Financial Statement Schedules of Republic New York Corporation (Parent Company Only) are shown in the notes to the respective financial statements. See Note 19 of the Notes to Consolidated Financial Statements accompanying the Corporation's financial statements in the 1993 Annual Report to Stockholders which is hereby incorporated herein by reference. (iii) Exhibits 3(a) Articles of Incorporation as amended through April 21, 1993. (b) By-Laws of the Corporation as amended through July 20, 1988. (1) 4(a) Articles Supplementary creating a series of Cumulative Preferred Stock, Floating Rate Series B dated March 7, 1984. (2) (b) Articles Supplementary creating a series of Dutch Auction Rate Transferable Securities, Preferred Stock, Series A and Series B, dated March 27, 1986. (2) (c) Articles Supplementary creating a series of Money Market Cumulative Preferred Stock, dated July 22, 1987. (2) (d) Articles Supplementary creating a series of Remarketed Preferred Stock, dated July 29, 1987. (2) (e) Articles Supplementary creating a series of $3.375 Cumulative Convertible Preferred Stock, dated May 14, 1991. (2) (f) Articles Supplementary creating a series of $1.9375 Cumulative Preferred Stock, dated February 26, 1992. (2) (g) Indenture, dated as of May 1, 1986, between Republic New York Corporation and Manufacturers Hanover Trust Company, as Trustee, for the issuance of the Corporation's 8 3/8% Notes Due 1996. (3) (h) Indenture dated January 15, 1987 between Republic New York Corporation and Bankers Trust Company, as Trustee, for the issuance of the Corporation's Putable Capital Notes. (4) (i) Standard Multiple - Series Indenture Provisions, dated as of May 15, 1986. (5) (j) Senior Indenture, dated as of May 15, 1986, between Republic New York Corporation and Manufacturers Hanover Trust Company, as Trustee. (5) (k) First Supplemental Indenture to Senior Indenture, dated as of May 15, 1991. (6) (l) Second Supplemental Indenture to Senior Indenture, dated as of April 15, 1993. (7) (m) Subordinated Indenture dated as of May 15, 1986, between Republic New York Corporation and Bankers Trust Company, as Trustee. (8) (n) First Supplemental Indenture to Subordinated Indenture, dated as of May 15, 1991. (6) (o) Second Supplemental Indenture to Subordinated Indenture, dated as of April 15, 1993. (7) (p) Subordinated Indenture, dated as of October 15, 1992, between Republic New York Corporation and Citibank, N.A., as Trustee. (9) (q) First Supplemental Indenture to 1992 Subordinated Indenture, dated as of April 15, 1993. (7) (r) Form of Senior Security. (10) (s) Form of Subordinated Security. (10) 10(a) Copy of agreement dated May 27, 1988 among Vito S. Portera and Republic New York Corporation and Republic National Bank of New York. (11) (b) Amended and Restated Deferral Agreement dated December 31, 1993 between Walter H. Weiner and Republic New York Corporation. (c) Form of Amended and Restated Deferral Agreement. (d) Form of Deferral Agreement. (e) 1994 Performance Based Incentive Compensation Plan (as approved by the Board of Directors of the Corporation on January 19, 1994 subject to stockholder approval). (12) 11 Computation of Earnings Per Share of Common Stock. 12 Calculation of Ratios of Earnings to Fixed Charges - Consolidated. 13 Annual Report to Stockholders for year 1993 (to the extent incorporated herein by reference). 21 Subsidiaries of the Corporation. 23 Consents of Experts and Counsel. (1) Incorporated herein by reference to such Exhibit filed with the Corporation's Annual Report on Form 10-K for its fiscal year ended December 31, 1988 (Exhibit 3(b)). (2) Filed herewith in Exhibit 3(a). (3) Incorporated herein by reference to such Exhibit filed with the Corporation's Registration Statement on Form S-3, No. 33-5074 (Exhibit 4.2). (4) Incorporated herein by reference to such Exhibit filed with the Corporation's Annual Report on Form 10-K for its fiscal year ended December 31, 1987 (Exhibit 4(y)). (5) Incorporated herein by reference to such Exhibits filed with the Corporation's Registration Statement on Form S-3, No. 33-5804 (Exhibits 4(a) and 4(b), respectively). (6) Incorporated herein by reference to such Exhibits filed with the Corporation's Registration Statement on Form S-3, No. 33-40703 (Exhibits 4(c) and 4(e), respectively). (7) Incorporated herein by reference to such Exhibits filed with the Corporation's Registration Statement on Form S-3, No. 33-49507, Amendment No. 1 (Exhibits 4(d), 4(g) and 4(i), respectively). (8) Incorporated herein by reference to such Exhibit filed with the Corporation's Current Report on Form 8-K dated February 8, 1989 (Exhibit 4(c)). (9) Incorporated herein by reference to such Exhibit filed with the Corporation's Registration Statement on Form S-3, No. 33-48651, Post-Effective Amendment No. 2 (Exhibit 4(f)). (10) Incorporated herein by reference to such Exhibits filed with the Corporation's Current Report on Form 8-K dated August 6, 1992 (Exhibits 4(h) and 4(i), respectively). (11) Incorporated herein by reference to such Exhibits filed with the Corporation's Annual Report on Form 10-K for its fiscal year ended December 31, 1991 (Exhibit 10(b)). (12) Incorporated herein by reference to such Exhibit filed with the Corporation's definitive Proxy Statement dated March 16, 1994 (Exhibit 99). (b)The following reports on Form 8-K were filed during the last quarter of the annual period covered by this Report: (i) Report dated October 21, 1993 regarding the issuance of $250 million aggregate principal amount of the Corporation's 5 7/8% Subordinated Notes due 2008, and filing the Corporation's press release announcing Results for Third Quarter and Nine Month Period Ended September 30, 1993. (ii) Report dated October 22, 1993 regarding the issuance of $250 million aggregate principal amount of the Corporation's 5 7/8% Subordinated Notes due 2008, and filing the Corporation's press release announcing Results for Third Quarter and Nine Month Period Ended September 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. Dated: March 29, 1994 REPUBLIC NEW YORK CORPORATION By: WALTER H. WEINER --------------------------- (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. REPUBLIC NEW YORK CORPORATION FORM 10-K EXHIBIT INDEX Exhibit No. Description - ----------- ----------- 3(a) Articles of Incorporation as amended through April 21, 1993. 10(b) Amended and Restated Deferral Agreement dated December 31, 1993 between Walter H. Weiner and Republic New York Corporation. (c) Form of Amended and Restated Deferral Agreement. (d) Form of Deferral Agreement. 11 Computation of Earnings per Share of Common Stock. 12 Calculation of Ratios of Earnings to Fixed Charges - Consolodated. 13 Annual Report to Stockholders for year 1993 (to the extent incorporated herein by reference). 21 Subsidiaries of the Corporation. 23 Consents of Experts and Counsel.

764037_1993.txt

764037_1993

1993

764037

Item 1 Business (a) General Development of Business Encore Computer Corporation ("Encore" or the "Company"), a worldwide company headquartered in Fort Lauderdale, Florida, is a supplier of open, scalable computer systems for data center and mission-critical applications. The Company was founded in 1983 as a Delaware corporation. With sales offices and distributors throughout the United States, Canada, Europe and the Far East, the Company designs, manufactures, distributes and supports mainframe class computer systems for on-line transaction processing and real-time applications. Many of the company's product lines employ Encore's patented MEMORY CHANNEL technology. Encore's alternative mainframe product, known as the Infinity 90 Series, exceeds proprietary mainframe computing requirements through cost-effective, massively scalable computer technology. The real-time product sets including the Infinity R/T and ENCORE RSX, provide optimum solutions for complex, real- time processing applications. In 1989, Encore enhanced its worldwide marketing presence when it acquired the assets and assumed the liabilities of the Gould Electronics Inc. (formerly Gould Inc.) Computer Systems Division (the "Computer Systems Business"), a business that was significantly larger than the Company itself. Since the acquisition, the Company has integrated the best of both business' technologies into a single, high performance open system architecture. However, as more fully discussed in Management's Discussion and Analysis of Financial Condition and Results of Operations and in Notes G and J of the Notes to Consolidated Financial Statements, since the acquisition of the Computer Systems Business, the Company has been unable to achieve a level of profitability and has sustained significant losses in all years since the acquisition. Japan Energy Corporation ("Japan Energy"; formerly Nikko Kyodo Co., Ltd.) and its wholly owned subsidiaries Gould Electronics Inc.("Gould") and EFI International, Ltd. ("EFI") (or collectively the "Japan Energy Group") have been the principal sources of the Company's financing since the acquisition. The Japan Energy Group has provided the Company with its revolving credit facility, provided certain loan guarantees and entered into various exchanges of indebtedness for preferred stock. The Company is and will remain dependent on the continued financial support of the Japan Energy Group until it achieves a state of continued profitability. Should Encore be unsuccessful in securing additional future financing from the Japan Energy Group as it is required, it is likely the Company will be unable to settle its liabilities on a timely basis. Approximately 37% of 1993 revenues were derived through sales to various U.S. government agencies. In certain cases, U.S. government agencies, such as the Department of Defense, are precluded from awarding contracts requiring access to classified information to foreign owned or controlled companies. As discussed above, the principal source of both debt and equity financing for the Company has been through Japan Energy (a Japanese corporation) and certain of its wholly owned subsidiaries. In light of various U.S government limitations on the ability of certain agencies to do business with foreign owned or controlled companies, Encore and Japan Energy have worked together to comply with all U.S. government requirements. In this connection, as indicated by the terms of the Series A, Series B, Series D, and Series E Preferred Stock, Japan Energy has agreed to accept certain terms and conditions relating to its equity security investments in the Company, including the limitation of voting rights of its shares, limitations on the number of seats it may have on the board of directors and restrictions with regards to converting its Preferred shares into Common Stock. Both the United States Defense Investigative Service ("DIS") and the Committee on Foreign Investment in the United States ("CFIUS") have reviewed the relationship between the Company and the Japan Energy Group under the United States Government requirements relating to foreign ownership, control or influence. Neither organization has indicated they have any objections. Encore is committed to complying with all U.S. government requirements regarding foreign ownership and control of U.S. companies. At this time, the Company is unaware of any circumstances that would adversely impact the determinations of either DIS or CFIUS. However, should either DIS or CFIUS change its opinion of the nature of the Japan Energy Group's influence or control on the Company, a significant portion of its future revenues realized through U.S. government agencies could be jeopardized. (b)(c) Industry Segments and Narrative Description of Business GENERAL The Company operates in a single industry segment, the information technology industry, which includes the design, manufacture, sale and service of computer hardware, software, and related peripheral equipment and products on a worldwide basis. Encore offers five principal families of computer systems targeted at certain niches within the information processing and real-time computing marketplaces. The product families are: (i) the Infinity 90 Series, (ii) the Infinity R/T Series, (iii) the Infinity SP (iv) the Encore 90 Series and (v) the Encore RSX line of real-time computers. Additionally, the Company continues to support its prior generation CONCEPT/32 product line. The Infinity 90 Family offers a powerful range of air-cooled, massively scalable, system solutions that exceed the performance of traditional mainframes at a fraction of their cost. Infinity 90 systems solve large or complex mainframe computing challenges by offering an array of easily expandable system and subsystem configurations for an enterprise-wide computing solution. With essentially unlimited configuration flexibility the Infinity 90 enables the connection of multiple processors and I/O subsystems, which packaged together in large or complex configurations, creates a powerful solution for demanding on-line transaction processing applications. The Infinity R/T family is a family of high-performance real-time computer systems. The term "real-time" defines an environment in which a computer interfaces with a physical occurrence in such a way that it can acquire and analyze data and then, on the basis of that data, respond to the occurrence so rapidly that virtually no time passes between acquisition of data and response to the occurrence. These systems incorporate real- time UNIX and an architecture based on second generation RISC processors in a symmetric multiprocessor design featuring deterministic performance with very large cache stores, extremely high-speed buses and a large standard base memory. The systems provide for integral multinode clustering capability and certain models support software which allows a single system view of the multiple compute and I/O elements of a large configured system. The Infinity SP leverages the Infinity 90 series of systems by combining its architectural elements with specialized software to provide a comprehensive set of storage products for solving mainframe storage requirements. Infinity SP products are designed utilizing new technologies that meet or exceed those used in existing mainframe storage solutions. These include the use of commodity microprocessors, high-performance/high-density 3 1/2 inch disk drive technologies as well as high-availability and fault-tolerant designs utilizing various levels of RAID (Redundant Arrays of Inexpensive Disks). Existing Encore Infinity SP storage subsystems are capable of delivering storage solutions with available capacities from 100 gigabytes to multiple terabytes and can provide direct attached storage devices (DASD) for IBM compatible mainframes as well as being concurrently capable of providing shared storage facilities to open systems environments. The Encore 90 Family consisting of the 91 Series and the 93 Series provides a range of computer technology with an open systems architecture for time-critical applications. These symmetric multiprocessor systems use industry-standard hardware platforms, I/O interfaces, operating systems and application software to achieve deterministic real-time capability. The Encore 91 Series provides the computing power necessary to meet the needs of applications from the low to midpoint of the performance range while the Encore 93 Series satisfies the more demanding application requirements at the high end of the performance spectrum. Encore RSX computer systems, based on the proprietary Mapped Programming Executive (MPX-32) operating system, are object code compatible throughout the product line and are designed to run time critical, real-time applications. Encore RSX systems provide capability for real-time event response, powerful computation, high volume data input/output and easy expansion. Because of its object code compatibility, the Encore RSX allows customers to easily migrate their existing applications developed on earlier generations of the Company's product offerings to today's technology. This preserves the customer's investment in its application software. - --------------------------------------------------------------------------- NOTE: The following products are trademarks of Encore Computer Corporation: Infinity R/T, MEMORY CHANNEL, Encore RSX, Infinity 90 Series, Encore 90 Series, Encore 91 Series, Encore 93 Series, MPX-32, and UMAX V R/T. CONCEPT/32 is a registered trademark of the Company. - --------------------------------------------------------------------------- MARKETS AND CUSTOMERS As discussed below, Encore participates in portions of both the information processing and real-time computing marketplaces. Information Processing The Company has introduced its massively scalable, symmetric multiprocessor-based open systems products into four new information processing markets: (i) On-Line Transaction Processing (OLTP) and Decision Support Systems (DSS), (ii) Mainframe Replacement, (iii) Interactive Information Network Servers and Switches and (iv) Data Storage. Encore's strategy is to provide a system that can continue to support a user's existing critical applications while allowing the user to re- engineer some or all of those applications to run in an open system environment at a much lower cost than traditional mainframes. During the 1960s, mainframe computers provided batch processing solutions for its information system customers. In the 1970s, minicomputers became the common computing paradigm. Then in the 1980s, the computing trend shifted towards PCs and workstations with data base management software. Due to the proliferation of data from workstations and PCs, many large commercial customers now require the immediate interactive processing of available data for enterprise-wide computing rather than the batch processing approach of traditional mainframes. Accordingly, today the market has begun to migrate to a client/server processing model served by both (i) mainframes and mainframe alternatives for on-line transaction processing and data base applications, and (ii) massively parallel systems for numerically intensive applications. The systems of the 90s will be characterized by their ability to meet the user's increasing computational power and I/O requirements as well as the ability to move customers easily from a proprietary technology environment into the open systems environment. Encore serves the Information Systems market with the Infinity 90 Series of computer systems. These systems are well suited to a wide range of applications including On-Line Transaction Processing (OLTP), client/server system management, data base management, decision support systems, and interactive information networks as these computer systems offer the high computational power, I/O bandwidth, and versatile communications required by such applications. The products are most effectively targeted at Fortune 500 and other large organizations such as U.S. government agencies with a need for cost-effective computing power to handle both existing and new centralized computing applications. Examples of successful market penetration of the Company's products include the selection of the Infinity 90 as part of a multi-million dollar contract issued to a government prime contractor for consolidating multiple mainframe data processing centers within the U.S. Air Force Materiel Command over the next five years. Additionally, Encore has signed agreements with several systems integrators in the United States, the Middle East and the Pacific Rim. Additionally, within the information processing market, Encore provides IBM mainframe system-compatible data storage products using high performance technologies leveraged from its Infinity 90 product line. Data storage demands within the information processing market are expanding due to increased requirements of capturing business data as well as storing new forms of information (e.g. document images, sound and video storage). Accordingly, the mainframe storage marketplace is undergoing changes similar to those of the information processing marketplace. These changes include the need for faster, denser and more cost effective storage solutions to reduce demands on existing facilities and shrinking mainframe data processing budgets. Today's data processing environments have developed a strong strategic requirement to leverage technology advances being applied to the open systems environment. The Company's Infinity Storage Product (Infinity SP) provides an innovative new approach to solving the storage processing requirements of today's increasingly complex mainframe environments. Many of the same technologies that Encore uses in its alternative mainframe products (Infinity 90) address these changes and are directly applicable to both the existing and emerging storage marketplace. These technologies have been optimized to provide reliable high performance I/O subsystems while being readily suited to addressing the needs of both mainframe and open systems environments. Real-Time The Company's real-time computer systems, the Infinity R/T Family, the Encore 90 Family and the Encore RSX, are used for the acquisition, processing, and interpretation of data primarily in four markets: (i) simulation, (ii) range and telemetry, (iii) energy, and (iv) transportation. Simulation is the Company's single largest real-time market segment. Encore products are widely used in simulators that duplicate complex situations in controlled environments. The Company's installed simulation systems are used to safely and economically train commercial and military personnel to operate and maintain complex systems such as space vehicles, aircraft, weapons systems, ships, ground-based vehicles, and nuclear power plants. In the range/telemetry market segment, the Company's real- time systems are used for the acquisition and processing of data by flight, space, sea, and ground ranges. These systems are used in the test and evaluation of state-of-the-art military and commercial aircraft, space vehicles, ground equipment, and instrumentation systems. Encore also competes in the power and electric utility market segments of the energy marketplace where the Company's real-time systems typically acquire, monitor and provide supervisory and can provide closed loop control in energy management, power plant monitoring and control, and power plant simulation systems. This is done at both nuclear and fossil fuel plants. The Company's systems monitor the transmission and distribution of electrical power from generation to substation to end use and facilitates the training of power plant operators by putting them in simulated environments to prepare them for emergency situations. Within the energy marketplace as a whole, Encore systems provide the same real-time capability of data acquisition and control to other market segments such as seismic, oil exploration, and off-shore oil platforms. Transportation is one of Encore's emerging markets. The Company's products are currently installed in rapid transit/metro rail and marine transportation applications. Strategically, the Company is focusing on other developing niches within this marketplace including intelligent vehicular highway systems (IVHS). The Company's real-time customers include original equipment manufacturers (OEMs) and systems integrators who combine Encore's products with other hardware and/or application software for resale to end users. The Company also sells its products to end users who require a compatible range of high performance systems which are used as the basis for major internal installations. The real-time customer base is technology and life cycle cost driven and constantly in need of increased performance at lower costs. Encore sales efforts are concentrated on "program" business where typically large contracts are awarded with multiple systems scheduled for delivery over an extended period of years, including continued demand for upgrades and spare parts as well as ongoing maintenance. Often an initial system is shipped to a systems integrator who may spend from six to eighteen months developing software and connecting other equipment to the system before final delivery to the end user. PRODUCTS AND SERVICES During 1993, net sales of the Company's Infinity 90, Infinity R/T, Encore RSX and Encore 90 product lines represented approximately 3%, 1%, 36%, and 7%, respectively of total net sales. In 1992, Infinity 90, Infinity R/T, Encore RSX and Encore 90 product lines represented 0%, 0%, 38%, and 14%, respectively of total net sales. Customer Service revenue represented 53% of 1993 net sales and 48% of 1992 net sales. Infinity 90 The Infinity 90 Family of computer systems is a highly scalable, open systems alternative mainframe computer that combines state of the art RISC technology, symmetric multiprocessing, a UNIX- based operating environment and a powerful open systems-based direct MEMORY CHANNEL bus architecture. The backbone of the architecture is Encore's patented MEMORY CHANNEL which provides direct memory to memory connections between functional nodes at bandwidths of up to 1.6 gigabytes per second. The MEMORY CHANNEL technology solves a fundamental problem associated with I/O bottlenecks by providing I/O bandwidth scaling from 26 megabytes per second to 1.6 gigabytes per second. The Infinity 90 Series can start with hundreds of users and can be expanded to thousands of users as an enterprise's compute and I/O requirements grow. This scalability can provide the user with over 100 times the compute power, 20 times the bandwidth and over 75 times the I/O capacity of today's traditional mainframes at significantly lower costs. Entry level systems offer compute power of 35 MIPS and can be scaled incrementally to 1000 MIPS. The I/O subsystems are designed to enhance overall system performance and provide unlimited capacity and throughput increases by nonintrusive upgrades as well as provide storage control, communications and data paths within the Infinity 90 architecture. The amount of CPU and I/O capacity can be balanced and intermixed as necessary to deliver significant price/performance advantages over traditional mainframes. The Infinity 90's scalability is achieved through a building block approach to system configuration which allows every aspect of the system to scale incrementally. Comprised of functionally specific standards- based computational and I/O subsystem building blocks, the Infinity 90 can be configured into many unique system configurations. The Infinity 90 provides a solution for companies with the need to downcost their data processing operations. The system saves up to 80% of the cost associated with traditional mainframes. High density packaging provides a high degree of serviceability and reduces the system's footprint significantly. Utilization of state of the art low power consumption components provide for low cost of operations. The Infinity 90 employs technologically advanced components and peripherals that deliver mainframe equivalent performance and capacity but require only one-tenth the cooling and power. This minimizes the life cycle cost of system ownership. As a file server, the Infinity 90 has overcome the low I/O bandwidth, small storage capacity and overall limited growth of other solutions by separating file processing from communications protocol processing. Intelligent storage and communication subsystems are independently scalable as are the 53 megabyte per second MEMORY CHANNEL buses that connect them. While partitioned internally, the Infinity 90 is seen by the user as one large file address space accessible from numerous communications ports. Because a user's initial storage demands may be minimal, the system is designed to provide incremental growth from gigabytes to terabytes of disk storage. All Infinity 90 systems provide a variety of communications offerings such as NetWare, LAN Manager, AppleTalk, TCP/IP, SNA and OSI which can grow incrementally with the hardware configuration. The list prices for entry level Infinity 90 systems begin at about $200,000 and can exceed $3,000,000 for very large systems. Infinity R/T The Infinity R/T Family is a symmetric multiprocessor design featuring deterministic performance, very large cache stores, extremely high speed buses, a large, tightly coupled standard base memory, as well as direct hardware connections to on-board interrupts and timers. The systems provide for integral multinode clustering capability, and optional models support Encore's Distributed Real-Time Extensions (DRTX) and Application Specific Embedded Processing. These features accommodate a single system view of multiple compute and I/O elements that can be configured specifically to the attributes of the target environment. Versions of these products are also CONCEPT/32 compatible and provide a seamless migration path for Encore legacy users. As with the Company's mainframe alternative, the Infinity 90, the Infinity R/T Family is based on the Motorola 88100 and 88110 RISC processors and is designed to grow to meet any mix of computational and I/O requirements. This protects the customer's software investment and significantly reduces the risk normally associated with system expansion or rehosting to satisfy ever- expanding requirements. The Infinity R/T Family offers UMAX V R/T as its operating system. UMAX V R/T is an enhanced symmetrical multiprocessing version of AT&T's System V UNIX with real-time extensions. The Infinity R/T architecture supports the standards of POSIX 1003.1, 1003.4 and 1003.4a, SVID and NFS as well as standard interfaces such as VME 32/64, SCSI, Ethernet and FDDI. A full complement of software including open system CASE tools, "Parasight" an exclusive graphics-based parallel development environment, parallel Fortran, C, Ada, and C++ is also available to the user. Pricing for Infinity R/T systems starts at $64,000 and increases to over $375,000 for a fully configured system. Infinity SP The Infinity SP product line leverages the technology of the Infinity 90 Series by combining its architectural elements with the specialized software necessary to provide a comprehensive set of storage products designed to meet mainframe storage requirements. The Company believes these elements result in the ability to deliver high performance storage solutions for IBM mainframe environments. It is the Company's intent to deliver performance and flexibility superior to existing mainframe disk storage systems at a price that is competitive with competitors. Infinity SP products are designed to utilize new technologies. These include the use of commodity microprocessors, high- performance/high-density 3 1/2 inch disk drive technologies as well as high-availability and fault-tolerant designs utilizing various levels of RAID (Redundant Arrays of Inexpensive Disks). The floor space required by Infinity SP to house equal levels of storage capacity is many times less than that of traditional storage suppliers resulting in savings in facility and utility costs. Additionally, while providing a lower cost solution, Encore's Infinity SP provides much greater performance which allows customers to defer their need to invest in costly mainframe upgrades and enhancements. Infinity SP storage subsystems are capable of delivering storage solutions from 100 gigabytes to multiple terabytes. These storage subsystems may be used as direct attached storage devices (DASD) for IBM compatible mainframes as well as being concurrently capable of providing shared storage facilities to open systems environments. The Company believes this innovative combination of functionality provides significant competitive differentiation within the marketplace. Encore 90 The Encore 90 Family consists of two principal classes of computer systems: (i) the Encore 91 Series and (ii) the Encore 93 Series. At the low end of the computing range, the 91 Series represents a true real-time system comprised of open system components, bus structures and I/O. The system is implemented on a symmetric RISC multiprocessor (the Motorola 88000) design with a multiple bus architecture to maintain the deterministic response to real-time applications that are both compute and I/O sensitive. Implementing the same RISC processing elements and system software architecture, Encore's second member of the Encore 90 Family is the Encore 93 Series. With a processor expandable from two (2) to thirty-two (32) symmetrical processors, the Encore 93 Series can satisfy computing needs at the higher end of the performance range. UMAX V, Encore's multiprocessing UNIX implementation, has been enhanced to accommodate real-time features and serves as the interactive environment to the Encore 90's Power Domain Management software system. In this arena, the multiprocessing, memory, and I/O resources can be dynamically tailored to become a very high speed real-time system, while maintaining the productivity of the UNIX development environment. This facilitates an extremely high speed option to very high demand real-time environments. Entry level systems begin at $59,000 and can exceed $175,000 for fully configured Encore 90 Family computer systems. Encore RSX Systems The Company's Encore RSX products provide the deterministic performance, high aggregate computational power and high system throughput required to process the demands associated with today's real-time applications. These features are achieved through a combination of a proven family of hardware products, a proprietary Mapped Programming Executive (MPX-32) operating system and innovative technology such as Encore's patented REFLECTIVE MEMORY. Replacing the Company's prior generation CONCEPT/32 Family, the Encore RSX can provide the customer with a migration path from the CONCEPT/32 Family to the open systems Encore 90 Family. The Encore RSX subscribes to the option of IEEE 754 floating point formats. This allows a seamless application mathematical interface to the UNIX-based Encore 90 Family while maintaining CONCEPT/32 object code and SelBUS compatibility. The Encore RSX can optionally run in RISC mode by converting existing object code to the RISC instruction set of the RSX. This significantly enhances system performance without the need for the user to rewrite his applications. The Encore RSX and the Encore 91 Series product offerings may be combined into a single system via REFLECTIVE MEMORY. This new combined system is a symmetric multiprocessor based on an open systems host architecture using real-time UNIX to provide a single point of control and management. All user interfaces to the system are UNIX-based and provide open systems CASE tools to increase development productivity. Because all of the Company's real-time products are object code compatible, a customer's original investment in software and specialized hardware is preserved as he migrates his installation to newer technology. The Company also continues to offer support for the large installed base of its prior generation CONCEPT/32 products. These flexible products were designed for OEM system integration, as embedded systems in customer supplied cabinets or as complete distributed processing systems for the most complex real-time tasks. Pricing for these systems starts at $50,000 and increases to over $750,000 for a fully configured system. Customer Service Service and support are critical elements in maintaining customer satisfaction. The Company offers its customers a variety of service and support programs for both hardware and software products principally through its customer service organization consisting of third party maintenance partners with locations throughout the world. The Company also offers maintenance service for selected third party equipment. Specific service and support programs include preventive maintenance, resident labor service, customer training and education, logistics support programs, data facility management and custom technical and consulting services. In addition, the Company provides a dial-in hotline as well as remote diagnostic capabilities to allow problem resolution from Encore's home office. The Company provides a standard warranty for parts and labor on its products, generally for 90 days, and maintains and services its products on a contractual basis after the initial warranty period has expired. SALES AND DISTRIBUTION Encore uses multiple channels of distribution to sell its products. The primary channel has been its direct sales force, consisting of approximately 51 salespersons in 36 sales offices located throughout the United States, Canada and Western Europe. The Company also has joint venture operations in Japan, Hong Kong and Malaysia and various arrangements with distributors throughout the world. The Company has expanded its utilization of systems integrators, value-added resellers (VARs) and independent software vendors (ISVs) in its distribution network. Strategically, the Company is committed to continued expansion of its distribution channels through the establishment of marketing alliances with other industry leaders. The Company's general policy is to sell rather than lease its products. The Company generally has a policy of no returns and does not typically extend payment terms beyond those prevalent in the computer industry. A significant portion of the Company's sales typically occur in the last month of a fiscal quarter, a pattern that is not uncommon in the computer industry. It is the Company's objective to minimize the time from receipt of a purchase order for a computer system to delivery of the system. Accordingly, the Company does not believe backlog reported at any point in time aids materially in the overall understanding of the business. Encore's business is not subject to pronounced seasonal fluctuations. The Company is not dependent upon any one customer for a material part of its business. However, in fiscal 1993, approximately 37% of its sales were derived either directly or indirectly from various United States government agencies. No single customer accounted for as much as 10% of sales in fiscal 1993. MANUFACTURING AND RAW MATERIALS The Company is primarily an assembler and integrator, thus reducing its capital requirements and increasing operating leverage. The Company's manufacturing operation, which includes the test and quality assurance of all parts, components, sub- assemblies and final systems is ISO 9002 certified and located in Melbourne, Florida. Encore assembles its printed circuit boards using surface mount technology and automatic placement equipment. Substantially all peripherals are purchased from third party vendors. Extensive testing and burn-in is performed at the board, component and sub- assembly level and at final systems integration. The Company believes that its manufacturing facilities are sufficient to meet its requirements for at least three years. Encore's manufacturing operations utilize a wide variety of electronic and mechanical components, raw materials, and other supplies and services. The Company relies heavily on external sources of supply and has developed multiple commercial sources for most components and raw materials, but it does utilize single sources for a limited number of custom components. While delays in delivery of such single-sourced components could cause delay in shipments of certain products by Encore, at this time, the Company has no reason to believe any of its single source vendors present a serious business risk to the Company. RESEARCH AND DEVELOPMENT In fiscal 1993, Encore spent $23,331,000 (24.9% of total net sales), on research and development (R&D) activities. In fiscal 1992 and 1991, research and development spending was $22,333,000 (17.1% of net sales) and $30,543,000 (19.9% of net sales), respectively. Fiscal 1993 expenses were $998,000 higher than 1992 due principally to higher spending in the fourth fiscal quarter on materials used in the new product development process. Spending in future periods are not planned to decrease below 1993 levels. Fiscal 1992 expenses were $8,210,000 lower than 1991 as efforts to accelerate the introduction of the Infinity 90 and Encore 90 Families concluded and the benefits of prior cost reduction programs were fully realized. During 1991, research and development activities were consolidated in Ft. Lauderdale, Florida and the scope of activities at the Marlborough, Massachusetts facility were greatly reduced. Additionally, R&D priorities were realigned focusing on those product offerings necessary for the future growth of the business while significantly reducing investment in areas outside the Company's strategic focus. The fiscal 1993, 1992, and 1991 amounts above do not include certain capitalized software development costs totaling $2,142,000, $2,365,000, and $2,640,000, respectively. The Company also spent approximately $1,187,000, $70,000, and $1,829,000 on customer-sponsored engineering activities in fiscal 1993, 1992, and 1991, respectively. These costs which are classified as a deferred cost at December 31, 1993 have been reimbursed by the customer in January, 1994. In 1992 and 1991 such costs are included in cost of goods sold. Because of the rapid technological change which characterizes the computer industry, the Company must continue to make substantial investments in the development of new products to enhance its competitive position. It is expected that future annual R&D expenditures will remain at or above current levels and, as a percent of sales, will remain high in relation to industry norms. Encore has established technical expertise in three critical technologies: parallel processing, real-time and shared memory distributed systems, and the UNIX environment. The Company's primary emphasis has been to build upon these established technologies and couple the best features of each into its new generation of products, the Infinity 90, Infinity RT, Infinity SP and Encore 90 Families. COMPETITION The computer industry is intensely competitive and is characterized by rapid technological advances, decreasing product life cycles, and price reductions. The principal competitive factors in the Company's markets are total system performance, product quality and reliability, price, compatibility and connectivity to other vendors' systems, and long term service and support. The primary competitors in the Company's real-time markets are established companies, such as Concurrent Computer Corporation, Digital Equipment Corporation (DEC) and Harris Corporation. Competitors in the information processing market include established companies like DEC, International Business Machines (IBM), NCR, Hewlett Packard Company (HP) and Sequent Computer Systems. Within the storage products marketplace , the Company competes with IBM, Hitachi Data Systems and EMC. Many of Encore's competitors have greater financial, technical, and marketing resources than Encore. In some cases, this places the Company at a disadvantage. However, the Company considers its level of experience and general understanding of real-time applications and its current parallel processing and UNIX technology position to be positive competitive factors. PATENTS AND LICENSES Encore owns a number of patents, copyrights and trademarks relating to its products and business. Management believes that because of the rapid technological advancements in the industry such patents, copyrights and trademarks, while valuable to Encore, are of less significance to its success than such factors as innovation, technical skills and management ability and experience. From time to time, companies in the industry have claimed that certain products and components manufactured by others are covered by patents held by such companies. It may, therefore, be necessary or desirable for Encore to obtain additional patent licenses. Management believes that such licenses could be obtained on terms which would not have a material adverse effect on the Company's financial position or the results of its operations. During 1992, the Company settled the outstanding patent infringement claim made by IBM against the Company with no financial impact to Encore. Encore has entered into licensing agreements with several third party software developers and suppliers. The licenses generally allow for use and sublicense of certain software provided as part of the computer systems marketed by the Company. Encore is licensed by UNIX Systems Laboratories Inc. to use and sublicense their UNIX operating system in the Company's computer systems. As part of a 1991 refinancing of the Company and as more fully described in Note I of the Notes to Consolidated Financial Statements, the Company granted a license to Gould for all of Encore's intellectual property. The intellectual property license is royalty free and contains certain covenants which do not allow Gould to use the Company's intellectual property unless certain sales revenue levels are not reached by the Company. Additionally, Encore has the option to extend the initial exclusivity period for up to 5 additional years by making cash payments to Gould, and the period will be automatically extended if Encore achieves certain operating income levels. Encore may also terminate the license agreement if all borrowings under its revolving credit agreement with Gould are repaid and either (i) the outstanding shares of the Series B and Series D Convertible Preferred Stock are converted or (ii) the outstanding shares of the Series B and Series D Convertible Preferred Stock are redeemed or (iii) Encore pays Gould the fair value of the license. The Company has not achieved the net sales or operating income levels necessary under the agreement to maintain its exclusive right to the use of its intellectual property and at December 31, 1993 was in default of covenants contained in the agreement. Gould has, however, extended the Encore exclusive period until December 31, 1994. In accordance with prior agreements made with the DIS, Gould must provide ninety days notice to DIS in the event it elects to take possession of the intellectual property. If Gould should take possession of the intellectual property, Encore would continue to have the right to use that property, but such action by Gould could have a material adverse effect on the Company's business. EMPLOYEES As of December 31, 1993, Encore had 952 full-time employees engaged in the following activities: Employees Customer Service 240 Manufacturing 142 Research and Development/Custom Products 270 Sales and Marketing 221 General and Administrative 79 ------ Total 952 The Company's future success will depend in large part on its ability to attract and retain highly skilled and motivated personnel, who are in great demand throughout the industry. None of the Company's domestic employees are represented by a labor union. EXECUTIVE OFFICERS OF THE REGISTRANT The names of the Company's executive officers and certain information about them are set forth below. Name Age Position with Company - ---------------- ---- --------------------- Kenneth G. Fisher 63 Chairman of the Board and Chief Executive Officer Rowland H. Thomas, Jr. 58 President and Chief Operating Officer Charles S. Anderson 64 Vice President, Corporate Relations Ziya Aral 41 Vice President, Systems Engineering and Chief Technology Officer Robert A. DiNanno 47 Vice President and General Manager, Real-Time Operations T. Mark Morley 45 Vice President, Finance and Chief Financial Officer Thomas F. Perry 50 Vice President, Worldwide Sales and Marketing Information Systems James C. Shaw 46 Vice President, Manufacturing Operations George S. Teixeira 37 Vice President, Product Development J. Thomas Zender 54 Vice President, Corporate Program Management Mr. Fisher is a founder of the Company and has served as a Director, Chairman and Chief Executive Officer of the Company since the Company's inception in May 1983. He was the Company's President from its inception until December 1985 and also served in that capacity from December 1987 to January 1991. From January 1982 until May 1983, Mr. Fisher was engaged in private venture transactions. From 1975 to 1981, Mr. Fisher was President and Chief Executive Officer of Computervision (formerly Prime Computer, Inc.). Before joining Computervision, Mr. Fisher was Vice President of Central Operations for Honeywell Information Systems, Inc. Mr. Thomas has been a member of the Board of Directors since December 1987 and Chief Operating Officer since June 1989. He presently serves as President of the Company, a position to which he was elected in January 1991. From June 1989 to January 1991, Mr. Thomas served as Executive Vice President of the Company. In February 1988, he was named President and Chief Executive Officer of Netlink Inc. Prior to joining Netlink, Mr. Thomas was Senior Executive Vice President of National Data Corporation ("NDC"), a transaction processing company, a position he held from June 1985 to February 1988. From May 1983 through June 1985, Mr. Thomas was Executive Vice President and Senior Vice President at NDC. Mr. Anderson, joined the Company in 1985. From 1984 until joining the Company, Mr. Anderson served as Director of Human Resource Operations at Data General Corporation. Before joining Data General, Mr. Anderson was with Honeywell Information Systems, Inc. serving in various management positions since 1970, most recently as Director of Employee Relations. Mr. Aral joined the Company in 1987 and was appointed to his present position of Chief Technology Officer during 1993. Since 1987, he has held various positions of increasing responsibility within the Company including Vice President of Systems Engineering and Senior Technology Consultant. While with the Company, Mr. Aral has been the key innovator and architect of much of the Company's current technology including the Infinity 90 Series. Prior to joining Encore, Mr. Aral was employed by the Reed-Prentice Division of PMCo. in a variety of software engineering positions. Robert A. DiNanno joined the Company in July 1986. Until June 1992, Mr. DiNanno served as Vice President and General Manager, Operations. At that time, he was appointed Vice President and General Manager, Real-Time Operations. Prior to joining the Company, he served as Vice President, Manufacturing at Adage, Inc. from November 1983 to June 1986. Mr. DiNanno also held domestic and international management assignments with Honeywell Information Systems, Inc. from June 1979 until November 1983. Mr. DiNanno has experience with military and commercial flight simulations acquired during his tenure at Singer Link. T. Mark Morley joined the Company in November 1986 as Chief Financial Officer and Vice President, Finance. Prior to that during 1986 he was Chief Financial Officer, Vice President, Finance and Treasurer of Iomega Corporation. From 1977 through 1985, Mr. Morley was employed by Computervision (formerly Prime Computer, Inc.), most recently as the Senior Director responsible for the Treasury department. From 1973 to 1977, Mr. Morley was associated with Deloitte and Touche and from 1971 to 1973 he was associated with the City of Boston Legal Department. He is an attorney and a C.P.A. Mr. Perry joined the Company in November 1992 as Vice President, Worldwide Sales and Marketing Information Systems. From May 1990 to October 1992, he was President of the Systems Division and a member of the Board of Directors for The Ultimate Corporation. Mr. Perry joined The Ultimate Corporation in March 1989 as Senior Vice President of Sales Operation. From March 1988 to March 1989 Mr. Perry served as Director, Alternative Channels for Stratus Computer. Prior to that, Mr. Perry held Senior Vice President positions with several high technology start-up companies responsible for various sales and marketing functions. He has also held sales management positions with Computervision (formerly Prime Computer Corporation). Mr. Shaw joined the Company in 1989 as Vice President, Manufacturing Operations. In November 1992, he was appointed an officer of the Company. From 1985 to 1989 he served as Senior Director, Manufacturing for Modicon, Inc. Prior to that time, he was Vice President, Manufacturing for Chomerics, Inc., a position he held from 1980 to 1985. Mr. Teixeira assumed his present position in August 1991. Previously he held the positions of Vice President of Marketing and Vice President of Product Management. Mr. Teixeira was Director of Product Marketing and Management for the Computer Systems Business of Gould which the Company acquired in 1989. Prior to that he held several progressively more responsible positions since joining Gould in 1981. J. Thomas Zender joined the Company in August 1989 as Vice President of Marketing. In January 1991, he was appointed Vice President Program Management and in 1992 was appointed Vice President, Corporate Program Management. From 1986 to August 1989, Mr. Zender was Vice President, Corporate Development at MAI Basic Four, Inc. Before joining MAI Basic Four, he was Vice President of Marketing of Calcomp/Terak Corporation. Mr. Zender served as Vice President of Marketing for Database Systems Corporation and Director of Marketing for Genrad, Inc. He also served as Vice President of Field Support for ITT Courier as well as holding various management positions with Honeywell Information Systems, Inc. and General Electric Company. (d) International Operations The Company maintains sales and service operations in Europe and Canada through wholly-owned subsidiaries. In the Far East, sales and service operations are performed through one or more joint ventures in Japan, Hong Kong and Malaysia and distributor agreements throughout the remainder of the Pacific Rim. In fiscal 1993, approximately 44% of consolidated net sales were derived from foreign operations. The Company believes that its overall profit margins with respect to foreign sales are not materially different from profit margins from domestic sales. In view of the locations and diversification of its foreign activities, the Company does not believe that there are any unusual risks beyond the normal business risks attendant to activities abroad. Encore uses a hedging program to reduce its exposure to foreign currency fluctuations. Additional information relating to the Company's international operations, including financial information segregated by major geographic area, is contained in Note K of the Notes to Consolidated Financial Statements. Item 2 Item 2 Properties Listed below are the Company's principal facilities as of December 31, 1993. Owned or Square Feet Location Principal Use Leased Approximately - ----------------- --------------- ------ -------------- Ft. Lauderdale, FL Administrative/ Owned 224,000 Development/ Marketing/ Ft. Lauderdale, FL Customer Service/ Leased 80,000 Development Melbourne, FL Manufacturing Owned 124,000 Paris, France Sales/Service Leased 47,000 London, England Sales/Service Leased 35,000 In addition to the facilities listed above, Encore also leases space in various other domestic and foreign locations for use as sales and service offices. The Company's owned facilities are encumbered by various mortgages, including mortgages which collateralize the Gould loan agreements (See Note G of Notes to the Consolidated Financial Statements). Item 3 Item 3 Legal Proceedings There are no material pending legal proceedings, other than ordinary routine litigation incidental to the business, to which the registrant or any of its subsidiaries are party to or of which any of their property is the subject. Item 4 Item 4 Submissions of Matters to a Vote of Security Holders No items were submitted to a vote of the security holders during the fiscal quarter ended December 31, 1993. PART II Item 5 Item 5 Market for Registrant's Common Equity and Related Stockholder Matters Prior to January 22, 1992, Encore' s common stock was quoted on Nasdaq with daily statistics found under the National Market Issues section of newspaper stock listings. Subsequent to that time, the Company was excluded from participation in the Nasdaq system because it was unable to meet the minimum capitalization requirements for its continuation in the system. As of February 22, 1992, the Company's common stock began trading on the OTC electronic bulletin board under the symbol ENCC. The high and low closing sale prices of Encore's common stock are shown for fiscal years 1993 and 1992 in the table below: Fiscal 1993 prices Fiscal 1992 prices High Low High Low -------- ------- ------ ------ 1st Quarter $ 1 15/16 $ 1 1/4 $ 2 $ 5/8 2nd Quarter 2 5/8 1 1/2 1 7/8 1 3rd Quarter 4 1/2 2 5/8 1 5/8 13/16 4th Quarter 4 1/4 2 3/4 2 1/8 1 1/4 Upon completion of its February 4, 1994 exchange of indebtedness for preferred stock discussed in Note L of the Notes to the Consolidated Financial Statements, the Company met the minimum requirements for inclusion in the Nasdaq National Market System. The Company was accepted for participation and began trading on March 18, 1994 under the symbol ENCC. Daily statistics on the Company's stock can be found in the Nasdaq National Market Issues listing of the newspaper's stock listings. The First National Bank of Boston is the stock transfer agent and registrar, and maintains shareholder records. The agent will respond to questions on change of ownership, lost stock certificates, consolidation of accounts, and change of address. Shareholder correspondence on these matters should be addressed to The First National Bank of Boston, Shareholder Services Division, P.O. Box 644, Boston, Massachusetts 02109. As of April 6, 1994, there were approximately 2,703 holders of record of the Company's common stock. The Company has never paid cash dividends on its common stock and does not anticipate the payment of cash dividends in the foreseeable future. Under the terms of the Company's current financing agreements, the Company is prohibited from paying dividends on its common stock. (1) See Notes A and J of the Notes to Consolidated Financial Statements for information on the calculation of net loss per share. During 1993 preferred stock dividends on the Series B payable in shares of Series B of $3,630,000 and dividends on the Series D payable in shares of Series D of $5,554,700 were accumulated by the Company. During 1992, preferred stock dividends on the Series B of $3,943,100 were paid with additional shares of Series B preferred stock. Additionally in 1992, preferred stock dividends of $528,300 were paid in additional shares of Series D Preferred Stock. (2) As discussed in Note L of the Notes to Consolidated Financial Statements, the Company and Gould Electronics Inc. completed a recapitalization of the Company subsequent to the Balance Sheet date. The column headed Pro Forma 1993 shows the Selected Financial Data on a Pro Forma basis as if the recapitalization had been done at December 31, 1993. (a) Quarter 4, 1993, Quarter 2, 1993, Quarter 3, 1992 and Quarter 2, 1992 include restructuring charges of $10,422,000, $12,843,000, $1,000,000 and $4,248,000, respectively. Item 7 Item 7 Management's Discussion and Analysis of Financial Condition and Results of Operations Overview Encore Computer Corporation ("Encore" or the "Company") was founded in May 1983 and was in the development stage until October 1986. During this period, the Company was primarily involved in the research, development and marketing of its UNIX- based Multimax computers and Annex terminal server. Initial sales of the Multimax and Annex products as well as revenues under certain U.S. government agency research contracts began in 1986. During 1989, Encore acquired substantially all of the assets of the Computer Systems Division of Gould Electronics Inc. (the "Computer Systems Business"). This was a significantly larger business which for over twenty-five years, provided real- time computer systems solutions to the simulation, range and telemetry, and energy marketplaces. Since the acquisition, the Company has fully integrated the businesses blending the strengths of each into next generation product offerings. This has resulted in the development of the Infinity 90 and Encore 90 Families of open systems targeted toward demanding, time critical applications in both the general purpose computing and real-time marketplaces. Based on RISC processors, a standard UNIX operating system and industry standard connectivity and networking protocols, both the Infinity 90 and Encore 90 Families offer massive I/O throughput, a broad I/O bandwidth, complete computational scalability and price/performance advantages over traditional mainframe solutions. The first members of the Encore 90 Family, the Encore 91 Series and the Encore 93 Series began shipments in 1991. The Infinity 90, an open system mainframe alternative, was available in the second half of 1992 and then during the second half of 1993, the Infinity R/T, a real-time version of the Infinity 90, was released for volume shipments. During the late 1980s, product demand in the computer marketplace began a migration away from more traditional proprietary computing technologies and towards an open systems technology. The Company anticipated this market trend and since the acquisition of the Computer Systems Business focused its research and development investments toward the development of a new generation of computer system based on a state of the art open system architecture. Since the beginning of 1991, the Company has spent approximately $76,000,000 in research and development activities with a significant portion of this directed toward programs aimed at bringing new open system technology products, such as the Infinity 90, Infinity SP and Encore 90 Families, to market. The Company must continue to invest heavily in the areas of research and development to remain competitive in the marketplace. As a percentage of net sales, research and development spending will remain high in comparison to industry averages. The Company believes that this will allow it to provide early availability of leading-edge computer technology which could position the Company favorably as the marketplace continues to migrate. During 1993 the Company's products have been favorably reviewed by certain market research firms and the Infinity 90 set a world record in performance of the industry-standard AIM-II TPC benchmarks. While the general opinion of industry analysts is that future computer solutions will be based on open systems and standards, this market is still in its infancy. Many data processing users are only now beginning to define their strategies for implementation of such technology. Accordingly, demand for the Company's open systems products has been weak. Over the three year reporting period, this has placed the Company in an extended period of product transition. Older, established products have reached the end of their competitive life cycle and are now experiencing a significant decline in revenues while the Company's newer technology product offerings have not yet generated the level of customer demand anticipated by the Company. Revenues have decreased from $153,302,000 in 1991 to $93,532,000 in 1993 and as a result the Company has incurred significant net losses. In response to the declining revenue base and resultant lower gross margin dollars, management has taken aggressive actions throughout this period to restructure the organization to levels more consistent with the declining size of the Company. These actions have included reducing the workforce to levels required to support the business, eliminating organizational redundancies and consolidating certain facilities to eliminate unneeded capacity. In connection with the restructuring activities, the Company has also recognized the non- recoverability of certain capitalized software products and the impairment in value of certain other long lived assets, including goodwill. As a result of the actions taken, the Company has recorded restructuring charges of $57,545,000 over the three year period. Because of the net losses incurred since the beginning of 1991, the Company has not generated sufficient levels of cash flow to fund its operations and cumulatively used cash in operating and investing activities of $104,998,000. While a portion of the losses incurred were funded by reductions in the working capital, the principal source of financing has been provided by Japan Energy Corporation ("Japan Energy"; formerly Nikko Kyodo Co., Ltd.) and certain of its wholly owned subsidiaries. Should the Company continue to incur significant losses, it will be difficult to operate as a going concern without the on-going financial support of Japan Energy. Until the Company returns to a sustained state of profitability, it will not be able to secure financing from other sources. Accordingly, should Japan Energy withdraw its financial support prior to the time the Company returns to profitability, the Company will experience a severe liquidity crisis and have difficulties settling its liabilities in the normal course of business. However, management believes the current availability of new technology products, such as the Infinity 90 and Infinity SP, could improve the Company's revenue stream and related profitability. Until such a time, the Company will continue to adjust spending to levels consistent with expected business conditions. Comparison of Calendar 1993, 1992 and 1991. Net sales for 1993 were $93,532,000 compared to net sales for 1992 and 1991 of $130,893,000 and $153,302,000, respectively. The 1993 revenue decline is due to both lower product and service sales. In 1993, equipment sales decreased to $43,622,000 from $67,840,000 and $81,272,000 in 1992 and 1991, respectively. Service revenues for fiscal 1993, 1992, and 1991 were $49,910,000, $63,053,000, and $72,030,000, respectively. In general as discussed below, the principal declines since 1990 are due to lower sales volumes. Despite the availability of new technology products such as the Infinity 90 and Encore 90 Families of products and continued enhancements to the Encore RSX product line, 1993 equipment sales decreased from prior years. This decline is due to a continued general softness in the computer industry as well as the fact that certain of the Company's products have reached the end of their life cycles. The computer industry is strongly influenced by changes in microchip technology. Customers tend to purchase those products offering leading-edge implementations of the most currently available technology. In recent years, product demand has begun a migration from proprietary to open system architectures. Prior to 1992, the Company's principal product offerings were proprietary architectures whose core technology was developed in the early 1980s. While product enhancements have been made, the Company's older products lost some of their technological edge. Accordingly, the Company was increasingly less competitive selling into new, long-term programs in its traditional real-time markets. This has contributed to the continuing decline in net sales. During 1992, both the Infinity 90 and Encore 90 Families based on new state of the art open systems technology, were available for sale. However, the open systems computer market place is still in its infancy and data processing users are now just beginning to adopt this technology. As a result, demand for new products based on an open systems architecture has not generated the levels of sales necessary to offset the declines realized on sales of the older, traditional product lines. It is possible that the Company will continue to experience declining revenues until such time as the overall market conditions improve and customer demand for open system products increases. Service revenues have declined from the prior year by 21% and 13% in 1993 and 1992, respectively reflecting the continued price competitiveness of the marketplace as well as the effect of the Company's declining system sales. However, as a percentage of total net sales, service revenues have increased from 47% in 1991 to 53% in 1993. Because most of the Company's installed equipment base remains in use for several years after installation and customers generally elect to purchase maintenance contracts for their system while it is in service, the rate of decline in service revenues has lagged that of equipment revenues. Accordingly, since 1991 service revenues have become an increasingly larger portion on the Company's sales mix. International sales in 1993, 1992 and 1991 were $41,371,000, $65,209,000, and $71,167,000 and 44%, 50%, and 46%, respectively of total net sales. The principal decreases in all years have occurred in Western Europe. The European markets have been adversely impacted by the same factors as the overall business, i.e. the effect of a prolonged product line transition combined with an overall general weakness in both the economy and the computer marketplace. Additionally, during 1993 a major United Kingdom distributor decided to delay the purchase of new computer systems until an enhanced version of the Infinity 90 product line becomes available for sale. This product offering is not anticipated until the middle of 1994. During 1993 sales to this distributor decreased by approximately 75% compared to 1992. In light of the downturn in international operations, management has taken actions as discussed below to reduce expenses to levels more consistent with expected future business levels. However, the decrease in international margins caused by the decline in international revenue has not been fully offset by lower international operating expenses. As displayed in Note K of the Notes to Consolidated Financial Statements, international operations have incurred operating losses in 1993 and 1992. While no single customer has accounted for as much as 10% of total net sales during the last three years, sales to various U.S. government agencies have represented approximately 37% and 29% of net sales in 1993 and 1992. The Company recognizes that reductions in current levels of U.S. government agency spending on computers and computer related services could adversely affect its traditional sources of revenue. To mitigate any potential risk, plans are in place to strategically expand into non- traditional, high growth markets with the Infinity 90 and Infinity SP Family of products. The high speed processing capabilities of these products combined with its architecture's scalability, make the product well suited for applications traditionally thought to be the sole domain of mainframe computers. Among the markets being targeted by the Company are Input-Output (I/O) intensive transaction processing data base applications and data storage applications where high speed performance is a critical factor. In certain cases, U.S. government agencies, such as the Department of Defense, are precluded from awarding contracts requiring access to classified information to foreign owned or controlled companies. The principal source of both debt and equity financing for the Company has been through Japan Energy (a Japanese corporation) and certain of its wholly owned subsidiaries. Aware of U.S. government limitations on the ability of certain agencies to do classified business with foreign owned or controlled companies, Encore and Japan Energy have proactively worked to comply with all U.S. government requirements. In this connection, Japan Energy has agreed to accept certain terms and conditions relating to its equity securities in the Company, including the limitation of voting rights of its shares, limitations on the number of seats it may have on the board of directors and certain restrictions on the conversion of its preferred shares into common stock. In connection with the recapitalizations discussed in more detail below and in Notes G, J, and L of the Notes to Consolidated Financial Statements, the Company requested the United States Defense Investigative Service ("DIS") to review the relationship between the Company, Japan Energy, and Japan Energy's wholly owned subsidiaries, Gould Electronics Inc. ("Gould") and EFI International Ltd. ("EFI"), under the United States Government requirements relating to foreign ownership, control or influence. DIS has indicated that it has no objection. Encore is committed to complying with all U.S. government requirements regarding foreign ownership and control of U.S. companies. At this time, the Company is unaware of any circumstances that would adversely affect the opinions previously issued by DIS. However, should DIS change its opinion of the nature of Japan Energy's influence or control on the Company, a significant portion of the Company's future revenues realized through U.S. government agencies could be jeopardized. Total cost of sales decreased in 1993 to $65,831,000 from $79,040,000 in 1992 and $98,163,000 in 1991. The decrease in 1993 was due generally to lower sales volumes when compared to 1992 and lower spending resulting from the restructuring of manufacturing and customer service operations during the three year period. Since the beginning of 1991, manufacturing and customer service headcount have been reduced by 54%, certain customer service field operations have been closed or scaled back, and all manufacturing operations have been consolidated in Melbourne, Florida. Gross margins on equipment sales in 1993 were $14,041,000 (32.2%) compared to 1992 gross margins of $33,557,000 (49.5%) and $30,182,000 (37.1%) in 1991. The decrease in 1993 equipment gross margins of $19,516,000 is due principally to: (i) lower margins of $12,500,000 on lower equipment sales, (ii) lower margins of $2,200,000 due to price erosion, (iii) increased obsolescence charges of $3,280,000 in connection with the Company's continued migration to its newer open systems product offerings and (iv) non-recurring engineering charges and other miscellaneous cost increases of $1,536,000. The 1992 gross margin improvement of $3,375,000 from 1991 on lower equipment sales is attributable primarily to lower manufacturing costs of $2,450,000 resulting from lower spending and improved operational efficiencies when compared to the prior year as well as lower inventory obsolescence costs of $6,437,000. These improvements more than offset the gross margin reduction from the year's lower revenue. In response to the reduced production volumes, expenditures have been reduced throughout the three year period to minimize the further deterioration of equipment gross margins. Among the actions taken since 1991 have been a 45% reduction in manufacturing personnel and the consolidation of all manufacturing activities in Melbourne, Florida. 1993 service gross margin was $13,660,000 (27.4%), a decrease of $4,636,000 from 1992. The lower margin is due to lower revenues of $13,143,000 which were only partially offset by lower operating costs achieved through restructuring actions taken during both 1992 and 1993. Among the principal cost reductions during 1993 were lower employee costs of approximately $5,500,000 due to reduced headcount, lower field office rental costs of approximately $1,200,000 as marginally profitable field locations have been consolidated or closed and other miscellaneous cost reductions of $1,807,000. Service gross margins also decreased in 1992 by $6,661,000 to $18,296,000 (29.0%) compared to prior year's gross margin of $24,957,000 (34.6%). The 1992 reduction was due to a decline of $8,977,000 in 1992 annual service revenues which were only partially offset by lower operating costs. Since 1990, the service business has been unfavorably affected by the Company's declining computer equipment sales, competitive pricing pressures, declining defense spending which has resulted in some maintenance program cancellations, and the termination of certain other service contracts as older installed systems are being decommissioned by their users. Since 1990 approximately 25% of each year's existing service contracts have not been renewed with the Company. Management will continue efforts to minimize the effect of declining service sales on the service gross margins by taking actions to maintain spending at levels consistent with expected future business levels. In the past, these actions have included reductions in workforce, the closing and consolidation of unprofitable field operations and the outsourcing of certain business functions. In the fourth quarter of 1993 the Company took further action to minimize the fixed cost associated with its domestic service business when it agreed to subcontract its equipment maintenance business to Halifax Corporation ("Halifax"). Under the terms of the agreement which takes full effect in 1994, Halifax will provide the manpower required to service equipment under maintenance contract with the Company. The agreement allows the Company to reduce the fixed cost base associated with its field maintenance operation while continuing to provide the same level of service to its customers. 1993 research and development expenses were $23,331,000 (24.9% of net sales) or an increase of $998,000 from 1992. The increase in the current year's spending is due to efforts in the fourth quarter to accelerate the availability of new products scheduled for release in the first half of 1994. For the first three quarters of 1993, spending was essentially unchanged from 1992 levels. Research and development expense increased only 4% in 1993, however, as a percentage of net sales it increased by 7.8% from 17.1% to 24.9% of net sales as a direct result of the year's net sales decline. During 1992, research and development expenses were $22,333,000 (17.1% of net sales) compared to expenses of $30,543,000 (19.9% of net sales) in 1991. In total and as a percentage of net sales, 1992 expenses decreased from 1991 levels as efforts to accelerate the introduction of the Encore 90 and Infinity 90 Family of computers concluded during 1992 and the benefit of cost reduction actions taken in 1991 were fully realized. During 1991 priorities were realigned to focus future expenditures toward those strategically aligned product offerings necessary to the future growth of the business. This significantly reduced the level of investment in areas outside the Company's strategic focus and has allowed the development organization to reduce its headcount by 30% since 1991. Activities at the Marlborough, Massachusetts facility were significantly reduced with on-going activities consolidated in Ft. Lauderdale, Florida, thereby eliminating the on-going fixed expenses associated with that facility. The reductions made in research and development spending since 1991 generally reflect operational efficiencies realized through the elimination of efforts not targeted toward the core business and are not expected to impact the Company's future competitiveness in the marketplace. To effectively compete in its market niches, the Company must continue to invest aggressively in research and development activities. Sales, general and administrative (SG&A) expenses in 1993 were $42,499,000 compared to $45,156,000 and $48,732,000 in 1992 and 1991, respectively. SG&A expenses decreased by $2,657,000 in 1993 when compared to 1992 due primarily to (i) the effect of prior restructuring actions taken by the Company, including lower labor on a reduced 1993 workforce and (ii) lower sales commissions due to lower 1993 revenues. These savings were partially offset by a non-recurring charge to compensation expense of $788,000 made in connection with the extension of the expiration date of certain stock options made during the Company's fourth fiscal quarter. A more complete discussion of this transaction is included in Note J of Notes to the Consolidated Financial Statements. The 1992 SG&A expense reduction of $3,576,000 from 1991 was due primarily to reductions in staff made in 1991 and worldwide facility consolidation programs implemented as part of earlier restructuring programs. As a percentage of net sales, sales, general and administrative expenses were 45.4%, 34.5%, and 31.8% in 1993, 1992, and 1991, respectively. The increase as a percentage of sales reflects the fact that reductions in sales, general and administrative spending have been more than offset by declines in net sales. This is partially due to the time delay in reducing certain fixed costs. In the future, sales, general and administrative costs should begin to return toward 1991 levels. The Company employs a multi-level distribution system to market its products, consisting of direct sales, OEMs, systems integrators and value added resellers (VARs). The Company is committed to expanding its distribution channels for its new products by aggressively seeking strategic alliances with other industry leaders in the marketplace. In this connection, during the first quarter of 1994, the Company and Amdahl Corporation entered into a non-exclusive multi-year agreement whereby Amdahl Corporation will remarket the Company's Infinity SP under the Amdahl brand. In each of the three years reported, the Company has taken actions to restructure its operations to levels consistent with the expected levels of future revenues. As discussed in Note F to Consolidated Financial Statements, 1993 operating expenses include restructuring charges of $23,265,000 compared to $5,248,000 and $29,032,000 for 1992 and 1991, respectively. In connection with the 1993 charges, during the second and fourth quarters management evaluated the latest financial projections of the business and based upon its evaluation concluded: (i) the rate of decline in real-time equipment and service revenues had exceeded its previous estimates, (ii) the rate of worldwide sales growth anticipated in newer product lines remained significantly below projected levels and (iii) overall business conditions in Western Europe had continued to deteriorate during the year. In light of these conclusions, management initiated the following actions to restructure its operations to levels required to meet expected future business conditions including: (i) reductions in the workforce to levels consistent with planned future sales (ii) the closure or consolidation of marginally profitable field offices and (iii) the reassessment of carrying values of certain long lived assets including property and equipment and goodwill. In June 1993, the Company reduced its workforce by approximately 10% with significant reductions made in manufacturing, customer services and international sales operations. In December 1993, plans were approved to further reduce the European workforce by 20% and U.S. headcount by approximately 8%. Because of the reduced field sales and service workforce, actions were also taken to eliminate the resulting excess field office space by closing those offices which were considered underutilized. Due to the decline in traditional real-time product line profits, the Company re-evaluated its investment in the property and equipment employed to support future real-time product sales. As a result of the analysis, management wrote down the carrying value of certain of these assets by $5,700,000 during the year. Finally, as discussed below, during June 1993 the Company wrote off the remaining carrying value of the goodwill originally recorded in connection with the 1989 acquisition of the Computer Systems Business. Of the total 1993 restructuring charges, approximately $12,000,000 reflects the write-off of long lived assets, resulting in a non-cash charge to the business. The actions taken during 1993 are intended to reduce the Company's future annual operating costs by approximately $12,000,000. Management will continue to assess its cost structure and the carrying value of its assets in light of expected future business. While there are no existing plans to take any additional actions, should future conditions necessitate it, management could approve additional plans to further reduce its cost base or recognize the additional impairment of certain long lived assets. The 1992 restructure charge includes severance and outplacement costs associated with a 9% reduction in the workforce, the write- off of certain capitalized software assets relating to the on- going transition of the Company's UNIX-based product lines, and certain costs to be incurred related to the closure of certain sales and service offices. $1,250,000 of this charge reflects non-cash charges to operation and as a result of the 1992 restructuring, annual operating expenses were reduced by approximately $6,000,000. The 1991 restructuring charge included: (i) severance and outplacement costs associated with a 24% reduction in the workforce, (ii) the write-down of goodwill related to the acquisition of the Computer Systems Business, (iii) costs incurred during the scale back of operations in Marlborough, Massachusetts, (iv) the write-off of certain capitalized software assets relating to the transition of the Company's UNIX-based product lines, and (v) costs incurred related to a facilities consolidation program including certain Ft. Lauderdale, Florida properties. $14,000,000 of the 1991 restructuring expense involved non-cash charges to operations. As a result of the 1991 restructuring actions, the Company lowered annual operating expenses by approximately $15,000,000. With regard to the write-off of goodwill, in 1989 the Company acquired the Computer Systems Business of Gould. In recording the acquisition, the Company recognized goodwill which represented the excess of acquisition cost over the fair value of assets acquired. During 1991 management determined the future earnings power associated with the certain portions of the acquired Computer Systems Business had diminished. However, the customer service business which represented in excess of 45% of the acquired Computer Systems Business revenues, continued to yield gross margins in excess of those of its direct competitors. The analysis indicated this earnings premium could result in additional future profits over the next seven years. Furthermore, at that time in management's judgment, the infrastructure acquired by the Company was still largely intact and continued to provide the potential for higher earnings in other portions of the business. In conjunction with this review, management assessed the carrying value assigned to goodwill and determined the future earnings potential of the Computer Systems Business was now less than the current carrying value of goodwill. Accordingly, in the fourth quarter of 1991, the Company wrote down the carrying value of goodwill from $12,979,000 to $4,979,000 by charging operations. The carrying value of goodwill after the write-down was equivalent to the estimated remaining earnings premium associated with the Computer Systems Business. During 1992 the Company's customer service operations came under increasing competitive pressure and some customers began to decommission installed systems canceling service contracts with the Company. In light of the declining base of acquired customer service business, management increased the rate of amortization of goodwill so that by the end of 1994 any excess value associated with the Computer Systems Business customer service base would be fully amortized. However, the continued decline in the earnings base during 1993 resulted in the write off of the remaining carrying value of goodwill ($2,628,000) by charging operations. Interest expense decreased to $6,380,000 in 1993 from $7,425,000 in 1992 and $9,175,000 in 1991 due primarily to lower average debt in 1993 when compared to the prior years. During 1992 and 1991, Encore completed a series of refinancing agreements with Japan Energy, Gould and EFI as discussed in more detail below and in Notes G and J of the Notes to Consolidated Financial Statements. As a result of the various refinancings, the Company's annual interest expense was reduced by approximately $12,000,000 through the conversion of debt with a face value of $140,000,000 into the Company's preferred stock. Interest income decreased in 1993 by $129,000 to $134,000 compared to $263,000 and $561,000 in 1992 and 1991, respectively due primarily to lower interest rates. Other expense was $780,000 in 1993, a decrease of $1,297,000 from 1992's $2,077,000, due principally to lower foreign exchange losses. In 1991, other expense was $1,259,000. Income taxes provided in 1992, 1991, and 1990 relate to taxes payable by foreign subsidiaries (see Note H of the Notes to Consolidated Financial Statements). Liquidity and Capital Resources Because of operating losses incurred for the three years ending December 31, 1993, the Company has been unable to generate cash from operating activities. In 1993, 1992, and 1991, the Company used cash in operating activities of $36,415,000, $15,307,000, and $8,817,000, respectively. During these years, losses incurred due to declining net sales were partially funded by reductions in current assets, principally accounts receivable. In 1993, 1992, and 1991 accounts receivable decreased by $11,857,000, $4,787,000, and $14,207,000, respectively. Further benefit of cash generated through the reduction in the Company's investment in accounts receivable is unlikely. During 1993 some of the benefit received from lower accounts receivable was offset as the Company used cash of $2,649,000 to increase its investment in new product inventories. The increase was due principally to acquisition of materials in the second half of 1993 to support forecasted deliveries of new products including the Infinity 90. Expenditures for property and equipment during 1993, 1992, and 1991 are $11,780,000, $10,119,000 and $17,025,000, respectively. Expenditures for capitalized software during 1993, 1992, and 1991 are $2,142,000, $2,365,000, and $2,640,000, respectively. As of December 31, 1993, there were no material commitments for capital expenditures. Total cash used in operating and investing activities during 1993, 1992 and 1991 of $50,277,000, $27,441,000 and $27,280,000, respectively. These cash outflows were principally offset by cash provided through financing activities of $49,007,000, $24,327,000, and $24,392,000 in 1993, 1992, and 1991, respectively. As discussed below, the principal source of financing has been through various agreements provided by Japan Energy and its wholly owned subsidiaries Gould and EFI (the "Japan Energy Group"). Most recently, on February 4, 1994, Gould exchanged $100,000,000 of indebtedness owed to it by the Company for Series E Convertible Preferred Stock ("Series E"). Also on April 11, 1994, the Company and Gould agreed to amend and restate its existing revolving loan agreement with the Company to increase the amount available under the agreement to $50,000,000 and extend the maturity date of the agreement to April 16, 1996. The other terms and conditions of the agreement are essentially unchanged from those of the prior agreement except certain financial covenants which were modified to more closely reflect the Company's financial position. The Company believes this credit agreement should be sufficient to meet the needs of the business through December 31, 1994. Since 1990, the Company and the Japan Energy Group have entered into the following financing transactions: On January 28, 1991, the Company exchanged Series B Convertible Preferred Stock ("Series B") and Series C Redeemable Preferred Stock ("Series C") for $60,000,000 of indebtedness owed to Gould and concurrently entered into a revolving loan agreement with Gould which, as amended, provided for borrowings of up to $50,000,000. Terms of the Series B are discussed in detail in Note J of the Notes to Consolidated Financial Statements. Effective March 31, 1992, the Company, Gould and Japan Energy completed an agreement whereby Gould converted the Company's existing revolving credit facility with a balance of $50,000,000 into a two year term loan and made available to Encore a new $10,000,000 revolving loan facility with a maturity date of March 31, 1993. Concurrently, Japan Energy through EFI agreed to refinance through its existing term an existing $80,000,000 subordinated loan the Company had with the Industrial Bank of Japan. On September 10, 1992, Gould exchanged 100,000 shares of the Series C with a liquidation preference of $10,000,000 which it held for 100,000 shares of Series D Convertible Preferred Stock ("Series D") also with a liquidation preference of $10,000,000. In connection with the transaction, the Company released Gould from any liability associated with certain outstanding claims related to or arising from the sale by Gould of its Computer System Business to the Company in 1989. Concurrently, EFI exchanged $80,000,000 ($65.5 million net of debt discount) of indebtedness owed to EFI by the Company for 800,000 shares of the Series D with an aggregate liquidation preference of $80,000,000. Completion of the exchange of Series D for the EFI subordinated loan lowered the Company's interest expense by approximately $6,000,000 per year. Terms of the Series D are discussed in detail in Note J of the Notes to Consolidated Financial Statements. On October 5, 1992, Gould agreed to increase the borrowing limit of the revolving loan agreement by $5,000,000 to $15,000,000 under essentially the same terms and conditions as the original agreement. However, as a result of fourth quarter operating losses, the Company exceeded the maximum amount available under the credit facility at December 31, 1992. Effective April 1, 1993, the Company and Gould agreed to: (i) increase the amount available under the revolving credit facility to $35,000,000 under essentially the same terms and conditions as the original agreement, (ii) extend the maturity date of the revolving credit facility to April 16, 1994, (iii) extend the maturity date of the Gould term loan to April 2, 1995 and (iv) waive the covenants contained in the revolving credit facility and the term loan through the end of the first quarter of 1994. Because of operating losses incurred during 1993, the Company reported a capital deficiency throughout the year and exceeded the maximum borrowing limit of the revolving loan agreement during its third fiscal quarter. At December 31, 1993 the Company had borrowed $61,924,000 under the agreement. During the fourth quarter, the Company initiated discussions with Gould to significantly recapitalize the Company. As discussed above and in Note G of Notes to the Consolidated Financial Statements, on February 4, 1994, the Company and Gould agreed to exchange the existing $50,000,000 term loan and $50,000,000 of borrowings under the revolving loan agreement for Series E convertible preferred stock. Terms of the Series E are discussed in detail in Note L of the Notes to Consolidated Financial Statements. On April 11, 1994, the terms of the revolving loan agreement were amended and restated to increase the amount available under the agreement to $50,000,000 and to extend the agreement's maturity date to April 16, 1996. All other terms and conditions of the agreement were essentially unchanged. The Company is dependent on the continued long-term financial support of the Japan Energy Group. Should the Japan Energy Group withdraw its financial support at any time prior to the time the Company returns to profitability by either (i) enforcement of its rights under the terms of its revolving credit agreement in the event of possible future defaults by the Company related to covenants contained therein, (ii) failing to renew existing debt agreements as they expire or (iii) failing to provide additional credit as needed, the Company anticipates it will not be able to secure financing from other sources. In such a case, the Company will suffer a severe liquidity crisis and it will have difficulties settling its liabilities in the normal course of business. The majority of the year end cash on hand of $3,751,000 was at various international subsidiaries. With minor exceptions, all cash is freely remittable to the United States. On January 22, 1992, the Company's stock was excluded from further participation in the Nasdaq National Market system because it was unable to meet minimum capitalization requirements for continuation. Effective February 22, 1992, the Company's common stock began trading on the OTC electronic bulletin board. Upon completion of the $100,000,000 exchange of preferred stock for indebtedness on February 4, 1994, the Company met the minimum requirements for participation in the Nasdaq National Market system and was accepted into the system on March 18, 1994. The Company's common stock trades under the symbol ENCC. ITEM 8 ITEM 8 Financial Statements and Supplementary Data REPORT OF INDEPENDENT ACCOUNTANTS To the Shareholders and Directors of Encore Computer Corporation We have audited the consolidated financial statements and the financial statement schedules of Encore Computer Corporation and Subsidiaries listed in Item 14 (a) 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 the 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. As discussed in Note L to the consolidated financial statements, Japan Energy Corporation and Gould Electronics Inc., a wholly owned subsidiary of Japan Energy Corporation (collectively, the "Japan Energy Group") has refinanced approximately $100 million of the Company's outstanding indebtedness and has committed to provide a working capital facility amounting to $50 million. The Company is dependent upon the support of the Japan Energy Group for its financing requirements. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Encore Computer Corporation 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. COOPERS & LYBRAND Coopers & Lybrand Miami, Florida February 25, 1994, except for Note L as to which the date is April 11, 1994. ENCORE COMPUTER CORPORATION Consolidated Statements of Operations (in thousands except per share data) Year Ended: December 31 , December 31, December 31, 1993 1992 1991 ----------- ---------- -------- Net sales: Equipment $ 43,622 $ 67,840 $ 81,272 Service 49,910 63,053 72,030 ------ ------ ------ Total 93,532 130,893 153,302 Costs and expenses: Cost of equipment sales 29,581 34,283 51,090 Cost of service sales 36,250 44,757 47,073 Research and development 23,331 22,333 30,543 Sales, general and administrative 42,499 45,156 48,732 Amortization of goodwill 691 1,660 1,770 Restructuring costs 23,265 5,248 29,032 ------- ------- ------- Total 155,617 153,437 208,240 ------- ------- ------- Operating loss (62,085) (22,544) (54,938) Interest expense, principally related parties (6,380) (7,425) (9,175) Interest income 134 263 561 Other expense, net (780) (2,077) (1,259) ------- ------ ------- Loss before income taxes (69,111) (31,783) (64,811) Provision for income taxes (Note H) 454 739 577 -------- -------- -------- Net loss $ (69,565) $ (32,522) $(65,388) ========== ========== ========= Net loss per common share (Note A): Net loss attributable to common shareholders $ (78,750) $ (36,993) $(68,107) Loss per common share $ (2.01) $ (0.98) $ (1.87) ========== ========== ========= Weighted average shares of common stock 39,273 37,899 36,466 ========== ========== ========= The accompanying notes are an integral part of the consolidated financial statements. The accompanying notes are an integral part of the consolidated financial statements. The accompanying notes are an integral part of the consolidated financial statements. Supplemental schedule of non-cash investing and financing activities: A. On January 28, 1991, the Company exchanged $60,000,000 of indebtedness, for among other things, preferred stock. Refer to Note G of Notes to Consolidated Financial Statements. B. On September 10, 1992, the Company exchanged indebtedness and redeemable preferred stock for, among other things, preferred stock. Refer to Note G of Notes to Consolidated Financial Statements. C. Accretion of the discount on Series C redeemable preferred stock for the years ended December 31, 1992 and 1991 was $721,000 and $746,000, respectively. D. Effective March 31, 1992, the Company's existing $50,000,000 revolving credit facility was converted to a term loan. Refer to Note G of Notes to Consolidated Financial Statements. The accompanying notes are an integral part of the consolidated financial statements. The accompanying notes are an intergral part of the consolidated financial statements. Notes to Consolidated Financial Statements A. Summary of Significant Accounting Policies Principles of Consolidation The accompanying financial statements include the accounts of Encore Computer Corporation and its wholly owned subsidiaries ("Encore" or the "Company"). All material intercompany transactions have been eliminated. Revenue Recognition Revenue related to equipment and software sales is recognized upon shipment. Service revenue is recognized over the term of the related maintenance agreements. Revenue related to contract research under U. S. government contracts is recognized as reimbursable costs are incurred. Such reimbursable costs include engineering and development costs incurred, outside procurements related to contract performance, and general and administrative costs. Cash and Cash Equivalents Cash equivalents consist of highly liquid investments with maturities at the date of purchase of three months or less. The Company maintains its cash in bank deposit accounts which, at times, may exceed insured limits. The Company has not experienced any losses related to these accounts. Inventories Inventories are stated at the lower of cost or market. Cost is determined by the first-in, first-out method. Loaned equipment which consists primarily of finished computer systems that are loaned to customers for test and evaluation is classified as inventory only if the equipment is intended for resale and anticipated to be in service for a period of less than 12 months prior to sale. Loaned equipment in service for more than 12 months is presented as property and equipment. Property and Equipment Property and equipment is stated at cost. Property and equipment includes customer service inventory which consists principally of spare parts utilized to support repairs at customer installations and is generally not available for resale. Additions, renewals and improvements are capitalized, and repair and maintenance costs are expensed. Upon retirement or sale, the cost of the assets disposed of and the related accumulated depreciation are removed from the accounts and any resulting gain or loss is reflected in the results of operations. Depreciation is provided on a straight line basis over the estimated lives of the assets, generally three years for loaned equipment, five years for equipment and customer service inventory, ten years for furniture and fixtures, and 25 to 30 years for buildings. Leasehold improvements are amortized over their expected useful lives or the lease term, whichever is shorter. Goodwill Goodwill originated from the 1989 acquisition of the Computer Systems Business of Gould Electronics Inc. (the "Computer Systems Business") and represented the excess of the acquisition cost over the estimated fair value of the net assets acquired. From 1989 until 1991, goodwill was being amortized on a straight line basis over a 10 year period. However in 1991, based on the operating losses incurred since the acquisition of the Computer Systems Business, the Company determined goodwill had been permanently impaired. Accordingly, the Company reduced its carrying value from $12,979,000 to $4,979,000 resulting in a charge of $8,000,000. In 1992, due to continuing operating losses, the Company reduced the amortization period for the remaining carrying value of goodwill to December 31, 1994. During 1993, due to the continued inability to achieve profitability, the remaining carrying value of goodwill of $2,628,000 was charged to operations. At December 31, 1992, accumulated amortization amounted to $6,379,000. Amortization of goodwill is presented as a component of operating expense. Capitalized Software The Company capitalizes certain internal costs associated with software development after the development projects reach technological feasibility. Such costs as well as capitalized costs for purchased software, are amortized to cost of sales at the greater of straight line amortization over the expected commercial life of each product, or the proportion of the current period's product revenues to total expected product revenues. The amortization periods range from 3 to 5 years. Software development costs incurred prior to reaching the point of technological feasibility are considered research and development costs and are expensed as incurred. Income Taxes The Company adopted Statement of Financial Accounting Standards (SFAS) No. 109, "Accounting for Income Taxes", effective January 1, 1993, 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 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 adoption of SFAS No. 109 had no cumulative effect on income for the year ended December 31, 1993. Per Share Data Per share data is calculated based upon the weighted average number of shares of common stock and common stock equivalents outstanding. In fiscal periods which report net losses, the calculation does not include the effect of common stock equivalents such as stock options since the effect on the amounts reported would be antidilutive. Series A Convertible Participating Preferred Stock has been considered common stock (on an assumed converted basis) for purposes of income (loss) per share calculations. The Series B Convertible Preferred Stock ("Series B") and Series D Convertible Preferred Stock ("Series D") have been determined to be common stock equivalents but are not included in the weighted average number of shares of common stock and equivalents because the effect would be antidilutive for the years presented. During the year ended December 31, 1993, the Company reported a capital deficiency and as such under Delaware law was precluded from paying dividends. During 1993, the Company accumulated dividends of $3,630,000 and $5,554,700 on shares of its Series B and Series D, respectively. This increased the 1993 net loss attributable to common shareholders by $9,184,700. During the years ended December 31, 1992 and 1991, dividends were paid to holders of the Series B and the then outstanding Series C Redeemable Preferred Stock with shares of Series B. In computing the loss per share, these dividends increased the 1992 and 1991 loss as reported for the per share calculation by $3,943,100 and $2,719,400, respectively. Additionally, during the year ended December 31, 1992, dividends were paid to holders of the Series D with shares of Series D. In computing the loss per share, these dividends increased the 1992 loss as reported for the per share calculation by $528,300. Foreign Currency Translation and Transactions Management has determined that the functional currency of each of the Company's subsidiaries is the United States dollar. Consequently, assets and liabilities of foreign operations are translated into U.S. dollars at period end exchange rates, except that, inventory and property and equipment are translated at historical exchange rates. Income and expenses are translated at the average rates prevailing during the year, except that cost of sales and depreciation are translated at historical exchange rates. All gains and losses arising from changes in exchange rates are included in operating results in the period incurred. The Company, at times, enters into forward exchange contracts to reduce the effect of foreign currency fluctuations on operations and the asset and liability positions of foreign subsidiaries. Resultant gains and losses on these contracts are included in operating results when the operating revenues and expenses are recognized and for assets and liabilities in the period in which the exchange rates change. At December 31, 1993 and December 31,1992, however, the Company had no forward exchange contracts. Foreign exchange losses amounted to $744,000, $1,576,000, and $732,000 in 1993, 1992, and 1991, respectively. Warranties The Company provides a standard product warranty for parts and labor which generally extends ninety days from the date of installation, but on certain contracts for up to one year. The estimated cost of providing such warranty on products sold is included in cost of sales at the time revenue is recognized. Other Certain reclassifications have been made to conform prior year data to current year presentation. B. Inventories Inventories consist of the following (in thousands): December 31, December 31, 1993 1992 ----------- ----------- Purchased parts $ 4,660 $ 2,139 Work in process 9,618 11,913 Finished goods 1,065 601 Loaned computer equipment and consignment inventory 2,421 1,160 -------- -------- $ 17,764 $ 15,813 ======== ========= C. Prepaid Expense and Other Current Assets Prepaid expense and other current assets consist of the following (in thousands): December 31, December 31, 1993 1992 ----------- ------------ Deferred customer sponsored engineering costs $ 1,187 $ - Prepaid rent 266 365 Prepaid expenses 1,477 743 Other current assets 117 407 -------- ------- $ 3,047 $ 1,515 ======== ======= D. Property and Equipment Property and equipment consists of the following (in thousands): December 31, December 31, 1993 1992 ------------ ----------- Land $ 5,100 $ 7,510 Buildings 14,874 14,849 Equipment 38,110 34,478 Customer service inventory 15,245 23,541 Furniture and fixtures 3,503 4,082 Leasehold improvements 1,872 2,100 Loaned equipment 2,735 4,488 Construction in progress 496 1,060 ----------- ----------- 81,935 92,108 Less: accumulated depreciation and amortization (44,332) (45,793) ------------ ----------- $ 37,603 $ 46,315 ============= =========== Depreciation expense in 1993, 1992 and 1991 amounted to $9,853,000, $12,297,000, and $13,683,000, respectively. E. Capitalized Software Capitalized software consists of the following (in thousands): December 31, December 31, 1993 1992 ----------- ----------- Capitalized software $ 8,878 $ 6,735 Accumulated amortization (4,475) (2,778) -------- -------- $ 4,403 $ 3,957 ======= ======= Software costs capitalized in 1993, 1992, and 1991 amounted to $2,142,000, $2,365,000, and $2,640,000, respectively. Amortization of capitalized software costs charged to expense amounted to $1,696,000, $2,043,000, and $2,870,000 in 1993, 1992, and 1991, respectively. The Company wrote down the carrying value of several of its software products by $1,248,000 and $1,271,000 in 1992 and 1991, respectively as part of its transitioning of the UNIX-based product line (See Note F). F. Accounts Payable and Accrued Liabilities; Accounts payable and accrued liabilities consist of the following (in thousands): December 31, December 31, 1993 1992 ----------- ------------ Accounts payable $ 10,805 $ 10,476 Accrued salaries and benefits 5,357 6,290 Accrued restructuring costs 10,974 6,429 Accrued interest 682 2,950 Accrued taxes 3,545 2,083 Deferred income, principally maintenance contracts 1,563 1,306 Other accrued expenses 4,495 6,959 --------- ---------- $ 37,421 $ 36,493 ========= ========= During 1993, 1992, and 1991, the Company recognized restructuring expenses of $23,265,000 $5,248,000, and $29,032,000, respectively. In 1993, restructuring expenses related to (i) the recognition of the permanent impairment in value of certain long lived assets including fixed assets and goodwill, (ii) severance and outplacement costs associated with a 12% reduction in workforce, (iii) the accrual of costs to be incurred for field offices which have been or will be abandoned due to the reduced sales and service workforce. The 1993 charge includes approximately $12,000,000 of non-cash charges related to the write down of the carrying value of assets deemed permanently impaired. It is expected a significant portion of the accrued restructuring costs at December 31, 1993 will be paid during the first half of 1994. In 1992, the Company recognized restructuring costs relating to severance and outplacement costs associated with a reduction in workforce as well as the write-off of capitalized software and certain other assets as part of the Company's continued transition of its product line. Restructuring charges in 1991 relate to severance and outplacement costs associated with a reduction in workforce, the reduction in the carrying value of goodwill, costs associated with the consolidation of operations at the Marlborough, Massachusetts facility as well as other excess facilities, and the write-off of certain capitalized software products due to the transitioning of UNIX-based product lines. Of the total 1992 and 1991 charges, approximately $1,250,000 and $14,000,000, respectively were non-cash charges to operations. G. Debt Debt consists of the following (in thousands): Unaudited (See Note L) Pro Forma December 31, December 31, December 31, 1993 1993 1992 ------------ ----------- ----------- Debt to unrelated parties: Mortgages payable and capital lease obligations $ 1,192 $ 1,192 $ 1,406 Less: Current portion 197 197 193 ----------- ----------- ------------ Total long term debt to unrelated parties $ 995 $ 995 $ 1,213 =========== =========== =========== Debt to related parties: Revolving loan agreements with Gould Electronics Inc. $ 11,924 $ 61,924 $ 15,200 Term Loan with Gould Electronics Inc. - 50,000 50,000 ----------- ----------- ------------ Total debt to related parties 11,924 111,924 65,200 Less: Current portion of debt - - - ---------- ----------- ------------ Total long term debt to related parties $ 11,924 $ 111,924 $ 65,200 ========== =========== =========== Related Party Transactions The Company, Japan Energy Corporation ("Japan Energy"; formerly Nikko Kyodo Co., Ltd.) and its subsidiaries Gould Electronics Inc. (formerly Gould Inc.; "Gould") and EFI International Limited ("EFI") are related parties due to the significant financial interests of Gould and EFI of the Company. As of December 31, 1993, assuming full conversion of their holdings in the Company's preferred stock, Gould and EFI beneficially owned 34.4% and 27.6%, respectively of the Company's common stock. As discussed in more detail in Note L of the Notes to Consolidated Financial Statements, on February 4, 1994, the Company and Gould completed an exchange of indebtedness for preferred stock. Upon completion of the transaction assuming full conversion of their holdings, Gould and EFI beneficially owned 50.2% and 20.9%, respectively. As described below, during 1993 and 1992, the Company had various debt agreements with both Gould and EFI. Total interest expense on indebtedness to Gould for 1993, 1992 and 1991 was $6,082,000, $3,040,000 and $1,299,000, respectively. Interest expense on then outstanding indebtedness to EFI during 1992 was $1,726,000. In addition to the loans described above, amounts due to Gould at December 31, 1993 and 1992, included accrued interest of $677,000 and $2,822,000, respectively. Revolving Loan Agreements Since 1989, Gould has provided the Company with its revolving credit facility. Effective March 31, 1992, Gould converted the then existing revolving loan agreement with an outstanding balance of $50,000,000 to a term loan ("Term Loan") with a maturity date of March 31, 1994. Concurrently, Gould made available to the Company a new $10,000,000 revolving loan facility with a maturity date of March 31, 1993. Borrowings under the revolving loan agreement were collateralized by substantially all of Encore's tangible and intangible assets and the agreement contains various covenants including maintenance of cash flow, leverage and tangible net worth ratios and limitations on capital expenditures, dividend payments and additional indebtedness. In connection with the conversion, compliance with financial covenants contained in the revolving loan agreement was waived through the loan's maturity. As a result of operating losses incurred during 1992, Company borrowings exceeded the maximum allowed under the loan agreement. Accordingly, the Company initiated discussions with Gould to increase the amount available under the revolving credit facility. On October 5, 1992, Gould agreed to increase the borrowing limit by $5,000,000 to $15,000,000 under essentially the same terms and conditions as the original agreement. On April 12, 1993, the Company and Gould agreed to further increase the amount available under the revolving credit facility to $35,000,000 effective April 1, 1993 and to extend its maturity until April 16, 1994, under essentially the same terms and conditions as the original agreement. Additionally, Gould provided the Company with waivers of compliance with the covenants contained in the agreement through the end of the first fiscal quarter of 1994. In light of the 1993 refinancing, the revolving credit facility was classified as a long-term obligation at December 31, 1992. Due to the operating losses incurred during 1993, as of the end of its third fiscal quarter the Company had exceeded the $35,000,000 maximum borrowing amount of its revolving line of credit by $14,415,000. Gould allowed the Company to borrow funds in excess of the agreement's maximum limit to fund its daily operations. At December 31, 1993 borrowings under the agreement were $61,924,000. Interest is equal to the prime rate plus 1% (7.0% at December 31, 1993) and is payable monthly in arrears. As discussed in more detail in Note L, on February 4, 1994, the Company and Gould agreed to exchange $100,000,000 of indebtedness owed to Gould by the Company for Series E convertible preferred stock with a liquidation preference of $100,000,000. $50,000,000 of the debt exchanged was indebtedness under the revolving credit agreement. Upon completion of the exchange, borrowings under the revolving loan agreement on February 4, 1994 were $19,134,000 or $15,866,000 below the maximum borrowing limit of the credit facility. Further, on April 11, 1994, the Company and Gould agreed to increase the amount available under the revolving credit facility to $50,000,000 and to extend its maturity date to April 16, 1996. All other terms and conditions of the revolving loan agreement were essentially unchanged except for certain financial covenants contained in the agreement which were modified to more closely reflect the Company's current financial position. Because of the 1994 refinancing, the revolving credit facility was classified as a long-term obligation at December 31, 1993. Until the Company returns to a state of continued profitability it is unlikely that it will be able to secure additional funding from unrelated parties or be able to generate the levels of cash through operations necessary to meet the on-going needs of the business. Accordingly, the Company is and will remain dependent on the continued financial support of Japan Energy and Gould. Should the Company be unsuccessful in securing additional future financing from Gould or Japan Energy as it is required, it is likely that the Company will have difficulty settling its liabilities on a timely basis. Term Loan The Term Loan due to Gould provided for interest at a rate equal to the prime lending rate plus 1% (7.0% at December 31, 1993). The terms and conditions of the loan were similar to those of the revolving loan agreement described above. The loan is collateralized by substantially all of Encore's tangible and intangible assets and contains various covenants, including maintenance of cash flow, leverage, and tangible net worth ratios and limitations on capital expenditures, dividend payments and additional indebtedness. On April 12, 1993, the Company and Gould agreed to extend the maturity date of the loan to April 2, 1995. Additionally, Gould agreed to provide the Company with waivers of compliance with the covenants contained in the agreement through the end of the first fiscal quarter of 1994. As discussed in more detail in Note L, on February 4, 1994, the Company and Gould cancelled the indebtedness owed by the Company to Gould under the Term Loan agreement in exchange for Series E convertible preferred stock. In light of the 1994 recapitalization and refinancing, the term loan was classified as a long-term obligation at December 31, 1993. 1992 Exchange of Indebtedness and Redeemable Preferred Stock for Preferred Stock On September 10, 1992, Encore and EFI entered into an agreement whereby EFI exchanged $80,000,000 ($65,451,000 net of debt discount) of indebtedness owed to EFI under the then existing subordinated loan agreement for 800,000 shares of the Company's Convertible Preferred Series D Stock ("Series D") with an aggregate liquidation preference of $80,000,000. In addition, Gould exchanged all of its outstanding 100,000 shares of Series C Redeemable Preferred Stock ("Series C") with a liquidation preference of $10,000,000 for 100,000 shares of the Series D also with a liquidation preference of $10,000,000. The Company had originally issued the 100,000 shares of Series C as part of a 1991 exchange of indebtedness for preferred stock. The Series C was redeemable at its liquidation preference plus accumulated dividends on January 28, 1996 and entitled to 6% cumulative annual dividends, payable quarterly. The Series C was recorded at its fair value at the date of issuance and the difference between the fair value and the redemption amount was recorded as a deferred credit in "Other Liabilities". The carrying amount of the Series C was increased by periodic accretions using the interest method so that the carrying amount would equal the mandatory redemption amount at the redemption date. Accretion recognized for year ended December 31, 1992 was $721,000. In connection with this transaction, the Company released Gould from any liability associated with certain outstanding claims related to or arising from the 1989 sale by Gould of its Computer Systems Business to the Company, including: (i) reimbursement to the Company of certain foreign income tax payments made by the Company on Gould's behalf and (ii) release of any liability arising from certain potential environmental clean-up matters associated with former Gould facilities acquired by the Company. The scope of the clean-up matters has been reviewed by an independent environmental engineering firm and, in their opinion, present no significant liability to the Company. Because of the related party nature of this transaction, the difference between the carrying amount of the indebtedness exchanged and the fair value of the securities issued, other considerations granted and accrued professional fees associated with the transaction, the amount of $73,230,000 was credited to additional paid-in capital as follows (in thousands): Total indebtedness exchanged (net of unamortized debt discount) $ 65,451 Total Series C exchanged at redemption value (equivalent to carrying value plus deferred credit) 10,000 Estimated value of claims against Gould forgiven by the Company (1,120) Estimated transaction costs (500) Write-off of debt issue costs related to indebtedness exchanged (592) Par value of Series D exchanged (9) -------- Addition to paid-in capital $ 73,230 ======== H. Income Taxes As discussed in Note A the Company adopted Statement of Financial Accounting Standards (SFAS) No. 109, "Accounting for Income Taxes", effective January 1, 1993. The Company has recorded a provision of $454,000, $739,000 and $577,000 for the years ended 1993, 1992 and 1991 respectively. The provision relates to the profitable operations of foreign subsidiaries. Income tax benefits have not been recorded since the Company has fully reserved the tax benefit of temporary differences, operating losses, capital losses and tax credit carryforwards due to the fact that the likelihood of realization of the tax benefits cannot be established. The significant components of the deferred tax account as of December 31, 1993 were as follows: Deferred tax assets: Net Operating Losses $ 57,775,000 Research & ExperimentaL Credits 1,750,000 Capital Losses 3,622,000 Inventory Reserves 3,535,000 Accrued Vacation 847,000 Various Reserves/Other 1,266,000 Accrued Restructuring 2,372,000 ------------ 71,167,000 Valuation Allowance 69,924,000 ---------- 1,243,000 Deferred tax liabilities: Capitalized Software $ (1,243,000) -------------- Net $ - ============== For income tax purposes the Company had a change in ownership, as defined by Internal Revenue Code Section 382, in connection with the Gould debt exchange on January 28, 1991. The change in ownership resulted in an annual limitation of approximately $2,000,000 on the amount of net operating losses incurred prior to January 28, 1991 that can be utilized to offset the Company's future taxable income. At December 31, 1993, the Company has available approximately $30,000,000 of pre change net operating losses which are allowable after application of the Section 382 limitation, as well as post change net operating losses of $132,767,000. These net operating losses expire in the years 2005 through 2008. The Company also has a net capital loss carryforward of $12,937,000 related to the Gould debt exchange on January 28, 1991, which expires in 1996. I. Commitments and Contingencies Contract Research The Company has performed services under U.S. Government contracts to develop and deliver prototype multiprocessor systems and a workstation which utilize parallel processing architecture. The contracts, issued by the Department of Navy and the Department of the Army for the Defense Advanced Research Project Agency ("DARPA"), included fixed price and cost plus fixed fee elements. While the Company retains certain commercial rights to the technology developed under the contract, the government has been granted rights to technical data developed. In 1991, the Company assigned to Worcester Polytechnic Institute ("WPI") all proposals and advance agreements proposed by the Company to DARPA related to certain potential project awards. Additionally, the Company agreed to subcontract to WPI completion of certain other contracts previously awarded to the Company by DARPA. The Government has reimbursed the Company for pre-award costs incurred in connection with the assigned proposals. WPI will make available to the Company any technological developments which may result from any of the assigned projects. While the novations and/or subcontract agreements are subject to the approval of the affected U.S. government agencies, the Company does not believe this transaction will have an adverse effect on the Company's future financial performance. There were no contract research revenues in 1993. In 1992 and 1991, contract research revenues amounted to $42,000 and $2,719,000, respectively. Leases The Company leases office, research facilities, sales offices and equipment under operating leases. Certain land and building leases have renewal options generally for periods ranging from one to five years. Rental expenses, net of sublease income, were approximately $4,127,000, $5,768,000 and, $7,923,000 for the years ended 1993, 1992, and 1991, respectively. Future minimum lease payments under capital lease obligations and minimum rental payments under operating leases for the next five years are approximately as follows: (in thousands) Capital Operating Year Leases Leases 1994 $ 62 4,180 1995 42 2,453 1996 - 1,548 1997 - 951 1998 - 792 ------- ------- Total Minimum Lease Payments 104 $ 9,924 ======= Less: Amounts representing interest 7 ------- Present value of net minimum lease payments $ 97 ====== Future minimum rental income under noncancelable subleases extending through 1998 amounts to $888,000. Litigation There are no material pending legal proceedings, other than ordinary routine litigation incidental to the business, to which the Company or any of its subsidiaries are party to or of which any of their property is the subject. The unfavorable settlement of any existing matter would not have an adverse impact on the financial results of the Company. Employer's Postemployment Benefits The Company has provided employee's with certain Company-paid postemployment benefits including salary continuation and job counseling services. The Company recognizes such costs on a terminal accrual basis recognizing the estimated cost of postemployment benefits at the date of the event giving rise to the liability to pay those benefits. Concentrations of Credit Risk Financial instruments which subject the Company to concentrations of credit risk are limited to trade receivables. The Company grants credit terms in the normal course of business to its customers which are consistent with industry practices. Generally, the Company's customers are United States government agencies or substantial international corporations often included among the Fortune 500. Additionally, as part of its ongoing control procedures, the Company monitors the credit worthiness of its major customers and establishes individual customer credit limits accordingly. Bad debts realized by the Company have historically not been excessive and doubtful accounts are adequately reserved when identified. Because of these facts, the concentration of credit risk in trade receivables is not considered to be material. Intellectual Property License As part of the 1991 exchange of preferred stock for indebtedness described in Note G, the Company and Gould entered into an intellectual property licensing agreement whereby the Company has agreed to license substantially all of its intellectual property to Gould under certain conditions. The intellectual property license is royalty free and provided that the Company achieved certain revenue levels, would not have allowed Gould to use the intellectual property until January, 1994. The Company has the option to extend its exclusivity period for up to five additional years by making certain cash payments to Gould. However, the period will be automatically extended if certain operating income levels are achieved by the Company. The intellectual property license can be terminated by the Company if all Gould borrowings are repaid and (i) the Series B and Series D are converted into common stock or (ii) the Series B and the Series D are redeemed or (iii) the Company pays Gould the fair value of the license. The Company has not achieved the net revenue or operating income levels necessary under the agreement to maintain its exclusive right to the use of the intellectual property. However, as part of the refinancing discussed in Note L, Gould has agreed to extend the Encore exclusivity period through December 31, 1994. Should the Company be unable to negotiate further extensions to its exclusivity period, Encore will lose its exclusive right to use the intellectual property and Gould may at its option begin to exercise its rights under the agreement. Such action by Gould could have a material adverse effect on the Company's business. J. Capital Stock Series A Convertible Participating Preferred Stock Certain of the Company's operations relate to classified U.S. Government contracts. Accordingly, the government expressed concern regarding the extent of Gould's ownership of the Company's common stock, since Gould, the Company's largest shareholder, is owned and controlled by Japan Energy, a foreign corporation. In this connection, the Company has issued to Gould 73,641 shares of Series A Convertible Participating Preferred Stock ("Series A") in lieu of common stock. The Company has agreed to reserve 7,364,100 shares of common stock for issuance to Gould upon exercise of the conversion option. The holder of Series A and the Company each have the option at any time, with 30 days prior notice, to convert or require to be converted, all or any portion of the Series A preferred shares to common at a ratio of 1 to 100. Dividend rights are equal to those of the common shares (on an assumed converted basis); however, there are significant restrictions on the voting rights of the Series A. The Series A is entitled to elect two members of the Board of Directors but is not entitled to participate in the election of other members of the Board. Based upon the characteristics and rights of the Series A, the Company has deemed these shares to be common stock (on an assumed converted basis) for purposes of loss per share calculations for the fiscal periods presented herein. Cumulative Series B Convertible Preferred Stock The Cumulative Series B Convertible Preferred ("Series B") has a 6% cumulative annual dividend payable quarterly, which the Company can accumulate or pay in additional shares of Series B (valued at its liquidation preference) until the Company's shareholders' equity exceeds $50,000,000. The Series B is convertible into the Company's common stock at $3.25 per share at the holder's option at any time and at the Company's option upon satisfaction of certain conditions. The shares are non-voting, except for the right to elect one director of the Company upon certain dividend payment defaults, the right to elect a majority of the directors of the Company if certain operating income levels are not achieved by the Company and the right to approve actions adversely affecting the Series B. The Series B may be redeemed by the Company at any time for cash equal to the liquidation preference plus accumulated dividends. The Company has reserved shares of common stock sufficient for issuance upon conversion of the Series B and additional shares of Series B which may be issued as a dividend. As of December 31, 1993, the number of common shares reserved for this purpose amounts to 19,320,769. During 1993, the Company reported a capital deficiency and under Delaware law was precluded from issuing dividends. Accordingly, the Company accumulated dividends during 1993 of $3,630,000. During 1992 the Company paid dividends of $3,943,100 in additional shares of Series B. A quarterly dividend on the Series B of $941,800 is payable on January 15, 1994. The Company has elected to accumulate this dividend. As discussed in more detail in Note L of the Notes to Consolidated Financial Statements, upon completion to the exchange of preferred stock for indebtedness, the Company eliminated its capital deficiency and paid all accumulated dividends in shares of Series B. Cumulative Series D Convertible Preferred Stock The Series D has a liquidation preference of $100 per share and carries a 6% cumulative annual dividend which the Company can elect to accumulate or pay currently. The Company may (i) pay the dividend in cash or additional shares of Series D valued at its liquidation preference until shareholders' equity exceeds $50,000,000, or (ii) pay the dividend in cash when shareholders' equity exceeds $50,000,000. The Series D is convertible, at the holder's option, into the Company's common stock at $3.25 per share only (a) if the shareholder is a United States citizen or a corporation or other entity owned in the majority by United States citizens or (b) in connection with an underwritten public offering. The stock is convertible, at the Company's option, if the price of the common stock exceeds $3.90 per share for twenty consecutive days and (a) a buyer is contractually committed to purchase for at least $3.90 per share at least 50% of the shares into which all outstanding Series D would be converted or (b) a buyer is contractually committed to purchase for at least $3.50 per share at least 75% of the shares into which all outstanding Series D would be converted. The shares are non-voting, except for the right to approve actions adversely affecting the Series D. The Company has reserved shares of common stock sufficient for issuance upon conversion of the Series D and additional shares of Series D which may be used for future stock dividends. As of December 31, 1993, the number of shares reserved for this purpose was 29,564,000. During 1993, the Company reported a capital deficiency and under Delaware law was precluded from issuing dividends. Accordingly, the Company accumulated dividends during 1993 of $5,554,700. Dividends of $528,300 were paid on the Series D for the year ended December 31, 1992. A quarterly dividend on the Series D of $1,441,200 is payable on January 15, 1994. The Company has elected to accumulate this dividend. As discussed in more detail in Note L of the Notes to Consolidated Financial Statements, upon completion of the exchange of preferred stock for indebtedness, the Company eliminated its capital deficiency and paid all accumulated dividends in shares of Series D. Impact of Foreign Ownership In connection with both the 1994 exchange of indebtedness for preferred stock discussed in Note L of the Notes to Consolidated Financial Statements and the 1993 and 1992 exchanges of indebtedness for preferred stock discussed in Note G of the Notes to Consolidated Financial Statements, the United States Defense Investigative Service ("DIS") has indicated that it has no objection to the relationships under the United States government requirements relating to foreign ownership, control or influence between Japan Energy Corporation (a Japanese corporation) and its wholly owned subsidiaries (EFI and Gould) and the Company. Shareholders' Agreement In conjunction with the 1994 exchange of Series E for indebtedness discussed in Note L of the Notes to Consolidated Financial Statements and the 1992 exchange of Series D for Series C and indebtedness discussed in Note G, the Company, Kenneth G. Fisher, the Company's Chairman, and Gould amended and restated an existing stockholders agreement. The agreement provides that as long as any shares of Series A are outstanding, Gould, in all elections of directors, will vote all of its common stock pro rata in accordance with the votes of the other shareholders of the Company. In addition, so long as the revolving credit facility with Gould is in effect, should Gould request it, Mr. Fisher has agreed to vote his common shares in favor of expanding the Board of Directors and electing an additional Gould representative to the Board. Adjustment of Accrued Transaction Costs In 1991, the Company exchanged preferred stock for indebtedness owed to Gould. In recording the exchange, the Company accrued estimated transaction costs of $1,812,000 to be incurred as part of the exchange. Actual costs incurred in connection with the exchange were less than those initially estimated and accrued. Accordingly, during 1992, the Company reduced the remaining accrued liability by $900,000 and increased additional paid-in capital. Stock Option and Stock Purchase Plans The Company has had two stock option plans, the 1983 Incentive Stock Option Plan (which expired in 1993) and the 1985 Non- Qualified Stock Option Plan. Under the terms of the plans a total of 12,000,000 shares of the Company's common stock were reserved for issuance to officers, directors and employees. On September 9, 1993, the shareholders voted to increase the number of shares reserved for issuance under the plan by 12,000,000 to a total of 24,000,000 shares. Stock option activity for the 1983 Incentive Stock Option Plan is as follows: Shares Under Option Shares Price Outstanding at December 31, 1990 176,380 $1.13 Fiscal 1991: Canceled (87,500) $1.13 -------- ----- Outstanding at December 31, 1991 88,880 $1.13 Fiscal 1992: No activity - $1.13 -------- ----- Outstanding at December 31, 1992 88,880 $1.13 Fiscal 1993: Exercised (88,880) $1.13 -------- ----- Outstanding at December 31, 1993 0 ======== Options granted under the Incentive Stock Option Plan were granted at exercise prices at least equal to the then current fair market value of the Company's common stock, and were immediately exercisable. Shares issued upon exercise of such options are subject to the Company's repurchase rights which expire ratably over three to five year periods from the date of grant, or automatically upon death or disability. Shares subject to such repurchase rights at the time of termination of employment may be purchased by the Company at the optionee's exercise price. At December 31, 1993, there were no incentive stock options outstanding under the plan. Stock Option activity for the 1985 Non-Qualified Stock Option Plan ("the 1985 Plan") is as follows: Shares Under Option Shares Price Outstanding at December 31, 1990 6,962,427 $0.63 to $3.13 Fiscal 1991: Granted 4,068,366 $0.69 to $1.88 Exercised (567,253) $0.81 to $2.31 Canceled (5,230,717) $0.63 to $3.13 ----------- -------------- Outstanding at December 31, 1991 5,232,823 $0.63 to $3.13 Fiscal 1992: Granted 6,181,530 $0.94 to $1.00 Exercised (352,248) $0.63 to $1.63 Canceled (227,122) $0.63 to $3.13 ----------- -------------- Outstanding at December 31, 1992 10,834,983 $0.63 to $2.31 Fiscal 1993: Granted 592,500 $1.50 to $4.00 Exercised (927,717) $0.63 to $2.00 Canceled (473,437) $0.63 to $2.31 ----------- -------------- Outstanding at December 31, 1993 10,026,329 $0.63 to $4.00 ========== ============== Exercise rights for options granted under the 1985 Plan vest over varying periods up to four years and options to purchase 6,138,280 shares were exercisable at December 31, 1993. Options granted under the 1985 Plan may be granted at an exercise price of not less than 50% of the current fair market value of the common stock. All options granted to date have been at the then current fair market value. During 1993, options granted in 1986 to Mr. Morley, an officer of the Company, were scheduled to expire if not exercised. However, at the time the options were scheduled to expire the Company's policy on insider trading effectively prevented Mr. Morley from exercising the options. Accordingly, the Board of Directors approved an extension of the expiration date until the options could be exercised and the underlying shares sold in accordance with Company policy, which is expected to occur during 1994. The extension has been treated as a cancellation of the old options and a grant of new options in the same amount at the same exercise price. A non-cash non-recurring charge of $788,000 was incurred in connection with the extension of the expiration date of such stock options. On January 31, 1991, the Board of Directors approved a program that permitted holders of certain stock options exercisable for shares of common stock, including the options granted during 1990 at a price of $2.00 per share, to exchange said options for new options (the "Exchange"). Under the terms of the Exchange, an individual was permitted to surrender his original option in exchange for a new option to purchase a number of shares equal to 80% of the number of shares subject to the original option at a new exercise price of $0.81 per share, such exercise price being equal to the closing price per share of the Company's common stock as reported on the National Market System of Nasdaq on February 1, 1991. The effective date of any new options granted pursuant to the Exchange was February 1, 1991; however, new options could not be exercised until June 1, 1991. Except as described above, the terms of the new options were substantially the same as those of the surrendered options. The amount of shares eligible for reissue under the exchange program was 5,306,340 of which 4,101,707 were canceled in exchange for new, repriced grants. In 1990, the shareholders approved the Employee Stock Purchase Plan and reserved 4,000,000 shares for issuance pursuant to rights granted under the Plan. On September 9, 1993, the shareholders voted to increase the number of shares reserved for issuance under the plan from 4,000,000 to 8,000,000. Substantially all employees are eligible to participate in the Employee Stock Purchase Plan. The purchase price per share of common stock in any offering under the Plan is the lower of (i) 85% of the closing price per share of common stock on the commencement of the offering or (ii) 85% of the closing price of a share of common stock on the termination of the offering. Each offering is for a period of approximately six months. Under the Plan, the Company issued 477,579 shares at a weighted average price of $1.56 in 1993, 815,411 shares at a weighted average price per share of $.86 in 1992 and 1,159,504 shares at a weighted average price of $0.64 per share in 1991. K. Segment Information The Company operates in a single industry segment which includes developing, manufacturing, marketing, installing and servicing business information processing systems, principally in the United States, Europe, the Far East, and Canada. In 1993, 1992, and 1991, no single customer accounted for as much as 10% of revenues. During 1993, 1992 and 1991 approximately 37%, 29%, and 33%, respectively, of its revenues were directly or indirectly derived from U.S. Government agencies. The Company maintains operations in Europe and Canada principally through consolidated subsidiaries. Far East operations are through joint ventures in Japan, Hong Kong and Malaysia and distributors throughout the remainder of the region. Information about the Company's operations for 1993, 1992, and 1991 is presented below (in thousands). Inter-geographic net sales, operating income and assets have been eliminated to arrive at the consolidated amounts. Net Sales to Inter- Identi- Unrelated Geographic Total Operating fiable Entities Net Sales Net Sales Income (loss) Assets 1993: United States $ 56,553 $ 11,664 $ 68,217 $ (55,443) $67,928 Europe 34,769 - 34,769 (7,554) 16,409 Other 2,210 - 2,210 (724) 686 -------- ------- ------- ------- ------- Geographic Total 93,532 11,664 105,196 (63,721) 85,023 Inter-Geographic - (11,664) (11,664) 1,636 (953) ------------ --------- -------- --------- -------- Total $ 93,532 $ - $ 93,532 $ (62,085) $84,070 United States $ 69,925 $ 24,232 $ 94,157 $ (19,658) $84,931 Europe 58,311 - 58,311 (4,316) 23,186 Other 2,657 728 3,385 ( 527) 918 ------ ------ ------- -------- ------- Geographic Total 130,893 24,960 155,853 (24,501) 109,035 Inter-Geographic - (24,960) (24,960) 1,957 (3,349) ------------ --------- -------- --------- -------- Total $ 130,893 $ - $130,893 $ (22,544) $105,686 1991: United States $ 86,984 $ 27,204 $114,188 $ (56,605) $ 90,125 Europe 61,291 - 61,291 1,039 35,053 Other 5,027 435 5,462 (899) 1,959 ------- ------ ------- ------- ------- Geographic Total 153,302 27,639 180,941 (56,465) 127,137 Inter-Geographic - (27,639) (27,639) 1,527 (5,951) ------------ --------- -------- --------- ---------- Total $ 153,302 $ - $153,302 $ (54,938) $ 121,186 Inter-geographic net sales are recorded principally at 60% of list price. Identifiable assets are all assets, including corporate assets, identified with operations in each region. L. Subsequent Events On February 4, 1994, Gould exchanged its term loan and a portion of its revolving credit loan totaling $100,000,000 for 1,000,000 shares of the Company's Series E Convertible Preferred Stock ("Series E") with a liquidation preference of $100,000,000 (See Note G). The principal terms of the Series E are: (i) The Series E is senior in liquidation priority to all other classes of the Company's preferred and common stock. (ii) 6% cumulative annual dividend which the Company can elect to (a) pay in additional shares of Series E valued at its liquidation preference until shareholders' equity exceeds $50,000,000 or (b) accumulate and pay in cash when shareholders' equity exceeds $50,000,000. (iii) a liquidation preference of $100 per share. (iv) convertible, at the holder's option, into the Company's common stock at the liquidation preference divided by $3.25 per share (subject to potential adjustments for splits, etc.) only (a) if the shareholder is a United States citizen or corporation or other entity owned in the majority by United States citizens or (b) in connection with an underwritten public offering. (v) convertible, at the Company's option in accordance with the conversion methodology described in (iv) above if the price of the common stock exceeds $3.90 per share for twenty consecutive days and (a) a buyer is contractually committed to purchase for at least $3.90 per share at least 50% of the shares into which all outstanding Series E would be converted or (b) a buyer is contractually committed to purchase for at least $3.50 per share at least 75% of the shares into which all outstanding Series E would be converted. (vi) non-voting, except for the right to approve actions adversely affecting the Series E. The accompanying unaudited Pro Forma Consolidated Balance Sheet as of December 31, 1993 is presented as if the transactions described above had been consummated as of that date. Because of the related party nature of the transaction, the difference between the carrying amount of the indebtedness exchanged and the fair value of the securities issued and other consideration granted has been credited to additional paid in capital. A summary of the financial effects of the transaction are as follows (in thousands): Reduction of debt $100,000 Less: Par value of shares issued (1,000,000 shares at $.01 par value) (10) Accrued transaction costs (700) Accrued interest on the remaining indebtedness under the revolving loan agreement for the remaining term of the agreement (1,043) --------- Increase in additional paid in capital $ 98,247 ======== Upon completion of the refinancing, the Company reported a capital surplus and was able to pay all dividends accumulated since January 15, 1993 and immediately did so in additional shares of preferred stock. Prior to the transaction, Japan Energy and its wholly owned subsidiaries beneficially owned 62.0% of the Company's outstanding common stock assuming the full conversion of all outstanding shares of its preferred stock. Upon completion of the transaction, their beneficial ownership increased to 71.1%. On April 11, 1994, the Company and Gould agreed to amend and restate the existing revolving loan agreement by increasing the maximum borrowing limit of the agreement to $50,000,000 and extending its maturity date to April 16, 1996. Other terms and conditions of the agreement are essentially unchanged except certain financial covenants contained in the agreement were modified to more closely reflect the Company's current financial position. 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 directors of the Company is included in the Company's Proxy Statement for the 1994 Annual Meeting of Shareholders under the caption "Election of Directors" and is incorporated herein by reference. Information regarding executive officers of the Company is included in Part I under the caption "Executive Officers of the Registrant" and is incorporated herein by reference. ITEM 11 ITEM 11 Executive Compensation Information regarding Executive Compensation is included in the Company's Proxy Statement for the 1994 Annual Meeting of Shareholders under the caption "Executive Compensation" and is incorporated herein by reference. Item 12 Item 12 Security Ownership of Certain Beneficial Owners and Management Information regarding Security Ownership of Certain Beneficial Owners and Management is included in the Company's Proxy Statement for the 1994 Annual Meeting of Shareholders under the caption "Principal Stockholders" and is incorporated herein by reference. Item 13 Item 13 Certain Relationships and Related Transactions Information regarding Certain Relationships and Related Transactions is included in the Company's Proxy Statement for the 1994 Annual Meeting of Shareholders under the caption "Certain Transactions" and 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. Index to Financial Statements and Financial Statement Schedules Form 10-K Page Number Report of independent public accountants relating to consolidated financial statements and financial statement schedules 28 Consolidated statements of operations for the years ended December 31, 1993, 1992 and 1991 29 Consolidated balance sheets at December 31, 1993 and 1992 30 Consolidated statements of cash flows for the years ended December 31, 1993, 1992 and 1991 31 Consolidated statements of shareholders' equity (capital deficiency) for the years ended December 31, 1993, 1992, and 1991 33 Notes to consolidated financial statements 34-51 The following consolidated financial statement schedules are submitted herewith: Form 10-K Page Number Schedule V Property, plant and equipment 54 Schedule VI Accumulated depreciation, depletion and amortization of property, plant and equipment 55 Schedule VIII Valuation and qualifying accounts 56 Schedule X Supplementary income statement information 57 The consolidated financial statement schedules should be read in conjunction with the consolidated financial statements included herein. All other schedules have been omitted since the required information is not present or is not present in amounts sufficient to require submission of the schedule, or because the information required is included in the consolidated financial statements and notes thereto. (a)3. Index to Exhibits The exhibits listed on the accompanying index to exhibits immediately following the consolidated financial statement schedules are filed as part of this report. (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. For purposes of complying with the amendments to the rules governing Form S-8 under the Securities Act of 1933, the undersigned registrant hereby undertakes as follows, which undertaking shall be incorporated by reference into the registrant's Registration Statements on Form S-8 Nos. 33-34171 and 33-33907. Insofar as indemnification of 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 as 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 the 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. (1) Other changes for the year ended December 31, 1991 represent obsolete inventory charged to customer service cost of sales. Other changes for the year ended December 31, 1992 represent reclassifications from and to inventory. Other changes for the year ended December 31, 1993 consist principally of assets written off as part of restructuring actions taken during 1993 (See Note F of the Notes to Consolidated Financial Statements). (1) Other changes for the year ended December 31, 1992 represent reclassifications to inventory. Other changes for the year ended December 31, 1993 consist principally of assets written off as part of restructuring actions taken during 1993 (See Note F of the Notes to Consolidated Financial Statements). (1) Includes amounts deemed uncollectible. ENCORE COMPUTER CORPORATION Schedule X Supplementary income statement information (in thousands) Year Ended Year Ended Year Ended December 31, December 31, December 31, Item 1993 1992 1991 - ---------------------- ---------- ---------- -------- Maintenance and repairs $ 2,553 $ 2,172 $ 2,705 Advertising costs 4,132 1,828 2,950 Taxes other than payroll taxes 2,011 2,076 2,256 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 as the chief accounting officer and an officer of the registrant thereunto duly authorized. ENCORE COMPUTER CORPORATION (Registrant) By: T. MARK MORLEY T. Mark Morley Vice President, Finance and Chief Financial Officer April 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. Signature Title Date - ----------------- --------------------- ------------- KENNETH G. FISHER Chairman of the Board Kenneth G. Fisher Chief Executive Officer April 11, 1994 ROWLAND H. THOMAS, JR. President and Chief Rowland H. Thomas, Jr. Operating Officer and Director April 11, 1994 C. DAVID FERGUSON C. David Ferguson Director April 11, 1994 ROBERT J FEDOR Robert J. Fedor Director April 11, 1994 DANIEL 0. ANDERSON Daniel O. Anderson Director April 11, 1994 T. MARK MORLEY Vice President, Finance T. Mark Morley and Chief Financial Officer April 11, 1994 KENNETH S. SILVESTEIN Kenneth S. Silverstein Corporate Controller April 11, 1994 (a)3. Index to Exhibits. The exhibit numbers in the following index correspond to the numbers assigned to such exhibits in the Exhibit Table of Item 601 of Regulation S-K. Exhibit No. Description 3.1 Certificate of Incorporation of the Company, as amended (incorporated herein by reference to the Company's Form 10-K for the year ended December 31, 1990) 3.1a Amendment to the Certificate of Incorporation filed with the Delaware Secretary of State on March 26, 1992 (incorporated herein by reference to Exhibit 3.1a to the Company's Form 10-K for the year ended December 31, 1991). 3.2 By-laws of the Company, as amended (incorporated herein by reference to Exhibit 3.2 to the Company's Form l0-K for the year ended December 31, 1989). *3.3 Amendment to the Certificate of Incorporation dated September 30, 1993 increasing the number of authorized common shares from 120,000,000 to 150,000,000. 4.1 Articles NINTH and TENTH of the Certificate of Incorporation of the Company, as amended, and Certificates of Stock Designation relating, respectively, to the Company's Series A Convertible Participating Preferred Stock, Series B Convertible Preferred Stock and Series C Redeemable Preferred Stock (see Exhibit 3.1). Incorporated herein by reference to the Company's Form 10-K for the year ended December 31,1990. 4.2 Article 1 of the By-laws of the Company, as amended (incorporated herein by reference to Exhibit 3.2 to the Company's Form 10-K for the year ended December 31,1989). 4.3 Certificate of Stock Designation relating to the Company's Series D Convertible Preferred Stock (incorporated herein by reference to Exhibit 4.3 to the Company's Form 10-K for the year ended December 31,1992). *4.4 Certificate of Stock Designation relating to the Company's Series E Convertible Preferred Stock. 10.1 The Company's 1983 Incentive Stock Option Plan, as amended (incorporated herein by reference to Exhibit 28.1 to the Company's Form S-8/Form S-3 Registration Statement No. 33-34171). 10.2 The Company's 1985 Non-Qualified Stock Option Plan, as amended (incorporated herein by reference to Exhibit 28.2 to the Company's Form S-8/Form S-3 Registration Statement No. 33-34171). 10.3 The Company's 1990 Employee Stock Purchase Plan as amended (incorporated herein by reference to the Company's Form S-8/Form S-3 Registration Statement No. 33-72458). 10.4 Form of Promissory Note and Pledge and Escrow Agreement between the Company and Mr. DiNanno (incorporated herein by reference to Exhibit 10.9 to the Company's Form 10-K for the year ended October 25, 1986). 10.5 Form of Indemnification Agreement between the Company and its executive officers (incorporated herein by reference to Exhibit 10.4 to the Company's Form 10-K for the year ended December 31, 1989). 10.6 Purchase Agreement dated as of March 20, 1989, among the Company, Gould Inc. and certain subsidiaries of Gould Inc. (incorporated herein by reference to Exhibit 2.1 to the Company's Form 8-K filed with the Commission on May 12, 1989, as amended by Form 8-S filed July 11, 1989 and February 7, 1990), as amended by an Agreement dated August 1, 1989, among the Company, Gould Inc. and Kenneth G. Fisher (incorporated herein by reference to Exhibit 10.8b to the Company's Form 10-K for the year ended December 31, 1989). 10.7a Master Purchase Agreement dated as of September 10, 1992, between the Company, Gould Inc. and EFI International Inc. (incorporated herein by reference to Exhibit 10.7a to the Company's Form 10-K for the year ended December 31,1992). *10.7b Master Purchase Agreement dated as of February 3, 1994 between the Company and Gould Electronics Inc. 10.8 Intellectual Property License Agreement dated as of January 28, 1991, among the Company, Encore Computer U.S., Inc. ("Encore U.S.") and Gould Inc. (incorporated herein by reference to Exhibit 10.9 of the Company's Form 10-K for the year ended December 31, 1990. 10.9a First Amendment to Amended and Restated Stockholder's Agreement among the Company, Gould Inc. and Kenneth G. Fisher dated March 31, 1992 (incorporated herein by reference to the Company's Form 10-K for the year ended December 31, 1991). *10.9.b Third Amendment to Amended and Restated Stockholders Agreement among the Company, Gould Electronics Inc. as assignee of Gould Inc. and Indian Creek Capital, Ltd as assignee of Kenneth G. Fisher dated February 3, 1994. 10.9c Amended and Restated Registration Agreement dated September 10, 1992, among Kenneth G. Fisher and his permitted transferees, the Company and Gould Inc. (incorporated herein by reference to Exhibit 10.9b to the Company's Form 10-K for the year ended December 31, 1992). 10.9d Second Amendment to Amended and Restated Stockholders Agreement among the Company, Gould Inc. and Kenneth G. Fisher dated September 10, 1992 (incorporated herein by reference to Exhibit 10.9c to the Company's Form 10-K for the year ended December 31, 1992). 10.9e Amended Agreement to the Revolving Loan Agreement among the Company and Gould Inc. and the Term Loan Agreement among the company and Gould Inc. dated April 12, 1993 (incorporated herein by reference to Exhibit 10.9d to the Company's Form 10-K for the year ended December 31, 1992). *10.9f Third Amended and Restated Registration Agreement dated February 3, 1994, among the Company, Gould Electronics Inc. as assignee of Gould Inc. and Indian Creek Capital, Ltd. as assignee of Kenneth G. Fisher. 10.11 Series B Convertible Stock Purchase Agreement dated January 28, 1991, between the Company and the Purchasers named therein (incorporated herein by reference to the Company's Form 10-K Exhibit 10.12 for the year ended December 31, 1990). 10.12 Acknowledgement of Cancellantion of Debt between the Company and EFI International Inc. dated September 10, 1992 (incorporated herein by reference to Exhibit 10.12 to the Company's Form 10-K for the year ended December 31, 1992). *10.12a Acknowledgement of Cancellation of Debt between the Company and Gould Electronics Inc. dated February 3, 1994. 10.13 Revolving Loan Agreement dated as of January 28, 1991, between the Company and Gould Inc. (incorporated herein by reference to the Company's Form 10-K Exhibit 10.13 for the year ended December 31, 1990). 10.13b Agreement to amend the Loan Agreement dated March 31, 1992 between the Company and Gould Inc. (incorporated herein by reference to the Company's Form 10-K Exhibit 10.13b for the year ended December 31, 1991). 10.13c The Amended and Restated Revolving Loan Agreement dated March 31, 1992 between Encore Computer Corporation and Gould Inc. (incorporated herein by reference to the Company's Form 10-K Exhibit 10.13c for the year ended December 31, 1991). 10.13d The Second Amended and Restated Revolving Loan Note dated March 31, 1992 between Encore Computer Corporation and Gould Inc. (incorporated herein by reference to the Company's Form 10-K Exhibit 10.13d for the year ended December 31, 1991). 10.13e The Renewal Term Notes dated March 31, 1992 between Encore Computer Corporation and Gould Inc. (incorporated herein by reference to the Company's Form 10-K Exhibit 10.13e for the year ended December 31, 1991). 10.13f Agreement to amend the Loan Agreement dated October 5, 1992 between the Company and Gould Inc. (incorporated herein by reference to Exhibit 10.13f to the Company's Form 10-K for the year ended December 31, 1992). *10.13g Amended Loan Agreement and related letter agreement dated April 11, 1994 between the Company and Gould Electronics Inc. 10.14 Amended and Restated General Security Agreement dated as of January 28, 1991, among the Company, Encore U.S. and Gould Inc. (incorporated herein by reference to the Company's Form 10-K Exhibit 10.14 for the year ended December 31, 1990). 10.15a Agreement of Encore Computer Corporation to Assign The Industrial Bank of Japan, Limited subordinated loan agreement to EFI International Inc. dated March 27, 1992 (incorporated herein by reference to the Company's Form 10-K Exhibit 10.15a for the year ended December 31, 1991). 10.15b Letter Agreement between Encore Computer Corporation and EFI International Inc. concerning the subordinated loan agreement dated March 31, 1992 (incorporated herein by reference to the Company's Form 10-K Exhibit 10.15b for the year ended December 31, 1991). 10.16 Memorandum of Agreement dated November 8, 1991 between Encore Computer Corporation and Worchester Polytechnic Institute to assign certain sales proposals to Worchester Polytechnic Institute (incorporated herein by reference to the company's Form 10-K Exhibit 10.16 for the year ended December 31, 1991). *10.17 Support Services Provider Agreement dated December 9, 1993 between Encore Computer Corporation and Halifax Corporation to subcontract certain customer service field maintenance activities to Halifax Corporation. *10.18 Amendment No. 1 to Nonqualified Stock Option Agreement between Encore Computer Corporation and T. Mark Morley dated November 10, 1993. *10.19 Description of the Company's Corporate Executive Compensation Plan *11.0 Calculation of Earnings per Share *22.0 Subsidiaries of the Company. *24.1 Consent of Independent Public Accountants. *Filed herewith.

92232_1993.txt

92232_1993

1993

92232

ITEM 1. BUSINESS The principal business of Southern Natural Gas Company ("Southern"), which is a wholly owned subsidiary of Sonat Inc. ("Sonat"), is the transmission of natural gas in interstate commerce. Southern, including its subsidiaries, owns approximately 9,230 miles of interstate pipeline. Its pipeline system has a certificated daily delivery capacity of approximately 2.4 billion cubic feet ("Bcf") of natural gas. Southern's pipeline system extends from gas fields in Texas, Louisiana, Mississippi, Alabama, and the Gulf of Mexico to markets in Louisiana, Mississippi, Alabama, Florida, Georgia, South Carolina, and Tennessee. Southern also has pipeline facilities offshore Texas connecting gas supplies to other pipelines that transport such gas to Southern's system. A map of Southern's pipeline system, including pipelines of its subsidiaries, appears on page I-8. Southern owns and operates Muldon Storage Field ("Muldon"), a large underground natural gas storage field in Mississippi connected to its pipeline system. Based on operating experience, Southern recently sought to have the working storage capacity of Muldon reduced from 52 to 31 billion cubic feet of gas. The Federal Energy Regulatory Commission ("FERC") approved this reduction for a one-year period ending November 1, 1994, subject to a further review of Muldon's operations during the 1993-94 winter period. Bear Creek Storage Company ("Bear Creek"), an unincorporated joint venture between wholly owned subsidiaries of Southern and Tenneco Inc., each of which is a 50-percent participant, owns a large underground natural gas storage field located in Louisiana that is operated by Southern and provides storage service to Southern and Tennessee Gas Pipeline Company, a subsidiary of Tenneco Inc. The Bear Creek Storage Field has a total certificated working storage capacity of approximately 65 billion cubic feet of gas, half of which is committed to Southern. At December 31, 1993, Bear Creek's gross facilities cost was approximately $246,923,000 and its participants' equity was $90,907,000. Southern had an investment in Bear Creek, including its equity in undistributed earnings, of $45,453,000 at December 31, 1993. Under the terms of Order No. 636, discussed below, effective November 1, 1993, Southern commenced providing contract storage services as part of its unbundled and restructured services. Consequently, most of Southern's working storage capacity at Muldon and its half of Bear Creek are now used for such services. As a part of making this new service available, effective November 1, 1993, Southern sold at its cost $123 million of its working storage gas inventory to its new storage customers. Southern's interstate pipeline business is subject to regulation by the FERC, the U.S. Department of Energy's Economic Regulatory Administration (the "ERA"), and the U.S. Department of Transportation under the terms of the Natural Gas Policy Act of 1978 (the "NGPA"), the Natural Gas Act, and various pipeline safety and environmental laws. See "Governmental Regulation" below for information concerning the regulation of natural gas transmission operations. Southern's business is subject to the usual operating risks associated with the transmission of natural gas through a pipeline system, which could result in property damage and personal injury. Sonat maintains broad insurance coverage on behalf of Southern limiting financial loss resulting from these operating risks. Additional business information concerning Southern and its wholly owned subsidiaries is contained in Management's Discussion and Analysis of Financial Condition and Results of Operations and in the Notes to Consolidated Financial Statements in Part II of this report and is hereby incorporated herein by reference. At January 1, 1994, Southern and its subsidiaries employed approximately 1,170 persons. Southern's principal executive offices are located at 1900 Fifth Avenue North, AmSouth-Sonat Tower, Birmingham, Alabama 35203, and its telephone number is (205) 325-7410. I-1 Order No. 636 Restructuring In 1992 the FERC issued its Order No. 636 (the "Order"). As required by the Order, interstate natural gas pipeline companies, including Southern and South Georgia Natural Gas Company ("South Georgia"), a wholly owned interstate pipeline subsidiary of Southern, have made significant changes in the way they operate. The Order required pipelines, among other things, to (1) separate (unbundle) their sales, transportation, and storage services; (2) provide a variety of transportation services, including a "no-notice" service pursuant to which the customer is entitled to receive gas from the pipeline to meet fluctuating requirements without having previously scheduled delivery of that gas; (3) adopt a straight-fixed-variable method for rate design (which assigns more costs to the demand component of the rates than do other rate-design methodologies previously utilized by pipelines); and (4) implement a pipeline capacity release program under which firm customers have the ability to "broker" the pipeline capacity for which they have contracted. The Order also authorizes pipelines to offer unbundled sales services at market-based rates and allows for pregranted abandonment of some services. Interstate pipeline companies, including Southern, are incurring certain costs ("transition costs") as a result of the Order, the principal one being costs related to amendment or termination of existing gas purchase contracts, which are referred to as gas supply realignment ("GSR") costs. The Order provides for the recovery of 100 percent of the GSR costs and other transition costs to the extent the pipeline can prove that they are eligible, that is, incurred as a result of customers' service choices in the implementation of the Order, and were incurred prudently. In its restructuring settlement discussions, Southern has advised its customers that the amount of GSR costs that it actually incurs will depend on a number of variables, including future natural gas and fuel oil prices, future deliverability under Southern's existing gas purchase contracts, and Southern's ability to renegotiate certain of these contracts. While the level of GSR costs is impossible to predict with certainty because of these numerous variables, based on current spot-market prices, a range of estimates of future oil and gas prices, and recent contract renegotiations, the amount of GSR costs would be approximately $275-$325 million on a present-value basis. This amount includes the payments made to amend or terminate gas purchase contracts described below. On September 3, 1993, the FERC generally approved a compliance plan for Southern and directed Southern to implement its restructured services pursuant to the Order on November 1, 1993 (the "September 3 order"). Pursuant to Southern's compliance plan, GSR costs that are eligible for recovery include payments to reform or terminate gas purchase contracts. Where Southern can show that it can minimize transition costs by continuing to purchase gas under the contract (i.e., it is more economic to continue to perform), eligible GSR costs would also include the difference between the contract price and the higher of (a) the sales price for gas purchased under the contract or (b) a price established by an objective index of spot-market prices. Recovery of these latter costs is permitted for an initial period of two years. Southern's compliance plan contains two mechanisms pursuant to which Southern is permitted to recover 100 percent of its GSR costs. The first mechanism is a monthly fixed charge designed to recover 90 percent of the GSR costs from Southern's firm transportation customers. The second mechanism is a volumetric surcharge designed to collect the remaining ten percent of such costs from Southern's interruptible transportation customers. This funding will continue until the GSR costs are fully recovered or funded. The FERC also indicated that Southern could file to recover any GSR costs not recovered through the volumetric surcharge after a period of two years. In addition, Southern's compliance plan provides for the recovery of other transition costs as they are incurred and any remaining transition costs may be recovered through a regular rate filing. Southern's customers have generally opposed the recovery of its GSR costs. The September 3 order rejected the argument of certain customers that a 1988 take-or-pay recovery settlement bars Southern from recovering GSR costs under gas purchase contracts executed before March 31, 1989, which comprise most of Southern's GSR costs. Those customers subsequently filed motions urging the FERC to reverse its ruling on that issue. On December 16, 1993, the FERC affirmed its September 3 ruling with respect to the 1988 take-or-pay recovery settlement (the "December 16 order"). The December 16 order generally approved Southern's restructuring tariff submitted pursuant to the September 3 order. Various parties have filed motions urging the FERC to modify the December 16 order and have sought judicial review I-2 of the September 3 order. Southern and its customers engaged in settlement discussions regarding Southern's restructuring filing prior to the September 3 order, but the parties were unable to reach a settlement. Those discussions are continuing. During 1993 Southern reached agreements to reduce significantly the price payable under a number of high cost gas purchase contracts in exchange for payments of approximately $114 million. On December 1, 1993, Southern filed with the FERC to recover such costs and approximately $3 million of prefiling interest (the "December 1 filing"). On December 30, 1993, the FERC accepted such filing to become effective January 1, 1994, subject to refund, and subject to a determination through a hearing before an administrative law judge that such costs were prudently incurred and eligible under Order No. 636. Southern's customers are opposing its recovery of these GSR costs in this proceeding. The December 30 order rejected arguments of various parties that a pipeline's payments to affiliates, in this case Southern's payment to a subsidiary of Sonat Exploration Company, that represented approximately $34 million of the December 1 filing, may not be recovered under Order No. 636. In December 1993 Southern reached agreement to reduce the price under another contract in exchange for payments having a present value of approximately $52 million. Payments will be made in equal monthly installments over an eight-year period ending December 31, 2001. On February 14, 1994, Southern made a rate filing to recover, beginning March 1, 1994, those costs as well as approximately $2 million of other settlement costs and $800,000 of prefiling interest. Southern also incurred approximately $17.5 million of GSR costs, plus prefiling interest, from November 1, 1993, through January 31, 1994, from continuing to purchase gas under contracts that are in excess of current market prices. On March 1, 1994, Southern made a rate filing to recover those costs beginning April 1, 1994. Southern plans to make additional rate filings quarterly to recover these "price differential" costs and any other GSR costs. Southern is unable to predict all of the elements of the ultimate outcome of its Order No. 636 restructuring proceeding, its settlement discussions with its customers regarding all of the pending issues arising in connection with the proceeding, or its rate filings to recover its transition costs. In requiring that Southern provide unbundled storage service, the Order resulted in a substantial reduction of Southern's working storage gas inventory and consequently a reduction in its rate base. This reduction was effective on November 1, 1993, when Southern restructured pursuant to the Order and sold at its cost $123 million of its working storage gas inventory to its customers. The Order also resulted in rates that are less seasonal, thereby shifting revenues and earnings for Southern out of the winter months. Markets -- Transportation and Sales As described above, effective November 1, 1993, Southern and South Georgia restructured their services in compliance with FERC Order No. 636 by separating their transportation, storage, and merchant services. With the exception of some limited sales necessary to dispose of its gas supply remaining under contract, Southern essentially became solely a transporter of natural gas. Effective May 5, 1992, South Georgia had converted all its sales service to transportation-only service and Southern had begun to provide a gas sales service to South Georgia's former sales customers. Southern transports or sells gas at wholesale for distribution for domestic, commercial, and industrial uses to nine gas distributing companies, to 114 municipalities and gas districts, and to nine connecting interstate pipeline companies. Southern also transported or sold gas directly to 55 industrial end-users in 1993. Southern principally transports gas to resale and industrial customers and to other pipelines, sells some limited volumes of gas at wholesale for distribution, and sells very minimal volumes of gas directly to industrial customers. The principal industries served directly by Southern's pipeline system and indirectly through its resale customers' distribution systems include the chemical, pulp and paper, textile, primary metals, stone, clay and glass industries. Transportation volumes in 1993 were 763 Bcf or 91 percent of Southern's total throughput of 836 Bcf, compared with 733 Bcf or 87 percent of Southern's total 1992 throughput of 842 Bcf. Sales to resale distribution customers, including municipalities and gas districts, accounted for virtually all of 1993 sales of I-3 73 Bcf (excluding the sale of storage inventory) and 1992 sales of 109 Bcf. Southern's sales to direct sales customers and interstate pipeline companies in both years were negligible. Southern had sales of 19 Bcf during November and December 1993 (following implementation of its Order No. 636 restructuring) that were made at receipt points where the gas entered its pipeline system; consequently, those volumes are included within the 763 Bcf of transportation volumes for 1993. Transportation service is rendered by Southern for its resale customers, direct industrial customers and other end-users, gas producers, other gas pipelines, and gas marketing and trading companies. Southern provides transportation service in both its gas supply and market areas. Transportation service is provided under rate schedules that are subject to FERC regulatory authority. Rates for transportation service depend on whether such service is on a firm or interruptible basis and the location of such service on Southern's pipeline system. Transportation rates for interruptible service (i.e., service of a lower priority than firm transportation) are charged for actual volumes transported. Firm transportation service also includes a demand charge designed so that the customer pays for a significant portion of the service each month based on a contract demand volume regardless of the actual volume transported. Rates for transportation service are discounted by Southern in individual instances to respond to competition in the markets it serves. Continued discounting could, under certain circumstances, increase the risk that Southern may not recover all of its costs allocated to transportation services. Sales by Southern are anticipated to continue only until Southern's remaining supply contracts expire, are terminated, or are assigned. As a result of Order No. 636 Southern is attempting to terminate its remaining gas purchase contracts through which it had traditionally obtained its long-term gas supply. Some of these contracts contain clauses requiring Southern either to purchase minimum volumes of gas under the contract or to pay for it ("take-or-pay" clauses). Although Southern currently is incurring essentially no take-or-pay liabilities under these contracts, the annual weighted average cost of gas under these contracts is in excess of current spot-market prices. Pending the termination of these remaining supply contracts, Southern has agreed to sell a portion of its remaining gas supply to a number of its firm transportation customers for a one-year term that began November 1, 1993. Recently, the sales agreements with Atlanta Gas Light Company and its subsidiary, Chattanooga Gas Company (collectively "Atlanta") were extended through March 31, 1995. The rest of Southern's remaining supply will be sold on a month-to-month basis. Southern will file to recover as a GSR cost pursuant to Order No. 636 the difference between the cost associated with the gas supply contracts and the revenue from the sale agreements and month-to-month sales and also any cost incurred to reduce the price under or to terminate Southern's remaining gas supply contracts. When long-term sales service agreements with substantially all of Southern's resale customers expired or were terminated in 1989, Southern entered into a series of short-term agreements on an annual basis with virtually all of such customers. Prior to the implementation of Order No. 636, several customers had already reduced their firm sales contract demand volumes or converted a portion of their firm sales volumes to firm transportation volumes. From 1988 until Southern's implementation of Order No. 636, total daily delivery obligations under firm sales contracts (the "contract demand" upon which monthly demand charges are based) were reduced by approximately 689 million cubic feet ("MMcf") from their level at the end of 1987 of approximately 2.1 Bcf. Prior to Southern's implementation of Order No. 636, approximately 74 percent of this reduction had been replaced with firm transportation volumes under contracts of varying terms and durations, which also provided for fixed monthly charges. In accordance with the September 3 order approving Southern's Order No. 636 compliance plan, Southern solicited service elections from its customers in order to implement its restructured services on November 1, 1993. Southern's largest customer, Atlanta, bid for firm transportation service on Southern at prices significantly below Southern's filed tariff rates. Southern rejected Atlanta's bids. Southern and Atlanta subsequently entered into an interim agreement under which Atlanta signed firm transportation service agreements with transportation demands of 582 million cubic feet per day for a minimum term of four months beginning November 1, 1993, and 118 million cubic feet per day for a term extending until April 30, 2007, at the maximum FERC-approved rates. This represented an aggregate reduction of 100 million cubic feet per day from Atlanta's level of service prior to November 1, 1993. In January 1994 Atlanta provided notice that it had elected to continue that level of firm service until October 31, 1994. Southern's other customers elected in I-4 aggregate to obtain an amount of firm transportation services that represented a slight increase from their level of firm sales and transportation services from Southern prior to Southern's implementation of Order No. 636, at the maximum FERC-approved tariff rates, for terms ranging from one to ten or more years. Although management believes that most of Southern's former resale customers ultimately will commit to some type of new long-term firm transportation agreements with Southern under its restructuring program, it is unable to predict at what total volume level or for what duration such commitments will be made. Transportation and sales by Southern to three unaffiliated distribution customers, Atlanta, Alabama Gas Corporation, and South Carolina Pipeline Corporation, accounted for approximately 40 percent, 18 percent, and nine percent, respectively, of Southern's 1993 consolidated revenues. Atlanta and Alabama Gas Corporation were the only two customers that accounted for ten percent or more of Southern's consolidated revenues for 1993. Southern is continuing to pursue growth opportunities to expand the level of services in its traditional market area and to connect new gas supplies. On May 13, 1993, Southern and South Georgia received approval from the FERC for a $27 million expansion of South Georgia's pipeline system into northern Florida and southwestern Georgia that will increase firm daily capacity by 40 million cubic feet per day. Construction on this project is under way and should be completed in mid-1994. In January 1994 Southern reached tentative agreement with a group of new customers to expand its service in the growing eastern Tennessee area. The proposed project entails a 20-mile pipeline extension that would deliver approximately nine million cubic feet of natural gas per day to a delivery point near Chattanooga. For additional information regarding Southern's transportation and sales of gas, see Management's Discussion and Analysis of Financial Condition and Results of Operations contained in Part II of this report. Gas Supplies During 1993 Southern purchased its gas supply from the following areas: 51 percent from southern Louisiana and from the Gulf of Mexico, offshore Louisiana, and Texas; three percent from northern Louisiana and Texas; and 46 percent from Mississippi and Alabama. Southern has approximately 60 gas purchase contracts remaining with gas producers that commit proved recoverable reserves to Southern. As described above, pursuant to Order No. 636, Southern is attempting to terminate its remaining gas purchase contracts. The following table contains information as to Southern's gas supply and the general sources from which that supply was obtained during the years 1991 through 1993. - --------------- * As used in this report, the term "Mcf" means thousand cubic feet; the term "MMcf" means million cubic feet; and the term "Bcf" means billion cubic feet. All volumes of natural gas referred to in this report are stated at a pressure base of 14.73 pounds per square inch absolute ("psia") and at 60 degrees Fahrenheit. Southern entered into no new long-term gas purchase agreements in 1993, due to the cessation of its merchant role because of Order No. 636 as discussed above. Since Order No. 636 prohibits Southern from providing its traditional bundled merchant service, Southern does not anticipate at this time that it will need to contract for the long-term purchase of any additional natural gas supplies in the future. Southern will purchase minimal volumes of gas from time to time as may be required for system management purposes. Southern does expect, however, that adequate gas supplies will need to continue to be available to its system; consequently, Southern has continued its efforts to have new gas supplies attached to its system. I-5 Potential Royalty Claims In connection with its settlements of take-or-pay claims made by producers over the past few years, Southern has in certain limited instances indemnified, to varying degrees, the producer from certain potential claims made by royalty owners. Southern has thus far been notified of 12 potential royalty claims under the indemnity provisions of various settlement agreements. The claims for which Southern may have to indemnify these producers have been asserted by both private lessors with respect to onshore leases and the Minerals Management Service Division of the U.S. Department of the Interior (the "MMS") with respect to offshore and Indian leases. Southern settled four of these claims during 1993 for approximately $1.2 million. In addition to the claims for which Southern has been put on notice, it is possible that other producers may make future claims against Southern for royalty indemnification. The June 26, 1992 decision of the Louisiana Supreme Court in Frey v. Amoco, in which the court held that royalty was due on take-or-pay payments, may form a basis for royalty claims for a share of take-or-pay settlements by private lessors in Louisiana and in other states that may follow the Frey decision. Because courts typically require that interest be paid on the royalty back to the date of settlement, the amount owed can substantially exceed the royalty amount. Management believes that Southern's maximum exposure under all of its various royalty indemnities in onshore take-or-pay settlements, including interest, approximates $15 million. Management is unable to state whether any additional royalty claims based on Southern's indemnification provisions in its take-or-pay settlements will be asserted or to predict the outcome of any such claims or resulting litigation. In addition to the potential royalty claims related to onshore production, Southern also faces exposure in connection with indemnifications in take-or-pay settlements with producers who have federal offshore or Indian leases. The MMS issued a policy statement and guidelines on May 3, 1993, declaring its intention to collect royalty payments for contract buy-downs, buy-outs, pricing disputes, and on any portion of take-or-pay settlement payments that are subject to future recoupment. In June 1993 the MMS began to issue letters to producers requiring payment of royalty on all such payments received under take-or-pay settlements, along with interest back to the date of payment. The MMS has been aggressively auditing producers since this time and issuing orders to pay. A lawsuit filed by the Independent Petroleum Association of America against the MMS and others challenging the validity of the MMS' new policy is pending in federal district court for the District of Columbia. Management is unable to predict the outcome of this litigation or the ultimate outcome of any collection efforts by the MMS. Management believes that Southern's maximum exposure for all royalty claims related to offshore production, including interest, approximates $10 million if no recovery from its customers is allowed. Under the terms of a 1988 take-or-pay recovery settlement with Southern's customers, Southern is entitled to seek recovery of these costs under the FERC's Order No. 500 cost-sharing procedures. The customers, however, are entitled to challenge any effort by Southern to recover those costs. Management is unable to predict the outcome of the efforts of the MMS to collect royalty on a portion of any offshore settlement or of Southern's efforts to recover any amounts it may ultimately pay from its customers. Southern believes that it is adequately reserved for any royalty claims that it may ultimately have to pay or to settle and that, in any event, such claims will not have a material adverse effect on its financial condition or results of operations. Southern Energy Company Southern Energy Company ("Southern Energy"), a wholly owned subsidiary of Southern, owns a liquefied natural gas ("LNG") receiving terminal near Savannah, Georgia, which was constructed for a project, now terminated, to import LNG from Algeria. The terminal has been inactive since the early 1980s. On July 22, 1992, the FERC issued an order approving a settlement relating to Southern Energy's LNG facilities. The settlement resolved a number of outstanding rate and accounting issues on a favorable basis and preserved an option for customers of Southern Energy to obtain LNG through this facility at least through the year 1999. I-6 Sea Robin Pipeline Company For many years Southern was a 50-percent participant, through a wholly owned subsidiary, with a wholly owned subsidiary of United Gas Pipe Line Company ("United"), in Sea Robin Pipeline Company ("Sea Robin"), an unincorporated gas supply pipeline joint venture. Sea Robin was originally constructed to obtain Gulf of Mexico gas supplies for Southern's and United's respective pipeline systems and was operated by United. In December 1990 Southern, through a newly formed subsidiary, acquired the 50-percent interest in Sea Robin formerly owned by the subsidiary of United. As a result of the acquisition, two wholly owned subsidiaries of Southern own 100 percent of Sea Robin, which is now being operated by Southern. Sea Robin has a 436-mile pipeline system located in the Gulf of Mexico through which it transports gas for others under its FERC-regulated tariffs. Sea Robin is a transportation-only pipeline that has restructured in compliance with FERC Order No. 636. Sea Robin's compliance filing has been accepted by the FERC. Sea Robin transported approximately 287 Bcf of natural gas in 1993. These Sea Robin volumes are included within the Southern transportation volumes discussed earlier. See Note 8 of the Notes to Consolidated Financial Statements in Part II of this report for additional information regarding Sea Robin. Competition and Current Business Conditions The natural gas transmission industry, although regulated, is very competitive. During the period from the mid-1980s until the Order No. 636 restructuring, customers had switched much of their volumes from a bundled merchant service to transportation service, reflecting an increased willingness to rely on gas supply under unregulated arrangements. Southern competes with several pipelines for the transportation business of its customers and at times discounts its transportation rates in order to maintain market share. Southern continues to provide a limited merchant service with gas supply remaining under contract and, in this capacity, competes with other suppliers, pipelines, gas producers, marketers, and alternate fuels. Natural gas is sold in competition principally with fuel oil, coal, liquefied petroleum gases, and electricity. An important consideration in Southern's markets is the ability of natural gas to compete with alternate fuels. Residual fuel oil, the principal competitive alternate fuel in Southern's market area, was at certain times in 1993, and currently is, priced at or below the comparable price of natural gas in industrial and electric generation markets. Some parts of Southern's market area are also served by one or more other pipeline systems that can provide transportation as well as sales service in competition with Southern. Southern's two largest customers are both able to obtain a portion of their natural gas requirements through transportation by other pipelines. I-7 [SOUTHERN NATURAL PIPELINE MAP GOES HERE] I-8 Governmental Regulation Southern is subject to regulation by the FERC and by the Secretary of Energy under the Natural Gas Act, the NGPA, and the Department of Energy Organization Act of 1977 (the "DOE Act"). Southern's operating subsidiaries are also subject to such regulation. The Natural Gas Act, modified by the DOE Act, grants to the FERC authority to regulate the construction and operation of pipeline and related facilities utilized in the transportation and sale of natural gas in interstate commerce, including the extension, enlargement, or abandonment of such facilities. Southern and its operating subsidiaries hold required certificates of public convenience and necessity issued by the FERC authorizing them to construct and operate all pipelines, facilities, and properties now in operation for which certificates are required, and to transport and sell natural gas in interstate commerce. The FERC also has authority to regulate the transportation of natural gas in interstate commerce and the sale of natural gas in interstate commerce for resale. Although the FERC still retains jurisdiction over their resale rates, following the implementation of Order No. 636, Southern and other interstate pipeline companies are now permitted to charge market-based rates for gas sold in interstate commerce for resale. Gas sold by marketing companies is not regulated by the FERC. Transportation rates remain fully regulated. The price at which gas is sold to direct industrial customers is not subject to the FERC's jurisdiction. As necessary, Southern and its operating subsidiaries file with the FERC applications for changes in their transportation rates and charges designed to allow them to recover fully their costs of providing such service to their customers, including a reasonable rate of return. These rates are normally allowed to become effective, subject to refund, until such time as the FERC rules on the actual level of rates. See "Rate and Regulatory Proceedings" below. The Natural Gas Wellhead Decontrol Act of 1989, enacted on July 26, 1989, phased in decontrol of the wellhead price of all gas then remaining subject to maximum lawful price limitations by January 1, 1993. Thus, the price of all gas sold at the wellhead is no longer regulated. Regulation of the importation of natural gas is vested in the Secretary of Energy, who has delegated various aspects of this import jurisdiction to the FERC and the ERA. Southern and its operating subsidiaries are subject to the Natural Gas Pipeline Safety Act of 1968, as amended, which regulates pipeline and LNG plant safety requirements, and to the National Environmental Policy Act and other environmental legislation. Southern and its operating subsidiaries have a continuing program of inspection designed to keep all of their facilities in compliance with pollution control and pipeline safety requirements and believe that they are in substantial compliance with applicable requirements. Southern's capital expenditures to comply with environmental and pipeline safety regulations were approximately $14 million in 1993. It is anticipated that such expenditures will be approximately $11 million in 1994 and approximately $10 million in 1995. For more information regarding environmental matters, see the discussion below. Rate and Regulatory Proceedings. Various matters pending before the FERC, or before the courts on appeal from the FERC, relating to, or that could affect, Southern or one or more of its subsidiaries are described in Part II of this report in Note 8 of the Notes to Consolidated Financial Statements and in Management's Discussion and Analysis of Financial Condition and Results of Operations, which are incorporated herein by reference. As described in Note 8, several general rate changes have been implemented by Southern and remain subject to refund. Environmental Matters Southern and certain of its subsidiaries are subject to extensive federal, state, and local environmental laws and regulations that affect their operations. Governmental authorities may enforce these laws and regulations with a variety of civil and criminal enforcement measures, including monetary penalties, assessment and remediation requirements, and injunctions as to future activities. Southern and certain of its subsidiaries' use and disposal of hazardous materials and toxic substances are subject to the requirements of the federal Toxic Substances Control Act ("TSCA") and the federal Resource Conservation and Recovery I-9 Act ("RCRA"), among others, and comparable state and local statutes. The Comprehensive Environmental Response, Compensation and Liability Act ("CERCLA"), also known as "Superfund," imposes liability, without regard to fault or the legality of the original act, for release of a "hazardous substance" into the environment. Southern is named as a potentially responsible party ("PRP") at three Superfund sites, at two of which it is a de minimis party. Based on the number of other financially responsible PRPs at each of the sites, the estimated relative volume of material contributed to the sites by Southern, the information that it currently possesses regarding the expected costs required to remediate the sites, and the amounts already contributed to remediation, Southern currently estimates that it should not ultimately be required to contribute in excess of $200,000 in the aggregate to the costs of remediation of all three sites. In addition, Southern has been advised by a joint defense group of PRPs ("JDG") at another Superfund site that the JDG might seek to add it as a PRP, but Southern has received no notification from the Environmental Protection Agency ("EPA") asserting that it is a PRP. Southern has been informed by representatives of the JDG that no characterization of soil or groundwater contamination at this site has yet taken place and, therefore, the extent of such contamination, if any, is not currently known. Southern has thus far elected not to join the JDG, because it believes that it has significant potential defenses to liability for this site and that, in any event, it shipped de minimis amounts of material to this site. Based on the number of other financially responsible PRPs and other information that it currently possesses, Southern currently estimates that it will not incur liabilities related to this site in an amount material to Southern. Liability under CERCLA (and applicable state law) can be joint and several with other PRPs. Although volumetric allocation is a factor in assessing liability, it is not necessarily determinative; thus, the ultimate liability at any of these sites could be substantially greater than the amounts described above. Southern does not believe that its status as a PRP at any of these sites will have a material adverse effect on its financial condition or results of operations. Southern has in the past used lubricating oils containing polychlorinated biphenyls ("PCBs") in conjunction with auxiliary compressed air systems at Southern's natural gas compressor stations. Although the use of such oils was discontinued in the early 1970's, Southern has discovered residual PCB contamination at certain of its gas compressor station sites. For some time, Southern has had an ongoing internal project to identify and deal with the presence of PCBs at these sites. A total of thirteen stations evidenced some level of on-site PCB contamination ranging from low to moderate. Southern has completed the characterization and clean-up of twelve of these sites based on the guidelines of the TSCA at a total cost of approximately $6 million. Southern has partially completed the characterization and clean-up of the remaining site and believes that it should be able to complete the remediation of this site for a total cost of less than $5 million. In the operation of their natural gas pipeline systems, Southern and South Georgia have used, and continue to use at several locations, gas meters containing elemental mercury. Many of these meters have been removed from service. Southern and South Georgia plan to remove the remaining mercury meters during the course of regularly scheduled facilities upgrades, but until such time, the meters are handled pursuant to established procedures that protect employees and comply with Occupational Safety and Health Administration standards. It is generally believed in the natural gas pipeline industry that, in the course of normal maintenance and replacement operations, elemental mercury may have been released from mercury meters. Although at this time neither the EPA nor any state in which Southern or South Georgia operates has yet issued clean-up levels or guidelines with respect to contamination from past releases or spills of mercury, Southern expects that guidelines will be forthcoming. Southern and South Georgia have nonetheless begun preliminary efforts to address this situation and plan to begin remediation if contamination is detected upon characterization of these sites. Because the number of sites involved and the extent of contamination at any site are not yet known, Southern is unable at this time to estimate the cost of remediation. Based on its experience with other remediation projects, the industry experience to date with remediation of mercury, and its preliminary analysis of the possible extent of the contamination, however, Southern believes that its remediation of any mercury contamination will not have a material adverse effect on its financial condition or results of operations. I-10 Southern generally considers environmental assessment and remediation costs and costs associated with compliance with environmental standards incurred by Southern and South Georgia to be recoverable through rates since they are prudent costs incurred in the ordinary course of business and, accordingly, will seek recovery of such costs through rate filings, although no assurance can be given with regard to their ultimate recovery. Southern and its subsidiaries are subject to the federal Clean Air Act and the federal Clean Air Act Amendments of 1990 ("1990 Amendments"), which added significantly to the existing requirements established by the federal Clean Air Act. The 1990 Amendments require that the EPA issue new regulations, mainly related to mobile sources, air toxics, ozone non-attainment areas, acid rain, permitting, and enhanced monitoring. While it will not be possible to estimate the additional costs of compliance with these new requirements until the EPA and the states complete their regulations, management expects that the regulations when issued may require significant capital spending to modify certain of the facilities of Southern and its subsidiaries, particularly with regard to modifications that may be required for certain natural gas compressor stations to reduce their emission of oxides of nitrogen. In the opinion of management, based on information currently possessed by Southern, the probability is remote that Southern or any of its subsidiaries will incur a liability as a result of the presently identified environmental contingencies described above in an amount material to Southern. While the nature of environmental contingencies makes complete evaluation impractical, Southern is currently aware of no other environmental matter that could reasonably be expected to have a material impact on its results of operations or financial condition. Southern has an active and ongoing environmental program at all levels of its organization and believes responsible environmental management is integral to its business. Southern believes that it and its subsidiaries have conducted their operations in substantial compliance with applicable environmental laws and regulations governing their activities. ITEM 2. ITEM 2. PROPERTIES A description of Southern's and its subsidiaries' properties is included under Item 1. Business above and is hereby incorporated by reference herein. ITEM 3. ITEM 3. LEGAL PROCEEDINGS For information regarding certain proceedings pending before federal regulatory agencies, see Note 8 of the Notes to Consolidated Financial Statements in Part II of this report. Arcadian Corporation v. Southern Natural Gas Company and Atlanta Gas Light Company was filed in January 1992 in the U.S. District Court for the Southern District of Georgia. In this lawsuit against Southern and Atlanta Gas Light Company for alleged violation of the antitrust laws in connection with Southern's refusal to provide direct service to the Plaintiff, Arcadian Corporation ("Arcadian"), Arcadian claims actual damages of at least $15 million, which could be trebled under the antitrust laws. Southern and Arcadian executed an agreement settling this lawsuit on November 30, 1993. The settlement provides that the lawsuit will be dismissed with prejudice upon final, nonappealable approval by the FERC of the direct connection and transportation service requested by Arcadian. Pending such approval, the lawsuit has been stayed. While management believes it has meritorious defenses and intends to defend the suit vigorously if the stay were to be lifted, given the inherently unpredictable nature of litigation and the relatively early state of discovery in the case, management is unable to predict the ultimate outcome of the proceeding if it were to go forward, but believes that it will not have a material adverse effect on Southern's financial position. Exxon Corporation v. Southern Natural Gas Company was filed in February 1994 in the U.S. District Court for the Southern District of Texas. Exxon Corporation ("Exxon"), the plaintiff in this suit, asked the court to declare that Southern has no right to terminate a gas purchase contract with Exxon providing for the sale and purchase of gas produced from Mississippi Canyon and Ewing Bank Area Blocks, offshore Louisiana (the "Contract"), which Southern gave notice of termination effective March 1, 1994. In the alternative, Exxon alleged that Southern has repudiated and breached the Contract and asked for an unspecified amount I-11 of monetary damages. Management is unable to predict the outcome of this litigation and whether its position that it has the right to terminate this contract will be sustained. Southern and its subsidiaries are involved in several other lawsuits, all of which have arisen in the ordinary course of business. Southern does not believe that any ultimate liability resulting from any of these other pending lawsuits will have a material adverse effect on the financial position or results of operations of Southern. I-12 ` PART II Item 5. Item 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS All of the common stock of Southern is held by its parent company, Sonat Inc.; accordingly, there is no market for the stock. The following table shows the quarterly dividends paid on Southern's common stock during the past two years. (1) In May 1992, Southern completed the restructuring of its capital structure by issuing $100 million in Notes and dividending the proceeds to Sonat. II-1 Item 6. Item 6. SELECTED FINANCIAL DATA Shown below is selected consolidated financial data for Southern and its subsidiaries. II-2 Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations SOUTHERN NATURAL GAS COMPANY MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS RESULTS OF OPERATIONS Southern Natural Gas Company and its subsidiaries (Southern) participate in the interstate transmission and sale of natural gas in the southeastern United States and are regulated by the Federal Energy Regulatory Commission (FERC). The natural gas transmission industry, although regulated, is very competitive. Effective November 1, 1993, Southern separated its transportation, storage and merchant services to comply with Order No. 636 (see following discussion) and essentially became solely a gas transporter. Even before the Order No. 636 restructuring, customers had switched much of their volumes from a bundled merchant service to transportation service, reflecting an increased willingness to rely on gas supply under unregulated arrangements. Southern competes with several pipelines for the transportation business of its customers and at times discounts its transportation rates in order to maintain market share. Although it is now predominantly a transporter of gas, Southern continues to provide a limited merchant service with gas supply remaining under contract and, in this capacity, competes with other suppliers, gas producers, marketers and alternate fuels. Southern is pursuing growth opportunities to expand the level of services in its traditional market area and to connect new gas supplies. South Georgia Natural Gas Company, a wholly owned subsidiary of Southern, received approval from the FERC on May 13, 1993, for an expansion of its pipeline system into northern Florida and southwestern Georgia that will increase firm daily capacity by 40 million cubic feet per day. Construction on this project is under way and should be completed by mid-1994. Southern has entered into an agreement in principle to expand its system to Chattanooga, Tennessee. II-3 OPERATIONS 1993 Versus 1992. Southern's operating results for 1993 were down primarily due to a favorable settlement of $9.6 million in 1992 relating to Southern Energy Company's idle liquified natural gas (LNG) facility. A settlement at Sea Robin Pipeline Company increased 1993 results by $4.5 million. General and administrative expenses were up in 1993 due to a $4 million increase in health insurance expense and an increase in stock-based employee compensation. Gas sales revenue and gas cost increased at Southern due to the sale of $123 million of storage gas inventory pursuant to the implementation of Order No. 636 on November 1, 1993. Total market throughput increased 2 percent; however, Order No. 636 resulted in a shift in volumes from sales to market transportation. Supply transportation volumes decreased due to competition from other pipelines. 1992 Versus 1991. Operating income for 1992 includes the effect of a favorable settlement of $9.6 million relating to Southern Energy's LNG facility, while 1991 was negatively affected by one-time charges totaling $11 million related to a cost-containment program and the cancellation of the Mobile Bay project. Excluding these items, operating income was lower primarily as a result of a $7 million increase in stock-based employee compensation. II-4 Southern's total volumes increased 8 percent in 1992. Market throughput was higher because of colder weather and new markets, offsetting the loss of a competitive load to coal that was served in 1991 when gas prices were substantially lower and losses to other pipeline competition. The 18 percent increase in supply transportation is primarily the result of higher deliverability and an aggressive program of hooking up new gas supply to the Sea Robin system. ORDER NO. 636 In 1992 the FERC issued its Order No. 636 (the Order). As required by the Order, interstate natural gas pipeline companies have made significant changes in the way they operate. The Order required pipelines, among other things, to: (1) separate (unbundle) their sales, transportation and storage services; (2) provide a variety of transportation services, including a "no- notice" service pursuant to which the customer will be entitled to receive gas from the pipeline to meet fluctuating requirements without having previously scheduled delivery of that gas; (3) adopt a straight fixed variable (SFV) method for rate design (which assigns more costs to the demand component of the rates than do other rate design methodologies previously utilized by pipelines); and (4) implement a pipeline capacity release program under which firm customers will have the ability to "broker" the pipeline capacity for which they have contracted. The Order also authorizes pipelines to offer unbundled sales services at market-based rates and allowed for pregranted abandonment of some services. As discussed in Note 8 of the Notes to Consolidated Financial Statements, Southern is incurring certain transition costs as a result of implementing Order No. 636, and for Southern, those are primarily gas supply realignment (GSR) costs relating to existing gas purchase contracts. In its restructuring settlement discussions, Southern has advised its customers that the amount of GSR costs that it actually incurs will depend on a number of variables, including future natural gas and fuel oil prices, future deliverability under Southern's existing gas purchase contracts and Southern's ability to renegotiate certain of these contracts. While the level of GSR costs is impossible to predict with certainty because of these numerous variables, based on current spot-market prices, a range of estimates of future oil and gas prices, and recent contract renegotiations, the amount of GSR costs would be approximately $275 million-$325 million on a present value basis. This includes the $168 million of settlements discussed below. In requiring that Southern provide unbundled storage service, the Order resulted in a substantial reduction of Southern's working storage gas inventory and consequently a reduction in its rate base. The reduction in rate base was effective on November 1, 1993, when Southern restructured pursuant to the Order and sold $123 million of its storage gas inventory to its customers. The Order also resulted in rates that are less seasonal, thereby shifting revenues and earnings for Southern out of the winter months. The FERC issued an order on September 3, 1993 (the September 3 order), that generally approved a compliance plan for Southern and directed it to implement restructured services on November 1, 1993. In accordance with the September 3 order, Southern solicited service elections from its customers in II-5 order to implement its restructure services on November 1, 1993. Southern's largest customer, Atlanta Gas Light Company and its subsidiary, Chattanooga Gas Company (collectively Atlanta), bid for firm transportation service on Southern at prices significantly below Southern's filed tariff rates. Southern rejected Atlanta's bids. Southern and Atlanta subsequently entered into an interim agreement under which Atlanta signed firm transportation service agreements with transportation demands of 582 million cubic feet per day for a minimum term of four months beginning November 1, 1993, and 118 million cubic feet per day for a term extending until April 30, 2007, at the maximum FERC-approved rates. This represented an aggregate reduction of 100 million cubic feet per day from Atlanta's level of services prior to November 1, 1993. In January 1994, Atlanta provided notice that it had elected to continue that level of firm service until October 31, 1994. Southern's other customers elected in aggregate to obtain an amount of firm transportation services that represented a slight increase from their previous level of firm sales and transportation services from Southern, at the maximum FERC-approved tariff rates, for terms ranging from one to 10 or more years. Southern is unable to predict all of the elements of the ultimate outcome of its Order No. 636 restructuring proceeding, its settlement discussions with Atlanta and its other customers, and the limited rate filings to recover its transition costs. NATURAL GAS SALES AND SUPPLY As a result of Order No. 636, Southern is attempting to terminate its remaining gas purchase contracts through which it had traditionally obtained its long-term gas supply. Some of these contracts contain clauses requiring Southern either to purchase minimum volumes of gas under the contract or to pay for it (take-or-pay clauses). Although Southern currently is incurring essentially no take-or-pay liabilities under these contracts, the annual weighted average cost of gas under these contracts is in excess of current spot-market prices. Pending the termination of these remaining supply contracts, Southern has agreed to sell a portion of its remaining gas supply to a number of its firm transportation customers for a one-year term which began November 1, 1993. The rest of Southern's remaining supply will be sold on a month-to-month basis. The difference between the cost associated with the gas supply contracts and the revenue from the sale agreements and month-to-month sales should be recoverable as a GSR cost pursuant to Order No. 636. In addition, any cost to terminate or reduce the price under Southern's remaining contracts should also be recoverable as a GSR cost pursuant to Order No. 636. During 1993 Southern reached agreements to reduce significantly the price payable under a number of high-cost gas purchase contracts in exchange for payments with a present value of approximately $168 million. II-6 Southern's purchase commitments under its remaining gas supply contracts for the years 1994 through 1998 are estimated as follows: These estimates are subject to significant uncertainty due both to the number of assumptions inherent in these estimates and to the wide range of possible outcomes for each assumption. None of the three major factors which determine purchase commitments (underlying reserves, future deliverability and future price) is known today with certainty. As explained above, Southern expects to recover all of these costs, including its costs to terminate these purchase commitments, either through the sale of the gas or as a GSR cost. RATE MATTERS Several general rate changes have been implemented by Southern and remain subject to refund. See Note 8 of the Notes to Consolidated Financial Statements for a discussion of rate matters. ________________________ 1993 Versus 1992. Interest income was higher in 1993 due to an increase in average levels and rates on notes from affiliates. The increase in interest income was largely offset by an increase in accrued interest expense of $8 million provided on certain income tax issues and to higher average debt levels. 1992 Versus 1991. Interest expense on debt increased due to an increase in average debt outstanding, resulting from the restructuring of Southern's capital structure in May 1992, partially offset by lower average interest rates. II-7 1993 Versus 1992. Income taxes were lower in 1993 due to tax adjustments. 1992 Versus 1991. Income taxes were higher primarily due to higher pretax income. FINANCIAL CONDITION CASH FLOWS 1993 Versus 1992. Net cash provided by operating activities increased due to the sale of storage gas inventory pursuant to Order No. 636 and lower cash outflows relating to gas imbalances. Partially offsetting the increase were GSR payments of approximately $128 million made in 1993. 1992 Versus 1991. Net cash provided by operating activities decreased as a result of lower cash outflows relating to gas imbalances. 1993 Versus 1992. Net cash used in investing activities was higher due to a $17 million increase in capital expenditures and increased loans to Southern's parent. 1992 Versus 1991. Net cash used in investing activities was lower due primarily to a $62 million decrease in capital expenditures partially offset by an increase in notes to Southern's parent. 1993 Versus 1992. Net cash used in financing activities increased slightly due to scheduled loan repayments. Southern did not refinance any debt during 1993. II-8 1992 Versus 1991. Net cash used in financing activities in 1992 was flat with 1991. In May 1992, Southern completed the restructuring of its capital structure by issuing $100 million in Notes and dividending the proceeds to Sonat. As a result, the debt to capitalization ratio increased 8 percent when compared to December 31, 1991. CAPITAL EXPENDITURES Capital expenditures for 1994, including joint ventures, are expected to be approximately $68 million, primarily for pipeline additions and replacements and other projects, some of which have not yet received regulatory approval. LIQUIDITY AND CAPITAL RESOURCES At December 31, 1993, Southern had available $50 million under lines of credit. Southern expects to use cash from operations, borrowing in the public or private markets or loans from affiliates to finance future capital or other corporate expenditures. CAPITALIZATION INFORMATION INFLATION AND THE EFFECT OF CHANGING ENERGY PRICES Although the rate of inflation in the United States has been moderate over the past several years, its potential impact should be considered when analyzing historical financial information. In past times of high general inflation, oil and gas prices have increased at comparable, and at times, higher rates. The changing regulatory environment in which the natural gas business operates, along with other competitive factors, would currently make it difficult to increase prices enough to recover significantly higher costs of operations. Southern's results of operations will be affected by future changes in domestic and international oil and gas prices and the interrelationship between oil, gas and other energy prices. ENVIRONMENTAL ISSUES Southern is involved in various environmental compliance and cleanup activities, and has been notified that it is one of many potentially responsible parties at certain federal Superfund sites. Southern does not expect costs relating to these activities, including any responsibility for cleanup of such sites, to be material, taken either separately or in the aggregate, with respect to the financial position or results of operations of Southern. In addition, Southern has taken steps to test for the presence of polychlorinated biphenyls (PCB) at its natural gas compressor stations. A total of 13 stations evidenced some level of on-site PCB contamination ranging II-9 from low to moderate. Southern has completed the characterization and cleanup of 12 of these sites at a cost of approximately $6 million. Southern has partially completed the characterization and cleanup of the 13th site and believes that it should be able to complete the remediation of this site for a total cost of less than $5 million, approximately half of which had been incurred at December 31, 1993. Southern generally considers environmental assessment and remediation costs and costs associated with compliance with environmental standards to be recoverable through rates since they are prudent costs incurred in the ordinary course of business, and accordingly, will seek recovery of such costs through rate filings, although no assurance can be given with regard to their ultimate recovery. Southern has an active and ongoing environmental program and believes responsible environmental management is integral to its business. II-10 Item 8. Item 8. Financial Statements and Supplementary Data Report of Ernst & Young, Independent Auditors The Board of Directors Southern Natural Gas Company We have audited the accompanying consolidated balance sheets of Southern Natural Gas Company and Subsidiaries as of December 31, 1993 and 1992, and the related statements of income, changes in 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)2. 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 Southern Natural Gas 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. /s/ Ernst & Young ERNST & YOUNG Birmingham, Alabama January 20, 1994 II-11 SOUTHERN NATURAL GAS COMPANY AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS December 31, 1993 and 1992 See accompanying notes. II-12 SOUTHERN NATURAL GAS COMPANY AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS December 31, 1993 and 1992 See accompanying notes. II-13 SOUTHERN NATURAL GAS COMPANY AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME Years Ended December 31, 1993, 1992 and 1991 CONSOLIDATED STATEMENTS OF CHANGES IN RETAINED EARNINGS Years Ended December 31, 1993, 1992 and 1991 See accompanying notes. II-14 SOUTHERN NATURAL GAS COMPANY AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS Years Ended December 31, 1993, 1992 and 1991 See accompanying notes. II-15 SOUTHERN NATURAL GAS COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. Significant Accounting Policies Principles of Consolidation - The Consolidated Financial Statements include the accounts of Southern Natural Gas Company and its subsidiaries, which is a wholly owned subsidiary of Sonat Inc. Intercompany transactions and accounts have been eliminated in consolidation. The equity method of accounting is used for investments in joint ventures owned 50 percent or less. Certain amounts in the 1992 and 1991 Consolidated Financial Statements have been reclassified to conform with the 1993 presentation. Inventories - At December 31, 1993, inventories consist primarily of materials and supplies, and are carried at cost. Gas Imbalance Receivables and Payables - Gas imbalances represent the difference between gas receipts from and gas deliveries to Southern's transportation and storage customers. Gas imbalances arise when these customers deliver more or less gas into the pipeline than they take out. Under the provisions of Order No. 636, these amounts are settled monthly. Plant, Property and Equipment, and Depreciation - Plant, property and equipment is carried at cost. Southern generally provides for depreciation on a composite basis. (See Note 5.) Revenue Recognition - Southern recognizes revenue from both natural gas sales and transportation in the period the service is provided. Reserves are provided on revenues collected subject to refund when appropriate. Income Taxes - Southern and its subsidiaries file federal income tax returns on a consolidated basis with its parent and other members of its affiliated group. For financial statement purposes, income taxes are provided as though Southern and its subsidiaries file separate income tax returns; however, those companies incurring losses are allocated the tax benefit of such losses due to the consolidated return. Southern and its subsidiaries follow an asset and liability approach in accounting for income taxes. Deferred tax assets and liabilities are determined using the tax rate for the period in which those amounts are expected to be received or paid. II-16 SOUTHERN NATURAL GAS COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 2. Financial Instruments The carrying amounts and fair values of Southern's financial instruments are as follows: The following methods and assumptions were used by Southern in estimating its fair value disclosures for financial instruments: Notes receivable from affiliates, gas supply realignment costs and recoverable natural gas purchase contract settlement costs: The carrying amount reported in the balance sheets approximates its fair value. Long-term debt: The fair values of Southern's long-term debt are based on quoted market values. II-17 SOUTHERN NATURAL GAS COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 3. Inventories The table below shows the values of various categories of Southern's inventories. Southern sold its inventory of gas stored underground pursuant to the implementation of Order No. 636 on November 1, 1993. (See Note 8.) 4. Joint Venture Southern owns 50 percent of Bear Creek Storage Company, an underground gas storage company. At December 31, 1993, Southern's investment in Bear Creek, accounted for by the equity method, equaled its share of underlying equity in net assets of the investee. Through December 31, 1993, Southern's cumulative equity in earnings of its joint venture was $126.2 million and cumulative dividends received from it totaled $117.3 million. II-18 SOUTHERN NATURAL GAS COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 4. Joint Ventures (Cont'd) The following is summarized financial information for Bear Creek. No provision for income taxes has been included since its income taxes are paid directly by the joint-venture participants. II-19 SOUTHERN NATURAL GAS COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 5. Plant, Property and Equipment and Depreciation A summary of plant, property and equipment by classification follows: Plant, property and equipment includes construction work in progress of $23.3 million and $4.1 million at December 31, 1993 and 1992, respectively. The annual depreciation rates and the accumulated depreciation and amortization amounts by classification are as follows: II-20 SOUTHERN NATURAL GAS COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 6. Long-Term Debt and Lines of Credit Long-Term Debt - Long-term debt consisted of: II-21 SOUTHERN NATURAL GAS COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 6. Long-Term Debt and Lines of Credit (Cont'd) Southern had no restrictions on the payment of dividends at December 31, 1993. Annual maturities of long-term debt at December 31, 1993, are as follows: Lines of Credit and Credit Agreement - As part of Sonat's cash management program, Southern regularly loans funds to or borrows funds from Sonat. Notes receivable and payable are in the form of demand notes with rates reflecting Sonat's return on funds loaned to its subsidiaries, average short-term investment rates and cost of borrowed funds. In certain circumstances, these notes are subordinated in right of payment to amounts payable by Sonat under certain long-term credit agreements. On May 31, 1993, Southern renewed its short-term lines of credit of $50 million for a period of 364 days. Borrowings are in the form of unsecured promissory notes and bear interest at rates based on the banks' prevailing prime, international or money-market lending rates. II-22 SOUTHERN NATURAL GAS COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 7. Income Taxes An analysis of Southern's income tax expense (benefit) is as follows: Net deferred tax liabilities are comprised of the following: Southern and its subsidiaries have not provided a valuation allowance to offset deferred tax assets because, based on the weight of available evidence, it is more likely than not that all deferred tax assets will be realized. II-23 SOUTHERN NATURAL GAS COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 7. Income Taxes (Cont'd) Consolidated income tax expense is different from the amount computed by applying the U.S. federal income tax rate to income before income tax. The reasons for this difference are as follows: The effect of the deferred tax rate increase to 35 percent due to the Omnibus Budget Reconciliation Act of 1993 has been reduced by the effect of the reduction of liabilities established for excess deferred income taxes expected to be returned over future periods to customers. II-24 SOUTHERN NATURAL GAS COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 8. Commitments and Contingencies Leases - Southern has operating lease commitments expiring at various dates, principally for office space and equipment. Southern has no significant capital leases. Rental expense for all operating leases is summarized below: At December 31, 1993, future minimum payments for non-cancelable operating leases for the years 1994 through 1998 are less than $4 million per year. Rate Matters - Periodically, Southern and its subsidiaries file general rate filings with the FERC to provide for the recovery of cost of service and a return on equity. The FERC normally allows the filed rates to become effective, subject to refund, until it rules on the approved level of rates. Southern and its subsidiaries provide reserves relating to such amounts collected subject to refund, as appropriate, and make refunds upon establishment of the final rates. On September 1, 1989, Southern implemented new rates, subject to refund, reflecting a general rate decrease of $6 million. In January 1991, Southern implemented new rates, subject to refund, that restructured its rates consistent with a FERC policy statement on rate design and increased its sales and transportation rates by approximately $65 million annually. These two proceedings have been consolidated for hearing. On October 7, 1993, the presiding administrative law judge certified to the FERC a contested offer of settlement pertaining to the consolidated rate cases which (1) resolved all outstanding issues in the rate decrease proceeding, (2) resolved the cost of service, throughput, billing determinant and transportation discount issues in the rate increase proceeding, and (3) provided a method to resolve all other issues in the latter proceeding, including the appropriate rate design. On December 16, 1993, the FERC issued an order (December 16 Order) approving the settlement, but with modifications. On December 22, 1993, Southern filed a letter with the FERC that outlined certain objections with respect to the FERC's modifications to the terms and conditions of the settlement. Southern advised the FERC that the December 16 Order undercut the economic compromise achieved in the settlement. Southern also filed a request for rehearing of the December 16 Order but is unable to determine at this time if or to what extent rehearing will be granted by the FERC. On September 1, 1992, Southern implemented another general rate change. The rates reflected the continuing shift in the mix of throughput volumes away from sales and toward transportation and a $5 million reduction in annual revenues. On April 30, 1993, Southern submitted a proposed settlement in the proceeding which, if approved by the FERC, would resolve the throughput and certain cost of II-25 SOUTHERN NATURAL GAS COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 8. Commitments and Contingencies (Cont'd) service issues. On June 4, 1993, the presiding administrative law judge certified the settlement to the FERC. In another order issued on December 16, 1993, the FERC also approved this settlement, but with modifications. Southern objects to these modifications and has also requested rehearing of this order, but is unable to determine at this time if rehearing will be granted by the FERC. In 1992 Southern placed in service certain facilities constructed to connect to its pipeline system gas reserves produced from certain Mississippi Canyon and Ewing Bank Area Blocks, offshore Louisiana. By order dated May 15, 1991, the FERC had authorized Southern, subject to certain conditions affecting Southern's ability to include the cost of the facilities in its rates, to construct and operate the pipeline, compression, and related facilities necessary to connect these reserves. Southern sought rehearing of the unacceptable certificate conditions, but in an order issued on January 13, 1993, the FERC left intact the conditions contained in its 1991 order. It deferred the specific application of the conditions to Southern's pending rate case implemented September 1, 1992. The certificate order itself is now on appeal. Southern is unable to predict the ultimate rate treatment of the $45 million cost of these facilities, but does not expect such treatment to have a material adverse effect on its financial position. On May 1, 1993, Southern implemented a general rate change, subject to refund, which increased its sales and transportation rates by approximately $57 million annually. The filing is designed to recover increased operating costs and to reflect the impact of competition on both Southern's level and mix of services. A hearing regarding various cost allocation and rate design issues in this proceeding is set for June 14, 1994. Sea Robin Pipeline Company has previously filed under the provisions of Order No. 500 to recover $83.1 million in gas purchase contract settlement payments from its former pipeline sales customers, Koch Gateway Pipeline Company, successor to United Gas Pipe Line Company (United), and Southern. Those filings remain subject to refund pending the outcome of any prudence challenges in the proceedings. Although the eligibility issues have been resolved, one party has reserved its rights to challenge prudence until such time as certain take-or-pay allocation issues are resolved with respect to the flow-through of costs billed to United. Southern is authorized to flow through to its jurisdictional customers $38.1 million of the costs allocated to it by Sea Robin as well as the $32.7 million in Order No. 500 costs allocated to it by United. Southern's flow-through of United and Sea Robin's costs remains subject to refund pending the outcome of any challenges to the costs or allocation of the costs in those pipelines' Order No. 500 proceedings. Southern does not believe that the outcome of any such challenges will have a material adverse effect on its financial position. II-26 SOUTHERN NATURAL GAS COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 8. Commitments and Contingencies (Cont'd) On July 2, 1993, the FERC issued an order reaffirming its approval of the non-take-or-pay aspects of a settlement filed by United in 1988, which included Southern's phased abandonment of its contract demand with United. The order rejected the take-or-pay aspects of the settlement, including United's proposed Order No. 528 allocation methodology. As a consequence, various parties that had originally supported the settlement are now contesting it. United has evidenced its intention to honor the non-take-or-pay aspects of the 1988 settlement and has induced several of the parties to withdraw their judicial appeals of the July 2 order. Southern does not believe that the final resolution of this matter will have a material adverse effect on its financial position. Gas Purchase Contracts - Gas purchase contract settlement payments (other than the gas supply realignment payments discussed below) made by Southern and not previously recovered or expensed are included on the Consolidated Balance Sheet at December 31, 1993, in "Current Assets". Pursuant to a final and nonappealable FERC order, Southern is entitled to collect these amounts from its customers over the remainder of a five-year period which commenced May 1, 1989. Southern currently is incurring essentially no take-or-pay liabilities under its gas purchase contracts. Southern regularly evaluates its position relative to gas purchase contract matters, including the likelihood of loss from asserted or unasserted take-or-pay claims or above-market prices. When a loss is probable and the amount can be reasonably estimated, it is accrued. Order No. 636 - In 1992 the FERC issued its Order No. 636 (the Order). The Order requires significant changes in interstate natural gas pipeline services. Interstate pipeline companies, including Southern, are incurring certain costs (transition costs) as a result of the Order, the principal one being costs related to amendment or termination of existing gas purchase contracts, which are referred to as gas supply realignment (GSR) costs. The Order provides for the recovery of 100 percent of the GSR costs and other transition costs arising out of the implementation of the Order to the extent that the pipeline can prove that they were prudently incurred. Numerous parties have appealed the Order to the Circuit Courts of Appeal. On September 3, 1993, the FERC generally approved a compliance plan for Southern and directed Southern to implement its restructured services pursuant to the Order on November 1, 1993 (the September 3 order). Pursuant to Southern's compliance plan, GSR costs that are eligible for recovery include payments to reform or terminate gas purchase contracts or, for contracts where Southern can show that it can minimize transition costs by continuing to purchase gas under the contract (i.e., it is more economic to continue to perform), the difference between the contract price and the higher of (a) the sales price for gas purchased under the contract, or (b) a price established by an objective index of spot-market prices. Recovery of these latter costs is permitted for an initial period of two years. Southern's compliance plan contains two mechanisms pursuant to which Southern is permitted to recover 100 percent of its GSR costs. The first mechanism is a monthly fixed charge designed to recover 90 percent of the GSR costs from Southern's firm transportation customers. The second mechanism is a volumetric surcharge designed to collect the remaining 10 percent of such costs II-27 SOUTHERN NATURAL GAS COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 8. Commitments and Contingencies (Cont'd) from Southern's interruptible transportation customers. This funding will continue until the GSR costs are fully recovered or funded. The FERC also permitted Southern to file to recover any GSR costs not recovered through the volumetric surcharge after a period of two years. In addition, Southern's compliance plan provides for the recovery of other transition costs as they are incurred and any remaining transition costs may be recovered through a regular rate filing. The September 3 order rejected the argument of certain customers that a 1988 take-or-pay recovery settlement bars Southern from recovering GSR costs under gas purchase contracts executed before March 31, 1989. Those customers have filed motions urging the FERC to reverse its ruling on that issue. On December 16, 1993, the FERC affirmed its September 3 ruling with respect to the 1988 take-or-pay recovery settlement. The December 16 Order generally approved Southern's restructuring tariff submitted pursuant to the September 3 order. Various parties have filed motions urging the FERC to modify the December 16 Order and have sought judicial review of the September 3 order. Southern and its customers engaged in settlement discussions regarding Southern's restructuring filing prior to the September 3 order, but the parties were unable to reach a settlement. Those discussions are continuing. During 1993 Southern reached agreements to reduce significantly the price payable under a number of high cost gas purchase contracts in exchange for payments of approximately $114 million. On December 1, 1993, Southern filed to recover such costs and approximately $3 million of prefiling interest. On December 30, 1993, the FERC accepted such filing to become effective January 1, 1994, subject to refund, and subject to a determination that such costs were prudently incurred and eligible under Order No. 636. The December 30 order rejected arguments of various parties that a pipeline's payments to affiliates, which represented approximately $34 million of the December 1, 1993 filing, may not be recovered under Order No. 636. In December 1993, Southern reached agreement to reduce the price under another contract in exchange for payments having a present value of approximately $52 million which is included in "Deferred Credits and Other" in the Consolidated Balance Sheet. Payments will be made in equal monthly installments over an eight-year period ending December 31, 2001. Southern expects to make a limited rate filing by mid-February 1994 to recover such costs beginning April 1, 1994. Southern has also incurred approximately $11 million of costs during November and December 1993 from continuing to purchase gas under contracts that are in excess of current market prices. Southern will make additional rate filings to recover these costs quarterly. The total costs of $180 million accrued through December 31, 1993, are included in current and long-term gas supply realignment costs in the Consolidated Balance Sheet. Southern is unable to predict all of the elements of the ultimate outcome of its Order No. 636 restructuring proceeding, its settlement discussions with its customers, and the limited rate filings to recover its transition costs. II-28 SOUTHERN NATURAL GAS COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 9. Transactions with Major Customers and Affiliates Revenues and accounts receivable relate to business conducted with gas distribution companies, municipalities, gas districts, industrial customers and other interstate pipeline companies in the Southeast. Southern performs ongoing credit evaluations of its customers' financial condition, and in some circumstances, requires collateral from its customers. The following table shows revenues from major unaffiliated customers. Southern and its subsidiaries enter into transactions with other Sonat subsidiaries and unconsolidated affiliates to transport, sell and purchase natural gas. Services provided by these affiliates for the benefit of Southern and its subsidiaries are billed accordingly. The following table shows revenues and charges from Southern's affiliates. II-29 SOUTHERN NATURAL GAS COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 10. Employee Benefit Plans Retirement Plans - Sonat has a trusteed, non-contributory, tax qualified defined benefit retirement plan (the Retirement Plan) covering substantially all employees of Southern. A supplemental benefit plan (the Supplemental Plan) that provides retirement benefits in excess of those allowed under Sonat's tax qualified retirement plan is also in effect. Benefits under the plans are based on a combination of years of service and a percentage of compensation. Benefits are vested over five years. Sonat determines the amount of funding to the Retirement Plan on a year-to-year basis, with amounts consistent with minimum and maximum funding requirements established by various governmental bodies. Southern's net periodic pension cost consists of the following components: For a limited period during 1993 and 1991, Sonat offered special early retirement programs to certain employees of Southern. The total cost of the programs applicable to Southern was $5.5 and $6.3 million, respectively. All of the 1993 costs have been deferred to be collected in future rates. II-30 SOUTHERN NATURAL GAS COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 10. Employee Benefit Plans (Cont'd) The following table sets forth Southern's allocated portion of the assets and liabilities of Sonat's plans and the amount of the net pension asset or liability recognized in Southern's Consolidated Balance Sheets. (1) The Retirement Plan. (2) The Supplemental Plan. (3) Plan assets consist of equity securities, commingled funds and debt securities. (4) Amortization periods for unrecognized net (asset) or obligation are 16.5 years for the Retirement Plan and 15 years for the Supplemental Plan. (5) Amortization periods for early retirement termination benefits are 10 years for the Retirement Plan and five years for the Supplemental Plan. II-31 SOUTHERN NATURAL GAS COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 10. Employee Benefit Plans (Cont'd) Until July 1993, Sonat set aside assets in fixed income securities such that values of those assets equal or exceed the present value of benefit obligations to current retirees (immunized obligations). After that date, a separate immunized portfolio has not been maintained. The assumed rates used to measure the projected benefit obligations and the expected earnings of plan assets are: Other Post Employment Benefits - Southern participates in plans of Sonat that provide for postretirement health care and life insurance benefits to its employees when they retire. Southern adopted Statement of Financial Accounting Standards (SFAS) No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," for all plans as of January 1, 1993. SFAS No. 106 requires companies to accrue the cost of postretirement health care and life insurance benefits within the employees' active service periods. Southern has elected to amortize the transition obligation over a 20-year period. Southern previously expensed the cost of its retiree medical benefits as they were paid. Expense for retiree life insurance benefits was recognized as Southern funded its Retiree Life Insurance Plan. The annual net periodic cost for postretirement health care and life insurance benefits for the year ended December 31, 1993, includes the following components: Prior to the adoption of SFAS No. 106, the cost of providing health care and life insurance benefits was $3.9 million in 1992 and 1991. Southern implemented rates effective May 1, 1993, which provide for the recovery of its SFAS No. 106 costs. Costs incurred in 1993 prior to that date, amounting to $2.6 million, were deferred to be amortized over a three-year period commencing when Southern's next rate case becomes effective. II-32 SOUTHERN NATURAL GAS COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 10. Employee Benefit Plans (Cont'd) Southern funds its Retiree Life Insurance Plan with the amount of funding determined on a year-to-year basis with the objective of having assets equal plan liabilities. In addition, during 1993 Southern initiated funding of postretirement health care benefits in an amount generally equal to its SFAS No. 106 expense. The following table sets forth the funded status at December 31, 1993, and at the date of SFAS No. 106 adoption, January 1, 1993, for Southern's postretirement health care and life insurance plans: (1) Plan assets are held in a life insurance reserve account and consist primarily of fixed income securities. The assumed rates used to measure the projected benefit obligation and the expected earnings of plan assets are: The rate of increase in the per capita costs of covered health care benefits is assumed to be 12.3 percent in 1994, decreasing gradually to 6 percent by the year 2002. Increasing the assumed health care cost trend rate by 1 percentage point would increase the accumulated postretirement benefit obligation as of December 31, 1993, by approximately $7.5 million and increase the service cost and interest cost components of the net periodic postretirement benefit cost by approximately $.6 million. II-33 SOUTHERN NATURAL GAS COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 10. Employee Benefit Plans (Cont'd) Executive Award Plan - Sonat has an Executive Award Plan that provides awards to certain key employees in the form of stock options, restricted stock, and stock appreciation rights (SARs) in tandem with any or all stock options. In years prior to 1991, tax offset payments were also generally provided in conjunction with these awards. SARs permit the holder of an exercisable option to surrender that option for an amount equal to the excess of the market price of the common stock on the date of exercise over the option price (appreciation). The appreciation is payable in cash, common stock, or a combination of both. SARs are subject to the same terms and conditions as the options to which they are related. No SARs have been issued since 1990. At December 31, 1993, 75,000 SARs were outstanding to employees of Southern. Sonat issued 7,000 shares of restricted stock to employees of Southern during 1993. The shares generally vest 10 years from the date of grant, unless the closing price of Sonat's common stock achieves certain specified levels. At December 31, 1993, 7,328 of the 29,400 cumulative restricted shares issued have vested. Stock-based employee compensation decreased Southern's pretax income in 1993 by $5.1 million, decreased Southern's pretax income in 1992 by $1.8 million and increased Southern's pretax income in 1991 by $2.3 million. II-34 SOUTHERN NATURAL GAS COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 11. Quarterly Results (Unaudited) Shown below are selected unaudited quarterly data. (1) Net income for the third quarter of 1992 includes favorable adjustments of $6 million, related to a settlement regarding Southern Energy Company's idle liquified natural gas facilities. II-35 Item 9. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure The Company has not had a change in accountants within twenty-four months prior to the date of its most recent financial statements or in any period subsequent to such date. II-36 PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) Index to Financial Statements, Financial Statement Schedules, and Exhibits 1. FINANCIAL STATEMENTS 2. FINANCIAL STATEMENT SCHEDULES All other schedules have been omitted as the subject matter is either not present or is not present in amounts sufficient to require submission of the schedule, in accordance with the instructions contained in Regulation S-X, or the required information is included in the financial statements or notes thereto. Financial statements of 50-percent or less owned companies and joint ventures are not presented herein because such companies and joint ventures do not meet the significance test. IV-1 3. EXHIBITS (1) - --------------- (1) Southern will furnish to requesting security holders any exhibit on this list upon the payment of a fee of 10 cents per page up to a maximum of $5.00 per exhibit. Requests must be in writing and should be addressed to R. David Hendrickson, Secretary, Southern Natural Gas Company, P. O. Box 2563, Birmingham, Alabama 35202. IV-2 Exhibit 21, Subsidiaries of the Registrant, has been omitted in reliance upon Instruction J(2)(b) of Form 10-K. Exhibits listed above which have heretofore been filed with the Securities and Exchange Commission, which were physically filed as noted above, are hereby incorporated herein by reference pursuant to Rule 12b-32 under the Securities Exchange Act of 1934 and made a part hereof with the same effect as if filed herewith. Certain instruments relating to long-term debt of Southern and its subsidiaries have not been filed as exhibits since the total amount of securities authorized under any such instrument does not exceed 10% of the total assets of Southern and its subsidiaries on a consolidated basis. Southern agrees to furnish a copy of each such instrument to the Commission upon request. (b) Reports on Form 8-K There were no reports on Form 8-K filed during the quarter ended December 31, 1993. (c) Exhibits Exhibits required by Item 601 of Regulation S-K and filed with this report on Form 10-K accompany this report in a separate exhibit volume. IV-3 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 NATURAL GAS COMPANY By: /s/ WILLIAM A. SMITH ---------------------------- WILLIAM A. SMITH CHAIRMAN AND PRESIDENT Dated: 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. IV-4 IV-5 SOUTHERN NATURAL GAS COMPANY AND SUBSIDIARIES SCHEDULE V - PLANT, PROPERTY AND EQUIPMENT YEAR ENDED DECEMBER 31, 1993 Notes: (a) Additions include $739,000 of funds capitalized. (b) Reflect the transfer of current working storage to noncurrent pursuant to Order No. 636 (See Notes 3 and 8 of the Notes to Consolidated Financial Statement located in Item 8.) SOUTHERN NATURAL GAS COMPANY AND SUBSIDIARIES SCHEDULE V - PLANT, PROPERTY AND EQUIPMENT - (CONTINUED) YEAR ENDED DECEMBER 31, 1992 Notes: (a) Additions include $692,000 of funds capitalized. (b) Other changes include transfers and reclassifications between plant and property and other accounts. SOUTHERN NATURAL GAS COMPANY AND SUBSIDIARIES SCHEDULE V - PLANT, PROPERTY AND EQUIPMENT - (CONTINUED) YEAR ENDED DECEMBER 31, 1991 Notes: (a) Additions include $3,386,000 of funds capitalized. (b) Other changes include transfers and reclassifications between plant and property and other accounts. SOUTHERN NATURAL GAS COMPANY AND SUBSIDIARIES SCHEDULE VI - ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PLANT, PROPERTY AND EQUIPMENT (a) YEAR ENDED DECEMBER 31, 1993 Notes: (a) Depreciation is provided as described in Note 1 and Note 5 of the Notes to Consolidated Financial Statements located in Item 8. (b) Other changes are either transfers or amounts received as reimbursement for alterations of facilities. SOUTHERN NATURAL GAS COMPANY AND SUBSIDIARIES SCHEDULE VI - ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PLANT, PROPERTY AND EQUIPMENT (a) - (CONTINUED) YEAR ENDED DECEMBER 31, 1992 Notes: (a) Depreciation is provided as described in Note 1 and Note 5 of the Notes to Consolidated Financial Statements located in Item 8. (b) Other changes are either transfers or amounts received as reimbursement for alterations of facilities. (c) Includes an adjustment of $9.6 million for a settlement relating to Southern Energy Company's idle liquefied natural gas facilities. SOUTHERN NATURAL GAS COMPANY AND SUBSIDIARIES SCHEDULE VI - ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PLANT, PROPERTY AND EQUIPMENT (a) - (CONTINUED) YEAR ENDED DECEMBER 31, 1991 Notes: (a) Depreciation is provided as described in Note 1 and Note 5 of the Notes to Consolidated Financial Statements located in Item 8. (b) Other changes are either transfers or amounts received as reimbursement for alterations of facilities. SOUTHERN NATURAL GAS COMPANY AND SUBSIDIARIES SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION YEARS ENDED DECEMBER 31, 1993, 1992 and 1991 Charged to Costs and Expenses -------------------------------------------- 1993 1992 1991 ---- ---- ---- (In Thousands) Maintenance and Repairs $21,776 $22,474 $21,547 ======= ======= ======= Ad Valorem Taxes $11,794 $11,869 $10,533 ======= ======= ======= No other information is required to be disclosed because amounts are less than 1% of consolidated revenues or the information has been included elsewhere herein. APPENDIX TO ANNUAL REPORT ON FORM 10-K OF SOUTHERN NATURAL GAS COMPANY FOR THE YEAR ENDED DECEMBER 31, 1993 In compliance with Section 304 of Regulation S-T, the following information describes pictorial and/or graphic materials contained herein: PAGE DESCRIPTION I-8 Map of the Southeastern United States showing the approximate location of the pipeline systems of Southern and its subsidiaries and the underground storage facilities of Southern (each described on page I-1); and the approximate location of Southern Energy's LNG terminal, as discussed on page I-6.

81100_1993.txt

81100_1993

1993

81100

ITEM 1. BUSINESS THE COMPANY The Company is an investor-owned public utility incorporated in the State of Washington furnishing electric service in a territory covering approximately 4,500 square miles, principally in the Puget Sound region of Washington State. The population of the Company's service area is over 1.8 million. In December 1993, the Company had approximately 804,600 total customers, consisting of 715,600 residential, 83,900 commercial, 3,800 industrial and 1,300 other customers. For the year 1993, the Company added approximately 17,500 customers, an annual growth rate of 2.2%. Growth in total kilowatt-hour sales to consumers increased 3.0% in 1993 over 1992, due to continuing growth in the number of customers in 1993 combined with unusually mild temperatures throughout 1992. During 1993, the Company's billed revenues were derived 48% from residential customers, 34% from commercial customers, 14% from industrial customers and 4% from sales to other utilities and others. During this period, the largest single customer accounted for 3.1% of the Company's operating revenues. The average number of kilowatt-hours billed per residential customer served by the Company in 1993 was 12,674 kilowatt- hours. At December 31, 1993, the peak power resources of the Company were approximately 5,367,000 KW. The Company's historical peak load of approximately 4,615,000 KW occurred on December 21, 1990. The Company is affected by various seasonal weather patterns throughout the year and, therefore, operating revenues and associated expenses are not generated evenly during the year. Variations in energy usage by consumers do occur from season to season and from month to month within a season, primarily as a result of weather conditions. The Company normally experiences its highest energy sales in the first and fourth quarters of the year. Sales to other utilities also vary by quarters and years depending principally upon water conditions for the generation of surplus hydro- electric power, customer usage and the energy requirements of other utilities. With the implementation of the Periodic Rate Adjustment Mechanism ("PRAM") in October 1991, earnings are no longer significantly influenced, up or down, by sales of surplus electricity to other utilities or by variations in normal seasonal weather or hydro conditions. (See "Management's Discussion and Analysis of Financial Condition and Results of Operations - Rate Matters") The electric utility industry in general is experiencing intensifying competitive pressures, particularly in wholesale generation and industrial customer markets. The National Energy Policy Act of 1992 was designed to increase competition in the wholesale electric generation market by easing regulatory restrictions on producers of wholesale power and by authorizing the Federal Energy Regulatory Commission ("FERC") to mandate access to electric transmission systems by wholesale power generators. The potential for increased competition at the retail level in the electric utility industry through state-mandated retail wheeling has also been the subject of legislative and administrative interest in a number of states, including the state of Washington. Electric utilities, including the Company, now face greater potential competition for resources and customers from a variety of sources, including privately owned independent power producers, exempt wholesale power generators, industrial customers developing their own generation resources, suppliers of natural gas and other fuels, other investor-owned electric utilities and municipal generators. All four of the major credit rating agencies have expressed the view that competitive developments in the electric utility industry are likely to increase business risks, with resulting pressure on utility credit quality. One of the rating agencies has stated that it is revising its financial ratio guidelines for electric utilities to reflect the changing risk profiles within the industry. These rating agency actions may result in higher capital costs and more limited access to capital markets for electric utilities, including the Company. Although the Company to date has not experienced any significant adverse impact on its business from these industry trends, the Company has taken a number of steps to prepare for a more competitive business environment. These include programs to become a lower-cost producer by improving productivity and reducing the work force. The Company is also reviewing the extent of its investment in regulatory assets that may not be readily marketable to others in a competitive marketplace. The Company is seeking state legislation to provide a firm statutory basis for recovery of demand-side management regulatory assets associated with the Company's conservation programs. During the period from January 1, 1989 through December 31, 1993, the Company made gross utility plant additions of $752 million and retirements of $84 million. Gross electric utility plant at December 31, 1993 was approximately $3.1 billion. The Company had 2,609 full-time equivalent employees on December 31, 1993. REGULATION AND RATES The Company is subject to the regulatory authority of (1) the Washington Utilities and Transportation Commission (the "Washington Commission") as to rates, accounting, the issuance of securities and certain other matters, and (2) the FERC in the transmission of electric energy in interstate commerce, the sale of electric energy at wholesale for resale, accounting and certain other matters. The Washington Commission consists of three Commissioners, each appointed for a six-year term by the Governor of the State of Washington. On September 21, 1993, the Washington Commission issued two rate orders, one regarding the Company's request for an increase in general rates, the other related to an annual rate adjustment under the PRAM. In its revised general rate request, the Company had requested a $97 million increase and in its PRAM request it had requested a first year recovery of between $27.6 and $38.1 million. The Washington Commission authorized a general rate increase of $21.9 million, reflecting increased costs of service, and collection of $35.7 million in the first year to recover previously deferred costs under the PRAM. The total increase in rates of $57.6 million was effective October 1, 1993. The Washington Commission also authorized the Company to increase rates by an additional $3.9 million effective October 1, 1993 to recognize, prospectively, the effect of the increase in the Federal corporate income tax rate from 34 to 35 percent. The general rate order also required the Company to file a case by November 1, 1993, demonstrating the prudency of its eight new power purchase contracts acquired since its last general rate case. Pending the resolution of the prudency review case, the Washington Commission ordered that the Company's new rates which became effective October 1, 1993, would be collected subject to refund to the extent this proceeding demonstrates any of those contracts to be imprudent. The Washington Commission calculated the annual revenue requirement at risk to be up to $86.1 million. The general rate case order allows a 10.5% return on common equity and 8.94% return on rate base, based on a capital structure of 47% debt, 8% preferred stock and 45% common equity. (See "Management's Discussion and Analysis of Financial Condition and Results of Operations - Rate Matters.") The decrease in allowed return on equity from 12.8 percent in the last general rate case to 10.5 percent approved in the present rate case has put downward pressure on earnings since the order became effective on October 1, 1993. In addition, it will be difficult for the Company to earn its full allowed rate of return because of changes made by the rate orders in the recovery methods of certain costs. Therefore, the Company continues to place strong emphasis on its ongoing improvement efforts designed to increase operating efficiencies. POWER RESOURCES During 1993, the Company's total energy production was supplied 30% by its own resources, 27% through long-term firm contracts with several of the PUDs that own hydroelectric projects on the Columbia River, 37% from other firm purchases and 6% from non-firm purchases. The following table shows the Company's resources at December 31, 1993, and energy production during the year: Peak Power Resources at December 31, 1993 1993 Energy Production ----------------------- ---------------------- Kilowatts % Kilowatt-Hours % --------- ----- -------------- ----- (Thousands) Hydro: Company resources 309,950 5.8 1,204,164 5.7 Purchased (Columbia River PUD Contracts) 1,474,282 27.5 5,681,522 26.8 Purchased (other)(a) 829,886 15.4 3,293,131 15.5 - ---------------------------------------------------------------------------- Total Hydro 2,614,118 48.7 10,178,817 48.0 - ---------------------------------------------------------------------------- Thermal: Company resources: Coal 771,900 14.4 4,790,625 22.6 Natural gas/oil 788,150 14.7 419,522 2.0 Purchased(a) 1,191,914 22.2 5,808,724 27.4 - ---------------------------------------------------------------------------- Total Thermal 2,751,964 51.3 11,018,871 52.0 - ---------------------------------------------------------------------------- Total Capability 5,366,082 100.0% 21,197,688 100.0% ============================================================================ (a) Power received from other utilities is classified between hydro and thermal based on the character of the utility system used to supply the power or, if the power is supplied from a particular resource, the character of that resource. The Pacific Northwest depends on the accumulation of snow in the Rocky and Cascade mountain ranges to supply the region's Columbia River hydroelectric resources. The Company derives much of its power supply from the Columbia River projects. For the third consecutive winter, snowpack was substantially below normal due to dry weather. Forecasts completed in early March 1994, indicate that the projected streamflow affecting the principal hydroelectric facilities from which the Company receives power is expected to be only 82 percent of normal for the period January through July, 1994. This reduction should not have a significant impact on the Company's ability to meet customer energy demands as it has recently entered into long term contracts to buy the output of four new cogeneration projects. The Company also owns 700 MW of installed combustion turbine capacity which can be used as an alternative energy supply under certain market conditions. Substantially all cost increases of combustion turbine operation or other alternative power supplies are expected to be recovered in rates through the PRAM mechanism. Company Owned - ------------- The Company and other utilities are joint owners of four mine-mouth, coal-fired, steam-electric generating units at Colstrip, Montana, approximately 100 miles east of Billings. The Company owns a 50% interest (330,000 KW) in Units 1 and 2 and a 25% interest (350,000 KW) in Units 3 and 4. The Company's share of the output of all four Colstrip units is transmitted over two 500 KV transmission lines from Colstrip to a point of interconnection with the main Northwest transmission grid at Garrison, Montana. The owners of the Colstrip Units purchase the coal requirements for the units from Western Energy Company, an affiliate of Montana Power - one of the joint owners, under the terms of long-term coal supply agreements, with escalation provisions to cover actual mining cost increases and inflationary factors. These contracts are expected to satisfy the majority of the requirements for the units over their anticipated useful life. A contract price reopener for both the base price and adjustment provisions of the Colstrip 1 & 2 Coal Supply Agreement became effective July 30, 1991. A dispute exists between the buyers, including the Company, and the seller on this reopener. This dispute will be arbitrated in the 4th quarter of 1994, the outcome of which is not expected to have material adverse impact on the financial condition or results of operations of the Company. The Company owns a 7% interest (91,900 KW) in a coal-fired, steam-electric generating plant near Centralia, Washington, with a net capability of 1,313,000 KW. In 1991, the Company and other owners of the Centralia Project renegotiated a long-term coal supply agreement with Pacific Power & Light Company. The Company also has the following plants with an aggregate net generating capability of 1,098,100 KW: Upper Baker River hydro project (103,000 KW) constructed in 1959; Lower Baker River hydro project (71,400 KW) reconstructed in 1968; White River hydro plant (63,400 KW) constructed in 1912 with installation of the last unit in 1924; Snoqualmie Falls hydro plant (44,000 KW), half the capability of which was installed during the period 1898 to 1910 and half in 1957; two smaller hydro plants, Electron (26,400 KW) and Nooksack Falls (1,750 KW), constructed during the period 1904 to 1929; Shuffleton residual oil-fired steam-electric generating plant (85,800 KW) constructed in 1929-30; a standby internal combustion unit (2,750 KW) installed in 1969; two oil-fired combustion turbine units (28,500 KW and 67,500 KW) installed in 1972 and 1974, respectively; four combustion turbine units (89,100 KW each) installed during 1981; and two combustion turbine units (123,600 KW each) installed during 1984. The Company's combustion turbines installed in 1981 and 1984 may be fueled with natural gas or distillate oil. The Company has not entered into contracts which assure a future long-term supply or price of fuel for the Company's combustion turbines, and the future availability and prices of fuel for the Company's combustion turbines are not assured. The Company has applied to the FERC for an initial license for its existing and operating White River project and authorization to install an additional 14,000 KW generating unit. The Company also has applied for a license for a proposed 8,000 KW capacity project at Nooksack Falls to replace the existing 1,750 KW capacity unlicensed facility. The initial license for the Snoqualmie Falls project expired in December 1993, and the Company is continuing the FERC application process to relicense the project and increase its capacity from 44,000 KW to 73,000 KW. FERC has granted a license extension through December 1994, and under its present policies will continue to grant one year extensions until the relicensing process is completed. Columbia River Projects - ----------------------- The purchase of power from the Columbia River projects is generally on a "cost of service" basis under which the Company pays a proportionate part of the annual debt service and operating and maintenance costs of each project in direct ratio to the amount of power annually allocated to it. Such payments are not contingent upon the projects being operable. These projects are financed through substantially level debt service payments, and their annual costs should not vary significantly over the term of the contracts unless additional financing is required to meet the costs of major maintenance, repairs or replacements or license requirements. The average cost of power purchased from these projects is approximately 11.9 mills per KWH. As of December 31, 1993, the Company was entitled to purchase portions of the power output of the PUDs' projects as set forth in the following tabulation: Company's Annual Amount Bonds Purchasable (Approximate) Outstanding -------------------------- Contract License 12/31/93(a) % of Kilowatt Costs(b) Project Exp.Date Exp.Date (Millions) Output Capacity (Millions) - ------------------------------------------------------------------------------ Rock Island Original units(c) 2012 2029(d) $ 79.8 62.5 ) ) 507,000 $ 45.7 Additional units 2012 2029(d) 326.8 100.0 ) Rocky Reach 2011 2006(e) 186.0 38.9 504,922 15.0 Wells 2018 2012(e) 199.9 34.8 292,320 10.0 Priest Rapids 2005 2005(e) 141.2 8.0 71,760 2.1 Wanapum 2009 2005(e) 189.4 10.8 98,280 2.8 - ------------------------------------------------------------------------------ Total 1,474,282 $ 75.6 ============================================================================== (a) The contracts for purchases are generally coextensive with the term of the PUD bonds associated with the project. Under the terms of some financings, however, long-term bonds were sold to finance certain assets whose estimated useful lives extend beyond the expiration date of the power sales contracts. Of the total outstanding bonds sold for each project, the percentage of principal amount of bonds which mature beyond the contract expiration dates are: 69.3% at Rock Island; 20.1% at Rocky Reach; 59.8% at Priest Rapids; and 39.4% at Wanapum. (b) Estimated debt service and operating costs for the year 1994. The components of 1994 costs associated with the interest portion of debt service are: Rock Island, $27.78 million for all units; Rocky Reach, $5.01 million; Wells, $3.42 million; Priest Rapids, $0.68 million; and Wanapum, $1.16 million. (c) For the period July 1, 1994 through June 30, 1995, the Company will pay 76.4% of the debt service and operating costs of the original units. This percentage will decrease thereafter in approximate relationship to the Company's share of the output until it reaches 50% on July 1, 1999 (see below). (d) Under a settlement agreement, FERC granted Chelan a license for 40 years beginning January 18, 1989. (e) The Company is unable to predict whether the licenses under the Federal Power Act will be renewed to the current licensees or what effect the term of the licenses may have on the Company's contracts. - -------------------- The Company has contracted to purchase a share of the output of the original units of the Rock Island Project that equals 63.5% through June 30, 1994, decreases gradually to 50% of the output until July 1, 1999, and remains unchanged thereafter for the duration of the contract. The Company has contracted to purchase the entire output of the additional Rock Island units for the duration of the contract, except that the Company's share of output of the additional units may be reduced not in excess of 10% per year beginning July 1, 2000, to a minimum of 50% upon the exercise of rights of withdrawal by Chelan for use in its local service area. The Company has contracted to purchase a share of the output of the Rocky Reach Project that remains unchanged for the duration of the contract. Under terms of a withdrawal of power settlement, the Company's share of the output of the Wells Project is currently 34.8%. However, the Company's share of the output can be reduced to 31.3% at any time upon the exercise of withdrawal rights by Douglas County PUD. The Company has contracted to purchase a share of the output of the Priest Rapids and Wanapum projects that remains unchanged for the duration of the contracts. Seven of the eleven turbines at Rocky Reach are in the process of being replaced. Studies are currently underway that are expected to lead to the replacement of the remaining four units. Turbine replacement is planned for all ten units at Wanapum. Also, as a result of FERC Settlements, it is anticipated that installation of fish screens will be required at Rocky Reach, Rock Island, Priest Rapids and Wanapum Dams. These multi-year capital projects are expected to result in increases in annual power costs as they progress. In 1964, the Company and fifteen other utilities and agencies in the Pacific Northwest entered into a long-term coordination agreement extending until June 30, 2003. This agreement provides for the coordinated operation of substantially all of the hydroelectric power plants and reservoirs in the Pacific Northwest. Among other things, it increases the ability of the Company to meet its customers' requirements with existing resources during periods of insufficient stream flows or forced outages of equipment. Certain utilities in the northwest United States and Canada are obtaining the benefits of over 1,000,000 KW of additional power as a result of the ratification of a treaty between the United States and Canada under which Canada is providing approximately 15,500,000 acre-feet of storage on the upper Columbia River. As a result of this storage, the Company obtains firm power based upon its percentage entitlement under its Columbia River contracts, currently approximately 163,800 KW. In addition, the Company has contracted to purchase 17.5% of Canada's share of the power resulting from such storage (132,100 KW capacity and 49,500 KW average energy in the 1993-94 contract year, April 1 to March 31, which amounts decrease gradually until expiration of the contract in 2003). The Company has also contracted to purchase from BPA supplemental capacity in amounts that decrease gradually until expiration of the contract in 2003. The amount of supplemental capacity currently purchased is approximately 43,900 KW. See "ENVIRONMENT - Federal Endangered Species Act" for discussion of the fishery enhancement plan related to these projects. Contracts and Agreements with Other Utilities - --------------------------------------------- On September 17, 1985, the Company and BPA entered into a settlement agreement settling the Company's claims against BPA resulting from BPA's action in halting construction on WPPSS Nuclear Project No. 3 in which the Company has a five percent interest. The settlement includes a Settlement Exchange Agreement ("Bonneville Exchange Power Contract") under which the Company is receiving from BPA for a period of approximately 30.5 years, beginning January 1, 1987, a certain amount of power determined by a formula and depending on the equivalent annual availability factors of several surrogate nuclear plants. The power is received during the months of November through April. Under the contract, the Company is guaranteed to receive not less than 191,667 MWH in each contract year until the Company has received total deliveries of 5,833,333 MWH. BPA may request energy at times not needed by the Company during the months of September through June of each contract year. The payment to the Company for such energy would be based on the actual costs to produce such energy up to the operating and maintenance costs of the Company's oil and natural gas fired combustion turbines. The Company is entitled to receive 80,000 KW of capacity and 68,000 KW of average energy from BPA under a WPPSS Nuclear Power Unit 1 Exchange Agreement through June 30, 1996. The calculation of the cost of the energy and capacity received by the Company has been in dispute, and the Company in 1990 entered into a settlement agreement with WPPSS and BPA as to prices for the July 1, 1990 through June 30, 1996 period. These prices range between 4.3 cents and 4.842 cents per KWH and are subject to certain increases or decreases as a result of settlement of or judgment on cost sharing claims with respect to the allocation of costs among WPPSS projects. On April 14, 1983, the Company contracted to purchase the output of Grays Harbor PUD's 4% interest (52,520 KW) in the Centralia generating plant subject to withdrawal on at least 7 years' notice. Grays Harbor PUD issued such notice in 1990; therefore this contract will terminate on June 30, 1997. On April 4, 1988, the Company executed a 15-year contract for the purchase of firm energy supply from Washington Water Power Company. This agreement calls for the delivery of 100 MW of capacity and 657,000 MWH of energy from the Washington Water Power system annually (75 annual average MW). Minimum and maximum delivery rates are prescribed. Under this agreement, the energy is to be priced at Washington Water Power's average generation and transmission cost. On October 27, 1988, the Company executed a 15-year contract for the purchase of firm power and energy from Pacific Power & Light Company. Under the terms of the agreement, the Company receives 120 average MW of energy and 200 MW of peak capacity. On November 23, 1988, the Company executed an agreement to purchase surplus firm power from BPA. Under the agreement, the Company receives 150 average MW of energy and 300 MW of peak capacity from BPA between October 1 and March 31 of each contract year. The contract extends for 20 years, ending in 2008. The sale will convert to a power-for-power exchange on June 30, 2001, or earlier, if BPA provides the Company with a five-year notice that it no longer has surplus energy available to support the power sale. On October 1, 1989, the Company signed a contract with Montana Power under which Montana Power provides, from its share of Colstrip Unit 4, to the Company 71 average MW of energy (94 MW of peak capacity) over a 21-year period. On December 11, 1989, the Company executed a conservation transfer agreement with Snohomish County PUD. Snohomish County PUD, together with Mason and Lewis County PUDs, will install conservation measures in their service areas. The agreement calls for the Company to receive the power saved over the expected 20-year life of the measures. The agreement calls for BPA to deliver the conservation power to the Company from March 1, 1990 through June 30, 2001, and for Snohomish County PUD to deliver the conser- vation power for the remaining term of the agreement. Power deliveries gradually increase over the first five years of the agreement, roughly matching the installation of the conservation measures, and will reach six average MW of energy in the fifth year. Under the agreement, deliveries of conservation power will then remain at six average MW of energy throughout the term of the agreement. The Company executed an exchange agreement with Pacific Gas & Electric Company which became effective on January 1, 1992. Under the agreement, 300 MW of capacity together with 413,000 MWH of energy are exchanged every year on a unit for unit basis. No payments are made under this agreement. Pacific Gas & Electric Company is a summer peaking utility and will provide power during the months of November through February. The Company is a winter peaking utility and will provide power during the months of June through September. By giving proper notice, either party may terminate the contract for various reasons. Contracts and Agreements with Non-Utilities - ------------------------------------------- The Company has contracted to purchase the output from a number of non- utility generating resources. The Company currently has available 410 MW of capacity from gas cogeneration, 40.5 MW from small hydro generation and 28 MW from municipal solid waste and others. In addition, the Company will add 245 MW of capacity in 1994 in the form of purchased power contracts with independent producers of gas-fired cogeneration. The Company's payments under these contracts are subject to the delivery of power. (See Note 14 to the Consolidated Financial Statements for further discussion.) Other Resources - --------------- The Company offers programs designed to help new and existing customers conserve electric energy. In the residential sector, free energy audits, cash grants, and on-site inspection of cost-effective energy conservation improvements generate a significant share of KWH savings. Further energy conservation savings are realized through electric water heater programs, energy efficient lighting rebates and special programs targeted at low-income customers. The commercial and industrial energy management programs offer customers engineering audits, computerized analyses, bid design criteria, cash grants and follow-up verification for a wide variety of electrical efficiency improvements. Energy conservation measures installed in 1993 are expected to result in annualized savings of approximately 260,400 MWH. The Company's energy conservation expenditures are accumulated and amortized to expense over a ten year period at the direction of the Washington Commission. The Company's total unamortized conservation balance at December 31, 1993, was $234 million. The amount included in rate base by the Washington Commission in its September 1993 order based on expenditures through April 30, 1993, was $201 million. The Washington Commission has authorized the Company to accrue, as non-cash income, the carrying costs on energy conservation expenditures until such investments are reflected in rates. (See "Management's Discussion and Analysis of Financial Condition and Results of Operations - Rate Matters.") CONSTRUCTION FINANCING The Company estimates its construction expenditures, which include energy conservation expenditures and exclude Allowance for Funds Used During Construction ("AFUDC") and Allowance for Funds Used to Conserve Energy ("AFUCE"), for 1994 and 1995 to be $261 million and $200 million, respectively. The estimate for 1994 includes a $72 million payment to BPA for capacity rights to the third AC transmission line. The Company expects to fund an average of 68% of its estimated construction expenditures (excluding AFUDC and AFUCE) in 1994 and 1995 from cash from operations (net of dividends and AFUDC), and to fund the balance through the sale of securities. (See "Management's Discussion and Analysis of Financial Condition and Results of Operations" for a discussion of the Company's construction program.) The Company's ability to finance its future construction program is dependent upon maintaining a level of earnings sufficient to permit the sale of additional securities. In determining the type and amount of future financings, the Company may be limited by restrictions contained in its Mortgage Indenture, Articles of Incorporation and certain loan agreements. Under the most restrictive tests, at December 31, 1993, the Company could issue (i) approximately $709 million of additional first mortgage bonds or (ii) approximately $564 million of additional preferred stock at an assumed dividend rate of 7.00% or (iii) a combination thereof. ENVIRONMENT The Company's operations are subject to environmental regulation by federal, state and local authorities. Capital expenditures for environmental controls on all Company facilities are estimated at $29.4 million for the period 1994 through 1996. Due to the inherent uncertainties surrounding the development of federal and state environmental and energy laws and regulations, the Company cannot determine the impact such laws may have on its existing and future facilities. Federal Comprehensive Environmental Response, Compensation and Liability Act, and the Washington State Model Toxics Control Act - ---------------------------------------------------------------- The federal Comprehensive Environmental Response, Compensation and Liability Act (commonly referred to as the "Superfund Act") subjects certain parties to liability for remedial action at contaminated disposal sites. The Company has been named by the Environmental Protection Agency ("EPA") as a Potentially Responsible Party ("PRP") at four sites in Washington State, which are: two locations formerly operated by Northwest Transformer, Inc. at Mission-Pole and South Harkness in Whatcom County; a site formerly operated by Ross Electric, Inc. at Coal Creek in Lewis County; and a site formerly operated by Simon & Sons, Inc. in Pierce County. A settlement was reached in July 1991 with the EPA on the Simon & Sons site in which the Company paid approximately $442,000. A settlement was reached with the EPA on the Northwest Transformer/Mission-Pole site in a Consent Decree approved by Federal Court in January 1992. Current estimates of future remedial costs by the Company under that settlement are approximately $0.7 million. A settlement was reached with the EPA for the Ross Electric/Coal Creek site in a Consent Decree approved by Federal Court in February 1992. Based upon December 1993 estimates of future remedial costs, the Company's estimated share would be approximately $0.3 million. A settlement was reached with the EPA on June 7, 1992, for the Northwest Transformer/South Harkness site in an Administrative Order of Consent in which the PRPs agreed to conduct a Remedial Investigation & Feasibility Study. Based on a December 1993 estimate of future costs, the Company's share would be approximately $1.6 million. The above sites represent all significant Superfund sites currently known to the Company. There is, however, no assurance that all contaminated sites and contaminants for which the Company may have a responsibility have been identified or that remedial actions planned to date at current sites, including actions pursuant to consent decrees, will be adequate. The Company has remediated two locations at the Company's Electron Generating Station which had been contaminated with chemicals formerly used to treat wooden timbers. These sites had been listed as Priority 1 by the Washington State Department of Ecology ("WDOE") because of potential groundwater contamination. Remedial actions at these sites under provisions of the state's Model Toxics Control Act began in 1991 and were completed in 1992. A final remedial report has been filed with the WDOE. The Company is also participating in a joint research project with the Electric Power Research Institute to clean up the Snoqualmie Railroad site in the town of Snoqualmie, Washington. The site has been leased from the Company since 1959 by the non-profit Puget Sound Railway Historical Association. The contamination consists of heavy petroleum hydrocarbons which were used as lubricants for railroad equipment. The purpose of the project is to provide a field demonstration of new technologies to treat heavy molecular weight petroleum hydrocarbons in soil. Remediation of the research project was completed in February 1994. The Company has also commenced a program to test, replace and take remedial actions on certain underground storage tanks as required by federal and state laws. Remedial actions and testing of Company vehicle service facilities and storage yards have also been commenced. (See Note 14 to the Consolidated Financial Statements for further discussion of environmental obligations and the related regulatory treatment.) Federal Clean Air Act Amendments of 1990 - ---------------------------------------- The Company has an ownership interest in coal-fired, steam-electric generating plants at Centralia, Washington and Colstrip, Montana which are subject to the federal Clean Air Act Amendments of 1990 ("CAAA") and other regulatory requirements. The Centralia Project and the Colstrip Projects meet the sulfur dioxide limits of the CAAA in Phase I (1995). Pacific Power & Light Company, which operates the Centralia Project, is working on compliance plans to meet the Phase II limits in the year 2000. Montana Power, which operates the Colstrip 3 & 4 Project, is working to meet the Phase II limits in the year 2000. Under the CAAA, allowances may be used to achieve compliance. It is believed that Units 1 and 2 may have an excess of allowances above what is currently set for Phase II requirements and that Units 3 and 4 appear to have enough allowances for Phase II requirements. The Company owns combustion turbine units which are capable of being fueled by natural gas or oil. The nature of these units provides operational flexibility in meeting air emission standards. There is no assurance that in the future environmental regulations affecting sulfur dioxide or nitrogen oxide emissions may not be further restricted, and there is no assurance that restrictions on emissions of carbon dioxide or other combustion by-products may not be imposed. Federal Endangered Species Act - ------------------------------ In November 1991, the National Marine Fisheries Service ("NMFS") listed the Snake River Sockeye as an endangered species pursuant to the federal Endangered Species Act. Since the Sockeye listing, the Snake River fall and spring/summer Chinook have also been listed as threatened. In response to the listings, a team of experts was formed to develop a plan for the recovery needs of these species. In anticipation of the listings, the Northwest Power Planning Council ("NWPPC") previously developed a fishery enhancement plan which combines increased springtime flows with habitat enhancements, harvest reductions, and other measures. The spring flow augmentation portion of the plan began in 1991. The draft plan developed by the NMFS recovery team late in 1993 concludes that there is no scientific evidence that increased flows during the spring outmigration period enhance fish survival. The recovery team essentially advocates a continuation of the flows called for in the Council's program, unless or until scientific research dictates something different. When finalized, the recovery team's plan may be used by the NMFS as the recovery plan required pursuant to the Act, but there is no assurance NMFS will in fact use that plan instead of some other plan. Federal agencies which operate the Federal Columbia River Power System must consult with the NMFS to determine whether any action they undertake will unduly jeopardize the listed species. Measures recently announced by NMFS covering the period 1994 through 1998 are the result of the most recent of those consultations. In general, the measures require the federal agencies to release more water during the spring and summer for fish enhancement than is required by either the NWPPC Fish and Wildlife Program or that recommended by the draft recovery plan. The NWPPC plan and plans developed by NMFS affect the Mid-Columbia projects from which the Company purchases power on a long-term basis, and will further reduce the flexibility of the regional hydroelectric system. Although the full impacts are unknown at this time, the plan ultimately developed by NMFS could shift an amount of the Company's generation from the Mid-Columbia projects from winter periods into the spring when it is not needed for system loads, and will increase the potential for spill and loss of generation at the Mid-Columbia projects. Under the Council's plan presently in effect, in years of critical water flows, the maximum amount of generation that the company would have to transfer to the spring is limited to approximately 275,000 MWH. The Company's share of energy production from the Mid-Columbia during 1993 was approximately 5,682,000 MWH and the total production from all resources was more than 21,198,000 MWH. Other species are also proposed for listing and could further restrict system flexibility and energy production. Puget Sound Power & Light Company EXECUTIVE OFFICERS AT DECEMBER 31, 1993: Name Age Offices - ---------------- --- --------------------------------------------------- R. R. Sonstelie 48 President and Chief Executive Officer since 1992; President and Chief Operating Officer 1991-1992; President and Chief Financial Officer 1987-1991; Executive Vice President 1985-1987; Senior Vice President Finance 1983-1985; Vice President Engineering and Operations 1980-1983; Director since 1987. W. S. Weaver 49 Executive Vice President and Chief Financial Officer and Director since 1991. For more than five years prior to that time, a Partner in the law firm Perkins Coie. N. L. McReynolds 59 Senior Vice President Corporate Relations since 1987; Vice President Corporate Relations 1980-1987. R. V. Myers 60 Senior Vice President Operations since 1985; Vice President Engineering and Operations 1983-1985; Vice President Generation Resources 1980-1983. R. G. Bailey 54 Vice President Power Systems since 1980. J. W. Eldredge 43 Corporate Secretary and Controller since 1993; Controller since 1988; Manager Budgets and Performance 1987-1988; Manager General Accounting 1984-1987. W. J. Finnegan 61 Vice President since January 11, 1994; Vice President Engineering 1986-1994; Director Environmental and Resource Services 1981-1986. J. L. Henry 48 Vice President Engineering and Operating Services since January 11, 1994; Vice President Operations Services 1991-1994; Director South Central Division 1990-1991; Director Division Operations 1984-1990. C. A. Knutsen 47 Vice President Administration and Corporate Services since February 10, 1994; Vice President Corporate Planning 1989-1994; Director Strategic Planning 1987-1988; Manager Demand and Resource Evaluation Project 1986-1987. J. R. Lauckhart 45 Vice President Power Planning since 1991; Director Power Planning 1986-1991. R. E. Olson 62 Vice President Finance and Treasurer since 1987; Vice President Financial Control 1986; Vice President and Treasurer 1980-1986. G. B. Swofford 52 Vice President Divisions and Customer Services since 1991; Vice President Rates and Customer Programs 1986-1991; Director Conservation and Division Services 1980-1986. S. M. Vortman 48 Vice President Strategic Planning and Regulatory Affairs since February 10, 1994; Vice President Corporate Services 1992-1994; Director Real Estate 1990-1992; Manager Community and Economic Development 1986-1990. Officers are elected for one-year terms. ITEM 2. ITEM 2. PROPERTIES The principal generating plants owned by the Company are described under Item 1 - "Business - Power Resources." The Company owns its transmission and distribution facilities, and various other properties. Substantially all properties of the Company are subject to the lien of the Company's Mortgage Indenture. ITEM 3. ITEM 3. LEGAL PROCEEDINGS See Notes 8 and 14 to the Consolidated Financial Statements. 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 common stock is traded on the New York Stock Exchange (symbol PSD). The number of stockholders of record of the Company's common stock at December 31, 1993, was 64,622. The Company has paid dividends on its common stock each year since 1943 when such stock first became publicly held. Future dividends will be dependent upon earnings, the financial condition of the Company and other factors. Certain provisions relating to the Company's senior securities limit funds available for payment of dividends to net income available for dividends on common stock (as defined in the Company's Mortgage Indenture) accumulated after December 31, 1957, plus the sum of $7.5 million. As of December 31, 1993, the balance of earnings reinvested in the business that was not restricted as to dividends on common stock was approximately $266 million. (See Note 5 to the Consolidated Financial Statements.) Dividends paid and high and low stock prices for each quarter over the last two years were: 1993 1992 --------------------------- --------------------------- Price Range Price Range --------------- Dividends --------------- Dividends Quarter Ended High Low Paid High Low Paid - ------------- ------ ------ --------- ------ ------ --------- March 31 28-3/4 26-1/8 $.45 26-3/4 23-7/8 $.44 June 30 29-3/8 26-1/4 $.46 26-3/8 24-1/2 $.45 September 30 29-3/4 25-5/8 $.46 27-7/8 25-7/8 $.45 December 31 26-7/8 23-1/2 $.46 27-3/8 25-7/8 $.45 ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS FINANCIAL CONDITION AND RESULTS OF OPERATIONS Net income in 1993 was $138.3 million on operating revenues of $1.113 billion, compared to $135.7 million on operating revenues of $1.025 billion in 1992 and $132.8 million on operating revenues of $956.8 million in 1991. Income for common stock was $121.9 million, $121.8 million and $122.7 million for 1993, 1992 and 1991, respectively. Earnings per share in 1993 were $2.00 on 60.9 million weighted average common shares outstanding during the period compared to $2.16 on 56.3 million weighted average common shares in 1992 and $2.21 on 55.6 million weighted average common shares in 1991. Return on the average book value of the Company's common equity in 1993 was 11.0%, compared to 12.6% in 1992 and 13.2% in 1991. The dividend payout ratio was 91.5% in 1993, compared to 82.9% in 1992 and 79.6% in 1991. Total kilowatt-hour sales to ultimate consumers in 1993 were 19.2 billion, compared with 18.4 billion in 1992 and 18.3 billion in 1991. Kilowatt-hour sales to other utilities were 0.9 billion in 1993, 1.2 billion in 1992 and 1.9 billion in 1991. The preferred stock dividend accrual increased $2.6 million in 1993 and $3.8 million in 1992 compared to 1991 primarily due to the issuance of the 7.75% Series Preferred Stock in March 1992 and the 7.875% Series Preferred Stock in July 1992. This was partially offset by the reacquisition of the Series A Flexible Dutch Auction Rate Transferable Securities $100 Par Value Preferred Stock ("FLEX DARTS") in April 1992. The 1993 increase was also partially offset by the reacquisition of the Series B FLEX DARTS in July 1993. Lower dividend rates associated with the FLEX DARTS were also an offsetting factor during 1992. In 1991, the preferred stock dividend accrual decreased $2.4 million compared to 1990 levels. A decrease of $1.8 million was due to lower dividend rates associated with the FLEX DARTS and a decrease of $0.7 million was attributed to the reacquisition of shares of the 9.36% Series Preferred Stock. The Company reacquired 162,000 shares of its 9.36% Series Preferred Stock in March 1990 and the remaining 324,000 shares over the subsequent twelve months. Years Ending December 31 Increase (Decrease) Over Preceding Year (Dollars in Millions) 1993 1992 1991 - ----------------------------------------------------------------------- Operating revenues General rate increase $ 14.2 $ -- $ 9.1 PRAM surcharge billed 48.8 44.8 9.6 Accrual of Revenue under the PRAM - Net -- 41.5 0.7 BPA Residential Purchase and Sale Agreement (15.0) (25.1) (10.6) Sales to other utilities (6.8) (0.8) 0.4 Load and other changes 46.7 7.8 12.3 - ----------------------------------------------------------------------- Total operating revenue changes 87.9 68.2 21.5 - ----------------------------------------------------------------------- Operating expenses Purchased and interchanged power 81.5 18.2 4.0 Fuel (4.4) 11.9 0.9 Other operation expenses 5.9 9.9 16.3 Maintenance (1.8) (0.4) 5.0 Depreciation and amortization (7.2) 6.6 5.1 Taxes other than federal income taxes 6.1 4.8 (0.3) Federal income taxes 11.5 16.3 (7.9) - ----------------------------------------------------------------------- Total operating expense changes 91.6 67.3 23.1 - ------------------------------------------------------------------------ Allowance for funds used during construction ("AFUDC") 1.5 (1.0) (0.4) Other income (5.5) 12.3 3.4 Interest charges (10.3) 9.3 1.0 - ----------------------------------------------------------------------- Net income changes $ 2.6 $ 2.9 $ 0.4 ======================================================================= The following information pertains to the changes outlined in the table above: OPERATING REVENUES Revenues since October 1, 1993 increased as a result of rates authorized by the Washington Utilities and Transportation Commission (the "Washington Commission") in its general rate order issued on September 21, 1993. Revenues since October 1, 1992, increased as a result of rates authorized by the Washington Commission under the second Periodic Rate Adjustment Mechanism ("PRAM") filing. Revenues since October 1, 1991, increased as a result of rates authorized under the first PRAM filing. (See "Rate Matters.") Revenues have been reduced by virtue of the credit which the Company received through the Residential Purchase and Sale Agreement with the Bonneville Power Administration ("BPA"). This agreement enables the Company's residential and small farm customers to receive the benefits of lower-cost federal power. A related reduction is included in purchased and interchanged power expenses. Revenues in 1992 were higher as a result of the recognition of $6.7 million of revenues in September 1992 related to incentive payments authorized by the Washington Commission for meeting energy conservation targets during 1991. These revenues were collected in rates beginning October 1, 1992. Revenues from the PRAM rate adjustments and continuing load growth contributed to higher revenues in 1991. Although the Company is dependent on purchased power to meet customer demand, it may, from time to time, have energy available for sale to other utilities, depending principally upon water conditions for the generation of hydroelectric power, customer usage and the energy requirements of other utilities. OPERATING EXPENSES Purchased and interchanged power expenses increased $81.5 million in 1993. Higher purchased power expenses of $95.8 million were due to new firm power purchase contracts with PURPA (Public Utility Regulatory Policies Act) qualifying facilities and higher secondary power purchases from other utilities. This increase was partially offset by the Residential Purchase and Sale Agreement with BPA, which resulted in a reduction of $14.4 million. (See discussion of the Residential Purchase and Sale Agreement under "Operating revenues.") Purchased and interchanged power expenses increased $18.2 million in 1992. Higher purchased power expenses of $42.3 million were influenced by new firm power purchase contracts with PURPA qualifying facilities and higher costs on certain firm power purchase contracts with other utilities. The Residential Purchase and Sale Agreement with BPA resulted in a reduction of $23.9 million. Purchased and interchanged power expenses increased $4.0 million in 1991. Higher levels of purchased power accounted for a $14.3 million increase. The Residential Purchase and Sale Agreement with BPA resulted in a reduction of $10.1 million. Fuel expense decreased $4.4 million in 1993 due to decreased use of the coal-fired plants. Fuel expense increased $11.9 million in 1992 over the previous year due to increased usage of the coal-fired and gas turbine plants. Other operation expenses increased $5.9 million in 1993 due primarily to a $5.1 million increase in the amortization of conservation expenditures. Also influencing 1993 expenses was an increase of $1.8 million in steam generation expenses and a decrease of $2.3 million in administration and general expenses. Other operation expenses increased $9.9 million in 1992. Transmission expense accounted for $5.3 million of the increase. Also contributing was a $2.2 million rise in customer service expenses and a $1.5 million increase in administration and general expenses. Other operation expenses increased $16.3 million in 1991. Contributing to this increase was a $8.1 million rise in administrative and general expenses; a $3.9 million increase in customer service expenses; and a $2.2 million increase in transmission and distribution expenses. Maintenance expense in 1993 declined $1.8 million compared to 1992 due primarily to a $2.2 million decrease in distribution maintenance expense. Maintenance expense in 1992 fell $0.4 million from 1991 levels due primarily to a decrease of $2.8 million in administration and general maintenance expenses. This was partially offset by a $2.0 million increase in steam plant expense. Maintenance expense in 1991 increased $5.0 million due primarily to $2.7 million for remedial action of Company owned facilities and a $1.5 million rise in transmission and distribution maintenance expenses. Depreciation and amortization expense declined $7.2 million in 1993 compared to the prior year. This decrease was due in part to a change in depreciation rates approved by the Washington Commission staff in the second quarter of 1993 which was made retroactive to the beginning of 1993. This adjustment had the effect of decreasing depreciation expense by $10.5 million during 1993. This adjustment was partially offset by the effects of additional plant being placed into service. Depreciation and amortization expense increased $6.6 million in 1992 and $5.1 million in 1991 as a result of additional plant being placed into service. Taxes other than federal income taxes increased $6.1 million in 1993 compared to 1992. Excise and municipal taxes, which are primarily revenue- based, increased $6.1 million. Taxes other than federal income taxes increased $4.8 million in 1992. An increase in Washington State property taxes of $2.2 million accounted for much of the increase. Taxes other than federal income taxes decreased $0.3 million in 1991. Contributing to the decrease was a $1.1 million decrease in property taxes. Excise and municipal taxes contributed increases of $2.1 million and $1.1 million in 1992 and 1991, respectively. Federal income taxes on operations increased $11.5 million in 1993. The increase was due in part to higher pre-tax operating income in 1993 and an increase in the corporate tax rate from 34 to 35 percent, retroactive to January 1, 1993. Federal income taxes on operations increased $16.3 million in 1992 due to an increase in pre-tax operating income and a change in the method in which energy conservation expenditures are deducted for federal tax purposes. (See Note 11 to the Consolidated Financial Statements.) Federal income taxes on operations decreased $7.9 million in 1991 due to tax benefits associated with energy conservation expenditures and lower taxable income. AFUDC (See Note 1 to the Consolidated Financial Statements.) OTHER INCOME Other income decreased $5.5 million in 1993. The decrease was due in part to a charge totaling $1.4 million as a result of the Washington Commission's September 1993 general rate case ruling and a $1.4 million decrease in excess AFUDC over the FERC maximum allowed by the Washington Commission. Also contributing to the 1993 decrease was a non-recurring $2.3 million decrease in non-operating federal income taxes in the second quarter of 1992 as a result of an IRS settlement. Other income increased $12.3 million in 1992 over 1991 levels. This increase was due in part to an increase of $4.2 million in Allowance for Funds Used to Conserve Energy ("AFUCE"). The Washington Commission, in its April 1, 1991 order authorizing the PRAM, ordered the Company to start accruing carrying costs on energy conservation expenditures until such investments are included in ratebase. These accruals commenced in May 1991 but did not become significant until the third quarter of 1991. The AFUDC allowed by the Washington Commission in excess of the FERC maximum contributed $2.0 million to the increase over 1991. In addition, other income increased $3.8 million because of net income from subsidiaries of $1.0 million in 1992 versus losses of $2.8 million in 1991 and $1.1 million from lower non-operating federal income taxes. Other income, which increased $3.4 million in 1991, included $2.0 million due to capitalized interest expense relating to construction activities of a subsidiary. Also contributing to the increase were lower non-operating federal income taxes of $1.6 million. INTEREST CHARGES Interest charges, which consist of interest and amortization on long-term debt and other interest, decreased $10.3 million in 1993 compared to the prior year. Interest and amortization on long-term debt decreased $3.5 million. Contributing $29.1 million in reduced interest expense were 11 issues of First Mortgage Bonds totaling $510 million redeemed or retired over the previous 21 months. Partially offsetting this was $23.7 million in new interest expense associated with 22 issues of Secured Medium-Term Notes totaling $549 million issued over the previous 23 months. Other interest expense decreased $6.8 million in 1993 compared to the prior year. Much of the decrease was the result of a $5.3 million non-recurring interest charge in 1992 relating to a federal income tax assessment. Also contributing were lower average daily short-term borrowings and lower weighted average interest rates in 1993. Interest charges increased $9.3 million in 1992 compared to the prior year. Interest and amortization on long-term debt increased $4.7 million. Contributing $24.0 million of new interest expense were 19 issues of Secured Medium-Term Notes totaling $645 million issued over the previous 19 months. Partially offsetting this were $21.1 million in interest reductions from First Mortgage Bond retirements or redemptions of $451 million over the same period. Also contributing an increase of $1.5 million were the effects of three issues of fixed rate pollution control bonds that were used to refund floating rate pollution control bonds of identical amounts. Other interest expense increased $4.6 million in 1992 compared to 1991. An interest charge of $5.3 million relating to a federal income tax assessment was partially offset by lower short-term interest rates in 1992. Interest charges increased $1.0 million in 1991 compared to 1990. Interest and amortization on long-term debt increased $3.0 million. This increase included $3.9 million attributable to a First Mortgage Bond issue in October 1990. Also contributing to the increase were four issues of Secured Medium-Term Notes that added $4.6 million of interest in 1991. Partially offsetting these increases was a decrease of $1.4 million due in part to lower interest rates on pollution control bonds. In addition, the effects of bond retirements decreased interest expense by $4.2 million in 1991. Other interest expense decreased $2.0 million in 1991 compared to the prior year due to lower weighted average interest rates and lower average daily short-term borrowings. CONSTRUCTION AND FINANCING PROGRAM Current construction expenditures are primarily transmission and distribution-related, designed to meet continuing customer growth. Expenditures on energy conservation resources have also taken on increased importance in recent years as the Company seeks to manage the growth in demand for electricity. Construction expenditures, which include energy conservation expenditures and exclude AFUDC and AFUCE, were $211.5 million in 1993 and are expected to be $261 million in 1994 and $200 million in 1995. The ratio of cash from operations (net of dividends, AFUDC and AFUCE) to construction expenditures (excluding AFUDC and AFUCE) was 59.1% in 1993. The Company expects to fund an average of 68% of its total 1994 and 1995 estimated construction expenditures (excluding AFUDC and AFUCE) from cash from operations (net of dividends, AFUDC and AFUCE) and the balance through the sale of securities, the nature, amount and timing of which will be subject to market and other relevant factors. The Company made an initial payment of $8.0 million in 1993 for capacity rights to BPA's third A.C. transmission line to the southwestern United States and expects to pay the remaining cost of $72 million in 1994. Construction expenditure estimates are subject to periodic review and adjustment. In April 1991, the Company filed a shelf registration statement with the Securities and Exchange Commission for the offering, on a delayed or continuous basis, of up to $450 million principal amount of First Mortgage Bonds. The First Mortgage Bonds were issued as Secured Medium-Term Notes, Series A, in 14 separate issues. The Company issued the last of the $450 million of Secured Medium-Term Notes, Series A, in September 1992. The weighted average coupon rate of the Series A Notes was 7.84%. In October 1992, the Company filed a shelf registration statement with the Securities and Exchange Commission for the offering, on a delayed or continuous basis, of up to an additional $450 million principal amount of First Mortgage Bonds. The First Mortgage Bonds can be issued as Secured Medium-Term Notes, through underwritten offerings, pursuant to delayed delivery contracts or any combination thereof. These Secured Medium-Term Notes were designated Series B. As of February 28, 1994, the Company has issued $334 million Series B Notes having an average coupon rate of 6.82%. On February 9, 1993, the Company issued a total of $50 million principal amount of Secured Medium-Term Notes which included the following: $10 million principal amount of Secured Medium-Term Notes, Series B, due February 9, 1998, bearing interest at 6.17% per annum; $10 million principal amount of Secured Medium-Term Notes, Series B, due February 9, 2000, bearing interest at 6.61% per annum; and $30 million principal amount of Secured Medium-Term Notes, Series B, due February 10, 2003, bearing interest at 7.02% per annum. Proceeds of these issues were used to redeem $20 million principal amount of First Mortgage Bonds, 7.50% Series due 1999 and $30 million principal amount of First Mortgage Bonds, 7.75% Series due 2002, on March 8, 1993. On March 5, 1993, the Company issued a total of $20 million principal amount of Secured Medium-Term Notes which consisted of $15 million principal amount of Secured Medium-Term Notes, Series B, due March 5, 1996, bearing interest at 4.85% per annum and $5 million principal amount of Secured Medium-Term Notes, Series B, due March 5, 1998, bearing interest at 5.70% per annum. Proceeds of these issues were used to redeem $20 million principal amount of First Mortgage Bonds, 6.625% Series due 1997, on April 2, 1993. On November 29, 1993, the Company issued a total of $14 million principal amount of Secured Medium-Term Notes which consisted of $3 million principal amount of Secured Medium-Term Notes, Series B, due December 1, 2003, bearing interest at 6.20% per annum and $11 million principal amount of Secured Medium-Term Notes, Series B, due December 2, 2003, bearing interest at 6.40% per annum. Proceeds of these issues were used to pay down short-term debt. On February 1, 1994, the Company issued $55 million principal amount of Secured Medium-Term Notes, Series B, due February 1, 2024, bearing interest at 7.35% per annum. Proceeds of this issue were used to extinguish $50 million principal amount of the Company's First Mortgage Bonds, 9.625% Series due 1997. The Company redeemed $24.5 million through a tender offer completed February 7, 1994. A portfolio of U.S. Government Treasury Securities was purchased to defease the remaining $25.5 million of the bonds. On April 29, 1993, the Company issued $23.46 million principal amount of Pollution Control Revenue Refunding Bonds, 5.875% Series due 2020. The proceeds were used to refund, on April 29, 1993, $16.46 million principal amount of Pollution Control Revenue Bonds, 5.90% 1973 Series and $7.0 million principal amount of Pollution Control Revenue Bonds, 6.30% 1977 Series. In February 1992, the Company filed a shelf registration statement with the Securities and Exchange Commission for the offering, on a delayed or continuous basis, of up to $200 million of preferred stock. Either $25 par value or $100 par value preferred stock may be issued. In 1992, the Company issued an aggregate of $150 million of preferred stock from this shelf. On February 3, 1994, the Company issued $50 million, Adjustable Rate Cumulative Preferred Stock, Series B ($25 par value). The proceeds were used to retire the $40 million principal amount of its Adjustable Rate Cumulative Preferred Stock, Series A ($100 par value)and to pay down short-term debt. On July 1, 1993, the Company sold 3.45 million shares of common stock. The stock was priced at $27.875 per share and resulted in proceeds to the Company of approximately $93 million. The proceeds were used to redeem the $50 million principal amount FLEX DARTS Series B Preferred Stock on July 6, 1993 with the balance used to pay down short-term debt. Short-term borrowings from banks and the sale of commercial paper are used to provide working capital for the construction program. At December 31, 1993, the Company had in place $152 million in lines of credit with several banks, which provide liquidity support for outstanding commercial paper of $70.0 million, effectively reducing the available borrowing capacity under these lines of credit to $82.0 million. (See Note 7 to the Consolidated Financial Statements.) RATE MATTERS On September 21, 1993, the Washington Commission issued two rate orders, one regarding the Company's request for an increase in general rates, the other relating to an annual rate adjustment under the Company's Periodic Rate Adjustment Mechanism ("PRAM"). In its revised general rate request, the Company had requested a $97 million increase and in its $76.3 million PRAM request it had requested a first year recovery of between $27.6 and $38.1 million of previously deferred costs under the PRAM. The Washington Commission authorized a general rate increase of $21.9 million, reflecting increased costs of service, and collection of $35.7 million in the first year to recover previously deferred costs under the PRAM. The Washington Commission authorized full recovery of the Company's PRAM request within two years from the end of the year in which the costs were deferred. The total increase in rates of $57.6 million was effective October 1, 1993. The Washington Commission also authorized the Company to increase rates by an additional $3.9 million effective October 1, 1993 to recognize, prospectively, the effect of the increase in the Federal corporate income tax rate from 34 to 35 percent. While the Washington Commission's order allowed only $57.6 million of the total requested rate relief, an additional amount of approximately $33.1 million remains eligible for deferral and future recovery through the continued operation of the PRAM. This amount includes such items as the Tenaska purchase power contract (a 245 megawatt cogeneration facility scheduled for operation in April of 1994), costs associated with the impact of hydro conditions and costs associated with fuel costs at the Colstrip plant in Montana. The Washington Commission authorized a 10.5 percent return on common equity and a common equity component of 45 percent, compared to the Company's request for a 12.25 percent return on common equity and a 45 percent common equity component. This lower return on equity reduced the amount the Washington Commission granted by approximately $30 million. Prior to October 1, 1993, provision was made for uninsured storm damage, with the approval of the Washington Commission, on the basis of the amount of outside insurance in effect and historical losses. To the extent actual costs varied from the provision, the difference was deferred for incorporation into future rates. The general rate order terminated, prospectively, the provision for deferral of uninsured storm damage except for certain losses associated with major catastrophic events. At December 31, 1993, the Company had no insurance coverage for storm damage. The general rate order also required the Company to file a case by November 1, 1993, demonstrating the prudency of its eight new power purchase contracts acquired since its last general rate case. Pending the resolution of the prudency review case, the Washington Commission ordered that the Company's new rates, effective October 1, 1993, would be collected subject to refund to the extent this proceeding demonstrates any of those contracts to be imprudent. The Washington Commission calculated the annual revenue requirement at risk to be up to $86.1 million. This amount is the difference between the Company's power costs under the new power purchase contracts and the Washington Commission's estimated cost of purchasing equivalent power on the secondary market. The Company filed its prudency case on October 18, 1993, and expects the Washington Commission to enter a final order before October 1, 1994. The decrease in allowed return on equity from 12.8 percent in the last general rate case to 10.5 percent approved in the present rate case has put downward pressure on earnings since the order became effective on October 1, 1993. In addition, it will be difficult for the Company to earn its full allowed rate of return because of changes made by the rate orders in the recovery methods of certain costs. Therefore, the Company continues to place strong emphasis on its ongoing improvement efforts designed to increase operating efficiencies. As a regulated electric utility, the Company's financial condition is largely dependent on continued cost-recovery regulation by the Washington Commission. Adverse action by the Washington Commission in regulatory matters involving the Company, including the pending prudency review case, could adversely impact the Company's financial condition and threaten its ability to maintain the dividend on its common stock at current levels. OTHER The Company and BPA have entered into a letter of intent, subject to various conditions, regarding pursuit of construction of a joint transmission project in Whatcom and Skagit counties in northern Washington state, the northernmost portion of the Company's service territory. The joint project is intended to provide the Company and BPA with certain transfer capacity with Canadian utilities and is intended to relieve certain transmission constraints on the respective systems of BPA and the Company. The joint project would involve a combination of existing facility upgrades and new construction and is currently under environmental review. The Company's efforts in this project are preliminary in nature and, as such, the Company cannot give assurance that any construction will result. The Company also continues to seek reasonable terms for acquiring capacity rights to BPA's planned third A.C. line, which would provide additional transmission capacity between the Pacific Northwest and the Southwestern states. The Company expects to receive 371 MW of southbound capacity on the line from BPA and 284 MW of northbound capacity. The price of participation is expected to be $215 per KW for each KW of rated southbound capacity or a total capital cost of $80 million. The Company is in the process of replacing the High Molecular Weight ("HMW") underground distribution cable installed during the 1960s and 1970s. The Company installed about 4,800 miles of industrial standard HMW cable between 1964 and 1979, but the Company and other utilities have experienced increasing cable failures in recent years. The Company is continuing to analyze cable failure trends to find ways to mitigate the long term effect of cable failures on customer service, within budgetary constraints. To minimize the impact of increasing cable failures, the Company replaces an increasing amount of HMW cable each year. The Company estimates that the total cost of replacing all 4,800 miles of cable will be about $550 million over a 15 to 20-year period. With 310 miles of cable replaced to date, the Company expects to spend $66 million during the period 1994-1997 for replacement of this cable. The Company presently has no plans for major diversification outside of the electric utility field and expects revenues in the near future to be generated almost entirely by electric utility operations. Investments in and advances to subsidiaries increased $14.2 million in 1993 primarily as a result of advances to a subsidiary developing small hydro projects. The electric utility industry in general is experiencing intensifying competitive pressures, particularly in wholesale generation and industrial customer markets. The National Energy Policy Act of 1992 was designed to increase competition in the wholesale electric generation market by easing regulatory restrictions on producers of wholesale power and by authorizing the FERC to mandate access to electric transmission systems by wholesale power generators. The potential for increased competition at the retail level in the electric utility industry through state-mandated retail wheeling has also been the subject of legislative and administrative interest in a number of states, including the state of Washington. Electric utilities, including the Company, now face greater potential competition for resources and customers from a variety of sources, including privately owned independent power producers, exempt wholesale power generators, industrial customers developing their own generation resources, suppliers of natural gas and other fuels, other investor-owned electric utilities and municipal generators. All four of the major credit rating agencies have expressed the view that competitive developments in the electric utility industry are likely to increase business risks, with resulting pressure on utility credit quality. One of the rating agencies has stated that it is revising its financial ratio guidelines for electric utilities to reflect the changing risk profiles within the industry. These rating agency actions may result in higher capital costs and more limited access to capital markets for electric utilities, including the Company. Although the Company to date has not experienced any significant adverse impact on its business from these industry trends, the Company has taken a number of steps to prepare for a more competitive business environment. These include programs to become a lower-cost producer by improving productivity and reducing the work force. The Company decided in January 1994 to offer an early separation plan to all officers, senior and middle managers and eligible professional staff. Benefits offered to those electing the program include a severance package based on years of service and enhanced retirement benefits for employees over 55 years of age. The number of employees that will accept the offer is presently not known. The Company has not set any specific job reduction targets. The Company, based on studies performed, currently estimates the total severance cost will not exceed $10 million. However, the total severance cost is dependent on the number of employees ultimately accepting the plan. The accrual for costs of this program will be recognized in the first quarter of 1994. Subsequent periods' expense will benefit from the savings associated with the reduced workforce. While the program will result in a net cost to the Company in 1994, the Company expects to see net savings in 1995 and beyond. The Company is also reviewing the extent of its investment in regulatory assets that may not be readily marketable to others in a competitive marketplace. The Company is seeking state legislation to provide a firm statutory basis for recovery of demand-side management regulatory assets associated with the Company's conservation programs. For a discussion of Environmental obligations, see Note 14 to the Consolidated Financial Statements. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA See index on page 35. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE - NONE. PART III Part III is incorporated by reference from the Company's definitive proxy statement issued in connection with the 1993 Annual Meeting of Shareholders. Certain information regarding executive officers is set forth in Part I. 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 statement schedules - see index on page 35. 2) Exhibits - see index on page 67. (b) Reports on Form 8-K: None 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. PUGET SOUND POWER & LIGHT COMPANY By /s/ R. R. Sonstelie -------------------------------------- R. R. Sonstelie President and Chief Executive Officer Date: March 1, 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 - --------------------------- -------------------------- --------- /s/ R. R. Sonstelie President and - --------------------------- Chief Executive Officer (R. R. Sonstelie) and Director /s/ William S. Weaver Executive Vice President and - --------------------------- Chief Financial Officer (William S. Weaver) and Director March 1, /s/ R. E. Olson Vice President Finance - --------------------------- and Treasurer (R. E. Olson) (Principal Accounting Officer) /s/ Douglas P. Beighle Director - --------------------------- (Douglas P. Beighle) /s/ Charles W. Bingham Director - --------------------------- (Charles W. Bingham) /s/ Phyllis J. Campbell Director - --------------------------- (Phyllis J. Campbell) /s/ John H. Dunkak Director - --------------------------- (John H. Dunkak III) /s/ John D. Durbin Director - --------------------------- (John D. Durbin) /s/ John W. Ellis Director - --------------------------- (John W. Ellis) /s/ Daniel J. Evans Director - --------------------------- (Daniel J. Evans) /s/ Nancy L. Jacob Director - --------------------------- (Nancy L. Jacob) Director - --------------------------- (R. Kirk Wilson) Puget Sound Power & Light Company Report of Management: March 2, 1994 The accompanying consolidated financial statements of Puget Sound Power & Light Company have been prepared under the direction of management, which is responsible for their integrity and objectivity. The statements have been prepared in accordance with generally accepted accounting principles and include amounts based on judgments and estimates by management where necessary. Management also has prepared the other information in the Form 10-K and is responsible for its accuracy and consistency with the financial statements. The Company maintains a system of internal control which, in management's opinion, provides reasonable assurance that assets are properly safeguarded and transactions are executed in accordance with management's authorization and properly recorded to produce reliable financial records and reports. The system of internal control provides for appropriate division of responsibility and is documented by written policy and updated as necessary. The Company's internal audit staff assesses the effectiveness and adequacy of the internal controls on a regular basis and recommends improvements when appropriate. Management considers the internal auditor's and independent auditor's recommendations concerning the Company's internal controls and takes steps to implement those that they believe are appropriate in the circumstances. In addition, Coopers & Lybrand, the independent auditors, have performed audit procedures deemed appropriate to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Board of Directors pursues its oversight role for the financial statements through the audit committee, which is composed solely of outside Directors. The audit committee meets regularly with management, the internal auditors and Coopers & Lybrand, jointly and separately, to review management's process of implementation and maintenance of internal accounting controls and auditing and financial reporting matters. The internal and independent auditors have unrestricted access to the audit committee. R. R. Sonstelie William S. Weaver Russel E. Olson ___________________ _______________________ ______________________ R. R. Sonstelie William S. Weaver Russel E. Olson President and Executive Vice President Vice President Finance Chief Executive and Chief Financial and Treasurer (Principal Officer Officer Accounting Officer) REPORT OF INDEPENDENT ACCOUNTANTS To the Shareholders of Puget Sound Power & Light Company We have audited the consolidated financial statements and the financial statement schedules of Puget Sound Power & Light Company listed on page 35 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. As more fully discussed in Note 14 to the financial statements, the Washington Commission, in its September 21, 1993 rate orders, authorized an increase in the Company's rates effective October 1, 1993 and required the Company to file another case demonstrating the prudency of certain power purchase contracts. Pending its decision in the prudency review case, the Washington Commission ordered that the new rates would be collected subject to refund to the extent any of the contract amounts were found to be imprudent. Management of the Company believes that the power purchase contracts are prudent. The Washington Commission's decision on the case is expected in September 1994. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Puget Sound Power & Light Company 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. 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 11 and 12, effective January 1, 1993, the Company changed its method of accounting for income taxes and postretirement benefits other than pensions. Coopers & Lybrand Seattle, Washington February 10, 1994 PUGET SOUND POWER & LIGHT COMPANY CONSOLIDATED FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES COVERED BY THE FOREGOING REPORT OF INDEPENDENT ACCOUNTANTS CONSOLIDATED FINANCIAL STATEMENTS: Page Consolidated Statements of Income for the years ended December 31, 1993, 1992 and 1991........................................36 Consolidated Balance Sheets, December 31, 1993 and 1992...................37 Consolidated Statements of Capitalization, December 31, 1993 and 1992.....39 Consolidated Statements of Earnings Reinvested in the Business for the years ended December 31, 1993, 1992 and 1991....................40 Consolidated Statements of Cash Flows for the years ended December 31, 1993, 1992 and 1991..................................41 Notes to Consolidated Financial Statements................................42 SCHEDULES: 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........................63 V. Property, Plant and Equipment for the years ended December 31, 1993, 1992 and 1991....................................64 VI. Accumulated Depreciation and Amortization of Property, Plant and Equipment for the years ended December 31, 1993, 1992 and 1991....................................65 VIII. Valuation and Qualifying Accounts and Reserves for the years ended December 31, 1993, 1992 and 1991........................66 All other schedules have been omitted because of the absence of the conditions under which they are required, or because the information required is included in the financial statements or the notes thereto. Financial statements of the Company's subsidiaries are not filed herewith inasmuch as the assets, revenues, earnings and earnings reinvested in the business of the subsidiaries are not material in relation to those of the Company. Puget Sound Power & Light Company Notes To Consolidated Financial Statements - ------------------------------------------------------------------------- 1) Summary of Accounting Policies Significant accounting policies are described below. Utility Plant: The costs of additions to utility plant, including renewals and betterments, are capitalized at original cost. Costs include indirect costs such as engineering, supervision, certain taxes and pension and other benefits, and an allowance for funds used during construction. Replacements of minor items of property are included in maintenance expense. The original cost of operating property together with removal cost, less salvage, is charged to accumulated depreciation when the property is retired and removed from service. Consolidation and Investment in Subsidiaries: The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiary, Puget Energy, Inc. ("Puget Energy"). Guaranteed Collateralized Bonds were issued by Puget Energy and the net proceeds from the sale of bonds were advanced to the Company (see Note 6). Puget Energy has no independent operations. Investments in all other subsidiaries are stated on an equity basis. Operating Revenues: Operating revenues are recorded on the basis of service rendered, which includes estimated unbilled revenue and revenue accrued under the Periodic Rate Adjustment Mechanism ("PRAM"). Energy Conservation: The Company accumulates energy conservation expenditures which are amortized to expense over a ten-year period when authorized by the Washington Utilities and Transportation Commission ("Washington Commission"). The Washington Commission allows an additional overall rate of return of .90% on the Company's unamortized energy conservation expenditures and on energy conservation loans to customers made prior to January 1, 1991. Self-Insurance: Prior to October 1, 1993, provision was made for uninsured storm damage, comprehensive liability, industrial accidents and catastrophic property losses, with the approval of the Washington Commission, on the basis of the amount of outside insurance in effect and historical losses. To the extent actual costs varied from the provision, the difference was deferred for incorporation into future rates. The amount deferred and included in other long-term assets at December 31, 1993, was approximately $26.8 million. In its September 21, 1993 order, the Washington Commission terminated, prospectively, the provision for deferral of uninsured storm damage except for certain losses associated with major catastrophic events. The Washington Commission in its order did provide for recovery annually of $2.8 million in deferred storm damage costs in retail rates, beginning October 1, 1993. The order also terminated the provision for deferral of other uninsured losses retroactively, resulting in an after-tax writeoff in 1993 of $2.0 million. At December 31, 1993, the Company had no insurance coverage for storm damage. Depreciation and Amortization: For financial statement purposes, the Company provides for depreciation on a straight-line basis. The depreciation of automobiles, trucks, power operated equipment and tools is allocated to asset and expense accounts based on usage. With the Washington Commission's approval, the Company reduced its depreciation rates in 1993. This adjustment had the effect of reducing depreciation expense by $10.5 million during 1993. The annual depreciation provision stated as a percent of average original cost of depreciable utility plant was 3.1% in 1993 and 3.4% for 1992 and 1991. The Company's investments in terminated generating projects are being amortized on a straight-line basis over ten years for regulatory purposes (included in operating income as "Depreciation and amortization"). Amounts recoverable through rates related to investments in terminated generating projects and the Bonneville Exchange Power Contract were adjusted to their present value in prior years in accordance with Statement of Financial Accounting Standards No. 90. These adjustments result in reduced net amortization expense over the recovery periods, the effect of which is included in miscellaneous income in the amount, net of federal income tax expense, of $2.7 million, $3.6 million and $4.5 million for 1993, 1992 and 1991, respectively. Federal Income Taxes: The Company normalizes, with the approval of the Washington Commission, certain items. Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 109. (See Note 11.) Allowance for Funds Used During Construction: The Allowance for Funds Used During Construction ("AFUDC") represents the cost of both the debt and equity funds used to finance utility plant additions during the construction period. The amount of AFUDC recorded in each accounting period varies depending principally upon the level of construction work in progress and the AFUDC rate used. AFUDC is capitalized as a part of the cost of utility plant and is credited as a non-cash item to other income and interest charges currently. Cash inflow related to AFUDC does not occur until these charges are reflected in rates. The AFUDC rate allowed by the Washington Commission is the Company's authorized rate of return, which was 10.22% effective January 30, 1990, 10.16% effective October 1, 1991 and 8.94% effective October 1, 1993. To the extent this rate exceeds the maximum AFUDC rate calculated using the Federal Energy Regulatory Commission ("FERC") formula, the Company capitalizes the excess as a deferred asset, crediting miscellaneous income. The amounts included in income were: $2,309,000 for 1993; $3,680,000 for 1992 and $1,686,000 for 1991. Allowance For Funds Used to Conserve Energy: Beginning in April 1991, the Washington Commission authorized the Company to capitalize, as part of energy conservation costs, related carrying costs calculated at a rate established by the Washington Commission. This Allowance for Funds Used to Conserve Energy ("AFUCE") has been credited as a non-cash item to miscellaneous income in the amount of $4,276,000 in 1993, $4,454,000 in 1992 and $767,000 in 1991. Cash inflow related to AFUCE occurs when these charges are reflected in rates. Periodic Rate Adjustment Mechanism: In April 1991, the Washington Commission issued an order establishing a PRAM designed to operate as an interim rate adjustment mechanism between tri-annual general rate cases. Under the PRAM, the Company is allowed to request annual rate adjustments, on a prospective basis, to reflect changes in certain costs as set forth in the PRAM order. Also, under terms of the order, recovery of certain costs is decoupled from levels of electricity sales. Rates established for the PRAM period are subject to future adjustment based on actual customer growth and variations in certain costs, principally those affected by hydro and weather conditions. To the extent revenue billed to customers varies from amounts allowed under the methodology established in the PRAM order, the difference is accumulated, without interest, for rate recovery which will be established in the next PRAM hearing. In its September 21, 1993 order, the Washington Commission approved the Company's latest PRAM filing. A receivable of approximately $85.0 million was recorded at December 31, 1993 under this methodology. Amounts expected to be collected within one year have been included in current assets. Other: The carrying amount of cash, which includes temporary investments with maturities of 3 months or less, is considered to be a reasonable estimate of fair value. Debt premium, discount and expenses are amortized over the life of the related debt. Certain costs have been deferred for amortization in subsequent years, as it is considered probable that such costs will be recovered through future rates. Earnings Per Common Share: Earnings per common share have been computed based on the weighted average number of common shares outstanding. On January 15, 1991, the Board of Directors declared a dividend of one preference share purchase right (a "Right") on each outstanding common share of the Company. The dividend was distributed on January 25, 1991, to shareholders of record on that date. The Rights will be exercisable only if a person or group acquires 10 percent or more of the Company's common stock or announces a tender offer which, if consummated, would result in ownership by a person or group of 10 percent or more of the common stock. Each Right entitles the registered holder to purchase from the Company one one-thousandth of a share of Preference Stock, $50 par value per share, at an exercise price of $45, subject to adjustments. The description and terms of the Rights are set forth in a Rights Agreement between the Company and The Chase Manhattan Bank, N.A., as Rights Agent. The Rights expire on January 25, 2001, unless earlier redeemed by the Company. In February 1992, the Company filed a shelf registration statement with the Securities and Exchange Commission for the offering, on a delayed or continuous basis, of up to $200 million of preferred stock. Either $25 par value or $100 par value preferred stock may be issued. On March 25, 1992, the Company issued $75 million, 7.75% Series, $100 par value Preferred Stock. The proceeds were used to retire $50 million principal amount of its Flexible Dutch Auction Rate Transferable Securities, $100 par value Preferred Stock ("FLEX DARTS"), Series A and to pay down short-term debt. On July 21, 1992, the Company issued $75 million, 7.875% Series, $25 par value Preferred Stock. The proceeds of this issue were used to pay down short-term debt. The 7.875% Series may be redeemed after July 14, 1997 at $25 per share plus accrued dividends. On July 1, 1993, the FLEX DARTS Series B were redeemed with the proceeds from the sale of the Company's common stock. The weighted average dividend rate for Series B was 3.30% for 1993, 3.60% for 1992 and 5.49% for 1991. The weighted average dividend rate for Series A was 4.18% in the first three months of 1992 and 5.28% for 1991. On February 3, 1994, the Company issued $50 million, Adjustable Rate Cumulative Preferred Stock ("ARPS"), Series B ($25 par value). The proceeds were used to retire the $40 million principal amount of its ARPS Series A ($100 par value). The weighted average dividend rate for the ARPS Series A was 7.00% for 1993, 7.17% for 1992 and 7.59% for 1991. For each quarterly period, dividends on the ARPS Series B, determined in advance of such period, will be set at 83% of the highest of three interest rates as defined in the Statement of Relative Rights and Preferences for ARPS Series B. The dividend rate for any dividend period will in no event be less than 4% per annum or greater than 10% per annum. Dividends from the date of issuance through May 14, 1994 will be payable at the rate of 5.24% per annum. The Company may redeem the ARPS Series B at any time on not less than 30 days notice at $27.50 per share on or prior to February 1, 1999, and at $25 per share thereafter, plus in each case accrued dividends to the date of redemption; provided however, that no shares shall be redeemed prior to February 1, 1999, if such redemption is for the purpose or in anticipation of refunding such share at an effective interest or dividend cost to the Company of less than 5.37% per annum. 3) Preferred Stock Subject to Mandatory Redemption The Company is required to deposit funds annually in a sinking fund sufficient to redeem the following number of shares of each series at $100 per share plus accrued dividends: 4.84% Series and 4.70% Series, 3,000 shares each; 8% Series, 6,000 and 1,000 shares through 2003 and 2004, respectively; and 7.75% Series, 37,500 shares on each February 15, commencing on February 15, 1998. Previous requirements have been satisfied by delivery of reacquired shares. At December 31, 1993, there were 13,939 shares of the 4.84% Series, 2,594 shares of the 4.70% Series and 704 shares of the 8% Series acquired by the Company and available for future sinking fund requirements. Upon involuntary liquidation, all preferred shares are entitled to their par value plus accrued dividends. The preferred stock subject to mandatory redemption (see Note 2) may also be redeemed by the Company at the following redemption prices per share plus accrued dividends: 4.84% Series, $102; 4.70% Series, $101; and 8% Series, $101. The 7.75% Series may be redeemed by the Company, subject to certain restrictions, at $106.72 per share plus accrued dividends through February 15, 1995 and at per share amounts which decline annually to a price of $100 after February 15, 2007. The preferred stock subject to mandatory redemption is estimated to have a fair value of $93.7 million or 100.6% of face value as of December 31, 1993. The fair value of preferred stock subject to mandatory redemption is estimated based on dealer quotes. 4) Additional Paid-in Capital 1993 1992 1991 - ----------------------------------------------------------------------------- (Dollars in Thousands) Balance at beginning of year $243,874 $198,733 $198,819 Excess of proceeds over stated values of: Common stock issued to trustee of employee investment plan 2,234 1,046 -- Common stock issued under the stock purchase and dividend reinvestment plan 24,584 10,841 -- Common stock sold to the public 61,669 37,950 -- Par value over(under) cost of reacquired preferred stock 612 579 (86) Issue costs of common stock (3,035) (1,950) -- Issue costs of preferred stock (16) (3,325) -- - ----------------------------------------------------------------------------- Balance at end of year $329,922 $ 243,874 $198,733 ============================================================================= 5) Earnings Reinvested in the Business Earnings reinvested in the business unrestricted as to payment of cash dividends on common stock approximated $266 million at December 31, 1993, under the provisions of the most restrictive covenants applicable to preferred stock and long-term debt contained in the Company's Articles of Incorporation and indentures. The adjustments made to the carrying value of costs associated with the terminated generating projects and Bonneville Exchange Power as a result of Statement of Financial Accounting Standards No. 90 and the disallowance of certain terminated generating project costs by the Washington Commission do not impact the amount of earnings reinvested in the business for purposes of payment of dividends on common stock under the terms of the aforementioned Articles and indentures. (See Note 1.) 6) Long-Term Debt First Mortgage Bonds and Guaranteed Collateralized Bonds - -------------------------------------------------------- First Mortgage Bonds at December 31: Series Due 1993 1992 Series Due 1993 1992 - --------------------------------------------------------------------------- (Dollars in Thousands) (Dollars in Thousands) 4.00% 1993 $ -- $ 40,000 9.14% 2001 $ 30,000 $ 30,000 4.75% 1994 15,000 15,000 7.75% 2002 -- 30,000 8.25% 1995 100,000 100,000 7.85% 2002 30,000 30,000 5.25% 1996 20,000 20,000 7.07% 2002 27,000 27,000 4.85% 1996 15,000 -- 7.15% 2002 5,000 5,000 6.625% 1997 -- 20,000 7.625% 2002 25,000 25,000 7.875% 1997 100,000 100,000 7.02% 2003 30,000 -- 9.625% 1997 50,000 50,000 6.20% 2003 3,000 -- 6.17% 1998 10,000 -- 6.40% 2003 11,000 -- 5.70% 1998 5,000 -- 7.70% 2004 50,000 50,000 8.83% 1998 25,000 25,000 8.06% 2006 46,000 46,000 7.50% 1999 -- 20,000 8.14% 2006 25,000 25,000 6.50% 1999 16,500 16,500 7.75% 2007 100,000 100,000 6.65% 1999 10,000 10,000 8.40% 2007 10,000 10,000 6.41% 1999 20,500 20,500 8.59% 2012 5,000 5,000 7.25% 1999 50,000 50,000 8.20% 2012 30,000 30,000 6.61% 2000 10,000 -- - --------------------------------------------------------------------------- Total First Mortgage Bonds $874,000 $900,000 =========================================================================== Guaranteed Collateralized Bonds at December 31: Series Due 1993 1992 Series Due 1993 1992 (Dollars in Thousands) (Dollars in Thousands) 8.05% 1993 $ -- $ 8,000 8.45% 1996 $ 8,000 $ 8,000 8.15% 1994 8,000 8,000 9.375% 2017 -- 114,000 8.30% 1995 8,000 8,000 - --------------------------------------------------------------------------- Total Guaranteed Collateralized Bonds $ 24,000 $146,000 =========================================================================== The Company has unconditionally guaranteed all payments of principal and premium, if any, and interest on each series of the Guaranteed Collateralized Bonds of Puget Energy issued in 1986. The guarantee of the Company with respect to each series of the Guaranteed Collateralized Bonds is backed by a related series of the Company's First Mortgage Bonds. Each related series of First Mortgage Bonds has been issued to the trustee for the Guaranteed Collateralized Bonds and so long as payment is made on the Guaranteed Collateralized Bonds no payment is due with respect to the related series of First Mortgage Bonds. Substantially all properties owned by the Company are subject to the lien of the First Mortgage Bonds. In February 1994, the Company extinguished $50 million principal amount of First Mortgage Bonds, 9.625% Series due 1997. The Company redeemed $24.5 million through a tender offer. A portfolio of U.S. Government Treasury Securities was purchased to defease the remaining $25.5 million of the bonds. The defeased bonds will be called on October 15, 1995. Pollution Control Revenue Bonds In June 1986, the Company entered into an agreement with the City of Forsyth, Montana, (the "City") borrowing $115 million obtained by the City from the sale of Customized Purchase Pollution Control Revenue Refunding Bonds due in 2012 (1986 Series) issued to finance the pollution control facilities of Colstrip Units 3 and 4. In April 1987, the Company entered into an agreement with the City, borrowing $23.4 million obtained by the City from the sale of Customized Purchase Pollution Control Revenue Refunding Bonds due December 1, 2016, (1987 Series) issued to finance additional pollution control facilities of Colstrip Unit 4. On August 7, 1991, the Company refunded $27.5 million of the 1986 Series and the entire $23.4 million of the 1987 Series with two new series of bonds, consisting of $27.5 million principal amount of a 7.05% Series due 2021 and $23.4 million principal amount of a 7.25% Series due 2021. In March 1992, the Company refunded the remaining $87.5 million of the 1986 Series with a new series at a rate of 6.80%, maturing in 2022. Each new series of bonds is collateralized by a pledge of the Company's First Mortgage Bonds, the terms of which match those of the pollution control bonds. No payment is due with respect to the related series of First Mortgage Bonds, so long as payment is made on the pollution control bonds. On April 29, 1993, the Company issued $23.46 million Pollution Control Revenue Refunding Bonds, 5.875% 1993 Series due 2020. The proceeds were used to refund $16.46 million Pollution Control Revenue Bonds, 5.90% 1973 Series and $7 million Pollution Control Revenue Bonds, 6.30% 1977 Series. Long-Term Debt Maturities and Sinking Fund Requirements - -------------------------------------------------------- The principal amounts of long-term debt maturities and sinking fund require- ments for the next five years are as follows: 1994 1995 1996 1997 1998 (Dollars in Thousands) Maturities of long-term debt $ 23,000 $108,000 $ 43,000 $150,000 $ 40,000 - ---------------------------------------------------------------------------- Sinking fund requirements $ 200 $ 200 $ -- $ -- $ -- - ---------------------------------------------------------------------------- The sinking fund requirement for the First Mortgage Bonds may be met by substitution of certain credits as provided in the indentures. The fair value of outstanding bonds including current maturities is estimated to be $1.126 billion or 106.2% of face value as of December 31, 1993. The fair value of long-term bonds is estimated based on quoted market prices. 7) Short-Term Debt The Company has short-term borrowing arrangements which include a $100 million line of credit with six major banks, a $50 million line of credit with four banks and a $2 million line with another three banks. The agreements provide the Company with the ability to borrow at different interest rate options. For the $100 million and $50 million lines of credit, the options are: (1) the higher of the prime rate or the Federal Funds rate plus 1/2 of 1 percent or (2) the bank Certificate of Deposit rate plus 1/2 of 1 percent or (3) the Eurodollar rate plus 3/8 of 1 percent. These Credit Agreements require an availability fee of 1/5 of 1% per annum on the unused loan commitment. Borrowings on the $2 million credit line are at the prime rate and compensating balances of 2-1/2% are required. In addition, the Company has agreements with several banks to borrow on an uncommitted, as available, basis at money-market rates quoted by the banks. There are no costs, other than interest, for these arrangements. The Company also uses commercial paper to fund its short-term borrowing requirements. At December 31: 1993 1992 1991 - ------------------------------------------------------------------------ (Dollars in Thousands) Short-term borrowings outstanding Bank notes $ 79,300 $ 69,800 $ 40,500 Commercial paper notes $ 70,006 $ 20,650 $ 71,289 Weighted average interest rate 3.49% 4.37% 5.49% Unused lines of credit (a) $152,000 $152,000 $153,000 During the year ended December 31: Maximum aggregate short-term borrowings $149,306 $146,158 $111,789 Average daily short-term borrowings (b) $ 55,244 $ 81,509 $ 59,931 Weighted average interest rate (c) 3.40% 4.15% 6.35% - ------------------------------------------------------------------------ (a) Provides liquidity support for outstanding commercial paper in the amount of $70.0 million, $20.7 million and $71.3 million for 1993, 1992 and 1991, respectively, effectively reducing the available borrowing capacity under these credit lines to $82.0 million, $131.3 million and $81.7 million, respectively. (b) The sum of dollar days of outstanding borrowings divided by actual days in period. (c) Actual accrued interest during the period divided by average daily borrowings. The carrying value of short-term debt is considered to be a reasonable estimate of fair value. 8) Investment in Bonneville Exchange Power Contract The Company has a five percent interest, as a tenant in common with three other investor-owned utilities and Washington Public Power Supply System ("WPPSS"), in the WPPSS Unit 3 project. Unit 3 is a partially constructed 1,240,000 kilowatt nuclear generating plant at Satsop, Washington, which is in a state of extended construction delay instituted by the Bonneville Power Administration ("BPA") and WPPSS in 1983. Under the terms of a settlement agreement (the "Settlement Agreement"), which includes a Settlement Exchange Agreement ("Bonneville Exchange Power Contract") between the Company and BPA dated September 17, 1985, the Company is receiving electric power (the "Bonneville Exchange Power") from the federal power system resources marketed by the BPA for a period of approximately 30.5 years which commenced January 1, 1987. The Settlement Agreement settled the claims of the Company against WPPSS and BPA relating to the construction delay of the WPPSS Unit 3 project. In its general rate case order issued on January 17, 1990, the Washington Commission found that all WPPSS Unit 3/Bonneville Exchange Power costs had been prudently incurred. Under terms of the order, approximately two-thirds or $97 million of the investment in Bonneville Exchange Power is included in rate base and amortized on a straight-line basis over the remaining life of the contract (amortization is included in "Purchased and interchanged power"). The remainder of the Company's investment is being recovered in rates over ten years, without a return during the recovery period. The related amortization is included in "Depreciation and amortization," pursuant to a FERC accounting order. Several issues in the litigation relating to WPPSS Unit 3, including claims on behalf of WPPSS Unit 5 against the Company and the other Unit 3 owners seeking recovery of certain common costs, have not been settled by the Settlement Agreement. The claims with respect to WPPSS Unit 3 and Unit 5 common costs, made in the United States District Court for the Western District of Washington, arise out of the fact that Unit 3 and Unit 5 were being constructed adjacent to each other and were planned to share certain costs. Unit 3 is in a state of extended construction delay and Unit 5 was terminated prior to completion. In 1989, the Company and other parties submitted arguments and affidavits to the United States District Court, in response to an order of the court, on the proper basis or bases upon which costs should have been allocated between Unit 3 and Unit 5 under the WPPSS Unit 4 and 5 Bond Resolution. On October 5, 1990, the District Court ruled that certain cost allocations between Unit 3 and Unit 5 (and between WPPSS Unit 1 and Unit 4) were improper. The District Court determined that principles of incremental cost sharing were not applied and, as a result, Unit 4 and Unit 5 apparently bore more than their fair and equitable share of construction costs. The District Court granted the motion by the trustee for WPPSS Unit 4 and Unit 5 bondholders for an accounting of all uses of WPPSS Unit 4 and Unit 5 bond proceeds to determine, among other things, the extent of improper allocation of such costs. In January 1991, the United States Court of Appeals for the Ninth Circuit granted the Company and others permission to appeal on an interlocutory basis from the District Court's orders. In February 1992, the Court of Appeals ruled on the District Court's October 5, 1990 order and held that principles of incremental cost sharing were not required and remanded the matter to the District Court for further proceedings. The ultimate resolution of these issues is not expected to have a material adverse impact on the financial condition or operations of the Company. 9) Supplementary Income Statement Information 1993 1992 1991 - ---------------------------------------------------------------------- (Dollars in Thousands) Taxes: Real estate and personal property $ 29,354 $ 30,839 $29,023 State business 40,102 35,798 33,709 Municipal, occupational and other 23,064 21,136 20,887 Payroll 9,664 9,517 8,933 Other 3,462 5,300 4,316 - ---------------------------------------------------------------------- Total taxes $105,646 $102,590 $96,868 - ---------------------------------------------------------------------- Charged to: Tax expense $100,598 $ 94,466 $89,640 Other accounts, including construction work in progress 5,048 8,124 7,228 - ---------------------------------------------------------------------- Total taxes $105,646 $102,590 $96,868 ====================================================================== See "Consolidated Statements of Income" for maintenance and depreciation expense. Advertising, research and development expenses and amortization of intangibles are not significant. The Company pays no royalties. 10) Leases The Company classifies leases as operating or capital leases. Capitalized leases are not material. The Company treats all leases as operating leases for ratemaking purposes as required by the Washington Commission. Rental and lease payments for the years ended December 31, 1993, 1992 and 1991 were approximately $14,016,000, $13,773,000 and $12,945,000, respectively. At December 31, 1993, future minimum lease payments for noncancelable leases are $8,279,000 for 1994, $8,211,000 for 1995, $8,158,000 for 1996, $8,194,000 for 1997, $7,934,000 for 1998 and in the aggregate $39,225,000 thereafter. 11) Federal Income Taxes The details of federal income taxes ("FIT") are as follows: 1993 1992 1991 - --------------------------------------------------------------------------- Charged to Operating Expense: (Dollars in Thousands) Current $56,908 $67,762 $54,004 Deferred investment tax credits - net (2,118) (4,018) (4,258) Deferred - net 29,180 8,705 6,434 - --------------------------------------------------------------------------- Total FIT charged to operations $83,970 $72,449 $56,180 =========================================================================== Charged to Miscellaneous Income: Current $(3,665) $(5,207) $(2,985) Deferred 3,087 2,596 2,175 - --------------------------------------------------------------------------- Total FIT charged to miscellaneous income $ (578) $(2,611) $ (810) =========================================================================== Total FIT $83,392 $69,838 $55,370 =========================================================================== The following is a reconciliation of the difference between the amount of FIT computed by multiplying pre-tax book income by the statutory tax rate, and the amount of FIT in the Consolidated Statements of Income: 1993 1992 1991 - --------------------------------------------------------------------------- (Dollars in Thousands) - --------------------------------------------------------------------------- FIT at the statutory rate $77,602 $69,890 $63,970 - --------------------------------------------------------------------------- Increase (Decrease): Depreciation expense deducted in the financial statements in excess of tax depreciation, net of depreciation treated as a temporary difference 4,698 5,295 4,754 AFUDC included in income in the financial statements but excluded from taxable income (2,563) (2,438) (2,112) Investment tax credit amortization (2,118) (4,018) (4,264) Amortization of Pebble Springs and Skagit/ Hanford projects, deducted for financial statements but not deducted for income tax purposes, net of amount treated as a temporary difference 1,465 1,748 1,748 Energy conservation expenditures, net 5,608 (1,245) (11,635) Other (1,300) 606 2,909 - --------------------------------------------------------------------------- Total FIT $83,392 $69,838 $55,370 =========================================================================== Effective tax rate 37.6% 34.0% 29.4% =========================================================================== The following are the principal components of FIT as reported: 1993 1992 1991 - --------------------------------------------------------------------------- (Dollars in Thousands) - --------------------------------------------------------------------------- Current FIT $53,243 $62,555 $51,019 =========================================================================== Deferred FIT - other: Conservation tax settlement (257) (22,645) -- Periodic rate adjustment mechanism (PRAM) 14,959 14,321 228 Deferred taxes related to insurance reserves 1,409 596 4,282 Terminated generating projects (5,735) (6,647) (6,647) Reversal of Statement No. 90 present value adjustments 1,477 2,374 3,096 Residential Purchase and Sale Agreement, net 4,136 2,491 (1,008) Normalized tax benefits of the accelerated cost recovery system 19,839 21,237 15,693 Energy conservation program (2,938) (3,360) (3,662) Other (623) 2,934 (3,373) - --------------------------------------------------------------------------- Total deferred FIT - other $32,267 $11,301 $ 8,609 =========================================================================== Deferred investment tax credits - net of amortization $(2,118) $(4,018) $(4,258) - ---------------------------------------------------------------------------- Total FIT $83,392 $69,838 $55,370 =========================================================================== Deferred tax amounts shown above result from temporary differences for tax and financial statement purposes. Deferred tax provisions are not recorded in the income statement on certain temporary differences for tax and financial statement purposes because they are not allowed for ratemaking purposes. Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" ("Statement No. 109"). Statement No. 109 requires recording deferred tax balances, at the currently enacted tax rate, for all temporary differences between the book and tax bases of assets and liabilities, including temporary differences for which no deferred taxes had been previously provided because of use of flow- through tax accounting for rate-making purposes. Under the provision of Statement No. 109, the Company recorded at the date of adoption an additional deferred tax liability of approximately $272 million. Because of prior, and expected future, ratemaking treatment for differences resulting from flow- through tax accounting, a corresponding regulatory asset for income taxes recoverable through future rates of $272 million was also established at the date of adoption. At December 31, 1993, the balance of this asset is $281 million. The cumulative effect on net income for the current period from adoption of Statement No. 109 was not significant. Adoption is not expected to significantly impact income tax expense in the future. The Company has reclassified as liabilities deferred income taxes previously netted with plant and other property and investments of $196 million in 1992. The deferred tax liability at December 31, 1993 is comprised of amounts related to the following types of temporary differences (thousands of dollars): Utility plant $425,210 PRAM 29,885 Energy conservation charges 44,548 Contributions in aid of construction (21,814) Bonneville Exchange Power 18,968 Other 31,868 ------- Total $528,665 ======== The total of $529 million consists of deferred tax liabilities of $559 million net of deferred tax assets of $30 million. In 1992, the Company reached an agreement with the Internal Revenue Service (the "Service") settling a number of issues. As part of the agreement, the Company agreed to accept the Service's position that energy conservation expenditures should be capitalized for tax purposes and deducted over the book life of the asset. Acceptance of the Service's position had no effect on net income because the Company obtained an accounting order from the Washington Commission with respect to additional tax expense associated with the settlement. The net income impact of other elements of the settlement was approximately $1.4 million. 12) Retirement Benefits The Company has a noncontributory defined benefit pension plan covering substantially all of its employees. The benefit formula is a function of both years of service and the average of the five highest consecutive years of basic earnings within the last ten years of employment. The Company funds pension cost using the "frozen entry-age" actuarial cost method. Through September 30, 1993, in accordance with the methodology confirmed in the January 17, 1990 general rate order from the Washington Commission, the Company has recognized pension costs for ratemaking and financial statement purposes using a formula based on a multi-year average of actual contributions to the plan. Effective October 1, 1993, because of a change in methodology made by the Washington Commission in its September 21, 1993 rate order, the Company's pension costs for financial statement purposes are determined in accordance with the provisions of Statement of Financial Accounting Standards No. 87, "Accounting for Pensions." Net pension costs for 1993, 1992 and 1991, including $1,440,000 for 1993, $811,000 for 1992 and $741,000 for 1991 which were charged to construction and other asset accounts, were comprised of the following components: 1993 1992 1991 - --------------------------------------------------------------------------- (Dollars in Thousands) Service cost (benefits earned during the period) $ 6,952 $ 6,492 $ 5,919 Interest cost on projected benefit obligation 14,676 13,743 12,510 Actual return on plan assets (21,786) (9,426) (31,492) Net amortization and deferral 5,121 (5,470) 17,826 - --------------------------------------------------------------------------- Net pension costs under FASB Statement No. 87 4,963 5,339 4,763 - --------------------------------------------------------------------------- Regulatory adjustment (2,083) (3,575) (2,999) - --------------------------------------------------------------------------- Net pension costs $ 2,880 $ 1,764 $ 1,764 =========================================================================== Funded Status of Plan At December 31: 1993 1992 - --------------------------------------------------------------------------- (Dollars in Thousands) Actuarial present value of benefit obligations: Vested $(151,399) $(125,019) Nonvested (1,090) (616) - ---------------------------------------------------------------------------- Accumulated benefit obligation (152,489) (125,635) Effect of future compensation levels (53,998) (51,072) - --------------------------------------------------------------------------- Total projected benefit obligation (206,487) (176,707) Plan assets at market value 214,580 191,776 - --------------------------------------------------------------------------- Plan assets in excess of projected benefit obligation 8,093 15,069 Unrecognized net gain due to variance between assumptions and experience (14,344) (26,145) Prior service cost 11,232 12,249 Transition asset as of January 1, 1986, being amortized on a straight-line basis over 18 years (4,194) (4,614) Regulatory adjustment, cumulative 7,453 5,370 - --------------------------------------------------------------------------- Prepaid pension cost recognized in long-term assets on balance sheet $ 8,240 $ 1,929 =========================================================================== Assumptions used for the above calculations are as follows: settlement (discount) rate for 1993 - 7.5%, for 1992 and 1991 - 8.5%; rate of annual compensation increase for 1993 - 5.5%, for 1992 and 1991 - 6%; and long-term rate of return on assets for 1993 - 8.5%, for 1992 and 1991 - 9%. Plan assets consist primarily of U.S. Government securities, corporate debt and equity securities. Effective October 1, 1991, the Company's Board of Directors approved supplemental retirement plans for officer and director level employees. Expenses for this plan for 1993, 1992 and 1991 were $651,000, $606,000 and $148,500, respectively. At December 31, 1993, a minimum liability and an intangible asset of $1,732,000 related to this plan are included in the financial statements. In addition to providing pension benefits, the Company provides certain health care and life insurance benefits for retired employees. Substantially all of the Company's employees may become eligible for those benefits if they reach normal retirement age while working for the Company. These benefits are provided through an insurance company whose premiums are based on the benefits paid during the year. The Company recognized the cost of providing those benefits by expensing $2,025,000 and $2,095,000 for the years 1992 and 1991, respectively. Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" ("Statement No. 106") which requires the costs associated with postretirement benefits to be accrued during the working careers of active employees. The Company is recognizing the impact of Statement No. 106 by amortizing its transition obligation of $24.9 million to expense over 20 years. The resulting 1993 annual cost under Statement No. 106 is approximately $3.8 million. In the rate order issued by the Washington Commission on September 21, 1993, the Washington Commission approved adoption of accrual accounting for postretirement benefits. For rate purposes, the difference between accrual and pay-as-you-go accounting will be phased in over five years. The Washington Commission's calculation of Statement No. 106 costs for rate purposes is lower than the Company's cost. In 1993, the expense recognized for postretirement benefits was $2.8 million, including $.5 million disallowed by the Washington Commission which was expensed. An additional $1.0 million was deferred under provisions of the Washington Commission's five year phase-in plan. 13) Employee Investment Plan The Company has a qualified employee Investment Plan under which employee salary deferrals and after-tax contributions are used to purchase several different investment fund options. The Company makes a monthly contribution equal to 55% of the basic contribution of each participating employee. The basic contribution is limited to 6% of the employee's eligible earnings. All Company contributions are used to purchase Company common stock on the open market or directly from the Company. The Company contributions to the plan were $3,520,000, $3,317,000 and $3,129,000 for the years 1993, 1992 and 1991, respectively. The shareholders have authorized the issuance of up to 1,000,000 shares of common stock under the plan, of which 959,142 were issued through December 31, 1993. The employee Investment Plan eligibility requirements are set forth in the plan documents. 14) Commitments and Contingencies Commitments For the twelve months ended December 31, 1993, approximately 27% of the Company's energy output was obtained at an average cost of approximately 11.9 mills per KWH through long-term contracts with several of the Washington public utility districts ("PUDs") owning hydroelectric projects on the Columbia River. The purchase of power from the Columbia River projects is generally on a "cost-of-service" basis under which the Company pays a proportionate part of the annual cost of each project in direct ratio to the amount of power allocated to it. Such payments are not contingent upon the projects being operable. These projects are financed through substantially level debt service payments, and their annual costs should not vary significantly over the term of the contracts unless additional financing is required to meet the costs of major maintenance, repairs or replacements or license requirements. The Company's share of the costs and the output of the projects is subject to reduction due to various withdrawal rights of the districts and others over the lives of the contracts. As of December 31, 1993, the Company was entitled to purchase portions of the power output of the PUDs' projects as set forth in the following tabulation: Company's Annual Amount Bonds Purchasable (Approximate) Outstanding -------------------------- Contract License 12/31/93(a) % of Kilowatt Costs(b) Project Exp.Date Exp.Date (Millions) Output Capacity (Millions) - ----------------------------------------------------------------------------- Rock Island Original units 2012 2029 $79.8 62.5 ) ) 507,000 $ 45.7 Additional units 2012 2029 326.8 100.0 ) Rocky Reach 2011 2006(c) 186.0 38.9 504,922 15.0 Wells 2018 2012(c) 199.9 34.8 292,320 10.0 Priest Rapids 2005 2005(c) 141.2 8.0 71,760 2.1 Wanapum 2009 2005(c) 189.4 10.8 98,280 2.8 - ----------------------------------------------------------------------------- Total 1,474,282 $ 75.6 ============================================================================= (a) The contracts for purchases are generally coextensive with the term of the PUD bonds associated with the project. Under the terms of some financings, however, long-term bonds were sold to finance certain assets whose estimated useful lives extend beyond the expiration date of the power sales contracts. Of the total outstanding bonds sold for each project, the percentage of principal amount of bonds which mature beyond the contract expiration dates are: 69.3% at Rock Island; 20.1% at Rocky Reach; 59.8% at Priest Rapids; and 39.4% at Wanapum. (b) Estimated debt service and operating costs for the year 1994. The components of 1994 costs associated with the interest portion of debt service are: Rock Island, $27.78 million for all units; Rocky Reach, $5.01 million; Wells, $3.42 million; Priest Rapids, $0.68 million; and Wanapum, $1.16 million. (c) The Company is unable to predict whether the licenses under the Federal Power Act will be renewed to the current licensees or what effect the term of the licenses may have on the Company's contracts. The Company's estimated payments for power purchases from the Columbia River projects are $75.6 million for 1994, $77.0 million for 1995, $77.7 million for 1996, $80.5 million for 1997, $84.3 million for 1998 and in the aggregate $1.044 billion thereafter through 2012. The Company also has numerous long-term firm purchased power contracts with other utilities and non-utility generators in the region. These contracts have varying terms and may include escalation and termination provisions. The Company is not obligated to make payments under these contracts unless power is delivered. The Company's estimated payments for firm power purchases from other utilities and non-utility generators, which includes the expected addition of 245 MW of capacity during 1994 in the form of a purchased power contract with an independent producer of gas-fired cogeneration, are $361.5 million for 1994, $409.6 million for 1995, $424.0 million for 1996, $427.7 million for 1997, $446.3 million for 1998 and in the aggregate $6.885 billion thereafter through 2012. Total purchased power contracts provided the Company with approximately 13.5 million, 12.7 million and 13.7 million MWH of firm energy at a cost of approximately $353.5 million, $274.6 million and $230.6 million for the years 1993, 1992 and 1991, respectively. The following table indicates the Company's percentage ownership and the extent of the Company's investment in jointly-owned generating plants in service at December 31, 1993: Energy Company's Plant in Accumulated Source Ownership Service Depreciation Project (Fuel) Share (%) (Millions) (Millions) Centralia Coal 7 $ 25.7 $ 15.3 Colstrip 1 & 2 Coal 50 177.4 81.0 Colstrip 3 & 4 Coal 25 440.3 119.2 Financing for a participant's ownership share in the projects is provided for by such participant. The Company's share of related operating and maintenance expenses is included in corresponding accounts in the Consolidated Statements of Income. Certain purchase commitments have been made in connection with the Company's construction program. Contingencies The Company is subject to environmental regulation by federal, state and local authorities. The Company has been named a Potentially Responsible Party by the Environmental Protection Agency at four sites. The Company is participating along with others in remedial action at various sites in the Pacific Northwest at which it is an alleged contributor of certain wastes. Based on the best estimates available at this time, the Company anticipates future costs for environmental remediation at all sites will approximate $4.4 million which was recorded as an accrued liability at December 31, 1993. On April 1, 1992, the Washington Commission issued an order regarding the treatment of costs incurred by the Company for certain sites under its environmental remediation program. The order authorizes the Company to accumulate and defer prudently incurred cleanup costs paid to third parties for recovery in rates established in future rate proceedings. The Company believes a significant portion of its past and future environmental remediation costs are recoverable from either insurance companies, third parties, or under the Washington Commission's order. At December 31, 1993, the recoverable amount for these costs is approximately $11.3 million. In its September 21, 1993 general rate order, the Washington Commission required the Company to file a case by November 1, 1993, demonstrating the prudency of its eight new power purchase contracts acquired since its last general rate case. Pending the resolution of the prudency review case, the Washington Commission ordered that the Company's new rates, effective October 1, 1993, would be collected subject to refund to the extent this proceeding demonstrates any of those contracts to be imprudent. The Washington Commission calculated the annual revenue requirement at risk to be up to $86.1 million. This amount is the difference between the Company's power costs under the new power purchase contracts and the Washington Commission's estimated cost of purchasing equivalent power on the secondary market. The Company filed its prudency case on October 18, 1993, and expects the Washington Commission to enter a final order before October 1, 1994. Revenues reported as of December 31, 1993 which are at risk under the prudency review case are approximately $19.7 million. The extent to which refunds, if any, are necessary is subject to the determination of the Washington Commission. However, based on the nature and terms of the contracts and existing regulatory precedents, management believes that these contracts are prudent and that the ultimate resolution of the review will not have a material adverse impact on the financial condition or results of operations of the Company. Other contingencies, arising out of the normal course of the Company's business, exist at December 31, 1993. The ultimate resolution of these issues is not expected to have a material adverse impact on the financial condition or results of operations of the Company. 15) Supplemental Quarterly Financial Data (Unaudited) The following amounts are unaudited but, in the opinion of the Company, include all adjustments necessary for a fair presentation of the results of operations for the interim periods. Annual amounts are not generated evenly by quarter during the year due to the seasonal nature of the utility business. 1993 Quarter Ended March 31 June 30 Sept. 30 Dec. 31 - ------------------------------------------------------------------------ (Dollars in Thousands except per share amounts) Operating revenues $323,974 $237,617 $230,178 $321,109 Operating income $ 72,922 $ 43,039 $ 35,505 $ 59,514 Other income $ 3,718 $ 4,614 $ 3,536 $ 1,712 Net income $ 54,682 $ 26,213 $ 18,071 $ 39,361 Earnings per common share $ 0.86 $ 0.37 $ 0.23 $ 0.56 - ------------------------------------------------------------------------ 1992 Quarter Ended March 31 June 30 Sept. 30 Dec. 31 - ------------------------------------------------------------------------ (Dollars in Thousands except per share amounts) Operating revenues $280,202 $240,643 $219,221 $284,904 Operating income $ 67,818 $ 51,557 $ 35,717 $ 59,579 Other income $ 3,765 $ 6,294 $ 4,627 $ 2,517 Net income $ 48,032 $ 29,538 $ 17,987 $ 40,163 Earnings per common share $ 0.83 $ 0.47 $ 0.25 $ 0.62 - ------------------------------------------------------------------------ 16) Consolidated Statement of Cash Flows For purposes of the Statement of Cash Flows, the Company considers all temporary investments to be cash equivalents. These temporary cash investments are securities held for cash management purposes, having maturities of three months or less. The net change in current assets and current liabilities for purposes of the Statement of Cash Flows excludes short-term debt, current maturities of long-term debt and the current portion of PRAM accrued revenues. The following provides additional information concerning cash flow activities: Year Ended December 31: 1993 1992 1991 - --------------------------------------------------------------------------- (Dollars in Thousands) Changes in certain current assets and current liabilities: Accounts receivable $ (5,050) $(13,848) $12,474 Deferred energy costs -- (20) 119 Unbilled revenues (14,410) (15,081) 16,217 Materials and supplies 1,054 (1,338) (2,840) Prepayments and Other 5,809 (6,346) (677) Accounts payable 10,731 (5,948) 9,624 Accrued expenses and Other 11,511 3,274 (9,018) - --------------------------------------------------------------------------- Net change in certain current assets and current liabilities $ 9,645 $(39,307) $25,899 =========================================================================== Cash payments: Interest (net of capitalized interest) $80,646 $97,242 $86,114 Income taxes $32,585 $76,050 $61,256 - --------------------------------------------------------------------------- 17) Subsequent Event In furtherance of its ongoing program to manage costs effectively and remain competitive with other energy providers, the Company decided in January 1994 to offer an early separation plan to all officers, senior and middle managers and eligible professional staff. Benefits offered to those electing the program include a severance package based on years of service and enhanced retirement benefits for employees over 55 years of age. The number of employees that will accept the offer is presently not known. The Company has not set any specific job reduction targets. The Company, based on studies performed, currently estimates the total severance cost will not exceed $10 million. However, the total severance cost is dependent on the number of employees ultimately accepting the plan. The accrual for costs of this program will be recognized in the first quarter of 1994. PUGET SOUND POWER & LIGHT COMPANY SCHEDULE II. Amounts Receivable From Related Parties and Underwriters, Promoters and Employees Other Than Related Parties - --------------------------------------------------------------------------- Column A Column B Column C Column D Column E Ending Beginning Balance Name of Debtor Balance Additions Deletions Non-Current - ---------------------------- --------- --------- --------- ----------- Year Ended December 31, 1993 Bill E. Covin (a) $262,000 $ 21,000 -- $283,000 - --------------------------------------------------------------------------- Year Ended December 31, 1992 Bill E. Covin (a) $589,000 $ 23,000 $350,000 $262,000 - --------------------------------------------------------------------------- Year Ended December 31, 1991 Bill E. Covin (a) $545,000 $ 44,000 -- $589,000 - --------------------------------------------------------------------------- (a) Note receivable at 8.06% interest, due March 31, 1995. Puget Sound Power & Light Company Schedule VIII. Valuation and Qualifying Accounts and Reserves - ----------------------------------------------------------------------------- (Dollars in Thousands) - ----------------------------------------------------------------------------- Column A Column B Column C Column D Column E - ----------------------------------------------------------------------------- Additions Balance at Charged to Balance Beginning Costs and at End of Period Expenses Deductions of Period Year Ended December 31, 1993 - ---------------------------- Accounts deducted from assets on balance sheet: Allowance for doubtful accounts receivable $ 488 $ 2,799 $ 2,764 $ 523 - ----------------------------------------------------------------------------- Reserves: Accumulated provision for self-insurance $ 87 $13,634(A) $13,721(A) $ -- ============================================================================= Year Ended December 31, 1992 - ---------------------------- Accounts deducted from assets on balance sheet: Allowance for doubtful accounts receivable $ 531 $ 1,981 $ 2,024 $ 488 - ----------------------------------------------------------------------------- Reserves: Accumulated provision for self-insurance $ 792 $ 4,610(A) $ 5,315(A) $ 87 ============================================================================= Year Ended December 31, 1991 - ---------------------------- Accounts deducted from assets on balance sheet: Allowance for doubtful accounts receivable $ 569 $ 2,954 $ 2,992 $ 531 Reserves: Accumulated provision for self-insurance $ 900 $16,047(A) $16,155(A) $ 792 ============================================================================= Note (A): Includes charges of $10.3 million in 1993, $1.8 million in 1992 and $12.5 million in 1991 which were transferred to a deferred asset account. EXHIBIT INDEX Certain of the following exhibits are filed herewith. Certain other of the following exhibits have heretofore been filed with the Commission and are incorporated herein by reference. 3-a Restated Articles of Incorporation of the Company. (Exhibit 1.2 to Registration Statement on Form 8-A filed February 14, 1994, Commission File No. 1-4393) 3-b Restated Bylaws of the Company. (Exhibit 4-b to Registration No. 33-18506) 4.1 Fortieth through Seventy-fifth Supplemental Indentures defining the rights of the holders of the Company's First Mortgage Bonds. (Exhibit 2- d to Registration No. 2-60200; Exhibit 4-c to Registration No. 2-13347; Exhibits 2-e through and including 2-k to Registration No. 2-60200; Exhibit 4- h to Registration No. 2-17465; Exhibits 2-l, 2-m and 2-n to Registration No. 2-60200; Exhibits 2-m to Registration No. 2-37645; Exhibit 2-o through and including 2-s to Registration No. 2-60200; Exhibit 5-b to Registration No. 2- 62883; Exhibit 2-h to Registration No. 2-65831; Exhibit (4)-j-1 to Registration No. 2-72061; Exhibit (4)-a to Registration No. 2-91516; Exhibit (4)-b to Annual Report on Form 10-K for the fiscal year ended December 31, 1985, Commission File No. 1-4393; Exhibits (4)(a) and (4)(b) to Company's Current Report on Form 8-K, dated April 22, 1986; Exhibit (4)a to Company's Current Report on Form 8-K, dated September 5, 1986; Exhibit (4)-b to Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1986, Commission File No. 1-4393; Exhibit (4)-c to Registration No. 33-18506; Exhibit (4)-b to Annual Report on Form 10-K for the fiscal year ended December 31, 1989, Commission File No. 1-4393; Exhibit (4)-b to Annual Report on Form 10-K for the fiscal year ended December 31, 1990, Commission File No. 1-4393; Exhibits (4)-b and (4)-c to Registration No. 33-45916; Exhibit (4)-c to Registration No. 33-50788; Exhibit (4)-a to Registration No. 33-53056; and Exhibit 4.3 to Registration No. 33-63278.) 4.2 Credit Agreement dated as of December 1, 1991, among the Company and various banks named therein, Seattle-First National Bank as Agent. (Exhibit (4)-d to Registration No. 33-45916) 4.3 Credit Agreement dated as of December 1, 1991, among the Company and various banks named therein, Bank of New York as Agent. (Exhibit (4)-e to Registration No. 33-45916) 4.4 Final form of Indenture dated as of November 1, 1986, among Puget Energy, the Company, and The First National Bank of Boston, as Trustee. (Exhibit 4-a to Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1986, Commission File No. 1-4393) 4.5 Final form of Pledge Agreement dated November 1, 1986, between the Company and The First National Bank of Boston, as Trustee. (Exhibit 4-c to Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1986, Commission File No. 1-4393) 4.6 Rights Agreement, dated as of January 15, 1991, between the Company and The Chase Manhattan Bank, N.A., as Rights Agent. (Exhibit 2.1 to Registration Statement on Form 8-A filed on January 17, 1991, Commission File No. 1-4393) 4.7 Pledge Agreement dated August 1, 1991, between the Company and The First National Bank of Chicago, as Trustee. (Exhibit (4)-j to Registration No. 33-45916) 4.8 Loan Agreement dated August 1, 1991, between the City of Forsyth, Rosebud County, Montana and the Company. (Exhibit (4)-k to Registration No. 33-45916) 4.9 Statement of Relative Rights and Preferences for the Adjustable Rate Cumulative Preferred Stock, Series B ($25 Par Value). (Exhibit 1.1 to Registration Statement on Form 8-A filed February 14, 1994, Commission File No. 1-4393) 4.10 Statement of Relative Rights and Preferences for the Series A Flexible Dutch Auction Rate Transferable Securities $100 Par Value Preferred Stock. (Exhibit 1.3 to Registration Statement on Form 8-A filed February 14, 1994, Commission File No. 1-4393) 4.11 Statement of Relative Rights and Preferences for the Series B Flexible Dutch Auction Rate Transferable Securities $100 Par Value Preferred Stock. (Exhibit 1.4 to Registration Statement on Form 8-A filed February 14, 1994, Commission File No. 1-4393) 4.12 Statement of Relative rights and Preferences for the Preference Stock, Series R, $50 Par Value. (Exhibit 1.5 to Registration Statement on Form 8-A filed February 14, 1994, Commission File No. 1-4393) 4.13 Statement of Relative Rights and Preferences for the 7 3/4% Series Preferred Stock Cumulative, $100 Par Value. (Exhibit 1.6 to Registration Statement on Form 8-A filed February 14, 1994, Commission File No. 1-4393) 4.14 Statement of Relative Rights and Preferences for the 7 7/8% Series Preferred Stock Cumulative, $25 Par Value. (Exhibit 1.7 to Registration Statement on Form 8-A filed February 14, 1994, Commission File No. 1-4393) *4.15 Pledge Agreement, dated as of March 1, 1992, by and between the Company and and Chemical Bank relating to a series of first mortgage bonds. *4.16 Pledge Agreement, dated as of April 1, 1993, by and between the Company and The First National Bank of Chicago, relating to a series of first mortgage bonds. 10.1 Assignment and Agreement, dated as of August 13, 1964, between Public Utility District No. 1 of Chelan County, Washington and the Company, relating to the Rock Island Project. (Exhibit 13-b to Registration No. 2-24262) 10.2 First Amendment, dated as of October 4, 1961, to Power Sales Contract between Public Utility District No. 1 of Chelan County, Washington and the Company, relating to the Rocky Reach Project. (Exhibit 13-d to Registration No. 2-24252) 10.3 Assignment and Agreement, dated as of August 13, 1964, between Public Utility District No. 1 of Chelan County, Washington and the Company, relating to the Rocky Reach Project. (Exhibit 13-e to Registration No. 2-24252) 10.4 Assignment and Agreement, dated as of August 13, 1964, between Public Utility District No. 2 of Grant County, Washington and the Company, relating to the Priest Rapids Development. (Exhibit 13-j to Registration No. 2-24252) 10.5 Assignment and Agreement, dated as of August 13, 1964, between Public Utility District No. 2 of Grant County, Washington and the Company, relating to the Wanapum Development. (Exhibit 13-n to Registration No. 2-24252) 10.6 First Amendment, dated February 9, 1965, to Power Sales Contract between Public Utility District No. 1 of Douglas County, Washington and the Company, relating to the Wells Development. (Exhibit 13-p to Registration No. 2-24252) 10.7 First Amendment, executed as of February 9, 1965, to Reserved Share Power Sales Contract between Public Utility District No. 1 of Douglas County, Washington and the Company, relating to the Wells Development. (Exhibit 13-r to Registration No. 2-24252) 10.8 Assignment and Agreement, dated as of August 13, 1964, between Public Utility District No. 1 of Douglas County, Washington and the Company, relating to the Wells Development. (Exhibit 13-u to Registration No. 2-24252) 10.9 Pacific Northwest Coordination Agreement, executed as of September 15, 1964, among the United States of America, the Company and most of the other major electrical utilities in the Pacific Northwest. (Exhibit 13-gg to Registration No. 2-24252) 10.10 Contract dated November 14, 1957, between Public Utility District No. 1 of Chelan County, Washington and the Company, relating to the Rocky Reach Project. (Exhibit 4-1-a to Registration No. 2-13979) 10.11 Power Sales Contract, dated as of November 14, 1957, between Public Utility District No. 1 of Chelan County, Washington and the Company, relating to the Rocky Reach Project. (Exhibit 4-c-1 to Registration No. 2-13979) 10.12 Power Sales Contract, dated May 21, 1956, between Public Utility District No. 2 of Grant County, Washington and the Company, relating to the Priest Rapids Project. (Exhibit 4-d to Registration No. 2-13347) 10.13 First Amendment to Power Sales Contract dated as of August 5, 1958, between the Company and Public Utility District No. 2 of Grant County, Washington, relating to the Priest Rapids Development. (Exhibit 13-h to Registration No. 2-15618) 10.14 Power Sales Contract dated June 22, 1959, between Public Utility District No. 2 of Grant County, Washington and the Company, relating to the Wanapum Development. (Exhibit 13-j to Registration No. 2- 15618) 10.15 Reserve Share Power Sales Contract dated June 22, 1959, between Public Utility District No. 2 of Grant County, Washington and the Company, relating to the Priest Rapids Project. (Exhibit 13-k to Registration No. 2- 15618) 10.16 Agreement to Amend Power Sales Contracts dated July 30, 1963, between Public Utility District No. 2 of Grant County, Washington and the Company, relating to the Wanapum Development. (Exhibit 13-1 to Registration No. 2-21824) 10.17 Power Sales Contract executed as of September 18, 1963, between Public Utility District No. 1 of Douglas County, Washington and the Company, relating to the Wells Development. (Exhibit 13-r to Registration No. 2- 21824) 10.18 Reserved Share Power Sales Contract executed as of September 18, 1963, between Public Utility District No. 1 of Douglas County, Washington and the Company, relating to the Wells Development. (Exhibit 13- s to Registration No. 2-21824) 10.19 Exchange Agreement dated April 12, 1963, between the United States of America, Department of the Interior, acting through the Bonneville Power Administrator and Washington Public Power Supply System and the Company, relating to the Hanford Project. (Exhibit 13-u to Registration 2- 21824) 10.20 Replacement Power Sales Contract dated April 12, 1963, between the United States of America, Department of the Interior, acting through the Bonneville Power Administrator and the Company, relating to the Hanford Project. (Exhibit 13-v to Registration No. 2-21824) 10.21 Contract covering undivided interest in ownership and operation of Centralia Thermal Plant, dated May 15, 1969. (Exhibit 5-b to Registration No. 2-3765) 10.22 Construction and Ownership Agreement dated as of July 30, 1971, between The Montana Power Company and the Company. (Exhibit 5-b to Registration No. 2-45702) 10.23 Operation and Maintenance Agreement dated as of July 30, 1971, between The Montana Power Company and the Company. (Exhibit 5-c to Registration No. 2-45702) 10.24 Coal Supply Agreement, dated as of July 30, 1971, among The Montana Power Company, the Company and Western Energy Company. (Exhibit 5-d to Registration No. 2-45702) 10.25 Power Purchase Agreement with Washington Public Power Supply System and the Bonneville Power Administration dated February 6, 1973. (Exhibit 5-e to Registration No. 2-49029) 10.26 Ownership Agreement among the Company, Washington Public Power Supply System and others dated September 17, 1973. (Exhibit 5-a-29 to Registration No. 2-60200) 10.27 Contract dated June 19, 1974, between the Company and P.U.D. No. 1 of Chelan County. (Exhibit D to Form 8-K dated July 5, 1974 10.28 Restated Financing Agreement among the Company, lessee, Chrysler Financial Corporation, owner, Nevada National Bank and Bank of Montreal (California), trustee, dated December 12, 1974 pertaining to a combustion turbine generating unit trust. (Exhibit 5-a-35 to Registration No. 2-60200) 10.29 Restated Lease Agreement between the Company, lessee, and the Bank of California, and National Association, lessor, dated December 12, 1974 for one combustion generating unit. (Exhibit 5-a-36 to Registration No. 2-60200) 10.30 Financing Agreement Supplement and Amendment among the Company, lessee, Chrysler Financial Corporation, owner, The Bank of California, National Association, trustee, Pacific Mutual Life Insurance Company, Bankers Life Company, and The Franklin Life Insurance Company, lenders, dated as of March 26, 1975, pertaining to a combustion turbine generating unit trust. (Exhibit 5-a-37 to Registration No. 2-60200) 10.31 Lease Agreement Supplement and Amendment between the Company, lessee, and The Bank of California, National Association, lessor, dated as of March 26, 1975 for one combustion turbine generating unit. (Exhibit 5-a- 38 to Registration No. 2-60200) 10.32 Exchange Agreement executed August 13, 1964, between the United States of America, Columbia Storage Power Exchange and the Company, relating to Canadian Entitlement. (Exhibit 13-ff to Registration No. 2-24252) 10.33 Loan Agreement dated as of December 1, 1980 and related documents pertaining to Whitehorn turbine construction trust financing. (Exhibit 10.52 to Annual Report on Form 10-K for the fiscal year ended December 31, 1980, Commission File No. 1-4393) 10.34 Letter Agreement dated March 31, 1980, between the Company and Manufacturers Hanover Leasing Corporation. (Exhibit b-8 to Registration No. 2-68498) 10.35 Coal Supply Agreement for Colstrip 3 and 4, dated as of July 2, 1980; Amendment No. 1 to Coal Supply Agreement, dated as of July 10, 1981; and Coal Transportation Agreement dated as of July 10, 1981. (Exhibit 20-a to Quarterly Report on Form 10-Q for the quarter ended September 30, 1981, Commission File No. 1-4393) 10.36 Residential Purchase and Sale Agreement between the Company and the Bonneville Power Administration, effective as of October 1, 1981. (Exhibit 20-b to Quarterly Report on Form 10-Q for the quarter ended September 30, 1981, Commission File No. 1-4393) 10.37 Letter of Agreement to Participate in Licensing of Creston Generating Station, dated September 30, 1981. (Exhibit 20-c to Quarterly Report on Form 10-Q for the quarter ended September 30, 1981, Commission File No. 1-4393) 10.38 Power sales contract dated August 27, 1982 between the Company and Bonneville Power Administration. (Exhibit 10-a to Quarterly Report on Form 10-Q for the quarter ended September 30, 1982, Commission File No. 1- 4393) 10.39 Agreement executed as of April 17, 1984, between the United States of America, Department of the Interior, acting through the Bonneville Power Administration, and other utilities relating to extension energy from the Hanford Atomic Power Plant No. 1. (Exhibit (10)-47 to Annual Report on Form 10-K for the fiscal year ended December 31, 1984, Commission File No. 1- 4393) 10.40 Agreement for the Assignment of Output from the Centralia Thermal Project, dated as of April 14, 1983, between the Company and Public Utility District No. 1 of Grays Harbor. (Exhibit (10)-48 to Annual Report on Form 10-K for the fiscal year ended December 31, 1984, Commission File No. 1-4393) 10.41 Settlement Agreement and Covenant Not to Sue executed by the United States Department of Energy acting by and through the Bonneville Power Administration and the Company dated September 17, 1985. (Exhibit (10)-49 to Annual Report on Form 10-K for the fiscal year ended December 31, 1985, Commission File No. 1-4393) 10.42 Agreement to Dismiss Claims and Covenant Not to Sue dated September 17, 1985 between Washington Public Power Supply System and the Company. (Exhibit (10)-50 to Annual Report on Form 10-K for the fiscal year ended December 31, 1985, Commission File No. 1-4393) 10.43 Irrevocable Offer of Washington Public Power Supply System Nuclear Project No. 3 Capability for Acquisition executed by the Company, dated September 17, 1985. (Exhibit A of Exhibit (10)-50 to Annual Report on Form 10-K for the fiscal year ended December 31, 1985, Commission File No. 1- 4393) 10.44 Settlement Exchange Agreement ("Bonneville Exchange Power Contract") executed by the United States of America Department of Energy acting by and through the Bonneville Power Administration and the Company, dated September 17, 1985. (Exhibit B of Exhibit (10)-50 to Annual Report on Form 10-K for the fiscal year ended December 31, 1985, Commission File No. 1- 4393) 10.45 Settlement Agreement and Covenant Not to Sue between the Company and Northern Wasco County People's Utility District, dated October 16, 1985. (Exhibit (10)-53 to Annual Report on Form 10-K for the fiscal year ended December 31, 1985, Commission File No. 1-4393) 10.46 Settlement Agreement and Covenant Not to Sue between the Company and Tillamook People's Utility District, dated October 16, 1985. (Exhibit (10)-54 to Annual Report on Form 10-K for the fiscal year ended December 31, 1985, Commission File No. 1-4393) 10.47 Settlement Agreement and Covenent Not to Sue between the Company and Clatskanie People's Utility District, dated September 30, 1985. (Exhibit (10)-55 to Annual Report on Form 10-K for the fiscal year ended December 31, 1985, Commission File No. 1-4393) 10.48 Stipulation and Settlement Agreement between the Company and Muckleshoot Tribe of the Muckleshoot Indian Reservation, dated October 31, 1986. (Exhibit (10)-55 to Annual Report on Form 10-K for the fiscal year ended December 31, 1986, Commission File No. 1-4393) 10.49 Transmission Agreement dated April 17, 1981, between the Bonneville Power Administration and the Company (Colstrip Project). (Exhibit (10)-55 to Annual Report on Form 10-K for the fiscal year ended December 31, 1987, Commission File No. 1-4393) 10.50 Transmission Agreement dated April 17, 1981, between the Bonneville Power Administration and Montana Intertie Users (Colstrip Project). (Exhibit (10)-56 to Annual Report on Form 10-K for the fiscal year ended December 31, 1987, Commission File No. 1-4393) 10.51 Ownership and Operation Agreement dated as of May 6, 1981, between the Company and other Owners of the Colstrip Project (Colstrip 3 and 4). (Exhibit (10)-57 to Annual Report on Form 10-K for the fiscal year ended December 31, 1987, Commission File No. 1-4393) 10.52 Colstrip Project Transmission Agreement dated as of May 6, 1981, between the Company and Owners of the Colstrip Project. (Exhibit (10)-58 to Annual Report on Form 10-K for the fiscal year ended December 31, 1987, Commission File No. 1-4393) 10.53 Common Facilities Agreement dated as of May 6, 1981, between the Company and Owners of Colstrip 1 and 2, and 3 and 4. (Exhibit (10)-59 to Annual Report on Form 10-K for the fiscal year ended December 31, 1987, Commission File No. 1-4393) 10.54 Agreement for the Purchase of Power dated as of October 29, 1984, between South Fork II, Inc. and the Company (Weeks Falls Hydroelectric Project). (Exhibit (10)-60 to Annual Report on Form 10-K for the fiscal year ended December 31, 1987, Commission File No. 1-4393) 10.55 Agreement for the Purchase of Power dated as of October 29, 1984, between South Fork Resources, Inc. and the Company (Twin Falls Hydroelectric Project). (Exhibit (10)-61 to Annual Report on Form 10-K for the fiscal year ended December 31, 1987, Commission File No. 1-4393) 10.56 Agreement for Firm Purchase Power dated as of January 4, 1988, between the City of Spokane, Washington, and the Company (Spokane Waste Combustion Project). (Exhibit (10)-62 to Annual Report on Form 10-K for the fiscal year ended December 31, 1987, Commission File No. 1-4393) 10.57 Agreement for Evaluating, Planning and Licensing dated as of February 21, 1985 and Agreement for Purchase of Power dated as of February 21, 1985 between Pacific Hydropower Associates and the Company (Koma Kulshan Hydroelectric Project). (Exhibit (10)-63 to Annual Report on Form 10- K for the fiscal year ended December 31, 1987, Commission File No. 1-4393) 10.58 Power Sales Agreement dated as of August 1, 1986, between Pacific Power & Light Company and the Company. (Exhibit (10)-64 to Annual Report on Form 10-K for the fiscal year ended December 31, 1987, Commission File No. 1-4393) 10.59 Agreement for Purchase and Sale of Firm Capacity and Energy dated as of August 1, 1986 between The Washington Water Power Company and the Company. (Exhibit (10)-65 to Annual Report on Form 10-K for the fiscal year ended December 31, 1987, Commission File No. 1-4393) 10.60 Amendment dated as of June 1, 1968, to Power Sales Contract between Public Utility District No. 1 of Chelan County, Washington and the Company (Rocky Reach Project). (Exhibit (10)-66 to Annual Report on Form 10- K for the fiscal year ended December 31, 1987, Commission File No. 1-4393) 10.61 Coal Supply Agreement dated as of October 30, 1970, between the Washington Irrigation & Development Company and the Company and other Owners of the Centralia Thermal Project (Centralia Generating Plant). (Exhibit (10)- 67 to Annual Report on Form 10-K for the fiscal year ended December 31, 1987, Commission File No. 1-4393) 10.62 Interruptible Natural Gas Service Agreement dated as of May 14, 1980, between Cascade Natural Gas Corporation and the Company (Whitehorn Combustion Turbine). (Exhibit (10)-68 to Annual Report on Form 10-K for the fiscal year ended December 31, 1987, Commission File No. 1-4393) 10.63 Interruptible Natural Gas Service Agreement dated as of January 31, 1983, between Cascade Natural Gas Corporation and the Company (Fredonia Generating Station). (Exhibit (10)-69 to Annual Report on Form 10- K for the fiscal year ended December 31, 1987, Commission File No. 1-4393) 10.64 Interruptible Gas Service Agreement dated May 14, 1981, between Washington Natural Gas Company and the Company (Fredrickson Generating Station). (Exhibit (10)-70 to Annual Report on Form 10-K for the fiscal year ended December 31, 1987, Commission File No. 1-4393) 10.65 Settlement Agreement dated April 24, 1987, between Public Utility District No. 1 of Chelan County, the National Marine Fisheries Service, the State of Washington, the State of Oregon, the Confederated Tribes and Bands of the Yakima Indian Nation, Colville Indian Reservation, Umatilla Indian Reservation, the National Wildlife Federation and the Company (Rock Island Project). (Exhibit (10)-71 to Annual Report on Form 10-K for the fiscal year ended December 31, 1987, Commission File No. 1-4393) 10.66 Amendment No. 2 dated as of September 1, 1981, and Amendment No. 3 dated September 14, 1987, to Coal Supply Agreement between Western Energy Company and the Company and the other Owners of Colstrip 3 and 4. (Exhibit (10)-72 to Annual Report on Form 10-K for the fiscal year ended December 31, 1987, Commission File No. 1-4393) 10.67 Amendatory Agreement No. 1 dated August 27, 1982, and Amendatory Agreement No. 2 dated August 27, 1982, to the Power Sales Contract between the Company and the Bonneville Power Administration dated August 27, 1982. (Exhibit (10)-73 to Annual Report on Form 10-K for the fiscal year ended December 31, 1987, Commission File No. 1-4393) 10.68 Transmission Agreement dated as of December 30, 1987, between the Bonneville Power Administration and the Company (Rock Island Project). (Exhibit (10)-74 to Annual Report on Form 10-K for the fiscal year ended December 31, 1988, Commission File No. 1-4393) 10.69 Agreement for Purchase and Sale of Firm Capacity and Energy between The Washington Water Power Company and the Company dated as of January 1, 1988. (Exhibit (10)-1 to Quarterly Report on Form 10-Q for the quarter ended March 31, 1988, Commission File No. 1-4393) 10.70 Amendment dated as of August 10, 1988, to Agreement for Firm Purchase Power dated as of January 4, 1988, between the City of Spokane, Washington, and the Company (Spokane Waste Combustion Project).(Exhibit (10)- 76 to Annual Report on Form 10-K for the fiscal year ended December 31, 1988, Commission File No. 1-4393) 10.71 Agreement for Firm Power Purchase dated October 24, 1988, between Northern Wasco People's Utility District and the Company (The Dalles Dam North Fishway). (Exhibit (10)-77 to Annual Report on Form 10-K for the fiscal year ended December 31, 1988, Commission File No. 1-4393) 10.72 Agreement for the Purchase of Power dated as of October 27, 1988, between Pacific Power & Light Company (PacifiCorp) and the Company. (Exhibit (10)-78 to Annual Report on Form 10-K for the fiscal year ended December 31, 1988, Commission File No. 1-4393) 10.73 Agreement for Sale and Exchange of Firm Power dated as of November 23, 1988, between the Bonneville Power Administration and the Company. (Exhibit (10)-79 to Annual Report on Form 10-K for the fiscal year ended December 31, 1988, Commission File No. 1-4393) 10.74 Agreement for Firm Power Purchase, dated as of February 24, 1989, between Sumas Energy, Inc. and the Company. (Exhibit (10)-1 to Quarterly Report on Form 10-Q for the quarter ended March 31, 1989, Commission File No. 1-4393) 10.75 Settlement Agreement, dated as of April 27, 1989, between Public Utility District No. 1 of Douglas County, Washington, Portland General Electric Company, PacifiCorp, The Washington Water Power Company and the Company. (Exhibit (10)-1 to Quarterly Report on Form 10-Q the for quarter ended September 30, 1989, Commission File No. 1-4393) 10.76 Agreement for Firm Power Purchase (Thermal Project), dated as of June 29, 1989, between San Juan Energy Company and the Company. (Exhibit (10)-2 to Quarterly Report on Form 10-Q for the quarter ended September 30, 1989, Commission File No. 1-4393) 10.77 Agreement for Verification of Transfer, Assignment and Assumption, dated as of September 15, 1989, between San Juan Energy Company, March Point Cogeneration Company and the Company. (Exhibit (10)-3 to Quarterly Report on Form 10-Q for the quarter ended September 30, 1989, Commission File No. 1-4393) 10.78 Power Sales Agreement between The Montana Power Company and the Company, dated as of October 1, 1989. (Exhibit (10)-4 to Quarterly Report on Form 10-Q for the quarter ended September 30, 1989, Commission File No. 1- 4393) 10.79 Conservation Power Sales Agreement dated as of December 11, 1989, between Public Utility District No. 1 of Snohomish County and the Company. (Exhibit (10)-87 to Annual Report on Form 10-K for the fiscal year ended December 31, 1989, Commission File No. 1-4393) 10.80 Memorandum of Understanding dated as of January 24, 1990, between the Bonneville Power Administrator and The Washington Public Power Supply System, Portland General Electric Company, Pacific Power & Light Company, The Montana Power Company, and the Company. (Exhibit (10)-88 to Annual Report on Form 10-K for the fiscal year ended December 31, 1989, Commission File No. 1-4393) 10.81 Amendment No. 1 to Agreement for the Assignment of Power from the Centralia Thermal Project dated as of January 1, 1990, between Public Utility District No. 1 of Grays Harbor County, Washington, and the Company. (Exhibit (10)-89 to Annual Report on Form 10-K for the fiscal year ended December 31, 1990, Commission File No. 1-4393) 10.82 Preliminary Materials and Equipment Acquisition Agreement dated as of February 9, 1990, between Northwest Pipeline Corporation and the Company. (Exhibit (10)-90 to Annual Report on Form 10-K for the fiscal year ended December 31, 1990, Commission File No. 1-4393) 10.83 Amendment No. 1 to the Colstrip Project Transmission Agreement dated as of February 14, 1990, among the Montana Power Company, The Washington Water Power Company, Portland General Electric Company, PacifiCorp and the Company. (Exhibit (10)-91 to Annual Report on Form 10-K for the fiscal year ended December 31, 1990, Commission File No. 1-4393) 10.84 Settlement Agreement dated as of February 27, 1990, among United States of America Department of Energy acting by and through the Bonneville Power Administrator, the Washington Public Power Supply System, and the Company. (Exhibit (10)-92 to Annual Report on Form 10-K for the fiscal year ended December 31, 1990, Commission File No. 1-4393) 10.85 Amendment No. 1 to the Fifteen-Year Power Sales Agreement dated as of April 18, 1990, between Pacificorp and the Company. (Exhibit (10)-93 to Annual Report on Form 10-K for the fiscal year ended December 31, 1990, Commission File No. 1-4393) 10.86 Settlement Agreement dated as of October 1, 1990, among Public Utility District No. 1 of Douglas County, Washington, the Company, Pacific Power and Light Company, The Washington Water Power Company, Portland General Electric Company, the Washington Department of Fisheries, the Washington Department of Wildlife, the Oregon Department of Fish and Wildlife, the National Marine Fisheries Service, the U.S. Fish and Wildlife Service, the Confederated Tribes and Bands of the Yakima Indian Nation, the Confederated Tribes of the Umatilla Reservation, and the Confederated Tribes of the Colville Reservation. (Exhibit (10)-95 to Annual Report on Form 10-K for the fiscal year ended December 31, 1990, Commission File No. 1-4393) 10.87 Agreement for Firm Power Purchase dated July 23, 1990, between Trans-Pacific Geothermal Corporation, a Nevada corporation, and the Company. (Exhibit (10)-1 to Quarterly Report on Form 10-Q for the quarter ended March 31, 1991, Commission File No. 1-4393) 10.88 Agreement for Firm Power Purchase dated July 18, 1990, between Wheelabrator Pierce, Inc., a Delaware corporation, and the Company. (Exhibit (10)-2 to Quarterly Report on Form 10-Q for the quarter ended March 31, 1991, Commission File No. 1-4393) 10.89 Agreement for Firm Power Purchase dated September 26, 1990, between Encogen Northwest, L.P., A Delaware Corporation and the Company. (Exhibit (10)-3 to Quarterly Report on Form 10-Q for the quarter ended March 31, 1991, Commission File No. 1-4393) 10.90 Agreement for Firm Power Purchase (Thermal Project) dated December 27, 1990, among March Point Cogeneration Company, a California general partnership comprising San Juan Energy Company, a California corporation; Texas-Anacortes Cogeneration Company, a Delaware corporation; and the Company. (Exhibit (10)-4 to Quarterly Report on Form 10-Q for the quarter ended March 31, 1991, Commission File No. 1-4393) 10.91 Agreement for Firm Power Purchase dated March 20, 1991, between Tenaska Washington, Inc. a Delaware corporation, and the Company. (Exhibit (10)-1 to Quarterly Report on Form 10-Q for the quarter ended June 30, 1991, Commission File No. 1-4393) 10.92 Letter Agreement dated April 25, 1991, between Sumas Energy, Inc., and the Company, to amend the Agreement for Firm Power Purchase dated as of February 24, 1989. (Exhibit (10)-2 to Quarterly Report on Form 10-Q for the quarter ended June 30, 1991, Commission File No. 1-4393) 10.93 Amendment dated June 7, 1991, to Letter Agreement dated April 25, 1991, between Sumas Energy, Inc., and the Company. (Exhibit (10)-3 to Quarterly Report on Form 10-Q for the quarter ended June 30, 1991, Commission File No. 1-4393) 10.94 Amendatory Agreement No. 3, dated August 1, 1991, to the Pacific Northwest Coordination Agreement, executed September 15, 1964, among the United States of America, the Company and most of the other major electrical utilities in the Pacific Northwest. (Exhibit (10)-4 to Quarterly Report on Form 10-Q for the quarter ended June 30, 1991, Commission File No. 1-4393) 10.95 Amendment dated July 11, 1991, to the Agreement for Firm Power Purchase dated September 26, 1990, between Encogen Northwest, L.P., a Delaware limited partnership and the Company. (Exhibit (10)-1 to Quarterly Report on Form 10-Q for the quarter ended September 30, 1991, Commission File No. 1-4393) 10.96 Agreement between the 40 parties to the Western Systems Power Pool (the Company being one party) dated July 27, 1991. (Exhibit (10)-2 to Quarterly Report on Form 10-Q for the quarter ended September 30, 1991, Commission File No. 1-4393) 10.97 Memorandum of Understanding between the Company and the Bonneville Po wer Administration dated September 18, 1991. (Exhibit (10)-3 to Quarterly Report on Form 10-Q for the quarter ended September 30, 1991, Commission File No. 1-4393) 10.98 Amendment of Seasonal Exchange Agreement, dated December 4, 1991, between Pacific Gas and Electric Company and the Company. (Exhibit (10)-107 to Annual Report on Form 10-K for the fiscal year ended December 31, 1991, Commission File No. 1-4393) 10.99 Capacity and Energy Exchange Agreement, dated as of October 4, 1991, between Pacific Gas and Electric Company and the Company. (Exhibit (10)-108 to Annual Report on Form 10-K for the fiscal year ended December 31, 1991, Commission File No. 1-4393) 10.100 Intertie and Network Transmission Agreement, dated as of October 4, 1991, between Bonneville Power Administration and the Company. (Exhibit (10)-109 to Annual Report on Form 10-K for the fiscal year ended December 31, 1991, Commission File No. 1-4393) 10.101 Amendatory Agreement No. 4, executed June 17, 1991, to the Power Sales Agreement dated August 27, 1982, between the Bonneville Power Administration and the Company. (Exhibit (10)-110 to Annual Report on Form 10-K for the fiscal year ended December 31, 1991, Commission File No. 1-4393) 10.102 Amendment to Agreement for Firm Power Purchase, dated as of September 30, 1991, between Sumas Energy, Inc. and the Company. (Exhibit (10)-112 to Annual Report on Form 10-K for the fiscal year ended December 31, 1991, Commission File No. 1-4393) 10.103 Centralia Fuel Supply Agreement, dated as of January 1, 1991, between Pacificorp Electric Operations and the Company and other Owners of the Centralia Steam-Electric Power Plant. (Exhibit (10)-113 to Annual Report on Form 10-K for the fiscal year ended December 31, 1991, Commission File No. 1-4393) 10.104 Agreement for Firm Power Purchase dated August 10, 1992, between Pyrowaste Corporation, Puget Sound Pyroenergy Corporation and the Company. (Exhibit (10)-114 to Annual Report on Form 10-K for the fiscal year ended December 31, 1992, Commission File No. 1-4393) 10.105 Memorandum of Termination dated August 31, 1992, between Encogen Northwest, L.P. and the Company. (Exhibit (10)-115 to Annual Report on Form 10-K for the fiscal year ended December 31, 1992, Commission File No. 1-4393) 10.106 Agreement Regarding Security dated August 31, 1992, between Encogen Northwest, L.P. and the Company. (Exhibit (10)-116 to Annual Report on Form 10-K for the fiscal year ended December 31, 1992, Commission File No. 1-4393) 10.107 Consent and Agreement dated December 15, 1992, between the Company, Encogen Northwest, L.P. and The First National Bank of Chicago, as collateral agent. (Exhibit (10)-117 to Annual Report on Form 10-K for the fiscal year ended December 31, 1992, Commission File No. 1-4393) 10.108 Subordination Agreement dated December 17, 1992, between the Company, Encogen Northwest, L.P., Rolls-Royce & Partners Finance Limited and The First National Bank of Chicago. (Exhibit (10)-118 to Annual Report on Form 10-K for the fiscal year ended December 31, 1992, Commission File No. 1- 4393) 10.109 Letter Agreement dated December 18, 1992, between Encogen Northwest, L.P. and the Company regarding arrangements for the application of insurance proceeds. (Exhibit (10)-119 to Annual Report on Form 10-K for the fiscal year ended December 31, 1992, Commission File No. 1-4393) 10.110 Guaranty of Ensearch Corporation in favor of the Company dated December 15, 1992. (Exhibit (10)-120 to Annual Report on Form 10-K for the fiscal year ended December 31, 1992, Commission File No. 1-4393) 10.111 Letter Agreement dated October 12, 1992, between Tenaska Washington Partners, L.P. and the Company regarding clarification of issues under the Agreement for Firm Power Purchase. (Exhibit (10)-121 to Annual Report on Form 10-K for the fiscal year ended December 31, 1992, Commission File No. 1-4393) 10.112 Consent and Agreement dated October 12, 1992, between the Company, and The Chase Manhattan Bank, N.A., as agent. (Exhibit (10)-122 to Annual Report on Form 10-K for the fiscal year ended December 31, 1992, Commission File No. 1-4393) 10.113 Settlement Agreement dated December 29, 1992, between the Company and the Bonneville Power Administration (BPA) providing for power purchase by BPA. (Exhibit (10)-123 to Annual Report on Form 10-K for the fiscal year ended December 31, 1992, Commission File No. 1-4393) *10-114 Contract with W. S. Weaver, Executive Vice President & Chief Financial Officer, dated April 24, 1991. *(12)-a Statement setting forth computation of ratios of earnings to fixed charges (1989 through 1993). *(12)-b Statement setting forth computation of ratios of earnings to combined fixed charges and preferred stock dividends (1989 through 1993). (21) List of subsidiaries. (Exhibit 22 to Annual Report on Form 10-K for the fiscal year ended December 31, 1992, Commission File No. 1-4393) *(23) Consent of accountants. _________________________________ *Filed herewith.

27430_1993.txt

27430_1993

1993

27430

Item 1 - BUSINESS* THE COMPANY The Dayton Power and Light Company (the "Company") is a public utility incorporated under the laws of Ohio in 1911. Located in West Central Ohio, it furnishes electric service to 464,000 retail customers in a 24 county service area of approximately 6,000 square miles and furnishes natural gas service to 286,000 customers in 16 counties. In addition, the Company provides steam heating service in downtown Dayton, Ohio. The Company serves an estimated population of 1.2 million. Principal industries served include electrical machinery, automotive and other transportation equipment, non-electrical machinery, agriculture, paper, rubber and plastic products. The Company's sales reflect the general economic conditions and seasonal weather patterns of the area. The solid performance of the economy of West Central Ohio and seasonal summer and winter weather in 1993 contributed to increased energy sales for the year. Electric sales to business customers were up 4% for the year while total electric and natural gas sales increased 4% and 3% respectively, as compared to 1992. During 1993, cooling degree days were 4% above the twenty year average and 35% above 1992. Heating degree days in 1993 were 3% above the thirty year average and 6% above 1992. Sales patterns will change in future years as weather and the economy fluctuate. The Company employed 3,147 persons as of December 31, 1993, of which 2,653 are full-time employees and 494 are part-time employees. All of the outstanding shares of common stock of the Company are held by DPL Inc., which became the Company's corporate parent, effective April 21, 1986. Subsidiaries of the Company include MacGregor Park, Inc., an owner and developer of real estate; DP&L Community Urban Redevelopment Corporation, the owner of a downtown Dayton office building; and Miami Valley Equipment, Inc., which presently owns no property and conducts no business. The Company's principal executive and business office is located at Courthouse Plaza Southwest, Dayton, Ohio 45402 - telephone (513)224-6000. Information relating to industry segments is contained in Item 8 - Note 11 of Notes to Consolidated Financial Statements on Page II-23 of this document, which Note is incorporated herein by reference. * Unless otherwise indicated, the information given in "Item 1 - BUSINESS" is current as of March 11, 1994. No representation is made that there have not been any subsequent changes to such information. I-1 COMPETITION The Company competes with privately and municipally owned electric utilities and rural electric cooperatives, natural gas suppliers and other alternate fuel suppliers. The Company competes on the basis of price and service. Like other utilities, the Company from time to time may have electric generating capacity available for sale to other utilities. The Company competes with other utilities to sell electricity provided by such capacity. The ability of the Company to sell this electricity will depend on how the Company's price, terms and conditions compare to those of other utilities. In addition, from time to time, the Company also makes power purchases from neighboring utilities. In an increasingly competitive energy environment, cogenerated power may be used by customers to meet their own power needs. Cogeneration is the dual use of a form of energy, typically steam, for an industrial process and for the generation of electricity. The Public Utilities Regulatory Policies Act of 1978 ("PURPA") provides regulations covering when an electric utility is required to offer to purchase excess electric energy from cogeneration and small power production facilities that have obtained qualifying status under PURPA. The National Energy Policy Act of 1992, which reformed the Public Utilities Holding Company Act, allows the federal government to mandate access by others to a utility's electric transmission system and may accelerate competition in the supply of electricity. General deregulation of the natural gas industry has continued to prompt the influence of market competition as the driving force behind natural gas procurement. The maturation of the natural gas spot market in combination with open access interstate transportation provided by pipelines has provided the Company, as well as its end-use customers, with an array of procurement options. Customers with alternate fuel capability can continue to choose between natural gas and their alternate fuel based upon overall economics. Therefore, demand for natural gas purchased from the Company or purchased elsewhere transported to the end-use customer by the Company could fluctuate based on the economics of each in comparison with changes in alternate fuel prices. For the Company, price competition and reliability among both natural gas suppliers and interstate pipeline sources are major factors affecting procurement decisions. I-2 In April 1992, FERC issued Order No. 636 ("Order 636") amending its regulations governing the service obligations, rate design and cost recovery of interstate pipelines. The Company's interstate pipeline suppliers have received approval from FERC to implement their restructuring plans to comply with the regulations. The Public Utilities Commission of Ohio ("PUCO") has held roundtable discussions and meetings regarding the implications of Order 636 for local distribution companies, producers and consumers. The PUCO has issued interim guidelines allowing utilities to file revised natural gas transportation tariffs to comply with the Order, and is continuing efforts to examine the impact via roundtable discussions. The Company's natural gas tariffs and operations comply with the PUCO's interim guidelines and the requirements of Order 636. In January 1994, the Company, the Staff of the PUCO and the Office of the Ohio Consumers' Counsel (the "OCC") submitted to the PUCO an agreement which resolves issues relating to the recovery of Order 636 "transition costs" to be billed to the Company by natural gas interstate pipeline companies. The agreement, which is subject to PUCO approval, provides for the full recovery of these transition costs from the Company's customers. The interstate pipelines will file with the FERC for authority to recover these transition costs, the exact magnitude of which has not been established. The Company provides service to 12 municipal customers which distribute electricity within their corporate limits. One municipality has signed a contract for the Company to provide 95% of its requirements. In addition to these municipal customers, the Company maintains an interconnection agreement with one municipality which can generate all or a portion of its energy requirements. Sales to municipalities represented 1.3% of total electricity sales in 1993. The Company maintains discussions with these municipalities concerning potential energy agreements. I-3 CONSTRUCTION AND FINANCING PROGRAM OF THE COMPANY 1994-1998 Construction Program - ------------------------------ The estimated construction additions for the years 1994-1998 are set forth below: Estimated 1994 1995 1996 1997 1998 1994-1998 ---- ---- ---- ---- ---- --------- millions Electric generation and transmission commonly owned with neighboring utilities................ $ 22 $ 28 $ 24 $ 41 $ 23 $138 Other electric generation and transmission facilities.. 43 33 34 18 13 141 Electric distribution...... 24 26 31 34 37 152 General.................... 3 3 2 1 1 10 Gas, steam and other facilities............... 13 13 11 12 12 61 --- --- --- --- --- --- Total construction..... $105 $103 $102 $106 $ 86 $502 Estimated construction additions over the next five years average $100 million annually which is approximately equal to the projected depreciation expense over the same period. The construction additions for the period include plans to construct a series of 70 MW combustion turbine generating units scheduled to be completed at varying intervals dependent upon need. The first unit is scheduled for completion in June 1995. Construction plans are subject to continuing review and are expected to be revised in light of changes in financial and economic conditions, load forecasts, legislative and regulatory developments and changing environmental standards, among other factors. The Company's ability to complete its capital projects and the reliability of future service will be affected by its financial condition, the availability of external funds at reasonable cost and adequate and timely rate increases. See ENVIRONMENTAL CONSIDERATIONS for a description of environmental control projects and regulatory proceedings which may change the level of future construction additions. The potential impact of these events on the Company's operations cannot be estimated at this time. I-4 1994-1998 Financing Program - --------------------------- The Company will require a total of $106 million during the next five years for bond maturities and preferred stock and bond sinking funds in addition to any funds needed for the construction program. At year-end 1993, the Company had a cash and temporary investment balance of $6 million. Proceeds from temporary cash investments, together with internally generated cash and future outside financings, will provide for the funding of the construction program, sinking funds and general corporate requirements. In mid-March 1994, DPL Inc. plans to file a registration statement with the Securities and Exchange Commission for the issuance and sale of approximately three-and-a-half million common shares. The net proceeds from the planned sale of shares, estimated to equal approximately $65 million, would be contributed to the Company which would use the funds, along with temporary cash investments and/or short-term borrowings, to redeem in May 1994 all of the outstanding shares of its Preferred Stock, Series D, E, F, H and I, which have an average dividend rate of 8.1%. During late 1992 and early 1993, the Company took advantage of favorable market conditions to reduce its cost of debt and extend maturities through early refundings. Three new series of First Mortgage Bonds were issued in 1992 in the aggregate principal amount of $320 million at an average interest rate of 7.8% to finance the redemption of a similar principal amount of debt securities. Additionally, in early 1993, the Company issued two new series of First Mortgage Bonds in the aggregate principal amount of $446 million at an average interest rate of 8.0% to finance the redemption of a similar principal amount of six series of First Mortgage Bonds. The amounts and timings of future financings will depend upon market and other conditions, rate increases, levels of sales and construction plans. In November 1989, DPL Inc. entered into a revolving credit agreement ("the Credit Agreement") with a consortium of banks renewable through 1998 which allows total borrowings by DPL Inc. and its subsidiaries of $200 million. The Company has authority from the PUCO to issue short term debt up to $200 million with a maximum debt limit of $300 million including loans from DPL Inc. under the terms of the Credit Agreement. At December 31, 1993, DPL Inc. had no outstanding borrowings under this Credit Agreement. The Company also has $97 million available in short term informal lines of credit. At year-end, the Company had $10 million outstanding from these lines of credit and $15 million in commercial paper outstanding. I-5 Under the Company's First and Refunding Mortgage, First Mortgage Bonds may be issued on the basis of (i) 60% of unfunded property additions, subject to net earnings, as defined, being at least two times interest on all First Mortgage Bonds outstanding and to be outstanding, and (ii) 100% of retired First Mortgage Bonds. The Company anticipates that, during 1994-98, it will be able to issue sufficient First Mortgage Bonds to satisfy its long-term debt requirements in connection with the financing of its construction and refunding programs discussed above. The maximum amount of First Mortgage Bonds which may be issued in the future will fluctuate depending upon interest rates, the amounts of bondable property additions, earnings and retired First Mortgage Bonds. There are no coverage tests for the issuance of preferred stock under the Company's Amended Articles of Incorporation. ELECTRIC OPERATIONS AND FUEL SUPPLY The Company's present winter generating capability is 3,053,000 KW. Of this capability, 2,843,000 KW (approximately 93%) is derived from coal-fired steam generating stations and the balance consists of combustion turbine and diesel-powered peaking units. Approximately 87% (2,472,000 KW) of the existing steam generating capability is provided by certain units owned as tenants in common with the Cincinnati Gas & Electric Company ("CG&E") or with CG&E and Columbus Southern Power Company ("CSP"). Under the agreements among the companies, each company owns a specified undivided share of each facility, is entitled to its share of capacity and energy output, and has a capital and operating cost responsibility proportionate to its ownership share. A merger agreement between CG&E and PSI Resources is currently pending. The Company has intervened in the merger proceeding currently pending at the FERC so that the operations of its commonly owned generating units will not be materially impacted by the merger. The remaining steam generating capability (371,000 KW) is derived from a generating station owned solely by the Company. The Company's all time net peak load was 2,765,000 KW, which occurred in July 1993. The present summer generating capability is 3,017,000 KW. I-6 GENERATING FACILITIES --------------------- MW Rating -------------- Owner- Operating Company Station ship* Company Location Portion Total - ----------- ----- --------- ------------ ------- ----- Coal Units - ---------- Hutchings W Company Miamisburg, OH 371 371 Killen C Company Wrightsville, OH 402 600 Stuart C Company Aberdeen, OH 820 2,340 Conesville-Unit 4 C CSP Conesville, OH 129 780 Beckjord-Unit 6 C CG&E New Richmond, OH 210 420 Miami Fort- Units 7&8 C CG&E North Bend, OH 360 1,000 East Bend-Unit 2 C CG&E Rabbit Hash, KY 186 600 Zimmer C CG&E Moscow, OH 365 1,300 Combustion Turbines or Diesel - ----------------------------- Hutchings W Company Miamisburg, OH 32 32 Yankee Street W Company Centerville, OH 144 144 Monument W Company Dayton, OH 12 12 Tait W Company Dayton, OH 10 10 Sidney W Company Sidney, OH 12 12 * W = Wholly Owned; C = Commonly Owned In order to transmit energy to their respective systems from their commonly-owned generating units, the companies have constructed and own, as tenants in common, 847 circuit miles of 345,000-volt transmission lines. The Company has several interconnections with other companies for the purchase, sale and interchange of electricity. The Company derived over 99% of its electric output from coal-fired units in 1993. The remainder was derived from units burning oil or natural gas which were used to meet peak demands. The Company estimates that approximately 65-85% of its coal requirements for the period 1994-1998 will be obtained through long term contracts, with the balance to be obtained by spot market purchases. The Company has been informed by CG&E and CSP through the procurement plans for the commonly owned units operated by them that sufficient coal supplies will be available during the same planning horizon. The prices to be paid by the Company under its long term coal contracts are subject to adjustment in accordance with various indices. Each contract has features that will limit price escalations in any given year. I-7 The total average price per million British Thermal Units ("MMBTU") of coal received in each of 1993 and 1992 was $1.46/MMBTU and $1.56/MMBTU in 1991. The average fuel cost per kWh generated of all fuel burned for electric generation (coal, gas and oil) for the year was 1.43cents/ which represents a decrease from 1.48cents/ in 1992 and 1.60cents in 1991. Through the operation of a fuel cost adjustment clause applicable to electric sales, the increases and decreases in fuel costs are reflected in customer rates on a timely basis. See RATE REGULATION AND GOVERNMENT LEGISLATION and ENVIRONMENTAL CONSIDERATIONS. GAS OPERATIONS AND GAS SUPPLY The Company has long term firm pipeline transportation agreements with ANR Gas Pipeline Company ("ANR") through 1997 and Columbia Gas Transmission Corporation ("Columbia"), Columbia Gulf Transmission Corporation, Texas Gas Transmission Corporation ("Texas Gas") and Panhandle Eastern Pipe Line Company ("Panhandle") through 2004. Along with the firm transportation services the Company has approximately 16 billion cubic feet of storage service with the various pipelines. The Company also maintains and operates four propane-air plants with a daily rated capacity of approximately 67,500 thousand cubic feet ("MCF") of natural gas. Coordinated with the pipeline service agreements, the Company has 14 firm natural gas supply agreements with various natural gas producers. The Company purchased approximately 90% of its 1993 supply under these producer agreements and the remaining supplies on the spot/short term market. The Company purchased natural gas during 1993 at an average price of $3.65 per MCF, compared to $3.31 per MCF and $2.70 per MCF in 1992 and 1991, respectively. Through the operation of a natural gas cost adjustment clause applicable to gas sales, increases and decreases in the Company's natural gas costs are reflected in customer rates on a timely basis. SEE RATE REGULATION AND GOVERNMENT LEGISLATION. The Company is also interconnected with CNG Transmission Corporation and Texas Eastern Transmission Corporation. Several interconnections with various interstate pipelines provide the Company the opportunity to purchase competitively-priced natural gas supplies and pipeline services. I-8 During 1993, the Company implemented requirements of Order 636 with all of its natural gas interstate pipeline suppliers. As a result of FERC's mandate that pipelines no longer bundle the product of natural gas with pipeline transportation into one package, the Company purchased the majority of its natural gas in 1993 under direct market purchases. Additionally, the implementation of Order 636 required the Company to purchase certain volumes of natural gas from interstate pipelines to fill storage. In the future, the Company will obtain its natural gas from direct market purchases or pipelines based on cost and reliability. The Company has natural gas agreements that meet 90% of its requirements. The remainder will be purchased to meet seasonal requirements under short term purchase agreements. The PUCO continues to support open access, nondiscriminatory transportation of natural gas by the state's local distribution companies for end-use customers. The PUCO has guidelines to provide a standardized structure for end-use transportation programs which requires a tariff providing the prices, terms and conditions for such service. The Company has filed a transportation tariff to comply with these guidelines and approval is pending. During 1993, the Company provided transportation service to 185 end-use customers, delivering a total quantity of 13,401,229 MCF. Columbia and Panhandle have obtained conditional approval from FERC to recover take-or-pay and contract reformation costs from the Company through fixed demand surcharges pursuant to revised FERC rules. The validity of the revisions was reviewed and dismissed by the U.S. Court of Appeals for the District of Columbia Circuit. Pursuant to a settlement approved by the PUCO, the Company may recover take-or-pay costs from its retail and transportation customers. On April 30, 1990, Columbia filed an application with FERC to implement a general rate increase in order to recover, among other things, costs associated with construction of certain "Global Settlement" facilities. The rates were accepted to become effective November 1, 1990. A partial offer of settlement was accepted on April 16, 1992, and an initial decision on the remaining issues was issued on November 13, 1992. On May 31, 1991, Columbia filed a second application with FERC to implement a general rate increase which was partially accepted effective December 1, 1991. On October 1, 1991, Columbia filed a third application to implement a general rate increase which was partially accepted to become effective April 1, 1992. The second and third applications were subsequently consolidated into one rate proceeding, and rate design, cost classification and cost allocations were further consolidated into Columbia's restructuring proceeding referenced in following paragraphs. A settlement dated November 9, 1992, regarding the remaining cost of service and throughput issues was approved by FERC April 2, 1993. I-9 On April 27, 1990, Texas Gas filed an application with FERC to implement a general rate increase which was accepted to become effective November 1, 1990. This docket was consolidated into the Texas Gas restructuring proceeding which was made effective November 1, 1993. On May 1, 1992, Panhandle filed an application with FERC to implement a general rate increase which rates were accepted effective November 1, 1992. A hearing on this matter is set for May 17, 1994. On April 29, 1993 Texas Gas filed a second application with FERC to implement a rate increase which was accepted effective November 1, 1993. A hearing on this matter is set for June 28, 1994. On November 1, 1993, ANR filed an application with FERC to implement a rate increase which was accepted effective May 2, 1994. Through the operation of a natural gas cost adjustment clause applicable to gas sales, increases and decreases in the Company's natural gas costs are reflected in customer rates on a timely basis. On July 31, 1991, Columbia Gas System Inc. and Columbia, one of the Company's major pipeline suppliers, filed separate Chapter 11 petitions in U.S. Bankruptcy Court. The bankruptcy court permitted Columbia to break approximately 4,500 long term natural gas contracts with upstream suppliers on August 22, 1991, January 6, 1992, and January 8, 1992. The bankruptcy court issued an order on March 18, 1992, granting approval of an agreement between the customers and Columbia which assures the continuation of all firm service agreements (including storage) through the winter of 1993, with year-to-year continuation unless adequate notice is provided. On February 13, 1992, the bankruptcy court ruled on a motion by Columbia to flow through to its customers all appropriate refunds, including take-or-pay refunds which were received from its upstream suppliers and excessive rate refunds except for approximately $18 million of pre-petition take-or-pay refunds. However, on July 6, 1992, the United States District Court for Delaware reversed the bankruptcy court. On July 8, 1993, the Third Circuit Court of Appeals reversed the District Court for Delaware and reinstated the U.S. Bankruptcy Court's ruling that Columbia may flow through to its customers all post petition take-or-pay refunds which were received from its upstream suppliers. The U.S. Supreme Court denied an appeal on February 18, 1994 of the Third Circuit Court of Appeals' decision. The Company expects full recovery of all take-or-pay refunds received by Columbia post petition. The parties to the bankruptcy are currently evaluating Columbia's proposed plan of reorganization. Based upon a July 1993 FERC order disallowing the recovery of natural gas producer contracts rejected in the bankruptcy case, the Company does not expect the bankruptcy proceedings to have a material adverse effect on its earnings or competitive position. In April 1992 FERC issued Order 636 which amended its regulations governing the service obligations of interstate pipelines. Some of the major changes enacted include unbundling I-10 of pipeline sales from transportation, the creation of a "no-notice" transportation service, pre-granted abandonment for all interruptible and short term firm transportation subject to a right-of-first-refusal, capacity brokering, rate design and transition costs. All interstate pipeline filings were made effective by November 1, 1993. In response to Order 636, the PUCO has initiated roundtable discussions with natural gas utilities and other interested parties to discuss the impact of the Order and the state regulation of natural gas utilities. The PUCO has issued interim guidelines allowing utilities to file revised natural gas transportation tariffs to comply with Order 636, and is continuing to examine the impact via ongoing roundtable discussions that run concurrently with the interstate pipelines' restructuring proceedings. The interim guidelines also require each natural gas utility to file plans for peak day operations. The Company's operations comply with all interim guidelines and the Company expects full recovery of all Order 636 transition costs. RATE REGULATION AND GOVERNMENT LEGISLATION The Company's sales of electricity, natural gas and steam to retail customers are subject to rate regulation by the PUCO and various municipalities. The Company's wholesale electric rates to municipal corporations and other distributors of electric energy are subject to regulation by FERC under the Federal Power Act. Ohio law establishes the process for determining rates charged by public utilities. Regulation of rates encompasses the timing of applications, the effective date of rate increases, the cost basis upon which the rates are based and other related matters. Ohio law also established the Office of the OCC, which is authorized to represent residential consumers in state and federal judicial and administrative rate proceedings. The Company's electric and natural gas rate schedules contain certain recovery and adjustment clauses subject to periodic audits by, and proceedings before, the PUCO. Electric fuel and gas costs are expensed as recovered through rates. Ohio legislation extends the jurisdiction of the PUCO to the records and accounts of certain public utility holding company systems, including DPL Inc. The legislation extends the PUCO's supervisory powers to a holding company system's general condition and capitalization, among other matters, to the extent that they relate to the costs associated with the provision of public utility service. Additionally, the legislation requires PUCO approval of (i) certain transactions and transfers of I-11 assets between public utilities and entities within the same holding company system, and (ii) prohibits investments by a holding company in subsidiaries which are not public utilities in an amount in excess of 15% of the aggregate capitalization of the holding company on a consolidated basis at the time such investments are made. In April 1991, the Company filed an application with the PUCO to increase its electric rates to recover costs associated with the construction of the William H. Zimmer Generating Station ("Zimmer"), earn a return on the Company's investment and recover the current costs of providing electric service to its customers. In November 1991, the Company entered into a settlement agreement with various consumer groups resolving all issues in the case. The PUCO approved the agreement on January 22, 1992. Pursuant to that agreement, new electric rates took effect February 1, 1992, January 2, 1993 and January 3, 1994. The agreement also established a baseline return on equity of 13% (subject to upward adjustment) until the Company's next electric rate case. In the event that the Company's return exceeds the allowed return by between one and two percent, then one half of the excess return will be used to reduce the cost of demand-side management ("DSM") programs. Any return that exceeds the allowed return by more than two percent will be entirely credited to these programs. Amounts deferred during the phase-in period, including carrying charges, will be capitalized and recovered over seven years commencing in 1994. Deferrals were $58 million in 1992 and $28 million in 1993. The recovery expected in 1994, net of additional carrying cost deferrals, is $10 million. The phase-in plan meets the requirements of the Financial Accounting Standards Board ("FASB") Statement No. 92. In addition, the Company agreed to undertake cost-effective DSM programs with an average annual cost of $15 million for four years commencing in 1992. The amount recovered in rates was $4.6 million in 1992. This amount increased to $7.8 million in 1993 and will remain at that level in subsequent years. The difference between expenditures and amounts recovered through rates is deferred and is eligible for recovery in future rates in accordance with existing PUCO rulings. In March 1991, the PUCO granted the Company the authority to defer interest charges, net of income tax, on its 28.1% ownership investment in Zimmer from the March 30, 1991, commercial in-service date through January 31, 1992. Deferred interest charges on the investment in Zimmer have been adjusted to a before tax basis in 1993 as a result of FASB Statement No. 109. Amounts deferred are being amortized over the life of the plant. I-12 Regulatory deferrals on the balance sheet were: Dec. 31 Dec. 31 1993 1992 -------- -------- --millions-- Phase-in $ 85.8 $ 57.7 DSM 23.3 2.2 Deferred interest - Zimmer 63.7 43.9 ------ ------ Total $172.8 $103.8 ====== ====== In 1989 the PUCO approved rules for the implementation of a comprehensive Integrated Resource Planning ("IRP") program for all investor-owned electric utilities in Ohio. Under this program, each utility is required to file an IRP as part of its Long Term Forecast Report ("LTFR"). The IRP requires each utility to evaluate available demand-side resource options in addition to supply-side options to determine the most cost-effective means for satisfying customer requirements. The rules currently allow a utility to apply for deferred recovery of DSM program expenditures and lost revenues between LTFR proceedings. Ultimate recovery of expenditures is contingent on review and approval of such programs as cost-effective and consistent with the most recent IRP proceeding. The rules also allow utilities to submit alternative proposals for the recovery of DSM programs and related costs. In 1991 the PUCO ruled that the Company's 1991 LTFR be consolidated and reviewed in conjunction with the Company's 1992 LTFR proceeding. The Company filed its 1992 LTFR in June 1992. The Company also filed its environmental compliance plan in June 1992, and asked the PUCO to consolidate the environmental compliance plan proceeding with the LTFR proceeding. The PUCO granted the Company's request to consolidate the cases. The evidentiary hearing on the Company's 1991/1992 LTFR and environmental compliance plan was held on February 17, 1993. The parties entered into a stipulation in settlement of all issues which continues the Company's commitment to DSM programs. The stipulation was approved by the PUCO on May 6, 1993. The Company has in place a percentage of income payment plan ("PIPP") for eligible low-income households as required by the PUCO. This plan prohibits disconnections for nonpayment of customer bills if eligible low-income households pay a specified percentage of their household income toward their utility bill. The PUCO has approved a surcharge by way of a temporary base rate tariff rider which allows companies to recover arrearages I-13 accumulated under PIPP. In 1993 the Company reached a settlement with the PUCO staff, the Office of the OCC and the Legal Aid Society to provide new and expanded programs for PIPP eligible customers. The expanded programs include greater arrears crediting, lower monthly payments, educational programs and information reports. In exchange, the Company may accelerate recovery of PIPP and pre-PIPP arrearages and recover program costs. The settlement also established a four year moratorium on changes to the program. The PUCO approved the settlement on December 2, 1993. Pursuant to the terms of the settlement, the Company filed an application on January 21, 1994 to lower its PIPP rate. To date, the PUCO has not acted on the Company's application. In 1991 the PUCO issued a Finding and Order which encourages electric utilities to undertake the competitive bidding of new supply-side energy projects. The policy also encourages utilities to provide transmission grid access to those supply-side energy providers awarded bids by utilities. Electric utilities are permitted to bid on their own proposals. The PUCO has issued for comment proposed rules for competitive bidding but has not issued final rules at this time. The Company initiated a competitive bidding process in January 1993 for the construction of up to 140 MW of electric peaking capacity and energy by 1997. Through an Ohio Power Siting Board ("OPSB") investigative process, the Company's self-built option was evaluated to be the least cost option. On March 7, 1994, the OPSB approved the Company's applications for up to three 70 MW combustion turbines and two natural gas supply lines for the proposed site. The OPSB issued rules on March 22, 1993 to provide electric and magnetic field information in applications for construction of major generating and transmission facilities. The Company has addressed the topics covered by the new rules in all recent projects. One utility requested a rehearing on the rules which was denied by the OPSB on May 24, 1993. At this time the Company cannot predict the ultimate impact on timing and costs associated with the siting of new transmission lines. On March 25, 1993, the PUCO adopted guidelines for the treatment of emission allowances created by the Clean Air Act Amendments of 1990. Under the guidelines, the Company's emission allowance trading plans, procedures, practices, activity and associated costs will be reviewed in its annual electric fuel component audit proceeding. The PUCO guidelines are being appealed by an industrial consumer group. In its Entry on emission allowances, the PUCO directed its Staff to develop proposed accounting guidelines for allowance trading I-14 programs in accordance with FERC rulemaking efforts. According to FERC Order No. 552 issued on March 23, 1993, the Company will value allowances based on a weighted average cost methodology. On May 26, 1993, the Senate of the State of Ohio approved the appointment of Mr. David W. Johnson as PUCO commissioner. On January 12, 1994, the Ohio Consumers' Counsel Governing Board appointed Robert S. Tongren, a former assistant attorney general, to the position of Consumers' Counsel. Mr. Tongren replaced William A. Spratley, whose resignation from this position became effective September 30, 1993. On February 22, 1994 a bill was introduced in the State of Ohio House of Representatives which, if approved, would give electric consumers the opportunity to obtain "retail" and "wholesale at retail" services from electric suppliers other than their current supplier at competitive rates. The ultimate disposition of the bill or its effect on the Company cannot be determined at this time. ENVIRONMENTAL CONSIDERATIONS The operations of the Company, including the commonly owned facilities operated by the Company, CG&E and CSP, are subject to federal, state, and local regulation as to air and water quality, disposal of solid waste and other environmental matters, including the location, construction and initial operation of new electric generating facilities and most electric transmission lines. The Company expended $6 million for environmental control facilities during 1993. The possibility exists that current environmental regulations could be revised which could change the level of estimated 1994-1998 construction expenditures. See CONSTRUCTION AND FINANCING PROGRAM OF THE COMPANY. Air Quality - ----------- In July 1985, the United States Environmental Protection Agency ("U.S. EPA") adopted final stack height rules which could result in the lowering of emission limits for sulfur dioxide and particulate matter from affected units. The Company operates one unit (Killen Station) potentially affected by these rules. The Ohio Environmental Protection Agency ("Ohio EPA") has determined that Killen Station is not impacting air quality and, therefore, no further action is needed at this time. CSP has informed the Company that Conesville Unit 4 is not affected by the rules. CG&E has informed the Company that Miami Fort Unit 7 is "grandfathered" from regulation and that Miami Fort I-15 Unit 8 is not affected by the rules because Miami Fort Unit 5 is picking up the necessary emission reductions. On June 17 and July 12, 1988, the Company and others filed with the U.S. Supreme Court two petitions for a Writ of Certiorari seeking a review of the D.C. Circuit Court of Appeals decision that addressed the 1985 stack height rules. Those petitions were denied in October 1988 and, as a result, the U.S. EPA planned to begin a remand rulemaking to address issues arising from lower Court's opinion. The U.S. EPA continues to work on a remand rulemaking. In December 1988, the U.S. EPA notified the State of Ohio that the portion of its State Implementation Plan ("SIP") dealing with sulfur dioxide emission limitations for Hamilton County (in southwestern Ohio) was deficient and required the Ohio EPA to develop a new SIP within 18 months. The notice affects industrial and utility sources and could require significant reductions in sulfur dioxide emission limitations at CG&E's Miami Fort Units 7 and 8 which are jointly owned with the Company. In February 1989, CG&E, together with other industrial sources affected by the notice, filed a petition for review in the U.S. Court of Appeals for the Sixth Circuit of the U.S. EPA's issuance of the notice. In July 1989, the Court of Appeals dismissed the petition for review. In April 1990, the Ohio EPA published its proposed revised SIP for comment. In June 1990, CG&E submitted its comments challenging the revisions, arguing that the proposed SIP is based on a computer model which is unsuitable and invalid for the hilly terrain of Hamilton County, and that in the last ten years, no violation of the National Ambient Air Quality Standards for SO2 has ever been monitored. In order to support its position, CG&E is taking part in an air monitoring program designed to prove that the present SIP adequately protects the ambient air quality. In October 1991, the Ohio EPA adopted new SO2 regulations for Hamilton County. These regulations do not change the preexisting requirements for Miami Fort Units 7 and 8. The new regulations have been submitted to the U.S. EPA. On January 27, 1994, the U.S. EPA provided notice in the Federal Register that the new regulations for the Ohio SIP for Hamilton County were conditionally approved. Changing environmental regulations continue to increase the cost of providing service in the utility industry. The Clean Air Act Amendments of 1990 (the "Act") will limit sulfur dioxide and nitrogen oxide emissions nationwide. The Act will restrict emissions in two phases with Phase I compliance completed by 1995 and Phase II completed by 2000. Final regulations were issued by the U.S. EPA on January 11, 1993. These regulations are consistent with earlier Act restrictions and do not change the expected costs of compliance of the Company. I-16 The Company's preliminary compliance plan was filed with the PUCO in June 1992 and consolidated with the 1991/1992 LTFR proceeding. The Company anticipates meeting the requirements of Phase I by switching to lower sulfur coal at several commonly owned electric generating facilities and increasing existing scrubber removal efficiency. Cost estimates to comply with Phase I of the Act are approximately $10 million in capital expenditures. Phase I compliance is expected to have a minimal 1% to 2% price impact. Phase II requirements can be met primarily by switching to lower sulfur coal at all non-scrubbed coal-fired electric generating units. The stipulation entered into on February 17, 1993 with regards to the LTFR, including the environmental compliance plan, was approved by the PUCO on May 6, 1993. The Company anticipates that costs to comply with the Act will be eligible for recovery in future fuel hearings and other regulatory proceedings. On March 16, 1993, the Company received a Finding of Violation from the U.S. EPA regarding opacity standards at Killen Station and, on March 17, 1993, a Notice of Violation from the U.S. EPA regarding opacity standards at Stuart Station. The Company has subsequently conducted conferences with the U.S. EPA to discuss the Finding and Notice. On October 11, 1993, the Company entered into negotiated Consent Orders with the U.S. EPA for the alleged violations at Killen and Stuart Stations. The Consent Orders do not require payment of any penalty but require the Company to formalize emissions control measures. Land Use - -------- The Company and numerous other parties have been notified by the U.S. EPA that it considers them Potentially Responsible Parties ("PRPs") for clean-up at three superfund sites in Ohio - the Sanitary Landfill Site on Cardington Road in Montgomery County, Ohio, the United Scrap Lead Site in Miami County, Ohio, and the Powell Road Landfill in Huber Heights, Montgomery County, Ohio. The Company received notification from the U.S. EPA in July 1987, for the Cardington Road site. The Company has not joined the PRP group formed at that site because of the absence of any known evidence that the Company contributed hazardous substances to this site. The Record of Decision issued by the U.S. EPA identifies the chosen clean-up alternative at a cost estimate of $8.1 million. The Company received notification from the U.S. EPA in September 1987, for the United Scrap Lead Site. The Company has joined a PRP group for this site, which is actively conferring with the U.S. EPA. The Record of Decision issued by the U.S. I-17 EPA estimates clean-up costs at $27.1 million. The Company is one of over 200 parties to this site, and its estimated contribution to the site is less than .01%. Nearly 60 PRPs are actively working to settle the case. The Company is participating in the sponsorship of a study to evaluate alternatives to the U.S. EPA's clean-up plan. The final resolution of these investigations will not have a material effect on the Company's financial position or earnings. The Company and numerous other parties received notification from the U.S. EPA on May 21, 1993 that it considers them PRPs for clean-up of hazardous substances at the Powell Road Landfill Site in Huber Heights, Ohio. The Company has joined the PRP group for the site. On October 1, 1993, the U.S. EPA issued its Record of Decision identifying a cost estimate of $20.5 million for the chosen remedy. The Company is one of over 200 PRPs to this site, and its estimated contribution is less than 1%. The final resolution will not have a material effect on the Company's financial position or earnings. I-18 I-19 I-20 Item 2 Item 2 - PROPERTIES Electric - -------- Information relating to the Company's electric properties is contained in Item 1 - BUSINESS, THE COMPANY (page I-1), CONSTRUCTION AND FINANCING PROGRAM OF THE COMPANY (pages I-4 through I-6), ELECTRIC OPERATIONS AND FUEL SUPPLY (pages I-6 through I-8) and Item 8 - Notes 2 and 7 of Notes to Consolidated Financial Statements on pages II-14 and II-19, respectively, which pages are incorporated herein by reference. Gas - --- Information relating to the Company's gas properties is contained in Item 1 - BUSINESS, THE COMPANY (page I-1), and GAS OPERATIONS AND GAS SUPPLY (pages I-8 through I-11), which pages are incorporated herein by reference. Steam - ----- The Company owns two steam generating plants and the steam distribution facility serving downtown Dayton, Ohio. Other - ----- The Company owns a number of area service buildings located in various operating centers. Substantially all property and plant of the Company is subject to the lien of the Mortgage securing the Company's First Mortgage Bonds. Item 3 Item 3 - LEGAL PROCEEDINGS Information relating to legal proceedings involving the Company is contained in Item 1 - BUSINESS, THE COMPANY (page I-1), GAS OPERATIONS AND GAS SUPPLY (pages I-8 through I-11), RATE REGULATION AND GOVERNMENT LEGISLATION (pages I-11 through I-15), ENVIRONMENTAL CONSIDERATIONS (pages I-15 through I-18) and Item 8 - Note 2 of Notes to Consolidated Financial Statements on page II-14, which pages are incorporated herein by reference. Item 4 Item 4 - SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. I-21 PART II - ------- Item 5 Item 5 - MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The Company's common stock is held solely by DPL Inc. and as a result is not listed for trading on any stock exchange. The information required by this item of Form 10-K is set forth in Item 8 - Selected Quarterly Information on page II-24 and the Financial and Statistical Summary on page II-25, which pages are incorporated herein by reference. The Company's Mortgage restricts the payment of dividends on the Company's Common Stock under certain conditions. In addition, so long as any Preferred Stock is outstanding, the Company's Amended Articles of Incorporation contain provisions restricting the payment of cash dividends on any of its Common Stock if, after giving effect to such dividend, the aggregate of all such dividends distributed subsequent to December 31, 1946 exceeds the net income of the Company available for dividends on its Common Stock subsequent to December 31, 1946, plus $1,200,000. As of year end, all earnings reinvested in the business of the Company were available for Common Stock dividends. The Credit Agreement requires that the aggregate assets of the Company and its subsidiaries constitute not less than 60% of the total consolidated assets of DPL Inc., and that the Company maintain common shareholder's equity (as defined in the Credit Agreement) at least equal to $550 million. Item 6 Item 6 - SELECTED FINANCIAL DATA The information required by this item of Form 10-K is set forth in Item 8 - Financial and Statistical Summary on page II-25, which page is incorporated herein by reference. II-1 II-2 Results of Operations - --------------------- The 1993 earnings on common stock are $135 million compared to $133 million in 1992 and $118 million in 1991. Electric revenues increased 11% in 1993 and 2% in 1992. Warm summer temperatures contributed to a 4% sales increase. Implementation of the second phase of the electric rate increase of 6.4% in January 1993 also contributed to the increase in revenues. (See Financial Statement Note 2.) An overall sales increase of 6% in 1992 reflected strong sales to other utilities despite mild temperatures throughout the year. Gas revenues increased 20% in 1993 due to significantly higher gas cost rates. A 6.2% increase in base rates in March 1992 contributed to the increased revenues. Gas sales increased by 3%. Gas revenues increased 1% in 1992 with lower gas cost rates offsetting increased weather-related sales of 5%. In 1993, interest and other income included $6 million of interest income associated with a federal income tax refund from the 1986-1988 audit period. Operating and administrative expenses increased 16% in 1993 and decreased 5% in 1992. Included are redemption premiums and other refinancing costs of $23 million in 1993 and $9 million in 1992. Maintenance expense increased 18% in 1993 and decreased 16% in 1992 reflecting changes in the level of planned maintenance programs on the Company's production and distribution equipment. Operating, administrative and maintenance expenses are expected to stabilize in 1994. Regulatory deferrals decreased in 1993 with the January implementation of the second phase of the Company's electric price increase. With this increase, current prices reflect more cost recovery and reduce the deferral needed to recognize the full revenue requirements of the phase-in plan. The phase-in plan established a baseline return on equity of 13% (subject to upward adjustment). In the event the return exceeds the allowed return by between one to two percent, then one half of the excess return will be used to reduce the cost of demand-side management programs, and any return that exceeds the allowed return by more than two percent will be entirely credited to these programs. Allowance for Funds Used During Construction ("AFC") relating to the William H. Zimmer Generating Station ("Zimmer") ceased upon its completion in March 1991. Prior to this essentially all AFC related to Zimmer. II-3 Total income taxes increased in 1993 and 1992 resulting from higher pre-tax income. Additionally, in 1993, the corporate tax rate was increased to 35% as enacted by the Omnibus Budget Reconciliation Act of 1993, increasing income taxes $3 million. Adopting FASB Statement No. 109 resulted in changes to the consolidated balance sheet. The increase in total assets is due to an increase in deferred interest-Zimmer (see Financial Statement Note 2) of $23 million and the recognition of income taxes recoverable through future revenues of $260 million. Offsetting these assets were additional deferred tax liabilities of $283 million. Credit Ratings - -------------- In July 1993, the Company's bond and preferred stock ratings were raised by Duff & Phelps, a credit rating agency. First mortgage bonds are now rated "AA-" and preferred stock is rated "A+". This upgrade reflects the Company's significantly improved financial performance and favorable qualitative credit factors. During the first quarter of 1992, the Company's bond, preferred stock and commercial paper ratings were upgraded by three credit rating agencies. Bonds were upgraded to "A2" by Moody's Investors Service, "A+" by Duff & Phelps and "A" by Standard & Poor's. These upgrades reflect the positive outcome of the Zimmer coal conversion project and rate settlement agreement. Each of these bond ratings is considered investment grade. Construction Program and Financing - ---------------------------------- Construction additions were $79 million, $58 million and $116 million in 1993, 1992 and 1991, respectively. For the period 1994 through 1998, total construction additions are projected to be $502 million with a total of $105 million occurring in 1994. During this same period, a total of $106 million will be required for sinking funds and mandatory redemptions for preferred stock and bonds. During 1993, total cash provided by operating activities was $246 million. At year end, cash and temporary investments were $6 million and short-term borrowings were $30 million. During late 1992 and early 1993, the Company took advantage of favorable market conditions to reduce its cost of debt and extend maturities through early refundings. Overall, five new series of First Mortgage Bonds were issued, aggregating approximately $766 million with an average interest rate of 7.9%. The proceeds were used to finance the redemption of a similar principal amount of debt securities with an average interest rate of 8.7%. II-4 Issuance of additional amounts of First Mortgage Bonds by the Company is limited by provisions of its mortgage. At December 31, 1993, more than $500 million of additional bonds could have been issued. The amounts and timing of future financings will depend upon market and other conditions, rate increases, levels of sales and construction plans. DPL Inc. has a revolving credit agreement, renewable through 1998, which allows total borrowings by DPL Inc. and its subsidiaries of $200 million. At year end 1993, DPL Inc. had no borrowings outstanding under this credit agreement. At December 31, 1992, DPL Inc. had $90 million outstanding under the revolving credit agreement which was used to fund share purchases for DPL Inc.'s Employee Stock Ownership Plan. These borrowings were repaid in January 1993 with the proceeds from the issuance of $90 million of DPL Inc. 7.83% Notes due 2007. The Company also has $97 million available in short-term lines of credit. At year end, the Company had $10 million outstanding from these lines of credit at a weighted average interest rate of 3.68% and $15 million in commercial paper outstanding at weighted average interest rate of 3.34%. Issues and Financial Risks - -------------------------- As a public utility, the Company is subject to processes which determine the rates it charges for energy services. Regulators determine which costs are eligible for recovery in the rate setting process and when the recovery will occur. They also establish the rate of return on utility investments which are valued under Ohio law based on historical costs. The utility industry is subject to inflationary pressures similar to those experienced by other capital-intensive industries. Because rates for regulated services are based on historical costs, cash flows may not cover the total future costs of providing services. Construction costs over the next five years average $100 million annually which approximates the projected depreciation over the same period. The passage of the National Energy Policy Act allows the federal government to mandate access by others to a utility's transmission system and may accelerate competition in the supply of electricity. In 1992, FERC issued Order 636 (the "Order") amending its regulations governing the service obligations, rate design and cost recovery of interstate pipelines. In response to the Order, the PUCO has approved interim guidelines for its implementation and is continuing efforts to examine the impact via round-table discussions. In 1993, the Company implemented the requirements of the Order. II-5 In January 1994, the Company, the Staff of the PUCO and the Office of the OCC submitted to the PUCO an agreement which resolves issues relating to the recovery of "transition costs" to be billed to the Company by interstate pipeline companies. The agreement, which is subject to PUCO approval, provides for the full recovery of these transition costs from customers. The interstate pipelines will file with the FERC in 1994 for authority to recover these transition costs, the exact magnitude of which has not been established. The U.S. EPA has estimated total costs of $56 million for its preferred clean-up plans of three hazardous waste sites in Ohio. The U.S. EPA notified numerous parties, including the Company, that they are considered "Potentially Responsible Parties" for cleanup of these sites. The final resolution of these investigations will not have a material effect on the Company's financial position, earnings or cash flow. Changing environmental regulations continue to increase the cost of providing service in the utility industry. The Clean Air Act Amendments of 1990 (the "Act") limit sulfur dioxide and nitrogen oxide emissions nationwide. The Act will restrict emissions in two phases with Phase I compliance completed by 1995 and Phase II completed by 2000. In May 1993, the PUCO approved the Company's Clean Air Act Compliance Plan. This plan outlines the methods by which the emission reduction requirements will be met. Overall compliance is expected to have a minimal 1% to 2% price impact. The Company anticipates that costs to comply with the Act will be eligible for recovery in future fuel hearings and other regulatory proceedings. Income Statement Highlights $ in millions 1993 1992 1991 - --------------------------------------------------------------- Electric Utility: Revenues..................... $901 $809 $791 Fuel used in production...... 225 219 235 ---- ---- ---- Net revenues............... 676 590 556 Gas Utility: Revenues..................... 245 204 201 Gas purchased for resale..... 156 118 130 ---- ---- ---- Net revenues............... 89 86 71 Interest and other income...... 12 4 4 Operating and administrative... 181 155 163 Maintenance of equipment and facilities................... 90 76 90 Regulatory deferrals........... (26) (59) (43) Income taxes................... 76 64 40 Earnings on common stock....... 135 133 118 II-6 Item 8 - FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Index to Consolidated Financial Statements Page No. - ------------------------------------------ -------- Consolidated Statement of Results of Operations for the three years in the period ended December 31, 1993............... II-8 Consolidated Statement of Cash Flows for the three years in the period ended December 31, 1993............................ II-9 Consolidated Balance Sheet as of December 31, 1993 and 1992................... II-10 - II-11 Notes to Consolidated Financial Statements... II-12 - II-23 Reports of Independent Accountants........... II-26 - II-27 Index to Supplemental Information Page No. - --------------------------------- -------- Selected Quarterly Information............................ II-24 Financial and Statistical Summary................................ II-25 II-7 See Notes to Consolidated Financial Statements. II-8 See Notes to Consolidated Financial Statements. II-9 II-10 See Notes to Consolidated Financial Statements. II-11 The Dayton Power and Light Company NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - ---------------------------------------------------------------- PRINCIPLES OF CONSOLIDATION The accounts of the Company and its wholly-owned subsidiaries are included in the accompanying consolidated financial statements. The consolidated financial statements principally reflect the results of operations and financial condition of the Company. The results of operations of the Company's subsidiaries currently do not have a material financial impact on the consolidated results. REVENUES AND FUEL Revenues include amounts charged to customers through fuel and gas recovery clauses, which are adjusted periodically for changes in such costs. Related costs that are recoverable or refundable in future periods are deferred along with the related income tax effects. Also included in revenues are amounts charged to customers through a surcharge for recovery of arrearages from certain eligible low-income households. The Company records revenue for services provided but not yet billed to more closely match revenues with expenses. "Accounts Receivable" on the Consolidated Balance Sheet includes unbilled revenue of (in millions) $30.0 in 1993 and $27.8 in 1992. ALLOWANCE FOR FUNDS USED DURING CONSTRUCTION ("AFC") AFC represents the cost of capital funds (equity and debt) used to finance construction projects. This cost is included in construction work in progress along with other construction costs. Essentially all AFC ceased upon completion of the William H. Zimmer Generating Station ("Zimmer") in March 1991. The average rate for 1991 was 10.3%, compounded semi-annually, net of income taxes. OPERATING AND ADMINISTRATIVE Operating and administrative expense includes $22.8 million in 1993 and $9.1 million in 1992 of redemption premiums and other costs relating to the refinancing of various bond issues. (See Note 5.) II-12 PROPERTY AND PLANT, MAINTENANCE AND DEPRECIATION Property and plant is shown at its original cost. When a unit of property is retired, the original cost of that property plus the cost of removal less any salvage value is charged to accumulated depreciation. Maintenance costs and replacements of minor items of property are charged to expense. Depreciation expense is calculated using the straight-line method, which depreciates the cost of property over its estimated useful life, at an annual rate which approximates 3.4% for 1993, 1992 and 1991. INCOME TAXES In 1993, the Company implemented Financial Accounting Standards Board ("FASB") Statement No. 109, "Accounting for Income Taxes." The new statement requires a change from the deferral method to the liability method for income tax accounting. Under the liability method, deferred taxes are provided for all differences between the financial statement basis and the tax basis of assets and liabilities using the enacted tax rate. Additional deferred income taxes and offsetting regulatory assets or liabilities are recorded to recognize that the income taxes will be recoverable/refundable through future revenues. (See Note 3.) CONSOLIDATED STATEMENT OF CASH FLOWS The temporary cash investments presented on this Statement consist of liquid investments with an original maturity of three months or less. FAIR VALUE OF FINANCIAL INSTRUMENTS The reported value of short-term financial instruments and other investments on the balance sheet approximates fair value. The long-term debt and preferred stock fair values are disclosed in Notes 5 and 9, respectively. RECLASSIFICATIONS Reclassifications have been made in certain prior years' amounts to conform to the current reporting presentation. II-13 2. ELECTRIC RATE MATTERS - ---------------------------------------------------------------- Pursuant to a PUCO-approved settlement agreement among the Company and various consumer groups, an electric rate increase was phased in with annual increases of 6.4% effective February 1992, January 1993 and January 1994. Deferrals (including carrying charges) during the phase-in period of $28.1 million in 1993 and $57.7 million in 1992 were capitalized and will be recovered over seven years commencing in 1994. The phase-in plan meets the requirements of FASB Statement No. 92. This settlement included an agreement by the Company to undertake cost-effective demand-side management ("DSM") programs with an average annual cost of $15 million for four years commencing in 1992. The amount recovered in rates was $4.6 million in 1992. This amount increases to $7.8 million in 1993 and subsequent years. The difference between expenditures and amounts recovered through rates is deferred and is eligible for future recovery in accordance with existing PUCO rulings. The agreement established a baseline return on equity of 13% (subject to upward adjustment). In the event that the return exceeds the allowed return by between one to two percent, then one half of the excess return will be used to reduce the cost of DSM programs, and any return that exceeds the allowed return by more than two percent will be entirely credited to these programs. The Company also deferred interest charges, net of income taxes, on its investment in Zimmer from the March 30, 1991, commercial in-service date through January 31, 1992, pursuant to PUCO approval. Deferred interest charges on the investment in Zimmer have been adjusted to a before tax basis in 1993 as a result of FASB Statement No. 109. Amounts deferred are being amortized over the life of Zimmer. Regulatory deferrals on the balance sheet were: At December 31, 1993 1992 ------- ------- --millions-- Phase-in $ 85.8 $ 57.7 DSM 23.3 2.2 Deferred interest-Zimmer 63.7 43.9 ------ ----- Total $172.8 $103.8 ====== ====== II-14 - ------------------------------------------------------------------------------- 3. INCOME TAXES Adopting FASB Statement No. 109 at January 1, 1993, resulted in an increase in deferred interest-Zimmer (see Note 2) of $22.6 million and the recognition of income taxes recoverable through future revenues of $259.6 million. Offsetting these assets is an additional $282.5 million of deferred tax liabilities. II-15 - ------------------------------------------------------------------------------ 4. PENSIONS AND POSTRETIREMENT BENEFITS A. PENSIONS Substantially all Company employees participate in pension plans paid for by the Company. Employee benefits are based on their years of service, age at retirement and, for salaried employees, their compensation. The plans are funded in amounts actuarially determined to provide for these benefits. An interest rate of 6.0% was used in 1993 and 1992 in developing the amounts in the following tables. Actual returns on plan assets for 1993 and 1992, respectively, were 6.2% and 8.8%. Increases in compensation levels approximating 5% were used for all years. The following table presents the components of pension cost (portions of which were capitalized): II-16 B. POSTRETIREMENT BENEFITS In 1993, the Company adopted FASB Statement No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions." Previously, the Company had used an accrual method to recognize these costs which approximated FASB Statement No. 106 amounts. Implementation did not create regulatory deferrals or have a material impact on expense. Qualified employees who retired prior to 1987 and their dependents are eligible for health care and life insurance benefits. The unamortized transition obligation associated with these benefits is being amortized over the approximate average remaining life expectancy of the retired employees. Active employees are eligible for life insurance benefits, and this unamortized transition obligation is being amortized over the average remaining service period. The following table sets forth the accumulated postretirement benefit amounts at December 31: The assumed health care cost trend rate used in measuring the unfunded accumulated postretirement benefit obligation is 15% for 1993 and decreases to 8% by 2004. A one percentage point increase in each future year's assumed health care trend rate would increase net periodic postretirement benefit cost by $0.4 million annually and would increase the accumulated postretirement benefit obligation by $6.4 million. The weighted average discount rate used in determining the accumulated postretirement benefit obligation was 6.0%. II-17 The amounts of maturities and mandatory redemptions for first mortgage bonds are (in millions) $4.7 in 1994, 1995 and 1996, $44.8 in 1997 and $25.4 in 1998. Substantially all property and plant of the Company is subject to the mortgage lien securing first mortgage bonds. New debt was issued during 1993 as follows: Principal Amount Issuances ($ in millions) --------- ---------------- First Mortgage Bonds: 8.15% Series due 2026 $226.0 7-7/8% Series due 2024 220.0 ------ Total $446.0 Proceeds of these financings were used to call several series of bonds and to repay short-term debt. There are no sinking fund provisions associated with any of these new debt issues. II-18 - ------------------------------------------------------------------------------- 6. NOTES PAYABLE AND COMPENSATING BALANCES DPL Inc., the Company's parent company, has $200 million available through a revolving credit agreement. This agreement with a consortium of banks is renewable through 1998. Commitment fees are approximately $350,000 per year, depending upon the aggregate unused balance of the loan. At December 31, 1993, DPL Inc. had no outstanding borrowings under this credit agreement. The Company also has $97.1 million available in short-term informal lines of credit. To support these lines of credit, the Company is required to maintain average daily compensating balances of approximately $700,000 and also pay $189,000 per year in fee compensation. At year-end, the Company had $10 million outstanding from these lines of credit at a weighted average interest rate of 3.68% and $15 million in commercial paper outstanding at a weighted average interest rate of 3.34%. - ------------------------------------------------------------------------------- 7. COMMONLY OWNED FACILITIES The Company owns certain electric generating and transmission facilities as tenants in common with other Ohio utilities. Each utility is obligated to pay its ownership share of construction and operation costs of each facility. As of December 31, 1993, the Company had $12.3 million of commonly owned facilities under construction. The Company's share of expenses is included in the Consolidated Statement of Results of Operations. The following table represents the Company's share of the commonly owned facilities: II-19 II-20 The shares without mandatory redemption provisions may be redeemed at the option of the Company at the per share prices indicated, plus accrued dividends. The shares with mandatory redemption provisions are redeemable pursuant to mandatory sinking fund requirements, but may also be redeemed at the option of the Company at the per share prices indicated, plus accrued dividends. The annual sinking fund requirements for Series H and I are 5% of the original amount of each issue. Over the next five years, mandatory redemptions are $4.3 million (42,500 shares) per year. Shares redeemed or purchased to meet sinking fund requirements may not be reissued. Sinking fund requirements and redemptions of outstanding shares were 85,000 shares in 1993 and 42,500 in 1992 and 1991. II-21 II-22 II-23 II-24 II-25 Report of Independent Accountants --------------------------------- To the Board of Directors and Shareholder of The Dayton Power and Light Company In our opinion, the consolidated financial statements listed in the index, appearing under Item 8 on page II-7 of this Form 10-K, present fairly, in all material respects, the financial position of The Dayton Power and Light 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. 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 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 consolidated financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated 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, the Company changed its method of accounting for income taxes in 1993. Price Waterhouse Dayton, Ohio January 25, 1994 II-26 Report of Independent Accountants on Financial Statement Schedules -------------------------------- To the Board of Directors of The Dayton Power and Light Company Our audits of the consolidated financial statements of The Dayton Power and Light Company and its subsidiaries referred to in our report dated January 25, 1994 appearing on page II-26 of 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. Price Waterhouse Dayton, Ohio January 25, 1994 II-27 Item 9 - CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III - -------- Item 10 - DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Directors of the Registrant - --------------------------- The Board is presently authorized to consist of nine directors. These nine directors are also directors of DPL Inc., the holding company of the Company. Eight incumbent directors plus one new nominee are to be elected this year to serve until 1995 or until their successors are duly elected and qualified. Should any nominee become unable to accept nomination or election, the Board will vote for the election of such other person as a director as the present directors may recommend in the place of such nominee. Dr. Robert J. Kegerreis will be retiring as a Director in April 1994. Dr. Kegerreis, the President Emeritus of Wright State University, has served as a Director since 1975, making significant and lasting contributions during the most challenging and successful period of the Company's history. We offer our sincere appreciation to Dr. Kegerreis on behalf of all of our Shareholders, Directors, Customers and Employees and wish him well in his future endeavors. Mr. David R. Holmes will stand for election to his first term as a member of the Board. Mr. Holmes is Chairman, President and Chief Executive Officer of The Reynolds and Reynolds Company in Dayton, Ohio. The Reynolds and Reynolds Company is a leading supplier of information management systems, including business forms and computer systems for automotive, professional, medical and general markets. His business experience and community leadership will be a valuable asset to the Board. III-1 The following information regarding the nominees is based on information furnished by them: Director Principal Occupation and Other Information Since - ------------------------------------------ -------- Incumbent Directors - ------------------- THOMAS J. DANIS, Age 44 1989 Former Chairman and Chief Executive Officer, The Danis Companies, Dayton, Ohio, construction, real estate and environmental services. Trustee: University of Dayton, Dayton Business Committee, Dayton Foundation. Member: Area Progress Council. JAMES F. DICKE, II, Age 48 1990 President, Crown Equipment Corporation, New Bremen, Ohio, international manufacturer and distributor of electric lift trucks and material handling products. Director: Regional Boys and Girls Clubs of America, Plaid Holdings Company. Treasurer: Trinity University Board of Trustees. Secretary: Culver Educational Foundation. PETER H. FORSTER, Age 51 1979 Chairman, President and Chief Executive Officer, DPL Inc.; Chairman, The Dayton Power and Light Company. Chairman: Miami Valley Research Foundation. Director: Bank One, Dayton, NA, Amcast Industrial Corp., Comair Holdings, Inc. Trustee: F. M. Tait Foundation, MedAmerica Health Systems Corp., Dayton Business Committee, Arts Center Foundation. ERNIE GREEN, Age 55 1991 President and Chief Executive Officer, Ernie Green Industries, Dayton, Ohio, automotive components manufacturer. Director: Bank One, Dayton, NA, Day-Med Health Maintenance Plan, Inc., WPTD-TV, The Duriron Company. Trustee: Central State University, Dayton Area Chamber of Commerce, YMCA, Childrens Medical Center, The Ronald McDonald Childrens Charities. III-2 JANE G. HALEY, Age 63 1978 President, Gosiger, Inc., Dayton, Ohio, national importer and distributor of machine tools. Director: Society Bank, NA, Advisory Board, Dayton, Ohio. Trustee: University of Dayton, Chaminade- Julienne High School, Dayton, Ohio. Member: Area Progress Council. ALLEN M. HILL, Age 48 1989 President and Chief Executive Officer, The Dayton Power and Light Company. Director: Citizens Federal Bank, F.S.B., Dayton Boys/Girls Club, Miami Valley Regional Planning Commission, Ohio Electric Utility Institute. Trustee: The University of Dayton, Hipple Cancer Research Center. W AUGUST HILLENBRAND, Age 53 1992 President and Chief Executive Officer, Hillenbrand Industries, Batesville, Indiana, a diversified public holding company with seven wholly-owned and autonomously operated subsidiaries manufacturing caskets, hospital furniture, hospital supplies, luggage and high-tech security locks and providing funeral planning services. Director: Forecorp, Inc., Forethought Life Insurance Company. Trustee: Denison University, National Committee for Quality Health Care, Batesville Girl Scouts. BURNELL R. ROBERTS, Age 66 1987 Chairman, Sweetheart Holdings, Inc. Retired Chairman of the Board and Chief Executive Officer, The Mead Corporation, Dayton, Ohio, forest products and electronic publishing. Director: Armco, Inc., National City Corporation, The Perkin-Elmer Corporation, Universal Protective Plastics, Inc. Trustee: Japan Society. III-3 Nominated for Election at 1994 Annual Meeting of Shareholders - ------------------------------------------------------------- DAVID R. HOLMES, Age 53 Chairman, President and Chief Executive Officer, The Reynolds and Reynolds Company, Dayton, Ohio, information management systems. Director: Bank One, Dayton, NA. Advisor: J.L. Kellogg Graduate School of Management, Northwestern University. Co-Chair: Downtown Dayton Partnership. Member: Dayton Business Committee, Area Progress Council. III-4 III-5 III-6 Item 11 - EXECUTIVE COMPENSATION COMPENSATION OF DIRECTORS - ------------------------- Directors of the Company who are not employees receive $12,000 annually for services as a director, $600 for attendance at a Board meeting, and $500 for attendance at a committee meeting or operating session, of DPL Inc. and the Company. Members of the Executive Committee of DPL Inc. receive $2,000 annually for services on that committee. Each committee chairman receives an additional $1,600 annually. Directors who are not employees of the Company also participate in a Directors' Deferred Stock Compensation Plan (the "Stock Plan") under which a number of DPL Inc. common shares are awarded to directors each year. All shares awarded under the Stock Plan are transferred to a grantor trust (the "Master Trust") maintained by DPL Inc. to secure its obligations under various directors' and officers' deferred and incentive compensation plans. Receipt of the shares or cash equal to the value thereof is deferred until the participant retires as a director or until such other time as designated by the participant and approved by the Compensation and Management Review Committee (the "Committee") of DPL Inc. In the event of a change of control (as defined in the Stock Plan), the authority and discretion which is exercisable by the Committee, will be exercised by the trustees of the Master Trust. In April 1993, each non-employee director was awarded 1,400 shares. DPL Inc. maintains a Deferred Compensation Plan (the "Compensation Plan") for non-employee directors of DPL Inc. and the Company in which payment of directors' fees may be deferred. The Compensation Plan also includes a supplementary deferred income program which provides that DPL Inc. will match $5,000 annually of deferred directors' fees for a maximum of ten years. Under the supplementary program, a $150,000 death benefit is provided until such director ceases to participate in the Compensation Plan. Under the standard deferred income program directors are entitled to receive a lump sum payment or payments in approximately equal installments over a ten-year period. A director may elect payment in either cash or common shares. Participants in the supplementary program are entitled to receive deferred payments over a ten-year period in equal installments. The Compensation Plan provides that in the event of a change in control of DPL Inc., as defined in the Compensation Plan, all benefits provided under the supplementary deferred income program become immediately vested without the need for further contributions by the participants and the discretion which, under the Compensation Plan, is exercisable by the Chief Executive Officer of DPL Inc. will be exercised by the trustees of the Master Trust. If the consent of the Chief Executive Officer of DPL Inc. is obtained, individuals who have attained the age of 55 and who are no longer directors of DPL Inc. or the Company may receive a lump sum payment of amounts credited to them under the supplementary deferred income program. III-7 EXECUTIVE OFFICER COMPENSATION - ------------------------------ Summary Compensation Table - -------------------------- Set forth below is certain information concerning the compensation of the Chief Executive Officer and each of the other four most highly compensated executive officers of the Company for the last three fiscal years, for services rendered in all capacities to the Company and its subsidiaries, DPL Inc., and the other subsidiaries of DPL Inc. (1) Amounts in this column represent awards made under the Management Incentive Compensation Program ("MICP"). Awards are based on achievement of specific predetermined operating and management goals in the year indicated and paid in the year earned or in the following year. III-8 (2) Amounts shown in this column have not been paid, but are contingent on performance and represent the dollar value of restricted stock incentive units ("SIU's") awarded to the named executive officer under the Management Stock Incentive Plan ("MSIP") based on the closing price of a DPL Inc. common share on the New York Stock Exchange--Consolidated Transactions Tape on the date of award. SIU's awarded for 1992 and 1993 vest only to the extent that the DPL Inc. average return on equity ("ROE") over a three-year performance period is above the RRA industry median. Depending on the performance of DPL Inc., these SIU's vest in amounts ranging from 0% to 100% of the target award at an ROE between 0 and 100 basis points above median ROE and from 100% to 150% of target award at an ROE between 100 and 200 basis points above median ROE. No units vest if the three-year average ROE is below 10%. Amounts shown for 1992 and 1993 reflect target awards. Amounts shown for 1991 represent the annual pro rata portion of SIU's earned over the eight-year period from inception of the MSIP in 1984 through 1991, including the pro rata portion of supplemental SIU awards made in 1991 to the named executive officers in recognition of corporate performance over the eight-year period. For each SIU which vests, a participant receives the cash equivalent of one DPL Inc. common share plus dividend equivalents from the date of award. Prior to payout at retirement, an individual may elect to convert a portion of vested SIU's to a cash equivalent and accrue interest thereon. As of December 31, 1993, the aggregate target number and value (based on the closing price of a DPL Inc. common share on the NYSE--Consolidated Transactions Tape on December 31, 1993) of unearned restricted SIU's contingently awarded to each named executive officer was as follows: Mr. Forster, 75,800 ($1,563,000); Mr. Hill, 36,612 ($755,000); Mr. Koziar, 14,911 ($307,000); Mr. Jenkins 25,640 ($528,000); and Mr. Santo, 26,012 ($536,000). These unearned restricted SIU's may vest in 1994, 1995 and 1996 at 0% to 150% of the target number depending on Company performance during the period from 1992 through 1996. All payouts of vested SIU's under the MSIP are deferred until retirement. (3) Amounts in this column represent employer matching contributions on behalf of each named executive under the DP&L Employee Savings Plan made to the DPL Inc. Employee Stock Ownership Plan. Certain Severance Pay Agreements - -------------------------------- DPL Inc. entered into severance pay agreements with each of Messrs. Forster, Hill, Koziar, Jenkins and Santo providing for the payment of severance benefits in the event that the individual's employment with DPL Inc. or its subsidiaries is terminated under specified circumstances within three years after a change in control of DPL Inc. or DP&L (as defined in the agreement). The agreements entered into between 1987 and 1991 require the individuals to remain with DPL Inc. throughout the period during which any change of control is pending in order to help put in place the best plan for the shareholders. The principal severance benefits under each agreement III-9 include payment of the following: (i) the individual's full base salary and accrued benefits through the date of termination and any awards for any completed or partial period under the MICP and the individual's award for the current period under the MICP (or for a completed period if no award for that period has yet been determined) fixed at an amount equal to his average annual award for the preceding three years; (ii) 300% of the sum of the individual's annual base salary at the rate in effect on the date of termination (or, if higher, at the rate in effect as of the time of the change in control) plus the average amount awarded to the individual under the MCIP for the three preceding years; (iii) all awarded or earned but unpaid SIU's; and (iv) continuing medical, life, and disability insurance. In the event any payments under these agreements are subject to an excise tax under the Internal Revenue Code of 1986, the payments will be adjusted so that the total payments received on an after-tax basis will equal the amount the individual would have received without imposition of the excise tax. The severance pay agreements are effective for one year but are automatically renewed each year unless DPL Inc. or the participant notifies the other one year in advance of its or his intent not to renew. DPL Inc. has agreed to secure its obligations under the severance pay agreements by transferring required payments to the Master Trust. Pension Plans - ------------- The following table sets forth the estimated total annual benefits payable under the Company retirement income plan and the supplemental executive retirement plan to executive officers at normal retirement date (age 65) based upon years of accredited service and final average annual compensation (including base and incentive compensation) for the three highest years during the last ten: Total Annual Retirement Benefits for Years of Accredited Service Final Average ------------------------------------ Annual Earnings 10 Years 30 Years --------------- -------- -------- $ 200,000 $ 53,000 $106,000 400,000 110,000 220,000 600,000 167,000 334,000 800,000 224,000 448,000 1,000,000 281,000 562,000 The years of accredited service for the named executive officers are Mr. Forster -- 29 yrs.; Mr. Hill -- 24 yrs.; Mr. Koziar -- 24 yrs.; Mr. Jenkins -- 16 yrs and Mr. Santo -- 18 years. Years of service under the retirement income plan are capped at 30 years, however, the retirement and supplemental plans, taken together, can provide full benefits after 20 years of accredited service. Benefits shown above are computed on a straight-life annuity basis, are subject to deduction for Social Security benefits and may be reduced by benefits payable under retirement plans of other employers. For each year an individual retires prior to age 62, benefits under the supplemental plan are reduced by 3% or 21% for early retirement at age 55. III-10 Item 12 - SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The Company's stock is beneficially owned by DPL Inc. Set forth below is information concerning the beneficial ownership of shares of Common Stock of DPL Inc. by each director of the Company as of January 31, 1994. Amount and Nature of Name of Director Beneficial Ownership (1) ---------------- ------------------------ Incumbent Directors ------------------- Thomas J. Danis 15,923 shares James F. Dicke, II 56,438 shares Peter H. Forster 21,416 shares Ernie Green 12,404 shares Jane G. Haley 23,414 shares Allen M. Hill 19,646 shares W August Hillenbrand 5,922 shares Burnell R. Roberts 14,125 shares Nominated for Election at the 1994 Annual Meeting of Shareholders ---------------------------------- David R. Holmes 100 shares Set forth below is information concerning the beneficial ownership of shares of Common Stock of DPL Inc. by each executive officer of the Company named in the Summary Compensation Table (other than executive officers who are directors of the Company whose security ownership is found above) as of January 31, 1994. Amount and Nature of Name of Executive Officer Beneficial Ownership (1) ------------------------- ------------------------ Stephen F. Koziar, Jr. 6,380 shares Thomas M. Jenkins 5,108 shares H. Ted Santo 1,430 shares (1) The number of shares shown represents in each instance less than 1% of the outstanding Common Shares of DPL Inc. There were 237,749 shares or 0.23% of the total number of Common Shares beneficially owned by all directors and executive officers of DPL Inc. and the Company as a group at January 31, 1994. The number of shares shown for the directors includes Common Shares transferred to the Master Trust for non-employee directors pursuant to the Directors' Deferred Stock Compensation Plan. Item 13 - CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS None. III-11 PART IV - ------- Item 14 - EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) Documents filed as part of the Form 10-K 1. Financial Statements -------------------- See Item 8 - Index to Financial Statements on page II-7, which page is incorporated herein by reference. 2. Financial Statement Schedules ----------------------------- For the three years in the period ended December 31, 1993: Page No. ------------- Schedule V - Property and plant IV-7 - IV-12 Schedule VI - Accumulated depreciation and amortization IV-13 - IV-15 Schedule VII - Obligations relating to securities of other issuers IV-16 Schedule VIII - Valuation and qualifying accounts IV-17 Schedule IX - Short-term borrowings IV-18 Schedule X - Supplementary income statement information IV-19 The information required to be submitted in Schedules I, II, III, IV, XI, XII and XIII is omitted as not applicable or not required under rules of Regulation S-X. IV-1 3. Exhibits -------- The following exhibits have been filed with the Securities and Exchange Commission and are incorporated herein by reference. Incorporation by Reference ----------------- 2 Copy of the Agreement of Merger among Exhibit A to the 1986 DPL Inc., Holding Sub Inc. and the Proxy Statement Company dated January 6, 1986................. (File No. 1-2385) 3(a) Regulations and By-Laws of the Company........ Exhibit 2(e) to Registration Statement No. 2-68136 to Form S-16. 3(b) Copy of Amended Articles of Incorporation Exhibit 3(b) to Report of the Company dated January 3, 1991.......... on Form 10-K for the year ended December 31, 1991 (File No. 1-2385) 4(a) Copy of Composite Indenture dated as of Exhibit 4(a) to Report October 1, 1935, between the Company and on Form 10-K for year The Bank of New York, Trustee with all ended December 31, 1985 amendments through the Twenty-Ninth (File No. 1-2385) Supplemental Indenture........................ 4(b) Copy of the Thirtieth Supplemental Indenture Exhibit 4(h) to dated as of March 1, 1982, between the Registration Statement Company and The Bank of New York, Trustee..... No. 33-53906 4(c) Copy of the Thirty-First Supplemental Exhibit 4(h) to Indenture dated as of November 1, 1982, Registration Statement between the Company and The Bank of New York, No. 33-56162 Trustee....................................... 4(d) Copy of the Thirty-Second Supplemental Inden- Exhibit 4(i) to ture dated as of November 1, 1982, between the Registration Statement Company and The Bank of New York, Trustee..... No. 33-56162 4(e) Copy of the Thirty-Third Supplemental Exhibit 4(e) to Indenture dated as of December 1, 1985, Report on Form 10-K between the Company and The Bank of New York, for year ended Trustee....................................... December 31, 1985 (File No. 1-2385) 4(f) Copy of the Thirty-Fourth Supplemental Exhibit 4 to Report Indenture dated as of April 1, 1986, on Form 10-Q for between the Company and The Bank of New York, quarter ended Trustee....................................... June 30, 1986 (File No. 1-2385) IV-2 4(g) Copy of the Thirty-Fifth Supplemental Exhibit 4(h) to Report Indenture dated as of December 1, 1986, on Form 10-K for the between the Company and The Bank of New York, year ended December 31, Trustee....................................... 1986 (File No. 1-9052) 4(h) Copy of the Thirty-Sixth Supplemental Exhibit 4(i) to Indenture dated as of August 15, 1992, Registration Statement between the Company and The Bank of New York, No. 33-53906 Trustee....................................... 4(i) Copy of the Thirty-Seventh Supplemental Exhibit 4(j) to Indenture dated as of November 15, 1992, Registration Statement between the Company and The Bank of New York, No. 33-56162 Trustee....................................... 4(j) Copy of the Thirty-Eighth Supplemental Exhibit 4(k) to Indenture dated as of November 15, 1992, Registration Statement between the Company and The Bank of New York, No. 33-56162 Trustee....................................... 4(k) Copy of the Thirty-Ninth Suplemental Exhibit 4(k) to Indenture dated as of January 15, 1993, Registration Statement between the Company and The Bank of New York, No. 33-57928 Trustee....................................... 4(l) Copy of the Fortieth Supplemental Indenture Exhibit 4(m) to Report dated as of February 15, 1993, between on Form 10-K for the the Company and The Bank of New York, year ended December 31, Trustee....................................... 1992 (File No. 1-2385) 10(a) Description of Management Incentive Exhibit 10(d) to Report Compensation Program for Certain Executive on Form 10-K for the Officers...................................... year ended December 31, 1986 (File No. 1-9052) 10(b) Copy of Severance Pay Agreement Exhibit 10(g) to Report with Certain Executive Officers............... on Form 10-K for the year ended December 31, 1987 (File No. 1-2385) 10(c) Copy of Supplemental Executive Retirement Exhibit 10(f) to Report Plan amended August 6, 1991................... on Form 10-K for the year ended December 31, 1991 (File No. 1-2385) 18 Copy of preferability letter relating to Exhibit 18 to Report change in accounting for unbilled revenues on Form 10-K for the from Price Waterhouse......................... year ended December 31, 1988 (File No. 1-2385) IV-3 The following exhibits are filed herewith: Page No. -------- 10(d) Amended description of Directors' Deferred Stock Compensation Plan effective January 1, 1993............................... 10(e) Amended description of Deferred Compensation Plan for Non-Employee Directors effective January 1, 1993............................... 10(f) Copy of Management Stock Incentive Plan amended January 1, 1993....................... 21 Copy of List of Subsidiaries of the Company... (b) Reports on Form 8-K ------------------- Date of Report Items Reported -------------- -------------- February 3, 1993 Item 5. Other Events. Item 7. Item 7. Financial Statements and Exhibits. IV-4 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 DAYTON POWER AND LIGHT COMPANY Registrant March 15, 1994 Peter H. Forster ------------------------------------ Peter H. Forster Chairman 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. P. R. Anderson Controller (principal March 15, 1994 - ------------------------- accounting officer) (P. R. Anderson) T. J. Danis Director March 15, 1994 - ------------------------ (T. J. Danis) Director March , 1994 - ------------------------- (J. F. Dicke, II) P. H. Forster Director and Chairman March 15, 1994 - ------------------------- (principal executive (P. H. Forster) officer) E. Green Director March 15, 1994 - ------------------------- (E. Green) IV-5 J. G. Haley Director March 15, 1994 - ------------------------- (J. G. Haley) A. M. Hill Director, President and March 15, 1994 - ------------------------- Chief Executive Officer (A. M. Hill) Director March , 1994 - ------------------------- (W A. Hillenbrand) T. M. Jenkins Group Vice President March 15, 1994 - ------------------------- (principal financial (T. M. Jenkins) officer) Director March , 1994 - ------------------------- (R. J. Kegerreis) Director March , 1994 - ------------------------- (B. R. Roberts) IV-6 IV-7 IV-8 IV-9 IV-10 IV-11 IV-12 IV-13 IV-14 IV-15 (1) The Company is obligated to pay the principal of and interest on $48 million of 6.50% Collateralized Pollution Control Revenue Refunding Bonds Series A Due 2022 issued by Boone County, Kentucky. In December 1992, the Company transferred $12.7 million of the proceeds from the sale of these bonds to The Cincinnati Gas & Electric Company (CG&E). CG&E is responsible for the payment of the principal and related interest; however the Company retains primary liability for the obligations. This transfer resulted from the reduction of the Company's ownership share in the first unit at the East Bend generating station, commonly owned with CG&E. IV-16 IV-17 IV-18 IV-19 EXHIBIT INDEX ------------- Exhibit Page No. - ------- -------- 10(d) Amended description of Directors' Deferred Stock Compensation Plan effective January 1, 1993............................... 10(e) Amended description of Deferred Compensation Plan for Non-Employee Directors effective January 1, 1993............................... 10(f) Copy of Management Stock Incentive Plan amended January 1, 1993....................... 21 Copy of List of Subsidiaries of the Company...

106413_1993.txt

106413_1993

1993

106413

ITEM 1. BUSINESS. General Westinghouse Electric Corporation was founded in 1886 and since 1889 has operated under a corporate charter granted by the Commonwealth of Pennsylvania in 1872. Today, Westinghouse is a diversified, global, technology-based corporation. The Corporation's key operations include television and radio broadcasting, advanced electronics systems, environmental services, management services at government-owned facilities, services and equipment for utility markets and transport temperature control. For management reporting purposes, Westinghouse applies a business unit concept to its operating organizations, with each business unit consisting of one or more divisions or subsidiaries that meet certain internal criteria for profit center decentralization. In November 1992, the Board of Directors of Westinghouse adopted a plan (the Plan) that included exiting the financial services and other non-strategic businesses. The Corporation classified the operations of Distribution and Control Business Unit (DCBU), Westinghouse Electric Supply Company (WESCO) (collectively, Other Operations) and Financial Services as discontinued operations in accordance with Accounting Principles Board Opinion No. 30, "Reporting the Results of Operations--Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions" (APB 30). Under the Plan, the disposition of The Knoll Group (Knoll) was scheduled to occur by the end of 1994 and WCI Communities, Inc. (WCI) by the end of 1995. Financial Services was comprised primarily of Westinghouse Credit Corporation (WCC) and Westinghouse Savings Corporation (WSAV), each subsidiaries of Westinghouse Financial Services, Inc. (WFSI) and the Corporation's leasing portfolio. On May 3, 1993, WFSI and WCC were merged into Westinghouse. See notes 2 and 20 to the financial statements included in Part II, Item 8 of this report. In January 1994, the Corporation announced that the sale of WCI will be accelerated from 1995 into 1994 and Knoll is no longer for sale. WCI will continue to be reported as part of Continuing Operations until the requirements of APB 30 are met. At that time, WCI will be classified as a discontinued operation and appropriate restatements will be made to the Corporation's financial statements. For financial reporting purposes, the Corporation's Continuing Operations are aligned into the following segments: Broadcasting, Electronic Systems, Environmental, Industries, Power Systems, Knoll and WCI. Engineering and repair services, previously included in the Industries segment, has been transferred to the Power Systems segment where these businesses have been consolidated with the power generation service organization. The Environmental segment now includes the U.S. naval nuclear reactors programs previously reported in Power Systems. The Longines-Wittnauer Watch Company and Westinghouse Communications have been transferred from the Broadcasting segment to the Industries segment as part of the Industrial Products and Services business unit. The financial results of manufacturing entities located outside the United States, and export sales and foreign licensee income are included in the financial information of the reporting segment that had operating responsibility for such activity. Financial and other information by segment and geographic area is included in note 21 to the financial statements included in Part II, Item 8 of this report. For information about principal acquisitions and divestitures during the three years ended December 31, 1993, see note 20 to the financial statements included in Part II, Item 8 of this report. During 1993, the largest single customer of Westinghouse was the United States government and its agencies, whose purchases accounted for 30% of 1993 consolidated sales of products and services. No material portion of the Corporation's business was seasonal in nature. REPORTING SEGMENTS BROADCASTING Westinghouse Broadcasting Company, Inc. (Group W), a wholly-owned subsidiary of the Corporation, provides a variety of communications services consisting primarily of commercial broadcasting, program production and distribution. It sells advertising time to radio, television and cable advertisers through national and local sales organizations. Group W currently owns and operates five network affiliated television broadcasting stations and 14 radio stations. Group W's television stations are located in Baltimore, Boston, Philadelphia, Pittsburgh and San Francisco and their signals reach approximately ten percent of the United States viewing audience. Four of the five Group W television stations are currently rated either first or second in prime time and in news among adult viewers. Group W's radio stations form the largest non-network radio group in the United States. They are located in Boston, Chicago, Detroit, Houston, Los Angeles, New York City, Philadelphia and Pittsburgh--seven of the top ten radio markets in the nation. In addition, WINS, Group W's all-news radio station in New York City, currently has more listeners over the age of 18 than any other radio station in the United States. Group W Satellite Communications provides sports programming and the marketing and advertising sales for two country music entertainment channels. Group W Satellite Communications is also the industry leader providing technical services to broadcast and cable television networks. The Broadcasting segment also includes Group W's program production and distribution business, Group W Productions, which supplies television series and special programs through national syndication to broadcast television stations and cable networks throughout the United States. Group W's broadcast stations have many competitors, both large and small, and compete principally on the basis of audience ratings, price and service. Group W's commercial broadcast television business experiences competition from cable television which provides program diversification in addition to improved reception. Broadcast television stations and cable television systems are also in competition in varying degrees with other communications and entertainment media, including movie theaters, videocassette distributors and over-the-air pay television. Due to the rapid pace of technological advancement, broadcast television stations can expect to face continued strong competition in the future. Still, after years of such intense competition, these broadcast television stations remain, by a wide margin, the dominant distributors of news and entertainment programming in their geographical markets. ELECTRONIC SYSTEMS Electronic Systems is a world leader in the research, development, production and support of advanced electronic systems for defense, government, and commercial customers. Products provided to the Department of Defense (DoD) and foreign governments include surveillance and fire control radars, command and control systems, electronic countermeasures equipment, electro-optical systems, satellite-based sensors, missile launching and handling equipment, marine propulsion systems, torpedoes, anti-submarine warfare systems and communications equipment. Purchases by DoD, directly and through subcontractors, accounted for 70% of Electronic Systems' sales in 1993. In 1991, Electronic Systems' DoD business began to experience a shift from high margin production to lower margin development programs. These high priority development programs, such as the Air Force Advanced Tactical Fighter and Army Comanche Helicopter, are expected to transition to high margin production in the late '90s. The termination of the Airborne Self Protection Jammer and reduced torpedo production options will impact near-term sales. Electronic Systems is pursuing growth of its core businesses and expansion of its DoD product and customer base. Strong growth opportunities also exist internationally for capitalizing on strong product positions in markets such as air traffic control and airborne sensor systems. Electronic Systems has been successful in using its technology leadership position to develop a broad spectrum of electronic products for domestic and international markets. International sales were 18% of Electronic Systems' total sales in 1993 and its products have a presence in over 100 countries. In general, sales to the United States government and foreign military sales through the United States government, are subject to termination procedures prescribed by statute. Government contracts vary from fixed-price contracts on production programs and some development programs, to cost-type contracts on development activities. Reliability, performance and competitive costs are the main criteria in the award of contracts of this type. This segment's business is influenced by changes in the budgetary plans and procurement policies of the United States government, as well as changes in its diplomatic posture. This segment encounters significant competition, primarily from large electronics companies, on the basis of technology, price, service, warranty and product performance. On any DoD weapons system platform, Electronic Systems might be a prime bidder, or teamed or in competition with any one of the major aerospace companies doing business within the United States or allied countries. ENVIRONMENTAL The Westinghouse Government & Environmental Services Company includes Environmental Services, the management of certain government-owned facilities and the U.S. naval nuclear reactors programs. Environmental Services provides a variety of environmental remediation and toxic, hazardous and radioactive waste treatment services. Through Aptus, Inc., the Corporation offers toxic and hazardous waste incineration, treatment, transportation, storage and analysis services. Facilities performing these services are located in Kansas, Utah and Minnesota. Westinghouse Remediation Services, Inc. provides comprehensive toxic and hazardous waste remediation services, including mobile, on-site environmental treatment technologies. The Scientific Ecology Group, Inc. offers a broad range of on-and off-site services to manage radioactive materials and mixed wastes, including the only commercially-licensed radioactive waste incinerator and the only recycling facility for radioactively contaminated metals in the United States. Through subsidiaries, Resource Energy Systems operates four waste-to-energy plants that convert municipal solid waste into clean electrical energy. Controlmatic, a group of affiliated indirect subsidiaries having principal operations in Germany, Switzerland, Austria and Italy, offers products and services relating to control, monitoring and industrial automation and instrumentation. Through the Westinghouse Savannah River Company and certain subsidiaries and divisions of Westinghouse Government & Environmental Services Company, the Corporation manages five government-owned facilities under contracts with the United States Department of Energy (DoE). These DoE facilities are involved in the production of uranium metal products, fuel reprocessing, nuclear waste disposal and environmental restoration. The mission at the defense facilities has been evolving in recent years to waste management and environmental cleanup. These businesses are under contracts with the federal government, which reserves the right to terminate these contracts for convenience. The U.S. naval nuclear reactors programs consist of the Corporation's Navy nuclear and technical support businesses. These businesses include the Bettis Atomic Power Laboratory, the Plant Apparatus Division, Machinery Apparatus Operation and the Machinery Technology Division, which provides technical engineering services to the Naval Sea Systems Command. Certain businesses within this segment have been identified for sale in connection with the Corporation's planned disposition of certain non-strategic businesses announced in January 1994. See Management's Discussion and Analysis--Restructuring and Other Actions included in Part II, Item 7 of this report. Competition for services provided by businesses in the Environmental segment is based on price, technology preference, environmental experience, performance reputation and, with respect to certain businesses, availability of permitted treatment or disposal facilities. INDUSTRIES The Industries segment is comprised of the transport temperature control business and the Industrial Products and Services business unit. Thermo King Corporation (Thermo King), the world leader in its primary businesses, manufactures a complete line of transport temperature control equipment, including units for trucks, truck trailers, container ships, buses and railway cars and service parts to support these units. The transport refrigeration units are powered by diesel fuel, gasoline, propane or electricity. Thermo King maintains international manufacturing facilities in Ireland, Brazil, Spain, the Dominican Republic, the United Kingdom, the Czech Republic and the People's Republic of China. It has dealerships throughout the world, and its equipment is used in virtually every country. Industrial Products and Services is a diverse group of businesses located primarily in the United States, providing products and services to commercial, industrial, utility, and government customers. These products and services include: wide area and local area voice and data communications services; watches; process rectifiers and associated renewal parts, electro-mechanical parts, and maintenance and repair of continuous casting machines within the steel industry; copper rod and magnet wire, liquid insulation and resins, and flexible insulation; decorative and industrial high-pressure laminates; large industrial motors; and commercial printing. Certain businesses within this business unit have been identified for sale in connection with the Corporation's planned disposition of certain non-strategic businesses announced in January 1994. See Management's Discussion and Analysis--Restructuring and Other Actions included in Part II, Item 7 of this report. Thermo King is subject to competition worldwide for all of its products. Its products compete on the basis of service, technology, warranty, product performance, and cost. In addition, Thermo King's customers and end users are concerned about environmental issues, especially chloroflourocarbons, noise pollution and engine emissions. Thermo King designs its products to meet or exceed all environmental requirements. Industry Products and Services competes in local geographic markets based on price, performance reputation, technology preference and experience. POWER SYSTEMS The Power Systems segment includes the Power Generation and Energy Systems business units which serve the worldwide market for electrical power generation. The Power Generation business unit designs, manufactures and services steam turbine-generators for commercial nuclear and fossil-fueled power plants, as well as combustion turbine-generators for natural gas and oil-fired power plants. In addition to serving the regulated electric utility industry, the business unit supplies, services and operates power plants for independent power producers and other non-utility customers. Growing demand for electrical energy has contributed to the business unit's growth. In 1993, the business unit was awarded orders for approximately 3,200 megawatts of new power generating capacity. The domestic market for new generating equipment from 1994 through the year 2002 is approximately 132 gigawatts; the international market is expected to be over five times the size of the domestic market. With more than 2,800 operating units worldwide based on Westinghouse power generation technology, the business unit has a substantial service business. The Power Generation business unit is a participant in the development of emerging technologies which could shape the future of power generation and place the business unit in a strong position for continued growth. The Energy Systems business unit primarily serves the worldwide nuclear energy market. It also designs and develops solar-based energy systems and process control systems for nuclear and fossil-fueled power plants and industrial facilities. About 40% of the world's operating commercial nuclear power plants incorporate Westinghouse technology. With virtually all of Westinghouse's worldwide nuclear power plant projects now in operation, the business unit focuses on supplying a wide range of operating plant services, ranging from performance-based maintenance programs to new products and services that enhance plant performance. The business unit also has complete capabilities for supplying customers with nuclear fuel. The annual market for operating plant services and fuel is over $10 billion in the United States and $30 billion globally. The business unit is also working with government agencies and industry leaders to revitalize the nuclear energy option, and is developing a simplified nuclear power plant design that incorporates passive safety systems. The Power Generation and Energy Systems business units have a number of domestic and foreign competitors in the electric utility industry where Westinghouse is recognized as a significant supplier. Positive factors with respect to competitive position are technology, service and worldwide presence. Negative factors are an increasing number of foreign competitors and small competitors, particularly in the service area. The principal methods of competition are technology, product performance, customer service, pricing and financing. KNOLL The Knoll Group is comprised of the Corporation's office furniture businesses. Knoll provides a wide range of furniture products ranging from designer-oriented individual pieces to systems designed to improve work environments and contribute to productivity. Products include individually hand-crafted furniture, executive furniture, general office furniture, furniture-grade textiles, office accessories and furniture systems. Knoll is subject to a high degree of competition (including price, service, design and product performance) for sales of products to the interior design, construction, industrial and consumer markets from both large and small competitors. WCI WCI develops land into master planned luxury communities located primarily in Florida and California. Among WCI's major community developments are Coral Springs, Parkland, Bermuda Bay, Pelican Bay, Pelican Marsh, Pelican Landing, Gateway and Bay Colony, all in Florida, Tortolita Mountain Properties in Arizona and Bighorn in Palm Springs, California. DISCONTINUED OPERATIONS Discontinued Operations consists of Financial Services and Other Operations. Other Operations is comprised of DCBU and WESCO. FINANCIAL SERVICES Financial Services was comprised primarily of WCC and WSAV, WFSI and the Corporation's leasing portfolio. WSAV sold Westinghouse Federal Bank, whose assets represented the substantial majority of WSAV's assets, in January 1993. On May 3, 1993, WFSI and WCC were merged into Westinghouse and, as a consequence, ceased to exist as separate legal entities and their debt was assumed by the Corporation. This merger gave management greater flexibility to liquidate the assets of Financial Services and execute the strategy of exiting the financial services business. During 1993, Financial Services disposed of assets ahead of schedule at prices more favorable than anticipated in the Plan. Financial Services disposed of real estate, corporate and leasing assets for approximately $4,150 million in cash during 1993, and significantly reduced debt. These dispositions included the sale of over half of the commercial real estate portfolio to LW Real Estate Investments, L.P. (LW) in several transactions. LW was formed in April 1993 between Westinghouse, the limited partner, and an affiliate of Lehman Brothers, an investment banking firm. The Lehman Brothers affiliate is the general partner. At December 31, 1993, the Corporation had a 44% limited partnership interest in LW. Financial Services portfolio investments are comprised of the remaining real estate and corporate assets, and the Corporation's leasing portfolio, which is expected to run-off in accordance with contractual terms. The remaining real estate assets are primarily comprised of real estate properties, receivables and the Corporation's investment in LW. The Corporation expects a significant portion of its investment in LW to be liquidated during 1994 and the remaining real estate assets by the end of 1995. The remaining corporate assets are expected to be liquidated during 1994. DISTRIBUTION AND CONTROL On August 11, 1993, the Corporation announced an agreement to sell the majority of DCBU to Eaton Corporation for a purchase price of $1.1 billion and the assumption by the buyer of certain liabilities. The Corporation completed this sale on January 31, 1994. WESTINGHOUSE ELECTRIC SUPPLY COMPANY On February 16, 1994, the Corporation announced an agreement to sell WESCO to an affiliate of Clayton Dubilier & Rice, Inc., a private investment firm, for a purchase price of approximately $340 million. The Corporation completed this sale on February 28, 1994. RAW MATERIALS The Corporation has experienced no significant difficulty with respect to sources and availability of raw materials essential to the business. PATENTS Westinghouse owns or is licensed under a large number of patents and patent applications in the United States and other countries that, taken together, are of material importance to its business. Such patent rights are, in the judgment of the Corporation, adequate for the conduct of its business. None of its important products, however, are covered by exclusive controlling patent rights that preclude the manufacture of competitive products by others. BACKLOG The backlog of firm orders of the Corporation from Continuing Operations was $9,925 million at the end of 1993 and $9,617 million at the end of 1992, excluding amounts associated with uranium supply contract settlements. Of the 1993 backlog, $5,686 million is expected to be liquidated after 1994. In addition to the reported backlog, the Corporation provides certain non-Westinghouse products primarily for nuclear steam supply systems customers. Backlog for the Corporation is as follows: Electronic Systems backlog at year-end 1993 and 1992 was $3,841 million and $3,969 million. Backlog of $2,118 million is expected to be liquidated after 1994. Environmental backlog at year-end 1993 and 1992 was $797 million and $778 million. Backlog of $645 million is expected to be liquidated after 1994. Industries backlog at year-end 1993 and 1992 was $215 million and $196 million. Backlog of $36 million is expected to be liquidated after 1994. Power Systems backlog at year-end 1993 and 1992 was $4,901 million and $4,518 million. Backlog of $2,850 million is expected to be liquidated after 1994. Knoll backlog at year-end 1993 and 1992 was $108 million and $106 million. Backlog of $24 million is expected to be liquidated after 1994. Also included in backlog at year-end of 1993 and 1992 was $63 million and $50 million attributable to Corporate-Other, of which $13 million is expected to be liquidated after 1994. ENVIRONMENTAL MATTERS Information with respect to Environmental Matters is incorporated herein by reference to Management's Discussion and Analysis--Environmental Matters included in Part II, Item 7 and note 17 to the financial statements included in Part II, Item 8 of this report. RESEARCH AND DEVELOPMENT Data with respect to research and development is incorporated herein by reference to note 21 to the financial statements included in Part II, Item 8 of this report. EMPLOYEE RELATIONS During 1993, Westinghouse employed an average of 103,063 people of whom approximately 79,000 were located in the United States. During the same period, approximately 14,000 domestic employees were represented in collective bargaining by 24 labor organizations. Two-thirds of these represented employees were represented by unions that are affiliated with, and/or bargain in conjunction with, one of three national unions, namely, the International Brotherhood of Electrical Workers, International Union of Electronic, Electrical, Salaried, Machine and Furniture Workers and the Federation of Independent Salaried Unions. The current three-year agreements for these national unions which were negotiated in August 1991 expire on August 27, 1994. The current agreements provide a balanced and competitive package of pay and benefits which were particularly well suited for Westinghouse and its employees. In 1994 negotiations, management will place particular emphasis on achieving an economic settlement and other provisions that are appropriate for and supportive of current business conditions. At December 31, 1993, the Corporation employed 101,654 people, of which 16,812 were employees of DCBU and WESCO. The Corporation completed the sales of DCBU and WESCO in January 1994 and February 1994, respectively. FOREIGN AND DOMESTIC OPERATIONS Data with respect to foreign and domestic operations and export sales is incorporated herein by reference to note 21 to the financial statements included in Part II, Item 8 of this report. ITEM 2. ITEM 2. PROPERTIES. At December 31, 1993, Westinghouse Continuing Operations owned or leased 791 locations totalling 40 million square feet of floor area in the United States and 32 foreign countries. Domestic operations of Continuing Operations comprised approximately 84% of the total space. Facilities leased in the United States accounted for approximately 23% of the total space occupied by Continuing Operations and facilities leased in foreign countries accounted for approximately 7% of the total space occupied by Continuing Operations. No individual lease was material. A number of manufacturing plants and other facilities formerly used in operations are either vacant, partially utilized, or leased to others. All of these plants are expected to be sold, leased, or otherwise utilized. Except for these facilities, the Corporation's physical properties are adequate and suitable, with an appropriate level of utilization, for the conduct of its business in the future. ITEM 3. ITEM 3. LEGAL PROCEEDINGS. (a) On December 1, 1988, the Republic of the Philippines (Republic) and National Power Corporation (NPC) filed a lawsuit in the United States District Court (USDC) for the District of New Jersey asserting claims against the Corporation, Westinghouse International Projects Company and Burns and Roe Enterprises, Inc. (Burns and Roe) relating to a contract between NPC and Westinghouse for the construction of a nuclear power plant in the Philippines as well as an earlier consulting contract between NPC and Burns and Roe relating to the same project. This action seeks recision of the Westinghouse and Burns and Roe contracts and restitution of all money and other property paid to Westinghouse and Burns and Roe or, alternatively, reformation of the NPC-Westinghouse contract. Plaintiffs requested compensatory, punitive and treble damages, costs and expenses of the lawsuit, and such other relief as the USDC deems just and proper. The complaint alleges, among other things, bribery and other fraudulent conduct, tortious interference with the fiduciary duty owed by Ferdinand E. Marcos to the Republic and the people of the Philippines, common law fraud, and violations of various New Jersey and federal statutes, including the Federal Racketeer Influenced and Corrupt Organizations Act (RICO) statute. Plaintiffs demanded a jury trial. Also on December 1, 1988, Westinghouse filed a request for arbitration with the International Chamber of Commerce Court of Arbitration (ICC) pursuant to the NPC-Westinghouse contract, setting forth certain claims Westinghouse has against NPC and the Republic and asking for arbitration of the anticipated claims of the Republic and NPC related to the Philippines nuclear power plant. The Republic and NPC challenged the jurisdiction of the ICC, arguing that the contract between the parties, including its arbitration provision, was invalid due to alleged bribery in the procurement of the contract. In December 1991, the ICC arbitration panel issued its award finding that the Republic and NPC had failed to carry their burden of proving the alleged bribery by the Corporation. The panel thereby concluded that the arbitration clause and contract were valid and that the panel has jurisdiction over the remaining disputes between NPC and the Corporation. In January 1992, NPC filed an action for annulment of the award by the ICC arbitration panel in the Swiss Federal Supreme Court. In September 1993, the Swiss Federal Supreme Court issued an order dismissing NPC's annulment action and assessing cost against NPC. Arbitration before the ICC is ongoing. An evidentiary hearing is scheduled to begin in the first quarter of 1994, and a final award is anticipated before the end of 1994. With respect to the suit filed in the USDC, Westinghouse filed a motion requesting that the action filed there be stayed in its entirety pending arbitration of the Republic's claims. In 1989, the Court granted a motion brought by the Corporation and ordered 14 of the 15 counts in the lawsuit stayed pending arbitration. The Court retained jurisdiction over the remaining count involving an alleged intentional interference with a fiduciary relationship. Trial commenced with respect to this one count in March 1993. In May 1993, a jury verdict was rendered in favor of the Corporation with respect to all claims relating to the alleged intentional interference with a fiduciary relationship. NPC and the Republic have indicated that they intend to appeal this decision. (b) Duke Power Company (Duke) filed a lawsuit against the Corporation in March 1990 in the USDC for the District of South Carolina, Charleston Division, for an unspecified amount of damages, including treble and punitive damages, based on 1970 and 1975 contracts for Westinghouse's supply of nuclear steam supply systems at Duke's McGuire and Catawba plants. Subsequently, Duke disclosed that it is seeking approximately $655 million for estimated past and future damages for the four nuclear steam supply systems. Duke asserted counts for negligence, promissory estoppel, fraud, negligent misrepresentation, violation of the RICO statute, and violation of North Carolina and South Carolina unfair trade practices statutes, and alleged that the steam generators delivered by the Corporation were defectively designed and manufactured. Alleged co-owners of the plants intervened in the litigation as additional plaintiffs. In February 1993, the USDC granted the Corporation's motion to dismiss Duke's negligent misrepresentation, negligent design and fabrication claims and portions of its RICO claims. A motion to dismiss the remaining counts is pending. Trial is scheduled for March 14, 1994. (c) In March 1990, South Carolina Electric and Gas (SCE&G) filed a lawsuit against the Corporation in the USDC for the District of South Carolina, Charleston Division, for an unspecified amount of damages, including treble and punitive damages, based on a 1970 contract for the Corporation's supply of a nuclear steam supply system at the Summer plant. Subsequently, plaintiff disclosed that it is seeking approximately $175 million for past damages and for estimated future replacement of the nuclear supply system. SCE&G asserted counts for breach of warranty, breach of contract, negligence, negligent misrepresentation, promissory estoppel, fraud, violation of the RICO statute and violation of a South Carolina unfair trade practices statute. SCE&G alleged that the steam generators delivered by the Corporation were defectively designed and manufactured. In February 1993, the court granted the Corporation's motion to dismiss with respect to SCE&G's negligent misrepresentation, negligent design and fabrication claim and portions of its RICO claims. On January 12, 1994, the Corporation and SCE&G entered into a settlement agreement resolving all claims asserted in this action and entered into a stipulated order dismissing the action with prejudice. (d) In October 1990, Commonwealth Edison Company (Commonwealth Edison) filed a lawsuit against the Corporation and four individual defendants (all employees of the Corporation or a Corporation subsidiary company) in Circuit Court in Cook County, Illinois, for an unspecified amount of damages, including treble and punitive damages, based on the Corporation's supply of nuclear steam supply systems for Commonwealth Edison's Zion, Byron and Braidwood plants. The complaint sets forth counts of common law fraud against the Corporation and the employees, and violation of the Illinois Consumer Fraud and Deceptive Practices Act and violations of the RICO statute against the Corporation. In November 1991 Commonwealth Edison dismissed the individual defendants and the parties are currently engaged in discovery. (e) In October 1990, Houston Lighting and Power Company and its co-owners filed a lawsuit against the Corporation and two individual defendants (one current and one retired employee of the Corporation) in the District Court of Matagorda County, Texas, for an unspecified amount of damages. The claims arise out of the Corporation's supply of nuclear steam supply systems for the South Texas Project. The petition alleges breach of contract warranty, misrepresentation, negligent misrepresentation and violation of the Texas Deceptive Trade Practices Act. Plaintiffs later alleged $14 million plus, for past damages. In January 1991, the parties reached agreement to dismiss the individual defendants and to stay the litigation for the purpose of discussing resolution of the issues between them. In November 1991, however, the plaintiffs gave notice that they were activating the litigation. In March 1993, plaintiffs filed an amended complaint seeking an unspecified amount of future damages for replacement of the steam generator. The parties are continuing discovery and a trial date is set for the third quarter of 1994. (f) In April 1991, Duquesne Light Company (Duquesne) and its co-owners filed a lawsuit against the Corporation in the USDC for the Western District of Pennsylvania for an undetermined amount of damages, including treble and punitive damages. Subsequently Duquesne disclosed that it is seeking approximately $320 million in damages. The claims arise out of the Corporation's supply of nuclear steam supply systems for the Beaver Valley plants. Duquesne asserts counts for breach of contract, fraud, negligent misrepresentation, and violations of the RICO statute. Pre-trial statements have been filed by all parties and this case could go to trial in 1994. (g) In February 1993, Portland General Electric Company (Portland) filed a lawsuit against the Corporation in the USDC for the Western District of Pennsylvania seeking unspecified damages based on claims for breach of contract, negligence, fraud, negligent misrepresentation, and violations of the RICO statute and the Oregon RICO statute relating to the Corporation's design, manufacture and installation of steam generators at the Trojan Nuclear Plant, an electric generating facility located in Ranier, Oregon. Portland also seeks a declaratory judgment that the steam generators are defective and that the Corporation is liable to plaintiff for expenses, including replacement power, incurred as a result of the alleged defects. In April 1993, Portland filed a motion to consolidate its case with a similar action filed by The Eugene Water & Electric Board relating to the Trojan Nuclear Plant. This motion was subsequently granted. In June 1993, the court granted the Corporation's motion to dismiss plaintiff's claims for negligence and negligent misrepresentation. The court also dismissed, in part, the plaintiff's claims under Section 1962(b) of the federal RICO statute relating to the Trojan project enterprise. The parties continue to engage in discovery. This case could go to trial in 1994. (h) In February 1993, the City of Eugene, Oregon, acting by and through The Eugene Water & Electric Board (the Board), filed a lawsuit against the Corporation in the USDC for the District of Oregon seeking unspecified damages based on claims for breach of contract, negligence, fraud, negligent misrepresentation, and violations of the RICO statute and the Oregon RICO statute relating to the Corporation's design, manufacture and installation of steam generators at the Trojan Nuclear Plant, an electric generating facility located in Ranier, Oregon. The Board is a 30% owner of the Trojan Nuclear Plant. The Board also seeks a declaratory judgment that the steam generators are defective and that the Corporation is liable to plaintiff for expenses incurred as a result of the alleged defects. Also in February 1993, the Board filed a motion to change venue from the USDC for the District of Oregon to the USDC for the Western District of Pennsylvania. The Board's motion was subsequently granted. This case was consolidated with the Portland case described in item (g) above. The parties in both actions are seeking total damages of approximately $350 million. In June 1993, the court granted the Corporation's motion to dismiss plaintiff's claims for negligence and negligent misrepresentation. The court also dismissed, in part, the plaintiff's claims under Section 1962(b) of the federal RICO statute relating to the Trojan project enterprise. The parties continue to engage in discovery. This case could go to trial in 1994. (i) In July 1993, Northern States Power Company (NSP) filed a lawsuit against the Corporation in the USDC for the District of Minnesota for an unspecified amount of damages, including treble and punitive damages, based on the Corporation's supply of steam generators at NSP's Prairie Island Nuclear Plant. The complaint sets forth counts for breach of contract, fraud, negligent misrepresentation, violations of RICO and violations of the Minnesota Prevention of Consumer Fraud Act. (j) In August 1988, the Pennsylvania Department of Environmental Resources (DER) filed a complaint against the Corporation alleging violations of the Pennsylvania Clean Streams Law at the Corporation's Gettysburg, Pennsylvania, elevator plant. The DER requested that the Environmental Hearing Board assess a penalty in the amount of $9 million. The Corporation has denied these allegations. The parties completed discovery and a portion of the hearing on the complaint began in 1991. The hearing resumed in 1992 and concluded in February 1993. All post-trial briefs have been filed and the parties await a decision. (k) The Corporation has been defending a consolidated class action, a consolidated derivative action and certain individual lawsuits that have been brought by shareholders of the Corporation against the Corporation, WFSI and WCC, previously subsidiaries of the Corporation and/or certain present and former directors and officers of the Corporation, as well as other unrelated parties. Together, these actions allege various federal securities law and common law violations arising out of alleged misstatements or omissions contained in the Corporation's public filings concerning the financial condition of the Corporation, WFSI and WCC in connection with a $975 million charge to earnings announced on February 27, 1991, a public offering of Westinghouse common stock in May 1991, a $1,680 million charge to earnings announced on October 7, 1991, and alleged misrepresentations regarding the adequacy of internal controls at the Corporation, WFSI and WCC. In July 1993, the USDC for the Western District of Pennsylvania dismissed in its entirety the derivative claim and dismissed most of the class action claims set forth above, with leave to replead both actions. In August 1993, the plaintiffs refiled, in its entirety, the derivative action. In September 1993, the plaintiffs refiled all dismissed claims in the class-action suit. In September 1993, the Corporation moved to strike and dismiss the refiled derivative action. In December 1993, the Corporation filed a motion to dismiss the refiled class action claims. The parties await a decision on both motions. (l) In June 1990, a suit was filed against WCC in the USDC for the Western District of Missouri by three affiliated entities (collectively American Carriers) for the alleged breach of a commitment letter issued by WCC to lend up to $65 million to American Carriers. American Carriers claims the alleged breach caused it to file bankruptcy. The complaint alleged counts for breach of contract, breach of implied duty of good faith, promissory estoppel and negligent misrepresentation, and sought compensatory and punitive damages. By agreement of the parties, in January 1992, the action in the USDC was dismissed and an action was filed in the Circuit Court of Jackson County, Missouri with substantially the same claims made, except allegations relating to negligent misrepresentation and punitive damages were dropped by stipulation of the parties. WCC counterclaimed alleging, among other things, fraud in the inducement, which if proven would defeat plaintiffs' claims in their entirety. In February 1993, the jury in this case returned a verdict in favor of the plaintiffs in the amount of $70 million. In April 1993, the Corporation appealed the decision of the court. A decision on the appeal is expected soon. (m) In February 1993, the Corporation was sued by 108 former employees who were laid off subsequent to the cancellation by the federal government of all contracts pertaining to the carrier based A-12 aircraft program. The complaint alleges age discrimination on the part of the Corporation. The suit was filed in the USDC for the District of Maryland. The plaintiffs seek back pay with benefits and reinstatement of jobs or front pay. Also, in April 1993, the Equal Employment Opportunity Commission (EEOC) filed a class-action, age discrimination suit against Westinghouse in the USDC for the District of Maryland on behalf of 388 former Westinghouse employees who were laid off or involuntarily terminated from employment subsequent to the federal government's cancellation of all contracts pertaining to the carrier based A-12 aircraft program. The suit alleges age discrimination and discriminatory employment practices. The suit seeks back pay, interest, liquidated damages, reinstatement of jobs, court costs and other appropriate relief. These two cases have been consolidated by the court. Presently, the EEOC is reviewing various discrimination charges relating to other involuntary terminations which have occurred at the Corporation's Electronic Systems business unit. In October 1993, EEOC issued a determination letter regarding age discrimination associated with certain layoffs at the Corporation's Electronic Systems business unit. The letter invited the Corporation to conciliate the issues. If the conciliation is unsuccessful, the EEOC may file another lawsuit in federal court. (n) Beginning in early 1990 and continuing into 1993, numerous asbestos lawsuits have been filed against the Corporation and numerous other defendants in the Circuit Court of Jackson County, Mississippi. The plaintiffs allege personal injury, wrongful death and loss of consortium claims arising out of exposure to products containing asbestos that were manufactured, supplied or installed by the defendants. In April 1993, trial commenced in the Circuit Court with respect to the claims of nine plaintiffs against a number of defendants, including the Corporation. In August 1993, a jury awarded a verdict in favor of five of the plaintiffs against the Corporation and certain other defendants and awarded a defense verdict in favor of the Corporation against the four other plaintiffs. The jury found Westinghouse approximately 38% liable on the aggregate damage verdict of some $8.75 million awarded the five plaintiffs, with punitive damages at 10% of compensatory damages. The Corporation is entitled to offsets on these verdicts from settlements previously paid by certain defendants and will also apply its insurance coverage to these verdicts. The judge has previously ruled that the jury's findings on certain questions may apply to approximately 6,400 other cases pending which, however, would still have to be tried on issues of exposure, causation and the amount of compensatory damages, if any. The Corporation, along with the other defendants who were found liable, have filed post-trial motions seeking a judgment notwithstanding the verdict on a new trial. The Corporation intends to appeal if the court denies its post-trial motions. (o) The Corporation is currently a defendant in approximately 7,400 out of more than 12,000 asbestos cases pending in the Circuit Court of Kanawha County, West Virginia. The plaintiffs allege personal injury, wrongful death and loss of consortium claims arising out of alleged exposure to asbestos-containing products that were manufactured, supplied or installed by the defendants, including the Corporation. On March 24 1994, a trial is scheduled to begin on the plaintiffs' claims generally, although no individual plaintiffs will be asserting their claims at that time. Rather, the trial will focus on whether the various defendants' asbestos-containing products were hazardous, and whether the defendants had and/or breached a duty to warn of the alleged hazards associated with those products. The trial will also determine whether the defendants are liable for punitive damages arising from a failure to warn of alleged hazards associated with their asbestos-containing products. The findings made in this phase of trial regarding "duty to warn" and punitive damages may be applied in future trials involving the individual plaintiffs. (p) The Corporation is a direct defendant in approximately 527 of 2,100 consolidated cases alleging personal injury, wrongful death and loss of consortium claims arising from exposure to asbestos-containing products manufactured, supplied or installed by various defendants, including the Corporation. Although pending in Baltimore County Circuit Court, Westinghouse has removed 508 of the cases to Federal Court, and has thus far successfully defended plaintiffs' attempts to remand the cases to state court. If the cases are remanded, they will become part of a trial scheduled for March 1994, which will adjudicate all issues raised by the claims of ten representative plaintiffs, including the issue of punitive damages. Certain findings made with respect to the representative plaintiffs will be applied to future trials of the remaining plaintiffs. The March 1994 trial will also address cross-claims and third-party claims filed by various defendants against the Corporation in an earlier consolidated proceeding in which the Corporation was not a direct defendant. (q) On March 10, 1993, the State of Washington Department of Ecology issued to the DoE and to Westinghouse Hanford Company (WHC) an administrative penalty in the amount of $100,000 for violation of the Washington Dangerous Waste regulations. Specifically, the penalty was assessed for failure to designate certain waste at the tank farms at the DoE's Hanford, Washington facility, which is managed by WHC. On November 1, 1993, the parties agreed to fund certain projects in lieu of paying this amount directly to the State. The Corporation believes that the penalty will be an allowable cost under WHC's contract with the DoE. (r) A description of the derivative litigation involving certain of the Corporation's current and past directors is incorporated herein by reference to "Litigation Involving Derivative Claims Against Directors" in the Proxy Statement. Management believes that the Corporation has meritorious defenses to all of the proceedings described above. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. None during the fourth quarter of 1993. EXECUTIVE OFFICERS The name, offices, and positions held during the past five years by each of the executive officers of the Corporation as of March 1, 1994 are listed below. Officers are elected annually. There are no family relationships among any of the executive officers of the Corporation. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. The principal markets for the Corporation's common stock are identified on page 1 of this report. The remaining information required by this item appears on page 58 of this report and is incorporated herein by reference. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA. The information required by this item appears on page 58 of this 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 on pages 16 through 28 of this report and is incorporated herein by reference. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. The information required by this item, together with the report of Price Waterhouse dated January 26, 1994, except as to the matter discussed in paragraph 9 of note 2 which is as of February 28, 1994, appears on pages 29 through 57 of this report and is incorporated herein by reference. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. None. FINANCIAL REVIEW MANAGEMENT'S DISCUSSION AND ANALYSIS OVERVIEW In November 1992, the Corporation adopted a plan which included the disposition of Distribution and Control Business Unit (DCBU), Westinghouse Electric Supply Company (WESCO) and exiting Financial Services. These businesses comprise the Corporation's Discontinued Operations. The Corporation's Continuing Operations consist of its Broadcasting, Electronic Systems, Environmental, Transport Temperature Control and Power Systems businesses, as well as The Knoll Group (Knoll), its furniture business, and WCI Communities, Inc. (WCI). The Corporation reported a net loss of $326 million, or $1.07 per share, for 1993. Net losses in 1992 and 1991 were $1,394 million and $1,086 million, or $4.11 and $3.46 per share, respectively. Included in 1993 results was a pre-tax provision of $750 million for restructuring, the disposition of certain non-strategic businesses and certain litigation and environmental contingencies. The 1993 results also included an after-tax charge of $95 million for Discontinued Operations to reflect management's current estimates of proceeds and costs associated with the plan adopted in November 1992. See notes 1 and 2 to the financial statements for a description of the plan. Included in 1992 results was an after-tax charge of $1,383 million to record the estimated loss on disposal of Discontinued Operations. See note 2 to the financial statements. The Corporation reported a loss from Continuing Operations of $175 million or $.64 per share for 1993. Excluding the pre-tax provision of $750 million recorded in the fourth quarter of 1993, income from Continuing Operations was $318 million or $.76 per share. Income from Continuing Operations was $357 million or $.95 per share for 1992 and $335 million or $1.07 per share for 1991. The loss from Discontinued Operations was $95 million or $.27 per share in 1993, $1,413 million or $4.08 per share in 1992 and $1,421 million or $4.53 per share in 1991. Included in 1993 results is the adoption, retroactive to January 1, 1993, of Statement of Financial Accounting Standards (SFAS) No. 112, "Employers' Accounting for Postemployment Benefits," which resulted in an after-tax charge of $56 million or $.16 per share. The Corporation's results for the first quarter of 1993 have been restated to reflect the implementation of SFAS No. 112. See notes 1 and 4 to the financial statements. The Corporation's 1992 results included the adoption of SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," concurrent with the adoption of SFAS No. 109, "Accounting for Income Taxes," which resulted in a net charge of $338 million or $.98 per share. See notes 1, 4, and 5 to the financial statements. The 1991 results included a pre-tax valuation provision at Financial Services of $1,680 million and a $160 million pre-tax charge for a corporate-wide workforce reduction, $22 million of which related to Discontinued Operations. In 1992, a $36 million pre-tax charge for corporate restructuring was recorded in Continuing Operations in connection with the November 1992 plan. The Corporation's goals during 1994 include improving the operating performance of the continuing businesses, continuing to pay down debt, rebuilding equity, and accelerating the pursuit of international opportunities by certain of its businesses. Operating profit and results of operations will, however, continue to be negatively impacted in 1994 by interest and litigation costs and increased pension expense. The Corporation's objective is to reduce these earnings constraints over the next several years. Sales for the first quarter of 1994 are expected to be down compared to the first quarter of 1993. Operating profit for the first quarter of 1994 is expected to be down approximately 10% compared to the same period of 1993, after considering the effects of higher pension expense and reduced licensee income in 1994, and a change in accounting for nuclear fuel revenues that favorably impacted the first quarter of 1993. The decline in the first quarter of 1994 operating profit is expected to be caused primarily by the nuclear energy business of the Power Systems segment and two businesses within the Environmental segment, Resource Energy Systems and Controlmatic, both scheduled to be sold. Reported earnings per share for the first quarter of 1994 are anticipated to be down approximately $.10 per share from the same period of 1993. RESTRUCTURING AND OTHER ACTIONS On January 11, 1994, the Corporation announced a restructuring of its continuing businesses, the disposition of certain non-strategic businesses and provisions for certain litigation and environmental contingencies. These actions resulted from an extensive review led by Chairman and Chief Executive Officer Michael Jordan of all of the Corporation's Continuing and Discontinued Operations and are designed to improve operating performance, accelerate the divestiture of non-strategic businesses and improve financial flexibility. The benefits of these actions are expected to be realized over the next several years. In addition to the charges resulting from restructuring and other actions, certain other charges were recorded related to Discontinued Operations and the adoption of SFAS No. 112. Restructuring of continuing businesses--$350 million: The $350 million charge includes costs directly related to employment reductions which are comprised of approximately $225 million related to separation costs for 3,400 employees, approximately $35 million associated with asset writedowns, and approximately $45 million for facility closedown and rationalization costs. The remaining portion of the $350 million charge is approximately $45 million related to asset writedowns for process and product redesign or reengineering. The Corporation anticipates that actions resulting from implementation of its restructuring plan, directed to improving productivity and operating performance, will result in the reduction of approximately 6,000 employees, which includes the previously- discussed 3,400 separations and an additional 2,600 reductions expected to result from normal attrition. The 3,400 employee separations that are included as part of the restructuring charge are expected to result in annual pre-tax savings of approximately $100 million primarily through reduced employment costs. A substantial portion of this annual savings is expected to be realized in 1994 and approximately $300 million over the next three-year period. Additional savings will be realized as the anticipated reductions resulting from normal attritions occur over the next two years. Total cash expenditures for restructuring over the next three years are expected to approximate $270 million with expenditures of approximately $180 million in 1994, $55 million in 1995 and $35 million in 1996. Net cash expenditures in excess of savings are expected to be funded through cash flows from operations of Continuing Operations. See Liquidity and Capital Resources--Other Actions. Disposition of non-strategic businesses--$215 million: The Corporation plans to dispose of certain non-strategic businesses including parts of the Environmental Services business unit and certain businesses in the Industrial Products and Services business unit. This charge includes all associated costs anticipated to be incurred in disposing of these businesses, including estimates for the cost of certain possible environmental remediation which may result from the selling process. Estimated sales proceeds for these businesses of approximately $175 million were determined from various sources, including offers contained in bona fide letters of interest received from third parties, estimates from investment banking firms retained by the Corporation or certain internal sources. Also included in the $215 million charge is approximately $20 million for the writedown of certain assets related to discontinued projects. Litigation provision--$125 million: As a result of a change in strategy with respect to certain litigation, the Corporation has determined to provide for the possible settlement of these matters when it is in the best interests of the Corporation and its shareholders. See Legal Matters for a description of certain pending litigation. Environmental provision--$60 million: The Corporation is a party to a 1985 Consent Decree to remediate toxic waste resulting from its former manufacturing operations in Bloomington, Indiana. In the Consent Decree, the Corporation agreed to construct and operate an incinerator, which would be permitted under federal and state law to burn excavated materials. Community opposition to the construction of the incinerator has continued. Further, the State of Indiana has enacted legislation that has resulted in indefinite delays in granting permits to construct and operate toxic waste incinerators. Finally, the parties to the Consent Decree have filed a status report with the court overseeing the Consent Decree which outlines a plan to investigate alternative remedial measures which would replace the incineration remedy. In light of these developments, the Corporation no longer believes that it is probable that the Consent Decree will be implemented under its present terms and has chosen to recognize and provide for what it has determined to be the most likely alternative environmental cleanup strategy if the Consent Decree is modified. Timing with respect to the expenditure of the $60 million is entirely dependent on the outcome of discussions between the parties and any resulting modifications to the Consent Decree. However, the Corporation believes that should a modification to the Consent Decree be agreed upon, the majority of these costs would be expended during the 1994 to 1996 time period. See also Environmental Matters. Estimated loss on disposal of Discontinued Operations-- $95 million, after-tax: In the fourth quarter of 1993, the Corporation recorded an additional provision for the estimated loss on disposal of Discontinued Operations of $95 million, after-tax. This change in the estimated loss resulted from additional information, obtained through negotiation activity, regarding the expected selling prices of WESCO and the Australian subsidiary of DCBU. Also contributing to this provision was a decision to bulk sell a Financial Services residential development that the Corporation, upon adoption of the November 1992 plan, had intended to transfer to WCI for development. These matters and a revision to the estimated interest costs expected to be incurred by the Discontinued Operations during the disposal period resulted in the additional fourth quarter provision. See note 2 to the financial statements. In January 1994, the Corporation announced that the planned sale of WCI will be accelerated from 1995 into 1994, and Knoll is no longer for sale. With respect to Knoll, the Corporation's strategy will now be directed to create shareholder value by continuing to operate this business. EQUITY AND DIVIDEND ACTIONS On January 11, 1994, the Corporation also announced its intention to take actions to rebuild its equity base. These actions include a reduction in the annual dividend on the Corporation's common stock from $.40 per share to $.20 per share and the issuance during 1994 of $700 million of new equity securities. Approximately $200 million of the equity securities, proceeds from the sale of such securities or a combination thereof, will be contributed to the Corporation's pension plans during 1994. As a result of the trend of declining long-term interest rates, the Corporation remeasured its pension obligation as of June 30, 1993 and December 31, 1993. SFAS No. 87, "Employers' Accounting for Pensions," requires that discount rates used to measure pension obligations reflect current and expected to be available interest rates on high quality fixed-income investments. The Corporation reduced its assumed discount rate from 9%, which was used at December 31, 1992, to 8% at June 30, 1993 and 7.25% at December 31, 1993. The Corporation also reduced its expected long-term rate of return on plan assets and the expected rate of increase in future compensation levels. See note 3 to the financial statements. These changes resulted in an increase in the Corporation's accumulated benefit obligation at June 30, 1993 and December 31, 1993 of $551 million and $389 million, respectively. Shareholders' equity was reduced after consideration of tax effects at June 30, 1993 and December 31, 1993 by $459 million and $260 million, respectively, or a total of $719 million for the year. RESULTS OF OPERATIONS--CONTINUING OPERATIONS In 1993, the Corporation's reporting segments were realigned to more closely reflect the ongoing businesses. Engineering and repair services, previously included in the Industries segment, have been transferred to the Power Systems segment, where these businesses have been consolidated with the power generation service organization. The Environmental segment now includes the U.S. naval nuclear reactors programs previously reported in Power Systems. The Longines-Wittnauer Watch Company and Westinghouse Communications have been transferred from the Broadcasting segment to the Industries segment as part of the Industrial Products and Services business unit. Segment information for 1992 and 1991 has been restated to reflect these changes. 1993 VERSUS 1992 The 1993 results for Continuing Operations included a $750 million charge for the restructuring and other actions announced on January 11, 1994 of which $555 million was charged to operating profit. The charges to operating profit were allocated to each of the Corporation's segments with the exception of the $60 million environmental provision which was included in Other. The 1992 results for Continuing Operations included a $36 million charge for corporate restructuring related to the previous strategy to sell Knoll and WCI. See Results of Operations--Discontinued Operations for a discussion of the November 1992 plan. Revenues for Broadcasting decreased 2% in 1993 compared to 1992 due to poor performance in a weak west coast television market and lower volume at Group W Productions, which was partially offset by stronger performance in radio and Group W Satellite Communications. In addition, 1992 benefitted from advertising revenues from the Olympics and political campaigns. Included in 1993 operating profit was $12 million of the charge for restructuring. Excluding that charge, operating profit decreased 7% in 1993 compared to 1992 due to lower revenues and an unfavorable mix of sales. Revenues for Electronic Systems decreased 9% in 1993 compared to 1992 due to lower revenues from Department of Defense (DoD) contracts and the 1992 divestitures of the Electrical Systems and Copper Laminates divisions. Included in 1993 operating profit was $136 million of the charge for restructuring. Included in 1992 operating profit was $35 million for a workforce reduction. Excluding the charges in both years, operating profit decreased 15% in 1993 compared to 1992 primarily due to the decrease in DoD revenues. Electronic Systems' business is influenced by changes in the budgetary plans and procurement policies of the U.S. government. Reductions in defense spending and program cancellations in recent years have adversely affected and are likely to continue to affect the results of this segment. DoD revenues are expected to be lower in 1994 than in 1993. However, the Corporation intends to maintain a strong focus on DoD opportunities and believes that it is well positioned, over the long-term, to benefit from the supply of advanced electronic systems to the United States and foreign governments. Revenues for Environmental decreased 10% in 1993 compared to 1992 due to lower volume and reduced prices in the remediation services and hazardous waste incineration businesses and the continued weak economic conditions in Europe. Included in 1993 operating profit was $32 million of the charge for restructuring and other actions. Excluding that charge, operating profit decreased 92% in 1993 compared to 1992 due to project cost overruns at a German subsidiary and the lower volume. Certain operations within this segment have been identified for sale. In addition, the Corporation is reviewing the remainder of the businesses in the Environmental segment to determine how best to reposition these businesses. The Corporation does not anticipate that the markets served by the businesses in the Environmental segment will improve in the near-term. Revenues for Industries increased 3% in 1993 compared to 1992. Thermo King's continued strong performance in North American truck and trailer and service parts was partially offset by its lower revenues in Europe, which continues to be impacted by a weak economy. Westinghouse Communications continues to experience revenue growth. Lower production and delayed deliveries contributed to lower revenues at Westinghouse Motor Company. Included in 1993 operating profit was $6 million of the charge for restructuring. Excluding that charge, operating profit increased 11% in 1993 compared to 1992 due to a favorable mix of sales and cost improvements, partially offset by the lower production and delayed deliveries at Westinghouse Motor Company. Certain operations within this segment have been identified for sale in connection with the Corporation's planned disposition of certain non-strategic businesses announced in January 1994. Revenues for Power Systems decreased 1% in 1993 compared to 1992 due to reduced shipments, lower sales in power generation services and projects partially offset by the recognition of revenues on a percentage of completion basis in the nuclear fuel business. Included in 1993 operating profit was $296 million of the charge for restructuring and other actions. Excluding that charge, operating profit decreased 8% in 1993 compared to 1992 due to the volume decreases, lower margin on power generation services and an unfavorable mix of power generation sales partially offset by the revenue recognition change in nuclear fuel. Revenues for Knoll decreased 12% in 1993 compared to 1992 due to lower shipments and reduced prices in the domestic market and poor economic conditions in Europe. Included in 1993 operating loss was $9 million of the charge for restructuring. Included in 1992 operating loss was $26 million of the charge for corporate restructuring related to the November 1992 plan. Excluding the charges in both years, the operating loss increased by $16 million due to the lower revenues. Revenues for WCI increased 8% in 1993 compared to 1992 as strong sales in South Florida were partially offset by the weak Southern California real estate market. Included in 1993 operating profit was $4 million of the charge for restructuring. Included in 1992 operating profit was $10 million of the charge for corporate restructuring related to the November 1992 plan. Excluding the charges in both years, the operating profit decreased 33% in 1993 compared to 1992 due to an unfavorable mix of sales. 1992 VERSUS 1991 The 1992 results for Continuing Operations included a $36 million charge for corporate restructuring related to the previous strategy to sell Knoll and WCI. The 1991 results for Continuing Operations included a charge of $138 million for the corporate-wide workforce reduction. Revenues for Broadcasting increased 2% in 1992 compared to 1991 primarily due to increased revenues in Group W Satellite Communications. Included in 1991 operating profit was $8 million of workforce reduction costs. Excluding that amount, operating profit increased 10% in 1992 compared to 1991 primarily due to cost reductions in television and radio and volume increases in Group W Satellite Communications. Revenues for Electronic Systems decreased 11% in 1992 compared to 1991 due to the termination settlement received in 1991 for the A-12 program cancellation, the 1992 divestitures of Electrical Systems and Copper Laminates divisions and lower DoD volume. In October 1992, Electronic Systems announced a workforce reduction to adjust for the DoD budget decline. Operating profit for 1992 included a $35 million charge for that workforce reduction, compared to a $69 million charge included in 1991 for the Electronic Systems portion of the corporate workforce reduction. Excluding the workforce reduction charges in both years, operating profit decreased 7% in 1992 compared to 1991 due to the lower DoD volume partially offset by cost improvements. Environmental revenues increased 8% in 1992 compared to 1991 due to increased volume in the incineration business. Included in 1991 was $9 million of workforce reduction costs. Excluding that amount, operating profit was up $71 million in 1992 compared to 1991 due to the absence of cost overruns in the waste-to-energy business, increased revenues in the incineration business and higher operating results at the government-owned facilities. Revenues for Industries increased 6% in 1992 compared to 1991 as higher revenues from a stronger domestic truck and trailer market were partially offset by lower revenues in industrial products and services, which continued to be impacted by weak markets. Included in 1991 operating profit was $8 million of workforce reduction costs. Excluding that amount, operating profit increased 1% in 1992 compared to 1991 as improvements in transport refrigeration were partially offset by continued weak performance in industrial products and services. Power Systems revenues increased 6% in 1992 compared to 1991 as power generation projects sales increased. These increases were partially offset by lower licensee income, reduced shipments of manufactured products and lower engineering and repair service revenues which continued to be impacted by weak markets. Included in 1991 operating profit was $29 million of workforce reduction costs. Excluding that amount, operating profit decreased 4% in 1992 compared to 1991 due to an unfavorable mix of products sold and lower engineering and repair revenues. Knoll revenues decreased 14% in 1992 compared to 1991 due to continued weak European markets and weak domestic demand for Knoll products. Included in 1992 operating loss was $26 million of the charge for corporate restructuring related to the November 1992 plan. Excluding that charge, the $14 million operating loss in 1992, compared to a $26 million operating profit in 1991, was due to reduced volume. WCI revenues decreased 9% in 1992 compared to 1991 due to lower levels of commercial and residential land sales. Included in 1992 operating profit was $10 million of the charge for corporate restructuring related to the November 1992 plan. Excluding that charge, operating profit decreased 20% in 1992 compared to 1991 due to lower volume and the shift from land to building sales. RESULTS OF OPERATIONS--DISCONTINUED OPERATIONS The Corporation adopted a plan in November 1992 (the Plan) to sell DCBU, WESCO (collectively, Other Operations), Knoll and WCI, exit the financial services business and pay down debt. The Corporation's financial services business (Financial Services) was comprised primarily of Westinghouse Credit Corporation (WCC) and Westinghouse Savings Corporation (WSAV), each subsidiaries of Westinghouse Financial Services, Inc. (WFSI) and the Corporation's leasing portfolio. On May 3, 1993, WFSI and WCC were merged into Westinghouse. Other Operations and Financial Services were classified as discontinued operations in accordance with Accounting Principles Board Opinion No. 30. Since adoption of the Plan, the Corporation has made significant progress in disposing of Financial Services assets. On August 11, 1993, the Corporation announced an agreement to sell the majority of DCBU to Eaton Corporation for a purchase price of $1.1 billion and the assumption by the buyer of certain liabilities. The Corporation completed this sale on January 31, 1994. On February 16, 1994, the Corporation announced an agreement to sell WESCO to an affiliate of Clayton Dubilier & Rice, Inc., a private investment firm, for a purchase price of approximately $340 million. The Corporation completed this sale on February 28, 1994. The reserve for the estimated loss on disposal of Discontinued Operations established in November 1992 consisted of an addition to the valuation allowance for Financial Services portfolios, estimated future results of operations and sales proceeds to be obtained from Discontinued Operations, as well as estimates as to the timing of the divestitures and assumptions regarding other relevant factors. During 1993, the Corporation reviewed its estimates of proceeds from the disposal of Discontinued Operations and the operating income or loss that would be generated by these businesses during their disposal periods. Through the third quarter of 1993, the Corporation had favorable experience with the sale of Financial Services assets, selling them at prices in excess of original estimates and on a more accelerated schedule than was anticipated at the time the Plan was developed. The more rapid liquidation of the assets had the effect of reducing the earned income from the Financial Services assets during the disposal period, which, to a large degree, offset the favorable price experience from the asset sales. In addition, the marketing process for Other Operations indicated that expected proceeds would be less than the initial forecast. Through the third quarter of 1993, all of these factors were reviewed and considered to be largely offsetting. During the fourth quarter of 1993, the Corporation recorded an additional provision for the estimated loss on disposal of Discontinued Operations of $95 million, after-tax. See Overview--Restructuring and Other Actions and note 2 to the financial statements. The reserve for the estimated loss on disposal of Discontinued Operations may require adjustment in future periods to reflect changes in any of the above constituent elements, which may be affected by adverse economic, market or other factors beyond what was anticipated at December 31, 1993. Management has considered all of the above factors and believes that the reserve for the estimated loss on disposal of Discontinued Operations should be adequate. The adequacy of the reserve is evaluated each quarter and the actual experience and any changes in expectations will be considered in determining whether adjustment to the reserve is required. 1993 VERSUS 1992 Revenues for Other Operations decreased 2% in 1993 compared to 1992 primarily due to lower Canadian sales in a continued weak Canadian economy. Operating profit decreased 35% in 1993 compared to 1992 due to lower revenues, an unfavorable mix of sales and non-recurring costs for strategic initiatives at WESCO partially offset by lower corporate support costs. 1992 VERSUS 1991 Other Operations revenues were flat in 1992 compared to 1991. Increased revenues resulting from the consolidation of a joint venture previously accounted for by the equity method for which the Corporation gained control in 1992, were offset by lower revenues due to weak U.S. and Canadian markets and price competition. Included in 1991 operating profit was $22 million of workforce reduction costs. Excluding that amount, operating profit increased 51% in 1992 compared to 1991 primarily due to cost reductions. Included in 1992 are $198 million of revenues from Other Operations and $11 million of operating profit realized after the Board of Directors adopted the Plan in November 1992. See notes 1 and 2 to the financial statements for additional information about results of Other Operations. FINANCIAL SERVICES During 1993, the Corporation continued to downsize Financial Services, resulting in a reduction in assets and debt. Financial Services revenues of $305 million for 1993 decreased 59% compared to 1992, reflecting the significant reduction in assets through dispositions. Revenues of $745 million for 1992 decreased 30% compared to 1991 due primarily to a reduction in assets through dispositions and reduced volume, and an increase in underperforming assets. The Financial Services pre-tax losses of $2,831 million and $1,660 million in 1992 and 1991, respectively, were due primarily to the valuation provisions recorded in each year. At December 31, 1993 and 1992, Financial Services portfolio investments totalled $1,551 million and $8,967 million, respectively. Portfolio investments include receivables, real estate properties, investments in partnerships and other entities and nonmarketable securities. In 1992, portfolio investments also included marketable securities and equipment on operating leases. Financial Services portfolio investments at December 31, 1993 are comprised of the remaining real estate and corporate assets, and the Corporation's leasing portfolio. In November 1992, the Financial Services real estate portfolio was valued using the Derived Investment Value (DIV) method. DIV is the process developed by the Resolution Trust Corporation for use in measuring the values of real estate owned and loans secured by income-producing assets and land. Likewise, the Financial Services corporate and leasing portfolios were valued using various techniques which consider a number of factors, including trading desk values with respect to the corporate portfolio and information provided by independent consultants. Trading desk values arise from actual or proposed current trades of identical or similar assets. See note 2 to the financial statements. Financial Services remaining real estate assets totalled $399 million at December 31, 1993 and included $212 million of investments in partnerships, $141 million of real estate properties and $46 million of receivables. At December 31, 1992 real estate assets totalled $4,748 million and included $3,442 million of receivables, $663 million of real estate properties, $402 million of investments in partnerships and $241 million of marketable securities. Of the real estate assets at December 31, 1992, $341 million of receivables and real estate properties and all of the marketable securities were assets of Westinghouse Federal Bank, WSAV's Illinois-based thrift, and were sold to First Financial Bank, F.S.B., in January 1993. Real estate investments in partnerships at December 31, 1993 were comprised primarily of the Corporation's investment in LW Real Estate Investments, L.P., discussed below. Real estate properties were acquired through foreclosure proceedings or represent "in-substance" foreclosures and are being operated by Financial Services or contracted professional management until sold. Real estate receivables consist of loans for commercial and residential real estate properties. At December 31, 1993, the remaining real estate receivables were primarily residential loans. Management expects a significant portion of the Corporation's investment in LW Real Estate Investments, L.P. to be liquidated during 1994, and the remaining real estate properties and real estate receivables by the end of 1995. On April 8, 1993, Westinghouse agreed to sell $1.7 billion, book value before reserves, of the remaining commercial real estate assets for in excess of $878 million after closing adjustments. The sale was completed in May 1993. Additionally, during the remainder of 1993, the Corporation sold additional commercial real estate assets totalling $349 million, book value before reserves, for $122 million after closing adjustments. The assets in these transactions were sold to LW Real Estate Investments, L.P., a partnership formed in April 1993. An affiliate of the investment banking firm, Lehman Brothers, is the general partner. Additionally, LW Real Estate Investments, L.P. assumed certain off-balance-sheet financing commitments related to the assets. Westinghouse initially invested a total of $141 million for a 49% limited partnership interest. At December 31, 1993, the Corporation's investment in the partnership totalled $133 million which represented a 44% interest. Financial Services entered into participation agreements with lending institutions which provided for the recourse sale of a senior interest in certain real estate loans. During 1993, Financial Services sold its subordinated interest in the remaining loans subject to certain servicing obligations. At December 31, 1992, the outstanding balance of receivables previously sold under participation agreements totalled $57 million. Financial Services remaining corporate portfolio assets totalled $144 million at December 31, 1993 and included $82 million of investments in partnerships and other entities, $47 million of receivables and $15 million of nonmarketable equity securities. Management expects the remaining corporate assets to be liquidated during 1994. At December 31, 1992, corporate assets totalled $2,929 million and included $2,140 million of receivables, $457 million of investments in partnerships and other entities and $332 million of nonmarketable equity securities. Corporate investments in partnerships and other entities represent investments in limited partnerships engaged in subordinated lending to, and investing in, highly leveraged borrowers. Corporate receivables are generally considered highly leveraged financing that involves a buyout, acquisition, or recapitalization of an existing business with a high debt-to-equity ratio. Borrowers in the corporate portfolio generally are middle market companies and located throughout the U.S. Industry concentrations included manufacturing, retail trade, media and financial services. The Corporation's leasing portfolio totalled $1,008 million at December 31, 1993 and included $969 million of receivables and $39 million of investments in partnerships. The Plan calls for the run-off of the leasing portfolio in accordance with contractual terms. At December 31, 1992, the leasing portfolio totalled $1,290 million and included $1,146 million of receivables, $101 million of equipment on operating leases and $43 million of investments in partnerships and other assets. The equipment on operating lease portfolio was sold during 1993. Leasing receivables consist of direct financing and leveraged leases. At December 31, 1993 and 1992, 77% and 66%, respectively, related to aircraft and 19% and 22%, respectively, related to cogeneration facilities. Leasing receivables at December 31, 1992 also included leases for railcars, marine vessels and trucking equipment. Certain leasing receivables classified as performing and totalling $162 million at December 31, 1993, have been identified by management as potential problem receivables. Management believes that the characterization of receivables as potential problems is mitigated by the valuation allowance attributed to such receivables at December 31, 1993. Nonearning receivables at December 31, 1993 totalled $30 million, a decrease of $1,893 million from year-end 1992. At December 31, 1993 there were no reduced earning receivables, compared to $881 million at year-end 1992. These decreases were primarily the result of dispositions and the write-off of receivables. The difference between the income for 1993 that would have been earned under original contractual terms on nonearning receivables at December 31, 1993, and the income that was actually earned, was not significant. The income for 1992 that would have been earned under original contractual terms on nonearning and reduced earning receivables at December 31, 1992 totalled $268 million, and the income actually earned was $98 million. Financial Services had issued various loan or investment commitments, guarantees, standby letters of credit and standby commitments. These commitments totalled $111 million at December 31, 1993, compared to $1,418 million at year-end 1992. The Corporation's efforts to reduce assets and debt were impacted by these commitments. However, management expects the remaining commitments to either expire unfunded, be assumed by the purchaser in asset dispositions or be funded with the resulting assets being sold shortly after funding. The primary reasons for the $1,307 million reduction in commitments during 1993 were that Financial Services was released from $959 million of commitments through asset sales, restructurings and commitment expirations, funded $340 million of commitments and transferred $76 million of guarantees to Continuing Operations. These decreases were partially offset by $68 million of new commitments. At December 31, 1993, the valuation allowance for portfolio investments totalled $424 million. Management believes that under current economic conditions, the valuation allowance at Financial Services should be adequate to cover losses that are expected from the disposal of the remaining portfolios. OTHER INCOME AND EXPENSES Other income and expenses was a net expense of $18 million in 1992 and a net expense of $165 million in 1993 and changed primarily due to a $195 million charge recorded for the disposition of certain non-strategic businesses in connection with the actions announced on January 11, 1994. Other income and expenses was a net expense of $19 million in 1991 and a net expense of $18 million in 1992 and changed due to lower interest income, partially offset by improved operating results from affiliates. In addition, 1991 included a provision for the loss on investment in an affiliate. Interest expense decreased $8 million in 1993 compared to 1992 due to lower effective interest rates on average outstanding debt, partially offset by higher fees associated with the revolving credit facility (see Liquidity and Capital Resources--Revolving Credit Facility) and the replacement of short-term floating-rate debt with higher coupon long-term fixed-rate debt. Interest expense decreased $6 million in 1992 compared to 1991 due to lower effective interest rates on average outstanding debt, partially offset by fees associated with the revolving credit facility. INCOME TAXES The Corporation's 1993 benefit for income taxes was 32.6% of the net losses from all sources. The 1993 benefit totalled $153 million and was comprised of a $70 million tax benefit from Continuing Operations, a benefit of $53 million from the estimated loss on disposal of Discontinued Operations, and a benefit of $30 million from the cumulative effect of the change in accounting principle for postemployment benefits. The Corporation's 1992 benefit for income taxes was 52.7% of the net losses from all sources. The 1992 benefit totalled $1,530 million and was comprised of $187 million tax expense on income from Continuing Operations, a benefit of $882 million on losses from Discontinued Operations, and a benefit of $835 million on the cumulative effect of changes in accounting principles for postretirement benefits other than pensions and for the adoption of SFAS No. 109. The consolidated net loss before taxes, minority interest in income of consolidated subsidiaries and provision for postretirement benefits other than pensions totalled $2,905 million and was comprised of income from Continuing Operations of $550 million, the loss from Discontinued Operations of $2,282 million and pre-tax charge for the adoption of SFAS No. 106 of $1,173 million. The net deferred tax asset at December 31, 1993 was $2,505 million as shown in the Consolidated Deferred Income Tax Sources table in note 5 to the financial statements. There are three significant components of the deferred tax asset balance: (i) the tax effect of net operating loss carryforwards of $3,437 million, $922 million of which will expire by the year 2007 and the balance by 2008, (ii) the tax effect of cumulative net temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes of $2,667 million that represents future net income tax deductions. Of this net temporary difference, approximately $1,100 million represents a net pension obligation and approximately $1,300 million represents an obligation for postretirement and postemployment benefits, and (iii) alternative minimum tax credit carryforwards of $257 million which have no expiration date. Management believes that the Corporation will have sufficient future taxable income to make it more likely than not that the net deferred tax asset will be realized. In making this assessment, management considered the net losses generated in recent years as aberrations caused by liquidation of a substantial portion of Financial Services assets and not recurring conditions; further that the Corporation's Continuing Operations have been consistently profitable and that the loss from Continuing Operations in 1993 is due to the decision to reduce the workforce and dispose of underperforming businesses. Management further considered the actual historic operating performance and taxable income generated by the Continuing Operations. Certain of the tax losses will not occur until future years. Each tax loss year would receive a new 15 year carryforward period. Under the most conservative assumption, however, that all net cumulative temporary differences reversed in 1993, the Corporation would have through the year 2008 to recover the tax asset. This would require the Corporation to generate a minimum of approximately $400 million of annual taxable income. Management believes that average annual future taxable income will exceed this minimum amount. In addition, there are certain tax planning strategies that could be employed to utilize a net operating loss carryforward that would otherwise expire. Some of the strategies that would be most feasible are sale and leaseback of facilities, adjustment of tax deductible depreciation, purchase of leases that would generate taxable income and capitalization of research and development expense. The following table shows a reconciliation of income or loss from Continuing Operations before income taxes to taxable income from Continuing Operations. Income from Continuing Operations in 1992 included a $36 million pre-tax charge for corporate restructuring related to the previous strategy to sell Knoll and WCI. Included in income from Continuing Operations for 1991 was a pre-tax provision for the corporate-wide workforce reduction totalling $138 million. LIQUIDITY AND CAPITAL RESOURCES OVERVIEW The Corporation's liquidity has improved through the disposition of Financial Services assets ahead of schedule and the sale of DCBU and WESCO. Management believes that the net proceeds anticipated from the disposition of assets of Discontinued Operations, WCI and certain identified and to be identified non-strategic businesses, as well as cash flow from Discontinued Operations until sold, will be sufficient but not in excess of the liquidity required to fund Discontinued Operations, including the repayment of its debt. Other sources of liquidity generally available to the Corporation include significant levels of cash and cash equivalents, unused borrowing capacity under the Corporation's revolving credit facility, cash flow from the operations of Continuing Operations and borrowings from other sources, including funds from the capital markets, subject to then existing market conditions and other considerations. Significant progress was made during 1993 in reducing net debt (total debt less cash and cash equivalents) due to the disposition of Financial Services assets ahead of schedule at prices more favorable than anticipated in the Plan. The Corporation's net debt was $5,102 million at December 31, 1993, a reduction of $3,277 million from $8,379 million at December 31, 1992. The principal source of cash for this reduction was the disposal of Financial Services assets for $4,150 million, partially offset by Financial Services commitment fundings of $340 million and investments totalling $141 million in LW Real Estate Investments, L.P. Funding of Financial Services commitments has slowed the Corporation's efforts to reduce debt. However, the level of remaining unfunded commitments has substantially declined. Unfunded commitments were $111 million at December 31, 1993 compared to $1,418 million at December 31, 1992, a decrease of $1,307 million. Management anticipates that the remaining commitments will either expire unfunded, be assumed by the purchaser in asset dispositions or be funded with the resulting assets being sold shortly after funding. See note 17 to the financial statements. On August 11, 1993, the Corporation announced an agreement to sell DCBU for a purchase price of approximately $1.1 billion. See note 2 to the financial statements. The proceeds of $1.1 billion were received on January 31, 1994 and were used primarily to reduce debt of Discontinued Operations. On February 16, 1994, the Corporation announced an agreement to sell WESCO for approximately $340 million. See note 2 to the financial statements. This sale was completed on February 28, 1994. The proceeds of approximately $340 million were comprised of approximately $275 million in cash, approximately $50 million in first mortgage notes and the remainder in stock and options in the new company. Cash proceeds were used primarily to reduce debt of Discontinued Operations. On October 8, 1993, the Corporation redeemed at par value $100 million of outstanding 8 3/8% senior notes due March 1, 1996 and the remaining $45 million of outstanding 7.60% debentures due October 15, 1997. These notes and debentures were originally issued by WCC, which until May 1993, was a subsidiary of the Corporation. Additionally, on November 30, 1993, the Corporation redeemed the remaining $41 million of its 9% convertible subordinated debentures due August 15, 2009. The notes, debentures and subordinated debentures were redeemed with a portion of the net proceeds received from the sale of $600 million principal amount of notes and debentures on September 1, 1993. This sale included $275 million principal amount of 6 7/8% notes due September 1, 2003 and $325 million principal amount of 7 7/8% debentures due September 1, 2023. SECURITIES RATINGS On March 9, 1993, Standard and Poor's (S&P) lowered its ratings on the Corporation's senior debt from A- to BBB; subordinated debt and preferred stock from BBB+ to BBB-; and commercial paper from A-2 to A-3. S&P cited the Corporation's weakened financial profile caused by the high level of impaired assets at Financial Services as the reason for the downgrades. On January 11, 1994, S&P affirmed its ratings of the Corporation's securities with a negative outlook. S&P cited that the ratings reflect an above average business profile, as a major diversified manufacturing firm, and a temporarily weakened financial profile. The affirmation was partially conditioned upon the completion by the Corporation of an equity financing plan announced on January 11, 1994 (see Overview--Equity and Dividend Actions) and the Corporation's progress in completing the Plan. On March 10, 1993, Fitch Investor's Service, Inc. (Fitch) lowered its ratings on the Corporation's senior debt from A to BBB+ and commercial paper from to. Fitch cited the Corporation's diminished financial flexibility resulting from large losses at Financial Services, lower than expected operating results from Continuing Operations and a less than favorable intermediate term outlook as reasons for the downgrades. On January 11, 1994, Fitch lowered its ratings on the senior debt from BBB+ to BBB and has placed the debt on FitchAlert with negative implications. Fitch cited the Corporation's continued operating difficulties and its announcement to take a substantial charge to its fourth quarter 1993 earnings as reasons for the downgrade. Fitch also noted that a further downgrade could occur if the Corporation fails to raise additional equity. On March 23, 1993, Moody's Investors Service (Moody's) affirmed its ratings of the Corporation's senior debt at Baa3 and commercial paper at Prime-3. Moody's cited its assessment that reserves taken for Financial Services' assets are adequate and the expected future benefits of restructuring activities as reasons for the affirmation. On January 7, 1994, Moody's lowered its ratings on the Corporation's senior debt from Baa3 to Ba1; its preferred stock from ba1 to ba3; and its commercial paper from Prime-3 to Not-Prime. Moody's downgrades were based on an expectation that the Corporation's efforts to rebuild its depleted capital structure will take longer than previously believed. The Corporation does not believe that the recent actions by the rating agencies will materially impact its operations or financial condition or its ability to borrow in the capital markets. REVOLVING CREDIT FACILITY In December 1991, the Corporation entered into a $6 billion revolving credit agreement (revolver) with a syndicate of domestic and international banks. This facility expires in December 1994. The revolver is available for use by the Corporation subject to the maintenance of certain financial ratios and compliance with other covenants and subject to there being no material adverse change with respect to the Corporation taken as a whole. Among other things, the covenants place restrictions on the incurrence of liens, the amount of debt on a consolidated basis and at the subsidiary level, and the amount of contingent liabilities. The covenants also require the maintenance of a maximum leverage ratio, minimum interest coverage ratios and a minimum consolidated net worth. Certain of the covenants become more restrictive over the term of the revolver. At December 31, 1993, the Corporation was in compliance with these covenants. See Financing Activities for a discussion of interest costs and fees related to this facility. The borrowing status of this facility at December 31, 1993 and 1992 is presented in the following table: During 1993, the Corporation made repayments of borrowings under this facility totalling $2,640 million and increased its use of the letter of credit portion of the facility by $149 million. Also during 1993, the Corporation and the bank syndicate negotiated certain amendments to the revolver wherein the Corporation agreed to reduce the commitment level by a total of $2 billion in 1993, and by an additional $500 million upon completion of the sale of DCBU. The Corporation decided to reduce the commitment level by an additional $500 million, to $3 billion in February 1994. Amendments to the revolver negotiated during 1993 also included changes which affect various covenants and calculations, as well as certain costs paid by the Corporation. These changes included a one-year delay of a scheduled increase in the minimum consolidated net worth covenant, additional provisions for increased costs in the event of certain rating agency downgrades, and an exclusion of certain of the provisions for restructuring and other actions announced on January 11, 1994 from the calculation of certain ratios until, in certain cases, such time as the Corporation expends cash for these charges. As a result of the January 7, 1994 downgrade by Moody's, discussed above, the margin paid by the Corporation under the revolver increased by an additional .125% per annum. The downgrade by Fitch on January 11, 1994 had no effect on the margin. The Corporation made several repayments of borrowings under the revolver during the first two months of 1994 totalling $1,565 million. The primary source of cash for these repayments was the $1.1 billion of cash proceeds received by the Corporation in January 1994 from the sale of DCBU and the $275 million of cash received from the sale of WESCO. Of the $1,565 million of total repayments, $1,355 million related to Discontinued Operations and the remainder related to Continuing Operations. The Corporation intends to negotiate a revolving credit facility during 1994 to replace its existing facility upon expiration. The new facility is expected to have a commitment level of $2 billion to $3 billion with terms and conditions based upon market conditions existing at the time of negotiation. OPERATING ACTIVITIES Cash provided by operating activities of Continuing Operations was $735 million for 1993, an increase of $118 million from the amount provided in 1992. Cash provided by operating activities of Discontinued Operations was $45 million for 1993, a decrease of $420 million from the amount provided in 1992. INVESTING ACTIVITIES Excluding cash provided to Discontinued Operations, investing activities of Continuing Operations used $164 million of cash in 1993, compared to $69 million of cash used in 1992. The principal reason for this additional use of cash was lower cash proceeds received in 1993 from business dispositions. In addition, during 1993, Continuing Operations purchased assets from Discontinued Operations for $233 million primarily for contribution to the Corporation's pension plans. Investing activities of Discontinued Operations provided $3,065 million of cash during 1993, primarily as a result of the sale of Financial Services assets, an increase of $2,800 million from 1992. Capital expenditures of Continuing Operations were $237 million in 1993 compared to $259 million in 1992. Management expects that capital expenditures for Continuing Operations in 1994 will exceed the 1993 level. Capital expenditures of Discontinued Operations were $35 million in 1993 compared to $45 million in 1992. FINANCING ACTIVITIES Total debt of the Corporation was $6,350 million at December 31, 1993, a decrease of $3,583 million from $9,933 million at December 31, 1992. Cash and cash equivalents of the Corporation were $1,248 million at December 31, 1993, a decrease of $306 million from $1,554 million at December 31, 1992, primarily related to the sale of Westinghouse Federal Bank in January 1993. Short-term debt, including current maturities of long-term debt, of the Corporation totalled $3,818 million at December 31, 1993 compared to $6,990 million at December 31, 1992. See notes 11 and 13 to the financial statements. Short-term debt, including current maturities of long-term debt, of Continuing Operations was $671 million at December 31, 1993 compared to $1,554 million at December 31, 1992. The decrease of $883 million was due primarily to the repayment of $600 million of revolver borrowings. Short-term debt, including current maturities of long-term debt, of Discontinued Operations totalled $3,147 million at December 31, 1993 compared to $5,436 million at December 31, 1992, a decrease of $2,289 million. This decrease is primarily attributed to repayment of $2,040 million of revolver borrowings. Total borrowings outstanding under the revolver were $2,855 million at December 31, 1993 (excluding $149 million of letters of credit), of which $500 million was attributable to Continuing Operations and $2,355 million to Discontinued Operations. These borrowings carried a composite interest rate of 4.0% for Continuing Operations and 4.1% for Discontinued Operations. The current interest rate for borrowings under the revolver is based on the London Interbank Offer Rate (LIBOR) plus an interest rate margin based upon the Corporation's debt ratings and interest coverage ratio, and utilization of the facility. An increase or decrease in LIBOR will result in higher or lower interest expense to the Corporation. The Corporation's interest rate margin increased .125% upon Moody's downgrade on January 7, 1994. The utilization fee has decreased from .25% to .125% as a result of a lower average revolver balance outstanding during the second half of 1993. The revolver is also subject to facility fees. The facility fee, also based on the Corporation's debt ratings and interest coverage ratio, increased .125% per annum upon the S&P downgrade on March 9, 1993. However, the commitment level on which the facility fee is based has declined (see Liquidity and Capital Resources--Revolving Credit Facility). Long-term debt of the Corporation totalled $2,532 million at December 31, 1993, a $411 million decrease from December 31, 1992. See note 13 to the financial statements. Long-term debt of Continuing Operations was $1,885 million at December 31, 1993 compared to $1,341 million at December 31, 1992. The $544 million increase was primarily due to the sale of notes and debentures as discussed in Liquidity and Capital Resources--Overview. Long-term debt of Discontinued Operations was $647 million at December 31, 1993, a decrease of $955 million since year-end 1992. The Corporation's net debt-to-capital ratio for Continuing Operations was 65% at December 31, 1993 compared to 49% at December 31, 1992. For this ratio, the reduction of net debt during 1993 was more than offset by non-cash charges to shareholders' equity. See notes 1, 4 and 5 to the financial statements. The Corporation's foreign exchange exposure policy includes selling in national currencies where possible, and hedging those transactions in excess of $250,000 which occur in currencies other than those of the originating country. In addition, the Corporation's accounting policies require translation of local currency financial statements of subsidiaries in highly inflationary and unstable economies into U.S. dollars in accordance with SFAS No. 52, "Foreign Currency Translation," in order to minimize foreign exchange rate risks and provide for appropriate accounting treatment where exchange rates are most volatile. With respect to the Corporation's operations in highly inflationary and unstable economies that are accounted for in accordance with SFAS No. 52, the combined total sales for those operations were less than 0.5% of the Corporation's sales for 1993. Any translation adjustments resulting from converting the local currency balance sheets and income statements of designated hyperinflationary subsidiaries into U.S. dollars are recorded as period costs in accordance with SFAS No. 52. OTHER ACTIONS The restructuring of the Corporation's continuing businesses, announced on January 11, 1994 (see Overview--Restructuring and Other Actions), is expected to require total cash expenditures over the next three years of approximately $270 million, with expenditures of approximately $180 million in 1994, $55 million in 1995 and $35 million in 1996. These expenditures are expected to be funded through cash flows from operations of the Continuing Operations and will be offset by savings, resulting in an expected net cash outflow of approximately $85 million in 1994, and net cash inflows of approximately $55 million and $70 million for 1995 and 1996, respectively. The disposition of certain non-strategic businesses is expected to generate, over the next two years, total cash proceeds of approximately $175 million as these businesses are sold. On January 11, 1994, the Corporation also announced its intention to take actions to rebuild its equity base. These actions include a reduction in the annual dividend on the Corporation's common stock from $.40 per share to $.20 per share and the issuance during 1994 of $700 million of new equity securities. Approximately $200 million of the equity securities, proceeds from the sale of such securities or a combination thereof, will be contributed to the Corporation's pension plans during 1994. The reduction in the common stock dividend became effective with the quarterly dividend declared by the Board of Directors in January 1994, which is payable on March 1, 1994. On August 26, 1992, Westinghouse filed a registration statement on Form S-3 for the issuance of up to $1 billion of Westinghouse debt securities. At December 31, 1993, $400 million of this shelf registration was unused. On May 3, 1993, WFSI and WCC were merged into Westinghouse and, as a consequence, WFSI and WCC ceased to exist as separate legal entities and their debt was assumed by the Corporation. This merger gave management greater flexibility to liquidate the assets of Financial Services and execute the strategy of exiting the financial services business. Prior to the merger, a support agreement existed between Westinghouse and WCC that required the Corporation to provide financial support necessary to maintain WCC's total debt-to-equity ratio at not more than 6.5 to 1 and maintain WCC's equity at a minimum of $1 billion. On December 31, 1992, Westinghouse assumed $1,800 million of WCC's revolver debt to satisfy its obligation under the support agreement. No payments were required under the support agreement during 1993. Payments of $73 million and $1,405 million were made under the support agreement during 1992 and 1991, respectively. The support agreement terminated on May 3, 1993, the effective date of the merger. ENVIRONMENTAL MATTERS Compliance with federal, state and local regulations relating to the discharge of substances into the environment, the disposal of hazardous wastes and other related activities affecting the environment have had and will continue to have an impact on the Corporation. While it is difficult to estimate the timing and ultimate costs to be incurred in the future due to uncertainties about the status of laws, regulations, technology and information available for individual sites, management estimates the total probable and reasonably possible remediation costs that could be incurred by the Corporation based on the facts and circumstances currently known. Such estimates include the Corporation's experience to date with investigating and evaluating site cleanup costs, the professional judgment of the Corporation's environmental experts, outside environmental specialists and other experts and, when necessary, counsel. In addition, the likelihood that other parties which have been named as potentially responsible parties (PRPs) will have the financial resources to fulfill their obligations at Superfund sites where they and the Corporation may be jointly and severally liable has been considered. These estimates have been used to assess materiality for financial statement disclosure purposes and in the following discussion. MANAGEMENT'S DISCUSSION AND ANALYSIS PRP SITES With regard to remedial actions under federal and state superfund laws, the Corporation has been named as a PRP at numerous sites located throughout the country. At many of these sites, the Corporation is either not a responsible party or its site involvement is very limited or de minimus. However, the Corporation may have varying degrees of cleanup responsibilities at 52 of these sites, excluding those discussed in the preceding sentence. With regard to cleanup costs at these sites, in many cases the Corporation will share these costs with other responsible parties and the Corporation believes that any liability incurred will be satisfied over a number of years. Management believes the total remaining probable costs which the Corporation could incur for remediation of these sites as of December 31, 1993 are approximately $69 million, all of which has been accrued. These remediation actions are expected to occur over a period of several years. As the remediation activities progress, additional information may be obtained which may require additional investigations or an expansion of the remediation activities. This may result in an increase in site remediation costs; however, until such time as additional requirements are identified during the remediation process, the Corporation is unable to reasonably estimate what those costs might be. BLOOMINGTON CONSENT DECREE The Corporation is a party to a 1985 Consent Decree relating to remediation of six sites in Bloomington, Indiana. The Corporation has additional responsibility for two other sites in Bloomington not included as part of the Consent Decree. In the Consent Decree, the Corporation agreed to construct and operate an incinerator, which would be permitted under federal and state law to burn excavated materials. The incinerator would also burn municipal solid waste provided by the City of Bloomington (City) and Monroe County. Applications for permits to build an incinerator are pending with the United States Environmental Protection Agency, the State of Indiana and other local permitting agencies. There is continuing community opposition to the construction of the incinerator and the State of Indiana has enacted legislation that has resulted in indefinite delays in granting permits. As a result, the parties to the Consent Decree have met several times on a cooperative basis and have decided to explore whether alternative remedial measures should be used to replace the incineration remedy set forth in the Consent Decree. On February 8, 1994 the parties filed a status report with the United States District Court for the Southern District of Indiana, which is responsible for overseeing the implementation of the Consent Decree. This report advised the court of the parties' intention to investigate alternatives and provided the court with operating principles for this process. It is the goal of the parties to reach a consensus on an alternative which is acceptable to all parties and to the Bloomington public. However, the parties recognize that at the end of the process they may conclude that the remedy currently provided in the Consent Decree is the most appropriate. The parties also recognize that the Consent Decree shall remain in full force during this process. These actions have resulted in the Corporation's belief that it no longer is probable that the Consent Decree will be implemented under its present terms. The Corporation and the other parties may have claims against each other under the Consent Decree if a mutually agreeable alternative is not reached. The Corporation may be required to post security for 125% of the net cost to complete remediation in the event certain requirements of the Consent Decree are not met. The Corporation believes it has met all of these requirements. If necessary permits were to be granted and the Consent Decree fully implemented in its present form, the Corporation estimates that its total remaining cost would be approximately $300 million at December 31, 1993. As part of the Consent Decree, and in addition to burning contaminated materials, the incinerator would also be used to burn municipal solid waste and generate electricity which would be purchased by various public utilities. The Corporation would receive revenues from tipping fees and sale of electricity which are estimated to be approximately $210 million. The Consent Decree also provides the City with an option to purchase the incinerator after the remediation is completed. The Corporation has assumed that proceeds from the sale of the incinerator would be in the range of $100 million to $160 million. Based on the above estimates, the Corporation continues to believe that the ultimate net cost of the environmental remediation under the present terms of the Consent Decree would not result in a material adverse effect on its future financial condition or results of operation. However, because the Corporation believes it is probable the Consent Decree will be modified to an alternate remediation action, the Corporation estimates that its cost to implement the most reasonable and likely alternative would be approximately $60 million, all of which has been accrued. Approximately $16 million of this estimate represents operating and maintenance costs which will be incurred over an approximate 30 year period. These costs are expected to be distributed equally over this period and, based on the Corporation's experience with similar operating and maintenance costs, have been determined to be reliably determinable on a year to year basis. Accordingly, the estimated $44 million gross cost of operating and maintenance has been discounted at a rate of 5% per year which results in the above described $16 million charge. The remaining portion of the $60 million charge represents site construction and other related costs and is valued as of the year of expenditure. Analyses of internal experts and outside consultants have been used in forecasting construction and other related costs. The estimates of future period costs include an assumed inflation rate of 5% per year. This estimate of $60 million is within a range of reasonably possible alternatives and one which the Corporation believes to be the most likely outcome. This alternative includes a combination of containment, treatment, remediation and monitoring. Other alternatives, while considered less likely, could cause such costs to be as much as $100 million. OTHER SITES The Corporation is involved with several administrative actions alleging violations of federal, state or local environmental regulations. For these matters the Corporation has estimated that its potential total remaining reasonably possible costs are insignificant. The Corporation currently manages under contract several government-owned facilities, which among other things are engaged in the remediation of hazardous and nuclear wastes. To date, under the terms of the contracts, the Corporation is not responsible for costs associated with environmental liabilities, including environmental cleanup costs, except under certain circumstances associated with negligence and willful misconduct. There are currently no known claims for which the Corporation believes it is responsible. In 1994, the U.S. Department of Energy (DoE) announced its intention to renegotiate its existing contracts for maintenance and operation of DoE facilities to address environmental issues. The Corporation has or will have responsibilities for environmental remediation such as dismantling incinerators, decommissioning nuclear licensed sites, and other similar commitments at various sites. The Corporation has estimated total potential cost to be incurred for these actions to be approximately $133 million, of which $35 million had been accrued at December 31, 1993. The Corporation's policy is to accrue these costs over the estimated lives of the individual facilities which in most cases is approximately 20 years. The anticipated annual costs currently being accrued are $6 million. As part of the agreement for the sale of DCBU to Eaton Corporation, the Corporation agreed to a cost sharing arrangement if future, but as yet unidentified, remediation is required as a result of any contamination caused during the Corporation's operation of DCBU prior to its sale. Under the terms of the agreement, the Corporation's share of any such environmental remediation costs, on an annual basis, will be at the rate of $2.5 million of the first $6 million expended, and 100% of such costs in excess of $6 million. The Corporation has provided for all known environmental liabilities related to DCBU. These estimated costs and related reserves are included in the discussion of PRP sites above. Environmental liabilities related to the sale of WESCO are insignificant. CAPITAL EXPENDITURES Capital expenditures related to environmental remediation activities in 1993 totalled $5 million. Management believes that the total estimated capital expenditures related to current operations necessary to comply with present governmental regulations will not have a material adverse effect on capital resources, liquidity, financial condition and results of operations. INSURANCE RECOVERIES In 1987, the Corporation filed an action in New Jersey against over 100 insurance companies seeking recovery for these and other environmental liabilities and litigation involving personal injury and property damage. The Corporation has received certain recoveries from insurance companies related to environmental costs. The Corporation has not accrued for any future insurance recoveries. Based on the above discussion and including all information presently known to the Corporation, management believes that the environmental matters described above will not have a material adverse effect on the Corporation's capital resources, liquidity, financial condition and results of operations. LEGAL MATTERS At present, there are seven pending actions brought by utilities claiming a substantial amount of damages in connection with alleged tube degradation in steam generators sold by the Corporation as components for nuclear steam supply systems. One previous action, which was pending in 1991 and was resolved in 1992 after a full arbitration hearing before the International Chamber of Commerce, found that no damages were warranted on any of the steam generator claims against the Corporation. Two other previous actions which were pending in 1992 were resolved, one in 1993 and the other in January 1994, through settlements with the respective utilities. The Corporation is also a party to six agreements with utilities or utility plant owners' groups which toll the statute of limitations regarding their steam generator tube degradation claims and permit the parties time to engage in discussions. The parties have agreed that no litigation will be initiated for agreed upon periods of time as set forth in the respective tolling agreements. The term of each tolling agreement varies. The Corporation has notified its insurance carriers of the pending steam generator actions and claims. While some of the carriers have denied coverage in whole or in part, most have reserved their rights with respect to obligations to defend and indemnify the Corporation. The coverage is the subject of litigation between the Corporation and these carriers. The Corporation has been defending a consolidated class action, a consolidated derivative action and certain individual lawsuits brought against the Corporation, WFSI and WCC, both previously subsidiaries of the Corporation, and/or certain present and former directors and officers of the Corporation, as well as other unrelated parties. Together, these actions allege various federal securities law and common law violations arising out of alleged misstatements or omissions contained in the Corporation's public filings concerning the financial condition of the Corporation, WFSI and WCC in connection with a $975 million charge to earnings announced on February 27, 1991, a public offering of Westinghouse common stock in May 1991, a $1,680 million charge to earnings announced on October 7, 1991, and alleged misrepresentations regarding the adequacy of internal controls at the Corporation, WFSI and WCC. Litigation is inherently uncertain and always difficult to predict. Substantial damages are sought in each of the foregoing cases and although management believes a significant adverse judgment is unlikely, any such judgment could have a material adverse effect upon the Corporation's results of operations for a quarter or a year. However, based on its understanding and evaluation of the relevant facts and circumstances, management believes the Corporation has meritorious defenses to the litigation described above and management believes that the litigation should not have a material adverse effect on the financial condition of the Corporation. CONSOLIDATED STATEMENT OF INCOME The Notes to the Financial Statements are an integral part of these financial statements. CONSOLIDATED BALANCE SHEET The Notes to the Financial Statements are an integral part of these financial statements. (a) Certain amounts have been reclassified for comparative purposes. CONSOLIDATED STATEMENT OF CASH FLOWS The Notes to the Financial Statements are an integral part of these financial statements. For a description of noncash transactions, see notes 1, 3, 4, 5 and 7. NOTES TO THE FINANCIAL STATEMENTS NOTE 1: SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES CONSOLIDATION The consolidated financial statements include the accounts of Westinghouse Electric Corporation (Westinghouse) and its subsidiary companies (together, the Corporation) after elimination of intercompany accounts and transactions. Investments in joint ventures and in other companies in which the Corporation does not have control, but has the ability to exercise significant management influence over operating and financial policies, are accounted for by the equity method. Certain previously reported amounts have been reclassified to conform to the 1993 presentation. DISCONTINUED OPERATIONS In November 1992, the Corporation's Board of Directors adopted a plan (the Plan) that included exiting the financial services and other non-strategic businesses. The Corporation classified the operations of Distribution and Control Business Unit (DCBU), Westinghouse Electric Supply Company (WESCO) (collectively, Other Operations) and Financial Services as discontinued operations in accordance with Accounting Principles Board Opinion No. 30, "Reporting the Results of Operations--Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions" (APB 30). Under this Plan, the disposition of The Knoll Group (Knoll) was scheduled to occur by the end of 1994 and WCI Communities, Inc. (WCI) by the end of 1995. Financial Services was comprised primarily of Westinghouse Credit Corporation (WCC) and Westinghouse Savings Corporation (WSAV), each subsidiaries of Westinghouse Financial Services, Inc. (WFSI) and the Corporation's leasing portfolio. On May 3, 1993, WFSI and WCC were merged into Westinghouse. See note 20 to the financial statements. In January 1994, the Corporation announced that the sale of WCI will be accelerated from 1995 into 1994 and Knoll is no longer for sale. WCI will continue to be reported as part of Continuing Operations until the requirements of APB 30 are met. At that time, WCI will be classified as a discontinued operation and appropriate restatements will be made to the Corporation's financial statements. See note 2 to the financial statements. REVENUE RECOGNITION Sales are recorded primarily as products are shipped and services are rendered. The percentage-of-completion method of accounting is used for nuclear steam supply system and related equipment orders with delivery schedules generally in excess of five years, major power generation systems with a cycle time in excess of one year, and certain construction projects where this method of accounting is consistent with industry practice. For certain long-term contracts in which development and production are combined, revenue is recognized as development milestones are completed or units are delivered. AMORTIZATION OF INTANGIBLE ASSETS Goodwill and other acquired intangible assets are amortized under the straight-line method over their estimated lives, but not in excess of 40 years. CASH AND CASH EQUIVALENTS The Corporation considers all investment securities with a maturity of three months or less when acquired to be cash equivalents. All cash and temporary investments are placed with high credit-quality financial institutions and the amount of credit exposure to any one financial institution is limited. At December 31, 1993 and 1992, cash and cash equivalents includes restricted funds of $73 million and $48 million, respectively. Cash and cash equivalents in the Consolidated Statement of Cash Flows includes those items from Continuing Operations, Financial Services and Other Operations. See note 2 to the financial statements. INVENTORIES Inventories are stated at the lower of standard cost, which approximates actual cost on a first-in, first-out (FIFO) basis, or market. The elements of cost included in inventories are direct labor, direct material and certain overheads. Prior to 1992, a portion of the value of the Corporation's domestic inventories were determined using the last-in, first-out (LIFO) method of inventory valuation. See note 7 to the financial statements. Long-term contracts in process include costs incurred plus estimated profits on contracts accounted for according to the percentage-of-completion method. PLANT AND EQUIPMENT Plant and equipment assets are recorded at cost and depreciated generally under the straight-line method over their estimated useful lives. Expenditures for additions and improvements are capitalized, and costs for repairs and maintenance are charged to operations as incurred. The Corporation limits capitalization of newly acquired assets to those assets with cost in excess of $1,000. ENVIRONMENTAL COSTS The Corporation expenses or capitalizes as appropriate environmental expenditures that relate to current operations. Expenditures that relate to an existing condition caused by past operations, and which do not contribute to current or future revenue generation, are expensed. The Corporation will record reserves when environmental assessments or remedial efforts are probable and the costs can be reasonably estimated. Such reserves are adjusted if necessary based upon the completion of a formal study or the Corporation's commitment to a formal plan of action. The Corporation accrues over their estimated remaining useful lives, the anticipated future costs of dismantling incinerators, decommissioning nuclear licensed sites and other such future commitments. CHANGES IN ACCOUNTING PRINCIPLES In December 1993, the Corporation adopted, retroactive to January 1, 1993, Statement of Financial Accounting Standards (SFAS) No. 112 "Employers' Accounting for Postemployment Benefits." This statement requires employers to adopt accrual accounting for workers' compensation, salary continuation, medical and life insurance continuation, severance benefits and disability benefits provided to former or inactive employees after employment but before retirement. See note 4 to the financial statements. Effective January 1, 1992, the Corporation adopted SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," on the immediate recognition basis. This statement requires that the expected costs of providing postretirement health care and life insurance benefits be accrued during the employees' service with the Corporation. The Corporation's previous practice was to expense these costs as incurred. See note 4 to the financial statements. In the first quarter of 1992, the Corporation adopted the provisions of SFAS No. 109, "Accounting for Income Taxes." This statement replaced SFAS No. 96, which the Corporation previously used to account for income taxes. SFAS No. 109 permitted the Corporation to recognize certain deferred tax benefits not recognized under SFAS No. 96. See note 5 to the financial statements. In December 1992, the Corporation adopted SFAS No. 107, "Disclosures about Fair Value of Financial Instruments." This statement is an extension of SFAS No. 105, "Disclosure of Information about Financial Instruments with Off-Balance-Sheet Risk and Financial Instruments with Concentrations of Credit Risk," adopted in a prior year, and requires the disclosure of the fair value of certain financial instruments. See note 22 to the financial statements. NOTE 2: DISCONTINUED OPERATIONS In November 1992, the Corporation announced the Plan that included exiting the financial services business through the disposition of its asset portfolios and the sale of other non-strategic businesses. The Plan provided for the sale of real estate and corporate finance portfolios over a three-year period and the run-off of the leasing portfolio over a longer period of time in accordance with contractual terms. Also, as part of the Plan, the Corporation was to divest the following other non-strategic operations: DCBU and WESCO; Knoll; and WCI. Financial Services and Other Operations have been accounted for as discontinued operations in accordance with APB 30. In January 1994, the Corporation announced that the planned sale of WCI will be accelerated from 1995 into 1994 and Knoll is no longer for sale. With respect to Knoll, the Corporation's strategy will now be directed to create shareholder value by continuing to operate this business. As a result of the adoption of the Plan, the Corporation recorded in Discontinued Operations, during the fourth quarter of 1992, a pre-tax charge of $2,201 million. This pre-tax charge consisted of $2,350 million for an addition to the valuation allowance for Financial Services portfolios, $300 million for estimated losses from operations for Financial Services during the phase-out period and $144 million for restructuring charges related to the change in corporate strategy. These charges were partially offset by an estimated $449 million gain from the disposition of Other Operations and an estimated $144 million of earnings from those operations during the phase-out period. Income tax benefits totalling $818 million were recorded in connection with the Plan. The after-tax estimated loss on the disposal of Discontinued Operations was $1,383 million. A $36 million charge for corporate restructuring was recorded in Continuing Operations in connection with the Plan. In November 1992, in determining the valuation provision for Financial Services real estate portfolio, management used the Derived Investment Value (DIV) method. DIV is the process developed by the Resolution Trust Corporation for use in measuring the values of real estate owned and loans secured by income-producing assets and land. In developing the provision for Financial Services corporate and leasing portfolios, management used various techniques which considered a number of factors, including trading desk values with respect to the corporate portfolio, and information provided by independent consultants. Trading desk values arise from actual or proposed current trades of identical or similar assets. These valuation processes provided portfolio valuations that reflect the strategy of exiting the financial services business. Under the Corporation's previous strategy of downsizing Financial Services over a period of up to five years and holding certain assets for the long term, the methods used to value assets resulted in higher asset values net of valuation allowances. The estimated gain from the disposition of Other Operations was determined by management using various techniques and assumptions which considered, among other factors, index multiples derived for comparable businesses as appropriately adjusted to reflect the characteristics of the businesses within Other Operations. Variances from estimates which may occur will be considered in determining if an adjustment of the estimated loss on disposal of Discontinued Operations is necessary. Since adoption of the Plan, the Corporation has made significant progress in disposing of Financial Services assets. On August 11, 1993, the Corporation announced an agreement to sell the majority of DCBU to Eaton Corporation for a purchase price of $1.1 billion and the assumption by the buyer of certain liabilities. The Corporation completed this sale on January 31, 1994. On February 16, 1994, the Corporation announced an agreement to sell WESCO to an affiliate of Clayton, Dubilier & Rice, Inc., a private investment firm, for a purchase price of approximately $340 million. The Corporation completed this sale on February 28, 1994. The reserve for the estimated loss on the disposal of Discontinued Operations established in November 1992 consisted of an addition to the valuation allowance for Financial Services portfolios, estimated future results of operations and sales proceeds to be obtained from Discontinued Operations, as well as estimates as to the timing of the divestitures and assumptions regarding other relevant factors. During 1993, the Corporation reviewed its estimates of proceeds from the disposal of Discontinued Operations and the operating income or loss that would be generated by these businesses during their disposal periods. Through the third quarter of 1993, the Corporation had favorable experience with the sale of Financial Services assets, selling them at prices in excess of original estimates and on a more accelerated schedule than was anticipated at the time the Plan was developed. The more rapid liquidation of the assets had the effect of reducing the earned income from the Financial Services assets during the disposal period, which, to a large degree, offset the favorable price experience from the asset sales. In addition, the marketing process for Other Operations indicated that expected proceeds would be less than the initial forecast. Through the third quarter of 1993, all of these factors were reviewed and considered to be largely offsetting. In the fourth quarter of 1993, the Corporation recorded an additional provision for loss on disposal of Discontinued Operations of $148 million, pre-tax or $95 million, after-tax. This change in the estimated loss resulted from additional information, obtained through negotiation activity, regarding the expected selling prices of WESCO and the Australian subsidiary of DCBU. Also contributing to this provision was a decision to bulk sell a Financial Services residential development that the Corporation, upon adoption of the Plan, had intended to transfer to WCI for development. These matters and a revision to the estimated interest costs expected to be incurred by the Discontinued Operations during the disposal period resulted in the additional fourth quarter provision. The reserve for the estimated loss on the disposal of Discontinued Operations may require adjustment in future periods to reflect changes in any of the above constituent elements, which may be affected by adverse economic, market or other factors beyond what was anticipated at December 31, 1993. Management has considered all of the above factors and believes that the reserve for the estimated loss on disposal of Discontinued Operations should be adequate. The adequacy of this reserve is evaluated each quarter, and the actual experience and any changes in expectations will be considered in determining whether adjustment to the reserve is required. In accordance with APB 30, the consolidated financial statements reflect the operating results of Discontinued Operations separately from Continuing Operations. Prior periods have been restated. Summarized operating results of Discontinued Operations follow: The composition of the estimated loss on disposal of Discontinued Operations recorded in the fourth quarter of 1992 follows: The assets and liabilities of Discontinued Operations have been separately classified on the balance sheet as net liabilities of Discontinued Operations. A summary of these assets and liabilities and additional information pertaining to Financial Services follows: FINANCIAL SERVICES Revenue Recognition Financial Services revenues are recognized generally on the accrual method, except that revenues for real estate accounts are being recognized only as payments are received. When accrual method accounts become delinquent for more than two payment periods, usually 60 days, income is recognized only as payments are received. Such delinquent accounts and all real estate accounts for which no payments are received in the current month, and other accounts on which income is not being recognized because the receipt of either principal or interest is questionable, are classified as nonearning receivables. Investment Tax Credit The investment tax credit earned prior to its repeal on property leased to others has been deferred and is recognized as income over the contractual terms of the respective leases. Portfolio Investments Portfolio investments by category of investment and financing at December 31, 1993 and 1992, are summarized in the table below. Real estate receivables consist of loans for commercial and residential real estate properties. At December 31, 1993, the remaining real estate receivables were primarily residential loans. Real estate properties were acquired through foreclosure proceedings or represent "in-substance" foreclosures and are being operated by Financial Services or contracted professional management until sold. Real estate investments in partnerships at December 31, 1993 was comprised primarily of the Corporation's investment in LW Real Estate Investments, L.P., which totalled $133 million at year-end. At December 31, 1993, there were no significant investment-type, individual borrower, or geographic concentrations in the remaining real estate receivables. At December 31, 1992, first mortgages on real estate properties, the majority of which were income-producing, comprised 84% of real estate receivables. Hotels and motels secured 29% of the receivables at December 31, 1992, apartments secured 18%, shopping centers and land each secured 8% and office buildings secured 7%. Of these properties, 18% were located in California, 12% in Illinois, 9% in Pennsylvania and 8% in Florida. No other significant geographic concentrations existed. The largest borrower exposure in the real estate portfolio totalled $299 million at December 31, 1992; average borrower exposure, excluding small-balance borrowers, was $20 million. Financial Services entered into participation agreements with lending institutions which provided for the recourse sale of a senior interest in certain real estate loans. During 1993, Financial Services sold its subordinated interest in the remaining loans subject to certain servicing obligations. At December 31, 1992, the outstanding balance of receivables previously sold under participation agreements totalled $57 million. Corporate receivables are generally considered highly leveraged financing that involves a buyout, acquisition, or recapitalization of an existing business with a high debt-to-equity ratio. Borrowers in the corporate portfolio generally are middle market companies and located throughout the U.S. Manufacturing, retail trade, media and financial services represented the significant industry concentrations in this portfolio. Corporate investments in partnerships and other entities represent investments in limited partnerships engaged in subordinated lending to, and investing in, highly leveraged borrowers. Nonmarketable equity securities relate to corporate financing transactions. Originally, corporate investments in partnerships and other entities and nonmarketable securities generally were acquired with the intent to realize appreciation upon disposition, reflecting an increase in the value of the underlying entity. However, many of these investments are now the result of debtor account restructurings. At December 31, 1993, there were no significant industry, subordinated or unsecured positions, or individual borrower exposures in the remaining corporate receivables. At December 31, 1992, 58% of corporate receivables were senior obligations of the borrower and 42% were subordinated. Variable-amount commercial line-of-credit loans secured by the borrowers' inventory or receivables represented 25% of the corporate receivables at December 31, 1992. An additional 33% of corporate receivables represented fixed-amount loans secured by specified assets, general assets, stock or other tangible assets of the borrower. The remaining corporate receivables were unsecured. Exposure to the largest borrower totalled $165 million at December 31, 1992; average borrower exposure was $15 million. Investments in partnerships or other entities are accounted for by either the equity or cost methods in those cases where the Corporation gains majority ownership of entities of a temporary nature or in those cases where the Corporation is legally prevented from exercising control even though it has majority ownership. Ownership is considered of a temporary nature if the entity is acquired through foreclosure and the Corporation expects to maximize its investment through near-term disposal or liquidation. At December 31, 1993 and 1992, the total carrying value of such non-consolidated entities related to Financial Services was $73 million and $147 million, respectively. Leasing receivables consist of direct financing and leveraged leases. At December 31, 1993 and 1992, 77% and 66%, respectively, related to aircraft and 19% and 22%, respectively, related to cogeneration facilities. Leasing receivables at December 31, 1992, also included leases for railcars, marine vessels and trucking equipment. These leasing receivables were sold during 1993. The components of the Corporation's net investment in leases at December 31, 1993 and 1992 are as follows: *Investment in leases for 1992 included lease receivables in both the leasing and real estate categories of financing. Contractual maturities for the Corporation's leasing receivables at December 31, 1993 are as follows: Nonearning receivables at December 31, 1993 totalled $30 million, a decrease of $1,893 million from year-end 1992. At December 31, 1993 there were no reduced earning receivables, compared to $881 million at year-end 1992. These decreases were primarily the result of dispositions and the write-off of receivables. The difference between the income for 1993 that would have been earned under original contractual terms on nonearning receivables at December 31, 1993 and the income that was actually earned, was not significant. The income for 1992 that would have been earned under original contractual terms on nonearning and reduced earning receivables at December 31, 1992 totalled $268 million, and the income actually earned was $98 million. The following table is a reconciliation of the valuation allowance for portfolio investments for the years ended December 31, 1993, 1992, and 1991. During 1993, portfolio investments written off represented 71.4% of average outstanding portfolio investments. The comparable percentages for 1992 and 1991 were 12.7% and 7.1%, respectively. Portfolio investments written off during 1993 reflects management's strategy to liquidate portfolios and exit the financial services business. Portfolio investments written off during 1992 and 1991 reflect management's strategy to liquidate or downsize portfolios. Marketable and nonmarketable securities written off usually resulted from the disposition of the securities for cash. Receivables and real estate properties written off generally resulted from the disposition of the investments for cash or management's determination of the recoverability of the receivable balance or property value in accordance with management's disposition strategy. The provision added during 1993 represents an allocation of the $148 million pre-tax charge recorded in the fourth quarter of 1993 and relates to a residential development that the Corporation had previously intended to transfer to WCI for development. During December 1993, the Corporation's intent regarding this asset changed to one of bulk sale out of the Financial Services real estate portfolio. The $38 million provision reduces the carrying value of the asset to its DIV. The increase in the provision added during 1992 compared to 1991 reflects management's current strategy to exit the financial services business, compared to management's prior strategy to downsize portfolios over a period of up to five years. The valuation allowance at December 31, 1992, adjusted by adding back amounts written off since January 1, 1991, totalling $988 million related to investments remaining in the portfolio at year-end 1992, represented 46.4% of the value of portfolio investments, with such investments similarly adjusted. The valuation allowance at December 31, 1991, comparably adjusted for amounts written off since January 1, 1991, totalling $375 million, represented 24.7% of the value of portfolio investments. Due to the significantly reduced levels of portfolio investments and the valuation allowance at December 31, 1993, management believes that this calculation would produce results of limited usefulness and, therefore, is not presented at December 31, 1993. Management believes under current economic conditions, the valuation allowance at Financial Services at December 31, 1993 should be adequate to cover losses that are expected from the disposal of the remaining portfolios. At December 31, 1992, the marketable securities of $241 million were assets of WSAV's Illinois-based thrift, Westinghouse Federal Bank, and thrift deposits of $693 million were obligations of the thrift. On January 4, 1993, Westinghouse Federal Bank was sold to First Financial Bank, F.S.B., and the thrift's assets and obligations were transferred. Marketable securities at December 31, 1992 were primarily comprised of U.S. and other government obligations, and mortgage-backed securities. At December 31, 1992, these marketable securities had gross unrealized gains of $8 million and no gross unrealized losses. During 1992, proceeds from sales of investments in debt securities totalled $367 million. Gross gains on such sales were $7 million and gross losses were $19 million. NOTE 3: PENSIONS The Corporation has various pension arrangements covering substantially all employees. Most plan benefits are based on either years of service and compensation levels at the time of retirement or a formula based on career earnings. Pension benefits are paid from trusts funded by contributions from employees and the Corporation. The pension funding policy for qualified plans is consistent with the funding requirements of U.S. federal and other government laws and regulations. Plan assets consist primarily of listed stocks, fixed income securities and real estate investments. The projected benefit obligation is the actuarial present value of that portion of the projected benefits attributable to employee service rendered to date. Service cost is the actuarial present value of that portion of the projected benefits attributable to employee service rendered during the year. As a result of the trend of declining long-term interest rates, the Corporation remeasured its pension obligation as of June 30, 1993 and December 31, 1993. The requirement of SFAS No. 87 to adjust the discount rate to reflect current and expected to be available interest rates on high quality fixed-income investments resulted in a decision by the Corporation to reduce its assumed discount rate from 9%, which was used at December 31, 1992, to 8% at June 30, 1993 and 7.25% at December 31, 1993. In addition, the Corporation has reduced its expected long-term rate of return on plan assets from 11% at December 31, 1992, to 10.5% at June 30, 1993, and 9.75% at December 31, 1993. The expected rate of increase in future compensation levels was also adjusted from 6% at December 31, 1992, to 5% at June 30, 1993, and 4% at December 31, 1993. The expected long-term rate of return on pension plan assets has been reduced to more closely reflect the plan's recent performance. The five-year average increase in compensation levels at the Corporation has, in recent years, approximated 5%; however, wage trends indicate that a 4% rate is more indicative of future compensation levels. For financial reporting purposes, a pension plan is considered underfunded when the fair value of plan assets is less than the accumulated benefit obligation. When that is the case, a minimum pension liability must be recognized for the sum of the underfunded amount plus any prepaid pension contributions. In recognizing such a liability, an intangible asset is usually recorded. However, the amount of the intangible asset may not be greater than the sum of the prior service cost not yet recognized and the unrecognized transition obligation as shown in the Funding Status table. When the liability to be recognized is greater than the intangible asset limit, a charge must be made to shareholders' equity for the difference, net of any tax effects which could be recognized in the future. At December 31, 1992, a minimum pension liability of $1,099 million was recognized for the sum of the underfunded amount of $303 million plus the prepaid pension contribution of $796 million. An intangible asset of $348 million and a charge to shareholders' equity of $751 million, which was reduced to $496 million due to tax deferrals of $255 million, offset the pension liability. At June 30, 1993, a minimum pension liability of $1,771 million was recognized for the sum of the underfunded amount of $940 million plus the prepaid pension contribution of $831 million. An intangible asset of $325 million and a charge to shareholders' equity of $1,446 million, which was reduced to $955 million due to tax deferrals of $491 million, offset the pension liability. As a result of this remeasurement, shareholders' equity was reduced by an additional $459 million from December 31, 1992. At December 31, 1993, a minimum pension liability of $2,143 million was recognized for the sum of the underfunded amount of $1,282 million plus the prepaid pension contribution of $861 million. An intangible asset of $295 million and a charge to shareholders' equity of $1,848 million, which was reduced to $1,215 million due to tax deferrals of $633 million, offset the pension liability. As a result of this remeasurement, shareholders' equity was reduced by an additional $260 million from June 30, 1993. During 1993, the Corporation contributed $273 million to its pension plans. As a result of the restructuring actions announced in January 1994 and the Plan announced in November 1992 (see notes 2 and 20 to the financial statements), a curtailment charge of $22 million was included in the loss from Continuing Operations for the year ended December 31, 1993, and $54 million was included in the estimated loss on disposal of Discontinued Operations for the year ended December 31, 1992 in accordance with the provisions of SFAS No. 88, "Employers' Accounting for Settlements and Curtailments of Defined Benefit Pension Plans and for Termination Benefits." These curtailment charges have reduced, by the same amount, the total of the unrecognized transition obligation and prior service costs not yet recognized in net periodic pension costs. NOTE 4: POSTRETIREMENT BENEFITS OTHER THAN PENSIONS AND POSTEMPLOYMENT BENEFITS The Corporation has defined benefit postretirement plans that provide medical, dental and life insurance for eligible retirees and dependents. The components of net periodic postretirement benefit cost follow. The adoption of SFAS No. 106 on the immediate recognition basis, concurrent with the adoption of SFAS No. 109, as of January 1, 1992, resulted in a net charge to first quarter 1992 earnings of $742 million, or $2.14 per share, net of $431 million of deferred income tax effects. *Decreasing 1/2% annually to 7.0% each year thereafter The Corporation's accumulated postretirement benefit obligation consists of the following: The accumulated postretirement benefit obligation was calculated using the terms of medical, dental, and life insurance plans, including the effects of established maximums on covered costs. SFAS No. 106 requires the discount rate used to measure the accumulated postretirement benefit obligation to be determined in a manner consistent with the method previously described for SFAS No. 87 in note 3 to the financial statements. As a result of the decline in long-term interest rates, the Corporation reduced its discount rate from 9%, which was used at December 31, 1992, to 8% at June 30, 1993 and 7.25% at December 31, 1993. These discount rates are consistent with the discount rate assumptions applied for measurement of the Corporation's pension obligation, since the duration of pension and postretirement benefit expected payments are both approximately 11 years. The actuarial loss resulting from the discount rate reduction will be considered in the determination of postretirement benefit costs in future periods. The effect of a 1% annual increase in the assumed cost trend rates would increase the accumulated postretirement benefit obligation by approximately $63 million and would increase net periodic postretirement benefit costs by approximately $8 million. Certain of the Corporation's non-U.S. subsidiaries have private and government-sponsored plans for retirees. The cost of these plans is not significant to the Corporation. The Corporation provides certain postemployment benefits to former or inactive employees and their dependents during the time period following employment but before retirement. In December 1993, the Corporation adopted, retroactive to January 1, 1993, SFAS No. 112, "Employers' Accounting for Postemployment Benefits." Prior to 1993, postemployment benefit expenses were recognized primarily as they were paid. The Corporation's charge for postemployment benefits at January 1, 1993 was $56 million, net of $30 million of deferred taxes, and was immediately recognized as the cumulative effect of a change in accounting for postemployment benefits. The effect of this change on 1993 operating results was an increase in pre-tax postemployment benefit expense of $5 million. At December 31, 1993, the Corporation's liability for postemployment benefits totalled $91 million and is included in other noncurrent liabilities. See note 14 to the financial statements. NOTE 5: INCOME TAXES Deferred federal income taxes for 1993 include a benefit of $62 million resulting from the enactment of an increase in the statutory federal income tax rate from 34% to 35%. Income tax expense (benefit) included in the consolidated financial statements follows: In addition to the amounts in the table above, during 1993, 1992 and 1991, $378 million of income tax benefit, $255 million of income tax benefit and $71 million of income tax expense, respectively, were recorded against shareholders' equity as a result of the pension liability adjustment. See note 3 to the financial statements. In January 1992, the Corporation adopted SFAS No. 109. This statement replaced SFAS No. 96 which the Corporation had used to account for income taxes since 1988. The effect of adopting SFAS No. 109 on the Corporation was to permit the recognition of deferred tax benefits as shown in the following table. The foreign portion of income or loss before income taxes and minority interest in income of consolidated subsidiaries in the consolidated statement of income consisted of a loss of $6 million in 1993 and income of $61 million in 1992 and $32 million in 1991. Such income or loss consists of profits and losses generated from foreign operations and can be subject to both U.S. and foreign income taxes. Deferred federal income taxes have not been provided on cumulative undistributed earnings from foreign subsidiaries, totalling $474 million at December 31, 1993, in which the earnings have been reinvested for an indefinite time. It is not practicable to determine the income tax liability that would result had such earnings been repatriated. The amount of withholding taxes that would be payable upon such repatriation is estimated to be $30 million. Income from Continuing Operations includes income of certain manufacturing operations in Puerto Rico which are exempt from U.S. federal income tax and partially exempt from Puerto Rican income tax under grants of industrial tax exemptions. These tax exemptions provided net tax benefits of $21 million or $.06 per share in 1993, $21 million or $.06 per share in 1992, and $22 million or $.07 per share in 1991. The exemptions will expire at various dates from 2002 through 2007. Deferred income taxes result from temporary differences in the financial bases and tax bases of assets and liabilities. The type of differences that give rise to significant portions of deferred income tax liabilities or assets are shown in the accompanying table. *Certain amounts have been reclassified for comparative purposes. The valuation allowance for deferred taxes represents foreign tax credits not anticipated to be utilized and operating loss carryforwards of certain foreign subsidiaries. The net balance of deferred income taxes is intended to offset income taxes on future taxable income expected to be earned by the Corporation's continuing businesses. See Management's Discussion and Analysis--Income Taxes. During 1992, federal income tax assessments were settled which reduced deferred income taxes by $70 million. At December 31, 1993, for federal income tax purposes, there were regular tax net operating loss carryforwards of $922 million which expire by the year 2007, $2,515 million which expire by the year 2008, alternative minimum tax operating loss carryforwards of $565 million which expire by the year 2007, $2,444 million which expire by the year 2008 and alternative minimum tax credit carryforwards of $257 million which have no expiration date. At December 31, 1993, there were $100 million of net operating loss carryforwards attributable to foreign subsidiaries. Of this total, approximately $35 million has no expiration date. The remaining amount will expire not later than 2000. A valuation allowance for the $38 million of deferred tax benefit related to these losses has been established since it is considered more likely than not that the benefit will not be realized. *Certain amounts have been reclassified for comparative purposes. The federal income tax returns of the Corporation and its wholly-owned subsidiaries are settled through the year ended December 31, 1986. The Corporation has reached a tentative agreement with the Internal Revenue Service regarding intercompany pricing adjustments applicable to operations in Puerto Rico for the years 1987 through 1992. Management believes that adequate provisions for taxes have been made through December 31, 1993. NOTE 6: CUSTOMER RECEIVABLES Customer receivables at December 31, 1993 included $273 million which represented the sales value of material shipped under long-term contracts but not billed to the customer. Billing will occur upon shipment of major components of the contract, and collection of these receivables is expected to be substantially completed within one year. Allowance for doubtful accounts of $54 million and $50 million at December 31, 1993 and 1992, respectively, were deducted from customer receivables. At December 31, 1993 and 1992, approximately 8% and 15%, respectively, of the Corporation's customer receivables were from sales on open account with various agencies of the U.S. government, which is the Corporation's largest single customer. The Corporation performs ongoing credit evaluations of its customers and generally does not require collateral. NOTE 7: INVENTORIES AND COSTS AND BILLINGS ON UNCOMPLETED CONTRACTS During the fourth quarter of 1992, the Corporation changed its method of determining the cost of a portion of its inventories from the LIFO method to the FIFO method. Previously, a substantial portion of the inventories of Continuing Operations had been valued using the FIFO method. The change to the FIFO method for all of Continuing Operations' inventories conforms such inventories to the same method of valuation. The Corporation believes that the FIFO method of inventory valuation provides a more meaningful presentation of the financial position of the Corporation since it reflects more recent inventory acquisition costs in the balance sheet. Under the current economic environment of low inflation, the Corporation believes that the FIFO method also results in a better matching of current costs with current revenues. The change in the method of valuing inventories was not applied retroactively to prior periods as the effect on the Corporation's financial position and its results of operations was not material. Raw materials, work in process and finished goods included contract-related costs of approximately $770 million at December 31, 1993, and $866 million at December 31, 1992. All costs in long-term contracts in process, progress payments to subcontractors, and recoverable engineering and development costs were contract-related. Inventories other than those related to long-term contracts are generally realized within one year. Inventoried costs do not exceed realizable values. NOTE 8: PREPAID AND OTHER CURRENT ASSETS NOTE 9: PLANT AND EQUIPMENT NOTE 10: INTANGIBLE AND OTHER NONCURRENT ASSETS Goodwill and other acquired intangible assets are shown net of accumulated amortization of $139 million and $102 million at December 31, 1993 and 1992, respectively. Joint ventures and other affiliates include investments in companies where the Corporation does not have the ability to exercise control. Uranium settlement assets relate to uranium inventory awaiting delivery and settlement items being produced under uranium supply contract settlement agreements. Inventory and other settlement items expected to be delivered within one year are included in other current assets. NOTE 11: SHORT-TERM DEBT In December 1991, the Corporation entered into a three-year $6 billion revolving credit facility agreement (revolver) with a syndicate of domestic and international banks. By December 31, 1993, the commitment level of the revolver had been reduced to $4 billion. The largest commitment from any one bank is less than 5% of the total facility. The revolver is available for use by the Corporation subject to the maintenance of certain ratios and compliance with other covenants and subject to there being no material adverse change with respect to the Corporation taken as a whole. Among other things, these covenants place restrictions on the incurrence of liens, the amount of debt on a consolidated basis and at the subsidiary level, and the amount of contingent liabilities. The covenants also require the maintenance of a maximum leverage ratio, minimum interest coverage ratios, and minimum consolidated net worth. Certain of the covenants become more restrictive over the term of the revolver. The interest rate for revolver borrowings is determined at the time of each borrowing and may be based on one of a variety of indices plus a margin based on the Corporation's debt ratings and interest coverage ratio, and utilization of the facility. The indices include the following: London Interbank Offer Rate (LIBOR), certificate of deposit, prime, and federal funds. A fee is also paid on letters of credit. The interest rates for the borrowings under the revolver at December 31, 1993 and 1992, were based on LIBOR. The utilization fee has decreased from .25% to .125% as a result of a lower average revolver balance outstanding during the second half of 1993. A utilization fee is charged if average revolver borrowings and outstanding letters of credit are $2,000 million or more. At December 31, 1993, consolidated borrowings under the revolver totalled $2,855 million, of which $500 million was attributed to Continuing Operations and $2,355 million was attributed to Discontinued Operations. There are no compensating balance requirements under the revolver. Origination fees of $91 million are being amortized and charged to Discontinued Operations over the term of the revolver. Facility fees averaged approximately .50% of the commitment level during 1993 and were charged to Continuing and Discontinued Operations on a pro-rata basis. As a result of rating agency actions and management's assessment of the capital markets, in October 1992, the Corporation discontinued the sale of commercial paper and replaced this debt with borrowings under the revolver. Average outstanding borrowings for Continuing Operations were determined based on daily amounts outstanding for commercial paper and the revolver, and on monthly balances outstanding for short-term foreign bank loans. The average rates for those bank loans compared to commercial paper reflect the impact of higher interest costs on local currency borrowings of subsidiaries. Average outstanding borrowings for Discontinued Operations were determined based on daily amounts outstanding for commercial paper and revolving credit facilities, and on monthly balances outstanding for variable-rate trust master notes. To manage interest costs on its debt, Financial Services has entered into various types of interest rate and currency exchange agreements. Interest rate exchange agreements generally involve the exchange of interest payments without the exchange of the underlying principal amounts. The notional amounts of the interest rate and currency exchange agreements totalled $1,326 million and $2,218 million at December 31, 1993 and 1992, respectively. The $892 million decrease in the notional amount during 1993 was due to the maturity of certain of the agreements. At December 31, 1993, interest rate swap agreements in which Financial Services paid a fixed interest rate totalled $575 million and had a weighted average rate of 8.7% with an average maturity of 1.31 years. In addition, those interest rate swap agreements in which Financial Services received a fixed interest rate totalled $430 million and had a weighted average rate of 8.1% with an average maturity of approximately 10 months. The remaining notional amount of $321 million at December 31, 1993 included forward interest rate exchange agreements, interest rate floor agreements, currency exchange agreements and basis swap agreements. Certain of these agreements are associated with long-term debt of Discontinued Operations. See note 13 to the financial statements. NOTE 12: OTHER CURRENT LIABILITIES NOTE 13: LONG-TERM DEBT During 1993, the 8.60% notes due 1993 and $29 million of medium-term notes were paid at maturity. Medium-term notes carry interest rates ranging from 7.5% to 9.4%. At December 31, 1992, $25 million of the medium-term notes and all of the 8 7/8% notes were subject to interest rate swap agreements. These agreements have effectively changed the fixed interest rate for the first two years of the notes' terms to a variable rate based on the 30-day commercial paper rate. At December 31, 1992, the effective interest rate on all of the medium-term notes was 7.8% and the effective interest rate on the 8 7/8% notes was 5.1%. Both interest rate swap agreements matured in June 1993. In June 1992, the Corporation issued $350 million of 8 3/8% notes due June 15, 2002. These notes were offered at a discount. In August 1992, the Corporation issued $275 million of 8 5/8% debentures due August 1, 2012. These debentures were offered at a discount. The 8 3/8% notes due 2002 and the 8 5/8% debentures due 2012 were issued under a shelf registration statement filed in 1991. In August 1992, the Corporation filed an additional debt shelf registration statement for $1 billion. In September 1993, the Corporation issued $275 million of 6 7/8% notes due September 1, 2003 and $325 million of 7 7/8% debentures due September 1, 2023. These notes and debentures were offered at a discount and were issued under the $1 billion shelf registration, of which $400 million was unused as of December 31, 1993. The 6 7/8% notes, the medium-term notes, the 7 3/4% notes, the 8 7/8% notes, the 8 3/8% notes, the 8 5/8% debentures, and the 7 7/8% debentures may not be redeemed prior to maturity. At December 31, 1993, Continuing Operations long-term debt maturing in each of the following years is: 1994--$9 million, 1995--$9 million, 1996--$322 million, 1997--$2 million, and 1998--$58 million. During 1993, $779 million of medium-term notes were paid at maturity. During 1992, $1,313 million of medium-term notes were paid at maturity and $55 million of new notes were issued. At December 31, 1993 and 1992, $291 million and $565 million, respectively, of medium-term notes had been issued either on a variable-rate basis or swapped to a variable-rate through interest rate swap agreements. After the effects of any interest rate swap agreements, the average interest rates on variable-rate medium-term notes outstanding at December 31, 1993 and 1992 were 3.7% and 4.4%, respectively. At December 31, 1993 and 1992, $756 million and $1,261 million, respectively, of medium-term notes had been issued either on a fixed-rate basis or swapped to a fixed rate through interest rate swap agreements. After the effects of any interest rate swap agreements, the average interest rate on fixed-rate medium-term notes outstanding at December 31, 1993 and 1992 was 8.6%. At December 31, 1993, the average interest rate, after the effects of the interest rate swap agreements, and average remaining maturity for all medium-term notes were 7.2% and 1.58 years, compared to 7.3% and 1.65 years at year-end 1992. At December 31, 1993, all of the 8-7/8% notes due 1995 were subject to an interest rate swap agreement as well as an interest rate floor agreement. The net effect of these agreements reduced the effective interest rate on these notes to 7.4% at December 31, 1993. In October 1993, the Corporation redeemed at par value $100 million of outstanding 8 3/8% senior notes due March 1, 1996. At December 31, 1993, Discontinued Operations long-term debt maturing in each of the following years is: 1994--$774 million, 1995--$230 million, 1996--$262 million, 1997--$2 million, and 1998--$96 million. Current maturities of $774 million at December 31, 1993 include the $150 million of 8 7/8% senior notes due 2014 as the noteholders have the right, during the sixty-day period ending June 14, 1994, to request that their notes be redeemed. These notes will be included in current maturities of long-term debt until such time as the request is made and the notes are redeemed, or the right to request redemption period expires. Management does not anticipate that the noteholders will exercise their right to redemption during the 1994 request period. The next right to request redemption period is the sixty days ending June 14, 1999. NOTE 14: OTHER NONCURRENT LIABILITIES NOTE 15: SHAREHOLDERS' EQUITY In June 1992, Westinghouse sold 32,890,000 Depositary Shares at $17 per share. Each of the Depositary Shares represents ownership of one quarter of a share of Westinghouse's $1 par value Series B Conversion Preferred Stock (B Preferred) deposited with Mellon Bank, N.A., as Depositary, and entitles the owner to all of the proportionate rights, preferences and privileges of the B Preferred. A total of 8,222,500 B Preferred shares were deposited. The Depositary Shares are listed on the New York Stock Exchange (NYSE) under the symbol "WXPrP." Since the Depositary Shares are claims against the Depositary which in turn holds all the shares of B Preferred in trust, only the B Preferred are shown as equity on the Corporation's balance sheet. Holders of Depositary Shares may redeem them for the B Preferred shares at the Depositary; however, only the Depositary Shares are listed for trading on the NYSE. The net proceeds to the Corporation from the sale of the Depositary Shares, after commissions, fees and out-of-pocket expenses, totalled $543 million which was used to reduce short-term debt of Continuing Operations. As a result of the transaction, par value of B Preferred was established for $8 million, and capital in excess of par value was increased by $535 million. Annual dividends are $1.53 per Depositary Share (equivalent to $6.12 for each B Preferred) and are payable quarterly in arrears on the first day of March, June, September and December. Dividends are cumulative and must be declared by the Board of Directors to be payable. Payments commenced September 1, 1992. On September 1, 1995 (the Mandatory Conversion Date), each of the outstanding Depositary Shares will automatically convert into (i) one share of common stock (equivalent to four shares for each B Preferred) subject to adjustment if certain events occur, and (ii) the right to receive on such date an amount in cash equal to all accrued and unpaid dividends thereon, or, in certain circumstances, a number of shares of common stock equal to 110% of such cash amount divided by the market value of the common stock. Conversion of the outstanding Depositary Shares (and the B Preferred) will also occur upon certain mergers, consolidations or similar extraordinary transactions involving the Corporation or in connection with certain other events, as described in the prospectus. At any time and from time to time prior to the Mandatory Conversion Date, Westinghouse may call the outstanding B Preferred (and thereby the Depositary Shares), in whole or in part, for redemption. Upon any such redemption, each owner of Depositary Shares will receive, in exchange for each Depositary Share so called, shares of common stock having a market value initially equal to $26.23 (equivalent to $104.92 for each B Preferred), declining by $0.002095 (equivalent to $0.008380 for each B Preferred) on each day following the date of issue of the B Preferred to $23.93 (equivalent to $95.72 for each B Preferred) on July 1, 1995, and equal to $23.80 (equivalent to $95.20 for each B Preferred) thereafter (the Call Price), plus an amount in cash equal to all proportionate accrued and unpaid dividends thereon. On September 1, 1995, the outstanding B Preferred shares mandatorily convert to one share of common stock at the then existing market price. The B Preferred shares are considered common stock equivalents, at a rate of four to one, for the calculation of primary and fully diluted earnings per share, unless such treatment would result in a lower net loss per share or higher net income per share. If common stock equivalency is not appropriate, the B Preferred shares are considered preferred stock for earnings per share purposes. At December 31, 1993 and 1992, 8,222,500 shares of B Preferred stock were issued and outstanding. During May 1991, Westinghouse issued 21,500,000 shares of its common stock in a public offering, the net proceeds of which totalled $551 million. The proceeds of the offering were used to reduce the Corporation's short-term debt. Beginning in the third quarter of 1991, the Corporation offered a Dividend Reinvestment and Common Stock Purchase Plan whereby shareholders may elect to reinvest cash dividends, and may optionally invest additional cash, in shares of Westinghouse common stock without paying commissions or service charges. Proceeds received from participants in this plan are used for general corporate purposes. During October 1991, the Corporation contributed 22,645,000 shares of common stock held in treasury to the Westinghouse Pension Plan. The contribution at that time was valued at $375 million by the pension plan trustee. See note 3 to the financial statements. At December 31, 1993, common shares outstanding totalled 352,175,746. On January 11, 1994, the Corporation announced its intention to take actions to rebuild its equity base. These actions include a reduction in the annual dividend on the Corporation's common stock from $.40 per share to $.20 per share and the issuance during 1994 of $700 million of new equity securities. Approximately $200 million of the equity securities, proceeds from the sale of such securities or a combination thereof, will be contributed to the Corporation's pension plans during 1994. The reduction in the common stock dividend became effective with the quarterly dividend declared by the Board of Directors in January 1994, which is to be payable on March 1, 1994. Earnings (loss) per common share is computed by dividing income, after deducting the preferred dividend requirements, by the weighted average number of common shares outstanding during the year plus the weighted average common stock equivalents. Common stock equivalents consist of shares subject to stock options and shares potentially issuable under deferred compensation programs. For this computation, net income or loss was adjusted for the after-tax interest expense applicable to the deferred compensation programs. The B Preferred shares may be treated as common stock equivalents or preferred stock depending on the effect as previously discussed. When treated as preferred stock, the B Preferred dividends are deducted for computing earnings available to common shareholders. During 1993, the B Preferred shares for earnings per share calculations were treated as preferred stock. During 1992, the B Preferred shares for earnings per share calculations were treated as common stock equivalents in the first and second quarters, and as preferred stock for the third and fourth quarters and the total year. No preferred shares were outstanding in 1991. The weighted average number of common shares used for computing earnings or loss per share was 352,902,000 in 1993, 346,103,000 in 1992 and 313,984,000 in 1991. In 1988, the Board of Directors adopted a shareholder rights plan pursuant to which one right was attached to each share of common stock outstanding on December 17, 1988, and to each share issued thereafter. In accordance with plan provisions, in December 1992, the Board of Directors elected to redeem the rights at a redemption price of $0.005 per share. The Corporation paid approximately $2 million to shareholders of record as of December 2, 1992, as the total redemption price for the rights. NOTE 16: STOCK OPTIONS AND OTHER LONG-TERM INCENTIVE COMPENSATION AWARDS The 1993, 1991 and 1984 Long-Term Incentive Plans provide for the granting of stock options and other performance awards to employees of the Corporation. The 1993 and 1991 Plans are similar in all material respects to the 1984 Plan. At December 31, 1993, four million shares have been authorized, subject to shareholder approval, for awards under the 1993 Plan. Unoptioned shares available under the 1993 Plan at December 31, 1993 totalled 1,787,500. At December 31, 1993 and 1992, an aggregate of 19.2 million and 16 million shares, respectively, have been authorized for awarding under the 1991 and 1984 Plans. Unoptioned shares available under the 1991 and 1984 Plans at December 31, 1993 and 1992, totalled 2,141,708 and 1,371,292, respectively. The option price under the Plans may not be less than the fair market value of the shares on the date the option is granted. The options were granted for terms of 10 years and generally become exercisable in whole or in part after the commencement of the second year of the term. All options outstanding under the 1984 and 1991 Plans, except those granted during 1993, were exercisable at December 31, 1993. Options outstanding under the 1993 Plan will not be exercisable until 1994. Outstanding options have expiration dates ranging from 1994 through 2003. During 1992 and 1993, Equity Plus dollar grants totalling approximately $17 million for the 1992-94 measurement period were granted to employees of the Corporation. Equity Plus dollar grants have the potential to increase in value through both financial performance and stock price appreciation. Payment of these grants is approved by a committee of the Board of Directors and is contingent upon achieving performance targets over the measurement period. If minimum levels of financial performance are not achieved, the grants will not be paid. Certain of these grants have been or will be prorated or terminated upon termination of employment. Payments are generally made in stock. In February 1994, 244,747 shares of Westinghouse common stock were issued to employees for Equity Plus grants made in 1991. NOTE 17: CONTINGENT LIABILITIES AND COMMITMENTS URANIUM SETTLEMENTS The Corporation had previously provided for all estimated future costs associated with the resolution of all uranium supply contract suits and related litigation. The remaining uranium reserve balance includes uranium settlement assets (see note 10 to the financial statements) and reserves for estimated future costs. The remaining balance at December 31, 1993, is deemed adequate considering all facts and circumstances known to management. The future obligations require providing specific quantities of uranium and products and services over a period extending beyond the year 2010. Variances from estimates which may occur will be considered in determining if an adjustment of the liability is necessary. LITIGATION Republic of the Philippines and National Power Corporation In December 1988, the Republic of the Philippines (Philippines) and National Power Corporation of the Philippines (NPC) (collectively, the Republic) filed a 15 count lawsuit against the Corporation in connection with the construction of a nuclear power plant in the Philippines. In 1989, the U.S. District Court (USDC) for the District of New Jersey stayed substantially all of the complaint pending arbitration by the International Chamber of Commerce (ICC) in Geneva, Switzerland. The USDC did not grant a stay with respect to the one count in the complaint alleging intentional interference with a fiduciary relationship. A jury verdict with respect to this count was rendered in favor of the Corporation on May 18, 1993. The Republic has stated its intention to appeal this verdict. In December 1991, the ICC arbitration panel issued an award finding that the NPC had failed to carry its burden of proving an alleged bribery by the Corporation. The panel thereby concluded that the arbitration clauses and the contracts were valid and the panel had jurisdiction over the disputes remaining before it with respect to NPC; the panel also concluded that it did not have jurisdiction over the Philippines. The NPC, in an attempt to attack the ICC decision regarding jurisdiction and contract validity, filed an action for annulment with the Swiss Federal Supreme Court which was not successful. Arbitration with respect to the remaining disputes before the ICC is ongoing. An evidentiary hearing is scheduled to begin during the first quarter of 1994, and a final award is anticipated before the end of 1994. Steam Generators At present, there are seven pending actions brought by utilities claiming a substantial amount of damages in connection with alleged tube degradation in steam generators sold by the Corporation as components for nuclear steam supply systems. One previous action, which was pending in 1991 and was resolved in 1992 after a full arbitration hearing before the ICC, found that no damages were warranted on any of the steam generator claims against the Corporation. Two other previous actions which were pending in 1992 were resolved, one in 1993 and the other in January 1994, through settlements with the respective utilities. The Corporation is also a party to six agreements with utilities or utility plant owners' groups which toll the statute of limitations regarding their steam generator tube degradation claims and permit the parties time to engage in discussions. The parties have agreed that no litigation will be initiated for agreed upon periods of time as set forth in the respective tolling agreements. The term of each tolling agreement varies. The Corporation has notified its insurance carriers of the pending steam generator actions and claims. While some of the carriers have denied coverage in whole or in part, most have reserved their rights with respect to obligations to defend and indemnify the Corporation. The coverage is the subject of litigation between the Corporation and these carriers. Securities Class Actions--Financial Services The Corporation has been defending a consolidated class action, a consolidated derivative action and certain individual lawsuits brought against the Corporation, WFSI and WCC, both previously subsidiaries of the Corporation, and/or certain present and former directors and officers of the Corporation, as well as other unrelated parties. Together, these actions allege various federal securities law and common law violations arising out of alleged misstatements or omissions contained in the Corporation's public filings concerning the financial condition of the Corporation, WFSI and WCC in connection with a $975 million charge to earnings announced on February 27, 1991, a public offering of Westinghouse common stock in May 1991, a $1,680 million charge to earnings announced on October 7, 1991, and alleged misrepresentations regarding the adequacy of internal controls at the Corporation, WFSI and WCC. Litigation is inherently uncertain and always difficult to predict. Substantial damages are sought in each of the foregoing cases and although management believes a significant adverse judgment is unlikely, any such judgment could have a material adverse effect upon the Corporation's results of operations for a quarter or a year. However, based on its understanding and evaluation of the relevant facts and circumstances, management believes the Corporation has meritorious defenses to the litigation described above and management believes that the litigation should not have a material adverse effect on the financial condition of the Corporation. ENVIRONMENTAL MATTERS Compliance with federal, state and local regulations relating to the discharge of substances into the environment, the disposal of hazardous wastes and other related activities affecting the environment have had and will continue to have an impact on the Corporation. While it is difficult to estimate the timing and ultimate costs to be incurred in the future due to uncertainties about the status of laws, regulations, technology and information available for individual sites, management estimates the total probable and reasonably possible remediation costs that could be incurred by the Corporation based on the facts and circumstances currently known. Such estimates include the Corporation's experience to date with investigating and evaluating site cleanup costs, the professional judgment of the Corporation's environmental experts, outside environmental specialists and other experts and, when necessary, counsel. In addition, the likelihood that other parties which have been named as potentially responsible parties (PRPs) will have the financial resources to fulfill their obligations at Superfund sites where they and the Corporation may be jointly and severally liable has been considered. These estimates have been used to assess materiality for financial statement disclosure purposes as follows. PRP Sites With regard to remedial actions under federal and state superfund laws, the Corporation has been named as a PRP at numerous sites located throughout the country. At many of these sites, the Corporation is either not a responsible party or its site involvement is very limited or de minimus. However, the Corporation may have varying degrees of cleanup responsibilities at 52 of these sites, excluding those discussed in the preceding sentence. With regard to cleanup costs at these sites, in many cases the Corporation will share these costs with other responsible parties and the Corporation believes that any liability incurred will be satisfied over a number of years. Management believes the total remaining probable costs which the Corporation could incur for remediation of these sites as of December 31, 1993 are approximately $69 million, all of which has been accrued. These remediation actions are expected to occur over a period of several years. As the remediation activities progress, additional information may be obtained which may require additional investigations or an expansion of the remediation activities. This may result in an increase in site remediation costs; however, until such time as additional requirements are identified during the remediation process, the Corporation is unable to reasonably estimate what those costs might be. Bloomington Consent Decree The Corporation is a party to a 1985 Consent Decree relating to remediation of six sites in Bloomington, Indiana. The Corporation has additional responsibility for two other sites in Bloomington not included as part of the Consent Decree. In the Consent Decree, the Corporation agreed to construct and operate an incinerator, which would be permitted under federal and state law to burn excavated materials. The incinerator would also burn municipal solid waste provided by the City of Bloomington (City) and Monroe County. Applications for permits to build an incinerator are pending with the United States Environmental Protection Agency, the State of Indiana and other local permitting agencies. There is continuing community opposition to the construction of the incinerator and the State of Indiana has enacted legislation that has resulted in indefinite delays in granting permits. As a result, the parties to the Consent Decree have met several times on a cooperative basis and have decided to explore whether alternative remedial measures should be used to replace the incineration remedy set forth in the Consent Decree. On February 8, 1994 the parties filed a status report with the United States District Court for the Southern District of Indiana, which is responsible for overseeing the implementation of the Consent Decree. This report advised the court of the parties' intention to investigate alternatives and provided the court with operating principles for this process. It is the goal of the parties to reach a consensus on an alternative which is acceptable to all parties and to the Bloomington public. However, the parties recognize that at the end of the process they may conclude that the remedy currently provided in the Consent Decree is the most appropriate. The parties also recognize that the Consent Decree shall remain in full force during this process. These actions have resulted in the Corporation's belief that it no longer is probable that the Consent Decree will be implemented under its present terms. The Corporation and the other parties may have claims against each other under the Consent Decree if a mutually agreeable alternative is not reached. The Corporation may be required to post security for 125% of the net cost to complete remediation in the event certain requirements of the Consent Decree are not met. The Corporation believes it has met all of these requirements. If necessary permits were to be granted and the Consent Decree fully implemented in its present form, the Corporation estimates that its total remaining cost would be approximately $300 million at December 31, 1993. As part of the Consent Decree, and in addition to burning contaminated materials, the incinerator would also be used to burn municipal solid waste and generate electricity which would be purchased by various public utilities. The Corporation would receive revenues from tipping fees and sale of electricity which are estimated to be approximately $210 million. The Consent Decree also provides the City with an option to purchase the incinerator after the remediation is completed. The Corporation has assumed that proceeds from the sale of the incinerator would be in the range of $100 million to $160 million. Based on the above estimates, the Corporation continues to believe that the ultimate net cost of the environmental remediation under the present terms of the Consent Decree would not result in a material adverse effect on its future financial condition or results of operations. However, because the Corporation believes it is probable the Consent Decree will be modified to an alternate remediation action, the Corporation estimates that its cost to implement the most reasonable and likely alternative would be approximately $60 million, all of which has been accrued. Approximately $16 million of this estimate represents operating and maintenance costs which will be incurred over an approximate 30 year period. These costs are expected to be distributed equally over this period and, based on the Corporation's experience with similar operating and maintenance costs, have been determined to be reliably determinable on a year-to-year basis. Accordingly, the estimated $44 million gross cost of operating and maintenance has been discounted at a rate of 5% per year which results in the above described $16 million charge. The remaining portion of the $60 million charge represents site construction and other related costs and is valued as of the year of expenditure. Analyses of internal experts and outside consultants have been used in forecasting construction and other related costs. The estimates of future period costs include an assumed inflation rate of 5% per year. This estimate of $60 million is within a range of reasonably possible alternatives and one which the Corporation believes to be the most likely outcome. This alternative includes a combination of containment, treatment, remediation and monitoring. Other alternatives, while considered less likely, could cause such costs to be as much as $100 million. Other Sites The Corporation is involved with several administrative actions alleging violations of federal, state or local environmental regulations. For these matters the Corporation has estimated that its potential total remaining reasonably possible costs are insignificant. The Corporation currently manages under contract several government-owned facilities, which among other things are engaged in the remediation of hazardous and nuclear wastes. To date, under the terms of the contracts, the Corporation is not responsible for costs associated with environmental liabilities, including environmental cleanup costs, except under certain circumstances associated with negligence and willful misconduct. There are currently no known claims for which the Corporation believes it is responsible. In 1994, the U.S. Department of Energy (DoE) announced its intention to renegotiate its existing contracts for maintenance and operation of DoE facilities to address environmental issues. The Corporation has or will have responsibilities for environmental remediation such as dismantling incinerators, decommissioning nuclear licensed sites, and other similar commitments at various sites. The Corporation has estimated total potential cost to be incurred for these actions to be approximately $133 million, of which $35 million had been accrued at December 31, 1993. The Corporation's policy is to accrue these costs over the estimated lives of the individual facilities which in most cases is approximately 20 years. The anticipated annual costs currently being accrued are $6 million. As part of the agreement for the sale of DCBU to Eaton Corporation, the Corporation agreed to a cost sharing arrangement if future, but as yet unidentified, remediation is required as a result of any contamination caused during the Corporation's operation of DCBU prior to its sale. Under the terms of the agreement, the Corporation's share of any such environmental remediation costs, on an annual basis, will be at the rate of $2.5 million of the first $6 million expended, and 100% of such costs in excess of $6 million. The Corporation has provided for all known environmental liabilities related to DCBU. These estimated costs and related reserves are included in the discussion above of PRP sites. Environmental liabilities related to the sale of WESCO are insignificant. Capital Expenditures Capital expenditures related to environmental remediation activities in 1993 totalled $5 million. Management believes that the total estimated capital expenditures related to current operations necessary to comply with present governmental regulations will not have a material adverse effect on capital resources, liquidity, financial condition and results of operations. Insurance Recoveries In 1987, the Corporation filed an action in New Jersey against over 100 insurance companies seeking recovery for these and other environmental liabilities and litigation involving personal injury and property damage. The Corporation has received certain recoveries from insurance companies related to environmental costs. The Corporation has not accrued for any future insurance recoveries. Based on the above discussion and including all information presently known to the Corporation, management believes that the environmental matters described above will not have a material adverse effect on the Corporation's capital resources, liquidity, financial condition and results of operations. FINANCING COMMITMENTS Discontinued Operations Financial Services commitments with off-balance-sheet credit risk represent financing commitments to provide funds, including loan or investment commitments, guarantees, standby letters of credit and standby commitments, generally in exchange for fees. The remaining commitments have fixed expiration dates from 1994 through 2002. At December 31, 1993, Financial Services commitments with off-balance-sheet credit risk totalled $111 million, compared to $1,418 million at year-end 1992. Of the $111 million of commitments at December 31, 1993, $90 million were guarantees, credit enhancements and other standby agreements, and $21 million were commitments to extend credit. Of the $1,418 million of commitments at year-end 1992, $619 million were guarantees, credit enhancements and other standby agreements, $575 million were commitments to extend credit, and $224 million were partnership calls and other investment commitments. Management expects the remaining commitments to either expire unfunded, be assumed by the purchaser in asset dispositions or be funded with the resulting assets being sold shortly after funding. The primary reasons for the $1,307 million reduction in commitments during 1993 were that Financial Services was released from $959 million of commitments through asset sales, restructurings and commitment expirations, funded $340 million of commitments and transferred $76 million of guarantees to Continuing Operations. These decreases were partially offset by $68 million of new commitments. Continuing Operations As discussed above, during 1993, $76 million of guarantees were transferred from Financial Services to Continuing Operations. These guarantees were issued primarily to improve the salability of securities of Financial Services corporate customers and are collateralized by the assets of the customer. Management does not expect the Corporation to be required to fund these guarantees. WCI was contingently liable at December 31, 1993 under guarantees for $54 million of sewer and water district borrowings. The proceeds of the borrowings were used for sewer and water improvements on residential and commercial real estate projects of WCI. Management expects these borrowings to be repaid as the projects are completed and sold, and the guarantees for such borrowings to expire unfunded. OTHER COMMITMENTS The Corporation's other commitments consisting primarily of those for the purchase of plant and equipment are not material. NOTE 18: LEASES The Corporation has commitments under operating leases for certain machinery and equipment and facilities used in various operations. Rental expense for Continuing Operations in 1993, 1992 and 1991 was $220 million, $225 million and $183 million, respectively. These amounts include immaterial amounts for contingent rentals and sublease income. NOTE 19: OTHER INCOME AND EXPENSES, NET The expected losses on disposition of non-strategic businesses of $195 million were recorded to reflect the Corporation's announced plan to dispose of certain of these businesses. Gain on disposition of other assets in 1993 includes a gain of $21 million on the sale of an equity participation in a production company. Loss on disposition of other assets in 1991 includes a $17 million provision for the loss on investment in an affiliate. All items in the other category are less than $10 million each. NOTE 20: RESTRUCTURING, MERGERS, ACQUISITIONS AND DIVESTITURES On January 11, 1994, the Corporation announced a restructuring of its continuing businesses resulting in a one-time charge of $350 million. The Corporation anticipates that actions resulting from its restructuring plan, directed to improving productivity and operating performance, will result in a reduction of approximately 6,000 employees, comprised of approximately 3,400 employee separations and expected reductions of 2,600 employees through normal attrition. These employment reductions will cause the Corporation to incur various other costs related to the rationalization and closedown of facilities which are included in the charge. The restructuring actions are expected to occur over a two to three year period. On May 3, 1993, WFSI and WCC were merged into Westinghouse and, as a consequence, WFSI and WCC ceased to exist as separate legal entities and their debt was assumed by the Corporation. This merger gave management greater flexibility to execute its liquidation of all assets of Financial Services and implement the strategy of exiting the financial services business. During 1992, WSAV executed a definitive agreement with First Financial Bank, F.S.B., to sell its Illinois-based thrift, Westinghouse Federal Bank. The sale was completed in January 1993. In August 1992, the Corporation sold the Copper Laminates Division (formerly part of the Electronic Systems segment) for $97 million in cash. In May 1992, the Corporation sold the Electrical Systems Division (formerly part of the Electronic Systems segment) for $125 million in cash. During 1991, there were no significant acquisitions or divestitures. NOTE 21: SEGMENT INFORMATION Westinghouse is a diversified, global, technology-based corporation operating in the principal business arenas of television and radio broadcasting, defense electronics, environmental services, transport refrigeration and the electric utility markets. The Corporation's continuing businesses are aligned for reporting purposes into the following segments: Broadcasting, Electronic Systems, Environmental, Industries, Power Systems, Knoll and WCI. Engineering and repair services, previously included in the Industries segment, have been transferred to the Power Systems segment where these businesses have been consolidated with the power generation service organization. The Environmental segment now includes the U.S. naval nuclear reactors programs previously reported in Power Systems. The Longines-Wittnauer Watch Company and Westinghouse Communications have been transferred from the Broadcasting segment to the Industries segment as part of the Industrial Products and Services business unit. Segment information for 1992 and 1991 has been restated to reflect these changes. Results of international manufacturing entities, export sales and foreign licensee income are included in the financial information of the segment that has operating responsibility. Broadcasting provides a variety of communications services consisting primarily of commercial broadcasting, program production and distribution. It sells advertising time to radio, television and cable advertisers through national and local sales organizations. Within Broadcasting, Group W currently owns and operates five network affiliated television broadcasting stations and 14 radio stations. Group W also provides programming and distribution services to the cable television industry. Group W Satellite Communications provides sports programming and the marketing and advertising sales for two country music entertainment channels. The Electronic Systems segment is a world leader in the research, development, production and support of advanced electronic systems for the Department of Defense (DoD), Federal Aviation Administration, National Aeronautics and Space Administration, other government agencies and U.S. allies. Products include surveillance and fire control radars, command and control systems, electronic countermeasures equipment, electro-optical systems, spaceborne sensors, missile launching and handling equipment, torpedoes, sonar and communications equipment. The group also engages in technologically complementary non-DoD markets such as air traffic control, security systems and drug traffic interdiction. The Environmental segment combines the Corporation's environmental businesses: toxic, hazardous and radioactive waste services, waste-to-energy plants and management and operation of several government-owned facilities and the U.S. naval nuclear reactors program. The Industries segment is comprised of a leading supplier of transport temperature control equipment for trucks, trailers, ships, fishing vessels and railway cars. The segment also includes the Industrial Products and Services business unit which is a diverse group of businesses providing a wide range of goods and services to consumer, industrial, utility and governmental customers. The Power Systems segment designs, develops, manufactures and services nuclear and fossil-fueled power generation systems and is a leading supplier of reload nuclear fuel to the global electric utility market. Knoll designs, manufactures and distributes office furniture to an expanding global market. WCI develops land into master planned luxury communities primarily in Florida and California. SALES OF PRODUCTS AND SERVICES AND SEGMENT OPERATING PROFIT FROM CONTINUING OPERATIONS (in millions) Segment sales of products and services include products that are transferred between segments generally at inventory cost plus a margin. Segment operating profit or loss consists of sales of products and services less segment operating expenses that include costs of products and services, marketing, administrative and general expenses, depreciation and amortization, and restructuring provisions. A provision for costs associated with the Corporation's 1991 workforce reduction was recorded in the third quarter of 1991 and totalled $138 million for Continuing Operations. Prior to that provision, operating profit totalled $145 million for Broadcasting, $276 million for Electronic Systems, $22 million for Environmental, $107 million for Industries, and $247 million for Power Systems. In 1992, a $36 million charge was recorded in Continuing Operations for corporate restructuring related to the previous strategy to sell Knoll and WCI. Prior to that charge, the operating loss for Knoll was $14 million and the operating profit for WCI was $97 million. In 1993, a $750 million charge was recorded in the fourth quarter for restructuring and other actions of which $555 million was charged to operating profit. Prior to that provision operating profit totalled $148 million for Broadcasting, $217 million for Electronic Systems, $7 million for Environmental, $120 million for Industries, $217 million for Power Systems, $65 million for WCI and a loss of $30 million for Knoll. Identifiable assets, depreciation and amortization, and capital expenditures are presented below. Assets not identified to segments principally include cash and marketable securities, deferred income taxes, prepaid pension contributions and unrecognized pension costs. OTHER FINANCIAL INFORMATION (in millions) Included in income from Continuing Operations is income of subsidiaries located outside the U.S. These subsidiaries reported a loss of $21 million in 1993, and income of $32 million and $48 million in 1992 and 1991, respectively. Subsidiaries located outside the U.S. comprised 6% of total assets of Continuing Operations in 1993, 5% in 1992 and 6% in 1991. Subsidiaries located outside the U.S. comprised 2% of total liabilities of Continuing Operations in 1993, 1992 and 1991. FINANCIAL INFORMATION BY GEOGRAPHIC AREA (in millions) The Corporation sells products manufactured domestically to customers throughout the world using domestic divisions and subsidiaries doing business primarily outside the U.S. Generally, products manufactured outside the U.S. are sold outside the U.S. SALES FROM PRODUCTS AND SERVICES SOLD OUTSIDE THE U.S. FROM CONTINUING OPERATIONS (in millions) The largest single customer of the Corporation is the U.S. government and its agencies, whose purchases accounted for 30% of sales of products and services from Continuing Operations in 1993 and 1992 and 32% in 1991. Of the 1993 purchases, 82% were from the Electronic Systems segment. No other customer made purchases totalling 10% or more of sales of products and services. RESEARCH AND DEVELOPMENT FROM CONTINUING OPERATIONS (in millions) Note 22: FAIR VALUE OF FINANCIAL INSTRUMENTS The estimated fair value of financial instruments has been determined by the Corporation using the best available market information and appropriate valuation methodologies. However, considerable judgment was necessary in interpreting market data to develop the estimates of fair value. Accordingly, the estimates presented are not necessarily indicative of the amounts that the Corporation could realize in a current market exchange or the value that ultimately will be realized by the Corporation upon maturity or disposition. Additionally, because of the variety of valuation techniques permitted under SFAS No. 107, comparability of fair values between entities may not be meaningful. The use of different market assumptions and/or estimation methodologies may have a material effect on the estimated fair value amounts. FAIR VALUE OF FINANCIAL INSTRUMENTS--CONTINUING OPERATIONS (in millions) FAIR VALUE OF FINANCIAL INSTRUMENTS--DISCONTINUED OPERATIONS (in millions) *Carrying amount refers to the amount included in net liabilities of Discontinued Operations at December 31, 1993 and 1992, after giving effect to the valuation allowances associated with each portfolio, exclusive of any recoveries or proceeds from the sale of assets that exceeded their initial reserved values. (a)Certain amounts have been reclassified for comparative purposes. The following methods and assumptions were used to estimate the fair value of financial instruments for which it was practicable to estimate that value. CASH AND CASH EQUIVALENTS The carrying amount for cash and cash equivalents approximates fair value. NONCURRENT CUSTOMER AND OTHER RECEIVABLES The fair value of noncurrent customer and other receivables is estimated by discounting the expected future cash flows at interest rates commensurate with the creditworthiness of the customers and other third parties. PORTFOLIO INVESTMENTS The carrying amount of financial instruments included in portfolio investments at Financial Services approximates their fair value. The fair value for marketable securities is determined by quoted market prices, if available, or estimated using quoted market prices for similar securities. Except for the Corporation's investment in LW Real Estate Investments, L.P., which is valued at cost, the real estate portfolio, including receivables, real estate properties and real estate investments in partnerships and other entities, was valued using the Resolution Trust Corporation's DIV method. The corporate portfolio, including receivables, investments in partnerships and other entities and nonmarketable equity securities, was valued using various valuation techniques, including trading desk values, which arise from actual or proposed current trades of identical or similar assets, plus other factors. SHORT-TERM DEBT The carrying amount of the Corporation's borrowings under the revolving credit facility and other arrangements approximate fair value. LONG-TERM DEBT The fair value of long-term debt has been estimated using quoted market prices or discounted cash flow analyses based on the Corporation's incremental borrowing rates for similar types of borrowing arrangements with comparable terms and maturities. THRIFT DEPOSITS The thrift deposits were assumed by the purchaser of Westinghouse Federal Bank on January 4, 1993, at their carrying amount. INTEREST RATE AND CURRENCY EXCHANGE AGREEMENTS The fair value of interest rate and currency exchange agreements (used for hedging purposes) is the amount that the Corporation would receive or pay to terminate the exchange agreements, considering interest rates, currency exchange rates and remaining maturities. FINANCIAL GUARANTEES The fair value of guarantees is based on the estimated cost to terminate or otherwise settle the obligations with the counterparties. FINANCING COMMITMENTS Most of the unfunded commitments relate to, and are inseparable from, specific portfolio investments. When establishing the fair value for those portfolio investments, consideration was given to the related financing commitments. REPORT OF MANAGEMENT The Corporation has prepared the consolidated financial statements and related financial information included in this report. Management has the primary responsibility for the financial statements and other financial information and for ascertaining that the data fairly reflect the financial position, results of operations and cash flows of the Corporation. The financial 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 with appropriate consideration given to materiality. Financial information included elsewhere in this report is presented on a basis consistent with the financial statements. The Corporation maintains a system of internal accounting controls, supported by adequate documentation, to provide reasonable assurance that assets are safeguarded and that the books and records reflect the authorized transactions of the Corporation. Limitations exist in any system of internal accounting controls based upon the recognition that the cost of the system should not exceed the benefits derived. Westinghouse believes its system of internal accounting controls, augmented by its corporate auditing function, appropriately balances the cost/benefit relationship. The independent accountants provide an objective assessment of the degree to which management meets its responsibility for fair financial reporting. They regularly evaluate the system of internal accounting controls and perform such tests and procedures as they deem necessary to express an opinion on the fairness of the financial statements. The Board of Directors pursues its responsibility for the Corporation's financial statements through its Audit Review Committee composed of directors who are not officers or employees of the Corporation. The Audit Review Committee meets regularly with the independent accountants, management and the corporate auditors. The independent accountants and the corporate auditors have direct access to the Audit Review Committee, with and without the presence of management representatives, to discuss the scope and results of their audit work and their comments on the adequacy of internal accounting controls and the quality of financial reporting. We believe that the Corporation's policies and procedures, including its system of internal accounting controls, provide reasonable assurance that the financial statements are prepared in accordance with the applicable securities laws and with a corresponding standard of business conduct. REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors and Shareholders of Westinghouse Electric Corporation In our opinion, the accompanying consolidated financial statements appearing on pages 29 through 56 of this Form 10-K present fairly, in all material respects, the financial position of Westinghouse Electric 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 Corporation'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 these financial statements, the Corporation adopted Statement of Financial Accounting Standards (SFAS) No. 112, "Employers' Accounting for Postemployment Benefits," in 1993 and SFAS No. 106, "Employers Accounting for Postretirement Benefits Other Than Pensions," and SFAS No. 109, "Accounting for Income Taxes," in 1992. /s/ Price Waterhouse Price Waterhouse 600 Grant Street Pittsburgh, Pennsylvania 15219-9954 January 26, 1994, except as to the matter discussed in paragraph 9 of note 2, which is as of February 28, 1994 PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. Part of the information concerning executive officers required by this item is set forth in Part I pursuant to General Instruction G to Form 10-K and part is incorporated herein by reference to "Security Ownership" in the Proxy Statement. The information as to directors is incorporated herein by reference to "Election of Directors" in the Proxy Statement. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION. The information required by this item is incorporated herein by reference to "Executive Compensation" in the Proxy Statement. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. The information required by this item is incorporated herein by reference to "Security Ownership" in the Proxy Statement. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. The information required by this item is incorporated herein by reference to "Transactions Involving Directors and Executive Officers" in the Proxy Statement. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. (A)(1) FINANCIAL STATEMENTS The financial statements required by this item are listed under Item 8, which list is incorporated herein by reference. (A)(2) FINANCIAL STATEMENT SCHEDULES The following financial statement schedules for Westinghouse Electric Corporation are included in Part IV of this report: Other schedules are omitted because they are not applicable or because the required information is included in the financial statements or notes thereto. (A) EXHIBITS * Identifies management contract or compensatory plan or arrangement. (B) REPORTS ON FORM 8-K: No reports on Form 8-K were filed during the fourth quarter of the year ended December 31, 1993. REPORT OF INDEPENDENT ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULES To the Board of Directors of Westinghouse Electric Corporation Our audits of the consolidated financial statements referred to in our report dated January 26, 1994, except as to the matter discussed in paragraph 9 of note 2, which is as of February 28, 1994, appearing on page 57 of this Form 10-K of Westinghouse Electric Corporation (which report and consolidated financial statements are included in this Annual Report on Form 10-K) also included an audit of the Financial Statement Schedules listed in Item 14(a)(2) 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 600 Grant Street Pittsburgh, Pennsylvania 15219-9954 January 26, 1994, except as to the matter discussed in paragraph 9 of note 2, which is as of February 28, 1994 SCHEDULE VIII VALUATION AND QUALIFYING ACCOUNTS - - --------- (a) at December 31, 1993, 1992 and 1991, all amounts were classified as current. SCHEDULE X SUPPLEMENTARY INCOME STATEMENT INFORMATION SIGNATURE 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 4th day of March, 1994. WESTINGHOUSE ELECTRIC CORPORATION /s/ Robert E. Faust By: -------------------------------- Robert E. Faust Vice President and Controller 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 and Title Frank C. Carlucci, Director Gary M. Clark, President and Director George H. Conrades, Director William H. Gray, III, Director Michael H. Jordan, Chairman and Chief Executive Officer (principal executive officer) and Director /s/ Robert E. Faust David T. McLaughlin, Director By -------------------------- Rene C. McPherson, Director Robert E. Faust Richard M. Morrow, Director Attorney-In-Fact Richard R. Pivirotto, Director Paula Stern, Director March 4, 1994 Fredric G. Reynolds, Executive Vice President, Finance (principal financial officer) Robert E. Faust, Vice President and Controller (principal accounting officer) Original powers of attorney authorizing Michael H. Jordan, Fredric G. Reynolds and Robert E. Faust, individually, to sign this report on behalf of the listed directors and officers of the Corporation and a certified copy of a resolution of the Board of Directors of the Corporation authorizing each of said persons to sign on behalf of the Corporation have been filed with the Securities and Exchange Commission and are included as Exhibit 24 to this report. EXHIBIT INDEX - - -------------------------------------------------------------------------------- * Incorporated by reference

106455_1993.txt

106455_1993

1993

106455

ITEM 1 - BUSINESS Coal Marketing Westmoreland Coal Company's (the "Company") principal business is the production and marketing of coal on a worldwide basis. More than half of the coal sold by the Company is processed at and shipped from its coal properties, and includes both steam coal, sold primarily to electric utilities, and metallurgical coal, sold primarily to the steel industry. The remaining coal sold by the Company is produced by other domestic mining companies, principally smaller producers seeking to utilize the Company's expertise in the marketing of coal. The following table shows, for each of the past five years, the total tons of coal sold, tons sold from company production and tons sold that were sourced from unaffiliated producers (tons ooo's): Total sales Company production Sales for others 1993 16,687 11,551 5,136 1992 19,380 11,774 7,606 1991 20,627 11,570 9,057 1990 20,279 11,679 8,600 1989 19,613 10,813 8,800 Of the total tons of coal sold for others, approximately 37%, 30% and 38% was produced by domestic mining companies affiliated with Adventure Resources, Inc. ("Adventure") in 1993, 1992 and 1991, respectively. The coal sold by the Company which is produced by Adventure decreased in 1992 and 1993 due to Adventure's mine closings caused by higher operating costs and depletion of its coal reserves. On December 2, 1992 Adventure filed voluntary petitions for reorganization under Chapter 11 of the Bankruptcy Code with the United States Bankruptcy Court for the Southern District of West Virginia. Adventure continues to operate its remaining mines and the Company is continuing in its role of sales agent. Acting as sales agent for Adventure, the Company purchases all of Adventure's clean coal production at the time it is produced thus carrying all inventory and accounts receivable related to the sale of Adventure's coal production. The Company's obligation to buy coal from Adventure expired on March 1, 1994 and discussions are underway to determine the ongoing relationship with Adventure. At this time, it is expected that this relationship will be terminated as of June 30, 1994 due to the Company's need to conserve its working capital in order to sufficiently fund its internal coal production activities and its independent power activities. In January 1993, another West Virginia coal operation for which the Company acted as sales agent, stopped producing coal. Approximately 2,178,000 tons were sold for this producer in 1992. See Management's Discussion and Analysis of Financial Condition and Results of Operations for additional discussion. In the case of coal sold for others, the Company may or may not take title to the coal, but in substantially all such transactions the Company assumes the credit risk of the purchaser. In 1993, the Company had no bad debt experience related to coal sold for others. In 1992, the Company established reserves for bad debts related to coal sold for others in the amount of $4,801,000. The bad debt expense in 1991 relating to coal sold for others was not material. The Company is able to offer customers a wide variety of coals, including both steam coal and metallurgical coal, and a range of services related to its coal sales, including sourcing, blending, quality control and transportation. Transportation services include arrangements with railroads, barge lines and vessel charterers. The Company's wholly owned subsidiary, Westmoreland Coal Sales Company, Inc. ("WCSC"), also has its own leased fleet of railcars to increase the availability of transportation and to reduce transportation costs. The Company markets coal worldwide, primarily through WCSC, using both its own sales force and a network of agents in foreign countries. WCSC has sales offices in Philadelphia, Pennsylvania and Charlotte, North Carolina. It also has field offices in Banner, Kentucky and Beckley, West Virginia. These field offices serve the function of sourcing coals from mines owned by unaffiliated producers. This gives WCSC access to coals which complement the Company's own production. The field offices also have full service quality control laboratories and sampling personnel in order to assure that coal being shipped to the customer meets specifications. Approximately 77% of the tonnage sold by the Company in 1993 was sold under contracts calling for deliveries over a period longer than one year. The table below presents the amount of coal tonnages sold under long-term contracts for the last five years: Sales under long- Total sales term contracts tonnage (000s) % Tons (000s) 1993 77% 12,774 16,687 1992 72% 13,867 19,380 1991 68% 13,969 20,627 1990 73% 14,761 20,279 1989 71% 13,850 19,613 On December 31, 1993, the Company, together with its subsidiaries (including 3,450,000 tons for 1994 at Westmoreland Resources, Inc. ("WRI"), its 60% owned subsidiary) had sales contracts requiring it to deliver in 1994 a minimum of 12,825,000 tons of coal, which commitments will be met from the production of the Company and other producers. Of this amount, approximately 554,000 tons are under contracts expiring in a year or less, and approximately 12,271,000 tons are under contracts for more than a year. The table below presents total sales tonnage under existing long-term contracts as they expire over the next five years: Total sales tonnage under existing long- term contracts (000s) 1994 12,271 1995 11,409 1996 9,242 1997 5,340 1998 4,781 Included in the tonnage figures above are certain coal sales covered by agreements of WRI. Under these agreements, WRI has exercised its right to receive "take or pay" payments from its customers if they elect not to purchase the minimum tonnages specified in the agreements. These payments will produce approximately the same net margin for WRI as if the coal were delivered. Substantially all of the Company's long-term contracts have price adjustment provisions for changes in specified production costs' indices which generally reflect changes in wage rates, costs of supplies, union benefits, general and administrative costs, taxes, environmental and safety legislation and royalties. Some of the long-term contracts also provide for periodic price renegotiation and allow for termination after one year's notice upon failure to agree on a new price. Virtually all long-term contracts contain provisions for suspension of deliveries in the event of force majeure. Before long-term commitments expire, it is the Company's practice to renegotiate them, when appropriate, and thereby extend the contract, or to acquire new contracts to replace them. In 1993, the 10 largest customers of the Company accounted for 62% of its coal revenues. Its two largest customers, Duke Power Company and Georgia Power Company, accounted for 22% and 10%, respectively, of the Company's coal revenues in 1993. No other customer accounted for as much as 10% of the Company's 1993 coal revenues. Sales to Georgia Power Company and Duke Power Company are made pursuant to long-term contracts expiring in April 1995 and July 1996, respectively. Pursuant to a scheduled price renegotiation under the Duke Power Company contract, on August 20, 1992 the Company agreed to reduce its price under this contract, effective January 1, 1993, by 10%. This price decrease, net of contractual price escalations in 1993, resulted in a reduction of revenues, and therefore profits, by approximately $7,100,000 in 1993 as compared to 1992. Cleancoal Terminal Company ("Cleancoal"), a wholly owned subsidiary of the Company, is a rail-to-barge transloading and storage facility on the Ohio River between Louisville, Kentucky and Cincinnati, Ohio. The terminal gives the Company increased access to producers in Kentucky and affords the Company greater access to midwestern, southern and foreign markets. The terminal is also able to blend western Powder River Basin coals with eastern Kentucky coals. Cleancoal has an annual transloading capacity of 6,000,000 tons. It transloaded 2,511,000 tons in 1993, 2,144,000 tons in 1992. Westmoreland Terminal Company, a wholly owned subsidiary of the Company, has a 20% interest in Dominion Terminal Associates ("DTA"), a consortium formed for the construction and operation of a coal storage and vessel-loading facility in Newport News, Virginia. DTA's annual throughput capacity is 20,000,000 tons, and its ground storage capacity is 1,700,000 tons. In 1993, DTA loaded 12,285,000 tons, including 2,428,000 tons for the Company. Coal Production The Company produces coal at properties in Virginia, West Virginia, Kentucky and Montana. Mining activities in the Eastern United States are conducted by the Company's Virginia Division, which mines reserves located in Virginia and eastern Kentucky, its Hampton Division, which mines reserves in West Virginia, Criterion Coal Company ("Criterion"), a wholly owned subsidiary of the Company, which mines reserves located in Kentucky and Pine Branch Mining Incorporated ("Pine Branch"), a wholly owned subsidiary of the Company, which mines reserves located in Virginia and eastern Kentucky. The Company's mining operations in Montana are conducted through WRI which is 60% owned by the Company. Virginia Division. The Company's Virginia Division consists of nine mines located in Virginia and eastern Kentucky, including five underground mines operated by the Company and four mines operated by contractors, three of which are underground mines and one of which is a surface mine. In 1993, 1992 and 1991, the Virginia Division shipped 4,878,000 tons, 4,708,000 tons, and 4,325,000 tons of coal, respectively, including coal produced by independent contractors on Virginia Division properties and coal purchased from off-property locations including Pine Branch Mining. The Virginia Division properties total approximately 60,000 acres and employs approximately 770 people. The Virginia Division is currently operating two preparation plants for processing and loading coal. In late 1994 one of these two plants and one mine will cease operations for economic reasons. See Management's Discussion and Analysis of Financial Condition and Results of Operations for additional discussion. Hampton Division. The Company's Hampton Division is situated in West Virginia. Its operations currently consist of two underground mines, a large surface mine and shop and preparation plant facilities. In 1993, 1992 and 1991, the Hampton Division shipped 1,561,000 tons, 1,745,000 tons and 1,543,000 tons of coal, respectively, including coal produced by an independent contractor on Hampton Division properties and coal purchased from off- property locations. The Hampton Division has one preparation plant for processing and loading coal. The Hampton Division's properties total approximately 14,000 acres and it employs approximately 130 people. During the first half of 1994 the Hampton Division will be closed down with the exception of the surface mine which is operated by a contractor with capacity to produce approximately 840,000 tons on an annual basis. All other mines together with the preparation plant and shop facilities will be closed down and the employees will be terminated. This closedown has been necessitated by market conditions, including the termination of an above-market coal sales contract. See Management's Discussion and Analysis of Financial Condition and Results of Operations for additional discussion. Criterion Coal Company. Criterion is a wholly owned subsidiary of the Company with mining operations in Kentucky. Criterion, through its wholly owned subsidiary, Kentucky Criterion Coal Company, consists of five mines, including two surface mines and three underground mines. All of these mining operations are conducted by independent contractors on Criterion's properties. Criterion's total shipments in 1993, 1992 and 1991 were 1,853,000 tons, 1,786,000 tons and 1,600,000 tons of coal, respectively. In 1993, Criterion began operating a new coal preparation plant, which increased the capacity of the property to 3,000,000 tons per year. Criterion expects to open a new underground mine in 1994. Westmoreland Resources, Inc. WRI is 60% owned by the Company, 24% owned by Morrison-Knudsen Corporation and 16% owned by Penn Virginia Corporation. WRI operates one large surface mine in Montana on approximately 15,000 acres of subbituminous coal lands. In 1993, WRI mined and shipped approximately 3,224,000 tons of coal. Morrison-Knudsen Corporation mines this coal under a contract with WRI. The majority of the coal sold by WRI is sold under long-term contracts. One of these long-term contracts, which expires in 2005, accounted for 62% of the coal sold by WRI in 1993. Pine Branch Mining Incorporated. Pine Branch is a wholly owned subsidiary of the Company with mining operations in Virginia and eastern Kentucky. Pine Branch began operations in 1992 and it consists of one surface mine. Pine Branch produced 210,000 tons in 1993 and 117,000 tons in 1992, the majority of which was sold to the Virginia Division where it was processed and loaded into railcars for shipment to customers. Cogeneration Westmoreland Energy, Inc.("WEI") a wholly owned subsidiary of the Company, has been offered for sale by the Company and is therefore being accounted for as a discontinued operation. (See Note 6 to the Consolidated Financial Statements.) WEI is engaged in the business of developing and owning interests in cogeneration and other non-regulated independent power plants throughout the United States. Cogeneration is a power production technology that provides for the sequential generation of two or more useful forms of energy (e.g., electricity and steam) from a single primary fuel source (e.g., coal). The key elements of a cogeneration project are contracts for sales of electricity and steam, contracts for fuel supply, a suitable site, required permits and project financing. The economic benefit of cogeneration technology can be substantial because a significant portion of the energy which is wasted in the application of conventional technology is used by cogeneration technology to produce steam or hot water for industrial processes or the generation of additional electricity. Electricity is sold to utilities and end-users of electrical power, including large industrial facilities. Thermal energy from the cogeneration plant is sold to commercial enterprises and other institutions. Large industrial users of thermal energy include plants in the chemical processing, petroleum refining, food processing, pharmaceutical and pulp and paper industries. A significant market has been rapidly developing in the United States for power generated by cogeneration and other independent power plants. This development was fostered by the energy crises of the 1970s, which led to the enactment of legislation that encouraged companies to enter the cogeneration and independent power generation industry by reducing regulatory requirements and facilitating the sale of electricity by such companies to utilities. Cogeneration and other independent power producers are also an attractive, economical source of energy for large industrial users which require dedicated energy sources for major facilities. WEI, through various subsidiaries, currently has an interest in the eight cogeneration projects described in the table filed as an exhibit to this report. Employees and Labor Relations The Company, including subsidiaries, employed 1,090 people on December 31, 1993 compared with 1,195 on December 31, 1992. On July 1, 1993, the Company, through its membership in the Independent Bituminous Coal Bargaining Alliance, ("IBCBA") entered into an interim agreement with the United Mine Workers of America ("UMWA"). This agreement provides for the Company and the UMWA at the local level to work together to reduce health care costs, maximize the utilization of the Company's investments, recognize special local operating and competitive conditions, provide flexibility in work and scheduling, create incentive programs, recognize employees' skills and performance, involve and integrate employees and the UMWA in the success of their mines and the Company, and improve overall labor management relations. These features were incorporated into a five-year agreement that succeeded the interim agreement, and became effective as of December 1993 ("1994 Agreement"). The Company and the UMWA are in the process of implementing the 1994 Agreement, including its health care cost reduction provisions, which should make those operations more competitive. The 1994 Agreement provides for a wage increase of $.50 per hour, retroactive to February 1, 1993, the date on which the prior five- year agreement expired. Employees will receive the retroactive portion of this wage increase in the form of an additional $.50 per hour until the retroactive portion is paid. The 1994 Agreement provides for additional wage increases of $.40 per hour on December 16, 1994 and December 16, 1995, and for additional reopeners in 1996 and 1997. Competition The coal industry is highly competitive, and the Company competes (principally in price and quality of coal) in both the steam coal and metallurgical coal markets with many other coal producers of all sizes. The Company, including the 1993 production of WRI, accounted for an estimated 1% of the nation's 1993 coal production, compared to the nation's largest coal producer which accounted for an estimated 9%. The Company's steam coal also competes with other energy sources in the production of electricity. WEI is subject to increasing competition with respect to the development of new cogeneration projects from unregulated affiliates of utility companies, affiliates of fuel and equipment suppliers and independent developers. Mining Safety and Health Legislation The Company is subject to state and federal legislation prescribing mining health and safety standards, including the Federal Coal Mine Safety and Health Act of 1969 and the 1977 Amendments thereto. In addition to authorizing fines and other penalties for violations, the Act empowers the Mine Safety and Health Administration to suspend or halt offending operations. Energy Regulation WEI's cogeneration operations are subject to the provisions of various laws and regulations, including the federal Public Utilities Regulatory Policies Act of 1978 ("PURPA"). PURPA provides qualifying cogeneration facility status ("QF") to operations such as WEI's which allows them certain exemptions from substantial federal and state legislation and regulation, including regulation of rates at which electricity can be sold. The most significant recent change in energy regulation was the passage of the National Energy Policy Act of 1992 ("EP Act"). The EP Act reformed the Public Utility Holding Company Act of 1935. Companies can apply for Exempt Wholesale Generator ("EWG") status with the Federal Energy Regulatory Commission. An EWG can exclusively provide electric energy at wholesale prices without the requirement to sell thermal energy to a steam user. WEI applied for and received EWG status for its Roanoke Valley I ("RV I") project in December 1993. WEI intends to maintain the QF status for all projects except RV I. In the future, a case-by-case determination of QF or EWG status will be completed to optimize project returns. Protection of the Environment Mining Operations. The Company believes its mining operations are substantially in compliance with applicable federal, state and local environmental laws and regulations, including those relating to surface mining and reclamation, and it is the policy of the Company to operate in compliance with such standards. The Company believes that this policy will not substantially affect its ability to compete with similarly situated companies in the marketplace. Present compliance is largely a result of capital expenditures made in prior years and of current capital investments, maintenance and monitoring activities. The Company invested approximately $413,000 for capital additions and charged approximately $7,247,000 to earnings and $2,306,000 to reserves in 1993 in order to comply with environmental regulations applicable to its mining operations. Of the $7,247,000 charged to earnings, $4,235,000 was accrued as part of the Company's mine closure costs, discussed in Management's Discussion and Analysis of Financial Condition and Results of Operations. In addition, reclamation fees imposed by the Federal Surface Mining Control and Reclamation Act of 1977 (the "Surface Mining Act") amounted to approximately $2,148,000 in 1993. Based on its present interpretation of existing applicable environmental requirements, the Company has projected that it will expense approximately $2,400,000 and will spend approximately $625,000 for capital expenditures related to its mining operations to meet such requirements in 1994. Estimates of capital expenditures will be adjusted as necessary, either to reflect the impact of new regulations or because presently unforeseeable conditions may be imposed on future mining permits. The Surface Mining Act regulations set forth standards, limitations and requirements for surface mining operations and for the surface effects of deep mining operations. Under the regulatory scheme contemplated by the Surface Mining Act, the Federal Office of Surface Mining ("OSM") issued regulations which set the minimum standards to which state agencies concerned with the regulation of coal mining must adhere. States that wish to regulate such coal mining must present their regulatory plans to OSM for approval. Once a state plan receives final approval, the state agency has primary regulatory authority over mining within the state, and OSM acts principally in a supervisory role. State agencies may impose standards more stringent than those required by OSM, and in some states this has been or is expected to be done. The four states in which the Company mines coal, Virginia, West Virginia, Kentucky and Montana, have all submitted regulatory plans to OSM, and these plans have received final approval. There is potential risk to the Company in the event it, or any of its independent contractors, fails to satisfy the obligations created by the Surface Mining Act. The Company's surface-mined Eastern coal production is mined to a large extent by independent contractors which, pursuant to their agreements with the Company, are primarily responsible for compliance with environmental laws. In the event, however, that any of its independent contractors fail to satisfy their obligations under the Surface Mining Act, the Company, depending upon the circumstances, might have, and has had, to carry out such obligations in order to avoid having its existing permits revoked or applications for new permits or permit modifications blocked. Compliance with the Surface Mining Act regulations has been costly for the Company and the coal mining industry in general. In 1990 certain amendments were enacted to the Clean Air Act ("1990 Amendments"). As the first major revisions to the Clean Air Act since 1977, the 1990 Amendments vastly expand the scope of federal regulations and enforcement in several significant respects. In particular, the 1990 Amendments require that the United States Environmental Protection Agency (the "EPA") issue new regulations related to ozone non-attainment, air toxics and acid rain. Phase I of the acid rain provisions require, among other things, that electrical utilities reduce their sulfur dioxide emissions by 1995. Phase II requires an additional reduction in emissions by the year 2000. The acid rain provisions of the 1990 Amendments may have a positive impact on the Company, in large part because a substantial amount of the Company's coal reserves are relatively low in sulfur content, i.e., less than 1 percent. This legislation allows utilities the freedom to choose the manner in which they will effect compliance with the required emission standards, increasing, in the opinion of the Company's management, the demand for low sulfur coal. The Company currently anticipates little or no impact on the coal industry from the ozone non- attainment provision of the 1990 Amendments, and is currently studying the potential impact of the air toxics provision, which management believes at this point will have a minimal effect on the coal industry. A significant, but indirect, cause of lower coal demand in the electric utility sector has been low gas prices. The perception that gas prices will remain low throughout the 1990's has allowed utilities to plan to meet electricity growth with a combination of demand-side management and small gas-fired capacity additions. This strategy may displace potential new coal-fired capacity through the 1990's. The Company's marketing response has been to concentrate on maintaining, and attempting to increase, its market share with existing customers and grow on the basis of utilities switching from high sulfur to low sulfur coal rather than on the basis of future coal-fired power plant additions. Cogeneration. The environmental laws and regulations applicable to the projects in which WEI participates primarily involve the discharge of emissions into the water and air, but can also include wetlands preservation and noise regulation. These laws and regulations in many cases require a lengthy and complex process of obtaining licenses, permits and approvals from federal, state and local agencies. Meeting the requirements of each jurisdiction with authority over a project can delay or sometimes prevent the completion of a proposed project, as well as require extensive modifications to existing projects. The limited partnerships formed to carry out these projects have the primary responsibility for obtaining the required permits and complying with the relevant environmental laws. The Clean Air Act and the 1990 Amendments contain provisions that regulate the amount of sulfur dioxide and nitrogen oxides that may be emitted by a project. These emissions may be a cause of acid rain. Most of the projects in which WEI has investments are fueled by low sulfur coal and are not expected to be significantly affected by the acid rain provisions of the 1990 Amendments. Segment Information For financial information about Westmoreland's industry segments and export sales for the years 1993, 1992 and 1991 refer to Note 12 to the Consolidated Financial Statements, appearing on pages 97-101 inclusive. For a discussion of certain factors affecting the business of Westmoreland in 1993, 1992 and 1991 refer to the section entitled "Management's Discussion and Analysis of Financial Condition and Results of Operations," appearing on pages 38-53 inclusive, and Notes 1, 6 and 7 to the Consolidated Financial Statements, appearing on pages 66-67, 76-83 inclusive. ITEM 2 ITEM 2 - PROPERTIES The Company owns or leases coal properties located in Virginia, West Virginia, Kentucky and Montana. The Company's estimated demonstrated reserves (excluding reserves deemed by the Company to be uneconomic to mine) in owned or leased property on December 31, 1993 in the three eastern states were 142,791,000 tons and in Montana were 672,378,000 tons. In the three eastern states the Company also owns or leases 347,093,000 tons currently classified by the Company as Unassigned Uneconomic. Unassigned Uneconomic tonnages require significant capital expenditures and construction of new mine openings and are legally recoverable with current technology, but are not in the Company's mining plans today, because they cannot be mined profitably based on current projected economic conditions. With the exception of the coal reserves in Kentucky, which reserves are owned in fee simple, nearly all of the Company's eastern reserves are leased from others including 343,242,000 tons under lease from Penn Virginia Resources Corporation, a wholly owned subsidiary of Penn Virginia Corporation (together "Penn Virginia") which controlled an 18.96% voting interest in the Company at December 31, 1993 and December 31, 1992. All leases with Penn Virginia run to exhaustion of the coal reserves. Properties located in Montana are leased by WRI from the Crow Tribe of Indians and run to exhaustion. The balance of the Company's leases are for varying terms, including to exhaustion. Refer to Note 5 to the Consolidated Financial Statements, on pages 74-75 inclusive. The table below shows the Company's estimated demonstrated coal reserve base and production in 1993. The term "demonstrated coal reserve base" is as defined in the "Coal Resource Classification System of the U.S. Geological Survey" (Circular 891). This represents the sum of the measured and indicated reserve bases and includes assigned and unassigned economic reserves. Estimates of reserves in the eastern states are based mainly upon yearly evaluations made by the Company's professional engineers and geologists. The Company periodically modifies estimates of reserves under lease which may increase or decrease previously reported amounts. The reserve evaluations are based on new information developed by bore-hole drilling, examination of outcrops, acquisitions, dispositions, production, changes in mining methods, abandonments and other information. Coal reserves in Montana represent recoverable tonnage held under the terms of the principal Crow Tribe lease, as amended in 1982, as well as other minor leases, and were estimated at 799,803,000 tons as of January 1, 1980, based principally upon a report by independent consulting geologists, prepared in February 1980. The reserve estimate has been adjusted for subsequent production, changes in mining practices and coal recovery experience. In addition to the coal reserves mentioned above, the Company owns a number of coal preparation and loading facilities in Virginia, West Virginia and Kentucky. WRI owns and operates a dragline and coal crushing and loading facilities at its mine in Montana. ITEM 3 ITEM 3 - LEGAL PROCEEDINGS No material proceedings. ITEM 4 ITEM 4 - SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS This item is inapplicable. Executive Officers of the Registrant Below is a table showing the executive officers of the Company, their ages as of March 1, 1994, positions held and year of election to their present offices. No family relationships exist among them. All of the officers are elected annually by the Board of Directors and serve at the pleasure of the Board of Directors. Name Age Position(s) Held Since Christopher K. Seglem 47 President and 1992 Chief Executive Officer (1) 1993 R. Page Henley, Jr. 58 Senior Vice President-Government Affairs (2) 1992 Theodore E. Worcester 53 Senior Vice President and 1992 General Counsel (3) 1990 Ronald W. Stucki 49 Senior Vice President- Operations (4) 1992 Francis J. Boyle 48 Senior Vice President, Chief Financial Officer and Treasurer (5) 1993 Joseph W. Lee 50 President Westmoreland Coal Sales Company (6) 1991 Charles J. Brown, III 46 President Westmoreland Energy, Inc. (7) 1987 Ronald R. Rominiecki 40 Controller (8) 1988 ____________________________ (1) Effective January 1988, Mr. Seglem was elected to the positions of Vice President, General Counsel, and Secretary for the Company. In November 1988 he was elected a Senior Vice President of the Company. In May 1990, he relinquished the position of Secretary. In December 1990, he was elected an Executive Vice President of the Company, at which time he relinquished the position of General Counsel. In June 1992, he was elected President and Chief Operating Officer, and in December 1992 he was elected a Director of the Company. In June 1993, he was elected Chief Executive Officer of the Company, at which time he relinquished the position of Chief Operating Officer. He is a member of the bar of Pennsylvania. (2) Mr. Henley was elected Vice President-Development and Government Affairs in May 1988, which position he held until he was elected Senior Vice President-Development and Government Affairs in May 1990. In June 1992, he was elected Senior Vice President-Government Affairs. In 1993, Mr. Henley was also elected Vice President, General Counsel and Secretary of the Company's WEI subsidiary, and undertook additional duties, including project development. Subsequently, on March 29, 1994, he was elected Senior Vice President-Development of the Company. (3) Mr. Worcester was a member of the law firm of Sherman & Howard, with its principal office in Denver, Colorado, from 1972, and a partner in the firm from 1978 until December 1990, at which time he was elected Vice President & General Counsel of the Company. In June 1992, he was elected Senior Vice President while retaining his position of General Counsel of the Company. He is a member of the bar of Colorado. (4) Mr. Stucki was General Manager and Vice President of Colorado Westmoreland Inc. (a former wholly owned subsidiary of the Company) until the operation was sold to Cyprus Coal Company (Cyprus) in November 1988, where he continued and became Vice President of Colorado and Wyoming operations. He left Cyprus to rejoin the Company as Senior Vice President-Operations in July 1992. (5) Mr. Boyle was Chief Financial Officer and Senior Vice President of El Paso Natural Gas Company from 1985 through 1992. He was elected Senior Vice President, Chief Financial Officer and Treasurer of the Company, effective August 9, 1993. (6) Mr. Lee was elected Vice President-Purchasing and Northern Sales of Westmoreland Coal Sales Company in 1988, which position he held until he was elected Senior Vice President of Westmoreland Coal Sales Company on July 1, 1991. Mr. Lee was elected President of Westmoreland Coal Sales Company on August 1, 1991. (7) Mr. Brown terminated employment with the Company effective April 8, 1994. (8) Mr. Rominiecki terminated employment with the Company effective March 31, 1994. PART II ITEM 5 ITEM 5 - MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS Reference is hereby made to the section entitled "Market Information on Capital Stock" appearing on pages 109-110. ITEM 6 ITEM 6 - SELECTED FINANCIAL DATA Reference is hereby made to the section entitled "Five-Year Review" appearing on pages 54-55 inclusive. ITEM 7 ITEM 7 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Reference is hereby made to the section entitled "Management's Discussion and Analysis of Financial Condition and Results of Operations" appearing on pages 38-53 inclusive. ITEM 8 ITEM 8 - FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Reference is hereby made to pages 56-61 inclusive. Reference is also made to the financial statement schedules included on pages 33-36 inclusive. ITEM 9 ITEM 9 - CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE This item is inapplicable. 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 For Items 10-13, inclusive, except for information concerning executive officers of Westmoreland included as an unnumbered item in Part I above, reference is hereby made to Westmoreland's definitive proxy statement dated April 29, 1994, to be filed in accordance with Regulation 14A pursuant to Section 14(a) of the Securities Exchange Act of 1934, which is incorporated herein by reference thereto. PART IV ITEM 14 ITEM 14 - EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K a) 1. The financial statements filed herewith are listed in the Index to Financial Statements on page 37 2. The financial statement schedules filed herewith are listed in the Index to Financial Statements on page 32. The financial statement schedules are on pages 33-36. 3. The following exhibits are filed herewith as required by Item 601 of Regulation S-K: (3) (a) Articles of incorporation, as amended to date. (b) Bylaws, as amended on December 4, 1990, were filed as Exhibit 3(b) to Westmoreland's Annual Report on Form 10-K for 1990 (SEC File No. 0-752), which Exhibit 3(b) is incorporated herein by reference thereto. (4) Instruments defining the rights of security holders (a) A Loan Agreement dated August 10, 1977 between Westmoreland and six insurance companies was filed as Exhibit 2(b) to Westmoreland's Annual Report on Form 10-K for 1977 (SEC File #0-752). That Loan Agreement is incorporated herein by reference thereto. (b) A Revolving Credit Loan Agreement dated September 25, 1990 between Westmoreland and four banks - Reference is hereby made to Exhibit 4(b) to Westmoreland's Annual Report on Form 10-K for 1990 (SEC File #0- 752), which Exhibit 4(b) is incorporated herein by reference thereto. (c) Certificate of Designation of Series A Convertible Exchangeable Preferred Stock of the Company defining the rights of holders of such stock, filed July 8, 1992 as an amendment to the Company's Certificate of Incorporation, and filed as Exhibit 3(a) to Westmoreland's Form 10-K for 1992. (d) Form of Indenture between Westmoreland and Fidelity Bank, National Association, as Trustee relating to the Exchange Debentures. Reference is hereby made to Exhibit 4.1 to Form S-2 Registration 33- 47872 filed May 13, 1992, and Amendments 1 through 4 thereto, which Exhibit is incorporated herein by reference. (e) Form of Exchange Debenture Reference is hereby made to Exhibit 4.2 to Form S-2 Registration 33-47872 filed May 13, 1992, and Amendments 1 through 4 thereto, which Exhibit is incorporated herein by reference. (f) Form of Deposit Agreement among Westmoreland, First Chicago Trust Company of New York, as Depositary and the holders from time to time of the Depositary Receipts. Reference is hereby made to Exhibit 4.3 to Form S-2 Registration 33- 47872 filed May 13, 1992, and Amendments 1 through 4 thereto, which Exhibit is incorporated herein by reference. (g) Form of Certificate of Designation for the Series A Convertible Exchangeable Preferred Stock. Reference is hereby made to Exhibit 4.4 to Form S-2 Registration 33-47872 filed May 13, 1992, and Amendments 1 through 4 thereto, which Exhibit is incorporated herein by reference. (h) Specimen certificate representing the common stock of Westmoreland, filed as Exhibit 4(c) to Westmoreland's Registration Statement on Form S-2, Registration No. 33- 1950, filed December 4, 1985, is hereby incorporated by reference. (i) Specimen certificate representing the Preferred Stock. Reference is hereby made to Exhibit 4.6 to Form S-2 Registration 33- 47872 filed May 13, 1992, and Amendments 1 through 4 thereto, which Exhibit is incorporated herein by reference. (j) Form of Depositary Receipt. Reference is hereby made to Exhibit 4.7 to Form S-2 Registration 33-47872 filed May 13, 1992, and Amendments 1 through 4 thereto, which Exhibit is incorporated herein by reference. (k) In accordance with paragraph (b)(4)(iii) of Item 601 of Regulation S-K, Westmoreland hereby agrees to furnish to the Commission, upon request, copies of all other long-term debt instruments. (10) Material Contracts (a) On January 5, 1982, the Board of Directors of Westmoreland adopted a Management by Objectives Plan (MBO Plan) for senior management. A description of this MBO Plan is set forth on page 9 of Westmoreland's definitive proxy statement dated March 31, 1982, which description is incorporated herein by reference thereto. (b) Westmoreland Coal Company 1982 Incentive Stock Option and Stock Appreciation Rights Plan--Reference is hereby made to Exhibit 10(b) to Westmoreland's Annual Report on Form 10-K for 1981 (SEC File #0-752), which Exhibit 10(b) is incorporated herein by reference thereto. (c) Westmoreland Coal Company 1985 Incentive Stock Option and Stock Appreciation Rights Plan--Reference is hereby made to Exhibits 10(d) to Westmoreland's Annual Report on Form 10-K for 1984 (SEC File #0-752), which Exhibit 10(d) is incorporated herein by reference thereto. (d) Agreement dated July 1, 1984 between Georgia Power Company and Westmoreland. Reference is hereby made to pages 33 - 79, inclusive, of Westmoreland's Annual Report on Form 10-K for 1985 (SEC File #0-752), which pages 33 - 79, inclusive, is incorporated herein by reference thereto. (e) Letter agreement dated June 11, 1987 relating to the coal supply agreement between Georgia Power Company and Westmoreland Coal Company. See (10)(d) above. (f) Agreement dated January 1, 1986 between Mill-Power Supply Company, agent for Duke Power Company, and Westmoreland Coal Sales Company, agent for Westmoreland, which is incorporated herein by reference thereto. Reference is hereby made to pages 80 - 103, inclusive, of Westmoreland's Annual Report on Form 10-K for 1985 (SEC File #0-752), which pages are incorporated herein by reference thereto. (g) In 1990, the Board of Directors established an Executive Severance Policy for certain executive officers, which provides a severance award in the event of termination of employment. Reference is hereby made to Exhibit 10(h) to Westmoreland's Annual Report on Form 10-K for 1990 (SEC File #0- 752), which Exhibit 10(h) is incorporated herein by reference thereto. (h) Westmoreland Coal Company 1991 Non- Qualified Stock Option Plan for Non- Employee Directors - Reference is hereby made to Exhibit 10(i) to Westmoreland's Annual Report on Form 10-K for 1990 (SEC File #0-752), which Exhibit 10(i) is incorporated herein by reference thereto. (i) Agreement dated April 1, 1986 between Finsider Mining Company, Ltd. and Westmoreland Coal Sales Company, relating to a contract for the purchase and sale of coking coal, and Assignment dated March 1, 1990 from Finsider to ILVA, S.p.A.- Reference is hereby made to Exhibit 10(j) to Westmoreland's Annual Report on Form 10- K for 1990 (SEC File #0-752), which Exhibit 10(j) is incorporated herein by reference thereto. (j) Effective January 1, 1992, the Board of Directors established a Supplemental Executive Retirement Plan ("SERP") for certain executive officers and other key individuals, to supplement Westmoreland's Retirement Plan by not being limited to certain Internal Revenue Code limitations. A description of this SERP is set forth on page 11 of Westmoreland's definitive proxy statement dated June 9, 1992, which description is incorporated herein by reference thereto. (k) Amended Coal Mining Agreement between Westmoreland Resources, Inc. and Crow Tribe of Indians, dated November 26, 1974, as further amended in 1982, filed as Exhibit (10)(a) to Westmoreland's Quarterly Report on Form 10-Q for the quarter ended March 31, 1992, is incorporated by reference thereto. (l) Amendment and Restatement of Virginia Lease between Penn Virginia Resources Corporation and Westmoreland, effective as of July 1, 1988, as further amended May 6, 1992, filed as Exhibit 10(b) to Westmoreland's Quarterly Report on Form 10-Q for the quarter ended March 31, 1992, is incorporated by reference thereto. (m) Amendment and Restatement of Hampton Lease between Penn Virginia Resources Corporation and Westmoreland, effective as of July 1, 1988, as further amended May 6, 1992, filed as Exhibit 10(c) to Westmoreland's Quarterly Report on Form 10-Q for the quarter ended March 31, 1992, is incorporated by reference thereto. (n) Acquisition Agreement, dated May 6, 1992 by and among Westmoreland, Penn Virginia Corporation and Penn Virginia Equities Corporation, including as Exhibit A thereto, a form of agreement to be executed by the parties on the Closing Date described therein, filed as Exhibit 10(d) to Westmoreland's Quarterly Report on Form 10-Q for the quarter ended March 31, 1992, is incorporated by reference thereto. (o) Agreement dated July 9, 1992 by and among Westmoreland, Penn Virginia Corporation and Penn Virginia Equities Corporation, with respect to (i) registration rights granted to Penn Virginia, (ii) the number of directors which Penn Virginia for a period of two years may designate to be elected to Westmoreland's Board of Directors and (iii) other conditions, as set forth therein, which is discussed in Item 13 of Westmoreland's Form 10-K for 1992. (p) Agreement dated October 9, 1992 by and among Westmoreland, Penn Virginia Corporation and Penn Virginia Equities Corporation amending and modifying prior agreements by and among the parties as set forth therein, which is discussed in Item 13 of Westmoreland's Form 10-K for 1992. Exhibits 10(a), (b), (c), (g), (h) and (j) represent management contracts or compensatory plan arrangements required to be filed as exhibits, pursuant to Item 14(c) of this report. (13) Annual Report to Security Holders. The Westmoreland Coal Company 1993 Annual Report to Shareholders, has not yet been distributed to shareholders. (21) Subsidiaries of the Registrant (23) Consent of Independent Certified Public Accountants b) Reports on Form 8-K. (1) On November 1, 1993 Westmoreland Coal Company filed a Report on Form 8-K. This report contained discussion related to the intended sale of its subsidiary, Westmoreland Energy, Inc. and its press release dated November 1, 1993 as an exhibit. (2) On December 2, 1993 Westmoreland Coal Company filed a Report on Form 8-K. This report contained discussion related to the termination of its proposed sale of Westmoreland Energy, Inc. to California Energy Company, Inc. and its press release dated December 1, 1993 as an exhibit. 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. WESTMORELAND COAL COMPANY April 15, 1994 By /s/ Francis J. Boyle Francis J. Boyle Senior Vice President, Chief Financial Officer & 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. Signature Title Date Principal Executive Officer: President, Chief Executive Officer /s/ Christopher K. Seglem and Director April 15, 1994 Christopher K. Seglem Directors: /s/ Pemberton Hutchinson Chairman of the Board April 15, 1994 Pemberton Hutchinson /s/ E. B. Leisenring, Jr. Director April 15, 1994 E. B. Leisenring, Jr. /s/ William R. Klaus Director April 15, 1994 William R. Klaus /s/ A. Linwood Holton, Jr. Director April 15, 1994 A. Linwood Holton, Jr. /s/ Brenton S. Halsey Director April 15, 1994 Brenton S. Halsey /s/ Edwin E. Tuttle Director April 15, 1994 Edwin E. Tuttle /s/ Lennox K. Black Director April 15, 1994 Lennox K. Black Principal Accounting Officer: /s/ Thomas C. Sharpe Acting Controller April 15, 1994 Thomas C. Sharpe Independent Auditors' Report The Board of Directors and Shareholders Westmoreland Coal Company: We have audited the consolidated financial statements of Westmoreland Coal Company and subsidiaries 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 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 Westmoreland Coal Company and subsidiaries 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, 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 adopted the provisions of the Financial Accounting Standards Board's Statement of Financial Accounting Standards No. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions, in 1993. The accompanying consolidated financial statements and financial statement schedules have been prepared assuming that Westmoreland Coal 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, is in violation of various covenants in its credit arrangements and other obligations and has a net working 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 and financial statement schedules do not include any adjustments that might result from the outcome of this uncertainty. KPMG Peat Marwick April 15, 1994 Philadelphia, PA WESTMORELAND COAL COMPANY AND SUBSIDIARIES The consolidated balance sheets of the Company and subsidiaries as of December 31, 1993 and December 31, 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 together with the related notes and the summary of significant accounting policies are contained on pages 56-108. The following schedules should be read in conjunction with the consolidated financial statements of the Company contained on pages 33-36. Schedules not included have been omitted because they are not applicable or the required information is presented in the consolidated financial statements or related notes. Year ended or at December 31 Schedules submitted: V - Property, plant and equipment 1993, 1992, 1991 VI - Accumulated depreciation and depletion of property, plant and 1993, 1992, 1991 equipment VIII - Valuation and qualifying accounts 1993, 1992, 1991 X - Supplementary income statement information 1993, 1992, 1991

897599_1993.txt

897599_1993

1993

897599

ITEM 1. BUSINESS General Martin Marietta Corporation is a diversified enterprise principally engaged in the conception, design, manufacture and integration of advanced technology products and services for the United States Government and private industry. Martin Marietta Corporation manages significant facilities for the Department of Energy and also produces construction aggregates and specialty chemical products. In April 1993, Martin Marietta Corporation consummated a transaction in which its businesses and the Aerospace businesses of the General Electric Company (GE) were combined (Combination). As a result of the Combination, which was approved by Martin Marietta Corporation's stockholders on March 25, 1993, the then existing Martin Marietta Corporation, which was formed in 1961 by the consolidation of the Glenn L. Martin Company (founded in 1909) and the American-Marietta Company (founded in 1913), was renamed Martin Marietta Technologies, Inc. (Technologies). In the Combination, Technologies became a wholly-owned subsidiary of a new corporation which assumed the Martin Marietta Corporation name. Martin Marietta Corporation and Technologies, although separate Maryland corporations, are operated functionally as an integrated organization and this Annual Report on Form 10-K treats them in this fashion. Unless the context otherwise requires, references to "Martin Marietta" or the "Corporation" refer to Martin Marietta Corporation, its consolidated subsidiaries (including Technologies) and certain nonconsolidated associated companies or joint ventures. See "Martin Marietta Technologies, Inc. - Reporting Status" on page 23. Business Segment Information In 1993, Martin Marietta conducted business in six reportable industry segments. These segments are: the Electronics Group, the Space Group, the Information Group, the Services Group, the Materials Group, and Energy and Other Operations. Information concerning Martin Marietta's net sales, operating profit, assets employed, and certain additional information attributable to each reportable business segment for each year in the three-year period ended December 31, 1993, is included in the "Analysis of Financial Condition and Operating Results" on page 56 through page 61 of the Corporation's 1993 Annual Report to Shareowners (1993 Annual Report) and in "Note R: Industry Segments" of the "Notes to Financial Statements" on page 54 of the 1993 Annual Report. Electronics Group The Electronics Group carries out its operations through the following organizations: Aero & Naval Systems, Armament Systems, Defense Systems, Communications Systems, Control Systems, Electronics & Missiles, Government Electronic Systems, and Ocean, Radar & Sensor Systems. The Group's activities are diverse, but - 2 - primarily relate to the design, development, engineering and production of electronic systems for precision guidance, navigation, detection and tracking of threats; missiles and missile launching systems; armaments; aircraft controls and subsystems (thrust reversers); and secure communications systems. The Group is the prime contractor for the United States Navy's AEGIS fleet air-defense system and produces the AEGIS Weapon System including the AN/SPY-1 radar. AEGIS was the Group's largest program in 1993 and is expected to be the largest in 1994. The Group serves as prime contractor for the development of the AN/BSY-2 Submarine Combat System for the Navy's new Seawolf attack submarine. The Group produces the LANTIRN system, an advanced night vision, navigation and targeting fire control system for fixed-wing aircraft and the Target Acquisition Designation Sight/Pilot Night Vision Sensor (TADS/PNVS) for the Army's AH-64 Apache Attack helicopter. The Group also produces the MK 41 Vertical Launching System (VLS) for the Navy's AEGIS-equipped Ticonderoga-class cruisers and Spruance- and Arleigh Burke-class destroyers. The VLS is a shipboard multi-missile launching system for various types of naval missiles. Sales by the Group represented approximately 41% of the Corporation's total sales in 1993. Sales to the United States Government represented approximately 89% of the Group's sales in 1993. - 3 - Space Group The Space Group's operations are carried out through three organizations: Astronautics, Astro Space and Manned Space Systems. The Group's activities include the design, development, engineering and production of spacecraft, space launch vehicles and supporting ground systems, electronics and instrumentation. The Group serves as the prime integration, systems production and launch contractor to the U.S. Air Force for the Titan series of expendable space launch vehicles. These include the Titan II, Titan III and Titan IV. The design, development and fabrication of the Titan IV, together with the provision of related payload integration and launch services, was the Group's (and the Corporation's) largest program in 1993, constituting approximately 45% of the Group's 1993 sales. The first Titan IV equipped with a newly developed Centaur upper stage was successfully launched in February, 1994. The new configuration allows the launching of significantly heavier payloads to geosynchronous orbit. Titan IV is expected to continue to be the Group's largest program over the next several years. Affirming its commitment to remain a leading contractor in the nation's civil and military space launch programs, on December 22, 1993, the Corporation signed an agreement with General Dynamics to purchase its Space Systems Division. The primary asset of the Space Systems Division is business relating to the Atlas series of space launch vehicles and the Centaur upper stages used with Atlas and Titan IV launch vehicles. Acquisition of the Atlas series of launch vehicles will allow the Corporation to enter the - 4 - intermediate lift launch market. Consummation of the transaction is subject to certain regulatory approvals and the satisfaction of certain other conditions. Assuming satisfaction of these conditions, the transaction is expected to close during the first half of 1994. See "Note D: Proposed Transactions" of the "Notes to Financial Statements" on page 46 of the 1993 Annual Report. A second focus of the Group is the design, development, assembly and testing of expendable external fuel tanks for the National Aeronautics and Space Administration's (NASA) Space Shuttle program. The external tank program is expected to remain a significant program in future years. A third area of operations is the design, development, production and integration of military, civil and commercial spacecraft and related subsystems. Spacecraft missions include communications (e.g., INTELSAT VIII, AsiaSat, Echostar, Inmarsat and the Defense Satellite Communications System), global positioning (e.g., GPS Block II), weather monitoring (e.g., the Television Infrared Observation Satellite program and the Defense Meteorological Satellite program), environmental/earth observing (e.g., Global Geospace Science Satellite, EOS AM, and Landsat satellites), and planetary exploring (e.g., Magellan and Cassini). Sales by the Group represented approximately 36% of the Corporation's total sales in 1993. Sales to the United States Government represented approximately 93% of the Group's sales in 1993. - 5 - Information Group The Information Group consists of four organizations: Automation Systems, Information Systems, Internal Information Systems and Management & Data Systems. The Group provides command and control systems, information processing services, systems engineering, integration, program management, software development, computer-based simulations and training products, computer-based test control, machinery control, and automated logistics systems to civil, military and commercial customers. The Group is the prime contractor for the Consolidated Automated Support System (CASS). CASS is an automated, self contained diagnostic unit for testing Navy electronic and avionic systems. The Group is the integration contractor for the Ballistic Missile Defense organization National Test Facility (NTF) at Falcon Air Force Base, Colorado. As part of the ballistic missile defense initiative, the NTF tests and evaluates simulated strategic defense concepts, architectures, battle-management plans and technologies that would not otherwise be feasible to test. In addition, the Group is providing systems engineering and integration services to the U.S. Federal Aviation Administration (FAA). These services assist the FAA in the implementation of the FAA's Capital Investment Plan, a plan for modernizing the nation's air traffic control system. Implementation of the FAA's plan requires upgrading the FAA's computer, weather, navigation and communication systems. - 6 - The Group is in the third year of a 12-year contract with the U.S. Department of Housing & Urban Development (HUD) to modernize HUD's data processing systems. In 1993, development of a communication system linking HUD's new computer center with its disaster-recovery facility, headquarters and 81 regional and field offices was completed. Sales by the Group represented approximately 13% of the Corporation's total sales in 1993. Sales to the United States Government represented approximately 90% of the Group's sales in 1993. Services Group The Services Group consists of three organizations: Martin Marietta Services, Inc., Martin Marietta Technical Services, Inc. and KAPL, Inc. The Group provides management, engineering, logistics, systems software and processing support, and other technical services to military, civil government and international customers as well as to other organizations within the Corporation. The Department of Defense is the Group's largest customer. The Group is responsible for the operation of the EPA's National Computer Center in Raleigh, North Carolina, the Washington Information Center in Washington, D.C., and the National Environmental Supercomputer Center in Bay City, Michigan. In addition, the Group provides information center support and various consulting and design services to the EPA. Work for the EPA is expected to remain one of the Group's major sources of revenue in 1994. - 7 - The Group provides scientific, engineering, operations and management services support to NASA's Johnson Space Flight Center with respect to that organization's efforts in life sciences experimentation. In this regard, the Group was recently selected to provide such support on the ten upcoming Russian/American Life Sciences Missions. The Group provides similar services supporting NASA missions at Goddard Space Flight Center, AMES Research Center, and the Dryden Flight Center. The Group also provides quality control and engineering services, training, installation and maintenance support of the U.S. Navy's AEGIS fleet air-defense system for which the Corporation's Electronics Group is prime contractor. In addition, the Group presently provides operation and maintenance support of 17 remote long-range radar sites throughout the State of Alaska for the U.S. Air Force. The contract's period of performance expires in September 1994 and currently the Group is competing for a new five-year contract. KAPL Inc., a component of the Group, provides high-level engineering and management support to the Department of Energy's Knolls Atomic Power Laboratory. Sales by the Group represented approximately 4% of the Corporation's total sales in 1993. Sales to the United States Government represented essentially all of the Group's sales in 1993. - 8 - Materials Group Historically, the Corporation's construction aggregates and specialty chemical products businesses had been conducted through Martin Marietta Aggregates and Martin Marietta Magnesia Specialties Inc. In November 1993, the aggregates business and the Common Stock of Martin Marietta Magnesia Specialties Inc. were transferred to a new company, Martin Marietta Materials, Inc. (Materials). On February 24, 1994, an initial public offering of Material's common stock was consummated and 8,797,500 shares of common stock (representing approximately 19% of the shares outstanding) were sold at an initial offering price of $23.00 per share. The Corporation continues to own all of the remaining shares and presently intends to maintain such ownership. Maintenance by the Corporation of at least an 80% ownership position will enable the Corporation to continue to include Materials in the Corporation's consolidated group for federal income tax purposes. See "Note D: Proposed Transactions" of the "Notes to Financial Statements" on page 46 of the 1993 Annual Report. Materials carries on its operations through two divisions, Aggregates and Magnesia Specialties. The Aggregates division is the United States' third largest producer of aggregates for the construction of highways and other infrastructure projects and for the commercial and residential construction industries. In 1993, Materials shipped approximately 65 million tons of aggregates to customers in 24 states, generating sales of $337.5 million. In 1993, approximately 94% of the aggregates shipped by Materials were crushed stone, primarily granite and limestone, and approximately - 9 - 6% were sand and gravel. Materials has focussed on the production of construction aggregates and has not integrated vertically into other construction materials businesses. As a result of dependence upon the construction industry, the profitability of construction aggregates producers is sensitive to regional economic conditions, particularly to cyclical swings in construction spending and changes in the level of infrastructure spending funded by the public sector. The aggregates business is also highly seasonal, due primarily to the effect of weather conditions on construction activity in the markets served. Materials' aggregates business is concentrated principally in the Southeast and the Midwest and is, therefore, primarily affected by the weather and economies in these regions. Management believes that raw material reserves are sufficient to permit production at present operational levels for the foreseeable future. Through its Magnesia Specialties Division, Materials manufactures and markets magnesia-based products, including refractory products for the steel industry and chemical products for industrial and agricultural uses. In 1993, the Magnesia Specialties Division generated net sales of $115.4 million. Magnesia Specialties' refractory and dolomitic lime products are sold primarily to the steel industry, and such sales may be affected by developments in that industry. Sales by the Group represented approximately 5% of the Corporation's total sales in 1993. - 10 - Energy and Other Operations Energy Group - The Energy Group's operations are performed through three organizations: Martin Marietta Energy Systems, Inc., Martin Marietta Utility Services, Inc. and Martin Marietta Specialty Components, Inc. A primary function performed by Martin Marietta Energy Systems, Inc. is managing the Department of Energy's (DOE) facilities at Oak Ridge, Tennessee. The Oak Ridge facilities include: (i) the K-25 site, which is host to a number of environmental and other technical programs performed for the DOE and other federal agencies, (ii) the Oak Ridge Y-12 Plant, a manufacturing and developmental engineering facility engaged primarily in programs vital to the national defense, and (iii) the Oak Ridge National Laboratory, one of the nation's largest multipurpose research centers. The Oak Ridge National Laboratory's primary mission is the development of safe, economic and environmentally acceptable technologies for the efficient production and use of energy. An additional critical mission is the transfer of technology to the private sector to enhance national competitiveness. In July 1993, the DOE's uranium enrichment operations were transferred to the United States Enrichment Corporation, a government corporation. These operations included the DOE's Paducah and Portsmouth Gaseous Diffusion Plants which produce enriched uranium for use as a fuel in nuclear power plants. The Energy Group, which had managed these facilities for the DOE, continues to perform this management role for the United States - 11 - Enrichment Corporation through Martin Marietta Utility Services, Inc. Martin Marietta Specialty Components, Inc. manages the Pinellas electronic components plant in Largo, Florida for the DOE. The plant manufactures electronic and electromechanical components, primarily for nuclear weapons. Recent defense-related budget reductions have decreased production at some of the Energy Group's facilities and the Secretary of the DOE recently announced that nuclear weapons components stockpile production will cease at both the Y-12 and the Specialty Components plants. Sandia Corporation - In 1993, the Corporation was selected to succeed AT&T as the operating contractor for the DOE's Sandia National Laboratories (Sandia). The Corporation, through Sandia Corporation (a wholly-owned subsidiary, the common stock of which was acquired from AT&T), assumed full management and operational responsibility for Sandia in October 1993. Sandia is a federal government research and development laboratory with significant responsibilities for national security programs in defense and energy. An additional critical mission is the transfer of technology to the private sector to enhance national competitiveness. Martin Marietta Overseas Corporation - Martin Marietta Overseas Corporation (MMOC), a wholly-owned subsidiary of Martin Marietta, is generally responsible for contracts, joint ventures, teaming and other agreements with international customers and parties. In recent years, the amount of business conducted by the - 12 - Corporation internationally (directly and through MMOC) has increased and international business now constitutes approximately 13% of the Corporation's business. Included in this percentage are Foreign Military Sales which, because such sales are made through the U.S. Government, are also taken into account in calculating the percentage of the Corporation's sales to the U.S. Government. International business includes the production of commercial communications satellites for customers such as AsiaSat, Japan Broadcasting Corporation, Korea Telecom, the 52-nation Inmarsat Consortium and the 124-nation INTELSAT consortium, and the sale of airborne, ground and naval surveillance radars, the Patriot Missile System, the LANTIRN system, and the TADS/PNVS system to various allied nations. Additional Activities - For information relating to activities undertaken by the Corporation included within this reportable business segment, including information pertaining to activities not discussed above, see "Note R: Industry Segments" of the "Notes to Financial Statements" on page 54 of the 1993 Annual Report. Competition, Contracts and Risk Martin Marietta competes with numerous other contractors on the basis of price and technical capability. Its business involves rapidly advancing technologies and is subject to many uncertainties including, but not limited to, those resulting from changes in federal budget priorities, particularly the size and scope of the defense budget, and dependence on Congressional appropriations. Within the context of the general market decline and resulting over - 13 - capacity and increased competition within the defense and aerospace industries, management views the operations of the Electronics and Space Groups as stable areas and is taking steps to maintain sales levels by these Groups. Management views the operations of the Information Group, Services Group, Materials Group and Energy Group as growth areas and is seeking to increase the business of these Groups particularly to civil, commercial and international customers. Due to the intense competition for available government business, the maintenance and/or expansion of government business increasingly requires the Corporation to invest in its working capital and fixed asset base. In addition, management continues to review opportunities to expand the Corporation's existing businesses and to diversify into closely related businesses through acquisitions. Approximately 87% of the 1993 sales of the Corporation were made to the United States Government, either as a prime contractor or as a subcontractor, principally to the Department of Defense (including Foreign Military Sales) and NASA and additionally to the U.S. Department of Energy, the U.S. Department of Housing & Urban Development, the U.S. Environmental Protection Agency, and the U.S. Postal Service. Accordingly, sales and earnings are subject to the size, schedule and funding of government programs and are subject to periodic review in light of changes in government policies and requirements, availability of funds and technical or schedule progress. Earnings may vary materially depending upon the types of long- term government contracts undertaken, the costs incurred in their - 14 - performance, the achievement of other performance objectives and the stage of performance at which the right to receive fees, particularly under incentive and award fee contracts, is finally determined. See "Note A: Accounting Policies" of the "Notes to Financial Statements" on page 44 and page 45 of the 1993 Annual Report for information concerning Martin Marietta's accounting policies governing recognition of revenues and earnings. All government contracts and, in general, subcontracts thereunder are subject to termination in whole or in part at the convenience of the United States Government as well as for default. Long-term government contracts and related orders are subject to cancellation if appropriations for subsequent performance periods become unavailable. Martin Marietta generally would be entitled to receive payment for work completed and allowable termination or cancellation costs if any of its government contracts were to be terminated for convenience. Upon termination for convenience of cost-reimbursement-type contracts, the contractor is normally entitled, to the extent of available funding, to reimbursement of allowable costs plus a portion of the fee related to work accomplished. Upon termination for convenience of fixed-price-type contracts, the contractor is normally entitled, to the extent of available funding, to receive the purchase price for delivered items, reimbursement for allowable costs for work in process, and an allowance for profit thereon or adjustment for loss if completion of performance would have resulted in a loss. - 15 - A portion of Martin Marietta's business includes classified programs. Although these programs are not discussed herein, the operating results relating to those programs are included in the Corporation's consolidated financial results. The nature of and business risks associated with classified programs do not differ materially from those of the Corporation's other government programs and products. An increasing percentage of Martin Marietta's business is conducted internationally. While this is one of the Corporation's objectives, international business may involve additional risks, such as exposure to currency fluctuations, offset obligations and changes in foreign economic and political environments. In addition, international transactions frequently involve increased financial and legal risks arising from stringent contractual terms and conditions and widely differing legal systems, customs and mores in various foreign countries. The Corporation owns numerous patents and patent applications some of which, together with licenses under patents owned by others, are utilized in its operations. While such patents and licenses are, in the aggregate, important to the operation of the Corporation's business, no existing patent, license or other similar intellectual property right is of such importance that its loss or termination would, in the opinion of management, materially affect the Corporation's business. Certain risks inherent in the current defense and aerospace business environment are discussed in "Analysis of Financial - 16 - Condition and Operating Results" on page 56 through page 61 of the 1993 Annual Report. Backlog Martin Marietta's backlog of orders at December 31, 1993, was $16.7 billion compared with $8.9 billion at the end of 1992. The 1993 amount includes funded backlog of $9.3 billion compared with $3.7 billion at the end of 1992. Martin Marietta's backlog and funded backlog did not include $10.4 billion and $6.3 billion, respectively, at December 31, 1992, attributable to the former GE Aerospace businesses that was added on April 2, 1993, as a result of the Combination. See Parent Corporation's Registration Statement on Form S-4 (Registration No. 33-58494). Typically, the United States Government funds its major programs only to the dollar level appropriated annually by the Congress despite total estimated program values being significantly higher. Accordingly, the government funded backlog reflected in the above amounts represents only the government's present obligation and represents the amount from which Martin Marietta can be reimbursed for work performed. Backlog information and comparisons thereof as of different dates may not be accurate indicators of future sales or the ratio of Martin Marietta's future sales to the United States Government versus its sales to other customers. Of the Corporation's total 1993 year-end backlog, approximately $10.4 billion, or 62%, is not expected to be filled within one year. - 17 - Environmental Regulation Martin Marietta's operations are subject to and affected by a variety of federal, state, and local environmental protection laws and regulations, including those regulating air and water quality, hazardous materials and solid wastes. Management believes that, on an overall basis, all of the facilities, owned or leased by the Corporation, are currently operated in substantial compliance with applicable statutes and regulations. Some of these facilities are currently subject to remedial actions for removing hazardous contamination that exists from prior operations. The Corporation is actively involved in environmental responses at certain of its facilities and at certain waste disposal sites not currently owned by the Corporation (third-party sites) where the Corporation, or its former aluminum subsidiary, or one of the GE Aerospace businesses acquired in the Combination has been designated a "Potentially Responsible Party" (PRP) by the U.S. Environmental Protection Agency (EPA). At such third-party sites, the EPA or a state agency has identified the site as requiring removal or remedial action under the federal "Superfund" and other related federal or state laws governing the remediation of hazardous materials. Generally, PRPs that are ultimately determined to be "responsible parties" are strictly liable for site clean-ups and usually agree among themselves to share, on an allocated basis, in the costs and expenses for investigation and remediation of the hazardous materials. Under existing environmental laws, however, responsible parties are jointly and severally liable and, therefore, the Corporation is potentially liable for the full cost - 18 - of funding such remediation. In the unlikely event that the Corporation were required to fund the entire cost of such remediation, the statutory framework provides that the Corporation may pursue rights of contribution from the other PRPs. At third-party sites, the Corporation continues to pursue a course of action designed to minimize and mitigate its potential liability through assessing the legal basis for its involvement, including an analysis of such factors as (i) the amount and nature of materials disposed of by the Corporation, (ii) the allocation process, if any, used to assign all costs to all involved parties, and (iii) the scope of the response action that is or may reasonably be required. The Corporation also continues to pursue active participation in steering committees, consent orders and other appropriate and available avenues. Management believes that this approach should allow the Corporation to establish its minimum percentage liability on an allocated or shared basis with other PRPs. Although the Corporation's involvement and extent of responsibility varies at each site, management, after an assessment of each site and consultation with environmental experts and counsel, has concluded that the probability is remote that the Corporation's actual or potential liability as a PRP in each or all of these sites will have a material adverse effect on the Corporation's financial position or results of operations. While the possibility of insurance coverage is considered in the Corporation's efforts to minimize and mitigate its potential liability, this possibility is not taken into account in - 19 - management's assessment of whether it is likely that its actual or potential liability will have a material adverse effect on the Corporation's financial position or results of operations. As part of its established environmental management program, the Corporation is currently engaged in waste-minimization projects designed to reduce generation of hazardous waste and to reduce future costs associated with waste disposal. Capital investments for environmental control purposes generally afford minimal financial return and result in increased operating costs. New and revised requirements are being continually imposed which may require further investment. Such requirements add to the costs of operations in the industries in which Martin Marietta does business, but the amount of such costs cannot reasonably be estimated. In addition, Martin Marietta manages various government-owned facilities on behalf of the government. At such facilities, environmental compliance and remediation costs have historically been the responsibility of the government and the Corporation relied (and continues to rely with respect to past practices) upon government funding to pay such costs. While the government remains responsible for capital costs associated with environmental compliance, responsibility for fines and penalties associated with environmental noncompliance is being shifted from the government to the contractor in certain instances with such fines and penalties no longer constituting allowable costs under the contracts pursuant to which such facilities are managed. - 20 - Management does not believe that adherence to presently applicable environmental regulations at its own facilities or in its contract management capacity at government-owned facilities will have a material adverse effect on Martin Marietta's financial position or results of operations. For additional details, see "Legal Proceedings" on page 26 through page 30. See also "Note I: Contingencies" of the "Notes to Financial Statements" on page 48 and "Analysis of Financial Condition and Operating Results" on page 56 through page 61 of the 1993 Annual Report. Research and Development Martin Marietta conducts significant research and development activities, both under contract funding and with Independent Research and Development (IR&D) funds. A large portion of these activities are carried out at the Corporation's Electronics Group, Space Group and Information Group facilities. Research and development projects at these facilities relate to such diverse areas as sensor technologies, state-of-the-art software, expert systems and computing technologies, space launch and space platform technologies, and electronics. In addition, the Corporation's Advanced Development & Technology Operations (ADTO), headquartered in San Diego, California, is chartered to identify, develop and demonstrate advanced technological concepts having broad applications in space, defense, information and communications systems, and commercial fields. An element of ADTO is Martin Marietta Laboratories, a research and development facility near Baltimore, Maryland. Martin Marietta Laboratories conduct basic - 21 - scientific and engineering research projects in fields such as advanced materials, photonics, micro-electronics and information processing. In addition, as a result of the Combination, the Corporation now has an Electronics Laboratory in Syracuse, New York, which conducts advanced research in solid-state microwave and millimeter- wave technology, infrared sensor focal plane electronics and specialized integrated microelectronic modules for radar, space, communications and infrared sensor systems. The Combination also brought to the Corporation the Advanced Technology Laboratory in Moorestown, New Jersey, which conducts research and development in advanced computing technologies. Finally, as a result of the Combination, the Corporation is afforded access to the General Electric Company's Corporate Research and Development Laboratories. See "Note P: Research and Development Expenses" of the "Notes to Financial Statements" on page 51 of the 1993 Annual Report. Employees As of January 31, 1994, Martin Marietta had approximately 92,000 employees, including approximately 22,000 persons employed by the Energy Group, 9,000 persons employed by Sandia Corporation and 3,000 employed by KAPL, Inc. Approximately 17,000 of Martin Marietta's employees are covered by 68 separate collective bargaining agreements with various international and local unions. Of these agreements, 40, covering approximately 6,000 employees, will expire during 1994. Management considers employee relations generally to be good and believes that the probability is remote - 22 - that renegotiating these contracts will have a material adverse effect on its business. Martin Marietta Technologies, Inc. - Reporting Status Martin Marietta Corporation and Martin Marietta Technologies, Inc. each have securities registered pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 (1934 Act). The staff of the Securities and Exchange Commission (SEC) has taken the position that the companies need not file separate 1934 Act reports if those reports filed by Martin Marietta Corporation are expanded so as to include additional information concerning Martin Marietta Technologies, Inc. Such additional information is included in this Annual Report on Form 10-K and in "Note J: Martin Marietta Technologies, Inc." of the "Notes to Financial Statements" on page 48 of the 1993 Annual Report. In addition, certain documents required to be filed as Exhibits to this Form 10-K or incorporated by reference to previous filings with the SEC are incorporated herein by reference to previous SEC filings by Technologies. At the time of such filings, Technologies was known as Martin Marietta Corporation and filed under Commission File Number 1-4552. See "Note B: Business Combination with GE Aerospace" of the "Notes to Financial Statements" on page 45 and page 46 of the 1993 Annual Report. ITEM 2. ITEM 2. PROPERTIES At December 31, 1993, excluding Martin Marietta Materials, Inc., the Corporation operated in approximately 186 offices, - 23 - facilities, plants and laboratories located throughout the United States and internationally. Of these, Martin Marietta owned approximately 18 locations, aggregating approximately 19 million square feet, in fee simple and leased approximately 168 locations aggregating just over 9 million square feet. In addition, Martin Marietta manages various government-owned facilities, including the NASA Michoud Assembly Facility at New Orleans, Louisiana, the Department of Energy facilities at Oak Ridge, Tennessee, and Largo, Florida, the United States Enrichment Corporation's facilities at Paducah, Kentucky, and Piketon, Ohio, the Sandia National Laboratories at Albuquerque, New Mexico and Livermore, California, the Knolls Atomic Power Laboratory at Niskayuna, New York, and an Army ordnance plant at Milan, Tennessee. Martin Marietta personnel also occupy government-owned facilities at Cape Canaveral Air Force Station and Kennedy Space Center in Florida, at Marshall Space Flight Center in Alabama, at Vandenberg Air Force Base in California and at Jericho, Vermont; Johnson City, New York; and Pittsfield, Massachusetts. The United States Government also furnishes certain equipment and property used by Martin Marietta. Martin Marietta owns its headquarters office building located in Bethesda, Maryland in fee simple. In addition, the Corporation owns 200 acres of land and approximately 2.1 million square feet of buildings at Middle River, Maryland, near Baltimore; a 1.8 million square foot office building and manufacturing park located in Syracuse, New York; approximately 3,200,000; 3,200,000; 675,000; 500,000 and 1,200,000 square feet of office and manufacturing facilities located in Orlando, Florida; Waterton, Colorado; East - 24 - Windsor, New Jersey; Utica, New York; and King of Prussia, Pennsylvania, respectively; approximately 1,500,000 square feet of office space in Littleton, Colorado; and approximately 700 acres of land which could be developed in Orlando, Florida. The Syracuse and Utica, New York facilities are occupied by the Electronics Group while the Waterton, Colorado; East Windsor, New Jersey; and King of Prussia, Pennsylvania facilities are occupied by the Space Group. In 1993, the Corporation announced a facilities consolidation plan which is expected to reduce operating costs by $1.5 billion over the next five years. Under this plan, approximately five million square feet of capacity will be eliminated from the Corporation's facilities in various locations. For additional details, see "Analysis of Financial Condition and Operating Results" on page 56 through page 61 of the 1993 Annual Report. In 1993, Martin Marietta Materials, Inc. (Materials) shipped aggregates from 140 quarries in 11 Southeastern and Midwestern states; mining operations were conducted at 133 of these quarries, of which 29 are located on land owned by Materials, 45 are on land owned in part and leased in part, 54 are on leased land, and 5 are on facilities leased on a temporary basis. Materials owns real property with a total area of approximately 38,000 acres and leases real property with a total area of approximately 46,000 acres. Materials conducts its specialty chemical products operations at facilities in Woodville, Ohio and Manistee, Michigan and at smaller plants in Bridgeport, Connecticut and River Rouge, Michigan. - 25 - Management believes that all of Martin Marietta's major physical facilities are in good condition and are adequate for their intended use. ITEM 3. ITEM 3. LEGAL PROCEEDINGS Martin Marietta is primarily engaged in providing products and services under contracts with the United States Government and, to a lesser degree, under foreign government contracts, some of which are funded by the United States Government. All such contracts are subject to extensive legal and regulatory requirements and, from time to time, agencies of the United States Government investigate whether Martin Marietta's operations are being conducted in accordance with these requirements. Such investigations could result in administrative, civil or criminal liabilities including reimbursements, fines or penalties being imposed upon Martin Marietta or could lead to suspension or debarment from future government contracting by Martin Marietta. Neither management nor counsel is aware of any such investigation presently ongoing which is likely to result in the suspension or debarment of the Corporation or which is likely to result in the imposition of reimbursements, fines or penalties which would have a material adverse effect on the Corporation's financial position. Martin Marietta is also involved in various other legal and environmental proceedings. Martin Marietta Energy Systems, Inc. (MMES), a wholly-owned subsidiary of Technologies, manages certain facilities on behalf of the Department of Energy (DOE) under contracts with the DOE. MMES - 26 - is involved in proceedings arising out of work performed under these contracts including the following: - - On June 7, 1990, Boggs, et al. v. Divested Atomic Corporation, et al., was filed against various defendants including MMES. Plaintiffs' request for class certification was granted and the case is pending in the United States District Court for the Eastern District of Ohio. Plaintiffs seek monetary damages of $600 million based upon allegations that the defendants discharged hazardous substances into the environment. In the event that any damages are awarded in these proceedings, such damages will be allowable costs under the contracts between MMES and the DOE. - - On May 28, 1992, the Arkansas State Attorney General filed a civil suit against MMES and the DOE relating to the shipment of hazardous waste (which may have contained trace amounts of radioactivity) from facilities managed for the DOE by MMES into the State of Arkansas. The suit, which is in the United States District Court for the Eastern District of Arkansas, Western Division, seeks civil penalties to be set by the Court plus an award to the State of Arkansas for the costs of its investigation plus reasonable attorney's fees and costs. In the event that any damages are awarded in these proceedings, such damages will be allowable costs under the contracts between MMES and the DOE. - - On December 28, 1993, MMES received a subpoena issued by a Federal Grand Jury in the Eastern District of Virginia requiring the production of documents relating to subcontracts - 27 - with two of MMES' suppliers. MMES has produced the documents required. The prosecutor has informed MMES that MMES is not, at this time, the target of the investigation. On August 5, 1991, Technologies (then known as Martin Marietta Corporation) was served with two subpoenas by the Department of Defense Inspector General relating to documents pertaining to a contract with the Navy for the full-scale development of the Supersonic Low Altitude Target (SLAT) and documents associated with six Independent Research and Development (IR&D) tasks, collectively known as Navy Missile Systems. Technologies has complied with these subpoenas. In addition, the Civil Division of the Justice Department is conducting a civil fraud investigation dealing with the same or similar allegations and has issued Civil Investigative Demands for the testimony of several current and former employees. The Inspector General of the Department of Defense has been investigating alleged defective pricing and labor mischarging in the Pershing II program since at least January 1987, when Technologies (then known as Martin Marietta Corporation) was served with an Inspector General's subpoena. Subsequently, Technologies was served with additional Inspector General's subpoenas seeking records relating to the Pershing II program. In addition, current and former employees were subpoenaed to appear and have testified before a Federal Grand Jury in Orlando, Florida. In January 1994, the Corporation was informed that criminal prosecution had been declined but that the Civil Division of the Justice Department intends to pursue the matter. - 28 - On January 6, 1994, the Corporation's Ordnance Systems facility at Milan, Tennessee, received a Federal Grand Jury subpoena issued in the Western District of Tennessee. The subpoena requested the production of certain purchase order files. On January 20, 1994, the Corporation received a second subpoena in this matter. The Corporation has complied with the initial subpoena and is in the process of responding to the second. The Corporation has not been identified as a target of the investigation and has not been informed of its purpose. On January 20, 1994, the Corporation received two subpoenas issued by the Defense Investigative Service relating to the LANTIRN program. One of the subpoenas requests documents relating to repairs to the navigation and targeting pods and relates to the charging of repair work under the warranty provisions of the LANTIRN contract. The other pertains to purchases from a subcontractor and relates to the disclosure of pricing data concerning these purchases. The Corporation is in the process of responding. The Corporation has been identified as a potential target in each of the investigations. As a result of the Combination, subject to certain limitations and subject to certain limited rights to indemnification all as discussed in Parent Corporation's Registration Statement on Form S-4 (Registration No. 33-58494), Martin Marietta assumed liabilities relating to or arising out of legal and environmental proceedings pertaining to the GE Aerospace businesses transferred to Martin Marietta. - 29 - In April 1992, GE voluntarily disclosed to the U.S. Department of Defense a matter involving allegations concerning payments, certifications, and acquisition of competitive information and related claims in connection with contracts with the Arab Republic of Egypt for the sale of radar units by one of the GE Aerospace businesses which is now part of Martin Marietta. Martin Marietta is cooperating, as did GE, with an ongoing Department of Defense investigation of this matter. Martin Marietta is involved in various other legal and environmental litigation and proceedings arising in the ordinary course of its business. In the opinion of management (which opinion is based in part upon consideration of the opinion of counsel) and in the opinion of counsel, the probability is remote that the outcome of any litigation or proceedings, whether or not specifically described above or otherwise referred to herein, will have a material adverse effect on the results of Martin Marietta's operations or its financial position. See also "Note I: Contingencies" of the "Notes to Financial Statements" on page 48 of the 1993 Annual Report and "Analysis of Financial Condition and Operating Results" on page 56 through page 61 of the 1993 Annual Report. 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. - 30 - ITEM 4(a). EXECUTIVE OFFICERS OF THE REGISTRANT The corporate officers of Martin Marietta Corporation are listed below. The Corporation's Board of Directors has determined that, as of February 24, 1994, the individuals whose names are followed by an * are executive officers of Martin Marietta for the purposes of Item 401(b) of Regulation S-K and officers for the purposes of Rule 16a-1(f) under Section 16 of the Securities Exchange Act of 1934. There are no family relationships among any of the executive officers and directors of the Corporation. All officers serve at the pleasure of the Board of Directors. Principal Positions and Occupation and Offices Held Business Name with Corporation** Experience** (Age at 3/30/94) (Year Elected) (Past Five Years) Norman R. Augustine*(58) Chairman of the Board (1988), Chief Executive Officer (1987) and Director (1986) A. Thomas Young*(55) President and Chief Executive Vice Operating Officer President, 1989 (1990) and Director (1989) Richard G. Adamson*(61) Corporate Vice Corporate Vice President, Strategic President, Business Development (1993) Development, 1988-1993 Joseph D. Antinucci*(53) Corporate Vice President, Martin President (1993) and Marietta Aero & Naval President, Electronics Systems, 1984-1993 and Missiles (1993) Marcus C. Bennett*(58) Corporate Vice President (1984), Chief Financial Officer (1988), and Director (1993) - 31 - Peter A. Bracken*(52) Corporate Vice President, Martin President (1992) and Marietta Electronics, President, Information Information & Missiles, Group (1993) 1992-1993; Vice President, Technical Operations for Information Systems, 1986-1992 Michael F. Camardo*(52) Corporate Vice President, GE President (1993) and Government Services, President, Services Inc., 1990-1993; Group (1993) President, GE Government Services, 1988-1990 Thomas A. Corcoran*(49) Corporate Vice Vice President and President (1993) and General Manager, President, Electronics General Electric Group (1993) Company, 1990-1993; General Manager, GE Government Communications, 1988- James B. Feller (56) Vice President, GE Aerospace, Research and Engineering and Development (1993) Research, 1989-1993 Clyde C. Hopkins*(64) Corporate Vice President, Martin President (1991) and Marietta Energy President, Energy Systems, Inc. since Group (1993) 1988 Alexander L. Horvath*(52) Corporate Vice President, Martin President (1993) Marietta Ocean, Radar & Sensor Systems since April 1993; Vice President and General Manager, GE Ocean, Radar & Sensor Systems, 1992-1993; General Manager, GE, 1989-1992 Bobby F. Leonard*(61) Corporate Vice President, Human Resources (1981) William B. Lytton (45) Corporate Vice General Counsel, GE President (1993) and Aerospace, 1989; Associate General Partner, Kohn, Savett, Counsel, Operations Klein & Graf, 1983-1989 and International (1993) - 32 - James W. McAnally*(57) President, Martin President, Martin Marietta Astronautics Marietta Defense (1993) Systems & Communications, 1987- Janet L. McGregor*(40) Treasurer (1992) Deputy Treasurer, 1991- 1992; Assistant Treasurer, 1984-1991 Frank H. Menaker, Jr.* Corporate Vice (53) President (1982) and General Counsel (1981) Dan A. Peterson*(63) Corporate Vice President, Information President (1986), and Systems, 1986-1989 Vice President, Washington Operations (1989) Robert J. Polutchko*(56) Corporate Vice Vice President, President (1991) and Technical Operations, Vice President, Space 1991-1993; President, Group Technical Information Systems Operations (1993) Group, 1989-1991; President, Martin Marietta Communications Systems, 1988-1989 Michael A. Smith*(50) Corporate Vice President, Martin President (1993) Marietta Astro Space since April 1993; Vice President and General Manager of General Electric Company, 1989- Peter B. Teets*(52) Corporate Vice President (1985) and President, Space Group (1993) Robert H. Tieken (54) Corporate Vice Vice President, Finance President (1993), and of GE Aerospace, 1988- Vice President, 1993 Finance (1993) Lillian M. Trippett (40) Corporate Secretary Counsel to the 1993 and Assistant Subcommittee on Space, General Counsel (1993) Committee on Science, Space and Technology, U.S. House of Representatives, 1986- 1989; Director Washington, Operations, 1989-1993 - 33 - Stephen P. Zelnak, Jr.* Corporate Vice (49) President (1989) and President, Materials Group (1993)*** ** In April 1993, as a result of the Combination, all of the Executive Officers of Technologies (then known as Martin Marietta Corporation) assumed the same offices with the new Martin Marietta Corporation. The above listing does not distinguish between their service with the two corporations. *** In November 1993, the Corporation's aggregates business and the Common Stock of Martin Marietta Magnesia Specialties Inc. were transferred to a subsidiary, Martin Marietta Materials, Inc. On February 24, 1994, approximately 19% of the common stock of Martin Marietta Materials, Inc. was sold to the public. See "Materials Group" on page 9. Mr. Zelnak is the President, Chief Executive Officer and a Director of Martin Marietta Materials, Inc. Effective upon the completion of the offering, Mr. Zelnak resigned his position as a corporate officer of Martin Marietta Corporation. - 34 - PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS There were approximately 32,644 holders of record of Martin Marietta Corporation Common Stock, $1 par value, as of January 31, 1994. The exchanges on which the Corporation's Common Stock is traded are listed on the cover of this Form 10-K. Information concerning stock prices and dividends paid during the past two years is included with "Quarterly Performance, (Unaudited)" under the caption "Common Dividends Paid and Stock Prices" on page 62 of the 1993 Annual Report, and that information is hereby incorporated by reference in this Form 10-K. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The information required by this Item 6 is included under the caption "Five Year Summary" on page 63 of the 1993 Annual Report, and that information is hereby incorporated by reference in this 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 7 is included under the caption "Analysis of Financial Condition and Operating Results" on page 56 through page 61 of the 1993 Annual Report, and that information is hereby incorporated by reference in this Form 10-K. - 35 - ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The information required by this Item 8 is included under the captions "Statement of Earnings," "Balance Sheet," "Statement of Cash Flows," "Statement of Shareowners' Equity," "Notes to Financial Statements," "Analysis of Financial Condition and Operating Results," and "Quarterly Performance (Unaudited)" on pages 40, 41, 42, 43, 44-54, 56-61 and 62, respectively, of the 1993 Annual Report. This information is hereby incorporated by reference in this Form 10-K. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not applicable. - 36 - PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information concerning directors required by this Item 10, is included under the caption "Election of Directors" in the Corporation's definitive Proxy Statement to be filed pursuant to Regulation 14A no later than March 28, 1994 (1994 Proxy Statement), and that information is hereby incorporated by reference in this Form 10-K. Information concerning executive officers required by this Item 10 is located under Part I, Item 4(a) of this Form 10-K on page 31 through page 34. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The information required by this Item 11 is included in the text and tables under the caption "Compensation of Executive Officers" in the 1994 Proxy Statement and that information, except for the information required by Item 402(k) and Item 402(l) of Regulation S-K, is hereby incorporated by reference in this Form 10-K. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information required by this Item 12 is included under the captions "Securities Owned by Management" and "Voting Securities and Record Date" in the 1994 Proxy Statement and that information is hereby incorporated by reference in this Form 10-K. - 37 - ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Pursuant to the terms of the Standstill Agreement entered into by the Corporation and GE as part of the Combination, GE is entitled to representation upon Martin Marietta's Board of Directors. See "General" page 1 through page 2. Messrs. Edward E. Hood, Jr., retired Vice Chairman and a former director of GE, and Eugene F. Murphy, President and Chief Executive Officer of GE Aircraft Engines, currently serve as GE's representatives on Martin Marietta's Board of Directors. The Standstill Agreement resulted from arm's-length negotiations between the Corporation and GE. A portion of the consideration received by GE in the Combination consisted of 20 million shares of Martin Marietta's Series A Preferred Stock, par value $1.00 per share, which is convertible into Martin Marietta Common Stock and which, if converted, would represent approximately 23% of the shares of Common Stock outstanding after giving effect to such conversion. Further, there are existing business relationships between the Corporation and GE. These relationships are the product of arm's- length negotiations between the corporations. During part of 1993, John J. Byrne, a director of Martin Marietta since 1978, also served on the Board of Directors of Lehman Brothers Inc. The Corporation retained Lehman Brothers Inc. to render financial services to the Corporation in connection with the Combination for which Lehman Brothers Inc. was paid an advisory fee. Lehman Brothers Inc. rendered a fairness opinion to the Corporation in connection with the Corporation's proposed acquisition of General Dynamics Corporation's Space Systems - 38 - Division for which Lehman Brothers Inc. received a fee. Finally, Lehman Brothers Inc. served as one of the underwriters of an initial public offering of approximately 19% of the common stock of Martin Marietta Materials, Inc. for which Lehman Brothers Inc. received underwriting fees. In addition, Mr. Byrne is the Chief Executive Officer of Fund American Enterprises, Inc. (Fund American). Hanover Advisors, Inc., formerly a wholly-owned subsidiary of Fund American, serves as an investment manager for the Corporation's Master Retirement Trust. Pursuant to the arrangement, Hanover Advisors receives management fees from the Corporation which aggregated approximately $342,000 in 1993. These engagements resulted from arm's-length negotiations in which Mr. Byrne played no part. Messrs. Richard G. Adamson, Marcus C. Bennett, Bobby F. Leonard and Frank H. Menaker, Jr., each of whom is an Executive Officer of Martin Marietta, serve as Directors (Mr. Bennett as Chairman) of Martin Marietta Materials, Inc. See "Materials Group" on Page 9. A summary description of the relationship between Martin Marietta and Martin Marietta Materials, Inc. is included under the caption "Relationship with Martin Marietta" in the Martin Marietta Materials, Inc. Registration Statement on Form S-1 (Registration Statement No. 33-72648) and such information is incorporated herein by reference. Messrs. Norman R. Augustine, Marcus C. Bennett, Peter B. Teets and A. Thomas Young, each of whom is an Executive Officer of Martin Marietta, borrowed $232,363, $68,447, $86,535 and $104,563, respectively, from the Corporation in 1993. The loans were used to - 39 - satisfy personal income tax obligations associated with the vesting of restricted stock previously granted to these individuals by the Corporation. The plan under which such restricted stock was granted envisions that recipients may satisfy such tax obligations by instructing the Corporation to withhold the appropriate number of shares from the certificate delivered to the recipient when the restricted stock vests. In this instance, as a result of possible restrictions on sales by the Corporation's Executive Officers imposed by Section 16 of the Securities Exchange Act of 1934 and resulting from the Combination, counsel for the Corporation recommended that its Executive Officers not utilize this tax withholding feature. As the restrictions on sale resulted from the Corporation's actions in effecting the Combination which was in the best interest of the Corporation, the Corporation offered short- term loans to such persons to enable them to satisfy their income tax obligations. The loans and their terms were approved by disinterested members of the Corporation's Board of Directors. No interest was paid on the loans. All of the loans had been repaid in full by January 31, 1994. See the caption "Compensation of Executive Officers" in the 1994 Proxy Statement. Mr. Alexander, a director of the Corporation, is counsel to Baker, Worthington, Crossley, Stansbury & Woolf, a law firm that provides legal services to the Corporation from time to time. Mr. Colodny, a director of the Corporation, is Of Counsel to Paul, Hastings, Janofsky & Walker, a law firm that provides legal services to the Corporation from time to time. - 40 - Allen E. Murray, a director of Martin Marietta since 1991, also served on the Board of Directors of Morgan Stanley Group Inc. Morgan Stanley International served as one of the underwriters of an initial public offering of approximately 19% of the common stock of Martin Marietta Materials, Inc. for which Morgan Stanley Group Inc. received underwriting fees. This engagement resulted from arm's-length negotiations in which Mr. Murray played no part. - 41 - PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a)(1) List of Financial Statements filed as part of the Form 10-K. The following financial statements of Martin Marietta Corporation and consolidated subsidiaries, included in the 1993 Annual Report, are incorporated by reference into Item 8 on page 36 of this Annual Report on Form 10-K. Page numbers refer to the 1993 Annual Report: Page Balance Sheet-- December 31, 1993 and 1992 41 Statement of Earnings-- Years ended December 31, 1993, 1992 and 1991 40 Statement of Shareowners' Equity-- Years ended December 31, 1993, 1992 and 1991 43 Statement of Cash Flows-- Years ended December 31, 1993, 1992 and 1991 42 Notes to Financial Statements-- Years ended December 31, 1993, 1992 and 1991 44-54 (2) List of Financial Statement Schedules filed as part of this Form 10-K. The following financial statement schedules of Martin Marietta Corporation and consolidated subsidiaries are included in Item 14(d). Page numbers refer to this Form 10-K: Schedule II - Amounts receivable from related parties and underwriters, promoters and employees other than related parties 53 Schedule V - Property, plant and equipment 54-55 - 42 - Page Schedule VI - Accumulated depreciation, depletion and amortization of property, plant and equipment 56 Schedule IX - Short-term borrowings 57 Schedule X - Supplementary income statement information 58 All other schedules have been omitted because they are not applicable, not required, or the information has been otherwise supplied in the financial statements or notes to the financial statements. The report of Martin Marietta's independent auditors with respect to the above-referenced financial statements appears on page 55 of the 1993 Annual Report and that report is hereby incorporated by reference in this Form 10-K. The report on the financial statement schedules and the consent of Martin Marietta's independent auditors appear on page 51. The report of the former GE Aerospace businesses' independent auditors with respect to the GE Aerospace businesses' financial statements as of December 31, 1992 and 1991, and for each of the years in the two year period ended December 31, 1992, included in Parent Corporation's Registration Statement on Form S-4 (Registration No. 33-58494), which report is hereby incorporated by reference in this Form 10-K. The consent of the former GE Aerospace businesses' independent auditors appears on page 52. (b) No reports on Form 8-K have been filed during the last quarter of the period covered by this report. (c) Exhibits (3)(i) Articles of Incorporation. (a) Articles of Restatement of Martin Marietta Corporation (formerly Parent Corporation) filed with the State Department of Assessments and Taxation of the State of Maryland on June 30, 1993. - 43 - (ii) Bylaws (a) Copy of the Bylaws of Parent Corporation (now Martin Marietta Corporation) as amended on January 13, 1993, effective April 2, 1993. (4) (a) Indenture dated April 22, 1993, between the Corporation, Technologies, and Continental Bank, National Association as Trustee (incorporated by reference to Exhibit 4 of the Corporation's filing on Form 8-K on April 15, 1993). No other instruments defining the rights of holders of long-term debt are filed since the total amount of securities authorized under any such instrument does not exceed 10% of the total assets of the Corporation on a consolidated basis. The Corporation agrees to furnish a copy of such instruments to the Securities and Exchange Commission upon request. (10)(iii) (a) Directors Deferred Compensation Plan, as amended (incorporated by reference to Exhibit 10(iii)(a) to Technologies' Form 10-K for the fiscal year ended December 31, 1988). (b) Post-Retirement Income Maintenance Plan for Directors, as amended. (c) Financial Counseling Program for directors, officers, company presidents, and other key employees as amended (incorporated by reference to Exhibit 10(iii)(c) to Technologies' Form 10-K for the fiscal year ended December 31, 1989). (d) Executive Incentive Plan, as amended. (e) Deferred Compensation and Estate Supplement Plan, as amended. (f) Post-Retirement Death Benefit Plan for Senior Executives, as amended (incorporated by reference to Exhibit (10)(iii)(f) to Technologies' Form 10-K for the fiscal year ended December 31, 1987). (g) 1979 Stock Option Plan for Key Employees, as amended. - 44 - (h) 1984 Stock Option Plan for Key Employees, as amended. (i) Martin Marietta Amended Omnibus Securities Award Plan, as amended March 25, 1993. (j) Format of the agreements between Technologies and its officers to provide for continuity of management in the event of a change in control of Technologies (incorporated by reference to Exhibit (10)(iii) to Technologies' Form 10-K for the fiscal year ended December 31, 1987). (k) Supplemental Excess Retirement Plan, as amended (incorporated by reference to Exhibit (10)(iii)(k) to Technologies' Form 10-K for the fiscal year ended December 31, 1990). (l) Restricted Stock Award Plan (incorporated by reference to Exhibit 10 to Technologies' Form 10-Q for the quarter ended June 30, 1989). (m) Long Term Performance Incentive Compensation Plan (incorporated by reference to Exhibit (10)(iii)(m) to Technologies' Form 10-K for the fiscal year ended December 31, 1990). (n) Amended and Restated Martin Marietta Corporation Long Term Performance Incentive Compensation Plan (incorporated by reference to Exhibit 10(iii)(o) of Technologies' Form 10-K for the fiscal year ended December 31, 1992). (o) Directors' Life Insurance Program. (p) (1) Transaction Agreement dated November 22, 1992, among General Electric Company, Technologies and the Corporation (incorporated by reference from Parent Corporation's Registration Statement on Form S-4 (Registration No. 33-58494) filed with the SEC on February 18, 1993). (2) Form of Amendment Agreement, dated as of February 17, 1993, among General Electric Company, Technologies and the Corporation - 45 - (incorporated by reference from Parent Corporation's Registration Statement on Form S-4 (Registration No. 33-58494) filed with the SEC on February 18, 1993). (3) Form of Amendment Agreement, dated as of March 28, 1993, among General Electric Company, Technologies and the Corporation (incorporated by reference from Parent Corporation's Registration Statement on Form S-4 (Registration No. 33-58494) filed with the SEC on February 18, 1993). . (q) Martin Marietta Executive Special Early Retirement Option and Plant Closing Retirement Option Plan. (r) Martin Marietta Supplementary Pension Plan for Employees of Transferred GE Operations. (11) Computation of net earnings per common share for the years ended December 31, 1993, 1992 and 1991. (12) Computation of ratio of earnings to fixed charges for the year ended December 31, 1993. (13) Martin Marietta Corporation 1993 Annual Report to Shareowners, portions of which are incorporated by reference in this Form 10-K. Those portions of the 1993 Annual Report to Shareowners which are not incorporated by reference shall not be deemed to be "filed" as part of this report. (21) List of Subsidiaries of Martin Marietta Corporation. (23) (a) Consent of Ernst & Young, Independent Auditors for Martin Marietta Corporation (included in this Form 10-K at page 51). (b) Consent of KPMG Peat Marwick, Independent Auditors for the former GE Aerospace businesses (included in this Form 10-K at page 52). (24) Powers of Attorney. - 46 - (27) The Financial Statement Schedules appear on page 53 through page 58 of this Form 10-K. (99) Other Exhibits (a) Assumption Agreement among Martin Marietta Materials, Inc. and Technologies dated as of November 12, 1993 (incorporated by reference to Exhibit 10.01 to Martin Marietta Materials, Inc.'s Registration Statement on Form S-1 (Reg. No. 33-72648). Exhibit filed with the SEC on December 8, 1993). (b) Transfer and Capitalization Agreement dated as of November 12, 1993, among Technologies, Martin Marietta Investments, Inc., and Martin Marietta Materials, Inc. (incorporated by reference to Exhibit 10.02 to Martin Marietta Materials, Inc.'s Registration Statement on Form S-1 (Reg. No. 33-72648). Exhibit filed with the SEC on December 8, 1993). (c) Form of Intercompany Services Agreement between Martin Marietta Materials, Inc. and the Corporation (incorporated by reference to Exhibit 10.03 to Martin Marietta Materials, Inc.'s Registration Statement on Form S-1 (Reg. No. 33- 72648). Exhibit filed with the SEC on February 2, 1994). (d) Form of Tax-Sharing Agreement between Martin Marietta Materials, Inc. and the Corporation (incorporated by reference to Exhibit 10.04 to Martin Marietta Materials, Inc.'s Registration Statement on Form S-1 (Reg. No. 33- 72648). Exhibit filed with the SEC on February 2, 1994). - 47 - (e) Form of Corporate Agreement between Martin Marietta Materials, Inc. and the Corporation (incorporated by reference to Exhibit 10.05 to Martin Marietta Materials, Inc.'s Registration Statement on Form S-1 (Reg. No. 33-72648). Exhibit filed with the SEC on February 2, 1994). (f) Form of Cash Management Agreement between Martin Marietta Materials, Inc. and Technologies (incorporated by reference to Exhibit 10.08 to Martin Marietta Materials, Inc.'s Registration Statement on Form S-1 (Reg. No. 33-72648). Exhibit filed with the SEC on February 2, 1994). Other material incorporated by reference: Martin Marietta Corporation's definitive Proxy Statement to be filed pursuant to Regulation 14A no later than March 28, 1994, portions of which are incorporated by reference in this Form 10-K. Those portions of the definitive Proxy Statement which are not incorporated by reference shall not be deemed to be "filed" as part of this report. - 48 - 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. MARTIN MARIETTA CORPORATION Date: February 25, 1994 By: /s/ FRANK H. MENAKER, JR. Frank H. Menaker, Jr. Vice President 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 and on the date indicated. Signature Title Date /s/ Norman R. Augustine Chairman of the February 25, 1994 Norman R. Augustine* Board, Chief Executive Officer /s/ Marcus C. Bennett Director, Vice February 25, 1994 Marcus C. Bennett* President, Chief Financial and Chief Accounting Officer /s/ A. James Clark Director February 25, 1994 A. James Clark* /s/ James L. Everett, III Director February 25, 1994 James L. Everett, III* /s/ Edward L. Hennessy, Jr. Director February 25, 1994 Edward L. Hennessy, Jr.* - 49 - Signature Title Date /s/ Edward E. Hood, Jr. Director February 25, 1994 Edward E. Hood, Jr.* /s/ Caleb B. Hurtt Director February 25, 1994 Caleb B. Hurtt* /s/ Gwendolyn S. King Director February 25, 1994 Gwendolyn S. King* /s/ Melvin R. Laird Director February 25, 1994 Melvin R. Laird* /s/ Gordon S. Macklin Director February 25, 1994 Gordon S. Macklin* /s/ Eugene F. Murphy Director February 25, 1994 Eugene F. Murphy* /s/ Allen E. Murray Director February 25, 1994 Allen E. Murray* /s/ John W. Vessey, Jr. Director February 25, 1994 John W. Vessey, Jr.* /s/ A. Thomas Young Director February 25, 1994 A. Thomas Young* *By: /s/ STEPHEN M. PIPER February 25, 1994 (Stephen M. Piper, Attorney-in-fact**) _____________________ **By authority of Powers of Attorney filed with this Annual Report on Form 10-K. - 50 - CONSENT OF ERNST & YOUNG, INDEPENDENT AUDITORS We consent to the incorporation by reference in this Annual Report on Form 10-K of Martin Marietta Corporation of our report dated January 21, 1994, included on page 55 of the Martin Marietta Corporation 1993 Annual Report to Shareowners. Our audits also included the financial statement schedules of Martin Marietta Corporation listed in Item 14(a). These schedules are the responsibility of the Corporation'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 of our report dated January 21, 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 the Annual Report on Form 10-K of Martin Marietta Corporation, in the following Registration Statements: (1) Pre-Effective Amendment No. 1, dated April 18, 1988, to Registration Statement Number 33-20931 of Martin Marietta Technologies, Inc. on Form S-3; (2) Registration Statement Number 33-59466-01 of Martin Marietta Corporation and Martin Marietta Technologies, Inc. on Form S-3, dated March 12, 1993; (3) Registration Statement Number 33-61210 of Martin Marietta Corporation on Form S-3, dated April 16, 1993; (4) Registration Statement Number 33-58494 of Parent Corporation (now known as Martin Marietta Corporation) on Form S-4, dated February 19, 1993; (5) Registration Statement Number 33-60476 of Martin Marietta Corporation on Form S-8, dated April 2, 1993; (6) Registration Statement Number 33-60478 of Martin Marietta Corporation on Form S-8, dated April 2, 1993; (7) Registration Statement Number 33-60480 of Martin Marietta Corporation on Form S-8, dated April 2, 1993; (8) Registration Statement Number 33-60484 of Martin Marietta Corporation on Form S-8, dated April 2, 1993; (9) Registration Statement Number 33-60486 of Martin Marietta Corporation on Form S-8, dated April 2, 1993; and (10) Registration Statement Number 33-60782 of Martin Marietta Corporation on Form S-8, dated April 2, 1993. /s/ Ernst & Young ERNST & YOUNG Washington, D.C. February 23, 1994 - 51 - CONSENT OF KPMG PEAT MARWICK, INDEPENDENT AUDITORS The Board of Directors General Electric Company: The Board of Directors Martin Marietta Corporation: We consent to the incorporation by reference of our report dated February 3, 1993 relating to the consolidated financial statements of GE Aerospace Businesses as of December 31, 1992 and 1991 and for each of the years in the two-year period ended December 31, 1992, which report is incorporated by reference in the December 31, 1993 annual report on Form 10-K of Martin Marietta Corporation, in the following Registration Statements: (1) Pre-Effective Amendment No.1, dated April 18, 1988, to Registration Statement Number 33-20931 of Martin Marietta Technologies, Inc. on Form S-3; (2) Registration Statement Number 33-59466-01 of Martin Marietta Corporation and Martin Marietta Technologies, Inc. on Form S- 3, dated March 12, 1993; (3) Registration Statement Number 33-61210 of Martin Marietta Corporation on Form S-3, dated April 16, 1993; (4) Registration Statement Number 33-58494 of Parent Corporation (now known as Martin Marietta Corporation) on Form S-4, dated February 19, 1993; (5) Registration Statement Number 33-60476 of Martin Marietta Corporation on Form S-8, dated April 2, 1993; (6) Registration Statement Number 33-60478 of Martin Marietta Corporation on Form S-8, dated April 2, 1993; (7) Registration Statement Number 33-60480 of Martin Marietta Corporation on Form S-8, dated April 2, 1993; (8) Registration Statement Number 33-60484 of Martin Marietta Corporation on Form S-8, dated April 2, 1993; (9) Registration Statement Number 33-60486 of Martin Marietta Corporation on Form S-8, dated April 2, 1993; and (10) Registration Statement Number 33-60782 of Martin Marietta Corporation on Form S-8, dated April 2, 1993. /s/ KPMG PEAT MARWICK Philadelphia, PA February 23, 1994 - 52 - INDEX TO THE EXHIBITS TO THE ANNUAL REPORT ON FORM 10-K FOR FISCAL YEAR ENDED DECEMBER 31, 1993 (3)(i) Articles of Incorporation. (a) Articles of Restatement of Martin Marietta Corporation (formerly Parent Corporation) filed with the State Department of Assessments and Taxation of the State of Maryland on June 30, 1993. (ii) Bylaws (a) Copy of the Bylaws of Parent Corporation (now Martin Marietta Corporation) as amended on January 13, 1993, effective April 2, 1993. (4) (a) Indenture dated April 22, 1993, between the Corporation, Technologies, and Continental Bank, National Association as Trustee (incorporated by reference to Exhibit 4 of the Corporation's filing on Form 8-K on April 15, 1993). No other instruments defining the rights of holders of long-term debt are filed since the total amount of securities authorized under any such instrument does not exceed 10% of the total assets of the Corporation on a consolidated basis. The Corporation agrees to furnish a copy of such instruments to the Securities and Exchange Commission upon request. (10)(iii) (a) Directors Deferred Compensation Plan, as amended (incorporated by reference to Exhibit 10(iii)(a) to Technologies' Form 10-K for the fiscal year ended December 31, 1988). (b) Post-Retirement Income Maintenance Plan for Directors, as amended. (c) Financial Counseling Program for directors, officers, company presidents, and other key employees as amended (incorporated by reference to Exhibit 10(iii)(c) to Technologies' Form 10-K for the fiscal year ended December 31, 1989). (d) Executive Incentive Plan, as amended. (e) Deferred Compensation and Estate Supplement Plan, as amended. (f) Post-Retirement Death Benefit Plan for Senior Executives, as amended (incorporated by reference to Exhibit (10)(iii)(f) to Technologies' Form 10-K for the fiscal year ended December 31, 1987). (g) 1979 Stock Option Plan for Key Employees, as amended. (h) 1984 Stock Option Plan for Key Employees, as amended. (i) Martin Marietta Amended Omnibus Securities Award Plan, as amended March 25, 1993. (j) Format of the agreements between Technologies and its officers to provide for continuity of management in the event of a change in control of Technologies (incorporated by reference to Exhibit (10)(iii) to Technologies' Form 10-K for the fiscal year ended December 31, 1987). (k) Supplemental Excess Retirement Plan, as amended (incorporated by reference to Exhibit (10)(iii) to Technologies' Form 10-K for the fiscal year ended December 31, 1991). (l) Restricted Stock Award Plan (incorporated by reference to Exhibit 10 to Technologies' Form 10-Q for the quarter ended June 30, 1989). (m) Long Term Performance Incentive Compensation Plan (incorporated by reference to Exhibit (10)(iii) to Technologies' Form 10-K for the fiscal year ended December 31, 1991). (n) Amended and Restated Martin Marietta Corporation Long Term Performance Incentive Compensation Plan (incorporated by reference to Exhibit 10(iii)(o) of Technologies' Form 10-K for the fiscal year ended December 31, 1992). (o) Directors' Life Insurance Program. (p) (1) Transaction Agreement dated November 22, 1992, among General Electric Company, Technologies and the Corporation (incorporated by reference from Parent Corporation's Registration Statement on Form S-4 (Registration No. 33-58494) filed with the SEC on February 18, 1993). - ii - (2) Form of Amendment Agreement, dated as of February 17, 1993, among General Electric Company, Technologies and the Corporation (incorporated by reference from Parent Corporation's Registration Statement on Form S-4 (Registration No. 33-58494) filed with the SEC on February 18, 1993). (3) Form of Amendment Agreement, dated as of March 28, 1993, among General Electric Company, Technologies and the Corporation (incorporated by reference from Parent Corporation's Registration Statement on Form S-4 (Registration No. 33-58494) filed with the SEC on February 18, 1993). (q) Martin Marietta Executive Special Early Retirement Option and Plant Closing Retirement Option Plan. (r) Martin Marietta Supplementary Pension Plan for Employees of Transferred GE Operations. (11) Computation of net earnings per common share for the years ended December 31, 1993, 1992 and 1991. (12) Computation of ratio of earnings to fixed charges for the year ended December 31, 1993. (13) Martin Marietta Corporation 1993 Annual Report to Shareowners, portions of which are incorporated by reference in this Form 10-K. Those portions of the 1993 Annual Report to Shareowners which are not incorporated by reference shall not be deemed to be "filed" as part of this report. (21) List of Subsidiaries of Martin Marietta Corporation. (23) (a) Consent of Ernst & Young, Independent Auditors for Martin Marietta Corporation (included in this Form 10-K at page 47). (b) Consent of KPMG Peat Marwick, Independent Auditors for the former GE Aerospace businesses (included in this Form 10-K at page 48). (24) Powers of Attorney. (27) The Financial Statement Schedules appear on page 53 through page 58 of this Form 10-K. (99) Other Exhibits (a) Assumption Agreement among Martin Marietta Materials, Inc. and Technologies dated as of November 12, 1993 (incorporated by reference to - iii - Exhibit 10.01 to Martin Marietta Materials, Inc.'s Registration Statement on Form S-1 (Reg. No. 33-72648) filed with the SEC on December 8, 1993). (b) Transfer and Capitalization Agreement dated as of November 12, 1993, among Technologies, Martin Marietta Investments, Inc. and Martin Marietta Materials, Inc. (incorporated by reference from Martin Marietta Materials, Inc.'s Registration Statement on Form S-1 (Reg. No. 33-72648) filed with the SEC on December 8, 1993). (c) Form of Intercompany Services Agreement between Martin Marietta Materials, Inc. and the Corporation (incorporated by reference from Martin Marietta Materials, Inc.'s Registration Statement on Form S-1 (Reg. No. 33-72648) filed with the SEC on December 8, 1993). (d) Form of Tax-Sharing Agreement between Martin Marietta Materials, Inc. and the Corporation (incorporated by reference from Martin Marietta Materials, Inc.'s Registration Statement on Form S-1 (Reg. No. 33-72648) filed with the SEC on December 8, 1993). (e) Form of Corporate Agreement between Martin Marietta Materials, Inc. and the Corporation (incorporated by reference from Martin Marietta Materials, Inc.'s Registration Statement on Form S-1 (Reg. No. 33-72648) filed with the SEC on December 8, 1993). (f) Form of Cash Management Agreement between Martin Marietta Materials, Inc. and Technologies (incorporated by reference from Martin Marietta Materials, Inc.'s Registration Statement on Form S-1 (Reg. No. 33-72648) filed with the SEC on December 8, 1993). Other material incorporated by reference: Martin Marietta Corporation's definitive Proxy Statement to be filed pursuant to Regulation 14A no later than March 28, 1994, portions of which are incorporated by reference in this Form 10-K. Those portions of the definitive Proxy Statement which are not incorporated by reference shall not be deemed to be "filed" as part of this report. - iv -

78066_1993.txt

78066_1993

1993

78066

Item 3. Legal Proceedings I. In October 1980, the Corporation, the American Mining Congress, and several mining and energy development companies filed a petition in the U.S. Court of Appeals for the District of Columbia for review of EPA's August 1980 regulations (45 Fed. Reg. 52,729 and 52,735) relating to the prevention of significant deterioration (PSD) of air quality. In February 1982, the industry petitioners and EPA entered into a settlement agreement pursuant to which EPA would propose amendments to the PSD and particulate matter regulations. The court of appeals stayed the petition for review, pending implementation of the settlement agreement. In August 1983, EPA proposed regulations (48 Fed. Reg. 38,742) which, if adopted, would have substantially implemented the settlement agreement dealing with fugitive emissions, but on October 26, 1984, EPA promulgated final regulations inconsistent with the August 1983 proposal. In December 1984, the Corporation, the American Mining Congress and several mining and energy development companies filed a petition (No. 84-1609) in the U.S. Court of Appeals for the District of Columbia for review of the October 26, 1984, regulations, asserting that the terms of the February 1982 settlement agreement had not been carried out. The court stayed the petition pending the outcome of further EPA rulemakings. The further EPA rulemakings also have been challenged by the American Mining Congress and others in federal court actions filed in 1989 and 1993. All of the pre-1993 cases are being held in abeyance at the request of the parties. Currently before the court in the 1993 case is a joint motion by the American Mining Congress and EPA to hold that case in abeyance while the parties engage in settlement discussions that could resolve some of the contested issues. Also, on October 7, 1993, the American Mining Congress filed with the Administrator of EPA a petition for reconsideration of yet another related rulemaking (58 Fed. Reg. 31,622). EPA's response to the petition also could resolve some of the contested issues in the stayed lawsuits. II. Reference is made to the discussion of "Copper Operations" in this report for information regarding proceedings that pertain to water used by the Corporation's Morenci, Arizona operations. A. The following state water rights adjudication proceedings are pending in Arizona Superior Court: 1. In re the General Adjudication of All Rights to Use Water in the Little Colorado River System and Source, No. 6417 (Superior Court of Arizona, Apache County). (a) Petition was filed by the Corporation on or about February 17, 1978, and process has been served on all potential claimants. Virtually all statements of claimant have been filed. (b) The principal parties, in addition to the Corporation, are the State of Arizona, the Navajo Tribe of Indians, the Hopi Indian Tribe, the San Juan Southern Paiute group of Indians and the United States on its own behalf and on behalf of those Indian tribes. In this adjudication and in the adjudications reported in items 2.(a), (b) and (c) below, the United States and the Indian tribes seek to have determined and quantified their rights to use water arising under federal law on the basis that, when the Indian reservations and other federal reservations were established by the United States, water was reserved from appropriation under state law for the use of those reservations. (c) This proceeding could affect, among other things, the Corporation's rights to impound water in Show Low Lake and Blue Ridge Reservoir and to transport this water into the Salt River and Verde River watersheds for exchange with the Salt River Valley Water Users' Association. The Corporation has filed statements of claimant for these and other water claims. The legal issues and procedures in this adjudication are presently being defined. Trial of the Corporation's Show Low Lake water rights under state law will likely be held during 1994. 2. In re the General Adjudication of All Rights to Use Water in the Gila River System and Source, Nos. W-1 (Salt River), W-2 (Verde River), W-3 (Gila River) and W-4 (San Pedro River) (Superior Court of Arizona, Maricopa County). As a result of consolidation proceedings, this action now includes general adjudication proceedings with respect to the following three principal river systems and sources: (a) The Gila River System and Source Adjudication: (i) Petition was filed by the Corporation on February 17, 1978. Process has been served on water claimants in the upper and lower reaches of the watershed and virtually all statements of claimant have been filed. (ii) The principal parties, in addition to the Corporation, are the Gila Valley Irrigation District, the San Carlos Irrigation and Drainage District, the State of Arizona, the San Carlos Apache Tribe, the Gila River Indian Community and the United States on its own behalf and on behalf of the tribe and the community. (iii) This proceeding could affect, among other things, the Corporation's claim to the approximately 3,000 acre-feet of water that it diverts annually from Eagle Creek, Chase Creek or the San Francisco River and its claims to percolating groundwater that is pumped from wells located north of its Morenci Branch operations in the Mud Springs and Bee Canyon areas and in the vicinity of the New Cor- nelia Branch at Ajo. The Corporation has filed statements of claimant with respect to waters that it diverts from these sources. (iv) By a letter agreement dated September 7, 1990, the Corporation and the San Carlos Apache Tribe agreed upon principles to settle the water claims of that Tribe. Legislation authorizing that settlement was enacted into law on October 30, 1992. A comprehensive settlement agreement is presently being negotiated. The settlement will become effective if it is approved by the Arizona Superior Court and certain conditions are met by December 31, 1994. (b) The Salt River System and Source Adjudication: (i) Petition was filed by the Salt River Valley Water Users' Association on or about April 25, 1974. Process has been served, and statements of claimant have been filed by virtually all claimants. (ii) Principal parties, in addition to the Corporation, include the petitioner, the State of Arizona and the United States, on its own behalf and on behalf of various Indian tribes and communities including the White Mountain Apache Tribe, the San Carlos Apache Tribe, the Fort McDowell Mohave-Apache Indian Community, the Salt River Pima-Maricopa Indian Community and the Gila River Indian Community. (iii) The Corporation has filed a statement of claimant to assert its interest in the water exchange agreement with the Salt River Valley Water Users' Association by virtue of which it diverts from the Black River water claimed by the Association and repays the Association with water impounded in Show Low Lake and Blue Ridge Reservoir on the Little Colorado River Watershed, and to assert its interest in "water credits" to which the Corporation is entitled as a result of its construction of the Horseshoe Dam on the Verde River. (iv) The Salt River Pima-Maricopa Indian Community, Salt River Valley Water Users' Association, the principal Salt River Valley Cities, the State of Arizona and others have negotiated a settlement as among themselves for the Verde and Salt River system. The settlement has been approved by Congress, the President and the Arizona Superior Court. Under the settlement, the Salt River Pima-Maricopa Indian Community waived all water claims it has against all other water claimants (including the Corporation) in Arizona. (v) Active proceedings with respect to other claimants have not yet commenced in this adjudication. (c) The Verde River System and Source Adjudication: (i) Petition was filed by the Salt River Valley Water Users' Association on or about February 24, 1976, and process has been served. Virtually all statements of claimant have been filed. (ii) The principal parties, in addition to the Corporation, are the petitioner, the Fort McDowell Mohave-Apache Indian Community, the Payson Community of Yavapai Apache Indians, the Salt River Pima-Maricopa Indian Community, the Gila River Indian Community, the United States on its own behalf and on behalf of those Indian com- munities, and the State of Arizona. (iii) This proceeding could affect, among other things, the Corporation's Horseshoe Dam "water credits" with the Salt River Valley Water Users' Association resulting from its construction of the Horseshoe Dam on the Verde River. (See the Black River water exchange referred to in Paragraph II.A. 2.(b)(iii) above.) The Corporation has filed statements of claimant with respect to Horseshoe Dam and water claims associated with the former operations of the United Verde Branch. (iv) The Fort McDowell Mohave-Apache Indian Community, Salt River Valley Water Users' Association, the principal Salt River Valley Cities, the State of Arizona and others have negotiated a settlement as among themselves for the Verde River system. This settlement has been approved by Congress, the President and the Arizona Superior Court. Under this settlement, the Fort McDowell Mohave-Apache Indian Community waived all water claims it has against all other water claimants (including the Corporation) in Arizona. B. The following proceedings involving water rights adjudication are pending in the U.S. District Court for the District of Arizona: 1. On June 29, 1988, the Gila River Indian Community filed a complaint-in-intervention in United States v. Gila Valley Irrigation District, et al., Globe Equity No. 59 (D. Ariz.). The underlying action was initiated by the United States in October 1925 to determine conflicting claims to water rights in certain portions of the Gila River watershed. Although the Corporation was named and served as a defendant in that action, it was dismissed without prejudice as a de- fendant in March 1935. In June 1935, the Court entered a decree setting forth the water rights of numerous parties, but not those of the Corporation. The Court retained, and still has, jurisdiction of the case. The complaint-in-intervention does not name the Corporation as a defendant; however, it does name the Gila Valley Irrigation District as a defendant. Therefore, the complaint-in-intervention could affect the approximately 3,000 acre-feet of water that the Corporation diverts annually from Eagle Creek, Chase Creek or the San Francisco River pursuant to the agreement between the Corporation and the Gila Valley Irrigation District. In April 1990, the Court entered Findings of Fact and Conclusions of Law on four of the counts in the complaint-in-intervention. Trial on additional issues (primarily is- sues raised by plaintiff-in-intervention San Carlos Apache Tribe) was conducted in November 1991. In November 1992, after submission of post-trial briefs, the Court entered a judgment on the additional issues. The Corporation believes that neither the Findings of Fact or the Conclusions of Law entered in 1990 nor the judgment entered in 1992 should affect the 3,000 acre feet of water that the Corporation diverts annually pursuant to the agreement with the Gila Valley Irrigation District. An appeal of the 1992 judgment, however, has been noticed by the Gila Valley Irrigation District and others. The major users on the mainstream of the Gila River (decreed right holders) are engaged in continuing mandatory settlement discussions under the supervision of the Court. It will be several months before the likelihood of any comprehensive settlement can be ascertained. 2. On December 30, 1982, the Gila River Indian Community initiated an action styled Gila River Indian Community v. Gila Valley Irrigation District, et al., No. CIA 82-2185 (D. Ariz.), complaining about allegedly improper uses by approximately 17,000 named defendants of "water from within the Gila River watershed." The Corporation was named as a defendant in the complaint, but it has not yet been served with process. The complaint seeks an injunction restraining future uses of water that interfere with the alleged prior rights of the Gila River Indian Community as well as compensatory and punitive damages in an unspecified amount. 3. Prior to December 1982, various Indian tribes filed several suits in the U.S. District Court for the District of Arizona claiming prior and paramount rights to use waters which are presently being used by many water users, including the Corporation, and claiming damages for prior use in derogation of their allegedly paramount rights. These federal proceedings have been stayed pending final adjudication in the state courts. III. Prior to the mid-1960s, a predecessor of Phelps Dodge Industries, Inc. (PDI), a subsidiary of the Corporation, manufactured and sold some cable and wire products that were insulated with material containing as- bestos. PDI believes that the use of these products did not result in sig- nificant releases of airborne asbestos fibers. PDI and the Corporation are collectively referred to herein as PDI. Since October 1991, PDI has been served with 26 complaints naming it as a defendant in the Ingalls Shipyard asbestos litigation pending in Pasca- goula, Mississippi. These cases involved about 12,503 claimants, each seeking from $2 million to $20 million in compensatory and punitive damages from approximately 100 to 150 defendants. By Order dated April 21, 1993, PDI was dismissed without prejudice from the consolidated action encaptioned Abrams, et al. v. GAF Corporation, et al., No. 88-5422(2). As a result, ap- proximately 6,562 of the claims against PDI were dismissed. Subsequently, PDI was dismissed from another 14 lawsuits pending in Mississippi during 1993, thus bringing to 9,806 the total number of claims dismissed in that jurisdiction during 1993. In addition to the claims dismissed in Mississippi, 605 other claims against PDI brought in federal and state courts in Alabama, Arkansas, California, Louisiana, Michigan, New Jersey, Ohio, Pennsylvania and Washington were dismissed during 1993. As of December 31, 1993, approximately 2,697 claims were pending against PDI in Mississippi. In addition, PDI is currently defending 347 claims in 12 other jurisdictions. In these various proceedings, plaintiffs allege bodily injury or death from exposure to asbestos and claim damages based on theories of strict liability and negligence. PDI is vigorously contesting and defending these cases. IV. Claims under CERCLA and related state acts involving the Corporation have been raised with respect to the remediation of 34 waste disposal and other sites. Most are sites where the Corporation has received information requests or other indications that the Corporation may be a Potentially Responsible Party (PRP) under CERCLA. CERCLA is intended to expedite the remediation of hazardous substances without regard to fault. Responsible parties for each site include present and former owners, operators, transporters, and generators of the substances at the site. Liability is strict, joint and several. Because of the ambiguity of the regulations, the difficulty of identifying the responsible parties for any particular site, the complexity of allocating the remediation costs among them, the uncertainty as to the most desirable remediation techniques and the amount of remediation costs, and the time period during which such costs may be incurred, the Corporation is unable to reasonably estimate the full cost of compliance with CERCLA or equivalent state statutes. With respect to these 34 sites, based on currently available information, which in many cases is preliminary and incomplete, the Corporation has no reason to believe that its ultimate responsibility for remediation costs will exceed $0.5 million at any site and believes most will be substantially under $0.1 million. Item 4. Item 4. Submission of Matters to a Vote of Security Holders No matters were submitted during the fourth quarter of 1993 to a vote of security holders, through the solicitation of proxies or otherwise. Executive Officers of Phelps Dodge Corporation The executive officers of Phelps Dodge Corporation are elected to serve at the pleasure of its Board of Directors. As of March 1, 1994, the executive officers of Phelps Dodge Corporation were as follows: Except as stated below, all of the above have been officers of Phelps Dodge Corporation for the past five years. Mr. Rethore was elected Senior Vice President in July 1989. Prior to joining Phelps Dodge he had been associated with Microdot Inc., a diversified manufacturer of industrial components, for 16 years, serving as President and Chief Executive Officer of Microdot Industries (the manufacturing division of Microdot Inc.) since 1984. Mr. St. Clair was elected Senior Vice President and Chief Financial Officer in May 1989. Prior to joining Phelps Dodge he had been associated with Koppers Company, Inc., a producer of road materials and chemicals, for 30 years, serving as Vice President, Treasurer and Chief Financial Officer since 1984. Part II Item 5. Item 5. Market for the Registrant's Common Equity and Related Stockholder Matters The information called for by Item 5 appears in Management's Discussion and Analysis. Item 7. Item 7. Management's Discussion and Analysis The information called for by Item 7 appears in Management's Discussion and Analysis. Item 8. Item 8. Financial Statements and Supplementary Data The information called for by Item 8 appears in the Consolidated Financial Statements and Notes thereto. Item 9. Item 9. Disagreements on Accounting and Financial Disclosure Not applicable. MANAGEMENT'S DISCUSSION AND ANALYSIS Phelps Dodge reported 1993 consolidated net income of $187.9 million, or $2.66 per common share, including after-tax revenues of $26.0 million, or 37 cents per common share, from copper price protection arrangements. Net income in 1993 was adversely affected by the passage of the Omnibus Budget Reconciliation Act of 1993 in the third quarter that retroactively raised the maximum corporate income tax rate from 34 percent to 35 percent effective January 1, 1993. The Corporation raised its 1993 tax provision by approximately $9.0 million, or 13 cents per common share, including $3.0 million for the effect of the tax rate increase on 1993 earnings and an additional $6.0 million for deferred taxes at December 31, 1992. All per share amounts in this report reflect average shares outstanding for the respective periods after giving effect to a two-for-one stock split in May 1992. The Corporation reported 1992 income of $301.6 million, or $4.28 per common share, before the cumulative effect of accounting changes. This 1992 income included a non-taxable gain of $36.4 million, or 52 cents per common share, on a subsidiary's stock issuance from two Sumitomo companies' acquisition of a 20 percent interest in the La Candelaria copper-gold project in Chile. Income taxes were not provided by Phelps Dodge on the $36.4 million book gain because the proceeds were indefinitely reinvested in the Chilean company. Consolidated net income for 1992 was $221.7 million, or $3.15 per common share, after recognizing the cumulative effect of accounting changes with respect to postretirement and postemployment benefits and income taxes. The Corporation reported net income of $272.9 million, or $3.93 per common share, in 1991. The Corporation's consolidated financial results for the last three years are summarized below (in millions except per common share amounts): Any material change in the price the Corporation receives for copper, or in its unit production costs, has a significant effect on the Corporation's results. The Corporation's present share of annual production is approximately 1.1 billion pounds of copper. Accordingly, each 1 cent per pound change in the average annual copper price received by the Corporation, or in average annual unit production costs, causes a variation in annual operating income before taxes of approximately $11 million. The New York Commodity Exchange (COMEX) spot price per pound of copper cathode, upon which the Corporation bases its selling price, averaged 85 cents in 1993, compared with $1.03 in 1992 and $1.05 in 1991. The COMEX price averaged 85 cents per pound for the first two months of 1994, closing at 87 cents per pound on March 2, 1994. The Corporation enters into price protection arrangements from time to time, depending on market circumstances, to ensure a minimum price for a portion of its expected future mine production. With respect to 1993 production, the Corporation entered into contracts with several financial institutions that provided for a minimum average annual realized price of 95 cents per pound for 475 million pounds of copper cathode, about 44 percent of 1993 production. These contracts were based on the average London Metal Exchange (LME) price for the entire year. During 1993, the Corporation recognized revenues of $39.4 million before taxes ($26.0 million, or 37 cents per common share, after taxes) from these arrangements. With respect to 1994 production, as of December 31, 1993, the Corporation had entered into contracts with several financial institutions that provide for minimum 1994 quarterly average prices of 75 cents per pound for 214 million pounds of copper cathode. As of March 2, 1994, total production covered by such contracts had been increased to 244 million pounds of copper cathode, approximately 22 percent of the Corporation's anticipated production for 1994. These contracts are based on the average LME price each quarter. Consolidated 1993 revenues were $2,595.9 million, compared with $2,579.3 million in 1992. Sales decreases in 1993 that resulted from lower average copper prices were more than offset by a higher volume of copper sold (including copper purchased for resale), a higher volume of wheels and rims sold, and increased sales by the international wire and cable operations (principally reflecting a late 1992 acquisition in Venezuela). A 6 percent increase in consolidated revenues from $2,434.3 million in 1991 to $2,579.3 million in 1992 also resulted from a higher volume of copper sold (including copper purchased for resale) and a higher volume of wheels and rims sold. In addition, the sales volume of wire and cable products increased in 1992 over 1991. Three new accounting standards adopted by the Corporation in the 1992 fourth quarter were treated as though they were in effect since the beginning of that year. As a result of its decision to elect early adoption of Statement of Financial Accounting Standards (SFAS) No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," No. 109, "Accounting for Income Taxes," and No. 112, "Employers' Accounting for Postemployment Benefits," the Corporation recorded a non-recurring, after- tax transition charge of $79.9 million that was reflected in revised 1992 first quarter results. More information on the effects of these new accounting standards is included later in Management's Discussion and Analysis, and in Notes 5, 16 and 17 to the Consolidated Financial Statements. The adoption of these new standards had no effect on cash flow. Phelps Dodge's results for 1993, 1992 and 1991 can be meaningfully compared by separate reference to its reporting segments, Phelps Dodge Mining Company and Phelps Dodge Industries. Phelps Dodge Mining Company includes the Corporation's worldwide copper operations from mining through rod production, marketing and sales, other mining operations and invest- ments, and worldwide exploration and development programs. Phelps Dodge Industries includes the Corporation's carbon black and synthetic iron oxide operations, its wheel and rim business, and its magnet wire, specialty conductor and cable operations. Within each such segment, significant events and transactions have occurred which, as indicated in the separate discussions presented below, are material to an understanding of the particular year's results and to a comparison with results of the other periods. Note 21 to the Consolidated Financial Statements contains further information to which reference should be made for a fuller understanding of the following discussion and analysis. Statistics on reserves and production can be found in "Copper Operations" and "Ore Reserves." RESULTS OF PHELPS DODGE MINING COMPANY Phelps Dodge Mining Company is an international business comprising a group of companies involved in vertically integrated copper operations including mining, concentrating, electrowinning, smelting and refining, rod production, marketing and sales, and related activities. Copper is sold primarily to others as rod, cathode or concentrates, and to the Phelps Dodge Industries segment. In addition, Phelps Dodge Mining Company at times smelts and refines copper and produces copper rod for others on a toll basis. Phelps Dodge Mining Company also produces gold, silver, molybdenum and copper chemicals, principally as by-products, and sulfuric acid from its air quality control facilities. This segment also includes the Corporation's other mining operations and investments (including gold, fluorspar, silver, lead and zinc operations) and its worldwide exploration and development programs. Phelps Dodge Mining Company recorded 1993 earnings from operations of $223.6 million, compared with $363.8 million in 1992 and $367.5 million in 1991. The decrease in operating earnings in 1993 resulted from lower average copper prices, offset in part by increased copper sales volume and the effect of price protection arrangements. Unit production costs of copper in 1993 were slightly higher than in 1992, principally as a result of increased depreciation charges from recent capital projects, slightly increased mining expenses associated with longer and steeper haulage requirements, and weather-related costs in the 1993 first quarter. Earnings in 1992 compared with 1991 were affected by slightly lower average realized copper prices and volumes of copper sold, partially offset by lower unit costs of copper production. The stability of unit production costs for the three-year period primarily have resulted from additional production of low-cost cathode copper at solvent extraction/electrowinning (SX/EW) plants in Morenci, Arizona; Tyrone, New Mexico; and Santa Rita, New Mexico, and from the clo- sure of the higher cost concentrator operations at Tyrone. Copper produced by SX/EW accounted for 47 percent of the Corporation's total production in 1993, compared with 45 percent in 1992 and 36 percent in 1991. The SX/EW method of copper production results in lower unit costs than conventional concentrating, smelting and refining, and is a major factor in the Corporation's continuing efforts to maintain internationally competitive costs. Annual production capacity at Chino's SX/EW facility at Santa Rita was raised to 60,000 tons of cathode copper, an increase of 15,000 tons, by an expansion project completed in April 1993. Substantial capital programs completed in 1992 also assisted in con- taining the escalation of unit production costs. Phelps Dodge Mining Company completed construction on the Northwest Extension mining project in May 1992. This project added 70,000 tons of SX/EW production capacity per year from a copper deposit adjacent to and north of the existing Morenci mine. Morenci now has an annual production capacity of 170,000 tons of cathode copper. In addition, reentry into the Metcalf area of the Morenci mine continued during the year, and the Corporation successfully completed an extension and relocation of the in-pit ore crushing and conveying systems. Each of these projects was designed and implemented to enable Phelps Dodge Mining Company to maintain its low-cost production levels. Concentrate production at Tyrone, which historically approximated 100,000 tons of copper annually, was indefinitely suspended in February 1992 because the higher grade sulfide copper ore reserves were substantially depleted. However, in order to operate the Burro Chief SX/EW plant near Ty- rone at capacity, a mine-for-leach operation will continue. In early 1992, the Corporation completed a fourth expansion of the SX/EW plant, increasing its production capacity to 70,000 tons of cathode copper per year. The Corporation expects to operate the plant for the next 10 years or more. Phelps Dodge Mining Company continued construction at its La Candelaria project throughout 1993. La Candelaria is a major copper-gold deposit lo- cated three miles southwest of Ojos del Salado near Copiapo in the Atacama desert of northern Chile. Discovered in 1987 by the Phelps Dodge exploration group, La Candelaria has estimated ore reserves of 403.3 million tons at an average grade of 1.09 percent copper and containing 3 million ounces of gold. Phelps Dodge owns an 80 percent interest in La Candelaria, and a jointly owned subsidiary of Sumitomo Metal Mining Co., Ltd. and Sumitomo Corporation, both of Japan, owns a 20 percent interest. In 1993, final agreements were executed for $290 million in limited- recourse debt project financing for La Candelaria with four lenders: the Export-Import Bank of Japan with $200 million; the Overseas Private In- vestment Corporation (OPIC) with $50 million; Banco de Chile with $30 million; and Kreditanstalt fur Wiederaufbau with $10 million. The initial loan draw-down under these agreements was made in September. These borrowings are limited recourse to the Corporation prior to satisfaction of certain completion tests, and non-recourse thereafter. Construction and pre-stripping at La Candelaria are on schedule and full production is anticipated for 1995. When completed, the $550 million project will consist of an open-pit mine, concentrator, port and associated facilities. La Candelaria, which will be operated by Phelps Dodge, is expected to produce more than 100,000 tons of copper and 80,000 ounces of gold annually over the 34-year mine life. The Corporation has additional sources of copper that could be placed in production should market circumstances warrant. Permitting and significant capital expenditures would be required, however, to develop such additional production capacity. In 1993, Phelps Dodge Mining Company's Santa Gertrudis gold project in Mexico produced 38,221 ounces of gold, a 27 percent reduction from 1992's already reduced production levels. The 1993 production shortfalls primarily resulted from lower-than-expected ore grades and recoveries, and production losses caused by heavy rains during the first quarter. Phelps Dodge is currently evaluating alternatives for the sale of its interest in Santa Gertrudis. RESULTS OF PHELPS DODGE INDUSTRIES Phelps Dodge Industries is a business segment comprising a group of international companies that manufacture engineered products principally for the transportation and electrical sectors worldwide. Its operations are characterized by products with significant market share, internationally competitive cost and quality, and specialized engineering capabilities. This business segment includes the Corporation's carbon black and synthetic iron oxide operations through Columbian Chemicals Company and its subsidiaries (Columbian Chemicals); its wheel and rim operations through Accuride Corporation and its subsidiaries (Accuride); its magnet wire operations through Phelps Dodge Magnet Wire Company and its subsidiaries; its U.S. specialty conductor operations through Hudson International Conductors (Hudson); and its international wire and cable manufacturing operations through Phelps Dodge International Corporation. Phelps Dodge Industries recorded earnings from operations of $120.6 million in 1993, compared with $75.2 million in 1992 and $76.3 million in 1991. Earnings increases in 1993 were attributable to economic recovery in North America, particularly in the automotive sector, offsetting continued weakness in the European economies. Over 80 percent of the improvement came from the wheel and rim, magnet wire and carbon black businesses. Columbian Chemicals' 1993 earnings were higher than in 1992 primarily because of higher margins in North America that offset weak sales volumes in Europe. Columbian Chemicals' 1992 earnings were lower than in 1991 pri- marily because of lower industrial carbon black margins and lower earnings in Europe. Demand for rubber carbon black in the United States, however, strengthened in 1992. The 1991 results of Columbian Chemicals reflected weak demand in the North American automotive sector in the form of lower margins for carbon black, especially for rubber applications. In late 1993, Columbian Chemicals and its joint venture partner, Tiszai Vegyi Kombinat (TVK), began operation through Columbian Tiszai Carbon Ltd. (CTC) of the first carbon black manufacturing plant in Hungary. Located in the northeastern Hungarian city of Tiszaujvaros, CTC has an annual production capacity of 55,000 tons of carbon black, more than enough to supply the entire Hungarian carbon black market. The remaining production, nearly 70 percent, will be exported. Financing for CTC was arranged through the Overseas Private Investment Corporation (OPIC) and the European Bank for Reconstruction and Development (EBRD). It is the first project in Hungary to benefit from a direct loan by OPIC. Columbian Chemicals holds a 60 percent interest in CTC; TVK, Hungary's largest petrochemical company, holds the remaining 40 percent interest. Accuride increased its 1993 sales volume of steel wheels, rims and components by 18 percent over 1992 as a result of strong North American demand for medium and heavy trucks and trailers. In addition, Accuride experienced higher margins in 1993 resulting from improved productivity and lower unit production costs. Accuride's 1992 earnings also reflected both improved demand and improved margins over the prior year. Accuride's 1992 sales of wheels and rims were up approximately 22 percent as the truck and trailer industry began to recover from the 10-year lows experienced in 1991. The margin improvement resulted from productivity increases and cost reductions attributable to the company's $48 million modernization program initiated in 1990. This margin improvement was achieved notwithstanding lower average selling prices for steel wheels and rims resulting from con- tinued competitive pricing pressures in an industry that still has some excess capacity. Phelps Dodge Magnet Wire Company's 1993 earnings exceeded its 1992 earnings as a result of sales volume increases and improved margins in North America. Phelps Dodge Magnet Wire Company experienced steady volume growth during 1992 over 1991, and benefited from productivity gains and cost savings initiatives. Operating margins in 1992, however, were relatively flat as a result of intense competitive pressures. In March 1993, Phelps Dodge Magnet Wire Company expanded its international presence with the acquisition of Elektrodraht Mureck, Phelps Dodge Eldra GmbH. The magnet wire joint venture with Eldra Elektrodraht- Erzeugung GmbH, a leading European magnet wire manufacturer, is located in Mureck, Austria. Phelps Dodge holds a 51 percent interest in the company; Eldra Elektrodraht-Erzeugung GmbH holds the remaining 49 percent. In March 1994, Phelps Dodge Magnet Wire Company acquired a fine wire manufacturing plant in Laurinburg, North Carolina, from Rea Magnet Wire Company, Inc., and a magnet wire manufacturing plant in El Paso, Texas, from Texas Magnet Wire Company, an affiliate of Rea and Fujikura International, Inc. In 1993, the Corporation's international wire and cable business experienced increased earnings, primarily from the integration of a group of Venezuelan wire and cable manufacturing companies acquired in late 1992, and the continued growth of telephone and power cable and commercial wire sales in other markets. These increases in 1993 earnings were offset in part by lower sales volumes in Thailand where certain large-scale utility projects were delayed by the Thai government. In 1992, the Corporation's international wire and cable business enjoyed improved operating earnings over 1991 primarily because of volume improvements in Chile and Thailand and an expanding telephone service installation business in Central and South America. Some margin deterioration was experienced, however, resulting from tariff reductions and increased competition. The 1991 results of the Corporation's majority-owned international wire and cable manufacturing com- panies benefited from continued recovery in international markets for wire and cable, especially in Chile and Thailand where these affiliates showed significant increases in sales. In December 1992, Phelps Dodge, through its 87 percent owned Venezuelan associate company, Alambres y Cables Venezolanos, C.A. (ALCAVE), acquired three Venezuelan companies. These companies, which operate as a group, together with ALCAVE constitute one of the largest manufacturers of electrical and telecommunication copper and aluminum wires and cables in Venezuela and the Andean Region. Phelps Dodge Industries' 1992 earnings reflected a $5.0 million reserve at Hudson for the consolidation of its conductor operations in Ossining and Walden, New York, into its expanded Inman, South Carolina, facility. The consolidation, which was initiated in response to changes in market conditions, especially in the defense sector, was completed in 1993. Continued weak market conditions in the defense sector resulted in a 1993 earnings performance at Hudson that was below expectations. In 1993, operations outside the United States provided 51 percent of Phelps Dodge Industries' sales, compared with 48 percent in 1992 and 45 percent in 1991. During the year, operations outside the United States con- tributed 63 percent of the segment's earnings from operations, compared with 82 percent in 1992 and 69 percent in 1991. OTHER MATTERS RELATING TO THE STATEMENT OF CONSOLIDATED OPERATIONS The Corporation reported net interest expense in 1993 of $37.0 million, com- pared with $39.5 million in 1992 and $39.1 million in 1991. Reported net interest expense has remained relatively constant over the three-year period despite a $158.7 million increase in debt in 1993. This has resulted from the capitalization of interest charges during the construction and development of two major projects -- the La Candelaria copper-gold project in Chile and the carbon black project in Hungary. The Corporation's 1993 miscellaneous income, net of miscellaneous expense, was $16.4 million, compared with $10.7 million in 1992 and $28.4 million in 1991. A major factor in miscellaneous income and expense fluctuations over the past three years has been the receipt of dividends from the Corporation's 16.25 percent minority interest in Southern Peru Copper Corporation. The Corporation received pre-tax dividends of $2.9 million in 1993, $2.4 million in 1992, and $9.8 million in 1991. For the year ended December 31, 1993, the Corporation recorded a provision for taxes of $105.9 million (an effective rate of approximately 36.0 percent). This compares with a 1992 provision for taxes of $114.4 million (an effective rate of approximately 27.5 percent) and a 1991 provision of $131.4 million (an effective rate of approximately 32.5 percent). The 1993 effective rate was adversely affected by the passage of the Omnibus Budget Reconciliation Act of 1993 that retroactively raised the maximum corporate tax rate from 34 percent to 35 percent effective January 1, 1993. In addition to the effect of the increase in the maximum tax rate, the Corporation provided an additional $6.0 million for deferred taxes on temporary differences existing at December 31, 1992. The principal factor in the lower 1992 effective rate was a non-taxable gain of $36.4 million on a subsidiary's stock issuance from two Sumitomo companies' acquisition of a 20 percent interest in the La Candelaria copper-gold project in Chile. (See Note 5 to the Consolidated Financial Statements for a reconciliation of the Corporation's effective tax rates to statutory rates.) On February 15, 1994, the Corporation received an examination report from the Internal Revenue Service proposing increases to the Corporation's federal income tax liabilities for the years 1988 and 1989. The Corporation is currently preparing its response to this report and intends to protest all material unagreed adjustments. Management believes it has made adequate provision so that the final resolution of the issues involved, including their application to subsequent periods, will not have a material adverse effect on the consolidated financial position or operating results of the Corporation. On January 25, 1993, the U.S. Supreme Court ruled in favor of the government in U.S. vs. Hill, U.S. Supreme Court, No. 91-1421, reversing a decision that had permitted a favorable approach to the computation of the depletion preference for purposes of determining the alternative minimum tax liability. As a result of this decision, the Corporation amended its 1991 tax return and paid additional federal income taxes of approximately $26.6 million in February 1993. This ruling does not affect the net income of the Corporation, but does affect the timing of its tax payments. Under current financial accounting standards, any significant year-to- year movement in the rate of interest on long-term, high-quality corporate bonds necessitates a change in the discount rate used to calculate the actuarial present value of the Corporation's accumulated pension and other postretirement benefit obligations. As a result of the 1993 decline in long-term interest rates, the Corporation reduced its discount rate from 8.5 percent at December 31, 1992, to 7.25 percent at December 31, 1993. The Corporation's estimated pension obligations increased by a net $60 million primarily as a result of this discount rate reduction offset in part by a reduction in the assumed rate of increase in compensation levels from 5 percent to 4 percent. Other estimated postretirement benefit obligations of the Corporation increased by a net $14 million. The effect of the reduced discount rate on this estimated obligation was mostly offset by a 1 percentage point reduction for each year in the assumed annual rate of increase in the per capita cost of covered health care benefits. The increases in these estimated obligations did not affect the earnings reported by the Corporation in 1993. In accordance with applicable accounting standards, the Corporation will amortize such increases beginning in 1994 and continuing in subsequent years. The combined incremental expense will not be significant in 1994. For a further discussion of these issues, please see Notes 15 and 16 to the Consolidated Financial Statements. CHANGES IN FINANCIAL CONDITION; CAPITALIZATION At the end of 1993, the Corporation had cash and short-term investments of $255.8 million, compared with $251.2 million at the beginning of the year. The Corporation's operating activities provided $385.0 million of cash during the year which was more than adequate to cover dividend payments on its common stock and its routine investing activities. The cash used for the Corporation's capital expenditures at its La Candelaria copper-gold project ($189.8 million) and its carbon black project in Hungary ($33.6 million) were mostly provided by limited-recourse debt project financings ($198.2 million). Investing activities during 1993 included capital expenditures of $387.2 million, compared with $270.8 million in 1992, and acquisitions and investments in subsidiaries of $3.8 million, compared with $58.6 million in 1992. The $116.4 million increase in capital expenditures principally resulted from the Corporation's La Candelaria copper-gold project and Hungarian carbon black project. The decrease in investment in subsidiaries primarily reflected the 1992 acquisition of a group of wire and cable manufacturing companies in Venezuela. Investing activities in 1993 included cash proceeds of $6.7 million from the 1992 acquisition by two Sumitomo companies of a 20 percent interest in La Candelaria; that transaction also resulted in $41.9 million in cash proceeds in 1992 (see Note 3 to the Consolidated Financial Statements). The Corporation's total debt was $647.2 million at December 31, 1993 (including $82.7 million of foreign short-term borrowings), compared with $488.5 million at the end of 1992 (including $72.5 million of foreign short- term borrowings). The increase in total debt during the year principally resulted from limited-recourse project financings for La Candelaria, $164.7 million, and the carbon black project in Hungary, $33.5 million. The ratio of total debt to total capitalization was 23.7 percent at the end of 1993, compared with 19.4 percent at the end of 1992. On May 6, 1992, the Board of Directors declared a two-for-one stock split and a 10 percent increase in the Corporation's quarterly cash dividend, to 41.25 cents per share from 37.5 cents per share on a post-stock split basis (equivalent to 82.5 cents per share from 75 cents per share on a pre-stock split basis). The stock split, in the form of a 100 percent stock dividend, and the cash dividend were both payable June 8, 1992, to common shareholders of record at the close of business on May 18, 1992. As a result of the stock split, the Corporation's outstanding shares increased from approximately 35 million to approximately 70 million. This was reflected on the Consolidated Balance Sheet as an increase in "Common shares, par value $6.25" of approximately $219 million, with an offsetting charge to "Capital in excess of par value." The $3.1 million increase in dividend payments on the Corporation's common shares, from $113.0 million in 1992 to $116.1 million in 1993, principally resulted from the 10 percent increase in the dividend rate in the 1992 second quarter (from a quarterly rate of 37.5 cents per share to 41.25 cents per share). During the second quarter of 1993, final agreements were executed with a group of lenders for $290 million of 13-year debt financing for the La Candelaria project. These borrowings are limited recourse to the Corporation prior to satisfaction of certain completion tests, and non- recourse thereafter. The $290 million includes $200 million of floating rate dollar debt, $60 million of fixed rate dollar debt, and $30 million of floating rate debt denominated in Chilean pesos. The agreements provide for a three and one-half year draw-down period and a nine and one-half year repayment period. As of December 31, 1993, $205.7 million had been drawn down under these agreements. As the Corporation consolidates its interest in majority owned mining joint ventures using the proportional consolidation method, only 80 percent of this debt and related financing charges have been reflected in the Corporation's consolidated financial statements. The Corporation also caused the project to enter into an interest rate protection agreement with certain financial institutions to limit the effect of increases in the cost of the $200 million of floating rate debt. Under the terms of the agreement, the project will receive payments from these institutions if the six-month London Interbank Offered Rate (LIBOR) exceeds 9 percent prior to December 31, 2001, and 11 percent during the two years ending December 31, 2003. During 1993, the Corporation's 60 percent owned Hungarian subsidiary, Columbian Tiszai Carbon Ltd., borrowed $33.5 million under facilities from the Overseas Private Investment Corporation (OPIC) and the European Bank for Reconstruction and Development (EBRD) to finance construction of a carbon black manufacturing plant. Both facilities are with recourse to the Corporation prior to satisfaction of certain completion tests, and non- recourse thereafter. The OPIC facility is a $24.5 million fixed rate dollar borrowing bearing interest rates of between 8.01 percent and 9.15 percent, while the EBRD $9.0 million loan is a floating rate dollar borrowing. These borrowings mature in the years 1995 through 2001. In February 1993, the Corporation sold $90 million of 6.5 percent refunding bonds due April 1, 2013. The proceeds from the sale of these bonds were used to repay the Corporation's 7 percent Installment Sale Obligations due in the years 1993 through 2003 ($90.0 million) on April 1, 1993. The Corporation filed a shelf registration statement with the Securities and Exchange Commission on December 6, 1991, for up to $250 million of debt securities to be issued from time to time in one or more se- ries to refinance debt and for general corporate purposes. During the 1992 first quarter, the Corporation sold $100 million of 10-year notes bearing a coupon of 7.75 percent, maturing January 1, 2002, and $50 million of 7.96 percent notes due in the years 1998 through 2000. The proceeds from the sales of these notes, together with a small amount of cash from the Corporation, were used to retire $154.8 million of higher interest rate debt of the Corporation during the 1992 first quarter. On January 19, 1994, the Corporation issued $81.1 million of 5.45 percent obligations due in 2009. The proceeds from the issue are being used to retire the Corporation's 5.75 percent to 6.25 percent Series A and B notes due in the years 1994 through 2004. The Corporation entered into a new revolving credit agreement with several lenders on June 30, 1993, at which time it terminated its then existing credit agreement. The new agreement permits borrowings of up to $200 million from time to time until its maturity on June 30, 1998. Interest is payable at a fluctuating rate based on the agent bank's prime rate or a fixed rate, based on the Eurodollar Interbank Offered Rate or at fixed rates offered independently by the several lenders, for maturities of from seven to 360 days. This agreement provides for a facility fee of three-sixteenths of 1 percent of total commitments. The agreement requires the Corporation to maintain a minimum consolidated tangible net worth of $1.1 billion and limits indebtedness to 40 percent of total consolidated capitalization. There were no borrowings under the current or the previous agreement at either December 31, 1993, or December 31, 1992. The Corporation has other lines of credit totaling $90.5 million that are subject to agreement as to availability, terms and amount. The Corporation pays a fee at the rate of three-eighths of 1 percent for $12.5 million of these lines. There were no borrowings outstanding under these lines of credit at either December 31, 1993, or December 31, 1992. Accuride Canada Inc. has a revolving credit facility that permits borrowings of up to U.S. $25.0 million. Interest on these borrowings is payable at a fluctuating rate based on the agent bank's Base Rate Canada, or a fixed rate based on LIBOR, for maturities of one to six months. The $25.0 million commitment under this facility extends through June 1994, afterwhich the commitment is determined using a specified borrowing base calculation. At December 31, 1993, borrowings outstanding under this facility totaled $6.0 million, compared with $28.7 million at the beginning of the year. The current portion of the Corporation's long-term debt, scheduled for payment in 1994, is $17.2 million, including $13.7 million for its international manufacturing operations and $3.5 million on its air quality control obligations. During 1993, net working capital (exclusive of cash and short-term investments and current debt) decreased $7.3 million. This decrease principally resulted from a $20.6 million decrease in accrued income taxes and a $2.8 million increase in deferred income tax assets, partially offset by a $16.1 million net increase in accounts payable and accrued expenses. The $20.6 million decrease in accrued income taxes in 1993 was the result of approximately $26.6 million in additional federal income taxes paid with the Corporation's amended 1991 income tax return. The $16.1 million net increase in accounts payable and accrued expenses in 1993 principally resulted from improved vendor credit terms and increased accruals resulting from improved business in North America. During 1992, net working capital (exclusive of cash and short-term investments and current debt) increased $20.3 million. This increase principally resulted from a $40.4 million increase in accounts receivable, partially offset by a $20.2 million increase in accrued expenses. The $40.4 million increase in accounts receivable in 1992 was the result of approximately $16.0 million of acquired receivables from the acquisition of a group of Venezuelan wire and cable manufacturing companies, approximately $11.0 million due from the minority participants in the La Candelaria project for their portion of certain development costs, and generally higher sales in November and December of 1992 compared with the same period in 1991. The $20.2 million increase in accrued expenses in 1992 principally resulted from increased activity at La Candelaria, the acquisition of a group of Venezuelan wire and cable manufacturing companies, and the adoption of new accounting standards for postretirement and postemployment benefits. The Corporation expects capital outlays in 1994 to be approximately $215.0 million for Phelps Dodge Mining Company, including $110.0 million for the Corporation's 80 percent share of the La Candelaria project, and approximately $75.0 million for Phelps Dodge Industries. The La Candelaria outlays will be funded from the debt commitments for this project referred to above and by Phelps Dodge and the Sumitomo companies. The other capital outlays will be funded from cash reserves and operating cash flow or, if necessary, from other borrowings. The Corporation is subject to federal, state and local environmental laws, rules and regulations, including the Comprehensive Environmental Response, Compensation and Liability Act of 1980 (CERCLA or Superfund), as amended by the Superfund Amendments and Reauthorization Act of 1986. Under Superfund, the Environmental Protection Agency (EPA) has identified approximately 35,000 sites throughout the United States for review, ranking and possible inclusion on the National Priorities List (NPL) for possible response. Among the sites identified, EPA has included 13 sites owned by the Corporation. The Corporation believes that most, if not all, of its sites so identified will not qualify for listing on the NPL. In addition, the Corporation may be required to remove hazardous waste or remediate the alleged effects of hazardous waste on the environment associated with past disposal practices at sites not owned by the Corpora- tion. The Corporation has received notice that it is a Potentially Responsible Party (PRP) from EPA and/or individual states under CERCLA or a state equivalent and is participating in environmental assessment and remediation activity at 34 sites. For further information about these proceedings, see Item 3. Legal Proceedings, Part IV. At December 31, 1993, the Corporation had reserves of $74.0 million for remediation of certain of the sites referred to above and other environmental costs in accordance with its policy to record liabilities for environmental expenditures when it is probable that obligations have been incurred and the costs can reasonably be estimated. The Corporation's estimates of these costs are based upon currently available facts, existing technology, and presently enacted laws and regulations. Where the available information is sufficient to estimate the amount of liability, that estimate has been used; where the information is only sufficient to establish a range of probable liability and no point within the range is more likely than any other, the lower end of the range has been used. The amounts of these liabilities are very difficult to estimate due to such factors as the unknown extent of the remedial actions that may be re- quired and, in the case of sites not owned by the Corporation, the unknown extent of the Corporation's probable liability in proportion to the probable liability of other parties. Moreover, the Corporation has other probable environmental liabilities that cannot in its judgment reasonably be estimated, and losses attributable to remediation costs are reasonably possible at other sites. The Corporation cannot now estimate the total additional loss it may incur for such environmental liabilities, but such loss could be substantial. The possibility of recovery of some of the environmental remediation costs from insurance companies or other parties exists; however, the Corporation does not recognize these recoveries in its financial statements until they become probable. The Corporation's operations are subject to myriad environmental laws and regulations in jurisdictions both in the United States and in other countries in which it does business. For further discussion of these laws and regulations, please see "Environmental and Other Regulatory Matters" and "Environmental Matters." The estimates given in those discussions of the capital expenditures for programs to comply with applicable environmental laws and regulations in 1994 and 1995, and the expenditures for those programs in 1993, are separate from the reserves and estimates described above. Bills have been proposed in both the U.S. House of Representatives and the U.S. Senate that would amend the Mining Law of 1872. The proposed amendments would impose royalties on mining operations on unpatented lands; restrict access to public lands for exploration, development and mining activities; and impose more stringent environmental protection requirements. While the effect on Phelps Dodge's current operations and other currently owned mineral resources would be minimal, adoption of either of the proposed bills in their current form would result in significant additional capital expenditures and operating expenses in the development and operation of new mines on federal lands. The resulting additional restrictions and delays in the development of such mines would seriously impact future exploration and development on federal lands in the United States. In 1993, the New Mexico legislature passed the New Mexico Mining Act. The Act requires that operators of new and existing mining operations, as well as exploration activities, submit permit applications and reclamation plans for their operations and provide sufficient financial assurance until reclamation or post-mining land use goals are met. Regulations to implement the Act are due by June 18, 1994. The Act will increase the Corporation's regulatory and compliance costs for its New Mexico operations, but until the implementing regulations are adopted it is not possible to determine the impact of the new requirements on the Corporation. During 1993, the Corporation purchased 130,000 of its common shares under its current 4 million common share buy-back program initiated in September 1989 (numbers of shares have been revised to give effect to the two-for-one stock split in May 1992). Under this program, the Corporation from time to time makes purchases in the open market and also considers purchasing common shares in negotiated transactions. From November 1988 through December 31, 1993, the Corporation purchased a total of 6,945,000 common shares -- 2,373,000 shares under the current program and the balance under the now superseded program begun in November 1988. These purchased shares were restored to the treasury. There were 70,531,081 common shares outstanding at December 31, 1993. During 1992, the Corporation elected early adoption of Statement of Financial Accounting Standards (SFAS) No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," No. 109, "Accounting for Income Taxes," and No. 112, "Employers' Accounting for Postemployment Benefits." All three standards have been treated as though they were in effect since January 1, 1992. The cumulative effects of the accounting changes required by these standards have been reflected in revised 1992 first quarter results. Adoption of the standards also requires recognition of certain ongoing operating costs in excess of those recorded under previously used accounting methods. For example, as a result of the new tax standard, Phelps Dodge increased the book value of certain purchased assets at Chino Mines Company, Columbian Chemicals Company, Accuride Corporation and Hudson International Conductors by $90.9 million as of January 1, 1992, with a corresponding increase in deferred tax liabilities. As a result, earnings from operations were reduced by $7.3 million for incremental 1992 depreciation and other expenses; net income was not affected because the tax provision was reduced by a corresponding amount. The combined cumulative effect of accounting changes from the adoption of these three new accounting standards was a one-time transition charge of $111.1 million before taxes ($79.9 million, or $1.13 per common share, after taxes). With respect to the Corporation's liability for postretirement benefits, if the Corporation's inflation assumptions prove to be incorrect, its estimates could be significantly different (for example, an increase in the medical inflation rate of 1 percent could result in an increase of as much as $12 million in the obligation). The adoption of these standards has had no effect on cash flow and has not affected adversely in any material respect the position of the Corporation under its debt agreements. The disclosures for these accounting changes are included in Note 16 for SFAS No. 106, Note 5 for SFAS No. 109 and Note 17 for SFAS No. 112. CAPITAL OUTLAYS The Corporation's capital outlays in each of the past three years are set forth in the following table. These capital outlays are exclusive of capitalized interest and the portions of the expenditures at Morenci, Chino and La Candelaria payable by minority interest holders. DIVIDENDS AND MARKET PRICE RANGES Phelps Dodge's common shares are listed on the New York Stock Exchange, the principal market on which they are traded. At March 2, 1994, there were 9,606 holders of record of the Corporation's common shares. The Corporation paid quarterly dividends of 37.5 cents on each common share throughout 1991 and in the 1992 first quarter (dividend amounts have been revised to give effect to the May 1992 two-for-one stock split). In the 1992 second quarter, the quarterly dividend was increased 10 percent to 41.25 cents on each common share and has continued at that rate. The table below sets forth the high and low prices per common share (composite quotation) in the periods indicated. INFLATION During the last three years, the principal impact of general inflation upon the financial results of the Corporation has been on unit production costs, especially energy and supply costs, at the Corporation's mining and industrial operations. In considering the impact of changing prices on the financial results of the Corporation, it is important to recognize that the selling price of the Corporation's principal product, copper, does not necessarily parallel the rate of inflation or deflation. PHELPS DODGE CORPORATION AND CONSOLIDATED SUBSIDIARIES INDEX TO CONSOLIDATED FINANCIAL STATEMENTS - ---------------------------------------------------------------------------- The consolidated balance sheet at December 31, 1993 and 1992, and the related consolidated statements of operations and of cash flows for each of the three years in the period ended December 31, 1993, and notes thereto, together with the report thereon of Price Waterhouse dated January 24, 1994, appear in this report. The additional financial data referred to below should be read in conjunction with these financial statements. Schedules not included with these additional financial data have been omitted because they are not applicable or the required information is shown in the financial statements or notes thereto. The individual financial statements of the Corporation have been omitted because the Corporation is primarily an operating company and all subsidiaries included in the consolidated financial statements, in the aggregate, do not have minority equity interests and/or indebtedness to any person other than the Corporation or its consolidated subsidiaries in amounts which together exceed 5 percent of total consolidated assets at December 31, 1993. Separate financial statements of subsidiaries not consolidated and 50 percent or less owned persons accounted for by the equity method, other than those for which summarized financial information is provided in Note 2 to the Consolidated Financial Statements, have been omitted because, if considered in the aggre- gate, such subsidiaries and 50 percent or less owned persons would not constitute a significant subsidiary. ADDITIONAL FINANCIAL DATA Financial statement schedules for the years ended December 31, 1993, 1992 and 1991: V - Property, plant and equipment VI - Accumulated depreciation, depletion and amortization of property, plant and equipment VII - Guarantees of securities of other issuers VIII - Valuation and qualifying accounts and reserves IX - Short-term borrowings X - Supplementary income statement information REPORT OF INDEPENDENT ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULES To the Board of Directors of Phelps Dodge Corporation Our audits of the consolidated financial statements referred to in our report dated January 24, 1994, appearing in this report also included an audit of the Financial Statement Schedules listed in the foregoing index titled "Additional Financial Data." 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 con- solidated financial statements. PRICE WATERHOUSE Phoenix, Arizona January 24, 1994 REPORT OF MANAGEMENT The management of Phelps Dodge Corporation is responsible for preparing the consolidated financial statements presented in this annual report and for their integrity and objectivity. The statements have been prepared in accordance with generally accepted accounting principles appropriate in the circumstances, and include amounts that are based on management's best estimates and judgments. Management has also prepared the other information in this annual report and is responsible for its accuracy and consistency with the financial statements. Management maintains a system of internal controls, including internal accounting controls, which in management's opinion provides reasonable assurance that assets are safeguarded and that transactions are properly recorded and executed in accordance with management's authorization. The system includes formal policies and procedures that are communicated to em- ployees with significant roles in the financial reporting process and updated as necessary. The system also includes the careful selection and training of qualified personnel, an organization that provides a segregation of responsibilities and a program of internal audits that independently assesses the effectiveness of internal controls and recommends possible improvements. The Audit Committee, consisting of six non-employee directors, meets at least three times a year to review, among other matters, internal control conditions and internal and external audit plans and results. It meets periodically with senior officers, internal auditors and independent accoun- tants to review the adequacy and reliability of the Corporation's ac- counting, financial reporting and internal controls. The consolidated financial statements have also been audited by Price Waterhouse, our independent accountants, whose appointment was ratified by the shareholders. The Price Waterhouse examination included a study and evaluation of internal accounting controls to establish a basis for reliance thereon in determining the nature, extent and timing of audit tests applied in the examination of the financial statements. Management also recognizes its responsibility for fostering a strong ethical climate so that the Corporation's affairs are conducted according to the highest standards of personal and corporate conduct. This responsibility is characterized and reflected in the Corporation's code of business ethics and policies, which is distributed throughout the Corporation. The code of conduct addresses, among other things, the necessity of ensuring open communication within the Corporation; potential conflicts of interest; compliance with all applicable laws, including those relating to financial disclosure; and the confidentiality of proprietary in- formation. The Corporation maintains a systematic program to assess com- pliance with these policies. REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors and Shareholders of Phelps Dodge Corporation In our opinion, the accompanying consolidated balance sheet and the related consolidated statements of operations, of retained earnings and of cash flows present fairly, in all material respects, the financial position of Phelps Dodge 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 Corporation'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 esti- mates 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 described in Note 1 to the Consolidated Financial Statements, the Corporation changed its method of accounting for postretirement and postemployment benefits and income taxes effective January 1, 1992. PRICE WATERHOUSE Phoenix, Arizona January 24, 1994 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollar amounts in tables stated in thousands except as noted) 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Accounting and Reporting Changes. In 1992, the Corporation elected early adoption of Statement of Financial Accounting Standards (SFAS) No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," No. 109, "Accounting for Income Taxes," and No. 112, "Employers' Accounting for Postemployment Benefits." All three standards were treated as though they were in effect since January 1, 1992. The cumulative effects of the accounting changes required by these standards were reflected in revised 1992 first quarter results. Adoption of the standards also required recognition of certain ongoing operating costs in excess of those recorded under previously used accounting methods. These costs have been allocated to each quarter of 1992 and were reflected in revised quarterly results. The adoption of these standards has had no effect on cash flow and has not affected adversely in any material respect the position of the Corporation under its debt agreements. The combined cumulative effect of accounting changes from the adoption of these three new accounting standards was a one-time transition charge of $111.1 million before taxes ($79.9 million, or $1.13 per common share, after taxes). The disclosures for these accounting changes are included in Note 16 for SFAS No. 106, Note 5 for SFAS No. 109 and Note 17 for SFAS No. 112. On May 6, 1992, the Board of Directors declared a two-for-one stock split effected in the form of a 100 percent stock dividend payable June 8, 1992, to common shareholders of record at the close of business on May 18, 1992. As a result of the stock split, the Corporation's outstanding shares increased from approximately 35 million to approximately 70 million. This was reflected on the Consolidated Balance Sheet as an increase in "Common shares, par value $6.25" of approximately $219 million, with an offsetting charge to "Capital in excess of par value." Per share amounts and the average number of shares outstanding have been retroactively revised for all periods presented. Basis of Consolidation. The consolidated financial statements include the accounts of the Corporation and its majority-owned subsidiaries. Interests in mining joint ventures in which the Corporation owns more than 50 percent are reported using the proportional consolidation method. Interests in other majority-owned subsidiaries are reported using the full consolidation method; the consolidated financial statements include 100 percent of the as- sets and liabilities of these subsidiaries and the ownership interests of minority participants are recorded as "Minority interest in subsidiaries" (minority interest in the net income of these subsidiaries was not sig- nificant). All material intercompany balances and transactions are eliminated. Investments in unconsolidated companies owned 20 percent or more are recorded on an equity basis. Investments in companies less than 20 percent owned are carried at cost. Foreign Currency Translation. Except as noted below, the assets and liabilities of foreign subsidiaries are translated at current exchange rates while revenues and expenses are translated at average rates in effect for the period. The related translation gains and losses are included in a separate component of common shareholders' equity. For the translation of the financial statements of certain foreign subsidiaries dealing pre- dominantly in U.S. dollars and for those affiliates operating in highly inflationary economies, assets and liabilities receivable or payable in cash are translated at current exchange rates, and inventories and other non- monetary assets and liabilities are translated at historical rates. Gains and losses resulting from translation of such financial statements are in- cluded in operating results, as are gains and losses incurred on foreign currency transactions. Statement of Cash Flows. For the purpose of preparing the Consolidated Statement of Cash Flows, the Corporation considers all highly liquid investments with a maturity of three months or less when purchased to be cash equivalents. Inventories and Supplies. Inventories and supplies are stated at the lower of cost or market. Cost for substantially all inventories is determined by the last-in, first-out method (LIFO). Cost for substantially all supplies is determined by a moving-average method. Property, Plant and Equipment. Property, plant and equipment are carried at cost. Cost of significant assets includes capitalized interest incurred during the construction and development period. Expenditures for replacements and betterments are capitalized; maintenance and repair expenditures are charged to operations as incurred. The principal depreciation methods used are the units of production method for mining, smelting and refining operations and, for other operations, the straight-line method based upon the estimated lives of spe- cific classes or groups of depreciable assets. Upon disposal of assets depreciated on a group basis, cost less salvage is charged to accumulated depreciation. Values for mining properties represent mainly acquisition costs or pre- 1932 engineering valuations. Depletion of mines is computed on the basis of an overall unit rate applied to the pounds of principal products sold from mine production. Mine exploration costs and development costs to maintain production of operating mines are charged to operations as incurred. Mine development expenditures at new mines and major development expenditures at operating mines that are expected to benefit future production are capitalized and amortized on the units of production method over the estimated commercially recoverable minerals. Environmental Expenditures. Environmental expenditures are expensed or capitalized depending upon their future economic benefits. Liabilities for such expenditures are recorded when it is probable that obligations have been incurred and the costs can be reasonably estimated. The Corporation's estimates of these costs are based upon currently available facts, existing technology, and presently enacted laws and regulations. Where the available information is sufficient to estimate the amount of liability, that estimate has been used; where the information is only sufficient to establish a range of probable liability and no point within the range is more likely than any other, the lower end of the range has been used. The possibility of recovery of some of these costs from insurance companies or other parties exists; however, the Corporation does not recognize these recoveries in its financial statements until they become probable. Goodwill. Included in "Other assets and deferred charges" are costs in excess of the net assets of businesses acquired. These amounts are amortized on a straight-line basis over periods of 20 to 40 years. Price Protection Programs. The Corporation may periodically use various price protection programs to ameliorate the effect of declining prices on a portion of its copper production. The costs of programs that guarantee a minimum price over a specified period are amortized on a straight-line basis over that period. Gains and losses from programs that effectively establish price ranges for future production are recognized in income during the periods affected. Income Taxes. In addition to charging income for taxes actually paid or payable, the provision for taxes reflects deferred income taxes resulting from temporary differences in 1993 and 1992 and timing differences in 1991 between financial and taxable income. Beginning with the 1992 adoption of SFAS No. 109, the effect on deferred income taxes of a change in tax rates is recognized in income in the period that includes the enactment date. Under the accounting method used in 1991, deferred income taxes were recognized using the tax rate applicable to the year of the calculation and were not adjusted for subsequent changes in tax rates. Pension Plans. The Corporation has trusteed, non-contributory pension plans covering substantially all of its U.S. employees and in some cases employees of international subsidiaries. The benefits are based on, in the case of certain plans, final average salary and years of service and, in the case of other plans, a fixed amount for each year of service. The Corporation's funding policy provides that payments to the pension trusts shall be at least equal to the minimum funding requirements of the Employee Retirement Income Security Act of 1974 for U.S. plans or, in the case of international subsidiaries, the minimum legal requirements in that particular country. Additional payments may also be provided by the Corporation from time to time. Postretirement Benefits Other Than Pensions. The Corporation has several postretirement health care and life insurance benefit plans covering most of its U.S. employees and in some cases employees of international subsidiaries. Postretirement benefits vary among plans and many plans require contributions from employees. Effective January 1, 1992, the Corporation began accounting for these benefits on an accrual basis. The Corporation's funding policy provides that payments shall be at least equal to its cash basis obligation, plus additional amounts that may be approved by the Corporation from time to time to the extent that they are deductible for income tax purposes. Postemployment Benefits. The Corporation has certain postemployment benefit plans covering most of its U.S. employees and in some cases employees of international subsidiaries. The benefit plans may provide severance, disability, supplemental health care, life insurance or other welfare benefits. Effective January 1, 1992, the Corporation began accounting for these benefits on an accrual basis. The Corporation's funding policy provides that payments shall be at least equal to its cash basis obligation, plus additional amounts that may be approved by the Corporation from time to time to the extent that they are deductible for income tax purposes. Earnings per Share. Earnings per share amounts are computed based on the weighted average number of shares actually outstanding during the period plus the shares that would be outstanding assuming the exercise of dilutive stock options, which are considered to be common stock equivalents. The number of equivalent shares that would be issued from the exercise of stock options is computed using the treasury stock method. Reclassification. For comparative purposes, certain prior year amounts have been reclassified to conform with the current year presentation. 2. EQUITY EARNINGS AND INVESTMENTS AND LONG-TERM RECEIVABLES Equity earnings (losses) were as follows: Dividends were received as follows: Investments and long-term receivables were as follows: Retained earnings of the Corporation include undistributed earnings of equity investments of (in millions): 1993 - $54.3; 1992 - $54.7; 1991 - $59.9. Condensed financial information for companies in which the Corporation has equity basis investments together with majority-owned foreign subsidiaries previously accounted for on an equity basis is as follows: 3. GAIN FROM SUBSIDIARY'S STOCK ISSUANCE In September 1992, a subsidiary of Sumitomo Metal Mining Co., Ltd. and Sumitomo Corporation, both of Japan, acquired a 20 percent interest in Compania Contractual Minera Candelaria, the Chilean contractual mining company that holds and is developing the La Candelaria project, for $52.8 million. Phelps Dodge, formerly the sole owner of the company, holds the remaining 80 percent interest. Phelps Dodge's share of the Sumitomo proceeds included a $40 million purchase price plus $1.9 million in closing adjustments. Deferred income taxes were not provided by Phelps Dodge on the $36.4 million book gain because the proceeds were indefinitely reinvested in the Chilean company to help fund construction and development of the project. 4. MISCELLANEOUS INCOME AND EXPENSE, NET Interest income totaled $10.9 million in 1993, principally from the Corporation's short-term investments, compared with $10.4 million and $12.0 million in 1992 and 1991, respectively. Miscellaneous income in 1993 also included a pre-tax $2.9 million dividend on its 16.25 percent minority interest in Southern Peru Copper Corporation, compared with $2.4 million and $9.8 million in 1992 and 1991, respectively. 5. INCOME TAXES As discussed in Note 1 to the Consolidated Financial Statements, the Corporation elected early adoption of SFAS No. 109, "Accounting for Income Taxes," as of January 1, 1992. SFAS No. 109 mandates an asset and liability approach for financial accounting and reporting of income taxes. One of the principal requirements of the new standard is that changes in tax rates and laws be reflected in income from operations in the period such changes are enacted. Under the Corporation's previous accounting method such changes were reflected over time. The new standard also requires balance sheet classification of deferred income taxes according to the balance sheet classification of the asset or liability to which the temporary difference is related. The cumulative effect on prior years of this change in accounting principle was a one-time transition charge of $10.0 million, or 14 cents per share. This charge was combined with the cumulative effect of other accounting changes (see Notes 16 and 17) and reported separately in the Consolidated Statement of Operations for the year ended December 31, 1992. One of the more significant effects of the new standard on the Corporation is the treatment of deferred income taxes resulting from prior business combinations. As a result of the new standard, Phelps Dodge in- creased the book value of certain purchased assets at Chino Mines Company, Columbian Chemicals Company, Accuride Corporation and Hudson International Conductors by $90.9 million as of January 1, 1992, with a corresponding increase in deferred income tax liabilities. Geographic sources of income before taxes and cumulative effect of accounting changes for the years ended December 31 were as follows: The provisions for income taxes for the years ended December 31 were as follows: A reconciliation of the U.S. statutory tax rate to the Corporation's effective tax rate is as follows: The Corporation paid federal, state, local and foreign income taxes of approximately $113 million in 1993, compared with approximately $85 million in 1992 and approximately $100 million in 1991. As of December 31, 1993, the Corporation had alternative minimum tax credits of approximately $110 million available for carryforward for federal income tax purposes. These credits can be carried forward indefinitely, but may only be used to the extent the regular tax exceeds the alternative minimum tax. The Corporation also has regular foreign tax credit and alternative minimum foreign tax credit carryforwards for federal income tax purposes of approximately $6 million and $34 million, which begin to expire in 1994. The Corporation's federal income tax returns for the years 1988 through 1989 and Arizona state income tax returns for the years 1988 through 1992 are currently under examination. The Corporation also has received a proposed assessment from the state of New Mexico relating to the Corporation's New Mexico state income tax liability for the years 1989 through 1990. Management believes that it has made adequate provision so that the final resolution of the issues involved, including application of those determinations to subsequent open years, will not have a material adverse effect on the consolidated financial condition or results of operations of the Corporation. Deferred income tax assets and (liabilities) comprised the following at December 31: Income taxes have not been provided on the Corporation's share ($198 million) of undistributed earnings of those manufacturing and mining interests abroad over which the Corporation has sufficient influence to control the distribution of such earnings and has determined that such earnings have been reinvested indefinitely. These earnings could become subject to additional tax if they were remitted as dividends, if foreign earnings were lent to the Corporation or a U.S. affiliate, or if the Corporation should sell its stock in the subsidiaries. It is not practicable to estimate the amount of additional U.S. tax that might be payable on the foreign earnings; however, the Corporation believes that U.S. foreign tax credits would largely eliminate any U.S. tax. Additional foreign withholding taxes which would be payable if all of the earnings were remitted as dividends are estimated to be $25.5 million. 6. INVENTORIES AND SUPPLIES Inventories are as follows (in millions): Inventories valued by the last-in, first-out method would have been greater if valued at current costs by approximately $101 million and $106 million at December 31, 1993 and 1992, respectively. Supplies in the amount of $103.3 million and $101.5 million at December 31, 1993 and 1992, respectively, are stated net of a reserve for obsolescence of $12.7 million and $16.7 million, respectively. 7. PROPERTY, PLANT AND EQUIPMENT Property, plant and equipment comprise the following (in millions): The net increases in property, plant and equipment of $231.6 million in 1993 and $214.1 million in 1992 are summarized below (in millions): 8. OTHER ASSETS AND DEFERRED CHARGES Other assets and deferred charges are as follows (in millions): 9. ACCOUNTS PAYABLE AND ACCRUED EXPENSES Accounts payable and accrued expenses are as follows (in millions): 10. OTHER LIABILITIES AND DEFERRED CREDITS Other liabilities and deferred credits are as follows (in millions): 11. LONG-TERM DEBT AND OTHER FINANCING Long-term debt due after one year is summarized below (in millions): Annual maturities of debt outstanding at December 31, 1993, are as follows (in millions): 1994 - $17.2; 1995 - $11.1; 1996 - $5.0; 1997 - $33.5; 1998 - $38.5. The Corporation filed a shelf registration statement with the Securities and Exchange Commission on December 6, 1991, for up to $250 million of debt securities to be issued from time to time in one or more se- ries to refinance debt and for general corporate purposes. During the 1992 first quarter, the Corporation sold $100 million of 10-year notes bearing a coupon of 7.75 percent, maturing January 1, 2002, and $50 million of 7.96 percent notes due in the years 1998 through 2000. The proceeds from the sales of these notes, together with a small amount of cash from the Corporation, were used to retire $154.8 million of higher interest rate debt of the Corporation during the 1992 first quarter. During 1993, the Corporation refunded its 7 percent installment sale obligations due in the years 1994 through 2004 through the issuance of $90 million of 6.50 percent obligations due 2013. On January 19, 1994, the Corporation issued $81.1 million of 5.45 percent obligations due 2009; the proceeds from the issue are being used to retire its 5.75 percent to 6.25 percent Series A and B notes due in the years 1994 through 2004 on March 1, 1994. The Corporation entered into a new revolving credit agreement with several lenders on June 30, 1993, at which time it terminated its then existing credit agreement. The new agreement permits borrowings of up to $200 million from time to time until its maturity on June 30, 1998. Interest is payable at a fluctuating rate based on the agent bank's prime rate or a fixed rate, based on the Eurodollar Interbank Offered Rate or at fixed rates offered independently by the several lenders, for maturities of from seven to 360 days. This agreement provides for a facility fee of three-sixteenths of 1 percent of total commitments. The agreement requires the Corporation to maintain a minimum consolidated tangible net worth of $1.1 billion and limits indebtedness to 40 percent of total consolidated capitalization. There were no borrowings under the previous or the current agreement at either December 31, 1992, or December 31, 1993. The Corporation has other lines of credit totaling $90.5 million which are subject to agreement as to availability, terms and amount. The Corporation pays a fee at the rate of three-eighths of 1 percent for $12.5 million of these lines. There were no borrowings outstanding under these lines of credit at either December 31, 1993, or December 31, 1992. The Corporation had $82.7 million in short-term debt at December 31, 1993, compared with $72.5 million at December 31, 1992, reflecting borrowings by its international mining and manufacturing operations. As of December 31, 1993, the Corporation's 80 percent owned Compania Contractual Minera Candelaria subsidiary had drawn down $205.7 million under limited-recourse debt project financing agreements to finance construction of the La Candelaria copper-gold project in Chile. Under the proportional consolidation method, the Corporation reflects $164.7 million of this amount in its financial statements. These borrowings are limited recourse to the Corporation prior to satisfaction of certain completion tests, and non- recourse thereafter. The financing arrangements for La Candelaria provide for a total of $290 million of 13-year financing including $200 million of floating rate dollar debt (with a rate based on the six-month London Interbank Offered Rate (LIBOR)), $60 million of fixed rate dollar debt, and $30 million of floating rate debt denominated in Chilean pesos (with a rate based on the 90-day Tasa Activa Bancaria), with a three and one-half year draw-down period and a nine and one-half year repayment period. These agreements were executed in June 1993, and the initial draw-down was made in September 1993. The Corporation also caused the project to enter into an interest rate protection agreement with certain financial institutions to limit the effect of increases in the cost of the $200 million of floating rate dollar debt. Under the terms of the agreement, the project will receive payments from these institutions if the six-month LIBOR exceeds 9 percent prior to December 31, 2001, and 11 percent during the two years ending December 31, 2003. The Corporation's 60 percent owned Hungarian subsidiary, Columbian Tiszai Carbon Ltd., has borrowed $33.5 million under facilities from the Overseas Private Investment Corporation (OPIC) and the European Bank for Reconstruction and Development (EBRD) to finance construction of a carbon black manufacturing plant. Both facilities are with recourse to the Corporation prior to satisfaction of certain completion tests, and non- recourse thereafter. The OPIC facility is a $24.5 million fixed rate dollar borrowing bearing interest rates of between 8.01 percent and 9.15 percent, while the EBRD $9 million loan is a floating rate dollar borrowing. These borrowings mature in the years 1995 through 2001. 12. SHAREHOLDERS' EQUITY Changes in common shareholders' capital accounts are summarized below: In 1988, the Corporation adopted a Preferred Share Purchase Rights Plan and declared a dividend of one right on each of its common shares. In certain circumstances, if a person or group of persons acquires or tenders for 20 percent or more of the Corporation's outstanding common shares, these rights vest and entitle the holder to certain share purchase rights. Until 10 days after vesting, the rights may be modified or redeemed by the Board of Directors. During 1993, the Corporation purchased 130,000 of its common shares under its current 4 million common share buy-back program initiated in September 1989 (numbers of shares have been revised to give effect to the two-for-one stock split in May 1992). Under this program the Corporation from time to time makes purchases in the open market and also considers purchasing common shares in negotiated transactions. From November 1988 through December 31, 1993, the Corporation purchased a total of 6,945,000 common shares -- 2,373,000 shares under the current program and the balance under the now superseded program begun in November 1988. These purchased shares were restored to the treasury. The Corporation has 6,000,000 authorized preferred shares with a par value of $1.00 each; no shares were outstanding at either December 31, 1993, or December 31, 1992. 13. STOCK OPTION PLANS; RESTRICTED STOCK Executives and other key employees have been granted options to purchase common shares under stock option plans adopted in 1979, 1987 and 1993. In each case, the option price equals the fair market value of the common shares on the day of the grant. Some of the options include limited stock appreciation rights under which an optionee has the right, in the event common shares are purchased pursuant to a third party tender offer or in the event a merger or similar transaction in which the Corporation shall not survive as a publicly held corporation is approved by the Corporation's shareholders, to relinquish the option and to receive from the Corporation an amount per share equal to the excess of the price payable for a common share in such offer or transaction over the option price per share. The 1993 plan provides (and the 1987 plan provided) for "reload" option grants to executives and other key employees. If an optionee exercises an option under the 1993 or 1987 plan with already-owned shares of the Corporation, the optionee receives a reload option that restores the option opportunity on a number of common shares equal to the number of shares used to exercise the original option. A reload option has the same terms as the original option except that it has an exercise price per share equal to the fair market value of a common share on the date the reload option is granted and is exercisable six months after the date of grant. The 1993 plan provides (and the 1987 plan provided) for the issuance to executives and other key employees, without any payment by them, of common shares subject to certain restrictions (Restricted Stock). The 1993 plan limits the award of Restricted Stock to 1,000,000 shares. Under a stock option plan adopted in 1989, options to purchase common shares have been granted to directors who have not been employees of the Corporation or its subsidiaries for one year or are not eligible to participate in any plan of the Corporation or its subsidiaries entitling participants to acquire stock, stock options or stock appreciation rights. At December 31, 1993, options for 5,812 shares, 944,110 shares, 27,160 shares and 1,950 shares were exercisable under the 1979 plan, the 1987 plan, the 1989 plan and the 1993 plan, respectively, at average prices of $10.35, $37.16, $31.42 and $44.81 per share. In addition, 49,200 shares of Restricted Stock issued under the 1987 plan and 51,000 shares of Restricted Stock issued under the 1993 plan were outstanding at December 31, 1993. Also at December 31, 1993, 4,257,004 shares were available for option grants (including 949,000 shares as restricted stock awards) under the 1993 plan (plus an additional 939,110 shares that may be issued as reload options) and 113,067 shares were available for option grants under the 1989 plan. These amounts are subject to future adjustment. No further options may be granted under the 1987 plan or the 1979 plan. Changes during 1991, 1992 and 1993 in options outstanding for the combined plans were as follows: Changes during 1991, 1992 and 1993 in Restricted Stock were as follows: 14. CUMULATIVE TRANSLATION ADJUSTMENTS Changes in the cumulative translation adjustments account during 1991, 1992 and 1993 are summarized below (in millions): 15. PENSION PLANS The Corporation has several non-contributory employee defined benefit pension plans covering substantially all U.S. employees. Employees covered under the salaried defined benefit pension plans are eligible to participate upon the completion of one year of service, and benefits are based upon final average salary and years of service. Employees covered under the remaining plans are generally eligible to participate at the time of em- ployment, and benefits are generally based on a fixed amount for each year of service. All employees are vested in the plans after five years of service. The Corporation also maintains pension plans for certain employees of international subsidiaries following the legal requirements in those countries. In a number of these plans, the plan assets exceed the projected benefit obligations (overfunded plans) and in the remainder of the plans, the projected benefit obligations exceed the plan assets (underfunded plans). The status of employee pension benefit plans at December 31 is summarized below (in millions): The Corporation's pension plans were valued between November 1, 1992, and January 1, 1993, and the obligations were projected to, and the assets were valued as of, the end of 1993. The majority of plan assets are invested in a diversified portfolio of stocks, bonds and cash or cash equivalents. A small portion of the plan assets is invested in pooled real estate and other private corporate investment funds. The components of net periodic pension cost (credit) were as follows (in millions): Assumptions used to develop the net periodic pension cost included an 8.5 percent discount rate in 1993 and 1992, compared with a discount rate of 9 percent in 1991. An expected long-term rate of return on assets of 10 percent and a rate of increase in compensation levels of 5 percent were used for all three years. For the valuation of pension obligations, the discount rate at the end of 1993 was 7.25 percent, reduced from 8.5 percent in 1992 and 1991, and the rate of increase in compensation levels was 4 percent, reduced from 5 percent in 1992 and 1991. The Corporation recognizes a minimum liability in its financial statements for its underfunded plans. "Other liabilities and deferred credits" at December 31, 1993, included $43 million relating to this minimum liability, compared with $23 million at December 31, 1992. This amount was offset by a $17 million intangible asset, a $16 million reduction in "Common Shareholders' Equity" and a $10 million deferred tax benefit at December 31, 1993, compared with a $17 million intangible asset, a $4 million reduction in "Common Shareholders' Equity" and a $2 million deferred tax benefit at December 31, 1992. The Corporation intends to fund at least the minimum amount required under the Employee Retirement Income Security Act of 1974 for U.S. plans or, in the case of international subsidiaries, the minimum legal requirements in that particular country. The excess of amounts accrued over minimum funding requirements, together with such excess amounts accrued in prior years, have been included in "Other liabilities and deferred credits." The anticipated funding for the current year is included in "Accounts payable and accrued expenses." 16. POSTRETIREMENT BENEFITS OTHER THAN PENSIONS As discussed in Note 1 to Consolidated Financial Statements, the Corporation elected early adoption of SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," as of January 1, 1992. SFAS No. 106 requires recognition of postretirement medical and life insurance benefits on an accrual rather than cash basis. One of the principal requirements of the method is that the expected cost of providing such postretirement benefits be accrued during the years employees render the necessary service. Under the Corporation's previous accounting method, such benefits were accounted for on a cash basis. In 1992, the Corporation elected to recognize immediately the cumulative obligation for benefits attributable to service of retired and active employees prior to 1992 rather than amortizing the cumulative obligation over future service periods. This election resulted in a one-time 1992 transition charge of $105.5 million before taxes ($66.4 million, or 94 cents per common share, after taxes). This charge was combined with the cumulative effect of other accounting changes (see Notes 5 and 17) and reported separately in the Consolidated Statement of Operations for the year ended December 31, 1992. Substantially all of the Corporation's U.S. employees who retire from active service on or after normal retirement age of 65 are eligible for life insurance benefits. The Corporation also provides postretirement life insurance for employees of international subsidiaries in some cases. Life insurance benefits are also available under certain early retirement programs or pursuant to the terms of certain collective bargaining agree- ments. The majority of the costs of such benefits were paid out of a previously established fund maintained by an insurance company, however, a portion was paid through an insured contract. Health care insurance benefits are also provided for many employees retiring from active service. The coverage is provided on a non-contributory basis for certain groups of employees and on a contributory basis for other groups. The majority of these benefits are paid by the Corporation. The status of employee postretirement benefit plans at December 31 is summarized below (in millions): The components of net periodic postretirement benefit cost (credit) were as follows (in millions): For 1993 measurement purposes, annual rates of increase in the per capita cost of covered health care benefits were assumed to average 11 percent for 1994 decreasing gradually to 5.3 percent by 2010 and remaining at that level thereafter. For 1992 measurement purposes, annual rates of increase in the per capita cost of covered health care benefits were assumed to average 13 percent for 1993 decreasing gradually to 6.3 percent by 2010 and remaining at that level thereafter. The health care cost trend rate assumption has a significant effect on the amounts reported. To illustrate, increasing the assumed health care cost trend rates by 1 percentage point in each year would increase the accumulated postretirement benefit obligation as of December 31, 1993, by approximately $12 million and the aggregate of the service and interest cost components of net periodic postretirement benefit cost for the year then ended by approximately $1 million. The weighted-average discount rate used in determining the accumulated postretirement benefit obligation was 7.25 percent for 1993, compared with 8.5 percent used for 1992. The expected long-term rate of return on plan assets was 8 percent for both years. 17. POSTEMPLOYMENT BENEFITS As discussed in Note 1 to the Consolidated Financial Statements, the Corporation elected early adoption of SFAS No. 112, "Employers' Accounting for Postemployment Benefits," as of January 1, 1992. SFAS No. 112 prescribes accounting methods for employers who provide certain benefits to former or inactive employees after employment but before retirement. Adoption of this standard resulted in a one-time 1992 transition charge of $5.6 million before taxes ($3.5 million, or 5 cents per common share, after taxes). 18. COMMITMENTS Rent expense for the years 1993, 1992 and 1991 was (in millions): $26.6, $25.1 and $26.4, respectively. Future minimum lease payments for all noncancelable operating leases having a remaining term in excess of one year totaled $72.1 million at December 31, 1993. These commitments for future periods are as follows (in millions): 1994 - $17.1; 1995 - $12.8; 1996 - $9.8; 1997 - $7.3; 1998 - $6.1; 1999 and thereafter - $19.0 million. The Corporation enters into price protection arrangements from time to time, depending on market circumstances, to ensure a minimum price for a portion of its expected future mine production. With respect to 1994 production, as of December 31, 1993, the Corporation had entered into contracts with several financial institutions that provide for a minimum average quarterly realized price of 75 cents per pound for 214 million pounds of copper cathode. 19. CONTINGENCIES The Corporation is from time to time involved in various legal proceedings of a character normally incident to its past and present businesses. Management does not believe that the outcome of these proceedings will have a material adverse effect on the financial condition or results of operations of the Corporation on a consolidated basis. The Corporation is subject to federal, state and local environmental laws, rules and regulations, including the Comprehensive Environmental Response, Compensation and Liability Act of 1980 (CERCLA or Superfund), as amended by the Superfund Amendments and Reauthorization Act of 1986. Under Superfund, the Environmental Protection Agency (EPA) has identified approximately 35,000 sites throughout the United States for review, ranking and possible inclusion on the National Priorities List (NPL) for possible response. Among the sites identified, EPA has included 13 sites owned by the Corporation. The Corporation believes that most, if not all, of its sites so identified will not qualify for listing on the NPL. In addition, the Corporation may be required to remove hazardous waste or remediate the alleged effects of hazardous waste on the environment associated with past disposal practices at sites not owned by the Corpora- tion. The Corporation has received notice that it is a Potentially Responsible Party (PRP) from EPA and/or individual states under CERCLA or a state equivalent and is participating in environmental assessment and remediation activity at 34 sites. At December 31, 1993, the Corporation had reserves of $74.0 million for remediation of certain of the sites referred to above and other environmental costs in accordance with its policy to record liabilities for environmental expenditures when it is probable that obligations have been incurred and the costs can reasonably be estimated. The Corporation's estimates of these costs are based upon currently available facts, existing technology, and presently enacted laws and regulations. Where the available information is sufficient to estimate the amount of liability, that estimate has been used; where the information is only sufficient to establish a range of probable liability and no point within the range is more likely than any other, the lower end of the range has been used. The amounts of these liabilities are very difficult to estimate due to such factors as the unknown extent of the remedial actions that may be re- quired and, in the case of sites not owned by the Corporation, the unknown extent of the Corporation's probable liability in proportion to the probable liability of other parties. Moreover, the Corporation has other probable environmental liabilities that cannot in its judgment reasonably be estimated, and losses attributable to remediation costs are reasonably possible at other sites. The Corporation cannot now estimate the total additional loss it may incur for such environmental liabilities, but such loss could be substantial. The possibility of recovery of some of the environmental remediation costs from insurance companies or other parties exists; however, the Corporation does not recognize these recoveries in its financial statements until they become probable. As part of the Corporation's 1986 acquisition of Kennecott Santa Fe Corporation (now called Phelps Dodge Chino, Inc.), The Standard Oil Company agreed to perform the obligation of Phelps Dodge Chino, Inc. to pay the debt service on $58.5 million of pollution control bonds due 2015, issued by the Town of Hurley, New Mexico. Accordingly, the Corporation views this obligation as contingent. The Corporation has guaranteed the debt facility undertaken by 49 percent owned Compania Minera Santa Gertrudis, S.A. de C.V. (Santa Gertrudis) to finance the development of a gold property located in Sonora, Mexico. The debt facility allows Santa Gertrudis to borrow gold under a commitment that reduces quarterly and terminates in 1996. At December 31, 1993, the available commitment stood at 38,000 ounces of gold, and this entire amount was outstanding. 20. FAIR VALUE OF FINANCIAL INSTRUMENTS The methods and assumptions used to estimate the fair value of each class of financial instrument for which it is practicable to estimate a value are as follows: Cash and short-term investments -- the carrying amount is a reasonable estimate of the fair value because of the short matur- ity of those instruments. Investments and long-term receivables -- the fair values of some investments are estimated based on quoted market prices for those or similar investments. The fair values of other types of loans are estimated by discounting the future cash flows using the current rates at which similar loans would be made with similar credit ratings and for the same remaining maturities. For those investments for which there are no quoted market prices, a reasonable estimate of fair value is not practicable. Additional information pertinent to the value of unquoted investments is provided below. Long-term debt -- the fair value of the Corporation's long-term debt is estimated based on the quoted market prices for the same or similar issues or on the current notes offered to the Corporation for debt of the same remaining maturities. Standby letters of credit and financial guarantees -- the fair values of guarantees and letters of credit are based on fees currently charged for similar agreements or on the estimated cost to terminate them or otherwise settle the obligations with the counterparties at the reporting date. The Corporation has guaranteed the borrowings of certain subsidiaries totaling $213.1 million. These guarantees include project financings for the La Candelaria copper-gold project in Chile and the Hungarian carbon black project; upon the satisfaction of completion requirements, those borrowings become non-recourse to the Corporation. There is no market for these guarantees and they were issued without explicit cost. Therefore, it is not practicable to establish their fair value. The estimated fair values of the Corporation's financial instruments as of December 31, 1993, are as follows (in millions): It is not practicable to estimate the fair value of investments in certain untraded foreign companies carried at historic cost. The Corporation's largest cost basis investment is its 16.25 percent interest in Southern Peru Copper Corporation, which is carried at a book value of $13.2 million. For the year ended December 31, 1993, that company reported total assets of $731.4 million, common stockholders' equity of $565.0 million, revenues of $474.0 million and net income of $194.2 million after including a $165.1 million gain from the cumulative effect of accounting changes for income taxes. 21. BUSINESS SEGMENT DATA The Corporation's business consists of two segments, Phelps Dodge Mining Company and Phelps Dodge Industries. The principal activities of each segment are described below, and the accompanying table presents results of operations and other financial information by segment. Phelps Dodge Mining Company is an international business comprising a group of companies involved in vertically integrated copper operations including mining, concentrating, electrowinning, smelting and refining, rod production, marketing and sales, and related activities. Copper is sold primarily to others as rod, cathode or concentrates, and to the Phelps Dodge Industries segment. In addition, Phelps Dodge Mining Company at times smelts and refines copper and produces copper rod for others on a toll basis, and produces gold, silver, molybdenum and copper chemicals, prin- cipally as by-products, and sulfuric acid from its air quality control facilities. This segment also includes the Corporation's other mining operations and investments (including gold, fluorspar, silver, lead and zinc operations) and its worldwide exploration and development programs. Phelps Dodge Industries is a business segment comprising a group of international companies that manufacture engineered products principally for the transportation and electrical sectors worldwide. Its operations are characterized by products with significant market share, internationally competitive cost and quality, and specialized engineering capabilities. This business segment includes the Corporation's carbon black and synthetic iron oxide operations through Columbian Chemicals Company and its subsidiaries; its wheel and rim operations through Accuride Corporation and its subsidiaries; its magnet wire operations through Phelps Dodge Magnet Wire Company and its subsidiaries; its U.S. specialty conductor operations through Hudson International Conductors; and its international wire and cable manufacturing operations through Phelps Dodge International Corpora- tion. The major portion of the sales of this segment is to customers primarily involved in the transportation industry ($602.3 million or 47 percent in 1993, compared with $528.0 million or 45 percent in 1992 and $473.6 million or 43 percent in 1991) and the electrical industry ($566.2 million or 44 percent in 1993, compared with $544.3 million or 46 percent in 1992 and $526.6 million or 47 percent in 1991). The Corporation's total 1993 sales include exports of $60.3 million from U.S. operations to unaffiliated foreign customers, including products sold through U.S. brokers, compared with $86.5 million in 1992 and $108.6 million in 1991. Intersegment sales reflect the transfer of copper from Phelps Dodge Mining Company to Phelps Dodge Industries at the same prices charged to outside customers. While the Corporation has foreign operations in several geographic areas, none is significant in itself. Sales by foreign operations to unaffiliated customers totaled $677.2 million in 1993, compared with $617.2 million in 1992 and $546.7 million in 1991; intercompany sales were $72.2 million in 1993, compared with $55.0 million in 1992 and $43.3 million in 1991. Earnings from operations from foreign subsidiaries were $47.1 million in 1993 (including $0.8 million of foreign equity losses), compared with $61.1 million in 1992 (including $1.1 million of foreign equity earnings) and $48.1 million in 1991 (including $3.7 million of foreign equity earn- ings). Identifiable foreign assets totaled $1,161.9 million at year-end 1993, compared with $846.2 million at year-end 1992 and $644.6 million at year-end 1991. Part III Items 10, 11, 12 and 13. The information called for by Part III (Items 10, 11, 12 and 13) is incorporated herein by reference from the material included under the captions "Election of Directors," "Beneficial Ownership of Securities," "Executive Compensation" and "Other Matters" in Phelps Dodge Corporation's definitive proxy statement (to be filed pursuant to Regulation 14A) for its Annual Meeting of Shareholders to be held May 4, 1994 (the 1994 Proxy Statement), except that the information regarding executive officers called for by Item 401 of Regulation S-K is included in Part I of this report. The 1994 Proxy Statement is being prepared and will be filed with the Securities and Exchange Commission and furnished to shareholders on or about April 1, 1994. Part IV Item 14. Item 14.Exhibits, Financial Statement Schedules, and Reports on Form 8-K. (a) 1. Financial Statements: Index. 2. Financial Statement Schedules: Index. 3. Exhibits: 3.1 Restated Certificate of Incorporation of the Corporation, effective June 16, 1987 (incorporated by reference to Exhibit 3.1 to the Corporation's Form 10-Q for the quarter ended June 30, 1987 (SEC File No. 1-82)). Certificate of Amendment of such Restated Certificate of Incorporation, effective August 4, 1988, and Certificate of Amendment of such Restated Certificate of Incorporation, effective August 9, 1988 (incorporated by reference to Exhibits 3.1 and 3.2 to the Corporation's Form 10-Q for the quarter ended September 30, 1988 (SEC File No. 1-82)). Complete composite copy of the Certificate of Incorporation of the Corporation as amended to date (incorporated by reference to Exhibit 3.1 to the Corporation's 1992 Form 10-K (SEC File No. 1-82)). 3.2 By-Laws of the Corporation, as amended to and including July 31, 1992 (incorporated by reference to Exhibit 3 to the Corporation's Form 10-Q for the quarter ended September 30, 1992 (SEC File No. 1-82)). 4.1 Reference is made to Exhibits 3.1 and 3.2 above. 4.2 Credit and Guaranty Agreement and Gold Overdraft Agreement, each dated as of August 9, 1990, and Amendment No. 1 to Credit and Guaranty Agreement, dated as of September 21, 1990, among Compania Minera Santa Gertrudis, S.A. de C.V. as Borrower, the Corporation as Guarantor, and Morgan Guaranty Trust Company of New York (incorporated by reference to Exhibit 4.1 to the Corporation's Form 10-Q for the quarter ended September 30, 1990 (SEC File No. 1-82)). Note: Certain instruments with respect to long- term debt of the Corporation have not been filed as Exhibits to this Report since the total amount of securities authorized under any such instrument does not exceed 10 percent of the total assets of the Corporation and its subsidiaries on a consolidated basis. The Corporation agrees to furnish a copy of each such instrument upon request of the Securities and Exchange Commission. 4.3 Rights Agreement, dated as of July 29, 1988 and Amended and Restated as of December 6, 1989, between the Corporation and Chemical Bank (formerly Manufacturers Hanover Trust Company), which includes the form of Certificate of Amendment setting forth the terms of the Junior Participating Cumulative Preferred Shares, par value $1.00 per share, as Exhibit A, the form of Right Certificate as Exhibit B and the Summary of Rights to Purchase Preferred Shares as Exhibit C (incorporated by reference to Exhibit 1 to the Corporation's Current Report on Form 8- K filed on December 7, 1989 (SEC File No. 1- 82)). 10. Management contracts and compensatory plans and agreements. 10.1 The Corporation's 1979 Stock Option Plan (the 1979 Plan), as amended to and including June 3, 1992 (incorporated by reference to Exhibit 10.1 to the Corporation's Form 10-Q for the quarter ended June 30, 1992 (SEC File No. 1-82)). Form of Stock Option Agreements under the 1979 Plan (incorporated by reference to the Corporation's Registration Statement on Form S-8 (Reg. No. 33- 34363)). Forms of amendments dated February 12, 1991 (incorporated by reference to the Corporation's 1990 10-K (SEC File No. 1-82)) and dated June 25, 1992, to Stock Option Agreements under the 1979 Plan (incorporated by reference to Exhibit 10.1 to the Corporation's 1992 Form 10-K (SEC File No. 1-82)). 10.2 The Corporation's 1987 Stock Option and Restricted Stock Plan (the 1987 Plan), as amended to and including June 3, 1992, and form of Stock Option Agreement and form of Reload Option Agreement as modified through June 3, 1992 (incorporated by reference to Exhibit 10.2 of the Corporation's Form 10-Q for the quarter ended June 30, 1992 (SEC File No. 1-82)). Form of Restricted Stock letter under the 1987 Plan (incorporated by reference to Exhibit 10.1 to the Corporation's 1990 10-K (SEC File No. 1-82)) and the amendment thereto dated June 25, 1992 (incorporated by reference to Exhibit 10.2 to the Corporation's 1992 Form 10-K (SEC File No. 1-82)). 10.3 The Corporation's 1989 Directors Stock Option Plan (the Plan), as amended to and including June 3, 1992 (incorporated by reference to Exhibit 10.3 to the Corporation's Form 10-Q for the quarter ended June 30, 1992 (SEC File No. 1- 82)). Form of Stock Option Agreement under the Plan (incorporated by reference to the Cor- poration's Registration Statement on Form S-8 (Reg. No. 33-34363)). Note: Omitted from filing pursuant to the Instruction to Item 601(b) (10) are actual Stock Option Agreements between the Corporation and certain officers under the Plans and certain Directors under the 1989 Directors Plan, which contain substantially similar provisions to Ex- hibits 10.1, 10.2 and 10.3 above. 10.4 The Corporation's 1993 Stock Option and Restricted Stock Plan (the 1993 Plan), as amended to and including December 1, 1993, and forms of Stock Option Agreement, Reload Option Agreement and Restricted Stock letter as currently in use under the 1993 Plan. 10.5 Description of the Corporation's Incentive Compensation Plan. 10.6 Deferred Compensation Agreement dated January 27, 1989 with Dr. Patrick J. Ryan (incorporated by reference to Exhibit 10.6 to the Corporation's 1987 Form 10-K (SEC File No. 1- 82)) and amendment to such agreement dated March 17, 1989 (incorporated by reference to Exhibit 10.7 to the Corporation's 1988 Form 10-K (SEC File No. 1-82)). 10.7 Deferred Compensation Plan for the Directors of the Corporation, amended and restated as of July 31, 1992 (incorporated by reference to Exhibit 10 to the Corporation's Form 10-Q for the quarter ended September 30, 1992 (SEC File No. 1-82)). 10.8 Form of Change-of-Control Agreement between the Corporation and certain executives, including all of the current executive officers to be listed in the summary compensation table to the 1994 Proxy Statement (incorporated by reference to Exhibit 10.7 to the Corporation's 1992 Form 10-K (SEC File No. 1-82)). 10.9 Form of Severance Agreement between the Corporation and certain executives, including all of the current executive officers to be listed in the summary compensation table to the 1994 Proxy Statement (incorporated by reference to Exhibit 10.11 to the Corporation's 1988 Form 10-K (SEC File No. 1-82)). 10.10 The Corporation's 1991 - 1993 Long-Term Performance Plan (incorporated by reference to Exhibit 10.12 to the Corporation's 1990 Form 10- K (SEC File No. 1-82)). 10.11 The Corporation's 1992 - 1994 Long-Term Performance Plan (incorporated by reference to Exhibit 10.14 to the Corporation's 1991 Form 10- K (SEC File No. 1-82)). 10.12 The Corporation's Retirement Plan for Directors, effective January 1, 1988 (incorporated by reference to Exhibit 10.13 to the Corporation's 1987 Form 10-K (SEC File No. 1-82)). 10.13 The Corporation's Comprehensive Executive Nonqualified Retirement and Savings Plan (the Nonqualified Plan), as amended November 7, 1990 (incorporated by reference to Exhibit 10.14 to the Corporation's 1990 Form 10-K (SEC File No. 1-82)). Amendment, effective January 1, 1991, to the Nonqualified Plan (incorporated by ref- erence to Exhibit 10.2 to the Corporation's Form 10-Q for the quarter ended June 30, 1991 (SEC File No. 1-82)). Two amendments, one effective as of January 1, 1991, and one effective as of November 15, 1993, to the Nonqualified Plan. 11 Statement re computation of per share earnings. 12 Statement re computation of ratios of total debt to total capitalization. 21 List of Subsidiaries and Investments. 23 Consent of Price Waterhouse. 24 Powers of Attorney executed by certain officers and directors who signed this Annual Report on Form 10-K. Note: Shareholders may obtain copies of Exhibits by making written request to the Secretary of the Corporation and paying copying costs of 10 cents per page, plus postage. (b) Reports on Form 8-K: No current Reports on Form 8-K were filed by the Corporation during the quarter ended December 31, 1993. Schedule VII PHELPS DODGE CORPORATION AND CONSOLIDATED SUBSIDIARIES GUARANTEES OF SECURITIES OF OTHER ISSUERS - ---------------------------------------------------------------------------- (In thousands) Name of issuer of securities Title of issue Amount owned guaranteed by of each class Total amount by person or person for which of securities guaranteed person for which statement is filed guaranteed & outstanding statement is filed - ------------------ ------------ ------------- ------------------ 1. Town of Hurley, Unit Priced Demand $58,500 - New Mexico; Adjustable Pollution The Standard Control Bonds, due Oil Company 2015; agreement by subsidiary of the Corporation to pay debt service assumed by The Standard Oil Company 2. Compania Minera Santa Gertrudis, S.A. de C.V. Gold Overdraft Agreement $14,887 - NOTE: A subsidiary of the Corporation has agreed to pay the debt service on item 1 but the obligation is viewed as the equivalent of a guarantee because the primary obligation has been assumed by The Standard Oil Company. See Note 19 to the Consolidated Financial Statements. Nature of any default by issuer of Amount in securities guaranteed treasury of in principal, interest, issuer of sinking fund or securities Nature of redemption provisions guaranteed guarantee or repayment of dividends ---------- --------- ------------------------- 1. Town of Hurley, - Bonds - New Mexico; The Standard Oil Company 2. Compania Minera Santa Gertrudis, S.A. de C.V. - Gold loan - 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. PHELPS DODGE CORPORATION ------------------------ (Registrant) March 21, 1994 By: Thomas M. St. Clair ------------------- Thomas M. St. Clair Senior 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. Chairman of the Board, President, Chief Executive Officer and Director Douglas C. Yearley (Principal Executive Officer) March 21, 1994 - ------------------ Douglas C. Yearley Senior Vice President and Chief Financial Officer Thomas M. St. Clair (Principal Financial Officer) March 21, 1994 - ------------------- Thomas M. St. Clair Vice President and Controller Thomas M. Foster (Principal Accounting Officer) March 21, 1994 - ---------------- Thomas M. Foster Edward L. Addison, Robert N. Burt, ) George C. Dillon, Cleveland E. Dodge, Jr., ) Paul W. Douglas, William A. Franke, Paul Hazen, ) Robert D. Krebs, Southwood J. Morcott, ) George B. Munroe, George L. Shinn, Directors ) March 21, 1994 By: Thomas M. St. Clair ------------------- Thomas M. St. Clair Attorney-in-fact

104918_1993.txt

104918_1993

1993

104918

ITEM 1. BUSINESS COMPANY OVERVIEW Incorporated in 1889 under the laws of the State of Washington, The Washington Water Power Company (WWP, the Company) is an investor-owned company primarily engaged as a combination electric and natural gas utility serving a 26,000 square mile area known as the Inland Northwest in eastern Washington and northern Idaho with a population estimated to be in excess of 750,000. Also, WP Natural Gas (WPNG), an operating division, provides natural gas service in northeast and southwest Oregon and the South Lake Tahoe region in California with a population estimated to be in excess of 450,000. The Company's utility operations include the generation, purchase, transmission, distribution and sale of electric energy on both a retail and wholesale basis plus the purchase, transportation, distribution and sale of natural gas. In addition to its utility operations, the Company owns Pentzer Corporation, parent company to the majority of the Company's non-utility businesses. Pentzer's portfolio of investments includes companies involved in advertising display manufacturing, electronic technology, energy services, financial services, real estate development and telecommunications. At December 31, 1993, the Company employed 1,696 people with 1,438 in its utility operations and 258 in its majority-owned non-utility operations. The Company headquarters are in Spokane, Washington, which with a population of about 480,000 in the Greater Spokane Area, serves as the Inland Northwest's center for business, transportation, health care, education, communication and agricultural interests. For the twelve months ended December 31, 1993 and 1992, respectively, the Company derived operating revenues and income from operations in the following proportions: UTILITY OVERVIEW The Company owns and operates nine hydroelectric projects, a wood-waste fueled generating station and a natural gas combustion turbine. The Company also retains a 15% ownership in two coal-fired generating facilities, one in southwestern Washington and one in southeastern Montana. In addition the Company is in the process of constructing a natural gas combustion turbine peaking unit in northern Idaho. Four natural gas pipelines provide the Company access to both domestic and Canadian natural gas supplies. With this diverse resource portfolio, the Company remains one of the nation's lowest-cost producers and sellers of energy services. At December 31, 1993, electric service was supplied to approximately 267,000 customers in eastern Washington and northern Idaho. The Company's average hourly load for 1993 was 900 aMW. The Company's annual peak load, including firm contractual obligations, was 2,126 MW. This peak occurred on January 13, 1993, at which time the maximum capacity available from the Company's generating facilities, contracts and non-firm purchases was 2,335 MW. At December 31, 1993, the Company's natural gas operations served approximately 196,000 customers in four states. The Company's natural gas business has more than doubled since 1990 due primarily to the acquisition of the natural gas distribution properties of CP National in Oregon and South Lake Tahoe, California in September, 1991. The peak load in 1993 occurred on February 16, 1993 when 2.7 million therms were required. During that peak 3.5 million therms were available under firm transportation and storage contracts. NON-UTILITY OVERVIEW The Company's principal subsidiary, Pentzer, is the parent company of all the Company's non-utility subsidiaries except for three non-operating subsidiaries. Wholly-owned Pentzer is a company with approximately $130 million in total assets and about $86 million in shareholder equity. Pentzer's business strategy is to acquire controlling interests in a broad range of middle market companies, to help these companies grow through internal development and strategic acquisitions, and to sell the portfolio investments either to the public or to strategic buyers when it becomes most advantageous in meeting Pentzer's return on invested capital objectives. THE WASHINGTON WATER POWER COMPANY ELECTRIC SERVICE ELECTRIC COMPETITION AND BUSINESS OVERVIEW The electric utility business is undergoing numerous changes and is becoming increasingly competitive as a result of economic, regulatory, and technological changes. The Company believes that it is well positioned to meet the challenges described below due to its low production costs, close proximity to major transmission lines, experience in the wholesale market and its commitment to high levels of customer satisfaction, cost reduction and continuous improvement of work processes. The Company currently competes for new retail electric customers with various rural electric cooperatives and public utility districts. Challenges facing the electric retail business include changing technologies which reduce energy consumption, self- generation and fuel switching by industrial and other large retail customers, the potential for retail wheeling (described below) and the costs of increasingly stringent environmental laws. Cogeneration has had only a minor impact on the Company to date. See "Purchases, Exchanges and Sales" for additional detail on cogeneration purchases and sales. In addition, if electric utility companies are eventually required to provide retail wheeling service, which is the transmission by an electric utility of electric power from another supplier to a customer located within such utility's service area, the Company believes it will be in a position to benefit since it is committed to remaining one of the country's lowest-cost providers of electric energy. The Company also competes in the wholesale electric market with other western utilities, including the BPA. Challenges facing the electric wholesale business include new entrants in the wholesale market and competition from lower cost generation being developed by independent power producers. The National Energy Policy Act (NEPA) enacted in 1992 addresses a wide range of issues affecting the wholesale electric business. NEPA gives the FERC expanded authority to order electric utilities (a) to transmit electric power to or for wholesale purchasers and sellers if the result would not unreasonably impair the continuing reliability of the affected electric systems and (b) to increase transmission capacity to provide access for wholesale purchasers and sellers of electric power at prices that permit the recovery by the utility of all costs incurred in connection with the transmission services. NEPA also created Exempt Wholesale Generators (EWG's), a new class of independent power plant owners who are able to sell generation only at the wholesale level. The Company believes NEPA provides future transmission, energy production and sales opportunities to the Company and complements the Company's commitment to the wholesale electric business. The Company's wholesale electric business remains an important part of the Company's overall business. Since 1987 the Company has entered into a number of long-term firm power sales contracts that have increased its wholesale electric business and the Company intends to continue active pursuit of wholesale business opportunities. In 1993, 31% of total KWH sales were to wholesale customers with 55% of these sales under firm contracts. ELECTRIC SYSTEM The Company owns and operates nine hydroelectric projects, a wood-waste fueled generating station and a natural gas combustion turbine in addition to retaining a 15% ownership in two coal-fired generating facilities. Hydroelectric Resources Hydroelectric generation is the Company's lowest cost source of electricity and the availability of hydroelectric generation has a significant effect on the Company's total power costs. The Company expects to meet about 49% of its total system requirements with its own hydroelectric generation and long-term hydro contracts in normal water years. The streamflows in the Company's drainage systems were 86%, 64% and 116% of normal in 1993, 1992 and 1991, respectively. For the years 1993, 1992 and 1991, respectively, the Company's own hydroelectric generation facilities provided 33%, 28% and 38%, while long-term hydro contracts provided approximately 10%, 12% and 14% of the Company's total system requirements. Thermal Resources The Company has a 15% interest in two coal-fired facilities - - the Centralia Power Plant (Centralia) in southwestern Washington and Units 3 and 4 of the Colstrip Generating Project (Colstrip) in southeastern Montana. In addition, the Company owns a woodwaste-fired facility known as the Kettle Falls Generating Station (Kettle Falls) in northeastern Washington and a natural gas-fired combustion turbine (CT) in Spokane. The CT is primarily used for peaking needs. In a normal water year about 32% of the Company's total system requirements are met by thermal sources. Company-owned thermal facilities provided 25%, 31% and 26% of the Company's total electricity requirements for the years 1993, 1992 and 1991, respectively. THE WASHINGTON WATER POWER COMPANY Centralia, which is operated by PacifiCorp, is supplied with coal under a fuel supply agreement in effect through December 31, 2020. In 1993, 1992 and 1991 Centralia provided approximately 46%, 40% and 40%, respectively, of the Company's thermal generation. Colstrip is supplied with fuel under coal supply and transportation agreements in effect through December 2019, from adjacent coal reserves owned and controlled by Entech, Inc. (Entech). Entech is a wholly-owned subsidiary of The Montana Power Company, which is also the operator of Colstrip. In 1993, 1992 and 1991 Colstrip provided approximately 43%, 51%, and 51% of the Company's thermal generation, respectively. Kettle Falls' primary fuel is waste wood generated as a by-product of forest product processing facilities such as sawmills within an approximate one hundred mile radius of the plant. Natural gas may be used as an alternate fuel. The cost of waste wood fuel is heavily influenced by operations of the forest products industry as well as transportation costs and, therefore, is subject to significant price variations. Current fuel supplies are adequate through the remainder of 1994. A combination of long term contracts already in place plus spot purchases allow the Company the flexibility to meet all expected future fuel requirements for the plant. In 1993, 1992 and 1991 Kettle Falls provided approximately 11%, 9% and 9% of the Company's thermal generation, respectively. Purchases, Exchanges and Sales In addition to the Company-owned hydro, long-term hydro contracts and thermal generating resources discussed above, total system requirements are met with other long-term purchases and exchanges of power. Other power purchases and exchanges for the years 1993, 1992 and 1991 provided approximately 32%, 29% and 22%, respectively, of the Company's total system requirements. The following table summarizes the Company's major long-term wholesale power agreements as of December 31, 1993 (1): (1) Available capacity may vary pursuant to the provisions of the specific contracts. See Notes 11 and 13 to Financial Statements for additional information Under PURPA, the Company is required to purchase generation from qualifying facilities, including small hydro and cogeneration projects, at avoided cost rates adopted by the WUTC and IPUC. The Company purchased approximately 623 million KWH, or about 6% of the Company's total energy requirements, from these sources at a cost of approximately $26 million in 1993. The largest such contract is a ten-year power purchase contract between the Company and Potlatch, one of the Company's major industrial customers, which became effective on January 1, 1992. Under the terms of the agreement, the Company purchases 50-55 aMW of Potlatch's electric generation and makes available approximately 95 aMW of firm energy for sale. In addition, the Company makes available 25 aMW of interruptible energy and Potlatch must provide an equivalent amount of reserve generation capacity in case of interruption. ELECTRIC REGULATORY ISSUES The Company, as a public utility, is currently subject to regulation by state utility commissions with respect to rates, accounting, the issuance of securities and other matters. The electric retail operations are subject to the jurisdiction of the WUTC and IPUC. The Company is also subject to the jurisdiction of the FERC for its accounting procedures and its wholesale transmission rates. In each regulatory jurisdiction, the prices the Company may charge for utility services (other than certain wholesale sales and specially negotiated retail rates for industrial or large commercial customers) are determined on a "cost of service" basis and are designed to provide, after recovery of allowable operating expenses, an opportunity to earn a reasonable return on "rate base" or assets employed in the business. "Rate base" is generally determined by reference to the original cost (net of accumulated depreciation) of utility plant in service, subject to various adjustments for deferred taxes and other items. Over time, rate base is increased by additions to utility plant in service and reduced by depreciation and retirements of utility plant from service. The Company is a licensee under the Federal Power Act and its licensed projects are subject to the provisions of Part I of that Act. See "Properties - Electric Properties" for additional information. These provisions include payment for headwater THE WASHINGTON WATER POWER COMPANY benefits, condemnation of licensed projects upon payment of just compensation and take-over of such projects after the expiration of the license upon payment of the lesser of "net investment" or "fair value" of the project, in either case plus severance damages. General Rate Cases The Company does not currently plan to file for any general electric rate increases in 1994. The following table summarizes information for the Company's most recent general electric rate cases: (1) Anticipated annual revenue effect. (2) Through June 30, 1994, the IPUC has approved a power cost adjustment (PCA) mechanism Integrated Resource Planning (IRP) IRP is a process required by both the WUTC and IPUC and represents the Company's responsibility to meet customer demand for reliable energy services at the lowest total cost to both the Company and its customers. The process entails (1) the forecasting of future energy needs, (2) the assessment of energy supplies, conservation options, customer costs, and social and environmental impacts and (3) the development of action plans which support a least cost resource strategy. The Company's need for future electric resources to serve retail loads is very minimal. The electric integrated resource plan accepted by both the IPUC and the WUTC in 1993 showed that, through the year 1998, the Company's additional electric load requirements will be met for the most part by a combination of demand side management, including conversions to natural gas, and the redevelopment of existing hydro generating plants. The cost of these resources is generally competitive with the costs of resources being developed by independent power producers. Demand Side Management (DSM) Energy efficiency programs, which include residential space and water heat conversion programs, are material components of the Company's long-term resource strategy. In 1992 the Company filed a request with both the WUTC and IPUC for approval of new electric DSM tariffs which would provide for the implementation of new and revised energy efficiency programs including the "Energy Exchanger" program, which offers incentives to the Company's electric space and/or hot water heating customers to convert to natural gas. In conjunction with the request for tariff approval, DSM accounting treatment was requested which would allow the Company to defer the costs in new program investments until the next general rate case. With only minor modifications, the applications were approved and the effective dates for implementation were May 1 and July 17, 1992 in Washington and Idaho, respectively. Reductions in the DSM incentives were approved by both the IPUC and WUTC in 1993. Justification will be required for continuation of the programs beyond December 31, 1994. Approximately 18 aMW were saved in 1993 under these programs and over 23 aMW have been saved since the program's inception. Power Cost Adjustment (PCA) The Company's PCA surcharge of $2.3 million in Idaho expired on November 1, 1993. The current balance in the account has not yet triggered either a surcharge or a refund. In June 1993 the IPUC approved an extension of the PCA to June 30, 1994. See Note 1 to Financial Statements for additional details. THE WASHINGTON WATER POWER COMPANY ELECTRIC OPERATING STATISTICS (1) Includes firm contract obligations of 485 MW, 462 MW and 323 MW and 120 MW, 63 MW and 247 MW of non-firm sales in 1993, 1992 and 1991, respectively. (2) Includes firm contract obligations of 610 MW, 468 MW and 474 MW in 1993, 1992 and 1991, respectively; 1991 results do not include 150 MW for non-firm sales. There were no non-firm sales in 1993 or 1992 during the summer system peak period. THE WASHINGTON WATER POWER COMPANY NATURAL GAS SERVICE NATURAL GAS COMPETITION AND BUSINESS OVERVIEW Natural gas is priced competitively compared to other alternative fuel sources for both residential and commercial customers. The Company provides programs that encourage electric customers to convert to natural gas. Significant growth has occurred in the Company's natural gas business in recent years due to these conversions. The Company also makes sales or provides transportation service directly to large natural gas customers. Challenges facing the Company's natural gas business include the potential for customers to by-pass the Company and securing competitively priced natural gas supplies for the future. Since 1988 one of the Company's large industrial customers has built its own pipeline interconnection. However, this customer still purchases some natural gas services from the Company. The Company prices its natural gas services, including transportation contracts, competitively and has varying degrees of flexibility to price its transportation and delivery rates by means of special contracts to assist in retaining potential by-pass customers. The Company has signed long-term transportation contracts with two of its largest industrial customers which minimizes the chances of these customers by-passing the Company's system. Order 636B adopted by FERC in 1992 provides the Company more flexibility in optimizing its natural gas transportation and supply portfolios. While rate design changes have increased the costs of firm transportation to low load factor pipeline customers such as the Company, flexible receipt and delivery points and capacity releases allow temporarily under-utilized transportation to be released to others when not needed to serve the Company's customers. NATURAL GAS SYSTEM The Company's natural gas operations are operated as separate divisions, with the WWP service territory including the Washington and Idaho properties and the WPNG service territory including Oregon and California properties. Natural Gas Supply The Company has access to four natural gas pipelines, Northwest Pipeline Company (NWP), Pacific Gas Transmission (PGT), Paiute Pipeline (Paiute) and Alberta Natural Gas Co. Ltd. (ANG), which provide the Company access to both domestic and Canadian natural gas supplies. Due to this resource portfolio, the Company remains one of the nation's lowest-cost local distribution companies. Both WWP and WPNG contract with (1) NWP for three types of firm service: transportation, liquefied natural gas storage and underground storage and (2) PGT and ANG for firm transportation. WPNG also contracts with Paiute for firm transportation and liquefied natural gas storage to deliver natural gas to its California customers. Firm winter natural gas supplies are purchased by the Company through negotiated agreements having terms ranging between one month and eleven years with a variety of natural gas suppliers. As a result of FERC Order 636B, WWP has completed the process of converting its NWP natural gas sales to firm transportation and assuming its share of NWP's natural gas supply contracts. In January 1993, the Company contracted with ANG, PGT, NWP and Paiute for additional transportation capacity to be available by November 1995 for service in the Oregon and California service territory of WPNG. The Company has also contracted with PGT and ANG for additional capacity for service beginning in 1995 for its Washington and Idaho properties. Jackson Prairie Natural Gas Storage Project (Storage Project) The Company retains a one-third ownership interest in the Storage Project, which is an underground natural gas storage field located near Chehalis, Washington. Under FERC's open access policy the role of the Storage Project in providing flexible natural gas supplies is increasingly important to the Company's natural gas operations. The Storage Project enables the Company to place natural gas into storage when prices are low or to meet minimum natural gas purchasing requirements, as well as to withdraw natural gas from storage when spot prices are high or as needed to meet high demand periods. The Company has released some of its Storage Project capacity to two other utilities until 1995 and 1996 with a provision under one of the releases to partially recall the released capacity if the Company determines additional natural gas is required for its own system supply. Natural Gas Transportation Services The Company provides transportation service to customers who obtain their own natural gas supplies. Transportation service continued to be a significant component of the Company's total system deliveries in 1993. The competitive nature of the spot natural gas market results in savings in the cost of purchased natural gas, which encourages large customers with fuel-switching capabilities to continue to utilize natural gas for their energy needs. The total volume transported on behalf of transportation customers was approximately 197.5 million therms in 1993. This total volume represented approximately 40% of the Company's total system deliveries in 1993. THE WASHINGTON WATER POWER COMPANY NATURAL GAS REGULATORY ISSUES The Company, as a public utility, is currently subject to regulation by several state utility commissions with respect to rates, accounting, the issuance of securities and other matters. The natural gas operations are subject to the jurisdiction of the WUTC, IPUC, OPUC and CPUC in addition to the FERC with respect to natural gas rates charged for the release of capacity from the Storage Project. Refer to Electric Regulatory Issues for additional details regarding the rate setting process. General Rate Cases The Company has no current plans to file for any natural gas general rate cases in 1994. The following table summarizes information for the Company's most recent general natural gas rate cases (1): (1) In addition, the Company from time to time, upon request, receives regulatory approval from the WUTC, the IPUC, the OPUC and the CPUC to adjust rates to reflect changes in the cost of purchased natural gas between general rate cases. (2) Anticipated annual revenue effect. In September 1991, the Company commenced operations in both California and Oregon upon the acquisition of the natural gas properties of CP National. The conditions of the CPUC order approving the acquisition included an exemption from filing a general rate case until January 1, 1994 and a rate "freeze" until January 1, 1995. On October 20, 1993, the CPUC granted a one year extension to January 1, 1995 before the Company is required to file a general rate case. As a result, the existing rate "freeze" will continue until at least January 1, 1996. The OPUC also authorized a general rate "freeze" which extends to December 31, 1995. Purchased natural gas costs will continue to be tracked through to customers in both jurisdictions during the rate "freeze" period. Integrated Resource Planning (IRP) In 1993 biannual natural gas IRP reports were accepted by both the WUTC and OPUC. Refer to Electric Regulatory Issues for a description of the IRP process. Demand Side Management (DSM) Included with the WUTC and IPUC electric DSM applications discussed above under Electric Regulatory Issues, the Company requested approval of new natural gas tariffs which would provide for the implementation of new and revised energy efficiency programs for the Company's residential, commercial and industrial natural gas customers. In conjunction with the request for tariff approval, the Company requested approval of associated natural gas DSM accounting treatment. With only minor modifications, the applications were approved. The effective dates for implementation were May 1 and July 17, 1992 in Washington and Idaho, respectively, with revisions made in July 1993 and future justification required for continuance of programs beyond December 31, 1994. On December 21, 1993, the OPUC authorized the Company to defer revenue requirement amounts associated with its WPNG DSM investments, and established an annual rate adjustment mechanism to reflect the deferred costs on a timely basis. Under this authorization, each December 1 the Company will file a rate adjustment to recover DSM program costs and margin losses. This filing will be concurrent with the Company's annual natural gas tracker filing. The effective date for both the deferrals and the rate adjustment mechanism was January 1, 1994. Natural Gas Trackers In the second quarter of 1993, the Company filed special natural gas trackers with the WUTC, IPUC, OPUC and CPUC due primarily to the increased costs from the pipelines related to the implementation of FERC Order 636B. The increases range from 3% to 25% but will result in no additional net income to the Company. The trackers were approved by all four state commissions. In a separate proceeding, the annual Oregon natural gas tracker became effective on December 1, 1993. The tracker will increase overall revenue by about $3.1 million or 8.74% in Oregon but will result in no additional net income to the Company as it is only a passthrough of changes in the cost of purchased natural gas and amortization rates pursuant to the Company's natural gas tracker. The filing also included the acquisition of additional capacity over the PGT system. THE WASHINGTON WATER POWER COMPANY NATURAL GAS OPERATING STATISTICS (1) Includes WPNG results from September 30 to December 31 except where otherwise noted; includes a three-month average of WPNG customers and a twelve-month average of WWP customers. THE WASHINGTON WATER POWER COMPANY ENVIRONMENTAL MATTERS The Company is subject to environmental regulation by federal, state and local authorities. The generation, transmission, distribution, service and storage facilities in which the Company has an ownership interest have been designed to comply with all environmental laws presently applicable. The Company was named a potentially responsible party under the Comprehensive Environmental Response, Compensation, and Liability Act of 1980 ("CERCLA" or "Superfund") at the Coal Creek site in Chehalis, Washington. The estimated cost of clean-up is $12,000,000, which is being shared by over 90 utilities. The Company is responsible for approximately $800,000 of this cost, the majority of which was spent in 1993. In 1993 the EPA referred a matter to the U.S. Justice Department requesting the Company and other potentially responsible parties to enter into negotiations for the recovery of costs incurred by EPA and for initiation of action in connection with the clean-up at the Spokane Junk Yard Site located in Spokane, Washington. If an action is commenced, the claim is expected to be for $2.4 million in site stabilization costs plus additional costs including attorneys' fees and site rehabilitation costs. The Company has no records showing that any Company equipment was ever deposited at the Spokane Junk Yard Site or that PCB contaminated equipment was delivered to any company which disposed of materials at the site. Therefore, the Company has disclaimed any liability with respect to the Spokane Junk Yard Site. If an action is commenced, the Company will vigorously defend against such claim. Refer to both Note 11 to Financial Statements: Commitments and Contingencies and Significant Trends in Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations for additional information. NON-UTILITY BUSINESS As of December 31, 1993, the Company had an investment of approximately $93 million in non-utility operations, of which about $86 million was invested in Pentzer. The remainder was invested in three non-operating subsidiaries, the largest of which is WIDCo, which maintains a small investment portfolio. Substantially all of the non-utility operations are controlled by Pentzer, a wholly owned subsidiary of the Company. As of December 31, 1993, Pentzer had approximately $130 million in total assets, or about 7% of the Company's consolidated assets. Pentzer's portfolio of investments includes companies involved in advertising display manufacturing, electronic technology, energy services, financial services, real estate development and telecommunications. Pentzer's current investment profile focuses on manufacturers and distributors of industrial and consumer products as well as service businesses. The Company seeks businesses with above average records of earnings growth in industries that are not cyclical or dependent upon high levels of research and development. Emphasis is placed on leading companies with strong market franchises, dominant or proprietary product lines or other significant competitive advantages. Pentzer is particularly interested in companies serving niche markets. Total investment in any one company is generally limited to $15 million, and control of the acquired company's board of directors is generally required. Pentzer's business strategy is to acquire controlling interests in a broad range of middle market companies, to help these companies grow through internal development and strategic acquisitions, and to sell the portfolio investments either to the public or to strategic buyers when it becomes most advantageous in meeting Pentzer's return on invested capital objectives. Pentzer's goal is to produce financial returns for the Company's shareholders that, over the long term, should be higher than that of the utility operations. From time to time, a significant portion of Pentzer's earnings contributions may be the result of transactional gains. Accordingly, although the income stream is expected to be positive, it may be uneven from year to year. THE WASHINGTON WATER POWER COMPANY ITEM 2. ITEM 2. PROPERTIES ELECTRIC PROPERTIES The Company's electric properties, located in the States of Washington, Idaho and Montana, include the following: Generating Plant N/A Not applicable. (1) Nameplate Rating, also referred to as "installed capacity", is the manufacturer's assigned rating under specified conditions. (2) Capability is the maximum generation of the plant without exceeding approved limits of temperature, stress and environmental conditions. (3) Due to the redevelopment project which was started during 1993, the actual plant capability at year end declined from 18 MW; upon completion of this project in mid-1994, the plant capability is expected to rise to 29 MW. (4) Reduced from 13 MW due to possible penstock enlargement; if completed, the plant capability is expected to return to 13 MW. (5) Due to the upgrade project started during 1993 on unit no. 1, the actual plant capability at year end declined from 230 MW; upon completion of this project in mid-1994, the plant capability is expected to rise to 240 MW. (6) Jointly-owned. Data above refers to Company's respective 15% interests. (7) Used primarily for peaking needs. Distribution and Transmission Plant The Company operates approximately 11,250 miles of distribution lines in its electric system. The Company's transmission system consists of approximately 550 miles of 230 KV line and 1,500 miles of 115 KV line. The Company also owns a 10% interest in 495 miles of a 500 KV line from Colstrip, Montana and a 15% interest in 3 miles of a 500 KV line from Centralia, Washington to the nearest BPA interconnections. The 230 KV lines are used primarily to transmit power from the Company's Noxon Rapids and Cabinet Gorge hydro generating stations to major load centers in the Company's service area. The 230 KV lines also transmit to points of interconnection with adjoining electric transmission systems for bulk power transfers. These lines interconnect with BPA THE WASHINGTON WATER POWER COMPANY at five locations and at one location each with PacifiCorp, Montana Power and Idaho Power Company. The BPA interconnections serve as points of delivery for power from the Colstrip and Centralia generating stations as well as for the interchange of power with the Southwest. The interconnection with PacifiCorp is the point of delivery for power purchased by the Company from Mid-Columbia projects' hydro generating stations. The 115 KV lines provide for transmission of energy as well as providing for the integration of the Spokane River hydro and Kettle Falls wood-waste generating stations with service area load centers. These lines interconnect with BPA at nine locations, Grant County PUD at three locations, Seattle City Light and Tacoma City Light at two locations and one each with Chelan County PUD, PacifiCorp, and Montana Power. Electric Projects Under Construction Rathdrum Combustion Turbine On October 5, 1993, the IPUC issued an order approving the combustion turbine project consisting of two 88 MW units. Construction has begun on the project, which is designed to meet the Company's peaking needs for both its retail and wholesale obligations. The air quality permit that has been issued, which allows for the operation of the project as scheduled, has been challenged and is currently under administrative review. Natural gas will be used as both the primary and back-up fuel. The Company has obtained separate construction and long-term lease financing for this project. The project is currently expected to be completed by early 1995 at an expected cost of $66 million, of which $29 million had been spent as of December 31, 1993. Company Hydro The Company continues to study its hydroelectric facilities on both the Spokane and Clark Fork Rivers to identify additional economic hydroelectric generating potential. Turbine efficiency improvements are underway at the Nine Mile project that would increase generating capacity by 12 MW to a total of 29 MW by mid-1994 at an expected cost of $20 million. Similar improvements are underway at the Cabinet Gorge powerhouse that would increase capacity by approximately 10 MW to a total of 240 MW at an expected cost of $12 million; it is expected back on-line by the end of the first quarter 1994. Feasibility studies for upgrading the Company's other hydroelectric facilities are continuing. Proposed Acquisition On February 15, 1994, the Company announced it had reached agreement to acquire the northern Idaho electric properties of Pacific Power and Light Company, an operating division of PacifiCorp. The cash purchase price will be $26 million, subject to closing adjustments, and includes a premium above the book value of the net assets acquired. Pacific Power's northern Idaho electric system currently serves approximately 9,300 residential, commercial and industrial customers. The purchase is subject to regulatory approval by the IPUC and the FERC. Closing of the transaction is expected to occur during the summer of 1994. See Note 14 to Financial Statements for additional information related to this acquisition. NATURAL GAS PROPERTIES The WWP and WPNG service territories' natural gas properties have natural gas distribution mains of approximately 2,912 miles and 1,410 miles, respectively. The Company, NWP and Washington Natural Gas Company each own a one-third undivided interest in the Storage Project. The Storage Project has a total peak day deliverability of 4.6 million therms, with a total working natural gas inventory of 155.2 million therms. ITEM 3. ITEM 3. LEGAL PROCEEDINGS Refer to Note 11 to Financial Statements: Commitments and Contingencies. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Not Applicable. THE WASHINGTON WATER POWER COMPANY PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS Outstanding shares of Common Stock are listed on the New York and Pacific Stock Exchanges. As of February 25, 1994, there were approximately 36,000 registered shareholders of the Company's no par value Common Stock. It is the intention of the Board of Directors to continue to pay dividends quarterly on the Common Stock, but the amount of such dividends is dependent on future earnings, the financial position of the Company and other factors. For further information, see Notes 8 and 15 to Financial Statements. THE WASHINGTON WATER POWER COMPANY ITEM 6. ITEM 6. SELECTED FINANCIAL DATA On November 9, 1993, the Company distributed, to shareholders of record on October 25, 1993, shares of its common stock, without par value, under a two-for-one stock split effected in the form of a 100% stock dividend. All references to number of shares and per share information have been adjusted to reflect the common stock split on a retroactive basis. In 1992, Pentzer's common stock ownership in ITRON was reduced from approximately 60% to approximately 40% as a result of the issuance of common stock by ITRON in an acquisition. Accordingly, beginning in 1992, Pentzer's share of ITRON's earnings is accounted for by the equity method and is included in Other Income-Net and its investment in ITRON is reflected on the balance sheet under Other Property and Investments. ITRON's initial public offering in November 1993 and Pentzer's sale of a portion of its ITRON stock resulted in a reduction in Pentzer's ownership interest in ITRON to approximately 25%. The Company purchased natural gas distribution properties in Oregon and California from CP National Corporation on September 30, 1991. The 1991 financial information reflects three months of operations of these properties. On July 31, 1990, WIDCo sold its 50% interest in its coal mining properties. The consolidated financial statements, notes and selected financial data have been reclassified to reflect the continuing operations of the Company. The revenues, expenses, assets and liabilities of the discontinued operations have been reclassified from those categories and netted into single line items in the income statements and balance sheets. (Thousands of Dollars except Per Share Data and Ratios) THE WASHINGTON WATER POWER COMPANY ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The Company is primarily engaged as a utility in the generation, purchase, transmission, distribution and sale of electric energy and the purchase, transportation, distribution and sale of natural gas. Natural gas operations are affected to a significant degree by weather conditions and customer growth. The Company's electric operations are highly dependent upon hydroelectric generation for its power supply. As a result, the electric operations of the Company are significantly affected by weather and streamflow conditions and, to a lesser degree, by customer growth. Revenues from the sale of surplus energy to other utilities and the cost of power purchases vary from year to year depending on streamflow conditions and the wholesale power market. The wholesale power market in the Northwest region is affected by several factors, including the availability of water for hydroelectric generation, the availability of base load plants in the region and the demand for power from the Southwest region. Usage by retail customers varies from year to year primarily as a result of weather conditions, the economy in the Company's service area, customer growth and conservation. The Company will continue to emphasize the efficient use of energy by its customers, increase efforts to grow its customer base, especially natural gas, and continue to manage its operating costs, increase revenues and improve margins. The Company will also pursue resource opportunities through demand side management, system upgrades, purchases and other options that will result in obtaining electric power and natural gas supplies at the lowest possible cost. The Company purchased natural gas distribution properties in Oregon and California from CP National Corporation on September 30, 1991. The 1991 financial statements reflect three months of operations of these properties. See Note 14 to Financial Statements for further information. On November 9, 1993, the Company distributed, to shareholders of record on October 25, 1993, shares of its common stock, without par value, under a two-for-one stock split effected in the form of a 100% stock dividend. All references to number of shares and per share information have been adjusted to reflect the common stock split on a retroactive basis. RESULTS OF OPERATIONS OVERALL OPERATIONS Overall earnings per share for 1993 were $1.44, compared to $1.37 in 1992 and $1.34 in 1991. The 1993 results include transactional gains totaling $12.8 million recorded by Pentzer Corporation (Pentzer) as a result of the sale of several investments in its portfolio and the sale of stock in the initial public offering by ITRON, Inc. (ITRON) in November 1993. The 1992 results include an after-tax gain of $4.4 million, or $0.09 per share, due to the issuance of common stock by ITRON in an acquisition and a transactional gain of $1.2 million due to the sale of Pentzer's interest in a company involved in power plant maintenance. Discontinued coal mining operations contributed $2.4 million to net income, or $0.05 per share, in 1992 and $1.6 million, or $0.03 per share, in 1991. Earnings per share from continuing operations were $1.44 for 1993, $1.32 for 1992 and $1.31 for 1991. Utility income available for common stock increased $4.0 million, or 7.0%, in 1993 after decreasing $2.8 million, or 4.6%, in 1992. Utility income available for common stock contributed $1.19 to earnings per share in 1993, compared to $1.15 in 1992 and $1.28 in 1991. Non-utility income available for common stock from continuing operations increased $5.0 million in 1993 and $6.9 million in 1992 and contributed $0.25 to earnings per share in 1993, compared to $0.17 in 1992 and $0.03 in 1991. Slightly colder-than-normal weather during 1993 impacted both electric and natural gas operations as compared to 1992. Income from electric operations decreased $1.8 million in 1993, as compared to 1992, primarily as a result of increases in purchased power costs due to thermal plant outages, a large sale of wholesale energy and lower hydroelectric generation due to below normal streamflows, and increases in other operating and maintenance expenses. Income from natural gas operations increased $9.3 million in 1993 over 1992 due primarily to increased customer usage from the colder weather and customer growth. Warmer-than-normal weather throughout most of 1992 significantly impacted both electric and natural gas operations during the year. Increased purchased power and fuel costs, due to low hydroelectric generation and reduced streamflows, combined with decreased customer usage, were responsible for a decrease of $10.2 million in 1992 income from electric operations as compared to 1991. Income from natural gas operations decreased $2.3 million in 1992, as compared to 1991, due primarily to reduced revenues as a result of the warmer-than-normal temperatures. THE WASHINGTON WATER POWER COMPANY Electric revenues and expenses were both impacted by a ten-year power purchase contract, effective January 1992, with Potlatch Corporation (Potlatch), one of the Company's major industrial customers. Under terms of the agreement, the Company purchases 50-55 average MW of Potlatch's electric generation and makes available up to approximately 95 average MW of firm energy for sale. In addition, the Company makes available 25 average MW of interruptible energy and Potlatch must provide an equivalent amount of reserve generation capacity in case of interruption. The increased KWH sales to Potlatch result in increased industrial revenues to the Company, while the purchase of Potlatch's generating output increases purchased power expense. Non-recurring adjustments were made in 1991 to establish reserves for potential write-offs related to the recovery of costs associated with the Creston Project, a proposed 2,000 MW coal-fired generating station located near Creston, Washington, and related transmission. The reserves were calculated assuming regulators would allow the Company to recover its investment, but would not allow the Company to earn a return on the investment during a recovery period. Through December 31, 1993, the Company had invested $11.0 million in the Creston Project. These adjustments decreased Other Income net of taxes in 1991 by $3.2 million. A non-recurring adjustment was also made during 1991 to adjust previous accruals of deferred federal income tax related to electric operations. This adjustment decreased income taxes by $4.0 million in 1991. Interest expense decreased $3.4 million in 1993 and $1.0 million in 1992. From 1991 through 1993, $69 million of long-term debt matured and $344 million of higher-cost debt was redeemed and refinanced at lower interest rates. Preferred stock dividend requirements increased $1.5 million, or 22.3%, in 1993 due to the issuance of preferred stock in late 1992. Preferred stock dividend requirements decreased $2.5 million, or 26.6%, in 1992. The redemption of preferred stock in early 1992, combined with an issuance later in the year at a lower dividend rate and lower rates on variable rate preferred stock were the primary reasons for the 1992 decrease. UTILITY OPERATIONS Electric Operating Income Summary (1) Does not include interest expense or other income. Electric revenues increased in all classes for 1993, as compared to 1992, as a result of customer growth, increased wholesale sales and a slight increase in customer usage due to colder than normal weather. As the Company's Demand Side Management programs grow, the electric load is becoming less weather-sensitive as a result of the shifting of a greater portion of the heat load to natural gas. Residential and commercial revenues increased by $12.8 million, primarily as a result of a 3% growth in customers in 1993. Industrial sales during 1993 increased by $6.2 million, or 12%, primarily due to increased KWH sales under the Potlatch agreement discussed earlier. Wholesale revenues increased by $16.8 million, or 18%, due primarily to a large sale of wholesale energy over a six-week period in the first quarter of 1993. THE WASHINGTON WATER POWER COMPANY Electric revenues increased by 3% in 1992, compared to 1991, due to a combination of increased industrial sales and customer growth, which offset the decrease in residential usage due to warm weather. The Company's electric customer base grew by 2% in 1992, in both the residential and commercial sectors, which helped to reduce the weather-related impact on revenues. Industrial sales increased by $11.5 million, or 29%, primarily due to increased KWH sales under the Potlatch agreement discussed earlier. Commercial sales increased $4.7 million, or 4%, in 1992, as compared to 1991, due to customer growth. Residential revenues decreased by $3.1 million, despite a 2% increase in customers, due to warm weather throughout most of 1992. Wholesale KWH sales were down 23% in 1992, reflecting low streamflow conditions during the year. However, increased prices in the secondary market resulted in decreased wholesale revenues of only $0.6 million, or 1%, in 1992 from 1991. Electric Revenues, KWH Sales, and Customers by Service Class Below-normal streamflow conditions and thermal plant outages significantly affected 1993 electric operating results. Hydroelectric generation was 11% below normal, caused by streamflows which were 86% of normal. Purchased power increased by $27.1 million, or 30%, in 1993 primarily due to reduced hydroelectric generation early in the year, a large sale of wholesale energy in the first quarter and to replace lost thermal generation due to plant outages. In October 1989, the Idaho Public Utilities Commission (IPUC) approved the Company's filing for a Power Cost Adjustment (PCA) designed to allow the Company to change rates to recover or rebate a portion of the difference between actual and allowed net power supply costs. Net PCA adjustments accounted for $4.6 million of the increase in other operating and maintenance expenses from 1992. Higher levels of purchased power resulted in higher transmission costs which also contributed to the increase in other operating and maintenance expenses in 1993 over 1992. Shutdowns at thermal generation plants and improved streamflows in the latter part of 1993 were the primary reasons for the $2.9 million decrease in fuel costs, and repairs at the plants resulted in an increase of nearly $2.0 million in other operating and maintenance expenses. Warmer-than-normal weather and below-normal streamflow conditions significantly affected 1992 electric operating results. Hydroelectric generation was 22% below normal, caused by streamflows which were 64% of normal in 1992. In 1991, streamflows were 116% of normal. Fuel costs and purchased power costs in 1992 were a combined $27.6 million, or 27%, over levels incurred during 1991, due to low hydroelectric generation and the Potlatch agreement previously discussed. Transmission and distribution costs, which decreased $2.2 million and $1.5 million, respectively, contributed to the $7.9 million, or 12%, decrease in other operating and maintenance expenses. Transmission expenses decreased in 1992 over 1991 due to decreased wholesale KWH sales. Distribution expense was lower in 1992, compared to 1991, due to mild weather and fewer storm-related damages. Net PCA adjustments, resulting from low hydroelectric conditions and prices of secondary energy, accounted for $3.3 million of the decrease in other operating and maintenance expenses from 1991. THE WASHINGTON WATER POWER COMPANY NATURAL GAS OPERATIONS Natural Gas Operating Income Summary (1) Does not include interest expense or other income. On September 30, 1991, the Company purchased the Oregon and South Lake Tahoe, California, natural gas distribution assets of CP National Corporation. The Company's natural gas operations are operated as separate divisions, with the WWP service territory including the Washington and Idaho properties and the WP Natural Gas (WPNG) service territory including the Oregon and California properties. As of December 31, 1993, there were approximately 73,300 WPNG natural gas customers and 122,500 WWP natural gas customers. The Company's natural gas business experienced weather-related impacts on operating results in both 1993 and 1992. In 1993, weather in the Washington and Idaho service territory was 5% colder than normal, compared to 11% warmer than normal in 1992. The Oregon service territory experienced temperatures only 8% warmer than normal in 1993, compared to 24% warmer in 1992. Substantial customer growth of 9% in 1993, along with colder weather, contributed to increased revenues. The 7% growth in customers in 1992 helped offset the impact of the weather. Total natural gas operating revenues increased $37.0 million, or 37%, in 1993. WPNG revenues accounted for an increase of $10.1 million, while WWP revenues increased $26.9 million. Total therm sales increased by 18% in 1993 due to customer growth in all service classes except transportation and higher customer usage due to colder weather in 1993 as compared to 1992. Approximately 40% of the customer growth in the WWP service area during 1993 was the result of the Company's emphasis on conversion from electric space and water heating to natural gas through Demand Side Management programs. Total natural gas revenues increased in all customer classes in 1992 from 1991 due to the WPNG acquisition. WPNG revenues accounted for an increase of $24.5 million in overall natural gas operating revenues, as compared to 1991. In 1992, natural gas revenues from WWP residential and commercial customers rose by $2.0 million and $0.5 million, respectively, due to growth in the number of customers, as usage per customer decreased as a result of warm temperatures. THE WASHINGTON WATER POWER COMPANY Natural Gas Revenues, Therm Sales, and Customers by Service Class Natural gas purchased expense increased $23.7 million, or 49%, in 1993 as compared to 1992, primarily as a result of an increase in therm sales of 76.3 million, or 18%, across all customer classes due to customer growth and colder weather. Taxes other than income and income taxes also increased substantially in 1993 due to increased revenues and income. Natural gas purchased expense and other operating and maintenance expenses increased $17.4 million and $5.1 million, respectively, in 1992 from 1991. All other expenses also increased substantially over 1991, primarily as a result of the operation of the WPNG properties, combined with the Company's continued emphasis on conversions from electric energy to natural gas. NON-UTILITY OPERATIONS Non-Utility Operations Summary Non-utility operations include the results of Pentzer and three non-operating subsidiary companies. Pentzer's business strategy is to acquire controlling interests in a broad range of middle-market companies, to help these companies grow through internal development and strategic acquisitions, and to sell the portfolio investments to the public or to strategic buyers when it becomes most advantageous in meeting Pentzer's return on invested capital objectives. Pentzer's goal is to produce financial returns for the Company's shareholders that, over the long term, should be higher than that of the utility operations. From time to time, a significant portion of Pentzer's earnings contributions may be the result of transactional gains. Accordingly, although the income stream is expected to be positive, it may be uneven from year to year. THE WASHINGTON WATER POWER COMPANY For the year ended December 31, 1993, Pentzer had consolidated earnings of $19.7 million before provision for possible losses. At the end of the year, Pentzer established a $7.0 million provision for possible write-off of a portion of its investment portfolio. The provision was recorded based on the determination that future cashflows may be lower than expected, impairing the value of certain investments. After deducting this provision, Pentzer reported consolidated earnings of $12.7 million, which represents a 50% increase over Pentzer's 1992 earnings of $8.5 million. Pentzer's return on invested capital increased from 12% in 1992 to 17% in 1993 due, in part, to transactional gains. Pentzer earnings for 1993 were significantly impacted by transactional gains of $7.1 million as a result of the sale of companies involved in telecommunications, technology and energy and by a transactional gain of $5.7 million resulting from the successful completion by ITRON, a company in which Pentzer is the largest shareholder, of an initial public offering which also resulted in the sale of a portion of the ITRON shares owned by Pentzer. This transaction reduced Pentzer's investment in ITRON from approximately 40% to approximately 25%. Included in other income, total 1993 transactional gains of $12.8 million compares with transactional gains of $5.6 million in 1992. In addition to the transactional gains from ITRON in 1993, Pentzer also recorded a $3.0 million increase in net income as a result of improved earnings at ITRON. Pentzer's earnings increase from 1991 to 1992 was primarily attributable to the 1992 transactional gains of $5.6 million relating to ITRON's issuance of common stock in an acquisition and the sale of Pentzer's interest in a company involved in power plant maintenance. This issuance of common stock reduced Pentzer's ownership from approximately 60% to approximately 40%. Accordingly, Pentzer's investment in ITRON after 1991 is accounted for by the equity method. The 1991 results presented include ITRON on a fully consolidated basis. The decrease in revenues and expenses from 1991 to 1992 was primarily due to the change to the equity method of accounting for ITRON. THE WASHINGTON WATER POWER COMPANY LIQUIDITY AND CAPITAL RESOURCES UTILITY Capital expenditures, excluding Allowance for Funds Used During Construction (AFUDC) and Allowance for Funds Used to Conserve Energy (AFUCE, a carrying charge similar to AFUDC for conservation-related capital expenditures), were $378 million for the 1991-1993 period. In addition, $69 million of long-term debt matured and $344 million of higher-cost debt and preferred stock was redeemed and refinanced at lower cost during the 1991-1993 period. Capital expenditures are funded with internally-generated cash and external financing. The level of cash generated internally and the amount that is available for capital expenditures fluctuates from year to year. During 1993, $274 million of long-term debt, with an average interest rate of 8.67% and 13.6 years remaining to maturity, was redeemed or matured and $250 million of long-term debt was issued at an average interest rate of 6.59% and with 16.1 years remaining to maturity. In January 1994, authorization was received for $250 million of Secured Medium Term Notes, Series B, which brings the total authorized but unissued Secured Medium Term Notes to $275 million as of February 28, 1994. Capital expenditures are financed on an interim basis with short-term debt. The Company has $160 million in committed lines of credit, a portion of which backs up a $50 million commercial paper facility. In addition, the Company may borrow up to $60 million through other borrowing arrangements with banks. As of December 31, 1993, $20 million in commercial paper was outstanding, $4 million was outstanding under the committed lines of credit and $44 million was outstanding under other short-term borrowing arrangements. The Company's total common equity increased by $47 million to $634 million at the end of 1993. The 1993 increase was primarily due to the issuance of approximately 1,900,000 shares of common stock through the Periodic Offering Program, the Dividend Reinvestment Plan and the Investment and Employee Stock Ownership Plan for proceeds of $36 million. The utility capital structure at December 31, 1993, was 49% debt, 10% preferred stock and 41% common equity as compared to 48% debt, 11% preferred stock and 41% common equity at year-end 1992. The Company is restricted under various agreements as to the additional securities it can issue. Under the most restrictive test of the Company's Mortgage, an additional $431 million of First Mortgage Bonds could be issued as of December 31, 1993. As of December 31, 1993, under its Restated Articles of Incorporation, approximately $670 million of additional preferred stock could be issued at an assumed dividend rate of 7.00%. During the 1994-1996 period, capital expenditures are expected to be $334 million, and $90 million will be required for long-term debt maturities and preferred stock sinking fund requirements. During this three-year period, the Company expects that internally- generated funds will provide approximately 50% of the funds for its capital expenditures. External financing will be required to fund maturing long-term debt, preferred stock sinking fund requirements and the remaining portion of capital expenditures. See Notes 4 through 8 to Financial Statements, inclusive, for additional details related to financing activities. NON-UTILITY Capital expenditures for the non-utility operations were $15 million for the 1991-1993 period. These capital expenditure requirements were financed primarily with internally-generated funds. In addition, $2 million of debt either matured or was redeemed during that same period. The non-utility operations have $26 million in borrowing arrangements ($20 million outstanding as of December 31, 1993) to fund capital expenditures and other corporate requirements on an interim basis. At December 31, 1993, the non-utility operations had $32 million in cash and marketable securities. The 1994-1996 non-utility capital expenditures are expected to be $8 million, and $1 million in debt maturities will also occur. During the next three years, internally-generated cash and other debt obligations are expected to provide the majority of the funds for the non-utility capital expenditure requirements. THE WASHINGTON WATER POWER COMPANY TOTAL COMPANY CASH REQUIREMENTS (Millions of Dollars) (1) Excludes $66 million for the combustion turbine project under construction in Rathdrum, Idaho; the Company has obtained separate construction and long-term lease financing for this project. Also excludes $26 million for the proposed acquisition of the northern Idaho electric properties of Pacific Power and Light, an operating division of PacifiCorp; see Note 14 to Financial Statements for additional information related to this proposed acquisition. (2) Excludes AFUDC and AFUCE. (3) Demand Side Management programs. (4) Includes $68 million for the acquisition of the CP National Corporation's natural gas distribution properties in Oregon and California. SIGNIFICANT TRENDS Competition The electric and natural gas utility businesses are undergoing numerous changes and are becoming increasingly competitive as a result of economic, regulatory and technological changes. The Company believes that it is well positioned to meet future challenges due to its low production costs, close proximity to major transmission lines and natural gas pipelines, experience in the wholesale electric market and its commitment to high levels of customer satisfaction, cost reduction and continuous improvement of work processes. The Company currently competes for new retail electric customers with various rural electric cooperatives and public utility districts. Challenges facing the electric retail business include changing technologies which reduce energy consumption, self-generation and fuel switching by industrial and other large retail customers, the potential for retail wheeling and the costs of increasingly stringent environmental laws. In addition, if electric utility companies are eventually required to provide retail wheeling service, which is the transmission by an electric utility of electric power from another supplier to a customer located within such utility's service area, the Company believes it will be in a position to benefit since it is committed to remaining one of the country's lowest-cost providers of electric energy. The Company also competes in the wholesale electric market with other Western utilities, including the Bonneville Power Administration. Challenges facing the electric wholesale business include new entrants in the wholesale market and competition from lower cost generation being developed by independent power producers. The National Energy Policy Act (NEPA) enacted in 1992 addresses a wide range of issues affecting the wholesale electric business. The Company believes NEPA provides future transmission, energy production and sales opportunities to the Company and complements the Company's commitment to the wholesale electric business. Natural gas is priced competitively compared to other alternative fuel sources for both residential and commercial customers. Challenges facing the Company's natural gas business include the potential for customers to by-pass the Company and securing competitively priced natural gas supplies for the future. Since 1988 one of the Company's large industrial customers has built its own pipeline interconnection. However, this customer still purchases some THE WASHINGTON WATER POWER COMPANY natural gas services from the Company. The Company prices its natural gas services, including transportation contracts, competitively and has varying degrees of flexibility to price its transportation and delivery rates by means of special contracts to assist in retaining potential by-pass customers. The Company has signed long-term transportation contracts with two of its largest industrial customers which minimizes the risks of these customers by-passing the Company's system. Order 636B adopted by FERC in 1992 provides the Company more flexibility in optimizing its natural gas transportation and supply portfolios. While rate design changes have increased the costs of firm transportation to low load factor pipeline customers such as the Company, flexible receipt and delivery points and capacity releases allow temporarily under-utilized transportation to be released to others when not needed to serve the Company's customers. Least cost planning for both the electric and natural gas businesses has been integrated so that the Company's customers are provided the most efficient and cost-effective products possible for all their energy requirements. The Company's need for future electric resources to serve retail loads is very minimal. The electric integrated resource plan accepted by both the IPUC and the Washington Utility and Transportation Commission (WUTC) in 1993 showed that, through the year 1998, the Company's additional electric load requirements will be met for the most part by a combination of demand side management, including conversions to natural gas, and the redevelopment of existing hydro generating plants. The cost of these resources is generally less than costs of resources being developed by independent power producers and other exempt wholesale generators. The Company's natural gas integrated resource plan was accepted by both the WUTC and Public Utility Commission of Oregon (OPUC) in 1993 and insures adequate supplies of natural gas are available at the least possible cost. The switching of electric heating customers to natural gas requires increased efforts on the Company's part in negotiating and securing competitively-priced natural gas supplies for the future. Economic and Load Growth The Company expects economic growth to continue in its eastern Washington and northern Idaho service area, although at a slower pace than seen in the past couple of years. The Company, along with others in the service area, continues its efforts to expand existing businesses and attract new businesses to the Inland Northwest. In the past, agriculture, mining and lumber have been the primary industries. However, health care, electronic and other manufacturing, tourism and the service sectors have become increasingly important industries that operate in the Company's service area. In addition, the Company also expects economic growth to continue in its Oregon and California service areas. The Company anticipates electric retail load growth to average approximately 0.4% annually for the next five years. Although the number of electric customers is expected to increase, the average annual usage by residential customers is expected to continue to decline on a weather-adjusted basis due to newer technologies, construction and appliance efficiency standards and continued conversions to natural gas where available. The Company anticipates natural gas load growth, including transportation volumes, in its Washington and Idaho service area to average approximately 2.7% annually for the next five years. The Oregon and South Lake Tahoe, California service area is anticipated to realize 2.6% growth annually during that same period. Environmental Matters The Company continues to assess both the potential and actual impact of the 1990 Clean Air Act Amendments (CAAA) on its thermal generating plants. The Centralia Power Plant (Centralia), which is operated by PacifiCorp, is classified as a "Phase II" coal-fired plant under the CAAA and as such, will be required to reduce sulfur dioxide (SO2) emissions by approximately 40% by the year 2000. Several methods to meet CAAA compliance by reducing SO2 are being evaluated and a plan is expected to be completed by early 1995. The alternatives most likely to be used in meeting the compliance standards will be some combination of lower sulfur coal, SO2 reduction through clean coal technology and SO2 allowances either purchased or pooled, if available, among the Centralia owners. The Colstrip Generating Project (Colstrip), which is also a "Phase II" coal-fired plant operated by Montana Power, is not expected to be required to implement any additional SO2 mitigation in the foreseeable future in order to continue operations. Reduction in nitrogen oxides (NOX) will be required at both Centralia and Colstrip prior to the year 2000. The anticipated costs for NOX compliance will have a minor economic impact on the Company. THE WASHINGTON WATER POWER COMPANY Since December 1991, a number of species of fish, including the Snake River sockeye salmon and chinook salmon, the Kootenai River white sturgeon and the bull trout have either been added to the endangered species list under the Federal Endangered Species Act (ESA), listed as "threatened" under the ESA or been petitioned for listing under the ESA. Thus far, measures which have been adopted and implemented to save both the Snake River sockeye and chinook salmon have not directly impacted generation levels at any of the Company's hydroelectric dams. The Company does, however, purchase power from four projects on the Columbia River that are being directly impacted by this operation. The reduction in generation is relatively small resulting in minimal economic impact on the Company. Future actions to save the Snake River salmon, Kootenai River white sturgeon and bull trout could further impact the Company's hydroelectric resources. However, it is unknown at this time what impact, if any, will occur from the processes discussed above on the Company's operations. See Note 11 to Financial Statements for discussion of additional environmental matters. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Independent Auditor's Report and Financial Statements begin on page 24. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not applicable. INDEPENDENT AUDITORS' REPORT The Washington Water Power Company Spokane, Washington We have audited the accompanying consolidated balance sheets and statements of capitalization of The Washington Water Power Company and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income and retained earnings, cash flows, and the schedules of information by business segments for each of the three years in the period ended December 31, 1993. 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 and schedules are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements and schedules. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement and schedule presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements and schedules 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. In addition, the schedules referred to above present fairly in all material respects, the segment information of the Company and its subsidiaries in accordance with generally accepted accounting principles. As discussed in Notes 2 and 3 to the financial statements, the Company changed its methods of accounting for other post-employment benefits and income taxes effective January 1, 1993, to conform with Statements of Financial Accounting Standards No. 106 and 109. Deloitte & Touche Seattle, Washington January 28, 1994 (February 15, 1994 as to Note 14) CONSOLIDATED STATEMENTS OF INCOME AND RETAINED EARNINGS The Washington Water Power Company For the Years Ended December 31 Thousands of Dollars The Accompanying Notes are an Integral Part of These Statements. CONSOLIDATED BALANCE SHEETS The Washington Water Power Company At December 31 Thousands of Dollars The Accompanying Notes are an Integral Part of These Statements. CONSOLIDATED STATEMENTS OF CAPITALIZATION The Washington Water Power Company At December 31 Thousands of Dollars The Accompanying Notes are an Integral Part of These Statements. CONSOLIDATED STATEMENTS OF CASH FLOWS Increase (Decrease) in Cash and Cash Equivalents The Washington Water Power Company For the Years Ended December 31 Thousands of Dollars The Accompanying Notes are an Integral Part of These Statements. SCHEDULE OF INFORMATION BY BUSINESS SEGMENTS The Washington Water Power Company For the Years Ended December 31 Thousands of Dollars The Accompanying Notes are an Integral Part of These Statements. THE WASHINGTON WATER POWER COMPANY NOTES TO FINANCIAL STATEMENTS NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES SYSTEM OF ACCOUNTS The accounting records of The Washington Water Power Company (Company) utility operations are maintained in accordance with the uniform system of accounts prescribed by the Federal Energy Regulatory Commission (FERC) and adopted by the appropriate state regulatory commissions. BASIS OF REPORTING The accompanying financial statements include the Company's proportionate share of utility plant and related operations resulting from its interests in jointly owned plants (See Note 12). The financial statements are presented on a consolidated basis and, as such, include the assets, liabilities, revenues and expenses of the Company and its wholly owned subsidiaries, Pentzer Corporation (Pentzer), Washington Irrigation and Development Company (WIDCo), The Limestone Company and WP Finance Company. All material intercompany transactions that are not allowed recovery under regulation have been eliminated in the consolidation. On July 31, 1990, WIDCo sold its 50% interest in the Centralia coal mining properties for $40.8 million. As discussed in Note 14, operating results for ITRON are no longer consolidated and are accounted for on the equity method. The financial activity of each of the Company's segments is reported in the "Schedule of Information by Business Segments." Such information is an integral part of these financial statements. UTILITY PLANT The cost of additions to utility plant, including internally developed information systems, an allowance for funds used during construction and replacements of units of property and betterments, is capitalized. Maintenance and repairs of property and replacements determined to be less than units of property are charged to operating expenses. Costs of depreciable units of property retired plus costs of removal less salvage are charged to accumulated depreciation. ALLOWANCE FOR FUNDS USED DURING CONSTRUCTION The Allowance for Funds Used During Construction (AFUDC) represents the cost of both the debt (Interest Capitalized) and equity funds used to finance utility plant additions during the construction period. In accordance with the uniform system of accounts prescribed by regulatory authorities, AFUDC is capitalized as a part of the cost of utility plant and is credited currently as a noncash item to Other Income and Interest Capitalized (see Other Income below). The Company generally is permitted, under established regulatory rate practices, to recover the capitalized AFUDC and a fair return thereon through its inclusion in rate base and the provision for depreciation after the related utility plant has been placed in service. Cash inflow related to AFUDC does not occur until the related utility plant is placed in service. The effective AFUDC rate was 10.67% in 1993, 1992 and 1991. The Company's AFUDC rates do not exceed the maximum allowable rates as determined in accordance with the requirements of regulatory authorities. ALLOWANCE FOR FUNDS USED TO CONSERVE ENERGY The Allowance for Funds Used to Conserve Energy (AFUCE) rate recovers carrying costs associated with Demand Side Management (DSM) program expenditures until such investment is included in rate base. AFUCE is capitalized as a part of the cost of the DSM investment and is credited currently as a noncash item to Other Income and Interest Capitalized. The AFUCE rate in effect is the last authorized, or otherwise stipulated, rate of return from the Company's proceeding for natural gas or electric operations. The rate for Washington is adjusted for the tax effect of interest. Cash inflow related to AFUCE does not occur until the related DSM investment is placed in service. DEPRECIATION For utility operations, depreciation provisions are computed by a method of depreciation accounting utilizing unit rates for hydroelectric plants and composite rates for other properties. Such rates are designed to provide for retirements of properties at the expiration of their service lives. The rates for hydroelectric plants include annuity and interest components, in which the interest component is 6%. For utility operations, the ratio of depreciation provisions to average depreciable property was 2.68% in 1993, 2.37% in 1992 and 2.44% in 1991. THE WASHINGTON WATER POWER COMPANY AMORTIZATION Deferred charges include regulatory assets which are amortized primarily over periods allowed by regulators. Also included in Deferred Charges, Other are debt issuance and redemption costs which are amortized over the terms of the respective debt issues. POWER AND NATURAL GAS COST ADJUSTMENT PROVISIONS In 1989, the Idaho Public Utilities Commission (IPUC) approved the Company's filing for a power cost adjustment mechanism (PCA). The PCA is designed to allow the Company to change electric rates to recover or rebate a portion of the difference between actual and allowed net power supply costs. In 1993 and 1991, the Company deferred $4.6 million and $1.8 million, respectively, of net power supply cost savings, which resulted in like increases in electric operating expenses. In 1992, the Company deferred $3.3 million of net power supply costs, which resulted in like decreases in electric operating expenses. Rate changes are triggered when the deferred balance reaches $2.2 million. A rate increase was implemented in November 1992 to pass through accumulated costs. A rate reduction was implemented in May 1991 to pass through accumulated cost savings. As of December 31, 1993, $0.6 million of costs not yet subject to a rate increase had accumulated in the PCA deferral account. The PCA is currently scheduled to end on June 30, 1994. Under established regulatory practices, the Company is also allowed to adjust its natural gas rates from time to time to reflect increases or decreases in the cost of natural gas purchased. Differences between actual natural gas costs and the natural gas costs allowed in rates are deferred and charged or credited to expense when regulators approve inclusion of the cost changes in rates. OPERATING REVENUES The Company accrues estimated unbilled revenues for services provided through month-end. INCOME TAXES Provisions for income taxes are based generally on income and expense as reported for financial statement purposes adjusted principally for the excess of tax depreciation over book depreciation. Beginning with 1981 property additions, deferred income taxes are provided for the tax effect of Accelerated Cost Recovery System (ACRS) depreciation over straight-line depreciation. Investment tax credits (ITC) are amortized over the period established by regulators. The Company and its eligible subsidiaries file consolidated federal income tax returns. Subsidiaries are charged or credited with the tax effects of their operations on a stand alone basis. The Company's federal income tax returns have been examined with all issues resolved, and all payments made, through the 1990 return. EARNINGS PER COMMON SHARE Earnings per common share have been computed based on the weighted average number of common shares outstanding during the period. On November 9, 1993, the Company distributed, to shareholders of record on October 25, 1993, shares of its common stock, without par value, under a two-for-one stock split effected in the form of a 100% stock dividend. All references to number of shares and per share information have been adjusted to reflect the common stock split on a retroactive basis. CASH For the purposes of the Consolidated Statements of Cash Flows, the Company considers all temporary investments with an initial maturity of three months or less to be cash equivalents. THE WASHINGTON WATER POWER COMPANY OTHER INCOME--NET Other income-net is composed of the following items: Non-recurring adjustments were made in 1991 to establish reserves for a potential write-off related to the recovery of costs associated with the Creston Project and related transmission. The reserves were calculated assuming regulators would not allow the Company to earn a return during a recovery period. These adjustments decreased other income by $4.8 million before income taxes and decreased income net of taxes by $3.2 million. The Company's costs of $10,990,000 less a reserve for a potential write-off of $3,967,000 related to this project as of December 31, 1993, are included in Other Deferred Charges on the Balance Sheet. NEW ACCOUNTING STANDARDS FAS No. 112, entitled "Employers' Accounting for Postemployment Benefits," was issued by the Financial Accounting Standards Board in November 1992 and is effective for fiscal years beginning after December 15, 1993. This Statement requires the accrual of the expected cost of providing benefits to former or inactive employees after employment but before retirement. It has been determined that the liabilities related to the Company's Long-Term Disability and Workers' Compensation programs are affected by this Statement. The Company does not expect FAS No. 112 to have a material effect on the Company's financial position or results of operations. NOTE 2. RETIREMENT PLANS AND OTHER POSTRETIREMENT BENEFITS Effective January 1, 1993, the Company adopted FAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions." FAS No. 106 requires the Company to accrue the estimated cost of postretirement benefit payments during the years the employee provides services. The Company previously expensed the cost of these benefits, which are principally health care, as claims were incurred. FAS No. 106 allows recognition of the unrecognized transition obligation in the year of adoption or the amortization of such obligation over a period of up to twenty years. The Company has elected to amortize this obligation of approximately $39,600,000 over a period of twenty years. Income from continuing operations during 1993 was not changed by the implementation of this Statement. The Company has received accounting orders from the Washington Utilities and Transportation Commission (WUTC) and the IPUC allowing the current deferral of expense accruals under this Statement as a regulatory asset for future recovery. At such time that rate recovery is requested and allowed, cumulative deferrals will be amortized over the remainder of the twenty-year amortization period. The Company expects to be able to recover the amortized amounts. Therefore, the Company's cash flows are not affected by implementation of this Statement. The Company provides certain health care and life insurance benefits for substantially all of its retired employees. In 1993, 1992 and 1991, the Company recognized $1,250,000, $1,290,000 and $1,233,000, respectively, as an expense for postretirement health care and life insurance benefits. The following table sets forth the health care plan's funded status at December 31, 1993. THE WASHINGTON WATER POWER COMPANY Accumulated postretirement benefit obligation: Net postretirement benefit cost for 1993 consisted of the following components: The currently assumed health care cost trend rate used in measuring the accumulated postretirement benefit obligation is 12.0% for 1993, decreasing linearly each successive year until it reaches 6.0% in 1997. 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 and net postretirement health care cost by approximately $3,079,000. The assumed discount rate used in determining the accumulated postretirement benefit obligation was 7.5%. The Company has a pension plan covering substantially all of its regular full-time employees. Some of the Company's subsidiaries also participate in this plan. Individual benefits under this plan are based upon years of service and the employee's average compensation as specified in the Plan. The Company's funding policy is to contribute annually an amount equal to the net periodic pension cost, provided that such contributions are not less than the minimum amounts required to be funded under the Employee Retirement Income Security Act, nor more than the maximum amounts which are currently deductible for tax purposes. Pension fund assets are invested primarily in marketable debt and equity securities. Net pension credit for 1993, 1992 and 1991 is summarized as follows: (1) The Company has received accounting orders from regulatory authorities requiring the Company to defer the difference between pension cost as determined under FAS 87 and that determined for ratemaking purposes. THE WASHINGTON WATER POWER COMPANY The funded status of the Plan and the pension liability at December 31, 1993, 1992 and 1991, are as follows: NOTE 3. ACCOUNTING FOR INCOME TAXES The Company adopted Statement of Financial Accounting Standards (FAS) No. 109, "Accounting for Income Taxes," effective January 1, 1993, which supersedes Accounting Principles Board Opinion 11 previously adopted by the Company. FAS No. 109 establishes revised financial accounting and reporting standards for the effects of income taxes. As of January 1, 1993, the Company accrued net regulatory assets of $171,365,000 related to the probable recovery of FAS No. 109 deferred tax liabilities from customers through future rates. In the third quarter, the balance was adjusted to account for the 35% federal income tax rate, which brought the accrued net regulatory assets balance to $182,196,000. As such, the Company's adoption of FAS No. 109 has no effect on income for 1993. The regulatory assets and deferred tax liabilities are being amortized over the estimated remaining life of the associated assets. 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) tax credit carryforwards. The tax effects of significant items comprising the Company's net deferred tax liability as of January 1, 1993, restated to reflect the 35% federal income tax rate, are as follows: THE WASHINGTON WATER POWER COMPANY The provision for income tax expense for 1993 was $42,503,000, of which $35,443,000 and $7,060,000 is current and deferred tax expense, respectively. The provision for income tax expense for 1992 was $41,330,000, of which $24,148,000 and $17,182,000 was current and deferred tax expense, respectively. The provision for income tax expense for 1991 was $38,086,000, of which $31,853,000 and $6,233,000 was current and deferred tax expense, respectively. The current and deferred effective tax rates are approximately the same during all periods. NOTE 4. LONG-TERM DEBT The annual sinking fund requirements and maturities for the next five years for First Mortgage Bonds and Medium-Term Notes outstanding at December 31, 1993 are as follows: The sinking fund requirements may be met by certification of property additions at the rate of 167% of requirements. All of the utility plant is subject to the lien of the Mortgage and Deed of Trust securing outstanding First Mortgage Bonds. In 1993, 1992 and 1991, $25,000,000, $113,000,000 and $37,000,000, respectively, of unsecured Medium-Term Notes, Series A and B (Notes) were issued. At December 31, 1993, the Company had outstanding $250,000,000 of the Notes with maturities between 1 and 29 years and with interest rates varying between 5.50% and 9.58%. As of December 31, 1993, the Company had authorization to issue up to $25,000,000 of the $250,000,000 originally authorized in aggregate principal amount of new First Mortgage Bonds issued in the form of Secured Medium-Term Notes, Series A (Secured MTNs). The Secured MTNs may be issued from time to time and may vary in term from 9 months to 30 years. At December 31, 1993, the Company had outstanding $225,000,000 of the Secured MTNs with maturities between 2 and 30 years and with interest rates varying between 4.72% and 7.54%. In January 1994, authorization was received for an additional $250,000,000 of Secured Medium-Term Notes, Series B, which may vary in term from 9 months to 40 years. At December 31, 1993, the Company had $68,000,749 outstanding under borrowing arrangements which will be refinanced in 1994. See Note 5 for details of credit agreements. Included in other long-term debt are the following items related to non-utility operations: In accordance with FAS No. 107 "Disclosures About Fair Value of Financial Instruments," the fair value of the Company's long-term debt at December 31, 1993 and 1992 is estimated to be $690.0 million, or 107% of the carrying value, and $612.1 million, or 103% of the carrying value, respectively. These estimates are based on available market information and appropriate valuation methodologies. THE WASHINGTON WATER POWER COMPANY NOTE 5. BANK BORROWINGS AND COMMERCIAL PAPER At December 31, 1993, the Company maintained total lines of credit with various banks under two separate credit agreements amounting to $160,000,000. The Company has a revolving line of credit expiring December 9, 1995, which provides a total credit commitment of $70,000,000. The second revolving credit agreement is composed of two tranches totaling $90,000,000. The one-year tranche is renewable each year through 1995 and provides for up to $50,000,000 of notes to be outstanding at any one time. The three-year tranche expires September 30, 1995, and provides for up to $40,000,000 of notes to be outstanding at any one time. The Company pays commitment fees of up to 1/5% per annum on the average daily unused portion of each credit agreement. In addition, under various agreements with banks, the Company can have up to $60,000,000 in loans outstanding at any one time, with the loans available at the banks' discretion. These arrangements provide, if funds are made available, for fixed-term loans for up to 180 days at a fixed rate of interest. Balances and interest rates of bank borrowings under these arrangements were as follows: Non-utility operations have $26 million of credit arrangements available. At December 31, 1993, 1992 and 1991, $19.7 million, $7.8 million and $9.3 million, respectively, were outstanding. NOTE 6. ACCOUNTS RECEIVABLE SALE The Company has entered into an agreement whereby it can sell, on a revolving basis, up to $40,000,000 of interests in certain accounts receivable, both billed and unbilled. The Company is obligated to pay fees which approximate the purchaser's cost of issuing commercial paper equal in value to the interests in receivables sold. The amount of such fees is included in operating expenses. At both December 31, 1993 and 1992, $40,000,000 in receivables had been sold pursuant to the agreement. THE WASHINGTON WATER POWER COMPANY NOTE 7. PREFERRED STOCK CUMULATIVE PREFERRED STOCK NOT SUBJECT TO MANDATORY REDEMPTION: The dividend rate on Flexible Auction Preferred Stock, Series J is reset every 49 days based on an auction. During 1993, the dividend rate varied from 3.00% to 3.27% and at December 31, 1993, was 3.14%. Series J is subject to redemption at the Company's option at a redemption price of 100% per share plus accrued dividends. CUMULATIVE PREFERRED STOCK SUBJECT TO MANDATORY REDEMPTION: Redemption requirements: $8.625, Series I - On June 15, 1996, 1997, 1998, 1999 and 2000, the Company must redeem 100,000 shares at $100 per share plus accumulated dividends. The Company may, at its option, redeem up to 100,000 shares in addition to the required redemption on any redemption date. $6.95, Series K - On September 15, 2002, 2003, 2004, 2005 and 2006, the Company must redeem 17,500 shares at $100 per share plus accumulated dividends through a mandatory sinking fund. Remaining shares must be redeemed on September 15, 2007. The Company has the right to redeem an additional 17,500 shares on each September 15 redemption date. There are $30 million in mandatory redemption requirements during the 1994-1998 period. In accordance with FAS No. 107 "Disclosures About Fair Value of Financial Instruments," the fair value of the Company's preferred stock at December 31, 1993 and 1992 is estimated to be $93.8 million, or 110% of the carrying value, and $89.4 million, or 105% of the carrying value, respectively. These estimates are based on available market information and appropriate valuation methodologies. NOTE 8. COMMON STOCK On November 9, 1993, the Company distributed, to shareholders of record on October 25, 1993, shares of its common stock, without par value, under a two-for-one stock split effected in the form of a 100% stock dividend. All references to number of shares and per share information have been adjusted to reflect the common stock split on a retroactive basis. In April 1990, the Company sold 1,000,000 shares of its common stock to the Trustee of the Investment and Employee Stock Ownership Plan for Employees of the Company (Plan) for the benefit of the participants and beneficiaries of the Plan. In payment for the shares of Common Stock, the Trustee issued a promissory note payable to the Company in the amount of $14,125,000. Dividends paid on the stock held by the Trustee, plus Company contributions to the Plan, if any, are used by the Trustee to make interest and principal payments on the promissory note. The balance of the promissory note receivable from the Trustee ($12,755,500 at December 31, 1993) is reflected as a reduction to common equity. The shares of Common Stock are allocated to the accounts of participants in the Plan as the note is repaid. During 1993, the cost recorded for the Plan was $2,216,000. This included the cost for an additional 165,335 shares which were issued for ongoing employee and Company contributions to the Plan. Interest on the note payable, cash and stock contributions to the Plan and dividends on the shares held by the Trustee were $1,238,000, $1,776,000 and $1,231,000, respectively. In February 1990, the Company adopted a shareholder rights plan pursuant to which holders of Common Stock outstanding on March 2, 1990, or issued thereafter, have been granted one preferred share purchase right ("Right") on each outstanding share of Common Stock. Each Right, initially evidenced by and traded with the shares of Common Stock, entitles the registered holder to purchase one one-hundredth of a share of Preferred Stock of the Company, without par value, at an exercise price of $40, subject to certain adjustments, regulatory approval and other specified conditions. The Rights will be exercisable only if a person or group acquires 10% or more of the Common Stock or announces a tender offer, the consummation of which would result in the beneficial ownership by a person or group of 10% or more of the Common Stock. The Rights may be redeemed, at a redemption price of $0.01 per Right, by the Board of Directors of the Company at any time until any person or group has acquired 10% or more of the Common Stock. The Rights will expire on February 16, 2000. THE WASHINGTON WATER POWER COMPANY In November 1991, the Company received authorization to issue from time to time 1,500,000 shares of Common Stock under a Periodic Offering Program (POP). During 1992, the remaining 1,107,600 shares of the first POP were issued under this program for net proceeds of $18.0 million. In the second half of 1992, the Company received authorization to issue a second 1,500,000 shares of common stock under the POP. Through December 31, 1993, 927,600 shares of the second POP were issued for net proceeds of $17.3 million. The Company has a Dividend Reinvestment and Stock Purchase Plan under which the Company's stockholders may automatically reinvest their dividends and make optional cash payments for the purchase of the Company's Common Stock. Sales of Common Stock for 1993, 1992 and 1991, are summarized below (dollar amounts in thousands): THE WASHINGTON WATER POWER COMPANY NOTE 9. FEDERAL INCOME TAXES A reconciliation of federal income taxes derived from statutory tax rates applied to income from continuing operations for accounting purposes and such taxes charged to expense for the consolidated Company is as follows: NOTE 10. DISCONTINUED COAL MINING OPERATIONS Washington Irrigation & Development Company (WIDCo) owned an undivided one-half interest in coal mining properties near Centralia, Washington, which it operated and which supplied coal to the Centralia Steam Electric Generating Plant owned 15% by the Company. On July 31, 1990, WIDCo sold its 50% interest in the Centralia coal mining properties for $40.8 million. A tax adjustment of $1.6 million related to the sale was recorded in 1991. Net income of $2.4 million in 1992 resulted from accounting adjustments and a refund of federal income taxes for years prior to the sale. The consolidated financial statements have been reclassified to reflect the continuing operations of the Company. The revenues, expenses, assets and liabilities of the discontinued operations have been reclassified from those categories and netted into single line items for discontinued operations in the Balance Sheets and Income Statements. THE WASHINGTON WATER POWER COMPANY NOTE 11. COMMITMENTS AND CONTINGENCIES SUPPLY SYSTEM PROJECT 3 In 1985, the Company and the Bonneville Power Administration (BPA) reached a settlement surrounding litigation related to the suspension of construction of Washington Public Power Supply System (Supply System) Project 3. Project 3 is a partially constructed 1,240 MW nuclear generating plant in which the Company has a 5% interest. Under the settlement agreement, the Company receives power deliveries from BPA from 1987 to 2017 in proportion to the Company's investment in Project 3. The settlement with BPA and other parties does not affect the Company's obligations under the Ownership Agreement among the owners of Project 3. In connection with its 1993 rate proceedings, BPA has proposed termination of Project 1 and 3. Termination of Project 3 will require proposal of a termination budget and approval by BPA and the Project 3 Owners under the Ownership Agreement. The Company would be reimbursed for the cost of termination under the settlement with BPA. The only material claim against the Company arising out of the Company's involvement in Project 3, which is still pending in the United States District Court for the Western District of Washington (District Court), is the claim of Chemical Bank, as bond fund trustee for Supply System Projects 4 and 5, against all owners of Projects 1, 2 and 3 for unjust enrichment in the allocation of certain costs of common services and facilities among the Supply System's five nuclear projects. Projects 4 and 5 were being constructed adjacent to Projects 1 and 3, respectively, under a plan to share certain costs. Chemical Bank is seeking a reallocation of $495 million in costs (plus interest since commencement of construction in 1976) originally allocated to Projects 4 and 5. On October 7, 1992, the District Court issued an order ruling in favor of the defendants, including the Company, that the "proportional" allocation methodology actually employed by the Supply System was permitted by the Projects 4 and 5 bond resolution. This ruling does not resolve all cost reallocation claims pending in the District Court, including whether the Supply System correctly followed its methodology. Chemical Bank has indicated its intent to assert claims for cost reallocations based upon other theories which have not been litigated. The case is now in the discovery phase on those claims, as settlement talks were not successful. The Company cannot predict whether Chemical Bank will ultimately be successful in its claim for reallocation of any of the costs of Supply System projects, nor can the Company predict any amounts which might be reallocated to Project 3 or to the Company due to its 5% ownership interest therein. The Company also has claims pending against the Supply System and Chemical Bank with respect to a subordinated loan made by the Company to Projects 4 and 5 in 1981, in the amount of approximately $11 million including interest. The District Court has deferred ruling on the Company's motion to set-off the amount due on the loan, including interest, against any recovery by Chemical Bank on its cost reallocation claims. The Company intends to continue to defend this suit vigorously. Since the discovery is not yet complete, the Company is unable to assess the likelihood of an adverse outcome in this litigation, or estimate an amount or range of potential loss in the event of an adverse outcome. NEZ PERCE TRIBE On December 6, 1991, the Nez Perce Tribe filed an action against the Company in U. S. District Court for the District of Idaho alleging, among other things, that two dams formerly operated by the Company, the Lewiston Dam on the Clearwater River and the Grangeville Dam on the South Fork of the Clearwater River, provided inadequate passage to migrating anadromous fish in violation of rights under treaties between the Tribe and the United States made in 1855 and 1863. The Lewiston and Grangeville Dams, which had been owned and operated by other utilities under hydroelectric licenses from the Federal Power Commission (the "FPC", predecessor of the FERC) prior to acquisition by the Company, were acquired by the Company in 1937 with the approval of the FPC, but were dismantled and removed in 1973 and 1963, respectively. The Tribe initially indicated through expert opinion disclosures that they were seeking actual and punitive damages of $208 million. However, supplemental disclosures reflect allegations of actual loss under different assumptions of between $425 million and $650 million. Discovery in this case has been stayed pending a decision by the Court on a case involving some similar issues between Idaho Power Company and the Nez Perce Tribe. The case is not yet set for trial. The Company intends to vigorously defend against the Tribe's claims. Since the discovery is not yet complete, the Company is unable to assess the likelihood of an adverse outcome in this litigation, or estimate an amount or range of potential loss in the event of an adverse outcome. THE WASHINGTON WATER POWER COMPANY LITTLE FALLS PROJECT Pending before the U. S. District Court in the Eastern District of Washington is the case of Spokane Tribe of Indians v. WWP. This matter involves a claim of the Spokane Tribe of Indians for damages arising out of the Company's Little Falls Hydroelectric Development that was constructed on the Spokane River pursuant to a 1905 Act of Congress. The Tribe is claiming the Company's dam interfered with Indian fishing rights. The Tribe is also seeking a declaratory judgment and quiet title to part of the property comprising the Little Falls Hydroelectric Development. Discovery conducted by the Company revealed that the Tribe may seek damages in the range of $100 million to $1.4 billion, to compensate them for the alleged loss of fishing rights, alleged lost opportunity to develop the properties, and alleged damage to the Tribe's cultural heritage. The trial of these matters is currently scheduled for April 1994 in the United States District Court for the Eastern District of Washington, in Spokane, Washington. On the merits, the Company claims that it has all of the right, title and interest necessary for the construction, operation and maintenance of the Little Falls Development, which rights, title and interest were duly acquired from the United States pursuant to a 1905 Act of Congress. The Company intends to vigorously defend against the Tribe's claims. The Company is unable to assess the likelihood of an adverse outcome in this litigation, or estimate an amount or range of potential loss in the event of an adverse outcome. STEAM HEAT PLANT The Company recently completed an updated investigation of an oil spill that occurred several years ago in downtown Spokane at the site of the Company's steam heat plant. The Company purchased the plant in 1916 and operated it as a non-regulated plant until it was deactivated in 1986 in a business decision unrelated to the leak. After the Bunker C fuel oil spill, initial studies suggested that the oil was being adequately contained by both geological features and man-made structures. The Washington State Department of Ecology (DOE) concurred with these findings. However, more recent tests confirm that the oil has migrated beyond the steam plant property. On December 6, 1993, the Company asked the DOE to approve a voluntary proposal to begin extracting the underground oil. The extraction process is intended to remove quantities of the oil and relieve any pressure on the deposit which might cause it to move. In December 1993, the Company established a reserve of $2.0 million, which is the current best estimate of mitigation costs. FIRESTORM On October 16, 1991, gale-force winds struck a five-county area in eastern Washington and a seven-county area in northern Idaho. These winds were responsible for causing 92 separate wildland fires, resulting in two deaths and the loss of 114 homes and other structures, some of which were located in the Company's service territory. On October 13, 1993, three separate class action lawsuits were filed by private individuals in the Superior Court of Spokane County in connection with fires occurring in the Midway, Nine Mile and Chattaroy regions of eastern Washington. Service of these suits, together with a fourth suit, occurred on January 7, 1994. Complainants allege various theories of tortious conduct, including negligence, creation of a public nuisance, strict liability and trespass. The lawsuits seek recovery for property damage, emotional and mental distress, lost income and punitive damages, but do not specify the amount of damages being sought. The Superior Court has yet to certify these lawsuits as class actions. The Company intends to vigorously defend against all such pending claims. Since the discovery is not yet complete, the Company is unable to assess the likelihood of an adverse outcome in this litigation, or estimate an amount or range of potential loss in the event of an adverse outcome. OTHER CONTINGENCIES The Company has long-term contracts related to the purchase of fuel for thermal generation, natural gas and hydroelectric power. Terms of the natural gas purchase contracts range from one month to five years and the majority provide for minimum purchases at the then effective market rate. The Company also has various agreements for the purchase, sale or exchange of power with other utilities, cogenerators, small power producers and government agencies. For information relating to certain long-term purchased power contracts, see Note 13. THE WASHINGTON WATER POWER COMPANY NOTE 12. JOINTLY-OWNED ELECTRIC FACILITIES The Company is involved in several jointly owned generating plants. Financing for the Company's ownership in the projects is provided by the Company. The Company's share of related operating and maintenance expenses for plants in service is included in corresponding accounts in the Consolidated Statements of Income. The following table indicates the Company's percentage ownership and the extent of the Company's investment in such plants at December 31, 1993: NOTE 13. LONG-TERM PURCHASED POWER CONTRACTS WITH REQUIRED MINIMUM PAYMENTS Under fixed contracts with Public Utility Districts, the Company has agreed to purchase portions of the output of certain generating facilities. Although the Company has no investment in such facilities, these contracts provide that the Company pay certain minimum amounts (which are based at least in part on the debt service requirements of the supplier) whether or not the facility is operating. The cost of power obtained under the contracts, including payments made when a facility is not operating, is included in operations and maintenance expense in the Consolidated Statements of Income. Information as of December 31, 1993, pertaining to these contracts is summarized in the following table: (1) The Company purchases 100% of the Lake Chelan Project output and sells back to the PUD about 40% of the output to supply local service area requirements. (2) The annual costs will change in proportion to the percentage of output allocated to the Company in a particular year. Amounts represent the operating costs for the year 1993. (3) Included in annual costs. Actual expenses for payments made under the above contracts for the years 1993, 1992 and 1991, were $8,721,000, $8,433,000 and $7,589,000, respectively. The estimated aggregate amounts of required minimum payments (the Company's share of debt service costs) under the above contracts for the next five years are $4,338,000 in 1994, $4,775,000 in 1995, $3,830,000 in 1996, $4,300,000 in 1997 and $4,684,000 in 1998 (minimum payments thereafter are dependent on then market conditions). In addition, the Company will be required to pay its proportionate share of the variable operating expenses of these projects. THE WASHINGTON WATER POWER COMPANY NOTE 14. ACQUISITIONS AND DISPOSITIONS During 1993, Pentzer acquired three companies, two involved in financial services and one in point-of-purchase display manufacturing. Sales of companies involved in telecommunications, technology and energy services resulted in transactional gains of $7.1 million. At December 31, 1993, Pentzer had approximately $130 million in assets compared to $103 million at the end of 1992. In 1992, Pentzer's common stock ownership in ITRON was reduced from approximately 60% to approximately 40% as a result of the issuance of common stock by ITRON in an acquisition. Accordingly, beginning in 1992, Pentzer's share of ITRON's earnings is accounted for by the equity method and is included in Other Income-Net and its investment in ITRON is reflected on the balance sheet under Other Property and Investments. As a result of ITRON's initial public offering in November 1993 and Pentzer's sale of a portion of its ITRON stock, Pentzer's ownership interest in ITRON was reduced to approximately 25%. In December 1992, the Company completed the purchase of the northern Idaho electric distribution assets of Citizens Utilities. The cash purchase price of $1.2 million included a premium above the book value of the net assets acquired. The premium will be amortized over a 19-month period. The purchase provided approximately 2,100 additional electric customers. The Company believes that this acquisition will not have a material impact on its revenues or its operations. On September 30, 1991, the Company completed the purchase of the Oregon and South Lake Tahoe, California, natural gas assets of CP National Corporation, a subsidiary of ALLTEL Corporation, for approximately $67.9 million. The cash purchase included a premium of approximately $24.9 million above the book value of the net assets acquired. The premium and other costs associated with acquiring the properties will be amortized under a straight-line method over 20 years and the amortization may be accelerated depending upon earnings. The California and Oregon Commissions have agreed to a general rate "freeze" which extends to January 1, 1996, in California and to December 31, 1995, in Oregon. Purchased natural gas costs will continue to be tracked through to customers during the rate "freeze" period. On February 15, 1994, the Company announced it had reached agreement to acquire the northern Idaho electric properties of Pacific Power & Light Company, an operating division of PacifiCorp. The cash purchase price will be $26 million, subject to adjustments upon closing. The approximate book value of the assets is $19 million. The purchase agreement is subject to approval by the IPUC and FERC. It is anticipated the acquisition will be completed mid-year 1994. Pacific Power's northern Idaho electric system currently serves approximately 9,300 customers. The Company believes this acquisition will not have a material impact on its revenues or its operations. THE WASHINGTON WATER POWER COMPANY NOTE 15. SELECTED QUARTERLY INFORMATION (UNAUDITED) The Company's electric and natural gas operations are significantly affected by weather conditions. Consequently, there can be large variances in revenues, expenses and net income between quarters based on seasonal factors such as temperatures and streamflow conditions. A summary of quarterly operations (in thousands of dollars except for per share amounts) for 1993 and 1992 follows. All references to number of shares and per share information have been adjusted to reflect the common stock split on a retroactive basis. THE WASHINGTON WATER POWER COMPANY PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Information regarding the directors of the Registrant has been omitted pursuant to General Instruction G to Form 10-K. Reference is made to the Registrant's Proxy Statement to be filed with the Securities and Exchange Commission in connection with the Registrant's annual meeting of shareholders to be held on May 12, 1994. Executive Officers of the Registrant All of the Company's executive officers, with the exception of Messrs. Harvey, Bryan, Ely, Fukai and Buergel and Ms. Racicot, were officers or directors of one or more of the Company's subsidiaries in 1993. Executive officers are elected annually by the Board of Directors. THE WASHINGTON WATER POWER COMPANY ITEM 11. ITEM 11. EXECUTIVE COMPENSATION Information regarding executive compensation has been omitted pursuant to General Instruction G to Form 10-K. Reference is made to the Registrant's Proxy Statement to be filed with the Securities and Exchange Commission in connection with the Registrant's annual meeting of shareholders to be held on May 12, 1994. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT (a) Security ownership of certain beneficial owners (owning 5% or more of Registrant's voting securities): None. (b) Security ownership of management: Information regarding security ownership of management has been omitted pursuant to General Instruction G to Form 10-K. Reference is made to the Registrant's Proxy Statement to be filed with the Securities and Exchange Commission in connection with the Registrant's annual meeting of shareholders to be held on May 12, 1994. (c) Changes in control: None. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Information regarding certain relationships and related transactions has been omitted pursuant to General Instruction G to Form 10-K. Reference is made to the Registrant's Proxy Statement to be filed with the Securities and Exchange Commission in connection with the Registrant's annual meeting of shareholders to be held on May 12, 1994. THE WASHINGTON WATER POWER COMPANY PART IV ITEM 14. ITEM 14. FINANCIAL STATEMENTS, FINANCIAL STATEMENT SCHEDULES, EXHIBITS AND REPORTS ON FORM 8-K (a) 1. Financial Statements (Included in Part II of this report): Independent Auditors' Report Consolidated Statements of Income and Retained Earnings for the Years Ended December 31, 1993, 1992 and 1991 Consolidated Balance Sheets, December 31, 1993 and 1992 Consolidated Statements of Capitalization, December 31, 1993 and Consolidated Statements of Cash Flows for the Years Ended December 31, 1993, 1992 and 1991 Schedule of Information by Business Segments for the Years Ended December 31, 1993, 1992 and 1991 Notes to Financial Statements (a) 2. Financial Statement Schedules (Included in Part IV of this report): Independent Auditors' Report (Relating to Supplemental Schedules) Supplemental Schedules for the Years Ended December 31, 1993, 1992 and 1991: Schedule V(a), (b), (c) - Property, Plant and Equipment Schedule VI(a),(b), (c) - Accumulated Depreciation and Amortization of Property, Plant and Equipment Schedule X - Supplementary Income Statement Information 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. (a) 3. Exhibits: Reference is made to the Exhibit Index commencing on page 58. The Exhibits include the management contracts and 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: Dated November 9, 1993 regarding the two-for-one stock split in the form of a 100% stock dividend. INDEPENDENT AUDITORS' REPORT The Washington Water Power Company Spokane, Washington We have audited the consolidated financial statement of The Washington Water Power Company 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 January 28, 1994 (February 15, 1994 as to Note 14); such financial statement and report are included in Part II of this Annual Report on Form 10-K. Our audits also comprehended the financial statement schedules of The Washington Water Power Company, listed in Item 14(a)2. 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 financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects, the information shown therein. Deloitte & Touche Seattle, Washington January 28, 1994 (February 15, 1994 as to Note 14) SCHEDULE V(a) THE WASHINGTON WATER POWER COMPANY Property, Plant and Equipment For the Year Ended December 31, 1993 (Thousands of Dollars) The cost of additions includes completed projects transferred from CWIP. The Company's 1993 construction program was financed with internally-generated funds, bank borrowings and commercial paper, and proceeds from the sales of preferred and common stock and long-term debt. (1) Represents balance of Citizen Utility acquisition adjustment. (2) Amortization of reserve for nonrecovery of a portion of the Kettle Falls project in accordance with FAS 90. (3) Represents the redistribution of Citizen Utility Electric Plant to appropriate category. (4) Represents $110,796,000 spent on construction less $88,344,000 closed to plant in service from CWIP. SCHEDULE V(b) THE WASHINGTON WATER POWER COMPANY Property, Plant and Equipment For the Year Ended December 31, 1992 (Thousands of Dollars) The cost of additions includes completed projects transferred from CWIP. The Company's 1992 construction program was financed with internally-generated funds, bank borrowings and commercial paper, and proceeds from the sales of preferred and common stock and long-term debt. (1) Amortization of reserve for nonrecovery of a portion of the Kettle Falls project in accordance with FAS 90. (2) Represents the purchase of Citizen Utility Electric Plant. (3) Acquisition adjustment related to purchase of natural gas assets from CP National Corporation. (4) Represents $89,748,000 spent on construction less $96,829,000 closed to plant in service from CWIP. (5) Deconsolidation of ITRON, Inc. SCHEDULE V(c) THE WASHINGTON WATER POWER COMPANY Property, Plant and Equipment For the Year Ended December 31, 1991 (Thousands of Dollars) NOTE: All balances have been restated to exclude the assets of the Company's discontinued coal mining operations. These properties were sold in 1990. The amount of WP Natural Gas assets in Column F is $73,828,000. The cost of additions includes completed projects transferred from CWIP. The Company's 1991 construction program was financed with internally-generated funds, bank borrowings and commercial paper, and proceeds from the sales of preferred and common stock and long-term debt. (1) Amortization of reserve for non-recovery of a portion of the Kettle Falls project in accordance with FAS 90. (2) Amortization of adjustment related to City of Worley acquisition. (3) Acquisition adjustment related to purchase of natural gas assets from CP National Corporation. (4) Reclassification of software development costs. (5) Includes $234,237 of computer software transferred from general plant to intangible plant. (6) Represents $143,915,000 spent on construction less $123,869,000 closed to plant in service from CWIP. SCHEDULE VI(a) THE WASHINGTON WATER POWER COMPANY Accumulated Depreciation and Amortization of Property, Plant and Equipment for the Year Ended December 31, 1993 (Thousands of Dollars) (1) Retirements are reported net of cost of removal and salvage. (2) Reference is made to Note 1 to Financial Statements for depreciation method. (3) Pertains to adjustment resulting from sale of equipment, transfers to non-utility, acquisition premium for Citizens Utility of ($340,298) and $838,911 accumulated depreciation acquired at the time of the purchase of Citizens Utility. (4) Represents a transfer relating to the accrued liability for Steam Heat Environmental clean-up. SCHEDULE VI(b) THE WASHINGTON WATER POWER COMPANY Accumulated Depreciation and Amortization of Property, Plant and Equipment for the Year Ended December 31, 1992 (Thousands of Dollars) NOTE: All balances have been restated to exclude the accumulated depreciation and amortization on the Company's discontinued coal mining operations. These properties were sold in 1990. The amount in Column F related to WP Natural Gas is $31,460. (1) Retirements are reported net of cost of removal and salvage. (2) Reference is made to Note 1 to Financial Statements for depreciation method. (3) Pertains to adjustment resulting from sale of equipment. (4) Deconsolidation of ITRON. SCHEDULE VI(c) THE WASHINGTON WATER POWER COMPANY Accumulated Depreciation and Amortization of Property, Plant and Equipment for the Year Ended December 31, 1991 (Thousands of Dollars) - --------- NOTE: All balances have been restated to exclude the accumulated depreciation and amortization on the Company's discontinued coal mining operations. These properties were sold in 1990. The amount in Column F related to WP Natural Gas is $29,404. (1) Retirements are reported net of cost of removal and salvage. (2) Reference is made to Note 1 to Financial Statements for depreciation method. (3) Represents balance of accumulated depreciation & amortization for WP Natural Gas at time of purchase. (4) Reclassification related to intangibles and software development costs. SCHEDULE X THE WASHINGTON WATER POWER COMPANY Supplementary Income Statement Information for the Years Ended December 31, 1993, 1992 and 1991 (Thousands of Dollars) Amounts of maintenance and repairs, and depreciation, other than as set out separately in the Consolidated Statements of Income and Retained Earnings, are not material. Amounts of advertising costs are not material. THE WASHINGTON WATER POWER 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 WASHINGTON WATER POWER COMPANY 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 WASHINGTON WATER POWER COMPANY INDEPENDENT AUDITORS' CONSENT We consent to the incorporation by reference in Registration Statement No. 2-81697 on Form S-8, in Registration Statement No. 2-94816 on Form S-8, in Registration Statement No. 33-10040 on Form S-3, in Registration Statement No. 33-32148 on Form S-8, in Registration Statement No. 33-40333 on Form S-3, in Registration Statement No. 33-49662 on Form S-3, in Registration Statement No. 33-60136 on Form S-3, and in Registration Statement No. 33-51669 on Form S-3 of our report dated January 28, 1994 (February 15, 1994 as to Note 14), appearing in this Annual Report on Form 10-K of The Washington Water Power Company for the year ended December 31, 1993. Deloitte & Touche Seattle, Washington March 4, 1994 THE WASHINGTON WATER POWER COMPANY EXHIBIT INDEX *Incorporated herein by reference. **Filed herewith. THE WASHINGTON WATER POWER COMPANY EXHIBIT INDEX (continued) *Incorporated herein by reference. **Filed herewith. THE WASHINGTON WATER POWER COMPANY EXHIBIT INDEX (continued) * Incorporated herein by reference. ** Filed herewith. THE WASHINGTON WATER POWER COMPANY EXHIBIT INDEX (continued) * Incorporated herein by reference. ** Filed herewith. THE WASHINGTON WATER POWER COMPANY EXHIBIT INDEX (continued) * Incorporated herein by reference. ** Filed herewith. THE WASHINGTON WATER POWER COMPANY EXHIBIT INDEX (continued) * Incorporated herein by reference. ** Filed herewith. THE WASHINGTON WATER POWER COMPANY EXHIBIT INDEX (continued) * Incorporated herein by reference. ** Filed herewith. *** Management contracts or compensatory plans filed as exhibits by reference per Item 601(10)(iii) of Regulation S-K. THE WASHINGTON WATER POWER COMPANY EXHIBIT INDEX (continued) * Incorporated herein by reference. ** Filed herewith. *** Management contracts or compensatory plans filed as exhibits by reference per Item 601(10)(iii) of Regulation S-K.

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ITEM 1. BUSINESS GENERAL The Chubb Corporation (the Corporation) was incorporated as a business corporation under the laws of the State of New Jersey in June 1967. The Corporation is a holding company and is principally engaged, through subsidiaries, in three industries: property and casualty insurance, life and health insurance and real estate development. The Corporation and its subsidiaries employed approximately 10,500 persons on December 31, 1993. Revenues, income from operations before income tax and identifiable assets for each industry segment for the three years ended December 31, 1993 are included in Note (16) of the notes to consolidated financial statements incorporated by reference from the Corporation's 1993 Annual Report to Shareholders. The property and casualty insurance subsidiaries provide insurance coverages on a direct and assumed basis, principally in the United States, Canada, Europe, Australia and the Far East. The life and health insurance and real estate development subsidiaries have no international operations. Revenues, income from operations before income tax and identifiable assets of the property and casualty insurance subsidiaries by geographic area for the three years ended December 31, 1993 are included in Note (17) of the notes to consolidated financial statements incorporated by reference from the Corporation's 1993 Annual Report to Shareholders. PROPERTY AND CASUALTY INSURANCE GROUP The Property and Casualty Insurance Group (the Group) is composed of Federal Insurance Company (Federal), Pacific Indemnity Company (Pacific Indemnity), Vigilant Insurance Company (Vigilant), Great Northern Insurance Company (Great Northern), Chubb Insurance Company of New Jersey (Chubb New Jersey), Chubb Custom Insurance Company (Chubb Custom), Chubb National Insurance Company (Chubb National), Texas Pacific Indemnity Company, Northwestern Pacific Indemnity Company, Chubb Insurance Company of Canada, Chubb Insurance Company of Europe, S.A., Chubb Insurance Company of Australia, Limited and Chubb Atlantic Indemnity Ltd. The Group presently underwrites most forms of property and casualty insurance. All members of the Group write non-participating policies. Several members of the Group also write participating policies, particularly in the workers' compensation class of business, under which dividends are paid to the policyholders. Premiums Written An analysis of the Group's premiums written during the past three years is shown in the following table. - --------------- (a) Intercompany items eliminated. The net premiums written during the last five years for major insurance classes of the Group are incorporated by reference from page 12 of the Corporation's 1993 Annual Report to Shareholders. One or more members of the Group are licensed and transact business in each of the 50 states of the United States, the District of Columbia, Puerto Rico, the Virgin Islands, Canada and parts of Europe, Australia and the Far East. In 1993, approximately 88% of the Group's direct business was produced in the United States, where the Group's businesses enjoy broad geographic distribution with a particularly strong market presence in the Northeast. The four states accounting for the largest amounts of direct premiums written were New York with 15%, California with 14%, New Jersey with 6% and Pennsylvania with 5%. No other state accounted for 5% or more of such premiums. Approximately 4% of the Group's direct premiums written were produced in Canada. Underwriting Results A frequently used industry measurement of property and casualty insurance underwriting results is the combined loss and expense ratio. This ratio is the sum of the ratio of incurred losses and related loss adjustment expenses to premiums earned (loss ratio) plus the ratio of underwriting expenses to premiums written (expense ratio) after reducing both premium amounts by dividends to policyholders. When the combined ratio is under 100%, underwriting results are generally considered profitable; when the combined ratio is over 100%, underwriting results are generally considered unprofitable. Investment income, deferred policy acquisition costs, other non-underwriting income or expense and income taxes are not reflected in the combined ratio. The profitability of property and casualty insurance companies depends on income from both underwriting operations and investments. The net premiums and the loss, expense and combined ratios of the Group for the last five years are shown in the following table. The 1993 ratios include the effects of a $675 million increase in unpaid claims related to an agreement for the settlement of asbestos-related litigation and a $125 million return premium to the Group related to the commutation of a medical malpractice reinsurance agreement. Excluding the effects of these items, the loss ratio, the expense ratio and the combined loss and expense ratio were 65.5%, 33.5% and 99.0%, respectively, for the year 1993 and 65.7%, 34.4% and 100.1%, respectively, for the five years ended December 31, 1993. The combined loss and expense ratios during the last five years for major classes of the Group's business are incorporated by reference from page 12 of the Corporation's 1993 Annual Report to Shareholders. Producing and Servicing of Business In the United States and Canada, the Group is represented by approximately 3,000 independent agents and accepts business on a regular basis from an estimated 500 insurance brokers. In most instances, these agents and brokers also represent other companies which compete with the Group. The offices maintained by the Group assist these agents and brokers in producing and servicing the Group's business. In addition to the administrative offices of Chubb & Son Inc. in Warren, New Jersey, the Group operates six zonal management offices and 63 branch and service offices in the United States and Canada. The Group's overseas business is developed by its foreign agents and brokers through local branch offices of the Group and by its United States and Canadian agents and brokers. Overseas business is also obtained from foreign treaty reinsurance assumed principally, but not exclusively, from the Sun Alliance Group plc (Sun Group). In conducting its overseas business, the Group attempts to minimize the risks relating to currency fluctuations. Business for the Group is also produced through participation in a number of underwriting pools and syndicates including, among others, Associated Aviation Underwriters, Industrial Risk Insurers, American Accident Reinsurance Group, American Excess Insurance Association, Cargo Reinsurance Association and American Cargo War Risk Reinsurance Exchange. Such pools and syndicates provide underwriting capacity for risks which an individual insurer cannot prudently underwrite because of the magnitude of the risk assumed or which can be more effectively handled by one organization due to the need for specialized loss control service. Reinsurance In accordance with the normal practice of the insurance industry, the Group assumes and cedes reinsurance with other insurers or reinsurers. These reinsurance arrangements provide greater diversification of business and minimize the Group's maximum net loss arising from large risks or from hazards of catastrophic potentialities. A large portion of the Group's reinsurance is effected under contracts known as treaties under which all risks meeting prescribed criteria are automatically covered. A substantial portion of the Group's ceded reinsurance is on a quota share basis with a subsidiary of the Sun Group. Most of the remaining reinsurance arrangements consist of excess of loss and catastrophe contracts with other insurers or reinsurers which protect against a specified part or all of certain types of losses over stipulated amounts arising from any one occurrence or event. In some instances, reinsurance is effected by negotiation on individual risks. The amount of each risk retained by the Group is subject to maximum limits which vary by line of business and type of coverage. Retention limits are continually reviewed and are revised periodically as the Group's capacity to underwrite risks changes. Reinsurance contracts do not relieve the Group of its obligation to the policyholders. The collectibility of reinsurance is subject to the solvency of the reinsurers. The Group is selective in regard to its reinsurers, placing reinsurance with only those reinsurers with strong balance sheets and superior underwriting ability. The Group monitors the financial strength of its reinsurers on an ongoing basis. As a result, uncollectible amounts have not been significant. The severity of recent catastrophes, particularly Hurricane Andrew in 1992, has demonstrated to insurers, including the Group, that assumptions on the damage potential of catastrophes have been too optimistic. The Group maintains records showing concentrations of risks in catastrophe prone areas such as California (earthquakes and brush fires) and the Southeast coast of the United States (hurricanes). The Group continually assesses its concentration of underwriting exposures in catastrophe prone areas. The Group is continuing to develop strategies which will further limit the aggregation of exposure in any one catastrophic event. The catastrophe reinsurance market has suffered large losses in recent years. As a result, the reinsurance market's capacity was substantially reduced in 1993 and the cost of available coverages rose significantly. In response, the Group has increased its retention levels for individual catastrophe losses. The effect on the Group's exposure to future catastrophe losses will depend on the severity of such losses. Unpaid Claims and Claim Adjustment Expenses and Related Amounts Recoverable from Reinsurers Insurance companies are required to make provision in their accounts for the ultimate costs (including claim adjustment expenses) of claims which have been reported but not settled and of claims which have been incurred but not reported as well as for the portion of such provision that will be recovered from reinsurers. The process of establishing the liability for unpaid claims and claim adjustment expenses is an imprecise science subject to variables that are influenced by both internal and external factors. This is true because claim settlements to be made in the future will be impacted by changing rates of inflation (particularly medical cost inflation) and other economic conditions, changing legislative, judicial and social environments and changes in the Group's claim handling procedures. In many liability cases, significant periods of time, ranging up to several years or more, may elapse between the occurrence of an insured loss, the reporting of the loss to the Group and the settlement of the loss. Approximately 50% of the Group's unpaid claims and claim adjustment expenses are provided for IBNR--claims which have not yet been reported to the Group, some of which were not yet known to the insured, and future development on reported claims. In spite of this imprecision, financial reporting requirements dictate that insurance companies report a single amount as the estimate of unpaid claims and claim adjustment expenses as of each evaluation date. These estimates are continually reviewed and updated. Any resulting adjustments are reflected in current operating results. The Group's estimates of losses for reported claims are established judgmentally on an individual case basis. Such estimates are based on the Group's particular experience with the type of risk involved and its knowledge of the circumstances surrounding each individual claim. These estimates are reviewed on a regular basis or as additional facts become known. The reliability of the estimating process is monitored through comparison with ultimate settlements. The Group's estimates of losses for unreported claims are principally derived from analyses of historical patterns of the development of paid and reported losses by accident year for each class of business. This process relies on the basic assumption that past experience, adjusted for the effects of current developments and likely trends, is an appropriate basis for predicting future events. For certain classes of business where anticipated loss experience is less predictable because of the small number of claims and/or erratic claim severity patterns, the Group's estimates are based on both expected and actual reported losses. Salvage and subrogation estimates are developed from patterns of actual recoveries. The Group's estimates of unpaid claim adjustment expenses are based on analyses of the relationship of projected ultimate claim adjustment expenses to projected ultimate losses for each class of business. Claims staff has discretion to override these expense formulas either upward or downward where judgment indicates such action is appropriate. In 1993, the Corporation adopted Statement of Financial Accounting Standards (SFAS) No. 113, Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts. SFAS No. 113 establishes the conditions required for a contract with a reinsurer to be accounted for as reinsurance and prescribes accounting and reporting standards for those contracts. SFAS No. 113 requires that reinsurance recoverable on unpaid claims be reported separately as an asset on the balance sheet rather than the previous practice of reducing the liability for unpaid claims and claim adjustment expenses by such amount. The Group's estimates of reinsurance recoverable related to reported and unreported claims and claim adjustment expenses, which represent the portion of such liabilities that will be recovered from reinsurers, are determined in a manner consistent with the liabilities associated with the reinsured policies. The anticipated effect of inflation is implicitly considered when estimating liabilities for unpaid claims and claim adjustment expenses. Estimates of the ultimate value of all unpaid claims are based in part on paid losses, which reflect actual inflation. Inflation is also reflected in estimates established on reported open claims which, when combined with paid losses, form another basis to derive estimates of reserves for all open claims. There is no precise method for subsequently evaluating the adequacy of the consideration given to inflation, since claim settlements are affected by many factors. The following table provides a reconciliation of the beginning and ending liability for unpaid claims and claim adjustment expenses, net of reinsurance recoverable, and a reconciliation of the ending net liability to the corresponding liability on a gross basis for the years ended December 31, 1993, 1992 and 1991. In 1993, Pacific Indemnity entered into a global settlement agreement with Continental Casualty Company (a subsidiary of CNA Financial Corporation), Fibreboard Corporation, and attorneys representing claimants against Fibreboard for all future asbestos-related bodily injury claims against Fibreboard. This settlement relates to an insurance policy issued to Fibreboard by Pacific Indemnity in 1956. Pacific Indemnity and Continental Casualty reached a separate agreement for the handling of all pending asbestos-related bodily injury claims against Fibreboard. Prior to the settlement, the Group had paid $40 million and had existing loss reserves of $545 million to cover a portion of its obligation under these agreements. This amount included $300 million of IBNR reserves which were not previously classified as specific reserves for asbestos claims since it was management's belief that doing so would increase the demands of plaintiffs' attorneys. At the time the settlement was negotiated, the Group increased its loss reserves by $675 million. The Fibreboard settlement is further discussed in Item 7 of this report on pages 23 and 24. As a result of the $675 million increase, in 1993, the estimated liability for unpaid claims and claim adjustment expenses, net of reinsurance recoverable, as established at the previous year-end was deficient by $664.8 million. This compares with favorable development of $27.6 million and $28.8 million during 1992 and 1991, respectively. Such deficiency and redundancies were reflected in the Group's operating results in these respective years. Excluding the $675 million, the Group experienced favorable development of $10.2 million in 1993. Each of the past three years benefited from favorable claim frequency and severity trends for certain liability classes; this was offset each year in varying degrees by increases in unpaid claims and claim adjustment expenses relating to asbestos and toxic waste claims. Unpaid claims and claim adjustment expenses, net of reinsurance recoverable, increased 22% in 1993, after increases of 11% and 10% in 1992 and 1991, respectively. The significant increase in 1993 was primarily due to the $675 million increase related to the Fibreboard settlement. Excluding this $675 million, reserves increased by 10% in 1993. Substantial reserve growth has occurred each year in those liability coverages, primarily excess liability and executive protection, that have delayed loss reporting and extended periods of settlement. These coverages have become a more significant portion of the Group's business in recent years. The Group continues to emphasize early and accurate reserving, inventory management of claims and suits, and control of the dollar value of settlements. The number of outstanding claims at year-end 1993 was approximately 7% lower than the number at year-end 1992. This decrease was due primarily to the settlement during 1993 of the large number of open claims at December 31, 1992 relating to Hurricane Andrew and the December 1992 storm in the Northeast. The uncertainties relating to unpaid claims, particularly for asbestos and toxic waste claims on insurance policies written many years ago, are discussed in Item 7 of this report on pages 23 through 25. There were approximately 4,000 asbestos and toxic waste claims outstanding at December 31, 1993 and 1992 compared with approximately 5,000 claims outstanding at December 31, 1991. The decrease in 1992 was primarily the result of fewer asbestos-related new arisings as well as increases in bulk settlements and closed claims relating to asbestos claims. The following table provides a reconciliation of the beginning and ending liability for unpaid claims and claim adjustment expenses, net of reinsurance recoverable, related to asbestos and toxic waste claims for the years ended December 31, 1993, 1992 and 1991. Reinsurance recoveries related to asbestos and toxic waste claims are not significant. During 1984, the Group discontinued writing medical malpractice business. The Group entered into a stop loss reinsurance agreement, effective year-end 1985, which provides that the reinsurer will pay up to $285 million of losses and allocated loss adjustment expenses for this discontinued class of business in excess of the initial $225 million to be paid by the Group subsequent to December 31, 1985. The agreement also provides that the Group may elect to commute the remaining liability from the reinsurer as of December 31, 1995 and receive payment, at that time, of an amount determined by the agreement. The cost of this reinsurance was $173.5 million. Since the effective date of this agreement, the Group has paid an aggregate of $249.9 million of medical malpractice losses and loss adjustment expenses and has recovered the amount in excess of $225 million from the reinsurer. The amount of paid losses is approximately 55% of what was anticipated at the time the business was reinsured eight years ago. As a result of the favorable loss experience over this extended period, the Group reduced both its gross medical malpractice liability for unpaid claims and claim adjustment expenses and the related reinsurance recoverable by approximately $125 million in 1993. At that time, the Group announced its intention to exercise the election to commute the stop loss reinsurance agreement. The commutation will result in a return premium to the Group of approximately $125 million, which was recognized in 1993. The table on page 9 presents the subsequent development of the estimated year-end liability for unpaid claims and claim adjustment expenses, net of reinsurance recoverable, for the ten years prior to 1993. The top line of the table shows the estimated liability for unpaid claims and claim adjustment expenses recorded at the balance sheet date for each of the indicated years. This liability represents the estimated amount of losses and loss adjustment expenses for claims arising in all prior years that are unpaid at the balance sheet date, including losses that had been incurred but not yet reported to the Group. The upper section of the table shows the reestimated amount of the previously recorded liability based on experience as of the end of each succeeding year. The estimate is increased or decreased as more information becomes known about the frequency and severity of claims for each individual year. The increase or decrease is reflected in the current year's operating results. The "cumulative deficiency" as shown in the table represents the aggregate change in the reserve estimates from the original balance sheet dates through December 31, 1993. The amounts noted are cumulative in nature; that is, an increase in a loss estimate that related to a prior period occurrence generates a deficiency in each intermediate year. For example, a deficiency recognized in 1993 relating to losses incurred prior to December 31, 1983, such as that related to the Fibreboard settlement, would be included in the cumulative deficiency amount for each year in the period 1983 through 1992. Yet, the deficiency would be reflected in operating results only in 1993. The effect of changes in estimates of the liabilities for claims occurring in prior years on income before income taxes in each of the past three years is shown in the reconciliation table on page 6. A substantial portion of the cumulative deficiencies in liability estimates from 1983 through 1992 relates to additional provisions for asbestos and toxic waste claims, particularly the Fibreboard settlement. The cumulative deficiencies in the 1983 through 1985 columns were also due to additional provisions for medical malpractice claims as well as the substantially increased severity and complexity of liability claims. The cumulative deficiencies experienced relating to asbestos and toxic waste claims were, to varying degrees, the result of: (1) an increase in the actual number of claims filed; (2) an increase in the number of unasserted claims estimated; (3) an increase in the severity of actual and unasserted claims; and (4) an increase in litigation costs associated with such claims. Conditions and trends that have affected development of the liability for unpaid claims and claim adjustment expenses in the past will not necessarily recur in the future. Accordingly, it is not appropriate to extrapolate future redundancies or deficiencies based on the data in this table. The lower section of the table on page 9 shows the cumulative amount paid with respect to the reestimated liability as of the end of each succeeding year. For example, in the 1983 column, as of December 31, 1993 the Group had paid $1,707.6 million of the currently estimated $3,142.9 million of claims and claim adjustment expenses that were unpaid at the end of 1983; thus, an estimated $1,435.3 million of losses incurred through 1983 remain unpaid as of December 31, 1993, most of which relates to the Fibreboard settlement. Members of the Group are required to file annual statements with state insurance regulatory authorities prepared on an accounting basis prescribed or permitted by such authorities (statutory basis). In 1993, the Group amended its statutory basis of accounting to reflect salvage and subrogation recoveries on an accrual basis as a reduction of the liability for unpaid claims and claim adjustment ANALYSIS OF CLAIM AND CLAIM ADJUSTMENT EXPENSE DEVELOPMENT (NET OF REINSURANCE RECOVERABLE) - --------------- * The cumulative deficiencies for the years 1983 through 1992 include the effect of the increase in the liability for unpaid claims and claim adjustment expenses related to the Fibreboard settlement. ** The medical malpractice gross liability for unpaid claims and claim adjustment expenses and the related reinsurance recoverable were both reduced by approximately $125 million in 1993. Excluding the effect of this item, the deficiency resulting from the reestimation of the December 31, 1992 liability for unpaid claims and claim adjustment expenses as of December 31, 1993 on a gross basis was not significantly different from that on a net basis. expenses. Prior to 1993, salvage and subrogation recoveries were recorded on a cash basis in the statutory basis financial statements. The differences between the liability for unpaid claims and claim adjustment expenses, net of reinsurance recoverable, reported in the accompanying consolidated financial statements in accordance with generally accepted accounting principles (GAAP) and that reported in the annual statutory statements are as follows: Investments For each member of the Group, current investment policy is implemented by management which reports to its Board of Directors. The main objective of the investment portfolio of the Group is to provide maximum support to the insurance underwriting operations. To accomplish this, the investment function must be highly integrated with the operating functions and capable of responding to the changing conditions in the marketplace. Investment strategies are developed based on a variety of factors including underwriting results and the Group's resulting tax position, fluctuations in interest rates and regulatory requirements. The investment portfolio of the Group is primarily composed of high quality bonds, principally tax-exempt, U.S. Treasury, government agency and corporate issues. In addition, the portfolio includes common stocks held primarily with the objective of capital appreciation. In 1993 and 1992, the Group invested new cash primarily in tax-exempt bonds. In each year the Group tried to achieve the appropriate mix in its portfolio to balance both investment and tax strategies. In 1993, the Group reduced its taxable bond portfolio by $225 million and increased its short term investments so that funds are readily available to pay amounts related to the Fibreboard settlement. At December 31, 1993, 75% of the Group's fixed maturity portfolio was invested in tax-exempt bonds compared with 71% at the previous year-end. The investment results of the Group for each of the past three years are shown in the following table. - --------------- (a) Average of amounts at beginning and end of calendar year. (b) Investment income after deduction of investment expenses, but before applicable income tax, excluding income from rental of real estate and fixed assets. (c) Before applicable income tax. (d) Relates to equity securities. CHUBB & SON INC. Chubb & Son Inc., a wholly-owned subsidiary of the Corporation, was incorporated in 1959 under the laws of New York as a successor to the partnership of Chubb & Son which was organized in 1882 by Thomas Caldecot Chubb to act as underwriter and manager of insurance companies. Chubb & Son Inc. is the manager of Federal, Vigilant, Great Northern, Chubb New Jersey, Chubb Custom and Chubb National. Chubb & Son Inc. also provides certain services to Pacific Indemnity and other members of the Property and Casualty Insurance Group for which it is reimbursed. Acting subject to the supervision and control of the Boards of Directors of the members of the Group, Chubb & Son Inc. provides day to day executive management and operating personnel and makes available the economy and flexibility inherent in the common operation of a group of insurance companies. In addition, Chubb & Son Inc. arranges for the exchange of reinsurance between members of the Group. Chubb & Son Inc. is the United States manager for Samsung Fire & Marine Insurance Company, Ltd. (formerly known as Ankuk Fire & Marine Insurance Company, Ltd.). Through December 31, 1993, Chubb & Son Inc. managed the aviation departments of certain other insurance companies. Effective January 1, 1994, Associated Aviation Underwriters, Inc., a company 50% owned by Chubb and Son Inc., assumed management of this aviation business. LIFE AND HEALTH INSURANCE GROUP The Life and Health Insurance Group (Life Group) includes Chubb Life Insurance Company of America (Chubb Life) and its wholly-owned subsidiaries, The Colonial Life Insurance Company of America (Colonial) and Chubb Sovereign Life Insurance Company (Sovereign). The Life Group, which markets a wide variety of insurance and investment products, is principally engaged in the sale of personal and group life and health insurance as well as annuity contracts. These products, some of which combine life insurance and investment attributes, include traditional insurance products such as term, whole life, and accident and health insurance, as well as fixed premium interest-sensitive life, universal life and variable universal life insurance and mutual funds. The target market of the Life Group is small-to medium-sized business establishments and those people, often the proprietors of such businesses, whose needs for financial planning are more complex and diverse than average. One or more of the companies in the Life Group are licensed and transact business in each of the 50 states, the District of Columbia, Puerto Rico, Guam and the Virgin Islands. Personal life and health insurance is marketed primarily through approximately 1,400 personal producing general agents and 20,600 brokers. Group life and health insurance is marketed through approximately 9,100 brokers. The executive, accounting, actuarial and administrative activities of the Life Group other than Sovereign are located at the Chubb Life headquarters in Concord, New Hampshire. Sovereign's activities are administered both in Concord and Santa Barbara, California. The group insurance operations are mainly located in Parsippany, New Jersey. Personal insurance operations are in Concord, Santa Barbara and Chattanooga, Tennessee. The following tables present highlights of the Life Group. LIFE INSURANCE IN-FORCE* - --------------- * Before deduction for reinsurance ceded. PREMIUM AND POLICY CHARGE REVENUES BY CLASS REVENUES, ASSETS AND CAPITAL AND SURPLUS The main objective of the investment portfolio of the Life Group is to earn a rate of return in excess of that required to satisfy the obligations to policyholders and to cover expenses. The portfolio of the Life Group is comprised primarily of mortgage-backed securities and corporate bonds. The Life Group invests predominantly in investment grade, current coupon fixed-income securities with stable cash flow characteristics and maturities which are consistent with life insurance reserve requirements. The investment strategy emphasizes maintaining portfolio quality while achieving competitive investment yields. The investment results of the Life Group for each of the past three years are shown in the following table. - --------------- (a) Average of amounts at beginning and end of calendar year. (b) Investment income after deduction of investment expenses, but before applicable income tax, excluding income from real estate. (c) Before applicable income tax. (d) Relates to equity securities. Reinsurance The companies in the Life Group, in accordance with common industry practice, reinsure portions of the life insurance risks they underwrite with other companies. At the present time, the maximum amount of life insurance retained on any one life by the Life Group is $1,250,000, excluding accidental death benefits. Including accidental death benefits, the Life Group accepts a maximum net retention of $1,400,000. Policy Liabilities Premium receipts from universal life and other interest-sensitive contracts are established as policyholder account balances. Charges for the cost of insurance and policy administration are assessed against the policyholder account balance. The amount remaining after such charges represents the policy liability before applicable surrender charges. Benefit reserves on individual life insurance contracts with fixed and guaranteed premiums and benefits are computed so that amounts, with additions from actuarial net premiums to be received and with interest on such reserves compounded annually at certain assumed rates, will be sufficient to meet expected policy obligations. In accordance with generally accepted accounting principles, certain additional factors are considered in the reserve computation as more fully set forth in Note (1)(e) of the notes to consolidated financial statements incorporated by reference from the Corporation's 1993 Annual Report to Shareholders. Group life reserves represent the unearned premium. Group medical reserves are computed utilizing "lag and adjusted lag" methods. These methods take into account historical claim experience and adjust for current medical inflation and changes in claim backlog. REAL ESTATE DEVELOPMENT GROUP The Real Estate Development Group (Real Estate Group) is composed of Bellemead Development Corporation and its subsidiaries. The Real Estate Group is involved with commercial and residential real estate development. The Real Estate Group develops real estate properties itself rather than through third party developers. It is distinguished from most other real estate developers in that it coordinates all phases of the development process from concept to completion. The services offered to its customers include land acquisition, site planning, architecture, engineering, construction, financing, marketing and property management. Upon completion of development, the properties may be either owned and operated for the Real Estate Group's own account or sold to third parties. The Real Estate Group directly manages virtually all of the properties which it either owns or has sold and retained interests in through secured loans. The Real Estate Group's continuing investment interests in joint ventures generally consist of the ownership and lease of the underlying land and the management and operation of the buildings. The Real Estate Group's commercial development activities center around acquiring suburban, multi-site land parcels in locations considered prime for office development, and then developing the land in progressive stages. The Real Estate Group's activities include a few metropolitan office building projects. Commercial development activities are primarily in northern and central New Jersey with additional operations in Connecticut, Florida, Illinois, Maryland, Michigan, Pennsylvania and Texas. The Real Estate Group owns 4,455,000 square feet of office and industrial space, of which 87% is leased. The Real Estate Group has varying interests in an additional 6,080,000 square feet of office and industrial space which is 92% leased. Residential development activities of the Real Estate Group are primarily in central Florida. The Real Estate Group currently has undeveloped land holdings of approximately 4,600 acres, with primary holdings in New Jersey and Florida and lesser holdings in six additional states. REGULATION, PREMIUM RATES AND COMPETITION The Corporation is a holding company primarily engaged in the insurance business and is therefore subject to regulation by certain states as an insurance holding company. California, Indiana, Minnesota, New Hampshire, New Jersey, New York and all other states have enacted legislation which regulates insurance holding company systems such as the Corporation and its subsidiaries. This legislation generally provides that each insurance company in the system is required to register with the department of insurance of its state of domicile and furnish information concerning the operations of companies within the holding company system which may materially affect the operations, management or financial condition of the insurers within the system. All transactions within a holding company system affecting insurers must be fair and equitable. Notice to the insurance commissioners is required prior to the consummation of transactions affecting the ownership or control of an insurer and of certain material transactions between an insurer and any person in its holding company system and, in addition, certain of such transactions cannot be consummated without the commissioners' prior approval. Property and Casualty Insurance The Property and Casualty Insurance Group is subject to regulation and supervision in the states in which it does business. In general, such regulation is for the protection of policyholders rather than shareholders. The extent of such regulation varies but generally has its source in statutes which delegate regulatory, supervisory and administrative powers to a department of insurance. The regulation, supervision and administration relate to, among other things, the standards of solvency which must be met and maintained; the licensing of insurers and their agents; restrictions on insurance policy terminations; unfair trade practices; the nature of and limitations on investments; premium rates; restrictions on the size of risks which may be insured under a single policy; deposits of securities for the benefit of policyholders; approval of policy forms; periodic examinations of the affairs of insurance companies; annual and other reports required to be filed on the financial condition of companies or for other purposes; limitations on dividends to policyholders and shareholders; and the adequacy of provisions for unearned premiums, unpaid claims and claim adjustment expenses, both reported and unreported, and other liabilities. In December 1993, the National Association of Insurance Commissioners adopted a risk-based capital formula for property and casualty insurance companies. This formula will be used by state regulatory authorities to identify insurance companies which may be undercapitalized and which merit further regulatory attention. The formula prescribes a series of risk measurements to determine a minimum capital amount for an insurance company, based on the profile of the individual company. The ratio of a company's actual policyholders' surplus to its minimum capital requirement will determine whether any state regulatory action is required. The risk-based capital requirement will be applicable to property and casualty insurance companies for the first time as of year-end 1994. Based on preliminary calculations using 1993 data, each member of the Group has more than sufficient capital to meet the risk-based capital requirement. Regulatory requirements applying to premium rates vary from state to state, but generally provide that rates not be "excessive, inadequate or unfairly discriminatory." Rates for many lines of business, including automobile and homeowners insurance, are subject to prior regulatory approval in many states. However, in certain states, prior regulatory approval of rates is not required for most lines of insurance which the Group underwrites. Ocean marine insurance rates are exempt from regulation. Subject to regulatory requirements, the Group's management determines the prices charged for its policies based on a variety of factors including claim and claim adjustment expense experience, inflation, tax law and rate changes, and anticipated changes in the legal environment, both judicial and legislative. Methods for arriving at rates vary by type of business, exposure assumed and size of risk. Underwriting profitability is affected by the accuracy of these assumptions, by the willingness of insurance regulators to grant increases in those rates which they control and by such other matters as underwriting selectivity and expense control. In all states, insurers authorized to transact certain classes of property and casualty insurance are required to become members of an insolvency fund. In the event of the insolvency of an insurer writing a class of insurance covered by the fund in the state, all members are assessed to pay certain claims against the insolvent insurer. Fund assessments are proportionately based on the members' written premiums for the classes of insurance written by the insolvent insurer. A portion of these assessments is recovered in certain states through premium tax offsets and policyholder surcharges. In 1993, such assessments to the members of the Group amounted to approximately $8 million. The amount of future assessments cannot be reasonably estimated. State insurance regulation requires insurers to participate in assigned risk plans, reinsurance facilities and joint underwriting associations, which are mechanisms to provide risks with various basic insurance coverages when they are not available in voluntary markets. Such mechanisms are most prevalent for automobile and workers' compensation insurance, but a majority of states also mandate participation in Fair Plans or Windstorm Plans, which provide basic property coverages. Some states also require insurers to participate in facilities that provide homeowners, crime and medical malpractice insurance. Participation is based upon the amount of a company's voluntary written premiums in a particular state for the classes of insurance involved. These involuntary market plans generally are underpriced and produce unprofitable underwriting results. In several states, insurers, including members of the Group, participate in market assistance plans. Typically, a market assistance plan is voluntary, of limited duration and operates under the supervision of the insurance commissioner to provide assistance to applicants unable to obtain commercial and personal liability and property insurance. The assistance may range from identifying sources where coverage may be obtained to pooling of risks among the participating insurers. The extent of insurance regulation on business outside the United States varies significantly among the countries in which the Group operates. Some countries have minimal regulatory requirements, while others regulate insurers extensively. Foreign insurers in many countries are faced with greater restrictions than domestic competitors. Such restrictions include the need to secure new licenses and compulsory cessions of reinsurance. In certain countries the Group has incorporated insurance subsidiaries locally to improve its position. The property and casualty insurance industry is highly competitive both as to price and service. Members of the Group compete not only with other stock companies but also with mutual companies, other underwriting organizations and alternative risk sharing mechanisms. Some competitors obtain their business at a lower cost through the use of salaried personnel rather than independent agents and brokers. Rates are not uniform for all insurers and vary according to the types of insurers and methods of operation. The Group competes for business not only on the basis of price, but also on the basis of availability of coverage desired by customers and quality of service, including claim adjustment service. The Group's products and services are generally designed to serve specific customer groups or needs and to offer a degree of customization that is of value to the insured. There are approximately 3,900 property and casualty insurance companies in the United States operating independently or in groups and no single company or group is dominant. According to A.M. Best, the Group is the 14th largest United States property and casualty insurance group based on 1992 net premiums written. The relatively large size and underwriting capacity of the Group make available opportunities not available to smaller companies. The property and casualty insurance industry has a history of cyclical performance with successive periods of deterioration and improvement over time. The industry and the Group experienced substantial underwriting losses from 1980 through 1984. Beginning in 1984, the industry and the Group were able to increase prices and tighten underwriting terms. Substantial price increases were achieved in most commercial lines from 1984 through 1986. Price competition increased in the property and casualty marketplace during 1987 and has continued through 1993, particularly in the commercial classes. In 1993, property related business experienced some rate firming in the wake of the unprecedented catastrophes of 1992; however, price increases in casualty lines continued to be difficult to achieve. The Group continues to be selective in the writing of new business and to reinforce the sound relationships with its customers who appreciate the stability, expertise and added value the Group provides. In the personal lines, the regulatory climate for obtaining rate increases continues to be difficult, particularly in the automobile class. Life and Health Insurance The members of the Life Group are subject to regulation and supervision in each state in which they do business. Such regulation and supervision is generally of the character indicated in the first two paragraphs under the preceding caption, "Property and Casualty Insurance." The risk-based capital formula for life and health insurers was first effective as of year-end 1993. Each member of the Life Group had more than sufficient capital at December 31, 1993 to meet the risk-based capital requirement. The Life Group operates in a highly competitive industry in which it does not hold a significant market share. The Life Group competes in the personal insurance market not only with other life insurance companies but also with other financial institutions. By offering a full line of products, including interest-sensitive and variable products, both with and without life contingencies, the Life Group meets this competition for its selected customer group. The Life Group also competes in the small group health insurance market by offering competitively priced indemnity products with comprehensive benefits, and a full line of ancillary products including group dental, life and long term disability. In 1993, the Life Group accelerated its involvement in managed care through the development of ChubbHealth Inc., a health maintenance organization that will serve the New York City metropolitan area. ChubbHealth is a joint venture with Healthsource, Inc. ChubbHealth is in the final stages of licensing and will be operational during the first half of 1994. Members of the Life Group also participate in insolvency funds. In 1993, insolvency fund assessments to the members of the Life Group amounted to approximately $2 million. There are approximately 2,000 legal reserve life insurance companies in the United States. According to the National Underwriter, a trade publication, as of January 1, 1993, Chubb Life, Colonial and Sovereign ranked 71st, 151st and 167th, respectively, among such companies based on total insurance in-force. Legislative and Judicial Developments Although the federal government and its regulatory agencies generally do not directly regulate the business of insurance, federal initiatives often have an impact on the business in a variety of ways. Current and proposed federal measures which may significantly affect the insurance business include health care reform initiatives, containment of medical care costs, limitations on health insurance premiums, toxic waste removal and liability measures, financial services deregulation, solvency regulation, employee benefits regulation, automobile safety regulation, the taxation of insurance companies, the tax treatment of insurance products and modification of the limited exemption for the business of insurance from the federal antitrust laws. Enacted and contemplated health care reform on both a national and state level are reshaping the health insurance industry. Federal legislation on health insurance is being considered which, if enacted, could create less favorable conditions for the health insurance industry. Significant changes are not expected to become operational for some time. It is currently not possible to predict the long term impact of health care reforms on the Life Group's business. Insurance companies are also affected by a variety of state and federal legislative and regulatory measures as well as by decisions of their courts that define and extend the risks and benefits for which insurance is provided. These include redefinitions of risk exposure in areas such as product liability and commercial general liability as well as extension and protection of employee benefits, including pension, workers' compensation and disability benefits. Regulatory concerns with insurance risk classification have increased significantly in recent years. There is continuous legislative, regulatory and judicial activity regarding the use of gender in determining premium rates and benefit payments. Also, some states have restricted the use of underwriting criteria related to Human Immunodeficiency Virus related illnesses. The Corporation's insurance subsidiaries have taken steps to limit their underwriting exposures in those jurisdictions that severely restrict underwriting freedom. In July 1992, New York adopted legislation implementing changes in the small employer group health insurance market. The major provisions became effective April 1, 1993. New Jersey adopted similar legislation in November 1992, which generally became effective January 1, 1994. Both laws significantly affect the manner in which the Life Group and other small group health indemnity insurers conduct business. In general, the laws create community based rating, mandate prior approval of rates by the insurance department, require open enrollment periods, limit pre-existing condition exclusions and eliminate health underwriting for insured groups with fewer than 50 covered lives. Several lawsuits have been filed by a number of insurers, including a member of the Life Group, to overturn the New York law and regulations. Certain provisions of the law have been successfully challenged; however, the New York Superintendent of Insurance has appealed such decisions. Approximately 80% of the Life Group's group health insurance premiums are written in New York and New Jersey. The Life Group has taken actions, including redesigning products and restructuring rates and sales commissions, which will allow the Life Group to remain competitive with other small employer group health indemnity insurers in New York and New Jersey. In 1988, voters in California approved Ballot Proposition 103, an insurance reform initiative, which is discussed in Item 7 of this report on page 22. In 1990, New Jersey adopted legislation imposing controls over automobile insurance risk selection, pricing, coverage and termination. The New Jersey statute also applied the state's antitrust laws to automobile insurers, abolished the deficit-ridden Automobile Joint Underwriting Association (JUA), established a Market Transition Facility (MTF) to issue automobile policies until the implementation of an assigned risk mechanism on October 1, 1992 and levied an assessment and surtax on certain insurance coverages to help defray the estimated $3 billion obligation of the JUA. Under the law, insurers must make special rate filings to recoup these added charges from their insurance customers. The MTF has also generated a deficit during its two year existence. Pursuant to statute, the deficit is required to be allocated to automobile insurers, including members of the Group, based on market share. Regulations permit insurers to apply for a surcharge to recover these allocations when paid. In December 1993, the Group entered into an agreement with the Insurance Commissioner to pay approximately $10 million as its share of the then projected deficit of $900 million. The Group's share is subject to adjustment based on any changes in the estimated deficit. The agreement also entitles the Group to a refund or credit of any payments made in the event that litigation commenced by representatives of the insurance industry challenging the Insurance Commissioner's authority to allocate the deficit to insurers is successful. Such litigation is currently pending. In March 1994, the acting Insurance Commissioner announced that the deficit had been reestimated to be approximately $1.3 billion. The Group's share of the reestimated deficit is approximately $15 million. ITEM 2. ITEM 2. PROPERTIES The executive offices of the Corporation and the administrative offices of the Property and Casualty Group are in Warren, New Jersey. The Life Group has its administrative offices in Concord, New Hampshire; Parsippany, New Jersey; Chattanooga, Tennessee and Santa Barbara, California. The Real Estate Group's corporate headquarters is located in Roseland, New Jersey. The insurance subsidiaries maintain zonal and branch offices in major cities throughout the United States, and members of the Property and Casualty Insurance Group also have offices in Canada, Europe, Australia and the Far East. Office facilities are leased with the exception of buildings in Branchburg, New Jersey, Chattanooga and Santa Barbara, and a portion of the Life Group's home office complex in Concord. Management considers its office facilities suitable and adequate for the current level of operations. See Note (11) of the notes to consolidated financial statements incorporated by reference from the Corporation's 1993 Annual Report to Shareholders. ITEM 3. ITEM 3. LEGAL PROCEEDINGS The Corporation and its subsidiaries are defendants in various lawsuits arising out of their businesses. It is the opinion of management that the final outcome of these matters will not materially affect the consolidated financial position of the registrant. Information regarding certain litigation to which property and casualty insurance subsidiaries of the Corporation are a party is included in Item 7 of this report on pages 23 and 24. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of the shareholders during the last quarter of the year ended December 31, 1993. EXECUTIVE OFFICERS OF THE REGISTRANT - --------------- (a) Ages listed above are as of April 26, 1994. (b) Date indicates year first elected or designated as an executive officer. All of the foregoing officers serve at the pleasure of the Board of Directors of the Corporation or listed subsidiary and have been employees of the Corporation or a subsidiary of the Corporation for more than five years except for Randell G. Craig, John J. Degnan and Theresa M. Stone. Mr. Craig joined Chubb Life in 1990 and was previously a vice president with Crown Life Insurance Company. Prior to joining Chubb & Son Inc. in 1990, Mr. Degnan was a senior partner in the New Jersey law firm of Shanley & Fisher. Ms. Stone, who joined the Corporation in 1990, was previously a principal with Morgan Stanley & Co. Incorporated. PART II. ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED SECURITY HOLDER MATTERS Incorporated by reference from the Corporation's 1993 Annual Report to Shareholders, page 67. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA Selected financial data for the five years ended December 31, 1993 are incorporated by reference from the Corporation's 1993 Annual Report to Shareholders, pages 38 and 39. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion presents our past results and our expectations for the near term future. The supplementary financial information and consolidated financial statements and related notes, all of which are integral parts of the following analysis of our results and our financial position, are incorporated by reference from the Corporation's 1993 Annual Report to Shareholders, pages 11, 12 and 40 through 61. Net income amounted to $324 million in 1993 compared with $617 million in 1992 and $552 million in 1991. Net income in 1993 reflects a net charge of $357 million after taxes related to an agreement for the settlement of asbestos-related litigation and the Corporation's intention to exercise its option to commute an unrelated existing medical malpractice reinsurance agreement. Net income in 1993 also reflects a one-time charge of $20 million for the cumulative effect of adopting new accounting requirements for postretirement benefits other than pensions and for income taxes. Net income included realized investment gains after taxes of $152 million, $124 million and $43 million in 1993, 1992 and 1991, respectively. Decisions to sell securities are governed principally by considerations of investment opportunities and tax consequences. Thus, realized investment gains and losses may vary significantly from year to year. As a result, net income may not be indicative of our operating performance for the period. PROPERTY AND CASUALTY INSURANCE Property and casualty income was significantly lower in 1993 compared with 1992 and 1991 due to a $675 million increase in loss reserves related to an agreement for the settlement of asbestos-related litigation (the "$675 million charge"), which is further described under Loss Reserves. This was partially offset by a $125 million return premium to the property and casualty insurance subsidiaries related to the Corporation's intention to exercise its option to commute an existing medical malpractice reinsurance agreement (the "$125 million return premium"). Property and casualty income after taxes was $118 million in 1993 compared with $407 million in 1992 and $416 million in 1991. Excluding the effects of the $675 million charge and the $125 million return premium, property and casualty income after taxes was $475 million in 1993. Results for 1993 benefited from lower catastrophe losses and an increase in investment income compared with the prior year. The earnings decrease in 1992 was due to a decline in underwriting results caused by substantial catastrophe losses, including those from Hurricane Andrew, partially offset by an increase in investment income. Catastrophe losses were $89 million in 1993 compared with $175 million in 1992 and $72 million in 1991. Net premiums written, excluding the $125 million return premium, amounted to $3.5 billion in 1993, an increase of 9% compared with 1992, which was in turn 4% higher than 1991. Personal coverages accounted for $814 million or 23% of 1993 premiums written, standard commercial coverages for $1,202 million or 34%, specialty commercial coverages for $1,270 million or 36% and reinsurance assumed for $235 million or 7%. The marketplace continued to be competitive, particularly in the commercial classes. Property related business experienced some rate firming in 1993 in the wake of the unprecedented catastrophes of 1992, but price increases in casualty lines continued to be difficult to achieve. We have continued to be selective in the writing of new business and to reinforce the sound relationships with our customers who appreciate the stability, expertise and added value we provide. Due to the adverse effect of the $675 million charge, underwriting results were extremely unprofitable in 1993. The combined loss and expense ratio, the common measure of underwriting profitability, was 114.8% in 1993 compared with 101.1% in 1992 and 99.5% in 1991. Excluding the effects of the $675 million charge and the $125 million return premium, the combined loss and expense ratio was 99.0% in 1993. The loss ratio was 82.5% in 1993 compared with 66.7% in 1992 and 64.4% in 1991. Excluding the effects of the $675 million charge and the $125 million return premium, the loss ratio was 65.5% in 1993, continuing to reflect the favorable experience resulting from the consistent application of our underwriting standards. Losses from catastrophes represented 2.5, 5.6 and 2.4 percentage points of the loss ratio in 1993, 1992 and 1991, respectively. Our expense ratio was 32.3% in 1993 compared with 34.4% in 1992 and 35.1% in 1991. Excluding the effect of the $125 million return premium, the expense ratio was 33.5% in 1993. The improvement from the comparable 1992 ratio was due to lower commissions and to growth in written premiums at a somewhat greater rate than the increase in overhead expenses. The decrease in the expense ratio in 1992 was due to lower commissions. Expenses were reduced by contingent profit sharing accruals of $9 million in each of the three years relating to the medical malpractice reinsurance agreement. We anticipate a similar accrual during 1994. There will be no further profit sharing allowance under this agreement after 1994. The effect of Hurricane Andrew on our underwriting results in 1992 was mitigated to a great extent by our catastrophe reinsurance program. The catastrophe reinsurance market has suffered large losses in recent years. As a result, the reinsurance market's capacity was substantially reduced in 1993 and the cost of available coverages rose significantly. We responded by increasing our retention levels for individual catastrophe losses. The effect of this change on our 1993 underwriting results was not significant due to the absence of severe catastrophe losses. PERSONAL INSURANCE Premiums from personal insurance increased 2% in 1993 compared with a 2% decrease in 1992. It continues to be difficult to write new homeowners and other non-automobile business due to our disciplined pricing as well as the weakness in residential real estate markets. Personal automobile premiums have remained level over the past three years as modest rate increases have offset a reduction in the number of in force policies, which is consistent with our plan to control our exposure in this class. Our personal insurance business produced an underwriting profit in 1993 compared with underwriting losses in 1992 and 1991. All classes contributed to the 1993 improvement. The combined loss and expense ratio was 95.8% in 1993 compared with 104.6% in 1992 and 103.1% in 1991. Underwriting results in each of these years were adversely affected by significant catastrophe losses in the homeowners class, particularly Hurricane Andrew in 1992. Homeowners results, excluding the impact of catastrophes, benefited in 1992 and 1993 from disciplined pricing and stable loss frequency and severity. Catastrophe losses for this class represented 13.4 percentage points of the loss ratio for 1993 compared with 25.0 percentage points in 1992 and 13.1 percentage points in 1991. Our automobile business was modestly profitable in 1993 compared with breakeven results in 1992 and unprofitable results in 1991. The improvement in 1993 was due to stable loss frequency and severity while in 1992 it was primarily due to a reduced frequency of losses. Automobile results were adversely affected each year by significant losses from the mandated business which we are required by law to accept for those individuals who cannot obtain coverage in the voluntary market. Other personal coverages, which include insurance for personal valuables and excess liability, were increasingly profitable in 1992 and 1993. STANDARD COMMERCIAL INSURANCE Excluding the $125 million return premium discussed below, premiums from standard commercial insurance, which include coverages for multiple peril, casualty and workers' compensation, increased 6% in 1993 compared with 2% in 1992. The competitive market has continued to place significant pressure on rates. Premium growth in 1993 was most significant in the multiple peril class; such growth was due primarily to improved renewal retention as well as exposure growth on such renewals. Medical malpractice business, which we stopped writing in 1984, was reinsured effective year-end 1985. Under the provisions of the reinsurance agreement, we may elect to commute the remaining liability from the reinsurer as of December 31, 1995 and receive payment, at that time, of an amount determined by the agreement. In August 1993, the Corporation announced its intention to exercise this election. As the result of the favorable loss payment pattern in the eight years since this business was reinsured, the commutation will result in a return premium to the property and casualty insurance subsidiaries of approximately $125 million, which was recognized in the third quarter of 1993. Our standard commercial underwriting results were unprofitable in each of the past three years. Such results were extremely unprofitable in 1993 due to the adverse effect of the $675 million charge. The combined loss and expense ratio was 149.7% in 1993 compared with 105.7% in 1992 and 102.6% in 1991. Excluding the effects of the $675 million charge and the $125 million return premium, the combined loss and expense ratio was 107.6% in 1993. Casualty results include the effects of the $675 million charge and the $125 million return premium. Excluding the effects of these items, casualty results were near breakeven in 1993 compared with profitable results in 1992 and 1991. The excess liability component deteriorated somewhat in 1993 but remained profitable due to the relative price adequacy and favorable loss experience in this class. These favorable results were offset in varying degrees in each of the past three years by increases in loss reserves on general liability business written in earlier years, particularly for asbestos-related and toxic waste claims. Results in the automobile component were modestly profitable in each of the last three years. Multiple peril results were similarly unprofitable in each of the last three years due to the less than adequate prices. Results in the property component of this business improved in 1993 due to a reduction in the impact of catastrophe losses. This was offset by a deterioration in the liability component that was due to an increase in the frequency and severity of losses. Results in 1992 were adversely affected by higher catastrophe losses, primarily from Hurricane Andrew and the civil disorder in Los Angeles. Catastrophe losses for this class represented 3.6 percentage points of the loss ratio for 1993 compared with 10.1 percentage points in 1992 and 1.3 percentage points in 1991. Workers' compensation results were extremely unprofitable in each of the past three years. Results in our voluntary business have benefited somewhat from rate increases and a reduced frequency of losses. Results in this class have been aggravated each year, but particularly in 1991, by our share of the significant losses incurred by the involuntary pools and mandatory business in which we must participate by law. SPECIALTY COMMERCIAL INSURANCE Premiums from specialty commercial insurance increased 10% in 1993 compared with 11% in 1992. The growth was due primarily to rate and exposure increases in several of our smaller specialty classes. Price increases for most of our executive protection and financial fidelity coverages were difficult to achieve. Our strategy of working closely with our customers and our ability to differentiate our products has enabled us to retain a large percentage of our business. The specialty commercial business produced substantial underwriting profits in each of the past three years with combined loss and expense ratios of 91.0% in 1993, 90.5% in 1992 and 90.3% in 1991. Our executive protection, financial fidelity and surety results were highly profitable in each year due to favorable loss experience. Marine results were profitable in 1993 and 1992 compared with near breakeven results in 1991. Results in several of our smaller specialty classes deteriorated in 1993 compared with the prior two years, due primarily to an increased frequency of large losses. REINSURANCE ASSUMED Premiums from reinsurance assumed, which is primarily treaty reinsurance assumed from the Sun Alliance Group plc, increased 46% in 1993 compared with 9% in 1992. The growth in 1993 was due to an increase in our participation in the business of Sun Alliance and a firming of rates in Sun Alliance's markets, primarily in the United Kingdom. Underwriting results for this segment, while substantially improved in 1993 due to the firming of rates, have been unprofitable in each of the last three years. The combined loss and expense ratio was 111.8% in 1993 compared with 126.9% in 1992 and 119.3% in 1991. Results in 1992 were adversely affected by our share of the substantial mortgage indemnity insurance losses experienced by Sun Alliance in the United Kingdom. Results in 1991 reflect the adverse effect on Sun Alliance of excessive price competition and a damaging recession in the United Kingdom. REGULATORY INITIATIVES In 1988, voters in California approved Ballot Proposition 103, an insurance reform initiative which affects most property and casualty insurers writing business in the state. Approximately 14% of the direct business of the Corporation's property and casualty subsidiaries is written in California. Provisions of Proposition 103 would have required insurers to roll back property and casualty insurance rates for certain lines of business to 20 percent below November 1987 levels and would have required an additional 20 percent reduction in automobile rates by November 1989. In 1989, the California Supreme Court, ruling on the constitutional challenge to Proposition 103, ruled that an insurer is entitled to a fair rate of return. The regulations implementing the rate determination and premium rollback provisions of Proposition 103 continue to evolve. A California Superior Court decision declared invalid and void the rollback and rate review regulations proposed by the elected Insurance Commissioner. The Court decision prohibits the Commissioner from enforcing the regulations as well. The Commissioner has appealed the Superior Court decision to the California Supreme Court and the outcome of that appeal is uncertain. In a separate action, a California Court of Appeal has ruled that Proposition 103 regulations need not be submitted for approval to the California Office of Administrative Law. A petition for review has been filed with the California Supreme Court. There are at present no regulations in force or proposed which establish a final rollback formula. None of our property and casualty subsidiaries have been among the companies thus far ordered to refund premiums for the rollback period. Based on our analysis of the operating results of our property and casualty subsidiaries in the State of California during the rollback period, it is management's belief that it is probable that any final court decision will not result in premium refunds of a material amount by the Corporation's property and casualty subsidiaries. LOSS RESERVES Loss reserves are our property and casualty subsidiaries' largest liability. At the end of 1993, gross loss reserves totaled $8.2 billion compared with $7.2 billion and $6.6 billion at year-end 1992 and 1991, respectively. Reinsurance recoverable on such loss reserves was $1.8 billion at the end of 1993 compared with $2.0 billion and $1.8 billion at year-end 1992 and 1991, respectively. Loss reserves, net of reinsurance recoverable, increased 22% in 1993, after increases of 11% and 10% in 1992 and 1991, respectively. The significant increase in 1993 was primarily due to the $675 million increase related to the settlement of asbestos-related litigation. Excluding this $675 million, loss reserves increased by 10% in 1993. Substantial reserve growth has occurred each year in those liability coverages, primarily excess liability and executive protection, that have delayed loss reporting and extended periods of settlement. These coverages have become a more significant portion of our business in recent years. The process of establishing loss reserves is an imprecise science and reflects significant judgmental factors. In many liability cases, significant periods of time, ranging up to several years or more, may elapse between the occurrence of an insured loss, the reporting of the loss and the settlement of the loss. In fact, approximately 50% of our loss reserves at December 31, 1993 were for claims that had not yet been reported to us, some of which were not yet known to the insured, and for future development on reported claims. Judicial decisions and legislative actions continue to broaden liability and policy definitions and to increase the severity of claim payments. As a result of this and other societal and economic developments, the uncertainties inherent in estimating ultimate claim costs on the basis of past experience have increased significantly, further complicating the already difficult loss reserving process. The uncertainties relating to asbestos and toxic waste claims on insurance policies written many years ago are exacerbated by judicial and legislative interpretations of coverage that in some cases have tended to erode the clear and express intent of such policies and in others have expanded theories of liability. The industry is engaged in extensive litigation over these coverage and liability issues and is thus confronted with a continuing uncertainty in its effort to quantify these exposures. Our most costly asbestos exposure relates to an insurance policy issued to Fibreboard Corporation by Pacific Indemnity Company in 1956. In 1993, Pacific Indemnity Company, a subsidiary of the Corporation, entered into a global settlement agreement with Continental Casualty Company (a subsidiary of CNA Financial Corporation), Fibreboard Corporation, and attorneys representing claimants against Fibreboard for all future asbestos-related bodily injury claims against Fibreboard. This agreement is subject to court approval. Pursuant to the global settlement agreement, a $1.525 billion trust fund will be established to pay future claims, which are claims that were not filed in court before August 27, 1993. Pacific Indemnity will contribute approximately $538 million to the trust fund and Continental Casualty will contribute the remaining amount. In December 1993, upon execution of the global settlement agreement, Pacific Indemnity and Continental Casualty paid their respective shares into an escrow account. Upon final court approval of the settlement, which could take up to two years or more, the amount in the escrow account, including interest earned thereon, will be transferred to the trust fund. All of the parties have agreed to use their best efforts to seek court approval of the global settlement agreement. Although it is likely that this agreement will be challenged, management is optimistic that the courts will approve the settlement. Pacific Indemnity and Continental Casualty have reached a separate agreement for the handling of all pending asbestos-related bodily injury claims against Fibreboard. Pacific Indemnity's obligation under this agreement is not expected to exceed $635 million, most of which is expected to be paid over the next two years. The agreement further provides that the total responsibility of both insurers with respect to pending and future asbestos-related bodily injury claims against Fibreboard will be shared between Pacific Indemnity and Continental Casualty on an approximate 35% and 65% basis, respectively. Pacific Indemnity, Continental Casualty and Fibreboard have entered into a trilateral agreement, subject to court approval, to settle all present and future asbestos-related bodily injury claims resulting from insurance policies that were, or may have been, issued to Fibreboard by the two insurers. The trilateral agreement will be triggered if the global settlement agreement is disapproved. Pacific Indemnity's obligation under the trilateral agreement is therefore similar to, and not duplicative of, that under those agreements described above. The trilateral agreement reaffirms portions of an agreement reached in March 1992 between Pacific Indemnity and Fibreboard. Among other matters, that 1992 agreement eliminates any Pacific Indemnity liability to Fibreboard for asbestos-related property damage claims. Pacific Indemnity, Continental Casualty and Fibreboard have requested a California Court of Appeal to delay its decisions regarding asbestos-related insurance coverage issues, which are currently before it and involve the three parties exclusively, while the approval of the global settlement is pending in court. Continental Casualty and Pacific Indemnity have dismissed disputes against each other which involved Fibreboard and were in litigation. Prior to the settlement, the Corporation's property and casualty subsidiaries had paid $40 million and had existing loss reserves of $545 million to cover a portion of their obligation under these agreements. This amount included $300 million of general liability incurred but not reported (IBNR) reserves which were not previously classified as specific reserves for asbestos claims since it was management's belief that doing so would increase the demands of plaintiffs' attorneys. Additional loss reserves of $675 million were provided in the third quarter of 1993 at the time the settlement was negotiated. Management believes that, as a result of the global settlement agreement and the trilateral agreement, the uncertainty of our exposure with respect to asbestos-related bodily injury claims against Fibreboard has been greatly reduced. However, if both the global settlement agreement and the trilateral agreement are disapproved, there can be no assurance that the loss reserves established for future claims would be sufficient to pay all amounts which ultimately could become payable in respect of future asbestos-related bodily injury claims against Fibreboard. Other than Fibreboard, our remaining asbestos exposures are mostly limited to peripheral regional defendants, principally distributors. We continue to receive new asbestos claims and new exposures on existing claims as more peripheral parties are drawn into litigation to replace the now defunct mines and bankrupt manufacturers. The recent claims are complex in that they include significant and yet unresolved liability issues. Further, we still do not know the universe of potential claims. Hazardous waste sites are another significant potential exposure. Under the existing "Superfund" law and similar state statutes, when potentially responsible parties (PRPs) fail to handle the clean-up, regulators will have the work done and then attempt to establish legal liability against the PRPs. The PRPs, with proper government authorization in many instances, disposed of toxic materials at a waste dump site or transported the materials to the site. Most sites have multiple PRPs. As the cost of environmental clean-up continues to grow, PRPs and others continue to file claims with their insurance carriers. Insurance policies issued to PRPs were not intended to cover the clean-up costs of pollution and, in many cases, did not intend to cover the pollution itself. Pollution was not a recognized hazard at the time many of these policies were written. In some cases, however, more recent policies specifically excluded such exposures. Ensuing litigation extends to issues of liability, coverage and other policy provisions. There is great uncertainty involved in estimating our liabilities related to these claims. First, the underlying liabilities of the claimants are extremely difficult to estimate. At any given clean-up site, the allocation of financial responsibility among the governmental authorities and PRPs varies greatly. Second, various courts have addressed liability and coverage issues regarding pollution claims and have reached inconsistent conclusions in their interpretation of several issues. These significant uncertainties are not likely to be resolved in the near future. Uncertainties also remain as to the Superfund law itself. The law, which is subject to reauthorization in 1994, has generated far more litigation than it has provided clean up. The Clinton Administration has recently unveiled its plan for rewriting the Superfund law. The proposal creates a new Superfund insurance trust and includes a new non-judicial arbitration process aimed at removing Superfund disputes from the courts. It also creates a new tax on commercial insurance companies to be used to fund the trust and to settle Superfund related lawsuits between PRPs and their insurers. It also provides for some relaxation of clean-up standards under certain conditions. We view this proposal as a positive first step. However, it does not yet come close to achieving its essential objectives -- resolving 90% of Superfund claims in litigation at a cost which is fair and affordable to the insurance industry. It is important to note that the proposal does not address non-Superfund site cases. For that reason, it does not cover all existing toxic waste litigation, for example, sites that are subject to state law only. Litigation costs continue to escalate, particularly for toxic waste claims. A substantial portion of the funds expended to date has been for legal fees incurred in the prolonged litigation of coverage issues. Many policies provide an indemnity policy limit but an unlimited contract for defense costs. This language in the policy sometimes leads to the payment of defense costs in sizable multiples of the policy limits. Reserves for asbestos and toxic waste claims cannot be estimated with traditional loss reserving techniques. Case reserves and costs of related litigation have been established where sufficient information has been developed to indicate the involvement of a specific insurance policy. In addition, IBNR reserves have been established to cover additional exposures on both known and unasserted claims. These reserves are continually reviewed and updated. Other than the $675 million increase in loss reserves related to the Fibreboard settlement and the reclassification of $300 million of general liability IBNR reserves as specific reserves for this settlement, the increase in loss reserves relating to asbestos and toxic waste claims was $101 million in 1993 compared with $120 million in 1992 and $88 million in 1991. Further increases in such reserves in 1994 and future years are possible as legal and factual issues concerning these claims are clarified, although the amounts cannot be reasonably estimated. During 1993, due to the $675 million increase in loss reserves related to the Fibreboard settlement, we experienced overall unfavorable development of $665 million on loss reserves established as of the previous year-end. This compares with favorable development of $28 million and $29 million in 1992 and 1991, respectively. Such deficiency and redundancies were reflected in operating results in these respective years. Excluding the effect of the $675 million increase in loss reserves related to the Fibreboard settlement, we experienced favorable development of $10 million during 1993. Each of the past three years benefited from favorable claim frequency and severity trends for certain liability classes; this was offset each year in varying degrees by increases in loss reserves relating to asbestos and toxic waste claims. Management believes that the aggregate loss reserves of the property and casualty subsidiaries at December 31, 1993 were adequate to cover claims for losses which had occurred, including both those known to us and those yet to be reported. In establishing such reserves, management considers facts currently known and the present state of the law and coverage litigation. However, given the expansion of coverage and liability by the courts and the legislatures in the past and the possibilities of similar interpretations in the future, particularly as they relate to asbestos and toxic waste claims, as well as the uncertainty in determining what scientific standards will be acceptable for measuring hazardous waste site clean-up, additional increases in loss reserves may emerge which may adversely affect results in future periods. This emergence cannot reasonably be estimated. INVESTMENTS AND LIQUIDITY Investment income after taxes increased 8% in 1993 compared with 6% in 1992. Growth was primarily due to significant increases in invested assets, which reflected strong cash flow from operations over the period, offset in part by lower yields on new investments. The effective tax rate on our investment income was 14.7% in 1993 compared with 14.3% in 1992 and 15.3% in 1991. The increase in the effective tax rate in 1993 was due to the increase in the federal corporate tax rate from 34% to 35%, offset in part by holding a larger proportion of tax-exempt securities in our investment portfolio. In 1992, the effective tax rate decreased due to our holding a larger proportion of tax-exempt securities in our investment portfolio. Generally, premiums are received by our property and casualty subsidiaries months or even years before we pay the losses under the policies purchased by such premiums. These funds are used first to make current claim and expense payments. The balance is invested to augment the investment income generated by the existing portfolio. Historically, more than sufficient funds have been provided from insurance revenues to pay losses, operating expenses and dividends to the Corporation. Cash available for investment was approximately $480 million in 1993 compared with $655 million in 1992 and $730 million in 1991. The decrease in 1993 was due to the $538 million paid in December into an escrow account related to the Fibreboard settlement. The main objective of the investment portfolio of the property and casualty companies is to provide maximum support to the insurance underwriting operations. Investment strategies are developed based on many factors including underwriting results and our resulting tax position, fluctuations in interest rates and regulatory requirements. In 1993 and 1992, we invested new cash primarily in tax-exempt bonds. In each year we tried to achieve the appropriate mix in our portfolio to balance both investment and tax strategies. In 1993, we reduced our taxable bond portfolio by approximately $225 million and increased our short-term investments. The property and casualty subsidiaries have consistently invested in high quality marketable securities. Taxable bonds in our domestic portfolio comprise U.S. Treasury, government agency and corporate issues. Approximately 90% of our taxable bonds are either backed by the U.S. government or rated AA or better by Moody's or Standard & Poor's. Of the tax-exempt bonds, practically all are rated A or better, with approximately half rated AAA. Both taxable and tax-exempt bonds have an average maturity of 9 years. Actual maturities could differ from contractual maturities because borrowers may have the right to call or prepay obligations. Common stocks are high quality and readily marketable. Foreign investments are managed to provide liquidity to support insurance operations outside of the United States, while minimizing our exposure to currency fluctuations. The property and casualty subsidiaries maintain sufficient investments in highly liquid, short-term securities at all times to provide for immediate cash needs. At year-end 1993, such investments were at a higher than normal level so that funds are readily available to pay amounts related to the Fibreboard settlement. The Corporation maintains bank credit facilities that are available to respond to unexpected cash demands. LIFE AND HEALTH INSURANCE Life and health insurance earnings after taxes were $63 million in 1993 compared with $56 million in 1992 and $51 million in 1991. Premiums and policy charges were $801 million in 1993 compared with $689 million in 1992 and $634 million in 1991. PERSONAL INSURANCE Earnings from personal insurance were $37 million in 1993 compared with $34 million in 1992 and $33 million in 1991. Earnings increased in 1993 primarily due to an increase in the spread between interest earned on our invested assets and interest credited to policyholders on interest-sensitive products. Earnings in 1992 were adversely affected by higher mortality experience, primarily in our universal life and term life products. As the result of various adjustments, the tax rate on personal insurance earnings was 26%, 18% and 28% in 1993, 1992 and 1991, respectively. Premiums and policy charges amounted to $240 million in 1993 compared with $214 million in 1992 and $192 million in 1991. New sales of personal insurance as measured by annualized premiums were $88 million in 1993 compared with $71 million in 1992 and $54 million in 1991. Marketing initiatives conducted with our property and casualty insurance distribution system together with the increasing popularity of variable universal life products have contributed to our growth. GROUP INSURANCE Earnings from group insurance were $26 million in 1993 compared with $22 million in 1992 and $18 million in 1991. Group health rate levels have kept pace with medical costs over this three year period. Group life insurance, which is primarily marketed as an ancillary product to group health insurance, contributed modestly to earnings in each of the last three years. Premiums were $561 million in 1993 compared with $475 million in 1992 and $442 million in 1991. New group sales as measured by annualized premiums were $323 million in 1993 compared with $118 million in 1992 and $161 million in 1991. Approximately 80% of our group health premiums are written in New York and New Jersey. Both states have adopted legislation which eliminates health insurance underwriting, creates community based rating and limits pre-existing condition exclusions for insured groups with fewer than 50 covered lives. As the result of this legislation, we had anticipated a reduction in premium and sales levels in 1993. However, we were able to offer a competitive product in New York, which is our major market, at a time when several insurers reduced their market share, resulting in substantial increases in premiums and sales. Sales decreased in 1992 due to our adherence to disciplined pricing as well as state legislative actions which disrupted our markets in several jurisdictions. We expect higher levels of competition in the small group market in 1994 and, as a result, anticipate that we will experience a reduction in premium and sales levels. Enacted and contemplated health care reform on both a national and state level are reshaping the health insurance industry. Federal legislation on health insurance is being considered which, if enacted, could create less favorable conditions for the health insurance industry. Significant changes are not expected to become operational for some time. It is currently not possible to predict the long term impact of health care reforms on our business. We believe that traditional indemnity plans will be a less viable product option in the long term for both the consumer and the companies selling such plans. Recognizing this, we have accelerated our involvement in managed care and also worked to lessen our dependence on medical premium. The most visible action we have taken in 1993 is the development of ChubbHealth Inc., a health maintenance organization that will serve the New York City metropolitan area. ChubbHealth is in the final stages of licensing and will be operational during the first half of 1994. We have also increased our emphasis on managed care outside New York by offering preferred provider organizations, which are networks of hospitals, clinics and doctors that offer cost savings compared with traditional indemnity plans. Ancillary coverages, like dental, long-term disability and group life, complete the product offering to this market segment. INVESTMENTS AND LIQUIDITY Gross investment income increased 7% in 1993 compared with 8% in 1992. Premium receipts in excess of payments for benefits and expenses, together with investment income, continue to provide cash for new investments. New cash available amounted to $225 million in 1993 compared with $120 million in 1992 and $115 million in 1991. The increase in new cash in 1993 was due to the significant increase in group health premiums and to new single premium sales. In 1993 and 1992, new cash was invested primarily in mortgage-backed securities and corporate bonds. We invest predominantly in investment grade current coupon fixed-income securities with stable cash flow characteristics and maturities which are consistent with life insurance reserve requirements. Approximately 95% are investment grade and nearly half are rated AAA. We maintain sufficient funds in short-term securities to meet unusual needs for cash. REAL ESTATE DEVELOPMENT Real estate operations resulted in a loss after taxes of $2 million in 1993 compared with income of $10 million in 1992 and $25 million in 1991. Earnings were adversely affected by progressively higher portions of interest costs being charged directly to expense rather than being capitalized and by provisions each year for possible uncollectible receivables related to mortgages. Results were also adversely affected in 1993 by a $3 million tax charge related to the federal corporate tax rate increase. Revenues were $161 million in 1993 compared with $150 million in 1992 and $141 million in 1991. Our commercial real estate activities centered around acquiring suburban, multi-site land parcels in locations considered prime for office development, and then developing the land in progressive stages. We expanded our activities to include a few metropolitan office building projects. We develop real estate properties ourselves rather than through third party developers. We are distinguished from most other real estate developers in that we coordinate all phases of the development process from concept to completion. Upon completion of development, the properties may be either owned and operated for our own account or sold to third parties. We directly manage virtually all of the properties which we either own or have sold and retained interests in through secured loans. Our continuing investment interests in joint ventures generally consist of the ownership and lease of the underlying land and the management and operation of the buildings. Our agreements with joint ventures to manage all aspects of the ventured properties, including debt structures, tenant leasing, and building improvements and maintenance, have put us in a strong position to protect our ongoing financial interests in the current difficult real estate environment. The real estate industry continues to suffer from a significantly reduced demand for real estate investment. For the past several years, the supply of available office space has exceeded the demand. The slowdown in the economy exacerbated the problem as businesses consolidated their facilities, increasing the supply of available space. While selected real estate markets have experienced increases in leasing activity and some stability in rental rates, the oversupply of available office space for lease in most markets and the resultant depressed rental rates will continue to cause downward pressure on the earnings of the real estate industry. In light of the current real estate market conditions, we have curtailed our construction of new office buildings in recent years. In 1991 and 1992, we completed high-rise office buildings in Washington, D.C. and New Jersey, which are currently approximately 95% leased. Also, in 1991, we acquired a 1.2 million square foot office building, which is 87% leased, and adjacent land in Dallas for approximately $200 million, which includes a $114 million assumed mortgage. In 1993, we focused on completing and leasing newly-constructed facilities and maintaining established properties at high occupancy levels. We also commenced construction on three new suburban office buildings in locations where there are indications of tenant interest. Other than this new construction, development activities consist almost exclusively of preconstruction type efforts such as site planning, zoning and similar activities. As a consequence, we expect revenues for the next several years to come from ongoing income from owned properties and from management and financing activities related to previously sold properties or properties held in joint ventures. This does not preclude us from entertaining proposals to purchase our properties when such offers provide a reasonable return. Our vacancy rates are better than the average in substantially all markets in which we operate. We have been successful in both retaining existing tenants and securing new ones and have not had significant credit problems with tenants. During 1993, a total of 1,710,000 square feet was leased compared with 1,790,000 square feet in 1992 and 1,402,000 square feet in 1991. At December 31, 1993, we owned or had interests in 10,915,000 square feet of office and industrial space. Our vacancy rate was 10% at year-end 1993 compared with 14% at year-end 1992 and 17% at year-end 1991. The high vacancy rate in 1991 was the result of several multi-year projects being completed in a difficult leasing market. The decreases in the vacancy rate in 1992 and 1993 were due to our ability to market a significant amount of the new space which became available in 1991. In certain markets, renewing leases in established buildings has been difficult as newly-constructed space is available nearby at similar rates. While we have experienced significant leasing activity over the past two years, we have had to enter into multiple year leases at depressed market rental rates. This, together with the lack of construction and transaction based activity, will place continued pressure on our real estate earnings for the next several years. We expect that in 1994 a larger portion of interest costs will be charged directly to expense as a result of several recently completed projects becoming fully operational during 1993 and development activities being curtailed at some of our office parks. Ultimate net realizable value for real estate assets is determined based on our ability to fully recover costs through a future revenue stream supported principally by rental revenues. In many instances, there currently is not an active market for commercial real estate. Therefore, the prices which might be realized if we were forced to liquidate such properties on an immediate sale basis would probably be less than the carrying values. In light of current market conditions and our intent and ability to hold properties for the long term, our primary focus is to ensure that we can recover our costs through ownership and operation rather than sale. Individual buildings and development sites are analyzed on a continuing basis with estimates made of both additional costs to be incurred to complete development where necessary and the estimated revenues and operating costs of the property in the future. The time value of money is not considered in assessing revenues versus costs. Revenue assumptions take into account local market conditions with respect to the lease-up periods, occupancy rates, and current and future construction activity. There are uncertainties as to the actual realization of the assumptions relative to future revenues and future costs. However, management does not believe there is any permanent impairment in real estate carrying values. The loans receivable issued in connection with our joint venture activities include primarily purchase money mortgages. Such loans, which represent only 2% of consolidated assets, are generally collateralized by buildings and land. The ultimate collectibility of such loans, of which no significant amounts are due in the near term, is evaluated continuously and appropriate reserves established. Our agreements to manage all aspects of the ventured properties have played a significant role in enabling us to control potential collectibility issues related to these receivables. We have had no significant foreclosures or in-substance foreclosures. The reserve for potential uncollectible amounts was increased by $22 million in both 1993 and 1992 and $9 million in 1991, principally related to loans on selected properties currently experiencing high vacancy rates. Management believes the reserve at December 31, 1993 adequately reflects the current condition of the portfolio; however, if conditions in the real estate market do not improve, additional reserves may be required. The fair value of these loans receivable is estimated through the use of valuation techniques which consider the net cash flows of the properties serving as the underlying collateral for the loans. The fair value of the loans represents a point-in-time estimate that is not relevant in predicting future earnings or cash flows related to such loans. The difference between the aggregate fair value of $394 million and the carrying value of $425 million at December 31, 1993 is not expected to be realized as we intend to hold the loan portfolio to maturity. Our Florida residential development activities continued during 1993. All but nine units at a 181 unit mid-rise condominium project completed in 1991 have been sold. We completed construction of a 120 unit oceanfront high-rise condominium during 1992. At year-end 1993, 103 units were sold. Construction of a 104 unit mid-rise condominium project commenced in 1993 with 41 units already under contract. Real estate activities are funded with short-term credit instruments, primarily commercial paper, as well as term loans and debt issued by the Corporation and Chubb Capital Corporation, a subsidiary of the Corporation. The weighted average interest cost on short-term credit instruments approximated 3.3% in 1993 compared with 4.6% in 1992 and 7.2% in 1991. The interest rates on term loans ranged from 4.3% to 9.9% in 1993. Cash from operations combined with the ability to utilize the Corporation's commercial paper facility will provide sufficient funds for 1994. Term loans and mortgages which become due in 1994 are expected in most cases to be refinanced under similar terms. CORPORATE The Corporation called for redemption on April 15, 1991 the $200 million of 5 1/2% convertible notes that were due in 1993. Prior to the redemption date, all but $85,000 of the notes were converted, resulting in the issuance of 4,687,123 shares of the Corporation's common stock. The Corporation has outstanding $150 million of unsecured 8 3/4% notes due in 1999. In each of the years 1995 through 1998, the Corporation will pay as a mandatory sinking fund an amount sufficient to redeem $30 million of principal. Chubb Capital has outstanding $100 million of unsecured 8 5/8% notes due in 1995, which are guaranteed by the Corporation. The proceeds have been used to support our real estate operations. In May 1991, Chubb Capital sold in the Eurodollar market $250 million of 6% subordinated notes due in 1998. The notes are guaranteed by the Corporation and exchangeable into its common stock. Of the proceeds, $150 million has been used to support our real estate operations. In February 1993, Chubb Capital sold $150 million of 6% notes due in 1998 and $100 million of 6 7/8% notes due in 2003. The notes are guaranteed by the Corporation. A substantial portion of the proceeds has been used to repay certain short-term debt and term loans incurred to support the real estate operations. In November 1991, the Corporation entered into a revolving credit agreement with a group of banks that provides for unsecured borrowings of up to $300 million. There have been no borrowings under this agreement. The agreement terminates on November 30, 1994 at which time any loans then outstanding become payable. Management anticipates that a similar credit agreement will replace this agreement. In November 1992, the Corporation and Sun Alliance partially reduced their investment in the shares of each other. The proceeds from our sale of Sun Alliance shares were approximately $230 million. The sales have not affected the ongoing business relationship between the Corporation's property and casualty subsidiaries and Sun Alliance. Investment income earned on corporate invested assets and interest expense not allocable to the operating subsidiaries are reflected in the corporate segment. Corporate income after taxes was $14 million in 1993 compared with $20 million in 1992 and $16 million in 1991. INVESTMENT GAINS AND LOSSES Investment gains were realized by the Corporation and its insurance subsidiaries in 1993, 1992 and 1991. Such gains before taxes consisted of the following: A restructuring of the equity security portfolio begun in 1992 resulted in significant realized investment gains in 1992 and 1993. In addition, approximately $75 million of investment gains were realized in 1992 from the Corporation's partial sale of its investment in Sun Alliance. Equity securities are reported in our financial statements at market value. The unrealized appreciation on such securities is reflected as a separate component of shareholders' equity, net of applicable deferred income tax. The Corporation and its insurance subsidiaries purchase long-term fixed maturity securities which have income, duration and credit quality characteristics which fit the long-range strategic plans of our businesses. We monitor the mix of taxable and tax-exempt fixed maturity securities in order to maximize after-tax returns. Those fixed maturity investments which may be sold prior to maturity to support our investment strategies, such as in response to changes in interest rates and the yield curve or to maximize after-tax returns, are considered available for sale and carried at the lower of the aggregate amortized cost or market value. At each of the last three year-ends, the aggregate market value of these securities has exceeded their amortized cost. Those fixed maturities which the Corporation and its insurance subsidiaries have the ability and intent to hold to maturity are considered held for investment and carried at amortized cost. A primary reason for the sale of fixed maturities in each of the last three years has been to improve our after-tax portfolio yield without sacrificing quality, where market opportunities have existed to do so. Declining interest rates and the resulting appreciation of our fixed maturity securities made it difficult to adjust our portfolio during those years without realizing significant investment gains. The significantly higher gains in 1993 were due to the sale of fixed maturities in the first half of the year as part of the realignment of our portfolio and in the latter part of the year to realize gains to partially offset the reduction of statutory surplus of the property and casualty subsidiaries resulting from the decrease in earnings related to the Fibreboard settlement. At December 31, 1993, 1992 and 1991, the unrealized market appreciation of our fixed maturity portfolio was $736 million, $523 million and $490 million, respectively. Such unrealized appreciation was not reflected in the consolidated financial statements. The 1993 amount comprises fixed maturities with gross unrealized appreciation aggregating $771 million and those with gross unrealized depreciation aggregating $35 million. FEDERAL INCOME TAXES The Omnibus Budget Reconciliation Act of 1993 was enacted in August 1993. One provision of the Act increased the federal corporate tax rate from 34% to 35%, retroactive to January 1, 1993. In addition to applying the higher tax rate to pre-tax income for 1993, the federal income tax provision for 1993 reflects the effect of the rate increase on deferred income tax assets and liabilities. This effect was a tax benefit of approximately $5 million. The effect on the various business segments was as follows: In 1992, property and casualty underwriting income after taxes included a benefit of $12 million resulting from a reversal of income tax reserves based on a settlement of prior years' taxes. Life and health insurance income after taxes included similar benefits of $5 million and $3 million in 1993 and 1992, respectively. The Tax Reform Act of 1986 requires the property and casualty subsidiaries to discount loss reserves for tax purposes as of January 1, 1987 and provides that the initial discount on such loss reserves be excluded from taxable income. The benefit of this exclusion amounted to $7 million in 1991 and $6 million in 1992. There was no similar benefit in 1993 since, for accounting purposes, the remaining "fresh start" benefit was recognized effective January 1, 1993 as part of the cumulative effect of the change in accounting principle upon the Corporation's adoption of the new accounting requirements for income taxes. The Corporation's federal income tax payments for 1991 and 1992 were $160 million and $175 million, respectively. Tax payments for 1993 are expected to approximate only $80 million due to the substantial underwriting loss resulting from the increase in loss reserves related to the settlement of asbestos-related litigation. NEW ACCOUNTING PRONOUNCEMENTS In 1993, the Corporation adopted Statement of Financial Accounting Standards (SFAS) No. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions, SFAS No. 109, Accounting for Income Taxes, and SFAS No. 113, Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts. These pronouncements and their effect on the consolidated financial statements are discussed in Note (2) of the Notes to Consolidated Financial Statements incorporated by reference from the Corporation's 1993 Annual Report to Shareholders. The Financial Accounting Standards Board has also issued SFAS No. 114, Accounting by Creditors for Impairment of a Loan, which is effective in 1995, and SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities, which is effective in 1994. These pronouncements, which will affect the Corporation's consolidated financial statements when adopted, are discussed in Note (1)(o) of the Notes to Consolidated Financial Statements incorporated by reference from the Corporation's 1993 Annual Report to Shareholders. SUBSEQUENT EVENTS In January 1994, the Los Angeles area experienced a major earthquake. Also, in January 1994, the Eastern and Midwestern parts of the United States experienced severe winter storms. Losses from these catastrophes are estimated to amount to $125 million net of reinsurance, including $90 million from the earthquake and $35 million from the storm activity. The effect of these catastrophe losses on after-tax earnings is expected to approximate $81 million, which will be reflected in the first quarter of 1994. Additional claims may be reported which could increase the estimate. ITEM 8. ITEM 8. CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Consolidated financial statements of the Corporation at December 31, 1993 and 1992 and for each of the three years in the period ended December 31, 1993 and the Report of Independent Auditors thereon and the Corporation's unaudited quarterly financial data for the two-year period ended December 31, 1993 are incorporated by reference from the Corporation's 1993 Annual Report to Shareholders, pages 40 through 63. 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 the Corporation's Directors is incorporated by reference from the Corporation's definitive Proxy Statement for the Annual Meeting of Shareholders on April 26, 1994, pages 2 through 5. Information regarding the executive officers is included in Part I of this report. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION Incorporated by reference from the Corporation's definitive Proxy Statement for the Annual Meeting of Shareholders on April 26, 1994, pages 14 through 30 other than the Performance Graph and the Organization and Compensation Committee Report appearing on pages 19 through 26. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Incorporated by reference from the Corporation's definitive Proxy Statement for the Annual Meeting of Shareholders on April 26, 1994, pages 6 through 9. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Incorporated by reference from the Corporation's definitive Proxy Statement for the Annual Meeting of Shareholders on April 26, 1994, pages 30 through 32. PART IV. ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENTS, SCHEDULES AND REPORTS ON FORM 8-K (a) 1. FINANCIAL STATEMENTS AND 2. SCHEDULES The financial statements and schedules listed in the accompanying index to financial statements and financial statement schedules are filed as part of this report. 3. EXHIBITS The exhibits listed in the accompanying index to exhibits are filed as part of this report. (b) REPORTS ON FORM 8-K There were no reports on Form 8-K filed during the last quarter of the period covered by this report. 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 into registrant's Registration Statements on Form S-8 Nos. 33-12208 (filed June 12, 1987), 33-29185 (filed June 7, 1989), and 33-30020 (filed July 18, 1989): 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 ANNUAL REPORT TO BE SIGNED ON ITS BEHALF BY THE UNDERSIGNED, THEREUNTO DULY AUTHORIZED. THE CHUBB CORPORATION (REGISTRANT) March 4, 1994 By /s/ DEAN R. O'HARE ---------------------------- (DEAN R. O'HARE, 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: THE CHUBB CORPORATION INDEX TO FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES COVERED BY REPORT OF INDEPENDENT AUDITORS (ITEM 14(A)) All other schedules are omitted since the required information is not present or is not present in amounts sufficient to require submission of the schedule, or because the information required is included in the financial statements and notes thereto. The consolidated financial statements and supplementary information listed in the above index, which are included in the Annual Report to Shareholders of The Chubb Corporation for the year ended December 31, 1993, are hereby incorporated by reference. CONSENT OF INDEPENDENT AUDITORS We consent to the incorporation by reference in this Annual Report (Form 10-K) of The Chubb Corporation of our report dated February 25, 1994, included in the 1993 Annual Report to Shareholders of The Chubb Corporation. Our audits also included the financial statement schedules of The Chubb Corporation listed in Item 14(a). These schedules are the responsibility of the Corporation'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 the Registration Statements (Form S-8: No. 33-12208, No. 33-29185, No. 33-30020, No. 33-49230 and No. 33-49232) of our report dated February 25, 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 The Chubb Corporation. /s/ ERNST & YOUNG New York, New York March 28, 1994 THE CHUBB CORPORATION SCHEDULE I CONSOLIDATED SUMMARY OF INVESTMENTS -- OTHER THAN INVESTMENTS IN RELATED PARTIES (IN THOUSANDS) DECEMBER 31, 1993 THE CHUBB CORPORATION SCHEDULE III CONDENSED FINANCIAL INFORMATION OF REGISTRANT BALANCE SHEETS -- PARENT COMPANY ONLY (IN THOUSANDS) DECEMBER 31, 1993 AND 1992 The condensed financial statements should be read in conjunction with the consolidated financial statements and notes thereto in the Corporation's 1993 Annual Report to Shareholders. THE CHUBB CORPORATION SCHEDULE III (CONTINUED) CONDENSED FINANCIAL INFORMATION OF REGISTRANT STATEMENTS OF INCOME -- PARENT COMPANY ONLY (IN THOUSANDS) YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 The Corporation and its domestic subsidiaries file a consolidated federal income tax return. The Corporation's federal income tax represents its share of the consolidated federal income tax under the Corporation's tax allocation agreements with its subsidiaries. The condensed financial statements should be read in conjunction with the consolidated financial statements and notes thereto in the Corporation's 1993 Annual Report to Shareholders. THE CHUBB CORPORATION SCHEDULE III (CONTINUED) CONDENSED FINANCIAL INFORMATION OF REGISTRANT STATEMENTS OF CASH FLOWS -- PARENT COMPANY ONLY (IN THOUSANDS) YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 In 1992, $401,634,000 of fixed maturities and equity securities was contributed at cost to a consolidated investment company subsidiary of the Corporation. In 1991, $199,915,000 of long term debt was converted into 4,687,123 shares of common stock of the Corporation. These noncash transactions have been excluded from the statements of cash flows. The condensed financial statements should be read in conjunction with the consolidated financial statements and notes thereto in the Corporation's 1993 Annual Report to Shareholders. THE CHUBB CORPORATION SCHEDULE V CONSOLIDATED SUPPLEMENTARY INSURANCE INFORMATION (IN THOUSANDS) * Property and casualty assets are available for payment of claims and expenses for all classes of business; therefore, such assets and the related investment income have not been identified with specific groupings of classes of business. Information as of December 31, 1993, 1992 and 1991 and for the years then ended is presented net of related reinsurance amounts. THE CHUBB CORPORATION SCHEDULE VI CONSOLIDATED REINSURANCE (IN THOUSANDS) THE CHUBB CORPORATION SCHEDULE IX CONSOLIDATED SHORT TERM BORROWINGS (IN THOUSANDS) - ------------------ (a) The maximum and average amounts outstanding during the period were based on month end balances. (b) The weighted average interest rate during the period was computed by dividing the actual interest cost by the average amount outstanding during the period. Notes payable to banks are obligations under revolving credit arrangements. Commercial paper and notes payable generally have terms ranging from thirty days to one year and are at interest rates generally extended to prime borrowers. THE CHUBB CORPORATION SCHEDULE X CONSOLIDATED SUPPLEMENTARY PROPERTY AND CASUALTY INSURANCE INFORMATION (IN THOUSANDS) YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 Information for the years ended December 31, 1993, 1992 and 1991 is presented net of related reinsurance amounts. THE CHUBB CORPORATION EXHIBITS (ITEM 14(A))

812427_1993.txt

812427_1993

1993

812427

ITEM 1. BUSINESS THE COMPANY The Company was formed in 1918 and was renamed Hoechst Celanese Corporation in February 1987. The Company manufactures and sells, principally to industrial customers, a diversified line of products including textile and technical fibers; acetate cigarette filter tow; specialty and bulk chemicals and pharmaceuticals; prescription drugs; crop protection products; veterinary pharmaceuticals and animal-feed additives; engineering plastics; polyethylene; presensitized offset printing plates; dyes and pigments; and polyester film. The Company's operations are currently segmented as follows: Chemicals; Fibers and Film; Specialties and Advanced Materials (comprised of the Advanced Materials Group and Specialty Chemicals Group); Life Sciences and Advanced Technology. The Company is wholly owned by Hoechst Corporation, which in turn is wholly owned by Hoechst Aktiengesellschaft ("Hoechst AG"), a large chemical company headquartered in Frankfurt, Federal Republic of Germany. Hoechst AG and its consolidated entities (the "Hoechst Group") consist of over 270 companies. The Hoechst Group operates in more than 120 countries. The Hoechst Group's sales in 1993 were approximately $27.7 billion. See "Certain Relationships and Related Transactions." The Hoechst Group is one of the largest manufacturers of prescription drugs and one of the four largest producers and marketers of chemicals and chemical-related products in the world. Beginning January 1, 1991, the Company consolidated Celanese Mexicana, S.A. ("Celmex"), a 40-percent-owned affiliate, in its financial statements. Hoechst Celanese with Hoechst AG owns 51 percent of the outstanding voting shares of Celmex. The Company previously accounted for Celmex under the equity method. In November 1993, the Company acquired 52.96 percent of the outstanding shares of Copley Pharmaceutical, Inc. ("Copley"), a generic drug manufacturer, in a tender offer for an aggregate purchase price of $546 million. The Company's principal executive offices are located at 1041 Route 202-206, Bridgewater, New Jersey 08807; its mailing address is Route 202-206, Post Office Box 2500, Somerville, New Jersey 08876-1258; and its telephone number is (908) 231-2000. DESCRIPTION OF BUSINESS SEGMENTS CHEMICALS SEGMENT This segment consists of Hoechst Celanese Chemical Group, Inc., the chemical operations of Celmex and the chemical operations of Celanese Canada Inc. ("Celanese Canada"), approximately 56% owned by the Company. The Company entered the petrochemical field in the United States in 1945, primarily to obtain supplies of acetic acid and related chemical raw materials for its fibers operations. As its internal chemical usage expanded and additional products were developed, the segment began selling chemicals to others. This segment employs approximately 4,100 people and produces more than 60 different chemicals. The segment produces chemicals by upgrading hydrocarbons such as ethylene, propylene, natural gas and butane. The hydrocarbon raw materials are purchased on the open market, principally under long-term contracts. The major chemicals produced fall into two broad product groups: (1) methyl chemicals, oxo-alcohols and solvents; and (2) acetyl chemicals, monomers and ethylene oxide/glycol. Methyl chemicals are principally used in plastics, polyesters, adhesives, solvents, synthetic lubricants, fuel additives and coatings. Ethylene oxide/glycol, oxo-alcohols and solvents are principally used in surfactants, coatings, rocket propellants, antifreeze, herbicides and polyesters. Monomers and acetyl chemicals are primarily used in water-based paints, adhesives, textile finishes, paper coatings, manufactured fibers, pharmaceuticals, herbicides and plastics. With respect to substantially all of its major products, this segment is either the largest or second largest United States merchant market supplier. Other major United States producers are: of methyl chemicals, Borden, Inc., E.I. duPont de Nemours & Co., Inc. ("duPont"), Georgia-Pacific Corporation and Hercules Incorporated; of alcohols, duPont, Eastman Chemical Products, Inc. ("Eastman"), Shell and Union Carbide Corporation; and of monomers and acetyl chemicals, BASF, duPont, Eastman, Quantum Chemical Corporation, Rohm and Haas Co. and Union Carbide Corporation. Celmex is the sole or a major Mexican producer of a variety of products including vinyl acetate, acetic acid, acetic anhydride, acrylates, and phthalic anhydride. A substantial portion of the chemical production of Celmex is sold in the export market, in competition with world producers. Celanese Canada is the sole or a major Canadian producer of acetic acid, acetic anhydride, formaldehyde, pentaerythritol and vinyl acetate monomer. A substantial portion of the chemical production of Celanese Canada is sold in the export market, in competition with world producers. Celanese Canada operates a world scale methanol unit at its Edmonton plant site in Alberta. The methanol operation is owned by Celanese Canada and the Company. Other major Canadian producers of methanol are Nova Corporation of Alberta and Methanex Corporation (formerly Ocelot Industries Ltd.). Utilizing both acquired and internally developed technology, the segment is continually working to upgrade its chemical processes to improve energy, raw material and capital utilization. By producing a number of its major chemicals at different plant locations, the segment attempts to avoid or minimize the effect of production disruptions at any one location. FIBERS AND FILM SEGMENT This segment is comprised of the following business areas: Textile Fibers, Technical Fibers and Polyester Resins and Films. The Fibers and Film segment employs approximately 17,200 people and operates plants in the United States and abroad. The major product lines include: polyester staple, filament, resins, monofilament, spunbond and film; acetate filament and tow; purified terephthalic acid ("PTA"); dimethylterephthalate ("DMT") and polybenzimidazole ("PBI"). The Company is one of the largest producers of manufactured fibers in the United States. It is also one of the leading producers of polyester film. The Company conducts research and development, manufactures, markets and sells a combination of branded and unbranded fibers and film products for a wide variety of end uses. The Company sells most of its fibers and yarns directly to textile mills, tire manufacturers, cigarette makers and other intermediate processors. Among the internationally registered trademarks are: Trevira(R), Celebrate!(R), Hostaphan(R) and Trespaphan(R). Polyester staple and filament, commonly recognized by their Trevira(R) trademark, are principally used in wearing apparel, upholstery, floor coverings, home furnishings, and woven and non-woven fabrics. Polyester staple and filament are also used in tires, belts, hoses, thread and plastic reinforcement. The Company is one of the largest producers in the United States of cellulose acetate products. Cellulose acetate flake is produced for sale or conversion to acetate tow for use in cigarette filters and to filament used in apparel and industrial applications. Polyester monofilament is used in zippers, conveyor belting and dryer and forming screen applications in the paper industry. Roofing and geotextile applications are the primary end uses for polyester spunbond. Polyester resins are primarily used in beverage, pharmaceutical and other containers and for the manufacture of polyester fibers. In 1991, the Company entered into a worldwide joint venture agreement with Hoechst AG and certain Mitsubishi companies to establish a joint venture for the production, marketing and sale of polyester film. The joint venture has regional centers in the United States, Germany and Japan. As provided by the joint venture agreement, the Company's polyester film business, in January 1992, was transferred to a partnership, the partners of which are subsidiaries of the Company and Mitsubishi. Hostaphan(R) polyester film, manufactured by the Company, is used in many consumer products including audio, video and computer tape; food packaging; solar window film; labels and decals; graphic arts film; photoresist; and other electronics applications. Trespaphan(R) polypropylene film is imported for resale from other companies in the Hoechst Group and is used in packaging, capacitors, pressure sensitive tape and electric motor insulators. The key raw materials used by the Fibers and Film segment in production are either supplied internally or purchased on the open market, generally under long-term contracts. Polyester fibers are produced from PTA or DMT, which are either purchased from other suppliers or produced by Cape Industries, 100% owned by the Company, and ethylene glycol which is purchased from other suppliers and is also produced by the Company. Acetate fibers are made principally from acetic anhydride produced mainly by the Company and from wood pulp purchased by the Company. See "Business-Raw Materials and Energy." Major manufactured polyester and acetate fibers competitors include: Allied- Signal, Inc., duPont, Eastman, ICI Americas, Inc. ("ICI"), Rhodia AG and Wellman, Inc. Major United States and foreign polyester film producers include: duPont, ICI, Toray Industries (America), Inc. and Teijin America, Inc. Competing producers of PTA and DMT in the United States are Amoco Chemicals Corporation and duPont, respectively. Celmex is the sole or a major Mexican producer of a variety of products including polyester high denier industrial yarn, industrial staple, textile staple and filament, carpet staple, textile nylon filament, industrial nylon filament, cellulose acetate flake, yarn, and cigarette filter tow, polyester bottle resin, laminated and printed film and bioriented polypropylene. Celanese Canada is the sole or a major Canadian producer of a variety of products including polyester, textile staple, carpet staple, cellulose acetate filament yarn, cellulose acetate flake and cigarette filter tow. A substantial portion of the fibers production of both Celmex and Celanese Canada is sold in export markets in competition with world producers. The Company (owning approximately a 30% interest) and China National Tobacco Company are involved in a joint venture that manufactures cellulose acetate tow for cigarette filters at a facility in Nantong, People's Republic of China. Two more joint venture manufacturing sites for the same product are under construction and expected to come on stream in late 1995. They are located at Kunming and Zhuhai, People's Republic of China. SPECIALTIES AND ADVANCED MATERIALS SEGMENT This segment consists of the Advanced Materials Group and Specialty Chemicals Group. This segment employs approximately 4,000 people and produces, imports and sells a wide variety of specialty products. Advanced Materials Group. The Advanced Materials Group produces a variety of high-performance engineering thermoplastics, including acetal copolymer sold under the trademarks Celcon(R) and Hostaform(R), Celanese(R) nylon 6/6 resins, thermoplastic polyester sold under the trademarks Celanex(R) and Impet(R), liquid crystal polymers sold under the trademark Vectra(R), long fiber- reinforced thermoplastics sold under the trademark Celstran(R) and thermo- plastic alloys sold under the trademark Vandar(R), as replacements for metals and other plastics in a wide variety of end uses. The Group's product lines also include Hostalen(R) GUR, ultra high molecular weight polyethylene. The Company produces the basic raw materials for Celcon(R), Celanex(R), Impet(R) and Vandar(R) resins and purchases them for Celanese(R) nylon 6/6 and Vectra(R) and Celstran(R) resins. Other major United States producers of one or more similar engineering thermoplastics are duPont, General Electric Company and BASF. The Group also resells Hostaflon(R) fluoropolymers manufactured by Hoechst AG.The Company participates in Fortron Industries, a joint venture (with a 50% interest; Kureha Chemical Industry Co., Ltd. ("Kureha") having a 50% interest). The joint venture has completed the construction of a plant to manufacture Fortron(R) polyphenylene sulfide. Since 1987 the Company has marketed Fortron(R) which is manufactured by Kureha. The Company participates in Polyplastics Co., Ltd. (with a 45% interest; Daicel Chemical Industries, Ltd. having a 55% interest) which produces and sells acetal copolymer, thermoplastic polyester resins and other polymeric products and in Ticona Polymerwerke GmbH (with a 41% interest; Hoechst AG having a 59% interest) which produces acetal copolymer resins marketed by both Hoechst AG and the Company. The Company also participates in Taiwan Engineering Plastics Co., Ltd. (with a 12% interest; Polyplastics Co., Ltd. having a 30% interest; Hoechst AG a 32% interest; Hoechst Taiwan Co., Ltd. a 1% interest; and Chang Chun Group a 25% interest) which produces and markets acetal copolymer resins. Specialty Chemicals Group. This Group's product lines include: textile dyes, organic pigments, colorant and additive masterbatches, resins, sodium hydrosulfite, surfactants, and other specialty chemicals which are mainly used in the textile, ink, pulp and paper, paint, coatings, plastics, personal care, detergent and food processing industries; organic intermediates used for synthesis of dyes, pigments, pharmaceuticals, cosmetics, agricultural chemicals, photochemicals, plastics, adhesives, and other chemical products; inorganic chemicals sold for broad industrial use, including pharmaceuticals, electrical and battery equipment and oil drilling; superabsorbent polymers used in personal care products; waxes and lubricants used for polish and plastics processing applications; a complete range of color and liquid photoresists and ancillaries used in the manufacture of internationally registered trademarks are: Remazol(R) dyes; Genapol(R) and Hostapon(R) surfactants; Sanwet(R) superabsorbent polymers (a registered trademark of Sanyo Chemical Industries, Ltd. licensed to the Company); and AZ(R) liquid photoresist. The Group also produces and sells Enco(R) printing systems which include presensitized printing plates, pre-press color proofing films and a complementary line of processing chemistry and equipment used by the graphic arts industry. The Group is among the leading suppliers of presensitized offset printing plates in the United States. Major U.S. competitors in offset printing plates are Minnesota Mining and Manufacturing Company, Polychrome Corporation, Eastman Kodak Co., duPont and Fuji Photo Film Company, Ltd. Aluminum for printing plates is purchased on the open market from a limited number of suppliers. The Group's product lines also include Sunette(R) (acesulfame K) a new high- intensity sweetener, Celgard(R) microporous membranes, Separex(R) gas membrane systems, and ultra fine polyolefin powders. LIFE SCIENCES SEGMENT This segment consists of Hoechst-Roussel Pharmaceuticals Incorporated ("HRPI"), Bulk Pharmaceuticals and Intermediates ("BPI") which includes the Pharmaceutical Production Division ("PPD"), Hoechst-Roussel Agri-Vet Company ("HRAVC") and Copley. This segment employs approximately 2,700 people. Its operations encompass the research and development, production and marketing of branded and generic prescription drugs, bulk pharmaceutical chemicals, veterinary pharmaceutical products, animal-feed additives and crop protection products. HRPI. The Company's prescription drug business is conducted through HRPI, a majority owned subsidiary. HRPI has two classes of common stock: Class R and Class H Common Stock. Class R Common Stock has 20% of the total voting rights and is owned entirely by Roussel-Uclaf, S.A. ("RU"), a French pharmaceutical company which is majority owned by Hoechst AG. Class H Common Stock has 80% of the total voting rights and is owned entirely by the Company. RU also owns warrants which, if exercised, would increase RU's interest in HRPI to 50% by 1994. The major products of HRPI are prescription drugs which are promoted by its field sales force to health professionals in physicians' offices, pharmacies, hospitals, group purchasing organizations and managed care organizations. Major products include: Altace(TM) (ramipril), Claforan(R) (cefotaxime sodium), DiaBeta(R) (glyburide), Lasix(R) (furosemide), Loprox(R) (ciclopirox olamine), Topicort(R) (desoximetasone), Dermatop(R) (prednicarbate) and Trental(R) (pentoxifylline). Altace(TM) is an ACE-inhibitor antihypertensive. Claforan(R) is an antibiotic used in the treatment of serious infectious diseases. DiaBeta(R) is an oral antidiabetic. Lasix(R) is a diuretic used for the mobilization of edema of varied origin. Loprox(R) is a topical antifungal. Topicort(R) is a high potency topical corticosteriod anti-inflammatory. Dermatop(R) is a mid-potency topical corticosteroid anti-inflammatory. Trental(R) is a hemorrheologic agent to relieve intermittent claudication (leg cramping pain associated with peripheral arterial disease). HRPI's major competitors include: for ACE-inhibitor antihypertensive, Merck & Co., Inc. and Bristol Myers Squibb; for diuretics, Merck & Co., Inc., SmithKline Beecham PLC and Hoffman-LaRoche Inc.; for oral antidiabetics, The Upjohn Company and Pfizer Inc.; for vasotherapeutics, Sandoz Corporation; for third generation cephalosporin antibiotics, Hoffman-LaRoche Inc., Glaxo, Inc., and Eli Lilly & Company; and for dermatologicals, Syntex Laboratories, Inc. and Schering-Plough Corporation. Active ingredients for HRPI's major products are produced by PPD or imported from Hoechst AG or RU. Formulation and packaging of most products are performed in the United States by HRPI under strict manufacturing practices governed by the United States Food and Drug Administration (the "FDA"). Other products are imported from companies in the Hoechst Group and are subject to the same FDA regulations. HRPI conducts research concentrated on the discovery of compounds which act on the central nervous system (e.g., Alzheimer's disease and schizophrenia) and those which treat diseases of the skin. At this time, HRPI is awaiting approval from the FDA of one new drug product. Approximately 22 additional products are in clinical investigation under FDA Investigational New Drug Applications. In addition, HRPI has the right of first refusal to market all future new Hoechst AG and RU pharmaceutical products in the United States. Copley. The company's generic drug business is conducted through its participation in Copley. Copley develops, manufactures and markets a broad range of off-patent prescription and over-the counter pharmaceuticals. BPI is a supplier of bulk analgesics, pharmaceutical bulk actives and pharmaceutical intermediates. The Company participates in BHC Company (with a 50% interest: Boots Company PLC having a 50% indirect interest) which manufactures and markets bulk ibuprofen. BHC's major competitor is Ethyl Corporation. BPI also manufactures acetaminophen for which its major competitors include Mallinckrodt Corporation and Rhone-Poulenc Corporation. PPD produces and supplies HRPI with active ingredients for DiaBeta(R), Lasix(R), Topicort(R) and Trental(R) products. HRAVC. HRAVC is a partnership between a wholly owned subsidiary of the Company (50%) and Uclaf Corporation (50%), which is indirectly wholly owned by RU. HRAVC is involved in developing and marketing animal health and crop protection products. It is anticipated that in 1994 the crop protection activities of HRAVC will be merged with NOR-AM Chemical Company, Inc. a wholly owned subsidiary of Schering Berlin Inc. The resulting partnership will be 60% owned by a wholly owned subsidiary of the Company. HRAVC's animal health products consist primarily of veterinary pharmaceuticals and animal-feed additives. HRAVC's crop protection products are used with four of the five major United States crops: wheat, soybeans, cotton and rice. HRAVC's products are promoted by a field sales force and primarily marketed through distributors. Animal health products are manufactured under tolling arrangements with HRPI and in some cases other toll manufacturers. The active ingredients for these products are imported from other companies in the Hoechst Group. ADVANCED TECHNOLOGY SEGMENT This segment consists of the Advanced Technology Group and includes research and development costs to seed and develop new businesses. These costs are not borne by any group and are shown separately beginning in 1993. Prior to 1993 this group was included in the Specialities and Advanced Materials segment. Emerging businesses are primarily based on products or processes that have been developed by the Company or other companies in the Hoechst Group. This segment employs 1,000 people. RESEARCH AND DEVELOPMENT The Company conducts research and development both independently and jointly with Hoechst AG and, additionally, has been a party to a broad research and development cost-sharing agreement with Hoechst AG since January 1, 1988. The Company is continuing to expand its own research and development activities in areas where specific developments for the United States market increase the Company's competitiveness. Research and development costs are included in expenses as incurred. The Company's research and development costs for 1993, 1992 and 1991 were $258 million, $262 million and $261 million, respectively. Management intends to maintain the Company's research and development expenditures in 1994 at approximately the same level as 1993. At December 31, 1993, approximately 2,000 employees, including approximately 1,000 professionals, were engaged in basic and applied research and development at the Company. These individuals work in coordination with the Hoechst Group's research and development personnel in the Federal Republic of Germany and other parts of the world. The Hoechst Group in turn has access to a significant portion of the Company's technology, know-how and patent rights. The Hoechst Group is one of the leading research-oriented chemical companies in the world, employing approximately 15,300 persons in its various research and development laboratories. Research and development expenditures of the Hoechst Group amounted to approximately $1.8 billion in 1993. Based on individual license agreements and the cost-sharing agreement, the Company has access to a significant portion of the Hoechst Group's technology, know-how and patent rights for the United States and other markets, including licenses for new developments. The Company's United States research and development facilities are located in Auburn Hills, Michigan (automotive plastic applications); Branchburg, New Jersey (photoresists); Bridgewater, New Jersey (pharmaceuticals); Charlotte, North Carolina (textile and technical fibers, specialty chemicals, separations products and polyester resins); Corpus Christi, Texas (chemicals, pharmaceutical intermediates and bulk actives); Coventry, Rhode Island (organic intermediates, dyes, pigments and specialty chemicals); Greer, South Carolina (polyester film); Winona, Minnesota (advanced materials); Florence, Kentucky (advanced materials); Portsmouth, Virginia (superabsorbent polymers) and Summit, New Jersey (advanced materials, polymers and engineering plastics). MARKETING AND COMPETITION The Company's products are generally sold in the United States directly or through distributors or agents. Foreign subsidiaries and affiliates sell principally through local sales personnel or agents. With the exception of products sold by the Life Sciences segment, the principal customers worldwide are other manufacturers which use the Company's products in a wide variety of industrial and consumer products. Products sold by the Life Sciences segment are primarily sold through wholesalers and distributors. In general, the Company sells its products in highly competitive worldwide markets. The number of competitors in a market or country and the Company's competitive position vary widely with the products and countries involved. See specific discussion of competitors in "Description of Business Segments" above. There is growing competition from private and state-owned industries in certain foreign countries in which there is an abundance of low-cost labor or raw materials. This competition has a direct or indirect effect on many product lines. For example, in the area of textile fibers, business is impacted by fabric and apparel imports into the United States, Canada and Mexico, particularly from the Far East. Depending upon the characteristics of the particular market, the Company competes on the basis of price, product quality and performance, technical support and customer service. Within the Chemicals and Fibers and Film segments, the Company competes primarily on the basis of price, product quality and performance. In general, Specialties and Advanced Materials products are sold based on product performance, technical support and, to a lesser extent, price. Life Sciences products compete based on product performance as well as technical support and expertise. The Company's business is affected to some degree by seasonality in the industries of its customers such as automotive, housing, agriculture, printing and textiles. The business is also sensitive to changes in the world economy, including changes in currency exchange rates. Operations outside the United States are subject to the economic and political risks inherent in the countries in which they operate. Additionally, the export and domestic markets can be affected significantly by import laws and regulations and energy cost differentials. During 1993, the Company's export sales from the United States were 12.3% of consolidated net sales. Indirect marketing activities of the Company are extended through technical and educational services, advertising and promotion. These activities reach each level of the manufacturing and distribution system, as well as consumers of apparel, home furnishings and industrial products. Product development and technical service personnel supplement direct sales efforts by assisting customers in using existing products and developing new ones. RAW MATERIALS AND ENERGY Most of the Company's products are made by chemically processing and upgrading several basic types of raw materials including petroleum hydrocarbons and derivatives, natural gas, wood pulp and aluminum. These derivatives include ethylene and paraxylene, which are primarily supplied by major United States and Canadian oil companies. Raw materials are purchased from affiliated and non- affiliated suppliers throughout the world. The Company's production facilities rely largely on coal, fuel oil, natural gas and electricity for energy. The Company currently has adequate supplies or access to sources of all purchased raw materials and energy for the foreseeable future. The Company does not consider itself dependent upon any one supplier for a material amount of its raw material or fuel purchases. However, in the United States, wood pulp (a raw material for cellulosics) is largely obtained from two suppliers, and Cape Industries is the sole supplier of DMT and is one of two suppliers of PTA used in the production of polyester. Celmex purchases the majority of its raw materials from Petroleos de Mexico. In addition, some active ingredients and other raw materials used by the Life Sciences segment, as well as the Specialty Chemicals and Advanced Technology Groups, are supplied by other companies in the Hoechst Group. GOVERNMENT REGULATIONS The pharmaceutical, agricultural and veterinary industries in the United States have for many years been subject to extensive regulations by the Federal government and to an increasing extent by state agencies, primarily as to product efficacy, safety, advertising and labeling. The general trend is toward more stringent regulations. Such regulations affect the cost of developing and marketing products. The Company believes it is in substantial compliance with all environmental, health and safety regulations and continues to devote attention to the health and safety of its employees and the protection of the public health and the environment in the regions where it operates. Such compliance has not had an adverse effect on the Company's competitive position or business. The Company cannot predict the effect of regulations which may be adopted in the future by governmental bodies responsible for air, water and solid waste pollution controls and employee and community health and safety. In November 1990, Congress passed, as part of the Omnibus Budget Reconciliation Act, legislation requiring pharmaceutical manufacturers to extend rebates to state Medicaid agencies based on each state's reimbursement of pharmaceutical products under the Medicaid program effective January 1, 1991. Medicaid rebates and related state programs reduced net sales and operating income by $26 million in 1993, $24 million in 1992 and $12 million in 1991. PATENTS AND LICENSES The Company owns, or is licensed under, more than 4,500 patents relating to its products and manufacturing processes, some of which are important to specific commercial operations. No single patent or group of patents is considered material to the business as a whole. The Company's principal licenses are either continuing licenses from third parties or relate to patents and know- how owned by other companies in the Hoechst Group. Generally in the latter cases, the licenses require no specific payment because, overall, the research and development costs have been shared. In cases where license fees are involved with the Hoechst Group, they are generally based on percentages of sales and do not require minimum payments. Management believes that the terms of such license agreements are similar to those competitively negotiated between unrelated parties. The Company has developed and acquired technical information and owns patents in the chemicals, fibers, life sciences, specialties and advanced materials fields, some of which have been licensed to affiliates and others worldwide. EMPLOYEES At December 31, 1993, worldwide employment for the Company was approximately 29,900. The Company employed about 9,000 persons outside the United States. In the United States, fewer than one-fourth of the plants and employees are organized by labor unions. Most labor agreements are for terms of three years. The Company offers comprehensive benefit plans for employees and their families and believes relations with employees are satisfactory. ENVIRONMENT The Company's worldwide operations are subject to environmental laws and regulations which impose limitations on the discharge of pollutants into the air and water and establish standards for the treatment, storage and disposal of solid and hazardous wastes. The Company believes that it is in substantial compliance with all applicable environmental laws and regulations. In 1993, combined worldwide expenditures, including third party and divested sites, for compliance with environmental control regulations and internal Company initiatives totaled $294 million, of which $149 million was for capital projects. In both 1994 and 1995, total annual environmental expenditures are expected to be approximately $300 million, of which $125 million is for capital projects. It is anticipated that stringent environmental regulations will continue to be imposed on the Company and the industry in general. Although the Company cannot predict expenditures beyond 1995, management believes that the current spending trends will continue. The Company may be subject to claims brought by Federal or state regulatory agencies or private individuals pursuant to statutory authority or common law. In particular, the Company has a potential liability under the Federal Comprehensive Environmental Response Compensation and Liability Act ("Superfund") and related state laws for investigation and cleanup costs at approximately 100 sites. At most of these sites, numerous companies, including either the Company or one of its predecessor companies, have been notified that the United States Environmental Protection Agency ("EPA"), state governing body or private individuals consider such companies to be potentially responsible parties under Superfund or related laws. The proceedings relating to these sites are in various stages. The cleanup process has not been completed at most sites and the status of the insurance coverage for most of these proceedings is in litigation. The Company has accrued its best estimate of its ultimate liability for investigation or cleanup costs, but, due to the many variables involved in such estimation, the ultimate liability may vary. Expenditures for investigation, clean up and related activities have been $31 million for the three years ended December 31, 1993 with expenditures in no year greater than $13 million. SEGMENT AND GEOGRAPHICAL INFORMATION See Note (14) of Notes to Consolidated Financial Statements for Segment and Geographical Information. ITEM 2. ITEM 2. PROPERTIES The Company owns and operates various manufacturing facilities within the United States and abroad. It also owns or leases facilities related to its operations such as warehouses, pipelines, tolling operations, research and development and sales offices. The Company's principal manufacturing facilities, which are owned by the Company (unless otherwise indicated), are summarized below: CHEMICALS SEGMENT: - ---------- *The methanol operation is owned by Celanese Canada and the Company. **Polyester film assets are owned by a partnership. See "Business--Description of Business Segments"(Item 1). Management believes that the Company's properties are suitable for its business and have adequate productive capacities to meet current and future business requirements. ITEM 3. ITEM 3. LEGAL PROCEEDINGS The Company is a defendant in a number of lawsuits, including environmental, product liability and personal injury actions. Certain of these lawsuits are or purport to be class actions. In some of these cases, claimed damages are substantial. While it is impossible at this time to determine with certainty the ultimate outcome of these lawsuits, management believes, based on the advice of legal counsel, that adequate provisions have been made for probable - ---------- * This facility is leased. losses with respect thereto and that the ultimate outcome will not have a material adverse effect on the financial position of the Company, but may have a material effect upon the results of operations in any given year. The Company was named in 1986, 1987, 1988 and 1991 as one of numerous defendants in fourteen lawsuits in the Twenty-First Judicial District Court, Parish of Livingston, Louisiana. These lawsuits arose out of shipments of allegedly toxic waste to a waste oil processing site in Livingston Parish, Louisiana. Claims totalling approximately $20 billion are being made against the defendants for property damages, personal injury and psychological and other damages. While a class consisting of approximately 3,000 plaintiffs has been certified by the court, it is difficult to assess the extent to which the Company may be liable, if at all, since individualized claims of class members are involved. However, considering the number of potentially responsible parties (over 80 defendants in each case), many of which are substantial corporations, and the Company's small proportion of the total volume of waste sent to the site (well under one percent), management believes, based on the advice of legal counsel, that its portion of such liability (including any site clean up costs) would not have a material adverse effect on the financial position of the Company or results of operations. Trial is expected to begin in late 1994. The Company is defending itself vigorously in these proceedings. In February 1990, Region IV of the EPA issued a notice of violation to the Company at its Rock Hill, South Carolina plant alleging that the plant is subject to the benzene fugitive emission standard promulgated by the EPA under the Clean Air Act in 1984. The Company learned in September 1990 that Region IV referred the matter to the United States Department of Justice ("DOJ") for consideration of the appropriateness of enforcement. Although the Company has voluntarily agreed to meet the fugitive emissions standard at this facility as soon as possible, it is the Company's position that the facility properly determined in 1984 that it qualified for an exemption from the standard and, therefore, enforcement and sanctions are not appropriate. The DOJ and the EPA filed a complaint in July, 1992 in U.S. District Court in Columbia, South Carolina, asking the Court to set a penalty of not more than $25,000 per violation per day. The Company asked the EPA and the DOJ to consider an Alternate Dispute Resolution ("ADR") and they rejected ADR. The Company is defending itself vigorously. In November 1993, the DOJ filed a complaint similar to the complaint described above with regard to the Company's plant in Narrows, Virginia. It is the Company's position that the Narrows plant also qualified for the same exemption that applied to the Rock Hill plant. The Company is defending itself vigorously. During the second quarter of 1991, it was discovered that the Aston, Pennsylvania facility of Custom Compounding, Inc., a company acquired in December 1990, required an air permit. The Company in December 1993 voluntarily entered into an Administrative Consent Order with the Pennsylvania Department of Environmental Resources that would require the payment over a period of time of a penalty of $300 thousand. In late June 1991, the Company entered into an agreement with the EPA to participate in a voluntary program known as the "Toxic Substances Control Act - Section 8 (e) CAP Program." Under this program, the EPA is allowing participating companies to conduct voluntary, retrospective self-audits, to submit newly discovered 8 (e) studies to the EPA and to pay a penalty of $6 thousand for each unreported study. Under the program, however, the total penalties to the Company cannot exceed $1 million. Based on the number of studies the Company's self-audit had identified by the end of August, 1992, it is now clear the Company's penalty, which is expected to be payable in mid to late 1995, will be the program's $1 million maximum amount. Under the terms of a December 1991 consent order with the City of Mount Holly, North Carolina (the "Consent Order"), the Company agreed with respect to its Mount Holly plant to meet certain effluent limits for its discharges to the City's water treatment plant and to upgrade its Mount Holly plant's pretreatment facility. The Consent Order establishes a date to "begin construction" of the pretreatment facility upgrade and requires the Company to pay a stipulated sum for each day it fails to comply with the schedule. The City has taken the position that the Company began construction late and has requested payment of $137 thousand. The Company disagrees with this position and, therefore, has not made such payment. The Company is a named defendant in twenty putative class actions, two of which have been certified as class actions as well as defendant in other non- class actions filed in nine states ("the Plumbing Actions"). In these lawsuits the plaintiffs typically seek recovery for alleged property damage to housing units, mental anguish from the alleged failure of plumbing systems, punitive damages, and, in certain cases, additional damages under the Texas Deceptive Trade Practices Act. The other defendants include United States Brass Corporation ("U.S. Brass")(formerly a wholly owned subsidiary of Household International, Inc.), Vanguard Plastics, Inc. ("Vanguard"), Shell Oil Company ("Shell") and E.I. duPont deNemours & Co., Inc. ("duPont"). Damage amounts are not specified. The plumbing systems were designed and manufactured primarily by U.S. Brass and Vanguard. The pipe was made from polybutylene resin supplied by Shell. The Company sold acetal copolymer resin and duPont sold acetal polymer resin to other companies who manufactured the fittings used in the plumbing systems. The class actions and the purported class actions are in the Superior Court of the State of Arizona in and for the County of Maricopa (two cases), in the Superior Court of the State of California for the Counties of San Diego (thirteen cases) and Stanislaus (one case), in the District Court of Clark County, Nevada (one case) and in the 2nd Judicial District Court of Washoe County, Nevada (one case), in the 164th Judicial District Court, Harris County, Texas (one case) and in the United States District Court for the Southern District of Texas (one case; filed, but not served). The Company does not believe its acetal copolymer was defective or caused the plumbing systems to fail. In many cases the Company's exposure may be limited by the fact that the other defendants and other responsible parties may be found liable in whole or substantial part or by invocation of the statute of limitations. The Company is defending itself vigorously in these actions. The Company has also commenced litigation against Household International, Inc. to recover, among other things, the portion of Plumbing Action judgements, settlements and expenses that are attributable to its former subsidiary, U.S. Brass. The Company and certain of its codefendants are currently involved in a nonbinding voluntary mediation effort relating to the plumbing claims with attorneys representing substantially all the plaintiffs in Texas cases and two uncertified nationwide class actions. This mediation seeks to settle the individual claims currently asserted in these Texas cases and to establish a nationwide framework for resolving future claims. However, it is currently too early to determine whether there will be any settlement of any of these pending or future claims, and, if there is a settlement, the manner in which it will be finally allocated among all the potentially responsible parties. Management believes that the Plumbing Actions are substantially covered by insurance. In September 1989, after being sued by one of its insurers in New York, the Company filed suit in the Superior Court of the State of Delaware in and for New Castle County against National Union Fire Insurance Co. of Pittsburgh, Pennsylvania, the primary general liability insurance carrier for the Company from April 1985 to May 1989 and a majority of the excess/umbrella carriers insuring the Company from 1978 to 1989, seeking a declaration that insurance coverage exists for these product liability claims. The insurers' New York action has been stayed and the Company's Delaware suit is proceeding. Negotiations with several of the carriers have resulted in settlement or agreements in principle to settle, resulting in substantial continuing coverage of the plumbing actions or cash payments for claims. There are ongoing discussions with several of the remaining insurers. Outside counsel believes that the Company has a substantial probability of prevailing in its litigation against the carriers. Management believes that the Plumbing Actions will not have a material adverse effect on the financial position of the Company, but may have a material effect upon the results of operations in any given year. See Note (15) of Notes to the Consolidated Financial Statements. In 1988 the Company was sued in Texas State Court by persons alleging injuries as a result of an explosion at the Pampa plant in November 1987. At various times since then the suit has been amended to add additional plaintiffs and to allege injuries resulting from exposure to chemicals either at the plant or in the surrounding environment as a result of plant activities. All explosion claims were settled in December 1990, but there remain approximately 900 "exposure" plaintiffs. Although many plaintiffs have not specified their alleged damages, those that have done so total in excess of $1.3 billion (including exemplary damages). The Santa Fe Railroad, also named as a defendant, has settled with plaintiffs for an undisclosed amount. The parties agreed on a case management order which provided for an initial trial of the claims of three families, chosen by plaintiffs as test cases, but with the agreement that any factual decisions in those cases would not have any effect on later cases. The claims of those families were abandoned by plaintiffs during a trial in the fall of 1993. A similar suit was filed by approximately 100 individuals ("Kingsmill" case) including many of the same plaintiffs, making similar exposure claims and claiming unspecified damages in Texas State court in Sweetwater (Nolan County) in September 1992. An agreement in principle to settle the remaining claims along with the Kingsmill claims has been negotiated with plaintiffs' lawyers. Management is of the opinion that any potential liability ultimately will be covered by insurance. The Company's insurance coverage for environmental matters is currently in litigation. A suit instituted by the Company, in February 1989, against certain of the Company's insurance carriers in the Superior Court, Somerset County, of the State of New Jersey, seeking coverage for environmental matters has been stayed in favor of a March 1989 suit in the Superior Court, Cleveland County, of the State of North Carolina, initiated by such insurance carriers. Both suits seek a determination whether certain of the Company's environmental liabilities are covered by insurance. Management believes that the Texas actions will not have a material adverse effect on the financial position of the Company 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 Not applicable. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA Note: This table should be read in conjunction with Management's Discussion and Analysis of Financial Condition and Results of Operations and the Financial Statements and Supplementary Schedules. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following sections should be read in conjunction with Note (14) of Notes to Consolidated Financial Statements for Segment and Geographical Information. RESULTS OF OPERATIONS 1993 COMPARED TO 1992 Net sales of $6,899 million in 1993 were 2%, or $145 million, below 1992 sales. Life Sciences sales were slightly higher than in 1992, but sales declined in all other operating segments. Chemicals segment sales were lower than 1992 as increased volumes were offset by lower selling prices as a result of continued overcapacity. Fibers and Film segment sales declined from 1992 as reduced export volumes and selling prices were slightly offset by improved domestic volumes. Textile Fibers sales were level compared to 1992. Higher acetate filament sales volumes and prices reflect continuing strength in the fashion industry. These improvements were offset by lower volumes in North American polyester filament and lower selling prices for polyester staple that resulted from increased competitive pressures. In Technical Fibers, sales volumes and prices were lower than in 1992 as filter product shipments to the Far East decreased and overall selling prices declined due to excess worldwide capacity and the strengthening of the dollar in Europe. Tire and MRG (mechanical rubber goods) volumes were lower as a result of the weak European economy, while increased spunbond sales reflected a stronger domestic roofing market. Polyester Resins and Films sales increased marginally over 1992 as packaging resin volumes increased due to higher demand, particularly in the Mexican market. After adjusting for the disposition of the high density polyethylene ("HDPE") business in 1992, Specialties and Advanced Materials sales improved as increased volumes offset lower selling prices. Specialty Chemicals sales were virtually unchanged as reduced selling prices, due to worldwide competitive pressures, and lower volumes, primarily in fine chemicals and printing products, were offset by increased selling prices and improved product mix for pigments and improved volumes for surfactants, electronic products, waxes, and superabsorbent materials. Within Advanced Materials, sales were higher as volumes increased for both high performance polymers and engineering thermoplastics due to general economic growth in their end use markets. Life Sciences sales were slightly higher as both price and volume improvements in crop protection and animal health, in part the result of new product introductions, offset lower full year pharmaceutical volumes. Fourth quarter pharmaceutical sales were higher than the prior 1993 quarters due to wholesaler purchases that normally would have occurred in the first quarter of 1994. Selling, General and Administrative expenses ("SG&A") for 1993 remained virtually the same as 1992 as improvements in Chemicals, Specialty Chemicals, and Advanced Materials offset unfavorable expenses in Fibers and Film. In addition, Fibers and Film SG&A includes a $50 million receipt in settlement of a litigation. Research and Development expenses of $258 million were slightly lower than in 1992. During 1993, the Company charged $29 million to operating income for restructuring (principally Mexican chemical operations), $19 million of which related to the write-down of property, plant and equipment. As part of an ongoing Fibers and Film Segment North American strategy, the company restructured its North American polyester fibers operations. During 1992, the Company charged $87 million to operating income for restructuring, $34 million of which related to the write-down of property, plant and equipment. An additional $15 million was charged to operations in 1992 for restructuring and regionalization of certain other businesses. Operating income of $360 million was $38 million, or 10%, lower than 1992. Improvements in the Fibers and Film and the Specialty and Advanced Materials segments were offset by lower Chemicals and Life Sciences segments operating income. Chemicals segment operating income declined from $210 million in 1992 to $88 million in 1993 due to several nonrecurring items. Operating income from continuing operations improved as manufacturing costs and product mix were favorable compared to the prior year. Operating income was reduced, however, due to 1993 restructuring charges and costs associated with a toxic tort suit involving the Pampa, Texas plant. Also, during 1992, Chemicals segment recorded income of $68 million related to the settlement of its Pampa insurance claims. Fibers and Film operating income improved by $117 million from $298 million in 1992 to $415 million in 1993. Textile Fibers operating income was relatively flat compared to 1992 as an increase in sales volume was offset by higher manufacturing costs. Technical Fibers operating income was lower than in 1992 primarily due to reduced shipments and lower selling prices of filter products. The decrease in Polyester Resins and Films operating income was due to increased manufacturing costs and higher raw material costs principally in Mexico. In addition, Fibers and Film 1993 operating income includes a $50 million receipt in settlement of a litigation while 1992 operating income included $87 million in restructuring costs. The Specialties and Advanced Materials segment operating income improved from $26 million to $58 million primarily due to higher volumes and lower selling and marketing expenses. Specialty Chemicals operating income was lower primarily due to increased manufacturing costs. Operating income increased significantly for Advanced Materials due to improved volumes and favorable manufacturing costs resulting from higher efficiencies and reduced maintenance expenses. Operating income in Life Sciences declined from $60 million in 1992 to $17 million in 1993 primarily due to reduced pharmaceutical sales and to research and development expenditures associated with strategic initiatives within the pharmaceuticals business. Beginning in 1993, the Company has segregated sales and costs associated with the Advanced Technology segment from segment sales and operating income of its operating segments. The Advanced Technology segment represents research and development costs to seed and develop new businesses. Prior to 1993 this group was included in the Specialties and Advanced Materials segment.These costs and results have not been borne by any operating group. When projects and/or businesses become viable, they are transferred to the appropriate operating segment. Equity in Net (Loss) Earnings of Affiliates declined by $12 million compared to 1992 primarily due to lower earnings by Japanese and German affiliates which reflect the continued sluggish economic conditions in those countries. Interest expense decreased $5 million, or 6%, primarily due to lower interest rates, particularly in Mexico. Interest and Other Income, net, was $22 million lower than in 1992 primarily due to lower interest income in 1993, the result of lower interest rates. In 1992, Interest and Other Income included a gain on the sale of the HDPE facility. The effective tax rate decreased to 35% in 1993 compared to 47% in 1992. The decrease is mainly attributable to the accounting change required by the Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" ("FAS 109"). The Company implemented Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" ("FAS 106"), effective January 1, 1992, and FAS 109 and Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits" (FAS 112), January 1, 1993. FAS 106, requires the Company to accrue the current cost of those benefits and resulted in a net after-tax cumulative charge of $141 million in the first quarter of 1992. FAS 109, which requires the asset and liability method of accounting for income taxes and the calculation of deferred taxes using enacted tax rates, resulted in a net after-tax cumulative charge of $31 million in 1993. In addition, by applying FAS 109, pre-tax operating income was reduced by $40 million due to the increase in depreciation and amortization expense resulting from the increased carrying amounts of assets and liabilities acquired in a purchase business combination. The increase in operating expense was offset by a lower deferred tax provision. FAS 112 requires recognition of postemployment benefits on an accrual basis and resulted in a net after-tax cumulative charge of $8 million in 1993. The effect of this change on 1993 earnings before the cumulative effect of accounting changes was not material. On November 11,1993, the Company purchased 52.96% of the outstanding shares of Copley Pharmaceutical, Inc. ("Copley") for approximately $546 million. Copley develops, manufactures and markets a broad range of off-patent prescription and over-the-counter pharmaceuticals. The acquisition was accounted for under the purchase method of accounting. Accordingly, the purchase price will be allocated to the assets acquired and liabilities assumed based on their estimated respective fair values as of the date of acquisition. The allocation of the purchase price will be finalized during 1994. The excess of cost over net assets acquired was approximately $510 million and is being amortized over its estimated life. The Company financed the acquisition through a revolving credit agreement with its parent, Hoechst Corporation. Copley's results of operations have been included in the Company's consolidated financial statements as of the date of acquisition. Copley's operations are not material in relation to the Company's consolidated financial statements and pro forma financial information, therefore, has not been presented. Copley is included in the Life Sciences segment. The following discussions and analyses of "1992 Compared to 1991" and "1991 Compared to 1990" have been restated to reflect Advanced Technology as a separate segment. 1992 COMPARED TO 1991 Net sales of $7,044 million for 1992 represented an increase of 3.7%, or $250 million, over 1991. Improvements in the Fibers and Film, Specialties and Advanced Materials and Life Sciences segments more than offset a decline in the Chemicals segment. Chemicals segment sales declined due to continued unfavorable selling prices, principally methanol and ethylene glycol/oxide, partially offset by domestic and export volume improvements, mostly acrylates and vinyl acetate monomer. In the Fibers and Film segment, 1992 full year sales increased due to improved volumes and, to a lesser extent, higher selling prices. Textile fibers sales were higher due to an increase in polyester staple, acetate filament and polyester textile filament prices. Volume improvements, primarily in polyester staple and spunbond, were partially offset by unfavorable acetate filament export volumes. Spunbond prices were lower due to increased competitive pressures. Strong fourth quarter sales contributed to 1992 increases in Technical Fibers. The improvement is attributable to higher sales volumes from filter products and the polyester high denier industrial fibers business units resulting from increased market demands. In Film and Fiber Intermediates, sales increased as a result of favorable pricing and higher volumes in polyethylene terephthalate film and packaging resins. Specialties and Advanced Materials segment sales were slightly higher, primarily due to volume improvements in superabsorbents, dyes and pigments, the last two increasing due to stronger apparel and automotive markets. Advanced Materials sales increased due to higher volumes in engineering thermoplastics and high performance polymers, the result of a general strengthening of the U.S. economy. These volume increases were partially offset by unfavorable selling prices due to competitive pressures. Life Sciences segment sales increased due to a strong fourth quarter. The heavy sales volumes were the result of significant wholesaler purchases which normally would have occurred in the first quarter of 1993. New product introductions in the crop protection and animal health area also contributed to the increase. Selling, general and administrative expenses were $946 million, an increase of $56 million, or 6.3%, from 1991. Selling, general and administrative expenses were higher as increased expenses within Life Sciences were partially offset by declines in the Fibers and Film and Specialties and Advanced Materials segments. Life Sciences expenses increased due to a field force expansion and higher costs to support new marketing programs. Research and Development expenses of $262 million were flat across all segments and unchanged from 1991 levels. The Company is restructuring its North American polyester fibers operations. As part of an ongoing North American strategy, Hoechst Celanese will install additional staple fiber capacity within Celanese Mexicana, S.A. This expansion should not result in a net increase in North American staple fiber capacity. The realignment of other polyester facilities in Canada and the United States is currently being studied. During 1992, $87 million has been charged to Fibers and Film operating income for restructuring, $34 million of which related to the write-down of property, plant and equipment. An additional $15 million has been established for restructuring and regionalization of certain other businesses. Operating income was $398 million, a decrease of $75 million, or 15.9%, from 1991. Excluding the effects of restructuring costs, all business areas within the Fibers and Film segment showed improvements in operating income and offset a decline in the Chemicals segment operating income. The favorability in operating income experienced by Textile Fibers was mainly due to sales improvements. Technical Fibers registered a modest improvement in operating income from increased sales. Film and Fiber Intermediates operating income was higher due to substantially improved sales volumes and, to a lesser extent, favorable raw materials costs (paraxylene and ethylene glycol). Although raw material costs were somewhat lower, Chemicals segment operating income declined as competitive pressures in the commodity chemicals market continued to have an adverse impact on selling prices and profit margins. Specialties and Advanced Materials segment operating income improved primarily due to higher sales volumes. In Specialty Chemicals, strong sales volumes were the main contributor to improved operating income. Improvements were also realized in Advanced Materials, which was aided by a strengthening in the automotive and electronics markets. Life Sciences segment operating income was relatively flat as fourth quarter sales volume improvements were offset by higher selling, general and administrative expenses. In addition to higher volumes of Trental(R) (pentoxifylline), Diabeta (R)(glyburide) and Altace(TM) (ramipril), earnings benefited from improved performance in the animal health and crop protection businesses. Equity in Net Earnings of Affiliates was $4 million, a decline of $14 million from the comparable 1991 period. The reduction is due, in part, to start up costs related to the Company's participation in a joint venture to manufacture and market bulk ibuprofen. In addition, lower volumes and increased price competition contributed to lower earnings by Japanese and German affiliates reflecting continued sluggish economic conditions in those countries. Interest expense declined $13 million to $81 million due primarily to lower interest rates, particularly in Mexico. Interest and other income, net, rose slightly to $74 million. The increase is predominantly due to gains realized on the sale of the HDPE facility and certain other cost investments, partially offset by lower 1992 interest income, the result of lower interest rates. The effective tax rate was 47.1% and 47.4% for 1992 and 1991, respectively. In November 1987, an explosion and fire caused severe damage resulting in the shutdown of the Chemical segment's Pampa, Texas plant. Rebuilding of the plant production facilities was completed in April 1989 with ancillary and support facilities completed in June of 1991. In 1989, the Company established a valuation allowance for any potential shortfall between the insurance claims and the ultimate insurance settlement. During the fourth quarter of 1992, the Company agreed to a settlement with its insurance carriers covering the explosion and business interruption claims. As a result of the settlement, approximately $68 million was credited to operating income. Effective January 1, 1992, the Company adopted the provisions of Statement of Financial Accounting Standards No. 106 "Employers' Accounting for Postretirement Benefits Other than Pensions" ("FAS 106") which decreased net income by $141 million, net of tax. See Note (12) of Notes to Consolidated Financial Statements. In the following discussion and analysis of "1991 Compared to 1990," 1990 is presented on a pro forma basis as if Celmex had been consolidated at January 1, 1990. 1991 COMPARED TO PRO FORMA 1990 FOR THE INCLUSION OF CELMEX Net sales of $6,794 million for 1991 increased $262 million, or 4%, from 1990 net sales. Sales increased in the Chemicals and Life Sciences segments, but were flat in the Fibers and Film and Specialties and Advanced Materials segments. Chemical segment sales improved due to higher selling prices and strong export sales volumes. However, sales prices have generally declined throughout the year, influenced by the decline in prices for purchased hydrocarbon feedstocks. Full year sales volumes were level as export volume improvement offset a decline in the domestic area. In the Fibers and Film segment, sales increased marginally as higher volumes offset lower selling prices. In Textile Fibers, polyester staple and filament volumes increased versus the prior year reflecting improved market conditions. Acetate filament and Trevira(R) Spunbond polyester geotextile and roofing products continued to operate at capacity levels. However, polyester staple selling prices were lower due to competitive and recessionary market conditions. Technical Fibers sales were level as higher filter products sales were offset by reductions in other product lines, particularly tire yarn and fabrics. Filter products sales improved in 1991 as strong worldwide demand for cigarette tow and acetate flake resulted in both higher sales prices and volumes. Although pricing improved marginally, sales volumes were lower for tire yarn and fabrics due to the continued sluggish economy, particularly in the automotive sector. In Film and Fiber Intermediates, higher volumes for polyester intermediates and packaging resins were offset by lower volumes for polyester film. Prices were lower for both film and intermediates. Specialty and Advanced Materials 1991 segment sales increased primarily due to increased sales in Specialty Chemicals. Specialty Chemicals experienced strong demand for fiber reactive dyes, superabsorbent materials and specialty and paper chemicals. Advanced Materials sales were slightly higher than the prior year due to higher sales of fluoropolymers. This increase was partially offset by slightly lower Engineering Plastics sales resulting from a weak domestic economy especially in the depressed automotive, electrical/electronics and housing industries. Life Sciences segment sales increased due predominantly to the continued strong sales of Diabeta(R) (glyburide), Trental(R) (pentoxifylline) and Claforan(R) (cefotaxime sodium) as well as sales from new products Altace/TM/ (ramipril) and Prokine/TM/ (sargramostim). Selling, general and administrative expenses (including research and development) were $1,151 million, an increase of $94 million, or 8.9%, from the comparable 1990 period. Selling, general and administrative expenses increased in all segments, but predominantly within Life Sciences and Specialties and Advanced Materials. Life Sciences expenses increased due to higher advertising and marketing expenses related to new products, Altace/TM /and Prokine/TM/, as well as additional personnel costs to support higher sales levels. Specialty and Advanced Materials segments expenses increased due to new business development and higher development costs. Operating income was $473 million, an increase of $37 million, or 8.5%, from the comparable 1990 period. Operating income improved significantly for the Chemicals and Life Sciences segments, remained flat for the Fibers and Film segment and declined in the Specialties and Advanced Materials segment. Chemicals segment operating income increased as higher sales and lower hydrocarbon feedstock costs more than offset higher manufacturing costs. Fibers and Film segment operating income was virtually unchanged from the prior year as improvement in the Celmex fibers and film businesses offset declines in the domestic businesses. Textile Fibers operating income declined as higher sales revenue was offset by higher manufacturing costs. Technical Fibers operating income was off slightly as unfavorable tire yarn results and higher manufacturing costs offset improvements in the filter products business. Film and Fiber Intermediates operating income improved due principally to lower hydrocarbon feedstock costs. Specialty and Advanced Materials segment operating income declined due to increased manufacturing costs. Life Sciences segment operating income improved as net sales more than offset increased selling, general and administrative and manufacturing costs. Equity in Net Earnings of Affiliates ($18 million) was virtually unchanged from 1990. Interest expense decreased $8 million to $94 million due primarily to a decline in Celmex's debt. Interest and other income, net, of $69 million represents a decrease of $62 million from 1990. The decrease resulted predominantly from a $20 million gain on the sales of businesses recognized during 1990 and a $28 million decrease in Celmex interest income in 1991. The effective tax rate for the full year 1991 was 47.4% compared to 45.8% for the comparable 1990 period. ENVIRONMENTAL In 1993, combined worldwide expenditures, including third party and divested sites, for compliance with environmental regulations and internal Company initiatives totaled $294 million of which $149 million was for capital projects. In both 1994 and 1995 total annual environmental expenditures are expected to be approximately $300 million of which $125 million is for capital projects. It is anticipated that stringent environmental regulations will continue to be imposed on the Company and the industry in general. Although the Company cannot predict expenditures beyond 1995, management believes that the current spending trends will continue. In 1993, 1992 and 1991 the total environmental costs charged to operations for remediation efforts amounted to $34 million, $46 million and $24 million, respectively. As of December 31, 1993 and 1992 the Company's total environmental liability recognized in the financial statements is $149 million and $156 million, respectively. The amounts are neither reduced for anticipated insurance recovery nor discounted from the anticipated payment date. In the opinion of management, environmental expenditures will not have a material adverse effect upon the Company's competitive position. INFLATION In recent years, inflation has not had a material impact on the Company's costs due principally to price competition among suppliers of raw materials. However, in certain segments of the Company's businesses, changes in the prices of raw materials, particularly petroleum derivatives, could have a significant impact on the Company's costs, which the Company may not be able to reflect fully in its pricing structure. RATIO OF EARNINGS TO FIXED CHARGES Ratio of earnings to fixed charges for 1993 was 3.6 compared to 4.0 for 1992. The ratio declined due to the decrease in operating income. For the purpose of calculating the ratio of earnings to fixed charges, earnings consist of earnings from operations before fixed charges, minority interests, income taxes and cumulative effect of accounting changes. Fixed charges consist of interest and debt expense, capitalized interest, interest on obligations under capital leases, the estimated interest portion of rents under operating leases and the majority-owned preferred stock dividend requirement. LIQUIDITY AND CAPITAL RESOURCES OF THE COMPANY Cash and cash equivalents of $171 million at December 31, 1993 represented a decrease of $42 million from 1992. The decrease primarily resulted from net cash used in investing activities of $978 million, partially offset by net cash provided by operating and financing activities of $537 million and $400 million, respectively. Investing activities in 1993 included expenditures for capital projects of $556 million compared with $592 million in 1992. In addition, as discussed above, the Company acquired 52.96% of the outstanding shares of Copley for approximately $546 million. The Company funded the purchase price with a loan under a revolving credit agreement with Hoechst Corporation ("Parent"). In 1993, the Company increased its commercial paper program from $250 million to $600 million to provide an additional source of financing flexibility. At December 31, 1993, there was no commercial paper outstanding. The Company has $600 million of committed domestic credit facilities, all of which were unused at December 31, 1993. These credit lines provide backup to the Company's commercial paper program. The Company also has a $750 million revolving credit agreement with its Parent. At December 31, 1993, the outstanding balance on this credit facility was $679 million, primarily the result of the Copley acquisition. In addition, the Company prepaid its 13% senior promissory notes and 8% notes in the amounts of $15 million and $7 million, respectively. In February 1993, the Company paid its Parent an $85 million dividend. The Company also declared a 1993 dividend of $70 million which was paid during the first quarter of 1994. The Company intends to continue its practice of paying a dividend to its Parent at the discretion of the Company's Board of Directors. On January 10, 1994, the Securities and Exchange Commission declared effective the Company's registration statement covering the offer and sale from time to time of its unsecured debt securities at an aggregate initial public offering price of not more than $650 million. On January 26, 1994, the Company issued $250 million of 6-1/8% Notes due February 2004. In March 1994, the Company also sold $100 million of its medium-term notes. The net proceeds from these transactions were used to repay a portion of the amount borrowed by the Company from its Parent. The Company may sell from time to time up to an additional $300 million of medium-term notes. The proceeds from any medium-term notes to be sold will be used for general corporate purposes. The Company expects that its capital expenditures, investments and working capital requirements will continue to be met primarily from internally generated funds from operations. However, the Company may, due to the timing of funding requirements or investments supplement its liquidity from external or affiliated sources. Such sources include the Company's medium-term note shelf registration, its commercial paper program or loans from its Parent or Hoechst AG and affiliates. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY SCHEDULES Index to Consolidated Financial Statements HOECHST CELANESE CORPORATION CONSOLIDATED BALANCE SHEETS See accompanying notes to consolidated financial statements. HOECHST CELANESE CORPORATION CONSOLIDATED STATEMENTS OF EARNINGS See accompanying notes to consolidated financial statements. HOECHST CELANESE CORPORATION CONSOLIDATED STATEMENTS OF STOCKHOLDER'S EQUITY See accompanying notes to consolidated financial statements. HOECHST CELANESE CORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS See accompanying notes to consolidated financial statements. HOECHST CELANESE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (A) PRINCIPLES OF CONSOLIDATION Hoechst Celanese Corporation (the "Company") is wholly owned by Hoechst Corporation ("Parent"), a holding company, itself a wholly owned subsidiary of Hoechst Aktiengesellschaft ("Hoechst AG"). The consolidated financial statements include the accounts of the Company and its majority owned subsidiaries, Celanese Mexicana, S.A. ("Celmex"), joint ventures and partnerships. All significant intercompany balances and transactions have been eliminated in consolidation. Certain reclassifications have been made in the 1992 consolidated financial statements to conform to the classifications used in 1993. Substantially all of the Company's minority interests are comprised of Celmex, Celanese Canada Inc. and Copley Pharmaceutical, Inc. On November 11, 1993, the Company purchased 52.96% of the outstanding shares of Copley Pharmaceutical, Inc. ("Copley") for approximately $546 million. Copley develops, manufactures and markets a broad range of off- patent prescription and over-the-counter pharmaceuticals. The acquisition has been accounted for under the purchase method of accounting. Accordingly, the Company will allocate the purchase price to the assets acquired and liabilities assumed based on their estimated respective fair values as of the date of acquisition. The allocation of the purchase price will be completed during 1994. The excess of costs over net assets acquired was approximately $510 million and is being amortized over its estimated life. The Company financed the acquisition through a revolving credit agreement with its Parent. Copley's results of operations have been included in the Company's consolidated financial statements as of the date of acquisition. Copley's operations are not material in relation to the Company's consolidated financial statements and pro forma financial information has therefore not been presented. (B) CASH EQUIVALENTS The Company considers all highly liquid investments with a maturity of three months or less to be cash equivalents. (C) INVENTORIES Inventories are stated at the lower of cost (first-in, first-out ["FIFO"] or last-in, first-out ["LIFO"]) or market. (D) INVESTMENTS AND EQUITY IN NET (LOSS) EARNINGS OF AFFILIATES In general, the Company's share of net earnings or losses of companies in which it owns at least 20% and less than a majority, and does not exercise management control, is included in the Consolidated Statements of Earnings as "Equity in net (loss) earnings of affiliates." (E) PROPERTY, PLANT AND EQUIPMENT Property, plant and equipment is stated at cost. Depreciation and amortization are computed on a straight-line basis over estimated useful lives. HOECHST CELANESE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) (E) PROPERTY, PLANT AND EQUIPMENT (CONTINUED) Amortization of leasehold improvements is provided on a straight-line basis over the estimated useful lives of the related assets or lease terms, whichever is shorter. Expenditures for maintenance and repairs are charged against operations; major replacements, renewals and significant improvements are capitalized. (F) INTANGIBLES Excess of cost over fair value of net assets of businesses acquired ("Goodwill") is being amortized using the straight-line method principally over periods of twenty-five and forty years. It is the Company's policy to review that the forecast cumulative, undiscounted cash flow of those acquired businesses is greater than the carrying value of the Goodwill. Amortization expense charged against operations amounted to $39 million in 1993, $37 million in 1992 and $38 million in 1991. Patents and trademarks are being amortized on a straight-line basis over their estimated useful or legal lives, whichever is shorter. Amortization expense charged against operations amounted to $15 million in 1993, $11 million in 1992 and $12 million in 1991. (G) INCOME TAXES The Company's consolidated results of operations are included in the consolidated Federal income tax return of its Parent. The Company's Parent allocates a provision for Federal income taxes equivalent to the tax effect on the operations of the Company as if a separate return were filed. Deferred income taxes have been provided to recognize the effect of temporary differences between financial statement and income tax accounting. The Company implemented Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" ("FAS 109"), effective January 1, 1993, which requires the asset and liability method of accounting for income taxes and the calculation of deferred taxes using the enacted tax rates in effect at the implementation date. HOECHST CELANESE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) (H) BENEFIT PLANS Pension costs for defined-benefit pension plans are computed in accordance with Statement of Financial Accounting Standards No. 87, "Employers' Accounting for Pensions" ("FAS 87"). Effective January 1, 1992, the Company adopted the provisions of Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" ("FAS 106"), which requires the Company to accrue the current cost of those benefits. Effective January 1, 1993, the Company adopted the provisions of Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits" ("FAS 112"). FAS 112 requires recognition of postemployment benefits on an accrual basis. (I) RESEARCH AND DEVELOPMENT COSTS Research and development costs are included in expenses as incurred. (J) FUNCTIONAL CURRENCIES In general, local currencies have been designated as the functional currencies for the Company's foreign operations. In Mexico, prior to 1993, the United States dollar was the functional currency. (K) NEW ACCOUNTING PRONOUNCEMENT Effective for years beginning after December 15, 1993, the Company is required to adopt the provisions of Statement of Financial Accounting Standards No. 115, "Accounting for Certain Investments in Marketable Equity and Debt Securities" ("FAS 115"). FAS 115 establishes standards of financial accounting and reporting for investments in equity securities that have readily determinable market values and for all investments in debt securities. The Company does not believe that the adoption of this standard will have a material impact on its financial position or results of operations. (2) RELATED PARTY TRANSACTIONS Purchases from Hoechst AG and its affiliates aggregated $495 million in 1993, $516 million in 1992 and $421 million in 1991. Net sales to Hoechst AG and its affiliates aggregated $216 million in 1993, $217 million in 1992 and $186 million in 1991. The Company's principal licenses are under patents owned by Hoechst AG and its affiliates. License fees, relating to license agreements between the Company and Hoechst AG and its affiliates, charged to operations, aggregated $48 million in 1993, $48 million in 1992 and $41 million in 1991. The Company has a revolving credit agreement with its Parent under which it may borrow up to $750 million. The Company has agreed to pay interest at 30 day LIBOR plus .0625 of 1%. During 1993 and 1992, HOECHST CELANESE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (2) RELATED PARTY TRANSACTIONS (CONTINUED) respectively, the Company borrowed $768 million and $90 million under this agreement. Repayments on the revolving credit agreements for 1993 and 1992, respectively, were $89 million and $90 million. Interest charges related to such borrowings aggregated $2 million in 1993 and $1 million in 1992. The outstanding balance on this credit facility was $679 million at December 31, 1993. There was no outstanding balance under this credit facility at December 31, 1992 and 1991. Note obligations payable to Parent aggregated $156 million at December 31, 1993 and $86 million at December 31, 1992. In 1991, the Company had note obligations payable to an affiliate of Hoechst AG which aggregated $8 million at December 31, 1991. Interest expense on these obligations aggregated $7 million in 1993, $2 million in 1992 and $1 million in 1991. Short-term note obligations payable to Parent aggregated $100 million at December 31, 1992. This obligation was repaid during 1993. No such obligations were outstanding at December 31, 1993. Interest expense on this obligation aggregated $6 million in 1993 and $2 million in 1992. As of December 31, 1992, the Company had an outstanding short-term loan to its Parent in the amount of $176 million. No such loan existed at December 31, 1993. Interest income on this loan was not material in 1992. (3) INVESTMENTS AND EQUITY IN NET EARNINGS (LOSS) OF AFFILIATES (IN MILLIONS, EXCEPT NUMBER OF AFFILIATES) HOECHST CELANESE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (4) INCOME TAXES Effective January 1, 1993, the Company adopted FAS 109 which requires the asset and liability method of accounting for income taxes, and deferred taxes are calculated using enacted tax rates. In addition, FAS 109 significantly changes the accounting for purchase business combinations. The provisions of FAS 109 have been applied without restating prior years' financial statements. Prior to FAS 109, acquired assets and liabilities in a purchase business combination were shown net of tax. Under FAS 109, these assets and liabilities are assigned their fair value and deferred taxes are provided on the difference between such value and their tax bases. Accordingly, in adopting FAS 109, the Company adjusted the carrying amount of the assets acquired and liabilities assumed in connection with the 1987 Celanese Corporation acquisition. The noncash effects from the application of FAS 109 were to increase Property, plant and equipment, $178 million; Investments in affiliates, $34 million; Other assets, $10 million and Other liabilities, $64 million. Pretax operating income for the year ended December 31, 1993 was reduced by $40 million due to the increase in depreciation and amortization expense resulting from the higher carrying amounts. The increase in operating expense was offset by a lower deferred tax provision. HOECHST CELANESE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (4) INCOME TAXES (CONTINUED) HOECHST CELANESE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (4) INCOME TAXES (CONTINUED) The tax effects of the temporary differences which give rise to a significant portion of deferred tax assets and liabilities as of December 31, 1993 are as follows: The cumulative effect of adopting FAS 109 as of January 1, 1993 amounted to $31 million and is included as part of the increase to deferred income taxes on the Consolidated Balance Sheets and a charge to the Consolidated Statement of Earnings as of December 31, 1993. The net adjustment represents the establishment of deferred taxes primarily due to differences between the book and tax bases of LIFO inventories and the adjustment of deferred taxes to reflect the currently enacted tax rate. A valuation allowance is provided when it is more likely than not that some portion or all of the deferred tax assets will not be realized. Based on the Company's historical and current pretax earnings, management believes it is more likely than not that the Company will realize the benefit of the deferred tax assets existing at December 31, 1993. Further, management believes the existing deductible temporary differences will reverse during periods in which the Company generates net taxable income. The financial reporting basis of investments in certain non-U.S. subsidiaries differs from their tax basis. In accordance with FAS 109, a deferred tax liability is not recorded on this temporary difference because the investments are essentially permanent in duration. A reversal of the Company's plans to permanently reinvest in these operations would cause such temporary differences to become taxable. At December 31, 1993 these temporary differences were approximately $424 million. A determination of the amount of unrecognized deferred tax liability related to these investments is not practicable. HOECHST CELANESE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (5) NET RECEIVABLES As of December 31, 1993 and 1992, the Company had no significant concentrations of credit risk. Concentrations of credit risk with respect to trade receivables are limited since the Company's customer base is dispersed across many different industries and geographies. In November 1987, an explosion and fire caused severe damage resulting in the shutdown of the Company's Pampa, Texas plant. Rebuilding of the plant production facilities was completed in April, 1989 with ancillary and support facilities completed in June, 1991. In 1992, as part of the rebuilding process, approximately $46 million was capitalized for safety and environmental enhancements. In 1989, the Company established a valuation allowance for any potential shortfall between the insurance claims and the ultimate insurance settlement. During the fourth quarter of 1992, the Company agreed to a settlement with its insurance carriers covering the explosion and business interruption claims. As a result of the settlement, approximately $68 million was credited to the operations of the Chemicals segment in the accompanying Consolidated Financial Statements. (6) INVENTORIES At December 31, 1993, $518 million ($566 million at December 31, 1992) of total inventories were valued by the LIFO method. During the first quarter of 1993, the Company changed its method of accounting for Celmex inventory from LIFO to FIFO. The impact of this change was to reduce the LIFO reserve by $16 million and increase net earnings by $4 million. The effect of this change is not material and prior years' financial statements have, therefore, not been restated. HOECHST CELANESE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (7) PROPERTY, PLANT AND EQUIPMENT, NET Interest costs capitalized in 1993, 1992 and 1991 were $21 million, $14 million and $10 million, respectively. (8) ACCOUNTS PAYABLE AND ACCRUED LIABILITIES (9) NOTES PAYABLE AND LONG-TERM DEBT HOECHST CELANESE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (9) NOTES PAYABLE AND LONG-TERM DEBT (CONTINUED) The Company has a commercial paper program aggregating $600 million. Included in "Commercial paper, notes payable and current installments of long-term debt" in the Consolidated Balance Sheet at December 31, 1992 is $135 million due to holders of commercial paper. There was no balance due at December 31, 1993. The Company has revolving credit agreements with banks that provide for loans up to $50 million through October, 1996. Under these agreements, the Company pays a commitment fee of 3/16 of 1% per annum based on unused amounts. The Company has additional revolving credit agreements with several banks that provide for loans up to $550 million for a renewable term of 364 days. The Company pays a commitment fee of 1/16 of 1% per annum on unused amounts. The above described credit lines provide the credit backup for the Company's commercial paper program. The credit lines were unused at December 31, 1993 and 1992. The Company had standby and trade letters of credit outstanding amounting to $105 million at December 31, 1993 and $101 million at December 31, 1992. The Company periodically enters into forward exchange contracts as hedges against foreign currency transactions and does not engage in speculative contracts. There were no significant foreign exchange contracts outstanding at December 31, 1993 and 1992. The Company has an interest rate conversion agreement. Under the terms of the agreement, the Company has fixed the interest rate on $12 million of debt at 6.27% through 1996. The Company's debt instruments include covenants, as defined in the loan agreements, that require maintenance of consolidated net worth of not less than $2.3 billion, and the limitation of dividends and other restricted payments. At December 31, 1993, $688 million was available for dividends or other restricted payments under existing loan agreements. The Company intends to continue its current policy to pay dividends to its Parent at the discretion of the Company's Board of Directors. Such dividends will be used by the Parent to service acquisition debt pertaining to the acquisition of Celanese Corporation. Annual maturities of long-term debt each year for the next five years are: $7 million in 1994; $10 million in 1995; $6 million in 1996; $336 million in 1997; and $76 million in 1998. (10) OTHER LIABILITIES HOECHST CELANESE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (11) BENEFIT PLANS The Company has several defined-benefit pension plans covering substantially all employees. Benefit formulas are based on years of service and compensation levels or years of service and negotiated benefits. The pension plans in the United States are being funded in accordance with the requirements of the Employee Retirement Income Security Act of 1974. Net periodic pension cost for defined-benefit pension plans consists of the following: The actuarial computations, based on the projected unit credit method, assumed a discount rate of 7.5%, 8.5% and 8.5% in 1993, 1992 and 1991, respectively. The assumed rate of return was 9.0%, 8.5% and 8.5% in 1993, 1992 and 1991, respectively. The assumed rate of increase in compensation levels was 4.5%, 5.6% and 6.0% in 1993, 1992 and 1991, respectively. The following table sets forth the funded status of the Company's qualified plans and the amounts recognized in the Company's Consolidated Balance Sheets at December 31, 1993 and 1992: HOECHST CELANESE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (11) BENEFIT PLANS (CONTINUED) Assets of the Company's pension plans consist of equity and fixed income securities, real estate and deposit administration contracts maintained in master trust funds, which are managed by various investment managers appointed by the Company. The Company has various investment savings plans for certain employees, some of which qualify under Section 401(k) of the Internal Revenue Code. The Company's contributions to the plans are based on specified percentages of employee contributions and aggregated $33 million in 1993, $31 million in 1992 and $30 million in 1991. The Company provides certain of its employees with non-qualified supplemental retirement benefits. The accumulated benefit obligation of these benefits totalled $96 million in 1993 and $87 million in 1992. (12) OTHER POSTRETIREMENT BENEFITS Under various employer sponsored plans, the Company provides certain health care and life insurance benefits for retired employees and their dependents. Substantially all of the Company's employees are eligible for health care benefits after reaching normal retirement age with 10 years of service. Benefits, eligibility and cost sharing provisions for union employees vary by location. Generally, the medical plans pay a stated percentage, based upon years of service, of most medical expenses reduced for any deductible and payments made by government programs and other group coverage. The Company is generally self-insured for these costs and has no plan assets. The plans' provisions include a cap which limits future Company contributions for medical coverage under these plans. It was the Company's policy to fund and account for these benefits on a cash basis. Amounts paid related to such benefits aggregated $19 million in 1993, $17 million in 1992 and $16 million in 1991. Effective January 1, 1992, the Company adopted the provisions of FAS 106 for all its plans. Under this statement, the Company accrues the current cost of those benefits. The Company previously had expensed the cost of these benefits as claims were paid, except for the portion related to unfunded actuarial liability of retiree health care benefits accrued as part of the acquisition of Celanese Corporation in 1987. In addition, the Company elected to recognize immediately the transition obligation measured as of January 1, 1992. This resulted in a one-time after-tax charge of $141 million (after a reduction for income taxes of $90 million and the effect of minority interests of $3 million). The effect of this change on operating results, after recording the cumulative effect for years prior to 1992, was to recognize an additional pretax expense of $23 million. The pro forma effect of the change on years prior to 1992 was not determinable. HOECHST CELANESE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (12) OTHER POSTRETIREMENT BENEFITS (CONTINUED) Net Periodic Postretirement Benefit Cost included the following components: The following table sets forth the unfunded status of the plans, which represents the accrued postretirement benefit cost recognized in the Company's Consolidated Balance Sheets at December 31, 1993 and 1992: For measuring the expected postretirement benefit obligation, the Company assumed a 10.6 percent rate of increase in the per capita claims cost in 1993 and assumed that the rate would decrease gradually over an eight year period to 6.0 percent and remain at that level thereafter. The weighted-average discount rate used in determining the accumulated postretirement benefit obligation was 7.5 and 8.5 percent at December 31, 1993 and December 31, 1992, respectively. If the health care cost trend were increased 1.0 percent, the accumulated postretirement benefit obligation as of December 31, 1993 would have increased by approximately $27 million, or 6.7 percent. The effect of the change on the aggregate of service and interest cost for 1993 would be an increase of approximately $2 million, or 6.1 percent. Effective January 1, 1993, the Company adopted the provisions of Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits" ("FAS 112"). This Statement requires an accrual method of recognizing postemployment benefits such as disability-related benefits. The cumulative effect at January 1, 1993 of adopting FAS 112 reduced net income by $8 million, net of $4 million of income tax benefits. The effect of this change on 1993 income before cumulative effect of accounting changes was not material. HOECHST CELANESE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (13) LEASED ASSETS AND LEASE COMMITMENTS At December 31, 1993, minimum lease commitments under long-term operating leases are as follows: Total minimum rent charged to operations under all operating leases was $68 million in 1993, $64 million in 1992 and $66 million in 1991. Effective December 31, 1992, the Parent increased its investment in the Company by contributing to the Company property, plant and equipment that had been leased under capital leases from its Parent. Rental payments made under such lease obligations amounted to $10 million for the period ended December 31, 1992, and $13 million for the period ended December 31, 1991. The effect of the transaction was to increase additional paid-in capital by $49 million, reverse $10 million of previously existing deferred income taxes and decrease debt (obligations under capital leases) by $59 million. Management expects that, in the normal course of business, leases that expire will be renewed or replaced by other leases. HOECHST CELANESE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (14) SEGMENT AND GEOGRAPHICAL INFORMATION /(a)/ Beginning in 1993, the Company segregated amounts associated with Advanced Technology. This new segment represents research and development costs to seed and develop new businesses. When projects or businesses become viable, they are transferred to the appropriate operating segment. The prior years' segment results have been restated to reflect this change. /(b)/ Includes $15 million of depreciation and a $4 million reserve for asset impairment related to the 1993 restructuring program (see note 16). /(c)/ Includes $29 million of assets related to the purchase of Copley and $3 million of assets related to the purchase of certain other businesses (see note (1)(a)). /(d)/ Includes a $30 million reserve for asset impairment related to 1992 restructuring program for North American Fibers (see note 16). HOECHST CELANESE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (14) SEGMENT AND GEOGRAPHICAL INFORMATION (CONTINUED) The following table presents financial information based on the geographic location of the manufacturing facilities of the Company: - ---------- /(a)/ Included in United States net sales are export sales of $845 million in 1993, $877 million in 1992 and $932 million in 1991. /(b)/ Product transfers between geographic areas are priced on a basis intended to reflect, as nearly as practicable, the prevailing market value of the products transferred. HOECHST CELANESE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (15) COMMITMENTS AND CONTINGENCIES The Company is a defendant in a number of lawsuits, including environmental, product liability and personal injury actions (see footnote 18 for discussion of environmental). Certain of these lawsuits are or purport to be class actions. In some of these cases, claimed damages are substantial. While it is impossible at this time to determine with certainty the ultimate outcome of these lawsuits, management believes, based on the advice of legal counsel, that adequate provisions have been made for probable losses with respect thereto and that the ultimate outcome will not have a material adverse effect on the financial position of the Company, but may have a material effect upon the results of operations in any given year. The Company is named a defendant in twenty putative class actions, two of which have been certified as class actions as well as a defendant in other non-class actions filed in nine states ("the Plumbing Actions"). In these lawsuits the plaintiffs typically seek recovery for alleged property damage to housing units, mental anguish from the alleged failure of plumbing systems, and punitive damages and, in certain cases, additional damages under the Texas Deceptive Trade Practices Act. The other defendants include United States Brass Corporation ("U.S. Brass")(formerly a wholly owned subsidiary of Household International, Inc.), Vanguard Plastics, Inc. ("Vanguard"), Shell Oil Company ("Shell") and E.I. duPont deNemours & Co., Inc ("duPont"). Damage amounts are not specified. The plumbing systems were designed and manufactured primarily by U.S. Brass and Vanguard. The pipe was made from polybutylene resin supplied by Shell. The Company sold acetal copolymer resin and duPont sold acetal polymer resin to other companies who manufactured the fittings used in the plumbing systems. Based on, among other things, the findings of outside experts and the successful use of the Company's acetal copolymer in similar applications, the Company does not believe that its acetal copolymer was defective or caused the plumbing systems to fail. In many cases the Company's exposure may be limited by the fact that the other defendants and other responsible parties may be found liable in whole or substantial part or by invocation of the statute of limitations since the Company ceased selling the resin for use in the plumbing systems in site built homes during 1986 and in manufactured homes during 1989. In order to mitigate the potential exposure to and cost of litigation, the Company, together with Shell and duPont, has established a company, Plumbing Claims Group ("PCG"), to assess individual repair requests and pay for certain repairs. The amount that each company contributes toward those repairs will ultimately be determined based on an allocation mechanism which the companies are currently negotiating. The Company believes that PCG repairs limit its exposure to future litigation. The Company has accrued its best estimate of its liability, asserted and unasserted, for the plumbing product liability and repair claims, taking into consideration anticipated insurance recoveries, but excluding other recoveries that may result from lawsuits against other parties to the Plumbing Actions. The Company has commenced litigation against Household International, Inc. to recover, among other things, the portion of Plumbing Action judgements, settlements and expenses that are attributable to its former subsidiary, U.S. Brass. Due to the many variables involved in the estimation process, as facts and circumstances change, the estimate will be adjusted. Since the Company was one of the suppliers of the resin used in the plumbing systems and not a manufacturer or marketer of these systems, the Company does not know the number of units that contain the plumbing fittings, the number of systems that will fail, if any, or the extent of any failures. Accordingly, it is impossible to estimate with any degree of certainty the level of unasserted plumbing claims. Due to the many variables, the timing of payments, which will be offset by any insurance proceeds, cannot be predicted with any certainty. HOECHST CELANESE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (15) COMMITMENTS AND CONTINGENCIES (CONTINUED) The Company and certain of its codefendants are currently involved in a nonbinding voluntary mediation effort relating to the plumbing claims with attorneys representing substantially all the plaintiffs in Texas cases and two uncertified nationwide class actions. This mediation seeks to settle the individual claims currently asserted in these Texas cases and to establish a nationwide framework for resolving future claims. However, it is currently too early to determine whether there will be any settlement of any of these pending or future claims, and, if there is a settlement, the manner in which it will be finally allocated among all the potentially responsible parties. Management believes that the Plumbing Actions, legal expenses and the Company's contributions to the PCG repair payments are substantially covered by insurance. The Company has initiated litigation seeking a declaration that insurance coverage exists for these product liability claims. Negotiations with several of the carriers have resulted in settlements or agreements in principle to settle, resulting in substantial continuing coverage of the Plumbing Actions or cash payments for claims. There are ongoing discussions with several of the remaining insurers. Outside counsel believes that the Company has a substantial probability of prevailing in its litigation against the carriers. Management believes that the plumbing claims will not have a material adverse effect on the financial position of the Company, but may have a material effect upon the results of operations in any given year. Copley is a defendant in numerous lawsuits alleging injury from the use of Albuterol Sulfate Inhalation Solution 0.5%. On January 5, 1994 Copley announced a voluntary nationwide recall of the product. Although the ultimate outcome of these lawsuits cannot be determined, in the opinion of the Company's management, these actions will not have a material adverse effect on the financial position of the Company or results of operations. At December 31, 1993, there were outstanding commitments relating to capital projects of approximately $118 million. (16) RESTRUCTURING The Company is restructuring its North American, principally Mexican, chemicals operations. During 1993, $29 million has been charged to Chemical operating income for restructuring, $19 million of which related to the write-down of property, plant and equipment. The Company is restructuring its North American polyester fibers operations. As part of an ongoing North American strategy, the Company will install additional staple fiber capacity within Celmex. This expansion should not result in a net increase in North American staple fiber capacity. The realignment of other polyester facilities in Canada and the United States is currently being studied. During 1992, $87 million was charged to Fibers and Film operating income for restructuring, $34 million of which related to the write-down of property, plant and equipment. An additional $15 million was established for restructuring and regionalization of certain other businesses. (17) FAIR VALUE OF FINANCIAL INSTRUMENTS In accordance with the provisions of Statement of Financial Accounting Standards No. 107, "Disclosures about Fair Value of Financial Instruments" ("FAS 107"), the Company is required to disclose the fair value of certain financial instruments as of the balance sheet dates. The fair value represents the Company's estimate and, therefore, should not be construed as the value that the Company would receive or give up for a financial instrument. The fair values of the Company's significant financial instruments are discussed below. HOECHST CELANESE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (17) FAIR VALUE OF FINANCIAL INSTRUMENTS (CONTINUED) The book value of cash and cash equivalents, marketable securities, net receivables, commercial paper, notes payable, and trade payables approximates fair market value due to the short maturity of these instruments. Included in other assets are certain investments accounted for under the cost method. In general, the investments are not publicly traded and, therefore, fair market values are not readily determinable. The Company believes that the carrying value of $43 million approximates the fair market value. The fair value of the Company's long-term debt is estimated based on quotations from investment bankers and on current rates of debt for similar types of issues. At December 31, 1993, the estimated fair value was $946 million versus the carrying value of $879 million. At December 31, 1992, the estimated fair value was $900 million versus the carrying value of $830 million. The carrying value of the current installments of long-term debt approximates the fair value. (18) ENVIRONMENTAL The Company's worldwide operations are subject to environmental laws and regulations which impose limitations on the discharge of pollutants into the air and water and establish standards for the treatment, storage and disposal of solid and hazardous wastes. The Company believes that it is in substantial compliance with all applicable environmental laws and regulations. The Company reviews the effects of any new laws and regulations on each of its locations; determines whether a liability exists based on that review; and records a liability, as appropriate. The company expenses all expenditures mandated by law or Company policy to ameliorate existing conditions. Liabilities that are established represent the company's best estimate based on all the available facts and are adjusted as facts and circumstances change. The Company may be subject to substantial claims brought by Federal or state regulatory agencies or private individuals pursuant to statutory authority or common law. In particular, the Company has a potential liability under the Federal Comprehensive Environmental Response compensation and Liability Act ("Superfund") and related state laws for investigation and cleanup costs at approximately 100 sites. At most of these sites, numerous companies, including either the Company or one of its predecessor companies, have been notified that the United States Environmental Protection Agency ("EPA"), state governing body or private individuals consider such companies to be potentially responsible parties (PRPs) under Superfund or related laws. The proceedings relating to these sites are in various stages. The cleanup process has not been completed at most sites and the status of the insurance coverage for most of these proceedings is uncertain. Consequently, the Company cannot determine accurately its ultimate liability for investigation or cleanup costs at these sites. Expenditures (including third party and divested sites) for investigation, clean up and related activities have been $31 million for the three years ended December 31, 1993 with expenditures in no year greater than $13 million. As events progress at each site for which it has been named a PRP, the Company accrues, as appropriate, a liability for site cleanup. Such liabilities include all costs that are probable and can be reasonably estimated. In establishing these liabilities, the Company considers: its shipments of waste to a site; its percentage of total waste shipped to the site; the types of wastes involved; the conclusions of any studies; the magnitude of any remedial actions that may be necessary; and the number and viability of other PRPs. Often HCC will join with other PRPs to sign joint defense agreements that will settle, among the PRPs, each party's percent allocation of HOECHST CELANESE CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (18) ENVIRONMENTAL (CONTINUED) costs at the site. Although the ultimate liability may differ from the estimate, the Company routinely reviews the liabilities and revises the estimate, as appropriate, based on the most current information available. In 1993, 1992 and 1991 the total environmental costs charged to operations for remediation efforts amounted to $34 million, $46 million and $24 million, respectively. As of December 31, 1993 and 1992 the Company's total environmental liability recognized in the financial statements is $149 million and $156 million. The amounts are neither reduced for anticipated insurance recovery nor discounted from the anticipated payment date. Moreover, environmental liabilities are paid over an extended period and the timing of such payments cannot be predicted with certainty. Management believes that environmental costs will not have a material adverse effect on the financial position of the Company or results of operations. (19) OTHER MATTERS Fibers and Film 1993 operating income includes a $50 million receipt in settlement of a litigation. The amount has been included in selling, general and administrative expenses. HOECHST CELANESE CORPORATION SCHEDULE V--PROPERTY, PLANT AND EQUIPMENT AT DECEMBER 31, 1993, 1992 AND 1991 - ---------- /(a)/ Includes $29 million of assets related to the purchase of Copley and $3 million of assets related to the purchase of certain other businesses (see note (1)(a)). /(b)/ Includes $92 million of assets related to the 1993 restructuring program (see note 16). /(c)/ Includes $20 million of assets related to the 1992 restructuring program for North American Fibers (see note 16). /(d)/ Includes $46 million of additions related to Pampa settlement (see note 5). /(e)/ Includes Celmex opening balances of $42 million in "Land and improvements," $55 million in "Buildings, improvements and leasehold improvements," $279 million in "Machinery and equipment," and $62 million in "Construction in progress." (see note (1)(a)). HOECHST CELANESE CORPORATION SCHEDULE VI--ACCUMULATED DEPRECIATION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT AT DECEMBER 31, 1993, 1992 AND 1991 - ---------- /(a)/ Includes $15 million of depreciation and a $4 million reserve for asset impairment related to the 1993 restructuring program (see note 16). /(b)/ Includes $92 million of assets related to the 1993 restructuring program (see note 16). /(c)/ Includes $30 million reserve for asset impairment related to the 1992 restructuring program for North American Fibers (see note 16). /(d)/ Includes $16 million of assets related to the 1992 restructuring program for North American Fibers (see note 16). /(e)/ Includes $5 million of additions related to Pampa settlement (see note 5). /(f)/ Includes Celmex opening balances of $9 million in "Land improvements," $9 million in "Buildings, improvements and leasehold improvements," and $221 million in "Machinery and equipment." (see note (1)(a)), HOECHST CELANESE CORPORATION SCHEDULE IX--SHORT-TERM BORROWINGS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 - ---------- /(a)/ Payable to banks consists predominantly of obligations of non-U.S. operations with a variety of interest rates and maturities. In 1993, includes $679 million payable to Parent. /(b)/ Amounts for payable to banks represents the maximum aggregate outstanding at any quarter end. Amounts for commercial paper represent the maximum outstanding at any time during the year. /(c)/ Represents the average quarterly amount outstanding for payable to banks and the average monthly outstanding for commercial paper. /(d)/ Computed by dividing appropriate interest expense by the weighted average amounts outstanding. HOECHST CELANESE CORPORATION SCHEDULE X--SUPPLEMENTARY INCOME STATEMENT INFORMATION YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 - -------------------------------------------------------------------------------- REPORT OF INDEPENDENT AUDITORS - -------------------------------------------------------------------------------- The Board of Directors Hoechst Celanese Corporation: We have audited the accompanying consolidated balance sheets of Hoechst Celanese Corporation as of December 31, 1993 and 1992, and the related consolidated statements of earnings, 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 the financial statement schedules listed in Item 14(a)(2) as of and for each of the years in the three-year period ended December 31, 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 consolidated financial statements referred to above present fairly, in all material respects, the financial position of Hoechst Celanese Corporation as of December 31, 1993 and 1992, and the results of its operations and its 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. As discussed in Notes 4 and 12 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" and No. 112, "Employers' Accounting for Postemployment Benefits" in 1993. As discussed in Note 12 to the consolidated financial statements, the Company adopted the provisions of the Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" in 1992. KPMG PEAT MARWICK Short Hills, New Jersey January 28, 1994 ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE There has been no change of accountants or reported disagreement on any matter of accounting principles or procedures or financial statement disclosure in 1993. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The directors and executive officers of Hoechst Celanese are as follows: - ---------- /(1)/ Member of Executive Committee, a committee of the Board of Directors. All directors of the Company have been appointed for a term commencing November 23, 1993. All terms of directors will end on the date of the next annual stockholder meeting. All executive officers were appointed for a term commencing December 6, 1993. All terms of executive officers will end at the first meeting of the Board following the next annual stockholder meeting. Mr. Dormann has been a Director and Chairman of the Company since January 1, 1990. Mr. Dormann has also served as Chairman of the Board of Directors of Hoechst Corporation since March 31, 1987 and from February 1987 until January 1988 he served as Chairman and Chief Executive Officer of the Company. Prior to that, he served as Director of American Hoechst Corporation ("AHC") from 1980 to February 1987 and as Chairman of AHC from October 1984 to February 1987. He is a member of the Board of Management and Chief Financial Officer of Hoechst AG and is responsible for all Hoechst Group activities in North America. Mr. Dormann has been with Hoechst AG for 31 years and is a resident of the Federal Republic of Germany. Dr. Drew has been President and Chief Executive Officer of the Company since January 1988. Prior to that, he was President and Chief Operating Officer from February 1987 until January 1988. He has been a Director of the Company since February 1987. He was formerly a Group Vice President with Celanese Corporation ("Celanese") from June 1985 to February 1987. He served as President of Celanese Fibers Operations and a Vice President of Celanese from June 1984 until June 1985 and was President and Chief Executive Officer of Celanese Canada Inc. from May 1982 until June 1984. Dr. Drew was a Director of Celanese from April 1986 to February 1987. He is also Director of Manville Corporation, Riverwood International Corporation, Thomas & Betts Corporation and Public Service Enterprise Group Incorporated. On January 1, 1991, Dr. Drew also assumed management responsibility within the Hoechst Group for certain areas of the Far East, including China, Hong Kong, Taiwan and Singapore. Mr. Benz has been Senior Vice President--Finance and Chief Financial Officer of the Company since April 1992 and Director of the Company since February 1987. From February 1987 to March 1992 he was Vice President--Finance and Chief Financial Officer of the Company. He was a Director and Chief Financial Officer with AHC from October 1980 to February 1987. Prior to 1980 he served as AHC's Treasurer for nine years. He also had responsibility for AHC's Petrochemicals and Plastics Group. Prior to joining AHC, he was employed by Peat, Marwick, Mitchell & Co. for 10 years. Mr. Engels has been Senior Vice President of the Company since April 1992 and director of the Company since September 1991. From September 1991 to March 1992 he was Vice President of the Company. He was Vice President--Marketing and Sales of the Fibers Division of Hoechst AG from November 1986 until August 1991. From January 1985 to October 1986 he was Director of Personnel and Social Policies for the Hoechst Group. From 1981 to December 1984, he was Divisional Director and head of the Staff Department of Hoechst AG, coordinating the Hoechst Group affiliates outside the Federal Republic of Germany. Mr. Engels has been with Hoechst AG for 21 years. Mr. Kennedy has been Executive Vice President of the Company since April 1992 and Director of the Company since March 1989. He was Group President of the Chemical Group from July 1989 to March 1992. From March 1989 to March 1992 he was Vice President of the Company. Prior to that, he was President of the Chemical Group from March 1989 to June 1989, Executive Vice President of the Chemical Group from January 1988 to February 1989 and Executive Vice President of Celanese Chemical Company, Inc. from September 1986 until December 1987. He previously served as Vice President and General Manager of Filter Products from October 1984 to September 1986. Prior to that, he was Business Director of Celanese Chemical Company, Inc. Dr. Patterson has been Executive Vice President of the Company since April 1992 and Director of the Company since January 1988. He has also been Chairman of the Board of Directors of HRPI since December 1992. From January 1988 to March 1992 he was Vice President of the Company. He was Group President of the Advanced Materials Group from November 1991 to March 1992, Group President of the Advanced Technology Group from May 1991 to March 1992 and Group President of the Fibers and Film Group form June 1989 to March 1992. Prior to that, he was President of Technical Fibers from March 1988 to May 1989, President of Industrial Fibers from January 1988 to March 1988, Vice President and General Manager of Celanese Industrial Fibers from December 1984 until January 1988 and Vice President, Technical of Celanese Fibers Operations from May 1984 until December 1984. He was Corporate Director of Planning of Celanese from March 1982 to May 1984. Dr. Patterson is a Director of Copley since November 1993. Mr. Harris has been Vice President of the Company since January 1988 and President, Textile Fibers Group since January 1990. He served as Treasurer of the Company from January 1988 until March 1989 and Executive Vice President, Textile Fibers Group from April 1989 until December 1989. He was formerly President of Celanese Fibers Operations, Ltd. from September 1986 until January 1988 and Vice President and General Manager of Polymer and Filter Products from September 1986 until December 1987. He served as Vice President, Administration of Celanese Fibers from November 1984 until August 1986. From May 1984 he was Executive Vice President of Celanese Canada Inc. and from November 1982 until April 1984 he was Vice President, Finance of Celanese Canada Inc. Mr. Jenkins has been Vice President--General Counsel of the Company since January 1989 and a Director since April 1989. Prior to that, he was Senior Vice President and General Counsel of The Pullman Company from January 1988 to December 1988. He served as Deputy General Counsel of the Company from June 1987 to December 1987 and as Vice President and General Counsel of the Hoechst Celanese Advanced Technology Company from August 1986 to June 1987. He was Secretary of Celanese from June 1984 to August 1986 and General Attorney of Celanese from September 1976 to August 1986. Dr. Langston has been Vice President of the Company since January 1991. Prior to that, he was Vice President, Human Resources of the Life Sciences Group from March 1989 to December 1990. From July 1987 to February 1989 he was the Company's Director of Compensation. From September 1982 to June 1987 he was Director, Human Resources of the Specialty Chemicals Group. Mr. Schmieder has been Vice President and Treasurer of the Company since January 1, 1992. He was Regional Manager for the Asia/Pacific Region of Hoechst AG from January 1990 to December 1991. From 1987 to December 1989 he worked on various assignments in the Central Staff and Legal Departments of Hoechst AG. From 1977 to 1987 he was in the Legal Department of Hoechst AG. Mr. Schmieder has been with Hoechst AG for 17 years. Mr. Schuele has been Vice President of the Company since February 1987 and responsible for Canadian Operations since May 1991. Prior to that, he was President of Specialty Products Group from February 1989 to April 1991 and Vice President--Quality and Communications from January 1988 to January 1989. He served as Treasurer from 1981 until January 1988 and became a Vice President in 1985. He joined AHC in 1980 as Assistant Treasurer after having been with The Chase Manhattan Bank, N.A. for 10 years. Mr. Smedley has been Vice President and Controller of the Company since February 1987. Prior to that, he served as Controller of AHC from 1975 and Vice President and Controller from 1980. Prior to joining AHC in 1972, he was with Price Waterhouse & Co. for 10 years. He is a Certified Public Accountant. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The following tables set forth the compensation paid during the past three years and, in the case of pensions, payable in the future to the Chief Executive Officer and the four next most highly compensated executive officers of the Company. COMPENSATION TABLE The following table sets forth the total amount of cash compensation paid to the named executives in 1993, 1992 and 1991. - ---------- /(1)/ Bonus paid early in the following year for services rendered in each of the listed years. /(2)/ Company contribution to Savings Plan. /(3)/ Amounts for 1991 reflect compensation for services performed from September through December of that year. 1993 LONG-TERM INCENTIVE AWARDS TABLE The following table sets forth the awards made under the Company's Long-Term Incentive Award Plan to the named executives in 1993. LONG-TERM INCENTIVE PLANS - AWARDS IN LAST FISCAL YEAR Payments and awards are tied to achieving specified levels of Return on Capital Employed (ROCE), both absolute and relative to a competitive group of other companies. The target amount will be earned if 100% of the targeted ROCE is achieved. If threshold levels are not achieved, no payments will be made from the Plan. If threshold levels are achieved but target levels are not achieved, payments as low as 25% of the target amounts will be made. If certain stretch goals beyond target levels are achieved, payments as high as 150% of the target amounts will be made. PENSION TABLE The following table sets forth estimated annual retirement benefits for the named executives under the Hoechst Celanese Retirement Plan and the Hoechst Celanese Executive Pension Plan. PENSION PLAN TABLE/(1)/ BENEFITS FOR REPRESENTATIVE YEARS OF CREDITED SERVICE/(2)/ ----------------------------------------------------------- - ---------- /(1)/ This table represents total benefits payable from both the Hoechst Celanese Retirement Plan and the Hoechst Celanese Executive Pension Plan. Drs. Drew and Patterson and Messrs. Kennedy and Benz are participants in both these plans. Mr. Engels is covered by the Hoechst AG Pension Plan. Benefits from the Executive Pension Plan are only payable in the event the executive retires directly from employment with the Company. /(2)/ Amounts shown assume the executive retires at age 65 (or earlier if certain years of service requirements with the Company are met) and are paid annually for the remainder of the executive's life regardless of marital status. Benefits listed in the table are not subject to any deduction for Social Security. /(3)/ Final Average Earnings are defined in the plans as the average of the three highest years' earnings (base salary plus bonus) out of the last 10 years before retirement. The current Final Average Earnings for Dr. Drew, Dr. Patterson, Mr. Kennedy and Mr. Benz are approximately $1,043,000; $504,700; $501,700 and $473,400, respectively. The approximate years of Credited Service of the executives covered by the plans are: Dr. Drew, 27 years; Dr. Patterson, 26 years; Mr. Kennedy, 27 years; Mr. Benz 22 years. Employment contract with Hoechst AG. Mr. Engels has a special contract with Hoechst AG that covers certain aspects of his assignment in the United States in the nature of foreign relocation allowances, such as moving and travel expenses, vacation, home leaves, contributions to the German health insurance system while employed in the United States, emergency home leaves, etc. His salary and benefits are provided by the Company as long as he is employed in the United States by the Company. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Collectively, the directors and executive officers of the Company beneficially own less than 1% of the outstanding capital stock of Hoechst AG. Each of Messrs. Benz, Harris, Kennedy, Schuele and Mr. John A. Downard, President of Technical Fibers Group, serves on the Board of Directors of Celanese Canada Inc. Each of Messrs. Benz, Downard, Drew, Harris, Kennedy and Schuele owns 100 shares of its common stock. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS RELATIONSHIP WITH HOECHST AG The Company is wholly owned by Hoechst Corporation, which in turn is wholly owned by Hoechst AG, a large chemical company headquartered in Frankfurt, Federal Republic of Germany. Hoechst AG is a publicly held company whose shares are listed and traded on the Tokyo stock exchange in Japan and on a number of major stock exchanges in Europe including the Frankfurt, Federal Republic of Germany; London, United Kingdom; and Geneva, Switzerland stock exchanges. The Company and Hoechst AG are parties to a broad research and development cost-sharing agreement. In most cases, licenses between the Company and Hoechst AG under patents owned by Hoechst AG require no specific payment because overall research and development costs have been shared. However, when license agreements are negotiated and utilized between the Company and Hoechst AG, they are on terms that are as favorable to the Company as could be obtained by third parties from Hoechst AG. The Company, from time to time, has entered into various financing agreements with its parent, Hoechst Corporation, and affiliates of Hoechst AG at competitive rates. See Note (2) of Notes to Consolidated Financial Statements. The Company has, from time to time, contracted for various plant and equipment design and consulting services from companies in the Hoechst Group on terms at least as favorable as could be obtained from third parties. The Company purchases from companies in the Hoechst Group many chemical raw materials at competitive prices for use in manufacturing chemically-related products. Several finished chemicals, which are resold in the United States, are also purchased from companies in the Hoechst Group. See Note (2) of Notes to Consolidated Financial Statements. The Company intends to continue its current policy of paying dividends to Hoechst Corporation at the discretion of the Company's Board of Directors. Payment of dividends by the Company is restricted by its public debt instruments, when there is, or a payment would result in, a default under these instruments or if the payments (when aggregated with other "Restricted Payments" as defined therein) would exceed a formula amount based on the total of $250 million plus Consolidated Net Income (as defined therein) plus certain Net Cash Proceeds from the sale, conversion or exchange of stock (as specified therein). Certain of the Company's employees, including a director, have employment contracts with Hoechst AG. See "Executive Compensation." PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (A)(1) FINANCIAL STATEMENTS The Consolidated Financial Statements of the Company and the Report of Independent Auditors of KPMG Peat Marwick are set forth in the Financial Statements and Supplementary Data (Item 8) and are filed as part of this report. (A)(2) FINANCIAL STATEMENT SCHEDULES The following additional financial information is filed as part of this report and should be read in conjunction with the Consolidated Financial Statements: Schedules not included with this additional financial information have been omitted either because they are not applicable or because the required information is shown in the financial statements or notes thereto. (A)(3) EXHIBITS The following Exhibits are filed as part of this report: (B) REPORTS ON FORM 8-K During the quarter ended December 31, 1993, no reports on Form 8-K were filed. SIGNATURES Pursuant to the requirements of Section 15(d) of the Securities Exchange Act of 1934, Hoechst Celanese has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. Hoechst Celanese Corporation By: /s/ Ernest H. Drew ------------------------------------- Ernest H. Drew President and Chief Executive Officer March 28, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed on March 28, 1994, by the following persons on behalf of the registrant and in the capacities indicated. - ---------- * Ernest H. Drew, by signing his name hereto, does sign this document on behalf of each of the persons indicated above pursuant to powers of attorney duly executed by such persons, filed with the Securities and Exchange Commission. By: /s/ Ernest H. Drew ------------------------------------- Ernest H. Drew Attorney-in-Fact SUPPLEMENTAL INFORMATION TO BE FURNISHED WITH REPORTS FILED PURSUANT TO SECTION 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 (THE "ACT") BY REGISTRANTS WHICH HAVE NOT REGISTERED SECURITIES PURSUANT TO SECTION 12 OF THE ACT: Hoechst Celanese Corporation is a wholly owned subsidiary of Hoechst Corporation. Accordingly, no annual report or proxy material has been sent to security holders. EXHIBITS TO 1993 ANNUAL REPORT ON FORM 10-K -------------------------------------------

54182_1993.txt

54182_1993

1993

54182

ITEM 1. BUSINESS Justin Industries, Inc. ("Justin") and its subsidiaries are herein collectively and/or singly referred to as the "company". The company where specifically indicated has incorporated by reference certain information contained in its 1993 Annual Report to Shareholders. Other references made to that report are for information purposes only and the information in the Annual Report to Shareholders is not deemed incorporated in this Form 10-K. GENERAL DEVELOPMENT OF BUSINESS Justin's business origins can be traced back to 1879, when H. J. Justin began making boots at Spanish Fort, Texas on the Chisholm Trail. Justin was incorporated under the laws of the State of Texas on April 26, 1916, as Acme Brick Company, the successor to an Illinois company incorporated in 1891. In August 1968, the company changed its name to First Worth Corporation and created a division, later incorporated with the name "Acme Brick Company" ("Acme"), to handle the company's business relating to brick, concrete block, concrete panels, and prestressed concrete structural components. The company changed its name in October 1972 to Justin Industries, Inc. In 1968, Justin purchased for cash and promissory notes all the outstanding Common Stock of Louisiana Concrete Products, Inc. ("Louisiana Concrete"). Also during 1968, Justin acquired the net assets or the outstanding stock of six additional small firms in the concrete products field for cash and shares of Justin Common Stock. The operations of Louisiana Concrete and the six small firms were combined with the concrete products operations of Featherlite Building Products Corporation and Featherlite Precast Corporation (whose acquisition is discussed below). In December 1968, Justin acquired all of the outstanding common stock of Justin Belt Company, Inc., H. J. Justin & Sons, Inc., and its subsidiary, Justin Leathergoods Company, which companies were reorganized in 1984 to be known as the "Justin Boot Company" ("Justin Boot"). Justin Boot's stock was acquired in exchange for Justin Common Stock and Justin voting Preferred Stock (subsequently converted into shares of Justin Common Stock). The acquisition of Justin Boot was treated as a pooling of interests for accounting purposes. In May 1973, Justin acquired all of the outstanding common stock of Northland Publishing Company, Inc. ("Northland") in exchange for shares of Justin Common Stock. The acquisition was accounted for as a purchase. In April 1974, Justin acquired for cash all the outstanding capital stock of Sanford Brick Corporation ("Sanford"), Sanford, North Carolina. The acquisition was accounted for as a purchase. On April 30, 1984, all of the common stock of Sanford was sold. In August 1976, Justin acquired 62.6% of the outstanding common stock of Kingstip, Inc. ("Kingstip") for cash and effective January 31, 1977, acquired the remaining 37.4% of Kingstip's capital stock in exchange for shares of Justin Common Stock. The acquisition was accounted for as a purchase. Through 1983, all operations of Kingstip were conducted through its subsidiary, The Featherlite Corporation. Effective December 31, 1983, these operations were reorganized into two distinct operating entities, Featherlite Building Products Corporation and Featherlite Precast Corporation. Ceramic Cooling Tower Company ("CCT") was incorporated by Justin in 1968, as an outgrowth of Acme's operations in the design and sale of water cooling systems. Effective December 31, 1991, the net assets and business of CCT were sold for $20 million cash. In June 1981, Justin issued shares of Justin Common Stock for all the outstanding common stock of Nocona Boot Company ("Nocona"). In September 1984, the company's Featherlite Building Products Corporation subsidiary purchased all of the common stock of Gulde Block and Brick, Inc. for cash. In 1985, the company acquired the operations of four additional companies for cash and the assumption of certain liabilities. These acquisitions were Chippewa Shoe Company, Builders Block Company, Inc., RLI, Inc. (name changed to Tradewinds Technologies, Inc. ("Tradewinds")), and MEGA Equipment Company. =========================================================================== (PAGE 2) In 1986, the company acquired the operating assets of Parr Block Company for cash and notes. Pursuant to a tender offer and subsequent merger effective October 15, 1990, the company acquired all of the outstanding shares of Tony Lama Company, Inc. ("Tony Lama") at a price of $9.00 per share in cash with the aggregate purchase price for such shares and related costs totalling approximately $18,787,000. Tony Lama is in the business of designing, manufacturing, and selling western style boots and leather accessories. The acquisition was accounted for as a purchase. On October 7, 1991, the company purchased the brick manufacturing assets of Elgin-Butler Brick Company for cash and subordinated notes totalling approximately $4,527,000. In December 1987, the company made the decision to discontinue operations of two of its businesses, Featherlite Precast Corporation (manufacturers of precast/prestressed concrete components) and MEGA Equipment Company (distributor of John Deere construction and utility earthmoving equipment). Both of these companies were more severely affected by the cyclical nature of the building industry and it was felt that Justin and its shareholders would be better served by concentrating the company's resources in its remaining core group of businesses. In 1988, the operations of MEGA Equipment Company and two of the three Featherlite Precast Corporation plants were sold to third parties. Justin's continuing operations are in two principal business areas: (i) manufacture and sale of building materials, which includes the operations of Acme, Featherlite Building Products Corporation, and Tradewinds, and (ii) manufacture and sale of footwear products, which includes the operations of Justin Boot, Nocona and Tony Lama. FINANCIAL INFORMATION ABOUT INDUSTRY SEGMENTS (LINES OF BUSINESS) A five year analysis of sales and operating profit contribution by industry segment is presented on page 17 of the company's 1993 Annual Report to Shareholders and additional financial information, including identifiable assets, by industry segment is included in Note 9 of Notes to Consolidated Financial Statements on page 26 of the shareholders' report. Such information is hereby incorporated by reference. NARRATIVE DESCRIPTION OF BUSINESS The following information is presented in addition to the information included in the Report on Operations contained on pages 5 through 11 of the company's 1993 Annual Report to Shareholders, which is incorporated herein by reference. MANUFACTURE AND SALE OF BUILDING MATERIALS The building materials segment includes clay brick manufactured and sold under the name Acme Brick for use in residential and commercial construction. The primary market for Acme Brick is the Central and Southwest United States where distribution is mainly through company operated sales offices. Acme also distributes through independent dealerships in other parts of the United States. Acme is one of the largest manufacturers of face brick in the United States. Other products in the company's building materials segment include concrete block manufactured and sold under the trade name Featherlite Building Products and cut limestone manufactured under the name Texas Quarries. The primary markets for these products are in Texas and its neighboring states. The company also represents other manufacturers as a distributor of such items as clay brick, glass block, glazed and unglazed tile and masonry units, fireplace equipment, masonry cleaners, masonry saws, wall reinforcements, masonry tools, masonry cement, and purchased used brick for resale. Tradewinds manufactures a unique line of premium quality evaporative coolers used primarily for central residential cooling and light commercial and spot cooling. In the states of Texas, Louisiana, Arkansas, Oklahoma, New Mexico, Kansas, Tennessee, and Missouri, Acme and Featherlite market their building materials through approximately 300 full-time company sales employees serving architects, contractors, home builders, and others in the construction market. These direct sales comprise the majority of =========================================================================== (PAGE 3) the company's building materials sales. In the other states, sales are made principally through independent distributors and dealers. The majority of these building materials manufactured by the company are utilized within a 250 mile radius of the plant where they are produced. Tradewinds' coolers are sold by direct sales personnel in selected major markets and by distribution elsewhere. MANUFACTURE AND SALE OF FOOTWEAR PRODUCTS Footwear operations include the design, manufacture and distribution of men's, women's, and children's western style, safety, work and sports boots and shoes, primarily for sale in the United States under the trade names "Justin(R)", "Nocona(R)", "Tony Lama(R)", "Chippewa(R)", and Diamond "J(R)". Justin Boot Company, headquartered in Fort Worth, Texas, started business in 1879 as H. J. Justin & Sons, Inc. The company owns and operates footwear manufacturing plants in Fort Worth, Texas, Cassville, Sarcoxie, and Carthage, Missouri. Nocona Boot Company, headquartered in Nocona, Texas, started business in 1925 and owns and operates its boot manufacturing plant in Nocona. Tony Lama Company, Inc., headquartered in El Paso, Texas, was established in 1911. The company owns and operates a western boot manufacturing plant in El Paso, Texas. The company's footwear products are marketed by company salesmen and independent sales representatives who are compensated on a commission basis. Sales are made throughout the United States to a network of approximately 7,000 authorized retail outlets and dealers such as western goods stores, department stores, chain stores, and mail order houses. Footwear products are sold in the general price range of other medium to high quality lines and are manufactured using a wide range of leathers. OTHER Northland's primary activity is publishing books about the history and art of the West. Many of these books have won awards for fine design, printing, and binding in major book competitions including the Western Heritage Awards at the National Cowboy Hall of Fame. Northland's books are marketed by company personnel and through independent sales representatives covering the entire United States. RAW MATERIALS The principal raw materials for the company's brick are clay and shale mined from company-owned or leased properties. The company has developed adequate clay reserves located at or near plant sites to supply its needs for the foreseeable future. Other raw materials used in the building materials operations, such as cement, aggregate, and additives, are purchased by the company in the open market and appear to be readily available for the foreseeable future from numerous domestic suppliers. Materials for evaporative coolers are purchased in the open market or manufactured to the company's specifications and all appear to be readily available for the foreseeable future from numerous suppliers. The company consumes large quantities of natural gas and other combustible fuels in the drying and firing of its clay products. In periods of severe cold weather and occasionally at other times, the company's natural gas supplies have been limited by its suppliers at certain locations. The company believes it will be able to obtain an adequate supply of energy in the future to meet its requirements. The primary raw material used in the footwear product line is finished leather. Finished leather, which is readily available, is purchased from various tanneries in the United States and from tanneries in foreign countries and their representatives in the United States. Inventories are maintained to meet production requirements. Other raw materials incidental to the production of these products such as thread, tacks, staples, buckles, and clasps appear to be readily available for the foreseeable future from numerous domestic suppliers. PATENTS AND TRADEMARKS Many of the company's products and processes are patented. In addition, most of the company's products are marketed under registered trademarks. =========================================================================== (PAGE 4) SEASONAL NATURE OF BUSINESS Demand for building materials and evaporative coolers is seasonal, with sales during periods of warm weather representing a higher than average proportion of total yearly sales while sales of footwear products are generally highest in the fourth quarter. WORKING CAPITAL REQUIREMENTS It is the company's policy to increase inventory levels during periods when production capabilities exceed sales. The company may also from time to time increase its inventory of raw materials in its footwear business segment to assure itself of an adequate supply of such raw materials. Historically, funds required for working capital have been generated from operations and from borrowings from commercial banks. SIGNIFICANT CUSTOMERS No material part of the company's business is dependent upon a single customer or upon a few customers, the loss of any one or more of whom would have a material adverse effect on the company's business. BACKLOG OF ORDERS AT END OF FISCAL YEAR An analysis of backlog orders is presented on page 16 of the company's 1993 Annual Report to Shareholders, which is incorporated herein by reference. In accordance with industry practice, unfilled orders for clay brick and footwear products are generally cancelable by customers at any time and for this reason may not be considered firm backlog in the traditional sense, despite the fact that in the past orders have been canceled only infrequently. Substantially all unfilled orders are expected to be filled within one year. COMPETITION The business environment in which the company operates is highly competitive in the areas of price, service, and product quality. Unless otherwise indicated below, the company's relative competitive position within its product lines and market areas is not readily available due to constant changes in the number and identity of competitors and types of competitive products. In the building materials segment, competition includes other suppliers of brick and concrete products, as well as suppliers of diverse alternative building materials such as steel, aluminum, glass, plastic, and wood products. There are numerous manufacturers of various types of brick and concrete products in the United States, virtually all of which operate on a regional or local basis. In every geographical area served by the company, there are numerous competitors in all significant building product lines. The company is one of the largest face brick manufacturers in the United States and the largest in the Southwest. There are numerous plants manufacturing concrete products in the area in which the company owns and operates plants. Tradewinds' evaporative coolers compete with approximately ten other major manufacturers, two of which currently have approximately 70 percent of the market. None of the competition, however, manufactures coolers constructed of injection molded polypropylene material. The company's western style boots and other footwear products compete with approximately 25 other major manufacturers of high quality merchandise, and many more manufacturers of lesser quality footwear. RESEARCH ACTIVITIES In the normal course of business, the company conducts research and development activities to improve existing products and to develop new products within its current product lines. These activities include developing new styles, effective use of new materials, and developing new manufacturing techniques. The amount spent during each of the last three fiscal years on these activities did not exceed one percent of the company's total operating revenues. =========================================================================== (PAGE 5) ENVIRONMENT There are numerous federal, state, and local statutes, regulations and ordinances regulating discharge of materials into the environment or otherwise relating to the protection of the environment, including those concerning clean air, water, and waste disposal. In management's opinion, none of these will materially affect the company's earnings or competitive position and should not require any material increase in capital expenditures. EMPLOYEES The company had 5,106 employees in its operations as of December 31, 1993. The number of employees by job position at December 31, 1993, was as follows: Building Parent Materials Footwear and Other Total --------- -------- --------- ----- Production 1,346 2,489 3 3,838 Sales 571 331 7 909 Administrative, Engineering, Clerical, and Other 135 192 32 359 ----- ----- --- ----- 2,052 3,012 42 5,106 FOREIGN OPERATIONS Footwear products are marketed in foreign countries, primarily Canada, Western Europe, and Japan. Foreign operations are not material to consolidated operations. ITEM 2. ITEM 2. PROPERTIES Information concerning the company's principal production facilities is as follows: The company's current annual brick manufacturing capacity is approximately 775 million brick. The company's 16 operating brick plants are located on approximately 6,000 acres of land, which includes associated clay mining operations. The plants have individual production capacities ranging from 16.5 million to 128 million brick each year. The company's concrete operations include 8 concrete block plants operated by Featherlite and one plant operated by Acme on tracts of land ranging from 5 acres to 24 acres. In addition, Featherlite operates a limestone mill on a 36 acre tract of land and owns 62 acres of volcanic cinder mines and leases mining rights on 2,100 acres of land for quarrying architectural limestone. Tradewinds manufactures its evaporative coolers in Phoenix, Arizona, in a leased facility containing approximately 90,000 square feet. The footwear manufacturing facilities consist of 7 plants and related warehouses containing approximately 784,000 square feet, located on land owned by the company. These plants have a designed capacity to produce in excess of 3 million pair of footwear annually. The company's corporate administrative headquarters in Fort Worth, Texas, is contained in 26,000 square feet of modern office facilities. The company owns various interests in oil and gas mineral leases in Texas, Oklahoma, Louisiana, and Arkansas. Revenues received to date from these interests have not and are not anticipated to have a material effect on consolidated revenues. =========================================================================== (PAGE 6) ITEM 3. ITEM 3. LEGAL PROCEEDINGS The company is involved in various claims and lawsuits incidental to its business. In the opinion of management, these claims and lawsuits in the aggregate will not have a material adverse effect on the company's consolidated financial statements. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of the company's security holders during the last quarter of its fiscal year ended December 31, 1993. EXECUTIVE OFFICERS Certain information regarding the executive officers is as follows: Employed by Date First Company Appointed Name Age In an Officer Title - - - ------------------- --- -------- ------------- ------------------------- John Justin 77 1936 December 1969 Chairman of the Board and Chief Executive Officer J. T. Dickenson 64 1974 September 1983 President and Chief Operating Officer Richard J. Savitz 47 1979 March 1982 Vice President-Finance and Treasurer Jon M. Bennett 62 1969 December 1979 Vice President- Administration and Secretary Edward L. Stout, Jr. 68 1949 March 1974 Vice President-Brick Operations Judy B. Hunter (1) 35 1990 October 1990 Controller, Assistant Treasurer There are no family relationships among any of the above officers and there are no known arrangements or understandings between any executive officer and any other person pursuant to which any of the above named persons was selected as an officer. (1) For more than five years prior to her employment with the company, Ms. Hunter was employed by Ernst & Young, Fort Worth. She was a senior manager. =========================================================================== (PAGE 7) PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS Incorporated by reference from the 1993 Annual Report to Shareholders, pages 28, 29, and 30. As of February 15, 1994, there were 1,731 common shareholders of record. In addition, approximately 2,263 shareholders are participants in the Justin Industries, Inc. Employee Stock Ownership Plan. Dividends declared for the most recent two fiscal years are as follows: Quarter Ended Cash Dividend Declared ------------- ---------------------- 3/31/92 - (a) 6/30/92 $.07 (a) 9/30/92 $.035 12/31/92 $.035 3/31/93 $.04 6/30/93 $.04 9/30/93 $.04 12/31/93 $.04 (a) No dividends were declared in the first quarter, and two dividends were declared in the second quarter of 1992 since the regular first quarter Board of Directors' meeting was not held until April 2, 1992. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA Incorporated by reference from the 1993 Annual Report to Shareholders, pages 28 and 29. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Incorporated by reference from the 1993 Annual Report to Shareholders, pages 13 through 17. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The consolidated balance sheets of the company at December 31, 1993 and 1992 and the consolidated statements of income, shareholders' equity, and cash flows for the years 1993, 1992, and 1991 and the report of independent auditors thereon, and the company's unaudited quarterly financial data for the two-year period ended December 31, 1993 are incorporated by reference from the 1993 Annual Report to Shareholders, pages 18 through 27 and page 30. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. =========================================================================== (PAGE 8) PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF REGISTRANT Incorporated herein by reference from the company's definitive proxy statement for the Annual Meeting of Shareholders held March 18, 1994 ("Proxy Statement"), pages 3, 4 and 7. Information regarding the executive officers is included in Part I. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION Incorporated herein by reference from the Proxy Statement, pages 7 through 12. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information required as to security ownership is incorporated herein by reference from the Proxy Statement, pages 5 and 6. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Incorporated herein by reference from the Proxy Statement, page 14. =========================================================================== (PAGE 9) PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) 1. Financial Statements Reference ------------------------- Annual Report to Shareholders Form 10-K (page) --------- ------------ Data incorporated by reference from attached Annual Report to Shareholders of Justin Industries, Inc.: Report of independent auditors 27 Consolidated balance sheet at December 31, 1993 18 and 1992 For the years ended December 31, 1993, 1992, and 1991: Consolidated statement of income 19 Consolidated statement of shareholders' equity 19 Consolidated statement of cash flows 20 Notes to consolidated financial statements 21-26 2. Financial Statement Schedules Report of Independent Auditors and Consent of S-1 Independent Auditors Schedules for years ended December 31, 1993, 1992, and 1991: V - Property, plant, and equipment S-2 VI - Accumulated depreciation, depletion, S-3 and amortization of property, plant, and equipment VIII - Valuation and qualifying accounts S-4 IX - Short-term borrowings S-5 X - Supplementary income statement S-6 information All other schedules and compliance information have been omitted since the required information is not present or is not present in amounts sufficient to require submission of the schedule, or because the information required is included in the financial statements and the notes thereto. =========================================================================== (PAGE 10) 3. Exhibits Exhibit No. Description - - - ------- ------------------------------------------------------------------- 3.1 Articles of Incorporation of Registrant, as amended (incorporated by reference to the Registrant's Current Report on Form S-8 dated March 22, 1994) 3.2 By-Laws of Registrant, as amended (incorporated by reference to the Registrant's Current Report on Form 8-K dated September 7, 1990) 4.1 Rights Agreement dated as of October 6, 1989 between Registrant and Team Bank, as Rights Agent (incorporated by reference to Registrant's Registration Statement on Form 8-A dated October 10, 1989) 4.2 First Amendment to Rights Agreement dated as of October 4, 1990 between Registrant and Ameritrust Texas, N.A., as successor Rights Agent (incorporated by reference to Registrant's Amendment No. 1 on Form 8 to Registration Statement on Form 8-A dated October 4, 1990) 10.1 Registrant's 1981 Stock Option Plan* 10.2 Registrant's 1984 Incentive Stock Option Plan* 10.3 Registrant's 1992 Stock Option Plan (incorporated by reference from the company's definitive proxy statement for the Annual Meeting of Shareholders held on April 3, 1992) 10.4 Registrant's Deferred Compensation Plan* 10.5 Form of Registrant's Special Executive Benefit Program* 10.6 Registrant's Supplemental Executive Retirement Plan of 1992 (incorporated by reference to Registrant's 1992 Annual Report on Form 10-K) 10.7 Registrant's Employee Stock Ownership Plan, as restated January 1, 1989 (incorporated by reference to the Registrant's Current Report on Form S-8 dated March 22, 1994) 10.8 Employment Agreement dated as of September 15, 1989 between Registrant and John S. Justin, Jr.* 10.9 Form of Severance Agreement dated March 23, 1990 between Registrant and its executive officers* 10.10 Form of Severance Agreement dated March 23, 1990 between Registrant and certain of its officers and employees* 10.11 Revolving Loan Agreement between Registrant, NationsBank of Texas, N.A. (formerly NCNB Texas National Bank) as Administrative Lender and the several banks listed on the signature pages thereof, as amended in the First and Second Amendments through June 9, 1990* 10.12 Third Amendment to the Revolving Loan Agreement dated as of December 3, 1990 among Registrant, NationsBank of Texas, N.A. (formerly NCNB Texas National Bank), Bank One, Texas, N.A. (formerly Team Bank), Citibank, N.A., The Bank of New York and Texas Commerce Bank--Fort Worth, N.A. (incorporated by reference to Registrant's Current Report on Form 8-K dated December 3, 1990) 10.13 Fourth Amendment to the Revolving Loan Agreement dated as of December 31, 1991 among Registrant, certain subsidiaries of the Registrant, NationsBank of Texas, N.A., as Administrative Lender, NationsBank of Texas, N.A., Bank One, Texas, N.A. (formerly Team Bank), Citibank, N.A., The Bank of New York and Texas Commerce Bank, National Association (successor by merger to Texas Commerce Bank--Fort Worth, N.A.) (incorporated by reference to Registrant's 1991 Annual Report on Form 10-K) =========================================================================== (PAGE 11) 10.14 Fifth Amendment to the Revolving Loan Agreement dated as of May 1, 1992 among Registrant, certain subsidiaries of the Registrant, NationsBank of Texas, N.A., as Administrative Lender, NationsBank of Texas, N.A., Bank One, Texas, N.A. (formerly Team Bank), Citibank, N.A., The Bank of New York and Texas Commerce Bank, National Association (successor by merger to Texas Commerce Bank-- Fort Worth, N.A.) (incorporated by reference to Registrant's 1992 Annual Report on Form 10-K) 10.15 Sixth Amendment to the Revolving Loan Agreement dated as of December 31, 1993 among Registrant, certain subsidiaries of the Registrant, NationsBank of Texas, N.A., as Administrative Lender, NationsBank of Texas, N.A., Bank One, Texas, N.A., Citibank, N.A., The Bank of New York and Texas Commerce Bank, National Association 10.16 Term Loan Agreement dated as of December 3, 1990 among the Registrant, NationsBank of Texas, N.A. (formerly NCNB Texas National Bank), Bank One, Texas, N.A. (formerly Team Bank), Citibank, N.A. and Texas Commerce Bank--Fort Worth, N.A. (incorporated by reference to Amendment No. 4 to Registrant's Schedule 14D-9 dated December 6, 1990) 10.17 First Amendment to the Term Loan Agreement dated as of December 31, 1991 among Registrant, certain subsidiaries of the Registrant, NationsBank of Texas, N.A., as Administrative Lender, NationsBank of Texas, N.A., Bank One, Texas, N.A. (formerly Team Bank), Citibank, N.A. and Texas Commerce Bank, National Association (successor by merger to Texas Commerce Bank--Fort Worth, N.A.) (incorporated by reference to Registrant's 1991 Annual Report on Form 10-K) 10.18 Second Amendment to the Term Loan Agreement dated as of May 1, 1992 among Registrant, certain subsidiaries of the Registrant, NationsBank of Texas, N.A., as Administrative Lender, NationsBank of Texas, N.A., Bank One, Texas, N.A. (formerly Team Bank), Citibank, N.A. and Texas Commerce Bank, National Association (successor by merger to Texas Commerce Bank--Fort Worth, N.A.) (incorporated by reference to Registrant's 1992 Annual Report on Form 10-K) 10.19 Third Amendment to the Term Loan Agreement dated as of December 31, 1993 among Registrant, certain subsidiaries of the Registrant, NationsBank of Texas, N.A., as Administrative Lender, NationsBank of Texas, N.A., Bank One, Texas, N.A., Citibank, N.A. and Texas Commerce Bank, National Association 13 Annual report to shareholders for the year ended December 31, 1993 21 Subsidiaries of the Registrant 23 Report of Independent Auditors and Consent of Independent Auditors (included herein at page S-1) 99.1 Financial statements required by Form 11-K for registrant's Employee Stock Ownership Plan for the year ended December 31, 1993 *Incorporated by reference to Registrant's Amendment No. 1 on Form 8 to Annual Report on Form 10-K dated August 23, 1990. (b) Reports on Form 8-K None. =========================================================================== (PAGE 12) 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. JUSTIN INDUSTRIES, INC. (Registrant) By: /S/ JOHN JUSTIN John Justin Chairman of the Board 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 dates indicated: /S/ JOHN JUSTIN /S/ BAYARD H. FRIEDMAN John Justin Bayard H. Friedman Chairman of the Board and Director, March 18, 1994 Chief Executive Officer March 18, 1994 /S/ J. T. DICKENSON /S/ DEE J. KELLY J. T. Dickenson Dee J. Kelly Director, President and Chief Director, March 18, 1994 Operating Officer March 18, 1994 /S/ RICHARD J. SAVITZ /S/ JOSEPH R. MUSOLINO Richard J. Savitz Joseph R. Musolino Vice President-Finance, Principal Director, March 18, 1994 Finance and Accounting Officer March 18, 1994 /S/ MARVIN GEARHART /S/ JOHN V. ROACH Marvin Gearhart John V. Roach Director, March 18, 1994 Director, March 18, 1994 /S/ ROBERT E. GLAZE /S/ WILLIAM E. TUCKER Robert E. Glaze William E. Tucker Director, March 18, 1994 Director, March 18, 1994 =========================================================================== (PAGE S-1) REPORT OF INDEPENDENT AUDITORS We have audited the consolidated financial statements of Justin Industries, Inc. 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 January 27, 1994, incorporated by reference in this Annual Report (Form 10-K). Our audits also included the financial statement schedules listed in Item 14(a) of the 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 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. /S/ ERNST & YOUNG Fort Worth, Texas January 27, 1994 CONSENT OF INDEPENDENT AUDITORS We consent to the incorporation by reference in this Annual Report (Form 10-K) of Justin Industries, Inc. of our report dated January 27, 1994, included in the 1993 Annual Report to Shareholders of Justin Industries, Inc. We also consent to the incorporation by reference in the Registration Statement (Form S-8 No. 33-11915) pertaining to the Justin Industries, Inc. 1981 Stock Option Plan and the Justin Industries, Inc. 1984 Incentive Stock Option Plan and in the related Prospectus of our reports dated January 27, 1994, with respect to the consolidated financial statements and schedules of Justin Industries, Inc. included or incorporated by reference in this Annual Report (Form 10-K) for the year ended December 31, 1993. We also consent to the incorporation by reference in the Registration Statement on Form S-8 pertaining to the Justin Industries, Inc. Employee Stock Ownership Plan and in the related Prospectus of our reports (a) dated January 27, 1994, with respect to the consolidated financial statements and schedules of Justin Industries, Inc. included or incorporated by reference in this Annual Report (Form 10-K) for the year ended December 31, 1993 and (b) dated March 10, 1994, with respect to the financial statements of Justin Industries, Inc. Employee Stock Ownership Plan included as Exhibit 99.1 to this Annual Report (Form 10-K) for the year ended December 31, 1993. We also consent to the incorporation by reference in the Registration Statement (Form S-8 No. 33-61776) pertaining to the Justin Industries, Inc. 1992 Stock Option Plan and in the related Prospectus of our reports dated January 27, 1994, with respect to the consolidated financial statements and schedules of Justin Industries, Inc. included or incorporated by reference in this Annual Report (Form 10-K) for the year ended December 31, 1993. /S/ ERNST & YOUNG Fort Worth, Texas March 21, 1994 =========================================================================== (PAGE S-2) JUSTIN INDUSTRIES, INC. CONSOLIDATED SCHEDULE V - PROPERTY, PLANT, AND EQUIPMENT Years Ended December 31, (in thousands of dollars) Balance Transfers Balance at Additions Retire- & at Beginning at Cost ments Reclassi- Close of Year (1) or Sales fications of Year ---------- --------- ---------- --------- ------- 1991: - - - ----- Land $ 19,713 $ 1,227 $ 8 $ (2,493) $ 18,439 Buildings & Equipment: Buildings & Leasehold Improvements 45,074 4,833 676 (259) 48,972 Machinery & Equipment 115,692 9,098 5,241 (663) 118,886 Office Furniture & Fixtures 10,090 808 1,842 - 9,056 Unfinished Improvements 2,630 (1,498) - - 1,132 -------- ------- ------- -------- -------- 173,486 13,241 7,759 (922) 178,046 -------- ------- ------- -------- -------- $193,199 $14,468 $ 7,767 $ (3,415) $196,485 ======== ======= ======= ======== ======== 1992: - - - ----- Land $ 18,439 $ 62 $ 5 $ (1,761) $ 16,735 Buildings & Equipment: Buildings & Leasehold Improvements 48,972 1,251 184 (563) 49,476 Machinery & Equipment 118,886 10,168 2,878 51 126,227 Office Furniture & Fixtures 9,056 1,137 956 6 9,243 Unfinished Improvements 1,132 (612) - - 520 -------- ------- ------- -------- -------- 178,046 11,944 4,018 (506) 185,466 -------- ------- ------- -------- -------- $196,485 $12,006 $ 4,023 $ (2,267) $202,201 ======== ======= ======= ======== ======== 1993: - - - ----- Land $16,735 $ 174 $ 230 $ (21) $16,658 Buildings & Equipment: Buildings & Leasehold Improvements 49,476 3,184 440 558 52,778 Machinery & Equipment 126,227 11,434 3,069 (489) 134,103 Office Furniture & Fixtures 9,243 800 302 (47) 9,694 Unfinished Improvements 520 1,686 - - 2,206 -------- ------- ------- -------- -------- 185,466 17,104 3,811 22 198,781 -------- ------- ------- -------- -------- $202,201 $17,278 $ 4,041 $ 1 $215,439 ======== ======= ======= ======== ======== (1) 1991 additions include $3,451 of property, plant, and equipment acquired in the acquisition of Elgin-Butler Brick Company. =========================================================================== (PAGE S-3) JUSTIN INDUSTRIES, INC. CONSOLIDATED SCHEDULE VI - ACCUMULATED DEPRECIATION, DEPLETION, AND AMORTIZATION OF PROPERTY, PLANT, AND EQUIPMENT Years Ended December 31, (in thousands of dollars) Additions Balance Charged Transfers Balance at to Retire- & at Beginning Expense ments Reclassi- Close of Year (1) or Sales fications of Year ---------- --------- ---------- --------- ------- 1991: - - - ----- Land $ 271 $ 5 $ - $ (1) $ 275 Buildings & Equipment: Buildings & Leasehold Improvements 21,130 2,764 500 57 23,451 Machinery & Equipment 78,906 9,253 3,936 (292) 83,931 Office Furniture & Fixtures 8,239 796 1,699 1 7,337 -------- ------- ------- -------- -------- 108,275 12,813 6,135 (234) 114,719 -------- ------- ------- -------- -------- $108,546 $12,818 $ 6,135 $ (235) $114,994 ======== ======= ======= ======== ======== 1992: - - - ----- Land $ 275 $ 5 $ - $ 75 $ 355 Buildings & Equipment: Buildings & Leasehold Improvements 23,451 2,649 168 380 26,312 Machinery & Equipment 83,931 10,377 2,587 51 91,772 Office Furniture & Fixtures 7,337 806 931 6 7,218 -------- ------- ------- -------- -------- 114,719 13,832 3,686 437 125,302 -------- ------- ------- -------- -------- $114,994 $13,837 $ 3,686 $ 512 $125,657 ======== ======= ======= ======== ======== 1993: - - - ----- Land $ 355 $ 5 $ - $ - $ 360 Buildings & Equipment: Buildings & Leasehold Improvements 26,312 2,784 310 77 28,863 Machinery & Equipment 91,772 9,861 2,939 (453) 98,241 Office Furniture & Fixtures 7,218 823 301 (35) 7,705 -------- ------- ------- -------- -------- 125,302 13,468 3,550 (411) 134,809 -------- ------- ------- -------- -------- $125,657 $13,473 $ 3,550 $ (411) $135,169 ======== ======= ======= ======== ======== (1) The company's 1991 balance sheet has been restated for certain of these reclassifications. =========================================================================== (PAGE S-4) JUSTIN INDUSTRIES, INC. CONSOLIDATED SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS Years Ended December 31, (in thousands of dollars) Balance at Additions Balance at Beginning Charged to Deductions End of of Year Income (1) Year (2) ---------- ---------- ---------- ---------- Reserve Deducted from Related Assets: 1991: - - - ----- Doubtful Accounts $ 2,558 $ 1,564 $ 1,470 $ 2,652 1992: - - - ----- Doubtful Accounts $ 2,652 $ 1,613 $ 1,211 $ 3,054 1993: - - - ----- Doubtful Accounts $ 3,054 $ 1,004 $ 1,044 $ 3,014 (1) Accounts written off, less recoveries. (2) The reserve for doubtful accounts is deducted from accounts receivable in the financial statements. =========================================================================== (PAGE S-5) JUSTIN INDUSTRIES, INC. CONSOLIDATED SCHEDULE IX - SHORT-TERM BORROWINGS Years Ended December 31 Weighted Average Maximum Average Interest Amount Amount Rate Category of Balance Weighted Outstanding Outstanding During Aggregate at End Average During the During the the Short-Term of Period Interest Period Period Period Borrowings (000 omitted) Rate (000 omitted) (000 omitted) (2) ------------- ------------- --------- ------------- ------------- --------- 1991: - - - ----- Notes Payable to Banks (1) $ - - % $16,500 $ 8,325 6.8% 1992: - - - ----- Notes Payable to Banks (1) $5,000 4.125% $ 8,000 $ 6,255 4.5% 1993: - - - ----- Notes Payable to Banks (1) $ - - % $12,500 $ 7,742 3.9% (1) Notes payable to banks represent unsecured borrowings generally for periods up to 90 days pursuant to credit arrangements with commercial banks. (2) Computed using the total interest expense on short-term indebtedness during the year as a percentage of the daily average amount outstanding during the year. =========================================================================== (PAGE S-6) JUSTIN INDUSTRIES, INC. CONSOLIDATED SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION Years Ended December 31, (in thousands of dollars) Amounts Charged to Operations in 1993 1992 1991 ------ ------ ------ Maintenance and Repairs $12,822 $11,599 $9,865 ======= ======= ======= Depreciation $13,473 $13,837 $12,818 ======= ======= ======= Advertising Expense $14,494 $12,712 $10,063 ======= ======= ======= Note: For the three years presented, the amounts for amortization of intangible assets, pre-operating costs, and similar deferrals, royalties, and taxes other than payroll and income are less than 1% of total sales. The information presented above is for continuing operations. =========================================================================== JUSTIN INDUSTRIES, INC. INDEX TO EXHIBITS (Item 14(a)(3)) Exhibit No. Description Page - - - ------- ------------------------------------------------------------ ---- 3.1 Articles of Incorporation of Registrant, as amended (incorporated by reference to the Registrant's Current Report on Form S-8 dated March 22, 1994) 3.2 By-Laws of Registrant, as amended (incorporated by reference to the Registrant's Current Report on Form 8-K dated September 7, 1990) 4.1 Rights Agreement dated as of October 6, 1989 between Registrant and Team Bank, as Rights Agent (incorporated by reference to Registrant's Registration Statement on Form 8-A dated October 10, 1989) 4.2 First Amendment to Rights Agreement dated as of October 4, 1990 between Registrant and Ameritrust Texas, N.A., as successor Rights Agent (incorporated by reference to Registrant's Amendment No. 1 on Form 8 to Registration Statement on Form 8-A dated October 4, 1990) 10.1 Registrant's 1981 Stock Option Plan* 10.2 Registrant's 1984 Incentive Stock Option Plan* 10.3 Registrant's 1992 Stock Option Plan (incorporated by reference from the company's definitive proxy statement for the Annual Meeting of Shareholders held on April 3, 1992) 10.4 Registrant's Deferred Compensation Plan* 10.5 Form of Registrant's Special Executive Benefit Program* 10.6 Registrant's Supplemental Executive Retirement Plan of 1992 (incorporated by reference to Registrant's 1992 Annual Report on Form 10-K) 10.7 Registrant's Employee Stock Ownership Plan, as restated January 1, 1989 (incorporated by reference to the Registrant's Current Report on Form S-8 dated March 22, 1994) 10.8 Employment Agreement dated as of September 15, 1989 between Registrant and John S. Justin, Jr.* 10.9 Form of Severance Agreement dated March 23, 1990 between Registrant and its executive officers* 10.10 Form of Severance Agreement dated March 23, 1990 between Registrant and certain of its officers and employees* 10.11 Revolving Loan Agreement between Registrant, NationsBank of Texas, N.A. (formerly NCNB Texas National Bank) as Administrative Lender and the several banks listed on the signature pages thereof, as amended in the First and Second Amendments through June 9, 1990* 10.12 Third Amendment to the Revolving Loan Agreement dated as of December 3, 1990 among Registrant, NationsBank of Texas, N.A. (formerly NCNB Texas National Bank), Bank One, Texas, N.A. (formerly Team Bank), Citibank, N.A., The Bank of New York and Texas Commerce Bank--Fort Worth, N.A. (incorporated by reference to Registrant's Current Report on Form 8-K dated December 3, 1990) 10.13 Fourth Amendment to the Revolving Loan Agreement dated as of December 31, 1991 among Registrant, certain subsidiaries of the Registrant, NationsBank of Texas, N.A., as Administrative Lender, NationsBank of Texas, N.A., Bank One, Texas, N.A. (formerly Team Bank), Citibank, N.A., The Bank of New York and Texas Commerce Bank, National Association (successor by merger to Texas Commerce Bank--Fort Worth, N.A.) (incorporated by reference to Registrant's 1991 Annual Report on Form 10-K) 10.14 Fifth Amendment to the Revolving Loan Agreement dated as of May 1, 1992 among Registrant, certain subsidiaries of the Registrant, NationsBank of Texas, N.A., as Administrative Lender, NationsBank of Texas, N.A., Bank One, Texas, N.A. (formerly Team Bank), Citibank, N.A., The Bank of New York and Texas Commerce Bank, National Association (successor by merger to Texas Commerce Bank--Fort Worth, N.A.) (incorporated by reference to Registrant's 1992 Annual Report on Form 10-K) 10.15 Sixth Amendment to the Revolving Loan Agreement dated as of December 31, 1993 among Registrant, certain subsidiaries of the Registrant, NationsBank of Texas, N.A., as Administrative Lender, NationsBank of Texas, N.A., Bank One, Texas, N.A., Citibank, N.A., The Bank of New York and Texas Commerce Bank, National Association 10.16 Term Loan Agreement dated as of December 3, 1990 among the Registrant, NationsBank of Texas, N.A. (formerly NCNB Texas National Bank), Bank One, Texas, N.A. (formerly Team Bank), Citibank, N.A. and Texas Commerce Bank--Fort Worth, N.A. (incorporated by reference to Amendment No. 4 to Registrant's Schedule 14D-9 dated December 6, 1990) 10.17 First Amendment to the Term Loan Agreement dated as of December 31, 1991 among Registrant, certain subsidiaries of the Registrant, NationsBank of Texas, N.A., as Administrative Lender, NationsBank of Texas, N.A., Bank One, Texas, N.A. (formerly Team Bank), Citibank, N.A. and Texas Commerce Bank, National Association (successor by merger to Texas Commerce Bank--Fort Worth, N.A.) (incorporated by reference to Registrant's 1991 Annual Report on Form 10-K) 10.18 Second Amendment to the Term Loan Agreement dated as of May 1, 1992 among Registrant, certain subsidiaries of the Registrant, NationsBank of Texas, N.A., as Administrative Lender, NationsBank of Texas, N.A., Bank One, Texas, N.A. (formerly Team Bank), Citibank, N.A. and Texas Commerce Bank, National Association (successor by merger to Texas Commerce Bank--Fort Worth, N.A.) (incorporated by reference to Registrant's 1992 Annual Report on Form 10-K) 10.19 Third Amendment to the Term Loan Agreement dated as of December 31, 1993 among Registrant, certain subsidiaries of the Registrant, NationsBank of Texas, N.A., as Administrative Lender, NationsBank of Texas, N.A., Bank One, Texas, N.A., Citibank, N.A. and Texas Commerce Bank, National Association 13 Annual report to shareholders for the year ended December 31, 1993 21 Subsidiaries of the Registrant 23 Report of Independent Auditors and Consent of Independent Auditors (included herein at page S-1) 99.1 Financial statements required by Form 11-K for registrant's Employee Stock Ownership Plan for the year ended December 31, 1993 * Incorporated by reference to Registrant's Amendment No. 1 on Form 8 to Annual Report on Form 10-K dated August 23, 1990.

316901_1993.txt

316901_1993

1993

316901

ITEM 1. BUSINESS GENERAL DESCRIPTION OF BUSINESS UST Corp. (the "Company"), a bank holding company registered with the Board of Governors of the Federal Reserve System (the "Federal Reserve Board"), was organized as a Massachusetts business corporation in 1967. The Company is also subject to examination by, and is required to file reports with, the Commissioner of Banks of the Commonwealth of Massachusetts (the "Massachusetts Commissioner"). The Company's banking subsidiaries are USTrust and United States Trust Company ("USTC"); each headquartered in Boston and each a Massachusetts trust company and UST Bank/Connecticut ("UST/Conn") headquartered in Bridgeport, a Connecticut trust company. All of the common stock of USTrust, USTC, and UST/Conn is issued to and owned by the Company. In addition, the Company owns, directly or indirectly, all of the outstanding stock of three active nonbanking subsidiaries, all Massachusetts corporations: UST Leasing Corporation, UST Data Services Corp. and UST Capital Corp. Through its banking and nonbanking subsidiaries, the Company provides a broad range of financial services, principally to individuals and small-and medium-sized companies in New England. In addition, an important component of the Company's financial services is the provision of trust and money management services to professionals, corporate executives, nonprofit organizations, labor unions, foundations, mutual funds and owners of closely-held businesses in the New England region. As of the close of business on December 31, 1993, the Company's total assets were approximately $2.0 billion and USTrust, the lead bank, had over $1.9 billion or 93% of the Company's consolidated assets. THE SUBSIDIARY BANKS USTrust and UST/Conn are engaged in a general commercial banking business and accept deposits which are insured by the Federal Deposit Insurance Corporation ("FDIC"). USTC, which has full banking powers and accepts deposits which are insured by the FDIC, focuses its activity on trust and money management and other fee generating businesses. Two of the Company's banking subsidiaries are located in Massachusetts and one is located in Connecticut. RECENT DEVELOPMENTS Recent Operating History The Company reported a loss of $20.1 million, or $1.31 per share, for 1993, resulting primarily from a loan loss provision of $42.7 million in the second quarter and writedowns of certain nonperforming assets. In addition, the Company incurred net losses in each of the two preceding recent fiscal years. See Note 19 to Consolidated Financial Statements of the Company. Proposed New Standards on Safety and Soundness -- Asset Quality Proposed regulations covering standards for safety and soundness at banks and bank holding companies have been put forth by the Company's primary federal banking regulators as required by Section 132 of the Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA"). Included in the proposal are standards (1) dealing with the maximum amount of classified assets an institution may have and (2) defining a minimum earnings amount. Failure to meet these standards would require the filing of a compliance action plan with and acceptable to the Company's supervisory agencies. If the proposed regulations were to be adopted in their present form, the Company would not have been in compliance with the first standard at December 31, 1993. The federal banking regulators have not publicly indicated at this time when passage of final regulations in this area will occur or whether final regulations will be substantially similar to those proposed. At December 31, 1993, the Company had approximately $49.3 million in nonaccrual loans, $.5 million in accruing loans 90 days or more past due, $41.5 million in restructured loans, $19.5 million in other real estate owned and $12 million in Special Mention loans 30 to 89 days past due and accruing. In addition, the Company had approximately $185 million of accruing commercial and real estate loans which, while current, have nonetheless been classified as Special Mention or Substandard in the Company's internal risk rating profile. Under the Company's definition, Substandard assets are characterized by the distinct possibility that some loss will be sustained if the credit deficiencies are not corrected. The Substandard classification, however, does not necessarily imply ultimate loss for each individual asset so classified. Special Mention assets, as defined by the Company, have potential weaknesses that deserve management's close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the assets. The risk ratings assigned to these loans were an important factor in the Company's analysis of the adequacy of its reserve for loan losses. The above-described, proposed regulations, if implemented in their current form, however, may require the Company to reduce significantly the level of these loans. Among the responses available to the Company, in this event, is a further acceleration of the Company's strategy to handle problem credits expeditiously. It is not possible to predict the future effects on the Company's financial condition or results of operations of actions which may be taken by the Company in response to final regulations in this area. Management of the Company has identified the reduction of the aggregate amount of non-performing and classified assets as a high priority. Management will continue to assess its alternatives with a view to implementing the most effective means of achieving such reduction. Potential Regulatory Sanctions Certain apparent and inadvertent violations of the insider lending provisions (and related lending limit provisions) of Regulation O of the FRB related to extensions of credit by USTrust to Director Francis X. Messina have led the FDIC to require that corrective action be taken and to advise USTrust orally that the FDIC may consider the imposition of civil money penalties with respect to such matters. No FDIC representative has suggested to USTrust or the Company that there was any willful or intentional misconduct on the part of USTrust, Director Messina or USTrust's other institution-affiliated parties in connection with these matters. To address these issues, USTrust and Director Messina have undertaken a program to reduce the aggregate balance of Mr. Messina's outstanding loans from USTrust and to improve the collateral support for the remaining outstanding loan balance. The elements of this program have been communicated to and reviewed by the FDIC. In furtherance of the program, since late 1993, the outstanding principal of the aggregate loans to Director Messina and his related interests has been reduced by more than $11 million from approximately $30 million to less than $19 million, and such loans are now below all applicable lending limits. To date, the Company has incurred no losses with respect to any of these loans, although they are characterized as "Substandard" in the Company's internal risk rating profile, and all such loans are current as to both principal and interest. There has been no further action taken by any bank regulatory agency to date. The FDIC has the authority to levy civil money penalties of various amounts for violations of law or regulations, orders and written conditions and agreements, which, depending upon the nature and severity of the violations, may be, in situations where conduct has been egregious, as high as $1 million per day for the period during which such violation continues. In connection with the apparent violations described above, the FDIC has the authority to impose penalties on any of USTrust, its Board of Directors, officers of the Bank, Director Messina personally, "institution-affiliated parties" of USTrust or any combination thereof. While it is not possible to predict with certainty the probability of penalties being assessed, the person or persons upon whom any penalty would be assessed or the amounts of any such penalties, were they to be assessed, management of the Company believes that it is unlikely that this matter will have a material adverse effect on the Company's financial condition or results of operations. Consequently, no provision in respect of penalties has been made in the Company's Consolidated Financial Statements. See Note 15 to Consolidated Financial Statements of the Company. Bank Regulatory Agreements and Orders In February 1992, USTC and USTrust entered into separate consent agreements and orders with the FDIC and the Massachusetts Commissioner. In mid-1992 and 1993, UST/Conn agreed to two addenda to its 1991 stipulation and agreement with the Connecticut Commissioner. The Company also entered into a written agreement with the Federal Reserve Bank of Boston (the "FRB-Boston") and the Massachusetts Commissioner in August 1992 (The foregoing are hereinafter collectively referred to as the "Regulatory Agreements."). In February 1994, the FDIC and the Massachusetts Commissioner terminated and lifted the Consent Agreement and Order with USTC. The Regulatory Agreements require that the Company, USTrust and UST/Conn refrain from paying dividends without prior regulatory consent and the Company has not paid a cash dividend to its stockholders since July 1991. Despite the termination of its Regulatory Agreement, USTC has agreed to continue to request regulatory consent prior to the payment of dividends. The Regulatory Agreements further require USTrust and UST/Conn to maintain Tier I leverage capital ratios at or in excess of 6%. Each of the Company's subsidiary banks is currently in compliance with its respective capital requirements. As provided in the Regulatory Agreements, the Company, USTrust and UST/Conn have instituted plans to reduce levels of nonperforming assets and have developed written plans and policies concerning, among other matters, credit administration, loan review and intercompany transactions. USTrust and UST/Conn have also revised and expanded their investment and funds management policies as required by the Regulatory Agreements. Moreover, the Company has agreed to give the FRB-Boston and the Massachusetts Commissioner prior notice of certain significant expenditures and certain increases in management compensation. The Company has filed (and will continue to file) with the regulatory agencies a broad range of periodic reports. For a discussion of capital in the context of the Regulatory Agreements, see "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Capital" below. For a discussion of related-party transactions, see Note 14 to Consolidated Financial Statements. BUSINESS SERVICES USTrust and UST/Conn provide commercial banking services, including deposit, investment, cash management, payroll, wire transfer, leasing and lending services throughout New England. Commercial and industrial lending takes the form primarily of direct loans and includes lines of credit, revolving credits, domestic and foreign letters of credit, term loans, mortgage loans, receivable, inventory and equipment loans and other specialized lending services. USTrust also provides merchant credit card services. USTC provides deposit services and other banking services, but focuses its activities on money management and other fee generating services. Through loan participations, each bank is able to provide credit to businesses in its area up to the limit available to the combined banks. At December 31, 1993, the combined lending limit to a single borrower of the subsidiary banks was approximately $28 million. CONSUMER SERVICES Consumer services are provided by USTrust and UST/Conn to customers in their respective areas. These services include savings and checking accounts, NOW and money market accounts, consumer loans, night depositories, credit cards (through a private label arrangement), safe deposit box facilities and travelers' checks. In late 1993, the Company introduced a Choice Checking retail account product which combines a relatively modest fee structure with ancillary travel, insurance and other "lifestyle" benefits. Consumer loans include residential first mortgage and home equity loans and loans to finance education costs as well as open-ended credit via cash reserve facilities. In 1993, the Company introduced an Affordable Mortgage Program designed to provide certain customers who may not qualify for traditional mortgage financing with an alternate means of financing or refinancing a residence. The Company's banking subsidiaries, which currently have an aggregate of 34 banking offices, maintain an automated teller machine system which through membership in the NYCE, Cirrus and Yankee 24 ATM networks provides the Company's customers with access to their accounts at locations throughout the United States. The Company provides a broad range of services in connection with its consumer automobile lending program. The Company's banking subsidiaries offer an integrated Preferred Banking Services which combines a wide range of the Company's retail banking products. SPECIALIZED SERVICES FOR INDIVIDUALS The Company provides services to meet the financial needs of individuals, such as self-employed professionals, corporate executives and entrepreneurs. The Company's services include deposit accounts, specialized credit facilities, an account management system for escrow funds, consumer banking and other personal financial products. REAL ESTATE SERVICES USTrust and UST/Conn provide a broad range of industrial and commercial real estate lending services, residential mortgage banking services and other related financial services. ASSET AND MONEY MANAGEMENT AND TRUST SERVICES Asset and money management, custodial and trust services are provided by USTC. In addition, USTC provides services as executor, administrator and trustee of estates and acts, under the terms of agreements, in various capacities such as escrow agent, bond trustee and trustee and agent of pension, profit-sharing and other employee benefit trusts. At December 31, 1993, the total assets under management of USTC were approximately $3.3 billion. INVESTMENTS The subsidiary banks maintain securities portfolios consisting primarily of U.S. Government Agency, corporate and municipal securities. USTrust's investment portfolio also includes certain other equity investments as allowed within limits prescribed by Massachusetts law. The Treasury Division of the Company provides investment portfolio advisory services to its affiliated banks. PRINCIPAL NONBANKING SUBSIDIARIES UST Leasing Corporation, organized in 1987 and a subsidiary of USTrust provides a broad range of equipment leasing services to major corporations headquartered throughout the United States. In 1994, UST Leasing Corporation intends to develop a line of leasing products designed to meet the needs of the Company's small business customers and other business entities with similar needs. UST Data Services Corp., organized in 1981 and a subsidiary of USTrust provides a full range of electronic data processing services to the Company and its affiliates. UST Capital Corp., organized in 1961, was acquired by the Company in 1969, is a subsidiary of USTC and is a licensed Small Business Investment Company. It specializes in equity and long-term debt financing for growth-oriented companies. COMPETITIVE CONDITIONS The Company's banking and nonbanking subsidiaries face substantial competition throughout Massachusetts and Connecticut. This competition is provided by commercial banks, savings banks, credit unions, consumer finance companies, insurance companies, "nonbank banks," money market mutual funds, government agencies, investment management companies, investment advisors, brokers and investment bankers. In addition, the Company anticipates increased competition from out-of-state and foreign banks and bank holding companies as those entities increase their usage of interstate banking powers granted during the past few years. During the past several years, acquisitions of small-and medium-sized banks and bank holding companies by the largest New England bank holding companies and the closing by regulators of a number of banks and bank holding companies in Eastern Massachusetts and Connecticut has resulted in fewer but financially stronger competitors in the local markets served by the Company's banking subsidiaries. SUPERVISION AND REGULATION OF THE COMPANY AND ITS SUBSIDIARIES GENERAL As a bank holding company registered under the Bank Holding Company Act of 1956, as amended, the Company is subject to substantial regulation and supervision by the Federal Reserve Board. As state-chartered banks, USTC, USTrust and UST/Conn (collectively, the "Subsidiary Banks") are subject to substantial regulation and supervision by the FDIC and the applicable state bank regulatory agencies. Such activities are often intended primarily for the protection of depositors or are aimed at carrying out broad public policy goals that may not be directly related to the financial services provided by the Company and its subsidiaries. Federal and state banking and other laws impose a number of requirements and restrictions on the business operations, investments and other activities of depository institutions and their affiliates. Since 1992, the Company and its banking subsidiaries have been operating under regulatory agreements and orders with state and federal bank regulatory authorities. In February 1994, the order under which USTC was operating was lifted and terminated. See "Recent Developments -- Bank Regulatory Agreements and Orders" above. GENERAL SUPERVISION AND REGULATION The Company, as a bank holding company under the Bank Holding Company Act of 1956, as amended in 1970 (the "BHC Act"), is registered with the Federal Reserve Board and is regulated under the provisions of the BHC Act. Under the BHC Act the Company 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, except that the Company may 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 nonbank subsidiaries of the Company is not restricted geographically under the BHC Act. In 1989, after the passage of the Financial Institutions Reform, Recovery and Enforcement Act of 1989 ("FIRREA"), the Federal Reserve Board amended its regulations under the BHC Act to permit bank holding companies, as a nonbanking activity, to own and operate savings associations without geographical restrictions. The Company is required by the BHC Act to file with the Federal Reserve Board an annual report and such additional reports as the Federal Reserve Board may require. The Federal Reserve Board also makes examinations of the Company and its subsidiaries. The BHC Act 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. Because the Company is also a bank holding company under the Massachusetts General Laws, the Massachusetts Commissioner has authority to require certain reports from the Company from time to time and to examine the Company and each of its subsidiaries. The Massachusetts Commissioner also has enforcement powers designed to prevent banks from engaging in unfair methods of competition or unfair or deceptive acts or practices involving consumer transactions. Prior approval of the Massachusetts Board of Bank Incorporation is also required before the Company may acquire any additional commercial banks located in Massachusetts or in those states which permit acquisitions of banking institutions located in their states by Massachusetts bank holding companies. The Connecticut General Statutes require that the Company furnish to the Connecticut Commissioner such reports as the Connecticut Commissioner deems appropriate to the proper supervision of the Company. The Connecticut Commissioner is also authorized to make examinations of the Company and its Connecticut subsidiaries including UST/Conn, and to order the Company to cease and desist from engaging in any activity which constitutes a serious risk to the financial safety, soundness or stability of a Connecticut subsidiary bank, or is inconsistent with sound banking principles or the provisions of Chapter 658 (the banking statute) of the Connecticut General Statutes. The Subsidiary Banks, whose deposits are insured by the FDIC, and the subsidiaries of such banks are subject to a number of regulatory restrictions, including certain restrictions upon: (i) extensions of credit to the Company and the Company's nonbanking affiliates (collectively with the Company, the "Affiliates"), (ii) the purchase of assets from Affiliates, (iii) the issuance of a guarantee, acceptance of letter of credit on behalf of Affiliates and (iv) investments in stock or other securities issued by Affiliates or acceptance thereof as collateral for an extension of credit. In addition. all transactions among the Company and its direct and indirect subsidiaries must be made on an arm's length basis and valued on fair market terms. The Subsidiary Banks pay substantial deposit insurance premiums to the FDIC. Such deposit premium rates were substantially increased in 1992. They were further increased for the first half of 1993 and decreased in the second half of 1993 pursuant to regulations issued under the Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA"). Federal Reserve Board Policy requires bank holding companies to serve as a source of strength to their subsidiary banks by standing ready to use available resources to provide adequate capital funds to subsidiary banks during periods of financial stress or adversity. A bank holding company also can be liable under certain provisions of FDICIA for the capital deficiencies of an undercapitalized bank subsidiary. In the event of a bank holding company's bankruptcy under Chapter 11 of the U.S. Bankruptcy Code, the trustee will be deemed to have assumed and is required to cure immediately any deficit under any commitment by the debtor to any of the federal banking agencies to maintain the capital of an insured depository institution, and any claim for breach of such obligation will generally have priority over most other unsecured claims. Under the cross-guarantee provisions of the Federal Deposit Insurance Act, if any or all of the Subsidiary Banks were placed in conservatorship or receivership, the Company, as sole stockholder, would likely lose its investment in the applicable Subsidiary Bank or Subsidiary Banks. The Company and all its subsidiaries 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 Section 106 of the 1970 Amendments to the BHC Act and regulations which have been issued by the Federal Reserve Board, the Company 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. Various consumer laws and regulations also affect the operations of the Subsidiary Banks. The Subsidiary Banks, two of which are chartered under Massachusetts law and one of which is chartered under Connecticut law, are subject to federal requirements to maintain cash reserves against deposits, and to state mandated restrictions upon the nature and amount of loans which may be made by the banks (including restrictions upon loans to "insiders" of the Company and its subsidiary banks) as well as to restrictions relating to dividends, investments, branching and other bank activities. See "Recent Developments -- Potential Regulatory Sanctions." FDICIA prescribes the supervisory and regulatory actions that will be taken against undercapitalized insured depository institutions for the purposes of promptly resolving problems at such institutions at the least possible long-term loss to the FDIC. Five categories of depository institutions have been established by FDICIA in accordance with their capital levels: "well capitalized," "adequately capitalized," "undercapitalized," "significantly undercapitalized," and "critically undercapitalized." The federal banking agencies have adopted uniform regulations to implement the prompt regulatory action provisions of FDICIA. Under the uniform regulations, a well-capitalized institution has a minimum tier 1 capital-to-total risk-based assets ratio of 6 percent, a minimum total capital-to-total risk-based assets ratio of 10 percent and a minimum leverage ratio of 5 percent and is not subject to any written capital order or directive. An adequately capitalized institution meets all of its minimum capital requirements under the existing capital adequacy guidelines. An undercapitalized institution is one that fails to meet any one of the three minimum capital requirements. A significantly undercapitalized institution has a tier 1 capital-to-total risk-based assets ratio of less than 3 percent, a tier 1 leverage ratio of less than 3 percent or a total capital-to-total risk-based assets ratio of less than 6 percent. A critically undercapitalized institution has a tier 1 leverage ratio of 2 percent or less. An institution whose capital ratios meet the criteria for a well capitalized institution may be classified as an adequately capitalized institution due to qualitative and/or quantitative factors other than capital adequacy. An adequately capitalized institution or undercapitalized institution, may under certain circumstances, be required to comply with supervisory action as it if were in the next lower category. An undercapitalized institution is required to submit a capital restoration plan for acceptance by the appropriate federal banking agency and will be subject to close monitoring of both its condition and compliance with. and progress made pursuant to, its capital restoration plan. The capital restoration plan will be accepted only if (i) it specifies the steps that will be taken to become adequately capitalized and the activities in which the institution will engage, (ii) it is based upon realistic assumptions and it is likely to succeed in restoring the institution's capital, (iii) it does not appreciably increase the institution's risk exposure and (iv) each holding company that controls the institution provides appropriate assurances of performance and guaranties that the institution will comply with the plan until the institution is adequately capitalized on an average basis for each of four consecutive quarters. Liability under the guaranty is the lesser of (i) five percent of the institution's total assets at the time it become undercapitalized and (ii) the amount necessary to bring the institution into compliance with all applicable capital standards as of the time the institution fails to comply with the plan. An institution that fails to submit an acceptable plan may be placed into conservatorship or receivership unless its capital restoration plan is accepted. An undercapitalized institution will also be subject to restrictions on asset growth, acquisitions, branching, new activities, capital distributions and the payment of management fees. FDICIA requires the appropriate regulatory agencies to take one or more specific actions against significantly undercapitalized institutions and undercapitalized institutions that fail to submit capital restoration plans, which actions include but are not limited to (i) requiring the institution to sell shares or other obligations to raise capital, (ii) limiting deposit interest rates, (iii) requiring the election of a new board of directors and/or dismissing senior executive officers and directors who held such positions for more than 180 days before the institution became undercapitalized, (iv) prohibiting receipt of deposits from correspondent banks, (v) requiring divestiture or liquidation of one or more subsidiaries and (vi) requiring the parent company to divest the institution if such divestiture will improve the institution's financial condition and future prospects. In addition, an insured institution that receives a less-than-satisfactory rating for asset quality, management, earnings or liquidity may be deemed by its appropriate federal banking regulator to be engaging in an unsafe or unsound practice for purposes of issuing an order to cease and desist or to take certain affirmative actions. If the unsafe or unsound practice is likely to weaken the institution, cause insolvency or substantial dissipation of assets or earnings or otherwise seriously prejudice the interest of depositors or the FDIC, a receiver or conservator could be appointed. Finally, subject to certain exceptions FDICIA requires critically undercapitalized institutions to be placed into receivership or conservatorship within 90 days after becoming critically undercapitalized. The Federal Reserve Board has indicated that it will consult with each federal banking agency regulating the bank subsidiaries of a holding company to monitor required supervisory actions, and based upon an assessment of these developments, will take appropriate action at the holding company level. Under FDICIA, federal bank regulators are also required to see that changes are made in the operations and/or management of a bank or bank holding company if the financial institution is deemed to be "undercapitalized." Under FDICIA. a depository institution that is "adequately capitalized" but not "well capitalized" is generally prohibited from accepting brokered deposits and offering interest rates on deposits higher than the prevailing rate in its market. In addition, "pass through" insurance coverage may not be available for certain employee benefit accounts. The Company believes that the application of these limitations to it would not have a material effect on its funding or liquidity. USTC is currently classified as "well capitalized" and USTrust and UST/Conn are each currently classified as "adequately capitalized". New regulations adopted pursuant to FDICIA include: (1) real estate lending standards for depository institutions, which provide guidelines concerning loan-to-value ratios for various types of real estate loans; (2) rules requiring depository institutions to develop and implement internal procedures to evaluate and control credit and settlement exposure to their correspondent banks: (3) rules implementing the FDICIA provisions prohibiting, with certain exceptions, insured state banks from making equity investments or engaging in activities of the types and amounts not permissible for national banks; and (4) rules and guidelines for enhanced financial reporting and audit requirements. Rules currently proposed for adoption pursuant to FDICIA include: (1) revisions to the risk-based capital guidelines regarding interest rate risk, concentrations of credit risk and the risks posed by "nontraditional activities;" and (2) rules addressing various "safety and soundness" issues, including operations and managerial standards, standards for asset quality, earnings and compensation standards. See "Recent Developments -- Proposed New Standards on Safety and Soundness -- Asset Quality." The status of the Company as a registered bank holding company does not exempt it from certain federal and state laws and regulations applicable to corporations generally, including, without limitation, certain provisions of the federal securities laws and the Massachusetts corporate laws. With the passage of FIRREA in 1989, the Crime Control Act in 1990 and FDICIA in 1991, federal bank regulatory agencies including the Federal Reserve Board and the FDIC were granted substantially broader enforcement powers to restrict the activities of financial institutions and to impose or seek the imposition of increased civil and/or criminal penalties upon financial institutions, the individuals who manage or control such institutions and "institution affiliated parties" of such entities. Pursuant to the Community Reinvestment Act ("CRA"), federal regulatory authorities review the performance of the Company and its subsidiary banks in meeting the credit needs of the communities served by the subsidiary banks. The applicable federal regulatory authority considers compliance with this law in connection with applications for, among other things, approval of branches, branch relocations and acquisitions of banks and bank holding companies. USTrust's current CRA rating is "outstanding" and UST/Conn's current CRA rating is "satisfactory." The FDIC has determined that it will no longer examine USTC, which focuses upon trust and asset management activities, for CRA compliance. The Massachusetts Commissioner has not yet determined whether it will continue to examine USTC for CRA compliance. Supervision, regulation and examination of the Subsidiary Banks by the bank regulatory agencies are not intended for the protection of the Company's security holders. From time to time various proposals are made in the United States Congress as well as state legislatures which would alter the powers of, and place restrictions on, different types of bank organizations as well as bank and nonbank activities. Such legislative proposals include interstate branching and expansion of bank powers. It is impossible to predict whether any of the proposals will be adopted and the impact of such adoption on the business of the Company or its subsidiaries. GOVERNMENTAL POLICIES, ECONOMIC CONDITIONS AND CREDIT RISK CONCENTRATION The earnings and business of the Company's subsidiaries are and will be affected by a number of external influences, including general economic conditions in the United States and particularly in New England and the policies of various regulatory authorities of the United States, including the Federal Reserve Board. The Federal Reserve Board regulates the supply of money and of bank credit to influence general economic conditions within the United States and throughout the world. From time to time, the Federal Reserve Board takes specific steps to dampen 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 the level of cash reserves banks, including nonmember banks such as all three of the Company's banking subsidiaries, 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, and the overall level of bank loans, investments and deposits. The impact upon the future business and earnings of the Company of prospective domestic economic conditions, and of the policies of the Federal Reserve Board as well as other U.S. regulatory authorities, cannot be predicted accurately. The Company's primary loan market, the New England region, continues to experience an uneven and slow recovery. Most of the loans outstanding are from Eastern Massachusetts and a substantial portion of these loans are various types of real estate loans; still others have real estate as additional collateral. At year-end 1993, the Company's exposure to credit risk for which the primary source of repayment is real estate collateral included $499 million of loans. Recent economic studies have concluded that the region's economy will remain sluggish for at least the balance of this year. While there have been pockets of growth, they have been rather anemic, and the forecast is for small increases in the overall job market with some industries increasing modestly and others not at all. Real estate prices and activity have both improved somewhat from extremely depressed levels. See "Management's Discussion and Analysis of Financial Conditions and Results of Operations" below. GENERAL No significant portion of the deposits of any of the Company's banking subsidiaries results from one or several accounts, the loss of which would materially affect its business. The Company does not experience significant seasonal fluctuations in its business. EMPLOYEES As of December 31, 1993, the Company and its subsidiaries employed approximately 870 people. ITEM 2. ITEM 2. PROPERTIES USTrust owns a twelve-story brick and steel building constructed in 1915 and located at Government Center, 30-40 Court Street, Boston, Massachusetts. The banking premises of USTrust, USTC and the offices of the Company and all of its nonbanking subsidiaries utilize approximately 99% of the 89,014 square feet in the building and the remaining space is leased as offices to a variety of tenants. The Company currently leases a three-story brick office building of approximately 37,900 square feet as well as 29,003 square feet in a recently-constructed adjacent office tower at 141 Portland Street, Cambridge, Massachusetts, all of which is used by USTrust and UST Data Services Corp. USTrust also leases approximately 19,160 square feet of space at 25-55 Court Street, Boston which is used primarily to house staff support services. In 1991, USTC sold the 25-55 Court Street, Boston building to a third party, unaffiliated with the Company. USTrust owns six branch offices in Boston, Milton Village, Norwood, Randolph, Stoughton and Swampscott, Massachusetts, all of which were acquired by the Company in 1991 from the Resolution Trust Corporation as part of the acquisition and assumption of certain assets, deposits and branches of Home Owners Savings Bank F.S.B. USTrust also owns four branch offices in Canton, Gloucester, Milton, and Natick, Massachusetts. UST/Conn owns two branch offices in Huntington and Shelton, Connecticut. The remaining branch offices of the Company occupy leased premises. The 1994 annual leasehold commitment for all premises leased by the Company's subsidiaries totals approximately $4,031,000. ITEM 3. ITEM 3. LEGAL PROCEEDINGS. In the ordinary course of operations, the Company and its subsidiaries become defendants in a variety of judiciary and administrative proceedings. In the opinion of management, however, other than as noted in item 1 above under "Recent Developments -- Potential Regulatory Sanctions" there is no proceeding pending, or to the knowledge of management threatened, which in the event of an adverse decision would be likely to result in a material adverse change in the financial condition or results of operations of the Company and its subsidiaries. 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 Such over-the-counter market quotations reflect inter-dealer prices, without retail markup, markdown or commission and may not represent actual transactions. The number of holders of record of common stock of the Company was 2,091 at January 31, 1994. There were no dividends declared during 1993 and 1992. Future dividends, including any extra cash dividends, will depend upon the earnings of the Company and its subsidiaries, their need for funds, their financial condition and other factors, including applicable government regulations and regulatory consent. See "Recent Developments -- Bank Regulatory Agreements and Orders" in Part I, Item 1. and the discussion of capital in Management's Discussion and Analysis of Financial Condition and Results of Operations on page 16 of this Form 10-K. In connection with the $20 million senior debt private placement transaction of August 1986 (see Note 9 to Consolidated Financial Statements of the Company), the Company agreed not to make dividend payments in excess of 60% of cumulative net earnings since December 31, 1985 plus $7 million. The Company does not expect that these provisions will adversely affect its ability to pay future dividends which it deems appropriate. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA UST CORP. AND SUBSIDIARIES SUMMARY OF SELECTED FINANCIAL DATA(1) - --------------- (1) This information should be read in connection with Management's Discussion and Analysis of Financial Condition and Results of Operations on pages 12 to 30 of this Form 10-K with particular reference to Credit Quality and Reserve for Loan Loss. (2) The Company declared a 5% stock dividend to holders of record on September 30, 1991. All share and per share data have been adjusted to reflect this transaction. (3) Includes federal funds purchased, repurchase agreements, short-term and other borrowings. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS FINANCIAL CONDITION AT DECEMBER 31, 1993 INTRODUCTION The Company's primary loan market, the New England region, continues to experience an uneven and slow recovery from the weak economic environment of 1990 to 1993. Recent economic studies have concluded that the region's economy will remain sluggish for at least the balance of 1994. This climate has contributed to the decline in commercial and residential real estate values, although there is recent evidence that these values are stabilizing. Generally, real estate prices and activity have both improved from extremely depressed levels. Specifically, in the Commonwealth of Massachusetts, home sales and home construction are both rising due to the prevailing low mortgage rates. The harsh economic environment over the last few years has adversely affected both the net worth of certain borrowing customers of the Company's subsidiary banks and the Company's collateral position with respect to certain loans. Massachusetts has seen both an exodus and failure of a number of businesses and unemployment continues to remain high although somewhat lower than experienced during the 1990 to 1993 period. While there have been pockets of growth, they have been sluggish, and the forecast is for small increases in the overall job market with some industries increasing modestly and others not at all. The foregoing factors continued to influence the Company's financial results for 1993, particularly in the areas of provision for loan losses and expenses related to foreclosed asset and workout expense, and are likely to continue to influence such results. This discussion should be read in conjunction with the financial statements, notes, and tables included elsewhere in this Form 10-K. Certain previous year numbers have been reclassified to conform with the 1993 presentation. ASSETS Total assets of $2.04 billion at December 31, 1993 have declined slightly from $2.18 billion at December 31, 1992. This was primarily caused by weak loan demand in the Company's market area consistent with the sluggish local economy and a reduction due to the chargeoffs of certain credits. As illustrated in the table on page 24, almost all categories of loans decreased. See also "Credit Quality and Reserve for Loan Loss" below. Presently, the Company does not plan a significant increase in assets. Therefore, any increase in loans outstanding would likely be funded by the sale of securities available-for-sale. Securities at $473.9 million remained essentially unchanged from December 31, 1992. In 1993, the Company adopted Statement of Financial Accounting Standards No. 115 (SFAS 115), issued by the Financial Accounting Standards Board. This Standard deals with the classification of all debt securities and equity securities that have a ready market. According to SFAS 115, these securities must be classified as either held-to-maturity, available-for-sale, or trading and are reported at either amortized cost or fair value, depending upon the classification. At December 31, 1993, all securities in the Company's portfolio were classified as available-for-sale. This change in accounting method resulted in an increase of $3.3 million to stockholders' equity, representing the after-tax effect of the unrealized gain on securities available-for-sale at December 31, 1993. LIQUIDITY AND FUNDING Liquidity is defined as a company's ability to fulfill its existing and anticipated financial obligations. It is provided either through the maturity or sale of an entity's assets, such as loans and securities, liability sources such as increased deposits and purchased or borrowed funds, or access to the capital markets. At December 31, 1993, liquidity, which includes excess cash, excess funds sold and unpledged securities totaled approximately $310 million or 15% of year end assets, a $35 million increase from 1992. The funds needed to support the Company's loan and securities portfolios are provided primarily by UST Corp.'s retail deposits which are relatively low cost and account for 73% of total deposits. The Company's deposits have decreased $151 million, or 8.4% during 1993, in the present low interest rate environment. Generally, high-yielding certificates of deposit which matured were not renewed at the prevailing rates, as investors are utilizing mutual funds and other non-bank vehicles to obtain higher returns. Short-term borrowings have been increased $24 million, or 12%, to maintain needed liquidity. As shown in the Consolidated Statements of Cash Flow, cash and cash equivalents decreased by approximately $26.3 million during 1993. This decrease primarily reflected the use of $107.2 million for financing activities, offset in part by $56.8 million in net cash provided by operations and $24.1 million provided by investments. Net cash used for financing activities was primarily the result of decreases in deposits offset in part by sales of common stock (see below). Cash provided by operations resulted largely from net interest income from loans (before provision for loan losses) and securities. This was reduced by $16 million due to writedowns of other real estate owned and the net difference of noninterest expense over noninterest income. Net cash provided by investing activities was due principally to the net decreases in loans through repayment and other real estate owned through sales, which offset an increase in short-term investments. Other borrowings decreased $4.3 million in 1993. On July 30, 1993 the parent company, UST Corp., paid the second annual installment of $4 million on its 8.5% senior notes. On June 2, 1993, the Company sold 500 thousand shares of its unregistered common stock in a private placement for cash proceeds of $3,750,000. Substantially all of the net proceeds of that placement were used to repay principal on the 8.5% senior notes. On August 12, 1993, the Company sold 2.87 million shares of its common stock in a European offering. These shares were placed with more than sixty institutional investors, and the offering was made under Regulation S of the United States Securities and Exchange Commission. Net proceeds of this placement were approximately $21 million after expenses. Substantially all of the net proceeds continue to be held in the general funds of the Company to be used for general corporate purposes. At December 31, 1993, the parent company had cash and liquid investments totaling approximately $23.3 million. Separately, during the last half of 1993, USTC received approval from the appropriate regulators to dividend $5.25 million to the Company. Of that total, $1.7 million was contributed by the Company as capital to its Connecticut banking subsidiary, UST Bank/Connecticut ("UST/Conn"), and $3.55 million was contributed by the Company as capital to its lead bank, USTrust. INTEREST RATE RISK Volatility in interest rates requires the Company to manage interest rate risk. Interest rate risk arises from mismatches between the repricing or maturity characteristics of assets and the liabilities which fund them. Management monitors and adjusts the difference between interest-sensitive assets and interest-sensitive liabilities ("GAP" position) within various time frames. An institution with more assets repricing than liabilities within a given time frame is considered asset sensitive ("positive GAP") and in time frames with more liabilities repricing than assets it is liability sensitive ("negative GAP"). Over a positive GAP time frame an institution will generally benefit from rising interest rates and over a negative GAP time frame will generally benefit from falling rates. With GAP limits established by the Board of Directors, the Company seeks to balance the objective of insulating the net interest margin from rate exposure with that of taking advantage of anticipated changes in rates in order to enhance income. The Company manages its interest rate GAP primarily by lengthening or shortening the maturity structure of the Company's portfolio of securities. The following table summarizes the Company's GAP position at December 31, 1993. Approximately eighty percent of the loans are included in the 0-30 day category as they reprice in response to changes in the interest rate environment. Securities and Demand Deposits are categorized according to their expected lives. They are evaluated in conjunction with the Company's asset/liability management strategy and may be sold in response to changes in interest rates, repayment risk, loan growth and similar factors. The reserve for loan losses is included in the "Over 1 Year" category of loans. At December 31, 1993, the one-year cumulative GAP position was slightly positive at $68 million, or approximately 3.3% of total assets. INTEREST SENSITIVITY PERIODS CREDIT QUALITY AND RESERVE FOR LOAN LOSS The Company maintains a reserve for loan losses to reduce the carrying value of its loans to an amount estimated to be collectible. Adequacy of the reserve for loan losses is determined using a consistent methodology which analyzes the size and risk of the loan portfolio on a monthly basis. Factors in this analysis include past loan loss experience and asset quality, as reflected by trends of delinquent, nonaccrual and restructured loans and the Company's credit risk rating profile. Consideration is also given to the current and expected economic conditions and in particular how such conditions affect the types of credits in the portfolio and the market area in general. Toward the end of the second quarter of 1993, a strategy was adopted which recognized that many troubled credit situations will need to be handled in an expeditious manner (including the possibility of bulk sales) in order to reduce the management and staff involvement and, in some cases, carrying costs of these workouts. This would allow the Company's resources to be redirected toward new business. It would increase the up-front cost of the workouts, however. As a result, the reserve for loan losses was increased by $19.8 million during the second quarter. To achieve the higher reserve level, the Company recorded a $42.7 million provision for loan losses in the second quarter. Included in that amount was a special provision of $30 million. This special provision was management's estimate of the additional losses to be incurred from the strategic change referred to above, the continued sluggish economic climate and losses occurring during the remainder of 1993 on these and other credits as a result of recent events or new facts. The provision for the year ended December 31, 1993 totaled $64.3 million. Net chargeoffs in 1993 were $51.8 million compared with $41.9 million in 1992. At December 31, 1993, the reserve for loan losses was $62.5 million and equaled 4.74% of loans outstanding, 127% of nonaccrual loans and 56% of total nonperforming assets. As a result of the Company's strategy adopted in the second quarter of 1993 to resolve troubled credits more aggressively, net chargeoffs increased as noted above, for 1993 compared with 1992. These chargeoffs and decline in other real estate owned through sales, contributed to a $65 million or 37% decrease in nonperforming assets in 1993. Adverse economic conditions in the future could result in further deterioration of the Company's loan portfolio and the value of its OREO portfolio. The effect of this would likely include increases in delinquencies, nonperforming assets, restructured loans, and OREO writedowns which individually or collectively could have a material negative effect on future earnings. These factors affect the Company's income statement negatively through reduced interest income, increased provisions for loan losses, and higher costs to collect loans and maintain repossessed collateral. In addition to loans on nonaccrual, loans over 90 days and accruing, troubled debt restructurings, other real estate owned and Special Mention accruing loans 30 to 89 days past due, the Company has approximately $185 million of loans which, while current, have nonetheless been classified as Special Mention or Substandard in the Company's internal risk rating profile. See information following the table titled "Nonaccrual, Restructured and Past Due Loans with Percentages of Loan Categories" on page 27 of this Form 10-K. The risk ratings assigned to these loans were an important factor in the Company's analysis of the adequacy of its reserve for loan losses. Proposed regulations if implemented in their current form, however, may require the Company to reduce significantly the level of these loans. See "Proposed New Standards on Safety and Soundness -- Asset Quality" in Part I, Item 1 of this Form 10-K. Among the responses available to the Company, in this event, is a further acceleration of the Company's strategy to handle problem credits expeditiously. It is not possible to predict the future effects on the Company's financial condition or results of operations of actions which may be taken by the Company in response to final regulations in this area. Management of the Company has identified the reduction of the aggregate amount of non-performing and classified assets as a high priority. Management will continue to assess its alternatives with a view to implementing the most effective means of achieving such reduction. Decisions regarding loan loss provisions and the reserve may be influenced by the views of the regulators having jurisdiction over the Company and its subsidiaries. CAPITAL There are three capital requirements which bank and bank holding companies must meet. Two requirements take into consideration risk inherent in investments, loans and other assets for both on-balance and off-balance sheet items on a weighted basis ("risk-based assets"). Under these requirements, the Company must meet minimum Tier 1 and Total risk-based capital ratios (capital as defined in the regulations divided by risk-based assets) of 4% and 8%, respectively. Tier 1 capital is essentially shareholders' equity, net of intangible assets and Tier 2 capital is the allowable portion of the loan loss reserve (as defined) and discounted subordinated debt. Total capital is the combination of Tier 1 and Tier 2. The Company's risk-based assets were $1.64 billion at December 31, 1993 and $1.81 billion at December 31, 1992. The third requirement is a leverage capital ratio, defined as Tier 1 capital divided by total average assets, net of intangibles. It requires a minimum of 3% for the highest rated institutions and higher percentages for others. In February 1992, the Company's two Massachusetts-based banking subsidiaries, USTC and USTrust, each entered into a Consent Agreement and Order with the FDIC and the Commissioner of Banks in the Commonwealth of Massachusetts. In accordance with these agreements, the banks agreed to, among other things, maintain a Tier 1 leverage capital ratio at or in excess of 6% by February 1993. At December 31, 1993 the Tier 1 leverage capital ratios based on average assets were 6.49% for USTrust and 23.75% for USTC. Since June 1991, UST/Conn has been operating under a Stipulation and Agreement with the Commissioner of Banks for the State of Connecticut. This agreement was amended in August 1992 and November 1993 and requires UST/Conn to maintain a 6% Tier 1 leverage capital ratio. UST/Conn Tier 1 leverage capital ratio based on average assets at December 31, 1993 was 6.21%. At December 31, 1993, the Company had a Tier 1 leverage capital ratio of 7.06% compared to 6.21% at December 31, 1992. Additionally, per these agreements, the Company has agreed not to pay any dividends to stockholders, nor take any dividends from its banking subsidiaries, without prior regulatory approval. Similarly, the banking subsidiaries have agreed to refrain from transferring funds in the form of dividends to the Company without prior regulatory approval. As previously mentioned in this Form 10-K regulatory approval was obtained for dividends totaling $5.25 million from USTC and these dividends were then contributed by the Company to its other banking subsidiaries. In February 1994, the FDIC and Massachusetts commissioner terminated and lifted the consent agreement and order with USTC. Despite the terminations of its Regulatory Agreement, USTC has agreed to continue to request regulatory consent prior to the payment of dividends. RESULTS OF OPERATIONS COMPARISON OF 1993 WITH 1992 The $64.3 million provision for loan losses coupled with a $3.1 million increase in foreclosed asset and workout expenses when compared with those of 1992 are the primary reasons the Company reported a $20.1 million loss, or $1.31 per share, for 1993. Positive factors in 1993 included a $21 million reduction in the costs to fund lending operations. The decreased cost outpaced the decrease in the yield on assets. As previously mentioned, nonperforming assets were reduced from $175.8 million at December 31, 1992 to $110.8 at December 31, 1993, a decrease of 37%. These factors were the principal reasons that net interest income increased in 1993. The Company's net interest income on a fully taxable equivalent basis was $4.2 million higher in 1993 compared with 1992. This compares with a $4.6 million increase on a reporting basis. The difference is due to the decline in tax-free income from 1992 to 1993. The Company's interest rate spread and margin also showed considerable improvement. See "Net Interest Income Analysis" below. Return on Average Equity -- Component Analysis Core Earnings The Company defines core earnings as pretax income before loan loss provision, foreclosed asset and workout expense, securities gains, and other nonrecurring income and expense items. Management believes that core earnings are a useful measure of a bank's ability to withstand the adverse effects of nonperforming assets. The following table reflects the Company's core earnings components on a comparative basis. Net Interest Income Analysis Substantial decreases continue to occur in the cost of the Company's interest-bearing liabilities while average noninterest-bearing funds volume has increased significantly since 1992. Specifically, the cost of interest-bearing funds declined to 3.13% in 1993 compared with 3.92% for 1992. The decreased cost has outpaced the decrease in the yield on assets. Noninterest-bearing funds averaged $274 million for 1992 and in 1993 averaged $335 million. This is due primarily to higher balances needed to offset costs associated with maintaining corporate demand deposit accounts. Due to these conditions and the decline in nonperforming assets (and the interest-related costs associated with these assets), the interest rate spread and margin (as these terms are defined on page 22) both increased significantly during 1993. The spread in 1993 was 4.47% compared with 3.88% for 1992. The margin was 5.03% in 1993 compared with 4.41% in 1992. These factors caused an increase of $4.2 million in net interest income on a taxable equivalent basis for 1993 compared with 1992. Current spreads are at historically high rates and, therefore, probably will not continue at these levels into the future. The following table attributes changes in interest income, interest expense and the related net interest income for the year ended December 31, 1993 when compared with 1992, either to changes in average balances or to the changes in average rates on interest-bearing assets and liabilities. In this table, changes attributable to both rate and volume are allocated on a weighted basis. Noninterest Income Total noninterest income of $36.7 million declined $5.6 million in 1993. Gains on sale of securities decreased $9.3 million. Asset management fees continued their positive trend due to new business and appreciation of existing clients' asset portfolios. This resulted in a $3.3 million increase in asset management fees, partly offsetting the decrease in securities gains noted above. Corporate services income increased $985 thousand, or 13%, in 1993. This was due to changes in the fee system and the continued expansion of the product base. Other noninterest income decreased $466 thousand in 1993 and the following are the more significant reasons: Leasing fee income declined $251 thousand as the Company continued to minimize its activity in this area until taxable income increases sufficiently. Real estate appraisal fees decreased $207 thousand due to a curtailment of third-party activities. Home equity loans purchased from the Resolution Trust Corporation at a substantial discount in late 1991 returned principal on a schedule closer to the original contractual amount. This accounted for an increase of $350 thousand compared with 1992 and partially offset the decreases noted above. Additionally, in the first quarter of 1992, the Company sold $5.7 million of its credit card portfolio to an unaffiliated bank. This transaction produced a gain of $161 thousand for the quarter ended March 31, 1992. All other miscellaneous noninterest income declined $197 thousand. Noninterest Expense Noninterest expense of $97.5 million remained essentially flat in 1993 compared with 1992. Increases in foreclosed asset and workout expense amounted to $3.1 million. Increases in writedowns to fair value minus estimated costs to sell foreclosed real estate properties totaled $1.7 million while other foreclosed asset and workout expenses increased $1.4 million. Writedown costs decreased $1.6 million in the fourth quarter of 1993 compared with the same period in 1992. However, as previously discussed under "Credit Quality and Reserve for Loan Loss," this trend may not continue. Other noninterest expense decreased $5.9 million in 1993. In 1992, the Company added $3.8 million to a reserve for losses arising from securitized loans. There was no comparable expense for 1993 as there were no loans securitized. The remaining decrease in other noninterest expense was principally due to a reduction in the Company's provision for litigation in 1993 as compared with 1992. Income Taxes The Company had a tax benefit of $11.5 million in 1993 compared with $2.9 million in 1992. The variations in income taxes are attributable to the level and composition of pretax income or loss. In 1993 the Company adopted Financial Accounting Standard No. 109 "Accounting for Income Taxes." This Standard changed the accounting for deferred income tax to the "liability method." This change, a one-time event, increased net income by $750 thousand in January 1993 representing the cumulative effect of adopting the new standard on the balance sheet. Refer to Note 1 to the financial statements of this Form 10-K for a discussion of this matter. Fair Value of Financial Instruments In December 1991, the FASB approved SFAS No. 107, "Disclosures about Fair Value of Financial Instruments," effective for fiscal year ending December 31, 1992. The methods and assumptions used by the Company to estimate the fair value of each class of Financial Instruments as of December 31, 1993 and 1992 are disclosed in Note 18 of the financial statements of this Form 10-K. Financial Instruments do not include all of the assets and liabilities recorded on a company's balance sheet. Therefore, the aggregate fair value amounts of the Financial Instruments do not represent the underlying value of a company. As a result of those assumptions and valuation methodologies, the estimated fair value of Financial Instrument assets and liabilities of the Company as of December 31, 1993 was $1.93 billion and $1.89 billion, respectively. The estimated fair value of Financial Instrument assets and liabilities of the Company as of December 31, 1992 was $2.03 billion and $2.02 billion, respectively. In the opinion of management, the excess in the valuation of Financial Instrument assets and liabilities over their carrying values for 1993 and 1992 is attributed primarily to the continued decline in interest rates. COMPARISON OF 1992 WITH 1991 Net Interest Income Analysis The following table attributes changes in interest income, interest expense and the related net interest income for the year ended December 31, 1992 when compared with the year ended December 31, 1991, either to changes in average balances or to the changes in average rates on interest-bearing assets and liabilities. In this table, changes attributable to both rate and volume are allocated on a weighted basis. Noninterest Income Total noninterest income decreased by $1.3 million in 1992 from 1991. Asset management fees increased $3.5 million in 1992 compared with 1991. Assets under management increased, including appreciation of existing assets, to nearly $3 billion from approximately $2.5 billion in the previous year. Net gains on securities were $13.5 million in 1992 compared with $10.5 million in 1991. Corporate services income increased $391 thousand, or 6%, in 1992. This was due to the expansion of the product base, growth in the number of clients, and increases in fees charged. A gain on the sale of real estate during 1991 accounted for $3 million of noninterest income. Lease residual income declined $2.6 million due to a reduction in the number of leases maturing. Other noninterest income decreased $2.7 million in 1992 and the following are the more significant reasons. Loan servicing fees decreased $575 thousand as a servicing contract with the Resolution Trust Corporation ended during 1992. Leasing fee income declined $680 thousand as the Company made a decision to minimize its activity in this area until taxable income increases sufficiently. Other fee income which the Company generates, including fees on acceptances and retail banking fees, declined $673 thousand as a result of a drop in the interest rates of the acceptances and a decrease in the levels of both acceptances and deposits. Noninterest Expense Total noninterest expense in 1992 increased to $96.2 million from $89.3 million in 1991. Foreclosed asset and workout expense rose $5.8 million, primarily due to writedowns to fair value minus estimated costs to sell foreclosed real estate properties. These writedowns totaled $14.4 million, an increase of $5.4 million over 1991. Increases in the amortization of core deposit intangibles of $450 thousand, legal fees of $262 thousand, plus additions to the reserves for litigation of $1.8 million, were partially offset by decreases in controllable expenses such as postage and telephone expense of $293 thousand. FDIC deposit assessment expense declined in 1992 due to the aforementioned reduction in deposits. In 1992, the FDIC voted to restructure the assessment system. This restructuring, which would be based on the strength of a bank and the amount of capital it has, could lead to higher assessments in the future, if the Company fails to maintain its capital ratios. In December 1992, the Company adopted Statement of Position 92-3 ("SOP 92-3"), issued by the American Institute of Certified Public Accountants. This statement concluded that foreclosed assets are presumed to be held for sale. Therefore, they should be carried at the lower of cost or fair value minus estimated costs to sell. For 1992, the pretax charge to income resulting from implementation of SOP 92-3 was $750 thousand and is included in the writedown expense of $14.4 million noted above. AVERAGE BALANCES, INTEREST RATES AND INTEREST RATE DIFFERENTIAL SECURITIES The Company has a policy of purchasing primarily securities rated A or better by Moody's Investors Services and in U.S. Government securities. Due to the Tax Reform Act of 1986, and the resulting reduction in their tax free nature, the Company has decided to forego major new investments in its tax exempt portfolio. The following table sets forth the book value of the securities owned by the Company. Data presented for 1993 includes only securities available-for-sale. Data presented for 1992 and 1991 includes both the investment portfolio and securities held for sale. In 1993 securities available-for-sale were $473.9 million. In 1992 and 1991, securities held for sale were $468.6 million and $425.8 million, respectively. - --------------- (1) Non-Taxable At December 31, 1993 the Company owned the following corporate notes, whose aggregate fair value was in excess of 10% of stockholders' investment: These securities are unsecured corporate notes of investment grade. They carry the normal credit risk associated with such instruments. All securities carry interest rate risk. Additionally, mortgage-backed securities carry prepayment risk. (See Footnote 1, Summary of Significant Accounting Policies on page 37 of this Form 10-K for a discussion of prepayment risk). COMPOSITION OF LOAN PORTFOLIO Indirect automobile installment loans represent loans purchased without recourse from automobile dealers. Automobile loans made directly to consumers are not a significant portion of the business and are included in the other consumer loan category. In 1989, a total of $80 million of indirect automobile installment loans was segregated for sale and not included in the above table. Unfavorable market conditions in 1990 and the assumption of longer-term deposits in connection with the Home Owners purchase and assumption transaction (See Note 2 on page 39 of this Form 10-K) resulted in a decision by the Company not to sell those loans and, consequently, they were reclassified to indirect automobile loans in that year. As a result of the Home Owners transaction, the Company had $513.6 million of loans held for sale at December 31, 1990, and, therefore, not included in the above table. All of these loans were put back to the Resolution Trust Corporation in 1991. LOAN MATURITY DISTRIBUTION The Company does not have an automatic rollover (renewal) policy for maturing loans. Renewal requests are reviewed and approved in substantially the same manner as applications by new customers for extensions of credit. Additionally, any renewal of a loan rated Substandard or lower in the Company's risk rating profile, irrespective of size, requires Senior Lending Management and Board of Directors approval. CREDIT QUALITY MONITORING Credit quality within the commercial and commercial real estate loan portfolios of each subsidiary is quantified by a corporate credit rating system designed to parallel regulatory criteria and categories of loan risk. Lenders monitor their loans to ensure appropriate rating assignments are made on a timely basis. Risk ratings and overall loan quality are also assessed on a regular basis by an independent Loan Review Department which reports to the Company's Board of Directors. Loan Review personnel conduct ongoing portfolio trend analyses and individual credit reviews to evaluate loan risk and compliance with corporate lending policies. Results and recommendations from this process provide senior management with independent information on loan portfolio condition. Installment and credit card loan quality is evaluated on the basis of delinquent data due to the large number of such loans and relatively small size of individual credits. Historical trend analysis reports are reviewed on a monthly basis by senior lending officers and the Company's Board of Directors. All past due loans, nonaccrual loans, and troubled debt restructurings are reviewed at least quarterly by the Loan Review Department management and Senior Credit Committee whose membership includes the most senior executive officers in the Company and the most senior lending officers in each subsidiary bank and major lending divisions. Loans are placed on nonaccrual when there is doubt as to the collectibility of interest or principal or if loans are 90 days or more past due unless they are both well secured and in the process of collection. In every case, a loan reaching 180 days past due is placed on nonaccrual. Greater levels of Board and Management attention are being focused on asset quality. In 1992 an asset quality committee of the Company's Board of Directors was established which monitors asset quality trends, reviews the loan loss reserve analyses in depth monthly and actively monitors the large credit exposures. Also in 1992 new loan administration function, the Credit Risk Control Department, was assigned the responsibility of ensuring compliance with the lending policies, procedures and administrative guidelines of the commercial lending portfolio. The Department reports to the Company's Board. An appraisal review function was established within the group to review third-party appraisals for adherence to Federal requirements and to establish policies relating to collateral appraisal. In a further step to increase the level of control over the troubled loan portfolio and in order to focus specialized expertise, a Workout Department was established during 1992 and most nonaccrual and other troubled loans are now largely handled by this group or in the Commercial Real Estate Department. In 1993, under the direction of new management, staffing was increased in both the Loan Review and the Credit Risk Control Departments. Furthermore, a number of systems changes were initiated to improve control over credit administration, and smaller commercial loans were transferred to the Installment Lending Department where they can be more efficiently monitored. As a result, the commercial loan officers' workload has been reduced. NONACCRUAL, PAST DUE, RESTRUCTURED LOANS, OTHER AUTOMOBILES OWNED AND OTHER REAL ESTATE OWNED. In addition to the amounts in the above table, accruing loans 30 to 89 days past due and rated Special Mention in the Company's internal risk rating profile amounted to $12 million at December 31, 1993. Also at December 31, 1993 there were approximately $185 million of accruing commercial and real estate loans which, while current, have nonetheless been classified as Special Mention or Substandard an increase from approximately $130 million at the end of 1992. There were no loans classified "Doubtful" in either year which were not disclosed in the above table. Approximately 84 percent of these loans were in the Substandard category. Under the Company's definition, Substandard assets are characterized by the distinct possibility that some loss will be sustained if the credit deficiencies are not corrected. The Substandard classification, however, does not necessarily imply ultimate loss for each individual asset so classified. Special Mention assets, as defined by the Company, have potential weaknesses that deserve management's close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the assets. The Company uses the internal risk rating profile along with a number of other factors in determining the adequacy of its reserve for loan loss. See Credit Quality and Reserve for Loan Losses on page 14 of this Form 10-K for a further discussion. ALLOCATION OF LOAN LOSS RESERVE The Company charges off loans or portions of loans when they are considered uncollectible. Therefore, no portion of the Reserve for Loan Losses is restricted to any loan or group of loans, and the entire Reserve is available to absorb all probable losses inherent in the portfolio. However, for internal analytical purposes the Company allocates its Reserve in conjunction with its risk rating profile. Since conditions within the profile are subject to change, the allocation presented below should not be interpreted as an indication that chargeoffs in 1994 will occur in these amounts or proportions, or that the allocation indicates future trends. - --------------- (1) Consumer loans include indirect automobile installment loans, residential mortgages and home equity lines of credit, credit cards, and check credit loans. (2) Prior to 1990 the Company assigned all of the Reserve in its analysis and, therefore, did not utilize an unallocated portion. SUMMARY OF LOAN LOSS EXPERIENCE - --------------- (1) This information is available separately for 1993 and 1992 only. Prior to 1992 the information is included in the other consumer category. (2) Refer to the discussion of the factors used in determining the reserve for loan losses in Management's Discussion of Financial Condition and Results of Operations on page 14 of this Form 10-K. DEPOSITS The following table sets forth the remaining maturities of certificates of deposit in the amount of $100 thousand or more at December 31, 1993, in thousands: SHORT-TERM BORROWINGS The Company's short-term borrowings consist primarily of federal funds purchased and securities sold under agreements to repurchase. These instruments are generally overnight funds. The following information relates to federal funds purchased and securities sold under agreements to repurchase which represents more than thirty percent of stockholders' equity: ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY MATERIAL. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Stockholders and Board of Directors of UST Corp.: We have audited the accompanying consolidated balance sheets of UST Corp. (a Massachusetts corporation) and Subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income, changes in stockholders' investment 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 consolidated 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 UST Corp. 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 explained in Note 1 to the consolidated financial statements, the Company changed its method of accounting for income taxes and investments by adopting Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" and Statement of Financial Accounting Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities," effective January 1, 1993 and December 31, 1993, respectively. Arthur Andersen & Co. Boston, Massachusetts January 31, 1994 The accompanying notes are an integral part of these consolidated financial statements. The accompanying notes are an integral part of these consolidated financial statements. The accompanying notes are an integral part of these consolidated financial statements. The accompanying notes are an integral part of these consolidated financial statements. UST CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993 (1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES The accounting and reporting policies of UST Corp. and Subsidiaries conform with generally accepted accounting principles and general practice in the banking industry. The significant policies are summarized below. PRINCIPLES OF CONSOLIDATION The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. All material intercompany balances and transactions have been eliminated. The parent company only financial statements contained in Note 17 reflect investments in Subsidiaries using the equity method of accounting. Certain reclassifications have been made to prior year balances to conform with the current year presentation. Assets owned by others held in a fiduciary or agency capacity are not included in the consolidated balance sheets. SECURITIES On December 31, 1993, the Company adopted Statement of Financial Accounting Standards No. 115 (SFAS 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. Under this statement securities are classified as held-to-maturity, available-for-sale, or trading. Debt securities which management has the positive intent and ability to hold to maturity are classified as held-to-maturity, and are carried at cost adjusted for the amortization of premium or the accretion of discount. At December 31, 1993 the Company had no securities classified as held-to-maturity. Debt and equity securities with readily determinable market values that are bought and held principally for the purpose of selling them in the near term are classified as trading securities and are carried at fair value, with unrealized gains and losses included in current earnings. At December 31, 1993 and 1992, the Company had no securities classified as trading. Debt and equity securities not classified as either held-to-maturity or trading are classified as available-for-sale and carried at fair value, with unrealized after-tax gains and losses reported as a separate component of stockholders' investment. The cumulative effect of adopting SFAS 115 was $5,749,000 before reduction for the income tax effect of $2,414,000. Prior to December 31, 1993, debt securities were designated at the time they were purchased as either held-for-sale or held to maturity, based on management intent at the time. Securities which management had the ability and intent to hold on a long-term basis or until maturity were classified as investment portfolio. Securities which were to be held for indefinite periods of time and not intended to be held to maturity or on a long-term basis were classified as securities held for sale and carried at the lower of aggregate cost or market value. Prior to the adoption of FASB 115 trading account securities were valued at market. For mortgage-backed securities, the Company recalculates the effective yield on the investment to reflect the actual prepayment results and anticipated future payments. The net investment in these securities is adjusted to the amount that would have existed had the new estimated average life and effective yield been applied since the acquisition of the securities. Such adjustments are charged or credited to interest income in the current period. UST CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) The Company determined the securities sold by the specific identification method. The amount of taxes paid on gains is dependent upon the overall results of operations of the subsidiary incurring the gain. PREMISES, FURNITURE AND EQUIPMENT Premises, furniture and equipment are stated at cost, less accumulated depreciation and amortization. The Company provides for depreciation using the straight-line method by charges to expense in amounts estimated to amortize the cost over the estimated useful lives of the respective assets as follows: Leasehold improvements are amortized over the life of the lease agreements. LOAN INCOME AND FEES Certain installment loans and commercial time loans are made on a discounted basis. The unearned discount applicable to such installment loans is taken into income monthly by use of the actuarial method. Interest income on nondiscounted loans is accrued based on the principal amount of loans outstanding. Loans are placed on nonaccrual, with the reversal of all accrued interest receivable, when there is doubt as to the collectibility of interest or principal or if loans are 90 days or more past due unless they are both well secured and in the process of collection. In every case, a loan reaching 180 days past due is placed on nonaccrual. Interest received on nonaccrual loans is applied to principal if collection of principal is doubtful; otherwise, it is reflected in interest income on a cash basis. In May 1993, the FASB issued Statement of Financial Accounting Standards No. 114 (SFAS No. 114), "Accounting by Creditors for Impairment of a Loan," which is to become effective for fiscal years beginning after December 15, 1994. SFAS No. 114 addresses the accounting by creditors for impairment of certain loans by requiring that the carrying value of impaired loans, as defined, be measured based upon the present value of expected future cash flows discounted at the loan's effective interest rate or the fair value of the collateral if the loan is collateral dependent. Management is currently evaluating the effect that this new standard will have on the Company's reported consolidated financial position and results of operations. RESERVE FOR LOAN LOSSES The reserve for loan losses is maintained at a level considered adequate by management to provide for possible losses from loans, leases and commitments to extend credit. Adequacy of the reserve is determined by management using a consistent methodology which analyzes the size and risk of the loan portfolio on a monthly basis. Factors in this analysis include past loan loss experience and asset quality, as reflected by trends of delinquent, nonaccrual and restructured loans and the Company's credit risk rating profile. Consideration is also given to the current and expected economic conditions and, in particular, how such conditions affect the types of credits in the portfolio and the market area in general. The reserve is based on estimates, and ultimate losses may vary from current estimates. These estimates are reviewed periodically and, as adjustments become necessary, they are reported in earnings in the current period. OTHER REAL ESTATE OWNED Other real estate owned includes both actual and in-substance repossessions. In December 1992 the Company adopted Statement of Position No. 92-3 ("SOP 92-3") issued by the American Institute of Certified Public Accountants. This SOP states that foreclosed assets are presumed to be held for sale. Therefore, they should be carried at the lower of cost or fair value, minus estimated costs to sell. In 1992 the pretax charge to income resulting from implementation was $750,000. UST CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) INCOME TAXES The Company provides for income taxes in accordance with the comprehensive income tax allocation method. This method recognizes the tax effects of all income and expense transactions in each year's statement of income regardless of the year in which the transactions are reported for tax purposes. The Company follows the deferral method of accounting for investment tax credits. Under the deferral method, the credit is reflected as a reduction of tax expense ratably over the period during which the asset is depreciated for financial reporting purposes. FASB has issued SFAS No. 109 "Accounting for Income Taxes," a modification of SFAS No. 96, effective January 1, 1993. While the FASB retained the existing requirement to record deferred taxes for transactions that are reported in different years for financial reporting and tax purposes, it revised the computation of deferred taxes so that the amount of deferred taxes on the balance sheet is adjusted whenever tax rates or other provisions of the income tax law are changed. This is known as the "liability method" of providing deferred income taxes. This change in accounting principle increased net income $750,000 in January 1993, representing the cumulative effect of the new standard on the balance sheet at the date of adoption. EARNINGS (LOSS) PER SHARE Earnings per share is computed using the weighted average number of shares of common stock and common stock equivalents outstanding. Common stock equivalents consist primarily of dilutive outstanding stock options computed under the treasury stock method. Loss per share computations do not include antidilutive common stock equivalents. GOODWILL Cost of purchased businesses in excess of net assets acquired includes amount being amortized over twenty-and forty-year periods. Amortization expense was $122,500 in 1993, 1992 and 1991. RETIREMENT BENEFITS The Company's policy is to fund pension costs accrued. In December 1990, the FASB issued SFAS No. 106, "Employer's Accounting for Post Retirement Benefits Other Than Pensions." SFAS No. 106 is effective for fiscal years beginning after December 15, 1992. This statement did not have any impact on the Company's financial position or results of operations. In November 1992, the FASB issued SFAS No. 112, "Employers' Accounting for Postemployment Benefits." SFAS No. 112 is effective for fiscal years beginning after December 15, 1993. It is not expected that this statement will have any impact on the Company's financial position or results of operations. STATEMENT OF CASH FLOWS For purpose of reporting cash flows, cash and cash equivalents include cash on hand, amounts due from banks and interest-bearing deposits. (2) HOME OWNERS PURCHASE AND ASSUMPTION On September 7, 1990, United States Trust Company ("USTC"), the Company's principal banking subsidiary at the time, assumed approximately $2 billion in deposits and acquired certain assets and branches located in the greater Boston area of the former Home Owners Savings Bank F.S.B. ("Home Owners") in a transaction with the Resolution Trust Corporation ("RTC"), an arm of the Federal Government. The UST CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Company paid the RTC cash of $6.1 million, approximately the amount allocated to core deposit intangible which is being amortized over seven years. As part of the approval process, the Company agreed with the Board of Governors of the Federal Reserve System and the Federal Deposit Insurance Corporation to restore the Company's and USTC's consolidated capital ratios to the levels at which they stood prior to the Home Owners transaction. Management developed a plan to achieve these objectives which included putting the $513.6 million loans held for sale back to the RTC in 1991 and continuing to reduce assets as the high rate Home Owners certificates of deposit rolled off. This plan is complete. (3) RESTRICTIONS ON CASH AND DUE FROM BANKS At December 31, 1993 and 1992, cash and due from banks included $42,072,000 and $23,659,000, respectively, to satisfy the reserve requirements of the Federal Reserve Bank. (4) SECURITIES Data presented for 1993 includes only securities available-for-sale. Data presented for 1992 in this footnote includes both the investment portfolio, consisting primarily of securities of states and municipalities, and other equity securities, with an amortized cost of $8,122,000, and securities held-for-sale, consisting primarily of U.S. Treasuries, mortgage-backed and auto-backed securities, and corporate notes, with an amortized cost of $468,643,000. UST CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) The amortized cost and estimated market value of debt securities at December 31, 1993 and 1992, by contractual maturity, are shown in the table below. Actual maturities are expected to differ from contractual maturities because some borrowers have the right to prepay without prepayment penalty. Mortgage-backed securities are shown at their final maturity but are expected to have shorter average lives. Equity securities, which have no contractual maturity, are presented in the aggregate. Gross unamortized premiums and discounts on mortgage-backed securities were $355,000 and $973,000, respectively, at December 31, 1992. Proceeds from sales of debt securities held in the investment portfolio, held-for-sale and trading accounts during 1993 were $162,956,000 and $514,072,000 during 1992. Gross gains of $3,038,000 for 1993 and $8,315,000 for 1992 and gross losses of $137,000 for 1993 and $939,000 for 1992 were realized on those sales. Gains on sales of all securities held in the investment portfolio, held-for-sale and trading accounts were $4,403,000, $13,724,000, and $10,560,000 for 1993, 1992, and 1991, respectively. UST CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) At December 31, 1993, securities carried at $223,156,000 were pledged to secure public and trust deposits, securities sold under agreements to repurchase and for other purposes as required by law. (5) LOANS The composition of the loan portfolio (net of unearned discount) at December 31, 1993 and 1992 was as follows: Nonaccrual loans were $49.3 million and $86.6 million at December 31, 1993 and December 31, 1992, respectively. Accruing restructured loans totaled $41.5 million and $44.9 million at December 31, 1993 and 1992, respectively. Had nonaccruing and accruing restructured loans been paying in accordance with their original terms, approximately $6,247,000 and $7,728,000 of additional interest income would have been recorded in 1993 and 1992, respectively. Most of the Company's business activity is with customers located within the states of Massachusetts and Connecticut. At year-end 1993, the Company's exposure to credit risk principally secured by real estate included $499 million of loans. See Note 16 for additional discussion of concentration of credit risk. An analysis of the reserve for loan losses for the years ended December 31, 1993, 1992 and 1991 is as follows: In June 1993, the Company recorded a special $30 million provision for loan losses which is included in the above table. See footnote 19 for information regarding this special provision. UST CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) (6) PREMISES, FURNITURE AND EQUIPMENT Depreciation and amortization expenses reflected in the consolidated statements of income were $3,661,558, $3,665,392 and $4,776,896 in 1993, 1992 and 1991, respectively. On January 3, 1991, the Company sold one of its buildings to a third party for $8.2 million. A portion of the building, which houses certain staff support functions of the Company, was leased back from the purchaser. This transaction resulted in a gain of approximately $5 million of which $3 million was recognized in 1991 with the difference amortized to income over the life of the lease. (7) OTHER REAL ESTATE OWNED Other real estate owned includes in-substance foreclosures of $8,197,000 and $14,861,000 at December 31, 1993 and 1992, respectively. The balance is stated net of valuation allowances of $6,553,000 in 1993 and $750,000 in 1992. In 1993 provisions charged to foreclosed asset and workout expense were $14,514,000 and chargeoffs were $8,711,000. The net cost of other real estate owned included in foreclosed asset and workout expense in the income statement was $21,256,000, $18,276,000 and $12,621,000 in 1993, 1992 and 1991, respectively. These costs include reductions in fair value, net gain or loss on sales and cost of maintaining and operating the properties. (8) SHORT-TERM BORROWINGS The average outstanding short-term borrowings were $227,944,000 in 1993 and $247,185,000 in 1992. The approximate weighted average interest rates were 2.7% in 1993 and 3.1% in 1992. The maximum amount of short-term borrowings outstanding at any month end was $320,338,000 in 1993 and $300,489,000 in 1992. UST CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) (9) OTHER BORROWINGS Other borrowings consisted of the following at December 31, 1993 and 1992: During 1986, the Company issued $20,000,000 of 8.5% subordinated notes to an insurance company. The debt is payable in annual installments of $4 million from 1992 through 1996. Under the terms of the agreement, the Company may not make dividend payments in excess of 60% of cumulative net earnings since December 31, 1985 plus $7 million. Payments required under the above obligations were $4,321,000 in 1993 and will amount to $4,321,000 in 1994, $5,822,000 in 1995, and the balance of $4,143,000 in 1996. The Company has an employee stock ownership plan which covers substantially all of its employees. The plan is administered by a committee designated by the Board of Directors and is maintained in a separate trust established for that purpose. The trustee obtained financing to purchase shares of UST Corp. common stock and UST Corp. has guaranteed this debt. The purchased shares are allocated to the participants on a pro-rata basis, over the period in which they are earned. (10) EMPLOYEE BENEFIT PLANS The Company has a noncontributory retirement plan covering all employees who meet specified age and employment requirements. The plan provides pension benefits that are based on the employee's compensation during the highest consecutive five of the last ten years before retirement. The following summary sets forth the plan's funded status and amounts included in the Company's consolidated balance sheets as of December 31, 1993 and 1992: UST CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) The weighted-average discount rate and rate of increase of future compensation levels used in determining the actuarial present value of the projected benefit obligation was 7.0% and 5.0%, respectively, for 1993 and 8.5% and 6%, respectively, for 1992. The expected long-term rate of return on assets used was 9.5% and 12%, respectively, for 1993 and 1992. The Company has a qualified profit-sharing plan covering substantially all employees. Under the plan, up to six percent of net income before income taxes, as defined, may be contributed to the profit-sharing trust. The Company did not make a contribution to the profit-sharing trust in 1993, 1992 or 1991. In January 1994, the Company added an Employee's Savings feature to the existing Profit-Sharing Plan that qualifies as a deferred salary arrangement under Section 401(k) of the Internal Revenue Code. The revised plan was renamed the UST Corp. Employee Savings Plan. Under the Savings Plan, participating employees may defer a portion up to 4% of their pretax earnings not to exceed the Internal Revenue Service annual contribution limits. The Company matches 25% of each employee's contributions up to 4% of the employee's earnings. Since the Savings Plan started in 1994, the Company did not make a contribution in 1993. The Company also has an employee stock ownership plan for substantially all salaried employees. Under the plan, the Company shall contribute either a fixed amount or a percentage of compensation of all participants as determined by the Board of Directors. The Company has a restricted stock ownership plan for key employees under which 389,375 shares of common stock have been granted. The shares vest to the employee from the first to the seventh year after the date of grant. The unvested shares granted are excluded from outstanding shares and included in the calculation of earnings per share, if dilutive, in periods of profit. Expenses (income) relating to the plans were as follows: (11) STOCK OPTIONS At December 31, 1993, 479,759 shares of the Company's common stock were reserved for future grants to officers and key employees. Under the Company's incentive stock option plan, options may be granted at prices not less than the fair market value of the Company's common stock at the date of grant. In May 1990, the stockholders approved a director's stock option plan under which each outside director would receive a grant of 5,250 shares. The total number of shares issuable under this plan is 63,000. All shares UST CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) to current outside directors have been granted. Each option is exercisable to the extent of 20% after one year from the date of grant and an additional 20% each succeeding year. In addition, the Company has a Director's Deferred Compensation Program under which up to 250,000 shares of the Company's common stock may be granted to Directors of the Company or its banking subsidiaries who choose to receive their Director's fees or stipend in shares of the Company in lieu of cash. The shares vest when the person ceases to be a Director. In 1993, 24,233 restricted shares vested under the Company's restricted stock ownership plan. In December 1989, April 1990, and April 1991, the Board of Directors authorized an option substitution program permitting employees to surrender options with an option price of more than $14.29, $10.00, and $6.07, respectively, in exchange for new options. Outstanding options for 149,331, 513,817, and 516,502, respectively, were exchanged under the program. Options were exchanged on a one-for-one basis at an option price of $14.29, $10.00, and $6.07, respectively, per share, the fair market value of the Company's common stock on the date of authorization. The new options vest ratably over a five-year period. (12) INCOME TAXES The income tax benefit shown on the consolidated statements of income consisted of the following: UST CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) The deferred tax provisions (benefit) consisted of the following: At December 31, 1993 and 1992, cumulative deferred income tax benefits amounting to $10,911,000 and $6,177,000 were included in the balance sheet as other assets. Additionally, at December 31, 1993 and December 31, 1992 there were tax refund receivables of $9,549,000 and $7,400,000, respectively, included in other assets (in thousands): The components of the net deferred tax asset at December 31, 1993 were as follows: UST CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) (13) CAPITAL AND REGULATORY AGREEMENTS On June 2, 1993 the Company sold 500,000 shares of its unregistered common stock in a private placement for a cash price of $3,750,000. Substantially all of the net proceeds of that placement were used to repay principal on the Company's long-term debt. On August 12, 1993, the Company sold 2.87 million shares of its common stock in a European offering. These shares were placed with more than sixty institutional investors and the offering was made under Regulation S of the United States Securities and Exchange Commission. Net proceeds of this placement were approximately $21 million after expenses. The Company and its banking subsidiaries' ability to pay dividends is subject to certain limitations imposed by statutes of the Commonwealth of Massachusetts and the State of Connecticut, and limitations imposed by bank and bank holding company regulators. Massachusetts statutes restrict the amount of dividends payable by banks to be the balance of their undivided profits, net of any amount transferred to capital in excess of par value. In the case of Connecticut law, the limit is undivided profits plus reserve for loan losses. In any event, it is not likely that bank and bank holding company regulators would allow an institution to dividend any amounts which would reduce that institution's capital to below the minimum capital requirement in effect at that time. The Company and its two Massachusetts-based banking subsidiaries, United States Trust Company ("USTC") and USTrust, have signed written agreements with the FRB, FDIC and the Banking Commissioner of the Commonwealth of Massachusetts ("Massachusetts Commissioner"). In accordance with the agreements the Company has agreed not to pay any dividends to stockholders, nor take any dividends from its banking subsidiaries, without prior regulatory approval. Similarly, the banking subsidiaries have agreed to refrain from transferring funds in the form of dividends to the Company without prior regulatory approval. In 1993, the Company and USTC received approval from the appropriate regulators such that USTC was allowed to transfer $5,250,000 in dividends to the Company. These proceeds were then contributed as equity to USTrust and the Company's Connecticut banking subsidiary, UST Bank/Connecticut ("UST/Conn"). The banks also agreed to, among other matters, maintain a Tier 1 leverage capital ratio at or in excess of 6% beginning in February 1993. Tier 1 leverage capital ratio is defined by the Company's Federal regulators to be essentially stockholders' equity, less intangible assets, divided by total average assets, less intangible assets. In February 1994, the FDIC and the Massachusetts Commissioner terminated and lifted the Consent Agreement and Order with USTC. Despite the termination of its Regulatory Agreement, USTC has agreed to continue to request regulatory consent prior to the payment of dividends. UST/Conn is under a Stipulation and Agreement with the Banking Commissioner of the State of Connecticut. In accordance with the agreement, the bank, among other matters, must maintain a Tier 1 leverage capital ratio of 6%. Based on average total assets, at December 31, 1993, the Tier 1 leverage capital UST CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) ratio was 23.75% for United States Trust Company, 6.49% for USTrust, and 6.21% for UST Bank/Connecticut. Additionally, the Company agreed to maintain its capital at levels consistent with the FRB's Capital Adequacy Guidelines. At December 31, 1993, based on period-end assets the Company's consolidated Tier 1 leverage capital ratio was 6.96% compared with 6.21% at December 31, 1992. Based on average total assets, this ratio was 7.06% at December 31, 1993. (14) RELATED PARTY TRANSACTIONS In the ordinary course of business, the Company's banking subsidiaries have granted loans to certain of the Company's directors and executive officers. All such transactions are made on substantially the same terms as those prevailing at the same time for individuals not affiliated with the Company and its subsidiaries and do not involve more than the normal risk of collectibility. At December 31, 1993, none of these transactions were on nonaccrual status, nor did they involve delinquent or restructured loans. However, at December 31, 1993 loans to a Director of the Company or to his affiliated companies in the amount of approximately $25 million were characterized as Substandard, in the Company's internal risk rating profile. Under the Company's definition, Substandard assets are characterized by the distinct possibility that some loss will be sustained if the credit deficiencies are not corrected. However, the Substandard classification does not imply ultimate loss for each individual asset so classified. Subsequent to December 31, 1993, $6.4 million of these loans were repaid. See Footnote 15 hereunder. (15) COMMITMENTS AND CONTINGENCIES Rent expense for the years ended December 1993, 1992 and 1991 was $3,932,074, $4,432,156 and $4,179,740, respectively. In the ordinary course of business, the Company and its subsidiaries become defendants in a variety of judicial and administrative proceedings. In the opinion of management there is no proceeding pending, or to UST CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) the knowledge of management threatened, which in the event of an adverse decision, would be likely to result in a material adverse change in the financial condition or results of operations of the Company and its subsidiaries. POTENTIAL REGULATORY SANCTIONS Certain apparent and inadvertent violations of the insider lending provisions (and related lending limit provisions) of Regulation O of the FRB related to extensions of credit by USTrust to Director Francis X. Messina have led the FDIC to require that corrective action be taken and to advise USTrust orally that the FDIC may consider the imposition of civil money penalties with respect to such matters. No FDIC representative has suggested to USTrust or the Company that there was any willful or intentional misconduct on the part of USTrust, Director Messina or USTrust's other institution-affiliated parties in connection with these matters. See Note 14 to Consolidated Financial Statements. To address these issues, USTrust and Director Messina have undertaken a program to reduce the aggregate balance of Mr. Messina's outstanding loans from USTrust and to improve the collateral support for the remaining outstanding loan balance. The elements of this program have been communicated to and reviewed by the FDIC. In furtherance of the program since late 1993, the outstanding principal of the aggregate loans to Director Messina and his related interests has been reduced by more than $11 million from approximately $30 million to less than $19 million, and such loans are now below all applicable lending limits. To date, the Company has incurred no losses with respect to any of these loans, although they are characterized as "Substandard" in the Company's internal risk rating profile, and all such loans are current as to both principal and interest. There has been no further action taken by any bank regulatory agency to date. The FDIC has the authority to levy civil money penalties of various amounts for violations of law or regulations, orders and written conditions and agreements, which, depending upon the nature and severity of the violations, may be, in situations where conduct has been egregious, as high as $1 million per day for the period during which such violation continues. In connection with the apparent violations described above, the FDIC has the authority to impose penalties on any of USTrust, its Board of Directors, officers of the Bank, Director Messina personally, "institution-affiliated parties" of USTrust or any combination thereof. While it is not possible to predict with certainty the probability of penalties being assessed, the person or persons upon whom any penalty would be assessed or the amounts of any such penalties, were they to be assessed, management of the Company believes that it is unlikely that this matter will have a material adverse effect on its financial condition or results of operations. Consequently, no provision in respect of penalties has been made in the Company's Consolidated Financial Statements. (16) FINANCIAL INSTRUMENTS WITH ON-AND OFF-BALANCE-SHEET RISK The Company is 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 extent credit, standby letters of credit and financial guarantees. Those instruments involve, to varying degrees, credit risk in excess of the amount contained in the balance sheet. 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 loss in the event of nonperformance by the other party to the financial instrument or commitments to extend credit and standby letters of credit and financial guarantees written is represented by the contractual notional amount of those instruments. The Company uses the same credit policies in making commitments and conditional obligations as it does for on-balance-sheet instruments. UST CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract during its term. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being fully drawn upon and, in fact, have a maturity of less than one year, 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. Of the total commitments to extend credit, approximately $31 million and $33 million were secured by real estate at December 31, 1993 and 1992, respectively. The amount of collateral obtained is based on management's evaluation of the credit risk. Collateral held on commitments and loans varies but may include cash, accounts receivable, inventory, property, plant and equipment. Standby and commercial letters of credit and financial guarantees written are conditional commitments issued by the Company to guarantee the performance of, or payment by, 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. The Company holds various collateral to support these commitments including (but not limited to) cash, accounts receivables, inventory, property plant and equipment. The extent of collateral held for those commitments varies from zero to one hundred percent. Of the total standby and commercial letters of credit, approximately $4 million and $13 million were secured by real estate at December 31, 1993 and 1992, respectively. The Company's primary loan market is the New England region. Most of the loans outstanding are from eastern Massachusetts and a substantial portion of these loans are various types of real estate loans; still others have real estate as additional collateral. Over 90% of the Company's outstanding commercial and real estate loans are collateralized. The Company's securities portfolio consists largely of mortgage-backed securities. These securities carry prepayment risk due to the fact that prevailing interest rates could continue to decline. Under such circumstances an unusually high percentage of homeowners may choose to refinance their first mortgages to take advantage of these lower rates with the result that, under the Company's accounting policy, adjustments reducing gross unamortized premiums would be required. See Note (1), Securities and Trading Account Policies. UST CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) (17) PARENT COMPANY FINANCIAL INFORMATION Summarized information relative to the balance sheets at December 31, 1993 and 1992 and statements of income and cash flows for the three years in the period ended December 31, 1993 of UST Corp. are presented as follows. All dividend income in the periods shown below are from banking subsidiaries: UST CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) STATEMENTS OF CASH FLOWS -- PARENT COMPANY ONLY Cash dividends paid to the Company in 1993 by bank subsidiaries totaled $5,250,000. There were no cash dividends paid to the Company in 1992. In 1991 the amount was $2,250,000. No cash dividends were paid to the Company by other subsidiaries in these years. (18) FINANCIAL INSTRUMENTS In December 1991, the FASB issued SFAS No. 107, "Disclosures about Fair Value of Financial Instruments." SFAS No. 107 is effective for fiscal years ending after December 15, 1992. SFAS 107 requires disclosure of the fair market value of financial instruments, whether assets, liabilities or off-balance sheet commitments, if practicable. The following methods and assumptions were used to estimate the fair value of each class of financial instruments. Fair value estimates which were derived from discounted cash flows or UST CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) broker quotes cannot be substantiated by comparison to independent markets and, in many cases, could not be realized in immediate settlement of the instrument. CASH AND DUE FROM BANKS, EXCESS FUNDS SOLD AND OTHER SHORT-TERM INVESTMENTS For these short-term instruments the carrying amount is a reasonable estimate of fair value. INVESTMENT PORTFOLIO AND SECURITIES HELD FOR SALE For marketable securities fair values are based on quoted market prices or dealer quotes. Nonmarketable investment securities are valued at cost. LOANS For certain homogenous categories of loans, such as residential mortgages and home equity loans, fair value is estimated based on broker quotes on sales of similar loans. The fair value of fixed rate loans was estimated by discounting anticipated future cash flows using current rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities. The fair value of performing variable rate loans is the same as the book value at the reporting date because the loans reprice when the market changes. DEPOSIT LIABILITIES The fair value of noncertificate deposit accounts is the amount payable on demand at the reporting date. The fair value of fixed-maturity certificates of deposit is estimated by discounting the anticipated future cash payments using the rates currently offered for deposits of similar remaining maturities. SHORT-TERM BORROWINGS For these short-term instruments the carrying amount is a reasonable estimate of fair value. OTHER BORROWINGS The fair value of other borrowings were determined by discounting the anticipated future cash payments by using the rates currently available to the Company for debt with similar terms and remaining maturities. COMMITMENTS TO EXTEND CREDIT/SELL LOANS The great majority of commitments, standby letters of credit and commercial letters of credit are short term in nature and therefore have been valued at their carrying amount. VALUES NOT DETERMINED SFAS No. 107 excludes certain assets from its disclosure requirements including real estate included in banking premises and equipment, and the intangible value inherent in the Company's deposit relationships (i.e., core deposits). Accordingly, the aggregate fair value amounts presented below do not represent the underlying value of the Company. UST CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) (19) CONSOLIDATED SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED) As shown above, the Company recorded high provisions for loan losses in the second quarter of 1993 and third and fourth quarters of 1992. Provisions for loan loss are recorded as necessary in order to maintain an adequate reserve for loan loss based upon the Company's methodology for quantifying the risk inherent in the loan portfolio. Toward the end of the second quarter of 1993, management changed its strategy regarding troubled credit situations. While the change would result in the handling of these situations in an expeditious manner, it was UST CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) recognized that the up-front costs of these workouts would increase. As a result, the reserve for loan losses was increased by $19.8 million during the second quarter. To achieve the higher reserve level, the Company recorded a $42.7 million provision for loan losses in the second quarter. Included in that amount was a special provision of $30 million. This special provision was management's estimate of the additional losses to be incurred from the strategic change referred to above and the continued sluggish economic climate and losses occurring during the remainder of 1993 on these and other credits. An increase in nonaccruals in the third quarter of 1992 was a major factor in the increased provisions for the last two quarters of 1992. In the third quarter of 1992, the Company achieved gains on sale of securities of $10.8 million, which was a significant factor in the results for that quarter. Noninterest income decreased after the first quarter of 1993 due primarily to a decrease in gains on sale of securities. Noninterest expense increased or decreased over the quarters presented due primarily to increases or decreases in the writedowns to fair value of foreclosed real estate properties. ITEM 9. ITEM 9. DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURE -- NONE -- PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE COMPANY EXECUTIVE POLICY COMMITTEE In 1987, the Board of Directors of the Company created an Executive Policy Committee which is the primary management forum of the Company for all strategic and policy decisions. All decisions of the Executive Policy Committee are subject to the review and approval of the Board of Directors of the Company. The Executive Policy Committee has been directed by the Board of Directors to make recommendations to the Board concerning adoption of policies, strategies and programs concerning the following, among other matters: (a) acquisitions and dispositions of corporate entities, assets and/or investments; (b) the issuance of equity and/or debt; (c) engaging in new business activities; (d) the hiring, termination, training and motivation of senior management; (e) the development of marketing programs concerning financial services; (f) improvements to operations, service delivery and implementation of procedures for cost control, (g) improvements to the financial reporting and financial controls systems; (h) improvements to the business information systems; and (i) improvements concerning risk management and legal and regulatory compliance programs. As of March 25, 1994, there were 11 members of the Executive Policy Committee. The members of the Committee are identified and the background of each Committee member is set forth below under "Executive Officers." EXECUTIVE OFFICERS The names and ages of the executive officers of the Company and each executive officer's position with the Company and its subsidiaries are listed below. Each such executive officer is elected annually by the Directors of the Company (or the Directors of the applicable subsidiary of the Company) and serves until his or her successor is duly chosen and qualified or until his or her earlier death, removal or disqualification. - --------------- * Member, Executive Policy Committee The following sets forth the principal occupation during the past five years of each of the executive of officers of the Company. Mr. Finnegan has served as President and Chief Executive Officer of the Company since April 1993. During the prior five years, Mr. Finnegan was Executive Vice President in charge of Private Banking at Bankers Trust Company, New York, New York. From 1986 to 1988, Mr. Finnegan was President and Chief Operating Officer of Bowery Savings Bank in New York City. From 1982 to 1986 he was Vice Chairman of Shawmut Corporation in Boston. Mr. Finnegan also serves as Vice Chairman of the Board of Trustees of Northeastern University. Mr. Finnegan is also a Director and President of USTrust and a Director and Chairman of the Executive Committee of USTC. Mr. Schwartz has served as Chairman of the Company since April 1993. Mr. Schwartz has been Vice Chairman of the Board of Directors of the Company since 1981. Mr. Schwartz is Vice President/Academic Affairs at Yeshiva University and is of counsel to the New York law firm of Cadwalader, Wickersham & Taft. Mr. Schwartz formerly served as Dean of Boston University School of Law. Mr. Siskind has served as Chairman of the Board of the Company since 1967. He was Chief Operating Officer of the Company from 1976 through 1984 and General Counsel of the Company in 1984 and 1985. From 1966 through 1976, Mr. Siskind served as Dean of Boston University School of Law. Mr. Huskins was elected Executive Vice President/Administration of the Company in August 1993. Mr. Huskins is also responsible for the leasing and retail banking activities of the Company. Prior to joining the Company, Mr. Huskins served as President, Sterling Protection Company, Watertown, MA (security systems) from 1990 to 1993 and as Vice Chairman of Chancellor Corporation, Boston, MA (leasing) from 1977 to 1989. Mr. Colasacco was elected Executive Vice President and a Director of the Company in 1990. In 1993, he was also elected Chairman of the Board and President of USTC. Prior to that time, he served as an Executive Vice President of USTC. He also directs the asset management and investment activities of the Company and its subsidiaries. Mr. Colasacco has been an officer of the Company or of one of its subsidiaries since 1974. Mr. Fischer was elected Executive Vice President, General Counsel and Clerk of the Company in 1992. Prior to 1992, he served as Senior Vice President, General Counsel and Assistant Clerk of the Company. Before joining the Company in 1986. he served as Assistant General Counsel of Bank of Boston Corporation and its principal subsidiary, The First National Bank of Boston. Mr. Fischer is, and has been since 1984, a member of the faculty of the Morin Center for Banking Law Studies of Boston University School of Law. He also serves as Executive Vice President, General Counsel and Secretary of USTC and USTrust, as a Director and Clerk of UST Leasing Corporation, as Clerk of UST Data Services Corp. and UST Capital Corp. and as Assistant Secretary of UST Bank/Connecticut. Mr. Brooks has been a Senior Vice President of the Company since 1984 and Treasurer since 1980. He is Chairman of the Asset and Liability Management Committee of the Company. In addition. he serves as a Director of UST Data Services Corp. and as a Director and Treasurer of UST Leasing Corporation. Mr. Brooks has been an officer of the Company since 1967. Ms. Lerner has served as Senior Vice President of the Company since she joined the Company in 1988. She directs the Human Resources activities of the Company. Prior to her joining the Company, Ms. Lerner served in a similar capacity for the Provident institution for Savings in Boston. Mr. Shediac was elected Chairman of the Board of USTrust in 1993. Prior to that time, he served as President of USTrust. His primary responsibilities involve of the retail banking operations of the Company's banking subsidiaries. Mr. Shediac has been an officer of the Company or its subsidiaries since 1980. Ms. Stevens was elected Executive Vice President and Senior Lending Officer of USTrust in 1993. Since joining the Company in 1985 and until 1993, Ms. Stevens served in the commercial banking function of USTC as Senior Vice President from 1985 through 1990 and as Executive Vice President from 1990 until 1993. Mr. Sullivan has served as President of UST Data Services Corp. since he joined the Company in 1988. In that capacity, he has responsibility for the data processing and information systems of the Company as well as for its operations activities. Prior to 1988, Mr. Sullivan served as Executive Vice President of Operations with BayBanks Systems, Inc. in Waltham, MA. Mr. McAlear has served as Vice Chairman of USTrust since he joined the Company in 1990. His primary responsibilities involve the supervision of the controlled loan and real estate lending and workout functions of USTrust and the Company Prior to 1990, Mr. McAlear served as an Executive Vice President in the lending area of the Bank of New England. Ms. Armstrong was named Senior Vice President/Credit Administration of USTrust in February 1994. She has served in the credit administration and credit risk control functions of USTrust since she joined the Company in 1985. Ms. Armstrong is the Chairman of the Senior Credit Committee of the Company and USTrust. Mr. Clarke has served as Vice President and Controller of the Company since 1988. Prior to joining the Company, Mr. Clarke was Deputy Comptroller of The First National Bank of Boston. Mr. Dwyer was elected Senior Vice President/Chief Loan Review Officer of the Company in August 1993. Prior to joining the Company, Mr. Dwyer served as Senior Vice President/Loan Workout at First New Hampshire Bank, Manchester, NH, from 1990 through mid-1993. Prior to 1990, Mr. Dwyer was Senior Vice President of Corporate Credit Review at Shawmut Bank, N.A. in Boston, MA. There are no arrangements or understandings between any executive officer and any other person pursuant to which he or she was selected as an executive officer. Other than the information provided in the preceding paragraph, this item has been omitted since the Company will have filed a definitive proxy statement within 120 days after December 31, 1993, the close of its fiscal year. The additional information required by this item is incorporated by reference to such proxy statement. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION This item has been omitted since the Company will have filed a definitive proxy statement within 120 days after December 31, 1993, the close of its fiscal year. The information required by this item is incorporated by reference to such proxy statement. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT This item has been omitted since the Company will have filed a definitive proxy statement within 120 days after December 31, 1993, the close of its fiscal year. The information required by this item is incorporated by reference to such proxy statement. Section 16(a) of the Securities Exchange Act of 1934 requires the Company's executive officers and directors to file reports of ownership and changes in ownership with the Securities and Exchange Commission. Executive Officers and Directors are required by the SEC regulation to furnish the Company with copies of all Section 16(a) forms they file. Based solely on its review of the copies of such forms received by it, the Company believes that, during 1993, all such filing requirements applicable to its executive officers and directors were complied with by such individuals. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS This item has been omitted since the Company will have filed a definitive proxy statement within 120 days after December 31, 1993, the close of its fiscal year. The information required by this item is incorporated by reference to such proxy statement. PART IV ITEM 14. ITEM 14. EXHIBITS. FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K a) List the following documents filed as part of this report: 1. All financial statements UST Corp. and Subsidiaries See Index to Financial Statements on page 31. 2. Financial statement schedules required to be filed by Item 8 of Form 10-K and by Item 14(d) None (Information included in Financial Statements). 3. Exhibits required to be filed by Item 501 of Regulation S-K and by Item 13(c) (3) Articles: By-Laws 3(a) Articles of Organization of the Company as amended to date. ** 3(b) By-laws of the Company as amended to date.** (4) Instruments defining the rights of security holders, including indentures: 4(a) Specimen of the Company's Common Stock Certificate. (Exhibit 4.1 to Registrant's Registration Statement No. 2-67787 on Form S-1.)** 4(b) Description of rights of the holders of the Company's Common Stock (Appearing on Page 76 of Registrant's Registration Statement No. 33-11118 on Form S-4).** 4(c) Note Agreement, dated August 8, 1986, between the Company ** and holders of the Company's 8.5% Senior Notes Due August 1, 1996. (Exhibit 4(d) to Registrant's Annual Report on Form 10-K for the year ended December 31, 1986.)** (10) Material Contracts 10(a) Deferred Compensation Program, as amended to June 16, 1992. (Exhibit to Form 10-K for year ended December 31, 1992)** 10(b) Incentive Stock Option Plan, as amended to May 15, 1990. (Exhibit to Form 10-K for year ended December 31, 1992)** l0(c) Pension Plan, as amended to January 1, 1990. (Exhibit to Form 10-K for year ended December 31, 1991)** 10(d) Employee Stock Ownership Plan, as amended to January 1, 1991. (Exhibit to Form 10-K for year ended December 31, 1991)** 10(e) Profit-Sharing Plan, as amended to January 1, 1991. (Exhibit to Form 10-K for year ended December 31, 1991)** 10(f) Stock Compensation Plan, (Registration Statement Nos. 33-54390 and 2-77803)** 10(g) Dividend Reinvestment Plan, as amended. (Exhibit to Registration Statement No. 33-38836 on Form S-3.)** 10(h) Directors Stock Option Plan (Exhibit to Form 10-K for year ended December 31, 1989)** 10(i) Purchase Agreement, dated as of June 1, 1993, between the Company and Kidder, Peabody Group, Inc. related to the private placement of 500,000 shares of UST Corp. Common Stock. (Exhibit to Form 8-K for quarter ended June 30, 1993)** 10(j) Registration Rights Agreement, dated as of June 1, 1993, between the Company and Kidder, Peabody Group, Inc. related to the private placement of 500,000 shares of UST Corp. Common Stock. (Exhibit to Form 8-K for quarter ended June 30, 1993)** 10(k) Employment Agreement, dated as of April 20, 1993, between the Company and Neal F. Finnegan, President and Chief Executive Officer of the Company. (Exhibit to Form 8-K dated March 25, 1993)** 10(1) Placing Agreement, dated July 28, 1993, between the Company and Fox-Pitt Kelton N.V., relating to the placement overseas of 2,870,000 shares of the Company's Common Stock. (Exhibit to Form 10-Q for quarter ended September 30, 1993)** 10(m) Transition Agreement, dated as of June 30, 1993, between the Company and James V. Sidell, former President and Chief Executive Officer of the Company. (Exhibit to Form 10-Q for quarter ended September 30, 1993)** 10(n) Separation Agreement dated August 16, 1993 between the Company and Robert G. Truslow, former President of the Company's wholly-owned subsidiary, USTrust. (Exhibit to Form 10-Q for quarter ended September 30, 1993)** 10(o) Separation Agreement dated September 20, 1993 between the Company Frank A. Morse, former President of the Company's wholly-owned subsidiary UST Bank/Connecticut. (Exhibit to Form 10-Q for quarter ended September 30, 1993)** (11) Statement re: computation of per share earnings (See Note 1 to Financial Statements.)* (21) Subsidiaries of the Registrant* (23) Consent of Arthur Andersen & Co.* - --------------- * Filed herewith ** Filed as part of a previous Commission filing and incorporated herein by reference. (b) Reports on Form 8-K Reports on Form 8-K or Form 8-K/A were filed by the Company on March 25, 1993 (UST Corp. Press Release naming new Chief Executive Officer); April 21, 1993 (Holding Company Director Falcone renounces claim against USTrust and USTC); July 16, 1993 (UST Corp. Press Release announcing loan loss provision and second quarter loss); and March 18, 1994 (filing of the Company's financial statements as of December 31, 1993). (c) Exhibits being filed See Exhibit Index (d) Financial Statement Schedules included in Financial Statements. 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. UST CORP. 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.

92050_1993.txt

92050_1993

1993

92050

Item 1. Business. Introduction Southeastern Public Service Company ("SEPSCO"), directly and through its subsidiaries, is currently engaged in three primary businesses: refrigeration, liquefied petroleum gas and natural gas and oil. In addition, SEPSCO also currently holds minority interests in several subsidiaries of Triarc Companies, Inc. ("Triarc"), a public corporation formerly known as DWG Corporation which, as a result of a recent merger, owns 100% of SEPSCO's voting securities. See "Item 1. Business -- Introduction -- Other Investments" and "Item 1. Business -- Introduction -- Recent Merger" below. As a result of a merger with a wholly-owned subsidiary of Triarc (the "Merger") which was consummated on April 14, 1994, (i) all of SEPSCO's voting securities are owned by Triarc and (ii) in the near future, SEPSCO's common stock will be delisted from the Pacific Stock Exchange, the principal market for such stock ("PSE"), and the registration of such stock under the Securities Exchange Act of 1934, as amended (the "1934 Act"), will be terminated. Triarc's Class A Common Stock (the only class of Triarc's voting securities) is traded on the New York Stock Exchange and the PSE. On April 23, 1993, approximately 28.6% of Triarc's then outstanding Class A Common Stock was acquired by DWG Acquisition Group, L.P. ("DWG Acquisition"), a Delaware limited partnership the sole general partners of which are Nelson Peltz and Peter W. May. See "Item 1. Business -- Introduction -- New Ownership and Executive Management" below. SEPSCO was incorporated in Delaware in 1947. SEPSCO's principal executive offices are located at 777 South Flagler Drive, Suite 1000E, West Palm Beach, Florida 33401, and its telephone number is (407) 653-4000. Reference herein to the Company includes collectively SEPSCO and its subsidiaries unless the context indicates otherwise. Other Investments In addition to its three primary businesses, SEPSCO also holds minority interests in several Triarc subsidiaries, including a 49% interest in Graniteville Company ("Graniteville"), which manufacturers, dyes and finishes cotton, synthetic and blended apparel fabrics, and a 5.4% interest in CFC Holdings Corp. ("CFC Holdings"), the indirect parent of Royal Crown Company, Inc. (the name of which was formerly Royal Crown Cola Co. and which produces and sells soft drink concentrates used in the production and distribution of soft drinks under such brand names as RC COLA and DIET RITE COLA) and Arby's, Inc. (the world's largest franchise restaurant system specializing in roast beef sandwiches). In July 1993, the Board of Directors of SEPSCO adopted a resolution (the "July Resolution") calling for the sale or discontinuance of substantially all of its operating businesses and assets, other than its minority equity interests in other Triarc subsidiaries. The actions contemplated by the July Resolution are referred to herein as the "Discontinued Operations Plan." See "Item 1. -- Business - - - Discontinued Operations." Discontinued Operations In October 1993, pursuant to the Discontinued Operations Plan, SEPSCO completed three transactions in which it disposed of businesses which provided a variety of services to electrical and telephone utilities and municipalities, which businesses formerly constituted SEPSCO's utilities and municipal services business segment. In April 1994, SEPSCO sold to Southwestern Ice, Inc. ("Southwestern") substantially all of the operating assets of the ice manufacturing and distribution portion of SEPSCO's refrigeration services and products business segment (the "Ice Business") for $5.0 million in cash and approximately $4.3 million principal amount of subordinated secured notes due on the fifth anniversary of the sale (the "Ice Sale") and the assumption by Southwestern of certain current liabilities and of certain environmental liabilities. For additional information regarding actions taken pursuant to the July Resolution, see "Item 1. Business -- Recent Transactions." In addition, in connection with the Discontinued Operations Plan, it is expected that in the near future SEPSCO will (a) sell to Triarc the stock of SEPSCO's subsidiaries that hold SEPSCO's natural gas and oil working and royalty interests for a net cash purchase price of $8.5 million and (b) transfer the liquefied petroleum gas business currently conducted by Public Gas Company, a 99.7% owned subsidiary of SEPSCO ("Public Gas"), to National Propane Corporation, a wholly-owned subsidiary of Triarc ("National Propane"). Once the sale and the transfer described in the immediately preceding sentence are completed, the only SEPSCO business remaining to be sold to an independent third party pursuant to the Discontinued Operations Plan will be the nationwide cold storage and warehouse facilities portion of SEPSCO's refrigeration products and services business segment (the "Cold Storage Business"). No agreements have been entered into as of the date hereof with respect to the Cold Storage Business, and the precise timetable for the disposition of such business will depend upon SEPSCO's ability to identify an appropriate purchaser and to negotiate acceptable terms of sale. Although SEPSCO currently anticipates completing the sale of that business by July 31, 1994, there can be no assurance that SEPSCO will be successful in this regard. Some or all of the net proceeds from the sale by SEPSCO of any such business or assets may be used to repurchase, redeem or prepay SEPSCO's outstanding indebtedness, including the indebtedness evidenced by SEPSCO's 11-7/8% Senior Subordinated Debentures due February 1, 1998 (the "Debentures"). Recent Merger On April 14, 1994, a wholly-owned subsidiary of Triarc was merged into SEPSCO and, as a result, SEPSCO became a wholly-owned subsidiary of Triarc. In the Merger, holders of outstanding shares of SEPSCO common stock, other than Triarc and its subsidiaries, received 0.8 of a share of Triarc's Class A Common Stock for each of their shares of SEPSCO common stock. The Merger was structured to satisfy Triarc's obligations under the terms of a Stipulation of Settlement (the "Settlement Agreement") relating to the settlement of a purported derivative action (the "Action") brought by William A. Ehrman, a SEPSCO stockholder, on behalf of SEPSCO against Triarc, certain of its affiliates and certain individuals. For more information regarding the Action and the Settlement Agreement, see SEPSCO's Definitive Proxy filed with the Securities and Exchange Commission pursuant to Regulation 14A on March 11, 1994 (the "SEPSCO Proxy"). New Ownership and Executive Management On April 23, 1993, DWG Acquisition acquired shares of Triarc Class A Common Stock from Victor Posner ("Posner") and certain entities controlled by him (together with Posner, the "Posner Entities"), representing approximately 28.6% of Triarc's then outstanding common stock. As a result of such acquisition and a series of related transactions which were also consummated on April 23, 1993 (collectively, the "Equity Transactions"), the Posner Entities no longer hold any shares of voting stock of Triarc or any of its subsidiaries. Concurrently with the consummation of the Equity Transactions, Triarc refinanced a significant portion of its high cost debt in order to reduce interest costs and to provide additional funds for working capital and liquidity purposes (the "Refinancing"). Following the consummation of the Equity Transactions and the Refinancing, the Board of Directors of each of Triarc and SEPSCO installed a new corporate management team, headed by Nelson Peltz and Peter W. May, who were elected Chairman and Chief Executive Officer and President and Chief Operating Officer of each of Triarc and SEPSCO, respectively. In addition, Leon Kalvaria was elected Vice Chairman of each of Triarc and SEPSCO. The Triarc Board of Directors also approved a plan to decentralize and restructure Triarc's management (the "Restructuring"). The Equity Transactions, the Refinancing and the Restructuring are collectively referred to herein as the "Reorganization". Change in Fiscal Year On October 27, 1993, Triarc announced that it was changing its fiscal year end from April 30 of each year to December 31 of each year effective with the transition period ended December 31, 1993, and that each of its subsidiaries that did not currently have a December 31 fiscal year end (including SEPSCO) would also change its fiscal year end to December 31 effective for the transition period ended December 31, 1993. Accordingly, this Form 10-K report relates to the ten month transition period from March 1, 1993 through December 31, 1993 ("Transition 1993"). References in this Form 10-K to a year preceded by the word "Fiscal" refer to the twelve months ended February 28 or 29 of such year. Business Overview As a result of the actions taken by the Board of Directors of SEPSCO in October 1993 pursuant to the Discontinued Operations Plan (see "Item 1. Business -- Introduction -- Discontinued Operations"), all of the businesses historically engaged in by SEPSCO other than the liquefied petroleum gas business have been reclassified as discontinued operations, and SEPSCO's consolidated financial statements have been restated to reflect such reclassification. See Note [3] to the Consolidated Financial Statements (the "Consolidated Financial Statements") of Southeastern Public Service Company and Subsidiaries included in "Item 8. Financial Statements and Supplementary Data" below. Set forth below is a brief description of the businesses which SEPSCO continues to operate pending the transfer, sale or discontinuance thereof, as well as a brief description of SEPSCO's other investments. Refrigeration Services SEPSCO's refrigeration business provides cold storage warehousing facilities. The principal customers of the warehousing activities are food distributors and supermarket chains. SEPSCO's refrigeration services are provided to domestic customers on a national basis. SEPSCO also enters into processing and storage agreements with certain customers. The availability of raw materials is not material to the operation of this business segment. SEPSCO's refrigeration business is seasonal. Operating revenues are lower during cold weather when demand declines for cold storage. The services provided by this business segment are marketed nationally in competition with three large national companies as well as many local concerns. No competitor is dominant in the industry, although several larger firms have greater resources than SEPSCO. The principal competitive factors in the refrigeration business are price and service. As a result of certain environmental audits in 1991, SEPSCO became aware of possible contamination by hydrocarbons and metals at certain sites of SEPSCO's refrigeration operations and has filed appropriate notifications with state environmental authorities and has begun a study of remediation at such sites. SEPSCO removed certain underground storage and other tanks at certain facilities of its refrigeration operations and has engaged in certain remediation in connection therewith. Such removal and environmental remediation involved a variety of remediation actions at various facilities of SEPSCO located in a number of jurisdictions. Such remediation varied from site to site, ranging from testing of soil and groundwater for contamination, development of remediation plans and removal in certain instances of certain contaminated soils. Remediation has recently been completed or is on-going at two sites in Miami, Florida, one site in Marathon, Florida, one site in Willard, Ohio, and one site in Provo, Utah. In addition, remediation will be required at thirteen sites at various locations which were sold or leased to Southwestern as part of the Ice Sale, and such remediation will be made in conjunction with Southwestern. See "Item 1. Business -- Recent Transactions." Based on preliminary information and consultations with, and certain reports of, environmental consultants and others, SEPSCO presently estimates SEPSCO's cost of all such remediation and/or removal will approximate $3.7 million, in respect of which charges of $1.3 million, $0.2 million and $2.2 million were made against earnings in SEPSCO's Fiscal 1991, 1992 and 1993, respectively. In connection therewith, through December 31, 1993, SEPSCO had incurred actual costs of $1.2 million and had a remaining accrual of approximately $2.5 million. In addition to the environmental costs borne by SEPSCO, in connection with the Ice Sale, Southwestern assumed liability for up to $1.0 million of remediation expenses relating to the Ice Business assets that were sold, with SEPSCO remaining liable for remediation expenses not so assumed. See "Item 1. Business -- Recent Transactions." SEPSCO believes that after such accrual and assumption of liability, the ultimate outcome of this matter will not have a material adverse effect on SEPSCO's consolidated results of operations or financial condition. See "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources." Liquefied Petroleum Gas Business SEPSCO, through Public Gas, distributes and sells liquefied petroleum gas ("LP gas") and related appliances and equipment throughout the state of Florida, for residential, agricultural, commercial and industrial uses, including, space heating, water heating, cooking and engine fuel. Following the Reorganization, management of SEPSCO's LP gas business was transferred to Triarc's National Propane subsidiary. In connection with the Discontinued Operations Plan, it is expected that in the near future, SEPSCO will transfer Public Gas' business to National Propane. The precise method by which such business will be transferred, however, has not yet been determined. Triarc has informed SEPSCO that prior to or in connection with transferring such business, it intends to cause Public Gas, which is currently 99.7% owned by SEPSCO, to become a wholly-owned subsidiary of SEPSCO. For a more complete description of SEPSCO's LP gas business, see "Business of Triarc Companies -- Business Segments -- Liquefied Petroleum Gas (National Propane and Public Gas)" in SEPSCO's Proxy. Natural Gas and Oil Interests SEPSCO has working and royalty interests in natural gas and oil producing properties located almost entirely in the states of Alabama, Kansas, Kentucky, Louisiana, Mississippi, North Dakota, West Virginia and Texas. SEPSCO produces most of the natural gas and all of the oil that it sells. Natural gas produced by SEPSCO is sold to major marketers and pipeline systems, under short and long-term contracts. Oil production is sold to crude oil refiners. The business is not dependent upon a single customer. SEPSCO has a very minor position in the natural gas and oil industry and competes with many larger independent natural gas and oil producers as well as with the major oil companies. This industry is not subject to seasonal factors. In the near future, SEPSCO expects to sell to Triarc the stock of SEPSCO's subsidiaries that hold SEPSCO's natural gas and oil working and royalty interests for a purchase price of $8.5 million. The sale will be consummated on or before July 22, 1994. Other Investments Graniteville SEPSCO owns 49% of the outstanding common stock of Graniteville, the remaining 51% of which is held by a wholly-owned subsidiary of Triarc. SEPSCO accounts for its investment in Graniteville on the equity method. Graniteville manufactures, dyes, and finishes cotton, synthetic and blended (cotton and polyester) apparel fabrics. Graniteville produces fabrics for utility wear including uniforms and other occupational apparel, piece-dyed fabrics for sportswear, casual wear and outerwear, indigo-dyed fabrics for jeans, sportswear and outerwear and specialty fabrics for recreational, industrial and military end-uses. Through its wholly-owned subsidiary, C.H. Patrick & Co., Inc., Graniteville also produces and markets dyes and specialty chemicals primarily to the textile industry. For additional information regarding the business of Graniteville, see "Business of Triarc Companies -- Business Segments -- Textiles (Graniteville)" in SEPSCO's Proxy. As a result of the discontinuance of substantially all of SEPSCO's other businesses, SEPSCO's investment in Graniteville will constitute its largest asset. Because of Graniteville's significance to SEPSCO, financial statements of Graniteville are included in this Form 10-K. See "Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K" below. CFC Holdings SEPSCO also has an investment in CFC Holdings. SEPSCO owns approximately 5.4% of the outstanding common stock of CFC Holdings, the remaining 94.6% of which is owned by Triarc. SEPSCO accounts for its investment in CFC Holdings on the equity method. CFC Holdings owns 100% of the outstanding common stock of RC/Arby's Corporation, formerly known as Royal Crown Corporation, whose principal subsidiaries are Royal Crown Company, Inc. ("Royal Crown") and Arby's, Inc. ("Arby's"). Royal Crown produces and sells soft drink concentrates used in the production and distribution of soft drinks by independent bottlers under the brand names RC COLA, DIET RC COLA, DIET RITE COLA, DIET RITE flavors, NEHI, UPPER 10 and KICK. RC COLA is the third largest national brand cola and is the only national brand cola alternative available to non-Coca-Cola and non-Pepsi-Cola bottlers. Royal Crown is also the exclusive supplier of proprietary cola concentrate to Cott Corporation, which sells private label soft drinks to major retailers such as Wal-Mart, A&P and Safeway. Arby's is the world's largest franchise restaurant system specializing in roast beef sandwiches with an estimated market share in 1993 of 65.1% of the roast beef sandwich segment of the quick-service restaurant category. In addition, SEPSCO believes that Arby's is the 14th largest restaurant chain in the United States, based on domestic system-wide sales. Worldwide sales for the Arby's system were approximately $1.6 billion in 1993. Arby's acts both as a franchisor and as an owner and operator in a system that included 2,682 restaurants as of December 31, 1993, of which 259 were company-owned. For a more detailed description of the business of Royal Crown and Arby's, see, respectively, "Business of Triarc Companies -- Business Segments -- Soft Drinks (RC Cola)" and "Business of Triarc Companies -- Business Segments -- Fast Food (Arby's)" in SEPSCO's Proxy. In addition, CFC Holdings also owns all of the outstanding common stock of Chesapeake Insurance Company Limited ("Chesapeake Insurance"), which historically provided certain property insurance coverage for Triarc, its subsidiaries (including SEPSCO) and certain of Triarc's former affiliates and reinsured a portion of certain insurance coverage which Triarc, its subsidiaries (including SEPSCO) and such former affiliates maintained with unaffiliated insurance companies. Chesapeake Insurance ceased writing insurance or reinsurance of any kind for periods commencing on or after October 1, 1993. SEPSCO also owns 15,000 shares of convertible redeemable preferred stock of Chesapeake Insurance which it purchased in 1992 for $1.5 million. Because the loss reserves of Chesapeake Insurance for insurance already written are approximately equal to its assets, Chesapeake Insurance's equity has been permanently impaired, and no dividends or liquidating distributions are expected to be made to Chesapeake Insurance's equity holders. Both SEPSCO and CFC Holdings have, therefore, reduced the value of the assets represented by their respective equity interests in Chesapeake Insurance to zero. For further information regarding Chesapeake Insurance, see "Business of Triarc Companies -- Discontinued and Other Operations" in SEPSCO's Proxy. Recent Transactions In October 1993, SEPSCO sold the businesses that formerly constituted its utilities and municipal services segment in three separate transactions. The first two of these transactions involved the sale by SEPSCO to Perkerson, Patton Management Corp. ("PPM Corp.") of the stock of each of Wright & Lopez, Inc. ("Wright & Lopez"), through which SEPSCO conducted its underground cable and conduit business, and Pressure Concrete Construction Co., through which SEPSCO conducted its concrete refurbishment business. These corporations were sold to PPM Corp. for a nominal amount subject to the adjustments described below. PPM Corp. has agreed to pay, as deferred purchase price, 75% of the net proceeds received from the sale or liquidation of these corporations' assets (cash of approximately $1.8 million had been received as of December 31, 1993) plus, in the case of Wright & Lopez, an amount equal to 1.25 times its adjusted book value as of the second anniversary of such sale. At the time Wright & Lopez was sold to PPM Corp., its adjusted book value was approximately $1.6 million. In addition, SEPSCO paid an aggregate of $2.0 million during October and November 1993 to cover the buyer's short-term operating losses and working capital requirements for the construction related operations. SEPSCO currently expects to break even on such sales, excluding any consideration of the potential book value adjustment. The other transaction involved the sale of substantially all of the assets of SEPSCO's tree maintenance subsidiaries to Asplundh Tree Expert Co. ("Asplundh") for a purchase price of approximately $69.6 million in cash and the assumption by Asplundh of certain liabilities aggregating $5.0 million resulting in a loss of approximately $4.8 million. The terms of each of these transactions was the result of arms'-length negotiations between SEPSCO and PPM Corp. and Asplundh, as the case may be. Neither PPM Corp. nor Asplundh is an affiliate of SEPSCO. In April 1994, SEPSCO sold to Southwestern substantially all of the operating assets of SEPSCO's Ice Business for $5.0 million in cash and approximately $4.3 million principal amount of subordinated secured notes due on the fifth anniversary of the Ice Sale and the assumption by Southwestern of certain current liabilities and certain environmental liabilities. SEPSCO, however, retained certain real estate assets associated with the Ice Business. An environmental remediation plan (the "Remediation Plan") was prepared in connection with the Ice Sale. The Remediation Plan indicated that remediation will be required at thirteen sites which were sold or leased to Southwestern as part of the Ice Sale, and such remediation will be made in conjunction with Southwestern, which is responsible for payment of the first and third $500,000 of expenses incurred in connection with the Remediation Plan, while SEPSCO remains liable for the second $500,000 of expenses and any expenses in excess of $1.5 million. Environmental Matters Although SEPSCO has not performed any environmental audits on any of the operations which it continues to own, other than with respect to the properties sold or leased in connection with the Ice Sale and certain inactive properties set forth below, SEPSCO currently does not anticipate that present environmental regulations will materially affect the capital expenditures, earnings or competitive position of any segment of SEPSCO's businesses, except for expenditures for environmental remediation required to be made in the remainder of its current fiscal year and thereafter in connection with its refrigeration business. See "Item 1. Business -- Business Overview -- Refrigeration Services" above. Working Capital SEPSCO's working capital requirements have generally been fulfilled from cash flow from operations, although from January 1991 through April 1993 SEPSCO had a credit facility with a commercial lender, secured by substantially all of the accounts receivable of the tree maintenance activities and the construction-related activities of the utility and municipal services segment and certain other receivables. In connection with the Reorganization, Triarc made certain payments on account of indebtedness owed by it to SEPSCO, and SEPSCO used a portion of the proceeds thereof to pay in full all amounts due under such credit facility, at which time such facility was terminated. Intellectual Property; Research and Development; Backlog Patents, trademarks, licenses, franchises and concessions are not material to any segment of SEPSCO's business. During Fiscal 1992, Fiscal 1993 and Transition 1993, SEPSCO had no material expenditures for research and development activities. The existence of a forward order backlog is not material to any segment of SEPSCO's businesses. Employees As of December 31, 1993, SEPSCO employed 624 employees, including approximately 169 salaried employees. Approximately 187 of such employees were covered by 13 collective bargaining agreements expiring from time to time through 1996. SEPSCO believes that relationships with employees are satisfactory. Item 2. Item 2. Properties. Certain information about the materially important physical properties of SEPSCO's operations as of December 31, 1993 is set forth in the following table: Sq. Ft. of Business Facilities-Location Land Title Floor Space Refrigeration Cold storage: Topeka, KS 1 owned 266,000 Bonner Springs, KS 1 owned 919,000 Denver, CO 1 owned 202,000 San Martin, CA 1 owned 131,000 Santa Maria, CA 1 owned 318,000 Portland, OR 1 owned 200,000 American Falls, ID 1 owned 169,000 Other locations 3 owned 166,000 throughout the United States Liquefied Petroleum Gas 27 Bulk Plants 18 owned * (including retail 9 leased depots) Natural Gas Office/warehouse 2 leased 8,000 and Oil various locations 4 owned 6,000 throughout the 6 leased 10,000 United States Other Facilities (inactive) Refrigeration Ice mfg. and cold storage 3 owned 189,000 Ice mfg. 11 owned 69,000 _______________ *Liquefied petroleum gas facilities have approximately 2,579,000 gallons of storage capacity. The natural gas and oil operations have net working interests in approximately 61,000 acres and net royalty interests in approximately 4,000 acres, located almost entirely in the states of Alabama, Kentucky, Louisiana, Mississippi, North Dakota, Texas and West Virginia. The Ice Business operations, which were sold in April 1994, consisted of 12 facilities with approximately 450,000 total square feet. The Company's management believes that the properties of the operations that the Company continues to own, taken as a whole, are generally well maintained and are adequate for current and foreseeable business needs. The majority of the properties are owned by the Company. All of the properties owned in fee by the Company are without encumbrances, except minor ones which do not affect the use thereof in the Company's business. Except as set forth in the table above with respect to properties listed as inactive, substantially all of the Company's materially important physical properties were being fully utilized as of December 31, 1993. Item 3. Item 3. Legal Proceedings. In December 1990, the Action was brought against Triarc and other defendants on behalf of SEPSCO. As a result of the Merger, the court in which the Action is pending will permanently bar and enjoin the institution or prosecution of all claims arising out of or in any way relating to the Action against Triarc and certain of its affiliates. For a detailed description of such legal proceedings, see "Special Factors -- Background to the Merger; Reasons for the Merger -- Legal Proceedings Related to SEPSCO and Triarc" in SEPSCO's Proxy. In addition to the Action and the matters referred to or described under "Item 1. Business -- Environmental Matters," the Company is involved in claims, litigation and administrative proceedings and investigations of various types in several jurisdictions. Such matters arise in the ordinary course of the Company's business, and it is the opinion of the Company's management that the outcome of any such matter, or all of them combined, will not have a material adverse effect on the Company's business or consolidated financial condition. 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. As a result of the Merger, (a) SEPSCO became a wholly-owned subsidiary of Triarc and (b) in the near future, SEPSCO's common stock will be delisted from the PSE and the registration of such stock under the 1934 Act will be terminated. Historically, however, the principal market for the SEPSCO Common Stock has been the PSE (symbol: SPV). The high and low closing prices of the SEPSCO Common Stock as reported in the consolidated transaction reporting system are as follows: Market Prices -------------- Calendar Quarters High Low ----------------- -------------- First Quarter............................. $ 3-3/8 $ 1-7/8 Second Quarter............................ 2-3/8 1-3/8 Third Quarter............................. 1-7/8 7/8 Fourth Quarter............................ 2-1/4 13/16 First Quarter............................. $ 6-5/8 $ 1-1/2 Second Quarter............................ 7-1/8 4-3/4 Third Quarter............................. 9-1/4 5-5/8 Fourth Quarter............................ 14 8-5/8 First Quarter............................. $14-1/2 $12-5/8 Second Quarter............................ 16-1/2 14-1/8 Third Quarter............................. 24-7/8 15-1/8 Fourth Quarter............................ 24-1/4 18-7/8 First Quarter............................. $20-1/8 $14-5/8 No dividends have been paid or declared on the SEPSCO Common Stock in the three most recent fiscal years, during Transition 1993, or in the current year to date. Under the provisions of the Debentures, the payment of cash dividends and the acquisition of shares of SEPSCO's capital stock by SEPSCO are limited to the sum of (i) 50% of the aggregate consolidated net income after November 30, 1982 (exclusive of equity in the net income (loss) of affiliates), (ii) the aggregate net proceeds received from the sale of capital stock and (iii) $7.5 million. Under such provisions, at December 31, 1993 SEPSCO was not permitted to pay cash dividends or acquire shares of SEPSCO's capital stock. The payment of cash dividends is also dependent upon, among other things, the availability of current and retained earnings. SEPSCO does not presently anticipate the declaration of cash dividends on the SEPSCO Common Stock in the near future. As a result of the Merger, on April 14, 1994, all of the outstanding shares of SEPSCO's voting securities were held by Triarc. PAGE Item 6. Item 6. Selected Financial Data PAGE Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Results of Operations TEN MONTHS ENDED DECEMBER 31, 1993 COMPARED WITH THE TEN MONTHS ENDED DECEMBER 31, 1992 (UNAUDITED) Net sales increased from $22.4 million in the ten months ended December 31, 1992 ("Comparable 1992") to $23.4 million in the ten months ended December 31, 1993 ("Transition 1993") principally as a result of higher volumes of LP gas due to colder weather in the regions serviced by such business in Transition 1993, partially offset by slightly lower average selling prices which resulted from lower product costs. Operating profit decreased from $2.5 million in Comparable 1992 to $1.7 million in Transition 1993 principally due to an increase in selling, general and administrative expenses which resulted from a facilities relocation and corporate restructuring charge of $0.8 million relating to continuing operations (see Note 14 to the consolidated financial statements), partially offset by a slight increase in gross profit. Interest expense was favorably impacted due primarily to the lower debt outstanding and, to a much lesser extent, lower interest rates during Transition 1993. Equity in earnings of affiliates before cumulative effect of changes in accounting principles and extraordinary items of affiliate was unfavorably impacted in Transition 1993 primarily due to the following equity in significant charges of affiliates: (i) a $1.9 million charge recorded in Transition 1993 related to facilities relocation and corporate restructuring, (ii) $0.9 million of estimated cost allocated to the affiliates by Triarc for compensation paid to a special committee relating to the change in control of Triarc and affiliates which took place April 23, 1993, (iii) $1.2 million from the write-off of Graniteville Company's ("Graniteville") investment in Chesapeake Insurance Company Limited ("Chesapeake Insurance") and (iv) $0.5 million from insurance loss reserves recorded by Chesapeake Insurance. Interest income from Triarc was unfavorably impacted due to lower debt outstanding in Transition 1993. SEPSCO also wrote off its $1.5 million investment in Chesapeake Insurance since such investment is no longer deemed recoverable as a result of Chesapeake Insurance reducing its stockholders' equity to a minimal amount following additional provisions for insurance losses of $10.0 million during Transition 1993 and the decision by Triarc effective October 1993 to cease writing new insurance or reinsurance of any kind through Chesapeake Insurance. The benefit from income taxes increased from $0.3 million during Comparable 1992 to $1.2 million in Transition 1993. The Transition 1993 benefit resulted primarily from the equity in earnings of affiliates. Loss from discontinued operations, net of income taxes increased $22.7 million from $0.7 million in Comparable 1992 to $23.4 million in Transition 1993 primarily due to the following reasons: In connection with the consummation of the sales of the tree maintenance services operations and the construction related operations and the letter of intent to sell (and subsequent sale) of the ice operations, SEPSCO reevaluated the estimated gain or loss from the sale of its discontinued operations and provided $13.9 million for the estimated loss on the sale of the discontinued operations during Transition 1993. The revised estimate principally reflects (i) $4.6 million of losses from the sales of the operations comprising the utility and municipal services business segment previously estimated to be approximately break-even, (ii) $6.7 million of losses from the sale of operations comprising the refrigeration business segment previously estimated to be a gain of $1.6 million, (iii) $2.5 million of estimated losses from operations from July 22, 1993 to the actual or estimated disposal dates and (iv) less previously estimated losses of $1.5 million from the sale of the natural gas and oil business segment which now will be sold to Triarc and accounted for as a transfer between entities under common control at net book value. The net loss from the sale of the utility and municipal services business segment reflects a reduction of $1.8 million in the estimated sales price for the construction related operations from previous estimates, a $2.0 million reduction in anticipated proceeds from asset sales by July 22, 1994, and other adjustments in finalizing the loss on the sale of the tree maintenance services operations. The reduction in proceeds from asset sales results from the buyer of such businesses successfully negotiating extensions of certain major contracts with respect to the larger of such businesses and as a result no longer intending to immediately dispose of the major portion of the assets. Should the buyer hold such assets through October 5, 1995, the $2.0 million reduction in proceeds would be effectively realized through the Book Value Adjustment (see subsequent discussion). The $8.2 million change relating to the sales of the refrigeration business segment principally results from (i) a $4.0 million reduction in the sales price for the ice operations and (ii) a $4.0 million reduction in the estimated sales price of the cold storage operations based on preliminary sales discussions and experience with respect to negotiating the sale of the other operations. SEPSCO recorded an $8.0 million write-down relating to the impairment of certain unprofitable properties in Transition 1993. During Transition 1993 SEPSCO was allocated by Triarc as well as directly incurred certain facilities relocation and corporate restructuring charges totaling $4.7 million, of which $3.9 million was allocated to discontinued operations (see Note 14 to the consolidated financial statements for a further discussion). Operating profits of certain business segments through July 22, 1993, exclusive of the above charges, also declined. The tree maintenance activities experienced a decline in earnings due to higher insurance costs, losses on certain contracts and start-up costs on new crews. The flooding conditions experienced during the second quarter of Transition 1993 prevented the generation of revenues by crews added in anticipation of increased workload, whereas the Comparable 1992 period was favorably affected by the additional work in connection with Hurricane Andrew. The construction related activities experienced a decline due to a lower number of contracts in progress and losses experienced on existing contracts. Refrigeration operations had lower margins due to lower revenues from cold storage due to lower occupancy rates and lower margins in the ice operations due to competitive conditions. The above charges were partially offset by the effect of deferring the $3.8 million net loss from discontinued operations subsequent to July 22, 1993, the measurement date, through December 31, 1993 which was considered in the loss on disposal of discontinued operations. SEPSCO expects that such net losses will be offset by seasonal net income of the natural gas and oil operations through its disposal date. Effective March 1, 1993, SEPSCO changed its method of accounting for income taxes when it adopted the provisions of Statement of Financial Accounting Standards No. 109 "Accounting for Income Taxes" ("SFAS 109"). The cumulative effect on prior years of the change in accounting principles decreased the net loss for Transition 1993 by $7.6 million or $.64 per share. Effective March 1, 1992 Graniteville adopted SFAS 109 and Statement of Financial Accounting Standards No. 106 "Employers' Accounting for Postretirement Benefits Other than Pensions". The change in accounting principles resulted in charges amounting to $6.0 million, (net of taxes of $0.4 million), or $.51 per share, which was reflected in the consolidated statement of operations in Fiscal 1993. FISCAL 1993 COMPARED WITH FISCAL 1992 Net sales decreased from $29.2 million in Fiscal 1992 to $28.5 million in Fiscal 1993 due to a decrease in the average selling prices, coupled with a slight decrease in volume due to unseasonably warmer weather and increased competitive conditions. Operating profit decreased from $4.6 million in Fiscal 1992 to $3.6 million in Fiscal 1993 principally due to the decrease in sales as explained above, and to a lesser extent higher cost of product. Equity in earnings of affiliates before extraordinary items and cumulative effect of changes in accounting principles increased from $5.2 million in Fiscal 1992 to $12.2 million in Fiscal 1993 due to increased earnings of Graniteville. The gain on sale of marketable security of $6.0 million resulted from the recognition of a gain previously deferred on the sale of the common stock of an unaffiliated company to Triarc which had been previously deferred until collection of a note was assured. As such note was collected in April 1993 prior to the issuance of the Fiscal 1993 consolidated financial statements, the gain was recorded in Fiscal 1993. Gains on repurchase of debentures for sinking fund requirement decreased from $4.0 million in Fiscal 1992 to $0.1 million in Fiscal 1993 due to the market price of the Debentures which increased to above par, and accordingly, since the repurchase of the Debentures was no longer beneficial, the sinking fund requirement was principally made in cash. Other, net decreased from income of $0.4 million in Fiscal 1992 to expense of $1.1 million in Fiscal 1993 principally due to a $1.3 million accrual for the proposed settlement of the Ehrman Litigation in Fiscal 1993. Provision for income taxes as a percentage of income from continuing operations before income taxes for Fiscal 1993 was lower than the statutory rate due to the equity in earnings of affiliates on which income taxes were provided only on the portion remaining after an 80% dividend exclusion. Loss from discontinued operations, net of income taxes, increased from $0.2 million in Fiscal 1992 to $5.5 million in Fiscal 1993 principally due to a $4.7 million reduction in gross profit in the utility and municipal services segment due to competitive conditions experienced principally in the construction related activities and the tree maintenance operations due to intensely competitive bidding in the first quarter of Fiscal 1993 which resulted in losses of certain contracts, most of which were replaced by ones with lower margins and the adjustment of prices to retain certain other existing contracts. Also, the refrigeration operations recorded a $2.1 million accrual before income taxes for potential environmental remediation in Fiscal 1993, whereas Fiscal 1992 included a credit of $1.4 million as proceeds from settlement of certain litigation of the construction operations. These factors were partially offset by a benefit from income taxes of $2.4 million in Fiscal 1993 compared to a benefit from income taxes of $0.3 million in Fiscal 1992. Equity in cumulative effect of changes in accounting principles of affiliate of $6.0 million resulted from Graniteville's adoption of SFAS 109 and SFAS 106 during Fiscal 1993. Equity in extraordinary items of affiliate of $0.3 million in Fiscal 1993 resulted from the early extinguishment of debt by CFC Holdings. LIQUIDITY AND CAPITAL RESOURCES At February 28, 1993 and December 31, 1993 cash and equivalents, excluding restricted cash, amounted to $0.2 million and $33.6 million (including ($10.8 million of marketable securities), respectively. The $22.6 million increase in cash is principally a result of the remaining excess proceeds from the sale of the tree maintenance services operations (see subsequent discussion). Total debt, excluding the debt of the discontinued operations, amounted to $58.3 million and $59.3 million at February 28, 1993 and December 31, 1993, respectively. As previously reported, a change in control of Triarc occurred on April 23, 1993 (the "Closing Date"), which as a result of Triarc's ownership of SEPSCO's voting securities constituted a change in control of SEPSCO. In connection therewith SEPSCO received from Triarc $27.1 million in cash and $3.5 million in the form of an offset of amounts due to Triarc as of April 23, 1993 in connection with the providing by Triarc of certain management services to SEPSCO. The aggregate $30.6 million of payments by Triarc included full payment of $6.8 million (including $0.3 million of accrued interest) on an unsecured promissory note issued to SEPSCO by Triarc in connection with the 1988 sale of an investment and partial payment of $23.8 million (including $1.4 million of accrued interest) on a $49.0 million promissory note due to SEPSCO resulting from the 1986 sale of approximately 51% of Graniteville's common stock to Triarc, as described below. SEPSCO used the $27.1 million of cash proceeds to pay $12.7 million due under its accounts receivable financing arrangement which was then terminated and to pay $14.4 million (including $0.4 million of accrued interest) owed to Chesapeake Insurance Company Limited ("Chesapeake Insurance"). At December 31, 1993 SEPSCO holds a promissory note (the "Note") of $28.0 million (including $1.4 million of accrued interest) from Triarc, which is included in "Due from Triarc Companies, Inc." in the consolidated balance sheet, which had an original face amount of approximately $49.0 million, bearing interest at the annual rate of 13% payable semi-annually. As described above, on the Closing Date, SEPSCO received partial payment of the Note of approximately $23.8 million including $1.4 million of accrued interest from Triarc. The Note, after giving effect to such prepayment, is due in August 1998 and resulted from the 1986 sale of approximately 51% of the outstanding common shares of Graniteville to Triarc and is secured by such shares. The Note is subordinated to senior indebtedness of Triarc to the extent, if any, that the payment of principal and interest thereon is not satisfied out of proceeds of the pledged Graniteville shares. SEPSCO has not received any cash dividends from its investment in Graniteville during Transition 1993 compared with $3.0 million in Fiscal 1993. Under its present credit agreement, Graniteville is permitted to pay dividends or make loans or advances to its stockholders, including SEPSCO in an amount equal to 50% of the net income of Graniteville accumulated from the beginning of the first fiscal year commencing on or after December 20, 1994, provided that the outstanding principal balance of Graniteville's term loan is less than $50.0 million at the time of the payment (the outstanding principal balance was $72.5 million as of December 31, 1993) and certain other conditions are met. Accordingly, Graniteville is unable to pay any dividends or make any loans or advances to SEPSCO prior to December 31, 1995. SEPSCO is required to pay interest on its 11 7/8% Senior Subordinated Debentures due February 1, 1998 (the "Debentures") semi-annually on February 1 and August 1 of each year. Interest payments due February 1, 1994 and August 1, 1994 aggregate $6.9 million. SEPSCO is also required to retire annually, through the operation of a mandatory sinking fund, $9.0 million principal amount of the Debentures on February 1 of each year. The indenture pursuant to which the Debentures were issued (the "Indenture") provides that, in lieu of making such payment in cash, SEPSCO may credit against the mandatory sinking fund requirement the principal amount of Debentures acquired by SEPSCO other than through the sinking fund. On February 1, 1994, SEPSCO satisfied such sinking fund requirement by payment of $9.0 million in cash through cash received from the sale of the tree maintenance services operations rather than through the delivery of Debentures. The indenture contains a provision which limits to $100.0 million the aggregate amount of specified kinds of indebtedness that SEPSCO and its consolidated subsidiaries can incur. At December 31, 1993 such indebtedness was $59.3 million resulting in allowable additional indebtedness, if SEPSCO desired to make such borrowings and if such financing could be obtained, of $40.7 million. On October 18, 1993, Triarc entered into a Settlement Agreement (the "Settlement Agreement") with the plaintiff (the "Plaintiff") in the Ehrman Litigation. The Settlement Agreement provides, among other things, that SEPSCO would be merged into, or otherwise acquired by, Triarc or an affiliate thereof, in a transaction in which each holder of SEPSCO's Common Stock other than Triarc will receive in exchange for each share of SEPSCO's Common Stock, 0.8 shares of Triarc's Class A Common Stock. On November 22, 1993 Triarc and SEPSCO entered into a merger agreement (the"Merger"). The Settlement Agreement was approved by the United States District Court For the Southern District of Florida on January 11, 1994 and the Merger was approved on April 14, 1994 by SEPSCO's stockholders other than Triarc. The Merger was consummated on April 14, 1994 pursuant to which a subsidiary of Triarc was merged into SEPSCO in the manner described in the Settlement Agreement. Following the Merger, Triarc owns 100% of the SEPSCO Common Stock. On July 22, 1993, SEPSCO's Board of Directors authorized the sale or liquidation of the utility and municipal services, refrigeration and natural gas and oil businesses. Accordingly, SEPSCO has retroactively restated the consolidated financial statements for each of the periods shown to reflect all of such businesses as discontinued operations through July 22, 1993. The operating results of the discontinued operations subsequent to July 22, 1993 have been deferred which was anticipated in the loss on disposal of discontinued operations and are included in "Net current liabilities of discontinued operations" in the consolidated balance sheets. In addition, on July 22, 1993 SEPSCO Board of Directors authorized the sale or liquidation of the liquefied petroleum gas business. Sepsco intends to transfer the liquified petroleum gas business to a subsidiary of Triarc and the transfer would be accounted for at net book value. The precise nature of such transfer has not been determined and is expected to occur by July 22, 1994. Based on these facts SEPSCO has continued to reflect the liquified petroleum gas business as a continuing operation. On December 9, 1993 SEPSCO's Board of Directors decided to sell the natural gas and oil business to Triarc following the Merger and the resulting minority interest in SEPSCO rather than selling such business to an independent third party. Such sale will be in the form of a sale of the stock of the entities comprising the natural gas and oil business for cash of $8.5 million which is equal to their fair value and approximately $4.0 million higher than their net book value. On October 15, 1993 SEPSCO sold the assets of its tree maintenance services operations previously included in its utility and municipal services business segment for $69.6 million in cash plus the assumption by the purchaser of $5.0 million in current liabilities resulting in a loss of $4.8 million. The $22.8 million cash balance as of December 31, 1993 is principally a result of such cash proceeds, less the repayment of $24.1 million of capitalized lease obligations relating to the tree maintenance services operations, repayment of $1.1 million of amounts due to Triarc, payment of $2.0 million to the purchasers of the construction related operations (see below) and general operating requirements since October 15, 1993. On October 7, 1993 SEPSCO sold the stock of its two construction related operations previously included in its utility and municipal services business segment for a nominal amount subject to adjustments described below. As the related assets are sold or liquidated the purchasers have agreed to pay, as deferred purchase price, 75% of the net proceeds received therefrom (cash of $1.8 million had been received as of December 31, 1993) plus, in the case of one of the two entities, an amount equal to 1.25 times the adjusted book value of such entity as of October 5, 1995 (the "Book Value Adjustment"). As of October 7, 1993, the adjusted book value of the assets of that entity aggregated approximately $1.6 million. In addition, SEPSCO paid $2.0 million in October and November 1993 to cover the buyer's short-term operating losses and working capital requirements for the construction related operations. SEPSCO currently expects to break-even the sales of the construction related operations excluding any consideration of the potential Book Value Adjustment. On April 8, 1994 SEPSCO sold substantially all of the operating assets of the ice operations of its refrigeration business segment for $5.0 million in cash, a $4.3 million note (discounted value $3.3 million) and the assumption by the buyer of certain current liabilities of up to $1.0 million. While the loss on the sale has not been finalized, SEPSCO currently estimates it will approximate $2,500,000. The note, which bears no interest during the first year and 5% thereafter, would be payable in installments of $120.0 thousand in 1995 through 1998 with the balance of approximately $3.8 million due in 1999. The only remaining discontinued operation to be sold to an independent third party is the cold storage operation of the refrigeration business. The precise timetable for the sale and liquidation of the cold storage operation will depend upon SEPSCO's ability to identify appropriate potential purchasers and to negotiate acceptable terms for the sale of such operation. SEPSCO currently anticipates completion of such sales by July 22, 1994. SEPSCO has $5.3 million of restricted cash and equivalents which support letters of credit which collateralize certain performance and other bonds relating to the utility and municipal services business segment. SEPSCO anticipates that buyers of the segment will provide the collateral for such bonds or that the performance secured by the bond will be completed and the restricted cash will revert to SEPSCO free of restrictions and at that time be used for general corporate purposes. SEPSCO had cash provided by operations of $4.1 million during Transition 1993. Such cash requirements, excluding cash flows from operations, for 1994 will include $3.9 million of capital expenditures, of which SEPSCO intends to seek financing from banks and other sources for $3.2 million, as well as a $9.0 million sinking fund payment on the Debentures (paid February 1, 1994). SEPSCO expects to meet all of its cash requirements during 1994 with the aforementioned financing for capital expenditures and its existing cash balances principally derived from the sale of the tree maintenance services operations. In 1987, Graniteville was notified by the South Carolina Department of Health and Environmental Control ("DHEC") that it discovered certain contamination of Langley Pond near Graniteville, South Carolina and DHEC asserted that Graniteville may be one of the parties responsible for such contamination. Graniteville entered into a consent decree providing for the study and investigation of the alleged pollution and its sources. The study report prepared by Graniteville's environmental consulting firm and filed with DHEC in April 1990, recommended that pond sediments be left undisturbed and in place. DHEC responded by requesting that Graniteville submit additional information concerning potential passive and active remedial alternatives, with accompanying supportive information. In May 1991 Graniteville provided this information to DHEC in a report of Graniteville's environmental consulting firm. The 1990 and 1991 reports concluded that pond sediments should be left undisturbed and in place and that other less passive remediation alternatives either provided no significant additional benefits or themselves involved adverse effects on human health, to existing recreational uses or to the existing biological communities. SEPSCO is unable to predict at this time what further actions, if any, may be required in connection with Langley Pond or what the cost thereof may be. However, given the passage of time since the submission of the two reports by DHEC and the absence of desirable remediation alternatives, other than continuing to leave the Langley Pond sediments in place and undisturbed as described in the reports, SEPSCO believes the ultimate outcome of this matter will not have a material adverse effect on SEPSCO's consolidated results of operations or financial position. As a result of certain environmental audits in 1991, SEPSCO became aware of possible contamination by hydrocarbons and metals at certain sites of SEPSCO's refrigeration operations and has filed appropriate notifications with state environmental authorities and has begun a study of remediation at such sites. SEPSCO has removed certain underground storage and other tanks at certain facilities of its refrigeration operations and has engaged in certain remediation in connection therewith. Such removal and environmental remediation involved a variety of remediation actions at various facilities of SEPSCO located in a number of jurisdictions. Such remediation varied from site to site, ranging from testing of soil and groundwater for contamination, development of remediation plans and removal in certain instances of certain contaminated soils. Based on preliminary information and consultations with, and certain reports of, environmental consultants and others, SEPSCO presently estimates the cost of such remediation and/or removal will approximate $3.7 million, all of which was provided in prior years. In connection therewith, SEPSCO has incurred actual costs through December 31, 1993 of $1.2 million and has a remaining accrual of $2.5 million. SEPSCO believes that after such accrual the ultimate outcome of this matter will not have a material adverse effect on SEPSCO's consolidated results of operations or financial position. PAGE Item 8. Item 8. Financial Statements and Supplementary Data Index: Report of Independent Certified Public Accountants Consolidated Balance Sheets - February 28, 1993 and December 31, 1993 Consolidated Statements of Operations and Retained Earnings (Deficit) - Two years ended February 28, 1993 and ten months ended December 31, 1993 Consolidated Statements of Cash Flows - Two years ended February 28, 1993 and ten months ended December 31, 1993 Notes to Consolidated Financial Statements REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS To the Board of Directors and Stockholders, SOUTHEASTERN PUBLIC SERVICE COMPANY: We have audited the accompanying consolidated balance sheets of Southeastern Public Service Company (a Delaware corporation and a 71.1% owned subsidiary of Triarc Companies, Inc., formerly DWG Corporation, prior to April 14, 1994 and a wholly-owned subsidiary thereafter) and subsidiaries as of February 28, 1993 and December 31, 1993 and the related consolidated statements of operations and retained earnings (deficit) and cash flows for each of the two years in the period ended February 28, 1993 and the ten months 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 Southeastern Public Service Company and subsidiaries as of February 28, 1993 and December 31, 1993, and the results of their operations and their cash flows for each of the two years in the period ended February 28, 1993 and for the ten months ended December 31, 1993, in conformity with generally accepted accounting principles. As discussed in Notes 7 and 1 to the consolidated financial statements, the Company's 49% owned affiliate accounted for under the equity method and the Company changed their methods of accounting for income taxes and postretirement benefits other than pensions, effective March 2, 1992 and March 1, 1993, respectively. Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. The schedules listed in Item 14.(A) 2. 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. Miami, Florida, April 14, 1994. PAGE See accompanying notes to consolidated financial statements. PAGE See accompanying notes to consolidated financial statements. PAGE Other: During the years ended February 29, 1992 and February 28, 1993 and ten months ended December 31, 1993, Southeastern Public Service Company ("SEPSCO"), a 71.1% owned subsidiary of Triarc Companies, Inc. ("Triarc", formerly DWG Corporation) prior to April 14, 1994 and a 100% owned subsidiary of Triarc thereafter, received interest payments from Triarc of $7,209, $6,026 and $3,308, respectively, in the form of offsets against amounts due from SEPSCO to Triarc. During the year ended February 28, 1993, amounts payable to Triarc were netted against a $6,500 promissory note receivable form Triarc (see Note 5). See accompanying notes to consolidated financial statements. PAGE SOUTHEASTERN PUBLIC SERVICE COMPANY AND SUBSIDIARIES Notes to Consolidated Financial Statements (1) Summary of Significant Accounting Policies Principles of Consolidation The consolidated financial statements include the accounts of Southeastern Public Service Company ("SEPSCO"), a 71.1% owned subsidiary of Triarc Companies, Inc. ("Triarc", formerly DWG Corporation) prior to April 14, 1994 and a 100% owned subsidiary of Triarc thereafter (see Note 15), and its subsidiaries. Due to their planned sale or liquidation (see Note 3), all subsidiaries, except for the liquefied petroleum gas business, have been reflected as discontinued operations. All significant intercompany balances and transactions have been eliminated in consolidation. Certain amounts in the prior years have been reclassified to conform to the current year presentation. On October 27, 1993 SEPSCO's Board of Directors approved a change in the fiscal year of SEPSCO from a fiscal year ending February 28 to a calendar year ending December 31, effective for the transition period ending December 31, 1993. Graniteville Company ("Graniteville"), a 49% owned investment, also changed its fiscal year to a calendar year ending December 31. As used herein, "Fiscal 1992" and "Fiscal 1993" refer to the years ended February 28, 1992 and 1993, respectively, and "Transition 1993" refers to the ten months ended December 31, 1993. SEPSCO's consolidated financial statements for each of the periods in Fiscal 1992, Fiscal 1993 and Transition 1993 include the results of Graniteville as a 49% owned affiliate and CFC Holdings Corp. ("CFC Holdings") as a 5.4% owned affiliate. Both investments are accounted for on the equity method. Also, as used herein February 28 shall mean the last day of SEPSCO's fiscal year for Fiscal 1992 and Fiscal 1993. Cash Equivalents SEPSCO considers all highly liquid instruments with an original maturity of three months or less when purchased to be cash equivalents. At December 31, 1993, SEPSCO had $20,646,000 invested in short-term commercial paper. Marketable Securities At December 31, 1993, marketable securities, which are stated at cost which approximates fair market value, consisted of the following (in thousands): Marketable equity securities $ 1,005 Marketable debt securities 9,790 -------- $ 10,795 ======== Inventories Inventories are determined under the lower of cost (first-in, first-out basis) or market. Depreciation, Depletion and Amortization Assets acquired prior to March 1, 1980 are depreciated on the straight- line basis using composite annual rates on the majority of properties of 5.2% to 7.2% for refrigeration properties; and 5% for liquefied petroleum gas properties. The development of these composite rates was based on the estimated useful lives of the related asset groups. Under the composite method of depreciation, upon normal retirement or replacement, the cost of property, less any salvage proceeds, is charged to accumulated depreciation. Gains and losses arising from abnormal retirements or disposal are included in current operations. Assets acquired on or after March 1, 1980 are depreciated on the straight-line basis using the estimated useful lives of the related major classes of properties; 3 to 9 years for automotive equipment; 5 to 20 years for machinery and equipment; and 20 to 30 years for buildings and improvements. Under this method, gains and losses arising from disposal are included in current operations. Depreciation and depletion on natural gas and oil properties are computed using the units of production method based on proven reserves estimated from engineering data. Financing costs incurred in connection with the issuance of SEPSCO's 11 7/8% Senior Subordinated Debentures (the "Debentures") are being amortized as interest expense over the term of the Debentures using the interest rate method. At February 28, 1993 and December 31, 1993, $1,063,000 and $846,000, respectively, of such unamortized deferred financing costs are included in "Other assets" in the accompanying consolidated balance sheets. The original issue debt discount on the Debentures is being amortized as interest expense over the term of the Debentures using the interest rate method. Such unamortized debt discount is reported as a reduction of related long-term debt in the accompanying consolidated balance sheets. Income Taxes Federal income tax returns for SEPSCO and its consolidated subsidiaries are filed on a consolidated basis. SEPSCO adopted Statement of Financial Accounting Standards ("SFAS") No. 109, "Accounting for Income Taxes" ("SFAS 109") effective March 1, 1993. This accounting change resulted in a benefit of $7,617,000, $.64 per share, which is reflected as the cumulative effect of changes in accounting principles for "The Company" in the accompanying consolidated statement of operations for Transition 1993. SEPSCO recognizes deferred income taxes for the tax consequences of temporary differences by applying the enacted statutory tax rates to the differences between the financial statement carrying amounts and the tax bases of existing assets and liabilities. Postretirement Benefits Other than Pensions Effective March 1, 1993, SEPSCO adopted the provisions of SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other than Pensions" ("SFAS 106"). This new standard requires the expected cost of these benefits be charged to expense during the years that employees render service. The effect of the adoption of SFAS 106 was immaterial. Oil and Gas The successful efforts method of accounting is followed for costs incurred in oil and gas exploration and development activities. Property acquisition costs for oil and gas properties are initially capitalized. When a property is determined to contain proven reserves, its property acquisition costs are transferred to proven properties and amortized using the units-of-production method. Exploration costs other than drilling, including geological and geophysical costs are expensed as incurred. Exploratory drilling costs are initially capitalized. If and when a property is determined to be nonproductive, property acquisition and exploratory drilling costs are expensed. Income (Loss) Per Share Income (loss) per share has been computed by dividing net income (loss), after the reduction for an insignificant amount of preferred stock dividends, by the 11,655,067 weighted average common shares outstanding during Fiscal 1992, Fiscal 1993 and Transition 1993. (2) Change in Fiscal Year The following sets forth unaudited condensed financial information for the ten months ended December 31, 1992, the comparable prior ten month period to Transition 1993 (in thousands, except per share amounts): (3) Discontinued Operations On July 22, 1993 SEPSCO's Board of Directors authorized the sale or liquidation of all of its operating businesses, consisting of its utility and municipal services, refrigeration and natural gas and oil businesses. Accordingly, SEPSCO has retroactively restated the accompanying consolidated financial statements for each of the periods shown to reflect all of such businesses as discontinued operations through July 22, 1993. The operating results of the discontinued operations subsequent to July 22, 1993 have been deferred and considered in the loss on disposal of discontinued operations and are included in "Net current liabilities of discontinued operations". In addition, on July 22, 1993 SEPSCO's Board of Directors authorized the sale or liquidation of the liquefied petroleum gas business. SEPSCO intends to transfer the liquefied petroleum gas business to a subsidiary of Triarc and the transfer would be accounted for at net book value. The precise nature of such transfer has not been determined and is expected to occur by July 22, 1994. Based on these facts SEPSCO has continued to reflect the liquefied petroleum gas business as a continuing operation. On December 9, 1993 SEPSCO's Board of Directors decided to sell the natural gas and oil business to Triarc following the Merger and the resulting elimination of the minority interest in SEPSCO (see Note 15) rather than selling such business to an independent third party. Such sale will be in the form of a sale of the stock of the entities comprising the natural gas and oil business for a net cash purchase price of $8,500,000, which Triarc and SEPSCO believe is equal to their fair value and which is approximately $4,000,000 higher than their net book value. On October 15, 1993 SEPSCO sold the assets of its tree maintenance services operations previously included in its utility and municipal services business segment for $69,600,000 in cash plus the assumption by the purchaser of $5,000,000 in current liabilities resulting in a loss of $4,571,000. On October 7, 1993 SEPSCO sold the stock of its two construction related operations previously included in its utility and municipal services business segment for a nominal amount subject to adjustments described below. As the related assets are sold or liquidated the purchasers have agreed to pay, as deferred purchase price, 75% of the net proceeds received therefrom (cash of $1,815,000 has been received as of December 31, 1993) plus, in the case of the larger of the two entities, an amount equal to 1.25 times the adjusted book value of such entity as of October 5, 1995 (the "Book Value Adjustment"). As of October 7, 1993, the adjusted book value of the assets of that entity aggregated approximately $1,600,000. In addition, SEPSCO paid $2,000,000 in October and November 1993 to cover the buyer's short-term operating losses and working capital requirements for the construction related operations. SEPSCO currently expects to break-even on the sales of the construction related operations, excluding any consideration of the potential Book Value Adjustment. On April 8, 1994 SEPSCO sold substantially all of the operating assets of the ice operations of its refrigeration business segment for $5,000,000 in cash, a $4,295,000 note (discounted value $3,327,000) and the assumption by the buyer of certain current liabilities of up to $1,000,000. The note, which bears no interest during the first year and 5% thereafter is payable in installments of $120,000 in 1995 through 1998 with the balance of $3,815,000 due 1999. The only remaining discontinued operations are the cold storage operation of the refrigeration business and the natural gas and oil business. The precise timetable for the sale and liquidation of the cold storage operations will depend upon SEPSCO's ability to identify appropriate potential purchasers and to negotiate acceptable terms for the sale of such operation. SEPSCO currently anticipates completion of such sales by July 22, 1994. In connection with the dispositions referred to above, SEPSCO reevaluated the estimated gain or loss from the sale of its discontinued operations and provided $13,910,000 for the revised estimated loss on the sale of the discontinued operations from an estimated break-even position as of August 31, 1993. The revised estimate principally reflects (i) approximately $4,600,000 of losses from the sales of the operations comprising the utility and municipal services business segment previously estimated to be approximately break-even, (ii) approximately $6,700,000 of losses from the sale of operations comprising SEPSCO's refrigeration business segment previously estimated to be a gain of $1,600,000, (iii) approximately $2,500,000 of estimated losses from operations from July 22, 1993 to the actual or estimated disposal of the discontinued operations and (iv) less previously estimated losses of $1,500,000 from the sale of SEPSCO's natural gas and oil business segment which will now be sold to Triarc and accounted for as a transfer between entities under common control at net book value. The net loss from the sale of the utility and municipal services business segment reflects a reduction of $1,800,000 in the estimated sales price for the construction related operations from previous estimates, a $2,000,000 reduction in anticipated proceeds from asset sales by July 22, 1994 and other adjustments in finalizing the loss on the sale of the tree maintenance services operations. The reduction in proceeds from asset sales result from the buyer of such business successfully negotiating extensions of certain major contracts with respect to the larger of such businesses and as a result no longer intending to immediately dispose of the major portion of the assets. Should the buyer hold such assets through October 5, 1995, the $2,000,000 reduction in proceeds would be effectively realized through the Book Value Adjustment. The $8,200,000 change relating to the sales of the refrigeration business segment principally results from (i) a $4,000,000 reduction in the sales price for the ice operations and (ii) a $4,000,000 reduction in the estimated sales price of the cold storage operations based on preliminary sales discussions and experience with respect to negotiating the sale of the other operations. SEPSCO expects that all remaining dispositions, including the results of their operations through the actual or anticipated disposal dates, will not in the aggregate result in any additional material loss to SEPSCO. The loss from discontinued operations consisted of the following (in thousands): PAGE Net current assets (liabilities) and non-current assets of discontinued operations consist of the following (for the purpose of the following tables, Natural Gas and Oil will be referred to as "NG&O" and Utility and Municipal Services and Refrigeration will be referred to as "Services and Refrig."): PAGE PAGE (4) Restricted Cash SEPSCO has an arrangement with a bank providing for the issuance of letters of credit for the purposes of securing certain performance and other bonds associated with the discontinued operations. These letters of credit are collateralized by cash deposited in restricted interest-bearing accounts not associated with the discontinued operations. (5) Change in Control As previously reported, a change in control of SEPSCO's parent, Triarc, occurred on April 23, 1993, which as a result of Triarc's ownership of SEPSCO's voting securities constituted a change in control of SEPSCO (the "Change in Control"). In connection with the Change in Control, the Board of Directors of SEPSCO was reconstituted and new senior executive officers were elected. In connection therewith, SEPSCO received from Triarc $27,115,000 in cash and $3,535,000 in the form of an offset of amounts due to Triarc as of April 23, 1993 in connection with the providing by Triarc of certain management services to SEPSCO. The aggregate $30,650,000 of payments by Triarc included full payment of $6,806,000 (including $306,000 of accrued interest) on an unsecured promissory note (the "Promissory Note") issued to SEPSCO by Triarc in connection with the 1988 sale of an investment and partial payment of $23,844,000 (including $1,430,000 of accrued interest) on a $48,952,000 promissory note (the "Note") due to SEPSCO. The remaining $26,538,000 principal balance of the Note is due on August 1, 1998. SEPSCO estimates that the carrying value of the Note at February 28, 1993 and December 31, 1993 approximates fair value based upon estimated market prices for a security with a comparable maturity, interest rate and security of principal. The Note resulted from the 1986 sale of approximately 51% of the outstanding common shares of Graniteville to Triarc and is secured by such shares. The Note is subordinated to senior indebtedness of Triarc to the extent, if any, that the payment of principal and interest thereon is not satisfied out of proceeds of the pledged Graniteville shares. SEPSCO used the $27,115,000 of cash proceeds to pay $12,689,000 due under its accounts receivable financing arrangement, which bore interest at the prime rate plus 1%, which was then terminated and to pay $14,426,000 (including $383,000 of accrued interest) owed to Chesapeake Insurance Company Limited ("Chesapeake Insurance"), a subsidiary of CFC Holdings. In connection with the collection of the Promissory Note, in Fiscal 1993 SEPSCO recognized a $6,000,000 gain on the sale of the common stock of an unaffiliated company to Triarc which had been previously deferred until collection of the Promissory Note was assured. As such note was collected in April 1993 prior to the issuance of the Fiscal 1993 consolidated financial statements, the $6,000,000 gain was recognized in Fiscal 1993. (6) Properties The following is a summary of properties, at cost: (7) Investment in Affiliates SEPSCO had a $1,500,000 investment in the preferred stock of Chesapeake Insurance and Graniteville had a $2,500,000 investment in such preferred stock. During its quarter ended September 30, 1993 Chesapeake Insurance increased its reserve for insurance and reinsurance losses by $10,000,000 and as a result reduced the stockholders' equity of Chesapeake Insurance to a minimal amount. Chesapeake Insurance ceased writing insurance or reinsurance of any kind for periods commencing on or after October 1, 1993. As a result Chesapeake Insurance will not have any future operating cash flows and its remaining liabilities, including payment of claims on insurance previously written, will be liquidated with assets on hand. Accordingly, the preferred stock investment is not recoverable and SEPSCO and Graniteville wrote off their investment in such stock since the decline in value was deemed to be other than temporary. This reduced equity in earnings of affiliates in Transition 1993 by $1,225,000 and $540,000 relating to Graniteville and CFC Holdings, respectively. Investments in affiliates consisted of the following: Equity in earnings of affiliates before income taxes on the ultimate distribution of earnings of affiliates of SEPSCO, cumulative effect of changes in accounting principles and extraordinary items consisted of the following: Graniteville Summary consolidated balance sheet information at February 28, 1993 and December 31, 1993 and summary consolidated income statement information for Fiscal 1992, Fiscal 1993 and Transition 1993 for Graniteville are as follows: In Fiscal 1993 Graniteville adopted SFAS 109 and SFAS 106 with the cumulative effect of changes in accounting principles resulting in charges to Graniteville's consolidated statement of earnings amounting to $12,314,000 for SFAS 109 and $722,000, net of Graniteville's taxes of $429,000 for SFAS 106. SEPSCO's equity, net of taxes of $434,000, in such cumulative effect, amounted to a charge of $5,954,000 or $.51 per share. Under its new credit facility, Graniteville is permitted to pay dividends or make loans or advances to its stockholders, including SEPSCO, in an amount equal to 50% of the net income of Graniteville accumulated from the beginning of the first fiscal year commencing on or after December 20, 1994, provided that the outstanding principal balance of Graniteville's term loan is less than $50,000,000 at the time of the payment (the outstanding principal balance was $72,500,000 as of December 31, 1993) and certain other conditions are met. Accordingly, Graniteville is unable to pay any dividends to or make any loans or advances to SEPSCO prior to December 31, 1995. Cash dividends received by SEPSCO from its investments in Graniteville under its previous credit facility were $1,038,000 and $3,004,000, in the years ended February 29, 1992 and February 28, 1993, respectively. CFC Holdings SEPSCO presently owns 5.4% of the outstanding common stock of CFC Holdings. The remaining 94.6% of such common stock is currently owned by Triarc. CFC Holdings owns 100% of RC/Arby's Corporation ("RCAC", formerly Royal Crown Corporation, the principal subsidiaries of which are Arby's, Inc. ("Arby's") and Royal Crown Company, Inc. ("Royal Crown", formerly Royal Crown Cola Co.) and Chesapeake Insurance). SEPSCO received its 5.4% in CFC Holdings in July 1991 in exchange for its then 5.4% interest in the common stock of RCAC which at that time owned 100% of Arby's, Royal Crown and Chesapeake Insurance. In connection with a capital restructuring in July 1991, all of the RCAC preferred stock which was owned by Triarc was converted into common stock of RCAC reducing SEPSCO's ownership percentage from its then 48% to 5.4%. The reduction in SEPSCO's ownership in connection with such restructuring resulted in SEPSCO reclassifying as of August 31, 1991, to "Additional paid-in capital", the cumulative equity in net losses of CFC Holdings amounting to $15,210,000 which was previously recorded in "Other liabilities". SEPSCO's equity in extraordinary items relates to CFC Holdings and consisted of a charge in Fiscal 1993 of $348,000 due to the early extinguishment of debt. (8) Income Taxes The benefit from (provision for) income taxes consisted of the following components: The difference between the reported tax benefit (provision) and a computed tax benefit (provision) at the Federal statutory rate (34% for Fiscal 1992, 34.2% for Fiscal 1993 and 35% for Transition 1993) is reconciled as follows: The current deferred tax assets and the non-current deferred tax assets (liabilities) consisted of the following components: The net change in the current deferred tax asset and non-current deferred tax liability from March 1, 1993 to December 31, 1993 of $5,307,000 is comprised of a deferred tax benefit from continuing operations of $1,195,000 and a deferred tax benefit from discontinued operations of $4,112,000. As of December 31, 1993 SEPSCO had net operating loss carryforwards for federal income tax reporting purposes of approximately $6,400,000. Such carryforwards will expire in the amount of approximately $2,200,000 in the year 2004 and approximately $4,200,000 in the year 2006. In addition SEPSCO has depletion carryforwards of $5,000,000 and alternative minimum tax credit carryforwards of approximately, $3,400,000 both of which have an unlimited carryforward period. Deferred income tax (provision) benefit results from timing differences in the recognition of income and expenses for tax and financial reporting purposes. The tax effect of the principal timing differences are as follows (such disclosure is not presented for Transition 1993 as it is not required under SFAS 109): Federal income tax returns of SEPSCO have been examined by the Internal Revenue Service ("IRS") for the tax years 1985 through 1988. Such audit has been substantially resolved at no material cost to SEPSCO. The IRS has recently commenced the examination of SEPSCO's Federal income tax returns for the tax years from 1989 through 1992. The amount and timing of any payments required as a result of the 1989 through 1992 audit cannot presently be determined. However, SEPSCO believes that it has adequate aggregate reserves for any tax liabilities, including interest, that may result from all such examinations. (9) Long-term Debt Long-term debt consists of the following (in thousands): Aggregate annual maturities, including required sinking fund payments, of long-term debt are as follows as of December 31, 1993 (in thousands): SEPSCO is required to retire annually, through a mandatory sinking fund, $9,000,000 principal amount of the Debentures through 1997 with a final payment of $27,000,000 due in 1998. On February 1, 1993 SEPSCO satisfied its mandatory sinking fund requirement due on such date by payment of $8,734,000 in cash and $266,000 of principal amount of the Debentures. The amortization of the discount on the Debentures purchased is reported as a separate line item in the accompanying consolidated statements of operations. Under provisions of the indenture (the "Indenture") pursuant to which the Debentures were issued, SEPSCO is not permitted to pay cash dividends and acquire shares of SEPSCO's capital stock as of December 31, 1993. The fair value of the Debentures was approximately $4,700,000 and $5,500,000 higher than the carrying values at February 28, 1993 and December 31, 1993, respectively, based on quoted market prices. The indenture contains a provision which limits to $100,000,000 the aggregate amount of specified kinds of indebtedness that SEPSCO and its consolidated subsidiaries can incur. At December 31, 1993 such indebtedness was $59,321,000 resulting in allowable indebtedness of $40,679,000. (10) Stockholders' Equity At December 31, 1993 71.1% of SEPSCO's outstanding common stock, $1.00 par value per share, (the "SEPSCO Common Stock") and all of the convertible preferred stock, Series B, was owned by Triarc. On April 14, 1994, Triarc increased its ownership of SEPSCO's Common Stock to 100% (see Note 15). The convertible preferred stock bears a dividend of 5 1/2% and is convertible into 8,167 shares of common stock at a rate of $3.00 per share. Included in "Retained earnings (deficit)" at February 28, 1993 and December 31, 1993 are $3,309,000 and $7,696,000 of net undistributed earnings of unconsolidated affiliates, respectively. (11) Lease Commitments SEPSCO leases certain machinery, automotive and other equipment primarily from an indirect, wholly-owned subsidiary of Triarc under long-term lease obligations which are accounted for as capital leases in the accompanying consolidated balance sheets. The cost of properties under capital leases amounted to $1,264,000 and $1,029,000 at February 28, 1993 and December 31, 1993, respectively, and the cost of properties under capital leases of discontinued operations (included in "Net non-current assets of discontinued operations") amounted to $54,698,000 and $1,246,000, respectively. The decrease in the cost of properties under capital leases of discontinued operations is the result of the sale of certain businesses (see Note 3). The future minimum lease payments (net of sublease rentals which are not significant) under capital leases and operating leases with an initial noncancelable term in excess of one year are as follows as of December 31, 1993: Rental expense under operating leases, which is primarily for the rental of office space, was $2,330,000 in Fiscal 1992, $2,012,000 in Fiscal 1993 and $1,470,000 in Transition 1993, of which $537,000, $485,000 and $370,000 related to continuing operations and $1,793,000, $1,527,000 and $1,100,000 related to discontinued operations. (12) Retirement and Incentive Compensation Plans Substantially all of the employees of the continuing and discontinued businesses are covered under SEPSCO's 401(k) defined contribution plan or one of the multi-employer union plans to which SEPSCO contributes. The defined contribution plan allows eligible employees to contribute up to 15% of their total earnings, subject to certain limitations. SEPSCO makes a matching contribution for eligible employees of 25% of the employee's contributions but limited to the first 5% of an employee's compensation and an additional contribution equal to 1/4 of 1% of such employee's total earnings. Total contributions were $368,000 in Fiscal 1992, and $394,000 in Fiscal 1993 and $133,000 in Transition 1993. SEPSCO had several defined benefit pension plans, all of which were frozen prior to February 28, 1990. SEPSCO's applications with the Pension Benefit Guaranty Corporation and the Internal Revenue Service for the termination and distribution of surplus pension assets of SEPSCO's defined benefit pension plans were approved during Fiscal 1992. After the purchase of annuities for plan participants, SEPSCO received the net surplus pension assets of $3,226,000 in Fiscal 1992 and $206,000 in Fiscal 1993. Substantially all of the gain on such reversions had previously been reflected through February 28, 1992 in accordance with SFAS 87, including $863,000 in Fiscal 1992. During Fiscal 1993 all remaining prepaid and accrued pension costs existing as of February 28, 1992 were eliminated resulting in a termination gain of $431,000. The components of the Fiscal 1992 net periodic pension benefits are as follows (in thousands): An assumed discount rate of 7.0% in Fiscal 1992 and an expected long- term rate on assets of 9%, were used in developing this data. Plan assets were invested in a managed portfolio consisting primarily of money market investments, corporate bonds and common stock of unaffiliated issuers. Under certain union contracts, SEPSCO is required to make payments to the union pension funds based upon hours worked by the eligible employees. Payments to the funds amounted to $819,000 in Fiscal 1992, $784,000 in Fiscal 1993 and $536,000 in Transition 1993. Information from the plan administrators of the funds is not available to permit SEPSCO to determine its share of unfunded vested benefits, if any. During Transition 1993 Triarc granted stock options to certain key employees of SEPSCO under Triarc's Amended and Restated 1993 Equity Participation Plan. Of such options 10,000 were granted at an option price of $20.00 that was lower than the fair market value of Triarc's Class A Common Stock at the date of grant of $31.75. The aggregate difference of $118,000 between the option price and the fair market value at the date of grant is being amortized to compensation expense over the applicable vesting period through 1998. Compensation expense resulting from the grants was $8,000 during Transition 1993 and is included in "Selling, general and administrative expenses" in the accompanying consolidated statement of operations. (13) Transactions with Affiliates In Fiscal 1993, SEPSCO increased its borrowings from Chesapeake Insurance by $8,400,000 to $14,043,000. The additional borrowings were used to provide the necessary funds to meet SEPSCO's mandatory sinking fund requirements due February 1, 1993. The loans from Chesapeake Insurance were payable on demand and bore interest at an annual rate of 11 7/8%. In addition such loans were secured by a pledge of approximately 100% of the stock of SEPSCO's Public Gas subsidiary. On April 23 1993 SEPSCO paid in full such loans amounting to $14,426,000 including $383,000 of accrued interest to Chesapeake Insurance (see Note 5). In Fiscal 1992 SEPSCO purchased 15,000 convertible redeemable preferred shares of Chesapeake Insurance for $1,500,000 (see Note 7). Prior to the Change in Control, SEPSCO received from Triarc certain management services including legal, accounting, tax, insurance, financial and other management services. The portion of these costs allocated to SEPSCO under a management services agreement (the "Former Management Services Agreement") was $2,063,000 in Fiscal 1992, $2,033,000 in Fiscal 1993 and $557,000 in Transition 1993 (of which $268,000, $264,000 and $92,000, respectively, was allocated to continuing operations and $1,795,000, $1,769,000 and $465,000, respectively, was allocated to discontinued operations). Such costs were allocated to SEPSCO by Triarc based first directly on the cost of the service provided and then, for those costs which could not be directly allocated, based upon the relative revenues and tangible assets of the affiliated companies. Management of SEPSCO believes the cost of such services would have been higher if SEPSCO had operated as an entity unaffiliated with Triarc. Effective April 23, 1993, SEPSCO entered into a new management services agreement (the "New Management Services Agreement") with Triarc which revised the allocation method of these costs which can not be directly allocated. As revised, such costs are allocated based upon the relative sum of the greater of earnings before income taxes, depreciation and amortization and 10% of revenues. The portion of these costs allocated to SEPSCO under the New Management Services Agreement was $2,699,000 in Transition 1993 (of which $447,000 was allocated to continuing operations and $2,252,000 was allocated to discontinued operations). Management of SEPSCO believes that such allocation method approximates the costs that would have been incurred if SEPSCO had operated as an entity unaffiliated with Triarc. Additionally, SEPSCO was allocated certain uncollectible amounts owed to Triarc for similar management services to certain former affiliates of SEPSCO amounting to $849,000 in Fiscal 1992, $1,781,000 in Fiscal 1993 and $150,000 in Transition 1993 (of which $110,000, $232,000 and $25,000, respectively, was allocated to continuing operations and $739,000, $1,549,000 and $125,000, respectively, was allocated to discontinued operations). These amounts were allocated principally on the same basis as the costs of the management services, an allocation method the management of SEPSCO believes is reasonable. Such costs to SEPSCO would have been lower if SEPSCO had operated as an unaffiliated entity of Triarc to the extent the cost of such services would not have been incurred had services not been provided to the entities unable to pay. Such amounts are included in "Selling, general and administrative expenses" and "Loss from discontinued operations, net of income taxes" in the accompanying consolidated statements of operations. Until January 31, 1994 SEPSCO, through Triarc, leased office space from a trust for the benefit of Victor Posner and his children (the "Posner Lease"). Rent allocated by Triarc to SEPSCO amounted to $1,467,000 in Fiscal 1992, $1,055,000 in Fiscal 1993 and $163,000 (which is net of a credit relating to prior years resulting from the decrease in rent noted below) in Transition 1993 (of which $191,000, $137,000 and $27,000, respectively, was allocated to continuing operations and $1,276,000, $918,000 and $136,000, respectively, was allocated to discontinued operations). The Posner Lease, which would have expired in 1993, was renewed by Triarc and in accordance therewith in January 1993 rental expense was reduced by approximately 50%. Such amounts are included in "Selling, general and administrative expenses" and "Income (loss) from discontinued operations, net of income taxes" in the accompanying consolidated statements of operations. During Transition 1993, SEPSCO also recorded a provision of $2,840,000 (of which $471,000 was allocated to continuing operations and $2,369,000 was allocated to discontinued operations) for its share of the remaining payments on the Posner Lease due to its cancellation effective January 31, 1994. Such amounts are included in "Selling, general and administrative expenses" and "Income (loss) from discontinued operations, net of income taxes" in the accompanying consolidated statements of operations. During Fiscal 1992, Fiscal 1993 and Transition 1993 until April 23, 1993, the rent was allocated based on direct square footage utilized and the relative net revenues and tangible assets of SEPSCO. Effective with the Change in Control the rent allocation method was changed and is now based solely on direct square footage utilized and the relative net revenues of SEPSCO, a method management of SEPSCO believes is reasonable. Had SEPSCO not occupied space under Triarc's long-term lease obligation or been allocated rent for indirect usage, given the competitive rental market during the relevant periods, management of SEPSCO believes that its rent costs on a stand alone basis would have been substantially lower through December 31, 1992. In addition, SEPSCO incurred interest expense at 18% on unpaid balances due to Triarc for management services and rent under the Former Management Services Agreement of $737,000 in Fiscal 1992, $652,000 in Fiscal 1993 and $(68,000) (which is net of a credit relating to prior years) in Transition 1993 (of which $96,000, $85,000 and $(11,000), respectively, was allocated to continuing operations and $641,000, $567,000 and $(57,000), respectively, was allocated to discontinued operations). Chesapeake Insurance provided certain insurance and reinsurance of certain risks to SEPSCO until October 1993 at which time Chesapeake Insurance ceased writing all insurance and reinsurance. The net premium expense incurred was $9,416,000 in Fiscal 1992, $10,688,000 in Fiscal 1993 and $9,791,000 in Transition 1993 (of which $997,000, $1,064,000 and $969,000 respectively, was allocated to continuing operations and $8,419,000, $9,624,000 and $8,822,000, respectively, was allocated to discontinued operations). In addition, Insurance and Risk Management, Inc., an affiliated company until April 23, 1993, acted as agent or broker in connection with insurance coverage obtained by SEPSCO and also provided claims processing services. The commissions and payments incurred for such services were $528,000 in Fiscal 1992, $488,000 in Fiscal 1993 and $50,000 in Transition 1993 (of which $56,000, $49,000 and $8,000, respectively, was allocated to continuing operations and $472,000, $439,000 and $42,000, respectively, was allocated to discontinued operations). SEPSCO's machinery and automotive equipment under capital lease for the continuing and discontinued operations are leased from an indirect, wholly- owned subsidiary of Triarc. Interest charges on these lease obligations amounted to $3,629,000 in Fiscal 1992, $3,156,000 in Fiscal 1993 and $1,885,000 in Transition 1993 (of which $76,000, $72,000 and $56,000, respectively, was allocated to continuing operations and $3,553,000, $3,084,000 and $1,829,000, respectively, was allocated to discontinued operations). (14) Significant Transition 1993 Charges The accompanying condensed consolidated statements of operations include the following significant charges recorded in Transition 1993 (in thousands): (1) $782,000 included in "Selling, general and administrative expenses" of continuing operations and $3,932,000 included in "Loss from discontinued operations." (2) $104,000 included in "Selling, general and administrative expenses" of continuing operations and $521,000 included in "Loss from discontinued operations." (3) $(301,000) included in "Benefit from income taxes" of continuing operations and $(4,222,000) included in "Loss from discontinued operations." (4) Included in "Loss from discontinued operations." (5) $100,000 included in "Benefit from income taxes" of continuing operations and $500,000 included in "Loss from discontinued operations." (a) During Transition 1993 results of operations were significantly impacted by facilities relocation and corporate restructuring charges aggregating $4,714,000 consisting of $4,214,000 of charges allocated to SEPSCO by Triarc: (i) estimated allocated cost of $2,840,000 to terminate the lease on Triarc's existing corporate facilities; (ii) total allocated costs of $1,374,000 relating to a five-year consulting agreement (the "Consulting Agreement") extending through April 1998 between Triarc and Steven Posner, the former Vice Chairman of Triarc and $500,000 of estimated direct costs to be incurred by SEPSCO to relocate SEPSCO's corporate office. All of such charges are related to the Change in Control described in Note 5. In connection with the Change in Control, Victor Posner and Steven Posner resigned as officers and directors of Triarc. In order to induce Steven Posner to resign, Triarc entered into the Consulting Agreement with him. The allocated cost related to the Consulting Agreement was recorded as a charge in Transition 1993 because the Consulting Agreement does not require any substantial services and SEPSCO and Triarc do not expect to receive any services that will have substantial value to them. As a part the Change in Control, the Triarc Board of Directors was reconstituted. The first meeting of the reconstituted Triarc Board of Directors was held on April 24, 1993. At that meeting, based on a report and recommendations from a management consulting firm that had conducted an extensive review of Triarc and its subsidiaries operations and management structure, the Triarc Board of Directors approved a plan of decentralization and restructuring which entailed, among other things, the following features: (i) the strategic decision to manage Triarc in the future on a decentralized rather than on a centralized basis; (ii) the hiring of new executive officers for Triarc; (iii) the termination of a significant number of employees as a result of both the new management philosophy and the hiring of an almost entirely new management team and (iv) the relocation of Triarc and certain subsidiaries, including SEPSCO's corporate headquarters. SEPSCO's allocated cost to terminate the lease on Triarc's existing corporate facilities ($2,840,000) and the cost to relocate SEPSCO's headquarters ($500,000) all stemmed from the decentralization and restructuring plan formally adopted at the April 24, 1993 meeting of the reconstituted Triarc Board of Directors and accordingly, were recorded in Transition 1993. (b) In accordance with certain court proceedings and related settlements, five directors, including three court-appointed directors, were appointed in 1991 to serve on a special committee (the "Special Committee") of Triarc's Board of Directors. Such committee was empowered to review and pass on transactions between Triarc and Victor Posner, the then largest shareholder of Triarc, and his affiliates. SEPSCO has been charged $625,000 as an allocation of the cash portion of a success fee payable to the Special Committee attributable to the closing of the Triarc reorganization and the resulting Change in Control. (c) Represents write-downs in the carrying value of certain unprofitable properties reflecting their estimated impairment as a result of management's re-valuation of such assets. (d) SEPSCO's equity in significant charges recorded in Transition 1993, which consisted of both direct charges and charges allocated by Triarc to Graniteville and CFC Holdings is summarized as follows (in thousands): (15) Legal Matters In December 1990, a purported shareholder derivative suit (the "Ehrman Litigation") was brought against SEPSCO's directors at that time and certain corporations, including Triarc, in the United States District Court for the Southern District of Florida(the "District Court"). On October 18, 1993, Triarc entered into a settlement agreement (the "Settlement Agreement") with the plaintiff (the "Plaintiff") in the Ehrman Litigation. The Settlement Agreement provides, among other things, that SEPSCO would be merged into, or otherwise acquired by, Triarc or an affiliate thereof, in a transaction in which each holder of SEPSCO's common stock other than Triarc will receive in exchange for each share of SEPSCO's common stock, 0.8 shares of Triarc's common stock. On November 22, 1993 Triarc and SEPSCO entered into a merger agreement which provided for a subsidiary of Triarc to be merged into SEPSCO in the manner described in the Settlement Agreement(the "Merger"). On January 11, 1994 the District Court approved the Settlement Agreement, and the Merger was approved on April 14, 1994 by SEPSCO's stockholders other than Triarc. As a result of the Merger, Triarc owns 100% of SEPSCO's Common Stock. The Settlement Agreement also provides that Plaintiff's counsel and financial advisor will be paid by Triarc, subject to court approval, cash not to exceed $1,250,000 and $50,000, respectively and that Triarc would be responsible for other expenses relating to the issuance of Triarc common shares pursuant to the Merger. SEPSCO had previously accrued such $1,300,000 in the fourth quarter of Fiscal 1993 and accrued additional expenses related to the settlement of the Ehrman Litigation of $400,000 and $1,200,000 in the first and second quarters of Transition 1993, respectively, since SEPSCO originally anticipated it would be responsible for such fees and expenses. However, as previously indicated, the Settlement Agreement established that Triarc and not SEPSCO was responsible for certain of these expenditures and, accordingly, SEPSCO reversed $1,900,000 of previously accrued expenses in the third quarter of Transition 1993 which is included in "Other, net" in the consolidated statement of operations. The Merger will be accounted for by Triarc in accordance with the purchase method of accounting. Accordingly, Triarc's additional 28.87% interest in SEPSCO's assets and liabilities will be recorded at their fair values and Triarc's minority interest in SEPSCO will be eliminated. This excess of purchase price over the fair value of the additional interest in the net assets acquired will be amortized on a straight-line basis over 30 years. Triarc has not yet performed a final evaluation of purchase accounting, and accordingly, cannot presently determine the amount of costs in excess of net assets of acquired companies ("Goodwill") that will result from the Triarc Merger. However, assuming that the fair value of the additional interest acquired approximates its book value and based on the market price per share of Triarc's Class A Common Stock on April 14, 1994, Goodwill would increase by approximately $25,000,000 which Triarc will push down to SEPSCO. Such increase in goodwill is net of the portion of the merger consideration which represents the settlement of the Ehrman Litigation (see above). Pro forma unaudited condensed summary operating results of SEPSCO for Transition 1993 giving effect to the Merger as if it had been consummated on March 1, 1993, are as follows (in thousands except per share amount): SEPSCO and its subsidiaries are defendants in certain other legal proceedings arising out of the conduct of SEPSCO's business. In the opinion of management and counsel, the ultimate outcome of these legal proceedings will not have material adverse effect on the consolidated financial position or results of operations of SEPSCO. As a result of certain environmental audits, SEPSCO became aware of possible contamination by hydrocarbons and metals at certain sites of SEPSCO's refrigeration operations and has filed appropriate notifications with state environmental authorities and began a study of remediation at such sites. SEPSCO has removed certain underground storage and other tanks at certain facilities of its refrigeration operations and has engaged in certain remediation in connection therewith. Such removal and environmental remediation involved a variety of remediation actions at various facilities of SEPSCO located in a number of jurisdictions. Such remediation varied from site to site, ranging from testing of soil and groundwater for contamination, development of remediation plans and removal, in certain instances, of certain contaminated soils. Based on preliminary information and consultations with, and certain reports of, environmental consultants and others, SEPSCO presently estimates their cost of such remediation and/or removal described above will approximate $3,661,000 of which $1,300,000 was provided in Fiscal 1991, $200,000 in Fiscal 1992 and $2,161,000 in Fiscal 1993 included in "Other, net" in the results of discontinued operations. In connection therewith SEPSCO has incurred actual costs of $1,224,000 through December 31, 1993 and has a remaining accrual of $2,437,000 included in "Net non-current assets of discontinued operations" in the balance sheet above as of December 31, 1993. SEPSCO believes that its current reserves for remediation costs are adequate. (16) Quarterly Information (Unaudited) - ------------ (a) Quarterly information has been retroactively restated to reflect the discontinuance of utility and municipal services, refrigeration and natural gas and oil operations in Transition 1993. (b) Includes a gain from sale of marketable security of $6,000,000 and a $1,300,000 provision for the settlement of certain litigation. (c) Includes a provision for anticipated losses on construction contracts in progress of $1,608,000 and other fourth quarter adjustments of $820,000 related to net realizable value of oil and gas properties and plugging and abandonment of wells. Includes a $375,000 provision for settlements of certain litigation and a $2,100,000 provision for environmental costs. (d) For discussion see Note 3 - Discontinued Operations. (e) For discussion see Note 1 - Summary of Significant Accounting Policies. (f) For discussion see Note 7 - Investment in Affiliates. Item 9. Item 9. Change in and Disagreements with Accountants on Accounting and Financial Disclosure. Not Applicable. PART III The information required by Part III of this Form 10-K is incorporated herein by reference from SEPSCO's Proxy. 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 (Item 8) 2. Financial Statement Schedules: II. Amounts Receivable From Related Parties -- Two Years Ended February 28, 1993 and Ten Months Ended December 31, 1993 IX. Short-term Borrowings -- Two Years Ended February 28, 1993 and Ten Months Ended December 31, 1993 X. Supplementary Income Statement Information -- Two Years Ended February 28, 1993 and Ten Months Ended December 31, 1993 All other schedules are omitted because they are not applicable or the required information in the Consolidated Financial Statements or notes thereto. 3. Exhibits: Copies of the following exhibits are available at a charge of $.25 per page upon written request to the Secretary of the Company at 777 South Flagler Drive, Suite 1000E, West Palm Beach, Florida 33401. 2.1 Agreement and Plan of Merger dated as of November 22, 1993 among Southeastern Public Service Company ("SEPSCO"), Triarc Companies, Inc. ("Triarc") and SEPSCO Merger Corporation, incorporated herein by reference to Exhibit 2.1 to SEPSCO's Definitive Proxy Statement (the "SEPSCO Proxy"), filed pursuant to Regulation 14A on March 11, 1994 (SEC file #1-4351). 3.1 Certificate of Incorporation of SEPSCO, incorporated herein by reference to Exhibit 3.1 to SEPSCO's Annual Report on Form 10-K for the fiscal year ended February 28, 1981 (SEC file #1-4351). 3.2 Certificate of Amendment dated September 24, 1984 to the Certificate of Incorporation of SEPSCO, incorporated herein by reference to Exhibit 3.2 to SEPSCO's Annual Report on Form 10-K for the fiscal year ended February 28, 1985 (SEC file #1-4351). 3.3 By-Laws of SEPSCO, incorporated herein by reference Exhibit 3.2 to SEPSCO's Annual Report on Form 10-K for the fiscal year ended February 28, 1981 (SEC file #1-4351). 4.1 SEPSCO Indenture dated as of February 1, 1983, incorporated herein by reference to Exhibit 4(a) to SEPSCO's Registration Statement on Form S-2 dated January 18, 1983 (SEC file #2-81393). 10.1 Memorandum of Understanding dated as of September 13, 1993 between Triarc and William Ehrman, individually and derivatively on behalf of SEPSCO, incorporated herein by reference to Exhibit 10.1 to Triarc's Current Report on Form 8-K dated September 13, 1993 (SEC file #1-2207). 10.2 Stipulation of Settlement of the Ehrman Litigation dated as of October 18, 1993, incorporated herein by reference to Exhibit 1 to Triarc's Current Report on Form 8-K dated October 15, 1993 (SEC file #1-2207). 10.3 Form of Former Management Services Agreement between Triarc and certain other corporations, including SEPSCO, incorporated herein by reference to Exhibit 10.10 to Triarc's Annual Report on Form 10- K for the fiscal year ended April 30, 1993 (SEC file #1-2207). 10.4 Form of New Management Services Agreement between Triarc and certain of its subsidiaries, including SEPSCO, incorporated herein by reference to Exhibit 10.10 to Triarc's Annual Report on Form 10- K for the fiscal year ended April 30, 1993 (SEC file #1-2207). 21.1 Subsidiaries of the Registrant* ____________ *being filed herewith (B) Reports on Form 8-K: During December 1993, the registrant filed reports on Form 8-K on the following dates with respect to the following matters: Date Subject Matter ---- -------------- December 22, 1993 Completion of the sale of SEPSCO's utility and municipal services business segment and reevaluation by SEPSCO of its estimated gain or loss from the role of its discontinued operations. (D) Financial Statements: Consolidated financial statements of Graniteville Company for each of the two years in the period ended February 28, 1993 and the ten month period from March 1, 1993 to January 2, 1994. Financial statements, financial statement schedules and report of independent certified public accountants with respect to Graniteville Company are included immediately following Exhibit 21.1. 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. SOUTHEASTERN PUBLIC SERVICE COMPANY (Registrant) NELSON PELTZ By:--------------------------------- Nelson Peltz Dated: April 15, 1994 Chairman and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below on the 15th day of April, 1994 by the following persons on behalf of the registrant in the capacities indicated. Signature Titles --------- ------ NELSON PELTZ Chairman and Chief Executive - --------------------------- Officer, and Director (Nelson Peltz) (Principal Executive Officer) PETER W. MAY President and Chief Operating - --------------------------- Officer, and Director (Peter W. May) (Principal Operating Officer) LEON KALVARIA Vice Chairman and Director - --------------------------- (Leon Kalvaria) JOSEPH A. LEVATO Executive Vice President and - -----------------------------Chief Financial Officer (Joseph A. Levato) (Principal Financial Officer) FRED H.SCHAEFER Vice President and Chief - ----------------------------- Accounting Officer (Fred H. Schaefer) (Principal Accounting Officer) PAGE PAGE PAGE PAGE Exhibit 21.1 SOUTHEASTERN PUBLIC SERVICE COMPANY AND SUBSIDIARIES Subsidiaries of the Registrant April 15, 1994 The subsidiaries of Southeastern Public Service Company, their respective states or jurisdictions of organization and the names under which such subsidiaries do business are as follows: State or Jurisdiction Under which Organized --------------------- Crystal Ice & Cold Storage, Inc. Delaware Houston Oil & Gas Company, Inc. Delaware Northwestern Ice & Cold Storage Company Oregon Public Gas Company (formerly Southeastern Propane Gas Company) Florida Royal Palm Ice Company Florida SEPSCO Merger Corporation Delaware Southeastern Gas Company Delaware Geotec Engineers, Inc. West Virginia Western Refrigeration & Cold Storage Company California PAGE GRANITEVILLE COMPANY AND SUBSIDIARIES CONSOLIDATED FINANCIAL STATEMENTS JANUARY 2, 1994 TOGETHER WITH REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS PAGE REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS To the Board of Directors and Stockholders, Graniteville Company: We have audited the accompanying consolidated balance sheets of Graniteville Company (a South Carolina corporation and 49% owned by Southeastern Public Service Company and 51% owned by Triarc Companies, Inc., formerly DWG Corporation) and Subsidiaries as of January 2, 1994 and February 28, 1993, and the related consolidated statements of income and retained earnings and cash flows for the ten month period ended January 2, 1994 and for each of the two years in the period ended February 28, 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 Graniteville Company and Subsidiaries as of January 2, 1994 and February 28, 1993, and the results of their operations and their cash flows for the ten month period ended January 2, 1994 and for each of the two years in the period ended February 28, 1993, in conformity with generally accepted accounting principles. As discussed in Note 4 to the consolidated financial statements, the Company changed its method of accounting for income taxes and postretirement benefits other than pensions effective March 2, 1992. Our audits were made for the purpose of forming an opinion on the basic consolidated financial statements taken as a whole. The schedules V, VI, VIII and IX for the ten month period ended January 2, 1994, and for each of the two years in the period ended February 28, 1993 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. Columbia, South Carolina February 25, 1994. (Except with respect to the matter discussed in Note 7, as to which the date is March 10, 1994). See accompanying notes to consolidated financial statements. See accompanying notes to consolidated financial statements. PAGE See accompanying notes to consolidated financial statements. PAGE GRANITEVILLE COMPANY AND SUBSIDIARIES Notes to Consolidated Financial Statements January 2, 1994 (1) Summary of Significant Accounting Policies Basis of Presentation Graniteville Company ("the Company") is a 51% owned subsidiary of Triarc Companies, Inc. (formerly DWG Corporation and referred to herein as "Triarc" and, collectively with its subsidiaries, "Triarc Companies") and 49% owned by Southeastern Public Service Company ("SEPSCO"). At January 2, 1994, SEPSCO was 71% owned by Triarc. Principles of Consolidation The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries, C. H. Patrick & Co., Inc. ("C. H. Patrick") and Graniteville International Sales, Inc. ("Graniteville International"), an inactive corporation. All significant intercompany balances and transactions have been eliminated in consolidation. Fiscal Year/Change in Fiscal Year On October 27, 1993, the Board of Directors of Triarc approved a change in Triarc's fiscal year from a fiscal year ending April 30 to a calendar year ending December 31 effective for the transition period ending December 31, 1993. The fiscal years of all of Triarc's subsidiaries which did not end on December 31 were also so changed. Accordingly, the Company has adopted a 52-53 week period ending on the Sunday nearest the last day of December. As used herein, "Transition 1993" refers to the ten month period (44 weeks) ended January 2, 1994, "Fiscal 1993" refers to the year (52 weeks) ended February 28, 1993 and "Fiscal 1992" refers to the year (52 weeks) ended March 1, 1992. Inventories The Company's inventories, consisting of materials, labor and overhead, are valued at the lower of cost or market. Cost for substantially all inventories is determined on the last-in, first-out ("LIFO") basis. Depreciation Depreciation is computed principally on the straight-line basis using the estimated useful lives of the related major classes of properties: 3 to 6 years for automotive and transportation equipment; 12 to 14 years for machinery and equipment; and 15 to 60 years for buildings and improvements. Gains and losses arising from disposals are included in current operations. Amortization of Deferred Financing Costs Deferred financing costs are being amortized as interest expense over the life of the respective debt using the interest rate method. Unamortized deferred financing costs are included in "Other assets" in the accompanying consolidated balance sheets. Research and Development Research and development costs are expensed during the year in which the costs are incurred and amounted to $691,000 in Fiscal 1992, $744,000 in Fiscal 1993, and $640,000 in Transition 1993. Income Taxes The Company files a consolidated Federal income tax return with its wholly-owned subsidiaries. The Company recognizes deferred tax liabilities and assets for the expected future tax consequences of temporary differences between the carrying amounts and the tax basis of assets and liabilities. Revenue Recognition The Company records revenues principally when inventory is shipped. The Company also records revenues to a lesser extent on a bill and hold basis under which the goods are complete, packaged and ready for shipment; such goods are effectively segregated from inventory which is available for sale; the risks of ownership of the goods have passed to the customer; and such underlying customer orders are supported by written confirmation. Concentration of Credit Risk Financial instruments which potentially subject the Company to concentration of credit risk consist primarily of trade accounts receivable. The Company's customers consist of domestic and foreign apparel producers and other users of textile products. The Company performs ongoing credit evaluations of its customers' financial condition and establishes an allowance for doubtful accounts based upon factors surrounding the credit risk of specific customers, historical trends and other information. In addition, the Company factors, on a non-recourse basis, a significant volume of accounts receivable, thereby reducing its exposure to credit risk. Historically, the Company has not incurred material credit-related losses. Major Customer Sales to a group of customers under common control totaled approximately 11%, 14%, and 11%, of the Company's sales in Fiscal 1992, Fiscal 1993, and Transition 1993, respectively. No other customer or similar group accounted for more than 10% of the Company's sales in such periods. Reclassifications Certain amounts included in the prior years' consolidated financial statements have been reclassified to conform with the current year's presentation. (2) Change in Control and the Triarc Reorganization On April 23, 1993, DWG Acquisition Group, LP ("DWG Acquisition"), a newly formed limited partnership controlled by Nelson Peltz and Peter W. May, acquired control of Triarc from Victor Posner, the former Chairman and Chief Executive Officer of Triarc, and certain entities controlled by him (collectively, "Posner") through a series of related transactions (the "Reorganization"). Immediately prior to the Reorganization, Posner owned approximately 46% of the outstanding common stock of Triarc. The principal elements comprising the equity portion of the Reorganization included the following components: DWG Acquisition purchased from Posner 5,982,867 shares of Triarc's Class A common stock, par value $.10 per share (the "Triarc Class A Common Stock"), representing approximately 28.6% of Triarc's common equity outstanding immediately after the Reorganization, for $12.00 per share, or an aggregate purchase price of $71,794,000. All of the remaining shares of the Class A Common Stock owned by Posner were exchanged for shares of newly-created, non-voting, convertible redeemable preferred stock of Triarc. Victor Posner and his son, Steven Posner, the former Vice Chairman of Triarc Companies, resigned as directors, officers and employees of Triarc Companies and all of its subsidiaries. In connection with such resignations, Victor Posner did not receive any severance payments. However, in order to induce Steven Posner to resign, Triarc entered into a five year consulting agreement (the "Consulting Agreement") with Steven Posner which provides for an initial payment of $1,000,000 at the commencement of the term of such agreement and an annual consulting fee of $1,000,000. The Consulting Agreement does not require Steven Posner to provide any substantial services to Triarc and Triarc presently does not expect that it will receive any such services from him. As a result, the $6,000,000 aggregate amount of payments required under the Consulting Agreement was expensed in Triarc's fiscal year ended April 30, 1993, of which $229,000 has been allocated to the Company and is included in "Facilities Relocation and Corporate Restructuring Charges" (see Note 14). Affiliates of Donaldson, Lufkin & Jenrette Securities Corporation ("DLJ") and of Merrill Lynch & Co. ("Merrill Lynch" and together with DLJ, the "DLJ/Merrill Lynch Investors") purchased from Triarc an aggregate of 833,332 newly issued shares of Triarc Class A Common Stock, representing approximately 4.0% of the Triarc Class A Common Stock outstanding immediately after the Reorganization, for $12.00 per share, the same price at which DWG Acquisition purchased its Triarc Class A Common Stock. The aggregate price approximated $10,000,000 (the "Equity Financing"). Concurrently with the consummation of the Reorganization (the "Closing"), certain debt of Triarc and its subsidiaries, including the Company, was refinanced in order to reduce borrowing costs and to make available additional funds for general working capital and liquidity purposes. The principal refinancing transactions consummated in connection with the Reorganization included the establishment of a new $180,000,000 credit facility for Graniteville (the "Graniteville Credit Facility") providing for $80,000,000 of term loans and $100,000,000 of revolving credit loans (see Note 7). The following table summarizes the intended aggregate sources and uses of funds by the Company in connection with the Triarc Reorganization (in thousands): The advance to Triarc is evidenced by a note receivable which bears interest at the rate of 9.5% per annum and is due on April 15, 2003. Interest only is payable semi-annually either in cash or by the issuance of additional notes identical to the original note, at the option of Triarc. However, at least 20% of each interest payment due through and including April 15, 1995 must be in cash and at least 40% of each interest payment thereafter must be in cash. As of January 2, 1994, the note receivable from Triarc consists of the following (in thousands): (3) Inventories The following is a summary of the major classifications of inventories: Had the first-in, first-out method been used, inventories would have been approximately $2,500,000 higher at February 28, 1993 and January 2, 1994. (4) Changes in Accounting Principles Effective March 2, 1992, the Company adopted Statement of Financial Accounting Standards ("SFAS") No. 109, "Accounting for Income Taxes" ("SFAS 109") and SFAS No. 106, "Accounting for Postretirement Benefits Other than Pensions" ("SFAS 106"). The Company's adoption of such standards resulted in a charge of $13,036,000 to the Company's results of operations for Fiscal 1993. Such charge consisted of $12,314,000 and $722,000, net of applicable income taxes of $429,000, related to SFAS 109 and SFAS 106, respectively, and is reported in the "Cumulative effect of changes in accounting principles". (5) Properties The following is a summary of the major classifications of properties: (6) Income Taxes The current deferred tax liability and the non-current deferred tax liability consists of the following components (in thousands): Deferred income tax expense results from temporary differences in recognition of revenue and expense for income tax and financial statement purposes. The tax effects of the principal temporary differences are as follows (such disclosure is not presented for Transition 1993 as it is not required under SFAS 109): Notes to Consolidated Financial Statements The difference between the reported provision for income taxes and a computed tax based on income before income taxes and cumulative effect of changes in accounting principles at the statutory rate of 34% in Fiscal 1992 and Fiscal 1993 and 35% in Transition 1993 is reconciled as follows: Federal income tax returns of the Company have been examined by the Internal Revenue Service ("IRS") for the tax years 1986 through 1988. Such audit has been substantially resolved at no material cost to the Company. The IRS has recently commenced the examination of the Company's Federal income tax returns for the tax years from 1989 through 1992. The amount and timing of any payments required as a result of the 1989 through 1992 audit cannot presently be determined. However, the Company believes that it has adequate reserves for any tax liabilities, including interest, that may result from all such examinations. (7) Long-term Debt Long-term debt consists of the following: Aggregate annual maturities of the long-term debt as of January 2, 1994 are as follows (in thousands): In connection with the Reorganization, on April 23, 1993 the Company and C. H. Patrick entered into a $180,000,000 senior secured credit facility with the Company's commercial lender as agent for itself and various lenders, repaid its prior term loan and repurchased all receivables that had been sold to such commercial lender under the Company's non-notification factoring arrangement. The Graniteville Credit Facility consists of a senior secured revolving credit facility of up to $100,000,000 (the "Revolving Loan") with a $7,500,000 sublimit for letters of credit and an $80,000,000 senior secured term loan (the "Term Loan") and expires in 1998. As part of the Graniteville Credit Facility, Graniteville's commercial lender will continue to factor the Company's and C. H. Patrick's receivables, with credit balances assigned to secure the Graniteville Credit Facility (the "Factoring Arrangement"). The Company incurred approximately $6,500,000 of fees and expenses, including $500,000 of such fees and expenses incurred in Fiscal 1993, in connection with the Graniteville Credit Facility which are recorded as deferred financing costs. Borrowings under the Revolving Loan bear interest, at the Company's option, at either the prime rate plus 1.25% per annum or the 90-day London Interbank Offered Rate (the "LIBOR rate") plus 3.00% per annum (weighted average interest rate of 7.15% at January 2, 1994). When the unpaid principal balance of the Term Loan is less than $55,000,000, the interest rate on the Revolving Loan will be reduced to the prime rate plus 1.00% or the 90-day LIBOR rate plus 2.75%. All LIBOR rate loans have a 90-day interest period and are limited to the lesser of $90,000,000 or 50% of the outstanding balance in multiples of $10,000,000 under the Graniteville Credit Facility. The borrowing base for the Revolving Loan is the sum of 90% of accounts receivable which are credit-approved by the factor ("Credit Approved Receivables"), plus 85% of all other eligible accounts receivable, plus 65% of eligible inventory, provided that advances against eligible inventory shall not exceed $35,000,000 at any one time. At January 2, 1994, the Company had approximately $11,000,000 of unused availability under the Revolving Loan. The Company, in addition to the aforementioned interest, pays a commission of 0.45% on all Credit-Approved Receivables, including a 0.20% bad debt reserve which will be shared equally by Graniteville's commercial lender and the Company after deducting customer credit losses. On March 10, 1994, the Company amended the Graniteville Credit Facility to provide for an increase in the maximum Revolving Loan to $107,000,000 during the period March 10, 1994 through September 1, 1994 with a corresponding increase in eligible inventory to $42,000,000. The Term Loan is repayable $11,500,000 in 1994, $12,000,000 in 1995 through 1997 and $25,000,000 in 1998. Until the unpaid principal of the Term Loan is equal to or less than $60,000,000 at the end of any year, the Company must make mandatory prepayments in an amount equal to 50% of Excess Cash Flow, as defined, for such year. The Term Loan bears interest at the prime rate plus 1.75% per annum or the 90-day LIBOR rate plus 3.5% per annum (weighted average interest rate of 7.39% at January 2, 1994). When the unpaid principal balance of the Term Loan is less than $55,000,000, the interest rate thereon will be reduced to the prime rate plus 1.375% or the 90-day LIBOR rate plus 3.125%. In each case, the LIBOR rate is limited to the lesser of $90,000,000 or 50% of the outstanding balance in multiples of $10,000,000 under the Graniteville Credit Facility. In the event that the Company prepays the Term Loan, in whole or in part, prior to the end of the third year, then a prepayment fee shall be payable as follows: 2% of the amount prepaid if the prepayment occurs in the first year, 1% of the prepayment during the second year and 1/2 of 1% in the third year. The Graniteville Credit Facility is secured by all of the assets of the Company and C. H. Patrick, including all accounts receivable, notes (including the $66,600,000 note the Company received from Triarc as an intercompany advance), inventory, machinery and equipment, trademarks, patents and other intangible assets, and all real estate. The Company has also pledged as collateral the stock of C. H. Patrick. Additionally, Triarc and Graniteville International have unconditionally guaranteed all obligations under the Graniteville Credit Facility. As collateral for such guarantee, Triarc pledged (i) 51% of the issued and outstanding stock of the Company (subject to pre- existing pledge of such stock in connection with Triarc's intercompany note payable to SEPSCO in the principal amount of $26,538,000), and (ii) the issued and outstanding common stock of SEPSCO owned by Triarc. The Graniteville Credit Facility contains various covenants which (a) require meeting certain financial amount and ratio tests; (b) limit, among other items (i) the incurrence of indebtedness, (ii) investments, (iii) asset dispositions, (iv) capital expenditures and (v) affiliate transactions other than in the normal course of business; and (c) restrict the payment of dividends (see below). If the Company becomes eligible to join in Triarc's consolidated Federal income tax return, the Company will be permitted to pay to Triarc an amount equal to the Federal income tax liability that the Company and its subsidiaries would have paid if they had filed a separate consolidated Federal income tax return. Additionally, the Company will be permitted to pay dividends or make loans or advances to its affiliates in an amount equal to 50% of the net income of the Company accumulated from the beginning of the first year commencing on or after December 20, 1994, provided that the outstanding principal balance of the Term Loan is less than $50 million at the time of the payments and certain other conditions are met. Accordingly, the Company in unable to pay any dividends or make any loans or advances to its stockholders, including Triarc, prior to December 31, 1995. (8) Lease Commitments The Company leases certain machinery and automotive and transportation equipment from an affiliate and from unrelated third parties under long-term lease obligations which are accounted for as capital leases and are included in "Properties, at cost" in the accompanying consolidated balance sheets at February 28, 1993 and January 2, 1994 in the amount of $4,392,000 and $987,000, respectively. The future minimum lease payments (net of sublease rentals which are not significant) under capital leases and operating leases with an initial noncancelable term in excess of one year are as follows: Rental expense under operating leases which is primarily for the rental of real estate and equipment, was $1,032,000 in Fiscal 1992, $1,794,000 in Fiscal 1993, and $1,911,000 in Transition 1993. (9) Postretirement Benefits Other than Pensions Postretirement benefits other than pensions consist of health care and life insurance benefits provided to a group of former employees who retired prior to January 1, 1990, and a limited health care benefit program provided to early retirees. With the exception of a group of retirees who retired prior to January 1, 1982, a portion of the cost of these benefits is paid by the retiree. Effective March 2, 1992, Graniteville adopted SFAS 106 and accordingly, provided for the unfunded accumulated postretirement obligation as of that date. Prior thereto, the Company accounted for postretirement obligation payments on a pay-as-you-go basis. In Fiscal 1992, such payments were immaterial. Net other postretirement benefit expense consists of the following: The accumulated postretirement benefit obligation consists of the following: For purposes of measuring the expected postretirement obligation, a 12% annual rate of increase in the per capita claims cost was assumed for 1994. This rate is assumed to decrease by 1% per year to 6% in the year 2000 and remain level thereafter. The discount rate used in determining the net other postretirement benefit expense for Fiscal 1993 and Transition 1993 and the accumulated postretirement benefit obligation as of February 28, 1993 was 8%. The discount rate used in determining the accumulated postretirement benefit obligation as of January 2, 1994 was 7%. If the health care cost trend rate were increased by 1%, the accumulated postretirement benefit obligation as of January 2, 1994 would have been increased by approximately $90,000. The effect of this change on the aggregate ot the service cost and interest cost components of the net other postretirement benefit expense for Transition 1993 would be an increase of approximately $8,300. (10) Transactions with Affiliates By agreement, Triarc provides certain management services including, among others, legal, insurance and financial services and incurs certain costs on behalf of the Company. In Fiscal 1992, Fiscal 1993 and Transition 1993 such costs aggregated $1,792,000, $2,441,000, and $7,904,000, respectively. Such amounts include approximately $640,000, $1,299,000, and $105,000 in Fiscal 1992, Fiscal 1993, and Transition 1993, respectively, representing allocations to the Company in accordance with the applicable management services agreement of certain reserves established by Triarc for amounts owed by certain former affiliates of the Company in connection with the providing by Triarc of such management services. The Company, through Triarc, also leased space from an affiliate for approximately $864,000, $824,000, and $612,000 in Fiscal 1992, Fiscal 1993, and Transition 1993, respectively. In July 1993, Triarc Companies gave notice to terminate the lease effective January 31, 1994 and the Company has recorded a charge of $1,614,000 in Transition 1993 representing the allocated cost of such lease termination (see Note 14). Prior to December 1993, the Company maintained certain property insurance coverage with Chesapeake Insurance Company Limited ("Chesapeake Insurance"), an affiliated company registered in Bermuda. Premiums attributable to such insurance coverage amounted to $203,000 in Fiscal 1992, $212,000 in Fiscal 1993 and $84,000 in Transition 1993. The Company also maintained certain insurance coverage with an unaffiliated insurance company for which Chesapeake Insurance reinsured a portion of the risk. Net premiums attributable to such reinsurance were approximately $3,047,000 in Fiscal 1992, $2,619,000 in Fiscal 1993 and $1,643,000 in Transition 1993. In addition, prior to July 1, 1993, Insurance and Risk Management Inc., an affiliate until April 23, 1993, acted as agent or broker in connection with insurance coverage obtained by the Company and provided claims processing services for the Company. The commissions and payments for such services paid to such company were $455,000, $459,000 and $77,000 in Fiscal 1992, Fiscal 1993 and the applicable period of Transition 1993, respectively. The Company had a $2,500,000 investment in the convertible preferred stock of Chesapeake Insurance. During its quarter ended September 30, 1993, Chesapeake Insurance increased its reserve for insurance and reinsurance losses by $10,000,000 and as a result reduced the stockholders' equity of Chesapeake Insurance to $308,000. In December 1993, Triarc decided to cease writing insurance and reinsurance of any kind through Chesapeake Insurance. As a result, Chesapeake Insurance will not have any future operating cash flows and its remaining liabilities, including payment of claims on insurance previously written, will be liquidated with assets on hand. Accordingly, the preferred stock investment is not recoverable and the Company has written off its investment in such stock since the decline in value was deemed to be other than temporary. Certain machinery and automotive equipment is leased from an affiliate (see Note 8). Interest charges on these lease obligations amounted to $97,000 in Fiscal 1992, $71,000 in Fiscal 1993, and $16,000 in Transition 1993. On October 1, 1993, Triarc began leasing corporate aircraft from Triangle Aircraft Services Corporation ("TASCO"), a company owned by Messrs. Peltz and May. Usage fees charged to the Company aggregated $17,000 during Transition 1993 (none in prior periods). (11) Legal Matters The Company participates in regional waste water treatment facilities and considers that it is in substantial compliance with water pollution regulations. In 1987, the Company was, however, notified by the South Carolina Department of Health and Environmental Control ("DHEC") that DHEC discovered certain contamination of Langley Pond near Graniteville, South Carolina and asserted that the Company may be one of the parties responsible for such contamination. The Company entered into a consent decree providing for the study and investigation of the alleged pollution and its sources. The study report prepared by the Company's environmental consulting firm and filed with DHEC in April 1990, recommended that pond sediments be left undisturbed and in place. DHEC responded by requesting that the Company submit additional information concerning potential passive and active remedial alternatives, with accompanying supportive information. In May 1991 the Company provided this information to DHEC in a report of its independent environmental consulting firm. The 1990 and 1991 reports concluded that pond sediments should be left undisturbed and in place and that other less passive remediation alternatives either provided no significant additional benefits or themselves involved adverse effects on human health, to existing recreational uses or to the existing biological communities. The Company is unable to predict at this time what further actions, if any, may be required in connection with Langley Pond or what the cost thereof may be. However, given the passage of time since the submission of the two reports by the Company's environmental consulting firm without any objection or adverse comment on such reports by DHEC and the absence of desirable remediation alternatives, other than continuing to leave the Langley Pond sediments in place and undisturbed as described in the reports, the Company believes the ultimate outcome of this matter will not have a material adverse effect on the Company's consolidated results of operations or financial position. The Company and its subsidiaries are defendants in certain other legal proceedings arising out of the ordinary conduct of the Company's business. In the opinion of management, the ultimate outcome of these legal proceedings will not have a material adverse effect on the consolidated financial position or results of operations of the Company. (12) Restructuring Costs In Fiscal 1992, the Company recorded a restructuring charge of $2,500,000 representing costs and expenses associated with plans to cease the manufacture and sale of cotton yarns and shuttle woven, industrial greige fabrics. Actual costs and expenses associated with the strategic restructuring exceeded management's original estimate and Fiscal 1993 results include an additional charge of $1,855,000. (13) Retirement and Incentive Compensation Plans The Company maintains a 401(k) defined contribution plan which covers substantially all employees. Employees may contribute from 1% to 8% of their total earnings, subject to certain limitations. In addition, the Company may make discretionary contributions to the plan. Discretionary retirement contribution expense was $1,000,000 in both Fiscal 1993 and Transition 1993 (none in Fiscal 1992). Effective with the first payroll period in March 1994, the Company made various changes to the retirement plan including an increase in allowable employee contributions. Employees may now contribute up to 15% of earnings and the Company will match up to 75% of employee contributions based on years of service but limited to the first 4%. In Fiscal 1993 and prior years, the Company maintained management incentive plans (the "Incentive Plans") which provided for incentive compensation of up to 10% of operating earnings and up to 10% of earnings from sales or other dispositions of assets. The plans were administered by the Compensation Committee of the Board of Directors of Triarc and awards for elected corporate officers were approved by the Board. In accordance with the terms of these Incentive Plans the Company provided $192,000 in Fiscal 1992 (net of reversal of $2,000,000 accrued in prior years) and $3,538,000 in Fiscal 1993 and reversed prior year accruals of $968,000 in Transition 1993 due to the termination of the plans. During Transition 1993, the Company replaced the previous Incentive Plans with annual and mid-term cash incentive plans (the "New Incentive Plans") for certain officers and key employees. The New Incentive Plans provide for discretionary cash awards depending upon the Company's financial performance as compared to target performance. The New Incentive Plans are designed to yield a target award in cash if the Company achieves an agreed-upon profit over a one-year and three-year performance cycle. An amount is accrued each year based upon the amount by which the Company's profit for such year exceeds the target performance. A new three-year performance cycle begins each year, such that after the third year the annual amount paid to participants will equal the target award if the Company's profit goals have been achieved. Amounts provided under the New Incentive Plans aggregated $1,998,000 in Transition 1993. Net incentive compensation expense under all plans was $192,000, $3,538,000 and $1,030,000 in Fiscal 1992, Fiscal 1993 and Transition 1993, respectively. During Transition 1993, Triarc granted 50,000 restricted shares of Triarc Class A common stock to the Company's chief executive officer under Triarc's Amended and Restated 1993 Equity Participation Plan (the "Triarc Equity Plan"). The value of the award at date of grant of $900,000 is being accrued as compensation expense over the applicable vesting period through December 31, 1996. In addition, during Transition 1993 Triarc granted stock options to certain key employees of the Company under the Triarc Equity Plan. Of such options, 65,000 were granted at an option price of $20.00 that was lower than the fair market value of Triarc's Class A common stock at the date of grant of $31.75. The aggregate difference of $764,000 between the option price and the fair market value at the date of grant was recorded by Triarc as unearned compensation and is being amortized to compensation expense over the applicable vesting period through September 28, 1998. Compensation expense resulting from the grants of restricted shares and below market stock options aggregated $255,000 during Transition 1993 and is included in "General and administrative expenses". (14) Significant Charges in Transition 1993 The accompanying consolidated statement of income includes the following significant charges recorded in Transition 1993 (in thousands): (15) Fair Value of Financial Instruments The estimated fair value of applicable financial instruments and related underlying assumptions are as follows as of January 2, 1994: Note receivable from Triarc - The carrying amount of $70,446,000 approximates fair value based upon scheduled cash flows discounted at an estimated current market rate of interest. Long-term debt - The Company estimates that the carrying value of $163,123,000 approximates the fair value of debt at January 2, 1994 based upon the floating rate of interest applicable to the Graniteville Credit Facility and the recent origination of such debt. (16) Prior Year Comparable Period The Company changed its year end effective January 2, 1994, as previously disclosed. The following unaudited operating results for the ten months ended December 27, 1992 are presented for comparative purposes (in thousands): PAGE PAGE PAGE PAGE

59478_1993.txt

59478_1993

1993

59478

Item 1. BUSINESS Eli Lilly and Company was incorporated in 1901 under the laws of Indiana to succeed to the drug manufacturing business founded in Indianapolis, Indiana, in 1876 by Colonel Eli Lilly. The Company*, including its subsidiaries, is engaged in the discovery, development, manufacture, and sale of products in one industry segment - Life Sciences. Products are manufactured or distributed through owned or leased facilities in the United States, Puerto Rico, and 27 other countries, in 19 of which the Company owns or has an interest in manufacturing facilities. Its products are sold in approximately 120 countries. Most of the Company's products were discovered or developed through the Company's research and development activities, and the success of the Company's business depends to a great extent on the introduction of new products resulting from these research and development activities. Research efforts are primarily directed toward the discovery of products to diagnose and treat diseases in human beings and animals and to increase the efficiency of animal food production. Research efforts are also directed toward developing medical devices. FINANCIAL INFORMATION RELATING TO INDUSTRY SEGMENTS AND CLASSES OF PRODUCTS Financial information relating to industry segments and classes of products, set forth in the Company's 1993 Annual Report at pages 18-19 under "Review of Operations - Segment Information" (pages 12-13 of Exhibit 13 to this Form 10-K), is incorporated herein by reference. Due to several factors, including the introduction of new products by the Company and other manufacturers, the relative contribution of any particular Company product to consolidated net sales is not necessarily constant from year to year, and its contribution to net income is not necessarily the same as its contribution to consolidated net sales. PRODUCTS Pharmaceutical Products Pharmaceutical products include Anti-infectives, including the oral cephalosporin antibiotics Ceclor (Registered), Keflex(Registered), and Keftab(Registered), used in the treatment of a wide range of bacterial infections; the oral carbacephem antibiotic Lorabid(Trademark), used to treat a variety of infections; the injectable cephalosporin antibiotics Mandol(Registered), Tazidime(Registered), Kefurox(Registered), and Kefzol(Registered), used to treat a wide range of infections in the hospital setting; Nebcin(Registered), an injectable aminoglycoside antibiotic used in hospitals to treat a broad range of infections caused by staphylococci and Gram-negative bacteria; and Vancocin(Registered) HCl, an antibiotic used primarily to treat staphylococcal infections; Central-nervous-system agents, including the antidepressant agent Prozac(Registered), a highly specific serotonin uptake inhibitor, indicated for the treatment of depression and, in certain countries, for bulimia and obsessive-compulsive disorder; and the analgesic Darvocet- N(Registered) 100, which is indicated for the relief of mild-to-moderate pain; * The terms "Company" and "Registrant" are used interchangeably herein to refer to Eli Lilly and Company or to Eli Lilly and Company and its consolidated subsidiaries, as the context requires. Diabetic care products, including Iletin(Registered) (insulin) in its various pharmaceutical forms; and Humulin(Registered), human insulin produced through recombinant DNA technology; Oncolytic agents, including Oncovin(Registered), indicated for treatment of acute leukemia and, in combination with other oncolytic agents, for treatment of several different types of advanced cancers; Velban(Registered), used in a variety of malignant neoplastic conditions; and Eldisine(Registered), indicated for treatment of acute childhood leukemia resistant to other drugs; An antiulcer agent, Axid(Registered), an H2 antagonist, indicated for the treatment of active duodenal ulcer, for maintenance therapy for duodenal ulcer patients after healing of an active duodenal ulcer, and for reflux esophagitis; and Additional pharmaceuticals, including cardiovascular therapy products, principally Dobutrex(Registered); hormones, including Humatrope(Registered), human growth hormone produced by recombinant DNA technology; and sedatives. Medical Devices and Diagnostic Products Medical devices include patient vital-signs measurement and electrocardiography systems, intravenous fluid-delivery and control systems, implantable cardiac pacemakers and implantable cardioverter/defibrillators, cardiac defibrillators and monitors, coronary angioplasty catheter systems, peripheral and coronary atherectomy catheter systems, and devices for use during minimally-invasive surgery procedures. Diagnostic products include monoclonal-antibody-based diagnostic tests for colon, prostate, and testicular cancer, as well as for infertility, pregnancy, heart attack, thyroid deficiencies, allergies, anemia, dwarfism, and infectious diseases. Animal Health Products Animal health products include Tylan(Registered), an antibiotic used to control certain diseases in cattle, swine, and poultry and to improve feed efficiency and growth; Rumensin(Registered), a cattle feed additive that improves feed efficiency and growth; Compudose(Registered), a controlled- release implant that improves feed efficiency and growth in cattle; Coban(Registered), Monteban(Registered) and Maxiban(Registered), anticoccidial agents for use in poultry; Apralan(Registered), an antibiotic used to control enteric infections in calves and swine; Micotil(Registered), an antibiotic used to treat bovine respiratory disease; and other products for livestock and poultry. MARKETING Most of the Company's major products are marketed worldwide. In the United States, the Company's Pharmaceutical Division distributes pharmaceutical products principally through approximately 225 wholesale distributing outlets. Marketing policy is designed to assure immediate availability of these products to physicians, pharmacies, hospitals, and appropriate health care professionals throughout the country. Four wholesale distributing companies in the United States accounted for approximately 11%, 9%, 6%, and 5% respectively, of consolidated net sales in 1993. No other distributor accounted for as much as 5% of consolidated net sales. The Company also makes direct sales of its pharmaceutical products to the United States government and to other manufacturers, but those direct sales do not constitute a material portion of consolidated net sales. The Company's pharmaceutical products are promoted in the United States under the Lilly and Dista trade names by one hospital and three retail sales forces employing salaried sales representatives. These sales representatives, approximately half of whom are registered pharmacists, call upon physicians, wholesalers, hospitals, managed-care organizations, retail pharmacists, and other health care professionals. Their efforts are supported by the Company through advertising in medical and drug journals, distribution of literature and samples of certain products to physicians, and exhibits for use at medical meetings. In the past few years, large purchasers of pharmaceuticals, such as managed-care groups and government and long-term care institutions, have begun to account for an increasing portion of total pharmaceutical purchases in the United States. In 1992, reflecting these changes, the Company created special sales groups to service government and long-term care institutions, and expanded its managed-care sales organization. In response to competitive pressures, the Company has entered into arrangements with a number of these organizations providing for discounts or rebates on one or more Company products. Pharmaceutical products are promoted outside the United States by salaried sales representatives. While the products marketed vary from country to country, anti-infectives constitute the largest single group in total volume. Distribution patterns vary from country to country. IVAC Corporation markets its patient temperature-measuring and vital-signs products and intravenous fluid-infusion systems principally to hospitals in the United States. Sales in the United States are conducted by a direct sales force. Sales outside the United States are conducted by both direct sales representatives and independent distributors. Cardiac Pacemakers, Inc. markets pacemaker products and automatic implantable cardioverter/defibrillators to physicians and hospitals. Sales are conducted by direct sales representatives and by independent distributors both inside and outside the United States. Physio-Control Corporation markets cardiac defibrillators and monitors, electrocardiography systems, and vital-signs-measurement equipment to hospitals and emergency care units. In the United States, sales are conducted by direct sales representatives. Sales outside the United States are conducted by both direct sales representatives and independent distributors. Physio-Control suspended production in May 1992 following an inspection of its operations by the U.S. Food and Drug Administration ("FDA"). During 1993, Physio-Control received FDA authorization to resume shipments of the majority of its product line. Physio-Control is seeking FDA authorization to resume shipments of its remaining products. Advanced Cardiovascular Systems, Inc. primarily markets coronary dilatation balloon catheter systems to cardiologists to open obstructed coronary arteries. In the United States, sales are conducted by a direct sales force. Sales outside the United States are conducted by both direct sales representatives and independent distributors. Devices for Vascular Intervention, Inc. markets atherectomy catheter systems for the treatment of coronary vascular disease by the removal of atherosclerotic plaque. In the United States, sales are conducted by direct sales representatives. Sales outside the United States are conducted by independent distributors. Origin Medsystems, Inc., acquired by the Company in 1992, markets devices for use in minimally invasive surgical procedures. Sales in the United States are conducted by direct sales representatives. Sales outside the United States are conducted by independent distributors and a direct sales force. Heart Rhythm Technologies, Inc. is developing catheter-based ablation systems to correct faulty signals at the heart, using a less-invasive approach than current therapy. Heart Rhythm Technologies has no products currently approved for marketing. Hybritech Incorporated and Pacific Biotech, Inc. market their immunodiagnostic products to hospitals, commercial laboratories, clinics, and physicians. Sales are conducted by direct sales representatives and by independent distributors both inside and outside the United States. Elanco Animal Health, a division of the Company, employs field salespeople throughout the United States to market animal health products. Sales are made to wholesale distributors, retailers, feed manufacturers, or producers in conformance with varying distribution patterns applicable to the various types of products. The Company also has an extensive sales force outside the United States to market its animal health products. RAW MATERIALS Most of the principal materials used by the Company in manufacturing operations are chemical, plant, and animal products that are available from more than one source. Certain raw materials are available or are purchased principally from only one source. Unavailability of certain materials from present sources could cause an interruption in production pending establishment of new sources or, in some cases, implementation of alternative processes. Although the major portion of the Company's sales abroad are of products manufactured wholly or in part abroad, a principal source of active ingredients for these manufactured products continues to be the Company's facilities in the United States. PATENTS AND LICENSES The Company owns, has applications pending for, or is licensed under, a substantial number of patents, both in the United States and in other countries, relating to products, product uses, and manufacturing processes. There can be no assurance that patents will result from the Company's pending applications. Moreover, patents relating to particular products, uses, or processes do not preclude other manufacturers from employing alternative processes or from successfully marketing substitute products to compete with the patented products or uses. Patent protection of certain products, processes, and uses - particularly that relating to Ceclor, Dobutrex, Humulin, Prozac, Axid, and Lorabid - is considered to be important to the operations of the Company. The United States product patent covering Ceclor, the Company's second largest selling product, expired in December 1992. The Company holds a U.S. patent on a key intermediate material that remains in force until December 1994. It has been reported that several abbreviated new drug applications for generic formulations of cefaclor (the active ingredient in Ceclor) have been filed in the U.S. and regulatory submissions have been made in other countries. Small quantities of a generic formulation are currently being marketed in India. Although the Company cannot predict the ultimate effect on the sales of Ceclor or the Company's results of operations, the Company believes that the expiration of the U.S. product and intermediate patents will not have a material adverse effect on the Company's near-term consolidated financial position. The United States patent covering Dobutrex expired in October 1993. Prior to the expiration, U.S. sales of Dobutrex accounted for approximately 2% of the Company's worldwide sales. The patent expiration has resulted in a significant decline in U.S. Dobutrex sales, and the Company expects this decline to continue. During the first two months of 1994, U.S. sales of the product declined approximately 75%. The contribution of Dobutrex to the Company's net income is greater than its contribution to net sales. The Company is unable to predict the effect of the expiration on the Company's consolidated results of operations; however, the Company believes the expiration will not have a material adverse effect on its consolidated financial position. The United States patent covering Humulin expires in 2000, the Prozac patent expires in 2001, the Axid patent expires in 2002, and the Lorabid patent expires in 2004. The Company also grants licenses under patents and know-how developed by the Company and manufactures and sells products and uses technology and know- how under licenses from others. Royalties received by the Company in relation to licensed pharmaceuticals, medical devices, and diagnostic products amounted to approximately $56.7 million in 1993, and royalties paid by it in relation to pharmaceuticals, medical devices, and diagnostic products amounted to approximately $92.5 million in 1993. COMPETITION The Company's pharmaceutical products compete with products manufactured by numerous other companies in highly competitive markets in the United States and throughout the world. Its medical devices compete with numerous domestic and foreign manufacturers of conventional mercury-glass thermometers, implantable cardiac pacemakers, cardiac defibrillators and monitors, electronic temperature-measuring systems, vital-signs measuring systems, intravenous systems, angioplasty catheter systems, and minimally- invasive surgery devices. The Company's diagnostic products compete with conventional immunodiagnostic assays as well as with monoclonal-antibody-based products marketed by numerous foreign and domestic manufacturers. Its animal health products compete on a worldwide basis with products of pharmaceutical, chemical, and other companies that operate animal health divisions or subsidiaries. Important competitive factors include price and cost-effectiveness, product characteristics and dependability, service, and research and development of new products and processes. The introduction of new products and the development of new processes by domestic and foreign companies can result in progressive price reductions or decreased volume of sales of competing products, or both. New products introduced with patent protection usually must compete with other products already on the market at the time of introduction or products developed by competitors after introduction. The Company believes its competitive position in these markets is dependent upon its research and development endeavors in the discovery and development of new products, together with increased productivity resulting from improved manufacturing methods, marketing efforts, and customer service. There can be no assurance that products manufactured or processes used by the Company will not become outmoded from time to time as a result of products or processes developed by its competitors. GOVERNMENTAL REGULATION The Company's operations have for many years been subject to extensive regulation by the federal government, to some extent by state governments, and in varying degrees by foreign governments. The Federal Food, Drug, and Cosmetic Act, other federal statutes and regulations, various state statutes and regulations, and laws and regulations of foreign governments govern testing, approval, production, labeling, distribution, post-market surveillance, advertising, promotion, and in some instances, pricing, of most of the Company's products. In addition, the Company's operations are subject to complex federal, state, local, and foreign environmental laws and regulations. It is anticipated that compliance with regulations affecting the manufacture and sale of current products and the introduction of new products will continue to require substantial scientific and technical effort, time, and expense and significant capital investment. In the United States, the federal administration has identified health care reform as a priority and introduced legislation that, if enacted, would make fundamental changes in the health care delivery system. In addition, a number of reform measures have been proposed by members of Congress. Many state legislatures are also considering health care reform measures. The nature of the changes that may ultimately be enacted and their impact on the Company and the pharmaceutical industry are unknown. However, several of the measures currently under discussion, if enacted, could affect the industry and the Company by, among other things, increasing pressures on pricing, restricting physicians' choice of therapies, raising effective tax rates, and reducing incentives to invest in research and development. Outside the United States, governments in several countries, including Germany, Italy, and the United Kingdom, are implementing health care cost-control measures that may adversely affect pharmaceutical industry revenues. The Company is unable to predict the extent to which its business may be affected by these or other future legislative and regulatory developments. RESEARCH AND DEVELOPMENT The Company's research and development activities are responsible for the discovery or development of most of the products offered by the Company today. Its commitment to research and development dates back more than 100 years. The growth in research and development expenditures and personnel over the past several years demonstrates both the continued vitality of the Company's commitment and the increasing costs and complexity of bringing new products to the market. At the end of 1993, approximately 5,600 people, including a substantial number who are physicians or scientists holding graduate or postgraduate degrees or highly skilled technical personnel, were engaged in research and development activities. The Company expended $766.9 million on research and development activities in 1991, $924.9 million in 1992, and $954.6 million in 1993. The Company's research is concerned primarily with the effects of synthetic chemicals and natural products on biological systems. The results of that research are applied to the development of products for use by or on humans and animals, and for other uses. Major effort is devoted to pharmaceutical products. In late 1993, the Company decided to concentrate its pharmaceutical research and development efforts on the search for compounds that will cure or treat diseases in five categories: central nervous system and related diseases; endocrine diseases, including diabetes and osteoporosis; infectious diseases; cancer; and cardiovascular diseases. The Company is engaged in biotechnology research programs involving recombinant DNA and monoclonal antibodies. The Company's biotechnology research is supplemented through its Hybritech and Pacific Biotech subsidiaries, which conduct research using monoclonal-antibody-based product technology for diagnosis of certain diseases or medical conditions. In addition to the research activities carried on in the Company's own laboratories, the Company sponsors and underwrites the cost of research and development by independent organizations, including educational institutions and research-based human health care companies, and contracts with others for the performance of research in their facilities. It utilizes the services of physicians, hospitals, medical schools, and other research organizations in the United States and numerous other countries to establish through clinical evidence the safety and effectiveness of new products. IVAC, Cardiac Pacemakers, Advanced Cardiovascular Systems, Physio-Control, Devices for Vascular Intervention, Origin Medsystems, and Heart Rhythm Technologies conduct research and development in the area of medical devices. Extensive work is also conducted in the animal sciences, including animal nutrition and physiology and veterinary medicine. Certain of the Company's research and development activities relating to pharmaceutical products may be applicable to animal health products. An example is the search for agents that will cure infectious disease. QUALITY ASSURANCE The Company's success depends in great measure upon customer confidence in the quality of the Company's products and in the integrity of the data that support their safety and effectiveness. The quality of the Company's products arises from the total commitment to quality in all parts of the Company, including research and development, purchasing, facilities planning, manufacturing, and distribution. Quality-assurance procedures have been developed relating to the quality and integrity of the Company's scientific information and production processes. With respect to pharmaceutical, diagnostic, and animal health products, control of production processes involves rigid specifications for ingredients, equipment, facilities, manufacturing methods, packaging materials, and labeling. Control tests are made at various stages of production processes and on the final product to assure that the product meets the Company's standards. These tests may involve chemical and physical chemical analyses, microbiological testing, testing in animals, or a combination of these tests. Additional assurance of quality is provided by a corporate quality-assurance group that monitors existing pharmaceutical and animal health manufacturing procedures and systems in the parent company, subsidiaries, and affiliates. The quality of medical devices is assured through specifications of components and finished products, inspection of certain components, certification of certain vendors, control of the manufacturing environment, and use of statistical process controls. Final products are tested to assure conformance with specifications. EXECUTIVE OFFICERS OF THE COMPANY The following table sets forth certain information regarding the executive officers of the Company. All but three of the executive officers have been employed by the Company in executive or managerial positions during the last five years. Randall L. Tobias became Chairman of the Board and Chief Executive Officer in June 1993. He had served as Vice Chairman of the Board of American Telephone and Telegraph Company from 1986 until he assumed his present position. He has been a member of the Board of Directors of the Company since 1986. August M. Watanabe joined the Company in 1990 as Vice President of Lilly Research Laboratories. Previously he had served as Chairman of the Department of Medicine at Indiana University School of Medicine from 1983 through 1990. From 1987 until he joined the Company in August 1990, Mitchell E. Daniels, Jr., President, North American Pharmaceutical Operations, Pharmaceutical Division, served as President and Chief Executive Officer of the Hudson Institute and was of counsel to Baker & Daniels. From 1985 to 1987 he served on former President Reagan's staff as Assistant to the President for Political and Intergovernmental Affairs. Except as indicated in the table below, the term of office for each executive officer indicated herein expires on the date of the annual meeting of the Board of Directors, to be held on April 18, 1994, or on the date his successor is chosen and qualified. No director or executive officer of the Company has a "family relationship" with any other director or executive officer of the Company, as that term is defined for purposes of this disclosure requirement. There is no understanding between any executive officer of the Company and any other person pursuant to which the executive officer was selected. NAME AGE OFFICES Randall L. Tobias 52 Chairman of the Board and Chief Executive Officer (since June 1993) and a Director Mel Perelman, Ph.D. 63 Executive Vice President (since December 1986) and a Director(1) Sidney Taurel 45 Executive Vice President (since January 1993) and a Director Joseph C. Cook, Jr. 52 Group Vice President, Manufacturing, Engineering, and Corporate Quality (since June 1992)(2) James M. Cornelius 50 Vice President, Finance and Chief Financial Officer (since January 1983) and a Director Mitchell E. Daniels, Jr. 44 President, North American Pharmaceutical Operations, Pharmaceutical Division (since April 1993)(3) Ronald W. Dollens 47 President, Medical Devices and Diagnostics Division (since July 1991)(3) Michael L. Eagle 46 Vice President, Manufacturing (since January 1994)(4) Brendan P. Fox 50 President, Elanco Animal Health Division (since January 1991)(3) Pedro P. Granadillo 46 Vice President, Human Resources (since April 1993) J. B. King 64 Vice President and General Counsel (since October 1987) Stephen A. Stitle 48 Vice President, Corporate Affairs (since April 1993) and a Director W. Leigh Thompson, Ph.D., M.D. 55 Chief Scientific Officer (since January 1993)(3) August M. Watanabe, M.D. 52 Vice President (since January 1994) and a Director(4) - -------------------- 1 Retired as an officer and director effective December 31, 1993 2 Retired as an officer effective December 31, 1993 3 Serves in office until his successor is appointed 4 Became executive officer January 1994 EMPLOYEES At the end of 1993, the Company had approximately 32,700 employees, including approximately 11,000 employees outside the United States. A substantial number of the Company's employees have long records of continuous service. Approximately 2,600 employees, including 1,900 U.S. employees, are retiring under voluntary early retirement programs announced in the fourth quarter of 1993. FINANCIAL INFORMATION RELATING TO FOREIGN AND DOMESTIC OPERATIONS Financial information relating to foreign and domestic operations, set forth in the Company's 1993 Annual Report at pages 18-19 under "Review of Operations - Segment Information" (pages 12-13 of Exhibit 13), is incorporated herein by reference. Eli Lilly International Corporation, a subsidiary, coordinates the Company's manufacture and sale of products outside the United States. Local restrictions on the transfer of funds from branches and subsidiaries located abroad (including the availability of dollar exchange) have not to date been a significant deterrent in the Company's overall operations abroad. The Company cannot predict what effect these restrictions or the other risks inherent in foreign operations, including possible nationalization, might have on its future operations or what other restrictions may be imposed in the future. RECENT DEVELOPMENTS On January 18, 1994, the Company announced its intent to divest itself of its medical device and diagnostics ("MDD") businesses. The final form of the divestiture has not been resolved. It will depend on tax, market, and other considerations, including the nature of any offers the Company may receive from prospective purchasers of one or more of the businesses. Current plans call for the creation of a new holding company comprising six of the businesses and the divestiture of the new company through a spin-off to Company shareholders, one or more public offerings of the holding company's shares, or a combination of these methods. These six businesses are Advanced Cardiovascular Systems, Cardiac Pacemakers, Devices for Vascular Intervention, Heart Rhythm Technologies, IVAC, and Origin Medsystems. The Company currently intends to sell separately the three other businesses in the MDD division - Hybritech, Pacific Biotech, and Physio- Control. The agreements under which the Company acquired Hybritech, Pacific Biotech, and Origin Medsystems include provisions that could affect the timing of these transactions. On March 8, 1994, the Company announced that it had signed a letter of intent with Sphinx Pharmaceuticals Corporation for the acquisition of Sphinx by the Company. Sphinx is engaged in drug discovery and development by generating combinatorial chemistry libraries of small organic molecules and by high-throughput screening of compounds for biological activity. The transaction is subject to the signing of a definitive agreement, applicable government approval, and approval by Sphinx shareholders. Three purported class actions have been filed by shareholders of Sphinx seeking, among other things, to enjoin the transaction. Item 2. Item 2. PROPERTIES The Company's principal domestic and international executive offices are located in Indianapolis. At December 31, 1993, the Company owned 14 production plants and facilities in the United States and Puerto Rico. These plants and facilities contain an aggregate of approximately 12 million square feet of floor area. Most of the plants and facilities involve production of both pharmaceutical and animal health products. The Company owns manufacturing, research, and administrative facilities for medical devices and diagnostic products, containing an aggregate of approximately 1.9 million square feet, in seven cities in the United States and Puerto Rico. The Company's Medical Devices and Diagnostics Division leases manufacturing, research, and administrative facilities in the United States containing an aggregate of approximately 800,000 square feet. The Company also leases sales offices in a number of cities located in the United States. The Company has 25 production plants and facilities in 19 countries outside the United States, containing an aggregate of approximately 3.9 million square feet of floor space. Leased production and warehouse facilities are utilized in some of these countries as well as in nine other countries including Puerto Rico. The Company's main research and development laboratories in Indianapolis and Greenfield, Indiana, consist of approximately 2.8 million square feet. Its major research and development facilities abroad are located in Belgium and the United Kingdom and contain approximately 435,000 square feet. The Company also owns two tracts of land, containing an aggregate of approximately 1,700 acres, a portion of which is used for field studies of products. The Company believes that none of its properties is subject to any encumbrance, easement, or other restriction that would detract materially from its value or impair its use in the operation of the business of the Company. The buildings owned by the Company are of varying ages and in good condition. Item 3. Item 3. LEGAL PROCEEDINGS The Company is currently a defendant in a variety of product and patent litigation matters. In approximately 205 actions, plaintiffs seek to recover damages on behalf of children or grandchildren of women who ingested diethylstilbestrol during pregnancy. In another approximately 170 actions, plaintiffs seek to recover damages as a result of the ingestion of Prozac. In the patent suits, it is asserted that one or more Company products or processes infringe issued patents. The holders of those patents seek monetary damages and injunctions against further infringement. Products involved include Humulin, Humatrope, bovine somatotropin and certain medical devices. A federal grand jury in Baltimore, Maryland is conducting an inquiry into the Company's compliance with the Food and Drug Administration's regulatory requirements affecting the Company's pharmaceutical manufacturing operations. The Company is cooperating fully with the inquiry. The Company has been named in approximately ten of more than 40 lawsuits filed in various federal courts against a number of U.S. pharmaceutical manufacturers and in some cases wholesalers. Most of the suits in which the Company is a defendant purport to be class actions on behalf of all retail pharmacies in the United States and allege an industry-wide agreement to deny favorable pricing on sales to certain retail pharmacies. At least one also alleges price discrimination. The suits are in an early procedural stage. The Company is also a defendant in other litigation, including product liability suits, of a character regarded as normal to its business. While it is not possible to predict or determine the outcome of the legal actions pending against the Company, in the opinion of the Company such actions will not ultimately result in any liability that would have a material adverse effect on its consolidated financial position. Item 4. Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS During the fourth quarter of 1993, no matters were submitted to a vote of security holders. PART II Item 5. Item 5. MARKET FOR THE COMPANY'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS Information relating to the principal market for the Company's common stock and related stockholder matters, set forth in the Company's 1993 Annual Report under "Review of Operations - Selected Quarterly Data (unaudited)," at page 20 (page 14 of Exhibit 13), is incorporated herein by reference. Item 6. Item 6. SELECTED FINANCIAL DATA Selected financial data for each of the Company's five most recent fiscal years, set forth in the Company's 1993 Annual Report under "Review of Operations - Selected Financial Data (unaudited)," at page 21 (page 15 of Exhibit 13), are incorporated herein by reference. Item 7. Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION Management's discussion and analysis of results of operations and financial condition, set forth in the Company's 1993 Annual Report under "Review of Operations - Operating Results" (pages 9-13), "Review of Operations - Financial Condition" (pages 13 and 16), and "Review of Operations - Environmental and Legal Matters" (page 16) (together, pages 1-7 of Exhibit 13), is incorporated herein by reference. Item 8. Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The consolidated financial statements of the Company and its subsidiaries, listed in Item 14(a)1 and included in the Company's 1993 Annual Report at pages 12, 14, 15, and 17 (Consolidated Statements of Income, Consolidated Balance Sheets, and Consolidated Statements of Cash Flows), pages 18-19 (Segment Information), and pages 22-33 (Notes to Consolidated Financial Statements) (together, pages 8-13 and 16-30 of Exhibit 13), and the Report of Independent Auditors set forth in the Company's 1993 Annual Report at page 34 (page 31 of Exhibit 13), are incorporated herein by reference. Information on quarterly results of operations, set forth in the Company's 1993 Annual Report under "Review of Operations - Selected Quarterly Data (unaudited)," at page 20 (page 14 of Exhibit 13), is incorporated herein by reference. Item 9. Item 9. DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III Item 10. Item 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Information relating to the Company's directors, set forth in the Company's Proxy Statement dated March 14, 1994, under "Election of Directors - Nominees for Election," at pages 2-5, is incorporated herein by reference. Information relating to the Company's executive officers is set forth at pages 6-7 of this Form 10-K under "Executive Officers of the Company." Additional information with respect to the Company's directors and certain of its officers, set forth in the Company's Proxy Statement dated March 14, 1994, under "Other Matters," at page 25, is incorporated herein by reference. Item 11. Item 11. EXECUTIVE COMPENSATION Information relating to executive compensation, set forth in the Company's Proxy Statement dated March 14, 1994, under "Election of Directors - Executive Compensation," at pages 9-20, is incorporated herein by reference, except that the Compensation and Management Development Committee Report and Performance Graph are not so incorporated. Item 12. Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Information relating to ownership of the Company's common stock by persons known by the Company to be the beneficial owners of more than 5% of the outstanding shares of common stock and by management, set forth in the Company's Proxy Statement dated March 14, 1994, under "Election of Directors - Common Stock Ownership by Directors and Executive Officers," at pages 6-7, and "Election of Directors - Principal Holders of Common Stock," at page 8, 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 following consolidated financial statements of the Company and its subsidiaries, included in the Company's 1993 Annual Report at the pages indicated in parentheses, are incorporated by reference in Item 8: Consolidated Statements of Income - Years Ended December 31, 1993, 1992, and 1991 (page 12) (page 8 of Exhibit 13) Consolidated Balance Sheets - December 31, 1993 and 1992 (pages 14-15) (pages 9-10 of Exhibit 13) Consolidated Statements of Cash Flows - Years Ended December 31, 1993, 1992, and 1991 (page 17) (page 11 of Exhibit 13) Segment Information (pages 18-19) (pages 12-13 of Exhibit 13) Notes to Consolidated Financial Statements (pages 22-33) (pages 16-30 of Exhibit 13) (a)2. Financial Statement Schedules The following consolidated financial statement schedules of the Company and its subsidiaries are included in this Form 10-K: Schedule I Marketable Securities - Other Investments (page) Schedule V Property, Plant, and Equipment (page) Schedule VI Accumulated Depreciation, Depletion, and Amortization of Property, Plant, and Equipment (page) Schedule VII Guarantees of Securities of Other Issuers (page) Schedule VIII Valuation and Qualifying Accounts (page) Schedule IX Short-Term Borrowings (page) Schedule X Supplementary Income Statement Information (page) All other schedules (Nos. II, III, IV, XI, XII, XIII, and XIV) for which provision is made in the applicable accounting regulation of the Securities and Exchange Commission are not required under the related instructions, are inapplicable, or are adequately explained in the financial statements and, therefore, have been omitted. Financial statements of interests of 50% or less, which are accounted for by the equity method, have been omitted because they do not, considered in the aggregate as a single subsidiary, constitute a significant subsidiary. The report of the Company's independent auditors with respect to the schedules listed above is contained herein as a part of Exhibit 23, Consent of Independent Auditors. (a)3. Exhibits 3.1 Amended Articles of Incorporation 3.2 By-laws 4.1 Form of 7% Bond 1984-1994/96 of Eli Lilly Overseas Finance N.V. 4.2 Form of Guarantee dated as of January 9, 1984, by Eli Lilly and Company to Holders of 7% Bonds 1984-1994/96 of Eli Lilly Overseas Finance N.V. 4.3 Form of Letter Agreement dated as of January 9, 1984, between Eli Lilly and Company, Eli Lilly Overseas Finance N.V., and Swiss Bank Corporation 4.4 Form of Bond Purchase Agreement dated as of December 3, 1984, including form of Bond, between City of Clinton, Indiana, Eli Lilly and Company, and Chemical Bank* 4.5 Form of Loan Agreement dated as of December 3, 1984, between Eli Lilly and Company and City of Clinton, Indiana* 4.6 Form of Bond Purchase Agreement dated as of December 3, 1984, including form of Bond, between Tippecanoe County, Indiana, Eli Lilly and Company, and Chemical Bank* 4.7 Form of Loan Agreement dated as of December 3, 1984, between Eli Lilly and Company and Tippecanoe County, Indiana* 4.8 Form of Indenture dated as of May 15, 1985, between Eli Lilly and Company and Merchants National Bank & Trust Company of Indianapolis, as Trustee 4.9 Form of Eli Lilly and Company Convertible Debenture due 1994 4.10 Form of Indenture with respect to Contingent Payment Obligation Units dated March 18, 1986, between Eli Lilly and Company and Harris Trust and Savings Bank, as Trustee - --------------------- * Exhibits 4.4-4.7 are not filed with this report. Copies of these exhibits will be furnished to the Securities and Exchange Commission upon request. 4.11 Rights Agreement dated as of July 18, 1988, between Eli Lilly and Company and Bank One, Indianapolis, NA 4.12 Form of Indenture dated as of February 21, 1989, between Eli Lilly and Company and Merchants National Bank & Trust Company of Indianapolis, as Trustee 4.13 Form of Eli Lilly and Company Five Year Convertible Note 4.14 Form of Indenture with respect to Debt Securities dated as of February 1, 1991, between Eli Lilly and Company and Citibank, N.A., as Trustee 4.15 Form of Standard Multiple-Series Indenture Provisions dated, and filed with the Securities and Exchange Commission on, February 1, 1991 4.16 Form of Indenture dated as of September 5, 1991, among the Lilly Savings Plan Master Trust Fund C, as Issuer; Eli Lilly and Company, as Guarantor; and Chemical Bank, as Trustee* 10.1 1984 Lilly Stock Plan, as amended 10.2 1989 Lilly Stock Plan, as amended 10.3 The Lilly Deferred Compensation Plan, as amended 10.4 The Lilly Directors' Deferred Compensation Plan, as amended 10.5 The Lilly Non-Employee Directors' Deferred Stock Plan, as amended 10.6 Eli Lilly and Company Senior Executive Bonus Plan, as amended 10.7 The Lilly Non-Employee Directors' Retirement Plan 10.8 Letter Agreement dated September 3, 1993, between the Company and Vaughn D. Bryson 11. Computation of Earnings Per Share on Primary and Fully Diluted Bases 12. Computation of Ratio of Earnings to Fixed Charges 13. Annual Report to Shareholders for the Year Ended December 31, 1993 (portions incorporated by reference into this Form 10-K) 21. List of Subsidiaries 23. Consent of Independent Auditors 99. Report to Holders of Eli Lilly and Company Contingent Payment Obligation Units (b) Reports on Form 8-K The Company filed no Reports on Form 8-K during the fourth quarter of 1993. - ----------------- * Exhibit 4.16 is not filed with this report. Copies of this exhibit will be furnished to the Securities and Exchange Commission upon request. 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. ELI LILLY AND COMPANY By s/Randall L. Tobias (Randall L. Tobias, Chairman of the Board and Chief Executive Officer) March 21, 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 s/Randall L. Tobias Chairman of the Board, March 21, 1994 (RANDALL L. TOBIAS) Chief Executive Officer, and a Director (principal executive officer) s/James M. Cornelius Vice President, Finance, March 21, 1994 (JAMES M. CORNELIUS) Chief Financial Officer, and a Director (principal financial officer) s/Keith E. Brauer Chief Accounting Officer March 21, 1994 (KEITH E. BRAUER) (principal accounting officer) s/Steven C. Beering, M.D. Director March 21, 1994 (STEVEN C. BEERING, M.D.) s/James W. Cozad Director March 21, 1994 (JAMES W. COZAD) Director March 21, 1994 (KAREN N. HORN, Ph.D.) s/J. Clayburn La Force, Jr., Ph.D. Director March 21, 1994 (J. CLAYBURN LA FORCE, JR., Ph.D.) s/Kenneth L. Lay, Ph.D. Director March 21, 1994 (KENNETH L. LAY, Ph.D.) s/Ben F. Love Director March 21, 1994 (BEN F. LOVE) s/Stephen A. Stitle Director March 21, 1994 (STEPHEN A. STITLE) s/Sidney Taurel Director March 21, 1994 (SIDNEY TAUREL) s/August M. Watanabe, M.D. Director March 21, 1994 (AUGUST M. WATANABE, M.D.) s/Alva O. Way Director March 21, 1994 (ALVA O. WAY) s/Richard D. Wood Director March 21, 1994 (RICHARD D. WOOD) TRADEMARKS Apralan(Registered) (apramycin sulfate, Elanco) Axid(Registered) (nizatidine, Lilly) Ceclor(Registered) (cefaclor, Lilly) Coban(Registered) (monensin sodium, Elanco) Compudose(Registered) (estradiol controlled-release implant, Elanco) Darvocet-N(Registered) (propoxyphene napsylate with acetaminophen, Lilly) Dobutrex(Registered) (dobutamine hydrochloride, Lilly) Eldisine(Registered) (vindesine sulfate, Lilly) Humatrope(Registered) (somatropin of recombinant DNA origin, Lilly) Humulin(Registered) (human insulin of recombinant DNA origin, Lilly) lletin(Registered) (insulin, Lilly) Keflex(Registered) (cephalexin, Dista) Keftab(Registered) (cephalexin hydrochloride, Dista) Kefurox(Registered) (cefuroxime sodium, Lilly) Kefzol(Registered) (cefazolin sodium, Lilly) Lorabid(Trademark) (loracarbef, Lilly) Mandol(Registered) (cefamandole nafate, Lilly) Maxiban(Registered) (narasin and nicarbazine, Elanco) Micotil(Registered) (tilmicosin phosphate, Elanco) Monteban(Registered) (narasin, Elanco) Nebcin(Registered) (tobramycin sulfate, Lilly) Oncovin(Registered) (vincristine sulfate, Lilly) Prozac(Registered) (fluoxetine hydrochloride, Dista) Rumensin(Registered) (monensin sodium, Elanco) Tazidime(Registered) (ceftazidime, Lilly) Tylan(Registered) (tylosin, Elanco) Vancocin(Registered) (vancomycin hydrochloride, Lilly) Velban(Registered) (vinblastine sulfate, Lilly) ELI LILLY AND COMPANY AND SUBSIDIARIES SCHEDULE I. MARKETABLE SECURITIES - OTHER INVESTMENTS DECEMBER 31, 1993 Col. A Col. B Col. C Col. D Col. E ------ ------ ------ ------ --------- Amount at Which Each Number Portfolio of of Shares Equity or Units- Market Security Issues Principal Value of and Each Other Amount of Cost of Issue at Security Issue Name of Issuer Bonds Each Balance Carried in the and Title of Issue and Notes Issue Sheet Date Balance Sheet - ------------------------------------------------------------------------ (Dollars in millions) CERTIFICATES OF DEPOSIT, TIME DEPOSITS, AND INTEREST-BEARING DEMAND DEPOSITS $ 491.8 $ 491.8 $ 492.1 $ 491.8 REPURCHASE AGREEMENTS Collateralized by U.S. government or U.S. government agency securities 28.0 28.0 28.0 28.0 Collateralized by other investments 42.3 42.3 42.3 42.3 EQUITY INVESTMENTS AND LIMITED PARTNERSHIPS 216.5 216.5 221.3 204.0 EURO COMMERCIAL PAPER AND BONDS 390.4 390.4 388.5 386.0 TOTALS $1,169.0 $1,169.0 $1,172.2 $1,152.1 ======= ======= ======= ======= Classified as: Current asset - Cash equivalent $ 482.9 - Short-term investments 447.5 Noncurrent asset 221.7 ----- TOTAL $1,152.1 ======= Securities classified as cash equivalents $ 482.9 Cash 56.7 ----- Cash and cash equivalents $ 539.6 ===== ELI LILLY AND COMPANY AND SUBSIDIARIES SCHEDULE V. PROPERTY, PLANT, AND EQUIPMENT Col. A Col. B Col. C Col. D Col E Col. F ------ ------ ------ ------ ------------------- ------- Other Balance at Changes Beginning (A) Add (Deduct) Add Balance of Additions Translation (Deduct) At End Classification Period At Cost Retirements Adjustments Describe of Period (Dollars in millions) Year Ended Dec 31, 1991 Land $ 102.1 $ 8.8 $ - $ .6 $ - $ 111.5 Buildings 1,141.3 228.0 9.2 (2.3) - 1,357.8 Equipment 2,376.9 500.2 76.2 (5.6) - 2,795.3 Construction- in-progress 895.5 405.4 - 3.1 - 1,304.0 ------ ----- ----- ----- ------- TOTALS $4,515.8 $1, 142.4 $ 85.4 $ (4.2) $ - $ 5,568.6 ======= ======== ==== ==== ======= Year Ended Dec 31, 1992 Land $ 111.5 $ 3.1 $ 0.3 $ (0.4) $ (1.1)(B) $ 112.8 Buildings 1,357.8 371.6 30.8 (30.4) (12.8)(B) 1,655.4 Equipment 2,795.3 756.5 126.6 (83.6) 2.7 (B) 3,344.3 Construction- in-progress 1,304.0 (218.3) - (16.9) (33.2)(B) 1,035.6 ------- ------ ----- ------- ------ ------- TOTALS $5,568.6 $ 912.9 $157.7 $(131.3) $(44.4)(B) $ 6,148.1 ======= ===== ===== ======= ===== ======= Year Ended Dec 31, 1993 Land $ 112.8 $ 15.4 $ 0.1 $ 0.2 $ 1.9 (B) $ 130.2 Buildings 1,655.4 312.3 10.4 (14.7) 14.7 (B) 1,957.3 Equipment 3,344.3 563.3 60.9 (39.6) (35.4)(B) 3,771.7 Construction- in-progress 1,035.6 (257.5) - (14.5) (56.3)(B) 707.3 ------- ----- ---- ------ ------ ------- TOTALS $6,148.1 $633.5 $ 71.4 $ (68.6) $(75.1)(B) $6,566.5 ======= ===== ==== ====== ====== ======= - ----------------- NOTE A Additions represent cash expenditures for projects in numerous locations both inside and outside the United States. In 1992 and 1993 there were no major projects for which cash expenditures exceeded 2% of total assets at either the beginning or the end of the year. In 1991 the 2% threshold was exceeded by one major project relating to an anticipated new product launch. Expenditures for this project were primarily for additions at Indiana locations. NOTE B Amounts shown are attributable to corporate restructuring, acquisitions, divestitures and miscellaneous reclassifications. The range of annual rates used in computing provisions for depreciation was 2 percent to 10 percent for buildings and generally 4 percent to 25 percent for equipment. ELI LILLY AND COMPANY AND SUBSIDIARIES SCHEDULE VI. ACCUMULATED DEPRECIATION, DEPLETION, AND AMORTIZATION OF PROPERTY, PLANT, AND EQUIPMENT Col. A Col. B Col. C Col. D Col E Col. F ------ ------ ------ ------ -------------------- ------ Other Balance at Additions Changes Beginning Charged to Add (Deduct) Add Balance of Costs and Translation (Deduct) At End Description Period Expenses Retirements Adjustments Describe of Period - ---------------------------------------------------------------------------- (Dollars in millions) Year Ended Dec 31, 1991 Buildings $ 377.1 $ 48.9 $ 6.3 $. 1 $ - $ 419.8 Equipment 1,202.0 218.5 52.5 (1.7) - 1,366.3 ------- ----- ---- ------ ----- ------- TOTALS $1,579.1 $267.4 $58.8 $( 1.6) $ - $1,786.1 ======= ====== ==== ===== ===== ======= Year Ended Dec 31, 1992 Buildings $ 419.8 $ 62.3 $ 21.3 $ (8.4) $ 32.2(A) $ 484.6 Equipment 1,366.3 268.3 97.6 (40.4) 94.8(A) 1,591.4 ------- ----- ----- ----- ----- ------- TOTALS $1,786.1 $330.6 $118.9 $(48.8) $127.0(A) $2,076.0 ======= ===== ===== ====== ===== ======= Year Ended Dec 31, 1993 Buildings $ 484.6 $ 74.1 $ 4.9 $ (4.6) $ 9.2(A) $ 558.4 Equipment 1,591.4 294.5 58.9 (20.1) 1.0(A) 1,807.9 ------- ----- ----- ------ ---- ------- TOTALS $2,076.0 $368.6 $63.8 $(24.7) $ 10.2(A) $2,366.3 ======= ===== ==== ====== ==== ======= NOTE A - Amounts shown are primarily attributable to corporate restructuring, divestitures and transfers between accounts. ELI LILLY AND COMPANY AND SUBSIDIARIES SCHEDULE VII. GUARANTEES OF SECURITIES OF OTHER ISSUERS Col. A Col. B Col. C Col. D Col. E Col. F Col. G ------ ------ ------ ------ ------ ------ ----------- Nature of any default by issuer of securities guaranteed in principal Name of interest, Issuer of sinking fund securities Title of Amount owned or guaranteed Issue Total by person Amount in redemption by person of each amount or persons treasury of provisions, for which class of guaranteed for which issuer of or statement securities and statement securities Nature of payments of is filed guaranteed outstanding is filed guaranteed guarantee dividends - ---------------------------------------------------------------------------- The Harding St. Indianapolis Project Debt Local Public Bonds $35,451,123 -0- Service None Improvement Bond Bank ELI LILLY AND COMPANY AND SUBSIDIARIES SCHEDULE VIII. VALUATION AND QUALIFYING ACCOUNTS Col. A Col. B Col. C Col. D Col.E ------ ------ ------ ------- ------ Additions (1) (2) Balance at Charged to Charged to Balance Beginning Costs and Other Accounts-Deductions- at End Description of Period Expenses Describe Describe of Period - ---------------------------------------------------------------------------- (Dollars in millions) (A) (A) (A) Year Ended December 31, 1991 Allowance for cash discounts and returns $ 6.2 $ 6.6 Allowance for doubtful accounts 17.1 21.0 ---- ---- TOTALS $23.3 $27.6 ==== ==== Year Ended December 31, 1992 Allowance for cash discounts and returns $ 6.6 $ 8.1 Allowance for doubtful accounts 21.0 26.9 ---- ---- TOTALS $27.6 $35.0 ==== ==== Year Ended December 31, 1993 Allowance for cash discounts and returns $ 8.1 $ 8.6 Allowance for doubtful accounts 26.9 23.7 ---- ---- TOTALS $35.0 $32.3 ==== ==== NOTE A - The information called for under columns C and D is not given, as the additions, deductions, and balances are not individually significant. ELI LILLY AND COMPANY AND SUBSIDIARIES SCHEDULE IX. SHORT-TERM BORROWINGS Col. A Col. B Col. C Col. D Col. E Col.F ------ ------ ------ ------ ------ -------- Weighted Average Average Maximum Amount Interest Balance Weighted Amount Outstanding Rate at Average Outstanding During During Category of Aggregate End of Interest During the the the Short-Term Borrowings Period Rate Period Period(C) Period(D) - --------------------------------------------------------------------------- (Dollars in millions) Year Ended December 31, 1991 Payable to banks (A) $315.0 6% $ 324.4 $ 188.5 7% Commercial paper (B) 375.2 5% 1,160.6 482.7 6% ----- Short-term borrowings $690.2 6% Year Ended December 31, 1992 Payable to banks (A) $174.9 6% $350.4 $ 287.3 7% Commercial paper (B) 416.3 3% 837.2 541.6 4% ----- Short-term borrowings $591.2 4% Year Ended December 31, 1993 Payable to banks (A) $178.4 7% $195.2 $114.7 9% Commercial paper (B) 346.4 3% 877.6 434.7 3% ----- Short-term borrowings $524.8 4% - ----------------------- NOTE A - Amounts payable to banks represent worldwide borrowings under lines-of-credit and the current portion of long- term debt. NOTE B - Commercial paper is issued in the United States for periods up to 270 days. NOTE C - Average of daily balances. NOTE D - Total interest divided by average borrowings outstanding. ELI LILLY AND COMPANY AND SUBSIDIARIES SCHEDULE X. SUPPLEMENTARY INCOME STATEMENT INFORMATION - --------------------------------------------------------------------------- Col. A Col. B ------- -------------------------------- Item Charged to Costs and Expenses Year Ended December 31 ------------------------------- 1993 1992 1991 ------------------------------- (Dollars in millions) Maintenance and repairs $178.8 $193.4 $178.7 Taxes, other than payroll and income 77.7 77.4 57.3 Advertising costs 29.6 24.3 21.0 Royalty expense 107.2 87.0 79.4 Amounts for depreciation and amortization of intangible assets are presented in the Statements of Cash Flows. INDEX TO EXHIBITS The following documents are filed as part of this report: Exhibit Location - ------- -------- 3.1 Amended Articles of Incorporated by reference Incorporation from Exhibit 3(i) to the Company's Registration Statement on Form S-8, Registration No. 33-50783 3.2 By-laws Filed herewith 4.1 Form of 7% Bond 1984-1994/96 Incorporated by reference of Eli Lily Overseas Finance from Exhibit 4.1 to the N.V. Company's Report on Form 10-K for the fiscal year ended December 31, 1990 4.2 Form of Guarantee dated as Incorporated by reference of January 9, 1984, by Eli from Exhibit 4.2 to the Lilly and Company to Holders Company's Report on Form of 7% Bonds 1984-1994/96 of 10-K for the fiscal year Eli Lilly Overseas Finance ended December 31, 1990 N.V. 4.3 Form of Letter Agreement Incorporated by reference dated as of January 9, 1984, from Exhibit 4.3 to the between Eli Lilly and Company's Report on Form Company, Eli Lilly Overseas 10-K for the fiscal year Finance N.V., and Swiss Bank ended December 31, 1990 Corporation 4.4 Form of Bond Purchase * Agreement dated as of December 3, 1984, including form of Bond, between City of Clinton, Indiana, Eli Lilly and Company, and Chemical Bank 4.5 Form of Loan Agreement dated * as of December 3, 1984, between Eli Lilly and Company and City of Clinton, Indiana 4.6 Form of Bond Purchase * Agreement dated as of December 3, 1984, including form of Bond, between Tippecanoe County, Indiana, Eli Lilly and Company, and Chemical Bank 4.7 Form of Loan Agreement dated * as of December 3, 1984, between Eli Lilly and Company and Tippecanoe County, Indiana - ------------------ * Exhibits 4.4-4.7 are not filed with this report. Copies of these exhibits will be furnished to the Securities and Exchange Commission upon request. 4.8 Form of Indenture dated as Incorporated by reference of May 15, 1985, between Eli from Exhibit 4(a) to the Lilly and Company and Company's Registration Merchants National Bank & Statement on Form S-15, Trust Company of Registration No. 2-96799 Indianapolis, as Trustee 4.9 Form of Eli Lilly and Incorporated by reference Company Convertible from Exhibit 4(b) to the Debenture due 1994 Company's Registration Statement on Form S-15, Registration No. 2-96799 4.10 Form of Indenture with Incorporated by reference respect to Contingent from Exhibit 4.3 to the Payment Obligation Units Company's Registration dated March 18, 1986, Statement on Form S-4, between Eli Lilly and Registration No. 33-3330 Company and Harris Trust and Savings Bank, as Trustee 4.11 Rights Agreement dated as of Filed herewith July 18, 1988, between Eli Lilly and Company and Bank One, Indianapolis, N.A. 4.12 Form of Indenture dated as Incorporated by reference of February 21, 1989, from Exhibit 4.16 to the between Eli Lilly and Company's Report on Form Company and Merchants 10-K for the fiscal year National Bank & Trust ended December 31, 1988 Company of Indianapolis, as Trustee 4.13 Form of Eli Lilly and Incorporated by reference Company Five Year from Exhibit 4.17 to the Convertible Note Company's Report on Form 10-K for the fiscal year ended December 31, 1988 4.14 Form of Indenture with Incorporated by reference respect to Debt Securities from Exhibit 4.1 to the dated as of February 1, Company's Registration 1991, between Eli Lilly and Statement on Form S-3, Company and Citibank, N.A., Registration No. 33-38347 as Trustee 4.15 Form of Standard Multiple- Incorporated by reference Series Indenture Provisions from Exhibit 4.2 to the dated, and filed with the Company's Registration Securities and Exchange Statement on Form S-3, Commission on, February 1, Registration No. 33-38347 4.16 Form of Indenture dated as * of September 5, 1991, among the Lilly Savings Plan Master Trust Fund C, as Issuer; Eli Lilly and Company, as Guarantor; and Chemical Bank, as Trustee - --------------------- * Exhibit 4.16 is not filed with this report. Copies of this exhibit will be furnished to the Securities and Exchange Commission upon request. 10.1 1984 Lilly Stock Plan, as Incorporated by reference amended from Exhibit 10.2 to the Company's Report on Form 10-K for the fiscal year ended December 31, 1988 10.2 1989 Lilly Stock Plan, as Filed herewith amended 10.3 The Lilly Deferred Incorporated by reference Compensation Plan, as from Exhibit 10.4 to the amended Company's Report on Form 10-K for the fiscal year ended December 31, 1991 10.4 The Lilly Directors' Incorporated by reference Deferred Compensation Plan, from Exhibit 10.5 to the as amended Company's Report on Form 10-K for the fiscal year ended December 31, 1991 10.5 The Lilly Non-Employee Incorporated by reference Directors' Deferred Stock from Exhibit 10.6 to the Plan, as amended Company's Report on Form 10-K for the fiscal year ended December 31, 1991 10.6 Eli Lilly and Company Senior Filed herewith Executive Bonus Plan, as amended 10.7 The Lilly Non-Employee Incorporated by reference Directors' Retirement Plan from Exhibit 10.7 to the Company's Report on Form 10-K for the fiscal year ended December 31, 1988 10.8 Letter Agreement dated Filed herewith September 3, 1993, between the Company and Vaughn D. Bryson 11. Computation of Earnings Per Filed herewith Share on Primary and Fully Diluted Bases 12. Computation of Ratio of Filed herewith Earnings to Fixed Charges 13. Annual Report to Filed herewith Shareholders for the Year Ended December 31, 1993 (portions incorporated by reference in this Form 10-K) 21. List of Subsidiaries Filed herewith 23. Consent of Independent Filed herewith Auditors 99. Report to Holders of Eli Filed herewith Lilly and Company Contingent Payment Obligation Units

862923_1993.txt

862923_1993

1993

862923

Item 1. Business. The Registrant is an indirect wholly-owned subsidiary of Merrill Lynch & Co., Inc., a corporation whose common stock is traded on the New York Stock Exchange. The information set forth under the caption "A. History and Business" in the preliminary prospectus contained in Registrant's registration statement filed March 31, 1994, pursuant to the Securities Act of 1933, File No. 33-60288 (the "Prospectus"), is incorporated herein by reference. Item 2. Item 2. Properties. The information set forth under the caption "J. Properties" in the Prospectus is incorporated herein by reference. Item 3. Item 3. Legal Proceedings. The information set forth under the caption "Legal Proceedings" in the Prospectus is incorporated herein by reference. Item 4. Item 4. Submission of Matters to a Vote of Security Holders. Information called for by this item is omitted pursuant to General Instruction J. of Form 10-K. PART II Item 5. Item 5. Market for Registrant's Common Equity and Related Stockholder Matters. The Registrant is a wholly-owned subsidiary of Merrill Lynch Insurance Group, Inc., which is the sole record holder of Registrant's shares. Therefore, there is no public trading market for Registrant's common stock. The Registrant has declared no cash dividends on its common stock at any time during the two most recent fiscal years. Under laws applicable to insurance companies domiciled in the State of New York, the Registrant's ability to pay dividends on its common stock is restricted. See Note 5 to the Registrant's financial statements. Item 6. Item 6. Selected Financial Data. Information called for by this item is omitted pursuant to General Instruction J. of Form 10-K. Item 7. Item 7. Management's Narrative Analysis of Results of Operations. The information set forth under the caption "C. Management's Discussion and Analysis of Financial Condition and Results of Operations" in the Prospectus is incorporated herein by reference. Item 8. Item 8. Financial Statements and Supplementary Data. The financial statements of Registrant are set forth in Part IV hereof and are incorporated herein by reference. Item 9. Item 9. Changes in and Disagreements With Accountants on Accounting and Financial Disclosure. Not applicable. PART III Information called for by items 10 through 13 of this part is omitted pursuant to General Instruction J. of Form 10-K. PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K. (a) Financial Statements and Exhibits. (1) The following financial statements of the Registrant are filed as part of this report: a. Independent Auditors' Report dated February 28, 1994. b. Balance Sheets at December 31, 1993 and 1992. c. Statements of Earnings for the Years Ended December 31, 1993, 1992 and 1991. d. Statements of Stockholder's Equity for the Years Ended December 31, 1993, 1992 and 1991. e. Statements of Cash Flows for the Years Ended December 31, 1993, 1992 and 1991. f. Notes to Financial Statements for the Years Ended December 31, 1993, 1992 and 1991. (2) The following exhibits are filed as part of this report as indicated below: 3.1 Certificate of Amendment and Restatement of Charter of Royal Tandem Life Insurance Company. (In- - 3 - corporated by reference to Exhibit 3(a) to the Registrant's registration statement on Form S-1, File No. 33-34562, filed April 26, 1990.) 3.2 By-Laws of Royal Tandem Life Insurance Company. (Incorporated by reference to Exhibit 3(b) to the Registrant's registration statement on Form S-1, File No. 33-34562, filed April 26, 1990.) 3.3 Certificate of Amendment of the Charter of ML Life Insurance Company of New York. (Incorporated by reference to Exhibit 3(c) to Post-Effective Amendment No. 3 to the Registrant's registration statement on Form S-1, File No. 33-34562, filed March 30, 1992.) 3.4 By-Laws of ML Life Insurance Company of New York. (Incorporated by reference to Exhibit 3(d) to Post- Effective Amendment No. 3 to the Registrant's registration statement on Form S-1, File No. 33-34562, filed March 30, 1992.) 4.1 Modified Guaranteed Annuity Contract. (Incorporated by reference to Exhibit 4(a) to Pre-Effective Amendment No. 1 to the Registrant's registration statement on Form S-1, File No. 33-34562, filed October 16, 1990.) 4.2 Modified Guaranteed Annuity Contract Application. (Incorporated by reference to Exhibit 4(b) to Pre- Effective Amendment No. 1 to the Registrant's registration statement on Form S-1, File No. 33-34562, filed October 16, 1990.) 4.3 Qualified Retirement Plan Endorsement. (Incorporated by reference to Exhibit 4(c) to Pre-Effective Amendment No. 1 to the Registrant's registration statement on Form S-1, File No. 33-34562, filed October 16, 1990.) 4.4 IRA Endorsement. (Incorporated by reference to Exhibit 4(d) to Pre-Effective Amendment No. 1 to the Registrant's registration statement on Form S-1, File No. 33-34562, filed October 16, 1990.) 4.5 Company Name Change Endorsement. (Incorporated by reference to Exhibit 4(e) to Post-Effective Amendment No. 3 to the Registrant's registration statement on Form S-1, File No. 33-34562, filed March 30, 1992.) - 4 - 4.6 IRA Endorsement, MLNY009 (Incorporated by reference to Exhibit 4(d)(2) to Post-Effective Amendment No. 1 to the Registrant's registration statement on Form S-1, File No. 33-60288, filed March 31, 1994). 10.1 General Agency Agreement between Royal Tandem Life Insurance Company and Merrill Lynch Life Agency Inc. (Incorporated by reference to Exhibit 10(a) to Pre-Effective Amendment No. 1 to the Registrant's registration statement on Form S-1, File No. 33-34562, filed October 16, 1990.) 10.2 Investment Management Agreement by and between Royal Tandem Life Insurance Company and Equitable Capital Management Corporation. (Incorporated by reference to Exhibit 10(b) to Pre-Effective Amendment No. 1 to the Registrant's registration statement on Form S-1, File No. 33-34562, filed October 16, 1990.) 10.3 Shareholders' Agreement by and among The Equitable Life Assurance Society of the United States and Merrill Lynch & Co., Inc. and Tandem Financial Group, Inc. (Incorporated by reference to Exhibit 10(c) to Pre- Effective Amendment No. 1 to the Registrant's registration statement on Form S-1, File No. 33-34562, filed October 16, 1990.) 10.4 Service Agreement by and between Royal Tandem Life Insurance Company and Tandem Financial Group, Inc. (Incorporated by reference to Exhibit 10(d) to Pre-Effective Amendment No. 1 to the Registrant's registration statement on Form S-1, File No. 33-34562, filed October 16, 1990.) 10.5 Service Agreement by and between Tandem Financial Group, Inc. and Merrill Lynch & Co., Inc. (Incorporated by reference to Exhibit 10(e) to Pre-Effective Amendment No. 1 to the Registrant's registration statement on Form S-1, File No. 33-34562, filed October 16, 1990.) 10.6 Form of Investment Management Agreement by and between Royal Tandem Life Insurance Company and Merrill Lynch Asset Management, Inc. (Incorporated by reference to Exhibit 10(f) to Post-Effective Amendment No. 1 to the Registrant's registration statement on Form S-1, File No. 33-34562, filed March 7, 1991.) - 5 - 10.7 Assumption Reinsurance Agreement between Merrill Lynch Life Insurance Company, Tandem Insurance Group, Inc. and Royal Tandem Life Insurance Company and Family Life Insurance Company. (Incorporated by reference to Exhibit 10(g) to Post-Effective Amendment No. 3 to the Registrant's registration statement on Form S-1, File No. 33-34562, filed March 30, 1992.) 10.8 Indemnity Agreement between ML Life Insurance Company of New York and Merrill Lynch Life Agency, Inc. (Incorporated by reference to Exhibit 10(h) to Post-Effective Amendment No. 3 to the Registrant's registration statement on Form S-1, File No. 33-34562, filed March 30, 1992.) 10.9 Amended General Agency Agreement between ML Life Insurance Company of New York and Merrill Lynch Life Agency, Inc. (Incorporated by reference to Exhibit 10(i) to Post-Effective Amendment No. 3 to the Registrant's registration statement on Form S-1, File No. 33-34562, filed March 30, 1992.) 10.10 Amended Management Agreement between ML Life Insurance Company of New York and Merrill Lynch Asset Management, Inc. (Incorporated by reference to Exhibit 10(j) to the Registrant's registration statement on Form S-1, File No. 33-60288, filed March 30, 1993.) 25.1 Power of attorney of Frederick J.C. Butler. (Incorporated by reference to Exhibit 25(a) to Post-Effective Amendment No. 1 to the Registrant's registration statement on Form S-1, File No. 33-60288, filed March 31, 1994.) 25.2 Power of attorney of Michael P. Cogswell. (Incorporated by reference to Exhibit 25(b) to Post-Effective Amendment No. 1 to the Registrant's registration statement on Form S-1, File No. 33-60288, filed March 31, 1994.) 25.3 Power of attorney of Sandra K. Cox. (Incorporated by reference to Exhibit 25(c) to Post-Effective Amendment No. 1 to the Registrant's registration statement on Form S-1, File No. 33-60288, filed March 31, 1994.) 25.4 Power of attorney of Joseph E. Crowne. (Incorporated by reference to Exhibit 25(d) to Post-Effective Amendment No. 1 to the Registrant's - 6 - registration statement on Form S-1, File No. 33-60288, filed March 31, 1994.) 25.5 Power of attorney of David M. Dunford. (Incorporated by reference to Exhibit 25(e) to Post-Effective Amendment No. 1 to the Registrant's registration statement on Form S-1, File No. 33-60288, filed March 31, 1994.) 25.6 Power of attorney of John C.R. Hele. (Incorporated by reference to Exhibit 25(f) to Post-Effective Amendment No. 1 to the Registrant's registration statement on Form S-1, File No. 33-60288, filed March 31, 1994.) 25.7 Power of attorney of Robert L. Israeloff. (Incorporated by reference to Exhibit 25(g) to Post-Effective Amendment No. 1 to the Registrant's registration statement on Form S-1, File No. 33-60288, filed March 31, 1994.) 25.8 Power of attorney of Allen N. Jones. (Incorporated by reference to Exhibit 25(h) to Post Effective Amendment No. 1 to the Registrant's registration statement on Form S-1, File No. 33-60288, filed March 31, 1994.) 25.9 Power of attorney of Cynthia L. Kahn. (Incorporated by reference to Exhibit 25(i) to Post-Effective Amendment No. 1 to the Registrant's registration statement on Form S-1, File No. 33-60288, filed March 31, 1994.) 25.10 Power of attorney of Robert A. King. (Incorporated by reference to Exhibit 25(j) to Post-Effective Amendment No. 1 to the Registrant's registration statement on Form S-1, File No. 33-60288, filed March 31, 1994.) 25.11 Power of attorney of Irving M. Pollack. (Incorporated by reference to Exhibit 25(k) to Post-Effective Amendment No. 1 to the Registrant's registration statement on Form S-1, File No. 33-60288, filed March 31, 1994.) 25.12 Power of attorney of Barry G. Skolnick. (Incorporated by reference to Exhibit 25(l) to Post-Effective Amendment No. 1 to the Registrant's registration statement on Form S-1, File No. 33-60288, filed March 31, 1994.) - 7 - 25.13 Power of attorney of William A. Wilde. (Incorporated by reference to Exhibit 25(m) to Post-Effective Amendment No. 1 to the Registrant's registration statement on Form S-1, File No. 33-60288, filed March 31, 1994.) 25.14 Power of attorney of Anthony J. Vespa. (Incorporated by reference to Exhibit 25(n) to Post-Effective Amendment No. 1 to the Registrant's registration statement on Form S-1, File No. 33-60288, filed March 31, 1994.) 28.1 Preliminary prospectus contained in Post-Effective Amendment No. 1 to the Registrant's registration statement, filed on March 31, 1994, pursuant to the Securities Act of 1933, File No. 33-60288. (3) Not applicable. (b) Reports on Form 8-K. No reports on Form 8-K have been filed during the last quarter of the fiscal year ended December 31, 1993. - 8 - Independent Auditors' Report . . . . . . . . . . . . . . . . . . . . . . . . . Balance Sheets at December 31, 1993 and 1992 . . . . . . . . . . . . . . . . . Statements of Earnings for the Years Ended December 31, 1993, 1992 and 1991 . . . . . . . . . . . . . . . . . . . . . . . . . . . . Statements of Stockholder's Equity 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 for the Years Ended December 31, 1993, 1992 and 1991 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 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. 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. *Signing in his own capacity and as Attorney-in-Fact. SUPPLEMENTAL INFORMATION TO BE FURNISHED WITH REPORTS FILED PURSUANT TO SECTION 15(D) OF THE ACT BY REGISTRANTS WHICH HAVE NOT REGISTERED SECURITIES PURSUANT TO SECTION 12 OF THE ACT. No annual report covering the Registrant's last fiscal year or proxy material has been or will be sent to Registrant's security holder. EXHIBIT INDEX - E-1 - - E-2 - - E-3 - - E-4 - - E-5 - - E-6 - - E-7 -

737287_1993.txt

737287_1993

1993

737287

ITEM 1 BUSINESS ITEM 2 ITEM 2 PROPERTIES ITEM 3 ITEM 3 LEGAL PROCEEDINGS ITEM 4 ITEM 4 SUBMISSION OF MATTERS TO A VOTE OF SECURITYHOLDERS NONE PART II ITEM 5 ITEM 5 MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED SECURITYHOLDER MATTERS ITEM 6 ITEM 6 SELECTED FINANCIAL DATA ITEM 7 ITEM 7 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERA- TIONS (FINANCIAL REVIEW) Guide 3 - Statistical Information ITEM 8 ITEM 8 FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Liberty Bancorp, Inc. and Subsidiaries (consolidated) Report of Independent Public Accountants Consolidated Balance Sheet Consolidated Statement of Income Consolidated Statement of Shareholders' Investment Consolidated Statement of Cash Flows Notes to Consolidated Financial Statement Reports of Other Independent Auditors Applicable to Certain Subsidiaries (of which separate financial statements are not required) Liberty Mortgage Company Liberty Real Estate Company Selected Quarterly Financial Data ITEM 9 ITEM 9 CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE NONE PART III (1) 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 PART IV ITEM 14 ITEM 14 EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K SIGNATURES (1) The information required by Part III is incorporated by reference from the Registrant's Proxy Statement, to be filed pursuant to Regulation 14A, relating to the Annual Meeting of Shareholders of the Registrant pursuant to General Instruction G to Form 10-K. An Overview of the Company's Operations - ------------------------------------------------------------------------------ Liberty Bancorp, Inc. ("Liberty") is incorporated under the laws of the State of Oklahoma and is registered as a bank holding company under the Bank Holding Company Act of 1956. As such, it holds all of the shares of its two major banking subsidiaries, Liberty Bank and Trust Company of Oklahoma City, N.A. ("Liberty Oklahoma City") and Liberty Bank and Trust Company of Tulsa, N.A. ("Liberty Tulsa"), as well as several other subsidiaries. Liberty coordinates the financial resources of the consolidated enterprise and also makes investments in and advances funds to its subsidiaries to provide portions of their capital and credit requirements. In addition, it supplies various managerial and support services to the sub- sidiaries and coordinates their general policies and activities. Both Liberty Oklahoma City and Liberty Tulsa provide a broad range of financial services to individuals, business enterprises, financial institutions and governmental authorities. Liberty Oklahoma City, which has a total of twenty locations in Oklahoma City and the surrounding communities of Choctaw, Edmond, Harrah, Midwest City and Norman, is Liberty's largest sub- sidiary having assets of $1.7 billion and deposits of $1.4 billion at December 31, 1993. Liberty Tulsa has eight locations and an autobank facility in Tulsa as well as banking centers in Broken Arrow and Jenks, and is the second largest subsidiary of Liberty with assets of $950 million and deposits of $711 million at December 31, 1993. Liberty Mortgage Company, a subsidiary of Liberty Oklahoma City, engages in mortgage banking activities. Liberty Real Estate Company, a nonbank subsidiary of Liberty, owns and operates Liberty Tower, in which Liberty and Liberty Oklahoma City maintain principal offices. Other subsidiaries are in- volved in insurance and other financial services. Fiduciary Services - ------------------------------------------------------------------------------ The principal activities of the trust departments of both banks include administration and investment management of personal trusts and estates, private and public employee benefit plans, including IRA's, corporate trusts and agencies for individuals, corporations, foundations and political entities. Trust assets under management at December 31, 1993 totaled $2.4 billion. Assets held in trust totaled $4.2 billion. These assets include fixed income and equity securities, residential, commercial and agricultural properties, mineral interests (mainly oil and gas) and private businesses throughout Oklahoma and the Southwest. In addition, Liberty Oklahoma City's Trust Department provides stock transfer, registration, dividend disbursing and dividend reinvestment services for corporations. Capital Market Services - ------------------------------------------------------------------------------ The capital markets group of each bank provides investment and money market services to individuals, trust accounts, corporations and correspondent banks. The capital markets groups are responsible for portfolio management, investment banking activities and the coordination of Liberty's funding and asset/liability management. The capital markets group also serves as broker/dealer in eligible investment securities and makes available a wide variety of investments to both retail and institutional customers. In addition, some 200 financial organizations utilize all or a portion of Liberty's institutional products including safekeeping, investment portfolio accounting, asset/liability consulting, and advanced portfolio strategies. Mortgage Banking Services - ------------------------------------------------------------------------------ Liberty Mortgage Company's ("LMC") residential mortgage operations are carried out through the main Liberty Oklahoma City location and two banking centers, one in Oklahoma City and one in Tulsa. Commercial mortgage operations are available at the main bank locations of Liberty Oklahoma City and the LMC branch in Tulsa. A major service provided by mortgage companies is the servicing of the loans marketed to investors through individual loan sales or by creating mortgage-backed pass-through securities. As of year-end 1993, LMC was servicing approximately $1.3 billion in mortgage loans. Personal Banking Services - ------------------------------------------------------------------------------ Liberty Oklahoma City and Liberty Tulsa provide an extensive array of retail banking products and services. The emphasis on individual and small business lines of credit, automobile loans, boat and recreational vehicle loans, home improvement and second mortgage loans, as well as acquisitions, have expanded retail loans to $195.4 million at December 31, 1993 compared to $107.0 million at the end of 1992. Retail loans accounted for 21% and 16% of total loans at the end of the respective years. Both banks offer checking, savings, certificates of deposit, money market investments, IRA's, Keogh and qualified retirement plan accounts. Commercial Banking Services - ------------------------------------------------------------------------------ Liberty Oklahoma City and Liberty Tulsa deliver comprehensive, competitively priced commercial banking services to commercial customers located in Oklahoma and contiguous states. Commercial customers use many commercial banking services including credit, depository and cash management. The commercial loan portfolio grew to $376.5 million at December 31, 1993 compared to $262.8 million at year end 1992. The commercial portfolio comprises approximately 40% of Liberty's loan portfolio. Commercial banking services are supported by an experienced lending staff. Liberty's statewide presence strengthens its ability to serve corporate, institutional, and individual financial requirements. In addition, Liberty commercial bankers coordinate their customer's use of other Liberty services including Group Plan Banking services provided to customer's employees. Real Estate Financing - ------------------------------------------------------------------------------ Liberty Oklahoma City and Liberty Tulsa actively provide construction, development and intermediate term loan products along with related real estate services. Real estate mortgage loans totaled $199.1 million at December 31, 1993 and accounted for 21% of total loans. Other real estate loans, including construction and development, were $85.6 million at December 31, 1993 and comprised 9% of total loans. This compares to real estate mortgage loans of $154.4 million (23% of total loans) and other real estate loans of $67.4 mil- lion (10% of total loans) one year ago. Correspondent Banking Activities - ------------------------------------------------------------------------------ Liberty Oklahoma City and Liberty Tulsa provide financial services to over 300 banks in Oklahoma and other parts of the Midwest. Both banks work closely with community and country banks, assisting them in satisfying the loan demands of their customers by participating in their lending activities. In addition, correspondents are provided with lending, investment, operations and other financial and advisory services. At December 31, 1993, correspondent and regional loans totaled $17.3 million or 2% of total loans. This compares to $16.9 million, or 2% of total loans at December 31, 1992. International Banking Activities - ------------------------------------------------------------------------------ Liberty Oklahoma City and Liberty Tulsa provide international trade finance and trade services to customers across Oklahoma and to banks within Oklahoma and in surrounding states. Liberty's broad network enhances the service capabilities of trade services representatives, foreign exchange traders and international tellers in providing wire and draft services, documentary collections, retail foreign currency products, foreign exchange contracts and letters of credit. At December 31, 1993, Liberty Oklahoma City's and Liberty Tulsa's outstanding international standby and commercial letters of credit totaled $44.1 million. Designated as a Priority Lender by the Export-Import Bank of the United States, Liberty works with exporters and local banks in providing government- backed financing for export sales. The trade finance officers work together with trade services to provide full service for Liberty customers requiring international financial expertise and service. Acquisitions - ------------------------------------------------------------------------------ Liberty continued to expand during 1993 with the acquisition of five banking companies. Information concerning these acquisitions is shown below. Financial Review - ------------------------------------------------------------------------------ Management's discussion and analysis of the 1993 financial results, important events and trends should be read in conjunction with the con- solidated financial statements, notes to the consolidated financial statements and the supplemental statistical and financial data presented elsewhere in this report. Performance Summary - ------------------------------------------------------------------------------ Liberty reported net income of $36.5 million for 1993. This compares to net income of $18.1 million for 1992 and $5.8 million for 1991. Net income per share for 1993 was $3.74, compared to $2.01 in 1992 and $.66 in 1991. Income for the fourth quarter of 1993 was $6.3 million or $.64 per share. This com- pares with income of $3.5 million or $.38 per share for the fourth quarter of 1992. The increase in net income from 1992 includes the cumulative effect of a change in accounting for income taxes of $14.3 million. Income for 1993 also included total negative provisions for loan losses and losses on other real estate and assets owned of $8.6 million compared to positive provisions of $548 thousand in 1992. The negative provisions were made to reduce the reserves to a level considered appropriate for the inherent risk in the current portfolios. Net Interest Income - ------------------------------------------------------------------------------ A volume-rate analysis of the changes in net interest income on a fully tax-equivalent basis is shown below. The volume-rate analysis reflects the changes in net interest income from both changes in asset and liability volumes and changes in interest rates. Because of numerous simultaneous bal- ance and rate changes, it is not possible to allocate precisely such changes between balances and rates. For purposes of this table, changes which are not due solely to balance changes or solely to rate changes are allocated to such categories based on the respective percentage changes in average daily balances and average rates. On a tax-equivalent basis, net interest income increased $10.4 million or 16% in 1993 to $76.9 million compared to $66.5 million in 1992 and $58.0 million in 1991. Liberty's tax-equivalent interest margin has increased to 3.8% for 1993 from 3.7% in 1992. The increase in net interest income between 1993 and 1992 is due principally to the increased investments in taxable securities and increased loan production as well as lower rates on interest- bearing liabilities. Investment securities, including securities available for sale and trading, increased $234.1 million over 1992 and accounted for 60.9% of average earning assets during 1993 compared to 55.9% for 1992. Average loans, including loans held for sale, increased $90.3 million during 1993. Further discussion of Liberty's management of net interest income can be found in "Interest Rate Sensitivity." Tax-equivalent interest income increased $4.0 million to $130.7 million in 1993. The increase is due to higher levels of earning assets, most particularly loans and investment securities which were offset in part by lower levels of federal funds sold. The average yield on average earning assets for 1993 decreased from 7.0% to 6.4%. Interest rates have decreased in all areas, with the yield on securities decreasing from 7.0% to 5.6% as a result of securities purchased in the lower rate environment. Paydowns in 1993 of approximately $306 million in higher yielding mortgage-backed securities have resulted in a net interest income reduction of $2.5 million. These paydown levels are expected to be insignificant after the first quarter of 1994, primarily due to reduced levels of these securities. Total interest expense amounted to $53.8 million in 1993 compared to $60.2 million in 1992. Of this $6.4 million decrease, $11.6 million is directly attributable to declining interest rates while the offsetting $5.2 million comes from increased levels of interest-bearing liabilities. The yield on interest-bearing liabilities declined from 4.2% in 1992 to 3.4% in 1993. Noninterest Income - ------------------------------------------------------------------------------ Noninterest income increased $8.1 million or 16.6% in 1993 from 1992. Primary increases were in net securities gains, service charges on deposits and other noninterest income. - -------------------------------------------------------------------- (In thousands) 1993 1992 1991 - -------------------------------------------------------------------- Trust fees $15,508 $15,523 $14,789 Service charges on deposits 12,925 10,900 9,235 Mortgage banking income 7,449 7,391 5,771 Trading profits 4,591 3,713 4,089 Net securities gains 2,750 11 (200) Loan fees 1,992 2,053 1,736 Other 11,501 9,065 8,480 - -------------------------------------------------------------------- Total $56,716 $48,656 $43,900 ==================================================================== Net securities gains increased during 1993, principally in the fourth quarter, to $2.8 million from $11 thousand in 1992 as Liberty elected to sell securities as part of its tax planning strategy. Service charges on deposits increased $2.0 million or 19% principally due to banks acquired during 1993. Other noninterest income increased $2.4 million or 27% due to $1.2 million recovered from other losses provided for in previous periods and $945 thousand of other income of acquired banks. Noninterest Expenses - ------------------------------------------------------------------------------ Noninterest expenses (excluding net costs of other real estate and assets owned ("OREO") which are discussed separately in "Provisions for Loan Losses and Net Income From Other Real Estate and Assets Owned") increased in 1993 by 24% to $122.1 million from $98.5 million in 1992 and $93.4 million in 1991. Increases were recorded in every major noninterest expense category. - ------------------------------------------------------------------------------ (In thousands) 1993 1992 1991 - ------------------------------------------------------------------------------ Salaries $44,701 $37,643 $36,586 Employee benefits 9,088 6,281 7,379 Professional and other services 10,001 8,543 8,128 Occupancy, net 8,806 7,336 6,861 Equipment 8,094 6,785 6,535 Amortization of intangibles 6,741 3,528 1,635 Data processing 5,901 5,866 5,735 Printing, postage and supplies 5,789 4,757 4,351 Deposit insurance assessment 4,564 3,814 3,191 Advertising and business development 4,382 3,119 2,463 Other 14,069 10,861 10,509 - ------------------------------------------------------------------------------ Total $122,136 $98,533 $93,373 ============================================================================== Salaries and employee benefits increased $9.9 million or 22.5% during 1993. Other than base salary increases, 1993 included $4.3 million in salary and benefits for employees of new banking locations. This increase also included an additional $906 thousand expensed for health care costs provided to retirees according to Statement of Financial Accounting Standards ("SFAS") No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," adopted in the first quarter of 1993. This standard moves companies from the recognition of postretirement benefits other than pensions when paid to an accrual of the present value of future benefits to be expensed during the years that the employee renders service. This obligation has been estimated to be approximately $10.8 million and is currently being recognized over a twenty-year period. The amortization of intangibles increased $3.2 million or 91.1%, as a result of accelerated write offs of the intangibles associated with purchased mortgage servicing rights due to refinancings. Occupancy expense increased $1.5 million or 20.0% primarily as a result of the additional locations. Professional and other services increased $1.5 million or 17.1% as a result of increased consulting fees, partially due to restructuring charges. Equipment expense increased $1.3 million or 19.3% primarily due to management and maintenance of a communications network. Other noninterest expense increased $3.2 million or 29.5% during 1993, a portion of which is attributable to the new banking centers. Also included in this increase is $1.1 million provided for losses on mortgage receivables in process of foreclosure which was offset by a similar negative provision for loan losses as discussed in the following section. Liberty's efficiency ratio for 1993 was 90.7% compared to 80.4% in 1992. The efficiency ratio is defined as noninterest expense as a percentage of tax- equivalent net interest income plus noninterest income excluding securities gains and losses. Liberty has engaged an outside consultant to review its operations and help implement plans to achieve greater operational efficiencies for 1994 and beyond. Provision for Loan Losses and Net Income from Other Real Estate and Assets Owned - ------------------------------------------------------------------------------ The provision for loan losses and losses on other real estate and assets owned amounted to a negative $8.6 million during 1993 compared to a negative $548 thousand during 1992 and charges of $2.4 million in 1991. As a result of continued improving asset quality trends, it is possible that negative provi- sions may continue in 1994. Total provisions for loan losses amounted to a negative $7.4 million in 1993 compared with charges of $1.8 million during 1992 and $2.3 million during 1991. Liberty reviews the adequacy of its reserve for loan losses on a quarterly basis. The reserve is based on a financial model which estimates the range of inherent loss in Liberty's loan portfolio. The model incorporates various factors required by guidelines of the Comptroller of the Currency, including trends and results in collecting loans, loss experience, evaluation of underlying collateral values, identification and review of specific problem loans, size of the loan portfolio and anticipated increases or declines in size, overall quality of the portfolio and business and economic conditions and trends. Variations in any or all of these factors may cause variations in quarterly provisions or annual provisions to the reserve. A similar analysis is conducted in connection with the reserve for losses on other real estate and assets owned. As a result of continuing improvement in asset quality trends, the levels of Liberty's reserves for loan losses and losses from other real estate and assets owned declined during 1993 compared to 1992. If asset quality trends continue to improve, it is possible that Liberty may record additional negative provisions in 1994 in either the provision for loan losses or the provision for losses on other real estate and assets owned, or both. The level of reserves is also influenced by the overall size of Liberty's loan portfolio. Since the volume of Liberty's loans has increased during 1993, the overall level of the reserve for loan losses may require adjustment to take into consideration any additional aggregate loan risk. These adjustments might offset, in whole or in part, the effects of any improving asset quality trends. Because reserve adequacy is based on a future evaluation of various factors, Liberty is unable to predict the specific level of provisions (or negative provisions) that may be appropriate in future periods. Net income from the operation of other real estate and assets owned is comprised of the following: Net Income from OREO - ------------------------------------------------------------------------------ (In thousands) 1993 1992 1991 - ------------------------------------------------------------------------------ Provisions ($1,207) ($2,341) $ 160 Expenses 856 1,676 2,992 Income (792) (1,524) (3,256) Gains on sales (2,265) (3,793) (2,382) - ------------------------------------------------------------------------------ Net income from OREO ($3,408) ($5,982) ($2,486) ============================================================================== Income Taxes - ------------------------------------------------------------------------------ Effective January 1, 1993, Liberty adopted SFAS No. 109 "Accounting for Income Taxes" and recognized a benefit of $14.3 million, net of providing a valuation allowance of $21.1 million against gross deferred tax assets of $35.4 million. During 1993, Liberty recorded an income tax benefit of $2.4 million. This benefit occurred primarily due to a reduction in the valuation allowance of $6.9 million. During 1993, Liberty generated taxable income sufficient to utilize $18.8 million of net operating loss carryforwards for which a valuation allowance had previously been provided. At December 31, 1993, Liberty had net operating loss carryforwards totaling $37 million which can be used to reduce its future income tax liabilities. Due to annual utilization limitations and uncertainties regarding Liberty's ability to generate sufficient taxable income in future periods, a valuation allowance has been provided against these net operating loss carryforwards. During 1994 income tax expense may be reduced as the valuation allowance is adjusted for, among other things, the use of net operating loss carryforwards. To the extent it is determined that it is more likely than not that Liberty will use its net operating loss carryforwards, the need for the valuation allowance will be reexamined and adjusted, if necessary. Liberty recorded $97 thousand and $93 thousand in net alternative minimum tax expenses in 1992 and 1991 respectively. Gross regular income tax expenses in those respective years of $4.7 million and $925 thousand were offset by $4.6 million and $832 thousand of net operating loss carryforwards. ============================================================================== Balance Sheet ============================================================================== Earning Assets - ------------------------------------------------------------------------------ Earning assets averaged $2.0 billion in 1993 compared to $1.8 billion in 1992 and 1991. The increase in average earning assets is attributable principally to Liberty's growth through acquisitions. During 1993, average earning assets comprised approximately 84% of average total assets, the same as 1992 and compared to 83% in 1991. Liberty's percentage of earning assets to total assets is lower than its peer group (which is in the 90% range) partially because of the significant amount of public funds processing done by Liberty. This activity, in which Liberty generates fee income, increases demand deposits and items in process in Liberty's consolidated balance sheet. The composition of Liberty's earning assets also changed in 1993. Because Liberty has been successful in increasing its access to federal funds lines, management elected to reinvest a portion of Liberty's federal funds sold in higher yielding U.S. Treasury securities. Average taxable securities in 1993 increased $263.1 million or 31% to $1.2 billion, while average federal funds sold decreased $115.8 million from $214.9 million in 1992 to $99.1 million in 1993. Average loans increased $88.1 million or 12.6% to $786.3 million. As a percentage of average earning assets, average federal funds sold were 4.6% in 1993 compared to 11.7% in 1992, and, average taxable securities were 54.0% in 1993 compares to 46.3% in 1992, while average loans were unchanged from 1992 to 1993. Investment Securities - ------------------------------------------------------------------------------ SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities," was issued in May, 1993 and becomes effective for fiscal years beginning after December 15, 1993, with early adoption allowed. Liberty adopted the new standard as of December 31, 1993. As a result of the adoption of SFAS No. 115, Liberty recorded an increase in shareholders' investment of $6.2 million at year-end. The statement requires securities to be classified into three categories: "securities held to maturity" (reported at amortized cost); "trading securities" (reported at fair value) with unrealized gains and losses including in earnings; and "securities available for sale" (reported at fair value) with unrealized gains and losses excluded from earnings and reported as a separate component of shareholders' investment. The carrying values for investment securities other than trading securities have traditionally been carried at their historical cost, adjusted for accretion of discounts and amortization of premiums. Trading securities, however, have been required to be recorded at their estimated market values. At December 31, 1992, Liberty classified $49.1 million of investment securities as "available for sale." These securities were accounted for at the lower of cost or market. The securities were principally U.S. Treasury Bills. Proceeds from securities sold during 1993 totaled $508.0 million. The following table shows the recorded amounts for Liberty's investment portfolio as of the end of the previous three years. Investment Portfolio - ------------------------------------------------------------------------------ (In thousands) 1993 1992 1991 - ------------------------------------------------------------------------------ U.S. Treasury Trading $ 195 $ 50 $ 2,548 Available for sale 605,586 49,137 _ Held to maturity 54,478 380,583 242,311 U.S. Government Agencies Mortgage-backed Available for sale 226 _ _ Held to maturity 216,519 370,326 350,450 Other Trading 660 708 1,977 Available for sale 108,550 _ _ Held to maturity 51,467 122,656 168,423 State and political Trading 1,036 1,092 1,574 Available for sale 9,393 _ _ Held to maturity 63,346 70,668 70,282 Other securities Mortgage-backed Available for sale 43,072 _ _ Held to maturity 75,276 124 656 Other Trading _ 1,741 _ Available for sale _ _ _ Held to maturity 1,998 6,392 2,526 Equity 18,628 12,875 11,826 - ------------------------------------------------------------------------------ Total $1,250,430 $1,016,352 $852,573 - ------------------------------------------------------------------------------ Totals Trading securities $ 1,891 $ 3,591 $ 6,099 ============================================================================== Available for sale $ 766,827 $ 49,137 $ _ ============================================================================== Held to maturity $ 463,084 $ 950,749 $834,648 ============================================================================== Equity securities $ 18,628 $ 12,875 $ 11,826 ============================================================================== The market value of Liberty's investment securities portfolio was approximately 100.7% of book value at December 31, 1993. Gross unrealized gains included in the portfolio amounted to $20.7 million and are primarily related to U.S. Treasury securities, U.S. government agencies and other corporate bonds and debentures. Gross unrealized losses in the securities portfolio amounted to $2.8 million, with $1.1 million of the unrealized losses related to Liberty's other mortgage-backed securities portfolio. In addition, Liberty's U.S. Treasury and U.S. government agencies mortgage-backed securities also have small unrealized losses. Loans - ------------------------------------------------------------------------------ Loan concentrations are an important factor in the assessment of risk in the loan portfolio. The composition of the loan portfolio at year-end for the past five years is presented below. Loan Portfolio - ------------------------------------------------------------------------------ (In thousands) 1993 1992 1991 1990 1989 - ------------------------------------------------------------------------------ Commercial and other (1) $376,454 $262,837 $388,493 324,650 $275,538 Energy 57,089 68,576 60,668 57,852 78,950 Real estate _ construction 85,566 67,417 89,704 84,388 129,629 Real estate _ mortgage 199,104 154,410 172,693 171,169 179,440 Correspondent and regional 17,336 16,855 29,063 36,364 57,703 Personal 195,392 106,958 104,970 105,011 100,872 - ------------------------------------------------------------------------------ Total $930,941 $677,053 $845,591 $779,434 $822,132 ============================================================================== (1) Includes term federal funds of $115.0 million in 1991, $35.5 million in 1990 and $10.0 million in 1989. Liberty had no term federal funds at the end of 1993 or 1992. Liberty's loan portfolio reflects significant sensitivity to the movement of interest rates because of its relatively short-term nature and variable pricing. Scheduled maturities of Liberty's loan portfolio (excluding real estate mortgage and personal loans) at December 31, 1993 are summarized below: - ------------------------------------------------------------------------------ After One Within But Within After (In thousands) One Year Five Years Five Years Total - ------------------------------------------------------------------------------ Commercial, correspondent and other $201,591 $146,049 $46,150 $393,790 Energy 18,105 38,984 _ 57,089 Real estate _ construction 50,262 23,514 11,790 85,566 - ------------------------------------------------------------------------------ Total $269,958 $208,547 $57,940 $536,445 ============================================================================== The loans shown above include both loans with an adjustable or floating rate as well as those with a fixed, predetermined rate. The adjustable or floating rate is tied to the national prime rate, Liberty`s base rate or other market rates of interest. The total amount of these loans due after one year which have pre-determined or floating or adjustable rates is summarized in the following table. - ------------------------------------------------- (In thousands) - ------------------------------------------------- Predetermined rate $ 80,966 Floating or adjustable rate 185,521 - ------------------------------------------------- Total $266,487 ================================================= Liberty's personal loans have grown 82% to $195.4 million and constituted 20.9% of total loans at year-end 1993 compared to 15.8% at year-end 1992. This growth is a result of bank acquisitions as well as a policy of emphasizing personal lending. Liberty also commenced credit card issuances during 1993. Credit card loans increased from $31 thousand at the end of 1992 to $1.2 million at the end of 1993. Loans to executive officers and directors (or their associates) of Liberty and its principal subsidiaries are made in the ordinary course of business. These transactions are conducted on substantially the same terms as those prevailing at the time for comparable transactions with other persons and, in management's opinion, do not involve more than normal risk or present other unfavorable features at the time they are made. No related-party borrowings were included in nonperforming loans or potential problem loans at December 31, 1993, 1992 or 1991. Liberty's practices in granting commitments and establishing lines of credit are typical of industry practices and standards. Terms, particularly rates and commitment fees, are subject to individual negotiations, with most commitments extended for a one year period. Liberty's credit standards and review practices with respect to loans are also used in granting commitments and establishing lines of credit. At December 31, 1993, the bank subsidiaries had legally binding loan commitments outstanding amounting to $558.8 million. Liberty does not expect a significant portion of these commitments to be exercised during the near-term. Management is of the opinion that no firm, unfunded commitments of material amounts which represent unusual risks are outstanding, except to the extent included in potential problem loans and/or allocated for in the reserve for loan losses. Nonperforming Loans - ------------------------------------------------------------------------------ Liberty's nonperforming loans consist of nonaccrual, 90 days or more past due and restructured loans. Liberty's consolidated financial statements are prepared on the accrual basis of accounting, including recognition of interest income on its loan portfolio. However, when the full collectibility of interest or principal on any loan becomes uncertain or is collectible only after an extended period of time, that loan is placed on nonaccrual status. Any accrued yet uncollected interest is usually reversed. Thereafter, interest is recognized as income only as it is collected in cash and only to the extent that the collectibility of the principal is not in doubt. Restructured loans include those loans earning interest at rates less than originally contracted due to a troubled debtor situation. Interest on such loans is included in income only to the extent of the reduced rate if it is deemed collectible. Past due loans, while not performing contractually, do not meet the criteria to become nonaccrual. Interest is accrued and payments are divided between income and principal based on the loan contract. Nonperforming loans decreased 32% or $6.3 million to $13.5 million at year-end 1993 from $19.7 million at year-end 1992. This decrease reflects Liberty's effort in reducing nonperforming loans since their year-end peak of $147.7 million in 1987. Of the nonperforming loans at December 31, 1993, approximately 62% were real estate-related. Nonaccrual loans totaled $10.2 million at December 31, 1993. Of these loans, $6.5 million or 64% were contractually current with a total of $7.0 million or 69% representing loans that have met at least 85% of their con- tractual payments during 1993. The contractual balance on total nonaccrual loans was $12.6 million at year-end 1993 with $8.4 million or 67% of these loans contractually current and a total of $9.3 million or 74% rated 85% current or better. Nonperforming Loans - ------------------------------------------------------------------------------ (In thousands) 1993 1992 1991 1990 1989 - ------------------------------------------------------------------------------ Nonaccrual $10,138 $19,244 $37,026 $27,307 $31,483 Restructured _ _ _ _ _ Past due 90 days or more 3,313 487 750 1,058 1,549 - ------------------------------------------------------------------------------ Total nonperforming loans $13,451 $19,731 $37,776 $28,365 $33,032 ============================================================================== Nonperforming Loans as % of Total Loans 1.44% 2.91% 4.47% 3.64% 4.02% ============================================================================== Analysis of Nonperforming Loans by Type - ------------------------------------------------------------------------------ (In thousands) 1993 1992 1991 1990 1989 - ------------------------------------------------------------------------------ Commercial and other $ 3,604 $ 6,436 $ 8,999 $ 6,101 $ 8,488 Energy 632 706 1,685 1,496 1,706 Real estate _ construction 3,236 3,826 7,921 1,197 15,091 Real estate _ mortgage 5,135 8,126 13,378 12,041 1,518 Correspondent and regional _ _ 4,547 6,387 5,129 Personal 844 637 1,246 1,143 1,100 - ------------------------------------------------------------------------------ Total nonperforming loans $13,451 $19,731 $37,776 $28,365 $33,032 ============================================================================== The gross interest income from nonaccrual loans outstanding at December 31, 1993, had they been performing in accordance with their original terms, would have been approximately $1.1 million for 1993. The amount of interest from nonaccrual loans included in interest income for 1993 was approximately $64 thousand. Foregone interest income from nonaccrual and restructured loans for the past five years beginning with 1993 was approximately $1.0 million, $1.5 million, $3.0 million, $1.6 million and $2.7 million, respectively. Potential Problem Loans - ------------------------------------------------------------------------------ "Potential problem loans" are those loans which, although currently performing, have credit weaknesses such that management has serious doubts as to the borrowers' future ability to comply with present terms, and thus may result in a change to nonperforming status. Management has identified, through internal credit ratings, certain performing loans which demonstrate some dete- rioration in credit quality and, accordingly, are scrutinized more carefully. At December 31, 1993, these loans totaled $17.0 million compared to $5.1 million and $13.3 million at December 31, 1992 and 1991, respectively. Of these amounts, approximately $98 thousand, $415 thousand and $3.7 million represented letters of credit and unfunded loan commitments at December 31, 1993, 1992 and 1991, respectively. The increase at year-end 1993 was primarily attributable to one large loan which was favorably resolved subsequent to the end of the year. Exposure to loss of principal on such loans and commitments has been considered in the establishment of the reserve for loan losses. Reserve for Loan Losses - ------------------------------------------------------------------------------ Liberty allocates the reserve for loan losses according to the amount deemed by management to be reasonably necessary to provide for inherent losses within the categories of loans set forth in the following table. It should be recognized that such allocations are not precise and are not necessarily indicative of future loan losses. Although the loan loss reserve has been allocated among loan categories, all of such reserve is available to absorb all losses on loans from any category. Known loan losses and recoveries are charged to the loan loss reserve on a monthly basis. Allocation of Reserve for Loan Losses - ------------------------------------------------------------------------------ (In thousands) 1993 1992 1991 1990 1989 - ------------------------------------------------------------------------------ Commercial and other Reserve amount $1,151 $2,382 $2,518 $3,610 $4,786 Loans as a percent of total loans 40.76% 39.55% 46.26% 41.93% 33.51% Energy Reserve amount 3,305 2,603 635 939 2,003 Loans as a percent of total loans 6.10% 10.00% 7.13% 7.38% 9.60% Real estate _ construction Reserve amount 999 2,533 4,611 3,605 7,454 Loans as a percent of total loans 9.14% 9.84% 10.55% 10.77% 15.77% Real estate _ mortgage Reserve amount 452 2,533 1,041 1,187 2,036 Loans as a percent of total loans 21.27% 22.54% 20.30% 21.88% 21.83% Correspondent and regional Reserve amount 183 545 3,490 3,756 4,358 Loans as a percent of total loans 1.85% 2.46% 3.42% 4.64% 7.02% Personal Reserve amount 1,834 1,232 1,191 1,676 2,097 Loans as a percent of total loans 20.88% 15.61% 12.34% 13.40% 12.27% Unallocated reserve 12,062 13,753 12,502 10,057 9,411 - ------------------------------------------------------------------------------ Total reserve $19,986 $25,581 $25,988 $24,830 $32,145 Reserve for loan losses as % of total loans 2.14% 3.73% 3.06% 3.17% 3.91% Reserve for loan losses as % of nonperforming loans 148.58% 129.65% 68.80% 87.54% 97.31% - ------------------------------------------------------------------------------ Net loan recoveries for 1993 totaled approximately $527 thousand versus net charge-offs of $2.3 million in 1992 and $1.1 million in 1991. At December 31, 1993, the consolidated reserve for loan losses amounted to $20.0 million or 2.1% of total loans and 148.6% of nonperforming loans. This level compares with a reserve of $25.6 million or 3.8% of total loans and 129.7% of nonperforming loans in 1992 and with a reserve of $26.0 million or 3.1% of total loans and 68.8% of nonperforming loans in 1991. The following table summarizes average loan balances, changes in the reserve for loan losses arising from loans charged off and recoveries on loans previously charged off, by loan category, and additions to the reserve which have been charged to operating expense. Analysis of Reserve for Loan Losses - ------------------------------------------------------------------------------ (In thousands) 1993 1992 1991 1990 1989 - ------------------------------------------------------------------------------ Balance at beginning of year $ 25,581 $ 25,988 $ 24,830 $ 32,145 $ 61,208 Charge-offs Commercial and other 258 1,369 1,901 1,653 6,453 Energy _ 22 81 957 5,315 Real estate _ construction 378 1,511 190 3,749 8,909 Real estate _ mortgage 61 435 224 890 734 Correspondent and regional 22 433 22 _ 2,701 Personal 1,154 835 779 1,111 1,240 - ------------------------------------------------------------------------------ Total charge-offs 1,873 4,605 3,197 8,360 25,352 - ------------------------------------------------------------------------------ Recoveries Commercial and other 680 520 863 818 1,116 Energy 106 100 338 1,542 1,072 Real estate _ construction 679 620 377 962 532 Real estate _ mortgage 264 562 55 166 79 Correspondent and regional 1 173 56 339 155 Personal 670 360 414 585 491 - ------------------------------------------------------------------------------ Total recoveries 2,400 2,335 2,103 4,412 3,445 - ------------------------------------------------------------------------------ Net charge-offs ( 527) 2,270 1,094 3,948 21,907 Provisions for loan losses (7,363) 1,793 2,252 (3,367) (7,156) Reserves from acquired banks 1,241 70 _ _ _ - ------------------------------------------------------------------------------ Balance at end of year $ 19,986 $ 25,581 $ 25,988 $ 24,830 $ 32,145 ============================================================================== Average loans outstanding (1) $786,275 $698,162 $757,411 $749,585 $901,033 ============================================================================== Ratio of net charge-offs (recoveries) to average loans outstanding (.07%) .32% .14% .53% 2.43% ============================================================================== (1) Includes loans held for sale. Other Real Estate and Assets Owned - ------------------------------------------------------------------------------ OREO (net of reserves) decreased to $10.8 million at December 31, 1993, compared to $15.7 million and $36.2 million at December 31, 1992 and 1991, respectively. At year-end 1993, foreclosed land represented 66% of other real estate and assets owned before reserves. Commercial office buildings and motels as well as single-family residential properties were also significant categories of other real estate at year-end 1993, representing 19% and 12%, respectively, of the total other real estate and assets owned. Other Real Estate and Assets Owned - ------------------------------------------------------------------------------ (In thousands) 1993 1992 1991 1990 1989 - ------------------------------------------------------------------------------ Land $ 8,791 $14,516 $21,773 $38,200 $ 52,530 Commercial _ office buildings and motels 2,487 2,481 7,541 20,639 16,987 Commercial _ shopping centers 200 660 8,429 17,125 19,382 Residential _ single-family 1,631 1,122 1,754 2,087 4,526 Residential _ multi-family _ 57 3,756 4,427 11,649 Oil and gas properties _ 306 523 765 980 Other 256 1,520 3,851 4,321 3,355 - ------------------------------------------------------------------------------ Total other real estate and assets owned $13,365 $20,662 $47,627 $87,564 $109,409 Less reserve for losses (2,521) (5,001) (11,447) (22,078) (26,516) - ------------------------------------------------------------------------------ Other real estate and assets owned, net $10,844 $15,661 $36,180 $65,486 $ 82,893 ============================================================================== Reserve for Losses on Other Real Estate and Assets Owned - ------------------------------------------------------------------------------ (In thousands) 1993 1992 1991 1990 1989 - ------------------------------------------------------------------------------ Balance at beginning of year $5,001 $11,447 $22,078 $26,516 $22,071 Charge-offs (1,515) (4,105) (10,791) (16,652) (15,540) Provisions for losses (1,207) (2,341) 160 12,214 19,985 Reserves from acquired banks 242 _ _ _ _ - ------------------------------------------------------------------------------ Balance at end of year $2,521 $5,001 $11,447 $22,078 $26,516 ============================================================================== Reserve for Losses on Other Real Estate and Assets Owned as % of Total Other Real Estate and Assets Owned 18.86% 24.20% 24.03% 25.21% 24.24% ============================================================================== Charge-offs (which include losses on sales and market writedowns) for 1993 were approximately $1.5 million compared to $4.1 million in 1992 and $10.8 million in 1991. As a result, the reserve for losses on other real estate and assets owned totaled $2.5 million, $5.0 million and $11.4 million at December 31, 1993, 1992 and 1991, respectively. These reserves as a percentage of total other real estate and assets owned were 19% for 1993 compared to 24% for 1992 and 1991. The reserves are in addition to recording foreclosed real estate at or below current appraisal values. Capital Funds - ------------------------------------------------------------------------------ Year-end equity capital as a percentage of total assets amounted to 8.5% for 1993, compared to 7.4% for 1992 and 6.4% for 1991. Capital adequacy is currently measured by banking regulators using various capital criteria and ratios under the heading of risk-based capital. Tier 1 capital for bank holding companies includes common equity and perpetual preferred stock (subject to certain limitations) minus intangible assets. Tier 2 capital includes supplementary elements such as limited amounts of reserve for loan losses, perpetual preferred stock (in excess of Tier 1 limits), subordinated debt and other items. The leverage ratio, defined as Tier 1 capital divided by average adjusted total assets, limits the amount of leverage a bank can undertake because of the ratio's emphasis on equity or core capital. All but the most highly-rated banks are required to carry a minimum leverage ratio of 3% plus a cushion of 1 to 2%. The risk-based capital ratio, defined as total capital (Tier 1 plus Tier 2) divided by risk-weighted assets, is the regulators' other primary determinant of capital adequacy and was de- signed principally as a measure of credit risk. Banking organizations have been given a risk-based capital ratio requirement of 8%. The Federal Deposit Insurance Corporation ("FDIC") assesses insurance premiums based in part on the level of capital with banks which are "well capitalized" paying assessments at lower rates. Liberty's and its subsidiary banks' capital ratios are significantly higher than the current guidelines and the subsidiary banks are "well capitalized" for deposit insurance purposes. Risk-based Capital - ------------------------------------------------------------ (In thousands) 1993 1992 - ------------------------------------------------------------ Tier 1 Capital Shareholders' investment $ 227,245 $ 178,841 Nonqualifying assets (18,770) _ Intangible assets (10,650) (3,160) Total Tier 1 Capital 197,825 175,681 Tier 2 Capital Reserve for loan losses (1) 17,519 13,103 - ------------------------------------------------------------ Total capital 215,344 188,784 ============================================================ Risk-weighted Assets $1,401,496 $1,035,729 ============================================================ Leverage Ratio 7.87% 7.97% Risk-based Ratio 15.37 18.23 (1) Limited to 1.25% of risk-weighted assets. Liberty Oklahoma City had a risk-based capital ratio of 13.1% and Liberty Tulsa had a risk-based capital ratio of 17.8%. Liberty and its subsidiary banks exceed required ratios for 1993 and plan to do so in the future. Deposits - ------------------------------------------------------------------------------ Deposits represent the principal source of funds for Liberty Oklahoma City and Liberty Tulsa. Average deposits constituted approximately 80% of Liberty's average level of total assets in 1993, with total deposits averaging $2.0 billion in 1993 and $1.7 billion in 1992 and 1991. Levels of both demand deposits and interest bearing deposits increased in 1993 and 1992 primarily due to bank acquisitions. Average Deposits - ------------------------------------------------------------------------------ (In thousands) 1993 1992 1991 - ------------------------------------------------------------------------------ Noninterest-bearing demand deposits $ 615,567 $ 551,121 $ 521,544 Interest-bearing demand deposits 481,595 408,474 350,665 Savings 142,174 98,196 85,497 Time deposits 717,977 682,799 718,295 - ------------------------------------------------------------------------------ Total $1,957,313 $1,740,590 $1,676,001 ============================================================================== The previous table includes average deposits with the branches of Liberty Oklahoma City and Liberty Tulsa in Nassau, The Bahamas of $33.0 million, $39.5 million and $52.1 million for the years 1993, 1992 and 1991, respectively. As of December 31, 1993, time certificates of deposit and other time deposits issued in amounts of $100,000 or more mature as follows: - ------------------------------------------------------------------------------ (In thousands) - ------------------------------------------------------------------------------ Within three months $226,950 After three but within six months 30,517 After six but within twelve months 39,338 After twelve months 17,014 - ------------------------------------------------------------------------------ Total $313,819 ============================================================================== Both Liberty Oklahoma City and Liberty Tulsa continue to be primarily funded in the local market place. In management's opinion, funding and liquidity at Liberty's bank subsidiaries are adequate to meet current and projected financial commitments. Short-term Borrowings - ------------------------------------------------------------------------------ The details of the major sources of short-term borrowings are included in the following tables. The general terms of these borrowings are consistent with industry standards. Federal Funds Purchased and Securities Sold Under Agreements to Repurchase - ------------------------------------------------------------------------------ (In thousands) 1993 1992 1991 - ------------------------------------------------------------------------------ Borrowings outstanding At year-end $116,486 $144,400 $136,781 Average for the year 122,103 120,173 170,608 Maximum month-end balance 167,608 144,400 208,814 Interest rates Average for the year 2.9% 3.3% 5.5% Average at end of year 2.9 2.5 3.8 - ------------------------------------------------------------------------------ Treasury, Tax and Loan Deposits and Other Short-Term Borrowings - ------------------------------------------------------------------------------ (In thousands) 1993 1992 1991 - ------------------------------------------------------------------------------ Borrowings outstanding At year-end $161,626 $140,693 $227,407 Average for the year 110,847 106,944 121,719 Maximum month-end balance 241,434 281,423 227,407 Interest rates Average for the year 3.2% 3.4% 5.3% Average at end of year 2.9 2.7 3.8 - ------------------------------------------------------------------------------ International Exposure - ------------------------------------------------------------------------------ Liberty has little direct exposure to foreign credits. This exposure has primarily been limited to federal funds sold to the domestic branches of foreign banks. Cross-border outstandings include loans, acceptances, interest-bearing deposits with other banks and interest-bearing investments or other monetary assets denominated in nonlocal currencies of foreign banks (including domestic branches of foreign banks). At December 31, 1993, Liberty had $1.2 million in cross-border outstandings (none of which was with domestic branches of foreign banks), compared to $35.9 million at December 31, 1992 and $246.5 million at December 31, 1991. There were no cross-border outstandings of foreign countries exceeding 1% of total assets at December 31, 1993. Cross-border outstandings of foreign countries exceeding 1% of total assets at December 31, 1992 included $25.0 million with Japan. This compares with $165.3 million with Japan, $35.4 million with Canada and $25.0 million with Italy at the end of 1991. Cross-border outstandings of foreign countries between .75% and 1% of total assets were $20.0 million with Australia at the end of 1991. There were no cross-border outstandings in this range in 1993 or 1992. This decrease is due to the maturity of those term federal funds sold. Asset and Liability Management - ------------------------------------------------------------------------------ A senior management committee, the Investment/Asset/Liability Committee, has the responsibility for monitoring and coordinating the asset and liability positions, interest rate sensitivity, liquidity and other resource planning strategies of Liberty on an ongoing basis. This committee monitors the anticipated effects of interest rate changes on both earnings and market value of capital of interest rate moves from 50 to 400 basis points. In addition, the committee has recommended policies which the Board of Directors has adopted setting limits within which the asset/liability risk positions are to be maintained. As a result of increased holdings of loans and marketable investment securities, Liberty was a net purchaser of federal funds averaging $28.5 million for 1993 compared to a net seller of federal funds averaging $91.7 million and $93.8 million in 1992 and 1991, respectively. Liquidity is the ability to meet financial obligations for the payment of funds. Some of the sources of funds to provide liquidity include core deposits, large certificates of deposit, federal funds purchased from both upstream and downstream banks, sale of securities under agreements to repurchase, Treasury Tax and Loan accounts, investment securities held in the available-for sale account which can be sold or pledged for borrowing at the Federal Reserve discount window or the Federal Home Loan Bank and the availability of loans and investment securities held in the held-to-maturity account which can be pledged for borrowing at the Federal Reserve discount window or the Federal Home Loan Bank. Interest Rate Sensitivity - ------------------------------------------------------------------------------ Liberty's long-standing policy is to maintain as balanced a position in interest-sensitive assets and liabilities as possible with a goal to achieve consistent interest margins in all interest rate environments. Liberty is liability sensitive largely due to the short-term nature of its deposits, especially savings and money market accounts, and short-term borrowings. Be- cause of this liability sensitivity, Liberty's net interest margin may be vulnerable to upward trends in interest rates. The net interest margin of Liberty has been impacted by a decline in interest rates, as experienced in the past year, in two ways. First, because Liberty is liability sensitive, its liabilities reprice at the lower rates sooner than its assets. As such, the net interest margin is widened as li- abilities are repriced or mature. However, the decline in liability rates, particularly in a lower rate environment, may not decrease as much as asset rates because there is a perceived level below which deposit rates likely will not fall. Liberty monitors its interest-sensitivity posture on a continuing basis to ensure that interest rate changes do not create a material adverse im- pact. Liberty also adjusts its asset and liability structures, to the extent possible, to allow for projected rate changes. A table showing the repricing of Liberty's earning assets and interest-bearing liabilities is below. Deposits without maturities, such as savings, now accounts and money market accounts, are classified as less than 90 days. Interest Rate Sensitivity - ------------------------------------------------------------------------------ 0-90 91-365 One to After (In thousands) Days Days Five Years Five Years Total - ------------------------------------------------------------------------------ Earning Assets Loans (1) $ 503,239 $ 39,888 $222,671 $165,143 $ 930,941 Securities 262,310 361,959 471,855 154,306 1,250,430 Other earning assets 27,152 _ _ _ 27,152 - ------------------------------------------------------------------------------ Total earning assets 792,701 401,847 694,526 319,449 2,208,523 - ------------------------------------------------------------------------------ Interest-bearing Liabilities Deposts 1,084,820 193,900 115,857 41,340 1,435,917 Short-term borrowings 261,112 8,000 9,000 _ 278,112 - ------------------------------------------------------------------------------ Total interest- bearing liabilities 1,345,932 201,900 124,857 41,340 1,714,029 - ------------------------------------------------------------------------------ Net position ($ 553,231) $199,947 $569,669 $278,109 $ 494,494 ============================================================================== Cumulative net position ($ 553,231) ($353,284) $216,385 $494,494 $ 494,494 ============================================================================== % of earning assets (25.0)% (16.0)% 9.8% 22.4% 22.4% ============================================================================== (1) Includes loans held for sale Parent Company Funding Sources and Dividends - ------------------------------------------------------------------------------ At December 31, 1993, the parent company had cash, including interest- bearing deposits, of $6.2 million. This compares to $7.3 million at December 31, 1992. The primary changes in the funding position of the parent company are due to the payoff of notes payable assumed in the acquisitions of financial institutions, the payoff of long-term notes of Liberty Real Estate Company, the payment of dividends, and advances to subsidiary companies offset by sales of other real estate and dividends received from subsidiary banks. Liberty's ability to fund various operating expenses and dividends is generally dependent on parent-only earnings, cash reserves and funds derived from its subsidiaries, principally Liberty Oklahoma City and Liberty Tulsa. These funds historically have been provided primarily by intercompany dividends and management fees. Management fees are generally limited to reimbursement of actual expenses. It is anticipated that Liberty's recurring cash sources will continue to include dividends and management fees from subsidiaries, proceeds from the sale of other assets (principally other real estate and assets owned) and retained rights to any gains from the sales of mortgage servicing or other assets. Dividends may be paid by subsidiary banks from time to time to support Liberty's acquisition activities. Liberty Oklahoma City and Liberty Tulsa are limited in their ability to pay dividends based on applicable provisions of the National Bank Act pertaining to earnings and undivided profits. As of January 1, 1994 the ability of Liberty Oklahoma City and Liberty Tulsa to pay dividends without regulatory approval was limited to $30,500,000 and $17,600,000, respectively. Liberty Real Estate Company, a wholly-owned subsidiary, is dependent upon Liberty for financial support to cover deficits in operating cash flows result- ing from operating costs, debt service, capital expenditures and other needs. These costs are primarily intercompany and insignificant to Liberty as a whole. It is anticipated that Liberty will continue to provide such support. During the fourth quarter of 1993 Liberty paid off a long-term 8% note which was secured by Liberty Tower. The principal on the note, entered into in 1982 in connection with the purchase of Liberty Tower, was $7.1 million along with a prepayment penalty of $82 thousand. Liberty also purchased the ground lease pertaining to Liberty Tower for $1.8 million. The prepayment of these obligations was considered beneficial in light of current interest rates. Liberty paid three quarterly cash dividends of $.10 per common share in 1993, totaling $2.7 million. Prior to 1993, Liberty had not paid cash dividends since 1986. It is expected that such cash dividends, at levels to be determined by the Board of Directors from time to time, will continue if justified by Liberty's earnings, capital adequacy and financial condition. In management's opinion, Liberty's current liquidity and cash sources are anticipated to be adequate to meet its obligations in the near term. Liberty Bancorp, Inc. CONSOLIDATED BALANCE SHEET December 31 (In thousands, except share data) 1993 1992 - ------------------------------------------------------------------------------ Assets Cash and due from banks Noninterest-bearing $ 310,127 $ 293,596 Interest-bearing 2,587 9,009 Federal funds sold and securities purchased under agreements to resell 24,565 333,148 Investment securities: Trading account 1,891 3,591 Available for sale 766,827 49,137 Held to maturity 463,084 950,749 Equity 18,628 12,875 - ------------------------------------------------------------------------------ Total securities 1,250,430 1,016,352 - ------------------------------------------------------------------------------ Loans 930,941 677,053 Less: Reserve for loan losses (19,986) (25,581) - ------------------------------------------------------------------------------ Loans, net 910,955 651,472 - ------------------------------------------------------------------------------ Other real estate and assets owned, net 10,844 15,661 Property and equipment, net 64,152 49,380 Accrued income receivable 23,675 18,035 Accounts receivable 17,639 12,546 Deferred tax asset, net 13,584 - Other assets 31,218 28,961 - ------------------------------------------------------------------------------ Total Assets $2,659,776 $2,428,160 ============================================================================== Liabilities and Shareholders' Investment Deposits Noninterest-bearing $ 689,227 $ 665,759 Interest-bearing 1,435,917 1,263,320 - ------------------------------------------------------------------------------ Total deposits 2,125,144 1,929,079 Short-term borrowings Federal funds purchased and securities sold under agreements to repurchase 116,486 144,400 Other 161,626 140,693 Accrued interest, expenses and taxes 15,503 16,745 Accounts payable 11,621 9,500 Long-term notes - 7,545 Other liabilities 2,151 1,357 - ------------------------------------------------------------------------------ Total Liabilities 2,432,531 2,249,319 - ------------------------------------------------------------------------------ Shareholders' Investment Common stock ($.01 par value; 50,000,000 shares authorized) 95 88 - -------------------------------------------------- 1993 1992 - -------------------------------------------------- Shares issued 9,477,870 8,815,450 Shares outstanding 9,477,819 8,815,399 Capital surplus 211,708 204,165 Retained earnings (accumulated deficit) 11,785 (22,587) Treasury stock, at cost - 51 common shares (1) (1) Unrealized security gains, net of tax 6,184 - Deferred compensation (2,526) (2,824) Total Shareholders' Investment 227,245 178,841 - ------------------------------------------------------------------------------ Total Liabilities and Shareholders' Investment $2,659,776 $2,428,160 ============================================================================== The accompanying notes are an integral part of these consolidated financial statements. Liberty Bancorp, Inc. CONSOLIDATED STATEMENT OF INCOME For the year (In thousands, except per share data) 1993 1992 1991 - ------------------------------------------------------------------------------- Interest Income Loans $62,093 $54,982 $68,872 Investments Taxable 60,261 58,137 56,897 Nontaxable 2,765 3,058 3,040 Trading 199 383 480 Federal funds sold and other 3,083 7,546 15,256 - ------------------------------------------------------------------------------- Total Interest Income 128,401 124,106 144,545 - ------------------------------------------------------------------------------- Interest Expense Deposits 46,162 51,846 72,625 Short-term borrowings 7,079 7,657 15,820 Long-term notes 592 700 977 - ------------------------------------------------------------------------------- Total Interest Expense 53,833 60,203 89,422 - ------------------------------------------------------------------------------- Net Interest Income 74,568 63,903 55,123 Provision for loan losses (7,363) 1,793 2,252 - ------------------------------------------------------------------------------- Net Interest Income After Provision for Loan Losses 81,931 62,110 52,871 - ------------------------------------------------------------------------------- Noninterest Income Trust fees 15,508 15,523 14,789 Service charges on deposits 12,925 10,900 9,235 Mortgage banking income 7,449 7,391 5,771 Trading account profits and commissions 4,591 3,713 4,089 Net securities gains (losses) 2,750 11 (200) Loan fees 1,992 2,053 1,736 Other 11,501 9,065 8,480 - ------------------------------------------------------------------------------- Total Noninterest Income 56,716 48,656 43,900 - ------------------------------------------------------------------------------- Noninterest Expense Salaries 44,701 37,643 36,586 Employee benefits 9,088 6,281 7,379 Professional and other services 10,001 8,543 8,128 Occupancy, net 8,806 7,336 6,861 Equipment 8,094 6,785 6,535 Amortization of intangibles, including purchased mortgage servicing rights 6,741 3,528 1,635 Data processing 5,901 5,866 5,735 Printing, postage and supplies 5,789 4,757 4,351 Deposit insurance assessments 4,564 3,814 3,191 Advertising and business development 4,382 3,119 2,463 Net income from operation of other real estate and assets owned (3,408) (5,982) (2,486) Other 14,069 10,861 10,509 - ------------------------------------------------------------------------------- Total Noninterest Expense 118,728 92,551 90,887 - ------------------------------------------------------------------------------- Income Before Provision (Benefit) for Income Taxes 19,919 18,215 5,884 Provision (benefit) for Income taxes (2,358) 4,737 925 - ------------------------------------------------------------------------------- Income Before Cumulative Effect of Change in Accounting Principle and Extraordinary Item 22,277 13,478 4,959 Cumulative effect of change in accounting principle 14,255 - - Extraordinary item - use of net operating loss carryforwards - 4,640 832 - ------------------------------------------------------------------------------- Net Income $36,532 $18,118 $5,791 =============================================================================== Income Per Share (Primary and Fully-Diluted) Income before cumulative effect of change in accounting principle and extraordinary item $2.28 $1.49 $.57 Cumulative effect of change in accounting principle 1.46 - - Extraordinary item - use of net operating loss carryforwards - .52 .09 - ------------------------------------------------------------------------------- Net Income - Primary and Fully-Diluted $3.74 $2.01 $.66 =============================================================================== The accompanying notes are an integral part of these consolidated financial statements. Liberty Bancorp, Inc. CONSOLIDATED STATEMENT OF CASH FLOWS - ------------------------------------------------------------------------------- For the year (In thousands) 1993 1992 1991 - ------------------------------------------------------------------------------- Cash provided (absorbed) by operating activities Net income $ 36,532 $ 18,118 $ 5,791 Adjustments to reconcile net income to net cash provided (absorbed) by operating activities Provisions for losses (7,335) 407 4,102 Cumulative effect of change in accounting principle (14,255) _ _ Extraordinary item - use of net operating loss carryforwards - (4,640) (832) Deferred income taxes (2,688) 4,640 832 Depreciation and amortization 12,833 8,018 6,626 Net amortiztion (accretion) of investment securities 12,125 (340) (1,319) Gain on sale of assets (9,418) (7,267) (6,296) Change in trading account securities 5,265 6,582 4,874 Loans made for purposes of resale (143,722) (121,993) (96,105) Proceeds from sale of loans held for resale 116,748 124,955 75,422 Change in accrued income and accounts receivable (10,642) 30,004 (14,593) Change in other assets (1,110) 6,131 (1,826) Change in accrued interest, expenses, taxes, accounts payable and other liabilities (3,093) (19,785) (71) - ------------------------------------------------------------------------------- Net cash provided (absorbed) by operating activities (8,760) 44,830 (23,395) - ------------------------------------------------------------------------------- Cash provided (absorbed) by investing activities Maturities of investment securities 399,023 265,814 103,325 Sales of investment securities 507,971 225,028 187,833 Purchases of investment securities (1,038,172) (643,325) (437,261) Change in net loans made by bank subsidiaries (109,283) 168,550 (50,637) Principal payments received on loans made by parent company and nonbank subsidiaries 1,545 2,226 1,995 Loans made to customers by nonbank subsidiaries (2,370) (212) (492) Expenditures for property and equipment (16,111) (5,777) (2,982) Proceeds from sale of property and equipment 487 164 26 Sale proceeds and collections from other real estate and assets owned 9,938 27,489 35,453 Capitalized expenditures for other real estate and assets owned _ _ (68) Cash and cash-equivalents received in financial institution acquisitions, net of consideration paid (1,552) 5,814 73,406 Purchases of mortgage servicing contracts (191) (3,176) (7,661) - ------------------------------------------------------------------------------- Net cash provided (absorbed) by investing activities (248,715) 42,595 (97,063) - ------------------------------------------------------------------------------- Cash provided (absorbed) by financing activities Change in savings and demand deposits 50,264 28,880 73,605 Change in time deposits (73,734) (41,891) (91,469) Change in short-term borrowings (7,709) (79,094) (28,861) Payment on long-term notes (7,627) (2,377) (1,150) Proceeds from issuance of common and treasury stock for employee benefit plans 949 595 238 Purchase of treasury stock (440) - - Dividends paid on common stock (2,702) _ _ - ------------------------------------------------------------------------------- Net cash absorbed by financing activities (40,999) (93,887) (47,637) - ------------------------------------------------------------------------------- Net change in cash and cash-equivalents (298,474) (6,462) (168,095) Cash and cash equivalents at beginning of year 635,753 642,215 810,310 - ------------------------------------------------------------------------------- Cash and cash equivalents at end of year $337,279 $635,753 $642,215 =============================================================================== The accompanying notes are an integral part of these consolidated financial statements. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 1 Accounting Policies The accounting and reporting policies of Liberty Bancorp, Inc. ("Liberty") reflect industry practices and are in accordance with generally accepted accounting principles. Certain reclassifications have been made to provide con- sistent financial statement classifications in the periods presented herein. Such reclassifications had no effect on net income or total assets. The more significant accounting policies are described below. Consolidation - The consolidated financial statements include the accounts of the parent company and all significant subsidiaries including Liberty Bank and Trust Company of Oklahoma City, N.A. ("Liberty Oklahoma City") and Liberty Bank and Trust Company of Tulsa, N.A. ("Liberty Tulsa"). All significant intercompany accounts and transactions have been eliminated in the accompanying consolidated financial statements. Investment Securities - Securities purchased for trading purposes are held in the trading portfolio at estimated market value, with unrealized gains and losses reported in earnings. Securities that are being held for indefinite periods of time, including securities that management intends to use as part of its asset/liability strategy, or that may be sold in response to changes in interest rates, changes in prepayment risk, the need to increase regulatory capital or other situations are classified as available for sale and are carried (at December 31, 1993) at estimated market value with unrealized gains and losses reported as a separate component of shareholders' investment, net of income tax. Prior to December 31, 1993, securities classified as available for sale were carried at the lower of amortized cost or estimated market value, with unrealized losses reported in earnings. Other debt securities that management has the ability and intent to hold to maturity are classified as held to maturity and are carried at cost, adjusted for amortization of premiums and accretion of discounts. Equity securities which do not have a readily determinable market value are carried at cost. Gains and losses on the sale of investment securities are reported as of the trade date and are included as a component of noninterest income. Applicable income taxes are included as income taxes in the accompanying consolidated statement of income. Gains and losses are determined by the use of the specific cost identification method. Loans - Loans are placed on nonaccrual status when they become 90 days past due unless their collateral position or other conditions warrant continued accrual status. Previously accrued but uncollected interest on these loans is usually reversed. Interest on nonaccrual loans is recognized only as it is re- ceived and only to the extent that the collectibility of the principal is not in doubt. Loan fees are deferred and recognized over the commitment and/or loan period. Fees that are an adjustment of yield are included in interest income and all other fees are included in noninterest income. Costs associated with the origination of loans are expensed as incurred rather than capitalized and amortized as the amount is not considered material. Loans which Liberty does not intend or does not expect to hold until maturity are reported as held for sale. These loans are carried at cost which approximates market value. Gains and losses on the sale of loans held for sale are determined by the use of the specific identification method and are reflected as a component of noninterest income. Reserve for Loan Losses - The reserve for loan losses is established by charges to income. The reserve is an amount which management believes will be adequate to absorb losses on existing loans that become uncollectible. The level of the reserve is based on a number of factors, including the collection of loans and the evaluation of underlying collateral values, loss experience, identification and review of specific problem loans, overall quality of the portfolios, and current business and economic conditions. The adequacy of the reserve is periodically reviewed and approved by the Board of Directors. Ul- timate losses, however, may differ from the current estimates. To the extent that adjustments to increase and decrease the reserve for loan losses become necessary, they are reported in earnings in the periods in which they become known. It is Liberty's policy to charge off any loan or portion thereof when it is deemed uncollectible in the ordinary course of business. Loan losses and recoveries are charged or credited directly to the reserve for loan losses. Other Real Estate and Assets Owned - Other real estate and assets owned are carried at the lower of loan carrying amount or fair value, net of estimated selling costs. Write-downs at the time of acquisition are accounted for as loan losses. The reserve for losses on other real estate and assets owned is established by charges to income. The reserve is an amount which management believes will be adequate to absorb inherent losses from the dispo- sition and/or decreases in fair value of those properties. Losses and subsequent writedowns are charged to the reserve for other real estate and assets owned. Operating income received and gains from the subsequent disposi- tion of these assets are included as a component of net income from operation of other real estate and assets owned. Property and Equipment - Property and equipment are stated at cost, less accumulated depreciation and amortization. Depreciation is computed on a straight-line basis over the estimated useful lives of the assets. Leasehold improvements are amortized over the estimated useful lives of the assets or the terms of the leases, whichever is shorter. Maintenance and repairs are charged to expense as incurred. Intangible Assets - Intangible assets consist primarily of premiums paid as a result of branch and bank acquisitions and purchased mortgage servicing rights. These assets are included as a component of other assets and amounted to $13,892,000 and $13,250,000 at December 31, 1993 and 1992, respectively, net of accumulated amortization. The intangible assets, other than purchased mortgage servicing rights, are being amortized over their estimated lives (ranging from 10 to 18 years) by either the straight-line or interest methods. Purchased mortgage servicing rights, which totaled $3,728,000 and $9,930,000 at the end of 1993 and 1992, respectively, are being amortized over the estimated servicing lives of the loans to which they relate in proportion to net servicing income. Income Taxes - Effective January 1, 1993, deferred income taxes are provided to reflect the future tax consequences of differences between the tax bases of assets and liabilities and their reported amounts in the consolidated balance sheet. Prior years' deferred taxes, if any, were provided for timing differences between items of income or expense reported for financial statement purposes and those reported for income tax purposes. See Note 11 for a discussion of the effects of the change in accounting for income taxes. Transactions with Related Parties - In the ordinary course of business, directors of Liberty, members of the advisory board, executive officers and principal shareholders of Liberty and their associates engage in business transactions with Liberty. These transactions are conducted on substantially the same terms as those prevailing at the time for comparable transactions with other persons and, in management's opinion, do not involve more than normal risk or present other unfavorable features. Earnings per Share - Earnings per share is calculated using Liberty's weighted average common and common-equivalent shares (primarily stock options) outstanding during the periods. The weighted average number of shares used to compute primary and fully-diluted earnings per share are presented as follows: - ------------------------------------------------------------------------------ (In thousands) 1993 1992 1991 - ------------------------------------------------------------------------------ Weighted average shares outstanding Primary 9,765 8,995 8,781 Fully-diluted 9,765 9,061 8,840 Statement of Cash Flows - For purposes of reporting cash flows, cash and cash-equivalents represent cash and due from banks, including interest-bearing deposits with original maturities less than 90 days, federal funds sold and securities purchased under agreements to resell. Supplemental cash flow information includes the following. - ------------------------------------------------------------------------------ (In thousands) 1993 1992 1991 - ------------------------------------------------------------------------------ Interest paid $54,899 $64,979 $91,858 Loans transferred to other real estate and assets owned 1,559 1,203 2,282 Income taxes paid 762 100 219 Loans made by Liberty to finance sales of other real estate and assets owned totaled approximately $630,000 in 1993 and $10,156,000 in 1992. Fair Value of Financial Instruments - Liberty discloses certain information regarding the fair value of its financial instruments. A financial instrument is defined as cash, evidence of ownership interest in an entity or a contractual arrangement that involves cash or another financial instrument. Market prices are the best evidence of the fair value of financial instruments. If quoted market prices are not available, a best estimate is made based on quoted market prices of a financial instrument with similar characteristics or on valuation techniques. Although the fair value of financial instruments with quoted market prices are generally indicative of the amount at which an instru- ment could be exchanged in a current transaction between willing parties, other than in a forced or liquidation sale, the fair value of financial instruments without an available quoted market price can vary greatly depending on the method and assumptions used in the valuation techniques. The process of determining the best estimate of the fair value of financial instruments is complex and requires significant judgments to be made by management. Computation of fair values for these financial instruments without an available quoted market price is based upon the computation of the present value of estimated future cash flows, utilizing a discount rate com- mensurate with the risks associated with the various financial instruments. The discount rate is based upon the U.S. Treasury yield curve with adjustments determined by management for consideration of, among others, credit risk, pre- payment risk and operational costs. The fair value of a given financial instrument may change substantially over time as a result of, among other things, changes in scheduled or fore- casted cash flows, movement of the U.S. Treasury yield curve, and changes in management's estimates of the related credit risk or operational costs. Conse- quently, significant revisions to fair value estimates may occur during future periods. Management believes it has taken reasonable efforts to ensure that fair value estimates presented are accurate. However, adjustments to fair value estimates may occur in the future and actual amounts realized from financial instruments held as of December 31, 1993 and 1992, may differ from the amounts presented herein. The fair value estimates of Liberty's financial instruments are pre- sented in the respective footnotes with the exception of cash and cash equivalents and demand deposits. The carrying amounts reported in the consolidated balance sheet for these instruments approximate their fair values. The fair values presented apply only to financial instruments and, as such, do not include such items as fixed assets, other real estate and assets owned, other assets and liabilities as well as other intangibles which have resulted over the course of business. As a result, the aggregation of the fair value estimates presented herein do not represent, and should not be construed to represent, the underlying value of Liberty. Note 2 Acquisitions Purchase Transactions _ On August 1, and October 1, 1993, Liberty acquired the First Oklahoma Bank and Trust Co. of Edmond and The First National Bank of Edmond, respectively, for a total cash purchase price of $20,148,000. The transactions were accounted for as purchases. Total assets acquired amounted to approximately $142,155,000. For each of these acquisitions, the consolidated statement of income includes only the income and expense of the acquired banks since acquisition. The purchase price was allocated to the net assets acquired based on their estimated fair values with the excess allocated to cost in excess of net assets acquired. The effect on Liberty's results of operations for 1993, had these transactions occurred at the beginning of the year, was not significant. Poolings-of-Interests _ The following table presents the new business combinations occurring during 1993 which have been accounted for as poolings- of-interests. A total of 637,312 shares of common stock were issued in connection with these business combinations. The consolidated statement of income for 1992 and 1991 have not been restated due to the immateriality of each business combination. Adjustments to conform the acquired banks' accounting policies to those of Liberty were not material. - ------------------------------------------------------------------------------ (In thousands) Assets Acquired - ------------------------------------------------------------------------------ First National Bank of Jenks $ 33,408 Midwest National Bank 38,581 Bank of Tulsa 62,820 - ------------------------------------------------------------------------------ Total $134,809 ============================================================================== The following table shows the effect of the three banks' 1993 results of operations prior to combination: - ------------------------------------------------------------------------ Pooled (In thousands) Liberty Banks Combined - ------------------------------------------------------------------------ Interest income $121,285 $7,116 $128,401 Net interest income 70,074 4,494 74,568 Cumulative effect of change in accounting principle 14,412 (157) 14,255 Net income (loss) 36,643 (111) 36,532 Note 3 Cash and Due from Banks As members of the Federal Reserve System, Liberty's subsidiary banks are required to maintain certain cumulative reserve balances based on deposits. Actual reserve balances amounted to $29,877,000 and $10,045,000, respectively, at December 31, 1993 and 1992, and averaged $26,603,000 and $22,228,000 for 1993 and 1992, respectively. These reserve balances are included in cash and due from banks in the accompanying consolidated balance sheet. This balance sheet category also includes checks in process of collection, and cash balances maintained at correspondent banks for services rendered. Note 4 Investment Securities As of December 31, 1993, Liberty changed its method of accounting for certain investment securities as allowed by Statement of Financial Accounting Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities" ("SFAS No. 115"). The effect of adopting SFAS No. 115 was to increase shareholders' investment approximately $6,184,000 for unrealized gains, net of income taxes, on investment securities classified as available for sale at December 31, 1993. The following table is a summary of investment securities at December 31, 1993 and 1992. The estimated market values of investment securities are based upon available market data and estimates, which often reflect transactions of relatively small size and are not necessarily indicative of the price at which large amounts of particular issues could be readily sold. The carrying value and estimated market value of debt securities, exclusive of trading securities, at December 31, 1993 are shown below by contractual maturity. Expected maturities will differ from contractual maturi- ties because borrowers may have the right to call or repay obligations with or without call or prepayment penalties. - ------------------------------------------------------------------------------ Estimated Carrying Market (In thousands) Value Value - ------------------------------------------------------------------------------ Due within one year $ 351,608 $ 351,330 Due after one but within five years 533,720 533,887 Due after five but within ten years 98,745 101,358 Due after ten years 245,838 249,085 - ------------------------------------------------------------------------------ $1,229,911 $1,235,660 =============================================================================== Proceeds from sales of investment securities during 1993 were $507,114,000 compared to $225,028,000 and $187,833,000 in 1992 and 1991, respectively. Gross gains on total sales amounted to $3,074,000, $137,000 and $340,000 along with gross losses of $364,000, $126,000 and $540,000 for the respective years 1993, 1992 and 1991. Total dividends on investments totaled $1,863,000 for 1993 compared to $1,153,000 for 1992 and $508,000 for 1991. Securities with carrying values of approximately $1,006,282,000 at December 31, 1993 were pledged to secure public and trust deposits and for other purposes as required or permitted by law. Note 5 Loans The composition of the loan portfolio is shown below. - ------------------------------------------------------------------------------ Loans - ------------------------------------------------------------------------------ In thousands) 1993 1992 - ------------------------------------------------------------------------------ Commercial and other (1) $376,454 $262,837 Energy 57,089 68,576 Real estate _ construction 85,566 67,417 Real estate _ mortgage (2) 199,104 154,410 Correspondent and regional 17,336 16,855 Personal 195,392 106,958 - ----------------------------------------------------------------------------- Total loans (3) $930,941 $677,053 ================================================================================ (1) Includes financing leases of $4,363,000 and $1,080,000 at December 31,1993 and 1992, respectively. (2) Includes loans held for sale of $26,452,000 and $20,778,000 at December 31, 1993 and 1992, respectively, which approximates estimated market value. (3) Includes unearned income of $3,525,000 and $2,443,000 at December 31, 1993 and 1992, respectively. Loans to executive officers and directors (or their associates) of Liberty and its principal subsidiaries and loans guaranteed by such persons are con- sidered related-party loans. The aggregate amount of such loans is presented in the following table. - ------------------------------------------------------------------------------ Related Party Loans - ------------------------------------------------------------------------------ (In thousands) - ------------------------------------------------------------------------------ Balance at beginning of year $33,795 Advances 2,071 Payments (19,295) - ------------------------------------------------------------------------------ Balance at end of year $16,571 =============================================================================== The estimated fair value of net loans at December 31, 1993 totaled approximately $914,000,000 compared to $653,000,000 at December 31, 1992. Variable rate loans whose rates are tied to Liberty's base rate have been val- ued at their respective carrying values. Loans with a fixed rate of interest have been estimated using a discounted cash flow analysis. Future cash flows are projected based on contracual rates then discounted at an estimated current market rate. The entire portfolio is adjusted to allow for estimated future losses of principal and interest. The following table summarizes the components of nonperforming loans. - ------------------------------------------------------------------------------ Nonperforming Loans - ------------------------------------------------------------------------------ (In thousands) 1993 1992 1991 - ------------------------------------------------------------------------------ Nonaccrual $10,138 $19,244 $37,026 Past due 90 days or more 3,313 487 750 - ------------------------------------------------------------------------------ Total nonperforming loans $13,451 $19,731 $37,776 =============================================================================== Generally, the largest concentrations of nonperforming loans for 1993, 1992 and 1991 were in the real estate and commercial categories. The gross interest income from nonaccrual loans outstanding at year-end, had they been performing in accordance with their original terms, would have been approximately $1,109,000 for 1993, $1,493,000 for 1992 and $3,490,000 for 1991. The amount of interest included in interest income from these loans was approximately $64,000 in 1993, $37,000 in 1992, and $505,000 in 1991. In addition, Liberty had certain loans which, although currently performing, have credit weaknesses such that doubts exist as to the borrowers' future ability to comply with present terms. At December 31, 1993, these po- tential problem loans totaled $16,979,000 compared to $5,147,000 at December 31, 1992 and $13,252,000 at December 31, 1991. The increase at year-end 1993 was principally attributable to one loan which was favorably resolved subsequent to year-end. Of these amounts, approximately $98,000, $415,000 and $3,680,000 represented letters of credit and unfunded loan commitments at December 31, 1993, 1992 and 1991, respectively. The principal portion of these loans and commitments exposed to loss has been considered in the establishment of the reserve for loan losses. The following is an analysis of the reserve for loan losses. - ------------------------------------------------------------------------------ Reserve for Loan Losses - ------------------------------------------------------------------------------ (In thousands) 1993 1992 1991 - ------------------------------------------------------------------------------ Balance at beginning of year $25,581 $25,988 $24,830 Additions Recoveries 2,400 2,335 2,103 Provisions (7,363) 1,793 2,252 Reserves of acquired banks 1,241 70 _ Less _ Charge-offs (1,873) (4,605) (3,197) - ------------------------------------------------------------------------------ Balance at end of year $19,986 $25,581 $25,988 =============================================================================== In May 1993, the Financial Accounting Standards Board ("FASB") issued SFAS No. 114, "Accounting by Creditors for Impairment of a Loan" ("SFAS No. 114"). SFAS No. 114 is effective for fiscal years beginning after December 15, 1994, although earlier adoption is permitted. SFAS No. 114 addresses the accounting by creditors for impairment of a loan by specifying how reserves for losses related to impaired loans, as defined, shall be determined. A discounted cash flow analysis is required for loans meeting the definition of impaired using the original contractual interest rate as the discount rate. If the discounted value is less than the contractual balance, the difference must be provided for through the reserve for loan losses. The adoption of SFAS No. 114 is not expected to have a material adverse effect on Liberty's financial position, based on impaired loans, as defined, at December 31, 1993. Note 6 Other Real Estate and Assets Owned The following table summarizes the components of other real estate and assets owned. - ------------------------------------------------------------------------------ Other Real Estate and Assets Owned - ------------------------------------------------------------------------------ (In thousands) 1993 1992 1991 - ------------------------------------------------------------------------------ Land $ 8,791 $14,516 $21,773 Commercial _ office buildings and motels 2,487 2,481 7,541 Commercial _ shopping centers 200 660 8,429 Residential _ single-family 1,631 1,122 1,754 Residential _ multi-family _ 57 3,756 Oil and gas properties _ 306 523 Other 256 1,520 3,851 - ------------------------------------------------------------------------------ Total other real estate and assets owned 13,365 20,662 47,627 Less reserve for losses (2,521) (5,001) (11,447) - ------------------------------------------------------------------------------ Other real estate and assets owned, net $10,844 $15,661 $36,180 =============================================================================== An analysis of the reserve for losses on other real estate and assets owned is presented below. - ------------------------------------------------------------------------------ Reserve for Losses on Other Real Estate and Assets Owned - ------------------------------------------------------------------------------ In thousands) 1993 1992 1991 - ------------------------------------------------------------------------------ Balance at beginning of year $5,001 $11,447 $22,078 Charge-offs (1,515) (4,105) (10,791) Provisions for losses (1,207) (2,341) 160 Reserve from acquired banks 242 _ _ - ------------------------------------------------------------------------------ Balance at end of year $2,521 $5,001 $11,447 =============================================================================== Note 7 Property and Equipment Property and equipment is stated at cost as follows. - ------------------------------------------------------------------------------ Estimated Useful (In thousands) 1993 1992 Lives - ------------------------------------------------------------------------------ Land $ 9,745 5,520 N/A Buildings and other bank premises 59,649 52,667 3-40 Years Leasehold improvements 8,264 5,318 4-50 Years Equipment, furniture and fixtures and other 37,071 31,797 3-10 Years - ------------------------------------------------------------------------------ Total property and equipment 114,729 95,302 Less _ Accumulated depreciation and amortization (50,577) (45,922) - ------------------------------------------------------------------------------ Property and equipment, net $64,152 $49,380 =============================================================================== Depreciation and amortization expense for the years 1993, 1992 and 1991 was approximately $5,365,000, $4,577,000 and $4,534,000, respectively. Note 8 Interest-Bearing Deposits The components of interest-bearing deposits are presented in the following table. - ------------------------------------------------------------------------------ (In thousands) 1993 1992 - ------------------------------------------------------------------------------ Savings and money market accounts $ 722,479 $ 562,716 Time _ $100,000 or more 131,829 140,234 Public funds 181,990 163,106 Other time deposits 399,619 397,264 - ------------------------------------------------------------------------------ Balance at end of year $1,435,917 $1,263,320 =============================================================================== Time deposits over $100,000 include international deposits with the branches of Liberty Oklahoma City and Liberty Tulsa in Nassau, The Bahamas of $24,981,000 and $30,892,000 at December 31, 1993 and 1992, respectively. The estimated fair value of interest bearing deposits at December 31, 1993 was approximately $1,442,000,000 compared to $1,270,000,000 at December 31, 1992. The fair value of the savings and money market accounts approximates the carrying value as shown. The fair value of the remaining classes of time deposits were estimated using a discounted cash flow analysis based on the market rate of interest being paid for similar deposits at December 31, 1993 and 1992. Note 9 Short-Term Borrowings The components of short-term borrowings are presented below. - ------------------------------------------------------------------------------- Federal Funds Purchased and Securities Sold Under Agreements to Repurchase - ------------------------------------------------------------------------------ (In thousands) 1993 1992 1991 - ------------------------------------------------------------------------------ Borrowings outstanding At year-end $116,486 $144,400 $136,781 Average for the year 122,103 120,173 170,608 Maximum month-end balance 167,608 144,400 208,814 Interest rates Average for the year 2.9% 3.3% 5.5% Average at end of year 2.9 2.5 3.8 - ------------------------------------------------------------------------------ Treasury, Tax and Loan Deposits and Other Short-Term Borrowings - ------------------------------------------------------------------------------ (In thousands) 1993 1992 1991 - ------------------------------------------------------------------------------ Borrowings outstanding At year-end $161,626 $140,693 $227,407 Average for the year 110,847 106,944 121,719 Maximum month-end balance 241,434 281,423 227,407 Interest rates Average for the year 3.2% 3.4% 5.3% Average at end of year 2.9 2.7 3.8 Federal funds purchased and securities sold under agreements to repurchase are generally issued on an overnight or demand basis. Treasury, tax and loan deposits and other short-term borrowings generally have maturities of less than one year. The fair value of these borrowings has been estimated to approximate their carrying value. Note 10 Long-Term Notes The first mortgage on Liberty Tower, an 8% installment note originally due in 2001, was paid in full during the fourth quarter of 1993. The balance of this note at December 31, 1992 was $7,545,000 and had an estimated fair value at that time of $7,693,000. This estimate was based on a discounted cash flow analysis of the note using a market rate for similar financing. Note 11 Income Taxes Effective January 1, 1993, Liberty adopted SFAS No. 109, "Accounting for Income Taxes." This standard requires, among other things, recognition of future tax benefits, measured at enacted tax rates, attributable to deductible temporary differences between financial statement and income tax bases of assets and liabilities and to tax net operating loss carryforwards, to the extent the realization of such benefits is more likely than not. Similarly, future tax liabilities are also required to be recognized. The adoption of SFAS No. 109 resulted in a net deferred asset and related benefit of $14.3 million or $1.46 per share on January 1, 1993. This change is reflected in the consolidated statement of income as a cumulative effect of change in accounting principle. Prior years' consolidated statements of income have not been restated. The total provision (benefit) for income taxes has been allocated as follows: - ------------------------------------------------------------------------------ (In thousands) 1993 1992 1991 - ------------------------------------------------------------------------------ Income from continuing operations ($2,358) $4,737 $925 Shareholders' investment 3,362 _ _ - ------------------------------------------------------------------------------ Total $1,004 $4,737 $925 =============================================================================== The provision (benefit) for income taxes on income from continuing operations before cumulative effect of change in accounting principle and extraordinary item is summarized below: - ------------------------------------------------------------------------------ Provision (Benefit) for Income Taxes - ------------------------------------------------------------------------------ (In thousands) 1993 1992 1991 - ------------------------------------------------------------------------------ Current expense $ 330 $ 97 $ 93 Deferred expense (benefit) (2,688) 4,640 832 - ------------------------------------------------------------------------------ Total provision (benefit) for income taxes ($2,358) $4,737 $ 925 =============================================================================== Deferred tax assets are composed of the following at December 31, 1993. - ------------------------------------------------------------------------------ (In thousands) - ------------------------------------------------------------------------------ Deferred tax assets _ Net operating loss carryforwards $12,913 Reserve for loan losses 6,807 Reserve for losses and writedowns on other real estate and assets owned 6,061 Other loss provisions 3,039 Unrealized gains on investment securities for income tax purposes 3,801 Accelerated amortization of purchased mortgage servicing rights 2,232 Deferred compensation 984 Tax credit carryforwards 2,334 Other 1,147 - ------------------------------------------------------------------------------ 39,318 - ------------------------------------------------------------------------------ Deferred tax liabilities _ Income reported on the cash basis for income tax purposes (1,071) Accelerated depreciation of property and equipment (6,413) Unrealized gains on investment securities for financial reporting purposes (3,362) - ------------------------------------------------------------------------------ (10,846) - ------------------------------------------------------------------------------ Net deferred tax asset 28,472 Valuation allowance (14,888) - ------------------------------------------------------------------------------ Deferred tax asset, net $13,584 ============================================================================== Prior to the change in accounting method, the sources of deferred taxes and related tax effects were as follows. - ------------------------------------------------------------------------------ (In thousands) 1992 1991 - ------------------------------------------------------------------------------ Writedowns on other real estate and assets owned $4,782 $5,268 Provision for losses on loans and other real estate and assets owned 797 (543) Other loss provisions 233 (796) Deferred compensation (489) (95) Income reported on cash basis for tax return purposes (445) 10 Net operating carryforwards generated (72) (3,053) Depreciation (25) (109) Gain on partnership dissolution _ (382) Other, net (44) 15 - ------------------------------------------------------------------------------ Regular deferred taxes 4,737 315 - ------------------------------------------------------------------------------ Items not benefited for alternative minimum tax purposes _ 610 - ------------------------------------------------------------------------------ Total deferred taxes $4,737 $ 925 =============================================================================== The effective income tax rates differ from the statutory federal income tax rate of 35% in 1993 and 34% in 1992 and 1991. A reconciliation of the provision (benefit) for income taxes based on the statutory rates with the effective rates follows. - ------------------------------------------------------------------------------ (In thousands) 1993 1992 1991 - ------------------------------------------------------------------------------ Income tax at statutory rate $6,971 $6,193 $2,000 Nontaxable interest and dividend income (1,805) (1,766) (1,808) Amortization of costs related to branch and other bank acquisitions 137 204 98 Interest expense related to funding tax-exempt assets 53 99 127 Change in valuation allowance due principally to use of net operating loss carryforwards (6,901) _ _ Current year statutory rate change (406) _ _ Other, net (407) 7 (102) - ------------------------------------------------------------------------------ Regular tax expense (benefit) (2,358) 4,737 315 Items not benefited for alternative minimum tax purposes _ _ 610 - ------------------------------------------------------------------------------ Total provision (benefit) for income taxes ($2,358) $4,737 $ 925 =============================================================================== At December 31, 1993, Liberty had net operating loss carryforwards approximating $37,000,000. Approximately $16,000,000 of the net operating loss carryforwards can be used to offset future taxable income through 1996. The remaining net operating loss carryforwards can be used through 2006. Liberty also has approximately $2,000,000 in investment tax credit carryforwards which will expire during the period from 1994 through 2000. At December 31, 1993 Liberty also had approximately $358,000 in alternative minimum tax credit carryforwards with no expiration. In accordance with the Tax Reform Act of 1986, use of net operating loss and investment tax credit carryforwards is subject to certain limitations in future years if an ownership change has occurred. Liberty's restructuring in October 1988 resulted in an ownership change. During the period following the ownership change, the limitation is an annual amount determined by the value of Liberty's capital stock immediately prior to the ownership change, multiplied by a statutorily determined interest rate. The carryforwards and the annual amounts available for use are subject to review and possible adjustment by the Internal Revenue Service ("IRS"). Approximately $27,000,000 of the net operating loss carryforwards expired during 1993 due to limitations caused by the ownership change. Due to these limitations as well as other uncertainties regarding Liberty's ability to ultimately realize the benefit of its tax loss and credit carryforwards, a valuation allowance of $14,888,000 has been provided. Liberty's federal income tax returns have been examined by and/or settled with the IRS through the year 1983. Certain state tax returns through 1984 have also been examined by the Oklahoma Tax Commission. Issues resulting from these examinations are in the process of discussion with the appropriate agencies. Due to the significant federal and state net operating loss carryforwards of Liberty at December 31, 1993, the unresolved items are not expected to have a significant effect on Liberty's future operating results. Note 12 Shareholders' Investment Liberty resumed cash dividends during 1993 with dividends declared of $.30 per share. Total dividends paid during 1993 were $2,702,000. Liberty Oklahoma City and Liberty Tulsa are limited in their ability to pay dividends based on applicable provisions of the National Bank Act pertaining to earnings and undivided profits. As of January 1, 1994 the amount of retained earnings of Liberty Oklahoma City and Liberty Tulsa available for the payment of dividends without regulatory approval was approximately $30,500,000 and $17,600,000, respectively. The Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA") contains "prompt corrective action" provisions in which banks are classified into one of five categories based primarily upon capital adequacy, ranging from "well capitalized" to "critically undercapitalized" and which require, subject to certain exceptions, the appropriate federal banking agency to take prompt corrective action with respect to an institution which becomes "undercapitalized" and to take additional actions if the institution becomes "significantly undercapitalized" or "critically undercapitalized." At December 31, 1993, the regulatory capital ratios of Liberty's subsidiary banks were in excess of those necessary to be considered "well capitalized." Note 13 Stock Options A summary of Liberty's stock options are as follows. - ------------------------------------------------------------------------------ Shares Price Range - ------------------------------------------------------------------------------ December 31, 1990 608,694 $9.50 - $11.25 Options granted 1,000 12.40 Options canceled (9,000) 12.40 - ------------------------------------------------------------------------------ December 31, 1991 600,694 $9.50 - $12.40 Options granted 217,200 14.75 - 28.89 Options exercised (4,800) 12.40 Options canceled (3,200) 12.40 - ------------------------------------------------------------------------------ December 31, 1992 809,894 $9.50 - $28.89 Options exercised (2,664) 12.40 - ------------------------------------------------------------------------------ December 31, 1993 807,230 $9.50 - $28.89 - ------------------------------------------------------------------------------ Exercisable 491,230 $9.50 - $28.89 Pursuant to an employment agreement with Liberty's former Chairman and Chief Executive Officer, options to purchase 289,694 shares of common stock were granted. An option covering 144,847 shares was granted on June 28, 1988 at an option price of $11.25 per share and an option on an additional 144,847 shares was granted on June 28, 1989 at a price of $9.50 per share, each price representing the fair market value at the date of grant. Each option is im- mediately exercisable and expires ten years from the date of grant. The Liberty Stock Option Plan, adopted in 1990, reserved 400,000 shares of common stock for granting options and was increased to 525,000 shares in 1992. Options may be granted to employees of Liberty and its subsidiaries who are executive, administrative, professional or technical personnel and who have principal responsibility for the management and direction of the financial success of Liberty. An employee owning more than 5% of the total combined voting power or value of all classes of stock of Liberty will not be eligible to receive an option under the plan. Options terminate and are no longer exer- cisable after ten years from the date of the grant or three months from termination of the employment of an optionee for any reason other than death, or twelve months after the date of death of an optionee. Note 14 Employee Benefits Liberty sponsors the Liberty Bancorp, Inc. Profit Sharing, Salary Deferral and Employee Stock Ownership Plan (the "Plan"). Under the stock ownership and salary deferral portion of the Plan, eligible participants may contribute from 1% to 10% of their regular monthly earnings. Depending upon length of employee service, Liberty will match from 50% to 125% of employee contributions not exceeding 6% of regular monthly earnings. Vesting ranges from 20% after two years of service to 100% after six years of service. Employee contributions can be invested in a variety of funds while the matching contributions are invested in Liberty's common stock. As part of Liberty's 1988 restructuring, the Plan borrowed $4,105,000 from Liberty to purchase stock for funding in future peri- ods. The loan is serviced from annual plan contributions made by Liberty. The loan is included as deferred compensation, a reduction of shareholders' invest- ment, in the accompanying consolidated financial statements and had a remaining balance of $2,375,000 at December 31, 1993. In addition to the contributions required under the terms of the loan, discussed above, the Board of Directors may make discretionary contributions to the Plan. The Board of Directors may vary the amount of the additional discretionary contributions, if any, from year to year. Contributions to the Plan amounted to $393,000 for 1993, $435,000 for 1992 and $766,000 for 1991. Under the profit sharing portion of the Plan, Liberty can make contributions for the benefit of eligible employees. All Liberty contributions are invested in Liberty's common stock. Liberty made contributions totaling $789,000 in 1993, $499,000 in 1992 and $290,000 in 1991. An Incentive Cash Bonus Plan (the "Bonus Plan") was approved by the Board of Directors in September 1990. The purpose of the Bonus Plan is to provide Liberty and its subsidiaries with the means, along with other elements of its compensatory system, to retain, motivate, reward and attract, if necessary, able and high quality persons to serve in key management positions with Liberty. The Bonus Plan is intended to provide such key employees with incen- tive and reward opportunities designed to enhance the profitable growth and operation of Liberty, thereby protecting depositors and increasing shareholder value. Participants in this plan are identified at the beginning of each year, along with the extent of potential awards and participants' individual objec- tives relating to such awards. One-half of a participant's award will relate to the attainment of individual goals, and the remaining one-half of the award will relate to the achievement of Liberty's consolidated profit plan or other corporate goals which may be determined by the Compensation Committee of the Board of Directors. Liberty must have net income before extraordinary items equal to or greater than the prior year's net income before extraordinary items in order for participants to be eligible to earn any award under the Bonus Plan. Charges to expense under this program totaled $760,000 in 1993 compared to $463,000 in 1992 and $330,000 in 1991. Additionally, the Board of Directors approved a one-time bonus in 1992 of $518,000 to be paid to all employees not participating in other incentive plans. The Stock Appreciation Rights Plan (the "SAR Plan"), which was approved by the Board of Directors in September, 1990, is intended as an incentive to em- ployees of Liberty and its subsidiaries. Its purposes are to retain and at- tract employees whose services are considered unusually valuable, to encourage a sense of proprietorship of such persons and to stimulate the active interests of such persons in the development and financial success of Liberty. Persons receiving a right pursuant to the SAR Plan will not be in any way construed to be a stockholder of Liberty or have any right to receive shares of common stock. Each right becomes exercisable at the rate of 20% per year, beginning one year following the date of grant. Expenses accrued under this plan, based on the fair market value of Liberty's common stock, totaled $95,000 in 1993, $473,000 in 1992 and $16,000 in 1991. The following table summarizes this plan since its inception. - ------------------------------------------------------------------------------ Rights Price Range - ------------------------------------------------------------------------------ December 31, 1990 _ Rights granted 25,000 $10.00 Rights canceled (1,500) 10.00 - ------------------------------------------------------------------------------ December 31, 1991 23,500 Rights granted 28,000 14.75 Rights exercised or canceled (930) 10.00 - ------------------------------------------------------------------------------ December 31, 1992 50,570 Rights exercised or canceled (7265) 10.00 - 14.75 - ------------------------------------------------------------------------------ December 31, 1993 43,305 10.00 - 14.75 - ------------------------------------------------------------------------------ Exercisable 13,105 10.00 - 14.75 During 1992, Liberty adopted the Management Incentive Bonus Plan with the purpose of attracting, retaining and motivating key executives by providing cash and stock incentive compensation for both organizational and individual performance. The plan provides for annual incentive bonuses tied to organiza- tional and individual goals with a portion of the bonuses payable in restricted stock. Under the Plan, 75,000 shares, to be available for awards, are restricted as to sale or transfer and are forfeited if the participant's em- ployment is terminated. The restrictions on the shares lapse at the rate of 20% per year, commencing with the first anniversary date of the respective awards. In 1993, 6,495 shares, valued at $219,000, were awarded to participants. Charges to expense during 1993 totaled $34,000 with the remainder reported as deferred compensation in the accompanying consolidated statement of shareholders' investment. During 1993, Liberty adopted the Supplemental Executive Retirement Plan with the purpose of protecting, retaining and rewarding key executives and certain highly compensated employees by providing supplemental retirement benefits in addition to the benefits provided under Liberty`s qualified retirement plan. The plan is intended to be an unfunded nonqualified deferred compensation arrangement for a select group of management or highly compensated employees. Liberty will contribute each year to a trust for each participant an amount equal to 7% of the participant's earnings reduced by the amount allocated to the participant's retirement plan, plus an actuarial amount calculated to fund the excess of the participant`s projected benefits over the anticipated value of the participant`s total retirement plan account balances at a normal retirement date. A participant`s benefit vests at a rate of 20% per year based upon number of years of participation service. A participant shall also become fully vested upon his death, disability or on a change in control. Benefits under the plan are payable upon a participant`s termination of service, disability or death. Charges to expense under the plan totaled $141,000 in 1993. Statement of Position ("SOP") 93-6, "Employers' Accounting for Employee Stock Ownership Plans," was issued in November 1993. This statement will bring about significant changes in the way employers report transactions with leveraged employer stock ownership plans ("ESOP's"). Among the changes are ESOP shares committed to be released in a period to compensate employees directly will be recognized as compensation cost equal to the fair value of the shares committed to be released. The SOP is effective for fiscal years beginning after December 15, 1993. Employers are required to apply the provisions of the SOP to shares purchased by ESOP's after December 31, 1992, that have not been committed to be released as of the beginning of the year of adoption. Employers are permitted, but not required, to apply the provisions of the SOP to shares purchased by ESOP's on or before December 31, 1992, that have not been committed to be released as of the beginning of the year of adoption. Liberty will likely not apply the provisions of this SOP to ESOP shares acquired before December 31, 1992. There were no shares acquired by the ESOP on or after December 31, 1992. Liberty provides certain health care and life insurance benefits to em- ployees subject to beneficiary-paid premiums, co-payment provisions and deduct- ibles. These benefits are paid to trusts established for the various plans. These trusts, in turn, provide the benefits to current and retired employees. Expenses relating to health care and life insurance benefits provided to current employees totaled $3,263,000 in 1993, $1,551,000 in 1992 and $2,026,000 in 1991. As part of Liberty's effort to reduce noninterest expenses, Liberty has engaged an outside consulting firm to assist in evaluating its operations. As a result of a preliminary analysis, Liberty has accrued $1.9 million for anticipated employee severance and other costs to be incurred in connection with actions to reduce noninterest expense. In 1991 Liberty instituted an early retirement program. Costs under this program totaled approximately $1,800,000. In November 1992, SFAS No. 112, "Employers' Accounting for Postemployment Benefits" was issued. Liberty is required to adopt SFAS No. 112 no later than 1994, although earlier implementation is permitted. Management does not an- ticipate the adoption of SFAS No. 112 to have a material adverse on its con- solidated financial position or results of future operations. Note 15 Postretirement Benefits Employees of Liberty over the age of 55 with fifteen years of service or over the age of 65 with ten years of service are entitled to postretirement health care and life insurance benefits subject to retiree-paid premiums, co- payment provisions and deductibles. Prior to 1993 these benefits were expensed as paid by Liberty and totaled $535,000 in 1992 and $568,000 in 1991. In December 1990, FASB issued a new standard on accounting for postre- tirement benefits other than pensions ("SFAS No. 106"). SFAS No. 106 requires that the anticipated postretirement costs for these benefits must be charged to expense during the years that the employees render service. Liberty adopted the new standard effective January 1, 1993 and is amortizing the discounted present value of the obligation at that date to expense over a twenty-year pe- riod. Estimates of the obligation are based on various assumptions, including health care costs, work force demographics, interest rates and plan changes. The accumulated postretirement benefit obligation was estimated to be approxi- mately $10,847,000 at January 1, 1993. Expenses for 1993 totaled $1,562,000 with net claims paid totaling $656,000. Any changes in the plan or revisions to assumptions that affect the amount of expected future benefits may have a significant effect on the amount of the reported obligation and annual expense. The following table reflects the funding status and amounts recognized in Liberty's consolidated balance sheet at December 31, 1993: - ------------------------------------------------------------------------------ (In thousands) - ------------------------------------------------------------------------------ Accumulated postretirement benefit obligation Current retirees ($ 9,001) Other fully eligible participants (725) Other active plan participants (1,484) - ------------------------------------------------------------------------------ Total accumulated postretirement benefit obligation (11,210) Fair value of plan assets _ - ------------------------------------------------------------------------------ Funded status (11,210) Unrecognized prior service cost _ Unrecognized net loss (gain) _ Unamortized net transition obligation 10,304 - ------------------------------------------------------------------------------ Accrued postretirement benefit cost ($ 906) =============================================================================== The weighted-average discount rate used to determine the actuarial present value of the projected postretirement benefit obligation was 8.25%. The following table provides a breakdown of net periodic postretirement benefit cost expensed during 1993. - ------------------------------------------------------------------------------- (In thousands) - ------------------------------------------------------------------------------- Service cost (with interest) $ 151 Interest cost 869 Actual return on plan assets _ Amortization of unrecognized transition obligation 542 - ------------------------------------------------------------------------------- Net periodic postretirement benefit cost $1,562 =============================================================================== The medical benefit trend assumption for eligible benefit recipients under age 65 was estimated to be 12.00% and was reduced each year to an ultimate level of 6.00% for fiscal 2003 over fiscal 2002. The medical benefit trend assumption for eligible benefit recipients age 65 and over was estimated to be 10.50% and was reduced each year to an ultimate level of 6.00% for fiscal 2003 over fiscal 2002. The dental, vision and hearing benefit trend assumption for eligible benefit recipients was estimated to be 8.50% and was reduced each year to an ultimate level of 5.00% for fiscal 2005 over fiscal 2004. Life insurance benefit trend assumptions were based on final pay of each eligible retiring employee adjusted for an assumed compensation rate increase of 4%. The initial estimated benefit was then subject to a 10% annual reduction but increased for each eligible retiring employee with age. A 1% increase in the assumed health care cost trend rates for each future year would increase the accumulated postretirement benefit obligation to $12,432,000, an increase of 10.9%. Additionally, the aggregate of the service and interest cost components of net periodic postretirement benefit cost would increase to $1,117,000, an increase of 9.6%. Note 16 Commitments and Contingencies In the normal course of business, Liberty is a party to financial instruments with off-balance sheet risk. These financial instruments include commitments to extend credit, letters of credit, interest-rate forward contracts and foreign exchange contracts. These instruments expose Liberty to varying degrees of credit and/or market risk in excess of the amount recognized in the accompanying consolidated balance sheet. To manage this risk, Liberty uses the same credit and trading risk management processes for financial instruments with off-balance sheet risk as it does for financial instruments whose risk is reflected on the consolidated balance sheet. The fair value of loan commitments and letters of credit, whether that value is an asset or liability, is considered negligible. Interest-rate forward and foreign exchange contracts used in trading activities are carried at their market value. Standby letters of credit and other commitments, including legally binding loan commitments, were outstanding in the total amount of $558,844,000 at December 31, 1993 and $390,869,000 at December 31, 1992. Liberty does not expect a significant portion of these commitments to be exercised during the near-term. Liberty's bank subsidiaries have sold to the Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation certain residential mortgage loans with recourse. Approximately $9,559,000 and $14,275,000 of loans subject to this condition remained outstanding at December 31, 1993 and 1992, respectively. For financial reporting purposes these loans have been treated as sales and therefore are not included in total loans. Liberty does not anticipate any significant adverse impact on its consolidated financial position or results of future operations as a result of the "with recourse" feature of these loans. Management believes Liberty has no other significant off-balance sheet exposure. At December 31, 1993, Liberty was committed to make future payments under several long-term lease agreements and a data processing agreement. The minimum payments required by these agreements are summarized below: - ------------------------------------------------------------------------------- (In thousands) Bank Data Equipment Premises Processing and Other Total - ------------------------------------------------------------------------------- 1994 $ 3,273 $ 5,214 $ 672 $ 9,159 1995 3,235 5,395 513 9,143 1996 2,991 5,568 480 9,039 1997 1,972 5,747 476 8,195 1998 1,869 5,931 476 8,276 Remainder 7,621 3,571 238 11,430 - ------------------------------------------------------------------------------- Total $20,961 $31,426 $2,855 $55,242 =============================================================================== Lease rentals included in Liberty's operating expenses for the years ended December 31, 1993, 1992 and 1991 amounted to $5,631,000, $5,043,000 and $4,918,000, respectively. Contingent rentals amounted to $324,000 in 1993, $910,000 in 1992 and $1,178,000 for 1991. Occupancy expense has been reduced by rental income from premises leased to third parties of $2,282,000, $2,108,000 and $2,212,000 for 1993, 1992 and 1991, respectively. In August 1992, an agreement with a facilities manager to manage Liberty's data processing operation was renewed for a seven year term. Under certain conditions the agreement may be terminated early after August 1, 1995 by Liberty paying a fee that decreases from $4.8 million in 1995 to $1.2 million in 1998. Under the agreement, data processing fees paid are increased semi- annually for the effects of inflation. The 1994 inflation adjustment of 3.21% has been assumed to remain constant in determining the data processing minimum payments. These fees totaled $5,043,000, $5,378,000 and $5,298,000 for 1993, 1992 and 1991, respectively. In the ordinary course of business, Liberty and its subsidiaries are subject to legal actions and complaints. Management, after consultation with legal counsel, and based upon available facts and proceedings to date, which are in preliminary stages in some instances, believes that the ultimate liability, if any, arising from such legal actions or complaints, will not have a material adverse effect on the financial position or results of future operations of Liberty or its subsidiaries. Many financial services companies, including Liberty, have been unable, or have chosen not to, obtain insurance for various risks. Consequently, Liberty is to some degree self-insured for various risks, including those associated with lender and fiduciary liability. Liberty has recorded estimated liabili- ties for uninsured risks to the extent permitted by generally accepted ac- counting principles. Note 17 Parent Company Summarized financial information for Liberty Bancorp, Inc. (parent company only) is presented in the following statements: - ------------------------------------------------------------------------------ Condensed Balance Sheet - ------------------------------------------------------------------------------ December 31 (In thousands) 1993 1992 - ------------------------------------------------------------------------------ Assets Cash in subsidiary banks $ 6,228 $ 4,193 Time deposits with subsidiary banks _ 3,079 Investment securities 1,400 1,016 Advances to subsidiary 22,530 15,813 Loans 847 723 Less _ Reserve for loan losses (38) (38) - ------------------------------------------------------------------------------ Net loans 809 685 - ------------------------------------------------------------------------------ Investment in subsidiaries Liberty Oklahoma City 129,227 102,984 Liberty Tulsa 90,377 68,090 Other subsidiaries (19,225) (14,821) - ------------------------------------------------------------------------------ Total investment in subsidiaries 200,379 156,253 - ------------------------------------------------------------------------------ Other real estate and assets owned, net 673 1,707 Other assets 4,336 2,951 - ------------------------------------------------------------------------------ Total assets $236,355 $185,697 ============================================================================== Liabilities Accrued interest and other expenses $ 3,168 $ 4,114 Advances from subsidiary 1,605 1,605 Other payables to subsidiaries 4,337 1,137 - ------------------------------------------------------------------------------ Total liabilities 9,110 6,856 Shareholders' investment 227,245 178,841 - ------------------------------------------------------------------------------ Total liabilities and shareholders' investment $236,355 $185,697 ============================================================================== - ------------------------------------------------------------------------------ Condensed Statements of Income - ------------------------------------------------------------------------------ For the year (In thousands) 1993 1992 1991 - ------------------------------------------------------------------------------ Dividends received from subsidiaries Cash dividends received from subsidiaries $ 12,000 $ - $ _ Noncash dividends received from subsidiaries - 77 _ Interest income Loans to subsidiaries 29 29 2 Commercial and real estate loans 52 22 51 Interest-bearing deposits with subsidiary banks 152 302 482 Dividends on investments 1,017 258 52 Management fees and expense reimbursements Bank subsidiaries 15,473 14,119 12,557 Nonbank subsidiaries 262 117 125 - ------------------------------------------------------------------------------ Other income (a) 81 (33) 174 - ------------------------------------------------------------------------------ Total income 29,066 14,891 13,443 - ------------------------------------------------------------------------------ Interest expense 212 135 392 Salaries and employee benefits 3,818 2,828 2,819 Data processing 5,094 5,318 5,081 Equipment 2,394 1,904 1,759 Occupancy 597 629 434 Professional and other services 1,659 1,416 782 Net income from operation of other real estate and assets owned (246) (630) (33) Other expenses 2,972 2,446 2,375 - ------------------------------------------------------------------------------ Total expenses 16,500 14,046 13,609 Income (loss) before provision (benefit) for income taxes 12,566 845 (166) Provision (benefit) for income taxes (1,249) (216) (50) - ------------------------------------------------------------------------------ Income before cumulative effect of change in accounting principle and equity in undistributed income of subsidiaries 13,815 1,061 (116) Cumulative effect of change in accounting principle 533 - - Equity in undistributed income of subsidiaries 22,184 17,057 5,907 - ------------------------------------------------------------------------------ Net income $36,532 $18,118 $ 5,791 =============================================================================== (a) Includes net securities losses of $60,000 in 1992. There were no securities gains or losses in 1993 or 1991. Condensed Statement of Cash Flows - ------------------------------------------------------------------------------ For the year (In thousands) 1993 1992 1991 - ------------------------------------------------------------------------------ Cash provided (absorbed) by operating activities Net income $36,532 $18,118 $5,791 Adjustments to reconcile net income to net cash provided (absorbed by) operating activities Provisions for losses on loans and other real estate and assets owned (85) 35 398 Cumulative effect of change in accounting principle (533) _ _ Deferred income taxes (1,249) (216) (50) Depreciation and amortization 607 376 533 Noncash dividend and equity in undistributed income of subsidiaries (22,184) (17,134) (5,907) Gain on sale of assets (147) (492) (135) Change in accrued income and accounts receivable (4,203) (346) 15 Change in other assets (4,278) (199) 60 Change in accrued interest, expenses, taxes, accounts payable and other liabilities (992) 328 (2,796) Change in other payables to subsidiaries 3,300 724 363 - ------------------------------------------------------------------------------ Net cash provided (absorbed) by operating activities 6,768 1,194 1,728 - ------------------------------------------------------------------------------ Cash provided (absorbed) by investing activities Principal payments received on loans 36 304 41 Repayments received on advances to subsidiaries _ _ 356 Advances on loans (162) (145) (288) Advances to subsidiaries (6,717) (2,826) (2,320) Proceeds from sale of property and equipment _ _ 1 Expenditures for property and equipment (50) (31) (4) Proceeds from sale of other real estate and other assets acquired in settlement of loans 882 2,167 2,394 Consideration, including cash and cash equivalents received or paid in bank acquisition and merger of non-bank subsidiary 392 (375) _ - ------------------------------------------------------------------------------ Net cash provided (absorbed) by investing activities (5,619) ( 906) 180 - ------------------------------------------------------------------------------ Cash provided (absorbed) by financing activities Payments on long-term notes _ (1,769) (590) Advances from subsidiaries 1,605 1,605 1,605 Repayments of advances from subsidiaries (1,605) (1,605) (1,605) Proceeds from sale of treasury stock and issuance of common stock for employees' and shareholders' plans 949 595 238 Purchase of treasury stock (440) _ _ Dividends paid (2,702) _ _ - ------------------------------------------------------------------------------ Net cash absorbed by financing activities (2,193) (1,174) (352) - ------------------------------------------------------------------------------ Net change in cash and cash-equivalents (1,044) ( 886) (1,900) Cash and cash-equivalents at beginning of year 7,272 8,158 10,058 - ------------------------------------------------------------------------------ Cash and cash-equivalents at end of year $ 6,228 $ 7,272 $ 8,158 ============================================================================== Supplemental disclosure of cash flow information: Interest paid $ 57 $170 $391 Income taxes paid 762 100 219 Supplemental disclosure of noncash investing activities: Transfer of advances to subsidiaries in investment in nonbank subsidiaries $ 4,807 _ - Contribution of acquired banks 10,919 _ _ Liberty Bancorp, Inc. MANAGEMENT REPORT ON RESPONSIBILITY FOR FINANCIAL REPORTING The management of Liberty Bancorp, Inc. has the responsibility for preparing the accompanying consolidated financial statements and for their integrity and objectivity. The statements were prepared in accordance with generally accepted accounting principles. The statements include amounts that are based on management's best estimates and judgment, where necessary. Management believes that all representations made to our external auditors during their audit of the financial statements were valid and appropriate. To meet its responsibility, management has established and maintained a comprehensive system of internal control that provides reasonable assurance as to the integrity and reliability of the financial statements, that assets are safeguarded, and that transactions are properly executed and reported. This system can provide only reasonable, not absolute, assurance that errors and irregularities can be prevented or detected. The concept of reasonable assur- ance is based on the recognition that the cost of a system of internal control must be related to the benefits derived. The system of internal control is subject to close scrutiny by management and is revised as considered necessary. The accounting policies and system of internal control are under the general oversight of the Liberty Bancorp, Inc. Board of Directors, acting through its Audit Committee, which is comprised entirely of outside directors who are not officers or employees of Liberty Bancorp, Inc. Liberty's General Auditor, who reports directly to the Audit Committee, conducts an extensive program of operational, financial and special audits to ensure the system of control is adequate and operating as intended. In addition, Arthur Andersen & Co., independent public accountants, has been engaged to conduct an audit and to express an opinion as to the fairness of the presentation of the consolidated financial statements. Liberty Bancorp, Inc. is also examined periodically by the examiners from the Federal Reserve Board and other regulatory agencies. The Board of Directors and management appropriately consider and comply with all reports that arise from such examinations. Management maintains and enforces a strong code of corporate conduct designed to foster a strong ethical climate so that the affairs of the corporation are conducted according to the highest standards of personal and corporate conduct. This code of conduct is furnished to all employees and is periodically audited to ensure compliance. Liberty Bancorp, Inc. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS TO LIBERTY BANCORP, INC: We have audited the accompanying consolidated balance sheets of Liberty Bancorp, Inc. (an Oklahoma corporation) and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income, shareholders' investment and cash flows for each of the three years in the period ended De- cember 31, 1993. These financial statements are the responsibility of Liberty'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 consolidated subsidiaries, which statements reflect assets constituting approximately 2% and 3% of the related December 31, 1993 and 1992 consolidated totals, respectively, and revenues of approximately 6% of consolidated revenues for 1993 and 1991 and 8% for 1992. Those statements were audited by other auditors whose reports have been furnished to us and our opin- ion, insofar as it relates to the amounts included for such subsidiaries, 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 esti- mates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits and the reports of other auditors provide a reasonable basis for our opinion. In our opinion, based on our audits and the reports of other auditors, the consolidated financial statements referred to above present fairly, in all ma- terial respects, the financial position of Liberty Bancorp, Inc. and sub- sidiaries 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 explained in Note 4 to the consolidated financial statements, effective December 31, 1993, Liberty changed its method of accounting for certain investment securities. Additionally, as explained in Notes 11 and 15, respectively, to the consolidated financial statements, effective January 1, 1993, Liberty changed its methods of accounting for income taxes and postretirement benefits other than pensions. ARTHUR ANDERSEN & CO. Oklahoma City, Oklahoma, January 21, 1994 Liberty Bancorp, Inc. OTHER BUSINESS MATTERS Personnel On December 31, 1993, Liberty and its subsidiaries employed 1,435 full- time persons, compared with 1,319 on December 31, 1992. The increase was primarily due to acquisitions in 1993. Competition The Oklahoma market is highly competitive, especially in the area of competition for loans because of the relatively low loan demand in the market. Liberty also competes with money center and regional banks, money market funds, consumer finance companies and mortgage banks, mutual fund sponsors, brokerage firms, insurance companies and various other entities in connection with the banking and related services provided by its subsidiaries. The market for such services is highly competitive. Supervision and Regulation Bank holding companies and banks are extensively regulated under both federal and state law. To the extent that the following information describes statutory or regulatory provisions, it is qualified in its entirety by ref- erence to the particular statutory and regulatory provisions described. Any change in applicable law or regulation may have a material effect on the business and prospects of Liberty, Liberty Oklahoma City or Liberty Tulsa. Bank Holding Companies Liberty is registered as a "bank holding company" under the Bank holding Company Act of 1956, as amended (the "Act"). As a bank holding company, Liberty is subject to regulation by the Federal Reserve Board. Registered bank holding companies are required to file certain reports and information with the Federal Reserve Board and are subject to examination by the Federal Reserve Board. The Act requires the prior approval of the Federal Reserve Board in any case where a bank holding company proposes to acquire direct or indirect ownership or control of more than 5% of the voting shares of any bank which is not already majority owned by it or to merge or consolidate with any other bank holding company. The Act further provides that the Federal Reserve Board shall not approve any such acquisition, merger or consolidation which would result in a monopoly or would be in furtherance of any combination or conspiracy to monopolize or attempt to monopolize the business of banking in any part of the United States, or the effect of which may be to substantially lessen competition or to tend to create a monopoly in any section of the country, or which in any other manner would be in restraint of trade, unless the anti- competitive effects of the proposed transaction are clearly outweighed in the public interest by the probable effect of the transaction in meeting the convenience and needs of the community to be served. The Act prohibits the Federal Reserve Board from approving an application from a bank holding company to acquire shares of a bank located outside the state in which the operations of the holding company's banking subsidiaries are principally conducted, unless such an acquisition is specifically authorized by statute of the state in which the bank whose shares are to be acquired is located. The Act also prohibits a bank holding company, with certain exceptions, from acquiring more than 5% of the voting shares of any company which is not a bank and from engaging in any business other than banking or managing or controlling banks. Under the Act, the Federal Reserve Board is authorized to approve the ownership of shares by a bank holding company in any company whose activities the Federal Reserve Board has determined to be so closely related to banking or to managing or to controlling banks as to be a proper incident thereto. In making such determinations, the Federal Reserve Board is required to weigh the expected benefits to the public (such as greater convenience, increased competition or gains in efficiency) against the possible adverse effects, such as undue concentration of resources, decreased or unfair competition, conflicts of interest or unsound banking practices. The Federal Reserve Board has by regulation determined that certain activities are closely related to banking within the meaning of the Act. These activities include operating a savings association, mortgage company, finance company, credit card company or loan company, providing certain data processing operations, providing investment financial advice, acting as insurance agent or serving as underwriter for certain types of credit-related insurance, leasing personal property on a full-payout nonoperating basis, providing management consulting advice to nonaffiliated banks, operating a discount brokerage firm and certain other activities. Under the Act, a bank holding company and its subsidiaries are prohibited from engaging in certain tie-in arrangements in connection with extensions of credit or provisions of property or services. The Oklahoma Banking Code permits a bank holding company to own or control more than one bank, subject to a limitation that a bank holding company may not acquire a bank if the acquisition would result in such bank holding company controlling banks whose deposits exceeded 11% of total deposits of insured banks, savings associations and credit unions in Oklahoma, as reported in the most recent reports of such institutions available at the time of any acquisition. At the end of 1992, 11% of Oklahoma's total insured deposits amounted to approximately $3.7 billion. Oklahoma also has enacted an interstate banking law. Under the law, out- of-state bank holding companies are permitted to acquire any Oklahoma bank or bank holding company; however, further expansion by the acquiring holding company within Oklahoma is prohibited for a four-year period from the date of any acquisition unless its principal place of business is in a state which has enacted reciprocal legislation authorizing Oklahoma bank holding companies to acquire banks or bank holding companies in such state. Banks National banking associations, such as Liberty Oklahoma City and Liberty Tulsa, are subject to the supervision of, and are regularly examined by, the Office of the Comptroller of the Currency ("Comptroller"). Each of these banks is a member of the Federal Reserve System and is therefore subject to applicable provisions of the Federal Reserve Act which restricts the ability of any such bank to extend credit to or purchase assets from its parent holding company or any of the parent's subsidiaries or to invest in the stock or securities thereof, or to take such stock or securities as collateral for loans to any borrower, and which require that the terms of any such transactions between a bank and its parent holding company or other subsidiaries meet certain fairness standards. Affiliates of national banks are also subject to certain restrictions concerning engaging in certain securities activities. Certain restrictions are placed on the banks' abilities to pay dividends by the National Banking Act and regulations of the Comptroller. Without the approval of the Comptroller, total dividends declared by a national bank of common stock in any calendar year may not exceed its net profits (as defined) for that year combined with its retained net profits (as defined) of the preceding two years, less any required transfers to surplus or a fund for the retirement of any preferred stock. Further, a national bank may not pay any dividends on common stock if it does not have undivided profits available. Under these provisions, Liberty Oklahoma City and Liberty Tulsa could pay dividends of no more than $30.5 million and $17.6 million, respectively, as of January 1, 1994. The Comptroller also has authority to prohibit a national bank from engaging in unsafe or unsound practices in the conduct of its business. Depending upon the financial condition of a national bank, the pay- ment of dividends could be deemed to constitute such an unsafe or unsound practice. It is anticipated that the banks will pay common dividends to the parent in 1994. The Comptroller has the authority to take various administrative actions concerning national banks when such actions are deemed necessary by the Comptroller. These actions include imposing civil monetary penalties against a bank or its directors and officers, removing directors or officers, entering cease and desist orders, requiring formal or informal agreements between the Comptroller and the bank, and various other actions. National banks are required by the National Banking Act to adhere to branch banking laws applicable to state banks in the states in which they are located. Under current Oklahoma law, a state or national bank located in Oklahoma may establish and maintain up to two branches (i) located within the same city as the main bank; or (ii) located within 25 miles of the main bank if located in a city or town which has no state or national bank. In addition, a state or national bank located in Oklahoma may acquire, maintain and operate as branches an unlimited number of banks, so long as such acquisitions do not result in a bank having direct or indirect ownership or control of more than eleven percent (11%) of the aggregate deposits of all financial institutions located in Oklahoma which have insured deposits. Certain exceptions to the deposit limitation exist in connection with the acquisition of stock of a bank which is acquired (i) in a good faith fiduciary capacity; (ii) in the regular course of securing or collecting a debt previously contracted in good faith; or (iii) at the request of or in connection with the exercise of regulatory authority in order to prevent imminent failure of a bank or to protect the depositors of a bank. Insured depository institutions are liable for any losses incurred by the Federal Deposit Insurance Corporation in connection with the closing of another insured depository institution under common control. These "cross-guarantee" provisions may have an effect on the ability of multi-bank holding companies, such as Liberty, and their subsidiary banks to raise capital and borrow funds because of the increased risk of loss. The Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA") provided for the recapitalization of the Bank Insurance Fund (which resulted in an increase in deposit insurance costs). FDICIA also made many far-reaching changes in the regulatory environment for insured banks and savings associations, many of which have a significant impact on the operations of banks and bank holding companies. These changes include: major revisions in the supervision, examination and audit processes; new requirements for corrective actions for undercapitalized institutions; required adoption of uniform safety and soundness standards; increases in disclosure requirements for deposit accounts; substantial new reporting requirements; changes in terms of insurance coverage for certain deposits; and a number of other changes. Most of the requirements of FDICIA are being implemented through regulations which have been and will continue to be promulgated by the appropriate regula- tory authority. FDICIA has resulted in increased regulatory compliance costs but does not affect Liberty to any materially greater extent than other comparable institutions. Government Policies The earnings of Liberty are affected not only by general economic conditions, both domestic and foreign, but also by legislative and administrative changes which, among other things, affect maximum lending rates, and by the monetary and fiscal policies of the U.S. Government and its agencies, including the Federal Reserve Board. An important function of the Federal Reserve Board is to regulate the national supply of bank credit. Among the instruments of monetary policy used by the Federal Reserve Board are open market operations in U.S. Government securities, changes in the discount rate on member bank borrowings, changes in reserve requirements against member bank deposits and limitations on interest rates which member banks may pay on time and savings deposits. These means are used in varying combinations to influence overall growth of bank loans, investments and deposits, and may also affect interest rates charged on loans or paid for deposits. The monetary policies of the Federal Reserve Board have had a significant effect on the operating results of commercial banks in the past and are expected to continue to have such an effect in the future. In view of the changing conditions in the national economy and in the money markets and the effect of actions by monetary and fiscal authorities, as well as other federal agencies and authorities, no prediction can be made as to possible future changes in interest rates, deposit levels, loan demand or the impact on the business and earnings of Liberty or its subsidiaries. Properties The principal business operations of Liberty and its Oklahoma City subsidiaries are conducted from Liberty Tower, located at 100 North Broadway, Oklahoma City, Oklahoma. In 1982, Liberty exercised an option to purchase this 36-story structure of approximately 512,000 square feet and ownership was placed in a wholly-owned subsidiary. Approximately 44% of the property is leased to Liberty. The ground lease pertaining to Liberty Tower was purchased during 1993. Liberty Tulsa maintains its offices in the 40-story First Place Tower and the adjoining 20-story Liberty Bank Building, located in the central business district of Tulsa, Oklahoma. Liberty Tulsa leases 183,000 square feet of the combined buildings and has an option to lease an additional 67,000 square feet. The lease agreement dated December 14, 1977, provides for a 25-year primary lease term with two ten-year renewal options. Legal Proceedings In 1988 Cadijah Helmerich Patterson filed a civil action in the state District Court of Tulsa County, Oklahoma against Liberty Tulsa claiming breaches of fiduciary duty by Liberty Tulsa as trustee of a 1939 trust of which Ms. Patterson is a contingent beneficiary. The lawsuit also named other beneficiaries as defendants because of their beneficial interest in the trust, including Ms. Patterson's mother, Cadijah C. Helmerich, and her brother, Walter H. Helmerich, III, a director of Liberty and Liberty Tulsa. The plaintiff alleges that Liberty Tulsa breached its duty of prudence by failing to diversify properly trust investments, breached its duty of loyalty by investing in securities of First Tulsa Bancorporation, Inc., Liberty and Helmerich & Payne, Inc. and breached its duty to keep the plaintiff informed of the status of the trusts. Plaintiff seeks compensatory damages of $21.5 million, and $5.0 million in punitive damages. The litigation is in a relatively preliminary stage despite its filing date. Limited document discovery has been conducted. Liberty Tulsa intends to vigorously contest this action and management of Liberty believes, based upon the facts available at this time and after consultation with legal counsel, that it will not have any material adverse effect on the financial position of Liberty. The 1939 trust suit was filed subsequent to other litigation filed by Ms. Patterson and her children as contingent beneficiaries against her brother, in which similar allegations are made as to his role in management of certain family trusts. Liberty Tulsa was added as a defendant to this litigation in 1989 due to Liberty Tulsa's position as co-trustee of a 1973 trust. In this 1973 trust action, the plaintiff alleges that the co-trustees have made improper and unauthorized contributions to charities from the assets of the trust in the amount of $977 thousand and certain gifts, plus interest, from the co-trustees. A trial court ruling in favor of Liberty Tulsa related to the 1973 trust was rendered in 1990. At December 31, 1993, the case is currently on appeal with the Supreme Court of Oklahoma. In the ordinary course of business, Liberty and its subsidiaries are subject to other legal actions and complaints. Management believes, after consultation with legal counsel, based upon available facts and proceedings to date, which are preliminary stages in some instances, that the ultimate liability, if any, arising from such legal actions or complaints, will not have a material adverse effect on the financial position or result of future operations of Liberty or its subsidiaries. REPORT OF OTHER INDEPENDENT AUDITORS APPLICABLE TO SUBSIDIARY REPORT OF INDEPENDENT AUDITORS The Board of Directors Liberty Mortgage Company We have audited the consolidated balance sheets of Liberty Mortgage Company as of December 31, 1993 and 1992, and the related consolidated statements of operations and retained earnings and cash flows for each of the three years in the period ended December 31, 1993 (not presented separately 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 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 reason- able basis for our opinion. Liberty Mortgage Company is one of several affiliated members of Liberty Bancorp, Inc. and a substantial portion of its activities is with or is ar- ranged by members of the affiliated group. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Liberty Mort- gage 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. Liberty Mortgage Company changed its method of accounting for income taxes and postretirement benefits other than pensions as more fully described in the notes to the consolidated financial statements (not presented separately herein). ERNST & YOUNG Oklahoma City, Oklahoma, January 21, 1994 Liberty Bank and Trust Company of Oklahoma City, N.A. and Subsidiaries STATEMENT OF CONDITION (Unaudited) - ------------------------------------------------------------------------------ December 31 (In thousands) 1993 1992 - ------------------------------------------------------------------------------ Assets Cash and due from banks $ 245,364 $ 206,003 Federal funds sold and other 17,964 199,334 Trading account securities 205 165 Investment securities 721,703 562,629 Loans 649,536 478,640 Less: Reserve for loan losses (13,498) (13,139) - ------------------------------------------------------------------------------ Loans, net 636,038 465,501 - ------------------------------------------------------------------------------ Other real estate and assets owned, net 7,823 29,713 Property and equipment, net 25,625 15,058 Deferred tax asset, net 10,416 _ Other assets 49,189 40,711 - ------------------------------------------------------------------------------ Total Assets $1,714,327 $1,519,114 ============================================================================== Liabilities and Shareholders' Investment Deposits Noninterest-bearing $ 480,662 $ 427,594 Interest-bearing 946,495 797,353 - ------------------------------------------------------------------------------ Total deposits 1,427,157 1,224,947 - ------------------------------------------------------------------------------ Short-term borrowings 140,626 174,444 Other liabilities 17,317 16,738 - ------------------------------------------------------------------------------ Total Liabilities 1,585,100 1,416,129 Total Shareholders' Investment 129,227 102,985 - ------------------------------------------------------------------------------ Total Liabilities and Shareholders' Investment $1,714,327 $1,519,114 ============================================================================== Liberty Bank and Trust Company of Oklahoma City, N.A. provides banking services at the following locations: Oklahoma City Norman Edmond 100 N. Broadway 116 S. Peters 18 E. 15th 320 N. Broadway 3600 W. Robinson 24 E. 1st 1112 N.W. 23rd 320 E. Comanche 300 S. Bryant 12324 N. May Ave. Midwest City 901 W. Edmond Rd. N.W. 122nd and Rockwell Ave. 301 N. Midwest Blvd. Choctaw 9350 S. Western Ave. 10100 S.E. 15th 14483 N.E. 23rd 1200 N.W. 63rd St. 2201 N. Douglas Harrah 200 N. Air Depot 19625 N.E. 23rd Liberty Bank and Trust Company of Tulsa, N.A. and Subsidiaries STATEMENT OF CONDITION (Unaudited) - ------------------------------------------------------------------------------ December 31 (In thousands) 1993 1992 - ------------------------------------------------------------------------------ Assets Cash and due from banks $ 73,274 $ 97,086 Federal funds sold and other 8,601 147,764 Trading account securities 1,687 3,426 Investment securities 525,361 447,541 Loans 308,369 207,917 Less: Reserve for loan losses (6,450) (12,385) - ------------------------------------------------------------------------------ Loans, net 301,919 195,532 - ------------------------------------------------------------------------------ Other real estate and assets owned, net 2,392 2,539 Property and equipment, net 10,108 6,650 Deferred tax asset, net 4,942 _ Other assets 21,347 15,844 - ------------------------------------------------------------------------------ Total Assets $949,631 $916,382 ============================================================================== Liabilities and Shareholders' Investment Deposits Noninterest-bearing $ 216,047 $ 237,277 Interest-bearing 495,322 468,767 - ------------------------------------------------------------------------------ Total deposits 711,369 706,044 Short-term borrowings 139,485 127,213 Other liabilities 9,404 16,039 - ------------------------------------------------------------------------------ Total Liabilities 860,258 849,296 Total Shareholders' Investment 89,373 67,086 - ------------------------------------------------------------------------------ Total Liabilities and Shareholders' Investment $949,631 $916,382 ============================================================================== Liberty Bank and Trust Company of Tulsa, N.A. provides banking services at the following locations: Tulsa Broken Arrow 15 E. Fifth Street 701 W. New Orleans 615 S. Boston Avenue Jenks 6660 S. Sheridan Road 700 W. Main 6985 S. Lewis 8015 E. 71st Street 2070 Utica Square 5307 E. 41st St. 601 E. Apache SHAREHOLDER INFORMATION Executive Offices Stock Transfer Agent and Registrar Liberty Bancorp, Inc. Liberty Bank and Trust Company of Oklahoma City, N.A. Liberty Tower 100 North Broadway 100 North Broadway P.O. Box 25848 Oklahoma City, OK 73102 Oklahoma City, OK 73125 (405) 231-6000 If you receive duplicate copies of this report, this indicates that you hold stock in more than one account name. By reviewing the mailing label on each report, you can determine the account listing for your holdings of Liberty Bancorp, Inc.'s stock. Consolidating your accounts decreases the cost of our stockholder relations activity. If you wish to consolidate any of your accounts, you can do so by writing to the stock transfer agent. Contact our stock transfer agent at the above address for assistance regarding: * Change of address * Transfer of stock certificates * Replacement of lost, stolen or destroyed certificates * Elimination of duplicate mailings Stock Prices The Common Stock of Liberty is traded over-the counter on the NASDAQ National Market System under the symbol LBNA. As of December 31, 1993 there were 2,587 shareholders of record. The following sets forth the range of closing prices of Common Stock and cash dividends declared for the periods indicated. These quotations represent inter-dealer prices, do not include mark-up, mark-down or commissions and do not necessarily represent actual transactions. Dividends Per Share High Low First Quarter $ _ $15.00 $12.75 Second Quarter _ 21.00 14.50 Third Quarter _ 27.63 19.75 Fourth Quarter _ 31.00 25.25 First Quarter $ _ $33.75 $31.25 Second Quarter .10 34.25 28.75 Third Quarter .10 35.50 32.50 Fourth Quarter .10 34.00 28.00 Liberty's annual report on Form 10-K for the fiscal year ended December 31, 1993 (other than the exhibits thereto) is available upon written request without charge. Requests for such copies should be directed to the attention of Corporate Secretary, Liberty Bancorp, Inc., P.O. Box 25848, Oklahoma City, OK 73125. Your comments, questions or suggestions on any aspect of our business are welcome. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K The following documents are filed as part of this report: (a) Financial Statements and Schedules 1. Financial Statements (See pages 26 through 44.) 2. Financial Statements Schedules. All schedules have been omitted because they are not applicable or not required. (b) Reports on Form 8-K No reports 8-K were filed during the last quarter of the period covered by this report. (c) Exhibits. The following Exhibits (unless incorporated by reference to another report) are included in a separate volume filed with this report and are identified by the numbers indicated. References to Liberty are to Liberty National Corporation, File No. 0-4547. Exhibit No. Description - ------------------------------------------------------------------------------ 3.1 Certificate of Incorporation of Liberty Bancorp, Inc. (incorporated by reference to Exhibit 3.1 to Registrant's Form 8-B dated May 26, 1992) 3.2 By-laws of Liberty Bancorp, Inc. (incorporated by reference to Exhibit 3.2 to Registrant's form 8-B dated May 26, 1992) 10.1 Copy of Lease Agreement between Liberty Bank and Trust Company of Oklahoma City, N.A. and Mid-America Plaza, Ltd. (incorporated by reference to Exhibit 9.75 to Liberty's Form 10-K for the year ended December 31, 1979) 10.2 Liberty Bancorp, Inc., 1990 Stock Option Plan, as amended (incorporated by reference to Exhibit 10.1 to Registrant's Form 8-B dated May 26, 1992) 10.3 Copy of documents relating to Liberty Bancorp, Inc. Executive Mortgage Assistance Plan (incorporated by reference to Exhibit 10.21 to Amendment No. 1 to Liberty's Registration Statement on Form S-14, Registration No. 2-87751) 10.4 Copy of Memorandum of Lease entered into December 14, 1977, between First Place Corporation and Liberty Tulsa (incorporated by reference to Exhibit 10.4 to Registrant's Form 10-K for the year ended December 31, 1990) 10.7 Option to Purchase Common Stock between Registrant and Frank X. Henke, III (incorporated by reference to Exhibit 10.16 to Amendment No. 1 to Registrant's Registration Statement on Form S-1, Registration No. 33-17239) 10.8 Management Incentive Bonus Plan (incorporated by reference to Exhibit 10.8 to Registrant's Form 10-K for the year ended December 31, 1992) 10.9 Supplemental Executive Retirement Plan and Trust 22 Subsidiaries of Registrant (incorporated by reference to Exhibit 22 to Registrant's Form 10-K for the year ended December 31, 1992) 24.1 Consent of Arthur Andersen & Co. 24.2 Consent of Ernst & Young 25 Powers of Attorney - ------------------------------------------------------------------------------ Liberty Bancorp, Inc. will furnish to any shareholder a copy of any of the above exhibits upon the payment of $.25 per page. Any request should be sent to Corporate Secretary, Liberty Bancorp, Inc., P.O. Box 25848, Oklahoma City, Oklahoma 73125. 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, this 20th day of March, 1994. Liberty Bancorp, Inc. (Registrant) /s/Mischa Gorkuscha - -------------------------- By Mischa Gorkuscha, Senior Vice President and Chief Financial Officer Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, this report has been signed by the following persons on behalf of the Registrant and in the capacities and on the dates indicated, this 23rd day of March, 1994. /s/Charles E. Nelson - -------------------------- Charles E. Nelson Chairman and Chief Executive Officer (Principal Executive Officer) /s/Mischa Gorkuscha - -------------------------- Mischa Gorkuscha Senior Vice President and Chief Financial Officer (Principal Financial Officer) /s/Rodney L. Lee - -------------------------- Rodney L. Lee Senior Vice President and Controller (Principal Accounting Officer) Molly Shi Boren* Director Donald L. Brawner, M.D.* Director Robert S. Ellis, M.D.* Director William J. Fischer, Jr.* Director C.W. Flint, Jr.* Director James L. Hall, Jr.* Director Raymond H. Hefner, Jr.* Director Walter H. Helmerich, III* Director Joseph S. Jankowsky* Director John E. Kirkpatrick* Director Edward C. Lawson, Jr.* Director Herb Mee, Jr.* Director William G. Paul* Director W.N. Pirtle* Director V. Lee Powell* Director Jon R. Stuart* Director Robert E. Torray* Director John S. Zink* Director /s/Kenneth R. Brown - -------------------------- *By Kenneth R. Brown, Attorney-in-fact EXHIBITS EXHIBIT 10.9 LIBERTY BANCORP, INC. SUPPLEMENTAL EXECUTIVE RETIREMENT PLAN This Liberty Bancorp, Inc. Supplemental Executive Retirement Plan ("Plan") is adopted by Liberty Bancorp, Inc. ("Company") for the benefit of certain officers, key management and highly compensated employees to be effective January 20, 1993. The Plan is intended to protect and retain certain qualified employees and to reward those qualified employees for loyal service to the Company by providing for supplemental retirement benefits in addition to the benefits provided to those employees under the qualified retirement plan maintained by the Company. The Plan is intended to be an unfunded nonqualified deferred compensation arrangement for a select group of management or highly compensated employees. ARTICLE I DEFINITIONS 1.1 Accrued Projected Benefit means the Projected Benefit multiplied by a fraction, not greater than one (1), the numerator of which is the Participant's years of Participation Service and the denominator of which is the aggregate number of years of Participation Service the Participant would have if such Participant is employed by the Company to Participant's Normal Retirement Date. 1.2 Actuarial Equivalence means a form of benefit differing in time, period, or manner of payment from the benefit provided under the Plan but having the same value when computed by assuming a life expectancy at age 65 of 18 years and an interest and discount rate of six percent (6%). 1.3 Average Annual Earnings means the average of the Participant's Earnings for the five (5) consecutive calendar years immediately preceding Participant's Normal Retirement Date or Termination of Service, whichever occurs first. 1.4 Board means the Board of Directors of the Company. 1.5 Change in Control means: (a) the date any entity or person, including a group as defined in Section 13(d)(iii) of the Securities Exchange Act of 1934 shall become the beneficial owner of, or shall have obtained voting control over, 25 percent or more of the outstanding common shares of the Company; (b) the date the shareholders of the Company approve a definitive agreement (i) to merge or consolidate the Company with or into another corporation, in which the Company is not the continuing or surviving corporation or pursuant to which any common shares of the Company would be converted into cash, securities or other property of another corporation, other than a merger of the Company in which holders of common shares immediately prior to the merger have the same proportionate interest of common stock of the surviving corporation immediately after the merger as immediately before, or (ii) to sell or otherwise dispose of substantially all of the assets of the Company; or (c) the date there shall have been change in a majority of the Board of the Company within a 12 month period unless the nomination of each new director was approved by the vote of two-thirds (2/3) of directors then still in office who were in office at the beginning of the 12 month period. 1.6 Company means Liberty Bancorp, Inc., an Oklahoma corporation, and any successor corporation. 1.7 Compensation Committee means the Human Resources and Compensation Committee of the Board. Any function exercisable by such Committee may also be exercised by the Board or such other committee as the Board designates. 1.8 Disability Date means the date a Participant commences benefits under the Company's long-term disability insurance plan as in effect from time to time. If the Company has no long-term disability plan in effect, a Participant's Disability Date shall be the first day of the seventh month following the date the Participant is determined to be disabled pursuant to the provisions of the Retirement Plan. 1.9 Earnings means only the base cash compensation paid to the Participant by the Company or any subsidiary and shall not include overtime, bonus, commissions, or any non-cash amounts (including amounts attributable to stock options) which are required to be included in compensation. Earnings shall not be reduced by amounts excluded from gross income under Sections 125, 402(a)(8) or 402(h) or limited as provided under Section 401(a)(17) of the Internal Revenue Code of 1986, as amended ("Code"). 1.10 Normal Retirement Date means the first day of the month following the Participant's 65th birthday. 1.11 Participant means the executive officers of the Company designated on the attached Exhibit A and any other executive who may be designated as a Participant as provided in Article II. A Participant shall also include a retired or terminated Participant who continues to be entitled to benefits under this Plan after Participant's Termination of Service. 1.12 Participation Service means full-time employment with the Company while a Participant in this Plan; provided, employment after a Participant's Normal Retirement Date shall be disregarded. The number of years of Participation Service shall be the Participant's completed months of employment, whether or not consecutive, divided by 12, counting each twelve months as one year and each additional full month as one-twelfth of a year. 1.13 Plan means this Liberty Bancorp, Inc. Supplemental Executive Retirement Plan and amendments thereto. 1.14 Projected Benefit means the lump sum Actuarial Equivalence of the right to receive at Normal Retirement Date thirty percent (30%) of the Participant's Average Annual Earnings payable over the Participant's life based on the mortality assumption used to calculate Actuarial Equivalence. 1.15 Retirement Plan means the Liberty Bancorp, Inc. Profit Sharing, Salary Deferral and Employee Stock Ownership Plan, as amended from time to time. 1.16 Termination of Service means the first day of the month next following the termination of a Participant's employment whether by voluntary or involuntary separation, retirement, disability or death; provided, if a Participant continues in active employment through Participant's 70th birthday, such Participant shall be deemed to retire on Participant's 70th birthday. 1.17 Trust means the trust established by the Company and maintained for the benefit of the Participants, a copy of which is attached hereto as Exhibit B. 1.18 Trust Accumulation Account means the account established and maintained for a Participant under the Trust. ARTICLE II DESIGNATION OF PARTICIPANTS AND ELIGIBILITY FOR BENEFITS 2.1 Designation of Participants. The Participants shall be those executive officers or key employees of the Company designated on Exhibit A any other executive officers or key employees designated by the Board or Compensation Committee from time to time as Participants in the Plan; provided no employee shall be designated as a Participant if such employee is not within a "select group of management" or a "highly compensated employee" as such terms are defined at Section 201(2) of the Employee Retirement Income Security Act of 1974, as amended ("ERISA"). 2.2 Eligibility for Benefits. Vested benefits under this Plan shall be payable to Participant upon: (a) a Participant's Termination of Service other than by disability or death; (b) a Participant's Disability Date which occurs before Participant's Normal Retirement Date and while actively employed by the Company; (c) a Participant's death before Normal Retirement Date and while actively employed by the Company. ARTICLE III BENEFITS 3.1 Benefit. Each Participant's benefit under this Plan shall be an amount equal to the greater of: (a) the sum of (i) the vested percentage of the Participant's Trust Accumulation Account, and (ii) the total of all such Participant's account balances to which he is entitled under the Retirement Plan as of the valuation date immediately following such Participant's Termination of Service; or (b) an amount equal to the vested percentage of the Actuarial Equivalence of the Participant's Accrued Projected Benefit as of such Participant's Termination of Service less the total of all such Participant's account balances to which he is entitled under the Retirement Plan as of the valuation date immediately following such Participant's Termination of Service. 3.2 Vested Percentage. A Participant's vested benefit shall be determined in accordance with the following schedule: Years of Participation Service Vested Percentage Less than 1 0% 1 but less than 2 20% 2 but less than 3 40% 3 but less than 4 60% 4 but less than 5 80% 5 or more 100% A Participant shall also become fully vested in Participant's benefit upon Participant's death, disability, or on a Change in Control. 3.3 Company Contributions. The Company shall contribute to the Trust for each Participant each calendar year an amount equal to (a) plus (b) where: (a) is equal to 7% of the Participant's Earnings for such year reduced by the amount allocated to such Participant's Retirement Plan account under Section 5.2(b)(vii) of the Retirement Plan as of the end of such Plan Year, and (b) is equal to the amount actuarially calculated to fund, in substantially equal payments, the excess of the lump sum Actuarial Equivalence of the Participant's Projected Benefit over the sum of the anticipated value of the Participant's Trust Accumulation Account and the anticipated value of the Participant's total Retirement Plan account balances at the Participant's Normal Retirement Date. Computation of anticipated values shall be made by assuming the same interest rate as is used to determine Actuarial Equivalence, maximum Participant contributions and matching contributions, and an additional allocation of 1.5% of the Participant's compensation under the Retirement Plan. Contributions to the Trust shall be made as soon as administratively feasible after the end of each calendar year, but in any event prior to March 31st. 3.4 Trust Assets. All Company contributions shall be held by the Trustee as a single investment fund. However, the Trustee shall maintain separate Trust Accumulation Accounts for the benefit of each Participant which shall be credited with the Company contributions allocated to each such Participant and the earnings attributable thereto. Each Participant's Trust Accumulation Account shall be each allocated its pro rata share of all earnings, interest, gain and losses as of the last day of each calendar year. It is expressly acknowledged that the assets of the Trust are and will remain subject to the creditors of the Company as set forth in the Trust Agreement. ARTICLE IV PAYMENT OF RETIREMENT BENEFITS 4.1 Payment of Benefit. Payment of benefits shall be made in the form of a lump sum payment. Benefit payment shall be made as soon as administratively feasible following the applicable date set forth at Section 2.2. All payments of benefits shall be reduced by the amount of applicable federal, state and local withholding taxes and FICA and FUTA taxes. 4.2 Survivor Benefit. If a Participant is entitled to a benefit under the Plan and such Participant dies prior to full payment of such benefit, payment shall be made to the personal representative of the Participant's estate. ARTICLE V MISCELLANEOUS 5.1 Amendment and Termination. The Board may at any time, or from time to time, amend this Plan in any respect or terminate this Plan without restriction and without consent of any Participant or beneficiary; provided, any such amendment or termination shall not impair the right of any Participant or any beneficiary of any deceased Participant to receive benefits vested hereunder prior to such amendment or termination without the consent of such Participant or such beneficiary. No beneficiary of a Participant shall have any right to benefits under this Plan or any other interest before the death of such Participant. The Company's funding obligation under this Plan may be terminated at any time. 5.2 Plan Administration. The administration of this Plan shall be the responsibility of the Compensation Committee which is hereby authorized, in its discretion, to delegate said responsibilities to an administrator or administrative committee. 5.3 No Guarantee of Employment. Nothing contained herein shall be construed as a contract of employment or give any Participant the right to be retained in the employ of the Company or any subsidiary, or to interfere with the rights of any such employer to discharge any individual at any time, with or without cause. 5.4 Alienation of Benefits. No benefit payable under the Plan may be assigned, pledged, mortgaged or hypothecated. Except as required by applicable law, no such benefit shall be subject to legal process or attachment for the payment of any claims of a creditor of a Participant or beneficiary. 5.5 Payment to Representatives. If any individual entitled to receive any benefits is determined by the Compensation Committee or is adjudicated by a court of competent jurisdiction to be legally incapable of giving valid receipt and discharge for such benefits, such benefit shall be paid to the duly appointed and acting guardian, if any, and if no such guardian is appointed and acting, to such persons as the Compensation Committee may designate. Such payment shall, to the extent made, be deemed a complete discharge for such payments under this Plan. 5.6 Governing Law. The provisions of this Plan shall be construed under federal law except to the extent that the laws of the State of Oklahoma would be applicable. 5.7 Gender and Number. The masculine pronoun wherever used shall include the feminine. Wherever any words are used herein in the singular, they shall be construed as though they were also used in the plural in all cases where they shall so apply. 5.8 Titles and Headings. The titles to articles and headings of sections are for convenience of reference and, in case of any conflict, the text of Plan rather than such titles and headings shall control. 5.9 Resolution of Disputes. Any dispute between a Participant and the Company, or any successor, shall be first submitted to mediation under the Commercial Mediation Rules of the American Arbitration Association, which may be initiated by a written request by Participant or Company. If such dispute is not resolved within sixty (60) days of the written request for mediation, it shall be submitted to arbitration in accordance with the Commercial Arbitration Rules of the American Arbitration Association and judgment upon the award rendered by the arbitrator may be entered in any court having jurisdiction thereof. In connection with such mediation and arbitration, the following rules shall apply: (i) Any mediation or arbitration shall be held in the city in which the Participant resides at the time of submission to mediation; (ii) Any mediation or arbitration shall be conducted by a single person who shall serve as both mediator and arbitrator; (iii) The costs of any mediation and arbitration shall be borne by the Company. LIBERTY BANCORP, INC. SUPPLEMENTAL EXECUTIVE RETIREMENT PLAN TRUST AGREEMENT This Agreement is made this day of , , by and between Liberty Bancorp, Inc. ("Company") and Liberty Bank and Trust Company of Oklahoma City, National Association ("Trustee"); WHEREAS, the Company has adopted the Liberty Bancorp, Inc. Supplemental Executive Retirement Plan ("Plan") which is intended to be a nonqualified deferred compensation plan as described in Section 201(2) of the Employee Retirement Income Security Act of 1974 as amended, ("ERISA"). WHEREAS, Company has incurred or expects to incur liability under the terms of such Plan with respect to the individuals participating in such Plan; WHEREAS, Company wishes to establish a trust ("Trust") and to contribute to the Trust assets that shall be held therein, subject to the claims of Company's creditors in the event of Company's Insolvency, as herein defined, until paid to Plan participants and their beneficiaries in such manner and at such times as specified in the Plan; WHEREAS, it is the intention of the parties that this Trust shall constitute an unfunded arrangement and shall not affect the status of the Plan as an unfunded plan maintained for the purpose of providing deferred compensation for a select group of management or highly compensated employees for purposes of Title I of ERISA; WHEREAS, it is the intention of Company to make contributions to the Trust to provide itself with a source of funds to assist it in the meeting of its liabilities under the Plan; NOW THEREFORE, the parties do hereby establish the Trust and agree that the Trust shall be comprised, held and disposed of as follows: ARTICLE I ESTABLISHMENT OF TRUST 1.1 Deposits. Company hereby deposits with Trustee in trust $100, and such other amounts as the Company may from time to time determine, which shall become the principal of the Trust to be held, administered and disposed of by Trustee as provided in this Trust Agreement. 1.2 Irrevocable Trust. The Trust hereby established shall be irrevocable. 1.3 Grantor Trust. The Trust is intended to be a grantor trust, of which Company is the grantor, within the meaning of subpart E, part I, subchapter J, chapter 1, subtitle A of the Internal Revenue Code of 1986, as amended ("Code"), and shall be construed accordingly. 1.4 Claims Against Trust. The principal of the Trust and any earnings thereon shall be held separate and apart from other funds of Company and shall be used exclusively for the uses and purposes of Plan participants and general creditors as herein set forth. Plan participants and their beneficiaries shall have no preferred claim on, or any beneficial ownership interest in, any assets of the Trust. Any rights created under the Plan and this Trust Agreement shall be mere unsecured contractual rights of Plan participants and their beneficiaries against Company. Any assets held by the Trust shall be subject to the claims of Company's general creditors under federal and state law in the event of Insolvency, as defined in Section 3.1. 1.5 Additional Deposits. Company, in its sole discretion, may at any time, or from time to time, make additional deposits of cash or other property in trust with Trustee to augment the principal to be held, administered and disposed of by Trustee as provided in this Trust Agreement. Neither Trustee nor any Plan participant or beneficiary shall have any right to compel such additional deposits. ARTICLE II PAYMENTS TO PLAN PARTICIPANTS AND BENEFICIARIES. 2.1 Payment Schedule. Company shall deliver to Trustee a schedule ("Payment Schedule") that indicates the amounts payable in respect of each Plan participant and his or her beneficiaries, that provides a formula or other instructions acceptable to Trustee for determining the amounts so payable, the form in which such amount is to be paid (as provided for or available under the Plan), and the time of commencement for payment of such amounts. Except as otherwise provided herein, Trustee shall make payments to the Plan participants and their beneficiaries in accordance with such Payment Schedule. The Trustee shall make provision for the reporting and withholding of any federal, state or local taxes that may be required to be withheld with respect to the payment of benefits pursuant to the terms of the Plan and shall pay amounts withheld to the appropriate taxing authorities or determine that such amounts have been reported, withheld and paid by Company. 2.2 Entitlement to Benefits. The entitlement of a Plan participant or his or her beneficiaries to benefits under the Plan shall be determined by Company or such party as it shall designate under the Plan, and any claim for such benefits shall be considered and reviewed under the procedures set out in the Plan. 2.3 Payment of Benefits. Company may make payment of benefits directly to Plan participants or their beneficiaries as they become due under the terms of the Plan. Company shall notify Trustee of its decision to make payment of benefits directly prior to the time amounts are payable to participants or their beneficiaries. In addition, if the principal of the Trust, and any earnings thereon, are not sufficient to make payments of benefits in accordance with the terms of the Plan, Company shall make the balance of each such payment as it falls due. Trustee shall notify Company where principal and earnings are not sufficient. ARTICLE III TRUSTEE'S RESPONSIBILITY UPON COMPANY'S INSOLVENCY. 3.1 Cessation of Payment. Trustee shall cease payment of benefits to Plan participants and their beneficiaries if the Company is Insolvent. Company shall be considered "Insolvent" for purposes of this Trust Agreement if (a) Company is unable to pay its debts as they become due, or (b) Company is subject to a pending proceeding as a debtor under the United States Bankruptcy Code. 3.2 Assets Subject to Claims. At all times during the continuance of this Trust, the principal and income of the Trust shall be subject to claims of general creditors of Company under federal and state law set forth below. 3.2.1 Notice of Insolvency. The Board of Directors and the Chief Executive Officer of Company shall have the duty to inform Trustee in writing of Company's Insolvency. If a person claiming to be a creditor of Company alleges in writing to Trustee that Company has become Insolvent, Trustee shall determine whether Company is Insolvent and, pending such determination, Trustee shall discontinue payment of benefits to Plan participants or their beneficiaries. 3.2.2 Duty of Inquiry. Unless Trustee has actual knowledge of Company's Insolvency, or has received notice from Company or a person claiming to be a creditor alleging that Company is Insolvent, Trustee shall have no duty to inquire whether Company is Insolvent. Trustee may in all events rely on such evidence concerning Company's solvency as may be furnished to Trustee and that provides Trustee with a reasonable basis for making a determination concerning Company's solvency. 3.2.3 Discontinuance of Benefits. If at any time Trustee has determined that Company is Insolvent, Trustee shall discontinue payments to Plan participants or their beneficiaries and shall hold the assets of the Trust for the benefit of Company's general creditors. Nothing in this Trust Agreement shall in any way diminish any rights of Plan participants or their beneficiaries to pursue their rights as general creditors of Company with respect to benefits due under the Plan or otherwise. 3.2.4 Resumption of Benefits. Trustee shall resume the payment of benefits to Plan participants or their beneficiaries in accordance with Article II of this Trust Agreement only after Trustee has determined that Company is not Insolvent or is no longer Insolvent. 3.3 Continuation of Payments. Provided that there are sufficient assets, if Trustee discontinues the payment of benefits from the Trust pursuant to Section 3.2 hereof and subsequently resumes such payments, the first payment following such discontinuance shall include the aggregate amount of all payments due to Plan participants or their beneficiaries under the terms of the Plan for the period of such discontinuance, less the aggregate amount of any payments made to Plan participants or their beneficiaries by Company in lieu of the payments provided for hereunder during any such period of discontinuance. ARTICLE IV INVESTMENT AUTHORITY 4.1 Reversion of Assets. Except as provided in Article III hereof, Company shall have no right or power to direct Trustee to return to Company or to divert to others any of the Trust assets before all payment of benefits have been made to Plan participants and their beneficiaries pursuant to the terms of the Plan. 4.2 Securities. In no event may Trustee invest in securities (including stock or rights to acquire stock) or obligations issued by Company, other than a de minimis amount held in common investment vehicles in which Trustee invests. All rights associated with assets of the Trust shall be exercised by Trustee or the person designated by Trustee, and shall in no event be exercisable by or rest with Plan participants. 4.3 Income Accumulation. During the term of this Trust, all income received by the Trust, net of expenses and taxes, shall be accumulated and reinvested. 4.4 Accounting. Trustee shall keep accurate and detailed records of all investments, receipts, disbursements, and all other transactions required to be made, including such specific records as shall be agreed upon in writing between Company and Trustee. Within 60 days following the close of each calendar year and within 60 days after the removal or resignation of Trustee, Trustee shall deliver to Company a written account of its administration of the Trust during such year or during the period from the close of the last preceding year to the date of such removal or resignation, setting forth all investments, receipts, disbursements and other transactions effected by it, including a description of all securities and investments purchased and sold with the cost or net proceeds of such purchases or sales (accrued interest paid or receivable being shown separately), and showing all cash, securities and other property held in the Trust at the end of such year or as of the date of such removal or resignation, as the case may be. ARTICLE V RESPONSIBILITY OF TRUSTEE 5.1 Fiduciary Standard. Trustee shall act with the care, skill, prudence and diligence under the circumstances then prevailing that a prudent person acting in like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims, provided, however, that Trustee shall incur no liability to any person for any action taken pursuant to a direction, request or approval given by Company which is contemplated by, and in conformity with, the terms of the Plan or this Trust and is given in writing by Company. In the event of a dispute between Company and a party, Trustee may apply to a court of competent jurisdiction to resolve the dispute. 5.2 Indemnification. If Trustee undertakes or defends any litigation arising in connection with this Trust, Company agrees to indemnify Trustee against Trustee's costs, expenses and liabilities (including, without limitation, attorneys' fees and expenses) relating thereto and to be primarily liable for such payments. If Company does not pay such costs, expenses and liabilities in a reasonably timely manner, Trustee may obtain payment from the Trust. 5.3 Consultation. Trustee may consult with legal counsel (who may also be counsel for Company generally) with respect to any of its duties or obligations hereunder. 5.4 Hiring of Professionals. Trustee may hire agents, accountants, actuaries, investment advisors, financial consultants or other professionals to assist it in performing any of its duties or obligations hereunder. 5.5 Powers. Trustee shall have, without exclusion, all powers conferred on Trustees by applicable law, unless expressly provided otherwise herein, provided, however, that if an insurance policy is held as an asset of the Trust, Trustee shall have no power to name a beneficiary of the policy other than the Trust, to assign the policy (as distinct from conversion of the policy to a different form) other than to a successor Trustee, or to loan to any person the proceeds of any borrowing against such policy. 5.6 Other Business. Notwithstanding any powers granted to Trustee pursuant to this Trust Agreement or applicable law, Trustee shall not have any power that could give this Trust the objective of carrying on a business and dividing the gains therefrom, within the meaning of Section 301.7701-2 of the Procedure and Administrative Regulations promulgated pursuant to the Code. 5.7 Fees and Expenses. Company shall pay all administrative and Trustee's fees and expenses. If not so paid, the fees and expenses shall be paid from the Trust. ARTICLE VI RESIGNATION, REMOVAL AND SUCCESSION OF TRUSTEE 6.1 Resignation. Trustee may resign at any time by written notice to Company, which shall be effective 30 days after receipt of such notice unless Company and Trustee agree otherwise. 6.2 Removal. Trustee may be removed by Company on 30 days notice or upon shorter notice accepted by Trustee. 6.3 Change of Control. Upon a Change of Control, as defined herein, Trustee may not be removed by Company for 3 years. 6.4 Successor Trustee. If Trustee resigns or is removed within 3 years of a Change of Control, as defined herein, Trustee shall select a successor Trustee in accordance with the provisions of Section 6.8 hereof prior to the effective date of Trustee's resignation or removal. 6.5 Transfer of Assets. Upon resignation or removal of Trustee and appointment of a successor Trustee, all assets shall subsequently be transferred to the successor Trustee. The transfer shall be completed within 30 days after receipt of notice of resignation, removal or transfer, unless Company extends the time limit. 6.6 Court Appointed Trustee. If Trustee resigns or is removed, a successor shall be appointed, in accordance with Sections 6.7 through 6.9 hereof, by the effective date of resignation or removal under Section 6.1 or 6.2. If no such appointment has been made, Trustee may apply to a court of competent jurisdiction for appointment of a successor or for instructions. All expenses of Trustee in connection with the proceeding shall be allowed as administrative expenses of the Trust. 6.7 Appointment of Successor by Company. If Trustee resigns or is removed in accordance with Section 6.1 or 6.2 hereof, Company may appoint any third party, such as a bank trust department or other party that may be granted corporate trustee powers under state law, as a successor to replace Trustee upon resignation or removal. The appointment shall be effective when accepted in writing by the new Trustee, who shall have all of the rights and powers of the former Trustee, including ownership rights in the Trust assets. The former Trustee shall execute any instrument necessary or reasonably requested by Company or the successor Trustee to evidence the transfer. 6.8 Appointment of Successor by Trustee. If Trustee resigns or is removed pursuant to the provisions of Section 6.4 hereof and selects a successor Trustee, Trustee may appoint any third party such as a bank trust department or other party that may be granted corporate trustee powers under state law. The appointment of a successor Trustee shall be effective when accepted in writing by the new Trustee. The new Trustee shall have all the rights and powers of the former Trustee, including ownership rights in Trust assets. The former Trustee shall execute any instrument necessary or reasonably requested by the successor Trustee to evidence the transfer. 6.9 Indemnification of Successor Trustee. The successor Trustee need not examine the records and acts of any prior Trustee and may retain or dispose of existing Trust assets, subject to Section 4.4 and Article V hereof. The successor Trustee shall not be responsible for and Company shall indemnify and defend the successor Trustee from any claim or liability resulting from any action or inaction of any prior Trustee or from any other past event, or any condition existing at the time it becomes successor Trustee. ARTICLE VII AMENDMENT OR TERMINATION 7.1 Amendment. This Trust Agreement may be amended by a written instrument executed by Trustee and Company. Notwithstanding the foregoing, no such amendment shall conflict with the terms of the Plan or shall make the Trust revocable after it has become irrevocable in accordance with Section 1.2 hereof. 7.2 Termination. The Trust shall not terminate until the date on which Plan participants and their beneficiaries are no longer entitled to benefits pursuant to the terms of the Plan. Upon termination of the Trust any assets remaining in the Trust shall be returned to Company. Termination with Approval of Participants. Upon written approval any Participants or Participant's beneficiaries entitled to payment of benefits pursuant to the terms of the Plan, Company may terminate this Trust as to such Participant prior to the time all benefit payments under the Plan have been made. All assets in the Trust held for the benefit of such Participant at termination shall be returned to Company. ARTICLE VIII MISCELLANEOUS 8.1 Severability. Any provision of this Trust Agreement prohibited by law shall be ineffective to the extent of any such prohibition, without invalidating the remaining provisions hereof. 8.2 Assignment of Benefits. Benefits payable to Plan participants and their beneficiaries under this Trust Agreement may not be anticipated, assigned, either at law or in equity, alienated, pledged, encumbered or subjected to attachment, garnishment, levy, execution or other legal or equitable process. 8.3 Governing Law. This Trust Agreement shall be governed by and construed in accordance with the laws of Oklahoma. 8.4 Change of Control. For purposes of this Trust, Change of Control shall mean: (i) the date any entity or person, including a group as defined in Section 13(d)(iii) of the Securities Exchange Act of 1934 shall become the beneficial owner of, or shall have obtained voting control over, 25 percent or more of the outstanding common shares of the Company; (ii) the date the shareholders of the Company approve a definitive agreement (a) to merge or consolidate the Company with or into another corporation, in which the Company is not the continuing or surviving corporation or pursuant to which any common shares of the Company would be converted into cash, securities or other property of another corporation, other than a merger of the Company in which holders of common shares immediately prior to the merger have the same proportionate interest of common stock of the surviving corporation immediately after the merger as immediately before, or (b) to sell or otherwise dispose of substantially all of the assets of the Company; or (iii) the date there shall have been change in a majority of the Board of the Company within a 12 month period unless the nomination of each new director was approved by the vote of two-thirds (2/3) of directors then still in office who were in office at the beginning of the 12 month period. 8.5 Effective Date. The effective date of this Trust Agreement shall be , 19 . TRUSTEE LIBERTY BANK AND TRUST COMPANY OF OKLAHOMA CITY, NATIONAL ASSOCIATION By: Authorized Officer COMPANY LIBERTY BANCORP, INC. By: Authorized Officer EXHIBIT 24.1 Consent of Independent Public Accountants As independent public accountants, we hereby consent to the incorporation of our report dated January 21, 1994, included in this Form 10-K for the year ended December 31, 1993, into Liberty Bancorp, Inc.'s previously filed registration statements No. 33-28760, Profit Sharing, Salary Deferral and Employee Stock Ownership Plan and Trust Agreement; No. 33-48170, 1990 Stock Option Plan of Liberty Bancorp, Inc. and No. 33-62814, Form S-3. ARTHUR ANDERSEN & CO. Oklahoma City, Oklahoma, March 30, 1994 EXHIBIT 24.2 Consent of Independent Auditors We consent to the incorporation by reference in the Registration Statement (Form S-3, No. 33-62814) of Liberty Bancorp, Inc. and in the related Prospectus and the Registration Statements pertaining to the Liberty Bancorp, Inc. Profit Sharing, Salary Deferral and Employee Stock Ownership Plan and Trust Agreement (Form S-8 No. 33-28760) and to the 1990 Stock Option Plan of Liberty Bancorp, Inc. (Form S-8 No. 33-48170) of our report dated January 21, 1994 with respect to the consolidated financial statements of Liberty Mortgage Company (not presented separately herein) included in the Annual Report (Form 10-K) of Liberty Bancorp, Inc. for the year ended December 31, 1993. ERNST & YOUNG Oklahoma City, Oklahoma March 28, 1994 EXHIBIT 25 POWER OF ATTORNEY The person whose signature appears below hereby appoints Mischa Gorkuscha and Kenneth R. Brown, and both of them, with full power to act alone, as attorney-in-fact to execute and fill in the name of and on behalf of Liberty Bancorp, Inc. ("Corporation"), and the person whose signature appears below, both individually and in the capacities indicated, the Corporation's Annual Report on Form 10-K for the fiscl year ended December 31, 1993 required under Section 13 of the Securities Exchange Act of 1934, and any and all amendments thereto. Dated this 23rd day of March, 1994 Signature Title --------- ----- /s/Molly Shi Boren Director - ------------------------------ Molly Shi Boren POWER OF ATTORNEY The person whose signature appears below hereby appoints Mischa Gorkuscha and Kenneth R. Brown, and both of them, with full power to act alone, as attorney-in-fact to execute and fill in the name of and on behalf of Liberty Bancorp, Inc. ("Corporation"), and the person whose signature appears below, both individually and in the capacities indicated, the Corporation's Annual Report on Form 10-K for the fiscl year ended December 31, 1993 required under Section 13 of the Securities Exchange Act of 1934, and any and all amendments thereto. Dated this 23rd day of March, 1994 Signature Title --------- ----- /s/Donald L. Brawner, M.D. Director - ------------------------------ Donald L. Brawner, M.D. POWER OF ATTORNEY The person whose signature appears below hereby appoints Mischa Gorkuscha and Kenneth R. Brown, and both of them, with full power to act alone, as attorney-in-fact to execute and fill in the name of and on behalf of Liberty Bancorp, Inc. ("Corporation"), and the person whose signature appears below, both individually and in the capacities indicated, the Corporation's Annual Report on Form 10-K for the fiscl year ended December 31, 1993 required under Section 13 of the Securities Exchange Act of 1934, and any and all amendments thereto. Dated this 23rd day of March, 1994 Signature Title --------- ----- /s/Robert S. Ellis, M.D. Director - ------------------------------ Robert S. Ellis, M.D. POWER OF ATTORNEY The person whose signature appears below hereby appoints Mischa Gorkuscha and Kenneth R. Brown, and both of them, with full power to act alone, as attorney-in-fact to execute and fill in the name of and on behalf of Liberty Bancorp, Inc. ("Corporation"), and the person whose signature appears below, both individually and in the capacities indicated, the Corporation's Annual Report on Form 10-K for the fiscl year ended December 31, 1993 required under Section 13 of the Securities Exchange Act of 1934, and any and all amendments thereto. Dated this 23rd day of March, 1994 Signature Title --------- ----- /s/William J. Fischer, Jr. Director - ------------------------------ William J. Fischer, Jr. POWER OF ATTORNEY The person whose signature appears below hereby appoints Mischa Gorkuscha and Kenneth R. Brown, and both of them, with full power to act alone, as attorney-in-fact to execute and fill in the name of and on behalf of Liberty Bancorp, Inc. ("Corporation"), and the person whose signature appears below, both individually and in the capacities indicated, the Corporation's Annual Report on Form 10-K for the fiscl year ended December 31, 1993 required under Section 13 of the Securities Exchange Act of 1934, and any and all amendments thereto. Dated this 23rd day of March, 1994 Signature Title --------- ----- /s/C.W. Flint, Jr. Director - ------------------------------ C.W. Flint, Jr. POWER OF ATTORNEY The person whose signature appears below hereby appoints Mischa Gorkuscha and Kenneth R. Brown, and both of them, with full power to act alone, as attorney-in-fact to execute and fill in the name of and on behalf of Liberty Bancorp, Inc. ("Corporation"), and the person whose signature appears below, both individually and in the capacities indicated, the Corporation's Annual Report on Form 10-K for the fiscl year ended December 31, 1993 required under Section 13 of the Securities Exchange Act of 1934, and any and all amendments thereto. Dated this 23rd day of March, 1994 Signature Title --------- ----- /s/James L. Hall, Jr. Director - ------------------------------ James L. Hall, Jr. POWER OF ATTORNEY The person whose signature appears below hereby appoints Mischa Gorkuscha and Kenneth R. Brown, and both of them, with full power to act alone, as attorney-in-fact to execute and fill in the name of and on behalf of Liberty Bancorp, Inc. ("Corporation"), and the person whose signature appears below, both individually and in the capacities indicated, the Corporation's Annual Report on Form 10-K for the fiscl year ended December 31, 1993 required under Section 13 of the Securities Exchange Act of 1934, and any and all amendments thereto. Dated this 23rd day of March, 1994 Signature Title --------- ----- /s/Raymond H. Hefner, Jr. Director - ------------------------------ Raymond H. Hefner, Jr. POWER OF ATTORNEY The person whose signature appears below hereby appoints Mischa Gorkuscha and Kenneth R. Brown, and both of them, with full power to act alone, as attorney-in-fact to execute and fill in the name of and on behalf of Liberty Bancorp, Inc. ("Corporation"), and the person whose signature appears below, both individually and in the capacities indicated, the Corporation's Annual Report on Form 10-K for the fiscl year ended December 31, 1993 required under Section 13 of the Securities Exchange Act of 1934, and any and all amendments thereto. Dated this 23rd day of March, 1994 Signature Title --------- ----- /s/Walter H. Helmerich, III Director - ------------------------------ Walter H. Helmerich, III POWER OF ATTORNEY The person whose signature appears below hereby appoints Mischa Gorkuscha and Kenneth R. Brown, and both of them, with full power to act alone, as attorney-in-fact to execute and fill in the name of and on behalf of Liberty Bancorp, Inc. ("Corporation"), and the person whose signature appears below, both individually and in the capacities indicated, the Corporation's Annual Report on Form 10-K for the fiscl year ended December 31, 1993 required under Section 13 of the Securities Exchange Act of 1934, and any and all amendments thereto. Dated this 23rd day of March, 1994 Signature Title --------- ----- /s/Joseph S. Jankowsky Director - ------------------------------ Joseph S. Jankowsky POWER OF ATTORNEY The person whose signature appears below hereby appoints Mischa Gorkuscha and Kenneth R. Brown, and both of them, with full power to act alone, as attorney-in-fact to execute and fill in the name of and on behalf of Liberty Bancorp, Inc. ("Corporation"), and the person whose signature appears below, both individually and in the capacities indicated, the Corporation's Annual Report on Form 10-K for the fiscl year ended December 31, 1993 required under Section 13 of the Securities Exchange Act of 1934, and any and all amendments thereto. Dated this 23rd day of March, 1994 Signature Title --------- ----- /s/John E. Kirkpatrick Director - ------------------------------ John E. Kirkpatrick POWER OF ATTORNEY The person whose signature appears below hereby appoints Mischa Gorkuscha and Kenneth R. Brown, and both of them, with full power to act alone, as attorney-in-fact to execute and fill in the name of and on behalf of Liberty Bancorp, Inc. ("Corporation"), and the person whose signature appears below, both individually and in the capacities indicated, the Corporation's Annual Report on Form 10-K for the fiscl year ended December 31, 1993 required under Section 13 of the Securities Exchange Act of 1934, and any and all amendments thereto. Dated this 23rd day of March, 1994 Signature Title --------- ----- /s/Edward C. Lawson Jr. Director - ------------------------------ Edward C. Lawson Jr. POWER OF ATTORNEY The person whose signature appears below hereby appoints Mischa Gorkuscha and Kenneth R. Brown, and both of them, with full power to act alone, as attorney-in-fact to execute and fill in the name of and on behalf of Liberty Bancorp, Inc. ("Corporation"), and the person whose signature appears below, both individually and in the capacities indicated, the Corporation's Annual Report on Form 10-K for the fiscl year ended December 31, 1993 required under Section 13 of the Securities Exchange Act of 1934, and any and all amendments thereto. Dated this 23rd day of March, 1994 Signature Title --------- ----- /s/Herb Mee, Jr. Director - ------------------------------ Herb Mee, Jr. POWER OF ATTORNEY The person whose signature appears below hereby appoints Mischa Gorkuscha and Kenneth R. Brown, and both of them, with full power to act alone, as attorney-in-fact to execute and fill in the name of and on behalf of Liberty Bancorp, Inc. ("Corporation"), and the person whose signature appears below, both individually and in the capacities indicated, the Corporation's Annual Report on Form 10-K for the fiscl year ended December 31, 1993 required under Section 13 of the Securities Exchange Act of 1934, and any and all amendments thereto. Dated this 23rd day of March, 1994 Signature Title --------- ----- /s/William G. Paul Director - ------------------------------ William G. Paul POWER OF ATTORNEY The person whose signature appears below hereby appoints Mischa Gorkuscha and Kenneth R. Brown, and both of them, with full power to act alone, as attorney-in-fact to execute and fill in the name of and on behalf of Liberty Bancorp, Inc. ("Corporation"), and the person whose signature appears below, both individually and in the capacities indicated, the Corporation's Annual Report on Form 10-K for the fiscl year ended December 31, 1993 required under Section 13 of the Securities Exchange Act of 1934, and any and all amendments thereto. Dated this 23rd day of March, 1994 Signature Title --------- ----- /s/W.N. Pirtle Director - ------------------------------ W.N. Pirtle POWER OF ATTORNEY The person whose signature appears below hereby appoints Mischa Gorkuscha and Kenneth R. Brown, and both of them, with full power to act alone, as attorney-in-fact to execute and fill in the name of and on behalf of Liberty Bancorp, Inc. ("Corporation"), and the person whose signature appears below, both individually and in the capacities indicated, the Corporation's Annual Report on Form 10-K for the fiscl year ended December 31, 1993 required under Section 13 of the Securities Exchange Act of 1934, and any and all amendments thereto. Dated this 23rd day of March, 1994 Signature Title --------- ----- /s/V. Lee Powell Director - ------------------------------ V. Lee Powell POWER OF ATTORNEY The person whose signature appears below hereby appoints Mischa Gorkuscha and Kenneth R. Brown, and both of them, with full power to act alone, as attorney-in-fact to execute and fill in the name of and on behalf of Liberty Bancorp, Inc. ("Corporation"), and the person whose signature appears below, both individually and in the capacities indicated, the Corporation's Annual Report on Form 10-K for the fiscl year ended December 31, 1993 required under Section 13 of the Securities Exchange Act of 1934, and any and all amendments thereto. Dated this 23rd day of March, 1994 Signature Title --------- ----- /s/Jon R. Stuart Director - ------------------------------ Jon R. Stuart POWER OF ATTORNEY The person whose signature appears below hereby appoints Mischa Gorkuscha and Kenneth R. Brown, and both of them, with full power to act alone, as attorney-in-fact to execute and fill in the name of and on behalf of Liberty Bancorp, Inc. ("Corporation"), and the person whose signature appears below, both individually and in the capacities indicated, the Corporation's Annual Report on Form 10-K for the fiscl year ended December 31, 1993 required under Section 13 of the Securities Exchange Act of 1934, and any and all amendments thereto. Dated this 23rd day of March, 1994 Signature Title --------- ----- /s/Robert E. Torray Director - ------------------------------ Robert E. Torray POWER OF ATTORNEY The person whose signature appears below hereby appoints Mischa Gorkuscha and Kenneth R. Brown, and both of them, with full power to act alone, as attorney-in-fact to execute and fill in the name of and on behalf of Liberty Bancorp, Inc. ("Corporation"), and the person whose signature appears below, both individually and in the capacities indicated, the Corporation's Annual Report on Form 10-K for the fiscl year ended December 31, 1993 required under Section 13 of the Securities Exchange Act of 1934, and any and all amendments thereto. Dated this 23rd day of March, 1994 Signature Title --------- ----- /s/John S. Zink Director - ------------------------------ John S. Zink

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51143

ITEM 1. BUSINESS: IBM develops, manufactures and sells advanced information processing products, including computers and microelectronic technology, software, networking systems and information technology-related services. IBM offers value worldwide through its United States, Canada, Europe/Middle East/Africa, Latin America, and Asia/Pacific business units, by providing comprehensive and competitive product choices. The value of unfilled orders is not a meaningful indicator of future revenues due to the significant proportion of revenue from services, the volume of products delivered from shelf inventories, and the shortening of product delivery schedules. Therefore, the Company believes that backlog information is not material to an understanding of its business. IBM owns or is licensed under a number of patents relating to its products. Licenses under patents owned by IBM have been and are being granted to others. IBM believes its business as a whole is not materially dependent upon any particular patent or license, or any particular group of patents or licenses. The following information is included in IBM's 1993 Annual Report to Stockholders and is incorporated herein by reference: 1. Segment information and revenue by classes of similar products or services--Pages 59 and 60 2. Financial information by geographic areas--Pages 61 and 62 3. Amount spent during each of the last three years on research and development activities--Page 45 4. The number of persons employed by the registrant--Page 31 5. Management discussion overview --Pages 20 and 21 ITEM 2. ITEM 2. PROPERTIES: At December 31, 1993, IBM's manufacturing and development facilities in the United States had aggregate floor space of 57.4 million square feet, of which 46.6 million was owned and 10.8 million was leased. Of these amounts, 4.3 million square feet was vacant and .7 million square feet was being leased to non-IBM businesses. Similar facilities in 15 other countries totaled 21.8 million square feet, of which 18.3 million was owned and 3.5 million was leased. Of these amounts, .6 million square feet was vacant and .3 million square feet was being leased to non-IBM businesses. Although improved production techniques, productivity gains, and restructuring actions have resulted in reduced manufacturing floor space, continuous upgrading of facilities is essential to maintain technological leadership, improve productivity, and meet customer demand. For additional information on expenditures for plant and other property, refer to page 27 (Investments) of IBM's 1993 Annual Report to Stockholders which is incorporated herein by reference. ITEM 3. ITEM 3. LEGAL PROCEEDINGS: No material pending legal proceedings. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS: Not applicable. PART I (CONTINUED) EXECUTIVE OFFICERS OF THE REGISTRANT (AT MARCH 28, 1994): - ------------ (1) Member of the Board of Directors. All officers are elected by the Board of Directors and serve until the next election of officers in conjunction with the annual meeting of the stockholders as provided in the By-laws. Each officer named above, with the exception of Gerald M. Czarnecki, Louis V. Gerstner, Jr., Paul J. Rizzo, G. Richard Thoman, Jerome B. York, and Frederick W. Zuckerman has been an officer or an executive of IBM or its subsidiaries during the past five years. Mr. Czarnecki was the chairman of the board and chief executive officer, of Bank of America-Hawaii from 1992 until joining IBM in 1993. From 1987 to 1992, he was chairman of the board and chief executive officer of HonFed Bank in Honolulu, Hawaii. Mr. Gerstner was the chairman of the board and chief executive officer of RJR Nabisco Holdings Corporation from 1989 until joining IBM in 1993. From 1985 to 1989, he was chairman and chief executive officer of American Express Travel Related Services Co., Inc. Mr. Rizzo was the Dean of the Kenan-Flagler Business School at the University of North Carolina-Chapel Hill from 1987 to 1992. He then became a partner in Franklin Street Partners, a Chapel Hill investment firm. He rejoined IBM in 1993, having previously retired in 1988. Mr. Thoman was the president of Nabisco International from 1992 until joining IBM in 1993. From 1985 to 1989, he was president of American Express Travel Related Services International, and co-CEO of American Express Travel Related Services Co., and CEO of American Express International from 1989 to 1992. Mr. York was the executive vice president-finance and chief financial officer of Chrysler Corporation from 1990 until joining IBM in 1993. From 1979 to 1990, he had also served as vice president and controller at Chrysler, vice president in charge of the company's Dodge car and truck division, and managing director of its operations in Mexico. Mr. Zuckerman was the senior vice president and treasurer of RJR Nabisco from 1991 until joining IBM in 1993. From 1981 to 1991, he was the corporate vice president and treasurer of Chrysler Corporation. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS: Refer to page 63 and the inside back cover of IBM's 1993 Annual Report to Stockholders which are incorporated herein by reference solely as they relate to this item. There were 738,948 common stockholders of record at February 10, 1994. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA: Refer to page 63 of IBM's 1993 Annual Report to Stockholders which is incorporated herein by reference. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS: Refer to pages 20 through 31 of IBM's 1993 Annual Report to Stockholders which are incorporated herein by reference. On March 1, 1994, Loral Corporation completed its acquisition of the Federal Systems Company for $1.503 billion in cash. The amount of any gain resulting from this sale may be dependent on future performance of the Advanced Automation System contract for the Federal Aviation Authority and certain other open matters. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA: Refer to pages 18 and 19 and 32 through 62 of IBM's 1993 Annual Report to Stockholders which are incorporated herein by reference. Also refer to the Financial Statement Schedules on pages S-1 to S-5 of this Form. 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: Refer to pages 2 through 4 and 7 of IBM's definitive Proxy Statement dated March 14, 1994 which are incorporated herein by reference solely as they relate to this item. Also refer to the Item entitled "Executive Officers of the Registrant" in Part I of this Form. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION: Refer to pages 9 through 16 of IBM's definitive Proxy Statement dated March 14, 1994, which are incorporated herein by reference. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT: (A) SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS: Not applicable. (B) SECURITY OWNERSHIP OF MANAGEMENT: Refer to the section entitled "Stock Ownership" appearing on pages 7 and 8 of IBM's definitive Proxy Statement dated March 14, 1994, which is incorporated herein by reference. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS: Refer to page 7 (Other Relationships) of IBM's definitive Proxy Statement dated March 14, 1994, which 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 PART OF THIS REPORT: 1. FINANCIAL STATEMENTS FROM IBM'S 1993 ANNUAL REPORT TO STOCKHOLDERS WHICH ARE INCORPORATED HEREIN BY REFERENCE: Report of Independent Accountants (page 19). Consolidated Statement of Operations for the years ended December 31, 1993, 1992 and 1991 (page 32). Consolidated Statement of Financial Position at December 31, 1993 and 1992 (page 33). Consolidated Statement of Cash Flows for the years ended December 31, 1993, 1992 and 1991 (page 34). Consolidated Statement of Stockholders' Equity at December 31, 1993, 1992 and 1991 (page 35). Notes to Consolidated Financial Statements (pages 36 through 62). 2. FINANCIAL STATEMENT SCHEDULES REQUIRED TO BE FILED BY ITEM 8 OF THIS FORM: All other schedules are omitted as the required matter is not present, the amounts are not significant or the information is shown in the financial statements or the notes thereto. 3. EXHIBITS: INCLUDED IN THIS FORM 10-K: PART IV (CONTINUED) NOT INCLUDED IN THIS FORM 10-K: -- A copy of the IBM 1989 Long-Term Performance Plan, a management compensatory plan, is contained in Registration Statement No. 33-29022 on Form S-8, filed on May 31, 1989, and is hereby incorporated by reference. -- Board of Directors compensatory plans, as described under Directors' Compensation on page 7 of IBM's definitive Proxy Statement dated March 14, 1994, which is incorporated herein by reference. -- The instruments defining the rights of the holders of the 6 3/8% Notes due 1997 and the 7 1/4% Notes due 2002 are Exhibits 4(a) through 4(1) to Registration Statement No. 33-33590 on Form S-3, filed on February 22, 1990, and are hereby incorporated by reference. -- The instruments defining the rights of the holders of the 9% Notes due 1998 are Exhibit 4 to the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1985, and Exhibit 4(b) to Registration Statement No. 33-6889 on Form S-3, filed on July 1, 1986, and are hereby incorporated by reference. -- The instruments defining the rights of the holders of the 6 3/8% Notes due 2000 and the 7 1/2% Debentures due 2013 are Exhibits 4(a) through 4(1) to Registration Statement No. 33-49475(1) on Form S-3, filed May 24, 1993, and are hereby incorporated by reference. -- The instruments defining the rights of holders of the 8 3/8% Debentures due 2019 are Exhibits 4(a)(b)(c) and (d) to Registration Statement 33-31732 on Form S-3, filed on October 24, 1989, and are hereby incorporated by reference. -- IBM's definitive Proxy Statement dated March 14, 1994, certain sections of which have been incorporated herein by reference. (B) REPORTS ON FORM 8-K: -- No reports on Form 8-K were filed during the last 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. INTERNATIONAL BUSINESS MACHINES CORPORATION (Registrant) By: LOUIS V. GERSTNER, JR. .................................. (LOUIS V. GERSTNER, JR. CHAIRMAN OF THE BOARD OF DIRECTORS AND CHIEF EXECUTIVE OFFICER) 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 DATES INDICATED. REPORT OF INDEPENDENT ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULES To the Board of Directors of INTERNATIONAL BUSINESS MACHINES CORPORATION Our audits of the consolidated financial statements referred to in our report dated February 16, 1994 (which refers to the changes in the methods of accounting for postemployment benefits in 1993, income taxes in 1992, and nonpension postretirement benefits in 1991) appearing on page 19 of the 1993 Annual Report to Stockholders of International Business Machines 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)2 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 1177 Avenue of the Americas New York, N.Y. 10036 February 16, 1994 SCHEDULE V INTERNATIONAL BUSINESS MACHINES CORPORATION AND SUBSIDIARY COMPANIES PLANT, RENTAL MACHINES AND OTHER PROPERTY FOR THE YEAR ENDED DECEMBER 31: (DOLLARS IN MILLIONS) DEPRECIATION: Plant, rental machines and other property are carried at cost and depreciated over their estimated useful lives using the straight-line method. With minor exceptions, the estimated useful lives of depreciable properties are as follows: Land improvements....................................... 20 years Buildings and building equipment........................ 5 to 50 years Plant, laboratory and office equipment.................. 2 to 16 years Rental machines......................................... 1 to 7 years S-1 SCHEDULE VI INTERNATIONAL BUSINESS MACHINES CORPORATION AND SUBSIDIARY COMPANIES ACCUMULATED DEPRECIATION OF PLANT, RENTAL MACHINES AND OTHER PROPERTY FOR THE YEAR ENDED DECEMBER 31: (DOLLARS IN MILLIONS) - ------------ (A) Includes charge for accelerated depreciation due to restructuring actions taken in 1993 of $1,068 million. (B) Includes charge for accelerated depreciation due to restructuring actions taken in 1992 of $4,185 million. (C) Includes charge for accelerated depreciation due to restructuring action taken in 1991 of $378 million. S-2 SCHEDULE VIII INTERNATIONAL BUSINESS MACHINES CORPORATION AND SUBSIDIARY COMPANIES VALUATION AND QUALIFYING ACCOUNTS FOR THE YEAR ENDED DECEMBER 31: (DOLLARS IN MILLIONS) - ------------ (A) Includes additions charged to costs and expenses less accounts written off and translation adjustments. Note-- The receivables upon which the above allowances are based are highly diversified by geography, industry, and individual customer. The allowances for receivable losses for the year ended 1993, approximate less than three and one-half percent of the company's current receivables and less than two percent of the company's non-current receivables. The allowances for the year ended 1992, approproximate less than three percent of the company's current receivables and less than two percent of the company's non-current receivables. The allowances for the year ended 1991, approximate less than two percent in both categories of receivables. S-3 SCHEDULE IX INTERNATIONAL BUSINESS MACHINES CORPORATION AND SUBSIDIARY COMPANIES SHORT-TERM BORROWINGS FOR THE YEAR ENDED DECEMBER 31: (DOLLARS IN MILLIONS) - ------------ Note-- The balance at end of period excludes the current portion of long-term debt of $4,006 million, $3,256 million, and $4,363 million for the years 1993, 1992, and 1991, respectively. Effective 1993, short-term loan amounts in subsidiaries where the economic environment is highly inflationary, were primarily denominated in U.S. dollars. In prior years, these loans were denominated in local currencies, and the high interest rates in those operations were largely offset by the effects of inflation on funds borrowed. If the inflationary effects of these loans were excluded, the weighted average interest rate at year-end would have been 7.5% and 8.7% for the years 1992 and 1991, respectively, and the weighted average interest rate during the year would have been 7.8% and 9.0% for 1992 and 1991, respectively. The average amount outstanding during the year and the weighted average interest rate during the year were calculated by averaging the quarterly balances and rates. S-4 SCHEDULE X INTERNATIONAL BUSINESS MACHINES CORPORATION AND SUBSIDIARY COMPANIES SUPPLEMENTARY INCOME STATEMENT INFORMATION FOR THE YEAR ENDED DECEMBER 31: (DOLLARS IN MILLIONS) - ------------ (A) Includes amounts charged to all accounts, including inventories and fixed assets. S-5 EXHIBIT INDEX

21271_1993.txt

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ITEM 1. BUSINESS Valero Energy Corporation was incorporated under the laws of the State of Delaware in 1955 and became a publicly held corporation in 1979. Its principal executive offices are located at 530 McCullough Avenue, San Antonio, Texas 78215 (telephone number 210/246-2000). Unless otherwise required by the context, the term "Energy" as used herein refers to Valero Energy Corporation, and the term "Company" refers to Energy and its consolidated subsidiaries individually and collectively. The Company's principal business is petroleum refining and marketing. Valero Refining Company ("VRC"), a wholly owned subsidiary of Valero Refining and Marketing Company ("VRMC"), owns a specialized petroleum refinery in Corpus Christi, Texas (the "Refinery") and engages in petroleum refining and marketing operations. VRMC is a wholly owned subsidiary of Energy. VRMC and VRC are collectively referred to herein as "Refining." The Company also owns an approximate 49% effective equity interest in Valero Natural Gas Partners, L.P. and its subsidiaries, which own and operate natural gas pipeline systems serving Texas intrastate and certain interstate markets. Valero Natural Gas Partners, L.P. and its subsidiaries also process natural gas for the extraction of natural gas liquids ("NGL"). See "Valero Natural Gas Partners, L.P." Unless otherwise required by the context, the term "VNGP, L.P." as used herein refers to Valero Natural Gas Partners, L.P. and the term "Partnership" refers to VNGP, L.P. and its consolidated subsidiaries individually and collectively. The Company's investment in and equity in earnings of the Partnership are shown separately in the accompanying consolidated financial statements. In addition to its interest in the Partnership, the Company owns a natural gas processing plant, a natural gas pipeline and certain natural gas liquids fractionation facilities that the Company leases to the Partnership. The Company also owns two additional natural gas processing plants, related gathering lines and a natural gas liquids line that the Partnership operates for a fee. See "Other Natural Gas Operations." For additional financial and statistical information regarding the Company's operations, see "Management's Discussion and Analysis of Financial Condition and Results of Operations" and Note 10 of Notes to Consolidated Financial Statements. For information regarding cash flows provided by and used in the Company's operations, see "Management's Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources." RECENT DEVELOPMENTS Proposal to Acquire the Partnership Effective December 20, 1993, Energy, VNGP, L.P. and Valero Natural Gas Company ("VNGC"), the general partner of VNGP, L.P., entered into an agreement of merger (the "Merger Agreement") providing for the merger of VNGP, L.P. with a wholly owned subsidiary of Energy (the "Merger"). In the Merger, the 9.7 million issued and outstanding common units of limited partner interests ("Common Units") in VNGP, L.P. held by persons other than the Company (the "Public Unitholders") will be converted into a right to receive cash in the amount of $12.10 per Common Unit, and VNGP, L.P. will become a wholly owned subsidiary of Energy. A special committee of outside directors (the "Special Committee") of VNGC, appointed to consider the fairness of the transaction to the Public Unitholders, has received an opinion from its independent financial advisor that the consideration to be received by the Public Unitholders in the transaction is fair from a financial point of view. The Special Committee has determined that such transaction is fair to, and in the best interest of, the Public Unitholders. The Board of Directors of VNGC has unanimously recommended that the Public Unitholders vote in favor of the Merger. The transaction is subject, among other things, to: (i) approval by the holders of a majority of the issued and outstanding Common Units; (ii) approval by the holders of a majority of the Common Units held by the Public Unitholders and voted at a special meeting to be called for the purpose of considering the Merger; (iii) receipt of satisfactory waivers, consents or amendments to certain of the Company's financial agreements; and (iv) completion of an underwritten public offering of preferred stock by Energy. See "Recent Developments - Convertible Preferred Stock Offering." A proposal to approve the Merger will be submitted to the holders of Common Units at the special meeting of Unitholders tentatively scheduled to be held during the second quarter of 1994. The Company owns approximately 47.5% of the outstanding Common Units and intends to vote its Common Units in favor of the Merger. There can be no assurance, however, that the Merger will be completed. The foregoing discussion of the Merger omits certain information contained in the Merger Agreement. Statements in this Report concerning the Merger Agreement are not necessarily complete, and are qualified by and are made subject to the Merger Agreement filed as an exhibit to this Report. The Company believes that the natural gas and NGL industries are undergoing a period of restructuring and consolidation that may create opportunities for expansions, acquisitions or strategic alliances which, if the Partnership could take advantage of them, could enable the Partnership to compete more effectively in the competitive natural gas environment. Because of Federal Energy Regulatory Commission ("FERC") Order No. 636 ("Order 636") which requires interstate pipeline companies to offer services on an unbundled, nondiscriminatory basis, the Company believes that intrastate pipelines such as the Partnership may enjoy increased opportunities to compete for interstate business. In addition, an emerging trend of west-to-east movement of gas may provide beneficial transportation opportunities for the Partnership if the Partnership were able to make the necessary capital expenditures for added west-to-east capacity on its pipeline system. However, the Partnership's competitive position could be eroded if the Partnership is unable to respond effectively to the changing dynamics of the industry. The Merger was proposed because the Company believes that the Partnership has insufficient financial flexibility to participate fully in opportunities that may arise in the natural gas and NGL industries. The Company believes that the ability of the Partnership to compete effectively in these businesses will be enhanced through the Merger. The Company also believes that potential conflicts of interest between the Partnership and the Company can be eliminated through the Merger. Convertible Preferred Stock Offering During the fourth quarter of 1993, Energy filed a registration statement on Form S-3 (as amended, the "Registration Statement"), registering for issuance and sale in an underwritten public offering (the "Public Offering") $150 million (up to $172.5 million with underwriters' over-allotments) of a series of Energy's authorized but unissued Preferred Stock. Energy intends to offer for sale up to 3,000,000 shares (3,450,000 shares with underwriters' over-allotments) of convertible preferred stock in the Public Offering (the "New Preferred Stock"). Energy intends to use a portion of the proceeds from the Public Offering to fund the cash payment to the Public Unitholders contemplated by the Merger. See "Recent Developments - Proposal to Acquire the Partnership." Any remaining proceeds will be used to pay expenses of the Merger and for general corporate purposes, including the reduction of existing indebtedness under the Company's bank credit agreements. If the Merger is not consummated, the proceeds from the Public Offering will be added to the Company's funds and used for general corporate purposes, including repayment of indebtedness, financing of capital projects and additions to working capital. Offers to sell or the solicitation of offers to buy shares of the New Preferred Stock will be made exclusively by means of a prospectus complying in all respects with the Securities Act of 1933, as amended. The description of the New Preferred Stock herein is not and shall not be construed as an offer to sell or the solicitation of an offer to buy any shares of the New Preferred Stock. Decline of Crude Oil and Refined Product Prices Beginning in November 1993, crude oil prices fell significantly and have not recovered to prior levels. During the November 1993 meeting of the Organization of Petroleum Exporting Countries ("OPEC"), the member countries declined to adopt any cuts in crude oil production. This decision, combined with increased production from non-OPEC regions, continued uncertainty regarding Iraq's possible re-entry into world oil markets and weakened global demand for energy, caused a precipitous drop in crude oil prices to their lowest levels in five years. Refined product and NGL prices fell in conjunction with the decline in crude oil prices. Moreover, refined product and NGL prices were further depressed due to continued high refinery-capacity utilization rates and unusually high gasoline and NGL inventories. These conditions caused a substantial decline in refining margins and required the Company to write down the carrying value of its refinery inventories as of December 31, 1993. See Note 1 of Notes to Consolidated Financial Statements. The conditions causing the recent decline in crude oil, refined product and NGL prices have continued in 1994. Although refined product prices and refining margins have increased modestly since late December 1993, the Company's operating income and net income in the first quarter of 1994 are expected to be in the same range as operating income and net income for the fourth quarter of 1993, excluding the effect of the write-down in the carrying value of the Company's refinery inventories. Refinery Facilities Additions During 1993, the Company added certain facilities at the Refinery to enable the Company to produce reformulated gasolines containing the levels of oxygenates required by the Clean Air Act Amendments of 1990 (the "Clean Air Act"). A facility to produce methyl tertiary butyl ether ("MTBE") from butane feedstock (the "Butane Upgrade Facility") was placed in service during the second quarter of 1993. MTBE is a high-octane blendstock used to manufacture oxygenated and reformulated gasolines. The Butane Upgrade Facility can produce 15,000 barrels per day of MTBE. The Company can blend the MTBE produced at the Refinery into the Company's own gasoline cargos or sell the MTBE separately as a gasoline blendstock. All the butane feedstocks required to operate the Butane Upgrade Facility are available to the Company through the Refinery's and the Partnership's operations. In November 1993, the Company placed in service an MTBE/TAME complex (the "MTBE/TAME Complex"). The MTBE/TAME Complex converts streams currently produced at the Refinery's heavy oil cracker into about 2,500 barrels per day of MTBE and 3,000 barrels per day of tertiary amyl methyl ether ("TAME"). TAME, like MTBE, is a high-octane, oxygen-rich gasoline blendstock. The Butane Upgrade Facility and MTBE/TAME Complex enable the Company to produce approximately 20,000 barrels per day of oxygenates for gasoline blending. During the fourth quarter of 1993, the Company also placed in service a 25,000 barrel per day reformate splitter (the "Reformate Splitter"). The Reformate Splitter extracts a benzene concentrate stream from reformate produced at the Refinery's naphtha reformer unit. The benzene concentrate stream may be shipped to other refineries that can recover and purchase the benzene at market prices and then return the balance of the concentrate stream to the Company for gasoline blending or for sale as a petrochemical feedstock. The 1993 facilities additions enable the Company to produce all of its gasoline as reformulated gasoline and represent investments totalling approximately $300 million. MTBE Plant in Mexico Productos Ecologicos, S.A. de C.V., a Mexican corporation ("Proesa"), has executed a Memorandum of Understanding with Petroleos Mexicanos, the Mexican state-owned oil company ("PEMEX"), to construct a MTBE plant in Mexico, and has proposed a butane supply contract and MTBE sales contract with PEMEX. Proesa is owned 35% by the Company; 10% by Dragados y Construcciones, the largest construction company in Spain; and 55% by a corporation formed by Banamex, Mexico's largest bank, and Groupo Infomin, a privately held Mexican company. Proesa has also executed an option agreement for a plant site near the Bay of Campeche. The proposed Mexican MTBE plant is expected to have a capacity of approximately 15,000 barrels per day and to be similar to the Refinery's Butane Upgrade Facility. The project is expected to cost approximately $440 million and is subject to, among other things, the arrangement of satisfactory financing. Proesa has been advised by lenders with whom it is negotiating for project financing that certain provisions will be required in the proposed PEMEX contracts in order to secure satisfactory financing for the project. Proesa has entered into negotiations with PEMEX regarding such provisions. As a result of delays incurred in completing financing, Proesa has determined that the commencement of plant construction will be delayed. If satisfactory financing is obtained, construction of the MTBE plant could not begin before late 1994, with approximately two years required for completion. As of February 1994, no material amounts have been invested in the project. The amount of the Company's equity contribution will depend upon the level of debt financing obtained by Proesa and the ultimate equity interest of each partner. Under the proposed commercial contracts, PEMEX will purchase approximately 75% of the MTBE plant's production, one-half at a formula price and one-half at market-related prices, with the remainder of the plant's production being sold to the Company at a formula price. In addition, the butane feedstocks required by the plant will be purchased from PEMEX at market-related prices. A subsidiary of Energy has agreed to provide technical advice and assistance to Proesa in connection with the design, engineering, construction and operation of the MTBE plant. There can be no assurance that financing for the project can be obtained or that the plant will be constructed. PETROLEUM REFINING AND MARKETING Refining Operations The Refinery is designed to process primarily high- sulfur atmospheric tower bottoms, a type of residual fuel oil ("resid"), into a product slate of higher value products, principally unleaded gasoline and middle distillates. The Refinery also processes crude oil, butanes and other feedstocks. The Refinery can produce approximately 140,000 barrels per day of refined products, with gasoline and gasoline-related products comprising approximately 85% of the Refinery's throughput. The remaining product slate from the Refinery is primarily middle distillates. The Refinery has substantial flexibility to vary its mix of gasoline products to meet changing market conditions. Refining owns feedstock and product storage facilities with a capacity of approximately 6.4 million barrels. Approximately 4.1 million barrels of storage capacity are heated tanks for heavy feedstocks. During 1994, the Company anticipates having approximately 850,000 barrels of fuel oil storage available under lease in Malta. The Malta storage site will allow the Company to accumulate small parcels of high-sulfur resid for shipment to the Refinery. Refining also owns dock facilities that can simultaneously unload two 150,000 dead weight ton capacity ships and can dock larger crude carriers after partial unloading. One of the Refinery's principal operating units is a hydrodesulfurization unit ("HDS Unit"), which removes sulfur and metals from resid, thereby improving its subsequent cracking characteristics. The HDS Unit has a capacity of approximately 64,000 barrels per day. The Refinery's other principal unit is a heavy oil cracking complex ("HOC"), which processes feedstock primarily from the HDS Unit. The capacity of the HOC is approximately 66,000 barrels per day. The Refinery also has a hydrocracker with a capacity of approximately 34,000 barrels per day (the "Hydrocracker"), a continuous catalyst regeneration reformer with a capacity of approximately 31,000 barrels per day (the "Reformer"), and a reformer feed hydrotreater, hydrogen purification unit and related equipment (collectively, the "H/R Units"). The Hydrocracker processes gas oil and distillate streams from the Refinery to produce reformer feed naphtha. The Hydrocracker naphtha and other naphtha streams produced at the Refinery provide feed for the Reformer to produce reformate, a high-octane, low vapor pressure gasoline blendstock, and other products. The Refinery's other refining units include a 30,000 barrel per day crude unit and a 24,000 barrel per day vacuum unit. In 1993, the Company added the Butane Upgrade Facility, MTBE/TAME Complex and Reformate Splitter. See "Recent Developments - Refinery Facilities Additions" for a discussion of these facilities. The HDS Unit was down 15 days for a scheduled maintenance and catalyst change completed in December 1993. The Refinery's principal refining units operated during 1991, 1992 and 1993 with no significant unscheduled downtime. The HOC is scheduled for a turnaround in late 1994. For additional information with respect to Refining's operating results for the three years ended December 31, 1993, see "Management's Discussion and Analysis of Financial Condition and Results of Operations." Feedstock Supply The principal feedstock for the Refinery is resid produced at refineries outside the United States. Most of the large refineries in the United States are complex, sophisticated facilities able to convert internally produced resid into higher value products. Many overseas refineries are less sophisticated, process smaller portions of resid internally and, therefore, produce larger volumes of resid for sale. As a result, Refining acquires and expects to acquire most of its resid in international markets. A substantial portion of Refining's feedstock supplies are obtained from Middle Eastern sources. These supplies are loaded aboard chartered vessels at ports in the Arabian Gulf and are subject to the usual maritime hazards. Refining maintains insurance on its feedstock cargos. Under a feedstock supply agreement with the Company, Saudi Aramco (successor to the Saudi Arabian Marketing and Refining Company "SAMAREC") has agreed to provide an average of 55,000 barrels per day of resid to the Company at market-related prices. Deliveries under the agreement will continue through 1994 and provide approximately 75% of Refining's resid requirements. During 1993, Refining also purchased approximately 11,000 barrels per day of South Korean resid at market-related prices under an agreement which expires in the first quarter of 1994. The Company is negotiating to renew the agreement for South Korean resid on pricing terms more favorable to the Company than the existing contract. The Company also renewed a contract for approximately 22,000 barrels of crude produced in the People's Republic of China. Although the volume for this contract has been committed to the Company, the price must be renegotiated each quarter. The remainder of the Refinery's feedstocks are purchased at market-based prices under short-term contracts. The Company believes that if any of Refining's existing feedstock arrangements were interrupted, adequate supplies of feedstock could be obtained from other sources or on the open market. Resid generally sells at a discount to crude oil. In recent years, however, developments in the market have reduced this discount. The Company generally expects the long-term trend in the relationship between the supply of and demand for resid to be favorable, and expects resid to continue to sell at a discount to crude oil. In the short term, other factors, including price volatility and political developments, are likely to play an important role in refining industry economics. See "Recent Developments - Decline in Crude Oil and Refined Product Prices." Sales Set forth below is a summary of Refining's throughput volumes per day, average throughput margin per barrel and sales volumes per day for the three years ended December 31, 1993. Average throughput margin per barrel is computed by subtracting total direct product cost of sales from product sales revenues and dividing the result by throughput. Refining sells refined products principally on a spot and truck rack basis. A truck rack sale is a sale to a customer that provides trucks to take delivery at loading facilities. In 1993, spot and truck rack sales volumes accounted for 79% and 21%, respectively, of combined gasoline and distillate sales. Spot sales of Refining's products are made principally to larger oil companies and gasoline distributors. The principal purchasers of Refining's products from truck racks have been wholesalers and jobbers in the southeastern and midwestern United States. Refining's products are transported through common-carrier pipelines, barges and tankers. Interconnects with common-carrier pipelines give Refining the flexibility to sell products to the midwestern or southeastern United States. Factors Affecting Operating Results Refining's results of operations are determined principally by the relationship between refined product prices and resid prices, which in turn are largely determined by market forces. In recent years, the crude oil and refined product markets have experienced periods of extreme price volatility. During such periods, disproportionate changes in the prices of refined products and resid usually occur. Such changes have sometimes reduced margins, and, in some cases, such as in August 1990 at the beginning of the Arabian Gulf crisis, margins have expanded significantly. During the fourth quarter of 1993, however, refined product prices fell sharply, significantly reducing margins and requiring a writedown of the carrying value of the Company's Refinery inventories. See "Recent Developments - Decline of Crude Oil and Refined Product Prices" and Note 1 of Notes to Consolidated Financial Statements. The potential impact of changing crude oil and refined product prices on Refining's results of operations is further affected by the fact that, on average, Refining buys its resid feedstock approximately 40 days prior to processing it in the Refinery. The Company believes that resid will continue to sell at a discount to crude oil, and expects to continue to generate higher margins in its refining operations than conventional refiners that use crude oil as a principal feedstock. The future price of resid will depend on the relationship between the growth in crude oil demand (which generates more resid when processed) and worldwide additions to resid conversion capacity (which has the effect of reducing the available supply of resid). The Company believes that industry-wide additions to resid conversion capacity are not likely to exceed the expected increase in resid availability caused by increasing crude runs, decreasing environmentally permissible uses for resid and other factors. Refined product prices are influenced principally by factors of supply and demand. The Company expects that global demand for light products, including gasoline, will continue to increase in relation to the level of general economic activity, while fuel oil demand will increase more slowly. Most of the demand growth is expected to occur outside of the United States, particularly in Asia. The supply of gasoline and other light products is influenced by a variety of factors. Factors that may reduce available supplies include refinery shutdowns, vapor pressure reduction programs (which effectively remove butanes from the gasoline supply pool), lead phase-out programs and requirements for reformulated gasoline (which effectively remove benzene and other aromatics from the gasoline supply pool). Factors tending to increase supplies include imports, additions of conversion capacity and requirements for oxygenated gasoline under the Clean Air Act (which effectively adds oxygenates such as MTBE and ethanol to the gasoline pool). Predictions of future supply and demand are necessarily uncertain. However, the Company believes that prior to 1995, conversion capacity additions and projects to produce MTBE and other oxygenates are likely to cause gasoline supplies to increase more rapidly than demand. Thereafter, possible refinery closings and the more prevalent use of reformulated gasolines may reduce gasoline supplies and improve refining margins. The anticipated growth in demand for MTBE may be adversely affected by recent oxygenate proposals promulgated by the EPA under the Clean Air Act. On December 15, 1993, the EPA issued proposed reformulated gasoline regulations requiring that at least 30% of the oxygenates used in reformulated gasolines come from renewable sources such as corn, grain, wood, and organic waste products. Ethanol and ether producers capable of manufacturing ethanol-based ethyl tertiary butyl ether ("ETBE") stand to benefit the most if the proposed oxygenate rules are adopted due to the resulting, immediate increase in demand for ethanol and ETBE likely to occur. The proposed mandate for renewable oxygenates is generally disfavored by the fossil fuel- based oxygenate industry, including producers of methanol and manufacturers of MTBE. The EPA is expected to issue a final rule on renewable oxygenates by June 1994. Domestic gasoline production is supplemented with foreign imports. However, the Company believes that the availability of foreign gasoline supplies may decline because of the implementation of lead phasedown programs in some countries and a gradual increase in other environmental restrictions. The Company also believes that beginning in 1995, United States gasoline production capacity may become limited because of the prohibitive costs of new refinery construction and the expense of compliance for many older refineries with environmental regulations, including the Clean Air Act. Under provisions of the Clean Air Act, U.S. refineries must apply for new federal operating permits in 1995. Because the Refinery was completed in 1984, the Company expects to be able to comply with present and future environmental legislation more easily than older, conventional refineries. See "Environmental Matters" for a further discussion of the Clean Air Act and its impact on the refining industry. Other Projects Through its wholly owned subsidiary, the Company is a 20% general partner in Javelina Company ("Javelina"), which completed construction in 1991 of a plant in Corpus Christi (the "Javelina Plant") to process waste gases from the Refinery and other refineries in the Corpus Christi area and to extract hydrogen, ethylene, propylene and NGLs from the gas stream. The Company has made capital contributions and advances to Javelina of approximately $19.3 million through December 31, 1993, for the Company's proportionate share of capital expenditures and operating expenses. Javelina maintains a term loan agreement and a working capital and letter of credit facility which mature on January 31, 1996. The Company's guarantees of these bank credit agreements were approximately $19.6 million at December 31, 1993. VALERO NATURAL GAS PARTNERS, L.P. The Company holds an approximate 49% effective equity interest in the Partnership, and various subsidiaries of Energy serve as general partners of VNGP, L.P. and its subsidiary partnerships. For information with respect to the Company's investment in the Common Units of Limited Partner Interest ("Common Units") in VNGP, L.P., see Note 2 of Notes to Consolidated Financial Statements. Natural Gas Operations The Partnership owns and operates natural gas pipeline systems principally serving Texas intrastate markets. The Partnership's principal natural gas pipeline system is the intrastate gas system ("Transmission System") operated by Valero Transmission, L.P. ("Transmission") in the State of Texas. The Partnership also owns a 3.5-mile, 24-inch pipeline that connects the Partnership's pipeline near Penitas in South Texas to PEMEX's 42-inch pipeline outside of Reynosa, Mexico. The Partnership's wholly owned, jointly owned and leased natural gas pipeline systems include approximately 7,200 miles of mainlines, lateral lines and gathering lines. The Partnership leases and operates several natural gas pipelines, including approximately 240 miles of 24-inch pipeline extending from near Dallas to near Houston which the Partnership leases from a third party, and approximately 105 miles of pipeline in East Texas extending to Carthage, near the Louisiana border, which the Partnership leases from the Company. These integrated systems include 39 mainline compressor stations with a total of approximately 162,000 horsepower, together with gas processing plants, dehydration and gas treating plants and numerous measuring and regulating stations. The Partnership's gas sales, including gas sales by those subsidiaries operating the Partnership's special marketing programs ("SMPs"), transportation volumes in million cubic feet ("MMcf") per day, average gas sales prices and average gas transportation fees for the three years ended December 31, 1993, are as follows: The Partnership's natural gas operating results have improved in 1993 as natural gas supply and demand have become more balanced. Although increased industry competition will continue to affect the Partnership's operating results from natural gas operations, in 1993 the Partnership's natural gas throughput benefitted from increased business opportunities arising under FERC Order 636, a west-to-east shift in natural gas supply patterns and the temporary shutdown of a nuclear power plan in the Partnership's service area. See "Governmental Regulations - Federal Regulation" and "Management's Discussion and Analysis of Financial Condition and Results of Operations." Natural Gas Liquids Operations The Partnership's NGL operations include the processing of natural gas to extract a mixed stream of NGLs comprised of ethane, propane, butanes and natural gasoline, the separation ("fractionation") of mixed NGLs into component products and the transportation and marketing of NGLs. Extracted NGLs are transported to downstream fractionation facilities and end-use markets through NGL pipelines owned or leased by the Partnership and certain common carrier NGL pipelines. The Partnership owns or operates for its own account nine gas processing plants including a plant near Thompsonville in South Texas, which is leased by the Partnership from the Company. The Partnership's owned and leased gas processing plants are located in the western and southern regions of Texas and process approximately 1.3 billion cubic feet of gas per day. The Partnership's NGL production is sold primarily in the Corpus Christi and Mont Belvieu (Houston) markets. A substantial portion of the Partnership's butane production is sold to the Company as a feedstock for the Refinery's Butane Upgrade Facility. Volumes of NGLs produced at the Partnership's owned and leased plants (in thousands of barrels per day) and the average market price per gallon for the three years ended December 31, 1993, are as follows: The Partnership also owns or leases approximately 375 miles of NGL pipelines and fractionation facilities at three locations. In 1993, the Partnership fractionated an average of 70,000 barrels per day, compared to 68,000 barrels per day in 1992 and 51,000 barrels per day in 1991. In addition, the Partnership operates for a fee two NGL processing plants, approximately 59 miles of NGL pipeline and 450 miles of gathering lines owned by a subsidiary of Energy. See "Other Natural Gas Operations." Additional information regarding the Partnership is set forth in the Partnership's Annual Report on Form 10-K (Commission File No. 1-9433), which is separately filed with the Securities and Exchange Commission (the "Commission"). Items 1 through 3 of the Partnership's Annual Report on Form 10-K for the year ended December 31, 1993, as filed with the Commission on March 1, 1994, are filed as an Exhibit to this Report. OTHER NATURAL GAS OPERATIONS In addition to the natural gas and NGL operations conducted through the Partnership, the Company, through its wholly owned subsidiary Valero NGL Investments Company, owns certain South Texas NGL assets including two natural gas processing plants in Starr and Dimmit Counties, 450 miles of associated natural gas gathering lines, a 59-mile NGL pipeline and a 17.5% interest in a third gas processing plant in Nueces County. The Partnership operates these facilities for a fee under operating agreements with the Company. During 1993, these plants produced a daily average of approximately 9,500 barrels per day of NGLs. Prices realized from the sale of plant products were comparable to those obtained by the Partnership for its own production. See "Valero Natural Gas Partners, L.P. - Natural Gas Liquids." The Company leases certain assets to the Partnership under capital leases. The leased assets include (i) a gas processing plant near Thompsonville in South Texas and 48 miles of NGL product pipeline (the "Thompsonville Project"), (ii) an interest in approximately 105 miles of pipeline in East Texas (the "East Texas pipeline"), and (iii) certain fractionation facilities in Corpus Christi. The Thompsonville Project lease commenced December 1, 1992, and has a term of 15 years. The East Texas pipeline lease commenced February 1, 1991, and has a term of 25 years. The lease for the fractionation facilities commenced December 1, 1991, and has a term of 15 years. The rate of return available to the Company from the leases is limited to the lease payments specified in the respective leases plus any related tax benefits. The Partnership has the right to purchase all or any portion of the leased assets, subject to certain restrictions, under purchase option provisions of the respective lease agreements. Effective September 30, 1993, the Company sold its stock of Rio Grande Valley Gas Company ("RGV"), a wholly owned subsidiary of Energy whose operations are included in "Other Operations" of the Company, for cash in the amount of approximately $31 million. The disposition of RGV resulted in an after-tax gain, net of other nonoperating charges, of approximately $5 million. RGV owns approximately 1,552 miles of retail distribution lines, sells gas to approximately 75,000 retail customers in a number of communities in the Lower Rio Grande Valley of Texas and transports gas for approximately 60 transportation customers. Pursuant to contracts with the Partnership, RGV will continue to acquire all of its gas supply from the Partnership through the year 2000. RGV had aggregate gas sales and transportation volumes averaging approximately 14 MMcf per day in each of 1992 and 1991, and 15 MMcf per day for the first nine months of 1993. Val Gas Company ("Val Gas"), a wholly owned subsidiary of VNGC, owns and operates several small gathering systems in Texas that are subject to regulation by the FERC. See "Governmental Regulations - Federal Regulation." Until December 31, 1993, Valero Interstate Transmission Company ("Vitco"), an indirect wholly owned subsidiary of Energy, operated a small interstate pipeline system in South Texas comprised of approximately 240 miles of transmission and gathering lines. Effective January 1, 1994, the FERC authorized Vitco's abandonment of its pipeline system which is no longer subject to FERC rate regulation. GOVERNMENTAL REGULATIONS Certain of the Company's subsidiaries are subject to regulations issued by the Railroad Commission under the Cox Act, the Gas Utilities Regulatory Act ("GURA") and the Natural Resources Code, all of which are Texas statutes, and the federal Natural Gas Policy Act ("NGPA"). In addition, certain activities of Val Gas Company are subject to the regulations of the FERC under the NGPA, the Department of Energy Organization Act of 1977 (the "DOE Act"), and the federal Natural Gas Act. The Company's activities are also subject to various state and federal environmental statutes and regulations. See "Environmental Matters." Texas Regulation The Railroad Commission regulates the intrastate transportation, sale, delivery and pricing of natural gas in Texas by intrastate pipeline and distribution systems, including those of the Partnership. During 1992, the Railroad Commission revised its rules governing the production and purchase of natural gas. As part of such revision, the Railroad Commission adopted the gas proration rule (the "gas proration rule") to prevent the production of gas in excess of market demand. The gas proration rule requires producers to tender and deliver, and gas purchasers, including pipelines and purchasers offering SMPs, to take, only volumes of gas equal to their market demand. The gas proration rule further requires purchasers to take gas by priority categories, ratably among producers without undue discrimination, and with high-priority gas (defined as casinghead gas, or gas from wells primarily producing oil, and certain special allowable gas that are the last to be shut in during periods of reduced market demand) having higher priority than gas well gas (defined as gas from wells primarily producing gas), notwithstanding any contractual commitments. The revised rules are intended to simplify the previous system of nominations and to bring production allowables in line with estimated market demand. Federal Regulation In 1992, the FERC issued Order 636 related to restructuring of the interstate natural gas pipeline industry. Order 636 requires pipelines subject to FERC jurisdiction to provide unbundled marketing, transportation, storage and load balancing services on a nondiscriminatory basis to producers and end users instead of offering only combined packages of services, thus increasing competition in the natural gas industry. No Company subsidiary or Partnership subsidiary operating partnership is directly subject to Order 636. However, Order 636 is expected to create new supply, marketing and transportation opportunities for the Partnership. See "Recent Developments - Proposal to Acquire the Partnership." The Natural Gas Act and DOE Act grant to the FERC the authority to regulate rates and charges for natural gas transported in interstate commerce or sold by natural gas companies in interstate commerce for resale. Interstate natural gas sales for resale are made at rates subject to FERC regulation. Val Gas Company is subject to regulation as a "natural gas company" under the Natural Gas Act. ENVIRONMENTAL MATTERS The Company's Refinery operations and natural gas and NGL operations are subject to environmental regulation by federal and state authorities, including the EPA, the Texas Natural Resources Conservation Commission ("TNRCC"), the Texas General Land Office and the Railroad Commission. Compliance with regulations promulgated by these authorities increases the cost of designing, installing and operating such facilities. The regulatory requirements relate to water and storm water discharges, waste management and air pollution control measures. In 1993, Refining's capital expenditures attributable to compliance with environmental regulations (exclusive of expenditures for the Butane Upgrade Facility, MTBE/TAME Complex and Reformate Splitter, for which the amount of expenditures attributable to environmental regulation is not determinable) were approximately $8 million and are currently estimated to be approximately $6 million for 1994. Under the Clean Air Act, U.S. refineries must apply for new federal operating permits in 1995. Compliance with this and other environmental requirements may prove difficult and expensive for many older refineries. As a result, many refineries during the next few years likely will focus their capital expenditures on bringing their facilities into compliance with environmental requirements, rather than adding to capacity. Because of the Clean Air Act and other environmental regulations, various U.S. refiners have announced their intention to sell or close those refineries where capital expenditures needed to ensure compliance are not economically feasible. Because the Refinery was completed in 1984, it was built under more stringent environmental requirements than most existing U.S. refineries. Accordingly, the Company expects to be able to comply with the Clean Air Act and future environmental legislation more easily than older, conventional refineries. The Company expects that the demand for oxygenates such as MTBE will increase. (But see "Factors Affecting Operating Results" for a discussion of recent regulations proposed by the EPA that require the use of renewable oxygenates such as ethanol and ETBE.) The increase in demand for oxygenates is expected not only because of the mandates of the Clean Air Act for the use of clean burning fuels, but also because of the expected election by many areas to use reformulated gasolines even though not formally required by the Clean Air Act. The Clean Air Act requires the 39 areas that have failed to attain carbon monoxide air quality standards to use oxygenated gasolines during winter months. Beginning in 1995, the Clean Air Act also requires the nine areas that have the worst ozone air quality to use reformulated gasoline throughout the year to decrease their emissions of hydrocarbons and toxic pollutants. Also beginning in 1995, another 87 areas that have failed to attain certain ozone air-quality standards may elect to use reformulated gasolines throughout the year to decrease their emissions of hydrocarbons and toxic pollutants. Already, 43 of the 87 areas have notified the EPA of their election to use reformulated gasolines. Recent additions to the Refinery's facilities enable the Company to produce all of its gasoline as reformulated gasoline. See "Recent Developments - Refinery Facilities Additions." During 1991, environmental legislation was passed in Texas which conformed Texas law with the Clean Air Act to allow Texas to administer the federal programs. The Company and the Partnership have been and will continue to be affected by provisions of these laws concerning control requirements for air toxins and new operating permit requirements. The Company and the Partnership also have been affected by the increasing regulation of wastes by the Railroad Commission and the TNRCC and the promulgation of EPA permitting requirements for storm water discharges associated with industrial activities. Although these new laws and requirements may increase operating costs, they are not expected to have a material adverse effect on the Company's or the Partnership's operations or financial condition. The Oil Pollution Act of 1990 requires newly constructed tank vessels carrying crude oil to U.S. ports to be equipped with double hulls or double containment systems, and provides for a phaseout of existing vessels without double hulls beginning in 1995. Although these requirements are expected to increase the cost of transporting feedstocks to the Refinery, the staggered phaseout of existing vessels is expected to give existing vessel operators sufficient time to replace their fleets to provide adequate shipping capability. COMPETITION The refining industry is highly competitive with respect to both supply and markets. Refining competes with numerous other companies for available supplies of resid and other feedstocks and for outlets for its refined products. Prices of feedstocks and refined products are established principally by market conditions. Many of the companies with which Refining competes obtain a significant portion of their feedstocks from company-owned production and are able to dispose of refined products at their own retail outlets. Competitors that have their own production or retail outlets may be able to offset losses from refining operations with profits from producing or retailing operations and may be better positioned than the Company to withstand periods of depressed refining margins. See "Environmental Matters" for a discussion of the effects of environmental regulations on refining competition. The natural gas industry is and is expected to remain highly competitive with respect to both gas supply and markets, with no company or small group of companies being dominant. Order 636 provides a mechanism for producers and marketers to sell gas directly to end users, resulting in increased competition for gas sales. See "Governmental Regulations - Federal Regulation." EMPLOYEES As of December 31, 1993, the Company had approximately 1,740 employees. EXECUTIVE OFFICERS OF THE REGISTRANT The following table sets forth certain information as of December 31, 1993 regarding the present executive officers of Energy. Each officer named in the following table has been elected to serve until his successor is duly appointed and elected or his earlier removal or resignation from office. No family relationship exists among any of the executive officers, directors or nominees for director of Energy. Similarly, there is no arrangement or understanding between any executive officer and any other person pursuant to which he was or is to be selected as an officer. Mr. Greehey has served as Chief Executive Officer and as a director of Energy since 1979 and as Chairman of the Board since 1983. Mr. Greehey is also a director of Weatherford International Incorporated and Santa Fe Resources, Inc., neither of which are affiliated with the Company or the Partnership. Mr. Benninger has served as a director of Energy since 1990. He was elected Executive Vice President in 1989 and served as Chief Financial Officer from 1986 to 1992. In 1992, he was elected Executive Vice President and Chief Operating Officer of Valero Natural Gas Company. Mr. McLelland was elected Executive Vice President and General Counsel in 1989 and had served as Senior Vice President and General Counsel of Energy since 1981. Mr. Heep was elected Senior Vice President and Chief Financial Officer of Energy in 1994, prior to which he served as Vice President Finance since 1990. He has been employed by the Company in various capacities since 1977. Mr. Fry was elected Vice President Administration of Energy in 1989 and served as Secretary of Energy from 1980 to 1992. Mr. Zanotti has served as Executive Vice President of VRMC since 1988 and as President and Chief Operating Officer of VRC since 1990, and has served in other positions with the Company since 1983. Mr. Manning has served as Senior Vice President of VRMC since 1986 and of VRC since 1987. ITEM 2. ITEM 2. PROPERTIES The Company's properties include a petroleum refinery and related facilities, three natural gas processing plants, and various natural gas and NGL pipelines, gathering lines and related facilities, all located in Texas. The Company also operates natural gas pipeline systems and NGL facilities, processing plants, compressor stations, treating plants, measuring and regulating stations, fractionation facilities, underground natural gas storage caverns and other properties owned or used by the Partnership, all of which are located in Texas. Substantially all of Refining's fixed assets are pledged as security under deeds of trust securing industrial revenue bonds issued on behalf of Refining, while its inventories and receivables are pledged as security under a bank credit agreement providing working capital to Refining. See Note 4 of Notes to Consolidated Financial Statements. The Partnership has pledged substantially all of its gas systems and processing facilities, except for certain pipeline, processing and fractionation assets leased from the Company, as collateral for its First Mortgage Notes. Reference is made to "Item 1. Business," which includes detailed information regarding properties of the Company. Management believes that the Company's facilities are generally adequate for their respective operations, and that the facilities of the Company are maintained in a good state of repair. The Company and the Partnership are lessees under a number of cancelable and noncancelable leases for certain real properties. See Note 14 of Notes to Consolidated Financial Statements. ITEM 3. ITEM 3. LEGAL PROCEEDINGS The Company is party to the following proceedings: Coastal Oil and Gas Corporation v. TransAmerican Natural Gas Corporation ("TANG"), 49th State District Court, Webb County, Texas (filed October 30, 1991) (reported in the Company's Form 10-K for the year ended December 31, 1992 as Transamerican Natural Gas Corporation v. The Coastal Corporation et al). In March 1993, Valero Transmission Company and Valero Industrial Gas Company were served as third party defendants in this lawsuit. In August 1993, Energy, VNGP, L.P. and certain of their respective subsidiaries were named as additional third-party defendants (collectively, including the original defendant subsidiaries, the "Valero Defendants"). In TANG's counterclaims against Coastal and third-party claims against the Valero Defendants, TANG alleges that it contracted to sell natural gas to Coastal at the posted field price of Valero Industrial Gas Company and that the Valero Defendants and Coastal conspired to set such price at an artificially low level. TANG also alleges that the Valero Defendants and Coastal conspired to cause TANG to deliver unprocessed or "wet" gas thus precluding TANG from extracting NGLs from its gas prior to delivery. TANG seeks actual damages of approximately $50 million, trebling of damages under antitrust claims, punitive damages of $300 million, and attorneys' fees. The Valero Defendants' motion for summary judgment on TANG's antitrust claim was argued on January 24, 1994. The court has not ruled on such motion. The current trial setting for this case is March 14, 1994. Toni Denman v. Valero Natural Gas Partners, L.P., Valero Natural Gas Company, Valero Energy Corporation, et al., (filed October 15, 1993); Howard J. Vogel v. Valero Natural Gas Partners, L.P., Valero Natural Gas Company, Valero Energy Corporation, et al., (filed October 15, 1993); 7547 Partners v. Valero Natural Gas Partners, L.P., Valero Natural Gas Company, Valero Energy Corporation, et al., (filed October 19, 1993); Robert Endler Trust v. Valero Natural Gas Partners, L.P., Valero Natural Gas Company, Valero Energy Corporation, et al., (filed October 27, 1993); Dorothy Real v. Valero Energy Corporation, Valero Natural Gas Company and Valero Natural Gas Partners, L.P., (filed November 4, 1993); Malcolm Rosenwald v. Valero Natural Gas Partners, L.P., Valero Natural Gas Company, Valero Energy Corporation, et al., (filed November 9, 1993); Norman Batwin v. Valero Natural Gas Partners, L.P., Valero Natural Gas Company, Valero Energy Corporation, et al., (filed November 15, 1993) Court of Chancery, New Castle County, Delaware. Each of the foregoing suits was filed in response to the announcement of Energy's proposal to acquire the publicly traded Common Units of VNGP, L.P. pursuant to a proposed merger of VNGP, L.P. with a wholly owned subsidiary of Energy. The suits were consolidated by the Court of Chancery on November 23, 1993. The plaintiffs sought to enjoin or rescind the proposed merger, alleging that the corporate defendants and the individual defendants, as officers or directors of the corporate defendants, engaged in actions in breach of the defendants' fiduciary duties to the holders of the Common Units by proposing the merger. The plaintiffs alternatively sought an increase in the proposed merger consideration, compensatory damages and attorneys' fees. In December 1993, the parties reached a tentative settlement of the consolidated lawsuit. The terms of the settlement will not require a material payment by the Company or the Partnership. Garcia, et al. v. Coastal Chemical Company, Inc., Valero Refining Company, Javelina Company, et al., 347th Judicial District Court, Nueces County, Texas (filed August 31, 1993). This action was brought by certain residents of the Oak Park Triangle area of Corpus Christi, Texas, against several defendants including Valero Refining Company. All named defendants are either refiners or gas processors having facilities located at or near Up River Road in Corpus Christi. Plaintiffs allege in general terms damages resulting from ground water contamination and air pollution allegedly caused by the operations of the defendants. Plaintiffs seek unspecified actual and punitive damages. The Long Trusts v. Tejas Gas Corporation, 123rd Judicial District Court, Panola County, Texas (filed March 1, 1989). Valero Transmission Company (an indirect wholly owned subsidiary of Energy, "VTC"), as buyer, and Tejas Gas Corporation ("Tejas"), as seller, are parties to various gas purchase contracts assigned to and assumed by Valero Transmission, L.P. upon formation of the Partnership in 1987. Tejas is also a party to a series of gas purchase contracts between Tejas, as buyer, and certain trusts ("The Long Trusts"), as seller, which are in litigation ("The Long Trusts Litigation"). Neither the Partnership nor VTC is a party to The Long Trusts Litigation or the Tejas/Long Trusts contracts. However, because of the relationship between the Transmission/Tejas contracts and the Tejas/Long Trusts contracts, and in order to resolve existing and potential disputes, Tejas, VTC and Valero Transmission, L.P. have agreed that Tejas, VTC and Valero Transmission, L.P. will cooperate in the conduct of The Long Trusts Litigation, and that VTC and Valero Transmission, L.P. will bear a substantial portion of the costs of any appeal and any nonappealable final judgment rendered against Tejas. In The Long Trusts Litigation, The Long Trusts allege that Tejas has breached various minimum take, take-or-pay and other contractual provisions of the Tejas/Long Trusts contracts, and assert a statutory non-ratability claim. The Long Trusts seek alleged actual damages of approximately $30 million including interest and an unspecified amount of punitive damages. The District Court ruled on the plaintiff's motion for summary judgment, finding that as a matter of law the three gas purchase contracts at issue were fully binding and enforceable, that Tejas breached the minimum take obligations under one of the contracts, that Tejas is not entitled to claimed offsets for gas purchased by third parties and that the "availability" of gas for take-or-pay purposes is established solely by the delivery capacity testing procedures in the contracts. Damages, if any, have not been determined. Because of existing contractual obligations of Valero Transmission, L.P. to Tejas, the lawsuit may ultimately involve a contingent liability for Valero Transmission, L.P. The Court recently granted Tejas's Motion for Continuance in connection with the former January 10, 1994 trial date. The Long Trusts Litigation is not currently set for trial. NationsBank of Texas, N.A., Trustee of The Charles Gilpin Hunter Trust, et al. v. Coastal Oil & Gas Corporation, Valero Transmission Company, et al., 160th State District Court, Dallas County, Texas (filed February 2, 1993) (formerly reported as "Williamson, et al. v. Coastal Oil & Gas Corporation, Valero Transmission Company, et al., 68th State District Court, Dallas County, Texas (filed June 30, 1988)" in Energy's Form 10-K for the fiscal year ended December 31, 1992). In a lawsuit filed in 1988, certain plaintiffs alleged that defendants Coastal Oil & Gas Corporation ("Coastal") and Energy, VTC, VNGP, L.P., the Management Partnership and Valero Transmission, L.P. (the "Valero Defendants") were liable for failure to take minimum quantities of gas, failure to make take-or-pay payments and other breach of contract and breach of fiduciary duty claims. The plaintiffs sought declaratory relief, actual damages in excess of $37 million and unquantified punitive damages. The lawsuit was settled on terms immaterial to the Valero Defendants, and the parties agreed to a dismissal of the lawsuit. On November 16, 1992, prior to entry of an order of dismissal, NationsBank of Texas, N.A., as trustee for certain trusts (the "Intervenors"), filed a plea in intervention to intervene in the lawsuit. The Intervenors asserted that they held a nonparticipating mineral interest in the lands subject to the litigation and that their rights were not protected by the plaintiffs in the settlement. On February 4, 1993, the Court struck the Intervenors' plea in intervention. However, on February 2, 1993, the Intervenors had filed a separate suit in the 160th State District Court, Dallas County, Texas, against all prior defendants and an additional defendant, substantially adopting the allegations and claims of the original litigation. In February 1994, the parties reached a tentative settlement of the lawsuit on terms immaterial to the Company or the Partnership. Valero Energy Corporation, et al. v. M.W. Kellogg Company, et al., 117th Judicial District Court, Nueces County, Texas (filed July 11, 1986). The Company claims that the defendants are liable for breach of warranty, breach of contract, negligence, gross negligence, breach of implied warranty of good and workmanlike performance, breach of the Texas Deceptive Trade Practices - Consumer Protection Act, breach of implied warranty of fitness for ordinary purposes and strict liability in tort in connection with services performed at the Refinery. The Company claims actual damages in excess of $165 million plus exemplary damages, statutory penalties, attorney's fees and costs of court. In September 1991, the court considered motions for summary judgment filed by the Company, Kellogg and Ingersoll-Rand, another primary defendant. On October 25, 1991, the court entered judgment which granted the motions of Kellogg and Ingersoll-Rand for summary judgment in their entirety, denied the motion for summary judgment filed by the Company and entered a take nothing judgment dismissing all of the Company's claims with prejudice. The Company appealed the trial court's decision to the Thirteenth Court of Appeals, Corpus Christi, Texas. On June 30, 1993, the Court of Appeals affirmed the trial court's decision. The Company has appealed the decision to the Texas Supreme Court. White, et al. v. Coastal Javelina, Inc., Valero Energy Corporation, et al., 94th State District Court, Nueces County, Texas (filed November 27, 1991). Plaintiffs, as owners of real property situated near the Javelina Plant, have alleged that the operation and maintenance of the Javelina Plant have (i) interfered with their use and enjoyment of their property, (ii) caused depreciation in the value of their property, (iii) caused physical and mental injuries, (iv) damaged persons and property, and (v) caused a nuisance. Plaintiffs seek unspecified actual damages, punitive damages, prejudgment and postjudgment interest, costs of the lawsuit and equitable relief. Javelina Company Litigation. Valero Javelina Company, a wholly owned subsidiary of Energy, is a general partner of Javelina Company, a general partnership. See "Petroleum Refining and Marketing - Other Projects" and Note 5 of Notes to Consolidated Financial Statements. In addition to White and Garcia (reported above), Javelina Company has been named as a defendant in five other lawsuits filed since 1992 in state district courts in Nueces County, Texas. Garcia and three other suits include as defendants several other companies that own refineries or other industrial facilities in Nueces County. These suits were brought by a number of plaintiffs who reside in neighborhoods near the facilities. The plaintiffs claim injuries relating to alleged exposure to toxic chemicals, and generally claim that the defendants were negligent, grossly negligent and committed trespass. The plaintiffs claim personal injury and property damages resulting from soil and ground water contamination and air pollution allegedly caused by the operations of the defendants. One of the suits seeks certification of the litigation as a class action. The plaintiffs seek an unspecified amount of actual and punitive damages. White and two other suits were brought by plaintiffs who either live or have businesses near the Javelina Company plant. The suits allege claims similar to those described above. These plaintiffs also fail to specify an amount of damages claimed. City of Houston Claim. In a letter dated September 1, 1993 from the City of Houston (the "City") to Valero Transmission Company ("VTC"), the City stated its intent to bring suit against VTC for certain claims asserted by the City under the franchise agreement between the City and VTC. VTC is the general partner of Valero Transmission, L.P. The franchise agreement was assigned to and assumed by Valero Transmission, L.P. upon formation of the Partnership in 1987. In the letter, the City declared a conditional forfeiture of the franchise rights based on the City's claims. In a letter dated October 27, 1993, the City claimed that VTC owes to the City franchise fees and accrued interest thereon aggregating approximately $13.5 million. In a letter dated November 9, 1993, the City claimed an additional $18 million in damages related to the City's allegations that VTC engaged in unauthorized activities under the franchise agreement by transmitting gas for resale and by transporting gas for third parties on the franchised premises. Any liability of VTC with respect to the City's claims has been assumed by the Partnership. The City has not filed a lawsuit. Take-or-Pay and Related Claims. As a result of past market conditions and contracting practices in the natural gas industry, numerous producers and other suppliers brought claims against Transmission and Vitco asserting breach of contractual provisions requiring that they take, or pay for if not taken, certain volumes of natural gas. The Company and the Partnership have settled substantially all of the significant take-or-pay claims, pricing differences and contractual disputes heretofore brought against them. In 1987, Transmission and a producer from whom Transmission has purchased natural gas entered into an agreement resolving certain take-or-pay issues between the parties in which Transmission agreed to pay one-half of certain excess royalty claims arising after the date of the agreement. The royalty owners of the producer recently completed an audit of the producer and have presented to the producer a claim for additional royalty payments in the amount of approximately $17.3 million, and accrued interest thereon of approximately $19.8 million. Approximately $8 million of the royalty owners' claim accrued after the effective date of the agreement between the producer and Transmission. The producer and Transmission are reviewing the royalty owners' claims. No lawsuit has been filed by the royalty owners. The Company believes that various defenses under the agreement may reduce any liability of Transmission to the producer in this matter. Although additional claims may arise under older contracts until their expiration or renegotiation, the Company believes that the Partnership and the Company have resolved substantially all of the significant take-or-pay claims that are likely to be made. The Company believes any remaining take-or-pay claims can be resolved on terms satisfactory to the Partnership and the Company. Any liability of Energy, VNGC or VNGC's wholly owned subsidiaries with respect to take-or-pay claims involving Transmission's intrastate pipeline operations has been assumed by the Partnership. If the Partnership were unable or otherwise failed to discharge any liability which it assumed, the Company would remain ultimately liable for such liability. Conclusion. The Company is also a party to additional claims and legal proceedings arising in the ordinary course of business. The Company believes it is unlikely that the final outcome of any of the claims or proceedings to which the Company is a party including the claims and proceedings described above would have a material adverse effect on the Company's financial position or results of operations; however, due to the inherent uncertainty of litigation, the range of possible loss, if any, cannot be estimated with a reasonable degree of precision and there can be no assurance that the resolution of any particular claim or proceeding would not have an adverse effect on the Company's results of operations for the fiscal period in which such resolution occurred. As described above, the Partnership has assumed the obligations and liabilities of the Company with respect to certain claims. If the Partnership were unable or otherwise failed to discharge any such obligation or liability, the Company could remain ultimately liable for the same. 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 Energy's Common Stock is listed on the New York Stock Exchange, which is the principal trading market for this security. As of February 14, 1994, there were 8,095 holders of record and an estimated 20,000 beneficial owners of Energy's Common Stock. The range of the high and low sales prices of the Common Stock as quoted in The Wall Street Journal, New York Stock Exchange-Composite Transactions listing, and the amount of per- share dividends for each quarter in the preceding two years, are set forth in the tables shown below: The Energy Board of Directors declared a quarterly dividend of $.13 per share of Common Stock at its January 20, 1994 meeting. Dividends are considered quarterly by the Energy Board of Directors and are limited by, among other things, the Company's financing agreements. See Note 4 of Notes to Consolidated Financial Statements. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The selected financial data set forth below for the year ended December 31, 1993 is derived from the Company's Consolidated Financial Statements contained elsewhere herein. The selected financial data for the years ended prior to December 31, 1993 is derived from the selected financial data contained in the Company's Annual Report on Form 10-K for the year ended December 31, 1992. The following summaries are in thousands of dollars except for per share amounts: ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS RESULTS OF OPERATIONS The following are the Company's financial and operating highlights for each of the three years in the period ended December 31, 1993. The Partnership operating income amounts presented below represent 100% of the Partnership's operating income by segment. The amounts in the following table are in thousands of dollars, unless otherwise noted: GENERAL The Company reported net income of $36.4 million or $.82 per share for the year ended December 31, 1993, compared to $83.9 million or $1.94 per share, respectively, for 1992. Operating income was $75.5 million in 1993 compared to $134 million in 1992. For the fourth quarter of 1993, the Company reported a net loss of $15.2 million or $.36 per share compared to net income of $8.2 million or $.18 per share for the same period in 1992. Operating loss was $17.7 million for the fourth quarter of 1993 compared to operating income of $15.9 million for the same period in 1992. The 1993 results were reduced by a $27.6 million, or $17.9 million after-tax, write-down in the carrying value of the Company's refinery inventories during the fourth quarter of 1993 to reflect existing market prices. Also affecting 1993 results compared to 1992 were depressed refining margins and the operation of the butane upgrade facility and other new refinery units discussed below. Crude oil, refined product prices and refining margins were weak throughout 1993. During the November meeting of the Organization of Petroleum Exporting Countries ("OPEC"), the member countries decided to forego any cuts in production. This decision, combined with increased production from the North Sea region, continued uncertainty regarding Iraq's possible re-entry into world oil markets and weak global demand for energy caused a precipitous drop in crude oil prices to their lowest levels in five years. Refined product prices decreased faster and further than crude oil prices due to continuing high refinery capacity utilization rates and high gasoline inventories. These conditions resulted in a substantial decline in refining margins and the write-down in the carrying value of the Company's refinery inventories. Refined product prices and refining margins have increased modestly since late December. The Company's operating income and net income for the first quarter of 1994, however, are expected to be in the same range as operating income and net income for the fourth quarter of 1993, excluding the effect of the write-down in the carrying value of the Company's refinery inventories. The following is a discussion of the Company's results of operations first comparing 1993 to 1992 results and then comparing 1992 to 1991 results: 1993 COMPARED TO 1992 Refining Operations During 1993, the Company's specialized petroleum refinery (the "Refinery") began operation of a butane upgrade facility which converts butane into MTBE, a MTBE/TAME complex and a reformate splitter. See Note 5 of Notes to Consolidated Financial Statements. These projects have increased the Refinery's production capacity to approximately 140,000 barrels per day of refined products. Refining's operating revenues were $1,044.7 million for the year ended December 31, 1993 compared to $1,056.9 million for 1992. Operating revenues remained level as an 8% decrease in the average sales price per barrel offset an 8% increase in sales volumes. Increased production capacity resulting from operation of the butane upgrade facility contributed to the increase in sales and throughput volumes. Refining's cost of sales increased $42.9 million to $910.2 million in 1993 compared to 1992. Cost of sales increased due to the increase in throughput volumes and the inventory write-down discussed above. Partially offsetting the increase in cost of sales was a decrease in the average feedstock cost per barrel. The average throughput margin per barrel, before operating costs, for 1993 was $5.99 ($5.44, including the effect of the inventory write-down) compared to $7.00 for 1992. Both Refinery operating costs, which are included in cost of sales, and depreciation expense increased for 1993 compared to 1992 due primarily to costs associated with operation of the butane upgrade facility and other new Refinery units. As a result of the above factors, Refining's operating income decreased 45% to $75.4 million. The Refinery's hydrodesulfurization unit (the "HDS Unit") and heavy oil cracking unit (the "HOC Unit"), collectively the HDS/HOC complex, process high-sulfur atmospheric tower bottoms, a type of residual fuel oil ("resid") which normally sells at a significant discount to crude oil, the conventional feedstock for refineries. The remainder of the Refinery units process crude oil, butanes, and other feedstocks. The Company does not have retailing or crude oil producing operations. Refining's operations and throughput margins continue to benefit from the discount at which resid sells to crude oil. This discount per barrel has averaged $4.43, $4.73 and $4.87 for the years ended December 31, 1993, 1992, and 1991, respectively. The discount at which resid sells to crude oil generally decreases with decreases in crude oil prices due to price competition for resid from natural gas and other markets. However, resid is expected to continue to sell at a discount to crude. The Company believes that the Refinery's ability to process resid, combined with a product slate consisting primarily of unleaded gasoline and related higher value products, positions the Company to effectively compete in the emerging clean fuels marketplace. Under a feedstock supply agreement with the Company, Saudi Aramco (successor to the Saudi Arabian Marketing and Refining Company "SAMAREC"), has agreed to provide an average of 55,000 barrels per day of resid to the Company at market-related prices. Deliveries under the agreement will continue through 1994 and provide approximately 75% of Refining's resid requirements. During 1993, Refining also purchased approximately 11,000 barrels per day of South Korean resid at market-related prices under an agreement which expires in the first quarter of 1994. The Company is negotiating to renew this agreement for South Korean resid on pricing terms more favorable to the Company than the existing contract. The Company also renewed a contract for approximately 22,000 barrels of crude produced in the People's Republic of China. Although the volume for this contract has been committed to the Company, the price must be renegotiated quarterly. The remainder of the Refinery's feedstocks are purchased at market-related prices under short- term contracts. The Company believes that if any of Refining's existing feedstock arrangements were interrupted, adequate supplies of feedstock could be obtained from other sources or on the open market. Scheduled maintenance and catalyst changes of the HDS Unit were completed in April 1991, October 1992 and December 1993, and a turnaround of the HOC was completed in November 1991. The HOC is scheduled for a turnaround in late 1994. Other Operations The Company's other operations consist of certain minor natural gas pipeline and natural gas distribution operations not transferred to Valero Natural Gas Partners, L.P. ("VNGP, L.P." or the "Partnership") and the natural gas liquids assets ("NGL Assets") acquired from Oryx Energy in May 1992. Also included in other operations are the Company's activities as the General Partner of the Partnership and other miscellaneous revenues. The Company receives a management fee, which is included in operating revenues, equal to the direct and indirect costs incurred by it on behalf of the Partnership. Operating income from other operations for 1993 increased $3.3 million from the same period in 1992 primarily due to an increase in operating income associated with the NGL Assets attributable to the full period effect of those operations in 1993 and decreased corporate expenses borne by the Company. On September 30, 1993, the Company sold Rio Grande Valley Gas Company ("RGV"), its natural gas distribution subsidiary, for approximately $31 million. The disposition of RGV resulted in an after-tax gain, net of other nonoperating charges, of approximately $5 million. Partnership Operations Effective December 20, 1993, Energy, Valero Natural Gas Company and Valero Natural Gas Partners, L.P. entered into an agreement of merger. In the merger, VNGP, L.P. will become a wholly owned subsidiary of Energy, with the public holders of common units receiving cash consideration of $12.10 per common unit, or a total of approximately $117.5 million. Energy has filed a registration statement with the Securities and Exchange Commission (the "Commission") for the issuance of $150 million (up to $172.5 million with underwriters' over-allotments) of convertible preferred stock to finance the merger and to use for general corporate purposes, including the reduction of existing indebtedness under the Company's bank credit agreements. The transaction is subject to approval by the holders of a majority of the issued and outstanding common units, approval by the holders of a majority of the common units held by the public unitholders and voted at a special meeting to be called to consider the merger, receipt of satisfactory waivers, consents or amendments to certain of the Company's financial agreements and completion of the offering of convertible preferred stock discussed above. These financial agreements, which include a new bank credit agreement as well as amendments to other financial agreements, are in the process of being negotiated to provide for the proposed merger. In the event that the proposed merger of VNGP, L.P. with the Company is not ultimately consummated, the proceeds from the offering would be added to the Company's funds and used for general corporate purposes, including the repayment of existing indebtedness, financing of capital projects and additions to working capital. There can be no assurance, however, that the merger can be completed. The Company believes that the natural gas and natural gas liquids industries are undergoing a period of restructuring and consolidation that may create opportunities for expansions, acquisitions or strategic alliances which, if the Partnership could take advantage of them, could enable the Partnership to compete more effectively in the competitive natural gas environment. Because of the Federal Energy Regulatory Commission's Order No. 636 which requires interstate pipeline companies to offer various services on an unbundled, nondiscriminatory basis, the Company believes that intrastate pipelines such as the Partnership may enjoy increased opportunities to compete for interstate business. In addition, an emerging trend of west-to-east movement of gas across the United States may provide beneficial transportation opportunities for the Partnership if the Partnership were able to make the necessary capital expenditures for added west-to-east capacity on its pipeline system. However, the Partnership's competitive position could be eroded if the Partnership is unable to respond effectively to the changing dynamics of the industry. The merger was proposed because the Company believes that the Partnership has insufficient financial flexibility to participate fully in opportunities that may arise in the natural gas and natural gas liquids ("NGL") industries. The Company believes that the ability of the Partnership to compete effectively in these businesses will be enhanced through the merger. The Company also believes that potential conflicts of interest between the Partnership and the Company can be eliminated through the merger. For additional information regarding the proposed acquisition and pro forma consolidated financial data, see Note 2 of Notes to Consolidated Financial Statements. During 1993, 1992 and 1991, the Company's equity in earnings of the Partnership contributed $6.8 million, $10.5 million and $15 million, respectively, to the Company's net income. The Company's equity in earnings of the Partnership decreased in 1993 due primarily to a decrease in operating income from the Partnership's NGL operations, partially offset by an increase in operating income from the Partnership's natural gas operations. The profitability of the Partnership's NGL operations depends principally on the margin between NGL sales prices and the cost of the natural gas from which such liquids are extracted ("shrinkage cost"). Operating income from the Partnership's NGL operations decreased $31.3 million, or 55%, in 1993 compared to 1992 due primarily to a decrease in NGL prices in the last six months of 1993 resulting from continuing high levels of NGL inventories and the significant decline in refined product prices discussed above, combined with an increase in fuel and shrinkage costs resulting from a 22% increase in the cost of natural gas. The decline in NGL prices resulted in a $1.4 million operating loss from NGL operations for the fourth quarter of 1993 compared to operating income of $12.9 million for the fourth quarter of 1992. Also reducing fourth quarter 1993 operating results was an increase in depreciation expense resulting from the recognition in the 1992 period of a change in the estimated useful lives of the majority of the Partnership's NGL facilities from 14 to 20 years retroactive to January 1, 1992. Operating income from the Partnership's natural gas operations increased $21 million, or 65%, for 1993 compared to 1992 due to a 10% increase in daily natural gas sales volumes and a 12% increase in transportation revenues resulting from continued strong demand for natural gas, certain favorable measurement, fuel usage and customer billing adjustments and an increase in income generated by the Partnership's Market Center Services Program. The Market Center Services Program was established in 1992 to provide price risk management services to gas producers and end users through the use of forward contracts and other tools which have traditionally been used in financial risk management. The Partnership recognized gas cost reductions and other benefits from this program of $18.7 million in 1993, which represents an increase of $5.8 million from 1992. Partially offsetting these increases in natural gas operating income was a decrease in the recovery of Valero Transmission, L.P.'s ("VT, L.P.", a subsidiary operating partnership) fixed costs resulting from the settlement of a customer audit of VT, L.P.'s weighted average cost of gas. For the fourth quarter of 1993, natural gas operating income increased $9.8 million to $15.8 million compared to $6 million in the fourth quarter of 1992 due to the factors noted above. During the first quarter of 1994, NGL prices have increased modestly since late December 1993, but remain below first quarter 1993 levels. Concurrently, natural gas prices and resulting shrinkage costs have increased during the first quarter of 1994 compared to the same period in 1993. As a result, Partnership operating income and the Company's equity in earnings of the Partnership are expected to be substantially lower in the first quarter of 1994 compared to the fourth quarter of 1993. Other Interest and debt expense, net of capitalized interest, increased due to the issuance of medium-term notes in 1992 (see Note 4 of Notes to Consolidated Financial Statements) and decreased capitalized interest primarily due to the placing in service of the butane upgrade facility during the second quarter of 1993. Income tax expense decreased primarily due to a decrease in pre-tax income. Partially offsetting this was the effect of a federal tax rate increase due to the enactment of the Omnibus Budget Reconciliation Act of 1993, which provides for an increase in the corporate tax rate from 34% to 35%, retroactive to January 1, 1993. As a result of this legislation, the Company recorded a onetime, noncash charge to 1993 third quarter earnings of $8.2 million related to deferred taxes as of the end of 1992. 1992 COMPARED TO 1991 Refining Operations Refining's operating revenues were $1,056.9 million for the year ended December 31, 1992, which represented a 19% increase over the same period in 1991. The increase in operating revenues was due to a 27% increase in sales volumes as a result of the commencement of operations of the hydrocracker/reformer units (the "H/R Units") during the early part of 1992, partially offset by the effect of a 7% decrease in Refining's average sales price per barrel in 1992. For 1992, Refining's operating income was $137.2 million, which represented a 3% increase over 1991. The average throughput margin for 1992 was $7.00 per barrel compared to $7.31 per barrel for 1991, calculated using total throughput volumes, or $8.84 per barrel for 1991, using only HDS/HOC complex volumes. The decrease in average throughput margin per barrel in 1992 compared to 1991 is primarily due to a decrease in refined product sales prices. Operating income in 1991 also benefitted significantly from a forward sale in 1991 of a significant portion of refined products at the higher prices which prevailed prior to the Arabian Gulf crisis in January 1991. Other Operations Operating income from other operations for 1992 increased $11.2 million primarily due to the inclusion of $9.3 million of operating income associated with the NGL Assets. Partnership Operations The Company's equity in earnings of the Partnership decreased in 1992 due to a decrease in operating income in both the Partnership's natural gas and NGL operations and a decrease in interest and other income. Operating income from the Partnership's NGL operations decreased $5.4 million, or 9%, during 1992 compared to 1991 due to a decrease in the average NGL market price, higher shrinkage costs and higher operating expenses. This was partially offset by an increase in production, transportation and fractionation volumes and a decrease in depreciation expense. Operating income from the Partnership's natural gas operations decreased $4.6 million, or 12%, to $32.5 million during 1992 compared to 1991 due to a decrease in natural gas sales volumes, lower average transportation fees and higher operating expenses, primarily due to higher pipeline transportation expense and the charge from the Company for the Partnership's allocable cost of the Company's early retirement program. The decrease in operating income as a result of these factors was partially offset by gas cost reductions and other benefits of $12.9 million from its Market Center Services Program. Other The Company's other income, net, decreased during 1992 due to decreased interest income caused by decreased average investments resulting from the gradual utilization of proceeds from the issuance of Energy's 10.58% Senior Notes in December 1990 and January 1991 and lower interest rates. Interest and debt expense, net of capitalized interest, increased due to an increase in interest incurred from substantially higher borrowings outstanding to finance a portion of the Company's capital expenditure program and decreased capitalized interest primarily due to the completion of a major part of the Company's capital expenditure program, the H/R Units, in early 1992, partially offset by interest capitalized on the butane upgrade facility and the Thompsonville gas processing plant (see Notes 2 and 5 of Notes to Consolidated Financial Statements). Income tax expense was relatively unchanged primarily due to Texas franchise taxes, which are based on income, offsetting the effect of reduced income taxes attributable to lower pre-tax income. The reporting of a portion of Texas franchise taxes as part of income tax expense commenced in 1992 as a result of new state legislation enacted during 1991. Preferred stock dividend requirements decreased in 1992 due to the redemption of one-half of the outstanding $68.80 Cumulative Preferred Stock, Series B ("Series B Preferred Stock") in September of 1991 and the remainder in January of 1992. See Note 8 of Notes to Consolidated Financial Statements. LIQUIDITY AND CAPITAL RESOURCES During 1993, net cash provided by the Company's operating activities totalled $141.3 million compared to $152.5 million during 1992. Net cash provided by operating activities includes a $39 million favorable effect in 1993 and a $15.1 million unfavorable effect in 1992 from cyclical changes in current assets and liabilities. These changes for 1993 include a decrease in inventories compared to 1992, attributable to the inventory write-down discussed above. The Company utilized the cash provided by its operating activities, as well as bank borrowings and proceeds from the disposition of RGV (described above), to fund capital expenditures, deferred turnaround and catalyst costs and investments in joint ventures, to pay dividends and to repay principal on outstanding debt. As described in Note 4 of Notes to Consolidated Financial Statements, during February 1992, Energy filed with the Commission a shelf registration statement to offer up to $150 million principal amount of medium-term notes (the "Medium-Term Notes"), $116 million of which had been issued through January 1994 with a weighted average life of 8.5 years and a weighted average interest rate of 8.56%. During March 1992, the Company issued 2,610,000 shares of Energy common stock ("Common Stock") at a price to the public of $30 per share which generated net proceeds of approximately $75 million. Refining currently maintains a $160 million revolving credit and letter of credit facility that is available for working capital purposes and matures September 30, 1996. Energy has an unsecured $30 million revolving credit and letter of credit facility which matures February 29, 1996. As of December 31, 1993, Refining and Energy had approximately $52 million and $29 million, respectively, available under their committed bank credit facilities for additional borrowings and letters of credit. Energy also currently has $60 million of unsecured short-term credit lines which are unrestricted as to use, of which no amounts were outstanding at December 31, 1993. Total borrowings under Energy's bank credit facility and short-term lines are limited to $50 million. Certain of the Company's financing agreements contain various financial ratio requirements, including fixed charge coverage and debt-to-capitalization and require each of the Company and Refining to maintain a minimum consolidated net worth and positive working capital (see Note 4 of Notes to Consolidated Financial Statements). Certain of these financial ratio requirements were amended, effective as of the fourth quarter of 1993, to improve the financial flexibility of the Company. Under the most restrictive of the debt-to-capitalization tests, the Company's indebtedness for borrowed money may not exceed 40% of its capitalization. At December 31, 1993, this ratio, as calculated under the most restrictive of the Company's financing agreements, was 38% and would permit additional borrowings or guarantees of $47 million. Increases or decreases in the Company's stockholders' equity, such as those resulting from incremental earnings or losses, cash dividends, stock issuances, or stock redemptions or repurchases, will disproportionately increase or decrease the amount of additional permitted borrowings or guarantees. As described in Note 4 of Notes to Consolidated Financial Statements, at December 31, 1993, the Company had the ability to pay $47.6 million in Common Stock dividends and other restricted payments under its principal bank credit agreements, which were the most restrictive of its provisions concerning restricted payments. In September 1991 Energy redeemed one-half, and in November 1991 called for redemption the other one-half, of its Series B Preferred Stock for a total of $42.4 million. In June 1992, the Energy Board of Directors approved a stock repurchase program of up to one million shares of Common Stock. Through December 31, 1993, Energy had repurchased 455,000 shares at an average price of $23.75 per share. During 1993, the Company incurred $166 million for capital expenditures, deferred turnaround and catalyst costs, investments and related expenditures. Expenditures for 1993 included $149 million for Refinery expenditures, such as the butane upgrade facility, the MTBE/TAME complex, the reformate splitter and the scheduled maintenance and catalyst change for the Refinery's HDS Unit completed in December 1993. Such amounts include $37 million for capital expenditures incurred in 1993, but not payable until 1994. For 1994, the Company currently expects to incur approximately $80 million for capital expenditures, deferred turnaround and catalyst costs, investments and related expenditures. In addition, the Company expects to pay approximately $117.5 million for an effective equity interest of 51% in VNGP, L.P. as discussed above. The Partnership currently expects to incur approximately $40 million in capital expenditures in 1994, much of which would be incurred after the expected merger date. The Company believes it has sufficient funds from operations, the convertible preferred stock offering discussed above, and to the extent necessary, from the public markets and private capital markets, to fund its current and ongoing operating requirements. The Energy Board of Directors increased the quarterly dividend on its Common Stock from $.11 per share to $.13 per share at its September 1993 meeting, effective in the fourth quarter of 1993. Dividends are considered quarterly by the Energy Board of Directors, and may be paid only when approved by the Board. The Company knows of no reason why Common Stock dividends at the current levels could not be continued. The Company's refining operations have a concentration of customers in the spot and retail gasoline markets. These concentrations of customers may impact the Company's overall exposure to credit risk, either positively or negatively, in that the customers may be similarly affected by changes in economic or other conditions. However, the Company believes that its portfolio of accounts receivable is sufficiently diversified to the extent necessary to minimize any potential credit risk. Historically, the Company has not had any significant problems collecting its accounts receivable. The accounts receivable and inventories of Refining are pledged as collateral under Refining's bank credit agreement. The Company is subject to environmental regulation at both the federal and state level. The Company's expenditures for environmental control and protection for its refining operations are expected to be approximately $6 million in 1994 and totalled approximately $8 million in 1993. These amounts are exclusive of any amounts related to recently constructed facilities for which the portion of expenditures relating to environmental requirements is not determinable. The Refinery was completed in 1984 under more stringent environmental requirements than most existing United States refineries, which are older and were built before such environmental regulations were enacted. As a result, the Company is able to more easily comply with present and future environmental legislation. Under provisions of the Clean Air Act Amendments of 1990 (the "Clean Air Act"), all U.S. refineries must obtain new operating permits by 1995. However, the Clean Air Act is not expected to have any significant adverse impact on the Refinery's operations and the Company does not anticipate that it will be necessary to expend any material amounts in addition to those mentioned herein to comply with such legislation. The Clean Air Act also has requirements for oxygenated gasolines, which add oxygenates such as MTBE and ethanol to the gasoline pool. Such requirements are expected to increase the demand for MTBE. However, recent renewable oxygenate rules proposed under the Clear Air Act may adversely affect the anticipated growth in demand for MTBE. The Company is not aware of any material environmental remediation costs related to its operations. Accordingly, no amount has been accrued for any contingent environmental liability. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Board of Directors and Stockholders of Valero Energy Corporation: We have audited the accompanying consolidated balance sheets of Valero Energy Corporation (a Delaware corporation) and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income, common stock and other stockholders' equity 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 Valero 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. Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. The supplemental schedules V, VI and IX 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. San Antonio, Texas February 17, 1994 VALERO ENERGY CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Principles of Consolidation and Basis of Presentation The accompanying consolidated financial statements include the accounts of Valero Energy Corporation ("Energy") and subsidiaries (collectively referred to herein as the "Company"). All significant intercompany transactions have been eliminated in consolidation. Energy conducts its refining operations through its wholly owned subsidiary, Valero Refining and Marketing Company ("VRMC"), and VRMC's principal operating subsidiary, Valero Refining Company ("VRC") (collectively referred to herein as "Refining"). Certain prior period amounts have been reclassified for comparative purposes. The Company accounts for its investment in Valero Natural Gas Partners, L.P. ("VNGP, L.P.") and VNGP, L.P.'s consolidated subsidiaries, including Valero Management Partnership, L.P. (the "Management Partnership") and various subsidiary operating partnerships ("Subsidiary Operating Partnerships" or "SOPs") (collectively referred to herein as the "Partnership") on the equity method of accounting. The Partnership acquired substantially all of the Company's natural gas and natural gas liquids operations in March 1987 in exchange for cash and an effective equity interest in the Partnership of approximately 49%. See Note 2 for a further discussion of the Partnership. Income taxes on the Company's equity in earnings of the Partnership are included in the provision for income taxes. Statements of Cash Flows In order to determine net cash provided by operating activities, net income has been adjusted by, among other things, changes in current assets and current liabilities, excluding changes in cash and temporary cash investments, current maturities of long-term debt and notes payable. Those changes are shown in the following table as an (increase) decrease in current assets and an increase (decrease) in current liabilities. The Company's temporary cash investments are highly liquid low- risk debt instruments which have a maturity of three months or less when acquired and whose carrying amounts approximate fair value. (Dollars in thousands.) The following provides information related to cash interest and income taxes paid by the Company for the periods indicated (in thousands): Noncash investing and financing activities for the years ended December 31, 1993, 1992 and 1991 include reductions of $1.3 million, $1.2 million and $1.1 million, respectively, of the recorded guarantee by Energy of a $15 million long-term borrowing by the Valero Employees' Stock Ownership Plan ("VESOP") to purchase Common Stock. Such reductions were a result of debt service by the VESOP. See Notes 4 and 12. Noncash investing and financing activities for 1993 also include the reclassification to property, plant and equipment of $5 million previously included in deferred charges and other assets on the Consolidated Balance Sheet. Noncash investing activities between Energy and the Partnership include the East Texas pipeline and fractionation facilities leases in 1991 and the Thompsonville Project lease in 1992 (see Note 2). Noncash financing activities for 1991 include a benefit of $.9 million credited to stockholders' equity for stock option exercises and represents the tax effect of the difference between market value at date of grant and market value at date of exercise for all options exercised during the period. Inventories Inventories are carried at the lower of cost or market with cost determined primarily under the last-in, first-out ("LIFO") method of inventory costing. Inventories as of December 31, 1993 and December 31, 1992 were as follows (in thousands): During the fourth quarter of 1993, Refining incurred a charge to earnings of $27.6 million to write down the carrying value of its inventories to reflect existing market prices. As a result of the inventory write-down, the replacement cost of Refining's inventories was approximately equal to its LIFO value at December 31, 1993. Property, Plant and Equipment Property additions and betterments include capitalized interest, and acquisition and administrative costs allocable to construction and property purchases. The costs of minor property units (or components thereof), net of salvage, retired or abandoned are charged or credited to accumulated depreciation. Gains or losses on sales or other dispositions of major units of property are credited or charged to income. Provision for depreciation of property, plant and equipment is made primarily on a straight-line basis over the estimated useful lives of the depreciable facilities. The rates for depreciation are as follows: Income Taxes Effective January 1, 1992, the Company adopted Statement of Financial Accounting Standards ("SFAS") No. 109, "Accounting for Income Taxes." SFAS No. 109 superseded SFAS No. 96 which the Company had adopted in 1987. These statements established financial accounting and reporting standards for deferred income tax liabilities that arise as a result of differences between the reported amounts of assets and liabilities for financial reporting and income tax purposes. Deferred Charges Catalyst and Refinery Turnaround Costs Catalyst cost is deferred when incurred and amortized over the estimated useful life of that catalyst, normally one to three years. Refinery turnaround costs are deferred when incurred and amortized over that period of time estimated to lapse until the next turnaround occurs. Other Deferred Charges Other deferred charges consist of technological royalties and licenses, debt issuance costs, and certain other costs. Technological royalties and licenses are amortized over the estimated useful life of each particular related asset. Debt issuance costs are amortized by the effective interest method over the estimated life of each instrument or facility. Transactions with Affiliates Transactions with affiliates primarily represent those conducted with the Partnership. See Note 2. Price Risk Management Activities The Company periodically enters into exchange-traded futures and options contracts and forward contracts to hedge against a portion of the price risk associated with price fluctuations from holding inventories of feedstocks and refined products. Changes in the market value of such contracts are accounted for as additions to or reductions in inventory. Gains and losses resulting from changes in the market value of such contracts are recognized when the related inventory is sold. The Company also enters into futures and options contracts that are not specific hedges and gains or losses resulting from changes in the market value of these contracts are recognized in income currently. As of December 31, 1993 and 1992, the Company had outstanding contracts for quantities totalling 2,700 thousand barrels ("Mbbls") and 2,260 Mbbls, respectively, for which the Company is the fixed price payor and 2,615 Mbbls and 1,613 Mbbls, respectively, for which the Company is the fixed price receiver. Such contracts run for a period of approximately two to five months. A portion of such contracts represented hedges of inventory volumes which totalled approximately 8,082 Mbbls and 8,693 Mbbls at December 31, 1993 and 1992, respectively. See "Inventories" above. The Company's activities in both hedging and nonhedging futures and options contracts were not material to the Company's results of operations for the years ended December 31, 1993, 1992 and 1991. Earnings Per Share Earnings per share of common stock were computed, after recognition of the preferred stock dividend requirements, based on the weighted average number of common shares outstanding during each year. Potentially dilutive common stock equivalents and other potentially dilutive securities were not material and therefore were not included in the computation. The weighted average number of common shares outstanding for the years ended December 31, 1993, 1992 and 1991 was 43,098,808, 42,577,368, and 40,570,798, respectively. Accounting Change Effective January 1, 1993, the Company adopted SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions." See Note 12. Accrued Expenses Accrued expenses for the periods indicated are as follows (in thousands): 2. VALERO NATURAL GAS PARTNERS, L.P. The Company holds an effective equity interest of approximately 49% in the Partnership at December 31, 1993, consisting of general partner interests and common units of limited partner interests (the "Common Units"). The remaining equity interest in the Partnership consisting of publicly traded common units of limited partner interests are referred to herein as "Public Units" and holders of such units are referred to as "Public Unitholders." Components of the line items Investment in and Leases Receivable from Valero Natural Gas Partners, L.P. in the accompanying Consolidated Balance Sheets and Equity in Earnings of and Income from Valero Natural Gas Partners, L.P. in the accompanying Consolidated Statements of Income, are as follows (in thousands): Summarized financial information for the Partnership for each of the three years in the period ended December 31, 1993 is as follows (in thousands, except per Unit amounts): The Partnership is required to make quarterly cash distributions with respect to all units in an amount equal to "Distributable Cash Flow" as defined in the Second Amended and Restated Agreement of Limited Partnership of VNGP, L.P. Beginning with the second quarter of 1992, the quarterly cash distributions were reduced from a rate of $.625 per unit to a rate of $.125 per unit. On January 25, 1994, the Board of Directors of VNGC declared a cash distribution of $.125 per unit for the fourth quarter of 1993 that is payable March 1, 1994. Net income is allocated to partners based on their effective ownership interest in the Partnership, except that additional depreciation expense pertaining to the excess of the Partnership's acquisition cost over the Company's historical cost basis in net property, plant and equipment and certain other assets in which the Public Unitholders currently have an ownership interest is allocated solely to the Public Unitholders as a noncash charge to net income. The allocation of additional depreciation expense to the Public Unitholders does not affect the cash distributions with respect to the Public Units or to the Company as holder of the Common Units. The Company enters into transactions with the Partnership commensurate with its status as the General Partner. The Company charges the Partnership a management fee equal to the direct and indirect costs incurred by it on behalf of the Partnership that are associated with managing the Partnership's operations. In addition, Refining purchases natural gas and NGLs from the Partnership and sells NGLs to the Partnership. The Company pays the Partnership a fee for operating the Company's NGL Assets. In connection with the NGL Assets, the Company also pays the Partnership a fee to process natural gas, buys natural gas from and sells natural gas and NGLs to the Partnership. The Company's retail natural gas distribution system operated by Rio Grande Valley Gas Company, a wholly owned subsidiary of Energy until its sale on September 30, 1993, purchases natural gas from the Partnership. Also, the Company and the Partnership enter into other operating transactions, including certain leasing transactions which are described below. As of December 31, 1993 and 1992, the Company had recorded approximately $31.8 million and $13.5 million, respectively, of accounts receivables, net of accounts payables, due from the Partnership. The following table summarizes transactions between the Company and the Partnership for each of the three years in the period ended December 31, 1993 (in thousands): During 1992, the Partnership entered into a capital lease with Energy to lease a 200-million cubic foot per day turboexpander gas processing plant near Thompsonville in South Texas and 48 miles of NGL product pipeline (the "Thompsonville Project") which were constructed by Energy. The Thompsonville Project lease commenced December 1, 1992 and has a term of 15 years. During 1991, the Company leased its interests in a newly constructed 105-mile pipeline in East Texas (the "East Texas Pipeline") and certain fractionation facilities in Corpus Christi, Texas, to the Partnership under capital leases. The fractionation facility lease, which commenced December 1, 1991, has a term of 15 years. The East Texas Pipeline lease, which commenced February 1, 1991, has a term of 25 years. Future minimum lease payments to be received from the Partnership for the years 1994 through 1998 are $12.9 million, $12.9 million, $13.9 million, $15.1 million and $15.4 million, respectively. Components of the Company's net investment in these capital leases at December 31, 1993, which is included in Investment in and Leases Receivable from Valero Natural Gas Partners, L.P. in the accompanying Consolidated Balance Sheet, are as follows (in thousands): Effective December 20, 1993, Energy, Valero Natural Gas Company ("VNGC", a wholly owned subsidiary of Energy and general partner of VNGP, L.P.,) and VNGP, L.P. entered into an agreement of merger. In the merger, the 9.7 million issued and outstanding Public Units will be converted into a right to receive cash consideration of $12.10 per Common Unit, and VNGP, L.P. will become a wholly owned subsidiary of Energy. A special committee of outside directors (the "Special Committee") of VNGC, appointed to consider the fairness of the transaction to the Public Unitholders, has received an opinion from its independent financial advisor that the consideration to be received by the Public Unitholders in the transaction is fair from a financial point of view. The Special Committee has determined that such transaction is fair to, and in the best interest of, the Public Unitholders. The Board of Directors of VNGC has unanimously recommended that the Public Unitholders vote in favor of the merger. The transaction is subject, among other things, to: (i) approval by the holders of a majority of the issued and outstanding Common Units, (ii) approval by the holders of a majority of the Common Units held by the Public Unitholders and voted at a special meeting to be called for the purpose of considering such merger; (iii) receipt of satisfactory waivers, consents or amendments to certain of the Company's financial agreements; and (iv) completion of the offering of convertible preferred stock (see Note 7 of Notes to Consolidated Financial Statements). These financial agreements, which include a new bank credit agreement as well as amendments to other financial agreements, are in the process of being negotiated to provide for the proposed merger. While Energy believes that it will obtain satisfactory new agreements and amendments, there can be no assurance in this regard. The Company currently owns approximately 47.5% of the Common Units and intends to vote such Common Units in favor of the transaction. A proposal to approve the merger agreement will be submitted to the holders of Common Units at a special meeting of unitholders tentatively scheduled to be held during the second quarter of 1994. There can be no assurance, however, that the merger can be completed. The accompanying unaudited pro forma condensed consolidated financial statements of Valero Energy Corporation and subsidiaries give effect to the sale of $150 million of convertible preferred stock and the utilization of approximately $117.5 million of the net proceeds therefrom to fund the acquisition by the Company of the Public Units. The remaining net proceeds, estimated to be approximately $28.4 million, are used to pay expenses of the proposed acquisition and reduce outstanding indebtedness under bank credit lines. The acquisition is accounted for as a purchase. The pro forma condensed consolidated financial statements are based on the historical consolidated financial statements of Valero Energy Corporation and Valero Natural Gas Partners, L.P. after certain adjustments as described below. The pro forma condensed consolidated balance sheet assumes that the above described transactions occurred on December 31, 1993. The pro forma consolidated statement of income assumes that the above described transactions occurred on January 1, 1993. Following these pro forma financial statements are accompanying explanatory notes. Such pro forma condensed consolidated financial statements are not necessarily indicative of the results of future operations. [FN] (a) Reflects the elimination of transactions between the Company and VNGP, L.P., including product sales and purchases, management fees billed by the Company to the Partnership for direct and indirect costs, and accrued interest receivable and payable on leases. (b) Adjustment to fair value of the portion of VNGP, L.P.'s assets acquired and liabilities assumed not currently held by the Company and the related income statement effects. Also included is the elimination of the noncurrent receivable and payable between the Company and VNGP, L.P. for postretirement benefits other than pensions. (c) Reflects the elimination of the Company's investment in and leases receivable from VNGP, L.P. and related equity in earnings and interest income. The corresponding VNGP, L.P. partners' capital and current and long-term portions of VNGP, L.P.'s capital lease obligations to the Company and related interest expense are also eliminated. (d) Represents the repayment of $21.7 million of indebtedness under bank credit lines with the excess of the net proceeds of the offering over the acquisition cost of the limited partner interests in VNGP, L.P. not currently held by the Company and the expenses of the acquisition, which causes a decrease in interest expense. (e) Represents the net proceeds from the sale of $150 million of assumed 6.5% convertible preferred stock and the related increase in preferred stock dividends. The preferred stock is assumed to be convertible into Common Stock at a premium of 25% above a Common Stock market price of $22 per share at the date of issuance of the preferred stock. Conversion of the convertible preferred stock into Common Stock is antidilutive to earnings per share of common stock for the year ended December 31, 1993. (f) Reflects the tax effects of the consolidation of VNGP, L.P. into the Company, primarily the taxability of VNGP, L.P.'s net income after its merger into the Company. 3. SHORT-TERM BANK LINES At December 31, 1993, Energy maintained five separate short-term bank lines of credit totalling $60 million, of which no amounts were outstanding. One of these lines is payable on demand, and the others mature at various times in 1994. These short-term lines bear interest at each respective bank's quoted money market rate, have no commitment or other fees or compensating balance requirements and are unsecured and unrestricted as to use. Total borrowings under these short-term lines and Energy's bank credit facility described in Note 4 are limited to $50 million. 4. LONG-TERM DEBT AND BANK CREDIT FACILITIES Long-term debt balances were as follows (in thousands): The Company's bank credit agreements include a $160 million revolving credit and letter of credit facility for Refining and a separate unsecured $30 million revolving credit and letter of credit facility for Energy. Borrowings under Refining's agreement bear interest, at Refining's option, at either (i) the agent bank's prime rate, (ii) certain reference banks' adjusted Eurodollar rate plus 3/4 of 1% or (iii) certain reference banks' average CD rate plus 7/8 of 1%. Borrowings under Energy's agreement bear interest, at its option, at either (i) the agent bank's prime rate plus 1/4 of 1%, (ii) certain reference banks' adjusted Eurodollar rate plus 1 3/8% or (iii) certain reference banks' average CD rate plus 1 1/2%. The Company is charged various fees in connection with the bank credit agreements, including commitment fees based on the unused portion of the commitments and various letter of credit and facility fees. As of December 31, 1993, Energy and Refining had approximately $29 million and $52 million, respectively, available under their bank credit facilities for additional borrowings and letters of credit. Energy filed with the Commission a shelf registration statement that became effective on February 28, 1992, and is being used to offer up to $150 million principal amount of Medium-Term Notes. Through January 1994, the Company has issued, in ten separate series, $116 million principal amount of Medium- Term Notes with a weighted average life of approximately 8.5 years and a weighted average interest rate of approximately 8.56%. Certain of the Company's financing agreements contain various financial ratio requirements including fixed charge coverage and debt-to-capitalization and require each of the Company and Refining to maintain a minimum consolidated net worth and positive working capital. Certain of these financial ratio requirements were amended, effective as of the fourth quarter of 1993, to improve the financial flexibility of the Company. Under the fixed charge coverage ratio tests in the Company's principal bank credit agreements, the ratio of the Company's earnings to its fixed charges must be at least 2:1 during the most recent four consecutive quarters; however, any fiscal quarter in which one of the Refinery's major units is shut down for scheduled or periodic maintenance for more than 14 days (a "turnaround quarter") is excluded from such fixed charge coverage ratio tests, provided that only one such quarter in each five quarter period may be excluded. In addition, the Company's unsecured $30 million revolving credit and letter of credit facility requires that the Company's ratio of earnings to fixed charges be at least 1.5:1 for each quarter (excluding a turnaround quarter). Under the most restrictive of the debt-to-capitalization tests, the Company's indebtedness for borrowed money may not exceed 40% of its capitalization. At December 31, 1993, this ratio, as calculated under the most restrictive of the Company's financing agreements, was 38%, and would permit additional borrowings or guarantees of $47 million. Increases or decreases in the Company's stockholders' equity, such as those resulting from incremental earnings or losses, cash dividends, stock issuances, or stock redemptions or repurchases, will disproportionately increase or decrease the amount of additional permitted borrowings or guarantees. The Company's principal bank credit agreements and certain other financing agreements contain covenants limiting Energy's ability to make certain "restricted payments," including dividend payments on and redemptions or repurchases of its capital stock and certain investments. Under its principal bank credit agreements, which currently contain the most restrictive of these covenants, Energy had the ability to pay $47.6 million in Common Stock dividends and other restricted payments at December 31, 1993. Under the Company's bank credit agreements, the amount available for such payments is increased by an amount equal to the Company's earnings, the net cash proceeds from any issuance of capital stock and funded indebtedness, and by an amount equal to the Company's depreciation and amortization expense (including amortization of deferred turnaround and catalyst costs), and is decreased by the amount of capital expenditures, turnaround and catalyst costs, previous dividends, investments (including advances to or assets leased to the Partnership), and repayments of funded indebtedness (other than under the Company's bank credit agreements). Certain of the Company's financing agreements also contain various other covenants, including capital expenditure limitations, limitations on creating liens or guaranteeing the obligations of others, limitations on additional debt and on certain transfers of assets, limitations on entering into new leases, restrictions on mergers or the acquisition of new subsidiaries or the capital stock or assets of other companies, customary default provisions and certain limitations on the businesses of the Company. Under the bank credit agreements, Energy and VRMC have guaranteed the obligations of Refining. The obligations of Refining are secured by a pledge of all inventories and receivables of Refining. The Company and Refining were in compliance with all required covenants as of December 31, 1993. Based on long-term debt outstanding at December 31, 1993, maturities of long-term debt, including sinking fund requirements and excluding borrowings under bank credit facilities, for the years ending December 31, 1995 through 1998 are approximately $31.9 million, $36.8 million, $37 million and $37.2 million, respectively. Maturities of long-term debt under bank credit facilities for the year ended December 31, 1996 are $75 million, however it is expected that at such time these bank credit facilities will be replaced with new bank credit facilities on similar terms and conditions. Based on the borrowing rates currently available to the Company for long-term debt with similar terms and average maturities, the fair value of the Company's long-term debt, including current maturities, was $584 million at December 31, 1993. The fair value of the Company's long-term debt was essentially equal to its carrying value at December 31, 1992. 5. INVESTMENTS AND CAPITAL EXPENDITURES Refinery Projects During the second quarter of 1993, the Refinery began operation of a butane upgrade facility which converts butane into MTBE, a high-octane blendstock used to manufacture oxygenated and reformulated gasolines. Also, during the fourth quarter of 1993, the Refinery placed in service a MTBE/TAME complex and a reformate splitter. The MTBE/TAME complex converts streams currently produced at the Refinery's heavy oil cracker into MTBE and TAME. TAME, like MTBE, is a high-octane, oxygen-rich gasoline blendstock. The reformate splitter extracts a benzene concentrate stream from the reformate produced at the Refinery's naphtha reformer unit. These projects, which represent investments totalling approximately $300 million, have increased the Refinery's production capacity to approximately 140,000 barrels per day of refined products. Proesa The Company holds a 35% interest in a Mexican corporation, Productos Ecologicos, S.A. de C.V. ("Proesa"). Proesa has executed a Memorandum of Understanding with Petroleos Mexicanos ("PEMEX") to construct a MTBE plant in Mexico, and has proposed a butane supply contract and MTBE sales contract with PEMEX. Proesa has also executed an option agreement for a plant site near the Bay of Campeche. The proposed Mexican MTBE plant is expected to have a capacity of approximately 15,000 barrels per day and to be similar to the Refinery's butane upgrade facility. The project is expected to cost approximately $440 million and is subject to, among other things, the arrangement of satisfactory financing. Proesa has been advised by lenders with whom it is negotiating for project financing that certain provisions will be required in the proposed PEMEX contracts in order to secure satisfactory financing for the project. Proesa has entered into negotiations with PEMEX regarding such provisions. However, as a result of delays incurred in completing financing, Proesa has determined that the commencement of plant construction will be delayed. If satisfactory financing is obtained, construction of the MTBE plant could not begin before late 1994, with approximately two years required for completion. As of February 1994, no material amounts have been invested in the project. The amount of the Company's equity contribution will depend upon the level of debt financing obtained by Proesa and the ultimate equity interest of each partner. Under the proposed commercial contracts, PEMEX will purchase approximately 75% of the MTBE plant's production, one- half at a formula price and one-half at market-related prices, with the remainder of the plant's production being sold to the Company at a formula price. In addition, the butane feedstocks required by the plant will be purchased from PEMEX at market- related prices. A subsidiary of Energy has agreed to provide technical advice and assistance to Proesa in connection with the design, engineering, construction and operation of the MTBE plant. There can be no assurance that financing for the project can be obtained or that the plant will be constructed. Javelina Partnership Valero Javelina Company, a wholly owned subsidiary of Energy, owns a 20% interest in Javelina Company ("Javelina"), a general partnership. Javelina maintains a term loan agreement and a working capital and letter of credit facility which mature on January 31, 1996. Because the Company accounts for its interest in Javelina on the equity method of accounting, its share of the borrowings outstanding under such bank credit agreements is not recorded on its Consolidated Balance Sheets. The Company's guarantees of these bank credit agreements were approximately $19.6 million at December 31, 1993. At December 31, 1993, the Company's investment in Javelina included its equity contributions and advances to Javelina of approximately $19.3 million to cover its proportionate share of expenditures in excess of the proceeds available under Javelina's bank credit agreements, and capitalized interest and overhead. 6. REDEEMABLE PREFERRED STOCK Energy is required to redeem and, commencing in 1986, has redeemed in December of each year its Cumulative Preferred Stock, $8.50 Series A ("Series A Preferred Stock"), at $100 per share at the rate of 11,500 shares annually ($1,150,000 per year). The redemption requirement for the Series A Preferred Stock for each of the five years following December 31, 1993 is also $1,150,000 per year. Energy also has the option to redeem shares of the Series A Preferred Stock at any time at $105.50 per share until November 30, 1994, with such amount being reduced by $.50 per share each year thereafter to $100 per share. In the event of an involuntary liquidation, the holders of the outstanding Series A Preferred Stock would be entitled, after the payment of all debts, to $100 per share, plus any accrued and unpaid dividends. In the event of a voluntary liquidation, the holders of the outstanding Series A Preferred Stock would be entitled to $100 per share, any applicable premium Energy would have had to pay if it had elected to redeem the Series A Preferred Stock at that time and any accrued and unpaid dividends. In the event dividends on the Series A Preferred Stock are six or more quarters in arrears, holders may vote to elect two directors. No arrearages currently exist. 7. CONVERTIBLE PREFERRED STOCK On October 18, 1993, Energy filed a registration statement with the Commission covering the offering of 2,500,000 shares of convertible preference stock. Energy intends to file an amended registration statement covering the offering of 3,000,000 shares (up to 3,450,000 shares with underwriters' over- allotments) of convertible preferred stock in March 1994. The proceeds from the offering would be utilized to fund the proposed acquisition of the Partnership (see Note 2). 8. REDEMPTION OF SERIES B PREFERRED STOCK On September 1, 1991, Energy redeemed one-half of its 1.6 million Depositary Preferred Shares ("Depositary Shares"), each of which represented one-twentieth share of Energy's $68.80 Cumulative Preferred Stock, Series B, at a price of $26.475 per Depositary Share representing a total expenditure of approximately $21.2 million. On November 21, 1991, Energy called the remaining half of the Depositary Shares for redemption on January 15, 1992, also at a price of $26.475 per Depositary Share. 9. PREFERENCE SHARE PURCHASE RIGHTS On November 15, 1985, Energy's Board of Directors declared a dividend distribution of one Preference Share Purchase Right ("Right") for each outstanding share of Energy's Common Stock. Until exercisable, the Rights are not transferable apart from Energy's Common Stock. Each Right will entitle shareholders to buy one-hundredth (1/100) of a share of a newly issued series of Junior Participating Serial Preference Stock, Series II, at an exercise price of $35 per Right. 10. INDUSTRY SEGMENT INFORMATION The Company is primarily engaged in the refining and marketing of petroleum products. The Company's primary refining activities involve the operation of its Refinery. Refining sells refined products principally on a spot and truck rack basis. Spot sales of Refining's products are made principally to larger oil companies and gasoline distributors. The principal purchasers of Refining's products from truck racks have been wholesalers and jobbers in the southeastern and midwestern United States. The Company has no foreign operations other than storage facilities and no single customer accounts for more than 10% of its operating revenues. 11. INCOME TAXES Components of income tax expense attributable to continuing operations are as follows (in thousands): The Company has credited the tax benefit associated with expenses for certain employee benefits recognized differently for financial reporting and income tax purposes directly to stockholders' equity. Such amounts (in thousands) were $903, $1,758 and $915 for 1993, 1992 and 1991, respectively. Total income tax expense differs from the amount computed by applying the statutory federal income tax rate to income before income taxes. The reasons for these differences are as follows (in thousands): The tax effects of significant temporary differences representing deferred income tax assets and liabilities are as follows (in thousands): At December 31, 1993, the Company had federal net operating loss carryforwards of approximately $7 million, which are available to reduce future federal taxable income and will expire in 1997 if not utilized. In addition, the Company had investment tax credit ("ITC"), Employee Stock Ownership Plan ("ESOP") tax credit and alternative minimum tax credit ("AMT") carryforwards of approximately $71 million which are available to reduce future federal income tax liabilities. The ITC and ESOP tax credits of approximately $55 million expire between 1995 and 2001 if not utilized and the AMT credit of approximately $16 million has no expiration date. The Company did not record any valuation allowances against deferred income tax assets at December 31, 1993. The Company's federal income tax returns have been examined by the IRS for all taxable years through 1989. All issues were resolved with the exception of one in which the Company has petitioned the Tax Court. A decision from the Tax Court is expected during 1994 . The Company believes that adequate provisions for income taxes have been reflected in its consolidated financial statements. 12. EMPLOYEE BENEFIT PLANS Pension and Other Employee Benefit Plans The following table sets forth for the pension plans of the Company, the funded status and amounts recognized in the Company's consolidated financial statements at December 31, 1993 and 1992 (in thousands): Net periodic pension cost for the years ended December 31, 1993, 1992 and 1991 included the following components (in thousands): A participant in the Company's pension plan vests in plan benefits after 5 years of vesting service or upon reaching normal retirement date. The pension plan provides a monthly pension payable upon normal retirement of an amount equal to a set formula which is based on the participant's 60 consecutive highest months of compensation during credited service under the plan. The weighted-average discount rate used in determining the actuarial present value of the projected benefit obligation was 7.2% and 8.3%, respectively, as of December 31, 1993 and 1992. The rate of increase in future compensation levels used in determining the projected benefit obligation as of December 31, 1993 was 4% for nonexempt personnel and 2% for exempt personnel, while the 1992 projected benefit obligation was based on an assumed overall 6.3% rate of compensation increase. The expected long-term rate of return on plan assets was 9% and 10% as of December 31, 1993 and 1992, respectively. Contributions, when permitted, are actuarially determined in an amount sufficient to fund the currently accruing benefits and amortize any prior service cost over the expected life of the then current work force. The Company also maintains a nonqualified Supplemental Executive Retirement Plan ("SERP") which provides additional pension benefits to the executive officers and certain other employees of the Company. The Company's contributions to the pension plan and SERP in 1993, 1992 and 1991 were approximately $7.5 million, $7.5 million and $8 million, respectively, and are currently estimated to be $5.9 million in 1994. The tables at the beginning of this note include amounts related to the SERP. The Company is the sponsor of the Valero Energy Corporation Thrift Plan ("Thrift Plan") which is an employee profit sharing plan. Participation in the Thrift Plan is voluntary and is open to employees of the Company who become eligible to participate following the completion of three months of continuous employment. Participating employees may make a base contribution from 2% up to 8% of their annual base salary, depending upon months of contributions by a participant. Prior to the establishment of the VESOP, 100% of these contributions were matched by the Company. Subsequent to the establishment of the VESOP, the Company has made contributions to the Thrift Plan only to the extent employees' base contributions have exceeded the amount of the Company's contribution to the VESOP for debt service. In 1994, the Thrift Plan was amended to provide for a total Company match in both the Thrift Plan and the VESOP aggregating either 75% or 100% of employee base contributions, subject to certain conditions. Participants may also make a supplemental contribution to the Thrift Plan of up to an additional 10% of their annual base salary which is not matched by the Company. Company contributions to the Thrift Plan during 1993, 1992 and 1991 were approximately $660,000, $348,000 and $1,027,000, respectively. In February 1989, the Company established the VESOP which is a leveraged employee stock ownership plan. Pursuant to a private placement in March 1989, the VESOP issued notes in the principal amount of $15 million, maturing February 15, 1999 (the "VESOP Notes"). The net proceeds from this private placement were used by the VESOP trustee to fund the purchase of Common Stock. The Company makes semi-annual contributions of approximately $1.16 million to the VESOP until maturity to fund the debt service on the VESOP Notes, and, as explained above, the Company's annual contribution to the Thrift Plan during such period is reduced accordingly. During the third quarter of 1991, the Company made an additional loan of $8 million to the VESOP which was also used by the Trustee to purchase Common Stock. This new VESOP loan matures on August 15, 2001. During 1993, the Company contributed $3,596,000 to the VESOP, incurred $947,000 of interest on the VESOP Notes and recognized $2,173,000 of compensation expense. During 1992, the Company contributed $3,596,000 to the VESOP, incurred $1,065,000 of interest on the VESOP Notes and recognized $2,055,000 of compensation expense. Such amounts for 1991 were $2,320,000, $1,172,000 and $1,448,000, respectively. Dividends paid on Common Stock during 1993, 1992 and 1991 have not been used to reduce the VESOP obligation. In addition to the above plans, the Company also sponsors other employee benefit plans, including the Valero Energy Corporation Employee's Stock Ownership Plan. During the third quarter of 1991, the Company contributed $2.3 million to the ESOP for investment tax credits claimed on Refining's separate 1982 federal income tax return which had not been utilized. The Company also sponsors the Executive Deferred Compensation Plan, the Key Employee Deferred Compensation Plan and the Excess Thrift Plan. At December 31, 1993 and 1992, the amount recorded as deferred compensation on the consolidated balance sheets under these plans was $4.9 million and $4.8 million, respectively. The Company also provides certain health care and life insurance benefits for retired employees, referred to herein as "postretirement benefits other than pensions." Substantially all of the Company's employees may become eligible for those benefits if, while still working for the Company, they either reach normal retirement age or take early retirement. Health care benefits are provided by the Company through a self-insured plan while life insurance benefits are provided through an insurance company. Effective January 1, 1993, the Company adopted SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions", which requires a change in the Company's accounting for postretirement benefits other than pensions from a pay-as-you-go basis to an accrual basis of accounting. The Company is amortizing the transition obligation over 20 years, which is greater than the average remaining service period until eligibility of active plan participants. The Company continues to fund its postretirement benefits other than pensions on a pay- as-you-go basis. The adoption of this standard resulted in a decrease to net income in 1993 of $1.7 million, or $.04 per share, after allocation to the Partnership of its pro rata portion of such costs. The following table sets forth for the Company's postretirement benefits other than pensions, the funded status and amounts recognized in the Company's consolidated financial statements at December 31, 1993 (in thousands): Net periodic postretirement benefit cost for the year ended December 31, 1993 included the following components (in thousands): For measurement purposes, the health care cost trend rate was 10% in 1993, decreasing gradually to 5.5% in 1998 and remaining level thereafter. The health care cost trend rate assumption has a significant effect on the amount of the obligation and periodic cost reported. An increase in the assumed health care cost trend rate by 1% in each year would increase the accumulated postretirement benefit obligation as of December 31, 1993 by $4.7 million and the aggregate of the service and interest cost components of net periodic postretirement benefit cost for the year then ended by $.6 million. The weighted-average discount rate used in determining the accumulated postretirement benefit obligation as of December 31, 1993 was 7.2%. Prior to 1993, the cost of providing health care and life insurance benefits to retired employees was recognized as expense as health care claims and life insurance premiums were paid. These costs totaled approximately $675,000 and $700,000 for 1992 and 1991, respectively. Stock Option and Bonus Plans Energy has three non-qualified stock option plans, Stock Option Plan No. 5, Stock Option Plan No. 4, and Stock Option Plan No. 3, collectively referred to herein as the "Stock Option Plans." The Stock Option Plans provide for the granting of options to purchase shares of Energy's Common Stock. Such options are granted to key officers, employees and prospective employees of the Company. Under the terms of the Stock Option Plans, the exercise price of the options granted will generally not be less than 75% of the fair market value of Common Stock at the date of grant. All stock options granted since 1990 contain exercise prices equal to the market value at the date of grant. Stock options become exercisable pursuant to the individual written agreements between Energy and the participants in the Stock Option Plans, which provide for options becoming exercisable in three equal annual installments beginning one year after the date of grant, with unexercised options expiring ten years from the date of grant. The aggregate difference between the market value of Common Stock at date of grant and the option price is recorded as compensation expense during the exercise period. At December 31, 1993, 1,261,624 options were outstanding, at a weighted-average exercise price of $23.69 per share, of which 357,258 options were exercisable at a weighted- average exercise price of $20.88 per share. During 1993, 597,050 options were granted at a weighted-average exercise price of $23.19, 140,588 options were exercised at a weighted-average exercise price of $10.46 and 53,433 options were terminated and/or forfeited. At December 31, 1993, there were 194,375 shares available for grant under these Stock Option Plans, including shares transferred from previously terminated stock option plans of the Company. For each share of stock that can be purchased thereunder pursuant to a stock option, Stock Option Plans No. 3 and 4 provide that a stock appreciation right ("SAR") may also be granted. A SAR is a right to receive a cash payment equal to the difference between the fair market value of Energy's Common Stock on the exercise date and the option price of the stock to which the SAR is related. SARs are exercisable only upon the exercise of the related stock options. At the end of each reporting period within the exercise period, Energy records an adjustment to deferred compensation expense based on the difference between the fair market value of Energy's Common Stock at the end of each reporting period and the option price of the stock to which the SAR is related. At December 31, 1993, 139,315 SARs were outstanding, at a weighted-average exercise price of $14.52 per share, of which 138,940 SARs were exercisable at a weighted- average exercise price of $14.52 per share. During 1993, 113,999 SARs were exercised at a weighted-average exercise price of $10.32 per share, and 1,466 SARs were terminated and/or forfeited. Compensation expense recognized during 1993 in connection with the grant of options and SARs under the Company's Stock Option Plans was $110,000. The Company maintains a Restricted Stock Bonus and Incentive Stock Plan ("Bonus Plan") for certain key executives of the Company. Under the Bonus Plan, 750,000 shares of Common Stock were reserved for issuance. At December 31, 1993, there were 18,927 shares available for award and 77,750 shares awarded under this plan during 1993. The amount of Bonus Stock and terms governing the removal of applicable restrictions, and the amount of Incentive Stock and terms establishing predefined performance objectives and periods, are established pursuant to individual written agreements between Energy and each participant in the Bonus Plan. Compensation expense recognized in connection with the Bonus Plan for 1993 was $570,000. The Company also maintains an executive incentive bonus plan (the "Incentive Plan") for the purpose of providing bonus compensation to key executive and managerial employees. During 1993, bonuses were paid in cash and Common Stock. Compensation expense recognized during 1993 in connection with the Incentive Plan was approximately $2.4 million. 13. DEFERRED CREDITS AND OTHER LIABILITIES Deferred credits and other liabilities are as follows (in thousands): Deferred management fees were recorded upon the formation of the Partnership in March 1987 and are being amortized over the ten-year period during which VNGC agreed not to withdraw as General Partner of the Partnership. 14. LEASE AND OTHER COMMITMENTS The Company has two major operating lease commitments in connection with a gas storage facility leased to the Partnership and its corporate headquarters office complex. The remaining primary lease term for the gas storage facility is six years, while the corporate headquarters lease has a primary term remaining of three years with eight optional renewal periods of five years each. The Company has the right to purchase the office complex at any time after the end of the third renewal period at the then determined fair market value. The Company also has other noncancelable operating leases with remaining terms ranging from one year to 7 years. The related future minimum lease payments as of December 31, 1993 are as follows (in thousands): The future minimum lease payments listed above under the caption "Other" exclude certain operating lease commitments which are cancelable by the Company upon notice of one year or less. Consolidated rent expense amounted to $12,948,000, $12,643,000, and $11,740,000 for 1993, 1992 and 1991, respectively, and includes various month-to-month and other short-term rentals in addition to rents paid and accrued under long-term lease commitments. A portion of these amounts was charged to and reimbursed by the Partnership for its proportionate use of the Company's corporate headquarters office complex and for the use of certain other properties managed by the Company. The obligations of Valero Gas Storage Company ("Gas Storage"), a wholly owned subsidiary of VNGC, under the gas storage facility lease include its obligation to make scheduled lease payments and, in the event of a declaration of default and acceleration of the lease obligation, to make certain lump sum payments based on a stipulated loss value for the gas storage facility less the fair market sales price or fair market rental value of the gas storage facility. Under certain circumstances, a default by Energy or a subsidiary of Energy under its bank credit facilities could result in a cross default under the gas storage facility lease. The Company believes that it is unlikely that a default by Energy or a subsidiary of Energy would result in actual acceleration of the gas storage facility lease, and further believes that such event, if it occurred, would not have a material adverse effect on the Company or the Partnership. The obligation of the Company to make certain payments to Gas Storage equal to the amount of Gas Storage's required payments under the gas storage facility lease has been assumed by the Partnership. 15. LITIGATION AND CONTINGENCIES Partnership Related Claims In 1987, VT, L.P. and a producer from whom VT, L.P. has purchased natural gas entered into an agreement resolving certain take-or-pay issues between the parties in which VT, L.P. agreed to pay one-half of certain excess royalty claims arising after the date of the agreement. The royalty owners of the producer recently completed an audit of the producer and have presented to the producer a claim for additional royalty payments in the amount of approximately $17.3 million, and accrued interest thereon of approximately $19.8 million. Approximately $8 million of the royalty owners' claim accrued after the effective date of the agreement between the producer and VT, L.P.. The producer and VT, L.P. are reviewing the royalty owners' claims. No lawsuit has been filed by the royalty owners. The Company believes that various defenses under the agreement may reduce any liability of VT, L.P. to the producer in this matter. Seven lawsuits were filed in Chancery Court in Delaware against VNGP, L.P., VNGC and Energy and certain officers and directors of VNGC and/or Energy in response to the announcement by Energy on October 14, 1993 of its proposal to acquire the publicly traded Common Units of VNGP, L.P. pursuant to a proposed merger of VNGP, L.P. with a wholly owned subsidiary of Energy. See Note 2. The suits were consolidated into a single proceeding by the Chancery Court on November 23, 1993. The plaintiffs sought to enjoin or rescind the proposed merger, alleging that the corporate defendants and the individual defendants, as officers or directors of the corporate defendants, engaged in actions in breach of the defendants' fiduciary duties to the Public Unitholders by proposing the merger. The plaintiffs alternatively sought an increase in the proposed merger consideration, unspecified compensatory damages and attorneys' fees. In December 1993, the parties reached a tentative settlement of the consolidated lawsuit. The terms of the settlement will not require a material payment by the Company or the Partnership. However, there can be no assurance that the settlement will be completed, or that it will be approved by the Chancery Court. In a letter dated September 1, 1993 from the City of Houston (the "City") to Valero Transmission Company ("VTC"), an indirect wholly owned subsidiary of Energy, the City stated its intent to bring suit against VTC for certain claims asserted by the City under the franchise agreement between the City and VTC. VTC is the general partner of VT, L.P., an indirect subsidiary partnership of VNGP, L.P. The franchise agreement was assigned to and assumed by VT, L.P. upon formation of the Partnership in 1987. In the letter, the City also declared a conditional forfeiture of the franchise rights based on the City's claims. In a letter dated October 27, 1993, the City claimed that VTC owes to the City franchise fees and accrued interest thereon aggregating approximately $13.5 million. In a letter dated November 9, 1993, the City claimed an additional $18 million in damages relating to the City's allegations that VTC engaged in unauthorized activities under the franchise agreement by transmitting gas for resale and by transporting gas for third parties on the franchised premises. The City has not filed a lawsuit. While any liability of VTC with respect to the City's claims has been assumed by the Partnership, if the proposed merger with VNGP, L.P. is consummated, the Company's financial position would necessarily reflect the full amount of any Partnership liability. Additionally, in the event that the Partnership failed to pay any such liability, the Company could remain ultimately responsible. The Company believes that the City's claims are significantly overstated, and that VTC has a number of meritorious defenses to the claims. VTC and one of its gas suppliers are parties to various gas purchase contracts assigned to and assumed by VT, L.P. upon formation of the Partnership in 1987. The supplier is also a party to a series of gas purchase contracts between the supplier, as buyer, and certain trusts, as seller, which are in litigation. Neither the Partnership nor VTC is a party to this litigation or the contracts between the supplier and the trusts. However, because of the relationship between VTC's contracts with the supplier and the supplier's contracts with the trusts, and in order to resolve existing and potential disputes, the supplier, VTC and VT, L.P. have agreed that they will cooperate in the conduct of this litigation, and that VTC and VT, L.P. will bear a substantial portion of the costs of any appeal and any nonappealable final judgment rendered against the supplier. In the litigation, the trusts allege that the supplier has breached various minimum take, take-or-pay and other contractual provisions and assert a statutory nonratability claim. The trusts seek alleged actual damages, including interest, of approximately $30 million and an unspecified amount of punitive damages. The District Court ruled on the plaintiff's motion for summary judgment, finding, among other things, that as a matter of law the three gas purchase contracts at issue were fully binding and enforceable, the supplier breached the minimum take obligations under one of the contracts, the supplier is not entitled to claimed offsets for gas purchased by third parties and the "availability" of gas for take-or-pay purposes is established solely by the delivery capacity testing procedures in the contracts. Damages, if any, have not been determined. Because of existing contractual obligations of the Partnership to its supplier, the lawsuit may ultimately involve a contingent liability for the Partnership. The Company believes that the claims brought against the supplier have been significantly overstated, and that the supplier has a number of meritorious defenses to the claims, including various regulatory, statutory, contractual and common law defenses. The Court recently granted the supplier's Motion for Continuance of the former January 10, 1994 trial date. This litigation is not currently set for trial. In March 1993, two indirect wholly owned subsidiaries of Energy serving as general partners of two of the Partnership's principal subsidiary operating partnerships were served as third- party defendants in a lawsuit originally filed in 1991 by a subsidiary of the Coastal Corporation ("Coastal") against TransAmerican Natural Gas Corporation ("TANG"). In August 1993, Energy, VNGP, L.P. and certain of their respective subsidiaries were named as additional third-party defendants (collectively, including the original defendant subsidiaries, the "Valero Defendants") in this lawsuit. In its counterclaims against Coastal and third-party claims against the Valero Defendants, TANG alleges that it contracted to sell natural gas to Coastal at the posted field price of one of the Valero Defendants and that the Valero Defendants and Coastal conspired to set such price at an artificially low level. TANG also alleges that the Valero Defendants and Coastal conspired to cause TANG to deliver unprocessed or "wet" gas thus precluding TANG from extracting NGLs from its gas prior to delivery. TANG seeks actual damages of approximately $50 million, trebling of damages under antitrust claims, punitive damages of $300 million, and attorneys' fees. The Company believes that the plaintiff's claims have been exaggerated, and that it has meritorious defenses to such claims. In the event of an adverse determination involving the Company, the Company likely would seek indemnification from the Partnership under terms of the partnership agreements and other applicable agreements between VNGP, L.P., its subsidiary partnerships and their respective general partners. The Valero Defendants' motion for summary judgment on TANG's antitrust claims was argued on January 24, 1994. The court has not ruled on such motion. The current trial setting for this case is March 14, 1994. The Company was a party to a lawsuit originally filed in 1988 in which Energy, VTC, VNGP, L.P. and subsidiaries of VNGP, L.P. (the "Valero Defendants") and a subsidiary of Coastal were alleged to be liable for failure to take minimum quantities of gas, failure to make take-or-pay payments and other breach of contract and breach of fiduciary duty claims. The plaintiffs sought declaratory relief, actual damages in excess of $37 million and unspecified punitive damages. During the third quarter of 1992, the plaintiffs, Coastal and the Valero Defendants settled this lawsuit on terms which were not material to the Valero Defendants and on July 19, 1993, this lawsuit was dismissed. On November 16, 1992, prior to entry of the order of dismissal, NationsBank of Texas, N.A., as trustee for certain trusts (the "Intervenors"), filed a plea in intervention to intervene in the lawsuit. The Intervenors asserted that they held a non-participating mineral interest in the lands subject to the litigation and that their rights were not protected by the plaintiffs in the settlement. On February 4, 1993, the Court struck the Intervenors' plea in intervention. However, on February 2, 1993, the Intervenors had filed a separate suit in the 160th State District Court, Dallas County, Texas, against all prior defendants and an additional defendant, substantially adopting in form and substance the allegations and claims in the original litigation. In February 1994, the parties reached a tentative settlement of the lawsuit on terms immaterial to the Company or the Partnership. The Partnership has settled substantially all of the significant take-or-pay claims, pricing differences and contractual disputes heretofore brought against it. Although additional take-or-pay claims may continue to be brought against the Partnership, the Company believes that the Partnership has resolved substantially all of the significant take-or-pay claims that are likely to be made. Any liability of the Company with respect to these claims has been assumed by the Partnership. No provision has been made with respect to these claims because the Company believes that the Partnership has valid defenses with respect to such claims and because the Company believes that the Partnership will fulfill its obligation to pay any such liability as may ultimately be determined to exist. The Company and the Partnership believe it is unlikely that the final outcome of any of the claims or proceedings described above would have a material adverse effect on either the Company's or the Partnership's financial position or results of operations; however, due to the inherent uncertainty of litigation, the range of possible loss, if any, cannot be estimated with a reasonable degree of precision and there can be no assurance that the resolution of any of these claims or proceedings would not have an adverse effect on either the Company's or the Partnership's results of operations for the fiscal period in which the resolution occurred. Other Litigation On August 31, 1993, suit was brought by certain residents of the Oak Park Triangle area of Corpus Christi, Texas, against several defendants including Valero Refining Company. All named defendants are either refiners or gas processors having facilities located at or near Up River Road in Corpus Christi. Plaintiffs allege in general terms damages resulting from ground water contamination and air pollution allegedly caused by the operations of the defendants. Plaintiffs seek unspecified actual and punitive damages. No provision has been made with respect to the claims of the plaintiffs because the Company believes that Valero Refining Company has meritorious defenses to the claims. Valero Javelina Company, a wholly owned subsidiary of Energy, owns a 20% general partner interest in Javelina Company, a general partnership. See Note 5 of Notes to Consolidated Financial Statements. Javelina Company has been named as a defendant in seven lawsuits filed since 1992 in state district courts in Nueces County, Texas. Four of the suits include as defendants other companies that own refineries or other industrial facilities in Nueces County. These suits were brought by a number of plaintiffs who reside in neighborhoods near the facilities. The plaintiffs claim injuries relating to an alleged exposure to toxic chemicals, and generally claim that the defendants were negligent, grossly negligent and committed trespass. The plaintiffs claim personal injury and property damages resulting from soil and ground water contamination and air pollution allegedly caused by the operations of the defendants. One of the suits seeks certification of the litigation as a class action. The plaintiffs seek unspecified actual and punitive damages. The other three suits were brought by plaintiffs who either live or have businesses near the Javelina Plant. The suits allege claims similar to those described above. These plaintiffs also fail to specify an amount of damages claimed. The Company is also a party to additional claims and legal proceedings arising in the ordinary course of business. The Company believes it is unlikely that the final outcome of any of the claims or proceedings to which the Company is a party, including those described above, would have a material adverse effect on the Company's financial position or results of operations; however, due to the inherent uncertainty of litigation, the range of possible loss, if any, cannot be estimated with a reasonable degree of precision and there can be no assurance that the resolution of any particular claim or proceeding would not have an adverse effect on the Company's results of operations for the fiscal period in which such resolution occurred. As is described above, the Partnership has assumed the obligations and liabilities of the Company with respect to claims relating to the business or properties transferred by the Company to the Partnership in 1987. If the Partnership were unable or otherwise failed to discharge any such liability of the Company which it assumed, the Company could remain ultimately liable for such liability. 16. QUARTERLY RESULTS OF OPERATIONS (Unaudited) The results of operations by quarter for the years ended December 31, 1993 and 1992 were as follows (in thousands of dollars, except per share amounts): For the fourth quarter of 1993, results of operations were affected by a $27.6 million or $17.9 million after-tax ($.42 per share) write-down in the carrying value of the Company's refinery inventories to reflect existing market prices. This was due to a significant decline in feedstock and refined product prices, which were weak throughout 1993. Also affecting the decrease in the Company's fourth quarter operating and net income compared to the first three quarters of 1993 is the effect of seasonal market conditions on the Company's refining operations. The Company's refinery processes a type of residual fuel oil as a feedstock to produce a product slate consisting primarily of unleaded gasoline. The national demand for and price of gasoline is typically lower in the fourth quarter compared to other quarters due to the lower level of driving during the winter season. Gasoline prices are typically higher during the second and third quarters due to the increased demand related to the summer driving season. In addition, demand for and the price of fuel oils are typically higher in the fourth quarter because of the approaching heating season; these factors tend to adversely affect feedstock costs in the fourth quarter. A typical combination of lower gasoline sales prices and higher feedstock costs decreases refining throughput margins in the fourth quarter. Quarterly results for 1992 were also affected by seasonal market conditions. 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 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. (a) 1. Financial Statements- The following Consolidated Financial Statements of Valero Energy Corporation and its subsidiaries are included in Part II, Item 8 of this Form 10-K: Page Report of independent public accountants . . . . . . . . . Consolidated balance sheets as of December 31, 1993 and 1992 . . . . . . . . . . . . . . . . . . . . . . . . Consolidated statements of income for the years ended December 31, 1993, 1992 and 1991 . . . . . . . . . . . . Consolidated statements of common stock and other stockholders' equity 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 . . . . . . . . . Notes to consolidated financial statements . . . . . . . . 2. Financial Statement Schedules and Other Financial Information- (A) Schedules required to be furnished for the years ended December 31, 1993, 1992 and Schedule V-Property, plant and equipment. . . . . . . . . . . . . . . Schedule VI-Accumulated depreciation, depletion and amortization of property, plant and equipment. . . . . Schedule IX-Short-term borrowings. . . . All other schedules are not submitted because they are not applicable or because the required information is included in the financial statements or notes thereto. 3. Exhibits Filed as part of this Form 10-K are the following exhibits: 2.1 - Agreement of Merger, dated December 20, 1993, among Valero Energy Corporation, Valero Natural Gas Partners, L.P., Valero Natural Gas Company and Valero Merger Partnership, L.P.-- incorporated by reference from Exhibit 2.1 to Amendment No. 2 to the Valero Energy Corporation Registration Statement on Form S-3 (Commission File No. 33-70454, filed December 29, 1993). 3.1 -- Restated Certificate of Incorporation of Valero Energy Corporation--incorporated by reference from Exhibit 4.1 to the Valero Energy Corporation Registration Statement on Form S-8 (Commission File No. 33-53796, filed October 27, 1992). 3.2 -- By-Laws of Valero Energy Corporation, as amended and restated October 17, 1991--incorporated by reference from Exhibit 4.2 to the Valero Energy Corporation Registration Statement on Form S-3 (Commission File No. 33-45456, filed February 4, 1992). 3.3 -- Amendment to By-Laws of Valero Energy Corporation, as adopted February 25, 1993-- incorporated by reference from Exhibit 3.3 to the Valero Energy Corporation Annual Report on Form 10-K (Commission File No. 1-4718, filed February 26, 1993). 4.1 -- Amended and Restated Rights Agreement, dated as of October 17, 1991, between Valero Energy Corporation and Ameritrust Texas, N.A., successor to Mbank Alamo, N.A., as Rights Agent --incorporated by reference from Exhibit 1 to the Valero Energy Corporation Current Report on Form 8-K (Commission File No. 1- 4718, filed October 18, 1991). 4.2 -- $200,000,000 Senior Notes Purchase Agreement dated as of December 19, 1990--incorporated by reference from Exhibit 4.2 to the Valero Energy Corporation Annual Report on Form 10-K (Commission File No. 1-4718, filed February 21, 1992). 4.3 -- $160,000,000 Amended and Restated Credit Agreement, dated as of December 4, 1992, among Valero Refining Company, Bankers Trust Company, as Agent and certain other banks party thereto--incorporated by reference from Exhibit 4.3 to the Valero Energy Corporation Form 10-K (Commission File No. 1-4718, filed February 26, 1993). 4.4 -- First Amendment to Amended and Restated Credit Agreement, dated as of August 25, 1993-- incorporated by reference from Exhibit 4.5 to the Valero Energy Corporation Registration Statement on Form S-3 (Commission File No. 33-70454, filed October 18, 1993). *4.5 -- Second Amendment to Amended and Restated Credit Agreement, dated as of December 31, 1993. +10.1 -- Valero Energy Corporation Executive Deferred Compensation Plan, amended and restated as of October 21, 1986--incorporated by reference from Exhibit 10.16 to the Valero Energy Corporation Annual Report on Form 10-K (Commission File No. 1-4718, filed February 26, 1988). +10.2 -- Valero Energy Corporation Key Employee Deferred Compensation Plan, amended and restated as of October 21, 1986--incorporated by reference from Exhibit 10.17 to the Valero Energy Corporation Annual Report on Form 10-K (Commission File No. 1-4718, filed February 26, 1988). +10.3 -- Valero Energy Corporation Amended and Restated Restricted Stock Bonus and Incentive Stock Plan dated as of January 24, 1984 (as amended through January 1, 1988)--incorporated by reference from Exhibit 10.19 to the Valero Energy Corporation Annual Report on Form 10-K (Commission File No. 1-4718, filed February 26, 1988). +10.4 -- Valero Energy Corporation Stock Option Plan No. 3, as amended and restated November 28, 1993--incorporated by reference from Exhibit 10.5 to the Valero Natural Gas Partners, L.P. Annual Report on Form 10-K (Commission File No. 1-9433, filed March 1, 1994). +10.5 -- Valero Energy Corporation Stock Option Plan No. 4, as amended and restated effective November 28, 1993--incorporated by reference from Exhibit 10.6 to the Valero Natural Gas Partners, L.P. Annual Report on Form 10-K (Commission File No. 1-9433, filed March 1, 1994). +10.6 -- Valero Energy Corporation 1990 Restricted Stock Plan for Non-Employee Directors, dated effective as of November 14, 1990--incorporated by reference from Exhibit 10.23 to the Valero Energy Corporation Annual Report on Form 10-K (Commission File No. 1- 4718, filed February 26, 1991). +10.7 -- Valero Energy Corporation Supplemental Executive Retirement Plan as amended and restated effective January 1, 1990--incorporated by reference from Exhibit 10.24 to the Valero Energy Corporation Annual Report on Form 10-K (Commission File No. 1- 4718, filed February 26, 1991). +10.8 -- Valero Energy Corporation Executive Incentive Bonus Plan--incorporated by reference from Exhibit 10.9 to the Valero Natural Gas Partners, L.P. Annual Report on Form 10-K (Commission File No. 1-4718, filed February 20, 1992). +10.9 -- Executive Severance Agreement between Valero Energy Corporation and William E. Greehey, dated December 15, 1982--incorporated by reference from Exhibit 10.11 to the Valero Natural Gas Partners, L.P. Annual Report on Form 10-K (Commission File No. 1-9433, filed February 25, 1993). +10.10 -- Schedule of Executive Severance Agreements-- incorporated by reference from Exhibit 10.12 to the Valero Energy Corporation Annual Report on Form 10-K (Commission File No. 1-4718, filed February 26, 1993). +10.11 -- Employment Agreement between Valero Energy Corporation and William E. Greehey, dated May 16, 1990--incorporated by reference from Exhibit 10.1 to the Valero Energy Corporation Quarterly Report on Form 10-Q (Commission File No. 1-4718, filed November 14, 1990). +10.12 -- Indemnity Agreement, dated as of February 24, 1987, between Valero Energy Corporation and William E. Greehey--incorporated by reference from Exhibit 10.16 to the Valero Energy Corporation Annual Report on Form 10-K (Commission File No. 1-4718, filed February 26, 1993). +10.13 -- Schedule of Indemnity Agreements--incorporated by reference from Exhibit 10.17 to the Valero Energy Corporation Annual Report on Form 10-K (Commission File No. 1-4718, filed February 26, 1993). *11 -- Computation of Earnings Per Share. *21.1 -- Valero Energy Corporation subsidiaries, including state or other jurisdiction of incorporation or organization. *23.1 -- Consent of Arthur Andersen & Co., dated March 1, 1994. *24.1 -- Power of Attorney, dated March 1, 1994--set forth at the signatures page of this Form 10-K. *99.1 -- Items 1 through 3 of the Valero Natural Gas Partners, L.P. Annual Report on Form 10-K for the year ended December 31, 1993 (Commission File No. 1-9433, filed March 1, 1994). ______________ * Filed herewith + Identifies management contracts or compensatory plans or arrangements required to be filed as an exhibit hereto pursuant to Item 14(c) of Form 10-K. Copies of exhibits filed as a part of this Form 10-K may be obtained by stockholders of record at a charge of $.15 per page, minimum $5.00 each request. Direct inquiries to Rand C. Schmidt, Corporate Secretary, Valero Energy Corporation, P.O. Box 500, San Antonio, Texas 78292. Pursuant to paragraph 601(b)(4)(iii)(A) of Regulation S- K, the registrant has omitted from the foregoing listing of exhibits, and hereby agrees to furnish to the Commission upon its request, copies of certain instruments, each relating to long- term debt not exceeding 10% of the total assets of the registrant and its subsidiaries on a consolidated basis. (b) No reports on Form 8-K were filed during the three- month period ended December 31, 1993. For the purposes of complying with the rules governing Form S-8 under the Securities Act of 1933, the undersigned registrant hereby undertakes as follows, which undertaking shall be incorporated by reference into registrant's Registration Statements on Form S-8 No. 2-66297 (filed December 21, 1979), No. 2-82001 (filed February 23, 1983), No. 2-97043 (filed April 15, 1985), No. 33-23103 (filed July 15, 1988), No. 33-14455 (filed May 21, 1987), No. 33-38405 (filed December 3, 1990) and No. 33-53796 (filed October 27, 1992). 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 of 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 PUBLIC ACCOUNTANTS To the Board of Directors of Valero Natural Gas Company as General Partner of Valero Natural Gas Partners, L.P. and to the Common Unitholders: We have audited the accompanying consolidated balance sheets of Valero Natural Gas Partners, L.P. (a Delaware limited partnership) as of December 31, 1993 and 1992, and the related consolidated statements of income, partners' capital 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 Partnership'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 Valero Natural Gas Partners, L.P. 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. The supplemental schedules V, VI and IX 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. San Antonio, Texas February 17, 1994 VALERO NATURAL GAS PARTNERS, L.P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Organization and Control Valero Natural Gas Partners, L.P. ("VNGP, L.P."), Valero Management Partnership, L.P. (the "Management Partnership") and various subsidiary operating partnerships (the "Subsidiary Operating Partnerships"), all Delaware limited partnerships, are the successors to substantially all of the natural gas and natural gas liquids businesses, assets and liabilities of substantially all of the subsidiaries of Valero Natural Gas Company ("VNGC") and the transmission division of Rio Grande Valley Gas Company ("Rio"). VNGC is, and Rio at the time of such succession was, a wholly owned subsidiary of Valero Energy Corporation (unless otherwise required by the context, the term "Energy" as used herein refers to Valero Energy Corporation and its consolidated subsidiaries, both individually and collectively). VNGC is the general partner of VNGP, L.P. and the Management Partnership (in such capacity, the "General Partner"), while subsidiaries of VNGC are general partners (the "Subsidiary General Partners") of the respective Subsidiary Operating Partnerships. In March 1987, VNGP, L.P. sold in an underwritten public offering 9.5 million preference units of limited partner interests (the "Preference Units"), representing a 52% limited partner interest in VNGP, L.P. VNGP, L.P. concurrently issued approximately 8.6 million common units of limited partner interests (the "Common Units"), representing a 47% limited partner interest, to subsidiaries of Energy, and issued a 1% general partner interest in VNGP, L.P. to VNGC. Subsequent to March 1987, VNGP, L.P. issued .4 million additional Common Units to a subsidiary of Energy. In addition, approximately .2 million Common Units held by a subsidiary of Energy were transferred to employees of Energy and converted into Preference Units in connection with an employee benefit plan adopted by Energy. During 1992, all outstanding Preference Units were automatically converted into Common Units (see "Allocation of Net Income and Cash Distributions"). The original Common Units and former Preference Units converted into Common Units are collectively referred to herein as the "Units." Holders of the Units are referred to herein as the "Unitholders." Under the partnership structure, VNGP, L.P. holds a 99% limited partner interest and VNGC holds a 1% general partner interest in the Management Partnership. The Management Partnership in turn holds a 99% limited partner interest and various wholly owned subsidiaries of VNGC each hold a 1% general partner interest in the various Subsidiary Operating Partnerships to which the acquired businesses, assets and liabilities were transferred. Valero Transmission, L.P. ("Transmission"), one of the Subsidiary Operating Partnerships, owns and operates the principal pipeline system of the Partnership. (References to Transmission prior to March 25, 1987 refer to Valero Transmission Company, a wholly owned subsidiary of VNGC, and after that date to its successor in interest, Valero Transmission, L.P.) Transmission is principally a transporter of natural gas as it transports gas for affiliates and third parties. Transmission also sells natural gas to intrastate customers under long-term contracts; however, most of the Partnership's gas sales are made through other Subsidiary Operating Partnerships which operate special marketing programs ("SMPs"). Subsequent to March 1987, VNGP, L.P. acquired a wholly owned subsidiary that makes certain intrastate gas sales, and formed certain subsidiary partnerships, one of which leases certain assets from Energy under capital leases as described in Note 5. Also, during 1992, an additional Subsidiary Operating Partnership was formed to make certain intrastate gas sales. VNGP, L.P., the Management Partnership, the original Subsidiary Operating Partnerships and the additional entities acquired or formed subsequent to March 1987 are collectively referred to herein as the "Partnership." As of December 31, 1993, Energy's total effective equity interest in the Partnership was approximately 49%. In October 1993, Energy publicly announced its proposal to acquire the 9.7 million issued and outstanding Common Units in VNGP, L.P. held by persons other than Energy (the "Public Unitholders") pursuant to a merger of VNGP, L.P. with a wholly owned subsidiary of Energy. The Board of Directors of VNGC appointed a special committee of outside directors (the "Special Committee") to consider the merger and to determine the fairness of the transaction to the Public Unitholders. The Special Committee thereafter retained independent financial and legal advisors to assist the Special Committee. Upon the recommendation of the Special Committee, the Board of Directors of VNGC unanimously approved the merger. Effective December 20, 1993, Energy, VNGP, L.P. and VNGC entered into an agreement of merger (the "Merger Agreement") providing for the merger. In the merger, the Common Units held by the Public Unitholders will be converted into the right to receive cash in the amount of $12.10 per Common Unit. As a result of the merger, VNGP, L.P. would become a wholly owned subsidiary of Energy. Consummation of the merger is subject to, among other things, (i) approval of the Merger Agreement by the holders of a majority of the issued and outstanding Common Units; (ii) approval by the holders of a majority of the Common Units held by the Public Unitholders and voted at a special meeting of holders of Common Units to be called to consider the Merger Agreement; (iii) receipt of satisfactory waivers, consents or amendments to certain of Energy's financial agreements; and (iv) completion of an underwritten public offering of convertible preferred stock by Energy. Energy currently owns approximately 47.5% of the outstanding Common Units and intends to vote its Common Units in favor of the merger. Basis of Presentation The accompanying consolidated financial statements have been prepared in accordance with generally accepted accounting principles and are not the basis for reporting taxable income to Unitholders. The consolidated financial statements include the accounts of VNGP, L.P. and its consolidated subsidiaries. All significant interpartnership transactions have been eliminated in consolidation. Statements of Cash Flows In order to determine net cash provided by operating activities, net income has been adjusted by, among other things, changes in current assets and current liabilities, excluding changes in cash and temporary cash investments, cash held in debt service escrow for principal (see Note 3), and current maturities of long-term debt and capital lease obligations. Those changes, shown as an (increase)/decrease in current assets and an increase/ (decrease) in current liabilities, are provided in the following table. Temporary cash investments are highly liquid low-risk debt instruments which have a maturity of three months or less when acquired and whose carrying amount approximates fair value. (Dollars in thousands.) Cash interest paid by the Partnership (net of amounts capitalized) for the years ended December 31, 1993, 1992 and 1991 was $62.7 million, $66.4 million and $62.5 million, respectively. No cash payments for federal income taxes were made during these periods as the Partnership is not subject to federal income taxes (see "Income Taxes" below). Cash payments for state income taxes made during these periods were insignificant. Noncash investing and financing activities for the years ended December 31, 1992 and 1991 included $26 million and $75 million, respectively, of various natural gas and natural gas liquids facilities acquired by the Partnership through capital lease transactions entered into with Energy. See Note 5. Transactions with Energy The Partnership enters into various types of transactions with Energy in the normal course of business on market-related terms and conditions. The Partnership is charged a management fee for the direct and indirect costs incurred by Energy on behalf of the Partnership that are associated with managing its operations. The Partnership sells natural gas and natural gas liquids ("NGLs") to, and purchases NGLs from, Energy's refining subsidiary. The Partnership sold natural gas to Energy's retail natural gas distribution business operated by Rio until September 30, 1993, when Rio was sold by Energy. The Partnership operates for a fee two natural gas processing plants and related facilities for Energy and sells natural gas to, purchases natural gas and NGLs from, and processes natural gas owned by Energy in connection with these NGL operations. The Partnership also enters into other operating transactions with Energy, including certain leasing transactions discussed in Note 5. As of December 31, 1993 and 1992, the Partnership had recorded approximately $31.8 million and $13.5 million, respectively, of accounts payable and accrued expenses, net of accounts receivable, due to Energy. During the fourth quarter of 1992, the Partnership recognized a charge to earnings through the management fee billed by Energy of approximately $4.4 million, or $.23 per limited partner unit, representing the Partnership's allocable portion of the cost of a voluntary early retirement program implemented by Energy. The following table summarizes transactions between the Partnership and Energy for the years ended December 31, 1993, 1992 and 1991 (in thousands): The direct and indirect costs incurred by the General Partner on behalf of the Partnership that are charged to the Partnership through the management fee include, among other things, salaries and wages and other employee-related costs. Effective January 1, 1993, Energy adopted the Financial Accounting Standards Board's Statement of Financial Accounting Standards ("SFAS") No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions." This statement requires a change in Energy's accounting for postretirement benefits other than pensions from a pay-as-you-go basis to an accrual basis of accounting. Energy is amortizing the transition obligation over 20 years, which is greater than the average remaining service period until eligibility of active plan participants. As a result of Energy's adoption of this statement, the Partnership's proportionate share of other postretirement employee benefits included in the management fee in 1993 increased by approximately $1.5 million and the Partnership's proportionate share of the total accumulated postretirement benefit obligation at December 31, 1993 was approximately $15 million. The adoption of this statement by Energy did not affect the Partnership's cash flows in 1993, nor is it expected to affect the Partnership's future cash flows, as Energy expects to continue to fund its postretirement benefits other than pensions, and require reimbursement from the Partnership for the Partnership's proportionate share of such funding, on a pay-as-you-go basis. Gas Sales and Transportation In the course of making gas sales and providing transportation services to customers, Transmission experiences measurement and other volumetric differences related to the amounts of gas received and delivered. Transmission has in the past experienced overall net volume gains due to such differences and its Rate Order allows such volumes to be sold to its customers. Transmission historically has derived a substantial benefit from such sales. The amount included in operating income in 1993 was substantially the same as in 1992. However, the implementation of more precise gas measurement equipment and standards and the reduction in Transmission's total sales volumes, discussed in Note 6 - "Customer Audit of Transmission", is expected to reduce operating income from such sales in future periods. Inventories Inventories are carried principally at weighted average cost not in excess of market. Inventories as of December 31, 1993 and 1992 were as follows (in thousands): In addition to the above noted natural gas storage inventories, which are located at the Wilson Storage Facility in Wharton County, Texas (see Note 5), the Partnership also had natural gas in third-party storage facilities, available under exchange agreements, totalling $10.8 million and $1.2 million at December 31, 1993 and 1992, respectively. Such amounts are included in receivables in the accompanying consolidated balance sheets. Property, Plant and Equipment Property, plant and equipment at date of inception of the Partnership was increased by the excess of the acquisition cost of the holders of the Preference Units over VNGC's historical net cost basis. Accordingly, approximately 51% of property, plant and equipment was recorded at fair value reflecting the value attributable to the holders of the Preference Units while the remaining 49% was recorded at historical net book cost to reflect the value attributable to the General Partner and the holders of the original Common Units. Property additions and betterments include capitalized interest and acquisition and administrative costs allocable to construction and property purchases. Assets under capital leases are included in property, plant and equipment and are recorded at the lesser of the fair value of the leased property at the inception of the lease or the present value of the related future minimum lease payments. The costs of minor property units (or components thereof), net of salvage, retired or abandoned are charged or credited to accumulated depreciation. Gains or losses on sales or other dispositions of major units of property are credited or charged to income. Provision for depreciation of property, plant and equipment is made primarily on a straight-line basis over the estimated useful lives of the depreciable facilities. Assets under capital leases are depreciated on a straight-line basis over the lease term. The rates for depreciation are as follows: During the fourth quarter of 1992, the Partnership extended the estimated useful lives of the majority of its natural gas liquids facilities from 14 to 20 years to better reflect the estimated periods during which such assets are expected to remain in service. The effect of this change in accounting estimate, which was made retroactive to January 1, 1992, was to decrease depreciation expense and increase net income for 1992 by approximately $5.6 million, or $.29 per limited partner unit. Other Assets Payments made or agreed to be made in connection with the settlement of certain disputed contractual issues with gas suppliers of Transmission are initially deferred. The balance of such payments is subsequently reduced as recoveries are made through Transmission's rates. The balance of deferred gas costs of $67 million and $72 million at December 31, 1993 and 1992, respectively, is included in noncurrent other assets and is expected to be recovered over future periods. See Note 6 - "Customer Audit of Transmission." Debt issuance costs are included in deferred charges and other assets and are amortized by the effective interest method over the term of each respective issue of the Management Partnership's First Mortgage Notes ("First Mortgage Notes"). See Note 3. Income Taxes Income and deductions of the Partnership for federal income tax purposes are includable in the tax returns of the individual partners. Accordingly, no recognition has been given to federal income taxes in the accompanying consolidated financial statements of the Partnership. At December 31, 1993 and 1992, the net difference between the tax bases and the reported amounts of assets and liabilities in the accompanying Consolidated Balance Sheets was $314 million and $322 million, respectively. Under the Revenue Act of 1987, certain publicly traded limited partnerships will be taxed as corporations after December 31, 1997 unless specifically exempted. This Act exempted natural resource partnerships including those dealing with natural gas transportation and processing of natural gas liquids, such as the Partnership, from its taxation provision. Price Risk Management Activities The Partnership, through its Market Center Services Program established in 1992, enters into exchange-traded futures and options contracts, forward contracts, swaps and other financial instruments with third parties to hedge natural gas inventories and certain anticipated natural gas purchase requirements in order to minimize the risk of market fluctuations. The Partnership also utilizes such price risk management techniques to provide services to gas producers and end users. Changes in the market value of these contracts are deferred until the gain or loss is recognized on the hedged transaction. As of December 31, 1993 and 1992, the Partnership had outstanding contracts for natural gas totalling approximately 15.0 billion cubic feet ("Bcf") and 4.8 Bcf, respectively, for which the Partnership is the fixed price payor and 27.1 Bcf and 10.0 Bcf, respectively, for which the Partnership is the fixed price receiver. Such contracts run for a period of one to twelve months. A portion of such contracts represented hedges of natural gas volumes in underground storage and in third-party storage facilities which totalled approximately 10.3 Bcf and 7.4 Bcf at December 31, 1993 and 1992, respectively. See "Inventories" above. In 1993 and 1992, the Partnership recognized $18.7 million and $12.9 million, respectively, in gas cost reductions and other benefits from this program. An additional $5.1 million and $3.6 million in other reductions of cost of gas was generated by transactions entered into in 1993 and 1992, respectively, which is recognized in income in the subsequent year as the related gas is sold. Allocation of Net Income and Cash Distributions Net income is allocated to partners based on their effective ownership interest in the operating results of the Partnership, except that additional depreciation expense pertaining to the excess of the Partnership's acquisition cost over the historical cost basis in net property, plant and equipment and certain other assets in which the former holders of Preference Units have an ownership interest is allocated solely to such holders as a noncash charge to net income. The allocation of additional depreciation expense to the former holders of Preference Units does not affect the cash distributions with respect to the Units. Under the Partnership structure, the income of the Subsidiary Operating Partnerships is allocated to the Subsidiary General Partners, which hold a 1% general partner interest, and to the Management Partnership, which holds a 99% limited partner interest. As a result, net income allocable to the Subsidiary General Partners is not reduced by interest expense associated with the Management Partnership's First Mortgage Notes. The Partnership is required to make quarterly cash distributions with respect to all Units in an amount equal to "Distributable Cash Flow" as defined in the Second Amended and Restated Agreement of Limited Partnership of VNGP, L.P. (the "Partnership Agreement") and as determined by the General Partner. With the payment on May 30, 1992 of the cash distribution of $.625 per Unit for the first quarter of 1992, the Partnership completed the payment of cumulative cash distributions of $12.50 per Preference Unit resulting in the termination of the period (the "Preference Period") during which the holders of Preference Units were entitled to a preferential distribution amount. As a result of the termination of the Preference Period, all outstanding Preference Units were automatically converted into Common Units in accordance with the terms of the Partnership Agreement. The Partnership subsequently reduced cash distributions to $.125 per Unit for the remaining quarters of 1992 and the first three quarters of 1993. On January 25, 1994, the VNGC Board of Directors declared a cash distribution of $.125 per Unit for the fourth quarter of 1993 that is payable March 1, 1994 to holders of record as of February 7, 1994. See "Management's Discussion and Analysis of Financial Condition and Results of Operations" for a discussion of factors that have reduced the amount of cash available for distribution to Unitholders. If the proposed merger with Energy described above under "Organization and Control" occurs after March 9, 1994, the General Partner intends and expects to declare and pay a pro rata distribution to holders of record of the Common Units on the effective date of the merger based upon the number of days elapsed between February 7, 1994 and such effective date. 2. SHORT-TERM BANK LINES The Partnership, through the Management Partnership, currently maintains five separate short-term bank lines of credit totalling $80 million. In accordance with the terms of the indenture of mortgage and deed of trust pursuant to which the Management Partnership's First Mortgage Notes were issued (the "Mortgage Note Indenture"), at least $20 million of revolving credit agreements must be maintained at all times; however, no more than $50 million of borrowings are permitted to be outstanding at any time. See Note 3. The Partnership had borrowings of as much as $39.9 million under its short-term bank lines during 1993. No borrowings were outstanding under these lines at December 31, 1993 or 1992. The lines of credit mature at various times during 1994, bear interest at each respective bank's prime, quoted money market or Eurodollar rate and require commitment fees based on the unused amount of the credit. If the proposed merger with Energy does not occur, the General Partner believes that these short-term bank lines could be renewed or replaced with other short-term lines during 1994 on terms and conditions similar to those currently existing. If the proposed merger with Energy is completed, the General Partner anticipates that new bank credit agreements will be negotiated and that the Partnership's existing short-term bank lines will be cancelled. 3. LONG-TERM DEBT Long-term debt balances were as follows (in thousands): The First Mortgage Notes, which are currently comprised of eight remaining series due serially from 1994 through 2009, are secured by mortgages on and security interests in substantially all of the currently existing and after-acquired property, plant and equipment of the Management Partnership and each Subsidiary Operating Partnership and by the Management Partnership's limited partner interest in each Subsidiary Operating Partnership (the "Mortgaged Property"). As of December 31, 1993, the First Mortgage Notes have a remaining weighted average life of approximately 7.3 years and a weighted average interest rate of 10.12% per annum. Interest on the First Mortgage Notes is payable semiannually, but one-half of each interest payment and one-fourth of each annual principal payment are escrowed quarterly in advance. At December 31, 1993 and 1992, $34.2 million and $32.9 million, respectively, had been deposited with the Mortgage Note Indenture trustee ("Trustee") in an escrow account. The amount on deposit is classified as a current asset (cash held in debt service escrow) and the liability to be paid off when the cash is released by the Trustee from escrow is classified as a current liability. The Mortgage Note Indenture contains covenants prohibiting the Management Partnership and the Subsidiary Operating Partnerships (collectively referred to herein as the "Operating Partnerships") from incurring additional indebtedness, including any additional First Mortgage Notes, other than (i) up to $50 million of indebtedness to be incurred for working capital purposes (provided that for a period of 45 consecutive days during each 16 consecutive calendar month period no such indebtedness will be permitted to be outstanding) and (ii) up to the amount of any future capital improvements financed through the issuance of debt or equity by VNGP, L.P. and the contribution of such amounts as additional equity to the Management Partnership. The Mortgage Note Indenture also prohibits the Operating Partnerships from (a) creating new indebtedness unless certain cash flow to debt service requirements are met; (b) creating certain liens; or (c) making cash distributions in any quarter in excess of the cash generated in the prior quarter, less (i) capital expenditures during such prior quarter (other than capital expenditures financed with certain permitted indebtedness), (ii) an amount equal to one-half of the interest to be paid on the First Mortgage Notes on the interest payment date occurring in or next following such prior quarter and (iii) an amount equal to one-quarter of the principal required to be paid on the First Mortgage Notes on the principal payment date occurring in or next following such prior quarter, plus cash which could have been distributed in any prior quarter but which was not distributed. The Operating Partnerships are further prohibited from purchasing or owning any securities of any person or making loans or capital contributions to any person other than investments in the Subsidiary Operating Partnerships, advances and contributions of up to $20 million per year and $100 million in the aggregate to entities engaged in substantially similar business activities as the Operating Partnerships, temporary investments in certain marketable securities and certain other exceptions. The Mortgage Note Indenture also prohibits the Operating Partnerships from consolidating with or conveying, selling, leasing or otherwise disposing of all or any material portion of their property, assets or business as an entirety to any other person unless the surviving entity meets certain net worth requirements and certain other conditions are met, or from selling or otherwise disposing of any part of the Mortgaged Property, subject to certain exceptions. The Mortgage Note Indenture also provides that it will be an event of default if VNGC withdraws as General Partner of the Management Partnership prior to 1997, if VNGC is removed as General Partner but the Subsidiary General Partners are not also removed, or if the General Partner or any Subsidiary General Partner withdraws or is removed and is not replaced within 30 days. Maturities of long-term debt for the years ending December 31, 1995 through 1998 are $30.3 million, $32.9 million, $35.3 million and $37.9 million, respectively. Based on the borrowing rates currently available to the Partnership for long-term debt with similar terms and average maturities, the fair value of the Partnership's First Mortgage Notes, including current maturities, at December 31, 1993 was approximately $562 million. At December 31, 1992, the fair value of the First Mortgage Notes was essentially equal to their carrying value. 4. INDUSTRY SEGMENT INFORMATION The Partnership operates in the natural gas and natural gas liquids industry segments. The natural gas operations consist of purchasing, gathering, transporting and selling natural gas, principally to gas distribution companies, electric utilities, pipeline companies and industrial customers. The Partnership also transports gas for a fee for sales customers, other pipelines and end users and provides price risk management services to gas producers and end users through its Market Center Services Program. The natural gas liquids operations include the extraction of natural gas liquids, principally from natural gas throughput of the natural gas operations, and the fractionation and transportation of natural gas liquids. The primary markets for sales of natural gas liquids are petrochemical plants, refineries and domestic fuel distributors. Intersegment revenue eliminations relate primarily to transportation provided by the natural gas segment for the natural gas liquids segment. During 1993, natural gas sales and transportation revenues from San Antonio City Public Service accounted for approximately 11% of the Partnership's total consolidated operating revenues. No single unaffiliated customer accounted for more than 10% of the Partnership's total consolidated operating revenues during 1992 or 1991. Energy and its consolidated subsidiaries accounted for approximately 12%, 12% and 11% of the Partnership's total consolidated operating revenues during 1993, 1992 and 1991, respectively. The Partnership's natural gas segment has a concentration of customers in the natural gas transmission and distribution industries while its natural gas liquids segment has a concentration of customers in the refining and petrochemical industries. These concentrations of customers may impact the Partnership's overall exposure to credit risk, either positively or negatively, in that the customers may be similarly affected by changes in economic or other conditions. However, the General Partner believes that the Partnership's portfolio of accounts receivable is sufficiently diversified to the extent necessary to minimize any potential credit risk. Historically, the Partnership has not had any significant problems in collecting its accounts receivable. The Partnership's accounts receivable are generally not collateralized. 5. LEASE AND OTHER COMMITMENTS Valero Gas Storage Company ("Gas Storage"), a wholly owned subsidiary of VNGC, is the lessee under an operating lease for a gas storage facility (the "Wilson Storage Facility"). Gas Storage and Valero Transmission Company had previously entered into a gas storage agreement ("Gas Storage Agreement") which required Valero Transmission Company to pay to Gas Storage amounts essentially equivalent to the lease payments and operating costs in connection with Valero Transmission Company's use of the Wilson Storage Facility. Upon formation of the Partnership, Valero Transmission Company assigned the Gas Storage Agreement to Valero Transmission, L.P., and Valero Transmission, L.P. assumed Valero Transmission Company's obligation to make such payments to Gas Storage. The remaining primary lease term for the Wilson Storage Facility is six years with options to renew at varying terms. The future minimum lease payments related to this lease are included in the table below. The Partnership has other noncancelable operating leases with remaining terms ranging generally from one year to 13 years. During 1992, the Partnership entered into a capital lease with Energy to lease a gas processing plant near Thompsonville in South Texas and 48 miles of NGL product pipeline (the "Thompsonville Project"). The Thompsonville Project lease commenced December 1, 1992 and has a term of 15 years. During 1991, the Partnership entered into capital leases with Energy to lease an interest in an approximate 105-mile pipeline in East Texas (the "East Texas pipeline") and certain fractionation facilities in Corpus Christi, Texas. The East Texas pipeline lease commenced February 1, 1991 and has a term of 25 years while the lease for the fractionation facilities commenced December 1, 1991 and has a term of 15 years. As a result of the settlement and dismissal in 1992 of certain claims asserted in litigation filed against Energy and certain of its affiliates, officers and directors, Energy agreed to adjust the payments and certain other terms under these capital leases. Such adjusted payments are reflected in the table of future minimum lease payments shown below. The assets and associated obligations related to the capital leases with Energy described above are not subject to the Mortgage Note Indenture. The Partnership has the right to purchase all or any portion of these assets, subject to certain restrictions, under purchase option provisions of the respective lease agreements. The total cost of these leased facilities, which is included in the accompanying consolidated balance sheets under property, plant and equipment, was approximately $101 million. Amortization of these capital leases, which is included in depreciation expense in the accompanying consolidated income statements, was $5.3 million, $3.5 million and $2.2 million for 1993, 1992 and 1991, respectively. The related future minimum lease payments under the Partnership's capital leases and noncancelable operating leases as of December 31, 1993 are as follows (in thousands): The future minimum lease payments listed above under the caption "Partnership Lease Commitments" exclude certain operating lease commitments which are cancelable by the Partnership upon notice of one year or less. Consolidated rent expense was approximately $698,000, $833,000 and $746,000 for the years ended December 31, 1993, 1992 and 1991, respectively, and excludes amounts billed by Energy to the Partnership for its proportionate use of Energy's corporate headquarters office complex and related charges which are included in the management fee charged to the Partnership. See Note 1 - "Transactions with Energy." Rentals paid of $10,438,000 per year for 1993, 1992 and 1991 in connection with the Wilson Storage Facility were included in the computation of Transmission's weighted average cost of gas. The obligations of Gas Storage under the gas storage facility lease include its obligation to make scheduled lease payments and, in the event of a declaration of default and acceleration of the lease obligation, to make certain lump sum payments based on a stipulated loss value for the gas storage facility less the fair market sales price or fair market rental value of the gas storage facility. Under certain circumstances, a default by Energy or a subsidiary of Energy, including VNGC, with respect to its own indebtedness could result in a cross default under the gas storage facility lease. The General Partner believes that it is unlikely that a default by Energy or a subsidiary of Energy would result in acceleration of the gas storage facility lease, and further believes that such event, if it occurred, would not have a material adverse effect on the Partnership. 6. LITIGATION AND CONTINGENCIES Take-or-Pay and Related Claims As a result of past market conditions and contracting practices in the natural gas industry, numerous producers and other suppliers brought claims against Transmission asserting that it was in breach of contractual provisions requiring that it take, or pay for if not taken, certain specified volumes of natural gas. The Partnership has settled substantially all of the significant take-or-pay claims, pricing differences and contractual disputes heretofore brought against it. Although additional claims may arise under older contracts until their expiration or renegotiation, the General Partner believes that the Partnership has resolved substantially all of the significant take-or-pay claims that are likely to be made. As described below, Energy and/or the Partnership have agreed to bear a portion of certain potential liabilities that may be incurred by certain Partnership suppliers. Although the General Partner is currently unable to predict the total amount Transmission or the Partnership ultimately may pay or be required to pay in connection with the resolution of existing and potential take-or- pay claims, the General Partner believes that any remaining claims can be resolved on terms satisfactory to the Partnership and that the resolution of such claims and any potential claims has not had and will not have a material adverse effect on the Partnership's financial position or results of operations. In 1987, Transmission and a producer from whom Transmission has purchased natural gas entered into an agreement resolving certain take-or-pay issues between the parties in which Transmission agreed to pay one-half of certain excess royalty claims arising after the date of the agreement. The royalty owners of the producer recently completed an audit of the producer and have presented to the producer a claim for additional royalty payments in the amount of approximately $17.3 million, and accrued interest thereon of approximately $19.8 million. Approximately $8 million of the royalty owners' claim accrued after the effective date of the agreement between the producer and Transmission. The producer and Transmission are reviewing the royalty owners' claims. No lawsuit has been filed by the royalty owners. The General Partner believes that various defenses under the agreement may reduce any liability of Transmission to the producer in this matter. Valero Transmission Company and one of its gas suppliers are parties to various gas purchase contracts assigned to and assumed by Valero Transmission, L.P. upon formation of the Partnership in 1987. The supplier is also a party to a series of gas purchase contracts between the supplier, as buyer, and certain trusts, as seller, which are in litigation. Neither the Partnership nor Valero Transmission Company is a party to this litigation or the contracts between Transmission's supplier and the trusts. However, because of the relationship between Transmission's contracts with the supplier and the supplier's contracts with the trusts, and in order to resolve existing and potential disputes, the supplier, Valero Transmission Company and Valero Transmission, L.P. have agreed that they will cooperate in the conduct of this litigation, and that Valero Transmission Company and Valero Transmission, L.P. will bear a substantial portion of the costs of any appeal and any nonappealable final judgment rendered against the supplier. In the litigation, the trusts allege that Transmission's supplier has breached various minimum take, take-or-pay and other contractual provisions, and assert a statutory nonratability claim. The trusts seek alleged actual damages, including interest, of approximately $30 million and an unspecified amount of punitive damages. The District Court ruled on the plaintiff's motion for summary judgment, finding, among other things, that as a matter of law the three gas purchase contracts at issue were fully binding and enforceable, the supplier breached the minimum take obligations under one of the contracts, the supplier is not entitled to claimed offsets for gas purchased by third parties and the "availability" of gas for take-or-pay purposes is established solely by the delivery capacity testing procedures in the contracts. Damages, if any, have not been determined. Because of existing contractual obligations of Valero Transmission, L.P. to its supplier, the lawsuit may ultimately involve a contingent liability for Valero Transmission, L.P. The General Partner believes that the claims brought against the supplier have been significantly overstated, and that the supplier has a number of meritorious defenses to the claims including various regulatory, statutory, contractual and common law defenses. The Court recently granted the supplier's Motion for Continuance of the former January 10, 1994 trial date. This litigation is not currently set for trial. Payments that Transmission has made or agreed to make in connection with settlements to date are included in its deferred gas costs. The General Partner believes that the rate order under which Transmission currently operates (the "Rate Order"), issued in 1979 by the Railroad Commission of Texas (the "Railroad Commission," which regulates the sale and transportation of natural gas by intrastate pipeline systems in Texas), allows for the recovery of such costs. See Note 1 - "Other Assets" and "Customer Audit of Transmission" below. Certain take-or-pay and other claims have been resolved through the Partnership agreeing to provide discounted transportation services. These agreements do not involve a cash outlay by the Partnership but in certain cases have the effect of reducing transportation margins over an extended period of time. Any liability of Energy with respect to take-or-pay claims involving Transmission's intrastate pipeline operations has been assumed by the Partnership. Based upon the General Partner's beliefs and rate considerations discussed above, no liabilities have been recorded for any unresolved take-or-pay claims. Other Litigation Seven lawsuits were filed in Chancery Court in Delaware against VNGP, L.P., VNGC and Energy and certain officers and directors of VNGC and/or Energy in response to the announcement by Energy on October 14, 1993 of its proposal to acquire the publicly traded Common Units of VNGP, L.P. pursuant to a proposed merger of VNGP, L.P. with a wholly owned subsidiary of Energy. See Note 1 - "Organization and Control." The suits were consolidated into a single proceeding by the Chancery Court on November 23, 1993. The plaintiffs sought to enjoin or rescind the proposed merger, alleging that the corporate defendants and the individual defendants, as officers or directors of the corporate defendants, engaged in actions in breach of the defendants' fiduciary duties to the Public Unitholders by proposing the merger. The plaintiffs alternatively sought an increase in the proposed merger consideration, unspecified compensatory damages and attorneys' fees. In December 1993, the parties reached a tentative settlement of the consolidated lawsuit. The terms of the settlement will not require a material payment by Energy or the Partnership. However, there can be no assurance that the settlement will be completed, or that it will be approved by the Chancery Court. In March 1993, two indirect wholly owned subsidiaries of Energy serving as general partners of two of VNGP, L.P.'s principal Subsidiary Operating Partnerships were served as third- party defendants in a lawsuit originally filed in 1991 by a subsidiary of The Coastal Corporation ("Coastal") against TransAmerican Natural Gas Corporation ("TANG"). In August 1993, Energy, VNGP, L.P. and certain of their respective subsidiaries were named as additional third-party defendants (collectively, including the original defendant subsidiaries, the "Valero Defendants") in this lawsuit. In its counterclaims against Coastal and third-party claims against the Valero Defendants, TANG alleges that it contracted to sell natural gas to Coastal at the posted field price of one of the Valero Defendants and that the Valero Defendants and Coastal conspired to set the posted field price at an artificially low level. TANG also alleges that the Valero Defendants and Coastal conspired to cause TANG to deliver unprocessed or "wet" gas, thus precluding TANG from extracting NGLs from its gas prior to delivery. TANG seeks actual damages of approximately $50 million, trebling of damages under antitrust claims, punitive damages of $300 million, and attorneys' fees. The General Partner believes that the plaintiff's claims have been exaggerated, and that Energy and the Partnership have meritorious defenses to such claims. In the event of an adverse determination involving Energy, Energy likely would seek indemnification from the Partnership under terms of the partnership agreements and other applicable agreements between VNGP, L.P., its subsidiary partnerships and their respective general partners. The Valero Defendants' motion for summary judgment on TANG's antitrust claims was argued on January 24, 1994. The court has not ruled on such motion. The current trial setting for this case is March 14, 1994. In September 1991, a lawsuit was filed by Valero Transmission, L.P. alleging breach of contract against a producer. On January 11, 1993, the defendant filed a cross- action against Valero Transmission, L.P., Valero Industrial Gas, L.P. and Reata Industrial Gas, L.P. The defendant asserted claims for actual damages for failure to pay for goods and services delivered. Additionally, the defendant asserted various other cross-claims, including conversion, breach of contract, breach of an alleged duty to market gas in good faith, tortious breach of a duty imposed by law and tortious negligence. The defendant sought actual damages aggregating not less than $1 million, injunctive relief, attorneys fees and costs, and exemplary damages in the amount of not less than $20 million. In January 1994, the parties reached a tentative settlement of the lawsuit on terms immaterial to the Partnership. The Partnership was a party to a lawsuit originally filed in 1988 in which Energy, Valero Transmission Company, VNGP, L.P., the Management Partnership and Valero Transmission, L.P. (the "Valero Defendants") and a subsidiary of Coastal were alleged to be liable for failure to take minimum quantities of gas, failure to make take-or-pay payments and other breach of contract and breach of fiduciary duty claims. The plaintiffs sought declaratory relief, actual damages in excess of $37 million and unspecified punitive damages. During the third quarter of 1992, the plaintiffs, Coastal and the Valero Defendants settled this lawsuit on terms which were not material to the Valero Defendants and on July 19, 1993, this lawsuit was dismissed. On November 16, 1992, prior to entry of the order of dismissal, NationsBank of Texas, N.A., as trustee for certain trusts (the "Intervenors"), filed a plea in intervention to intervene in the lawsuit. The Intervenors asserted that they held a non-participating mineral interest in the lands subject to the litigation and that their rights were not protected by the plaintiffs in the settlement. On February 4, 1993, the Court struck the Intervenors' plea in intervention. However, on February 2, 1993, the Intervenors had filed a separate suit in the 160th State District Court, Dallas County, Texas, against all prior defendants and an additional defendant, substantially adopting in form and substance the allegations and claims in the original litigation. In February 1994, the parties reached a tentative settlement of the lawsuit on terms immaterial to the Partnership. City of Houston Franchise Fee Audit In a letter dated September 1, 1993 from the City of Houston (the "City") to Valero Transmission Company ("VTC"), the City stated its intent to bring suit against VTC for certain claims asserted by the City under the franchise agreement between the City and VTC. VTC is the general partner of Valero Transmission, L.P. The franchise agreement was assigned to and assumed by Valero Transmission, L.P. upon formation of the Partnership in 1987. In the letter, the City declared a conditional forfeiture of the franchise rights based on the City's claims. In a letter dated October 27, 1993, the City claimed that VTC owes to the City franchise fees and accrued interest thereon aggregating approximately $13.5 million. In a letter dated November 9, 1993, the City claimed an additional $18 million in damages related to the City's allegations that VTC engaged in unauthorized activities under the franchise agreement by transmitting gas for resale and by transporting gas for third parties on the franchised premises. The City has not filed a lawsuit. The General Partner believes that the City's claims are significantly overstated and that VTC has a number of meritorious defenses to the claims. Any liability of VTC with respect to the City's claims has been assumed by the Partnership. Customer Audit of Transmission Transmission's Rate Order provides for Transmission to sell gas at its weighted average cost of gas, as defined ("WACOG"), plus a margin of $.15 per Mcf. In addition to the cost of gas purchases, Transmission's WACOG has included storage, gathering and other fixed costs totalling approximately $19 million per year, and amortization of deferred gas costs related to the settlement of take-or-pay and related claims (see Note 1 - "Other Assets" and "Take-or-Pay and Related Claims" above). Transmission's gas purchases include high-cost casinghead gas and certain special allowable gas that Transmission is required to purchase contractually and under the Railroad Commission's priority rules. Transmission's sales volumes have been decreasing with the expiration of its sales contracts including the July 1992 expiration of a contract representing approximately 37% of Transmission's sales volumes for the first six months of 1992. As a result of each of these factors, Transmission's WACOG and gas sales price are substantially in excess of market clearing levels. Transmission's WACOG has been periodically audited by certain of its customers, as allowed under the Rate Order. One such customer (the "Customer") questioned the application of certain of Transmission's current rate policies to future periods in light of the decreases that have occurred in Transmission's throughput, and the Customer has recently completed its audit of Transmission's WACOG with respect thereto. For 1993, the Customer represented approximately 70% of Transmission's sales volumes and such percentage is expected to increase as other sales contracts expire and are not renewed. As a result of the Customer's audit, Transmission and the Customer entered into a settlement agreement which excludes certain of the fixed costs described above from Transmission's WACOG, effective with July 1993 sales, resulting in a reduction of the Partnership's annual net income by approximately $6 million. Upon the termination of Transmission's gas sales contract with the Customer in 1998, Transmission's fixed costs, including storage (see Note 5), would be charged to income instead of recovered through its gas sales rates. Transmission expects to recover its deferred gas costs over a period of approximately eight years. The recovery of any additional payments made in connection with any future settlements would be limited. The Partnership is also a party to additional claims and legal proceedings arising in the ordinary course of business. The General Partner believes it is unlikely that the final outcome of any of the claims or proceedings to which the Partnership is a party, including those described above, would have a material adverse effect on the Partnership's financial position or results of operations; however, due to the inherent uncertainties of litigation, the range of possible loss, if any, cannot be estimated with a reasonable degree of precision and there can be no assurance that the resolution of any particular claim or proceeding would not have an adverse effect on the Partnership's results of operations for the fiscal period in which such resolution occurred. 7. QUARTERLY RESULTS OF OPERATIONS (Unaudited) The results of operations by quarter for the years ended December 31, 1993 and 1992 were as follows (in thousands of dollars, except per Unit amounts): 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. VALERO ENERGY CORPORATION (Registrant) By /s/ William E. Greehey (William E. Greehey) Chairman of the Board and Chief Executive Officer Date: March 1, 1994 POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENTS, that each person whose signature appears below hereby constitutes and appoints William E. Greehey, Stan L. McLelland and Rand C. Schmidt, or any of them, each with power to act without the other, 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 any or all subsequent amendments and supplements to this Annual Report on Form 10-K, and to file the same, or cause to be filed the same, with all exhibits thereto, and other documents in connection therewith, with the Securities and Exchange Commission, granting unto each said attorney-in-fact and agent full power 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 intents and purposes as he might or could do in person, hereby qualifying and confirming all that said attorney-in-fact and agent or his substitute or substitutes may 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 by the following persons on behalf of the registrant and in the capacities and on the dates indicated. Signature Title Date Director, Chairman of the Board and Chief Executive Officer (Principal /s/ William E. Greehey Executive Officer) March 1, 1994 (William E. Greehey) Senior Vice President and Chief Financial Officer (Principal Financial /s/ Don M. Heep and Accounting Officer) March 1, 1994 (Don M. Heep) /s/ Edward C. Benninger Director March 1, 1994 (Edward C. Benninger) /s/ Robert G. Dettmer Director March 1, 1994 (Robert G. Dettmer) /s/ A. Ray Dudley Director March 1, 1994 (A. Ray Dudley) /s/ James L. Johnson Director March 1, 1994 (James L. Johnson) /s/ Lowell H. Lebermann Director March 1, 1994 (Lowell H. Lebermann) /s/ Sally A. Shelton Director March 1, 1994 (Sally A. Shelton) Director (Philip K. Verleger, Jr.)

7649_1993.txt

7649_1993

1993

7649

ITEM 1. BUSINESS Asarco, a New Jersey corporation organized in 1899, is one of the world's leading producers of nonferrous metals, principally copper, lead, zinc, silver and gold. Asarco also produces specialty chemicals, minerals and provides environmental services. Asarco has substantial interests in three mining companies; a 17.2% stake in M.I.M. Holdings Limited (MIM) in Australia, a 52.3% interest in Southern Peru Copper Corporation (SPCC) and a 28.3% holding in Mexico Desarrollo Industrial Minero, S.A. de C.V. (MEDIMSA). Asarco or its associated companies operate mines in the United States, Australia, Mexico and Peru. Asarco and its associated companies together in 1993 accounted for about 13% of western world mine production of copper, 13% of silver, 22% of lead and 13% of zinc. All tonnages are expressed in short tons. All ounces are troy ounces. Dollar amounts are expressed in U.S. dollars unless otherwise indicated. "Asarco" or "the Company" includes Asarco and its consolidated subsidiaries. Reference is made to the following Financial Statement footnotes included in this report: Acquisitions on page A40, Investments on pages A40 through A43, and Business Segments on pages A49 through A51. Additional business information follows: PRIMARY METALS PRINCIPAL PRODUCTS AND MARKETS COPPER The primary domestic uses of copper are in the building and construction industry, electrical and electronic products and, to a lesser extent, industrial machinery and equipment, consumer and general products and transportation. A substantial portion of Asarco's copper sales are made under annual contracts to industrial users. In the second quarter of 1993, the Company was reorganized to bring under common management all of the Company's copper properties. This organizational change coincided with the completion of Asarco's copper modernization and expansion program, begun in 1989. That program raised the Company's mined copper production sufficiently to fully supply its smelter capacity. The Company's copper operations are now managed from Tucson, Arizona. The principal focus of copper operations management's attention in 1993 was to establish operating goals for all employees, defining what each needed to accomplish daily for the Company to meet its long-term production and cost objectives. Today, employees in the copper operations know specifically what is required of them and improvements in production are becoming increasingly evident. The Mission and Ray mines and the Hayden smelter in Arizona, and the El Paso smelter and the Amarillo refinery in Texas are the Company's principal copper operating units. Asarco also owns a 49.9% interest in Montana Resources, which supplies copper concentrates to the Company's smelters, and owns the Silver Bell mine in Arizona and the Troy mine in Montana, which are temporarily shut down. Since 1985, the Company has increased its ore reserves eight fold to more than 2 billion tons at the end of 1993. Mine production of 332,600 tons of contained copper, including electrowon cathodes, in 1993 was five times the 1985 level of production. The Ray mine is Asarco's largest copper mine, which can produce 165,000 tons per year of contained copper. Last year was the first full year of production for Ray's expanded copper concentrate operation. Concentrate capacity has been increased by two-thirds at Ray since its acquisition by Asarco in 1986. Production at the mine was hampered in late 1992 and early 1993 by severe rains and flooding. Flooding severed the rail line to the Hayden concentrator for three weeks in the first quarter and disrupted mining operations, resulting in lost production and added costs totalling $22 million after-tax. While the severe effect of the rains was overcome by the second quarter, substantial amounts of water retained in the pit continued to affect operations for the balance of the year. A2 The Ray mine produced 159,300 tons of copper in 1993. Production of copper in concentrates in 1993 was 122,700 tons which, despite the rain and flooding, was about the same level of production as in 1992. Production of solvent extraction/electro-winning (SX/EW) copper in 1993 decreased 13% from 1992 to 36,600 tons of copper in cathodes. This reduction represented both rain-related production losses and a reduction in the rate at which silicate ore is being processed. As a result of the reduction in the processing of silicate ore, future SX/EW production rates will be approximately the same level as 1993 production. Ray's ore reserves at year-end were 1.1 billion tons. Asarco's Mission mine has more than doubled its capacity since 1985. Asarco began production at the Mission mine in 1961. Over the last several years the contiguous Eisenhower and Pima mines were acquired and incorporated into a single open pit. Production at the Mission Complex in 1993 increased 14% over 1992 to 117,900 tons of copper contained in concentrates. Mission's ore reserves at year-end were 543 million tons. Production of copper concentrates from the Ray and Mission mines and Montana Resources in 1993 fully met the concentrate feed requirements at the Hayden and newly modernized El Paso smelters. The Hayden smelter processes copper concentrate from the Mission and the Ray Mines, using oxygen flash furnace technology. Production of copper in anodes at Hayden decreased 7% to 194,200 tons in 1993 due to scheduled maintenance during the first quarter of the year. The El Paso plant uses a new continuous top-feed oxygen process (CONTOP) to produce copper in anode. The new system, which expanded smelter capacity from 80,000 to 110,000 tons per year of copper in anode, also improved the sulfur dioxide recapture rate from 65% to 98%. Sulfur dioxide is recovered and treated at El Paso's acid plants. The new furnace achieved 90% of design capacity by year-end, following modifications during a nine month shakedown period. Although production was affected by the startup, the 272,700 tons of concentrates smelted at El Paso in 1993 equalled the amount smelted in 1992. Anode production at El Paso was 15% lower due to lower copper content in concentrates processed and lower blister and scrap treated. Anodes produced by the El Paso and Hayden smelters are refined at Asarco's Amarillo refinery, which produces copper cathodes. Late in the year, the Amarillo Copper Refinery completed installation and startup of a new electrolyte purification facility to improve copper quality and permit the refinery to operate at a higher rate. The facility removes impurities, principally antimony and bismuth from the electrolyte. Amarillo's 1993 cathode production of 460,000 tons was slightly below that of 1992. Asarco also processes about half of the output of Montana Resources, in which the Company has a 49.9% interest. Montana Resources produced 47,200 tons of copper in concentrates in 1993. LEAD, ZINC, SILVER AND MINERAL OPERATIONS The Company's lead, zinc, silver and mineral operations also were integrated under common management in the second quarter of 1993. Management's attention was focused principally on spending and production targets and on fully utilizing existing capacity. Each operation developed plans identifying the resources needed to meet these targets and specific responsibilities were established with each employee. Progress toward achieving these targets is monitored through new reporting techniques developed to track results and to provide feedback. As a result, operations during the second half of 1993 improved and became more consistent and predictable. Total Quality Management programs, emphasizing employee empowerment, were used extensively in 1993 to improve purchasing practices and reduce costs. LEAD The primary domestic uses of lead are for automotive and industrial batteries and, to a lesser extent, for lead oxide for glass, solder and other industrial users. A substantial portion of Asarco's lead sales are made under annual contracts to industrial users. Asarco's lead business consists of two quite distinct operations. In Missouri, the Company operates an integrated lead circuit consisting of the West Fork and Sweetwater mines which provide over 90% of the feed for the nearby Glover smelter and refinery. In the west, the Company operates a custom lead business, processing concentrates for others at the East Helena smelter and the Omaha refinery. This circuit also is supplied with A3 concentrates from the Company's mine in Leadville, Colorado and the Quiruvilca mine in Peru. The West Fork and Sweetwater mines produce lead concentrates and achieved record concentrate production of 158,900 tons, 16% more than in 1992. Refined production at the Glover smelter declined 5% to 124,200 tons due to equipment failures early in the year. During the second half of the year, the consistency of operations at Glover and production rates improved significantly. The 73,500 tons of refined lead production from the custom lead circuit declined 2% from 1992 due to interruptions of concentrate deliveries from South America early in the year. These interruptions were eliminated later in 1993 due to changes in shipping arrangements, resulting in improved production. ZINC Zinc is primarily used in the United States to make galvanized metal products, zinc-based alloys, brass products, zinc oxide, rolled zinc and for other industrial uses. Zinc is sold in concentrate form under contracts of 1-3 years duration. Asarco is one of the nation's leading zinc miners producing 61,800 tons of zinc contained in concentrates from its four mines in Tennessee. In addition, the Sweetwater, West Fork and Leadville mines produced 32,800 tons of zinc contained in concentrate. The Company sells all of its zinc concentrates to smelters owned by others. A failure of the ball mill at the Young mill in July suspended operations at three of the Tennessee mines for over three months. The production lost was partially offset by improved zinc production in Missouri. The Company's Quiruvilca mine in Peru produced 18,600 tons of zinc contained in concentrates. Total zinc production declined 6%, to 113,200 tons, from the previous year. SILVER The principal uses for silver in the United States are for photographic, electrical and electronic products and, to a lesser extent, brazing alloys and solder, jewelry, coinage, silverware, catalysts and other miscellaneous uses. Silver is sold under monthly contracts or in spot sales to industrial users. While silver is found as a co-product in the ores mined at various Asarco properties, Asarco put its last major silver-producing mine, the Troy mine, on standby in April 1993 due to low silver prices. Asarco's two silver mines in Idaho, Coeur and Galena, also are on standby. Silver production declined 29% in 1993 as a result of these mine closures. While the price of silver rose in 1993 to $4.22 per ounce, from $3.97 per ounce in 1992, it will take higher sustained silver prices to justify the reopening of the Company's silver mines. GOLD The Company's principal gold mining activities have been conducted through Asarco Australia Limited (Asarco Australia). In mid 1993, Asarco sold a portion of its previously 60% owned subsidiary and shortly after year-end sold its remaining interest in Asarco Australia. The results of the final sale will be recorded in 1994. In the last eight years Asarco has realized over $106 million in cash from its original investment of $4 million in Asarco Australia. MINERALS Sales of American Limestone Company, Asarco's wholly owned construction aggregate and ready-mixed concrete and agricultural limestone subsidiary, grew slightly in 1993 due to increased construction activity in its operating area in the southeastern part of the United States. Earnings, however, remained level due to increased competition and higher production costs. SPECIALTY CHEMICALS Enthone-OMI produces high performance coating technologies for engineering, functional and decorative applications which it supplies worldwide to the electronics and metal finishing industries. Earnings improved in 1993 as a result of the recovery in U.S. chemical sales and continued growth in Asia. European operations were restructured in mid 1993 in response to sales declines in that region. This restructuring brought European operations to break-even by year-end 1993 and places Enthone-OMI in a good position to capitalize on the expected recovery in European business levels in 1994. A4 ENVIRONMENTAL SERVICES Asarco's Environmental Services business include: Encycle/Texas, Inc. of Corpus Christi, Texas, Hydrometrics, Inc. of Helena, Montana and Biotrace Laboratories, Incorporated of Salt Lake City, Utah. Encycle operates a waste recycling facility in Corpus Christi which recovers and recycles nonferrous metals from hazardous and nonhazardous inorganic solids and solutions. The recovered metals are returned to commerce. Hydrometrics, with several offices in the west, provides a wide range of professional consulting services for industrial clients, municipalities and public agencies. The construction division of Hydrometrics provides complete remediation and cleanup services for contaminated industrial sites as well as Superfund sites. Biotrace specializes in biological laboratory analysis for trace metals and chemicals. The three companies, while small, are growing. ASSOCIATED COMPANIES Asarco made good progress in 1993 in its efforts to improve the cash returns on its investments in associated companies. M.I.M Holdings Limited (MIM) of Australia, in which Asarco has a 17.2% interest, had net earnings in its latest fiscal year of A$74.0 million, compared with prior year earnings of A$106.3 million. Sales for the most recent fiscal year were A$1.93 billion, compared with A$1.75 billion the year earlier. Asarco received $8.3 million in dividends from MIM in 1993, compared with $8.8 million in 1992. MIM has been pursuing cost-reduction measures throughout its copper, lead, zinc, silver, gold and coal operations. MIM, which also has interests in metals companies in Europe and North America, completed a five-year program of capital expenditures in 1993 that increases mine capacity and production and enhances processing technology and environmental performance. In November 1993, Asarco reached agreement with Grupo Industrial Minera Mexico, S.A. de C.V. (Grupo Mexico) to restructure Asarco's 28.3% holding in Mexico Desarrollo Industrial Minero S.A. de C.V. (MEDIMSA). Under the terms of the agreement, MEDIMSA will be combined with Grupo Mexico, a publicly traded company, and Asarco will own a 23.6% stake in the new public corporation. The agreement is subject to governmental and regulatory approvals. The agreement with Grupo Mexico, by giving Asarco access to public international financial markets for a portion of its investment in Grupo Mexico, will improve the liquidity of Asarco's investment. Southern Peru Copper Corporation (SPCC), 52.3% owned by Asarco, operates two open-pit copper mines and a smelter in Peru. SPCC paid dividends to Asarco of $9.4 million in 1993, compared with $7.8 million in 1992. During 1993, Peru reached agreement with a number of major international financial organizations, including the World Bank and the IMF, and in November, following a national referendum, a constitutional government was restored. As a consequence of these and other favorable developments, Asarco resumed equity accounting for its investment in SPCC in the fourth quarter of 1993. SPCC signed an agreement in May 1993 for $60 million of financing for a 41,000 ton solvent extraction/electro-winning operation near its Cuajone and Toquepala mines. The plant, which will cost $106 million, is part of a five-year, $300 million capital program to expand production, replace equipment and improve the environmental operations at SPCC's facilities. SPCC also received commitments from Peruvian banks for $25 million of financing. In January 1994, SPCC signed an agreement for $115 million of financing with a group of European banks which, combined with previously completed financing, provides SPCC with a total of $200 million of financing for its expansion program. ENVIRONMENTAL PROTECTION AT ASARCO Asarco's objective is not only to comply with existing environmental, safety and health laws and regulations but also to support activities that contribute to environmental protection, responsible resource management and the safety and health of employees, customers and members of the community. The Company policy states: "ASARCO Incorporated recognizes and believes that all operations and activities of the Company should be conducted responsibly and in a manner designed to protect the health and safety of its employees, its customers, the public and the environment. Asarco's operations interact with the environment daily, and consideration of these concerns must be a way of life within the Company. Asarco is committed to responsible management of our natural resources." A5 To assure compliance with this policy, a senior executive was named in 1993 to oversee all of Asarco's environmental efforts. The Company has extensive internal compliance review programs and all domestic units will have been visited by mid-1994 by compliance review teams. BACKLOG OF ORDERS Substantially all of the Company's metal production is sold under annual contracts. To the extent not sold under annual contracts, production can be sold in terminal markets or on commodities exchanges. Sales values cannot be determined until the sale is priced based on prevailing commodity prices at the time the price is fixed under the terms of the contract. The backlog for other product classes and services is not material. COMPETITIVE CONDITIONS In the United States and abroad, Asarco and its foreign nonconsolidated asso- ciated companies are subject to competition from other producers in all major product lines. Asarco's metal products also compete with other materials, including aluminum, stainless steel, plastics, glass and wood. Competition in nonferrous metals is principally on a price and service basis, with price being by far the most important consideration when supplies of the commodities involved are ample. In construction aggregates, geographic location of facilities in relation to the point of consumption, and price are by far the most important competitive factors. In specialty chemicals, Asarco competes against a substantial number of large and small companies both in the United States and overseas. EMPLOYEES At December 31, 1993, Asarco employed about 8,500 persons, of whom about 3,900 were covered by contracts with various unions, most of which were affiliated with the AFL-CIO. ENERGY MATTERS Asarco's energy requirements are met from a variety of sources, including fuel oil, diesel fuel, gasoline, natural gas, coke and electric power. Asarco has a large number of contracts of varying duration for its energy needs, typically negotiated on an individual basis from time to time. Generally, substitute sources are available except where requirements are guaranteed by local utility companies. No reductions or interruptions of any operations because of energy shortages were experienced in 1993. The cost of coke decreased; fuel oil, diesel fuel and natural gas increased, while cost of gasoline and electric power remained about the same on average. A6 ENVIRONMENTAL, SAFETY AND HEALTH MATTERS Asarco's operations are subject to environmental regulation by various federal, state, local, and foreign governments. Asarco's principal involvement in this area concerns compliance by its existing and former operations with federal and state air and water quality and solid and hazardous waste regulations. The Company believes that its operations are currently in substantial compliance with applicable environmental laws and regulations. As of December 31, 1993, there remained $11.6 million of previously appropriated funds yet to be expended for ongoing environmental control projects at the Company's operating units. The majority of these funds are scheduled to be expended during 1994. Capital expenditures by Asarco at its operating U.S. mines and plants in order to comply with environmental standards in the past three years have been (in millions): 1993-$21.3; 1992-$8.3; 1991-$4.8. In 1993, these expenditures included modernization and improvement of environmental controls at the Amarillo, Texas, East Helena, Montana, Glover, Missouri, Omaha, Nebraska, Hayden, Arizona, El Paso, Texas plants, the Ray and Mission mines in Arizona and the Immel Mine in Tennessee. Estimated environmental operating costs before taxes and depreciation but including interest on environmental improvement bonds and other debt incurred for environmental control facilities reduced pre-tax earnings by (in millions): 1993-$96; 1992-$87; 1991-$73. Environmental matters are discussed in the Contingencies and Litigation Note to the Financial Statements on page A43 and A44 of this report and in Management's Discussion and Analysis of Operations and Financial Condition on pages A28 through A31. The following is additional information with respect to notices that Asarco has received from the United States Environmental Protection Agency ("EPA") that it and, in most instances, numerous other parties are potentially responsible to correct alleged hazardous substance releases under the Comprehensive Environmental Response, Compensation and Liability Act of 1980 ("CERCLA") at the following locations on the dates indicated: the Commencement Bay and related areas in Tacoma, Washington (1982 and subsequent years); the Leadville, Colorado site, including the Yak drainage tunnel (1983); the Company's former Tacoma smelter site (1984); lead and zinc mining areas in the Picher Mining Field in southeastern Cherokee County, Kansas (1985); the East Helena smelter (1987); the Ruston, Washington area (1988); the Kansas City smelter site in Kansas (1989); the Bunker Hill mining and smelting site in Kellogg, Idaho (1990); Jasper County, Missouri (1990); the Summitville site in Rio Grande County, Colorado (1993); the Circle Smelting site in Beckemeyer, Illinois (1993); the Apache Powder site in Benson, Arizona (1993); the Colorado School of Mines Research Institute in Golden, Colorado (1993); the ILCO Superfund site in Leeds, Alabama (1993); the Mingo smelter site in Sandy, Utah (1993); the Triumph Mine Tailings Pile proposed site in Triumph, Idaho (1993). In December 1992 and June 1993, the Company received similar notices from the United States Forest Service with respect to, respectively, the Bonanza mining site in Saguache County, Colorado and a former exploration project known as the Buckskin Mine located in Humboldt County, Nevada. In addition, as a result of the acquisition in June 1989 of a 49.9% partnership interest in the Montana copper mine owned by Montana Resources, Inc., Asarco and a subsidiary have been named as potentially responsible parties for certain CERCLA sub-sites in Butte, Montana. In 1993, the Murray smelter site in Murray, Utah, formerly owned by the Company, and the Company's Globe plant have been proposed for inclusion on the EPA's National Priority List. In 1987, part of a subsidiary's former plant site in Houston was listed on the Texas "Superfund Registry." In 1991, the State of Washington named the Company as a potentially liable person at a site in Everett, Washington where the Company operated a smelter early in the century. The State of Montana notified Asarco in 1991 that it had been identified as a potentially liable person for hazardous or deleterious substance contamination of the Upper Blackfoot River allegedly resulting from the release of materials from Asarco's former Mike Horse mine in Lewis and Clark County, Montana, a property previously mined by Asarco and several others. In June 1992, the State of Mississippi informed the Company it may be responsible for remediation at the Pascagoula Marine Terminal at the Port of the same name. In March 1992 the New Mexico Environmental Department notified the Company that it was evaluating sites near Deming and Magdalena for potential inclusion on the National Priorities List and invited the Company to negotiate investigation and remediation actions at the sites. In April 1993, the State of Texas notified the Company that it and ten other persons were potentially responsible parties with respect to the Col-Tex Refinery State Superfund Site in Mitchell County, Texas, where the Company stored diesel fuel in the mid-1970's. The A7 Company has also been named as one of a number of other defendants in eleven lawsuits filed by or on behalf of 188 persons who have lived or owned property near the Col-Tex Refinery Site seeking compensatory and punitive damages for alledged wrongful death, personal injury, and property damage. The Company and certain of its subsidiaries are cooperating with environmental authorities at other sites to undertake studies of the sites and remediate where necessary. Remedial action is being undertaken by the Company at the Yak drainage tunnel, Ruston, Bunker Hill, Mike Horse, Deming, Magdalena and Everett sites. At the Everett site, the Company has offered to purchase approximately 20 residences located on the former smelter site. The Company is discussing with the United States Forest Service a voluntary remedial action for the Bonanza mine. At the Yak drainage tunnel, the Res-Asarco Joint Venture has been ordered to conduct a remediation program which was substantially completed in 1992. The Company's fifty percent share of this program is expected to cost approximately $13.7 million most of which has been expended. Over the next several years, additional remedial programs not included in this order, and remedial programs addressing other areas in and around Leadville, will be required. With respect to Leadville, the Company is currently involved in detailed multi-party settlement negotiations with the EPA and several others and has included in its environmental reserves a provision for the anticipated cost of a settlement to the extent that a reasonable estimate can be made. At the Jasper, Missouri site the Company and other potentially responsible parties have been ordered to supply bottled water to over 60 residences because of contamination in the shallow aquifer. At Ruston, Washington, remediation consisting of removal and replacement of soils at ten public access sites as part of an expedited response action has been completed. In 1993, the EPA issued an Administrative Order to the Company to remediate residential soils in the town. At the Bunker Hill site, remediation is currently being undertaken as part of an emergency response action. The Company and at least five other potentially responsible parties are negotiating with the EPA an overall long-term remediation program that will involve substantial additional costs to be shared among the parties. Resolution of this matter is expected later in 1994. The Company signed a Consent Decree with the EPA on August 28, 1991 in which the Company agreed to undertake partial remediation, including certain stabilization and demolition activities, at the Company's former Tacoma, Washington smelter. The program commenced in January 1993 and is estimated to cost approximately $12 million over a period of two to three years. The Company signed a Consent Decree with EPA on July 16, 1991 to resolve some of the issues in proceedings involving the Company's East Helena, Montana smelter. In the Consent Decree, the Company agreed to take certain remedial actions with regard to residential soils surrounding the smelter involving approximately $10 million in ongoing remediation costs over the next three to five years. In addition, other remediation activities at East Helena are taking place pursuant to a 1990 Consent Decree. In early 1992, the Company notified the EPA that it would not contest an order issued by the EPA to undertake remediation work at a former Kansas City, Kansas smelter site which had been owned by a former subsidiary early in this century. The remediation work has been completed. In 1992, the Company completed initial remediation work at a former smelter site in Everett, Washington pursuant to an order from the Washington Department of Ecology. Additional sampling is ongoing. With respect to the Circle Smelting Superfund site in Beckemeyer, Illinois, on March 9, 1994, the Company and Federated Metals Corporation ("Federated"), a wholly-owned subsidiary, were notified that the EPA is planning to conduct a time-critical emergency removal action at the site. The notice requested the Company and Federated to perform or finance those actions and reimburse the EPA for its costs. The Company is negotiating with EPA concerning implementation of the removal at the site. The Company is involved in litigation under CERCLA and state law involving alleged hazardous substance releases at the Leadville site, various log sort yards and a landfill in Tacoma, the Company's Globe Plant in Denver, and Everett, Washington. The suits seek substantial damages and remediation costs. With respect to the Globe case, on February 18, 1993, the State of Colorado issued its Record of Decision regarding its proposed remediation plan for the Company's plant located in Denver, Colorado. The Record of Decision has been approved by the U.S. District Court. With respect to the log sort yard cases, in 1991 a federal court and jury in Tacoma determined that Asarco's responsibility A8 for remediation costs at six log yards and a landfill ranges from 75 percent to 100 percent. The cost of the remediation at one log yard has been determined to be approximately $5.6 million. The costs at the other yards and at the landfill are expected to be determined in future proceedings. Asarco was also found responsible for attorneys' fees and interest in the amount of approximately $5 million. Asarco appealed these rulings to the United States Court of Appeals for the Ninth Circuit which in September 1993 affirmed the lower court rulings except for certain elements of the state law claims, the award of attorneys' fees, and damages for the loss of use of the properties in question. Certain claims were also remanded to the trial court for further proceedings. Petitions for rehearing of certain aspects of the decision remain pending. The Company is considering whether to seek further judicial review. Certain events and circumstances arising in 1990 and 1992 allowed Asarco to make reasonable estimates of the extent and cost of environmental contingencies at the above and other sites and thus record additional reserves. At Tacoma, Leadville, Bunker Hill, and East Helena there were developments such as draft feasibility studies, work plans and negotiations or agreements with the EPA. Based on these and other developments, the reserves for these and other sites were increased. In total, the Company's environmental and closed plant reserves were increased by $75.5 million in 1990, $7.3 million in 1991, $72.4 million in 1992 and $6.2 million during 1993. In October 1992, the United States Department of Justice on behalf of EPA notified the Company that it intends to sue seeking civil penalties for alleged violation of the Company's water discharge permit at the Company's Ray Complex. Under the Clean Water Act civil penalties may amount to $25,000 per day for each violation. The Company is negotiating with EPA and the Department of Justice to resolve this matter. On March 2, 1994, the Company was notified by the United States Department of Justice that it was seeking a civil penalty of $389,000 in connection with emissions from the ore storage building baghouse at the East Helena Plant. The Company is currently negotiating with EPA and the Department of Justice to resolve this matter. Also in 1993, the Company's Glover Smelter and West Fork Mine were issued Notices of Violation of their National Pollution Discharge Elimination System ("NPDES") permits by the State of Missouri Department of Natural Resources. The Company is negotiating settlements in both matters. In January 1994, the Company received a notice from the EPA regarding alleged violations of the Resource Conservation and Recovery Act ("RCRA") at the smelter facility in El Paso, Texas. The proposed civil penalty in this matter is $140,400. The citation relates to sand-blasting material utilizing slag from the smelter's operations left on site by a contractor prior to May 1993. The Company is cooperating with the EPA to resolve this matter. In January 1994 the Company received notification dated January 13, 1994 from an attorney that upon the expiration of a 60-day statutory notice period a suit on behalf of two citizens would be filed against it under the Clean Water Act for operating the Company's Omaha plant without a NPDES permit unless the Nebraska Department of Environmental Quality ("NDEQ") took appropriate enforcement action. Asarco had applied to NDEQ for a NPDES permit in 1982 and had been operating the plant under stipulations with NDEQ entered in 1985 and 1988. On March 14, 1994 the Company filed an action in federal district court in Lincoln, Nebraska with the NDEQ as defendant, seeking a declaration that by reason of the stipulations with NDEQ, and actions taken in conjunction with the stipulations, Asarco is not discharging in violation of the Clean Water Act. On March 15, 1994 the citizens' suit was filed in the federal district court in Omaha, Nebraska seeking to enjoin further discharges from the Omaha Plant, penalties of up to $25,000 per day for past and future discharges, and costs and fees. On March 16 Asarco moved to consolidate the two actions in federal court in Lincoln, Nebraska and to stay the citizens' suit until the underlying issues in the first action are decided. On March 4, 1992 the Company's Glover, Missouri lead smelter and refinery received a Notice of Violation for monitored levels of lead in excess of the ambient air lead standard at two off-site monitoring stations. The Company is investigating the cause of these excess levels and intends to work with the Missouri Department of Natural Resources to develop a new State Implementation Plan for lead. Additionally, the Missouri Department of Natural Resources ordered the Company to conduct stack testing at the plant to determine whether the plant is in compliance with applicable emission regulations. State implementation plans designed to achieve compliance within two to three years with the EPA ambient air quality standard for lead of 1.5 micrograms per cubic meter of air have been or are being developed in each state in which Asarco has a facility. These plans will require the construction of additional controls at Asarco's East Helena, A9 Glover, and Omaha facilities. The Omaha Plant has been issued a complaint and compliance order by the Nebraska Department of Environmental Quality for violating the lead standard. A request for a hearing before the Department has been filed. With respect to regulation of the Company's wastes under RCRA, the Company is studying means of compliance through process changes at its facilities, where feasible, to manage the wastes not presently excluded from regulation. Mine tailings; slag and slag tailings from primary copper processing; calcium sulfate wastewater treatment plant sludge from primary copper processing; and slag from primary lead processing of the Company's operations are still automatically excluded from RCRA regulation. The Company's Glover smelter has executed a proposed Consent Decree with the Missouri Department of Natural Resources, in which the Company has agreed to implement certain process changes and conduct various sampling and testing plans to remain in compliance with RCRA requirements. Asarco is subject to federal and state legislation and regulations pertaining to plant and mine safety and health conditions, including the Occupational Safety and Health Act of 1970 and the Federal Mine Safety and Health Act of 1977. Asarco has made, and is likely to continue to make, expenditures to comply with such legislation and regulations. A10 ITEM 2. ITEM 2. PROPERTIES ASARCO WORLDWIDE OPERATIONS METALS COPPER MINES(1) Mission; Sahuarita, Arizona Montana Resources; Butte, Montana Ray; Hayden Arizona Silver Bell(3); Silver Bell, Arizona PLANTS Amarillo, Texas (Refinery) (Also Selenium, Tellurium) El Paso, Texas (Smelter) (Also Sulfuric Acid) Hayden, Arizona (Smelter) (Also Sulfuric Acid) Ray; Hayden, Arizona (Smelter(3)) (Electrowinning Plant) LEAD MINES (1) Leadville; Leadville, Colorado Sweetwater; Reynolds County, Missouri West Fork, Reynolds County, Missouri PLANTS East Helena, Montana (Smelter) (Also Sulfuric Acid) Glover, Missouri (Smelter, Refinery) Omaha, Nebraska (Refinery) (Also Bismuth) ZINC MINES (1) Coy; Jefferson County, Tennessee Immel; Knox County, Tennessee New Market; Jefferson County, Tennessee Young; Jefferson County, Tennessee A11 SILVER MINES (1) Coeur(3); Wallace, Idaho Galena(3); Wallace, Idaho Troy(3); Troy, Montana Quiruvilca (Corporacion Minera Nor Peru, S.A.) (Also Copper, Lead and Zinc); Peru GOLD MINES (1) Aquarius(3); Timmins, Ontario, Canada Asarco Australia Limited(4); Wiluna, Western Australia Jundee, Western Australia PRECIOUS METALS PLANTS SILVER AND GOLD, Amarillo, Texas (Refinery) PALLADIUM AND PLATINUM (CRUDE) Amarillo, Texas SPECIALTY CHEMICALS ENTHONE-OMI North America Long Beach, California Bridgeview, Illinois West Haven, Connecticut Orange, Connecticut Warren, Michigan Toronto, Canada Mexico City, Mexico Europe Barcelona, Spain s-Hertogenbosch, Netherlands Woking, United Kingdom Milan, Italy Turin, Italy Marne-La-Vallee, France Brunn Am Gebirge, Austria Erkrath, Germany Norrkoping, Sweden Geneva, Switzerland Pacific Rim Thomastown, Australia Kowloon, Hong Kong Singapore (2) Shen Zhen, People's Republic of China (2) Tokyo, Japan (2) Taipei, Taiwan MINERALS AMERICAN LIMESTONE COMPANY Construction Aggregates Concrete, Agricultural Limestone Knoxville, Tennessee Tri-Cities, Tennessee Nashville, Tennessee Abingdon, Virginia A12 ENVIRONMENTAL SERVICES Encycle/Texas, Inc. Corpus Christi, Texas Hydrometrics, Inc. Helena, Montana Biotrace Laboratories, Inc., Salt Lake City, Utah OTHER ANTIMONY OXIDE, Omaha, Nebraska HIGH PURITY METALS, Denver, Colorado LEAD FABRICATION Lone Star Lead Construction Corp. Houston, Texas ASSOCIATED COMPANIES M.I.M. HOLDINGS LIMITED (17.2%) Australia Mount Isa (copper, silver, lead, zinc) Hilton (silver, lead, zinc) Townsville (copper refinery) Newlands, Collinsville (coal) (75% MIM interest) Oaky Creek (coal) (86.5% MIM interest) Ravenswood, Tick Hill (gold) England Britannia Refined Metals Limited (lead and silver refiners, secondary lead plant) Britannia Recycling Limited (secondary lead plant) Avonmouth (zinc smelter) Datteln, Germany Zinc refinery (45% MIM interest) Zinc products (33.3% MIM interest) Hamburg, Germany (Copper smelter, copper, lead and gold refineries) (35% MIM interest) Duisburg, Germany (50% MIM interest) zinc-lead smelting/refining Brixlegg, Austria Copper refinery, recycling (25.5% MIM interest) Papua New Guinea Highlands Gold Limited (65% MIM interest) 30% Porgera mine (gold) Investments in resources companies: ASARCO Incorporated (25.0%), Cominco Ltd. (effectively 22.5%), Granges Inc. (37.5%) and Metallgesellschaft AG (3.5%) and Metal Trader Metallgesellschaft Limited (33.3%). A13 MEXICO DESARROLLO INDUSTRIAL MINERO, S.A. de C.V. (MEDIMSA) (28.3%) Thirteen mines, nine metallurgical plants throughout Mexico, including: La Caridad and Cananea (Copper, Lead, Zinc, Silver, Gold, Coal, Coke, Fluorspar, Sulfuric Acid) SOUTHERN PERU COPPER CORPORATION (52.3%) Cuajone (Copper, Silver, Molybdenum) Toquepala (Copper, Silver, Molybdenum) Ilo (Copper Smelter) (1)Interest in mines is shown in Mineral Reserves tables starting on page A15 (2)Joint venture interests (3)On standby (4)Asarco's investment in Asarco Australia was sold in January 1994. (5)(Percent ownership of companies shown in parentheses) COEUR, GALENA AND LEADVILLE These mines are operated by Asarco under lease and joint venture agreements. In Coeur (50%) and Leadville (53.1%), Asarco has a interest in operating expenses and profits or losses in proportion to the related ownership interest. In Galena, Asarco receives 75% of profits remaining after royalty payments to the lessor of 50% of operating profits before depletion, depreciation and Idaho tax. The Coeur mine was temporarily shut down commencing in April 1991 due to depressed silver prices. The Galena mine was temporarily shut down commencing in July, 1992, also due to depressed silver prices. TROY Troy is operated by Asarco under a lease agreement. Asarco retains 75% of net proceeds after operating expenses but before depletion, depreciation and income taxes. The Troy mine was temporarily shut down commencing in April 1993 due to depressed silver prices. QUIRUVILCA The Quiruvilca mine is operated under a Peruvian government concession held by Corporacion Minera Nor Peru, S.A., an 80% owned subsidiary of a wholly owned Asarco subsidiary. MISSION MINE A portion of the mine is held under long-term leases in which the lessors have retained a royalty interest. SILVER BELL Only copper precipitates are currently produced. WEST FORK A portion of the mine is held under a long-term lease in which the lessor has retained a royalty interest. ASSOCIATED COMPANIES Southern Peru Copper Corporation, a 52.3% owned associated company, operates the Cuajone and Toquepala mines under Peruvian government concessions. Mexico Desarrollo Industrial Minero, S.A. de C.V. (MEDIMSA), a 28.3% owned associated company, operates thirteen mines under concessions granted by the Mexican government. The Company sold its remaining 45.3% interest (66.5 million shares) in Asarco Australia for $79.5 million, in January 1994. A14 The following production information is provided: A15 METAL PRODUCTION STATISTICS COPPER A16 METAL PRODUCTION STATISTICS (continued) LEAD A17 METAL PRODUCTION STATISTICS (continued) ZINC (000s TONS) A18 METAL PRODUCTION STATISTICS (continued) SILVER A19 METAL PRODUCTION STATISTICS (continued) GOLD A20 All mineral reserves represent 100% of the reserves for that mine and the percentage ownership of Asarco and associated companies is separately indicated. All mineral reserves are as of December 31, 1993, except for M.I.M. Holdings Limited which are as of June 30, 1993, and MEDIMSA which are as of December 31, 1992. Reserves are estimated quantities of proven and probable ore that under present and anticipated conditions may be economically mined and processed for the extraction of their mineral content. The data for MIM and MEDIMSA are as published by those companies and supplemental information to support the reserves for those companies has not been reviewed by the U.S. Securities and Exchange Commission. Controlled mineral deposits include those owned, directly or indirectly through subsidiaries, partnerships or joint ventures, optioned, leased, or held under government concession. All production figures represent entire amounts of operations, including those under lease, joint venture, government concessions or operated by subsidiaries or associated companies. Metal production figures for associated companies are from mines. Data for MIM are based on its June 30 fiscal year. OTHER OPERATIONS The following is additional information on other operations of the Company. The principal activities included in the business segment entitled "Other" are those of Capco Pipe Company, Inc. ("Capco"), a wholly owned subsidiary that manufactures polyvinyl chloride pipe, ("PVC") the environmental services operations of other subsidiaries and the zinc oxide production of a unit operating in Hillsboro, Illinois. None of these operations constitute a significant portion of the total operations of the Company. During 1993 Capco permanently shut down its asbestos cement pipe business. The Company plans to dispose of its PVC and zinc oxide operations in 1994. ITEM 3. ITEM 3. LEGAL PROCEEDINGS Reference is made to the Contingencies and Litigation Note to the Financial Statements on page A43 and A44 of this report. The following is additional information with respect to the asbestos personal injury litigation. While no one personal injury action is exactly like any other, the following three pending lawsuits are typical of those in which employees of other companies allege death or injury resulting from alleged exposure to asbestos fiber supplied by Lac d'Amiante du Quebec, Ltee ("LAQ"), a wholly-owned subsidiary, and other suppliers to their employers' manufacturing operations: 1) In POGORZELSKI, ET AL. V. AMTORG TRADING CORPORATION, ET AL., Docket No. L-12274-91, pending since October 31, 1991 in the Superior Court of New Jersey, Middlesex County, 19 primary and 8 secondary plaintiffs sued LAQ and 25 other defendants that allegedly supplied asbestos fiber or asbestos containing products to Johns-Manville's Manville, New Jersey facility for substantial compensatory and punitive damages for death or injuries allegedly resulting from the primary plaintiffs' exposure to asbestos fiber while employed at that facility. The claims of seven of the primary plaintiffs were dismissed as to LAQ in June 1992. The plaintiffs allege a broad range of respiratory and other injuries including disabling lung changes, asbestosis, cancer, and mesothelioma. Liability is alleged on theories of strict liability, negligence, breach of warranty, misrepresentation, ultra hazardous activity and conduct, conspiracy, concert of action, market share or enterprise liability, and alternative liability. The thrust of the complaint is that the defendants, individually or collectively, failed to warn the primary plaintiffs of the possible hazards associated with inhalation of asbestos fibers while working with or being exposed to such fibers. 2) In CAMPBELL V. W.R. GRACE AND COMPANY, ET AL., Docket No. CV-92-0295147S, pending since May 14, 1992 in the Superior Court of Connecticut for the Judicial District of Fairfield at Bridgeport, one primary and one secondary plaintiff sued LAQ and 14 other defendants that allegedly supplied asbestos fiber or asbestos containing products to various job sites in Connecticut including the Raybestos-Manhattan facility in Stratford, Connecticut. Plaintiffs seek substantial compensatory and punitive damages for pleural plaques allegedly resulting from primary plaintiff's exposure to asbestos fiber while employed at these job sites. The thrust of the complaint is similar to the POGORZELSKI case. A21 3) In RETTBERG V. ARMSTRONG WORLD INDUSTRIES, INC., ET AL., Case No. May Term 1993, No. 1734, pending since May 11, 1993 in the Pennsylvania Court of Common Pleas, Philadelphia County, one primary and one secondary plaintiff sued LAQ and nine other defendants that allegedly supplied asbestos fiber or asbestos containing products to Owens-Corning Fiberglas Corporation's Berlin, New Jersey facility or various other job sites including Quaker Shipyard, R.T.C. Shipyard, Universal-Dundle, New York Shipyard, and RCA. The plaintiffs demand substantial compensatory and punitive damages for "bilateral pleural thickening" allegedly resulting from primary plaintiff's exposure to asbestos fiber while employed at these facilities. The thrust of the complaint is similar to the POGORZELSKI case. The WELSH V. ASBESTOS CORPORATION, LTD., ET AL. case described in Item 3 of Asarco's 1992 Form 10-K was settled in February 1993 and the BATTEN V. GARLOCK, INC. ET AL. case also described in the same item was administratively dismissed in October 1993. In addition to these personal injury lawsuits arising out of alleged asbestos exposure to employees of other companies using asbestos fiber in their manufacturing operations, included in the asbestos product liability lawsuits pending against LAQ and Asarco are numerous lawsuits arising from products (such as insulation and brake linings) manufactured by others. These cases typically allege a failure to warn of possible health hazards associated with those products and proceed on theories similar to those asserted in the POGORZELSKI case. In many such cases LAQ and Asarco, having never manufactured such products, have obtained dismissals. Typical of lawsuits in which plaintiffs allege asbestos exposure due to products manufactured by others are: 1) BITTINGER V. ACME SAFETY PRODUCTS, ET AL., Case No. 88-7-2206, pending since July 10, 1989 in the Ohio Court of Common Pleas, Summit County, where 120 primary and 99 secondary plaintiffs sued LAQ and 69 other defendants that allegedly supplied asbestos, talc and/or products or components containing asbestos or talc, to the primary plaintiffs' employers in the tire and rubber industry in Ohio. (The claims of two of the primary plaintiffs were dismissed as to all defendants in 1992 and 1993). The plaintiffs demand substantial compensatory and punitive damages for injuries allegedly resulting from their exposure to talc and asbestos. The thrust of the complaint is similar to the POGORZELSKI case. 2) ABRAMS, ET AL. V. OWENS-CORNING FIBERGLAS CORP., ET AL., Civil Action Nos. 93-C-6152 through 93-C-6265 (made part of IN RE: MASS III KANAWHA COUNTY ASBESTOS CASES, Civil Action No. 92-C-8888), pending since September 22, 1993 in the Circuit Court of Kanawha County, West Virginia, where 114 primary and 91 secondary plaintiffs sued LAQ, Asarco and 65 other defendants that allegedly supplied asbestos and/or products containing asbestos to the primary plaintiffs' employers in West Virginia. The plaintiffs demand substantial compensatory and punitive damages for injuries allegedly resulting from their exposure to asbestos. The thrust of the complaint is similar to the POGORZELSKI case. 3) ABERNATHY V. AC&S, INC., ET AL., Case No. A9209667-C, pending since September 17, 1992 in the District Court of Orange County, Texas, where 2,733 primary and 2,229 secondary plaintiffs sued Asarco and its wholly-owned subsidiary Capco as well as 70 other defendants that allegedly supplied asbestos and/or products containing asbestos (or that were allegedly alter egos to or "controlling producers" of such suppliers) to the primary plaintiffs' employers in Alabama. The plaintiffs demand substantial compensatory and punitive damages for injuries allegedly resulting from their exposure to asbestos. The thrust of the complaint is similar to the POGORZELSKI case. During 1993 the case was settled as to Asarco. Capco remains a defendant in this and 69 other cases brought by 1,399 additional primary plaintiffs. The total of 13,940 pending primary plaintiffs reported for the Company and two of its subsidiaries at December 31, 1993 includes approximately 8,100 primary plaintiffs' claims in West Virginia, that were settled in February 1994. In 1991, the Judicial Panel on Multidistrict Litigation transferred all asbestos cases pending in federal court to the United States District Court for the Eastern District of Pennsylvania for coordinated and consolidated pretrial proceedings. Cases containing approximately 2 percent of LAQ's primary plaintiffs are affected by this action. As of December 31, 1993, LAQ, Asarco and Capco have settled or been dismissed from a total of approximately 4,357 asbestos personal injury lawsuits brought by approximately 18,114 primary and approximately 10,554 secondary plaintiffs. A22 With respect to the actions relating to asbestos-containing products in structures reported in the Contingencies and Litigation Note, the following supplemental information is provided. THE SCHOOL DISTRICT OF LANCASTER, ET AL. V. LAKE ASBESTOS OF QUEBEC, LTD., ET AL., Civil Action No. 83-0286, was filed in 1983 in United States District Court for the Eastern District of Pennsylvania. Subsequently, cases were filed by different school districts in the same court seeking the same relief on behalf of the same class (BARNWELL SCHOOL DISTRICT NO. 45 V. U.S. GYPSUM, ET AL., Civil Action No. 83-1395, filed in 1983; BOARD OF EDUCATION OF THE MEMPHIS CITY SCHOOLS, ET AL. V. U.S. GYPSUM, ET AL., Civil Action No. 84-2312, filed in 1984). In 1984, these actions were consolidated as IN RE ASBESTOS SCHOOL LITIGATION, Civil Action No. 83-0268, and the case was certified to proceed on behalf of a class of all public school districts and private primary and secondary educational institutions in the United States. LAQ settled this action in March 1989, and all necessary court approvals have been obtained. The other actions, including some purported class actions, involve colleges and universities, real estate companies, transit corporations, private buildings under lease to the federal government, schools, and public buildings in cities and states. Each of these actions seeks substantial actual damages, and most but not all seek punitive damages. As of December 31, 1993, LAQ has settled four and been dismissed from another 79 actions involving asbestos in structures. Asarco has been dismissed from all eleven actions in which it had been named. In 1987, LAQ began litigation against certain excess liability insurers for a declaration of insurance coverage for its asbestos cases similar to the one that had been obtained by LAQ against certain other insurers in a 1985 court ruling that held that the comprehensive continuous theory of coverage applies to those insurers' policies as regards LAQ's asbestos personal injury and property damage litigation. Settlements have been reached with certain of these insurers and the case remains pending in federal court in the Southern District of New York. In June 1993, the Company was sued by two of its liability insurance carriers, the Insurance Company of North America and California Union Insurance Company, in state court in New Brunswick, New Jersey for a declaration that the insurance companies have no insurance obligation for environmental matters for which the Company is seeking coverage. The insurance companies also included Asarco's other liability insurers in the lawsuit, and they have sought similar declaratory relief. Asarco has filed cross claims and counterclaims in this lawsuit seeking a court declaration that insurance coverage of its environmental matters does exist. In November 1990 the Company filed a lawsuit against several of its liability insurers in state court in King County, Washington seeking insurance coverage for the Tacoma log sort yard cases. In January 1994 the Company filed a similar lawsuit in state court in Denver, Colorado seeking insurance coverage for a class action lawsuit concerning the Company's Globe Plant that had been settled during 1993. In March 1993 a lawsuit was filed in United States District Court in Tacoma, Washington on behalf of classes of persons who own or rent residential property within two miles of the Company's former Tacoma plant. In May 1993, it was transferred to the United States District Court in Seattle, Washington. The action asserts claims of trespass, nuisance, negligence, strict liability, and unjust enrichment, as well as under CERCLA, for property damage due to past emissions of metals from the plant. The action also seeks the establishment of a fund to pay for the medical monitoring of an alleged class of persons who now reside or who in the future will reside on property located within two miles of the plant. In September 1993 the court certified the action to proceed as a class action. Plaintiffs' counsel has represented that the Medical Monitoring Class consists of an estimated 18,000 individuals, and the other two classes consist of more than 5,000 owners or renters. The Company has legal and factual defenses including the comprehensive remediation programs that have been and will be taken under EPA Superfund proceedings regarding the subject matter of the lawsuit. In April 1993, the Town of Ruston, Washington filed a lawsuit against the Company in United States District Court in Tacoma, Washington. The lawsuit asserts claims for damage to property owned by the town due to the operation of the Company's former Tacoma plant similar to the claims asserted in the class action lawsuit referred to in the immediately preceding paragraph, and it has been consolidated with that suit and transferred to the United States District Court in Seattle. The lawsuit had originally stated claims for lost tax revenue, but these claims were dismissed by the court on Asarco's motion. A23 In May 1989, a lawsuit was filed in state court in Butte, Montana by Montana Mining Properties ("MMP") which claims to have had a contractual first right of refusal on the 49.9% interest in the Montana copper mining business of Montana Resources, Inc. that was sold to Asarco in June 1989. MMP seeks an injunction and compensatory and punitive damages from Asarco for alleged tortious interference with its contract with Montana Resources, Inc. On October 8, 1991, ARCO Incorporated ("ARCO") filed suit in federal court in Montana against Montana Resources and its partners, including Asarco and one of its subsidiaries, alleging breach of contract resulting from defendants' failure to reclaim contaminated water in an abandoned mining pit (the Berkeley Pit) at partnership-owned property in Butte, Montana. ARCO demanded compensation for study costs under CERCLA with respect to such water, and a determination that defendants are responsible for reclamation of the pit. The defendants assert that ARCO is responsible for such CERCLA and reclamation costs. Trial has been set for mid-1995. In March 1993 the Arizona Department of Environmental Quality notified the Company that it was seeking fines of approximately $700,000 for alleged violations of the Clean Air Act at the Company's Ray Complex in Arizona relating to disposal of asbestos cement pipe. On July 6, 1993 the State of Arizona filed suit seeking civil penalties for the alleged violations and other relief. The Company is negotiating to resolve this matter. The opinion of management regarding the outcome of legal proceedings and environmental contingencies, set forth in the Contingencies and Litigation Note (Note 8) to the Financial Statements, is based on considerations including experience relating to previous court judgments and settlements and remediation costs and terms. The financial viability of other potentially responsible parties has been considered when relevant and no credit has been assumed for any potential insurance recoveries when availability of insurance is not established. The Company considered such factors in establishing its environmental reserve in December of 1990 and in determining modifications to its reserve in 1991, 1992 and 1993. See also Item 1, "Environmental, Safety and Health Matters," for further information concerning pending legal or administrative proceedings involving Asarco. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. A24 EXECUTIVE OFFICERS OF ASARCO AND BUSINESS EXPERIENCE DURING THE PAST FIVE YEARS (As of February 23, 1994) Officer Name Office and Experience Age Since - ---- --------------------- --- ------- Richard de J. Osborne 1989-1994 Chairman of the Board, Chief 59 1975 Executive Officer and President Francis R. McAllister 1993-1994 Executive Vice President, 51 1978 Copper Operations 1992-1993 Executive Vice President, Finance and Administration and Chief Financial Officer 1989-1992 Vice President, Finance and Administration and Chief Financial Officer Robert J. Bothwell, Jr. 1989-1994 Vice President, Sales 56 1987 Thomas J. Findley, Jr. 1991-1994 Treasurer 46 1991 1989-1990 Director of Management Information Services James J. Kerr 1992-1994 Vice President, Commercial 63 1991 1991-1992 Vice President, Ore 1989-1991 Vice President-Elders Raw Materials Limited Augustus B. Kinsolving 1989-1994 Vice President, General 54 1983 Counsel and Secretary Kevin R. Morano 1993-1994 Vice President, Finance and 40 1993 Chief Financial Officer 1991-1993 General Manager, Ray Complex 1989-1991 Treasurer Robert J. Muth 1989-1994 Vice President, Government 60 1977 and Public Affairs Robert M. Novotny 1993-1994 Vice President, Lead, Zinc, 45 1988 Silver and Mineral Operations 1989-1993 Vice President, Operations Ronald J. O'Keefe 1989-1994 Controller 52 1982 Gerald D. Van Voorhis 1992-1994 Vice President, Exploration 55 1992 1989-1991 Vice President-Socorro Mining Company Michael O. Varner 1993-1994 Vice President, Environmental 52 1993 Operations 1992-1993 General Manager, Western Metals 1989-1992 Director, Technical Services James L. Wiers 1989-1994 General Auditor 49 1987 David B. Woodbury 1993-1994 Vice President, Human 53 1993 Resources 1989-1993 Vice President, Human Resources - Ferro Corporation A25 PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANTS COMMON SHARE AND RELATED STOCKHOLDER MATTERS At March 16, 1994, there were approximately 10,072 common stockholders of record. The principal market for Asarco's Common Stock is the New York Stock Exchange. The Stock Exchange symbol for Asarco's common stock is AR. High and low stock prices and dividends for last two years were: A26 ITEM 6. ITEM 6. SELECTED FINANCIAL DATA FIVE-YEAR SELECTED FINANCIAL AND STATISTICAL DATA (in millions, except per share data) A27 A28 ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS EARNINGS: The Company reported net earnings for the year ended December 31, 1993 of $15.6 million, or $.38 per share, compared with a net loss of $83.1 million, or $2.01 per share in 1992 and net earnings of $46.0 million, or $1.12 per share, in 1991. Net earnings in 1993 include $104.5 million of previously unrecognized results of the Company's investments in Peru. In the fourth quarter of 1993, the Company resumed equity accounting for its 52.3% interest in Southern Peru Copper Corporation (SPCC) and recorded the results of its 80% owned subsidiary Corporacion Minera Nor Peru, S.A. (Nor Peru). The change in accounting for Asarco's investments in Peru resulted from the improvements in the political, economic and operating conditions in Peru, which included the ratification of a new constitution and the successful completion of SPCC's capital program financing, which restored management's influence over its Peruvian operations. To reflect this change, the Company recorded $18.2 million of previously unrecognized earnings relating to the period 1988 through 1993 from its investments in Peru and $86.3 million, or $2.08 per share, for the cumulative effect of a change in accounting principle resulting from SPCC's adoption of SFAS 109, "Accounting for Income Taxes". The Company also recorded an after-tax charge of $16.7 million ($25.6 million pre-tax) related to the valuation of certain inventories and additions to reserves, principally for assets planned for disposition. Also included in 1993 earnings are LIFO profits of $5.9 million after-tax ($9.2 million pre-tax) resulting from the reduction of inventories accounted for on a LIFO basis due principally to the completion of the integration of the Company's copper business. Results were adversely impacted beginning in late 1992 and into early 1993 by unusually heavy rains in Arizona which affected operations at two of the Company's principal copper properties. While the most severe effect of the rains was overcome by the second quarter of 1993, the limitations imposed on mining operations at the Ray mine by the substantial amount of water retained in the pit continued to affect operations through the balance of the year. As a result, copper production was reduced from expected levels, costs were higher and net earnings were reduced by $22 million. Completion of the major expansions at the Company's Mission and Ray mines in Arizona resulted in increased copper mine production in 1993 and 1992 compared with 1991, but principally because of the heavy rains in Arizona, copper mine production did not meet expectations. Asarco earnings are heavily influenced by the metals markets. The economic recovery in the United States created increasingly strong demand for the Company's products domestically but economic weakness in continental Europe and in Japan offset most of the growth in the U.S., Southeast Asia and Latin America. As a result of the imbalance in supply and demand, prices for all of the Company's principal base metal products, copper, lead and zinc, reached new lows for this economic cycle in 1993. Silver prices however, increased in 1993 compared to 1992 and 1991 as speculative buying and concern over inflation renewed investor demand for precious metals. Compared with 1992, the Company's 1993 earnings were lowered by $96 million due to these price declines. The net loss of $83.1 million in 1992 includes an after-tax charge of $122.1 million consisting of $56 million for the adoption of SFAS 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions", $44 million for environmental costs, and $21.1 million for the reduction in carrying value of certain facilities. Net earnings of $46 million in 1991 were reduced by a charge of $6.6 million after-tax, to establish a reserve for a receivable from a copper customer which filed for bankruptcy protection and were benefited by an after-tax profit of $5.4 million from the sale of the Company's direct interest in Highlands Gold Limited. In August 1993, the Company sold a 9.9% interest in Asarco Australia Limited (Asarco Australia), its gold mining subsidiary for $13.8 million. The sale resulted in a pre-tax gain of approximately $10.3 million ($5.4 million after- tax). Owning less than 50% of Asarco Australia following the sale, the Company began to account for this investment by the equity method. In September 1993, Asarco Australia offered 13.3 million shares of previously unissued common stock to the public, resulting in net cash proceeds of A$16.4 million. As a result of this share issuance, the Company's ownership was reduced to 45.3% and a $3.3 million pre-tax gain ($2.1 million after-tax) was recognized as the shares were sold at a price exceeding the book value per share of the Company's investment. In January 1994, the Company sold its remaining 45.3% interest (66.5 million shares) for $79.5 million. The sale resulted in a pre-tax gain of $58.5 million which will be reported in the first quarter of 1994. A29 PRICES: Prices for the Company's metals are established principally on the New York Commodity Exchange (COMEX) or the London Metal Exchange (LME). Thus, it is not possible to predict prices for future metal sales. Price volume analysis: The following prices and volumes were realized. SALES: Sales in 1993 were $1,736.4 million, compared with $1,908.5 million in 1992 and $1,911.8 million for 1991. The decline in sales dollars caused by lower prices for copper and lead in 1993 was partially offset by increased volumes for both metals. Accounting for the Company's investment in Asarco Australia as an equity investment rather than as a consolidated subsidiary reduced 1993 sales by approximately $25 million. COST OF PRODUCTS AND SERVICES: Cost of products and services in 1993 were $1,638.0 million, compared with $1,647.3 million in 1992 and $1,634.2 million in 1991. The decrease in 1993 was caused principally by the elimination of operating costs at operations on standby status. In April 1993, the Company put its Troy, Montana, copper-silver mine on standby due to low silver prices. The Troy shutdown followed the suspension of production at the Galena mine in 1992 and the Coeur mine in 1991. LIFO profits of $9.2 million, the deconsolidation of Asarco Australia and other operating cost reductions, $8.2 million of previously unrecognized losses of Nor Peru and higher purchases of refined copper also affected cost of products and services. The Company's cost for purchased refined copper approximates the market price at which it is sold. Cost of products and services were negatively impacted by the heavy rains in Arizona in late 1992 and early 1993. The increase in 1992 was from increases in copper sales volumes, net of the impact of lower lead and silver sales volumes and lower purchases of refined copper. In 1991, equipment availability problems, higher reagent usage, pump repairs and train derailments at the Ray mine, resulted in reduced production and higher operating costs. OTHER EXPENSES: Selling and administrative costs decreased by $1.8 million in 1993 and $7.1 million in 1992, principally as a result of cost reduction programs. The 1991 provision for doubtful accounts includes a $10.6 million bad debt reserve for receivables from Laribee Wire Manufacturing Company, Inc. and its affiliated companies. Depreciation and depletion expense decreased by $6 million in 1993 as a result of the temporary closure of the Troy mine, the deconsolidation of Asarco Australia and lower production at the Ray mine due to heavy rains. Depreciation and depletion expense increased by $11.8 million in 1992 primarily as a result of higher production following the completion of the expansion programs at Mission in October 1991 and Ray in February 1992. Increases in ore reserves at Ray extended the economic life of the mine, reducing depreciation and depletion expense. Research and exploration expense declined by $5.0 million in 1992 as a result of reduced levels of exploration activity, and that level was maintained in 1993. A30 NONOPERATING ITEMS: Interest expense increased a further $6.1 million in 1993 after increasing by $5.0 million in 1992 as compared to 1991 as a result of higher borrowings. The amount of interest capitalized has been declining as a result of the completion of portions of the copper expansion program. Interest expense has been reduced by lower interest rates paid on floating rate debt. The weighted average interest rate on this debt was 3.7% in 1993 compared to 4.2% in 1992 and 6.5% in 1991. Other income was $30.2 million in 1993, $23.9 million in 1992 and $22.9 million in 1991. Other income in 1993 includes a $10.3 million gain on the sale of a 9.9% interest in Asarco Australia and $9.4 million of dividends from SPCC, recorded prior to resuming equity accounting. Other income in 1992 includes $7.8 million of dividends from SPCC and in 1991 an $8.7 million gain on the sale of Highlands Gold Limited shares. Dividends from M.I.M. Holdings Limited included in other income were $8.3 million in 1993, $8.8 million in 1992 and $9.5 million in 1991. TAXES ON INCOME: The tax benefits in 1993 and 1992 result principally from operating losses and, in 1992, from the settlement of a Canadian tax assessment. Taxes in 1993 include $2.8 million for additional deferred Federal Income taxes as a result of the increase in the statutory tax rate to 35% and higher taxes on the gain realized on the sale of 9.9% of the shares of Asarco Australia, as a result of providing taxes on earnings previously treated as permanently reinvested while Asarco Australia was a consolidated subsidiary. Taxes on income were reduced for 1991 as a result of percentage depletion, partially offset by the tax effect of the pro rata repurchase of outstanding shares by SPCC. Net operating loss carryforwards have reduced the Company's deferred tax liability by $127.6 million at December 31, 1993. The Company believes that these carryforwards, which expire in 2006, 2007 and 2008, will reduce future federal income taxes otherwise payable and, if necessary, the Company could implement available tax planning strategies, including the sale of certain assets, to realize the tax benefit of the carryforwards. EQUITY IN EARNINGS OF NONCONSOLIDATED ASSOCIATED COMPANIES: Equity earnings in 1993 are principally from the previously unrecognized results of SPCC. In the second quarter of 1991, the Company discontinued equity accounting for its investment in Mexico Desarrollo Industrial Minero, S.A. de C.V. (MEDIMSA), after announcing that it was considering the sale or other form of disposition of some or all of its investment. In light of this and other factors, the Company's equity earnings from MEDIMSA include earnings for the first quarter of 1991 only. In January 1994, the Company signed an agreement with Grupo Industrial Minera Mexico, S.A. de C.V. (Grupo Mexico) for combining MEDIMSA with Grupo Mexico, its publicly traded parent. The agreement is subject to a number of approvals. Under the terms of the agreement with Grupo Mexico, the Company will hold a 23.6% stake in the new Grupo Mexico upon completion of the transaction. This transaction will ultimately provide greater liquidity for the Company as its holdings will be in a publicly traded entity. CASH FLOWS - OPERATING ACTIVITIES: Net cash provided from operating activities was $38.9 million in 1993, compared with $105.7 million in 1992 and $67.5 million in 1991. The $66.8 million decrease in 1993 from 1992, was from lower earnings due to a decline in metals prices and other items noted above, net of $101.5 million of operating cash provided from inventory and receivable reductions and higher accounts payable. Setting aside the effect of the $122.1 million provision, which is a noncash charge, and other noncash items, the $38.2 million increase in 1992 from 1991 results from $13.9 million from operating activities and $24.3 million from a reduction in operating assets net of liabilities. CASH FLOWS - INVESTING ACTIVITIES: Capital expenditures were $112.3 million in 1993, of which $23.8 million was spent on the completion of the El Paso copper smelter modernization. Capital expenditures in 1992 were $134.6 million, including $70.3 million for the copper expansion and modernization program at the Ray mine and El Paso smelter and $9.5 million for participation payments on previously acquired properties. Capital expenditures in 1991 were $282.9 million, of which $207.5 million was spent on the expansion and modernization program at the Mission and Ray mines and the El Paso smelter. The expansion and modernization at Mission was completed in the fourth quarter of 1991 and at Ray in the first quarter of 1992. The Company's planned capital expenditures in 1994 are estimated to be about $90 million. The proceeds from sale of securities and property represents, principally, the investment portfolio of Geominerals Insurance Company, Ltd. which for the most part is reinvested by purchasing additional securities. Proceeds of $13.8 million from the sale of a 9.9% interest in Asarco Australia are included in proceeds from sale of securities in 1993. In 1992, the Company did not exercise a $40 million option to purchase 16,705,527 shares of MEDIMSA which it held under a 1989 agreement, effectively lowering its ownership interest to 28.3%. Included in purchases of investments in 1991 is $24.9 million for a stock subscription of MEDIMSA by a wholly owned subsidiary of the Company. The Company received A31 proceeds of $25.8 million in 1991 from the sale of shares of Highlands Gold Limited and received $31.4 million from a SPCC pro rata repurchase of outstanding shares which is included in proceeds from sale of securities. The Company reduced its carrying value in SPCC by the amount of these proceeds. In 1991, Asarco Australia, previously a 60% owned subsidiary of the Company, acquired the remaining 50% interest in the Wiluna gold mine owned by its former partner for $17.4 million. LIQUIDITY AND CAPITAL RESOURCES: Debt securities in the amount of $250 million were issued in 1993 including $100 million of 7 3/8% Notes due in 2003, $100 million of 7 7/8% Debentures due in 2013 and $50 million of 7% Notes due in 2001. Proceeds of these debt issues were used to reduce borrowings under revolving credit loan agreements. In addition, after year-end, the Company prepaid its 9 3/4% Sinking Fund Debentures at par value plus a premium of .9%. In 1993, the Company also entered into a new five-year $320 million revolving credit agreement to replace a $260 million revolving credit agreement which expired. At December 31, 1993, the Company's debt as a percentage of total capitalization was 38.0%, compared with 39.0% at the end of 1992 and 35.2% at the end of 1991. Debt at the end of 1993 was $900.5 million, compared with $868.8 million in 1992 and $801.6 million at the end of 1991. Additional available credit under existing loan agreements totaled $339 million at the end of 1993. The Company adopted SFAS 115, "Accounting for Certain Investments in Debt and Equity Securities" in the fourth quarter of 1993, which increased stockholders equity by an after-tax credit of $112.7 million ($173.4 million pre-tax) to reflect the increased net value of its cost investments, principally M.I.M. Holdings Limited. Earnings were not affected by this accounting change. The Company expects that it will meet its cash requirements in 1994 and beyond from internally generated funds, from proceeds of the sale of its remaining interest in Asarco Australia in January 1994 and from borrowings, if necessary, under its revolving credit agreements, or from additional debt financing. DIVIDENDS AND CAPITAL STOCK: The Company paid dividends of $20.8 million, or 50 cents per share, in 1993 and $33.0 million, or 80 cents per share, in 1992. In 1991, the Company purchased 67,314 shares of common stock at a cost of $1.8 million and paid dividends of $65.8 million, or $1.60 per share. At the end of 1993, the Company had 41,718,000 common shares issued and outstanding, compared with 41,467,000 at the end of 1992 and 41,249,000 at the end of 1991. CLOSED FACILITIES AND ENVIRONMENTAL MATTERS: During 1993, the reserve for environmental matters was increased by $6.2 million for ongoing evaluations of environmental costs. As a result of developments during 1992, at a number of the Company's properties where it was probable that an environmental liability had been incurred, the Company was able to further refine previous estimates with requisite certainty for a substantial portion of the anticipated costs at those sites. Accordingly, in 1992, the Company recorded a pre-tax charge of $72.4 million to provide additional reserves for these environmental costs. At the end of 1993, reserves for closed plant and environmental matters totaled $116.1 million. Cash expenditures charged to these reserves were $44 million in 1993, $36 million in 1992 and $32 million in 1991. The increased level of expenditures in 1993 are due to settlement of litigation concerning past operations at the Company's Globe plant in Denver. Future environmentally related expenditures cannot be reliably determined in many circumstances due to the early stages of investigation, the uncertainties relating to specific remediation and clean-up methods and therefore the related costs, the possible participation of other potentially responsible parties, insurance coverage issues and changing environmental laws and interpretations. It is the opinion of Management that the outcome of these environmental matters will not materially adversely affect the financial position of Asarco and its consolidated subsidiaries. However, it is possible that future environmental contingencies could have a material effect on quarterly or annual operating results, when they are resolved in future periods. This opinion is based on considerations including experience related to previous court judgments and settlements and remediation costs and terms. The financial viability of other potentially responsible parties has been considered when relevant and no credit has been assumed for any potential insurance recoveries when the availability of insurance has not been determined. In 1992, the Company concluded that certain facilities, primarily at the El Paso, Texas, smelter, were unlikely to be used following completion of its modernization and expansion program in 1993. Accordingly, the Company recorded a pre-tax charge of $31.9 million to reduce the carrying value of these facilities. ACCOUNTING MATTERS: In 1993, the Company adopted SFAS 112, "Employers' Accounting for Post Employment Benefits", which had no net effect on earnings. A32 ITEM 8 ITEM 8 - FINANCIAL STATEMENTS AND SUPPLEMENTAL DATA ASARCO Incorporated and Consolidated Subsidiaries CONSOLIDATED STATEMENT OF EARNINGS A33 ASARCO Incorporated and Consolidated Subsidiaries CONSOLIDATED BALANCE SHEET A34 ASARCO Incorporated and Consolidated Subsidiaries CONSOLIDATED STATEMENT OF CASH FLOWS A35 ASARCO Incorporated and Consolidated Subsidiaries CONSOLIDATED STATEMENT OF CHANGES IN COMMON STOCKHOLDERS' EQUITY A36 ASARCO Incorporated and Consolidated Subsidiaries NOTES TO FINANCIAL STATEMENTS (1) Summary of Significant Accounting Policies Principles of Consolidation: The consolidated financial statements include all significant subsidiaries in which the Company has voting control. Significant investments in the capital stock of associated companies and subsidiaries over which the Company has significant influence but does not have voting control are accounted for by the equity method. Cash Equivalents: The Company considers all highly liquid investments with a maturity of three months or less when purchased to be cash equivalents. Inventories: Company-owned metals processed by smelters and refineries are valued at the lower of last-in, first-out (LIFO) cost or market. Other inventories are valued at the lower of first-in, first-out (FIFO) or average cost or market. Investments: The Company adopted Statement of Financial Accounting Standards (SFAS) 115 "Accounting for Certain Investments in Debt and Equity Securities", in 1993. Investment in equity securities that have readily determinable fair values and all debt securities are classified as held to maturity, trading, or available-for-sale securities. The unrealized gains or losses for trading securities are included in net earnings, while the unrealized gains or losses on securities classified as available-for-sale (reported at fair value) are included as a separate component of Stockholders' equity. Property: Assets are valued at cost or less. Betterments, renewals, costs of bringing new mineral properties into production, and the cost of major development programs at existing mines are capitalized. Maintenance, repairs, development costs to maintain production at existing mines, and gains or losses on assets retired or sold are reflected in earnings as incurred. Plant assets are depreciated over their estimated useful lives, generally by the units-of- production method. Depreciation and depletion of mine assets are computed generally by the units-of-production method using proven and probable ore reserves. Revenue Recognition: Revenue is recognized on metals sold at the time a sales contract is executed and the sales price is fixed in accordance with the terms of the contract. Exploration: Tangible and intangible costs incurred in the search for mineral properties are charged against earnings when incurred. Hedge Contracts: The Company periodically uses futures and options contracts to hedge the effect of price changes on a portion of the primary metals it sells. Gains and losses on hedge contracts are reported as a component of the related transaction. Taxes on Income: Deferred income taxes reflect the future tax consequences of differences between the tax bases of assets and liabilities and their financial reporting amounts at each year-end. No deferred income taxes have been provided for the income tax liability which would be incurred on repatriation of the undistributed earnings of the Company's consolidated foreign subsidiaries because the Company intends indefinitely to reinvest these earnings outside the United States. General business credits are accounted for by the flow-through method. The Company adopted SFAS 109 "Accounting for Income Taxes", in 1992, and restated prior period financial statements to reflect the change. A37 Subsidiary Stock Issuance: Gains or losses arising from the sale of previously unissued shares to an unrelated party by a subsidiary are recognized as a component of net earnings to the extent that the net book value of the shares owned by the parent after the sale exceeds or is lower than the net book value per share immediately prior to the sale of the shares by the subsidiary. (2) Other Income - ----------------- Other Income consists of the following: (3) Taxes on Income - -------------------- Earnings (loss) before taxes on income is as follows: A38 Tax Expense: The components of the provision for taxes on income are as follows: Total taxes paid (refunded) were: 1993-($3.1) million; 1992-$2.6 million and 1991-($16.3) million. Reconciliation of Statutory Income Tax Rate: A39 Temporary differences and carryforwards which give rise to deferred tax assets and liabilities are as follows: At December 31, 1993, the Company had $364.6 million of net operating loss carryforwards which expire, if unused, in 2006, 2007 and 2008 and $7.4 million of alternative minimum tax credits which are not subject to expiration. The Company believes that these carryforwards will be available to reduce future federal income tax liabilities and has recorded the tax benefit of these carryforwards as deferred tax assets. Because of shorter carryforward periods and other statutory differences, the Company's net operating loss carryforwards for state purposes are not significant and, therefore, have not been recorded as deferred tax assets. U.S. deferred income taxes have not been recognized on approximately $267.0 million in 1993 ($167.0 million in 1992 and $174.6 million in 1991) of undistributed earnings of foreign subsidiaries and nonconsolidated associated companies more than 50% owned, because assets representing those earnings are permanently invested. It is not practicable to determine the amount of income taxes that would be payable upon remittance of assets that represent those earnings. The amount of foreign withholding taxes that would be payable upon remittance of assets that represent those earnings would be approximately $2.8 million in 1993 ($3.4 million in 1992 and $3.9 million in 1991). A40 (4) Inventories - ---------------- Replacement cost exceeds inventories valued at LIFO cost by approximately $114.1 million in 1993 (1992-$125.2 million). Liquidation of LIFO inventories resulted in recognition of pre-tax earnings of $9.2 million in 1993. (5) Acquisitions - ----------------- Asarco Australia Limited, previously a 60% owned subsidiary of the Company, invested $17.4 million in 1991 to acquire the remaining 50% interest in the Wiluna gold mine owned by its former partner. Acquisitions are accounted for as purchases and, accordingly, acquired assets and liabilities have been recorded at their estimated fair market values at the date of acquisition. Operating results are included in the Consolidated Statement of Earnings from the acquisition dates. The excess of the purchase price over the valuation of the net assets acquired of $59.0 million at December 31, 1993 is recorded as goodwill in Intangible and other assets. Goodwill is generally amortized over either the mine life up to a maximum of 40 years on a units-of-production basis or over 40 years on a straight-line basis. Accumulated amortization was $9.3 million and $7.7 million at December 31, 1993 and 1992, respectively. (6) Investments - ---------------- The Company has substantial interests in associated companies in Mexico, Peru and Australia, which are engaged principally in mining, smelting and refining nonferrous metals. These companies are Mexico Desarrollo Industrial Minero, S.A. de C.V. (MEDIMSA), Southern Peru Copper Corporation (SPCC), M.I.M. Holdings Limited (MIM) and Asarco Australia Limited (Asarco Australia). The fiscal year for MIM ends June 30. MEDIMSA, Asarco Australia and SPCC report on a calendar- year basis. MEDIMSA: In 1991, the Company announced that it was considering the sale or other form of disposition of some or all of its investment in MEDIMSA. In light of this action and other factors, the Company changed from the equity method of accounting for its interest in MEDIMSA to the cost method, effective with the second quarter of 1991. At December 31, 1993, cumulative losses that would have been recognized had equity accounting been continued totaled $7 million. In the second quarter of 1991, a wholly owned subsidiary of Asarco invested an additional $24.9 million in MEDIMSA under a rights offering. As a result of not subscribing to its full share of the offering, the Company's interest in MEDIMSA declined to 31.2% from 34.0%. Pursuant to a financing and option agreement entered into in 1989 with a subsidiary of the Chase Manhattan Bank, N.A., the Company exchanged 16,705,527 shares of MEDIMSA for $38.4 million of previously issued exchangeable preferred stock of a wholly owned subsidiary of the Company in December 1992, decreasing ownership to 28.3%. In January 1994, the Company signed an agreement with Grupo Industrial Minera Mexico S.A. de C.V. (Grupo Mexico) on terms for combining Medimsa with Grupo Mexico, its publicly traded parent. Under the terms of the agreement, which is subject to regulatory and other approvals, the Company will hold a 23.6% stake in the new Grupo Mexico, upon completion of the transaction. A41 SPCC: In 1988, the Company changed from the equity method of accounting for SPCC to the cost method. This change followed the deterioration in the economy of Peru, inflation and level of foreign exchange reserves, the economic uncertainty for the near term outlook and the foreign exchange restrictions on the remittance of profits then in place. In addition, the Company discontinued consolidating its interest in Corporacion Minera Nor Peru, S.A. (Nor Peru) for similar reasons. Conditions have improved and stabilized to the point where the Company has the ability to reassert influence and act without the governmental oversight that previously existed. Economic and political conditions have improved significantly as indicated by the ratification of a new constitution by voters in Peru in October 1993 and the successful completion of SPCC's financing of its $300 million capital program in December. Therefore, in the fourth quarter of 1993, the Company resumed equity accounting and recorded $26.4 million of previously unrecognized equity earnings for SPCC and resumed consolidation of Nor Peru by recording $8.2 million of previously unrecognized losses. Effective January 1, 1993, SPCC adopted SFAS 109, "Accounting for Income Taxes". The impact of adopting this statement on SPCC was to increase retained earnings as of January 1, 1993 and decrease deferred taxes by $165 million, ASARCO's share of which is $86.3 million, which is reported as the cumulative effect of a change in accounting principle. In December 1991, SPCC repurchased approximately 13.8% of its outstanding common shares pro rata from its shareholders, from which Asarco received proceeds of $31.4 million. The Company reduced its carrying value in SPCC by the amount of these proceeds. Dividends received (prior to the resumption of equity accounting) of $9.4 million in 1993 and $7.8 million in 1992 were recorded as dividend income. Asarco Australia: In August 1993, the Company sold a 9.9% interest in Asarco Australia, its gold mining subsidiary for $13.8 million. The sale resulted in a pre-tax gain of approximately $10.3 million ($5.4 million after-tax) and reduced the Company's interest in Asarco Australia to 49.8%. As a result of this sale, the Company began to account for its investment in Asarco Australia using the equity method. In September 1993, Asarco Australia offered 13.3 million shares of previously unissued common stock to th e public, resulting in net cash proceeds of A$16.4 million. As a result of this share issuance, the Company's ownership interest was reduced to 45.3% and a $3.3 million pre-tax gain ($2.1 million after-tax) was recognized as the shares were sold at a price exceeding the book value per share of the Company's investment. In January 1994, the Company sold its remaining 45.3% interest (66.5 million shares) in Asarco Australia for $79.5 million. The sale resulted in a pretax gain of $58.5 million which will be reported in the first quarter of 1994. SFAS 115: In the fourth quarter of 1993, the Company adopted SFAS 115. Accordingly, certain of the Company's investments, principally M.I.M., have been classified as available-for-sale securities and are reported at their fair value of $482.6 million compared to a historical cost of $309.1 million. The unrealized gains of $173.4 million are reported as a separate component of stockholders' equity, before deferred taxes of $60.7 million. Investments accounted for using the equity method of accounting (SPCC) and investments which do not have readily determinable fair market values (MEDIMSA), are not affected by this accounting principle. A42 Investments in Associated Companies - ----------------------------------- (in millions - U.S. dollars) A43 GAAP-Generally Accepted Accounting Principles (a) Quoted market prices on Asarco's investments in MEDIMSA and SPCC are not available since the shares are not publicly traded. It is not cost effective to estimate fair value; however, in management's opinion, the fair value is equal to or exceeds the carrying amount. (b) Translated into U.S. dollars at the rate in effect at December 31, 1992 ($1 U.S. = MN$3.123). December 31, 1993 financial statements are not available. (c) Translated at the average exchange rates of $1 U.S. = MN$3.114 in 1993 (MN$3.089 - 1992; MN$2.949 - 1991). (d) Includes an adjustment of $(4.6) million in 1991 to reflect the differences between U.S. and Mexican accounting standards. Effective with the second quarter of 1991, MEDIMSA is accounted for using the cost method. (e) Investment classified as available-for-sale security, and is reported at fair value, including unrealized gain of $172.3 million. Fair value is based on the December 31, 1993 closing market price of MIM's shares on the Sydney (Australia) Stock Exchange. Fair value is not necessarily indicative of an amount realizable in the event of a sale. (f) Includes $26.4 million of previously unrecognized equity earnings and $86.3 million (Asarco share) relating to the adoption of SFAS 109 by SPCC. (g) Includes $165 million relating to the adoption of SFAS 109 by SPCC. (h) $31.4 million from pro-rata repurchase of shares by SPCC in 1991. Asarco reduced its carrying value in SPCC by the amount of these proceeds. (7) Property - ------------- Property is stated at cost and consists of the following: Accumulated depreciation applicable to capitalized leases amounted to $39.9 million in 1993, $27.0 million in 1992 and $16.5 million in 1991, including depreciation charged to earnings of $13.4 million in 1993, $11.1 million in 1992 and $6.5 million in 1991. An increase in the proven and probable ore reserves at the Ray mine resulting from normal reassessments had the effect of lowering depreciation by $3.7 million in 1992. In the fourth quarter of 1993, the Company recorded a pre-tax charge of $13.2 million to provide for the closure and sale of a secondary metal processing plant, a zinc plant, and its pipe business. In 1992, the Company recorded a pre-tax charge of $31.9 million to reduce the carrying value of certain facilities, primarily at the El Paso, Texas smelter, which were unlikely to be used following the completion of the modernization and expansion program at the copper smelter in 1993. (8) Contingencies and Litigation - --------------------------------- The Company is a defendant in a lawsuit brought on behalf of classes of persons who live or have lived within a two mile radius from the site of the Company's former smelter located in Tacoma, Washington, seeking damages and medical monitoring due to substances allegedly emitted from the smelter. A44 The Company and two subsidiaries, as of December 31, 1993, are defendants in 726 lawsuits brought by 13,940 primary and 11,329 secondary plaintiffs seeking substantial actual and punitive damages for personal injury or death allegedly caused by exposure to asbestos as well as four lawsuits for removal or containment of asbestos-containing products in structures. In addition, the Company and certain subsidiaries are defendants in product liability lawsuits involving various other products, including metals. The Company is a defendant in lawsuits in Arizona brought by Indian Tribes and some other Arizona water users contesting the right of the Company and numerous other individuals and entities to use water and, in some cases, seeking damages for water usage and contamination of ground water. The lawsuits could potentially affect the Company's use of water at its Ray Complex, Mission Complex and other Arizona operations. The Company and certain of its subsidiaries have received notices from the United States Environmental Protection Agency ("EPA") that they and in most cases numerous other parties are potentially responsible to remediate alleged hazardous substance releases at certain sites under the Comprehensive Environmental Response, Compensation and Liability Act of 1980 ("CERCLA" or "Superfund"). In addition, the Company and certain of its subsidiaries are defendants in lawsuits brought under CERCLA or state laws which seek substantial damages and remediation. Remedial action is being undertaken by the Company at some of the sites. In connection with the sites referred to above, as well as at other closed plants and sites where the Company is working with the EPA and state agencies to resolve environmental issues, the Company has made reasonable estimates, where possible, of the extent and cost of necessary remedial action and damages. As a result of feasibility studies, public hearings, engineering studies and discussions with the EPA and similar state agencies, for sites where it is probable that a liability has been incurred and the amount of cost could be reasonably estimated, the Company recorded pre-tax charges to earnings in 1990 of $75.5 million and in 1992 of $72.4 million. Recorded reserves for these matters total $116.1 million at December 31, 1993. The Company anticipates that expenditures relating to these reserves will be made over the next several years. Net cash expenditures charged to these reserves were $44.3 million in 1993, $35.6 million in 1992 and $32.2 million in 1991. Future environmental related expenditures cannot be reliably determined in many circumstances due to the early stages of investigation, the uncertainties relating to specific remediation and clean-up methods and therefore the related costs, the possible participation of other potentially responsible parties, insurance coverage issues and changing environmental laws and interpretations. It is the opinion of management that the outcome of the legal proceedings and environmental contingencies mentioned, and other miscellaneous litigation and proceedings now pending, will not materially adversely affect the financial position of Asarco and its consolidated subsidiaries. However, it is possible that future environmental contingencies could have a material effect on quarterly or annual operating results, when they are resolved in future periods. This opinion is based on considerations including experience related to previous court judgments and settlements and remediation costs and terms. The financial viability of other potentially responsible parties has been considered when relevant and no credit has been assumed for any potential insurance recoveries when the availability of insurance has not been determined. A45 (9) Debt and Available Credit Facilities - ----------------------------------------- The fair value of the debt instruments was determined using quoted market prices of publicly traded securities, or securities of similar maturities and credit ratings. Maturities of debt instruments and future minimum payments under capital leases as of December 31, 1993 are as follows: Total interest paid (excluding amounts capitalized of $4.0 million in 1993, $7.4 million in 1992 and $12.3 million in 1991) was $51.1 million in 1993, $52.6 million in 1992 and $41.7 million in 1991. Debt securities in the amount of $250 million were issued in 1993 including $100 million of 7 3/8% Notes due in 2003, $100 million of 7 7/8% Debentures due in 2013 and $50 million of 7% Notes due in 2001. The Company has two revolving credit agreements that permit borrowings of up to $686.7 million, of which approximately $339 million was available at December 31, 1993. One facility allows the Company to borrow up to $366.7 million as of December 31, 1993, after which the facility will decline by $36.7 million quarterly until 1996. The second facility expires in March 1998. Borrowings under these agreements bear interest based on LIBOR, the CD or the prime rate, and averaged 3.8% at December 31, 1993. Rates may vary based upon the Company's debt rating. A commitment fee of 1/8% per annum is payable on the unused portion of the $366.7 facility in addition to a 1/8% per annum fee on the full amount of the facility. A commitment fee of 1/4% per annum is payable on the unused portion of the other facility. A46 The highest level of revolving credit borrowings during 1993 was $535.0 million (1992-$535.0 million; 1991-$450.0 million). Borrowings under these agreements averaged $397.7 million for 1993 (1992-$465.4 million; 1991-$390.3 million), with a weighted average interest rate of 3.7% in 1993 (1992-4.2%; 1991-6.5%). Under the most restrictive terms of the agreements, the Company must maintain a tangible net worth, as defined, of at least $1 billion. Tangible net worth was $1.4 billion at December 31, 1993. The ratio of current assets to current liabilities cannot be less than 125% and at December 31, 1993 this ratio was 153%. During 1991 the Company entered into two sale and leaseback transactions for mobile mining equipment and railroad rolling stock. Proceeds from these transactions were used principally to replace interim financing which was used to fund property additions. In January 1994, the Company prepaid its 9 3/4% Sinking Fund Debentures at par value plus a premium of .9%, using a portion of the proceeds of the 7% Notes issued in December 1993. The Company has two agreements expiring in 1994 which fix the rate on a notional $7.0 million of its variable-rate debt. During 1993, agreements covering $105.4 million of notional debt expired. The effect of the remaining agreements is to limit the interest rate exposure to 12.7% and is recorded as an adjustment to interest expense which resulted in 1993 in a $2.4 million charge (1992-$5.3 million; 1991-$2.5 million). The Company has exposure to credit risk but does not anticipate nonperformance by the counterparties to these agreements. (10) Stockholders' Equity - -------------------------- The Company purchased 5,393 of its common shares in 1993 (1992-5,649 shares; 1991-67,314 shares). In 1993, 256,620 common shares (1992-223,568 shares; 1991- 211,163 shares) were used for savings, stock option and incentive plans. The effect on the calculations of net earnings per common share of the Company's common stock equivalents (shares under option) was insignificant. Retained earnings at December 31, 1993, included undistributed earnings of $260.2 million for nonconsolidated subsidiaries and $263.0 million for all other investments. Retained earnings has been increased by cumulative foreign currency adjustments of $1.6 million at December 31, 1993 ($0.1 million in 1992; $6.6 million in 1991). In 1993, a charge of $0.6 million was transferred from cumulative foreign currency adjustments and used to determine the gain on the sale and dilution of ownership interest in Asarco Australia. Stockholders' equity at December 31, 1993 has been increased by $112.7 million for the unrealized gains on securities classified as available-for-sale (net of deferred taxes of $60.7 million). Stock Options: The Company has a stockholder-approved Stock Incentive Plan and a Stock Option Plan. The Stock Incentive Plan replaces the Stock Option Plan. No additional options will be granted under the Stock Option Plan and unexpired options continue to be governed by, and exercised under, the Stock Option Plan. The Stock Incentive Plan provides for the granting of nonqualified or incentive stock options, as defined under current provisions of the Internal Revenue Code, as well as for the award of restricted stock and bonuses payable in stock. The option price for options granted under the Stock Incentive Plan shall not be less than 100% of the fair market value of the Common Stock on the date of grant in the case of incentive stock options, or 50% in the case of other options. In general, options expire after 10 years and are not exercisable for six months from the date of grant. A47 Options granted may provide for "Stock Appreciation Rights" (SARs). An SAR permits an optionee, in lieu of exercising the option, to receive from the Company payment in an amount equal to the difference between the market value of the stock on the date of exercise of the SAR and the purchase price of the stock under the terms of the option. At December 31, 1993, twenty individuals held SARs covering options for 550,882 shares, ranging in price from $18.00 to $29.69 per share, exercisable as either regular stock options or SARs. The authorized number of shares under the Stock Incentive Plan is 2,000,000 of which 300,000 shares may be awarded as restricted stock. As of December 31, 1993, 1,029,050 shares are available for future grants under the Stock Incentive Plan. Stock option activity over the past three years under the Stock Incentive Plan and Stock Option Plan is summarized as follows: In 1989, the Company adopted a Shareholder Rights plan and declared a dividend of one Right for each of its Common Shares. In certain circumstances, if a person or group becomes the beneficial owner of 15% or more of the outstanding common shares (or in the case of MIM, more than 33 1/3%), with certain exceptions, these rights vest and entitle the holder to certain share purchase rights. In connection with the Rights dividend, 800,000 shares of Junior Participating Preferred Stock were authorized for issuance upon exercise of the Rights. (11) BENEFIT PLANS - ------------------- The Company maintains several noncontributory, defined benefit pension plans covering substantially all employees. Benefits for salaried plans are based on salary and years of service. Hourly plans are based on negotiated benefits and years of service. The Company's funding policy is to contribute amounts to the plans sufficient to meet the minimum funding requirements set forth in the Employee Retirement Income Security Act of 1974, plus such additional amounts as the Company may determine to be appropriate from time to time. Plan assets are invested principally in commingled stock funds and United States government securities. A48 Net pension costs consist of: The funded status of the plans using the projected unit credit method is presented below: The actuarial computations presented above are based upon a discount rate on benefit obligations of 7% in 1993 and 8% in 1992 and 1991; an expected long-term rate of return on plan assets of 10%; and annual salary increases of 4% in 1993 and 5% in 1992 and 1991. Noncontributory postretirement health care coverage under the Asarco Health Plan is provided to substantially all retirees not eligible for Medicare. A cost sharing Medicare supplement plan is available for retired salaried employees and life insurance coverage is provided to substantially all retirees. In 1992 the Company adopted SFAS 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions". The effect of adopting the new standard increased 1992 net periodic postretirement benefit cost by $3.2 million and decreased 1992 net income by $2.1 million. Postretirement benefit costs for 1991 of $5.1 million which were recorded on a cash basis, have not been restated. In addition, the projected benefit obligation of $54.0 million (net of tax benefit of $27.8 million) related to prior service cost was recognized as the cumulative effect of a change in accounting principle as of January 1, 1992. A49 The following sets forth the plan's status reconciled with amounts reported in the Company's Consolidated Balance Sheet: Net periodic postretirement benefit cost included the following components: The weighted-average annual assumed rate increase in the per capita cost of covered benefits (i.e., health cost trend rate) is 10% for 1993 (11% for 1992) and is assumed to decrease gradually to 5% for 1999 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 rates by one percentage point in each year would increase the accumulated postretirement benefit obligation as of December 31, 1993 by $7.0 million, and the aggregate of the service and interest cost components of net periodic postretirement benefit cost for 1993 by $.8 million. The weighted-average discount rate used in determining the accumulated postretirement benefit obligation was 7% at December 31, 1993 (8 1/2%-1992). The plans are currently unfunded. (12) BUSINESS SEGMENTS - ----------------------- The Company operates principally in the nonferrous metals industry, involving mining, smelting, refining and selling of copper, silver, lead, and gold and mining and selling zinc and molybdenum in the form of concentrates. The Company is also engaged in specialty chemicals for metals plating and electronics industries and in minerals comprising limestone, sand and gravel operations. Included in the caption Other are the Company's polyvinyl chloride pipe and cement pipe businesses and its environmental services operations. Foreign operations are conducted by affiliates in Australia, Asia, Europe and North and South America. A50 General corporate administrative expenses are allocated among the segments generally in proportion to their operating expenses. Exploration expenses are attributable to the metals segment, while research expenses are attributable to metals and specialty chemicals. Identifiable assets are those directly used in the operations of each segment. Corporate assets are principally cash and investments. Export sales from the United States to unaffiliated customers were $278.3 million in 1993, $297.7 million in 1992 and $246.3 million in 1991. There can be no assurance that operations and assets of the Company and nonconsolidated associated companies that are subject to the jurisdiction of foreign governments may not be affected adversely by future actions by such governments. METAL SALES, EXCLUDING INTERSEGMENT SALES - ----------------------------------------- BUSINESS SEGMENTS AND LINES OF BUSINESS - --------------------------------------- A51 A52 Unaudited Quarterly Data - ------------------------ Accounting For Investments In Peru ---------------------------------- The following presents the 1993 and 1992 quarterly earnings (losses) of SPCC and Nor Peru including the cumulative effect of the change in accounting principle by SPCC, which were recognized by ASARCO as part of the $104.5 million recorded in the fourth quarter of 1993. The balance of $0.9 million relates to the period 1988 to 1991. Dividends received prior to the resumption of equity accounting were recorded as dividend income. A53 REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors and Stockholders of ASARCO Incorporated We have audited the accompanying consolidated balance sheets of ASARCO Incorporated and Consolidated Subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of earnings, cash flows, and changes in common stockholders' 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 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 ASARCO Incorporated and Consolidated 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 Note 6 to the financial statements, the Company changed its method of accounting for investments classified as available-for-sale, as of December 31, 1993 and its equity investee Southern Peru Copper Corporation changed its method of accounting for income taxes as of January 1, 1993. In addition, in 1992, as discussed in Note 11 to the financial statements, the Company changed its method of accounting for postretirement benefits other than pensions. COOPERS & LYBRAND 1301 Avenue of The Americas New York, New York January 25, 1994 A54 ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND - ------------------------------------------------------------------------ FINANCIAL DISCLOSURE -------------------- None PART III ITEMS 10, 11, 12 and 13 - ----------------------- Reference is made to Executive Officers of Asarco and Business Experience During the Past Five Years on page A24. Information in response to the disclosure requirements specified by these items appears under the captions and pages of the 1993 Proxy Statement indicated below: The information referred to above is incorporated herein by reference. A55 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 The following financial statements of ASARCO Incorporated and its subsidiaries are included at the indicated pages of the document as stated below: 2. Financial Statement Schedules The following schedules are included at indicated pages in this Annual Report on Form 10K: Schedules other than those listed above are omitted, as 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. Any other information omitted from schedules filed has been omitted due to immateriality. A56 3. Exhibits A57 A58 Item 14 Exhibit 23 REPORT OF INDEPENDENT ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULES To the Board of Directors and Stockholders of ASARCO Incorporated Our report on the consolidated financial statements of ASARCO Incorporated and consolidated subsidiaries has been included in this Form 10-K on page A53. In connection with our audits of such financial statements, we have also audited the related financial statement schedules which appear on pages B1 through B8 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. New York, New York January 25, 1994 COOPERS & LYBRAND CONSENT OF INDEPENDENT ACCOUNTANTS We consent to the incorporation by reference in the Prospectuses constituting part of the Registration Statements on Form S-3 (File No. 33-45631) and Form S-8 (File Nos. 2-83782, 2-67732 and 33-34606) of ASARCO Incorporated of our report dated January 25, 1994, appearing on page A53 of this Annual Report on Form 10- K. Our report includes an explanatory paragraph that describes the change in the method of accounting for investments classified as available-for-sale and its equity investee Southern Peru Copper Corporation's change in method of accounting for income taxes. In addition, in 1992, the Company changed its method of accounting for postretirement benefits other than pensions. We also consent to the incorporation by reference of our report on the financial statement schedules, which appears above. New York, New York January 25, 1994 COOPERS & LYBRAND A59 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: February 23, 1994 ASARCO Incorporated (Registrant) By /s/ Richard de J. Osborne ----------------------------- (Richard de J. Osborne, Chairman of the Board, Chief Executive Officer and President) Pursuant to 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: February 23, 1994 B1 B2 B3 B4 B5 B6 B7 B8 C1 SOUTHERN PERU COPPER CORPORATION AND CONSOLIDATED SUBSIDIARIES INDEX TO FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES Report of Independent Accountants C2 Consolidated Balance Sheets as of December 31, 1993 and 1992 C3-4 Consolidated Statements of Operations for the years ended December 31, 1993, 1992 and 1991 C5 Consolidated Statements of Cash Flows for the years ended December 31, 1993, 1992 and 1991 C6-7 Consolidated Statements of Stockholders' Equity for the years ended December 31, 1993, 1992 and 1991 C8 Notes to Consolidated Financial Statements C9-15 FINANCIAL STATEMENT SCHEDULES V - Property, plant and equipment for the years ended December 31, 1993, 1992 and 1991 C16 VI - Accumulated depreciation, depletion and amortization of property, plant and equipment for the years ended December 31, 1993 1992 and 1991 C17 X - Supplementary income statement information for the years ended December 31, 1993, 1992 and 1991 C18 NOTES Financial statement schedules other than the above are omitted because they are either not applicable, not required or the information is included in the notes to the financial statements. The individual financial statements of Southern Peru Copper Corporation have been omitted since the Company is primarily an operating company and the subsidiaries included in the consolidation are wholly owned. The financial statements and the related financial statement schedules referred to above are as submitted to the Registrant by Southern Peru Copper Corporation. C2 REPORT OF INDEPENDENT ACCOUNTANTS - -------------------------------------------------------------------------------- To the Board of Directors and Stockholders of Southern Peru Copper Corporation: We have audited the consolidated balance sheets of SOUTHERN PERU COPPER CORPORATION and CONSOLIDATED SUBSIDIARIES 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. We have also audited the financial statement schedules (pages C16 to C18, inclusive). 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. These 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 Southern Peru Copper Corporation and Consolidated 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 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 described in Note 2 to the consolidated financial statements, the Company changed its method of accounting for income taxes in 1993. New York, New York February 4, 1994 COOPERS & LYBRAND C3 See accompanying notes to consolidated financial statements. C4 See accompanying notes to consolidated financial statements. C5 See accompanying notes to consolidated financial statements. C6 C7 See accompanying notes to consolidated financial statements. C8 SOUTHERN PERU COPPER CORPORATION AND CONSOLIDATED SUBSIDIARIES CONSOLIDATED STATEMENTS of CHANGES IN STOCKHOLDERS' EQUITY FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 See accompanying notes to consolidated financial statements. C9 SOUTHERN PERU COPPER CORPORATION AND CONSOLIDATED SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - ------------------------------------------------------------------------------- 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: Principles of Consolidation: Southern Peru Copper Corporation (the Company) is a Delaware Corporation which prepares its financial statements in accordance with generally accepted accounting principles in the United States. The Company operates two copper mines and a smelter in Peru (Peruvian Branch) and substantially all of its assets are located there. The consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries. Certain reclassifications have been made in prior years' financial statements to conform to the 1993 presentation. Net Sales: Net sales represent the invoiced value of products containing copper, silver and molybdenum after deducting Peruvian sales and export taxes, commissions, insurance, freight, toll refining charges and hedging costs. Price estimates used for provisionally priced shipments are based on the Company's judgment of the current price level and its susceptibility to decline during the settlement period. Cash Equivalents: The Company considers all highly liquid investments with a maturity of three months or less when purchased to be cash equivalents. Marketable Securities: Marketable securities include liquid investments with a maturity of more than three months when purchased and are carried at cost, which approximates market value. Peruvian Tax Credits: Excess Peruvian tax credits are classified as prepaid expenses on the balance sheet and are utilized to either pay Peruvian taxes or are sold. The carrying value of the Peruvian tax credits approximates their market value. Inventories: Inventories are carried at the lower of average cost or market value. Property: Maintenance, repairs and gains or losses on assets retired or sold are reflected in earnings as incurred. The cost of renewals is capitalized and the property unit being replaced is retired. The cost of betterments is capitalized. Buildings and equipment are depreciated on the straight-line method over estimated lives from 5 to 34 years, or the estimated life of the mine if shorter. Mine development cost and the cost of Toquepala and Cuajone mineral lands are capitalized and charged to earnings on the unit-of-production method using economic ore reserves. Income Taxes: The Company adopted Statement of Financial Accounting Standards No. 109 "Accounting for Income Taxes" (SFAS No. 109) effective January 1, 1993. SFAS No. 109, issued in February 1992, requires the adoption of the "liability" method of calculating deferred taxes. Prior to the adoption of SFAS No. 109, the Company provided for income taxes under the provisions of APB No. 11. Deferred income taxes reflect the future tax consequences of differences between the tax bases of assets and liabilities and their financial reporting amounts at each year-end. C10 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED - ------------------------------------------------------------------------------- 2. CHANGE IN ACCOUNTING PRINCIPLE: The Company adopted SFAS No. 109 effective January 1, 1993. The cumulative effect of this change in accounting principle was a credit to income of $165.1 million and is shown separately on the Company's Consolidated Statement of Operations for the year ended December 31, 1993. The adoption of the new method resulted in an additional charge to 1993 net earnings of $4.1 million. 3. FOREIGN EXCHANGE CONTROL: All income, except for dividend and interest income of $1.5 million, $1.3 million and $7.4 million earned in the United States in 1993, 1992 and 1991, respectively, is derived from operations conducted by the Company's Peruvian Branch. Export proceeds are deposited directly to the Company's accounts, which can be maintained either in Peru or abroad. 4. PERUVIAN AND U.S. TAXES: Taxes on income represent Peruvian income taxes, except for provision (benefit) for U.S. taxes of ($1.5) million, $0.4 million and $2.5 million in 1993, 1992 and 1991, respectively, on income earned in the United States. United States taxes on foreign source income have been eliminated through the utilization of foreign taxes as either credits or deductions from taxable income. At December 31, 1993, the foreign tax credit carry forward available to reduce possible future U.S. income taxes amounted to approximately $67.8 million of which $23.8 million expires in 1994, $9.3 million expires in 1996 and $34.7 million expires in 1998. In addition, the Company has $0.2 million in Alternative Minimum Tax (AMT) credits which have no expiration dates. The Company has not recognized the benefit of existing foreign tax credits and AMT credits, since it is unlikely that realization will occur. The components of the Peruvian deferred tax liabilities (assets) are: *After the adoption of SFAS No. 109. Peruvian source income is taxed at graduated rates up to a maximum of 37% with monthly payments required. Income generated by the Cuajone mine, however, was subjected to a contract rate of 54.5% during the post-investment recovery period which concluded in October 1993. The results of the Cuajone mine were taxed at the lower general rate of 37% following the conclusion of the recovery period. Income taxes paid were $47.7 million, $60.0 million and $21.6 million in 1993, 1992 and 1991, respectively. C11 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED - ------------------------------------------------------------------------------- The Peruvian income tax at the maximum statutory rate is reconciled to the actual tax provisions as follows: Pursuant to a contract which expires in the year 2000, the Company delivers blister copper to Empresa Minera del Peru (Minero Peru), the Peruvian Government-owned Ilo refinery, for refining on toll. In 1993, the Company delivered 202,364 short tons of blister to Minero Peru for toll refining. 6. LABOR SHARES: Peruvian law in effect through 1991 provided that all employees in mining companies have increasing participation (up to a maximum of 33 1/3%) in profits, proceeds from liquidation and "management committees" of Peruvian branches of foreign companies. Employees participated in 10% of Branch results in two principal ways: (a) 4.5% of pre-tax profits payable in cash, hereafter referred to as liquid participation; and (b) 5.5% of pre-tax results, patrimonial participation, in the form of ownership shares and general debt obligations of the Branch. In October 1991, a legislative decree was issued changing the workers' participation law so that, effective 1992, workers had an 8% cash participation in pre-tax profits and no longer received patrimonial participation. Labor shares represented 17.5% of the Branch capital for the years 1993 and 1992, and 16.5% for 1991. C12 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED - ------------------------------------------------------------------------------- 7. DEBT AND AVAILABLE CREDIT FACILITIES: At December 31, 1993, the Company had $15.6 million outstanding in long-term debt, pursuant to various loan agreements described below, and no outstanding short-term borrowings. Lines of credit available for export financing at December 31, 1993, amounted to $28 million. Interest paid for short-term borrowings was $0.6 million, $1.7 million and $8.6 million in 1993, 1992 and 1991, respectively. The carrying value of the debt approximates its fair market value, since the interest rates are variable. The total amount of fees and interest paid relating to the long-term debt was $621,000. At December 31, 1993, the Company had three loan agreements that permit borrowings of up to $85 million, of which $69.4 million was available at December 31, 1993. One facility allows the Company to borrow up to $60.0 million until May 1995. The other two facilities allow for draw downs through December 31, 1994. Borrowings under these agreements bear interest based on LIBOR, Prime or other indices and averaged 8.01% at December 31, 1993. In addition, there are commitment fees ranging from approximately 0.37% to 0.75% on the unused balances of the Company's loan agreements. Aggregate maturities of the notes outstanding at December 31, 1993 are as follows: In addition to the loan agreements mentioned above, the Company has signed two additional loan agreements subsequent to December 31, 1993. On January 21, 1994, the Company signed a credit agreement to borrow up to $115 million. On January 25, 1994, the Company signed a second loan agreement for $50 million. The latter loan will be effective upon approval of the Japanese Ministry of International Trade and Industry (MITI). Under the most restrictive terms of the agreements, the Company must maintain a debt to equity ratio, as defined, which cannot exceed 80%. This ratio was 3% at December 31, 1993. In addition, the ratio of current assets to current liabilities, as defined, cannot be less than 150% and at December 31, 1993, this ratio was 497%. Dividends are limited to a portion of net income, as defined, and by debt service coverage ratios, as defined. One of the agreements, signed in January of 1994, may require the Company to hedge up to 130,000 metric tons of its annual production based on defined conditions. As of December 31, 1993 the Company had purchased put options with an exercise price of $0.70 per pound in compliance with the loan agreement. These options are accounted for as hedges and the cost of these options and any gains are reported as a component of the related sales transactions. 8. PENSION BENEFIT PLAN: The Company has a noncontributory, defined benefit pension plan covering the salaried employees in the United States and the expatriate employees in Peru. Benefits are based on salary and years of service. The Company's funding policy is to contribute amounts to the plan sufficient to meet the minimum funding requirements set forth in the Employee Retirement Income Security Act of 1974, plus such additional amounts as the Company may determine to be appropriate from time to time. Plan assets are primarily invested in guaranteed investment contracts with the Metropolitan Life Insurance Company of New York. The net pension costs consist of: C13 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED - -------------------------------------------------------------------------------- The funded status of the plan using the projected unit credit method is: The actuarial computations are based upon a discount rate on benefit obligations of 7%, an expected long-term rate of return on plan assets of 8%, and annual salary increases of 4%. The pension information for 1992 is not presented due to immateriality. C14 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED - -------------------------------------------------------------------------------- 9. Common Stock: At December 31, 1993, the stockholders of the Company were as follows: The Company declared and paid cash dividends of $18 million and $15 million in 1993 and 1992, respectively. Additionally, in 1991, the Company purchased 13.8 percent of its previously outstanding shares from its stockholders pro rata for an aggregate purchase price of $60 million. The repurchased shares are held in the Company's treasury and are available for issuance for general corporate purposes. 10. RELATED PARTY TRANSACTIONS: ASARCO Incorporated (ASARCO), a stockholder of the Company, provides various support services to the Company. In 1993 and 1992, these activities were principally related to legal, tax and treasury support services. In 1991, these services also included the purchase and shipment of materials to the Company's operations in Peru. The amounts paid to ASARCO for these services were $0.4 million, $0.2 million and $1.0 million in 1993, 1992 and 1991, respectively. Sales to ASARCO and other affiliates are disclosed in Note 5. Fomenta, S.A., a wholly owned Peruvian subsidiary, holds a 19% interest in the capital of Metalurgica Peruana S.A., (MEPSA). MEPSA, a Peruvian company, is engaged in the manufacture of metallurgical products used in the mining industry. The Company purchases grinding media from MEPSA for use at the Company's concentrators. Purchases were $5.3 million, $6.7 million and $9.7 million in 1993, 1992 and 1991, respectively. 11. CUAJONE JOINT VENTURER: In September 1991, the Company purchased the Joint Venture interest in the Cuajone mine from Billiton, B.V. for $15.2 million, to be paid in annual installments through 1996. Provision exists, however, for acceleration of these payments as stockholder dividends are made. Under the terms of this agreement, $4.3 million, $4.2 million and $2.5 million were paid in 1993, 1992 and 1991, respectively. The 1993 and 1992 amounts include acceleration payments of the entire 1996 installment and part of the 1995 installment. Therefore, as of December 31, 1993, only the 1994 and 1995 installments remain outstanding. Prior to the purchase, the participation of the Joint Venturer in the net earnings of the Company represented a pro rata allocation of Cuajone net earnings based on the percentage of equity contribution made by the Joint Venturer to the Cuajone operation. Cash distributions were made in accordance with terms of the Joint Venture agreement, and were consequently determined by other factors as well as net earnings. 12. COMMITMENTS AND CONTINGENCIES: Refining Assessment: In 1986 and 1987, Minero Peru claimed additional refining charges for the period 1981 through March 1987 from the Company and two of its blister customers. The Company negotiated with Minero Peru on behalf of all parties and agreed to reimburse the two blister customers involved for their pro rata portion of any negotiated settlement. Claims for all years concern the application of escalator clauses in toll refining contracts. Claims for the period 1983 through March 1987 were settled in 1988. During 1993, the assessment claims relating to the 1981 and 1982 years was settled by arbitration in the Company's favor. This resulted in the reversal of prior years' accruals of $11.1 million which is included in 1993's earnings. C15 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED - ------------------------------------------------------------------------------- CUAJONE INVESTMENT RECOVERY: In December 1991, the Company and the Government of Peru entered an agreement resolving all open issues concerning the conclusion of the investment recovery contract which governed the development and operation of the Cuajone mine. The Company agreed to undertake a $300 million investment program over the five years 1992-1996, and the Peruvian Government agreed not to discriminate against the Company in comparison with treatment given to other mining companies. As part of this agreement, in 1991 the Company transferred $55 million from its accounts in New York to an account with the Central Reserve Bank of Peru, to be withdrawn by the Company at its discretion solely for application to the $300 million investment program. At December 31, 1993, the balance of this account with the Central Reserve Bank of Peru was $58.3 million. The projects specified in the investment program are in various stages. External financing, as described in Note 7 above, has been obtained by the Company for use in the investment program. Litigation: On February 26, 1993, the Mayor of Tacna brought a lawsuit against the Company seeking $100 million in damages from alleged harmful deposition of tailings and slag, and smelter emissions. In another lawsuit previously brought by the Mayor of Tacna, also relating to the disposal of mine tailings, the Peruvian Supreme Court has ruled that the Company must cease its current method of disposal. The Company has submitted plans to the Ministry of Mines and Energy and is awaiting the Ministry's approval for modifying the tailings disposal. Adoption of the modified tailings disposal plan should, in the Company's belief, resolve this matter. In another pending lawsuit, a group named the Association of Retired Employees of Southern Peru Copper Corporation has challenged the accounting of the Company's Peruvian branch and its allocations of financial results to the Mining Community in the 1970's. It is the opinion of the Company's management that the outcome of the legal proceedings mentioned, and other miscellaneous litigation and proceedings now pending, will not materially adversely affect the financial position of the Company and its consolidated subsidiaries. C16 C17 (a) Does not include $5,534 relating to the amortization of goodwill. C18 D1 Form 10K ASARCO Incorporated EXHIBIT INDEX Exhibit Indexed No. Description on page - ------- ----------- ------- 3. Certificate of Incorporation and By-Laws (a) Certificate of Incorporation - restated, filed May 4, 1970 (Filed as an Exhibit to the Company's 1980 Annual Report on Form 10-K and incorporated herein by reference) (b) Certificate of Amendment to the Certificate of Incorporation effective April 23, 1975 (Filed as an Exhibit to the Company's 1980 Annual Report on Form 10-K and incorporated herein by reference) (c) Certificate of Amendment of Certificate of Incorporation executed April 14, 1981 (Filed as an Exhibit to the Post-Effective Amendment No. 8 to Registration Statement No. 2-47616, filed April 30, 1981 and incorporated herein by reference) (d) Certificate of Amendment of Restated Certificate of Incorporation filed on May 6, 1985 (Filed as an Exhibit to the Company's Quarterly Report on Form 10-Q for the quarter ended March 31, 1985 and incorporated herein by reference) (e) Certificate of Amendment of Certificate of Incorporation filed July 21, 1986 (Filed as an Exhibit to the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1986 and incorporated herein by reference) (f) Certificate of Amendment of Restated Certificate of Incorporation, as amended filed April 22, 1987 (Filed as an Exhibit to the Company's 1987 Annual Report on Form 10-K and incorporated herein by reference) (g) Statement of Cancellation filed July 31, 1987 whereby 155,000 shares of Series A Cumulative Preferred Stock and 862,500 shares of $9.00 Convertible Exchangeable Preferred Stock were cancelled (Filed as an Exhibit to the Company's 1987 Annual Report on Form 10-K and incorporated herein by reference) (h) Statement of Cancellation filed November 20, 1987 whereby 1,026,900 shares of Series A Cumulative Preferred Stock were cancelled (Filed as an Exhibit to the Company's 1987 Annual Report on Form 10-K and incorporated herein by reference) (i) Statement of Cancellation filed December 18, 1987 whereby 1,250,000 shares of Series B Cumulative Convertible Preferred Stock were cancelled (Filed as an Exhibit to the Company's 1987 Annual Report on Form 10-K and incorporated herein by reference) (j) Statement of Cancellation filed March 3, 1988 whereby 27,000 shares of Series A Cumulative Preferred Stock were cancelled (Filed as an Exhibit to the Company's 1987 Annual Report on Form 10-K and incorporated herein by reference) D2 Form 10K ASARCO Incorporated EXHIBIT INDEX (Continued) Exhibit Indexed No. Description on page - ------- ----------- ------- (k) Certificate of Amendment of Restated Certificate of Incorporation, as amended, filed August 7, 1989 (Filed as an Exhibit to the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1989 and incorporated herein by reference) (l) By-Laws as last amended on June 26, 1991 (Filed as an Exhibit to the Company's 1991 Annual Report on Form 10-K and incorporated herein by reference.) 4. Instruments defining the rights of security holders, including indentures (a) There are currently various separate indentures, agreements or similar instruments under which long-term debt of Asarco is currently outstanding. The Registrant hereby agrees to furnish to the Commission, upon request, a copy of any of the instruments which define the rights of holders of long-term debt securities. None of the outstanding instruments represents long-term debt securities in excess of 10% of the total assets of Asarco as of December 31, 1993 (b) Form of Rights Agreement dated as of July 26, 1989, between the Company and First Chicago Trust Company of New York, as Rights Agent, defining the rights of shareholders under a July 1989 Shareholders' Rights plan and dividend declaration (Filed as an Exhibit to the Company's report on Form 8-K filed on July 28, 1989 and incorporated herein by reference) (c) Rights Agreement Amendment dated as of September 24, 1992, between the Company and The Bank of New York, as Successor Rights Agent under the Rights Agreement listed above (Filed as an Exhibit to the Company's 1992 Annual Report on Form 10-K and incorporated herein by reference) (d) Indenture Agreement dated as of February 1, 1993 between the Company and Bankers Trust Company, as Trustee, covering the issuance of debt securities registered by the Company in April 1992, not to exceed $250 million (Filed as an Exhibit to the Company's 1992 Annual Report on form 10-K and incorporated herein by reference) 10. (a) Stock Option Plan as amended through November 24, 1987 (Filed as an Exhibit to the Company's 1988 Annual Report on Form 10-K and incorporated herein by reference) (b) Form of Employment Agreement entered into in 1985, as amended in March and April 1989, among the Company and currently 12 of its executive officers, including Messrs. R. de J. Osborne, F.R. McAllister, A.B. Kinsolving, R.J. Muth and R.M. Novotny (Filed as an Exhibit to the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1989 and incorporated herein by reference) (c) Deferred Fee Plan for Directors, as amended through D9-D13 January 26, 1994 (d) Supplemental Pension Plan for Designated Mid-Career Officers, as amended through January 31, 1990 (Filed as an Exhibit to the Company's 1989 Annual Report on Form 10-K and incorporated herein by reference) D3 ASARCO Incorporated EXHIBIT INDEX (Continued) Exhibit Indexed No. Description on page - ------- ----------- ------- (e) Retirement Plan for Non-Employee Directors, as amended through January 25, 1989 (Filed as an Exhibit to the Company's 1988 Annual Report on Form 10-K and incorporated herein by reference) (f) Directors' Stock Award Plan, as amended through January 27, 1993 (Filed as an Exhibit to the Company's 1992 Annual Report on Form 10-K and incorporated herein by reference) (g) Stock Incentive Plan adopted by the Company's Shareholders on April 25, 1990 (Filed as an Exhibit to the Company's 1990 Annual Report on Form 10-K and incorporated herein by reference) 11. Statement re Computation of Earnings Per Share D-4 21. Subsidiaries of the registrant D-5 - D-8 23. Report of Independent Accountants on Financial Statement Schedules and Consent of Independent Accountants are included on page A58 of this Annual Report on Form 10-K. Report on Form 11-K relating to the Savings Plan for Salaried Employees of ASARCO Incorporated and Participating Subsidiaries is to be filed by amendment on Form 8. Copies of exhibits may be acquired upon written request to the Treasurer and the payment of processing and mailing costs.

710979_1993.txt

710979_1993

1993

710979

Item 1. Business GENERAL The Company is an international entertainment company with businesses operating in the home video, music retailing and filmed entertainment industries. The Company also has investments in other entertainment related businesses. The Company was incorporated in the State of Delaware in December 1982. HOME VIDEO RETAILING Since July 1985, the Company has been engaged in the home video retailing business, which accounted for 72%, 94% and 100% of the Company's total revenue in 1993, 1992 and 1991, respectively. Over the past five years, the Company has rapidly expanded its home video operations through the development, acquisition and franchising of stores. The following table sets forth the number of video stores in operation as of December 31 for each of the years indicated: Company-owned video stores at December 31, 1993 included 1,803 stores operating under the "Blockbuster Video" trade name, 775 stores operating under the "Ritz" trade name and 120 stores operating under the "Video Towne," "Alfalfa," "Movies at Home" and "Movieland" trade names which the Company acquired in November 1993 as a result of its acquisition of Super Club Retail Entertainment Corporation and subsidiaries ("Super Club"). The Blockbuster video system operates in 49 states in the United States and in nine foreign countries. All financial data, including the number of stores, has been restated to reflect the Company's merger with WJB Video Limited Partnership and certain of its affiliates ("WJB") in August 1993 in a transaction accounted for under the pooling of interests method of accounting. THE HOME VIDEO INDUSTRY The home video industry has experienced substantial growth since 1980. This growth is largely a result of the increase in the number of videocassette recorders ("VCRs") in use both domestically and internationally. Technological advances have improved the dependability, portability, picture quality and convenience of VCRs. Furthermore, many VCRs are now moderately priced. These factors have enhanced significantly the consumer appeal of VCRs. According to Paul Kagan Associates, Inc., VCR unit sales in the United States have remained relatively constant during the past five years, averaging approximately 12,000,000 units per year, while VCR market penetration in the United States has grown significantly, increasing from 53.3% in 1987 to 80.5% in 1993. VCR penetration continues to increase in many areas of the world in which the Company currently has operations, including Europe, the Pacific Rim and Central and South America. By the end of 1994, VCR penetration is expected to increase to approximately 77% in Australia, 74% in the United Kingdom, 75% in Canada and 72% in Japan, according to industry analysts. The Company believes that VCR unit sales in 1994 will continue to remain strong both in the United States and foreign countries as VCR penetration and the number of households owning more than one VCR continue to increase. However, annual increases in VCR penetration levels may continue to be less than in the past as a result of the constantly increasing base of VCRs. There can be no assurance that VCR penetration will continue to increase. The consumer market for feature and other films on prerecorded videocassette is a rental and sales market. An analysis of estimated historical and projected retail home video revenue in the United States (in billions) is as follows: _____________________ Source: Paul Kagan Associates, Inc. According to Paul Kagan Associates, Inc., total worldwide retail home video revenue was $25.3 billion in 1993, up from $23.6 billion in 1992, $22.1 billion in 1991 and $20.7 billion in 1990. New release feature films on videocassette have generally been priced for retail sale in the United States at approximately $60 to $99. This price range tends to discourage retail consumer purchases. In recent years, movie producers have released certain new release feature films priced for retail sale at approximately $15 to $30. This price level has resulted in more unit sales in the United States for these new release feature films than would have been the case at higher retail prices. The Company believes that in the absence of additional significant reductions in feature film retail sales prices, the consumer market in the United States for videocassettes will be primarily a rental market in the foreseeable future. In the event of a significant reduction in retail sales prices, the Company would be able to devote more space in its stores for display of prerecorded videocassettes for sale, although there can be no assurance that such a change would not have a material adverse effect on the Company's results of operations. The Company intends to increase its share of the domestic home video market as the industry continues to grow. Additional video stores are also scheduled to be opened in 1994 in various international markets, including Japan, Europe, Australia, Canada and Mexico and in other areas of Central and South America, by the Company and its franchise owners. COMPANY HOME VIDEO OPERATIONS The Company owns, operates and franchises Blockbuster Video stores. These stores rent and sell prerecorded videocassettes and other entertainment software, as well as sell confectionary items and video accessories. Blockbuster Video stores generally carry a comprehensive selection of 7,000 to 13,000 prerecorded videocassettes, consisting of more than 5,000 titles. The Company believes, based on industry trade publications and its informal inspection of competitors, that Blockbuster Video stores generally offer a greater number of copies of the more popular titles, have greater selection, stay open for longer hours and have faster and more convenient computerized check-in/check-out procedures than most of its competitors. The Company's home video stores do not sell video hardware. Blockbuster Video stores, however, offer customers a limited number of video hardware units for rental. Based on a survey published in the December 1993 issue of Video Store Magazine, the Company believes that the Company's and its franchise owners' systemwide revenue from the rental and sale of prerecorded videocassettes is significantly greater than that of any other home video retail chain in the United States. The Company believes that Blockbuster Video stores are generally larger than most home video retail stores, ranging in size from approximately 3,800 to 11,500 square feet. It is the Company's current intention that all new Company-opened Blockbuster Video stores will be no less than 5,500 square feet in size and that the square footage of its smaller Blockbuster Video stores will be increased where appropriate. Company-owned Blockbuster Video stores generally are, and it is anticipated that most future stores developed by the Company will be, highly visible and located in free-standing structures or at the end of strip shopping centers with ample parking facilities. Blockbuster Video stores are designed and located to be highly visible and to attract their own customers rather than to rely solely on customers generated by neighboring stores. Based on current Blockbuster Video store design and operating criteria, each Company-owned Blockbuster Video store generally requires a capital expenditure, including purchase of initial inventories, of between $375,000 and $700,000, depending on the size and location of the store, leasehold improvement costs and the number of videocassettes and other products stocked for rental and sale. The proprietary computer software used in each Blockbuster Video store has been designed and developed by the Company, and is available only to Company-owned and franchise-owned Blockbuster Video stores and to other video stores which are to be converted to the Blockbuster Video format. The Company developed its computerized point-of-sale system to simplify rental and sale transactions. This system utilizes a laser bar code scanner to read key data from products and from the member's identification card. This system provides management with a daily summary report for financial control of each store and considerable information concerning demographics of each Blockbuster Video store's membership, rental and sale patterns and the number of times each item or title in inventory has been rented or sold. The Company believes this information to be a valuable asset as it relates to its buying and marketing decisions. Since the acquisition of Cityvision plc ("Cityvision") in February 1992, the Company has operated video stores under the trade name "Ritz" in the United Kingdom. These stores average approximately 1,100 square feet in size with, on average, approximately 3,000 videocassettes available for rental and sale. Since the acquisition of Super Club in November 1993, the Company has operated video stores under the trade names "Video Towne", "Alfalfa", "Movies at Home" and "Movieland" in the United States. These stores average approximately 6,700 square feet in size with, on average, approximately 5,000 videocassettes available for rental and sale. The Company has a policy of excluding titles which have been rated either "X" or "NC-17" by the Motion Picture Association of America ("MPAA") from the videocassette inventory of each of its Blockbuster Video stores. The Company also has a Youth Restricted Viewing Program that allows parents to restrict their children under 17 years of age from renting movies that have been rated "R" by the MPAA or movies that have similar themes or content. FRANCHISING In order to maximize its ability to expand rapidly in the home video business, the Company has employed a strategy of developing Blockbuster Video stores through a combination of Company and franchise development. The extent to which a domestic or international market is to be developed, and the balance between Company and franchise development in a given market, is determined by evaluating a number of different criteria, including resources available and operating efficiencies. As of March 1994, the Company's franchise owners are committed under their franchise agreements to open 558 additional Blockbuster Video stores. Under the Company's current franchising program, the Company will grant to a franchise owner the right to develop one or a specified number of Blockbuster Video stores at an approved location or locations within a defined geographic area pursuant to the terms of a development agreement. The franchise owner generally is charged a development fee in advance for each Blockbuster Video store to be developed during the term of the development agreement. Each of the Company's development agreements provides that if a franchise owner fails to open the minimum number of Blockbuster Video stores required by the agreement, the franchise owner may lose exclusivity for the development area as well as the right to open additional Blockbuster Video stores. Prior to the opening of a Blockbuster Video store, the franchise owner enters into the Company's standard franchise agreement. This form of agreement governs the operation of a single Blockbuster Video store during a term of 20 years and in certain circumstances gives the franchise owner the right to renew the franchise agreement for an additional five-year term. At the time the franchise agreement is executed, the franchise owner generally is required to pay to the Company a franchise fee for the right to operate under the Blockbuster Video service marks and a software license fee for the right to use required proprietary software. After a Blockbuster Video store is opened, the franchise agreement requires the franchise owner to pay the Company a continuing royalty and service fee (currently, franchise owners pay fees ranging from 3% to 8% of gross revenue) and a continuing monthly payment for maintenance of the proprietary software. Franchise owners are also required to contribute funds for the development of national advertising and marketing programs and are required to spend an additional amount for local advertising. Each franchise owner has sole responsibility for all financial commitments relating to the opening and operation of Blockbuster Video stores in the franchised territory, including rent, utilities, payroll and other incidental expenses. The Company provides extensive product and support services to its franchise owners and derives income from providing these services. These products and support services include, among other things, site selection reviews, the packaging of the initial rental inventory and providing computer hardware and software. DISTRIBUTION AND INVENTORY MANAGEMENT ACTIVITIES The Company believes that the success of Blockbuster Video stores depends, in part, on effective and timely distribution and inventory management activities. For its distribution center, the Company leases a facility of approximately 69,000 square feet in Dallas, Texas. The Dallas facility, which has storage capacity for over 400,000 videocassettes, is used for shipping, receiving and packaging rental inventories according to the Company's uniform standards. This packaging process involves removing each rental videocassette from its original carton, applying labels and security devices to each videocassette, matching each videocassette with its bar coded information and placing the videocassette into its hard plastic rental case. In addition, a display carton is created for each videocassette by inserting foam and a security device into the original videocassette carton and shrink wrapping the carton. The end result of the packaging process for a Blockbuster Video store's initial rental inventory is a shipment that arrives already sorted alphabetically within categories and ready to be placed on display shelves. This level of packaging and distribution service is enhanced by the Company's automated packaging lines. The Company also provides computer software and hardware, and substantially all related items and fixtures necessary to equip and operate a Blockbuster Video store. The Company has established an inventory management department to select and purchase titles to be carried in Blockbuster Video stores. Several hundred new titles are released every month which are reviewed and evaluated by the inventory management department. This department selects appropriate titles for inclusion in the Company-owned Blockbuster Video stores and recommends to the Company's franchise owners and managers of Company-owned stores the number of copies to be placed in their inventories. Prerecorded videocassettes and other entertainment software rented and sold by the Company are generally purchased directly from distributors. For new release videocassettes, the Company, like others in the home video industry, places a pre-order with a distributor specifying the number of copies of the new title it desires to purchase. Approximately three to four weeks thereafter, the new release becomes available for shipment on an industry-wide basis. On average, home video businesses are currently able to purchase a title for rent or sale about six months after its release to motion picture theaters. Prerecorded videocassettes which exceed the number needed in a particular store because of changing customer demand may be moved to other stores or sold to customers. The Company believes that its ability to move videocassettes from store to store and to sell previously viewed rental videocassettes assists it in effectively controlling videocassette inventories. The Company has been able to negotiate certain favorable terms from one particular distributor, which the Company uses on an exclusive basis. These terms include discounts from suggested retail prices on certain titles, and the ability to return defective merchandise under certain circumstances. The Company is able to return to this distributor a pre-determined number of video cassettes purchased for sale (whether or not defective) within a certain amount of time. SERVICE MARKS The Company owns United States federal registrations for its service marks "Blockbuster", "Blockbuster Video", a torn ticket design, "Blockbuster Video" with the torn ticket design, and other related marks. The federal registrations for "Blockbuster", "Blockbuster Video" and "Blockbuster Video" with the torn ticket design have become incontestable. The Company is in the process of federally registering "Blockbuster Entertainment" and various other trademarks, service marks and slogans. In addition, the Company has registered the service mark "Blockbuster", "Blockbuster Video" and "Blockbuster Video" with torn ticket design in certain foreign jurisdictions and is in the process of registering other related marks in such jurisdictions. The Company considers its service marks important to its continued success. COMPETITION The home video business is highly competitive. The Company believes that the principal competitive factors in the business are title selection, number of copies of titles available, the quality of customer service and, to a lesser extent, pricing. The Company believes that it has generally addressed the selection and service demands of consumers more adequately than most of its competitors. The Company and its franchise owners compete with video retail stores, as well as supermarkets, drug stores, convenience stores, book stores, mass merchandisers and others. According to industry analysts, video retail stores alone have grown from approximately 7,000 outlets in 1983 to approximately 28,000 outlets in 1993. The Company believes that the success of its business depends in part on its large and attractive Company-owned and franchise-owned Blockbuster Video stores offering a wider selection of titles and larger and more accessible inventory than its competitors, in addition to more convenient store locations, faster and more efficient computerized check-in/check-out procedures, extended operating hours, effective customer service and competitive pricing. In addition to competing with other home video retailers, the Company and its franchise owners compete with all other forms of entertainment and recreational activities including, but not limited to movie theaters, network television and other events, such as sporting events. The Company also competes with cable television, which includes pay-per-view television. Currently, pay-per-view television provides less viewing flexibility to the consumer than videocassettes, and the more popular movies are generally available on videocassette prior to appearing on pay-per-view television. However, technological advances could result in greater viewing flexibility for pay-per-view or in other methods of electronic delivery, and such industry developments could have an adverse impact on the Company and its franchise owners' businesses. Notwithstanding these possible technological advances, the Company believes that home video will continue to have the competitive advantages of being not only the first source of filmed entertainment in the home before pay-per-view but also the most convenient source. The Company's corporate marketing department, with the assistance of its advertising agencies, has developed advertising campaigns for implementation systemwide. The Company aggressively uses both local and national advertising, including television commercials. The Company uses vendor advertising allowances, cooperative advertising and promotional programs that are currently made available to the home video industry by producers and distributors of home video products. Generally, these programs provide an allowance to the industry as a whole of approximately 1% to 2% of industry-wide purchases of a particular title for use in advertising and promoting the title. Recently, advertising expense (net of cooperative advertising allowances and amounts received from franchise owners pursuant to various franchise agreements) has averaged between 3% and 5% of the revenue generated by Company-owned video stores. The Company believes that cooperative advertising and promotional programs will continue to be provided by producers and distributors in the future, but such allowances might not continue at current levels. AVAILABILITY OF PRODUCT Prerecorded videocassettes and other entertainment software are readily available from numerous distributors and other suppliers. Although a specific title may only be available from a single source, the Company does not anticipate that the Company or its franchise owners will experience difficulty in obtaining these products. SEASONALITY The Company's home video business may be affected by a variety of factors, including, but not limited to, general economic trends, acquisitions made by the Company, additional and existing competition, marketing programs, weather, special or unusual events, variations in the number of store openings, the quality of new release titles available for rental and sale, and similar factors that may affect retailers in general. As compared to other months of the year, revenue from Blockbuster Video stores in the United States has been, and the Company believes will continue to be, subject to a decline during the months of April and May, due in part to the change to Daylight Savings Time, and during the months of September, October and November, due in part to the start of school and introduction of new television programs. REGULATION Certain states, the United States Federal Trade Commission and certain foreign jurisdictions require a franchisor to transmit specified disclosure statements to potential owners before issuing a franchise. Additionally, some states and foreign jurisdictions require the franchisor to register its franchise before its issuance. The Company believes the offering circulars used to market its franchises comply with the Federal Trade Commission guidelines and all applicable laws of states in the United States and foreign jurisdictions regulating the offering and issuance of franchises. The Company's home video business, other than the franchising aspect thereof, is not generally subject to any government regulation other than customary laws and local zoning and permit requirements. MUSIC RETAILING As of December 31, 1993, the Company was one of the largest specialty retailers of prerecorded music in the United States with 511 retailing outlets operating throughout the country. The Company has been engaged in the music retailing business since November 1992, when it acquired 235 stores in connection with its acquisition of Sound Warehouse, Inc. and subsidiary and Show Industries, Inc. ("Sound Warehouse" and "Music Plus"). In connection with its acquisition of Super Club in November 1993, the Company acquired 270 stores operating under the trade names "Record Bar", "Tracks", "Turtles" and "Rhythm and Views". The Company also owns and operates music stores under the trade name "Blockbuster Music Plus". Additionally, the Company is a partner in an international joint venture with Virgin Retail Group Limited ("Virgin") to develop and operate "Megastores" in continental Europe, Australia and the United States. Through its purchase of Sound Warehouse, Music Plus and Super Club and its joint venture with Virgin, the Company has embarked on a major new expansion effort in the music retailing industry. THE MUSIC RETAILING INDUSTRY In the last decade, the music retailing industry has experienced substantial growth. According to industry analysts, worldwide retail revenue generated by the music industry increased from approximately $12 billion in 1983 to approximately $29 billion in 1992. Retail music revenue in the United States alone was approximately $10 billion in 1993, and is projected by industry analysts to reach approximately $13 billion by the year 1997. An important element of this growth in the music retailing industry has been the increasing worldwide penetration of compact disc players. According to industry analysts, approximately 43% of households in the United States presently have a compact disc player. Industry sources place compact disc player penetration at approximately 40% in Europe and nearly 100% in Japan. Compact discs, the top selling prerecorded music format, are generally more expensive than audiocassette tapes but are considered to be superior due to the higher quality of the sound reproduction and the durability of the discs. Audiocassette tapes were the top selling prerecorded music format prior to the introduction and acceptance of the compact disc. Audiocassette tapes continue to comprise a large percentage of prerecorded music sales due to the large number of audiocassette players in use in homes and automobiles and the large base of portable cassette players in active use. Technology may produce new format media which could affect the Company's future sales. The compact disc has had a positive impact on the prerecorded music retailing business. There is no assurance, however, that other new technologies will gain significant consumer acceptance generally or among the Company's customers. Also, past experience with new technology indicates that, even if successful in gaining acceptance, any significant impact on sales would not be experienced for several years. COMPANY MUSIC OPERATIONS The Company's music stores sell compact discs and audiocassettes manufactured by all major domestic and certain foreign manufacturers. These stores offer a wide selection of prerecorded music. The number of prerecorded music titles offered for sale in the Company's music stores averages approximately 17,400 per music store. The assortment of music titles offered by the Company includes those of prominent artists and established labels. Music selections cover a broad range including, among others, pop, rock, country, classical, jazz and soul. The Company believes that its music stores generally offer a wider selection of prerecorded music than most of its competitors in the markets in which these stores operate. The Company currently also rents and sells prerecorded videocassettes in most of its music stores, but on a much more limited basis than in its Company-owned video stores. The Company anticipates that most future music stores developed by the Company will be highly visible and located in free-standing structures or strip shopping centers with ample parking facilities. Such music stores are designed and located to be highly visible and to attract their own customers rather than relying solely on customers generated by neighboring stores. At December 31, 1993, the Company operated 331 music stores which are located in free-standing structures or strip shopping centers and 180 music stores located in shopping malls. The average size of the Company's music stores is approximately 6,400 square feet. The Company has recently developed its own prototype music store called "Blockbuster Music Plus". New Blockbuster Music Plus stores offer personal listening posts which allow the customer to preview selections prior to purchase and other state-of-the-art features as well as a broad range of musical selections. The Company currently projects that the cost to open a new "Blockbuster Music Plus" store will require an initial investment, including capital expenditures and merchandise inventory of generally between $700,000 and $1,000,000. Retail point-of-sale computer systems at the Company's music stores are currently being standardized for uniformity of use in all of the Company's music stores. Similar to the system in use at the Company's video stores, the Company's music store systems use an optical scanner to read the product's unique bar code, record the appropriate price or charge, and create a customer receipt. Product information is stored on the system for retrieval and analysis, providing valuable information about inventory movement and customer tastes which is considered in subsequent stocking of product inventories. The Company is currently examining the feasibility of integrating its video and music store computer systems. In December 1992, the Company formed an international joint venture with Virgin to take advantage of opportunities in the retailing of music and related products through the ownership and development of Megastores. As of December 31, 1993, the joint venture owned interests in and operated 20 Megastores in France, Germany, Austria, Spain, Italy, Holland, Australia and Los Angeles, California. These Megastores, ranging in size from approximately 25,000 to 40,000 square feet, are generally larger than most retail music stores. The Megastores offer an extremely wide range of music, video and game products, as well as special interest departments, interactive entertainment facilities, personal listening posts, video viewing posts, information centers and even cafes. The Company and Virgin will continue to build Megastores in major metropolitan areas throughout Continental Europe, Australia and the United States. DISTRIBUTION AND INVENTORY MANAGEMENT ACTIVITIES Sound Warehouse, Music Plus and Blockbuster Music Plus operate a central warehouse distribution center located in Dallas, and the Company's remaining music retailing chains operate a central distribution center in Atlanta. Generally, these distribution centers maintain large quantities of popular music titles available for immediate shipment to their respective music stores. The Company believes that the maintenance of the distribution centers allows it to support a wide selection of merchandise within its music stores, minimize music store inventory requirements and labor costs, and maintain effective controls. The Company is currently examining the feasibility of consolidating the Dallas and Atlanta distribution centers. Each of the Company's music chains have product buyers who make initial purchasing decisions on new titles and products for each music store and for the central warehouse distribution centers. In making purchasing decisions, the product buyers consider such factors as knowledge of the new title or product, product background and historical sales from each store. Music store personnel reorder products for the store as needed based upon recent sales of each item compared to the amounts on hand in the store's inventory. Centralized product buyers reorder products for the warehouses by monitoring both detailed sales information and the reorders placed by music store personnel. The Company is in the process of further centralizing purchasing decisions. Most of the products sold by the Company through its music stores are purchased directly from manufacturers. The Company is generally able to lower its cost per product due to favorable volume purchasing terms from its suppliers. Under current trade practices, retailers of prerecorded music are entitled to return products they have purchased from major suppliers. Generally, prerecorded music may be returned as long as it remains in the current catalog of its manufacturer. Suppliers will typically notify retailers before titles are removed from the manufacturer's current catalog. This industry practice permits the Company to carry a wide selection of music, and at the same time reduce the risk of obsolete inventory. Major manufacturers of prerecorded music typically do not limit the amount of merchandise that may be returned by a customer although certain manufacturers penalize the customer through return handling charges. The Company currently does not have any significant amounts of excess prerecorded music inventory that could not be returned to manufacturers under current return policies. The manufacturers' exchange privilege policies have previously been subject to change and may change in the future. Any change in these policies could adversely affect the value of the Company's inventory and affect its business policies. SERVICE MARKS The Company owns United States federal registrations for its service marks "Music Plus", "Music Plus" with design, "Sound Warehouse", "Sound Warehouse" with design and other related marks. The Company is in the process of registering "Blockbuster Music", "Blockbuster Music Plus" with design and various other trademarks, service marks and slogans relating to its music business in the United States and certain foreign jurisdictions. COMPETITION The retail sale of prerecorded music and related products is highly competitive among numerous chain and department stores, discount stores, mail order clubs and specialty music stores. Some mail order clubs are affiliated with major manufacturers of prerecorded music and may have advantageous marketing arrangements with their affiliates. Since music stores generally serve individual or local markets, competition is fragmented and varies substantially from one location or geographic area to another. The Company believes that its ability to compete successfully in the music retailing business depends on its ability to secure and maintain attractive and convenient locations, manage merchandise efficiently, offer broad merchandise selections at competitive prices and provide effective service to its customers. The Company frequently advertises its music stores and products which they carry in newspapers, on radio and television and by direct mail. In addition, the Company frequently engages in promotions which offer products at reduced prices. The Company's advertising emphasizes price, breadth and depth of merchandise, and the convenience of music store locations. Most of the vendors from whom the Company purchases its music store products offer their customers, including the Company, an advertising allowance which is often based on a percentage of a customer's purchases. The Company also receives significant advertising allowances from suppliers of prerecorded music products to promote new artists. The terms of such advertising allowances generally require the Company to submit advertising campaigns to the vendor for approval prior to their use. The Company currently takes full advantage of vendors' advertising allowances. AVAILABILITY OF PRODUCTS The Company has no long-term agreements for the purchase of prerecorded music and related products and deals with its suppliers principally on an order-by-order basis. The Company has not experienced difficulty in obtaining satisfactory sources of supply and believes that adequate sources of supply will continue to exist for the products sold in its music stores. SEASONALITY The Company's music business may be affected by a variety of factors including, but not limited to, general economic trends and conditions in the music industry, including the quality of new titles and artists, existing and additional competition, changes in technology and similar factors that may affect retailers in general. The Company's music business is seasonal, with higher than average monthly revenue experienced during the Thanksgiving and Christmas seasons, and lower than average monthly revenue experienced in September and October. REGULATION The Company's retail music business is not generally subject to any governmental regulation other than customary laws and local zoning and permit requirements. FILMED ENTERTAINMENT In April 1993, the Company expanded into the filmed entertainment business through the acquisition of a majority of the common stock of Spelling Entertainment Group Inc. ("Spelling"). The operations of Spelling encompass a broad range of businesses in the filmed entertainment industry, supported by an extensive library of television series, mini-series, movies-for-television, pilots and feature films (collectively "film product"). At December 31, 1993, the Company owned 45,658,640 shares, or approximately 70.5% of Spelling's outstanding common stock. The Company owns 2,550,000 shares, and warrants to acquire an additional 810,000 shares, of the common stock of Republic Pictures Corporation ("Republic"). At December 31, 1993, the Company's investment in Republic represented approximately 39% of Republic's outstanding common stock, including shares subject to such warrants. Republic is engaged in the development and production of television programming and the distribution of this programming and its extensive library of feature films, television movies and mini-series. In December 1993, Spelling and Republic entered into a definitive agreement pursuant to which a wholly-owned subsidiary of Spelling would be merged with Republic and Republic, as a result of the merger, would become a wholly-owned subsidiary of Spelling. Spelling will exchange $13.00 in cash for each share of Republic common stock issued and outstanding at the effective time of the merger. Options and warrants to acquire shares of Republic common stock will be converted into the right to receive upon payment of the exercise price 1.6508 shares of Spelling common stock for each share of Republic common stock into which such option or warrant was exercisable immediately prior to the effective time of the merger. Consummation of the merger, which is currently anticipated to occur in April 1994, is subject, among other things, to approval by the stockholders of Republic and other customary conditions. Following the merger, the operations of Spelling and Republic will be substantially consolidated. With the Company's ownership of a majority interest in Spelling, the Company has a significant presence in the development, production and distribution of television programming and filmed entertainment. COMPANY FILMED ENTERTAINMENT OPERATIONS Spelling is engaged primarily in the development, production, acquisition and distribution of television programming. Spelling also produces feature films for others, distributes films in international markets and licenses music and merchandising rights associated with its television programming. Television programming is developed and produced by Spelling primarily through two subsidiaries, Spelling Television and Laurel Entertainment ("Laurel"). Spelling's distribution activities are carried out by its Worldvision Enterprises subsidiary ("Worldvision"). Additionally, Worldvision engages in production by advancing funds to producers in exchange for all or a portion of the distribution rights. The primary markets for the television programming produced, funded or otherwise acquired by the Company include first-run network exhibition, domestic first-run and repeat syndication (including cable), international syndication and home video. NETWORK PROGRAMMING Scripts written for network television programming are submitted to the network for review. If the network accepts the script, it will typically order production of a pilot or a prototype episode, for which it will pay Spelling a negotiated fixed license fee. Spelling's cost of producing such a pilot usually exceeds the network license fee. As of March 1994, Spelling had received orders for two new series projects. One is an eight episode order of a one-hour series for the Fox network, tentatively titled "Models, Inc." and the other is a six episode order of a one-hour series for the Fox network, tentatively titled "Shock Rock". The Company has other projects under network consideration. Spelling is currently producing the television series "Beverly Hills, 90210" and "Melrose Place" which are being aired on the Fox network. "Beverly Hills, 90210" is in its fourth season and has been renewed for the 1994-95 television season. "Melrose Place", which debuted during the summer of 1992, is in its second full season, and has also been renewed for the 1994-95 television season. Spelling is also producing the television series "Winnetka Road" and "Burke's Law", both mid-season replacements, and has received an order for an additional 13 episodes of "Burke's Law" from the CBS network for the 1994-95 television season. In 1993, Laurel produced "The Stand", an eight-hour mini-series based on one of Stephen King's best selling books, which was delivered to the ABC network in December 1993 and is scheduled to air in May 1994. Spelling has recently received orders for two four-hour mini-series from the ABC network, one based on James Michener's novel, "Texas" and the other based on Stephen King's novel, "The Langoliers". Laurel has also produced a movie-for-television, "Precious Victims", which aired on the CBS network in September 1993. As with television series, the network license fees received for mini-series and movies-for-television are normally less than the costs of production, and such deficits must be covered by revenue derived from other sources of distribution, primarily through the exploitation of rights in international markets. Spelling had revenue from one customer, the Fox network, representing 22%, 22% and 13% of Spelling's revenues in 1993, 1992 and 1991, respectively. FIRST-RUN SYNDICATED PROGRAMMING First-run syndicated television series are produced and sold directly to television stations in the United States without any prior network broadcast. These programs are licensed to individual or groups of television stations, on a market by market basis, in contrast to network distribution, which provides centralized access to a national audience. In first run syndication, Spelling licenses its film product in exchange for cash payments, advertising time (barter) or a combination of both. In cash licensing, a broadcaster normally agrees to pay a fixed licensing fee in one or more installments in exchange for the right to broadcast the product a specified number of times over an agreed upon period of time. Where product is licensed in exchange for advertising time, through what are known as "barter agreements", a broadcaster agrees to give Spelling a specified amount of advertising time, which Spelling subsequently sells. Particuarly in the initial years of such programming, domestic syndication revenue can be less than Spelling's costs of producing the programming. Worldvision is currently marketing for first-run barter syndication 22 episodes each of two series, currently titled "Robin's Hoods" and "Heaven Help Us", to be produced by Spelling Television. Worldvision has also begun to distribute these programs to international television markets for cash license fees. In first-run syndication, the Company retains greater control over creative and production decisions than is the case with network programming; however, there is a greater financial risk associated with such programming, and potentially greater financial upside. Fixed license fees paid by networks usually cover at least 75% of Spelling's production costs; however, Spelling does not share in the network's advertising revenue which can be substantial. Barter revenue is not fixed but is dependent on the viewing public's acceptance or rejection of the show as reflected in the ratings. If a show's ratings are high, the advertising revenue received by the Company through its barter arrangement could be substantial. ACQUIRING DISTRIBUTION RIGHTS A substantial portion of Worldvision's revenue is derived from fees earned from the distribution and licensing of television programming produced by Spelling. In addition, since 1989, Worldvision has invested approximately $150 million in the acquisition of distribution rights to film product from third parties. Worldvision acquires the exhibition rights to television programming and feature films through contracts with the producers or other owners of such products. These contracts generally give Worldvision the exclusive distribution rights to license an unlimited number of exhibitions of the film products over a period of time, typically in excess of twenty years. Worldvision also acquires distribution rights from third party producers by partially financing production costs through advances to such producers which are recovered by Worldvision from revenue earned from distribution. Usually Worldvision recovers its distribution fees, expenses and advances before the producers or owners receive any additional proceeds. Worldvision currently distributes programming in 110 countries through offices in New York, Chicago, Atlanta, Los Angeles, London, Paris, Rome, Toronto, Sydney, Tokyo and Rio de Janeiro. In September 1992, Worldvision purchased from Carolco Television Inc. the domestic television rights to a film library of more than 150 feature films along with certain related receivables. The library includes box-office hits such as "Terminator 2", "Basic Instinct", the "Rambo" trilogy, "L.A. Story", "Red Heat", "Total Recall", "Platoon", "The Last Emperor" and "Universal Soldier". Due to pre-existing licensing agreements covering these films, the Company will not recognize significant revenue from the exploitation of the rights until after 1996. LICENSING AND MERCHANDISING Hamilton Projects, Inc. ("Hamilton Projects"), a subsidiary of Spelling, merchandises products and licenses music associated with several of the Company's television properties, including "Beverly Hills, 90210", and "Melrose Place". Hamilton Projects is a full-service licensing and merchandising company, providing strategic planning, concept development and program execution to the Company as well as third parties. SERVICE MARKS Spelling or its subsidiaries own various United States federal trademark or service mark registrations including "Spelling", "Beverly Hills, 90210", "Melrose Place", and has applied for registration for numerous other marks relating to its film products in the United States and foreign countries. Spelling or its subsidiaries own various foreign trademark or service mark registrations or have applied for trademark or service mark registrations including "Tele Uno". COMPETITION The motion picture and television industry is highly competitive. Many companies compete to obtain access to the available literary properties, creative personnel, talent, production personnel, television acceptance, distribution commitments and financing, which are essential to produce and sell their film products. Certain of Spelling's competitors have greater available resources for promotion and marketing and more people engaged in the acquisition, development, production and distribution of both television programming and feature films. Spelling must continue to acquire distribution rights to television programming and feature films to maintain its competitive position. In order to acquire rights to distribute new third party film product, Spelling may be required to increase its advances to producers or to reduce its distribution fees. Spelling's arrangements with the networks provide it with pilot, series and movies-for-television commitments; however, the networks are under no obligation to actually broadcast Spelling's product. Spelling's sucessful domestic repeat syndication of a network series generally depends upon the ratings achieved through network exhibition of such a series over a number of years sufficient to generate a minimum of 65 episodes. In turn, Spelling's overall success in achieving multiple years of network exhibition of a series is dependent upon factors such as the viewing public's taste (as reflected in the ratings) and critical reviews. Licensing television programming to broadcasters and cable networks has also become increasingly competitive as new products continually enter the syndication market and certain producers attempt to develop an additional network to distribute their product. Likewise, Spelling is competing with numerous well-financed, experienced companies engaged in feature film production and international feature film distribution. Spelling's relative lack of experience and financial strength in distributing feature films in the international market may hinder its ability to compete effectively with companies which are more experienced and have greater financial capabilities. GOVERNMENT REGULATION The production and distribution of television programming by independent producers is not directly regulated by the federal or state governments, but the marketplace for television programming is substantially affected by regulations of the Federal Communications Commission ("FCC") applicable to television stations, television networks and cable television systems. In 1993, the FCC further relaxed its rules governing financial interests in and syndication of programming by the broadcast television networks (known as the "fin syn" rules). The relaxed rules still prohibit the three largest broadcast networks from (i) holding or acquiring financial interests and syndication rights in any first-run program, except in programs produced solely by the network and in programs distributed only outside the United States, (ii) domestically syndicating any prime time network or first-run non-network program, and (iii) withholding a prime time program in which it has syndication rights from syndication for more than a specified period. However, these remaining restrictions on program syndication by the networks are set to expire in November 1995, and are currently the subject of judicial review. In addition, in November 1993 a Federal district court vacated certain provisions of consent decrees which prohibited television networks from acquiring financial interests and syndication rights in television programming developed or created by non-network suppliers such as the Company. The effect of the relaxed fin syn rules and the district courts' action on the operations of the Company is as yet unclear; however, these regulatory changes could result in increased competition for the Company's filmed entertainment business. Foreign regulations may also affect the Company's filmed entertainment business. In 1989, the twelve-member European Community ("EC") adopted a "directive" that its member states ensure that more than 50% of the programming shown on their television stations be European-produced "where practicable". These guidelines could restrict the amount of American television programming and feature films that are shown on European television. In addition, certain European countries have adopted individual national restrictions on broadcasting of programming based on country of origin. Other countries in which the Company distributes its programming may adopt similar restrictions, which may have an adverse effect on its ability to distribute its programs or create stronger incentives for the Company to establish ventures with international films. OTHER ENTERTAINMENT In October 1993, the Company purchased 24,000,000 shares of newly-issued Series A Cumulative Convertible Preferred Stock ("Preferred Stock") of Viacom Inc. ("Viacom") for an aggregate purchase price of $600,000,000. The Preferred Stock provides for dividends at an annual rate of 5% and is convertible into non-voting Viacom Class B common stock at a conversion price of $70 per share. In January 1994, the Company and Viacom entered into a subscription agreement ("the Subscription Agreement") pursuant to which, in March 1994, the Company purchased from Viacom 22,727,273 shares of non-voting Viacom Class B common stock for an aggregate purchase price of $1,250,000,000 or $55 per share. Under the terms of the Subscription Agreement, the Company was granted certain rights to a make-whole amount in the event that the Merger Agreement discussed below under the caption "Viacom Merger Agreement" is terminated and the highest average trading price of the non-voting Viacom Class B common stock during any consecutive 30 trading day period prior to the first anniversary of such termination is below $55 per share. Such make-whole amount would be based on the difference between $55 per share and such highest average trading price but may not exceed $275,000,000. See "Viacom Inc. Agreements" of Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations and Note 12, Other Matters, of Notes to Consolidated Financial Statements for further discussion of the Company's investment in Viacom. At December 31, 1993, the Company owned 7,153,750 shares or approximately 19.1% of the outstanding common stock, of Discovery Zone, Inc. ("Discovery Zone"). Discovery Zone owns, operates and franchises indoor recreational facilities for children. The Company currently operates 34 Discovery Zone facilities and has franchise rights to develop an additional 91 Discovery Zone facilities. The Company has also entered into a joint venture agreement with Discovery Zone pursuant to which the joint venture has been granted the right to develop an additional 10 Discovery Zone facilities in the United Kingdom. EMPLOYEES In March 1994, the Company had approximately 46,000 employees, including 43 officers, 37,000 video and music retail employees in the United States and 9,000 other employees. Other employees consist principally of the Company's international employees. Of the retail employees in the United States, the Company had approximately 8,800 full-time and 28,200 part-time store employees. The total staffing for a Blockbuster Video store is generally 10 to 15 employees (full-time and part-time), including a store manager. The total staffing for a music store is generally 15 to 18 employees (full-time and part-time), including a store manager. The required staffing in the Company's video and music stores at any one point in time generally ranges between 2 to 10 employees, and is dependant upon the time of season, day of the week and time of the day. At December 31, 1993, Spelling employed or had service agreements with approximately 223 employees who were employed in administrative or other positions which are relatively independent of the Company's current level of production activities. In addition, Spelling employs individuals for particular production projects. As a result, the number of employees and production project employees providing services to Spelling can vary substantially during the course of a year depending upon the number and scheduling of its productions. Certain subsidiaries of Spelling are signatories to certain collective bargaining agreements relating to the various types of employees and independent contractors required to produce the television programming and feature films. The Company's other employees are not represented by a labor union or covered by a collective bargaining agreement. The Company believes its relationship with employees to be good. VIACOM MERGER AGREEMENT In January 1994, the Company and Viacom entered into a merger agreement under which the Company would merge with and into Viacom, with Viacom being the surviving corporation. Under the terms of the merger agreement, each outstanding share of the Company's common stock, other than shares owned by Viacom or any subsidiary of Viacom or the Company and any dissenting shares (if applicable), shall be converted into the right to receive (i) .08 of one share of Viacom Class A common stock, (ii) .60615 of one share of non-voting Viacom Class B common stock, and (iii) up to an additional .13829 of one share of non-voting Viacom Class B common stock, with such amount to be determined in accordance with, and the right to receive such shares evidenced by, one variable common right (a "VCR") issued by Viacom. Employee stock options and warrants to acquire Company common stock outstanding as of the effective time of the merger will become exercisable thereafter for the merger consideration described above. The number of shares of non-voting Viacom Class B common stock into which the VCRs convert will generally be based upon the highest 30 consecutive trading day average price of the non-voting Viacom Class B common stock during the 90 trading day period prior to the conversion date, which occurs on the first anniversary of the completion of the merger. In the event that such value is more than $40.00 per share but less than $48.00 per share, the VCRs will convert into the right to receive .05929 of a share of non-voting Viacom Class B common stock. If such value is below $40.00 per share, such number of shares will increase ratably to the maximum of .13829 of a share of non-voting Viacom Class B common stock at a value of $36.00 per share or, if such value is above $48.00 per share, the number of shares into which the VCR will convert will decrease ratably to have no value at a price of $52.00 per share. The upward adjustment in the value of the VCR in excess of .05929 of a share of non-voting Viacom Class B common stock will not be made in the event that, during any 30 trading day period following the completion of the merger and prior to the conversion date, the average closing price exceeds $40.00 per share. In the event that during any such period such average price exceeds $52.00 per share, the VCR will terminate. Consummation of the merger is subject to certain conditions, including, among other things, approval by the stockholders of the Company and Viacom. Item 2. Item 2. Properties The Company owns its corporate headquarters which total approximately 133,200 square feet located in Fort Lauderdale, Florida. The Company owns the land and building for 54 of its Blockbuster Video stores and leases all of the remaining real estate sites (including the buildings and improvements thereon) upon which Company-owned video stores are located. The Company's principal home video distribution and warehouse facility is located in Dallas, Texas in a leased facility of approximately 69,000 square feet. The lease for the distribution center expires on December 31, 1995. The Company also has leased office facilities in eleven cities in the United States serving as regional and district offices and has leased office space in Toronto, Canada, in London, England and in Tokyo, Japan in connection with its home video businesses. The Company owns the land and building for two of its retail music stores and owns the building of a third music store location which is located on leased land. The Company leases the remaining real estate sites (including the buildings and improvements thereon) upon which the Company's music stores are located. The Company leases space for offices and a distribution center in Dallas, Texas relating to the operations of Sound Warehouse, Music Plus and Blockbuster Music Plus. The space consists of two buildings in which the Company leases approximately 155,000 square feet of total floor space. The Company also has leased office space in Los Angeles, California and Atlanta, Georgia and distribution centers in Atlanta, Georgia and Durham, North Carolina in connection with its music business. Spelling leases office space of approximately 51,000 square feet in Los Angeles and approximately 63,000 square feet in New York. In addition, Spelling leases offices in other cities in the United States and in various other countries throughout the world in connection with its international distribution activities. Spelling also rents facilities on a short-term basis for the production of its film product, including approximately 80,000 square feet in Vancouver, British Columbia. The Company owns approximately 1,770 acres of land in Southeast Florida upon which it is considering the development of a sports and entertainment complex. The Company is currently undertaking various studies and analyses to determine whether such a project would be feasible. Management believes that the Company's distribution, warehouse and office facilities will be adequate for its home video, music retailing and filmed entertainment businesses in the foreseeable future. Item 3. Item 3. Legal Proceedings The Company has become subject to various lawsuits, claims and other legal matters in the course of conducting its business, including its business as a franchisor. The Company believes that such lawsuits, claims and other legal matters should not have a material adverse effect on the Company's consolidated results of operations or financial condition. Spelling is involved in a number of legal actions including threatened claims, pending lawsuits and contract disputes, environmental clean-up assessments, damages from alleged dioxin contamination and other matters. While the outcome of these suits and claims cannot be predicted with certainty, the Company believes based upon its knowledge of the facts and circumstances and applicable law that the ultimate resolution of such suits and claims will not have a material adverse effect on the Company's results of operations or financial condition. This belief is also based upon the adequacy of approximately $30,000,000 of accruals that have been established for estimated losses on disposal of former operations and remaining Chapter 11 disputed claims, and an insurance-type indemnity agreement which covers up to $35,000,000 of certain such liabilities in excess of a threshold amount of $25,000,000, subject to certain adjustments. Substantial portions of such accruals are intended to cover environmental costs associated with Spelling's former operations. Such accruals are recorded without discount or offset for either the time value of money prior to the anticipated date of payment or expected recoveries from insurance or contribution claims against unaffiliated entities. Item 4. Item 4. Submission of Matters to a Vote of Security Holders No matters were submitted to a vote of security holders. EXECUTIVE OFFICERS OF THE COMPANY See Part III, Item 10 of this report. PART II. Item 5. Item 5. Market for the Registrant's Common Equity and Related Stockholder Matters The common stock, $.10 par value ("Common Stock"), of the Company is listed on the New York Stock Exchange and the London Stock Exchange. The following table sets forth the quarterly high and low prices of the Common Stock for the period from January 1, 1992 through December 31, 1993 on the New York Stock Exchange Composite Tape as reported by the Wall Street Journal (Southeast Edition). At March 18, 1994, there were 12,728 holders of record of the Common Stock. In April 1992, the Board of Directors of the Company adopted a policy providing for the payment of quarterly cash dividends to the Company's stockholders and declared a cash dividend of two cents per share which was paid on July 1, 1992 to stockholders of record on May 4, 1992. On May 11, 1993, the Board of Directors of the Company amended such policy to provide for the payment of quarterly cash dividends to the Company's stockholders of two and one half cents per share. Item 6. Item 6. Selected Financial Data In August 1993, the Company merged with WJB. This transaction has been accounted for under the pooling of interests method of accounting and, accordingly, the Company's financial statements have been restated for all periods as if the companies had operated as one entity since inception. The following Selected Financial Data should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations", the Company's Consolidated Financial Statements and Notes thereto, and other financial information appearing elsewhere in this Form 10-K. See Notes 2 and 12, Business Combinations and Investments and Other Matters, of Notes to Consolidated Financial Statements for a discussion of business combinations and their effect on comparability of year-to-year data as well as events occurring subsequent to December 31, 1993. Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations VIACOM INC. AGREEMENTS In January 1994, the Company entered into a merger agreement pursuant to which the Company has agreed to merge into Viacom Inc. ("Viacom"), with Viacom being the surviving corporation. The closing of the merger is subject to customary conditions, including approval of the merger by the Company's stockholders. Concurrently with the merger agreement, the Company entered into a subscription agreement pursuant to which in March 1994 the Company purchased from Viacom 22,727,273 shares of non-voting Viacom Class B common stock for an aggregate purchase price of $1,250,000,000, or $55 per share. Under the terms of the subscription agreement, the Company was granted certain rights to a make-whole amount in the event that the merger agreement is terminated and the highest average trading price of the non-voting Viacom Class B common stock during any consecutive 30 trading day period prior to the first anniversary of such termination is below $55 per share. Such make-whole amount would be based on the difference between $55 per share and such highest average trading price per share. However, the aggregate make-whole amount may not exceed $275,000,000. Viacom is entitled to satisfy its obligation with respect to any such make-whole amount, at Viacom's option, either through the payment to the Company of cash or marketable equity or debt securities of Viacom, or a combination thereof, with an aggregate value equal to the make-whole amount or through the sale to the Company of the theme parks currently owned and operated by Paramount Communications Inc., a subsidiary of Viacom. In the event that Viacom were to elect to sell the theme parks to the Company, the purchase price would be $750,000,000, payable through delivery to Viacom of shares of non-voting Viacom Class B common stock valued at $55 per share. If the theme parks were so purchased by the Company, the subscription agreement further provides that the Company would grant an option to Viacom, exercisable for a period of two years after the date of grant, to purchase a 50% equity interest in the theme parks at a purchase price of $375,000,000. See "Capital Structure" under the heading of "Financial Condition" and "Recently Issued Accounting Standards" of Management's Discussion and Analysis of Financial Condition and Results of Operations and Note 12, Other Matters, of Notes to Consolidated Financial Statements for a further discussion related to these transactions. BUSINESS COMBINATIONS AND INVESTMENTS The Company makes its decisions to acquire or invest in businesses based on financial and strategic considerations. All business combinations discussed below, except for the merger with WJB Video Limited Partnership and certain of its affiliates ("WJB"), were accounted for under the purchase method of accounting and, accordingly, are included in the Company's financial statements from the date of acquisition. In November 1993, the Company acquired all of the outstanding capital stock of Super Club Retail Corporation and subsidiaries ("Super Club") from certain subsidiaries of Philips Electronics N.V. ("Philips"). The purchase price paid by the Company was approximately $150,000,000 and consisted of 5,245,211 shares of Common Stock and warrants to acquire additional shares of Common Stock. The warrants give Philips the right to acquire 1,000,000 and 650,000 shares of Common Stock at exercise prices of $31.00 and $32.42 per share, respectively. As a result of the acquisition, the Company added to its system 270 music stores and 120 video stores operating primarily in the southeastern United States. In October 1993, the Company purchased 24,000,000 shares of newly-issued Series A cumulative convertible preferred stock of Viacom for an aggregate purchase price of $600,000,000, representing a purchase price of $25 per share. The preferred stock provides for the payment of quarterly dividends at an annual rate of 5% and is convertible into non-voting Viacom Class B common stock at a conversion price of $70 per share. The preferred stock is redeemable at the option of Viacom beginning in October 1998. In August 1993, the Company merged with WJB, the Company's then largest franchise owner with 209 stores operating in the southeastern United States. In connection with the merger, the Company issued 7,214,192 shares of its Common Stock in exchange for the equity interests of WJB. This transaction has been accounted for under the pooling of interests method of accounting and, accordingly, the Company's financial statements have been restated for all periods as if the companies had operated as one entity since inception. During the second quarter of 1993, the Company acquired a majority of the common stock of Spelling Entertainment Group Inc. ("Spelling"), a producer and distributor of filmed entertainment. The aggregate consideration paid by the Company was approximately $163,369,000 and consisted of cash and 9,278,034 shares of Common Stock. The Company also issued to certain sellers of Spelling's common stock, warrants to acquire an aggregate of 2,000,000 shares of the Company's Common Stock, at an exercise price of $25 per share. Additionally, in October 1993, the Company exchanged 3,652,542 shares of Common Stock for 13,362,215 newly issued shares of Spelling's common stock. See Note 7, Shareholders' Equity, of Notes to Consolidated Financial Statements for a further discussion of this transaction. As a result of the transactions described above, the Company owned approximately 70.5% of the outstanding common stock of Spelling at December 31, 1993. During 1993, the Company also acquired or invested in businesses that own and operate video stores, are involved in the production and distribution of filmed entertainment, and own, operate and franchise indoor recreational facilities for children. The aggregate purchase price paid by the Company was approximately $195,610,000 and consisted of cash and 5,631,180 shares of Common Stock. In November 1992, the Company acquired Sound Warehouse, Inc. and subsidiary and Show Industries, Inc. ("Sound Warehouse" and "Music Plus"). Sound Warehouse and Music Plus are among the largest specialty retailers of prerecorded music in the United States with 235 stores operating in 40 metropolitan areas in 15 states at December 31, 1993. The purchase price paid by the Company was approximately $190,000,000 and consisted of cash and 4,142,051 shares of Common Stock. In February 1992, the Company acquired Cityvision plc ("Cityvision"), the largest home video retailer in the United Kingdom. The purchase price paid by the Company was approximately $125,000,000 and consisted of cash and 3,999,672 shares of Common Stock. At December 31, 1993, Cityvision operated 775 stores under the trade name "Ritz". During 1992, the Company also acquired or invested in several other businesses that own and operate video and music stores. The aggregate purchase price paid by the Company was approximately $103,774,000 and consisted of cash and 2,112,977 shares of Common Stock. During 1991, the Company acquired several businesses that own and operate video stores. The aggregate purchase price paid by the Company was approximately $89,614,000 and consisted of cash and 6,492,757 shares of Common Stock. The Company may from time to time invest in or acquire other businesses, properties or securities. See "Capital Structure" under the heading "Financial Condition" of Management's Discussion and Analysis of Financial Condition and Results of Operations and Notes 2 and 12, Business Combinations and Investments and Other Matters, of Notes to Consolidated Financial Statements for a further discussion of business combinations and their effect on comparability of year-to-year data. RESULTS OF OPERATIONS The Company continued its record of profitable growth during 1993. Revenue was $2,227,003,000, an increase of 69% over the prior year. Net income was $243,646,000 and net income per share was $1.10, increases of 64% and 45%, respectively, over 1992. The strong performance of a greater number of stores in operation, including newly acquired video and music stores, the addition of the Company's filmed entertainment business and a 9.2% increase in same store revenue for video stores in operation for more than one year contributed to the significant increases in revenue, net income and net income per share. The following table reflects the Company's operating performance ratios (shown as a percentage of revenue or average investment) as of December 31 for each of the years indicated: The ratios presented above generally met or exceeded the Company's performance goals. Returns on average capital, equity and assets declined in 1993 due primarily to the Company's strategic $600,000,000 investment in Series A cumulative convertible preferred stock of Viacom which provides a fixed rate of return which is less than the return historically achieved by the Company's video, music and filmed entertainment businesses. Return on average equity also decreased due to the increase in equity resulting from the conversion of the Company's Liquid Yield Option Notes ("LYONs") to shares of Common Stock. There can be no assurance that the ratios presented above will continue at the same levels. See also "Capital Structure" under the heading "Financial Condition" of Management's Discussion and Analysis of Financial Condition and Results of Operations. The following table sets forth the number of video and music stores in operation as of December 31 for each of the years indicated: Company-owned video stores at December 31, 1993 included 775 stores operating under the "Ritz" trade name and 120 Super Club stores operating under the "Video Towne", "Alfalfa", "Movies at Home" and "Movieland" trade names. Company-owned music stores at December 31, 1993 consist of 511 retailing outlets currently operating under the "Blockbuster Music Plus", "Sound Warehouse", "Music Plus", "Record Bar", "Tracks", "Turtles" and "Rhythm and Views" trade names. Joint venture music stores at December 31, 1993 consist of "Megastores" operating under joint ventures with the Virgin Retail Group Limited ("Virgin"). The Company may from time-to-time convert certain Company-owned video and music stores operating under non-Blockbuster trade names to Blockbuster format stores. Additionally, the Company may decide to close or relocate certain Company-owned stores for various strategic reasons. As a franchisor of video stores, the Company may from time-to-time purchase certain franchise-owned stores or sell certain Company-owned stores to franchise owners in order to achieve the optimum mix of franchise-owned and Company-owned video stores within specific markets and the optimum division of geographic territory between the Company and its franchise owners. The Company's video business may be affected by a variety of factors including, but not limited to, general economic trends, acquisitions made by the Company, additional and existing competition, marketing programs, weather, special or unusual events, variations in the number of store openings, the quality of new release titles available for rental and sale, and similar factors that may affect retailers in general. As compared to other months of the year, revenue from Company-owned video stores in the United States has been, and the Company believes will continue to be, subject to a decline during the months of April and May, due in part to the change to Daylight Savings Time, and during the months of September, October and November, due in part to the start of school and introduction of new television programs. The Company's video business may also be affected by technological advances including, but not limited to, those relating to pay-per-view television. Currently, pay-per-view television provides less viewing flexibility to the consumer than videocassettes, and the more popular movies are generally available on videocassette prior to appearing on pay-per-view television. However, technological advances could result in greater viewing flexibility for pay-per-view television or in other methods of electronic delivery, and such industry developments could have an adverse impact on the Company and its franchise owners' businesses. Notwithstanding these possible technological advances, the Company believes that home video will continue to have the competitive advantages of being not only the first source of filmed entertainment in the home before pay-per-view but also the most convenient source. The Company's music business in general may be affected by economic conditions and conditions in the music industry including, but not limited to, the quality of new titles and artists, existing and additional competition, changes in technology and similar factors that may affect retailers in general. The Company's music business is seasonal with higher than average monthly revenue normally experienced during the Thanksgiving and Christmas seasons, and somewhat lower than average revenue normally experienced in September and October. The Company believes that as it continues to open and acquire video and music stores in areas in which there are existing Company stores, revenue and operating income of such existing stores may decline. The Company believes such a decline could result from certain customers of existing stores choosing to become customers of new Company stores due to more convenient locations. The Company, however, believes that aggregate revenue and operating income generated by all stores in operation will most likely increase because newly-opened and acquired Company stores typically not only draw customers from existing Company stores, but may also draw customers of competitors' stores who prefer the more favorable selection, convenience and shopping experience of a nearby Company store. The success of the Company's filmed entertainment business depends, in part, upon the network exhibition of its television series over several years to allow for more profitable licensing and syndication arrangements. During the initial years of a television series, network and international license fees normally approximate the production costs of the series, and accordingly, the Company recognizes only minimal profit or loss during this period. If a sufficient number of episodes of a series are produced, the Company is reasonably assured that it will also be able to sell the series in the domestic off-network market, and the Company would then expect to realize a more substantial profit with respect to the series. The Company's filmed entertainment business in general may also be affected by the public taste, which is unpredictible and subject to change, and by conditions within the filmed entertainment industry including, but not limited to, the quality and availability of creative talent and the negotiation and renewal of union contracts relating to writers, directors, actors, musicians and studio craftsmen, as well as any changes in the law and governmental regulation. In 1993, a Federal district court vacated certain provisions of consent decrees which prohibited television networks from acquiring financial interests and syndication rights in television programming developed or created by non-network suppliers such as the Company. Accordingly, subject to certain restrictions imposed by the Federal Communications Commission, the networks will be able to negotiate with program suppliers to acquire financial interests and syndication rights in television programs that air on the networks and therefore could become competitors of the Company. The following is a discussion of significant items in the Consolidated Statements of Operations for the three years ended December 31, 1993: RENTAL REVENUE Rental revenue consists primarily of the rental of videocassettes and was $1,285,412,000 in 1993, as compared to $969,333,000 in 1992 and $742,013,000 in 1991, representing annual increases of 33% and 31%, respectively. The significant increases in rental revenue in 1993 and 1992 are primarily the result of the increased number of Company-owned video stores in operation and increased same store rental revenue for video stores in operation for more than one year. PRODUCT SALES The following table sets forth the components of product sales revenue for the years ended December 31 (in thousands): Product sales at music stores, which consist principally of the sales of compact discs, audiocassettes and other music related items, represent sales made at Sound Warehouse and Music Plus stores which were acquired by the Company in November 1992 and Super Club music stores which were acquired in November 1993. The significant increases in product sales at Company-owned video stores, which consist principally of the sales of prerecorded videocassettes, confectionery items and video accessories, are primarily due to a greater number of stores in operation and an increase in product sales on a per store basis. Revenue from product sales in Company-owned video stores represented approximately 16% of total video store revenue for 1993 and 1992 and 15% for 1991. See Revenue Recognition of Note 1, Summary of Significant Accounting Policies, of Notes to Consolidated Financial Statements for a further discussion of product sales. OTHER REVENUE Other revenue consists primarily of programming and distribution revenue generated by the Company's filmed entertainment business, which was acquired during 1993, and royalties from video franchising activities. Programming and distribution revenue is derived primarily from network license fees, first run syndication sales and fees arising from domestic and international television licensing agreements. The following table sets forth the components of other revenue for the years ended December 31 (in thousands): See Revenue Recognition of Note 1, Summary of Significant Accounting Policies, of Notes to Consolidated Financial Statements for a further discussion of other revenue. OPERATING COSTS AND EXPENSES The following table sets forth the cost of product sales as a percentage of product sales revenue and programming and distribution expenses as a percentage of programming and distribution revenue. All other operating expenses and selling, general and administrative expenses are shown as a percentage of total revenue for the years ended December 31: The above table represents consolidated percentages of operating costs and expenses which include the addition of the Company's music business in November 1992 and its expansion during 1993 and the addition of the Company's programming and distribution business in April 1993. The inclusion of these businesses affect the comparability of year-to-year data as more fully described below. COST OF PRODUCT SALES Cost of product sales was $430,171,000, $196,175,000 and $126,746,000 for the years ended December 31, 1993, 1992 and 1991, respectively. These increases are consistent with the increases in product sales revenue for such periods. The decrease in cost of product sales as a percentage of product sales revenue for the years ended December 31, 1993 and 1992 is primarily attributable to the addition of the Company's music business in late 1992 and its expansion during 1993. The sale of music products generated higher gross margins than those historically achieved from the sale of video related products. OPERATING EXPENSES Programming and distribution expenses were $151,610,000 for the year ended December 31, 1993. Such expenses relate to the Company's filmed entertainment business and include amortization of film costs and program rights, amounts paid or due to producers, and other residual and profit participation expenses. See Film Costs and Program Rights of Note 1, Summary of Significant Accounting Policies, of Notes to Consolidated Financial Statements for a further discussion of programming and distribution expenses. Compensation, occupancy, and depreciation and amortization expenses, as percentages of revenue, declined in 1993 compared to 1992. These decreases relate principally to the addition of the Company's music and filmed entertainment businesses for the 1993 periods. The ratios of compensation, occupancy, and depreciation and amortization expenses to the revenue of such businesses were lower than the ratios historically achieved in the Company's video business. Compensation expenses were $349,798,000, $238,531,000 and $187,199,000 for the years ended December 31, 1993, 1992 and 1991, respectively. These increases are primarily a result of the continued expansion of the Company's business through the development and acquisition of video stores and the addition of the Company's music and filmed entertainment businesses. Occupancy expenses were $297,953,000, $217,860,000 and $154,289,000 for the years ended December 31, 1993, 1992 and 1991, respectively. These increases are primarily the result of the continued expansion of the Company's business through the development and acquisition of video and music stores. Depreciation and amortization expenses were $396,122,000, $306,829,000 and $223,672,000 for the years ended December 31, 1993, 1992 and 1991, respectively. The increases are primarily the result of the Company's continued investment in capital additions, particularly videocassette rental inventory, and, in 1992, the Company's adoption of a shorter economic life for certain videocassettes purchased after December 31, 1991. See Videocassette Rental Inventory and Property and Equipment of Note 1, Summary of Significant Accounting Policies, of Notes to Consolidated Financial Statements for a further discussion of depreciation and amortization. SELLING, GENERAL AND ADMINISTRATIVE Selling, general and administrative expenses were $178,322,000, $113,587,000 and $108,607,000 for the years ended December 31, 1993, 1992 and 1991, respectively. These increases primarily reflect the expansion of the Company's business through the development and acquisition of video and music stores. However, as a percentage of revenue, these expenses declined due to the addition of the Company's music businesses in November 1992 and 1993 and filmed entertainment business in April 1993. The ratio of selling, general and administrative expenses to the revenue of such businesses is lower than the ratio historically achieved in the Company's video business. INTEREST EXPENSE Interest expense was $33,773,000, $17,793,000 and $21,780,000 for the years ended December 31, 1993, 1992 and 1991, respectively. The increase in 1993 is primarily attributable to increases in average indebtedness resulting from the expansion of the Company's business. GAIN FROM EQUITY INVESTMENT The Company's consolidated results of operations for the year ended December 31, 1993 include a gain before income taxes of $2,979,000 resulting from the Company's investment in Discovery Zone, Inc. ("Discovery Zone") and a subsequent initial public offering of 5,000,000 common shares by Discovery Zone in June 1993. See Gain on Equity Investment of Note 1, Summary of Significant Accounting Policies, of Notes to Consolidated Financial Statements for a further discussion of this transaction. OTHER EXPENSE Other expense, net, was $9,217,000, $893,000 and $2,345,000 for the years ended December 31, 1993, 1992 and 1991, respectively. The increase in 1993 is primarily a result of minority interest expense arising from the Company's filmed entertainment business, which is less than 100% owned. PROVISION FOR INCOME TAXES The Company's effective tax rate was 37.5%, 35.9% and 36.8% for the years ended December 31, 1993, 1992 and 1991, respectively. The increased rate in 1993 is primarily attributable to the increase in the statutory federal corporate tax rate. The decreased rate in 1992 is primarily the result of reductions in the Company's effective foreign income tax rate. See Note 5, Income Taxes, of Notes to Consolidated Financial Statements for a further discussion of income taxes. FINANCIAL CONDITION The Company believes that its financial condition remains strong and that it has sufficient operating cash flow and other financial resources necessary to meet its anticipated capital requirements and obligations as they come due. WORKING CAPITAL Working capital at December 31, 1993 amounted to $105,485,000 as compared to a deficit of $54,992,000 at December 31, 1992. The increase of $160,477,000 during 1993 was due primarily to cash provided by operating and financing activities and working capital resulting from the addition of the Company's filmed entertainment business. Videocassette rental inventories are deemed non-current assets under generally accepted accounting principles as they are not assets which are reasonably expected to be completely realized in cash or sold in the normal business cycle. Although the rental of such inventory generates a significant portion of the Company's revenue, the classification of such assets as non-current under generally accepted accounting principles requires their exclusion from the computation of working capital. For this reason, the Company believes working capital is not as significant as a measurement of financial condition for companies operating in the home video industry as it is for companies without operations in the home video industry. Accounts and notes receivable consist primarily of amounts due from customers. At December 31, 1993, accounts and notes receivable were $135,172,000, an increase of $91,022,000 over December 31, 1992. This increase relates primarily to the addition of receivables from licensing agreements related to the Company's filmed entertainment business. The current portion of film costs and program rights was $117,324,000 at December 31, 1993 and also relates to the addition of the Company's filmed entertainment business. Other current assets were $50,210,000 at December 31, 1993, an increase of $27,111,000 as compared to December 31, 1992. This increase was primarily due to the expansion of the Company's music business and an increase in current deferred income tax assets related to the Company's foreign operations. Merchandise inventories and accounts payable at December 31, 1993 were $350,763,000 and $369,815,000, respectively, an increase of $170,761,000 and $153,453,000 over December 31, 1992. These increases are primarily a result of the Company's expanded music business where it is customary to carry larger merchandise inventories as compared to Company-owned video stores, as well as its expanding video operations. Accrued liabilities were $177,695,000 at December 31, 1993, an increase of $78,177,000 as compared to December 31, 1992. This increase primarily reflects the Company's addition of its filmed entertainment business and expansion of its music business. Accrued participation expenses were $43,013,000 at December 31, 1993 and relate to the addition of the Company's filmed entertainment business. VIDEOCASSETTE RENTAL INVENTORY AND PROPERTY AND EQUIPMENT See "Cash Flows From Investing Activities" under the heading "Cash Flows" of Management's Discussion and Analysis of Financial Condition and Results of Operations and Videocassette Rental Inventory and Property and Equipment of Note 1, Summary of Significant Accounting Policies, of Notes to Consolidated Financial Statements for a discussion of videocassette rental inventory and property and equipment policies and other information. INTANGIBLE ASSETS Intangible assets increased approximately $434,163,000 during 1993 primarily as a result of acquisitions made by the Company during the year. See Intangible Assets of Note 1, Summary of Significant Accounting Policies and Note 2, Business Combinations and Investments, of Notes to Consolidated Financial Statements for a further discussion of intangible assets. OTHER ASSETS Other assets consist primarily of equity investments in less than majority-owned businesses and the non-current portion of film costs and program rights and increased approximately $205,824,000 during 1993 primarily as a result of the addition of the Company's filmed entertainment business and investments in less than majority-owned businesses. See Other Assets of Note 1, Summary of Significant Accounting Policies, of Notes to Consolidated Financial Statements for a further discussion of other assets. MINORITY INTERESTS IN SUBSIDIARIES Minority interests in subsidiaries increased during 1993 as a result of the Company's acquisition of its filmed entertainment business which is less than 100% owned. CAPITAL STRUCTURE In February 1994, the Company entered into a credit agreement with certain banks pursuant to which such banks advanced the Company on an unsecured basis $1,000,000,000 for a term of twelve months. In March 1994, the Company used the proceeds from such borrowing along with $250,000,000 of proceeds from borrowings under its existing credit facility for the purchase of shares of non-voting Viacom Class B common stock. See "Business Combinations and Investments" of Management's Discussion and Analysis of Financial Condition and Results of Operations and Note 12, Other Matters, of Notes to Consolidated Financial Statements for a further discussion of the Viacom transactions. The following table sets forth the components of the Company's capital structure, as a percentage of total capital, at December 31: The changes in long-term debt, subordinated convertible debt and shareholders' equity as a percentage of total capital in 1993 primarily reflects the conversion of substantially all of the Company's subordinated convertible debt into shares of Common Stock during 1993. Significant transactions affecting long-term debt, subordinated convertible debt and shareholders' equity are discussed below. In December 1993, the Company entered into a credit agreement (the "Credit Agreement") with certain banks pursuant to which such banks have agreed to advance the Company on an unsecured basis an aggregate of $1,000,000,000 for a term of 40 months. The Credit Agreement significantly increased the Company's committed borrowing capacity and contains terms and conditions generally consistent with those existing under the prior 1992 revolving credit facility which the Credit Agreement replaced. At December 31, 1993, approximately $411,000,000 was outstanding under the Credit Agreement. In November 1993, the Company completed an underwritten public offering of 14,650,000 shares of Common Stock, realizing net proceeds of approximately $424,118,000 which were used to reduce existing indebtedness. Subordinated convertible debt represented the Company's issuance of $300,000,000 principal amount at maturity of LYONs. The LYONs were zero-coupon notes subordinated to all existing and future senior indebtedness. In August 1993, the Company called the LYONs for redemption. As a consequence of the call, substantially all such LYONs were converted to approximately 8,303,000 shares of Common Stock. In December 1992, the Company filed with the Securities and Exchange Commission a shelf registration statement covering up to $300,000,000 of unsecured senior and unsecured subordinated debt securities. In February 1993, the Company issued $150,000,000 of 6.625% senior notes under the registration statement, which notes mature in February 1998 and pay interest semi-annually. The proceeds from such issuance were used to refinance existing indebtedness. In January 1992, the Company received approximately $66,000,000 from Philips for the purchase of 6,000,000 shares of Common Stock. Philips subsequently exercised an option to acquire an additional 5,000,000 shares of Common Stock at $11.00 per share. The sale of the additional 5,000,000 shares of Common Stock was completed in July 1992 with the Company receiving from Philips a $54,500,000 promissory note which was paid on June 30, 1993. During 1992, in addition to the option exercised by Philips, the Company received net proceeds of approximately $15,808,000 in connection with the exercise of warrants and options to acquire 7,371,084 shares of Common Stock. During 1993 and 1992, the Company issued Common Stock valued at approximately $369,407,000 and $113,974,000, respectively, in connection with its acquisitions and investments. See Notes 2, 3, 4 and 7, Business Combinations and Investments, Long-Term Debt, Subordinated Convertible Debt and Shareholders' Equity, of Notes to Consolidated Financial Statements for a further discussion of business combinations, investments, indebtedness and shareholders' equity. CASH FLOWS Cash and cash equivalents increased by $51,896,000 in 1993 compared to decreases of $8,306,000 in 1992 and $94,000 in 1991. The major components of these changes are discussed below. CASH FLOWS FROM OPERATING ACTIVITIES Cash flows provided by operating activities increased to $522,284,000 in 1993 from $450,785,000 in 1992 and $350,351,000 in 1991. Such increases are primarily a result of the increased number of Company-owned video stores in operation. Cash provided by operating activities combined with cash provided by financing activities in 1993, 1992 and 1991 were used to fund capital additions and acquisitions as the Company's business expanded during these years. Cash provided by operating activities generated substantially all of the cash needed for capital additions, net of disposals of videocassette rental inventory, during the three years ended December 31, 1993, 1992 and 1991. CASH FLOWS FROM INVESTING ACTIVITIES Capital additions for new and existing stores and cash used in business combinations and investments comprise most of the Company's investing activities. Capital additions, which consist primarily of purchases of videocassette rental inventory and property and equipment, were $615,657,000, $394,532,000 and $300,694,000 in 1993, 1992 and 1991, respectively. Cash used in business combinations and investments was $673,241,000, $252,888,000 and $8,244,000 in 1993, 1992 and 1991, respectively, and includes the $600,000,000 investment in Series A cumulative convertible preferred stock of Viacom as well as acquisitions of Spelling and Super Club in 1993 and the acquisitions of Cityvision, Sound Warehouse and Music Plus in 1992. See "Viacom Inc. Agreements" and "Business Combinations and Investments" of Management's Discussion and Analysis of Financial Condition and Results of Operations and Note 2, Business Combinations and Investments and Note 12, Other Matters, of Notes to Consolidated Financial Statements for a further discussion of businesses acquired and other investments. During 1993, 1992 and 1991 the Company opened or acquired a net of 483, 980 (including 775 stores related to the Cityvision acquisition) and 307 video stores, respectively. During 1993 and 1992, the Company also opened or acquired a net of 273 and 238 music stores, respectively. Company-opened video stores require initial capital expenditures, including the purchase of videocassettes for rental, of generally between $375,000 to $700,000 per store. The Company has recently developed its own prototype music store called "Blockbuster Music Plus". The Company currently projects that the cost to open a new "Blockbuster Music Plus" store will require an initial investment, including capital expenditures and merchandise inventory, of generally between $700,000 to $1,000,000. The cost of acquiring video and music stores varies, depending upon the size, location, operating history of the store, and, in the case of video stores, the value associated with any reacquisition of franchise rights for the territory related to the video store acquired. Thus, although the Company can reasonably estimate the dollar amount necessary to open a new video or music store, it is impossible to know the cost of each acquisition or what mix of new store openings and acquisitions will occur in the future. The Company believes that during 1994 it will continue to purchase new release videocassettes and property and equipment in a manner substantially consistent with historical practices. The Company currently intends to continue to expand in the entertainment industry, which may include acquiring and opening additional video and music stores, as well as developing, making investments in or acquiring other entertainment related concepts or businesses. In addition, the Company plans on converting a substantial number of its existing music stores to the "Blockbuster Music Plus" format during 1994. The Company believes that cash provided by operating activities as well as cash available under the Company's Credit Agreement will be adequate to finance capital additions and other funding requirements during 1994. The Company from time to time may seek additional or alternate sources of financing. See Note 3, Long-Term Debt, of Notes to Consolidated Financial Statements for a further discussion of financing available under the Company's credit facilities and from other sources. CASH FLOWS FROM FINANCING ACTIVITIES Cash flows from financing activities during 1993, 1992 and 1991 resulted from commercial bank borrowings, repayments of such bank borrowings, issuances of Common Stock and, in 1993 and 1992, the payment of cash dividends. Proceeds from the issuance of Common Stock were $595,698,000 in 1993 and primarily consisted of the sale of 14,650,000 shares of Common Stock in an underwritten public offering. These financing activities combined with cash provided by operating activities were used to fund capital additions and the development and acquisition of stores as the Company's business expanded during these years. See "Capital Structure" under the heading "Financial Condition" of Management's Discussion and Analysis of Financial Condition and Results of Operations and Notes 3, 4, 6 and 7, Long-Term Debt, Subordinated Convertible Debt, Stock Options and Warrants and Shareholders' Equity, of Notes to Consolidated Financial Statements for a further discussion of indebtedness and shareholders' equity transactions. INFLATION The Company anticipates that its business will be affected by general economic trends. While the Company has not operated in the videocassette rental industry, the music retailing industry or filmed entertainment industry during a period of high inflation, the Company believes that if costs increase, it should be able to pass such increases on to its customers. FOREIGN EXCHANGE The Company has foreign operations, primarily in the United Kingdom and Canada. Exchange rate fluctuations between the currencies of these countries and the U.S. Dollar may result in the translation and reporting of varying amounts of U.S. Dollars in the Company's consolidated financial statements. Based on the current scope of its foreign operations, the Company believes that any such fluctuations would not have a material adverse effect on the Company's consolidated financial condition or results of operations as reported in U.S. Dollars. RECENTLY ISSUED ACCOUNTING STANDARDS Effective January 1, 1994, the Company adopted Statement of Financial Accounting Standards ("SFAS") No. 112, Employers' Accounting for Postemployment Benefits, and SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities. The Company believes the adoption of SFAS No. 112 will not have a material effect on its results of operations or financial condition. However, the adoption of SFAS No. 115 will require the Company to adjust its investment in non-voting Viacom Class B common stock to fair value. Pursuant to the provisions of SFAS No. 115, the Company has classified such investment as an "available-for-sale security". Accordingly, any adjustment to fair value will be excluded from net income and reported as a separate component of shareholders' equity. Based on the quoted market price at March 23, 1994 and after satisfaction of Viacom's make-whole obligation, the maximum adjustment to fair value would result in a reduction of total assets and shareholders' equity of approximately $186,000,000, net of income taxes, at such date. See "Viacom Inc. Agreements" of Management's Discussion and Analysis of Financial Condition and Results of Operations for a further discussion of the Viacom investment. Item 8. Item 8. Financial Statements and Supplementary Data Index to Consolidated Financial Statements All other schedules are omitted as not applicable or not required. REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS To Blockbuster Entertainment Corporation: We have audited the accompanying consolidated balance sheets of Blockbuster Entertainment Corporation (a Delaware corporation) and subsidiaries 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. 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 Blockbuster Entertainment 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. Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. The schedules included in Item 14.(a)(2) 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. Fort Lauderdale, Florida, March 23, 1994. The accompanying notes are an integral part of these statements. The accompanying notes are an integral part of these statements. The accompanying notes are an integral part of these statements. The accompanying notes are an integral part of these statements. BLOCKBUSTER ENTERTAINMENT CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (000's omitted in all tables except per share amounts) 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES The accompanying consolidated financial statements present the consolidated financial position and results of operations of Blockbuster Entertainment Corporation and subsidiaries (the "Company"). All material intercompany accounts and transactions have been eliminated. In order to maintain consistency and comparability between periods presented, certain amounts have been reclassified from the previously reported financial statements in order to conform with the financial statement presentation of the current period. The accompanying consolidated financial statements also include the financial position and results of operations of WJB Video Limited Partnership and certain of its affiliates ("WJB"), with which the Company merged in August 1993. This transaction has been accounted for under the pooling of interests method of accounting and, accordingly, these financial statements and notes thereto have been restated as if the companies had operated as one entity since inception. See Note 2, Business Combinations and Investments, for a further discussion of this transaction. Accounts and Notes Receivable: Accounts and notes receivable, which are stated net of an allowance for doubtful accounts, consist primarily of amounts due from customers. The current portion of notes receivable was approximately $13,298,000 and $15,432,000 at December 31, 1993 and 1992, respectively. The Company believes that the carrying amounts of accounts and notes receivable at December 31, 1993 and 1992 approximate fair value at such dates. Merchandise Inventories: Merchandise inventories, consisting primarily of prerecorded music and videocassettes, are stated at the lower of cost or market. Cost is determined using the moving weighted average or the retail inventory method, the uses of which approximate the first-in, first-out basis. Film Costs and Program Rights: Film costs and program rights relate to the operations of the Company's filmed entertainment business. See Note 2, Business Combinations and Investments. Film costs and program rights include production or acquisition costs (including advance payments to producers), capitalized overhead and interest, prints, and advertising expected to benefit future periods. These costs are amortized, and third party participations and residuals are accrued, in the ratio that the current year's gross revenue bears to estimated future gross revenue, calculated on an individual product basis. BLOCKBUSTER ENTERTAINMENT CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Film costs and program rights are stated at the lower of cost, net of amortization, or estimated net realizable value on an individual film product basis. Estimates of total gross revenue, costs and participation expenses are reviewed quarterly and write-downs to net realizable value are recorded and future amortization expense is revised as necessary. Based on the Company's estimates of future gross revenue as of December 31, 1993, approximately 60% of unamortized released film costs and program rights will be amortized within the next three years. The components of film costs and program rights, net of amortization, at December 31, 1993 are as follows: The non-current portion of film costs and program rights is included in other assets. Videocassette Rental Inventory: Videocassettes are recorded at cost and amortized over their estimated economic life with no provision for salvage value. Videocassettes which are considered base stock are amortized over thirty-six months on a straight-line basis. Videocassettes which are considered new release feature films frequently ordered in large quantities to satisfy initial demand ("hits") are, except as discussed below, amortized over thirty-six months on an accelerated basis. "Hit" titles for which twelve or more copies per store were purchased during the period from January 1, 1990 through December 31, 1991 were, for the twelfth and any succeeding copies, amortized over twelve months on an accelerated basis. Effective January 1, 1992, "hit" titles for which ten or more copies per store are purchased are, for the tenth and any succeeding copies, amortized over nine months on an accelerated basis. For the twelve months ended December 31, 1992, the adoption of this shorter economic life had the effect of reducing net income by approximately $9,556,000 and net income per common and common equivalent share by approximately five cents per share. BLOCKBUSTER ENTERTAINMENT CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Videocassette rental inventory and related amortization at December 31 are as follows: Amortization expense related to videocassette rental inventory was $295,729,000, $234,862,000 and $171,509,000 in 1993, 1992 and 1991, respectively. As videocassette rental inventory is sold or retired, the applicable cost and accumulated amortization are eliminated from the accounts and any gain or loss thereon is recorded. Property and Equipment: Property and equipment is stated at cost. Depreciation and amortization expense is provided over the estimated lives of the related assets using the straight-line method. Property and equipment at December 31 consists of the following: Depreciation and amortization expense related to property and equipment was $74,772,000, $59,094,000 and $43,868,000 in 1993, 1992 and 1991, respectively. Additions to property and equipment are capitalized and include acquisitions of property and equipment, costs incurred in the development and construction of new stores, major improvements to existing property and management information systems. As property and equipment is sold or retired, the applicable cost and accumulated depreciation and amortization are eliminated from the accounts and any gain or loss thereon is recorded. Intangible Assets: Intangible assets primarily consist of the cost of acquired businesses in excess of the market value of net tangible assets acquired. The cost in excess of the market value of net tangible assets is amortized on a straight-line basis over periods ranging from 15 to 40 years. Subsequent to its acquisitions, the Company continually evaluates factors, events and circumstances which include, but are not limited to, the historical and projected operating performance of acquired businesses, specific industry trends and general economic conditions to assess whether the BLOCKBUSTER ENTERTAINMENT CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) remaining estimated useful life of intangible assets may warrant revision or that the remaining balance of intangible assets may not be recoverable. If such factors, events or circumstances indicate that intangible assets should be evaluated for possible impairment, the Company uses an estimate of undiscounted net income over the remaining life of the intangible assets in measuring their recoverability. Accumulated amortization of intangible assets at December 31, 1993 and 1992 was $45,286,000 and $20,168,000, respectively. Other Assets: Other assets consist primarily of equity investments in less than majority-owned businesses, the non-current portion of film costs and program rights related to the Company's filmed entertainment business and the non-current portion of accounts and notes receivable. The non-current portion of such receivables was approximately $39,153,000 and $47,288,000 at December 31, 1993 and 1992, respectively. The Company believes the carrying amounts of the non-current portion of accounts and notes receivable approximate fair value at such dates. Accrued Participation Expenses: Accrued participation expenses relate to the Company's filmed entertainment business and include amounts due to producers and other participants for their share of programming and distribution revenue. Foreign Currency Translation: Foreign subsidiaries' assets and liabilities are translated at the rates of exchange at the balance sheet date while income statement accounts are translated at the average exchange rates in effect during the periods presented. The resulting translation adjustments are reported as a separate component of shareholders' equity. Gains and losses resulting from foreign currency transactions are included in net income. The aggregate transaction gain included in the determination of net income for the year ended December 31, 1992 was $6,778,000. There were no transaction gains or losses during the years ended December 31, 1993 and 1991. Revenue Recognition: Revenue from Company-owned video and music stores is recognized at the time of rental or sale. Revenue from franchise owners is recognized when all material services or conditions required under the Company's franchise agreements have been performed by the Company. Revenue from programming and distribution is recognized as follows: (1) revenue from licensing agreements covering film product owned by the Company is recognized when the film product is available to the licensee for telecast, exhibition or distribution, and other conditions of the licensing agreements have been met and (2) revenue from television distribution of film product which is not owned by the Company is recognized when billed. BLOCKBUSTER ENTERTAINMENT CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Gain From Equity Investment: It is the Company's policy to record gains or losses from the sale or issuance of previously unissued stock by its subsidiaries or by companies in which the Company is an equity investor and accounts for its investment using the equity method. The Company's consolidated results of operations for the year ended December 31, 1993 include a gain before income taxes of $2,979,000, resulting from the Company's investment in Discovery Zone, Inc. ("Discovery Zone") and a subsequent initial public offering of 5,000,000 common shares by Discovery Zone in June 1993. Discovery Zone owns, operates and franchises indoor recreational facilities for children. Cash Flow Information: Cash equivalents consist of interest bearing securities with original maturities of less than ninety days. See Notes 2, 3, 5 and 7, Business Combinations and Investments, Long-term Debt, Income Taxes and Shareholders' Equity, of Notes to Consolidated Financial Statements for a discussion of supplemental cash flow information. 2. BUSINESS COMBINATIONS AND INVESTMENTS All business combinations discussed below, except for the merger with WJB, were accounted for under the purchase method of accounting and, accordingly, are included in the Company's financial statements from the date of acquisition. In November 1993, the Company acquired all of the outstanding capital stock of Super Club Retail Entertainment Corporation and subsidiaries ("Super Club"), which owns and operates video and music stores. The purchase price paid by the Company was approximately $150,000,000 and consisted of 5,245,211 shares of the Company's common stock, $.10 par value ("Common Stock") and warrants to acquire shares of Common Stock. The warrants give the holders the right to acquire 1,000,000 and 650,000 shares of Common Stock at exercise prices of $31.00 and $32.42 per share, respectively. In October 1993, the Company purchased 24,000,000 shares of newly-issued Series A cumulative convertible preferred stock of Viacom Inc. ("Viacom") for an aggregate purchase price of $600,000,000, representing a purchase price of $25 per share. The preferred stock provides for the payment of quarterly dividends at an annual rate of 5% and is convertible into non-voting Viacom Class B common stock at a conversion price of $70 per share. The preferred stock is redeemable at the option of Viacom beginning in October 1998. Although the preferred stock is currently an unlisted equity security, based upon a valuation which considered the terms and conditions of the preferred stock as well as comparisons to other similar securities, the Company estimates the fair BLOCKBUSTER ENTERTAINMENT CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) value of such investment to be approximately $552,000,000 at December 31, 1993. In August 1993, the Company merged with WJB, its largest franchise owner. In connection with the merger, the Company issued 7,214,192 shares of its Common Stock in exchange for the equity interests of WJB. This transaction has been accounted for under the pooling of interests method of accounting and, accordingly, the Company's financial statements have been restated for all periods as if the companies had operated as one entity since inception. Revenue and net income of the previously separate companies for the periods before the pooling of interests business combination was consummated (after reflecting the effects of intercompany eliminations) are as follows: During the second quarter of 1993, the Company acquired a majority of the common stock of Spelling Entertainment Group Inc. ("Spelling"), a producer and distributor of filmed entertainment. The aggregate consideration paid by the Company totaled approximately $163,369,000 and consisted of cash and 9,278,034 shares of Common Stock. The Company also issued to certain sellers of Spelling's common stock, warrants to acquire an aggregate of 2,000,000 shares of its Common Stock at an exercise price of $25 per share. Additionally, in October 1993, the Company exchanged 3,652,542 shares of Common Stock for 13,362,215 newly issued shares of Spelling's common stock as more fully discussed in Note 7, Shareholders' Equity. As a result of the transactions described above, the Company owned approximately 70.5% of the outstanding common stock of Spelling at December 31, 1993. During 1993, the Company acquired or invested in businesses that own and operate video stores, are involved in the production and distribution of filmed entertainment, and own, operate and franchise indoor recreational facilities for children. The aggregate purchase price paid by the Company was approximately $195,610,000 and consisted of cash and 5,631,180 shares of Common Stock. BLOCKBUSTER ENTERTAINMENT CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) In November 1992, the Company acquired Sound Warehouse, Inc. and subsidiary and Show Industries, Inc. ("Sound Warehouse" and "Music Plus") which own and operate music stores. The purchase price paid by the Company was approximately $190,000,000 and consisted of cash and 4,142,051 shares of Common Stock. In February 1992, the Company acquired Cityvision plc ("Cityvision"), the largest home video retailer in the United Kingdom. The purchase price paid by the Company was approximately $125,000,000 and consisted of cash and 3,999,672 shares of Common Stock. At December 31, 1993, Cityvision operated 775 stores under the trade name "Ritz". During 1992, the Company also acquired or invested in several other businesses that own and operate video and music stores. The aggregate purchase price paid by the Company was approximately $103,774,000 and consisted of cash and 2,112,977 shares of Common Stock. During 1991, the Company acquired several businesses that own and operate video stores. The aggregate purchase price paid by the Company was approximately $89,614,000 and consisted of cash and 6,492,757 shares of Common Stock. Such shares of Common Stock include 1,297,921 shares issued by the Company in connection with the repayment of a $12,586,000 short-term promissory note which was issued by the Company in connection with an acquisition during 1991. The Company's consolidated results of operations for the years ended December 31 on an unaudited pro forma basis assuming the acquisitions of Super Club, Spelling, Sound Warehouse and Music Plus had occurred as of January 1, 1992, are as follows: BLOCKBUSTER ENTERTAINMENT CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) The purchase price allocations for all business combinations and investments discussed above, except for the merger with WJB which was accounted for under the pooling of interests method of accounting, were as follows for the years ended December 31: The amounts presented above for 1993 reflect the preliminary purchase price allocations for business combinations. BLOCKBUSTER ENTERTAINMENT CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) 3. LONG-TERM DEBT Long-term debt at December 31 is as follows: In December 1993, the Company entered into a credit agreement (the "Credit Agreement") with certain banks pursuant to which such banks have agreed to advance the Company on an unsecured basis an aggregate of $1,000,000,000 for a term of 40 months. Outstanding advances, if any, are payable at the expiration of the 40-month term. The Credit Agreement requires, among other items, that the Company maintain certain financial ratios and comply with certain financial covenants. Interest is generally determined and payable monthly using a competitive bid feature. The Credit Agreement replaces a 1992 revolving credit arrangement among the Company and certain other banks. BLOCKBUSTER ENTERTAINMENT CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) In December 1992, the Company filed with the Securities and Exchange Commission a shelf registration statement covering up to $300,000,000 of unsecured senior debt securities and unsecured subordinated debt securities. In February 1993, the Company issued $150,000,000 of 6.625% senior notes under the registration statement. Such notes mature in February 1998 and pay interest semi- annually. The proceeds from such issuance were used to refinance existing indebtedness. The notes are registered on the New York Stock Exchange and at December 31, 1993 had a quoted market price of approximately $101.25 per note resulting in a fair value for all outstanding notes of approximately $151,875,000. All outstanding advances under the bank term loan, which were related to the Company's filmed entertainment business, were repaid and such loan terminated in January 1994. Excluding the unsecured senior notes discussed above, substantially all of the Company's long-term debt at December 31, 1993 and 1992 carried interest rates that were adjusted regularly to reflect current market conditions. Accordingly, the Company believes the carrying amount of such indebtedness approximated fair value at such dates. The Company made interest payments of $26,301,000, $9,707,000 and $12,913,000 in 1993, 1992 and 1991, respectively. 4. SUBORDINATED CONVERTIBLE DEBT In August 1993, the Company called its Liquid Yield Option Notes ("LYONs") for redemption. As a consequence of the call, substantially all such LYONs were converted to approximately 8,303,000 shares of Common Stock resulting in an increase to shareholders' equity of approximately $122,272,000. The LYONs were issued initially in November 1989 in the aggregate principal amount at maturity of $300,000,000 and required no periodic interest payments. Each LYON had an issue price of $308.32 and would have had a principal amount due at maturity of $1,000 (representing a yield to maturity of 8% per annum computed on a semi-annual bond equivalent basis). Each LYON was convertible into 27.702 shares of Common Stock, at the option of the holder, at any time on or prior to maturity, was subordinated to all existing and future Senior Indebtedness (as defined in the LYONs indenture agreement) of the Company, and was redeemable under certain circumstances in whole or in part, at the option of the Company, for cash in an amount equal to the issue price plus accrued original issue discount to the date of redemption. The LYONs were registered on the New York Stock Exchange and at December 31, 1992 had a quoted market price of approximately $530 per LYON resulting in a fair value for all outstanding LYONs of approximately $159,000,000. BLOCKBUSTER ENTERTAINMENT CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) 5. INCOME TAXES In February 1992, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards ("SFAS") No. 109 - Accounting for Income Taxes, which superceded SFAS No. 96. The Company adopted SFAS No. 109 in 1991. The income tax provision for the years ended December 31 consists of the following components: A reconciliation of the federal income tax rate to the Company's effective income tax rate for the years ended December 31 is as follows: BLOCKBUSTER ENTERTAINMENT CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities at December 31 are as follows: During 1993, the Company's valuation allowance increased by $43,544,000 to $47,275,000. Such increase relates primarily to certain deferred tax assets of acquired businesses which consist principally of net operating loss carryforwards. Should future circumstances result in a change in the valuation allowance, such change may be allocated so as to increase or decrease intangible assets. The foreign component of income before income taxes for the years ended December 31, 1993 and 1992 was approximately $15,200,000 and $22,723,000, respectively. At December 31, 1993, the Company had approximately $210,000,000 of operating and capital loss carryforwards available to reduce future income taxes, of which approximately $29,000,000 have unlimited carryforward periods and approximately $181,000,000 expire in varying amounts commencing in 2001. These carryforwards relate primarily to businesses acquired by the Company and to periods prior to their respective acquisition dates. The Company made income tax payments of approximately $63,621,000, $61,002,000 and $14,857,000 in 1993, 1992 and 1991, respectively. BLOCKBUSTER ENTERTAINMENT CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) 6. STOCK OPTIONS AND WARRANTS The Company has various stock option plans under which shares of Common Stock may be granted to key employees and directors of the Company. Options granted under the plans are non-qualified and are granted at a price equal to the fair market value of the Common Stock at the date of grant. A summary of stock option and warrant transactions for the years ended December 31 is as follows: In February 1992, warrants to acquire 5,138,323 shares of Common Stock, originally issued in 1987 in connection with the initial equity investment in the Company by its Chairman, were exercised with the Company receiving proceeds of approximately $6,293,000. In April 1992, the Company granted a call option, for 5,000,000 shares of Common Stock, to Philips Electronics N.V. ("Philips") that was subsequently exercised as more fully described in Note 7, Shareholders' Equity. 7. SHAREHOLDERS' EQUITY The Board of Directors has the authority to issue up to 500,000 shares of $1 par value preferred stock at such time or times, in such series, with such designations, preferences, special rights, limitations or restrictions thereof as it may determine. No shares of preferred stock have been issued. BLOCKBUSTER ENTERTAINMENT CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) In November 1993, the Company registered with the Securities and Exchange Commission 14,650,000 shares of its Common Stock to be offered in an underwritten public offering. Upon the sale of such shares, the Company realized net proceeds of approximately $424,118,000 which were used to reduce existing indebtedness. In October 1993, the Company issued 3,652,542 shares of its Common Stock to Spelling in exchange for 13,362,215 newly issued shares of Spelling's common stock increasing the Company's ownership to approximately 70.5% of the outstanding common stock of Spelling. Spelling subsequently resold such shares of the Company's Common Stock resulting in an increase to the Company's shareholders' equity of approximately $100,445,000. In 1993, the Company received net proceeds of approximately $16,635,000 in connection with the exercise of warrants and options to acquire 2,674,933 shares of Common Stock. Sales of Common Stock as shown on the Consolidated Statements of Changes in Shareholders' Equity for the year ended December 31, 1992 include $66,000,000 received in January 1992 from Philips for the purchase of 6,000,000 shares of Common Stock and $55,000,000 from Philips related to the exercise of an option to purchase 5,000,000 shares of Common Stock. The sale of the additional 5,000,000 shares of Common Stock was completed in July 1992 with the Company receiving from Philips a $54,500,000 promissory note which was subsequently collected in June 1993. In addition to the option exercised by Philips, the Company received net proceeds of approximately $15,808,000 in connection with the exercise of warrants and options to acquire 7,371,084 shares of Common Stock in 1992. In April 1992, the Board of Directors of the Company adopted a policy providing for the payment of quarterly cash dividends to the Company's shareholders. Cash dividends of nine and one half and six cents per common share were declared during 1993 and 1992, respectively. In 1991, the Company received net proceeds of approximately $11,516,000 in connection with the exercise of warrants and options to acquire 6,439,748 shares of Common Stock. As of December 31, 1993, approximately 34,624,000 shares of Common Stock were reserved for issuance under employee benefit and dividend reinvestment plans, upon exercise of certain warrants and options and in connection with potential acquisitions of other businesses, properties or securities. BLOCKBUSTER ENTERTAINMENT CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) 8. COMMITMENTS AND CONTINGENCIES The Company leases substantially all of its retail, distribution and administration facilities under non-cancellable operating leases, which in most cases contain renewal options. Rental expense was approximately $212,803,000, $153,522,000 and $106,608,000 for the years ended December 31, 1993, 1992 and 1991, respectively. Future minimum lease payments under non-cancellable operating leases at December 31, 1993 are due as follows: The Company has guaranteed obligations of certain of its joint ventures aggregating approximately $53,755,000 at December 31, 1993. After considering its interest in the underlying assets of such joint ventures, the Company believes it is not exposed to any potential material losses in connection with these guarantees. Subject to certain conditions, the Company is committed to purchase all of the outstanding common stock of Republic Pictures Corporation ("Republic") for approximately $68,000,000 in cash in connection with the merger of Republic into Spelling. The Company has become subject to various lawsuits, claims and other legal matters in the course of conducting its business, including its business as a franchisor. The Company believes that such lawsuits, claims and other legal matters will not have a material adverse effect on the Company's consolidated results of operations or financial condition. Spelling is involved in a number of legal actions including threatened claims, pending lawsuits and contract disputes, environmental clean-up assessments, damages from alleged dioxin contamination and other matters primarily resulting from its discontinued operations. Some of the parties involved in such actions seek significant amounts of damages. While the outcome of these suits and claims cannot be predicted with certainty, the Company believes based upon its knowledge of the facts and circumstances and applicable law that the ultimate resolution of such suits and claims will not have a material adverse effect on the Company's results of operations or financial condition. This belief is also based upon the adequacy of approximately $30,000,000 of accruals that have been established for probable losses on disposal of former operations and remaining Chapter 11 disputed claims and an insurance-type indemnity agreement which covers up to $35,000,000 of certain possible liabilities in excess of a threshold amount of $25,000,000, subject to certain adjustments. Substantial portions of such accruals are intended to cover environmental costs associated with Spelling's former operations. Such accruals are recorded without discount or offset for either the time value of money prior to the BLOCKBUSTER ENTERTAINMENT CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) anticipated date of payment or expected recoveries from insurance or contribution claims against unaffiliated entities. Although there are significant uncertainties inherent in estimating environmental liabilities, based upon the Company's experience it is considered unlikely that the amount of possible environmental liabilities and Chapter 11 disputed claims would exceed the amount of accruals by more than $50,000,000. 9. NET INCOME PER SHARE Net income per common and common equivalent share is based on the combined weighted average number of common shares and common share equivalents outstanding which include, where appropriate, the assumed exercise or conversion of warrants and options. In computing net income per common and common equivalent share, the Company utilizes the treasury stock method. For the year ended December 31, 1992, computation of net income per common and common equivalent share on a fully diluted basis assumes conversion of the LYONs, resulting in an increase to net income for the hypothetical elimination of interest expense, net of tax, related to the LYONs. No such adjustment was necessary for 1993 as the LYONs were converted to shares of Common Stock as more fully described in Note 4, Subordinated Convertible Debt. The information required to compute net income per share on a primary and fully diluted basis for the years ended December 31 is presented below: 10. BUSINESS SEGMENT INFORMATION Prior to 1992, the Company's operations consisted primarily of operating and franchising video stores. With the acquisition of Sound Warehouse and Music Plus in November 1992, the acquisition of a majority interest in Spelling in April 1993 and the acquisition of Super Club in November 1993, the Company's operations were expanded to include the sale BLOCKBUSTER ENTERTAINMENT CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) of prerecorded music and related items and the production and distribution of filmed entertainment. Financial information about the Company's operations by industry segment for the years ended December 31 is as follows: BLOCKBUSTER ENTERTAINMENT CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) 11. SELECTED QUARTERLY FINANCIAL DATA (Unaudited) The following is an analysis of certain items in the Consolidated Statements of Operations by quarter for 1993 and 1992. 12. OTHER MATTERS In January 1994, the Company entered into a merger agreement pursuant to which the Company has agreed to merge with and into Viacom, with Viacom being the surviving corporation. Under the terms of the agreement each share of Common Stock shall be converted into the right to receive .08 shares of Viacom Class A common stock, .60615 shares of non-voting Viacom Class B common stock and under certain circumstances, up to an additional .13829 shares of non-voting Viacom Class B common stock. The closing of the merger is subject to customary conditions including approval of the merger by the Company's shareholders. Concurrently with the merger agreement, the Company entered into a subscription agreement pursuant to which, in March 1994, the Company purchased from Viacom 22,727,273 shares of non-voting Viacom Class B common stock for an aggregate purchase price of $1,250,000,000, or $55 per share. In February 1994, the Company entered into a credit agreement with certain banks pursuant to which such banks advanced the Company on an unsecured basis $1,000,000,000 for a term of twelve months. In March 1994, the Company used the proceeds from such borrowing along with $250,000,000 of proceeds from borrowings under its existing Credit Agreement for the purchase of shares of non-voting Viacom Class B common stock. BLOCKBUSTER ENTERTAINMENT CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Under the terms of the subscription agreement the Company was granted certain rights to a make-whole amount in the event that the merger agreement is terminated and the highest average trading price of the non-voting Viacom Class B common stock during any consecutive 30 trading day period prior to the first anniversary of such termination is below $55 per share. Such make-whole amount would be based on the difference between $55 per share and such highest average trading price per share. However, the aggregate make-whole amount may not exceed $275,000,000. Viacom is entitled to satisfy its obligation with respect to any such make-whole amount, at Viacom's option, either through the payment to the Company of cash or marketable equity or debt securities of Viacom, or a combination thereof, with an aggregate value equal to the make-whole amount or through the sale to the Company of the theme parks currently owned and operated by Paramount Communications Inc., a subsidiary of Viacom. In the event that Viacom were to elect to sell the theme parks to the Company, the purchase price would be $750,000,000, payable through delivery to Viacom of shares of non-voting Viacom Class B common stock valued at $55 per share. If the theme parks were so purchased by the Company, the subscription agreement further provides that the Company would grant an option to Viacom, exercisable for a period of two years after the date of grant, to purchase a 50% equity interest in the theme parks at a purchase price of $375,000,000. Effective January 1, 1994, the Company adopted Statement of Financial Accounting Standards ("SFAS") No. 115, Accounting for Certain Investments in Debt and Equity Securities. The adoption of SFAS No. 115 will require the Company to adjust its investment in non- voting Viacom Class B common stock to fair market value. Pursuant to the provisions of SFAS No. 115, the Company has classified such investment as an "available-for-sale security". Accordingly, any adjustment to fair value will be excluded from net income and reported as a separate component of shareholders' equity. Based on the quoted market price at March 23, 1994 and after satisfaction of Viacom's make-whole obligation, the maximum adjustment to fair value would result in a reduction of total assets and shareholders' equity of approximately $186,000,000, net of income taxes, at such date. 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 as of March 18, 1994, the names of the directors and executive officers of the Company, their respective ages and their respective positions with the Company. Each director holds office until the next annual meeting of stockholders and until his successor has been elected and qualified. Officers are elected by the Board of Directors and serve at its discretion. Mr. Huizenga became a Director of the Company in February 1987, was elected as Chairman of the Board, Chief Executive Officer and President of the Company in April 1987 and is Chairman of the Executive Committee. Mr. Huizenga served as President of the Company until June 1988. He is a co-founder of Waste Management, Inc. (now known as WMX Technologies, Inc. ("WMX")), a waste disposal and collection company, where he served in various capacities, including President, Chief Operating Officer and a Director, until May 1984. From May 1984 to present, Mr. Huizenga has been an investor in other businesses and is the sole stockholder and Chairman of the Board of Huizenga Holdings, Inc. ("Holdings"), a holding and management company with various business interests. In connection with these business interests, Mr. Huizenga has been actively involved in strategic planning for, and executive management of, these businesses. Mr. Huizenga also has a majority ownership interest in Florida Marlins Baseball, Ltd. ("the "Florida Marlins"), a Major League Baseball sports franchise, owns the Florida Panthers Hockey Club, Ltd., a National Hockey League sports franchise (the "Florida Panthers"), a limited partnership interest in Miami Dolphins, Ltd. (the "Miami Dolphins"), a National Football League sports franchise, and an ownership interest in Robbie Stadium Corporation and certain affiliated entities, which own and operate Joe Robbie Stadium in South Florida. Mr. Huizenga has entered into an agreement to purchase the remaining ownership interest in the Miami Dolphins. Mr. Huizenga is Chairman of the Board of Directors of Spelling. Mr. Huizenga is also a member of the Boards of Directors of Republic, Discovery Zone, Viacom, Viacom International Inc. and Paramount Communications, Inc. Mr. Allen became a Director of the Company in July 1986 and is Chairman of the Compensation Committee. Since October 1988, Mr. Allen has served as Chairman and Chief Executive Officer of A.C. Allen & Co., a financial services consulting firm. He also is a Director and Vice Chairman of both Psychemedics Corporation ("Psychemedics") and the DeWolfe Companies, Inc. He is also a director of the Forschner Group. Prior to October 1988, Mr. Allen was Executive Vice President of Advest Group, Inc., an investment banking firm. Mr. Allen was Chairman and Chief Executive Officer of Burgess and Leith, a New York Stock Exchange member firm from 1984 to 1986. Mr. Barrett joined the Company in July 1989 as Director of Information Services and became Vice President of Corporate Information Systems in February 1992. He became Senior Vice President of Information Services in February 1994. From January 1983 until July 1989, he was a management consultant with Andersen Consulting in Dallas, Texas. Mr. Berrard joined the Company in June 1987 as Senior Vice President, Treasurer and Chief Financial Officer and became a Director of the Company in May 1989. Mr. Berrard became Vice Chairman of the Board in November 1989 and President and Chief Operating Officer in January 1993. He served as Treasurer of the Company from June 1987 until February 1989, as Senior Vice President of the Company from June 1987 until November 1989 and as Chief Financial Officer of the Company from June 1987 to June 1992. Mr. Berrard is President, Chief Executive Officer and a Director of Spelling. He is also a member of the Board of Directors of Republic. He is also a limited partner of the Florida Marlins. Prior to his tenure with the Company, Mr. Berrard served as President of Holdings, which was known prior to June 1988 as Waco Services, Inc. From January 1983 to April 1985, Mr. Berrard served in various positions with Waco Leasing Company and Port-O-Let International, Inc., including President, Chief Financial Officer, Treasurer and Secretary. Prior to January 1983, Mr. Berrard was employed by Coopers & Lybrand, an international public accounting firm, for over five years. Mr. Castell joined the Company in February 1989 as Senior Vice President of Programming and Merchandising and became Senior Vice President of Programming and Communications in August 1991. From October 1985 to February 1989, he was Vice President of Marketing and Merchandising at Erol's Inc., then a chain of two hundred video stores headquartered in the Washington, D.C. area. From October 1984 to October 1985, Mr. Castell was the President and sole stockholder of Big Think, Inc., a marketing consulting company. Mr. Castell is also Vice President of Spelling. Mr. Croghan became a Director of the Company in July 1987 and is currently Chairman of the Audit and Finance Committee. He is also a Director of Lindsay Manufacturing Company, St. Paul Bancorp, Inc. and the Morgan Stanley Emerging Markets Fund. Mr. Croghan is, and has been for more than the past five years, the Chairman of Lincoln Capital Management Company, an investment advisory firm. Mr. Detz joined the Company in January 1991 as Assistant Corporate Controller and became Vice President and Corporate Controller in February 1992. From 1980 until he joined the Company, Mr. Detz served in various finance related positions with Encore Computer Corporation, including Vice President and Corporate Controller. Prior to 1980, Mr. Detz was employed by Coopers and Lybrand, an international public accounting firm, for four years. Mr. Fairbanks joined the Company in June 1992 as Senior Vice President and Chief Financial Officer and became Treasurer of the Company in March 1993. From October 1980 until the time he joined the Company, Mr. Fairbanks served in a number of finance related capacities, including Executive Vice President and Chief Financial Officer of Waste Management International plc. Prior to October 1980, Mr. Fairbanks was employed by Arthur Andersen & Co., an international public accounting firm, for approximately four years. Mr. Fairbanks is also Senior Vice President of Spelling. Mr. Flynn became a Director of the Company in February 1987 and is Chairman of the Nominating Committee. He is Chairman and Chief Executive Officer of Flynn Enterprises, Inc., a business consulting and venture capital company, and since July 1992 has been Chairman and Chief Executive Officer of Discovery Zone, a franchisor and operator of fun and fitness centers for children. Mr. Flynn also currently serves as a Director of WMX, Chemical Waste Management, Inc., Waste Management International plc., Wheelabrator Technologies, Inc. and Psychemedics. From 1972 to 1990, Mr. Flynn served in various positions with WMX, including Senior Vice President and Chief Financial Officer. Mr. Guerin became Senior Vice President of Domestic Franchising of the Company in January 1992. From October 1989 until December 1991, Mr. Guerin was Senior Vice President of Administration and Development for the Company. He joined the Company as a Vice President in March 1988. From March 1986 to March 1988, he served as Vice President and Region Manager of Waste Management of North America, Inc., a subsidiary of WMX, where he was responsible for operations with over 6,000 employees. From June 1982 to March 1986, he served as President of Wells Fargo Armored Service Corp., a transporter of currency and valuables with over 7,000 employees. Mr. Hawkins joined the Company in November 1989 as Senior Corporate Counsel and became Associate General Counsel and Secretary in August 1991 and Vice President, General Counsel and Secretary in February 1993. He became Senior Vice President, General Counsel and Secretary in February 1994. He is also Vice President, General Counsel and Secretary of Spelling. From May 1986 until October 1989, he was associated with the law firm of Bell, Boyd & Lloyd in Chicago, Illinois. Mr. Hilmer joined the Company in February 1993 as Senior Vice President and Chief Marketing Officer. From 1984 to 1992, he served as Division President and Managing Partner as well as a member of the Board of Directors of Whittle Communications L.P., a media and education company. From 1969 to 1984, Mr. Hilmer held various senior marketing-related positions including Senior Vice President and Management Director at Leo Burnett & Co., a worldwide advertising agency. Mr. Johnson became a director and President - Consumer Division of the Company in August 1993. From 1987 until August 1993, Mr. Johnson was managing general partner of WJB, which prior to its consolidation with the Company in August 1993 was the Company's largest franchise owner. From 1967 through 1987, Mr. Johnson served as counsel to the law firm of Johnson, Smith, Hibbard & Wildman in Spartanburg, South Carolina. Mr. Johnson is a member of the Board of Directors of Duke Power Company. Mr. Martin-Busutil joined the Company in July 1992 as President - International Division. From 1981 to 1992, Mr. Martin-Busutil held various positions with Cadbury-Schweppes, including President of Cadbury Beverages in Europe. From 1961 to 1981, Mr. Martin-Busutil served in a number of international management and marketing related capacities with General Foods. Mr. Melk was re-elected a director of the Company in May 1993. Since 1988, Mr. Melk has been Chairman and Chief Executive Officer of H20 Plus Inc., which develops and manufactures health and beauty aid products. Mr. Melk has been a private investor in various businesses since March 1984 and prior to March 1984, he held various positions with WMX and its subsidiaries, including President of Waste Management International, plc. Mr. Melk also currently serves as a director of Psychemedics and Discovery Zone. From February 1987 until March 1989, Mr. Melk served as a director and Vice Chairman of the Company. Mr. Weber joined the Company in January 1988 as Regional Manager, became Zone Vice President in May 1989, was promoted to Vice President of Operations in June 1990 and became Senior Vice President of Operations in February 1991. From January 1986 to December 1987 he was President and Chief Operating Officer of Spirits, Inc., a Ft. Lauderdale, Florida company. From November 1982 to January 1986, he held the position of Vice President of the Gray/Drug Fair Division of Sherwin-Williams Co. Prior to that, Mr. Weber held various management positions with the Shoppers Drug Mart division of the Imasco Corporation. In 1993, the Board of Directors held an aggregate of 13 regular and special meetings. Each member of the Board who is not an employee of the Company is currently paid a quarterly fee of $6,250 plus $1,250 for each meeting attended. In addition, each non-employee member of the Board who serves as the Chairman of a Board Committee is paid $625 for each meeting of such committee attended. Item 11. Item 11. Executive Compensation The information required by this item will be set forth in the Proxy Statement of the Company relating to the 1994 Annual Meeting of Stockholders, and is incorporated herein by reference. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management The information required by this item will be set forth in the Proxy Statement of the Company relating to the 1994 Annual Meeting of Stockholders, and is incorporated herein by reference. Item 13. Item 13. Certain Relationships and Related Transactions The information required by this item will be set forth in the Proxy Statement of the Company relating to the 1994 Annual Meeting of Stockholders, 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 of the Company are set forth in Part II, Item 8. (2) The following financial statement schedules for each of the three years ended December 31, 1993 are submitted herewith: Schedule V - Property, Plant and Equipment. Schedule VI - Accumulated Depreciation, Depletion and Amortization of Property, Plant and Equipment. Schedule VIII - Valuation and Qualifying Accounts. Schedule X - Supplementary Statements of Operations Information. (3) Exhibits - (See the Index to Exhibits included elsewhere herein). (b) Form 8-K dated October 6, 1993 relating to an agreement in principle pursuant to which the Company will purchase Super Club Retail Entertainment Corporation from Philips Electronics N.V. for approximately $150,000,000. Form 8-K dated October 22, 1993 relating to the Company's restated financial information which reflects the consolidation with WJB Video Limited Partnership and certain of its affiliates which was accounted for under the pooling of interests method of accounting, and a $600,000,000 credit agreement obtained by the Company. Form 8-K dated November 1, 1993 relating to the consummation of the investment in Viacom Inc. and pro forma capitalization information. Form 8-K dated November 5, 1993 relating to certain financial statements and pro forma financial information related to the Company's proposed acquisition of Super Club Retail Entertainment Corporation. Form 8-K dated November 19, 1993 relating to the completion of the acquisition of Super Club Retail Entertainment Corporation and related pro forma information. Form 8-K dated December 22, 1993 relating to the Company's amended and restated Credit Agreement pursuant to which certain financial institutions have agreed to advance the Company and/or certain subsidiaries of the Company on an unsecured basis an aggregate of $1,000,000,000. Form 8-K dated January 7, 1994 relating to the Company's Agreement and Plan of Merger with Viacom Inc. and Subscription Agreement pursuant to which the Company will purchase from Viacom Inc. 22,727,273 shares of non-voting Viacom Class B common stock for an aggregate purchase price of $1,250,000,000. Form 8-K dated February 15, 1994 relating to the Company's Credit Agreement pursuant to which certain financial institutions have agreed to advance the Company on an unsecured basis an aggregate of $1,000,00,000 for the purchase of shares of capital stock of Viacom Inc. pursuant to the Subscription Agreement dated January 7, 1994 between the Company and Viacom Inc. Form 8-K dated March 10, 1994 relating to the Company's completed purchase from Viacom Inc. of 22,727,273 shares of non-voting Viacom Class B common stock pursuant to the Subscription Agreement dated January 7, 1994, between the Company and Viacom for an aggregate purchase price of $1,250,000,000. BLOCKBUSTER ENTERTAINMENT CORPORATION AND SUBSIDIARIES SCHEDULE V PROPERTY, PLANT AND EQUIPMENT (In Thousands) For the year ended December 31, 1993 (1) Assets acquired in business combinations accounted for under the purchase method of accounting. (2) Primarily represents the effects of foreign currency translation. BLOCKBUSTER ENTERTAINMENT CORPORATION AND SUBSIDIARIES SCHEDULE V PROPERTY, PLANT AND EQUIPMENT (In Thousands) For the year ended December 31, 1992 (1) Assets acquired in business combinations accounted for under the purchase method of accounting. (2) Primarily represents the effects of foreign currency translation. BLOCKBUSTER ENTERTAINMENT CORPORATION AND SUBSIDIARIES SCHEDULE V PROPERTY, PLANT AND EQUIPMENT (In Thousands) For the year ended December 31, 1991 (1) Assets acquired in business combinations accounted for under the purchase method of accounting. BLOCKBUSTER ENTERTAINMENT CORPORATION AND SUBSIDIARIES SCHEDULE VI ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT (In Thousands) For the year ended December 31, 1993 (1) Primarily represents the effects of foreign currency translation. BLOCKBUSTER ENTERTAINMENT CORPORATION AND SUBSIDIARIES SCHEDULE VI ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT (In Thousands) For the year ended December 31, 1992 (1) Primarily represents the effects of foreign currency translation. BLOCKBUSTER ENTERTAINMENT CORPORATION AND SUBSIDIARIES SCHEDULE VI ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT (In Thousands) For the year ended December 31, 1991 BLOCKBUSTER ENTERTAINMENT CORPORATION AND SUBSIDIARIES SCHEDULE VIII VALUATION AND QUALIFYING ACCOUNTS (In Thousands) For the years ended December 31, BLOCKBUSTER ENTERTAINMENT CORPORATION AND SUBSIDIARIES SCHEDULE X SUPPLEMENTARY STATEMENTS OF OPERATIONS INFORMATION (In Thousands) For the years ended December 31, (1) Items not presented are less than one percent of revenue. 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. BLOCKBUSTER ENTERTAINMENT CORPORATION Date: March 30, 1994 By: /S/ H. Wayne Huizenga ---------------------------------- H. Wayne Huizenga 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 dates indicated. Date: March 30, 1994 By: /S/ H. Wayne Huizenga ---------------------------------- H. Wayne Huizenga Chairman of the Board and Chief Executive Officer (Principal Executive Officer) March 30, 1994 By: /S/ Steven R. Berrard ---------------------------------- Steven R. Berrard Vice Chairman of the Board, President and Chief Operating Officer March 30, 1994 By: /S/ Gregory K. Fairbanks ---------------------------------- Gregory K. Fairbanks Senior Vice President, Chief Financial Officer and Treasurer (Principal Financial Officer) March 30, 1994 By: /S/ Albert J. Detz ---------------------------------- Albert J. Detz Vice President and Corporate Controller (Principal Accounting Officer) March 30, 1994 By: /S/ A. Clinton Allen, III ---------------------------------- A. Clinton Allen, III Director March 30, 1994 By: /S/ John W. Croghan ---------------------------------- John W. Croghan Director March 30, 1994 By: /S/ Donald F. Flynn --------------------------------- Donald F. Flynn Director March 30, 1994 By: /S/ George D. Johnson, Jr. --------------------------------- George D. Johnson, Jr. Director March 30, 1994 By: /S/ John J. Melk --------------------------------- John J. Melk Director EXHIBIT INDEX - ---------------- * Not applicable

840216_1993.txt

840216_1993

1993

840216

ITEM 1. BUSINESS Koll Real Estate Group, Inc., a Delaware corporation, formerly known as The Bolsa Chica Company (from July 16, 1992 to September 30, 1993) and as Henley Properties Inc. (from December 1989 to July 16, 1992), is a real estate development company with properties principally in Southern California, as well as New Hampshire. The principal activity of Koll Real Estate Group, Inc. and its consolidated subsidiaries (the "Company") has been to obtain zoning and other entitlements for land it owns and to improve the land principally for residential development. Once the land is entitled, the Company may sell unimproved land to other developers or investors; sell improved land to home builders; or participate in joint ventures with other developers, investors or home builders to finance and construct infrastructure and homes. With the acquisition of the domestic real estate development business of The Koll Company on September 30, 1993, the Company's principal activities have been expanded to include providing commercial, industrial, retail and residential real estate development services to third parties, including feasibility studies, entitlement coordination, project planning, construction management, financing, marketing, acquisition, disposition and asset management services on a national basis, through its current offices throughout California, and in Seattle, Dallas and Denver. The Company intends to consider additional real estate acquisition opportunities; however, over the next two years the Company's principal objective is to maintain adequate liquidity to fully support the Bolsa Chica project entitlement efforts. The Company's executive offices are located at 4343 Von Karman Avenue, Newport Beach, California 92660 (telephone: (714) 833-3030). PRINCIPAL PROPERTIES The following sections describe the Company's principal properties. BOLSA CHICA. The Bolsa Chica property is the principal property in the Company's portfolio. The Company owns approximately 1,200 acres of the 1,700 acres of undeveloped Bolsa Chica land located on the Pacific Ocean in northwestern Orange County, California. Bolsa Chica is bordered on the north and east by residential development, to the south by open space and residential development, and to the west by the Pacific Coast Highway and the Bolsa Chica State Beach. Bolsa Chica is one of the last large undeveloped coastal properties in Southern California, approximately 35 miles south of downtown Los Angeles. In 1986, the California State Coastal Commission certified a local coastal program/land use plan for the Bolsa Chica property, which was subject to the satisfaction of certain conditions, including presentation of favorable economic, environmental and physical feasibility studies. The proposed development of the Bolsa Chica property as a marina/residential development provoked substantial controversy and highlighted public awareness of an earlier lawsuit related to the potential impact of development on the environmentally sensitive wetland areas, among other issues. In order to achieve a public consensus on the plans for Bolsa Chica's development and to expedite development of the property, in November 1988 the Company helped organize the Bolsa Chica Planning Coalition (the "Coalition"), consisting of representatives of the Company, city, county and state officials, and the Amigos de Bolsa Chica, a local environmental organization which had previously opposed the project and was a party to the earlier lawsuit. The objective of the Coalition was to consider alternative land use plans for Bolsa Chica. In 1989, the Coalition reached an agreement in principle on a concept plan permitting the development of an oceanfront residential community featuring protected wetlands (the "Coalition Plan"). The parties to the litigation also dismissed the litigation which had halted development of Bolsa Chica. In November 1991, in accordance with the Coalition Plan, the Company announced its plan to develop a master planned community of approximately 4,900 homes at Bolsa Chica, including approximately 4,300 units on the Company's land. The planned community at Bolsa Chica is expected to offer a broad mix of home choices, including single-family homes, townhomes and condominiums at a wide range of prices. In September 1992, environmental impact documents for the Bolsa Chica project's master planned community were released by the City of Huntington Beach, California, and the U.S. Army Corps of Engineers for a ninety-day public comment period which concluded in December 1992. In March 1993, the Company transferred local processing of the Coalition Plan to the County of Orange in order to integrate the Bolsa Chica regional park and wetlands restoration with the rest of the land use planning. Given the extent of comments received from the public, including a variety of state and federal agencies, the County of Orange recirculated a revised draft of the environmental impact report in December 1993, for public omment which concluded on February 18, 1994. The revised draft contains an in-depth analysis of an alternative plan which includes 3,500 homes, in addition to the in-depth analysis of the Coalition Plan. Despite efforts to date in the Bolsa Chica entitlement process, the Company has not yet obtained any of the final approvals from local, state or federal governmental entities that are required for development of the project. Due to a number of factors beyond the Company's control, including possible objections to the Coalition Plan by various environmental and so-called public interest groups that may be made in legislative, administrative or judicial forums, such approvals could be delayed substantially. Subject to these and other uncertainties inherent in the entitlement process, the Company's goal is to obtain all material governmental approvals in the first half of 1995 and to begin infrastructure construction in the second half of 1995, depending on economic and market conditions. Realization of the Company's investment in Bolsa Chica will also depend upon various economic factors, including the demand for residential housing in the Southern California market and the availability of credit to the Company and to the housing industry. EAGLE CREST. In the City of Escondido in San Diego County, approximately 30 miles north of downtown San Diego, the Company is developing an 860-acre, gated community consisting of 580 residential lots surrounding an 18-hole championship golf course. The golf course opened during May 1993. Construction of the remaining infrastructure and the permanent clubhouse has been deferred until the residential market for trade-up homes improves and financing for such infrastructure construction becomes available. FAIRBANKS HIGHLANDS. This property consists of approximately 390 acres near the communities of Fairbanks Ranch and Rancho Santa Fe in the northern part of the City of San Diego. The property is located within an area designated by the City of San Diego as the "Future Urbanizing Area." The City of San Diego recently approved a "Framework Plan" which generally defines land use, locations and densities for the Future Urbanizing Area, subject to voter approval. The Framework Plan could allow development of significantly greater density (up to 800 residential units) on the Company's Fairbanks Highlands property if ultimately approved by the voters in June 1994, along with approximately 12,000 acres to be developed by neighboring landowners. WENTWORTH BY THE SEA. This project is currently being managed, at the direction of the Company, by a local real estate management and development company, with the objective of developing 130 new residential and vacation homes in New Hampshire, approximately 60 miles north of Boston. The project currently includes an 18-hole golf course, a 170-slip marina, 21 single-family detached condominium homes built by the previous owner and related commercial development. The Company began marketing the 21 existing homes in September 1993, and since then four homes have been sold and nine additional homes are in escrow. The Company is continuing to hold discussions with a community group interested in purchasing and restoring the original Wentworth Hotel, which closed in 1981. OTHER PROPERTIES. The Company owns various other commercial and industrial properties in Southern California, including land zoned for commercial/industrial use in Coronado, Rancho Murrieta and Signal Hill, California. All of these properties are currently held for sale, subject to market conditions. PROPERTY DISPOSITIONS. See Item 7 "Management's Discussion and Analysis of Financial Condition and Results of Operations" for a description of the Company's property dispositions during 1992 and 1993. ENVIRONMENTAL AND REGULATORY MATTERS Before the Company can develop a property, it must obtain a variety of discretionary approvals from local and state governments, as well as the federal government in certain circumstances, with respect to such matters as zoning, subdivision, grading, architecture and environmental matters. The entitlement approval process is often a lengthy and complex procedure requiring, among other things, the submission of development plans and reports and presentations at public hearings. Because of the provisional nature of these approvals and the concerns of various environmental and public interest groups, the approval process can be delayed by withdrawals or modifications of preliminary approvals and by litigation and appeals challenging development rights. Accordingly, the ability of the Company to develop properties and realize income from such projects could be delayed or prevented due to difficulties in obtaining necessary governmental approvals. As more fully described above, the Company is in the process of seeking the necessary local, state and federal approvals and permits to begin development of its Bolsa Chica property. The Company reached an agreement in 1989 on the Coalition Plan, and the Company's goal is to obtain the necessary approvals in the first half of 1995. Nevertheless, the approval process for the Bolsa Chica property remains subject to the uncertainties described above, and there is no assurance that such approvals will ultimately be obtained or will not be substantially delayed. Failure to obtain such approvals would have, and a substantial delay in obtaining such approvals could have, a material adverse effect on the Company. The Company has expended and will continue to expend significant financial and managerial resources to comply with environmental regulations and local permitting requirements. Although the Company believes that its operations are in general compliance with applicable environmental regulations, certain risks of unknown costs and liabilities are inherent in developing and owning real estate. However, the Company does not believe that such costs will have a material adverse effect on its business or financial condition, including current environmental litigation discussed in Part I, Item 3 -- "Legal Proceedings" and the potential remediation expenditures required in connection with certain indemnity obligations discussed below in "Corporate Indemnification Matters." CORPORATE INDEMNIFICATION MATTERS The Company and its predecessors have, through a variety of transactions effected since 1986, disposed of several assets and businesses, many of which are unrelated to the Company's current operations. By operation of law or contractual indemnity provisions, the Company has retained liabilities relating to certain of these assets and businesses, including certain tax liabilities. See Note 9 "Income Taxes -- Tax Sharing Agreements" in Notes to Financial Statements on pages to of this Annual Report. Many of such liabilities are supported by insurance or by indemnities from certain of the Company's predecessor and currently or previously affiliated companies. The Company believes its balance sheet reflects adequate reserves for these matters. Abex Inc. ("Abex") and the Company have agreed that, following the Company's 1992 merger with The Henley Group, Inc., each company will be responsible for environmental liabilities relating to its existing, past and future assets and businesses and will indemnify the other in respect thereof. The United States Environmental Protection Agency ("EPA") has designated Universal Oil Products ("UOP"), among others, as a Potentially Responsible Party ("PRP") with respect to an area of the Upper Peninsula of Michigan (the "Torch Lake Site") under the Federal Comprehensive Environmental Response, Compensation and Liability Act of 1980, as amended ("CERCLA"). UOP is allegedly the successor in interest to one of the companies that conducted mining operations in the Torch Lake area and an affiliate of Allied-Signal Inc., a predecessor of the Company. The Company has not been named as a PRP at the site. However, Allied-Signal has, through UOP, asserted a contractual indemnification claim against the Company for claims that may be asserted against UOP by EPA or other parties with respect to the site. EPA has proposed a cleanup plan which would involve covering certain real property both contiguous and non-contiguous to Torch Lake with soil and vegetation in order to address alleged risks posed by copper tailings and slag at an estimated cost of approximately $7.2 million. EPA estimates that it has spent in excess of $2 million to date in performing studies of the site. Under CERCLA, EPA could assert claims against the Torch Lake PRPs, including UOP, to recover the cost of these studies, the cost of all remedial action required at the site, and natural resources damages. An earlier settlement in principle with EPA staff pursuant to which UOP would pay $1.7 million in exchange for a release similar to those normally granted by EPA in such circumstances was rejected by certain other governmental authorities in July 1993. Settlement negotiations between the Company, on behalf of UOP, and EPA resumed shortly thereafter and are ongoing. EMPLOYEES As of March 1, 1994, the Company and its subsidiaries had approximately 92 employees. EXECUTIVE OFFICERS OF THE COMPANY Certain of the executive officers of the Company are also executive officers of The Koll Company ("Koll") and its affiliates. Accordingly, they will devote less than all of their working time to the businesses of the Company. Set forth below is information with respect to each executive officer. ITEM 2. ITEM 2. PROPERTIES The Company's principal executive offices are located in Newport Beach, California. The Company and each of its subsidiaries believe that their properties are generally well maintained, in good condition and adequate for their present and proposed uses. The inability to renew any short-term real property lease would not be expected to have a material adverse effect on the Company's results of operations. The principal properties of the Company and its subsidiaries, which are owned in fee unless otherwise indicated, are as follows: ITEM 3. ITEM 3. LEGAL PROCEEDINGS The owners of undeveloped real property located in San Diego County sued Signal Landmark, a subsidiary of the Company ("Signal"), in San Diego Superior Court, in May 1990, alleging that Signal had deposited contaminated soils on their property and was liable under theories of nuisance, negligence, trespass and strict liability. The plaintiffs sought general damages in the amount of approximately $40 million and, additionally, punitive damages in an unspecified amount, plus prejudgment interest and costs. On August 5, 1991, the plaintiffs filed a complaint in federal court against Signal, the Company and several other parties asserting claims under CERCLA seeking essentially the same relief sought in the state action. In April 1992, a jury awarded the plaintiffs damages in the amount of $2.5 million following a trial in the state action. Signal appealed the verdict in the state action and posted a bond and cash collateral of $3.75 million in August 1992. On March 5, 1993, Signal reached an agreement in principle with the plaintiffs in such litigation to settle both the federal and state actions. On July 2, 1993, the Federal Court for The Southern District of California approved the settlement under the terms of which funds from such cash collateral account were disbursed approximately as follows: 1) $1.3 million deposited in trust for remediation expenditures, 2) $1.3 million disbursed to the plaintiffs, and 3) $1.1 million returned to Signal. 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 following tables set forth information with respect to bid quotations for the Class A Common Stock of the Company for the periods indicated as reported by NASDAQ. These quotations are interdealer prices without retail markup, markdown or commission and may not necessarily represent actual transactions. The number of holders of record of the Company's Class A Common Stock as of March 1, 1994 was approximately 28,000. The Company has not paid any cash dividends on its Class A Common Stock to date, nor does the Company currently intend to pay regular cash dividends on the Class A Common Stock. Such dividend policy is and will continue to be subject to prohibitions on the declaration or payment of dividends contained in debt agreements of the Company. See Note 7 -- Notes to Financial Statements on pages to of this Annual Report, which Note is incorporated herein by reference. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The Selected Financial Data with respect to the Company and its subsidiaries are set forth on pages to of this Annual Report. 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 set forth on pages to of this Annual Report. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Financial statements, schedules and supplementary data of the Company and its subsidiaries, listed under Item 14, are submitted as a separate section of this Annual Report, commencing on page. 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 DIRECTORS. The information appearing under the caption "Election of Directors" of the Company's Proxy Statement for its 1994 Annual Meeting of Stockholders is incorporated herein by reference in this Annual Report. EXECUTIVE OFFICERS. Information with respect to executive officers appears under the caption "Executive Officers of the Company" in Item 1 of this Annual Report. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION Information in answer to this Item appears under the caption "Compensation of Directors and Executive Officers" of the Company's Proxy Statement for its 1994 Annual Meeting of Stockholders, and is incorporated herein by reference in this Annual Report. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Information in answer to this Item appears under the captions "Voting Securities and Principal Holders Thereof" and "Election of Directors" of the Company's Proxy Statement for its 1994 Annual Meeting of Stockholders, and is incorporated herein by reference in this Annual Report. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Information in answer to this Item appears under the captions "Certain Transactions" and "Compensation of Directors and Executive Officers" of the Company's Proxy Statement for its 1994 Annual Meeting of Stockholders, and is incorporated herein by reference in this Annual Report. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL SCHEDULES, AND REPORTS ON FORM 8-K (a)(1) Financial Statements: The following financial statements and supplementary data of the Company are included in a separate section of this Annual Report on Form 10-K commencing on the page numbers specified below: (2) Financial Statement Schedules: All schedules have been omitted since they are not applicable, not required, or the information is included in the financial statements or notes thereto. (3) Listing of Exhibits: - ------------------------ * Filed herewith. (b) Reports on Form 8-K: Report on Form 8-K dated December 17, 1993, reporting under Item 5 Other Events, regarding (i) the disposition of Lake Superior Land Company to Libra Invest & Trade Ltd. ("Libra"), and; (ii) the issuance of common stock to Libra in exchange for Libra's subordinated debentures of the Company. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. Date: March 30, 1994 KOLL REAL ESTATE GROUP, INC. By: /s/ RAYMOND J. PACINI ------------------------------------ Raymond J. Pacini 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 and on the date indicated. KOLL REAL ESTATE GROUP, INC. SELECTED FINANCIAL DATA The following selected financial data of Koll Real Estate Group, Inc. and its consolidated subsidiaries (the "Company") should be read in conjunction with the financial statements included elsewhere herein. The financial statements for the year ended December 31, 1989 do not necessarily reflect the results of operations of the Company had it been a separate, stand-alone company. For further discussion of the formation of the Company and the basis of presentation see the Notes to Financial Statements. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS GENERAL The principal activity of the Company has been to obtain zoning and other entitlements for land it owns and to improve the land for residential development. Once the land is entitled, the Company may sell unimproved land to other developers or investors; sell improved land to home builders; or participate in joint ventures with other developers, investors or home builders to finance and construct infrastructure and homes. With the acquisition of the domestic real estate development business of The Koll Company on September 30, 1993, the Company's principal activities have been expanded to include providing commercial, industrial, retail and residential development services to third parties, including feasibility studies, entitlement coordination, project planning, construction management, financing, marketing, acquisition, disposition and asset management services on a national basis, through its current offices throughout California, and in Seattle, Dallas and Denver. The Company intends to consider additional real estate acquisition opportunities; however, over the next two years the Company's principal objective is to maintain adequate liquidity to fully support the Bolsa Chica project entitlement efforts. Real estate held for development or sale and land held for development (real estate properties) are carried at the lower of cost or estimated net realizable value (Note 2). The Company's real estate properties are subject to a number of uncertainties which can affect the future values of those assets. These uncertainties include delays in obtaining zoning and regulatory approvals, withdrawals or appeals of regulatory approvals and availability of adequate capital, financing and cash flow. In addition, future values may be adversely affected by heightened environmental scrutiny, limitations on the availability of water in Southern California, increases in property taxes, increases in the costs of labor and materials and other development risks, changes in general economic conditions, including higher mortgage interest rates, and other real estate risks such as the demand for housing generally and the supply of competitive products. Real estate properties do not constitute liquid assets and, at any given time, it may be difficult to sell a particular property for an appropriate price. The state of the nation's economy, and California's economy in particular, has had a negative impact on the real estate market generally, on the availability of potential purchasers for such properties and upon the availability of sources of financing for carrying and developing such properties. LIQUIDITY AND CAPITAL RESOURCES The principal assets remaining in the Company's portfolio are residential land which must be held over an extended period of time in order to be developed to a condition that, in management's opinion, will ultimately maximize the return to the Company. Consequently, the Company requires significant capital to finance its real estate development operations. Sales of the Company's non-strategic assets, such as its 44% interest in Deltec Panamerica S.A. ("Deltec"), the LaJolla, California office buildings and Lake Superior Land Company (Note 4) have been pursued as a source of capital. During 1993, the Company generated an aggregate of approximately $97 million through the Lake Superior Land Company financing, the disposition of the Company's investment in Deltec and the sale of its LaJolla office buildings, and utilized $58.4 million of such proceeds to reduce outstanding senior bank debt. At December 31, 1993 the Company's cash, cash equivalents and short-term investments aggregated $43.5 million. Historically, sources of capital have included bank lines of credit, specific property financings, asset sales and available internal funds. Although the Company reported income in 1993 as a result of gains on dispositions and extinguishment of debt, it reported losses in 1991 and 1992, and expects to report losses in the foreseeable future. While a significant portion of such losses is attributable to noncash interest expense on the Company's subordinated debentures, the Company's capital expenditures for project development are significant. In addition, the Company was notified in March 1994 that a Stipulation of Settlement has been entered into between a predecessor company and the Internal Revenue Service regarding the settlement of an alleged tax deficiency that is the subject of certain tax sharing agreements (Note 9). The Company has been informed by the other parties to these tax sharing agreements that it is being charged with a net obligation of approximately $21 million under this settlement, which the Company accrued for in December 1989. The Company is currently evaluating the scope of this claimed obligation under the settlement and potential sources of financing for such amount that the Company may ultimately be obligated to pay. However, there can be no assurance that any financing will be available, or that if available, it can be obtained on terms that are favorable to the Company and its stockholders. Given the limited availability of capital for real estate development under current conditions in the financial markets, the Company will be dependent primarily on cash and short-term investments on hand to fund project investments, and general and administrative costs during 1994 and 1995. However, if the Company is required to pay all or a significant portion of the $21 million claimed under the tax sharing agreements as discussed above, and any such amount is not financed, the Company will need to obtain other sources of financing or sell additional assets in order to meet projected cash requirements for the first quarter of 1995. In January 1993, Lake Superior Land Company, which was a wholly owned subsidiary of the Company at that time, sold $45 million of secured notes due May 1, 2012 to certain pension funds of the State of Michigan. The obligations under the note agreement are secured by all of the assets of Lake Superior Land Company, which principally consist of approximately 300,000 acres of timberlands and shorefront property on Lake Superior in Michigan and Wisconsin. Lake Superior Land Company dividended the proceeds to the Company, which used $21 million of the financing proceeds to make a principal prepayment in accordance with a term loan agreement with Bank of America. At December 31, 1993, the Company's only outstanding senior bank debt is due to the Bank of Boston in the principal amount of $7.0 million, under a term note due on July 31, 1995. The term note agreement with Bank of Boston requires additional principal prepayments to be made from the net proceeds from the sales of Wentworth and other assets. The term note agreement also requires additional principal repayments of $.2 million in the second half of 1994 and $.4 million in the first half of 1995, with any remaining balance due at maturity on July 31, 1995. Amounts outstanding under the term note bear interest at prime plus 1%. The term note agreement with Bank of Boston is secured by a first mortgage on the Wentworth property, stock pledge agreements of substantially all significant subsidiaries of the Company and first mortgages on certain other properties. The term note agreement contains certain restrictive covenants that prohibit the declaration or payment of dividends and limit, among other things, (i) the incurrence of indebtedness, (ii) the making of investments, loans and advances, (iii) the creation or incurrence of liens on existing and future assets of Wentworth or its subsidiaries, (iv) stock repurchases, and (v) project development spending in excess of certain planned levels. The term note agreement also contains various financial covenants and events of default customary for such agreements. FINANCIAL CONDITION DECEMBER 31, 1993 COMPARED WITH DECEMBER 31, 1992 Cash, cash equivalents and short-term investments aggregated $43.5 million at December 31, 1993 compared with $41.6 million at December 31, 1992. The change in cash and cash equivalents reflects the activity presented in the Statements of Cash Flows and described below. The $15.9 million decrease in real estate held for development or sale is primarily due to the November 1993 sale of the Company's office properties in LaJolla, California, as well as the placement into service in May 1993 of the Eagle Crest golf course and its related reclassification to operating properties. The $25.0 million decrease in other assets primarily reflects the sale of the Company's investment in Deltec, partially offset by the acquisition of the domestic real estate development business of The Koll Company (Note 4). The $9.5 million increase in accounts payable and accrued liabilities primarily reflects reclassification of approximately $21 million in taxes payable from other liabilities in 1993 (Notes 8 and 9), partially offset by the 1993 payments of $7.6 million in income taxes (Note 9) and $3.2 million to settle shareholder litigation related to the July 1992 merger with The Henley Group, Inc. (the "Merger") (Note 1). The $58.4 million decrease in senior bank debt reflects principal prepayments to Bank of America and Bank of Boston in connection with Lake Superior Land Company's financing, the disposition of the Company's investment in Deltec (Note 4) and the sale of the Company's office properties in LaJolla, California. The $30.2 million decrease in subordinated debentures reflects the exchange of approximately $42.4 million in aggregate face amount of senior subordinated debentures held by Libra Invest & Trade Ltd. ("Libra") for the Company's Lake Superior Land Company subsidiary, and the exchange of approximately $10.6 million in aggregate face amount of subordinated debentures held by Libra for approximately 3.4 million shares of the Company's Class A Common stock (Notes 4 and 7), offset by payments of interest through the issuance of additional pay-in-kind debentures on March 15 and September 15, 1993 and the accrual of interest since September 15, 1993. The $25.4 million increase in other liabilities is principally due to the adoption of FAS 109 (Note 9), as well as the tax effect of the extraordinary gain on extinguishment of debt, partially offset by the reclassification of approximately $21 million in taxes payable to accounts payable and accrued liabilities. DECEMBER 31, 1992 COMPARED WITH DECEMBER 31, 1991 Cash aggregated $41.6 million at December 31, 1992 compared with $7.8 million at December 31, 1991. The increase in cash principally reflects the Merger, along with the activity presented in the Statement of Cash Flows and described below. The Company received $58.3 million of cash in connection with the Merger, $15 million of which was used to repay senior bank debt on July 16, 1992 (Note 7). The $7.7 million decrease in real estate held for development or sale primarily reflects the sale of the Company's Ontario, California property for net cash proceeds of approximately $6.1 million and a $1.7 million note. The $35.2 million increase in other assets primarily reflects the Company's investment in Deltec as a result of the Merger (Note 1). On February 4, 1993, the Long Beach Airport Marriott Hotel (the "Hotel") was transferred to California Federal Bank ("CalFed") in a foreclosure sale. The foreclosure process was initiated as a result of the Hotel's inability to make its July 1992 interim interest payment deposits under a letter of credit reimbursement agreement with CalFed, which secured $25 million in principal amount of Industrial Revenue Bonds (the "Bonds") issued by the City of Long Beach on September 1, 1985 for construction of the Hotel. The Bonds and letter of credit were nonrecourse to an indirect subsidiary of the Company that previously owned the Hotel, and neither the Company nor any of its other subsidiaries was a party to, or a guarantor with respect to, these obligations. On September 15, 1992, the Company stipulated to the appointment of a receiver to control and manage the assets of the Hotel, and the receiver took control of the Hotel on September 16, 1992. Accordingly, the December 31, 1992 balance sheet reflects the elimination of $24.9 million in nonrecourse project debt of the Hotel, $.9 million of related Hotel liabilities, and a corresponding reduction in assets of $24.3 million, with the difference of $1.5 million reflected in other income in the 1992 statement of operations. The $30.7 million decrease in operating properties in 1992 principally reflects the elimination from the Company's balance sheet of the Hotel's assets as discussed above, along with the sale of the Company's Long Beach, California office building for approximately $6 million. The $8.4 million increase in accounts payable and accrued liabilities primarily reflects the classification of $7.6 million of obligations paid in January 1993 under the tax sharing agreement with a predecessor company, Wheelabrator Technologies Inc. ("WTI") (Note 9), as current at December 31, 1992. The $41.0 million increase in other liabilities primarily reflects liabilities received in connection with the Merger (Note 1), partially offset by the reclassification of certain tax liabilities as discussed above. The $17.0 million decrease in senior bank debt primarily reflects a $15.0 million principal prepayment in connection with the Merger (Note 7). The $19.6 million decrease in subordinated debentures reflects the $42.5 million book value reduction in connection with the Merger (Notes 1 and 7), partially offset by a $22.9 million increase related to pay-in-kind interest. The changes in stockholders' equity primarily reflect the issuance by the Company of preferred and common stock in connection with the Merger (Notes 2 and 13), partially offset by the net loss for the year. RESULTS OF OPERATIONS The nature of the Company's business is such that individual transactions often cause significant fluctuations in operating results from year to year. 1993 COMPARED WITH 1992 The $11.6 million decrease in revenues from $28.3 million in 1992 to $16.7 million in 1993 and the decrease in cost of sales from $26.5 million in 1992 to $16.3 million in 1993 were both principally related to the Company's 1992 sale of California properties in Ontario, Long Beach and Coronado, along with the February 1993 foreclosure sale of the Hotel, offset by the Company's sale in November 1993 of two office buildings located in LaJolla, California and revenues from golf operations and the domestic real estate development business acquired from The Koll Company (Note 4). The pro forma impact of this acquisition assuming it had occurred on January 1, 1993, would have been to increase the Company's revenues and income from continuing operations before income taxes and amortization of goodwill by $10.0 million and $2.4 million, respectively. The $1.8 million decrease in general and administrative expenses for 1993 as compared with 1992 was primarily attributed to reduced personnel and occupancy costs. The decrease in interest expense from $31.2 million in 1992 to $24.4 million in 1993 primarily reflects the reduction in outstanding subordinated debentures and senior bank debt in connection with the July 1992 Merger and the 1993 prepayments of senior bank debt (Note 7). The improvement in other expense (income), net from $2.9 million of expense for 1992 to $2.4 million of income for 1993 primarily reflects $3.0 million received in 1993 in connection with the termination of a put option agreement with Abex Inc. ("Abex"), a former subsidiary of The Henley Group, Inc., and a $2.0 million insurance reimbursement received in 1993 related to prior year environmental litigation costs. The Company adopted Financial Accounting Standard No. 109 "Accounting for Income Taxes," in the first quarter of 1993, resulting in an increase in its deferred tax liability of $36.0 million through a charge to income at the time of adoption (Notes 2 and 9). Under this new accounting standard, the Company also recognized $10.4 million of tax benefits on continuing operations for the year ended December 31, 1993. 1992 COMPARED WITH 1991 The decrease in revenues from $34.7 million in 1991 to $28.3 million in 1992 and the decrease in cost of sales from $28.8 million in 1991 to $26.5 million in 1992 were both principally due to the commencement of foreclosure proceedings against the Hotel in September 1992, and lower Hotel operating revenues prior to that date. The decrease in gross operating margin from $5.9 million in 1991 to $1.8 million in 1992 is primarily attributable to lower margins on asset sales and lower Hotel operating margins in 1992 discussed above. The $3.3 million decrease in interest expense from 1991 to 1992 is primarily due to the reduction in outstanding subordinated debentures and senior bank debt in connection with the Merger, as well as lower interest rates on the senior bank debt. The change in other expense (income), net from $65.5 million of expense for 1991 to $2.9 million of expense for 1992 primarily reflects approximately $65 million of charges in 1991 related to asset revaluations. 1991 COMPARED WITH 1990 The decrease in revenues from $97.0 million in 1990 to $34.7 million in 1991, the decrease in cost of sales from $78.9 million in 1990 to $28.8 million in 1991, and the decrease in gross operating margin from $18.1 million in 1990 to $5.9 million in 1991, principally reflect the $42 million sale in 1990 of a 90% interest in approximately 3,500 acres of land on the island of Hawaii, along with the substantial completion of residential sales at Coronado Cays in 1990. The change in other expense (income), net from $97.5 million of income for 1990 to $65.5 million of expense in 1991 primarily reflects the gain on sale of the Company's interest in two trash-to-energy facilities to WTI in 1990 and asset revaluations in 1991. INDEPENDENT AUDITORS' REPORT To The Board of Directors and Stockholders of Koll Real Estate Group, Inc.: We have audited the accompanying balance sheets of Koll Real Estate Group, Inc. (formerly The Bolsa Chica Company) as of December 31, 1993 and 1992 and the related statements of operations, cash flows and changes in stockholders' equity 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. The financial statements of the Company for the year ended December 31, 1991 were audited by other auditors whose report, dated February 3, 1992, expressed an unqualified opinion on those statements and included explanatory paragraphs that described the uncertainties associated with the Company's ability to continue as a going concern and the inherent uncertainty involved in the process of estimating the net realizable value of its real estate properties. 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 1993 and 1992 financial statements present fairly, in all material respects, the financial position of Koll Real Estate Group, Inc. at December 31, 1993 and 1992 and the results of its operations and its cash flows for the years ended December 31, 1993 and 1992 in conformity with generally accepted accounting principles. The Company carries its real estate properties at the lower of cost or estimated net realizable value. As discussed in Note 2, the estimation process is inherently uncertain and relies to a considerable extent on future events and market conditions. As discussed in Note 6, the development of the Company's Bolsa Chica project is dependent upon obtaining various governmental approvals and various economic factors. Accordingly, the amount ultimately realized from such project may differ materially from the current estimate of net realizable value. As discussed in Note 9, the Company changed its method of accounting for income taxes in 1993. Also as discussed in Note 9, the Company was notified in March 1994 that a Stipulation of Settlement has been entered into between a predecessor company and the Internal Revenue Service regarding the settlement of an alleged tax deficiency that is the subject of certain tax sharing agreements. The Company has been informed by the other parties to these tax sharing agreements that it is being charged with a net obligation of approximately $21 million under this settlement, which has been accrued in the Company's financial statements since December 1989. DELOITTE & TOUCHE San Diego, California February 15, 1994 (March 28, 1994 as to the last paragraph of Note 9) INDEPENDENT AUDITORS' REPORT To The Board of Directors and Stockholders of Koll Real Estate Group, Inc.: We have audited the accompanying statements of operations, changes in stockholders' equity and cash flows of Koll Real Estate Group, Inc. (formerly The Bolsa Chica Company and Henley Properties Inc.) for the year ended December 31, 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 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 results of operations and cash flows of Koll Real Estate Group, Inc. for the year ended December 31, 1991 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. The Company has suffered losses from operations and must obtain significant capital for financing its real estate development activities and scheduled repayments of debt obligations during 1992. The uncertainties associated with the Company's ability to obtain sufficient capital, restructure its debt agreements and return to profitable operations raise substantial doubt about the Company's ability to continue as a going concern. The Company has announced a recapitalization and merger plan to deal with these matters. The financial statements referred to above do not include any adjustments that might result from the outcome of these uncertainties. The Company carries its real estate held for development or sale and land held for development at the lower of cost or estimated net realizable value. As discussed in Note 2, the estimation process is inherently uncertain and relies to a considerable extent on future events and market conditions, the ability to achieve financing for its real estate development activities and the resolution of political, environmental and other related issues. Accordingly, ultimate realization of asset values may differ materially from amounts presently estimated. KENNETH LEVENTHAL & COMPANY Orange County, California February 3, 1992 KOLL REAL ESTATE GROUP, INC. BALANCE SHEETS See the accompanying notes to financial statements. KOLL REAL ESTATE GROUP, INC. STATEMENTS OF OPERATIONS See the accompanying notes to financial statements. KOLL REAL ESTATE GROUP, INC. STATEMENTS OF CASH FLOWS See the accompanying notes to financial statements. KOLL REAL ESTATE GROUP, INC. STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY See the accompanying notes to financial statements. KOLL REAL ESTATE GROUP, INC. NOTES TO FINANCIAL STATEMENTS NOTE 1 -- FORMATION AND BASIS OF PRESENTATION On December 31, 1989, The Henley Group, Inc. separated its business into two public companies through a distribution to its Class A and Class B common stockholders of all of the common stock of a newly formed Delaware corporation to which The Henley Group, Inc. had contributed its non-real estate development operations, assets and related liabilities. The new company was named The Henley Group, Inc. ("Henley Group") immediately following the distribution. The remaining company was renamed Henley Properties Inc. ("Henley Properties") and consisted of the real estate development business and assets of Henley Group. On July 16, 1992, a subsidiary of Henley Properties merged with and into Henley Group (the "Merger") and Henley Group became a wholly owned subsidiary of Henley Properties. Henley Properties, through its Henley Group subsidiary, received in the Merger net assets having a book value as of July 16, 1992 of approximately $45.3 million, consisting of approximately $103.6 million of assets, including $58.3 million of cash and a 44% interest in Deltec Panamerica S.A. ("Deltec"), and $58.3 million of liabilities. In connection with the Merger, Henley Properties was renamed The Bolsa Chica Company. On September 30, 1993, a subsidiary of The Bolsa Chica Company acquired the domestic real estate development business and related assets of The Koll Company (Note 4). In connection with this acquisition, The Bolsa Chica Company was renamed Koll Real Estate Group, Inc. (the "Company"). Immediately prior to the July 1992 Merger, Henley Group distributed to its stockholders among other consideration (the "Distribution"), in respect of each share of its outstanding common stock (the "Henley Group Common Stock"): (i) $6.00 aggregate principal amount of the 12% Senior Subordinated Pay-In-Kind Debentures due March 15, 2002 of the Company (the "Senior Subordinated Debentures"); and (ii) $1.50 aggregate principal amount of the 12% Subordinated Pay-In-Kind Debentures due March 15, 2002 of the Company (the "Subordinated Debentures", and, together with the Senior Subordinated Debentures, the "Debentures"). Approximately $159.4 million aggregate principal amount of the Debentures were distributed in the Distribution and approximately $43.8 million aggregate principal amount of the Debentures were retained by the Company's Henley Group subsidiary in the Merger. In the Merger, Henley Group stockholders also received, in respect of each share of Henley Group Common Stock, the following securities of the Company: (i) two shares of Series A Convertible Redeemable Preferred Stock (the "Series A Preferred Stock"); and (ii) one share of Class A Common Stock (the "Class A Common Stock"). Certain prior-period amounts have been reclassified to conform with the current presentation. NOTE 2 -- SIGNIFICANT ACCOUNTING POLICIES The accompanying financial statements include the accounts of the Company and all majority-owned subsidiaries. All significant intercompany accounts and transactions have been eliminated. STATEMENTS OF CASH FLOWS For purposes of the Statements of Cash Flows, all highly liquid instruments purchased with a maturity of three months or less are considered to be cash equivalents. EARNINGS PER COMMON SHARE In connection with the Merger, on July 16, 1992, the Company issued approximately 19.7 million shares of its Class A Common Stock and 42.5 million shares of its Series A Preferred Stock. On December 17, 1993, the Company issued 3.4 million shares of its Class A Common Stock to Libra Invest & Trade Ltd. ("Libra") in exchange for all of Libra's approximately $10.6 million in aggregate principal amount of Subordinated Debentures plus accrued interest. The weighted average numbers of common shares outstanding for the years ended December 31, 1991, 1992, and 1993 were 20.0 million, 29.0 million, and 83.0 million, respectively. The Series A Preferred Stock is KOLL REAL ESTATE GROUP, INC. NOTES TO FINANCIAL STATEMENTS (CONTINUED) NOTE 2 -- SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) not included in the loss per share calculation for 1991 and 1992 because the effect is antidilutive. The 1993 earnings per share calculation includes the Series A Preferred Stock and the effect of 5.7 million shares of common and preferred stock granted under the 1988 Stock Option Plan (Note 14). SHORT-TERM INVESTMENTS The Company accounts for short-term investments at the lower of cost or market value. REAL ESTATE Real estate held for development or sale and land held for development (real estate properties) are carried at the lower of cost or estimated net realizable value. The estimation process involved in the determination of net realizable value is inherently uncertain since it requires estimates as to future events and market conditions. Such estimation process assumes the Company's ability to complete development and dispose of its real estate properties in the ordinary course of business based on management's present plans and intentions. Economic, market, environmental and political conditions may affect management's development and marketing plans. In addition, the implementation of such development and marketing plans could be affected by the availability of future financing for development and construction activities. Accordingly, the ultimate net realizable values of the Company's real estate properties are dependent upon future economic and market conditions, the availability of financing, and the resolution of political, environmental and other related issues. The cost of sales of multi-unit projects is computed using the relative sales value method. Direct construction costs are accumulated by phase, using the specific identification method; land and all other common costs are allocated between phases benefited, using area or unit methods. These methods do not differ significantly from the relative sales value method. Interest, carrying costs, indirect general and administrative costs that relate to several real estate projects and property taxes are capitalized to projects during their development period. No interest expense incurred during the years ended December 31, 1991, 1992, and 1993 was capitalized. Operating properties are generally depreciated using estimated lives that range principally from 5 to 30 years. For financial statement purposes, depreciation is computed utilizing the straight-line method. For tax purposes, depreciation is generally computed by accelerated methods based on allowable useful lives. Accumulated depreciation amounted to $12.6 million and $9.7 million at December 31, 1992 and 1993, respectively. The Company's rental operations consist primarily of the leasing of office and marina space and all of the Company's leases are classified as operating leases. Such leases are generally for periods of up to 5 years. INTANGIBLE ASSETS Goodwill, which represents the difference between the purchase price of a business acquired in 1993 (Note 4) and the related fair value of net assets acquired, is amortized on a straight-line basis over 15 years. Goodwill of $8.7 million as of December 31, 1993 is included in other assets. POSTRETIREMENT BENEFITS OTHER THAN PENSIONS Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other than Pensions," ("FAS 106") was implemented by the Company on the immediate recognition basis effective January 1, 1991 resulting in a $2 million charge to earnings. This standard requires that the cost of these benefits, which are primarily health care related, be recognized in the financial statements during each employee's active working career. The Company's previous practice was to charge these costs to expense as they were paid. As of December 31, 1993 the accrued unfunded costs totalled $1.5 million. KOLL REAL ESTATE GROUP, INC. NOTES TO FINANCIAL STATEMENTS (CONTINUED) NOTE 2 -- SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) INCOME TAXES In February 1992, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" ("FAS 109"). FAS 109 supersedes both APB Opinion No. 11 and FAS No. 96, "Accounting for Income Taxes." With the adoption of FAS 109 in the first quarter of 1993, the Company changed to the liability method of accounting for income taxes, which resulted in an increase in its deferred tax liability of approximately $36 million, through a charge to income (Note 9). Also see Note 9 for a discussion of the tax sharing agreements with Abex Inc.("Abex") and Wheelabrator Technologies Inc. ("WTI"). RECOGNITION OF REVENUES Sales are recorded using the full accrual method when title to the real estate sold is passed to the buyer and the buyer has made an adequate financial commitment. When it is determined that the earning process is not complete, income is deferred using the installment, cost recovery or percentage of completion methods of accounting. NOTE 3 -- ASSET REVALUATIONS During the fourth quarter of 1991, the Company recorded approximately $65 million of charges for the revaluation of certain assets, including goodwill. Management believes that these revalued amounts better reflected market values based on real estate market conditions and the Company's plan to sell certain non-strategic assets. NOTE 4 -- ACQUISITIONS AND DISPOSITIONS On August 27, 1993 the Company disposed of its entire 44% interest in Deltec for $43.7 million in net cash proceeds, resulting in a gain of $1.9 million. Discontinued operations for the years ended December 31, 1992 and 1993 also includes $.9 million and $4.2 million of net income through the date of disposition. The Company used $23.8 million of the proceeds to make principal prepayments in accordance with term loan agreements with Bank of America and Bank of Boston. The Company also terminated its put option agreement with Abex (Note 10) on August 27, 1993 and received $3 million in cash from Abex which was used to prepay senior bank debt. On September 30, 1993, the Company acquired the domestic real estate development business and related assets of The Koll Company ("Koll"). The principal activity of the acquired business is to provide commercial, industrial, retail and residential real estate development services, including feasibility studies, entitlement coordination, project planning, construction management, financing, marketing, acquisition, disposition and asset management services throughout the nation. The acquired business generates income principally through fees and participating interests in equity partnerships. No real property was involved in the transaction. In connection with the acquisition, the Company paid $4.75 million in cash, approximately $1 million in reimbursement of investments in transferred development projects, and agreed to pay an earn-out over the next four and one-quarter years based on the future profitability of the business acquired. On December 29, 1993 the Company amended its agreement with Koll, under which the Company paid $4.25 million in cash to Koll in exchange for the immediate termination of the earn-out payments with retroactive effect to the initial date of the acquisition agreement. Under the earn-out, the Company was entitled to a 20% preferred return on its original $4.75 million investment, Koll was then entitled to a matching return subject to available profits, with all remaining profits split equally between the Company and Koll. In addition, on September 30, 1993, Koll and Mr. Donald M. Koll (an officer and director of the Company and owner of Koll) entered into covenants not to compete with the Company with respect to domestic real estate development, subject to certain limited exceptions. The Koll covenant is perpetual in duration while the covenant of Mr. Koll is limited to the five-year period following his ceasing to be either an officer, director or stockholder of the Company. In connection with the acquisition, the Company also paid KOLL REAL ESTATE GROUP, INC. NOTES TO FINANCIAL STATEMENTS (CONTINUED) NOTE 4 -- ACQUISITIONS AND DISPOSITIONS (CONTINUED) Koll $325,000 to terminate its June 11, 1990 management agreement in lieu of continuing to receive and pay for duplicative services during the 90-day notice period which would otherwise have been required under the management agreement. On September 30, 1993, the Company and Koll also entered into various other agreements regarding services they provide to one another (Note 11). On December 17, 1993, the Company completed a transaction with Libra whereby it exchanged the Company's Lake Superior Land Company subsidiary for (1) approximately $42.4 million in aggregate face amount of Senior Subordinated Debentures held by Libra; (2) net cash proceeds to be generated by Libra's periodic sale of up to approximately 3.4 million shares of the Company's Class A Common Stock held by Libra through a series of transactions to be effected in an orderly manner within a three-year period; and (3) the right of the Company to receive a contingent payment if the proceeds from any disposition by Libra of Lake Superior Land Company during the 15 year period following the closing of the transaction exceed a 20% preferred return on the negotiated value of Libra's investment. Accordingly, the financial information included in the statements of operations for all periods has been reclassified to present Lake Superior Land Company as a discontinued operation. Lake Superior Land Company owns and manages a commercial hardwood timber business on approximately 300,000 acres of forest lands and shoreline property on Lake Superior in Michigan and Wisconsin. Revenues related to the discontinued operation were $6.2 million and $8.9 million for the years ended December 31, 1991 and 1992, respectively and $10.6 million for 1993 through the date of the disposition. Net income from the discontinued operation for 1991 , 1992 and 1993 through the date of disposition was $.8 million, $2.6 million and $1.6 million, respectively. The accumulated deficit of Lake Superior Land Company at the date of the disposition was approximately $24.8 million. The Company also completed a separate transaction with Libra in December 1993, whereby the Company exchanged approximately 3.4 million newly issued shares of its Class A Common Stock for approximately $10.6 million in aggregate face amount of Subordinated Debentures held by Libra. In connection with these transactions, the Company recorded an after-tax gain of $39.1 million on the disposition of Lake Superior Land Company and an after-tax extraordinary gain on extinguishment of the Debentures of $23.6 million (Note 7). After these transactions, Libra and affiliates presently hold approximately 7.4 million shares, or 17%, of the Company's Class A Common Stock, including approximately 3.4 million shares which have been deposited in a custodial account for periodic sale in accordance with instructions from the Company, and approximately 11.9 million shares, or 28%, of the Company's preferred stock. In February 1994, the Company received $1 million in cash from Libra in exchange for the immediate termination of the contingent payment provision described above. NOTE 5 -- REAL ESTATE HELD FOR DEVELOPMENT OR SALE Real estate held for development or sale consists of the following at December 31 (in millions): The decrease in real estate held for development or sale during 1993 relates primarily to the sale of the Company's LaJolla, California office property for $10.0 million in cash, as well as the placement into service of the Eagle Crest golf course and its related reclassification to operating properties. NOTE 6 -- LAND HELD FOR DEVELOPMENT Land held for development consists of approximately 1,200 acres known as Bolsa Chica located in Orange County, California, surrounded by the City of Huntington Beach and approximately 35 miles south of downtown Los Angeles ("Bolsa Chica"). The Company is currently seeking approvals from local, state and federal governmental entities for a 4,900 unit (approximately 4,300 units on Company-owned land) KOLL REAL ESTATE GROUP, INC. NOTES TO FINANCIAL STATEMENTS (CONTINUED) NOTE 6 -- LAND HELD FOR DEVELOPMENT (CONTINUED) residential project on this site. A revised environmental impact report was released for public comments in December 1993 for a 60-day period ending February 18, 1994. The County of Orange requested that this document contain an in-depth analysis of an alternative plan which includes 3,500 homes, in addition to the in-depth analysis of the Company's plan. Due to a number of factors beyond the Company's control, including possible objections of various environmental and so-called public interest groups that may be made in legislative, administrative or judicial forums, the required approvals could be delayed substantially. Subject to these and other uncertainties inherent in the entitlement process, the Company's goal is to obtain all material governmental approvals in the first half of 1995 and to begin construction in the second half of 1995, depending on economic and market conditions. Realization of the Company's investment in Bolsa Chica will also depend upon various economic factors, including the demand for residential housing in the Southern California market and the availability of credit to the Company and to the housing industry. NOTE 7 -- DEBT SENIOR BANK DEBT TERM LOAN During 1993, the Company retired the entire balance of senior bank debt owed to Bank of America with proceeds from the January 1993 Lake Superior Land Company financing, the August Deltec disposition and termination of the Abex put option agreement (see Note 4), and the November sale of two office buildings located in La Jolla, California. TERM NOTE On July 16, 1992, in connection with the Merger, the Company entered into a $13.8 million term note agreement due on July 31, 1995 with the Bank of Boston, principally secured by resort and residential property in New Hampshire ("Wentworth"). Approximately $6.4 million of the proceeds from the August 1993 Deltec disposition and termination of the Abex put option agreement (Note 4) were used to make principal prepayments to Bank of Boston. The term note agreement with Bank of Boston requires additional principal prepayments to be made from the net proceeds from the sale of Wentworth and other assets. The term note agreement also requires additional principal repayments of $.2 million in the second half of 1994 and $.4 million in the first half of 1995, with any remaining balance due at maturity on July 31, 1995. Amounts outstanding under the term note bear interest at prime plus 1%. The term note agreement with Bank of Boston is secured by a first mortgage on the Wentworth property, stock pledge agreements of substantially all significant subsidiaries of the Company and first mortgages on certain other properties. The term note agreement contains certain restrictive covenants that prohibit the declaration or payment of dividends and limit, among other things, (i) the incurrence of indebtedness, (ii) the making of investments, loans and advances, (iii) the creation or incurrence of liens on existing and future assets of Wentworth or its subsidiaries, (iv) stock repurchases, and (v) project development spending in excess of certain planned levels. The term note agreement also contains various financial covenants and events of default customary for such agreements. SUBORDINATED DEBENTURES The Debentures were comprised of the following as of December 31 (in millions): KOLL REAL ESTATE GROUP, INC. NOTES TO FINANCIAL STATEMENTS (CONTINUED) NOTE 7 -- DEBT (CONTINUED) The Debentures give the Company the right to pay interest in-kind, in cash or, subject to certain conditions, in the Company's common stock. It is currently anticipated that interest on the Debentures will be paid in-kind. The Debentures, which are due March 15, 2002, do not require any sinking fund payments and may be redeemed by the Company at any time in cash only, or at maturity in cash or stock, subject to certain conditions. The Debentures prohibit the payment of any dividends or other distributions on the Company's equity securities. As a result of the Distribution and the Merger on July 16, 1992 (Note 1), approximately $159.4 million aggregate principal amount of the Debentures were distributed to stockholders of Henley Group and approximately $43.8 million aggregate principal amount of the Debentures were retained by Henley Group, which is now a wholly owned subsidiary of the Company. As a result of the transactions with Libra (Note 4) in which approximately $42.4 million in aggregate principal amount of Senior Subordinated Debentures and $10.6 million in aggregate principal amount of Subordinated Debentures held by Libra were retired, the Company recorded on extraordinary gain of $36.1 million, less an applicable income tax provision of $12.5 million, in the accompanying consolidated financial statements. At December 31, 1993 the estimated fair value of the Company's Debentures was within a range of approximately $40 million to $60 million. The fair value of the Debentures is estimated based on the negotiated values in the Libra transactions (lower end of range) and current quotes from certain bond traders making a market in the Debentures (upper end of range). However, due to the low trading volume and illiquid market for the Debentures, current quotes from bond traders may not be meaningful indications of value. The carrying amount for all other debt of the Company approximates market primarily as a result of floating interest rates. INTEREST The Company made cash payments of interest of $10.6 million, $7.4 million and $2.5 million for the years ended December 31, 1991, 1992 and 1993, respectively. NOTE 8 -- OTHER LIABILITIES Other liabilities were comprised of the following as of December 31 (in millions): NOTE 9 -- INCOME TAXES Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" ("FAS 109"). FAS 109 requires a change from the deferred method of accounting for income taxes under APB Opinion No. 11 to the asset and liability method of accounting for income taxes. Under FAS 109, deferred income taxes are determined based on the difference between the financial statement and tax bases of assets and liabilities, using enacted tax rates in effect in the years in which these differences are expected to reverse. At January 1, 1993, the Company recorded the cumulative effect of this change in accounting for income taxes as a $36 million charge to earnings in the consolidated statement of operations. KOLL REAL ESTATE GROUP, INC. NOTES TO FINANCIAL STATEMENTS (CONTINUED) NOTE 9 -- INCOME TAXES (CONTINUED) The tax effects of items that gave rise to significant portions of the deferred tax accounts as of December 31, 1993 are as follows: At December 31, 1993, the Company had available tax net operating loss carryforwards of approximately $106 million which expire in the years 2003 through 2008 if not utilized. The Internal Revenue Code (the "Code") imposes an annual limitation on the use of loss carryforwards upon the occurrence of an "ownership change" (as defined in Section 382 of the Code). Such an ownership change occurred in connection with the Merger. As a result, approximately $25 million of the Company's net operating loss carryforwards will generally be limited to the extent that Henley Properties and its subsidiaries recognize certain gains in the five-year period following the ownership change (ending July 16, 1997). The following is a summary of the income tax provision (benefit) on continuing operations for the years ended December 31 (in millions): Cash payments for federal, state and local income taxes were approximately $1.6 million, $1.3 million and $7.8 million for the years ended December 31, 1991, 1992 and 1993, respectively. Tax refunds received in 1993 were approximately $5.1 million. KOLL REAL ESTATE GROUP, INC. NOTES TO FINANCIAL STATEMENTS (CONTINUED) NOTE 9 -- INCOME TAXES (CONTINUED) The principal items accounting for the difference in taxes on income computed at the statutory rate and as recorded are as follows for the years ended December 31 (in millions): TAX SHARING AGREEMENTS Henley Group and Abex, a former subsidiary of Henley Group whose stock was distributed to stockholders of Henley Group, entered into a tax sharing agreement in 1992 prior to the Distribution to provide for the payment of taxes for periods during which Henley Group and Abex were included in the same consolidated group for federal income tax purposes, the allocation of responsibility for the filing of tax returns, the cooperation of the parties in realizing certain tax benefits, the conduct of tax audits and various related matters. 1989-1992 INCOME TAXES. The Company is generally charged with responsibility for all of its federal, state, local or foreign income taxes for this period and, pursuant to the tax sharing agreement with Abex, all such taxes attributable to Henley Group and their consolidated subsidiaries, including any additional liability resulting from adjustments on audit (and any interest or penalties payable with respect thereto), except that Abex is generally charged with responsibility for all such taxes attributable to it and its subsidiaries for 1990-1992. In addition, under a separate tax sharing agreement between Henley Group and a former subsidiary of Henley Group, Fisher Scientific International Inc. ("Fisher"), Fisher is generally charged with responsibility for its own income tax liabilities for this period. PRE-1989 INCOME TAXES. Under tax sharing agreements with WTI and Abex, the parties are charged with sharing responsibility for paying any increase in the federal, state or local income tax liabilities (including any interest or penalties payable with respect thereto) for any consolidated, combined or unitary tax group which included WTI, Henley Group or any of their subsidiaries for tax periods ending on or before December 31, 1988. WTI is charged with responsibility for paying the first $51 million of such increased taxes, interest and penalties, plus any amounts payable with respect to such liabilities by certain former affiliates of WTI under their tax sharing agreements with WTI. Should the amounts payable exceed $51 million, the Company is charged with responsibility for paying the next $25 million, plus amounts payable with respect to liabilities which are attributable to certain of the Company's subsidiaries. Liabilities in excess of amounts payable by WTI and the Company, as described above, will generally be assumed by Abex (the "Abex Indemnification"). In the first quarter of 1993, the Company paid approximately $7.6 million related to the tax sharing agreements. Of this amount, approximately $4.5 million will be applied against the Company's $25 million limitation (as discussed above). The remaining $3.1 million relates to liabilities which are attributable to certain of the Company's subsidiaries. Therefore the Company's potential liability for additional payments under these tax sharing agreements is approximately $21 million, which has been accrued in the Company's financial statements since December 1989 and is included in accounts payable and accrued liabilities as of December 31, 1993. KOLL REAL ESTATE GROUP, INC. NOTES TO FINANCIAL STATEMENTS (CONTINUED) NOTE 9 -- INCOME TAXES (CONTINUED) In January 1993, the Internal Revenue Service completed its examination of the Federal tax returns of WTI for the periods May 27, 1986 through December 31, 1988 and asserted a material deficiency relating to the tax basis of a former subsidiary of WTI. WTI, Abex and the Company disagreed with the position taken by the IRS and WTI filed a petition with the U.S. Tax Court. A trial date had been scheduled for June 1994; however, in March 1994, WTI and the IRS entered into a Stipulation of Settlement that will result in a tax payable together with interest of approximately $72 million which is due in April 1994. The Company has been informed by the other parties to these tax sharing agreements that it is being charged with a net obligation of approximately $21 million under this settlement. The Company is currently evaluating the scope of this claimed obligation under the settlement and potential sources of financing for such amount that the Company may ultimately be obligated to pay. However, there can be no assurance that any financing will be available, or that if available, it can be obtained on terms that are favorable to the Company and its stockholders. NOTE 10 -- COMMITMENTS AND CONTINGENCIES TRANSITION AGREEMENTS Pursuant to a 1989 transition agreement, Henley Group provided to the Company and its subsidiaries certain services, including management, strategic planning and advice, legal, tax, accounting, data processing, cash management, employee benefits, operational, corporate secretarial, insurance purchasing and claims administration consulting services for a quarterly fee of $750,000, commencing on the date of the 1989 distribution, plus an amount for the use of office space in Henley Group's Hampton, New Hampshire offices for such period. This rent amounted to approximately $.8 million for the year ended December 31, 1991, and $.4 million for the first half of 1992. The 1989 Transition Agreement was cancelled in July 1992 in connection with the Merger. Pursuant to a 1992 transition agreement, each of Abex and the Company provides to the other certain administrative support services until the first anniversary of the Merger, and thereafter until 60 days' prior written notice of termination is given by one company to the other and each company reimburses the other for its out-of-pocket expenses. Effective March 16, 1993, the 1992 transition agreement was amended to provide that all transitional services would be provided by Abex to the Company for a period ending on March 31, 1994, and that the Company would pay $.5 million quarterly for such services. Accordingly, the Company reimbursed Abex approximately $1.0 million and $1.8 million for the years ended December 31, 1992 and 1993. The amendment also provided for the termination of the New Hampshire facilities lease on March 31, 1993. In connection with the Merger, the Company entered into a put option agreement with Abex, through December 31, 1995, which provided the Company the right to require Abex to purchase certain assets of the Company at 85% of appraised value, subject to an annual limitation of no more than $50 million and an aggregate limitation of $75 million for such assets. On August 27, 1993, the Company received $3.0 million from Abex in exchange for the termination of this agreement (Note 4). LEGAL PROCEEDINGS The owners of undeveloped real property located in San Diego County sued Signal Landmark, a subsidiary of the Company ("Signal"), in San Diego Superior Court, in May 1990, alleging that Signal had deposited contaminated soils on their property and was liable under theories of nuisance, negligence, trespass and strict liability. The plaintiffs sought general damages in the amount of approximately $40 million and additionally, punitive damages in an unspecified amount, plus prejudgment interest and costs. On August 5, 1991, the plaintiffs filed a complaint in Federal court against Signal and several other parties asserting claims under the Federal Comprehensive Environmental Response, Compensation and Liability Act, seeking essentially the same relief sought in the state action. KOLL REAL ESTATE GROUP, INC. NOTES TO FINANCIAL STATEMENTS (CONTINUED) NOTE 10 -- COMMITMENTS AND CONTINGENCIES (CONTINUED) In April 1992, a jury awarded the plaintiffs damages in the amount of $2.5 million following a trial in the state action. Signal appealed the verdict in the state action and posted a bond and cash collateral of $3.75 million in August 1992. On March 5, 1993, Signal reached an agreement in principle with the plaintiffs in such litigation to settle both the federal and state actions. On July 2, 1993, the Federal Court for the Southern District of California approved the settlement agreement under the terms of which funds from such cash collateral account were disbursed approximately as follows: 1) $1.3 million was deposited in trust for remediation expenditures; 2) $1.3 million was disbursed to the plaintiffs; and 3) $1.1 million was returned to Signal. There are various other lawsuits and claims pending against the Company and certain subsidiaries. In the opinion of the Company's management, ultimate liability, if any, will not have a material adverse effect on the Company's liquidity or financial condition. CORPORATE INDEMNIFICATION MATTERS The Company and its predecessors have, through a variety of transactions effected since 1986, disposed of several assets and businesses, many of which are unrelated to the Company's current operations. By operation of law or contractual indemnity provisions, the Company has retained liabilities relating to certain of these assets and businesses. Many of such liabilities are supported by insurance or by indemnities from certain of the Company's predecessor and currently or previously affiliated companies. The Company believes its balance sheet reflects adequate reserves for these matters. Abex and the Company agreed that, following the Distribution and the Merger, each company will be responsible for environmental liabilities relating to its existing, past and future assets and businesses and will indemnify the other in respect thereof. The United States Environmental Protection Agency ("EPA") has designated Universal Oil Products ("UOP"), among others, as a Potentially Responsible Party ("PRP") with respect to an area of the Upper Peninsula of Michigan (the "Torch Lake Site") under the Federal Comprehensive Environmental Response, Compensation and Liability Act of 1980, as amended ("CERCLA"). UOP is allegedly the successor in interest to one of the companies that conducted mining operations in the Torch Lake area and an affiliate of Allied-Signal Inc., a predecessor of the Company. The Company has not been named as a PRP at the site. However, Allied-Signal has, through UOP, asserted a contractual indemnification claim against the Company for claims that may be asserted against UOP by EPA or other parties with respect to the site. EPA has proposed a cleanup plan which would involve covering certain real property both contiguous and non-contiguous to Torch Lake with soil and vegetation in order to address alleged risks posed by copper tailings and slag at an estimated cost of approximately $7.2 million. EPA estimates that it has spent in excess of $2 million to date in performing studies of the site. Under CERCLA, EPA could assert claims against the Torch Lake PRPs, including UOP, to recover the cost of these studies, the cost of all remedial action required at the site, and natural resources damages. An earlier settlement in principle with EPA staff pursuant to which UOP would pay $1.7 million in exchange for a release similar to those normally granted by EPA in such circumstances was rejected by certain other governmental authorities in July 1993. Settlement negotiations between the Company, on behalf of UOP, and EPA resumed shortly thereafter and are ongoing. NOTE 11 -- RELATED PARTY TRANSACTIONS MANAGEMENT AGREEMENT In June 1990 the Company entered into a management agreement with Koll. On September 30, 1993, in connection with the Company's acquisition of the domestic real estate development business and related assets of Koll, the Company paid Koll $325,000 to terminate the management agreement in lieu of continuing to receive and pay for duplicative services during the 90-day notice period which would otherwise have been required under the management agreement. Under the terms of the management agreement, the KOLL REAL ESTATE GROUP, INC. NOTES TO FINANCIAL STATEMENTS (CONTINUED) NOTE 11 -- RELATED PARTY TRANSACTIONS (CONTINUED) Company was obligated to pay a quarterly management fee equal to .125% of the average book value of its assets managed by Koll. Additionally, the Company was obligated to reimburse Koll for certain personnel costs and other expenses and Koll was generally entitled to a disposition fee of 1% of the net sale proceeds (as defined) upon the sale of any real estate property (other than the Bolsa Chica and Wentworth properties) managed by Koll. During 1991, 1992 and 1993 the Company incurred management fees of $2.5 million, $2.0 million and $1.4 million through September 30, 1993, respectively, and reimbursable personnel costs and other expenses of $1.6 million, $.9 million and $.1 million, respectively, under this management agreement. In 1990, the Company also entered into construction management agreements with Koll Construction, a wholly owned subsidiary of Koll, with respect to the Eagle Crest and Murrieta projects. In 1993, the Company entered into a construction management agreement with Koll Construction for demolition of bunkers at the Bolsa Chica project. During 1991, 1992 and 1993 the Company incurred fees aggregating approximately $.5 million, $.2 million and $.1 million, respectively, to Koll Construction in consideration of these services and related reimbursements. SERVICE AGREEMENTS On September 30, 1993, the Company entered into a Financing and Accounting Services Agreement to provide Koll with financing, accounting, billing, collections and other related services until 30 days' prior written notice of termination is given by one company to the other. Fees earned for the year ended December 31, 1993 were approximately $.1 million. The Company also entered into a Management Information Systems and Human Resources Services Agreement on September 30, 1993 with Koll Management Services, Inc. ("KMS"), a public company majority owned by Koll. Under this agreement, KMS provides computer programming, data organization and retention, record keeping, payroll and other related services until 30 days' prior written notice of termination is given by one company to the other. Fees and related reimbursements accrued during the year ended December 31, 1993 were approximately $.1 million. SUBLEASE AGREEMENTS On September 30, 1993, the Company entered into a month-to-month Sublease Agreement with Koll to sublease a portion of a Koll affiliate's office building located in Newport Beach, California. The Company also entered into lease agreements on a month-to-month basis for office space in Northern California and San Diego, California with KMS and Koll Construction, respectively. Combined annual lease costs on these month-to-month leases during the year ended December 31, 1993 were approximately $.1 million. DEVELOPMENT FEES For the year ended December 31, 1993, the Company earned fees of approximately $.7 million for real estate development services provided to partnerships in which Koll and certain directors and officers of the Company have an ownership interest. LOAN RECEIVABLE In December 1993, the Company purchased a nonrecourse construction loan, secured by a first trust deed on four multi-tenant industrial buildings, for which the borrower is a partnership in which Koll and certain directors and officers of the Company have an ownership interest. The loan balance of $.8 million as of December 31, 1993 is included in other assets. OTHER TRANSACTIONS See Notes 4, 9 and 10 for descriptions of other transactions and agreements with Koll, Libra, Abex and WTI. KOLL REAL ESTATE GROUP, INC. NOTES TO FINANCIAL STATEMENTS (CONTINUED) NOTE 12 -- RETIREMENT PLANS The Company has noncontributory defined benefit retirement plans covering substantially all employees of the Company prior to September 30, 1993 who had completed one year of continuous employment. Net periodic pension cost for the years ended December 31, consisted of the following (in millions): The curtailment loss in 1993 resulted from the freeze of benefit accruals for former participants in April 1993. The funded status and accrued pension cost at December 31, 1992 and 1993 for defined benefit plans were as follows (in millions): The development of the projected benefit obligation for the plans at December 31, 1991, 1992 and 1993 are based on the following assumptions: discount rates of 8.5%, 8% and 7%, respectively, rates of increase in employee compensation of 5.5%, 4% and 0%, respectively, and expected long-term rates of return on assets of 9%. The date used to measure plan assets and liabilities was October 31 in each year. Assets of the plans are invested primarily in stocks, bonds, short-term securities and cash equivalents. NOTE 13 -- CAPITAL STOCK COMMON STOCK Under its restated certificate of incorporation, the Company has authority to issue up to 750 million shares of common stock, par value $.05 per share, subject to approval of the Board of Directors (the "Board"), of which 625 million shares of Class A Common Stock and 25 million shares of Class B Common Stock are initially authorized for issuance and an additional 100 million shares may be issued in one or more series, and have such voting powers or other rights and limitations as the Board may authorize. KOLL REAL ESTATE GROUP, INC. NOTES TO FINANCIAL STATEMENTS (CONTINUED) NOTE 13 -- CAPITAL STOCK (CONTINUED) On June 11, 1992, all shares of Class B Common Stock (convertible nonvoting) were converted into an equal number of shares of Class A Common Stock (voting). On July 16, 1992, in connection with the Merger, the Company issued approximately 19.7 million shares of its Class A Common Stock (Notes 1 and 2). On December 17, 1993, the Company issued 3.4 million shares of its Class A Common Stock in exchange for all of Libra's approximately $10.6 million in aggregate principal amount of Subordinated Debentures plus accrued interest. In connection with the Company's sale of Lake Superior Land Company to Libra, the net cash proceeds from the sale of 3.4 million shares of Class A Common Stock held by Libra will be forwarded to the Company. The estimated amount of proceeds to be received from such sale is reflected in the equity section of the balance sheet as deferred proceeds from stock issuance. Under the Company's term loan agreement with Bank of Boston and Indentures for the Debentures (Note 7), the Company is prohibited from purchasing shares of its common stock. PREFERRED STOCK Under its restated certificate of incorporation, the Company has authority to issue 150 million shares of preferred stock, par value $.01 per share, in one or more series, with such voting powers and other rights as authorized by the Board. Effective July 16, 1992, in connection with the Merger, the Board authorized approximately 42.5 million shares of Series A Preferred Stock, which have a liquidation preference of $.75 per share, participate in any dividend or distribution paid on the Class A Common Stock on a share for share basis, and have no voting rights, except as required by law (Notes 1 and 2). The Series A Preferred Stock is redeemable at the Company's option, on 30 days' notice given at any time after the second anniversary of issuance, at the liquidation preference of $.75 per share, in cash or generally in shares of Class A Common Stock. Each share of the Series A Preferred Stock is convertible at the holder's option, at any time after the second anniversary of issuance, generally into one share of Class A Common Stock. NOTE 14 -- STOCK PLANS The Company has various plans which are described below: 1993 STOCK OPTION/STOCK ISSUANCE PLAN The 1993 Stock Option/Stock Issuance Plan ("1993 Plan"), was adopted by the Board on November 29, 1993, subject to stockholder approval at the 1994 Annual Meeting of Stockholders, as the successor equity incentive program to the Company's 1988 Stock Plan. Outstanding options under the 1988 Stock Plan will be incorporated into the 1993 Plan upon its approval. Under the 1993 Plan 7,500,000 shares each (including 3,000,000 shares each authorized under the 1988 Stock Plan) of Series A Preferred Stock and Class A Common Stock have been reserved for issuance to officers, key employees and consultants of the Company and its subsidiaries and the non-employee members of the Board. Options generally become exercisable for 40% of the option shares upon completion of one year of service and become exercisable for the balance in two equal annual installments thereafter. The 1993 Plan includes an automatic option grant program, pursuant to which each individual serving as a non-employee Board member on the November 29, 1993 effective date of the 1993 Plan received an option grant for 125,000 shares each of Series A Preferred Stock and Class A Common Stock with an exercise price of $.4063 per share, equal to the fair market value of the underlying securities on the grant date. Each individual who first joins the Board as a non-employee director after such effective date will receive a similar option grant. Of the shares subject to each option, 40% will vest upon completion of one year of Board service measured from the grant date, and the balance will vest in two equal annual installments thereafter. Each automatic grant will have a maximum term of 10 years, subject to earlier termination upon the optionee's cessation of Board service. KOLL REAL ESTATE GROUP, INC. NOTES TO FINANCIAL STATEMENTS (CONTINUED) NOTE 14 -- STOCK PLANS (CONTINUED) Each non-employee Board member may also elect to apply all or any portion of his or her annual retainer fee to the acquisition of shares of Series A Preferred Stock or Class A Common Stock which will vest incrementally over the individual's period of Board service during the year for which the election is in effect. During the fiscal year ended December 31, 1993, options for 3,520,000 shares each of Series A Preferred Stock and Class A Common Stock were granted under the 1993 Plan, including options for an aggregate of 500,000 shares of each class to non-employee directors, subject to stockholder approval at the 1994 Annual Meeting. The exercise price for these options is $.4063 per share, equal to the fair market value of the underlying securities as of the grant date. 1988 STOCK PLAN The 1988 Stock Plan will be replaced by the 1993 Plan, subject to stockholder approval at the 1994 Annual Meeting of Stockholders. The 1988 Stock Plan of the Company provides for the grant of awards covering a maximum of 3,000,000 shares each of Class A Common Stock and Series A Preferred Stock to officers and other executive employees of the Company and to persons who provide management services to the Company. Awards under the 1988 Stock Plan may be granted in the form of: (i) incentive stock options, (ii) non-qualified stock options, (iii) restricted shares, (iv) restricted units to acquire shares, (v) stock appreciation rights or (vi) limited stock appreciation rights. No incentive stock options grants may be made thereunder after December 14, 1999. Options may be accompanied by stock appreciation rights or limited stock appreciation rights. During the year ended December 31, 1993, options for 1,860,000 shares each of Class A Common Stock and Series A Preferred Stock were cancelled and options for 2,630,000 shares of each class were granted at an exercise price of $.25 and $.2813, respectively. No Class A Common Stock options were granted during 1991 and no Series A Preferred Stock options were granted prior to 1992. Options vest 40%, 70%, and 100% at the first, second, and third anniversaries, respectively, from the grant date. RESTRICTED STOCK PLAN Under the Restricted Stock Plan, each individual joining the Company as an non-employee Board member received an immediate one-time grant of 2,000 shares of Class A Common Stock. The shares are subject to certain transfer restrictions for a specified period, during which the director has the right to receive dividends and the right to vote the shares. After the restricted period expires, the shares will vest based upon certain terms related to service. The shares are forfeited if the director ceases to be a nonemployee director prior to the end of the restricted period. During 1993, 8,000 shares were granted and 3,600 shares were forfeited under such Restricted Stock Plan. No shares were granted during 1991 or 1992. The Restricted Stock Plan was terminated in November 1993 in connection with the implementation of the 1993 Plan. KOLL REAL ESTATE GROUP, INC. NOTES TO FINANCIAL STATEMENTS (CONTINUED) NOTE 15 -- UNAUDITED QUARTERLY FINANCIAL INFORMATION The following is a summary of quarterly financial information for 1992 and 1993 (in millions, except per share amounts):

730409_1993.txt

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Item 1. BUSINESS General Development of the Business - ----------------------------------- The Claridge Hotel and Casino Corporation (the "Corporation"), a New York corporation was formed on August 26, 1983, and qualified to engage in business in New Jersey as a foreign corporation in September 1983. The Corporation holds all of the shares of capital stock of The Claridge at Park Place, Incorporated, a New Jersey corporation ("New Claridge"), which was formed on August 29, 1983. On October 31, 1983, New Claridge acquired certain assets of The Claridge Hotel and Casino ("Claridge"), including gaming equipment ("Casino Assets"), from Del E. Webb New Jersey, Inc. ("DEWNJ") a wholly-owned subsidiary of Del Webb Corporation ("Webb"); leased certain other of the Claridge's assets, including the buildings, parking facility and non-gaming, depreciable, tangible property of the Claridge ("Hotel Assets"), from Atlantic City Boardwalk Associates, L.P., a New Jersey limited partnership ("Partnership"); subleased the land on which the Claridge is located from the Partnership; assumed certain liabilities related to the acquired assets; and undertook to carry on the business of the Claridge. These transactions were entered into in connection with the private placement of equity interests in the Corporation and the Partnership. The offering was structured to furnish the investors with certain tax benefits available under the federal tax law then in effect. Following the 1983 transactions, Webb and its affiliates retained significant interests in the Claridge. The common stock of the Corporation and the limited partnership interests of the Partnership were sold together in the private placement as units, and because there has been relatively little trading in the stock or Partnership interests, there is a substantial similarity between the equity ownership of the Corporation and the Partnership. Although the Corporation and the Partnership are independent entities, over 93% of the Corporation's common stock is owned by persons who also own limited partnership interests in the Partnership. The Partnership does not currently engage in any significant business activities other than those relating to the Claridge. In October 1988, the Corporation and New Claridge entered into an agreement to restructure the financial obligations of the Corporation and New Claridge (the "Restructuring Agreement"). The restructuring, which was consummated in June 1989, resulted in (i) a reorganization of the ownership interests in the Claridge; (ii) modifications of the rights and obligations of certain lenders; (iii) satisfaction and termination of the obligations and commitments of Webb and DEWNJ under the original structure; (iv) modifications of the lease agreements between New Claridge and the Partnership; and (v) the forgiveness by Webb of substantial indebtedness (see Item 1. Business - "1989 Restructuring"). In October 1983, the Partnership granted to New Claridge the Wraparound Mortgage which was inclusive of and subordinate to an $80 million first mortgage (the "First Mortgage") granted by the Partnership to a group of banks and a $47 million purchase money second mortgage (the "Purchase Money Second Mortgage") granted by the Partnership to DEWNJ. The Purchase Money Second Mortgage was subsequently cancelled upon satisfaction of certain conditions agreed to in the Restructuring Agreement. (see Item 1. Business -"1989 Restructuring" and "Certain Transactions and Agreements"). The current relationships of the Corporation, New Claridge and the Partnership are described below. The Casino Assets are owned by New Claridge. The Hotel Assets and underlying land are owned by the Partnership and leased by the Partnership to New Claridge. The lease obligations are set forth in a lease (the "Operating Lease"), originally entered into on October 31, 1983, and an expansion operating lease (the "Expansion Operating Lease"), covering additions to the Claridge made in 1986. Pursuant to the Restructuring Agreement, the Operating Lease and Expansion Operating Lease were amended to provide for the deferral by the Partnership of $15.1 million of rental payments and the abatement by the Partnership of $38.8 million of basic rent payable through 1998 (see Item 1. Business - "Certain Transaction and Agreements"). The Corporation maintains its executive and administrative offices at Indiana Avenue and the Boardwalk, Atlantic City, New Jersey 08401, telephone number (609) 340-3400. Recent Business Developments - ---------------------------- On January 31, 1994, the Corporation completed an offering of $85 million of First Mortgage Notes (the "Notes") due 2002, bearing interest at 11 3/4%. A portion of the net proceeds of $82.2 million, after deducting fees and expenses, was used to repay in full the Corporation's outstanding debt under the Revolving Credit and Term Loan Agreement (the "Loan Agreement"), including the outstanding balance of the Corporation's revolving credit line, which was secured by the First Mortgage. In conjunction with the full satisfaction of the Loan Agreement, the Corporation's revolving credit line arrangement was terminated. The Corporation is currently seeking to obtain a new line of credit arrangement; however, the Corporation believes that its current resources are adequate to fund future obligations as they become due. The Notes are secured by a non-recourse mortgage granted by the Partnership representing a first lien on the Hotel Assets, and by a pledge granted by the Corporation of all outstanding shares of capital stock of New Claridge. New Claridge's guarantee of the Notes is secured by a collateral assignment of the second lien Wraparound Mortgage, and by a lien on the Claridge's gaming and other assets, which lien will be subordinated to liens that may be placed on those gaming and other assets to secure any future revolving credit line arrangement. The balance of the net proceeds from the offering of the Notes will be used (i) to fund internal improvements intended to expand the Claridge's casino capacity, which will result in the addition of approximately 550 slot machines, as well as a poker and simulcast area; (ii) the possible acquisition of an adjacent parcel of land and construction on that land of a self-parking garage facility; (iii) the possible purchase of the Contingent Payment (see Item 1. Business - "1989 Restructuring") granted in 1989 and now held in a trust for the benefit of the United Way of Arizona; and (iv) the potential expansion of the Corporation's activities into emerging gaming markets. On December 30, 1992, the Corporation and Fitzgeralds Las Vegas, L.P. ("Fitzgeralds") executed a Letter of Intent to combine the business and assets of the two organizations. A definitive agreement was not reached and the Letter of Intent expired by its own terms on June 28, 1993. The Claridge - ------------ The Claridge, located in the Boardwalk casino section of Atlantic City, New Jersey, is a 26-story building that contains the Corporation's casino and hotel facilities. The Claridge's casino consists of approximately 43,600 square feet of casino space on three main levels with various adjacent mezzanine levels. The casino currently contains approximately 1,390 slot machines and 67 table games, including 44 blackjack tables, ten craps tables, six roulette tables, two mini-baccarat tables, one baccarat table, one big six wheel, one red dog table, one sic bo table and one pai gow poker table. The hotel with related amenities consists of 501 guest rooms (including 66 two- and three-room suites, 26 specialty suites and four tower penthouse suites), five restaurants, a snack shop, a buffet area, three lounges, a private player's club, a 600-seat theater, limited meeting rooms, a gift shop, a beauty salon and a health club with an indoor swimming pool. Built in 1929 as a hotel, the Claridge was remodeled at a cost of approximately $138 million prior to its reopening as a casino hotel in 1981. The Claridge was further renovated and expanded in 1986 at a cost of approximately $20 million, which provided approximately 10,000 square feet of casino space together with a 3,600 square foot lounge ("Expansion Improvements"). Since 1991 the Claridge's exterior, lobby and other public areas have been refurbished. The Claridge currently is in the process of redecorating all of its guest rooms and has completed the redecoration of over 125 rooms, with the remainder scheduled for completion by 1995. New Claridge experiences a seasonal fluctuation in demand, which is typical of casino-hotel operations in Atlantic City. Historically, peak demand has occurred during the summer season. New Claridge's principal market is the Mid-Atlantic area of the United States. Casino gaming in Atlantic City is highly competitive and is strictly regulated under the New Jersey Casino Control Act ("Casino Control Act") and regulations thereunder which affect virtually all aspects of casino operations. (See Item 1. Business - "Competition" and "Gaming Regulation and Licensing"). 1989 Restructuring - ------------------ On October 27, 1988, the parties with an economic interest in the Corporation and New Claridge, including the banks holding the First Mortgage (the "First Mortgage Lenders"), executed the Restructuring Agreement with respect to the restructuring of the financial obligations of the Corporation and New Claridge. Had the Corporation not entered into the Restructuring Agreement, New Claridge probably would not have been relicensed by the New Jersey Casino Control Commission (the "Commission") for the license period beginning October 31, 1988 and ending October 31, 1989, and would have had to consider filing for bankruptcy protection. The Restructuring Agreement by its terms was subject to approval by at least two-thirds in interest of the limited partners of the Partnership and the holders of at least two- thirds of the Class A Stock of the Corporation. These approvals were received, and the restructuring was consummated in June 1989. The restructuring resulted in (i) a reorganization of the ownership interest in the Corporation; (ii) modifications of the rights and obligations of certain lenders; (iii) satisfaction and termination of the obligations and commitments of Webb and DEWNJ under the original structure; (iv) modifications of the lease agreements between New Claridge and the Partnership; and (v) the forgiveness by Webb of substantial indebtedness. As a result of the restructuring, an aggregate of $132 million of indebtedness was forgiven. The principal amount secured by the First Mortgage was reduced by approximately $15 million to approximately $74.5 million outstanding at June 16, 1989, and the Purchase Money Second Mortgage was subsequently cancelled upon satisfaction of certain conditions agreed to in the Restructuring Agreement. DEWNJ assigned to the First Mortgage Lenders all right, title and interest of DEWNJ in, to and under the Purchase Money Second Mortgage previously executed and delivered by the Partnership. New Claridge retained the right to require the First Mortgage Lenders to cancel and release the Purchase Money Second Mortgage and the obligations secured thereunder upon the occurrence of one or more specified conditions. New Claridge met one of these conditions, and accordingly, the First Mortgage Lenders cancelled the Purchase Money Second Mortgage, including interest which accrued at 14%, and released the obligations secured thereunder. At the closing of the restructuring on June 16, 1989, Webb transferred all of its right, title, and interest to its Claridge land, easements, and air rights to the Partnership, which had the effect of eliminating the land lease between Webb and the Partnership and of subjecting that land to a direct lease (rather than a sublease) from the Partnership to New Claridge. Pursuant to amendments to the Operating Lease and Expansion Operating Lease, the Partnership agreed to deferrals and abatement of basic rent (see Item 1. Business - "Certain Transactions and Agreements"). In addition, the Partnership loaned $3.6 million to New Claridge. That amount represented substantially all the cash and cash equivalents remaining in the Partnership as of June 16, 1989 other than funds needed to pay expenses incurred through the closing of the restructuring. The Partnership paid to New Claridge $100,000 for the cancellation of an option agreement relating to the land underlying the Claridge. The Restructuring Agreement provided that Webb would retain an interest equal to $20 million plus interest from December 1, 1988 at the rate of 15% per annum compounded quarterly (the "Contingent Payment") in any proceeds ultimately recovered from the operations and/or the sale or refinancing of the Claridge facility in excess of the first mortgage loan and other liabilities. To give effect to this Contingent Payment, the Corporation and the Partnership agreed not to make any distributions to the holders of their equity securities, whether derived from operations or from sale or refinancing proceeds, until Webb had received the Contingent Payment. In connection with the restructuring, Webb agreed to grant those investors in the Corporation and the Partnership ("Releasing Investors") from whom Webb had received written releases from all liabilities rights ("Contingent Payment Rights") to receive certain amounts to the extent available for application to the Contingent Payment. Approximately 81% in interest of the investors provided releases and became Releasing Investors. Payments to Releasing Investors are to be made in accordance with the following schedule of priorities: (i) Releasing Investors would receive 81% of the first $10 million of any net proceeds from operations or a sale or a refinancing of the Claridge facility pursuant to an agreement executed within five years ("Five-Year Payments") after the restructuring (i.e., the sum obtained by multiplying the lesser of $10 million of, or the total of, any Five-Year Payments by 81%, with the balance of any such funds to be applied against the Contingent Payment), and (ii) All distributions of funds other than Five-Year Payments, or of Five-Year Payments in excess of the $10 million, would be shared by Webb and Releasing Investors in the following proportions: Releasing Investors will receive 40.5% (one- half of 81%) of any such excess proceeds, with the balance of any such funds to be applied against the Contingent Payment, until the Contingent Payment is paid in full ($20 million plus accrued interest.) On April 2, 1990, Webb transferred its interest in the Contingent Payment to an irrevocable trust for the benefit of the United Way of Arizona, and upon such transfer Webb was no longer required to be qualified or licensed by the Commission. As a result, the Releasing Investors and the Trustee for the United Way of Arizona share the Contingent Payment granted to Webb. The Corporation has recently offered to purchase the Contingent Payment from the United Way of Arizona for the amount of $10 million; this offer was not accepted. The Corporation is continuing its negotiations with the Trustee for the United Way of Arizona in an attempt to purchase the Contingent Payment. (See Item 1. Business - "Recent Business Developments"). Certain Transactions and Agreements - ----------------------------------- On October 31, 1983, the Corporation and/or New Claridge completed the following transactions and entered into the following agreements. On March 17, 1986, certain of these agreements were amended and certain new agreements were entered into relating to the construction and financing of the Expansion Improvements. On June 16, 1989, with the closing of the restructuring, certain of these agreements were further amended. a. Closing of Offering of Class A Stock. The Corporation sold 4,500,000 shares of Class A Stock through a private offering, with net proceeds to the Corporation after payment of selling commissions and fees (but before payment of other expenses of the offering) of $5,051,000. b. Asset Purchase Agreement. Pursuant to an asset purchase agreement (the "Asset Purchase Agreement"), New Claridge purchased the Casino Assets from DEWNJ, as successor to Claridge Limited ("Old Claridge") and assumed related liabilities and paid approximately $5 million. New Claridge assumed the collective bargaining contracts and employment contracts of employees of Old Claridge employed in connection with the operation of the Claridge other than those providing maintenance and engineering services, which employees were employed by DEWNJ. c. Operating Lease/Expansion Operating Lease. New Claridge leased from the Partnership the Hotel Assets and subleased from the Partnership the land on which the Claridge is located for an initial term of 15 years with three 10-year renewal options. Basic annual rent payable during the initial term of the Operating Lease in equal monthly installments was $34,940,000 in 1991, $36,055,000 in 1992, $37,080,000 in 1993 and escalates yearly thereafter up to $41,775,000 in 1997 and $32,531,000 for the nine month period ending September 30, 1998. If New Claridge exercises its option to extend the term of the Operating Lease, basic rent during the renewal term will be calculated pursuant to a formula, with such rent not to be more than $29,500,000 nor less than $24,000,000 for the lease year commencing October 1, 1998 through September 30, 1999, and, subsequently, not to be greater than 10% more than the basic rent for the immediately preceding lease year in each lease year thereafter. New Claridge is also required to pay as additional rent amounts including certain taxes, insurance and other charges relating to the occupancy of the land and Hotel Assets, certain expenses and debt service relating to furniture, fixture and equipment replacements and building improvements (collectively, "FF&E Replacements") and the general and administrative costs of the Partnership. The Partnership will be required during the entire term of the Operating Lease to provide FF&E Replacements to New Claridge and until September 30, 1998 will be required to provide facility maintenance and engineering services to New Claridge. Under the Operating Lease, New Claridge is required to lend the Partnership any amounts ("FF&E Loans") necessary to fund the cost of FF&E Replacements, and if the Partnership's cash flow, after allowance for certain distributions, is insufficient to provide the facility maintenance and engineering services required of it, New Claridge is also required to lend the Partnership the funds required to provide those services. Any advances by New Claridge for either of the foregoing will be secured. Under the terms of the Operating Lease, New Claridge has an option to purchase, on September 30, 1998 and, if it renews the Operating Lease, on September 30, 2003, the Hotel Assets and the underlying land for their fair market value at the time the option is exercised. On March 17, 1986, New Claridge entered into the Expansion Operating Lease Agreement with the Partnership under which New Claridge leased the Expansion Improvements for an initial term beginning March 17, 1986 and ending on September 30, 1998 with three 10-year renewal options. Basic annual rent payable during the initial term of the Expansion Operating Lease was $3,870,000 in 1986 (prorated based on the day that the Expansion Improvements opened to the public) and determined based on the cost of the construction of the Expansion Improvements. Annually thereafter the rental amount will be adjusted based on the Consumer Price Index with any increase not to exceed two percent per annum. Basic annual rent for 1993 was $4,445,000. If New Claridge exercises its option to extend the term of the Expansion Operating Lease, basic rent during the renewal term will be calculated pursuant to a formula, with annual basic rent not to be more than $3 million nor less than $2.5 million and, subsequently, not to be greater than 10% more than the basic annual rent for the immediately preceding lease year in each lease year thereafter. New Claridge also is required under the Expansion Operating Lease to pay as additional rent amounts equal to certain expenses and the debt service relating to furniture, fixture and equipment replacements and building improvements (collectively "Expansion FF&E Replacements") for the Expansion Improvements. The Partnership will be required during the entire term of the Expansion Operating Lease to provide New Claridge with Expansion FF&E Replacements and until September 30, 1998, will be required to provide facility maintenance and engineering services to New Claridge. New Claridge will be obligated to lend the Partnership any amounts necessary to fund the cost of Expansion FF&E Replacements. Any advances by New Claridge for the foregoing will be secured under the Wraparound Mortgage. Effective with the consummation of the restructuring in June 1989, the Operating Lease and the Expansion Operating Lease were amended to provide for the deferral of up to $15.1 million of rental payments during the period July 1, 1988 through the beginning of 1992, and to provide for the abatement of $38.8 million of basic rent through 1998, thereby reducing the Partnership's cash flow to an amount estimated to be necessary only to meet the Partnership's cash requirements. During the third quarter of 1991, the maximum deferral of rent was reached. On August 1, 1991, the Operating Lease and Expansion Operating Lease were amended further to revise the abatement provisions so that, commencing January 1, 1991, for each calendar year through 1998, the lease abatements may not exceed $10 million in any one calendar year, and $38,820,000 in the aggregate. If the Partnership should fail to make any payment due under the Wraparound Mortgage, New Claridge may exercise a right of offset against rent or other payments due under the Operating Lease and Expansion Operating Lease to the extent of any such deficiency. d. Expandable Wraparound Mortgage. On October 31, 1983, the Partnership executed and delivered to New Claridge the Wraparound Mortgage, which was subordinate to the First Mortgage and the Purchase Money Second Mortgage. The Purchase Money Second Mortgage, which was due on September 30, 2000, was cancelled upon satisfaction of certain conditions set forth in an agreement entered into at the time of the restructuring. In conjunction with the offering of $85 million of Notes on January 31, 1994, the outstanding debt under the Loan Agreement, which included the First Mortgage and the revolving credit line, was satisfied in full (see "Recent Business Developments"). By its terms, the Wraparound Mortgage may secure up to $25 million of additional borrowings by the Partnership from New Claridge to finance FF&E Replacements and facility maintenance and engineering shortfalls. The Wraparound Mortgage provides that, so long as the Partnership is not in default on its obligations under the Wraparound Mortgage, New Claridge is obligated to make payments required under any senior mortgage indebtedness. The indebtedness secured by the Wraparound Mortgage, which will mature on September 30, 2000, bears interest at an annual rate equal to 14% with certain interest installments that accrued in 1983 through 1988 totalling $20 million being deferred until maturity. In addition, the Partnership is required under the Wraparound Mortgage to make payments of principal and interest in respect of any loans made to finance FF&E Replacements or facility maintenance or engineering costs as described above. To the extent those borrowings exceed $25 million in the aggregate outstanding at any time, they will be secured under separate security agreements and not by the lien of the Wraparound Mortgage. On March 17, 1986, the First Mortgage was amended and assumed by New Claridge. The amount of the amended and assumed First Mortgage was increased to secure up to $96.5 million to provide financing for the Expansion Improvements. Indebtedness secured by the Wraparound Mortgage was increased by an amount up to $17 million to provide the Partnership with the necessary funding. Effective August 28, 1986, the Partnership commenced making level monthly payments of principal and interest so as to repay on September 30, 1998, in full, the principal balance of this $17 million increase in the Wraparound Mortgage. The Wraparound Mortgage was amended to require that the $127 million aggregate principal amount secured by it would be repayable in installments during the years 1988 through 1998 in escalating amounts totalling $80 million, with a balloon payment of $47 million and the $20 million of deferred interest due on September 30, 2000. Competition - ----------- Competition in the Atlantic City casino-hotel market is intense. At the present time, twelve casino-hotels are operating in Atlantic City. The most recent property to open in Atlantic City was the Taj Mahal Casino Hotel, which opened April 2, 1990 with a 120,000 square foot casino, the largest in the Atlantic City marketplace. The opening of the Taj Mahal further heightened the already intense competition for casino patrons. For the years ended December 31, 1993 and 1992, citywide gaming revenues, as reported, increased 2.7% and 7.5%, respectively, over prior year levels. The primary markets for Atlantic City casino patrons are Philadelphia, New Jersey and New York City, together with the secondary markets of central Pennsylvania, Delaware, Baltimore and Washington, D.C. Many of the Atlantic City casino patrons arrive by bus and stay for approximately six hours. Competitive factors in Atlantic City require the payment of cash incentives in the form of coins to play slot machines and coupons for use toward the price of meals to patrons arriving under bus programs sponsored by the casino operators. During 1993, 8.4 million casino patrons arrived in Atlantic City by bus, a 10.6% decrease from 1992 figures. Casinos also offer cash incentives to their drive-in customers based on their casino play. In recent years competition for, and incentives offered to, drive-in customers have increased significantly. Although New Claridge offers similar promotional coin incentives to attract drive-in customers, it is at a distinct disadvantage since it remains the only casino without a public self-parking facility. All casinos in Atlantic City are part of hotels which offer dining, entertainment and other guest facilities. Competition among casino facilities is based primarily on such factors as promotional allowances and incentives; the attractiveness of the casino area; advertising; service, quality and price of rooms, food and beverage; restaurant, parking and convention facilities; and entertainment. The Atlantic City business is seasonal with the highest level of activity occurring during the summer months and the lowest level of activity during the winter months. The Claridge has positioned itself as the "smaller, friendlier" alternative to the other Atlantic City casinos. This strategy, implemented in 1989, is designed to capitalize on the Claridge's unique physical facility, which the Corporation believes retains an atmosphere of Atlantic City's former grandeur, and on the Claridge's size relative to the larger Atlantic City casinos. By emphasizing an environment that is intimate, friendly and service-oriented, the Claridge targets a market niche different than that of a majority of its competitors. The Claridge seeks to attract and retain as customers the player whose wagering, while significant, is below the high-wagering of patrons targeted by several of the other larger Atlantic City casinos. The Claridge's typical patron wagers less on credit and warrants fewer complimentaries than the higher wagering player. The majority of the Claridge's casino revenue is generated by slot machine play. In 1993, 74% of the Claridge's casino revenue came from slot play as compared to 67% reported for all Atlantic City properties. The Claridge's positioning statement "Because Smaller is Friendlier" conveys its operating and marketing strategy. In order to assure that the advertising campaign is fulfilled, all Claridge employees are required to attend extensive in-house training programs, which emphasize courteous, customized service. In common with other Atlantic City casinos, the Claridge operates a direct marketing program. Through this program, customer loyalty is encouraged with incentives including gifts, coupons for coins and services, and complimentaries. A sophisticated computer database marketing system is utilized to identify prospective customers, track customers who meet the Corporation's target profile, and analyze the effectiveness of promotional activities. Information for this database is compiled through a customer's use of a Compcard Gold rating card provided by the Claridge. All Claridge customers are encouraged to request a Compcard Gold rating card and to use it when playing at table games and slot machines. Use of the Compcard Gold rating card provides the Claridge with data on the level, style and duration of casino play of its customers. In 1993, approximately 83% of the amounts wagered at the Claridge's table games and approximately 61% of the amounts wagered at the Claridge's slot machines were wagered by players who used the Compcard Gold rating card. The database derived from use of the Compcard Gold rating card furnishes the Corporation with a powerful marketing tool. This database allows the Claridge to target identified players with incentives. Incentives are tailored to the identified player's potential for future play, thus assuring that direct marketing expenditures are effective. Additionally, through analysis of demographic and other information contained in the Compcard Gold database, the value of customers with certain characteristics can be assessed and used as a basis for identifying prospective customers. The Claridge, as do all other Atlantic City casinos, maintains a bus program. Customers arriving by bus generally stay in Atlantic City six to eight hours before returning home. Bus customers are given coupons for coins and/or other services. The Corporation continually monitors the incentives offered to bus customers by other Atlantic City casinos to assure that the Claridge's offerings are attractive. Competition in Atlantic City also extends to the employment market. The Commission has promulgated regulations which require staffing levels at Atlantic City casinos which are sharply higher than those for casino-hotels in Nevada. All of New Claridge's casino employees must be licensed under the Casino Control Act. Casino employees and support personnel are subject to more stringent requirements than non-casino employees. Non-casino employees need only be registered with the Commission, while each casino employee must meet applicable standards pertaining to such matters as financial responsibility, good character, ability, casino training and experience. Partly as a result of such requirements, there is intense competition for experienced casino employees in Atlantic City. Difficulties in hiring personnel licensed by the Commission have elevated labor costs and licensed personnel often leave their current positions for higher paying jobs in other casinos. In addition, competition for experienced casino management personnel has increased as a result of the expansion of casino gaming into other jurisdictions. In 1993, the gaming industry continued its rapid expansion, and now includes casino gaming of some form in approximately twenty-two states. The most significant growth has occurred in the riverboat and Indian land gaming segments. To date, riverboats operate in Iowa, Illinois, Louisiana and Mississippi; have been legalized in Indiana and Missouri; and studies/action are pending in other states, including Connecticut, New York, Pennsylvania and Virginia. In addition, under the Indian Gaming Regulatory Act of 1988, unrestricted gaming is permitted on Indian land in any state that already allows similar gaming. (For example, if the state allows charitable gaming for non-profit organizations, then Indians can run similar operations on their land for profit.) Indian gaming is currently authorized in nineteen states including New York, Connecticut, Michigan, Minnesota and California. There are also efforts by Indian groups to negotiate gaming compacts in other states. A number of commentators believe legalization of at least limited forms of casino gaming in Philadelphia, Pennsylvania in the relatively near future is a significant possibility. Management believes that the effect on Atlantic City casinos and on the Claridge of legalized gaming in Philadelphia will depend upon the form and scope of such gaming. On February 15, 1992, the Foxwoods High Stakes Casino and Bingo Hall ("Foxwoods"), operated by the Mashantucket Pequot Indian tribe in Ledyard, Connecticut commenced operations. In addition to offering the table games found in Atlantic City, Foxwoods offers bingo rooms. In January 1993, approval was granted by the Connecticut government for Foxwoods to offer slot machines. Currently, approximately 3,100 slot machines are operational at Foxwoods; a total of over 4,000 slot machines are expected to be operational once the new casino floor configuration is complete. The continued expansion of casino gaming, lotteries, including video lottery terminals (VLT's), and offtrack betting in nearby states could have a negative effect on the Atlantic City market. Gaming Regulation and Licensing - ------------------------------- a. The New Jersey Casino Control Commission and Division of Gaming Enforcement. The ownership and operation of casino-hotel facilities in Atlantic City are subject to extensive state regulation under the Casino Control Act. No casino-hotel may operate in Atlantic City unless necessary corporate and individual officer, director and employee licenses are obtained from the Commission. The Commission is authorized under the Casino Control Act to adopt regulations covering a broad spectrum of gaming-related activities. The Casino Control Act also establishes a Division of Gaming Enforcement (the "Division") to investigate all applications for licenses, enforce the provisions of the Casino Control Act and the regulations thereunder, and prosecute before the Commission all proceedings for violations of the Casino Control Act or any regulations thereunder. The Division conducts audits and continually reviews casino operations, maintains information with respect to any changes in ownership of the casino-hotel and conducts investigations of casino owners and investors when appropriate. b. Licensing Requirements. The Casino Control Act provides that various categories of persons or entities must hold casino licenses. The Casino Control Act also provides that each officer, director and person who directly or indirectly holds any beneficial interest or ownership in a casino licensee; or any person who, in the opinion of the Commission, has the ability to control a casino licensee or elect a majority of the board of directors; or each principal employee or any other employee of a casino licensee (and any lender to or underwriter, agent or employee of the licensee) whom the Commission may consider appropriate for approval or qualification, be qualified for approval pursuant to the provisions of the Casino Control Act. In addition, all contracts and leases entered into by the licensee may, upon request of the Commission, have to be submitted to the Commission, are subject to its review, and, if found unacceptable, are voidable. All enterprises which provide gaming-related services to the licensee must be licensed. All other enterprises dealing with the licensee must register with the Commission, which may require that they be licensed if they do $75,000 or more per year in business with a single licensee, and $225,000 or more per year if with more than one licensee. New Claridge holds a casino license because it carries on the casino business of the Claridge and owns the Casino Assets. As a result, New Claridge's officers and directors are subject to Commission qualification. The Corporation, as the sole owner of the stock of New Claridge, is also required to be qualified. As a part of its determination of the Corporation's qualification, the Commission will require the qualification of each officer, each director, and each person who directly or indirectly holds any beneficial interest or ownership in the Corporation, and who the Commission requires to be qualified, or any person who, in the opinion of the Commission, has the ability to control the Corporation or elect a majority of its Board of Directors; or each principal employee or any other employee whom the Commission may consider appropriate for approval or qualification. The Commission has determined that no stockholders of the Corporation owning less than 5% of its stock will be required to be qualified unless the Commission determines that such stockholder has the ability to control the Corporation or elect a majority of its Board of Directors. Prior to June 16, 1989, Webb was the only stockholder in this category. The names and addresses of all stockholders have been supplied to the Commission and any changes are reported when they occur. c. Licensing Status. The Commission issues casino licenses, which are renewable every two years, subject to a series of requirements including a requirement of demonstrating financial viability. In 1989, and again in 1991, the First Mortgage Lenders agreed to modify the schedule of principal payments under the Loan Agreement, in order in part to allow New Claridge to demonstrate financial viability to the Commission. In connection with the 1993 relicensing, for the period ending in 1995, the First Mortgage Lenders agreed for the first time to modify the schedule of principal payments required under the Loan Agreement to beyond the two-year licensing period. On September 22, 1993, New Claridge was issued a two year casino license by the Commission for the period commencing September 30, 1993. The relicensing approval was based in part on the execution of this amendment to the Loan Agreement. d. Investigations and Disqualifications. The Commission may find any holder of any amount of securities of the Corporation not qualified to own securities of the Corporation. Further, as required by New Jersey, the charter and the by-laws of the Corporation and New Claridge provide that securities of the Corporation and New Claridge are held subject to the condition that if a holder is found to be disqualified by the Commission the holder must dispose of the securities of the Corporation or New Claridge, as the case may be. The Corporation will periodically report the names and addresses of owners of record of Class A Stock to the Commission as is required for all publicly traded holding companies that have wholly-owned subsidiaries holding casino licenses. e. Casino Fees and Taxes. The Casino Control Act provides for a casino license issue fee of not less than $200,000, based upon the cost of the investigation and consideration of the license application, and an annual renewal fee of not less than $100,000, based upon the cost of maintaining control and regulatory activities. In addition, a licensee is subject to a tax of eight percent (8%) of gaming revenues, less the provision for bad debt, and to an annual license fee of $500 on each slot machine and an alcoholic beverage fee computed on the basis of the cost of investigatory time spent monitoring each beverage outlet. The Casino Control Act as amended in December 1984 further provides for the imposition of an investment obligation pursuant to criteria set forth in the Act or the payment of an alternative tax. The investment obligation is 1.25% of the total gaming revenues for each calendar year. Gaming revenues are the total revenues derived from gaming operations less the provision for bad debt. If the casino licensee opts not to make an investment, it is assessed an alternative tax of 2.5% of total gaming revenues less the provision for bad debt. The licensee has two options in satisfying its investment obligation; it can make a direct investment in a project approved by the Casino Reinvestment Development Authority ("CRDA"), which is the agency responsible for administering this portion of the Casino Control Act, or it can buy bonds issued by the CRDA which will, if tax exempt, bear interest at the rate of 66 and 2/3% of the average rate of the Bond Buyer Weekly 25 Revenue Bond Index for the 26 weeks preceding the issue of the bonds. If the bonds are not tax exempt they will bear interest at the rate of 66 and 2/3% of the average rate of Moody's A Rated Utility Index for the 26 weeks preceding the issue of the CRDA bonds. The investment obligation must be paid on the 15th day of the first, fourth, seventh, and tenth months of each year based on the estimated gaming revenues for the three month period immediately preceding the first day of those months. The alternative tax must be paid not later than April 30 of the following year. New laws and regulations as well as amendments to existing laws and regulations relating to gaming activities in Atlantic City are periodically adopted. Effective July 1, 1993, the New Jersey state legislature passed a law requiring the payment of parking fees by casinos in New Jersey in the amount of $2.00 per day for each motor vehicle parked in a casino parking space. In 1992 the New Jersey state legislature passed a law requiring the payment of a tourism marketing fee of $2.00 per occupied room by casino hotels in Atlantic City. While the Corporation believes that these fees have not had a significant impact on its operations, there is no assurance that future laws or changes in existing laws will not have an adverse effect. Employees - --------- As of December 31, 1993, New Claridge employed approximately 2,300 persons of whom approximately 750 are represented by labor unions. Approximately 600 of the 750 are represented by the Hotel, Restaurant Employees and Bartender International Union, AFL-CIO, Local 54. During the past two years, local unions have been active in their efforts to organize non-union employees in Atlantic City. The management of the Claridge believes that its employee relations are generally satisfactory. All of the employees represented by labor unions are covered by collective bargaining agreements which prohibit work stoppages during their terms. The Corporation's collective bargaining agreement covering the approximately 600 employees represented by Local 54 is scheduled to expire in September 1994. The collective bargaining agreements of all Atlantic City properties with respect to Local 54 also expire at that time. Item 2. Item 2. PROPERTIES The Claridge hotel was constructed in 1929 at the northeastern end of Absecon Island, on which Atlantic City is located. After remodeling, modernization and expansion at a cost of approximately $138 million, the Claridge opened as a casino-hotel in July 1981. Located in the Boardwalk Casino section of Atlantic City on Brighton Park, approximately 550 feet north of the Boardwalk, the Claridge occupies three parcels of property. The casino-hotel, situated on the main parcel (41,408 square feet with 138 feet fronting the park and 300 feet deep), is a concrete steel frame structure, 26 stories high at its highest point. The garage, situated on an adjacent parcel of land (21,840 square feet) west of the casino-hotel site, is an eight-level reinforced concrete ramp structure, built in 1981. Including the bus drive-through area, a bus patron waiting room and an electrical room, it totals an area of 197,100 square feet and provides parking for approximately 475 automobiles. The office building, situated on an adjacent parcel of land (7,766 square feet), is a two-story reinforced concrete and brick structure with a flat roof. Constructed about 50 years ago, its interior has been modernized. The building is utilized as an administration facility, and totals an area of 14,020 square feet. All of these facilities are owned by the Partnership and are leased to New Claridge under the Operating Lease and the Expansion Operating Lease. Item 3. Item 3. LEGAL PROCEEDINGS The Corporation and New Claridge are not parties to any litigation which is not in the ordinary course of business. 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 All issued and outstanding shares of the Corporation have been offered and sold in reliance on exemptions from the registration requirements of the Securities Act of 1933 as amended (the "Securities Act"). Therefore, there is no established trading market for any class of shares of the Corporation. 562,500 shares of Class A Stock were sold to Oppenheimer Holdings, Inc., and certain officers and employees of Oppenheimer & Co., Inc., (placement agent for the Partnership and the Corporation) at its par value, $.001 per share, and 4,500,000 shares of Class A Stock were privately offered and sold at $1.2336306 per share. 562,500 shares of Class B Stock were sold to Webb at its par value, $.001 per share. The Contingent Payment Rights (see Item 1. "1989 Restructuring") received by Releasing Investors may or may not be securities. The Corporation, the Partnership and Webb filed a registration statement under the Securities Act with respect to the Contingent Payment Rights as if they were securities and each of the Corporation, the Partnership and Webb were an issuer of such securities. However, by such action none of the Corporation, the Partnership or Webb admitted that the Contingent Payment Rights are securities or that any of them is the issuer of any such securities. There is no market for the Contingent Payment Rights. As of March 1, 1994, there were approximately 450 holders of record of the Class A Stock. On March 24, 1989, Oppenheimer Holdings, Inc. returned to the Corporation all of its shares (273,938) of the Corporation's Class A Stock. On June 16, 1989, all of the outstanding shares of the Corporation's Class B Stock, all of which was owned by Webb, was returned to the Corporation and cancelled. New Claridge was prohibited under the Cross Option Agreement from paying dividends to the Corporation (other than for its operating expenses) until the later of March 31, 1989 or, if Webb had exercised its option to purchase the capital stock of New Claridge, the date of closing of such purchase. As a result, the Corporation was effectively precluded from the payment of dividends to its stockholders prior to March 31, 1989. Webb did not exercise its option. The Restructuring Agreement provided for Webb to retain an interest, equal to $20 million plus interest from December 1, 1988 at the rate of 15% per annum compounded quarterly, in any proceeds ultimately recovered from the operations and/or the sale or refinancing of the Claridge facility in excess of the first mortgage loan and other liabilities. To give effect to this Contingent Payment, the Corporation and the Partnership agreed not to make any distributions to the holders of their equity securities, whether derived from operations or from sale or refinancing proceeds, until Webb had received the Contingent Payment. Webb agreed to grant to Releasing Investors, Contingent Payment Rights to receive certain amounts to the extent available for application to the Contingent Payment (See Item 1. Business - "1989 Restructuring"). On April 2, 1990, Webb, subject to the Corporation's consent, transferred its interest in the Contingent Payment to an irrevocable trust for the benefit of the United Way of Arizona, and upon such transfer Webb was no longer required to be qualified or licensed by the Commission. Item 6. Item 6. SELECTED FINANCIAL DATA The following table summarizes certain selected consolidated financial data for the years ended December 31, 1993, 1992, 1991, 1990 and 1989. (1) For 1993, refer to Note 17 of the Consolidated Financial Statements regarding unaudited proforma effect on the Balance Sheet Data as of December 31, 1993, resulting from the sale of $85 million of Notes on January 31, 1994, and the repayment in full of the outstanding debt under the Loan Agreement. Item 7. Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Results of Operations for the Year Ended December 31, 1993 - ---------------------------------------------------------- The Corporation had net income of $5,132,000 for the year ended December 31, 1993, as compared to net income of $6,048,000 for the year ended December 31, 1992. Net income in 1992 was favorably impacted by the reversal of progressive slot liability of $2,437,000, as further discussed below. Casino revenue, which is the difference between amounts wagered by and paid to casino patrons, was $154,615,000 for the year ended December 31, 1993, a 5.6% increase over 1992 casino revenue of $146,357,000, and a 14.2% increase over 1991 casino revenues of $135,406,000. Citywide casino revenue for 1993 increased 2.7% over 1992 revenues. These favorable comparisons can be attributed to the first full year of unlimited twenty- four hour gaming in 1993, as well as, improved economic conditions in the Northeastern United States. In addition, the passage of live poker and simulcast wagering in 1993 and other Commission policy changes (i.e. extended hours of operation) have had a positive impact on casino revenues. Citywide casino revenues in early 1993 were adversely affected by poor weather conditions, most notably the March 13, 1993 storm, which covered portions of the Northeastern United States with over a foot of snow. For the year ended December 31, 1993, Claridge table games revenue was $40,959,000, a slight increase over 1992 table games revenue of $40,758,000. Table games drop, which represents the amount of gaming chips purchased by patrons, increased 1.0% over 1992 levels. The 1993 hold percentage (the ratio of win to drop) was 14.7%, compared to a hold percentage of 14.8% in 1992. Citywide table games revenue and drop decreased 1.4% and 3.1%, respectively, as compared to 1992 figures. This decrease is attributed in part to the industry's continued shift in focus from table games to slots. During 1993, citywide slot machine units increased 10.4% over 1992, while citywide table game units, excluding the addition of poker games, decreased 6.1% from 1992. Claridge slot machine revenue for the year ended December 31, 1993 was $113,656,000, a 7.6% increase over 1992 slot machine revenue. Citywide slot machine revenue increased 4.8% over 1992 revenue. New Claridge offers promotional incentives through its direct marketing program to its customers based on their casino play, as well as to prospective customers based on demographic models; coin incentives issued through these programs totalled $10,912,000 and $6,959,000 for the years ended December 31, 1993 and 1992, respectively. In addition, New Claridge offers cash incentives in the form of coin to play slot machines to patrons arriving by bus. During 1993, 829,000 bus passengers were brought to the Claridge, and were issued $7,772,000 in coin incentives; in 1992, $8,816,000 in coin incentives was issued to 854,000 bus passengers. The increase in direct marketing coin incentive costs reflects an increased focus on attracting the more profitable drive-in patrons. Hotel, food and beverage revenues for the year ended December 31, 1993 were $30,013,000, a slight decrease from 1992 revenues of $30,092,000. Net of promotional allowances, hotel, food and beverage revenues in 1993 increased 3.1% over 1992 net revenues. Promotional allowances for the year ended December 31, 1993 decreased as a result of eliminating food coupons from the bus program incentive packages. The total number of covers (meals served) in 1993 were 1,724,000, a 15.2% increase over the number of covers in 1992 as a result of offering a $4.75 buffet in 1993 compared to a $9.95 buffet in 1992. Hotel occupancy for the years ended December 31, 1993 and 1992 was 93% and 87%, respectively, while the average room rate was $69 in 1993 compared to $71 in 1992. Other revenues for the year ended December 31, 1993 decreased from the prior year due primarily to revisions to New Claridge's entertainment policy, from the presentation of daily Broadway- style shows in 1992 to a headliner performance approximately one weekend per month in 1993. Total costs and expenses for the year ended December 31, 1993 were $181,118,000, a 5.3% increase over 1992 expenses of $172,081,000. The increase is primarily evident in the casino operating expenses, due to the reversal of progressive slot liability in 1992 of $2,437,000, resulting from the removal of certain progressive slot machines as approved by the Commission, as well as higher labor costs resulting from increased levels of business and the extended gaming hours, and higher coin redemption and other marketing costs. In addition, general and administrative expenses increased as a result of higher payroll costs. Other costs decreased as a result of the reduced entertainment schedule as previously discussed. As a result of the income earned for the year ended December 31, 1993, income tax expense of $3,422,000 was recorded. Results of Operations for the Year Ended December 31, 1992 - ---------------------------------------------------------- The Corporation had net income of $6,048,000 for the year ended December 31, 1992, as compared to net income of $2,181,000 for the year ended December 31, 1991. Casino revenue for the year ended December 31, 1992 was $146,357,000, an 8.1% increase over 1991 casino revenue of $135,406,000, and an 8.7% increase over 1990 casino revenue of $134,686,000. Citywide casino revenues for 1992 increased 7.5% over 1991 revenues. This favorable comparison can be attributed to the following factors: 1991 revenues were unfavorably impacted by the Persian Gulf War in the first quarter of the year, as well as the depressed economic conditions in the Northeastern United States; 1992 revenues were favorably impacted by the commencement of unlimited twenty-four hour gaming, in July, as well as improved economic conditions in the final quarter of the year. In addition, the Commission enacted policies which have given casinos greater flexibility in managing operations (i.e. increased percentage of casino floor allotted towards slot machines). For the year ended December 31, 1992, Claridge table games revenue was $40,758,000, a slight increase over 1991 table games revenue of $40,504,000. Table games drop for 1992 was $276,036,000, an increase of 1.0% over 1991 levels. The 1992 hold percentage was 14.8%, comparable to the hold percentage in 1991. Citywide table games revenue and drop decreased 3.4% and 2.3%, respectively, as compared to 1991 figures. This decrease was attributed in part to the industry's continued shift in focus from table games to slots. Claridge slot machine revenue for the year ended December 31, 1992 was $105,599,000, an 11.3% increase over 1991 slot machine revenue. Citywide slot machine revenues increased 14.2% over 1991 revenues. Coin issued to bus patrons for the year ended December 31, 1992 amounted to $8,816,000, compared to $9,352,000 in 1991. This decrease was due in part to the allocation of additional coin distribution from the bus program to the direct marketing program; during 1992, $6,959,000 in coin was issued through this program, as compared to $4,615,000 in 1991. For the year ended December 31, 1992, hotel and food and beverage revenues, including promotional allowances, were $30,092,000, a decrease of 4.2% from 1991 revenues of $31,396,000. The decrease in revenues from 1991 was attributable to a reduction in covers (1,496,000 in 1992 as compared to 1,559,000 in 1991), offset by an increase in hotel occupancy (87% in 1992 as compared to 85% in 1991). The decrease in the number of covers from 1991 was due primarily to the elimination of food incentives issued to bus patrons in mid-1992. The average room rate in 1992 was $71, compared to $72 in 1991. Total costs and expenses increased 1.7% to $172,081,000 for the year ended December 31, 1992 from 1991 expenses of $169,280,000 due primarily to increased casino expenses relating to unlimited twenty-four hour gaming, as well as the increased distribution of coin incentives. Casino expenses in 1992 were reduced somewhat due to the elimination of $2,437,000 of progressive slot liability, as previously discussed. In addition, general and administrative expenses for 1992 of $25,026,000 increased 10.6% over 1991 expenses, primarily due to increases in payroll costs, legal and professional fees relating to the negotiation of union contract renewals, and costs associated with rejoining the Atlantic City Casino Association. Interest expense for the year ended December 31, 1992 of $4,240,000 decreased 33.2% from 1991 due to the reduction in the average outstanding principal balance, as well as a lower prime interest rate in effect through 1992. As a result of the income earned for the year ended December 31, 1992, income tax expense of $4,075,000 was recorded. Liquidity and Capital Resources - ------------------------------- On October 27, 1988 the Corporation entered into the Restructuring Agreement in an attempt to implement a plan pursuant to which it could remain financially viable through at least October 1989. On June 16, 1989, the restructuring was concluded pursuant to the terms of the Restructuring Agreement. The implementation of this agreement resulted in a reorganization of the ownership interests in the Corporation, modification of the rights and obligations of the First Mortgage Lenders, satisfaction and termination of the obligations and commitments of Webb and DEWNJ, and modifications of the lease arrangements between New Claridge and the Partnership. Had the parties not executed the Restructuring Agreement, New Claridge would probably have exhausted its working capital resources by December 1988, would probably not have been relicensed for the license period beginning October 31, 1988 and ending October 31, 1989, and would have had to consider filing for protection under the bankruptcy laws. Upon the closing of the restructuring on June 16, 1989, the principal amount of the First Mortgage was reduced by approximately $15 million and the principal payment schedule was modified. The modification of principal payments on the First Mortgage under the terms of the Restructuring Agreement was sufficient, however, only to permit the New Claridge to demonstrate to the Commission that New Claridge would remain financially viable for the one year licensing renewal effective October 1988. As a result, in connection with the two-year renewals of the casino license for the Company in 1989, 1991 and 1993, it was necessary for New Claridge to negotiate further modifications of the principal payment schedule under the First Mortgage. In connection with the 1993 relicensing, the First Mortgage Lenders agreed for the first time to modify the principal payment schedule beyond the two-year relicensing period commencing in October 1993. On September 22, 1993, New Claridge was issued a two-year casino license effective September 30, 1993 and expiring September 30, 1995. On January 31, 1994, the Corporation completed an offering of $85 million of Notes (see Item 1. "Recent Business Developments"). A portion of the net proceeds of $82.2 million, after deducting fees and expenses, was used to repay in full the Corporation's outstanding debt under the Loan Agreement, including the outstanding balance of the Corporation's revolving credit line, which was secured by the First Mortgage. In conjunction with the full satisfaction of the Loan Agreement, the Corporation's revolving credit line arrangement was terminated. The Corporation is currently seeking to obtain a new line of credit arrangement; however, the Corporation believes that its current resources are adequate to fund future obligations as they become due. The Notes are secured by a non-recourse mortgage granted by the Partnership representing a first lien on the Hotel Assets, and by a pledge granted by the Corporation of all outstanding shares of capital stock of New Claridge. New Claridge's guarantee of the Notes is secured by a collateral assignment of the second lien Wraparound Mortgage, and by a lien on the Claridge's gaming and other assets, which lien will be subordinated to liens that may be placed on those gaming and other assets to secure any future revolving credit line arrangement. Prior to the full satisfaction of the Loan Agreement on January 31, 1994, as discussed above, the terms of the First Mortgage as of December 31, 1993 required mandatory principal payments of $3 million annually, payable in equal monthly installments, as well as a requirement for New Claridge to pay quarterly, to the Bank, for permanent application to the outstanding principal balance of the first mortgage loan any "excess cash flow" as defined in the Loan Agreement. The maturity date of the first mortgage loan was December 31, 1996. The Loan Agreement, as amended, also provided for a revolving working capital facility of $7.5 million. At December 31, 1993, the Corporation had a working capital deficit of $11,534,000, as compared to a working capital deficit of $13,915,000 at December 31, 1992. The decrease in the working capital deficit is principally attributable to a decrease in the current installments of long- term debt of $1,200,000, a decrease in the outstanding revolving credit line borrowings of $1,000,000, increases in receivables of $1,065,000, in prepaid expenses of $722,000, in cash and cash equivalents of $435,000, and a decrease in progressive slot liability of $432,000, offset by increases in the provision for federal income tax of $845,000, in accounts payable of $659,000, in accrued payroll of $560,000 and in accrued interest of $432,000. Current liabilities at December 31, 1993 and 1992 included deferred rental payments of $15,078,000, and the $3.6 million loan from the Partnership plus accrued interest thereon of $1,962,000 and $1,530,000 at December 31, 1993 and 1992, respectively. The deferred rental payments and $3.6 million loan will only be payable upon (i) a sale or refinancing of the Claridge; (ii) full or partial satisfaction of the Wraparound Mortgage; and (iii) full satisfaction of any first mortgage then in place. If these amounts were not included in current liabilities, the Corporation's working capital surplus at December 31, 1993 and 1992 would have been $9,106,000 and $6,293,000, respectively. New Claridge is obligated under the Operating Lease to lend the Partnership, at an annual interest rate of 14%, any amounts necessary to fund the cost of furniture, fixtures and equipment replacements. The Wraparound Mortgage, granted by the Partnership to New Claridge, by its terms may secure up to $25 million of additional borrowings by the Partnership from New Claridge to finance the replacements of furniture, fixtures and equipment, facility maintenance, and engineering shortfalls. The advances to the Partnership are in the form of FF&E Loans and are secured by the Hotel Assets. One half of the principal is due on the 48th month following advance, with the remaining balance due on the 60th month following the date of issuance. In connection with the offering of $85 million of First Mortgage Notes on January 31, 1994, the Corporation agreed to use not less than $8 million from the net proceeds of the offering to finance internal improvements to the Claridge which will be funded through additional FF&E Loans. In connection therewith, the Wraparound Mortgage Loan agreement as well as the Operating Lease, and the Expansion Operating Lease were amended to provide that the principal on these additional FF&E Loans will be payable at final maturity of the Wraparound Mortgage. New Claridge is obligated to pay as additional rent to the Partnership the debt service on the FF&E Loans. The Wraparound Mortgage requires monthly principal payments to be made by the Partnership to New Claridge, commencing in the year 1988 and continuing through the year 1998, in escalating amounts totalling $80 million. The Wraparound Mortgage, which will mature on September 30, 2000, bears interest at an annual rate equal to 14% with the deferral until maturity of $20 million of certain interest payments which accrued between 1983 and 1988. In addition, in 1986 the principal amount secured by the Wraparound Mortgage was increased to provide the Partnership with funding for the construction of an expansion improvement, which resulted in approximately 10,000 square feet of additional casino space and a 3,600 square foot lounge. Effective August 28, 1986, the Partnership commenced making level monthly payments of principal and interest calculated to provide for the repayment in full of the principal balance of this increase in the Wraparound Mortgage by September 30, 1998. Under the terms of the Wraparound Mortgage, New Claridge is not permitted to foreclose on the Wraparound Mortgage and take ownership of the Hotel Assets so long as a senior mortgage is outstanding. The face amount outstanding of the Wraparound Mortgage at December 31, 1993 (including the outstanding FF&E Loans and the $20 million of deferred interest) was $138.3 million. The Hotel Assets are owned by the Partnership and leased by the Partnership to New Claridge under the terms of the Operating Lease originally entered into on October 31, 1983, and the Expansion Operating Lease, which covered the expansion improvements made to the Claridge in 1986. The initial terms of both leases are scheduled to expire on September 30, 1998 and each lease provides for three 10-year renewal options at the election of New Claridge. The Operating Lease requires basic rental payments to be made in equal monthly installments escalating annually up to $41,775,000 in 1997, and $32,531,000 for the remainder of the initial lease term. Prior to the Corporation's 1989 restructuring, basic rent expense (recognized on a leveled basis in accordance with Statement of Financial Accounting Standards No. 13), was $31,902,000 per year. Therefore, in the early years of the lease term, required cash payments under the Operating Lease (not including the Expansion Operating Lease) were significantly lower than the related expense recognized for financial reporting purposes. Rental payments under the Expansion Operating Lease are adjusted annually based on a Consumer Price Index with any increase not to exceed two percent per year. Pursuant to the Restructuring Agreement, the Operating Lease and the Expansion Operating Lease were amended to provide for the abatement of $38.8 million of basic rent payable through 1998 and the deferral of $15.1 million of rental payments, thereby reducing the Partnership's cash flow to an amount estimated to be necessary only to meet the Partnership's cash requirements. Effective on completion of the 1989 restructuring, lease expense recognized on a level basis was reduced prospectively, based on a revised schedule of rent leveling based on the agreed rental abatements. At December 31, 1993, the Corporation had accrued the maximum amount of $15.1 million of deferred rent liability under the lease arrangements. The deferred rent liability will become payable (i) upon a sale or refinancing of the Claridge; (ii) upon full or partial satisfaction of the Wraparound Mortgage; and (iii) upon full satisfaction of any first mortgage then in place. Also as of December 31, 1993, $14.4 million of basic rent had been abated. The remaining $24.4 million of available abatement is expected to be fully utilized by the fourth quarter of 1996. Because the initial term of the Operating Lease continues through September 30, 1998, rental payments after the $38.8 million abatement is fully utilized will increase substantially to approximately $41.8 million in 1997, as compared to $31.2 million (net of projected abatement) in 1996. However, if New Claridge exercises its option to extend the term of the Operating Lease, basic rent during the renewal term will be calculated pursuant to a formula with annual basic rent not to be more than $29.5 million or less than $24 million for the twelve months commencing October 1, 1998, and subsequently, not to be greater than 10% more than the basic rent for the immediately preceding lease year in each lease year thereafter. If New Claridge exercises it option to extend the term of the Expansion Operating Lease, basic rent also will be calculated pursuant to a formula with annual basic rent not to be more than $3 million or less than $2.5 million for the twelve months commencing October 1, 1998, and subsequently, not to be greater than 10% more than the basic rent for the immediately preceding lease year in each lease year thereafter. If the term of both leases is extended under their renewal options, the aggregate basic rent payable during the initial years of renewal term will be significantly below the 1997 level. If the Partnership should fail to make any payment due under the Wraparound Mortgage, New Claridge may exercise a right of offset against rent or other payments due under the Operating Lease and Expansion Operating Lease to the extent of any such deficiency. In February 1992, the Financial Accounting Standards Board issued Statement No. 109, "Accounting for Income Taxes". Statement No. 109 requires 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 estimated future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax basis. Effective January 1, 1993, the Corporation adopted Statement No. 109 on a prospective basis. There is no effect on the Corporation's statement of operations for the year ended December 31, 1993 as a result of the adoption of Statement No. 109. No valuation allowance has been provided on deferred tax assets since management believes that it is more likely than not that such assets will be realized through the reversal of existing deferred tax liabilities and future taxable income. The effective tax rate and components of income tax expense at December 31, 1993 did not change significantly from that at December 31, 1992. Factors Which May Influence the Corporation's Future Operating Results - ---------------------------------------------------------------------- The legalization of casino and other gaming ventures in states close to New Jersey, particularly Delaware, Maryland, New York or Pennsylvania, may have an adverse effect on the Corporation's future operating results. A number of commentators believe legalization of at least limited forms of casino gaming in Philadelphia, Pennsylvania in the relatively near future is a significant possibility. The future results of the Corporation's operations could be adversely affected by certain proposed regulatory changes. In August 1988, the United States Department of the Treasury (the "Treasury") proposed amendments to Bank Secrecy Act ("BSA") regulations relating to financial reporting and recordkeeping by casinos, which are treated as financial institutions for BSA purposes. While the amendments would generally clarify existing rules, several special requirements specific to casinos have also been proposed. The most significant proposed change to the BSA is a reduction in the threshold at which additional information concerning the identity of individuals engaging in reportable transactions would be sought, and records would have to be maintained, from the present level of amounts greater than $10,000 to a new $2,500 level. Additionally, the proposed amendments would substantially increase the current recordkeeping requirements imposed upon casinos relative to customer data, currency and non-currency transactions. Management believes the proposed regulations, if enacted in their current form, could result in a reduction in the volume of play by certain customers while adding operating costs associated with the more extensive recordkeeping requirements. However, Treasury delayed the effective date (originally September 8, 1993) of the regulations and has formed a study committee to revisit various issues raised by the gaming industry including the shift of the $10,000 reporting threshold to $2,500. Item 8. Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The Financial Statements and Financial Statement Schedules are set forth at pages to of the report. Item 9. Item 9. DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III Item 10. Item 10. DIRECTORS AND EXECUTIVE OFFICERS OF THIS REGISTRANT Name Office Age ---- ------ --- David W. Brenner Chairman, Director 58 Robert M. Renneisen President, Director 47 James W. O'Brien Director 58 Jean I. Abbott Director 38 Mark H. Sayers Director 44 John D. Feehan Director 64 Shannon L. Bybee Director 56 Gloria E. Soto Vice President, Assistant Secretary 45 Raymond A. Spera Executive Vice President, Treasurer, Assistant Secretary 37 Albert T. Britton Vice President 37 Peter F. Tiano Vice President 58 Glenn S. Lillie Vice President 45 Frank A. Bellis, Jr. Vice President, Secretary 40 Business Experience - ------------------- Mr. Brenner has served as a member of the Board of Directors of the Corporation since February 1991, and became Chairman of the Board of Directors in August 1993. He has served as President of the Philadelphia Sports Congress since January 1987. Mr. Brenner served as Chairman of the Hospital and Higher Education Facilities Authority of Philadelphia from January 1986 to June 1992, and as Director of Commerce of the City of Philadelphia from January 1984 to September 1986. He was with the accounting firm of Arthur Young & Company from 1957 to September 1983. He was managing partner of the Philadelphia office of Arthur Young from November 1969 until March 1980. Mr. Renneisen has served as President of the Corporation since June 1992, and as Chief Executive Officer of the Corporation and New Claridge since July 1993. Mr. Renneisen was Executive Vice President of the Corporation from June 1991 to June 1992. He has served as President of New Claridge since January 1991. He was Chief Operating Officer of New Claridge from January 1991 to July 1993. Mr. Renneisen was Executive Vice President of New Claridge, responsible for marketing and later casino operations from February 1988 to January 1991. Prior to joining New Claridge, Mr. Renneisen served from January 1987 to December 1987 as Vice President of Marketing of Treasure Island Hotel and Casino in St. Maarten. From June 1986 to May 1987, he served as President of Renneisen, Kincade & Associates, Inc. of Las Vegas, Nevada, a marketing consulting firm. He was Senior Vice President of Marketing of the Tropicana Hotel and Casino in Atlantic City from May 1982 to August 1984. Mr. O'Brien has served as a member of the Board of Directors of the Corporation since June 1988. Mr. O'Brien was the Corporation's Acting Chairman of the Board from October 20, 1988 to November 22, 1988. Mr. O'Brien served as Vice President of Human Resources of Genesco, Inc. of Nashville, Tennessee from July 1987 to August 1993. He was Vice President of Human Resources of Southwest Forest Industries of Phoenix, Arizona from February 1986 to May 1987. He was President of Del E. Webb Hotel Group from April 1982 to January 1986 and as Chief Executive Officer and a Director of the Corporation from October 1983 to January 1986. Ms. Abbott has served as a member of the Board of Directors of the Corporation since August 1989, and served as a consultant to the Corporation until March 26, 1994, at which time she became a Vice President of New Claridge. From October 1992 to July 1993, Ms. Abbott was Finance Director for the United Way of Atlantic County. She was Assistant Professor at Stockton State College from September 1989 to June 1991. She served as Senior Vice President, Treasurer of the Corporation and Senior Vice President, Controller of New Claridge from May 1987 to September 1989. She was Vice President, Controller of New Claridge from October 1985 to May 1987 and she was Director of Finance of New Claridge from April 1984 to October 1985. From October 1980 through April 1984, Ms. Abbott held various executive positions with New Claridge and Old Claridge. Mr. Sayers has served as a member of the Board of Directors of the Corporation since February 1990. Mr. Sayers has served as Vice President of EMES Management Corporation, a real estate management and development company, of New York, New York, since February 1976. Mr. Feehan has served as a member of the Board of Directors of the Corporation since April 1990. He served as Chairman of the Board of Atlantic Energy, Inc. from 1983 until 1989 and Chairman, President and Chief Executive Officer of Atlantic Energy from 1983 to 1985. Mr. Bybee has served as a member of the Board of Directors of the Corporation since July 1988. He presently serves as President and Chief Operating Officer for United Gaming, Inc., a position he has held since July 1993. Mr. Bybee was the Corporation's Chairman of the Board from November 1988 to July 1993, and from August 1988 to October 1988. In June 1989, Mr. Bybee was appointed to serve as the Chief Executive Officer of the Corporation and New Claridge, a position held through July 1993. Mr. Bybee has been of counsel in the law firm of Schreck, Jones, Bernhard, Woloson & Godfrey since 1978. From 1983 to 1987, he was Senior Vice President of Golden Nugget, Incorporated which operated the Golden Nugget Casino Hotel in Atlantic City. From 1981 to 1983, Mr. Bybee was President of GNAC Corporation, which operated the Golden Nugget Casino Hotel in Atlantic City. Ms. Soto has served as Vice President of the Corporation since February 1987, and as Assistant Secretary of the Corporation since August 1993. She served as Secretary of the Corporation from February 1987 to August 1993. Ms. Soto has served as Vice President, Legal and Governmental Affairs of New Claridge since December 1991. She was Vice President of Compliance and Legal Affairs from November 1986 to December 1991 and Director of Regulatory Affairs from August 1985 to November 1986. Prior to joining New Claridge, Ms. Soto served as Associate General Counsel for Harrah's in Atlantic City. In 1980, former Governor Byrne appointed Ms. Soto to the New Jersey State Parole Board, where she served as member until 1983. Mr. Spera has served as Executive Vice President of the Corporation since August 1993. He served as Vice President of the Corporation from December 1989 to August 1993, and as Assistant Secretary of the Corporation since December 1991. He also has served as Executive Vice President of Finance and Corporate Development of New Claridge since December 1992. Mr. Spera was Senior Vice President of Finance and Corporate Development of New Claridge from December 1991 to December 1992 and Vice President of Finance of New Claridge from December 1989 to December 1991. From April 1982 through November 1989, Mr. Spera has held various accounting positions with New Claridge and Old Claridge. Prior to joining New Claridge, he spent three years with the accounting firm of KPMG Peat Marwick. Mr. Britton has served as Vice President of the Corporation since June 1992, and as Executive Vice President of Operations of New Claridge since December 1992. He was Senior Vice President of Operations of New Claridge from December 1991 to December 1992, and Vice President of Casino Operations from June 1990 to November 1991. From July 1981 through June 1990, Mr. Britton has held various positions in both accounting and casino operations with New Claridge and Old Claridge. Mr. Tiano has served as Vice President of the Corporation since June 1992, and as Executive Vice President of Administration of New Claridge since December 1992. Mr. Tiano was Senior Vice President of Administration of New Claridge from December 1991 to December 1992, Vice President of Administration from September 1986 to December 1991, and Director of Human Resources from June 1984 to September 1986. Prior to joining New Claridge, he was Assistant Director of Human Resources for the Institute of Scientific Information of Philadelphia, Pennsylvania from 1972 to 1984. Mr. Lillie has served as Vice President of the Corporation since June 1992, and as Vice President of Public Affairs of New Claridge since February 1990. He was Vice President of Marketing Communications of New Claridge from April 1985 to February 1990, Director of Public Relations from March 1982 to January 1983, and Training Manager from November 1980 to March 1982. From February 1983 to April 1985, Mr. Lillie was employed as the Director of Public Relations of the Tropicana Hotel and Casino in Atlantic City. Mr. Bellis has served as Vice President, General Counsel and Secretary to the Corporation since August 1993. He also has served as Vice President and General Counsel of New Claridge since September 1992, and as Secretary of New Claridge since August 1993. Previously, from May 1985 to August 1992, Mr. Bellis was Corporate Counsel and Secretary to Inductotherm Industries, Inc., Rancocas, New Jersey. During 1984 and 1985, Mr. Bellis was Associate General Counsel for New Claridge. Prior to joining New Claridge, he was a Deputy Attorney General in the New Jersey Division of Criminal Justice in the State Attorney General's office. Further information regarding the directors and certain executive officers of the Corporation and/or New Claridge is incorporated by reference to the information contained under the caption "Voting" in the Corporation's Proxy Statement. Item 11. Item 11. EXECUTIVE COMPENSATION Information contained under the caption "Executive Compensation" in the Corporation's Proxy Statement for the Annual Meeting of Shareholders to be held on June 7, 1994 is incorporated herein by reference. Item 12. Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT On March 24, 1989, Oppenheimer Holdings, Inc. returned to the Corporation all of its shares (273,938) of the Corporation's Class A Common Stock. On June 16, 1989, in accordance with the terms of the Restructuring Agreement, all of the outstanding shares of the Corporation's Class B Stock, all of which was owned by Webb was returned to the Corporation and cancelled. As of December 31, 1993 there were no beneficial owners of more than 5% of the Corporation's Class A Stock. On February 12, 1992, the Corporation's Board of Directors approved a Long Term Incentive Plan which provided for the grant to certain key officers of the Corporation and/or New Claridge of the 273,938 shares which were held as treasury shares by the Corporation. These shares were issued to the key employees upon approval by the Casino Control Commission on April 15, 1992, and upon receipt the transfer of, and right to continue to hold the shares, are subject to certain vesting restrictions. On July 25, 1993, Shannon Bybee, resigned his position as Chairman and Chief Executive Officer of the Corporation, resulting in the return to the Corporation of 73,963 shares of the Corporation's Class A stock, which had previously been awarded under the Plan. Mr. Bybee continues to serve as a member of the Board of Directors of the Corporation. Item 13. Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The Partnership has a direct material interest in the Expandable Wraparound Mortgage Loan Agreement, the Operating Lease and the Expansion Operating Lease together with amendments thereto. See Item 1. Business - "1989 Restructuring" and "Certain Transactions and Agreements." PART IV Item 14. Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a)(1) and (2): The response to this portion of Item 14 is submitted as a separate section of this report beginning on page. All other schedules have been omitted as inapplicable, or not required, or because the required information is included in the Consolidated Financial Statements or notes thereto. (a)(3) Exhibits. The exhibits required to be filed as part of this annual report on Form 10-K are listed in the attached Index to Exhibits. (b) Reports on Form 8-K. The Corporation filed no reports on Form 8-K during the last quarter of the period covered by this report. (c) Index to Exhibits and Exhibits filed as a part of this report. 3(a) Copy of Certificate of Incorporation of the Corporation. Incorporated by reference to Exhibit 3.1 to Form 8 Amendment No. 1 to Form 10 dated February 21, 1984. 3(b) Copy of By-Laws of the Corporation as amended. Incorporated by reference to Exhibit 3(b) to Form 10-K for the period August 26, 1983 to December 31, 1983. 3(c) Copy of Certificate of Amendment of The Certificate of Incorporation of the Corporation dated June 15, 1989, incorporated by reference to Exhibit 3(c) to Form 10-K for the year ended December 31, 1990. 3(d) Copy of Certificate of Amendment of The Certificate of Incorporation dated June 26, 1991. Incorporated by reference to Exhibit 3(d) to Form 10-K for the year ended December 31, 1991. 4(a) Form of Indenture (including the Guarantee of The Claridge at Park Place, Incorporated). Incorporated by reference to Exhibit 4.1 to Pre-Effective Amendment No. 2 to Form S-1 Registration Statement (file number 33-71550) dated January 18, 1994. 4(b) Form of 11 3/4% First Mortgage Note due 2002 certificate. Incorporated by reference to Exhibit 4.2 to Pre-Effective Amendment No. 2 to Form S-1 Registration Statement (file number 33-71550) dated January 18, 1994. 10(a) Copy of Operating Lease Agreement between New Claridge and Atlantic City Boardwalk Associates, L.P. Incorporated by reference to Exhibit 2.2 to Form 8 Amendment No. 1 to Form 10 dated February 21, 1984. 10(b) Copy of Expandable Wraparound Mortgage and Security Agreement between New Claridge and Atlantic City Boardwalk Associates, L.P. Incorporated by reference to Exhibit 10(b) to Form 10-K for the period August 26, 1983 to December 31, 1983. 10(c) Copy of Expandable Wraparound Mortgage Loan Agreement between New Claridge and Atlantic City Boardwalk Associates, L.P. Incorporated by reference to Exhibit 10(c) for Form 10-K for the period August 26, 1983 to December 31, 1983. 10(d) Copy of Management Agreement between New Claridge and Del E. Webb New Jersey, Inc. Incorporated by reference to Exhibit 2.3 to Form 8 Amendment No. 1 to Form 10 dated February 21, 1984. 10(e) Copy of Casino Expansion Agreement among Atlantic City Boardwalk Associates, L.P., New Claridge, the Corporation and Del E. Webb New Jersey, Inc. Incorporated by reference to Exhibit 10.1 to Form 8 Amendment No. 1 to Form 10 dated February 21, 1984. 10(f) Copy of Cross Option Agreement between the Corporation and Del E. Webb New Jersey, Inc. Incorporated by reference to Exhibit 10.2 to Form 8 Amendment No. 1 to Form 10 dated February 21, 1984. 10(g) Land Option Agreement between Del E. Webb New Jersey, Inc., and New Claridge. Incorporated by reference to Exhibit 10.3 to Form 8 Amendment No. 1 to Form 10 dated February 21, 1984. 10(h) Copy of Expansion Operating Lease Agreement between New Claridge and Atlantic City Boardwalk Associates, L.P. Incorporated by reference to Exhibit 10(h) to Form 10-K for the year ended December 31, 1985. 10(i) Copy of First Supplemental Amendment to Expandable Wraparound Mortgage and Security Agreement between New Claridge and Atlantic City Boardwalk Associates, L.P. Incorporated by reference to Exhibit 10(i) to Form 10-K for the year ended December 31, 1985. 10(j) Copy of First Supplemental Amendment to Expandable Wraparound Mortgage Loan Agreement between New Claridge and Atlantic City Boardwalk Associates, L.P. Incorporated by reference to Exhibit 10(j) to Form 10-K for the year ended December 31, 1985. 10(k) Copy of Fourth Amendment to Management Agreement between New Claridge and Del E. Webb New Jersey, Inc. Incorporated by reference to Exhibit 10(k) to Form 10-K for the year ended December 31, 1985. 10(l) Copy of Amended and Restated Land Option Agreement between New Claridge and Del E. Webb New Jersey, Inc. Incorporated by reference to Exhibit 10(l) to Form 10-K for the year ended December 31, 1985. 10(n) Copy of the Restructuring Agreement, among The Claridge Hotel and Casino Corporation, The Claridge at Park Place, Incorporated, Del Webb Corporation, Del E. Webb New Jersey, Inc., Atlantic City Boardwalk Associates, L.P. and First Fidelity Bank, National Association, New Jersey, dated October 27, 1988. Incorporated by reference to Exhibit 10(n) to Form 10-Q for the quarter ended September 30, 1988. 10(v) Copy of Employment Agreement between Shannon L. Bybee and The Claridge Hotel and Casino Corporation dated July 1, 1990. Incorporated by reference to Exhibit 10(v) to Form 10-Q for the quarter ended June 30, 1991. 10(w) Copy of Employment Agreement between Robert M. Renneisen and The Claridge at Park Place, Inc. dated June 26, 1991. Incorporated by reference to Exhibit 10(w) to Form 10-Q for the quarter ended June 30, 1991. 10(x) Copy of Long Term Management Incentive Plan of The Claridge Hotel and Casino Corporation effective January 1, 1992. Incorporated by reference to Exhibit 10(x) to Form 10-K for the year ended December 31, 1991. 10(y) Copy of Employment Agreement between Raymond A. Spera and The Claridge at Park Place, Incorporated dated November 1, 1992. Incorporated by reference to Exhibit 10(y) to Form 10-K for the year ended December 31, 1992. 10(z) Copy of Employment Agreement between Peter Tiano and The Claridge at Park Place, Incorporated dated November 1, 1992. Incorporated by reference to Exhibit 10(z) to Form 10-K for the year ended December 31, 1992. 10(aa) Copy of Employment Agreement between Albert T. Britton and The Claridge at Park Place, Incorporated dated November 1, 1992. Incorporated by reference to Exhibit 10(aa) to Form 10-K for the year ended December 31, 1992. 10(ab) Amendment to Operating Lease Agreement and Expansion Operating Lease Agreement between New Claridge and Atlantic City Boardwalk Associates, L.P., dated June 15, 1989. Incorporated by reference to Exhibit 10.5 to Form S-1 Registration Statement (file number 33-71550) dated November 12, 1993. 10(ac) Second Amendment to Operating Lease Agreement and Expansion Operating Lease Agreement between New Claridge and Atlantic City Boardwalk Associates, L.P., dated March 27, 1990. Incorporated by reference to Exhibit 10.6 to Form S-1 Registration Statement (file number 33-71550) dated November 12, 1993. 10(ad) Third Amendment to Operating Lease Agreement and Expansion Operating Lease Agreement between New Claridge and Atlantic City Boardwalk Associates, L.P., dated August 1, 1991. Incorporated by reference to Exhibit 10.7 to Form S-1 Registration Statement (file number 33-71550) dated November 12, 1993. 10(ae) First Amendment to Expandable Wraparound Mortgage Loan Agreement between New Claridge and Atlantic City Boardwalk Associates, L.P., dated March 17, 1986. Incorporated by reference to Exhibit 10.8 to Form S-1 Registration Statement (file number 33-71550) dated November 12, 1993. 10(af) Second Amendment to Expandable Wraparound Mortgage Loan Agreement between New Claridge and Atlantic City Boardwalk Associates, L.P., dated June 15, 1989. Incorporated by reference to Exhibit 10.9 to Form S-1 Registration Statement (file number 33-71550) dated November 12, 1993. 10(ag) Second Amendment to Expandable Wraparound Mortgage and Security Agreement between New Claridge and Atlantic City Boardwalk Associates, L.P., dated June 15, 1989. Incorporated by reference to Exhibit 10.11 to Form S-1 Registration Statement (file number 33-71550) dated November 12, 1993. 10(ah) The 1992 Claridge Management Incentive Plan. Incorporated by reference to Exhibit 10.18 to Form S-1 Registration Statement (file number 33-71550) dated November 12, 1993. 10(ai) The 1993 Claridge Management Incentive Plan. Incorporated by reference to Exhibit 10.19 to Form S-1 Registration Statement (file number 33-71550) dated November 12, 1993. 10(aj) Form of Mortgage, Assignment of Leases and Rents, Security Agreement and Financing Statement. Incorporated by reference to Exhibit 4.3 to Pre-Effective Amendment No. 2 to Form S-1 Registration Statement (file number 33-71550) dated January 18, 1994. 10(ak) Form of Collateral Trust Agreement among the Corporation, New Claridge, the Partnership and the Collateral Trustee. Incorporated by reference to Exhibit 4.4 to Pre-Effective Amendment No. 2 to Form S-1 Registration Statement (file number 33-71550) dated January 18, 1994. 10(al) Form of Corporation Pledge Agreement between the Corporation and the Collateral Trustee. Incorporated by reference to Exhibit 4.5 to Pre-Effective Amendment No. 2 to Form S-1 Registration Statement (file number 33-71550) dated January 18, 1994. 10(am) Form of New Claridge Pledge Agreement between New Claridge and the Collateral Trustee. Incorporated by reference to Exhibit 4.6 to Pre-Effective Amendment No. 2 to Form S-1 Registration Statement (file number 33-71550) dated January 18, 1994. 10(an) Form of New Claridge Cash Collateral Pledge Agreement between New Claridge and the Collateral Trustee. Incorporated by reference to Exhibit 4.7 to Pre-Effective Amendment No. 2 to Form S-1 Registration Statement (file number 33-71550) dated January 18, 1994. 10(ao) Form of New Claridge Security Agreement between New Claridge and the Collateral Trustee. Incorporated by reference to Exhibit 4.8 to Pre-Effective Amendment No. 2 to Form S-1 Registration Statement (file number 33-71550) dated January 18, 1994. 10(ap) Form of New Claridge Trademark Security Agreement between New Claridge and the Collateral Trustee. Incorporated by reference to Exhibit 4.9 to Pre-Effective Amendment No. 2 to Form S-1 Registration Statement (file number 33-71550) dated January 18, 1994. 10(aq) Form of Collateral Assignment of Expandable Wraparound Mortgage and Security Agreement. Incorporated by reference to Exhibit 4.10 to Pre-Effective Amendment No. 2 to Form S-1 Registration Statement (file number 33-71550) dated January 18, 1994. 10(ar) Form of Collateral Assignment of Lessor's Interest in Operating Leases. Incorporated by reference to Exhibit 4.13 to Pre-Effective Amendment No. 2 to Form S-1 Registration Statement (file number 33-71550) dated January 18, 1994. 10(as) Form of Subordination Agreement among the Partnership, New Claridge and the Collateral Trustee. Incorporated by reference to Exhibit 4.14 to Pre-Effective Amendment No. 2 to Form S-1 Registration Statement (file number 33-71550) dated January 18, 1994. 10(at) Form of Assignment of Leases and Rents and Other Contract Rights. Incorporated by reference to Exhibit 4.15 to Pre-Effective Amendment No. 2 to Form S-1 Registration Statement (file number 33-71550) dated January 18, 1994. 12(a) Statement of Computation of Ratio of Earnings to Fixed Charges. Incorporated by reference to Exhibit 12.1 to Form S-1 Registration Statement (file number 33-71550) dated November 12, 1993. 22(a) Subsidiaries of the Corporation. Incorporated by reference to Exhibit 22.1 Form 8 Amendment No. 1 to Form 10 dated February 21, 1984. 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. CLARIDGE HOTEL AND CASINO CORPORATION Dated: March 28, 1994 By:/s/ ROBERT M. RENNEISEN - ---------------------- ---------------------------------- Robert M. Renneisen 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 Capacity Date --------- -------- ---- /s/ DAVID W. BRENNER Chairman, Director March 28, 1994 - --------------------------- David W. Brenner /s/ ROBERT M. RENNEISEN President, Director March 28, 1994 - --------------------------- (Chief Executive Officer) Robert M. Renneisen /s/ JAMES W. O'BRIEN Director March 28, 1994 - --------------------------- James W. O'Brien /s/ JEAN I. ABBOTT Director March 28, 1994 - --------------------------- Jean I. Abbott /s/ MARK H. SAYERS Director March 28, 1994 - --------------------------- Mark H. Sayers /s/ JOHN D. FEEHAN Director March 28, 1994 - --------------------------- John D. Feehan /s/ SHANNON L. BYBEE Director March 28, 1994 - --------------------------- Shannon L. Bybee /s/ RAYMOND A. SPERA Executive Vice President March 28, 1994 - --------------------------- (Chief Financial Officer/ Raymond A. Spera Treasurer) THE CLARIDGE HOTEL AND CASINO CORPORATION AND SUBSIDIARY INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES Page Reference In Report on Form 10-K ------------ Independent Auditors' Report............................... Consolidated Balance Sheets at December 31, 1993 and 1992.. Consolidated Statements of Operations and Accumulated Earnings (Deficit) 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......................... Notes to Consolidated Financial Statements................. Financial Statement Schedules: Schedule VIII - Valuation and Qualifying Accounts..... Schedule X - Supplementary Income Statement Information.............................. All other schedules for which provision is made in the applicable accounting regulations promulgated by the Securities and Exchange Commission are not required under the related instructions or are inapplicable and therefore have been omitted. Independent Auditors' Report ---------------------------- The Board of Directors and Stockholders The Claridge Hotel and Casino Corporation: We have audited the consolidated financial statements of The Claridge Hotel and Casino Corporation and subsidiary 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 Corporation'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 The Claridge Hotel and Casino Corporation and subsidiary 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 Short Hills, New Jersey March 4, 1994 THE CLARIDGE HOTEL AND CASINO CORPORATION AND SUBSIDIARY Consolidated Balance Sheets December 31, 1993 and 1992 (dollars in thousands) See accompanying notes to consolidated financial statements. THE CLARIDGE HOTEL AND CASINO CORPORATION AND SUBSIDIARY Consolidated Statements of Operations and Accumulated Earnings (Deficit) For the Years Ended December 31, 1993, 1992 and 1991 (in thousands except per share data) See accompanying notes to consolidated financial statements. THE CLARIDGE HOTEL AND CASINO CORPORATION AND SUBSIDIARY Consolidated Statements of Cash Flows For the Years Ended December 31, 1993, 1992 and 1991 (in thousands) 1993 1992 1991 ---- ---- ---- Cash Flows from Operating Activities: Net income $ 5,132 6,048 2,181 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 1,445 1,321 1,274 Deferred rent to the Partnership (3,183) (2,884) (4,282) Deferred interest receivable and discount from the Partnership (1,004) (873) (760) Valuation reserve 665 977 1,465 Gain on disposal of assets (52) (18) (149) Deferred income taxes - noncurrent 1,154 1,339 1,030 Change in assets and liabilities: Receivables, net, excluding current portion of long-term receivables (36) 1,036 232 Inventories (131) (7) 7 Prepaid expenses and other current assets excluding current portion of reinvestment obligation credit (722) 124 (296) Accounts payable 659 248 (973) Other current liabilities 1,513 (1,235) 3,731 -------- ------- ------- Net cash flows provided by operating activities 5,440 6,076 3,460 -------- ------- ------- Continued THE CLARIDGE HOTEL AND CASINO CORPORATION AND SUBSIDIARY Consolidated Statements of Cash Flows (Cont'd.) For the Years Ended December 31, 1993, 1992 and 1991 (in thousands) 1993 1992 1991 ---- ---- ---- Cash Flows from Investment Activities: Increase in intangible assets and deferred charges $ (529) (230) (248) Additions to gaming equipment (1,535) (1,281) (1,213) Additions to other assets, net (1,946) (1,296) (302) Proceeds from disposition of property 53 87 149 Increase in long-term receivables (3,287) (2,295) (1,343) Receipt of long-term receivables 9,481 8,625 8,367 -------- ------- ------- Net cash flows provided by investment activities 2,237 3,610 5,410 -------- ------- ------- Cash Flows from Financing Activities: Payment of long-term debt (7,942) (10,566) (8,404) Payment of revolving credit line borrowings (21,900) (6,000) (25,000) Increase in revolving credit line borrowings 22,600 7,000 24,100 -------- ------- ------- Net cash flows used in financing activities (7,242) (9,566) (9,304) -------- ------- ------- Increase (decrease) in cash and cash equivalents 435 120 (434) Cash and cash equivalents at beginning of period 4,758 4,638 5,072 -------- ------- ------- Cash and cash equivalents at end of period $ 5,193 4,758 4,638 ======== ======= ======= Supplemental cash flow disclosures: Interest paid $ 3,741 3,808 5,912 ======== ======= ======= Income taxes paid $ 1,393 2,841 220 ======== ======= ======= See accompanying notes to consolidated financial statements. THE CLARIDGE HOTEL AND CASINO CORPORATION AND SUBSIDIARY Notes to Consolidated Financial Statements 1. THE CORPORATION a) Organization The Claridge Hotel and Casino Corporation (the "Corporation"), was formed on August 26, 1983 to hold all of the shares of capital stock of The Claridge at Park Place, Incorporated ("New Claridge"), which was formed on August 29, 1983. On October 31, 1983, New Claridge acquired certain assets of The Claridge Hotel and Casino (the "Claridge"), including gaming equipment (the "Casino Assets"), from Del E. Webb New Jersey, Inc. ("DEWNJ"), a wholly-owned subsidiary of Del Webb Corporation ("Webb"); leased certain other of the Claridge's assets, including the buildings, parking facility and non-gaming, depreciable, tangible property of the Claridge (the "Hotel Assets"), from Atlantic City Boardwalk Associates, L.P. (the "Partnership"); subleased the land on which the Claridge is located from the Partnership; assumed certain liabilities related to the acquired assets; and undertook to carry on the business of the Claridge. b) Recent Business Developments On January 31, 1994, the Corporation completed an offering of $85 million of First Mortgage Notes (the "Notes") due 2002, bearing interest at 11 3/4%. A portion of the net proceeds of $82.2 million, after deducting fees and expenses, was used to repay in full the Corporation's outstanding debt under the Revolving Credit and Term Loan Agreement (the "Loan Agreement"), including the outstanding balance of the Corporation's revolving credit line, which was secured by the First Mortgage. In conjunction with the full satisfaction of the Loan Agreement, the Corporation's revolving credit line arrangement was terminated. The Notes are secured by a non-recourse mortgage granted by the Partnership representing a first lien on the Hotel Assets, and by a pledge granted by the Corporation of all outstanding shares of capital stock of New Claridge. New Claridge's guarantee of the Notes is secured by a collateral assignment of the second lien Wraparound Mortgage, and by a lien on the Claridge's gaming and other assets, which lien will be subordinated to liens that may be placed on those gaming and other assets to secure any future revolving credit line arrangement. The balance of the net proceeds from the offering of the Notes will be used (i) to fund internal improvements intended to expand the Claridge's casino capacity, which will result in the addition of approximately 550 slot machines, as well as a poker and simulcast area; (ii) the possible acquisition of an adjacent parcel of land and construction on that land of a self-parking garage facility; (iii) the possible purchase of the Contingent Payment (see "1989 Restructuring") granted in 1989 and now held in trust for the benefit of the United Way of Arizona; and (iv) the potential expansion of the Corporation's activities into emerging gaming markets. c) 1989 Restructuring On October 27, 1988, the parties with an economic interest in the Corporation and New Claridge, including the banks holding the First Mortgage (the "First Mortgage Lenders"), entered into an agreement to restructure the financial obligations of the Corporation and New Claridge (the "Restructuring Agreement"). Had the Corporation not entered into the Restructuring Agreement, New Claridge probably would not have been relicensed by the New Jersey Casino Control Commission (the "Commission") for the license period beginning October 31, 1988 and ending October 31, 1989, and would have had to consider filing for bankruptcy protection. The Restructuring Agreement by its terms was subject to approval by at least two- thirds in interest of the limited partners of the Partnership and the holders of at least two-thirds of the Class A Stock of the Corporation. These approvals were received, and the restructuring was consummated in June 1989. The restructuring resulted in (i) a reorganization of the ownership interest in the Corporation; (ii) modifications of the rights and obligations of certain lenders; (iii) satisfaction and termination of the obligations and commitments of Webb and DEWNJ under the original structure; (iv) modifications of the lease agreements between New Claridge and the Partnership; and (v) the forgiveness by Webb of substantial indebtedness. At the closing of the restructuring on June 16, 1989, Webb transferred all of its right, title, and interest to its Claridge land, easements, and air rights to the Partnership, which had the effect of eliminating the land lease between Webb and the Partnership and of subjecting that land to a direct lease (rather than a sublease) from the Partnership to New Claridge. Pursuant to amendments to the Operating Lease and Expansion Operating Lease, the Partnership agreed to deferrals of basic rent (see Note 12, "Operating Lease"). In addition, the Partnership loaned $3.6 million to New Claridge. That amount represented substantially all the cash and cash equivalents remaining in the Partnership as of June 16, 1989 other than funds needed to pay expenses incurred through the closing of the restructuring. The Partnership paid to New Claridge $100,000 for the cancellation of an option agreement relating to the land underlying the Claridge. The Restructuring Agreement provided that Webb would retain an interest equal to $20 million plus interest from December 1, 1988 at the rate of 15% per annum compounded quarterly (the "Contingent Payment") in any proceeds ultimately recovered from the operations and/or the sale or refinancing of the Claridge facility in excess of the first mortgage loan and other liabilities. To give effect to this Contingent Payment, the Corporation and the Partnership agreed not to make any distributions to the holders of their equity securities, whether derived from operations or from sale or refinancing proceeds, until Webb had received the Contingent Payment. In connection with the restructuring, Webb agreed to grant those investors in the Corporation and the Partnership ("Releasing Investors") from whom Webb had received written releases from all liabilities rights ("Contingent Payment Rights") to receive certain c) 1989 Restructuring (Cont'd) amounts to the extent available for application to the Contingent Payment. Approximately 81% in interest of the investors provided releases and became Releasing Investors. Payments to Releasing Investors are to be made in accordance with the following schedule of priorities: (i) Releasing Investors would receive 81% of the first $10 million of any net proceeds from operations or a sale or a refinancing of the Claridge facility pursuant to an agreement executed within five years ("Five-Year Payments") after the restructuring (i.e., the sum obtained by multiplying the lesser of $10 million of, or the total of, any Five-Year Payments by 81%, with the balance of any such funds to be applied against the Contingent Payment), and (ii) All distributions of funds other than Five-Year Payments, or of Five-Year Payments in excess of the $10 million, will be shared by Webb and Releasing Investors in the following proportions: Releasing Investors will receive 40.5% (one-half of 81%) of any such excess proceeds, with the balance of any such funds to be applied against the Contingent Payment, until the Contingent Payment is paid in full ($20 million plus accrued interest.) On April 2, 1990, Webb transferred its interest in the Contingent Payment to an irrevocable trust for the benefit of the United Way of Arizona, and upon such transfer Webb was no longer required to be qualified or licensed by the Commission. As a result, the Releasing Investors and the Trustee for the United Way of Arizona share the Contingent Payment granted to Webb. The Corporation has recently offered to purchase the Contingent Payment from the United Way of Arizona for the amount of $10 million; this offer was not accepted. The Corporation is continuing its negotiations with the Trustee for the United Way of Arizona in an attempt to purchase the Contingent Payment. (See Note 1(b) "Recent Business Developments"). 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES a) Basis of Presentation The financial statements are prepared in accordance with generally accepted accounting principles. The consolidated financial statements include the accounts of the Corporation and its wholly-owned subsidiary, New Claridge. All material intercompany accounts and transactions have been eliminated in consolidation. b) Cash and Cash Equivalents Cash and cash equivalents includes investments in interest bearing repurchase agreements in government securities with maturities of three months or less when purchased. Interest income is recorded as earned. c) Casino Receivables and Revenues Credit is issued to certain casino customers and the Corporation records all unpaid credit as casino receivables on the date the credit was issued. Allowances for estimated uncollectible casino receivables are provided to reduce these receivables to amounts anticipated to be collected. The Corporation recognizes as casino revenue, the net win (which is the difference between amounts wagered and amounts paid to winning patrons) from gaming activity. d) Inventories Inventories are stated at the lower of cost or market, cost being determined principally on a first-in, first-out basis. e) Gaming Equipment Gaming equipment is stated at cost. Depreciation is provided over the estimated useful lives (5 years) of the respective assets using the straight line method. f) Income Taxes Deferred income taxes are provided for temporary differences between financial statement reporting and income tax reporting for rent levelling provisions, asset basis differences, and various other expenses recorded for financial statement purposes. g) Earnings Per Share Earnings per share is calculated based on the weighted average shares outstanding (5,030,078 for the year ended December 31, 1993, 4,983,696 for the year ended December 31, 1992, and 4,788,562 for the year ended December 31, 1991). 3. RECEIVABLES Receivables at December 31, 1993 and 1992 consists of the following: Current Receivables 1993 1992 ------------------- ---- ---- (in thousands) Casino, less allowance for doubtful accounts of $1,243,000 and $1,424,000 at December 31, 1993 and 1992, respectively $ 707 836 Hotel, less allowance for doubtful accounts of $26,000 and $7,000 at December 31, 1993 and 1992, respectively 263 257 Interest receivable due from the Partnership 1,444 1,519 Current portion Expandable Wraparound Mortgage due from the Partnership 8,000 7,000 Current portion of FF&E Promissory notes 975 1,146 Current portion of Expansion/Construction promissory note 1,534 1,335 Other, less allowance for doubtful accounts of $13,000 at December 31, 1993 and 1992 416 181 -------- ------- $ 13,339 12,274 ======== ======= Long-Term Receivables --------------------- $127,000,000 Expandable Wraparound Mortgage 14%, maturities through September 30, 2000 (net of $12,295,000 discount and $13,299,000 discount at December 31, 1993 and 1992, respectively) $ 79,705 86,701 Deferred interest receivable, due September 30, 2000 20,000 20,000 FF&E promissory notes, 14% 7,504 5,193 Expansion/Construction promissory note, 14% 8,285 9,819 -------- ------- $115,494 121,713 ======== ======= The Expandable Wraparound Mortgage Loan Agreement ("Expandable Wraparound Mortgage") was executed and delivered by the Partnership to New Claridge and is secured by all property of the Partnership. As part of the agreement, New Claridge will service the First Mortgage and the Partnership's debt under the Purchase Money Second Mortgage indebtedness (note 8). $20 million in interest was deferred between 1983 and 1988 and will be due upon maturity. Principal payments required under the Expandable Wraparound Mortgage commenced in 1988. 3. RECEIVABLES (Cont'd.) The Expandable Wraparound Mortgage also includes a provision whereby New Claridge will loan the Partnership up to $25 million in the form of FF&E promissory notes, secured under the Expandable Wraparound Mortgage, for the purchase of property and equipment. One half of the principal is due in 48 months and the remaining balance is due 60 months from the date of the respective FF&E promissory note. During the year ended December 31, 1994, $975,000 of principal payments will become due. The Expandable Wraparound Mortgage was increased up to $17 million to provide the Partnership with funding for the construction of the expansion. Effective on the date that the expansion opened to the public (August 28, 1986), the Partnership commenced making level monthly payments of principal and interest so as to repay on September 30, 1998, in full, the principal balance of this increase in the Expandable Wraparound Mortgage. The Expandable Wraparound Mortgage was amended to require, in addition to the above, principal payments (in equal monthly installments) due during the years 1988 through 1998 in escalating amounts totalling $80 million and on September 30, 2000 a balloon payment of $67 million which includes $20 million of deferred interest. 4. OTHER ASSETS The Casino Control Act (the "Act") provides for the imposition of an investment obligation, calculated at 1.25% of the total revenues from gaming operations, less the provision for bad debt. If a casino licensee opts not to make the investment as required, it is assessed an alternative tax of 2.5% of total gaming revenues less the provision for bad debt. The licensee can satisfy its obligation by making a direct investment in a project approved by the Casino Reinvestment Development Authority ("CRDA"), the agency responsible for administering this portion of the Act, or it can buy bonds issued by the CRDA. These bonds bear interest at two-thirds of market rates, as set forth in the Act. New Claridge has opted to deposit its reinvestment obligation funds with the State Treasurer. Through December 31, 1993, the Corporation has deposited $12,733,000 of which $2,025,000 has been used to purchase bonds issued by the CRDA. Since interest on these bonds and funds deposited is paid at a discounted rate, New Claridge records a valuation allowance of approximately one- third of the reinvestment obligation. In addition, in January 1990, it was determined that certain bonds issued by the CRDA had become impaired, and that the payment of principal and interest was uncertain. As a result, New Claridge has recorded a valuation allowance for the full amount of its investment in these bonds, totalling $1,654,000. In December 1989, and again in July 1990, New Claridge made to the CRDA donations of funds, totalling $7,088,000 which had previously been deposited with the State Treasurer. In exchange for these donations, New Claridge received credits from the CRDA equal to 51% of the donations, to be applied to satisfy portions of the reinvestment obligations 4. OTHER ASSETS (cont'd.) commencing after the date of the donations. At of December 31, 1993, $20,000 of these credits remained available. 5. WORKING CAPITAL LOANS Pursuant to the terms of the Loan Agreement, First Fidelity Bank, N.A., New Jersey ("Bank") established a revolving working capital facility, which as of December 31, 1993 was in the amount of $7.5 million. Interest on the working capital facility borrowings, which was payable monthly in arrears, accrued at a rate equal to the prime rate plus four percent, as amended effective April 1, 1993 (see Note 8, Long-Term Debt). New Claridge was also required to pay quarterly a commitment fee equal to .5% per annum of the unused portion of the revolving working capital facility. New Claridge's outstanding borrowings on the revolving working capital facility at December 31, 1993 and 1992 were $1,700,000 and $1,000,000, respectively. The amount outstanding on the revolving working capital facility at December 31, 1993 has been classified as long-term debt, due to the repayment in full on January 31, 1994, in conjunction with the full satisfaction of the Loan Agreement (see Note 17, Subsequent Events). As a result of the full satisfaction of the Loan Agreement, the Corporation's revolving credit line arrangement was terminated. 6. LOAN FROM THE PARTNERSHIP In accordance with the terms of the Restructuring Agreement, on June 16, 1989 the Partnership loaned to New Claridge $3.6 million, which represented substantially all cash and cash equivalents remaining in the Partnership other than funds needed to pay expenses incurred through the closing of the Restructuring. This loan is evidenced by an unsecured promissory note and is not due and payable until such time as the full or partial satisfaction of the Wraparound Mortgage and the First Mortgage has been made in connection with a refinancing or sale of all or a partial interest in the Claridge. Interest which accrues at 12% per annum is payable in full upon maturity. As of December 31, 1993, such interest, which is included in other current liabilities, amounted to $1,962,000. 7. OTHER CURRENT LIABILITIES Other current liabilities at December 31, 1993 and 1992 consist of the following (in thousands): 1993 1992 ---- ---- Deferred rent, current $15,078 15,078 Accrued payroll and related benefits 6,245 5,685 Progressive jackpots liability 51 483 Auto/General insurance reserves 1,404 1,425 Accrued interest due to Partnership 1,962 1,530 Other current liabilities 3,421 2,447 ------- ------ $28,161 26,648 ======= ====== The amount of deferred rent as of December 31, 1993 of $15,078,000 represents the maximum deferral allowed in accordance with the Operating Lease Agreement and Expansion Operating Lease Agreement, as amended. The deferred rent liability will become payable (i) upon a sale or refinancing of the Claridge; (ii) upon full or partial satisfaction of the Wraparound Mortgage; and (iii) upon full satisfaction of any first mortgage then in place. In September 1992, certain progressive slot machines were removed from the casino, resulting in the reversal of $2,437,000 of progressive jackpot liability. In 1993, $432,000 of progressive liability was reversed as a result of removing additional progressive slot machines from the casino floor. The removal of these units was made following receipt of approval from the Commission. 8. LONG-TERM DEBT Long-term debt at December 31, 1993 and 1992 consists of the following: 1993 1992 ---- ---- (in thousands) First Mortgage Note, prime plus 4%, effective April 1, 1993 $33,559 41,501 Revolving line of credit 1,700 -0- ------- ------ 35,259 41,501 Less current installments -0- 1,200 ------- ------ $35,259 40,301 ======= ====== 8. LONG-TERM DEBT (cont'd.) On October 7, 1991, New Claridge was issued a two year license by the Commission for the period commencing October 31, 1991. The relicensing approval was based in part on the execution of the second amendment to the Loan Agreement on April 23, 1991. In addition, New Claridge was required to submit to the Commission by April 30, 1993 a plan to satisfy the balloon payment due on the term loan on January 1, 1994, pursuant to the terms of the Loan Agreement, with implementation of the plan by June 30, 1993. The third amendment to the Loan Agreement was executed, effective April 1, 1993. The modifications resulting from this amendment included (i) the extension of the maturity date of the first mortgage loan from January 1, 1994 to December 31, 1996; (ii) an increase in the interest rate to the prime rate of Marine Midland Bank, N.A. plus four percent (from the previous prime rate plus one and one-half percent); (iii) an increase in the mandatory principal payments from $1.2 million to $3 million annually, payable in equal monthly installments; (iv) an increase in the maximum annual capital expenditure limitation from $3.5 million per year to $5 million per year; and (v) an increase in the co-agent's fee to $70,000 per year. Prior to this amendment, New Claridge was required to pay a co- agent's fee equal to one-fortieth of one percent of the average daily outstanding balance of the first mortgage loan. In addition, New Claridge paid an extension fee of $200,000 upon the execution of this amendment to the Loan Agreement. In addition to the mandatory principal payments, New Claridge was also required to pay quarterly, to the Bank, for permanent application to the outstanding principal balance of the first mortgage loan, any excess cash flow as defined in the Loan Agreement. The total principal balance outstanding on the first mortgage loan at December 31, 1993 has been classified as long-term debt, due to the repayment in full of the first mortgage on January 31, 1994, in conjunction with the full satisfaction of the Loan Agreement (see Note 17, Subsequent Events). 9. OTHER NONCURRENT LIABILITIES Pursuant to the Restructuring Agreement, Webb retained an interest, which was assigned to the United Way of Arizona on April 2, 1990, equal to $20 million plus interest at a rate of 15% per annum, compounded quarterly, commencing December 1, 1988, in any proceeds ultimately recovered from operations and/or the sale or refinancing of the Claridge facility in excess of the first mortgage loan ("Contingent Payment"), which amount is payable under certain circumstances. Consequently, New Claridge has deferred the recognition of $20 million of forgiveness income with respect to the Contingent Payment obligation. Interest on the Contingent Payment has not been recorded in the accompanying financial statements since the likelihood of paying such amount is not considered probable at this time. As of December 31, 1993, accrued interest would have amounted to approximately $22.3 million. 10. PROMOTIONAL ALLOWANCES The retail value of complimentary rooms, food and beverages and other complimentaries furnished to patrons is included in gross revenue and then deducted as promotional allowances. The estimated cost of providing such promotional allowances for the years ended December 31, 1993, 1992 and 1991 has been allocated to casino expenses as follows (in thousands): 1993 1992 1991 ---- ---- ---- Hotel $ 2,251 1,972 1,540 Food and beverage 9,650 9,936 9,167 Entertainment 667 981 1,409 ------- ------ ------ Total $12,568 12,889 12,116 ======= ====== ====== 11. INCOME TAXES In February 1992, the Financial Accounting Standards Board issued Statement No. 109, "Accounting for Income Taxes". Statement No. 109 requires 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 estimated future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax basis. Effective January 1, 1993, the Corporation adopted Statement No. 109 on a prospective basis. There is no effect on the Corporation's statement of operations for the year ended December 31, 1993 as a result of the adoption of Statement No. 109. The provision for income taxes is comprised of the following (in thousands): 1993 1992 1991 ---- ---- ---- Current: Federal $1,928 2,325 280 State 340 411 190 Deferred 1,154 1,339 1,030 ------ ----- ----- $3,422 4,075 1,500 ====== ===== ===== 11. INCOME TAXES (Cont'd.) The provision for income tax differs from the amount computed at the statutory rate as follows (in thousands): 1993 1992 1991 Federal income tax at ---- ---- ---- statutory rates $2,908 3,442 1,251 State income tax less Federal benefit 514 633 249 ------ ----- ----- $3,422 4,075 1,500 ====== ===== ===== The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and liabilities at December 31, 1993 are presented below (in thousands): Deferred tax asset/(liability): Depreciation $ (699) Rent leveling 14,015 Difference between book and tax basis of receivables (1,772) Accrued expenses 1,373 Difference between book and tax basis of Wraparound Mortgage receivable (19,574) Other differences between tax and financial statement values 554 -------- Net Deferred Tax Liability $ (6,103) ======== No valuation allowance has been provided on deferred tax assets since management believes that it is more likely than not that such assets will be realized through the reversal of existing deferred tax liabilities and future taxable income. The principal items comprising the deferred tax provision in 1993 included rent levelling of $1,270,000, Wraparound Mortgage discount expense of $402,000, bad debt expense of $42,000, and income related to debt forgiveness of ($520,000). The principal items comprising the deferred tax provision in 1992 included rent levelling of $1,150,000, Wraparound Mortgage discount expense of $350,000, reversal of progressive jackpot liability of $615,000, bad debt expense of ($66,000), and income related to debt forgiveness of ($678,000). The principal items comprising the deferred tax provision in 1991 included bad debt expense of $480,000, rent levelling of $1,720,000, Wraparound Mortgage discount expense of $304,000, and income related to debt forgiveness of ($1,538,000). 11. INCOME TAXES (Cont'd.) As a result of the restructuring in 1989, the amount of debt forgiven resulted in the loss or reduction of various tax attributes including tax operating loss carryforwards of $30,400,000, unused tax credits of $1,041,000 and reduction in tax basis of assets by $89,178,000. As a result of the reduction in tax basis of assets, cash payments for income taxes will significantly exceed income tax expense for financial statement purposes in future years. The above amounts have been adjusted to reflect settlements of the IRS audits of the years 1983 through 1987. 12. OPERATING LEASE New Claridge leases the Hotel Assets and subleased the land on which The Claridge Hotel and Casino is located from the Partnership under an Operating Lease for an initial lease term of 15 years with three 10-year renewal options. If New Claridge exercises its option to extend the term of the Operating Lease, basic rent during the renewal term will be calculated pursuant to a formula, with such rent not to be more than $29,500,000 nor less than $24,000,000 for the lease year commencing October 1, 1998 through September 30, 1999 and, subsequently, not to be greater than 10% more than the basic rent for the immediately preceding lease year in each lease year thereafter. New Claridge is also required to pay as additional rent amounts including certain taxes, insurance and other charges relating to the occupancy of the land and Hotel Assets, certain expenses and debt service relating to furniture, fixture and equipment replacements and building improvements and the general and administrative costs of the Partnership. Under the terms of the Operating Lease, New Claridge has an option to purchase, on September 30, 1998 and, if it renews the Operating Lease, on September 30, 2003, the Hotel Assets and the underlying land for their fair market value at the time the option is exercised. Minimum future basic lease payments under the initial term of the Operating Lease, as amended, as of December 31, 1993 (net of expected abatements, as discussed below) are as follows (in thousands): 1994 $ 30,821 1995 30,762 1996 31,199 1997 41,775 1998 32,531 -------- Total Minimum $167,088 ======== Also, additional rent payments are required based upon fixed assets purchased by the Partnership (the FF&E Replacements, note 3) and then leased to New Claridge. For the years ended December 31, 1993, 1992 and 1991, expense resulting from the Operating Lease amounted to $34,580,000, $34,658,000 and $36,645,000, respectively, of which ($3,183,000), ($2,884,000) and ($4,282,000) of rental expense is attributable to the 12. OPERATING LEASE (Cont'd.) requirement under Statement of Financial Accounting Standards #13 to provide a level rent expense for those leases with escalating payments. Under terms of the Operating Lease, the Partnership is responsible for taxes, assessments, insurance, maintenance and repairs and other costs related to use and occupancy of the Hotel Assets. New Claridge entered into an Expansion Operating Lease Agreement with the Partnership whereby New Claridge leased the expansion facility for an initial term beginning March 17, 1986 and ending on September 30, 1998 with three 10-year renewal options. Basic annual rent payable during the initial term of the Expansion Operating Lease was $3,870,000 in 1986 (prorated based on the day that the Expansion Improvements opened to the public) and determined based on the cost of the construction of the Expansion Improvements. Annually thereafter the rental amount is adjusted based on the Consumer Price Index but any increase may not exceed two percent per annum. Basic annual rent for 1993, 1992, and 1991 amounted to $4,445,000, $4,358,000, and $4,273,000, respectively. If the term of the Expansion Operating Lease is extended, basic annual rent will be calculated pursuant to a formula, with such rent not to be more than $3,000,000 nor less than $2,500,000 and not to be greater than 10% more than the basic annual rent for the immediately preceding lease year in each lease year thereafter. New Claridge is also required to pay as additional rent certain expenses and the debt service relating to Furniture, Fixture and Equipment Replacements and building improvements (collectively "Expansion FF&E Replacements") for the expanded facility. The Partnership will be required during the entire term of the Expansion Operating Lease to provide New Claridge with Expansion FF&E Replacements and until September 30, 1998, will be required to provide facility maintenance and engineering services to New Claridge. New Claridge will be obligated to lend the Partnership any amounts necessary to fund the cost of Expansion FF&E Replacements. Any advances by New Claridge for the foregoing will be secured under the Expandable Wraparound Mortgage. New Claridge will have the option to purchase, on September 30, 1998 and, if it renews the Expansion Operating Lease, on September 30, 2003, the expansion facility (including air rights) for their fair market value at the time the option is exercised. Effective with the consummation of the restructuring in June 1989, the Operating Lease Agreement and the Expansion Operating Lease Agreement were amended to provide for the deferral of $15,078,000 of rental payments during the period July 1, 1988 through the beginning of 1992, and to provide for the abatement of $38.8 million of basic rent payable through 1998, thereby reducing the Partnership's cash flow to an amount estimated to be necessary to meet the Partnership's cash requirements. During the third quarter of 1991, the maximum deferral of basic rent allowable under the Operating Lease of $15,078,000 was reached. On August 1, 1991, the Operating Lease Agreement and Expansion Operating Lease Agreement were further amended to revise the abatement provisions so that, commencing January 1, 1991, for each calendar year through 1998, the lease abatements may not exceed $10 million in any one calendar year, and $38,820,000 12. OPERATING LEASE (Cont'd.) in the aggregate. Effective with the closing of the Restructuring on June 16, 1989, lease expense recognized on a level basis is reduced prospectively, from the use of a revised schedule of rent levelling relative to the abatement of certain rents beginning in 1992. If the Partnership should fail to make any payment due under the Wraparound Mortgage, New Claridge may exercise a right of offset against rent or other payments due under the Operating Lease and Expansion Operating Lease to the extent of any such deficiency. New Claridge also leases supplemental office, warehouse, and surface parking spaces in nearby lots. For the years ended December 31, 1993, 1992, and 1991, operating lease expense for these facilities amounted to $1,645,000, $1,776,000 and $1,836,000, respectively. The minimum future lease payments due under these leases total $840,000 in 1994, $626,000 in 1995, $600,000 in 1996, and $600,000 in 1997. On March 8, 1991, New Claridge entered into an operating lease agreement to lease certain computer equipment. For the years ended December 31, 1993 and 1992, operating lease expense for the computer equipment amounted to $308,000. The minimum future lease payments due under this agreement are $76,950 in 1994. New Claridge has an option to acquire the equipment at the end of the lease term at the then fair market value of the equipment. This option was exercised on February 28, 1994. On June 11, 1991, New Claridge entered into an operating lease agreement to lease one hundred slot machines for a period of thirty-six months. For the years ended December 31, 1993 and 1992, operating lease expense for these slot machines amounted to $170,000. The minimum future lease payments due under this agreement are $86,000 in 1994. At the end of the three-year lease term, New Claridge has the option to purchase the slot machines for an amount as specified in the lease agreement, or to extend the lease term for two additional one year periods. On February 24, 1992, New Claridge entered into an operating lease agreement to lease an additional one hundred slot machines, under the same terms and conditions as the June 11, 1991 lease agreement. For the years ended December 31, 1993 and 1992, operating lease expense for these slot machines amounted to $174,000 and $146,000, respectively. Minimum future lease payments under this agreement are as follows: $174,000 in 1994, and $28,000 in 1995. 13. CONTINGENCIES a) Licensing On September 22, 1993, New Claridge was issued a two-year casino license by the Commission for the period commencing September 30, 1993. The relicensing approval was based in part on the execution of the third amendment to the Loan Agreement on April 1, 1993 (as discussed in note 8, Long- Term Debt). b) Legal Proceedings The Corporation and New Claridge are defendants in various legal proceedings arising in the normal course of business. In the opinion of management, it is not reasonably likely that any such matters individually or collectively would result in an outcome having a material adverse effect on the consolidated financial statements. 14. OTHER EVENTS On December 30, 1992, the Corporation and Fitzgeralds Las Vegas, L.P. ("Fitzgeralds") executed a Letter of Intent to combine the business and assets of the two organizations. A definitive agreement was not reached and the Letter of Intent expired by it own terms on June 28, 1993. 15. RELATED PARTY TRANSACTIONS a. The Restructuring Agreement provided for Webb to retain an interest, equal to $20 million plus interest at a rate of 15% per annum, compounded quarterly, commencing December 1, 1988, in any proceeds ultimately recovered from operations and/or in the sale or refinancing of the Claridge facility in excess of the first mortgage loan. Webb was also entitled to retain a seat on the Board of Directors of the Corporation and New Claridge (a right it subsequently relinquished). Effective with the closing of the Restructuring on June 16, 1989, all or substantially all of the financial, contractual, ownership, guarantee and other relationships of the Corporation and New Claridge with Webb were terminated. b. The Partnership has a direct material interest in the Expandable Wraparound Mortgage Loan Agreement, the Operating Lease and the Expansion Operating Lease together with the amendments thereto as described in the preceding notes. The ownership interests in the Partnership which have a relationship to the Corporation are currently as follows: - Limited Partners representing approximately 98% interest in the Partnership own approximately 4,500,000 shares of the Corporation's Class A Stock; and 15. RELATED PARTY TRANSACTIONS (cont'd.) - Special Limited Partners (Oppenheimer Holdings, Inc. and certain officers and employees of Oppenheimer & Co., Inc.) represent approximately 1% interest in the Partnership and prior to March 24, 1989 owned the remaining 562,500 shares of Class A Stock. On March 24, 1989, Oppenheimer Holdings, Inc. returned to the Corporation all of its shares (273,938) of the Corporation's Class A Stock. See footnote 1.b, "1989 Restructuring", for a summary of the transactions consummated pursuant to the terms of the Restructuring Agreement. c. In February 1992, the Corporation's Board of Directors adopted a Long-Term Incentive Plan (the "Plan") in which certain key employees of the Corporation and/or New Claridge participate. The Plan provides for the grant of the 273,938 shares of the Corporation's Class A stock, which were held as treasury shares of the Corporation, and for the issuance of 100 Equity Units. The aggregate value of the 100 Equity Units is equal to 5.41 percent of certain amounts as further defined in the Plan. Specified portions of the awarded treasury shares and Equity Units held by participants vest upon the attainment of specific goals as described in the Plan. The treasury shares and Equity Units fully vest upon a further restructuring or a change in control as defined in the Plan. Payment with respect to the Equity Units will only be made (a) upon the occurrence of a transaction in which substantially all of the assets and business operations of the Claridge entities are transferred to one or more entities in a merger, sale of assets or other acquisition- type transaction, (b) upon termination of employment of any participant in the Plan within one year after any change in control of the Corporation occurs, as defined in the Plan, or (c) if the Corporation pays dividends to its stockholders, if the Partnership makes distributions to its partners, or if the Corporation or the Partnership makes certain distributions under the Restructuring Agreement. With respect to such Plan, no vesting has occurred through December 31, 1993. On April 15, 1992, the Casino Control Commission approved the Plan and the treasury shares were delivered to the participants. A participant is entitled to vote all awarded treasury shares whether or not vested in such shares. On July 25, 1993, Shannon Bybee, resigned his position as Chairman and Chief Executive Officer of the Corporation, resulting in the return to the Corporation of 73,963 shares of the Corporation's Class A stock, which had previously been awarded under the Plan. In addition, the Equity Units held by Mr. Bybee were returned to the Corporation upon his resignation. Mr. Bybee continues to serve as a member of the Board of Directors of the Corporation. 16. PARENT COMPANY INFORMATION The Corporation owns all of the outstanding common stock of New Claridge, which it purchased for $5,000,000. Other than the investment in its subsidiary at December 31, 1993 and 1992 the balance sheet accounts of the Corporation include other assets of $457,000 and $-0-, respectively, and related current liabilities of $6,030,000 and $4,974,000, respectively. Expenses amounted to $599,000, $611,000 and 321,000 for the years ended December 31, 1993, 1992 and 1991, respectively. These amounts represent the net loss of the Corporation for the respective periods before equity in the results of New Claridge. For the year ended December 31, 1993, New Claridge had net income of $5,731,000 as compared to net income of $6,659,000 and $2,502,000 for the years ended December 31, 1992 and 1991, respectively. 17. SUBSEQUENT EVENT On January 31, 1994, the Corporation completed an offering of $85 million of Notes due 2002, bearing interest at 11 3/4%. A portion of the net proceeds of $82.2 million, after deducting fees and expenses, was used to repay in full the Corporation's outstanding debt under the Loan Agreement, including the outstanding balance of the Corporation's revolving credit line, which was secured by the First Mortgage. In conjunction with the full satisfaction of the Loan Agreement, the Corporation's revolving credit line arrangement was terminated. The balance of the net proceeds from the offering of the Notes will be used (i) to fund internal improvements intended to expand the Claridge's casino capacity, which will result in the addition of approximately 550 slot machines, as well as a poker and simulcast area; (ii) the possible acquisition of an adjacent parcel of land and construction on that land of a self-parking garage facility; (iii) the possible purchase of the Contingent Payment (see "1989 Restructuring") granted in 1989 and now held in trust for the benefit of the United Way of Arizona; and (iv) the potential expansion of the Corporation's activities into emerging gaming markets. 17. SUBSEQUENT EVENT (cont'd.) The following table sets forth the condensed consolidated financial position of the Corporation and New Claridge as of December 31, 1993, and as adjusted to give unaudited proforma effect to the net proceeds from the sale of the Notes and the application of approximately $35 million of the proceeds to repay in full the outstanding debt under the Loan Agreement: At December 31, 1993 --------------------- Unaudited Actual Proforma ------ --------- (in thousands) Cash and cash equivalents $ 5,193 $ 52,140 Total assets 146,338 196,079 Current liabilities 34,270 34,270 Long-term debt 35,259 85,000 Stockholders' equity 14,364 14,364 Total liabilities and stockholders' equity 146,338 196,079 SCHEDULE VIII THE CLARIDGE HOTEL AND CASINO CORPORATION AND SUBSIDIARY Valuation and Qualifying Accounts Years Ended December 31, 1993, 1992 and 1991 (in thousands) (a) Accounts written-off. SCHEDULE X THE CLARIDGE HOTEL AND CASINO CORPORATION AND SUBSIDIARY Supplementary Income Statement Information Years Ended December 31, 1993, 1992 and 1991 (in thousands) 1993 1992 1991 ---- ---- ---- Charged to Costs and Expenses: Maintenance and Repairs (1) $ -0- -0- -0- ======= ======= ====== Depreciation and Amortization of intangible assets, pre- opening cost and similar deferrals: Intangible assets $ 175 $ 197 96 ======= ======= ====== Taxes, other than payroll and income taxes: New Jersey casino gross revenue tax $12,360 $11,669 10,790 Property taxes 3,789 3,575 3,876 ------- ------- ------ $16,149 $15,244 14,666 ======= ======= ====== Advertising Costs $ 2,709 $ 2,376 3,099 ======= ======= ====== (1) In accordance with the terms of the Operating Lease Agreement between New Claridge and Atlantic City Boardwalk Associates, L.P., the Partnership is required to provide facility maintenance and engineering services to New Claridge.

799274_1993.txt

799274_1993

1993

799274

ITEM 1. BUSINESS Reeves Industries, Inc., incorporated in Delaware in 1982 ("Reeves" or "the Company"), a wholly-owned subsidiary of Hart Holding Company Incorporated ("Hart Holding"), is a holding company whose principal asset is the common stock of its wholly-owned subsidiary, Reeves Brothers, Inc. ("Reeves Brothers"). The Company was acquired by Hart Holding on May 6, 1986. Reeves is a diversified industrial company with operations in two principal business segments, industrial coated fabrics, conducted through its Industrial Coated Fabrics Group ("ICF"), and apparel textiles, conducted through its Apparel Textile Group ("ATG"). Effective October 25, 1993, HHCI, Inc., a newly formed, wholly-owned subsidiary of Hart Holding, merged with and into the Company with the Company surviving the merger. HHCI, Inc. was formed as a shell corporation (no operations). As a result of this merger, Hart Holding obtained ownership of 100% of the outstanding shares of the common stock of the Company. See Footnote 10, Stockholder's Equity, of the Notes to Consolidated Financial Statements of Reeves. INDUSTRY SEGMENTS Reeves is a diversified industrial company with operations in two principal business segments, industrial coated fabrics, conducted through its Industrial Coated Fabrics Group, and apparel textiles, conducted through its Apparel Textile Group. In 1993, ICF contributed approximately 49.6% of the Company's net sales and approximately 71.7% of its operating income, and ATG contributed approximately 50.4% of the Company's net sales and approximately 28.3% of its operating income (in each case, excluding corporate expenses, goodwill amortization and facility restructuring charges). Throughout its businesses, the Company emphasizes specialty products, product quality, technological innovation and rapid responses to the changing needs of its customers. ICF specializes in the coating of various substrate fabrics with a variety of products such as synthetic rubber, vinyl, neoprene, urethane and other elastomers, to produce a diverse line of products for industrial applications. ICF's principal products include: (1) a complete line of printing blankets used in offset lithography, (2) coated automotive airbag materials, (3) specialty coated fabrics and (4) coated fabrics used in industrial coverings. The Company believes that ICF is one of the world's leading producers of offset printing blankets and that ICF has the leading share of the domestic market for coated automotive airbag materials. The Company also believes that ICF is a leading domestic producer of specialty coated fabrics used for a broad range of industrial applications. ICF's products generally involve significant amounts of technological expertise and precise production tolerances. The Company believes that ICF's product development, formulation and production methods are among the most sophisticated in the coated fabrics industry. ATG manufactures, processes and sells specialty textile fabrics to apparel and other manufacturers. Through its Greige Goods Division, ATG processes raw materials into greige goods (i.e., undyed woven fabrics). Through its Finished Goods Division, ATG functions as a converter and commission finisher, purchasing greige goods (from the Greige Goods Division and others) and contracting to have the goods dyed and finished or dyeing and finishing the goods itself. The dyed and finished goods are then sold for use in a variety of end-products. The Company believes that ATG has developed strong positions in niche markets in the apparel textile industry by offering unique, custom-designed fabrics to leading apparel and specialty garment manufacturers. ATG emphasizes "short-run" product orders and targets market segments in which its manufacturing flexibility, rapid response time, superior service and quality and the ability to supply exclusive blends are key competitive factors. The Company's business strategy has focused on the sale of higher-margin niche products and the establishment of leading positions in its principal markets. The Company believes that this strategy, combined with its diverse product and customer base, the development of new products and substantial capital investment, has helped the Company increase its sales and profitability in spite of adverse economic conditions in its U.S. and European markets during 1990-1993. The following table shows the amount of total revenue contributed by product lines which accounted for 10% or more of the Company's consolidated revenues in any of the last three fiscal years (in thousands). Year Ended December 31, ---------------------------- 1991 1992 1993 -------- -------- -------- Industrial Coated Fabrics Group: Specialty Materials $ 55,581 $ 61,684 $ 78,151 Graphic Arts 65,683 64,892 62,584 -------- -------- -------- $121,264 $126,576 $140,735 ======== ======== ======== Apparel Textile Group: Finished Goods and Dyeing and Finishing $ 74,893 $ 72,977 $ 77,416 Greige Goods 73,402 71,551 65,502 -------- -------- -------- $148,295 $144,528 $142,918 ======== ======== ======== Reeves does not hold any patents, trademarks, licenses and/or franchises the loss of which would have a material adverse affect on any of its industry segments. Additional information about industry segments of Reeves is contained in Footnote 14, Financial Information About Industry Segments, of the Notes to Consolidated Financial Statements of Reeves. INDUSTRIAL COATED FABRICS GROUP The Industrial Coated Fabrics Group specializes in the coating of various substrate fabrics with a variety of products, such as synthetic rubber, vinyl, neoprene, urethane, and other elastomers, to produce a diverse line of products for industrial applications. ICF's products comprise four categories: (1) a complete line of printing blankets used in offset lithography, (2) coated automotive airbag materials, (3) specialty coated fabrics, including fluid control diaphragm materials, tank seals, ducting materials and coated fabric materials used for military and commercial life rafts and vests, aircraft escape slides, flexible fuel tanks and general aviation products, and (4) coated fabrics used in industrial coverings, including fabrics coated with rubber and vinyl which are used to make tarpaulins, loading dock shelters and other industrial products. ICF's products require significant amounts of technological expertise and the Company believes that ICF's product development, formulation and production methods are among the most sophisticated in the coated fabrics industry. Since 1990, ICF has been awarded six patents with respect to polyurethane coatings and has nine pending patent applications relating to printing blankets, airbag fabric and specialty coatings. Approximately eight other patent applications are in process. ICF generally manufactures specialty coated fabrics according to a production backlog. ICF's products, other than printing blankets and coated automotive airbag material, involve relatively short runs and custom manufacturing. Printing blankets are sold primarily to distributors and dealers. ICF's other products are sold directly to end users and fabricators by its direct sales force. Printing Blankets The Company believes that ICF is one of the world's leading producers of printing blankets used in offset lithography, the predominant printing process for the commercial, financial, publication and industrial printing markets. Offset printing blankets are used in the printing process to transfer a printed image from a metal printing plate onto paper or other printing material. ICF markets a complete line of conventional, compressible and sticky-back blankets under the VULCAN (registered trademark) name. The Company's line includes the 714 (registered trademark), the first compressible printing blanket, the 2,000 (registered trademark) PLUS, an advanced general purpose blanket, the VISION SR (trademark), a premium blanket targeted at the sheet-fed market, and the MARATHON (registered trademark), a blanket targeted to the high-speed web press market. Each blanket in the product line is designed for a specific printing need and ICF sells an appropriate blanket for most types of commercial, financial, publication and industrial printing applications. The Company believes that ICF's blankets consistently offer high performance and quality. This performance is due to a number of proprietary features of the blankets, many of which are the subject of pending patent applications. Distinctive characteristics of ICF's blankets include unique printing surface compounds, improved composition and placement of compressible layers, surface buffing and water and solvent-resistant back plies. Purchasers of ICF's blankets include commercial, financial and industrial printers and publishers of newspapers and magazines. ICF's blankets are sold to over 10,000 U.S. printers and more than 15,000 foreign printers, in 64 countries worldwide. ICF has established a network of over 60 distributors and 125 dealers in the United States, Canada and Latin America to market its printing blankets. In addition, ICF is represented by a distributor in most of the other countries in which it does business. The Company's distributors typically purchase rolls of uncut blankets from ICF and then cut, finish and package the blankets prior to delivery to dealers or end-users. Internationally, ICF's relationships with distributors tend to be long-standing and exclusive, with most distributors dealing only in ICF's printing blankets and ICF selling only to such distributors in their respective territories. Domestic distributors tend to carry printing blankets from a number of manufacturers. Dealers generally purchase finished blankets from distributors for resale. ICF services all of its customers, and its direct sales force actively markets and promotes ICF's printing blankets. Automotive Airbag Materials Reeves believes that ICF has the leading share of the domestic market for coated automotive airbag materials. ICF is a significant supplier of such material to TRW, Inc. ("TRW") and the Safety Restraints Division of Allied-Signal, Inc. ("Allied-Signal"). Allied-Signal supplies Morton International ("Morton") with airbag components. TRW and Morton are two of four major domestic manufacturers of airbag systems and, together with Allied-Signal, supply all of the domestic automobile manufacturers and many of the European and Japanese automobile manufacturers. The Company believes that TRW and Morton account for in excess of 50% of the worldwide market for airbag systems. National Highway Traffic Safety Administration regulations currently mandate the use of both driver-side and passenger-side airbags for all 1998 model year passenger cars and 1999 model year light trucks, vans and multipurpose vehicles ("LTVs"). A phase-in schedule establishes that at least 95% of a manufacturer's passenger cars built on or after September 1, 1996 for sale in the United States, must be equipped with an airbag at the driver's and the right front passenger's seating positions. All LTVs built after September 1, 1997, must have some form of automatic occupant protection, and at least 80% must have either driver-side or driver-side and passenger-side airbags. Due to market demand for airbag-equipped vehicles, automobile manufacturers have been installing airbags (primarily driver-side) more extensively than required by the foregoing regulations. The Company expects sales of airbag systems and coated airbag fabric to increase substantially in future years and believes that ICF is well-positioned to benefit from such growth. Following the lead of the U.S. automobile manufacturers, European and Asian automobile manufacturers have begun installation of automobile airbags. No legislation or regulation presently requires the installation of airbags outside of the United States market. Reeves' Italian subsidiary, Reeves S.p.A., has sufficient capacity for production of coated airbag material if demand develops outside of the United States for such products. Company participation in the airbag market to date has been through the use of coated airbag fabric in driver-side applications where coated airbag fabric offers certain advantages such as greater thermal insulation to withstand the rapid inflation of the airbag by means of hot gases and impermeability to prevent the escape of gases. Side-impact airbags (presently offered on certain models of Volvo and Mercedes Benz) are expected to use coated airbag fabric. Most passenger-side airbags are currently designed to use uncoated fabrics. Passenger-side airbags deploy more slowly than driver-side airbags. Consequently, they can be manufactured at a lower cost using uncoated fabric. The Company does not presently produce an uncoated airbag fabric. Although there can be no assurance that it will be able to do so, the Company plans to participate in the growth of passenger-side applications through an expansion program capitalizing on its textile expertise and research and development efforts. As part of this program, the Company is constructing an approximately 100,000 square foot facility in Spartanburg, South Carolina for weaving both coated and uncoated airbag fabric. The facility is expected to be operational by the end of 1994. Through its research and development activities, the Company is continuously working to develop new proprietary fabric technologies and procedures for the next generation of driver-side and passenger-side airbags. Airbag fabrics must meet rigorous specifications, testing and certification requirements and airbag fabric contracts tend to be awarded several years in advance. These factors may deter the entry of other manufacturers into this business. Specialty Coated Fabrics The Company believes that ICF is a leading domestic producer of specialty coated fabrics used for a broad range of industrial applications. ICF's specialty coated fabrics business is largely customer or "job shop" oriented. In 1993, more than 90% of ICF's sales of specialty coated fabrics were derived from fabrics manufactured to meet particular customer's specifications. Specialty coated fabrics generally consist of a fabric base, or substrate layer, and an elastomer coating (i.e., coating consisting of an elastic substance, such as rubber) which is applied to the fabric base. The Company believes that ICF's line of elastomer-fabric combinations is the most comprehensive in the industry, enabling it to design products to satisfy its customers' needs. Fabric bases used in ICF's specialty coated fabrics include polyester, nylon, cotton, fiberglass and silk. ICF's elastomers include natural rubber, nitrile, THIOKOL (registered trademark), NEOPRENE (registered trademark), silicone, HYPALON (registered trademark), VITON (registered trademark) and polyurethane. ICF sells its specialty coated fabrics under the registered trademark REEVECOTE (registered trademark). The Company believes that ICF has established a reputation for quality and product innovation in specialty coated fabrics by virtue of ICF's technological capability, advanced plant and equipment, research and development facilities and specialized chemists and engineers. ICF's specialty coated fabrics are separated into five product lines: General purpose goods. This product line includes air cells, tank seals, gaskets, compressor valves, aerosol seals and washers and coated fabrics used by other manufacturers in the production of insulation materials, soundproofing and inflatable "lifting bags" used to jack up automobiles or trucks. Gas meter diaphragms. ICF manufactures a line of rubber diaphragm material for use in gas meters which are the primary mechanisms in gas meters for controlling gas flow. ICF's products are sold to most of the major manufacturers of gas meters. Synthetic diaphragms. The Company's synthetic diaphragms are used in carburetors, controls, meters, compressors, fuel pumps and other applications. Specialty products. ICF manufactures a large number of miscellaneous specialty coated products, including v-cups for oil rig drills, expansion joints and urethane specialty items, such as fuel containers, commercial diaphragms and desiccant bags. Military, marine and aerospace products. ICF produces coated fabrics used in truck and equipment covers, waterproof duffel bags, pneumatic air mattresses, collapsible tanks for fuel and water storage, temporary shelters, rafts, inflatable boats, various types of safety devices, pneumatic and electrical plane de-icers, specialty molded aircraft parts, aerospace fuel cells, aircraft evacuation slides, helicopter floats, surveillance balloons and miscellaneous items. A portion of ICF's work in this area is performed as a subcontractor on United States government contracts. ICF's direct sales force sells primarily to fabricators who use ICF's specialty coated fabrics in products sold to end-users. Industrial Coverings Fabrics ICF sells coated fabrics to customers that produce a wide variety of industrial coverings, including truck tarpaulins, trailer covers, cargo covers, agricultural covers, hangar curtains, industrial curtains, boat covers, athletic field covers, temporary shelters, semi-bulk containers and specialized flotation devices used for the containment of oil spills and other environmental pollutants. ICF's industrial coverings fabrics are produced by the same methods as its specialty coated fabrics and are sold under the COVERLIGHT registered trademark. The industrial coverings fabrics business also includes coated fabric for loading dock shelters, which are pads or bumpers placed around the exterior of a loading dock door for weathersealing. ICF sells to manufacturers of loading dock shelter systems and believes it is the leading supplier of loading dock shelter material produced with rubber and other special elastomers. ICF's sales force sells primarily to fabricators of industrial coverings who in turn sell to end-users. Sales personnel concentrate on the largest producers of industrial coverings and loading dock shelter systems in the United States. Principal Customers ICF did not have a customer accounting for more than 10% of consolidated Reeves' sales during the years 1991, 1992 or 1993. Competition ICF's competitive environment varies by product line. For graphic arts products, the Company's principal competitors are Day International and W. R. Grace. To a lesser extent, the Company also competes with a number of other firms, including David M, Kinyo, Zippy, Sumitomo, DYC and Meiji. The specialty materials product line, except for airbag materials, competes in a number of highly fragmented market segments where competition varies by product. In the United States, competition comes from Chemprene, Archer Rubber, Seaman Corp., Cooley, Fairprene and selected foreign suppliers. Airbag products compete against those of Milliken and Highland Industries as well as several other small manufacturers. Quality, compliance with exacting product specifications, delivery terms and price are important factors in competing effectively in ICF's markets. APPAREL TEXTILE GROUP The Apparel Textile Group consists of two divisions, Greige Goods and Finished Goods. ATG concentrates on segments of the market where its manufacturing flexibility, rapid response time, superior service, quality and the ability to supply customers with exclusive blends are key competitive factors. ATG's Greige Goods Division processes raw materials into undyed woven fabrics known as greige goods. The Greige Goods Division manufactures greige goods of synthetic fibers, wool, silk, flax and various combinations of these fibers. Products of the Greige Goods Division are primarily utilized for apparel and the Greige Goods Division's most significant customers are outside converters and, to a lesser extent, ATG's Finished Goods Division. The Company believes that the Greige Goods Division is distinguished from its competitors by its ability to efficiently manufacture small yardage runs, its rapid response time, the high quality of its products and its ability to produce samples rapidly on demand. ATG's greige goods plants engage principally in short production runs producing specialty fabrics requiring a variety of blends and textures. Fabrics are produced by the Greige Goods Division according to an order backlog and are typically "sold ahead" three to four months in advance. Most of the Greige Goods Division's sales are sold under firm contracts. In comparison to manufacturers of large volume commodity fabrics such as print cloth, corduroy and denim, the Greige Goods Division has been less adversely affected in recent years by foreign imports because of its position as a small quantity, specialty fabric producer. ATG's Finished Goods Division functions as a converter and commission finisher. The Finished Goods Division purchases greige goods from the Greige Goods Division and other greige suppliers and either contracts to have such goods converted into finished fabrics of varying weights, colors, designs and finishes or converts them itself. The dyed and finished fabrics are used in various end-products and sold primarily to apparel manufacturers in the women's wear, rainwear/outerwear, men's/boys' wear and career apparel markets. The Company believes that ATG's Finished Goods Division is one of the most flexible operations of its kind in the United States due to the variety of products it can finish and the broad range of dyeing processes and finishes it is able to offer. The Finished Goods Division focuses on high value-added fabrics with unique colors and specialty finishes. The Finished Goods Division's fabrics are currently being used by a number of the leading men's and women's sportswear manufacturers and its dyeing and finishing services are sold to major domestic converters. A wide variety of fabrics can be woven at the Greige Goods Division's two weaving plants. The dyeing and finishing plant of the Finished Goods Division is equipped to do a variety of piece dyeing, as well as to provide specialty finishings. This manufacturing flexibility increases ATG's ability to respond rapidly to changes in market demand. Substantially all of the Apparel Textile Group's products are sold directly to customers through its own sales force. The balance is sold through brokers and agents. Principal Customers ATG markets its fabrics to a wide range of customers including H.I.S., the THOMPSON (registered trademark) men's pants division of Salant Corporation, Eddie Haggar Ltd. and V.F. Corporation. ATG also markets its fabrics to major retailers, including J.C. Penney, which specify the Company's fabrics. ATG is a direct supplier of rainwear fabric to Londontown Corporation, the maker of LONDON FOG (registered trademark), and also markets its fabrics to specialty catalogue houses such as Patagonia, L.L. Bean and Eddie Bauer. ATG did not have a customer accounting for more than 10% of consolidated Reeves sales during the years 1991, 1992 or 1993. Competition The textile industry is highly competitive. While there are a number of integrated textile companies, many larger than ATG, no single company dominates the United States market. Competition from imported fabrics and garments continues to be a significant factor adversely affecting much of the domestic textile industry. Because of the nature of ATG's markets, the Company believes it is less susceptible to foreign imports than the industry as a whole and is more insulated from the risk of foreign imports than high-volume commodity producers. The most important factors in competing effectively in ATG's product markets are service, price, quality, styling, texture, pattern design and color. ATG seeks to maintain its market position in the industry through a high degree of manufacturing flexibility, product quality and competitive pricing policies. The Greige Goods Division distinguishes itself from its competitors by its ability to manufacture runs as small as 40,000 square yards, its rapid response time and the high quality of the products manufactured. The Greige Goods Division has extensive proprietary technical knowledge in the structure of its spinning and weaving operations, which the Company believes represents a significant competitive advantage. The Finished Goods Division is capable of finishing a wide variety of products and offers a broad range of dyeing processes and finishes. This manufacturing flexibility increases the Finished Goods Division's ability to respond rapidly to changes in market demand, which the Company believes enhances its competitive position. RAW MATERIALS, MANUFACTURERS AND SUPPLIERS The principal raw materials used by ICF include polymeric resins, natural and synthetic elastomers, organic and inorganic pigments, aromatic and aliphatic solvents, polyurethanes, polyaramids and calendered fabrics. ATG principally utilizes wool, flax, specialty yarn, man-made fibers, including acrylics, polyesters, acetates, rayon and nylon and a wide variety of dyes and chemicals. Such raw materials are largely purchased in domestic markets and are available from a variety of sources. The Company is not presently experiencing any difficulty in obtaining raw materials. However, the Company has from time to time experienced difficulty in obtaining the substrate fabric that it uses to produce coated automotive airbag materials. The Company anticipates that the completion of its new weaving facility in Spartanburg, South Carolina may reduce the risk of such supply shortages. Airbag fabric produced by the new facility will be subject to rigorous testing and certification before it will be available for production. FOREIGN OPERATIONS All of Reeves' foreign operations are conducted through Reeves S.p.A., a wholly-owned subsidiary located in Lodi Vecchio, Italy. Reeves S.p.A. forms a part of Reeves' ICF Group. The financial data of Reeves S.p.A. is as follows (in thousands): 1991 1992 1993 -------- -------- -------- Sales $ 35,437 $ 38,444 $ 36,932 Net income 6,808 9,165 7,446 Assets 33,011 31,608 33,092 The financial results of Reeves S.p.A. do not include any allocations of corporate expenses or consolidated interest expense. BACKLOG The following is a comparison of open order backlogs at December 31 of each year presented (in thousands): 1991 1992 1993 -------- -------- -------- Industrial Coated Fabrics Group $ 16,942 $ 16,824 $ 17,072 Apparel Textile Group 47,129 32,994 39,390 -------- -------- -------- Totals $ 64,071 $ 49,818 $ 56,462 ======== ======== ======== The increase in ICF's backlog from 1992 to 1993 is due to growth in the coated automotive airbag materials business. The decrease in the Apparel Textile Group backlog from 1991 to 1992 was the result of a decrease in government business and reduced orders due to market uncertainty. The increase in the ATG backlog from 1992 to 1993 is due to the addition of several new customers in the Finished Goods Division. The December 31, 1993 backlogs for the Industrial Coated Fabrics Group and the Apparel Textile Group are reasonably expected to be filled in 1994. Under certain circumstances, orders may be canceled at the Company's discretion prior to the commencement of manufacturing. Any significant decrease in backlog resulting from lost customers could adversely affect future operations if these customers are not replaced in a timely manner. ENVIRONMENTAL MATTERS The Company is subject to a number of federal, state and local laws and regulations pertaining to air emissions, water discharges, waste handling and disposal, workplace exposure and release of chemicals. During 1993, expenditures in connection with the Company's compliance with federal, state and local environmental laws and regulations did not have a material adverse effect on its earnings, capital expenditures or competitive position. Although the Company cannot predict what laws, regulations and policies may be adopted in the future, based on current regulatory standards, the Company does not expect such expenditures to have a material adverse effect on its operations. EMPLOYEES On February 1, 1994, the Company employed approximately 2,289 people, of whom 1,855 were in production, 183 were in general and administrative functions, 52 were in sales and 199 were at Reeves S.p.A. At such date, ICF had approximately 639 employees and ATG had approximately 1,398 employees, with the remainder of the Company's employees in general and administrative positions. ITEM 2. ITEM 2. PROPERTIES The Company's principal facilities, their primary functions and their locations as of March 31, 1994 are as follows: Size (Sq. Ft.) --------------- Location Function Owned Leased Manufacturing Facilities Industrial Coated Fabrics Group Rutherfordton, NC Specialty Materials 215,000 Spartanburg, SC Graphic Arts 308,364 Lodi Vecchio, Italy Graphic Arts and Specialty Materials 160,000 4,900 --------- ------- Subtotal 683,364 4,900 --------- ------- Apparel Textile Group Woodruff, SC Greige Goods 368,587 Chesnee, SC Greige Goods 303,100 Bessemer City, NC Greige Goods 218,992 Bishopville, SC Finished Goods 226,684 2,400 Bishopville, SC Warehouse 72,650 --------- ------- Subtotal 1,117,363 75,050 --------- ------- Total Manufacturing Facilities 1,800,727 79,950 --------- ------- Non-Manufacturing Facilities New York, NY Administrative & Sales 12,000 Spartanburg, SC Administrative & Sales 43,000 Darien, CT Administrative 6,800 --------- ------- Total Non-Manufacturing Facilities 43,000 18,800 --------- ------- TOTAL 1,843,727 98,750 ========= ======= The Company is a party to leases with terms ranging from month-to-month to fifteen years, with rental expense aggregating $1.5 million for the twelve months ended December 31, 1993. The Company believes that all of its facilities are suitable and adequate for the current conduct of its operations. ITEM 3. ITEM 3. LEGAL PROCEEDINGS The Company believes that there are no legal proceedings, other than ordinary routine litigation incidental to the business of the Company, to which the Company or any of its subsidiaries is a party. Management is of the opinion that the ultimate outcome of existing legal proceedings would 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 On November 8, 1993, James W. Hart was re-elected as a director of Reeves. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS At March 31, 1994, 100% or 35,021,666 shares of Reeves' Common Stock was held by Hart Holding. There is no established public trading market for the Common Stock. Reeves' debt instruments restrict Reeves from declaring or paying any dividends or making any distributions in respect of its capital stock (other than dividends payable solely in shares of common stock), except under certain conditions as defined therein. See Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operation, and Footnote 7, Long-Term Debt, of the Notes to Consolidated Financial Statements of Reeves. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The historical operations and balance sheet data included in the selected financial data set forth below are derived from the consolidated financial statements of Reeves (in thousands except per share data and ratios). December 31, ------------------------------------------------ 1989 1990 1991 1992 1993 ---- ---- ---- ---- ---- Statement of Operations Data (1): Net sales Industrial Coated Fabrics Group $114,313 $119,749 $121,264 $126,576 $140,735 Apparel Textile Group 143,035 138,110 148,295 144,528 142,918 -------- -------- -------- -------- -------- Total net sales $257,348 $257,859 $269,559 $271,104 $283,653 ======== ======== ======== ======== ======== Operating income Industrial Coated Fabrics Group $ 24,715 $ 23,250 $ 23,940 $ 24,732 $ 29,287 Apparel Textile Group 11,513 10,059 10,121 10,693 11,583 Corporate expenses (5,278) (7,503) (7,278) (8,318) (10,433) Goodwill amortization (1,140) (1,140) (1,157) (1,340) (1,340) Facility restructuring charges (1,003) -------- -------- -------- -------- -------- Total operating income $ 29,810 $ 24,666 $ 25,626 $ 25,767 $ 28,094 ======== ======== ======== ======== ======== Income from continuing operations $ 6,100 $ 5,757 $ 4,544 $ 5,976 $ 7,857 ======== ======== ======== ======== ======== Interest expense and amortization of financing costs and debt discount $ 22,590 $ 19,935 $ 21,777 $ 17,633 $ 16,394 ======== ======== ======== ======== ======== Income from continuing operations per share $ .32 $ .30 $ .23 $ .16 $ .22 Supplemental earnings per share data - income from continuing operations (2) .17 .16 .12 Ratio of earnings to fixed charges (3) 1.6x 1.3x 1.2x 1.5x 1.7x ==== ==== ==== ==== ==== Earnings (loss) per common share Primary and Fully Diluted: Income from continuing operations $ .32 $ .30 $ .23 $ .16 $ .22 Income (loss) before extraordinary item 1.19 (1.78) .39 .16 .22 Dividends paid Net income (loss) 1.09 (1.78) .39 .08 .22 Weighted average number of shares Primary 17,471 17,938 18,118 36,724 34,978 Fully diluted 17,500 17,883 18,118 36,724 34,978 Operating Data: Depreciation and goodwill amortization expense $ 6,230 $ 6,637 $ 7,108 $ 8,116 $ 8,544 Capital expenditures 6,718 7,007 11,015 15,788 16,506 Balance Sheet Data: Total assets (4) $246,910 $228,256 $214,987 $192,931 $203,025 Long-term debt (including current portion) 149,863 148,837 148,960 132,576 132,677 Stockholder's equity (5) 40,890 13,195 20,477 15,565 21,411 Footnotes to Statement of Operations and Balance Sheet Data: (1) The fiscal year ended December 31, 1989 has been restated to reflect the exclusion of the discontinued operations of the ARA Automotive Group. See Footnote 3, Discontinued Operations and Facility Restructuring Charges, of the Notes to Consolidated Financial Statements of Reeves. (2) Effective December 31, 1991, Reeves' Board of Directors approved the exchange of all of its outstanding Series I Preferred Stock, $1.00 par value, valued in the aggregate at $9,410,000, for 18,820,000 shares of Reeves' Common Stock, $.01 par value, valued at $.50 per share. The supplemental earnings per share data is presented for each period as if the exchange occurred on January 1, 1989. (3) For the purpose of calculating the ratio of earnings to fixed charges, earnings consist of income from continuing operations before income taxes, plus fixed charges. Fixed charges consist of interest on all indebtedness, which includes amortization of financing costs and debt discounts, and one-third of all rentals, which is considered representative of the interest portion included therein, after adjustments for amounts related to discontinued operations. (4) Total assets include the assets of discontinued operations prior to disposal. In 1990, Reeves discontinued the operations of Reeves' ARA Automotive Group. (5) The decline in stockholder's equity from 1989 to 1990 includes the recognition of a net loss of $34,594,000 from the disposal of the remaining operations of Reeves' ARA Automotive Group. The decline in stockholder's equity from 1991 to 1992 primarily reflects translation adjustments of $6,626,000 caused by foreign currency fluctuations. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS RESULTS OF OPERATIONS (1991-1993) SALES Consolidated sales increased from $269.6 million in 1991 to $283.7 million in 1993 (5.2%) due to increased sales of the Industrial Coated Fabrics Group (16.0%) related primarily to growth in coated automotive airbag materials, partially offset by a decline in sales of the Apparel Textile Group (3.6%) due to a shift to basic, lower margin products, price competition, adverse recessionary influences affecting domestic textile markets and the cessation of ATG's weaving operations at its Woodruff, South Carolina facility in 1993. Industrial Coated Fabrics Group. ICF's sales were $121.3 million, $126.6 million and $140.7 million in 1991, 1992 and 1993, respectively. The 16.0% increase during the period was due to increased sales of specialty coated fabrics, primarily coated automotive airbag materials, partially offset by a decline in offset printing blanket volume. The increase in coated automotive airbag materials sales was due to an increase in unit volume caused by the increased use of driver-side airbags primarily in cars manufactured in the United States. The decline in domestic printing blanket sales was primarily due to reduced demand as a result of the slowdown in the printing industry. Sales of Reeves Brothers' Italian subsidiary ("Reeves S.p.A.") fluctuated during the period primarily due to movements in foreign currency exchange rates. Apparel Textile Group. ATG's sales were $148.3 million, $144.5 million and $142.9 million in 1991, 1992 and 1993, respectively. The 2.6% sales decline in 1992 as compared to 1991 was evenly distributed between ATG's greige and finishing divisions. The decline in each division was primarily due to unusually strong sales in 1991 to the U.S. military as a result of Operation Desert Storm and, to a lesser extent, the economic recession in the United States in 1992. ATG's products experienced both a decline in unit volume as well as a shift to more basic, lower margin products in 1992 as compared to 1991. The 1.1% decline experienced in 1993 as compared to 1992 resulted from a decrease in greige goods sales as a result of the cessation of weaving operations at the Woodruff, South Carolina facility due to declining sales to the U.S. military, offset partially by the increased sales of finished goods due to greater demand for higher quality and more varied product offerings and styles. OPERATING INCOME Consolidated operating income was $25.6 million, $25.8 million and $28.1 million in 1991, 1992 and 1993, respectively. The 9.8% increase between 1991 and 1993 resulted primarily from increased profits contributed by ICF's specialty materials products (predominantly coated automotive airbag materials) and to a lesser extent, increased profits contributed by ATG (in spite of reduced sales volume) as a result of cost reductions and productivity gains achieved during the period related to its capital investment program. The operating income increase experienced during the period was partially offset by increased corporate expenses and, in 1993, by facility restructuring charges of $1.0 million. Operating income, as a percentage of sales, increased from 9.5% in 1991 and 1992 to 9.9% in 1993. Industrial Coated Fabrics Group. ICF's operating income was $23.9 million, $24.7 million and $29.3 million in 1991, 1992 and 1993, respectively, and represented 19.7%, 19.5% and 20.8% of ICF's sales in such years. Operating income growth in 1992 as compared to 1991 was due primarily to increased sales of coated automotive airbag materials and, to a lesser extent, the elimination of certain lower-margin specialty coated fabric products. The 18.6% increase in operating income in 1993 as compared to 1992 was primarily due to the benefits of economies of scale realized in connection with increased sales of coated automotive airbag materials. Operating income from printing blankets declined in 1992 and 1993 reflecting the worldwide slowdown in the printing industry partially offset by efficiencies experienced by Reeves S.p.A. primarily related to increased material yields. Apparel Textile Group. ATG's operating income was $10.1 million, $10.7 million and $11.6 million in 1991, 1992 and 1993, respectively, and represented 6.8%, 7.4% and 8.1% of ATG's sales in such years. The operating income and margin improvement experienced during the period was achieved in spite of an overall 3.6% sales decline reflecting the benefits of cost reductions and productivity improvements realized from ATG's capacity modernization program initiated at its Chesnee and Bishopville, South Carolina facilities. Corporate Expenses. Corporate expenses were $7.3 million, $8.3 million and $10.4 million in 1991, 1992 and 1993, respectively, and represented 2.7%, 3.1% and 3.7% of consolidated sales in such years. The increase in corporate expenses during the period related primarily to increased staffing and compensation expense necessary to support corporate development activities. In 1993, corporate expenses included a provision for costs related to the Company's discontinued Buena Vista, Virginia facility of $.5 million. Goodwill Amortization and Facility Restructuring Charges. The Company recorded provisions for goodwill amortization of $1.2 million in 1991 and $1.3 million in 1992 and 1993. In 1993, Reeves also recorded facility restructuring charges of $1.0 million. The one-time charges related primarily to the cessation of weaving activities at the Company's Woodruff, South Carolina facility due to declining sales to the U.S. military, the conversion of that facility into a captive yarn mill and consolidation of weaving capacity at ATG's remaining facilities. INTEREST EXPENSE, NET Interest expense, net consists of consolidated interest expense plus amortization of financing costs and debt discounts less interest income on investments. Interest expense, net was $20.7 million, $17.2 million and $16.2 million in 1991, 1992 and 1993, respectively. Included in such net amounts are provisions for the amortization of financing costs and debt discounts totaling $1.3 million, $1.0 million and $.7 million in 1991, 1992 and 1993, respectively. The decline in interest expense, net during the period resulted primarily from the repayment of bank debt, the refinancing of Reeves' long-term debt in 1992 with proceeds from the sale of the 11% Senior Notes and the repurchase of a portion of the 13 3/4% Subordinated Debentures. INCOME TAXES The Company's effective income tax rate on income from continuing operations before income taxes for 1991, 1992 and 1993 was 7.6%, 30.3% and 33.7%, respectively. The effective income tax rate on income from continuing operations for 1991 and 1992 differed from the federal statutory rate of 34% primarily due to the impact of goodwill amortization and Reeves S.p.A.'s lower effective tax rate. The higher effective income tax rate in 1992 as compared to 1991 was primarily due to an increase in domestic taxable income which is taxed at a higher rate than income earned at Reeves S.p.A., a new Italian tax affecting Reeves S.p.A.'s tax liability and the adoption of Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" ("FAS 109"). During 1993, Reeves established a $.8 million valuation reserve against the Company's deferred tax assets reflecting estimated utilization of foreign tax credits. The Company has foreign tax credit carryforwards of $1.9 million of which $1.7 million expire in 1994 and $.2 million expire at varying dates through 1997. The valuation reserve was established based on the Company's estimate of foreign source taxable income expected to be received from Reeves S.p.A. during the foreign tax credit carryover period. INCOME FROM CONTINUING OPERATIONS Income from continuing operations was $4.5 million, $6.0 million and $7.9 million in 1991, 1992 and 1993, respectively. Income from continuing operations excluded (i) a gain on disposal of discontinued operations, net of taxes, aggregating $2.8 million in 1991, (ii) an extraordinary loss of $6.1 million in 1992 from the write-off of financing costs and debt discounts related to the early extinguishment of long-term debt in the Company's 1992 refinancing and (iii) a gain of $3.2 million in 1992 related to the cumulative effect of adopting a change in accounting principle (FAS 109). LIQUIDITY AND CAPITAL RESOURCES Capital Expenditures Commmencing in 1991, the Company began significantly increasing its levels of capital investment in its businesses in order to modernize and expand capacity, reduce its overall cost structure, increase productivity and enhance its competitive position. Between 1991 and 1993, the Company invested approximately $52.1 million in aggregate ($11.0 million in 1991, $15.8 million in 1992, and $16.5 million in 1993 and $8.8 million, representing the cost of manufacturing equipment leased under operating leases, in 1992 and 1993). Between 1991 and 1993, the Company invested approximately $13 million in ICF's domestic facilities in order to purchase new production equipment, to increase productivity and expand capacity in its traditional lines of business as well as to enter the coated automotive airbag materials market. In addition, ICF spent approximately $12 million in its Reeves S.p.A. facilities to construct an 80,000 square foot addition and purchase related equipment. Such investment increased capacity to manufacture offset printing blankets and installed coated fabrics capacity in Europe to meet anticipated demand for sophisticated specialty materials. Between 1991 and 1993, the Company invested approximately $24.2 million in ATG's facilities at Chesnee and Bishopville, South Carolina to increase productivity and manufacturing flexibility, expand capacity for more sophisticated fabrics and allow more rapid response to market demand and a broader product offering. Of such $24.2 million, approximately $8.8 million represents the cost of manufacturing equipment leased under operating leases. The Company intends to substantially increase its capital investment in its existing businesses during the 1994-1997 period. The Company currently anticipates in excess of $40 million of capital expenditures in 1994 and in excess of $100 million of aggregate spending between 1995 and 1997. In 1994, the Company anticipates spending approximately $17 million to construct, furnish and equip a state-of-the-art plant in Spartanburg, South Carolina to weave automotive airbag materials, approximately $5 million to complete the capacity expansion of ATG's Chesnee, South Carolina plant and approximately $16 million to expand the capacity of and improve productivity at ICF's worldwide coated fabrics and offset printing blanket facilities. Projected capital expenditures beyond 1994 are expected to complete ATG's modernization and expansion of its textile capacity, expand ICF's automotive airbag materials capacity in response to anticipated domestic and international market requirements and enhance the profitability and competitive position of ICF's printing blanket and traditional coated fabrics businesses through additional spending for cost reductions and productivity improvements. As a result of the nature of the Company's business and its substantial expenditures for capital improvements over the last several years, current and future capital expenditure requirements are flexible as to both timing and amount of capital required. In the event that cash flow proves inadequate to fund currently projected expenditures, such expenditures can be adjusted so as not to exceed available funds. Liquidity The Company's net cash provided by operating activities increased from $7.6 million in 1991 to $15.2 million in 1992 and $25.2 million in 1993. The improvement in net cash provided by operating activities resulted from higher levels of income from continuing operations and significant improvements in working capital management. The Company anticipates that it will be able to meet its projected working capital, capital expenditure and debt service requirements through internally generated funds and borrowings available under its existing $35 million Bank Credit Agreement. In August 1992, in conjunction with the refinancing of the Company's bank and institutional indebtedness, the Company entered into the Bank Credit Agreement which provides the Company with an aggregate $35 million revolving line of credit and letter of credit facility. The Bank Credit Agreement expires on December 31, 1995 and is secured by accounts receivable and inventories. As of March 31, 1994, the Company had available borrowing capacity (net of $1.3 million of outstanding letters of credit) of $28.6 million under the Bank Credit Agreement. IMPACT OF INFLATION The Company does not believe that its financial results have been materially impacted by the effects of inflation. OTHER MATTERS In February 1992, the Company received approximately $17 million from the federal government in payment of a tax refund. The refund resulted from the Company carrying back tax operating losses generated in 1991, primarily related to the disposal of the ARA Automotive Group, to offset previous years' taxable income. In 1992, Reeves adopted FAS 109 effective as of the beginning of 1992. Under FAS 109, in the year of adoption, previously reported results of operations for the year are restated to reflect the effects of applying FAS 109, and the cumulative effect of adoption on prior years' results of operations is shown in the income statement in the year of change. The cumulative effect of this change in accounting principle increased net income by $3.2 million in 1992. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA See Part IV, Item 14, for index to financial statements. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors and Stockholder of Reeves Industries, Inc. In our opinion, the consolidated financial statements listed in the index appearing under Item 14(a)(1) and (2) present fairly, in all material respects, the financial position of Reeves Industries, Inc. and its subsidiary at December 31, 1992 and 1993, 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 Notes 2 and 8 to the consolidated financial statements, the Company changed its method of accounting for income taxes in 1992. PRICE WATERHOUSE Atlanta, Georgia February 11, 1994, except as to Note 16, which is as of March 31, 1994 REEVES INDUSTRIES, INC. CONSOLIDATED BALANCE SHEET (in thousands except share data) December 31, ---------------- 1992 1993 ------ ------ ASSETS Current assets Cash and cash equivalents of $3,936 and $7,222 $ 4,165 $ 12,015 Accounts receivable, less allowance for doubtful accounts of $1,570 and $1,467 38,876 45,925 Inventories (Note 4) 35,310 33,969 Deferred income taxes (Note 8) 6,477 5,442 Other current assets 9,814 3,300 Investment in discontinued operations (Note 3) 2,466 -------- -------- Total current assets 97,108 100,651 Property, plant and equipment, at cost less accumulated depreciation (Note 5) 43,526 51,415 Unamortized financing costs, less accumulated amortization of $550 and $1,177 4,390 3,946 Goodwill, less accumulated amortization of $8,091 and $9,431 44,697 43,357 Deferred income taxes (Note 8) 1,951 2,153 Other assets 603 1,503 Investment in discontinued operations (Note 3) 656 -------- -------- Total assets $192,931 $203,025 ======== ======== LIABILITIES AND STOCKHOLDER'S EQUITY Current liabilities Accounts payable $ 15,352 $ 22,810 Accrued expenses and other liabilities (Note 6) 18,991 21,197 Liabilities related to discontinued operations (Note 3) 3,367 -------- -------- Total current liabilities 37,710 44,007 Long-term debt (Note 7) 132,576 132,677 Deferred income taxes (Note 8) 4,505 4,367 Other liabilities 563 Liabilities related to discontinued operations (Note 3) 2,575 -------- -------- Total liabilities 177,366 181,614 -------- -------- Stockholder's equity (Note 10) Common stock, $.01 par value, 50,000,000 shares authorized; 34,967,973 and 35,021,666 shares issued and outstanding 350 350 Capital in excess of par value 5,069 5,099 Retained earnings 12,107 19,964 Equity adjustments from translation (1,961) (4,002) -------- -------- Total stockholder's equity 15,565 21,411 -------- -------- Commitments and contingencies (Note 15) -------- -------- Total liabilities and stockholder's equity $192,931 $203,025 ======== ======== The accompanying notes are an integral part of these financial statements. REEVES INDUSTRIES, INC. CONSOLIDATED STATEMENT OF INCOME (in thousands except per share data) Year Ended December 31, ---------------------------- 1991 1992 1993 -------- -------- -------- Net sales $269,559 $271,104 $283,653 Cost of sales 216,179 216,043 222,016 -------- -------- -------- Gross profit on sales 53,380 55,061 61,637 Selling, general and administrative expenses 27,754 29,294 32,540 Facility restructuring charges (Note 3) 1,003 -------- -------- -------- Operating income 25,626 25,767 28,094 Other income (expense) Other income, net 1,068 435 158 Interest expense and amortization of financing costs and debt discounts (21,777) (17,633) (16,394) -------- -------- -------- (20,709) (17,198) (16,236) -------- -------- -------- Income from continuing operations before income taxes, extraordinary item and cumulative effect of a change in accounting principle 4,917 8,569 11,858 Income taxes (Note 8) 373 2,593 4,001 -------- -------- -------- Income from continuing operations 4,544 5,976 7,857 Discontinued operations Net gain on disposal of discontinued operations, less applicable income tax provision of $1,732 (Note 3) 2,830 -------- -------- -------- 2,830 -------- -------- -------- Income before extraordinary item and cumulative effect of a change in accounting principle 7,374 5,976 7,857 Extraordinary loss from early extinguishment of debt, less applicable income tax benefits of $3,148 (Note 7) (6,112) Cumulative effect of a change in accounting for income taxes (Note 8) 3,221 -------- -------- -------- Net income $ 7,374 $ 3,085 $ 7,857 ======== ======== ======== Earnings per common share (Note 10) Primary and fully diluted Income from continuing operations $ .23 $ .16 $ .22 Income before extraordinary item and cumulative effect of a change in accounting principle .39 .16 .22 Cumulative effect of a change in accounting for income taxes .09 Net income .39 .08 .22 Weighted average number of common shares outstanding Primary and fully diluted 18,118 36,724 34,978 The accompanying notes are an integral part of these financial statements. REEVES INDUSTRIES, INC. CONSOLIDATED STATEMENT OF CASH FLOWS (in thousands) Year Ended December 31, ------------------------ 1991 1992 1993 ------ ------ ------ Cash flows from operating activities Net income $ 7,374 $ 3,085 $ 7,857 Adjustments to reconcile net income to net cash provided by operating activities Write-off of financing costs due to early extinguishment of debt 6,112 Cumulative effect of a change in accounting for income taxes (3,221) Net gain on disposal of discontinued operations (2,830) Depreciation and amortization 8,388 9,146 9,272 Deferred income taxes 601 (112) 694 Changes in operating assets and liabilities Decrease (increase) in accounts receivable 565 2,574 (7,049) Decrease in inventories 486 4,200 1,341 (Increase) decrease in other current assets (1,949) (9,167) 6,514 (Increase) decrease in other assets (254) 134 (900) Increase (decrease) in accounts payable 492 (546) 7,458 (Decrease) increase in accrued expenses and other liabilities (4,920) 6,451 133 Equity adjustments from translation (356) (3,450) (117) ------- -------- ------- Net cash provided by operating activities 7,597 15,206 25,203 ------- -------- ------- Cash flows from investing activities Purchases of property, plant and equipment (11,015) (15,788) (16,506) Net proceeds (payments) from disposal of discontinued operations 2,331 12,438 (536) ------- -------- ------- Net cash used by investing activities (8,684) (3,350) (17,042) ------- -------- ------- Cash flows from financing activities Principal payments of long-term debt (56) (108,726) Net payments on revolving loans (30,000) Borrowings of long-term debt 121,644 Debt issuance costs (5,115) Premium on early retirement of debt (4,876) Purchases of common stock (1,075) (270) Issuance of common stock 300 ------- -------- ------- Net cash (used) provided by financing activities (56) (28,148) 30 ------- -------- ------- Effect of exchange rate changes on cash 122 (535) (341) ------- -------- ------- (Decrease) increase in cash and cash equivalents (1,021) (16,827) 7,850 Cash and cash equivalents, beginning of year 22,013 20,992 4,165 ------- -------- ------- Cash and cash equivalents, end of year $20,992 $ 4,165 $12,015 ======= ======== ======= The accompanying notes are an integral part of these financial statements. REEVES INDUSTRIES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1992 AND 1993 1. BUSINESS AND ORGANIZATION Reeves Industries, Inc. ("Reeves" or the "Company"), a wholly-owned subsidiary of Hart Holding Company Incorporated ("Hart Holding"), is a holding company whose principal asset is the common stock of its wholly-owned subsidiary, Reeves Brothers, Inc. ("Reeves Brothers"). The Company was acquired by Hart Holding on May 6, 1986. Reeves Brothers is a diversified industrial company engaged in two business segments: industrial coated fabrics and apparel textiles. 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Principles of consolidation The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiary, Reeves Brothers. All significant intercompany balances and transactions have been eliminated. Inventories Inventories are stated at the lower of cost or market. Cost for approximately 29% and 27% of total inventories was determined on the last-in, first-out (LIFO) method at December 31, 1992 and 1993, respectively. With respect to the remainder of the inventories, cost is determined principally on the first-in, first-out (FIFO) method. Market is determined on the basis of replacement costs or selling prices less costs of disposal. The application of Accounting Principles Board Opinion No. 16, "Business Combinations," for the acquisition of Reeves caused the inventories in the accompanying consolidated balance sheet to exceed inventories used for income tax purposes by approximately $7,320,000 as of December 31, 1993. Property, plant and equipment Property, plant and equipment are stated at cost. Improvements which extend the useful lives of the assets are capitalized while repairs and maintenance are charged to operations as incurred. Depreciation is provided using primarily the straight-line method for financial reporting purposes while accelerated methods are used for income tax purposes. When assets are replaced or otherwise disposed of, the cost and related accumulated depreciation are removed from the accounts and any gain or loss is reflected in income. Fair value of financial instruments Cash, accounts receivable, accounts payable and accrued expenses and other liabilities are reflected in the financial statements at fair value because of the short-term maturity of these instruments. The fair value of the Company's debt instruments is determined based upon a recent market price quote and is disclosed in Note 7. The fair value of the foreign exchange contracts (used for hedging purposes) is estimated using quoted exchange rates and is disclosed in Note 11. Foreign currency exchange and translation For Reeves Brothers' wholly-owned foreign subsidiary, the local currency of the country of operation is used as the functional currency for purposes of translating the local currency asset and liability accounts at current exchange rates into the reporting currency. The resulting translation adjustments are accumulated as a separate component of stockholder's equity reflected in the equity adjustments from translation account in the accompanying consolidated financial statements. Gains and losses resulting from translating asset and liability accounts that are denominated in currencies other than the functional currency are included in income. Amortization policy The Company is amortizing goodwill on a straight-line basis over forty years. Financing costs and debt discounts are being amortized by the interest method over the life of the respective debt securities. Pre-operating costs associated with the start-up of significant new operations are deferred and amortized over five years. Revenue recognition Sales are generally recorded when the goods are shipped. At the customer's request, shipment of the completed product is sometimes delayed. In such instances, revenues are recognized when the customer acknowledges transfer of title and accepts the related billing. Income taxes The Company is a member of an affiliated group of which Hart Holding is the common parent. Pursuant to a tax allocation agreement with Hart Holding, the Company files a consolidated federal income tax return with Hart Holding. Under the agreement, the Company's tax liability is determined on a separate return basis and any taxes payable are remitted to Hart Holding. During 1992, the Company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" (FAS 109). Income tax accounting information is disclosed in Note 8 to the consolidated financial statements. For the years ended December 31, 1992 and 1993, the provision for income taxes was based on reported earnings before income taxes, and includes appropriate provisions for deferred income taxes resulting from the tax effect of the differences between the tax basis of assets and liabilities and their carrying amounts for financial reporting purposes. Prior to January 1, 1992, deferred income taxes arose from the reporting of certain expenses, principally depreciation, pension costs and other expenses, differently for financial reporting purposes than for income tax reporting purposes. At December 31, 1993, unremitted earnings of Reeves Brothers' foreign subsidiary were approximately $19,500,000. United States income taxes have not been provided on these unremitted earnings as it is the Company's intention to indefinitely reinvest these earnings. However, Reeves Brothers' foreign subsidiary has, in previous years, remitted a portion of its current year earnings as dividends and expects to continue this practice in the future. Pension plans The Company has noncontributory pension plans covering all eligible domestic employees (Note 9). Earnings per share Earnings per share are computed based on the weighted average number of common and common equivalent shares, where dilutive, outstanding during each period. A deduction has been made for cumulative preferred dividends earned during such periods the preferred stock was outstanding even though such dividends were not declared or paid. Fully diluted earnings per share are computed assuming that outstanding warrants, where dilutive, were exercised at the beginning of the period or date of issuance, if later. Supplemental earnings per share data is provided giving effect to the exchange of preferred stock for common stock as discussed in Note 10. Statement of cash flows For purposes of the statement of cash flows, cash equivalents are defined as highly liquid investment securities with an original maturity of three months or less. 3. DISCONTINUED OPERATIONS AND FACILITY RESTRUCTURING CHARGES During 1990 the Company elected to dispose of the operations of its ARA Automotive Group. The Company has realized all of the significant assets and continues to settle remaining estimated liabilities related to the discontinued operation. The remaining estimated amounts to settle such liabilities have been included in accrued expenses and other liabilities as of December 31, 1993. During 1993, a facility restructuring plan was implemented to reduce the Company's overall cost structure and to improve productivity. The Consolidated Statement of Income includes a charge of approximately $1,003,000 related to this plan. The plan included the cessation of weaving activities at one location and conversion of that facility into a captive yarn mill, consolidating weaving capacity at remaining facilities and implementing cost saving/state-of-the-art finishing technology. 4. INVENTORIES Inventories at December 31, 1992 and 1993, are comprised of the following (in thousands): 1992 1993 Raw materials $ 7,084 $ 6,815 Work in process 8,777 8,792 Manufactured and finished goods 19,449 18,362 -------- -------- $ 35,310 $ 33,969 ======== ======== If inventories had been calculated on a current cost basis, they would have been valued higher by approximately $2,933,000 and $2,038,000 at December 31, 1992 and 1993, respectively. 5. PROPERTY, PLANT AND EQUIPMENT The principal categories of property, plant and equipment at December 31, 1992 and 1993, are as follows (in thousands): 1992 1993 Land and land improvements $ 794 $ 797 Buildings and improvements 14,355 16,654 Machinery and equipment 56,801 65,400 -------- -------- 71,950 82,851 Less - Accumulated depreciation and amortization (28,424) (31,436) -------- -------- $ 43,526 $ 51,415 ======== ======== 6. ACCRUED EXPENSES AND OTHER LIABILITIES Accrued expenses and other liabilities at December 31, 1992 and 1993, are comprised of the following (in thousands): 1992 1993 Accrued salaries, wages and incentives $ 3,013 $ 3,145 Product claims reserve 1,277 1,237 Interest payable 6,493 6,512 Income taxes payable 530 548 Deferred compensation 1,322 1,187 Accrued costs related to discontinued operations 145 1,390 Italian severance pay program 2,405 2,391 Other 3,806 4,787 -------- -------- $ 18,991 $ 21,197 ======== ======== 7. LONG-TERM DEBT Long-term debt at December 31, 1992 and 1993, consists of the following (in thousands): 1992 1993 11% Senior Notes due July 15, 2002, net of unamortized discount of $835 and $747 $121,665 $121,753 13 3/4% Subordinated Debentures due May 1, 2000, net of unamortized discount of $89 and $76 10,911 10,924 -------- -------- $132,576 $132,677 ======== ======== In June 1992, the Company completed a public offering of $122,500,000 of 11% Senior Notes due 2002 (the "Senior Notes"). Proceeds of the offering were used to redeem all of the Company's then outstanding 12 1/2% Senior Notes and 13% Senior Subordinated Debentures and to pay and terminate the revolving loan outstanding under a prior loan agreement. In connection with the liquidation of the 12 1/2% Senior Notes, the 13% Senior Subordinated Debentures and the prior revolving loan, the Company paid early payment premiums of $4,601,000 and wrote off related debt issuance costs and debt discounts of $3,016,000. In addition, during 1992, the Company purchased $5,000,000 face value of its 13 3/4% Subordinated Debentures for $5,275,000. As a result of these transactions, the Company recognized an extraordinary loss of $5,775,000 ($.16 per share), net of applicable income tax benefits of $2,974,000. The Company is required to make sinking fund payments with respect to the remaining 13 3/4% Subordinated Debentures of $6,000,000 on May 1, 1999 and $5,000,000 on May 1, 2000. On August 7, 1992, the Company and Reeves Brothers entered into the Bank Credit Agreement with a group of banks, which was amended in 1993, and which provides the Company and Reeves Brothers with an aggregate $35,000,000 revolving line of credit (the "Revolving Loan") and letter of credit facility. The Revolving Loan bears interest at the Alternate Base Rate (defined below) plus 1 1/2% or Eurodollar Rate plus 2 1/2%, at the election of the borrower. The Alternate Base Rate is defined as the higher of the Prime Rate (6% at December 31, 1993), Base CD Rate plus 1%, or the Federal Funds Effective Rate plus 1/2%. The applicable rates above the Alternate Base Rate and Eurodollar Rate decline based on a ratio of earnings to fixed charges, as defined. The Revolving Loan is due December 31, 1995. The Revolving Loan is secured by Reeves Brothers' accounts receivable and inventories. As of December 31, 1993, the Company and Reeves Brothers had available borrowings, net of $1,415,000 of outstanding letters of credit, of $33,585,000. A commitment fee of 1/2% per annum is required on the unused portion of the Revolving Loan. The Senior Notes, Revolving Loan, and 13 3/4% Subordinated Debentures contain certain restrictive covenants with respect to Reeves and Reeves Brothers including, among other things, maintenance of working capital, limitations on the payments of dividends, the incurrence of additional indebtedness and certain liens, restrictions on capital expenditures, mergers or acquisitions, investments and transactions with affiliates, and require the maintenance of certain financial ratios and compliance with certain financial tests and limitations. Interest paid amounted to $18,155,000, $12,350,000 and $15,306,000 in 1991, 1992 and 1993, respectively. The estimated fair value of the Company's 11% Senior Notes and 13 3/4% Subordinated Debentures at December 31, 1993 is $131,075,000 and $12,980,000, respectively. 8. INCOME TAXES During the third quarter of 1992, the Company adopted FAS 109 effective as of the beginning of 1992. Under FAS 109, in the year of adoption, previously reported results of operations for the year are restated to reflect the effects of applying FAS 109, and the cumulative effect of adoption on prior years' results of operations is shown in the income statement in the year of change. The adoption of FAS 109 did not have a material effect on the Company's 1992 income from continuing operations before income taxes. The provision (benefit) for income taxes from continuing operations is comprised of the following (in thousands): 1991 1992 1993 Current Federal $ (2,698) $ (401) $ 1,278 Foreign 354 954 811 State 147 174 138 -------- -------- -------- (2,197) 727 2,227 -------- -------- -------- Deferred Federal 1,770 983 945 Foreign 641 826 State 800 242 3 -------- -------- -------- 2,570 1,866 1,774 -------- -------- -------- $ 373 $ 2,593 $ 4,001 ======== ======== ======== The provision (benefit) for income taxes from continuing operations differs from taxes computed using the statutory federal income tax rate as follows (in thousands): 1991 1992 1993 Consolidated computed statutory taxes $ 1,672 $ 2,914 $ 4,050 State income taxes, net of federal income tax benefit 412 275 93 Amortization of goodwill 393 456 456 Foreign tax rate less than statutory rate (2,081) (868) (1,451) Valuation reserve 800 Other, net (23) (184) 53 -------- -------- -------- $ 373 $ 2,593 $ 4,001 ======== ======== ======== In 1990, Reeves Brothers' foreign subsidiary implemented a reorganization allowed under the applicable country's income tax laws. This transaction resulted in the foreign subsidiary revaluing upward its net assets for income tax purposes. Additional depreciation and amortization relating to this revaluation is deductible in determining income tax expense for both financial and income tax reporting. The effect of this revaluation resulted in the foreign subsidiary's effective income tax rate declining from its statutory rate of approximately 46% to 5% for 1991. Due to tax rate increases, other tax law changes, and the adoption of FAS 109, the foreign subsidiary's effective income tax rate for both 1992 and 1993 is approximately 22% versus the statutory rate of 52.2%. The provision from continuing operations for deferred federal income taxes for 1991, the year prior to the effective date of adoption of FAS 109, is comprised of timing differences related to provisions for items not deductible until incurred, principally product claims, bad debts and insurance, depreciation and amortization, compensation agreements and pension costs. Deferred tax liabilities and assets under FAS 109 are comprised of the following temporary differences (in thousands): 1992 1993 Deferred tax liabilities Inventories $ 2,523 $ 2,584 Depreciation 1,982 1,783 ------- ------- Total deferred tax liabilities $ 4,505 $ 4,367 ======= ======= Deferred tax assets Current Tentative minimum tax credits $ 854 $ 854 Accrued expenses 3,677 3,490 Foreign tax credit carryforwards 1,946 1,898 Valuation reserve (800) ------- ------- 6,477 5,442 ------- ------- Long-term Depreciation on foreign subsidiary assets 1,951 1,219 Foreign exchange 934 ------- ------- 1,951 2,153 ------- ------- Total deferred tax assets $ 8,428 $ 7,595 ======= ======= In adopting FAS 109, the Company recorded deferred tax assets which included foreign tax credit carryovers and the benefits of future depreciation related to Reeves Brothers' foreign subsidiary. The realization of these deferred tax assets is evaluated annually based on expected future taxable income and the carryover period of the credits. During 1993, the Company established an $800,000 valuation reserve against the benefit for utilization of foreign tax credits. The Company has foreign tax credit carry forwards of $1,898,000 of which $1,680,000 expire in 1994 and $218,000 expire at varying dates through 1997. The valuation reserve was established based on the Company's estimate of foreign source taxable income expected to be received from Reeves Brothers' foreign subsidiary during the foreign tax credit carryover period. The sources of income (loss) from continuing operations before income taxes are as follows (in thousands): 1991 1992 1993 Domestic $(2,245) $ 1,327 $ 2,774 Foreign 7,162 7,242 9,084 ------- ------- ------- $ 4,917 $ 8,569 $11,858 ======= ======= ======= Income taxes paid amounted to approximately $0, $2,406,000 and $1,686,000 in 1991, 1992 and 1993, respectively. 9. PENSION PLANS The Company sponsors two noncontributory defined benefit pension plans covering substantially all of its domestic salaried and hourly employees. The Reeves Brothers salaried pension plan benefits are based on an employee's years of accredited service. The Reeves Brothers hourly pension plan provides benefits, exclusive of benefits related to former ARA Automotive Group retirement plan participants, of stated amounts based on years of accredited service. The Reeves Brothers hourly pension plan also provides benefits to both the ARA union and non-union employees in accordance with their separate benefit calculations. The ARA non-union plan was merged with the Reeves Brothers hourly pension plan effective December 1990; the ARA union plan was merged with the Reeves Brothers' hourly pension plan effective April 1993. The Company's funding policy is to fund at least the minimum amount required by the Employee Retirement Income Security Act of 1974. Combined data The following table presents the combined funded status of the Company's plans at December 31, 1992 and 1993 (in thousands): 1992 1993 Actuarial present value of accumulated benefit obligation Vested $ 13,731 $ 19,300 Nonvested 866 914 -------- -------- Accumulated benefit obligation $ 14,597 $ 20,214 ======== ======== Plan assets at fair value $ 24,148 $ 25,450 Projected benefit obligation for services rendered to date 19,129 24,553 -------- -------- Plan assets greater than projected benefit obligation 5,019 897 Unrecognized net transition obligation 2,132 1,955 Unrecognized net gain subsequent to transition (7,097) (3,696) -------- -------- Pension asset (liability) recognized in the consolidated balance sheet $ 54 $ (844) ======== ======== Plan assets consist primarily of fixed income securities, equity securities, and certificates of deposit. Pension cost includes the following components (in thousands): 1991 1992 1993 Service cost - benefits earned during the period $ 929 $ 942 $ 936 Interest cost on projected benefit obligation 1,409 1,456 1,643 Actual return on plan assets (3,700) (2,961) (2,531) Net amortization and deferral 2,283 1,351 754 ------ ------ ------ Pension cost $ 921 $ 788 $ 802 ====== ====== ====== A weighted average discount rate of 8.5% and 7.25%, and rate of increase in future compensation of 5.5% and 5.0% were used in determining the actuarial present value of the projected benefit obligation in 1992 and 1993, respectively. The long-term expected rate of return on assets was 8.0% in both 1992 and 1993. In December 1990, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" (FAS 106), which requires accrual, during an employee's active years of service, of the expected costs of providing postretirement benefits to employees and their beneficiaries and dependents. The Company adopted FAS 106 in 1992, the effect of which was not material to the consolidated financial statements. 10. STOCKHOLDER'S EQUITY Capital stock The capitalization of Reeves consists of one class of common stock, $.01 par value (the "Common Stock"). The previously outstanding Series I Preferred Stock, $1.00 par value with a stated value of $5,001,000 (the "Preferred Stock") was wholly- owned by Hart Holding. Effective December 31, 1991, the Company's Board of Directors approved the exchange of all the outstanding Preferred Stock held by Hart Holding for 18,820,000 shares of the Company's Common Stock. 250,000 shares of Preferred Stock remain authorized, with no Preferred Stock currently outstanding. Supplemental earnings per share data The following supplemental earnings per share data is presented for the year ended December 31, 1991 as if the exchange of Preferred Stock for Common Stock described above occurred on January 1, 1991: Income from continuing operations $ .12 Income before extraordinary item and cumulative effect of a change in accounting principle .20 Net income .20 Weighted average number of common shares outstanding - primary and fully diluted (in thousands) 36,886 Settlement of litigation In November 1992, pursuant to a court ordered settlement of a lawsuit brought by the Company against Drexel Burnham Lambert and certain of its affiliates (collectively, the "Defendants"), Reeves received 1,918,132 shares of its common stock from the Defendants which were subsequently cancelled and retired. Merger with HHCI, Inc. Effective October 25, 1993, HHCI, Inc., a newly formed, wholly- owned subsidiary of Hart Holding, merged with and into the Company with the Company surviving the merger. HHCI, Inc. was formed as a shell corporation (no operations) with a $300,000 capital contribution from Hart Holding. As a result of the merger, Hart Holding was issued 535,000 shares of the Company's common stock and acquired the 481,307 shares of its common stock not held by Hart Holding. These shares were subsequently cancelled and retired. As a result of this merger, Hart Holding obtained ownership of 100% of the outstanding shares of the common stock of the Company and the other stockholders of Reeves received $.56 per share in cash. 11. FOREIGN EXCHANGE The Company enters into foreign exchange forward contracts to hedge risk of changes in foreign currency exchange rates associated with certain assets and future foreign currency transactions, primarily cash flows from accounts receivable and firm purchase commitments. The Company does not engage in speculation. While the forward contracts affect the Company's results of operations, they do so only in connection with the underlying transactions. Gains and losses on these contracts are deferred until the underlying hedged transaction is completed. The cash flows from the forward contracts are classified consistent with the cash flows from the transactions being hedged. As a result, they do not subject the Company to risk from foreign exchange rate movements, because gains and losses on these contracts offset losses and gains on the transactions being hedged. At December 31, 1993, the Company had foreign currency hedge contracts outstanding, equivalent to $14,883,000, to exchange various currencies, including the U.S. dollar, Japanese yen, pound sterling, Deutsche mark, and French franc into Italian Lire. The contracts mature during 1994. The December 31, 1993 fair value of these foreign currency hedge contracts was $14,407,000. 12. CONCENTRATIONS OF CREDIT RISK Concentrations of credit risk with respect to trade receivables are limited due to the wide variety of customers and markets into which the Company's products are sold, as well as their dispersion across many different geographic areas. As a result, at December 31, 1993, the Company does not consider itself to have any significant concentrations of credit risk. 13. RELATED PARTY TRANSACTIONS During the years ended December 31, 1991, 1992 and 1993, the Company and its subsidiary paid management fees to Hart Holding of $1,200,000, $1,910,000 and $1,804,000, respectively. During 1992, Reeves Brothers purchased the residences of three officers of Reeves Brothers for an aggregate amount of $1,015,000. During 1993, the Company recognized a loss of approximately $161,000 on the sale of two of the properties including related expenses. The remaining residence, which has a carrying value of $244,000 at December 31, 1993, is presently being marketed for sale. 14. FINANCIAL INFORMATION ABOUT INDUSTRY SEGMENTS The Company, through Reeves Brothers, operates in two principal industry segments: industrial coated fabrics and apparel textiles. The Industrial Coated Fabrics Group manufactures newspaper and graphic art printing press blankets, protective coverings, inflatable aerospace and survival equipment, diaphragms for meters, pump and tank seals and material used in automotive airbags. The Apparel Textiles Group manufactures, dyes and finishes greige goods. The products of the Industrial Coated Fabrics Group and the Apparel Textiles Group are sold in the United States and in certain foreign countries primarily by Reeves Brothers' merchandising and sales personnel and through a network of independent distributors to a variety of customers including converters, apparel manufacturers, industrial users and contractors. Sales offices are maintained in New York, New York, Dallas, Texas, Spartanburg, South Carolina and Milan, Italy. The following table presents certain information concerning each segment (in thousands): 1991 1992 1993 Net sales Industrial coated fabrics $121,264 $126,576 $140,735 Apparel textiles 148,295 144,528 142,918 -------- -------- -------- $269,559 $271,104 $283,653 ======== ======== ======== Operating income Industrial coated fabrics $ 23,940 $ 24,732 $ 29,287 Apparel textiles 10,121 10,693 11,583 Corporate expenses (8,435) (9,658) (11,773) Facility restructuring charges (1,003) -------- -------- -------- Operating income 25,626 25,767 28,094 Other income, net 1,068 435 158 Interest expense and amortization of financing costs (21,777) (17,633) (16,394) -------- -------- -------- Income from continuing operations before income taxes, extraordinary item and cumulative effect of a change in accounting principle $ 4,917 $ 8,569 $ 11,858 ======== ======== ======== Depreciation Industrial coated fabrics $ 2,598 $ 3,175 $ 3,632 Apparel textiles 2,983 2,913 3,465 Corporate 370 688 107 -------- -------- -------- $ 5,951 $ 6,776 $ 7,204 ======== ======== ======== Capital expenditures Industrial coated fabrics $ 7,579 $ 6,353 $ 11,459 Apparel textiles 2,994 8,623 4,693 Corporate 442 812 354 -------- -------- -------- $ 11,015 $ 15,788 $ 16,506 ======== ======== ======== Identifiable assets Industrial coated fabrics $ 68,403 $ 65,752 $ 75,625 Apparel textiles 60,410 65,111 63,822 Corporate, principally discontinued operations (in 1991 and 1992), goodwill and debt issuance costs 86,174 62,068 63,578 -------- -------- -------- $214,987 $192,931 $203,025 ======== ======== ======== Financial data of Reeves Brothers' foreign operation is as follows (in thousands): 1991 1992 1993 Sales $ 35,437 $ 38,444 $ 36,932 Net income 6,808 9,165 7,446 Assets 33,011 31,608 33,092 Intersegment sales are not material. 15. COMMITMENTS AND CONTINGENCIES The Company leases certain operating facilities and equipment under long-term operating leases. At December 31, 1993 future minimum rentals, related to continuing operations, required by operating leases having initial or remaining noncancellable lease terms in excess of one year are as follows: 1994 - $1,853,000; 1995 - $1,811,000; 1996 - $1,800,000; 1997 - $1,800,000; 1998 - $1,800,000; thereafter - $2,945,000. Rental expense charged to continuing operations was approxi- mately $1,187,000, $1,420,000 and $1,473,000 during the years ended December 31, 1991, 1992 and 1993, respectively. There are various lawsuits and claims pending against the Company and its subsidiary, including those relating to commercial transactions. The outcome of these matters is not presently determinable but, in the opinion of management, the ultimate resolution of these matters will not have a material adverse effect on the results of operations and financial position of the Company. 16. SUBSEQUENT EVENTS On January 26, 1994, the Board of Directors approved a non- qualified stock option agreement between the Company and the Chairman of the Board of Directors. The agreement grants an option to purchase up to 3,800,000 shares of common stock of the Company, par value $.01 per share, and has an expiration date of December 31, 2023. The option is exercisable at $.56 per share for 1,400,000 shares (exercisable immediately), $.75 per share for 1,400,000 shares (exercisable one year from grant date) and $1.00 per share for 1,000,000 shares (exercisable two years from grant date). On March 9, 1994 Hart Holding organized Reeves Holdings, Inc. as a wholly-owned subsidiary (the "Issuer") through a capital contribution of $1,000. The Issuer was formed for the purpose of holding all of the outstanding common stock of the Company. On March 31, 1994 the Issuer filed a Registration Statement on Form S-1 under the Securities Act of 1933, as amended, for the purpose of offering Senior Discount Debentures due 2006 anticipated to yield proceeds of approximately $100,000,000. As of March 31, 1994 the Company's common stock has not been contributed to the Issuer. PART III ITEM 10. ITEM 10. DIRECTOR AND EXECUTIVE OFFICERS The sole director of Reeves and Reeves Brothers is James W. Hart. The following table sets forth the name, positions with Reeves and Reeves Brothers, age and principal business experience during the past five years of each executive officer of Reeves and Reeves Brothers. Any executive officer, unless otherwise stated, holds the identical position or positions in both Reeves and Reeves Brothers. Name Position Age Richard W. Ball Treasurer 47 Anthony L. Cartagine Vice President; President - 59 Apparel Textile Group David L. Dephtereos Vice President and 39 General Counsel Jennifer H. Fray Secretary and Assistant 29 General Counsel Douglas B. Hart Senior Vice President - 31 Operations James W. Hart Chairman of the Board 60 James W. Hart, Jr. President, Chief Executive 40 Officer and Chief Operating Officer Steven W. Hart Executive Vice President 37 and Chief Financial Officer V. William Lenoci Vice President; 58 President and Chief Executive Officer - Industrial Coated Fabrics Group Joseph P. O'Brien Vice President - Finance 53 Patrick M. Walsh Vice President - Administration 53 Mr. Ball joined Reeves and Reeves Brothers in January 1992 as Treasurer. He served as Treasurer of Hart Holding from June 1992 to December 1992. From 1990 through 1991, Mr. Ball was Corporate Treasurer for Turner Corporation, a world-wide construction and development company. From 1988 through 1989, Mr. Ball was Vice President and Chief Financial Officer of Nuclear Energy Services, Inc., an engineering services subsidiary of Penn Central Corporation. Mr. Cartagine has been with Reeves Brothers since 1964. He was named President - Greige Goods Division of the Apparel Textile Group in 1984 and President of the Apparel Textile Group in 1986. He was named Vice President of Reeves and Reeves Brothers in 1988. Mr. Dephtereos joined Hart Holding, Reeves and Reeves Brothers in May 1991 as Vice President, General Counsel and Secretary. He served as Vice President and Secretary of Hart Holding from 1991 to 1992 and Secretary of Reeves and Reeves Brothers from 1991 until 1992. From 1985 through May 1991, Mr. Dephtereos was Vice President, General Counsel and Secretary of Air Express International Corporation, a publicly-held, international transportation company. Ms. Fray joined Hart Holding, Reeves and Reeves Brothers in September 1992 as Assistant General Counsel. In 1992, she was named Secretary of Hart Holding, Reeves and Reeves Brothers. From 1990 to 1992, Ms. Fray was engaged in studies leading to a Master of Laws Degree in Taxation from Boston University, from 1990 to 1991 she was employed as a Tax Associate at Coopers & Lybrand, certified public accountants, in Boston, Massachusetts and from 1987 to 1990 she was engaged in studies leading to a Juris Doctor Degree from Suffolk University. Mr. Douglas B. Hart served as a Director of Reeves and Reeves Brothers from 1991 to 1992. He was named Vice President - Real Estate in 1989, Senior Vice President in 1991 and Senior Vice President - Operations in 1992 of Reeves and Reeves Brothers. Mr. Hart served as a Director of Hart Holding from 1991 to 1992, as Vice President - Real Estate of Hart Holding from 1989 to 1991 and as Senior Vice President of Hart Holding from 1991 to 1992. In 1992, Mr. Hart became President, Chief Executive Officer and Chief Operating Officer of Hart Investment Properties Corporation, a wholly-owned diversified corporate investment entity of Hart Holding, with current holdings in real estate. Prior to 1989, Mr. Hart was an Assistant Vice President at Sentinel Real Estate Corporation in New York, an owner/developer of malls, shopping centers, office buildings and single family residential communities throughout the United States. Mr. James W. Hart has been a Director of Reeves and Reeves Brothers since 1986 and became Chairman of the Board in 1987. Mr. Hart served as President and Chief Executive Officer of Reeves and Reeves Brothers from 1988 until 1992. Mr. Hart has been a Director, President, Chief Executive Officer, and Chairman of the Board of Hart Holding since 1975 and became Chief Operating Officer and Chief Financial Officer of Hart Holding in 1992. Mr. James W. Hart, Jr. served as a Director of Reeves and Reeves Brothers from 1986 to 1992. Mr. Hart became Vice President of Reeves and Reeves Brothers in 1987 and was named Senior Vice President - Operations in 1988 and Executive Vice President and Chief Operating Officer in 1989. In 1992, he was named President, Chief Executive Officer and Chief Operating Officer of Reeves and Reeves Brothers. Mr. Hart served as a Director of Hart Holding from 1984 to 1992. He served as Vice President of Hart Holding from 1984 to 1992, Senior Vice President - Operations of Hart Holding from 1988 to 1992 and as Executive Vice President and Chief Operating Officer of Hart Holding from 1989 to 1992. Mr. Steven W. Hart served as a Director of Reeves and Reeves Brothers from 1986 to 1992. He became Vice President of Reeves and Reeves Brothers in 1987 and was named Senior Vice President and Chief Financial Officer in 1988 and Executive Vice President and Chief Financial Officer in 1989. Mr. Hart served as a Director, Treasurer and Chief Financial Officer of Hart Holding from 1984 to 1992, Vice President of Hart Holding from 1984 to 1988, Senior Vice President of Hart Holding from 1988 to 1989 and Executive Vice President of Hart Holding from 1989 to 1992. Mr. Hart joined Hart Holding in 1983 as Vice President - Strategic Planning. Mr. Lenoci has been with Reeves since 1967. He was named President - Industrial Coated Fabrics Group in 1986 and Vice President of Reeves and Reeves Brothers in 1988. In 1990, he became Chief Executive Officer of the Industrial Coated Fabrics Group. Mr. O'Brien joined Reeves and Reeves Brothers in 1993 as Vice President - Finance. From 1980 to 1993, Mr. O'Brien served as Vice President - Finance of Howmet Corporation, an integrated manufacturer of components for gas turbine jet engines and aircraft structural parts. Mr. Walsh has been with Reeves since 1987, as Director of Human Resources. In 1990, he was elected Vice President - Administration of Reeves Brothers and in 1993, Vice President - Administration of Reeves. Mr. James W. Hart is the father of Ms. Fray and Messrs. Douglas B. Hart, James W. Hart, Jr. and Steven W. Hart. Directors of Reeves and Reeves Brothers are elected at each annual meeting of the stockholders. The term of office of each director is from the time of his election and qualification until the next annual meeting of stockholders and until his successor shall have been duly elected and qualified, unless such director shall have earlier been removed. Executive officers serve at the discretion of the Boards of Directors of Reeves and Reeves Brothers. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION EXECUTIVE COMPENSATION The following table sets forth information concerning the cash compensation and cash equivalent remuneration paid or accrued by the Company for the years ended December 31, 1993, 1992 and 1991, for those persons who were at December 31, 1993, (i) the chief executive officer, and (ii) the other four most highly compensated executive officers of the Company. Summary Compensation Table Annual Compensation All ---------------------------- Other Name and Principal Position Year Salary Bonus(1) Compensation Anthony L. Cartagine 1993 $256,357 $ 92,000 - Vice President; 1992 235,144 100,000 - President - Apparel 1991 205,430 112,500 - Textile Group Douglas B. Hart 1993 204,500 125,000 - Senior Vice President 1992 - 100,000 - - Operations 1991 - 70,000 - James W. Hart, Jr. 1993 398,750 380,000 - President, Chief 1992 365,000 200,000 - Executive Officer and 1991 355,000 185,000 - Chief Operating Officer Steven W. Hart 1993 398,750 230,000 - Executive Vice 1992 365,000 200,000 $31,819 (2) President and Chief 1991 355,000 185,000 - Financial Officer V. William Lenoci 1993 293,750 142,000 - Vice President; President 1992 240,249 105,000 - and Chief Executive 1991 204,079 87,500 19,272 (3) Officer - Industrial Coated Fabrics Group (1) Annual bonus amounts are earned and accrued under the Management Incentive Bonus Plan during the years indicated and paid subsequent to the end of each year except for a portion of those amounts awarded and paid to the executive officers during 1993. Also, a portion of those amounts awarded during 1992 for James W. Hart, Jr., Steven W. Hart and Anthony L. Cartagine were paid in 1992. (2) Represents reimbursement of certain moving expenses. (3) Represents the payment of certain life insurance premiums. EMPLOYMENT CONTRACTS Reeves Brothers entered into employment agreements with Messrs. Cartagine and Lenoci during 1991 that provide for base compensation and participation in the Management Incentive Bonus Plan, plus certain other benefits. DIRECTORS' COMPENSATION Reeves and Reeves Brothers pay no remuneration to directors for serving as such. PENSION PLANS Annual Pension at Age 65 After Years of Service Remuneration 15 20 25 30 35 $ 125,000 $ 21,357 $ 30,732 $ 40,107 $ 49,482 $ 58,857 150,000 26,982 38,232 49,482 60,732 71,982 175,000 32,607 45,732 58,857 71,982 85,107 200,000 38,232 53,232 68,232 83,232 98,232 225,000 43,857 60,732 77,607 94,482 111,357 250,000 49,482 68,232 86,982 105,732 118,800 300,000 60,732 83,232 105,732 118,800 118,800 350,000 71,982 98,232 118,800 118,800 118,800 Notes To Pension Plan Table (A)(1) Compensation covered by the tax-qualified salaried employees pension plan each year is generally all compensation reported on a participant's Form W-2. The plan's formula is based on average compensation for the participant's highest five consecutive calendar years. However, except in the cases of Messrs. Cartagine and Lenoci, compensation for any year is limited by the compensation cap for that year under section 401(a)(17) of the Internal Revenue Code. For 1993, that limit is $235,840. A supplemental plan provides Messrs. Cartagine and Lenoci the benefits limited under the tax-qualified plan. (2) Starting in 1994, the maximum annual compensation that may be taken into account is $150,000. Participants in the pension plan prior to 1994 may have accrued higher benefits than those shown in the table to the extent their average highest compensation exceeded $150,000. Those higher accrued benefits are preserved by law. (3) For 1994, the maximum benefit under the pension plan is $118,800. (B) Years of service for named executive officers: Officer Years of Service Anthony L. Cartagine 30.02 Douglas B. Hart 4.42 James W. Hart, Jr. 9.68 Steven W. Hart 10.59 V. William Lenoci 26.63 (C) Benefits are computed on the basis of a straight life annuity and are reduced by 50% of the participant's primary Social Security benefit. COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION IN COMPENSATION DECISIONS The Reeves' and Reeves Brothers' Boards of Directors do not have compensation committees, and all final compensation decisions are made by the respective Boards of Directors. The Reeves Brothers Salary Compensation Committee, which is comprised of Douglas B. Hart, James W. Hart, Jr., Steven W. Hart and Patrick M. Walsh, all of whom are officers of Reeves Brothers, advises Reeves Brothers' Board with respect to compensation. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Ownership of Common Stock of Reeves The following table sets forth certain information at March 31, 1994 with respect to ownership of Reeves and Hart Holding common stock by each person who is known to own beneficially, or who may be deemed to own beneficially, more than 5% of the outstanding shares of common stock, directors, the chief executive officer, the other four most highly compensated executive officers and all directors and executive officers as a group. Unless otherwise stated, common stock is directly owned. Reeves ----------------------------- Amount and Name and Nature of Percent of address of beneficial Class beneficial owner ownership Hart Holding Company Incorporated 35,021,666 100.0% 1120 Boston Post Road Darien, CT 06820 Anthony L. Cartagine (1) 0 0.0% 104 West 40th Street New York, NY 10018 Douglas B. Hart 0 0.0% 1120 Boston Post Road Darien, CT 06820 James W. Hart (2) 36,421,666 100.0% 1120 Boston Post Road Darien, CT 06820 James W. Hart, Jr. (3) 0 0.0% 1120 Boston Post Road Darien, CT 06820 Steven W. Hart (4) 0 0.0% 1120 Boston Post Road Darien, CT 06820 V. William Lenoci (5) 0 0.0% Highway 29 South Spartanburg, SC 29304 Directors and Executive Officers as a Group (6) 36,421,666 100.0% (1) As of March 31, 1994, Anthony L. Cartagine is the indirect beneficial owner of 1,000 shares of Hart Holding's common stock, respresenting less than 1% of such outstanding common stock. (2) On January 26, 1994, James W. Hart was granted an option to purchase up to 3,800,000 shares of common stock of Reeves, which has an expiration date of December 31, 2023. The option is exercisable at $.56 per share for 1,400,000 shares (exercisable immediately), $.75 per share for 1,400,000 shares (exercisable one year from grant date) and $1.00 per share for 1,000,000 shares (exercisable two years from grant date). Mr. James W. Hart and Hart Holding may be deemed to be controlling persons of Reeves. As of March 31, 1994, James W. Hart is the beneficial owner of 13,623,507 shares of Hart Holding's commmon stock (94.6%) of which (i) 12,123,507 shares are owned directly, and (ii) 1,500,000 shares are subject to a presently exercisable option (the "Hart Holding Option") issued in November 1993. The Hart Holding Option expires on December 31, 2028 and provides for the issuance of up to 4,000,000 shares upon exercise of options as follows: 1,500,000 immediately exercisable at $2.25 per share; 1,500,000 exercisable one year from grant date at $2.50 per share; and 1,000,000 exercisable two years from grant date at $2.75 per share. (3) As of March 31, 1994, James W. Hart, Jr. is the beneficial owner of 60,300 shares of Hart Holding common stock (representing less than 1% of such outstanding common stock), of which 300 shares are owned directly and the balance is subject to a presently exercisable option. (4) As of March 31, 1994, Steven W. Hart is the beneficial owner of 240,300 shares of Hart Holding common stock (1.9%) of which 180,300 shares are owned directly and the balance is subject to a presently exercisable option. (5) As of March 31, 1994, V. William Lenoci is the beneficial owner of 5,000 shares of Hart Holding common stock, representing less than 1% of such outstanding common stock. (6) As of March 31, 1994, the directors and executive officers of Hart Holding as a group beneficially own an aggregate of 13,930,107 shares of Hart Holding common stock (96%). ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS In connection with the acquisition of the Company, Hart Holding, the Company, Reeves Brothers and three subsidiaries of Reeves Brothers entered into a Tax Allocation Agreement dated as of May 1, 1986, which has been amended and restated from time to time (the "Tax Agreement"). The Tax Agreement provides that Hart Holding and its subsidiaries will file consolidated federal income tax returns as long as they remain members of the same affiliated group. Pursuant to the Tax Agreement, the Company and its subsidiaries generally will pay to Hart Holding amounts equal to the taxes that the Company and its subsidiaries would otherwise have to pay if they were to file separate federal, state or local income tax returns but for the use of tax deductible items of Hart Holding. Hart Holding charges a management fee and allocates portions of its corporate expenses to Reeves on a monthly basis. The management fee and expense allocation aggregated $1.2 million, $1.9 million and $1.8 million for the years ended December 31, 1991, 1992 and 1993, respectively. Effective October 25, 1993, HHCI, Inc., a newly formed, wholly-owned subsidiary of Hart Holding, merged with and into Reeves with Reeves surviving the merger. HHCI, Inc. was formed as a shell corporation (no operations) with a $300,000 capital contribution from Hart Holding. As a result of this merger, Hart Holding obtained ownership of 100% of the outstanding shares of common stock of Reeves and the other stockholders of Reeves received $.56 in cash for each share held by such stockholders. 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. Consolidated Financial Statements of Reeves Industries, Inc. and Subsidiary: Report of Independent Accountants Consolidated Balance Sheet at December 31, 1992 and 1993 Consolidated Statement of Income for the years ended December 31, 1991, 1992, and 1993 Consolidated Statement of Changes in Stockholder's Equity for the years ended December 31, 1991, 1992, and 1993 Consolidated Statement of Cash Flows for the years ended December 31, 1991, 1992, and 1993 Notes to Consolidated Financial Statements 2. Financial Statement Schedules for the years ended December 31, 1991, 1992 and 1993 Schedule V - Property, plant and equipment Schedule VI - Accumulated depreciation, depletion 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 required information is shown in the consolidated financial statements or notes thereto. 3. Exhibits Exhibit No. Name 3.1 @ Restated Certificate of Incorporation of Reeves Industries, Inc. 3.2 (1) Bylaws of Reeves Industries, Inc. 4.1 (2) Purchase Agreement, dated as of May 1, 1986, among Schick Acquisition Corp., A.R.A. Manufacturing Company of Delaware, Inc. and each of the Purchasers. 4.2 (2) Subordinated Debenture Indenture, dated as of May 1, 1986, between Schick Acquisition Corp. and Fleet National Bank, as Trustee (the "Subordinated Debenture Trustee"). 4.3 (2) First Supplemental Indenture, dated as of May 6, 1986, between Reeves Industries, Inc. and the Subordinated Debenture Trustee. 4.4 (2) Second Supplemental Indenture, dated as of October 15, 1986, between Reeves Industries, Inc. and the Subordinated Debenture Trustee. 4.5 (3) Third Supplemental Indenture, dated as of March 24, 1988, between Reeves Industries, Inc. and the Subordinated Debenture Trustee. 4.6 (4) Fourth Supplemental Indenture, dated as of May 7, 1991, between Reeves Industries, Inc. and the Subordinated Debenture Trustee. 4.7 (1) Fifth Supplemental Indenture, dated as of June 30, 1992, between Reeves Industries, Inc. and the Subordinated Debenture Trustee. 4.8 (2) Registration Rights Agreement, dated as of May 1, 1986, among Schick Acquisition Corp. and the purchasers. 4.9 (5) Senior Note Indenture dated as of June 1, 1992, between Reeves Industries, Inc. and Chemical Bank, as Trustee. 10.01 (1) Credit Agreement, dated as of August 6, 1992 (the "Credit Agreement") among Reeves Brothers, Inc., Reeves Indus- tries, Inc., the Banks signatory thereto and Chemical Bank, as Agent. 10.02 (6) First Amendment, Waiver and Consent, dated as of October 25, 1993, to the Credit Agreement. 10.03 @ Second Amendment, dated as of December 28, 1993, to the Credit Agreement. 10.04 (7) Tax Allocation Agreement, effective as of January 1, 1992 by and among Hart Holding Company Incorporated, Reeves Industries, Inc., Reeves Brothers, Inc., Fenchurch, Inc., Turner Trucking Company, Reeves Penna, Inc., A.R.A. Manufacturing Company, Hart Investment Properties Corpo- ration and Hart Capital Corporation. 10.05 (8) * Reeves Corporate Management Incentive Bonus Plan. 10.06 (4) * Employment Agreement dated July 1, 1991, between Reeves Brothers, Inc. and Anthony L. Cartagine. 10.07 @* Employment Agreement dated November 1, 1991, and amended May 18, 1993, between Reeves Brothers, Inc. and Vito W. Lenoci. 10.08 @* Reeves Brothers, Inc. 401(a)(17) Plan, effective January 1, 1989. 10.09 @ Non-Qualified Stock Option Agreement, dated as of January 26, 1994, between Reeves Industries, Inc. and James W. Hart. 10.10 (6) Agreement and Plan of Merger, dated as of October 22, 1993, between Reeves Industries, Inc. and HHCI, Inc. 10.11 (4) Lease Agreement, dated March 28, 1991, between Springs Industries, Inc., Lessor, and Reeves Brothers, Inc., Lessee. 11 Calculation of primary and fully diluted earnings per common share. 12 Computation of Ratio of Earnings to Fixed Charges. 21 Subsidiaries of Reeves Industries, Inc. (1) Previously filed by Reeves Industries, Inc. as an exhibit to Reeves Industries' Annual Report on Form 10-K dated March 31, 1993, which is incorporated by reference herein. (2) Previously filed by Reeves Industries, Inc. as an exhibit to Newreeveco's Registration Statement on Form S-1, Registration No. 33-8192, dated August 21, 1986, as amended October 20, 1986, which is incorporated by reference herein. (3) Previously filed by Reeves Industries, Inc. as an exhibit to Reeves Industries' Annual Report on Form 10-K dated April 12, 1988, which is incorporated by reference herein. (4) Previously filed by Reeves Industries, Inc. as an exhibit to Reeves Industries' Annual Report of Form 10-K dated March 30, 1992, which is incorporated by reference herein. (5) Previously filed by Reeves Industries, Inc. as an exhibit to Reeves Industries' Quarterly Report on Form 10-Q dated August 12, 1992, which is incorporated by reference herein. (6) Previously filed by Reeves Industries, Inc. as an exhibit to Reeves Industries' Quarterly Report on Form 10-Q dated November 10, 1993, which is incorporated by reference herein. (7) Previously filed by Reeves Industries, Inc. as an exhibit to Reeves Industries' Registration Statement on Form S-2, Registration No. 33-47254, dated April 16, 1992, as amended May 28, 1992, which is incorporated by reference herein. (8) Previously filed by Reeves Industries, Inc. as an exhibit to Reeves Industries' Annual Report on Form 10-K dated March 28, 1991, which is incorporated by reference herein. @ Available from the Company. * Management contract or compensatory plan filed pursuant to Item 14(c) of this report. (b) Reports on Form 8-K: There were no reports on Form 8-K 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. REEVES INDUSTRIES, INC. Registrant Date: March 31, 1994 By: /s/ Steven W. Hart ------------------ Steven W. Hart 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 (i) Principal Executive Officer: /s/ James W. Hart, Jr. President, Chief March 31, 1994 Executive Officer and James W. Hart, Jr. Chief Operating Officer (ii) Principal Financial Officer: /s/ Steven W. Hart Executive Vice President, March 31, 1994 Chief Financial Officer Steven W. Hart (iii) Principal Accounting Officer: /s/ Joseph P. O'Brien Vice President - Finance March 31, 1994 Joseph O'Brien (iii) A Majority of the Board of Directors: /s/ James W. Hart Director March 31, 1994 James W. Hart SUPPLEMENTAL INFORMATION TO BE FURNISHED WITH REPORTS FILED PURSUANT TO SECTION 15(d) OF THE ACT BY REGISTRANTS WHICH HAVE NOT REGISTERED SECURITIES PURSUANT TO SECTION 12 OF THE ACT No annual report to security holders covering the Registrant's last fiscal year or proxy material with respect to any meeting of security holders has been sent to security holders of the Registrant. SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION REEVES INDUSTRIES, INC. AND SUBSIDIARY Column A Column B Charged to Item (1) Costs and Expenses ------------------ (In thousands) Maintenance and repairs Year ended December 31, 1991 $ 7,922 ======== Year ended December 31, 1992 $ 7,745 ======== Year ended December 31, 1993 $ 6,328 ======== (1) Other items are less than 1% of revenues or not applicable. INDEX TO EXHIBITS Exhibit No. Name 3.1 Restated Certificate of Incorporation of Reeves Industries, Inc. 10.03 Second Amendment, dated as of December 28, 1993, to the Credit Agreement. 10.07 Employment Agreement dated November 1, 1991, and amended May 18, 1993, between Reeves Brothers, Inc. and Vito W. Lenoci. 10.08 Reeves Brothers, Inc. 401(a)(17) Plan, effective January 1, 1989. 10.09 Non-Qualified Stock Option Agreement, dated as of January 26, 1994, between Reeves Industries, Inc. and James W. Hart. 11 Calculation of primary and fully diluted earnings per common share. 12 Computation of Ratio of Earnings to Fixed Charges. 21 Subsidiaries of Reeves Industries, Inc.

22767_1993.txt

22767_1993

1993

22767

Item 1. BUSINESS. General Development of Business Texas - New Mexico Power Company Texas-New Mexico Power Company (Utility) is a public utility engaged in the generation, purchase, transmission, distribution and sale of electricity to customers within the States of Texas and New Mexico. The Utility is qualified to do business as a foreign corporation in the State of Arizona. Business conducted in Arizona is limited to ownership as tenant-in-common with two other electric utility corporations in a 345-KV electric transmission line which transmits electrical energy into New Mexico for sale to customers in New Mexico. The Utility is the principal subsidiary of TNP Enterprises, Inc. (TNPE), a Texas corporation which owns all of the Utility's common stock. TNPE also files a Form 10-K. The Utility and TNPE are holding companies as defined in the Public Utility Holding Company Act but each is exempt from regulation as a "registered holding company" as defined in said act. The Utility is subject to regulation by the Public Utility Commission of Texas (PUCT) and the New Mexico Public Utility Commission (NMPUC). The Utility is subject in some of its activities, including the issuance of securities, to the jurisdiction of the Federal Energy Regulatory Commission (FERC), and its accounting records are maintained in accordance with the FERC Uniform System of Accounts. The Utility has two wholly owned subsidiaries, Texas Generating Company (TGC), organized in 1988, and Texas Generating Company II (TGC II), organized in 1991. All financial information presented herein or incorporated by reference is on a consolidated basis and all intercompany transactions and balances have been eliminated. TNP One Prior to 1990, the Utility purchased virtually all of its electric requirements, primarily from other utilities. In an effort to diversify its energy and fuel sources, the Utility contracted with a consortium consisting of Westinghouse Electric Corporation, Combustion Engineering, Inc. and H. B. Zachry Company to construct TNP One. TNP One is a two- unit lignite-fueled, circulating fluidized bed generating plant in Robertson County, Texas. Unit 1 and Unit 2 of TNP One together provide, on an annualized basis, approximately 30% of the Utility's electric capacity requirements in Texas. The Utility acquired Unit 1 on July 20, 1990, and Unit 2 on July 26, 1991, through TGC and TGC II, respectively. The Utility operates the two units and sells the output of TNP One to its Texas customers. Unit 1 began commercial operation on September 12, 1990, and Unit 2 on October 16, 1991. As of December 31, 1993, the costs of Unit 1 and Unit 2 were approximately $357 million and approximately $282.9 million, respectively. Portions of the costs were funded by the Utility, with the majority of the costs borrowed by TGC and TGC II under separate financing facilities for the two units, which are guaranteed by the Utility. Regulatory Proceedings The Utility has received rate orders from the PUCT placing the majority of the costs of each of the two units of TNP One in rate base. The Utility and other parties to the proceedings have appealed both orders. For a review of the history of the two rate proceedings and the pending judicial proceedings, see Item 3, "Legal Proceedings" and note 5 to the consolidated financial statements. See note 2 to the consolidated financial statements for a discussion of the financings of the two units including, during 1993, substantial reduction of the TNP One construction indebtedness and extension of the payment schedule for the remaining balance of the construction debt. For a discussion of the effects of the construction and financing of TNP One on the Utility's financial condition, including the detrimental regulatory treatment received to date, see Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations." TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES Financial Information About Industry Segments 1993 1992 1991 Operating Revenues (thousands of dollars): Residential $193,484 175,885 176,651 Commercial 138,680 128,550 119,745 Industrial 124,474 121,027 128,356 Other 17,604 18,365 16,591 Total $474,242 443,827 441,343 Sales (thousand kilowatt-hours): Residential 2,047,360 1,947,593 2,017,349 Commercial 1,567,083 1,499,927 1,485,211 Industrial 2,567,552 2,508,837 2,798,369 Other 104,882 109,954 115,406 Total 6,286,877 6,066,311 6,416,335 Number of customers (at year-end): Residential 181,298 178,154 174,859 Commercial 30,235 30,359 30,300 Industrial 141 155 160 Other 237 229 230 Total 211,911 208,897 205,549 Kilowatt-hour (KWH) sales in 1993 were assisted by more typical weather experienced in 1993 as compared to 1992. KWH sales declined in 1992 from 1991 due in part to milder than normal temperatures in the Utility's service area in Texas; however, revenues were approximately the same for the two years due primarily to an increase in the Utility's Texas customers' rates in 1992. Also contributing to the sales decline was the failure of new customers and revenues to materialize as expected within the industrial class to ameliorate the loss of KWH sales to certain industrial customers. During 1993, the number of industrial customers decreased by 14, but that decrease included the consolidation of 10 customers into 2 customers for billing purposes and the reclassification of 3 customers to the commercial class of customers. See Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations," for a discussion of the changes in operating revenues, including rate increases. It is not possible to attribute operating profit or loss and identifiable assets to each of the classes of customers listed in the above table. Narrative Description of Business The Utility purchases and generates electricity for sales to its customers wholly within the States of Texas and New Mexico. The Utility's purchases of electricity are primarily from other utilities and cogenerators (see "Sources of Energy" in this section). The Utility's current generation of electricity is from TNP One. The Utility owns and operates electric transmission and distribution facilities in 90 municipalities and adjacent rural areas in Texas and New Mexico. The areas served contain a population of approximately 616,000. The Utility's service is delivered to customers in four operating divisions in Texas and one operating division in New Mexico. TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES The Utility's Southeast Division, on the Texas Gulf Coast, is adjacent to the Johnson Space Center and lies between the cities of Houston and Galveston. The economy is supported by the oil and petrochemical industries, agriculture and the general commercial activity of the Houston area. This division produced 49.5% of the total operating revenues in 1993. The Utility's Northern Division is based in Lewisville, just north of the Dallas-Fort Worth International Airport, and extends to include municipalities along the Red River and in the Texas Panhandle. This division serves a variety of commercial, agricultural and petroleum industry customers and produced 19.5% of the Utility's revenues in 1993. The economy of the Utility's New Mexico Division is primarily dependent upon mining and agriculture. Copper mines are the major industrial customers in the New Mexico Division. This division produced 16.8% of the total operating revenues in 1993. The Utility's Central Division includes municipalities and communities located to the south and west of Fort Worth. This area's economy is largely dependent on agriculture and to lesser degrees tourism and oil production. In far west Texas, between Midland and El Paso, the Utility's Western Division serves municipalities whose economies are primarily related to oil and gas production, agriculture and food processing. The Utility serves and intends to continue serving members of the public in all of its present service areas. The Utility will construct facilities as needed to meet increasing demand for its service. The Utility will also extend service beyond its present service territories to the extent permitted by law and the orders of regulatory commissions. For a description of the properties utilized to provide this service, see Item 2, "Properties." Operating Revenues Revenues contributed by the Utility's operating divisions in 1993, 1992 and 1991 and the corresponding percentages of total operating revenues are shown below: 1993 1992 1991 Operating Revenues Revenues Revenues Division (000's) %'s (000's) %'s (000's) %'s Central $39,460 8.3% $35,421 8.0% $34,625 7.8% Northern 92,265 19.5 83,626 18.9 84,227 19.1 Southeast 234,895 49.5 222,460 50.1 220,581 50.0 Western 28,084 5.9 27,193 6.1 27,487 6.2 New Mexico 79,538 16.8 75,127 16.9 74,423 16.9 Total $474,242 100.0% $443,827 100.0% $441,343 100.0% In 1993, 1992 and 1991, no single customer accounted for greater than 10% of operating revenues, although the Utility has two affiliated industrial customers in the New Mexico Division which, together, contributed between 8% and 10% of the Utility's revenues in each of these years. Sources of Energy The Utility obtained its electric energy requirements during the year ended December 31, 1993, from sources shown in the following table. TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES Sources of Energy * The Utility also has a continual contract with Union Carbide to provide energy from natural gas sources for the Texas Gulf Coast. This source did not contribute to the percent of energy required in 1993. ** Except as to one point of delivery, a major source of supply under the contract with an expiration date of 2010, the contract expires in 2006. TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES The Utility's future load growth is considered by the Utility and its suppliers in planning their future construction expenditures based on projections or official contract notifications furnished to its suppliers by the Utility. Currently the resources of TNP One and the suppliers' availability of lignite-, coal-, nuclear-, and gas-fired units are adequate to assure projected requirements for power. To the extent the Utility's suppliers experience delays or increases in the costs of construction of new generating facilities, additional costs of complying with regulatory and environmental laws, or increases in the cost of fuel or shortages in fuel supplies, the availability and cost of energy to the Utility will likewise be affected for that portion of supply purchased by the Utility. The Utility does not expect that the factors discussed in this section will result in the inability of its suppliers to provide the portions of power requirements to be purchased by the Utility. Terminations of service by those suppliers regulated by the FERC (El Paso Electric Company, Southwestern Public Service Company, West Texas Utilities Company and Public Service Company of New Mexico) would require authorization by that commission. The Utility anticipates renewing and amending its purchased power contracts with its suppliers as necessary. As a result of the Utility's efforts in contracting for lower costs of purchased power, the Utility's New Mexico customers are expected to benefit from a scheduled decrease of approximately $7.1 million in annualized firm purchased power costs in 1994, the effect of which will be reduced by a $400,000 increase in base rates. In 1990 and 1991, the Utility commenced replacing portions of its Texas purchased power requirements when Unit 1 and Unit 2, respectively, became operational. Beginning in 1992, the full effect of the electric generation of both units was realized. Provisions in the contracts with Texas Utilities Electric Company and Houston Lighting & Power Company allow for reductions in future purchased power commitments. Power generated at TNP One is transmitted over the Utility's own transmission line to other utilities' transmission systems for delivery to the Utility's Texas service area systems. To aid in maintaining a reliable supply of power for its customers and to coordinate interconnected operations, the Utility is a member of the Electric Reliability Council of Texas (ERCOT), the Inland Power Pool and the New Mexico Power Pool. See Item 3, "Legal Proceedings," Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations" and notes 2 and 5 to the consolidated financial statements for additional information about TNP One. Recovery of Purchased Power and Fuel Costs The Utility expects to refund or collect within two months or less those amounts of total purchased power costs (including supplier fuel costs) billed to the Utility from suppliers that are over- or under- collected in the current month. Purchased power cost recovery adjustment clauses in the Utility's rate schedules have been authorized by the regulatory authorities in Texas and New Mexico. A fixed fuel recovery factor in Texas has also been approved. Both are of substantial benefit to the Utility in efforts to recover timely and adequately these significant elements of operating expenses as described in note 1(g) to the consolidated financial statements. Franchises The Utility holds franchises from each of the 90 municipalities in which it renders electric service. On December 31, 1993, these franchises had expiration dates varying from 1994 to 2039, 86 having stated terms of 25 years or more and two having stated terms of 20 years and two having stated terms of 15 years. The Utility also holds certificates of public convenience and necessity from the PUCT covering all of the territories it serves in Texas. The Utility has been issued certificates for other areas after hearings before the PUCT. These certificates include terms which are customary in the public utility industry. In New Mexico, the Utility operates generally under the grandfather clause of that state's Public Utility Act which authorizes the continuance of existing service following the date of the adoption of such act. Seasonality of Business The Utility's business is seasonal in character. Summer weather causes increased use of air-conditioning equipment which produces higher revenues during the months of June, July, August and September. For the year ended December 31, 1993, approximately 40% of annual revenues were recorded in June, July, August and September, and 60% in the other eight months. TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES Working Capital The Utility's major demands on working capital are (1) the monthly payments for purchased power costs from the Utility's suppliers, (2) monthly and semi-annual interest payments on long-term debt and (3) semi-monthly payments for the lignite fuel source for TNP One. The purchased power and fuel costs are eventually recovered through the Utility's customers' rates and the purchased power and fuel costs recovery adjustment clauses and fixed fuel factors, more fully described in note 1(g) to the consolidated financial statements. Unlike many other generating utilities, the Utility does not have the requirement of maintaining a large fuel inventory (lignite) due to the proximity of TNP One with the lignite mine site. The Utility sells customer receivables, as do many other utilities. The Utility sells its customer receivables to a nonaffiliated company on a nonrecourse basis. Competitive Conditions As a regulated public utility, the Utility operates with little direct competition throughout most of its service territory. Pursuant to the Texas Public Utility Regulatory Act, the PUCT has issued to all electric utilities in the State certificates of public convenience and necessity authorizing them to render electric service. Rural electric cooperatives, investor-owned electric utilities and municipally owned electric utilities are all defined in such act as public utilities. In 72 of the 81 Texas municipalities served, the Utility has been the only electric utility issued a certificate to serve customers within the municipal limits. The Utility is also the only electric utility authorized to serve customers in some of the rural areas where it has electric facilities. In other rural areas served by the Utility, other electric utilities have also been authorized to serve customers; however, rural electric cooperatives may, under certain circumstances, become exempt from the PUCT's rate regulation. Where other electric utilities have also been certificated to serve customers within the same service area, the Utility may be subject to competition. From time to time, industrial customers of the Utility express interest in cogeneration as a method of reducing or eliminating reliance upon the Utility as a source of electric service, or to lower fuel costs and improve operating efficiency of process steam generation. During 1993, a major industrial customer in the Utility's Southeast Division requested proposals for a cogeneration project for evaluation by the customer. The Utility's operating revenues from this customer during 1993 were approximately $28 million. In January 1994, a potential developer for the proposed project was selected by the customer. The Utility's goal is to retain this customer and to lower overall system operating costs through coordination with the potential developer. Although the Utility cannot predict the ultimate outcome of the process, the current project as proposed by the customer, and as outlined by the potential developer, appears to present a means by which the Utility may retain electric service to this customer, at current levels. The Utility is actively pursuing the development of the necessary agreements with the potential developer to further define the degree to which electric service to this customer is retained and overall system operating costs may be lowered. In New Mexico, a utility subject to the jurisdiction of the NMPUC may not extend into territory served by another utility or into territory not contiguous to its service territory without a certificate of public convenience and necessity from the NMPUC. Investor-owned electric utilities and rural electric cooperatives are subject to the juris- diction of the NMPUC. The Energy Policy Act of 1992, adopted in October 1992, significantly changed the U.S. energy policy, including the governing of the electric utility industry. Among the features of this act is the creation of Exempt Wholesale Generators and the authorization of the FERC to order, on a case-by-case basis, wholesale transmission access. It appears that these particular features will create competition for the generation and supply of electricity. Management continues to evaluate the effects of this act on the Utility. Although the act may not affect the Utility directly, the Utility believes that this increased competition will not have an unfavorable impact on it. TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES Environmental Requirements Environmental requirements are not expected to materially affect capital outlays or materially affect the Utility directly. As the Utility's electric suppliers may be affected by environmental requirements and resulting costs, the rates charged by them to the Utility may be increased and thus the Utility will be affected indirectly. The Utility's facilities in Texas and New Mexico are regulated by federal and state environmental agencies. These agencies have jurisdiction over air emissions, water quality, wastewater discharges, solid wastes and hazardous substances. The Utility maintains continuous procedures to insure compliance with all applicable environmental laws, rules and regulations. Various Utility activities require permits, licenses, registrations and approvals from such agencies. The Utility has received all necessary authorizations for the construction and continued operation of its generation, transmission and distribution systems. TNP One's circulating fluidized bed technology produces "clean" emissions, without the addition of costly scrubbers. Unit 1 and Unit 2 meet the standards of the Clean Air Act of 1990. Under this act, an entity will be given an allotted number of allowances which permit emissions up to a specified level. The Utility believes the allowances received to be sufficient for the level of emissions to be created by TNP One. The construction costs for TNP One included approximately $89 million for environmental protection facilities. During 1993, 1992 and 1991, as an ongoing operation of air pollution abatement, including ash removal, TNP One incurred expenses of approximately $2.6 million, $2.7 million and $1.9 million, respectively. The Utility anticipates additional capital expenditures of $875,000 by 1995 for air emissions monitoring equipment for TNP One. The operations of the Utility are subject to a number of federal, state and local environmental laws and regulations, which govern the storage of motor fuels, including those regulating underground storage tanks. In September 1988, the Environmental Protection Agency (EPA) issued regulations that required all newly installed underground storage tanks be protected from corrosion, be equipped with devices to prevent spills and overfills, and have a leak detection method that meets certain minimum requirements. The effective commencement date for newly installed tanks was December 22, 1988. Underground storage tanks in place prior to December 22, 1988, must conform to the new standards by December 1998. The Utility currently estimates the cost over the next five years to bring its existing underground storage tanks into compliance with the EPA guidelines will be $100,000. The Utility also has the option of removing any existing underground storage tanks. During 1993, 1992, and 1991, the Utility incurred cleanup and testing costs on both leaking and nonleaking storage tanks of approximately $98,000, $89,000, and $84,000, respectively, in complying with these EPA regulations. A change in the regulations in the State of Texas permitted the Utility to collect in 1992 from the state environmental trust fund $65,000 of expenditures paid in prior years. Both states in which the Utility owns or operates underground storage tanks have state operated funds which reimburse the Utility for certain cleanup costs and liabilities incurred as a result of leaks in underground storage tanks. These funds, which essentially provide insurance coverage for certain environmental liabilities, are funded by taxes on underground storage tanks or on motor fuels purchased within each respective state. The funds require the Utility to pay deductibles of less than $5,000 per occurrence. During 1992, the Texas state environmental trust fund delayed reimbursement payments after September 30, 1992, of certain cleanup costs due to an increase in claims. Because the state and federal government have the right, by law, to levy additional fees on fuel purchases, the Utility believes these cleanup costs will ultimately be reimbursed. Employees The number of employees on December 31, 1993, was 1,051. TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES Item 2. Item 2. PROPERTIES. The Utility's electric properties served a total of 211,911 customers at year-end and consisted of the installations described in the following sections. (1) Electric generation, transmission and distribution facilities located in the State of Texas are as follows: (A) Central Division. Electric transmission and distribution systems serving 25 municipalities and 18 unincorporated communities in 17 counties to the south and west of Fort Worth, Texas. The division is based at Clifton, Texas. (B) Northern Division. Electric transmission and distribution systems serving 36 municipalities and 19 unincorporated communities in 14 North Texas counties and 3 counties in the Texas Panhandle. The division is based at Lewisville, Texas. (C) Southeast Division. Electric transmission and distribution systems serving 14 municipalities and 2 unincorporated communities in 3 counties on the Texas Gulf Coast. The division is based at Texas City, Texas. (D) Western Division. Electric transmission and distribution systems serving 6 municipalities and 1 unincorporated community in 5 counties in West Texas. The division is based at Pecos, Texas. (E) Robertson County, Texas. Two 150-megawatt lignite-fueled generating units (Unit 1 and Unit 2, collectively referred to as TNP One) using circulating fluidized bed technology. The Utility also has an 18-mile long transmission line to connect TNP One to a major transmission grid in Texas. (2) Electric generation, transmission and distribution facilities in the State of New Mexico serve 5 municipalities and 5 unincorporated communities in Grant and Hidalgo Counties, and 4 municipalities and 1 unincorporated community in Otero and Lincoln Counties. The New Mexico Division is based at Silver City, New Mexico. (3) The facilities owned by the Utility include those normally used in the electric utility business. The facilities are of sufficient capacity to adequately serve existing customers, and such facilities may be extended and expanded to serve future customer growth of the Utility in existing service areas. The Utility generally constructs its transmission and distribution facilities upon real property held pursuant to easements or public rights of way and not upon real property held in fee simple by the Utility. (4) All real and personal property of the Utility, with certain exceptions such as much of TNP One, is subject to the lien of the Indenture of Mortgage and Deed of Trust (Bond Indenture) under which the Utility's First Mortgage Bonds are issued. Certain exceptions are set forth in the Bond Indenture. The lenders in the Unit 2 financing facility and the holders of all secured debentures hold a second lien on all real and personal Texas property of the Utility. Holders of the Utility's Secured Debentures, due 1999 and Series A, Secured Debentures, due 2003 equally and ratably hold first liens on approximately 59% of Unit 1. The remaining amount of Unit 1 property is subject to a first lien under the Utility's Bond Indenture and a second lien under the secured debentures' indentures. The lenders under the Unit 2 financing facility and the Utility's Secured Debentures, due 1999, equally and ratably hold first liens on approximately 74% of Unit 2. The remaining amount of Unit 2 property is subject to a first lien under the Utility's Bond Indenture and a second lien under the secured debentures' indentures. Under certain conditions, upon repayment of portions of the loans or secured debentures under the financing facilities, the Utility may purchase undivided interests in Unit 1 or Unit 2 from TGC or TGC II, respectively, whereupon such undivided interests become subject to the first lien of the Utility's Bond Indenture. See note 2 to the consolidated financial statements for additional information. TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES Item 3. Item 3. LEGAL PROCEEDINGS. Appeals of Regulatory Orders The following summary discusses the Utility's most recent regulatory proceedings before the PUCT and the judicial appeals. While the ultimate outcome of these cases and of other matters discussed below cannot be predicted, the Utility is vigorously pursuing their favorable conclusion. Material adverse resolution of certain of the matters discussed below would have a material adverse impact on earnings in the period of resolution. More detailed discussions of the proceedings and related impacts are included in note 5 to the consolidated financial statements and Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations." PUCT Docket No. 9491 On April 11, 1990, the Utility filed a rate application, Docket No. 9491, with the PUCT for inclusion of the costs of Unit 1 in the Utility's rate base and for the setting of rates to recover the costs of that unit. On February 7, 1991, the Utility received a final order which allowed $298.5 million of the costs of Unit 1 in rate base; however, the PUCT disallowed from rate base $39.5 million of the requested investment costs of $338 million for that unit. The PUCT approved an increase in annualized revenues of approximately $36.7 million, or 67% of the Utility's original $54.9 million rate request. The PUCT also found that the Utility failed to prove that its decision to start construction of Unit 2 was prudent. Nevertheless, the PUCT granted rate base treatment for Unit 2 in Docket No. 10200, as discussed below. On appeal by the Utility of the PUCT's order in Docket No. 9491, a State district court in Travis County, Texas, ruled that the PUCT's disallowance of rate base treatment for certain costs of Unit 1 was in error and that the PUCT's "decision to deny $39,508,409 in capital costs for TNP One Unit 1 is not supported by substantial evidence and is arbitrary and capricious." On appeal of the State district court's order by the Utility , the PUCT and certain of the intervenor cities (the Cities), a Third District Court of Appeals in Austin, Texas, rendered a judgment partially reversing the State district court and affirming the PUCT's disallowances for $30.4 million of the total $39.5 million. The Court of Appeals remanded the cause to the district court with instructions that the cause be remanded to the PUCT for proceedings not inconsistent with the appellate opinion. On September 9, 1993, the Utility, the Cities and the PUCT filed motions for rehearing with the Court of Appeals. The Utility's opponents are seeking, among other things, lower rates and greater disallowances, and the Utility is seeking higher rates and no disallowances. The PUCT is not expected to act upon the district court's ordered remand, discussed above, until the appellate process, including appeals to the Texas Supreme Court, has been completed. Based upon the opinions of the Utility's Texas regulatory counsel, Johnson & Gibbs, a Professional Corporation, management believes that it will prevail in obtaining a remand of a significant portion of the disallowances in Docket No. 9491; however, the ultimate disposition and quantification of these items cannot presently be determined. Accordingly, no provision for any loss that may ultimately be required upon resolution of these matters has been made in the consolidated financial statements. If the Utility is not successful in obtaining a final favorable disposition in the appellate proceedings relating to the disallowances in Docket No. 9491, a write-off of some portion of the $39.5 million disallowances would be required, which could result in a significant negative impact on earnings in the period of final resolution. TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES PUCT Docket No. 10200 On April 11, 1991, the Utility filed a rate application, Docket No. 10200, with the PUCT for inclusion of $275.2 million of capital costs of Unit 2 in the Utility's rate base and for the setting of rates to recover the costs of that unit. On March 18, 1993, the Utility received a final order which allowed $250.7 million of the Unit 2 costs in rate base; however, the PUCT disallowed from rate base $21.1 million associated with Unit 2 and $0.8 million additional costs requested for Unit 1. The PUCT also determined that $11.1 million of Unit 2 costs would be addressed in a future Texas rate application. The PUCT approved an increase in annualized revenues of approximately $19 million, or 53% of the Utility's original $35.8 million rate request. The order in Docket No. 10200 also reflects application to the Utility of a new method for calculating the amount of Federal income tax expense allowed in cost of service, which significantly reduced the Utility's level of annualized revenue increase from $26 million to $19 million. The Docket No. 10200 rate order has been appealed to a Texas district court by the Utility and other parties. Because of the Court of Appeals judgment relating to the prudence of starting construction of Unit 2 (FF No. 84 in the docket No. 9491), the presiding judge in the Texas district court for the Docket No. 10200 appeal has ordered that the procedural schedule in this appeal be abated until final resolution of the FF No. 84 issue in Docket No. 9491. The Utility will vigorously pursue reversal of the PUCT's new position regarding Federal income tax expenses, in addition to seeking judicial relief from the disallowances and certain other rulings by the PUCT in Docket No. 10200. The opposing parties are seeking a variety of relief to obtain lower rates and greater disallowances, including overturning the basis of the Utility's case as presented to the PUCT and sustaining the PUCT's adverse Federal income tax position without regard to any IRS ruling on the normalization issue. Based upon the opinions of the Utility's Texas regulatory counsel, Johnson & Gibbs, a Professional Corporation, management believes that it will prevail in obtaining a remand of a significant portion of the disallowances in Docket No. 10200; however, the ultimate disposition and quantification of these items cannot presently be determined. Accordingly, no provision for any loss that may ultimately be required upon resolution of these matters has been made in the consolidated financial statements. If the Utility is not successful in obtaining a final favorable disposition in the appellate proceedings relating to the disallowances in Docket No. 10200, a write-off of some portion of the $21.9 million disallowances would be required, which could result in a significant negative impact on earnings in the period of final resolution. Other Legal Matters The Utility is involved in various claims and other legal actions arising in the ordinary course of business. In the opinion of management, the ultimate disposition of these matters will not have a material adverse effect on the Utility's consolidated 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 in the fourth quarter of 1993. PART II Item 5. Item 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED SHAREHOLDER MATTERS. All of the Utility's issued and outstanding common stock, 10,705 shares, is privately held, beneficially and of record, by its parent, TNPE, and is not publicly traded. For the years ended December 31, 1993 and 1992, the Utility paid $17,344,000, and $13,840,200, respectively, in common dividends to its parent, TNPE. Dividends were paid on a quarterly basis. Restrictions on the Utility's ability to pay dividends are discussed in notes 2 and 3 to the consolidated financial statements. TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES Item 6. Item 6. SELECTED CONSOLIDATED FINANCIAL DATA. Included in the First Mortgage Bond sinking fund payments and retirements amount for 1997 is $130 million of First Mortgage Bonds, Series T, which mature January 15, 1997. The Utility anticipates that it will refinance these bonds and the Secured Debentures due in 1999 through the issuance of additional First Mortgage Bonds or other debt securities, and/or the receipt of common equity from TNPE. The Utility does not need additional Available Additions (described below under "Capital Resources") in order to issue First Mortgage Bonds for the purpose of refunding outstanding First Mortgage Bonds. As a result of the assumption of the financing facilities for Unit 1 and Unit 2 in 1990 and 1991, respectively, and related refinancings, the Utility's capital structure consisted of 75.2% debt, 23.7% common equity and 1.1% preferred stock at December 31, 1993. Prior to 1990, the Utility's capital structure contained less than 50% debt. The Utility's long-term goal is to strive for a conservative capital structure with a debt ratio of less than 50%. Capital Resources At any time, the Utility's ability to access the capital markets on a reasonable basis or otherwise obtain needed financing for operating and capital requirements is subject to the receipt of adequate and timely regulatory relief and market conditions. The Utility's ability to access the capital markets at reasonable costs will specifically be impacted by the ultimate resolution of (1) the amount of rate relief granted for Unit 1 and Unit 2, (2) the contested disallowances of up to $40.3 million and $21.1 million of the costs of Unit 1 and Unit 2, respectively, and (3) the adverse PUCT ruling concerning the treatment of the Federal income tax component of the Utility's cost of service. In addition to the aforementioned Unit 2 financing facility, the Utility's external sources for acquiring capital are outlined below: First Mortgage Bonds. Assuming an interest rate of 9.25% and satisfactory market conditions, based upon December 31, 1993 financial information, the Utility could have issued approximately $59 million of additional First Mortgage Bonds under the Interest Coverage Ratio requirement. With certain exceptions, the amount of additional First Mortgage Bonds that may be issued is also limited by the Bond Indenture to a certain amount of physical properties which are to be collateralized by the first lien mortgage of the Bond Indenture (Available Additions). Because of the issuance of the New Bonds in September 1993, the Utility has limited ability to issue additional First Mortgage Bonds until more Available Additions are provided upon further repayment of amounts under the financing facilities. Secured Debentures. The indenture, under which the Series A Secured Debentures were issued, permits, generally, the issuance of additional secured debentures to the extent that the proceeds from such issuance are used to purchase an equal amount of loans under the Unit 1 and Unit 2 financing facilities. TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES Preferred Stock. Due to interest and dividend coverage tests required for issuance of its preferred stock, the Utility cannot presently issue any preferred stock. The Utility does not expect to have the ability to issue preferred stock through 1996. Receipt of Common Equity One source for repayment of the Unit 2 financing facility is anticipated to be the receipt of common equity from TNPE. Receipt of future equity contributions by the Utility from TNPE will be largely dependent upon TNPE's ability to issue common stock. Since most of the assets, liabilities and earnings capability of TNPE are those of the Utility, the ability of TNPE to issue common stock and pay dividends will be largely dependent upon the Utility's operations and the Utility's restrictions regarding payment of cash dividends on its common stock. The Utility may not pay dividends on its common stock unless all past and current dividends on outstanding preferred stock of the Utility have been paid or declared and set apart for payment and all requisite sinking or purchase fund obligations for the preferred stock of the Utility have been fulfilled. Charter provisions relating to the preferred stock and the Bond Indenture under which First Mortgage Bonds are issued contain restrictions regarding the retained earnings of the Utility. At December 31, 1993, pursuant to the terms of the Bond Indenture, approximately $12.8 million of the Utility's $38.9 million of retained earnings was restricted. In addition, the financing facilities place certain restrictions on the Utility's ability to pay dividends on its common stock, unless certain threshold tests are met. The Utility has satisfied the threshold tests since they became effective, and the Utility does not expect that any of the aforementioned contractual restrictions on the payment of dividends will become operative in 1994. However, the Utility can give no assurance that the Utility will satisfy such tests in the future. The Utility's 1993 common stock dividends of $17.3 million exceeded 1993 earnings available for common stock of $10.6 million; however, the Utility's retained earnings were sufficient to allow the dividends to be paid. Contributing to the low-level of earnings in 1993 were the lower rates from the December 1992 adverse ruling of the PUCT regarding the Utility's Federal income tax component in its cost of service and significant interest charges. As discussed in "Net Earnings" under "Results of Operations", management has implemented cost saving measures during 1993 and is seeking equitable regulatory treatment in efforts to improve future results of operations. Cash dividend payments are subject to approval of the Board of Directors and are dependent, especially in the longer term, on the Utility's and TNPE's future financial condition and adequate and timely regulatory relief, including favorable resolution of pending judicial appeals of rate cases. Other Matters Accounting for Postretirement Benefits On January 1, 1993, the Utility implemented Statement of Financial Accounting Standards No. 106 (SFAS 106), "Employers' Accounting for Postretirement Benefits Other Than Pensions," which addresses the accounting for other postretirement employee benefits (OPEBs). For the Utility, OPEBs are comprised primarily of health care and death benefits for retired employees. Prior to 1993, the costs of these OPEBs were expensed on a "pay-as-you-go" basis. Beginning in 1993, SFAS 106 requires a change from the "pay-as-you-go" basis to the accrual basis of recognizing the costs of OPEBs during the periods that employees render service to earn the benefits. The 1993 accrual for OPEBs of $2,952,000, based on adoption of SFAS 106, was $2,276,000 greater than the amount that would have been recorded under the "pay- as-you-go" basis. In March 1993, the PUCT issued its rules for ratemaking treatment of OPEBs. As part of a general rate case, a utility may request OPEBs expense in cost of service for ratemaking purposes on an accrual basis in accordance with generally accepted accounting principles. The PUCT's rule requires that the amounts included in rates shall be placed in an irrevocable external trust fund dedicated to the payment of OPEBs expenses. Based on the PUCT's rule, the Utility intends to seek recovery of OPEBs expense attributable to its Texas jurisdiction in its next Texas rate case. In order to comply with the PUCT's condition for possible recovery of OPEBs expenses, the Utility established in June 1993 a Voluntary Employees' Beneficiary Association (VEBA) trust fund, dedicated to the payment of OPEBs expenses. Monthly cash payments made to the VEBA, which began in June 1993, will fund OPEBs costs for the Utility's Texas and New Mexico operations. See note 1(j) to the consolidated financial statements for information about the funded status of the plan. TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES On August 23, 1993, the Utility filed a rate application with the NMPUC which included a request for recovery of the applicable costs of OPEBs. A stipulated agreement among the parties to the proceeding, dated January 28, 1994, subject to approval by the NMPUC, would include such applicable costs in the proposed New Mexico rates, beginning in 1994. For future periods, the costs of OPEBs will be affected by changes in the assumed interest rate and the trends in health care costs; based on actuarial assumptions, national health care costs are expected to increase in the future, resulting in further increases in the Utility's costs. Accounting for Income Taxes On January 1, 1993, the Utility implemented Statement of Financial Accounting Standards No. 109 (SFAS 109), "Accounting for Income Taxes." The implementation of SFAS 109 did not result in any significant charge to operations. See note 4 to the consolidated financial statements for details relating to the implementation of SFAS 109. Accounting for Postemployment Benefits The FASB has issued Statement of Financial Accounting Standards No. 112 (SFAS 112), "Employers' Accounting for Postemployment Benefits" which addresses the accounting and reporting for the estimated costs of benefits provided by an employer to former or inactive employees after employment but before retirement. SFAS 112 is effective for fiscal years beginning after December 15, 1993. The Utility estimates such costs to be immaterial. Effects of Inflation The Utility does not believe that the effects of inflation, as measured by the Consumer Price Index over the last three years, have had a material impact on the Utility's consolidated results of operations and financial condition. Tax Law Change The Omnibus Budget Reconciliation Act of 1993 was signed into law on August 10, 1993. Beginning in 1994, the act provides for the disallowance of certain business deductions, the effect of which is not expected to be material for the Utility. The act also provided, effective January 1, 1993, for a corporate income tax rate increase from 34% to 35% to be phased in for taxable income between $10 million and $18 million. Results of Operations The following table sets forth the percentage relationship of items to operating revenues in the consolidated statements of earnings: TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES Operating Revenues Operating revenues for 1993 and 1992 reflect increases of $30,415,000 and $2,484,000 over the respective prior years. The following table presents the components of the changes in operating revenues: Base operating revenues are affected primarily by changes in base rates resulting from regulatory commission orders and the effects of variations in sales between customer classifications. The significant increase in base operating revenues for 1992 was primarily attributable to bonded rates for Docket No. 10200 being placed into effect in October 1991. The PUCT's final order approving these rates was received on October 16, 1992 and subsequently was amended by the PUCT in an Order on Rehearing on December 22, 1992. The result of this Order on Rehearing was to lower the previously approved increase in annualized revenues by approximately $7 million, from $26 million to approximately $19 million. The PUCT later increased, subject to refund, the annualized revenues by an additional $1.6 million. Because the increase continued to be subject to a possible refund, no additional revenues were recognized in 1992 or 1993 and such amounts were included in revenues subject to refund in the consolidated balance sheets. For more information regarding Docket No. 10200, see note 5 to the consolidated financial statements. Purchased power costs are recovered through cost recovery factor clauses in both Texas and New Mexico. Fuel costs are recovered through a fixed fuel factor approved by the PUCT. Recoveries of purchased power and fuel costs are discussed further in "Operating Expenses." Customer usage increased in 1993 due to a 3.6% increase in kilowatt- hour (KWH) sales to residential, commercial and industrial customers. The residential usage increase related to an increase in the number of residential customers and warmer temperatures in the Texas service areas; in 1992, milder than normal weather was experienced in the Texas service areas. Commercial usage increased in the Utility's Texas service areas as the result of general retail development in the Northern Division and Southeast Division and the addition of a greyhound race track in the Southeast Division. During 1993, the number of industrial customers decreased by 14, but that decrease included the consolidation of 10 customers into 2 customers for billing purposes and the reclassification of 3 customers to the commercial class of customers. The industrial usage increase in the Utility's New Mexico service area resulted from increased consumption of an existing mining customer and the addition of a new mining customer. The 1992 decrease in customer usage primarily reflected a 5.46% KWH sales decline. Part of the decrease in customer usage was attributable to the milder than normal temperatures experienced in Texas during 1992. Also contributing to the sales decline was the failure of new customers and revenues to materialize as expected within the industrial class to ameliorate the loss of KWH sales to certain industrial customers. From time to time, industrial customers of the Utility express interest in cogeneration as a method of reducing or eliminating reliance upon the Utility as a source of electric service, or to lower fuel costs and improve operating efficiency of process steam generation. During 1993, a major industrial customer in the Utility's Southeast Division requested proposals for a cogeneration project for evaluation by the customer. The Utility's operating revenues from this customer during 1993 were approximately $28 million. In January 1994, a potential developer for the proposed project was selected by the customer. The Utility's goal is to retain this customer and to lower overall system operating costs through coordination with the potential developer. Although the Utility cannot predict the ultimate outcome of the process, the current project as proposed by the customer, and as outlined by the potential developer, appears to present a means by which the Utility may retain electric service to this customer, at current levels. The Utility is actively pursuing the development of the necessary agreements with the potential developer to further define the degree to which electric service to this customer is retained and overall system operating costs may be lowered. TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES For information relating to actual KWH sales, number of customers, and revenues, see Item 1, "Financial Information about Industry Segments." Operating Expenses As a regulated entity, the Utility must demonstrate to the regulatory commissions in its rate filings that its requests for recovery of operating expenses to provide service to its customers are reasonable and necessary. In order to provide reliable service to its customers at reasonable rates, management endeavors to control costs through budgeting and monitoring of operating expenses. Commencement of commercial operations of Unit 1 in September 1990 and Unit 2 in October 1991 led to increases in certain expenses and interest charges over prior years; however, the Utility experienced decreases in the potential cost of power purchased for resale as a result of the operations of Unit 1 and Unit 2. The 1993 and 1992 levels of expenses each reflect a full year's operations of both units. Variances in expenses from 1991 to 1992 due to a partial year's operation of Unit 2 in 1991 are noted in the following discussion. Power Purchased for Resale Factors affecting the expense of power purchased for resale are (1) the number of KWH purchased from suppliers, (2) the cost per KWH purchased, (3) the recovery or refund of prior under- or over-collections, respectively, of purchased power costs (deferred purchased power costs), and (4) occasional fuel cost refunds from the Utility's suppliers. The Utility's policy regarding the accounting for deferred purchased power costs is discussed in note 1(g) to the consolidated financial statements. Power purchased for resale increased $25,926,000 in 1993, and a decrease of $42,561,000 was experienced in 1992. The increase in purchased power expense for 1993 was mainly due to an increase in the average cost of KWH purchased from suppliers. Information concerning the Utility's suppliers is disclosed in Item 1 under "Sources of Energy." Also contributing to the increase in 1993 was an increase in the number of KWH purchased as a result of increased customer usage, discussed under "Operating Revenues." The decrease in 1992 resulted from a decline in the number of KWH purchased. This KWH decrease was caused by the replacement of purchased power with a full year's generation of Unit 2 of TNP One and the decrease in customer usage, discussed under "Operating Revenues." Partially offsetting the effect of this reduction in the number of KWH purchased in 1992 was an increase in the recovery of deferred purchased power costs. As in 1992, the 1993 level of KWH purchases reflects a full year's generation of TNP One; therefore, KWH purchases for 1993 and 1992 are comparable in this respect. No significant changes in KWH purchased resulting from TNP One's operations are expected in the future. While costs per KWH from purchased power suppliers are not directly controllable, wholesale rates charged by various suppliers are subject to regulatory authority. The Utility has intervened and will continue to intervene in suppliers' rate cases for the purpose of assuring fair and equitable costs to its customers. Fuel Fuel expense decreased $629,000 in 1993, as compared to an increase of $19,204,000 in 1992. The decrease in recovery of fuel costs for 1993 resulted from a slightly lower fuel cost recovery factor than that utilized in 1992. These differing fuel factors resulted from using a factor related to bonded rates in 1992 which was adjusted downward in 1993 to comply with the final order in Docket No. 10200. The large increase in 1992 was related to a full year's commercial operation of both Unit 1 and Unit 2. Fuel expense primarily represents the recovery of fuel costs through a fixed fuel factor set by the PUCT. The fixed fuel factor is intended to permit the Utility to recover the cost of fuel utilized to generate electricity sold in Texas. The factor may be changed only upon approval of the PUCT and is expected to be adjusted for any cumulative under- or over-recovery of fuel costs. At December 31, 1993, the Utility had under-recovered fuel costs, including interest, of approximately $13.6 million related to both units of TNP One. Any requests to the PUCT for recovery of fuel costs require the Utility's demonstration that the costs were reasonable. TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES Beginning in 1993, a filing with the PUCT for a reconciliation of fuel costs is required if for any given period of time there is an over- or under-recovery of fuel costs of at least 4% of revenues. Under the PUCT's rules, the months in which utilities may initiate fuel reconciliation proceedings are specified; for the Utility, these months are June and December. In the event of an over- or under-recovery of fuel costs less than the 4% threshold, a filing to adjust the fuel factor may be made at the discretion of management. The Utility expects to file a fuel reconciliation with its next Texas rate application during the first half of 1994. Management will continue to monitor its fuel cost recovery to determine the need to request a change in its fixed fuel factor. For a discussion of the fuel supply agreement for TNP One, see "Other TNP One Matters" under "Financial Condition." Other Operating and General Expenses and Maintenance Other operating and general expenses decreased $597,000 in 1993 after an increase of $4,716,000 in 1992. The 1993 decrease represents primarily decreases in employee pension and thrift benefits and payroll costs which were offset somewhat by an increase in employee postretirement medical costs resulting from implementation of SFAS 106. The decrease in the employee benefits for 1993 was due to an amendment to the pension plan and the curtailment of employer thrift plan contributions on January 1, 1993. Payroll costs declined due to a 3.2% reduction in the number of employees. The increase in other operating and general expenses for 1992 was due primarily to additional wheeling costs which were incurred for a full year's transfer of power generated by Unit 2 and to amortization of previously deferred rate case expenses. Wheeling costs are incurred for the transfer of TNP One power over other utilities' transmission systems for delivery to the Utility's Texas systems. The years 1993 and 1992 reflected wheeling costs for both Unit 1 and Unit 2; therefore, any future changes in this level of expense would be the result of changes in monthly wheeling charges. Regarding deferred rate case expenses, a full year's amortization was reflected in both 1993 and 1992, making them comparable in this respect; in 1994, another year's amortization remains for the deferred rate case expenses. As previously discussed under "Financial Condition," implementation of SFAS 106 may lead to additional costs in the future. Other operating and general expenses will be affected in 1994 because of a 3% cost-of-living payroll adjustment for full-time employees effective January 10, and the restoration of employer thrift plan contributions scheduled to resume beginning July 1. Since the last cost-of-living payroll adjustment granted to the Utility's employees was in 1991, these changes were made to maintain the level of experienced personnel necessary for providing quality service to the Utility's customers. No significant variances have occurred in maintenance expense over the last three years. Maintenance outages are scheduled in the first and fourth quarters of 1994 for Unit 2 and Unit 1, respectively. Since prior years reflect expenses for past scheduled outages of the units, no significant increase in maintenance expense is anticipated in 1994. Depreciation of Utility Plant Depreciation expense increased $917,000 and $7,071,000 in 1993 and 1992, respectively. The 1993 increase was related to normal additions to utility plant while the large increase in 1992 reflects a full year's expense for Unit 2 and Unit 1. Future increases in depreciation would be the result of normal utility plant additions and regulatory approvals of changes in depreciation rates as supported by required periodic independent studies. Taxes, Other Than On Income Taxes, other than on income increased $1,046,000 and $5,462,000 in 1993 and 1992, respectively. The 1993 increase related primarily to an increase in revenue-related taxes which resulted from increased revenues upon which the taxes are based. The increase in 1992 was primarily related to an increase in property-related taxes resulting from (1) a full year's expense related to Unit 2 as compared to only a partial year in 1991 and (2) increases in the property tax rates in Texas. Income Taxes Income taxes increased $2,397,000 in 1993 after a decrease of $5,963,000 in 1992. The increase in 1993 resulted from an increase in earnings over 1992, a decline in the regulatory-ordered amortization of excess deferred taxes, and an increase in Federal income tax rates. Income taxes decreased in 1992 due to the decline in net earnings compared to 1991. For the years 1993, 1992 and 1991, the Utility incurred tax net operating losses due to accelerated tax depreciation deductions and increased interest charges on debt related to TNP One and subsequent refinancings; however, payments of current income taxes were required based on minimum tax (MT) requirements. To the extent that the Utility is subject to MT requirements and limitations on the utilization of available credits, payments of current Federal income taxes are expected to be required in 1994. TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES As discussed in "Accounting for Income Taxes" under "Financial Condition," implementation of SFAS 109 did not result in any significant charge to earnings. For more information regarding the Utility's income taxes, see note 4 to the consolidated financial statements. As with all areas of the Utility's cost of service, recovery of income tax expenses is expected in rates charged to customers. However, as discussed in "PUCT Docket No. 10200" under "Financial Condition," uncertainties exist with respect to the Utility's Federal income tax expense component of cost of service. The Utility is pursuing reversal of the PUCT's adverse decisions. Other Income, Net of Taxes Other income, net of taxes increased in 1992 by $1,290,000 primarily because of interest earned on short-term investments, principally repurchase agreements and government money trusts, during the year. Considerable cash was used in 1993 to make optional payments under the Unit 2 financing facility thereby reducing cash available for the aforementioned investments. This contributed to the decrease of $901,000 in 1993. Interest Charges Total interest charges decreased slightly by $342,000 in 1993 after an increase of $24,723,000 in 1992. The slight decrease in interest on long-term debt in 1993 was the net result of several transactions. Decreases in 1993 expense resulted from (1) redemption of Series G First Mortgage Bonds at maturity on July 1, 1993, (2) redemption of Series H, I, J and K First Mortgage Bonds to permit issuance of Series U First Mortgage Bonds and (3) prepayments made under the Unit 1 and Unit 2 financing facilities. Partially offsetting these decreases in interest on long-term debt were the issuances of Series U First Mortgage Bonds and Series A Secured Debentures in September 1993. Interest on long-term debt increased in 1992 due to the issuance in January 1992 of $130 million of 11.25% Series T First Mortgage Bonds and $130 million of 12.50% Secured Debentures, due in 1999. The Utility used $194 million of the proceeds from the issuance to retire a portion of the Unit 1 and Unit 2 financing facilities, as was required for extended payment dates under the amended terms of the financing facilities. The notes payable under the financing facilities had lower interest rates than the new securities. Interest charges also increased in 1992 due to the debt for Unit 2 being outstanding for a full year as compared to a partial year in 1991. In 1994, the full effects of the 1993 redemptions and new issuances are expected to result in a net increase in interest on long-term debt. Any changes in the interest rates or balances related to the Unit 2 financing facility in 1994 will also have an effect on long-term debt interest. Other interest and amortization of debt discount, premium and expense for 1993 reflects a fourth quarter amortization of debt expense associated with the issuances of Series U Bonds and Series A Secured Debentures and further amendments to the Unit 1 and Unit 2 financing facilities; therefore, an increase in this expense can be expected in 1994 due to a full year's amortization. In 1993, other interest included interest on the provision for a refund of bonded revenues billed in excess of the amounts allowed under Docket No. 10200. Other interest and amortization of debt discount, premium and expense increased during 1992 primarily as the result of the issuances of the Series T Bonds and Secured Debentures, due 1999 discussed above, as well as the amortization of expenses related to the amendments of the Unit 1 and Unit 2 financing facilities. Other interest expense increased due to the accrual of interest on the provision for a refund of bonded revenues billed in excess of the amounts allowed in Docket No. 10200. Partially offsetting these increases was a decrease in interest on unsecured notes payable to banks. The Utility utilized a portion of the proceeds from the issuance of the Series T Bonds and Secured Debentures, due 1999 to retire $26 million of unsecured notes payable to banks. The remaining $10 million portion of such notes was retired in August 1992. Allowance for borrowed funds used during construction (AFUDC) decreased in 1992 when compared to 1991 because Unit 2 was placed in commercial operation on October 16, 1991. AFUDC for 1991 reflected primarily the qualified capitalization of interest on the financing facility for Unit 2 from the date of assumption (July 26, 1991) until the date Unit 2 began commercial operation. Receipt of equity contributions and proceeds from future issuances of debt securities are anticipated to help satisfy the scheduled repayments of the Unit 2 financing facility. Interest rates on debt securities are expected to be greater than those interest rates under the financing facility. Interest rates on additional debt may be further increased if the Utility's outstanding regulatory matters are not satisfactorily resolved. TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES Net Earnings Net earnings increased $678,000 in 1993 after a significant decline of $8,995,000 in 1992. The decline of net earnings in 1992 was due primarily to (1) the decrease in customer usage as discussed in "Operating Revenues," (2) the PUCT's abandonment of its long-standing methodology for determination of the Federal income tax expense component of cost of service in the PUCT's Order on Rehearing in Docket No. 10200 and (3) the increases in interest expense. The slight increase in 1993 resulted from increased KWH sales, the effect of which was reduced by increases in depreciation expense, taxes, other than on income and income taxes and a decrease in other income as previously discussed. The level of 1993 net earnings also reflects the adverse tax ruling by the PUCT, discussed above in "PUCT Docket No. 10200" under "Financial Condition." Early in 1993, the Utility implemented cost saving measures such as (1) suspension of the Utility's matching contributions to the employees' thrift plan, (2) revision to the Utility's pension plan and (3) implementation of a general employee salary and wage freeze and limitations on hiring new employees and replacements. These cost saving measures more than offset the increase in expenses related to the health care and death benefits plans resulting from implementation of SFAS 106. With the exception of the Utility's wage-step progression increases reactivated in April 1993, these measures continued in effect throughout 1993. The Utility reduced its labor force by 3.2% during 1993, trimming $1.1 million from operations and maintenance expenses. Even so, the Utility's return on common equity for 1993 and 1992 was 4.97% and 4.80%, respectively, although the Utility's rate of return granted in Docket No. 10200 authorized a return on common equity of 13.16%. Based on the Utility's earnings for 1993 and 1992 and the expected increases in interest on long-term debt and certain other expenses, equitable rate relief in Texas appears to be necessary for any significant improvement in financial results to occur during 1994. Future regulatory treatment and court decisions regarding Docket Nos. 9491 and 10200, as previously discussed, will have a direct bearing on future earnings. TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES Item 8. Item 8. Consolidated Financial Statements and Supplementary Data. Independent Auditors' Report The Board of Directors Texas-New Mexico Power Company: We have audited the consolidated financial statements of Texas-New Mexico Power Company (a wholly owned subsidiary of TNP Enterprises, Inc.) and subsidiaries as listed in the accompanying index at Part IV. 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 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 Texas-New Mexico Power Company and subsidiaries 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, 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 5 to the consolidated financial statements, uncertainties exist with respect to the outcome of certain regulatory matters. The ultimate outcome of these matters cannot presently be determined. Accordingly, no provision for any loss that may ultimately be required upon resolution of these matters has been made in the accompanying consolidated financial statements and financial statement schedules. As discussed in note 4 to the consolidated financial statements, the Company changed its method of accounting for income taxes in 1993 to adopt the provisions of the Financial Accounting Standards Board's Statement of Financial Accounting Standards (SFAS) No. 109, Accounting for Income Taxes. As discussed in note 1(j), the Company also adopted the provisions of the Financial Accounting Standards Board's SFAS No. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions in 1993. KPMG PEAT MARWICK Fort Worth, Texas January 28, 1994 TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES (a wholly owned subsidiary of TNP Enterprises, Inc.) CONSOLIDATED STATEMENTS OF EARNINGS Three Years Ended December 31, 1993 TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES (a wholly owned subsidiary of TNP Enterprises, Inc.) CONSOLIDATED BALANCE SHEETS December 31, 1993 and 1992 TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES (a wholly owned subsidiary of TNP Enterprises, Inc.) CONSOLIDATED STATEMENTS OF COMMON STOCK EQUITY AND REDEEMABLE CUMULATIVE PREFERRED STOCKS Three Years Ended December 31, 1993 TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES (a wholly owned subsidiary of TNP Enterprises, Inc.) CONSOLIDATED STATEMENTS OF CASH FLOWS Three Years Ended December 31, 1993 TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES (a wholly owned subsidiary of TNP Enterprise, Inc.) Notes to Consolidated Financial Statements December 31, 1993, 1992, and 1991 (1) Summary of Significant Accounting Policies (a) Principles of Consolidation The consolidated financial statements include the accounts of Texas-New Mexico Power Company (Utility) and its wholly owned subsidiaries, Texas Generating Company (TGC) and Texas Generating Company II (TGC II). All intercompany transactions and balances have been eliminated in consolidation. The Utility is a wholly owned subsidiary of TNP Enterprises, Inc. (TNPE). The Utility is a public utility engaged in the generation, purchase, transmission, distribution and sale of electricity within the states of Texas and New Mexico. The Utility is subject to regulation by the Public Utility Commission of Texas (PUCT) and the New Mexico Public Utility Commission (NMPUC). The Utility is subject in some of its activities, including the issuance of securities, to the jurisdiction of the Federal Energy Regulatory Commission (FERC), and its accounting records are maintained in accordance with the FERC's Uniform System of Accounts. TGC and TGC II were incorporated in Texas in 1988 and 1991, respectively, as financing entities for the assumption of ownership and liabilities related to two 150-megawatt lignite-fueled generating units, Unit 1 and Unit 2, respectively, collectively referred to as TNP One. The units were constructed by a nonaffiliated consortium in Robertson County, Texas, and are operated by the Utility under the terms of operating agreements between the Utility and its subsidiaries. Notes 2 and 5 provide additional information about the financings and regulatory treatments of Unit 1 and Unit 2. (b) Utility Plant The costs of additions to utility plant and replacement of retired units of property are capitalized. Costs include labor, materials and similar items and indirect charges for such items as engineering, supervision and transportation. Property repairs and replacement of minor items of property are included in maintenance expense. The cost of depreciable units of plant retired or disposed of in the normal course of business is eliminated from utility plant accounts, and such cost plus removal expenses less salvage is charged to accumulated depreciation. When complete operating units are disposed of, appropriate adjustments are made to accumulated depreciation, and the resulting gains or losses, if any, are recognized. (c) Depreciation Depreciation is provided on a straight-line basis over the estimated service lives of the properties. Depreciation of utility plant, other than transportation equipment, is charged to earnings. Depreciation of transportation equipment is charged to earnings and property accounts in accordance with the equipment's use. Depreciation as a percentage of average depreciable cost was 3.00%, 3.10% and 3.17% in 1993, 1992 and 1991, respectively. (d) Unamortized Debt Expense, Discount and Premium on Debt Expenses incurred in connection with the issuance of outstanding long-term debt and discount and premium related to such debt are amortized on a straight-line basis over the lives of the respective issues. TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES (a wholly owned subsidiary of TNP Enterprise, Inc.) Notes to Consolidated Financial Statements December 31, 1993, 1992, and 1991 (1) Summary of Significant Accounting Policies - continued (e) Revenues and Purchased Power Revenues are recognized on the basis of meter readings which are made on a monthly cycle. The Utility does not accrue revenues for power sold but not billed at the end of an accounting period. Power purchased is recorded on the basis of billings from suppliers; no accrual is made for power delivered to the Utility between the dates of such billings and the end of an accounting period. (f) Customer Receivables The Utility sells customer receivables to a nonaffiliated company on a nonrecourse basis. (g) Deferred Purchased Power and Fuel Costs The deferral method of accounting is used for the portions of purchased power and fuel costs which are recoverable in subsequent periods under purchased power costs recovery adjustment clauses. These clauses provide the ability to refund or collect, in the second succeeding month, those amounts of purchased power costs over- or under-collected in the current month. At December 31, 1993 and 1992, the Utility had under-recovered purchased power costs of approximately $1,520,000 and $6,640,000, respectively. At December 31, 1993 and 1992, the Utility also had under-recovered fuel costs of approximately $13,631,000 and $11,095,000, respectively, related to TNP One. A fixed fuel factor approved by the PUCT is intended to permit the Utility to recover the cost of fuel utilized to generate electricity sold in Texas. The factor may be changed only upon approval of the PUCT and is expected to be adjusted for any cumulative over- or under-recovery of fuel costs. (h) Allowance for Borrowed Funds Used During Construction The applicable regulatory uniform system of accounts defines allowance for funds used during construction as including the net cost during the period of construction of borrowed funds used for construction purposes and a reasonable rate on other funds when so used. In that connection, the Utility used an accrual rate of 7.53% in 1993, 5.8% in 1992 and 8.0% in 1991 for borrowed funds used during construction, excluding capitalized interest related to the financing facilities. Capitalized interest related to the financing facility for Unit 2 (note 2) was approximately $4,234,000 in 1991. Interest was capitalized from the date of assumption of the Unit 2 indebtedness, July 26, 1991, until the date on which Unit 2 began commercial operation, October 16, 1991. (i) Income Taxes The Utility and its subsidiaries account for certain income and expense items differently for financial reporting purposes than for income tax purposes. Provisions for deferred income taxes are made for such differences. As discussed in note 4, the Utility changed its method of accounting for income taxes in 1993 to adopt the provisions of the Financial Accounting Standards Board's Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes." Investment tax credits utilized are deferred and amortized to earnings ratably over the estimated service lives of the related assets. TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES (a wholly owned subsidiary of TNP Enterprise, Inc.) Notes to Consolidated Financial Statements December 31, 1993, 1992, and 1991 (1) Summary of Significant Accounting Policies - continued (i) Income Taxes - continued The consolidated Federal income tax return filed by TNPE includes the consolidated operations of the Utility and its subsidiaries. The amounts of income taxes and investment tax credits recognized in the accompanying consolidated financial statements were computed as if the Utility and its subsidiaries filed a separate consolidated Federal income tax return, and the amounts could differ from those recognized as a member of TNPE's consolidated group. (j) Employee Benefit Plans The Utility has in effect a trusteed defined benefit retirement plan available to employees who are 21 years of age and over and have at least one year of service with the Utility. The Utility's funding policy is to contribute annually at least the minimum amount required by government funding standards, but not more than that which can be deducted for Federal income tax purposes. The net pension costs for 1993, 1992 and 1991 included the following components: The following table is a summary of the plan's funded status at December 31, 1993 and 1992: TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES (a wholly owned subsidiary of TNP Enterprise, Inc.) Notes to Consolidated Financial Statements December 31, 1993, 1992, and 1991 (1) Summary of Significant Accounting Policies - continued (j) Employee Benefit Plans - continued The weighted average discount rate and the rate of increase in future compensation levels used in determining the actuarial present value of the projected benefit obligation were 7.15% and 4.15%, respectively, for 1993 and 8.5% and 5.75%, respectively, for 1992. The weighted average expected long-term rate of return on plan assets for 1993 and 1992 was 9.5%. The vested benefit obligations at December 31, 1993 and 1992, were approximately $50,457,000 and $39,757,000, respectively. The defined benefit retirement plan was amended to change, for all participants retiring after December 31, 1992, the determination of average monthly compensation used in calculating the amount of retirement benefits from the average of the three highest consecutive calendar years to the average of the completed calendar years of compensation after 1992. The Utility has a voluntary thrift plan, administered by a trustee, with a provision for the Utility to contribute to the plan amounts equal to certain percentages of amounts contributed by employees. Employees have the option of investing their contributions and contributions of the Utility, if any, in either, or a combination of, certain government securities, TNPE's common stock or, since January 1, 1992, two mutual funds. Effective January 1, 1992, the plan calls for the Utility's contributions to be used to purchase TNPE's common stock which the employees may later convert into investments in one or more of the other investing options. Effective January 1, 1993, the Utility suspended its matching contributions to the thrift plan for an indefinite period; however, the Utility's Board of Directors has approved restoration of the Utility's matching contributions, to be effective for employee contributions made after June 30, 1994. The Utility's contributions to the thrift plan amounted to approximately $1,592,000 and $1,487,000 in 1992 and 1991, respectively. Thrift plan assets included 1,471,213 shares and 1,482,490 shares of TNPE's common stock at December 31, 1993 and 1992, respectively. On November 9, 1993, the Board of Directors of the Utility renewed forms of employment contracts between the Utility and its officers and its other key personnel. The principal purpose of the contracts is to encourage retention of management and other key personnel required for the orderly conduct of the business of the Utility during any threatened or pending acquisition of TNPE or the Utility and during any transition of ownership. The terms of the contracts, from date of execution, are three years as to certain officers and managers of the Utility and two years as to the other key personnel. Upon the expiration date of each contract, the Utility, at its option, may extend the contract for additional three or two year periods, as appropriate. The contracts provide for lump sum compensation payments and other rights to the officers and the other key personnel in the event of termination of employment or other adverse treatment of such persons following a "change in control" of TNPE or the Utility, which event is defined to include, among other things, substantial changes in the corporate structure or ownership of either entity or in the Board of Directors of either entity. Health care and death benefits and an excess benefit plan have been provided at minimal or no cost to retired employees. The excess benefit plan is provided under an insurance policy arrangement and is backed by a letter of credit which will be funded only if a change in control occurs. TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES (a wholly owned subsidiary of TNP Enterprise, Inc.) Notes to Consolidated Financial Statements December 31, 1993, 1992, and 1991 (1) Summary of Significant Accounting Policies - continued (j) Employee Benefit Plans - continued On January 1, 1993, the Utility implemented Statement of Financial Accounting Standards No. 106 (SFAS 106), "Employers' Accounting for Postretirement Benefits Other Than Pensions," which addresses the accounting for other postretirement employee benefits (OPEBs). For the Utility, OPEBs are comprised primarily of health care and death benefits for retired employees. Prior to 1993, the costs of these OPEBs were expensed on a "pay-as-you-go" basis. For 1992, these costs were approximately $760,000. Beginning in 1993, SFAS 106 requires a change from the "pay-as-you-go" basis to the accrual basis of recognizing the costs of OPEBs during the periods that employees render service to earn the benefits. SFAS 106 also requires employers to recognize the costs of benefits already earned by active employees and retirees at the date of adoption of SFAS 106 (the transition obligation). For the Utility, an annual accrual for OPEBs is comprised of (1) the portion of the expected postretirement benefit obligation attributed to employee service during that period (the service cost), (2) amortization of the transition obligation and (3) the interest costs associated with the total unfunded accumulated obligation for future benefits. For 1993, these costs amounted to approximately $508,000, $934,000 and $1,510,000, respectively. This total cost of $2,952,000 based on adoption of SFAS 106 was $2,276,000 greater than the amount of $676,000 that would have been recorded under the "pay-as-you-go" basis. The assumed health care cost trend rate used to measure the expected cost of benefits was 11.5% for 1993 and is assumed to diminish to 8.4% for 1994, then trend downward slightly each year to a level of 6% for 2003 and thereafter. The Utility's remaining transition obligation of $17,750,000 at December 31, 1993 is to be amortized over a remaining nineteen-year period. A 1% increase in the assumed health care cost trend rate would result in (1) an increase of $3,235,000 in the Utility's accumulated benefit obligation at December 31, 1993 and (2) an increase of $538,000 for 1993 in the aggregate service and interest costs. In March 1993, the PUCT issued its rules for ratemaking treatment of OPEBs. As part of a general rate case, a utility may request OPEBs expense in cost of service for ratemaking purposes on an accrual basis in accordance with generally accepted accounting principles. The PUCT's rule includes recovery of the transition obligation and requires that the amounts included in rates shall be placed in an irrevocable external trust fund dedicated to the payment of OPEBs expenses. Based on the PUCT's rule, the Utility intends to seek recovery of OPEBs expense attributable to its Texas jurisdiction in its next Texas rate case. In order to comply with the PUCT's condition for possible recovery of OPEBs expenses, the Utility established in June 1993 a Voluntary Employees' Beneficiary Association (VEBA) trust fund, dedicated to the payment of OPEBs expenses. Monthly cash payments made to the VEBA, which began in June 1993, will fund the three OPEBs expense components of the Utility's total Texas and New Mexico operations. On August 23, 1993, the Utility filed a rate application with the NMPUC which included a request for recovery of the applicable costs of OPEBs. A stipulated agreement among the parties in the application, dated January 28, 1994, subject to approval by the NMPUC, would include such applicable costs in the proposed New Mexico rates, beginning in 1994. TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES (a wholly owned subsidiary of TNP Enterprise, Inc.) Notes to Consolidated Financial Statements December 31, 1993, 1992, and 1991 (1) Summary of Significant Accounting Policies - continued (j) Employee Benefit Plans - continued The following table presents the plan's funded status reconciled with amounts recognized in the consolidated balance sheets at December 31, 1993 and 1992: The discount rate used in determining the actuarial present value of the accumulated postretirement benefit obligation was 7.15% and 8.50% for 1993 and 1992, respectively. (k) Fair Values of Financial Instruments The fair value amounts of certain financial instruments included in the accompanying consolidated balance sheets at December 31, 1993 and 1992 were as follows: The fair value of cash and cash equivalents approximates the carrying amount because of the short maturity of those instruments. The total estimated fair value of long-term debt was approximately $723 million and $755 million in 1993 and 1992, respectively. The total estimated fair value of preferred stocks was $7.6 million and $7.7 million in 1993 and 1992, respectively. The estimated fair values of long-term debt and preferred stocks were based on quoted market prices of the same or similar issues. (l) Statements of Cash Flows For purposes of the consolidated statements of cash flows, the Utility considers temporary cash investments with original maturities of three months or less to be cash equivalents. TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES (a wholly owned subsidiary of TNP Enterprise, Inc.) Notes to Consolidated Financial Statements December 31, 1993, 1992, and 1991 (2) Long-term Debt Long-term debt outstanding was as follows: Issuance of Additional First Mortgage Bonds and Secured Debentures On September 29, 1993, the Utility issued $100 million of 9.25% First Mortgage Bonds, Series U, due September 15, 2000 (New Bonds), and $140 million of 10.75% Secured Debentures, Series A, due September 15, 2003 (Debentures, due 2003). After fees and expenses, combined net proceeds available to the Utility from the issuances of the New Bonds and the Debentures, due 2003, and existing cash were utilized as follows: (a) $146 million was used to prepay or purchase all of the outstanding secured notes payable to lenders under the Unit 1 financing facility, as discussed below; (b) $75.75 million was used to prepay secured notes payable under the Unit 2 financing facility, as discussed below; (c) $21.78 million was deposited for the call for redemption of the aggregate principal amount, including redemption premiums, of Series H, I, J and K First Mortgage Bonds; and (d) $9.14 million was used to reimburse the Utility's treasury for funds used to redeem Series G First Mortgage Bonds at maturity on July 1, 1993. TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES (a wholly owned subsidiary of TNP Enterprise, Inc.) Notes to Consolidated Financial Statements December 31, 1993, 1992, and 1991 (2) Long-term Debt - continued Supplemental indentures relating to Series H, I, J and K First Mortgage Bonds contained a requirement that Net Earnings Available for Interest of the Utility for 12 consecutive months out of the preceding 15 months be at least two-and-one-half (2.5) times the aggregate amount of annual Interest Charges on Bonded Indebtedness which gives effect to the interest on the additional Bonds to be issued (the Interest Coverage Ratio). Under the 2.5 times Interest Coverage Ratio required for issuance of additional First Mortgage Bonds, only a minimal amount of additional First Mortgage Bonds could have been issued. Under the supplemental indentures for the series of Bonds outstanding after the deposit of proceeds from the offering for the redemption of Series H, I, J and K Bonds, the Interest Coverage Ratio was reduced to two (2) times. The maturity of Series G Bonds on July 1, 1993, and the call for redemption of Series H, I, J and K Bonds permitted the issuance of additional Bonds and consummation of the offering of $100 million of New Bonds. Amendments to the Financing Facilities At December 31, 1992, secured notes payable represented loans issued under two financing facilities, which were originally entered into by separate subsidiaries of a construction consortium, for the construction of Unit 1 and Unit 2 of the TNP One generating plant. The Unit 1 financing facility was assumed by TGC on July 20, 1990. The Unit 2 financing facility was assumed by TGC II on July 26, 1991. On September 29, 1993, the balance of the secured notes payable under the Unit 1 financing facility was purchased or prepaid, and $75.75 million of secured notes payable under the Unit 2 financing facility was prepaid, reducing that outstanding commitment to $147.75 million; funds used for these prepayments and purchases were provided from issuance of the New Bonds and the Debentures, due 2003, and from existing cash, as discussed above. Thereafter, the Utility made additional unscheduled prepayments of approximately $69 million under the Unit 2 financing facility. The $78.8 million balance at December 31, 1993 represents secured notes payable under the Unit 2 financing facility, consisting of a series of renewable loans from various lenders in a financing syndicate. In contemplation of the prepayments of the Unit 1 and Unit 2 financing facilities, the related credit agreements between the secured lenders and the Utility were amended as of September 21, 1993 to facilitate the issuance of the Debentures, due 2003, and to extend the maturities of the remaining loans from due dates in 1994 and 1995. The effectiveness of the amendments was contingent upon the application of proceeds from the sale of the Debentures, due 2003, and the New Bonds. The extension of the maturities of the remaining loans to be outstanding under the Unit 2 financing facility is subject to further approvals from the FERC and the NMPUC. The Utility expects to receive the necessary approvals within the period required by the amendments. Upon the effective date of the extension, the lenders will receive an extension fee of 1/4 of 1% on their pro-rata share of the $147.75 million commitment. Based upon the December 31, 1993 balance and assuming the regulatory approvals of the extensions of the maturities under the Unit 2 financing facility, $1.6 million will be due on December 31, 1995, $3.4 million will be due on December 31, 1996, with the remaining amounts due in two equal installments of approximately $36.9 million on December 31, 1997 and 1998. Under the amendments to the Unit 2 credit agreement, the Utility is permitted to prepay up to $141.5 million of the $147.75 million commitment under the Unit 2 financing facility and reborrow thereunder up to the amount of such prepayments, subject to scheduled reductions of the commitment of approximately $36.9 million each in 1996, 1997 and 1998. Such reborrowings under the Unit 2 financing facility will be subject to compliance with the EBIT test (as described below) and maintenance of an equity to total capital ratio of 20% or more as defined in the credit agreement. As of December 31, 1993, the unused commitment available to be borrowed under the Unit 2 financing facility was approximately $69 million. A commitment fee of 1/4 of 1% per annum is payable on the unused portion of the reducing commitment. TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES (a wholly owned subsidiary of TNP Enterprise, Inc.) Notes to Consolidated Financial Statements December 31, 1993, 1992, and 1991 (2) Long-term Debt - continued The financing facilities contain certain covenants which, under specified conditions, restrict the payment of cash dividends on common stock of the Utility. The most restrictive of such covenants are an interest coverage test and an equity ratio test. Under the interest coverage test, the Utility may not pay cash dividends on its common stock unless its prior twelve months' earnings (exclusive of any writedowns resulting from actions of the PUCT, to the extent included in operating expenses) before interest and income taxes equals or exceeds the sum of all of the interest expense on indebtedness for the same period (said calculation, the EBIT Test). This restriction becomes effective only after the third consecutive calendar quarter during which the Utility does not meet the EBIT Test and continues in effect until after the quarter in which the Utility has met the twelve-month EBIT Test. The Utility has met the EBIT Test at each quarterly date since this test became effective. Under the recently required equity ratio test, the Utility may not pay cash dividends on its common stock if, at the preceding quarterly date, the Utility's ratio of equity capitalization to total capitalization is less than 20%. As of December 31, 1993, this test was met. Under the two financing facilities, interest rates were determined under several alternative methods. During 1993, all rates at the time of each borrowing were no higher than the prime lending rate plus a margin of 1- 3/8%. The effective costs of borrowing under the secured notes payable were 7.23% and 5.61% at December 31, 1993 and 1992, respectively. Under the amended Unit 2 financing facility, the margins will increase by 1/2 of 1% each year in 1994 and 1995 and by 1/4 of 1% each year in 1996, 1997 and 1998. Additional Information Substantially all utility plant owned directly by the Utility is subject to the first lien of the Utility's first mortgage bond indenture, as supplemented (the Bond Indenture). Until repaid, the holders of the secured notes payable and of the secured debentures have a lien junior to the first lien of the Bond Indenture on substantially all utility plant in Texas owned directly by the Utility. The Debentures, due 2003, are secured by a pledge by the Utility to the new debenture trustee of a replacement note (1993 Unit 1 Replacement Note) in an amount equal to the principal amount of the Debentures, due 2003, purchased by the Utility from secured lenders under the Unit 1 financing facility. The 1993 Unit 1 Replacement Note is secured ratably by the original Unit 1 First Lien Mortgage of the Unit 1 financing facility on the assets of TGC, the existing second mortgage lien on the Utility's Bond Indenture trust estate assets in Texas and certain other collateral. The Debentures, due 2003, rank pari passu with the outstanding secured debentures, due 1999, in their Unit 1 mortgage lien on the assets of TGC and other security interests. The secured debentures, due 1999, are secured ratably by a 1992 Unit 1 replacement note and a 1992 Unit 2 replacement note ($65 million each), which are in turn secured by first liens on the assets of TGC and TGC II, respectively, and by the existing second mortgage lien on the Utility's Bond Indenture trust estate assets in Texas and certain other collateral. Under the terms of each financing facility, the secured notes payable and the replacement notes are secured by related first liens on Unit 1 and Unit 2 until undivided interests in Unit 1 and Unit 2 have been purchased from TGC and TGC II, respectively, by the Utility, whereupon such undivided interests become subject to the lien of the Bond Indenture. In connection with the prepayments of the secured notes payable under the Unit 1 and Unit 2 financing facilities in September 1993, the Utility purchased from TGC and TGC II certain undivided direct interests in Unit 1 and Unit 2, respectively; accordingly, these interests were released from the first liens of the financing facilities. These purchases were in addition to interests in Unit 1 acquired by the Utility in 1992 and 1990. TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES (a wholly owned subsidiary of TNP Enterprise, Inc.) Notes to Consolidated Financial Statements December 31, 1993, 1992, and 1991 (2) Long-term Debt - continued As of December 31, 1993, TGC owns a 205/345 undivided interest in Unit 1 with the remaining fractional interest being owned directly by the Utility. (The denominator of 345 represents the historical maximum balance of $345 million that was originally borrowed under the Unit 1 financing facility; the numerator of 205 represents $205 million of replacement notes secured by the Unit 1 First Lien Mortgage.) TGC's interest in Unit 1 is subject to the lien of the Unit 1 First Lien Mortgage, which secures equally and ratably the 1993 Unit 1 replacement note of $140 million and the 1992 Unit 1 replacement note of $65 million. As of December 31, 1993, TGC II owns a 212.75/288.50 undivided interest in Unit 2 with the remaining fractional interest being owned directly by the Utility. (The denominator of 288.50 represents the historical maximum balance of $288.50 million that was originally borrowed under the Unit 2 financing facility; the numerator of 212.75 represents $212.75 million of debt and available loan commitment that remains secured by the Unit 2 First Lien Mortgage.) TGC II's interest in Unit 2 is subject to the lien of the Unit 2 First Lien Mortgage, which secures all remaining secured notes payable outstanding under the Unit 2 financing facility and the 1992 Unit 2 replacement note of $65 million. During the repayment periods, the Utility will operate and finance Unit 1 and Unit 2. Under the terms of each financing facility, upon or after each repayment of construction debt or replacement notes by TGC or TGC II through financings by the Utility, the Utility may purchase a proportionate undivided direct interest in the respective unit from TGC or TGC II to the extent such purchase is necessary to enable the Utility to issue, from time to time, first mortgage bonds. Upon such purchase, the undivided interest will be released from the lien of such unit's financing facility. In any event, the Utility may not purchase and the respective subsidiary may not transfer any undivided interest which would cause the fraction of the undivided interest remaining subject to the lien of the respective financing facility to be less than a certain fraction. The numerator of such fraction is the sum of (a) the unused commitment provided by lenders and the outstanding principal amounts owed to the lenders under such financing facility and (b) the principal amount of the respective replacement notes held as security for secured debentures. The denominator of such fraction is (i) $345 million under the Unit 1 financing facility and (ii) $288.5 million under the Unit 2 financing facility. The Utility guarantees the obligations of TGC and TGC II under each respective financing facility. The Utility expects, assuming adequate regulatory treatment, to be able to repay the remaining amount due under the Unit 2 financing facility primarily through the receipt of common equity from the Utility's parent, internal cash generation and issuance of debt. Based upon the December 31, 1993 balance and assuming the approvals of the extensions of the maturities of secured notes payable under the Unit 2 financing facility, maturities and sinking fund requirements for the Utility's long-term debt for the five years following 1993 are as follows: First mortgage bonds Secured notes payable (In Thousands) 1994 $ 1,070 - 1995 1,070 1,600 1996 1,070 3,400 1997 131,070 36,900 1998 1,070 36,900 TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES (a wholly owned subsidiary of TNP Enterprise, Inc.) Notes to Consolidated Financial Statements December 31, 1993, 1992, and 1991 (4) Income Taxes Income taxes as set forth in the consolidated statements of earnings consisted of the following components: The provisions for deferred income taxes for 1992 and 1991 resulted from the following timing differences: 1992 1991 (In Thousands) Charged (credited) to operating expenses: Tax depreciation in excess of book depreciation $13,615 19,540 Deferred charges and other costs expensed for tax purposes, net 674 1,943 Deferred purchased power and fuel costs expensed for tax purposes 1,765 2,049 Unbilled revenues for tax purposes 519 (1,778) Accrual for revenues subject to refund (5,069) - Minimum tax credit (2,608) (8,085) Amortization of excess deferred taxes (1,153) (810) Change in deferred taxes due to tax net operating loss (6,256) - Other (140) 87 $1,347 12,946 TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES (a wholly owned subsidiary of TNP Enterprise, Inc.) Notes to Consolidated Financial Statements December 31, 1993, 1992, and 1991 (4) Income Taxes - continued Total income tax expense for 1993, 1992 and 1991 was less than the amount computed by applying the appropriate statutory Federal income tax rate to income before income taxes. The reasons for the differences were as follows: The Omnibus Budget Reconciliation Act of 1993 (Act) was signed into law on August 10, 1993. Among other provisions, the Act provided, effective January 1, 1993, for a corporate income tax rate increase from 34% to 35% to be phased in for taxable income between $10 million and $18 million. Adjustments have been made to deferred tax amounts to reflect the future reversal of temporary differences at the higher tax rate. Under transitional rules of the Tax Reform Act of 1986, certain capital expenditures incurred after December 31, 1985 continued to qualify for investment tax credits (ITC). Accordingly, ITC adjustments reflect credits for the utilized portion of ITC generated in 1990 associated with ITC applicable to transitional property. The Utility has ITC carryforwards for Federal income tax purposes of approximately $18,700,000 which are available to reduce future Federal income taxes through 2005. The Utility generated a Federal minimum tax (MT) for the year ended December 31, 1993. The MT resulted in a net current Federal income tax expense of approximately $266,000, after utilization of ITC. At December 31, 1993, the Utility has net operating loss (NOL) carryforwards for Federal income tax purposes of approximately $44,600,000 which are available to offset future Federal taxable income through 2008. In addition, the Utility has minimum tax credit carryforwards of approximately $14,900,000 which are available to reduce future Federal regular income taxes over an indefinite period. In order to fully realize the Federal regular tax NOL carryforwards, the Utility will need to generate future taxable income of approximately $44,600,000 prior to expiration of the Federal regular tax NOL carryforwards which will begin to expire in 2006. Based on the Utility's historical and projected pretax earnings, management believes it is more likely than not that the Utility will realize the benefit of the Federal regular tax NOL carryforwards existing at December 31, 1993 before such carryforwards begin to expire in 2006. In addition, the remaining deferred tax assets, exclusive of the MT credit carryforwards, are considered current and expected to reverse in the next twelve months. TNPE's consolidated Federal income tax returns for the years 1987 through 1989 have been examined by the Internal Revenue Service resulting in a revenue agent report (RAR). The Utility's carryforwards referred to above and the accompanying consolidated financial statements reflect adjustments resulting from the RAR. The RAR had no effect on the Utility's results of operations. TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES (a wholly owned subsidiary of TNP Enterprise, Inc.) Notes to Consolidated Financial Statements December 31, 1993, 1992, and 1991 (4) Income Taxes - continued On January 1, 1993, the Utility implemented Statement of Financial Accounting Standards No. 109 (SFAS 109), "Accounting for Income Taxes." Prior to implementation of SFAS 109, the Utility accounted for income taxes under Accounting Principles Board Opinion No. 11 (APB 11). Implementation of SFAS 109 changed the method of accounting for income taxes from the deferred method required under APB 11 to the asset and liability method. Under the deferred method, annual income tax expense was matched with pretax accounting income by providing deferred taxes at the then current tax rates for timing differences between pretax accounting income and taxable income. The objective of the asset and liability method is to establish deferred tax assets and liabilities for the 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 temporary differences are realized or settled. The Utility elected to implement SFAS 109 on a prospective basis. SFAS 109 provides that regulated enterprises are allowed to recognize adjustments resulting from the adoption of SFAS 109 as regulatory tax assets or liabilities if such amounts are probable of being recovered from or returned to customers through future rates. Deferred taxes recorded under APB 11 were attributable primarily to differences associated with book and tax depreciation. Temporary differences under SFAS 109 include all items considered timing differences under APB 11, as well as certain new items including (1) a reduction in the depreciable tax basis due to ITC, (2) ITC accounted for under the deferred method and (3) prior flow-through treatment of tax benefits. Adoption of SFAS 109 has affected the consolidated balance sheet due to deferred Federal income tax effects for temporary differences associated with prior flow-through ratemaking accounting practices, treatment of tax rate changes and unamortized ITC. Unamortized ITC represent amounts being "shared" with customers as future revenue requirements are reduced by the amortization of accumulated deferred ITC. This gives rise to a corresponding regulatory liability to reflect the ratemaking treatment. SFAS 109 requires the recognition of regulatory and deferred tax assets and liabilities for the cumulative unrecognized temporary differences. The result as of January 1, 1993 of implementing SFAS 109 was as follows (in thousands): December 31, January 1, 1992 Reclassifications 1993 Assets: Deferred charges $46,689 (17,529) 29,160 Regulatory tax assets - 17,974 17,974 Accumulated deferred taxes on income - current - 6,006 6,006 46,689 6,451 53,140 Liabilities: Accrued taxes $20,136 (890) 19,246 Accumulated deferred taxes on income - noncurrent 84,917 (15,852) 69,065 Regulatory tax liabilities - 23,193 23,193 $105,053 6,451 111,504 The above reclassifications resulted from the recognition of regulatory and deferred tax assets and liabilities for the cumulative unrecognized temporary differences, recognition of the 1992 Federal regular tax NOL carryforward and reclassification of certain other balances to comply with the provisions of SFAS 109. The implementation of SFAS 109 did not result in any significant charge to operations. TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES (a wholly owned subsidiary of TNP Enterprise, Inc.) Notes to Consolidated Financial Statements December 31, 1993, 1992, and 1991 (4) Income Taxes - continued The tax effects of temporary differences that gave rise to significant portions of net current accumulated deferred taxes on income and net noncurrent accumulated deferred taxes on income at December 31, 1993 are presented below (in thousands): (5) Commitments and Contingencies In October 1991, the second unit of TNP One, the Utility's two-unit, 300- megawatt, circulating fluidized bed generating facility, was completed and successfully placed in operation. At December 31, 1993, the costs of Unit 1 totalled approximately $357 million and the costs of Unit 2 totalled approximately $282.9 million. The Utility has received rate orders (in Docket Nos. 9491 and 10200) from the PUCT placing the majority of the costs of the two units of TNP One in rate base, resulting in rate increases for the Utility's Texas customers. In Docket No. 9491, the PUCT disallowed from rate base approximately $39.5 million of the costs of Unit 1. On appeal, a State district court overturned the disallowances; however, a Texas Court of Appeals rendered a judgment partially reversing the State district court. In its October 16, 1992 rate order in Docket No. 10200, the PUCT disallowed $21.1 million of the costs of Unit 2 . On rehearing of Docket No. 10200, the PUCT unexpectedly reversed consistent precedent to adopt a new methodology for calculating the amount allowed in rates for Federal income taxes. The immediate result was a reduction in the rate increase previously granted on October 16, 1992. Each of the rate orders is the subject of continuing appellate process in the courts. Further detailed information of Docket Nos. 9491 and 10200 is provided below. TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES (a wholly owned subsidiary of TNP Enterprise, Inc.) Notes to Consolidated Financial Statements December 31, 1993, 1992, and 1991 (5) Commitments and Contingencies - continued In litigating Docket Nos. 9491 and 10200, the Utility's opponents are seeking, among other things, lower rates and greater disallowances, and the Utility is seeking higher rates and no disallowances. While the ultimate outcome of these cases and of other matters discussed below cannot be predicted, the Utility is vigorously pursuing their favorable conclusion. Material adverse resolution of certain of the matters discussed below would have a material adverse impact on earnings in the period of resolution. PUCT Docket No. 9491 On February 7, 1991, in Docket No. 9491, the PUCT approved an increase in annualized revenues of approximately $36.7 million, or 67% of the Utility's original $54.9 million rate request filed in 1990. The approval allowed $298.5 million of the costs of TNP One, Unit 1 in rate base; however, the PUCT disallowed $39.5 million of the requested investment costs of $338 million for that unit. Additional Unit 1 costs, not requested in Docket No. 9491, were included in the Utility's subsequent Texas rate request, Docket No. 10200, filed on April 11, 1991. In Docket No. 9491 in Finding of Fact No. 84 (FF No. 84), the PUCT also found that the Utility failed to prove that its decision to start construction of Unit 2 was prudent. Since the costs incurred for Unit 2 construction were not at issue in the Docket No. 9491 proceeding, the quantification of a disallowance, if any, that might result from this finding was to be determined subsequently in Docket No. 10200. On June 5, 1991, the Utility filed a petition in a Travis County district court which sought to overturn the PUCT's ruling regarding the disallowances and prudence decisions in Docket No. 9491. Certain intervenors also appealed other aspects of the PUCT's decisions in Docket No. 9491. On July 6, 1992, the presiding judge of the district court signed a judgment finding that the PUCT's disallowance of rate base treatment for certain costs of Unit 1 was in error and that the PUCT's "decision to deny $39,508,409 in capital costs for TNP One Unit 1 is not supported by substantial evidence and is arbitrary and capricious." The Utility, the PUCT and certain of the intervenor cities (the Cities) appealed the district court's judgment regarding the appeal of the PUCT's decision in Docket No. 9491 to the Third District Court of Appeals in Austin, Texas. The Utility's appeal related to the district court's decision which upheld the PUCT finding that the Utility failed to prove that its decision to start construction of Unit 2 was prudent and certain other matters. The PUCT and the Cities sought to reinstate the disallowances, and the Cities sought, among other things, to deny rate base treatment and to significantly lower rates granted by the PUCT. On August 25, 1993, the Third District Court of Appeals rendered a judgment partially reversing the district court and affirming the PUCT's disallowances for $30.4 million of the total $39.5 million. The Court of Appeals judgment states that the district court erred in (1) reversing that part of the PUCT's order disallowing "the Compressed Schedule Payment, the Force Majeure Payment, and a portion of the increased costs for the installation of a natural gas pipeline in Change Order No. 9, Item 2;" (2) affirming that part of the PUCT's order dealing with the prudence of the decision to construct Unit 2 (FF No. 84); and (3) affirming that part of the PUCT's order that failed to pass on to ratepayers the federal income tax savings for expenses disallowed by the PUCT. The Court of Appeals remanded the cause to the district court with instructions that the cause be remanded to the PUCT for proceedings not inconsistent with the appellate opinion. On September 9, 1993, the Utility, the Cities and the PUCT filed motions for rehearing with the Court of Appeals. The PUCT is not expected to act upon the district court's ordered remand, discussed above, until the appellate process, including appeals to the Texas Supreme Court, has been completed. TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES (a wholly owned subsidiary of TNP Enterprise, Inc.) Notes to Consolidated Financial Statements December 31, 1993, 1992, and 1991 (5) Commitments and Contingencies - continued Based upon the opinions of the Utility's Texas regulatory counsel, Johnson & Gibbs, a Professional Corporation, management believes that it will prevail in obtaining a remand of a significant portion of the disallowances in Docket No. 9491; however, the ultimate disposition and quantification of these items cannot presently be determined. Accordingly, no provision for any loss that may ultimately be required upon resolution of these matters has been made in the accompanying consolidated financial statements. If the Utility is not successful in obtaining a final favorable disposition in the appellate proceedings relating to the disallowances in Docket No. 9491, a write-off of some portion of the $39.5 million disallowances would be required, which could result in a significant negative impact on earnings in the period of final resolution. PUCT Docket No. 10200 On April 11, 1991, the Utility filed a rate application, Docket No. 10200, with the PUCT for inclusion of $275.2 million of capital costs of Unit 2 and $16.1 million of additional capital costs of Unit 1 in the Utility's rate base. The Administrative Law Judge (ALJ) in Docket No. 10200 initially required briefs of all parties on the issue of whether the inclusion of Unit 2 in the Utility's rate base would be precluded by the PUCT finding in Docket No. 9491, FF No. 84, that the Utility failed to prove that its decision to start construction of Unit 2 was prudent. In its brief to the ALJ, the Utility argued that FF No. 84 could not have the effect of barring litigation in Docket No. 10200 of all aspects of Unit 2 costs, asserting that evidence as to Unit 2 costs presented in Docket No. 9491 had been presented for the purpose of discussion of facilities which were common to both Unit 1 and Unit 2. The General Counsel of the PUCT argued that the issue of the Utility's prudence as to Unit 2 was barred by FF No. 84 and requested that the Utility's entire prudence testimony in Docket No. 10200 be stricken, along with all associated schedules and exhibits. The ALJ ruled on June 7, 1991 that the PUCT's finding in Docket No. 9491 could not be "relitigated" in Docket No. 10200. However, the ALJ determined that the PUCT did not decide "what specific action by TNP, instead of beginning construction when it did, would have been prudent" and that the PUCT did not "quantify the disallowance resulting from its finding that TNP had failed to prove that beginning construction of Unit 2 was prudent." Therefore, the ALJ concluded that the parties could raise those particular issues in Docket No. 10200. The ALJ further stated that, "The disallowance, if any, will be determined using principles set forth in previous cases regarding prudence." The ALJ determined that, in order for the Utility's request for inclusion of the Unit 2 investment in rate base as plant in service to be considered, the Utility must present a prima facie case in its direct testimony as to how a disallowance resulting from FF No. 84 should be quantified. The Utility appealed the ALJ's ruling to the PUCT, which voted not to hear the appeal. On August 16, 1991, the Utility filed supplemental prudence testimony, under protest, responding to the ALJ's order and supporting the Utility's entitlement to rate base treatment for the costs of Unit 2. In its supplemental testimony, the Utility contended that it prudently could have released Unit 2 for construction in February 1989, rather than September 1988, when the unit was actually released. The Utility argued that this alternative would cost no less than the actual cost of Unit 2, and thus no disallowance should result from any imprudence in releasing Unit 2 for construction in September 1988. Two intervenors in this proceeding objected to the Utility's presentation of a prudent alternative, but the PUCT included such evidence in the record. In a "final" order dated October 16, 1992, the PUCT commissioners approved an increase in annualized revenues of $26 million, or 72% of the Utility's original $35.8 million requested increase. The PUCT's order determined that the reasonable costs for Unit 2 were $261.8 million. The PUCT allowed in rate base $250.7 million of the $275.2 million requested for Unit 2 costs. The difference between the $261.8 million in costs found to be prudent by the PUCT and the $282.9 million total costs of Unit 2 consisted of disallowances of approximately $21.1 million. The PUCT also determined that $11.1 million of Unit 2 costs will be addressed in a future Texas rate application. TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES (a wholly owned subsidiary of TNP Enterprise, Inc.) Notes to Consolidated Financial Statements December 31, 1993, 1992, and 1991 (5) Commitments and Contingencies - continued The order in Docket No. 10200 also allowed approximately $15.3 million of the requested approximately $16.1 million of Unit 1 costs not sought by the Utility in Docket No. 9491. The approximately $800,000 disallowance was primarily related to debt service on disallowed costs determined in Docket No. 9491. Subsequent to the issuance of the "final" order on October 16, 1992, motions for rehearing of certain issues were filed by parties to the case. On December 22, 1992, the PUCT issued an Order on Rehearing which reduced the $ 26 million increase in annualized revenues that was originally granted by the PUCT in its order on October 16, 1992. The primary issue in the Order on Rehearing was the PUCT's reversal of its original Docket No. 10200 order as to the use of the "return method" for calculating the amount allowed in cost of service for the Utility's Federal income tax expense. The "return method" of computing Federal income tax expense requested by the Utility followed consistent precedent of the PUCT. The concept of the "return method" is to match a utility's taxes with the same revenues and expenses included in rates. The new method adopted by the PUCT in the Order on Rehearing flowed through to ratepayers the tax benefits of expenses disallowed and not included in rates. The net effect of this Order on Rehearing was a decrease of approximately $7 million from the October 16, 1992 order, resulting in a $19 million increase in annualized revenues. On January 26, 1993, the PUCT considered motions for rehearing on the December 22, 1992 Order on Rehearing but did not alter the $19 million increase in annualized revenues or the disallowances. In its Order on Rehearing, dated February 4, 1993, the PUCT ordered the Utility to seek a private letter ruling from the Internal Revenue Service (IRS) to determine if the Order on Rehearing resulted in violations of the "normalization" rules concerning investment tax credits and accelerated tax depreciation on public utility property. The PUCT's February 4, 1993 Order on Rehearing stated that the tax method utilized does not violate the "normalization" rules of the Internal Revenue Code; however, a December 1992 private letter ruling of the IRS to an unrelated utility indicates that regulatory treatment which flows through tax benefits of investment tax credits on disallowed public utility property violates the "normalization" rules. A "normalization" violation ultimately results in a utility's loss of benefits from investment tax credit and/or accelerated depreciation on public utility property. Without the curative action of the PUCT on March 10, 1993, discussed in the following paragraph, an IRS determination that a "normalization" violation had occurred would subject the Utility to paying additional income taxes for the amount of the accumulated deferred investment tax credits as of the time of the violation and taxes on the amount of tax depreciation in excess of book depreciation for all tax years open for IRS review. On March 10, 1993, the PUCT considered motions for rehearing on the February 4, 1993 Order on Rehearing and expressed its position that its earlier actions not create a "normalization" violation for the Utility. As a result, in its Order on Rehearing, dated March 18, 1993, the PUCT ordered that the Utility be granted, subject to refund, an additional $1.6 million in annualized revenues which matches recovery in rates with only the investment tax credits and accelerated tax depreciation related to utility property included in rate base. Accordingly, the benefits of investment tax credits and accelerated tax depreciation related to disallowed public utility property would not be passed through to ratepayers; therefore, the Utility believes that the "normalization" rules with respect to investment tax credits and accelerated tax depreciation would not be violated. Further, the PUCT affirmed its February 4, 1993 Order on Rehearing directing the Utility to seek a private letter ruling from the IRS to determine if the earlier methodology adopted in the December 22, 1992 Order on Rehearing would violate the "normalization" rules concerning investment tax credits and accelerated tax depreciation on public utility property. If the IRS determines that the PUCT's December 22, 1992 order would not constitute a "normalization" violation, then the additional $1.6 million in annualized revenues would be revoked by the PUCT, and the Utility would be required to refund excess amounts collected. The PUCT did not reverse its December 22, 1992 position to pass through to ratepayers the tax benefits of interest charges related to disallowed public utility property. The net resultant effect of Docket No. 10200 (by the PUCT action of March 10, 1993) is an increase in annualized revenues of $20.6 million, of which $1.6 million is subject to refund. TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES (a wholly owned subsidiary of TNP Enterprise, Inc.) Notes to Consolidated Financial Statements December 31, 1993, 1992, and 1991 (5) Commitments and Contingencies - continued The March 18, 1993 Order on Rehearing was appealed by the Utility and certain intervening parties to a State district court. Because of the Court of Appeals judgment relating to FF No. 84 in the Docket No. 9491 appeals, the presiding judge in the State district court for the Docket No. 10200 appeal has ordered that the procedural schedule in this appeal be abated until final resolution of the FF No. 84 issue in Docket No. 9491. The Utility will vigorously pursue reversal of the PUCT's new position regarding Federal income tax expense in addition to seeking judicial relief from the disallowances and certain other rulings by the PUCT in Docket No. 10200. During the third quarter of 1993, the Utility refunded, to the appropriate Texas customers, amounts collected under bonded rates in excess of the $20.6 million in annualized revenues granted on rehearing in Docket No. 10200. The refund (approximately $18 million, including interest) was related to the period beginning on the effective date for bonded rates (October 16, 1991) through April 1993. After receiving PUCT approval on October 19, 1993, the Utility filed, on October 20, 1993, a request with the IRS for a private letter ruling on the issue of a "normalization" violation resulting from the PUCT's proposed treatment of investment tax credits and accelerated tax depreciation. Revenues related to the conditionally granted $1.6 million annualized increase will not be refunded unless the IRS determines that a "normalization" violation would not result from flowing through benefits of investment tax credits and accelerated tax depreciation related to disallowed public utility property. If the IRS so determines, a refund will be made after that determination. Accordingly, revenues associated with the $1.6 million annualized increase have not been recognized in results of operations as of December 31, 1993, and a provision for revenues subject to refund, including interest, has been made for $3.4 million in the consolidated balance sheet as of December 31, 1993. The Utility expects to receive the private letter ruling in 1994. Based upon the opinions of the Utility's Texas regulatory counsel, Johnson & Gibbs, a Professional Corporation, management believes that it will prevail in obtaining a remand of a significant portion of the disallowances in Docket No. 10200; however, the ultimate disposition and quantification of these items cannot presently be determined. Accordingly, no provision for any loss that may ultimately be required upon resolution of these matters has been made in the accompanying consolidated financial statements. If the Utility is not successful in obtaining a final favorable disposition in the appellate proceedings relating to the disallowances in Docket No. 10200, a write-off of some portion of the $21.9 million disallowances would be required, which could result in a significant negative impact on earnings in the period of final resolution. Other TNP One Matters In Docket No. 9491, the Utility requested deferred accounting treatment (DAT) for Unit 1 which would (1) defer $1.4 million and $2.8 million of operating costs and interest costs, respectively, (2) recover such amounts in rates through amortizations over the life of the unit and (3) include such unamortized amounts in the Utility's rate base, thereby recovering a carrying cost on the unamortized amount. The PUCT granted the Utility's DAT request except the inclusion of interest costs ($2.8 million) in rate base. In the final order meeting for Docket No. 9491, the PUCT commissioners indicated that their decision to exclude interest costs from the Utility's rate base was influenced by a recent appeals court ruling. In that ruling, which involved an appeal of a decision by the PUCT granting DAT to an unrelated electric utility, the appeals court found that the DAT component for interest costs could not be included in rate base. The electric utility has filed an application for writ of error with the Texas Supreme Court regarding the appeals court ruling. The ultimate effect of the appeals court ruling on the order granting DAT for Unit 1 is uncertain at this time. TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES (a wholly owned subsidiary of TNP Enterprise, Inc.) Notes to Consolidated Financial Statements December 31, 1993, 1992, and 1991 (5) Commitments and Contingencies - continued The Utility entered into a fuel supply agreement dated November 18, 1987 with Phillips Coal Company (Phillips), owner of a 300-million-ton lignite reserve in Robertson County in proximity to TNP One. The agreement provides for a lignite fuel source for the 38-year life of TNP One. Phillips subsequently entered into an agreement with a subsidiary of Peter Kiewit Sons', Inc. for development of the lignite mine by a joint venture partnership, Walnut Creek Mining Company. Unit 1 and Unit 2 are capable of utilizing Western coal, petroleum coke and natural gas as alternative fuel sources. Legal Actions The Utility is involved in various claims and other legal actions arising in the ordinary course of business. In the opinion of management, the ultimate disposition of these matters will not have a material adverse effect on the Utility's consolidated financial position. TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES 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. Identification of Directors and Directorships Set forth below is certain information concerning the nominees: NOMINEES FOR DIRECTOR Principal occupation Director and business experience of the during past five years; Name/Age Utility since and other directorships R. Denny Alexander, 48 1989 Owner, R. Denny Alexander & Company, since 1978 (investment management) Managing Partner, OPNB Building Joint Venture, since 1978 (real estate investment) Chairman, Overton Bank and Trust, National Association, since May 1984 Director of: Overton Bancshares, Inc., since 1982 Cass O. Edwards, II, 67 1975 Managing Partner, Edwards - Geren Limiated (ranching and farming) Chairman, Overton Bancshares, Inc., since Chairman and President, Cassco Land Company, Inc. Director of: Overton Bank and Trust, National Association John A. Fanning, 54 1984 Executive Vice President, Snyder Oil Corporation, since March 1990 (oil and gas producer) December 1987 to March 1990 Director of: Snyder Oil Company, Inc., since 1981 Harris L. Kempner, Jr., 54 1980 President, Kempner Capital Management, since 1981 (investment advisor) Trustee, H. Kempner Trust Association Chairman Emeritus and Advisor to the Board of United States National Bank, since 1992 Director of: Balmorhea Ranches; Imperial Holly Corp.; Cullen/Frost Bankers, Inc., since 1982; American Indemnity Company, since 1987; American Indemnity Financial, since 1990 TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES Dr. Thomas S. Mackey, 63* 1977 President, Key Metals and Minerals Engineering Corporation, since 1970 (consulting engineers) President, Texas Copper Corporation, from 1989 to 1993 (primary copper processing) Thomas S. Mackey, P.C., a law firm, since 1978 President, Airtrust International Corporation, since 1982 (logistic services to oil industry) President, USA Offshore Industries Corporation; USA Logestics Services Corporation since 1982(equipment exports) Chairman, Board of Directors, Neomet Corporation, since 1989 (neodymium eutectic alloy production) President and Director, Neomet Corporation, from 1986 to 1989, and since 1992 President and Director, Cox Creek Refining Company, since 1990 (copper cathode and rod provider) Director of: United States National Bank, since 1970; Reactive Metals and Alloys, Inc., since 1986 (mischmetal and ferro alloy producer); Siltec Corporation and Siltec Epitaxial Corp., since 1986 (silicon wafer manufacturer); Malaysian Titanium Corporation, since 1990 (titanium dioxide pigment for paper and paint industry) D. R. Spurlock, 61 1993 Interim President & Chief Executive Officer of TNPE and the Utility, since November 9, 1993 Sector Vice President - Operations of the Utility, September 1990 through 1992 (Retired) Vice President - Division Manager of the Utility, August 1979 to September 1990 Director of: TNPE, since April 1993; Texas City National Bank, since 1976 R. D. Woofter, 70 1975 Chairman of the Board of TNPE and the Utility, since July 2, 1988 * A member of the Board and Committees, and a nominee until the time of his death on February 25, 1994. Three vacancies currently exist on the Board of Directors of the Utility. One vacancy resulted from the resignation of John Justin as a Director on February 25, 1993 and the unexpected decision of an advisory director not to stand for election to the position previously held by Mr. Justin. The resignation of J. M. Tarpley from the position of President & Chief Executive Officer and from the Board of Directors as of November 9, 1993, resulted in the second vacancy. The third vacancy occurred as the result of the untimely death of Dr. T. S. Mackey on February 25, 1994. It is expected that upon selection of a successful candidate for the position of President & Chief Executive Officer of the Utility, the Board of Directors will appoint that person to the directorship vacated by Mr. Tarpley's resignation. At such time as the Board of Directors has evaluated and selected persons who are qualified to act as directors of the Utility, the Board will make appointments of such persons to fill the two remaining vacant director positions. It is anticipated that appointees will stand for election at the 1995 Annual Meeting of the Shareholders of the Utility. TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES Identification of Executive Officers Positions & Offices Held Period of with the Utility Such Office Name Age Within the Past 5 Years1 Years Months D. R. Spurlock2 61 Interim President & Chief 0 1 Executive Officer and Director Sector Vice President - 2 4 Operations Vice President - 11 1 Division Manager D. R. Barnard 61 Sector Vice President & 3 8 Chief Financial Officer Vice President & 1 0 Chief Financial Officer Vice President & 17 0 Treasurer J. V. Chambers, Jr. 44 Sector Vice President - 3 8 Revenue Production Vice President - Contracts 3 2 & Regulation M. C. Davie 58 Vice President - Corporate 10 11 Affairs A. B. Davis 56 Vice President - Chief Engineer 1 8 Chief Engineer 1 4 Assistant Chief Engineer 0 1 Manager - Engineering 5 8 L.W. Dillon 39 Vice President - Operations 0 1 Division Manager 3 6 Division Engineering Manager 4 11 R. J. Wright 46 Vice President - 0 6 Corporate Services/Generation Vice President - Manager - Generation 4 8 M. D. Blanchard 43 Corporate Secretary & 6 4 General Counsel Monte W. Smith 40 Treasurer 4 8 Director - Internal Audit 2 11 1 All officers are elected annually by the Utility's Board of Directors for a one-year term until the next annual meeting of the Board of Directors or until their successors shall be elected and qualified. The term of an officer elected at any other time by the Board also will run until the next succeeding annual meeting of the Board of Directors or until a successor shall be elected and qualified. 2 Retired as Sector Vice President effective December 31, 1992; named Interim President & Chief Executive Officer effective November 9, 1993. With the exception of D. R. Spurlock, each of the above-named officers is a full-time employee of the Utility and has been for more than five years prior to the date of the filing of this Form 10-K. TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES Item 11. Item 11. Executive Compensation. Compensation Committee Interlocks and Insider Participation The Personnel, Organization & Nominating Committee is responsible for recommending to the Board the appropriate levels of Executive Compensation. The members of the Committee are Messrs. Edwards and Woofter. Prior to his death, Dr. Mackey was a member of this Committee. Mr. Woofter, the Chairman of the Board and formerly the Chief Executive Officer and President of TNPE and the Utility, retired as an officer of both companies in 1988. Mr. Edwards is a director of Overton Bank and Trust, National Association, with which the Utility and TNPE maintain a banking relationship in the ordinary course of business. To the Utility's knowledge, there were no other inter- relationships involving members of the Committee. The following table sets forth information regarding cash compensation paid for services rendered to the Utility and its subsidiaries to the former CEO, the Interim President and CEO, and each of the four most highly compensated executive officers of the Utility whose cash compensation exceeded $100,000, for each of the last three fiscal years. Summary Compensation Table TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES Utility's Pension Plan The following table sets forth annual benefits payable to employees of the Utility under the Utility's Pension Plan at the normal retirement age of 65. PENSION PLAN TABLE The Utility maintains for the benefit of all eligible employees a non- contributory defined benefit retirement plan (the "Pension Plan") under which contributions are actuarially determined each year. All employees who have one year of service with the Utility and who are 21 years of age are eligible. As a defined benefit plan, the Utility's Pension Plan contributions, which are computed on an actuarial basis, cannot be readily calculated on a per person basis by Plan actuaries. Benefits for each eligible employee are based on the employee's number of years of service computed through the month in which he or she retires multiplied by a specified percentage of the employee's average monthly compensation for each full calendar year completed after 1993. The average monthly compensation for the named executive officers consists only of amounts included beneath the Salary column of the Summary Compensation Table. Pension benefits are not subject to deduction for Social Security benefits. Pension benefits are subject to reduction for retirement prior to age 62. For 1993, the Utility made no contribution to the Pension Plan. The Utility also maintains an unfunded Excess Benefit Plan to compensate certain highly compensated employees. Such highly compensated employees must first have their pensions subject to being reduced below the amount which would have been provided by the Pension Plan because of compliance with Section 415 of the Internal Revenue Code of 1986, as amended, and must be designated as eligible by the Board of Directors for participation in the Excess Benefit Plan. There are three participants currently designated by the Board of Directors. A Letter of Credit is purchased each year which will provide sufficient funds to the Trust to make payments to all persons who are covered by the Excess Benefit Plan if a "change in control" were to occur as that term is defined in certain employment contracts which are discussed hereafter. The Utility owns life insurance policies on the lives of two employees currently eligible to receive payments under such plan upon their retirement and one retiree who is currently receiving benefits under the Excess Benefit Plan. The proceeds of the policies are payable to the Utility to compensate the Utility for its payments to the eligible employees pursuant to the terms of the Excess Benefit Plan. TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES As of December 31, 1993, the years of credited service for calculation of the retirement benefits for the named executive officers of the Utility were as follows: NAME YEARS OF CREDITED SERVICE Mr. Tarpley 35 years, 6 months Mr. Spurlock Retired as of 12-31-92 with 33 years, 7 months Mr. Barnard 32 years, 6 months Mr. Chambers 14 years, 11 months Mr. Davis 28 years, 7 months Mr. Wright 14 years, 10 months Except for the Chairman, each member of the Board of Directors who is not also an officer of the Utility receives an annual retainer fee of $4,500 from each of TNPE and the Utility. The Chairman of the Board of Directors receives an annual retainer fee of $36,000 from each of TNPE and the Utility. The Chairman acts as agent for the Board of Directors and is a member of all Committees of the Board. Each director also receives $500 for attending each meeting of the Board of Directors of either TNPE or the Utility or Board committees of either entity of which he is a member. In the event that meetings of Boards of both entities or their Committees are held on the same day, the meeting fee is limited to $500 and is allocated evenly between TNPE and the Utility. Utility's Employment Contracts Employment contracts between the Utility and its officers and its other key personnel have continued since 1988, in form and substance last reviewed and approved by the Board of Directors of the Utility at the November, 1993 Board meeting. The principal purpose of the contracts is to encourage retention of management and other key personnel required for the orderly conduct of the business of the Utility during any threatened or pending acquisition of the Utility or TNPE and during any transition of ownership. The terms of the contracts, from date of execution, are three years as to certain officers and managers of the Utility and two years as to the other key personnel. Upon the expiration of each contract, the Utility, at its option, may extend the contract for additional three or two year periods, as appropriate. The contracts for certain officers and managers, including the named executive officers, provide for lump sum compensation payments equal to three times their current annual salary, and other rights. The contracts for the other key personnel provide for payments equal to their annual salary. The lump sum payments for both the officers and other key personnel only become effective in the event of termination of employment or other adverse treatment of such persons following a "change in control" of the Utility or TNPE, which event is defined to include, among other things, substantial changes in the corporate structure or ownership of either entity or in the Board of Directors of either entity. Pursuant to an agreement between J. M. Tarpley and TNPE and its subsidiaries, including the Utility, Mr. Tarpley resigned his positions as officer and member of the Boards of Directors of all such companies, including his positions as President, Chief Executive Officer and a member of the Boards of TNPE and the Utility. The agreement provides for November 9, 1993, as the effective time of resignation of such officer and director positions and, effective January 1, 1994, a contract of employment between Mr. Tarpley and the Utility. The agreement also sets forth other covenants and arrangements between the parties safeguarding confidential and proprietary information of TNPE and its subsidiaries and prohibiting areas of participation by Mr. Tarpley in opposition to TNPE and the Utility. Upon attaining age 62 (August 23, 1996), Mr. Tarpley will retire as an employee and have all rights of a retired employee of the Utility. As an employee and in consideration of the safeguarding and restricting covenants of Mr. Tarpley, his annual compensation until retirement, or his earlier death, will aggregate $284,000 per year. Mr. Tarpley has the rights as an employee to participate in the benefit plans and programs of the Utility, including such rights as a retired employee after age 62. Effective as of November 9, 1993, the Utility entered into an agreement with D. R. Spurlock to serve as President and Chief Executive Officer on an interim basis. The agreement provides for the Utility to pay Mr. Spurlock $30,000 per month, and to reimburse him for certain expenses incurred during the interim period. Mr. Spurlock does not receive any benefits generally made available to employees, such as pension accrual and enhanced medical benefits. The agreement is terminable by either party upon twenty-four hour written notice. TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management. Director, Nominee and Management Shareholding The following table sets forth information with respect to the beneficial ownership of the common stock of TNPE by its directors, nominees for directors, each executive officer named in the Summary Compensation Table and all directors and officers as a group, as of January 31, 1994. Name of Individual or Group Position with Company Shares Beneficially Owned R. D. Woofter Chairman of the Board 9,893 (1) R. Denny Alexander Director 500 Cass O. Edwards, II Director 6,737 Harris L. Kempner, Jr. Director 200 (2) Thomas S. Mackey * Director 1,386 D. R. Spurlock Director; 1,584 Interim President and CEO since 11-9-93 J. M. Tarpley ** President, Chief 11,347 (3) Executive Officer and Director D. R. Barnard Sector Vice President 18,491 and Chief Financial Officer J. V. Chambers Sector Vice President - 13,964 Revenue Production A. B. Davis Vice President - 4,002 Chief Engineer R. J. Wright Vice President - 10,201 Corporate Services/ Generation Directors and officers as a group (16 persons)(4) 96,370 *** _____________________________________ * A member of the Board and Committees until the time of his death on February 25, 1994. **Resigned effective November 9, 1993 as President and CEO and Director. ***Less than one (1) percent of outstanding shares of Common Stock. (1) Does not include 66 shares owned by the wife of Mr. Woofter as her sole and separate property. Mr. Woofter disclaims any beneficial interest in all such shares. (2) Does not include 200 shares owned by the wife of Mr. Kempner as her sole and separate property. Mr. Kempner disclaims any beneficial interest in all such shares. (3) Subsequent to January 31, 1994, Mr. Tarpley disposed of all shares. (4) Of the nine executive officers of subsidiaries, four are also executive officers of TNPE. All shares held by such officers and directors are shares of TNPE. TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES Item 13. Item 13. Certain Relationships and Related Transactions. Mr. R. Denny Alexander is Chairman of the Board and director of Overton Bank and Trust, National Association. Mr. Cass O. Edwards, II is a director of Overton Bank and Trust, National Association. The Utility maintains banking relations with Overton Bank and Trust, National Association. These banking relations are in the ordinary course of business for general banking and short-term investments, and all banking transactions are made on substantially the same terms, including collateral and interest rates, as those prevailing at the time for comparable transactions between such bank and other persons. PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K. (a) Items Filed as Part of This Report Financial Statements Page Independent Auditors' Report . . . . . . . . . . . . . . . . . . 25 Consolidated Statements of Earnings, Three Years Ended December 31, 1993. . . . . . . . . . . . . . . 26 Consolidated Balance Sheets, December 31, 1993 and 1992 27 Consolidated Statements of Common Stock Equity and Redeemable Cumulative Preferred Stocks, Three Years Ended December 31, 1993. . . . . . . . . . . . . . . 28 Consolidated Statements of Cash Flows, Three Years Ended December 31, 1993. . . . . . . . . . . . . . . 29 Notes to Consolidated Financial Statements . . . . . . . . . . .30-49 Financial Statement Schedules V - Utility Plant, Three Years Ended December 31, 1993. . 58 VI - Accumulated Depreciation of Utility Plant, Three Years Ended December 31, 1993. . . . . . . . . . 59 IX - Short-term Borrowings, Three Years Ended December 31, 1993. . . . . . . . . . 60 X - Supplementary Consolidated Earnings Statement Information Three Years Ended December 31, 1993. . . . . . . . . 61 All other schedules are omitted, as the required information is inapplicable or the information is presented in the consolidated financial statements or related notes. Exhibits See Exhibit Index, Pages 63-72. (b) Reports on Form 8-K None during the last quarter covered by this report. TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES Utility Plant Schedule V Three Years Ended December 31, 1993 (In Thousands) Other Balance at changes: Balance at beginning Additions add end of Classification of period at cost(1) Retirements(deduct) period Year ended December 31, 1993: Electric plant $1,184,635 17,587 5,436 6,850 1,203,636 Construction work in progress 3,922 8,210 - (6,850) 5,282 $1,188,557 25,797 5,436 - 1,208,918 Year ended December 31, 1992: Electric plant $1,159,511 30,365 (6,683) 1,442 1,184,635 Construction work in progress 2,279 3,085 - (1,442) 3,922 $1,161,790 33,450 (6,683) - 1,188,557 Year ended December 31, 1991: Electric plant $ 850,160 313,259 (6,650) 2,742 1,159,511 Construction work in progress 2,844 2,177 - (2,742) 2,279 $ 853,004 315,436 (6,650) - 1,161,790 Note: See note 1(c) to the consolidated financial statements for disclosure of depreciation method. (1) On July 26, 1991, the Utility's wholly owned subsidiary, TGCII, assumed ownership of TNP One, Unit 2 and assumed the related liabilities totaling approximately $269 million. In addition, approximately $12 million of deferred charges related to TNP One, Unit 2 were reclassified to utility plant. These amounts are included in the 1991 additions above. See note 5 to the consolidated financial statements and Items 1, 2, and 7, for more information about Unit 2. During 1992, the Utility reclassified approximately $12 million of deferred charges to utility plant. TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES Accumulated Depreciation of Utility Plant Schedule VI TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES Supplementary Consolidated Earnings Statement Information Schedule X Three Years Ended December 31, 1993 (In Thousands) Charged to costs and expenses Item 1993 1992 1991 Taxes, other than payroll and income taxes: Gross receipts and street rentals $ 11,386 10,064 9,484 Property 14,119 14,272 10,302 Other 2,448 2,431 1,689 $ 27,95 26,767 21,475 TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES 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. (Registrant) TEXAS-NEW MEXICO POWER COMPANY By \s\ D. R. Barnard D. R. Barnard, Sector Vice President & Date: March 22, 1994 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. Title Date By \s\ R. D. Woofter Chairman March 22, 1994 R. D. Woofter By \s\ Dwight R. Spurlock Interim President & March 22, 1994 D. R. Spurlock Chief Executive Officer By \s\ D. R. Barnard Sector Vice President & March 22, 1994 D. R. Barnard Chief Financial Officer By \s\ Monte W. Smith Treasurer (Principal March 22, 1994 Monte W. Smith Accounting Officer) By \s\ R. Denny Alexander Director March 22, 1994 R. Denny Alexander By \s\ Cass O. Edwards, II Director March 22, 1994 Cass O. Edwards, II By \s\ John A. Fanning Director March 22, 1994 John A. Fanning By \s\ Harris L. Kempner, Jr. Director March 22, 1994 Harris L. Kempner, Jr. No annual report to security holders of the Registrant covering the Registrant's last fiscal year and no proxy material with respect to solicitations during such fiscal year have been sent to the Registrant's security holders. TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES EXHIBIT INDEX Exhibits filed herewith are denoted by "*." The other exhibits have heretofore been filed with the Commission and are incorporated herein by reference. Exhibit No. Description 3(a) - Restated Articles of Incorporation of the Utility (Exhibit 4(a), File No. 2-86282). 3(b) - Amendment to Restated Articles of Incorporation dated October 26, 1983 (Exhibit 3(b) to Form 10-K for the year ended December 31, 1984, File No. 1-2660-2). 3(c) - Amendment to Restated Articles of Incorporation dated April 8, 1984 (Exhibit 3(c) to Form 10-K for the year ended December 31, 1984, File No. 1-2660-2). 3(d) - Amendment to Restated Articles of Incorporation dated October 2, 1984 (Exhibit 3(d) to Form 10-K for the year ended December 31, 1984, File No. 1-2660-2). 3(e) - Articles of Merger dated October 3, 1984 (Exhibit 3(e) to Form 10-K for the year ended December 31, 1984, File No. 1-2660-2). 3(f) - Amendment to Restated Articles of Incorporation dated May 22, 1985 (Exhibit 3(a) to Form 10-K for the year ended December 31, 1985, File No. 2-97230). 3(g) - Amendment to Restated Articles of Incorporation dated August 20, 1985 (Exhibit 3(b) to Form 10-K for the year ended December 31, 1985, File No. 2-97230). 3(h) - Amendment to Restated Articles of Incorporation dated October 7, 1985 (Exhibit 3(c) to Form 10-K for the year ended December 31, 1985, File No. 2-97230). 3(i) - Amendment to Restated Articles of Incorporation dated June 12, 1986 (Exhibit 3(a) to Form 10-K for the year ended December 31, 1986, File No. 2-97230). 3(j) - Amendment to Restated Articles of Incorporation dated October 17, 1986 (Exhibit 3(b) to Form 10-K for the year ended December 31, 1986, File No. 2-97230). 3(k) - Amendment to Restated Articles of Incorporation dated July 14, 1987 (Exhibit 3(k) to Form 10-K for the year ended December 31, 1987, File No. 2-97230). 3(l) - Amendment to Restated Articles of Incorporation dated October 23, 1987 (Exhibit 3(l) to Form 10-K for the year ended December 31, 1987, File No. 2-97230). 3(m) - Amendment to Restated Articles of Incorporation dated May 4, 1988 (Exhibit 3(m) to Form 10-K for the year ended December 31, 1988, File No. 2-97230). 3(n) - Amendment to Restated Articles of Incorporation dated May 5, 1988 (Exhibit 3(n) to Form 10-K for the year ended December 31, 1988, File No. 2-97230). 3(o) - Amendment to Restated Articles of Incorporation dated May 5, 1988 (Exhibit 3(o) to Form 10-K for the year ended December 31, 1988, File No. 2-97230). TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES Exhibit No. Description 3(p) - Amendment to Restated Articles of Incorporation dated December 5, 1988 (Exhibit 3(p) to Form 10-K for the year ended December 31, 1988, File No. 2-97230). 3(q) - Amendment to Restated Articles of Incorporation dated April 11, 1989 (Exhibit 3(q) to Form 10-K for the year ended December 31, 1989, File No. 2-97230). 3(r) - Amendment to Restated Articles of Incorporation dated July 27, 1989 (Exhibit 3(r) to Form 10-K for the year ended December 31, 1989, File No. 2-97230). 3(s) - Amendment to Restated Articles of Incorporation dated October 23, 1989 (Exhibit 3(s) to Form 10-K for the year ended December 31, 1989, File No. 2-97230). 3(t) - Amendment to Restated Articles of Incorporation dated May 16, 1990 (Exhibit 3(t) to Form 10-K for the year ended December 31, 1990, File No. 2-97230). 3(u) - Amendment to Restated Articles of Incorporation dated June 26, 1990 (Exhibit 3(u) to Form 10-K for the year ended December 31, 1990, File No. 2-97230). 3(v) - Amendment to Restated Articles of Incorporation dated November 27, 1990 (Exhibit 3(v) to Form 10-K for the year ended December 31, 1990, File No. 2-97230). 3(w) - Amendment to Restated Articles of Incorporation dated May 1, 1991 (Exhibit 3(w) to Form 10-K for the year ended December 31, 1991, File No. 2-97230). 3(x) - Amendment to Restated Articles of Incorporation dated July 18, 1991 (Exhibit 3(x) to Form 10-K for the year ended December 31, 1991, File No. 2-97230). 3(y) - Amendment to Restated Articles of Incorporation dated October 18, 1991 (Exhibit 3(y) to Form 10-K for the year ended December 31, 1991, File No. 2-97230). 3(z) - Amendment to Restated Articles of Incorporation dated April 30, 1992 (Exhibit 3(z) to Form 10-K for the year ended December 31, 1992, File No. 2-97230). 3(aa) - Amendment to Restated Articles of Incorporation dated June 19, 1992 (Exhibit 3(aa) to Form 10-K for the year ended December 31, 1992, File No. 2-97230). 3(bb) - Amendment to Restated Articles of Incorporation dated November 3, 1992 (Exhibit 3(bb) to Form 10-K for the year ended December 31, 1992, File No. 2-97230). *3(cc) - Amendment to Restated Articles of Incorporation dated April 7, 1993. *3(dd) - Amendment to Restated Articles of Incorporation dated July 22, 1993. *3(ee) - Amendment to Restated Articles of Incorporation dated October 21, 1993. 3(ff) - Bylaws of the Utility, as amended February 18, 1992 (Exhibit 3(cc) to Form 10-K for the year ended December 31, 1992, File No. 2-97230). 4(a) - Indenture of Mortgage and Deed of Trust dated as of November 1, 1944 (Exhibit 2(d), File No. 2-61323). 4(b) - Seventh Supplemental Indenture dated as of May 1, 1963 (Exhibit 2(k), File No. 2-61323). TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES Exhibit No. Description 4(c) - Eighth Supplemental Indenture dated as of July 1, 1963 (Exhibit 2(1), File No. 2-61323). 4(d) - Ninth Supplemental Indenture dated as of August 1, 1965 (Exhibit 2(m), File No. 2-61323). 4(e) - Tenth Supplemental Indenture dated as of May 1, 1966 (Exhibit 2(n), File No. 2-61323). 4(f) - Eleventh Supplemental Indenture dated as of October 1, 1969 (Exhibit 2(o), File No. 2-61323). 4(g) - Twelfth Supplemental Indenture dated as of May 1, 1971 (Exhibit 2(p), File No. 2-61323). 4(h) - Thirteenth Supplemental Indenture dated as of July 1, 1974 (Exhibit 2(q), File No. 2-61323). 4(i) - Fourteenth Supplemental Indenture dated as of March 1, 1975 (Exhibit 2(r), File No. 2-61323). 4(j) - Fifteenth Supplemental Indenture dated as of September 1, 1976 (Exhibit 2(e), File No. 2-57034). 4(k) - Sixteenth Supplemental Indenture dated as of November 1, 1981 (Exhibit 4(x), File No. 2-74332). 4(l) - Seventeenth Supplemental Indenture dated as of December 1, 1982 (Exhibit 4(cc), File No. 2-80407). 4(m) - Eighteenth Supplemental Indenture dated as of September 1, 1983 (Exhibit (a) to Form 10-Q for the quarter ended September 30, 1983, File No. 1-4756). 4(n) - Nineteenth Supplemental Indenture dated as of May 1, 1985 (Exhibit 4(v), File No. 2-97230). 4(o) - Twentieth Supplemental Indenture dated as of July 1, 1987 (Exhibit 4(o) to Form 10-K for the year ended December 31, 1987, File No. 2-97230). 4(p) - Twenty-First Supplemental Indenture dated as of July 1, 1989 (Exhibit 4(p) to Form 10-Q for the quarter ended June 30, 1989, File No. 2-97230). 4(q) - Twenty-Second Supplemental Indenture dated as of January 15, 1992 (Exhibit 4(q) to Form 10-K for the year ended December 31, 1991, File No. 2-97230). *4(r) - Twenty-Third Supplemental Indenture dated as of September 15, 1993. 4(s) - Indenture and Security Agreement for Secured Debentures dated as of January 15, 1992 (Exhibit 4(r) to Form 10-K for the year ended December 31, 1991, File No. 2-97230). *4(t) - Indenture and Security Agreement for Secured Debentures dated as of September 15, 1993. TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES Exhibit No. Description Material Contracts Relating to TNP One 10(a) - Fuel Supply Agreement, dated November 18, 1987, between Phillips Coal Company and the Utility (Exhibit 10(j) to Form 10-K for the year ended December 31, 1987, File No. 2-97230). 10(b) - Unit 1 First Amended and Restated Project Loan and Credit Agreement, dated as of January 8, 1992 (the "Unit 1 Credit Agreement"), among the Utility, Texas Generating Company ("TGC"), the banks named therein as Banks (the "Unit 1 Banks") and The Chase Manhattan Bank (National Association), as Agent for the Unit 1 Banks (the "Unit 1 Agent"), amending and restating the Project Loan and Credit Agreement among such parties dated as of December 1, 1987 (Exhibit 10(c) to Form 10- K for the year ended December 31, 1991, File No. 2-97230). 10(b)1 - Participation Agreement, dated as of January 8, 1992, among the banks named therein as Banks, the parties named therein as Participants and the Unit 1 Agent (Exhibit 10(c)1 to Form 10-K for the year ended December 31, 1991, File No. 2-97230). *10(b)2 - Amendment No. 1, dated as of September 21, 1993, to the Unit 1 Credit Agreement. 10(c) - Assignment and Security Agreement, dated as of January 8, 1992, among TGC and the Unit 1 Agent, for the benefit of the Secured Parties, as defined in the Unit 1 Credit Agreement, amending and restating the Assignment and Security Agreement among such parties dated as of December 1, 1987 (Exhibit 10(d) to Form 10- K for the year ended December 31, 1991, File No. 2-97230). 10(d) - Assignment and Security Agreement, dated December 1, 1987, executed by the Utility in favor of the Unit 1 Agent for the benefit of the Secured Parties, as defined therein (Exhibit 10(u) to Form 10-K for the year ended December 31, 1987, File No. 2-97230). 10(e) - Amended and Restated Subordination Agreement, dated as of October 1, 1988, among the Utility, Continental Illinois National Bank and Trust Company of Chicago and the Unit 1 Agent, amending and restating the Subordination Agreement among such parties dated as of December 1, 1987 (Exhibit 10(uu) to Form 10-K for the year ended December 31, 1988, File No. 2- 97230). 10(f) - Mortgage and Deed of Trust (With Security Agreement and UCC Financing Statement for Fixture Filing), dated to be effective as of December 1, 1987, and executed by Project Funding Corporation ("PFC"), as Mortgagor, to Donald H. Snell, as Mortgage Trustee, for the benefit of the Secured Parties, as defined therein (Exhibit 10(ee) to Form 10-K for the year ended December 31, 1987, File No. 2-97230). 10(f)1 - Supplemental Mortgage and Deed of Trust (With Security Agreement and UCC Financing Statement for Fixture Filing), executed by TGC, as Mortgagor, on January 27, 1992, to be effective as of December 1, 1987, to Donald H. Snell, as Mortgage Trustee, for the benefit of the Secured Parties, as defined therein (Exhibit 10(g)4 to Form 10-K for the year ended December 31, 1991, File No. 2-97230). 10(f)2 - First TGC Modification and Extension Agreement, dated as of January 24, 1992, among the Unit 1 Banks, the Unit 1 Agent, the Utility and TGC (Exhibit 10(g)1 to Form 10-K for the year ended December 31, 1991, File No. 2-97230). TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES Exhibit No. Description 10(f)3 - Second TGC Modification and Extension Agreement, dated as of January 27, 1992, among the Unit 1 Banks, the Unit 1 Agent, the Utility and TGC (Exhibit 10(g)2 to Form 10-K for the year ended December 31, 1991, File No. 2-97230). 10(f)4 - Third TGC Modification and Extension Agreement, dated as of January 27, 1992, among the Unit 1 Banks, the Unit 1 Agent, the Utility and TGC (Exhibit 10(g)3 to Form 10-K for the year ended December 31, 1991, File No. 2-97230). *10(f)5 - Fourth TGC Modification and Extension Agreement, dated as of September 29, 1993, among the Unit 1 Banks, the Unit 1 Agent, the Utility and TGC. *10(f)6 - Fifth TGC Modification and Extension Agreement, dated as of September 29, 1993, among the Unit 1 Banks, the Unit 1 Agent, the Utility and TGC. 10(g) - Indemnity Agreement, made as of the 1st day of December, 1987, by Westinghouse, CE and Zachry, as Indemnitors, for the benefit of the Secured Parties, as defined therein (Exhibit 10(ff) to Form 10-K for the year ended December 31, 1987, File No. 2- 97230). 10(h) - Second Lien Mortgage and Deed of Trust (With Security Agreement) executed by the Utility, as Mortgagor, to Donald H. Snell, as Mortgage Trustee, for the benefit of the Secured Parties, as defined therein (Exhibit 10(jj) to Form 10-K for the year ended December 31, 1987, File No. 2-97230). 10(h)1 - Correction Second Lien Mortgage and Deed of Trust (with Security Agreement), dated as of December 1, 1987, executed by the Utility, as Mortgagor, to Donald H. Snell, as Mortgage Trustee, for the benefit of the Secured Parties, as defined therein (Exhibit 10(vv) to Form 10-K for the year ended December 31, 1988, File No. 2-97230). 10(h)2 - Second Lien Mortgage and Deed of Trust (with Security Agreement) Modification, Extension and Amendment Agreement, dated as of January 8, 1992, executed by the Utility to Donald H. Snell, as Mortgage Trustee, for the benefit of the Secured Parties, as defined therein (Exhibit 10(i)2 to Form 10-K for the year ended December 31, 1991, File No. 2-97230). *10(h)3 - TNP Second Lien Mortgage Modification No. 2, dated as of September 21, 1993, executed by the Utility to Donald H. Snell, as Mortgage Trustee, for the benefit of the Secured Parties, as defined therein. 10(i) - Agreement for Conveyance and Partial Release of Liens, made as of the 1st day of December, 1987, by PFC and the Unit 1 Agent for the benefit of the Utility (Exhibit 10(kk) to Form 10-K for the year ended December 31, 1987, File No. 2-97230). 10(j) - Inducement and Consent Agreement, dated as of June 15, 1988, between Phillips Coal Company, Kiewit Texas Mining Company, the Utility, Phillips Petroleum Company and Peter Kiewit Son's, Inc. (Exhibit 10(nn) to Form 10-K for the year ended December 31, 1988, File No. 2-97230). 10(k) - Assumption Agreement, dated as of October 1, 1988, executed by TGC, in favor of the Issuing Bank, as defined therein, the Unit 1 Banks, the Unit 1 Agent and the Depositary, as defined therein (Exhibit 10(ww) to Form 10-K for the year ended December 31, 1988, File No. 2-97230). TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES Exhibit No. Description 10(l) - Guaranty, dated as of October 1, 1988, executed by the Utility and given in respect of the TGC obligations under the Unit 1 Credit Agreement (Exhibit 10(xx) to Form 10-K for the year ended December 31, 1988, File No. 2-97230). 10(m) - First Amended and Restated Facility Purchase Agreement, dated as of January 8, 1992, among the Utility, as the Purchaser, and TGC, as the Seller, amending and restating the Facility Purchase Agreement among such parties dated as of October 1, 1988 (Exhibit 10(n) to Form 10-K for the year ended December 31, 1991, File No. 2-97230). 10(n) - Operating Agreement, dated as of October 1, 1988, among the Utility and TGC (Exhibit 10(zz) to Form 10-K for the year ended December 31, 1988, File No. 2-97230). 10(o) - Unit 2 First Amended and Restated Project Loan and Credit Agreement, dated as of January 8, 1992 (the "Unit 2 Credit Agreement"), among the Utility, Texas Generating Company II ("TGCII"), the banks named therein as Banks (the "Unit 2 Banks") and The Chase Manhattan Bank (National Association), as Agent for the Unit 2 Banks (the "Unit 2 Agent"), amending and restating the Project Loan and Credit Agreement among such parties dated as of October 1, 1988 (Exhibit 10(q) to Form 10-K for the year ended December 31, 1991, File No. 2-97230). *10(o)1 - Amendment No. 1, dated as of September 21, 1993, to the Unit 2 Credit Agreement. 10(p) - Assignment and Security Agreement, dated as of January 8, 1992, among TGCII and the Unit 2 Agent, for the benefit of the Secured Parties, as defined in the Unit 2 Credit Agreement, amending and restating the Assignment and Security Agreement among such parties dated as of October 1, 1988 (Exhibit 10(r) to Form 10-K for the year ended December 31, 1991, File No. 2- 97230). 10(q) - Assignment and Security Agreement, dated as of October 1, 1988, executed by the Utility in favor of the Unit 2 Agent for the benefit of the Secured Parties, as defined therein (Exhibit 10(jjj) to Form 10-K for the year ended December 31, 1988, File No. 2-97230). 10(r) - Subordination Agreement, dated as of October 1, 1988, among the Utility, Continental Illinois National Bank and Trust Company of Chicago and the Unit 2 Agent (Exhibit 10(mmm) to Form 10-K for the year ended December 31, 1988, File No. 2-97230). 10(s) - Mortgage and Deed of Trust (With Security Agreement and UCC Financing Statement for Fixture Filing), dated to be effective as of October 1, 1988, and executed by Texas PFC, Inc., as Mortgagor, to Donald H. Snell, as Mortgage Trustee, for the benefit of the Secured Parties, as defined therein (Exhibit 10(uuu) to Form 10-K for the year ended December 31, 1988, File No. 2-97230). 10(s)1 - First TGCII Modification and Extension Agreement, dated as of January 24, 1992, among the Unit 2 Banks, the Unit 2 Agent, the Utility and TGCII (Exhibit 10(u)1 to Form 10-K for the year ended December 31, 1991, File No. 2-97230). 10(s)2 - Second TGCII Modification and Extension Agreement, dated as of January 27, 1992, among the Unit 2 Banks, the Unit 2 Agent, the Utility and TGCII (Exhibit 10(u)2 to Form 10-K for the year ended December 31, 1991, File No. 2-97230). TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES Exhibit No. Description 10(s)3 - Third TGCII Modification and Extension Agreement, dated as of January 27, 1992, among the Unit 2 Banks, the Unit 2 Agent, the Utility and TGCII (Exhibit 10(u)3 to Form 10-K for the year ended December 31, 1991, File No. 2-97230). *10(s)4 - Fourth TGCII Modification and Extension Agreement, dated as of September 29, 1993, among the Unit 2 Banks, the Unit 2 Agent, the Utility and TGCII. 10(t) - Release and Waiver of Liens and Indemnity Agreement, made effective as of the 1st day of October, 1988, by a consortium composed of Westinghouse, CE, and Zachry (Exhibit 10(vvv) to Form 10-K for the year ended December 31, 1988, File No. 2- 97230). 10(u) - Second Lien Mortgage and Deed of Trust (With Security Agreement), dated as of October 1, 1988, and executed by the Utility, as Mortgagor, to Donald H. Snell, as Mortgage Trustee, for the benefit of the Secured Parties, as defined therein (Exhibit 10(www) to Form 10-K for the year ended December 31, 1988, File No. 2-97230). 10(u)1 - Second Lien Mortgage and Deed of Trust (with Security Agreement) Modification, Extension and Amendment Agreement, dated as of January 8, 1992, executed by the Utility to Donald H. Snell, as Mortgage Trustee, for the benefit of the Secured Parties, as defined therein (Exhibit 10(w)1 to Form 10-K for the year ended December 31, 1991, File No. 2-97230). *10(u)2 - TNP Second Lien Mortgage Modification No. 2, dated as of September 21, 1993, executed by the Utility to Donald H. Snell, as Mortgage Trustee, for the benefit of the Secured Parties, as defined therein. 10(v) - Intercreditor and Nondisturbance Agreement, dated as of October 1, 1988, among PFC, Texas PFC, Inc., the Utility, the Project Creditors, as defined therein, and the Collateral Agent, as defined therein (Exhibit 10(xxx) to Form 10-K for the year ended December 31, 1988, File No. 2-97230). 10(v)1 - Amendment #1, dated as of January 8, 1992, to the Intercreditor and Nondisturbance Agreement, dated as of October 1, 1988, among TGC, TGCII, the Utility, the Unit 1 Banks, the Unit 2 Banks and The Chase Manhattan Bank (National Association) in its capacity as collateral agent for the Unit 1 Banks and the Unit 2 Banks (Exhibit 10(x)1 to Form 10-K for the year ended December 31, 1991, File No. 2-97230). *10(v)2 - Amendment No. 2, dated as of September 21, 1993, to the Intercreditor and Nondisturbance Agreement, among TGC, TGCII, the Utility, the Unit 1 Banks, the Unit 2 Banks and The Chase Manhattan Bank (National Association) in its capacity as collateral agent for the Unit 1 Banks and the Unit 2 Banks. 10(w) - Grant of Reciprocal Easements and Declaration of Covenants Running with the Land, dated as of the 1st day of October, 1988 between PFC and Texas PFC, Inc. (Exhibit 10(yyy) to Form 10-K for the year ended December 31, 1988, File No. 2-97230). 10(x) - Non-Partition Agreement, dated as of May 30, 1990, among the Utility, TGC and The Chase Manhattan Bank (National Association), as Agent for the Banks which are parties to the Unit 1 Credit Agreement (Exhibit 10(ss) to Form 10-K for the year ended December 31, 1990, File No. 2-97230). TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES Exhibit No. Description 10(y) - Assumption Agreement, dated July 26, 1991, to be effective as of May 31, 1991, by TGCII in favor of the Issuing Bank, the Unit 2 Banks, the Unit 2 Agent and the Depositary, as defined therein (Exhibit 10(kkk) to Amendment No. 1 to File No. 33- 41903). 10(z) - Guaranty, dated July 26, 1991, to be effective as of May 31, 1991, by the Utility and given in respect of the TGCII obligations under the Unit 2 Credit Agreement (Exhibit 10(lll) to Amendment No. 1 to File No. 33-41903). 10(aa) - First Amended and Restated Facility Purchase Agreement, dated as of January 8, 1992, among the Utility, as the Purchaser, and TGCII, as the Seller, amending and restating the Facility Purchase Agreement among such parties dated July 26, 1991, to be effective as of May 31, 1991 (Exhibit 10(dd) to Form 10-K for the year ended December 31, 1991, File No. 2-97230). *10(aa)1 - Amendment No. 1 to the Unit 2 First Amended and Restated Facility Purchase Agreement, dated as of September 21, 1993, among the Utility, as the Purchaser, and TGCII, as the Seller. 10(bb) - Operating Agreement, dated July 26, 1991, to be effective as of May 31, 1991, between the Utility and TGCII (Exhibit 10(nnn) to Amendment No. 1 to File No. 33-41903). 10(cc) - Non-Partition Agreement, executed July 26, 1991, to be effective as of May 31, 1991, among the Utility, TGCII and The Chase Manhattan Bank (National Association) (Exhibit 10(ppp) to Amendment No. 1 to File No. 33-41903). Power Supply Contracts 10(dd) - Contract dated May 12, 1976 between the Utility and Houston Lighting & Power Company (Exhibit 5(a), File No. 2-69353). 10(dd)1 - Amendment, dated January 4, 1989, to the Contract dated May 12, 1976 between the Utility and Houston Lighting & Power Company (Exhibit 10(cccc) to Form 10-K for the year ended December 31, 1988, File No. 2-97230). 10(ee) - Contract dated May 1, 1986 between the Utility and Texas Electric Utilities Company, amended September 29, 1986, October 24, 1986 and February 21, 1987 (Exhibit 10(c) of Form 8 applicable to Form 10-K for the year ended December 31, 1986, File No. 2-97230). 10(ff) - Amended and Restated Agreement for Electric Service dated May 14, 1990 between the Utility and Texas Utilities Electric Company (Exhibit 10(vv) to Form 10-K for the year ended December 31, 1990, File No. 2-97230). 10(ff)1 - Amendment, dated April 19, 1993, to Amended and Restated Agreement for Electric Service, dated May 14, 1990, As Amended between the Utility and Texas Utilities Electric Company (Exhibit 10(ii)1 to Form S-2 Registration Statement, filed on July 19, 1993, File No. 33-66232). 10(gg) - Contract dated June 11, 1984 between the Utility and Southwestern Public Service Company (Exhibit 10(d) of Form 8 applicable to Form 10-K for the year ended December 31, 1986, File No. 2-97230). TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES Exhibit No. Description 10(hh) - Contract dated April 27, 1977 between the Utility and West Texas Utilities Company amended April 14, 1982, April 19, 1983, May 18, 1984 and October 21, 1985 (Exhibit 10(e) of Form 8 applicable to Form 10-K for the year ended December 31, 1986, File No. 2-97230). 10(ii) - Contract dated April 29, 1987 between the Utility and El Paso Electric Company (Exhibit 10(f) of Form 8 applicable to Form 10-K for the year ended December 31, 1986, File No. 2-97230). 10(jj) - Contract dated February 28, 1974, amended May 13, 1974, November 26, 1975, August 26, 1976 and October 7, 1980 between the Utility and Public Service Company of New Mexico (Exhibit 10(g) of Form 8 applicable to Form 10-K for the year ended December 31, 1986, File No. 2-97230). 10(jj)1 - Amendment, dated February 22, 1982, to the Contract dated February 28, 1974, amended May 13, 1974, November 26, 1975, August 26, 1976, and October 7, 1980 between the Utility and Public Service Company of New Mexico (Exhibit 10(iiii) to Form 10-K for the year ended December 31, 1988, File No. 2-97230). 10(jj)2 - Amendment, dated February 8, 1988, to the Contract dated February 28, 1974, amended May 13, 1974, November 26, 1975, August 26, 1976, and October 7, 1980 between the Utility and Public Service Company of New Mexico (Exhibit 10(jjjj) to Form 10-K for the year ended December 31, 1988, File No. 2-97230). 10(jj)3 - Amended and Restated Contract for Electric Service, dated April 29, 1988, between the Utility and Public Service Company of New Mexico (Exhibit 10(zz)3 to Amendment No. 1 to File No. 33- 41903). 10(kk) - Contract dated December 8, 1981 between the Utility and Southwestern Public Service Company amended December 12, 1984, December 2, 1985 and December 19, 1986 (Exhibit 10(h) of Form 8 applicable to Form 10-K for the year ended December 31, 1986, File No. 2-97230). 10(kk)1 - Amendment, dated December 12, 1988, to the Contract dated December 8, 1981 between the Utility and Southwestern Public Service Company amended December 12, 1984, December 2, 1985 and December 19, 1986 (Exhibit 10(llll) to Form 10-K for the year ended December 31, 1988, File No. 2-97230). 10(kk)2 - Amendment, dated December 12, 1990, to the Contract dated December 8, 1981 between the Utility and Southwestern Public Service Company (Exhibit 19(t) to Form 10-K for the year ended December 31, 1990, File No. 2-97230). 10(ll) - Contract dated August 31, 1983, between the Utility and Capitol Cogeneration Company, Ltd. (including letter agreement dated August 14, 1986) (Exhibit 10(i) of Form 8 applicable to Form 10-K for the year ended December 31, 1986, File No. 2-97230). 10(ll)1 - Agreement Substituting a Party, dated May 3, 1988, among Capitol Cogeneration Company, Ltd., Clear Lake Cogeneration Limited Partnership and the Utility (Exhibit 10(nnnn) to Form 10-K for the year ended December 31, 1988, File No. 2-97230). TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES Exhibit No. Description 10(ll)2 - Letter Agreements, dated May 30, 1990 and August 28, 1991, between Clear Lake Cogeneration Limited Partnership and the Utility (Exhibit 10(oo)2 to Form 10-K for the year ended December 31, 1992, File No. 2-97230). 10(ll)3 - Notice of Extension Letter, dated August 31, 1992, between Clear Lake Cogeneration Limited Partnership and the Utility (Exhibit 10(oo)3 to Form 10-K for the year ended December 31, 1992, File No. 2-97230). 10(ll)4 - Scheduling Agreement, dated September 15, 1992, between Clear Lake Cogeneration Limited Partnership and the Utility (Exhibit 10(oo)4 to Form 10-K for the year ended December 31, 1992, File No. 2-97230). 10(mm) - Interconnection Agreement between the Utility and Plains Electric Generation and Transmission Cooperative, Inc. dated July 19, 1984 (Exhibit 10(j) of Form 8 applicable to Form 10-K for the year ended December 31, 1986, File No. 2-97230). 10(nn) - Interchange Agreement between the Utility and El Paso Electric Company dated April 29, 1987 (Exhibit 10(l) of Form 8 applicable to Form 10-K for the year ended December 31, 1986, File No. 2-97230). 10(oo) - DC Terminal Participation Agreement between the Utility and El Paso Electric Company dated December 8, 1981 amended April 29, 1987 (Exhibit 10(m) of Form 8 applicable to Form 10-K for the year ended December 31, 1986, File No. 2-97230). Employment Contracts *10(pp) - Texas-New Mexico Power Company Executive Agreement for Severance Compensation Upon Change in Control, executed November 11, 1993, between Sector Vice President and Chief Financial Officer and the Utility (Pursuant to Instruction 2 of Reg. 229.601(a), accompanying this document is a schedule: (i) identifying documents substantially identical to the document which have been omitted from the Exhibits; and (ii) setting forth the material details in which such omitted documents differ from the document). *10(qq) - Texas-New Mexico Power Company Key Employee Agreement for Severance Compensation Upon Change in Control, executed November 11, 1993, between Assistant Treasurer and the Utility (Pursuant to Instruction 2 of Reg. 229.601(a), accompanying this document is a schedule: (i) identifying documents substantially identical to the document which have been omitted from the Exhibits; and (ii) setting forth the material details in which such omitted documents differ from the document). *10(rr) - Agreement between James M. Tarpley and TNPE and the Utility, effective January 1, 1994. *10(ss) - Agreement between Dwight R. Spurlock and TNPE and the Utility, effective November 9, 1993. *21 - Subsidiaries of the Registrant.

754673_1993.txt

754673_1993

1993

754673

ITEM 1. Business SUFFOLK BANCORP ("Registrant") Registrant was incorporated on January 2, 1985 for the purpose of becoming a bank holding company. On that date, the Registrant acquired, and now owns, all of the outstanding capital stock of The Suffolk County National Bank. On July 14, 1988, the Registrant acquired and now owns all the outstanding capital stock of Island Computer Corporation of New York, Inc. The business of the Registrant consists primarily of the ownership, supervision, and control of its subsidiaries. The registrant's chief competition is local banking institutions with main or branch offices in the service area of The Suffolk County National Bank, including North Fork Bank and Trust Co., Bridgehampton National Bank, and Bank of the Hamptons. Additionally, New York City money center banks and regional banks provide competition. These banks include Bank of New York, Chemical Bank, Fleet Bank, European American Bank and National Westminster Bank USA. Registrant and its subsidiaries had 286 full-time and 38 part-time employees as of December 31, 1993. THE SUFFOLK COUNTY NATIONAL BANK ("Bank") The Suffolk County National Bank of Riverhead was organized under the National Banking laws of the United States of America on January 6, 1890. The Bank is a member of the Federal Reserve System, and its deposits are insured by the Federal Deposit Insurance Corporation to the extent provided by law. Directed by members of the communities it serves, the Bank's main service area includes the towns of Brookhaven, Riverhead, Southampton, and Southold. The main office of the Bank is situated at 6 West Second Street, Riverhead, New York. Its branch offices are located at Center Moriches, Cutchogue, Hampton Bays, Mattituck, Medford, Port Jefferson, Riverhead-Ostrander Avenue, Westhampton Beach, Shoreham, and Wading River. Separate retail lending and trust facilities are located in Riverhead, New York. The Bank is a full-service bank serving the needs of the local residents of eastern Suffolk County. Approximately 90 percent of the Bank's business is devoted to rendering services to those residing in the immediate area of the Bank's main and branch offices. Among the services rendered by the Bank are the maintenance of checking accounts, savings accounts, time and savings certificates, money market accounts, negotiable-order-of-withdrawal accounts, holiday club accounts and individual retirement accounts; the making of secured and unsecured loans, including commercial loans to individuals, partnerships and corporations, agricultural loans to farmers, installment loans to finance small businesses, mobile home loans, automobile loans, home equity and real estate mortgage loans; the maintenance of safe deposit boxes; the performance of trust and estate services, and the maintenance of a master pension plan for self-employed individuals' participation. The business of the Bank is not seasonal, as a great majority of the Bank's business is devoted to those residing in the Bank's service area. ISLAND COMPUTER CORPORATION OF NEW YORK, INC. ("Island Computer") Island Computer Corporation of New York, Inc. is a data processing company which serves several bank and thrift institutions, including The Suffolk County National Bank. STATISTICAL DISCLOSURE Pages 6 through 17 of this Annual Report to Shareholders for the fiscal year ended December 31, 1993. ITEM 2. ITEM 2. Properties Registrant Registrant as such has no physical properties. Office facilities of the Registrant are located at 6 West Second Street, Riverhead, New York. Bank The Bank's main offices are also located at 6 West Second Street, Riverhead, New York, which the Bank owns in fee. The Bank owns a total of seven buildings in fee, and holds nine buildings under lease agreements. Island Computer Island Computer's offices are located at 40 Orville Drive, Bohemia, New York, which Island Computer holds under a lease agreement. In the opinion of management of the Registrant, the physical facilities are suitable and adequate and at present are being fully utilized. The Company, however, is evaluating future needs, and anticipates changes in its facilities during the next several years. ITEM 3. ITEM 3. Legal Proceedings There are no material legal proceedings, individually or in the aggregate to which the Registrant or its subsidiaries are a party or of which any of the property is subject. 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 Pages 6 and 20 of this Annual Report to Shareholders for the fiscal year ended December 31, 1993. At December 31, 1993, there were approximately 1,400 equity holders of record of the Company's common stock. ITEM 6. ITEM 6. Selected Financial Data Page 30 of this Annual Report to Shareholders for the fiscal year ended December 31, 1993. ITEM 7. ITEM 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Pages 7 through 17 of this Annual Report to Shareholders for the fiscal year ended December 31, 1993. ITEM 8. ITEM 8. Financial Statements and Supplementary Data Pages 18 to 30 of this Annual Report to Shareholders for the fiscal year ended December 31, 1993. 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 Pages 2 - 6 of Registrant's Proxy Statement for its Annual Meeting of Shareholders to be held on April 12, 1994 is incorporated herein by reference. Executive Officers ITEM 11. ITEM 11. Executive Compensation Pages 3 - 6 of Registrant's Proxy Statement for its Annual Meeting of Shareholders to be held on April 12, 1994 is incorporated herein by reference. ITEM 12. ITEM 12. Security Ownership of Certain Beneficial Owners and Management Pages 2, 4, 5, and 6 of Registrant's Proxy Statement for its Annual Meeting of Shareholders to be held on April 12, 1994 is incorporated herein by reference. There were no beneficial owners of more than five percent of the Common Stock of the Registrant as of February 10, 1994. ITEM 13. ITEM 13. Certain Relationships and Related Transactions Pages 7 and 8 of Registrant's Proxy Statement for its Annual Meeting of Shareholders to be held on April 12, 1994 is incorporated herein by reference. PART IV ITEM 14. ITEM 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K The following consolidated financial statements of the Registrant and Subsidiaries, and the accountant's report thereon, included on Page 18 through 32 inclusive, of Registrant's Annual Report to Shareholders for the fiscal year ended December 31, 1993. Financial Statements (Consolidated) Statements of Condition - December 31, 1993 and 1992 Statements of Income - For the years ended December 31, 1993, 1992, and 1991 Statements of Changes in Stockholders' Equity - For the years ended December 31, 1993, 1992, and 1991 Statements of Cash Flows - For the years ended December 31, 1993, 1992, and Notes to Consolidated Financial Statements EXHIBITS The following exhibits, which supplement this report, have been filed with the Securities and Exchange Commission. Suffolk Bancorp will furnish a copy of any or all of the following exhibits to any person so requesting in writing to Secretary, Suffolk Bancorp, 6 West Second Street, Riverhead, New York 11901. A. Certificate of Incorporation of Suffolk Bancorp (filed by incorporation by reference to Suffolk Bancorp's Form 10-K for the fiscal year ended December 31, 1985, filed March 18, 1986) B. Bylaws of Suffolk Bancorp (filed by incorporation by reference to Suffolk Bancorp's Form 10-K for the fiscal year ended December 31, 1985, filed March 18, 1986.) The following Exhibit is submitted herewith: C. Notice of Annual Meeting and Proxy Statement. Reports on Form 8-K There were no reports filed on Form 8-K for the three month period ended December 31, 1993. EXHIBIT INDEX 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 it's behalf by the undersigned, thereunto duly authorized. SUFFOLK BANCORP February 28, 1994 - -------------------- (Registrant) By /s/ Raymond A. Mazgulski ------------------------- RAYMOND A. MAZGULSKI Chairman of the Board By /s/ Edward J. Merz ------------------- EDWARD J. MERZ President Chief Executive Officer Director By /s/ Victor F. Bozuhoski, Jr. ----------------------------- VICTOR F. BOZUHOSKI, JR. Executive Vice President, Chief Financial Officer & Treasurer /s/ Joseph A. Deerkoski /s/ Howard M. Finkelstein - ------------------------- -------------------------- JOSEPH A. DEERKOSKI HOWARD M. FINKELSTEIN Director Director /s/ Edgar F. Goodale /s/ J. Douglas Stark - ---------------------- --------------------- EDGAR F. GOODALE J. DOUGLAS STARK Director Director /s/ Hallock Luce III /s/ Peter Van de Wetering - ---------------------- -------------------------- HALLOCK LUCE III PETER VAN DE WETERING Director Director EXHIBIT INDEX EXHIBIT NUMBER DESCRIPTION - ------- ----------- 13 Annual Report to Shareholders

60549_1993.txt

60549_1993

1993

60549

ITEM 1. Business. - ------------------ General Incorporated July 2, 1913, Louisville Gas and Electric Company (the Company) is an operating public utility that supplies natural gas to approximately 258,000 customers and electricity to approximately 336,000 customers in Louisville and adjacent areas in Kentucky. The Company's service area covers approximately 700 square miles in 17 counties and has an estimated population of 800,000. Included in this area is the Fort Knox Military Reservation, to which the Company provides both gas and electric service, but which maintains its own distribution systems. The Company also provides gas service in limited additional areas. The Company's coal fired generating plants, which are all equipped with systems to remove sulfur dioxide, produce most of the Company's electricity; the remainder is generated by a hydroelectric power plant and combustion turbines. Underground gas storage fields help the Company provide economical and reliable gas service to customers. In August 1990, the Company and LG&E Energy Corp. (Energy Corp.) implemented a corporate reorganization pursuant to a mandatory share exchange whereby each share of outstanding common stock of the Company was exchanged on a share-for-share basis for the common stock of Energy Corp. The reorganization created a corporate structure that gives the holding company the flexibility to take advantage of opportunities to expand into other businesses while insulating the Company's utility customers and senior security holders from any risks associated with such businesses. The Company's preferred stock and first mortgage bonds were not exchanged and remained securities of the Company. The Company's Trimble County Unit 1 (Trimble County or the Unit), a 495-megawatt, coal-fired electric generating unit, which the Company began constructing in 1979, was placed in commercial operation on December 23, 1990. The Unit has been subject to numerous reviews by the Public Service Commission of Kentucky (the "Kentucky Commission" or "Commission"). In July 1988, the Kentucky Commission issued an order stating that 25% of the total cost of the Unit would not be allowed for ratemaking purposes. For a more detailed discussion of the proceedings relating to Trimble County Unit 1, see Note 8 of the Notes to Financial Statements under Item 8. In February 1993, the Company sold a 12.88% ownership interest in the Unit to Indiana Municipal Power Agency, completing the Company's plan to sell the 25% not allowed for ratemaking. The Company had previously sold a 12.12% ownership interest in the Unit to the Illinois Municipal Electric Agency in 1991. See Note 9 of the Notes to Financial Statements, Jointly Owned Electric Utility Plant, under Item 8 for a further discussion. The Clean Air Act Amendments of 1990 impose stringent limits on emissions of sulfur dioxide and nitrogen oxides by electric utility generating plants. The legislation is extremely complex and its effect will substantially depend on regulations issued by the U.S. Environmental Protection Agency. The Company is closely monitoring the continuing rule-making process, in order to assess the precise impact of the legislation on the Company. All of the Company's coal-fired boilers are equipped with sulfur dioxide "scrubbers" and already achieve the final sulfur dioxide emission rates required by the year 2000 under the legislation. However, as part of its ongoing capital construction program, the Company anticipates incurring capital expenditures during the next four years of approximately $40 million for remedial measures necessary to meet the Act's requirements for nitrogen oxides. The overall impact of the legislation on the Company is expected to be minimal. The Company is well-positioned in the market to be a "clean" power provider without the large capital expenditures which are expected to be incurred by many other utilities. For a more detailed discussion of the Clean Air Act and other environmental issues, see Environmental Matters under this Item, Item 3, Item 7, and Note 7 of the Notes to Financial Statements under Item 8. Competition among energy suppliers is increasing. In particular, competition for off-system sales, which is based primarily on price and availability of energy, has become much more intense in recent years. The addition of electric generating capacity by other utilities in the Midwest has reduced the opportunities for the Company to make interchange sales and has heightened price competition for such sales. However, such additional capacity has made lower cost power available for purchase by the Company which, in certain instances, is at a cost lower than the variable cost of generating power from the generating stations owned by the Company. In addition, the 1992 Energy Policy Act provides utilities a wider choice of sources for their electrical supply than previously available. The Act also creates generating supply options that did not exist under previous legislation and is expected to increase competition for wholesale electric sales. (See Energy Policy Act of 1992 under Item 7 for a further discussion.) The Company is responding to increased competition in a number of ways designed to lower its costs and increase sales. One such response has been for the Company's parent, LG&E Energy Corp., to realign into new business units effective January 1, 1994. Under the realignment, Energy Corp. formed a national business unit, LG&E Energy Services, to develop and manage all of its utility and non-utility electric power generation and concentrate on the marketing and brokering of electric power on a regional and national basis. The realignment will allow the Company to increase its focus on customer service and to develop more customer options as the utility industry becomes more competitive. The realignment does not affect the regulation of the Company by the Commission. In addition to the realignment, the Company is re-evaluating its regulatory strategy to pursue full cost recovery of certain deferred expenses which are recorded as a regulatory asset. See Notes 1, 2, and 7 of Notes to Financial Statements under Item 8, for a discussion of these regulatory assets. On May 24, 1993, the Federal Energy Regulatory Commission (FERC) gave final approval for a market-based rate tariff and two transmission service tariffs that were filed by the Company. The market-based rate tariff enables the Company to sell up to 75 Mw of firm generation capacity at market-based rates. It also enables the Company to sell an unlimited amount of non-firm power at market-based rates, as long as the power is from the Company's own generation resources. Under the two transmission service tariffs that were approved by FERC, utilities, independent power producers, and qualifying co-generation or small power production facilities may obtain firm or coordination transmission service from the Company. These tariffs provide open access to the Company's transmission system and enable parties requesting either type of transmission service to transmit wholesale power across the Company's system. However, service under these tariffs is not available to ultimate consumers of electric utility service. In responding to competition in the gas distribution business, the Company has upgraded gas storage facilities and invested in new equipment. By using the storage fields strategically, the Company can buy gas when prices are low, store it, and retrieve the gas when demand is high. Accessing least cost gas was made easier in November 1993 when FERC's Order No. 636 went into effect. Previously, the Company and other utilities purchased most of their gas services from pipeline companies. The order "unbundled" gas services, allowing utilities to purchase gas, transportation, and storage services separately from many different sources. Currently, the Company buys competitively priced gas from several large producers under contracts of varying duration. By purchasing from multiple suppliers, and storing any excess gas, the Company is able to secure favorably priced gas for its customers. Without storage capacity, the Company would be forced to buy gas when customer demand increases, which is usually when the price is highest. (See FERC Order No. 636 under Item 7 for a further discussion.) The Company is experiencing some of the issues common to electric and gas utility companies, namely, increased competition for customers, delays and uncertainties in the regulatory process and costs of compliance with environmental laws and regulations. For the year ended December 31, 1993, 74% of total operating revenues was derived from electric operations and 26% from gas operations. Electric and gas operating revenues and the percentages by classes of service on a combined basis for this period were as follows: (Thousands of $) ----------------------------- Electric Gas Combined % Combined -------- --- -------- ---------- Residential................. $195,273 $112,508 $307,781 44% Commercial.................. 154,337 43,568 197,905 28 Industrial.................. 104,506 28,310 132,816 19 Public authorities.......... 52,183 13,846 66,029 9 ------- ------- ------- --- Total-ultimate consumers.. 506,299 198,232 704,531 100% --- --- Other utilities............. 58,959 - 58,959 Gas transportation-net...... - 5,147 5,147 Miscellaneous............... 4,952 1,536 6,488 ------- ------- ------- Total.................... $570,210 $204,915 $775,125 ------- ------- ------- ------- ------- ------- See Note 10 of the Notes to Financial Statements under Item 8 for financial information concerning segments of business for the three years ended December 31, 1993. Electric Operations The sources of electric operating revenues and the volumes of sales for the three years ended December 31, 1993, were as follows: 1993 1992 1991 ---- ---- ---- ELECTRIC OPERATING REVENUES (Thousands of $): Residential........................ $195,273 $174,559 $193,923 Small commercial and industrial.... 70,106 66,183 68,332 Large commercial................... 84,231 80,041 81,171 Large industrial................... 104,506 101,699 102,558 Public authorities................. 52,183 49,599 51,390 ------- ------- ------- Total-ultimate consumers.......... 506,299 472,081 497,374 Other electric utilities........... 58,959 45,698 40,745 Miscellaneous...................... 4,952 3,890 4,296 ------- ------- ------- Total............................. $570,210 $521,669 $542,415 ------- ------- ------- ------- ------- ------- ELECTRIC SALES (Thousands of kwh): Residential.......................... 3,230,463 2,923,517 3,229,153 Small commercial and industrial...... 1,056,977 1,010,830 1,042,543 Large commercial..................... 1,696,686 1,624,441 1,650,894 Large industrial..................... 2,736,269 2,671,212 2,625,915 Public authorities................... 1,053,928 1,004,911 1,046,035 ---------- ---------- ---------- Total-ultimate consumers............ 9,774,323 9,234,911 9,594,540 Other electric utilities............. 3,299,510 3,234,758 2,476,921 ---------- ---------- ---------- Total............................... 13,073,833 12,469,669 12,071,461 ---------- ---------- ---------- ---------- ---------- ---------- At December 31, 1993, the Company had 336,124 electric customers. The Company uses efficient coal-fired boilers that are fully equipped with sulfur dioxide removal systems to generate electricity. The Company's system wide emission rate for sulfur dioxide in 1993 was approximately .78 lbs./MMBtu of heat input, which is significantly below the Phase II limit of 1.2 lbs./MMBtu established by the Clean Air Act Amendments for the year 2000. On Monday, August 30, 1993, the Company set a record local peak load of 2,239 Mw, when the temperature at the time of peak reached 94 degrees Fahrenheit (average for the day was 84 degrees Fahrenheit). The record system peak of 3,223 Mw (which included purchases from and short-term sales to other electric utilities) occurred on Thursday, May 30, 1991. The reliability criterion for generation capacity planning is to provide a minimum reserve margin of 18%. At February 28, 1994, the Company owned steam and combustion turbine generating facilities with a capacity of 2,613 Mw and an 80 Mw hydroelectric facility on the Ohio River. See Item 2, Properties. The Company is a participating owner with 14 other electric utilities of Ohio Valley Electric Corporation (OVEC) whose primary customer is the Portsmouth Area uranium-enrichment complex of the U.S. Department of Energy at Piketon, Ohio. The Company has electric transmission interconnections and/or interconnection/interchange agreements with PSI Energy, Kentucky Utilities Company, Southern Indiana Gas and Electric Company, The Cincinnati Gas & Electric Company, Indiana Michigan Power Company, OVEC, Big Rivers Electric Corporation, Tennessee Valley Authority, Wabash Valley Power Association, Indiana Municipal Power Agency, East Kentucky Power Cooperative (East Kentucky), Illinois Municipal Electric Agency, Jacksonville Electric Authority, and Ogelthorpe Power Corporation providing for various interchanges, emergency services, and other working arrangements. The Company and East Kentucky have an agreement that allows East Kentucky to purchase power during its peak season, that period during which the utility's customers use the greatest amount of power, and the Company to sell power during its off-peak season. The agreement entitles East Kentucky to buy from the Company 30 to 145 megawatts from mid-December to mid-February through 1994-95. On February 28, 1991, the Company sold a 12.12% ownership interest in Trimble County Unit 1 to the Illinois Municipal Electric Agency (IMEA), based in Springfield, Illinois, which is an agency of 30 municipalities that own and operate their own electric systems. On February 1, 1993, the Indiana Municipal Power Agency (IMPA), based in Carmel, Indiana, purchased a 12.88% interest in the Trimble County Unit. IMPA is composed of 31 municipalities that have joined together to meet their long-term electric power needs. Both IMEA and IMPA pay their proportionate share for operation and maintenance expenses of the Unit and for fuel and reactant used. They are also responsible for their proportionate share of incremental capital assets acquired. Electric and magnetic fields (sometimes referred to as 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 the Company. Certain studies have suggested a possible association between electric and magnetic fields and adverse health effects. The Electric Power Research Institute, of which the Company is a participating member, has expended approximately $65 million since 1987 in its investigation and research with regard to possible health effects posed by exposure to electric and magnetic fields. Gas Operations The sources of gas operating revenues and the volumes of sales for the three years ended December 31, 1993, were as follows: 1993 1992 1991 ---- ---- ---- GAS OPERATING REVENUES (Thousands of $): Residential........................ $112,508 $ 96,175 $ 92,142 Commercial......................... 43,568 36,801 34,913 Industrial......................... 28,310 26,156 18,683 Public authorities................. 13,846 13,884 13,107 ------- ------- ------- Total-ultimate consumers.......... 198,232 173,016 158,845 Gas transportation-net............. 5,147 4,169 5,886 Miscellaneous...................... 1,536 1,341 1,560 ------- ------- ------- Total............................. $204,915 $178,526 $166,291 ------- ------- ------- ------- ------- ------- GAS SALES (Millions of cu. ft.): Residential........................ 24,330 22,465 21,795 Commercial......................... 10,308 9,527 9,160 Industrial......................... 7,817 8,077 5,945 Public authorities................. 3,515 3,864 3,721 ------- ------- ------- Total-ultimate consumers.......... 45,970 43,933 40,621 Gas transported.................... 5,249 4,155 6,231 ------- ------- ------- Total............................. 51,219 48,088 46,852 ------- ------- ------- ------- ------- ------- At December 31, 1993, the Company had 258,185 gas customers. The Company has extensive underground natural gas storage fields that help provide economical and reliable gas service to ultimate consumers. Reflecting the changing nature of the gas business, a number of industrial customers purchase their natural gas requirements directly from producers or brokers for delivery through the Company's distribution system. Transportation of natural gas for the Company's customers does not have an adverse effect on earnings because of the offsetting decrease in gas supply expenses. The transportation rates are designed to make the Company economically indifferent as to whether gas is sold or merely transported. The all-time maximum day gas sendout of 545,000 Mcf occurred on Sunday, January 20, 1985, when the average temperature for the day was -11 degrees Fahrenheit. During 1993, the maximum day gas sendout was 447,000 Mcf, occurring on February 18, when the average temperature for the day was 11 degrees Fahrenheit. Supply on that day consisted of 171,000 Mcf from purchases, 238,000 Mcf delivered from underground storage, and 38,000 Mcf transported for industrial customers. For further discussion, see Gas Supply. On November 1, 1993, the Company began purchasing and transporting its natural gas supplies under the new requirements created by FERC Order No. 636 which was issued in 1992. While the Company had previously been able to purchase natural gas and pipeline transportation services from Texas Gas Transmission Corporation (Texas Gas), the Company now purchases only transportation services from Texas Gas pursuant to its FERC-approved tariff and acquires its supply of natural gas from several other sources. Throughout 1993, the Company undertook a review to evaluate and select the pipeline services and gas supplies needed. As a result of this review, the Company entered into several distinct transportation and purchase agreements. The Company should benefit from FERC Order No. 636 through enhanced access to competitively priced natural gas supplies as well as more flexible transportation services. The Company has made the necessary modifications to its operations and to its gas supply clause to reflect these Order No. 636 changes. (For further discussion see Gas Supply.) Regulation and Rates The Kentucky Commission has regulatory jurisdiction over the rates and service of the Company and over the issuance of certain of its securities. The Company is a "public utility" as defined in the Federal Power Act, and is subject to the jurisdiction of the Department of Energy and the FERC with respect to the matters covered in such Act, including the sale of electric energy at wholesale in interstate commerce. In addition, the FERC has sole jurisdiction over the issuance by the Company of short-term securities. For a discussion of the most recent rate order of the Kentucky Commission, see Rates and Regulation under Item 7 and Note 8 of the Notes to Financial Statements under Item 8. Increases and decreases in the cost of fuel for electric generation are reflected in the rates charged to all of the Company's electric customers by means of the Company's fuel adjustment clause. The Kentucky Commission requires public hearings at six-month intervals to examine past fuel adjustments, and at two-year intervals for the purpose of additional examination and transfer of the then current fuel adjustment charge or credit to the base charges. The Commission also requires that electric utilities, including the Company, file certain documents relating to fuel procurement and the purchase of power and energy from other utilities. The Company's gas rates contain a gas supply clause (GSC), whereby increases or decreases in the cost of gas supply are reflected in the Company's rates, subject to approval of the Kentucky Commission. The GSC procedure prescribed by order of the Commission provides for quarterly rate adjustments to reflect the expected cost of gas supply in that quarter. In addition, the GSC contains a mechanism whereby any over- or under-recoveries of gas supply cost from prior quarters will be refunded to or recovered from customers through the adjustment factor determined for subsequent quarters. In November 1993, the Commission approved a comprehensive agreement on demand side management (DSM) programs. The agreement contains a rate mechanism that provides for the recovery of DSM program costs, allows the Company to recover revenues due to lost sales associated with the DSM programs and provides the Company an incentive for implementing DSM programs. See Rates and Regulation under Item 7 for a further discussion of DSM. As part of the corporate reorganization whereby the Company became the subsidiary of LG&E Energy Corp., the Company obtained the approval of the Kentucky Commission. The order of the Kentucky Commission authorizing the Company to reorganize into a holding company structure contains certain provisions, which, among other things, ensure the Kentucky Commission access to books and records of Energy Corp. and its affiliates which relate to transactions with the Company; require Energy Corp. and its subsidiaries to employ accounting and other procedures and controls to protect against subsidization of non-utility activities by the Company's customers; and preclude the Company from guaranteeing any obligations of Energy Corp. without prior written consent from the Kentucky Commission. In addition, such order provides that the Company's board of directors has the responsibility to use its dividend policy consistent with preserving the financial strength of the Company and that the Kentucky Commission, through its authority over the Company's capital structure, can protect the Company's ratepayers from the financial effects resulting from non-utility activities. Construction Program and Financing The Company's construction program is designed to assure that there will be adequate capacity to meet the future electric and gas needs of its service area. These needs are continually being reassessed and appropriate revisions are made, when necessary, in construction schedules. The Company's estimates of its construction expenditures can vary substantially due to numerous items beyond the Company's control, such as changes in rates, economic conditions, construction costs, and new environmental or other governmental laws and regulations. At December 31, 1993, the Company's embedded cost of long-term debt was 6.4% and its ratio of earnings to fixed charges was 3.87. See Exhibit 12. For a further discussion of construction expenditures and financing, see Construction Expenditures and Capitalization and Liquidity under Item 7. During the five years ended December 31, 1993, gross property additions amounted to $580 million. Funds for about 97% of these gross additions were generated internally. The gross additions during this period amounted to approximately 24% of total utility plant at December 31, 1993, and consisted of $480 million for electric properties and $100 million for gas properties. Gross retirements during the same period were $40 million, consisting of $29 million for electric properties and $11 million for gas properties. Coal Supply Ninety percent of the Company's present electric generating capacity is coal-fired, the remainder being made up of a hydroelectric plant and combustion turbine peaking units fueled by natural gas and oil. Coal will be the predominant fuel used by the Company in the foreseeable future, with natural gas and oil being used for peaking capacity and flame stabilization in coal-fired boilers or in emergencies. The Company has no nuclear generating units and has no plans to build any in the foreseeable future. In 1992, the Company entered into coal supply agreements with various suppliers for coal deliveries for 1993 and beyond. The Company normally augments its coal supply agreements with spot market purchases which, during 1993, were about 10% of total purchases. The Company has a coal inventory policy, which is in compliance with the Kentucky Commission's directives and which the Company believes provides adequate protection under most contingencies. The Company had on hand at December 31, 1993, a coal inventory of approximately 433,000 tons, or a 28 day supply. The Company expects, for the foreseeable future, to continue purchasing most of its coal from western Kentucky and southwest Indiana, which has a sulfur content in the 2%-3.5% range. The abundant supply of this relatively low priced coal, combined with present and future desulfurization technologies, is expected to enable the Company to continue to provide adequate electric service in a manner acceptable under existing environmental laws and regulations. Coal for the Company's Mill Creek plant is delivered by rail and barge, whereas deliveries to the Cane Run plant are primarily by rail and also by truck. Deliveries to the Trimble County plant are by barge only. The average delivered cost of coal purchased by the Company, per ton and per million Btu, for the periods shown were as follows: 1993 1992 1991 ---- ---- ---- Per ton.............................. $26.58 $25.17 $24.51 Per million Btu...................... 1.14 1.09 1.06 Gas Supply During 1993, the Company continued to purchase natural gas from and transport other natural gas supplies through Texas Gas at rates and terms regulated by the FERC. The Company also continued purchasing a portion of its natural gas supplies on the spot-market and transporting those supplies under various transportation agreements with Texas Gas pursuant to applicable FERC-approved tariffs. The Company received standby service from Texas Gas until its implementation of FERC Order No. 636. As a result of FERC Order No. 636 and effective November 1, 1993, the Company entered into new transportation service agreements with Texas Gas. These agreements provide for 30,000 MMBtu (29,268 Mcf) per day in Firm Transportation (FT) throughout the year. This FT agreement expires October 31, 1997. During the winter months, the Company also has 184,900 MMBtu (180,390 Mcf) per day in No-Notice Service (NNS); during the summer months that NNS level is 135,000 MMBtu (131,707 Mcf) per day. The Company's NNS agreements with Texas Gas incorporate terms of 2, 5, and 8 years, and include unilateral roll-over provisions at the Company's option. These transportation services are provided by Texas Gas pursuant to its FERC-approved tariff. Contemporaneously with the conclusion of its transportation arrangements with Texas Gas, the Company also entered into a series of long-term firm supply arrangements with various suppliers in order to meet its firm sales obligations. The gas supply arrangements include pricing provisions which are market-responsive. These firm supplies, in tandem with pipeline transportation services, provide the reliable and flexible supply needed to replace the bundled sales service formerly supplied by the pipeline. During 1994, the Company will be participating in several regulatory proceedings at FERC. Particularly, the Company will be involved in reviewing Texas Gas' most recent rate filing, and Texas Gas' filing to recover certain transition costs associated with the FERC-mandated implementation of FERC Order No. 636. As a separate matter, the Kentucky Commission has indicated in an order issued in its Administrative Case No. 346 that transition costs, which are clearly identified as being related to the cost of the commodity itself, are appropriately recovered as a gas cost through the Company's purchased gas adjustment. The Company operates five underground gas storage fields with a current working gas capacity of 14.6 million Mcf. Gas is purchased and injected into storage during the summer season and is then withdrawn to supplement pipeline supplies to meet the gas-system load requirements during the winter heating season. The estimated maximum deliverability from storage during the early part of the 1992-1993 heating season was approximately 373,000 Mcf per day. Deliverability decreases during the latter portion of the heating season as the storage inventory is reduced by seasonal withdrawals. The average cost per Mcf of natural gas purchased by the Company was $2.91 in 1993, $2.77 in 1992, and $2.39 in 1991. Although upcoming regulatory changes may alter the ways in which the Company contracts for natural gas supplies, it is expected that the Company will continue to have adequate access to natural gas supplies at market sensitive prices. Environmental Matters Protection of the environment is a major priority for the Company. The Company engages in a variety of activities within the jurisdiction of federal, state, and local regulatory agencies. Those agencies have issued the Company permits for various activities subject to air quality, water quality, and waste management laws and regulations. For the five year period ending with 1993, expenditures for pollution control facilities represented $128 million or 22% of total construction expenditures. The cost of operating and maintaining these facilities amounted to $22 million in both 1993 and 1992. The Company's anticipated capital expenditures for 1994 to comply with environmental laws are approximately $22 million. See Item 3 and Note 7 of Notes to Financial Statements under Item 8 for a discussion of specific environmental proceedings affecting the Company. Labor Relations The Company's 1,652 operating, maintenance and construction employees are members of the International Brotherhood of Electrical Workers (IBEW) Local 2100. On May 31, 1992, the IBEW voted to ratify a new three-year collective bargaining agreement. The new agreement became effective in November 1992 and will expire in November 1995. Employees The Company had 2,749 full-time employees at December 31, 1993. During the last quarter of 1993 and early 1994, the Company eliminated a number of full-time positions, and made early retirement available to a number of other employees. See Note 2 of Notes to Financial Statements under Item 8 for a further discussion of this matter. ITEM 2. ITEM 2. Properties. - -------------------- At February 28, 1994, the Company owned and operated the following electric generating stations: Year in Steam Stations: Service Capability Rating (Kw) ------- ---------------------- Mill Creek-Kosmosdale, Ky. Unit 1.......................... 1972 303,000 Unit 2.......................... 1974 301,000 Unit 3.......................... 1978 386,000 Unit 4.......................... 1982 466,000 1,456,000 ------- Cane Run-near Louisville, Ky. Unit 3.......................... 1958 115,000 Unit 4.......................... 1962 155,000 Unit 5.......................... 1966 168,000 Unit 6.......................... 1969 240,000 678,000 ------- Trimble County-Bedford, Ky. Unit 1.......................... 1990 371,000 (1) Combustion Turbine Generators (Peaking capability): Zorn............................ 1969 16,000 Paddy's Run..................... 1968 43,000 Cane Run........................ 1968 16,000 Waterside....................... 1964 33,000 108,000 ------- --------- 2,613,000 --------- --------- (1) Amount shown represents the Company's 75% interest in the Unit. See Note 9 of the Notes to Financial Statements, Jointly Owned Electric Utility Plant, under Item 8 for a discussion of the sale of 25% of the Unit to IMEA and IMPA. The Company is responsible for operation of the Unit and is reimbursed by IMEA and IMPA for expenditures related to the Unit based on their proportionate share of ownership interest. The Company's steam stations consist mainly of coal-fired units except for Cane Run Unit 3 which must use natural gas because of restrictions mandated by environmental regulations. The Company also owns an 80 Mw hydroelectric generating station located in Louisville, operated under license issued by the FERC. At December 31, 1993, the Company's electric transmission system included 20 substations with a total capacity of approximately 10,518,897 Kva and approximately 645 structure miles of lines. The electric distribution system included 84 substations with a total capacity of approximately 2,948,768 Kva, 3,499 structure miles of overhead lines, 231 miles of underground conduit, and 5,170 miles of underground conductors. The Company's gas transmission system includes 177 miles of transmission mains, and the gas distribution system includes 3,226 miles of distribution mains. The Company operates underground gas storage facilities with a current working gas capacity of approximately 14.6 million Mcf. See Gas Supply under Item 1. In 1990, the Company entered into an operating lease for its corporate office building located in downtown Louisville, Kentucky. The lease is for a period of 15 years and is scheduled to expire June 30, 2005. Other properties owned by the Company include office buildings, service centers, warehouses, garages, and other structures and equipment, the use of which is common to both the electric and gas departments. The trust indenture securing the Company's First Mortgage Bonds constitutes a direct first mortgage lien upon substantially all property owned by the Company. ITEM 3. ITEM 3. Legal Proceedings. - --------------------------- Rate Case and Trimble County Station For a discussion of the most recent rate order of the Public Service Commission of Kentucky and a detailed discussion of the orders of the Kentucky Commission and rulings of the Franklin Circuit Court and the Kentucky Court of Appeals concerning Trimble County Unit 1, see Item 7 and Note 8 of Notes to Financial Statements under Item 8. Statewide Power Planning As required by the regulations of the Kentucky Commission, on November 15, 1993, the Company filed its 1993 biennial Integrated Resource Plan with the Kentucky Commission. The plan which updates the Company's first Integrated Resource Plan filed in 1991, proposes to meet customers' future demand through 2007 by adding resources in small increments such as short-term power purchases (1996-1999), a customer-owned standby generation program (1997), two combustion turbines (1999-2000), an air conditioner load controls program (2001-2003), an upgrade to the Company's existing hydroelectric plant (2003), and a compressed air energy storage plant (2004). The Kentucky Commission staff is in the process of reviewing the Company's plan, and is not expected to issue its report and recommendations concerning the plan until late 1994 at the earliest. The Kentucky Commission's regulations do not require it to hold any hearings or issue any formal orders regarding the Plan. Environmental The Clean Air Act Amendments of 1990 impose stringent limits on emissions of sulfur dioxide and nitrogen oxides by electric utility generating plants. This legislation is extremely complex and its effect will substantially depend on regulations issued by the U.S. Environmental Protection Agency. While the Company will incur some capital expenditures to comply with the Act's requirements, the overall impact of the Act on the Company is expected to be minimal. The Company is closely monitoring the continuing rule-making process in order to assess the precise impact of the legislation on the Company. For a complete discussion of the Company's environmental issues concerning its Mill Creek and Cane Run generating plants, manufacturing gas plant sites, and certain other environmental issues, see Note 7 of the Notes to Financial Statements under Item 8. Based upon prior precedents established by the Kentucky Commission and the Environmental Cost Recovery legislation, the Company expects to have an opportunity to recover through future ratemaking proceedings, its costs associated with remedial measures required to comply with environmental laws and regulations. Other The Company is a defendant in lawsuits seeking compensatory and, in certain instances, punitive damages for injuries purportedly incurred by individuals coming into contact with the Company's electric or gas facilities and/or services. To the extent that damages are assessed in any of these lawsuits, the Company believes that its insurance coverage is adequate and that the effect of any such damages will not be material. ITEM 4. ITEM 4. Submission of Matters to a Vote of Security Holders. - ------------------------------------------------------------- None Executive Officers of the Company. Effective Date of Election Name Age Position to Present Position - ---- --- -------- -------------------------- Roger W. Hale 50 Chairman of the Board and Chief Executive Officer January 1, 1992 Victor A. Staffieri 38 President January 1, 1994 David R. Carey 40 Senior Vice President, Operations January 1, 1994 Raymond A. Bennett 60 Vice President, Gas Service Business January 1, 1994 M. Lee Fowler 57 Vice President and Controller September 1, 1988 Wendy C. Heck 40 Vice President, Information Services January 1, 1994 Chris Hermann 46 Vice President and General Manager, Wholesale Electric Business January 1, 1993 Charles A. Markel III 46 Treasurer January 1, 1993 The present term of office of each of the above executive officers extends to the meeting of the Board of Directors following the Annual Meeting of Stockholders, scheduled to be held May 24, 1994. There are no family relationships between executive officers of the Company. Mr. Fowler, Ms. Heck, Mr. Hermann, and Mr. Markel have been employed for more than five years in executive or management positions with the Company. Prior to election to the position shown in the table, the following executive officers held other positions with the Company since January 1, 1989: Ms. Heck was Manager-Internal Audit prior to January 1990, Vice President-Internal Auditing prior to January 1, 1992, Vice President-Fuels and Operating Services prior to January 1, 1993, and Vice President-Fuels and Information Services thereafter; Mr. Hermann was Manager-Administration, Power Production prior to November 1989, General Manager-Power Production prior to January 1992 and General Manager-Wholesale Electric thereafter; Mr. Markel was Vice President and Treasurer prior to March 1, 1990, Vice President-Finance and Treasurer prior to January 1, 1992, and Senior Vice President and Chief Financial Officer thereafter. Effective January 1, 1993, Mr. Markel was named Corporate Vice President-Finance and Treasurer of the parent company, LG&E Energy Corp. Prior to election to his current position, Mr. Hale was Chairman of the Board, President and Chief Executive Officer of the Company, and prior to February 1, 1990, President and Chief Executive Officer. Prior to June 1, 1989, Mr. Hale was employed by BellSouth Enterprises, Inc. and held the position of Executive Vice President. Prior to election to his current position, Mr. Staffieri was Senior Vice President-Public Policy, and General Counsel of the Company, and prior to November 15, 1992, Senior Vice President, General Counsel and Corporate Secretary. Prior to March 15, 1992, Mr. Staffieri was employed by Long Island Lighting Company and held the position of General Counsel and Secretary from April 1989 to March 1992, and Deputy General Counsel prior to April 1989. Prior to election to his current position, Mr. Carey was Vice President and General Manager, Retail Electric Business of the Company, prior to January 1, 1993, Vice President-Marketing and General Manager, Electric Service, prior to January 1, 1992, Vice President-Marketing and Planning, and prior to July 14, 1990, Vice President-Marketing and Sales. Prior to January 1990, Mr. Carey was employed by AT&T General Business Systems and held the position of Director-Strategic and Business Planning. Prior to election to his current position, Mr. Bennett was Vice President and General Manager, Gas Service Business of the Company, and prior to January 1, 1992, General Manager, Gas Operations. Prior to May 1990, Mr. Bennett was employed by the Railroad Commission of Texas and held the position of Director of Transportation-Gas Utility Division. PART II ------- ITEM 5. ITEM 5. Market for the Registrant's Common Equity and Related Stockholder Matters. - -------------------------------------------------------------------------- All Louisville Gas and Electric Company common stock, 21,294,223 shares, is held by LG&E Energy Corp. Therefore, there is no public trading market for the Company's common stock. The following table sets forth the cash distributions on common stock paid to LG&E Energy Corp. for the periods indicated: 1993 1992 ---- ---- (Thousands of $) First Quarter................................ $17,000 $16,000 Second Quarter............................... 16,500 16,000 Third Quarter................................ 16,500 17,000 Fourth Quarter............................... 17,000 17,500 ITEM 6. ITEM 6. Selected Financial Data. - --------------------------------- Years Ended December 31 (Thousands of $) ----------------------------------------------------- 1993 1992 1991 1990 1989 ---- ---- ---- ---- ---- Operating Revenues.... $775,125 $700,195 $708,706 $698,758 $686,996 Net Operating Income.. 136,118 125,829 142,730 137,717 127,560 Net Income............ 90,535 73,793 94,643 101,686 76,091 Net Income Available for Common Stock.... 84,554 66,620 85,179 92,221 66,625 Total Assets.......... 2,072,910 1,973,039 1,948,410 1,995,782 1,905,306 Long-Term Obligations (including amounts due within one year)............... 662,800 686,262 687,662 688,250 629,500 ITEM 7. ITEM 7. Management's Discussion and Analysis of Results of Operations and Financial Condition. - -------------------------------------------------------------------------- OVERVIEW The Company's financial condition improved during 1993. Net income increased $16.7 million or 23% over 1992 due primarily to higher electric sales which resulted from the warmer summer weather experienced in 1993. The Company also maintained its strong credit ratings throughout 1993. Effective January 1, 1994, the Company's parent, LG&E Energy Corp., announced a major realignment of its business units to reflect its outlook for rapidly emerging competition in all segments of the energy services industry. In addition to the organizational change implemented by the parent, the Company is presently re-evaluating its regulatory strategy to pursue full cost recovery of certain deferred expenses which the Company has recorded as regulatory assets. See Future Outlook for a further discussion of this matter. The following discussion and analysis by management focuses on those factors that had a material effect on the Company's financial results of operations and financial condition during 1993 and 1992 and should be read in connection with the financial statements and notes thereto. RESULTS OF OPERATIONS Net Income Available for Common Stock The $17.9 million increase in earnings for 1993 over 1992 resulted primarily from increased electric sales attributable to warmer summer weather experienced in 1993, higher sales to other utilities, reduced costs for debt and preferred stock attributable to favorable refinancing activities, and a gain recognized on the sale of the remaining disallowed portion of the Trimble County plant to the Indiana Municipal Power Agency (IMPA). These items were partially offset by a higher level of operation and maintenance expense. The decrease in earnings for 1992 from 1991 resulted primarily from decreased electric sales to residential customers as a result of the cooler summer weather experienced in 1992, the gain recognized in 1991 on the sale of a portion of the Trimble County plant to the Illinois Municipal Electric Agency (IMEA), higher depreciation and operation expenses and decreased interest earned on temporary cash investments. These decreases were partially offset by favorable financing activities and decreased maintenance expenses. Rates and Regulation The Company is subject to the jurisdiction of the Public Service Commission of Kentucky (Commission) in virtually all matters related to electric and gas utility regulation. The Company last filed for a rate increase with the Commission in June 1990 based on the test-year ended April 30, 1990. The request was for a general rate increase of $34.9 million ($31.0 million electric and $3.9 million gas). A final order was issued in September 1991 that effectively granted the Company an annual increase in rates of $6.8 million ($6.1 million electric and $.7 million gas). The Commission's order authorized a rate of return on common equity of 12.5%. On April 21, 1993, the Company, the Kentucky Attorney General, the Jefferson County Attorney, and representatives of several customer-interest groups filed with the Commission a request for approval of a comprehensive agreement on demand side management (DSM) programs. Under the agreement, the Company will commit up to $3.3 million over three years (from 1994 through 1996) for initial programs that include a residential energy conservation and education program and a commercial conservation audit program. Future programs will be developed through a formal collaborative process. The agreement contains a rate mechanism that will (1) provide the Company concurrent recovery of DSM program costs, (2) provide the Company an incentive for implementing DSM programs, and (3) allow the Company to recover revenues due to lost sales associated with the DSM programs. On November 12, 1993, the Commission approved the agreement. Revenues from lost sales to residential customers are collected through a "decoupling mechanism". The Company's residential decoupling mechanism breaks the link between the level of the Company's residential kilowatt-hour and Mcf sales and its non-fuel revenues. Under traditional regulation, a utility's revenue varies with changes in its level of kilowatt-hour or Mcf sales. The residential decoupling mechanism will allow the Company to recover a predetermined level of revenue per customer based on the rate set in the Company's last rate case, which will not vary with the level of kilowatt-hour or Mcf sales. Residential revenues will be adjusted to reflect (1) changes in the number of residential customers and (2) a pre-established annual growth factor in residential revenue per customer. Decoupling, in effect, removes the impact on the Company's non-fuel revenues from changes in kilowatt-hour or Mcf sales due to weather, fluctuations in the economy, and conservation efforts. Under this mechanism, if actual sales produce lower revenues than are produced by the predetermined per-customer amount, the difference is deferred for recovery from customers through an adjustment in rates over a period that will not exceed two years. Conversely, if actual sales produce more revenues than would be realized using the predetermined per-customer amount, the difference will be returned to customers through subsequent rate adjustments over a period not to exceed two years. Residential revenues reported in the financial statements for 1994 through 1996 will be determined in accordance with the agreed upon predetermined amount per-customer plus growth, and recovery of fuel and gas costs. The difference between the revenues shown in the financial statements and the amounts billed to customers will be recorded on the balance sheet and deferred for future recovery from or return to customers. As more fully discussed in Note 8 of Notes to Financial Statements under Item 8, the Commission has set a procedural schedule to determine the appropriate ratemaking treatment to exclude 25% of the Trimble County plant from customer rates. On May 24, 1993, the Federal Energy Regulatory Commission (FERC) gave final approval for a market-based rate tariff and two transmission service tariffs that were filed by the Company. This tariff enables the Company to sell up to 75 Mw of firm generation capacity at market-based rates. It also enables the Company to sell an unlimited amount of non-firm power at market- based rates, as long as the power is from the Company's own generation resources. Under the two transmission service tariffs that were approved by FERC, utilities, independent power producers, and qualifying co-generation or small power production facilities may obtain firm or coordination transmission service from the Company. These tariffs provide open access to the Company's transmission system and enable parties requesting either type of transmission service to transmit wholesale power across the Company's system. However, service under these tariffs is not available to ultimate consumers of electric utility service. Revenues A comparison of operating revenues for the years 1993 and 1992 with the immediately preceding years reflects both increases and decreases which have been segregated by the following principal causes (in thousands of $): Increase (Decrease) From Prior Period ---------------------------------------- Electric Revenues Gas Revenues ------------------ ------------------- Cause 1993 1992 1993 1992 ----- ---- ---- ---- ---- Sales to Ultimate Consumers: Rate increases effective in 1991. $ - $ 748 $ - $ 173 Fuel and gas supply adjustments, etc............... 6,832 313 19,479 1,044 Variation in sales volumes....... 27,385 (26,354) 5,736 12,954 ------ ------ ------ ------ Total.......................... 34,217 (25,293) 25,215 14,171 Sales to other utilities........... 13,261 4,953 - - Gas transportation-net............. - - 978 (1,717) Other.............................. 1,063 (406) 196 (219) ------ ------ ------ ------- Total.......................... $48,541 $(20,746) $26,389 $12,235 ------ ------ ------ ------ ------ ------ ------ ------ Electric revenues increased in 1993 primarily because of the warmer summer weather. Sales of electricity to other utilities increased over 1992 levels due to the Company's aggressive efforts in marketing off-system sales of energy. The increase in gas sales for 1993 is largely attributable to cooler winter weather in the region and customer growth. Expenses Fuel for electric generation and gas supply expenses account for a large segment of the Company's total operating costs. The Company's electric and gas rates contain a fuel adjustment clause and a gas supply clause, respectively, whereby increases or decreases in the cost of fuel and gas supply may be reflected in the Company's rates, subject to the approval of the Commission. Fuel expenses increased in 1993 primarily because of an increase in generation and the higher cost of coal purchased. The average delivered cost per ton of coal purchased was $26.58 in 1993, $25.17 in 1992, and $24.51 in 1991. The increase in power purchased expense reflects an increase in the quantity of power purchased mainly because of wheeling arrangements with other utilities. Gas supply expenses increased in 1993 and 1992 largely because of an increase in both the cost and the volume of gas purchased. The average unit cost per Mcf of purchased gas was $2.91 in 1993, $2.77 in 1992, and $2.39 in 1991. Other operation and maintenance expenses increased $7.4 million in 1993. This increase is primarily attributable to increased expenses for the operation and maintenance of electric generating plants and higher administrative and general costs. The increase in 1992 over 1991 resulted primarily from costs associated with legal settlements relating to personal injury claims and storm damage expenses. General increases in labor and material costs are also reflected in operation and maintenance expenses. Variations in income tax expenses are largely attributable to changes in pre-tax income and an increase in the corporate Federal income tax rate from 34% to 35% effective January 1, 1993. Other income and (deductions) increased in 1993 primarily because of a $3.2 million after-tax gain recorded on the sale of a 12.88% ownership interest in the Trimble County plant to IMPA in February 1993. A decrease in 1992 from 1991 resulted primarily from a $4.2 million after-tax gain recorded in 1991 on the sale of a 12.12% ownership interest in Trimble County to IMEA and decreased interest income of $1.1 million from temporary cash investments. Interest charges decreased in 1993 and 1992 primarily because of an aggressive program to refinance at lower interest rates. The Company refinanced approximately $205 million of its outstanding debt in 1993. The embedded cost of long-term debt at December 31, 1993, was 6.4%; at December 31, 1992, 7.0%. Preferred dividends reflect the lower dividend rates that resulted from the Company's refunding of the $25 million, $8.90 Series with a $5.875 Series in May 1993. In February 1992, the Company refunded the $8.72 and $9.54 Series with $50 million of Auction Rate Series. The weighted average preferred dividend rate at December 31, 1993, was 4.72%; at December 31, 1992, 5.36%. The rate of inflation may have a significant impact on the Company's operations, its ability to control costs, and the need to seek timely and adequate rate adjustments. However, relatively low rates of inflation in the past few years have moderated the impact on current operating results. Reference is made to Note 2 of Notes to Financial Statements under Item 8 Item 8. Financial Statements and Supplementary Data - --------------------------------------------------- LOUISVILLE GAS AND ELECTRIC COMPANY STATEMENTS OF INCOME (Thousands of $) Years Ended December 31 ------------------------------ 1993 1992 1991 ---- ---- ---- Operating Revenues Electric................................. $570,210 $521,669 $542,415 Gas...................................... 204,915 178,526 166,291 ------- ------- ------- Total operating revenues (Note 1)...... 775,125 700,195 708,706 ------- ------- ------- Operating Expenses Fuel for electric generation............. 149,436 132,551 132,392 Power purchased.......................... 17,228 12,044 11,478 Gas supply expenses...................... 139,054 115,521 104,212 Other operation expenses................. 136,693 130,740 126,842 Maintenance.............................. 48,414 46,931 49,079 Depreciation and amortization............ 79,655 76,903 73,273 Federal and State income taxes (Note 3)......................... 52,334 43,840 53,195 Property and other taxes................. 16,193 15,836 15,505 ------- ------- ------- Total operating expenses............... 639,007 574,366 565,976 ------- ------- ------- Net Operating Income....................... 136,118 125,829 142,730 Other Income and (Deductions).............. 1,913 (2,203) 4,593 ------- ------- ------- Income before Interest Charges............. 138,031 123,626 147,323 Interest Charges........................... 47,496 49,833 52,680 ------- ------- ------- Net Income................................. 90,535 73,793 94,643 Preferred Stock Dividends.................. 5,981 7,173 9,464 ------- ------- ------- Net Income Available for Common Stock...... $ 84,554 $ 66,620 $ 85,179 ------- ------- ------- ------- ------- ------- The accompanying notes are an integral part of these financial statements. LOUISVILLE GAS AND ELECTRIC COMPANY STATEMENTS OF RETAINED EARNINGS (Thousands of $) Years Ended December 31 ------------------------------ 1993 1992 1991 ---- ---- ---- Balance January 1.......................... $178,667 $181,694 $219,515 Add net income............................. 90,535 73,793 94,643 ------- ------- ------- 269,202 255,487 314,158 ------- ------- ------- Deduct: Cash dividends declared on stock: 5% cumulative preferred........... 1,075 1,076 1,076 7.45% cumulative preferred........ 1,598 1,598 1,598 $8.72 cumulative preferred........ - 454 2,180 $8.90 cumulative preferred........ 1,113 2,225 2,225 $9.54 cumulative preferred........ - 497 2,385 Auction rate cumulative preferred. 1,322 1,323 - $5.875 cumulative preferred....... 873 - - Common............................ 67,500 67,500 123,000 Preferred stock redemption expense. 818 2,147 - ------- ------- ------- 74,299 76,820 132,464 ------- ------- ------- Balance December 31........................ $194,903 $178,667 $181,694 ------- ------- ------- ------- ------- ------- The accompanying notes are an integral part of these financial statements. LOUISVILLE GAS AND ELECTRIC COMPANY BALANCE SHEETS (Thousands of $) ASSETS December 31 ----------------------------- 1993 1992 ---- ---- Utility Plant, at original cost Electric................................... $2,019,139 $1,976,206 Gas........................................ 260,485 240,818 Common..................................... 132,692 121,105 --------- --------- 2,412,316 2,338,129 Less: Reserve for depreciation............ 823,141 754,429 --------- --------- 1,589,175 1,583,700 Construction work in progress.............. 51,785 35,367 --------- --------- 1,640,960 1,619,067 --------- --------- Other Property and Investments - less reserve (Note 1)...................... 22,067 98,832 --------- --------- Current Assets Cash and temporary cash investments........ 44,105 946 Accounts receivable - less reserve of $1,474 in 1993 and $1,109 in 1992........ 104,397 92,719 Materials and supplies - at average cost Fuel (predominantly coal)................ 12,075 21,360 Gas stored underground................... 33,370 34,079 Other.................................... 40,357 41,034 Prepayments................................ 360 467 --------- --------- 234,664 190,605 --------- --------- Deferred Debits and Other Assets Unamortized debt expense................... 24,698 17,282 Accumulated deferred income taxes (Notes 1 and 3)................................... 58,675 12,179 Regulatory asset-income taxes (Note 1)..... 39,651 - Other...................................... 52,195 35,074 --------- --------- 175,219 64,535 --------- --------- $2,072,910 $1,973,039 --------- --------- --------- --------- The accompanying notes are an integral part of these financial statements. LOUISVILLE GAS AND ELECTRIC COMPANY CAPITAL AND LIABILITIES (Thousands of $) December 31 ----------------------------- 1993 1992 ---- ---- Capitalization (see Statements of Capitalization) Common equity.............................. $ 619,237 $ 603,001 Cumulative preferred stock................. 116,716 116,740 Long-term debt............................. 662,879 686,119 --------- --------- 1,398,832 1,405,860 --------- --------- Current Liabilities Long-term debt due within one year......... - 400 Notes payable (Note 6)..................... - 8,000 Accounts payable........................... 93,551 72,452 Dividends declared......................... 18,878 18,522 Accrued taxes.............................. 9,494 7,151 Accrued interest........................... 12,864 12,107 Other...................................... 11,127 11,494 --------- --------- 145,914 130,126 --------- --------- Deferred Credits and Other Credits Accumulated deferred income taxes (Notes 1 and 3)................................... 340,235 295,677 Investment tax credit, in process of amortization............... 91,572 104,623 Customers' advances for construction....... 7,384 6,849 Regulatory liability-income taxes (Note 1). 46,528 - Other...................................... 42,445 29,904 --------- --------- 528,164 437,053 --------- --------- Commitments and Contingencies (Notes 7 and 8) $2,072,910 $1,973,039 --------- --------- --------- --------- The accompanying notes are an integral part of these financial statements. LOUISVILLE GAS AND ELECTRIC COMPANY STATEMENTS OF CASH FLOWS (Thousands of $) Years Ended December 31 -------------------------------- 1993 1992 1991 ---- ---- ---- Cash Flows from Operating Activities Net income............................. $ 90,535 $ 73,793 $ 94,643 Items not requiring cash currently: Depreciation and amortization........ 79,887 79,686 76,431 Deferred income taxes - net.......... 4,938 28,911 23,292 Investment tax credit - net.......... (7,821) (5,033) (11,472) Gain on sale of capital asset........ (3,869) - (7,908) Other................................ 5,877 3,768 3,548 (Increase) decrease in certain net current assets: Accounts receivable.................. (11,678) (7,494) (4,629) Materials and supplies............... 10,671 (8,014) 5,390 Accounts payable..................... 21,099 4,546 (2,963) Accrued taxes........................ 2,343 1,967 (6,353) Accrued interest..................... 757 (1,716) 471 Prepayments and other................ (260) 538 71 Other.................................. (15,587) (11,321) (1,928) ------- ------- ------- Net cash provided from operating activities............... 176,892 159,631 168,593 ------- ------- ------- Cash Flows from Investing Activities Sale of capital asset.................. 91,076 - 94,164 Long-term investment in securities..... (11,097) (10,441) - Construction expenditures.............. (98,787) (101,175) (88,052) ------- ------- ------- Net cash provided from (used for) investing activities............... (18,808) (111,616) 6,112 ------- ------- ------- Cash Flows from Financing Activities Issuance of preferred stock............ 24,716 49,099 - Issuance of first mortgage bonds and pollution control bonds.............. 198,918 88,462 4,233 Redemption of preferred stock.......... (25,558) (51,443) - Retirement of first mortgage bonds and pollution control bonds.......... (231,876) (92,400) (5,088) Decrease in notes payable.............. (8,000) (4,000) (13,000) Payment of dividends................... (73,125) (74,517) (131,662) ------- ------- ------- Net cash used for financing activities......................... (114,925) (84,799) (145,517) ------- ------- ------- The accompanying notes are an integral part of these financial statements. LOUISVILLE GAS AND ELECTRIC COMPANY STATEMENTS OF CASH FLOWS (Thousands of $) Years Ended December 31 -------------------------------- 1993 1992 1991 ---- ---- ---- Net Increase (Decrease) in Cash and Temporary Cash Investments............. $ 43,159 $(36,784) $ 29,188 Cash and Temporary Cash Investments at Beginning of Year...................... 946 37,730 8,542 ------- ------- ------- Cash and Temporary Cash Investments at End of Year............................ $ 44,105 $ 946 $ 37,730 ------- ------- ------- ------- ------- ------- Supplemental Disclosures of Cash Flow Information Cash paid during the year for: Income taxes......................... $ 54,686 $ 19,741 $ 46,481 Interest on borrowed money........... 45,360 50,508 50,744 The accompanying notes are an integral part of these financial statements. LOUISVILLE GAS AND ELECTRIC COMPANY STATEMENTS OF CAPITALIZATION (Thousands of $) December 31 ----------------------------- 1993 1992 ---- ---- Common Equity Common stock, without par value - Authorized 75,000,000 shares, outstanding 21,294,223 shares........... $ 425,170 $ 425,170 Common stock expense...................... (836) (836) Retained earnings......................... 194,903 178,667 --------- --------- $ 619,237 $ 603,001 --------- --------- Cumulative Preferred Stock (Note 4) Redeemable on 30 days notice by the Company Shares Current Outstanding Redemption Price ----------- ---------------- $25 par value, 1,720,000 shares authorized - 5% series........ 860,287 $ 28.00 $ 21,507 $ 21,507 7.45% series..... 858,128 25.75 21,453 21,453 Without par value, 6,750,000 shares authorized - $8.90 series..... - - - 25,000 Auction Rate..... 500,000 100.00 50,000 50,000 $5.875 series.... 250,000 Not Redeemable 25,000 - Preferred stock expense..................... (1,244) (1,220) --------- --------- $ 116,716 $ 116,740 --------- --------- The accompanying notes are an integral part of these financial statements. LOUISVILLE GAS AND ELECTRIC COMPANY STATEMENTS OF CAPITALIZATION (Thousands of $) December 31 ----------------------------- 1993 1992 ---- ---- Long-Term Debt (Note 5) First mortgage bonds - Series due June 1, 1996, 5 5/8%......... $ 16,000 $ 16,000 Series due June 1, 1998, 6 3/4%......... 20,000 20,000 Series due August 1, 2001, 8 1/4%....... - 19,700 Series due July 1, 2002, 7 1/2%......... 20,000 20,000 Series due August 15, 2003, 6%.......... 42,600 - Series due November 1, 2006, 8 1/2%..... - 21,362 Pollution control series: B due September 1, 2006, 6 1/8%....... - 35,200 C due June 1, 1998, 6 1/8%............ - 7,000 C due June 1, 2008, 6 3/8%............ - 35,000 D due October 1, 2004, 6.6%........... - 20,000 D due October 1, 2009, 6.7%........... - 40,000 I due February 15, 2011, 9 3/4%....... - 26,000 J due July 1, 2015, 9 1/4%............ 40,000 40,000 K due December 1, 2016, 7 1/4%........ 27,500 27,500 L due December 1, 2016, 7 1/4%........ 22,500 22,500 N due February 1, 2019, 7 3/4%........ 35,000 35,000 O due February 1, 2019, 7 3/4%........ 35,000 35,000 P due June 15, 2015, 7.45%............ 25,000 25,000 Q due November 1, 2020, 7 5/8%........ 83,335 100,000 R due November 1, 2020, 6.55%......... 41,665 50,000 S due September 1, 2017, variable..... 31,000 31,000 T due September 1, 2017, variable..... 60,000 60,000 U due August 15, 2013, variable....... 35,200 - V due August 15, 2019, 5 5/8%......... 102,000 - W due October 15, 2020, 5.45%......... 26,000 - --------- --------- Total bonds outstanding................. 662,800 686,262 Less long-term debt due within one year. - 400 --------- --------- Long-term first mortgage bonds.......... 662,800 685,862 Unamortized premium on bonds.............. 79 257 --------- --------- 662,879 686,119 --------- --------- Total Capitalization........................ $1,398,832 $1,405,860 --------- --------- --------- --------- The accompanying notes are an integral part of these financial statements. LOUISVILLE GAS AND ELECTRIC COMPANY ----------------------------------- NOTES TO FINANCIAL STATEMENTS ----------------------------- Note 1 - Summary of Significant Accounting Policies - --------------------------------------------------- Louisville Gas and Electric Company (the Company) completed a corporate restructuring on August 17, 1990, pursuant to which the Company became the primary subsidiary of LG&E Energy Corp. All of the Company's Common Stock is held by LG&E Energy Corp. The Company conforms with generally accepted accounting principles as applied to regulated public utilities and as prescribed by the Federal Energy Regulatory Commission (FERC) and the Public Service Commission of Kentucky (Commission). The Company is subject to Statement of Financial Accounting Standards No. 71, Accounting for the Effects of Certain Types of Regulation. The Company has recorded certain regulatory assets at December 31, 1993, totaling approximately $31 million. See Note 2, Post-Retirement Benefits and Early Retirement/Work Force Reduction, and Note 7, Environmental, for a discussion of these regulatory assets. See Future Outlook under Item 7, Management's Discussion and Analysis, for a discussion of the Company's re-evaluation of its current regulatory strategy in regards to these assets. Utility Plant. The Company's plant is stated at original cost, which includes payroll-related costs such as taxes, fringe benefits, and administrative and general costs. Construction work in progress has been included in the rate base, and, accordingly, the Company has not recorded any allowance for funds used during construction. The cost of plant retired or disposed of in the normal course of business is deducted from plant accounts and such cost plus removal expense less salvage value is charged to the reserve for depreciation. When complete operating units are disposed of, appropriate adjustments are made to the reserve for depreciation and gains and losses, if any, are recognized. In December 1990, the 25% portion of the construction costs of the Trimble County Generating Station (Trimble County), which the Commission disallowed in setting customer rates, was reclassified from the Utility Plant section on the balance sheet to Other Property and Investments. In February 1991, the Company sold a 12.12% undivided interest in Trimble County to the Illinois Municipal Electric Agency (IMEA). In February 1993, the remaining 12.88% of Trimble County not allowed in rates was sold to the Indiana Municipal Power Agency (IMPA). See Notes 8 and 9, Trimble County Generating Plant and Jointly Owned Electric Utility Plant, respectively, for a further discussion. Depreciation. Depreciation is provided on the straight-line method over the estimated service lives of depreciable plant. The amounts provided for 1993 were approximately 3.3% (3.2% electric, 3.2% gas, and 5% common); for 1992, 3.3% (3.2% electric, 3.2% gas, and 5.4% common); and for 1991, 3.3% (3.2% electric, 3% gas, and 6.3% common) of average depreciable plant. Cash and Temporary Cash Investments. The Company considers all highly liquid debt instruments purchased with a maturity of three months or less to be cash equivalents. Temporary cash investments are carried at cost, which approximates fair value. Deferred Income Taxes. Deferred income taxes have been provided for all book-tax temporary differences. The Company adopted Statement of Financial Accounting Standards (SFAS) No. 109, Accounting for Income Taxes, effective January 1, 1993. SFAS No. 109 adopts the liability method of accounting for income taxes, requiring deferred income tax assets and liabilities to be computed using tax rates that will be in effect when the book and tax temporary differences reverse. For the Company, the change in tax rates applied to accumulated deferred income taxes was not immediately recognized in operating results because of ratemaking treatment. At December 31, 1993, the deferred tax asset, which resulted primarily from unamortized investment tax credits, amounted to approximately $47 million. The deferred tax liability, which resulted primarily from book/tax utility property basis differences, totaled approximately $40 million. Regulatory assets and liabilities were established to recognize the future revenue requirement impact from these deferred taxes. The adoption of SFAS No. 109 did not have a material impact on the results of operations or financial position. The deferred tax balances and related regulatory assets and liabilities have been adjusted to reflect the increase in the corporate income tax rate from 34% to 35%. Investment Tax Credits. Investment tax credits resulted from provisions of the tax law which permitted a reduction of the Company's tax liability based on credits for certain construction expenditures. Investment tax credits deferred and charged to income in prior years are being amortized to income over the estimated lives of the related property that gave rise to the credits. Debt Premium and Expense. Debt premium and expense are amortized over the lives of the related debt issues, consistent with regulatory practices. Revenue Recognition. Revenues are recorded based on service rendered to customers through month end. The Company accrues an estimate for unbilled revenues from the date of each meter reading date to the end of the accounting period. See Management's Discussion and Analysis, Rates and Regulation, under Item 7, for changes in recording residential revenues effective January 1, 1994. Fuel and Gas Costs. The cost of fuel for electric generation is charged to expense as used, and the cost of gas supply is charged to expense as delivered to the distribution system. Revenues and Customer Receivables. The Company is an operating public utility that supplies natural gas to approximately 258,000 customers and electricity to approximately 336,000 customers in Louisville and adjacent areas in Kentucky. Customer receivables and gas and electric revenues arise from deliveries of natural gas and electric energy to a diversified base of residential, commercial and industrial customers and to public authorities and other utilities. For the year ended December 31, 1993, 74% of total operating revenues was derived from electric operations and 26% from gas operations. Fair Value of Financial Instruments. Pursuant to the Financial Accounting Standards Board SFAS No. 107, Disclosures about Fair Value of Financial Instruments, the Company is required to disclose the fair value of financial instruments where practicable. The fair value for certain of the Company's investments and debt are estimated based on quoted market prices for those or similar instruments. Investments for which there are no quoted market prices are stated at cost because a reasonable estimate of fair value cannot be made without incurring excessive costs. The cost and estimated fair value of the Company's financial instruments as of December 31, 1993 and 1992, are as follows (in thousands of $): 1993 1992 ------------------ ------------------ Fair Fair Cost Value Cost Value ---- ----- ---- ----- Long-term investments: Practicable to estimate fair value................. $ 21,538 $ 21,538 $ 10,441 $ 10,441 Not practicable.............. 490 490 557 557 Preferred stock subject to mandatory redemption......... 25,000 24,750 - - Long-term debt................. 662,800 706,078 686,262 726,801 Note 2 - Pension Plans and Retirement Benefits - ---------------------------------------------- Pension Plans. The Company has two non-contributory, defined-benefit pension plans, covering all eligible employees. Retirement benefits are based on the employee's years of service and compensation. The Company's policy is to fund annual actuarial costs, up to the maximum amount deductible for income tax purposes, as determined under the frozen entry age actuarial cost method. In addition, the Company has a supplemental executive retirement plan that covers officers of the Company. The plan provides retirement benefits based on average earnings during the final three years prior to retirement, reduced by social security benefits, any pension benefits received from plans of prior employers, and by amounts received under the pension plans referred to above. Pension cost was $2,669,000 for 1993, $2,598,000 for 1992, and $2,245,000 for 1991, of which approximately $425,000, $241,000, and $306,000, respectively, were charged to construction. The components of periodic pension expense are shown below (in thousands of $): 1993 1992 1991 ---- ---- ---- Service cost-benefits earned during the period.................. $ 4,516 $ 5,459 $ 4,098 Interest cost on projected benefit obligation................. 12,117 11,006 9,340 Actual return on plan assets......... (13,602) (8,850) (26,805) Amortization of transition asset..... (1,112) (1,076) (1,076) Net amortization and deferral........ 750 (3,941) 16,688 ------ ------ ------ Net pension cost..................... $ 2,669 $ 2,598 $ 2,245 ------ ------ ------ ------ ------ ------ The assets of the plans consist primarily of common stocks, corporate bonds, United States government securities, and interests in a pooled real estate investment fund. The funded status of the pension plans at December 31 is shown below (in thousands of $): 1993 1992 ---- ---- Actuarial present value of accumulated plan benefits: Vested.............................................. $137,655 $102,980 Non-Vested.......................................... 17,158 12,900 ------- ------- Accumulated benefit obligation...................... 154,813 115,880 Effect of projected future compensation............. 25,234 31,336 ------- ------- Projected benefit obligation........................ 180,047 147,216 Plan assets at fair value........................... 165,088 155,937 ------- ------- Plan assets (less than) in excess of projected benefit obligation...................... (14,959) 8,721 Unrecognized net transition asset................... (13,636) (14,403) Unrecognized prior service cost..................... 28,671 25,863 Unrecognized net gain............................... (23,860) (41,703) ------- ------- Accrued pension liability............................. $(23,784) $(21,522) ------- ------- ------- ------- The projected benefit obligation was determined using an assumed discount rate of 7.5% for 1993 and 8.5% for 1992. An assumed annual rate of increase in future compensation levels ranged from 3.5% to 4.5% for 1993 and 3.5% to 6.5% for 1992. The assumed long-term rate of return on plan assets was 8.5% for both periods. Transition assets and prior service costs are being amortized over the average remaining service period of active participants. Post-Retirement Benefits. The Company adopted Statement of Financial Accounting Standards No. 106, Employers' Accounting for Post-Retirement Benefits Other Than Pensions (SFAS No. 106) January 1, 1993. SFAS No. 106 requires the accrual of the expected cost of retiree benefits other than pensions during the employee's years of service with the Company. The Company is amortizing the discounted present value of the post-retirement benefit obligation at the date of adoption over 20 years. The Company provides certain health care and life insurance benefits for eligible retired employees. Post-retirement health care benefits are subject to a maximum amount payable by the Company. Prior to January 1, 1993, the cost of retiree health care and life insurance benefits was generally recognized when paid. Beginning in 1993, the Company began to account for post-retirement benefits according to the provisions of SFAS No. 106. The Company, based on an order from the Commission, has created a regulatory asset and is deferring the level of SFAS No. 106 expense in excess of the previous level of pay-as-you-go expense. The Commission's generic order stated that the proper level of expense for SFAS No. 106 would be determined in each utility's next general rate case. The components of the net periodic post-retirement benefit cost for 1993 as calculated under SFAS No. 106 are as follows (in thousands of $): Service cost .............................................. $ 701 Interest cost.............................................. 2,614 Amortization of transition obligation...................... 1,395 ------ Post-retirement benefit cost............................... $ 4,710 ------ ------ The accumulated post-retirement benefit obligation as calculated under SFAS No. 106 at December 31, 1993, is shown below (in thousands of $): Retirees................................................... $(17,826) Fully eligible active employees............................ (4,001) Other active employees..................................... (15,945) ------ Accumulated post-retirement benefit obligation............. (37,772) Unrecognized net loss...................................... 4,966 Unrecognized transition obligation......................... 26,508 Previously recognized amount............................... 3,696 ------ Accrued post-retirement benefit liability.................. $ (2,602) ------ ------ The annual service cost was calculated using an assumed discount rate of 8.5% at January 1, 1993, and 7.5% at December 31, 1993. A medical cost increase factor that ranged between 6% and 11% was also used. A 1% increase in the health care cost trend rate would increase the Accumulated Post-Retirement Benefit Obligation by approximately $1.8 million and the annual service and interest cost by approximately $200,000. No funding has been established by the Company for post-retirement benefits. Post-Employment Benefits. The Financial Accounting Standards Board issued SFAS No. 112, Employers' Accounting for Post-Employment Benefits, which requires the accrual of the expected cost of benefits to former or inactive employees after employment but before retirement. The Company adopted the new standard effective January 1, 1994, as required. Adoption of SFAS No. 112 will not have a material adverse impact on the financial position or results of operation of the Company. Early Retirement/Work Force Reduction. During the last quarter of 1993 and early 1994, the Company eliminated approximately 350 full-time positions. The cost of the employee reduction program, approximately $11.5 million, consists primarily of separation payments, enhanced early retirement benefits, and health care benefits. In 1992, an early retirement program was made available to all the Company union employees who had reached age 55, or who had 35 years or more of continuous service regardless of age. The cost of the program was approximately $7 million and consisted primarily of enhanced early retirement and post-retirement health care benefits. Thrift Savings Plan. The Company has a Thrift Savings Plan under Section 401(k) of the Internal Revenue Code. The plan covers all regular full-time employees with one year or more of service at the Company. Under the plan, eligible employees may defer and contribute to the plan a portion of current compensation in order to provide future retirement benefits. The Company makes contributions to the plan by matching a portion of employee contributions according to a formula established by the plan. These costs were approximately $1,795,000 for 1993, $767,000 for 1992, and $584,000 for 1991. The increase in 1993 401(k) expenses is due to the expansion of the program to the Company's union employees. Note 3 - Federal and State Income Taxes - --------------------------------------- Components of income tax expense are shown in the table below (in thousands of $): 1993 1992 1991 ---- ---- ---- Included in Operating: Current - Federal.................... $31,082 $20,756 $33,727 - State...................... 8,920 6,354 8,126 Deferred - Federal-net................ 13,185 15,771 16,642 - State-net.................. 3,933 5,774 5,939 Deferred investment tax credit........ - - (6,385) Amortization of investment tax credit. (4,786) (4,815) (4,854) ------ ------ ------ Total............................... $52,334 $43,840 $53,195 ------ ------ ------ Included in Other Income and (Deductions): Current - Federal.................... $11,009 $(6,971) $ 1,763 - State...................... 4,034 (3,214) 299 Deferred - Federal-net................ (8,473) 4,670 565 - State-net.................. (3,707) 2,696 146 Deferred investment tax credit........ - 390 26 Amortization of investment tax credit. (3,035) (608) (259) ------ ------ ------ Total............................... $ (172) $(3,037) $ 2,540 ------ ------ ------ Total Income Tax Expense................ $52,162 $40,803 $55,735 ------ ------ ------ ------ ------ ------ Variations in the 1993 income tax expense from 1992 and 1991 are largely attributable to changes in pre-tax income and an increase in the corporate Federal income tax rate from 34% to 35%, effective January 1, 1993. Provisions for deferred income taxes consist of the tax effects of the following temporary differences (in thousands of $): 1993 1992 1991 ---- ---- ---- Depreciation and amortization........... $ (255) $33,839 $23,440 Alternative minimum tax................. 5,387 (5,387) - Other................................... (194) 459 (148) ----- ------ ------ Total................................. $4,938 $28,911 $23,292 ----- ------ ------ ----- ------ ------ Depreciation and amortization fluctuations for 1993 are primarily attributable to the reversal of prior years' accumulated taxes as a result of the sale of a portion of Trimble County Unit 1 to IMPA. See Note 8, Trimble County Generating Plant, for a further discussion of the sale. The following are the tax effects of book-tax temporary differences resulting in deferred tax assets and liabilities as of December 31, 1993 (in thousands of $): Deferred Tax Assets: Investment tax credit................................. $ 36,961 Income taxes due to customers......................... 14,361 Other assets.......................................... 7,353 ------- $ 58,675 ------- ------- Deferred Tax Liabilities: Depreciation and other plant related items............ $322,544 Income taxes due from customers....................... 10,233 Other liabilities..................................... 7,458 ------- $340,235 ------- ------- The Company's effective income tax rate is computed by dividing the aggregate of current income taxes, deferred income taxes-net, and the investment tax credit-net, by net income before the deduction of such taxes. Reconciliation of the statutory Federal income tax rate to the effective income tax rate is shown in the table below: 1993 1992 1991 ---- ---- ---- Statutory Federal income tax rate........ 35.0% 34.0% 34.0% State income taxes net of Federal benefit. 6.0 6.7 6.4 Amortization of investment tax credit..... (5.5) (4.7) (3.4) Other differences-net..................... 1.1 (.4) .1 ---- ---- ---- Effective Income Tax Rate................. 36.6% 35.6% 37.1% ---- ---- ---- ---- ---- ---- Note 4 - Preferred Stock - ------------------------ In May 1993, the Company issued $25 million of $5.875 Cumulative Preferred Stock. The proceeds from the sale were used to redeem the outstanding $8.90 Cumulative Preferred Stock. Note 5 - First Mortgage Bonds - ----------------------------- Annual requirements for the sinking funds of the Company's First Mortgage Bonds (other than the First Mortgage Bonds issued in connection with the Pollution Control Bonds) are the amounts necessary to redeem 1% of the highest principal amount of each series of bonds at any time outstanding. Property additions (166 2/3% of principal amounts of bonds otherwise required to be so redeemed) have been applied in lieu of cash. It is the intent of the Company to apply property additions to meet 1994 sinking fund requirements of the First Mortgage Bonds. The trust indenture securing the First Mortgage Bonds constitutes a direct first mortgage lien upon substantially all property owned by the Company. The indenture, as supplemented, provides in substance that, under certain specified conditions, portions of retained earnings will not be available for the payment of dividends on common stock. No portion of retained earnings is presently restricted by this provision. Pollution Control Bonds (Louisville Gas and Electric Company Projects) issued by Jefferson and Trimble Counties, Kentucky, are secured by the assignment of loan payments by the Company to the Counties pursuant to loan agreements, and further secured by the delivery from time to time of an equal amount of the Company's First Mortgage Bonds, Pollution Control Series. First Mortgage Bonds so delivered are summarized in the Statements of Capitalization. No principal or interest on these First Mortgage Bonds is payable unless default on the loan agreements occurs. The interest rate reflected in the Statements of Capitalization applies to the Pollution Control Bonds. In March 1993, due to the sale of 12.88% of Trimble County Unit 1, the Company completed the defeasance of $25 million of its Pollution Control Bonds ($16.665 million of the 7.625% Series and $8.335 million of the 6.55% Series). The Company issued several series of lower interest bearing First Mortgage and Pollution Control Bonds in 1993 to refinance bonds with higher interest rates. In August, the Company issued two separate series of Pollution Control Bonds (a $35.2 million, Variable Rate Series, which had an interest rate of 2.586% at December 31, 1993, and a $102 million, 5.625% Series) and redeemed five series of Pollution Control Bonds totaling $137.2 million with interest rates ranging from 6.125% to 6.7%. In August, the Company also issued $42.6 million of 6% First Mortgage Bonds and redeemed two series of First Mortgage Bonds ($19.7 million at 8.25% and $21.362 million at 8.5%). In November, the Company issued $26 million of Pollution Control Bonds, 5.45% Series and redeemed the $26 million, 9.75% Series. The Company also entered into an agreement in November 1993 with Goldman, Sachs & Co. to issue $40 million of tax-exempt Pollution Control Bonds in 1995 at a 5.9% rate. The issuance of the bonds in 1995 is subject to certain conditions. If issued, the proceeds will be used to redeem, in 1995, the outstanding 9.25% Series of Pollution Control Bonds due July 1, 2015. The Company has outstanding interest rate swap agreements totaling $30 million. Under the agreements, which were entered into in 1992, the Company pays a fixed rate of 4.35% on $15 million for a five-year period and 4.74% on $15 million for a seven-year period. In return, the Company receives a floating rate based on the weighted average JJ Kenny index. At December 31, 1993, the rate on the JJ Kenny index was 3.25%. The Company's First Mortgage Bonds, 5.625% Series of $16 million is scheduled to mature in 1996 and the 6.75% Series of $20 million is scheduled to mature in 1998. There are no scheduled maturities of Pollution Control Bonds for the five years subsequent to December 31, 1993. Note 6 - Notes Payable - ---------------------- The Company had no notes payable at December 31, 1993. At December 31, 1992, trust demand notes amounted to $8 million on which the composite interest rate was 3.45%. At December 31, 1993, the Company had unused lines of credit of $145 million, for which it pays commitment fees. The credit lines are scheduled to expire at various periods throughout 1994. Management intends to renegotiate these lines when they expire. Note 7 - Commitments and Contingencies - -------------------------------------- Construction Program. The Company had commitments, primarily in connection with its construction program, aggregating approximately $6 million at December 31, 1993. Construction expenditures for the calendar years 1994 and 1995 are estimated to total approximately $200 million. FERC Order No. 636. Order No. 636, which was issued by FERC in 1992, required the Company and all other local distribution companies to revise their practices for purchasing and transporting gas. Whereas the Company had previously purchased natural gas and pipeline transportation services from Texas Gas Transmission Corporation (Texas Gas), the Company now purchases only transportation services from Texas Gas and purchases natural gas from other sources. Under Order No. 636 pipelines may recover costs associated with the transition to and implementation of this order from pipeline customers, including the Company. Based on pipeline filings to date, the Company estimates that its share of transition costs, which must be approved by FERC, will be approximately $2 million to $3 million a year for both 1994 and 1995. The Commission issued an order, based on proceedings that were held to investigate the impact of Order No. 636 on utilities and ratepayers in Kentucky, providing that transition costs assessed on utilities by the pipelines, which are clearly identifiable as being related to the cost of the commodity itself, are appropriate to be recovered from customers through the gas supply clause. Operating Lease. The Company has an operating lease for its corporate office building that is scheduled to expire in June 2005. Total expense in connection with this lease for 1993, 1992, and 1991 was $2,436,000, $2,478,000, and $2,471,000, respectively. The future minimum annual lease payments under the lease agreement for years subsequent to December 31, 1993, are as follows (in thousands of $): 1994.............................. $ 2,148 1995.............................. 2,499 1996.............................. 2,850 1997.............................. 2,850 1998.............................. 2,850 Thereafter........................ 21,810 ------ Total.......................... $35,007 ------ ------ Environmental. The Clean Air Act Amendments of 1990 impose stringent limits on emissions of sulfur dioxide and nitrogen oxides by electric utility generating plants. The legislation is extremely complex and its effect will substantially depend on regulations issued by the U.S. Environmental Protection Agency (USEPA). The Company is closely monitoring the continuing rule-making process in order to assess the precise impact of the legislation on the Company. All of the Company's coal-fired boilers are equipped with sulfur dioxide "scrubbers" and already achieve the final sulfur dioxide emission rates required by the year 2000 under the legislation. However, as part of its ongoing capital construction program, the Company anticipates incurring capital expenditures during the next four years of approximately $40 million for remedial measures necessary to meet the Act's requirements for nitrogen oxides. The overall financial impact of the legislation on the Company is expected to be minimal. The Company is well-positioned in the market to be a "clean" power provider without the large capital expenditures that are expected to be incurred by many other utilities. In 1992, the Company entered two agreed orders with the Air Pollution Control District (APCD) of Jefferson County in which the Company committed to undertake remedial measures to address certain particulate emissions and excess sulfur dioxide emissions from its Mill Creek generating plant. The Company is currently conducting work in compliance with the agreed-upon schedule for remedial measures and has incurred total capital expenditures of approximately $24 million through 1993. Based on current remedial designs, the Company anticipates incurring additional capital costs of approximately $14 million for this project in 1994 as part of its ongoing capital construction program. In an effort to resolve property damage claims relating to particulate emissions from the Mill Creek plant, in July 1993, the Company commenced extensive negotiations and property damage settlements with adjacent residents. The Company currently estimates that property damage claims for the particulate emissions should be settled for an aggregate amount of approximately $12 million. Accordingly, the Company has recorded an accrual of this amount. In August 1993, 34 persons filed a complaint in Jefferson Circuit Court against the Company in which they are seeking certification of a class consisting of all persons within 2.5 miles of the Mill Creek plant. The court has not acted on the request for certification of a class. The plaintiffs seek compensation for alleged personal injury and property damage attributable to the particulate emissions from the Mill Creek plant, injunctive relief, a fund to finance future medical monitoring of area residents, and other relief. The Company intends to vigorously defend itself in the pending litigation. In response to a notification from the APCD that the Company's Cane Run plant may be the source of a potential exceedance of the National Ambient Air Quality Standards for sulfur dioxide, the Company retained a contractor to conduct certain air dispersion modeling. In 1992, the Company submitted a draft action plan and modeling schedule to the APCD and USEPA. The APCD and USEPA have approved the submittals and the Company's contractor is currently conducting additional modeling activities. Although it is expected that corrective action will be accomplished through capital improvements, until the contractor completes its modeling activities, the Company cannot determine the precise impact of this matter. The Company owns or formerly owned three primary sites where manufactured gas plant operations were located. Such manufactured gas plant operations, conducted in the 1838 to 1960 time period, typically produced coal tar byproducts and other constituents that may necessitate cleanup measures. The Company commenced site investigations at the two Company owned sites to determine if significant levels of contaminants are present. The Company has commenced discussions with the current owner of the third site regarding joint performance of a site investigation. The Company anticipates spending a total of approximately $1.3 million on site investigations expected to be completed by 1995. Preliminary testing at all three sites has identified contaminants typical of manufactured gas plant operations. Until an investigation and associated regulatory review is completed for each site, the Company will be unable to predict what, if any, cleanup activities may be necessary. In November 1993, the Company was served with a third-party complaint filed in federal district court in Illinois by three third-party plaintiffs. The third-party plaintiffs allege that the Company and 31 other parties are liable for contributions under the Comprehensive Environmental Response, Compensation, and Liability Act as amended (CERCLA) for $1.4 million in costs allegedly incurred by USEPA in conducting cleanup activities at the M.T. Richards site in Crossville, Illinois. A number of de minimis third-party defendants, including the Company, have commenced preliminary discussions with the third-party plaintiffs. In the Company's opinion, the resolution of the issue will not have a material adverse impact on its financial position or results of operations. In February 1993, the Company was served with an amended complaint filed in federal district court in West Virginia by three potentially responsible parties (PRPs) against the Company and 39 other parties. The plaintiffs alleged that the parties were liable under CERCLA for in excess of $3 million in costs allegedly incurred by the plaintiffs in conducting cleanup activities at the Spencer Transformer Site located in Roane County, West Virginia. In November 1993, the federal court approved a consent decree that resolved the case as to the Company and nine other de minimis parties. Under the terms of the consent decree, the Company reimbursed the plaintiffs for $10,000 in cleanup costs. No further involvement of the Company is anticipated. In June 1992, USEPA identified the Company as a PRP allegedly liable under CERCLA for $1.6 million in costs allegedly incurred by USEPA in cleanup of the Sonora Site and Carlie Middleton Burn Site located in Hardin County, Kentucky. In November 1992, USEPA demanded immediate payment from the PRPs. To date, USEPA has identified nine PRPs for the site. The Company and several other parties have commenced discussions with USEPA. In the Company's opinion, the resolution of this issue will not have a material adverse impact on its financial position or results of operations. In 1987, USEPA identified the Company as one of the numerous PRPs allegedly liable under CERCLA for the Smith's Farm site in Bullitt County, Kentucky. In March 1990, USEPA issued an administrative order requiring the Company and 35 other PRPs to conduct certain cleanup activities. In February 1992, four PRPs filed a complaint in federal district court in Kentucky against the Company and 52 other PRPs. Under the law, each PRP could be held jointly and severally liable for the cost of site cleanup, but would have the right to seek contributions from other PRPs. In July 1993, upon motion of the plaintiffs, the federal court dismissed the Company and a number of others from the litigation in order to facilitate settlement negotiations among the parties. Cleanup costs for the site are currently estimated at approximately $70 million. The Company and several other parties have shared certain cleanup costs in the interim until a voluntary allocation of liability can be reached among the parties. It is not possible at this time to predict the outcome or precise impact of this matter. However, management believes that this matter should not have a material adverse impact on the financial position or results of operations of the Company as other financially viable PRPs appear to have primary liability for the site. Based upon prior precedents established by the Commission and the Environmental Cost Recovery legislation, the Company expects to have an opportunity to recover, through future ratemaking proceedings, its costs associated with remedial measures required to comply with environmental laws and regulations. Charitable Foundation. The Board of Directors of the Company has approved the formation of a tax-exempt charitable foundation with an initial contribution of up to $15 million. See Future Outlook under Item 7, Management's Discussion and Analysis, for a further discussion of this matter. Note 8 - Trimble County Generating Plant - ---------------------------------------- Trimble County Unit 1, a 495-megawatt, coal-fired electric generating unit, was placed in commercial operation on December 23, 1990. This Unit, which during its first three years of commercial operations has operated more reliably than projected, has been the subject of numerous regulatory and legal proceedings. The current regulatory process involving Trimble County is related to an order issued by the Commission on July 1, 1988, which stated that 25% of the total cost of the Unit would not be allowed for ratemaking purposes. In a rehearing order issued in April 1989, the Commission reaffirmed its decision that the Company would not be allowed to include 25% of the cost of the Unit in customer rates; however, this order stated that "the disallowed portion of Trimble County remains with the Company and stockholders for their use." In 1989, the Commission initiated a proceeding to determine the appropriate ratemaking treatment to carry out the order that disallowed rate recovery for 25% of the Unit. Prior to the start of the hearings in this proceeding, the Company filed a motion requesting the Commission to adopt a proposed plan to settle all of the issues surrounding Trimble County. Settlement discussions ensued between the Company, intervenors, and the Commission staff. On October 2, 1989, the Commission approved the settlement agreement reached between the Company and the Commission staff and, in accordance with the terms of the agreement, the Company refunded $2.5 million to its customers in 1989 and reduced its electric rates by $8.5 million for the year beginning January 1, 1990. Certain intervenors, who participated in the proceedings but did not agree to the settlement, appealed the Commission's order approving the settlement to Franklin Circuit Court, claiming, among other things, that the Commission lacked the statutory authority to approve the agreement and that the intervenors who refused to sign the agreement were deprived of due process rights. In February 1991, the Franklin Circuit Court vacated the October 2, 1989 order of the Commission approving the settlement agreement. On September 27, 1991, the Court issued an opinion requiring a refund to ratepayers in excess of $100 million as a result of the Commission's order that disallowed 25% of the total cost of Trimble County from customer rates. The Court further ordered the Company to post a bond if it appealed the Circuit Court's decision. The Company posted a bond of $107 million and appealed all orders of the Circuit Court to the Kentucky Court of Appeals. On April 23, 1993, the Kentucky Court of Appeals overturned the Franklin Circuit Court ruling previously entered in the case. Although the decision upheld the Circuit Court's order vacating the 1989 settlement agreement approved by the Commission, the appeals court ruled that the Franklin Circuit Court order of September 27, 1991, improperly set utility rates in ordering refunds. The intervenor parties requested the Kentucky Supreme Court to review the case, and their request for review was denied on October 20, 1993. Under Kentucky procedural rules, this ruling makes final the Court of Appeals decision and returns the case to the Commission for further proceedings. The Commission has issued orders which set a portion of the procedural schedule for the case. Pursuant to the Commission's orders, the Company filed direct testimony on January 7, 1994. Intervenor parties are scheduled to file testimony on March 28, 1994. No date has been set for a hearing. The Company anticipates that the focus of Commission proceedings will be the determination of the appropriate ratemaking treatment to insulate ratepayers from 25% of Trimble County's costs and the amount of additional refunds, if any, that the Company should return to ratepayers. In previous proceedings in 1988, the Commission had authorized rate increases, subject to refund, of $11.4 million on an annual basis, pending a determination of the appropriate ratemaking treatment for the disallowance. The order remained in effect from May 1988 through December 1990, resulting in an amount subject to refund of approximately $30 million. The Company, through refunds and rate reductions, has already returned to its customers approximately $11 million of the total amount subject to refund. The Company's position is that no additional refunds are needed to carry out the Commission's objective of reflecting the disallowance of 25% of Trimble County in customer rates and the Company may be entitled to recover a portion, or all, of the amounts previously returned to customers. However, the Company is unable to predict the outcome of the Commission proceedings, the amount of additional refunds or recoveries, if any, that may be ordered or whether the Commission will revise its earlier position. Sale of Portion of Trimble County. On February 28, 1991, the Company sold a 12.12% ownership interest in the Trimble County Unit to the Illinois Municipal Electric Agency, based in Springfield, Illinois, which is an agency of 30 municipalities that own and operate their own electric systems. The sale price was $94.2 million and a book gain of $4.2 million, after-tax, was recognized in 1991 as a result of this sale. On February 1, 1993, the Indiana Municipal Power Agency (IMPA), based in Carmel, Indiana, purchased a 12.88% interest in the Trimble County plant. IMPA is composed of 31 municipalities that have joined together to meet their long-term electric power needs. The sale price was $91.1 million and an after-tax book gain of $3.2 million was recorded in 1993 as a result of this sale. The Company has now completed the sale of the entire 25% of Trimble County that the Commission disallowed from customer rates. Note 9 - Jointly Owned Electric Utility Plant - --------------------------------------------- As of December 31, 1993, the Company owned a 75% undivided interest in Trimble County Unit 1. Accounting for the 75% portion of the Unit, which the Commission has allowed to be reflected in customer rates, is similar to the Company's accounting for other wholly owned utility plants. Of the remaining 25% of the Unit: . Illinois Municipal Electric Agency (IMEA) purchased a 12.12% undivided interest in the Unit on February 28, 1991. IMEA pays for 12.12% of the operation and maintenance expenses, their proportionate share of incremental assets acquired and for fuel used. . Indiana Municipal Power Agency (IMPA) purchased a 12.88% undivided interest in the Unit on February 1, 1993. IMPA is responsible for 12.88% of the operation and maintenance expenses, their proportionate share of incremental assets acquired and for fuel used. The following data represent shares of the jointly owned property: Trimble County -------------------------------------- LG&E IMPA IMEA Total ---- ---- ---- ----- Ownership interest.......... 75% 12.88% 12.12% 100% Mw capacity................. 371.25 63.75 60 495 Note 10 - Segments of Business - ------------------------------ The Company is an operating public utility engaged in the generation, transmission, distribution, and sale of electricity and the transmission, distribution, and sale of natural gas. 1993 1992 1991 ---- ---- ---- (Thousands of $) Operating Information Operating Revenues Electric........................ $ 570,210 $ 521,669 $ 542,415 Gas............................. 204,915 178,526 166,291 --------- --------- --------- Total......................... $ 775,125 $ 700,195 $ 708,706 --------- --------- --------- --------- --------- --------- Pre-tax Operating Income Electric........................ $ 171,016 $ 154,547 $ 182,349 Gas............................. 17,436 15,122 13,576 --------- --------- --------- Total......................... $ 188,452 $ 169,669 $ 195,925 --------- --------- --------- --------- --------- --------- Other Information Depreciation and Amortization Electric........................ $ 69,753 $ 67,869 $ 65,236 Gas............................. 9,902 9,034 8,037 Non-Jurisdictional.............. 232 2,783 3,158 --------- --------- --------- Total......................... $ 79,887 $ 79,686 $ 76,431 --------- --------- --------- --------- --------- --------- Construction Expenditures Electric........................ $ 74,165 $ 75,630 $ 69,514 Gas............................. 24,622 25,545 18,538 --------- --------- --------- Total......................... $ 98,787 $ 101,175 $ 88,052 --------- --------- --------- --------- --------- --------- Investment Information-December 31 Identifiable Assets Electric........................ $1,616,595 $1,537,219 $1,524,018 Gas............................. 261,048 226,041 195,251 --------- --------- --------- Total......................... $1,877,643 $1,763,260 $1,719,269 Trimble County (a)................ - 87,794 89,824 Other Assets (b).................. 195,267 121,985 139,317 --------- --------- --------- Total Assets.................... $2,072,910 $1,973,039 $1,948,410 --------- --------- --------- --------- --------- --------- (a) Represents the portion of Trimble County not allowed in customer rates. (b) Includes cash and temporary cash investments, accounts receivable, unamortized debt expense, and other property and investments. REPORT OF MANAGEMENT The management of Louisville Gas and Electric Company is responsible for the preparation and integrity of the financial statements and related information included in this Annual Report. These statements have been prepared in accordance with generally accepted accounting principles applied on a consistent basis and, necessarily, include amounts that reflect the best estimates and judgment of management. The Company's financial statements have been audited by Arthur Andersen & Co., independent public accountants whose report follows this Report of Management. Management has made available to Arthur Andersen & Co. all the Company's financial records and related data as well as the minutes of shareholders' and directors' meetings. Management has established and maintains a system of internal controls that provide reasonable assurance that transactions are completed in accordance with management's authorization, that assets are safeguarded and that financial statements are prepared in conformity with generally accepted accounting principles. Management believes that an adequate system of internal controls is maintained through the selection and training of personnel, appropriate division of responsibility, establishment and communication of policies and procedures and by regular reviews of internal accounting controls by the Company's internal auditors. Management reviews and modifies its system of internal controls in light of changes in conditions and operations, as well as in response to recommendations from the internal auditors and the independent public accountants. These recommendations for the year ended December 31, 1993 did not identify any significant deficiencies in the design and operation of the Company's internal control structure. The Audit Committee of the Board of Directors is composed entirely of outside directors. In carrying out its oversight role for the financial reporting and internal controls of the Company, the Audit Committee meets regularly with the Company's independent public accountants, internal auditors and management. The Audit Committee reviews the results of the independent accountants' audit of the financial statements and their audit procedures, and discusses the adequacy of internal accounting controls. The Audit Committee also approves the annual internal auditing program, and reviews the activities and results of the internal auditing function. Both the independent public accountants and the internal auditors have access to the Audit Committee at any time. Louisville Gas and Electric Company maintains and internally communicates a written code of business conduct that addresses, among other items, potential conflicts of interest, compliance with laws, including those relating to financial disclosure, and the confidentiality of proprietary information. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS TO LOUISVILLE GAS AND ELECTRIC COMPANY: We have audited the accompanying balance sheets and statements of capitalization of Louisville Gas and Electric Company (a Kentucky corporation and a wholly owned subsidiary of LG&E Energy Corp.) 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 Louisville Gas and Electric 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 further discussed in Note 8, the potential amount of future rate refunds that may be required, if any, once the outcome of the legal and regulatory process is known, is uncertain at this time. As discussed in Notes 1 and 2 to the financial statements, effective January 1, 1993, the Company changed its methods of accounting for income taxes and post-retirement benefits other than pensions. Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. The schedules listed under Item 14(a)2 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 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. Louisville, Kentucky, Arthur Andersen & Co. January 28, 1994 -------------------------------------- SELECTED QUARTERLY FINANCIAL DATA (Unaudited) Operating revenues, net operating income, net income and net income available for common stock for the four quarters of 1993 and 1992 are shown below. Because of seasonal fluctuations in temperature and other factors, results for quarters may fluctuate throughout the year. Quarters Ended ---------------------------------------------- (Thousands of $) March June September December ----- ---- --------- -------- Operating Revenues...... $208,631 $166,906 $200,408 $199,180 Net Operating Income.... 32,754 28,395 47,786 27,183 Net Income.............. 20,786 16,566 36,447 16,736 Net Income Available for Common Stock.......... 19,199 14,898 35,099 15,358 Operating Revenues...... $182,699 $150,908 $179,491 $187,097 Net Operating Income.... 28,985 27,849 41,850 27,145 Net Income.............. 15,915 15,301 29,050 13,527 Net Income Available for Common Stock.......... 13,510 13,676 27,474 11,960 -------------------------------------- ITEM 9. ITEM 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure. - --------------------------------------------------------------------- None. PART III -------- ITEMS 10, 11, 12 and 13 are omitted pursuant to General Instruction G, inasmuch as the Company filed copies of a definitive proxy statement with the Commission on March 28, 1994, pursuant to Regulation 14A under the Securities Exchange Act of 1934. Such proxy statement is incorporated herein by this reference. In accordance with General Instruction G of Form 10-K, the information required by Item 10 ITEM 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K. - ---------------------------------------------------------------------------- (a) 1. Financial Statements (included in Item 8): Statements of Income for the three years ended December 31, 1993 (page 29). Statements of Retained Earnings for the three years ended December 31, 1993 (page 30). Balance Sheets - December 31, 1993, and 1992 (page 31-32). Statements of Cash Flows for the three years ended December 31, 1993 (page 33-34). Statements of Capitalization - December 31, 1993, and 1992 (page 35-36). Notes to Financial Statements (pages 37-53). Report of Management (page 54). Report of Independent Public Accountants (page 55). Selected Quarterly Financial Data for 1993, and 1992 (page 56). 2. Financial Statement Schedules (included in Part IV): Schedule V - Property, Plant and Equipment for the three years ended December 31, 1993 (pages 72-77). Schedule VI - Accumulated Depreciation, Depletion, and Amortization of Property, Plant and Equipment for the three years ended December 31, 1993 (pages 78-80). Schedule VIII - Valuation and Qualifying Accounts for the three years ended December 31, 1993 (page 81). Schedule IX - Short-Term Borrowings for the three years ended December 31, 1993 (page 82). Schedule X - Supplementary Income Statement Information for the three years ended December 31, 1993 (page 83). All other schedules have been omitted as not applicable or not required or because the information required to be shown is included in the Financial Statements or the accompanying Notes to Financial Statements. 3. Exhibits: Exhibit No. Description -------- ----------- 3.01 Copy of Restated Articles of Incorporation, as amended. [Filed as Exhibit 4.01 to Registration Statement 33-18302 and incorporated by reference herein] 3.02 Copy of Amendment to Articles of Incorporation, effective May 25, 1989. [Filed as Exhibit 3.01 to the Company's Form 10-Q for the quarter ended June 30, 1989 and incorporated by reference herein] 3.03 Copy of Amendment to Articles of Incorporation, effective February 6, 1992. [Filed as Exhibit 3.03 to the Company's Annual Report on Form 10-K for the year ended December 31, 1991, and incorporated by reference herein] 3.04 Copy of Amendment to Articles of Incorporation, effective April 8, 1993. [Filed as Exhibit 3.01 to the Company's Form 10-Q for the quarter ended March 31, 1993, and incorporated by reference herein] 3.05 Copy of Amendment to Articles of Incorporation, effective May 19, 1993. 3.06 Copy of Bylaws, as amended through May 13, 1993. [Filed as Exhibit 3.01 to the Company's Form 10-Q for the quarter ended June 30, 1993, and incorporated by reference herein] 4.01 Copy of Trust Indenture dated November 1, 1949, from the Company to Harris Trust and Savings Bank, Trustee. [Filed as Exhibit 7.01 to Registration Statement 2-8283 and incorporated by reference herein] 4.02 Copy of Supplemental Indenture dated February 1, 1952, which is a supplemental instrument to Exhibit 4.01 hereto. [Filed as Exhibit 4.05 to Registration Statement 2-9371 and incorporated by reference herein] 4.03 Copy of Supplemental Indenture dated February 1, 1954, which is a supplemental instrument to Exhibit 4.01 hereto. [Filed as Exhibit 4.03 to Registration Statement 2-11923 and incorporated by reference herein] 4.04 Copy of Supplemental Indenture dated September 1, 1957, which is a supplemental instrument to Exhibit 4.01 hereto. [Filed as Exhibit 2.04 to Registration Statement 2-17047 and incorporated by reference herein] 4.05 Copy of Supplemental Indenture dated October 1, 1960, which is a supplemental instrument to Exhibit 4.01 hereto. [Filed as Exhibit 2.05 to Registration Statement 2-24920 and incorporated by reference herein] 4.06 Copy of Supplemental Indenture dated June 1, 1966, which is a supplemental instrument to Exhibit 4.01 hereto. [Filed as Exhibit 2.06 to Registration Statement 2-28865 and incorporated by reference herein] 4.07 Copy of Supplemental Indenture dated June 1, 1968, which is a supplemental instrument to Exhibit 4.01 hereto. [Filed as Exhibit 2.07 to Registration Statement 2-37368 and incorporated by reference herein] 4.08 Copy of Supplemental Indenture dated June 1, 1970, which is a supplemental instrument to Exhibit 4.01 hereto. [Filed as Exhibit 2.08 to Registration Statement 2-37368 and incorporated by reference herein] 4.09 Copy of Supplemental Indenture dated August 1, 1971, which is a supplemental instrument to Exhibit 4.01 hereto. [Filed as Exhibit 2.09 to Registration Statement 2-44295 and incorporated by reference herein] 4.10 Copy of Supplemental Indenture dated June 1, 1972, which is a supplemental instrument to Exhibit 4.01 hereto. [Filed as Exhibit 2.10 to Registration Statement 2-52643 and incorporated by reference herein] 4.11 Copy of Supplemental Indenture dated February 1, 1975, which is a supplemental instrument to Exhibit 4.01 hereto. [Filed as Exhibit 2.11 to Registration Statement 2-57252 and incorporated by reference herein] 4.12 Copy of Supplemental Indenture dated September 1, 1975, which is a supplemental instrument to Exhibit 4.01 hereto. [Filed as Exhibit 2.12 to Registration Statement 2-57252 and incorporated by reference herein] 4.13 Copy of Supplemental Indenture dated September 1, 1976, which is a supplemental instrument to Exhibit 4.01 hereto. [Filed as Exhibit 2.13 to Registration Statement 2-57252 and incorporated by reference herein] 4.14 Copy of Supplemental Indenture dated October 1, 1976, which is a supplemental instrument to Exhibit 4.01 hereto. [Filed as Exhibit 2.14 to Registration Statement 2-65271 and incorporated by reference herein] 4.15 Copy of Supplemental Indenture dated June 1, 1978, which is a supplemental instrument to Exhibit 4.01 hereto. [Filed as Exhibit 2.15 to Registration Statement 2-65271 and incorporated by reference herein] 4.16 Copy of Supplemental Indenture dated February 15, 1979, which is a supplemental instrument to Exhibit 4.01 hereto. [Filed as Exhibit 2.16 to Registration Statement 2-65271 and incorporated by reference herein] 4.17 Copy of Supplemental Indenture dated September 1, 1979, which is a supplemental instrument to Exhibit 4.01 hereto. [Filed as Exhibit 4.17 to the Company's Annual Report on Form 10-K for the year ended December 31, 1980, and incorporated by reference herein] 4.18 Copy of Supplemental Indenture dated September 15, 1979, which is a supplemental instrument to Exhibit 4.01 hereto. [Filed as Exhibit 4.18 to the Company's Annual Report on Form 10-K for the year ended December 31, 1980, and incorporated by reference herein] 4.19 Copy of Supplemental Indenture dated September 15, 1981, which is a supplemental instrument to Exhibit 4.01 hereto. [Filed as Exhibit 4.19 to the Company's Annual Report on Form 10-K for the year ended December 31, 1981, and incorporated by reference herein] 4.20 Copy of Supplemental Indenture dated March 1, 1982, which is a supplemental instrument to Exhibit 4.01 hereto. [Filed as Exhibit 4.20 to the Company's Annual Report on Form 10-K for the year ended December 31, 1982, and incorporated by reference herein] 4.21 Copy of Supplemental Indenture dated March 15, 1982, which is a supplemental instrument to Exhibit 4.01 hereto. [Filed as Exhibit 4.21 to the Company's Annual Report on Form 10-K for the year ended December 31, 1982, and incorporated by reference herein] 4.22 Copy of Supplemental Indenture dated September 15, 1982, which is a supplemental instrument to Exhibit 4.01 hereto. [Filed as Exhibit 4.22 to the Company's Annual Report on Form 10-K for the year ended December 31, 1982, and incorporated by reference herein] 4.23 Copy of Supplemental Indenture dated February 15, 1984, which is a supplemental instrument to Exhibit 4.01 hereto. [Filed as Exhibit 4.23 to the Company's Annual Report on Form 10-K for the year ended December 31, 1984, and incorporated by reference herein] 4.24 Copy of Supplemental Indenture dated July 1, 1985, which is a supplemental instrument to Exhibit 4.01 hereto. [Filed as Exhibit 4.24 to the Company's Annual Report on Form 10-K for the year ended December 31, 1985, and incorporated by reference herein] 4.25 Copy of Supplemental Indenture dated November 15, 1986, which is a supplemental instrument to Exhibit 4.01 hereto. [Filed as Exhibit 4.25 to the Company's Annual Report on Form 10-K for the year ended December 31, 1986, and incorporated by reference herein] 4.26 Copy of Supplemental Indenture dated November 16, 1986, which is a supplemental instrument to Exhibit 4.01 hereto. [Filed as Exhibit 4.26 to the Company's Annual Report on Form 10-K for the year ended December 31, 1986, and incorporated by reference herein] 4.27 Copy of Supplemental Indenture dated August 1, 1987, which is a supplemental instrument to Exhibit 4.01 hereto. [Filed as Exhibit 4.27 to the Company's Annual Report on Form 10-K for the year ended December 31, 1987, and incorporated by reference herein] 4.28 Copy of Supplemental Indenture dated February 1, 1989, which is a supplemental instrument to Exhibit 4.01 hereto. [Filed as Exhibit 4.28 to the Company's Annual Report on Form 10-K for the year ended December 31, 1988, and incorporated by reference herein] 4.29 Copy of Supplemental Indenture dated February 2, 1989, which is a supplemental instrument to Exhibit 4.01 hereto. [Filed as Exhibit 4.29 to the Company's Annual Report on Form 10-K for the year ended December 31, 1988, and incorporated by reference herein] 4.30 Copy of Supplemental Indenture dated June 15, 1990, which is a supplemental instrument to Exhibit 4.01 hereto. [Filed as Exhibit 4.30 to the Company's Annual Report on Form 10-K for the year ended December 31, 1990, and incorporated by reference herein] 4.31 Copy of Supplemental Indenture dated November 1, 1990, which is a supplemental instrument to Exhibit 4.01 hereto. [Filed as Exhibit 4.31 to the Company's Annual Report on Form 10-K for the year ended December 31, 1990, and incorporated by reference herein] 4.32 Copy of Supplemental Indenture dated September 1, 1992, which is a supplemental instrument to Exhibit 4.01 hereto. [Filed as Exhibit 4.32 to the Company's Annual Report on Form 10-K for the year ended December 31, 1992, and incorporated by reference herein] 4.33 Copy of Supplemental Indenture dated September 2, 1992, which is a supplemental instrument to Exhibit 4.01 hereto. [Filed as Exhibit 4.33 to the Company's Annual Report on Form 10-K for the year ended December 31, 1992, and incorporated by reference herein] 4.34 Copy of Supplemental Indenture dated August 15, 1993, which is a supplemental instrument to Exhibit 4.01 hereto. 4.35 Copy of Supplemental Indenture dated August 16, 1993, which is a supplemental instrument to Exhibit 4.01 hereto. 4.36 Copy of Supplemental Indenture dated October 15, 1993, which is a supplemental instrument to Exhibit 4.01 hereto. 10.01 Copy of Agreement dated September 1, 1970, between Texas Gas Transmission Corporation and the Company covering the purchase of natural gas. [Filed as Exhibit 4.01 to Registration Statement 2-40985 and incorporated by reference herein] 10.02 Copies of Agreement between Sponsoring Companies re: Project D of Atomic Energy Commission, dated May 12, 1952, Memorandums of Understanding between Sponsoring Companies re: Project D of Atomic Energy Commission, dated September 19, 1952 and October 28, 1952, and Power Agreement between Ohio Valley Electric Corporation and Atomic Energy Commission, dated October 15, 1952. [Filed as Exhibit 13(y) to Registration Statement 2-9975 and incorporated by reference herein] 10.03 Copy of Modification No. 1 dated July 23, 1953, to the Power Agreement between Ohio Valley Electric Corporation and Atomic Energy Commission. [Filed as Exhibit 4.03(b) to Registration Statement 2-24920 and incorporated by reference herein] 10.04 Copy of Modification No. 2 dated March 15, 1964, to the Power Agreement between Ohio Valley Electric Corporation and Atomic Energy Commission. [Filed as Exhibit 5.02c to Registration Statement 2-61607 and incorporated by reference herein] 10.05 Copy of Modification No. 3 and No. 4 dated May 12, 1966 and January 7, 1967, respectively, to the Power Agreement between Ohio Valley Electric Corporation and Atomic Energy Commission. [Filed as Exhibits 4(a)(13) and 4(a)(14) to Registration Statement 2-26063 and incorporated by reference herein] 10.06 Copy of Modification No. 5 dated August 15, 1967, to the Power Agreement between Ohio Valley Electric Corporation and Atomic Energy Commission. [Filed as Exhibit 13(c) to Registration Statement 2-27316 and incorporated by reference herein] 10.07 Copies of (i) Inter-Company Power Agreement, dated July 10, 1953, between Ohio Valley Electric Corporation and Sponsoring Companies (which Agreement includes as Exhibit A the Power Agreement, dated July 10, 1953, between Ohio Valley Electric Corporation and Indiana-Kentucky Electric Corporation); (ii) First Supplementary Transmission Agreement, dated July 10, 1953, between Ohio Valley Electric Corporation and Sponsoring Companies; (iii) Inter-Company Bond Agreement, dated July 10, 1953, between Ohio Valley Electric Corporation and Sponsoring Companies; (iv) Inter-Company Bank Credit Agreement, dated July 10, 1953, between Ohio Valley Electric Corporation and Sponsoring Companies. [Filed as Exhibit 5.02f to Registration Statement 2-61607 and incorporated by reference herein] 10.08 Copy of Modification No. 1 and No. 2 dated June 3, 1966 and January 7, 1967, respectively, to Inter-Company Power Agreement dated July 10, 1953. [Filed as Exhibits 4(a)(8) and 4(a)(10) to Registration Statement 2-26063 and incorporated by reference herein] 10.09 Copies of Amendments to Agreements (iii) and (iv) referred to under 10.07 above as follows: (i) Amendment to Inter-Company Bond Agreement and (ii) Amendment to Inter-Company Bank Credit Agreement. [Filed as Exhibit 5.02h to Registration Statement 2-61607 and incorporated by reference herein] 10.10 Copy of Modification No. 1, dated August 20, 1958, to First Supplementary Transmission Agreement, dated July 10, 1953, among Ohio Valley Electric Corporation and the Sponsoring Companies. [Filed as Exhibit 5.02i to Registration Statement 2-61607 and incorporated by reference herein] 10.11 Copy of Modification No. 2, dated April 1, 1965, to the First Supplementary Transmission Agreement, dated July 10, 1953, among Ohio Valley Electric Corporation and the Sponsoring Companies. [Filed as Exhibit 5.02j to Registration Statement 2-6l607 and incorporated by reference herein] 10.12 Copy of Modification No. 3, dated January 20, 1967, to First Supplementary Transmission Agreement, dated July 10, 1953, among Ohio Valley Electric Corporation and the Sponsoring Companies. [Filed as Exhibit 4(a)(7) to Registration Statement 2-26063 and incorporated by reference herein] 10.13 Copy of Modification No. 6 dated November 15, 1967, to the Power Agreement between Ohio Valley Electric Corporation and Atomic Energy Commission. [Filed as Exhibit 4(g) to Registration Statement 2-28524 and incorporated by reference herein] 10.14 Copy of Modification No. 3 dated November 15, 1967, to the Inter-Company Power Agreement dated July 10, 1953. [Filed as Exhibit 4.02m to Registration Statement 2-37368 and incorporated by reference herein] 10.15 Copy of Modification No. 7 dated November 5, 1975, to the Power Agreement between Ohio Valley Electric Corporation and Atomic Energy Commission. [Filed as Exhibit 5.02n to Registration Statement 2-56357 and incorporated by reference herein] 10.16 Copy of Modification No. 4 dated November 5, 1975, to the Inter-Company Power Agreement dated July 10, 1953. [Filed as Exhibit 5.02o to Registration Statement 2-56357 and incorporated by reference herein] 10.17 Copy of Modification No. 4 dated April 30, 1976, to First Supplementary Transmission Agreement, dated July 10, 1953, among Ohio Valley Electric Corporation and the Sponsoring Companies. [Filed as Exhibit 5.02p to Registration Statement 2-6l607 and incorporated by reference herein] 10.18 Copy of Modification No. 8 dated June 23, 1977, to the Power Agreement between Ohio Valley Electric Corporation and Atomic Energy Commission. [Filed as Exhibit 5.02q to Registration Statement 2-61607 and incorporated by reference herein] 10.19 Copy of Modification No. 9 dated July 1, 1978, to the Power Agreement between Ohio Valley Electric Corporation and Atomic Energy Commission. [Filed as Exhibit 5.02r to Registration Statement 2-63149 and incorporated by reference herein] 10.20 Copy of Modification No. 10 dated August 1, 1979, to the Power Agreement between Ohio Valley Electric Corporation and Atomic Energy Commission. [Filed as Exhibit 2 to the Company's Annual Report on Form 10-K for the year ended December 31, 1979, and incorporated by reference herein] 10.21 Copy of Modification No. 11 dated September 1, 1979, to the Power Agreement between Ohio Valley Electric Corporation and Atomic Energy Commission. [Filed as Exhibit 3 to the Company's Annual Report on Form 10-K for the year ended December 31, 1979, and incorporated by reference herein] 10.22 Copy of Modification No. 5 dated September 1, 1979, to Inter-Company Power Agreement dated July 5, 1953, among Ohio Valley Electric Corporation and Sponsoring Companies. [Filed as Exhibit 4 to the Company's Annual Report on Form 10-K for the year ended December 31, 1979, and incorporated by reference herein] 10.23 Copy of Agreement dated December 16, 1966, between Peabody Coal Company and the Company covering the purchase of coal. [Filed as Exhibit 10.23 to the Company's Annual Report on Form 10-K for the year ended December 31, 1980, and incorporated by reference herein] 10.24 Copy of Amendments to Coal Supply Agreement referred to in 10.23 above as follows: (i) Amendment effective July 1, 1970, (ii) effective January 1, 1975, and (iii) effective December 1, 1976. [Filed as Exhibit 10.24 to the Company's Annual Report on Form 10-K for the year ended December 31, 1980, and incorporated by reference herein] 10.25 Copy of Modification No. 12 dated August 1, 1981, to the Power Agreement between Ohio Valley Electric Corporation and Atomic Energy Commission. [Filed as Exhibit 10.25 to the Company's Annual Report on Form 10-K for the year ended December 31, 1981, and incorporated by reference herein] 10.26 Copy of Modification No. 6 dated August 1, 1981, to Inter-Company Power Agreement dated July 5, 1953, among Ohio Valley Electric Corporation and Sponsoring Companies. [Filed as Exhibit 10.26 to the Company's Annual Report on Form 10-K for the year ended December 31, 1981, and incorporated by reference herein] 10.27 Copy of Agreement dated December 20, 1985, between Shawnee Coal Company and the Company covering the purchase of coal. [Filed as Exhibit 10.27 to the Company's Annual Report on Form 10-K for the year ended December 31, 1985, and incorporated by reference herein] 10.28 Copy of Diversity Power Agreement dated September 9, 1987, between East Kentucky Power Cooperative and the Company covering the purchase and sale of power between the two companies from 1988 through 1995. [Filed as Exhibit 10.28 to the Company's Annual Report on Form 10-K for the year ended December 31, 1987, and incorporated by reference herein] 10.29 Copy of Supplemental Executive Retirement Plan as amended through January 3, 1990, covering all officers of the Company. [Filed as Exhibit 10.29 to the Company's Annual Report on Form 10-K for the year ended December 31, 1989, and incorporated by reference herein] 10.30 Copy of Termination Agreement and Release dated February 1, 1989, between Peabody Coal Company and the Company canceling the Coal Supply Agreement dated December 16, 1966 referred to in Exhibit Nos. 10.23 and 10.24. [Filed as Exhibit 10.30 to the Company's Annual Report on Form 10-K for the year ended December 31, 1988, and incorporated by reference herein] 10.31 Copy of Agreements dated February 1 and February 15, 1989, between Peabody Development Company and the Company covering the purchase of coal. [Filed as Exhibit 10.31 to the Company's Annual Report on Form 10-K for the year ended December 31, 1988, and incorporated by reference herein] 10.32 Copy of Omnibus Long-Term Incentive Plan effective January 1, 1990, covering officers and key employees of the Company. [Filed as Exhibit 4.01 to the Company's Registration Statement 33-38557 and incorporated by reference herein] 10.33 Copy of Key Employee Incentive Plan effective January 1, 1990, covering officers and key employees of the Company. [Filed as Exhibit 10.33 to the Company's Annual Report on Form 10-K for the year ended December 31, 1989, and incorporated by reference herein] 10.34 Copy of LG&E Energy Corp. Deferred Stock Compensation Plan effective January 1, 1992, covering non-employee directors of LG&E Energy Corp. and its subsidiaries. [Filed as Exhibit 10.34 to LG&E Energy Corp.'s Annual Report on Form 10-K for the year ended December 31, 1991, and incorporated by reference herein] 10.35 Copy of Agreement dated August 1, 1991, between Texas Gas Transmission Corporation and the Company covering the purchase of natural gas. [Filed as Exhibit 10.35 to the Company's Annual Report on Form 10-K for the year ended December 31, 1991, and incorporated by reference herein] 10.36 Copy of Sales Service Agreement between Texas Gas Transmission Corporation and the Company effective February 1, 1992. [Filed as Exhibit 10.36 to the Company's Annual Report on Form 10-K for the year ended December 31, 1992, and incorporated by reference herein] 10.37 Copy of Sales Service Agreement between Texas Gas Transmission Corporation and the Company effective November 1, 1992. [Filed as Exhibit 10.37 to the Company's Annual Report on Form 10-K for the year ended December 31, 1992, and incorporated by reference herein] 10.38 Copy of form of change in control agreement for officers of Louisville Gas and Electric Company. [Filed as Exhibit 10.38 to the Company's Annual Report on Form 10-K for the year ended December 31, 1992, and incorporated by reference herein] 10.39 Copy of Employment Agreement between Roger W. Hale and Louisville Gas and Electric Company, effective June 1, 1989, as amended. [Filed as Exhibit 10.39 to the Company's Annual Report on Form 10-K for the year ended December 31, 1992, and incorporated by reference herein] 10.40 Copy of Supplemental Executive Retirement Plan for R. W. Hale, effective June 1, 1989. [Filed as Exhibit 10.40 to the Company's Annual Report on Form 10-K for the year ended December 31, 1992, and incorporated by reference herein] 10.41 Copy of Nonqualified Savings Plan covering officers of the Company, effective January 1, 1992. [Filed as Exhibit 10.41 to the Company's Annual Report on Form 10-K for the year ended December 31, 1992, and incorporated by reference herein] 10.42 Copy of Modification No. 13 dated September 1, 1989, to the Power Agreement between Ohio Valley Electric Corporation and Atomic Energy Commission. 10.43 Copy of Modification No. 14 dated January 15, 1992, to the Power Agreement between Ohio Valley Electric Corporation and Atomic Energy Commission. 10.44 Copy of Modification No. 7 dated January 15, 1992, to Inter-Company Power Agreement dated July 10, 1953, among Ohio Valley Electric Corporation and Sponsoring Companies. 10.45 Copy of Modification No. 15 dated February 15, 1993, to the Power Agreement between Ohio Valley Electric Corporation and Atomic Energy Commission. 10.46 Firm Transportation Agreement, dated November 1, 1993, between Texas Gas Transmission Corporation and the Company covering the transmission of natural gas. 10.47 Firm No Notice Transportation Agreement effective November 1, 1993, between Texas Gas Transmission Corporation and the Company (8-year term) covering the transmission of natural gas. Firm No Notice Transportation Agreement effective November 1, 1993, between Texas Gas Transmission Corporation and the Company (2-year term) covering the transmission of natural gas. Firm No Notice Transportation Agreement effective November 1, 1993, between Texas Gas Transmission Corporation and the Company (5-year term) covering the transmission of natural gas. 10.48 Employment Contract between LG&E Energy Corp. and Roger W. Hale effective November 3, 1993. [Filed as Exhibit 10.50 to LG&E Energy Corp.'s Annual Report on Form 10-K for the year ended December 31, 1993, and incorporated by reference herein] 10.49 Copy of LG&E Energy Corp. Stock Option Plan for Non-Employee Directors. [Filed as Exhibit 10.51 to LG&E Energy Corp.'s Annual Report on Form 10-K for the year ended December 31, 1993, and incorporated by reference herein] 12 Computation of Ratio of Earnings to Fixed Charges 23 Consent of Independent Public Accountants 24 Power of Attorney (b) Executive Compensation Plans and Arrangements: Supplemental Executive Retirement Plan as amended through January 3, 1990, covering all officers of the Company. [Filed as Exhibit 10.29 to the Company's Annual Report on Form 10-K for the year ended December 31, 1989, and incorporated by reference herein] Omnibus Long-Term Incentive Plan effective January 1, 1990, covering officers and key employees of the Company. [Filed as Exhibit 4.01 to the Company's Registration Statement 33-38557 and incorporated by reference herein] Key Employee Incentive Plan effective January 1, 1990, covering officers and key employees of the Company. [Filed as Exhibit 10.33 to the Company's Annual Report on Form 10-K for the year ended December 31, 1989, and incorporated by reference herein] LG&E Energy Corp. Deferred Stock Compensation Plan effective January 1, 1992, covering non-employee directors of LG&E Energy Corp. and its subsidiaries. [Filed as Exhibit 10.34 to LG&E Energy Corp.'s Annual Report on Form 10-K for the year ended December 31, 1991, and incorporated by reference herein] Form of change in control agreement for officers of Louisville Gas and Electric Company. [Filed as Exhibit 10.38 to the Company's Annual Report on Form 10-K for the year ended December 31, 1992] Employment Agreement between Roger W. Hale and Louisville Gas and Electric Company, effective June 1, 1989, as amended. [Filed as Exhibit 10.39 to the Company's Annual Report on Form 10-K for the year ended December 31, 1992] Supplemental Executive Retirement Plan for R. W. Hale, effective June 1, 1989. [Filed as Exhibit 10.40 to the Company's Annual Report on Form 10-K for the year ended December 31, 1992] Nonqualified Savings Plan covering officers of the Company effective January 1, 1992. [Filed as Exhibit 10.41 to the Company's Annual Report on Form 10-K for the year ended December 31, 1992] Employment Contract between LG&E Energy Corp. and Roger W. Hale effective November 3, 1993. [Filed as Exhibit 10.50 to LG&E Energy Corp.'s Annual Report on Form 10-K for the year ended December 31, 1993, and incorporated by reference herein] LG&E Energy Corp. Stock Option Plan for Non-Employee Directors. [Filed as Exhibit 10.51 to LG&E Energy Corp.'s Annual Report on Form 10-K for the year ended December 31, 1993, and incorporated by reference herein] (c) Reports on Form 8-K: The following 8-K reports were filed during the fourth quarter of 1993: (i) On October 27, 1993, a report on Form 8-K was filed announcing the following: Trimble County Generating Plant. On October 20, 1993, the Kentucky Supreme Court declined to review a Kentucky Court of Appeals order overturning a lower court's order that had improperly directed the Company to refund approximately $150 million to its customers in a case involving the Company's Trimble County electric generating station. Management Change. Walter M. Higgins, III, President and Chief Operating Officer of the Company resigned to accept the position of President and Chief Operating Officer of Sierra Pacific Resources. Sierra Pacific Resources indicated plans for Mr. Higgins to become Chief Executive Officer early in 1994. (ii) On November 23, 1993, a report on Form 8-K was filed announcing that LG&E Energy Corp., of which the Company is the principal subsidiary, would undergo a major realignment and formation of new business units effective January 1, 1994, to reflect its outlook for rapidly emerging competition in all segments of the energy services industry. The amounts of royalties and advertising costs charged to operating expenses were each less than one percent of total operating revenues. 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. LOUISVILLE GAS AND ELECTRIC COMPANY ----------------------------------- Registrant March 28, 1994 By M. L. Fowler - -------------- ----------------------------------- Vice President and Controller 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 Date --------- ----- ---- ROGER W. HALE Chairman of the Board and Chief Executive Officer (Principal Executive Officer); CHARLES A. MARKEL III Treasurer (Principal Financial Officer); M. L. FOWLER Vice President and Controller (Principal Accounting Officer); WILLIAM C. BALLARD, JR. Director; OWSLEY BROWN II Director; S. GORDON DABNEY Director; GENE P. GARDNER Director; DAVID B. LEWIS Director; ANNE H. MCNAMARA Director; T. BALLARD MORTON, JR. Director; and DR. DONALD C. SWAIN Director. By M. L. FOWLER March 28, 1994 - ------------------------------------------------ (Attorney-In-Fact)

52485_1993.txt

52485_1993

1993

52485

Item 2. Properties The Company's principal electric generating stations at December 31, 1993, are as follows: Net Kilowatts Accredited Major Generating Name and Location of Station Fuel Type Capability Duane Arnold Energy Center, Palo, Iowa Nuclear 371,000 (1) Ottumwa Generating Station, Ottumwa, Iowa Coal 339,840 (2) Prairie Creek Station, Cedar Rapids, Iowa Coal 234,000 Sutherland Station, Marshalltown, Iowa Coal 145,500 Sixth Street Station, Cedar Rapids, Iowa Coal 66,000 Peaking Turbines, Marshalltown, Iowa Oil 210,000 Diesel Stations, all in Iowa Oil 12,200 Burlington Generating Station, Burlington, Iowa Coal 211,800 Grinnell Station, Grinnell, Iowa Gas 47,200 George Neal Unit 3, Sioux City, Iowa Coal 144,200 (3) Total generating capability 1,781,740 (1) The capability represents the Company's 70% ownership interest in the 530,000 Kw generating station. The other owners are Central Iowa Power Cooperative (20%) and Corn Belt Power Cooperative (10%). The plant is operated by the Company. (2) The Company owns 48% of this 708,000 Kw generating station. The plant is operated by the Company. (3) This represents the Company's 28% ownership interest in this 515,000 Kw generating station which is operated by an unaffiliated utility. At December 31, 1993, the transmission lines of the Company, operating from 34,000 to 345,000 volts, approximated 4,259 circuit miles (all located in Iowa). The Company owned 107 transmission substations (all located in Iowa) with a total installed capacity of 8,426.4 MVa and 464 distribution substations (all located in Iowa) with a total installed capacity of 2,445.3 MVa. The Company's principal properties are suitable for their intended use and are held subject to liens of indentures relating to its First Mortgage Bonds. Item 3. Item 3. Legal Proceedings On December 24, 1990, IS filed in the United States Federal District Court (Court) for the Southern District of Iowa, a Complaint for Declaratory and Other Relief against the Iowa Department of Transportation (IDOT) for declaratory relief and contribution under CERCLA to recover costs that have been and will be incurred by IS (subsequently the Company) in connection with FMGP clean-up costs related to certain real property located in the City of Burlington, Iowa, and nearby areas, including the Mississippi River. On February 11, 1991, IDOT filed an Answer and Counterclaim against IS pursuant to CERCLA, alleging that it had incurred costs and expenses in excess of $1.3 million responding to the release of contamination and requesting judgment against IS for such costs and for all such future costs. Subsequently, in correspondence to IS's counsel, IDOT alleged that it had incurred in excess of $4.7 million in response costs. On June 3, 1993, the Court approved a Settlement Agreement and Order Confirming Settlement between IS (subsequently the Company) and IDOT. Under the terms of the agreement, the Company and IDOT agreed to dismiss the suit and countersuit discussed above. Additionally, the Company and IDOT have agreed to a cost-sharing arrangement for future investigation and clean-up costs at the Burlington site, whereby the Company will absorb the next $15 million of such costs and 75% of additional costs thereafter, to the extent any such costs are incurred pursuant to clean-up plans acceptable to regulatory agencies. The Company will also supervise the investigation and clean-up activities. Reference is made to Notes 4 and 12 of the Notes to Financial Statements for a discussion of the Company's rate proceedings and environmental matters. Also see Item 1. "Business - Environmental Matters." Item 4. Item 4. Submission of Matters to a Vote of Security Holders At a special meeting of the IE preferred shareholders held on October 22, 1993, the proposed merger of IE and IS was voted upon and approved. A summary of the results of the vote is as follows: Shares Eligible Shareholder Class to Vote For Against Abstain 4.30% preferred 120,000 110,917 - 308 4.80% preferred 146,406 91,625 267 2,535 6.10% preferred 100,000 63,174 - 2,853 The Company's sole common shareholder, Industries, approved the merger on May 4, 1993. PART II Item 5. Item 5. Market for the Registrant's Common Stock and Related Stockholder Matters All outstanding common stock of the Company is held by its parent (Industries) and is not publicly traded. The amounts of dividends declared for the last two years are as follows: Quarter Dividends Declared (000's) First Quarter $ 10,000 Second Quarter 5,700 Third Quarter 3,800 Fourth Quarter 11,800 $ 31,300 First Quarter $ 13,231 Second Quarter 3,000 Third Quarter 4,462 Fourth Quarter 4,028 $ 24,721 Under terms of the Fifty-fifth and Fifty-sixth Supplemental Indentures relating to Series W and Series X First Mortgage Bonds, the Company has agreed that no cash dividends shall be paid or declared, nor shall any distribution be made on any capital stock, nor shall any shares of such stock be purchased, redeemed or otherwise acquired for any consideration by the Company or any subsidiary of the Company, if after immediately giving effect to such payment, distribution or retirement, (A) the principal amount of all outstanding defined Unsecured Indebtedness exceeds 20% of defined Total Capitalization, or (B) the aggregate amount of all such payments, distributions and retirements made since December 31, 1987 exceeds net income since December 31, 1987 plus $50,000,000. Pursuant to these terms, at December 31, 1993, $18,209,000 of retained earnings was restricted as to the payment of cash dividends. The Company may periodically pay cash dividends on any shares of its preferred or preference stock at any time issued and outstanding, provided that all such payments shall be included in the above payments as determined since December 31, 1987. Item 6. Item 6. Selected Financial Data The following selected financial data, in the opinion of the Company, includes adjustments, which are normal and recurring in nature, necessary for the fair presentation of the results of operations and financial position. See Item 7. Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF THE RESULTS OF OPERATIONS AND FINANCIAL CONDITION The following discussion analyzes significant changes in the components of net income and financial condition during the years 1993 and 1992. See Note 1 of the Notes to Financial Statements for a discussion of the merger of Iowa Electric Light and Power Company (IE) and Iowa Southern Utilities Company (IS), effective December 31, 1993, that formed the Company. RESULTS OF OPERATIONS The Company's net income increased $23.5 million during 1993 and decreased $1.8 million during 1992. The 1993 results reflect the acquisition of the Iowa service territory of Union Electric Company (UE) (as discussed in Note 3 of the Notes to Financial Statements) and a return to more normal weather conditions in the Company's service territory. The floods in Iowa in 1993 did not significantly affect the Company's results of operations. The 1992 results were adversely affected by extremely cool summer weather and a mild winter in the Company's service territory. The Company's operating income increased $25.0 million and $0.6 million during 1993 and 1992, respectively, as compared to prior years. Reasons for the changes in the results of operations are explained in the following discussion. ELECTRIC REVENUES Electric revenues and Kwh sales (excluding off-system sales) increased $87.5 million and 25%, respectively, during 1993. In 1992, electric revenues and Kwh sales decreased $19.6 million and 1.5%, respectively. The 1993 sales increase is attributable to the acquisition of the UE territory and a return to more normal weather conditions. After adjusting for these items, underlying electric sales increased 6% in 1993, which reflects the economic growth in the industrial and commercial customer base. The 1992 Kwh sales decrease reflects unusually mild weather conditions in the Company's service territory. Residential sales, which are the most weather sensitive, decreased 9.5%. However, industrial sales, which are less sensitive to weather, increased approximately 5.5%. Adjusting for the effects of weather, Kwh sales increased 2.7%, reflecting economic growth in the Company's service territory. The Company's electric tariffs include energy adjustment clauses (EAC) that are designed to currently recover the costs of fuel and the energy portion of purchased power billings to customers. See Note 2(g) of the Notes to Financial Statements for discussion of the EAC. The increase in electric revenues for 1993 is primarily because of the sales increase and increased recovery of fuel costs through the EAC. The revenue decrease in 1992 was primarily related to the lower Kwh sales discussed above and lower off-system sales to other utilities. A rate decrease in the former IS service territory that became effective in September 1991 contributed to the revenue decrease to a lesser extent. These items were partially offset by the effect of the rate increase in the former IE service territory that became effective in December 1991. See Note 4(b) of the Notes to Financial Statements for a discussion of the electric rate case in the former IE service territory. GAS REVENUES Gas revenues increased $14.9 million and $8.4 million during 1993 and 1992, respectively. Gas sales in therms (including transported volumes) increased 5.3% in 1993 and were flat in 1992. Gas sales also reflect the effects of weather. Adjusting for the effects of weather, gas sales decreased 1.5% in 1993 and increased 1.5% in 1992. The Company's tariffs include purchased gas adjustment clauses (PGA) that are designed to currently recover the cost of gas sold. See Note 2(g) of the Notes to Financial Statements for discussion of the PGA. Gas revenues increased in 1993 and 1992 substantially because of increased costs of gas recovered through the PGA and the effect of gas rate increases in the former service territory of both IE and IS, that became effective in September 1992. The 1993 sales increase also contributed to the revenue increase for that year. See Note 4(a) of the Notes to Financial Statements for a discussion of the gas rate increases. STEAM REVENUES Steam revenues increased $1.1 million during 1993 and decreased $0.6 million during 1992, primarily related to fluctuations in sales volumes among large industrial customers. OPERATING EXPENSES Fuel for production increased $14.3 million in 1993 because of increased availability of the Company's fossil-fueled generating stations, which experienced extended maintenance outages in 1992, and because of increased sales. Fuel for production decreased $17.8 million during 1992 primarily because of a nuclear refueling outage at the Duane Arnold Energy Center (DAEC), maintenance outages at the fossil-fueled generating stations and the lower electric sales. There were refueling outages in 1993 and 1992, but no such outage in 1991. The decrease in Kwh generation during the refueling and maintenance outages was substantially replaced by purchased power. Purchased power increased $18.7 million in 1993, of which approximately $14.7 million represents increased energy purchases and approximately $4.0 million is a net increase in capacity charges. The increase in energy purchases is because of the increased Kwh sales. The increased capacity costs reflect the contracts associated with the acquisition of the UE service territory, partially offset by the expiration, in April 1993, of the purchase power agreement with the City of Muscatine. (See Note 12(b) of the Notes to Financial Statements). Purchased power increased $4.5 million in 1992 because of increased purchases during the refueling and maintenance outages, partially offset by lower purchases related to lower off-system sales. Gas purchased for resale increased $7.5 million and $5.1 million during 1993 and 1992, respectively. The increases are primarily because of increased per unit gas costs, and in 1993, increased sales. Other operating expenses increased $3.6 million in 1993 and decreased $5.2 million during 1992. The 1993 increase is primarily because of increased labor and benefit costs and higher electric and gas transmission and distribution costs, partially offset by lower non-labor costs at the DAEC. The 1992 decrease was substantially related to a regulatory disallowance of $3.9 million recorded in April 1991, after the Iowa Utilities Board (IUB) denied recovery of previously deferred former manufactured gas plant (FMGP) clean-up costs. Lower non-labor costs at the DAEC and lower Nuclear Regulatory Commission fees, partially offset by increased labor and benefit costs, also affected 1992. Maintenance expenses increased $6.6 million during 1993 and were flat in 1992. The 1993 increase is primarily because of increased maintenance at the Company's fossil-fueled generating stations and the DAEC. The 1992 maintenance expenses reflect increased maintenance at fossil-fueled generating stations, substantially offset by lower maintenance costs at the DAEC. Depreciation and amortization increased during both years primarily because of increases in utility plant in service, including the acquisition of the UE territory on December 31, 1992. An increase in the average gas utility property depreciation rate, resulting from an updated depreciation study, also contributed to the 1993 increase. Depreciation and amortization expenses for both years include $5.5 million for the DAEC decommissioning provision, which is collected through rates. Property taxes increased $4.8 million during 1993, primarily because of the acquisition of the UE service territory and increases assessed values. Federal and state income taxes included in operating expenses increased $18.0 million in 1993 primarily because of increases in taxable income and an increase of 1% in the Federal statutory income tax rate. Such income taxes decreased $1.9 million in 1992 primarily because of adjustments of $1.5 million recorded in the second quarter of 1992 to previously recorded tax reserves and a reduction in taxable income. INTEREST EXPENSE Interest expense (long-term debt and other combined) increased in 1993 and 1992 primarily because of an increase in the average amount of debt outstanding. A reduction in the average interest rate in 1993 substantially offset the effect of the higher average outstanding debt. The lower average interest rate reflects the refinancing of certain long-term debt issues at lower rates and lower-cost short-term borrowings outstanding for interim periods between the redemption of certain long-term debt series and the issuance of their long-term replacements. Interest expense related to the Company's reserves for rate refunds also contributed to the increase in 1992. LIQUIDITY AND CAPITAL RESOURCES The Company's capital requirements are primarily attributable to its construction programs and debt maturities. Cash and temporary cash investments increased $16.6 million during 1993. In 1993, cash flows from operating activities were $149 million. These funds were primarily used for construction and acquisition expenditures and to pay dividends. It is anticipated that the Company's future capital requirements will be met by cash generated from operations and external financing. The level of cash generated from operations is partially dependent upon economic conditions, legislative activities, environmental matters and timely rate relief. (See Notes 4 and 12 of the Notes to Financial Statements). Access to the long-term and short-term capital and credit markets is necessary for obtaining funds externally. The Company's liquidity and capital resources will be affected by environmental and legislative issues, including the ultimate disposition of remediation issues surrounding the FMGP issue, the Clean Air Act as amended, the National Energy Policy Act of 1992, and Federal Energy Regulatory Commission (FERC) Order 636, as discussed in Note 12 of the Notes to Financial Statements. Consistent with rate making principles of the IUB, management believes that the costs incurred for the above matters will not have a material adverse effect on the financial position or results of operations of the Company. The IUB has adopted rules which require the Company to spend 2% of electric and 1.5% of gas gross retail operating revenues annually for energy efficiency programs. Energy efficiency costs in excess of the amount in the most recent electric and gas rate cases are being recorded as regulatory assets. At December 31, 1993, the Company had $18.5 million of such costs recorded as regulatory assets. The Company will make its initial filing for recovery of the costs in 1994. CONSTRUCTION AND ACQUISITION PROGRAM The Company's construction and acquisition program anticipates expenditures of $150 million for 1994, of which approximately 44% represents expenditures for electric transmission and distribution facilities, 18% represents fossil-fueled generation expenditures and 10% represents nuclear generation expenditures. Substantial commitments have been made in connection with such expenditures. The Company's levels of construction and acquisition expenditures are projected to be $149 million in 1995, $144 million in 1996, $149 million in 1997 and $160 million in 1998. It is estimated that approximately 80% of construction expenditures will be provided by cash from operating activities (after payment of dividends) for the five year period 1994-1998. Capital expenditure and investment and financing plans are subject to continual review and change. The capital expenditure and investment program may be revised significantly as a result of many considerations including changes in economic conditions, variations in actual sales and load growth compared to forecasts, requirements of environmental, nuclear and other regulatory authorities, acquisition opportunities, the availability of alternate energy and purchased power sources, the ability to obtain adequate and timely rate relief, escalations in construction costs and conservation and energy efficiency programs. LONG-TERM FINANCING Other than periodic sinking fund requirements which the Company intends to meet by pledging additional property, $124 million of long-term debt, including four series of First Mortgage Bonds aggregating $123 million, will mature prior to December 31, 1998. The Company intends to refinance the majority of the debt maturities with long-term debt. In order to provide an up-to-date instrument for the issuance of bonds, notes or other evidence of indebtedness, the Company has entered into an Indenture of Mortgage and Deed of Trust dated September 1, 1993 (New Mortgage). The lien of the New Mortgage is subordinate to the lien of the Company's first mortgages until such time as all bonds issued under the first mortgages have been retired and such mortgages satisfied. The New Mortgage provides for, among other things, the issuance of Collateral Trust Bonds upon the basis of First Mortgage Bonds being issued. Accordingly, to the extent that the Company issues Collateral Trust Bonds on the basis of First Mortgage Bonds, it must comply with the requirements for the issuance of First Mortgage Bonds under the Company's first mortgages. Under the terms of the New Mortgage, the Company has covenanted not to issue any additional First Mortgage Bonds under its first mortgages except to provide the basis for issuance of Collateral Trust Bonds. In November 1993, the Company entered into arrangements with various cities in the State of Iowa (Cities), whereby the Cities issued an aggregate of $19.4 million of pollution control revenue refunding bonds (PCRRBs), all at 5.5%, due 2023. Each series of the PCRRBs is secured, in part, by payments on a corresponding principal amount of Collateral Trust Bonds, at 5.5%, due 2023. The proceeds received by the Company in the transaction were used to redeem $10.2 million of Pollution Control Obligations, 5.75%, due serially 1995-2003 and an aggregate of $9.2 million of First Mortgage Bonds, Series P & Q, 6.7%, due 2006. In October 1993, the Company sold $100 million aggregate principal amount of Collateral Trust Bonds, 6% Series, due 2008, and 7% Series, due 2023. A portion of the proceeds from the Collateral Trust Bonds was used to retire short-term debt, with the balance used for general corporate purposes, including support of the Company's construction program. In May 1993, the Company redeemed First Mortgage Bonds Series K, 8-5/8%, principal amount of $20 million, and Series R, 8-1/4%, principal amount of $25 million and First Mortgage Bonds Series 8-3/4%, principal amount of $15 million. The redemptions were completed with proceeds from short-term borrowings and, as discussed above, long-term debt was ultimately issued to replace the short-term borrowings. The Indentures pursuant to which the Company issues First Mortgage Bonds constitute direct first mortgage liens upon substantially all tangible public utility property and contain covenants which restrict the amount of additional bonds which may be issued. At December 31, 1993, such restrictions would have allowed the Company to issue $258 million of additional First Mortgage Bonds. The Company intends to file in the first quarter of 1994 with the FERC for authority to issue $250 million of long-term debt. The Company is currently authorized by the SEC to issue $50 million of long-term debt under an existing registration statement. The Company expects to issue up to $150 million in 1994. The proceeds are expected to be used for the early redemption of three series of First Mortgage Bonds aggregating $55 million, which have not yet been called, and for general corporate purposes, including support of its construction program. The Articles of Incorporation of the Company authorize and limit the aggregate amount of additional shares of Cumulative Preferred Stock and Cumulative Preference Stock which may be issued. At December 31, 1993, the Company could have issued an additional 700,000 shares of Cumulative Preference Stock and 100,000 additional shares of Cumulative Preferred Stock. The Company's capitalization ratios at year-end were as follows: 1993 1992 Long-term debt 48% 50% Preferred stock 2 2 Common equity 50 48 100% 100% SHORT-TERM FINANCING For interim financing, the Company is authorized by the FERC to issue, through 1994, up to $125 million of short-term notes. This availability of short-term financing provides the Company flexibility in the issuance of long-term securities. At December 31, 1993, the Company had outstanding short-term borrowings of $24 million. The Company has two agreements, both of which expire in 1994, with separate financial institutions to sell up to $65 million of its utility accounts receivable. The Company intends to consolidate the agreements into one new agreement in 1994. At December 31, 1993, the Company had sold $53.2 million under the agreements. At December 31, 1993, the Company had bank lines of credit aggregating $67.7 million and was using $19.0 million of its lines to support commercial paper and $7.7 million to support certain pollution control obligations. Commitment fees are paid to maintain these lines and there are no conditions which restrict the unused lines of credit. In addition to the above, the Company has an uncommitted credit facility with a financial institution whereby it can borrow up to $50 million. Rates are set at the time of borrowing and no fees are paid to maintain this facility. At December 31, 1993, $5.0 million was borrowed at 3.4% under this facility. The Company also has a letter of credit in the amount of $3.4 million supporting two of its variable rate pollution control obligations. EFFECTS OF INFLATION Under the rate making principles prescribed by the regulatory commissions to which the Company is subject, only the historical cost of plant is recoverable in revenues as depreciation. As a result, the Company has experienced economic losses equivalent to the current year's impact of inflation on utility plant. In addition, the regulatory process imposes a substantial time lag between the time when operating and capital costs are incurred and when they are recovered. The Company does not expect the effects of inflation at current levels to have a significant effect on its results of operations. Selected Quarterly Financial Data (unaudited) The following unaudited quarterly data, in the opinion of the Company, includes adjustments, which are normal and recurring in nature, necessary for the fair presentation of the results of operations and financial position. Quarter Ended March June September December 31 30 30 31 (in thousands) Operating revenues $193,784 $148,919 $187,392 $183,655 Operating income 24,100 18,095 36,095 25,629 Net income 14,422 10,491 26,213 16,844 Net income available for common stock 14,193 10,262 25,985 16,616 Operating revenues $166,494 $132,843 $145,003 $165,922 Operating income 17,721 15,755 26,034 19,429 Net income 9,522 7,501 17,561 10,707 Net income available for common stock 9,022 7,002 17,059 10,479 The above amounts were affected by seasonal weather conditions and the timing of utility rate changes. Rate activities are discussed in Note 4 of the Notes to Financial Statements. The 1993 results were affected by the acquisition of the Iowa service territory from Union Electric Company, as discussed in Note 3 of the Notes to Financial Statements. Refer to Management's Discussion and Analysis for discussion of the adverse effect of weather upon 1992 results, primarily in the third quarter. Item 8. Item 8. Financial Statements and Supplementary Data Information required by Item 8. begins on page 48. MANAGEMENT'S RESPONSIBILITY FOR FINANCIAL STATEMENTS The Company's management has prepared and is responsible for the presentation, integrity and objectivity of the financial statements and related information included in this report. The financial statements have been prepared in conformity with generally accepted accounting principles applied on a consistent basis and, in some cases, include estimates that are based upon management's judgment and the best available information, giving due consideration to materiality. Financial information contained elsewhere in this report is consistent with that in the financial statements. The Company 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 financial statements. The system of internal accounting controls is supported by written policies and procedures, by a staff of internal auditors and by the selection and training of qualified personnel. The internal audit staff conducts comprehensive audits of the Company's system of internal accounting controls. Management strives to maintain an adequate system of internal controls, recognizing that the cost of such a system should not exceed the benefits derived. In accordance with generally accepted auditing standards, the independent public accountants (Arthur Andersen & Co.), obtained a sufficient understanding of the Company's internal controls to plan their audit and determine the nature, timing and extent of other tests to be performed. No material internal control weaknesses have been reported to management, nor is management aware of any such weaknesses. The Board of Directors, through its Audit Committee comprised entirely of outside directors, meets periodically with management, the internal auditor and Arthur Andersen & Co. to discuss financial reporting matters, internal control and auditing. To ensure their independence, both the internal auditor and Arthur Andersen & Co. have full and free access to the Audit Committee. /s/ Lee Liu (Signature) Lee Liu Chairman of the Board, President & Chief Executive Officer /s/ Blake O. Fisher, Jr. (Signature) Blake O. Fisher, Jr. Executive Vice President & Chief Financial Officer /s/ Richard A. Gabbianelli (Signature) Richard A. Gabbianelli Controller & Chief Accounting Officer ARTHUR ANDERSEN & CO. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Board of Directors of IES Utilities Inc.: We have audited the accompanying balance sheets and statements of capitalization of IES UTILITIES INC. (an Iowa 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 financial statement schedules referred to below 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 IES Utilities Inc. 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. 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 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. As discussed in Note 8 to the financial statements, effective January 1, 1993, IES Utilities Inc. changed its method of accounting for postretirement benefits other than pensions. /s/ Arthur Andersen & Co. (Signature) ARTHUR ANDERSEN & CO. Chicago, Illinois, January 28, 1994 IES UTILITIES INC. STATEMENTS OF INCOME Year Ended December 31 1993 1992 1991 (in thousands) Operating revenues: Electric $550,521 $462,999 $482,578 Gas 154,318 139,455 131,019 Steam 8,911 7,808 8,396 713,750 610,262 621,993 Operating expenses: Fuel for production 87,702 73,368 91,182 Purchased power 93,449 74,794 70,245 Gas purchased for resale 109,122 101,605 96,504 Other operating expenses 123,210 119,607 124,855 Maintenance 46,219 39,573 39,571 Depreciation and amortization 69,407 64,107 61,466 Property taxes 36,426 31,586 31,770 Federal and state income taxes 39,411 21,422 23,307 Miscellaneous taxes 4,885 5,261 4,800 609,831 531,323 543,700 Operating income 103,919 78,939 78,293 Other income and deductions: Allowance for equity funds used during construction 824 1,831 820 Miscellaneous, net 2,248 2,803 3,950 3,072 4,634 4,770 Interest: Long-term debt 34,926 35,689 31,171 Other 5,243 3,939 5,595 Allowance for debt funds used during construction (1,148) (1,346) (1,266) 39,021 38,282 35,500 Net income 67,970 45,291 47,563 Preferred and preference dividend requirements 914 1,729 2,170 Net income available for common stock $ 67,056 $ 43,562 $ 45,393 The accompanying Notes to Financial Statements are an integral part of these statements. IES UTILITIES INC. STATEMENTS OF RETAINED EARNINGS Year Ended December 31 1993 1992 1991 (in thousands) Balance at beginning of year $153,106 $134,822 $134,750 Add: Net income 67,970 45,291 47,563 221,076 180,113 182,313 Deduct: Cash dividends declared - Common stock 31,300 24,721 45,321 Preferred stock, at stated rates 914 1,665 1,956 Preference stock, at stated rates - 64 214 Preferred stock redemption premiums - 557 - 32,214 27,007 47,491 Balance at end of year ($18,209,000 restricted as to payment of cash dividends) $188,862 $153,106 $134,822 The accompanying Notes to Financial Statements are an integral part of these statements. IES UTILITIES INC. BALANCE SHEETS December 31 1993 1992 (in thousands) ASSETS Utility plant, at original cost: Plant in service - Electric $1,707,278 $1,641,536 Gas 147,956 137,227 Other 75,845 73,970 1,931,079 1,852,733 Less - Accumulated depreciation 813,312 759,754 1,117,767 1,092,979 Leased nuclear fuel, net of amortization 51,681 48,505 Construction work in progress 41,937 30,324 1,211,385 1,171,808 Current assets: Cash and temporary cash investments 18,313 1,743 Accounts receivable - Customer, less reserve 22,679 24,517 Other 10,330 10,429 Income tax refunds receivable 8,767 - Production fuel, at average cost 14,338 19,418 Materials and supplies, at average cost 26,861 28,765 Adjustment clause balances - 1,217 Regulatory assets 6,421 3,636 Prepayments and other 31,502 26,085 139,211 115,810 Other assets: Regulatory assets 149,978 118,215 Nuclear decommissioning trust funds 28,059 21,327 Deferred charges and other 18,345 13,731 196,382 153,273 $1,546,978 $1,440,891 CAPITALIZATION AND LIABILITIES Capitalization (See Statements of Capitalization): Common stock $ 33,427 $ 33,427 Paid-in surplus 279,042 229,042 Retained earnings 188,862 153,106 Total common equity 501,331 415,575 Cumulative preferred stock 18,320 18,320 Long-term debt 480,074 441,522 999,725 875,417 Current liabilities: Short-term borrowings 24,000 92,000 Notes payable - associated companies - 560 Capital lease obligations 15,345 13,211 Sinking funds and maturities 224 224 Accounts payable 47,179 45,384 Dividends payable 5,229 229 Accrued interest 9,438 9,247 Accrued taxes 39,763 41,987 Accumulated refueling outage provision 2,660 7,549 Adjustment clause balances 5,149 - Provision for rate refund liability 8,670 9,020 Other 27,038 17,848 184,695 237,259 Long-term liabilities: Capital lease obligations 36,336 35,294 Liability under National Energy Policy Act of 1992 11,984 12,054 Environmental liabilities 9,130 9,815 Other 25,197 17,645 82,647 74,808 Deferred credits: Accumulated deferred income taxes 237,464 206,099 Accumulated deferred investment tax credits 42,447 47,308 279,911 253,407 Commitments and contingencies (Note 12) $1,546,978 $1,440,891 The accompanying Notes to Financial Statements are an integral part of these statements. IES UTILITIES INC. STATEMENTS OF CAPITALIZATION December 31 1993 1992 (in thousands) Common equity: Common stock - par value $2.50 per share - authorized 24,000,000 shares; outstanding 13,370,788 shares $ 33,427 $ 33,427 Paid-in surplus 279,042 229,042 Retained earnings 188,862 153,106 501,331 415,575 Cumulative preferred stock - par value $50 per share - authorized 466,406 shares; outstanding 366,406 shares - 6.10% - Outstanding 100,000 shares 5,000 5,000 4.80% - Outstanding 146,406 shares 7,320 7,320 4.30% - Outstanding 120,000 shares 6,000 6,000 18,320 18,320 Long-term debt: Collateral trust bonds - 6% series, due 2008 50,000 - 7% series, due 2023 50,000 - 5.5% series, due 2023 19,400 - 119,400 - First mortgage bonds - Series J, 6-1/4%, due 1996 15,000 15,000 Series K, 8-5/8%, retired in 1993 - 20,000 Series L, 7-7/8%, due 2000 15,000 15,000 Series M, 7-5/8%, due 2002 30,000 30,000 Series P & Q, 6.70%, retired in 1993 - 9,200 Series R, 8-1/4%, retired in 1993 - 25,000 Series W, 9-3/4%, due 1995 50,000 50,000 Series X, 9.42%, due 1995 50,000 50,000 Series Y, 8-5/8%, due 2001 60,000 60,000 Series Z, 7.60%, due 1999 50,000 50,000 6-1/8% series, due 1997 8,000 8,000 9-1/8% series, due 2001 21,000 21,000 7-3/8% series, due 2003 10,000 10,000 7-1/4% series, due 2007 30,000 30,000 8-3/4% series, retired in 1993 - 15,000 339,000 408,200 Pollution control obligations - 5.75%, retired in 1993 - 10,200 4.90% to 5.75%, due serially 1994 to 2003 3,920 4,144 5.95%, due 2007, secured by First mortgage bonds 10,000 10,000 Variable rate (3.15% at December 31, 1993), due 2000 to 2010 11,100 11,100 25,020 35,444 Unamortized debt premium and (discount), net (3,122) (1,898) 480,298 441,746 Less - Amount due within one year 224 224 480,074 441,522 $ 999,725 $ 875,417 The accompanying Notes to Financial Statements are an integral part of these statements. IES UTILITIES INC. STATEMENTS OF CASH FLOWS Year Ended December 31 1993 1992 1991 (in thousands) Cash flows from operating activities: Net income $67,970 $45,291 $47,563 Adjustments to reconcile net income to net cash flows from operating activities - Depreciation and amortization 69,407 64,107 61,466 Principal payments under capital lease obligations 11,429 11,725 15,471 Deferred taxes and investment tax credits 10,531 (2,406) (13,068) Amortization of deferred charges 860 961 7,778 Refueling outage provision (4,889) (5,503) 11,553 Allowance for equity funds used during construction (824) (1,831) (820) (Gain) loss on disposition of assets, net (655) - 30 Other (1,321) (4,742) (4,026) Other changes in assets and liabilities - Accounts receivable (8,553) (571) (3) Sale of utility accounts receivable 10,490 7,710 (5,000) Accounts payable 5,620 345 569 Accrued taxes (10,991) 6,118 3,375 Production fuel 5,080 2,579 1,234 Adjustment clause balances 6,366 (4,122) 184 Deferred energy efficiency costs (9,747) (6,877) (1,905) Provision for rate refunds (350) 7,528 (197) Other (1,281) (4,519) 2,307 Net cash flows from operating activities 149,142 115,793 126,511 Cash flows from financing activities: Dividends declared on common stock (31,300) (24,721) (45,321) Dividends on preferred and preference stock (914) (1,729) (2,170) Proceeds from issuance of long-term debt 119,400 83,400 88,700 Equity infusion from parent company 50,000 - 40,000 Net change in short-term borrowings (68,560) 51,660 (55,750) Sinking fund requirements and reductions in long-term debt and preferred and preference stock (79,624) (39,429) (31,589) Principal payments under capital lease obligations (11,276) (12,337) (14,738) Dividends payable 5,000 - - Other (1,295) 476 (500) Net cash flows from financing activities (18,569) 57,320 (21,368) Cash flows from investing activities: Construction and acquisition expenditures (113,212) (171,013) (105,009) Nuclear decommissioning trust funds (5,532) (5,532) (5,505) Proceeds from disposition of assets 837 - 203 Other 3,904 (246) (620) Net cash flows from investing activities (114,003) (176,791) (110,931) Net increase (decrease) in cash and temporary cash investments 16,570 (3,678) (5,788) Cash and temporary cash investments at beginning of year 1,743 5,421 11,209 Cash and temporary cash investments at end of year $ 18,313 $ 1,743 $ 5,421 Supplemental cash flow information: Cash paid during the year for - Interest $ 39,747 $ 36,503 $ 36,932 Income taxes $ 40,130 $ 23,640 $ 32,925 Noncash investing and financing activities - Capital lease obligations incurred $ 14,605 $ 1,973 $ 11,874 The accompanying Notes to Financial Statements are an integral part of these statements. NOTES TO FINANCIAL STATEMENTS (1) GENERAL: IES Utilities Inc. (the Company) is a wholly-owned subsidiary of IES Industries Inc. (Industries) and is subject to regulation by the Iowa Utilities Board (IUB) and the Federal Energy Regulatory Commission (FERC). On June 4, 1993, Industries announced that its wholly-owned utility subsidiaries, Iowa Electric Light and Power Company (IE) and Iowa Southern Utilities Company (IS), filed applications for regulatory authority to merge. The merger became effective December 31, 1993, following receipt of all necessary Boards of Directors, shareholder and regulatory approvals. IE is the surviving corporation and has been renamed IES Utilities Inc. The separate existence of IS has ceased. The Company serves a total of 325,000 electric and 170,000 natural gas retail customers as well as 32 resale customers in more than 550 Iowa communities. The merger was accounted for under a method of accounting similar to pooling of interests, which combined the ownership interests of IE and IS. The assets and liabilities of IE and IS were combined at their recorded amounts as of the merger date. (2) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: (a) Regulatory Assets - The Company is subject to the provisions of Statement of Financial Accounting Standards No. 71 "Accounting for the Effects of Certain Types of Regulation" (SFAS 71). The regulatory assets represent probable future revenue associated with certain incurred costs as these costs are recovered through the ratemaking process. At December 31, 1993, regulatory assets were comprised of the following items, and were reflected in the Balance Sheets as follows: Regulatory Assets (in millions) Deferred income taxes (Note 2(b)) $ 88.6 Energy efficiency programs 18.5 Employee pension and benefit costs (Note 8) 14.1 Environmental liabilities (Note 12(f)) 12.9 National Energy Policy Act of 1992 (Note 12(h)) 12.5 FERC Order No. 636 transition costs (Note 12(i)) 5.0 Cancelled plant costs 3.3 Regulatory study costs 1.5 156.4 Less current amounts 6.4 $150.0 Refer to the individual footnotes referenced above for a discussion of the specific items reflected in regulatory assets. The amounts reflected for energy efficiency programs are a result of an IUB mandate whereby 2% of electric and 1.5% of gas gross retail operating revenues are to be expended annually for energy efficiency programs. Under this mandate, the Company will make its initial filing for recovery of the costs in 1994. (b) Income Taxes - The Company follows the liability method of accounting for deferred income taxes, which requires the establishment of deferred tax liabilities and assets, as appropriate, for all temporary differences between the tax basis of assets and liabilities and the amounts reported in the financial statements. Deferred taxes are recorded using currently enacted tax rates. Except as noted below, income tax expense includes provisions for deferred taxes to reflect the tax effects of temporary differences between the time when certain costs are recorded in the accounts and when they are deducted for tax return purposes. As temporary differences reverse, the related accumulated deferred income taxes are reversed to income. Investment tax credits have been deferred and are subsequently credited to income over the average lives of the related property. Consistent with ratemaking practices, deferred tax expense is not recorded for certain temporary differences (primarily related to utility property, plant and equipment). Accordingly, the Company has recorded deferred tax liabilities and regulatory assets, as discussed in Note 2(a). (c) Temporary Cash Investments - Temporary cash investments are stated at cost which approximates market value and are considered cash equivalents for the Statements of Cash Flows. These investments consist of short-term liquid investments which have maturities of less than 90 days from the date of acquisition and at December 31, 1993, include $15 million invested with affiliated companies. (d) Depreciation of Utility Property, Plant and Equipment - The average rates of depreciation for electric and gas properties, including the Company's nuclear generating station, the Duane Arnold Energy Center (DAEC), which is being depreciated over a 36 year life using a remaining life method, were as follows: 1993 1992 1991 Electric 3.5% 3.5% 3.5% Gas 3.5% 3.0% 3.0% Based on the most recent site specific study, completed in 1992, the Company's 70% share of the estimated cost to decommission the DAEC and return the underlying property to its original state approximated $223 million in 1992 dollars. The study is based on the prompt removal and dismantling decommissioning alternative and is assumed to begin at the end of the DAEC's operating license in 2014. The level of annual recovery through rates of decommissioning costs is $5.5 million, which is deposited in external trust funds, and is based on a remaining life recovery method. The annual recovery level is reviewed and, if necessary, adjusted in each rate case. Decommissioning costs, at the level collected through rates, are included in "Depreciation and amortization" expense in the Statements of Income. In addition to the $28.1 million invested in the external trust funds as indicated in the Balance Sheets, the Company has an internal decommissioning reserve of $21.7 million recorded as accumulated depreciation. Earnings on the external funds are recognized as income and a corresponding amount of interest expense is recorded for the reinvestment of the earnings. (e) Allowance for Funds Used During Construction - The allowance for funds used during construction (AFC), which represents the cost during the construction period of funds used for construction purposes, is capitalized as a component of the cost of utility plant. The amount of AFC applicable to debt funds and to other (equity) funds, a non-cash item, is computed in accordance with the prescribed FERC formula. The aggregate gross rates used for 1993-1991 were 5.7%, 9.2% and 8.5%, respectively. (f) Operating Revenues - The Company accrues revenues for services rendered but unbilled at month-end in order to more properly match revenues with expenses. (g) Adjustment Clauses - The Company's tariffs provide for subsequent adjustments to its electric and natural gas rates for changes in the cost of fuel and purchased energy and in the cost of natural gas purchased for resale. Changes in the under/over collection of these costs are reflected in "Fuel for production" and "Gas purchased for resale" in the Statements of Income. The cumulative effects are reflected in the Balance Sheets as a current asset or current liability, pending automatic reflection in future billings to customers. (h) Accumulated Refueling Outage Provision - The IUB allows the Company to collect, as part of its base revenues, funds to offset other operating and maintenance expenditures incurred during refueling outages at the DAEC. As these revenues are collected, an equivalent amount is charged to other operating and maintenance expenses with a corresponding credit to a reserve. During a refueling outage, the reserve is reversed to offset the refueling outage expenditures. (i) Reclassifications - Certain prior period amounts have been reclassified on a basis consistent with the 1993 presentation. (3) ACQUISITION OF IOWA SERVICE TERRITORY OF UNION ELECTRIC COMPANY: Effective December 31, 1992, the Company acquired the Iowa distribution system and a portion of the Iowa transmission facilities of Union Electric Company (UE) for $65.0 million in cash. The acquisition was accounted for as a purchase. The net book value of the acquired assets was approximately $34.4 million and the amount of the purchase price in excess of the book value ($30.6 million) has been recorded as an acquisition adjustment. The acquisition adjustment is being amortized over the life of the property and is included in "Other income and deductions - Miscellaneous, net" in the Statements of Income. Recovery of the acquisition adjustment through rates will be addressed in future rate proceedings. See Note 12(b) for a discussion of the purchase power contracts with UE associated with this acquisition. (4) RATE MATTERS: (a) Gas Rate Cases - Former IE Service Territory In July 1992, IE applied to the IUB for an increase in gas rates of $6.3 million annually, or 5.9%. Effective September 30, 1992, the IUB authorized an interim increase of $5.4 million, subject to refund. On April 30, 1993, the IUB issued its "Final Decision and Order," which approved stipulations between IE and certain intervenors providing for an annual increase in revenues of $5.5 million. IE did not have any refund liability as a result of the Order. Former IS Service Territory In July 1992, IS applied to the IUB for an increase in gas rates of $2.3 million annually, or 6.2%. Effective September 30, 1992, the IUB authorized an interim increase of $1.9 million, subject to refund. In February 1993, the IUB approved stipulations between IS and certain intervenors in the proceeding that provided for an annual increase in revenues of $1.6 million. As a result of the Order, IS refunded approximately $0.2 million, including interest, in the second quarter of 1993. (b) 1991 Electric Rate Case - In October 1991, IE applied to the IUB for an increase in interim and final retail electric rates of $18.9 million annually, or 6.0%. The IUB approved an interim rate increase of $15.6 million, annually, which became effective in December 1991, subject to refund. In July 1992, the IUB issued its "Final Decision and Order" approving an annual electric rate increase of $7.9 million. The application of double leverage ratemaking theory to IE's capital structure accounted for approximately $4 million of the difference between the interim rate level and the amount allowed in the Order. After a limited rehearing of the double leverage issue, the IUB issued its "Order On Rehearing" in December 1992, which affirmed the original decision. IE appealed the IUB's Order to the Iowa District Court (Court). In December 1993, the Court issued its decision, which upholds the IUB's Order. The Company did not appeal the Court's decision to the Iowa Supreme Court. In the second quarter of 1993, IE refunded approximately $4.1 million, including interest, which represented a refund down to the level of revenues that would have resulted had it won the appeal. An additional refund, including interest, of $8.7 million is required at December 31, 1993, as a result of the Court's decision. The refund is expected to be completed in the second quarter of 1994. There will be no effect on electric revenues and net income when the additional refund is made because the Company has been reserving for the effect of the additional refund. (5) LEASES: The Company has a capital lease covering its 70% undivided interest in nuclear fuel purchased for the DAEC. Future purchases of fuel may also be added to the fuel lease. This lease provides for annual one year extensions and the Company intends to exercise such extensions through the DAEC's operating life. Interest costs under the lease are based on commercial paper costs incurred by the lessor. The Company is responsible for the payment of taxes, maintenance, operating cost, risk of loss and insurance relating to the leased fuel. The lessor has an $80 million credit agreement with a bank supporting the nuclear fuel lease. The agreement continues on a year to year basis, unless either party provides at least a three year notice of termination; no such notice of termination has been provided by either party. Annual nuclear fuel lease expenses include the cost of fuel, based on the quantity of heat produced for the generation of electric energy, plus the lessor's interest costs related to fuel in the reactor and administrative expenses. These expenses (included in "Fuel for production" in the Statements of Income) for 1993-1991 were $12.4 million, $12.9 million and $17.5 million, respectively. The Company's operating lease rental expenses for 1993-1991 were $8.4 million, $6.8 million and $7.0 million, respectively. The Company's future minimum lease payments by year are as follows: Capital Operating Year Lease Leases (in thousands) 1994 $ 16,994 $ 6,511 1995 11,970 6,353 1996 10,784 4,865 1997 9,940 3,420 1998 4,145 3,549 1999-2003 4,111 12,130 57,944 $ 36,828 Less: Amount representing interest 6,263 Present value of net minimum capital lease payments $ 51,681 (6) UTILITY ACCOUNTS RECEIVABLE: Customer accounts receivable, including unbilled revenues, arise primarily from the sale of electricity and natural gas. At December 31, 1993, the Company was serving a diversified base of residential, commercial and industrial customers consisting of approximately 325,000 electric and 170,000 gas customers. The Company has entered into two agreements, one with limited recourse, to sell undivided fractional interests of an aggregate of $65 million in its pool of utility accounts receivable. At December 31, 1993, $53.2 million was sold under the agreements. The agreements expire in June and December 1994. The Company intends to consolidate the agreements into one new agreement in 1994. (7) INCOME TAXES: The components of federal and state income taxes for the years ended December 31, were as follows: 1993 1992 1991 (in millions) Classified as Federal and State Income Taxes: Current tax expense $ 28.4 $ 24.0 $ 36.3 Deferred tax expense 15.9 0.2 (10.1) Amortization and adjustment of investment tax credits (4.9) (2.8) (2.9) 39.4 21.4 23.3 Included in Miscellaneous, net: Current tax expense (0.9) (0.8) 0.4 Deferred tax expense (0.5) 0.1 (0.2) (1.4) (0.7) 0.2 Total income tax expense $ 38.0 $ 20.7 $ 23.5 The overall effective income tax rates shown below were computed by dividing total income tax expense by income before income taxes. Year Ended December 31 1993 1992 1991 Statutory Federal income tax rate 35.0% 34.0% 34.0% Add (deduct): Amortization of investment tax credits (2.5) (4.2) (4.0) State income taxes, net of Federal benefits 5.8 5.6 6.4 Property basis and other temporary differences for which deferred taxes are not provided under ratemaking principles 1.5 0.5 2.1 Reversal through tariffs of deferred taxes provided at rates in excess of the current statutory Federal income tax rate (1.7) (2.7) (3.7) Adjustment of prior period taxes (2.0) (2.0) (1.3) Other items, net (0.3) 0.2 (0.4) Overall effective income tax rate 35.8% 31.4% 33.1% The accumulated deferred income taxes as set forth below and in the Balance Sheets arise from the following temporary differences: December 31 1993 1992 (in millions) Property related $ 272 $ 256 Decommissioning related (12) (11) Investment tax credit related (30) (32) Other 7 (7) $ 237 $ 206 (8) BENEFIT PLANS: The Company has one contributory and two non-contributory retirement plans which, collectively, cover substantially all of its employees. Plan benefits are generally based on years of service and compensation during the employees' latter years of employment. Payments made from the pension funds to retired employees and beneficiaries during 1993 totaled $10.4 million. In addition to these payments, the Company purchased annuities totaling $6.3 million for all previous employees who had retired as of January 1993, under one of the plans. The cost of the annuities and the reduction in the projected benefit obligation were substantially equivalent. The Company's policy is to fund the pension cost at an amount which is at least equal to the minimum funding requirements mandated by the Employee Retirement Income Security Act (ERISA) and which does not exceed the maximum tax deductible amount for the year. Pursuant to the provisions of SFAS 71, certain adjustments to the Company's pension provision are necessary to reflect the accounting for pension costs allowed in the most recent rate cases. The components of the pension provision are as follows: Year Ended December 31 1993 1992 1991 (in thousands) Service cost $ 4,275 $ 4,439 $ 4,517 Interest cost on projected benefit obligation 11,131 9,999 8,959 Assumed return on plans' assets (12,177) (11,640) (10,026) Amortization of unrecognized gain (763) (135) (19) Amortization of prior service cost 1,195 938 775 Amortization of unrecognized plans' assets as of January 1, 1987 (384) (382) (392) Pension cost 3,277 3,219 3,814 Adjustment to funding level (2,867) 301 (228) Total pension costs paid to the Trustees $ 410 $ 3,520 $ 3,586 Actual return on plans' assets $ 12,718 $ 8,861 $ 37,085 A reconciliation of the funded status of the plans to the amounts recognized in the Balance Sheets is presented below: December 31 1993 1992 (in thousands) Fair market value of plans' assets $ 174,133 $ 177,514 Actuarial present value of benefits rendered to date - Accumulated benefits based on compensation to date, including vested benefits of $100,905,000 and $91,303,000, respectively 110,676 100,288 Additional benefits based on estimated future salary levels 42,938 31,324 Projected benefit obligation 153,614 131,612 Plans' assets in excess of projected benefit obligation 20,519 45,902 Remaining unrecognized net asset existing at January 1, 1987, being amortized over 20 years (4,109) (5,256) Unrecognized prior service cost 16,708 14,961 Unrecognized net gain (28,830) (52,709) Prepaid pension cost recognized in the Balance Sheets $ 4,288 $ 2,898 Assumed rate of return, all plans 8.00% 8.00% Weighted average discount rate of projected benefit obligation, all plans 7.50% 8.25% Range of assumed rates of increase in future compensation levels for the plans 4.00-5.75% 4.00-5.75% The decrease in the discount rate used to compute the projected benefit obligation, from 8.25% at December 31, 1992 to 7.50% at December 31, 1993, accounted for a significant portion of the reduction in the unrecognized net gain between periods and, similarly, contributed to the increase in the projected benefit obligation at December 31, 1993. The Company provides certain benefits to retirees (primarily health care benefits). Through 1992, the Company expensed such costs as benefits were paid, which was consistent with ratemaking practices. Such costs totaled $2.2 million for 1992 and $1.9 million for 1991. Effective January 1, 1993, the Company adopted SFAS 106, which requires the accrual of the expected cost of postretirement benefits other than pensions during the employees' years of service. The IUB has adopted rules stating that postretirement benefits other than pensions will be included in rates pursuant to the provisions of SFAS 106. The rules permit the Company to amortize the transition obligation as of January 1, 1993 over 20 years and require that all amounts collected are to be funded into an external trust to pay benefits as they become due. Beginning in 1993, the gas portion of these costs is being recovered in the Company's gas rates, and are funded in external trust funds; recovery of the electric portion will be addressed in future electric proceedings. The IUB has adopted a rule that permits a deferral of the incremental electric SFAS 106 costs until the earlier of: 1) an order in an electric rate case, or 2) December 31, 1995. Accordingly, pursuant to the provisions of SFAS 71, the Company had deferred $2.9 million of such costs at December 31, 1993, and it expects to file electric rate cases seeking recovery of the deferred costs before December 31, 1995. The components of postretirement benefit costs for the year ended December 31, 1993, are as follows: (in thousands) Service cost $ 1,685 Interest cost on accumulated postretirement benefit obligation 3,247 Amortization of transition obligation existing at January 1, 1993 2,024 Postretirement benefit costs 6,956 Less: Deferred postretirement benefit costs 2,858 Net postretirement benefit costs $ 4,098 A reconciliation of the funded status of the plans to the amounts recognized in the Balance Sheets is presented below: December 31, January 1, 1993 1993 (in thousands) Fair market value of plans' assets $ 1,171 $ - Accumulated postretirement benefit obligation - Active employees not yet eligible 18,325 18,232 Active employees eligible 4,130 3,698 Retirees 20,140 18,558 Total accumulated postretirement benefit obligation 42,595 40,488 Accumulated postretirement benefit obligation in excess of plans' assets (41,424) (40,488) Unrecognized transition obligation 38,463 40,488 Unrecognized net gain (1,167) - Accrued postretirement benefit cost in the Balance Sheets $ (4,128) $ - Assumed rate of return 8.0% - Weighted average discount rate of accumulated postretirement benefit obligation 7.5% 8.25% Medical trend on paid charges: Initial trend rate 12.0% 13.0% Ultimate trend rate 6.5% 8.0% The assumed medical trend rates are critical assumptions in determining the service cost and accumulated postretirement benefit obligation related to postretirement benefit costs. A 1% change in the medical trend rates, holding all other assumptions constant, would have changed the 1993 service cost by $1.1 million (22%) and the accumulated postretirement benefit obligation at December 31, 1993 by $6.7 million (16%). The Company will adopt the provisions of SFAS 112 "Employers' Accounting for Postemployment Benefits" as of January 1, 1994 and its adoption will not have a material effect on the Company's financial position or results of operations. This statement requires that benefits offered to former or inactive employees after termination of employment, but before retirement, be accrued over the service lives of the employees if all of the following conditions are met: 1) the obligation relates to services already performed, 2) the employees' rights vest, 3) the payments are probable, and 4) the amounts are reasonably determinable. Otherwise, such obligations are to be recognized at the time they become probable and reasonably determinable. The Company has generally accounted for these obligations as they were paid. (9) PREFERRED AND PREFERENCE STOCK: The Company has 466,406 shares of Cumulative Preferred Stock, $50 par value, authorized for issuance at December 31, 1993, of which the 6.10%, 4.80% and 4.30% Series had 100,000, 146,406 and 120,000 shares, respectively, outstanding at both December 31, 1993 and 1992. These shares are redeemable at the Company's option upon 30 days notice at $51.00, $50.25 and $51.00 per share, respectively, plus accrued dividends. The Company also has 700,000 shares of Cumulative Preference Stock ($100 par value) authorized for issuance, of which none were outstanding at December 31, 1993. (10) DEBT: (a) Long-Term Debt - In November 1993, the Company entered into arrangements with various cities in the State of Iowa (Cities), whereby the Cities issued an aggregate of $19.4 million of pollution control revenue refunding bonds (PCRRBs), all at 5.5%, due 2023. Each series of the PCRRBs is secured, in part, by payments on a corresponding principal amount of Collateral Trust Bonds, at 5.5%, due 2023. The proceeds received by the Company in the transaction were used to redeem $10.2 million of Pollution Control Obligations, 5.75%, due serially 1995-2003 and an aggregate of $9.2 million of First Mortgage Bonds, Series P & Q, 6.7%, due 2006. In October 1993, the Company sold $100 million aggregate principal amount of Collateral Trust Bonds, 6% Series, due 2008, and 7% Series, due 2023. A portion of the proceeds from the Collateral Trust Bonds was used to retire short-term debt, with the balance used for general corporate purposes, including support of its construction program. In May 1993, the Company redeemed First Mortgage Bonds Series K, 8-5/8%, principal amount of $20 million, and Series R, 8-1/4%, principal amount of $25 million and First Mortgage Bonds Series 8-3/4%, principal amount of $15 million. The redemptions were completed with proceeds from short-term borrowings and, as discussed above, long-term debt was ultimately issued to replace the short-term borrowings. The Company's Indentures and Deeds of Trust securing its First Mortgage Bonds constitute direct first mortgage liens upon substantially all tangible public utility property. The Company's Indenture and Deed of Trust securing its Collateral Trust Bonds constitutes a second lien on substantially all tangible public utility property while First Mortgage Bonds remain outstanding. Total sinking fund requirements, which the Company intends to meet by pledging additional property under the terms of the Company's Indentures and Deeds of Trust, and debt maturities for 1994-1998 are as follows: Debt maturities (in thousands) Debt Issue 1994 1995 1996 1997 1998 Sinking Fund Requirements $ 780 $ 780 $ 630 $ 550 $ 550 Pollution Control 224 140 140 140 140 Series W - 50,000 - - - Series X - 50,000 - - - Series J - - 15,000 - - 6 1/8% Series - - - 8,000 - $1,004 $100,920 $ 15,770 $ 8,690 $ 690 The Company intends to refinance the majority of the debt maturities with long-term debt. (b) Short-Term Debt - At December 31, 1993, the Company had bank lines of credit aggregating $67.7 million and was using $19.0 million to support commercial paper and $7.7 million to support certain pollution control obligations. Commitment fees are paid to maintain these lines and there are no conditions which restrict the unused lines of credit. In addition to the above, the Company has an uncommitted credit facility with a financial institution whereby it can borrow up to $50 million. Rates are set at the time of borrowing and no fees are paid to maintain this facility. At December 31, 1993, $5.0 million was borrowed at 3.4% under this facility. The Company also has a letter of credit in the amount of $3.4 million supporting two of its variable rate pollution control obligations. (11) ESTIMATED FAIR VALUE OF FINANCIAL INSTRUMENTS: The estimated fair values of financial instruments at December 31, 1993, and the basis upon which they were estimated are as follows: Current assets and current liabilities - The carrying amount approximates fair value because of the short maturity of such financial instruments. Nuclear decommissioning trust funds - The estimated fair value of these trust funds, as reported by the trustee based upon current market values, is $29.5 million. Cumulative preferred stock - The estimated fair value of this stock of $12.8 million is based upon quoted market prices. Long-term debt - The carrying amount of long-term debt was $480 million compared to estimated fair value of $507 million. The estimated fair value of long-term debt is based upon quoted market prices. Since the Company is subject to regulation, any gains or losses related to the difference between the carrying amount and the fair value of financial instruments may not be realized by the Company's parent. (12) COMMITMENTS AND CONTINGENCIES: (a) Construction Program - The Company's construction and acquisition program anticipates expenditures of approximately $150 million, for which substantial commitments have been made. (b) Purchase Power Contracts - The Company has a purchase power contract with Terra Comfort Company (Terra Comfort), a wholly-owned subsidiary of Industries, for annual capacity purchases of 114 Mw that expires on December 31, 1994. In connection with the acquisition of the UE properties discussed in Note 3, the Company is purchasing power from UE under a five-year firm capacity contract with a 1994 requirement of 120 Mw of delivered capacity declining to 60 Mw in 1997. The Company will also purchase an additional maximum interruptible capacity of up to 54 Mw of 25 Hz power. This 25 Hz power purchase will extend through 1998 and will continue thereafter unless either party gives a three-year notice of cancellation. The costs of capacity purchases for these contracts are reflected in "Purchased power" in the Statements of Income. Total capacity charges under all existing contracts will approximate $21.0 million, $14.7 million, $11.4 million, $8.7 million and $0.3 million for the years 1994-1998, respectively. (c) Coal Contract Commitments - The Company has entered into coal supply contracts which expire between 1994 and 2001 for its fossil-fueled generating stations. At December 31, 1993, the contracts cover approximately $147 million of coal over the life of the contracts, which includes $34 million expected to be incurred in 1994. The Company expects to supplement these coal contracts with spot market purchases to fulfill its future fossil fuel needs. (d) Information Technology Services - In 1992, the Company entered into an agreement with Electronic Data Systems Corporation (EDS) for information technology services. The term of the contract is twelve years and the contract is subject to declining termination fees. The Company's anticipated expenditures under the agreement for 1994 are estimated to be approximately $8.9 million. Future costs under the agreement are variable and are dependent upon the Company's level of usage of technological services from EDS, as well as inflation. (e) Nuclear Insurance Programs - The Price-Anderson Amendments Act of 1988 (1988 Act) provides the Company with the benefit of $9.4 billion of public liability coverage consisting of $200 million of insurance and $9.2 billion of potential retroactive assessments from the owners of nuclear power plants. Under the 1988 Act, the Company could be assessed a maximum of $79 million per nuclear incident, with a maximum of $10 million per year (of which the Company's 70% ownership portion would be $55 million and $7 million, respectively) if losses relating to the incidents exceeded $200 million. These limits are subject to adjustments for inflation in future years. Pursuant to provisions in various nuclear insurance policies, the Company could be assessed retroactive premiums in connection with future accidents at a nuclear facility owned by a utility participating in the particular insurance plan. With respect to excess property damage and replacement power coverages, the Company could be assessed annually a maximum of $8.5 million and $1 million, respectively, if the insurer's losses relating to accidents exceeded its reserves. While assessments may also be made for losses in certain prior years, the Company is not aware of any losses in such years that it believes are likely to result in an assessment. (f) Environmental Liabilities - At December 31, 1993, the Company's Balance Sheet reflects $13.1 million (including $4.0 million as current) of environmental liabilities, which, pursuant to generally accepted accounting principles, represents the minimum amount of the estimated range of such costs that the Company expects to incur. The minimum amount of the range is used because no amount within the range represents a better estimate. These estimates are subject to continuing review. The Company has been named as a Potentially Responsible Party (PRP) for certain former manufactured gas plant (FMGP) sites by either the Iowa Department of Natural Resources (IDNR) or the Environmental Protection Agency (EPA). The Company is working with the IDNR and EPA to investigate its 27 sites and to determine the appropriate remediation activities that may be needed to mitigate health and environmental concerns. Such investigations are expected to be completed by 1999 and site-specific remediations are anticipated to be completed within 3 years after the completion of the investigations of each site. The Company may be required to monitor these sites for a number of years upon completion of remediation. The Company is investigating the possibility of insurance and third party cost sharing for FMGP clean-up costs. The amount of shared costs, if any, can not be reasonably determined and, accordingly, no potential sharing has been recorded. Regulatory assets of $12.9 million have been recorded in the Balance Sheets, which reflects the future recovery that is being provided through the Company's rates (See Note 2(a)). Considering the recorded reserves for environmental liabilities and the past rate treatment allowed by the IUB, management believes that the clean-up costs incurred by the Company for these FMGP sites will not have a material adverse effect on its financial position or results of operations. (g) Clean Air Act - The Clean Air Act Amendments of 1990 (Act) requires emission reductions of sulfur dioxide and nitrogen oxides to achieve reductions of atmospheric chemicals believed to cause acid rain. The provisions of the Act will be implemented in two phases with Phase I affecting two of the Company's units beginning in 1995 and Phase II affecting all units beginning in the year 2000. The Company expects to meet the requirements of the Act by switching to lower sulfur fuels and through capital expenditures primarily related to fuel burning equipment and boiler modifications. The Company estimates capital expenditures at approximately $28 million, including $4 million in 1994, in order to meet these requirements of the Act. (h) National Energy Policy Act of 1992 - The National Energy Policy Act of 1992 requires owners of nuclear power plants to pay a special assessment into a "Uranium Enrichment Decontamination and Decommissioning Fund." The assessment is based upon prior nuclear fuel purchases and, for the DAEC, averages $1.3 million annually through 2007, of which the Company's 70% share is $0.9 million. The Company is recovering the costs associated with this assessment through its electric fuel adjustment clauses over the period the costs are assessed. The Company's 70% share of the future assessment, $12.7 million payable through 2007, has been recorded as a liability in the Balance Sheets, including $0.7 million included in "Current liabilities - other," with a related regulatory asset for the unrecovered amount (See Note 2(a)). (i) FERC Order No. 636 - The FERC issued Order No. 636 (Order 636) in 1992. Order 636 as modified on rehearing, (1) requires the Company's pipeline suppliers to unbundle their services so that gas supplies are obtained separately from transportation service, and transportation and storage services are operated and billed as separate and distinct services, (2) requires the pipeline suppliers to offer "no notice" transportation service under which firm transporters (such as the Company) can receive delivery of gas up to their contractual capacity level on any day without prior scheduling, (3) allows pipelines to abandon long-term (one year or more) transportation service to a customer whenever the customer fails to match the highest rate and longest term (up to 20 years) offered to the pipeline by other customers for the particular capacity, and (4) provides for a mechanism under which pipelines can recover prudently incurred transition costs associated with the restructuring process. The Company may benefit from enhanced access to competitively priced gas supply and more flexible transportation services as a result of Order 636. However, the Company will be required to pay certain transition costs passed on from its pipeline suppliers as they implement Order 636. The Company's three pipeline suppliers have filed new tariffs with the FERC implementing Order 636 and the pipelines have also made filings with the FERC to begin collecting their respective transition costs. The Company began paying the transition costs in November 1993, and has recorded a liability of $5.0 million for such transition costs that have been incurred by the pipelines to date, including $1.7 million expected to be billed in 1994. While the magnitude of the total transition costs to be charged to the Company cannot yet be determined, the Company believes any transition costs the FERC would allow the pipelines to collect would be recovered from its customers, based upon past regulatory treatment of similar costs by the IUB. Accordingly, regulatory assets, in amounts corresponding to the liabilities, have been recorded to reflect the anticipated recovery. (13) JOINTLY-OWNED ELECTRIC UTILITY PLANT: Under joint ownership agreements with other Iowa utilities, the Company has undivided ownership interests in jointly-owned electric generating stations and related transmission facilities. Each of the respective owners is responsible for the financing of its portion of the construction costs. Kilowatt-hour generation and operating expenses are divided on the same basis as ownership with each owner reflecting its respective costs in its Statements of Income. Information relative to the Company's ownership interest in these facilities at December 31, 1993 is as follows: Ottumwa Neal DAEC Unit 1 Unit 3 ($ in millions) Utility plant in service $ 484 $ 179 $ 43 Accumulated depreciation $ 221 $ 69 $ 22 Construction work in progress $ 7 $ - $ - Plant capacity - Mw 530 708 515 Percent ownership 70% 48% 28% In-service date 1974 1981 1975 (14) SEGMENTS OF BUSINESS: The principal business segments of the Company are the generation, transmission, distribution and sale of electric energy and the purchase, distribution and sale of natural gas. Certain financial information relating to the Company's significant segments of business is presented below: Year Ended December 31 1993 1992 1991 (in thousands) Operating results: Revenues - Electric $ 550,521 $ 462,999 $ 482,578 Gas 154,318 139,455 131,019 Operating income (pre-tax) - Electric 128,994 90,891 100,402 Gas 13,750 8,367 (360)* Other information: Depreciation and amortization - Electric 63,832 59,707 57,612 Gas 5,186 4,024 3,480 Construction and acquisition expenditures - Electric 84,720 154,902 77,646 Gas 12,582 17,308 21,100 Assets - Identifiable assets - Electric 1,288,505 1,226,614 1,115,310 Gas 164,773 141,801 108,851 1,453,278 1,368,415 1,224,161 Other corporate assets 93,700 72,476 79,949 Total assets $1,546,978 $1,440,891 $1,304,110 * Includes a $3.9 million pre-tax write-off of previously deferred FMGP clean-up costs pursuant to disallowance of recovery in an IUB order. Item 9. Item 9. Changes 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 Information regarding the identification of directors is included in Exhibit 99 and is incorporated herein by reference. Exhibit 99 is primarily an excerpt from IES Industries Inc. definitive proxy statement prepared for the 1994 annual meeting of stockholders, which will be filed on or about April 4, 1994. The executive officers of the registrant are as follows: Executive Officers of the Registrant (Effective February 1, 1994) Lee Liu, 60, Chairman of the Board, President & Chief Executive Officer. First elected officer in 1975. Larry D. Root, 57, President and Group Executive, Energy Delivery and Nuclear Group and Director. First elected officer in 1979. Rene H. Males, 61, President and Group Executive, Generation and Engineering Group and Director. First elected officer in 1991. (i) Blake O. Fisher, Jr., 49, Executive Vice President & Chief Financial Officer and Director. First elected officer in 1991. (ii) Dr. Robert J. Latham, 51, Senior Vice President, Finance and Corporate Affairs, & Treasurer. First elected officer in 1985. Stephen W. Southwick, 47, Vice President & General Counsel. First elected officer in 1982. John F. Franz, Jr., 54, Vice President, Nuclear. First elected officer in 1992. (iii) Phillip D. Ward, 53, Vice President, Engineering. First elected officer in 1990. Harold W. Rehrauer, 56, Vice President, Field Operations. First elected officer in 1987. Thomas R. Seldon, 55, Vice President, Human Resources. First elected officer in 1987. Robert J. Kucharski, 61, Vice President, Administration & Secretary. First elected officer in 1976. Richard A. Gabbianelli, 37, Controller & Chief Accounting Officer. First elected officer in 1994. Officers are elected annually by the Board of Directors and each of the officers named above, except Rene H. Males, Blake O. Fisher, Jr. and John F. Franz, Jr., have been employed by the Company (or IS) as an officer or in other responsible positions at such companies for at least five years. There are no family relationships among these officers. There are no arrangements or understandings with respect to election of any person as an officer. (i) Prior to the appointment of Rene H. Males as an officer of IS in 1990, he was President of Joy Environment Equipment Company of Monrovia, California. He was Senior Vice President for Wisconsin Electric Power Company from 1987 to 1989. (ii) Prior to the appointment of Blake O. Fisher, Jr. as Executive Vice President & Chief Financial Officer of the Company in January 1991, he was employed by Consumers Power Company as Vice President Finance and Treasurer. (iii) Prior to the appointment of John F. Franz, Jr. as Vice President, Nuclear in 1992, he was employed by Philadelphia Electric Company as Plant Manager, Peach Bottom Atomic Power Station. Item 11. Item 11. Executive Compensation Information regarding executive compensation is included in Exhibit 99 and is incorporated herein by reference. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management Information regarding security ownership of certain beneficial owners and management is included in Exhibit 99 and is incorporated herein by reference. Item 13. Item 13. Certain Relationships and Related Transactions Information regarding certain relationships and related transactions is included in Exhibit 99 and is incorporated herein by reference. PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K Page No. (a) 1. Financial Statements - Included in Part II of this report - Management's Responsibility for Financial Statements. 45 - 46 Report of Independent Public Accountants. 47 Statements of Income for the years ended December 31, 1993, 1992 and 1991. 48 Statements of Retained Earnings for the years ended December 31, 1993, 1992 and 1991. 49 Balance Sheets at December 31, 1993 and 1992. 50 - 51 Statements of Capitalization at December 31, 1993 and 1992. 52 Statements of Cash Flows for the years ended December 31, 1993, 1992 and 1991. 53 Notes to Financial Statements. 54 - 81 (a) 2. Financial Statement Schedules - Included in Part IV of this report - 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. 87 Schedule V - Utility Plant for the years ended December 31, 1993, 1992 and 1991. 88 - 90 Schedule VI - Accumulated Depreciation for the years ended December 31, 1993, 1992 and 1991. 91 Schedule VII - Guarantees of Securities of Other Issuers as of December 31, 1993. 92 Schedule VIII - Valuation and Qualifying Accounts and Reserves for the years ended December 31, 1993, 1992 and 1991. 93 Schedule IX - Short-term Borrowings for the years ended December 31, 1993, 1992 and 1991. 94 Other schedules are omitted as not required under Rules of Regulation S-X. (a) 3. Exhibits - See Exhibit Index beginning on page 97. (b) Reports on Form 8-K and Form 8-K/A - Items Financial Reported Statements Date of Report File No. 5,7 None December 9, 1993 0-4117-1 (1) 5,7 None December 9, 1993 0-849 (2) 2,5,7 None January 7, 1994 0-4117-1 (3) 2,7 None January 7, 1994 0-849 (3) 7 (4) March 2, 1994 0-4117-1 (4) Notes: (1) Form 8-K filed by Iowa Electric Light and Power Company. (2) Form 8-K filed by Iowa Southern Utilities Company. (3) Form 8-K filed by IES Utilities Inc. subsequent to the merger of Iowa Electric Light and Power Company and Iowa Southern Utilities Company effective December 31, 1993. (4) Form 8-K/A filed by IES Utilities Inc. amending Form 8-K filed on January 7, 1994, File No. 0-4117-1, providing the audited financial statements of the Company for the year ended December 31, 1993. IES UTILITIES INC. SCHEDULE II - AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS AND EMPLOYEES OTHER THAN RELATED PARTIES BALANCE AT DECEMBER 31 (in thousands) Affiliated Company 1991 1992 1993 Cedar Rapids and Iowa City Railway Company $ 54 $ 46 $ 19 IES Industries Inc. 842 613 985 IES Diversified Inc. - - 48 Industrial Energy Applications, Inc. 41 130 21 Total $ 937 $ 789 $1,073 NOTE: All receivables are collected from the affiliated companies within one month, thus all amounts are current and are recorded in the Balance Sheets as Current Assets - Accounts Receivable - Other. IES UTILITIES INC. SCHEDULE VIII--VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 Column A Column B Column E Balance Balance Description January 1 December 31 (in thousands) 1993: Accumulated provision for uncollectible accounts $ 567 $ 268 Accumulated provision for rate refunds $ 9,020 $ 8,670 1992: Accumulated provision for uncollectible accounts $ 804 $ 567 Accumulated provision for rate refunds $ 1,492 $ 9,020 1991: Accumulated provision for uncollectible accounts $ 727 $ 804 Accumulated provision for rate refunds $ 2,022 $ 1,492 IES UTILITIES INC. SCHEDULE IX--SHORT-TERM BORROWINGS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 Column A Column B Column C Column D Column E Column F Average Weighted Category of Weighted Maximum Daily Daily Aggregate Average Amount Amount Average Short-term Balance Interest Outstanding Outstanding Interst Rate Borrowings December 31 Rate During During During the Period the Period the Period 1993: Commercial paper $19,000,000 3.50% $92,000,000 $39,182,000 3.33% Uncommitted Credit Facility $ 5,000,000 3.40% $ 5,000,000 $ 1,027,000 3.30% 1992: Commercial paper $92,000,000 3.71% $92,000,000 $ 9,160,000 4.14% 1991: Commercial paper $40,900,000 5.02% $51,000,000 $30,298,000 6.43% 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 29th day of March 1994. IES UTILITIES INC. By /s/ Blake O. Fisher, Jr. Blake O. Fisher, Jr. Executive Vice President & Chief Financial Officer and Director Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons in the capacities indicated on March 29, 1994: /s/ Lee Liu Chairman of the Board, President & Lee Liu Chief Executive Officer (Principal Executive Officer) /s/ Blake O. Fisher, Jr. Executive Vice President & Chief Blake O. Fisher, Jr. Financial Officer and Director (Principal Financial Officer) /s/ Richard A. Gabbianelli Controller & Chief Accounting Officer Richard A. Gabbianelli (Principal Accounting Officer) /s/ C.R.S. Anderson Director C.R.S. Anderson /s/ J. Wayne Bevis Director J. Wayne Bevis /s/ Robert F. Brewer Director Robert F. Brewer /s/ Dr. George Daly Director Dr. George Daly /s/ G. Sharp Lannom, IV Director G. Sharp Lannom, IV /s/ Salomon Levy Director Dr. Salomon Levy /s/ Rene H. Males Director Rene H. Males /s/ Robert D. Ray Director Robert D. Ray /s/ David Q. Reed Director David Q. Reed /s/ Larry D. Root Director Larry D. Root /s/ Henry Royer Director Henry Royer /s/ Robert W. Schlutz Director Robert W. Schlutz /s/ Anthony R. Weiler Director Anthony R. Weiler EXHIBIT INDEX The Exhibits designated by an asterisk are filed herewith and all other Exhibits as stated to be filed are incorporated herein by reference. Exhibit 2(a) Agreement and Plan of Merger between IE and IS dated as of June 4, 1993 (Agreement and Plan of Merger) (Filed as Exhibit 2 to the Company's Current Report on Form 8-K, dated June 4, 1993 (File No. 0-4117-1). 2(b) Amendment 1 dated June 16, 1993, to the Agreement and Plan of Merger (Filed as Exhibit 2(b) to the IE Registration Statement on Form S-3, dated September 14, 1993 (File No. 33-68796)). 2(c) Amendment 2 dated September 8, 1993, to the Agreement and Plan of Merger (Filed as Exhibit 2(c) to the IE Registration Statement on Form S-3, dated September 14, 1993 (File No. 33-68796)). 2(d) Amendment 3 dated September 27, 1993, to the Agreement and Plan of Merger (Filed as Exhibit 2(d) to the IE Current Report on Form 8-K, dated December 9, 1993 (File No. 0-4117-1)). 3(a) Articles of Incorporation of the Registrant, Amended and Restated as of January 6, 1994. (Filed as Exhibit 4(b) to the Company's Current Report on Form 8-K, dated January 7, 1994 (File No. 0-4117-1)). * 3(b) Bylaws of Registrant, Amended as of February 1, 1994. 4(a) Indenture of Mortgage and Deed of Trust, dated as of September 1, 1993, between the Company (formerly IE) and the First National Bank of Chicago, as Trustee (Mortgage) (Filed as Exhibit 4(c) to IE's Form 10-Q for the quarter ended September 30, 1993). 4(b) Supplemental Indentures to the Mortgage: IE File Number Dated as of Reference Exhibit First October 1, 1993 Form 10-Q, 11/12/93 4(d) Second November 1, 1993 Form 10-Q, 11/12/93 4(e) 4(c) Indenture of Mortgage and Deed of Trust, dated as of August 1, 1940, between the Company (formerly IE) and the First National Bank of Chicago, Trustee (1940 Indenture) (Filed as Exhibit 2(a) to IE's Registration Statement File No. 2-25347). 4(d) Supplemental Indentures to the 1940 Indenture: Number Dated as of IE File Reference Exhibit First March 1, 1941 2-25347 2(a) Second July 15, 1942 2-25347 2(a) Third August 2, 1943 2-25347 2(a) Fourth August 10, 1944 2-25347 2(a) Fifth November 10, 1944 2-25347 2(a) Sixth August 8, 1945 2-25347 2(a) Seventh July 1, 1946 2-25347 2(a) Eighth July 1, 1947 2-25347 2(a) Ninth December 15, 1948 2-25347 2(a) Tenth November 1, 1949 2-25347 2(a) Eleventh November 10, 1950 2-25347 2(a) Twelfth October 1, 1951 2-25347 2(a) Thirteenth March 1, 1952 2-25347 2(a) Fourteenth November 5, 1952 2-25347 2(a) Fifteenth February 1, 1953 2-25347 2(a) Sixteenth May 1, 1953 2-25347 2(a) Seventeenth November 3, 1953 2-25347 2(a) Eighteenth November 8, 1954 2-25347 2(a) Nineteenth January 1, 1955 2-25347 2(a) Twentieth November 1, 1955 2-25347 2(a) Twenty-first November 9, 1956 2-25347 2(a) Twenty-second November 6, 1957 2-25347 2(a) Twenty-third November 4, 1958 2-25347 2(a) Twenty-fourth November 3, 1959 2-25347 2(a) Twenty-fifth November 1, 1960 2-25347 2(a) Twenty-sixth January 1, 1961 2-25347 2(a) Twenty-seventh November 7, 1961 2-25347 2(a) Twenty-eighth November 6, 1962 2-25347 2(a) Twenty-ninth November 5, 1963 2-25347 2(a) Thirtieth November 4, 1964 2-25347 2(a) Thirty-first November 2, 1965 2-25347 2(a) Thirty-second September 1, 1966 Form 10-K, 1966 4.10 Thirty-third November 30, 1966 Form 10-K, 1966 4.10 Thirty-fourth November 7, 1967 Form 10-K, 1967 4.10 Thirty-fifth November 5, 1968 Form 10-K, 1968 4.10 Thirty-sixth November 1, 1969 Form 10-K, 1969 4.10 Thirty-seventh December 1, 1970 Form 8-K, 12/70 1 Thirty-eighth November 2, 1971 2-43131 2(g) Thirty-ninth May 1, 1972 Form 8-K, 5/72 1 Fortieth November 7, 1972 2-56078 2(i) Forty-first November 7, 1973 2-56078 2(j) Forty-second September 10, 1974 2-56078 2(k) Forty-third November 5, 1975 2-56078 2(l) Forty-fourth July 1, 1976 Form 8-K, 7/76 1 Forty-fifth November 1, 1976 Form 8-K, 12/76 1 Forty-sixth December 1, 1977 2-60040 2(o) Forty-seventh November 1, 1978 Form 10-Q, 6/30/79 1 Forty-eighth December 1, 1979 Form S-16, 2-65996 2(q) Forty-ninth November 1, 1981 Form 10-Q,3/31/82 2 Fiftieth December 1, 1980 Form 10-K, 1981 4(s) Fifty-first December 1, 1982 Form 10-K, 1982 4(t) Fifty-second December 1, 1983 Form 10-K, 1983 4(u) Fifty-third December 1, 1984 Form 10-K, 1984 4(v) Fifty-fourth March 1, 1985 Form 10-K, 1984 4(w) Fifty-fifth March 1, 1988 Form 10-Q, 5/12/88 4(b) Fifty-sixth October 1, 1988 Form 10-Q, 11/10/88 4(c) Fifty-seventh May 1, 1991 Form 10-Q, 8/31/91 4(d) Fifty-eighth March 1, 1992 Form 10-K, 1991 4(c) Fifty-ninth October 1, 1993 Form 10-Q, 11/12/93 4(a) Sixtieth November 1, 1993 Form 10-Q, 11/12/93 4(b) 4(e) Indenture or Deed of Trust dated as of February 1, 1923, between the Company (successor to IS as result of merger of IS and IE) and The Northern Trust Company (The First National Bank of Chicago, successor) and Harold H. Rockwell (Richard D. Manella, successor), as Trustees (1923 Indenture) (Filed as Exhibit B-1 to File No. 2- 1719). 4(f) Supplemental Indentures to the 1923 Indenture: IS File Dated as of Reference Exhibit May 1, 1940 2-4921 B-1-k May 2, 1940 2-4921 B-1-l October 1, 1945 2-8053 7(m) October 2, 1945 2-8053 7(n) January 1, 1948 2-8053 7(o) September 1, 1950 33-3995 4(e) February 1, 1953 2-10543 4(b) October 2, 1953 2-10543 4(q) August 1, 1957 2-13496 2(b) September 1, 1962 2-20667 2(b) June 1, 1967 2-26478 2(b) February 1, 1973 2-46530 2(b) February 1, 1975 2-53860 2(aa) July 1, 1975 2-54285 2(bb) September 2, 1975 2-57510 2(bb) March 10, 1976 2-57510 2(cc) February 1, 1977 2-60276 2(ee) January 1, 1978 0-849 2 March 1, 1979 0-849 2 March 1, 1980 0-849 2 May 31, 1986 33-3995 4(g) July 1, 1991 0-849 4(h) September 1, 1992 0-849 4(m) 10(a) Agreement dated December 15, 1971 between Central Iowa Power Cooperative and IE. (Filed as Exhibit 5(a) to IE's Registration Statement File No. 2-43131). 10(b) Duane Arnold Energy Center Ownership Participation Agreement dated June 1, 1970 between Central Iowa Power Cooperative, Corn Belt Power Cooperative and IE. (Filed as Exhibit 5(kk) to IE's Registration Statement, File No. 2-38674). 10(c) Duane Arnold Energy Center Operating Agreement dated June 1, 1970 between Central Iowa Power Cooperative, Corn Belt Power Cooperative and IE. (Filed as Exhibit 5(ll) to IE's Registration Statement, File No. 2-38674). 10(d) Duane Arnold Energy Center Agreement for Transmission, Transformation, Switching, and Related Facilities dated June 1, 1970 between Central Iowa Power Cooperative, Corn Belt Power Cooperative and IE. (Filed as Exhibit 5(mm) to IE's Registration Statement, File No. 2-38674). 10(e) Basic Generating Agreement dated April 16, 1975 between Iowa Public Service Company, Iowa Power and Light Company, Iowa- Illinois Gas and Electric Company and IS for the joint ownership of Ottumwa Generating Station-Unit 1 (OGS-1). (Filed as Exhibit 1 to IE's Form 10-K for the year 1977). 10(f) Addendum Agreement to the Basic Generating Agreement for OGS-1 dated December 7, 1977 between Iowa Public Service Company, Iowa-Illinois Gas and Electric Company, Iowa Power and Light Company, IS and IE for the purchase of 15% ownership in OGS-1. (Filed as Exhibit 3 to IE's Form 10-K for the year 1977). 10(g) Fuel Lease dated August 21, 1973, as amended by Amendment No. 1 dated August 29, 1973, and by Amendment dated September 17, 1987, between Arnold Fuel, Inc. and IE for the procurement and financing of nuclear fuel. (Filed as Exhibit 10(l) to IE's Form 10-K for the year 1984). 10(h) Amendment dated as of September 17, 1987 to the Fuel Lease dated as of August 21, 1973 between Arnold Fuel, Inc. and IE. (Filed as Exhibit 10(i) to IE's Form 10-K for the year 1987). 10(i) Second Amended and Restated Credit Agreement dated as of September 17, 1987 between Arnold Fuel, Inc. and the First National Bank of Chicago and the Amended and Restated Consent and Agreement dated as of September 17, 1987 by IE. (Filed as Exhibit 10(j) to IE's Form 10-K for the year 1987). MANAGEMENT CONTRACTS AND/OR COMPENSATORY PLANS (EXHIBITS 10(j) THROUGH 10(u)) 10(j) Service Contract between S. Levy, Incorporated and IE. (Filed as Exhibit 10(m) to IE's Form 10-K for the year 1985). 10(k) Supplemental Retirement Plan. (Filed as Exhibit 10(l) to Industries' Form 10-K for the year 1987). 10(l) Management Incentive Compensation Plan. (Filed as Exhibit 10(m) to Industries' Form 10-K for the year 1987). 10(m) Key Employee Deferred Compensation Plan. (Filed as Exhibit 10(n) to Industries' Form 10-K for the year 1987). 10(n) Long-Term Incentive Plan. (Filed as Exhibit 10(o) to Industries' Form 10-K for the year 1987). 10(o) Executive Guaranty Plan. (Filed as Exhibit 10(p) to Industries' Form 10-K for the year 1987). 10(p) Executive Change of Control Severance Agreement. (Filed as Exhibit 10(s) to Industries' Form 10-K for the year 1989). 10(q) Amendments to Key Employee Deferred Compensation Agreement for Directors. (Filed as Exhibit 10(u) to Industries' Form 10-Q for the quarter ended March 31, 1990). 10(r) Amendments to Key Employee Deferred Compensation Agreement for Key Employees. (Filed as Exhibit 10(v) to Industries' Form 10-Q for the quarter ended March 31, 1990). 10(s) Amendments to Management Incentive Compensation Plan. (Filed as Exhibit 10(y) to Industries' Form 10-Q for the quarter ended March 31, 1990). 10(t) Director Retirement Plan. (Filed as Exhibit 10(t) to Industries' Form 10-K for the year 1993). 10(u) Copy of Supplemental Retirement Income Plan and Form of Supplemental Retirement Income Agreement. (Filed as Exhibit 10-A-6 to File No. 33-3995). 10(v) Agreement for Purchase and Sale of Certain Assets and Real Estate and Assignment of Easements, Leases and Licenses between Union Electric Company (Seller) and IE (Buyer). Filed as exhibit 10(t) to IE's Form 10-K for the year 1991. 10(w) Copy of Coal Supply Agreement, dated July 27, 1977, between IS and Sunoco Energy Development Co., and letter memorandum thereto, dated October 29, 1984, relating to the purchase of coal supplies for the fuel requirements at the Ottumwa Generating Station. (Filed as Exhibit 10-A-4 to File No. 33-3995). 10(x) Receivables Purchase and Sale Agreement. (Filed as Exhibit 10(a) to IE's Form 10-Q for the quarter ended June 30, 1989). 10(y) Terra Comfort Capacity and Energy Agreement dated August 14, 1989 between IE and Terra Comfort Corporation. (Filed as Exhibit 10(n) to IE's Form 10-K for the year 1989). 10(z) Capacity and Energy Agreement dated December 20, 1990 between Terra Comfort Corporation and IE. 10(aa) Operating and Transmission Agreement between Central Iowa Power Cooperative and IE. 10(ab) Capacity and Energy Agreement dated April 3, 1991 between Terra Comfort Corporation and IE. (Filed as Exhibit 10(r) to IE's Form 10-Q for the quarter ended March 31, 1991). *12 Ratio of Earnings to Fixed Charges. *23 Consent of Independent Public Accountants. *99 Director and Officer Information. Note: Pursuant to (b)(4)(iii)(A) of Item 601 of Regulation S-K, the Company has not filed as an exhibit to this Form 10-K certain instruments with respect to long-term debt that has not been registered if the total amount of securities authorized thereunder does not exceed 10% of total assets of the Company but hereby agrees to furnish to the Commission on request any such instruments.

65100_1993.txt

65100_1993

1993

65100

ITEM 1. BUSINESS - ---------------- OVERVIEW Merrill Lynch & Co., Inc., a Delaware corporation ("ML & Co."),/*/ is a holding company that, through its subsidiaries and affiliates, provides investment, financing, insurance and related services. Such services include securities underwriting, trading and brokering, investment banking and other corporate finance advisory activities, investment advisory services, trading of foreign exchange, commodities and derivatives, banking and lending, and insurance sales and underwriting services. ML & Co.'s principal subsidiary, Merrill Lynch, Pierce, Fenner & Smith Incorporated ("MLPF&S"), which traces its origin to a brokerage business founded in 1820, is one of the largest securities firms in the world. MLPF&S is a broker in securities, options contracts, and commodity and financial futures contracts, an underwriter of selected insurance products, a dealer in options and in corporate and municipal securities, and an investment banking firm. Merrill Lynch International Incorporated ("MLI"), through its branches, subsidiaries and affiliates, provides investment, financing, and related services on a global basis outside the United States and Canada. The principal subsidiaries and affiliates providing such services are Merrill Lynch International Limited ("MLIL"), Merrill Lynch Japan Incorporated ("MLJ") and Merrill Lynch Capital Markets A.G. ("ML Capital Markets"). In addition, Merrill Lynch International Bank Limited ("MLIB, Ltd."), Merrill Lynch Bank A.G. ("ML BAG") and other subsidiaries and affiliates of MLI engage in international banking and foreign exchange activities. Merrill Lynch Canada Inc. ("MLC"), a subsidiary of MLPF&S, provides institutional securities and futures contracts sales, trading and financing, corporate finance, and mergers and acquisitions services in Canada. Merrill Lynch Government Securities Inc. ("MLGSI") is a primary dealer in obligations issued by the U.S. Government or guaranteed or issued by Federal agencies or instrumentalities. Merrill Lynch Asset Management, L.P. and its affiliates ("MLAM") manage mutual funds and provide investment advisory services. Merrill Lynch Capital Services, Inc. ("MLCS") and Merrill Lynch Derivative Products, Inc. ("MLDP") are ML & Co.'s primary derivative product dealers and act as intermediaries and principals in a variety of interest- rate, currency and other derivative contracts. ML & Co.'s insurance operations consist of the underwriting of life insurance and annuity products by Merrill Lynch Life Insurance Company ("MLLIC") and ML Life Insurance Company of New York ("ML Life"), and the sale of life insurance and annuities through Merrill Lynch Life Agency Inc. and other life insurance agencies associated with MLPF&S. ML & Co. and certain subsidiaries engage in lending activities, including bridge financing, and extend credit in the form of senior term and subordinated debt to leveraged companies. The Corporation also provides investment, financing and related services through Merrill Lynch Business Financial Services Inc. ("MLBFS"), Merrill Lynch Money Markets Inc. ("MLMMI"), Merrill Lynch Mortgage Capital Inc. - ---------- /*/ For the purpose of convenient presentation, the term "Corporation," as it appears in the Consolidated Financial Statements and related Notes, Management's Discussion and Analysis of Financial Condition and Results of Operations, and in this description of ML & Co.'s business, refers to Merrill Lynch & Co., Inc. and its consolidated subsidiaries. In addition, where the context requires, the term "ML & Co." includes such consolidated subsidiaries. ("MLMCI"), ML Futures Investment Partners Inc. ("MLFIP"), Merrill Lynch Credit Corporation ("MLCC"), Merrill Lynch Capital Partners, Inc. ("MLCP"), Merrill Lynch Interfunding Inc. ("MLIF"), Merrill Lynch, Hubbard Inc. ("MLH") and other subsidiaries of ML & Co. ML & Co. undertakes specialist activities through Merrill Lynch Specialists Inc. ("MLSI"). Financial information concerning ML & Co. for each of the three fiscal years ended on the last Friday in December of 1993, 1992 and 1991 set forth on page 30 of the 1993 Annual Report to Stockholders (the "Annual Report") is incorporated herein by reference. Financial information with respect to ML & Co. by revenue category, including the amount of total revenue contributed by classes of similar products or services that accounted for 10% or more of ML & Co.'s consolidated revenues in any one of ML & Co.'s last three fiscal years, set forth on page 68 of the Annual Report is incorporated herein by reference. In addition, financial information with respect to ML & Co.'s operations by geographic area set forth in the Notes to Consolidated Financial Statements under the caption "Industry and Global Operations" on pages 66-67 of the Annual Report is incorporated herein by reference. On December 31, 1993, ML & Co. had approximately 41,900 full-time employees, compared to approximately 40,100 full-time employees on December 25, 1992. Of these full-time employees, as of year-end 1993 (1992 year-end numbers being indicated parenthetically), there were approximately 750 (675) employees in Canada and Latin America, 2,450 (2,160) employees in Europe and the Middle East, 1,200 (1,200) employees in the Asia/Pacific region and Australia, and 37,530 (36,045) employees in the United States. The financial services industry is highly competitive and highly regulated. The industry is also directly affected by general economic conditions, trends in business and finance and investor sentiment, as well as by interest rate changes, both domestically and internationally. Financial services revenues are particularly sensitive to the volume of securities transactions and securities price levels. Also, ML & Co.'s business activities are subject to varying degrees of risk and profitability depending upon the nature of the activity and the extent to which ML & Co. has placed its capital at risk. Capital is typically placed at risk in dealer transactions, investment banking and related transactions (including leveraged buyouts). The discussion on highly leveraged transactions set forth on pages 39-40 of the Annual Report under the caption "Non-Investment Grade Holdings and Highly Leveraged Transactions" and the information in the Notes to Consolidated Financial Statements under the caption "Concentrations of Credit Risk" on pages 65-66 of the Annual Report is incorporated herein by reference. In addition, the business of ML & Co. is subject to foreign exchange rate fluctuations, restrictive regulations by foreign governments and other factors inherent in international operations. While the discussion set forth below is organized by ML & Co. entity, the business activities involving these entitles are highly integrated, frequently requiring multiple affiliates to participate in a single transaction. MERRILL LYNCH, PIERCE, FENNER & SMITH INCORPORATED As of December 31, 1993, there were at MLPF&S approximately 6.9 million retail and institutional customer accounts worldwide (as compared to 7.0 million in 1992). In the United States, these accounts were served by approximately 12,100 financial consultants, including trainees (as compared to approximately 11,700 at year-end 1992), in approximately 470 retail branch and institutional offices in 49 states, the District of Columbia, Guam, the Virgin Islands, Puerto Rico, Canada (through its affiliate, MLC) and Taiwan. The discussion of international financial consultants and offices is set forth below under the caption "Merrill Lynch International Incorporated". BROKERAGE TRANSACTIONS A large portion of MLPF&S's revenues is generated by commissions earned as a broker (i.e., agent) for investors in the purchase and sale of corporate securities (primarily bonds and common and preferred stocks traded on securities exchanges or in the over-the-counter market). MLPF&S also acts as a broker for investors in the purchase and sale of mutual funds, money market instruments, government securities, corporate and high yield bonds, municipal securities, futures and options. MLPF&S provides such services to institutional investors and to individual investors. MLPF&S has established commission rates for all brokerage services it performs. However, for accounts that are actively traded, including institutional accounts, MLPF&S's policy is to negotiate commissions based on economies of size and the complexity of the transaction and, for institutional customers, the competitive climate and trading opportunities. Also, under the Blueprint/SM/ program, due to order processing efficiencies, individual customers can receive commission discounts on small transactions in equity securities, mutual funds and precious metals. MLPF&S also acts as a broker for investors in the purchase and sale of options contracts to purchase or sell common stocks, non-U.S. Government securities and currencies, as well as in the purchase and sale of options contracts on various indices. These options contracts are currently traded on the Chicago Board Options Exchange, the American Stock Exchange, the New York Stock Exchange, the Philadelphia Stock Exchange, the Pacific Stock Exchange and in the over-the-counter market. MLPF&S is a futures commission merchant that introduces to its affiliate, Merrill Lynch Futures Inc. ("MLF"), customer business for the purchase and sale of futures contracts and options on such futures contracts in substantially all exchange-traded commodity and financial futures products. All futures and futures options transactions are cleared through and carried by MLF, which holds memberships on all major commodity and financial futures exchanges in the United States. MLF also carries positions reflecting trades executed on exchanges outside of the United States. Memberships on certain of these exchanges are held by other affiliated companies, including Merrill Lynch, Pierce, Fenner & Smith (Brokers and Dealers) Limited and Merrill Lynch Futures (S) Pte. Ltd. As with any margin transaction, the risk of loss to MLF and its customers from the trading of futures contracts is greater than the risk in cash securities transactions, primarily as a result of the low initial margin requirements (good faith deposits) relative to the nominal value of the actual futures contracts. MLF may have financial exposure if a customer fails to meet a margin call. However, net worth requirements, financial reviews, margin procedures and other credit standards established for MLF customer futures accounts are intended to limit this exposure. Futures contracts and options thereon are traded in the various futures markets, including the Chicago Board of Trade and the Chicago Mercantile Exchange and exchanges outside of the United States, such as the London International Financial Futures Exchange and the Singapore International Monetary Exchange. MLPF&S and certain of its affiliates, including MLGSI and MLCS, may also take proprietary market positions in the futures and futures options markets in certain instances. As a result of its membership in the clearing associations of various futures exchanges, MLF or any other futures clearing affiliates of the Corporation have potentially significant financial exposure in the event that other members of futures clearing houses default materially in their obligations to such clearing houses. DEALER TRANSACTIONS MLPF&S regularly makes a market in approximately 1,015 domestic common stocks and approximately 350 foreign securities traded in the over-the-counter market. Its market-making activities are conducted with customers and with other dealers. In addition, as a block positioner, MLPF&S regularly acts as a market maker in certain listed securities. MLPF&S is a dealer in municipal, mortgage-backed, asset-backed and corporate fixed-income securities, which are traded primarily in the over-the-counter market. As an adjunct to its trading activities, MLPF&S places its capital at risk by engaging in block positioning to facilitate transactions for customers in large blocks of listed and over-the-counter securities and by engaging, from time to time, in arbitrage transactions for its own account. In block positioning, MLPF&S purchases securities, including options, or sells such securities short for its own account without full commitments for their resale or covering purchase, thereby employing its capital to effect large transactions. Positions typically are liquidated as soon as practicable and are not taken without an analysis of a given security's marketability. In addition, MLPF&S facilitates various trading strategies involving the purchase and sale of financial futures contracts and options, in connection with which it may establish positions for its own account and risk. MLPF&S engages as principal in certain commodity-related transactions, such as purchase and repurchase transactions and precious metals consignments. Other subsidiaries of ML & Co. also engage in interest rate and foreign currency swaps, and other derivative products transactions with third parties on a principal or an intermediary basis, and act as foreign exchange dealers. For further information on dealer transactions, see discussions set forth below under the captions "Merrill Lynch Government Securities Inc.," "Merrill Lynch Capital Services, Inc.," "Merrill Lynch Derivative Products, Inc." and "Banking and Trust Activities." MARGIN LENDING Securities transactions with customers are executed on either a cash or a margin basis. In a margin transaction, MLPF&S extends credit to the customer for a portion of the dollar value of the securities in the customer's account up to the limit imposed by internal MLPF&S policies and applicable margin regulations. The margin loan is collateralized by securities in the customer's margin account. Interest on margin debit balances is an important source of revenue to MLPF&S; the rates charged are higher than the rates paid on the funds that finance those loans. To finance margin loans, MLPF&S uses both funds on which it pays interest, which include borrowings from ML & Co., and funds on which it does not pay interest, which include its own capital and, to the extent permitted by regulations, customers' free credit balances. Also, funds derived from securities loaned may be used for making margin loans. INVESTMENT BANKING MLPF&S is a major investment banking firm that participates in every aspect of investment banking and acts in principal, agency and advisory capacities. It underwrites the sale of securities to the public and arranges for the private placement of securities with investors. MLPF&S also provides a broad range of financial and corporate advisory services, including advice on mergers and acquisitions, project financing, mortgage and lease financing, capital structure and specific financing opportunities. MLPF&S and its affiliates provide advice, valuations, and financing assistance, including the underwriting and private placement of high-yield securities, in connection with leveraged buyouts and other related transactions. MLPF&S and its affiliates have, from time to time, taken principal positions in such transactions, which vary in amount and form. In addition, the Corporation may provide substantial funds to clients on a temporary basis until permanent financing is obtained. Before MLPF&S and its affiliates take such positions, analysis is performed to establish the underlying creditworthiness of the client and to determine the likelihood of refinancing the transaction within a reasonable period. Additionally, MLPF&S and its affiliates occasionally retain equity interests in the subject companies in connection with their non-investment grade underwriting and merchant banking activities. The information set forth on pages 39-40 of the Annual Report under the caption "Non-Investment Grade Holdings and Highly Leveraged Transactions" and in the Notes to Consolidated Financial Statements under the caption "Concentrations of Credit Risk" on pages 65-66 of the Annual Report are incorporated herein by reference. See also discussions set forth below under the captions "Merrill Lynch Capital Partners, Inc." and "Merrill Lynch Interfunding Inc." SECURITIES AND ECONOMIC RESEARCH To provide its institutional and retail sales forces and customers with current information on investments and securities markets, MLPF&S maintains a Global Securities Research and Economics Group. It provides equity, fixed income, and economic research services on a global basis. The Securities Research Division includes a U.S. fundamental equity research staff of 90 analysts (as compared with 70 analysts in 1992) who follow companies in 57 major industry categories. The Global Securities Research and Economics Group provides fundamental equity research on a worldwide basis, with 35 analysts (as compared with 34 analysts in 1992) in London, Hong Kong, Tokyo, Singapore and Seoul. Fixed- income research professionals and economists are also located in London, Tokyo, Singapore and Frankfurt. By means of a computer-based opinion retrieval system available in each MLPF&S office or, if outside of the United States, in each affiliate office, current information and investment opinions on the common stocks of approximately 1,485 corporations worldwide are readily available to all MLPF&S customers through their financial consultants. The Securities Research Division also provides technical market and quantitative analysis, investment and fixed income strategy and credit research on municipal securities, preferred stock and corporate bonds, as well as futures research. OTHER ACTIVITIES In 1993, MLPF&S sold over $36.6 billion of mutual funds, including income, balanced and growth funds, of which approximately $19.4 billion represented sales of mutual funds that are advised by MLAM and its affiliates. MLPF&S also sponsors series of funds under the name Defined Asset Funds/SM/ that are unit investment trusts registered under the Investment Company Act of 1940. These funds consist of municipal obligations, corporate fixed-income securities, U.S. Government obligations, equity securities, or foreign debt and equity securities. The Merrill Lynch Consults (Registered Trademark) service, introduced in 1988, offers individual and institutional clients with $100,000 or more to invest, a convenient way to select and retain a discretionary investment manager from a pre-selected roster of investment managers participating in the service. The professional portfolio managers within the Merrill Lynch Consults service have been screened for many factors, including risk adjusted performance (generally for a period of ten years), depth of management experience and consistent application of investment style. The roster of more than twenty-five investment managers manages portfolios in seven risk categories consisting of equity, balanced and fixed-income accounts. For an annual fee, MLPF&S, through the Merrill Lynch Consults service, assists clients in identifying their investment objectives, selecting an investment manager based on those stated objectives, and periodically providing performance reports on their managed account. Merrill Lynch financial consultants and the investment manager are available to clients for ongoing consultation and can respond to questions clients may have regarding their portfolios. At the end of 1993, over $16 billion was held in accounts of clients subscribing to the Merrill Lynch Consults service. MLPF&S provides the Cash Management Account (Registered Trademark) ("CMA (Registered Trademark) account") financial service, which is offered in all MLPF&S retail offices. Through Visa (Registered Trademark) cards issued by Merrill Lynch National Financial and Merrill Lynch Bank & Trust Co. and checking services provided by Bank One, Columbus, N.A., the CMA service allows participating customers to access the assets in their securities accounts, including the redemption value of shares, if any, owned by the participating customer in various CMA money market funds and any balances maintained in certain money market deposit accounts maintained by one or more banks or savings associations (which may include Merrill Lynch National Financial and Merrill Lynch Bank & Trust Co.) through the Insured Savings/SM/ Account and, if the account is a margin account, the loan value of margin securities in such account. It also provides a vehicle for the automatic investment of free credit balances in shares of the CMA money market funds, or the automatic deposit of funds through the Insured Savings Account. MLPF&S domestically had over 1,442,000 CMA accounts at the close of 1993, with aggregate assets of approximately $320 billion. MLPF&S also offers the Capital Builder/SM/ Account ("CBA (Registered Trademark) account") service, which was developed to meet the needs of the emerging investor, through all MLPF&S retail offices. At the close of 1993 MLPF&S had approximately 294,000 CBA accounts with assets of over $11.7 billion. Through its subsidiary Broadcort Capital Corp. ("BCC"), MLPF&S provides security clearing services to approximately 70 unaffiliated broker-dealers, primarily on a basis that is fully disclosed to their customers. Introducing firms may also execute transactions through BCC's fixed-income desk and participate in unit investment trust fund underwritings sponsored by MLPF&S. While the introducing firm retains all sales functions, the customers of the introducing firm have their accounts serviced by BCC, and BCC handles all settlement and credit aspects of transactions. Wagner Stott Clearing Corp. ("WSCC"), also a subsidiary of MLPF&S, engages in professional clearing and other businesses similar to that of BCC. It clears transactions for specialists and market makers on the New York Stock Exchange, the American Stock Exchange, the Chicago Board Options Exchange, the Philadelphia Stock Exchange and the Pacific Stock Exchange, clears commodities futures transactions for its clients through a divisional clearing arrangement with MLF and other futures commissions merchants, and clears transactions of arbitrageurs, customers and other professional trading entities. WSCC, which is a futures commissions merchant, also clears commodity futures transactions for its clients on the Philadelphia Board of Trade through the Intermarket Clearing Corporation. MLC, another subsidiary of MLPF&S, provides institutional securities and futures sales, trading and financing, corporate finance, and mergers and acquisitions services in Canada. MERRILL LYNCH INTERNATIONAL INCORPORATED MLI provides comprehensive investment, financing and related services to governments, corporations, other institutions and individuals on a global basis outside the U.S. and Canada through MLIL, MLJ, ML Capital Markets and other subsidiaries and affiliates. Information on international banking and foreign exchange activity is set forth below under the caption "Banking and Trust Activities." MLI's worldwide trading operations, through its subsidiaries and affiliates, particularly in London and Tokyo, make it one of the largest dealers and secondary market makers in Eurobonds and other internationally traded securities and futures. Subsidiaries and affiliates of MLI also engage in foreign exchange transactions (including options on foreign currencies) as a dealer, and, consequently, assume principal positions in numerous currencies and related options. Subsidiaries and affiliates of MLI are members of stock exchanges in Frankfurt, Hong Kong, London, Luxembourg, Montreal, Sydney, Tokyo, Toronto, Vancouver and Zurich among others. The investment, financing and market-making operations of MLI and its affiliates are conducted through a network of offices located in 29 countries outside the U.S. and Canada. This office system serves major "money center" institutions as well as thousands of smaller regional institutions and individual investors. As of December 31, 1993, these offices, and a small number of U.S. offices with international responsibilities, were staffed by approximately 1,010 retail and institutional financial consultants (which was the same number of financial consultants as in 1992) who were linked with the communications and trading network of MLPF&S. MERRILL LYNCH GOVERNMENT SECURITIES INC. MLGSI is a primary dealer in obligations issued or guaranteed by the U.S. Government or guaranteed or issued by Federal agencies or other government- sponsored entities including Government National Mortgage Association ("GNMA"), Federal National Mortgage Association ("FNMA") and Federal Home Loan Mortgage Corporation ("FHLMC"). It is one of 39 primary dealers in Government securities that reports its positions and activity daily to the Federal Reserve Bank of New York. It is also a dealer in GNMA, FNMA and FHLMC mortgage-backed-pass-through certificates. MLGSI's transactions in obligations of the U.S. Government, Federal agencies and government-sponsored entities involve large dollar amounts and small dealer spreads. It also deals in futures, options and forward contracts for its own account, to hedge its own risk and to facilitate customers' transactions. As an integral part of its business, MLGSI enters into repurchase agreements wherein it obtains funds by pledging its own securities as collateral. The repurchase agreements provide financing for MLGSI's dealer inventory, and serve as short-term investments for MLGSI's customers. MLGSI also enters into reverse repurchase agreements wherein it lends funds against the pledge of collateral by customers; such agreements provide MLGSI with needed collateral and provide MLGSI's customers with temporary liquidity for their investments in U.S. Government and agency securities. MLGSI enters into reverse repurchase agreements at an interest rate that generally is fractionally higher than that of repurchase agreements. MERRILL LYNCH ASSET MANAGEMENT, L.P. MLAM, the investment management arm of ML & Co., is one of the largest mutual fund managers in the world. Effective January 1, 1994, MLAM was restructured as a limited partnership. In 1993, sales of equity and bond funds managed by MLAM approximated $19.4 billion, as compared with $16.8 billion in 1992. MLAM's other major activity is separate account management. In this area, assets under management increased to $22.3 billion at the end of 1993 (which amount included approximately $6.0 billion of general account assets managed on behalf of insurance companies affiliated with MLAM) from approximately $20.2 billion in 1992 (which amount included approximately $7.7 billion of general account assets managed on behalf of insurance companies affiliated with MLAM). By the end of 1993, total assets under management approximated $160 billion, as compared with $138 billion at year-end 1992. MERRILL LYNCH CAPITAL SERVICES, INC. MLCS primarily acts as a counterparty in interest rate swaps and other interest rate and commodity related agreements, such as caps and floors, currency and commodity swaps, and other derivative products, including currency options, credit derivatives and certain equity-linked contracts. MLCS maintains positions in interest bearing securities, equity securities, financial futures and forward contracts, primarily to hedge assets and liabilities. In the normal course of business, MLCS enters into repurchase and resale agreements with certain affiliated companies. MERRILL LYNCH DERIVATIVE PRODUCTS, INC. MLDP intermediates certain derivative products (e.g., interest rate and currency swaps) between MLCS and highly-rated counterparties, addressing the increasing trend by swap customers to limit their trading to dealers with the highest credit quality. MLDP has been assigned an Aaa, AAA and an AAA counterparty rating by the rating agencies, Moody's, Standard & Poor's and Fitch, respectively. Customers meeting certain credit criteria enter into swaps with MLDP, and, in turn, MLDP enters into offsetting mirror swaps with MLCS. However, MLCS is required to provide MLDP with collateral to meet certain exposures MLDP may have to MLCS. MERRILL LYNCH MONEY MARKETS INC. MLMMI provides a full range of origination, trading and marketing services with respect to money market instruments such as commercial paper, bankers' acceptances and certificates of deposit. MLMMI also originates medium-term notes issued by domestic and non-U.S. corporations and financial institutions, and, through its affiliate, MLPF&S, trades and markets such notes. It is a commercial paper dealer for domestic and non-U.S. corporations and financial institutions. MLMMI also acts as a dealer in connection with the purchase of certificates of deposit from Federally- insured depository institutions; such instruments are resold to certain institutional customers such as thrift institutions, banks, insurance companies, pension plans and state and local governments. MLMMI, in cooperation with MLPF&S, originates the placement of additional certificates of deposit issued by such depository institutions that are sold to a broad range of retail customers of MLPF&S. MLMMI is a dealer for domestic and non- U.S. financial institutions in the certificate of deposit and bankers' acceptance markets. MERRILL LYNCH MORTGAGE CAPITAL INC. MLMCI is a dealer in whole loan mortgages and mortgage servicing. MLMCI, through its CMO Passport (Registered Trademark) service, provides dealers and investors with general indicative information and analytic capability with respect to collateralized mortgage obligations (CMOs) and asset-backed securities. As an integral part of its business, MLMCI enters into repurchase agreements wherein it obtains funds by pledging its own whole loans as collateral. The repurchase agreements provide financing for MLMCI's inventory, and serve as short-term investments for MLMCI's customers. MLMCI also enters into reverse repurchase agreements wherein it lends funds against the pledge of whole loan collateral by customers; such agreements provide MLMCI's customers with temporary liquidity for their investments in secured whole loans. MLMCI enters into reverse repurchase agreements at an interest rate that is fractionally higher than that of repurchase agreements. MERRILL LYNCH SPECIALISTS INC. MLSI acts as a specialist on the New York Stock Exchange and the Pacific Stock Exchange in equities that are allocated to MLSI by such exchanges. In addition, through arrangements with other organizations, it acts as a specialist in equities on the Boston Stock Exchange and in options on equities on the American Stock Exchange and Philadelphia Stock Exchange. MERRILL LYNCH CAPITAL PARTNERS, INC. MLCP acts as the general partner of two leveraged buyout funds, whose limited partners are institutional investors. The investment period for the first fund has expired and the investment period for the second fund will expire no later than June 30, 1994. During the investment periods, MLCP identifies, initiates, and completes, as the principal equity investor, acquisitions of companies or divisions of companies. Investments made by MLCP are funded by the limited partners. For each investment made by an MLCP-sponsored partnership, ML & Co. (through an affiliate) makes a co-investment of up to 20%. Total funds under management in the two funds now approximate $1.6 billion. The primary investment objective of the funds is to realize long- term capital appreciation. To further this objective, MLCP representatives assist in the development and implementation of corporate strategy and financial policy, and are involved in overall corporate governance through participation on the boards of directors of portfolio companies. On May 11, 1993, ML & Co. announced that, consistent with its desire to reduce the level of new commitments in long-term illiquid investments, MLCP would not act as the general partner of another leveraged buyout fund. As a result of this determination, ML & Co. stated that the principal employees of MLCP announced their intention to leave MLCP and ML & Co. and start a new fund. To better protect the interests of the investors in the two existing leveraged buyout funds for which MLCP acts as general partner, ML & Co. has entered into agreements with the principal employees of MLCP providing that ML & Co. will participate in the new fund as a limited partner with up to a $50 million contribution and will act as placement agent. In addition, at the time of the initial closing of the new fund, the principal employees of MLCP will cease being employees of MLCP, and will become consultants to MLCP under long-term contracts and as consultants will provide advice with respect to the management of the portfolio of investments in the two existing leveraged buyout funds. MERRILL LYNCH INTERFUNDING INC. MLIF has been a participant in middle-market leveraged acquisitions. Utilizing ML & Co.'s capital, MLIF has, as principal, provided senior and subordinated ("mezzanine") financing to, and acquired equity interests in, a portfolio consisting of approximately 50 companies. Currently, MLIF is not seeking new investment opportunities. ML FUTURES INVESTMENT PARTNERS INC. MLFIP serves principally as the general partner and commodity pool operator of commodity pools for which MLF acts as commodity broker and MLPF&S as selling agent. MLFIP also structures and sponsors managed futures investments to meet a variety of client objectives. MLFIP is one of the largest managed futures sponsors in the world as measured by assets under management and financial and personal resources. As of December 31, 1993, there was approximately $1.296 billion in equity invested or to be invested in 35 domestic and international commodity futures funds (as compared to $852 million in equity invested in 26 commodity futures funds at the end of 1992) which it has sponsored or has been selected to manage. MLFIP is an integrated business, whose capabilities include research, trading, finance, systems, operations, sales and marketing. MLFIP's responsibilities include selecting and monitoring trading advisors, as well as allocating and reallocating capital among them. Additionally, MLFIP is responsible for control of and accounting for the transactions and settlements for its funds, calculating net asset values on a daily basis, and providing monthly and annual fund reports to investors. MERRILL LYNCH INSURANCE GROUP, INC. Operations in insurance services consist of the underwriting of life insurance and annuities by MLLIC and ML Life, wholly-owned subsidiaries of Merrill Lynch Insurance Group, Inc. ("MLIG"), and the sale of life insurance and annuity products by insurance agencies affiliated with MLIG or otherwise associated with MLPF&S. MLLIC is an Arkansas stock life insurance company authorized to underwrite life insurance, annuities and accident and health insurance in 49 states, the District of Columbia, Guam and the U.S. Virgin Islands. MLLIC underwrites life insurance and annuities that are marketed to customers of MLPF&S; however, it does not presently underwrite accident and health insurance. At year-end 1993, MLLIC had approximately $10.9 billion of life insurance in force, as compared with $10.6 billion at year-end 1992. At year-end 1993, MLLIC had annuity contracts in force of approximately $6.1 billion in value as compared with $6.0 billion at year end 1992. ML Life is a New York stock life insurance company authorized to underwrite life insurance, annuities and accident and health insurance in nine states; however, it does not presently underwrite accident and health insurance. At year-end 1993, ML Life had approximately $850 million of life insurance in force, compared to $802 million of life insurance in force at year-end 1992. At year-end 1993, ML Life had annuity contracts in force of approximately $533 million in value, as compared with $637 million at year-end 1992. MLIG, through licensed affiliate insurance agencies and other insurance agencies associated with MLPF&S, sells life and health insurance and annuities. On a selective basis, such entities have entered into agency agreements with certain insurance companies for the sale of various life and health insurance and annuity products. A significant portion of these sales consists of products underwritten by MLLIC and ML Life. MERRILL LYNCH CREDIT CORPORATION MLCC provides real estate-based lending products enabling clients to finance their residences, as well as to manage other personal credit needs. MLCC's PrimeFirst (Registered Trademark) mortgage is an adjustable rate first mortgage. As of December 31, 1993, the PrimeFirst program was available throughout the U.S., the Virgin Islands and the District of Columbia. MLCC also provides jumbo fixed-rate mortgages, as well as conventional fixed and adjustable rate mortgages, in all 50 states. MLCC's ParentPower (Registered Trademark) and Mortgage 100/SM/ products provide mortgage financing that is secured in part by securities in a client's MLPF&S brokerage account in lieu of the amount normally required as a down payment; these programs were available in 17 and 19 states, respectively as of December 31, 1993. MLCC's OMEGA/SM/ account provides financing secured by securities in an MLPF&S account. This program was introduced in 1993 and was available in 14 states as of December 31, 1993. Through the Equity Access (Registered Trademark) credit account service, MLCC provides to clients a revolving credit line, which is secured by their residential properties and may be accessed by check, and in most states, by a VISA (Registered Trademark) card. As of December 31, 1993, the Equity Access program was available in 48 states, the District of Columbia and the Virgin Islands. MLCC also acquires and services home equity credit lines and other mortgage loans for affiliated and unaffiliated financial institutions. MLCC also purchases mortgage servicing rights. MLCC uses a variety of financing techniques to fund its loan portfolio, including securitizing its mortgages for sale into the secondary marketplace. MERRILL LYNCH BUSINESS FINANCIAL SERVICES INC. MLBFS is engaged in providing financing services to small- and medium-sized businesses in conjunction with the Working Capital Management/SM/ account ("WCMA (Registered Trademark) account") which MLPF&S provides to business customers. The WCMA account combines business checking, borrowing, investment and electronic funds transfer services into one account for participating business customers. As of December 31, 1993, including those offering Merrill Lynch Consults services, there were over 108,000 WCMA accounts which in the aggregate have investment assets of over $33 billion. In addition to providing qualifying customers with short-term working capital financing through the WCMA Commercial Line of Credit, MLBFS offers assistance to business customers with their term lending, equipment and other asset-based financing needs. In 1993, MLBFS originated over $495 million in new commercial loans for business customers. As of December 31, 1993, total outstanding loans were $535.2 million. Of this total, 97% were secured by tangible assets pledged by the businesses. MERRILL LYNCH, HUBBARD INC. MLH and its various subsidiaries are responsible for managing real estate investment programs that they sponsored and that were purchased by individual and institutional investors. As of December 31, 1993, a subsidiary of MLH functioned as the managing general partner of 9 public real estate limited partnerships with approximately 220,000 investors and managed, commercial and residential real estate investments, with an aggregate approximate value of $1.0 billion. BANKING AND TRUST ACTIVITIES Merrill Lynch Bank & Trust Co., a New Jersey state chartered institution insured by the Federal Deposit Insurance Corporation issues certificates of deposit and money market deposit accounts (including the Insured Savings Account for the CMA service), makes Equity Access and other secured consumer loans and issues CMA Visa (Registered Trademark) cards. Merrill Lynch National Financial, a Utah state chartered institution insured by the Federal Deposit Insurance Corporation, issues certificates of deposit and money market deposit accounts (including the Insured Savings Account for the CMA service), issues CMA Visa (Registered Trademark) Gold cards, and through a wholly-owned subsidiary, provides Equity Access loans. MLIB, Ltd., a United Kingdom bank, with branch offices in Singapore, Bahrain and Luxembourg, provides foreign exchange trading and collateralized lending services and accepts deposits. Merrill Lynch International Bank, an Edge Act corporation, provides foreign exchange trading services to corporations and institutions. Merrill Lynch Bank (Suisse) S.A., a Swiss bank, provides portfolio management and individual client services to international private banking clients. Merrill Lynch Bank A.G., a German bank (with a branch office in Japan), engages in capital markets activities, such as underwriting, foreign exchange and swap and other derivative transactions. The Merrill Lynch Trust Companies (Merrill Lynch Trust Company, a New Jersey trust company; Merrill Lynch Trust Company, a Florida trust company; Merrill Lynch Trust Company of America, an Illinois trust company; Merrill Lynch Trust Company of California; and Merrill Lynch Trust Company of Texas) provide personal trust, employee benefit trust and custodial services in certain states. Trust services outside of the United States are provided by Merrill Lynch Bank and Trust Company (Cayman) Limited. OTHER ACTIVITIES Other subsidiaries develop investments for ML & Co. and for marketing to others, and are engaged in leasing transactions, venture capital investments, providing funds in connection with private placements, project financings, the origination and master servicing of hospital/health care facility mortgages and serving as a recordkeeping and dividend disbursing agent. COMPETITION All aspects of ML & Co.'s business are intensely competitive. Through its subsidiaries, it competes directly, both in the United States and internationally, with other domestic and foreign investment banking and securities firms, and with brokers and dealers in securities and commodities. Competition has also come from other sources, such as commercial banks and insurance companies and has included numerous international competitors, many having competitive advantages in their home markets. ML & Co., through its subsidiaries, also competes indirectly for investment funds with mutual fund management companies, insurance companies, finance and investment advisory companies, and banks. ML & Co.'s competitive position depends to an extent on prevailing world-wide economic conditions and domestic and foreign governmental policies. ML & Co. competes for customers on the basis of price, the range of products it offers, the quality of its services, its financial resources, and product innovation. Financial services companies also compete to attract and retain successful financial consultants and other revenue-producing personnel. U.S. judicial and regulatory actions in recent years concerning, among other things, the authority of bank affiliates to engage in securities underwriting and brokerage activities have resulted in increased competition in those aspects of MLPF&S's business. In addition, domestic legislative proposals are made from time to time which, if enacted, would also result in increased competition from banks and their affiliates. The insurance businesses of MLLIC and ML Life are highly competitive. Many companies, both stock and mutual, are older and larger and have more substantial financial resources and larger agency relationships than MLLIC and ML Life. REGULATION The securities and futures businesses conducted by subsidiaries of ML & Co. are subject to stringent regulation by the Securities and Exchange Commission ("SEC"), the Commodity Futures Trading Commission ("CFTC"), and other Federal and state agencies. MLPF&S, BCC, MLSI, and WSCC are also subject to regulation by the National Association of Securities Dealers, Inc. (the "NASD") and by the securities exchanges of which each is a member. They are further regulated as broker-dealers under the laws of the jurisdictions in which they operate. MLF, MLPF&S and WSCC are futures commission merchants regulated by the CFTC, the National Futures Association ("NFA") and the commodity exchanges of which each is a member. The CFTC and the NFA impose net capital requirements on MLF, MLPF&S and WSCC. MLGSI is a registered government securities dealer under the Government Securities Act of 1986 and is also subject to regulation by the NASD and the Chicago Board of Trade. The securities industry is one of the most highly regulated industries, and violations can result in the revocation of broker-dealer licenses, the imposition of censures or fines and the suspension or expulsion from the securities business of a firm, its officers or employees. With the enactment of the Insider Trading and Securities Fraud Enforcement Act of 1988, the SEC and the securities exchanges have intensified their regulation of broker- dealers, emphasizing in particular the need for supervision and control by broker-dealers of their employees. In addition, the SEC, various banking regulators, the Financial Accounting Standards Board and Congressional committees, among others, are considering increased regulation of, and disclosure for, the derivatives business. As broker-dealers registered with the SEC and as members of U.S. exchanges, MLPF&S, MLSI, BCC and WSCC are subject to the SEC Uniform Net Capital Rule, designed to measure the general financial condition and liquidity of a broker-dealer. They are required to maintain minimum net capital deemed necessary to meet broker-dealers' continuing commitments to customers and others. Under certain circumstances, this rule limits the ability of ML & Co. to make withdrawals of capital from such broker-dealers. MLGSI, as a government securities dealer, is required to maintain minimum net capital pursuant to rules of the U.S. Department of the Treasury. Additional information regarding net capital requirements set forth in the Notes to Consolidated Financial Statements under the caption "Regulatory Requirements and Dividend Restrictions" appearing on page 58 of the Annual Report is incorporated herein by reference. In 1992 the SEC adopted its temporary risk assessment rules under the Market Reform Act of 1990. These rules require brokers and dealers to maintain and preserve records and other information concerning their material associated persons, as defined by the SEC. The rules also require such brokers and dealers to file with the SEC quarterly reports containing detailed financial information with respect to such affiliates. MLPF&S is the reporting broker and dealer for BCC and WSCC under these risk assessment rules; MLSI and Merrill Lynch Funds Distributor, Inc. are exempt from these rules; and MLGSI is not subject to these rules. MLPF&S and MLAM are registered with the SEC as investment advisers, as they are with certain states that require such registration. MLC is an investment dealer in Canada. It is regulated under the laws of the respective provinces, by their securities authorities and by the Investment Dealers Association of Canada. MLC is a member of all major Canadian exchanges and is subject to their rules and regulations. MLFIP is a commodity pool operator and commodity trading adviser registered with the CFTC, and is a member of the NFA in such capacities. ML Life is subject to extensive regulation and supervision by the New York State Insurance Department. MLLIC is subject to extensive regulation and supervision by the Insurance Department of the State of Arkansas. Both MLLIC and ML Life are subject to similar regulation in the other states in which they are licensed. Merrill Lynch Bank & Trust Co. is regulated by the State of New Jersey and by the Federal Deposit Insurance Corporation. Merrill Lynch National Financial is regulated by the State of Utah and by the Federal Deposit Insurance Corporation. Merrill Lynch Trust Company (New Jersey), and its wholly-owned subsidiaries, MLBFS and MLCC, are regulated by the New Jersey Department of Banking. Merrill Lynch Trust Company (Florida) is regulated by the Florida Office of the Comptroller, Department of Banking and Finance. Merrill Lynch Trust Company of America is regulated by the Illinois Office of the Commissioner of Banks and Trust Companies. Merrill Lynch Trust Company of California is regulated by the California State Banking Department. Merrill Lynch Trust Company of Texas is regulated by the Texas State Banking Department. MLIB, Ltd. is regulated by the Bank of England and by the New York State Banking Department. The Bahrain branch of MLIB, Ltd. is supervised by the Bahrain Monetary Authority and the Bank's branch in Luxembourg is supervised by the Institute Monetaire Luxembourgeois. The Singapore branch of this bank is also regulated by the Monetary Authority of Singapore. Merrill Lynch International Bank is regulated by the Federal Reserve Bank of New York. Merrill Lynch Bank (Suisse) S.A. is regulated by the Swiss Federal Banking Commission. Merrill Lynch Bank A.G. is regulated by the Federal Banking Supervisory Agency of the Federal Republic of Germany, and its branch in Japan is regulated by the Ministry of Finance of Japan. Merrill Lynch Bank and Trust Company (Cayman) Limited is regulated by the Cayman Islands Bank Examiner. MLJ is regulated by the Ministry of Finance of Japan. The Corporation's business in the United Kingdom is governed by investment business regulations adopted in the United Kingdom pursuant to The Financial Services Act 1986, in particular by regulations administered by The Securities and Futures Authority Limited, a self-regulatory organization of financial services companies. ML Capital Markets is regulated by the Swiss Federal Banking Commission. ITEM 2. ITEM 2. PROPERTIES - ------------------- The executive offices and a significant portion of ML & Co.'s business activities are located in a building on 250 Vesey Street (the "North Tower") in the World Financial Center ("WFC") in New York City. Additional offices, operations and functions are located at 225 Liberty Street (the "South Tower") in the WFC. An ML & Co. affiliate is a partner in the partnership that holds the ground lessee's interest (including the right to grant occupancy and possession to tenants) in the North Tower. Another affiliate of ML & Co. holds separate long term leases in each of the North Tower and the South Tower. The rent commitments of the ML & Co. affiliate holding the leases in the North Tower and South Tower aggregate approximately $122 million per year for the first 15 years and approximately $179 million per year for the remaining 10 years of the leases, which commenced in 1988. The aforesaid rent commitments do not include offsetting rental income for approximately two- thirds of the South Tower which is subleased. In addition to the rent commitment, the affiliate holding the leases is generally responsible for all expenses incurred by the lessee in operating the buildings. Additional principal locations for ML & Co.'s business activities are held by affiliates of ML & Co. at the following facilities located in New Jersey: a fee-owned facility on 275 acres of property in Plainsboro; a fee-owned facility on 35 acres at 300 Davidson Avenue, Somerset (which is the replacement facility for a leased location in Somerset where the leases are expiring in 1994 and 1995); a leased facility in Piscataway (lease expiring in 2005); and a facility at 101 Hudson Street in Jersey City in which an ML & Co. affiliate holds an interest in partnerships that own the land and the building and in which another ML & Co. affiliate holds a long-term lease for office space housing support functions. Other significant properties used by the Corporation are at three New York City locations held by MLPF&S under leases expiring in 2000, 2007 and 2024, all exclusive of extensions. Affiliates of ML & Co. own in fee the regional service centers in Lakewood, Colorado and Somerset, New Jersey. Insurance activities are conducted by insurance subsidiaries of ML & Co. at locations in Plainsboro, New Jersey, Jacksonville, Florida (lease expiring in 1994), New York City (lease expiring in 2000), Springfield, Massachusetts (sublease expiring in 1997) and at additional locations at MLPF&S branch offices throughout the United States. Merrill Lynch Europe Limited leases a building with approximately 250,000 square feet at Ropemaker Place, London. The lease commenced in 1987 and continues for 25 years with a right to cancel in the year 2002. This building serves as the headquarters for ML & Co.'s European and Middle Eastern operations. MLJ leases 90,000 square feet of office space in Tokyo. The lease, which expires in the year 2003, can be canceled at any time on six-months notice. Substantially all other offices, including over 500 branch offices, of ML & Co.'s subsidiaries throughout the world, are located in leased premises. The information regarding lease commitments of ML & Co. (including commitments for leases of premises) set forth in the Notes to Consolidated Financial Statements under the caption "Commitment and Contingencies - Leases" on page 66 of the Annual Report is hereby incorporated by reference. ITEM 3. ITEM 3. LEGAL PROCEEDINGS - -------------------------- ML & Co. and certain of its subsidiaries, including MLPF&S, have been named as parties in numerous civil actions, including the following, arising out of their business activities. Each of the following actions is reported as of March 28, 1994. With respect to those actions that have not been terminated, ML & Co. and its subsidiaries are vigorously contesting their alleged liabilities and have asserted denials and defenses they believe to be meritorious. Several legal proceedings have arisen from securities trading transactions that occurred at year ends 1984-86 and 1988 between MLPF&S and MLGSI and a Florida insurance company, Guarantee Security Life Insurance Company ("GSLIC"), which is now in liquidation. One of the proceedings was resolved on December 22, 1993, when MLPF&S, without admitting or denying any violation, settled an SEC administrative proceeding concerning violations of the SEC's recordkeeping rules with respect to the year-end securities trades with GSLIC and certain unrelated securities transactions in 1986 with Reliance Insurance Company ("Reliance"). The SEC's order, which imposed a censure, is limited to recordkeeping violations with respect to the manner in which particular GSLIC and Reliance transactions were recorded on MLPF&S's books. The settlement is described in SEC Release No. 34-33367, issued December 22, 1993. A principal focus of the allegations in the following civil proceedings is an assertion that GSLIC's purpose in engaging in the year-end transactions was to distort its apparent financial condition. It is claimed that GSLIC's former officers and employees improperly took assets from the company and its investment portfolio declined substantially in value before its true financial condition became known to insurance regulators, GSLIC's policyholders, and the creditors of GSLIC and its parent company, Transmark USA, Inc. ("Transmark"). A complaint was brought by the Florida Department of Insurance as Receiver of GSLIC (the "Receiver") naming MLPF&S, MLGSI and a former managing director of MLPF&S among the defendants. Other defendants include former officers, directors, and shareholders of GSLIC and Transmark and GSLIC's former outside attorneys and accountants. State of Florida Department of Insurance, as Receiver of Guarantee Security Life Insurance Company v. Merrill Lynch, Pierce, Fenner & Smith Incorporated, et al. (4th Judicial Circuit, Duval County, Florida, December 20, 1991). The complaint alleges state law claims against the above-mentioned Merrill Lynch defendants for fraud, breach of fiduciary duty, conspiracy, and aiding and abetting breach of duty arising from their involvement in the year-end trades with GSLIC, alleges that GSLIC was damaged in excess of $300 million, and seeks relief in an unspecified amount from the Merrill Lynch defendants. Substantially the same defendants are named in two consolidated lawsuits brought in federal court in Jacksonville, Florida, on behalf of an uncertified alleged class of purchasers of GSLIC insurance policies and annuities between 1984 and 1991. Haag v. Transmark U.S.A. Inc., et al., No. 91-864-CIV-J-16 (M.D. Fla., October 15, 1991), and Levine v. Transmark U.S.A. Inc., et al., No. 92-226-CIV-J-14 (M.D. Fla., February 28, 1992). The complaint alleges substantially the same claims as the Receiver's state court action as well as claims grounded in the Racketeer Influenced and Corrupt Organizations Act ("RICO") and Section 10(b) of the Securities Exchange Act of 1934 and seeks unspecified money damages. The court has stayed the actions pending resolution of the Receiver's action. The Resolution Trust Corporation ("RTC") as receiver for four failed savings institutions (CenTrust Association Savings Bank, Imperial Savings Association, FarWest Savings and Loan Association, and Columbia Savings and Loan Association) in January and April, 1993 filed civil actions in federal court in Jacksonville, Florida, seeking to recover damages as a result of purchases by the four institutions of securities issued by Transmark, GSLIC's parent corporation. The Merrill Lynch defendants had no role in the purchases and sales of the Transmark securities, but the year-end transactions with GSLIC allegedly inflated the value of the Transmark securities purchased. Resolution Trust Corporation v. Transmark U.S.A. Inc., et al., No. 93-112-CIV-J-16 (M.D. Fla.); Resolution Trust Corporation v. Merrill Lynch & Co., Inc., et al., No. 93-523-CIV-J-16 (M.D. Fla.). Resolution Trust Corporation v. Merrill Lynch & Co., Inc., et al., No. 93-524-CIV-J-16 (M.D. Fla.). The claims alleged are substantially similar to those in the Haag/Levine action mentioned above. The defendants include ML & Co., MLPF&S, MLGSI, a former MLPF&S managing director and former officers, directors and employees of Transmark and GSLIC. In April, 1993, Trans-Resources Inc., a company that alleges it also purchased Transmark securities, filed a complaint substantially following the allegations of the RTC's complaints and naming substantially the same defendants. Trans- Resources, Inc. v. Transmark U.S.A. Inc., et al., No. 93-601-CIV-J-16 (M.D. Fla.). The RTC and Trans-Resources complaints seek compensatory and punitive damages in unspecified amounts, trebling of damages under the RICO claim, rescissory relief, and reimbursement of costs of suit. Two stockholders of ML & Co., Charles Miller and Kenneth Steiner, in October, 1991 commenced derivative actions, now consolidated, in New York State Supreme Court. (Index No. 29885/91). The plaintiffs assert claims for breach of fiduciary duties in connection with the year-end securities transactions with GSLIC against all present directors of ML & Co. who were directors at the times of those trades, and other claims against Transmark and one of Transmark's principals. The damages sought in this action are unspecified. The defendants' motions to dismiss on various grounds were denied, subject to possible further appellate review. However, the court has stayed the action for all purposes pending a resolution of the above- mentioned related litigation in Florida. Management believes that ML & Co. and its subsidiaries have strong defenses to any allegations of wrongdoing by them in connection with all actions involving the year-end trades with GSLIC and intends to contest such claims vigorously. The ultimate outcome of the actions described above and other civil actions, arbitration proceedings and claims pending against ML & Co. or its subsidiaries as of March 28, 1994 cannot be ascertained at this time and the results of legal proceedings cannot be predicted with certainty. Nevertheless, it is the opinion of the management of ML & Co. that the resolution of these matters will not have a material adverse effect on the consolidated financial statements of ML & Co. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS - ------------------------------------------------------------ None. EXECUTIVE OFFICERS OF THE REGISTRANT ------------------------------------ The following table sets forth certain information concerning executive officers of ML & Co. as of March 15, 1994. - ---------- /*/ Unless otherwise indicated, the offices listed are of ML & Co. Under ML & Co.'s By-Laws, elected officers are elected annually to hold office until their successors are elected and qualify; all Executive Officers are elected by the Board of Directors. - ---------- /*/ Unless otherwise indicated, the offices listed are of ML & Co. Under ML & Co.'s By-Laws, elected officers are elected annually to hold office until their successors are elected and qualify; all Executive Officers are elected by the Board of Directors. PART II ------- ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS - ------------------------------------------------------------------------------ In response to this Item 5, the information set forth in the Notes to Consolidated Financial Statements under the caption "Regulatory Requirements and Dividend Restrictions" on page 58 of the Annual Report; the information on page 69 of the Annual Report under the caption "Dividends Per Common Share" and the caption "Stockholder Information" is incorporated herein by reference. The Common Stock of ML & Co. (trading symbol MER) is listed on the following stock exchanges: New York Stock Exchange, Chicago Stock Exchange, Pacific Stock Exchange, Paris Bourse, London Stock Exchange and Tokyo Stock Exchange. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA - -------------------------------- In response to this Item 6, the information contained in the financial table "Selected Financial Data" on page 30 of the Annual Report excluding the financial ratios and the other data set forth therein under the headings "Financial Ratios" and "Other Statistics" and the information set forth on page 68 of the Annual Report is incorporated herein by reference and should be read in conjunction with the Consolidated Financial Statements and the Notes thereto on pages 45-67 in the Annual Report. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND - ------------------------------------------------------------------------- RESULTS OF OPERATIONS --------------------- In response to this Item 7, the financial information set forth under the caption "Financial Ratios--Leverage" on page 30 of the Annual Report, the discussion on pages 32-42 (up to the caption "Risk Management") of the Annual Report and the information in the Notes to Consolidated Financial Statements under the caption "Regulatory Requirements and Dividend Restrictions" on page 58 of the Annual Report is incorporated herein by reference and such information should be read in conjunction with the Consolidated Financial Statements and the Notes thereto on pages 45-67 in the Annual Report. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA - ---------------------------------------------------- In response to this Item 8, the information set forth in the Consolidated Financial Statements and the Notes thereto on pages 45-67 in the Annual Report, the Independent Auditors' Report on page 67 in the Annual Report and the information on page 69 of the Annual Report under the caption "Quarterly Information" is incorporated by reference herein. 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 - ------------------------------------------------------------- In response to this Item 10, the information set forth under the caption "Election of Directors" on pages 4-7 and in the fourth paragraph on page 25 of ML & Co.'s Proxy Statement dated March 14, 1994 (the "Proxy Statement") and the information set forth in Part I hereof under the caption "Executive Officers of the Registrant" is incorporated herein by reference. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION - -------------------------------- In response to this Item 11, the information set forth under the caption "Executive Compensation" on pages 14-27 of the Proxy Statement is incorporated herein by reference. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT - ------------------------------------------------------------------------ In response to this Item 12, the information set forth on pages 1-2 and the information set forth under the caption "Election of Directors" on pages 4-7 of the Proxy Statement is incorporated herein by reference. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS - -------------------------------------------------------- In response to this Item 13, the information set forth on pages 24-25 of the Proxy Statement under the caption "Certain Transactions" is 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: 1. Financial Statements The financial statements are listed on page hereof by reference to the corresponding page number in the Annual Report. 2. Financial Statement Schedules The financial statement schedules required to be filed hereunder are listed on page hereof and the schedules included herewith appear on pages through hereof. 3. EXHIBITS Certain of the following exhibits were previously filed as exhibits to other reports or registration statements filed by the Registrant and are incorporated herein by reference to such reports or registration statements as indicated parenthetically below by the appropriate report reference date or registration statement number. For convenience, Quarterly Reports on Form 10-Q, Annual Reports on Form 10-K, Current Reports on Form 8-K and Registration Statements on Form S-3 are designated herein as "10-Q," "10-K," "8-K" and "S-3," respectively. (3) ARTICLES OF INCORPORATION AND BY-LAWS. (i)(a) Restated Certificate of Incorporation of ML & Co., as amended April 24, 1987 (Exhibit 3(i) to 10-K for fiscal year ended December 25, 1992 ("1992 10-K")). (b) Certificate of Amendment, dated April 29, 1993, of the Certificate of Incorporation of ML & Co. (Exhibit 3(i) to 10-Q for the quarter ended March 26, 1993 ("1st Quarter 1993 10-Q")). (c) Certificate of Designation dated March 30, 1988 for Remarketed Preferred Stock Series C (Exhibit 3(ii) to 1st Quarter 1993 10-Q). (d) Certificate of Designation dated December 17, 1987 for Series A Junior Preferred Stock (Exhibit 3(f) to S-3 (File No. 33-19975)). (e) Form of Rights Agreement dated as of December 16, 1987 between ML & Co. and Chemical Bank (successor by merger to Manufacturers Hanover Trust Company) (Exhibit 3(iv) to 1992 10-K). (ii) By-Laws of ML & Co., effective as of October 25, 1993 (Exhibit 3(i) to 10-Q for the quarter ended September 24, 1993 ("3rd Quarter 1993 10-Q")). (4) INSTRUMENTS DEFINING THE RIGHTS OF SECURITY HOLDERS, INCLUDING INDENTURES Pursuant to Item 601(b)(4)(iii) (A) of Regulation S-K , the Registrant hereby undertakes to furnish to the Securities and Exchange Commission, upon request, copies of the instruments defining the rights of holders of long-term debt securities of the Registrant, none of which instruments, including the Exhibits listed in 4(iv) to (xxxv) below, authorize an amount of securities that exceed 10% of the total assets of the Registrant and its subsidiaries on a consolidated basis. For convenience purposes, the Registrant hereby files as Exhibits 4(iv) through (xxxv) the form of each long-term security issued by the Registrant from January 1, 1993 through March 25, 1994. (i) Senior Indenture, dated as of April 1, 1983, as amended and restated, between ML & Co. and Chemical Bank (successor by merger to Manufacturers Hanover Trust Company) (Exhibit 99(c) to ML & Co.'s Registration Statement on Form 8-A dated July 20, 1992. (ii) Supplemental Indenture to the Senior Indenture, dated as of March 15, 1990, between ML & Co., and Chemical Bank (successor by merger to Manufacturers Hanover Trust Company) (Exhibit 99(c) to ML & Co.'s Registration Statement on Form 8-A dated July 20, 1992). (iii) Senior Indenture, dated as of October 1, 1993, between ML & Co. and The Chase Manhattan Bank, N.A. (Exhibit 4 to 8-K dated October 7, 1993). (iv) Form of ML & Co.'s Step-Up Notes due January 26, 2000 (Exhibit 4 to 8-K dated January 26, 1993). (v) Form of ML & Co.'s S&P 500 (Registered Trademark) Market Index Target-Term Securities/SM/ due July 31, 1998 (Exhibit 4 to 8-K dated January 28, 1993). (vi) Form of ML & Co.'s Global Telecommunications Portfolio Market Index Target-Term Securities/SM/ due October 15, 1998 (Exhibit 4 to 8-K dated September 13, 1993). - ---------------------- "S&P 500" is a registered service mark of Standard & Poor's Inc. (vii) Form of ML & Co.'s European Portfolio Market Index Target- Term Securities/SM/ due June 30, 1999 (Exhibit 4 to 8-K dated December 30, 1993). (viii) Form of ML & Co.'s Currency Protected Notes due December 31, 1998 (Exhibit 4 to 8-K dated July 7, 1993). (ix) Form of ML & Co.'s Equity Participation Securities with Minimum Return Protection due June 30, 1999 (Exhibit 4 to 8-K dated June 28, 1993). (x) Form of ML & Co.'s Japan Index Equity Participation Securities with Minimum Return Protection due January 31, 2000 (Exhibit 4 to 8-K dated January 27, 1994). (xi) Form of ML & Co.'s Stock Market Annual Reset Term Notes/SM/, Series A, due December 31, 1999 (Exhibit 4 to 8-K dated April 29, 1993). (xii) Form of ML & Co.'s Global Bond Linked Securities due December 31, 1998 (Exhibit 4 to 8-K dated February 22, 1993). (xiii) Form of ML & Co.'s Fixed Rate Medium-Term Notes, Series B (Exhibit 4(xiii) to 3rd Quarter 1993 10-Q). (xiv) Form of ML & Co.'s Floating Rate Medium-Term Notes, Series B (Exhibit 4(xiv) to 3rd Quarter 1993 10-Q). (xv) Form of ML & Co.'s New Peso-Linked Medium-Term Notes, Series B, due February 9, 1995 (Exhibit 4(ppp) to S-3 (File No. 33-52647)). (xvi) Form of ML & Co.'s Italian Lira Principal Linked Medium- Term Notes, Series B, due February 3, 1995 (Exhibit 4(lll) to S-3 (File No. 33-52647)). (xvii) Form of ML & Co.'s Multi-Currency Medium-Term Notes, Series B (Exhibit 4(fff) to S-3 (File No. 33-52647)). (xviii) Form of ML & Co.'s Japanese Yen Swap Rate Linked Medium- Term Notes, Series B (Exhibit 4(mmm) to S-3 (File No. 33-52647)). (xix) Form of ML & Co.'s Nine-Month Renewable Floating Rate Medium-Term Notes, Series B, due October 9, 1996 (Exhibit 4(ix) to 3rd Quarter 1993 10-Q). (xx) Form of ML & Co.'s Three Year Japanese Yen Duration Enhanced Medium-Term Notes, Series B, with JPY Exposure on Gain/Loss due November 1, 1996 (Exhibit 4(xv) to 3rd Quarter 1993 10-Q). (xxi) Form of ML & Co.'s Swap Spread Linked Medium-Term Notes due May 20, 1998 (Exhibit 4(vii) to 2nd Quarter 1993 10-Q). (xxii) Form of ML & Co.'s Inverse Floating Rate Medium-Term Notes due September 15, 1998 (Exhibit 4(vii) to 3rd Quarter 1993 10-Q). (xxiii) Form of ML & Co.'s Inverse Floating Rate Medium-Term Notes, Series B, due October 19, 1998 (Exhibit 4(xii) to 3rd Quarter 1993 10-Q). (xxiv) Form of ML & Co.'s Step-Up Medium-Term Notes due May 20, 2008 (Exhibit 4(viii) to 2nd Quarter 1993 10-Q). (xxv) Form of ML & Co.'s Constant Maturity Treasury Rate Indexed Medium-Term Notes, Series B (Exhibit 4(ccc) to S-3 (File No. 33-52647)). (xxvi) Form of ML & Co.'s Japanese Yen Yield Curve Flattening Medium-Term Notes, Series B (Exhibit 4(ddd) to S-3 (File No. 33-52647)). (xxvii) Form of ML & Co.'s 4 3/4% Notes due June 24, 1996 (Exhibit 4 to 8-K dated June 24, 1993). (xxviii) Form of ML & Co.'s 5% Notes due December 15, 1996 (Exhibit 4 to 8-K dated December 22, 1993). (xxix) Form of ML & Co.'s 6 1/4% Notes due January 15, 2006 (Exhibit 4 to 8-K dated January 20, 1994). (xxx) Form of ML & Co.'s 6 1/4% Notes due October 15, 2008 (Exhibit 4 to 8-K dated October 15, 1993). (xxxi) Form of ML & Co.'s 6 3/8% Notes due September 8, 2006 (Exhibit 4 to 8-K dated September 8, 1993). (xxxii) Form of ML & Co.'s 6 7/8% Notes due March 1, 2003 (Exhibit 4 to 8-K dated March 1, 1993). (xxxiii) Form of ML & Co.'s 7% Notes due April 27, 2008 (Exhibit 4 to 8-K dated April 27, 1993). (xxxiv) Form of ML & Co.'s 7.05% Notes due April 15, 2003 (Exhibit 4 to 8-K dated April 15, 1993). (xxxv) Form of ML & Co.'s Constant Maturity Treasury Indexed Notes due March 24, 1997 (Exhibit 4 to 8-K dated March 24, 1994). (10) MATERIAL CONTRACTS COMPENSATION PLANS AND ARRANGEMENTS (i) ML & Co. 1978 Incentive Equity Purchase Plan, as amended July 27, 1992 (Exhibit 10(iv) to 2nd Quarter 1992 10-Q). (ii) Form of ML & Co. 1994 Deferred Compensation Agreement for a Select Group of Eligible Employees (Exhibit 10(i) to 3rd Quarter 1993 10-Q). (iii) ML & Co. Long-Term Incentive Compensation Plan, as amended as of October 25, 1993. (iv) ML & Co. Equity Capital Accumulation Plan, as amended as of October 25, 1993 (Exhibit 10(iii) to 3rd Quarter 1993 10-Q). (v) ML & Co. Executive Officer Compensation Plan (effective as of January 1, 1994 upon receipt of ML & Co. stockholder approval) (Exhibit 10(i) to ML & Co.'s Proxy Statement for the 1994 Annual Meeting of Stockholders filed in Schedule 14A on March 14, 1994 ("Proxy Statement")). (vi) Written description of Retirement Program for Non-Employee Directors of ML & Co., as amended June 29, 1988 (Page 24 of ML & Co.'s Proxy Statement). (vii) ML & Co. Non-Employee Directors' Equity Plan (Exhibit 10(iv) to 3rd Quarter 1992 10-Q). (viii) Executive Annuity Agreement, dated July 24, 1991, by and between ML & Co. and Daniel P. Tully (Exhibit 10(iii) to 2nd Quarter 1991 10-Q). (ix) Amendment dated April 30, 1992 to Executive Annuity Agreement, dated July 24, 1991, by and between ML & Co. and Daniel P. Tully (Exhibit 10(ii) to 2nd Quarter 1992 10-Q). (x) Form of Severance Agreement between ML & Co. and certain of its directors and executive officers (Exhibit 10(i) to 3rd Quarter 1992 10-Q). (xi) Form of Indemnification Agreement entered into with all current directors of ML & Co. and to be entered into with all future directors of ML & Co. (xii) Written description of ML & Co.'s incentive compensation programs. (xiii) Written description of ML & Co.'s compensation policy for directors (Page 24 of ML & Co.'s Proxy Statement). (xiv) Merrill Lynch KECALP Growth Investments Limited Partnership 1983 (Exhibit 1(b) to Registration Statement on Form N-2 (File No. 2-81619)). (xv) Merrill Lynch KECALP L.P. 1984 (Exhibit 1(b) to Registration Statement on Form N-2 (File No. 2-87962)). (xvi) Merrill Lynch KECALP L.P. 1986 (Exhibit 1(b) to Registration Statement on Form N-2 (File No. 2-99800)). (xvii) Merrill Lynch KECALP L.P. 1987 (Exhibit 1(b) to Registration Statement on Form N-2 (File No. 33-11355)). (xviii) Merrill Lynch KECALP L.P. 1989 (Exhibit 1(b) to Registration Statement on Form N-2 (File No. 33-26561)). (xix) Merrill Lynch KECALP L.P. 1991 (Exhibit 1(b) to Registration Statement on Form N-2 (File No. 33-39489)). -- 10(xx) to (xxv) intentionally omitted -- AGREEMENTS RELATING TO THE WORLD FINANCIAL CENTER ------------------------------------------------- (xxvi) The following documents relate to the Registrant's occupation of office space in buildings at the World Financial Center, New York, New York: (a) Reimbursement Agreement between Olympia & York Tower D Company ("D Company") and Merrill Lynch/WFC/L, Inc. ("WFC/L"), dated as of August 24, 1984 (Exhibit 10(i) to 8-K dated January 22, 1990). (b) Reimbursement Agreement between Olympia & York Tower B Company ("B Company") and WFC/L, dated as of August 24, 1984 (Exhibit 10(ii) to 8-K dated January 22, 1990). /*/(c) Agreement of Lease (with respect to Parcel D), dated as of February 26, 1988, between WFC Tower D Company (formerly known as Olympia & York Tower D Company) ("D Company") and WFC/L (Exhibit 10(xxx)(c) to 1992 10-K). /*/(d) Guaranty and Assumption Agreement dated as of February 26, 1988 between ML & Co. and D Company (Exhibit 19(xxx)(d) to 1992 10-K). /*/(e) Agreement of Lease (with respect to Parcel B) dated as of September 29, 1988 between B Company and WFC/L (Exhibit 10(i) to 1st Quarter 1993 10-Q). /*/(f) Guaranty and Assumption Agreement dated as of September 29, 1988 between ML & Co. and B Company (Exhibit 10(ii) to 1st Quarter 1993 10-Q). /*/(g) Restated and Amended Partnership Agreement of D Company, executed on December 24, 1986 (Exhibit 10(xxx)(g) to 1992 10-K). /*/(h) Agreement of Sublease dated as of September 29, 1988 between WFC/L and Olympia & York Tower B Lease Company (Exhibit 10(iii) to 1st Quarter 1993 10-Q). - ------------- /*/ Confidential treatment has been requested for portions of this exhibit. /*/(i) Agreement of Sublease (with respect to a portion of Parcel B) dated November 26, 1990 between WFC/L and Nomura Holding America, Inc. (Exhibit 10(xviii)(i) to Form 8 dated June 6, 1991). /*/(j) Agreement of Sublease (with respect to a portion of Parcel B), dated December 17, 1993 between WFC/L and Deloitte & Touche. (xxvii) The following are amendments to certain of the documents that are related to ML & Co. occupation of office space in buildings at the World Financial Center, New York, New York: (a) First Amendment to Building D Agreement to Lease, Leasehold Improvements Agreement and Reimbursement Agreement (with respect to Parcel D) dated as of July 12, 1985 between D Company and WFC/L (Exhibit 10(iii) to 8-K dated January 22, 1990). (b) First Amendment to Building B Agreement to Lease, Reimbursement Agreement Second Amendment to Leasehold Improvements Agreement (with respect to Parcel B) dated as of July 12, 1985 between B Company and WFC/L (Exhibit 10(iv) to 8-K dated January 22, 1990). (c) Second Amendment to Reimbursement Agreement (with respect to Parcel D) dated as of February 26, 1988 between D Company and WFC/L (Exhibit 10(iv) to 1st Quarter 1993 10-Q). /*/(d) Amended and Restated Second Amendment to Reimbursement Agreement (with respect to Parcel B) dated as of September 29, 1988 between B Company and WFC/L (Exhibit 10(v) to 1st Quarter 1993 10-Q). (e) Amendment of Agreement of Lease (with respect to Parcel D) dated as of September 29, 1988 between D Company and WFC/L (Exhibit 10(vi) to 1st Quarter 1993 10-Q). (f) First Amendment to Agreement of Sublease, dated as of September 29, 1988, between WFC/L and Olympia & York Tower B Lease Company (Exhibit 10(v) to 1st Quarter 1989 10-Q). (g) Letter Amendment to the Restated and Amended Partnership Agreement of WFC Tower D Company, dated as of February 26, 1988, between O&Y Tower D Holding Company I (which has succeeded to the interest of O&Y U.S. Development Corp.), O&Y Tower D Holding Company II and HQ North Company, Inc. (formerly known as O&Y Delta Corp.) ("HQ North") (Exhibit 10(vii) to 1st Quarter 1993 10-Q). - ----------------- /*/ Confidential treatment has been requested for portions of this exhibit. (h) Third Amendment to Restated and Amended Partnership Agreement of WFC Tower D Company, dated as of July 12, 1990, among O&Y I, O&Y II and HQ North (Exhibit 10(xxix)(i) to 1990 10-K). /*/(i) Second Amendment, dated as of December 26, 1990, to Agreement of Sublease dated as of September 29, 1988 between WFC/L and Olympia & York Tower B Lease Company (Exhibit 10(xxix)(j) to 1990 10-K). /*/(j) Second Amendment, dated as of January 5, 1994 to Agreement of Sublease (with respect to a portion of Parcel B), dated November 26, 1990 between WFC/L and Nomura Holding America Inc. In addition to the foregoing agreements, various guarantees, security agreements and related documents were granted by or to Olympia & York Developments Limited and by or to O & Y Equity Corp. to or by ML & Co. in connection with the World Financial Center transactions. Exhibits to the documents listed in items (xxvi) and (xxvii) above have been omitted, except where such exhibits are material to the transactions. (11) STATEMENT RE COMPUTATION OF PER SHARE EARNINGS. (12) STATEMENT RE COMPUTATION OF RATIOS (Exhibit 12 to 8-K dated March 9, 1994). (13) 1993 ANNUAL REPORT TO STOCKHOLDERS. (21) SUBSIDIARIES OF THE REGISTRANT. (23) CONSENT OF INDEPENDENT AUDITORS. (b) REPORTS ON FORM 8-K The following Current Reports on Form 8-K were filed by the Registrant during the fourth quarter of 1993 with the Commission under the caption "Item 5. Other Events": (i) Current Report on Form 8-K dated October 7, 1993, for the purpose of filing the form of ML & Co. Indenture between ML & Co. and The Chase Manhattan Bank, N.A., dated as of October 1, 1993. (ii) Current Report on Form 8-K dated October 11, 1993, for the purpose of filing Preliminary Unaudited Earnings Summaries for the three- and nine-month periods ended September 24, 1993. (iii) Current Report on Form 8-K dated October 15, 1993, for the purpose of filing the form of ML & Co.'s 6 1/4% Notes due October 15, 2008 and the opinion of counsel relating hereto. - ---------- /*/ Confidential treatment has been requested for portions of this exhibit. (iv) Current Report on Form 8-K dated October 27, 1993, for the purpose of filing ML & Co.'s Preliminary Unaudited Consolidated Balance Sheet as of September 24, 1993 and statements regarding computation of ratios. (v) Current Report on Form 8-K dated December 22, 1993, for the purpose of filing the form of ML & Co.'s 5% Notes due December 15, 1996 and the opinion of counsel relating thereto. (vi) Current Report on Form 8-K dated December 22, 1993, for the purpose of reporting the settlement of a SEC administrative proceeding. (vii) Current Report on Form 8-K dated December 27, 1993, for the purpose of filing the form of Warrant Agreement between ML & Co. and Citibank, N.A., dated as of December 27, 1993, including a form of the AMEX Hong Kong 30 Index Call Warrants and the opinion of counsel relating thereto. (viii) Current Report on Form 8-K dated December 30, 1993, for the purpose of filing the form of ML & Co.'s European Portfolio Market Index Target-Term Securities due June 30, 1999 and the opinion of counsel relating thereto. INDEMNIFICATION 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: 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. DESCRIPTION OF COMMON STOCK The authorized capital stock of ML & Co. consists of 500,000,000 shares of capital stock, par value $1.33 1/3 per share ("Common Stock"), and 25,000,000 shares of preferred stock, par value $1.00 per share, issuable in series ("Preferred Stock"). As of February 23, 1994, 212,582,125 shares of Common Stock were outstanding. The shares of Common Stock have no preemptive or conversion rights, redemption provisions or sinking fund provisions. The outstanding shares of Common Stock are duly and validly issued, fully paid and nonassessable. Each share is eligible to participate in the Rights under the Rights Plan referenced below, to the extent specified therein, to purchase certain securities upon the occurrence of certain events specified in such Rights Plan. The Board of Directors of ML & Co., without further action by stockholders, has the authority to issue all of the 25,000,000 shares of Preferred Stock, which are currently authorized, from time to time in one or more series and, with respect to each such series, has authority to fix the powers (including voting power), designations, preferences as to dividends and liquidation, and relative, participating, optional or other special rights and the qualifications, limitations or restrictions thereof. As of February 23, 1994, there were 3,000 shares of ML & Co.'s Remarketed Preferred/SM/ Stock issued of which 1,938 were outstanding, which has dividend and liquidation preferences over Common Stock and over Series A Junior Preferred Stock issuable pursuant to a Rights Agreement dated as of December 16, 1987 between ML & Co. and Chemical Bank (successor by merger to Manufacturers Hanover Trust Company), which is set forth herein as Exhibit 3(i)(e). MERRILL LYNCH & CO., INC. AND FINANCIAL STATEMENT SCHEDULES ITEMS (14)(A)(1) AND (14)(A)(2) Schedules not listed are omitted because of the absence of the conditions under which they are required or because the information is included in the consolidated financial statements and notes thereto which are incorporated herein by reference to the Registrant's Annual Report. INDEPENDENT AUDITORS' REPORT To the Board of Directors and Stockholders of Merrill Lynch & Co., Inc.: We have audited the consolidated financial statements of Merrill Lynch & Co., Inc. and subsidiaries (the "Company") as of December 31, 1993 and December 25, 1992 and for each of the three years in the period ended December 31, 1993 and have issued our report thereon dated February 28, 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 Schedules III, IX and X, listed in the Index to Financial Statements and Financial Statement Schedules. 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 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 New York, New York February 28, 1994 SCHEDULE III CONDENSED FINANCIAL INFORMATION OF REGISTRANT --------------------------------------------- MERRILL LYNCH & CO., INC. ------------------------- (PARENT COMPANY ONLY) --------------------- CONDENSED STATEMENTS OF EARNINGS -------------------------------- YEARS ENDED DECEMBER 31, 1993, DECEMBER 25, 1992 AND DECEMBER 27, 1991 ---------------------------------------------------------------------- (DOLLARS IN THOUSANDS) ---------------------- See Notes to Condensed Financial Statements SCHEDULE III CONDENSED FINANCIAL INFORMATION OF REGISTRANT --------------------------------------------- MERRILL LYNCH & CO., INC. ------------------------- (PARENT COMPANY ONLY) --------------------- CONDENSED BALANCE SHEETS ------------------------ DECEMBER 31, 1993 AND DECEMBER 25, 1992 --------------------------------------- (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) ------------------------------------------------ See Notes to Condensed Financial Statements SCHEDULE III CONDENSED FINANCIAL INFORMATION OF REGISTRANT --------------------------------------------- MERRILL LYNCH & CO., INC. ------------------------- (PARENT COMPANY ONLY) --------------------- CONDENSED STATEMENTS OF CASH FLOWS ---------------------------------- YEARS ENDED DECEMBER 31, 1993, DECEMBER 25, 1992 AND DECEMBER 27, 1991 ---------------------------------------------------------------------- (DOLLARS IN THOUSANDS) ---------------------- See Notes to Condensed Financial Statements SCHEDULE III CONDENSED FINANCIAL INFORMATION OF REGISTRANT --------------------------------------------- MERRILL LYNCH & CO., INC. ------------------------- (PARENT COMPANY ONLY) --------------------- NOTES TO CONDENSED FINANCIAL STATEMENTS --------------------------------------- (DOLLARS IN THOUSANDS) ---------------------- CONSOLIDATED FINANCIAL STATEMENTS AND NOTES The condensed financial statements of Merrill Lynch & Co., Inc. (the "Parent Company") should be read in conjunction with the consolidated financial statements of Merrill Lynch & Co., Inc. and subsidiaries (the "Corporation") and the notes thereto incorporated elsewhere herein by reference. Where appropriate, prior years' financial statements have been reclassified to conform to the 1993 presentation. DIVIDENDS RECEIVED FROM AFFILIATES The Parent Company received cash dividends totaling $913,554, $1,067,091, and $1,253,727 from its consolidated subsidiaries in 1993, 1992 and 1991, respectively. LONG-TERM BORROWINGS AND GUARANTEES Long-term borrowings included on pages 56 and 57 of the Annual Report, incorporated elsewhere herein by reference, represent borrowings of the Parent Company. At December 31, 1993, Parent Company borrowings totaling $155,403 were held for purposes of resale by affiliates which also purchased $672,649 and resold $579,561 of such borrowings during the year. In certain instances, the Parent Company guarantees obligations of subsidiaries that may include obligations associated with foreign exchange forward contracts and swap transactions. Substantially all of the Parent Company's fixed-rate long-term borrowings are swapped into floating interest rates. These swaps, generally made with an affiliate which is a dealer in such instruments, are used to hedge interest rate and foreign currency exposures associated with long-term borrowings. At December 31, 1993 and December 25, 1992, the notional amounts of these instruments were $11,904,797 and $10,359,046, respectively. SCHEDULE III CONDENSED FINANCIAL INFORMATION OF REGISTRANT --------------------------------------------- MERRILL LYNCH & CO., INC. ------------------------- (PARENT COMPANY ONLY) --------------------- NOTES TO CONDENSED FINANCIAL STATEMENTS (CONTINUED) --------------------------------------------------- (DOLLARS IN THOUSANDS) ---------------------- ACCOUNTING CHANGES During the fourth quarter of 1993, the Parent Company adopted Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits" ("SFAS No. 112") and SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities". SFAS No. 112 was effective as of the 1993 first quarter. The cumulative effect of this change in accounting principle, reported in the Condensed Statements of Earnings, resulted in a charge of $35,420 (net of applicable income tax benefits), including $31,970 (net of applicable income tax benefits) from equity in earnings of affiliates. SFAS No. 115 was effective as of the last day of the fiscal year. The effect of this change, reported in the Condensed Balance Sheet under Stockholders' Equity, was an increase of $21,355 (net of applicable income taxes), all from equity in affiliates. In 1992, the Parent Company adopted SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" and SFAS No. 109, "Accounting for Income Taxes". These accounting changes were effective as of the 1992 first quarter. The cumulative effect of these changes, reported in the Condensed Statements of Earnings, resulted in a net charge of $58,580 (net of applicable income taxes), including a net charge of $61,083 (net of applicable income taxes)from equity in earnings of affiliates. Reference is made to pages 51 and 52 of the Annual Report for additional information on Accounting Changes. NON-INTEREST EXPENSES - OTHER The Parent Company recorded a non-recurring pretax occupancy charge totaling $103,000 ($59,700 after income taxes) in the 1993 first quarter. The non- recurring charge related to the Corporation's decision not to occupy certain office space at its World Financial Center Headquarters facility and, instead, to offer for sublease the unused space to third parties. An agreement to sublease this space was entered into in December 1993. SCHEDULE III CONDENSED FINANCIAL INFORMATION OF REGISTRANT --------------------------------------------- MERRILL LYNCH & CO., INC. ------------------------- (PARENT COMPANY ONLY) --------------------- NOTES TO CONDENSED FINANCIAL STATEMENTS (CONTINUED) --------------------------------------------------- (DOLLARS IN THOUSANDS) ---------------------- STOCKHOLDERS' EQUITY During 1993 the Corporation's Board of Directors declared a two-for-one common stock split, effected in the form of a 100 percent stock dividend. In addition, stockholders of the Corporation approved an increase in the authorized number of shares of common stock from 200 million to 500 million shares. The Corporation also issued 1,637,314 shares of common stock in connection with certain employee benefit plans. Reference is made to page 55 of the Annual Report for additional information on Stockholders' Equity. SCHEDULE IX MERRILL LYNCH & CO., INC. AND SUBSIDIARIES SHORT-TERM BORROWINGS YEARS ENDED DECEMBER 31, 1993, DECEMBER 25, 1992 AND DECEMBER 27, 1991 (Dollars in Thousands) (1) Computation is based upon the total annual interest cost divided by the average daily loan balances outstanding, multiplied by the number of days in the year. SCHEDULE X MERRILL LYNCH & CO., INC. ------------------------- AND SUBSIDIARIES ---------------- SUPPLEMENTARY INCOME STATEMENT INFORMATION YEARS ENDED DECEMBER 31, 1993, DECEMBER 25, 1992 AND DECEMBER 27, 1991 (Dollars in Thousands) - -------------------------------------------------------------------------------- ...Charged to Costs and Expenses... Item 1993 1992 1991 - -------------------------------------------------------------------------------- Advertising $255,495 $201,200 $164,785 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 30th day of March, 1994. MERRILL LYNCH & CO., INC. By: /s/ Daniel P. Tully --------------------------------- Daniel P. Tully 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 in the capacities indicated on the 30th day of March, 1994. Signature Title --------- ----- /s/ Daniel P. Tully Chairman of the Board, Chief --------------------------- Executive Officer, President (Daniel P. Tully) and Director /s/ Joseph T. Willett Senior Vice President, --------------------------- Chief Financial Officer and (Joseph T. Willett) Controller /s/ William O. Bourke Director --------------------------- (William O. Bourke) /s/ Jill K. Conway Director --------------------------- (Jill K. Conway) /s/ William J. Crowe, Jr. Director ---------------------------- (William J. Crowe, Jr.) /s/ Stephen L. Hammerman Director ---------------------------- (Stephen L. Hammerman) /s/ Robert A. Hanson Director ---------------------------- (Robert A. Hanson) /s/ Earle H. Harbison, Jr. Director ---------------------------- (Earle H. Harbison, Jr.) /s/ George B. Harvey Director --------------------------- (George B. Harvey) /s/ Robert P. Luciano Director ------------------------------ (Robert P. Luciano) /s/ John J. Phelan, Jr. Director ------------------------------ (John J. Phelan, Jr.) /s/ Charles A. Sanders Director ----------------------------- (Charles A. Sanders) /s/ William L. Weiss Director ----------------------------- (William L. Weiss) NOTE CONCERNING EXHIBITS This Annual Report on Form 10-K is accompanied by a 1993 Annual Report to Stockholders containing the required financial statements and most of the financial statement schedules; the balance of the financial statement schedules appear on the foregoing pages through. Merrill Lynch will furnish copies of any other exhibits, for which Merrill Lynch may impose a reasonable charge, to any person upon request addressed to: Gregory T. Russo, Esq. Secretary Merrill Lynch & Co., Inc. 100 Church Street 12th Floor New York 10080-6512 SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 MERRILL LYNCH & CO., INC. 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 Commission file number 1-7182 ended December 31, 1993 INDEX TO EXHIBITS Certain of the following exhibits were previously filed as exhibits to other reports or registration statements filed by the Registrant and are incorporated herein by reference to such reports or registration statements as indicated parenthetically below by the appropriate report reference date or registration statement number. For convenience, Quarterly Reports on Form 10-Q, Annual Reports on Form 10-K, Current Reports on Form 8-K and Registration Statements on Form S-3 are designated herein as "10-Q," "10-K," "8-K" and "S-3," respectively. EXHIBIT - ------- (3) Articles of Incorporation and By-Laws (i)(a) Restated Certificate of Incorporation of ML & Co., as amended April 24, 1987 (Exhibit 3(i) to 10-K for fiscal year ended December 25, 1992 ("1992 10-K")). (b) Certificate of Amendment, dated April 29, 1993, of the Certificate of Incorporation of ML & Co. (Exhibit 3(i) to 10-Q for the quarter ended March 26, 1993 ("1st Quarter 1993 10-Q")). (c) Certificate of Designation dated March 30, 1988 for Remarketed Preferred Stock Series C (Exhibit 3(ii) to 1st Quarter 1993 10-Q). (d) Certificate of Designation dated December 17, 1987 for Series A Junior Preferred Stock (Exhibit 3(f) to S-3 (File No. 33-19975)). (e) Form of Rights Agreement dated as of December 16, 1987 between ML & Co. and Chemical Bank (successor by merger to Manufacturers Hanover Trust Company) (Exhibit 3(iv) to 1992 10-K). (ii) By-Laws of ML & Co., effective as of October 25, 1993 (Exhibit 3(i) to 10-Q for the quarter ended September 24, 1993 ("3rd Quarter 1993 10-Q")). (4) Instruments defining the rights of security holders, including indentures (i) Senior Indenture, dated as of April 1, 1983, as amended and restated, between ML & Co. and Chemical Bank (successor by merger to Manufacturers Hanover Trust Company) (Exhibit 99(c) to ML & Co.'s Registration Statement on Form 8-A dated July 20, 1992. (ii) Supplemental Indenture to the Senior Indenture, dated as of March 15, 1990, between ML & Co., and Chemical Bank (successor by merger to Manufacturers Hanover Trust Company) (Exhibit 99(c) to ML & Co.'s Registration Statement on Form 8-A dated July 20, 1992). E-1 EXHIBIT - ------- (iii) Senior Indenture, dated as of October 1, 1993, between ML & Co. and The Chase Manhattan Bank, N.A. (Exhibit 4 to 8-K dated October 7, 1993). (iv) Form of ML & Co.'s Step-Up Notes due January 26, 2000 (Exhibit 4 to 8-K dated January 26, 1993). (v) Form of ML & Co.'s S&P 500 (Registered Trademark) Market Index Target- Term Securities/SM/ due July 31, 1998 (Exhibit 4 to 8-K dated January 28, 1993). (vi) Form of ML & Co.'s Global Telecommunications Portfolio Market Index Target-Term Securities/SM/ due October 15, 1998 (Exhibit 4 to 8-K dated September 13, 1993). (vii) Form of ML & Co.'s European Portfolio Market Index Target-Term Securities/SM/ due June 30, 1999 (Exhibit 4 to 8-K dated December 30, 1993). (viii) Form of ML & Co.'s Currency Protected Notes due December 31, 1998 (Exhibit 4 to 8-K dated July 7, 1993). (ix) Form of ML & Co.'s Equity Participation Securities with Minimum Return Protection due June 30, 1999 (Exhibit 4 to 8-K dated June 28, 1993). (x) Form of ML & Co.'s Japan Index Equity Participation Securities with Minimum Return Protection due January 31, 2000 (Exhibit 4 to 8-K dated January 27, 1994). (xi) Form of ML & Co.'s Stock Market Annual Reset Term Notes/SM/, Series A, due December 31, 1999 (Exhibit 4 to 8-K dated April 29, 1993). (xii) Form of ML & Co.'s Global Bond Linked Securities due December 31, 1998 (Exhibit 4 to 8-K dated February 22, 1993). (xiii) Form of ML & Co.'s Fixed Rate Medium-Term Notes, Series B (Exhibit 4(xiii) to 3rd Quarter 1993 10-Q). (xiv) Form of ML & Co.'s Floating Rate Medium-Term Notes, Series B (Exhibit 4(xiv) to 3rd Quarter 1993 10-Q). (xv) Form of ML & Co.'s New Peso-Linked Medium-Term Notes, Series B, due February 9, 1995 (Exhibit 4(ppp) to S-3 (File No. 33-52647)). - ---------- "S&P 500" is a registered service mark of Standard & Poor's Inc. E-2 EXHIBIT - ------- (xvi) Form of ML & Co.'s Italian Lira Principal Linked Medium-Term Notes, Series B, due February 3, 1995 (Exhibit 4(lll) to S-3 (File No. 33- 52647)). (xvii) Form of ML & Co.'s Multi-Currency Medium-Term Notes, Series B (Exhibit 4(fff) to S-3 (File No. 33-52647)). (xviii) Form of ML & Co.'s Japanese Yen Swap Rate Linked Medium-Term Notes, Series B (Exhibit 4(mmm) to S-3 (File No. 33-52647)). (xix) Form of ML & Co.'s Nine-Month Renewable Floating Rate Medium-Term Notes, Series B, due October 9, 1996 (Exhibit 4(ix) to 3rd Quarter 1993 10-Q). (xx) Form of ML & Co.'s Three Year Japanese Yen Duration Enhanced Medium- Term Notes, Series B, with JPY Exposure on Gain/Loss due November 1, 1996 (Exhibit 4(xv) to 3rd Quarter 1993 10-Q). (xxi) Form of ML & Co.'s Swap Spread Linked Medium-Term Notes due May 20, 1998 (Exhibit 4(vii) to 2nd Quarter 1993 10-Q). (xxii) Form of ML & Co.'s Inverse Floating Rate Medium-Term Notes due September 15, 1998 (Exhibit 4(vii) to 3rd Quarter 1993 10-Q). (xxiii) Form of ML & Co.'s Inverse Floating Rate Medium-Term Notes, Series B, due October 19, 1998 (Exhibit 4(xii) to 3rd Quarter 1993 10-Q). (xxiv) Form of ML & Co.'s Step-Up Medium-Term Notes due May 20, 2008 (Exhibit 4(viii) to 2nd Quarter 1993 10-Q). (xxv) Form of ML & Co.'s Constant Maturity Treasury Rate Indexed Medium- Term Notes, Series B (Exhibit 4(ccc) to S-3 (File No. 33-52647)). (xxvi) Form of ML & Co.'s Japanese Yen Yield Curve Flattening Medium-Term Notes, Series B (Exhibit 4(ddd) to S-3 (File No. 33-52647)). (xxvii) Form of ML & Co.'s 4 3/4% Notes due June 24, 1996 (Exhibit 4 to 8-K dated June 24, 1993). (xxviii) Form of ML & Co.'s 5% Notes due December 15, 1996 (Exhibit 4 to 8-K dated December 22, 1993). (xxix) Form of ML & Co.'s 6 1/4% Notes due January 15, 2006 (Exhibit 4 to 8- K dated January 20, 1994). (xxx) Form of ML & Co.'s 6 1/4% Notes due October 15, 2008 (Exhibit 4 to 8-K dated October 15, 1993). (xxxi) Form of ML & Co.'s 6 3/8% Notes due September 8, 2006 (Exhibit 4 to 8-K dated September 8, 1993). E-3 EXHIBIT - ------- (xxxii) Form of ML & Co.'s 6 7/8% Notes due March 1, 2003 (Exhibit 4 to 8-K dated March 1, 1993). (xxxiii) Form of ML & Co.'s 7% Notes due April 27, 2008 (Exhibit 4 to 8-K dated April 27, 1993). (xxxiv) Form of ML & Co.'s 7.05% Notes due April 15, 2003 (Exhibit 4 to 8-K dated April 15, 1993). (xxxv) Form of ML & Co.'s Constant Maturity Treasury Indexed Notes due March 24, 1997 (Exhibit 4 to 8-K dated March 24, 1994). (10) Material Contracts Compensation Plans and Arrangements ----------------------------------- (i) ML & Co. 1978 Incentive Equity Purchase Plan, as amended July 27, 1992 (Exhibit 10(iv) to 2nd Quarter 1992 10-Q). (ii) Form of ML & Co. 1994 Deferred Compensation Agreement for a Select Group of Eligible Employees (Exhibit 10(i) to 3rd Quarter 1993 10-Q). (iii) ML & Co. Long-Term Incentive Compensation Plan, as amended as of October 25, 1993. (iv) ML & Co. Equity Capital Accumulation Plan, as amended as of October 25, 1993 (Exhibit 10(iii) to 3rd Quarter 1993 10-Q). (v) ML & Co. Executive Officer Compensation Plan (effective as of January 1, 1994 upon receipt of ML & Co. stockholder approval) (Exhibit 10(i) to ML & Co.'s Proxy Statement for the 1994 Annual Meeting of Stockholders filed in Schedule 14A on March 14, 1994 ("Proxy Statement")). (vi) Written description of Retirement Program for Non-Employee Directors of ML & Co., as amended June 29, 1988 (Page 24 of ML & Co.'s Proxy Statement). (vii) ML & Co. Non-Employee Directors' Equity Plan (Exhibit 10 (iv) to 3rd Quarter 1992 10-Q). E-4 EXHIBIT - ------- (viii) Executive Annuity Agreement, dated July 24, 1991, by and between ML & Co. and Daniel P. Tully (Exhibit 10(iii) to 2nd Quarter 1991 10-Q). (ix) Amendment dated April 30, 1992 to Executive Annuity Agreement, dated July 24, 1991, by and between ML & Co. and Daniel P. Tully (Exhibit 10(ii) to 2nd Quarter 1992 10-Q). (x) Form of Severance Agreement between ML & Co. and certain of its directors and executive officers (Exhibit 10(i) to 3rd Quarter 1992 10-Q). (xi) Form of Indemnification Agreement entered into with all current directors of ML & Co. and to be entered into with all future directors of ML & Co. (xii) Written description of ML & Co.'s incentive compensation programs. (xiii) Written description of ML & Co.'s compensation policy for directors (Page 24 of ML & Co.'s Proxy Statement). (xiv) Merrill Lynch KECALP Growth Investments Limited Partnership 1983 (Exhibit 1(b) to Registration Statement on Form N-2 (File No. 2- 81619)). (xv) Merrill Lynch KECALP L.P. 1984 (Exhibit 1(b) to Registration Statement on Form N-2 (File No. 2-87962)). (xvi) Merrill Lynch KECALP L.P. 1986 (Exhibit 1(b) to Registration Statement on Form N-2 (File No. 2-99800)). (xvii) Merrill Lynch KECALP L.P. 1987 (Exhibit 1(b) to Registration Statement on Form N-2 (File No. 33-11355)). (xviii) Merrill Lynch KECALP L.P. 1989 (Exhibit 1(b) to Registration Statement on Form N-2 (File No. 33-26561)). (xix) Merrill Lynch KECALP L.P. 1991 (Exhibit 1(b) to Registration Statement on Form N-2 (File No. 33-39489)). -- 10(xx) to (xxv) intentionally omitted -- Agreements Relating to the World Financial Center ------------------------------------------------- (xxvi)(a) Reimbursement Agreement between Olympia & York Tower D Company ("D Company") and Merrill Lynch/WFC/L, Inc. ("WFC/L"), dated as of August 24, 1984 (Exhibit 10(i) to 8-K dated January 22, 1990). E-5 EXHIBIT - ------- (b) Reimbursement Agreement between Olympia & York Tower B Company ("B Company") and WFC/L, dated as of August 24, 1984 (Exhibit 10(ii) to 8-K dated January 22, 1990). /*/(c) Agreement of Lease (with respect to Parcel D), dated as of February 26, 1988, between WFC Tower D Company (formerly known as Olympia & York Tower D Company) ("D Company") and WFC/L (Exhibit 10(xxx)(c) to 1992 10-K). /*/(d) Guaranty and Assumption Agreement dated as of February 26, 1988 between ML & Co. and D Company (Exhibit 19(xxx)(d) to 1992 10-K). /*/(e) Agreement of Lease (with respect to Parcel B) dated as of September 29, 1988 between B Company and WFC/L (Exhibit 10(i) to 1st Quarter 1993 10-Q). /*/(f) Guaranty and Assumption Agreement dated as of September 29, 1988 between ML & Co. and B Company (Exhibit 10(ii) to 1st Quarter 1993 10-Q). /*/(g) Restated and Amended Partnership Agreement of D Company, executed on December 24, 1986 (Exhibit 10(xxx)(g) to 1992 10-K). /*/(h) Agreement of Sublease dated as of September 29, 1988 between WFC/L and Olympia & York Tower B Lease Company (Exhibit 10(iii) to 1st Quarter 1993 10-Q). /*/(i) Agreement of Sublease (with respect to a portion of Parcel B) dated November 26, 1990 between WFC/L and Nomura Holding America, Inc. (Exhibit 10(xviii)(i) to Form 8 dated June 6, 1991). /*/(j) Agreement of Sublease (with respect to a portion of Parcel B), dated December 17, 1993 between WFC/L and Deloitte & Touche. (xxvii)(a) First Amendment to Building D Agreement to Lease, Leasehold Improvements Agreement, and Reimbursement Agreement (with respect to Parcel D) dated as of July 12, 1985 between D Company and WFC/L (Exhibit 10(iii) to 8-K dated January 22, 1990). (b) First Amendment to Building B Agreement to Lease, Reimbursement Agreement, Second Amendment to Leasehold Improvements Agreement (with respect to Parcel B) dated as of July 12, 1985 between B Company and WFC/L (Exhibit 10(iv) to 8-K dated January 22, 1990). - ---------- /*/ Confidential treatment has been requested for portions of this exhibit. E-6 EXHIBIT - ------- (c) Second Amendment to Reimbursement Agreement (with respect to Parcel D) dated as of February 26, 1988 between D Company and WFC/L (Exhibit 10(iv) to 10-Q to 1st Quarter 1993 10-Q). /*/(d) Amended and Restated Second Amendment to Reimbursement Agreement (with respect to Parcel B) dated as of September 29, 1988 between B Company and WFC/L (Exhibit 10(v) to 1st Quarter 1993 10-Q). (e) Amendment of Agreement of Lease (with respect to Parcel D) dated as of September 29, 1988 between D Company and WFC/L (Exhibit 10(vi) to 1st Quarter 1993 10-Q). (f) First Amendment to Agreement of Sublease, dated as of September 29, 1988, between WFC/L and Olympia & York Tower B Lease Company (Exhibit 10(v) to 1st Quarter 1989 10-Q). (g) Letter Amendment to the Restated and Amended Partnership Agreement of WFC Tower D Company, dated as of February 26, 1988, between O&Y Tower D Holding Company I (which has succeeded to the interest of O&Y U.S. Development Corp.), O&Y Tower D Holding Company II and HQ North Company, Inc. (formerly known as O&Y Delta Corp.) ("HQ North") (Exhibit 10(vii) to 1st Quarter 1993 10-Q). (h) Third Amendment to Restated and Amended Partnership Agreement of WFC Tower D Company, dated as of July 12, 1990, among O&Y I, O&Y II and HQ North (Exhibit 10(xxix)(i) to 1990 10-K). /*/(i) Second Amendment, dated as of December 26, 1990, to Agreement of Sublease dated as of September 29, 1988 between WFC/L and Olympia & York Tower B Lease Company (Exhibit 10(xxix)(j) to 1990 10-K). /*/(j) Second Amendment, dated as of January 5, 1994 to Agreement of Sublease (with respect to a portion of Parcel B), dated November 26, 1990 between WFC/L and Nomura Holding America Inc. In addition to the foregoing agreements, various guarantees, security agreements and related documents were granted by or to Olympia & York Developments Limited and by or to O & Y Equity Corp. to or by ML & Co. in connection with the World Financial Center transactions. Exhibits to the documents listed in items (xxvi) and (xxvii) above have been omitted, except where such exhibits are material to the transactions. - ---------- /*/ Confidential treatment has been requested for portions of this exhibit. E-7 EXHIBIT - ------- (11) Statement re computation of per share earnings (12) Statement re computation of ratios (Exhibit 12 to 8-K dated March 9, 1994). (21) Subsidiaries of the Registrant (23) Consent of Independent Auditors E-8

872552_1993.txt

872552_1993

1993

872552

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

764044_1993.txt

764044_1993

1993

764044

ITEM 3. LEGAL PROCEEDINGS Questar Pipeline is involved in various legal and regulatory proceedings. While it is not currently possible to predict or determine the outcome of these proceedings, it is the opinion of management that the outcome will not have a material adverse effect on the Company's financial position or liquidity. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS The Company, as the wholly owned subsidiary of a reporting person, is entitled to omit the information requested in this Item. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The Company's outstanding shares of common stock, $1.00 par value, are currently owned by Questar. Information concerning the dividends paid on such stock and the Company's ability to pay dividends is reported in the Statements of Shareholder's Equity and Notes to Financial Statements included in Item 8. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The Company, as the wholly owned subsidiary of a reporting person, is entitled to omit the information requested in this Item. ITEM 7. ITEM 7. MANAGEMENT'S ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS RESULTS OF OPERATIONS Following is a summary of operating income and operating information for the Company's operations: Effective September 1, 1993, Questar Pipeline began operating in accordance with FERC Order No. 636, which restructured the operations of natural gas transmission companies. The order unbundled the sales-for-resale service from the transportation, gathering and storage services. Questar Pipeline eliminated its existing merchant function when it transferred to its affiliate, Mountain Fuel, the rights and obligations of its gas-purchase contracts. These changes affect the comparison of revenues and volumes of the sales-for-resale, transportation, and gathering functions between periods. Order No. 636 requires a greater percentage of the cost of service to be collected through reservation charges. The percentage of costs included in the demand component of rates increased from 66% prior to implementation to about 94% after implementation. Substantially all of Questar Pipeline's transportation capacity has been reserved by firm-transportation customers. Roughly 98% of firm-transportation contracts have remaining terms of at least six years. The customers can release that capacity to third parties when it is not required for their own needs. Mountain Fuel has reserved transportation capacity from Questar Pipeline of approximately 800,000 decatherms per day, or approximately 85% of the total reserved daily transportation capacity. As a result of these changes in the rate structure, Questar Pipeline's transportation throughput volumes do not have a significant impact on short-term operating results. Firm-transportation customers continue to pay the same reservation charges regardless of actual volumes transported. After $1.5 million in revenues are received from interruptible transportation customers, 90% of the remaining revenues from the transportation of gas for interruptible customers is credited back to firm customers. Questar Pipeline is allowed to retain all interruptible-transportation revenues from projects that have not been included in setting existing transportation rates. Total transmission system throughput decreased 2% in 1993 and 1% in 1992. Throughput for Mountain Fuel (including sales for resale and transportation) increased 23% in 1993 and decreased 11% in 1992. The 1993 increase was primarily due to colder weather in Mountain Fuel's service area. Expiring contracts resulted in decreased throughput for other customers. Revenues from gathering services were $20,386,000 in 1993, $17,822,000 in 1992 and $6,572,000 in 1991. The 1993 change was due largely to an 87% increase in gathering volumes for customers other than Mountain Fuel. The 1992 increase was mostly due to a change in rate structure that unbundled gathering from sales for resales. Questar Pipeline began billing separately for gas gathering service provided on sales-for-resale volumes in November 1991. Storage revenues increased 88% in 1993 and 19% in 1992. Customers have subscribed to all available working natural gas storage at Questar Pipeline's Clay Basin storage field. A large portion of the 1993 increase was due to unbundling of storage services for Mountain Fuel that were included with the sales for resale prior to the implementation of Order No. 636. Order No. 636 allows pipelines to receive rate coverage for all prudently incurred transition costs associated with the restructuring. Questar Pipeline incurred capital costs of approximately $9 million in conjunction with Order No. 636 implementation. Most of these costs were for electronic metering and a bulletin board system and are expected to be included in the next general rate case. Natural gas purchases decreased 40% in 1993 and 25% in 1992, consistent with changes in sales-for-resale volumes. Operating and maintenance expenses increased 4% in 1993 after remaining level in 1992. Depreciation expense rose 3% in 1993 and 4% in 1992 due to capital expenditure programs. The Company adopted the provisions of Statement of Financial Accounting Standards (SFAS) No. 106 on Employer's Accounting for Postretirement Benefits Other than Pensions effective January 1, 1993. This statement requires the Company to expense the costs of postretirement benefits, principally health-care benefits, over the service life of employees using an accrual method. The Company is amortizing the transition obligation over a 20-year period. Total cost of postretirement benefits other than pensions under SFAS No. 106 was $1,059,000 in 1993 compared with the costs based on cash payments to retirees plus the prefunding of some benefits totaling $569,000 in 1992 and $560,000 in 1991. The FERC issued an order granting rate recovery methodology for SFAS No. 106 costs to the extent that pipeline companies contribute the amounts to an external trust. Questar Pipeline expects to receive coverage of future SFAS No. 106 costs in its next general rate case and to recover costs in excess of the amounts currently included in rates for the period from 1993 to the rate case filing if the rate case is filed prior to January 1, 1996. A regulatory asset of $487,000 was recorded in anticipation of future rate coverage. Debt expense decreased 5% in 1993 because of lower rates. Debt expense increased 1% in 1992. Interest and other income (expense) in 1993 reflects the impairment of some assets. The effective income tax rate was 35.6% in 1993, 35.4% in 1992, and 32.9% in 1991. Effective January 1, 1993, the federal income tax rate increased 1% to 35%. Questar Pipeline recorded the change in deferred income taxes resulting from the increase in the federal tax rate as an increase to income taxes recoverable from customers since the regulatory commissions have adopted procedures to include underprovided deferred taxes in rates on a systematic basis. The Financial Accounting Standards Board (FASB) has issued SFAS No. 112, Accounting for Postemployment Benefits. This statement requires the Company to recognize the liability for postemployment benefits when employees become eligible for such benefits. Postemployment benefits are paid to former employees after employment has been terminated but before retirement benefits are paid. The Company's principal liability under SFAS No. 112 is a long-term disability program. The Company is required to adopt SFAS No. 112 in the first quarter of 1994 and recognize a cumulative effect of a change in accounting method amounting to approximately $1,256,000. This amount may be recovered from customers through subsequent rate changes and a regulatory asset will be recorded. The effect on ongoing net income is not expected to be significant. LIQUIDITY AND CAPITAL RESOURCES The Company has met the majority of its cash needs for capital expenditures and dividend payments with cash from operations for the last three years. Net cash from operating activities was $68,548,000 in 1993, $41,479,000 in 1992, and $42,850,000 in 1991. Higher income and increased depreciation contributed to the higher 1993 amount. Changes in operating assets and liabilities also provided a source of cash in 1993. As a result of adopting FERC Order No. 636, receivables and payables decreased, and gas stored underground was transferred to Mountain Fuel. Following is a summary of capital expenditures for 1993, and a forecast of 1994 expenditures, which is subject to board of director approval. Questar Pipeline is expanding the capacity of its Clay Basin underground gas storage facility. After expansion, the storage field will have a total capacity of 110 Bcf, including 46 Bcf of working gas storage. Capital expenditures include the purchase of cushion gas. The first phase of the expansion project is expected to be completed in mid-1994. Questar Pipeline is a one-third partner in the TransColorado pipeline project. The Company estimates the total cost of this project at $184 million, with Questar Pipeline's equity investment approximately $18 million. Construction of the pipeline has been delayed pending receipt of final regulatory approvals and completion of contracts with shippers. In March 1994, the Company along with affiliate Universal Resources Corporation, Tenneco Gas and Entech Inc. announced plans to establish the first-ever full-service center for marketing natural gas. The facility, to be called The Western Market Center, will begin operations in 1994. Initial investment by the companies will be $600,000 climbing to $4 million as the center develops. Questar Pipeline's unconsolidated affiliate, Overthrust Pipeline, has borrowings which are due and subject to refinancing July 30, 1994. There are some uncertainties associated with Overthrust caused by bankruptcy proceedings of Overthrust Pipeline firm-shipper, Columbia Gas Transmission Company. Management cannot presently predict the outcome of the bankruptcy proceedings or its impact on the refinancing of Overthrust Pipeline's debt. At December 31, 1993, the Company's 18% investment in Overthrust Pipeline amounted to $3,740,000. The Company funded its 1993 capital expenditures primarily with cash provided from operations. The Company expects to finance the 1994 capital expenditure program with cash provided from operations, borrowing under short-term line-of-credit arrangements and issuing common equity. The Company has a short-term line-of-credit arrangement with a bank under which it may borrow up to $200,000. This line offers interest rates generally below the prime interest rate and is renewable on an annual basis. At December 31, 1993, there were no outstanding short-term bank loans. Questar loans funds to the Company under a short-term borrowing arrangement. Outstanding short-term notes payable to Questar totaled $3,000,000 and had an interest rate of 3.59% at December 31, 1993. Questar Pipeline's capital structure was 42% long-term debt and 58% common shareholder's equity. Two national debt-rating agencies have rated the Company's long-term debt A1 and A+. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The Company's financial statements are included in Part IV, Item 14, herein. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE The Company has not changed its independent auditors or had any disagreements with them concerning accounting matters and financial statement disclosures within the last 24 months. PART III The Company, as the wholly owned subsidiary of a reporting person, is entitled to omit all information requested in Part III (Items 10-13). 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. The financial statements and schedules identified on the List of Financial Statements and Financial Statement Schedules are filed as part of this Report. (a)(3) Exhibits. The following is a list of exhibits required to be filed as a part of this Report in Item 14(c). Exhibit No. Exhibit 2.* 1 Agreement of Transfer among Mountain Fuel Supply Company, Entrada Industries, Inc. and Mountain Fuel Resources, Inc., dated July 1, 1984. (Exhibit No. 2. to Registration Statement No. 2-96102 filed February 27, 1985.) 3.1.* Articles of Incorporation dated January 2, 1975; Articles of Amendment to the Articles of Incorporation dated September 14, 1976; Articles of Amendment to the Articles of Incorporation dated May 25, 1984. (Exhibit No. 3.1. to Registration Statement No. 2-96102 filed February 27, 1985.) 3.2.* Articles of Amendment to the Articles of Incorporation dated March 7, 1988. (Exhibit No. 3.2. to Form 10-K Annual Report for 1987.) 3.3.* Bylaws (as amended on August 11, 1992). (Exhibit No. 3. to Form 10-Q Report for quarter ended June 30, 1992.) 4.1.* Indenture dated June 1, 1990, for 9-7/8% Debentures due 2020, with Morgan Guaranty Trust Company of New York as Trustee. (Exhibit No. 4. to Form 10-Q Report for quarter ended June 30, 1990.) 4.2.* Indenture dated as of June 1, 1991, for 9-3/8% Debentures due June 1, 2021, with Morgan Guaranty Trust Company of New York as Trustee. (Exhibit No. 4. to Form 10-Q Report for quarter ended June 30, 1991.) 10.1.* 1 Overthrust Pipeline Company General Partnership Agreement dated September 20, 1979, as amended and restated as of October 11, 1982, and as amended August 21, 1991, among CIG Overthrust, Inc., Columbia Gulf Transmission Company; Mountain Fuel Resources, Inc.; NGPL-Overthrust Inc.; Northern Overthrust Pipeline Company; and Tennessee Overthrust Gas Company. (Exhibit No. 10.4. to Form 10-K Annual Report for 1985, except that the amendment dated August 21, 1991, is included as Exhibit No. 10.4. to Form 10-K Annual Report for 1992.) 10.2.* 1 Data Processing Services Agreement effective July 1, 1985, between Questar Service Corporation and Mountain Fuel Resources, Inc. (Exhibit No. 10.11. to Form 10-K Annual Report for 1988.) 10.3.* 2 Questar Pipeline Company Annual Management Incentive Plan, as amended February 11, 1992. (Exhibit No. 10.10. to Form 10-K Annual Report for 1991.) 10.4.* Partnership Agreement for the TransColorado Gas Transmission Company effective June 30, 1990, between KN TransColorado, Inc., Westgas TransColorado, Inc., and Questar TransColorado, Inc. (Exhibit No. 2.8. to Form 10-Q Report for quarter ended June 30, 1990.) 10.5. 3 Firm Transportation Service Agreement with Mountain Fuel Supply Company under Rate Schedule T-1 dated August 10, 1993, for a term from November 2, 1993 to June 30, 1999. 10.6. 3 Storage Service Agreement with Mountain Fuel Supply Company under Rate Schedule FSS, for 3.5 Bcf of working gas capacity at Clay Basin, with term a from September 1, 1993, to August 31, 2008. 10.7. 3 Storage Service Agreement with Mountain Fuel Supply Company under Rate Schedules FSS, for 3.5 Bcf of working gas capacity at Clay Basin with a term from September 1, 1993, to August 31, 2013. 22. Subsidiary Information. 25. Power of Attorney. * Exhibits so marked have been filed with the Securities and Exchange Commission as part of the indicated filing and are incorporated herein by reference. 1 The documents listed here have not been formally amended to refer to the Company's current name. They still refer to the Company as Mountain Fuel Resources, Inc. 2 Exhibit so marked is management contract or compensation plan or arrangement. 3 Agreement incorporates specified terms and conditions of Questar Pipeline's FERC Gas Tariff, First Revised Volume No. 1. The tariff provisions are not filed as part of the exhibit, but are available upon request. (b) Questar Pipeline did not file a Current Report on Form 8-K during the last quarter of 1993. ANNUAL REPORT ON FORM 10-K ITEM 8, ITEM 14(a) (1) and (2), and (d) LIST OF FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA FINANCIAL STATEMENT SCHEDULES YEAR ENDED DECEMBER 31, 1993 QUESTAR PIPELINE COMPANY SALT LAKE CITY, UTAH FORM 10-K -- ITEM 14 (a) (1) AND (2) QUESTAR PIPELINE COMPANY LIST OF FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES The following financial statements of Questar Pipeline Company are included in Item 8: Statements of income -- Years ended December 31, 1993, 1992 and 1991 Balance sheets -- December 31, 1993 and 1992 Statements of cash flows -- Years ended December 31, 1993, 1992 and 1991 Statements of shareholder's equity -- Years ended December 31, 1993, 1992 and 1991 Notes to financial statements The following financial statement schedules of Questar Pipeline Company are included in Item 14(d): 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, depletion and amortization of property, plant and equipment 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. Report of Independent Auditors Board of Directors Questar Pipeline Company We have audited the accompanying balance sheets of Questar Pipeline Company as of December 31, 1993 and 1992, and the related statements of income, shareholder's 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 financial position of Questar Pipeline Company 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, 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 H to the financial statements, in 1993 Questar Pipeline changed its method of accounting for postretirement benefits other than pensions. ERNST & YOUNG Salt Lake City, Utah February 11, 1994 QUESTAR PIPELINE COMPANY STATEMENTS OF INCOME See notes to financial statements. QUESTAR PIPELINE COMPANY BALANCE SHEETS ASSETS LIABLILTIES AND SHAREHOLDER'S EQUITY See notes to financial statements. QUESTAR PIPELINE COMPANY STATEMENTS OF SHAREHOLDER'S EQUITY See notes to financial statements. QUESTAR PIPELINE COMPANY STATEMENTS OF CASH FLOWS See notes to financial statements. QUESTAR PIPELINE COMPANY NOTES TO FINANCIAL STATEMENTS Note A - Summary of Accounting Policies Business: Questar Pipeline Company (the Company or Questar Pipeline) is a wholly-owned subsidiary of Questar Corporation (Questar). The Company's primary activities are the transportation, gathering and storage of natural gas. Prior to September 1993, Questar Pipeline was also engaged in the sale for resale of natural gas. Significant accounting policies are presented below. Regulation: The Company is regulated by the Federal Energy Regulatory Commission (FERC) which establishes rates for the transporation and storage of natural gas. The FERC also regulates, among other things, the extension and enlargement or abandonment of jurisdictional natural gas facilities. Regulation is intended to permit the recovery, through rates, of the cost of service including a rate of return on investment. The financial statements are presented in accordance with regulatory requirements. Methods of allocating costs to time periods, in order to match revenues and expenses, may differ from those of nonregulated businesses because of cost allocation methods used in establishing rates. See Note G. Credit Risk: The Company's primary market area is the Rocky Mountain region of the United States. The Company's exposure to credit risk may be impacted by the concentration of customers in this region due to changes in economic or other conditions. The Company's customers include several industries that may be impacted differently by changing conditions. The Company believes that credit-related losses are unlikely. Property, Plant and Equipment: Property, plant and equipment is stated at cost. The provision for depreciation is based upon rates, which will amortize costs of assets over their estimated useful lives. The costs of property, plant and equipment are depreciated in the financial statements using the straight-line method, ranging from 3 to 33% per year and averaging 3.6% in 1993. Investment in Unconsolidated Affiliates: The Company has an 18% partnership interest in the Overthrust Pipeline Company which built and operates the Overthrust Segment of the Trailblazer Pipeline System. The Company is a one-third partner in the TransColorado Gas Transmission Company, which plans to construct a pipeline from the Piceance Basin in Colorado to connections with other pipelines in northern New Mexico. The Company accounts for its investment in these partnerships using the equity method. The Company's investment in these affiliates equals the underlying equity in net assets. Income Taxes: On December 31, 1992, the Company adopted Statement of Financial Accounting Standards (SFAS) No. 109 effective January 1, 1992. The deferred tax balance represents the temporary differences between book and taxable income multiplied by the effective tax rates. These temporary differences relate primarily to depreciation. The Company uses the deferral method to account for investment tax credits as required by regulatory commissions. See Note E. Reacquisition of Debt: Gains and losses on the reacquisition of debt are deferred and amortized as debt expense over the remaining life of the issue in order to match regulatory treatment. Allowance for Funds Used During Construction: The Company capitalizes the cost of capital during the construction period of plant and equipment. This amounted to $856,000 in 1993, $421,000 in 1992, and $371,000 in 1991. Reclassifications: Certain reclassifications were made to the 1992 and 1991 financial statements to conform with the 1993 presentation. Note B - Cash and Short-Term Investments Short-term investments at December 31, 1993, and 1992, valued at cost (approximates market), amounted to $2,406,000 and $3,153,000, respectively. Short-term investments consisted principally of Euro-time deposits and repurchase agreements with maturities of three months or less. Note C - Debt The Company has a short-term line-of-credit arrangement with a bank under which it may borrow up to $200,000. This line offers interest rates generally below the prime interest rate and is renewable on an annual basis. At December 31, 1993, there were no outstanding short-term bank loans. Questar loans funds to the Company under a short-term borrowing arrangement. Outstanding short-term notes payable to Questar totaled $3,000,000 and had an interest rate of 3.59% at December 31, 1993. The details of long-term debt at December 31, were as follows: There are no maturities of long-term debt for the five years following December 31, 1993. Cash paid for interest on debt was $13,018,000 in 1993, $13,573,000 in 1992, and $15,173,000 in 1991. Note D - Estimated Fair Values of Financial Instruments The carrying amounts and estimated fair values of the Company's financial instruments at December 31, were as follows: The Company used the following methods and assumptions in estimating fair values: (1) Cash and short-term investments - the carrying amount approximates fair value; (2) Notes payable to affiliates - the carrying amount approximates fair value; (3) Long-term debt - the fair value of long-term debt is based on quoted market prices. Note E - Income Taxes The Company's operations are consolidated with those of Questar and its subsidiaries for income tax purposes. The income tax arrangement between the Company and Questar provides that amounts paid to or received from Questar are substantially the same as would be paid or received by the Company if it filed a separate return except that the Company is paid for tax benefits used in the consolidated tax return even if such benefits would not have been usable had the Company filed a separate return. Effective January 1, 1992, the Company changed its method of accounting for income taxes from the deferred method to the liability method required by SFAS No. 109, Accounting for Income Taxes. The Company did not restate prior years' financial statements. The application of the new rules did not have a significant impact on the 1992 income before cumulative effect. The Company records cumulative increases in deferred taxes as income taxes recoverable from customers. The Company has adopted procedures with the FERC to include under-provided deferred taxes in customer rates on a systematic basis. The amounts of income taxes recoverable from customers was higher in 1993 due to an increase in the federal income tax rate. The components of income taxes charged to income for years ended December 31, were as follows: The difference between income tax expense and the tax computed by applying the statutory federal income tax rate to income from continuing operations before income taxes is explained as follows: Significant components of the Company's deferred tax liabilities and assets at December 31, were as follows: Cash paid for income taxes was $12,404,000 in 1993, $7,146,000 in 1992, and $12,203,000 in 1991. Note F - Litigation and Commitments There are various legal proceedings against the Company. While it is not currently possible to predict or determine the outcome of these proceedings, it is the opinion of management that the outcome will not have a material adverse effect on the Company's results of operations, financial position or liquidity. Note G - Rate Matters On September 1, 1993, Questar Pipeline began operating in compliance with FERC Order No. 636. The order unbundled the sale-for-resale service from the transportation, gathering and storage services provided by natural gas pipelines. Questar Pipeline eliminated its merchant function. That activity was assumed by Mountain Fuel along with the gas-purchase contracts. In its order approving Questar Pipeline's Order No. 636 implementation plan, the FERC accepted Questar Pipeline's plan for the assignment of gas-purchase contracts to Mountain Fuel. Order No. 636 requires a greater percentage of the cost of service to be collected through demand charges. The percentage of costs included in the demand component of rates increased from 66% prior to implementation to about 94% after implementation. The majority of Questar Pipeline's transportation capacity has been reserved by firm transportation customers, which, under Order No. 636, can release that capacity to third parties when it is not required for their own needs. After $1.5 million of revenues are received from interruptible transportation customers, 90% of the remaining revenues from the transportation of gas for interruptible customers is credited back to firm customers. Questar Pipeline is allowed to retain all interruptible transportation revenues on projects that have not been included in the transportation rate case. Note H - Employment Benefits Substantially all Company employees are covered by Questar's defined benefit pension plan. Benefits are generally based on years of service and the employee's 36-month period of highest earnings during the ten years preceding retirement. It is Questar's policy to make contributions to the plan at least sufficient to meet the minimum funding requirements of applicable laws and regulations. Plan assets consist principally of equity securities and corporate and U.S. government debt obligations. Pension cost was $1,372,000 in 1993, $1,259,000 in 1992, and $1,137,000 in 1991. The Company's portion of plan assets and benefit obligations is not determinable because plan assets are not segregated or restricted to meet the Company's pension obligations. If the Company were to withdraw from the pension plan, the pension obligation for the Company's employees would be retained by the pension plan. At December 31, 1993, Questar's fair value of plan assets exceeded the accumulated benefit obligation. The Company participates in Questar's Employee Investment Plan, which allows the majority of employees to purchase Questar common stock or other investments through payroll deductions. The Company makes contributions to the plan of approximately 75% of the employees' purchases. The Company's expense and contribution to the plan was $483,000 in 1993, $522,000 in 1992 and $605,000 in 1991. The Company participates in a Questar program than pays a portion of the health-care costs and all the life insurance costs for retired employees. Effective January 1, 1992, this program was changed for employees retiring after January 1, 1993, to link the health-care benefit to years of service and to limit Questar's monthly health-care contribution per individual to 170% of the 1992 contribution. Questar's policy is to fund amounts allowable for tax deduction under the Internal Revenue Code. Plan assets consist of equity securities, corporate and U.S. government debt obligations, and insurance company general accounts. The Company adopted the provisions of SFAS No. 106 on Employer's Accounting for Postretirement Benefits Other than Pensions effective January 1, 1993. This statement requires the Company to expense the costs of postretirement benefits, principally health-care benefits, over the service life of employees using an accrual method. Questar Pipeline is amortizing the transition obligation over a 20-year period. The Company's cost of postretirement benefits other than pensions under SFAS No. 106 was $1,059,000 in 1993 compared with the costs based on cash payments to retirees plus the prefunding of some benefits totaling $569,000 in 1992 and $560,000 in 1991. Of the $1,059,000 recognized in 1993, $487,000 was recorded as a regulatory asset to be recovered in a future rate proceeding. The impact of SFAS No. 106 on the Company's future net income will be mitigated by recovery of these costs from customers. The FERC issued an order granting rate recovery methodology for SFAS No. 106 costs to the extent that the Company contributes the amounts to an external trust. The Company's portion of plan assets and benefit obligations related to postretirement medical and life insurance benefits is not determinable because the plan assets are not segregated or restricted to meet the Company's obligations. The Financial Accounting Standards Board (FASB) has issued SFAS No. 112, Accounting for Postemployment Benefits. This statement requires the Company to recognize the liability for postemployment benefits when employees become eligible for such benefits. Postemployment benefits are paid to former employees after employment has been terminated but before retirement benefits are paid. The Company's principal liability under SFAS No. 112 is a long-term disability program. The Company is required to adopt SFAS No. 112 in the first quarter of 1994 and recognize a cumulative effect of a change in accounting method amounting to approximately $1,256,000. The Company plans to record a regulatory asset for the entire amount in anticipation of future rate recovery. The effect on ongoing net income is not expected to be significant. Note I - Related Party Transactions The Company receives a substantial portion of its revenues from Mountain Fuel. Revenues received from Mountain Fuel amounted to $124,807,000 or 73% of the total in 1993, $161,900,000 or 79% in 1992, and $192,748,000 or 84% in 1991. The Company also received revenues from other affiliated companies totaling $5,072,000 in 1993, $6,730,000 in 1992, and $8,020,000 in 1991. Natural gas purchases include $4,844,000 in 1993, $11,237,000 in 1992, and $17,337,000 in 1991 from affiliated companies. The Company did not purchase gas for resale after August 31, 1993. Questar performs certain administrative functions for the Company. The Company was charged for its allocated portion of these services which totaled $3,408,000 in 1993, $3,260,000 in 1992, and $3,316,000 in 1991. These costs are included in operating and maintenance expenses and are allocated based on each company's proportional share of revenues, net of gas costs; property, plant and equipment; and payroll. Management believes that the allocation method is reasonable. The Company terminated an operating service agreement on July 1, 1993, with Wexpro Company (Wexpro), a wholly-owned subsidiary of Questar. Under that agreement Wexpro operated certain gathering, compressor, measurement and other production-related facilities owned by the Company. Those functions were subsequently assumed by Company employees. The Company reimbursed Wexpro's expenses with respect to such services and paid a fee equal to 15% of such expenses. The Company paid Wexpro $3,443,000 in 1993, $5,954,000 in 1992, and $5,328,000 in 1991 for such services. Questar Service Corporation is an affiliated company that provides data processing and communication services to Questar Pipeline. The Company paid Questar Service $6,607,000 in 1993, $5,979,000 in 1992 and $6,691,000 in 1991. The Company received interest income from affiliated companies of $327,000 in 1993, $740,000 in 1992, and $1,510,000 in 1991. The Company had debt expense to affiliated companies of $21,000 in 1993, $39,000 in 1992, and $18,000 in 1991. SCHEDULE II - AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS, AND EMPLOYEES OTHER THAN RELATED PARTIES QUESTAR PIPELINE COMPANY SCHEDULE V - PROPERTY , PLANT AND EQUIPMENT QUESTAR PIPELINE COMPANY NOTE A - Other changes include the transfer of a portion of current gas stored underground to cushion gas stored underground in 1993. Remaining other changes consist of transfers to or from affiliated companies. SCHEDULE VI- ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT QUESTAR PIPELINE COMPANY NOTE A - Other changes consist of transfers to or from affiliated companies. SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION QUESTAR PIPELINE COMPANY The company has no depreciation and amortization of intangible assets, advertising costs, or royalties. 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 28th day of March, 1994. QUESTAR PIPELINE COMPANY (Registrant) By /s/ A. J. Marushack A. J. Marushack President & 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. /s/ A. J. Marushack President & Chief Executive Officer; A. J. Marushack Director (Principal Executive Officer) /s/ W. F. Edwards Vice President & Chief Financial W. F. Edwards Officer (Principal Financial Officer) /s/ R. P. Ord Controller & Assistant Treasurer R. P. Ord (Principal Accounting Officer) *R. D. Cash Chairman of the Board; Director *W. F. Edwards Director *U. Edwin Garrison Director *A. J. Marushack Director *Neal A. Maxwell Director *Mary Mead Director March 28, 1994 *By /s/ A. J. Marushack Date A. J. Marushack, Attorney in Fact EXHIBIT INDEX Sequential Exhibit Page Number Number Exhibit 2.* 1 Agreement of Transfer among Mountain Fuel Supply Company, Entrada Industries, Inc. and Mountain Fuel Resources, Inc., dated July 1, 1984. (Exhibit No. 2. to Registration Statement No. 2-96102 filed February 27, 1985.) 3.1.* Articles of Incorporation dated January 2, 1975; Articles of Amendment to the Articles of Incorporation dated September 14, 1976; Articles of Amendment to the Articles of Incorporation dated May 25, 1984. (Exhibit No. 3.1. to Registration Statement No. 2-96102 filed February 27, 1985.) 3.2.* Articles of Amendment to the Articles of Incorporation dated March 7, 1988. (Exhibit No. 3.2. to Form 10-K Annual Report for 1987.) 3.3.* Bylaws (as amended on August 11, 1992). (Exhibit No. 3. to Form 10-Q Report for quarter ended June 30, 1992.) 4.1.* Indenture dated June 1, 1990, for 9- 7/8% Debentures due 2020, with Morgan Guaranty Trust Company of New York as Trustee. (Exhibit No. 4. to Form 10-Q Report for quarter ended June 30, 1990.) 4.2.* Indenture dated as of June 1, 1991, for 9-3/8% Debentures due June 1, 2021, with Morgan Guaranty Trust Company of New York as Trustee. (Exhibit No. 4. to Form 10-Q Report for quarter ended June 30, 1991.) 10.1.* 1 Overthrust Pipeline Company General Partnership Agreement dated September 20, 1979, as amended and restated as of October 11, 1982, and as amended August 21, 1991, among CIG Overthrust, Inc., Columbia Gulf Transmission Company; Mountain Fuel Resources, Inc.; NGPL-Overthrust Inc.; Northern Overthrust Pipeline Company; and Tennessee Overthrust Gas Company. (Exhibit No. 10.4. to Form 10-K Annual Report for 1985, except that the amendment dated August 21, 1991, is included as Exhibit No. 10.4. to Form 10-K Annual Report for 1992.) 10.2.* 1 Data Processing Services Agreement effective July 1, 1985, between Questar Service Corporation and Mountain Fuel Resources, Inc. (Exhibit No. 10.11. to Form 10-K Annual Report for 1988.) 10.3.* 2 Questar Pipeline Company Annual Management Incentive Plan, as amended February 11, 1992. (Exhibit No. 10.10. to Form 10-K Annual Report for 1991.) 10.4.* Partnership Agreement for the TransColorado Gas Transmission Company effective June 30, 1990, between KN TransColorado, Inc., Westgas TransColorado, Inc., and Questar TransColorado, Inc. (Exhibit No. 2.8. to Form 10-Q Report for quarter ended June 30, 1990.) 10.5. 3 Firm Transportation Service Agreement with Mountain Fuel Supply Company under Rate Schedule T-1 dated August 10, 1993, for a term from November 2, 1993 to June 30, 1999. 10.6. 3 Storage Service Agreement with Mountain Fuel Supply Company under Rate Schedule FSS, for 3.5 Bcf of working gas capacity at Clay Basin, with term a from September 1, 1993, to August 31, 2008. 10.7. 3 Storage Service Agreement with Mountain Fuel Supply Company under Rate Schedules FSS, for 3.5 Bcf of working gas capacity at Clay Basin with a term from September 1, 1993, to August 31, 2013. 22. Subsidiary Information. 25. Power of Attorney. * Exhibits so marked have been filed with the Securities and Exchange Commission as part of the indicated filing and are incorporated herein by reference. 1 The documents listed here have not been formally amended to refer to the Company's current name. They still refer to the Company as Mountain Fuel Resources, Inc. 2 Exhibit so marked is management contract or compensation plan or arrangement. 3 Agreement incorporates specified terms and conditions of Questar Pipeline's FERC Gas Tariff, First Revised Volume No. 1. The tariff provisions are not filed as part of the exhibit, but are available upon request.

732716_1993.txt

732716_1993

1993

732716

Item 1. Business. GENERAL Pacific Telesis Group (the "Corporation") was incorporated in 1983 under the laws of the State of Nevada and has its principal executive offices at 130 Kearny Street, San Francisco, California 94108 (telephone number (415) 394-3000). The Corporation is one of seven regional holding companies ("RHCs") formed in connection with the 1984 divestiture by American Telephone and Telegraph Company ("AT&T") of its 22 wholly owned operating telephone companies ("BOCs") pursuant to a consent decree settling antitrust litigation (the "Consent Decree") approved by the United States District Court for the District of Columbia (the "Court"), which has retained jurisdiction over the interpreta- tion and enforcement of the Consent Decree. Under the terms of the Consent Decree, all territory served by the BOCs was divided into geographical areas called "Local Access and Transport Areas" ("LATAs", also referred to as "service areas"). The Consent Decree generally prohibits BOCs and their affiliates* from providing communications services that cross service area boundaries; however, the networks of the BOCs interconnect with carriers that provide such services (commonly referred to as "interexchange carriers"). The Corporation includes a holding company, Pacific Telesis; two BOCs, Pacific Bell and Nevada Bell (the "Telephone Companies"); and certain diversified subsidiaries, all described more fully below. The holding company provides financial, strategic planning, legal and general administrative functions on its own behalf and on behalf of its subsidiaries. THE TELEPHONE COMPANIES AND LINE OF BUSINESS RESTRICTIONS Pacific Bell and its wholly-owned subsidiaries, Pacific Bell Directory and Pacific Bell Information Services, and Nevada Bell provide a variety of communications services in California and Nevada. These services include: (1) dial tone and usage services, including local service (both exchange and private line), message toll services within a service area, Wide Area Toll Service (WATS)/800 services, Centrex service (a central office-based switching service) and various special and custom calling services; (2) exchange access to interexchange carriers and information service providers for the origination and termination of switched and non-switched (private line) voice and data traffic; (3) billing services for interexchange carriers and information service providers; (4) various operator services; (5) installation and maintenance of customer premises wiring; (6) public communications services (including service for coin telephones); (7) directory publishing; and (8) selected information services, such as voice mail and electronic mail (See also "Pacific Bell Information Services," below). Efforts to develop additional advanced services are described below. - ------------------- * The terms of the Consent Decree, with certain exceptions, apply generally to all the BOCs and their affiliates. The Consent Decree provides that the RHCs shall not engage in certain lines of business. The principal restrictions initially prohibited the provision of interexchange telecommunications, information services and telecommunications equipment. As described below, the information services prohibition was lifted in 1991. The telecommunications businesses permitted by the Consent Decree include the provision of exchange telecommunications* and exchange access services, customer premises equipment ("CPE") and printed directory advertising. The RHCs are prohibited from manufacturing telecommunications equipment and CPE. On December 3, 1987, the Court interpreted the manufacturing restriction to mean that the RHCs are prohibited from designing and developing telecommunications equipment and CPE as well as from fabricating them. The Consent Decree provides that the Court may waive the line of business restrictions (i.e., grant a "Waiver") upon a showing that there is no substantial possibility that the RHCs could use their monopoly power to impede competition in the market they seek to enter. The Court has placed certain conditions on the Waivers it has granted and may do so again on future Waivers. In May 1993, the U.S. Court of Appeals for the District of Columbia affirmed the Court's removal of the ban on the provision of information services by the Corporation. The removal of this ban in July 1991 allowed the Telephone Companies to offer a variety of new information services, subject to regulatory approvals, such as enhanced voice mail and electronic yellow pages. In November 1993, the U.S. Supreme Court declined to review the Appeals Court decision. In November 1993, legislation was introduced in Congress that would simplify the procedures under which BOCs seek relief from provisions of the Consent Decree that prohibit the Telephone Companies from manufacturing telephone equipment or providing long-distance service. The legislation would set conditions and establish waiting periods of up to five years before the RHCs could seek authority to enter all aspects of these businesses. One of the bills would also impose stringent separate subsidiary requirements on RHC electronic publishing ventures. SPIN-OFF OF THE CORPORATION'S WIRELESS OPERATIONS In December 1992, Pacific Telesis' Board of Directors approved a plan to spin off the Corporation's wireless operations. In connection with the separation, AirTouch Communications ("AirTouch"), formerly PacTel Corporation, completed an initial public offering of common stock in December 1993. The Corporation will spin off AirTouch and its domestic and international wireless operations as a separate entity. These wireless operations principally include cellular, paging, radiolocation and other wireless telecommunications services in the United States, Europe and Asia. (See "AirTouch Communications," below.) The Corporation will continue to own the Telephone Companies, Pacific Bell's directory publishing and information services subsidiaries, and several smaller diversified entities, including real estate assets. - ------------------- * "Exchange telecommunications" includes toll or long-distance services within a service area as well as local service. In February 1993, the California Public Utilities Commission ("CPUC") instituted an investigation of the proposed spin-off of the Corporation's wireless businesses for the purpose of assessing any effects it might have on telephone customers of Pacific Bell and regulated cellular and paging firms in California. On November 2, 1993, the CPUC adopted a decision permitting the spin-off to proceed. The CPUC further ordered a refund by the Corporation of approximately $50 million (including interest) of cellular pre-operational and development expenses. Further proceedings will determine how the refund will be disbursed. The CPUC decision was effective immediately. The Public Services Commission of Nevada (the "PSCN") approved the spin-off in August 1993. Two parties to the CPUC investigation filed Applications for Rehearing by the CPUC of its treatment of the claims for compensation owed to Pacific Bell customers. The CPUC's Division of Ratepayer Advocates filed a Petition for Modification of the CPUC's decision. In March 1994 the CPUC denied these requests. One of these parties further stated that if it were unsuccessful with the CPUC it would seek review by the California Supreme Court. In the event the California Supreme Court were to review and reverse the CPUC's decision, no assurance can be given that the CPUC might not reach a new decision materially less favorable to the Corporation or AirTouch with respect to the compensation issues. In addition, a substantial period of time could elapse before final resolution of these issues should a review be granted. The Corporation believes that the California Supreme Court will deny a review. On March 10, 1994, the Board gave final approval to the spinoff of AirTouch. The spin-off will be effected April 1, 1994. The remaining 86 percent of AirTouch's common shares currently owned by the Corporation will be distributed to the Corporation's shareowners of record on March 21, 1994 in proportion to their shares in the Corporation. The distribution has been ruled as qualifying as a tax-free transaction to shareowners by the Internal Revenue Service. The distribution will be accounted for as a stock dividend by the Corporation when made. Upon the spin-off of AirTouch, the Corporation and AirTouch will have no common directors, officers or employees. Philip J. Quigley will become Chairman and Chief Executive Officer of the Corporation and will remain as President and Chief Executive Officer of Pacific Bell. Sam Ginn, currently Chairman and Chief Executive Officer of the Corporation, will leave Pacific Telesis Group but will continue as Chairman and Chief Executive Officer of AirTouch. C. Lee Cox, currently Group President of the PacTel Companies, will also leave Pacific Telesis Group and will continue as President and Chief Operating Officer of AirTouch. The Corporation and AirTouch have entered into a separation agreement that provides for the disengagement of the two corporations' affairs in an orderly manner and their complete separation after the spin-off. For example, the agreement provides for the allocation of procedural and financial responsibility with respect to contingent liabilities that become certain after the spin-off and for the exchange of information necessary for governmental reporting requirements. Pacific Bell Directory Pacific Bell Directory ("Directory") is a publisher of the Pacific Bell SMART Yellow Pages(R). Directory is the oldest and largest publisher of directory information products in California and is among the largest Yellow Pages publishers in the United States. Directory has enhanced the content, organization and visual appeal of the local information in its directories and improved other features to make the SMART Yellow Pages even more helpful and easier to use. Most recently, a "Government Officials" section was added that contains the names, address, telephone numbers and photographs of elected officials, along with a map identifying congressional and state representative boundaries. An audiotext feature called "Local Talk" is planned for 60 markets statewide by the end of 1994. In addition, government, business and residential listings have been divided into separate sections in the White Pages for faster accessibility, with colored tabs on the outer edges of the pages identifying each section. As part of its ongoing small business advocacy efforts, Directory also produces Small Business Success in partnership with the U.S. Small Business Administration. Small Business Success is an annual publication now in its seventh year that addresses subjects of critical importance to entrepreneurs. Pacific Bell Information Services Effective January 1, 1993, Pacific Bell transferred its Information Services Group to Pacific Bell Information Services ("PBIS"). PBIS provides business and residential voice mail and other selected information services. Current products include The Message Center for home use, Pacific Bell Voice Mail for businesses, and Pacific Bell Call Management, a service that routes incoming business calls and connects computer data bases to answer routine customer questions. (See page of 1994 Proxy Statement* for discussion of CPUC proceeding concerning PBIS.) - ------------------- * All references herein to the 1994 Proxy Statement shall be deemed to incorporate the specific pages or notes into the section of this Form 10-K where the reference appears. OTHER SUBSIDIARIES AND TELESIS FOUNDATION PacTel Finance, formerly a subsidiary of AirTouch, is now directly owned by the Corporation. Among subsidiaries held by PacTel Finance are PacTel Cable and CalFront Associates (formerly PacTel Properties). PacTel Cable has sold all of its wholly-owned subsidiaries which owned cable franchises in the United Kingdom. The final sales were made to a subsidiary of Jones InterCable, Inc. in January 1994. PacTel Cable retains options to purchase from TC Cable, Inc. up to a 75 percent interest in Prime Cable of Chicago, Inc., which acquired certain Chicago cable television properties in June 1990 for $213 million. Under the terms of the current agreements, PacTel Cable would be required to exercise its minority option (for 18.8 percent ownership) if it receives the necessary regulatory approvals, including a Waiver to provide interLATA services. If PacTel Cable does not obtain the necessary regulatory approvals, it will be prohibited from exercising this option but it has guaranteed TC Cable a minimum price for a sale to another party. (See discussion of related loan guarantees on page in Note L to the Consolidated Financial Statements contained in the 1994 Proxy Statement.) PacTel Cable's majority option (for 56.2 percent ownership) is exercisable at its sole discretion. CalFront Associates holds a portfolio of real estate assets which the Corporation plans to sell over the next three to five years. As of December 31, 1993, the balance of the reserves taken for real estate losses totaled $338 million. (See discussion of restructuring reserve on page of the 1994 Proxy Statement.) PacTel Capital Resources ("PTCR") was formed to provide funding for the former PacTel Corporation and its subsidiaries, primarily through the sale of debt securities in the United States and other markets. PTCR has issued commercial paper and medium-term notes guaranteed by the Corporation from time to time since 1987. In the future, PTCR may also provide funding or issue guarantees and other forms of financial support for its other affiliates. PacTel Capital Funding ("PTCF") was formed to provide funding for the former PacTel Corporation and its subsidiaries and third parties engaged in business with those companies, primarily through the nonpublic sale of debt securities. In the future, PTCF may provide funding or issue guarantees and other forms of financial support for its other affiliates and third parties. PacTel Re Insurance Company, Inc. reinsures policies of outside insurance companies covering workers' compensation, general liability and auto liability exposures of the Corporation and its subsidiaries and affiliates. The subsidiary also issues policies of property insurance directly to the Corporation's subsidiaries and engages in property reinsurance transactions in insurance markets worldwide. Pacific Telesis Group - Washington represents the Corporation's interests in Washington, D.C. before the three branches of the federal government. It also acts as a liaison with other telecommunications companies, trade associations and a wide variety of interest groups. Telesis Foundation, a private foundation organized under section 501(c)(3) of the Internal Revenue Code, makes grants in the areas of education, health and welfare, cultural, community and civic activities. Telesis Foundation is a newly formed foundation, replacing Pacific Telesis Foundation. Pacific Telesis Foundation is being terminated and its assets distributed to two new foundations, Telesis Foundation and PacTel Foundation. As of December 31, 1993, Pacific Telesis Foundation had total assets with an estimated market value of $68 million. RESEARCH AND DEVELOPMENT Bell Communications Research, Inc. ("Bellcore") furnishes the BOCs, including the Telephone Companies, with technical and consulting assistance to support their provision of exchange telecommunications and exchange access services. Each of the other six RHCs or their BOCs, including Pacific Bell, holds one-seventh of the voting stock of Bellcore, which serves as a central point of contact for coordinating the efforts of the RHCs in meeting the national security and emergency preparedness requirements of the federal government. In addition, the Corporation conducts research and development through Pacific Bell and through Telesis Technologies Laboratory, Inc., a wholly-owned subsidiary of the Corporation. The Corporation, excluding spin-off operations, spent approximately $30 million, $30 million and $31 million in 1993, 1992 and 1991, respectively, on research and development activities. FINANCING ACTIVITIES OF THE CORPORATION In 1993, the Corporation redeemed $2.62 billion and issued $2.65 billion of long-term debt. As of December 31, 1993, Pacific Bell had remaining authority to issue up to $1.25 billion in long- and intermediate-term debt pursuant to a CPUC order issued in September 1993. As of December 31, 1993, Pacific Bell had authority to issue up to $650 million in long- and intermediate-term debt through a shelf registration statement on file with the Securities and Exchange Commission (the "SEC"). Proceeds from debt issuances in 1993 and future issuances will be used to refund maturing debt and to refinance other debt issues. Effective April 23, 1993, AT&T redeemed $300 million in long- term debt for which Pacific Bell was a secondary obligor. This debt was assumed by AT&T at divestiture. Pursuant to a shelf registration on file with the SEC, PTCR has authority to issue up to $192 million of medium-term notes, guaranteed by the Corporation as to payment of principal and interest. The following are bond and commercial paper ratings for the Corporation and its subsidiaries: | Long- and |Intermediate-Term Commercial Paper | Debt - ----------------------------------------------------------|----------------- Pacific | Telesis Pacific | Pacific Group PTCR Bell | PTCR Bell - ----------------------------------------------------------|----------------- Moody's Investors Service, Inc. Prime-1 Prime-1 Prime-1 | A1 Aa3 Standard & Poor's Corporation A-1 A-1 A-1+ | A+ AA- Duff and Phelps, Inc. - - Duff 1+ | - AA - ----------------------------------------------------------------------------- Pacific Bell and PTCR are the only subsidiaries of the Corporation with any long- or intermediate-term publicly held debt issues outstanding as of December 31, 1993. The holding company itself has no publicly held debt issues outstanding. No recapitalization of Pacific Bell is planned as a result of the Corporation's spin-off of AirTouch. After the announcement of the Board's decision in December 1992 to spin off AirTouch and its wireless operations, Duff and Phelps, Inc. ("D&P") reaffirmed its rating of Pacific Bell's debt. Standard & Poor's ("S&P") affirmed its rating on the outstanding long-term debt of PTCR and Pacific Bell, and on the commercial paper programs of Pacific Bell, PTCR and the Corporation. S&P also revised its ratings outlook for the long-term debt of PTCR and Pacific Bell from "stable" to "positive." Additionally, Moody's stated that the debt ratings of all three entities are unlikely to be affected by the spin-off. The Corporation expects that each of the separate businesses will continue upon separation to have access to the public and private markets for debt, although the terms are likely to be less favorable for AirTouch. S&P has assigned an implied senior debt rating of BBB+ to the post-spin AirTouch. AirTouch has been capitalized through an initial public offering of stock in December 1993. The ratings noted above reflect the views of the rating agencies; they should be evaluated independently of one another and are not recommendations to buy, sell or hold the securities of the Corporation. There is no assurance that such ratings will continue for any period of time or that they will not be changed or withdrawn. Additional discussion of the Corporation's financing activities is on pages through and in Notes H and I to the 1993 Consolidated Financial Statements contained in the 1994 Proxy Statement. PRINCIPAL SERVICES Due to the impending spin-off, the operations of AirTouch have been classified separately within the Corporation's financial statements as "spin-off operations" and are excluded from the amounts of revenues and expenses of the Corporation's "continuing operations." Under this presentation, the Telephone Companies accounted for almost all of the Corporation's operating revenues in 1993. For these reasons, the following discussion focuses on selected operating information for the Telephone Companies. Additional information regarding revenues, operating profit or loss and assets of the Corporation, relating primarily to the Telephone Companies, is incorporated from the 1994 Proxy Statement by reference in "Item 8. Financial Statements and Supplementary Data" below. Significant components of Pacific Telesis Group's operating revenues are depicted in the chart below: % of Total Operating Revenues* ------------------------------ Revenues by Major Category 1993 1992 1991 - --------------------------------------------------------------------------- Local Service Recurring .............................. 22% 21% 20% Other Local ............................ 16% 16% 16% Network Access Carrier Access Charges ................. 18% 18% 18% End User & Other ....................... 7% 7% 7% Toll Service** Message Toll Service ................... 20% 19% 19% Other .................................. 2% 4% 5% Other Service Revenues Directory Advertising .................. 11% 11% 11% Other .................................. 4% 4% 4% ------ ------ ------ TOTAL ...................................... 100% 100% 100% =========================================================================== * Excludes revenues of spin-off operations. ** Percentages for 1993 are not comparable to prior years' percentages due to reclassifications in the current presentation. The percentages of Pacific Telesis Group's operating revenues attributable to interstate and intrastate telephone operations are displayed below: % of Total Operating Revenues* ------------------------------ 1993 1992 1991 - --------------------------------------------------------------------------- Interstate telephone operations ............ 18% 18% 17% Intrastate telephone operations ............ 82% 82% 83% ------ ------ ------ TOTAL ...................................... 100% 100% 100% =========================================================================== * Excludes revenues of spin-off operations. As of December 31, 1993 about 33 percent of the network access lines of Pacific Bell were in Los Angeles and vicinity and about 25 percent were in San Francisco and vicinity. On that date, about 64 percent of Nevada Bell's network access lines were in Reno and vicinity. The Telephone Companies provided approximately 77 percent and 30 percent of the total access lines in California and Nevada, respectively, on December 31, 1993. The Telephone Companies do not furnish local service in certain sizeable areas of California and Nevada which are served by nonaffiliated telephone companies. MAJOR CUSTOMER Payments from AT&T for access charges and other services accounted for 11 percent of the Corporation's operating revenues during 1993. No other customer accounted for more than 10 percent of the Corporation's operating revenues in 1993. STATE REGULATION As a provider of telecommunications services in California, Pacific Bell is subject to regulation by the CPUC with respect to intrastate rates and services, the issuance of securities and other matters. The Public Service Commission of Nevada ("PSCN") regulates Nevada Bell on similar issues. The CPUC adopted a new regulatory framework, which is a form of "price cap" or "incentive" regulation, for Pacific Bell and one other large local exchange carrier in California in October 1989. The authorized market-based rate of return under the CPUC's new regulatory framework is 11.5 percent. If Pacific Bell's rate of return exceeds 13 percent, earnings above the 13 percent benchmark must be shared 50-50 with customers. Earnings above 16.5 percent must be returned 100 percent to customers. The third phase of the CPUC's ongoing investigation into alternative regulatory frameworks has addressed competition for intra-service area toll and related services. The CPUC's formal authorization of competition into Pacific Bell's intra-service area toll market is expected in 1994. (See "Toll Services Competition" below.) Under incentive-based regulation, the CPUC requires Pacific Bell to submit an annual price cap filing to determine prices for categories of services for each new year. Price adjustments reflect the effects of any change in the Gross National Product Price Index ("GNPPI") less 4.5 percent, the productivity factor established by the CPUC under the new incentive regulation. The annual price adjustments also reflect the effects on Pacific Bell's costs of exogenous events beyond its control. In December 1993, the CPUC approved Pacific Bell's annual price cap filing for 1994 in which Pacific Bell had proposed a $105 million rate reduction. This reduction includes a decrease of $85 million because the 4.5 percent productivity factor of the price cap formula exceeded the increase in the GNPPI by 1.3 percent. The filing also included several additional factors which will decrease revenues* by an additional $20 million. In 1992, the CPUC began its scheduled review of the current incentive-based regulatory framework. Among other issues, this review has examined elements of the price cap formula, including the productivity factor and the benchmark rate of return on investment adopted in the 1989 New Regulatory Framework ("NRF") order. Pacific Bell proposed no significant changes to the new framework because the Corporation's experience to date suggests that it is working as intended. - ---------------- * Unless otherwise indicated, revenue changes from CPUC price cap orders are estimated on an annual basis and may be more or less than the amount ordered, due to later changes in volumes of business. In March 1994, a CPUC Administrative Law Judge issued a proposed decision in the NRF review. The proposed decision would eliminate an element of the regulatory framework which requires equal sharing with customers of earnings exceeding a benchmark rate of return. Earnings above a rate of return of 16.5 percent would continue to be returned to customers. The proposed decision also recommends increasing the productivity factor of the price cap formula from 4.5 percent to 6.0 percent for the period 1994 through 1996. If adopted by the CPUC, the change in the productivity factor would reduce annualized revenues by approximately $100 million each year through 1996. Pacific Bell plans to file comments objecting to the proposed increase in productivity factor. The Corporation is unable to predict the final outcome of these proceedings or the effective date of any rate reductions. In August 1993, the CPUC issued a proposal to allow competition in the provision of intrastate switched transport services. The CPUC proposes to allow competitors to locate transmission facilities in Pacific Bell's central offices; adopt a new transport rate structure that includes pricing flexibility for dedicated traffic; and authorize competition for switched transport services within the state. Revenues from intrastate switched transport services represent approximately four percent of Pacific Bell's total revenues. The Corporation is unable to predict the outcome of this proceeding. In April 1993, the CPUC initiated an investigation to establish a framework to govern open network access i.e., access to so-called "bottleneck" services. The CPUC proposes to adopt specific requirements for the unbundling and nondiscriminatory provision of functions underlying services provided by dominant telecommunications providers. Functions considered bottleneck and subject to open access for competitive telecommunications providers include all transport switching, call processing and call management. In comments filed in February 1994, Pacific Bell urged the CPUC to recognize that widespread competition exists throughout the telecommunications industry and asked the CPUC to consider rules for local competition immediately. Pacific Bell's proposal calls for the separation of the loop (the telephone line between a customer's location and the telephone company's central office) from the switch (the central office equipment that selects the paths to be used for transmission of information.) Pacific Bell has filed an application for authority to conduct tests and trials with a variety of industry participants to test the feasibility of unbundling the loop from the switch and of various points of interconnection. The trials would allow competitors to connect to Pacific Bell's network to carry calls. Eventually, customers would be able to decide whether they want Pacific Bell to provide all of their telecommunications services, including local service, or if they want to subscribe to another provider for dialtone and other services. Pacific Bell also believes it should be given the opportunity to compete in other markets, such as long-distance, cable television programming and manufacturing. The Corporation's entry into these markets would benefit consumers by providing them alternatives to existing sources of products and services. The Corporation is unable to predict the outcome of this proceeding. In December 1993, the CPUC released a report to the Governor of California proposing streamlined regulation of telecommunications companies. The report states that the benefits of deregulation and fostering advanced telecommunications in California would be substantial. It predicts that expanded use of telecommunications will create new products, services and job opportunities and could increase the productivity of the state's businesses. The CPUC proposes that within the next year California should: streamline regulation where markets are workably competitive; continue the CPUC's focus on consumer protection in all markets; develop policies and partnerships that encourage consumer demand and the increased use of advanced telecommunications networks; and establish a grant program to enhance development and use of advanced telecommunications in schools and libraries. The report recommends that disincentives to investments (such as the current cap on earnings and sharing mechanisms) be removed, that restrictions on Pacific Bell's ability to provide certain services be removed and that interconnection and interoperability among competing networks be required to expand customer choice. Additionally, the CPUC proposed that within three years California open all markets to all competitors, thereby making the state an "open competition zone." It would also restructure universal service funding, and gradually redefine the concept of basic service to ensure that all residents benefit from advanced telecommunications technologies. In addition, it would make digital access to networks available as a prelude to making switched video and mobile services available throughout the state by the end of the decade. By opening markets to competition, the policies proposed by the CPUC would increase demand for and stimulate the private development of new types of telecommunications and video services, bringing innovative new products into businesses, homes, and communities. Various elements of these proposals require consideration by the California Legislature as well as formal review by the CPUC. Discussion of other CPUC proceedings, including regulatory and ratemaking treatment for postretirement benefits in connection with the adoption of Financial Accounting Standard No. 106, and the limited rehearing of a decision involving certain erroneous late payment charges, is on pages through F- 24 of the 1994 Proxy Statement. In Nevada, the PSCN authorized an Alternative Plan of Regulation for telephone companies, including Nevada Bell, beginning in 1991. Nevada Bell was awarded an equity-based rate of return ("ROE") of 13 percent and a sharing formula allows Nevada Bell to share in any earnings above the benchmark ROE of 13 percent. The new incentive-based framework places a five-year cap on basic rates. The earnings and sharing review conducted in 1993 based upon 12 months of results of operations resulted in no sharing due to an ROE under 13 percent. The PSCN has also recently opened a proceeding to consider revising existing regulations for telecommunications providers; we hope this proceeding will streamline regulation in Nevada. The Corporation continues to support changes in public policy and regulation that will allow it to offer the products and services that customers want. FEDERAL REGULATION The Telephone Companies are subject to the jurisdiction of the Federal Communications Commission (the "FCC") with respect to interstate access charges and other matters. The FCC prescribes a Uniform System of Accounts and interstate depreciation rates for operating telephone companies. The FCC also prescribes "separations procedures," which are the principles and standard procedures used to separate plant investment, expenses, taxes and reserves between those applicable to interstate services under the jurisdiction of the FCC, and intrastate services under the jurisdiction of state regulatory authorities. The Telephone Companies are also required to file tariffs with the FCC for the services they provide. In addition, the FCC establishes procedures for allocating costs and revenues between regulated and unregulated activities. Beginning in 1991, the FCC adopted a price cap system of incentive-based regulation for local exchange carriers. Pacific Bell's access rates were retargeted to a new 11.25 percent rate of return on rate base assets. The FCC's price cap system provides a formula for adjusting rates annually for changes in the GNPPI, less a productivity factor and changes in certain costs that are triggered by administrative, legislative or judicial action beyond the control of the local exchange carriers. The FCC's price cap plan allows the Telephone Companies to choose between two productivity offset factors of 3.3 or 4.3 percent on an annual basis. This choice affects both the sharing threshold and the threshold above which all earnings must be returned to customers. In its third annual access filing, Pacific Bell again chose the productivity factor of 3.3 percent, which the FCC approved in June 1993. Nevada Bell elected the productivity factor of 4.3 percent. For Pacific Bell, the 3.3 percent factor sets the benchmark rate of return for sharing of earnings at 12.25 percent. For Nevada Bell, the 4.3 percent factor changes the sharing threshold to 13.25 percent. If earnings for 1993 are determined to exceed their respective sharing thresholds, Pacific Bell and Nevada Bell must share the excess earnings equally with customers. Pacific Bell's earnings above 16.25 percent must be returned entirely to customers. For Nevada Bell, all earnings above 17.25 percent must be returned to customers. New interstate access rates became effective July 1, 1993. Pacific Bell and Nevada Bell's annual interstate access rates were decreased by $17 and $3.7 million, respectively, for the 12 months July 1993 through June 1994. The reductions reflect the net effects of inflation, productivity gains and other required cost adjustments. In February 1994, the FCC issued a notice of proposed rulemaking to review its price cap alternative regulatory framework. Parties, including the Telephone Companies, will file comments with the FCC in April 1994. The FCC is looking for comments on three main sets of issues: (1) refining the goals of price caps to better meet the public interest and the purposes of the Communications Act; (2) whether to revise the current plan (which became effective January 1, 1991) to help it better meet the FCC's goals, or to adjust the plan to changes in circumstances; and (3) possible transition from the baseline price cap plan toward reduced or streamlined regulation of services provided by local exchange carriers ("LECs") as competition grows. The FCC released a Notice of Inquiry in December 1991 "to open public debate on the interrelationship of Open Network Architecture with emerging network design" and to gather information on future network capabilities. The FCC stated that its goal is to encourage development of future local exchange networks that are as open, responsive and procompetitive as possible, consistent with the FCC's other public interest goals. The Telephone Companies filed comments on March 3, 1993, stating that market forces must drive network evolution. In August 1993, the FCC issued a notice of proposed rulemaking to require Tier I local telephone companies implementing intelligent networks to offer third party mediated access to their networks. In comments filed with the FCC, the Telephone Companies asserted that access to intelligent networks should not be mandated because market forces are sufficient to bring about open access. Effective in June 1993, the FCC ordered expanded network interconnection for interstate special access services. Special access services are used primarily by large businesses to connect to their branch offices or to interexchange carriers. The decision requires large LECs, including the Telephone Companies, to offer expanded interconnection to customers, including other access providers. The decision permits these customers to locate their transmission facilities in the LECs central offices. The FCC granted additional, but limited, pricing flexibility to the LECs to respond to the increased competition that will result. Along with other LECs, the Telephone Companies have filed a petition for review of this FCC decision with the U.S. Court of Appeals for the D.C. Circuit. We are unable to predict the outcome of this appeal. Pacific Bell currently has orders from Competitive Access Providers to locate facilities in more than 20 of its central offices, with more requests expected to follow. Interstate special access revenues subject to increased competition represent less than three percent of the Telephone Companies' total revenues. Effective in February 1994, the FCC ordered LECs, including the Telephone Companies, to provide all interested customers, including competitors, with expanded interconnection for interstate switched transport services. The LECs must allow interconnectors to physically locate their transmission facilities in the LECs' central offices and certain other LEC locations, in order to terminate their own switched transport facilities. Switched transport services help connect a business or residential customer with an interexchange carrier. One of the FCC's goals is to promote increased competition for these services. The FCC granted additional, but limited, pricing flexibility for these services so that the LECs can better respond to the competition that will result. Along with other LECs, the Telephone Companies have filed a petition for review of this FCC decision with the U.S. Court of Appeals for the D.C. Circuit. The Court has held this case in abeyance pending the Court's decision in the appeal of the FCC's special access collocation order. Revenues from interstate switched transport services represent approximately three percent of the Telephone Companies' total revenues. Rates reflecting the new rules became effective in early 1994. To facilitate expanded interconnection for switched transport services, the FCC ordered a new interim rate structure effective December 1993. Under the new structure, interexchange carriers pay different rates based on volume, distance and other factors. The FCC intends these interim rates to be revenue neutral. Pacific Bell and others have petitioned the FCC for reconsideration of this decision, contending that the interim rate structure will cause revenue losses. The Corporation is unable to predict the outcome of this proceeding. In August 1992, the FCC modified its rules to permit LECs, including the Telephone Companies, to provide a tariffed basic platform ("video dialtone") that will deliver video programming developed by others on a nondiscriminatory basis. (See "Video Services," below, for a discussion of Pacific Bell's four applications to provide video dialtone services.) The FCC's order has been appealed but the appeals are stayed pending the FCC's reconsideration decision. The FCC also recommended that Congress repeal the statutory cross- ownership restriction imposed on cable and telephone companies. Until Congress acts, additional services authorized by the FCC rules include video gateways, interactive enhanced services, video transport, video customer premises equipment, and billing and collection. In July 1993, five of the RHCs, including the Corporation, filed a petition with the FCC asking for new rules governing the provision of long-distance services. The RHCs are currently prohibited from providing long-distance services by the terms of the Consent Decree. Even with a favorable ruling from the FCC, the RHCs must still obtain relief from the Consent Decree from Congress, or the courts, before providing long-distance services. During 1993, Pacific Bell joined other members of the United States Telephone Association ("USTA") in a petition to the FCC to establish a rulemaking for the purpose of reforming regulation of interstate access services. USTA urges the FCC to address several major matters needing reform including existing subsidy funding and recovery mechanisms, the need for greater pricing flexibility as competition increases and the need to revise current price cap rules. NEW TECHNOLOGY AND ADVANCED SERVICES The Telephone Companies continue to modernize and expand their telephone networks to meet customer demands for faster and more reliable services as well as demands for new products and services. New technologies being deployed include optical fiber, digital switches and Signaling System 7 ("SS- 7"). Digital switches and optical fiber, a technology using thin filaments of glass or other transparent materials to transmit coded light pulses, greatly increase the capacity and reliability of transmitted data while reducing maintenance costs. SS-7 permits faster call setup and new custom calling features. Investments in key technologies are summarized on pages and of the 1994 Proxy Statement. SS-7 has made it possible for Pacific Bell to offer many new custom calling features, subject to regulatory approvals. New custom calling features include call return, priority ringing, call trace and other Custom Local Area Signaling Services ("CLASS"). Pacific Bell began offering priority ringing, repeat dialing and select call forwarding services in selected areas in 1992. Pacific Bell introduced call trace, call screen and call return services in 1993. Over half a million customers subscribed to these new services in 1993. Pacific Bell will introduce additional features and expand the availability of the "CLASS" Services in 1994. However, as a result of a CPUC decision in November 1992, Pacific Bell has decided not to offer caller identification ("Caller ID"). The stringent number blocking requirements placed on the service by the CPUC prevent Pacific Bell from offering customers a viable service at a reasonable price. Pacific Bell continues to work with the CPUC in this area, with the goal of providing California customers the benefits of Caller ID service. In March 1994, the FCC adopted free per call blocking as the national standard for the offering of Caller ID on interstate calls, effective April, 1995. Pacific Bell, either directly or through its subsidiary, Pacific Bell Information Services, also offers voice mail, electronic messaging and interactive voice response services. (See "Pacific Bell Information Services," above.) Other enhanced services may be offered in the future. The Corporation does not expect revenues from enhanced services to have a material effect on reported earnings in 1994 but the new services are expected to increase the use of the networks of the Telephone Companies. In November 1993, Pacific Bell announced a capital investment plan totaling $16 billion over the next seven years to upgrade its core network infrastructure and to begin building California's "communications superhighway." This will be an integrated telecommunications, information and entertainment network providing advanced voice, data and video services. Using a combination of fiber optics and coaxial cable, Pacific Bell expects to provide broadband services to more than 1.5 million homes by the end of 1996 and more than 5.0 million homes by the end of the decade. As part of its current plan, Pacific Bell has made purchase commitments totaling nearly $600 million in accordance with its previously announced $1 billion program for deploying an all digital switching platform with ISDN (Integrated Services Digital Network) and SS-7 capabilities. The advanced network will make possible capital and operational cost savings, service quality improvements and new revenues from the array of new service possibilities. The offering of any new advanced services will depend upon their economic and technological feasibility. Construction of the portions of the network that are not video- specific will begin early in the second quarter of 1994. (See "Video Services," below.) The network should be capable of offering fully interactive digital telephone services by the end of 1996. In order to offer the new products and services customers want, the Telephone Companies have been making substantial investments to improve the telephone networks. During 1993, the Telephone Companies invested $1.9 billion in their networks. Capital expenditures in 1994 for the Telephone Companies are forecast to be $1.9 billion including $1,136 million for projects designed to generate revenues and $589 million for projects designed to reduce costs. Capital expenditures under Pacific Bell's seven year investment plan are not expected to increase until 1996 due to the timing of capital expenditures associated with the construction of the broadband network. The PSCN has approved CLASS services for Nevada Bell. Effective August 1, 1992, Nevada Bell began offering Caller ID, call return, priority ringing, call tracing, repeat dialing, call screening and select call forwarding. Nevada Bell offers two free blocking options to Caller ID -- per call and per line blocking. Nevada Bell is also working with the Nevada Telephone Association on a major contract to provide a digital telecommunications system for the State of Nevada. This digital microwave network will provide an advanced infrastracture for all communications in the public sector, permitting both video conferencing and high-speed data applications. CHANGING INDUSTRY ENVIRONMENT One of the challenges facing the Telephone Companies is the accelerating convergence of the telecommunications, computer and video industries. The new information services industry is being shaped by advances in digital and fiber-optic technologies that will make possible the provision of interactive broadband services by the Telephone Companies as well as others. Although this convergence will bring further competition, it also should mean unprecedented reasons to enter new businesses from which we have been barred historically. The Clinton administration has indicated it will support legislation to remove many of the legal restrictions that have prevented telephone companies from offering video services. The administration has also indicated it will support the removal of restrictions which prevent the RHCs from providing long-distance services. Similar proposals have been made by the CPUC to the Governor of California. The public policy initiatives discussed below will determine the terms and conditions under which the Telephone Companies may offer new services in this dynamic marketplace. Video Services As described above, the FCC currently permits LECs, including the Telephone Companies, to provide a tariffed basic platform that will deliver video programming developed by others ("video dialtone") and to provide certain other services to customers of this basic platform. In December 1993, Pacific Bell filed an application with the FCC seeking authority to offer video dialtone services in specific locations in four of its service areas: the San Francisco Bay Area; Los Angeles; San Diego; and Orange County. The advanced integrated broadband telecommunications network which Pacific Bell plans to build over the next seven years will be capable of delivering an array of services including traditional voice, data and video services. Once FCC approval is obtained, Pacific will deploy the video exclusive components of the advanced network. In addition to providing advanced telecommunications services, the new network will also serve as a platform for other information providers, and will offer customers an alternative to existing cable television providers. The integrated network is also expected to spur the development of new interactive consumer services in education, entertainment, government and health care. In November 1993, the Corporation sued to overturn the 1984 Cable Act provision barring telephone companies from providing video programming in their service areas. The Cable Act bars telephone companies from having more than a de minimis ownership stake in video programming services, although it permits them to carry other companies' programs. The Corporation believes that video programming is a form of speech protected by the First Amendment of the United States Constitution. If the suit is successful, the Corporation plans to begin providing programming in California as soon as its video dialtone network is deployed. In November 1993, legislation was introduced in Congress that would permit LECs, including the Telephone Companies, to provide video programming to subscribers in their own service areas, subject to separate subsidiary requirements and other safeguards. The legislation would also permit competition in the provision of local telephone service and allow access to LEC facilities by competitors. In January 1994, Pacific Telesis Video Services, a newly created Pacific Telesis subsidiary, announced an advanced interactive television services trial with AT&T that will test consumer acceptance of sophisticated services such as multi-player games, interactive home shopping and educational programs, movies-on-demand and time-shifted television programs. PTVS will purchase transport from Pacific Bell when video dialtone tariffs are approved. Pacific Telesis Video Services is also working with Hewlett-Packard Company to build an interactive video system that will offer consumers movies and other programs "on demand" by late 1994 or early 1995. Hewlett-Packard will provide large video servers to distribute digital video "streams" to individual subscribers' homes. The servers will be built around a new technology, or "video transfer engine," that is flexible, reliable and upgradeable. Electronic Publishing Services In November 1993, legislation was introduced in Congress that would simplify the procedures under which BOCs may seek relief from provisions of the Consent Decree. (See "The Telephone Companies and Line of Business Restrictions" above.) However, the bill would also impose stringent separate subsidiary requirements on RHC electronic publishing ventures. In November 1993, Pacific Bell filed an application with the CPUC stating its intent to enter the electronic publishing business, either by itself or through an affiliate. In January 1994, the Los Angeles Times and Pacific Telesis Electronic Publishing Services, a newly created Pacific Telesis Group subsidiary, announced a plan to form a joint venture to design and offer electronic shopping information and transaction services beginning in late 1994. A combination of business listings, classified and display advertising, consumer ratings, and editorial and promotional material will form a comprehensive electronic resource that will give consumers the product, service and business information they want from one convenient, integrated source. The joint venture will also offer consumers in-depth information on a wide variety of topics, including home repair and maintenance, real estate rental and sales, and auto, travel and entertainment services. Personal Communications Services In October 1993, the FCC issued an order allocating radio spectrum and setting forth licensing requirements to provide PCS. PCS relies on a network of transceivers that may be placed throughout a neighborhood, business complex or community to provide customers with mobile voice and data communications. The FCC established two different sizes of service areas nationwide for PCS: 47 large areas referred to as Major Trading Areas ("MTAs") and 487 smaller areas. The MTA licenses are for 30 megahertz of spectrum. In any given area, there will be as many as seven licenses, including two MTA licenses. Most of the licenses will be awarded by competitive bidding in auctions expected in late 1994 or early 1995. The Corporation plans to aggressively pursue PCS licenses at these auctions and is well-placed to be part of the expected multi-billion dollar market for PCS. On December 23, 1993, the FCC awarded a "pioneer preference" to another company for one of the two larger MTA licenses covering the Los Angeles, San Diego, and Las Vegas market area. That company will receive the license without charge. This is expected to place the successful bidder for the remaining MTA license in that area at a significant competitive disadvantage because of its higher cost structure. Winning bids in major PCS markets are expected to require large capital expenditures. The Corporation has filed petitions for review of the FCC decisions that granted pioneer preferences for PCS licenses without charge with the U.S. Court of Appeals for the D.C. Circuit. We are unable to predict the outcome of these appeals. The Corporation's wholly-owned subsidiary, Telesis Technologies Laboratory, Inc. ("TTL"), has been conducting PCS experiments and investigating various technological issues under an experimental license granted by the FCC. With a spin-off of the Corporation's wireless operations, the Corporation will be eligible to bid on PCS licenses in the service areas of the Telephone Companies. The Corporation also believes that AirTouch will be eligible to bid on the larger MTA licenses in areas where it does not provide cellular service after the spin-off. Some of the assets that have been engaged in PCS research and development work were transferred to AirTouch in late 1993 in accordance with the terms of the Separation Agreement between the Corporation and AirTouch. TTL employees originally employed by AirTouch will transfer back to AirTouch before the spin-off. Pacific Bell will form a new subsidiary to receive remaining assets of TTL that have been engaged in PCS research and development work and it will provide PCS services if the Corporation wins a license at auction. Future TTL research will assess wireless broadband technologies, the effects of consumer electronics on telecommunications networks, and continued work in the area of PCS. COMPETITION Regulatory, legislative and judicial actions since the Consent Decree, as well as advances in technology, have expanded the types of available communications services and products and the number of companies offering such services. Various forms of competition are growing steadily and are already having a significant effect on the Telephone Companies' earnings, primarily Pacific Bell's. An increasing amount of this competition is from large companies with substantial capital, technological and marketing resources. There is also increased competition among existing and new common carriers, including subsidiaries of the RHCs and AT&T, for the provision of voice and data communications services. Toll Services Competition In 1993, the CPUC continued Phase III of its ongoing investigation into alternative regulatory frameworks (See "State Regulation" above). In Phase III, the CPUC is considering how to lift its current ban on intra- service area competition for toll and toll-related services and how to rebalance Pacific Bell's rates. In September 1993, the CPUC announced a decision providing that, beginning in 1994, long-distance and other telecommunications companies would be allowed to compete with Pacific Bell and other local telephone companies in providing toll service, among other services. The decision would have also lowered local exchange company toll and switched access rates, while increasing basic rates, bringing each closer to cost. Other rates would have also changed. Overall, the CPUC's order was intended to be revenue neutral; that is, the effect of rate decreases would be offset by the effect of rate increases. In October 1993, the CPUC rescinded its September decision after questions were raised about its decision-making process. The CPUC has requested additional comments on its original decision. The Corporation expects a final decision in 1994, but is unable to predict the revenue impacts of the decision and the increased competition that will follow. In a future proceeding, the CPUC intends to address whether to require LECs to provide a way for customers to presubscribe to their carrier of choice for intra-service area toll services. In 1993, Pacific Bell experienced a decline in revenues from services subject to competition, while revenues from other services continued to grow. The total impact of competition on revenues, however, cannot be quantified separately from the effects of the recession in California. (See "California Economy" on page of the 1994 Proxy Statement.) In Nevada, the PSCN adopted a rule change effective October 1993 that permits limited intra-service area competition. Interexchange carriers may complete intra-service area calls either through dedicated special access or if the customer initiates the call with certain designated prefixes. Interstate Special Access Competition Expanded interconnection for interstate special access services became effective on June 16, 1993. Special access services are used primarily by large businesses to connect their branch offices or to connect directly to interexchange carriers. Expanded interconnection allows customers, including other access providers, to locate their transmission facilities in an LEC central office. This allows interexchange carriers ("IECs") to choose among competing providers for transport into the LECs' central offices. (See "Federal Regulation" above.) Switched Transport Competition Effective February 15, 1994, expanded interconnection became available for the transport portion of interstate switched access services under similar price, terms and conditions as for special access services. Switched access services link IECs with most residential and business customers. In recognition of the local transport competition which exists today and the increased competition that will result from expanded interconnection, the FCC has approved limited rate deaveraging by zones of central offices and volume and term discounts for LEC access transport services, once certain conditions are met. In August 1993, the CPUC also issued a proposal to allow competition in the provision of intrastate switched transport services. The CPUC proposes to allow competitors to locate transmission facilities in Pacific Bell's central offices; adopt a new transport rate structure that includes pricing flexibility for dedicated traffic; and authorize competition for switched transport services within the state. (See "State Regulation" and "Federal Regulation" above.) Open Network Access/Local Competition Early in 1993, the CPUC initiated a rulemaking proceeding and set forth a number of proposed policies, rules and issues for comment on ways to establish a receptive environment for competitive providers of telecommunications services. The rulemaking focuses on one approach: Requiring local exchange carriers to unbundle "bottleneck" elements of their network and make those elements available to unaffiliated providers on an open and nondiscriminatory basis. Pacific Bell's response to this rulemaking urges the CPUC to examine the full set of issues that result from a competitive local exchange market. Among such issues are: the need to establish a new universal service mechanism that spreads the subsidy burden to all telecommunications providers, to reform pricing rules to be consistent with increasing competition, to remove entry barriers including current in-state long distance restrictions on Pacific Bell, to remove investment disincentives such as sharing and to establish standards for interconnection, interoperability and unbundling of essential facilities that apply to all competing networks and not just those of the LECs. (See "State Regulation" above.) Bypass Artificially high prices for toll and access services create an economic incentive for large business users (and IECs) to use alternative communications systems capable of originating and/or terminating calls and thus bypass the local exchange network. This bypass reduces the revenues that the Telephone Companies collect from toll and access services to support the total costs of the local exchange network and increases the amounts the Telephone Companies have to recover from other services, notably basic exchange services. The Telephone Companies are unable to determine precisely to what extent bypass has occurred and may continue to occur in the future. (See preceding sections, from "Toll Services Competition" through "Open Network Access/Local Competition" above.) To reduce the threat of bypass of the local networks, the Telephone Companies have strongly supported the use of cost-based pricing policies before both their state regulatory commissions and the FCC. (See "State Regulation" and "Federal Regulation" above.) Centrex The Telephone Companies provide Centrex service to business customers in California and Nevada. Centrex is a central office-based switching system for customers who require sophisticated call transport and management capabilities as part of their business communication systems. Businesses not using Centrex service generally use Private Branch Exchange ("PBX") and other systems provided by other companies. The Telephone Companies offer Centrex by contract, as approved by the CPUC for Pacific Bell, as well as pursuant to tariff. The ability to offer Centrex by contract gives the Telephone Companies pricing flexibility as well as the opportunity to tailor the specific features and conditions of a given transaction. The market for multi-line business telephone products is very competitive and includes large well-financed competitors. Directory Publishing Other producers of printed directories offer products that compete with certain Pacific Bell Directory SMART Yellow Pages products. Competitors include large companies that have significant resources. Competition is not limited to directory publishers, but includes newspapers, radio, television and increasingly, direct mail. In addition, new advertising and information products may compete directly or indirectly with the SMART Yellow Pages. The Corporation is unable to predict the extent to which these competitors may affect future revenues of the Corporation. AIRTOUCH COMMUNICATIONS (SPIN-OFF OPERATIONS) AirTouch Communications (formerly PacTel Corporation) and its wireless operations will be spun off to the Corporation's shareholders in a one-for-one stock distribution effective April 1, 1994. The wireless operations of AirTouch Communications ("AirTouch") include cellular, paging, vehicle location and other wireless telecommunications services in the United States, Europe and Asia. AirTouch's worldwide cellular interests represented 75.3 million POPs* and more than 1.2 million proportionate subscribers at December 31, 1993. In the United States, AirTouch has 34.9 million POPs** and controls or shares control over cellular systems in ten of the thirty largest markets, including Los Angeles, San Francisco, San Diego, Detroit and Atlanta. Internationally, AirTouch has 40.4 million POPs and holds significant ownership interests, with board representation and substantial operating influence, in national cellular systems operating in Germany, Portugal and Sweden and in cellular systems under construction in three major metropolitan areas in Japan, including Tokyo and Osaka. AirTouch is also the fourth largest provider of paging services in the United States, with approximately 1.2 million units in service at December 31, 1993. - -------------------- * POPs are the estimated market population multiplied by AirTouch's ownership interest in the cellular licensee for the market. International cellular information reflects networks under construction. Domestic cellular subscriber information reflects subscribers to cellular systems over which AirTouch has or shares operational control. ** POPs and proportionate subscribers for the Michigan/Ohio region reflect both AirTouch's 50% interest in a joint venture between AirTouch and Cellular Communications, Inc. ("CCI") and AirTouch's ownership of approximately 12% of the equity in CCI at December 31, 1993. Principal AirTouch operations are discussed below. AirTouch Cellular AirTouch Cellular is one of the largest providers of cellular services in the United States, with interests in some of the most attractive cellular markets based upon total population and demographic characteristics. AirTouch's United States cellular interests represented 34.9 million POPs and more than 1 million proportionate subscribers at December 31, 1993. AirTouch has or shares operational control over cellular systems in Los Angeles, San Francisco, San Diego, Atlanta, Detroit, Cleveland, San Jose, Sacramento, Cincinnati and Kansas City. These cities represent ten of the thirty largest cellular markets in the United States. AirTouch also has or shares operational control over cellular systems in 34 additional markets, including Columbus, Dayton and Toledo, Ohio, and owns minority interests in cellular systems serving 10 other markets, including Dallas/Forth Worth, Tucson and Las Vegas. AirTouch has formed six regional networks, in Southern California, the San Francisco Bay Area, the Sacramento Valley, Michigan/Ohio, Georgia and Kansas/Missouri. Regional networks permit AirTouch to meet customers' needs for broad areas of uninterrupted service, to carry out coordinated marketing efforts and to reduce capital expenditures and administrative expenses. Through its participation in marketing alliances such as MobiLink and Cellular One, AirTouch provides national cellular service to its customers. AirTouch's transactions with CCI and McCaw Cellular Communications, Inc. ("McCaw") are examples of the implementation of AirTouch's regional network strategy. AirTouch's cellular network in Michigan/Ohio was created in 1991 through New Par, an equally owned joint venture between AirTouch and CCI ("New Par"), in which AirTouch's interests in Michigan and northwestern Ohio were combined with CCI's interests in Cleveland, Cincinnati, Columbus and elsewhere throughout Ohio to create one of the largest regional cellular systems in the United States, covering an area with a total population of over 15 million. In connection with the formation of New Par, AirTouch acquired 5% of the equity of CCI, agreed to purchase up to 12.44 million shares (including shares underlying certain stock options) of CCI's stock in October 1995 at $60 per share (less the exercise price in the case of stock options) and obtained the right to acquire all of CCI's remaining equity in stages over the next several years. (See "Spin-off Operations" on page in Note L to the 1993 Consolidated Financial Statements contained in the 1994 Proxy Statement.) AirTouch currently owns approximately 12% of CCI. In September 1993, AirTouch formed an equally owned joint venture with McCaw ("CMT Partners") that holds controlling interests in cellular systems serving markets in and around San Francisco, San Jose and Kansas City, thereby permitting AirTouch to broaden its coverage of the San Francisco Bay Area and providing it with shared control over an additional regional network in Kansas/Missouri. International Operations AirTouch has been highly successful in obtaining significant interests in cellular licenses in some of the world's most attractive markets. In 1990, Mannesmann Mobilfunk GmbH ("MMO"), in which AirTouch currently holds a 29.15% interest and is the second largest shareholder, won the second national digital cellular license in Germany. AirTouch's interest in MMO includes a 2.25% interest which, under the terms of MMO's license, AirTouch is under a current obligation to sell to small or medium-sized German businesses. MMO began commercial operations in June 1992 and at December 31, 1993 had approximately 493,000 subscribers. The system presently covers approximately 94% of the population, including all of the major cities and highways. In 1991, Telecel Communicacoes Pessoais. S.A. ("Telecel"), in which AirTouch holds a 23% interest, was chosen to construct and operate one of two national digital cellular systems in Portugal. Telecel initiated service in October 1992 and at December 31, 1993 had approximately 40,000 subscribers. Telecel currently covers all of Portugal's major cities and highways and approximately 92% of the population and is required under the terms of its license to cover 99% by October 1996. In 1992, AirTouch's consortia were selected to construct and operate digital cellular systems in the Tokyo, Kansai (Western) and Tokai (Central) regions of Japan. AirTouch has a 15% interest in Tokyo Digital Phone Company and 13% interests in each of Kansai Digital Phone Company and Tokai Digital Phone Company. The three systems are expected to be operational by the end of 1994. Such systems are expected to be able to offer service to approximately 74 million people, or 60% of the Japanese population, by 1997. In February 1994, AirTouch agreed to acquire a 4.5% interest in a fourth company, which plans to build a digital cellular system that will reach about 70% of the population of the Kyushu/Okinawa region when it begins offering service in 1996. There are approximately 15 million people in the region, which is the fourth most populous of Japan's 11 cellular regions. In October 1993, AirTouch acquired a 51% interest in NordicTel Holdings AB ("NordicTel"), which owns and operates one of three national digital cellular systems in Sweden, for $153 million. NordicTel's cellular system began commercial operations in late 1992 and currently covers approximately 80% of Sweden's population and all of the major cities. Paging Operations AirTouch had approximately 1.2 million paging units in service at December 31, 1993 in 100 markets throughout the United States, including Atlanta, Dallas/Fort Worth, Detroit, Houston, Los Angeles, Phoenix, St. Louis, San Diego, the San Francisco Bay Area, Seattle and Tampa/St. Petersburg. AirTouch became one of the first paging companies in the United States to offer paging service through retail outlets and the success of AirTouch's retail marketing efforts has contributed significantly to the growth of its paging business. AirTouch also owns significant interests in paging companies in Portugal, Spain and Thailand. In September 1993, a joint venture in which AirTouch has an 18.5% interest was awarded one of three national digital paging licenses in France. Other Operations AirTouch owns a majority interest in a provider of vehicle location services ("Teletrac") in six markets in the United States. Teletrac is in the start-up phase of its operations and to date its services have not achieved a significant degree of commercial acceptance. In February 1994, AirTouch reduced Teletrac's workforce by 30%, to approximately 200 employees. In addition, AirTouch provides air-to-ground telephone service in four domestic cities. AirTouch also owns interests in a long distance telephone company in Japan and a credit card verification business in South Korea. EMPLOYEES As of December 31, 1993, the Corporation and its subsidiaries employed 55,355 persons. This number does not include employees who will continue to be employed by AirTouch Communications after the spin-off. About 70 percent of the employees of the Corporation's continuing operations are represented by unions. In September 1992, the unions which represent these employees ratified labor contracts for a three-year term. The agreements provide for a 12 percent increase in wages, including job upgrades and a 13 percent increase in pensions over the three-year term. In addition, the contracts include incentives for early retirement, enhanced employment security, improvements in work and family life benefits and increases in health and dental care coverage. In 1993, Pacific Bell reduced the number of employees by 1,516, leaving a total of 54,026 employees at year-end. Looking ahead, Pacific Bell has begun a major effort to reengineer its internal business processes. This effort confronts an increasingly competitive and complex telecommunications environment by streamlining and consolidating operations, including business offices, network, installation and collection centers, as well as other facilities. As a result, Pacific Bell has announced a force reduction program that will result in a net reduction of 10,000 positions from 1994 through 1997. (See page of the 1994 Proxy Statement for discussion of related 1993 restructuring charge.) The Pacific Telesis holding company and Pacific Bell deferred salary increases for all managers, including officers, for an indefinite period of time pending a review of 1994 business needs. At Nevada Bell, an early retirement program was offered during November 1993 under which approximately 70 employees elected early retirement. EXECUTIVE OFFICERS OF THE REGISTRANT The list below gives the names of executive officers as of March 28, 1994, their present titles and the dates they were elected to these positions. Name Age Title Since S. L. Ginn* ........... 56 Chairman of the Board, President and Chief Executive Officer .......... 4/88 P. J. Quigley* ........ 51 Group President .................... 1/88 C. L. Cox ............. 52 Group President .................... 1/88 R. W. Odgers* ......... 57 Executive Vice President - General Counsel, External Affairs** and Secretary......................... 3/88 L. L. Christensen* .... 59 Executive Vice President and Chief Financial Officer .......... 5/92 J. R. Moberg* ......... 58 Executive Vice President - Human Resources ........................ 9/87 W. E. Downing* ........ 54 Vice President ..................... 3/93 F. E. Miller .......... 41 Vice President-Corporate Strategy*** and Development ................... 3/93 A. Sarin .............. 39 Vice President-Organization Design . 3/93 M. S. Gyani ........... 42 Vice President and Treasurer ....... 3/93 Effective upon the spin-off of AirTouch Communications, the executive officers and their titles will be as follows: Name Age Title P. J. Quigley* ........ 51 Chairman of the Board, President and Chief Executive Officer R. W. Odgers* ......... 57 Executive Vice President - General Counsel, External Affairs and Secretary J. R. Moberg* ......... 58 Executive Vice President - Human Resources W. E. Downing* ........ 54 Executive Vice President, Chief Financial Officer and Treasurer F. E. Miller .......... 41 Vice President - Corporate Strategy and Development All of the officers have held responsible managerial positions with the Corporation or one of its subsidiaries for at least the past five years. Officers are not elected for a fixed term, but serve at the discretion of the Corporation's Board of Directors. - ------------------ * Also executive officers of Pacific Bell. ** Executive Vice President - External Affairs since 11/92. *** Vice President - Corporate Strategy since 3/94. Item 2. Item 2. Properties. As of December 31, 1993 the properties of the Telephone Companies represented approximately 98 percent of all plant, property and equipment of the Corporation, excluding spin-off operations. The properties of the Telephone Companies do not lend themselves to description by character and location of principal units. At December 31, 1993, the percentage distribution of total telephone plant by major category for the Telephone Companies was as follows: Pacific Nevada Telephone Property, Plant, and Equipment Bell Bell ------------------------------------------------------------------------- Land and buildings (occupied principally by central offices) ............................ 10% 7% Cable and conduit ................................ 40% 53% Central office equipment ......................... 37% 32% Other ............................................ 13% 8% ------- ------- Total ............................................ 100% 100% ========================================================================= At December 31, 1993, the percent utilization of central office equipment capacity for Pacific Bell and Nevada Bell was approximately 90 percent and 95 percent, respectively. Substantially all of the installations of central office equipment and administrative offices are in owned buildings on land held in fee. Many garages, business offices and telephone service centers are in rented quarters. Item 3. Item 3. Legal Proceedings. Contingent Liabilities Related to Predivestiture Events The Plan of Reorganization ("Plan") approved by the Court in connection with the Consent Decree provides for the recognition and payment of liabilities of the BOCs and AT&T (collectively, the former "Bell System") that are attributable to predivestiture events (including transactions to implement the divestiture), which were not certain and hence not recorded in the books of account until after divestiture. These contingent liabilities relate principally to litigation and other claims with respect to the Bell System's rates, taxes, contracts and torts (including business torts, such as alleged violations of the antitrust laws). The Plan provides various rules for the sharing of such contingent liabilities among the BOCs and AT&T which have been followed since divestiture. AT&T, its subsidiaries and the BOCs, including the Telephone Companies, may have liability under the contingent liabilities provisions of the Plan in a number of tax matters relating to the audit by various taxing authorities of predivestiture periods and in a number of tort, contract and environmental proceedings relating to predivestiture Bell System operations. While complete assurance cannot be given as to the outcome of any litigation, with respect to such tax matters and tort, contract and environmental proceedings, in the opinion of the Corporation, the likelihood is remote that any liability resulting from them under the contingent liabilities provisions of the Plan would have a material effect on the reported earnings of the Corporation. Item 4. Item 4. Submission of Matters to a Vote of Security Holders. No matter was submitted for a vote of security holders during the fourth quarter of the year covered by this report. PART II Item 5. Item 5. Market for Registrant's Common Equity and Related Stockholder Matters. DESCRIPTION OF COMMON STOCK AND DIVIDEND AND MARKET INFORMATION All shares of Common Stock (par value $0.10 per share) (See "Articles of Incorporation and By-Laws - Common Shares" below) of the Corporation are entitled to participate equally in dividends. Each shareowner has one vote for each share registered in the shareowner's name. All shares of Common Stock would rank equally on liquidation. Owners of shares of Common Stock have no preemptive or cumulative voting rights. At February 28, 1994, there were 798,771 holders of record of the Corporation's Common Stock. The markets for trading in the Common Stock are the New York, Pacific, Chicago, Swiss and London Stock Exchanges. The Corporation from time to time purchases shares of its Common Stock on the open market or through privately negotiated purchases and holds these shares as treasury stock. All shares of Common Stock are fully paid and nonassessable. Information regarding dividends paid on the Common Stock for 1993 and 1992 and the quarterly high and low sales prices of the Common Stock during 1993 and 1992 are included in the 1994 Proxy Statement on page thereof under the heading "Stock Trading Activity and Dividends Paid," incorporated herein by reference pursuant to General Instruction G(2). The declaration and timing of all dividends are at the discretion of the Corporation's Board of Directors and are dependent upon the Corporation's earnings and financial requirements, general business conditions and other factors; there can be no assurances as to the amount or frequency of any future dividends on the Common Stock. SHAREOWNER RIGHTS PLAN The Board of Directors of the Corporation adopted a Shareowner Rights Plan in 1989. Under the terms of the plan, shareowners of record as of October 10, 1989 received one right for each share of the Corporation's Common Stock held on that date. Initially, the rights are not exercisable and trade automatically with the Corporation's Common Stock. The rights become exercisable, originally for a 1/100 share of Preferred Stock of the Corporation, upon the earlier of (i) a person ("Acquiring Person") becoming the beneficial owner of securities having 20 percent or more of the voting power of the Corporation, (ii) ten days following the commencement of a tender or exchange offer which would result in a person becoming an Acquiring Person or (iii) ten days after the date on which the Board of Directors of the Corporation declares a person to be an Adverse Person, as defined in the Plan. Once a person becomes an Acquiring or Adverse Person all rights held by such person become void. If a person becomes an Adverse Person or Acquiring Person, the rights will be adjusted so that upon exercise a holder will receive a number of shares of Common Stock of the Corporation having a market value of two times the exercise price of the right. If a person becomes an Acquiring Person and thereafter the Corporation is involved in a merger or other business combination, or 50 percent or more of the Corporation's assets or earning power are sold, then each holder of a right will have the right to receive, on exercise of the right, a number of shares of Common Stock of the surviving corporation having a market value of two times the exercise price of the right. At any time prior to the time a person becomes an Acquiring Person or Adverse Person, the Corporation may redeem the rights at a price of $.01 per right. After a person becomes an Acquiring Person or an Adverse Person, the Board of Directors may exchange each outstanding and exercisable right for one share of Common Stock. The rights do not have any voting rights, may be redeemed under certain circumstances at $0.01 per right, and expire on October 10, 1999. ARTICLES OF INCORPORATION AND BY-LAWS Set forth below is a brief description of some of the important provisions of the Corporation's Articles of Incorporation (the "Articles") and By-Laws. Board of Directors The Articles provide for a Board of Directors which is divided into three approximately equal classes of directors serving staggered three-year terms. As a result, approximately one-third of the Board of Directors are elected at each annual meeting. The Articles also provide that the number of directors may be increased or decreased by resolution of the Board of Directors, provided that the number of directors shall not be reduced to less than three. All directors serve until their term of office expires and their successor is elected and qualified, or until their earlier resignation, removal from office, death or incapacity. No director may be removed from office before the end of the term for which such director has been elected except by the affirmative vote of 66-2/3 percent of the voting power of the shares entitled to vote thereon. Common Shares The Articles provide for the issuance of up to 1.1 billion common shares (par value $.10 per share) in one or more series. The authorized number of the first series of common shares is 1,095,000,000 shares, and that series is designated the "Common Stock." (See "Description of Common Stock and Dividend and Market Information" above.) The remaining five million common shares may be issued from time to time as one or more additional series of common shares with such full or limited rights with respect to voting, dividends or distributions upon liquidation, and such other designations, preferences and rights as the Board of Directors may determine. Preferred Shares The Articles include a provision for the issuance of up to 50 million preferred shares (par value $.10 per share) in one or more series with full or limited voting powers or without voting powers, and with such designations, preferences and rights as the Board of Directors may determine. Shareowner Meetings The Corporation has held Annual Meetings of Shareowners each year in April since 1985. Shareowner proposals intended for inclusion in the proxy statement for the 1995 Annual Meeting should be sent to the Corporation's Secretary at 130 Kearny Street, Room 3609, San Francisco, California 94108 no later than November 12, 1994. The Corporation's By-Laws also provide that special meetings of shareowners may be called by certain corporate officers, and that special meetings shall be called at the request in writing of a majority of the Board of Directors or the holders of 66-2/3 percent of the voting power of the shares entitled to vote at such meetings. Amendment of By-Laws The By-Laws further provide that such By-Laws may be amended or repealed at any time by action of the Board of Directors and that they may also be amended or repealed at a meeting of the shareowners by a vote of at least 66-2/3 percent of the voting power of the shares entitled to vote in the election of directors. Item 6. Item 6. Selected Financial Data. The information required by this Item is included in the 1994 Proxy Statement on pages and under the heading "Selected Financial and Operating Data," and is incorporated by reference pursuant to General Instruction G(2). Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. The information required by this Item is included in the 1994 Proxy Statement on pages through and is incorporated by reference pursuant to General Instruction G(2). Item 8. Item 8. Financial Statements and Supplementary Data. REPORT OF INDEPENDENT ACCOUNTANTS Our report on the consolidated financial statements of Pacific Telesis Group and Subsidiaries has been incorporated by reference in this Form 10-K from page of the 1994 Proxy Statement of Pacific Telesis Group and Subsidiaries. In connection with our audits of such financial statements, we have also audited the related financial statement schedules listed in Item 14 on page 34 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 San Francisco, California March 3, 1994 All other information required by this Item is included in the 1994 Proxy Statement on pages and (entire text under the heading "Report of Management"), and on pages through thereof (all text and data through Note N on such pages, comprising the Corporation's consolidated financial statements) and is incorporated herein by reference pursuant to General Instruction G(2). Item 9. Item 9. Changes in and Disagreements on Accounting and Financial Disclosure. No disagreements with accountants on any accounting or financial disclosure occurred during the period covered by this report. PART III Item 10. Item 10. Directors and Executive Officers of Registrant. For information with respect to executive officers of the Corporation, see "Executive Officers of the Registrant" at the end of Part I of this report. For information with respect to the directors of the Corporation, see "Election of Directors" on pages 4 through 6 of the 1994 Proxy Statement. Item 11. Item 11. Executive Compensation. For information with respect to executive compensation, see "Report of the Compensation and Personnel Committee" through "Executive Compensation" on pages 10 through 12 of the 1994 Proxy Statement. For information with respect to director compensation, see "Director Compensation and Related Transactions" on pages 6 through 8 of the 1994 Proxy Statement. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management. For information with respect to the security ownership of the directors and officers of the Corporation, see page 9 of the 1994 Proxy Statement. Item 13. Item 13. Certain Relationships and Related Transactions. For information with respect to certain relationships and related transactions, see "Director Compensation and Related Transactions" on pages 6 through 8 of the 1994 Proxy Statement. 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 Report of Management .............................. * Report of Independent Accountants ................. * Financial Statements: Consolidated Statements of Income ............. * Consolidated Balance Sheets ................... * Consolidated Statements of Shareowners' Equity ...................................... * Consolidated Statements of Cash Flows ......... * Notes to Consolidated Financial Statements .................................. * Quarterly Financial Data ...................... * (2) Financial Statement Schedules: II - Amounts Receivable From Related Parties and Underwriters, Promoters, and Employees Other Than Related Parties ........................ 44 V - Property, Plant and Equipment ............... 45 VI - Accumulated Depreciation .................... 49 VIII - Valuation and Qualifying Accounts ........... 52 IX - Short-term Borrowings ....................... 55 Financial statement schedules other than those listed above have been omitted either because the required information is contained in the Consolidated Financial Statements and the notes thereto or because such schedules are not required or applicable. * Incorporated herein by reference to the appropriate portions of the 1994 Proxy Statement (File No. 1-8609). (See Part II.) (3) Exhibits: Exhibits identified in parentheses below, on file with the SEC, are incorporated herein by reference as exhibits hereto. Unless otherwise indicated, all exhibits so incorporated are from File No. 1-8609. Exhibit Number Description ------- ----------- 2a Modification of Final Judgment (Exhibit (28) to Form 8-K, date of report August 24, 1982, File No. 1-1105). 2b Plan of Reorganization (Exhibit (2) to Form 8-K, date of report December 16, 1982, File No. 1-1105). 2c March 14, 1983 Motion to Approve Amended Plan of Reorganization (Exhibit (2)a to Form 8-K, date of report March 14, 1983, File No. 1-1105). 2d March 25, 1983 Motion to Approve Plan of Reorganization as Further Amended (Exhibit (2)b to Form 8-K, date of report March 14, 1983, File No. 1-1105). 2e April 7, 1983 Motion to Approve Plan of Reorganization as Further Amended (Exhibit (2)c to Form 8-K, date of report March 14, 1983, File No. 1-1105). 2f Order issued April 20, 1983 in "U.S. v. Western Electric Company, Incorporated et al.," by the United States District Court for the District of Columbia, Civil Action No. 82-0192 (Exhibit (2) to Form 8-K, date of report April 20, 1983, File No. 1-1105). 2g August 5, 1983 Memorandum and Order of United States District Court for the District of Columbia approving Plan of Reorganization as Amended (Exhibit (2) to Form 8-K, date of report July 8, 1983, File No. 1-1105). 2h September 10, 1987 Opinion and Order of the United States District Court for the District of Columbia in "U.S. v. Western Electric Company, Incorporated, et. al.," Civil Action No. 82-0192 (Exhibit 2h to Form SE filed November 10, 1987 in connection with the Corporation's Form 10-Q for the quarter ended September 30, 1987). 2i March 7, 1988 Opinion and Order of the United States District Court for the District of Columbia in "U.S. v. Western Electric Company, Incorporated et al.," Civil Action No. 82-0192 (Exhibit 2h to Form SE filed March 29, 1988 in connection with the Corporation's Form 10-K for 1987). 2j April 3, 1990 Opinion of the United States Court of Appeals, District of Columbia in "U.S. v. Western Electric Company, Incorporated, et al., "Case Nos. 87-5388 et al. (Exhibit 2j to Form SE filed May 11, 1990 in connection with the Corporation's Form 10-Q for the quarter ended March 31, 1990). 2k July 25, 1991 Opinion & Order of the United States District Court for the District of Columbia in "U.S. v. Western Electric Company, Incorporated, et al.," Civil Action No. 82-0192 (Exhibit 2k to Form SE filed August 12, 1991 in connection with the Corporation's Form 10-Q for the quarter ended June 30, 1991). 2l October 7, 1991 Order of the United States Court of Appeals, District of Columbia in "U.S. v. Western Electric Company, Incorporated, et al.," Case Nos. 91-5263, et al. (Exhibit 2l to Form SE filed March 26, 1992 in connection with the Corporation's Form 10-K for 1991). 2m May 28, 1993 Order of the United States Court of Appeals, District of Columbia in "U.S. v. Western Electric Company, Incorporated, et al., and National Assn. of Broadcasters, et al.," Case Nos. 91-5263, et al. (Exhibit 2m filed August 12, 1993, in connection with the Corporation's Form 10-Q for the quarter ended June 30, 1993). 2n December 28, 1993 Order of the United States Court of Appeals, District of Columbia in "U.S. v. Western Electric Company, Incorporated, et al.," Case Nos. 92-5111, et al. 3a Articles of Incorporation of Pacific Telesis Group, as amended to June 17, 1988 (Exhibit 2b to Registration Statement No. 33-24765). 3b By-Laws of Pacific Telesis Group, as amended to September 24, 1993 (Exhibit 3b to Registration Statement No. 33-50897, filed November 2, 1993, File No. 1-8609). 4a No instrument which defines the rights of holders of long- and intermediate-term debt of Pacific Telesis Group and its subsidiaries is filed herewith pursuant to Regulation S-K, Item 601(b)(4)(iii)(A). Pursuant to this regulation, Pacific Telesis Group hereby agrees to furnish a copy of any such instrument to the SEC upon request. 4b Rights Agreement, dated as of September 22, 1989, between Pacific Telesis Group and The First National Bank of Boston, as successor Rights Agent, which includes as Exhibit B thereto the form of Rights Certificate (Exhibits 1 and 2 to Form SE filed September 25, 1989 as part of Form 8-A, File No. 1-8609). 10a Reorganization and Divestiture Agreement dated as of November 1, 1983 between American Telephone and Telegraph Company, Pacific Telesis Group and its affiliates (Exhibit (10)a to Form 10-K for 1983). 10b Agreement Concerning Patents, Technical Information and Copyrights dated as of November 1, 1983 between American Telephone and Telegraph Company and Pacific Telesis Group (Exhibit (10)g to Form 10-K for 1983). 10c Agreement Concerning Contingent Liabilities, Tax Matters and Termination of Certain Agreements dated as of November 1, 1983 among American Telephone and Telegraph Company, Bell System Operating Companies and Regional Holding Companies (including Pacific Telesis Group and affiliates) (Exhibit (10)j to Form 10-K for 1983). 10d Agreement Regarding Allocation of Contingent Liabilities dated as of January 28, 1985 between American Telephone and Telegraph Company, American Information Technologies Corporation, Bell Atlantic Corporation, BellSouth Corporation, NYNEX Corporation, Pacific Telesis Group and Southwestern Bell Corporation (Exhibit 10c to Form SE filed March 26, 1986 in connection with the Corporation's Form 10-K for 1985). 10e Separation Agreement by and between the Corporation and PacTel Corporation dated as of October 7, 1993, and amended November 2, 1993 and March 25, 1994. 10aa Pacific Telesis Group Senior Management Short Term Incentive Plan (Exhibit 10aa to Registration Statement No. 2-87852). 10aa(i) Resolutions amending the Plan, effective August 28, 1987 (Exhibit 10aa(i) Form SE filed March 26, 1992 in connection with the Corporation's Form 10-K for 1991). 10bb Pacific Telesis Group Senior Management Long Term Incentive Plan (Exhibit 10bb to Form SE filed March 26, 1986 in connection with the Corporation's Form 10-K for 1985). 10cc Pacific Telesis Group Executive Life Insurance Plan (Exhibit 10cc to Form SE filed March 27, 1987 in connection with the Corporation's Form 10-K for 1986). 10cc(i) Resolutions amending the Plan, effective April 1, 1994. 10dd Pacific Telesis Group Senior Management Long Term Disability and Survivor Protection Plan (Exhibit 10dd to Form SE filed March 23, 1989 in connection with the Corporation's Form 10-K for 1988). 10dd(i) Resolutions amending the Plan effective May 22, 1992 and November 20, 1992 (Exhibit 10dd(i) to Form SE filed March 26, 1993 in connection with the Corporation's Form 10-K for 1992). 10ee Pacific Telesis Group Senior Management Transfer Program (Exhibit 10ee to Registration Statement No. 2-87852). 10ff Pacific Telesis Group Senior Management Financial Counseling Program (Exhibit 10ff to Registration Statement No. 2-87852). 10gg Pacific Telesis Group Deferred Compensation Plan for Nonemployee Directors (Exhibit 10gg to Form SE filed April 1, 1991 in connection with the Corporation's Form 10-K for 1990). 10gg(i) Resolutions amending the Plan effective December 21, 1990, November 20, 1992 and December 18, 1992 (Exhibit 10gg(i) to Form SE filed March 26, 1993 in connection with the Corporation's Form 10-K for 1992). 10gg(ii) Resolutions amending the Plan, effective April 1, 1994. 10hh Description of Pacific Telesis Group Directors' and Officers' Liability Insurance Program. 10ii Description of Pacific Telesis Group Plan for Nonemployee Directors' Travel Accident Insurance (Exhibit 10ii to Form SE filed March 26, 1990 in connection with the Corporation's Form 10-K for 1989). 10jj Pacific Telesis Group 1994 Stock Incentive Plan (Attachment A to Pacific Telesis Group's 1994 Proxy Statement, including Pacific Telesis Group's 1993 Consolidated Financial Statements (Filed March 11, 1994, and amended March 14 and March 25, 1994, File No. 1-8609)). 10kk Pacific Telesis Group Executive Non-Qualified Pension Plan (Exhibit 10kk to Form SE filed April 1, 1991 in connection with the Corporation's Form 10-K for 1990). 10kk(i) Resolutions amending the Plan, effective as of June 28, 1991. (Exhibit 10kk(i) to Form SE filed March 26, 1992 in connection with the Corporation's Form 10-K for 1991). 10kk(ii) Resolutions amending the Plan effective May 22, 1992 and November 20, 1992 (Exhibit 10kk(ii) to Form SE filed March 26, 1993 in connection with the Corporation's Form 10-K for 1992). 10kk(iii) Resolutions amending the Plan, effective date April 1, 1994. 10kk(iv) Trust Agreement No. 3 between Pacific Telesis Group and Bankers Trust Company in connection with the Corporation's executive supplemental pension benefits. 10ll Pacific Telesis Group Executive Deferral Plan (Exhibit 10ll to Form SE filed March 26, 1990 in connection with the Corporation's Form 10-K for 1989). 10ll(i) Resolutions amending the Plan effective November 20, 1992 and December 23, 1992 (Exhibit 10ll(i) to Form SE filed March 26, 1993 in connection with the Corporation's Form 10-K for 1992). 10ll(ii) Resolutions amending the Plan, effective November 15, 1993 and January 1, 1994. 10ll(iii) Resolutions amending the Plan, effective April 1, 1994. 10mm Pacific Telesis Group Mid-Career Hire Program (Exhibit 10mm to Form SE filed March 23, 1989 in connection with the Corporation's Form 10-K for 1988). 10nn Pacific Telesis Group Mid-Career Pension Plan (Exhibit 10nn to Form SE filed March 27, 1987 in connection with the Corporation's Form 10-K for 1986). 10nn(i) Resolutions amending the Plan effective May 22, 1992 and November 20, 1992 (Exhibit 10nn(i) to Form SE filed March 26, 1993 in connection with the Corporation's Form 10-K for 1992). 10nn(ii) Resolutions amending the Plan, effective April 1, 1994 (Filed as exhibit 10kk(iii) to this Form 10- K). 10nn(iii) Trust Agreement No. 3 between Pacific Telesis Group and Bankers Trust Company in connection with the Corporation's executive supplemental pension benefits (Filed as Exhibit 10kk(iv) to this Form 10-K). 10oo Pacific Telesis Group Stock Option and Stock Appreciation Rights Plan (Plan Text, Sections 1-17, in Registration Statement No. 33-15391). 10oo(i) Resolutions amending the Plan effective November 17, 1989 and June 26, 1992 (Exhibit 10oo(i) to Form SE filed March 26, 1993 in connection with the Corporation's Form 10-K for 1992). 10oo(ii) Resolutions amending the Plan, effective April 1, 1994. 10pp Employment Contracts for Certain Senior Officers of Pacific Telesis Group (Exhibit 10pp to Form SE filed March 23, 1989 in connection with the Corporation's Form 10-K for 1988). 10pp(i) Schedule to Exhibit 10pp. 10pp(ii) Employment contracts for certain senior officers of Pacific Telesis Group. 10qq Reserved. 10rr Executive supplemental benefit agreement. 10ss Pacific Telesis Group Outside Directors' Retirement Plan (Exhibit 10ss to Form SE filed March 15, 1985 in connection with the Corporation's Form 10-K for 1984). 10ss(i) Resolution amending the Plan effective May 25, 1990 (Exhibit 10ss(i) to Form SE filed March 26, 1993 in connection with the Corporation's Form 10-K for 1992). 10tt Representative Indemnity Agreement between Pacific Telesis Group and certain of its officers and each of its directors (Exhibit 10tt to Form SE filed March 29, 1988 in connection with the Corporation's Form 10-K for 1987). 10uu Trust Agreement between Pacific Telesis Group and Bankers Trust Company, as successor Trustee, in connection with the Pacific Telesis Group Executive Deferral Plan (Exhibit 10uu to Form SE filed March 23, 1989 in connection with the Corporation's Form 10-K for 1988). 10uu(i) Amendment to Trust Agreement No. 1 effective December 11, 1992 (Exhibit 10uu(i) to Form SE filed March 26, 1993 in connection with the Corporation's Form 10-K for 1992). 10uu(ii) Amendment to Trust Agreement No. 1, effective May 28, 1993. 10uu(iii) Amendment to Trust Agreement No. 1, effective November 15, 1993. 10vv Trust Agreement between Pacific Telesis Group and Bankers Trust Company, as successor Trustee, in connection with the Pacific Telesis Group Deferred Compensation Plan for the Nonemployee Directors (Exhibit 10vv to Form SE filed March 23, 1989 in connection with the Corporation's Form 10-K for 1988). 10vv(i) Amendment to Trust Agreement No. 2 effective December 11, 1992 (Exhibit 10vv(i) to Form SE filed March 26, 1993 in connection with the Corporation's Form 10-K for 1992). 10vv(ii) Amendment to Trust Agreement No. 2, effective May 28, 1993. 10ww Pacific Telesis Group Long Term Incentive Award Deferral Plan (Exhibit 10ww to Form SE filed March 27, 1990 in connection with the Corporation's Form 10-K for 1989). 10ww(i) Resolutions merging the Plan with the Executive Deferral Plan effective May 22, 1992 (Exhibit 10ww(i) to Form SE filed March 26, 1993 in connection with the Corporation's Form 10-K for 1992). 10xx Pacific Telesis Group Nonemployee Director Stock Option Plan (Exhibit A to Pacific Telesis Group's 1990 Proxy Statement filed February 26, 1990). 10xx(i) Resolutions amending the Plan, effective April 1, 1994. 10xx(ii) Provisions of 1994 Stock Incentive Plan terminating the Plan, contingent upon approval of the 1994 Stock Incentive Plan by the Corporation's shareowners on April 29, 1994. (Exhibit 10jj to this Form 10-K). 10yy Pacific Telesis Group Supplemental Executive Retirement Plan (Exhibit 10yy to Form SE filed April 1, 1991 in connection with the Corporation's Form 10-K for 1990). 10yy(i) Resolutions amending the Plan effective November 20, 1992 (Exhibit 10yy(i) to Form SE filed March 26, 1993 in connection with the Corporation's Form 10-K for 1992). 10yy(ii) Resolutions amending the Plan, effective April 1, 1994 (Filed as Exhibit 10kk(iii) to this Form 10- K). 10yy(iii) Trust Agreement No. 3 between Pacific Telesis Group and Bankers Trust Company in connection with the Corporation's executive supplemental pension benefits (Filed as Exhibit 10kk(iv) to this Form 10-K). 10zz Pacific Telesis Group Nonemployee Director Stock Grant Plan (Exhibit 10zz to Form SE filed March 26, 1992 in connection with the Corporation's Form 10-K for 1991). 10zz(i) Provisions of 1994 Stock Incentive Plan terminating the Plan, contingent upon approval of the 1994 Stock Incentive Plan by the Corporation's shareowners on April 29, 1994. (Exhibit 10jj to this Form 10-K). 11 Computation of Earnings per Common Share. 12 Computation of Ratio of Earnings to Fixed Charges. 13 Pacific Telesis Group's 1994 Proxy Statement, including Pacific Telesis Group's 1993 Consolidated Financial Statements (Filed March 11, 1994, and amended March 14 and March 25, 1994, File No. 1-8609). 21 Subsidiaries of Pacific Telesis Group. 23 Consent of Coopers & Lybrand. 24 Powers of Attorney executed by Directors and Officers who signed this Form 10-K. 99a Annual Report on Form 11-K for the Pacific Telesis Group Supplemental Retirement and Savings Plan for Salaried Employees for the year 1993 (To be filed as an amendment within 180 days). 99b Annual Report on Form 11-K for the Pacific Telesis Group Supplemental Retirement and Savings Plan for Nonsalaried Employees for the year 1993 (To be filed as an amendment within 180 days). 99c Annual Report on Form 11-K for the AirTouch Communications Retirement Plan for the year 1993 (To be filed as an amendment within 180 days). The Corporation will furnish to a security holder upon request a copy of any exhibit at cost. (b) Reports on Form 8-K: Form 8-K, date of report November 2, 1993 was filed with the SEC with the Corporation's two press releases, both issued November 2, 1993 with the following titles: "Pacific Telesis Encouraged by Spin off Decision" and "Pacific Telesis Board Approves Public Stock Offering." 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 TELESIS GROUP BY /s/ Lydell L. Christensen ------------------------- Lydell L. Christensen, Executive Vice President and Chief Financial Officer (Principal Accounting Officer) DATE: March 29, 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. Sam Ginn,* Chairman of the Board, President and Chief Executive Officer L. L. Christensen,* Executive Vice President and Chief Financial Officer P. J. Quigley,* Group President and Director C. L. Cox,* Group President and Director William Clark,* Director Ivan J. Houston,* Director Herman E. Gallegos,* Director Mary S. Metz,* Director Donald E. Guinn,* Director Lewis E. Platt,* Director J. R. Harvey,* Director Toni Rembe,* Director P. Hazen,* Director S. Donley Ritchey,* Director F. C. Herringer,* Director *BY /s/ Richard W. Odgers --------------------------------- Richard W. Odgers, attorney-in-fact DATE: March 29, 1994 Sheet 1 of 1 PACIFIC TELESIS GROUP AND SUBSIDIARIES SCHEDULE II - AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS, AND EMPLOYEES OTHER THAN RELATED PARTIES (Dollars in millions) - ----------------------------------------------------------------------------- COL. A COL. B COL. C COL. D COL. E - ----------------------------------------------------------------------------- Balance Deductions at End of --------------------- Balance Prior Amounts | Amounts at End of Name of Debtor Period Additions Collected|Written-off Period - ----------------------------------------------------------------------------- AirTouch Communications (a) - ----------------------- 1993 $858 $874 $1,732 - $ - 1992 $523 $971 $ 636 - $858 1991 $244 $765 $ 486 - $523 - --------------- (a) Amounts presented herein reflect intercompany borrowings by AirTouch from PacTel Capital Resources ("PTCR"), a wholly owned subsidiary of Pacific Telesis Group. These borrowings, less certain amounts payable to AirTouch, are reflected as current assets within the Corporation's balance sheets as net receivables due from spin-off operations. The borrowings from PTCR were primarily in the form of promissory notes bearing interest at variable rates which averaged 6.1, 5.7, and 8.1 percent, respectively, during 1993, 1992, and 1991. (See also Note J to the 1993 Consolidated Financial Statements contained in the 1994 Proxy Statement.) Sheet 1 of 4 PACIFIC TELESIS GROUP AND SUBSIDIARIES SCHEDULE V - PROPERTY, PLANT, AND EQUIPMENT (Dollars in millions) - --------------------------------------------------------------------------- COL. A COL. B COL. C COL. D COL. E COL. F - --------------------------------------------------------------------------- Balance at Balance at End of Prior Additions Other End of Period at Cost Retirements Changes Period Classification 12/31/92 (a) (b) (c) 12/31/93 - --------------------------------------------------------------------------- Year 1993* Land and buildings.. $ 2,960 $ 108 $ 88 $ - $ 2,980 Cable, conduit, and connections....... 10,111 506 123 - 10,494 Central office equipment......... 9,493 794 748 3 9,542 Furniture, equipment, and other ........ 3,028 383 405 (1) 3,005 Construction in progress.......... 529 63 6 - 586 ------------------------------------------------------- Total Property, Plant, and Equipment ........ $26,121 $1,854 $1,370 $ 2 $26,607 =========================================================================== See accompanying notes on Sheet 4 of 4. Sheet 2 of 4 PACIFIC TELESIS GROUP AND SUBSIDIARIES SCHEDULE V - PROPERTY, PLANT, AND EQUIPMENT (Dollars in millions) - --------------------------------------------------------------------------- COL. A COL. B COL. C COL. D COL. E COL. F - --------------------------------------------------------------------------- Balance at Balance at End of Prior Additions Other End of Period at Cost Retirements Changes Period Classification 12/31/91 (a) (b) (c) 12/31/92 - --------------------------------------------------------------------------- Year 1992** Land and buildings.. $ 2,784 $ 221 $ 45 $ - $ 2,960 Cable, conduit, and connections....... 9,724 490 103 - 10,111 Central office equipment......... 9,256 645 406 (2) 9,493 Furniture, equipment, and other ........ 2,922 426 320 - 3,028 Construction in progress.......... 469 62 2 - 529 ------------------------------------------------------- Total Property, Plant, and Equipment ........ $25,155 $1,844 $876 $(2) $26,121 =========================================================================== See accompanying notes on Sheet 4 of 4. Sheet 3 of 4 PACIFIC TELESIS GROUP AND SUBSIDIARIES SCHEDULE V - PROPERTY, PLANT, AND EQUIPMENT (Dollars in millions) - --------------------------------------------------------------------------- COL. A COL. B COL. C COL. D COL. E COL. F - --------------------------------------------------------------------------- Balance at Balance at End of Prior Additions Other End of Period at Cost Retirements Changes Period Classification 12/31/90 (a) (b) (c) 12/31/91 - --------------------------------------------------------------------------- Year 1991** Land and buildings.. $ 2,628 $ 196 $ 40 $ - $ 2,784 Cable, conduit, and connections....... 10,905 494 1,675 - 9,724 Central office equipment......... 8,802 793 339 - 9,256 Furniture, equipment, and other ........ 2,902 306 283 (3) 2,922 Construction in progress.......... 507 (34) 4 - 469 ------------------------------------------------------- Total Property, Plant, and Equipment ........ $25,744 $1,755 $2,341 $(3) $25,155 =========================================================================== See accompanying notes on Sheet 4 of 4. Sheet 4 of 4 PACIFIC TELESIS GROUP AND SUBSIDIARIES SCHEDULE V - PROPERTY, PLANT, AND EQUIPMENT - -------------------- * Excludes amounts for spin-off operations. ** Restated to reflect the planned spin-off of the Corporation's wireless operations, which are excluded from amounts for continuing operations in the current financial statement presentation of Pacific Telesis Group. (a) Property, plant, and equipment (which consists primarily of telephone plant dedicated to providing telecommunications services) is carried at cost. The cost of self-constructed plant includes employee wages and benefits, materials, and other costs. Regulators allow the Telephone Companies to accrue an allowance for funds used during construction as a cost of constructing certain plant and as an item of miscellaneous income. Additions to property, plant, and equipment under construction are reported net of amounts transferred to in-service classifications upon completion and, as a result, may be negative. (b) When the Telephone Companies retire or sell property, plant, and equipment, the original cost is credited to the corresponding plant accounts and charged to accumulated depreciation. When the Corporation's holding company and its diversified subsidiaries sell or otherwise dispose of property, plant, and equipment, the original cost is credited to the corresponding asset account, the related accumulated depreciation is debited, and any gain or loss realized is included in miscellaneous income (see Consolidated Statements of Income in "Item 8. Financial Statements and Supplementary Data"). (c) Primarily reflects the reclassification of amounts within asset categories. - ------------------- The Telephone Companies' provision for depreciation is computed primarily using the remaining-life method, essentially a form of straight-line depreciation, using depreciation rates prescribed by state and federal regulatory agencies. The remaining-life method provides for the full recovery of the investment in telephone plant. For the years 1993, 1992, and 1991 depreciation expressed as a percentage of average depreciable plant was 6.9%, 6.9%, and 7.0%, respectively. - -------------------- Sheet 1 of 3 PACIFIC TELESIS GROUP AND SUBSIDIARIES SCHEDULE VI - ACCUMULATED DEPRECIATION (Dollars in millions) - --------------------------------------------------------------------------- COL. A COL. B COL. C COL. D COL. E COL. F - --------------------------------------------------------------------------- Balance at Additions Balance at End of Prior Charged to Other End of Period Costs and Retire- Changes Period Classification 12/31/92 Expenses ments (a) 12/31/93 - --------------------------------------------------------------------------- Year 1993* Land and buildings.. $ 456 $ 82 $ 26 $(12) $ 500 Cable, conduit, and connections....... 3,458 495 122 (34) 3,797 Central office equipment......... 4,043 797 748 36 4,128 Furniture, equipment, and other ........ 1,554 363 365 (16) 1,536 ------------------------------------------------------- Total Property, Plant, and Equipment ........ $9,511 $1,737 $1,261 $(26) $9,961 =========================================================================== * Excludes amounts for spin-off operations. (a) Other changes for 1993 primarily reflects Pacific Bell salvage, cost of removal and reclassifications of amounts within asset categories, offset, in part, by $12 million depreciation charged by the Corporation's real estate subsidiary to a restructuring reserve. Sheet 2 of 3 PACIFIC TELESIS GROUP AND SUBSIDIARIES SCHEDULE VI - ACCUMULATED DEPRECIATION (Dollars in millions) - --------------------------------------------------------------------------- COL. A COL. B COL. C COL. D COL. E COL. F - --------------------------------------------------------------------------- Balance at Additions Balance at End of Prior Charged to Other End of Period Costs and Retire- Changes Period Classification 12/31/91 Expenses ments (a) 12/31/92 - --------------------------------------------------------------------------- Year 1992* Land and buildings.. $ 401 $ 76 $ 23 $ 2 $ 456 Cable, conduit, and connections....... 3,119 459 101 (19) 3,458 Central office equipment......... 3,683 810 404 (46) 4,043 Furniture, equipment, and other ........ 1,458 364 329 61 1,554 ------------------------------------------------------- Total Property, Plant, and Equipment ........ $8,661 $1,709 $857 $ (2) $9,511 =========================================================================== * Restated to reflect the planned spin-off of the Corporation's wireless operations, which are excluded from amounts for continuing operations in the current financial statement presentation of Pacific Telesis Group. (a) Other changes for 1992 primarily reflects Pacific Bell salvage, cost of removal and reclassifications of amounts within asset categories, the effects of which are significantly offset by $12 million depreciation charged by the Corporation's real estate subsidiary to a restructuring reserve. Sheet 3 of 3 PACIFIC TELESIS GROUP AND SUBSIDIARIES SCHEDULE VI - ACCUMULATED DEPRECIATION (Dollars in millions) - --------------------------------------------------------------------------- COL. A COL. B COL. C COL. D COL. E COL. F - --------------------------------------------------------------------------- Balance at Additions Balance at End of Prior Charged to Other End of Period Costs and Retire- Changes Period Classification 12/31/90 Expenses ments (a) 12/31/91 - --------------------------------------------------------------------------- Year 1991* Land and buildings.. $ 355 $ 63 $ 25 $ 8 $ 401 Cable, conduit, and connections....... 4,272 502 1,656 1 3,119 Central office equipment......... 3,186 806 352 43 3,683 Furniture, equipment, and other ........ 1,361 365 276 8 1,458 ------------------------------------------------------- Total Property, Plant, and Equipment ........ $9,174 $1,736 $2,309 $60 $8,661 =========================================================================== * Restated to reflect the planned spin-off of the Corporation's wireless operations, which are excluded from amounts for continuing operations in the current financial statement presentation of Pacific Telesis Group. (a) Other Changes for 1991 consists of: Pacific Bell - primarily includes salvage, and amortization deferred to 1992 relating to a depreciation reserve deficiency per FCC order $46 Real estate subsidiary - depreciation charged to a restructuring reserve 11 Other 3 ---- $60 ==== Sheet 1 of 3 PACIFIC TELESIS GROUP AND SUBSIDIARIES SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS (Dollars in millions) - --------------------------------------------------------------------------- COL. A COL. B COL. C COL. D COL. E - --------------------------------------------------------------------------- Allowance for Doubtful Accounts - ------------------------------- Additions -------------------- (1) (2) Charged to Charged Balance at Costs and to Other Balance at End of Prior Expenses Accounts Deductions End of Period (a) (b) (c) Period - --------------------------------------------------------------------------- Year 1993 $130 $163 $140 $295 $138 Year 1992* $ 98 $160 $165 $293 $130 Year 1991* $ 85 $124 $126 $237 $ 98 =========================================================================== Reserve for Discontinuance of Real Estate Operations - ---------------------------------------------------- Additions -------------------- (1) (2) Charged to Charged Balance at Costs and to Other Balance at End of Prior Expenses Accounts Deductions End of Period (d) Period - --------------------------------------------------------------------------- Year 1993 $ 33 $347 $0 $42 $338 Year 1992 $ 75 $ 0 $0 $42 $ 33 Year 1991 $100 $ 0 $0 $25 $ 75 =========================================================================== See accompanying notes on Sheet 3 of 3. Sheet 2 of 3 PACIFIC TELESIS GROUP AND SUBSIDIARIES SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS (Dollars in millions) - --------------------------------------------------------------------------- COL. A COL. B COL. C COL. D COL. E - --------------------------------------------------------------------------- Reserve for Restructuring-Pacific Bell - -------------------------------------- Additions -------------------- (1) (2) Charged to Charged Balance at Costs and to Other Balance at End of Prior Expenses Accounts End of Period (e) (f) Deductions Period - --------------------------------------------------------------------------- Year 1993 $101 $977 $43 $ 24 $1,097 Year 1992 $165 $ 0 $ 0 $ 64 $ 101 Year 1991 $ 0 $166 $21 $ 22 $ 165 =========================================================================== Various Other Reserves - ---------------------- Additions -------------------- (1) (2) Balance at Charged to Charged Balance at End of Prior Costs and to Other End of Period Expenses Accounts Deductions Period - --------------------------------------------------------------------------- Year 1993 $27 $107 $0 $44 $90 Year 1992 $ 9 $ 18 $0 $ 0 $27 Year 1991 $ 9 $ 0 $0 $ 0 $ 9 =========================================================================== See accompanying notes on Sheet 3 of 3. Sheet 3 of 3 PACIFIC TELESIS GROUP AND SUBSIDIARIES SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS - -------------------- * Restated to reflect the planned spin-off of the Corporation's wireless operations, which are excluded from amounts for continuing operations in the current financial statement presentation of Pacific Telesis Group. (a) Provision for uncollectibles includes certain direct write-off items which are not reflected in this account. (b) Amounts in this column reflect items of uncollectible interstate and intrastate accounts receivable purchased from and billed for AT&T and other interexchange carriers under contract arrangements. (c) Amounts in this column reflect items written off, net of amounts previously written off but subsequently recovered. (d) Costs and expenses for 1993 reflect an additional pre-tax loss reserve of $347 million to cover potential future losses on real estate sales and estimated operating losses of the Corporation's wholly owned real estate subsidiary during the planned sales period. An earlier reserve of $100 million had been recorded in 1990. (e) In 1993 and 1991, respectively, Pacific Bell recorded pre-tax restructuring charges to recognize the incremental cost of force reductions. (f) Amounts in this column reflect items capitalized to construction. - -------------------- Sheet 1 of 4 PACIFIC TELESIS GROUP AND SUBSIDIARIES SCHEDULE IX - SHORT-TERM BORROWINGS (Dollars in millions) - --------------------------------------------------------------------------- Col. A Col. B Col. C Col. D Col. E Col. F - --------------------------------------------------------------------------- Weighted Average Weighted Average Interest Average Maximum Amount Rate Interest Amount Outstanding During Balance Rate at Outstanding During the the at End End of at any Period Period Description of Period Period Month-End (a) (b) - --------------------------------------------------------------------------- Year 1993* Notes Payable to Banks (c)...... $ 4 6.12% $ 168 $ 45 5.06% Commercial Paper (d)...... 586 3.23% $1,002 $567 3.20% ------ Total ........... $590 ====== =========================================================================== See accompanying notes on Sheet 4 of 4. Sheet 2 of 4 PACIFIC TELESIS GROUP AND SUBSIDIARIES SCHEDULE IX - SHORT-TERM BORROWINGS (Dollars in millions) - --------------------------------------------------------------------------- Col. A Col. B Col. C Col. D Col. E Col. F - --------------------------------------------------------------------------- Weighted Average Weighted Average Interest Average Maximum Amount Rate Interest Amount Outstanding During Balance Rate at Outstanding During the the at End End of at any Period Period Description of Period Period Month-End (a) (b) - --------------------------------------------------------------------------- Year 1992** Notes Payable to Banks (c)...... $ 183 4.44% $283 $212 6.81% Commercial Paper (d)...... 880 3.48% $880 $707 3.74% ------ Total ........... $1,063 ====== =========================================================================== See accompanying notes on Sheet 4 of 4. Sheet 3 of 4 PACIFIC TELESIS GROUP AND SUBSIDIARIES SCHEDULE IX - SHORT-TERM BORROWINGS (Dollars in millions) - --------------------------------------------------------------------------- Col. A Col. B Col. C Col. D Col. E Col. F - --------------------------------------------------------------------------- Weighted Average Weighted Average Interest Average Maximum Amount Rate Interest Amount Outstanding During Balance Rate at Outstanding During the the at End End of at any Period Period Description of Period Period Month-End (a) (b) - --------------------------------------------------------------------------- Year 1991** Notes Payable to Banks (c)....... $204 5.34% $ 215 $201 7.33% Commercial Paper (d)....... 707 4.94% $1,143 $752 5.97% ---- Total ............ $911 ==== =========================================================================== See accompanying notes on Sheet 4 of 4. Sheet 4 of 4 PACIFIC TELESIS GROUP AND SUBSIDIARIES SCHEDULE IX - SHORT-TERM BORROWINGS - -------------------------- * Excludes amounts for spin-off operations. ** Restated to reflect the planned spin-off of the Corporation's wireless operations, which are excluded from amounts for continuing operations in the current financial statement presentation of Pacific Telesis Group. (a) Computed by dividing the aggregate daily amount outstanding by the number of days in the year. (b) Computed by dividing the aggregate related interest expense by the average amount outstanding during the year. (c) Comprised primarily of borrowings under informal lines of credit with original maturities of 360 days or less. (d) Original maturities of 120 days or less. - -------------------------- TELESIS(R) is a registered trademark of Pacific Telesis Group. EXHIBIT INDEX Exhibits identified in parentheses below, on file with the SEC, are incorporated herein by reference as exhibits hereto. All other exhibits are provided as part of the electronic transmission. Unless otherwise indicated, all exhibits so incorporated are from File No. 1-8609. Exhibit Number Description ------- ----------- 2a Modification of Final Judgment (Exhibit (28) to Form 8-K, date of report August 24, 1982, File No. 1-1105). 2b Plan of Reorganization (Exhibit (2) to Form 8-K, date of report December 16, 1982, File No. 1-1105). 2c March 14, 1983 Motion to Approve Amended Plan of Reorganization (Exhibit (2)a to Form 8-K, date of report March 14, 1983, File No. 1-1105). 2d March 25, 1983 Motion to Approve Plan of Reorganization as Further Amended (Exhibit (2)b to Form 8-K, date of report March 14, 1983, File No. 1-1105). 2e April 7, 1983 Motion to Approve Plan of Reorganization as Further Amended (Exhibit (2)c to Form 8-K, date of report March 14, 1983, File No. 1-1105). 2f Order issued April 20, 1983 in "U.S. v. Western Electric Company, Incorporated et al.," by the United States District Court for the District of Columbia, Civil Action No. 82-0192 (Exhibit (2) to Form 8-K, date of report April 20, 1983, File No. 1-1105). 2g August 5, 1983 Memorandum and Order of United States District Court for the District of Columbia approving Plan of Reorganization as Amended (Exhibit (2) to Form 8-K, date of report July 8, 1983, File No. 1-1105). 2h September 10, 1987 Opinion and Order of the United States District Court for the District of Columbia in "U.S. v. Western Electric Company, Incorporated, et. al.," Civil Action No. 82-0192. (Exhibit 2h to Form SE filed November 10, 1987 in connection with the Corporation's Form 10-Q for the quarter ended September 30, 1987). 2i March 7, 1988 Opinion and Order of the United States District Court for the District of Columbia in "U.S. v. Western Electric Company, Incorporated et al.," Civil Action No. 82-0192 (Exhibit 2h to Form SE filed March 29, 1988 in connection with the Corporation's Form 10-K for 1987). 2j April 3, 1990 Opinion of the United States Court of Appeals, District of Columbia in "U.S. v. Western Electric Company, Incorporated, et al., "Case Nos. 87-5388 et al. (Exhibit 2j to Form SE filed May 11, 1990 in connection with the Corporation's Form 10-Q for the quarter ended March 31, 1990). 2k July 25, 1991 Opinion & Order of the United States District Court for the District of Columbia in "U.S. v. Western Electric Company, Incorporated, et al.," Civil Action No. 82-0192 (Exhibit 2k to Form SE filed August 12, 1991 in connection with the Corporation's Form 10-Q for the quarter ended June 30, 1991). 2l October 7, 1991 Order of the United States Court of Appeals, District of Columbia in "U.S. v. Western Electric Company, Incorporated, et al.," Case Nos. 91-5263, et al. (Exhibit 2l to Form SE filed March 26, 1992 in connection with the Corporation's Form 10-K for 1991). 2m May 28, 1993 Order of the United States Court of Appeals, District of Columbia in "U.S. v. Western Electric Company, Incorporated, et al., and National Assn. of Broadcasters, et al.," Case Nos. 91-5263, et al. (Exhibit 2m filed August 12, 1993, in connection with the Corporation's Form 10-Q for the quarter ended June 30, 1993). 2n December 28, 1993 Order of the United States Court of Appeals, District of Columbia in "U.S. v. Western Electric Company, Incorporated, et al.," Case Nos. 92-5111, et al. 3a Articles of Incorporation of Pacific Telesis Group, as amended to June 17, 1988 (Exhibit 2b to Registration Statement No. 33-24765). 3b By-Laws of Pacific Telesis Group, as amended to September 24, 1993 (Exhibit 3b to Registration Statement No. 33-50897, filed November 2, 1993, File No. 1-8609). 4a No instrument which defines the rights of holders of long- and intermediate-term debt of Pacific Telesis Group and its subsidiaries is filed herewith pursuant to Regulation S-K, Item 601(b)(4)(iii)(A). Pursuant to this regulation, Pacific Telesis Group hereby agrees to furnish a copy of any such instrument to the SEC upon request. 4b Rights Agreement, dated as of September 22, 1989, between Pacific Telesis Group and The First National Bank of Boston, as successor Rights Agent, which includes as Exhibit B thereto the form of Rights Certificate (Exhibits 1 and 2 to Form SE filed September 25, 1989 as part of Form 8-A, File No. 1-8609). 10a Reorganization and Divestiture Agreement dated as of November 1, 1983 between American Telephone and Telegraph Company, Pacific Telesis Group and its affiliates (Exhibit (10)a to Form 10-K for 1983). 10b Agreement Concerning Patents, Technical Information and Copyrights dated as of November 1, 1983 between American Telephone and Telegraph Company and Pacific Telesis Group (Exhibit (10)g to Form 10-K for 1983). 10c Agreement Concerning Contingent Liabilities, Tax Matters and Termination of Certain Agreements dated as of November 1, 1983 among American Telephone and Telegraph Company, Bell System Operating Companies and Regional Holding Companies (including Pacific Telesis Group and affiliates) (Exhibit (10)j to Form 10-K for 1983). 10d Agreement Regarding Allocation of Contingent Liabilities dated as of January 28, 1985 between American Telephone and Telegraph Company, American Information Technologies Corporation, Bell Atlantic Corporation, BellSouth Corporation, NYNEX Corporation, Pacific Telesis Group and Southwestern Bell Corporation (Exhibit 10c to Form SE filed March 26, 1986 in connection with the Corporation's Form 10-K for 1985). 10e Separation Agreement by and between the Corporation and PacTel Corporation dated as of October 7, 1993, and amended November 2, 1993 and March 25, 1993. 10aa Pacific Telesis Group Senior Management Short Term Incentive Plan (Exhibit 10aa to Registration Statement No. 2-87852). 10aa(i) Resolutions amending the Plan, effective August 28, 1987 (Exhibit 10aa(i) Form SE filed March 26, 1992 in connection with the Corporation's Form 10-K for 1991). 10bb Pacific Telesis Group Senior Management Long Term Incentive Plan (Exhibit 10bb to Form SE filed March 26, 1986 in connection with the Corporation's Form 10-K for 1985). 10cc Pacific Telesis Group Executive Life Insurance Plan (Exhibit 10cc to Form SE filed March 27, 1987 in connection with the Corporation's Form 10-K for 1986). 10cc(i) Resolutions amending the Plan, effective April 1, 1994. 10dd Pacific Telesis Group Senior Management Long Term Disability and Survivor Protection Plan (Exhibit 10dd to Form SE filed March 23, 1989 in connection with the Corporation's Form 10-K for 1988). 10dd(i) Resolutions amending the Plan effective May 22, 1992 and November 20, 1992 (Exhibit 10dd(i) to Form SE filed March 26, 1993 in connection with the Corporation's Form 10-K for 1992). 10ee Pacific Telesis Group Senior Management Transfer Program (Exhibit 10ee to Registration Statement No. 2-87852). 10ff Pacific Telesis Group Senior Management Financial Counseling Program (Exhibit 10ff to Registration Statement No. 2-87852). 10gg Pacific Telesis Group Deferred Compensation Plan for Nonemployee Directors (Exhibit 10gg to Form SE filed April 1, 1991 in connection with the Corporation's Form 10-K for 1990). 10gg(i) Resolutions amending the Plan effective December 21, 1990, November 20, 1992 and December 18, 1992 (Exhibit 10gg(i) to Form SE filed March 26, 1993 in connection with the Corporation's Form 10-K for 1992). 10gg(ii) Resolutions amending the Plan, effective April 1, 1994. 10hh Description of Pacific Telesis Group Directors' and Officers' Liability Insurance Program. 10ii Description of Pacific Telesis Group Plan for Nonemployee Directors' Travel Accident Insurance (Exhibit 10ii to Form SE filed March 26, 1990 in connection with the Corporation's Form 10-K for 1989). 10jj Pacific Telesis Group 1994 Stock Incentive Plan (Attachment A to Pacific Telesis Group's 1994 Proxy Statement, including Pacific Telesis Group's 1993 Consolidated Financial Statements (Filed March 11, 1994, and amended March 14 and March 25, 1994, File No. 1-8609)). 10kk Pacific Telesis Group Executive Non-Qualified Pension Plan (Exhibit 10kk to Form SE filed April 1, 1991 in connection with the Corporation's Form 10-K for 1990). 10kk(i) Resolutions amending the Plan, effective as of June 28, 1991. (Exhibit 10kk(i) to Form SE filed March 26, 1992 in connection with the Corporation's Form 10-K for 1991). 10kk(ii) Resolutions amending the Plan effective May 22, 1992 and November 20, 1992 (Exhibit 10kk(ii) to Form SE filed March 26, 1993 in connection with the Corporation's Form 10-K for 1992). 10kk(iii) Resolutions amending the Plan, effective April 1, 1994. 10kk(iv) Trust Agreement No. 3 between Pacific Telesis Group and Bankers Trust Company in connection with Pacific Telesis Group executive supplemental pension benefits. 10ll Pacific Telesis Group Executive Deferral Plan (Exhibit 10ll to Form SE filed March 26, 1990 in connection with the Corporation's Form 10-K for 1989). 10ll(i) Resolutions amending the Plan effective November 20, 1992 and December 23, 1992 (Exhibit 10ll(i) to Form SE filed March 26, 1993 in connection with the Corporation's Form 10-K for 1992). 10ll(ii) Resolutions amending the Plan, effective November 15, 1993 and January 1, 1994. 10ll(iii) Resolutions amending the Plan, effective April 1, 1994. 10mm Pacific Telesis Group Mid-Career Hire Program (Exhibit 10mm to Form SE filed March 23, 1989 in connection with the Corporation's Form 10-K for 1988). 10nn Pacific Telesis Group Mid-Career Pension Plan (Exhibit 10nn to Form SE filed March 27, 1987 in connection with the Corporation's Form 10-K for 1986). 10nn(i) Resolutions amending the Plan effective May 22, 1992 and November 20, 1992 (Exhibit 10nn(i) to Form SE filed March 26, 1993 in connection with the Corporation's Form 10-K for 1992). 10nn(ii) Resolutions amending the Plan, effective April 1, 1994 (Filed as exhibit 10kk(iii) to this Form 10-K). 10nn(iii) Trust Agreement No. 3 between Pacific Telesis Group and Bankers Trust Company in connection with the Corporation's executive supplemental pension benefits (Filed as Exhibit 10kk(iv) to this Form 10-K). 10oo Pacific Telesis Group Stock Option and Stock Appreciation Rights Plan (Plan Text, Sections 1-17, in Registration Statement No. 33-15391). 10oo(i) Resolutions amending the Plan effective November 17, 1989 and June 26, 1992 (Exhibit 10oo(i) to Form SE filed March 26, 1993 in connection with the Corporation's Form 10-K for 1992). 10oo(ii) Resolutions amending the Plan, effective April 1, 1994. 10pp Employment Contracts for Certain Senior Officers of Pacific Telesis Group (Exhibit 10pp to Form SE filed March 23, 1989 in connection with the Corporation's Form 10-K for 1988). 10pp(i) Schedule to Exhibit 10pp. 10pp(ii) Employment contracts for certain senior officers of Pacific Telesis Group. 10qq Reserved. 10rr Executive supplemental benefit agreement. 10ss Pacific Telesis Group Outside Directors' Retirement Plan (Exhibit 10ss to Form SE filed March 15, 1985 in connection with the Corporation's Form 10-K for 1984). 10ss(i) Resolution amending the Plan effective May 25, 1990 (Exhibit 10ss(i) to Form SE filed March 26, 1993 in connection with the Corporation's Form 10-K for 1992). 10tt Representative Indemnity Agreement between Pacific Telesis Group and certain of its officers and each of its directors (Exhibit 10tt to Form SE filed March 29, 1988 in connection with the Corporation's Form 10-K for 1987). 10uu Trust Agreement between Pacific Telesis Group and and Bankers Trust Company, as successor Trustee, in connection with the Pacific Telesis Group Executive Deferral Plan (Exhibit 10uu to Form SE filed March 23, 1989 in connection with the Corporation's Form 10-K for 1988). 10uu(i) Amendment to Trust Agreement No. 1 effective December 11, 1992 (Exhibit 10uu(i) to Form SE filed March 26, 1993 in connection with the Corporation's Form 10-K for 1992). 10uu(ii) Amendment to Trust Agreement No. 1, effective May 28, 1993. 10uu(iii) Amendment to Trust Agreement No. 1, effective November 15, 1993. 10vv Trust Agreement between Pacific Telesis Group and Bankers Trust Company, as successor Trustee, in connection with the Pacific Telesis Group Deferred Compensation Plan for the Nonemployee Directors (Exhibit 10vv to Form SE filed March 23, 1989 in connection with the Corporation's Form 10-K for 1988). 10vv(i) Amendment to Trust Agreement No. 2 effective December 11, 1992 (Exhibit 10vv(i) to Form SE filed March 26, 1993 in connection with the Corporation's Form 10-K for 1992). 10vv(ii) Amendment to Trust Agreement No. 2, effective May 28, 1994. 10ww Pacific Telesis Group Long Term Incentive Award Deferral Plan (Exhibit 10ww to Form SE filed March 27, 1990 in connection with the Corporation's Form 10-K for 1989). 10ww(i) Resolutions merging the Plan with the Executive Deferral Plan effective May 22, 1992 (Exhibit 10ww(i) to Form SE filed March 26, 1993 in connection with the Corporation's Form 10-K for 1992). 10xx Pacific Telesis Group Nonemployee Director Stock Option Plan (Exhibit A to Pacific Telesis Group's 1990 Proxy Statement filed February 26, 1990). 10xx(i) Resolutions amending the Plan, effective April 1, 1994. 10xx(ii) Provisions of 1994 Stock Incentive Plan terminating the Plan, contingent upon approval of the 1994 Stock Incentive Plan by the Corporation's shareowners on April 29, 1994. (Exhibit 10jj to this Form 10-K). 10yy Pacific Telesis Group Supplemental Executive Retirement Plan (Exhibit 10yy to Form SE filed April 1, 1991 in connection with the Corporation's Form 10-K for 1990). 10yy(i) Resolutions amending the Plan effective November 20, 1992 (Exhibit 10yy(i) to Form SE filed March 26, 1993 in connection with the Corporation's Form 10-K for 1992). 10yy(ii) Resolutions amending the Plan, effective April 1, 1994 (Filed as Exhibit 10kk(iii) to this Form 10-K). 10yy(iii) Trust Agreement No. 3 between Pacific Telesis Group and Bankers Trust Company in connection with the Corporation's executive supplemental pension benefits (Filed as Exhibit 10kk(iv) to this Form 10-K). 10zz Pacific Telesis Group Nonemployee Director Stock Grant Plan (Exhibit 10zz to Form SE filed March 26, 1992 in connection with the Corporation's Form 10-K for 1991). 10zz(i) Provisions of 1994 Stock Incentive Plan terminating the Plan, contingent upon approval of the 1994 Stock Incentive Plan by the Corporation's shareowners on April 29, 1994. (Exhibit 10jj to Form 10-K). 11 Computation of Earnings per Common Share. 12 Computation of Ratio of Earnings to Fixed Charges. 13 Pacific Telesis Group's 1994 Proxy Statement, including Pacific Telesis Group's 1993 Consolidated Financial Statements (Filed March 11, 1994, and amended March 14 and March 25, 1994, File No. 1-8609). 21 Subsidiaries of Pacific Telesis Group. 23 Consent of Coopers & Lybrand. 24 Powers of Attorney executed by Directors and Officers who signed this Form 10-K. 99a Annual Report on Form 11-K for the Pacific Telesis Group Supplemental Retirement and Savings Plan for Salaried Employees for the year 1993 (To be filed as an amendment within 180 days). 99b Annual Report on Form 11-K for the Pacific Telesis Group Supplemental Retirement and Savings Plan for Nonsalaried Employees for the year 1993 (To be filed as an amendment within 180 days). 99c Annual Report on Form 11-K for the AirTouch Communications Retirement Plan for the year 1993 (To be filed as an amendment within 180 days).

107889_1993.txt

107889_1993

1993

107889

ITEM 1 -- BUSINESS (a) GENERAL DEVELOPMENT OF BUSINESS The Company is a global manufacturer and marketer of specialty chemical and petroleum products for use in a wide variety of industrial and consumer applications. Most of the Company's products are sold to industrial customers for use as additives and intermediates which impart particular characteristics to such customers' end products. The Company provides manufacturing flexibility and a high degree of technical service to create value-added chemical and petroleum products that meet customers' specialized needs. Established in 1920, Witco has ranked among the Fortune 500 largest U.S. industrial firms for many years, ranking 242 for 1992. At December 31, 1993, the Company had 8,161 employees worldwide. The Company's operations are divided among three business segments: Chemical, Petroleum and Diversified Products. Principal products of the Chemical segment include surface active agents, resins, oleochemicals, and polymer additives. Surface active agents (also known as surfactants) are used as emulsifiers in agricultural and food products, and are ingredients in personal care, laundry, and cleaning products; resins are used as adhesion promoters in shoes, coatings, flooring, and construction materials; oleochemicals are used in the production of personal care products, rubber, plastics, paper, and textiles; and polymer additives are used in the production and processing of vinyl, polyethylene, and other polymers. Principal products of the Petroleum segment include white oils, and petrolatums used in cosmetics, pharmaceuticals, and plastics; petroleum sulfonates used as additives in lubricating oils, greases and metalwork fluids; Lubrimatic brand and private label lubricating greases and equipment; asphalt, napthenic oils and road restorative products; and Kendall and Amalie brand motor oils and lubricants. The Diversified Products segment manufactures battery containers and other molded plastics products, as well as carbon black and metal finishing and metalworking products. In 1992 the Company completed the acquisition of the Industrial Chemicals and Natural Substances divisions of Schering AG Berlin (the 'Schering Acquisition') for approximately $440 million. As a result of the acquisition, the Company's international presence expanded with the addition of a large chemical manufacturing base in Germany and operations in Spain, the United Kingdom, France, Italy, and Ecuador. In addition, the Company's specialty businesses in surfactants, polymer additives, and oleochemicals broadened significantly. The Company completed a two-for-one common stock split during the fourth quarter of 1993. In 1993 the Company also disposed of the operations of its Chemprene, Inc. subsidiary, a manufacturer of conveyor belting and other specialized belts. The Company expects to complete the sale of its Allied-Kelite and Battery Parts divisions' businesses in 1994. On March 11, 1994 the Company called for redemption on March 28, 1994 all of its 5 1/2% Convertible Subordinated Debentures due 2012 of which $150 million are outstanding. The debentures are convertible into common stock of the Company at a conversion price of $27.28 per share, which price was below the market price for the Company's common stock on the New York Stock Exchange on March 10, 1994. If all debentures are converted, approximately 5.5 million additional shares of common stock will become issued and outstanding. However, the issuance of additional common stock by reason of conversion of any debentures will have no effect upon the Company's earnings per share calculations as the shares underlying the debentures have been considered as common stock equivalents in such calculations. If all debentures were to be redeemed rather than converted, the total cost to the Company would be $152.8 million. The Company will fund any redemptions through a combination of available cash and short-term borrowings. Witco Corporation was incorporated in 1958 under the laws of Delaware as Witco Chemical Company, Inc., at which time it succeeded by merger to the business of Witco Chemical Company, an Illinois corporation formed in 1920. Its executive offices are located at 520 Madison Avenue, New York, New York 10022-4236, telephone (212) 605-3800. (b) FINANCIAL INFORMATION ABOUT INDUSTRY SEGMENTS Reference is made to Note 15 of the Notes to Financial Statements. See Item 8 -- Financial Statements and Supplementary Data following Part IV of this report. (c) NARRATIVE DESCRIPTION OF BUSINESS The Company's operations are divided among three business segments: Chemical, Petroleum and Diversified Products. Chemical Products Oleochemicals/Surfactants Witco offers one of the broadest lines of surfactants and oleochemicals in the chemical industry, providing 'one-stop shopping' for its customers. These products are sold to a range of industries, including cosmetics and pharmaceuticals; personal care, soap and detergent; agricultural; rubber; food; paint and protective coatings; and textile. Surfactants change the surface tension of liquids. They include agricultural emulsifiers, which are used to break up pesticides into small particles, thereby increasing dispersion and improving penetration, and food emulsifiers, which impart particular characteristics (such as consistency) to certain foods. In addition, surfactants are used in personal care products, fabric softeners, and detergents to improve penetration and cleaning capability. These products are marketed in coordination with the Petroleum Specialties Group of the Company's Petroleum Products segment. Oleochemicals are derived from natural fats and oils, and include fatty acids, fatty amines, esters, and glycerines. Oleochemicals modify surfaces either as direct lubricants, or as components of ingredients that modify surfaces. Examples of their diverse applications include acting as lubricants in plastics; imparting mold release features for the rubber industry; and acting as curing systems for rubber. The Schering Acquisition significantly broadened the Company's surfactants product base to include offerings in all significant specialty surfactants product categories and made Witco a leading U.S. and worldwide producer of cationic surfactants. Cationic surfactants are the major ingredient in fabric softeners, hair conditioners, and other personal care products. The acquisition also complements Witco's oleochemical business with additional fatty amines, which are used as chemical intermediates and to make cationic surfactants. Polymer Additives Witco is a worldwide supplier of polymer additives, producing an extensive array of chemicals used as additives in the plastics industry, including stabilizers for use in the manufacture of polyvinyl chloride products (PVC) for such applications as pipes, fittings, siding, and packaging materials. It is an international supplier of lubricant additives to polyolefin and PVC manufacturers. The Company also makes peroxides for use in the polyolefin and PVC industries, epoxy plasticizers, and stearates used as lubricants in the plastics industry. As a result of the Schering Acquisition, the Company is the leading European producer of aluminum alkyls, used as co-catalysts in the production of polyolefins (including polyethylene and polypropylene, which are among the world's largest volume plastics used in packaging, cars, furniture, and appliances) and produces organotin compounds for the production of PVC stabilizers and biocides for the marine paints. Polyurethanes Witco has long been a major supplier of polyesters, coatings, and urethane chemicals to the construction, leather and textile finishing, and paint industries. The Company is a leading producer of saturated polyester polyols which are used in the manufacture of flexible foam that is sold to a wide variety of industries, including textile and automotive. Witco is currently expanding its polyester polyol business for use in non-cellular urethane applications such as coatings, adhesives, cast elastomers, and thermoplastic urethanes. Resins With the Schering Acquisition, the Company added a resins product line augmenting its polyurethane business, broadening the range of products sold to similar industries and adding complementary research and development capabilities. As a result, Witco has a major share of the European market for thermoplastic polyamide and polyester products used by the adhesives, shoe and textile industries, adhesion promoters used in vinyl plastisol production, and amine and polyamide epoxy resin curing agents and epoxy resins used to manufacture industrial floorings and adhesives and as coatings for infrastructure and building purposes. Customers The Company markets its specialty chemical products directly through its own sales force and through an organized distribution program to a large number of customers in a broad range of industries. Its chemical business is not dependent upon any single customer or a few customers. During the year ended December 31, 1993, no customer accounted for more than 5.2% of Chemical Segment sales, and sales to the ten largest customers accounted for approximately 15.8% of Chemical Segment sales. Competition Many of the specialty chemical products produced by the Company are characterized by a need for a high degree of manufacturing competence and technical service, particularly because customer specifications vary considerably and special formulations must be devised to meet customers' needs. Competition is fragmented, with no one competitor offering products across all of the Company's chemical product lines. Competition is primarily on the basis of performance of the Company's products compared with similar products produced by its competitors. Petroleum Products Petroleum Specialties Witco is an important manufacturer and marketer of white mineral oils, petrolatums, refrigeration oils and telecommunication cable filling compounds, as well as natural and synthetic petroleum sulfonates. White mineral oils and petrolatums are extensively refined, high purity petroleum products suitable for food grade, pharmaceutical and cosmetic applications. They are inert and non-reactive, and impart emolliency, moisture resistance, lubrication and insulation properties. These products are marketed in coordination with the Oleochemicals/Surfactants Group of the Company's Chemical Segment. In addition to personal care and food applications, white mineral oils and petrolatums are used in plastics, agriculture, textiles and chemical processing. Petroleum sulfonates are oil soluble, surface active agents derived from both synthetic and natural petroleum feedstocks. They provide properties of emulsification, dispersion, wetting of solids, and rust and corrosion inhibition, and are used in lubricant additives and metalworking fluids. The Company is also a supplier of fully refined, FDA-quality microcrystalline waxes, which are primarily used in paper lamination and packaging applications including cheese coatings. Lubricants The Company produces motor oils and lubricants which it sells under the Kendall and Amalie brand names. Kendall and Amalie brand products are sold worldwide through a network of over 300 warehouse distributors. Kendall and Amalie brand products are also sold directly to large national accounts domestically. In addition, Witco is the largest domestic private label grease manufacturer and markets Lubrimatic brand products and lubricating equipment directly to its customers. Witco is also a supplier of specialty naphthenic oils, which are marketed to the rubber, plastics, ink and agricultural industries, and asphalt and surface treatment products, which are sold primarily for highway construction and maintenance. Customers The Company's petroleum products are marketed directly through its own sales force and through distributors and agents. During the year ended December 31, 1993, no customer accounted for more than 3.0% of Petroleum Segment sales, and sales to the ten largest customers accounted for approximately 17.0% of Petroleum Segment sales. Competition Many of the specialty petroleum products produced by Witco, like its specialty chemical products, are characterized by a need for a high degree of manufacturing competence and technical service. The petroleum products market is highly competitive with the Company's products competing primarily on the basis of pricing and quality. The Company believes its technical expertise, reputation for quality products, and, in the case of consumer products, brand name recognition, give it advantages in the marketplace. Diversified Products Diversified Products include battery containers, covers and parts, metalworking and metal finishing substances, and carbon black. In the U.S., Witco is the leading independent producer of battery containers. Metalworking and metal finishing products are marketed to the aerospace, automotive, electronics, and hardware industries. The Company expects to complete the sale of its Allied-Kelite and Battery Parts divisions' businesses in 1994. Carbon black is sold to the domestic tire and other rubber products industries. The Company is a leading supplier of specialty carbon black for the tire industry. Customers During the year ended December 31, 1993, one customer accounted for approximately 15.9% of this segment's 1993 sales and the ten largest customers for approximately 70.0%. International Operations Sales of Witco's non-U.S. operations were $588.7 million, or 28% of total sales, for the year ended December 31, 1993. Through the Schering Acquisition, Witco added two plants in Germany (surfactants, polymer additives, and resins), one each in Spain (surfactants), the United Kingdom (surfactants), France (resins), Italy (resins), and Ecuador (oleochemicals/surfactants), as well as three in the U.S. which manufacture oleochemicals, surfactants, and polymer additives. With the ten properties acquired from Schering, Witco now operates 64 manufacturing facilities in 12 countries. Patents Witco owns and has been licensed to use a number of patents, some of which are important in connection with particular products but all of which, as a group, are not material to the Company. Backlog The nature of the Company's business is such that customer orders are usually filled within 30 days. Accordingly, backlog is not significant to the Company's business. Research and Development Witco expended approximately $49.5 million in 1993, $29.2 million in 1992 and $27.9 million in 1991 on research and development of new products and services, and for improvements and new applications of existing products and services. General The chemical and petroleum industries in which Witco operates have experienced increased operating costs and capital investments due to statutes and regulations at the federal, state and local levels for the protection of the environment and the health and safety of employees and others. Witco believes that expenditures for compliance with these statutes and regulations will continue to have a significant impact upon the conduct of its business. The trend for greater environmental awareness and more stringent environmental regulations is likely to continue and while Witco cannot accurately predict how this trend will affect future operations and earnings, Witco does not believe its costs will significantly vary from those of its competitors in the chemical and petroleum industries. Witco evaluates and reviews environmental reserves for future remediation and compliance costs on a quarterly basis. To determine the appropriate reserve amounts, management reviews all available facts and evaluates the probability and scope of potential liabilities. Inherent in this process are considerable uncertainties which affect Witco's ability to estimate the ultimate costs of remediation efforts. Such uncertainties include the nature and extent of contamination at each site, evolving governmental standards regarding remediation requirements, the number and financial condition of other potentially responsible parties at multi-party sites, innovations in remediation and restoration technology, and the identification of additional environmental sites. As a result, as remediation efforts proceed at existing sites and new sites are assimilated into the review process, charges against income for environmental reserves could have a material effect on results of operations in a particular quarter or year. However, such charges are not expected to have a material adverse effect on Witco's consolidated financial position, cash flow or liquidity. At December 31, 1993, environmental reserves amounted to $99.6 million, of which $52.8 million was provided for in 1993. These reserves reflect management's assessment of future remediation and compliance costs in light of all available information. Witco expended $15.1 million in 1993 against these reserves and anticipates 1994 expenditures to approximate $29 million. The Company's current construction projects include up-to-date methods and equipment for protecting the environment. In addition, Witco is continuing its program for modification of its facilities to meet current standards for the control of emissions, effluents and solid wastes. Capital expenditures to improve safety and to conform to environmental regulations amounted to approximately $17.6 million in 1993 and $15.6 million in 1992. Witco is continuing its efforts to reduce hazardous waste and emissions generated by its operations. Through improved operating efficiencies, installation of additional environmental control equipment, and utilization of the latest innovations in waste treatment technology, management believes that operating costs associated with managing hazardous substances and pollution can be controlled. Such operating costs amounted to $23.6 million in 1993. (d) FINANCIAL INFORMATION ABOUT FOREIGN AND DOMESTIC OPERATIONS AND EXPORT SALES Witco's foreign subsidiaries generally manufacture products similar to the principal products manufactured domestically. Subsidiaries in the Netherlands and Canada manufacture petroleum products; subsidiaries in Canada, Denmark, Ecuador, England, France, Germany, Israel, Italy, Mexico and Spain manufacture chemical products. In accord with normal market conditions, sales made outside the United States are generally made on longer terms of payment than would be normal within the United States. Foreign operations are subject to certain risks inherent in carrying on international business, including currency devaluations and controls, export and import restrictions, inflationary factors, product supply, economic controls, nationalization and expropriation. The likelihood of such occurrences varies from country to country and is not predictable. However, the Company's primary foreign operations are based in Western Europe, Canada, and other stable areas, and, therefore, the Company does not believe these risks will have a significant impact upon the Company. Reference is made to Note 15 of the Notes to Financial Statements. See Item 8 -- Financial Statements and Supplementary Data following Part IV of this report. ITEM 2 ITEM 2 -- PROPERTIES Witco currently conducts its manufacturing operations in 64 plants, owned in fee or occupied under lease, of which 42 are in the United States and 22 in other countries. Of these facilities, 34 are utilized for Chemical product manufacturing, 19, including 2 refineries, are utilized for Petroleum product manufacturing and 11 are utilized for the manufacture of Diversified Products. All of the facilities are in good operating condition. PRINCIPAL PLANTS AND OTHER IMPORTANT PHYSICAL PROPERTIES -- LOCATIONS BY INDUSTRY SEGMENT (OWNED IN FEE EXCEPT WHERE PARENTHETICAL DATES REFER TO LEASE EXPIRATION) ITEM 3 ITEM 3 -- LEGAL PROCEEDINGS The Company has been notified, or is named as a potentially responsible party ('PRP') or a defendant in a number of governmental (federal, state, and local) and private actions associated with environmental matters, such as those relating to hazardous wastes. These actions seek remediation costs, penalties and/or damages for personal injury or damage to property or natural resources. As of December 31, 1993, the Company had been identified as a PRP in connection with 40 sites which are subject to the federal Superfund Program under the Comprehensive Environmental Response, Compensation and Liability Act of 1980 ('CERCLA'). With 2 exceptions, all the Superfund sites in which the Company is involved are multi-party sites, and, in most cases, there are numerous other potentially responsible parties in addition to the Company. CERCLA authorizes the federal government to remediate a Superfund site itself and to assess the costs against the responsible parties, or to order the responsible parties to remediate the site. The Company evaluates and reviews environmental reserves for future remediation and other costs on a quarterly basis to determine appropriate reserve amounts. Inherent in this process are considerable uncertainties which affect the Company's ability to estimate the ultimate costs of remediation efforts. Such uncertainties include the nature and extent of contamination at each site, evolving governmental standards regarding remediation requirements, the number and financial condition of other potentially responsible parties at multi-party sites, innovations in remediation and restoration technology, and the identification of additional environmental sites. The Company is a defendant in a case filed in October 1992 by the United States Department of Justice on behalf of the United States Environmental Protection Agency styled United States v. Witco, et. all. pending in the United States District Court for the Eastern District of California. The United States alleged that the Company has violated the Clean Air Act, the Safe Water Drinking Act, and the Resource Conservation and Recovery Act in connection with certain activities at its Oildale, California, refinery. The United States seeks unspecified civil penalties and certain injunctive relief in this action. The Company has numerous insurance policies which it believes provide coverage at various levels for environmental liabilities. The Company is currently in litigation with many of its insurers concerning the applicability and amount of insurance coverage for environmental costs under certain of these policies. No provision for recovery under any of these policies is included in the Company's financial statements. The Company is not a party to any legal proceedings, including environmental matters, which it believes will have a material adverse effect on its consolidated 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 ended December 31, 1993. EXECUTIVE OFFICERS OF THE COMPANY The following sets forth information regarding executive officers of the Company as of February 28, 1994, and is included in Part I in accordance with Instruction 3 of Item 401(b) of Regulation S-K. (table continued on next page) (table continued from previous page) PART II ITEM 5 ITEM 5 -- MARKET FOR THE COMPANY'S COMMON STOCK AND RELATED SHAREHOLDER MATTERS Witco's Common Stock is listed on the New York Stock Exchange. The following table reflects the high and low sales prices, adjusted to give retroactive effect to the 2-for-1 stock split effective October 5, 1993, as reported on such exchange for each quarterly period during the past two years: The approximate number of holders of record of the Company's Common Stock as of February 28, 1994, was 5,114. Dividends on the Common Stock have been declared quarterly during the past two years as follows: ITEM 6 ITEM 6 -- SELECTED FINANCIAL DATA The data for this item is submitted as a separate section following Part IV of this report. ITEM 7 ITEM 7 -- MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The data for this item is submitted as a separate section following Part IV of this report. ITEM 8 ITEM 8 -- FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The consolidated financial statements and supplementary data of the Company and its subsidiaries are included in a separate 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 AND EXECUTIVE OFFICERS OF THE COMPANY DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS (a) Identification of Directors Reference is made to pages 2 through 7 of the Proxy Statement to be filed pursuant to Regulation 14A no later than March 31, 1994. (b) Identification of Executive Officers Reference is made to Part I of this Form 10-K. (c) Business Experience Reference is made to pages 2 through 7 of the Proxy Statement to be filed pursuant to Regulation 14A no later than March 31, 1994 and Part I of this Form 10-K. COMPLIANCE WITH SECTION 16(a) OF THE EXCHANGE ACT Reference is made to page 8 of the Proxy Statement to be filed pursuant to Regulation 14A no later than March 31, 1994. ITEM 11 ITEM 11 -- EXECUTIVE COMPENSATION Reference is made to the information set forth under the captions 'Compensation of Directors' and 'Executive Compensation' on pages 10 through 14 of the Proxy Statement to be filed pursuant to Regulation 14A no later than March 31, 1994. ITEM 12 ITEM 12 -- SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT For information with respect to beneficial ownership of the Company's voting securities, and rights thereto, reference is made to the information set forth under the captions 'Ownership of Securities by Directors and Officers' and 'Security Ownership of Certain Beneficial Owners' on pages 7 and 8 of the Proxy Statement to be filed pursuant to Regulation 14A no later than March 31, 1994. ITEM 13 ITEM 13 -- CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS (a) Transactions with Management and Others Reference is made to the information set forth under the caption 'Compensation of Directors' on page 10 of the Proxy Statement to be filed pursuant to Regulation 14A no later than March 31, 1994. (b) Certain Business Relationships Reference is made to the information set forth under the captions 'Other Transactions' on page 9 and 'Compensation Committee Interlocks and Insider Participation' on page 14 of the Proxy Statement to be filed pursuant to Regulation 14A no later than March 31, 1994. PART IV ITEM 14 ITEM 14 -- EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) 1 and 2 -- The response to this portion of Item 14 is submitted as a separate section of this report. (a) 3 -- Exhibits: (b) Reports on Form 8-K. The Company filed a Current Report on Form 8-K, dated January 19, 1994, pertaining to the Company's announcement that it would take a $92.6 million charge ($60.1 million after tax, or $1.10 per common share) against earnings in the fourth quarter which ended December 31, 1993. (c) The Exhibits filed with this report are listed in response to Item 14(a)3. (d) The response to this portion of Item 14 is submitted as a separate section of this report. - ------------ (1) This Exhibit was included as an exhibit to the annual report on Form 10-K for the fiscal year ended December 31, 1980, and such Exhibit is hereby incorporated by reference. (2) These Exhibits were included as exhibits to the quarterly report on Form 10-Q for the quarter ended June 30, 1983, the annual report on Form 10-K for the fiscal year ended December 31, 1985, the quarterly report on Form 10-Q for the quarter ended June 30, 1987, and the quarterly report on Form 10-Q for the quarter ended June 30, 1988, and such Exhibits are hereby incorporated by reference. From time to time, the Company has filed, as a result of the conversion of the Company's outstanding $2.65 Cumulative Convertible Preferred Stock, certificates reducing such authorized Preferred Stock. Such certificates of reduction are not filed as Exhibits. (3) The 1986 Stock Option Plan, as amended, was filed as an Exhibit to Registration Statement on Form S-8, registration number 33-10715, Post-Effective Amendment No. 1 to Form S-8 effective October 3, 1988, and Post-Effective Amendment No. 2 to Form S-8 effective June 23, 1992. Such Exhibit is incorporated herein by reference. (4) The 1989 Stock Option Plan was filed as an Exhibit to Registration Statement on Form S-8, registration number 33-30995 effective October 2, 1989, and Post-Effective Amendment No. 1 to Form S-8 effective June 23, 1992, and such Exhibit is hereby incorporated by reference. (5) The 1992 Stock Option Plan was filed as an Exhibit to Registration Statement on Form S-8, registration number 33-48806, effective June 23, 1992, and such Exhibit is hereby incorporated by reference. (6) This Exhibit was included as an exhibit to the annual report on Form 10-K for the fiscal year ended December 31, 1992, and such Exhibit is hereby incorporated by reference. (7) The Power of Attorney appears on the Signatures 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 on the 21st day of March, 1994. WITCO CORPORATION By /s/ WILLIAM R. TOLLER ................................... WILLIAM R. TOLLER CHAIRMAN OF THE BOARD AND CHIEF EXECUTIVE OFFICER POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints WILLIAM R. TOLLER, DENIS ANDREUZZI, WILLIAM E. MAHONEY, MICHAEL D. FULLWOOD, OR DUSTAN E. MCCOY, acting severally, 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 any or 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, 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 intents and purposes as he might or could do in person, hereby ratifying and confirming all that said attorney-in-fact and agent, or his substitute or substitutes, may 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 by the following persons on behalf of the registrant and in the capacities and on the dates indicated. ANNUAL REPORT ON ------------------------ FORM 10-K ITEM 6, ITEM 7, ITEM 8, ITEM 14 (a)(1) AND (2) AND ITEM 14(d) INDEX OF FINANCIAL STATEMENTS YEAR ENDED DECEMBER 31, 1993 ------------------------ WITCO CORPORATION NEW YORK, NEW YORK INDEX ANNUAL REPORT ON FORM 10-K ITEM 6, ITEM 7, ITEM 8, ITEM 14(a)(1) AND (2), AND ITEM 14(d) DECEMBER 31, 1993 The following consolidated financial statements of Witco Corporation and subsidiary companies, for the year ended December 31, 1993, are included in Item 8: The following consolidated financial statement schedules of Witco Corporation and subsidiary companies are included in Part IV, Item 14(d): All other schedules (Nos. I, II, III, IV, VII, XI, XII, XIII and XIV) 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. Financial statements (and summarized financial information) of 50% or less owned persons accounted for by the equity method have been omitted because they do not, considered individually or in the aggregate, constitute a significant subsidiary. WITCO CORPORATION AND SUBSIDIARY COMPANIES ELEVEN-YEAR FINANCIAL AND STATISTICAL SUMMARY - ------------ (a) Common share data have been adjusted to reflect the two-for-one stock split effective October 5, 1993. (b) Includes provisions for environmental remediation and compliance, disposition of a business, work force reduction, and other matters of $92.6 million. (c) Includes a provision for consolidation of offices of $20.1 million. (d) Includes a provision of $59.8 million primarily related to environmental projects and plant shutdowns. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS LIQUIDITY AND FINANCIAL RESOURCES Cash flow from operations continues to be a prime source of funds for Witco. Over the past three years, cash provided by operations exceeded $436 million, an amount sufficient to fund working capital requirements, support the Company's internal capital investment program, and sustain an increasing rate of dividends paid. The Company anticipates that cash flow from operations will be sufficient to fund, for the foreseeable future, capital investments, dividend payments, commitments on environmental remediation projects, and operating requirements. In the fourth quarter Witco sold the operations of a subsidiary, Chemprene, Inc., for $24.2 million in cash. This divestiture is consistent with management's intent to divest assets that do not meet the Company's long-term strategic objectives. Management expects to complete the sale of other non-core businesses in 1994, with the resulting cash flow from these divestitures being used to further strengthen the Company's core businesses of specialty chemical and petroleum products. During 1993 Witco repaid the $440 million short-term indebtedness incurred in connection with the November 1992 acquisition of the Industrial Chemicals and Natural Substances divisions of Schering AG (Schering Acquisition). The funds used to repay this debt were provided by the completion of all phases of the Company's long-term financing strategy, which included a public offering of common stock, issuance of 10 and 30 year notes and debentures, and 5 year German bank loans. Net proceeds from these long-term financings totalled $457.8 million. Additional details regarding the impact of operating, investing, and financing activities on the Company's cash position can be found in the Consolidated Statements of Cash Flows. On March 11, 1994 the Company called for redemption on March 28, 1994 all of its 5 1/2% Convertible Subordinated Debentures due 2012 of which $150 million is outstanding. The debentures are convertible into common stock of the Company at a conversion price of $27.28 per share, which price was below the market price for the Company's common stock on the New York Stock Exchange on March 10, 1994. Therefore, the Company believes most of the debentures will be converted into common stock. If all debentures are converted, approximately 5.5 million additional shares of common stock will become issued and outstanding. However, the issuance of additional common stock by reason of conversion of any of these debentures will have no effect upon the Company's earnings per share calculations as the shares underlying the debentures have been considered as common stock equivalents in such calculations. If all debentures were to be redeemed rather than converted, the total cost to the Company would be $152.8 million. The Company will fund any redemptions through a combination of available cash and short-term borrowings. The Company, through certain of its international subsidiaries, has arrangements with various banks for lines of credit. At December 31, 1993, these lines of credit aggregated $40.2 million, of which $37.4 million was unused at year-end. Witco has also entered into certain long-term hedging arrangements to protect against possible adverse currency exchange and interest rate fluctuations (see Note 8 of the Notes to Financial Statements for additional details). CAPITAL INVESTMENTS AND COMMITMENTS In 1993 the Company continued its program of upgrading existing facilities for efficiencies to best meet changing market demands. Internal capital expenditures in 1993 were $103.7 million, bringing the total for the past three years to $250.6 million. Capital expenditures are expected to approximate $110 million in 1994. The Company's European manufacturing base, which was greatly expanded by the Schering Acquisition, remains a focal point of Witco's capital investment program. In 1993 management authorized capital projects at the Company's European facilities of $44.4 million, reflecting management's commitment to enhancing manufacturing capabilities to better position itself to take advantage of growth opportunities as the European economy stabilizes. In the fourth quarter of 1993 the Board of Directors authorized certain amendments to the domestic salaried pension plans. These improvements, in conjunction with changes to actuarial assumptions relating to the discount rate on pension obligations and the expected long-term rate of return on plan assets, will increase 1994 pension costs by approximately $9.2 million. The Company anticipates that cash flow will not be materially affected by these changes. Also in the fourth quarter, the Company announced its intention to sell its Battery Parts Division, and to effect a reduction of approximately four percent in its worldwide employee population of 8,200. Reserves of $31.4 million have been recorded, principally for severance costs and the anticipated loss on the sale of Battery Parts' net assets. The Company anticipates that cash outlays of $16.9 million relative to these reserves will be made over the next two years and will be funded through cash flow from operations. ENVIRONMENTAL MATTERS The chemical and petroleum industries in which Witco operates have experienced increased operating costs and capital investments due to statutes and regulations at the federal, state, and local levels for the protection of the environment and the health and safety of employees and others. Witco believes that expenditures for compliance with these statutes and regulations will continue to have a significant impact upon the conduct of its business. The trend for greater environmental awareness and more stringent environmental regulations is likely to continue and while Witco cannot accurately predict how this trend will affect future operations and earnings, Witco does not believe its costs will significantly vary from those of its competitors in the chemical and petroleum industries. Witco evaluates and reviews environmental reserves for future remediation and compliance costs on a quarterly basis. To determine the appropriate reserve amounts, management reviews all available facts and evaluates the probability and scope of potential liabilities. Inherent in this process are considerable uncertainties which affect Witco's ability to estimate the ultimate costs of remediation efforts. Such uncertainties include the nature and extent of contamination at each site, evolving governmental standards regarding remediation requirements, the number and financial condition of other potentially responsible parties at multi-party sites, innovations in remediation and restoration technology, and the identification of additional environmental sites. As a result, as remediation efforts proceed at existing sites and new sites are assimilated into the review process, charges against income for environmental reserves could have a material effect on results of operations in a particular quarter or year. However, such charges are not expected to have a material adverse effect on Witco's consolidated financial position, cash flow, or liquidity. At December 31, 1993, environmental reserves amounted to $99.6 million, of which $52.8 million was provided for in 1993. These reserves reflect management's assessment of future remediation and compliance costs in light of all currently available information. Witco expended $15.1 million in 1993 against these reserves and anticipates 1994 expenditures to approximate $29 million. Capital expenditures for environmental control equipment and facilities amounted to $12.3 million in 1993, and $34.1 million for the past three years. The Company estimates that from 1994 through 1996, approximately $45 million will be expended on environmental capital projects. Witco is continuing its efforts to reduce hazardous waste and emissions generated by its operations. Through improved operating efficiencies, installation of additional environmental control equipment, and utilization of the latest innovations in waste treatment technology, management believes that direct recurring operating costs associated with managing hazardous substances and pollution can be controlled. Such costs amounted to $23.6 million in 1993. RESULTS OF OPERATIONS The Company's reported net income of $19.8 million for 1993 and $39.2 million for 1992 included several non-recurring items. Comparisons of net income for the three year period ended December 31, 1993 are affected by these items. The following table shows the effect of these non-recurring items on net income. The pre-tax values of these items, except the accounting change which was shown separately, were included in the 'Other expense (income) -- net' caption of the Consolidated Statements of Income. The current year's $34.3 million environmental provision reflected the Company's assessment of the remediation and compliance costs it will incur to comply with regulatory requirements and standards. Additionally, the Company has established provisions of $12.4 million for the planned divestiture of the Battery Parts Division and $7.9 million for the reduction of approximately 4 percent of the Company's worldwide work force, as part of its strategy to realign and reorganize operations to emphasize core businesses. Consistent with this strategy, during 1993 the Company sold the operations of its Chemprene subsidiary for a net gain of $5.7 million. The $7.6 million legal settlement recorded in 1993 resulted from a judgment against the Company in the Lightning Lube litigation. Current year results also included a loss of $6.1 million attributable to an agreement to sublease two office facilities resulting from the Company's commitment to relocate to a new world headquarters. 1992 results included a charge of $13.3 million relating to the Company's decision to bring certain operating management together with executive management and administrative functions through the consolidation of offices into a new world headquarters. An accounting change resulting from the adoption of Statement of Financial Accounting Standards No. 106 for postretirement benefits other than pensions further reduced net income by $14.7 million in 1992. 1993 VS. 1992 Net income, adjusted to exclude non-recurring items, was $87.8 million in 1993, compared to $67.2 million in 1992. The 31 percent increase in net income, before non-recurring items, was primarily attributable to record sales, which rose 24 percent to $2.1 billion, and a 1 percent improvement in gross margins. The acquisition of the Schering businesses accounted for the higher sales and approximately 50 percent of the improved margins. The remaining improvement in margins was attributable to a reduction in key raw material feedstock costs and operating efficiencies in both the Petroleum and Diversified Products Segments. Increases in selling and administrative expenses, depreciation and amortization, and interest, primarily attributable to the Schering Acquisition, partially offset the higher sales and improved margins. The Company does not allocate income and expenses that are of a general corporate nature to industry segments in computing operating income. These include general corporate expenses, interest income and expense, and certain other income and expenses (see Note 15 of the Notes to Financial Statements). Current year's operating income was $114.5 million, compared to $129.7 million in 1992. A comparison of the results of these periods was affected by a net non-recurring charge of $74.8 million recorded in 1993. Excluding non-recurring items, operating income increased $59.6 million to $189.3 million. All segments reported operating earnings, exclusive of non-recurring items, that were appreciably higher than the preceding year (see segment information below). CHEMICAL SEGMENT Chemical net sales of $1.2 billion in 1993 exceeded the previous year by approximately $396 million. The segment was able to sustain sales, excluding those relating to the acquisition, at 1992 levels despite a soft demand due to sluggish domestic and European economies. Sales attributable to the Schering Acquisition accounted for the 47 percent increase. Excluding the segment's $5.6 million of environmental charges recorded in 1993, current year's operating income of $113.8 million increased $39.5 million, or 53 percent, from 1992. Each of the segment's business groups reported 1993 earnings that were substantially higher than the preceding year. The inclusion of the acquired Schering businesses' full year operating results in 1993, compared to two months for 1992, accounted for the higher earnings. The Schering Acquisition contributed $41 million to the segment's 1993 operating earnings, compared to the reported loss of $2.2 million in 1992. International, principally Western Europe, and domestic operations contributed equally to the Schering Acquisition's current year earnings. The favorable earnings were also, in part, attributable to cost saving programs and the consolidation of sales and administrative functions in Europe, which minimized the effect the persistent European recession had on operations. Partially offsetting the positive impact that the Schering Acquisition and cost saving programs had on operations, the Oleochemicals/Surfactants Group was adversely affected by $3 million as a result of an increase in the cost of major commodity raw material feedstocks. Many of the benefits derived from the actions initiated in 1993, particularly cost reduction programs in the acquired Schering businesses, will not be fully realized until 1994 and beyond. PETROLEUM SEGMENT Net sales in 1993 were $746 million, an increase of $11.7 million over the $734.3 million recorded in 1992. Despite a soft global economy and the strengthening of the dollar overseas, both 1993 sales volume and prices were generally comparable to the prior year. The acquisition of the business of IGI Petroleum Specialties, Inc. (PSI) late in 1992 bolstered 1993 sales. This business, which enhanced the segment's white oils and petroleum jellies marketing capabilities, contributed approximately $30 million to sales in 1993, compared to $2 million in 1992. Operating income for 1993 included non-recurring charges of $50.6 million attributable to an environmental provision and legal judgment. 1993 operating income, excluding these charges, was $65.6 million, an increase of $14.1 million, or 27 percent, over 1992. The Petroleum Specialties Group accounted for approximately two-thirds of the segment's higher earnings, excluding non-recurring charges, while the Lubricants Group's results accounted for the remaining improvement. Earnings from the Petroleum Specialties Group's domestic operations rose despite a sluggish economy and a shortage of critical sulfonate feedstocks. The PSI business added approximately $3 million to current year earnings. In addition, the ability to hold down manufacturing expenses and the inclusion of $3.1 million of demolition costs in 1992 contributed to the improved domestic results. The group's Holland operation reported lower earnings attributable to the depressed European economy and a stronger dollar. Lubricants Group's earnings improved approximately 20 percent during 1993. Higher earnings were primarily due to a stronger asphalt market and a 10 percent decline in crude oil feedstock costs at its California refinery. Additionally, the group's lube oil and grease operations reported 1993 earnings that were marginally higher than the previous year's. Lower crude oil and feedstock costs boosted these operations' material margins by 1 percent. DIVERSIFIED PRODUCTS SEGMENT Segment operating earnings for 1993 included a net non-recurring charge of $18.7 million. The charge covered an expected loss on the disposition of the Battery Parts Division and environmental provisions, partially offset by a gain on the sale of the operations of the segment's Chemprene, Inc. subsidiary. Net sales, excluding those attributable to Chemprene, Inc., were $154 million in 1993, an increase of 7 percent above sales for the corresponding operations in 1992. Operating income, excluding the results of Chemprene, Inc. and non-recurring items, increased $7.4 million, from $.4 million in 1992, to $7.8 million in 1993. Higher carbon black sales and earnings more than offset declines from each of the segment's other businesses. The carbon black business benefited from a 12 percent increase in volume, higher sales prices, and manufacturing efficiencies. The divestiture of assets that do not meet the Company's long-term business objectives is an important part of Witco's strategic focus to reorganize and grow core businesses. Hence, two of the segment's three remaining divisions, Battery Parts and Allied-Kelite, are slated for disposition in 1994. The disposition of the Battery Parts Division is expected to result in a loss, which was recognized in 1993. 1992 VS. 1991 Excluding non-recurring charges, net income amounted to $67.2 million in 1992, a decrease of 9 percent compared to net income of $73.5 million in 1991. Included in the $67.2 million was a net loss of $2.8 million related to the Schering Acquisition. 1992 sales, which included $72.3 million from the operations of the acquired Schering businesses, rose 6 percent above 1991 to a record level of $1.7 billion. Despite record sales attributed to a 5 percent increase in volume, earnings declined as a result of increased selling and administrative expenses, higher depreciation and amortization, and an erosion of sales prices. The Schering Acquisition and increased litigation costs accounted for the higher expenses, while competitive pressures, reflective of a soft global economy, resulted in depressed selling prices. Operating income generated by the Company's business segments in 1992 was $129.7 million, a decrease of $6.8 million, or 5 percent, from 1991. CHEMICAL SEGMENT 1992 net sales, which included $72.3 million from the acquired Schering businesses, reached $836.8 million, an increase of 12 percent from 1991. Sales, excluding those credited to the Schering Acquisition, increased $14.7 million, or 2 percent, primarily due to a 4 percent increase in sales volume attributable to the segment's domestic operations. Operating income was $74.3 million in 1992, an increase of $3.7 million, or 5 percent, from 1991. Operating earnings for 1992 contained a $2.2 million operating loss reported by the acquired Schering businesses. These operations were adversely affected by the sharp downturn in the German economy and normal cyclical weaknesses. Income from the segment's domestic operations improved $7.1 million, while international earnings for 1992 were $3.4 million below those reported in 1991. The segment's Oleochemicals/Surfactants Group's domestic operations reported increased operating income as a result of greater shipment volume and higher sales prices, while the Polymer Additives Group's domestic operation's earnings declined due to the recession sensitive nature of its business. The segment's international operating results reflected a loss from the Schering Acquisition and lower sales volume reported by Witco Israel. PETROLEUM SEGMENT Segment net sales increased less than 1 percent from $732.1 million in 1991 to $734.3 million in 1992. The effect of a 5 percent increase in sales volume during this period was offset by a decline in prices. Operating income was $51.5 million for 1992, a decrease of $14 million, or 21 percent, from 1991. The decline in profitability was confined to the segment's domestic operations, which reported a $14.5 million, or 30 percent, decrease in operating income. These results were indicative of a soft economy, as evidenced by a 5 percent decline in sales prices. Material margins were adversely affected by the reduction in sales prices that outpaced a reduction in average material costs. Also contributing to the decline in operating income were significant 1992 charges for litigation and demolition costs. Operating income for the segment's international subsidiaries increased $.5 million, a result of lower material costs and higher sales volume. DIVERSIFIED PRODUCTS SEGMENT Net sales in 1992 were $175.1 million, a $10.1 million, or 6 percent, increase over 1991. Improved sales were attributed to greater volume and higher sales prices. Operating income reported in 1992 of $4 million represented an increase of $3.5 million over 1991. Despite significant losses experienced in carbon black products before industry price increases took hold and volumes increased late in the year, the segment's improved operating performance was reflective of increased sales and a gain from the sale of a former manufacturing facility. OUTLOOK Witco will divest its Allied-Kelite and Battery Parts divisions' businesses in 1994 as a part of its effort to concentrate on its core businesses in the Petroleum and Chemical Segments. Evaluation of possible divestiture of other business units within Witco will continue on the basis of return-on-equity performance, strategic significance, and other factors. Global expansion of core businesses in the Chemical and Petroleum Segments will remain a Company focus in 1994. With the continuation of the European recession, Witco's businesses in Europe may not exceed their 1993 performance levels in 1994. Witco's European operations should benefit from additional operational efficiencies and any future economic recovery in Europe. As the North American recovery slowly grows in 1994, Witco's results from operations for its businesses operating there should continue to improve. The Pacific Rim has been targeted as a growth market for certain of Witco's product lines and implementation of the market entry strategy for that region will continue in 1994. Acquisitions and joint ventures which will enhance existing market positions in core product lines will be evaluated on a case- by-case basis in 1994. REPORT OF INDEPENDENT AUDITORS Board of Directors and Shareholders WITCO CORPORATION We have audited the accompanying consolidated balance sheets of Witco Corporation and Subsidiary Companies 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. 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 Witco Corporation and Subsidiary Companies 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 statements taken as a whole, present fairly in all material respects the information set forth therein. As discussed in Note 12 to the financial statements, in 1992, the Company changed its method of accounting for postretirement benefits other than pensions. ERNST & YOUNG Stamford, Connecticut January 27, 1994, except for Note 7, as to which the date is March 11, 1994 WITCO CORPORATION AND SUBSIDIARY COMPANIES CONSOLIDATED BALANCE SHEETS See accompanying notes. WITCO CORPORATION AND SUBSIDIARY COMPANIES CONSOLIDATED STATEMENTS OF INCOME See accompanying notes. WITCO CORPORATION AND SUBSIDIARY COMPANIES CONSOLIDATED STATEMENTS OF CASH FLOWS See accompanying notes. WITCO CORPORATION AND SUBSIDIARY COMPANIES CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY (IN THOUSANDS OF DOLLARS) See accompanying notes. WITCO CORPORATION AND SUBSIDIARY COMPANIES NOTES TO FINANCIAL STATEMENTS NOTE 1 -- SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Principles of Consolidation: The consolidated financial statements include the accounts of all majority owned subsidiaries after the elimination of inter-company transactions. Cash Equivalents: Cash equivalents consist of highly liquid investments with a maturity of three months or less when purchased. Inventories: Inventories are stated at cost, principally on the Last-In, First-Out (LIFO) basis which is not in excess of market. The balance of inventories is stated at the lower of cost on the First-In, First-Out (FIFO) basis or market. Property, Plant and Equipment: Property, plant and equipment is stated at cost and depreciation is provided principally using the straight-line method based on estimated useful lives. Intangible Assets: Intangible assets primarily include the excess of purchase price paid over the estimated fair value of net assets acquired (goodwill) and other intangibles which are principally being amortized over periods not in excess of forty years. Postemployment Benefits: The Company adopted Statement of Financial Accounting Standards (SFAS) No. 112 'Employers' Accounting for Postemployment Benefits' effective January 1, 1993. SFAS 112 requires employers to accrue the cost of postemployment benefits, such as medical and disability benefits, as employees render services instead of when benefits are paid. The adoption of SFAS 112 did not have a material impact on the Company's financial position, results of operations, or cash flow. Research and Development Costs: The Company's research and development costs are charged to expense as incurred. These charges amounted to $49,494,000 (1993), $29,207,000 (1992), and $27,908,000 (1991). Environmental Remediation Costs: Environmental remediation costs are charged to expense if the remediation is the result of past practices or events and the expenditures are not expected to contribute to future operations. Projected costs are accrued when it is probable that a liability has been incurred and the amount can be reasonably estimated. Income Taxes: The Company elected to adopt SFAS No. 109 'Accounting for Income Taxes' effective January 1, 1992. The Company previously accounted for income taxes under SFAS 96. There was no significant effect on the financial results of the Company as the result of this change in accounting. Common Share Data: On September 2, 1993, the Board of Directors of the Company authorized a two-for-one common stock split in the form of a 100 percent stock distribution issuable to shareholders of record as of September 16, 1993. The distribution was made on October 5, 1993. All common stock share and per share data for 1993 and prior years, except for prior years' shareholders' equity, have been adjusted to reflect the split. Net income per common share is based upon net income adjusted for interest (net of tax) on the 5 1/2% convertible debentures and the dividend requirements of preferred stock. The weighted average number of common shares outstanding during each year includes common stock equivalents, principally shares issuable in connection with the 5 1/2% convertible debentures and the Company's stock option plans. Fully diluted net income per common share additionally reflects the assumed conversion of the outstanding convertible preferred stock. NOTE 2 -- ACQUISITIONS AND DISPOSITIONS On November 1, 1993, the Company sold the operations of its Chemprene, Inc. subsidiary to CMP Acquisition Corporation for $24,160,000 resulting in a gain of $5,726,000, or $.11 per common share. Chemprene manufactures lightweight belting, coated fabrics, and industrial diaphragms. The operating results of this subsidiary were not significant to the consolidated results of operations. WITCO CORPORATION AND SUBSIDIARY COMPANIES NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) In October 1992 the Company acquired the businesses of IGI Petroleum Specialties, Inc. (PSI), a wholly owned subsidiary of The International Group, Inc. (U.S.) and certain associated Canadian assets for $14,500,000. PSI was involved in the manufacturing and selling of white oils, petrolatums, and refrigeration oils. The acquisition was recorded as a purchase and the results since the acquisition have not been significant to the consolidated results of operations. On November 2, 1992, the Company acquired for cash the Industrial Chemicals and Natural Substances divisions of Schering AG. The acquired divisions manufacture and market surfactants, oleochemicals, and polymer additives with operations at ten manufacturing facilities in seven countries. The acquisition was accounted for as a purchase and results of operations have been included in the consolidated financial statements from the acquisition date. The purchase price of approximately $440,000,000 is subject to adjustment based on changes in net worth of the businesses acquired for a defined period to the acquisition date. The amount of any net worth based adjustment is not expected to be material in relation to the purchase price. An allocation of the purchase price resulted in an excess over the estimated fair value of net assets acquired (goodwill) of approximately $119,000,000. This is being amortized on a straight-line basis over forty years. Results for 1993 included net sales of $474,700,000 and net income of $16,200,000, or $.30 per common share, compared to net sales of $72,300,000 and a net loss of $2,800,000, or $.06 per common share, in 1992 as the result of the acquisition, including associated financing costs. The following unaudited pro forma results present the estimated consolidated financial results as if the Schering Acquisition had occurred at the beginning of the years indicated and are not indicative of the results that would have occurred had this acquisition been made on these dates, and are not indicative of future results. NOTE 3 -- OTHER EXPENSE (INCOME) -- NET The components of other expense (income) -- net are as follows: WITCO CORPORATION AND SUBSIDIARY COMPANIES NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) NOTE 4 -- INVENTORIES Inventories are classified as follows: Work in progress included above is not significant. Inventories valued on a LIFO basis, at December 31, 1993 and 1992, amounted to $143,317,000 and $147,670,000, respectively. Inventories would have been $57,849,000 and $71,023,000 higher than reported at December 31, 1993 and 1992 if the FIFO method (which approximates current cost) had been used by the Company for all inventories. NOTE 5 -- PROPERTY, PLANT AND EQUIPMENT A summary of property, plant and equipment follows: NOTE 6 -- INTANGIBLE ASSETS Intangible assets consist of the following: NOTE 7 -- INDEBTEDNESS In 1993 the Company repaid the $440,000,000 short-term debt incurred to finance the Schering Acquisition. The funds were provided by net proceeds from a public offering of shares of common stock and the issuance of long-term debt, which included $165,000,000 of 6.60% notes due 2003, $110,000,000 of 7.75% debentures due 2023, and 70,000,000 Deutsche Marks of 7.325% notes from German banks due 1998 ($40,313,000 at December 31, 1993). WITCO CORPORATION AND SUBSIDIARY COMPANIES NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) Following is a summary of long-term debt: The 8.94% Pollution Control Revenue Bond due 1993 in the amount of $10,000,000 was refinanced with the proceeds from the issuance of the 5.85% Pollution Control Revenue Bonds due 2023 for the same amount. The Company's 5 1/2% convertible debentures are convertible into common stock at $27.28 per share and are redeemable at a premium for cash at the option of the Company. On March 11, 1994, the Company announced its intention to redeem these debentures. The Company has arrangements with various banks for lines of credit for its international subsidiaries aggregating $40,190,000 of which $2,823,000 was utilized at December 31, 1993. Principal maturities of long-term debt at December 31, 1993 are $2,210,000 (1994), $2,985,000 (1995), $2,009,000 (1996), $9,539,000 (1997), and $48,627,000 (1998). Following is a summary of interest: NOTE 8 -- FINANCIAL INSTRUMENTS In 1993 and 1992, the Company entered into several foreign currency forward contracts, currency swaps, and other financial market instruments to hedge the effect of foreign currency fluctuations on the financial statements. The foreign exchange contracts are accounted for as hedges of net investments, commitment hedges, and transaction hedges. Gains and losses on hedges of net investments are recognized as a component of shareholders' equity. Generally, gains and losses on the commitment hedges are deferred and included in the basis of the transaction underlying the commitment. Gains and losses on transaction hedges are recognized in income and offset the foreign exchange gains and losses on the related transaction. At December 31, 1993 and 1992, the Company had outstanding contracts to hedge its foreign net investments and other foreign exposures. The aggregate face value of these contracts, with notional amounts of $210,626,000 (1993) and $414,894,000 (1992), also fix the interest rates on approximately $209,326,000 of indebtedness at a weighted average interest rate of approximately 8 percent. The net WITCO CORPORATION AND SUBSIDIARY COMPANIES NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) interest rate differentials that are paid or received are reflected currently as adjustments to interest expense. The foreign currency contracts are primarily in German marks and expire at various dates through March 2003. These contracts have been entered into with major international financial institutions. The risk associated with these transactions is the cost of replacing, at current market rates, agreements in the event of default by the counterparties. Management believes the risk of incurring such losses is remote. The following methods and assumptions were used to estimate the fair value of financial instruments as required by Statement of Financial Accounting Standards No. 107, 'Disclosures about Fair Value of Financial Instruments.' Cash and cash equivalents: The carrying amount approximates fair value due to the short maturity of these instruments. Notes receivable: The fair value is estimated by discounting the future cash flows using the interest rates at which similar loans would be made under current conditions. Long-term debt (including short-term portion): The fair value of the 5 1/2% Convertible Subordinated Debentures and the 7.45% Debentures are based on their quoted market price on the New York Stock Exchange. The fair value for the 6.60% Notes and the 7.75% Debentures were based on market values as furnished by investment banking firms. For all other long-term debt which has no quoted market price, the fair value is estimated by discounting projected future cash flows using the Company's incremental borrowing rate. Foreign currency/interest rate swap contracts: The fair value is the amount at which the contracts could be settled based on quotes provided by investment banking firms. Fair Values of Financial Instruments: The following table shows the carrying amounts and estimated fair values of material financial instruments used by the Company in the normal course of its business. NOTE 9 -- SHAREHOLDERS' EQUITY On September 2, 1993, the Board of Directors of the Company declared a two-for-one stock split on the Company's common stock. This was paid in the form of a 100 percent stock distribution of 25,409,000 shares on October 5, 1993, to shareholders of record as of September 16, 1993. Accordingly, all share and per share data, as appropriate, reflect the effects of this split. The par value for the additional shares issued was transferred from capital in excess of par value to common stock. At December 31, 1993, unissued common stock of the Company was reserved for issuance in accordance with the terms of the convertible subordinated debentures (5,500,000 shares), the stock option plans (2,743,000 shares), and the $2.65 Cumulative Convertible Preferred Stock (143,000 shares). The Company has several stock option plans for certain employees. All options are granted at market value as of the date of grant and are exercisable in installments within a period not to exceed ten years from the date of grant. The options outstanding at December 31, 1993 expire on various dates WITCO CORPORATION AND SUBSIDIARY COMPANIES NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) through June 2003. At December 31, 1993 and 1992, options for 1,271,000 and 1,964,000 shares of common stock, respectively, were available for grant. Stock option transactions were as follows: Each share of $2.65 Cumulative Convertible Preferred Stock is entitled to one vote and has a minimum liquidating preference of $66 per share. Each share is subject to redemption at the Company's option at $66 per share and is convertible into 16.8075 shares of the Company's common stock. The Company has authorized 8,300,000 shares of series preferred stock, which, when issued, will have such rights, powers, and preferences as shall be fixed by the Company's Board of Directors. Dividends declared per share on the Company's common stock amounted to $.96 (1993), $.92 (1992), and $.91 (1991). Common and preferred stock transactions were as follows: WITCO CORPORATION AND SUBSIDIARY COMPANIES NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) NOTE 10 -- FEDERAL AND FOREIGN INCOME TAXES The components of income (loss) before federal and foreign income taxes and the cumulative effect of accounting change are: The provision for federal and foreign income taxes (exclusive of the tax benefit related to the cumulative effect of an accounting change of $7,567,000 in 1992) consists of the following: The effective income tax rate from continuing operations varied from the statutory federal income tax rate as follows: The components of deferred federal and foreign income taxes are as follows: WITCO CORPORATION AND SUBSIDIARY COMPANIES NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) U.S. federal income taxes have not been provided on approximately $160,000,000 of unremitted earnings of the Company's international subsidiaries at December 31, 1993. As a result of the availability of foreign tax credits, based on current rates, no significant U.S. federal income taxes would be payable if these earnings were distributed. Provision has been made for foreign withholding taxes due upon remittance of 1993 and 1992 foreign earnings. If unremitted earnings accumulated prior to 1992 were distributed it is estimated the related taxes due on these earnings would not be significant. Cash payments for federal and foreign income taxes amounted to $29,817,000 (1993), $21,811,000 (1992), and $39,879,000 (1991). Unamortized investment tax credits aggregated $2,068,000 at December 31, 1993 and are being amortized over the estimated useful lives of the related assets. NOTE 11 -- PENSION PLANS The Company has various non-contributory defined benefit pension plans covering substantially all of its domestic employees and certain international employees. Benefits are primarily based upon levels of compensation and/or years of service. The Company's funding policy is based upon funding at the minimum annual amounts required by applicable federal laws and regulations plus such additional amounts as the Company may determine to be appropriate from time to time. Plan assets consist of publicly traded securities and investments in commingled funds administered by independent investment advisors. Certain union employees of the Company participate in multi-employer plans and the Company makes contributions primarily based upon hours worked. These plans provide defined benefits to these employees. In November 1992 the Company acquired certain domestic and international operations of Schering AG. The related international plans accounted for approximately $4,800,000 of the 1993 net periodic pension cost. In the years prior to 1993, net periodic pension cost of the international plans was not significant. Employees of international subsidiaries are covered by various pension benefit arrangements, some of which are considered to be defined benefit plans for financial reporting purposes. Assets of the plans are comprised of insurance contracts and equity securities. Benefits under these plans are primarily based upon levels of compensation. Funding policies are based on legal requirements, tax considerations, and local practices. WITCO CORPORATION AND SUBSIDIARY COMPANIES NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) Net pension charge (credit) includes the following components: Assumptions used to calculate costs were as follows: The funded status and amounts recognized in the Company's Consolidated Balance Sheets at December 31, 1993 and 1992 for the U.S. plans were as follows: WITCO CORPORATION AND SUBSIDIARY COMPANIES NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) Assumptions used to calculate December 31, 1993 and 1992 obligations for U.S. plans were as follows: Effective January 1, 1994, the pension benefit formula of the Retirement Plan of Witco was amended to a 'final average pay offset' formula and several plan provisions were revised. Modifications were also made to the benefit formula and plan provisions of the Supplemental Executive Retirement Plan. These amendments resulted in increases of approximately $11,800,000 and $19,600,000 in the 1993 accumulated benefit obligation and projected benefit obligation, respectively. Also effective January 1, 1994, Witco revised the discount rate, long-term rate of return on plan assets and rate of future compensation levels to 7%, 10%, and 4.5%, respectively. These changes resulted in increases of approximately $28,000,000 and $24,000,000 in the 1993 accumulated benefit obligation and projected benefit obligation, respectively. The plan amendments and assumption changes together are anticipated to increase domestic net periodic pension cost for 1994 by approximately $9,200,000. The funded status and amounts recognized in the Company's Consolidated Balance Sheets at December 31, 1993 and 1992 for the international plans were as follows: Assumptions used to calculate December 31, 1993 and 1992 obligations for international plans were as follows: WITCO CORPORATION AND SUBSIDIARY COMPANIES NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) The 1993 funded status includes the Netherlands' pension plan. The inclusion of this plan resulted in an increase of approximately $14,000,000, $17,500,000, and $19,800,000, in the accumulated benefit obligation, projected benefit obligation, and plan assets, respectively. NOTE 12 -- POSTRETIREMENT BENEFITS OTHER THAN PENSIONS The Company provides health and life insurance benefits to certain eligible retired employees, most of whom contribute to its cost. Substantially all employees presently become eligible for retiree health benefits after reaching retirement age while working for the Company. The cost of the medical plan is provided by retiree contributions that are adjusted annually to reflect current estimates of health costs. For employees subject to collective bargaining arrangements the cost is shared by the Company in accordance with the bargained agreements. Life insurance benefits for certain retired employees are provided with the Company assuming the cost. The Company's policy is to fund the plans at the discretion of management. In 1992 the Company adopted Financial Accounting Standard No. 106, 'Employers' Accounting for Postretirement Benefits Other Pensions'. This statement requires the accrual of the cost of providing postretirement benefits, including medical and life insurance coverage, during the active service period of the employee. The Company elected to record the effect of this adoption as a cumulative effect of a change in accounting principle and immediately recognize the accumulated liability, measured as of January 1, 1992. This resulted in a one-time after-tax charge of $14,690,000. In accordance with the standard, prior year's costs have not been restated. In November 1992 the Company acquired certain U.S. operations of Schering AG. These operations provided certain retiree medical and life insurance benefits. In 1993 the Company negotiated or revised many of the provisions and assumptions related to these benefits to be in compliance with the Company's other comparable plans. Postretirement benefit obligations at December 31, 1993 and 1992 were as follows: Net periodic postretirement benefit costs include the following components: Postretirement benefit cost for the year ended December 31, 1991 was approximately $2,300,000. For measuring the expected postretirement benefit obligation, an 11 and 12 percent annual rate of increase in the per capita claims cost was assumed for 1993 and 1992, respectively. The rate was assumed to decrease by 1 percent per year to 6 percent in 1998 and remain at that level thereafter. The WITCO CORPORATION AND SUBSIDIARY COMPANIES NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) weighted average discount rate used in determining the accumulated postretirement benefit obligation was 7 percent for 1993 and 7.9 percent for 1992. The weighted average discount rates used in determining the net periodic postretirement benefit costs for 1993 and 1992 were 7.9 and 8.2 percent, respectively. The effect of a one percent increase in the health care cost trend rate would increase the present value of the accumulated postretirement benefit obligation at December 31, 1993 by approximately $4,300,000 and the net periodic postretirement benefit cost for 1993 by approximately $400,000. Certain union employees of the Company participate in multi-employer plans that provide defined postretirement health and life insurance benefits. The net periodic postretirement benefit cost for these employees is not distinguishable. The Company's cost associated with these plans on a cash basis is not significant. Employees in operations in countries outside the U.S. are covered by various postretirement benefit arrangements, none of which are presently considered to be defined benefit plans. NOTE 13 -- ACCOUNTS PAYABLE AND OTHER CURRENT LIABILITIES Components of accounts payable and other current liabilities consist of the following: NOTE 14 -- COMMITMENTS AND CONTINGENCIES Leases: At December 31, 1993, minimum rental commitments under noncancelable operating leases amounted to $14,834,000 (1994), $15,241,000 (1995), $12,693,000 (1996), $9,829,000 (1997), $7,858,000 (1998), and $103,345,000 (1999 and thereafter). Aggregate future minimum rentals to be received under noncancelable subleases, the majority of which are subject to barter provisions, amount to $26,921,000. Rental expenses under operating leases were $19,849,000 (1993), $16,518,000 (1992), and $17,114,000 (1991). Capital Commitments: At December 31, 1993, the estimated costs to complete authorized projects under construction amounted to $100,906,000. Litigation, Claims and Contingencies: The Company has been notified, or is a named or a potentially responsible party in a number of governmental (federal, state, and local) and private actions associated with environmental matters, such as those relating to hazardous wastes, including certain sites which are on the United States EPA National Priorities List. These actions seek cleanup costs, penalties, and/or damages for personal injury or damage to property or natural resources. The Company evaluates and reviews environmental reserves for future remediation and compliance costs on a quarterly basis to determine appropriate reserve amounts. Inherent in this process are considerable uncertainties which affect the Company's ability to estimate the ultimate costs of remediation efforts. Such uncertainties include the nature and extent of contamination at each site, evolving governmental standards regarding remediation requirements, the number and financial condition of other potentially responsible parties at multi-party sites, innovations in remediation and restoration technology, and the identification of additional environmental sites. WITCO CORPORATION AND SUBSIDIARY COMPANIES NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) At December 31, 1993, the Company's reserves for environmental remediation and compliance costs amounted to $99,613,000 reflecting Witco's estimate of the costs which will be incurred over an extended period of time in respect of these matters which are reasonably estimable. The Company has numerous insurance policies which it believes provide coverage at various levels for environmental liabilities. The Company is currently in litigation with many of its insurers concerning the applicability and amount of insurance coverage for environmental costs under certain of these policies. No provision for recovery under any of these policies is included in the Company's financial statements. The Company is also a defendant in certain suits relating to the sale of lubricants to a quick lube oil franchisor. In one of such suits, Lightning Lube, Inc. v. Witco, in the United States District Court of New Jersey, after a trial the plaintiff was awarded $9,500,000 in compensatory damages for breach of contract and tortious interference, and approximately $2,000,000 pre-judgment interest. Both the plaintiff and the Company appealed this result to the Third Circuit Court of Appeals. In an opinion filed on September 10, 1993, the Third Circuit Court of Appeals affirmed the trial court's result. On October 8, 1993, the Company deposited $11,600,000 with the trial court in payment of the total amount of the judgment, together with interest, to discharge its liability in this action. The Company is not a party to any other legal proceedings, including environmental matters and the other suits relating to the sale of lubricants, which it believes will have a material adverse effect on its consolidated financial position. NOTE 15 -- OPERATIONS BY INDUSTRY SEGMENT AND GEOGRAPHIC AREA The Company is an international producer of a wide range of specialty chemical and petroleum products and diversified products for industrial and consumer uses. The following is a summary of the Company's operations by industry segment and geographic area: (table continued on next page) WITCO CORPORATION AND SUBSIDIARY COMPANIES NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) (table continued from previous page) Intersegment and inter-area sales are accounted for on the same basis used to price sales to similar non-affiliated customers and such sales are eliminated in arriving at consolidated amounts. Income and expenses not allocated to industry segments or geographic areas in computing operating income include general corporate expenses, interest income and expense, and other income and expenses of a general corporate nature. In 1993 general corporate expenses -- net include provisions for a work force reduction, loss on sublease of office facilities, and other matters totalling $29,784,000. General corporate expenses in 1992 include $20,135,000 for the provision for the consolidation of offices. International subsidiaries had liabilities of $211,182,000 in 1993 and $163,058,000 in 1992. Foreign currency translation and transaction gains and losses included in net income are not significant. QUARTERLY FINANCIAL DATA (UNAUDITED) - ------------ (a) Includes depreciation and amortization. (b) Per share data for all periods have been adjusted to reflect the two-for-one stock split effective October 5, 1993. 1993 quarterly per share amounts do not add to total for the year as each quarter and the total year are computed independently. (c) Includes a charge of $6,061, or $.11 per common share, for a provision for loss on sublease of office facilities. (d) Includes a charge of $7,563, or $.14 per common share, as a result of a legal judgment against the Company and $1,718, or $.03 per common share, as a result of the increase in the U.S. federal income tax rate. (e) Includes a charge of $60,126, or $1.10 per common share, for provisions for environmental remediation and compliance, disposition of a business, work force reduction, and other matters and a gain of $5,726, or $.11 per common share, on the sale of the operations of a subsidiary. (f) Includes a charge of $14,690, or $.29 per common share, as a result of adopting a change in accounting for postretirement benefits. (g) Includes a charge of $13,289, or $.27 per common share, for a provision for the consolidation of offices. SCHEDULE V WITCO CORPORATION AND SUBSIDIARY COMPANIES PROPERTY, PLANT AND EQUIPMENT - ------------ Notes: (a) Principally represents new equipment and replacement of retired equipment for existing plants. (b) Net of assets completed and transferred to appropriate property, plant and equipment accounts of $81,688 (1993), $58,121 (1992), and $87,743 (1991). (c) Principally represents assets acquired in connection with the acquisition of the Industrial Chemicals and Natural Substances divisions of Schering AG (1992) and adjustments relating to the finalization of the allocation of the purchase price (1993). Also includes the results of translating the financial statements of foreign subsidiaries in accordance with FASB Statement No. 52. (d) Depreciation is computed principally in accordance with the following estimated useful lives: S-1 SCHEDULE VI WITCO CORPORATION AND SUBSIDIARY COMPANIES ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT - ------------ Note: (a) Principally represents the result of the translation of the financial statements of foreign subsidiaries in accordance with FASB Statement No. 52. S-2 SCHEDULE VIII WITCO CORPORATION AND SUBSIDIARY COMPANIES VALUATION AND QUALIFYING ACCOUNTS - ------------ Note: (a) Uncollectible receivables charged against the allowance provided therefor. S-3 SCHEDULE IX WITCO CORPORATION AND SUBSIDIARY COMPANIES SHORT-TERM BORROWINGS - ------------ Notes: (a) The weighted average interest rate was affected by interest rates associated with the utilization of bank lines of credit by the Company's international subsidiaries. (b) The average amount outstanding during the period was computed by dividing the total of daily outstanding principal balances by the total days outstanding. (c) The weighted average interest rate during the period was computed by dividing the actual interest expense by average short-term debt outstanding. (d) To finance the acquisition of the Industrial Chemicals and Natural Substances divisions of Schering AG, the Company entered into a $440 million short-term financing arrangement on October 1, 1992, with a syndicate of banks. This borrowing was repaid during the period from March through May 1993 with a combination of proceeds from public offerings for shares of the Company's common stock, long-term debt securities, and proceeds from international borrowings. S-4 SCHEDULE X WITCO CORPORATION AND SUBSIDIARY COMPANIES SUPPLEMENTARY INCOME STATEMENT INFORMATION - ------------ Notes: (a) The 1993 increase is primarily due to businesses acquired in November 1992. (b) Amount for this caption is not presented as it is less than 1% of total revenues. S-5

832428_1993.txt

832428_1993

1993

832428

ITEM 1. BUSINESS The Company is a diversified media company operating principally in three segments: publishing, broadcasting, and cable television. In 1993 the Company announced plans to introduce the Home & Garden Television Network, a 24-hour cable channel, and established a new business, Scripps Howard Productions, to develop news and entertainment programming for domestic and international distribution. In February 1994 the Company acquired Cinetel Productions, one of the largest independent producers of cable television programming. See "Business - New Businesses." A summary of segment information for the three years ended December 31, 1993 is set forth on page of this Form 10-K. Publishing General - The Company publishes 19 metropolitan and suburban daily newspapers. From its Washington bureau the Company operates the Scripps Howard News Service ("SHNS"), a supplemental wire service covering stories in the capital, other parts of the United States, and abroad. While the revenue for this service is not significant, management believes the Company's image is enhanced by the wide distribution of SHNS. In addition to its newspaper operations, the Company, under the trade name United Media, is a leading distributor of news columns, comics, and other features for the newspaper industry. United Media owns and licenses worldwide copyrights relating to "Peanuts" and "Garfield," and other character properties for use on numerous products, including plush toys, greeting cards, and apparel, and for exhibit on television, video cassettes, and other media. The Company acquired or divested the following publishing operations in the three years ended December 31, 1993: 1993 - The Company acquired the remaining 2.7% minority interest in the Knoxville News-Sentinel. The Company divested its book publishing operations and its newspapers in Tulare, California, and San Juan. 1992 - The Company purchased three daily newspapers in California (including The Monterey County Herald in connection with the sale of The Pittsburgh Press). The Company sold The Pittsburgh Press and its television listings business. Revenues - The composition of the Company's publishing operating revenues for the most recent five years is as follows: Substantially all of the Company's newspaper publishing operating revenues are derived from advertising and circulation. Advertising rates and revenues vary among the Company's newspapers depending on circulation demographics, type of advertising, local market conditions, and competition. Advertising revenues are derived from "run-of-paper" advertisements included in each copy of a newspaper's editions, from "zoned" editions which feature sections with stories and advertisements intended for limited areas of distribution, from "preprinted" advertisements that are inserted into newspapers, and from "shoppers" which have little or no news content and contain primarily advertising run in the regular edition of the newspaper. Run-of-paper advertisements are generally more profitable to the Company than other advertisements. Advertising revenues vary through the year, with the first and third quarters generally having lower revenues than the second and fourth quarters. Advertising rates and volume are highest on Sundays, primarily because circulation and readership is greater on Sundays. Circulation revenues are derived from home delivery sales of newspapers to subscribers and from single-copy sales made through retail outlets and vending machines serviced by delivery and collection agents. Circulation information for the Company's newspapers is as follows: Joint operating agency distributions represent the Company's share of profits of newspapers managed by the other party to a joint operating agency (see "Joint Operating Agencies"). Other newspaper operating revenues include commercial printing. Under the trade names United Feature Syndicate and Newspaper Enterprise Association, the Company sells news columns, comic strips, crossword puzzles, editorial cartoons, and miscellaneous features and games to newspapers and other organizations throughout the world. Included among these features are "Peanuts" and "Garfield," two of the most successful strips in the history of comic art. These syndication revenues are included in miscellaneous revenues. Licensing revenues are derived from royalties on the sale of merchandise such as plush toys, greeting cards, and apparel. Such royalties are generally a negotiated percentage of the licensee's sales. More than half of the licensing revenues are from markets outside the United States. The Company generally pays a percentage of gross syndication and licensing royalties to the creators of these properties. Joint Operating Agencies - The Company is currently a party to newspaper joint operating agencies ("JOAs") in five markets. JOAs combine all but the editorial operations of two competing newspapers in a market in order to reduce aggregate expenses and take advantage of economies of scale, thereby allowing the continuing operation of both newspapers in that market. The Newspaper Preservation Act of 1970 ("NPA") provides a limited exemption from anti-trust laws, generally permitting the continuance of JOAs in existence prior to the enactment of the NPA and the formation, under certain circumstances, of new JOAs between newspapers. Except for the Company's JOA in Cincinnati, all of the Company's JOAs were entered into prior to the enactment of the NPA. From time to time the legality of pre-NPA JOAs has been challenged on anti-trust grounds but no such challenge has yet succeeded in the courts. JOA revenues less JOA expenses, as defined in each JOA, equals JOA profits, which are split between the parties to the JOA. In each case JOA expenses exclude editorial expenses. The Company manages the JOA in Evansville and receives approximately 80% of JOA profits. Each of the other four JOAs are managed by the other party to the JOA. The Company receives approximately 20% to 40% of JOA profits for those JOAs. The table below provides certain information about the Company's JOAs. The JOAs generally provide for automatic renewal terms of ten years unless an advance notice of termination ranging from two to five years is given by either party. The Company has notified Hartmann Publications of its intent to terminate the Evansville JOA. Competition - Competition occurs primarily in local markets, however certain newspapers, such as The New York Times and The Wall Street Journal, are sold in all of the Company's markets. The Company's newspapers compete for advertising revenues in varying degrees with other types of publications, such as magazines, and with other media such as television, radio, cable television, and direct mail. Competition for advertising revenues is based upon circulation levels, readership demographics, price, and effectiveness. The Company's newspapers compete for readership with other publications and compete for readers' discretionary time with other information and entertainment media. All of the Company's newspaper markets are highly competitive, particularly Denver, which is the largest market in which the Company operates a newspaper. Newspaper Production - The Company's daily newspapers are printed using letterpress, offset, or flexographic presses and use computer systems for writing, editing, and composing and producing the printing plates used in each edition. Raw Materials and Labor Costs - The Company consumed approximately 188,000 metric tonnes of newsprint in 1993. The Company purchases newsprint from various suppliers, many of which are Canadian. Management believes that the Company's sources of supply of newsprint are adequate for its anticipated needs. Newsprint costs accounted for approximately 17% of the Company's newspaper operating expenses in 1993. Labor costs accounted for approximately 47% of the Company's newspaper operating expenses in 1993. A substantial number of the Company's newspaper employees are represented by labor unions. See "Employees." Broadcasting General - The Company's broadcasting operations are owned by Scripps Howard Broadcasting Company ("SHB"), an Ohio corporation. The Company, through Scripps Howard, Inc. (its wholly-owned subsidiary), owns 86.1% of the outstanding shares of SHB Common stock. The remainder of the shares trade in the over-the-counter market under the NASDAQ symbol "SCRP." On February 17, 1994 the Company announced it had offered to acquire the 13.9% of SHB that it does not already own. See Item 7 "Management's Discussion and Analysis of Financial Condition and Results of Operations - Proposed Merger." The Company's broadcast operations consist of six network-affiliated VHF television stations and three Fox-affiliated UHF television stations. The Company acquired or divested the following broadcast operations in the three years ended December 31, 1993: 1993 - The Company purchased 589,000 shares of SHB Common stock, increasing the Company's ownership from 80.4% to 86.1%, and sold its radio stations and its Memphis television station. 1991 - The Company purchased its Baltimore television station. Revenues - The composition of the Company's broadcasting operating revenues for the most recent five years is as follows: Substantially all of the Company's broadcasting operating revenues are derived from advertising. Local advertising consists of short announcements and sponsored programs on behalf of advertisers in the area served by the station. National advertising consists of short announcements and sponsored programs on behalf of regional and national advertisers. The first and third quarters of each year generally have lower advertising revenues than the second and fourth quarters, due in part to higher retail advertising during the holiday seasons and political advertising in election years. Advertising rates charged by the stations are based primarily upon the population of the market, the number of stations competing in the market, as well as the station's ability to attract audiences. Information concerning the Company's stations and the markets in which they operate is as follows: Competition - Competition occurs primarily in local markets. The Company's television stations compete for advertising revenues with other television stations and other providers of video entertainment in their market, and in varying degrees with other media, such as newspapers and magazines, radio, and direct mail. Competition for advertising revenues is based upon audience levels, demographics, price, and effectiveness. The Company's television stations compete for viewers' time with other information and entertainment media. All of the Company's television markets are highly competitive. Network Affiliation and Programming - The Company's television stations are affiliated with national television networks under standard two-year affiliation agreements. These agreements are customarily renewed for successive two-year terms. The networks offer a variety of programs to affiliated stations, which have the right of first refusal before such programming may be offered to other television stations in the same market. Pursuant to the affiliation agreements, compensation is paid to the affiliated station for carrying network programming. The network has the right to decrease the amount of such compensation during the terms of the affiliation agreements but, upon any such decrease, an affected station has the right to terminate the agreement. The ranking of a station in its local market is affected by fluctuations in the national ranking of the affiliated network. Management believes such fluctuations are normal and has not sought to change the Company's network affiliations because of declines in national rankings of the affiliated networks. In addition to network programs, the Company's television stations broadcast locally produced programs, syndicated programs, sports events, movies, and public service programs. Local news is the focus of the Company's network-affiliated stations' locally produced programming and is an integral factor in developing the station's ties to its community and viewer loyalty. Advertising relating to local news and information programs generally represent more than 30% of a station's revenues. The Company's Kansas City Fox-affiliated station began broadcasting local news in 1993 and the Company expects to add local news programming at its Phoenix and Tampa stations. Federal Regulation of Broadcasting - Television broadcasting is subject to the jurisdiction of the Federal Communications Commission ("FCC") pursuant to the Communications Act of 1934, as amended ("Communications Act"). The Communications Act prohibits the operation of television broadcasting stations except in accordance with a license issued by the FCC and empowers the FCC to revoke, modify, and renew broadcasting licenses, approve the transfer of control of any corporation holding such licenses, determine the location of stations, regulate the equipment used by stations, and adopt and enforce necessary regulations. Television broadcast licenses are granted for a maximum of five years, and are renewable upon application. Application for renewal of the license for the Company's Phoenix station was filed in 1993 and is still pending. While there can be no assurances the Company's existing licenses will be renewed, the Company has never been denied a renewal and all previous renewals have been for the maximum term. The Company's application for renewal of the FCC license for its Baltimore station has been challenged by a competing applicant. The FCC is required to hold a hearing to assess which applicant's proposal would better serve the public interest. That hearing is proceeding on qualifications issues added by the presiding judge against both applicants, but the FCC has "frozen" its consideration of the comparative issues in light of an appeals court decision invalidating one of the principal criteria the FCC had used in assessing new applicants' qualifications. Revising the process so as to permit continuation of the comparative hearing may take an extended period of time, but the Company will continue to operate the station while its renewal of license application is pending. Management believes that granting of the Company's renewal would best serve the public interest and thus expects the renewal application to be granted. FCC regulations govern the multiple ownership of television stations and other media. Under the multiple ownership rule, a license for a television station will generally not be granted or renewed if (i) the applicant already owns, operates, or controls a television station serving substantially the same area, or (ii) the grant of the license would result in the applicant's owning, operating, or controlling, or having an interest in, more than twelve television stations or in television stations whose total national audience reach exceeds 25% of all television households. FCC rules also generally prohibit "cross-ownership" of a television station and daily newspaper or cable television system in the same service area. The Company's television station and daily newspaper in Cincinnati were owned by the Company at the time the cross-ownership rules were enacted and enjoy "grandfathered" status. These properties would become subject to the cross-ownership rules upon their sale. Under the Cable Television Consumer Protection and Competition Act of 1992 ("1992 Act"), each television broadcast station gained "must-carry" rights on any cable system defined as "local" with respect to that station. Stations may waive their must-carry rights and instead negotiate retransmission consent agreements with local cable companies. The Company's stations have generally elected to negotiate retransmission consent agreements with cable companies. Management believes the Company is in substantial compliance with all applicable regulatory requirements. Cable Television General - The Company's cable television systems in Lake County, Florida; Sacramento, California; and the Longmont, Colorado cluster are owned by SHB. Other wholly-owned subsidiaries of the Company operate cable television systems in Florida, Georgia, Indiana, Kentucky, South Carolina, Tennessee, Virginia, and West Virginia. In the three years ended December 31, 1993 the Company purchased several cable television systems adjacent to existing service areas. Revenues - The composition of the Company's cable television operating revenues for the most recent five years is as follows: Substantially all of the Company's cable television operating revenues are derived from services provided to subscribers of the Company's systems. Subscriber information as of December 31 for the Company's cable television systems is as follows: The Company's cable television systems carry a wide variety of entertainment and information services. Basic cable generally consists of video programming broadcast by local television stations, locally produced programming, and distant broadcast television signals. Advertiser- supported video programming such as ESPN and CNN and other entertainment and information services are included in various "enhanced basic" service packages. Premium programming consists of non-advertiser supported entertainment services such as Home Box Office and Showtime. Certain of the Company's systems are equipped with addressable decoding converters which enable the Company to offer interactive services, such as pay-per- view programming, and to change customer services without visiting the customer's home. Other monthly services includes revenues from services such as remote control and converter rental and audio programming. Competition - Competition occurs primarily in local markets. The Company's cable television systems compete for subscribers with other cable television systems in certain of its franchise areas. All of the Company's cable television systems compete for subscribers with other methods of delivering entertainment and information programming to the subscriber's home, such as broadcast television, multi-point distribution systems, master and satellite antenna systems, television receive-only satellite dishes, and home systems such as video cassette and laser disc players. In the future the Company's cable television systems may compete with new technologies such as more advanced "wireless cable systems" and broadcast satellite delivery services, as well as "video dial tone" services whereby the local telephone company leases video distribution lines to programmers on a common carrier basis. Management believes additional technologies for delivering entertainment and information programming to the home will continue to be developed, and that some of those competitive services will be capable of offering interactive services. Programming - The Company purchases programming from a variety of suppliers, the charge for which is generally based upon the number of subscribers receiving the service. Programming expenses as a percentage of basic and premium programming service revenues have risen in recent years, primarily due to additional and improved services provided to basic subscribers and to discounts offered to subscribers receiving multiple premium channels. See Item 7 "Management's Discussion and Analysis of Financial Condition and Results of Operations." Under the Copyright Act of 1976 cable television system operators are granted compulsory licenses permitting the carriage of the copyrighted works of local and distant broadcast signals for a statutory fee. The Copyright Royalty Tribunal is empowered to review and adjust such fees. FCC rules on syndicated exclusivity provide that if a local broadcast licensee has purchased the exclusive local distribution rights for a particular syndicated program, such licensee is generally entitled to insist that a local cable television system operator delete that program from any distant television signal carried by the cable television system. Regulation and Legislation - Cable television systems are regulated by federal, local, and in some instances, state authorities. Certain powers of regulatory agencies and officials, as well as various rights and obligations of cable television operators, are specified under the Cable Communications Policy Act of 1984 ("1984 Act") and the 1992 Act. Pursuant to the 1984 Act, local franchising authorities are given the right to award and renew one or more franchises for the community over which they have jurisdiction, the fees for which are prohibited from exceeding 5% of a cable television system's gross annual revenues. The 1992 Act, among other things: (i) reimposes rate regulations on most cable television systems; (ii) reimposes "must carry" rules with respect to local broadcast television signals (see "Federal Regulation of Broadcasting"); (iii) grants all broadcasters the option to refuse carriage of their signals; (iv) requires that vertically integrated cable television companies not unreasonably refuse to deal with any multichannel programming distributor or discriminate in the price, terms, and conditions of carriage of programming between cable television operators and other multichannel programming distributors if the effect would be to impede retail competition; and (v) establishes cross-ownership rules with respect to cable television systems and direct broadcast satellite systems, multi- channel multipoint distribution systems, and satellite master antenna systems. In April 1993 the FCC issued rules that established allowable rates for cable television services (other than programming offered on a per-channel or per-program basis) and for cable equipment based on benchmarks established by the FCC. The rules require rates for equipment to be cost- based, and require reasonable rates for regulated cable television services based upon, at the election of the cable television system operator, application of the benchmarks established by the FCC or a cost-of-service showing based upon standards established by the FCC. The rules became effective in September 1993 and were recently revised to further reduce regulated rates. The revised rules are expected to become effective in May 1994. Management believes the Company is in substantial compliance with all applicable regulatory requirements. New Businesses Entertainment - The Company plans to introduce the Home & Garden Television Network ("Home & Garden") in late 1994. This network will feature 24 hours of daily programming focused on home repair and remodeling, gardening, decorating, and home electronics. While most of the programming will be produced by the new network, local television stations affiliated with the network will have the opportunity for daily programming and advertised inserts. The subscriber base of the new network will be established through a collaboration of local television stations and cable television systems. Several cable television system operators, including Time Warner Cable and Continental Cablevision, the nation's second- and third-largest cable television system operators, have entered into agreements to carry the new network in exchange for permission to carry the signals of local television stations affiliated with the network. The Company is discussing carriage agreements with other cable television systems and intends to expand the network's affiliate group to include additional broadcast stations. The Company's cable television systems will carry the network and all of the Company's television stations (except the Fox-affiliated stations) are members of the network's affiliate group. In February 1994 the Company announced that it had agreed to purchase Cinetel Productions in Knoxville, Tennessee. Cinetel is one of the largest independent producers of cable television programming. Cinetel's production facility will also be the primary production facility for Home & Garden. In September 1993 the Company established Scripps Howard Productions to acquire, create, develop, produce, and own programming product for domestic and international television, including prime-time series for network and first-run syndication, movies, and miniseries for network, cable, and pay cable television broadcast, along with news, information, and entertainment services for the emerging multimedia marketplace. Employees As of December 31, 1993 the Company had approximately 7,600 full-time employees, of whom approximately 5,100 were engaged in publishing, 1,200 in broadcasting, and 1,200 in cable television. Various labor unions represent approximately 2,400 employees, primarily in the publishing segment. Collective bargaining agreements covering approximately 50% of union-represented employees are being negotiated currently or will be negotiated in 1994. Except for work stoppages at The Pittsburgh Press, which was sold in 1992, the Company has not experienced any work stoppages since March 1985. The Company considers its relationship with employees to be generally satisfactory. ITEM 2. ITEM 2. PROPERTIES The properties used in the Company's publishing operations generally include business and editorial offices and printing plants. The Company has added or upgraded production facilities at three of its major daily newspapers in recent years, including a state-of-the-art production plant for the Denver Rocky Mountain News. The Company's broadcasting operations require offices and studios and other real property for towers upon which broadcasting transmitters and antenna equipment are located. Ongoing advances in the technology for delivering video signals to the home, such as "high definition television" may, in the future, require a high level of expenditures by the Company for new equipment in order to maintain its competitive position of the Company's television stations. The properties required to support the Company's cable television operations generally include offices and other real property for towers, antennas, and satellite earth stations. In recent years the Company has completed rebuilding the cable television distribution system for its Rome, Georgia, cable television system and the Company is currently upgrading the distribution systems for its Chattanooga, Knoxville, and Sacramento systems. Ongoing advances in the technology for delivering video signals to the home and emergence of the multimedia marketplace could require a high level of expenditures to further upgrade the Company's cable television distribution systems. The Company's new entertainment operations will require offices and studios and other real and personal property to deliver programming product. The Company plans to expand the 60,000 square foot Cinetel production facility by approximately one-third to accommodate Home & Garden. Management believes the Company's present facilities are generally well- maintained and are sufficient to serve its present needs. ITEM 3. ITEM 3. LEGAL PROCEEDINGS In September 1991 Four Jacks Broadcasting, Inc., a company whose principals own and operate an existing Baltimore television station, submitted to the FCC an application for a construction permit to build and operate a new television station on channel 2 in Baltimore. This application is mutually exclusive with the Company's application for renewal of its license for its Baltimore television station. See Item 1 "Business - Broadcasting - Federal Regulation of Broadcasting." The Company is involved in other litigation arising in the ordinary course of business, such as defamation actions. In addition, the Company is involved from time to time in various governmental and administrative proceedings relating to, among other things, renewal of broadcast licenses, none of which is expected to result in material loss. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS There were no matters submitted to a vote of security holders for the quarter ended December 31, 1993. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS Shares of the Company's Class A Common stock are traded on the New York Stock Exchange under the symbol "SSP." There are approximately 4,500 owners of the Company's Class A Common stock and 27 owners of the Company's Common Voting stock, which does not have a public market, based on security position listings. The Company has declared cash dividends in every year since its incorporation in 1922. Future dividends are subject to the Company's earnings, financial condition, and capital requirements. The range of market prices of the Company's Class A Common stock, which represents the high and low sales prices for each full quarterly period, and quarterly cash dividends are as follows: ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The information required by this item is filed as part of this Form 10- K. See Index to Consolidated Financial Statement Information at page F- 1 of this 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 filed as part of this Form 10- K. See Index to Consolidated Financial Statement Information at page F- 1 of this Form 10-K. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The information required by this item is filed as part of this Form 10- K. See Index to Consolidated Financial Statement Information at page F- 1 of this Form 10-K. 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 executive officers of the Company are as follows: Name Age Position Charles E. Scripps 74 Chairman of the Board of Directors ( since 1953) Lawrence A. Leser 58 President, Chief Executive Officer and Director (since 1985) William R. Burleigh 58 Executive Vice President and Director (since 1990); Vice President, Newspapers and Publishing (1986 to 1990) Daniel J. Castellini 54 Senior Vice President, Finance and A dministration (since 1986) F. Steven Crawford 45 Senior Vice President, Cable Televis ion (since September 1992); Vice President, Cable Television (1990 to September 1992); General Manager, TeleScripps Cable Company (1983 to 1990) Paul F. Gardner 51 Vice President, Television (since Ap ril 1993); Senior Vice President, News Programming, Fox Broadcasting Company (1991 to 1993); Vice President and General Manager, WCPO Television, Cincinnati (1989 to 1991) J. Robert Routt 40 Vice President and Controller (since 1985) E. John Wolfzorn 48 Treasurer (since 1979) M. Denise Kuprionis 37 Secretary (since 1987) The executive officers of the Company serve at the pleasure of the Board of Directors. The information required by Item 10 of Form 10-K relating to directors of the Company is incorporated herein by reference to the material captioned "Election of Directors" in the Company's definitive proxy statement for the Annual Meeting of Stockholders ("Proxy Statement"). The Proxy Statement will be filed with the Securities and Exchange Commission on or before April 11, 1994. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The information required by Item 11 of Form 10-K is incorporated herein by reference to the material captioned "Executive Compensation" in the Proxy Statement. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information required by Item 12 of Form 10-K is incorporated herein by reference to the material captioned "Security Ownership of Certain Beneficial Owners and Management" in the Proxy Statement. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information required by Item 13 of Form 10-K is incorporated herein by reference to the material captioned "Certain Transactions" in the Proxy Statement. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K Financial Statements and Supplemental Schedules (a) The consolidated financial statements of the Company are filed as part of this Form 10-K. See Index to Consolidated Financial Statement Information at page. The report of Deloitte & Touche, Independent Auditors, dated January 26, 1994 is filed as part of this Form 10-K. See Index to Consolidated Financial Statement Information at page. (b) The consolidated supplemental schedules of the Company are filed as part of this Form 10-K. See Index to Consolidated Financial Statement Schedules at page S-1. Exhibits The information required by this item appears at page E-1 of this Form 10- K. Reports on Form 8-K No reports on Form 8-K were filed for the quarter ended December 31, 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, thereby duly authorized, on March 28, 1994. THE E.W. SCRIPPS COMPANY By /s/ Lawrence A. Leser Lawrence A. Leser 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 indicated, on March 28, 1994. Signature Title /s/ Lawrence A. Leser President, Chief Executive Officer and Director Lawrence A. Leser (Principal Executive Officer) /s/ Daniel J. Castellini Senior Vice President, Finance and Administration Daniel J. Castellini (Principal Financial and Accounting Officer) /s/ Charles E. Scripps Charles E. Scripps Chairman of the Board of Directors /s/ William R. Burleigh William R. Burleigh Executive Vice President and Director /s/ John H. Burlingame John H. Burlingame Director /s/ Daniel J. Meyer Daniel J. Meyer Director /s/ Nicholas B. Paumgarten Nicholas B. Paumgarten Director /s/ Paul K. Scripps Paul K. Scripps Director /s/ Robert P. Scripps Robert P. Scripps Director /s/ David R. Huhn David R. Huhn Director THE E.W. SCRIPPS COMPANY Index to Consolidated Financial Statement Information Selected Financial Data Management's Discussion and Analysis of Financial Condition and Results of Operations Independent Auditors' Report Consolidated Balance Sheets Consolidated Statements of Income Consolidated Statements of Cash Flows Consolidated Statements of Stockholders' Equity Notes to Consolidated Financial Statements MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Consolidated results of operations were as follows: The following items affected the comparability of the Company's reported results of operations: (i) The Company divested the following operations: 1993 - Book publishing; newspapers in Tulare, California, and San Juan; Memphis television station; radio stations. 1992 - The Pittsburgh Press; TV Data; certain other investments. 1991 - George R. Hall Company. The businesses referred to above, and any related gains on the sales of the businesses, are hereinafter referred to as the "Divested Operations." See Note 3B to the Consolidated Financial Statements. The following items related to Divested Operations affected the comparability of the Company's reported results of operations: The Herald, a newspaper with a circulation of approximately 37,000 in Monterey, California, was acquired on December 31, 1992 in connection with the sale of The Pittsburgh Press. (ii) In 1993 management changed the estimate of the additional amount of copyright fees the Company would owe when a dispute between the television industry and the American Society of Composers, Authors and Publishers was resolved ("ASCAP Adjustment"). The adjustment increased broadcasting operating income $4,300,000 and net income $2,300,000, $.03 per share. See Note 4 to the Consolidated Financial Statements. (iii) In 1993 the Company's agreement to guarantee up to $53,000,000 of the Ogden, Utah, Standard Examiner's debt expired with a change in ownership of the Standard Examiner. The Company received a $2,500,000 fee in connection with the transaction ("Ogden Fee"). The fee increased net income $1,600,000, $.02 per share. See Note 4 to the Consolidated Financial Statements. (iv) In 1993 the Company realized a gain on the sale of certain publishing equipment ("Gain on Sale"). The gain increased publishing operating income $1,100,000 and net income $700,000, $.01 per share. See Note 4 to the Consolidated Financial Statements. (v) In 1993 the Company recorded a charge to restructure operations at the Denver Rocky Mountain News and United Media ("Restructuring Charge"). The charge included severance payments and a write-down of certain assets to estimated realizable value. The charge reduced publishing operating income $6,300,000 and net income $3,600,000, $.05 per share. See Note 4 to the Consolidated Financial Statements. (vi) In August 1993 the federal income tax rate was increased to 35%, retroactive to January 1, 1993, and management changed its estimate of the tax basis and lives of certain assets ("Income Tax Changes"). The net effect was to increase net income $1,700,000, $.02 per share. See Note 5 to the Consolidated Financial Statements. (vii) The Pittsburgh Press was not published after May 17, 1992 due to a strike ("Pittsburgh Strike"). Reported 1992 results include operating losses of $32,700,000 and net losses of $20,200,000, $.27 per share, during the strike period. See Note 4 to the Consolidated Financial Statements. The Company sold The Pittsburgh Press on December 31, 1992 (see (i) above). (viii) In 1992 the Company adopted Financial Accounting Standard No. 106 - Employers' Accounting for Postretirement Benefits Other Than Pensions. The cumulative effect of the accounting change ("Cumulative Effect") decreased net income $22,413,000, $.30 per share, of which $18,000,000, $.24 per share, was associated with Divested Operations. See Note 2 to the Consolidated Financial Statements. (ix) In 1992 the Company reduced the carrying value of certain property and investments to estimated realizable value ("Write-downs"). The resultant $3,500,000 charge reduced net income $2,300,000, $.03 per share. See Note 4 to the Consolidated Financial Statements. (x) In 1991 the Company agreed to settle a lawsuit filed in 1988 by Pacific West Cable Company that alleged violations of antitrust and unfair trade practice laws ("Sacramento Settlement"). The resultant charge reduced cable television operating income by $12,000,000 and net income by $6,300,000, $.08 per share. See Note 4 to the Consolidated Financial Statements. The items above are excluded from the consolidated and segment operating results presented in the following pages of this Management's Discussion and Analysis. Management believes they are not relevant to understanding the Company's ongoing operations. Net income per share was as follows: The Company's average debt balance in 1993 was $101,000,000 less than in 1992. The combined effects of reduced rates and lower average debt balances were in part offset by a decrease in capitalized interest in 1993. Interest expense decreased in 1992 as reduced rates and an increase in capitalized interest more than offset a $37,000,000 increase in average debt balances. Capitalized interest costs, which in 1992 and 1991 primarily related to the construction of the new production facility at the Denver Rocky Mountain News, were as follows: Miscellaneous includes the net gains described in (i), the Ogden Fee described in (iii), and the Write-downs described in (ix) above. In 1993 the Company purchased 589,000 shares of Scripps Howard Broadcasting Company common stock, increasing the Company's ownership from 80.4% to 86.1%. The Company also acquired the remaining 2.7% minority interest in the Knoxville News-Sentinel. The effective income tax rate decreased in 1993 and 1992 because pre-tax income increased, thereby reducing the relative impact of non-deductible amortization of goodwill. The rate in 1993 was also affected by the Income Tax Changes. See Note 5 to the Consolidated Financial Statements. The effective income tax rate in 1994 is expected to be approximately 43%. RESULTS OF OPERATIONS CONSOLIDATED - Operating results, excluding the Divested Operations (including the Pittsburgh Strike), ASCAP Adjustment, Gain on Sale, Restructuring Charge, and Sacramento Settlement, were as follows: SEGMENTS - Operating results, excluding the Divested Operations (including the Pittsburgh Strike), ASCAP Adjustment, Gain on Sale, Restructuring Charge, and Sacramento Settlement, for each of the Company's business segments are presented on the following pages. Earnings before interest, income taxes, depreciation, and amortization ("EBITDA") is included in the discussion of segment results because: - Acquisitions of communications media businesses are based on multiples of EBITDA. - Financial analysts use EBITDA to value communications media companies. - Changes in depreciation and amortization are often unrelated to current performance. Management believes the year-over-year change in EBITDA is a more useful measure of year-over-year performance than the change in operating income because, combined with information on capital spending plans, it is a more reliable indicator of results that may be expected in future periods. - Banks and other lenders use EBITDA to determine the Company's borrowing capacity. EBITDA should not, however, be construed as an alternative measure of the amount of the Company's income or cash flows from operating activities. PUBLISHING - Operating results for the publishing segment, excluding the Divested Operations (including the Pittsburgh Strike), Gain on Sale, and Restructuring Charge, were as follows: Publishing revenues in 1993 were boosted by the fourth quarter 1992 acquisition of three California daily newspapers. See Note 3A to the Consolidated Financial Statements. Excluding the acquired newspapers, total advertising revenues increased 5.0% in 1993 and 3.0% in 1992. The strengthening demand for classified advertising that began in 1992 continued throughout 1993. Excluding the acquired newspapers, classified advertising revenues increased 11.2% and volume increased 5.7% in 1993. Demand for local advertising remained sluggish in 1993, particularly in the Company's California markets, but began to improve in the fourth quarter of the year. Local advertising revenues increased 1.9% in the fourth quarter to finish the year up 0.3%, excluding the effects of the acquired newspapers. Domestic licensing revenues decreased 0.8% and foreign licensing revenues decreased 5.3% in 1993, after decreasing 11% and 6.3% in 1992. In Japan, which accounts for approximately 60% of foreign licensing revenue and 37% of total licensing revenue, revenues in local currency decreased 12% in 1993 and 8.3% in 1992. The change in the exchange rate for the Japanese yen increased licensing revenues $2,700,000 in 1993 and $1,100,000 in 1992. Operating expenses in 1993 were affected by the inclusion of the acquired newspapers for the full year. Excluding the acquired newspapers, employee compensation and benefits increased approximately 4% and other expenses increased approximately 10% in 1993. Other expenses increased primarily because of start-up costs associated with a new production facility and new editions at the Denver Rocky Mountain News. Depreciation expense for 1992 and 1991 includes charges of $5,500,000 and $4,000,000, respectively, to reduce the book value of certain equipment to estimated net realizable value. Depreciation and amortization increased in 1993 because of the acquired newspapers and the new production facility in Denver. Capital expenditures were unusually high in 1992 and in 1991 due to the construction of the new production facility in Denver. Capital expenditures in 1994 are expected to be approximately $20,000,000. Depreciation and amortization is expected to increase approximately 5% in 1994. BROADCASTING - Operating results for the broadcasting segment, excluding the Divested Operations and ASCAP Adjustment, were as follows: Revenues increased at most of the Company's television stations in 1993 and in 1992. Revenues at the Fox affiliates have been particularly strong. Program costs decreased in 1993 as several syndicated programs previously aired by the Company's stations were replaced with less-costly programs. Revenues and operating expenses in 1992 were affected by the inclusion of Baltimore television station WMAR, acquired May 30, 1991, for the full year. Capital expenditures in 1994 are expected to be approximately $14,000,000. Depreciation and amortization is expected to increase approximately 5% in 1994. CABLE TELEVISION - Operating results for the cable television segment, excluding the Sacramento Settlement, were as follows: The legislation passed in October 1992 to re-regulate the cable television industry affected the Company's cable television operations in 1993. Basic rates were frozen April 5, 1993 and new regulated rates became effective September 1, 1993. The Federal Communications Commission recently announced revised rules that will further reduce regulated rates. Based upon the revised rules, revenues and EBITDA will decline in 1994. Program costs as a percent of basic and premium programming service revenues increased from 23.2% in 1991 to 24.8% in 1993, primarily due to expanded and improved programming offered to basic subscribers and discounts provided to customers receiving multiple premium channels. Program costs as a percentage of basic and premium programming service revenues are expected to increase in 1994. The Company is upgrading the distribution systems for its Knoxville, Chattanooga, and Sacramento systems. Capital expenditures on these and other projects are expected to be approximately $60,000,000 in 1994. Depreciation and amortization is expected to increase approximately 3% in 1994. LIQUIDITY AND CAPITAL RESOURCES Cash flow from operating activities was $227,000,000 in 1993 compared to $205,000,000 in 1992. Cash flow from operating activities and cash received in the sales of subsidiary companies totaled $367,000,000 in 1993 and was used primarily for capital expenditures of $104,000,000, acquisitions (including minority interests in subsidiary companies) and investments of $41,700,000, debt reduction of $194,000,000, and dividend payments of $38,300,000. The debt to total capitalization ratio at December 31 was .22 in 1993 and .38 in 1992. Consolidated capital expenditures are expected to total approximately $100,000,000 in 1994, including The Home & Garden Television Network ("Home & Garden"), a 24-hour cable channel set for launch in late 1994. Scheduled maturities of long-term debt in 1994 total $96,400,000. The Company expects to finance its capital requirements and start-up costs for Home & Garden primarily through cash flow from operations. EFFECTS OF PRICE CHANGES General inflation has not been detrimental to the Company's long-term operating results. However, year-to-year comparisons can be significantly affected by newsprint price changes. Because the supply of newsprint has exceeded demand, its price generally declined from 1988 through August 1992. The price of newsprint has moved in a narrow band since that time, but has trended higher. The price of newsprint peaked in 1988 when it was approximately 25% higher than the current price. PROPOSED MERGER On February 17, 1994 the Company announced it had offered to acquire the 13.9% of Scripps Howard Broadcasting Company ("SHB") that it does not already own. In a merger proposal made to the SHB board of directors, the Company offered to exchange three shares of Class A Common stock for each SHB share. Directors of SHB have formed a special committee to evaluate the offer. The merger is subject to the execution of a mutually agreeable definitive agreement, regulatory approvals, and a vote of SHB shareholders. If the merger is effected under the terms proposed by the Company, an additional 4,300,000 shares of Class A Common stock would be issued. There can be no assurance that the merger will be entered into or that any transaction will be consummated. INDEPENDENT AUDITORS' REPORT To the Board of Directors and Stockholders, The E.W. Scripps Company: We have audited the accompanying consolidated balance sheets of The E.W. Scripps Company and subsidiary companies (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. 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 the Company 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 2 to the consolidated financial statements, as of December 31, 1993 the Company changed its method of accounting for certain investments to conform with Statement of Financial Accounting Standards No. 115. As discussed in Note 2 to the consolidated financial statements, in 1992 the Company changed its method of accounting for postretirement benefits other than pensions to conform with Statement of Financial Accounting Standards No. 106. DELOITTE & TOUCHE Cincinnati, Ohio January 26, 1994 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Consolidation - The consolidated financial statements include the accounts of The E.W. Scripps Company and its majority-owned subsidiary companies ("Company"). Newspaper Joint Operating Agencies - The Company is currently a party to newspaper joint operating agencies ("JOAs") in five markets. JOAs combine all but the editorial operations of two competing newspapers in a market. In each JOA the managing party distributes a portion of JOA profits to the other party. The Company manages the JOA in Evansville. The JOAs in Albuquerque, Birmingham, Cincinnati, and El Paso are managed by the other parties to the JOAs. The Company managed the JOA in Pittsburgh prior to the sale of The Pittsburgh Press (see Note 3B). The Company includes the full amount of Company-managed JOA assets and liabilities, and revenues earned and expenses incurred in the operation of the JOA, in the consolidated financial statements. Distributions of JOA operating profits to the non-managing party are included in other operating expenses in the Consolidated Statements of Income. For JOAs managed by the other party, the Company includes distributions of JOA operating profits in operating revenues in the Consolidated Statements of Income. The Company does not include any assets or liabilities of JOAs managed by other parties in its Consolidated Balance Sheets as the Company has no residual interest in the net assets of the JOAs. Goodwill and Other Intangible Assets - Goodwill and other intangible assets are stated at the lower of unamortized cost or fair value. Fair value is estimated based upon estimated future net cash flows. An impairment loss is recognized when the undiscounted estimated future net cash flows exceed the unamortized cost of the asset. Goodwill represents the cost of acquisitions in excess of tangible assets and identifiable intangible assets received. Cable television franchises are amortized generally over the remaining terms of acquired cable systems' franchise agreements and non- competition agreements over the terms of the agreements. Goodwill acquired after October 1970, customer lists, and other intangible assets are amortized over periods of up to 40 years. Goodwill acquired before November 1970 ($6,600,000) is not amortized. Income Taxes - Deferred income tax liabilities are provided for temporary differences between the tax basis and reported amounts of assets and liabilities that will result in taxable or deductible amounts in future years. The Company's temporary differences primarily result from accelerated depreciation and amortization for tax purposes and accrued expenses not deductible for tax purposes until paid. Also, the Company received a tax certificate from the Federal Communications Commission upon the sale of the Memphis television and radio stations, enabling the Company to defer payment of income taxes on the $60,500,000 tax-basis gain for a minimum of two years. Property, Plant, and Equipment - Depreciation is computed using the straight-line method over estimated useful lives. Interest costs related to major capital projects are capitalized and classified as property, plant, and equipment. Program Rights - Program rights are recorded at the time such programs become available for broadcast. Program rights are stated at the lower of unamortized cost or fair value. Amortization is computed using the straight-line method based on the license period or based on usage, whichever yields the greater accumulated amortization for each program. The portion of the unamortized balance expected to be amortized within one year is classified as a current asset. The liability for program rights is not discounted for imputed interest. The current portion of the liability is included in accounts payable in the Consolidated Balance Sheets. Estimated fair values (which are based on current rates available to the Company for debt of the same remaining maturity) and the carrying amounts of the Company's program rights liabilities were as follows: Investments - The Company adopted Financial Accounting Standard ("FAS") No. 115 - Accounting for Certain Investments in Debt and Equity Securities effective December 31, 1993 (see Note 2). Investments in such securities are classified as either held to maturity, trading, or available for sale. Securities classified as held to maturity are carried at amortized cost. Securities classified as trading and available for sale are carried at fair value. Fair value is determined by reference to quoted market prices for those or similar securities. Unrealized gains or losses on securities classified as trading are recognized in income and unrealized gains or losses on securities available for sale are recognized as a separate component of stockholders' equity. The cost of securities sold is determined by specific identification. Investments in 20%- to 50%-owned companies and joint ventures are accounted for under the equity method. Inventories - Inventories are stated at the lower of cost or market. The cost of newsprint included in inventory is computed using the last in, first out ("LIFO") method. At December 31 newsprint inventories were approximately 25% of total inventories in 1993 and in 1992. The cost of other inventories is computed using the first in, first out ("FIFO") method. Inventories would have been $200,000 higher at December 31, 1993 and 1992 if FIFO (which approximates current cost) had been used to compute the cost of newsprint. Postemployment Benefits - The Company adopted FAS No. 112 - Employers' Accounting for Postemployment Benefits in 1993 (see Note 2). Postretirement benefits are recognized during the years that employees render service. Other postemployment benefits, such as disability-related benefits and severance, are recognized when the benefits become payable. Self Insurance - The Company is primarily self-insured for employee health, workers' compensation, and general liability insurance. Self-insurance liabilities are estimated based upon claims filed and estimated claims incurred but not reported. The self-insurance liabilities are not discounted. Amounts estimated to be paid within one year are included in accrued liabilities in the Consolidated Balance Sheets. Cash and Cash Equivalents - Cash and cash equivalents represent cash on hand, bank deposits, and highly liquid debt instruments with an original maturity of up to three months. Cash equivalents are stated at cost plus accrued interest, which approximates fair value. Net Income Per Share - Net income per share computations are based upon the weighted average common shares outstanding. Common stock equivalents in the form of stock options are excluded from the computations as they have no material effect on the per share amounts. Weighted average shares outstanding were as follows: Reclassifications - For comparison purposes certain 1992 and 1991 items have been reclassified to conform with 1993 classifications. 2. ACCOUNTING CHANGES The Company adopted FAS No. 115 - Accounting for Certain Investments in Debt and Equity Securities on December 31, 1993. As a result of the change, total assets increased $42,125,000 and stockholders' equity increased $27,381,000. Adoption of the new standard had no effect on retained earnings. The Company also adopted FAS No. 112 - Employers' Accounting for Postemployment Benefits in 1993. The change had no effect on the Company's financial statements. In 1992 the Company adopted FAS No. 106 - Employers' Accounting for Postretirement Benefits Other Than Pensions. As a result of the change, operating income decreased $2,100,000 and income before the cumulative effect decreased $1,400,000, $.02 per share. The Pittsburgh Press accounted for $1,800,000 of the decrease in operating income and $1,200,000, $.02 per share, of the decrease in income before the cumulative effect (see Note 3B). 3. ACQUISITIONS AND DIVESTITURES A. Acquisitions 1993 - The Company purchased 589,000 shares of Scripps Howard Broadcasting Company common stock for $28,900,000, increasing the Company's ownership percentage from 80.4% to 86.1%. The Company also acquired the remaining 2.7% minority interest in the Knoxville News- Sentinel for $2,800,000 and purchased a cable television system. 1992 - The Company purchased three daily newspapers in California (including The Herald in connection with the sale of The Pittsburgh Press - see Note 3B) and several cable television systems. 1991 - The Company purchased Baltimore television station WMAR for $125,000,000 in cash and assumed liabilities totaling $29,000,000. The Company also purchased several cable television systems. The following table presents additional information about the acquisitions: The acquisitions have been accounted for as purchases, and accordingly the purchase prices were allocated to assets and liabilities based on the estimated fair value as of the dates of acquisition. The acquired operations have been included in the consolidated statements of income from the dates of acquisition. The following table summarizes, on an unaudited, pro forma basis, the estimated combined results of the Company and WMAR for 1991, assuming the acquisition was completed at the beginning of the year. These results include certain adjustments, primarily increased interest expense and depreciation and amortization, and are not necessarily indicative of what the results would have been had the Company owned WMAR during 1991: B. Divestitures The Company divested the following operations: 1993 - Book publishing; newspapers in Tulare, California, and San Juan; Memphis television station; radio stations. 1992 - The Pittsburgh Press; TV Data; certain other investments. 1991 - George R. Hall Company. The following table presents additional information about the divestitures: Included in net assets (liabilities) disposed in 1992 are pension and other postretirement benefit obligations totaling $36,500,000. Included in the consolidated financial statements are the following results of divested operations (excluding gains on sales): 4. UNUSUAL CREDITS AND CHARGES The Company's operating results include net after-tax gains on the sales of subsidiary companies of $46,800,000, $.63 per share, in 1993 and $45,600,000, $.61 per share, in 1992 (see Note 3B). 1993 - Management changed the estimate of the additional amount of copyright fees the Company would owe when a dispute between the television industry and the American Society of Composers, Authors and Publishers ("ASCAP") was resolved. The adjustment increased operating income $4,300,000 and net income $2,300,000, $.03 per share. The U.S. television industry challenged the copyright fees required to be paid to ASCAP under a formula established in 1950. The dispute concerned payments for the past ten years. The U.S. District Court of the Southern District of New York ruled on February 26, 1993, and the change in estimate was based on that ruling. The Company's agreement to guarantee up to $53,000,000 of the Ogden, Utah, Standard Examiner's debt expired with a change in ownership of the Standard Examiner. The Company received a $2,500,000 fee in connection with the transaction. The fee increased net income $1,600,000, $.02 per share. The Company realized a gain of $1,100,000 on the sale of certain publishing equipment. The gain increased net income $700,000, $.01 per share. In August 1993 the federal income tax rate was increased to 35%, retroactive to January 1, 1993, and management changed its estimate of the tax basis and lives of certain assets. The net effect was to increase net income $1,700,000, $.02 per share (see Note 5). The Company recorded a $6,300,000 charge to restructure operations at the Denver Rocky Mountain News and United Media. The charge included severance payments and a write-down of certain assets to estimated realizable value. The charge reduced net income $3,600,000, $.05 per share. 1992 - The Pittsburgh Press was not published after May 17 due to a strike. Reported 1992 results include operating losses of $32,700,000 and net losses of $20,200,000, $.27 per share, during the strike period. The Company reduced the carrying value of certain property and investments to estimated realizable value. The resultant $3,500,000 charge reduced net income $2,300,000, $.03 per share. 1991 - The Company agreed to settle a lawsuit filed in 1988 by Pacific West Cable Company that alleged violations of antitrust and unfair trade practice laws. The resultant charge reduced operating income by $12,000,000 and net income by $6,300,000, $.08 per share. 5. INCOME TAXES The Internal Revenue Service ("IRS") is currently examining the Company's consolidated income tax returns for the years 1985 through 1990. Management believes that adequate provision for income taxes has been made for all open years. In 1991 the Company reached agreement with the IRS to settle the audits of its 1982 through 1984 federal income tax returns. The IRS required the Company's broadcast operations to change to the accrual method of accounting for income tax purposes. There was no charge to income resulting from the settlement. In August 1993 the federal income tax rate was increased to 35%, retroactive to January 1, 1993. The change in the tax rate increased the Company's deferred tax liabilities $3,700,000. The resultant charge to income taxes reduced net income $3,700,000, $.05 per share. Also in 1993, management changed its estimate of the tax basis and lives of certain assets. The resulting change in the estimated tax liabilities for prior years increased net income $5,400,000, $.07 per share. The approximate effect of the temporary differences giving rise to the Company's deferred income tax liabilities (assets) are as follows: The Company's state net operating loss carryforwards expire from 2000 through 2018. The provision for income taxes consists of the following: The difference between the statutory rate for federal income tax and the effective income tax rate is summarized as follows: 6. LONG-TERM DEBT Long-term debt consisted of the following at December 31: The Company has a Competitive Advance/Revolving Credit Agreement which, at December 31, 1993, permitted maximum borrowings up to $165,000,000, and additional lines of credit which, at December 31, 1993, totaled $60,000,000 (collectively "Variable Rate Credit Facilities"). Maximum borrowings under the Variable Rate Credit Facilities are changed as the Company's anticipated needs change and are not indicative of the Company's short-term borrowing capacity. The Variable Rate Credit Facilities expire at various dates through September 1994 and may be extended upon mutual agreement. In 1993 the Company prepaid the scheduled 1994 payment on the 10.3% note. Certain long-term debt agreements contain maintenance requirements on net worth and coverage of interest expense and restrictions on dividends and incurrence of additional indebtedness. Interest costs capitalized were as follows: 7. INVESTMENTS Investments consisted of the following at December 31: 8. PROPERTY, PLANT, AND EQUIPMENT AND INTANGIBLE ASSETS Property, plant, and equipment consisted of the following at December 31: Goodwill and other intangible assets consisted of the following at December 31: 9. EMPLOYEE BENEFIT PLANS The Company sponsors defined benefit plans covering substantially all non- union employees. Benefits are generally based on the employees' compensation and years of service. Funding is based on the requirements of the plans and applicable federal laws. The Company also sponsors defined contribution plans covering substantially all non-union employees. The Company matches a portion of employees' voluntary contributions to these plans. Union-represented employees are covered by retirement plans jointly administered by subsidiaries of the Company and the unions or by union- administered, multi-employer plans. Funding is based upon negotiated agreements. Retirement plans expense consisted of the following: Assumptions used in the accounting for the defined benefit plans were as follows: The funded status of the defined benefit plans at December 31 was as follows: Plan assets consist of marketable equity and fixed-income securities. The Company has unfunded health and life insurance benefit plans that are provided to certain retired employees. The combined number of 1) active employees eligible for such benefits and 2) retired employees receiving such benefits is approximately 5% of the Company's current workforce. The actuarial present value of the projected benefit obligation at December 31 was $6,300,000 in 1993 and $6,100,000 in 1992. The cost of the plan was $600,000 in 1993 and in 1992 (excluding $3,200,000 attributable to The Pittsburgh Press in 1992). 10. SEGMENT INFORMATION The net effect of the gain on sale of equipment and the restructuring charges reduced publishing operating income $5,200,000 in 1993 (see Note 4). The change in accounting for health and life insurance benefits provided to certain retired employees reduced publishing operating income in 1992 by $2,100,000 (of which $1,800,000 relates to The Pittsburgh Press) (see Note 2). Broadcasting operating income in 1993 was increased by $4,300,000 as a result of the change in estimate of the additional amount of copyright fees owed ASCAP (see Note 4). Cable television operating income was reduced in 1991 by the $12,000,000 charge related to settlement of the Sacramento cable television litigation (see Note 4). Other segment amounts represent the operating results of George R. Hall Company, which was sold by the Company in March 1991 (see Note 3B). Financial information relating to the Company's business segments is as follows: Corporate assets are primarily cash, investments, and deferred income taxes. 11. COMMITMENTS AND CONTINGENCIES The Company is involved in litigation arising in the ordinary course of business, none of which is expected to result in material loss. The Company is committed to purchase approximately $68,000,000 of program rights currently not available for broadcast, including programs not yet produced. If such programs are not produced the Company's commitment would expire without obligation. The Company is diversified geographically and has a diverse customer base. The Company grants credit to substantially all of its customers. Management believes bad debt losses resulting from default by a single customer, or defaults by customers in any depressed region or business sector, would not have a material effect on the Company's financial position. Minimum payments on non-cancelable leases at December 31, 1993 were as follows: Rental expense for cancelable and non-cancelable leases was as follows: 12. CAPITAL STOCK AND INCENTIVE PLANS The capital structure of the Company includes Common Voting stock and Class A Common stock. The articles of the Company provide that the holders of Class A Common stock, who are not entitled to vote on any other matters except as required by Delaware law, are entitled to elect the greater of three or one-third of the directors of the Company. The 1987 Long-Term Incentive Plan ("1987 Plan") provides for the awarding of stock options, stock appreciation rights, performance units, and Class A Common stock to key employees. The number of shares authorized for issuance under the 1987 Plan is 2,500,000. Stock options may be awarded to purchase Class A Common stock at not less than 100% of the fair market value on the date the option is granted. Stock options will vest over an incentive period, conditioned upon the individual's employment through that period. The plan expires on December 9, 1997, except for options then outstanding. Information related to stock options is as follows: Awards of Class A Common stock will vest over an incentive period, conditioned upon the individual's employment throughout that period. During the vesting period shares issued are non-transferable, but the shares are entitled to all the rights of an outstanding share. Upon vesting, when the stock awards become taxable to the employees, additional awards of cash may also be made. Information related to awards of Class A Common stock is as follows: 13. SUMMARIZED QUARTERLY FINANCIAL INFORMATION (Unaudited) Summarized financial information is as follows: The sum of the quarterly net income per share amounts may not equal the reported annual amount because each is computed independently based upon the weighted average number of shares outstanding for that period. THE E.W. SCRIPPS COMPANY Index to Consolidated Financial Statement Schedules Marketable Securities - Other Investments S-2 Property, Plant, and Equipment S-3 Accumulated Depreciation of Property, Plant, and Equipment S-4 Valuation and Qualifying Accounts S-5 Supplementary Income Statement Information S-6

106170_1993.txt

106170_1993

1993

106170

ITEM 1. BUSINESS THE NORTHEAST UTILITIES SYSTEM Northeast Utilities (NU) is the parent company of the Northeast Utilities system (the System). It is not itself an operating company. Through four of NU's wholly-owned subsidiaries (The Connecticut Light and Power Company [CL&P], Public Service Company of New Hampshire [PSNH], Western Massachusetts Electric Company [WMECO] and Holyoke Water Power Company [HWP]), the System furnishes electric service in Connecticut, New Hampshire and western Massachusetts. In addition to their retail electric service, CL&P, PSNH, WMECO and HWP (including its wholly-owned subsidiary Holyoke Power and Electric Company) together furnish firm wholesale electric service to eight municipalities and utilities. The System companies also supply other wholesale electric services to various municipalities and other utilities. NU serves about 30 percent of New England's electric needs and is one of the 20 largest electric utility systems in the country. NU acquired PSNH, the largest electric utility in New Hampshire, in June 1992. PSNH was in bankruptcy reorganization proceedings from January 1988 to May 1991, when it emerged from bankruptcy in the first step of an NU- sponsored two-step plan of reorganization. NU's acquisition of PSNH was the second step of the reorganization plan. On October 1, 1993, the Bankruptcy Court in New Hampshire formally terminated the bankruptcy proceeding. See Item 3, Legal Proceedings. PSNH continues to operate its core electric utility business, but pursuant to the reorganization plan, PSNH transferred its 35.6 percent interest in the Seabrook nuclear generating facility (Seabrook) in Seabrook, New Hampshire to North Atlantic Energy Corporation (NAEC), a special purpose subsidiary of NU which sells the capacity and output of that unit to PSNH under two life-of-unit, full cost recovery contracts. In June 1992, NU's subsidiary North Atlantic Energy Service Corporation (North Atlantic) assumed operational responsibility for Seabrook. Before that, Seabrook had been operated by a division of PSNH. Other wholly-owned subsidiaries of NU provide support services for the System companies and, in some cases, for other New England utilities. Northeast Utilities Service Company (NUSCO or the Service Company) provides centralized accounting, administrative, data processing, engineering, financial, legal, operational, planning, purchasing and other services to the System companies. Northeast Nuclear Energy Company (NNECO) acts as agent for the System companies and other New England utilities in operating nuclear generating facilities in Connecticut. North Atlantic acts as agent for the System companies and other New England utilities in operating Seabrook. Two other subsidiaries construct, acquire or lease some of the property and facilities used by the System companies. NU has two other principal subsidiaries, Charter Oak Energy, Inc. (Charter Oak) and HEC Inc. (HEC), which have non-utility businesses. Directly and through subsidiaries, Charter Oak develops and invests in cogeneration, small power production and independent power production facilities. HEC provides energy management services for commercial, industrial and institutional electric customers. See "Non-Utility Businesses." COMPETITION AND MARKETING Competition within the electric utility industry is increasing. In response, NU has developed, and is continuing to develop, a number of initiatives to retain and continue to serve its existing customers and to expand its retail and wholesale customer base. These initiatives are aimed at keeping customers from either leaving NU's retail service territory or replacing NU's electric service with alternative energy sources and at attracting new customers. Management believes that CL&P, PSNH and WMECO must continue to be responsive to their business customers, in particular, in dealing with the price of electricity and to recognize that many business customers have alternatives such as fuel switching, relocation and self- generation if the price of electricity is not competitive. A System-wide emphasis on improved customer service is a central focus of the reorganization of NU that became effective on January 1, 1994. The reorganization entails realignment of the System into two new core business groups. The first core business group, the energy resources group, is devoted to energy resource acquisition and wholesale marketing and focuses on nuclear, fossil and hydroelectric generation, wholesale power marketing and new business development. The second core business group, the retail business group, oversees all customer service, transmission and distribution operations and retail marketing in Connecticut, New Hampshire and Massachusetts. These two core business groups are served by various support functions known collectively as the corporate center. In connection with NU's reorganization, the System has begun a corporate reengineering process which should help it to identify opportunities to become more competitive while improving customer service and maintaining a high level of operational performance. ECONOMIC DEVELOPMENT The cost of doing business, including the price of electricity, is higher in the System's service area, and the Northeast generally, than in most other parts of the country. Relatively high state and local taxes, labor costs and other costs of doing business in New England also contribute to competitive disadvantages for many industrial and commercial customers of CL&P, PSNH and WMECO. These disadvantages have aggravated the pressures on business customers in the current weakened regional economy. As a result, state and local governments in the region frequently offer incentives to attract new business development to, and to expand existing businesses within, their states. Since 1991, CL&P and WMECO have worked actively with state and local economic development authorities to package incentives for a variety of prospective or expanding customers. These economic development packages typically include both electric rate discounts and incentive payments for energy efficient construction, as well as technical support and energy conservation services. In general, electric rate discounts are phased out over varying periods generally not in excess of ten years. From September 1991 through March 1, 1994, economic development rate agreements had been reached with approximately 45 industrial and commercial customers in the three states served by the System, including 38 customers in CL&P's service territory, one customer in PSNH's service territory and six customers in WMECO's service territory. As an adjunct to their economic development efforts, CL&P and WMECO have also developed programs which provide incentives to customers planning to construct or significantly renovate commercial or industrial buildings within the System's service territory. Approximately 40 percent of all such construction qualifies for incentive payments for the installation or retrofitting of energy-efficient equipment designed to result in permanent savings for the customer in addition to any savings that result from the rate discounts. The business expansion-related rate agreements cover small-to- medium-sized industrial companies and a few medium-sized commercial business relocations. In all cases where economic development rates are in effect, the additional load and associated revenues, even though received under discounted rates, result in a net benefit to the System by making a contribution towards the System's fixed costs. During 1993, 28 customers were on economic development rate riders, including 24 CL&P customers and four WMECO customers. The net benefit to the System during 1993 as a result of these agreements was approximately $300,000. BUSINESS RETENTION/BUSINESS RECOVERY From 1983 through 1989, the System's retail kilowatt-hour sales grew by an annual average rate of 3.8 percent. Since the end of 1989, retail sales have been level, except for the addition of PSNH's electric load as a result of NU's acquisition of PSNH, effective in June 1992. The leveling effect has resulted in part from the System's conservation and load management (C&LM) efforts, but is largely due to the region's persistent weak economy. Management expects a modest improvement in the economy in 1994 and moderate electric sales growth is anticipated. To spur economic activity, NU's subsidiaries have worked in concert with state and local authorities to retain businesses that are considering relocating outside of the NU service territory. C&LM incentives are used with temporary rate reductions to produce both short-term and long-term cost savings for customers. These reductions are generally limited to five years but may be for as long as ten years. As of the end of 1993, 25 System customers received such reductions, including 19 CL&P customers, two PSNH customers and five WMECO customers. These customers in the aggregate represented less than 0.5 percent of System revenues. The NU operating subsidiaries also offer rate reductions to business entities that can demonstrate that they are encountering financial problems threatening their viability but have reasonable prospects for improvement. These "business recovery" reductions can be brief in duration, sometimes lasting only a few months, or may extend for up to five years. From the time these rates became available in late 1991 through the end of 1993, 23 CL&P customers, two PSNH customers and eight WMECO customers have been granted such rate reductions. The CL&P customers provided approximately $10 million in annual revenues; the PSNH customers provided approximately $10 million in annual revenues and the WMECO customers provided approximately $1.5 million in annual revenues. The bulk of the cost of the presently estimated discounts has been anticipated in base rates. The cost of the C&LM program is also collected from ratepayers. COMPETITIVE GENERATION A growing source of competition in the electric utility industry comes from companies that are marketing co-generation systems, primarily to those customers who can use both the electricity and the steam created by such systems. See "Regulatory and Environmental Matters - Public Utility Regulation." For instance, the Pratt & Whitney Aircraft Division of United Technologies Corporation, the System's largest industrial customer, put into service a 25-megawatt generating system in January 1993, reducing CL&P's industrial sales by approximately 1.5 percent, or $8 million, during 1993. While only a few other such systems have been installed in the System's service territory to date, the extent of growth of further self-generation cannot be predicted. To help convince retail customers not to generate their own power, CL&P, PSNH and WMECO have offered a competitive generation rate or special rate contracts that typically provide for up to ten years of rate reductions in return for a commitment not to self-generate. Two of CL&P's largest customers, together accounting for approximately $12 million of annual revenues in 1993, are operating under these arrangements. The New Hampshire Public Utilities Commission (NHPUC) also approved a special PSNH rate available for operators of sawmills to help prevent those customers from installing diesel generation. Altogether, approximately 28 System customers were on some type of competitive generation rate or special contract at the end of 1993, consisting of two CL&P customers, 20 PSNH customers and six WMECO customers. The PSNH customers provided approximately $3 million in annual revenues and the WMECO customers provided approximately $1.5 million in annual revenues. Overall, all types of flexible rate riders and special contracts offered by the System have preserved System revenues of approximately $50 million. As each subsidiary intensifies its efforts to retain existing customers and gain new customers, the number of customers covered under such flexible rates, and the number and amount of overall discounts, are expected to rise moderately over the next few years. RETAIL WHEELING In principle, retail wheeling would enable a retail customer to select an electricity supplier and force the local electric utility to transmit the power to the customer's site. While wholesale wheeling was mandated by the Energy Policy Act of 1992 (Energy Policy Act) under certain circumstances, retail wheeling is generally not required in any of the System's jurisdictions. See "Regulatory and Environmental Matters - Public Utility Regulation." In Connecticut, the Department of Public Utility Control (DPUC) has begun an investigation into the desirability of retail wheeling; a similar DPUC study undertaken in 1987 concluded that full-scale ail wheeling was not in the public interest at that time. See "Rates-Connecticut Retail Rates." In New Hampshire, there have been no legislative proposals on full- scale retail wheeling to date. In Massachusetts, bills being reviewed by legislative committees could permit limited retail wheeling in economically distressed areas and to municipal and state-owned facilities. FUEL SWITCHING/ELECTROTECHNOLOGIES A customer's ability to switch to or from electricity as an energy source for heating, cooling or industrial processes (fuel switching) will continue to provide the System with both opportunities and risks over the coming years. While it is an important load, residential electric space heating makes up only five percent of the System's retail sales. In Connecticut and Massachusetts, the risk of fuel switching among residential customers is concentrated in the area of electric to natural gas conversions with lesser risks of oil and propane conversions, while in New Hampshire, conversions to oil and propane are more common. During 1993, approximately three percent of WMECO and PSNH space heating customers converted their heating systems from electric resistance or baseboard heating. Conversion activity in CL&P's service territory was minimal during 1993 and the net number of electric space heating customers in CL&P's territory increased during 1993. Since 1992, space heating conversions on the System have not represented more than a 0.1 percent loss of annual retail sales. Nonetheless, the System operating companies have implemented a number of programs to mitigate these losses. In New Hampshire, a new thermal energy storage program is being reviewed for approval by the NHPUC. In Connecticut and Massachusetts, programs are in place to encourage the use of ground source and advanced air-to-air heat pumps in both new and existing construction. In addition, in 1993 WMECO lowered rates for its electric space heating cusomters by approximately five percent with permission from the Massachusetts Department of Public Utilities (DPU) to address the competitive threat. Because of these programs and other initiatives, NU forecasts a continued increase in the net number of electric space heating customers. With respect to residential sales, central air conditioning continues to become more common in the System's service territory. The System has also begun to test the use of electric vehicles in all three of its service territories and is working to promote the manufacture of electric vehicles and their components in the System's service area. The System's energy conservation programs which target electric heat and hot water customers can be effective in lowering electric bills substantially. In 1993, the System embarked upon two aggressive field testing programs involving heat pumps to provide residential heating, cooling and hot water heating in cost effective ways. These programs, in Massachusetts and at Heritage Village in Southbury, Connecticut, are intended to demonstrate that the combination of cost effective conservation and the use of heat pumps will provide lower cost heating, cooling and water heating than other available fuels. The System also faces commercial load loss because of fuel switching, such as in the area of electrically heated commercial buildings. Additionally, natural gas distribution companies have been actively marketing gas-fired chillers to commercial and industrial customers. Electric space and hot water heating and air conditioning have come under increasing pressure in recent years from aggressive campaigns by natural gas distribution companies seeking to add new customers. In Connecticut and Massachusetts, NU's subsidiaries have initiated market driven heating, ventilating and air-conditioning (HVAC) incentive programs, which include some design assistance, to promote efficient, nonchlorofluorocarbon refrigerant electric chillers. In response to the threat of load loss due to alternative fuel sources, the System's marketing and customer service staff works proactively to compare relative costs of alternative fuels. In most instances, accurate cost comparisons and energy conservation programs allow the System to preserve most of each customer's load by assisting the customer to achieve a more efficient use of its electric energy. WHOLESALE MARKETING In general and subject to existing contractual restrictions, the System's wholesale customers, both within and outside the System's retail service area, are free to select any supplier they choose. NU's subsidiaries do not have an exclusive franchise right to serve such customers. Thus, the wholesale segment of the System's business is highly competitive. As a result of very limited load growth throughout the Northeast in the past five years and the operation of several new generating plants, competition has grown, and a seller's market for electricity has turned into a buyer's market. Of the approximately 2,000 - 3,000 megawatts of surplus capacity in New England, the System's total is approximately 1,000 megawatts. The prices the System has been able to receive for new wholesale contracts have generally been far lower than the prices prevalent in recent years. Nevertheless, in 1993, the System sold a monthly average of 350 megawatts on a daily and short-term basis and 1,150 megawatts under preexisting long-term commitments of capacity to over 20 utilities throughout the Northeast. These sales resulted in approximately $150 million of capacity revenues. The majority of these revenues have been recognized in System company base rates. In addition, System companies entered into approximately 11 long- term sales contracts in 1993 with both new and existing customers. These contracts are expected to increase sales by a yearly average of 60 megawatts from late 1993 through 2005. The new wholesale customers include the municipal electric systems in Georgetown, Middletown, South Hadley, Princeton, Danvers, Littleton and Mansfield, all in Massachusetts. Including these new sales, the System currently has capacity sales commitments with other New England utilities to sell an aggregate 4,000 megawatt-years of capacity from 1994 through 2008. The net benefits after costs from these sales are estimated at approximately $550 million over the remaining life of the contracts. Most of these benefits will be realized over the next few years. In addition, a contract for the sale of approximately 450 megawatt- years to the municipal electric system in Madison, Maine has been signed and is awaiting certain approvals. For information on competitive pressures affecting wholesale transmission, see "Electric Operations - Generation and Transmission." Over the next five years, intense competition in the Northeast market is expected to continue as new generating facilities, located for the most part outside the System's retail service areas and contracted to sell to others, become operational. See "Regulatory and Environmental Matters - Public Utility Regulation." This increase in power supply sources could put further downward pressure on prices, but the potential price decreases may be somewhat offset by an improvement in the region's economy and the retirement of a number of the region's existing generating plants. See "Electric Operations - Generation and Transmission." SUMMARY To date, the System has not been materially affected by competition, and it does not foresee substantial adverse effect in the near future unless the current regulatory structure or practice is substantially altered. The rate, service, business development and conservation initiatives described above, portions of which are funded in base rates, plus other cost containment efforts described below, have been adequate to date in retaining customers, preventing fuel switching and attracting new customers at a level sufficient to maintain the System's revenue and profit base and should have significant positive effects in the next few years. As noted above, however, the DPUC has begun a retail wheeling investigation in Connecticut, and its outcome is uncertain at this time. In Massachusetts, retail wheeling legislation is under consideration. To date, no such initiatives are underway in New Hampshire. NU's subsidiaries benefit from a diverse retail base, and the System has no significant dependance on any one customer or industry. The System's extensive transmission facilities and diversified generating capacity position it to be a strong factor in the regional wholesale power market for the foreseeable future. The System's wholesale power business should further cushion the financial effects of competitive inroads within its service area. The System believes that the corporate reengineering process initiated in early 1994 and structural reorganization effective January 1, 1994 should better position it to compete in the retail and wholesale electric businesses in the future. RATES CONNECTICUT RETAIL RATES GENERAL CL&P's retail electric rate schedules are subject to the jurisdiction of the DPUC. Connecticut law provides that increased rates may not be put into effect without the prior approval of the DPUC, which has 150 days to act upon a proposed rate increase, with one 30-day extension possible. If the DPUC does not act within that period, the proposed rates may be put into effect subject to refund. Connecticut law authorizes the DPUC to order a rate reduction before holding a full-scale rate proceeding if it finds that (i) a utility's earnings exceed authorized levels by one percentage point or more for six consecutive months, (ii) tax law changes significantly increase the utility's profits, or (iii) the utility may be collecting rates that are more than just and reasonable. The law requires the DPUC to give notice to the utility and any customers affected by the interim decrease. The utility would be afforded a hearing. If final rates set after a full rate proceeding or court appeal are higher, customers would be surcharged to make up the difference. 1992-1993 CL&P RETAIL RATE CASE In December 1992, CL&P filed an application for rate relief with the DPUC. The updated request sought to increase CL&P's revenues by $344 million or 15.4 percent in total over three years. That increase incorporated requested annual increases of $130 million, $104 million and $110 million starting in May 1993. As an alternative to the multi-year plan, CL&P also proposed a one-time increase totaling about $280 million, or 13.9 percent. On June 16, 1993, the DPUC issued a decision (Decision) approving the multi-year plan and providing for annual rate increases of $46.0 million, or 2.01 percent, in July 1993, $47.1 million, or 2.04 percent, in July 1994 and $48.2 million, or 2.06 percent, in July 1995. The total increase granted of $141.3 million, or 6.11 percent, is approximately 42 percent of CL&P's updated request. In light of the State of Connecticut's concern over economic development and industrial and commercial rates, one important aspect of the Decision was that industrial and manufacturing rates will rise only about 1.1 percent anually over the three-year period. Other significant aspects of the Decision include the reduction of CL&P's return on equity (ROE) from 12.9 percent (CL&P had sought to continue its ROE at that level) to 11.5 percent for the first year of the multi-year plan, 11.6 percent for the second year and 11.7 percent for the third year; recognition in CL&P's rates, by 1998, of non-pension, post-retirement benefit cost accruals required under Statement of Financial Accounting Standards (SFAS) No. 106; the identification of $49 million of prior fuel overrecoveries and the use of that amount to offset a similar amount of the unrecovered balance in CL&P's generation utilization adjustment clause (GUAC); the reduction of CL&P's projected operating and maintenance expense for contingency funding by approximately $53.6 million spread over three years; and the deferral of cogeneration expenses projected for 1994 and 1995 and the future recovery of those deferred amounts (approximately $63 million in total) plus carrying costs over five years beginning July 1, 1996. The Decision also required CL&P to allocate to customers $10 million of after tax earnings from a $47.7 million property tax accounting change made in the first quarter of 1993. CL&P recorded this $10 million adjustment as a reduction to second quarter net income. On August 2, 1993, two appeals were filed from the Decision. CL&P filed an appeal on four issues. The second appeal was filed by the Connecticut Office of Consumer Counsel (OCC) and the City of Hartford, challenging the legality of the multi-year plan approved by the DPUC. The two appeals were consolidated. CL&P moved to dismiss the appeal by the City of Hartford and the OCC on jurisdictional grounds. Oral arguments were held on October 15, 1993 and February 14, 1994 on CL&P's motion to dismiss the appeals challenging the multi-year rate plan. It is not known when a decision on CL&P's motion will be issued. In addition, the Court rejected (without prejudice to renewal) the City of Hartford's and the OCC's motion to stay implementation of the second and third year of the rate plan pending the outcome of their appeal. The City of Hartford and the OCC could renew a request for a stay following the outcome of their appeal. CL&P ADJUSTMENT CLAUSES CL&P has a fossil fuel adjustment clause and a GUAC applicable to its retail electric rates. In Connecticut, the DPUC is required to approve each month the charges or credits proposed for the following month under the fossil fuel adjustment clause. These charges and credits are designed to recover or refund changes in purchased power (energy) and fossil fuel prices from those set in base rates. Monthly fossil fuel charges or credits are also subject to review and appropriate adjustment by the DPUC each quarter after full public hearings. The Connecticut clause allows CL&P to recover substantially all prudently incurred fossil fuel expenses. CL&P's current retail electric base rate schedules assume that the nuclear units in which CL&P has entitlements will operate at a 72 percent composite capacity factor. The GUAC levels the effect on rates of fuel costs incurred or avoided due to variations in nuclear generation above and below that performance level. When actual nuclear performance is above the specified level, net fuel costs are lower than the costs reflected in base rates, and when nuclear performance is below the specified level, net fuel costs are higher than the costs reflected in base rates. At the end of a twelve-month period ending July 31 of each year, with DPUC approval, these net variations from the costs reflected in base rates are generally refunded to or collected from customers over the subsequent eleven-month period beginning September 1. This clause, however, does not permit automatic collection from customers to the extent the capacity factor is less than 55 percent for the twelve-month period. When and to the extent the annual nuclear capacity factor is less than 55 percent, it is necessary for CL&P to apply to the DPUC for permission to recover the additional fuel expense. In the Decision, the DPUC disallowed recovery of $41.5 million, the GUAC deferral balance associated with operation at a nuclear capacity factor below 55 percent during the 12-month GUAC period ending July 31, 1992. In the same Decision, the DPUC also disallowed $7.5 million of the $96 million deferral balance, representing operation at a nuclear capacity factor above 55 percent for that period, which had already been approved for collection from customers through December 31, 1993. The reason given for the disallowances was CL&P's $49 million overrecovery of fuel costs through base rates and the fuel adjustment clauses for the period August 1991 to July 1992. The Decision also cut short the previously allowed recovery of $96 million in GUAC deferrals by four months. The DPUC ordered the remaining unrecovered GUAC balance of $24.6 million to be "trued-up" against the deferral for the 1992-93 GUAC year. As result of two previous prudence decisions imposing disallowances for outages at the nuclear unit (CY) operated by the Connecticut Yankee Atomic Power Company (CYAPC) and Millstone I, the DPUC also ordered CL&P to refund to customers a total of $5.1 million in the GUAC billing period beginning September 1, 1993. In the most recent GUAC period, which ended July 31, 1993, the actual level of nuclear generating performance was 72.6 percent, resulting in a GUAC deferral of $4.0 million to be credited to customers beginning in September 1993. The GUAC rate filed by CL&P for the September 1993 - August 1994 GUAC billing period had five components: the $7.5 million disallowance from the rate case, the $5.1 million of prudence disallowances, the $4.0 million credit deferral for the most recent GUAC period, and the $24.6 million debit of previously unrecovered GUAC deferrals, for a total of $7.9 million. On September 1, 1993, the DPUC issued an interim order setting a GUAC rate of zero beginning September 1, 1993, subject to a proceeding to consider further CL&P's GUAC rate for the period September 1, 1993 to July 31, 1994. On January 5, 1994, the DPUC issued a decision fixing the GUAC rate at zero through August 31, 1994 and disallowing recovery of $7.9 million through the GUAC. The disallowance was based on a comparison of fuel revenues with fuel expenses, in the August 1992 - July 1993 period. On January 24, 1994, CL&P requested the DPUC to clarify its January 5, 1994 decision with respect to future application of the GUAC. Based on management's interpretation of the January 5, 1994 decision, CL&P does not expect that any future DPUC review using this methodology will have a material adverse impact on its future earnings. On March 4, 1994, CL&P appealed the January 5 GUAC decision to Connecticut Superior Court. For the 1984-1991 GUAC periods, CL&P refunded more than $112 million to its customers through the GUAC mechanism. For the five months ended December 31, 1993, the composite nuclear generation capacity factor was 66.7 percent. For the full twelve-month period ending July 31, 1994, the factor is projected to be approximately 74.7 percent. The DPUC has opened a docket to review the prudence of the 1992 outage related to the Millstone 2 steam generator replacement project. Discovery and filing of testimony is expected to continue through May 1994 and hearings, if required, will be held in the summer of 1994. CL&P incurred approximately $88 million in replacement power costs associated with Millstone outages that occurred during the period October 1990 - February 1992. These outages were the subject of several separate prudence reviews conducted by the DPUC, three of which are either on appeal or still pending at the DPUC. On May 19, 1993, the DPUC issued a final decision allowing recovery of costs related to the July 1991 shutdown of Millstone 3 caused by mussel- fouling of the heat exchangers. Approximately $0.9 million of replacement power costs are at issue. The OCC has appealed that decision to the Connecticut Superior Court. On September 1, 1993, the DPUC issued a final decision in the prudence investigation of outages at all four Connecticut nuclear plants resulting from an erosion/corrosion-induced pipe rupture at Millstone 2 on November 6, 1991. The decision concluded that CL&P's management of its erosion/corrosion program was reasonable and prudent and that expenses incurred as a result of the outages, which total approximately $65 million ($51 million of which represents replacement power costs) for CL&P, should be allowed. The OCC has also appealed this decision to the Connecticut Superior Court. The third ongoing prudence investigation involves a Millstone 3 outage caused by repairs to the service water piping in the fall of 1991. The OCC's witness filed testimony that, as a result of the DPUC's decision finding that the concurrent mussel-fouling outage was prudent, and the fact that the mussel-fouling outage continued at least as long as the service water outage, there was no economic impact on ratepayers from the service water outage. On September 23, 1993, the DPUC suspended the service water docket pending the outcome of OCC's appeal of the decision on the mussel- fouling outage. Approximately $26 million of replacement power costs are at issue. For further information on the shutdowns of Millstone units currently under review by the DPUC, see "Electric Operations -- Nuclear Generation -- Millstone Units." Some portion of the replacement power costs reflected in the three Millstone outages, as to which the DPUC has not completed its review or as to which the DPUC's decision has been appealed, may be disallowed. However, management believes that its actions with respect to these outages have been prudent, and it does not expect the outcome of the prudence reviews to result in material disallowances. CL&P has recognized that it will not recover in rates approximately $9.4 million in replacement power costs resulting from two other shutdowns at Millstone 1: one related to the unit's licensed operators failing requalification exams and the other related to seaweed blockage at the intake structure. CL&P owns 34.5 percent of the common stock of CYAPC, a regional nuclear generating company. During the 1987-1988 refueling outage, repairs were made to CY's thermal shield. During an extended 1989-1990 refueling outage, the thermal shield was removed due to continued degradation. The DPUC reviewed these outages. In a report issued in 1990, the DPUC's auditors concluded that the actions of CYAPC's personnel and its contractors were reasonable with respect to the thermal shield's repair and removal. However, the auditors also concluded that the failure to clean the entire refueling cavity during the 1987-1988 outage was the most likely cause of debris left in the cavity that subsequently resulted in the additional damage that was repaired during the 1989-1990 outage. In October 1992, the DPUC disallowed CL&P's recovery of $3 million in replacement power costs and $230,000 of related operating and maintenance costs resulting from CY's 1989-1990 extended outage. CL&P appealed the DPUC's decision. On December 2, 1993, the Connecticut Superior Court issued a decision reversing the DPUC, in part, and upholding it in part. The court ruled in favor of CL&P by reversing the $230,000 disallowance and in favor of the DPUC by upholding the $3 million disallowance of replacement power costs. The partial reversal in favor of CL&P was based on the principle of federal preemption and is an important legal precedent for future CYAPC matters. CONSERVATION AND LOAD MANAGEMENT CL&P participates in a collaborative process for the development and implementation of C&LM programs for its residential, commercial and industrial customers. In September 1992, the DPUC approved a Conservation Adjustment Mechanism (CAM) that allows CL&P to recover C&LM costs to the extent not recovered through current base rates. The CAM authorized continued recovery of C&LM costs over a ten-year period with a return on the unrecovered costs. In December 1992, CL&P filed an application with the DPUC for approval of budgeted C&LM expenditures for 1993 of $47.5 million and a proposed CAM for 1993. On April 14, 1993, the DPUC issued an order approving a new CAM rate, which allows CL&P to recover $24 million of its budgeted $47 million C&LM expenditures during 1993 and associated true-ups of past C&LM expenditures. The order also provided that any unrecovered expenditures would be recovered over eight years. CL&P's actual 1993 C&LM expenditures were approximately $42.8 million. The unrecovered C&LM costs at December 31, 1993 excluding carrying costs were $116.2 million. On December 30, 1993, CL&P and the other participants in the collaborative process filed an offer of settlement with the DPUC regarding CL&P's 1994 C&LM expenditures, program designs, performance incentive and lost fixed cost revenue recovery. The settlement proposed a budget level of $39 million for 1994 C&LM and a reduction in the amortization period for new expenditures from eight to 3.85 years. CL&P expects additional 1994 C&LM expenditures of approximately $1 million for state facilities. The DPUC began hearings on the proposed settlement during March 1994. NEW HAMPSHIRE RETAIL RATES RATE AGREEMENT AND FPPAC NU acquired PSNH, the largest electric utility in New Hampshire, in June 1992. See "The Northeast Utilities System." PSNH's 1989 Rate Agreement (Rate Agreement) provides the financial basis for the plan under which PSNH was reorganized and became an NU subsidiary. The Rate Agreement sets out a comprehensive plan of retail rates for PSNH, providing for seven base rate increases of 5.5 percent per year and a comprehensive fuel and purchased power adjustment clause (FPPAC). The first of these base retail rate increases was put into effect in January 1990. The second rate increase took place on May 16, 1991, when PSNH reorganized as an interim, stand-alone company; the third rate increase occurred on June 1, 1992, just before NU's acquisition of PSNH; and the fourth rate increase went into effect on June 1, 1993. The remaining three increases are to be placed in effect by the NHPUC annually beginning June 1, 1994, concurrently with a semi-annual adjustment in the FPPAC. The Rate Agreement also provides for the recovery by PSNH through rates of a regulatory asset, which is the aggregate value placed by PSNH's reorganization plan on PSNH's assets in excess of the net book value of PSNH's non-Seabrook assets and the value assigned to Seabrook. In accordance with the Rate Agreement, approximately $265 million of the remaining regulatory asset is scheduled to be amortized and recovered through rates by 1998, and the remaining amount, approximately $504 million, is scheduled to be amortized and recovered through rates by 2011. PSNH is entitled to a return each year on the unamortized portion of the asset. The unrecovered balance of the regulatory asset at December 31, 1993 was approximately $769.5 million. In order to provide protection from significant variations from the costs assumed in the base rates over the period of the seven base rate increases (Fixed Rate Period), the Rate Agreement established a return on equity (ROE) collar to prevent PSNH from earning an ROE in excess of an upper limit or below a lower limit. To date, PSNH's ROE has been within the limits of the ROE collar. The FPPAC provides for the recovery or refund by PSNH, for the ten- year period beginning on May 16, 1991, of the difference between the actual prudent energy and purchased power costs and the costs included in base rates. The rate is calculated for a six-month period based on forecasted data and is reconciled to actual data in subsequent FPPAC billing periods. PSNH costs included in the FPPAC calculation are the cost of fuel used at its generating plants and purchased power, energy savings and support payments associated with PSNH's participation in the Hydro-Quebec arrangements, the Seabrook Power Contract costs billed to PSNH from NAEC, NEPOOL Interchange expense and savings, fifty percent of the joint dispatch energy expense savings resulting from the combination of PSNH and the System companies as a single pool participant, purchased capacity costs associated with other System power and unit contract capacity purchases excluding the Yankee nuclear companies and the cost to amortize capital expenditures for, and to operate, environmental or safety backfits or fuel switching. The FPPAC also provides for the recovery of a portion of the payments made currently to qualifying facilities and a portion of the costs associated with the PSNH buyback of the New Hampshire Electric Cooperative, Inc. (NHEC) entitlement in Seabrook. For information on NHEC's 1991 filing for bankruptcy and its subsequent reorganization, see "Rates - Wholesale Rates." The balance of the current payments to qualifying facilities, representing a part of the payments made currently to eight specific small power producers (SPPs), are deferred each year and amortized and recovered over the succeeding ten years. A portion of the current payments to NHEC is also deferred and will be recovered either through the FPPAC during the fixed rate period or through base rates after the fixed rate period. Recovery of the NHEC deferral through the FPPAC occurs only if the FPPAC rate is negative; in such instance, deferred NHEC costs would be recovered to the extent required to bring the FPPAC rate to zero. From June to November 1992, the FPPAC rate, which would otherwise have been negative, was set at zero, and some NHEC deferrals were amortized. The operation of the FPPAC during this period resulted in an overrecovery, which was also netted against NHEC deferrals in December 1992 and March 1993. As of December 31, 1993, SPP and NHEC deferrals totaled approximately $107.6 and $14.8 million, respectively. Under the Rate Agreement, PSNH has an obligation to use its best efforts to renegotiate the purchase power arrangements with 13 specified SPPs that were selling their output to PSNH under long term rate orders. Agreements have been reached with all five of the hydroelectric facilities under which the rates PSNH pays for their output would be reduced but the term of years for sales from the hydro producers would be extended by five years. The NHPUC held a hearing concerning these agreements on February 25, 1994. PSNH has also reached agreements with three of the eight wood-fired qualifying facilities with long term rate orders. Under each agreement, PSNH would pay each operator a lump sum in exchange for canceling the operator's right to sell its output to PSNH under rate orders. The total payment to the three operators would be approximately $91.8 million (covering approximately 35 MW of capacity). The three wood operators' agreements will be considered in hearings before the NHPUC in late spring 1994. PSNH is unable to predict if any or all of these agreements will be consummated. Although the Rate Agreement provides an unusually high degree of certainty about PSNH's future retail rates, it also entails a risk if sales are lower than anticipated, as they were in 1991 and 1992, or if PSNH should experience unexpected increases in its costs other than those for fuel and purchased power, since PSNH has agreed that it will not seek additional rate relief before 1997, except in limited circumstances. Even if allowed under the Rate Agreement, any additional increases above 5.5 percent per year are subject to political and economic pressures that tend to limit overall retail rate increases, including FPPAC increases. In accordance with the Rate Agreement, PSNH increased its average retail electric rates by about 4.5 percent in June 1993 and by 1.8 percent on December 1, 1993. The 4.5 percent increase in June resulted from the combined effect of decreasing to $.00110 per kilowatthour the FPPAC charge at the same time that (1) the fourth of the seven increases in base electric rates of 5.5 percent and (2) a temporary increase associated with recently enacted legislation associated with the settlement of the Seabrook tax suit described below took effect. The decrease in the FPPAC charge also reflected lower costs paid by PSNH through the Seabrook Power Contract for Seabrook property tax imposed on NAEC. The December 1993 increase resulted from an increase in the FPPAC rate. In its decision on the June 1, 1993 increase, the NHPUC disallowed replacement power costs for three Seabrook outages totalling about $0.4 million. On August 16, 1993, the NHPUC affirmed its decision to disallow that amount. In the August 16 decision, the NHPUC also rejected a request by the New Hampshire Office of Consumer Advocate (OCA) to allow access to certain confidential, self-critical documents generated at Seabrook station by plant personnel following outages and power reductions. PSNH has been providing summary analyses of the circumstances surrounding outages; however, it declined to provide the original self-critical documents in an effort to maintain an atmosphere in which employees would be encouraged to report and comment on all possible problems. The OCA filed an appeal of the NHPUC's decision on its request for access to these documents with the New Hampshire Supreme Court on November 16, 1993. On February 8, 1994, the court accepted the appeal. On September 14, 1993, PSNH filed a request for an increase in its FPPAC rate for the period December 1, 1993 through May 31, 1994. The increase of one percent of the average retail rate was expected to produce less than the revenues necessary to cover PSNH's FPPAC costs over these six months, a period during which Seabrook will undergo a two-month refueling outage. PSNH waived its right to immediate collection and proposed to defer about $13 million of FPPAC costs for later collection in order to limit its total rate increases for 1993 to 5.5 percent. Hearings on the FPPAC rate request were held on November 9 and 10, 1993. On November 29, 1993, the NHPUC approved a higher FPPAC rate than the rate requested by PSNH. The increase was 1.8 percent higher than rates previously in effect and allowed PSNH to recover a deferral of $10.5 million over a twelve month period beginning June 1, 1994, which ends prior to the next scheduled Seabrook refueling outage. In its June 1992 decision concerning PSNH's FPPAC rate, the NHPUC had determined that PSNH should not be entitled to recover approximately $1.3 million with respect to wholesale power agreements with two New England utilities. Also, the NHPUC had questioned the prudence of a series of short term contractual agreements (SWAP Agreements) for energy and capacity exchanges entered into between the System and PSNH prior to the merger and the allocation of savings resulting from the SWAP Agreements. In November 1992, PSNH entered into proposed settlements with the NHPUC staff and the OCA to settle these issues. The settlements proposed disallowances of approximately $500,000 for the two wholesale power agreements and $250,000 for the SWAP Agreements. On March 23, 1993, the NHPUC approved the settlements. SETTLEMENT OF THE SEABROOK TAX SUIT On April 16, 1993, the Governor of New Hampshire signed into law legislation that implemented the settlement of a suit concerning property tax on Seabrook station (the Seabrook Tax) that was filed with the United States Supreme Court by Attorneys General of Connecticut, Massachusetts and Rhode Island. The legislation made various changes to New Hampshire tax laws, resulting in taxes of approximately $5.8 million to be paid by NU on a consolidated basis in each of 1993 and 1994 and $3.0 million in 1995, a reduction from the $9.5 million paid by NU on a consolidated basis in 1992. Of such amounts to be paid, CL&P's portion will be approximately $0.6 million in each of 1993 and 1994 and approximately $0.3 million in 1995 and NAEC's portion will be approximately $5.2 million in each of 1993 and 1994 and approximately $2.7 million in 1995. MEMORANDUM OF UNDERSTANDING On May 6, 1993, PSNH, NAEC, NUSCO and the Attorney General of the State of New Hampshire entered into a Memorandum of Understanding (Memorandum) relating to certain issues which had arisen under the Rate Agreement. In part, the issues addressed relate to the enactment of the legislation implementing the settlement of the Seabrook Tax lawsuit. Pursuant to the Memorandum, tax changes imposed by the legislation will not increase PSNH's overall ratepayer charges, but will be reflected in PSNH rates pursuant to the Rate Agreement through offsetting adjustments to PSNH's base rates and FPPAC charges. On June 1, 1993, PSNH put into effect a temporary increase of $0.00074 per kilowatthour in base rates designed to recover the increased costs associated with the enactment of the legislation. A corresponding decrease in the FPPAC costs collected after June 1, 1993 offset the base rate increase. The FPPAC decrease reflected the reduction of the Seabrook property tax resulting from the legislation. The Memorandum also addresses the implementation of new accounting standards imposed by SFAS 106 and SFAS 109. The Memorandum establishes the method of accounting under SFAS 106 for employees' post-retirement benefits other than pensions for PSNH ratemaking purposes. Under SFAS 109, companies may recognize as a deferred tax asset the value of certain tax attributes. The Memorandum provides for the establishment of a regulatory liability attributable to significant net operating loss carryforwards and establishes that such liability should be amortized over a six-year period beginning on May 1, 1993. Other provisions of the Memorandum cover: NAEC's acquisition of the Vermont Electric Generation and Transmission Cooperative's (VEG&T) 0.41259% interest in Seabrook for approximately $6.4 million and NAEC's sale of the output to PSNH. All necessary regulatory approvals for NAEC's acquisition have been received and NAEC acquired VEG&T's interest on February 15, 1994. The Rate Agreement will be amended to ensure that this acquisition will not impact PSNH rates during the fixed rate period. The Rate Agreement's ROE collar floor provisions were amended to provide for the adjustment by PSNH of its revenue received from James River Corporation and Wausau Papers of New Hampshire by the amount of the demand charge discount previously approved by the NHPUC. The Rate Agreement was also amended to provide that any adjustments to the amount of PSNH's liability under the Seabrook Power Contract to reimburse NAEC for payments to the Seabrook Nuclear Decommissioning Financing Fund (a fund administered by the State of New Hampshire to finance decommissioning of Seabrook) will be recovered through adjustments to PSNH's base rates; however, such adjustments will not be subject to the annual 5.5 percent increases established under the Rate Agreement. See "Electric Operations - Nuclear Generation - Decommissioning" for further information on decommissioning costs for Seabrook station and other nuclear units that the System owns or participates in. On May 11, 1993, PSNH and the State of New Hampshire filed a petition with the NHPUC seeking approval of the Memorandum. As required for implementation, PSNH's lenders approved the Memorandum. The NHPUC hearing on the petition seeking approval of the Memorandum and a request to make the June 1, 1993, temporary base rate increase permanent was held on December 2, 1993. PSNH entered into a stipulation with the NHPUC staff and the OCA which modified the Memorandum slightly, clarifying terms of the NAEC power contract applicable to the VEG&T interest in Seabrook. The NHPUC approved the Memorandum as modified by the stipulation, the permanent base rate increase and the Third Amendment to the Rate Agreement on January 3, 1994. As a result of the approval of the Memorandum, PSNH's earnings in 1993 increased by $10 million. The cumulative impact of the issues resolved by the Memorandum is not expected to have a significant impact on PSNH's future earnings. SEABROOK POWER CONTRACT PSNH and NAEC entered into the Seabrook Power Contract (Contract) on June 5, 1992. Under the terms of the Contract, PSNH is obligated to purchase NAEC's initial 35.56942% ownership share of the capacity and output of Seabrook 1 for the term of Seabrook's NRC operating license and to pay NAEC's "cost of service" during this period, whether or not Seabrook 1 continues to operate. NAEC's cost of service includes all of its prudently incurred Seabrook-related costs, including maintenance and operation expenses, cost of fuel, depreciation of NAEC's recoverable investment in Seabrook 1 and a phased-in return on that investment. The payments by PSNH to NAEC under the Contract constitute purchased power costs for purposes of the FPPAC and are recovered from customers under the Rate Agreement. Decommissioning costs are separately collected by PSNH in its base rates. See "Rates - New Hampshire Retail Rates - Rate Agreement and FPPAC" for information relating to the Rate Agreement. If Seabrook 1 is retired prior to the expiration of the Nuclear Regulatory Commission (NRC) operating license term, NAEC will continue to be entitled under the Contract to recover its remaining Seabrook investment and a return of that investment and its other Seabrook-related costs for 39 years, less the period during which Seabrook 1 has operated. At December 31, 1993, NAEC's net utility plant investment in Seabrook 1 was $732 million. The Contract provides that NAEC's return on its "allowed investment" in Seabrook 1 (its investment in working capital, fuel, capital additions after the date of commercial operation of Seabrook 1 and a portion of the initial investment) is calculated based on NAEC's actual capitalization from time to time over the term of the Contract, its actual debt and preferred equity costs, and a common equity cost of 12.53 percent for the first ten years of the Contract, and thereafter at an equity rate of return to be fixed in a filing with the FERC. The portion of the initial investment which is included in the "allowed investment" was 20 percent for the twelve months commencing May 16, 1991, increasing by 20 percent in the second year and by 15 percent in each of the next four years, resulting in 100 percent in the sixth and each succeeding year. As of December 31, 1993, 55 percent of the investment was included in rates. NAEC is entitled to earn a deferred return on the portion of the initial investment not yet phased into rates. The deferred return on the excluded portion of the initial investment will be recovered, together with a return on it, beginning in the first year after PSNH's Fixed Rate Period, and will be fully recovered prior to the tenth anniversary of PSNH's reorganization date. Effective February 15, 1994, NAEC also owns the 0.41259% share of capacity and output of Seabrook it purchased from VEG&T. NAEC sells that share to PSNH under an agreement that has been approved by FERC and is substantially similar to the Contract; however, the agreement does not provide for a phase-in of allowed investment and associated deferrals of capital recovery. MASSACHUSETTS RETAIL RATES GENERAL WMECO's retail electric rate schedules are subject to the jurisdiction of the DPU. The rates charged under HWP's contracts with industrial customers are not subject to the ratemaking jurisdiction of any state or federal regulatory agency. Massachusetts law allows the DPU to suspend a proposed rate increase for up to six months. If the DPU does not act within the suspension period, the proposed rates may be put into effect. Under present rate-making standards, the DPU allows few adjustments to historic test year expenses to reflect the conditions anticipated by a company during the first year amended rate schedules are to be in effect. The principal adjustments that are permitted are inflation adjustments to historic test year non-fuel operation and maintenance expenses. Rate base is based on test year-end levels, and capital structure is based on test year-end levels adjusted for known and measurable changes. Current DPU practices permit WMECO to normalize most income tax timing differences. In Holyoke, Massachusetts, where HWP and Holyoke Gas and Electric Department, a municipal utility, operate side-by-side, approximately 30 HWP industrial customers sought bids as a group in 1993 for future electric service. HWP retained the load and has a 10-year contract, at substantially lower rates than in the past, to supply the group. WMECO REGULATORY ACTIVITY In December 1991, WMECO filed an application with the DPU for a retail rate increase of approximately $36 million or 9.1 percent. In April 1992, WMECO and the Massachusetts Attorney General filed a partial settlement agreement for approval by the DPU. Also in April 1992, a settlement agreement on WMECO's C&LM program budget was filed with the DPU jointly by WMECO, the Massachusetts Attorney General, Massachusetts Division of Energy Resources (DOER), the Conservation Law Foundation, Inc. (CLF) and the DPU's Settlement Intervention Staff. The settlement agreement covered WMECO's C&LM program through 1993 and included an annual budget of $17 million for both years. The parties also agreed that all expenditures and other charges relating to C&LM would be collected through a conservation charge (CC). In May 1992, the DPU accepted the WMECO retail rate case and the C&LM settlement agreements. As a result, WMECO's annual retail rates increased by $12 million, or three percent, on July 1, 1992, and by a further $11 million, or 2.7 percent, on July 1, 1993. In June 1992, the DPU resolved the remaining issues in the rate case filed in December 1991, when it issued an order on WMECO's rate design. The DPU order required the first and second year base revenue increases to be allocated so that all classes contribute the same percentage increase. In July 1992, the DPU approved an amended settlement agreement for 1992 and 1993 C&LM programs that established a CC that promoted rate stability by spreading the costs and subsequent recovery of 1992 and 1993 C&LM programs over the 18-month period from July 1, 1992 through December 31, 1993. The CC includes incremental C&LM program costs above or below base rate recovery levels, C&LM fixed cost recovery adjustments, and the provision for a C&LM incentive mechanism. In January 1993, WMECO filed with the DPU a request to reduce the CC rate by an aggregate of $3 million in 1993. On February 5, 1993, the DPU directed WMECO to file a revised CC to be effective on March 1, 1993 based on actual 1992 expenditures and the preapproved 1993 budget. The DPU approved the new CC on February 26, 1993. A motion for reconsideration was filed by certain of the parties to the original settlement. The DPU rejected that motion on July 9, 1993. WMECO filed for approval of a new CC on February 2, 1994. The DPU held a hearing on the proposed new CC on February 18, 1994. In October 1992, the DPU approved an Integrated Resource Management (IRM) settlement agreement that had been proposed by WMECO, the Attorney General, CLF, DOER and the Massachusetts Public Interest Research Group (MASSPIRG) concerning WMECO's IRM. The settlement required WMECO to submit its C&LM programs for 1994, 1995 and a portion of 1996 for approval by the DPU prior to October 1993, and to file its next IRM draft initial filing on January 3, 1994. The settlement also requires WMECO to prepare a competitive resource solicitation at least six months before its C&LM filing for any new C&LM programs it proposes. On March 16, 1993 WMECO filed a motion with the DPU to request authority to eliminate the separate (and higher) rates for residential electric heating customers by placing those customers on the same rates as the residential non-electric heating customers. WMECO proposed this change in order to be more competitive and to stem its losses of electric heating customers. On April 30, 1993, the DPU denied WMECO's request to eliminate the separate rates for residential electric heating customers but reduced the customer and energy charges for the electric heating customers to equal the comparable charges for non-electric heating customers. In November 1993, WMECO submitted its C&LM filing required in the settlement of the IRM proceeding, along with a settlement offer from WMECO, the Attorney General, DOER, CLF and MASSPIRG. The settlement offer incorporated preapproved C&LM funding levels for 1994 and 1995 of $14.2 million and $15.8 million, respectively. The settlement also provides for the recovery of lost fixed revenue and a bonus incentive if certain implementation objectives are met. On January 21, 1994, the DPU approved the settlement. On January 3, 1994, WMECO submitted its next draft initial IRM filing required by the October 1992 settlement to the DPU. The filing indicates the System does not need additional resources until at least the year 2007 and, therefore, WMECO does not intend to issue any solicitation for additional resources anytime in the foreseeable future. WMECO is presently participating in settlement discussions concerning this IRM filing. Should no settlement be reached, WMECO is scheduled to submit its initial IRM filing to the DPU in April 1994. WMECO ADJUSTMENT CLAUSE In Massachusetts, all fuel costs are collected on a current basis by means of a forecasted quarterly fuel clause. The DPU must hold public hearings before permitting quarterly adjustments in WMECO's retail fuel adjustment clause. In addition to energy costs, the fuel adjustment clause includes capacity and transmission charges and credits that result from short-term transactions with other utilities and from the operation of the Northeast Utilities Generation and Transmission Agreement (NUG&T). The NUG&T is the FERC-approved contract among the System operating companies, other than PSNH, that provides for the sharing among the companies of system-wide costs of generation and transmission and serves as the basis for planning and operating the System's bulk power supply system on a unified basis. Massachusetts law establishes an annual performance program related to fuel procurement and use, and requires the DPU to review generating unit performance and related fuel costs if a utility fails to meet the fuel procurement and use performance goals set for that utility. Goals are established for equivalent availability factor, availability factor, capacity factor, forced outage rate and heat rate. Fuel clause revenues collected in Massachusetts are subject to potential refund, pending the DPU's examination of the actual performance of WMECO's generating units. Currently pending before the DPU are investigations into the performance of WMECO's generating units for the 12-month periods ending May 31, 1992 and May 31, 1993. The DPU held a hearing on February 1, 1994 on WMECO's non-nuclear performance for the 12-month period ending May 31, 1992. Except for the order concerning CYAPC discussed below, the DPU has completed investigations of, but not yet issued decisions reviewing WMECO's actual generating unit performance for the program years between June 1987 and May 1991. The DPU has consistently set performance goals for generating units that are not wholly-owned and operated by the company whose goals are being set. The DPU has found that possession of a minority ownership interest in a generating plant does not relieve a company of its responsibilities for the prudent operation of that plant. Accordingly, the DPU has established goals, as discussed above, for the three Millstone units and for the three regional nuclear generating units (the Yankee plants) in which WMECO has minority ownership interests. The total amount of WMECO retail replacement power costs attributable to the major outages in the 1991 performance year -- the Millstone 3 July 1991 outage (mussel-fouling and service water), the Millstone 1 October 1991 outage (operator requalification examinations) and the November 1991 outages to perform pipe inspections, analysis and repair -- is approximately $17 million. In December 1992, WMECO notified the DPU that it will forego recovery of $1.2 million in replacement power costs associated with the October 1991 Millstone 1 operator requalification examination outage. The total amount of WMECO retail replacement power costs attributable to outages in the 1992-1993 performance year is approximately $17 million. Management believes that some portion of these replacement power costs may be subject to refund upon completion of the DPU's performance program reviews. However, management believes that its actions with respect to these outages have been prudent and does not expect the outcome of the DPU review to have a material adverse impact on WMECO's future earnings. In September 1992, the DPU issued a partial order pertaining to CY's extended 1989-1990 refueling outage (discussed above), disallowing the recovery of $0.6 million of incremental replacement power costs that could be attributable to the outage. WMECO filed a motion for reconsideration with the DPU in the same month, which motion is pending before the DPU. WHOLESALE RATES CL&P currently furnishes firm wholesale electric service to one Connecticut municipal electric system. PSNH serves NHEC, three New Hampshire municipal electric systems and one investor-owned utility in Vermont. HWP and its wholly-owned subsidiary, Holyoke Power and Electric Company, serve one Massachusetts municipal electric system. WMECO serves one New York investor-owned electric utility. The System's 1993 firm wholesale load was approximately 275 megawatts (MW). In 1993, firm wholesale electric service accounted for approximately 2.5 percent of the System's consolidated electric operating revenues (approximately 1.2 percent of CL&P's operating revenue, 6.0 percent of PSNH's operating revenue, 0.1 percent of WMECO's operating revenue and 21.5 percent of HWP's operating revenue). NHEC, PSNH's largest customer, representing 5.9 percent of its revenues for 1993, filed a petition for reorganization in 1991 under Chapter 11 of the United States Bankruptcy Code. A plan of reorganization for NHEC, which was confirmed by the Bankruptcy Court in March 1992 and became effective on December 1, 1993, resolves a series of disputes between PSNH and NHEC and provides for PSNH to continue to serve NHEC. The contract covering this continued service has been filed with and accepted by FERC. In addition to firm service, the System engages in numerous other bulk supply transactions that reduce retail customer costs, at rates that are subject to FERC jurisdiction, and it transmits power for other utilities at FERC-regulated rates. See "Electric Operations - Generation and Transmission" for further information on those bulk supply transactions and for information on pending FERC proceedings relating to transmission service. All of the wholesale electric transactions of CL&P, PSNH, WMECO, NAEC and HWP are subject to the jurisdiction of the FERC. For a discussion of certain FERC-regulated sales of power by CL&P, PSNH, WMECO and HWP to other utilities, see "Electric Operations -- Distribution and Load." For a discussion of sales of power by NAEC to PSNH, see "Rates - Seabrook Power Contract." For a discussion of the effects of competition on the System, see "Competition and Marketing." RESOURCE PLANS CONSTRUCTION The System's construction program expenditures, including allowance for funds used during construction (AFUDC), in the period 1994 through 1998 are estimated to be as follows: 1994 1995 1996 1997 1998 (Millions of Dollars) PRODUCTION CL&P . . . . . $ 60.9 $54.5 $44.3 $41.5 $39.6 PSNH . . . . . 10.5 7.0 13.3 8.7 15.8 WMECO . . . . 17.3 13.5 10.1 9.3 17.4 NAEC . . . . . 8.2 8.5 8.3 7.0 5.8 Other . . . . 16.2 3.0 2.0 0.7 0.5 System Total . 113.1 86.5 78.0 67.2 79.1 SUBSTATIONS AND TRANSMISSION LINES CL&P . . . . . 12.2 9.4 11.6 12.3 14.6 PSNH . . . . . 3.0 6.9 9.9 6.1 6.7 WMECO. . . . . 0.8 0.4 0.5 0.8 1.3 NAEC . . . . . 0.0 0.0 0.0 0.0 0.0 Other . . . . 0.0 0.0 0.0 0.0 0.0 System Total 16.0 16.7 22.0 19.2 22.6 DISTRIBUTION OPERATIONS CL&P . . . . . 76.1 78.8 80.9 84.1 85.5 PSNH . . . . . 22.0 11.7 10.6 14.5 14.2 WMECO. . . . . 17.4 19.3 17.3 17.2 18.7 NAEC . . . . . 0.0 0.0 0.0 0.0 0.0 Other . . . . 0.4 0.2 0.2 0.2 0.2 System Total 115.9 110.0 109.0 116.0 118.6 GENERAL CL&P . . . . . 8.6 8.8 7.2 5.8 5.1 PSNH . . . . . 2.0 3.3 1.9 2.4 2.0 WMECO . . . . 2.0 2.1 1.9 1.5 1.3 NAEC . . . . . 0.0 0.0 0.0 0.0 0.0 Other . . . . 9.9 7.4 7.8 9.8 9.8 System Total 22.5 21.6 18.8 19.5 18.2 TOTAL CONSTRUCTION CL&P . . . . . 157.8 151.5 144.0 143.7 144.8 PSNH . . . . . 37.5 28.9 35.7 31.7 38.7 WMECO . . . . 37.5 35.3 29.8 28.8 38.7 NAEC . . . . . 8.2 8.5 8.3 7.0 5.8 Other . . . . 26.5 10.6 10.0 10.7 10.5 System Total $267.5 $234.8 $227.8 $221.9 $238.5 The construction program data shown above include all anticipated capital costs necessary for committed projects and for those reasonably expected to become committed, regardless of whether the need for the project arises from environmental compliance, nuclear safety, improved reliability or other causes. The construction program data shown above generally include the anticipated capital costs necessary for fossil generating units to operate at least until their scheduled retirement dates. Whether a unit will be operated beyond its scheduled retirement date, be deactivated or be retired on or before its scheduled retirement date is regularly evaluated in light of the System's needs for resources at the time, the cost and availability of alternatives, and the costs and benefits of operating the unit compared with the costs and benefits of retiring the unit. Retirement of certain of the units could, in turn, require substantial compensating expenditures for other parts of the System's bulk power supply system. Those compensating capital expenditures have not been fully identified or evaluated and are not included in the table. FUTURE NEEDS The System's integrated demand and supply planning process is the means by which the System periodically updates its long-range resource needs. The current resource plan identifies a need for new resources beginning in 2007. Because New England and the System have surplus generating capacity and are forecasting low load growth over the next several years, the System has no current plans to construct or to contract for any new generating units. Additional capacity beyond 2007, the projected System year of need, can come from a variety of sources. The design and implementation of new C&LM programs, the timely development of economic, reliable and efficient qualifying cogeneration and small power production facilities (QFs) or independent power producer (IPP) capacity through state-sanctioned resource acquisition processes, economic utility-sponsored generating resources (including the possibility of repowering retired power plants) and purchases from other utilities will all receive consideration in the System's integrated resource planning process. With respect to demand-side management measures, the System's long- term plans rely, in part, on encouraging additional C&LM by customers. These measures, including installations to date, are projected to lower the System summer peak load in 2007 by over 1000 MW. In addition, System companies have long-term arrangements to purchase the output from QFs and IPPs under federal and state laws, regulations and orders mandating such purchases. CL&P's, PSNH's and WMECO's plans anticipate the development of QFs and IPPs supplying 710 MW of firm capacity by 1995, of which approximately 695 MW was operational in 1993. See "New Hampshire Retail Rates -- Rate Agreement and FPPAC" for information concerning PSNH's efforts to renegotiate its agreements with thirteen QFs. CL&P and WMECO filed applications with the U.S. Environmental Protection Agency to receive 203 SO2 allowances for C&LM activity as authorized by the Clean Air Act Amendments. See "Regulatory and Environmental Matters - Environmental Regulation - Air Quality Requirements." The DPUC has issued regulations establishing competitive bidding systems for future purchases by Connecticut electric utilities from QFs and IPPs and from C&LM vendors. The regulations also implement a state law which provides that a utility may seek a premium of between one and five percentage points above its most recently authorized rate of return for each multi-year C&LM program requiring capital investment by the utility. In April 1993, CL&P submitted its eighth annual filing to the DPUC on private power production, C&LM, projected avoided costs and related matters. CL&P stated that the System's existing and committed resources are expected to be sufficient to meet System capacity requirements until 2007, and therefore, CL&P did not solicit new capacity from QFs or C&LM vendors in 1993. In December 1993, the DPUC issued its final decision approving CL&P's avoided cost estimates as filed. In 1993, regulatory preapproval was obtained for all 1993 C&LM expenditures in each of the three retail jurisdictions. In addition, the DPUC authorized a maximum of 3 percent premium rate of return (after tax) on CL&P C&LM investment in 1993. WMECO is currently projected to earn $1.2 million of incentive (after tax) based on 1993 program savings. See "Rates - Connecticut Retail Rates - Conservation and Load Management" and "Rates - Massachusetts Retail Rates -WMECO Regulatory Activity" for information about rate treatment of C&LM costs. In 1988, the DPU adopted regulations requiring preapproval of Massachusetts utilities' major investments in electric generating facilities, including life extensions. In 1990, the DPU adopted new IRM regulations, which established procedures by which additional resources are planned, solicited and processed to provide for reliable electric service in a least- cost manner. The regulations provide a mechanism for preapproval (rather than after-the-fact review) of utility plant construction, procurement of non-utility generation (QFs and IPPs), and C&LM programs. The regulations specifically require that environmental externalities be considered in the evaluation of resource alternatives. In January 1994, WMECO filed its initial draft IRM filing, stating that WMECO's year of need is estimated to be 2007, and that no new capacity need be solicited at this time. WMECO is presently in settlement discussions. See "Rates-Massachusetts Retail Rates - WMECO Regulatory Activity" for further information relating to WMECO C&LM issues. In 1993, the NHPUC approved a settlement agreement related to PSNH's 1992 least cost planning filing, which defers various planning issues to PSNH's April 1, 1994 filing. In addition to the contributions from C&LM, QFs and IPPs, the System's long-term resource plan includes consideration of continued operation of certain of the System's fossil generating units beyond their current book retirement dates to the extent that it is economic, and possibly repowering certain of the System's older fossil plants. Continued operation of existing fossil units past their book retirement dates (and replacing certain critically located peaking units if they fail) is expected by 2007 to provide approximately 1,400 MW of resources that would otherwise have been retired. Repowering of some of the System's retired generating plants could make available an additional 900 MW of capacity. The capacity could be brought on line in various increments timed with the year of need. The System's need for new resources may be affected by any additional retirements of the System's existing generating units. The System companies periodically study the economics of their generating units as part of their overall resource planning process. In 1992, the DPUC ordered CL&P to submit economic analyses of the continued operation of 11 fossil steam units by April 1, 1993, and of Millstone Units 1 and 2 and CY, of which the System companies own 49 percent) by April 1, 1994. In 1993, the DPUC reviewed the continued unit operation (CUO) studies submitted by CL&P for the eleven fossil units in Connecticut and Massachusetts in its annual review of Integrated Resource Planning. The DPUC concluded that a decision was inappropriate at that time and that it would review the issue again in its management audit of CL&P and in CL&P's 1994 integrated resource planning docket. For Millstone 1 and 2 and CY, the CUO studies are in progress. Preliminary indications are that the operation of the units continues to be economic for customers. Final analyses for CY and the Millstone units will be filed with the DPUC in 1994. For planning and budgetary purposes, the System assumes that CL&P's Montville Station (497.5 MW) will be deactivated from November 1994 through October 1998. A final decision is expected to be made in 1994. Since reactivation is expected to occur in 1998, the System year of need of 2007 is unaffected. The System year of need of 2007 assumes PSNH's Merrimack 2 continues to operate. However, Merrimack 2's continued operation is in question because Merrimack 2 produces significant NOx emissions. The concern has been raised as to whether the emissions can be lowered to acceptable levels in the short and long term. In 1993, PSNH worked successfully with local, state and federal interests to arrive at a solution for Merrimack 2 NOx compliance by 1995, while deferring a decision on continued unit operation beyond 1999 to the future. For information regarding the agreement concerning NOX emissions at the Merrimack units, see "Regulatory and Environmental Matters - Environmental Regulation - Air Quality Requirements." See "Regulatory and Environmental Matters -- NRC Nuclear Plant Licensing" for further information on the NRC rule on nuclear plant operating license renewal and information on the expiration dates of the operating licenses of the nuclear plants in which System companies have interests. Before the System can make any decisions about whether license extensions for any of its nuclear units are feasible, detailed technical and economic studies will be needed. FINANCING PROGRAM 1993 FINANCINGS In January 1993, WMECO issued $60 million in principal amount of 6 7/8 percent first mortgage bonds due in 2000. In July 1993, CL&P issued $200 million and $100 million, respectively, of 5 3/4 percent and 7 1/2 percent first mortgage bonds due in 2000 and 2023, respectively. In December 1993, CL&P issued $125 million of 7 3/8 percent first mortgage bonds due in 2025. The proceeds from the foregoing issues were used to redeem outstanding bonds with interest rates ranging from 8 3/4 percent to 9 3/4 percent. In October 1993, CL&P issued $80 million of 5.30 percent preferred stock, $50 par value. The proceeds of this issuance, together with $30 million of short-term debt, were used to redeem $110 million of preferred stock with dividend rates ranging from 7.6 percent to 9.1 percent. In September 1993, the Connecticut Development Authority (CDA) issued, on behalf of CL&P, two tax-exempt variable rate pollution control revenue bonds (PCRBs) in the amounts of $245.5 million and $70 million, respectively. At the same time, the CDA issued, on behalf of WMECO, $53.8 million of tax-exempt variable rate PCRBs. The proceeds of these issues were used to redeem like amounts of tax-exempt PCRBs having less favorable structures. These refinancings will result in savings from the extension of maturities, the redemption of two issues of fixed-rate bonds with proceeds of the issuance of variable-rate bonds, the improved credit ratings of new supporting letter of credit banks and associated administrative savings. In December 1993, the New Hampshire Business Finance Authority (BFA) issued, on behalf of PSNH, $44.8 million of tax-exempt variable rate PCRBs. The proceeds of this issue were used to redeem a like amount of taxable PCRBs. Taxable BFA bonds issued on behalf of PSNH in the amount of $109.2 million are outstanding and may be refinanced with tax-exempt bonds upon the receipt of an allocation of the state's private activity volume allocation. In January 1993, CL&P, PSNH and WMECO purchased $340 million, $75 million and $52 million, respectively, of three-year variable rate debt caps. The caps were purchased to hedge the interest rate risk of the companies' respective variable rate PCRBs and were sized to approximate each respective company's then-current tax-exempt variable rate PCRB issuances. If the interest rate, based on the J. J. Kenny index, exceeds 4.5 percent (the strike rate), each company will receive payments under the terms of its respective interest rate cap agreement. In June 1993, PSNH purchased a $50 million six-month interest rate cap, a $50 million 12 month cap and a $100 million 18 month cap to hedge its interest rate exposure on its variable rate term note. The six-month and 12 month caps have a strike rate of 4.5 percent and the 18 month cap has a strike rate of 5.0 percent, all based on 90 day LIBOR. These caps were sized to approximate portions of a PSNH term note which has a quarterly sinking fund of $23.5 million. In February 1993, NU, CL&P, WMECO and the Niantic Bay Fuel Trust (NBFT) began a co-managed commercial paper program with two commercial paper dealers. Prior to this time, each company's commercial paper program was managed by one commercial paper dealer. The co-managed program was implemented to promote competition between commercial paper dealers, to increase the investor universe and to increase the range of maturities available to the issuers. On December 31, 1993, $113.0 million commercial paper was outstanding under these programs. In December 1993, NNECO issued $25 million of 7.17 percent unsecured amortizing notes maturing in 2019. The proceeds of this issuance are being used to finance the construction of a new building at Millstone station to house various administrative and technical support functions. FINANCING NUCLEAR FUEL The System requires nuclear fuel for the three Millstone units and for Seabrook 1. The requirements for the Millstone 1, Millstone 2 and CL&P's and WMECO's share of the Millstone 3 units are financed through a third party trust financing arrangement described below. All nuclear fuel for NAEC's and CL&P's shares of Seabrook 1 and PSNH's share of Millstone 3 is owned and financed directly by the respective companies. For the period 1994 through 1998, NAEC's and CL&P's shares of the cost of nuclear fuel for Seabrook 1 are estimated at $56.8 million and $6.4 million, respectively, excluding AFUDC. For the same period, PSNH's share of the cost of nuclear fuel for Millstone 3 is estimated at $6 million, excluding AFUDC. In 1982, CL&P and WMECO entered into arrangements under which NBFT owns and finances the nuclear fuel for Millstone 1 and 2 and CL&P's and WMECO's share of the nuclear fuel for Millstone 3. NBFT finances the fuel from the time uranium is acquired, during the off-site processing stages and through its use in the units' reactors. NBFT obtains funds from bank loans, the sale of commercial paper and the sale of intermediate term notes. The fuel is leased to CL&P and WMECO by the trust while it is used in the reactors, and ownership of the fuel is transferred to CL&P and WMECO when it is permanently discharged from the reactors. CL&P and WMECO are severally obligated to make quarterly lease payments, to pay all expenses incurred by NBFT in connection with the fuel and the financing arrangements, to purchase the fuel under certain circumstances and to indemnify all the parties to the transactions. The trust arrangements presently allow up to $530 million to be financed by NBFT with bank loans and commercial paper (up to $230 million) and with intermediate term notes (up to $300 million). The arrangements with the banks are in effect until February 19, 1996, and can be extended for an additional three years if the parties so agree. On December 31, 1993, NBFT had $80 million of intermediate term notes and $113 million of commercial paper outstanding. As of December 31, 1993, NBFT's investment in nuclear fuel, net of the fourth quarter 1993 lease payment made on January 31, 1994, for all three Millstone units was $172.1 million, as follows: Total CL&P WMECO System (Millions of Dollars) In process.......... $20.3 $4.7 $25.0 In stock............ 8.0 1.9 9.9 In reactor.......... 111.2 26.0 137.2 Total.......... $139.5 $32.6 $172.1 For the period 1994 through 1998, CL&P and WMECO's share of the cost of nuclear fuel for the three Millstone units that will be acquired through NBFT will be $313.5 million and $73.2 million, respectively, excluding AFUDC. Nuclear fuel costs and a provision for spent fuel disposal costs are being recovered through rates as the fuel is consumed in reactors. 1994 FINANCING REQUIREMENTS In addition to financing the construction requirements described under "Resource Plans - Construction," the System companies are obligated to meet $1,373.8 million of long-term debt maturities and cash sinking fund requirements and $76.4 million of preferred stock cash sinking fund requirements in 1994 through 1998. In 1994, long-term debt maturity and cash sinking fund requirements will be $295.3 million, consisting of $182 million of long-term debt maturities and $7 million of debt cash sinking fund requirements to be met by CL&P, $94 million of cash sinking fund requirements to be met by PSNH, $1.5 million of cash sinking funds to be met by WMECO and $10.7 million of cash sinking fund requirements to be met by other subsidiaries. These figures do not include $125 million of long-term debt redeemed by CL&P on January 7, 1994 with the proceeds of its issuance of $125 million mortgage bonds in December 1993. See "Financing Program - 1993 Financings." See "Electric Operations -- Nuclear Generation -- Operations -- Seabrook" for information on CL&P's commitment to advance funds to cover payments that a 12 percent Seabrook owner might be unable to pay with respect to Seabrook project costs. The System's aggregate capital requirements for 1994, exclusive of requirements under NBFT, are as follows: Total CL&P PSNH WMECO NAEC Other System (Millions of Dollars) Construction (including AFUDC)..... $157.8 $37.5 $37.5 $ 8.2 $26.5 $267.5 Nuclear Fuel (excluding AFUDC). (.3) 1.8 (.2) 5.8 - 7.1 Maturities......... 182.0 - - - - 182.0 Cash Sinking Funds. 7.0 94.0 1.5 - 10.7 113.2 Total.......... $346.5 $133.3 $38.8 $14.0 $37.2 $569.8 1994 FINANCING PLANS The System companies, other than CL&P, currently expect to finance their 1994 requirements through internally generated funds. CL&P may issue up to $200 million of long-term debt, primarily to finance maturing securities. This estimate excludes the nuclear fuel requirements financed through the NBFT. See "Financing Nuclear Fuel" above for information on the NBFT. In addition to financing their 1994 requirements, the System companies intend, if market conditions permit, to continue to refinance a portion of their outstanding long-term debt and preferred stock, if that can be done at a lower effective cost. On February 17, 1994, CL&P issued $140 million in principal amount of 5 1/2 percent first mortgage bonds due in 1999 and $140 million in principal amount of 6 1/2 percent first mortgage bonds due in 2004. The net proceeds were used to redeem higher cost first mortgage bonds. On March 8, 1994, WMECO contracted to issue $40 million principal amount of 6 1/4 percent first mortgage bonds due in 1999 and $50 million in principal amount of 7 3/4 percent first mortgage bonds due in 2024. The net proceeds will be used to redeem higher cost first mortgage bonds. FINANCING LIMITATIONS The amounts of short-term borrowings that may be incurred by NU, CL&P, PSNH, WMECO, HWP, NAEC, NNECO, The Rocky River Realty Company (RRR), The Quinnehtuk Company (Quinnehtuk) (RRR and Quinnehtuk are real estate subsidiaries), and HEC are subject to periodic approval by the SEC under the Public Utility Holding Company Act of 1935 (1935 Act). The following table shows the amount of short-term borrowings authorized by the SEC for each company and the amounts of outstanding short term debt of those companies at the end of 1993. Maximum Authorized Short-Term Debt Short-Term Debt Outstanding at 12/31/93* (Millions of Dollars) NU.................. $ 175.0 $ 72.5 CL&P ............... 375.0 96.2 PSNH ............... 125.0 2.5 WMECO............... 75.0 6.0 HWP................. 8.0 - NAEC................ 50.0 - NNECO............... 65.0 - RRR................. 25.0 16.5 Quinnehtuk.......... 8.0 4.3 HEC................. 11.0 2.9 ______ $200.9 _________________ * This column includes borrowings of various System companies from NU and other System companies through the Northeast Utilities System Money Pool (Money Pool). Total System short term indebtedness to unaffiliated lenders was $173.5 million at December 31, 1993. The supplemental indentures under which NU issued $175 million in principal amount of 8.58 percent amortizing notes in December 1991 and $75 million in principal amount of 8.38 percent amortizing notes in March 1992 contain restrictions on dispositions of certain System companies' stock, limitations of liens on NU assets and restrictions on distributions on and acquisitions of NU stock. Under these provisions, neither NU, CL&P, PSNH nor WMECO may dispose of voting stock of CL&P, PSNH or WMECO other than to NU or another System company, except that CL&P may sell voting stock for cash to third persons if so ordered by a regulatory agency so long as the amount sold is not more than 19 percent of CL&P's voting stock after the sale. The restrictions also generally prohibit NU from pledging voting stock of CL&P, PSNH or WMECO or granting liens on its other assets in amounts greater than five percent of the total common equity of NU. As of March 1, 1994, no NU debt was secured by liens on NU assets. Finally, NU may not declare or make distributions on its capital stock, acquire its capital stock (or rights thereto), or permit a System company to do the same, at times when there is an Event of Default under the supplemental indentures under which the amortizing notes were issued. The charters of CL&P and WMECO contain preferred stock provisions restricting the amount of short term or other unsecured borrowings those companies may incur. As of December 31, 1993, CL&P's charter would permit CL&P to incur an additional $570 million of unsecured debt and WMECO's charter would permit it to incur an additional $141.1 million of unsecured debt. In connection with NU's acquisition of PSNH, certain financial conditions intended to prevent NU from relying on CL&P resources if the PSNH acquisition strains NU's financial condition were imposed by the DPUC. The principal conditions provide for a DPUC review if CL&P's common equity falls to 36 percent or below, require NU to obtain DPUC approval to secure NU financings with CL&P stock or assets, and obligate NU to use its best efforts to sell CL&P preferred or common stock to the public if NU cannot meet CL&P's need for equity capital. At December 31, 1993, CL&P's common equity ratio was 39.1 percent. While not directly restricting the amount of short-term debt that CL&P, WMECO, RRR, NNECO and NU may incur, credit agreements to which CL&P, WMECO, HWP, RRR, NNECO and NU are parties provide that the lenders are not required to make additional loans, or that the maturity of indebtedness can be accelerated, if NU (on a consolidated basis) does not meet a common equity ratio that requires, in effect, that the NU consolidated common equity (as defined) be at least 27 percent for three consecutive quarters. At December 31, 1993, NU's common equity ratio was 30.9 percent. Credit agreements to which PSNH is a party forbid its incurrence of additional debt unless it is able to demonstrate, on a pro forma basis for the prior quarter and going forward, that its equity ratio (as defined) will be at least 21 percent of total capitalization (as defined) through June 30, 1994, 23 percent through June 30, 1995 and 25 percent thereafter. In addition, PSNH must demonstrate that its ratio of operating income to interest expense will be at least 1.5 to 1 for each period of four fiscal quarters ending after June 30, 1993 through June 30, 1994 and 1.75 to 1 thereafter. At December 31, 1993, PSNH's common equity ratio was 28.2 percent and its operating income to interest expense ratio was 2.27 to 1. See "Short-Term Debt" in the notes to NU's, CL&P's, PSNH's and WMECO's financial statements for information about credit lines available to System companies. The indentures securing the outstanding first mortgage bonds of CL&P, PSNH, WMECO and NAEC provide that additional bonds may not be issued, except for certain refunding purposes, unless earnings (as defined in each indenture, and before income taxes, and, in the case of PSNH, without deducting the amortization of PSNH's regulatory asset) are at least twice the pro forma annual interest charges on outstanding bonds and certain prior lien obligations and the bonds to be issued. The preferred stock provisions of CL&P's, WMECO's and PSNH's charters also prohibit the issuance of additional preferred stock (except for refinancing purposes) unless income before interest charges (as defined and after income taxes and depreciation) is at least 1.5 times the pro forma annual interest charges on indebtedness and the annual dividend requirements on preferred stock that will be outstanding after the additional stock is issued. Beginning with the dividends paid on NU common shares by NU in June 1990, NU's Dividend Reinvestment Plan (DRP) was amended to authorize the dividends and optional cash purchases of participating shareholders to be reinvested in NU common shares purchased either in the open market or directly from NU. NU received approximately $42.4 million in 1991 and approximately $35.6 million in 1992 of new common shareholders' equity from the reinvestment of dividends and voluntary cash investments. No funds have been raised by NU through DRP since August 1992, when management ended direct purchases and caused shares to be purchased for DRP participants in the open market. As part of the PSNH acquisition in June 1992, NU issued warrants for the purchase of NU common stock at a price of $24 per share. In 1993, NU received $8.3 million from the exercise of these warrants. As of December 31, 1993, warrants for 7,975,516 shares of NU common stock remained unexercised. NU is dependent on the earnings of, and dividends received from, its subsidiaries to meet its own financial requirements, including the payment of dividends on NU common shares. At the current indicated annual dividend of $1.76 per share, NU's aggregate annual dividends on common shares outstanding at December 31, 1993, including unallocated shares held by the ESOP trust, would be approximately $236.2 million. Dividends are payable on common shares only if, and in the amounts, declared by the NU Board of Trustees. SEC rules under the 1935 Act require that dividends on NU's shares be based on the amounts of dividends received from subsidiaries, not on the undistributed retained earnings of subsidiaries. The SEC's order approving NU's acquisition of PSNH under the 1935 Act approved NU's request for a waiver of this requirement through June 1997. PSNH and NAEC were effectively prohibited from paying dividends to NU through May 1993. Through the remainder of 1993, PSNH and NAEC did not pay dividends to permit them to build up the common equity portion of their capitalizations. Until PSNH and NAEC can begin to fund a part of NU's dividend requirements, NU expects to fund that portion of its dividend requirements with the proceeds of borrowings. The supplemental indentures under which CL&P's and WMECO's first mortgage bonds and the indenture under which PSNH's first mortgage bonds have been issued limit the amount of cash dividends and other distributions these subsidiaries can make to NU out of their retained earnings. As of December 31, 1993, CL&P had $210.6 million, WMECO had $26.5 million and PSNH had $60.8 million of unrestricted retained earnings. PSNH's preferred stock provisions also limit the amount of cash dividends and other distributions PSNH can make to NU if after taking the dividend or other distribution into account, PSNH's common stock equity is less than 25 percent of total capitalization. The indenture under which NAEC's Series A Bonds have been issued also limits the amount of cash dividends or distributions NAEC can make to NU to retained earnings plus $10 million. At December 31, 1993, $48.7 million was available to be paid under this provision. PSNH's credit agreements prohibit PSNH from declaring or paying any cash dividends or distributions on any of its capital stock, except for dividends on the preferred stock, unless minimum interest coverage and common equity ratio tests are satisfied. Certain subsidiaries of NU established the Money Pool to provide a more effective use of the cash resources of the System, and to reduce outside short term borrowings. The Service Company administers the Money Pool as agent for the participating companies. Short term borrowing needs of the participating companies (except NU) are first met with available funds of other member companies, including funds borrowed by NU from third parties. NU may lend to, but not borrow from, the Money Pool. Investing and borrowing subsidiaries receive or pay interest based on the average daily Federal Funds rate, except that borrowings based on loans from NU bear interest at NU cost. Funds may be withdrawn or repaid to the Money Pool at any time without prior notice. ELECTRIC OPERATIONS DISTRIBUTION AND LOAD The System operating companies own and operate a fully-integrated electric utility business. The System operating companies' retail electric service territories cover approximately 11,335 square miles (4,400 in CL&P's service area, 5,445 in PSNH's service area and 1,490 in WMECO's service area) and have an estimated total population of approximately 3.7 million (2.5 million in Connecticut, 780,000 in New Hampshire and 450,000 in Massachusetts). The companies furnish retail electric service in 149, 198 and 59 cities and towns in Connecticut, New Hampshire and Massachusetts, respectively. In December 1993, CL&P furnished retail electric service to approximately 1.085 million customers in Connecticut, PSNH provided retail electric service to approximately 397,000 customers in New Hampshire and WMECO served approximately 193,000 retail electric customers in Massachusetts. HWP serves approximately 25 customers in a portion of the town of Holyoke, Massachusetts. The following table shows the sources of 1993 electric revenues based on categories of customers: CL&P PSNH WMECO NAEC Total System Residential........... 39% 35% 38% - 39% Commercial............ 33 17 30 - 29 Industrial ........... 14 28 20 - 18 Wholesale* ........... 11 17 8 100% 11 Other ................ 3 3 4 - 3 ____ ____ ____ ____ ____ Total ................ 100% 100% 100% 100% 100% ______________________ * Includes capacity sales. NAEC's 1993 electric revenues were derived entirely from sales to PSNH under the Seabrook Power Contract. See "Rates - Seabrook Power Contract" for a discussion of the contract. Through December 31, 1993, the all-time maximum demand on the System was 6,191 MW, which occurred on July 8, 1993. At the time of the peak, the System's generating capacity, including capacity purchases, was 8,965 MW. The System was also selling approximately 1,431 MW of capacity to other utilities at that time. In 1993, System energy requirements were met 62 percent by nuclear units, nine percent by oil burning units, 10 percent by coal burning units, three percent by hydroelectric units, two percent by natural gas burning units and 14 percent by cogenerators and small power producers. By comparison, in 1992 the System's energy requirements were met 48 percent by nuclear units, 24 percent by oil burning units, 10 percent by coal burning units, four percent by hydroelectric units, one percent by natural gas burning units and 13 percent by cogenerators and small power producers. See "Electric Operations-Generation and Transmission" for further information. The actual changes in kWh sales for the last two years and the forecasted sales growth estimates for the 10-year period 1993 through 2003, in each case exclusive of bulk power sales, for the System, CL&P, PSNH and WMECO are set forth below: 1993 over 1992 over Forecast 1993-2003 (under) 1992 (under) 1991 Compound Rate of Growth System......... 10.9%(1) 15.3%(1) 1.4% CL&P........... (0.3)% 0.2% 1.3% PSNH........... 1.0% 1.1% 1.7% WMECO....... 0.1% (1.6)% 1.1% ___________________ (1) The percent increase in System 1992 sales over 1991 sales and 1993 sales over 1992 sales is due to the inclusion of PSNH sales beginning in June 1992. In 1990, FERC required the reclassification of bulk power sales from "purchased power" to "sales for resale" for the 1990 and later reporting years. Bulk power sales are not included in the development of any long-term forecasted growth rates. The actual changes in kWh sales for the last two years, adjusted for bulk power sales (by adding back the bulk power sales), for the System, CL&P, PSNH and WMECO are set forth below: 1993 over (under) 1992 1992 over (under) 1991 System ................... 11.8%(1) 19.7%(1) CL&P ..................... 1.2% 3.3% PSNH ..................... (9.3)% 6.7% WMECO .................... 13.5% 9.9% __________________ (1) System sales percentages reflect the inclusion of PSNH sales beginning in June 1992. Despite a warmer than normal summer that added to cooling requirements, sales showed negligible growth in 1993. Widespread economic recovery throughout the System's service territory did not occur in 1993, but there were mixed pockets of regional economic growth aided by very favorable interest rates. Curtailments in defense spending continue to affect the Connecticut, New Hampshire and western Massachusetts economies, which are heavily dependent on defense-related industries. Competition in various forms may also adversely affect the projected growth rate of sales over the next ten years. Where energy costs are a significant part of operating expenses, business customers may turn to self-generation, switch fuel sources, or relocate to other states and countries which have aggressive programs to attract new businesses. For further information on the effect of competition on sales growth rates, see "Marketing and Competition." The forecasted load growth for the System as a whole is significantly below historic rates in part because of forecasted savings from NU-sponsored C&LM programs, which are designed to minimize operating expenses for System customers and postpone the need for new capacity on the System. The forecasted ten-year growth rate of System sales would be approximately 1.8 percent instead of 1.4 percent if the System did not pursue C&LM savings. See "Resource Plans - Future Needs" for an estimate of the impact of C&LM programs on the System's need for new generating resources and for information about C&LM cost impacts and cost recovery. See "Rates - Connecticut Retail Rates" and "Rates - Massachusetts Retail Rates" for information about rate treatment of C&LM costs. With the System's generating capacity of 8,268 MW as of January 1, 1994 (including the net of capacity sales to and purchases from other utilities, and approximately 690 MW of capacity to be purchased from QFs and IPPs under existing contracts and contracts under negotiation), the System expects to meet its projected annual peak load growth of 1.3 percent reliably until at least the year 2007. The availability of new resources and reduced demand for electricity have combined to place the System and most other New England electric utilities in a surplus capacity situation. The principal resource changes were Seabrook 1's commercial operation, the full operation of the second phase of the Hydro-Quebec project, and increased availability of power from QF and IPP projects. As a consequence, the competition from capacity-long utilities as sellers and the loss of utilities that are no longer capacity- short as buyers have adversely affected the System companies' efforts to sell additional surplus capacity at the price levels that prevailed in the late 1980s. Taking into account projected load growth for the System and committed capacity sales, but not taking into account future potential capacity sales to other utilities that are not subject to firm commitments, the System's surplus capacity is expected to be approximately 1,000 MW in 1994. For further information on the effect of competition on sales of surplus capacity, see "Competition and Marketing." The System operating companies operate and dispatch their generation as provided in the New England Power Pool (NEPOOL) Agreement. In 1993, the peak demand on the NEPOOL system was 19,570 MW, which occurred in July, above the 1992 peak load of 18,853 MW in January of that year. NEPOOL has projected that there will be an increase in demand in 1994 and estimates that the summer 1994 peak load could reach 19,800 MW. NEPOOL projects that sufficient capacity will be available to meet this anticipated demand. GENERATION AND TRANSMISSION The System operating companies and most other New England utilities with electric generating facilities are parties to the NEPOOL Agreement. Under the NEPOOL Agreement, the region's generation and transmission facilities are planned and operated as part of the regional New England bulk power system. System transmission lines form part of the New England transmission system linking System generating plants with one another and with the facilities of other utilities in the northeastern United States and Canada. The generating facilities of all NEPOOL participants are dispatched as a single system through the New England Power Exchange, a central dispatch facility. The NEPOOL Agreement provides for a determination of the generating capacity responsibilities of participants and certain transmission rights and responsibilities. Pool dispatch results in substantial purchases and sales of electric energy by pool participants, including the System companies, at prices determined in accordance with the NEPOOL Agreement. The System operating companies, except PSNH, pool their electric production costs and the costs of their principal transmission facilities under the NUG&T agreement. In addition, a ten-year agreement between PSNH and CL&P, WMECO and HWP provides for a sharing of the capability responsibility savings and energy expense savings resulting from a single system dispatch. In connection with NU's acquisition of PSNH, the System proposed a comprehensive plan for opening up a transmission corridor between northern and southern New England for use in "wheeling" power of other utilities. The plan was designed to accomplish a level of access to transmission resources of the PSNH and New England Electric System (NEES) systems that could formerly be accomplished only after a series of multilateral negotiations. The plan includes provisions to (i) make 452 MW of long term transmission service available across the PSNH system from Maine to Massachusetts, Rhode Island, Connecticut and Vermont at embedded cost rates, (ii) make 200 MW of long term transmission service available by NEES for those utilities requiring deliveries across NEES's system in order to make use of access to the PSNH system, and (iii) construct new facilities as needed to expand the corridor from Maine to Massachusetts, if the cost of expansion is supported and if regulatory approvals for the expansion are received. Further, NU committed to make access to the combined NU-PSNH transmission system available for third-party wheeling transactions whenever capacity is available, and to expand the system when expansion is feasible. The principal constraints are that NU and PSNH have reserved a priority on the use of their transmission systems to serve the reliability needs of their own native load customers, and the commitment to expand would be subject to obtaining all necessary approvals. This plan became effective in October 1992, subject to the outcome of a hearing ordered by FERC in this proceeding, and the Commission's final decision in the compliance phase of the merger proceeding discussed below. NU and NEES filed offers of settlement in this proceeding in May and June 1993, respectively, and the Presiding Administrative Law Judge certified both settlement offers to the Commission in July 1993. The only contested issue was the refund and surcharge provision that was included in both offers of settlement. The Commission has not yet acted on these settlement offers. These commitments, and the entire issue of access to the NU and PSNH transmission systems by other utilities and non-utility generators, were the subject of extensive controversy in New England. On January 29, 1992, FERC issued a decision approving the acquisition and allowing NU and PSNH customers to be held harmless if other utilities and non-utility generators need to use the NU-PSNH transmission to buy or sell electricity. In accordance with the January 29 decision, on April 23, 1992 and August 4, 1992, NU made compliance filings, including transmission tariffs implementing the FERC's conditions. All tariffs have been accepted by FERC and were effective as of the merger date. FERC has issued summary determinations (without hearing) and NU has filed for rehearing of FERC's compliance tariff order in an effort to reinstate the originally proposed rates. FERC has not yet acted on NU's rehearing petition. FERC's approval of NU's acquisition of PSNH was appealed to the United States Court of Appeals for the First Circuit. On May 19, 1993, the First Circuit Court affirmed FERC's decision approving the merger but remanded to FERC one issue brought by NU related to FERC's ability to change the terms of the Seabrook Power Contract. FERC filed for en banc (full court) review by the First Circuit Court on the Seabrook Power Contract issue, which was denied. No petitions for review were filed in the U.S. Supreme Court, therefore, the First Circuit Court's decision is final. FERC has yet to initiate any proceeding on the court's remand, which would address whether FERC could modify the Seabrook Power Contract under a more stringent "public interest standard." On December 21, 1993, NU filed an appeal in the United States Court of Appeals for the District of Columbia Circuit of a FERC order directing NU to put itself on its own transmission tariffs in connection with all NU sales of wholesale power. NU had committed, as part of the PSNH merger, to place itself on its tariff when it was competing with other wholesale power suppliers to make a sale in order to "level the playing field." In its order, FERC expanded NU's merger commitment to include all transactions, regardless of whether or not NU's competitors need to use the NU transmission system. The controversy about the terms on which wheeling transactions are to be effected in New England has stimulated a series of negotiations among utilities, regulators and non-utility generators, directed at the possible development of new regional transmission arrangements. While an original draft regional transmission arrangement was not supported by all parties, there have been negotiations on a less comprehensive arrangement. Any arrangement would be subject to approval by NEPOOL members and FERC. HYDRO-QUEBEC Along with other New England utility companies, CL&P, PSNH, WMECO and HWP is each a participant in agreements to finance, construct, and operate the United States portion of direct current transmission circuits between New England and Quebec, Canada. The project was built in two phases, and now provides 2,000 MW of rated transfer capacity with Canadian facilities constructed and owned by Hydro-Quebec, a Canadian utility system. Phase 1, which entered into commercial operation in 1986, initially provided 690 MW of North-South transfer capacity. In Phase 2, the transmission line was extended to a new converter station in eastern Massachusetts. Phase 2 entered into full operation in 1991. The actual transfers over the interconnection to date have averaged in the 1,400 to 1,800 MW range. The interconnection permits a reduction in oil consumption in New England and has the potential to produce cost savings to customers through the purchase of power from Hydro-Quebec's hydroelectric generating facilities. The interconnection also reduces the level of reserves New England utilities must carry to assure that pool reliability criteria are met. The System companies are obligated to pay 34.22 percent of the annual costs of the Phase 1 facilities and 32.78 percent of the annual cost of the Phase 2 facilities. They are entitled, on the basis of a composite of these percentages, to use the capacity of the facilities for their own transactions and to share in the savings from pool energy transactions with Hydro-Quebec. The Phase 1 total project cost was $141 million and the Phase 2 total project cost was approximately $495 million. Phase 2 was constructed and is owned and operated by two companies in which NU has a 22.66 percent equity ownership interest. As an equity participant, NU guarantees certain obligations in connection with the debt financing of certain other participants that have lower credit ratings, and it receives compensation for such undertakings. When the Phase 2 facilities became fully operational in 1991, a contract covering the purchase by the New England utilities of 70 terawatthours of energy from Hydro-Quebec over a period of approximately ten years came into effect. While transactions under this contract are expected to constitute the principal use of the interconnection during the 1990s, the interconnection is also available for other energy transactions and for the "banking" of energy in Canada during off-peak hours in New England, with equivalent amounts of energy available to New England during peak hours. FOSSIL FUELS OIL The System's residual oil-fired generation stations used approximately 5.89 million barrels of oil in 1993. The System obtained the majority of its oil requirements in 1993 through contracts with three large, independent oil companies. Those contracts allow for some spot purchases when market conditions warrant, but spot purchases represented less than 15 percent of the System's fuel oil purchases in 1993. The contracts expire annually or biennially. The average 1993 price paid for fuel oil used for electric generation was approximately $14 per barrel, which was the same as the average 1992 price. No. 6 fuel oil prices were high during the first quarter of 1993 due to increased demand and firm crude oil prices. Fuel oil prices declined slightly during the second and third quarters, weakened in the fourth quarter due to weak crude prices associated with OPEC over-production and then firmed in the first quarter of 1994 due to severe weather in the Northeast. On February 1, 1994, the weighted average price being paid for the System's fuel oil had increased to $17 per barrel. The System-wide fuel oil storage capacity is approximately 2.5 million barrels. In 1993, inventories were maintained at levels between 40 - 60 percent of capacity. This inventory constitutes approximately 13 days of full load operation. GAS Currently, three system generating units, PSNH's Newington unit, WMECO's West Springfield Unit 3 and CL&P's Montville 5, can burn either residual oil or natural gas as economics dictate. The System is currently in the process of converting CL&P's Devon Units 7 & 8 into oil and gas dual-fuel generating units. Devon Unit 8's boiler conversion, which gave it gas burning capability, was completed in December 1993. Devon Unit 7's boiler conversion is scheduled for completion during its upcoming April 1994 outage. The System plans to have both units operational by the end of July 1994. Annual gas consumption depends on factors such as oil prices, gas prices and unit availability. In 1993, gas was used sparingly at the System's dual-fuel units because of the attractiveness of oil prices relative to those for natural gas. CL&P, PSNH and WMECO all have contracts with the local gas distribution companies where the Montville, Newington and West Springfield units are located, under which natural gas is made available by those companies on an interruptible basis. While WMECO and PSNH meet all of their gas supply needs for the West Springfield and Newington units through purchases from the local gas distribution company, CL&P can supply its Montville unit either by purchasing gas from the local gas distribution company at a DPUC-approved rate or by purchasing gas directly from producers or brokers and transporting that gas through the interstate pipeline system and the local gas distribution system. In 1993, all of the gas burned at Montville Unit 5 was purchased from a local gas distribution company. It is expected that gas for the Devon units will be purchased directly from producers or brokers on an interruptible basis and transported through the interstate pipeline system and the local gas distribution company. The System expects that interruptible natural gas will continue to be available for its dual-fuel electric generating units and will continue to supplement fuel oil requirements. The Iroquois Gas Transportation System, which became fully operational in November 1992, is expected to increase New England's gas supplies by at least 35 percent by November 1994. The increased availability of gas may make the option of converting other oil- burning electric generating units to gas on an interruptible dual-fuel basis more attractive to the System. COAL Currently, coal is purchased for HWP's Mt. Tom Station and for PSNH's Merrimack Units 1 and 2 and its coal-oil Schiller Units 4, 5 and 6. Mt. Tom Station received approximately 314,000 tons of coal in 1993 at an average delivered coal price of $ 43.40 per ton, which is down from the average 1992 coal price of $44.25 per ton. In 1993, HWP extended an existing contract for the majority of the coal to be supplied to Mt. Tom Station. This contract provides the System with assurance of coal supply and the flexibility to purchase some coal on the spot market. In the future, the System will evaluate whether to continue to purchase coal by contract or return to the spot market. The coal inventory for Mt. Tom Station varies between a minimum level of 30 days fuel and a maximum of approximately 100 days fuel. Typically, the higher level is achieved in December, when deliveries are suspended for the winter. The stockpile provides the plant's operating fuel until deliveries are resumed in March. Because of changes in federal and state air quality requirements, by 1995 HWP will need to change the kinds of coal that it purchases for use at Mt. Tom Station. The potential impact of changing air quality requirements on coal supplies is being evaluated, and HWP is testing various types of coal to meet these requirements. See "Regulatory and Environmental Matters - Environmental Regulation-Air Quality Requirements." In December 1991, PSNH executed a contract for the purchase of up to 100 percent of the coal requirements for PSNH's Merrimack Units 1 and 2 through December 31, 1993. This contract has been extended through December 31, 1994. Under this agreement, PSNH may also purchase coal on the spot market. In 1993, Merrimack Station received approximately 1.1 million tons of coal. The average delivered coal price in 1993 was $43.00 per ton. The coal inventory at Merrimack Station varies between a minimum of 60 days and a maximum of 90 days of fuel. Schiller Units 4, 5 and 6, PSNH's dual-fuel coal and oil fired units, are dispatched on the most economical fuel in accordance with the provisions of the NEPOOL Agreement. Schiller Station consumed approximately 236,000 tons of coal in 1993 at an average delivered price of $39.40 per ton. Schiller's 1993 coal requirements were fulfilled through three primary contracts, pursuant to which 77 percent was provided by foreign suppliers and the remaining 23 percent by a domestic supplier. FOSSIL PLANT RETIREMENTS In 1991, the System retired seven of the System's oldest, least used, and most costly oil-fired steam generating units. In 1992, five oil-burning combustion turbines were retired. The decision to retire these units reflected both the surplus of generating capacity in New England and the System's continuing efforts to reduce operation and maintenance costs. There were no significant fossil plant retirements in 1993, but the System's plan calls for deactivating, by the end of 1994 Montville Units 5 and 6, which have a capacity of 82 MW and 410 MW, respectively. A final decision on the future of these units will be made following the completion of further economic evaluations and consideration of possible alternatives. NUCLEAR GENERATION GENERAL The System companies have interests in seven operating nuclear units: Millstone 1, 2 and 3, Seabrook 1 and three other units owned by regional nuclear generating companies (the Yankee companies). System companies operate the three Millstone units, Seabrook 1 and CY. The System companies also have interests in the owned by the Yankee Atomic Electric Company (Yankee Rowe), which was permanently removed from service in 1992. CL&P and WMECO own 100 percent of Millstone 1 and 2 as tenants in common. Their respective ownership interests are 81 percent and 19 percent. CL&P, PSNH and WMECO have agreements with other New England utilities covering their joint ownership as tenants in common of Millstone 3. CL&P's ownership interest in the unit is 52.9330 percent (608 MW), PSNH's ownership interest in the unit is 2.8475 percent (32.7 MW) and WMECO's interest is 12.2385 percent (140.6 MW). NAEC and CL&P are parties to an agreement, similar to the Millstone 3 agreements, with respect to their 35.98201 percent (413.8 MW) and 4.05985 percent (46.7 MW) interests, respectively, in Seabrook. The agreements all provide for pro rata sharing of the construction and operating costs and the electrical output of each unit by the owners, as well as associated transmission costs. CL&P, PSNH, WMECO and other New England electric utilities are the stockholders of the Yankee companies. Each Yankee company owns a single nuclear generating unit. The stockholder-sponsors of a Yankee company are responsible for proportional shares of the operating costs of the Yankee company and are entitled to proportional shares of the electrical output. The relative rights and obligations with respect to the Yankee companies are approximately proportional to the stockholders' percentage stock holdings, but vary slightly to reflect arrangements under which non-stockholder electric utilities have contractual rights to some of the output of particular units. The Yankee companies and CL&P's, PSNH's and WMECO's stock ownership percentages and approximate MW entitlements in each are set forth below: CL&P PSNH WMECO System % MW % MW % MW % MW Connecticut Yankee Atomic Power Company (CYAPC) ...... 34.5 204 5.0 29 9.5 56 49.0 289 Maine Yankee Atomic Power Company (MYAPC) ............ 12.0 95 5.0 39 3.0 24 20.0 158 Vermont Yankee Nuclear Power Corporation (VYNPC)... 9.5 44 4.0 19 2.5 12 16.0 75 Yankee Atomic Electric Company (YAEC)* ............ 24.5 - 7.0 - 7.0 - 38.5 - _____________________________ * See "Yankee Units" for information about the permanent shutdown of the unit owned and operated by YAEC. CL&P, PSNH and WMECO are obligated to provide their percentages of any additional equity capital necessary for the Yankee companies. CL&P, PSNH and WMECO believe that the Yankee companies, excluding YAEC, will require additional external financing in the next several years to finance construction expenditures and nuclear fuel and for other purposes. Although the ways in which each Yankee company will attempt to finance these expenditures have not been determined, CL&P, PSNH and WMECO could be asked to provide direct or indirect financial support for one or more Yankee companies. OPERATIONS Capacity factor is a ratio that compares a unit's actual generating output for a period with the unit's maximum potential output. In 1993, the nuclear units in which the System companies have entitlements achieved an actual composite (weighted by entitlement) capacity factor of 79.9 percent. The five nuclear units operated by the System had a composite capacity factor of 80.3 percent based on normal winter claimed capability. The average capacity factor for operating nuclear units in the United States was 73.2 percent for January through September 1993 and 80.4 percent for the five System nuclear units operated in 1993, in each case using the design electrical rating method rather than normal winter claimed capability. When the nuclear units in which they have interests are out of service, CL&P, PSNH and WMECO need to generate and/or purchase replacement power. Recovery of prudently incurred replacement power costs is permitted, with limitations, through the GUAC for CL&P, through a retail fuel adjustment clause for WMECO and through a comprehensive fuel and purchased power adjustment clause (FPPAC) for PSNH. For the status of regulatory and legal proceedings related to recovery of replacement power costs for the 1990-1993 period, see "Rates - Connecticut Retail Rates," "Rates-Massachusetts Retail Rates" and "Rates - New Hampshire Retail Rates." MILLSTONE UNITS The 1993 overall performance of the three nuclear electric generating units located at Millstone station and operated by the System was substantially better than in 1992. For the twelve months ended December 31, 1993, the three units' composite capacity factor was 79.3 percent, compared with a composite capacity factor of 53.1 percent for the twelve months ended December 31, 1992 and 38.4 percent for the same period in 1991. In 1993 Millstone 1 operated at a 92.4 percent capacity factor with no extended outages. The unit began a planned refueling and maintenance outage on January 15, 1994 that is expected to last seventy-one days. Major work includes replacement of the main condenser tubes and installation of a new low pressure turbine. These modifications are intended to reduce the number of unplanned outages and improve the overall plant efficiency. In 1993 Millstone 2 operated at a 82.5 percent capacity factor. On January 13, 1993, the plant returned to service following a refueling outage that commenced on May 29, 1992. During that outage, both steam generators were replaced. The DPUC has opened a docket to review CL&P's performance in replacing Millstone 2's steam generators. See "Rates-Connecticut Retail Rates" for further information on the steam generator replacement docket. In addition to several short outages during 1993, Millstone 2 was shut down for two unplanned outages of significant duration. The first such outage began on August 5, 1993, to replace a leaking primary system valve. That outage lasted ten days. For more information on this outage, see "Electric Operations - Nuclear Generation - Operations - NRC Regulation." The second significant unplanned outage lasted twenty-six days, commencing on September 15, 1993, and was necessary to upgrade the motor-operated feedwater isolation valves. Millstone 2 is scheduled to begin a refueling and maintenance outage on July 30, 1994. The outage is currently planned for a 63-day duration. Major work activities will include a reactor vessel in-service inspection, erosion/corrosion piping inspections, motor-operated valve testing and service water piping replacement. In 1993 Millstone 3 operated at a 64.8 percent capacity factor. The unit began a refueling and maintenance outage on July 31, 1993 and completed it in 99 days. During the outage two significant issues were identified and resolved. Each of these issues resulted in an outage extension beyond original plans. The first issue required replacement of all four reactor coolant pumps due to concerns over turning vane cap screw and locking cup integrity. The second issue related to problems identified during inspection and testing of the supplementary leak collection and release system (SLCRS) and the auxiliary building ventilation system (ABVS), which provide secondary protection against radiological releases to the atmosphere. For more information on this issue, see "Electric Operations - Nuclear Generation - Operations - NRC Regulation." Resolution of these problems necessitated various modifications to these systems. No refueling or maintenance outages are planned for Millstone 3 during 1994. NUCLEAR PERFORMANCE IMPROVEMENT INITIATIVES The System's nuclear organization is taking major steps to correct identified performance weaknesses. For instance, on a 1992 to 1995 cumulative basis, NU anticipates total expenditures of approximately $2.3 billion for operation and maintenance and $440 million in capital improvements for the five plants that it operates. In addition, the comprehensive Performance Enhancement Program (PEP), authorized in 1992, continues to be one of the major initiatives that the nuclear organization is implementing to improve its overall performance. The program, in conjunction with other actions to address the long-term performance of the nuclear group, is designed to correct the root causes of the declining performance trend noted in the early 1990's. The PEP is organized into four major areas of activities, each focusing on a particular aspect of nuclear operations. The areas are management practices, programs and processes, performance assessments and functional programs. These areas were established based on an internal self-assessment completed in 1992. Detailed action plans have been prepared to address the specific activities. At the end of 1992, six of the forty-two action plans were completed and validated. An additional fourteen action plans were completed in 1993 and are awaiting validation. Seven action plans are to be completed in 1994, leaving fifteen action plans to complete during the remainder of the program. The 1993 PEP budget was $32.9 million. The System also announced a major reorganization of its Connecticut-based nuclear organization on November 8, 1993. The primary focus was realignment of engineering services along unit lines. The changes also included the appointment of a new senior vice president for Millstone station, some management consolidation, and a reorganization of the nuclear plant maintenance staff. See "Employees." In addition, most of the nuclear support staff currently located in Berlin, Connecticut will be centralized at the generating stations by the summer of 1994. To support these efforts, the System is constructing a five-story office building at Millstone station. This building will replace several temporary modular buildings and will house most of the nuclear technical support staff that is now located at various System locations. The prudence of this construction project is the subject of an ongoing inquiry by the DPUC. SEABROOK In 1993 Seabrook 1 operated at a capacity factor of 89.8 percent. The unit is currently in an 18-month operating cycle that began in November 1992. The unit is scheduled to begin a 57-day refueling and maintenance outage on April 16, 1994. During this outage, the main plant computer will be replaced. CL&P, PSNH and NAEC could be affected by the ability of other Seabrook joint owners to fund their share of Seabrook costs. Great Bay Power Corporation (GBPC), a former subsidiary of Eastern Utilities Associates and owner of 12.13 percent of Seabrook, has been in bankruptcy since February 1991. The Bankruptcy Court confirmed GBPC's reorganization plan on March 5, 1993 and approvals are required from NRC, FERC and NHPUC to consummate the plan. CL&P has committed to advance GBPC up to $12 million, secured by a high priority lien on GBPC's share of Seabrook, to cover GBPC's shortfalls in funding its share of the operation of Seabrook through June 30, 1994. As of March 1, 1994, CL&P was lending approximately $2 million to GBPC under this arrangement. GBPC has advised CL&P that it expects to consummate its reorganization plan, emerge from bankruptcy and repay CL&P for all advances by June 30, 1994. CL&P is unable to predict what impact, if any, failure of the reorganization plan to become effective will have on the operating license for Seabrook or what actions CL&P and the other joint owners of the unit may be required to take. On May 6, 1991, NHEC, PSNH's largest customer and one of the joint owners of Seabrook, filed a petition for reorganization under Chapter 11 of the Federal Bankruptcy Code. The plan of reorganization for NHEC was confirmed by the United States Bankruptcy Court on March 20, 1992 and wholesale power arrangements were accepted by FERC on July 22, 1992. On October 5, 1992, the NHPUC released an order approving NHEC's plan of reorganization. Under the plan of reorganization, NHEC will remain a customer of PSNH. The plan also provides that PSNH will purchase the capacity and energy of NHEC's 2.2 percent ownership interest in Seabrook 1 and pay all of NHEC's Seabrook costs for a ten-year period, which began July 1, 1990. On December 1, 1993, the United States Bankruptcy Court for the District of New Hampshire declared the NHEC reorganization plan effective as of that date. See "Rates--Wholesale Rates" for further information on the bankruptcy and subsequent reorganization of NHEC. At certain times, VEG&T failed to pay its share of Seabrook costs. Certain joint owners, including PSNH and CL&P, provided funds against future payments due from VEG&T to assure that funds were available to meet its ownership share of Seabrook costs. PSNH initially participated in such payments, but ceased providing such funds in January 1988, when it commenced bankruptcy proceedings under Chapter 11 of the Bankruptcy Code. The total amount contributed by PSNH until then was $976,000. The total amount contributed by CL&P was $265,000. As part of an agreement to resolve issues raised during the bankruptcy of PSNH, PSNH agreed that it or its designee would purchase the VEG&T 0.41259 percent interest in Seabrook for approximately $6.4 million. NAEC, the current owner of PSNH's ownership share in Seabrook, agreed to purchase the interest and to enter into a separate power contract with PSNH, under which PSNH would be obligated to buy from NAEC all of the capacity and output of Seabrook attributable to such interest for a period equal to the length of the NRC full power operating license for Seabrook. On January 7, 1994, the NRC approved the transfer of VEG&T's ownership share of Seabrook to NAEC. All other regulatory approvals for NAEC's purchase were received and the acquisition became effective on February 15, 1994. In settlement of their claims against VEG&T for advances, PSNH and CL&P received payment of the amounts advanced, $1.78 million and $390,000, respectively, out of proceeds of the sale, with interest thereon, for the period each advance was outstanding at the prime rate. See "Rates-New Hampshire Retail Rates-Memorandum of Understanding" and "Rates-New Hampshire Retail Rates-Seabrook Power Contract" for further information on NAEC's acquisition of VEG&T's share of Seabrook. In 1989, as part of a comprehensive settlement of Seabrook issues, PSNH agreed to make certain payments totaling $16 million to Massachusetts Municipal Wholesale Electric Company during the first eight years of Seabrook operation. As of December 31, 1993, PSNH had made approximately $7.2 million of these payments. YANKEE UNITS CY, the nuclear unit owned by MYAPC (MY) and the nuclear unit owned by VYAPC (VY) operated in 1993 at capacity factors of 73.1 percent, 74.3 percent and 74.1 percent, respectively, based on normal winter claimed capability. Yankee Rowe has not operated since October 1991. CY. As of December 31, 1993, CY, since it began commercial operation in 1968, had generated over 99 billion kWh (gross) of electricity, making it one of the most productive nuclear generating units in the United States. The unit completed, on schedule, a 66-day refueling and maintenance outage that began on May 15, 1993. The second reload of fuel clad with zircalloy was installed during this outage to replace the stainless steel clad fuel. There is one more phase to this upgrade project that, when completed, will make the operation of the reactor core more economical by allowing longer operating cycles. CY's next refueling and maintenance outage is scheduled to begin on November 12, 1994 and is expected to last 54 days. Major work activities will include auxiliary feedwater system modifications and motor-operated valve testing. The start date and length of this refueling outage may be impacted by an unplanned shutdown which occurred on February 12, 1994, when the plant was required to come off line to address integrity concerns in the safety-related service water system. CYAPC is reviewing the scope of work required and schedule for returning the unit to service from the unplanned outage. In October 1992, CYAPC filed an application with the FERC for wholesale rate relief. CYAPC requested the increase to become effective on January 1, 1993. The filing requested an increase in estimated decommissioning cost collections from $130 million to $309.1 million (in July 1992 dollars) and also proposed to adjust decommissioning accruals automatically on an annual basis beginning January 1, 1993. In December 1992, FERC accepted CYAPC's increased rates for filing, to become effective on June 1, 1993, subject to refund, and rejected the proposal to automatically adjust decommissioning accruals. A settlement between all the parties was reached in 1992 and was accepted by FERC in 1993. This included an accrual level for decommissioning of $294.2 million in 1992 dollars and an automatic increase of 5.5% annually in the decommissioning accrual for each of the next five years. MY. MY began a refueling and maintenance outage on July 31, 1993 and completed it in 75 days. During the outage, repairs were made to the reactor vessel thermal shield. VY. VY began a refueling and maintenance outage on August 27, 1993, and completed it in 59 days, including recovery from a dropped fuel bundle that suspended fuel movement for approximately 20 days. Yankee Rowe. In February 1992, YAEC's owners voted to shut down Yankee Rowe permanently and to begin preparations for an orderly decommissioning of the facility. The decision to close the generating plant eight years before the end of its operating license was based on an economic evaluation of the cost of a proposed safety review, the reduced demand for electricity in New England, the price of alternative energy sources and uncertainty about the regulatory requirements that the unit would need to meet in order to restart. See "Electric Operations-Nuclear Generation-Operations-Decommissioning" for information on YAEC's filing with FERC to collect for shutdown and decommissioning costs and the recovery of the remaining investment in the Yankee Rowe plant. The power contracts between CL&P, PSNH and WMECO and YAEC permit YAEC to recover from each its proportional share of these costs from CL&P, PSNH and WMECO. Management believes that, although Yankee Rowe was shut down eight years before the end of the unit's current license, CL&P, PSNH and WMECO will recover their investments in YAEC, along with any other costs associated with the shutdown and decommissioning of Yankee Rowe. Accordingly, the System has recognized these costs as a regulatory asset on its consolidated balance sheet and as a corresponding obligation to YAEC. NRC REGULATION As holders of licenses to operate nuclear reactors, CL&P, PSNH, WMECO, NAEC, North Atlantic, NNECO and the Yankee companies are subject to the jurisdiction of the NRC. The NRC has broad jurisdiction over the design, construction and operation of nuclear generating stations, including matters of public health and safety, financial qualifications, antitrust considerations and environmental impact. In its latest Systematic Assessment of Licensee Performance Report (SALP report) issued on October 19, 1993, the NRC gave the three Millstone nuclear plants a Category 1 rating in the area of radiological controls and a Category 2 rating in five of the seven areas rated: plant operations, maintenance/surveillance, emergency preparedness, security and engineering/technical support. The Millstone units received a Category 3 rating in the area of safety assessment/quality verification. Category 1 indicates "a superior level of performance," Category 2 indicates "a good level of performance" and Category 3 denotes "an acceptable level of performance." The evaluation covered plant activities for the period February 16, 1992 through April 3, 1993. Management expects to continue to improve performance, thereby raising these scores. The NRC issued its latest SALP report for Seabrook 1 on November 18, 1993. The report covered the interval from March 1, 1992 through August 28, 1993. This report reflects the recent revisions to the SALP program in which the number of functional evaluation areas has been reduced from seven to four: plant operations, maintenance, engineering and plant support. The evaluation rated Seabrook 1 a Category 1 in the engineering and plant support areas. In the areas of plant operations and maintenance, the unit was rated a Category 2. The NRC issued its latest SALP report for CY on May 21, 1993. The report covered the interval from July 14, 1991 through January 9, 1993. This evaluation recognized the superior performance of CY by awarding the unit a Category 1 in six of the seven areas rated: plant operations, emergency preparedness, security, engineering/technical support, safety assessment/quality verification and radiological controls. In the final area, maintenance/surveillance, CY was rated as a Category 2. Despite the overall improved performance of the Millstone units, there were a number of regulatory enforcement actions taken by the NRC in 1993. On May 4, 1993, the NRC issued to NNECO a Notice of Violation (NOV) identifying two potential violations. The first violation concerned NRC findings that a former employee was subjected to harassment and intimidation in 1989 for raising a nuclear safety concern and that senior management was not effective in dealing with the situation. The second violation involved NRC concerns that an employee may have deliberately delayed the processing of a contemplated substantial safety hazard evaluation conducted to fulfill the requirements of federal law. Following NNECO's response to the NOV, the NRC withdrew the second violation. To resolve this matter, NNECO paid a fine of $100,000 in connection with the first violation. On August 5, 1993, Millstone Unit 2 was shut down by plant personnel after extensive efforts to repair a leaking primary system valve proved unsuccessful, and a sudden increase in the leak rate was experienced. Following replacement of the damaged valve, the unit was returned to service on August 16, 1993. Recognizing the seriousness of this event and the potentially severe consequences of the failed repair efforts, NNECO performed a detailed evaluation of this event to consider potential deficiencies and identify the actions needed to prevent recurrence. The NRC also conducted a special investigation of this event and on September 22, 1993, identified to NNECO three apparent violations, related to work control planning and implementation, which were being considered for escalated enforcement. On December 3, 1993, the NRC informed NNECO that it was imposing a civil penalty of $237,500 for the three violations. NNECO has since paid the fine. On September 10, 1993, NNECO was informed by the NRC that, as a result of an investigation by the NRC Office of Investigation and a routine safety inspection of the Millstone Unit 1 nuclear power plant, two apparent violations arising from 1989 events were being considered for possible civil monetary penalties. The first issue concerned the alleged failure to initiate and perform a required engineering analysis to determine the operability of safety-related system in a timely manner. The second issue relates to allegations that the engineer who identified the system as being potentially inoperable was harassed and discriminated against in retaliation for the findings of his technical evaluations. These matters were investigated between early 1992 and June 1993 by a grand jury acting under the direction of the U.S. Attorney's Office in Bridgeport, Connecticut. The U.S. Attorney's office issued a letter on June 30, 1993, stating that no prosecutorial action would be initiated. On March 17, 1994, the NRC informed NNECO that further enforcement action with respect to this matter was not planned, because their review had determined that there was insufficient evidence to support the apparent violations. On September 20, 1993, the NRC issued to NNECO an NOV concerning two violations at the Millstone Station identified during its evaluation of the licensed operator requalification training (LORT) program. The first violation concerned an inspection finding that various licensed operators at Millstone 1 and 2 did not fully complete the LORT program for the 1991 and 1992 training periods. The second violation cited the failure of NNECO's internal nuclear review board to perform comprehensive audits of the training, retaining, requalification, and performance of the operations staff at Millstone 2 and 3. NNECO chose not to contest the violations nor the imposition of a $50,000 civil penalty. On December 15, 1993, the NRC issued an inspection report concerning the SLCRS and ABVS systems deficiencies that were identified during the 1993 Millstone 3 refueling outage. The report identified two apparent violations that are being considered for escalated enforcement. The apparent violations involve the inability of the systems to provide the necessary drawdown of secondary containment following a postulated accident and NNECO's failure to fully resolve these problems earlier, as a result of previous similar violations identified in September 1992. On March 11, 1994, the NRC notified NNECO that it proposed to impose a civil penalty of $50,000 in respect of these violations. NNECO has 30 days to respond to the NRC. In January 1994, the NRC issued a report finding that the overall Millstone 1 operator requalification training program was satisfactory. The NRC had previously found the program to be unsatisfactory. The recent conclusion was based on the results of a number of NRC inspections and the operator examinations conducted in September 1993. The NRC reviewed NNECO's corrective actions and determined that all actions necessary to obtain and maintain a satisfactory requalification training program had been completed and verified. INDUSTRY-WIDE NUCLEAR ISSUES The NRC regularly conducts generic reviews of technical and other issues, a number of which may affect the nuclear plants in which System companies have interests. Issues currently under review include individual plant examination programs to evaluate the likelihood and effects of severe accidents at operating nuclear plants, pipe crack phenomena, post-accident measures for controlling hydrogen, reactor vessel embrittlement, upgrading of emergency response facilities and communications, the ability of plants to cope with a total loss of power, emergency response planning, fitness for duty policies, operator requalification training, reactor containment suitability, maintenance adequacy, motor-operated valve testing, design basis reconstitution, diesel generator reliability, life extension, equipment procurement, electrical distribution system adequacy, reactor coolant pump seal integrity, plant risk during shutdown and low power operation, technical specification improvements, accident management, component aging, steam generator degradation phenomena, service water system adequacy, seismic qualification of equipment and other issues. At present, the outcome of the NRC's reviews of these and other technical issues, and the ways in which the different nuclear plants in which System companies have interests may be affected, cannot be determined. The cost of complying with any new requirements that may result from these reviews cannot be estimated at this time, but such costs could be substantial. Further, the NRC is currently evaluating a staff report on the reporting of nuclear safety concerns, which may result in changes in the way such concerns are addressed. The NRC has authorized the conduct of various regulatory activities designed to lower costs to its licensees while maintaining or improving public safety. Public controversy concerning nuclear power could affect the nuclear units in which System companies have ownership interests. Over the past decade, proposals to force the premature shutdown of nuclear units have become issues of serious and recurring attention in Maine, Massachusetts, Vermont and New Hampshire. States' efforts to deal with the siting of low level radioactive waste repositories have also stimulated negative reactions in communities being considered for those facilities. The continuing controversy about nuclear power may affect the cost of operating the nuclear units in which System companies have interests. While much of the public policy debate about nuclear power has been critical in the past, some trends in the energy environment have stimulated renewed support for nuclear power in the northeastern United States. Among these trends are the growing national environmental concerns and legislation about acid rain, air quality and global warming associated with fossil fuels. These concerns particularly affect the densely populated areas in the Northeast, downwind of coal-burning regions like the Midwest and mid-Atlantic states. In addition, at times when the price and availability of fuel oil have been volatile, the System's commitment to nuclear power has allowed it to minimize the oil-related rise in customers' bills. While the public controversy about nuclear power is not expected to disappear, recent trends suggest a more balanced public policy debate about the impacts of fossil fuel generation as well. NUCLEAR INSURANCE The NRC's nuclear property insurance rule requires nuclear plant licensees to obtain a minimum of $1.06 billion in insurance coverage. The rule requires that, although such policies may provide traditional property coverage, proceeds from the policy following an accident in which estimated stabilization and decontamination expenses exceed $100 million will first be applied to pay such expenses. The insurance carried by the licensees of the Millstone units, Seabrook 1, CY, MY and VY meets the requirements of this rule. YAEC has obtained an exemption for the Yankee Rowe plant from the $1.06 billion requirement and currently carries $25 million of insurance that otherwise meets the requirements of the rule. The Price-Anderson Act currently limits public liability from a single incident at a nuclear power plant to $9.4 billion. The first $200 million of liability would be provided by purchasing the maximum amount of commercially available insurance. Additional coverage of up to $8.8 billion would be provided by an assessment of $75.5 million per incident, levied on each of the 116 United States nuclear units that are currently subject to the secondary financial protection program, subject to a maximum assessment of $10 million per incident per nuclear unit in any year. In addition, if the sum of all public liability claims and legal costs arising from any nuclear incident exceeds the maximum amount of financial protection, each reactor operator can be assessed an additional five percent, up to $3.8 million or $437.9 million in total for all 116 reactors. The maximum assessment is to be adjusted for inflation at least every five years. Based on CL&P's, PSNH's and WMECO's ownership interests in the three Millstone units and CL&P's and NAEC's interests in Seabrook 1, the System's current maximum direct liability would be $244.2 million per incident. In addition, through CL&P's, PSNH's and WMECO's power purchase contracts with the four Yankee regional nuclear electric generating companies, the System would be responsible for up to an additional $97.9 million per incident. These payments would be limited to a maximum in any year of $43.2 million per incident. Insurance has been purchased from Nuclear Electric Insurance Limited (NEIL) to cover: (1) certain extra costs incurred in obtaining replacement power during prolonged accidental outages with respect to CL&P's and WMECO's ownership interests in Millstone 1, 2, 3, and CY, CL&P's ownership interest in Seabrook, and PSNH's Seabrook Power Contract with NAEC; and (2) the cost of repair, replacement, or decontamination or premature decommissioning of utility property resulting from insured occurrences with respect to CL&P's ownership interests in Millstone 1, 2, 3, CY, MY, VY, and Seabrook 1; WMECO's ownership interests in Millstone 1, 2, 3, CY, MY, and VY; PSNH's ownership interest in Millstone 3, CY, MY and VY; and NAEC's ownership interest in Seabrook 1. All companies insured with NEIL are subject to retroactive assessments if losses exceed the accumulated funds available to NEIL. The maximum potential assessments against CL&P, PSNH, WMECO, and NAEC with respect to losses arising during current policy years are approximately $13.9 million under the replacement power policies and $29.9 million under the property damage, decontamination, and decommissioning policies. Although CL&P, PSNH, WMECO, and NAEC have purchased the limits of coverage currently available from the conventional nuclear insurance pools, the cost of a nuclear incident could exceed available insurance proceeds. Insurance has been purchased from American Nuclear Insurers/Mutual Atomic Energy Liability Underwriters, aggregating $200 million on an industry basis, for coverage of worker claims. All companies insured under this coverage are subject to retrospective assessments of $3.2 million per reactor. The maximum potential assessments against CL&P, PSNH, WMECO, and NAEC with respect to losses arising during the current policy period are approximately $13.9 million. CYAPC expects that it will receive an insurance recovery for costs related to the CY thermal shield repair which occurred during the 1987 outage, and the removal which occurred during the 1989 outage, but the amount and time of payment are not certain. See "Rates-Connecticut Retail Rates-Adjustment Clauses." NUCLEAR FUEL The supply of nuclear fuel for the System's existing units requires the procurement of uranium concentrates, followed by the conversion, enrichment and fabrication of the uranium into fuel assemblies suitable for use in the System's units. These materials and services are available from a number of domestic and foreign sources. The System companies have predominantly relied on long term contracts with both domestic and foreign suppliers, supplemented with short term contracts and market purchases, to satisfy the units' requirements. Although the System has increased the use of foreign suppliers, domestic suppliers still provide the majority of the materials and services. The System companies have maintained diversified sources of supply, relying on no single source of supply for any one component of the fuel cycle, with the exception of enrichment services of which the majority of the System companies' requirements are provided under a long term contract with the U.S. Enrichment Corporation, a wholly-owned government corporation, established on July 1, 1993, in accordance with the Energy Policy Act and the successor to the U.S. DOE Uranium Enrichment Enterprise. The System expects that uranium concentrates and related services for the units operated by the System and for the other units in which the System companies are participating, that are not covered by existing contracts, will be available for the foreseeable future on reasonable terms and prices. As a result of the Energy Policy Act, the U.S. utility industry is required to pay to the DOE, via a special assessment for the costs of the decontamination and decommissioning of uranium enrichment plants operated by the DOE, $150 million each U.S. Government fiscal year for 15 years beginning in 1993. Each domestic utility will make a payment proportioned on its past purchases from the DOE's Uranium Enrichment Enterprise. Each year, the DOE will adjust the annual assessment using the Consumer Price Index. The Energy Policy Act provides that the assessments are to be treated as reasonable and necessary current costs of fuel, which costs shall be fully recoverable in rates in all jurisdictions. The System's total share of the estimated assessment was approximately $56.7 million. Management believes that the DOE assessments against CL&P, WMECO, PSNH and NAEC will be recoverable in future rates. Accordingly, each of these companies has recognized these costs as regulatory asset, with corresponding obligation on its balance sheet. Costs associated with nuclear plant operations include amounts for disposal of nuclear wastes, including spent fuel, and for the ultimate decommissioning of the plants. The System companies include in their nuclear fuel expense spent fuel disposal costs accepted by the DPUC, the NHPUC and the DPU in rate case or fuel adjustment decisions. Spent fuel disposal costs are also reflected in wholesale charges. Such provisions include amortization and recovery in rates of previously unrecovered disposal costs of accumulated spent nuclear fuel. HIGH-LEVEL RADIOACTIVE WASTES Under the Nuclear Waste Policy Act of 1982, the DOE is required to design, license, construct and operate a permanent repository for high level radioactive wastes and spent nuclear fuel. The act requires the DOE to provide, beginning in 1998, for the disposal of spent nuclear fuel and high level radioactive waste from commercial nuclear plants through contracts with the owners and generators of such waste. The System companies have entered into such contracts with the DOE with respect to Millstone 1, 2 and 3 and Seabrook 1, and have been advised that the Yankee companies have entered into similar contracts. The DOE has established disposal fees to be paid to the federal government by electric utilities owning or operating nuclear generating units. The System companies have been paying for such services for fuel burned starting in April 1983 on a quarterly basis since July 1983 in accordance with the contracts; the DPUC, the NHPUC and the DPU permit the fee to be recovered through rates. The disposal fee for fuel burned before April 1983 (previously burned fuel) is determined in accordance with a fee structure based on fuel burnup. Under the contract payment option selected, the System companies anticipate making payment to the DOE for disposal of previously burned fuel just before the first delivery of spent fuel to the DOE. That payment obligation is not a funded obligation. The liability under the selected payment option for previously burned fuel, including interest, through December 31, 1993, and the amounts recovered through rates for previously burned fuel through the end of 1993 for Millstone 1 and 2, are as follows: Previously Burned Fuel Liability, Amounts Recovered for Previously Including Interest, Thru 12/31/93 Burned Fuel Thru 12/31/93 (Millions) CL&P $136.1 $134.5 WMECO 31.9 32.3 Total $168.0 $166.8 Because Millstone 3 and Seabrook 1 went into service after 1983, there is no previously burned fuel liability for those units. In return for payment of the fees prescribed by the Nuclear Waste Policy Act, the federal government is to take title to and dispose of the utilities' high level wastes and spent nuclear fuel beginning no later than 1998. Until the federal government begins receiving such materials, operating nuclear generating plants will need to retain high-level wastes and spent fuel on-site or make some other provisions for their storage. With the addition of new storage racks or through fuel consolidation, storage facilities for Millstone 3 and CY are expected to be adequate for the projected life of the units. With the storage facilities for Millstone 1 and 2 are expected to be adequate (maintaining the capacity to accommodate a full-core discharge from the reactor) until 2000. Fuel consolidation, which has been licensed for Millstone 2, could provide adequate storage capability for the projected lives of Millstone 1 and 2. In addition, other licensed technologies, such as dry storage casks or on-site transfers, are being considered to accommodate spent fuel storage requirements. With the addition of new racks, Seabrook 1 is expected to have spent fuel storage capacity until at least 2010. Under the terms of a license amendment approved by the NRC in 1984, MY's present storage capacity of the spent fuel pool at the unit will be reached in 1999, and after 1996 the available capacity of the pool will not accommodate a full-core removal. After consideration of available technologies, MYAPC elected to provide additional capacity by replacing the fuel racks in the spent fuel pool at the unit and, on January 25, 1993, filed with the NRC seeking authorization to implement the plan. MYAPC believes that the replacement of the fuel racks, if approved, will provide adequate storage capacity through the unit's licensed operating life. While no intervention has occurred, MYAPC cannot predict with certainty whether the NRC authorization will be granted or whether or to what extent the storage capacity limitation at the unit will affect the operation of the unit or the future cost of disposal. Under the terms of a license amendment approved by the NRC in 1991, the storage capacity of the spent fuel pool at VY is expected to be reached in 2003, and the available capacity of the pool is not expected to be able to accommodate a full-core removal after 1998. Because the Yankee Rowe plant was permanently shut down effective February 26, 1992, YAEC is planning to construct a temporary facility to store the spent nuclear fuel produced by the Yankee Rowe plant over its operating lifetime until that fuel is removed by the DOE. See "Electric Operations - Nuclear Generation - Decommissioning" for further information on the closing and decommissioning of Yankee Rowe. LOW-LEVEL RADIOACTIVE WASTES Disposal costs for low-level radioactive wastes (LLRW) have continued to rise in recent years despite significant reductions in volume. Approximately $7.65 million was spent on LLRW disposal for the Millstone units and CY in 1993. In accordance with the provisions of the federal Low-Level Radioactive Waste Policy Act of 1980, as amended (the Waste Policy Act), on December 31, 1992 the disposal site at Beatty, Nevada closed, and the Richland, Washington facility closed to disposal of LLRW from outside its compact region. During 1992, the Barnwell, South Carolina site announced its intention to remain open for disposal of out-of-region LLRW until June 30, 1994. In November 1992, the Northeast Compact commission entered into an agreement with the Southeast Interstate Low-Level Radioactive Waste Management Compact (the Southeast Compact) commission providing for continued access to the Barnwell facility until June 30, 1994 by Connecticut LLRW generators, and the System agreed to pay, in addition to disposal fees, an access fee of $220 per cubic foot, with a minimum of $4.73 million, for the right to dispose of LLRW at Barnwell during this period. The Connecticut Hazardous Waste Management Service (the Service), a state quasi-public corporation, is charged with coordinating the establishment of a facility for disposal of LLRW originating in Connecticut. In June 1991, the Service announced that it had selected three potential sites in north-central Connecticut for further study. The Service's announcement provoked intense controversy in the affected municipalities and resulted in legislative action to stop the selection process. On February 1, 1993, the Service presented the legislature with a new site selection plan under which communities are urged to volunteer a site for a facility in return for financial and other incentives. The volunteer process is being continued in 1994. The Service's activities in this regard are funded by assessments on Connecticut's LLRW generators. The System was assessed approximately $1.8 million for the state's 1992-1993 fiscal year. Due to the change to a volunteer process, there was no assessment for the 1993-1994 fiscal year and the state projects no assessment for the 1994-1995 and 1995-1996 fiscal years. The System has plans to acquire or construct additional LLRW storage capacity at the Millstone and CY sites to provide for temporary storage of LLRW should that become necessary. The System can manage its Connecticut LLRW by volume reduction, storage or shipment at least through 1999. Management cannot predict whether and when a disposal site will be designated in Connecticut. Since January 1, 1989, the State of New Hampshire has been barred from shipping Seabrook LLRW to the operating disposal facilities in South Carolina, Nevada and Washington for failure to meet the milestones required by the Waste Policy Act. Seabrook 1 has never shipped LLRW but has capacity to store at least five years' worth of the LLRW generated on-site, with the capability to expand this on-site capacity if necessary. The Seabrook station accrued approximately $1.3 million in off-site disposal costs in 1993. New Hampshire is pursuing options for out-of-state disposal of LLRW generated at Seabrook. Massachusetts and Vermont have arranged for continued access to the Barnwell facility until mid-1994 for the nuclear waste generators in their states. YAEC is currently disposing of its LLRW at the Barnwell facility. MY has been storing its LLRW on-site since January 1993. VY and MY each has on-site storage capacity for at least five years' production of LLRW from its respective plants. Maine and Vermont are in the process of finalizing an agreement with the state of Texas to provide access to a facility that will be developed in that state. DECOMMISSIONING The System's most recent comprehensive site-specific updates of the decommissioning costs for each of the three Millstone units were completed in 1992 and for Seabrook was completed in 1991. The recommended decommissioning method reflected in the cost estimates continues to be immediate and complete dismantlement of those units at their retirement. The table below sets forth the estimated Millstone and Seabrook decommissioning costs for the System companies. The estimates are based on the latest site studies, escalated to December 31, 1993 dollars, and include costs allocable to NAEC's share of Seabrook recently acquired from VEG&T. CL&P PSNH WMECO NAEC NU System (Millions) Millstone 1 $312.5 $ - $ 73.3 $ - $385.8 Millstone 2 251.0 - 58.9 - $309.9 Millstone 3 223.0 12.0 51.6 - 286.6 Seabrook 1 14.9 - - 131.7 146.6 Total $801.4 $12.0 $183.8 $131.7 $1,128.9 Pursuant to Connecticut law, CL&P has periodically filed plans with the DPUC for financing the decommissioning of the three Millstone units. In 1986, the DPUC approved the establishment of separate external trusts for the currently tax-deductible portions of decommissioning expense accruals for Millstone 1 and 2 and for all expense accruals for Millstone 3. In its 1993 CL&P multi-year rate case decision, the DPUC allowed CL&P's full decommissioning estimate for the three Millstone units to be collected from customers. This estimate includes an approximately 16 percent contingency factor for each unit. The estimated aggregate cost of decommissioning the Millstone units is $1.1 billion in December 1993 dollars. WMECO has established independent trusts to hold all decommissioning expense collections from customers. In its 1990 WMECO multi-year rate case decision, the DPU allowed WMECO's decommissioning estimate for the three Millstone units ($840 million in December 1990 dollars) to be collected from customers. Due to the settlement in the 1992 WMECO rate case, the aggregate decommissioning estimate for the three Millstone units remains unchanged. The decommissioning cost estimates for the Millstone units are reviewed and updated regularly to reflect inflation and changes in decommissioning requirements and technology. Changes in requirements or technology, or adoption of a decommissioning method other than immediate dismantlement, could change these estimates. CL&P, PSNH and WMECO attempt to recover sufficient amounts through their allowed rates to cover their expected decommissioning costs. Only the portion of currently estimated total decommissioning costs that has been accepted by regulatory agencies is reflected in rates of the System companies. Although allowances for decommissioning have increased significantly in recent years, ratepayers in future years will need to increase their payments to offset the effects of any insufficient rate recoveries in previous years. New Hampshire enacted a law in 1981 requiring the creation of a state-managed fund to finance decommissioning of any units in that state. In 1992, the New Hampshire Nuclear Decommissioning Financing Committee (NDFC) established approximately $323 million (in 1991 dollars) as the decommissioning cost estimate for immediate and complete dismantlement of Seabrook 1 upon its retirement. On March 10, 1993, FERC approved this estimate. The estimated total decommissioning cost for Seabrook 1 is $366 million in December 1993 dollars. The NHPUC is authorized to permit the utilities subject to its jurisdiction that own an interest in Seabrook 1 to recover from their customers on a per-kilowatt-hour basis amounts paid into the decommissioning fund over a period of years. NAEC's costs for decommissioning are billed by it to PSNH and recovered by PSNH under the Rate Agreement. Under the Rate Agreement, PSNH is entitled to a base rate increase to recover increased decommissioning costs. See "Rates - New Hampshire Retail Rates" for further information on the Rate Agreement. North Atlantic submitted its annual update of the 1991 Decommissioning Study and Funding Schedule to the NDFC on March 31, 1993. It included an updated estimate for the prompt removal and dismantling of Seabrook station in 2026 at the end of licensed life and a review of the assumptions on inflation and rate-of-return on fund investments used to develop the joint owner contribution schedule. North Atlantic concluded that the 1991 estimate, escalated in accordance with these assumptions to 1993 dollars, is still valid. Although a schedule has not been set by the NDFC, public hearings on the decommissioning estimate and funding schedule will probably be held in the third quarter of 1994. The new Investment Guidelines for the Seabrook Nuclear Decommissioning Financing Fund, which were approved by the New Hampshire State Treasurer and would have gone into effect on November 1, 1993, have been put on hold by a recent decision of FERC. The October 20, 1993 FERC order effectively reinstated the so-called "black lung" investment restrictions on decommissioning funds subject to its jurisdiction, although Congress, in the Energy Policy Act, had repealed the IRS regulation which mandated them. Under these restrictions, investments are limited to public debt securities that are fully backed by the U.S. government, tax exempt obligations of state or local governments and time deposits with a bank or insured credit union. The new guidelines would allow equity holdings by the joint owners of Seabrook, beginning with a limit of 10 percent in 1994 and gradually increasing to a limit of 40 percent in 1997. The strategies also call for a gradual reduction in the equity position as the plant approaches the end of its licensed life. Implementation of new investment guidelines for the Millstone units and CY have also been delayed because of the FERC decision. The System is party to petitions filed with FERC in November 1993, seeking reconsideration of the FERC decision. As of December 31, 1993, the balances (at cost) in the external decommissioning trust funds were as follows: Millstone 1 Millstone 2 Millstone 3 Seabrook 1 (Millions of Dollars) CL&P........... $70.4 $45.5 $30.9 $ .9 PSNH........... * * 1.5 * WMECO.......... 24.0 16.5 8.6 * NAEC........... * * * 7.9 _____ _____ _____ ____ Total........ $94.4 $62.0 $41.0 $8.8 *PSNH has no ownership interest in the Millstone 1 and 2 units. WMECO has no ownership interest in Seabrook 1. NAEC's only ownership interest is in Seabrook 1. YAEC, MYAPC, VYNPC and CYAPC are all collecting revenues for decommissioning from their power purchasers. The table below sets forth the estimated decommissioning costs of the Yankee units for the System companies. The estimates are based on the latest site studies, escalated to December 31, 1993 dollars. For information on the equity ownership of the System companies in each of the Yankee units, see "Electric Operations - Nuclear Generation - General." CL&P PSNH WMECO NU System (Millions) CY $117.3 $17.0 $32.3 $166.6 MY 38.8 16.2 9.7 64.7 VY * * * * Yankee Rowe 68.7 19.6 19.6 107.9 ______ _____ _____ ______ Total $255.3 $65.6 $69.6 $390.5 *VYNPC is currently reestimating the cost of decommissioning VY. Based on recent estimates for comparable units, the projected cost is expected to fall into the $300 - $350 million range. The System's share of these costs is expected to be between $48 million and $56 million. The results of the VYNPC study are expected to be available in the spring of 1994. In June 1992, YAEC filed a rate filing to obtain FERC authorization for an increase in rates to cover the costs of closing and decommissioning the Yankee Rowe plant and for the recovery of the remaining investment in the unit over the remaining period of its NRC operating license. At December 31, 1993, the System's share of these estimated costs was approximately $132.8 million. A settlement agreement among YAEC, the FERC staff and intervenors to the FERC proceeding addressing all issues has been filed with and accepted by FERC. YAEC has submitted its decommissioning plan to the NRC for approval. Due to the unexpected continued availability of the low level waste disposal facility in Barnwell, South Carolina, YAEC requested NRC permission to use decommissioning funds prior to final NRC approval of the complete plan. On April 16, 1993, the NRC approved YAEC's request to use funds for removal of the steam generators, pressurizer and reactor internals. By December 31, 1993, all major components were successfully disposed of at Barnwell and only a small number of internals shipments remain to be made. YAEC will continue its dismantling of the plant in 1994. The NRC's review of the decommissioning plan is expected to be completed by December 31, 1994 at which time YAEC will, depending upon the availability of a low level waste site, move to completely dismantle the facility. CYAPC accrues decommissioning costs on the basis of immediate dismantlement at retirement. The most current estimated decommissioning cost, based on a 1992 study, is approximately $339.9 million in year-end 1993 dollars. As a result of a 1987 study approved by FERC, CYAPC has been accruing expenses based on an estimated decommissioning level of $130 million. On October 30, 1992, CYAPC filed with FERC a proposed change in rates to recover the increase in estimated decommissioning costs. On May 11, 1993, FERC approved a settlement agreement allowing a decommissioning estimate of $294.2 million (in July 1992 dollars) to be recovered in rates effective June 1, 1993. See "Electric Operations - Nuclear Generation - Operations - Yankee Units." In 1984, CYAPC established an independent irrevocable decommissioning trust fund, which was modified for tax purposes in 1987 to create two trusts. Each month, CYAPC's sponsors are billed for their proportionate share of decommissioning expense as allowed by FERC and payments are made directly to the trust. The combined balance of the trusts at December 31, 1993 was $137.8 million. The trust balances must be used exclusively to discharge decommissioning costs as incurred. MYAPC estimates the cost of decommissioning MY at $323.7 million in December 31, 1993 dollars based on a study completed in July 1993. NON-UTILITY BUSINESSES GENERAL In addition to its core electric utility businesses in Connecticut, New Hampshire and Massachusetts, in recent years the System has begun a diversification of its business activities into two energy-related fields: private power development and energy management services. PRIVATE POWER DEVELOPMENT In 1988, NU organized a new subsidiary corporation, Charter Oak, through which the System participates as a developer and investor in domestic and international private power projects. With the passage of the Energy Policy Act, Charter Oak can invest in cogeneration and small power production (SPP) facilities anywhere in the world. This legislation also expands Charter Oak's permissible involvement in exempt wholesale generators (EWGs) to include development, construction and ownership. Management currently does not permit Charter Oak to invest in facilities which are located within the System service territory or to sell its electric output to any of the System electric utility companies. For a discussion of certain highlights of the Energy Policy Act relating to EWGs, see "Regulatory and Environmental Matters - - Public Utility Regulation." Under the Public Utility Regulatory Policies Act of 1978 (PURPA), as a subsidiary of an electric utility holding company, Charter Oak is effectively limited to no more than 50 percent ownership in a QF within the United States. To work within this constraint, Charter Oak has made strategic alliances with several experienced developers to pursue development opportunities. Through these relationships, Charter Oak is pursuing development opportunities nationwide and internationally. Although Charter Oak has no full-time employees, eight NUSCO employees are dedicated to Charter Oak activities on a full-time basis. Other NUSCO employees provide services as required. Charter Oak owns, through a wholly-owned special purpose subsidiary, a ten percent equity interest in a 220 MW natural gas-fired combined cycle cogeneration QF in Texas which provides steam to Campbell Soup Company's Paris, Texas manufacturing facility and electricity to Texas Utilities Electric Company. Charter Oak also owns 56 MW of the 1,875 MW Teesside natural gas-fired cogeneration facility in the United Kingdom. Charter Oak is pursuing other project development opportunities in both the domestic and international markets with a combined capacity over 1,000 MW. Charter Oak is currently participating in the development stage of projects in Texas, the West Coast, the Midwest, Latin America and the Pacific Rim. NU's total investment in Charter Oak was approximately $23.0 million as of December 31, 1993. NU, Charter Oak and its subsidiary, Charter Oak Energy Development, have received approval from the SEC to increase NU's authorized investment in Charter Oak to up to $100 million and to increase Charter Oak's authorized investment in COE Development to up to $100 million for preliminary development activities in QFs, IPPs, EWGs and foreign utility companies. ENERGY MANAGEMENT SERVICES In 1990, NU organized a new subsidiary corporation, HEC, which acquired substantially all of the assets and personnel of an existing, non-affiliated energy management services company. In general, the energy management services that HEC provides are performed for customers pursuant to contracts to reduce the customers' overall energy consumption and reduce energy costs and/or conserve energy resources. HEC also provides demand side management consulting services to utilities. HEC's energy management and consulting services are directed primarily to the commercial, industrial and institutional markets and utilities in New England and New York, although the SEC's order under the 1935 Act that authorized NU to operate HEC also permits HEC to serve customers outside that area, so long as over half of its revenues are attributable to customers in New England and New York. NU's initial equity investment in HEC was approximately $4 million and NU has made additional capital contributions of approximately $300,000 through March 1, 1994. Under the SEC order authorizing HEC's participation in the Money Pool, HEC may borrow up to $11 million from the Money Pool. At December 31, 1993, HEC had $2.9 million outstanding from its borrowings from the Money Pool. REGULATORY AND ENVIRONMENTAL MATTERS PUBLIC UTILITY REGULATION NU is registered with the SEC as an electric utility holding company under the 1935 Act. Under the 1935 Act, the SEC has jurisdiction over NU and its subsidiaries with respect to, among other things, securities issues, sales and acquisitions of securities and utility assets, intercompany loans, services performed by and for associated companies, accounts and records, involvement in non-utility operations and dividends. The Energy Policy Act amended the 1935 Act to give registered holding companies, like NU, broadened authority to invest in small power production facilities qualifying under PURPA and to own a new class of IPPs known as EWGs. An EWG is an entity exclusively in the business of owning and/or operating generating facilities that sell electricity at wholesale. EWGs are exempt from most regulation under the 1935 Act. A registered holding company may also invest in foreign utility companies with SEC approval. EWGs, however, are subject to state regulation with respect to siting and financial regulation to prevent cross-subsidies and self-dealing among utilities and affiliated EWGs. The Energy Policy Act also amended the Federal Power Act to authorize FERC to order wholesale transmission wheeling services, including the enlargement of transmission capacity necessary to provide such services, unless such transmission would unreasonably impair the reliability of the electric systems affected or the utility ordered to provide transmission is unable to obtain necessary governmental approvals or property rights. Rates for transmission ordered under the Energy Policy Act are to be designed to protect the wheeling utilities' existing customers. FERC's authority to order wheeling does not extend to retail wheeling, and FERC may not issue a wheeling order that is inconsistent with state franchise laws. CL&P is subject to regulation by the DPUC, which has jurisdiction over, among other things, retail rates, accounting procedures, certain dispositions of property and plant, mergers and consolidations, securities issues, standards of service, management efficiency and construction and operation of generation, transmission and distribution facilities. Because of their ownership interests in the Millstone units, PSNH and WMECO are also subject to the jurisdiction of the DPUC with respect to their activities in Connecticut and their securities issues. PSNH and NAEC are subject to regulation by the NHPUC, which has jurisdiction over retail rates, accounting procedures, certain dispositions of property and plant, quality of service, securities issues, acquisitions of securities of other utilities, mortgages of property, declaration of dividends, contracts with affiliates, management efficiency, construction and operation of generation, transmission and distribution facilities, integrated resource planning and other matters. Although the Seabrook Power Contract between PSNH and NAEC is a wholesale contract subject to the jurisdiction of FERC, pursuant to the terms of the Rate Agreement, the NHPUC has the right to review the prudence of costs incurred by NAEC to determine whether they should be passed on to ratepayers through FPPAC, and the NHPUC and the State of New Hampshire have additional rights and limited jurisdiction over certain other Seabrook Power Contract issues. NU and its subsidiaries are subject to the general supervision of the NHPUC with respect to all dealings with PSNH and NAEC. Based upon PSNH's ownership of generating and transmission facilities in Maine and transmission and hydroelectric facilities in Vermont, PSNH is also subject to limited regulatory jurisdiction in those states. WMECO is subject to regulation by the DPU, which has jurisdiction over retail rates, accounting procedures, quality of service, contracts for the purchase of electricity, mergers, securities issues and other matters. The DPU has adopted regulations that provide for DPU preapproval of utility plant construction, procurement of non-utility generation (QFs and IPPs), and C&LM programs. HWP is subject to regulation by the DPU with respect to certain contracts and quality of service. NU and its subsidiaries are subject to the general supervision of the DPU with respect to all dealings with WMECO and HWP. CL&P is subject to the jurisdiction of the NHPUC for limited purposes in connection with its ownership interest in Seabrook. CL&P, PSNH, WMECO, NAEC and HWP are public utilities under Part II of the Federal Power Act and are subject to regulation by the FERC with respect to, among other things, interconnection and coordination of facilities, wholesale rates and accounting procedures. The System incurs substantial capital expenditures and operating expenses to identify and comply with environmental, energy, licensing and other regulatory requirements, including those described in the following subsections, and it expects to incur additional costs to satisfy further requirements in these and other areas of regulation. Because of the continually changing nature of regulations affecting the System, the total amount of these costs is not determinable. The System has active auditing programs addressing a variety of legal and regulatory areas, including an environmental auditing program. To the extent it is determined that a System operation or facility is not in full compliance with applicable environmental or other laws or regulations, the System attempts to resolve non-compliance through the auditing response process or other management processes. Compliance with existing and proposed regulations also affects the time needed to complete new facilities or to modify present facilities, and it affects System companies' rates, sales, revenues and net income, all in ways that may be substantial but are not readily calculable. NRC NUCLEAR PLANT LICENSING The operators of the Millstone 1, 2 and 3 units, the CY, MY and VY and Seabrook 1 all have full term full power operating licenses from the NRC. The following table sets forth the current license expiration dates for each unit: Operating License Unit Expiration Date (*) Millstone 1 October 6, 2010 Millstone 2 July 31, 2015 Millstone 3 November 25, 2025 Seabrook 1 October 17, 2026 CY June 29, 2007 MY October 21, 2008 VY March 21, 2012 _________________________ (*) For all units except Seabrook 1 and MY, the current operating license expires 40 years from the date the operating licensee was issued. The Seabrook license expires 40 years from the date on which the NRC issued a license for the unit to load nuclear fuel, which was about 3 1/2 years before the full power operating license was issued. MY's operating license expires 40 years from the date the construction license was issued, which was about four years before the operating license was issued. The System will determine at the appropriate time whether to seek to recapture these periods and add them to the operating license terms for those units. YAEC had been working with the NRC on a preliminary analysis to extend the license expiration date for Yankee Rowe from 2000 to 2020, but that effort was suspended when the unit was shut down for evaluation. YAEC received a "possession only" license from the NRC in August 1992. See "Electric Operations - Nuclear Generation - Operations - Yankee Units" for further information on the decision to shut down the Yankee Rowe unit permanently. Currently the NRC issues 40-year operating licenses to nuclear units. In December 1991, the NRC issued a final rule that establishes the requirements that must be met by an applicant for renewal of a nuclear power plant operating license, the information that must be submitted to the NRC for review, so that the agency can determine whether those requirements have in fact been met, and the application procedures that must be used to obtain an extension of a nuclear plant operating license beyond 40 years. A renewal license may be granted for not more than 20 years beyond the current licensed life. The licensing requirements for a nuclear plant during the renewal term will consist of the plant's current licensing requirements and new commitments to monitor, manage, and correct age-related degradation of plant systems, structures, and components that is unique to the license renewal term but will not encompass the higher licensing standards imposed on new plants. An opportunity for a formal public hearing is provided to permit interested persons to raise contentions on the adequacy of the renewal applicant's proposals to address age-related degradation and compliance with applicable requirements relating to an environmental impact statement. The NRC rule was challenged on antitrust grounds and upheld in the District of Columbia Court of Appeals. ENVIRONMENTAL REGULATION GENERAL The National Environmental Policy Act (NEPA) requires that detailed statements of the environmental effects of major federal actions be prepared by federal agencies. Major federal actions can include licenses or permits issued to the System by FERC, NRC and other federal agencies for construction or operation of generation and transmission facilities. NEPA requires that federal licensing agencies make an independent evaluation of the alternatives and environmental impacts of the proposed actions. Under Connecticut law, major generation or transmission facilities may not be constructed or significantly modified without a certificate of environmental compatibility and public need from the Connecticut Siting Council (CSC). After public hearings, CSC may issue the certificate, which addresses the public need for the facility and probable environmental impact of the facility and may impose specific conditions for protection of the environment. In New Hampshire, construction of major new generation or transmission facilities, or sizeable additions to existing facilities, requires a certificate of site and facility from the New Hampshire Site Evaluation Committee (NHSEC) and NHPUC under the state's energy facility siting law. In addition to review by all state agencies having jurisdiction over any aspect of the construction or operation of the proposed facility, the law requires full review by NHSEC of the environmental impact of the proposed site or route after allowing for public comment and conducting public hearings. Issuance of a certificate requires, among other findings, a finding that the proposed site and facility will not have an unreasonable adverse effect on environmental values. Massachusetts law requires all state agencies to determine the environmental impact of any projects proposed by private companies requiring state permits, or involving state funding or participation. Massachusetts state agencies are required to make a finding that all feasible measures have been taken to avoid or minimize the environmental impact of the project. In certain instances, Massachusetts law also requires the preparation and dissemination, among various state agencies, of an environmental impact report for the proposed project. Major generation or transmission facilities may not be constructed or significantly modified without approval by the Massachusetts Energy Facilities Siting Board; new transmission facilities also require approval by the DPU. The System anticipates that additional environmental legislation will be seriously considered by Congress and state legislatures in the coming years. The issues of global warming, air pollution, hazardous waste handling and disposal and water pollution control are receiving a significant amount of public and political attention and are likely areas for federal or state legislative activity in the near future. Until and unless any such legislation is enacted and implementing regulations are issued, the effects on the System cannot be determined. Compliance with environmental laws and regulations, particularly air and water pollution control requirements, may limit operations or require substantial investments in new equipment at existing facilities. Such laws and regulations may also require substantial investments that are not included in the estimated construction budget set forth herein. See "Resource Plans" for a discussion of the System's construction plans. SURFACE WATER QUALITY REQUIREMENTS The federal Clean Water Act (CWA) provides that every "point source" discharger of pollutants into navigable waters must obtain a National Pollutant Discharge Elimination System (NPDES) permit from EPA specifying the allowable quantity and characteristics of its effluent. To obtain an NPDES permit, a discharger must meet technology-based and biologically-based effluent standards and must also demonstrate that its effluent will not cause a violation of established standards for the quality of the receiving waters. Connecticut, Massachusetts and New Hampshire regulations contain similar permit requirements and these states can impose more stringent requirements. All of the System's steam-electric generating plants have NPDES permits in effect. Any of the permits may be reopened to incorporate more stringent regulations adopted by EPA or state environmental agencies. Compliance with NPDES and state water discharge permit requirements has necessitated substantial expenditures and may require further expenditures because of additional requirements that could be imposed in the future. The CWA requires EPA and state permitting authorities to approve the cooling water intake structure design and thermal discharge of steam-electric generating plants. All System steam-electric plants have received these approvals. In the renewed discharge permit for the three Millstone nuclear units, issued in 1992, CDEP included a condition requiring a feasibility study of various structural or operational modifications of the cooling water intake system to reduce the entrainment of winter flounder larvae. This study was submitted to CDEP in January 1993 and includes analyses of the costs and benefits of each alternative considered. The costs ranged from $1.8 million to $519 million. The study concluded that the substantial incremental costs of each of the alternatives studied are not justified by the small benefits to the winter flounder population. In a letter dated January 14, 1994, CDEP approved the report requiring only that Millstone station continue efforts to schedule refueling outages to coincide with the period of high winter flounder larvae abundance and that the station continue to monitor the Niantic River winter flounder population in accordance with existing NPDES permit conditions. Merrimack station's NHDES discharge permit requires site work to isolate adjacent wetlands from the station's waste water system. Plans have been approved by the New Hampshire Department of Environmental Services (NHDES), and PSNH is now preparing a permit application to begin construction. The new permit may require PSNH to perform further biological studies because significant numbers of migratory fish are being restored to lower reaches of the Merrimack River. Should the studies indicate that Merrimack Station's once-through cooling system interferes with the establishment of a balanced aquatic community, PSNH could be required to construct a partially enclosed cooling water system for Merrimack station. The amount of capital expenditures relating to the foregoing cannot be determined at this time. However, if such expenditures were to be required, they would likely be substantial and a reduction of Merrimack station's net generation capability could result. The ultimate cost impact of the CWA and state water quality regulations on the System cannot be estimated because of uncertainties such as the impact of changes to the effluent guidelines or water quality standards. Additional modifications, in some cases extensive and involving substantial cost, may ultimately be required for some or all of the System's generating facilities. In response to several major oil spills in recent years, Congress passed the Oil Pollution Act of 1990 (OPA 90). OPA 90 sets out the requirements for facility response plans and periodic inspections of spill response equipment at certain facilities. The requirements apply to facilities that can cause substantial harm or significant and substantial harm to the environment by discharging oil or hazardous substances into the navigable waters of the United States and adjoining shorelines. Pursuant to OPA 90, EPA has authority to regulate non-transportation-related fixed onshore facilities and the Coast Guard has the authority to regulate transportation-related onshore facilities. Response plans were filed for all System facilities believed to be subject to this requirement. EPA and the Coast Guard have reviewed these plans and accepted the information provided in them as certification of contracted resources for response to a worst case discharge. The Coast Guard expects to complete its review process by February 17, 1995, and EPA by August 18, 1995. Both agencies have authorized continued operation pending final plan approval. OPA 90 includes limits on the liability that may be imposed on persons deemed responsible for release of oil. The limits do not apply to oil spills caused by negligence or violation of laws or regulations. OPA 90 also does not preempt state laws regarding liability for oil spills. In general, the laws of the states in which the System owns facilities and through which the System transports oil could be interpreted to impose strict liability for the cost of remediating releases of oil and for damages caused by releases. The System and its principal oil transporter currently carry a total of $890 million in insurance coverage for oil spills. AIR QUALITY REQUIREMENTS Under the federal Clean Air Act, EPA has promulgated national ambient air quality standards for certain air pollutants, including sulfur dioxide, particulate matter, nitrogen oxides and ozone. EPA has approved a Connecticut implementation plan prepared by CDEP, a New Hampshire plan prepared by NHDES and a Massachusetts plan prepared by MDEP for the achievement and maintenance of these standards. The Connecticut, New Hampshire and Massachusetts plans impose limits on the amounts of various airborne pollutants that can be emitted from utility boilers. Under the Clean Air Act, emissions from new or substantially modified sources are limited by new source performance standards and very strict technology-based emission limits. The Clean Air Act Amendments of 1990 (CAAA) made extensive revisions and additions to the Clean Air Act and imposed many stringent new requirements on air emissions sources. The CAAA contains provisions further regulating emissions of sulfur dioxide (SO2) and nitrogen oxides (NOX) for the purpose of controlling acid rain, toxic air pollutants and other pollutants, requiring installation of continuous emissions monitors (CEMs) and expanding permitting provisions. Existing and additional federal and state air quality regulations could hinder or possibly preclude the construction of new, or modification of existing, fossil units in the System's service area, could raise the capital and operating cost of existing units, and may affect the operations of the System's work centers and other facilities. The ultimate cost impact of these requirements on the System cannot be estimated because of uncertainties about how EPA and the states will implement various requirements of the CAAA. NOX. The CAAA identifies NOX emissions as a precursor of ambient ozone for the northeastern region of the United States, much of which is in violation of the ambient air quality standard for ozone. Pursuant to the CAAA, Connecticut, New Hampshire and Massachusetts must implement plans to address ozone nonattainment. Probable actions include additional NOX controls that could impose costs on the System's generating units. The capital cost to comply with 1995's anticipated Phase I requirements is expected to approximate $10 million for CL&P, $11 million for PSNH, $1 million for WMECO and $3 million for HWP, while compliance costs for Phase II, effective in 1999, could be substantially higher depending on the level of NOX reductions required. Costs for meeting the 1999 NOX emission reduction requirements cannot be estimated at this time. Connecticut and New Hampshire have not as yet issued final regulations to implement NOX reduction requirements, although both have previously indicated that they will attempt to achieve NOX reduction requirements at the lowest possible costs. The System companies are in the process of reviewing compliance strategies and costs and of providing input to state environmental regulators. Massachusetts issued final NOX Reasonably Available Control Technology (RACT) rules in September, 1993. In December 1993, PSNH reached a revised agreement regarding NOX emissions with various environmental groups and the New Hampshire Business and Industrial Association. The agreement has been submitted to the New Hampshire Air Resources Division (NHARD) in the form of proposed regulations. The agreement provides for aggressive unit specific NOX emission rate limits for PSNH's generating facilities, effective May 31, 1995. The agreement no longer requires a PSNH commitment to retire or repower Merrimack Unit 2 by May 15, 1999, however more stringent emission rate limits equivalent to the range of 0.1 to 0.4 pounds of NOX per million Btu are required for the unit by that date. PSNH recently received an amendment to its Permit to Operate for Merrimack Unit 1 from NHARD to allow the testing of wood chips as a fuel. Testing has begun and if it is successful it may assist PSNH in compliance with the CAAA. SO2. The CAAA mandates reductions in sulfur dioxide (SO2) emissions to control acid rain. These reductions are to occur in two phases. First, high SO2 emitting plants are required to reduce their emissions beginning January 1, 1995. The only System units subject to the Phase I reduction requirements are PSNH's Merrimack Units 1 and 2. Management plans to meet the requirements of both Phase I and Phase II by burning low sulfur fuels and substituting (i.e. adding) Newington and Mt. Tom stations as Phase I units, if allowed by EPA regulations. On January 1, 2000, the start of Phase II, a nationwide cap of 8.9 million tons per year of utility SO2 emissions will be imposed and existing units will be granted allowances to emit SO2. These allowances are freely tradable. One allowance entitles a source to emit one ton of SO2 in a year. No unit may emit more SO2 in a particular year than the amount for which it has allowances. The System expects to be allocated allowances by EPA that substantially exceed its expected SO2 emissions for 2000 and subsequent years. In 1993, the System agreed to donate, subject to regulatory approval, 10,000 of its surplus SO2 allowances to the American Lung Association thereby effectively preventing 10,000 tons of SO2 from being emitted into the atmosphere. The System expects to be able to sell some of its surplus allowances. The price of allowances depends on the market. The amount of surplus allowances and the allocation of the revenues received from such sales between ratepayers and shareholders have not been determined. On February 15, 1993, as required by the CAAA, PSNH filed Phase I Acid Rain Permit Applications for Merrimack Station. In addition, as allowed by the CAAA, PSNH designated its Newington station unit, and HWP designated its Mt. Tom unit, as conditional Phase I substitution units. EPA is currently reviewing whether it will accept Newington and Mt. Tom as substitution units and the number of allowances each will be awarded. All Phase I units, including substitution units accepted by EPA, will be allocated SO2 allowances for the period 1995-1999. On December 31, 1992, pursuant to Connecticut Public Act 92-106, CL&P filed a report with the Energy and Public Utilities Committee of the Connecticut General Assembly and the DPUC describing its plan for allocation of revenues from sale of SO2 allowances. CL&P proposed that its shareholders receive 20 percent of the proceeds from sales of allowances to compensate for the risks they have taken to reduce CL&P's SO2 emissions and to provide appropriate incentive to CL&P to sell allowances at the maximum price. In 1993 the DPUC approved a proposal by The United Illuminating Company (UI) to grant an option to another utility for the purchase of SO2 allowances, and ruled that shareholders would receive 15 percent of the proceeds from the eventual sale. The DPUC opened a docket and held hearings to review the reports filed by CL&P and UI. This review is addressing development of a policy on allocation between shareholders and ratepayers of SO2 allowance proceeds as well as CL&P's allowance donation. CDEP's air quality regulations permit CL&P to burn 1.0 percent sulfur oil at oil-fired generating stations in Connecticut, except that 0.5 percent sulfur oil must be burned at Middletown station. Current CDEP policy requires CL&P to use 0.5 percent or lower sulfur oil when replacing older (1.0 percent sulfur oil fueled) plant auxiliary boilers needed for unit start-up and plant space heating. The regulations also permit the burning of coal with a sulfur content of up to 0.7 percent at CL&P's plants, or up to 1.0 percent if a special permit is obtained. New Hampshire air quality regulations permit PSNH to emit 55,150 tons of SO2 annually. The New Hampshire acid rain control law required a 25 percent reduction in SO2 emissions from the 1979-1982 baseline emissions at PSNH's units, which has been achieved. Compliance with New Hampshire's acid rain control law has brought PSNH very close to compliance with the SO2 emission limits of Phase I of the CAAA. PSNH may need to install additional pollution control equipment or use fuel with lower sulfur content in order to meet the requirements of the CAAA. The EPA has issued an order requiring modeling of the impact on ambient air quality of SO2 emissions from Merrimack Station. Work on this study has begun and the final results of the modeling are expected to be available in mid-1995. If the modeling study indicates that compliance with the primary ambient air quality standards for SO2 is not being achieved, additional control strategies, possibly including the addition of emission control devices or a higher stack, will be required. Management cannot at this time predict the results of the modeling or estimate the cost of any additional control strategies that may be required. The Massachusetts air quality regulations permit HWP to burn 1.5 percent sulfur coal with an ash content up to 9 percent at Mt. Tom Station. Coal with a higher ash content can be burned with MDEP approval. Mt. Tom Station is required to reduce sulfur emissions to the equivalent of 1.0 percent sulfur oil if certain air quality monitors show levels of SO2 approaching ambient air quality limits. WMECO's West Springfield station currently burns 1.0 percent sulfur oil or natural gas. The Massachusetts acid rain control law requires MDEP to adopt regulations to limit future sulfur dioxide emissions. These regulations limit the allowable SO2 emissions from utility power plants and other major fuel burning sources to 1.2 pounds per million BTUs averaged over all of the System's Massachusetts plants, effective January 1, 1995. The System's generating plants in Massachusetts on average emit approximately 1.9 pounds of SO2 per million BTUs. The System expects to meet the new sulfur dioxide limitation by using natural gas and lower sulfur oil and coal in its plants. The System could incur additional costs for the lower sulfur fuels it may burn to meet the requirements of this legislation. Under the existing fuel adjustment clauses in Connecticut, New Hampshire and Massachusetts, the System would be able to recover the additional fuel costs of compliance with the CAAA and state laws from its customers. Management does not believe that the acid rain provisions of the CAAA will have a significant impact on the System's overall costs or rates due to the very strict limits on SO2 emissions already imposed by Connecticut, New Hampshire and Massachusetts and on NOX limitations imposed by Connecticut and New Hampshire. EPA, Connecticut, New Hampshire and Massachusetts regulations also include other air quality standards, emission standards and monitoring, and testing and reporting requirements that apply to the System's generating stations. They require that new or modified fossil fuel-fired electric generating units operate within stringent emission limits. Air Toxics. Title III of the CAAA imposes new stringent discharge limitations on hazardous air pollutants. EPA is required to study toxic emissions and mercury emissions from power plants. Pending completion of these studies, power plants are exempt from the hazardous air pollutant requirements. Should EPA or Congress determine that power plant emissions must be controlled to the same extent as emissions from other sources under Title III, the System could be required to make substantial capital expenditures to upgrade or replace pollution control equipment, but the amount of these expenditures cannot be readily estimated. Connecticut and New Hampshire have enacted, and Massachusetts is considering, toxic air pollution regulations limiting emissions of numerous substances that may extend beyond those regulated under federal law. TOXIC SUBSTANCES AND HAZARDOUS WASTE REGULATIONS PCBs. Under the federal Toxic Substances Control Act of 1976 (TSCA), EPA has issued regulations that control the use and disposal of polychlorinated biphenyls (PCBs). PCBs had been widely used as insulating fluids in many electric utility transformers and capacitors before TSCA prohibited any further manufacture of such PCB equipment. System companies have taken numerous steps to comply with these regulations and have incurred increased costs for disposal of used fluids and equipment that are subject to the regulations. One disposal measure involves the System's burning of some waste oil with a low level of PCB contamination (up to 500 parts per million (ppm)) as supplemental fuel at CL&P's Middletown station Unit 3. EPA and CDEP have approved this disposal method. In general, the System sends fluids with concentrations of PCBs equal to or higher than 500 ppm but lower than 8,500 ppm to an unaffiliated company to dispose of using a chemical treatment process. Electrical capacitors that contain PCB fluid are sent offsite to dispose of through burning in high temperature incinerators approved by EPA. Currently, there are only four such approved incinerators operating in the United States, which has resulted in a sharp rise in the price of disposal through these facilities. The System disposes of solid wastes containing PCBs in secure chemical waste landfills. In 1993, the System incurred costs of approximately $450,000 for disposal of materials at these facilities. Asbestos. Federal, Connecticut, New Hampshire and Massachusetts asbestos regulations have required the System to expend significant sums on removal of asbestos including measures to protect the health of workers and the general public and to properly dispose of asbestos wastes. Areas of the System currently undergoing removal of asbestos include nuclear, fossil/hydro production, transmission and distribution and facilities operations. The System expects to expend approximately $3.4 million in 1994 on the removal of asbestos in nuclear units, fossil and hydro generating stations and buildings. Even greater costs are likely to be incurred annually in the future if federal and state asbestos regulations become more stringent and the System's need to remove asbestos grows. RCRA. Under the federal Resource Conservation and Recovery Act of 1976, as amended (RCRA), the generation, transportation, treatment, storage and disposal of hazardous wastes are subject to EPA regulations. Connecticut, New Hampshire and Massachusetts have adopted state regulations that parallel RCRA regulations but in some cases are more stringent. A change in interpretation of RCRA by EPA now requires that nuclear facilities obtain EPA permits to handle radioactive wastes that are also hazardous under RCRA (so-called mixed wastes). The notifications and applications required by these regulations have been made by all units to which these regulations apply. The procedures by which System companies handle, store, treat and dispose of hazardous wastes are regularly revised, where necessary, to comply with these regulations. CL&P has discontinued operation of surface impoundments in its four Connecticut wastewater treatment facilities used to treat hazardous waste. This is because CL&P was unable to obtain variances from EPA to exempt the facilities from the double lining requirement under the 1984 RCRA amendments. CL&P has constructed replacement above-ground concrete tanks at an estimated cost of approximately $22 million. It is expected that in early 1994, EPA and DEP will approve clean closure for CL&P's Montville Station's impoundment. Accordingly, CL&P will no longer be required to maintain liability insurance or financial assurance for closure and post-closure for this former impoundment site. EPA's final approval of the closure of the remaining three surface impoundments is pending. The System estimates that it will incur approximately $2 million in costs of monitoring and closure of the container storage areas for these sites in the future, but the ultimate amount will depend on EPA's final disposition. Underground Storage Tanks. Federal and state regulations regulate underground tanks storing petroleum products or hazardous substances. The System has about 130 underground storage tanks that are used primarily for gasoline, diesel, house-heating and fuel oil. To reduce its environmental and financial liabilities, the System has begun implementing a policy calling for the permanent removal of all non-essential underground vehicle fueling tanks. Costs for this program are not substantial. Hazardous Waste Liability. As many other industrial companies have done in the past, System companies have disposed of residues from operations by depositing or burying such materials on-site or disposing of them at off-site landfills or facilities. Typical materials disposed of include coal gasification waste and oils that might contain PCBs. In recent years it has been determined that deposited or buried wastes, under certain circumstances, could cause groundwater contamination or other environmental harm. The System continues to evaluate the environmental impact of its former disposal practices. Under federal and state law, government agencies and private parties can attempt to impose liability on System companies for such past disposal. Under the federal Comprehensive Environmental Response, Compensation and Liability Act of 1980, as amended, commonly known as Superfund, EPA has the authority to clean up hazardous waste sites and to impose the cleanup costs on parties deemed responsible for the hazardous waste activities on the sites. Responsible parties include the current owner of a site, past owners of a site at the time of waste disposal, waste transporters and waste generators. It is EPA's position that all responsible parties are jointly and severally liable, so that any single responsible party can be required to pay the entire costs of cleaning up the site. As a practical matter, however, the costs of cleanup are usually allocated by agreement of the parties, or by the courts on an equitable basis among the parties deemed responsible, and several recent federal appellate court decisions have rejected EPA's position on strict joint and several liability. Superfund also contains provisions that require System companies to report releases of specified quantities of hazardous materials and require notification of known hazardous waste disposal sites. Management believes that the System companies are in compliance with these reporting and notification requirements. The System is or has recently been involved in eight Superfund sites. Three of these sites are in Connecticut, one is in Kentucky, one is in West Virginia and three are in New Hampshire. The level of study of each site and the information about the waste contributed to the site by the System and other parties differs from site to site. Where reliable information is available that permits the System to make a reasonable estimate of the expected total costs of remedial action and/or the System's likely share of remediation costs for a particular site, those cost estimates are provided below. All cost estimates were made, in accordance with Financial Accounting Standards Board Statement No. 5, where remediation costs were probable and reasonably estimable. Any estimated costs disclosed for cleaning up the sites discussed below were determined without consideration of possible recoveries from third parties, including insurance recoveries. Where the System has not accrued a liability, the costs either were not material or there was insufficient information to accurately assess the System's exposure. At two Connecticut sites, the Beacon Heights and Laurel Park landfills, the major parties formed coalitions to clean the sites and settled their suits with EPA and CDEP. The coalitions then attempted to join as defendants a large number of potential contributors, including "Northeast Utilities (Connecticut Light and Power)." Litigation on both sites was consolidated in a single case in the federal district court. In January 1993, Judge Dorsey denied the motion of the Laurel Park Coalition to join NU (CL&P). In December 1993, Judge Dorsey dismissed the claims of Beacon Heights Coalition against many of the defendants and directed the coalition to indicate which remaining defendants it intended to pursue claims against. In January 1994, the Beacon Heights Coalition filed a response listing NU (CL&P) as a defendant they would not continue to pursue. As a result of Judge Dorsey's rulings and the coalition's actions, it is not likely that CL&P will incur any cleanup costs for these sites. In June, 1993, EPA notified the System that it was a Potentially Responsible Party (PRP) at the Solvents Recovery Service of New England site in Southington, Connecticut. PSNH is a de minimis PRP at this site and does not expect its cost to be substantial. At the Maxey Flats nuclear waste disposal site in Fleming County, Kentucky, EPA has issued a notice of potential liability to NNECO and CYAPC. The System had sent a substantial volume of LLRW from Millstone 1, Millstone 2 and CY to this site. CL&P and WMECO had previously recorded a liability for future remediation costs for this site based on System estimates. To date, the costs have not been material with respect to their earnings or financial positions. In September 1991, EPA issued its record of decision for the Maxey Flats nuclear waste disposal site. The EPA-approved remedy requires pumping and treatment of leachate, installing of an initial cap, allowing materials in the trenches to settle and ultimately constructing a permanent cap. EPA estimated that the cost of the remedy is approximately $33.5 million. Based on that estimate and the volume contributed, the System's share would be approximately $0.5 million. However, the System believes that the cost of the remedy could be substantially higher. The System estimates that its total cost for cleanup could be approximately $1-$2 million. EPA provided an opportunity for PRPs, including certain System companies, to enter into a consent decree with EPA under which each PRP would reimburse EPA for its past costs and would undertake remedial action at the site or pay the costs of EPA undertaking remedial action. On October 20, 1992, PRPs that are members of the Maxey Flats PRP Steering Committee, including System companies, and several federal government agencies, including DOE and the Department of Defense, made a settlement offer to EPA involving a commitment to perform a substantial portion of the remedial work required by EPA in its record of decision. On that same date, the Commonwealth of Kentucky made a settlement offer. EPA rejected the settlement offers in December 1992, but gave the parties an additional 60 days to make a "good faith" offer. On March 16, 1993, the PRP Steering Committee and the federal government agencies made a revised offer to EPA. Since then all parties have been actively involved in settlement negotiations. PSNH has settled with EPA and other PRPs at sites in West Virginia and Kingston, New Hampshire. PSNH paid approximately $33,700 to cash out of these sites. PSNH has committed approximately $280,000 as its share of the costs to clean up municipal landfills in Dover and North Hampton, New Hampshire. Some additional costs may be incurred at these sites but they are not expected to be significant. Other New Hampshire sites include municipal landfills in Somersworth and Peterborough, and the Dover Point site owned by PSNH in Dover, New Hampshire. PSNH's liability at the landfills is not expected to be significant and its liability at the Dover Point site cannot be estimated at this time. PSNH contacted NHDES in December 1993 concerning possible coal tar contamination in the headwater of Lake Winnipesaukee near an area where PSNH formerly owned and operated a coal gasification plant which was sold in 1945. PSNH agreed to conduct an historical review and provide a report to NHDES in February 1994. PSNH, along with two other identified PRPs, most likely will be conducting a site investigation in the spring of 1994. In 1987, CDEP published a list of 567 hazardous waste disposal sites in Connecticut. The System owns two sites on this list. The System has spent approximately $0.5 million to date completing investigations at these sites. Both sites were formerly used by CL&P predecessor companies for the manufacture of coal gas (also known as town gas sites) from the late 1800s to the 1950s. This process resulted in the production of coal tar residues, which, when not sold for roofing or road construction, were frequently deposited on or near the production facilities. Site investigations are being carried out to gain an understanding of the environmental and health risks of these sites. Should future site remediation become necessary, the level of cleanup will be established in cooperation with CDEP. Connecticut is currently developing cleanup standards and guidelines for soil and groundwater. One of the sites is a 25.8 acre site located in the south end of Stamford, Connecticut. Site investigations have located coal tar deposits covering approximately 5.5 acres and having a volume of approximately 45,000 cubic yards. A final risk assessment report for the site was completed in January 1994. Several remedial options are currently being evaluated to clean up the site; however, CL&P is focusing on institutional and engineering controls, such as capping and paving, which would reduce the potential health risks and secure the site. The estimated costs of institutional controls range from $2 million to $3 million. As part of the 1989 divestiture of CL&P's gas business, site investigations were performed for properties that were transferred to Yankee Gas Services Company (Yankee Gas). As a result of those investigations, ten properties were identified for which negative declarations under the Property Transfer Act could not be filed. A negative declaration is a statement that there has been no discharge of hazardous wastes at the site, or that if there was such a discharge, it has been cleaned up or determined to pose no threat to health, safety or the environment and is being managed lawfully. Of the ten sites, CL&P agreed to accept liability for required cleanup for the three sites it retained. At one location, CL&P and Yankee Gas share the site and any liability for any required cleanup. Yankee Gas accepted liability for any required cleanup of the other sites. CL&P and Yankee Gas will share the costs of cleanup of sites formerly used in CL&P's gas business but not currently owned by either of them. In Massachusetts, System companies have been designated by MDEP as PRPs for ten sites under MDEP's hazardous waste and spill remediation program. The System does not expect that its share of the remaining remediation costs for any of these sites will be material. At some of these sites, the System is responsible for only a small portion or none of the hazardous wastes. For some of these and for other sites, the total remediation costs are not expected to be material. At one of the sites, the System has spent approximately $2 million for cleanup and it expects to incur approximately $250,000 for the remaining remediation costs. HWP has been identified by MDEP as a PRP in a coal tar site in Holyoke, Massachusetts. HWP owned and operated the Holyoke Gas Works from 1859 to 1902. It was sold to the city of Holyoke and operated by its Gas and Electric Department (HG&E) from 1902 to 1951. Currently, one third of the two acre property is owned by HG&E, with the remaining portion owned by a construction company. The site is located on the west side of Holyoke, adjacent to the Connecticut River and immediately downstream of HWP's Hadley Falls Station. MDEP has classified both the land and river deposit areas as Tier I priority waste disposal sites. Due to the presence of tar patches in the vicinity of the spawning habitat of the shortnose sturgeon (SNS) - an endangered species - the National Oceanographic and Atmospheric Administration (NOAA) and National Marine Fisheries Service have taken an active role in overseeing site activities. Although HWP denies that it is a PRP, it has cooperated with the agencies in investigating this problem. Both MDEP and NOAA have indicated they may require the removal of tar deposits from the vicinity of the SNS spawning habitat. To date, HWP has spent approximately $200,000 for river studies and construction costs for an oil containment boom to prevent leaching hydrocarbons from entering the Hadley Falls tailrace and the Connecticut River. The System has received other claims from government agencies and third parties for the cost of remediating sites not currently owned by the System but affected by past System disposal activities and expects to receive more such claims in the future. The System expects that the costs of resolving claims for remediating sites about which it has been notified will not be material, but cannot estimate the costs with respect to sites about which it has not been notified. If the System, regulatory agencies or courts determine that remedial actions must be taken in relation to past disposal practices on property owned or used for disposal by the System in the past, the System could incur substantial costs. ELECTRIC AND MAGNETIC FIELDS In recent years, published reports have discussed the possibility of adverse health effects from electric and magnetic fields (EMF) associated with electric transmission and distribution facilities and appliances and wiring in buildings and homes. On the basis of scientific reviews of these reports conducted by various state, federal and international panels, management does not believe that a causal relationship has been established or that significant capital expenditures are appropriate to minimize unsubstantiated risks. The System supports further research into the subject and is participating in the funding of the National EMF Research and Public Information Dissemination Program and other industry-sponsored studies. If further investigation were to demonstrate that the present electricity delivery system is contributing to increased risk of cancer or other health problems, the industry could be faced with the difficult problem of delivering reliable electric service in a cost-effective manner while managing EMF exposures. In addition, if the courts were to conclude that individuals have been harmed and that utilities are liable for damages, the potential monetary exposure for all utilities, including the System companies, could be enormous. Without definitive scientific evidence of a causal relationship between EMF and health effects, and without reliable information about the kinds of changes in utilities' transmission and distribution systems that might be needed to address the problem, if one is found, no estimates of the cost impacts of remedial actions and liability awards are available. Epidemiological studies, rather than laboratory studies, have been primarily responsible for increased scientific interest in and public concern over EMF exposures in the past decade. New epidemiological study results from international researchers were released and publicized in late-1992 and in 1993, but these only added to a picture of inconsistency from previous studies. Researchers from Sweden and Denmark concluded that their statistical results support the hypothesis that EMF may be a causative factor in certain types of cancer (although they disagreed on which types), while researchers from Finland and Greece found no evidence to support such a hypothesis. These researchers, as well as scientific review panels considering all significant EMF epidemiological and laboratory research to date, all agree that current information remains inconclusive, inconsistent and insufficient for risk assessment of EMF exposures. NU is closely monitoring research and government policy developments. In 1993, there were several notable events on the federal government level regarding EMF. The EPA has indefinitely postponed completion of a report on EMF, citing as its reasons high costs and the unlikelihood of shedding new light on the issue. Instead, it now plans to issue a 30-page "summary of science" in early 1994. In a related development, the Department of Energy has initiated a scientific review of EMF research by the National Academy of Sciences. Also on the federal level, the National EMF Research and Public Information Dissemination Program (created by the Energy Policy Act) moved forward in 1993 by establishing a federal interagency committee and an advisory committee, and by soliciting the required non-federal matching funds (through The Edison Electric Institute, NU will be making a voluntary contribution of approximately $62,000 for each year of the five-year program). The Connecticut Interagency EMF Task Force (Task Force) provided reports to the state legislature in March 1993 and in January 1994. The Task Force recognizes and supports the need for more research, and has suggested a policy of "voluntary exposure control," which involves providing people with information to enable them to make individual decisions about EMF exposure. Neither the Task Force, nor any Connecticut state agency, has recommended changes to the existing electrical supply system. Finally, the Connecticut Siting Council adopted a set of EMF "best management practices" in February 1993, which must now be considered in the justification, siting and design of new transmission lines and substations. EMF has become increasingly important as a factor in facility siting decisions in many states. Several bills were introduced in Massachusetts in January 1993, and were last reported to be pending before various legislative committees. It is not known whether there will be further action on the bills, which would require certain disclosures to real estate purchasers and utility employees, a scientific literature review, establishment of a fund to reduce certain field exposures, identification of schools and day care centers within 500 feet of transmission lines and development of EMF regulations. No action was taken on EMF bills previously pending in 1992. CL&P has been the focus of media reports charging that EMF associated with a CL&P substation and related distribution lines in Guilford, Connecticut, is linked with various cancers and other illnesses in several nearby residents. See Item 3, Legal Proceedings, for information about two suits brought by plaintiffs who now live or formerly lived near that substation. FERC HYDRO PROJECT LICENSING Federal Power Act licenses may be issued for hydroelectric projects for terms of up to 50 years as determined by FERC. Any hydroelectric project so licensed is subject to recapture by the United States for licensing to others after expiration of the license upon payment to the licensee of the lesser of fair value or the net investment in the project plus severance damages less certain amounts earned by the licensee in excess of a reasonable rate of return. Licenses are customarily conditioned on the licensee's development of recreational and other non-power uses at each licensed project. Conditions may be imposed with respect to low flow augmentation of streams and fish passage facilities. On September 28, 1993, the United States Fish and Wildlife Service (FWS) was petitioned to list the anadromous Atlantic salmon (Salmo salar) as an endangered species in the United States. After a 90-day review, the petition was found to be complete and was accepted. The National Marine Fisheries Service and FWS were given joint jurisdiction over this petition. Within the next 12 months, these agencies will decide if the petition is warranted. If salmon are listed as an endangered species, the System may be required to take a number of actions including increasing spillage over some dams during the salmon migration period resulting in loss of generation capacity at the affected hydroelectric facilities; modifying spillways to accommodate safe fish passage; curtailing pumping at Northfield Mountain during the salmon migration period; improving upstream and downstream passage facilities at all hydroelectric dams on the Connecticut and Merrimack Rivers; and modifying intake structures and curtailing operations during salmon migration periods at certain of the System's thermal structures. Although these are all possible implications of a listing, the System cannot estimate the impact on System facilities at this time. The System is continuing to conduct studies on the Connecticut River in fulfillment of the Memorandum of Agreement (MOA) concerning downstream passage of anadromous fishes (Atlantic salmon, American shad and blueback herring). The MOA was signed by the System and the Connecticut River Atlantic Salmon Commission and its member agencies in 1990. The System conducted studies in 1991 and 1992 of the entrainment of salmon smolts and juvenile shad and herring in water pumped to the upper reservoir of the Northfield Mountain Pumped Storage Project. Studies of entrainment of shad and herring indicated that Northfield's impact on these species is low, and further studies have not been conducted. Studies of salmon smolts, however, indicated the potential for unacceptable losses of smolts due to entrainment, but the results also indicated that firm conclusions could not be drawn. Accordingly, the System conducted a more definitive study indicating that about 10 percent of the 1993 smolt run was entrained at Northfield. The System will continue to pursue practical techniques to reduce salmon smolt entrainment at Northfield and has agreed to alter its 1994 maintenance schedule to reduce the amount of time when all four pump/turbine units will be pumping simultaneously during the smolt migration period. Should the system be unable to reduce smolt entrainment through operational changes or practical exclusion techniques, substantial additional costs are possible. The total cost cannot be determined at this time. The System operating companies hold licenses granted under Part I of the Federal Power Act for the operation and maintenance of thirteen existing hydroelectric projects, four of which are in Massachusetts (Northfield, Turners Falls, Gardners Falls and Holyoke [river and canal units]), three of which are in Connecticut (Scotland, Housatonic [encompassing Bulls Bridge, Rocky River, Shepaug and Stevenson] and Falls Village) and six of which are in New Hampshire (Merrimack [encompassing Garvins Falls, Hooksett and Amoskeag], Smith, Ayers Island, Eastman Falls, Canaan and Gorham). In 1992, FERC issued orders exempting from licensing WMECO's four Chicopee River projects: Dwight, Indian Orchard, Putts Bridge and Red Bridge. To date, FERC has not claimed jurisdiction over CL&P's Bantam, Robertsville, Taftville and Tunnel Projects or PSNH's Jackman project. Four of the System's FERC licenses expired at the end of 1993 (Gardners Falls, Ayers Island, Gorham and Smith). Relicensing efforts have been under way for these projects for several years. As no third parties have filed competing license applications with FERC for these projects, it is highly likely that FERC will grant renewal licenses for these projects to the System. However, certain operating, environmental and/or recreational conditions may be placed on these licenses. Because FERC was unable to complete its relicensing process prior to the December 31, 1993 expiration of these licenses, under the provision of section 15 of the Federal Power Act, FERC has issued one-year extensions to each of these licensees. FERC will continue to issue annual licenses until it completes the relicensing process. EMPLOYEES As of December 31, 1993, the System companies had approximately 9,697 full and part time employees on their payrolls, of which approximately 2,697 were employed by CL&P, approximately 1,452 by PSNH, approximately 656 by WMECO, approximately 119 by HWP, approximately 1,252 by NNECO, approximately 2,584 by NUSCO and approximately 937 by North Atlantic. NU and NAEC have no employees. Approximately 2,242 employees of CL&P, PSNH, WMECO and HWP are covered by union agreements, which expire between October 1994 and May 1996. Certain employees of North Atlantic negotiated a union contract in 1993. On August 3, 1993, the System announced that it intended to reduce its total workforce by 600 to 700 positions and offered a voluntary early retirement program to about 800 eligible employees. The program was available generally to all nonbargaining unit employees of NU's subsidiaries, NUSCO, CL&P, WMECO, HWP, PSNH and NAESCO, who would be at least age 55 with ten years of service as of November 1, 1993. Most nuclear-related job classifications at NUSCO and NAESCO were not eligible. The program enhanced pension benefits by adding an additional three years to age and service for the purpose of calculating pension benefits and early retirement reduction factors, as well as providing a supplemental payment to employees who retired prior to becoming eligible for social security benefits. Each program participant has retired or will retire on a date to be established by the employer between November 1, 1993 and November 1, 1994. A similar program was offered to approximately 300 bargaining unit employees working for System companies and 12 employees of NEPOOL/NEPEX. The workforce reduction affected approximately 811 employees, of which 498 individuals accepted the early retirement program and another 313 individuals who were involuntarily terminated. Involuntarily terminated employees were eligible to receive a lump sum severance payment of up to a maximum of 52 weeks salary, depending on years of credited service. In addition, as part of the System's reorganization of its Connecticut-based nuclear organization, 32 employees were involuntarily terminated through January 12, 1994. For more information on the reorganization see "Nuclear Generation - Operations - Nuclear Performance Improvement Initiatives." The total cost of the workforce reduction program and the nuclear reorganization was approximately $38 million, including pension, severance and other benefits. Item 2. Item 2. Properties The physical properties of the System are owned or leased by subsidiaries of NU. CL&P's principal plants and other properties are located either on land which is owned in fee or on land, as to which CL&P owns perpetual occupancy rights adequate to exclude all parties except possibly state and federal governments, which has been reclaimed and filled pursuant to permits issued by the United States Army Corps of Engineers. The principal properties of PSNH are held by it in fee. In addition, PSNH leases space in an office building under a 30-year lease expiring in 2002. WMECO's principal plants and a major portion of its other properties are owned in fee, although one hydroelectric plant is leased. NAEC owns a 35.98201 percent interest in Seabrook 1, and approximately 719 acres of exclusion area land located around the unit. In addition, CL&P, PSNH, and WMECO have certain substation equipment, data processing equipment, nuclear fuel, nuclear control room simulators, vehicles, and office space that are leased. With few exceptions, the System's companies' lines are located on or under streets or highways, or on properties either owned, leased, or in which the company has appropriate rights, easements, or permits from the owners. CL&P's properties are subject to the liens of CL&P's first mortgage indenture and, with respect to properties formerly owned by The Hartford Electric Light Company (HELCO), to the lien of HELCO's first mortgage indenture. PSNH's properties are subject to the lien of its first mortgage indenture. In addition, PSNH's outstanding term loan and revolving credit agreement borrowings are secured by a second lien, junior to the lien of the first mortgage indenture, on PSNH property located in New Hampshire. WMECO's properties are subject to the lien of its first mortgage indenture. NAEC's First Mortgage Bond are secured by a lien on the Seabrook 1 interest described above, and all rights of NAEC under the Seabrook Power Contract. In addition, CL&P's and WMECO's interests in Millstone 1 are subject to second liens for the benefit of lenders under agreements related to pollution control revenue bonds. Various ones of these properties are also subject to minor encumbrances which do not substantially impair the usefulness of the properties to the owning company. The System companies' properties are well maintained and are in good operating condition. Notes: 1. Until 1991, awards under the short-term programs of the Northeast tilities Executive Incentive Compensation Program (EICP) were made in restricted stock. In 1991, the Northeast Utilities Executive Incentive Plan (EIP) was adopted, which did not require restricted stock awards. Awards under the 1991 and 1992 short-term programs under the EIP were paid in 1992 and 1993, respectively, in the form of unrestricted stock and, in accordance with the requirements of the SEC, are included as "bonus" in the years earned. 2. The five executive officers listed in the table above each received an award of restricted stock in May, 1991 (which vested in January, 1993), under the EICP. The number of shares in each such award is shown below. All restricted stock awards under the EICP vested prior to December 31, 1993. Name Shares B. M. Fox 1,807 W. B. Ellis 2,585 J. F. Opeka 1,349 R. E. Busch 1,090 J. P. Cagnetta 847 3. "All Other Compensation" consists of employer matching contributions under the Northeast Utilities Service Company Supplemental Retirement and Savings Plan (401(k) Plan), generally available to all eligible employees. In 1993, the employer match for non-union employees was 100 percent of the first three percent of compensation contributed on a before-tax basis. 4. Awards under the short-term program of the EIP have typically been made by NU's Committee on Organization, Compensation and Board Affairs in April each year. Based on preliminary estimates of corporate performance, and assuming that the individual performance levels of Messrs. Opeka, Busch and Cagnetta approximate those of other system officers, it is estimated that the five executive officers listed in the table above would receive the following awards: Mr. Fox - $180,780; Mr. Ellis - $160,693; Mr. Busch - $64,946; Mr. Opeka - $64,946; and Dr. Cagnetta - $43,828. 5. Mr. Fox served as President and Chief Operating Officer of CL&P, NAEC and WMECO and Vice Chairman and Chief Operating Officers of PSNH until July 1, 1993, when he became President and Chief Executive Officer of CL&P, NAEC and WMECO and Vice Chairman and Chief Executive Officer of PSNH. Mr. Ellis served as Chairman and Chief Executive Officer of these companies until July 1, 1993, when he became Chairman. Amounts listed in the "Long Term Incentive Program" column of the Summary Compensation Table for 1993 were received by these individuals prior to their change in responsibilities. $267,500 of Mr. Ellis's 1993 salary was paid prior to July 1, 1993, while he was Chief Executive Officer, and $253,750 was paid after July 1, 1993. $217,500 of Mr. Fox's 1993 salary was paid prior to July 1, 1993, and $261,275 was paid after Mr. Fox became Chief Executive Officer on July 1, 1993. PENSION BENEFITS The following table shows the estimated annual retirement benefits payable to an executive officer of NU, CL&P, WMECO, PSNH and NAEC upon retirement, assuming that retirement occurs at age 65 and that the officer is at that time not only eligible for a pension benefit under the Northeast Utilities Service Company Retirement Plan (the Retirement Plan) but also eligible for the "make-whole benefit" and the "target benefit" under the Supplemental Executive Retirement Plan for Officers of Northeast Utilities System Companies (the Supplemental Plan). The Supplemental Plan is a non-qualified pension plan providing supplemental retirement income to System officers. The "make-whole benefit" under the Supplemental Plan makes up for benefits lost through application of certain tax code limitations on the benefits that may be provided under the Retirement Plan, and is available to all officers. The "target benefit" further supplements these benefits and is available to officers at the Senior Vice President level and higher who are selected by the NU Board of Trustees to participate in the target benefit and who remain in the employ of NU companies until at least age 60 (unless the NU Board of Trustees sets an earlier age). Each of the executive officers of NU, CL&P, WMECO, PSNH and NAEC named in the summary compensation table above is currently eligible for a target benefit. If an executive officer were not eligible for a target benefit at the time of retirement, a lower level of retirement benefits would be paid. The benefits presented are based on a straight life annuity beginning at age 65 and do not take into account any reduction for joint and survivorship annuity payments. Years of Credited Service Final Average ------------------------------------------------------ Compensation 15 20 25 30 35 - ------------------ ------------------------------------------------------ $ 125,000 $ 45,000 $ 60,000 $ 75,000 $ 75,000 $ 75,000 $ 150,000 $ 54,000 $ 72,000 $ 90,000 $ 90,000 $ 90,000 $ 175,000 $ 63,000 $ 84,000 $105,000 $105,000 $105,000 $ 200,000 $ 72,000 $ 96,000 $120,000 $120,000 $120,000 $ 225,000 $ 81,000 $108,000 $135,000 $135,000 $135,000 $ 250,000 $ 90,000 $120,000 $150,000 $150,000 $150,000 $ 300,000 $108,000 $144,000 $180,000 $180,000 $180,000 $ 350,000 $126,000 $168,000 $210,000 $210,000 $210,000 $ 400,000 $144,000 $192,000 $240,000 $240,000 $240,000 $ 450,000 $162,000 $216,000 $270,000 $270,000 $270,000 $ 500,000 $180,000 $240,000 $300,000 $300,000 $300,000 $ 600,000 $216,000 $288,000 $360,000 $360,000 $360,000 $ 700,000 $252,000 $336,000 $420,000 $420,000 $420,000 $ 800,000 $288,000 $384,000 $480,000 $480,000 $480,000 Final average compensation for purposes of calculating the "target benefit" is the highest average annual compensation of the participant during any 36 consecutive months compensation was earned. Compensation taken into account under the "target benefit" described above includes salary, bonus, restricted stock awards, and long-term incentive payouts shown in the Summary Compensation Table above, but does not include employer matching contributions under the Northeast Utilities Service Company Supplemental Retirement and Savings Plan (401(k)) Plan. In the event that an officer's employment terminates because of disability, the retirement benefits shown above would be offset by the amount of any disability benefits payable to the recipient that are attributable to contributions made by NU and its subsidiaries under long term disability plans and policies. As of December 31, 1993, the five executive officers named in the Summary Compensation Table above had the following years of credited service for retirement compensation purposes: Mr. Fox - 29, Mr. Ellis - 17, Mr. Opeka - 23, Mr. Busch - 20 and Dr. Cagnetta - 21. Assuming that retirement were to occur at age 65 for these officers, retirement would occur with 43, 29, 35, 38 and 25 years of credited service, respectively. NU has entered into agreements with Messrs. Ellis and Fox to provide for an orderly management succession. The agreement with Mr. Ellis calls for him to work with the NU Board of Trustees and Mr. Fox to effect the orderly transition of his responsibilities to Mr. Fox. In accordance with the agreement, Mr. Ellis stepped down as Chief Executive Officer of NU, CL&P, WMECO, PSNH and NAEC as of July 1, 1993. The agreement anticipates his retirement as of August 1, 1995. The agreement provides that, upon his retirement, Mr. Ellis will be entitled to receive from NU and its subsidiaries a target benefit under the Supplemental Plan. His target benefit will be based on the greater of his actual final average compensation or an amount determined as if his salary had increased each year since 1991 at a rate equal to the average rate of the increases of all other target benefit participants and as if he had received incentive awards each year based on this modified salary, but with the same performance as the Chief Executive Officer at the time. The agreement also provides specified death and disability benefits for the period before Mr. Ellis's 1995 retirement. The agreement with Mr. Fox states that if he is terminated as Chief Executive Officer without cause, he will be entitled to specified severance pay and benefits. Those benefits consist primarily of (i) two years' base pay, medical, dental and life insurance benefits, (ii) a supplemental retirement benefit equal to the difference between the target benefit he would be entitled to receive if he had reached the age of 55 on the termination date and the actual target benefit to which he is entitled as of the termination date, and (iii) a target benefit under the Supplemental Plan, notwithstanding that he might not have reached age 60 on the termination date and notwithstanding other forfeiture provisions of that plan. The agreement also provides specified death and disability benefits. The agreement terminates two years after NU gives Mr. Fox a notice of termination, but no earlier than the date he becomes 55. The agreements do not address the officers' normal compensation and benefits, which are to be determined by NU's Committee on Organization, Compensation and Board Affairs and the NU Board of Trustees in accordance with their customary practices. Item 12. Security Ownership of Certain Beneficial Owners and Management NU. Incorporated herein by reference are pages 5 through 12 of the definitive proxy statement for solicitation of proxies by NU's Board of Trustees, dated April 1, 1994 and filed with the Commission pursuant to Rule 14a-6 under the Act. CL&P, PSNH, WMECO and NAEC. As of February 28, 1994, the Directors of CL&P, PSNH, WMECO and NAEC, beneficially owned the following number of shares of each class of equity securities of NU. No equity securities of CL&P, PSNH or WMECO are owned by the Directors and Executive Officers. CL&P, PSNH, WMECO, and NAEC DIRECTORS AND NAMED EXECUTIVE OFFICERS Amount and Nature of Title Of Name of Beneficial Percent of Class Beneficial Owner Ownership (1) Class (2) NU Common Robert G. Abair (3) (621) 4,271 shares NU Common Robert E. Busch (772) 6,054 shares NU Common John P. Cagnetta (4) (581) 3,979 shares NU Common John C. Collins (5) 0 shares NU Common William B. Ellis (6) (1,259) 14,837 shares NU Common Ted C. Feigenbaum(7) 151 shares NU Common Bernard M. Fox (8) (1,072) 17,428 shares NU Common William T. Frain, Jr. 885 shares NU Common Cheryl W. Grise (221) 1,349 shares NU Common John B. Keane (9) (368) 1,146 shares NU Common Francis L. Kinney (10) (303) 3,781 shares NU Common Gerald Letendre (5) 0 shares NU Common Hugh C. MacKenzie (4)(11) (779) 4,277 shares NU Common Jane E. Newman (5) 0 shares NU Common Dale F. Nitzschke (5) 0 shares NU Common John W. Noyes (658) 2,789 shares NU Common John F. Opeka (4)(12) (1,075) 16,463 shares NU Common Robert P. Wax (5) (651) 1,436 shares Amount beneficially owned by Directors and Executive Officers as a group - CL&P (7,709) 77,259 shares - PSNH (6,790) 69,299 shares - WMECO (7,709) 77,259 shares - NAEC (7,088) 73,139 shares (1) Unless otherwise noted, each Director and Executive Officer of CL&P, PSNH, WMECO and NAEC has sole voting and investment power with respect to the listed shares. The numbers in parentheses reflect the number of shares owned by each Director and Executive Officer under the Northeast Utilities Service Company Supplemental Retirement and Savings Plan (401(k) Plan), as to which the Officer has no investment power. (2) As of February 28, 1994 there were 134,208,461 common shares of NU outstanding. The percentage of such shares beneficially owned by any Director or Executive Officer, or by all Directors and Executive Officers of CL&P, PSNH, WMECO and NAEC as a group, does not exceed one percent. (3) Mr. Abair is a Director of CL&P and WMECO only. (4) Mr. Opeka and Dr. Cagnetta are not officers of PSNH, but each in his capacity as an officer (with the stated title) of NUSCO, an affiliate of PSNH, performs policy-making functions for PSNH. (5) Messrs. Collins, Letendre, Nitzschke and Wax and Ms. Newman areDirectors of PSNH only. (6) Mr. Ellis shares voting and investment power with his wife for 1,117 shares. (7) Mr. Feigenbaum is a Director and an Executive Officer of NAEC only. (8) Mr. Fox shares voting and investment power with his wife for 3,031 of these shares. In addition, Mr. Fox's wife has sole voting and investment power for 140 shares, as to which Mr. Fox disclaims beneficial ownership. (9) Mr. Keane is a Director of CL&P, WMECO and NAEC only. (10) Mr. Kinney shares voting and investment power with his wife for 2,155 shares. (11) Mr. MacKenzie shares voting and investment power with his wife for 1,259 shares. (12) Mr. Opeka shares voting and investment power with his wife for 1,718 shares. Item 13. Certain Relationships and Related Transactions NU. Incorporated herein by reference is page 14 of the definitive proxy statement for solicitation of proxies by NU's Board of Trustees, dated April 1, 1994 and filed with the Commission pursuant to Rule 14a-6 under the Act. CL&P, PSNH, WMECO and NAEC. No relationships or transactions that would be described in response to this item exist now or existed during 1993 with respect to CL&P, PSNH, WMECO and NAEC. PART IV Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K (a) 1. Financial Statements: The Report of Independent Public Accountants and financial statements of NU, CL&P, PSNH, WMECO, and NAEC are hereby incorporated by reference and made a part of this report (see "Item 8. Financial Statements and Supplementary Data"). Reports of Independent Public Accountants on Schedules S-1 Consents of Independent Public Accountants S-3 2. Schedules: Financial Statement Schedules for NU (Parent), NU and Subsidiaries, CL&P, PSNH, WMECO, and NAEC are listed in the Index to Financial Statement Schedules S-5 3. Exhibits Index E-1 (b) Reports on Form 8-K: During the fourth quarter of 1993, the companies filed Form 8-Ks dated December 2, 1993 disclosing the following: o On December 2, 1993, the Northeast Utilities system announced a reorganization of its corporate structure. o On December 3, 1993, NNECO was informed by the NRC that it was being assessed a civil penalty in response to repair activities at Millstone 2. In addition, the Form 8-K dated December 2, 1993 which was filed by PSNH also discussed the following: o On June 8, 1992, PSNH changed its independent public accountant. NORTHEAST UTILITIES 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. NORTHEAST UTILITIES ------------------- (Registrant) Date: March 18, 1994 By /s/ William B. Ellis -------------- --------------------------- William B. Ellis 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. Date Title Signature ---- ----- --------- March 18, 1994 Trustee and Chairman /s/ William B. Ellis - -------------- of the Board ------------------------- William B. Ellis March 18, 1994 Trustee, President /s/ Bernard M. Fox - -------------- and Chief Executive ------------------------- Officer Bernard M. Fox March 18, 1994 Executive Vice /s/ Robert E. Busch - -------------- President and Chief ------------------------- Financial Officer Robert E. Busch March 18, 1994 Vice President and /s/ John B. Keane - -------------- Treasurer ------------------------- John B. Keane March 18, 1994 Vice President and /s/ John W. Noyes - -------------- Controller ------------------------- John W. Noyes NORTHEAST UTILITIES SIGNATURES (CONT'D) Date Title Signature ---- ----- --------- March 18, 1994 Trustee /s/ Cotton Mather Cleveland - -------------- --------------------------- Cotton Mather Cleveland March 18, 1994 Trustee /s/ George David - -------------- --------------------------- George David March 18, 1994 Trustee /s/ Donald J. Donahue - -------------- --------------------------- Donald J. Donahue March 18, 1994 Trustee /s/ Eugene D. Jones - -------------- --------------------------- Eugene D. Jones March 18, 1994 Trustee /s/ Elizabeth T. Kennan - -------------- --------------------------- Elizabeth T. Kennan Trustee - -------------- --------------------------- Denham C. Lunt, Jr. March 18, 1994 Trustee /s/ William J. Pape II - -------------- --------------------------- William J. Pape II March 18, 1994 Trustee /s/ Robert E. Patricelli - -------------- --------------------------- Robert E. Patricelli Trustee - -------------- --------------------------- Norman C. Rasmussen Trustee - -------------- --------------------------- John F. Swope THE CONNECTICUT LIGHT AND POWER 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 CONNECTICUT LIGHT AND POWER COMPANY --------------------------------------- (Registrant) Date: March 18, 1994 By /s/ William B. Ellis -------------- --------------------- William B. Ellis 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. Date Title Signature ---- ----- --------- March 18, 1994 Chairman and Director /s/ William B. Ellis - -------------- -------------------------- William B. Ellis March 18, 1994 Vice Chairman and /s/ Bernard M. Fox - -------------- Director -------------------------- Bernard M. Fox March 18, 1994 President and Director /s/ Hugh C. MacKenzie - -------------- -------------------------- Hugh C. MacKenzie March 18, 1994 Executive Vice /s/ Robert E. Busch - -------------- President, Chief -------------------------- Financial Officer Robert E. Busch and Director March 18, 1994 Vice President and /s/ John W. Noyes - -------------- Controller -------------------------- John W. Noyes THE CONNECTICUT LIGHT AND POWER COMPANY SIGNATURES (CONT'D) Date Title Signature ---- ----- --------- - ------------------- Director -------------------------- Robert G. Abair March 18, 1994 Director /s/ John P. Cagnetta - ------------------- -------------------------- John P. Cagnetta March 18, 1994 Director /s/ William T. Frain, Jr. - ------------------- -------------------------- William T. Frain, Jr. March 18, 1994 Director /s/ Cheryl W. Grise - ------------------- ----------------------- Cheryl W. Grise March 18, 1994 Director /s/ John B. Keane - ------------------- ----------------------- John B. Keane March 18, 1994 Director /s/ John F. Opeka - ------------------- ----------------------- John F. Opeka PUBLIC SERVICE COMPANY OF NEW HAMPSHIRE 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 HAMPSHIRE --------------------------------------- (Registrant) Date: March 18, 1994 By /s/ William B. Ellis -------------- ------------------------- William B. Ellis 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. Date Title Signature ---- ----- --------- March 18, 1994 Chairman and Director /s/ William B. Ellis - -------------- -------------------------- William B. Ellis March 18, 1994 Vice Chairman, Chief /s/ Bernard M. Fox - -------------- Executive Officer and -------------------------- Director Bernard M. Fox March 18, 1994 President, Chief /s/ William T. Frain, Jr. - -------------- Operating Officer -------------------------- and Director William T. Frain, Jr. March 18, 1994 Executive Vice /s/ Robert E. Busch - -------------- President, Chief -------------------------- Financial Officer Robert E. Busch and Director March 18, 1994 Vice President and /s/ John W. Noyes - -------------- Controller -------------------------- John W. Noyes PUBLIC SERVICE COMPANY OF NEW HAMPSHIRE SIGNATURES (CONT'D) Date Title Signature ---- ----- --------- March 18, 1994 Director /s/ John C. Collins - ------------------- -------------------------- John C. Collins March 18, 1994 Director /s/ Gerald Letendre - ------------------- -------------------------- Gerald Letendre March 18, 1994 Director /s/ Hugh C. MacKenzie - ------------------- -------------------------- Hugh C. MacKenzie March 18, 1994 Director /s/ Jane E. Newman - ------------------- -------------------------- Jane E. Newman March 18, 1994 Director /s/ Dale S. Nitzschke - ------------------- -------------------------- Dale S. Nitzschke March 18, 1994 Director /s/ Robert P. Wax - ------------------- -------------------------- Robert P. Wax WESTERN MASSACHUSETTS ELECTRIC 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. WESTERN MASSACHUSETTS ELECTRIC COMPANY -------------------------------------- (Registrant) Date: March 18, 1994 By /s/ William B. Ellis -------------- -------------------- William B. Ellis 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. Date Title Signature ---- ----- --------- March 18, 1994 Chairman and Director /s/ William B. Ellis - -------------- -------------------------- William B. Ellis March 18, 1994 Vice Chairman and /s/ Bernard M. Fox - -------------- Director -------------------------- Bernard M. Fox March 18, 1994 President and Director /s/ Hugh C. MacKenzie - -------------- -------------------------- Hugh C. MacKenzie March 18, 1994 Executive Vice /s/ Robert E. Busch - -------------- President, Chief -------------------------- Financial Officer Robert E. Busch and Director March 18, 1994 Vice President and /s/ John W. Noyes - -------------- Controller -------------------------- John W. Noyes WESTERN MASSACHUSETTS ELECTRIC COMPANY SIGNATURES (CONT'D) Date Title Signature ---- ----- --------- - ------------------- Director -------------------------- Robert G. Abair March 18, 1994 Director /s/ John P. Cagnetta - ------------------- -------------------------- John P. Cagnetta March 18, 1994 Director /s/ William T. Frain, Jr. - ------------------- -------------------------- William T. Frain, Jr. March 18, 1994 Director /s/ Cheryl W. Grise - ------------------- ----------------------- Cheryl W. Grise March 18, 1994 Director /s/ John B. Keane - ------------------- ----------------------- John B. Keane March 18, 1994 Director /s/ John F. Opeka - ------------------- ----------------------- John F. Opeka NORTH ATLANTIC ENERGY 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. NORTH ATLANTIC ENERGY CORPORATION --------------------------------- (Registrant) Date: March 18, 1994 By /s/ William B. Ellis -------------- --------------------- William B. Ellis 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. Date Title Signature ---- ----- --------- March 18, 1994 Chairman and Director /s/ William B. Ellis - -------------- -------------------------- William B. Ellis March 18, 1994 Vice Chairman, Chief /s/ Bernard M. Fox - -------------- Executive Officer and -------------------------- Director Bernard M. Fox March 18, 1994 President, Chief /s/ Robert E. Busch - -------------- Operating Officer -------------------------- and Director Robert E. Busch March 18, 1994 Vice President and /s/ John W. Noyes - -------------- Controller -------------------------- John W. Noyes NORTH ATLANTIC ENERGY CORPORATION SIGNATURES (CONT'D) Date Title Signature ---- ----- --------- March 18, 1994 Director /s/ John P. Cagnetta - -------------- -------------------------- John P. Cagnetta - -------------- Director -------------------------- Ted C. Feigenbaum March 18, 1994 Director /s/ William T. Frain. Jr. - -------------- -------------------------- William T. Frain, Jr. March 18, 1994 Director /s/ Cheryl W. Grise - -------------- -------------------------- Cheryl W. Grise March 18, 1994 Director /s/ John B. Keane - -------------- -------------------------- John B. Keane March 18, 1994 Director /s/ Hugh C. MacKenzie - -------------- -------------------------- Hugh C. MacKenzie March 18, 1994 Director /s/ John F. Opeka - -------------- -------------------------- John F. Opeka REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS ON SCHEDULES We have audited in accordance with generally accepted auditing standards, the financial statements included in Northeast Utilities' annual report to shareholders and The Connecticut Light and Power Company's, Western Massachusetts Electric Company's, North Atlantic Energy Corporation's, and Public Service Company of New Hampshire's annual reports, incorporated by reference in this Form 10-K, and have issued our reports thereon dated February 18, 1994. Our reports on the financial statements include an explanatory paragraph with respect to the change in methods of accounting for property taxes, postretirement benefits other than pensions, income taxes, and employee stock ownership plans, as applicable to each company, as explained in Note 1 to the related company's financial statements. Our audits were made for the purpose of forming an opinion on each company's statements taken as a whole. The schedules listed in the index to financial statement schedules are the responsibility of each company's management and are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of each company's basic financial statements. The schedules have been subjected to the auditing procedures applied in the audits of each company's 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 each company's basic financial statements taken as a whole. /s/ ARTHUR ANDERSEN & CO. ARTHUR ANDERSEN & CO. Hartford, Connecticut February 18, 1994 S-1 INDEPENDENT AUDITORS' REPORT ON SCHEDULES The Board of Directors Public Service Company of New Hampshire: Under date of February 7, 1992, we reported on the balance sheet and statement of capitalization of Public Service Company of New Hampshire as of December 31, 1991 (not presented in the 1993 annual report to stockholders) and the related statements of income, cash flows and common stock equity for the periods January 1, 1991 to May 15, 1991 and May 16, 1991 to December 31, 1991, as contained in the annual report to stockholders of Public Service Company for the year 1993. These financial statements and our report thereon are incorporated by reference herein. In connection with our audits of the aforementioned financial statements, we have also audited the related financial statement schedules as listed in the accompanying index. These financial statement schedules are the responsibility of the Company's management. Our responsiblity is to express an opinion on these financial statement schedules based on our audit. 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. /s/ KPMG Peat Marwick KPMG Peat Marwick Boston, Massachusetts February 7, 1992 S-2 CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS As independent public accountants, we hereby consent to the incorporation by reference of our reports in this Form 10-K, into previously filed Registration Statement No. 33-13444, No. 33-46291 , No. 33-59430, and No. 33-50853 of The Connecticut Light and Power Company, No. 33-34886, No. 33-51185 and No. 33-25619 of Western Massachusetts Electric Company, and No. 33-34622 and No. 33-40156 of Northeast Utilities. /s/ ARTHUR ANDERSEN & CO. ARTHUR ANDERSEN & CO. Hartford, Connecticut March 18, 1994 S-3 INDEPENDENT AUDITORS' CONSENT The Board of Directors Public Service Company of New Hampshire: We consent to the use of our reports included or incorporated by reference herein. /s/ KPMG Peat Marwick KPMG Peat Marwick Boston, Massaschusetts March 18, 1994 S-4 INDEX TO FINANCIAL STATEMENT SCHEDULES Schedule Page - -------- ---- III. Financial Information of Registrant: Northeast Utilities (Parent) Balance Sheets 1993 and 1992 S-7 Northeast Utilities (Parent) Statements of Income 1993, 1992, and 1991 S-8 Northeast Utilities (Parent) Statements of Cash Flows 1993, 1992, and 1991 S-9 V. Utility Plant 1993, 1992, and 1991: Northeast Utilities and Subsidiaries S-10 -- S-12 The Connecticut Light and Power Company S-13 -- S-15 Public Service Company of New Hampshire S-16 -- S-20 Western Massachusetts Electric Company S-21 -- S-23 North Atlantic Energy Corporation S-24 -- S-25 V. Nuclear Fuel 1993, 1992, and 1991: Northeast Utilities and Subsidiaries S-26 -- S-28 The Connecticut Light and Power Company S-29 -- S-31 Public Service Company of New Hampshire S-32 -- S-36 Western Massachusetts Electric Company S-37 -- S-39 North Atlantic Energy Corporation S-40 -- S-41 VI. Accumulated Provision for Depreciation of Utility Plant 1993, 1992, and 1991: Northeast Utilities and Subsidiaries S-42 -- S-44 The Connecticut Light and Power Company S-45 Public Service Company of New Hampshire S-46 -- S-48 Western Massachusetts Electric Company S-49 North Atlantic Energy Corporation S-50 VIII. Valuation and Qualifying Accounts and Reserves 1993, 1992, and 1991: Northeast Utilities and Subsidiaries S-51 -- S-53 The Connecticut Light and Power Company S-54 -- S-56 Public Service Company of New Hampshire S-57 -- S-61 Western Massachusetts Electric Company S-62 -- S-64 S-5 Schedule Page - -------- ---- IX. Short-Term Borrowings 1993, 1992, and 1991: Northeast Utilities and Subsidiaries S-65 The Connecticut Light and Power Company S-66 Public Service Company of New Hampshire S-67 Western Massachusetts Electric Company S-68 North Atlantic Energy Corporation S-69 X. Supplementary Income Statement Information 1993, 1992, and 1991: Northeast Utilities and Subsidiaries S-70 The Connecticut Light and Power Company S-71 Public Service Company of New Hampshire S-72 Western Massachusetts Electric Company S-73 North Atlantic Energy Corporation S-74 All other schedules of the companies' for which provision is made in the applicable regulations of the Securities and Exchange Commission are not required under the related instructions or are not applicable, and therefore have been omitted. S-6 SCHEDULE III NORTHEAST UTILITIES (PARENT) ---------------------------- FINANCIAL INFORMATION OF REGISTRANT ----------------------------------- BALANCE SHEETS -------------- AT DECEMBER 31, 1993 AND 1992 ------------------------------ (Thousands of Dollars) S-7 SCHEDULE III NORTHEAST UTILITIES (PARENT) ---------------------------- FINANCIAL INFORMATION OF REGISTRANT ----------------------------------- STATEMENTS OF INCOME -------------------- YEARS ENDED DECEMBER 31, 1993, 1992, AND 1991 --------------------------------------------- (Thousands of Dollars Except Share Information) S-8 SCHEDULE III NORTHEAST UTILITIES (PARENT) FINANCIAL INFORMATION OF REGISTRANT STATEMENTS OF CASH FLOWS YEARS ENDED DECEMBER 31, 1993, 1992, AND 1991 (Thousands of Dollars) 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 S-32 S-33 S-34 S-35 S-36 S-37 S-38 S-39 S-40 S-41 S-42 S-43 S-44 S-45 S-46 S-47 S-48 S-49 S-50 S-51 S-52 S-53 S-54 S-55 S-56 S-57 S-58 S-59 S-60 S-61 S-62 S-63 S-64 S-65 S-66 S-67 S-68 S-69 S-70 S-71 S-72 S-73 S-74 EXHIBIT INDEX Each document described below is incorporated by reference to the files of the Securities and Exchange Commission, unless the reference to the document is marked as follows: * - Filed with the 1993 Annual Report on Form 10-K for NU and herein incorporated by reference from the 1993 NU Form 10-K, File No. 1-5324 into the 1993 Annual Reports on Form 10-K for CL&P, PSNH, WMECO and NAEC. # - Filed with the 1993 Annual Report on Form 10-K for NU and herein incorporated by reference from the 1993 NU Form 10-K, File No. 1-5324 into the 1993 Annual Report on Form 10-K for CL&P. @ - Filed with the 1993 Annual Report on Form 10-K for NU and herein incorporated by reference from the 1993 NU Form 10-K, File No. 1-5324 into the 1993 Annual Report on Form 10-K for PSNH. ** - Filed with the 1993 Annual Report on Form 10-K for NU and herein incorporated by reference from the 1993 NU Form 10-K, File No. 1-5324 into the 1993 Annual Report on Form 10-K for WMECO. ## - Filed with the 1993 Annual Report on Form 10-K for NU and herein incorporated by reference from the 1993 Form 10-K, File No. 1-5324 into the 1993 Annual Report on Form 10-K for NAEC. Exhibit Number Description 3 Articles of Incorporation and By-Laws 3.1 Northeast Utilities 3.1.1 Declaration of Trust of NU, as amended through May 24, 1988. (Exhibit 3.1.1, 1988 NU Form 10-K, File No. 1-5324) 3.2 The Connecticut Light and Power Company # 3.2.1 Certificate of Incorporation of CL&P, restated to March 22, 1994. # 3.2.2 By-laws of CL&P, as amended to March 1, 1982. 3.3 Public Service Company of New Hampshire @ 3.3.1 Articles of Incorporation, as amended to May 16, 1991. @ 3.3.2 By-laws of PSNH, as amended to November 1, 1993. 3.4 Western Massachusetts Electric Company 3.4.1 Certificate of Organization of WMECO, as amended, to August 31, 1954. (Exhibit 3.1, File No. 2-11114) 3.4.2 Amendments to Certificate of Organization of WMECO of May 19, 1966 and of December 5, 1967. (Exhibit 3.2, File No. 2-30534) E-1 3.4.3 Articles of Amendment dated December 9, 1981. (Exhibit 3.1.2, 1981 WMECO Form 10-K, File No. 0-7624) 3.4.4 Certificate of Vote of Directors Establishing a Series of a Class of Stock, dated December 16, 1981. (Exhibit 3.1.3, 1981 WMECO Form 10-K, File No. 0-7624) 3.4.5 Articles of Amendment dated April 7, 1983. (Exhibit 3.3.5, 1983 NU Form 10-K, File No. 1-5324) 3.4.6 Certificate of Vote of Directors Establishing a Series of a Class of Stock, dated April 12, 1983. (Exhibit 3.3.6, 1983 NU Form 10-K, File No. 1-5324) 3.4.7 Articles of Amendment dated January 29, 1987. (Exhibit 3.3.7, 1986 NU Form 10-K, File No. 1-5324) 3.4.8 Articles of Amendment dated February 11, 1987. (Exhibit 3.3.8, 1986 NU Form 10-K, File No. 1-5324) 3.4.9 Articles of Amendment dated February 19, 1988. (Exhibit 3.3.9, 1987 NU Form 10-K, File No. 1-5324) 3.4.10 Certificate of Vote of Directors Establishing a Series of a Class of Stock, dated February 23, 1988. (Exhibit 3.3.10, 1987 NU Form 10-K, File No. 1-5324) ** 3.4.11 By-laws of WMECO, as amended to February 24, 1988. 3.5 North Atlantic Energy Corporation ## 3.5.1 Articles of Incorporation of NAEC dated September 20, 1991. ## 3.5.2 Articles of Amendment dated October 16, 1991 and June 2, 1992 to Articles of Incorporation of NAEC. ## 3.5.3 By-laws of NAEC, as amended to November 8, 1993. 4 Instruments defining the rights of security holders, including indentures 4.1 Northeast Utilities 4.1.1 Indenture dated as of December 1, 1991 between Northeast Utilities and IBJ Schroder Bank & Trust Company, with respect to the issuance of Debt Securities. (Exhibit 4.1.1, 1991 NU Form 10-K, File No. 1-5324) 4.1.2 First Supplemental Indenture dated as of December 1, 1991 between Northeast Utilities and IBJ Schroder Bank & Trust Company, with respect to the issuance of Series A Notes. (Exhibit 4.1.2, 1991 NU Form 10-K, File No. 1-5324) 4.1.3 Second Supplemental Indenture dated as of March 1, 1992 between Northeast Utilities and IBJ Schroder Bank & Trust Company with respect to the issuance of 8.38% Amortizing Notes. (Exhibit 4.1.3, 1992 NU Form 10-K, File No. 1-5324) E-2 4.1.4 Warrant Agreement dated as of June 5, 1992 between Northeast Utilities and the Service Company. (Exhibit 4.1.4, 1992 NU Form 10-K, File No. 1-5324) 4.1.4.1 Additional Warrant Agent Agreement dated as of June 5, 1992 between Northeast Utilities and State Street Bank and Trust Company. (Exhibit 4.1.4.1, 1992 NU Form 10-K, File No. 1-5324) 4.1.4.2 Exchange and Disbursing Agent Agreement dated as of June 5, 1992 among Northeast Utilities, Public Service Company of New Hampshire and State Street Bank and Trust Company. (Exhibit 4.1.4.2, 1992 NU Form 10-K, File No. 1-5324) 4.1.5 Credit Agreements among CL&P, NU, WMECO, NUSCO (as Agent) and 19 Commercial Banks dated December 3, 1992 (364 Day and Three-Year Facilities). (Exhibit C.2.38, 1992 NU Form U5S, File No. 30-246) 4.1.6 Credit Agreements among CL&P, WMECO, NU, Holyoke Water Power Company, RRR, NNECO and NUSCO (as Agent) dated December 3, 1992 (364 Day and Three-Year Facilities). (Exhibit C.2.39, 1992 NU Form U5S, File No. 30-246) 4.2 The Connecticut Light and Power Company 4.2.1 Indenture of Mortgage and Deed of Trust between CL&P and Bankers Trust Company, Trustee, dated as of May 1, 1921. (Composite including all twenty-four amendments to May 1, 1967.) (Exhibit 4.1.1, 1989 NU Form 10-K, File No. 1-5324) Supplemental Indentures to the Composite May 1, 1921 Indenture of Mortgage and Deed of Trust between CL&P and Bankers Trust Company, dated as of: 4.2.2 April 1, 1967. (Exhibit 4.16, File No. 2-60806) 4.2.3 January 1, 1968. (Exhibit 4.18, File No. 2-60806) 4.2.4 December 1, 1969. (Exhibit 4.20, File No. 2-60806) 4.2.5 June 30, 1982. (Exhibit 4.33, File No. 2-79235) 4.2.6 June 1, 1989. (Exhibit 4.1.24, 1989 NU Form 10-K, File No. 1-5324) 4.2.7 September 1, 1989. (Exhibit 4.1.25, 1989 NU Form 10-K, File No. 1-5324) 4.2.8 December 1, 1989. (Exhibit 4.1.26, 1989 NU Form 10-K, File No. 1-5324) 4.2.9 April 1, 1992. (Exhibit 4.30, File No. 33-59430) 4.2.10 July 1, 1992. (Exhibit 4.31, File No. 33-59430) E-3 4.2.11 October 1, 1992. (Exhibit 4.32, File No. 33-59430) 4.2.12 July 1, 1993. (Exhibit A.10(b), File No. 70-8249) 4.2.13 July 1, 1993. (Exhibit A.10(b), File No. 70-8249) # 4.2.14 December 1, 1993. # 4.2.15 February 1, 1994. # 4.2.16 February 1, 1994. 4.2.17 Financing Agreement between Industrial Development Authority of the State of New Hampshire and CL&P (Pollution Control Bonds) dated as of December 1, 1986. (Exhibit C.1.47, 1986 NU Form U5S, File No. 30-246) 4.2.18 Financing Agreement between Industrial Development Authority of the State of New Hampshire and CL&P (Pollution Control Bonds) dated as of October 1, 1988. (Exhibit C.1.55, 1988 NU Form U5S, File No. 30-246) 4.2.19 Financing Agreement between Industrial Development Authority of the State of New Hampshire and CL&P (Pollution Control Bonds) dated as of December 1, 1989. (Exhibit C.1.39, 1989 NU Form U5S, File No. 30-246) 4.2.20 Loan and Trust Agreement among Business Finance Authority of the State of New Hampshire and CL&P (Pollution Control Bonds) dated as of December 1, 1992. (Exhibit C.2.33, 1992 NU Form U5S, File No. 30-246) # 4.2.21 Series A (Tax Exempt Refunding) PCRB Loan Agreement between Connecticut Development Authority and CL&P (Pollution Control Bonds) dated as of September 1, 1993. # 4.2.22 Series B (Tax Exempt Refunding) PCRB Loan Agreement between Connecticut Development Authority and CL&P (Pollution Control Bonds) dated as of September 1, 1993. # 4.2.23 Series A (Tax Exempt Refunding) PCRB Letter of Credit and Reimbursement Agreement (Pollution Control Bonds) dated as of September 1, 1993. # 4.2.24 Series B (Tax Exempt Refunding) PCRB Letter of Credit and Reimbursement Agreement (Pollution Control Bonds) dated as of September 1, 1993. 4.3 Public Service Company of New Hampshire 4.3.1 First Mortgage Indenture dated as of August 15, 1978 between PSNH and First Fidelity Bank, National Association, New Jersey, Trustee, (Composite including all amendments to May 16, 1991). (Exhibit 4.4.1, 1992 NU Form 10-K, File No. 1- 5324) E-4 4.3.1.1 Tenth Supplemental Indenture dated as of May 1, 1991 between PSNH and First Fidelity Bank, National Association. (Exhibit 4.1, PSNH Current Report on Form 8-K dated February 10, 1992, File No. 1-6392). 4.3.2 Revolving Credit Agreement dated as May 1, 1991. (Exhibit 4.12, PSNH Current Report on Form 8-K dated February 10, 1992, File No. 1-6392) 4.3.3 Term Credit Agreement dated as of May 1, 1991. (Exhibit 4.11, PSNH Current Report on Form 8-K dated February 10, 1992, File No. 1-6392) 4.3.4 Series A (Tax Exempt New Issue) PCRB Loan and Trust Agreement dated as of May 1, 1991. (Exhibit 4.2, PSNH Current Report on Form 8-K dated February 10, 1992, File No. 1-6392) 4.3.5 Series B (Tax Exempt Refunding) PCRB Loan and Trust Agreement dated as of May 1, 1991. (Exhibit 4.3, PSNH Current Report on Form 8-K dated February 10, 1992, File No. 1-6392) 4.3.6 Series C (Tax Exempt Refunding) PCRB Loan and Trust Agreement dated as of May 1, 1991. (Exhibit 4.4, PSNH Current Report on Form 8-K dated February 10, 1992, File No. 1-6392) 4.3.7 Series D (Taxable New Issue) PCRB Loan and Trust Agreement dated as of May 1, 1991. (Exhibit 4.5, PSNH Current Report on Form 8-K dated February 10, 1992, File No. 1-6392) 4.3.7.1 First Supplement to Series D (Tax Exempt Refunding Issue) PCRB Loan and Trust Agreement dated as of December 1, 1992. (Exhibit 4.4.5.1, 1992 NU Form 10-K, File No. 1-5324) 4.3.8 Series E (Taxable New Issue) PCRB Loan and Trust Agreement dated as of May 1, 1991. (Exhibit 4.6, PSNH Current Report on Form 8-K dated February 10, 1992, File No. 1-6392) @ 4.3.8.1 First Supplement to Series E (Tax Exempt Refunding Issue) PCRB Loan and Trust Agreement dated as of December 1, 1993. @ 4.3.9 Series D (May 1, 1991 Taxable New Issue and December 1, 1992 Tax Exempt Refunding Issue) PCRB Letter of Credit and Reimbursement Agreement dated as of October 1, 1992. @ 4.3.9.1 Amended and Restated Letter of Credit dated December 17, 1992. 4.3.10 Series E (May 1, 1991 Taxable New Issue and December 1, 1993 Tax Exempt Refunding Issue) PCRB Letter of Credit and Reimbursement Agreement dated as of May 1, 1991. (Exhibit 4.8, PSNH Current Report on Form 8-K dated February 10, 1992, File No. 1-6392) E-5 @ 4.3.10.1 Amended and Restated Letter of Credit dated December 15, 1993. 4.4 Western Massachusetts Electric Company ** 4.4.1 First Mortgage Indenture and Deed of Trust between WMECO and Old Colony Trust Company, Trustee, dated as of August 1, 1954. Supplemental Indentures thereto dated as of: 4.4.2 March 1, 1967. (Exhibit 2.5, File No. 2-68808) 4.4.3 March 1, 1968. (Exhibit 2.6, File No. 2-68808) 4.4.4 December 1, 1968. (Exhibit 2.7, File No. 2-68808) 4.4.5 July 1, 1972. (Exhibit 2.9, File No. 2-68808) 4.4.6 May 1, 1986. (Exhibit 4.3.18, 1986 NU Form 10-K, File No. 1-5324) 4.4.7 December 1, 1988. (Exhibit 4.3.20, 1988 NU Form 10-K, File No. 1-5324.) 4.4.8 September 1, 1990. (Exhibit 4.3.15, 1990 NU Form 10-K, File No. 1-5324.) 4.4.9 December 1, 1992. (Exhibit 4.15, File No. 33-55772) 4.4.10 January 1, 1993. (Exhibit 4.5.13, 1992 NU Form 10-K, File No. 1-5324) ** 4.4.11 March 1, 1994. ** 4.4.12 March 1, 1994. ** 4.4.13 Series A (Tax Exempt Refunding) PCRB Loan Agreement between Connecticut Development Authority and WMECO (Pollution Control Bonds) dated as of September 1, 1993. ** 4.4.14 Series A (Tax Exempt Refunding) PCRB Letter of Credit and Reimbursement Agreement (Pollution Control Bonds) dated as of September 1, 1993. 4.5 North Atlantic Energy Corporation 4.5.1 First Mortgage Indenture and Deed of Trust between NAEC and United States Trust Company of New York, Trustee, dated as of June 1, 1992. (Exhibit 4.6.1, 1992 NU Form 10-K, File No. 1-5324) 4.5.2 Note Indenture dated as of May 15, 1991. (Exhibit 4.10, PSNH Current Report on Form 8-K dated February 10, 1992, File No. 1-6392) E-6 4.5.3 First Supplemental Indenture dated as of June 5, 1992 between NAEC, PSNH and United States Trust Company of New York, Trustee. (Exhibit 4.6.3, 1992 NU Form 10-K, File No. 1-5324) 10 Material Contracts 10.1 Stockholder Agreement dated as of July 1, 1964 among the stockholders of Connecticut Yankee Atomic Power Company (CYAPC). (Exhibit 13.1, File No. 2-22958) 10.2 Form of Power Contract dated as of July 1, 1964 between CYAPC and each of CL&P, HELCO, PSNH and WMECO. (Exhibit 13.2, File No. 2-22958) 10.2.1 Form of Additional Power Contract dated as of April 30, 1984, between CYAPC and each of CL&P, PSNH and WMECO. (Exhibit 10.2.4, 1984 NU Form 10-K, File No. 1-5324) 10.2.2 Form of 1987 Supplementary Power Contract dated as of April 1, 1987, between CYAPC and each of CL&P, PSNH and WMECO. (Exhibit 10.2.6, 1987 NU Form 10-K, File No. 1-5324) 10.3 Capital Funds Agreement dated as of September 1, 1964 between CYAPC and CL&P, HELCO, PSNH and WMECO. (Exhibit 13.3, File No. 2-22958) #@** 10.4 Stockholder Agreement dated December 10, 1958 between Yankee Atomic Electric Company (YAEC) and CL&P, HELCO, PSNH and WMECO. 10.5 Form of Amendment No. 3, dated as of April 1, 1985, to Power Contract between YAEC and each of CL&P, PSNH and WMECO, including a composite restatement of original Power Contract dated June 30, 1959 and Amendment No. 1 dated April 1, 1975 and Amendment No. 2 dated October 1, 1980. (Exhibit 10.5, 1988 NU Form 10-K, File No. 1-5324.) 10.5.1 Form of Amendment No. 4 to Power Contract, dated May 6, 1988, between YAEC and each of CL&P, PSNH and WMECO. (Exhibit 10.5.1, 1989 NU Form 10-K, File No. 1-5324) 10.5.2 Form of Amendment No. 5 to Power Contract, dated June 26, 1989, between YAEC and each of CL&P, PSNH and WMECO. (Exhibit 10.5.2, 1989 NU Form 10-K, File No. 1-5324) 10.5.3 Form of Amendment No. 6 to Power Contract, dated July 1, 1989, between YAEC and each of CL&P, PSNH and WMECO. (Exhibit 10.5.3, 1989 NU Form 10-K, File No. 1-5324) #@** 10.5.4 Form of Amendment No. 7 to Power Contract, dated February 1, 1992, between YAEC and each of CL&P, PSNH and WMECO. 10.6 Stockholder Agreement dated as of May 20, 1968 among stockholders of MYAPC. (Exhibit 4.15, File No. 2-30018) 10.7 Form of Power Contract dated as of May 20, 1968 between MYAPC and each of CL&P, HELCO, PSNH and WMECO. (Exhibit 4.14, File No. 2-30018) E-7 #@** 10.7.1 Form of Amendment No. 1 to Power Contract dated as of March 1, 1983 between MYAPC and each of CL&P, PSNH and WMECO. #@** 10.7.2 Form of Amendment No. 2 to Power Contract dated as of January 1, 1984 between MYAPC and each of CL&P, PSNH and WMECO. 10.7.3 Form of Amendment No. 3 to Power Contract dated as of October 1, 1984 between MYAPC and each of CL&P, PSNH and WMECO. (Exhibit 10.7.3, 1985 NU Form 10-K, File No. 1-5324) #@** 10.7.4 Form of Additional Power Contract dated as of February 1, 1984 between MYAPC and each of CL&P, PSNH and WMECO. 10.8 Capital Funds Agreement dated as of May 20, 1968 between Maine Yankee Atomic Power Company (MYAPC) and CL&P, PSNH, HELCO and WMECO. (Exhibit 4.13, File No. 2-30018) 10.8.1 Amendment No. 1 to Capital Funds Agreement, dated as of August 1, 1985, between MYAPC, CL&P, PSNH and WMECO. (Exhibit 10.6.1, 1985 NU Form 10-K, File No. 1-5324) 10.9 Sponsor Agreement dated as of August 1, 1968 among the sponsors of VYNPC. (Exhibit 4.16, File No. 2-30285) 10.10 Form of Power Contract dated as of February 1, 1968 between VYNPC and each of CL&P, HELCO, PSNH and WMECO. (Exhibit 4.18, File No. 2-30018) 10.10.1 Form of Amendment to Power Contract dated as of June 1, 1972 between VYNPC and each of CL&P, HELCO, PSNH and WMECO. (Exhibit 5.22, File No. 2-47038) #@** 10.10.2 Form of Second Amendment to Power Contract dated as of April 15, 1983 between VYNPC and each of CL&P, PSNH and WMECO. 10.10.3 Form of Third Amendment to Power Contract dated as of April 24, 1985 between VYNPC and each of CL&P, PSNH and WMECO. (Exhibit 10.10.3, 1986 NU Form 10-K, File No. 1-5324) 10.10.4 Form of Fourth Amendment to Power Contract dated as of June 1, 1985 between VYNPC and each of CL&P, PSNH and WMECO. (Exhibit 10.10.4, 1986 NU Form 10-K, File No. 1-5324) 10.10.5 Form of Fifth Amendment to Power Contract dated as of May 6, 1988 between VYNPC and each of CL&P, PSNH and WMECO. (Exhibit 10.10.5, 1990 NU Form 10-K, File No. 1-5324) 10.10.6 Form of Sixth Amendment to Power Contract dated as of May 6, 1988 between VYNPC and each of CL&P, PSNH and WMECO. (Exhibit 10.10.6, 1990 NU Form 10-K, File No. 1-5324) E-8 10.10.7 Form of Seventh Amendment to Power Contract dated as of June 15, 1989 between VYNPC and each of CL&P, PSNH and WMECO. (Exhibit 10.10.7, 1990 NU Form 10-K, File No. 1-5324) 10.10.8 Form of Eighth Amendment to Power Contract dated as of December 1, 1989 between VYNPC and each of CL&P, PSNH and WMECO. (Exhibit 10.10.8, 1990 NU Form 10-K, File No. 1-5324) #@** 10.10.9 Form of Additional Power Contract dated as of February 1, 1984 between VYNPC and each of CL&P, PSNH and WMECO. 10.11 Capital Funds Agreement dated as of February 1, 1968 between Vermont Yankee Nuclear Power Corporation (VYNPC) and CL&P, HELCO, PSNH and WMECO. (Exhibit 4.16, File No. 2-30018) 10.11.1 Form of First Amendment to Capital Funds Agreement dated as of March 12, 1968 between VYNPC and CL&P, HELCO, PSNH and WMECO. (Exhibit 4.17, File No. 2-30018) #@** 10.11.2 Form of Second Amendment to Capital Funds Agreement dated as of September 1, 1993 between VYNPC and CL&P, HELCO, PSNH and WMECO. 10.12 Amended and Restated Millstone Plant Agreement dated as of December 1, 1984 by and among CL&P, WMECO and Northeast Nuclear Energy Company (NNECO). (Exhibit 10.17, 1985 NU Form 10-K, File No. 1-5324) 10.13 Sharing Agreement dated as of September 1, 1973 with respect to 1979 Connecticut nuclear generating unit (Millstone 3). (Exhibit 6.43, File No. 2-50142) 10.13.1 Amendment dated August 1, 1974 to Sharing Agreement - 1979 Connecticut Nuclear Unit. (Exhibit 5.45, File No. 2-52392) 10.13.2 Amendment dated December 15, 1975 to Sharing Agreement - 1979 Connecticut Nuclear Unit. (Exhibit 7.47, File No. 2-60806) 10.13.3 Amendment dated April 1, 1986 to Sharing Agreement - 1979 Connecticut Nuclear Unit. (Exhibit 10.17.3, 1990 NU Form 10-K, File No. 1-5324) 10.14 Agreement dated July 19, 1990, among NAESCO and Seabrook Joint owners with respect to operation of Seabrook. (Exhibit 10.53, 1990 NU Form 10-K, File No. 1-5324) 10.15 Sharing Agreement between CL&P, WMECO, HP&E, HWP and PSNH dated as of June 1, 1992. (Exhibit 10.17, 1992 NU Form 10- K, File No. 1-5324) 10.16 Form of Seabrook Power Contract between PSNH and NAEC, as amended and restated. (Exhibit 10.45, NU 1992 Form 10-K, File No. 1-5324) E-9 10.17 Agreement for joint ownership, construction and operation of New Hampshire nuclear generating units dated as of May 1, 1973. (Exhibit 13-57, File No. 2-48966) 10.17.1 Amendments to Exhibit 10.17 dated May 24, 1974, June 21, 1974 and September 25, 1974. (Exhibit 5.15, File No. 2-51999) 10.17.2 Amendments to Exhibit 10.17 dated October 25, 1974 and January 31, 1975. (Exhibit 5.23, File No. 2-54646) 10.17.3 Sixth Amendment to Exhibit 10.17 dated as of April 18, 1979. (Exhibit 5.4.3, File No. 2-64294) 10.17.4 Seventh Amendment to Exhibit 10.17 dated as of April 18, 1979. (Exhibit 5.4.4, File No. 2-64294) 10.17.5 Eighth Amendment to Exhibit 10.17 dated as of April 25, 1979. (Exhibit 5.4.5, File No. 2-64815) 10.17.6 Ninth Amendment to Exhibit 10.17 dated as of June 8, 1979. (Exhibit 5.4.6, File No. 2-64815) 10.17.7 Tenth Amendment to Exhibit 10.17 dated as of October 10, 1979. (Exhibit 5.4.2, File No. 2-66334) 10.17.8 Eleventh Amendment to Exhibit 10.17 dated as of December 15, 1979. (Exhibit 5.4.8, File No. 2-66492) 10.17.9 Twelfth Amendment to Exhibit 10.17 dated as of June 16, 1980. (Exhibit 5.4.9, File No. 2-68168) 10.17.10 Thirteenth Amendment to Exhibit 10.17 dated as of December 31, 1980. (Exhibit 10.6, File No. 2-70579) * 10.17.11 Fourteenth Amendment to Exhibit 10.17 dated as of June 1, 1982. 10.17.12 Fifteenth Amendment to Exhibit 10.17 dated as of April 27, 1984. (Exhibit 10.14.12, 1984 NU Form 10-K, File No. 1-5324) 10.17.13 Sixteenth Amendment to Exhibit 10.17 dated as of June 15, 1984. (Exhibit 10.14.13, 1984 NU Form 10-K, File No. 1-5324) 10.17.14 Seventeenth Amendment to Exhibit 10.17 dated as of March 8, 1985. (Exhibit 10.13.14, 1985 NU Form 10-K, File No. 1-5324) 10.17.15 Eighteenth Amendment to Exhibit 10.17 dated as of March 14, 1986. (Exhibit 10.13.15, 1986 NU Form 10-K, File No. 1-5324) 10.17.16 Nineteenth Amendment to Exhibit 10.17 dated as of May 1, 1986. (Exhibit 10.13.16, 1986 NU Form 10-K, File No. 1-5324) E-10 10.17.17 Twentieth Amendment to Exhibit 10.17 dated as of July 15, 1986. (Exhibit 10.13.17, 1986 NU Form 10-K, File No. 1-5324) 10.17.18 Twenty-first Amendment to Exhibit 10.17 dated as of November 12, 1987. (Exhibit 10.13.18, 1987 NU Form 10-K, File No. 1-5324) 10.17.19 Twenty-second Amendment to Exhibit 10.17 dated as of January 13, 1989. (Exhibit 10.13.19, 1989 NU Form 10-K, File No. 1-5324) 10.17.20 Twenty-third Amendment to Exhibit 10.17 dated as of November 1, 1990. (Exhibit 10.13.20, 1990 NU Form 10- K, File No. 1-5324) 10.17.21 Memorandum of Understanding dated November 7, 1988 between PSNH and Massachusetts Municipal Wholesale Electric Company (Exhibit 10.17, PSNH 1989 Form 10-K, File No. 1-6392) 10.17.22 Agreement of Settlement among Joint Owners dated as of January 13, 1989. (Exhibit 10.13.21, 1988 NU Form 10- K, File No. 1-5324) 10.17.22.1 Supplement to Settlement Agreement, dated as of February 7, 1989, between PSNH and Central Maine Power Company. (Exhibit 10.18.1, PSNH 1989 Form 10-K, File No. 1-6392) 10.18 Amended and Restated Agreement for Seabrook Project Disbursing Agent dated as of November 1, 1990. (Exhibit 10.4.7, File No. 33-35312) 10.18.1 Form of First Amendment to Exhibit 10.18. (Exhibit 10.4.8, File No. 33-35312) * 10.18.2 Form (Composite) of Second Amendment to Exhibit 10.18. 10.19 Agreement dated November 1, 1974 for Joint Ownership, Construction and Operation of William F. Wyman Unit No. 4 among PSNH, Central Maine Power Company and other utilities. (Exhibit 5.16 , File No. 2-52900) 10.19.1 Amendment to Exhibit 10.19 dated June 30, 1975. (Exhibit 5.48, File No. 2-55458) 10.19.2 Amendment to Exhibit 10.19 dated as of August 16, 1976. (Exhibit 5.19, File No. 2-58251) 10.19.3 Amendment to Exhibit 10.19 dated as of December 31, 1978. (Exhibit 5.10.3, File No. 2-64294) #** 10.20 Form of Service Contract dated as of July 1, 1966 between each of NU, CL&P and WMECO and the Service Company. 10.20.1 Service Contract dated as of June 5, 1992 between PSNH and the Service Company. (Exhibit 10.12.4, 1992 NU Form 10-K, File No. 1-5324) E-11 10.20.2 Service Contract dated as of June 5, 1992 between NAEC and the Service Company. (Exhibit 10.12.5, 1992 NU Form 10-K, File No. 1-5324) * 10.20.3 Form of Annual Renewal of Service Contract. 10.21 Memorandum of Understanding between CL&P, HELCO, Holyoke Power and Electric Company (HP&E), Holyoke Water Power Company (HWP) and WMECO dated as of June 1, 1970 with respect to pooling of generation and transmission. (Exhibit 13.32, File No. 2-38177) #** 10.21.1 Amendment to Memorandum of Understanding between CL&P, HELCO, HP&E, HWP and WMECO dated as of February 2, 1982 with respect to pooling of generation and transmission. 10.22 New England Power Pool Agreement effective as of November 1, 1971, as amended to November 1, 1988. (Exhibit 10.15, 1988 NU Form 10-K, File No. 1-5324.) 10.22.1 Twenty-sixth Amendment to Exhibit 10.22 dated as of March 15, 1989. (Exhibit 10.15.1, 1990 NU Form 10-K, File No. 1-5324) 10.22.2 Twenty-seventh Amendment to Exhibit 10.22 dated as of October 1, 1990. (Exhibit 10.15.2, 1991 NU Form 10-K, File No. 1-5324) 10.22.3 Twenty-eighth Amendment to Exhibit 10.22 dated as of September 15, 1992. (Exhibit 10.18.3, 1992 NU Form 10-K, File No. 1-5324) * 10.22.4 Twenty-ninth Amendment to Exhibit 10.22 dated as of May 1, 1993. 10.23 Agreements among New England Utilities with respect to the Hydro-Quebec interconnection projects. (See Exhibits 10(u) and 10(v); 10(w), 10(x), and 10(y), 1990 and 1988, respectively, Form 10-K of New England Electric System, File No. 1-3446.) 10.24 Trust Agreement dated February 11, 1992, between State Street Bank and Trust Company of Connecticut, as Trustor, and Bankers Trust Company, as Trustee, and CL&P and WMECO, with respect to NBFT. (Exhibit 10.23, 1991 NU Form 10-K, File No. 1-5324) 10.24.1 Nuclear Fuel Lease Agreement dated as of February 11, 1992, between Bankers Trust Company, Trustee, as Lessor, and CL&P and WMECO, as Lessees. (Exhibit 10.23.1, 1991 NU Form 10-K, File No. 1-5324) 10.25 Simulator Financing Lease Agreement, dated as of February 1, 1985, by and between ComPlan and NNECO. (Exhibit 10.52, 1985 NU Form 10-K, File No. 1-5324) E-12 10.26 Simulator Financing Lease Agreement, dated as of May 2, 1985, by and between The Prudential Insurance Company of America and NNECO. (Exhibit 10.53, 1985 NU Form 10-K, File No. 1-5324) 10.27 Lease dated as of April 14, 1992 between The Rocky River Realty Company (RRR) and Northeast Utilities Service Company (NUSCO) with respect to the Berlin, Connecticut headquarters (office lease). (Exhibit 10.29, 1992 NU Form 10-K, File No. 1-5324) 10.27.1 Lease date as of April 14, 1992 between RRR and NUSCO with respect to the Berlin, Connecticut headquarters (project lease). (Exhibit 10.29.1, 1992 NU Form 10-K, File No. 1-5324) * 10.28 Millstone Technical Building Note Agreement dated as of December 21, 1993 between, by and between The Prudential Insurance Company of America and NNECO. 10.29 Lease and Agreement, dated as of December 15, 1988, by and between WMECO and Bank of New England, N.A., with BNE Realty Leasing Corporation of North Carolina. (Exhibit 10.63, 1988 NU Form 10-K, File No. 1-5324.) 10.30 Note Agreement dated April 14, 1992, by and between The Rocky River Realty Company (RRR) and Purchasers named therein (Connecticut General Life Insurance Company, Life Insurance Company of North America, INA Life Insurance Company of New York, Life Insurance Company of Georgia), with respect to RRR's sale of $15 million of guaranteed senior secured notes due 2007 and $28 million of guaranteed senior secured notes due 2017. (Exhibit 10.52, 1992 NU Form 10-K, File No. 1-5324) 10.30.1 Note Guaranty dated April 14, 1992 by Northeast Utilities pursuant to Note Agreement dated April 14, 1992 between RRR and Note Purchasers, for the benefit of The Connecticut National Bank as Trustee, the Purchasers and the owners of the notes. (Exhibit 10.52.1, 1992 NU Form 10-K, File No. 1-5324) 10.30.2 Assignment of Leases, Rents and Profits, Security Agreement and Negative Pledge, dated as of April 14, 1992 among RRR, NUSCO and The Connecticut National Bank as Trustee, securing notes sold by RRR pursuant to April 14, 1992 Note Agreement. (Exhibit 10.52.2, 1992 NU Form 10-K, File No. 1-5324) 10.31 Master Trust Agreement dated as of September 2, 1986 between CL&P and WMECO and Colonial Bank as Trustee, with respect to reserve funds for Millstone 1 decommissioning costs. (Exhibit 10.80, 1986 NU Form 10-K, File No. 1-5324) 10.31.1 Notice of Appointment of Mellon Bank, N.A. as Successor Trustee, dated November 20, 1990, and Acceptance of Appointment. (Exhibit 10.41.1, 1992 NU Form 10-K, File No. 1-5324) E-13 10.32 Master Trust Agreement dated as of September 2, 1986 between CL&P and WMECO and Colonial Bank as Trustee, with respect to reserve funds for Millstone 2 decommissioning costs. (Exhibit 10.81, 1986 NU Form 10-K, File No. 1-5324) 10.32.1 Notice of Appointment of Mellon Bank, N.A. as Successor Trustee, dated November 20, 1990, and Acceptance of Appointment. (Exhibit 10.42.1, 1992 NU Form 10-K, File No. 1-5324) 10.33 Master Trust Agreement dated as of April 23, 1986 between CL&P and WMECO and Colonial Bank as Trustee, with respect to reserve funds for Millstone 3 decommissioning costs. (Exhibit 10.82, 1986 NU Form 10-K, File No. 1-5324) 10.33.1 Notice of Appointment of Mellon Bank, N.A. as Successor Trustee, dated November 20, 1990, and Acceptance of Appointment. (Exhibit 10.43.1, 1992 NU Form 10-K, File No. 1-5324) 10.34 NU Executive Incentive Plan, effective as of January 1, 1991. (Exhibit 10.44, NU 1991 Form 10-K, File No. 1-5324) 10.35 Supplemental Executive Retirement Plan for Officers of NU System Companies, Amended and Restated effective as of January 1, 1992. (Exhibit 10.45.1, NU Form 10-Q for the Quarter Ended June 30, 1992, File No. 1-5324) * 10.35.1 Amendment 1 to Exhibit 10.35, effective as of August 1, 1993. * 10.35.2 Amendment 2 to Exhibit 10.35, effective as of January 1, 1994. 10.36 Loan Agreement dated as of December 2, 1991, by and between NU and Mellon Bank, N.A., as Trustee, with respect to NU's loan of $175 million to an ESOP Trust. (Exhibit 10.46, NU 1991 Form 10-K, File No. 1-5324) * 10.36.1 First Amendment to Exhibit 10.36 dated February 7, 1992. 10.36.2 Loan Agreement dated as of March 19, 1992 by and between NU and Mellon Bank, N.A., as Trustee, with respect to NU's loan of $75 million to the ESOP Trust. (Exhibit 10.49.1, 1992 NU Form 10-K, File No. 1-5324) * 10.36.3 Second Amendment to Exhibit 10.36 dated April 9, 1992. 10.37 Management Succession Agreement. (Exhibit 10.47, NU Form 10-Q for the Quarter Ended June 30, 1992, File No. 1-5324) 10.38 Employment Agreement. (Exhibit 10.48, NU Form 10-Q for the Quarter Ended June 30, 1992, File No. 1-5324) 13 Annual Report to Security Holders (Each of the Annual Reports is filed only with the Form 10-K of that respective registrant.) E-14 * 13.1 Portions of the Annual Report to Security Holders of NU (pages 17 - 54) that have been incorporated by reference into this Form 10-K. 13.2 Annual Report of CL&P. 13.3 Annual Report of WMECO. 13.4 Annual Report of PSNH. 13.5 Annual Report of NAEC. 21 Subsidiaries of the Registrant (Exhibit 22, 1992 NU Form 10-K, File 1-5324) E-15 Item 12. Security Ownership of Certain Beneficial Owners and Management NU. Incorporated herein by reference are pages 5 through 12 of the definitive proxy statement for solicitation of proxies by NU's Board of Trustees, dated April 1, 1994 and filed with the Commission pursuant to Rule 14a-6 under the Act. CL&P, PSNH, WMECO and NAEC. As of February 28, 1994, the Directors of CL&P, PSNH, WMECO and NAEC, beneficially owned the following number of shares of each class of equity securities of NU. No equity securities of CL&P, PSNH or WMECO are owned by the Directors and Executive Officers. CL&P, PSNH, WMECO, and NAEC DIRECTORS AND NAMED EXECUTIVE OFFICERS Amount and Nature of Title Of Name of Beneficial Percent of Class Beneficial Owner Ownership (1) Class (2) NU Common Robert G. Abair (3) (621) 4,271 shares NU Common Robert E. Busch (772) 6,054 shares NU Common John P. Cagnetta (4) (581) 3,979 shares NU Common John C. Collins (5) 0 shares NU Common William B. Ellis (6) (1,259) 14,837 shares NU Common Ted C. Feigenbaum(7) 151 shares NU Common Bernard M. Fox (8) (1,072) 17,428 shares NU Common William T. Frain, Jr. 885 shares NU Common Cheryl W. Grise (221) 1,349 shares NU Common John B. Keane (9) (368) 1,146 shares NU Common Francis L. Kinney (10) (303) 3,781 shares NU Common Gerald Letendre (5) 0 shares NU Common Hugh C. MacKenzie (4)(11) (779) 4,277 shares NU Common Jane E. Newman (5) 0 shares NU Common Dale F. Nitzschke (5) 0 shares NU Common John W. Noyes (658) 2,789 shares NU Common John F. Opeka (4)(12) (1,075) 16,463 shares NU Common Robert P. Wax (5) (651) 1,436 shares Amount beneficially owned by Directors and Executive Officers as a group - CL&P (7,709) 77,259 shares - PSNH (6,790) 69,299 shares - WMECO (7,709) 77,259 shares - NAEC (7,088) 73,139 shares (1) Unless otherwise noted, each Director and Executive Officer of CL&P, PSNH, WMECO and NAEC has sole voting and investment power with respect to the listed shares. The numbers in parentheses reflect the number of shares owned by each Director and Executive Officer under the Northeast Utilities Service Company Supplemental Retirement and Savings Plan (401(k) Plan), as to which the Officer has no investment power. (2) As of February 28, 1994 there were 134,208,461 common shares of NU outstanding. The percentage of such shares beneficially owned by any Director or Executive Officer, or by all Directors and Executive Officers of CL&P, PSNH, WMECO and NAEC as a group, does not exceed one percent. (3) Mr. Abair is a Director of CL&P and WMECO only. (4) Mr. Opeka and Dr. Cagnetta are not officers of PSNH, but each in his capacity as an officer (with the stated title) of NUSCO, an affiliate of PSNH, performs policy-making functions for PSNH. (5) Messrs. Collins, Letendre, Nitzschke and Wax and Ms. Newman areDirectors of PSNH only. (6) Mr. Ellis shares voting and investment power with his wife for 1,117 shares. (7) Mr. Feigenbaum is a Director and an Executive Officer of NAEC only. (8) Mr. Fox shares voting and investment power with his wife for 3,031 of these shares. In addition, Mr. Fox's wife has sole voting and investment power for 140 shares, as to which Mr. Fox disclaims beneficial ownership. (9) Mr. Keane is a Director of CL&P, WMECO and NAEC only. (10) Mr. Kinney shares voting and investment power with his wife for 2,155 shares. (11) Mr. MacKenzie shares voting and investment power with his wife for 1,259 shares. (12) Mr. Opeka shares voting and investment power with his wife for 1,718 shares. Item 13. Item 13. Certain Relationships and Related Transactions NU. Incorporated herein by reference is page 14 of the definitive proxy statement for solicitation of proxies by NU's Board of Trustees, dated April 1, 1994 and filed with the Commission pursuant to Rule 14a-6 under the Act. CL&P, PSNH, WMECO and NAEC. No relationships or transactions that would be described in response to this item exist now or existed during 1993 with respect to CL&P, PSNH, WMECO and NAEC. PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K (a) 1. Financial Statements: The Report of Independent Public Accountants and financial statements of NU, CL&P, PSNH, WMECO, and NAEC are hereby incorporated by reference and made a part of this report (see "Item 8. Financial Statements and Supplementary Data"). Reports of Independent Public Accountants on Schedules S-1 Consents of Independent Public Accountants S-3 2. Schedules: Financial Statement Schedules for NU (Parent), NU and Subsidiaries, CL&P, PSNH, WMECO, and NAEC are listed in the Index to Financial Statement Schedules S-5 3. Exhibits Index E-1 (b) Reports on Form 8-K: During the fourth quarter of 1993, the companies filed Form 8-Ks dated December 2, 1993 disclosing the following: o On December 2, 1993, the Northeast Utilities system announced a reorganization of its corporate structure. o On December 3, 1993, NNECO was informed by the NRC that it was being assessed a civil penalty in response to repair activities at Millstone 2. In addition, the Form 8-K dated December 2, 1993 which was filed by PSNH also discussed the following: o On June 8, 1992, PSNH changed its independent public accountant. NORTHEAST UTILITIES 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. NORTHEAST UTILITIES ------------------- (Registrant) Date: March 18, 1994 By /s/ William B. Ellis -------------- --------------------------- William B. Ellis 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. Date Title Signature ---- ----- --------- March 18, 1994 Trustee and Chairman /s/ William B. Ellis - -------------- of the Board ------------------------- William B. Ellis March 18, 1994 Trustee, President /s/ Bernard M. Fox - -------------- and Chief Executive ------------------------- Officer Bernard M. Fox March 18, 1994 Executive Vice /s/ Robert E. Busch - -------------- President and Chief ------------------------- Financial Officer Robert E. Busch March 18, 1994 Vice President and /s/ John B. Keane - -------------- Treasurer ------------------------- John B. Keane March 18, 1994 Vice President and /s/ John W. Noyes - -------------- Controller ------------------------- John W. Noyes NORTHEAST UTILITIES SIGNATURES (CONT'D) Date Title Signature ---- ----- --------- March 18, 1994 Trustee /s/ Cotton Mather Cleveland - -------------- --------------------------- Cotton Mather Cleveland March 18, 1994 Trustee /s/ George David - -------------- --------------------------- George David March 18, 1994 Trustee /s/ Donald J. Donahue - -------------- --------------------------- Donald J. Donahue March 18, 1994 Trustee /s/ Eugene D. Jones - -------------- --------------------------- Eugene D. Jones March 18, 1994 Trustee /s/ Elizabeth T. Kennan - -------------- --------------------------- Elizabeth T. Kennan Trustee - -------------- --------------------------- Denham C. Lunt, Jr. March 18, 1994 Trustee /s/ William J. Pape II - -------------- --------------------------- William J. Pape II March 18, 1994 Trustee /s/ Robert E. Patricelli - -------------- --------------------------- Robert E. Patricelli Trustee - -------------- --------------------------- Norman C. Rasmussen Trustee - -------------- --------------------------- John F. Swope THE CONNECTICUT LIGHT AND POWER 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 CONNECTICUT LIGHT AND POWER COMPANY --------------------------------------- (Registrant) Date: March 18, 1994 By /s/ William B. Ellis -------------- --------------------- William B. Ellis 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. Date Title Signature ---- ----- --------- March 18, 1994 Chairman and Director /s/ William B. Ellis - -------------- -------------------------- William B. Ellis March 18, 1994 Vice Chairman and /s/ Bernard M. Fox - -------------- Director -------------------------- Bernard M. Fox March 18, 1994 President and Director /s/ Hugh C. MacKenzie - -------------- -------------------------- Hugh C. MacKenzie March 18, 1994 Executive Vice /s/ Robert E. Busch - -------------- President, Chief -------------------------- Financial Officer Robert E. Busch and Director March 18, 1994 Vice President and /s/ John W. Noyes - -------------- Controller -------------------------- John W. Noyes THE CONNECTICUT LIGHT AND POWER COMPANY SIGNATURES (CONT'D) Date Title Signature ---- ----- --------- - ------------------- Director -------------------------- Robert G. Abair March 18, 1994 Director /s/ John P. Cagnetta - ------------------- -------------------------- John P. Cagnetta March 18, 1994 Director /s/ William T. Frain, Jr. - ------------------- -------------------------- William T. Frain, Jr. March 18, 1994 Director /s/ Cheryl W. Grise - ------------------- ----------------------- Cheryl W. Grise March 18, 1994 Director /s/ John B. Keane - ------------------- ----------------------- John B. Keane March 18, 1994 Director /s/ John F. Opeka - ------------------- ----------------------- John F. Opeka PUBLIC SERVICE COMPANY OF NEW HAMPSHIRE 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 HAMPSHIRE --------------------------------------- (Registrant) Date: March 18, 1994 By /s/ William B. Ellis -------------- ------------------------- William B. Ellis 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. Date Title Signature ---- ----- --------- March 18, 1994 Chairman and Director /s/ William B. Ellis - -------------- -------------------------- William B. Ellis March 18, 1994 Vice Chairman, Chief /s/ Bernard M. Fox - -------------- Executive Officer and -------------------------- Director Bernard M. Fox March 18, 1994 President, Chief /s/ William T. Frain, Jr. - -------------- Operating Officer -------------------------- and Director William T. Frain, Jr. March 18, 1994 Executive Vice /s/ Robert E. Busch - -------------- President, Chief -------------------------- Financial Officer Robert E. Busch and Director March 18, 1994 Vice President and /s/ John W. Noyes - -------------- Controller -------------------------- John W. Noyes PUBLIC SERVICE COMPANY OF NEW HAMPSHIRE SIGNATURES (CONT'D) Date Title Signature ---- ----- --------- March 18, 1994 Director /s/ John C. Collins - ------------------- -------------------------- John C. Collins March 18, 1994 Director /s/ Gerald Letendre - ------------------- -------------------------- Gerald Letendre March 18, 1994 Director /s/ Hugh C. MacKenzie - ------------------- -------------------------- Hugh C. MacKenzie March 18, 1994 Director /s/ Jane E. Newman - ------------------- -------------------------- Jane E. Newman March 18, 1994 Director /s/ Dale S. Nitzschke - ------------------- -------------------------- Dale S. Nitzschke March 18, 1994 Director /s/ Robert P. Wax - ------------------- -------------------------- Robert P. Wax WESTERN MASSACHUSETTS ELECTRIC 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. WESTERN MASSACHUSETTS ELECTRIC COMPANY -------------------------------------- (Registrant) Date: March 18, 1994 By /s/ William B. Ellis -------------- -------------------- William B. Ellis 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. Date Title Signature ---- ----- --------- March 18, 1994 Chairman and Director /s/ William B. Ellis - -------------- -------------------------- William B. Ellis March 18, 1994 Vice Chairman and /s/ Bernard M. Fox - -------------- Director -------------------------- Bernard M. Fox March 18, 1994 President and Director /s/ Hugh C. MacKenzie - -------------- -------------------------- Hugh C. MacKenzie March 18, 1994 Executive Vice /s/ Robert E. Busch - -------------- President, Chief -------------------------- Financial Officer Robert E. Busch and Director March 18, 1994 Vice President and /s/ John W. Noyes - -------------- Controller -------------------------- John W. Noyes WESTERN MASSACHUSETTS ELECTRIC COMPANY SIGNATURES (CONT'D) Date Title Signature ---- ----- --------- - ------------------- Director -------------------------- Robert G. Abair March 18, 1994 Director /s/ John P. Cagnetta - ------------------- -------------------------- John P. Cagnetta March 18, 1994 Director /s/ William T. Frain, Jr. - ------------------- -------------------------- William T. Frain, Jr. March 18, 1994 Director /s/ Cheryl W. Grise - ------------------- ----------------------- Cheryl W. Grise March 18, 1994 Director /s/ John B. Keane - ------------------- ----------------------- John B. Keane March 18, 1994 Director /s/ John F. Opeka - ------------------- ----------------------- John F. Opeka NORTH ATLANTIC ENERGY 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. NORTH ATLANTIC ENERGY CORPORATION --------------------------------- (Registrant) Date: March 18, 1994 By /s/ William B. Ellis -------------- --------------------- William B. Ellis 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. Date Title Signature ---- ----- --------- March 18, 1994 Chairman and Director /s/ William B. Ellis - -------------- -------------------------- William B. Ellis March 18, 1994 Vice Chairman, Chief /s/ Bernard M. Fox - -------------- Executive Officer and -------------------------- Director Bernard M. Fox March 18, 1994 President, Chief /s/ Robert E. Busch - -------------- Operating Officer -------------------------- and Director Robert E. Busch March 18, 1994 Vice President and /s/ John W. Noyes - -------------- Controller -------------------------- John W. Noyes NORTH ATLANTIC ENERGY CORPORATION SIGNATURES (CONT'D) Date Title Signature ---- ----- --------- March 18, 1994 Director /s/ John P. Cagnetta - -------------- -------------------------- John P. Cagnetta - -------------- Director -------------------------- Ted C. Feigenbaum March 18, 1994 Director /s/ William T. Frain. Jr. - -------------- -------------------------- William T. Frain, Jr. March 18, 1994 Director /s/ Cheryl W. Grise - -------------- -------------------------- Cheryl W. Grise March 18, 1994 Director /s/ John B. Keane - -------------- -------------------------- John B. Keane March 18, 1994 Director /s/ Hugh C. MacKenzie - -------------- -------------------------- Hugh C. MacKenzie March 18, 1994 Director /s/ John F. Opeka - -------------- -------------------------- John F. Opeka REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS ON SCHEDULES We have audited in accordance with generally accepted auditing standards, the financial statements included in Northeast Utilities' annual report to shareholders and The Connecticut Light and Power Company's, Western Massachusetts Electric Company's, North Atlantic Energy Corporation's, and Public Service Company of New Hampshire's annual reports, incorporated by reference in this Form 10-K, and have issued our reports thereon dated February 18, 1994. Our reports on the financial statements include an explanatory paragraph with respect to the change in methods of accounting for property taxes, postretirement benefits other than pensions, income taxes, and employee stock ownership plans, as applicable to each company, as explained in Note 1 to the related company's financial statements. Our audits were made for the purpose of forming an opinion on each company's statements taken as a whole. The schedules listed in the index to financial statement schedules are the responsibility of each company's management and are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of each company's basic financial statements. The schedules have been subjected to the auditing procedures applied in the audits of each company's 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 each company's basic financial statements taken as a whole. /s/ ARTHUR ANDERSEN & CO. ARTHUR ANDERSEN & CO. Hartford, Connecticut February 18, 1994 S-1 INDEPENDENT AUDITORS' REPORT ON SCHEDULES The Board of Directors Public Service Company of New Hampshire: Under date of February 7, 1992, we reported on the balance sheet and statement of capitalization of Public Service Company of New Hampshire as of December 31, 1991 (not presented in the 1993 annual report to stockholders) and the related statements of income, cash flows and common stock equity for the periods January 1, 1991 to May 15, 1991 and May 16, 1991 to December 31, 1991, as contained in the annual report to stockholders of Public Service Company for the year 1993. These financial statements and our report thereon are incorporated by reference herein. In connection with our audits of the aforementioned financial statements, we have also audited the related financial statement schedules as listed in the accompanying index. These financial statement schedules are the responsibility of the Company's management. Our responsiblity is to express an opinion on these financial statement schedules based on our audit. 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. /s/ KPMG Peat Marwick KPMG Peat Marwick Boston, Massachusetts February 7, 1992 S-2 CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS As independent public accountants, we hereby consent to the incorporation by reference of our reports in this Form 10-K, into previously filed Registration Statement No. 33-13444, No. 33-46291 , No. 33-59430, and No. 33-50853 of The Connecticut Light and Power Company, No. 33-34886, No. 33-51185 and No. 33-25619 of Western Massachusetts Electric Company, and No. 33-34622 and No. 33-40156 of Northeast Utilities. /s/ ARTHUR ANDERSEN & CO. ARTHUR ANDERSEN & CO. Hartford, Connecticut March 18, 1994 S-3 INDEPENDENT AUDITORS' CONSENT The Board of Directors Public Service Company of New Hampshire: We consent to the use of our reports included or incorporated by reference herein. /s/ KPMG Peat Marwick KPMG Peat Marwick Boston, Massaschusetts March 18, 1994 S-4 INDEX TO FINANCIAL STATEMENT SCHEDULES Schedule Page - -------- ---- III. Financial Information of Registrant: Northeast Utilities (Parent) Balance Sheets 1993 and 1992 S-7 Northeast Utilities (Parent) Statements of Income 1993, 1992, and 1991 S-8 Northeast Utilities (Parent) Statements of Cash Flows 1993, 1992, and 1991 S-9 V. Utility Plant 1993, 1992, and 1991: Northeast Utilities and Subsidiaries S-10 -- S-12 The Connecticut Light and Power Company S-13 -- S-15 Public Service Company of New Hampshire S-16 -- S-20 Western Massachusetts Electric Company S-21 -- S-23 North Atlantic Energy Corporation S-24 -- S-25 V. Nuclear Fuel 1993, 1992, and 1991: Northeast Utilities and Subsidiaries S-26 -- S-28 The Connecticut Light and Power Company S-29 -- S-31 Public Service Company of New Hampshire S-32 -- S-36 Western Massachusetts Electric Company S-37 -- S-39 North Atlantic Energy Corporation S-40 -- S-41 VI. Accumulated Provision for Depreciation of Utility Plant 1993, 1992, and 1991: Northeast Utilities and Subsidiaries S-42 -- S-44 The Connecticut Light and Power Company S-45 Public Service Company of New Hampshire S-46 -- S-48 Western Massachusetts Electric Company S-49 North Atlantic Energy Corporation S-50 VIII. Valuation and Qualifying Accounts and Reserves 1993, 1992, and 1991: Northeast Utilities and Subsidiaries S-51 -- S-53 The Connecticut Light and Power Company S-54 -- S-56 Public Service Company of New Hampshire S-57 -- S-61 Western Massachusetts Electric Company S-62 -- S-64 S-5 Schedule Page - -------- ---- IX. Short-Term Borrowings 1993, 1992, and 1991: Northeast Utilities and Subsidiaries S-65 The Connecticut Light and Power Company S-66 Public Service Company of New Hampshire S-67 Western Massachusetts Electric Company S-68 North Atlantic Energy Corporation S-69 X. Supplementary Income Statement Information 1993, 1992, and 1991: Northeast Utilities and Subsidiaries S-70 The Connecticut Light and Power Company S-71 Public Service Company of New Hampshire S-72 Western Massachusetts Electric Company S-73 North Atlantic Energy Corporation S-74 All other schedules of the companies' for which provision is made in the applicable regulations of the Securities and Exchange Commission are not required under the related instructions or are not applicable, and therefore have been omitted. S-6 SCHEDULE III NORTHEAST UTILITIES (PARENT) ---------------------------- FINANCIAL INFORMATION OF REGISTRANT ----------------------------------- BALANCE SHEETS -------------- AT DECEMBER 31, 1993 AND 1992 ------------------------------ (Thousands of Dollars) S-7 SCHEDULE III NORTHEAST UTILITIES (PARENT) ---------------------------- FINANCIAL INFORMATION OF REGISTRANT ----------------------------------- STATEMENTS OF INCOME -------------------- YEARS ENDED DECEMBER 31, 1993, 1992, AND 1991 --------------------------------------------- (Thousands of Dollars Except Share Information) S-8 SCHEDULE III NORTHEAST UTILITIES (PARENT) FINANCIAL INFORMATION OF REGISTRANT STATEMENTS OF CASH FLOWS YEARS ENDED DECEMBER 31, 1993, 1992, AND 1991 (Thousands of Dollars) 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 S-32 S-33 S-34 S-35 S-36 S-37 S-38 S-39 S-40 S-41 S-42 S-43 S-44 S-45 S-46 S-47 S-48 S-49 S-50 S-51 S-52 S-53 S-54 S-55 S-56 S-57 S-58 S-59 S-60 S-61 S-62 S-63 S-64 S-65 S-66 S-67 S-68 S-69 S-70 S-71 S-72 S-73 S-74 EXHIBIT INDEX Each document described below is incorporated by reference to the files of the Securities and Exchange Commission, unless the reference to the document is marked as follows: * - Filed with the 1993 Annual Report on Form 10-K for NU and herein incorporated by reference from the 1993 NU Form 10-K, File No. 1-5324 into the 1993 Annual Reports on Form 10-K for CL&P, PSNH, WMECO and NAEC. # - Filed with the 1993 Annual Report on Form 10-K for NU and herein incorporated by reference from the 1993 NU Form 10-K, File No. 1-5324 into the 1993 Annual Report on Form 10-K for CL&P. @ - Filed with the 1993 Annual Report on Form 10-K for NU and herein incorporated by reference from the 1993 NU Form 10-K, File No. 1-5324 into the 1993 Annual Report on Form 10-K for PSNH. ** - Filed with the 1993 Annual Report on Form 10-K for NU and herein incorporated by reference from the 1993 NU Form 10-K, File No. 1-5324 into the 1993 Annual Report on Form 10-K for WMECO. ## - Filed with the 1993 Annual Report on Form 10-K for NU and herein incorporated by reference from the 1993 Form 10-K, File No. 1-5324 into the 1993 Annual Report on Form 10-K for NAEC. Exhibit Number Description 3 Articles of Incorporation and By-Laws 3.1 Northeast Utilities 3.1.1 Declaration of Trust of NU, as amended through May 24, 1988. (Exhibit 3.1.1, 1988 NU Form 10-K, File No. 1-5324) 3.2 The Connecticut Light and Power Company # 3.2.1 Certificate of Incorporation of CL&P, restated to March 22, 1994. # 3.2.2 By-laws of CL&P, as amended to March 1, 1982. 3.3 Public Service Company of New Hampshire @ 3.3.1 Articles of Incorporation, as amended to May 16, 1991. @ 3.3.2 By-laws of PSNH, as amended to November 1, 1993. 3.4 Western Massachusetts Electric Company 3.4.1 Certificate of Organization of WMECO, as amended, to August 31, 1954. (Exhibit 3.1, File No. 2-11114) 3.4.2 Amendments to Certificate of Organization of WMECO of May 19, 1966 and of December 5, 1967. (Exhibit 3.2, File No. 2-30534) E-1 3.4.3 Articles of Amendment dated December 9, 1981. (Exhibit 3.1.2, 1981 WMECO Form 10-K, File No. 0-7624) 3.4.4 Certificate of Vote of Directors Establishing a Series of a Class of Stock, dated December 16, 1981. (Exhibit 3.1.3, 1981 WMECO Form 10-K, File No. 0-7624) 3.4.5 Articles of Amendment dated April 7, 1983. (Exhibit 3.3.5, 1983 NU Form 10-K, File No. 1-5324) 3.4.6 Certificate of Vote of Directors Establishing a Series of a Class of Stock, dated April 12, 1983. (Exhibit 3.3.6, 1983 NU Form 10-K, File No. 1-5324) 3.4.7 Articles of Amendment dated January 29, 1987. (Exhibit 3.3.7, 1986 NU Form 10-K, File No. 1-5324) 3.4.8 Articles of Amendment dated February 11, 1987. (Exhibit 3.3.8, 1986 NU Form 10-K, File No. 1-5324) 3.4.9 Articles of Amendment dated February 19, 1988. (Exhibit 3.3.9, 1987 NU Form 10-K, File No. 1-5324) 3.4.10 Certificate of Vote of Directors Establishing a Series of a Class of Stock, dated February 23, 1988. (Exhibit 3.3.10, 1987 NU Form 10-K, File No. 1-5324) ** 3.4.11 By-laws of WMECO, as amended to February 24, 1988. 3.5 North Atlantic Energy Corporation ## 3.5.1 Articles of Incorporation of NAEC dated September 20, 1991. ## 3.5.2 Articles of Amendment dated October 16, 1991 and June 2, 1992 to Articles of Incorporation of NAEC. ## 3.5.3 By-laws of NAEC, as amended to November 8, 1993. 4 Instruments defining the rights of security holders, including indentures 4.1 Northeast Utilities 4.1.1 Indenture dated as of December 1, 1991 between Northeast Utilities and IBJ Schroder Bank & Trust Company, with respect to the issuance of Debt Securities. (Exhibit 4.1.1, 1991 NU Form 10-K, File No. 1-5324) 4.1.2 First Supplemental Indenture dated as of December 1, 1991 between Northeast Utilities and IBJ Schroder Bank & Trust Company, with respect to the issuance of Series A Notes. (Exhibit 4.1.2, 1991 NU Form 10-K, File No. 1-5324) 4.1.3 Second Supplemental Indenture dated as of March 1, 1992 between Northeast Utilities and IBJ Schroder Bank & Trust Company with respect to the issuance of 8.38% Amortizing Notes. (Exhibit 4.1.3, 1992 NU Form 10-K, File No. 1-5324) E-2 4.1.4 Warrant Agreement dated as of June 5, 1992 between Northeast Utilities and the Service Company. (Exhibit 4.1.4, 1992 NU Form 10-K, File No. 1-5324) 4.1.4.1 Additional Warrant Agent Agreement dated as of June 5, 1992 between Northeast Utilities and State Street Bank and Trust Company. (Exhibit 4.1.4.1, 1992 NU Form 10-K, File No. 1-5324) 4.1.4.2 Exchange and Disbursing Agent Agreement dated as of June 5, 1992 among Northeast Utilities, Public Service Company of New Hampshire and State Street Bank and Trust Company. (Exhibit 4.1.4.2, 1992 NU Form 10-K, File No. 1-5324) 4.1.5 Credit Agreements among CL&P, NU, WMECO, NUSCO (as Agent) and 19 Commercial Banks dated December 3, 1992 (364 Day and Three-Year Facilities). (Exhibit C.2.38, 1992 NU Form U5S, File No. 30-246) 4.1.6 Credit Agreements among CL&P, WMECO, NU, Holyoke Water Power Company, RRR, NNECO and NUSCO (as Agent) dated December 3, 1992 (364 Day and Three-Year Facilities). (Exhibit C.2.39, 1992 NU Form U5S, File No. 30-246) 4.2 The Connecticut Light and Power Company 4.2.1 Indenture of Mortgage and Deed of Trust between CL&P and Bankers Trust Company, Trustee, dated as of May 1, 1921. (Composite including all twenty-four amendments to May 1, 1967.) (Exhibit 4.1.1, 1989 NU Form 10-K, File No. 1-5324) Supplemental Indentures to the Composite May 1, 1921 Indenture of Mortgage and Deed of Trust between CL&P and Bankers Trust Company, dated as of: 4.2.2 April 1, 1967. (Exhibit 4.16, File No. 2-60806) 4.2.3 January 1, 1968. (Exhibit 4.18, File No. 2-60806) 4.2.4 December 1, 1969. (Exhibit 4.20, File No. 2-60806) 4.2.5 June 30, 1982. (Exhibit 4.33, File No. 2-79235) 4.2.6 June 1, 1989. (Exhibit 4.1.24, 1989 NU Form 10-K, File No. 1-5324) 4.2.7 September 1, 1989. (Exhibit 4.1.25, 1989 NU Form 10-K, File No. 1-5324) 4.2.8 December 1, 1989. (Exhibit 4.1.26, 1989 NU Form 10-K, File No. 1-5324) 4.2.9 April 1, 1992. (Exhibit 4.30, File No. 33-59430) 4.2.10 July 1, 1992. (Exhibit 4.31, File No. 33-59430) E-3 4.2.11 October 1, 1992. (Exhibit 4.32, File No. 33-59430) 4.2.12 July 1, 1993. (Exhibit A.10(b), File No. 70-8249) 4.2.13 July 1, 1993. (Exhibit A.10(b), File No. 70-8249) # 4.2.14 December 1, 1993. # 4.2.15 February 1, 1994. # 4.2.16 February 1, 1994. 4.2.17 Financing Agreement between Industrial Development Authority of the State of New Hampshire and CL&P (Pollution Control Bonds) dated as of December 1, 1986. (Exhibit C.1.47, 1986 NU Form U5S, File No. 30-246) 4.2.18 Financing Agreement between Industrial Development Authority of the State of New Hampshire and CL&P (Pollution Control Bonds) dated as of October 1, 1988. (Exhibit C.1.55, 1988 NU Form U5S, File No. 30-246) 4.2.19 Financing Agreement between Industrial Development Authority of the State of New Hampshire and CL&P (Pollution Control Bonds) dated as of December 1, 1989. (Exhibit C.1.39, 1989 NU Form U5S, File No. 30-246) 4.2.20 Loan and Trust Agreement among Business Finance Authority of the State of New Hampshire and CL&P (Pollution Control Bonds) dated as of December 1, 1992. (Exhibit C.2.33, 1992 NU Form U5S, File No. 30-246) # 4.2.21 Series A (Tax Exempt Refunding) PCRB Loan Agreement between Connecticut Development Authority and CL&P (Pollution Control Bonds) dated as of September 1, 1993. # 4.2.22 Series B (Tax Exempt Refunding) PCRB Loan Agreement between Connecticut Development Authority and CL&P (Pollution Control Bonds) dated as of September 1, 1993. # 4.2.23 Series A (Tax Exempt Refunding) PCRB Letter of Credit and Reimbursement Agreement (Pollution Control Bonds) dated as of September 1, 1993. # 4.2.24 Series B (Tax Exempt Refunding) PCRB Letter of Credit and Reimbursement Agreement (Pollution Control Bonds) dated as of September 1, 1993. 4.3 Public Service Company of New Hampshire 4.3.1 First Mortgage Indenture dated as of August 15, 1978 between PSNH and First Fidelity Bank, National Association, New Jersey, Trustee, (Composite including all amendments to May 16, 1991). (Exhibit 4.4.1, 1992 NU Form 10-K, File No. 1- 5324) E-4 4.3.1.1 Tenth Supplemental Indenture dated as of May 1, 1991 between PSNH and First Fidelity Bank, National Association. (Exhibit 4.1, PSNH Current Report on Form 8-K dated February 10, 1992, File No. 1-6392). 4.3.2 Revolving Credit Agreement dated as May 1, 1991. (Exhibit 4.12, PSNH Current Report on Form 8-K dated February 10, 1992, File No. 1-6392) 4.3.3 Term Credit Agreement dated as of May 1, 1991. (Exhibit 4.11, PSNH Current Report on Form 8-K dated February 10, 1992, File No. 1-6392) 4.3.4 Series A (Tax Exempt New Issue) PCRB Loan and Trust Agreement dated as of May 1, 1991. (Exhibit 4.2, PSNH Current Report on Form 8-K dated February 10, 1992, File No. 1-6392) 4.3.5 Series B (Tax Exempt Refunding) PCRB Loan and Trust Agreement dated as of May 1, 1991. (Exhibit 4.3, PSNH Current Report on Form 8-K dated February 10, 1992, File No. 1-6392) 4.3.6 Series C (Tax Exempt Refunding) PCRB Loan and Trust Agreement dated as of May 1, 1991. (Exhibit 4.4, PSNH Current Report on Form 8-K dated February 10, 1992, File No. 1-6392) 4.3.7 Series D (Taxable New Issue) PCRB Loan and Trust Agreement dated as of May 1, 1991. (Exhibit 4.5, PSNH Current Report on Form 8-K dated February 10, 1992, File No. 1-6392) 4.3.7.1 First Supplement to Series D (Tax Exempt Refunding Issue) PCRB Loan and Trust Agreement dated as of December 1, 1992. (Exhibit 4.4.5.1, 1992 NU Form 10-K, File No. 1-5324) 4.3.8 Series E (Taxable New Issue) PCRB Loan and Trust Agreement dated as of May 1, 1991. (Exhibit 4.6, PSNH Current Report on Form 8-K dated February 10, 1992, File No. 1-6392) @ 4.3.8.1 First Supplement to Series E (Tax Exempt Refunding Issue) PCRB Loan and Trust Agreement dated as of December 1, 1993. @ 4.3.9 Series D (May 1, 1991 Taxable New Issue and December 1, 1992 Tax Exempt Refunding Issue) PCRB Letter of Credit and Reimbursement Agreement dated as of October 1, 1992. @ 4.3.9.1 Amended and Restated Letter of Credit dated December 17, 1992. 4.3.10 Series E (May 1, 1991 Taxable New Issue and December 1, 1993 Tax Exempt Refunding Issue) PCRB Letter of Credit and Reimbursement Agreement dated as of May 1, 1991. (Exhibit 4.8, PSNH Current Report on Form 8-K dated February 10, 1992, File No. 1-6392) E-5 @ 4.3.10.1 Amended and Restated Letter of Credit dated December 15, 1993. 4.4 Western Massachusetts Electric Company ** 4.4.1 First Mortgage Indenture and Deed of Trust between WMECO and Old Colony Trust Company, Trustee, dated as of August 1, 1954. Supplemental Indentures thereto dated as of: 4.4.2 March 1, 1967. (Exhibit 2.5, File No. 2-68808) 4.4.3 March 1, 1968. (Exhibit 2.6, File No. 2-68808) 4.4.4 December 1, 1968. (Exhibit 2.7, File No. 2-68808) 4.4.5 July 1, 1972. (Exhibit 2.9, File No. 2-68808) 4.4.6 May 1, 1986. (Exhibit 4.3.18, 1986 NU Form 10-K, File No. 1-5324) 4.4.7 December 1, 1988. (Exhibit 4.3.20, 1988 NU Form 10-K, File No. 1-5324.) 4.4.8 September 1, 1990. (Exhibit 4.3.15, 1990 NU Form 10-K, File No. 1-5324.) 4.4.9 December 1, 1992. (Exhibit 4.15, File No. 33-55772) 4.4.10 January 1, 1993. (Exhibit 4.5.13, 1992 NU Form 10-K, File No. 1-5324) ** 4.4.11 March 1, 1994. ** 4.4.12 March 1, 1994. ** 4.4.13 Series A (Tax Exempt Refunding) PCRB Loan Agreement between Connecticut Development Authority and WMECO (Pollution Control Bonds) dated as of September 1, 1993. ** 4.4.14 Series A (Tax Exempt Refunding) PCRB Letter of Credit and Reimbursement Agreement (Pollution Control Bonds) dated as of September 1, 1993. 4.5 North Atlantic Energy Corporation 4.5.1 First Mortgage Indenture and Deed of Trust between NAEC and United States Trust Company of New York, Trustee, dated as of June 1, 1992. (Exhibit 4.6.1, 1992 NU Form 10-K, File No. 1-5324) 4.5.2 Note Indenture dated as of May 15, 1991. (Exhibit 4.10, PSNH Current Report on Form 8-K dated February 10, 1992, File No. 1-6392) E-6 4.5.3 First Supplemental Indenture dated as of June 5, 1992 between NAEC, PSNH and United States Trust Company of New York, Trustee. (Exhibit 4.6.3, 1992 NU Form 10-K, File No. 1-5324) 10 Material Contracts 10.1 Stockholder Agreement dated as of July 1, 1964 among the stockholders of Connecticut Yankee Atomic Power Company (CYAPC). (Exhibit 13.1, File No. 2-22958) 10.2 Form of Power Contract dated as of July 1, 1964 between CYAPC and each of CL&P, HELCO, PSNH and WMECO. (Exhibit 13.2, File No. 2-22958) 10.2.1 Form of Additional Power Contract dated as of April 30, 1984, between CYAPC and each of CL&P, PSNH and WMECO. (Exhibit 10.2.4, 1984 NU Form 10-K, File No. 1-5324) 10.2.2 Form of 1987 Supplementary Power Contract dated as of April 1, 1987, between CYAPC and each of CL&P, PSNH and WMECO. (Exhibit 10.2.6, 1987 NU Form 10-K, File No. 1-5324) 10.3 Capital Funds Agreement dated as of September 1, 1964 between CYAPC and CL&P, HELCO, PSNH and WMECO. (Exhibit 13.3, File No. 2-22958) #@** 10.4 Stockholder Agreement dated December 10, 1958 between Yankee Atomic Electric Company (YAEC) and CL&P, HELCO, PSNH and WMECO. 10.5 Form of Amendment No. 3, dated as of April 1, 1985, to Power Contract between YAEC and each of CL&P, PSNH and WMECO, including a composite restatement of original Power Contract dated June 30, 1959 and Amendment No. 1 dated April 1, 1975 and Amendment No. 2 dated October 1, 1980. (Exhibit 10.5, 1988 NU Form 10-K, File No. 1-5324.) 10.5.1 Form of Amendment No. 4 to Power Contract, dated May 6, 1988, between YAEC and each of CL&P, PSNH and WMECO. (Exhibit 10.5.1, 1989 NU Form 10-K, File No. 1-5324) 10.5.2 Form of Amendment No. 5 to Power Contract, dated June 26, 1989, between YAEC and each of CL&P, PSNH and WMECO. (Exhibit 10.5.2, 1989 NU Form 10-K, File No. 1-5324) 10.5.3 Form of Amendment No. 6 to Power Contract, dated July 1, 1989, between YAEC and each of CL&P, PSNH and WMECO. (Exhibit 10.5.3, 1989 NU Form 10-K, File No. 1-5324) #@** 10.5.4 Form of Amendment No. 7 to Power Contract, dated February 1, 1992, between YAEC and each of CL&P, PSNH and WMECO. 10.6 Stockholder Agreement dated as of May 20, 1968 among stockholders of MYAPC. (Exhibit 4.15, File No. 2-30018) 10.7 Form of Power Contract dated as of May 20, 1968 between MYAPC and each of CL&P, HELCO, PSNH and WMECO. (Exhibit 4.14, File No. 2-30018) E-7 #@** 10.7.1 Form of Amendment No. 1 to Power Contract dated as of March 1, 1983 between MYAPC and each of CL&P, PSNH and WMECO. #@** 10.7.2 Form of Amendment No. 2 to Power Contract dated as of January 1, 1984 between MYAPC and each of CL&P, PSNH and WMECO. 10.7.3 Form of Amendment No. 3 to Power Contract dated as of October 1, 1984 between MYAPC and each of CL&P, PSNH and WMECO. (Exhibit 10.7.3, 1985 NU Form 10-K, File No. 1-5324) #@** 10.7.4 Form of Additional Power Contract dated as of February 1, 1984 between MYAPC and each of CL&P, PSNH and WMECO. 10.8 Capital Funds Agreement dated as of May 20, 1968 between Maine Yankee Atomic Power Company (MYAPC) and CL&P, PSNH, HELCO and WMECO. (Exhibit 4.13, File No. 2-30018) 10.8.1 Amendment No. 1 to Capital Funds Agreement, dated as of August 1, 1985, between MYAPC, CL&P, PSNH and WMECO. (Exhibit 10.6.1, 1985 NU Form 10-K, File No. 1-5324) 10.9 Sponsor Agreement dated as of August 1, 1968 among the sponsors of VYNPC. (Exhibit 4.16, File No. 2-30285) 10.10 Form of Power Contract dated as of February 1, 1968 between VYNPC and each of CL&P, HELCO, PSNH and WMECO. (Exhibit 4.18, File No. 2-30018) 10.10.1 Form of Amendment to Power Contract dated as of June 1, 1972 between VYNPC and each of CL&P, HELCO, PSNH and WMECO. (Exhibit 5.22, File No. 2-47038) #@** 10.10.2 Form of Second Amendment to Power Contract dated as of April 15, 1983 between VYNPC and each of CL&P, PSNH and WMECO. 10.10.3 Form of Third Amendment to Power Contract dated as of April 24, 1985 between VYNPC and each of CL&P, PSNH and WMECO. (Exhibit 10.10.3, 1986 NU Form 10-K, File No. 1-5324) 10.10.4 Form of Fourth Amendment to Power Contract dated as of June 1, 1985 between VYNPC and each of CL&P, PSNH and WMECO. (Exhibit 10.10.4, 1986 NU Form 10-K, File No. 1-5324) 10.10.5 Form of Fifth Amendment to Power Contract dated as of May 6, 1988 between VYNPC and each of CL&P, PSNH and WMECO. (Exhibit 10.10.5, 1990 NU Form 10-K, File No. 1-5324) 10.10.6 Form of Sixth Amendment to Power Contract dated as of May 6, 1988 between VYNPC and each of CL&P, PSNH and WMECO. (Exhibit 10.10.6, 1990 NU Form 10-K, File No. 1-5324) E-8 10.10.7 Form of Seventh Amendment to Power Contract dated as of June 15, 1989 between VYNPC and each of CL&P, PSNH and WMECO. (Exhibit 10.10.7, 1990 NU Form 10-K, File No. 1-5324) 10.10.8 Form of Eighth Amendment to Power Contract dated as of December 1, 1989 between VYNPC and each of CL&P, PSNH and WMECO. (Exhibit 10.10.8, 1990 NU Form 10-K, File No. 1-5324) #@** 10.10.9 Form of Additional Power Contract dated as of February 1, 1984 between VYNPC and each of CL&P, PSNH and WMECO. 10.11 Capital Funds Agreement dated as of February 1, 1968 between Vermont Yankee Nuclear Power Corporation (VYNPC) and CL&P, HELCO, PSNH and WMECO. (Exhibit 4.16, File No. 2-30018) 10.11.1 Form of First Amendment to Capital Funds Agreement dated as of March 12, 1968 between VYNPC and CL&P, HELCO, PSNH and WMECO. (Exhibit 4.17, File No. 2-30018) #@** 10.11.2 Form of Second Amendment to Capital Funds Agreement dated as of September 1, 1993 between VYNPC and CL&P, HELCO, PSNH and WMECO. 10.12 Amended and Restated Millstone Plant Agreement dated as of December 1, 1984 by and among CL&P, WMECO and Northeast Nuclear Energy Company (NNECO). (Exhibit 10.17, 1985 NU Form 10-K, File No. 1-5324) 10.13 Sharing Agreement dated as of September 1, 1973 with respect to 1979 Connecticut nuclear generating unit (Millstone 3). (Exhibit 6.43, File No. 2-50142) 10.13.1 Amendment dated August 1, 1974 to Sharing Agreement - 1979 Connecticut Nuclear Unit. (Exhibit 5.45, File No. 2-52392) 10.13.2 Amendment dated December 15, 1975 to Sharing Agreement - 1979 Connecticut Nuclear Unit. (Exhibit 7.47, File No. 2-60806) 10.13.3 Amendment dated April 1, 1986 to Sharing Agreement - 1979 Connecticut Nuclear Unit. (Exhibit 10.17.3, 1990 NU Form 10-K, File No. 1-5324) 10.14 Agreement dated July 19, 1990, among NAESCO and Seabrook Joint owners with respect to operation of Seabrook. (Exhibit 10.53, 1990 NU Form 10-K, File No. 1-5324) 10.15 Sharing Agreement between CL&P, WMECO, HP&E, HWP and PSNH dated as of June 1, 1992. (Exhibit 10.17, 1992 NU Form 10- K, File No. 1-5324) 10.16 Form of Seabrook Power Contract between PSNH and NAEC, as amended and restated. (Exhibit 10.45, NU 1992 Form 10-K, File No. 1-5324) E-9 10.17 Agreement for joint ownership, construction and operation of New Hampshire nuclear generating units dated as of May 1, 1973. (Exhibit 13-57, File No. 2-48966) 10.17.1 Amendments to Exhibit 10.17 dated May 24, 1974, June 21, 1974 and September 25, 1974. (Exhibit 5.15, File No. 2-51999) 10.17.2 Amendments to Exhibit 10.17 dated October 25, 1974 and January 31, 1975. (Exhibit 5.23, File No. 2-54646) 10.17.3 Sixth Amendment to Exhibit 10.17 dated as of April 18, 1979. (Exhibit 5.4.3, File No. 2-64294) 10.17.4 Seventh Amendment to Exhibit 10.17 dated as of April 18, 1979. (Exhibit 5.4.4, File No. 2-64294) 10.17.5 Eighth Amendment to Exhibit 10.17 dated as of April 25, 1979. (Exhibit 5.4.5, File No. 2-64815) 10.17.6 Ninth Amendment to Exhibit 10.17 dated as of June 8, 1979. (Exhibit 5.4.6, File No. 2-64815) 10.17.7 Tenth Amendment to Exhibit 10.17 dated as of October 10, 1979. (Exhibit 5.4.2, File No. 2-66334) 10.17.8 Eleventh Amendment to Exhibit 10.17 dated as of December 15, 1979. (Exhibit 5.4.8, File No. 2-66492) 10.17.9 Twelfth Amendment to Exhibit 10.17 dated as of June 16, 1980. (Exhibit 5.4.9, File No. 2-68168) 10.17.10 Thirteenth Amendment to Exhibit 10.17 dated as of December 31, 1980. (Exhibit 10.6, File No. 2-70579) * 10.17.11 Fourteenth Amendment to Exhibit 10.17 dated as of June 1, 1982. 10.17.12 Fifteenth Amendment to Exhibit 10.17 dated as of April 27, 1984. (Exhibit 10.14.12, 1984 NU Form 10-K, File No. 1-5324) 10.17.13 Sixteenth Amendment to Exhibit 10.17 dated as of June 15, 1984. (Exhibit 10.14.13, 1984 NU Form 10-K, File No. 1-5324) 10.17.14 Seventeenth Amendment to Exhibit 10.17 dated as of March 8, 1985. (Exhibit 10.13.14, 1985 NU Form 10-K, File No. 1-5324) 10.17.15 Eighteenth Amendment to Exhibit 10.17 dated as of March 14, 1986. (Exhibit 10.13.15, 1986 NU Form 10-K, File No. 1-5324) 10.17.16 Nineteenth Amendment to Exhibit 10.17 dated as of May 1, 1986. (Exhibit 10.13.16, 1986 NU Form 10-K, File No. 1-5324) E-10 10.17.17 Twentieth Amendment to Exhibit 10.17 dated as of July 15, 1986. (Exhibit 10.13.17, 1986 NU Form 10-K, File No. 1-5324) 10.17.18 Twenty-first Amendment to Exhibit 10.17 dated as of November 12, 1987. (Exhibit 10.13.18, 1987 NU Form 10-K, File No. 1-5324) 10.17.19 Twenty-second Amendment to Exhibit 10.17 dated as of January 13, 1989. (Exhibit 10.13.19, 1989 NU Form 10-K, File No. 1-5324) 10.17.20 Twenty-third Amendment to Exhibit 10.17 dated as of November 1, 1990. (Exhibit 10.13.20, 1990 NU Form 10- K, File No. 1-5324) 10.17.21 Memorandum of Understanding dated November 7, 1988 between PSNH and Massachusetts Municipal Wholesale Electric Company (Exhibit 10.17, PSNH 1989 Form 10-K, File No. 1-6392) 10.17.22 Agreement of Settlement among Joint Owners dated as of January 13, 1989. (Exhibit 10.13.21, 1988 NU Form 10- K, File No. 1-5324) 10.17.22.1 Supplement to Settlement Agreement, dated as of February 7, 1989, between PSNH and Central Maine Power Company. (Exhibit 10.18.1, PSNH 1989 Form 10-K, File No. 1-6392) 10.18 Amended and Restated Agreement for Seabrook Project Disbursing Agent dated as of November 1, 1990. (Exhibit 10.4.7, File No. 33-35312) 10.18.1 Form of First Amendment to Exhibit 10.18. (Exhibit 10.4.8, File No. 33-35312) * 10.18.2 Form (Composite) of Second Amendment to Exhibit 10.18. 10.19 Agreement dated November 1, 1974 for Joint Ownership, Construction and Operation of William F. Wyman Unit No. 4 among PSNH, Central Maine Power Company and other utilities. (Exhibit 5.16 , File No. 2-52900) 10.19.1 Amendment to Exhibit 10.19 dated June 30, 1975. (Exhibit 5.48, File No. 2-55458) 10.19.2 Amendment to Exhibit 10.19 dated as of August 16, 1976. (Exhibit 5.19, File No. 2-58251) 10.19.3 Amendment to Exhibit 10.19 dated as of December 31, 1978. (Exhibit 5.10.3, File No. 2-64294) #** 10.20 Form of Service Contract dated as of July 1, 1966 between each of NU, CL&P and WMECO and the Service Company. 10.20.1 Service Contract dated as of June 5, 1992 between PSNH and the Service Company. (Exhibit 10.12.4, 1992 NU Form 10-K, File No. 1-5324) E-11 10.20.2 Service Contract dated as of June 5, 1992 between NAEC and the Service Company. (Exhibit 10.12.5, 1992 NU Form 10-K, File No. 1-5324) * 10.20.3 Form of Annual Renewal of Service Contract. 10.21 Memorandum of Understanding between CL&P, HELCO, Holyoke Power and Electric Company (HP&E), Holyoke Water Power Company (HWP) and WMECO dated as of June 1, 1970 with respect to pooling of generation and transmission. (Exhibit 13.32, File No. 2-38177) #** 10.21.1 Amendment to Memorandum of Understanding between CL&P, HELCO, HP&E, HWP and WMECO dated as of February 2, 1982 with respect to pooling of generation and transmission. 10.22 New England Power Pool Agreement effective as of November 1, 1971, as amended to November 1, 1988. (Exhibit 10.15, 1988 NU Form 10-K, File No. 1-5324.) 10.22.1 Twenty-sixth Amendment to Exhibit 10.22 dated as of March 15, 1989. (Exhibit 10.15.1, 1990 NU Form 10-K, File No. 1-5324) 10.22.2 Twenty-seventh Amendment to Exhibit 10.22 dated as of October 1, 1990. (Exhibit 10.15.2, 1991 NU Form 10-K, File No. 1-5324) 10.22.3 Twenty-eighth Amendment to Exhibit 10.22 dated as of September 15, 1992. (Exhibit 10.18.3, 1992 NU Form 10-K, File No. 1-5324) * 10.22.4 Twenty-ninth Amendment to Exhibit 10.22 dated as of May 1, 1993. 10.23 Agreements among New England Utilities with respect to the Hydro-Quebec interconnection projects. (See Exhibits 10(u) and 10(v); 10(w), 10(x), and 10(y), 1990 and 1988, respectively, Form 10-K of New England Electric System, File No. 1-3446.) 10.24 Trust Agreement dated February 11, 1992, between State Street Bank and Trust Company of Connecticut, as Trustor, and Bankers Trust Company, as Trustee, and CL&P and WMECO, with respect to NBFT. (Exhibit 10.23, 1991 NU Form 10-K, File No. 1-5324) 10.24.1 Nuclear Fuel Lease Agreement dated as of February 11, 1992, between Bankers Trust Company, Trustee, as Lessor, and CL&P and WMECO, as Lessees. (Exhibit 10.23.1, 1991 NU Form 10-K, File No. 1-5324) 10.25 Simulator Financing Lease Agreement, dated as of February 1, 1985, by and between ComPlan and NNECO. (Exhibit 10.52, 1985 NU Form 10-K, File No. 1-5324) E-12 10.26 Simulator Financing Lease Agreement, dated as of May 2, 1985, by and between The Prudential Insurance Company of America and NNECO. (Exhibit 10.53, 1985 NU Form 10-K, File No. 1-5324) 10.27 Lease dated as of April 14, 1992 between The Rocky River Realty Company (RRR) and Northeast Utilities Service Company (NUSCO) with respect to the Berlin, Connecticut headquarters (office lease). (Exhibit 10.29, 1992 NU Form 10-K, File No. 1-5324) 10.27.1 Lease date as of April 14, 1992 between RRR and NUSCO with respect to the Berlin, Connecticut headquarters (project lease). (Exhibit 10.29.1, 1992 NU Form 10-K, File No. 1-5324) * 10.28 Millstone Technical Building Note Agreement dated as of December 21, 1993 between, by and between The Prudential Insurance Company of America and NNECO. 10.29 Lease and Agreement, dated as of December 15, 1988, by and between WMECO and Bank of New England, N.A., with BNE Realty Leasing Corporation of North Carolina. (Exhibit 10.63, 1988 NU Form 10-K, File No. 1-5324.) 10.30 Note Agreement dated April 14, 1992, by and between The Rocky River Realty Company (RRR) and Purchasers named therein (Connecticut General Life Insurance Company, Life Insurance Company of North America, INA Life Insurance Company of New York, Life Insurance Company of Georgia), with respect to RRR's sale of $15 million of guaranteed senior secured notes due 2007 and $28 million of guaranteed senior secured notes due 2017. (Exhibit 10.52, 1992 NU Form 10-K, File No. 1-5324) 10.30.1 Note Guaranty dated April 14, 1992 by Northeast Utilities pursuant to Note Agreement dated April 14, 1992 between RRR and Note Purchasers, for the benefit of The Connecticut National Bank as Trustee, the Purchasers and the owners of the notes. (Exhibit 10.52.1, 1992 NU Form 10-K, File No. 1-5324) 10.30.2 Assignment of Leases, Rents and Profits, Security Agreement and Negative Pledge, dated as of April 14, 1992 among RRR, NUSCO and The Connecticut National Bank as Trustee, securing notes sold by RRR pursuant to April 14, 1992 Note Agreement. (Exhibit 10.52.2, 1992 NU Form 10-K, File No. 1-5324) 10.31 Master Trust Agreement dated as of September 2, 1986 between CL&P and WMECO and Colonial Bank as Trustee, with respect to reserve funds for Millstone 1 decommissioning costs. (Exhibit 10.80, 1986 NU Form 10-K, File No. 1-5324) 10.31.1 Notice of Appointment of Mellon Bank, N.A. as Successor Trustee, dated November 20, 1990, and Acceptance of Appointment. (Exhibit 10.41.1, 1992 NU Form 10-K, File No. 1-5324) E-13 10.32 Master Trust Agreement dated as of September 2, 1986 between CL&P and WMECO and Colonial Bank as Trustee, with respect to reserve funds for Millstone 2 decommissioning costs. (Exhibit 10.81, 1986 NU Form 10-K, File No. 1-5324) 10.32.1 Notice of Appointment of Mellon Bank, N.A. as Successor Trustee, dated November 20, 1990, and Acceptance of Appointment. (Exhibit 10.42.1, 1992 NU Form 10-K, File No. 1-5324) 10.33 Master Trust Agreement dated as of April 23, 1986 between CL&P and WMECO and Colonial Bank as Trustee, with respect to reserve funds for Millstone 3 decommissioning costs. (Exhibit 10.82, 1986 NU Form 10-K, File No. 1-5324) 10.33.1 Notice of Appointment of Mellon Bank, N.A. as Successor Trustee, dated November 20, 1990, and Acceptance of Appointment. (Exhibit 10.43.1, 1992 NU Form 10-K, File No. 1-5324) 10.34 NU Executive Incentive Plan, effective as of January 1, 1991. (Exhibit 10.44, NU 1991 Form 10-K, File No. 1-5324) 10.35 Supplemental Executive Retirement Plan for Officers of NU System Companies, Amended and Restated effective as of January 1, 1992. (Exhibit 10.45.1, NU Form 10-Q for the Quarter Ended June 30, 1992, File No. 1-5324) * 10.35.1 Amendment 1 to Exhibit 10.35, effective as of August 1, 1993. * 10.35.2 Amendment 2 to Exhibit 10.35, effective as of January 1, 1994. 10.36 Loan Agreement dated as of December 2, 1991, by and between NU and Mellon Bank, N.A., as Trustee, with respect to NU's loan of $175 million to an ESOP Trust. (Exhibit 10.46, NU 1991 Form 10-K, File No. 1-5324) * 10.36.1 First Amendment to Exhibit 10.36 dated February 7, 1992. 10.36.2 Loan Agreement dated as of March 19, 1992 by and between NU and Mellon Bank, N.A., as Trustee, with respect to NU's loan of $75 million to the ESOP Trust. (Exhibit 10.49.1, 1992 NU Form 10-K, File No. 1-5324) * 10.36.3 Second Amendment to Exhibit 10.36 dated April 9, 1992. 10.37 Management Succession Agreement. (Exhibit 10.47, NU Form 10-Q for the Quarter Ended June 30, 1992, File No. 1-5324) 10.38 Employment Agreement. (Exhibit 10.48, NU Form 10-Q for the Quarter Ended June 30, 1992, File No. 1-5324) 13 Annual Report to Security Holders (Each of the Annual Reports is filed only with the Form 10-K of that respective registrant.) E-14 * 13.1 Portions of the Annual Report to Security Holders of NU (pages 17 - 54) that have been incorporated by reference into this Form 10-K. 13.2 Annual Report of CL&P. 13.3 Annual Report of WMECO. 13.4 Annual Report of PSNH. 13.5 Annual Report of NAEC. 21 Subsidiaries of the Registrant (Exhibit 22, 1992 NU Form 10-K, File 1-5324) E-15

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Item 1. Business KU Energy Corporation KU Energy Corporation (KU Energy or the Company), an exempt utility holding company, was incorporated in the state of Kentucky on June 23, 1988. On December 1, 1991, a corporate reorganization was completed under which KU Energy became the holder of all common stock of Kentucky Utilities Company (Kentucky Utilities). KU Energy has two wholly owned subsidiaries, Kentucky Utilities, an electric utility, and KU Capital Corporation (KU Capital), a nonutility subsidiary. Kentucky Utilities is KU Energy's principal subsidiary. The Company has adopted a core energy investment strategy for its nonutility investments. Under this strategy, energy-related investments that utilize the Company's knowledge and expertise will be targeted. In particular, the Company is focusing its attention on independent power projects (including qualifying facilities and exempt wholesale generators) and equipment leased to other utilities. The Company is a public utility holding company as defined in the Public Utility Holding Company Act of 1935 (the Holding Company Act). On November 13, 1991, the Company obtained an order from the Securities and Exchange Commission which granted an exemption from all provisions of the Holding Company Act, except Section 9(a)(2) thereof which relates to the acquisition of securities of public utility companies. The ability of the Company to pay dividends on its common stock is dependent upon distributions made to it by Kentucky Utilities and on amounts that may be earned by the Company on future investments. Kentucky Utilities Company Kentucky Utilities is a public utility engaged in producing and selling electric energy. Kentucky Utilities provides electric service to about 409,700 customers in over 600 communities and adjacent suburban and rural areas in 77 counties in central, southeastern and western Kentucky, and to about 27,900 customers in 5 counties in southwestern Virginia. Of the Kentucky communities, 160 are incorporated municipalities served under unexpired municipal franchises and the rest are unincorporated communities where no franchises are required. Service has been provided in Virginia without franchises for a number of years. This lack of Virginia franchises is not expected to have a material effect on Kentucky Utilities' operations. Kentucky Utilities also sells electric energy at wholesale for resale in 12 municipalities. For a complete description of Kentucky Utilities' business, reference is made to its Annual Report on Form 10-K for the year ended December 31, 1993, filed herewith as Exhibit 99B and incorporated herein by reference. Item 2. Item 2. Properties Refer to Kentucky Utilities Company's Annual Report on Form 10-K for the year ended December 31, 1993 for a description of its properties. Presently, KU Energy has no significant physical property. Item 3. Item 3. Legal Proceedings None. Item 4. Item 4. Submission of Matters to a Vote of Security Holders None. Executive Officers of the Registrant Current Positions Positions Held During at Least the Name and Age Held Last 5 Years John T. Newton Chairman and Chairman of the Board, President Age 63 President and and Director of KU Energy since Director* 1988. Michael R. Whitley Senior Vice- Director of KU Energy since March Age 50 President and 1992 and Senior Vice-President Director* since 1988. Secretary of KU Energy from 1988 to November 1992. Roger C. Grimm Vice- Vice-President of KU Energy since Age 55 President November 1992. Director of Nonutility Investments of KU Energy from August 1992 to November 1992. President of KUE Corp. of NY (financial consulting) from April 1991 to July 1992. Managing Director of Financial Security Assurance, Inc. (credit enhancement company) from September 1985 to March 1991. George S. Brooks II General General Counsel and Corporate Age 43 Counsel and Secretary of KU Energy since Corporate November 1992. Secretary* William N. English Treasurer* Treasurer of KU Energy since 1988. Age 43 Michael D. Robinson Controller* Controller of KU Energy since June Age 38 1990. Note: Officers are elected annually by the Board of Directors. There is no family relationship between any executive officer and any other executive officer or any director. * Identified persons hold positions with the same titles at Kentucky Utilities. Refer to Kentucky Utilities Form 10-K for information concerning positions held during last five years. 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 and Pacific stock exchanges under the ticker symbol "KU." Quotes in daily newspapers can be found under the listing "KU Engy." KU Energy's Board has declared a common stock dividend of $.41 per share payable March 15, 1994, to shareholders of record. As of December 31, 1993, the Company had approximately 34,490 common shareholders of record. Kentucky Utilities has paid cash dividends quarterly since 1949. KU Energy expects to continue this policy, although future dividends are dependent on future earnings, capital requirements and financial conditions. See Note 6 of the Notes to Consolidated Financial Statements in the Annual Report to Shareholders (Exhibit 13). Such information is incorporated herein by reference. Item 6. Item 6. Selected Financial Data Item 6. Selected Financial Data (continued) Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Refer to the caption "Management's Discussion and Analysis" in the Annual Report to Shareholders (Exhibit 13) for the information required by this item. Such information is incorporated herein by reference. Item 8. Item 8. Financial Statements and Supplementary Data Refer to the Annual Report to Shareholders (Exhibit 13) for the information required by this item which is incorporated herein by reference, including: Consolidated Statements of Income and Retained Earnings, Consolidated Statements of Cash Flows, Consolidated Balance Sheets, Consolidated Statements of Capitalization, Notes to Consolidated Financial Statements, and Report of Independent Public 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 The information required by Item 10 relating to each director and each nominee for election as a director at the Company's 1994 Annual Shareholders Meeting is set forth in the Company's definitive proxy statement (the "Proxy Statement") filed with the Securities and Exchange Commission pursuant to Regulation 14A under the Securities Exchange Act of 1934 in connection with the Company's 1994 Annual Shareholders Meeting. Such information is incorporated herein by reference to the material appearing in the Proxy Statement under the caption "Election of Directors--General." Information required by this item relating to executive officers of the Company is set forth under a separate caption in Part I hereof. On January 12, 1993, a report on Form 4 (due January 10, 1993) was filed on behalf of John T. Newton, Chairman, President and Chief Executive Officer of the Company, with the Securities and Exchange Commission reporting a purchase of Company Common Stock. Item 11. Item 11. Executive Compensation The information required by Item 11 is incorporated herein by reference to the material appearing in the Proxy Statement under the caption Election of Directors--"Directors' Compensation", and -- "Executive Compensation" (but excluding any information contained under the subheadings --"Report of Compensation Committee on Executive Compensation", and --"Performance Graph"). Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management The information required by Item 12 is incorporated herein by reference to the material appearing in the Proxy Statement under the caption "Election of Directors--Voting Securities Beneficially Owned by Directors, Nominees and Executive Officers; Other Information." 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 (1) financial statements, (2) schedules, and (3) exhibits, are filed as a part of this Annual Report. (1) Financial Statements (incorporated by reference under Item 8, Financial Statements and Supplementary Data) Consolidated Statements of Income and Retained Earnings for the three years ended December 31, 1993, Consolidated Statements of Cash Flows for the three years ended December 31, 1993, Consolidated Balance Sheets as of December 31, 1993 and 1992, Consolidated Statements of Capitalization as of December 31, 1993 and 1992, Notes to Consolidated Financial Statements, and Report of Independent Public Accountants. (2) Schedules Schedule V Property, plant and equipment. Schedule VI 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. The following Schedules are omitted as not applicable or not required under Regulation S-X: I, II, III, IV, VII, XI, XII, XIII, XIV. (3) Exhibits No. Description Page 3.A Amended and Restated Articles of Incorporation of KU Energy Corporation. (Exhibit 3A to Form 10-K Annual Report of KU Energy Corporation for the year ended December 31, 1992). Incorporated by reference. - 3.B By-laws of KU Energy Corporation (Exhibit 3B to Form 10-K Annual Report of KU Energy Corporation for the year ended December 31, 1992). Incorporated by reference. - 4.A Rights Agreement, dated as of January 27, 1992, by and between KU Energy Corporation and Illinois Stock Transfer Company (Exhibit 4.1 to Form 8-K Current Report of KU Energy Corporation, dated January 27, 1992). Incorporated by reference. - 4.B Indenture of Mortgage or Deed of Trust dated May 1, 1947, between Kentucky Utilities Company and Continental Illinois National Bank and Trust Company of Chicago and Edmond B. Stofft, as Trustees (Amended Exhibit 7(a) in File No. 2-7061), and Supplemental Indentures thereto dated, respectively, January 1, 1949 (Second Amended Exhibit 7.02 in File No. 2-7802), July 1, 1950 (Amended Exhibit 7.02 in File No. 2-8499), June 15, 1951 (Exhibit 7.02(a) in File No. 2-8499), June 1, 1952 (Amended Exhibit 4.02 in File No. 2-9658), April 1, 1953 (Amended Exhibit 4.02 in File No. 2-10120), April 1, 1955 (Amended Exhibit 4.02 in File No. 2-11476), April 1, 1956 (Amended Exhibit 2.02 in File No. 2-12322), May 1, 1969 (Amended Exhibit 2.02 in File No. 2-32602), April 1, 1970 (Amended Exhibit 2.02 in File No. 2-36410), September 1, 1971 (Amended Exhibit 2.02 in File No. 2-41467), December 1, 1972 (Amended Exhibit 2.02 in File No. 2-46161) April 1, 1974 (Amended Exhibit 2.02 in File No. 2-50344), September 1, 1974 (Exhibit 2.04 in File No. 2-59328), July 1, 1975 (Exhibit 2.05 in File No. 2-9328), May 15, 1976 (Amended Exhibit 2.02 in File No. 2-56126), April 15, 1977 (Exhibit 2.06 in File No. 2-59328, August 1, 1979 (Exhibit 2.04 in File No. 2-64969), May 1, 1980 (Exhibit 2 to Form 10-Q Quarterly Report of Kentucky Utilities for the quarter ended June 30, 1980), September 15, 1982 (Exhibit 4.04 in File No. 2-79891), August 1, 1984 (Exhibit 4B to Form 10-K Annual Report of Kentucky Utilities Company for the year ended December 31, 1984), June 1, 1985 (Exhibit 4 to Form 10-Q Quarterly Report of Kentucky Utilities Company for the quarter ended June 30, 1985), May 1, 1990 (Exhibit 4 to Form 10-Q Quarterly Report of Kentucky Utilities Company for the quarter ended June 30, 1990), May 1, 1991 No. Description Page 4.B (Exhibit 4 to Form 10-Q Quarterly Report of Kentucky cont Utilities Company for the quarter ended June 30, 1991), May 15, 1992 (Exhibit 4.02 to Form 8-K of Kentucky Utilities Company dated May 14, 1992), August 1, 1992 (Exhibit 4 to Form 10-Q Quarterly Report of Kentucky Utilities Company for the quarter ended September 30, 1992), June 15, 1993 (Exhibit 4.02 to Form 8-K of Kentucky Utilities Company dated June 15, 1993) and December 1, 1993 (Exhibit 4.01 to Form 8-K of Kentucky Utilities Company dated December 10, 1993). Incorporated by reference. - 4.C Supplemental Indenture dated March 1, 1992 between Kentucky Utilities and Continental Bank, National Association and M. J. Kruger, as Trustees, providing for the conveyance of properties formerly held by Old Dominion Power Company (Exhibit 4B to Form 10-K Annual Report of Kentucky Utilities Company for the year ended December 31, 1992). Incorporated by reference. - 10.A Kentucky Utilities' Amended and Restated Performance Share Plan (Exhibit 10A to Form 10-Q Quarterly Report of Kentucky Utilities Company for the quarter ended June 30, 1993). Incorporated by reference. - 10.B Kentucky Utilities' Annual Performance Incentive Plan (Exhibit 10B to Form 10-K Annual Report of Kentucky Utilities Company for the year ended December 31, 1990). Incorporated by reference. - 10.C Amendment No. 1 to Kentucky Utilities' Annual Performance Incentive Plan (Exhibit 10D to Form 10-K Annual Report of Kentucky Utilities Company for the year ended December 31, 1991). Incorporated by reference. - 10.D Kentucky Utilities' Executive Optional Deferred Compensation Plan (Exhibit 10C to Form 10-K Annual Report of Kentucky Utilities Company for the year ended December 31, 1990). Incorporated by reference. - 10.E Amendment No. 1 to Kentucky Utilities' Executive Optional Deferred Compensation Plan (Exhibit 10F to Form 10-K Annual Report of Kentucky Utilities Company for the year ended December 31, 1991). Incorporated by reference. - No. Description Page 10.F Kentucky Utilities' Director Retirement Retainer Program, and Amendment No. 1 (Exhibit 10G to Form 10-K Annual Report of Kentucky Utilities Company for the year ended December 31, 1991). Incorporated by reference. - 10.G Kentucky Utilities' Supplemental Security Plan (Exhibit 10I to Form 10-K Annual Report of Kentucky Utilities Company for the year ended December 31, 1991). Incorporated by reference. - 10.H KU Energy's Director Retirement Retainer Program (Exhibit 10J to Form 10-K Annual Report of KU Energy Corporation for the year ended December 31, 1992). Incorporated by reference. - 10.I KU Energy's Performance Share Plan (Exhibit 10A to Form 10-Q Quarterly Report of KU Energy Corporation for the quarter ended June 30, 1993). Incorporated by reference. - 10.J KU Energy's Annual Performance Incentive Plan N/A 10.K Amendment No. 1 to KU Energy's Annual Performance Incentive Plan N/A 10.L Amendment No. 2 to Kentucky Utilities' Annual Performance Incentive Plan (Exhibit 10.H to Form 10-K Annual Report of Kentucky Utilities Company for the year ended December 31, 1993). Incorporated by reference. - 10.M Amendment No. 3 to Kentucky Utilities' Annual Performance Incentive Plan (Exhibit 10.I to Form 10-K Annual Report of Kentucky Utilities Company for the year ended December 31, 1993). Incorporated by reference. - 10.N Amendment No. 2 to Kentucky Utilities' Executive Optional Deferred Compensation Plan (Exhibit 10.J to Form 10-K Annual Report of Kentucky Utilities Company for the year ended December 31, 1993). Incorporated by reference. - 10.O Kentucky Utilities' Amended and Restated Director Deferred Compensation Plan (Exhibit 10.K to Form 10-K Annual Report of Kentucky Utilites Company for the year ended December 31, 1993). Incorporated by reference. - 10.P KU Energy's Executive Optional Deferred Compensation Plan N/A 10.Q KU Energy's Director Deferred Compensation Plan N/A 13 Portions of 1993 Annual Report to Shareholders N/A 21 List of Subsidiaries N/A 23 Consent of Independent Public Accountants N/A No. Description Page 99.A Description of Common Stock N/A 99.B Kentucky Utilities Company Form 10-K for the year ended December 31, 1993 N/A Note - Exhibit numbers 10.A through 10.Q are management contracts or compensatory plans or arrangements required to be filed as exhibits to this Form 10-K. The following instruments defining the rights of holders of certain long-term debt of Kentucky Utilities Company have not been filed with the Securities and Exchange Commission but will be furnished to the Commission upon request. 1. Loan Agreement dated as of May 1, 1990 between Kentucky Utilities and the County of Mercer, Kentucky, in connection with $12,900,000 County of Mercer, Kentucky, Collateralized Solid Waste Disposal Facility Revenue Bonds (Kentucky Utilities Company Project) 1990 Series A, due May 1, 2010 and May 1, 2020. 2. Loan Agreement dated as of May 1, 1991 between Kentucky Utilities and the County of Carroll, Kentucky, in connection with $96,000,000 County of Carroll, Kentucky, Collateralized Pollution Control Revenue Bonds (Kentucky Utilities Company Project) 1992 Series A, due September 15, 2016. 3. Loan Agreement dated as of August 1, 1992 between Kentucky Utilities and the County of Carroll, Kentucky, in connection with $2,400,000 County of Carroll, Kentucky, Collateralized Pollution Control Revenue Bonds (Kentucky Utilities Company Project) 1992 Series C, due February 1, 2018. 4. Loan Agreement dated as of August 1, 1992 between Kentucky Utilities and the County of Muhlenberg, Kentucky, in connection with $7,200,000 County of Muhlenberg, Kentucky, Collateralized Pollution Control Revenue Bonds (Kentucky Utilities Company Project) 1992 Series A, due February 1, 2018. 5. Loan Agreement dated as of August 1, 1992 between Kentucky Utilities and the County of Mercer, Kentucky, in connection with $7,400,000 County of Mercer, Kentucky, Collateralized Pollution Control Revenue Bonds (Kentucky Utilities Company Project) 1992 Series A, due February 1, 2018. 6. Loan Agreement dated as of August 1, 1992 between Kentucky Utilities and the County of Carroll, Kentucky, in connection with $20,930,000 County of Carroll, Kentucky, Collateralized Pollution Control Revenue Bonds (Kentucky Utilities Company Project) 1992 Series B, due February 1, 2018. 7. Loan Agreement dated as of December 1, 1993, between Kentucky Utilities and the County of Carroll, Kentucky, in connection with $50,000,000 County of Carroll, Kentucky, Collateralized Solid Waste Disposal Facilities Revenue Bonds (Kentucky Utilities Company Project) 1993 Series A due December 1, 2023. (B) No reports on Form 8-K were filed by the Company during the last quarter of 1993. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To KU Energy Corporation & Subsidiaries: We have audited, in accordance with generally accepted auditing standards, the consolidated financial statements included in KU Energy Corporation's Annual Report to Shareholders incorporated by reference in this Form 10-K and have issued our report thereon dated January 26, 1994. Our audits were 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 KU Energy Corporation'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. Arthur Andersen & Co. Chicago, Illinois January 26, 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, on March 14, 1994. KU ENERGY CORPORATION /s/ John T. Newton John T. Newton Chairman and 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 in the capacities and on the date indicated. Signature Title /s/ John T. Newton John T. Newton Chairman and President (Principal Executive Officer) and Director /s/ Michael R. Whitley Michael R. Whitley Senior Vice-President (Principal Financial Officer) and Director /s/ Michael D. Robinson Michael D. Robinson Controller (Principal Accounting Officer) /s/ Mira S. Ball Mira S. Ball Director /s/ W. B. Bechanan W. B. Bechanan Director /s/ Harry M. Hoe Harry M. Hoe Director /s/ Milton W. Hudson Milton W. Hudson Director /s/ Frank V. Ramsey, Jr. Frank V. Ramsey, Jr. Director /s/ Warren W. Rosenthal Warren W. Rosenthal Director /s/ William L. Rouse, Jr. William L. Rouse, Jr. Director /s/ Charles L. Shearer Charles L. Shearer Director March 14, 1994

356130_1993.txt

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ITEM 1. BUSINESS. - ------- -------- GENERAL - ------- EMC Insurance Group Inc. is an insurance holding company incorporated in Iowa in 1974. EMC Insurance Group Inc. is approximately 67 percent owned by Employers Mutual Casualty Company ("Employers Mutual"), a multiple-line property and casualty insurance company organized as an Iowa mutual insurance company in 1911 that is licensed in all 50 states and the District of Columbia. EMC Insurance Group Inc. and its subsidiaries are referred to herein as the "Company". Employers Mutual and all of its subsidiaries (including the Company), which collectively have assets totaling $1,228,334,000 and written premiums of $562,817,000, are referred to as the "EMC Insurance Companies". The Company conducts its insurance business through four business segments as follows: ............................... : : : EMC INSURANCE GROUP INC. : :.............................: : Excess and Property and : Nonstandard Surplus Lines Casualty : Risk Automobile Insurance Insurance Reinsurance : Insurance Agency ................................:................................. : : : : : : : : EMCASCO Insurance EMC Farm and City EMC Company (EMCASCO) Reinsurance Insurance Underwriters, Illinois EMCASCO Company Company Ltd. Insurance Company (EMC Re) (Farm and (Underwriters, (Illinois EMCASCO) City) Ltd.) Dakota Fire Insurance Company (Dakota Fire) EMCASCO was formed in Iowa in 1958, Illinois EMCASCO was formed in Illinois in 1976, and Dakota Fire was formed in North Dakota in 1957 for the purpose of writing property and casualty insurance lines. These companies are licensed to write insurance in a total of 35 states and are participants in a pooling agreement with Employers Mutual. (See "Property and Casualty Insurance - - Pooling Agreement"). EMC Re was formed in 1981 to assume reinsurance business of Employers Mutual. EMC Re assumes 95 percent of Employers Mutual's assumed reinsurance business, exclusive of certain reinsurance contracts, and is licensed to do business in 11 states. Farm and City was purchased in January of 1984. Farm and City was formed in Iowa in 1962 to write nonstandard risk automobile insurance and is licensed in 5 states. Underwriters, Ltd. was acquired in January of 1985. Underwriters, Ltd. was formed in Iowa in 1975 as a broker for excess and surplus lines insurance and acts as managing underwriter for such lines for several of the property and casualty pool members. (See "Property and Casualty Insurance - Pooling Agreement"). The Company sold its life insurance subsidiary to Employers Mutual on December 31, 1991. All information presented in this report reflects the life segment as a discontinued operation. Additional information regarding the discontinued operation is included in note 5 of Notes to Consolidated Financial Statements under Item 8 of this Form 10-K. FINANCIAL INFORMATION ABOUT INDUSTRY SEGMENTS - --------------------------------------------- For information concerning the Company's revenues, operating income and identifiable assets attributable to each of its industry segments over the past three years, see note 9 of Notes to Consolidated Financial Statements under Item 8 of this Form 10-K. PROPERTY AND CASUALTY INSURANCE - ------------------------------- POOLING AGREEMENT The three property and casualty insurance subsidiaries of the Company and two subsidiaries of Employers Mutual (Union Insurance Company of Providence and American Liberty Insurance Company) are parties to reinsurance pooling agreements with Employers Mutual (collectively the "pooling agreement"). Under the terms of the pooling agreement, each company cedes to Employers Mutual all of its insurance business and assumes from Employers Mutual an amount equal to its participation in the pool. All losses, settlement expenses and other underwriting and administrative expenses are prorated among the parties on the basis of participation in the pool. The investment programs and income tax liabilities of the pool participants are not subject to the pooling agreement. The purpose of the pooling agreement is to reduce the risk of an exposure insured by any of the pool participants by spreading it among all the companies. The pooling agreement produces a more uniform and stable underwriting result from year to year for all companies in the pool than might be experienced individually. In addition, each company benefits from the capacity of the entire pool, rather than being limited to policy exposures of a size commensurate with its own assets, and from the wide range of policy forms and lines of insurance written and the variety of rate filings and commission plans offered by each of the companies. A single set of reinsurance treaties is maintained for the protection of all six companies in the pool. Effective January 1, 1992, the aggregate participation of the property and casualty insurance subsidiaries was increased to 22 percent from 17 percent. In connection with this change in pool participation, the Company's liabilities increased $31,427,861 and invested assets increased $29,402,411. The Company reimbursed Employers Mutual $2,025,450 for commissions incurred to generate this business. Employers Mutual voluntarily assumes reinsurance business from nonaffiliated insurance companies and cedes 95 percent of this business to the Company's reinsurance subsidiary, exclusive of certain reinsurance contracts. Amounts not ceded to the reinsurance subsidiary have historically been retained by Employers Mutual and have been subject to cession to the pool members. Under the terms of the pooling agreement, the property and casualty subsidiaries had a 22 percent participation (17 percent in 1991) in the amounts assumed from these nonaffiliated companies. Effective January 1, 1993, the pooling agreement was amended so that the voluntary assumed reinsurance business written by Employers Mutual is no longer subject to cession to the pool members. In connection with this change in the pooling agreement, the Company's liabilities decreased $4,470,204 and invested assets decreased $4,426,945. Employers Mutual reimbursed the Company $43,259 for commissions incurred to generate this business. The parties to the pooling agreement have historically recorded amounts assumed from the National Workers' Compensation Reinsurance Pool on a net basis. Under this approach, reserves for outstanding losses and unearned premiums were reported as liabilities under "Indebtedness to Related Party" in the Company's consolidated financial statements. Effective December 31, 1993, the parties to the pooling agreement began recording these amounts as outstanding losses and unearned premiums. As a result, outstanding losses increased $11,436,543, unearned premiums increased $1,711,288 and indebtedness to related party decreased $13,147,831. There was no income effect from this reclassification. Prior year consolidated financial statements have been restated for comparative purposes. SERVICES PROVIDED BY EMPLOYERS MUTUAL Employers Mutual and the Company's property and casualty insurance subsidiaries utilize many common services and facilities. These services are provided to all parties to the pooling agreement by Employers Mutual. The parties receive the benefit of greater expertise in a broader range of services at a lower cost than would otherwise be possible if each party was individually required to provide these services. Costs of these services are charged by Employers Mutual to the pool, and each party shares in the total cost in proportion to its participation percentage. Common data processing, claims, financial, investment, actuarial, auditing, risk management, risk improvement, marketing and underwriting services are among the services provided by Employers Mutual for the Company's property and casualty insurance subsidiaries. This interrelationship means that Employers Mutual has the ability to determine the types and extent of services available to the property and casualty insurance subsidiaries. PRINCIPAL PRODUCTS The Company's property and casualty insurance subsidiaries and the other parties to the pooling agreement underwrite both commercial and personal lines of insurance. The following table sets forth the aggregate direct written premiums of all parties to the pooling agreement for the three years ended December 31, 1993. The pooling agreement is continuous but may be amended or terminated at the end of any calendar year as to any one or more parties. Percent Percent Percent of of of Line of Business 1993 Total 1992 Total 1991 Total - ---------------- -------- ----- -------- ----- -------- ----- (Dollars in thousands) Commercial Lines: Automobile ............ $ 83,415 16.0% $ 77,102 14.9% $ 70,406 14.2% Property .............. 72,743 13.9 71,856 13.9 68,710 13.8 Workers' compensation 134,529 25.8 141,245 27.2 136,594 27.5 Liability ............. 99,976 19.1 98,029 18.9 92,721 18.7 Other ................. 11,948 2.3 11,858 2.3 10,016 2.0 -------- ----- -------- ----- -------- ----- Total commercial lines 402,611 77.1 400,090 77.2 378,447 76.2 -------- ----- -------- ----- -------- ----- Personal Lines: Automobile ............ 83,068 15.9 82,346 15.9 81,178 16.4 Property .............. 36,515 7.0 35,785 6.9 35,912 7.2 Liability ............. - - 200 - 988 .2 Other ................. 56 - 57 - 58 - -------- ----- -------- ----- -------- ----- Total personal lines 119,639 22.9 118,388 22.8 118,136 23.8 -------- ----- -------- ----- -------- ----- Total ............ $522,250 100.0% $518,478 100.0% $496,583 100.0% ======== ===== ======== ===== ======== ===== MARKETING Marketing of insurance by the parties to the pooling agreement is conducted through 18 offices located throughout the United States and approximately 2,400 independent agents. These offices maintain close contact with the local market conditions and are able to react rapidly to change. Each office employs underwriting, claims, marketing, and risk improvement representatives, as well as field auditors and branch administrative technicians. The offices are supported by Employers Mutual technicians and specialists. Systems are in place to monitor the underwriting results of each office and to maintain guidelines and policies consistent with the underwriting and marketing environment in each region. The following table sets forth the geographic distribution of the aggregate direct written premiums of all parties to the pooling agreement for the three years ended December 31, 1993. 1993 1992 1991 ---- ---- ---- Arizona ............................ 3.7% 3.6% 3.6% Illinois ........................... 6.8 7.0 6.6 Iowa ............................... 26.2 26.7 26.4 Kansas ............................. 7.4 7.1 6.0 Michigan ........................... 3.1 2.8 2.4 Minnesota .......................... 5.3 5.3 5.4 Nebraska ........................... 7.5 7.6 7.1 North Carolina ..................... 3.3 3.3 3.8 Rhode Island ....................... 3.2 2.9 3.2 Texas .............................. 2.8 3.2 4.3 Wisconsin .......................... 6.7 7.0 7.1 Other * ............................ 24.0 23.5 24.1 ----- ----- ----- 100.0% 100.0% 100.0% ===== ===== ===== * Includes all other jurisdictions, none of which accounted for more than 3%. REINSURANCE CEDED The parties to the pooling agreement cede insurance in the ordinary course of business for the purpose of limiting their maximum loss exposure through diversification of their risks. The pool participants also purchase catastrophe reinsurance to cover multiple losses arising from a single event. All major reinsurance treaties, with the exception of the pooling agreement, are on an "excess of loss" basis whereby the reinsurer agrees to reimburse the primary insurer for covered losses in excess of a predetermined amount, up to a stated limit. Facultative reinsurance from approved domestic markets, which provides reinsurance on an individual risk basis and requires specific agreement of the reinsurer as to the limits of coverage provided, is purchased when coverage by an insured is required in excess of treaty capacity or where a high-risk type policy could expose the treaty reinsurance programs. Retention levels are adjusted according to reinsurance market conditions and the surplus position of Employers Mutual. The intercompany pooling arrangement aids efficient buying of reinsurance since it allows for higher retention levels and correspondingly decreased dependence on the reinsurance marketplace. A summary of the reinsurance treaties benefiting the parties to the pooling agreement follows: Type of Coverage Retention Limits ---------------- --------- ------ Property per risk ....... $2,000,000 100 percent of $18,000,000 Property catastrophe .... $9,000,000 95 percent of $51,000,000 Casualty ................ $2,000,000 100 percent of $43,000,000 Umbrella ................ $5,000,000 100 percent of $ 5,000,000 The property per risk, property catastrophe and casualty reinsurance programs are handled by a reinsurance intermediary (broker). The reinsurance of those programs is syndicated to approximately 90 domestic and foreign reinsurers that meet Employers Mutual's financial security guidelines. The umbrella reinsurance is written by one large domestic direct writing reinsurer (General Reinsurance Corporation). Although reinsurance does not discharge the original insurer from its primary liability to its policyholders, it is the practice of insurers for accounting purposes to treat reinsured risks as risks of the reinsurer since the primary insurer would only reassume liability in those situations where the reinsurer is unable to meet the obligations it assumed under the reinsurance agreements. The collectability of reinsurance is subject to the solvency of the reinsurers. The major participants in the pool members' reinsurance program are presented below. These percentages represent the reinsurers' share of the total reinsurance protection under all coverages. Each type of coverage is purchased in layers, and an individual reinsurer may participate in more than one coverage and at various layers within these coverages. Percent of Total 1993 Reinsurance Best's Reinsurer Protection Rating - --------- ----------- ------ Underwriters at Lloyd's of London .................. 19.9% (1) Insurance Company of North America ................. 7.2 A- Prudential Reinsurance Company ..................... 6.0 A General Reinsurance Corporation .................... 3.6 A++ NAC Reinsurance Corporation ........................ 3.3 A Hartford Fire Insurance Company .................... 3.0 A+ AXA Reinsurance Company ............................ 2.7 A (1) Not rated; however, the individual members of the Lloyd's organization are required to pledge their entire net worth toward the satisfaction of their liabilities. In response to reported losses of $3.8 billion, $4.2 billion, $1.9 billion (estimated) and $758 million (estimated) in 1989, 1990, 1991 and 1992, respectively, Lloyd's has developed a business plan to improve its profitability. The plan is described in detail in the "Rowland" report published by Lloyd's in April, 1993. This plan outlines several significant changes: a new management team will play a more active role in the administration of affairs, corporate capital will be allowed, names are to continue with unlimited liability, "NewCo" will be incorporated with assets of 4.0 billion pounds sterling to manage old liabilities, a table will be published on an annual basis of the best syndicate performers, and independent regulations will be enforced. All of these changes may help to reduce the risk of doing business with Lloyd's. In addition, standing behind the means of individual members is the Lloyd's Central Fund. This Fund is considered by Lloyd's to be a safety net, whereby Lloyd's membership as a whole can be compelled to make up deficiencies caused by individual names defaulting. There is also a multi-billion dollar trust fund to secure Lloyd's obligations to United States policyholders. The Company has not experienced any difficulty in collecting its reinsurance receivables from any Lloyd's syndicates. However, the substantial losses noted above could affect the ability of certain syndicates to continue to trade and the ability of the Company to continue to place business with the syndicates. Premiums ceded by all parties to the pooling agreement and by the property and casualty insurance subsidiaries for the year ended December 31, 1993 are presented below. Each type of reinsurance coverage is purchased in layers, and an individual reinsurer may participate in more than one coverage and at various layers within these coverages. Since each layer of each coverage is priced separately, with the lower layers being more expensive than the upper layers, a reinsurer's overall participation in a reinsurance program does not necessarily correspond to the amount of premiums it receives. Premiums Ceded By ------------------------ Property All Pool and Casualty Reinsurer Members Subsidiaries - --------- ----------- ------------ General Reinsurance Corporation ...................... $ 3,517,725 $ 773,900 Underwriters at Lloyd's London ....................... 1,670,393 367,486 Hartford Steam Boiler Inspection and Insurance Company 1,138,371 250,442 Hartford Fire Insurance Company ...................... 632,192 139,082 Michigan Mutual Insurance Company .................... 629,529 138,496 Pennsylvania Mfg. Assn. Insurance Company ............ 629,529 138,496 Transamerica Insurance Company ....................... 553,987 121,877 Utica Mutual Insurance Company ....................... 497,328 109,412 Other Reinsurers ..................................... 9,734,638 2,141,621 ----------- ------------ Total ............................................. $19,003,692 $ 4,180,812 =========== ============ The parties to the pooling agreement also cede reinsurance on both a voluntary and a mandatory basis to state and national organizations in connection with various workers' compensation and assigned risk programs. Premiums ceded by all parties to the pooling agreement and by the property and casualty insurance subsidiaries for the year ended December 31, 1993 are presented below. Premiums Ceded By ------------------------ Property All Pool and Casualty Reinsurer Members Subsidiaries - --------- ----------- ------------ Wisconsin Compensation Rating Bureau ................. $13,887,977 $ 3,055,355 National Workers' Compensation Reinsurance Pool ...... 13,297,246 2,925,394 North Carolina Reinsurance Facility .................. 1,387,107 305,164 Michigan Catastrophe Claims Association .............. 814,504 179,191 Other reinsurers ..................................... 252,574 55,566 ----------- ------------ $29,639,408 $ 6,520,670 =========== ============ In formulating reinsurance programs, Employers Mutual is selective in its choice of reinsurers. Employers Mutual selects reinsurers on the basis of financial stability and long-term relationships, as well as price of the coverage. Reinsurers are generally required to have a Best's rating of "A-" or higher and policyholders surplus of $50,000,000 ($100,000,000 for casualty reinsurance). For information concerning amounts due the Company from reinsurers for losses and settlement expenses and prepaid reinsurance premiums and the effect of reinsurance on premiums written and earned and losses and settlement expenses incurred, see "Property and Casualty Insurance Subsidiaries, Reinsurance Subsidiary and Nonstandard Risk Automobile Insurance Subsidiary - Reinsurance Ceded". RELATIONSHIP BETWEEN NET PREMIUMS WRITTEN AND SURPLUS The volume of insurance which a property and casualty insurance company writes under industry standards is a multiple of its surplus calculated in accordance with statutory accounting practices. Generally, a ratio of 3 to 1 or less is considered satisfactory. The ratios of the pool members for the past three years are as follows: Year ended December 31, -------------------------------- 1993 1992 1991 ---- ---- ---- Employers Mutual .................. 1.33 1.32 1.43 EMCASCO ........................... 2.51 2.56 2.06 Illinois EMCASCO .................. 2.44 2.65 2.17 Dakota Fire ....................... 2.18 2.49 2.26 American Liberty .................. 1.38 1.38 1.40 Union Mutual ...................... 1.63 1.68 1.70 OUTSTANDING LOSSES AND SETTLEMENT EXPENSES The property and casualty insurance subsidiaries' reserve information is included in the property and casualty loss reserve development for 1993. See "Property and Casualty Insurance Subsidiaries, Reinsurance Subsidiary and Nonstandard Risk Automobile Insurance Subsidiary - Outstanding Losses and Settlement Expenses". COMPETITION The property and casualty insurance business is highly competitive. The Company competes in the United States insurance market with numerous insurers, many of which have greater financial resources than the Company. Competition in the types of insurance in which the Company is engaged is based on many factors, including the perceived overall financial strength of the insurer, premiums charged, contract terms and conditions, services offered, speed of claim payments, reputation and experience. In this competitive environment, insureds have tended to favor large, financially strong insurers and the Company faces the risk that insureds may become more selective and may seek larger and/or more highly rated insurers. BEST'S RATING A.M. Best rates insurance companies based on their relative financial strength and ability to meet their contractual obligations. The "A (Excellent)" rating assigned to the Company's property and casualty insurance subsidiaries and the other pool members is based on the pool members' 1992 operating results and financial condition as of December 31, 1992. Best's reevaluates its ratings from time to time (normally on an annual basis) and there can be no assurance that the Company's property and casualty insurance subsidiaries and the other pool members will maintain their current rating in the future. Management believes that a Best's rating of "A (Excellent)" or better is important to the Company's business since many insureds require that companies with which they insure be so rated. Best's defines both "A" and "A-" as "Excellent". Best's publications indicate that these ratings are assigned to companies which Best's believes have achieved excellent overall performance and have a strong ability to meet their obligations over a long period of time. Best's ratings are based upon factors of concern to policyholders and insurance agents and are not necessarily directed toward the protection of investors. REINSURANCE - ----------- EMC Re is a property and casualty treaty reinsurer with a concentration in property lines. EMC Re began its operations in 1981 with a five percent quota share assumption of Employers Mutual's assumed reinsurance business. The quota share percentage has been gradually increased over the years and since 1988 EMC Re has assumed a 95 percent quota share of Employers Mutual's assumed reinsurance business. EMC Re receives 95 percent of all premiums and assumes 95 percent of all related losses and expenses of this business. EMC Re does not reinsure any of Employers Mutual's direct insurance business, nor any "involuntary" facility or pool business that Employers Mutual assumes pursuant to state law. In addition, EMC Re is not liable for credit risk in connection with the insolvency of any reinsurers of Employers Mutual. Effective January 1, 1993, the quota share agreement with Employers Mutual was amended so that losses in excess of $1,000,000 per event are retained by Employers Mutual. EMC Re pays an annual override commission to Employers Mutual for this additional protection, which totaled $1,808,527 in 1993. Employers Mutual retained losses totaling $615,000 under this agreement in 1993. Effective June 30, 1993, Employers Mutual commuted the portion of the quota share agreement that pertains to a casualty pool that is in a run-off position. In connection with this change in the quota share agreement, the Company's liabilities decreased $19,783,037 and invested assets decreased $17,806,179. The reserve discount amount of $1,976,858 was recorded as deferred income and is being amortized into operations over the estimated settlement period of the reserves, which is ten years. During 1993, $259,217 was recognized as income. Effective October 31, 1993, Employers Mutual commuted the portion of the quota share agreement that pertains to a voluntary pool that handles large "highly protected" risks. This pool has experienced deteriorating underwriting results over the last several years and Employers Mutual is presently considering whether to continue its participation in the pool beyond 1994. In connection with this change in the quota share agreement, the Company's liabilities decreased $3,827,201 and invested assets decreased $2,619,776. Employers Mutual reimbursed the Company $1,207,425 for commissions incurred to generate this business. No reserve discount was calculated as this business involves short-tail property coverage. REINSURANCE CEDED In conjunction with the change in the quota share agreement noted above, EMC Re terminated its catastrophe reinsurance treaties with Employers Mutual and other nonaffiliated reinsurers effective January 1, 1993. The reinsurance treaty with Employers Mutual paid losses in excess of $1,000,000 resulting from any one catastrophe, subject to a maximum loss of $3,000,000. Maximum recovery was limited to $6,000,000. The catastrophe protection placed on the open market amounted to 95 percent of $8,000,000 in excess of $4,000,000. Ceded reinsurance on the books at December 31, 1992 is being allowed to run-off. EMC Re has an aggregate "excess of loss" treaty with Employers Mutual which provides protection from a large accumulation of retentions resulting from multiple catastrophes in any one calendar year. The coverage provided is $2,000,000 excess of $2,500,000 ($2,000,000 in 1991) aggregate losses retained, excess of $200,000 per event. Maximum recovery is limited to $4,000,000 per accident year. For information concerning amounts due the Company from reinsurers for losses and settlement expenses and prepaid reinsurance premiums and the effect of reinsurance on premiums written and earned and losses and settlement expenses incurred, see "Property and Casualty Insurance Subsidiaries, Reinsurance Subsidiary and Nonstandard Risk Automobile Insurance Subsidiary - Reinsurance Ceded". OUTSTANDING LOSSES AND SETTLEMENT EXPENSES EMC Re's reserve information is included in the property and casualty loss reserve development for 1993. See "Property and Casualty Insurance Subsidiaries, Reinsurance Subsidiary and Nonstandard Risk Automobile Insurance Subsidiary - Outstanding Losses and Settlement Expenses". COMPETITION Competition for reinsurance business abated somewhat in 1993. This reduction in competition is primarily due to reduced market capacity for catastrophe reinsurance, which has resulted in higher rates for this segment of business. EMC Re continues to reduce its aggregate liabilities in hurricane exposed areas in favor of writing new business away from coastal areas. Despite a decrease in overall exposure, written premiums are expected to increase in 1994 due to the increased rates currently available. BEST'S RATING The most recent Best's Property Casualty Key Rating Guide gives EMC Re an A (Excellent) policyholders' rating. Best's ratings are based upon factors of concern to policyholders and insurance agents and are not necessarily directed toward the protection of investors. NONSTANDARD RISK AUTOMOBILE INSURANCE - ------------------------------------- Farm and City was acquired by the Company in January of 1984. Farm and City specializes in insuring private passenger automobile risks that are found to be unacceptable in the normal automobile market. MARKETING Farm and City is admitted in a five state area which includes Iowa, Kansas, Nebraska, North Dakota and South Dakota. Personal automobile policies are solicited through the American Agency System and are written for two, three or six month terms. Limits of liability are offered equal to the state responsibility laws. Physical damage coverages are written at normal insurance deductibles. REINSURANCE CEDED Farm and City has a reinsurance treaty on an "excess of loss" basis with Employers Mutual, which provides reinsurance for 100 percent of each loss in excess of $100,000, up to $1,000,000. No recoveries have been made under this treaty. OUTSTANDING LOSSES AND SETTLEMENT EXPENSES Farm and City's reserve information is included in the property and casualty loss reserve development for 1993. See "Property and Casualty Insurance Subsidiaries, Reinsurance Subsidiary and Nonstandard Risk Automobile Insurance Subsidiary - Outstanding Losses and Settlement Expenses". For information concerning amounts due the Company from reinsurers for losses and settlement expenses and prepaid reinsurance premiums and the effect of reinsurance on premiums written and earned and losses and settlement expenses incurred, see "Property and Casualty Insurance Subsidiaries, Reinsurance Subsidiary and Nonstandard Risk Automobile Insurance Subsidiary - Reinsurance Ceded". COMPETITION The nonstandard risk marketplace is very competitive. Policies are written for relatively short periods of time and insureds continually search for the most attractive rates. The number of companies willing to write nonstandard coverage remained fairly constant during 1993, as did availability in the standard market. Nevertheless, Farm and City was able to increase its market share through competitive pricing. Demand for nonstandard coverage, which is primarily a result of availability in the standard market, is expected to remain fairly constant in 1994. Future premium growth will therefore continue to be dependent upon competitive pricing and expansion into new markets. BEST'S RATING The most recent Best's Property Casualty Key Rating Guide gives Farm and City an A+ (Superior) policyholders' rating. Best's ratings are based upon factors of concern to policyholders and insurance agents and are not necessarily directed toward the protection of investors. PROPERTY AND CASUALTY INSURANCE SUBSIDIARIES, REINSURANCE SUBSIDIARY AND - ------------------------------------------------------------------------ NONSTANDARD RISK AUTOMOBILE INSURANCE SUBSIDIARY. - ------------------------------------------------ STATUTORY COMBINED RATIOS The following table sets forth the Company's subsidiaries' statutory combined ratios and the property and casualty insurance industry average for the five years ended December 31, 1993. The combined ratios below are the sum of the following: the loss ratio, calculated by dividing losses and settlement expenses by net premiums earned, and the expense ratio, calculated by dividing underwriting expenses and policyholder dividends by net premiums written. Generally, if the combined ratio is below 100 percent, a company has an underwriting profit; if it is above 100 percent, a company has an underwriting loss. Year ended December 31, -------------------------------------- 1993 1992 1991 1990 1989 ------ ------ ------ ------ ------ Property and casualty insurance Loss ratio .................... 72.6% 76.1% 76.8% 73.8% 68.1% Expense ratio ................. 30.9 30.1 30.5 30.8 32.9 ------ ------ ------ ------ ------ Combined ratio .............. 103.5% 106.2% 107.3% 104.6% 101.0% ====== ====== ====== ====== ====== Reinsurance Loss ratio .................... 77.7% 109.1% 82.9% 92.6% 126.1% Expense ratio ................. 33.1 34.8 36.6 37.2 37.4 ------ ------ ------ ------ ------ Combined ratio .............. 110.8% 143.9% 119.5% 129.8% 163.5% ====== ====== ====== ====== ====== Nonstandard risk automobile insurance Loss ratio .................... 94.3% 92.3% 72.4% 77.8% 67.4% Expense ratio ................. 23.7 23.7 25.2 24.7 29.7 ------ ------ ------ ------ ------ Combined ratio .............. 118.0% 116.0% 97.6% 102.5% 97.1% ====== ====== ====== ====== ====== Total insurance operations Loss ratio .................... 75.6% 83.4% 77.8% 78.0% 79.3% Expense ratio ................. 30.7 30.5 31.4 31.5 33.4 ------ ------ ------ ------ ------ Combined ratio .............. 106.3% 113.9% 109.2% 109.5% 112.7% ====== ====== ====== ====== ====== Property and casualty insurance industry averages (1) Loss ratio .................... 81.8% 88.1% 81.2% 82.3% 82.0% Expense ratio ................. 27.4 27.6 27.7 27.3 27.2 ------ ------ ------ ------ ------ Combined ratio .............. 109.2% 115.7% 108.9% 109.6% 109.2% ====== ====== ====== ====== ====== (1) As reported by A.M. Best Company. The ratio for 1993 is an estimate; the actual combined ratio is not currently available. REINSURANCE CEDED The following table presents amounts due to the Company from reinsurers for losses and settlement expenses and prepaid reinsurance premiums as of December 31, 1993: Amount Percent Best's Recoverable of Total Rating ----------- -------- ------ Wisconsin Compensation Rating Bureau .. $ 9,328,318 43.8% (1) National Workers' Compensation Reinsurance Pool .................... 2,862,700 13.4 (1) Employers Mutual Casualty Company ..... 1,250,209 5.9 A General Reinsurance Corporation ....... 1,074,942 5.0 A++ North Carolina Reinsurance Facility ... 618,930 2.9 (2) American Re-Insurance Company ......... 596,830 2.8 A+ New England Reinsurance Corporation ... 474,113 2.2 (3) Old Republic Insurance Company ........ 442,972 2.1 A+ Minnesota Workers' Compensation Reinsurance Association ............. 398,992 1.9 (4) Allstate Insurance Company ............ 351,076 1.6 A- Underwriters at Lloyd's London ........ 341,961 1.6 (3) Other Reinsurers ...................... 3,568,547 16.8 ----------- -------- Total ........................... $21,309,590(5) 100.0% =========== ======== (1) Amounts recoverable reflect the property and casualty insurance subsidiaries' pool participation percentage of amounts ceded to these organizations by Employers Mutual in connection with its role as "service carrier". Under these arrangements, Employers Mutual writes business for these organizations on a direct basis and then cedes 100 percent of the business to these organizations. Credit risk associated with these amounts is minimal as all companies writing direct business in the states that participate in these organizations are responsible for the liabilities of such organizations on a pro rata basis. (2) The amount recoverable reflects the property and casualty insurance subsidiaries' pool participation percentage of amounts ceded to this organization by the pool members in conjunction with the state run assigned risk program ("state fund"). Under this program, all insurers writing direct business in the state of North Carolina are required by law to write insurance for risks that are not insurable in the normal marketplace. Business written under this program is ceded 100 percent to the state fund and each respective company assumes from the state fund its share of such business in proportion to its direct writings in the state. Credit risk associated with this amount is minimal as all companies writing direct business in the state are responsible for the liabilities of this organization on a pro rata basis. (3) Not rated. (4) The amount recoverable reflects the property and casualty insurance subsidiaries' pool participation percentage of amounts ceded to this association by the pool members under a reinsurance contract that provides protection for workers' compensation losses in excess of $430,000 per occurrence. Credit risk associated with this amount is minimal as all companies writing direct workers' compensation business in the state of Minnesota are responsible for the liabilities of this association on a pro rata basis. (5) The total amount at December 31, 1993 represented $1,234,983 in paid losses and settlement expenses recoverable, $17,242,423 in unpaid losses and settlement expenses recoverable and $2,832,184 in unearned premiums recoverable. The effect of reinsurance on premiums written and earned and losses and settlement expenses incurred for the years ended December 31, 1993, 1992 and 1991 is presented below. Amounts for the year ended December 31, 1993 reflect (1) the change in the property and casualty insurance subsidiaries' pooling agreement whereby effective January 1, 1993, the voluntary assumed reinsurance business written by Employers Mutual is no longer subject to cession to the pool members and (2) the change in the reinsurance subsidiary's quota share agreement whereby effective January 1, 1993 losses in excess of $1,000,000 per event are retained by Employers Mutual and the reinsurance subsidiary therefore no longer purchases catastrophe protection. (See notes 2 and 3 of Notes to Consolidated Financial Statements under Item 8 of this Form 10-K). Year ended December 31, ---------------------------------------- 1993 1992 1991 ------------ ------------ ------------ Premiums written: Direct ........................ $135,277,129 $138,829,576 $139,292,883 Assumed from nonaffiliates .... 6,636,942 16,467,613 9,477,850 Assumed from affiliates ....... 147,620,705 150,070,741 108,847,230 Ceded to nonaffiliates ........ (10,701,482) (17,721,207) (11,113,238) Ceded to affiliates ........... (120,898,914) (129,826,840) (130,675,014) ------------ ------------ ------------ Net premiums written ....... $157,934,380 $157,819,883 $115,829,711 ============ ============ ============ Premiums earned: Direct ........................ $137,141,457 $142,391,771 $134,675,865 Assumed from nonaffiliates .... 6,758,364 14,980,642 9,056,890 Assumed from affiliates ....... 148,366,487 140,442,245 106,783,050 Ceded to nonaffiliates ........ (11,507,217) (16,775,394) (11,051,459) Ceded to affiliates ........... (124,321,553) (133,628,977) (126,045,108) ------------ ------------ ------------ Net premiums earned ........ $156,437,538 $147,410,287 $113,419,238 ============ ============ ============ Losses and settlement expenses incurred: Direct ........................ $ 97,842,980 $112,579,261 $101,910,680 Assumed from nonaffiliates .... 6,575,099 17,415,319 8,671,495 Assumed from affiliates ....... 107,369,274 114,359,445 77,845,953 Ceded to nonaffiliates ........ (5,845,414) (16,862,082) (4,735,272) Ceded to affiliates ........... (85,586,640) (105,404,110) (95,587,937) ------------ ------------ ------------ Net losses and settlement expenses incurred ........ $120,355,299 $122,087,833 $ 88,104,919 ============ ============ ============ OUTSTANDING LOSSES AND SETTLEMENT EXPENSES The Company maintains reserves for losses and settlement expenses with respect to both reported and unreported claims. The amount of reserves for reported claims is primarily based upon a case-by-case evaluation of the specific type of claim, knowledge of the circumstances surrounding each claim and the policy provisions relating to the type of loss. Reserves on assumed business are the amounts reported by the ceding company. The amount of reserves for unreported claims is determined on the basis of statistical information for each line of insurance with respect to the probable number and nature of claims arising from occurrences which have not yet been reported. Established reserves are closely monitored and are frequently recomputed using a variety of formulas and statistical techniques for analyzing current actual claim cost, frequency data and other economic and social factors. The Company does not discount reserves. Inflation is implicitly provided for in the reserving function through analysis of cost trends, reviews of historical reserving results and projections of future economic conditions. Large ($25,000 and over) incurred and reported gross reserves are reviewed regularly for adequacy. In addition, long-term and lifetime medical claims are periodically reviewed for cost trends and the applicable reserves are appropriately revised. Loss reserves are estimates at a given time of what the insurer expects to pay on incurred losses, based on facts and circumstances then known. During the loss settlement period, which may be many years, additional facts regarding individual claims become known, and accordingly, it often becomes necessary to refine and adjust the estimates of liability on a claim. Settlement expense reserves are intended to cover the ultimate cost of investigating claims and defending lawsuits arising from claims. These reserves are established each year based on previous years' experience to project the ultimate cost of settlement expenses. To the extent that adjustments are required to be made in the amount of outstanding loss reserves each year, settlement expense reserves are correspondingly revised. Despite the inherent uncertainties of estimating insurance company loss and settlement expense reserves, management believes that the Company's reserves are being calculated in accordance with sound actuarial practices and, based upon current information, that the Company's reserves for losses and settlement expenses at December 31, 1993 are adequate. Over the past several years, the Company's financial results have been affected by losses associated with environmental exposures. The Company's environmental claims activity is predominately from hazardous waste and pollution-related claims. The parties to the pooling agreement have not written primary coverage for the major oil or chemical companies; the greatest exposure arises out of commercial general liability and umbrella policies issued to municipalities during the 1970s which allegedly cover contamination emanating from closed landfills. The remaining exposure is from claims from small regional operations or local businesses involved with disposing wastes at dump sites or having pollution on their own property due to hazardous material use or leaking underground storage tanks. These insureds include small manufacturing operations, tool makers, automobile dealerships, contractors, gasoline stations and real estate developers. Prior to July 1, 1993, the Company's reinsurance subsidiary assumed reinsurance business that included environmental exposures from a casualty pool that is in a run-off position. Effective June 30, 1993, Employers Mutual commuted the portion of the quota share agreement that pertains to this pool. As a result of this commutation, the Company's environmental reserves decreased $502,818 on June 30, 1993. Environmental losses associated with this pool totaled $197,859, $161,693 and $152,384 in 1993, 1992 and 1991, respectively. The following table presents selected data on environmental losses and settlement expenses incurred and reserves outstanding for the Company: Year Ended December 31, -------------------------------- 1993 1992 1991 ---------- ---------- ---------- Total losses incurred ....................... $ 485,197 $ 563,652 $ 304,833 Total settlement expenses incurred .......... 85,282 43,845 82,345 ---------- ---------- ---------- Total losses and settlement expenses incurred ................................ $ 570,479 $ 607,497 $ 387,178 ========== ========== ========== Loss reserves ............................... $ 676,511 $ 873,292 $ 676,398 Settlement expense reserves ................. 235,426 197,808 173,274 ---------- ---------- ---------- Total loss and settlement expense reserves $ 911,937 $1,071,100 $ 849,672 ========== ========== ========== Number of outstanding claims ................ 63 74 78 ========== ========== ========== Estimating environmental reserves is one of the most difficult aspects of the reserving process. The legal definition of environmental damage is still evolving, the assignment of responsibility varies widely by state, defense costs are often much greater than the claim costs and claims often emerge long after the policy has expired, making assignment of damages to the time period covered by a particular policy difficult. Management periodically reviews the adequacy of environmental reserves as part of the reserve review process and believes that the stated reserves are adequate. The Company has two policyholders which have filed claims at three separate sites in connection with the transportation of hazardous waste to landfills. Included in the above table at December 31, 1993 are five pollution sites which involve multiple claims as follows: Number Pollution site of claims -------------- --------- Closed landfill ................... 4 Closed landfill ................... 2 Oil recycling facility ............ 2 Battery reclamation site .......... 2 Battery reclamation site .......... 2 Pollution coverage is being disputed in 40 of the 63 claims which were outstanding at December 31, 1993. Coverage is disputed in all claims involving the removal of underground storage tanks or the clean up of (i) underground storage tank sites, (ii) landfills based on ownership of the landfill or the generation of waste disposed of at landfills or (iii) insured property. Pollution coverage is not being disputed in the remaining 23 claims which were outstanding as of December 31, 1993. These claims are the result of petroleum misdeliveries or spills where coverage has been accepted under a commercial automobile policy that had an applicable endorsement. The Company has 39 bodily injury claims involving asbestosis as of December 31, 1993. In each case, a former insured has been named as one of multiple defendants covering exposure over many years. The Company has not paid any defense costs or loss payments and there is no evidence of injury as a result of exposure to the Company's insured's products during the policy periods. Prior to July 1, 1993, the Company's reinsurance subsidiary assumed reinsurance business that included asbestosis related exposures from a casualty pool that is in a run-off position. Effective June 30, 1993, Employers Mutual commuted the portion of the quota share agreement that pertains to this pool. As a result of this commutation, the Company's asbestosis related reserves decreased $1,037,738 on June 30, 1993. Asbestosis related losses associated with this pool totaled $226,470, $330,653 and $292,478 in 1993, 1992 and 1991, respectively. The following table presents selected data on asbestosis related losses and settlement expenses incurred and reserves outstanding for the Company: Year Ended December 31, -------------------------------- 1993 1992 1991 ---------- ---------- ---------- Total losses incurred ....................... $ 198,267 $ 347,764 $ 262,575 Total settlement expenses incurred .......... (3,299) 7,995 (5,690) ---------- ---------- ---------- Total losses and settlement expenses incurred ................................ $ 194,968 $ 355,759 $ 256,885 ========== ========== ========== Loss reserves ............................... $ 49,161 $ 982,197 $ 646,022 Settlement expense reserves ................. 16,616 20,966 11,767 ---------- ---------- ---------- Total loss and settlement expense reserves $ 65,777 $1,003,163 $ 657,789 ========== ========== ========== Number of outstanding claims ................ 39 44 44 ========== ========== ========== The following table sets forth a reconciliation of beginning and ending reserves for losses and settlement expenses of the property and casualty insurance subsidiaries, the reinsurance subsidiary and the nonstandard risk automobile insurance subsidiary. Amounts presented are on a net basis, with a reconciliation of beginning and ending reserves to the gross amounts presented in the consolidated financial statements in accordance with SFAS 113. (See note 1 of Notes to Consolidated Financial Statements.) Year ended December 31, ---------------------------------------- 1993 1992 1991 ------------ ------------ ------------ Gross reserves for losses and settlement expenses, beginning of year .......................... $215,388,865 $158,814,130 $151,242,287 Ceded reserves for losses and settlement expenses, beginning of year .......................... 25,253,507 13,951,033 16,484,739 ------------ ------------ ------------ Net reserves for losses and settlement expenses, beginning of year .......................... 190,135,358 144,863,097 134,757,548 ------------ ------------ ------------ Incurred losses and settlement expenses: - ------------------------- Provision for insured events of the current year .............. 119,896,526 116,615,951 83,477,534 Increase in provision for insured events of prior years .... 458,773 5,471,882 4,627,385 ------------ ------------ ------------ Total incurred losses and settlement expenses ...... $120,355,299 $122,087,833 $ 88,104,919 ------------ ------------ ------------ Year ended December 31, ---------------------------------------- 1993 1992 1991 ------------ ------------ ------------ Payments: - --------- Losses and settlement expenses attributable to insured events of the current year .............. $ 47,600,851 $ 46,436,360 $ 35,398,095 Losses and settlement expenses attributable to insured events of prior years ................... 45,508,460 53,810,715 42,601,275 Adjustment to beginning reserves due to the change in the property and casualty insurance subsidiaries' pooling agreement .. 4,373,629 (23,431,503) - Adjustment to reserves due to the commutation of two reinsurance contracts under the reinsurance subsidiary's quota share agreement 21,904,001 - - Adjustment to reserves due to the gross-up of amounts associated with the National Workers' Compensation Reinsurance Pool .... 11,436,543 - - ------------ ------------ ------------ Total payments .............. 130,823,484 76,815,572 77,999,370 ------------ ------------ ------------ Net reserves for losses and settlement expenses, end of year 179,667,173 190,135,358 144,863,097 Ceded reserves for losses and settlement expenses, end of year 17,454,679 25,253,507 13,951,033 ------------ ------------ ------------ Gross reserves for losses and settlement expenses, end of year $197,121,852 $215,388,865 $158,814,130 ============ ============ ============ The following table shows the calendar year development of the unpaid loss and settlement expense reserves of the property and casualty insurance subsidiaries, the reinsurance subsidiary and the nonstandard risk automobile insurance subsidiary (beginning in 1984). Amounts presented are on a net basis with (i) a reconciliation of the net loss and settlement expense reserves at the end of 1992 and 1993 to the gross amounts presented in the consolidated financial statements in accordance with SFAS 113 and (ii) disclosure of the gross re-estimated loss and settlement expense reserves as of the end of 1993 and the related re-estimated reinsurance receivables. Reflected in this table is (1) the increase in the reinsurance subsidiary's quota share assumption of Employers Mutual's assumed reinsurance business from 50 percent in 1983 to 75 percent in 1984 and 95 percent in 1988, (2) the increase in the property and casualty insurance subsidiaries' collective participation in the pool from 17 percent to 22 percent in 1992, (3) the change in the pooling agreement whereby effective January 1, 1993 the voluntary reinsurance business written by Employers Mutual is no longer subject to cession to the pool members, and (4) the commutation of two reinsurance contracts under the reinsurance subsidiary's quota share agreement in 1993. In addition, prior year amounts have been restated to reflect the gross-up of reserve amounts associated with the National Workers' Compensation Reinsurance Pool. In evaluating the table, it should be noted that each cumulative redundancy (deficiency) amount includes the effects of all changes in reserves for prior periods. Conditions and trends that have affected development of the liability in the past, such as the time lag in the reporting of assumed reinsurance business and the high rate of inflation associated with medical services and supplies, may not necessarily occur in the future. Accordingly, it may not be appropriate to project future development of reserves based on this table. The increase in reserves for losses and settlement expenses for prior year claims was $5,472,000 in 1992 and $459,000 in 1993. The large increase in 1992 primarily relates to a strengthening of workers' compensation reserves in the property and casualty insurance subsidiaries, a time lag in the reporting of assumed reinsurance business in the reinsurance subsidiary and a strengthening of reserves in the nonstandard risk automobile insurance subsidiary. The increase in 1993 is primarily related to development on reserves associated with Hurricane Andrew in the reinsurance subsidiary. Additional strengthening of workers' compensation reserves in the property and casualty insurance subsidiaries was offset by savings in the products liability line of business. See "Management's Discussion and Analysis of Financial Condition and Results of Operations - Results of Operations". Time lags in the reporting of assumed reinsurance business do not have a material affect on the income of the Company since the premium income associated with this business is recorded at the same time the losses are recorded. However, management recognizes the financial reporting problems associated with such time lags and procedures are now in place to monitor the reporting of assumed reinsurance business and to record estimates for the time periods not yet reported. EXCESS AND SURPLUS LINES INSURANCE AGENCY - ----------------------------------------- Underwriters, Ltd. is an excess and surplus lines insurance agency providing brokerage and underwriting facilities. Underwriters, Ltd. was acquired by the Company in January of 1985. Incorporated in 1974, Underwriters, Ltd. provides access to the excess and surplus lines markets through independent agents and managing general agents. Underwriters, Ltd. also functions as managing underwriter for such lines for several of the pool members and represents several major excess and surplus lines companies, including Lloyds of London. Lines of insurance handled range from relatively straight forward property and casualty insurance to the more exotic hole-in-one, kidnap and ransom, ocean marine, aircraft and professional liability lines. Income is derived from fees and commissions and not from underwriting the risk. INVESTMENTS - ----------- Effective December 31, 1993, the Company adopted Statement of Financial Accounting Standards No. 115 (SFAS 115) "Accounting for Certain Investments in Debt and Equity Securities." SFAS 115 requires that investments in all debt securities and those equity securities with readily determinable market values be classified into one of three categories: held-to-maturity, trading or available-for-sale. Classification of investments is based upon management's current intent. Debt securities that management has the intent and ability to hold until maturity are classified as securities held-to-maturity and are carried at amortized cost. Unrealized holding gains and losses on securities held-to-maturity are not reflected in the consolidated financial statements. Debt and equity securities that are purchased for short-term resale are classified as trading securities. Trading securities are carried at market value, with unrealized holding gains and losses included in earnings. All other debt and equity securities not included in the above two categories are classified as securities available-for-sale. Securities available-for-sale are carried at market value, with unrealized holding gains and losses reported as a separate component of stockholders' equity, net of tax. At December 31, 1993, the Company did not have any investments categorized as trading securities. Adoption of this statement had no effect on the income of the Company. Unrealized holding gains associated with fixed maturity securities available-for-sale increased stockholders' equity by $2,068,451, net of deferred income taxes of $1,065,565. Prior to December 31, 1993, investments in fixed maturities were carried at amortized cost, equity securities were carried at market value and short- term investments were carried at cost. Changes in the unrealized holding gains and losses resulting from the revaluation of equity securities were reported as direct increases and decreases in stockholders' equity. Unrealized holding gains and losses on fixed maturities and short-term investments were not recognized in the consolidated financial statements. The assets of the property and casualty insurance subsidiaries, the reinsurance subsidiary and the nonstandard risk automobile insurance subsidiary are primarily invested in government bonds. At December 31, 1993, approximately 89 percent of the Company's fixed maturity bonds were invested in government backed securities. Investments in bonds categorized as held-to- maturity are purchased with the intent of being held to maturity. A variety of maturities are maintained in the Company's portfolio to assure adequate liquidity. The maturity structure of bond investments is also established by the relative attractiveness of yields on short, intermediate, and long-term bonds. The Company does not invest in any high-yield debt investments (commonly referred to as junk bonds). Investments of the Company's insurance subsidiaries are subject to the insurance laws of the state of their incorporation. These laws prescribe the kind, quality and concentration of investments which may be made by insurance companies. In general, these laws permit investments, within specified limits and subject to certain qualifications, in federal, state and municipal obligations, corporate bonds, preferred and common stocks and real estate mortgages. The Company believes it is in compliance with these laws. Failure to comply could result in administrative supervision. A committee of the National Association of Insurance Commissioners (NAIC) is developing model legislation to govern insurance company investments. A discussion draft was released at the September 1993 NAIC meeting to which the industry is in the process of responding. Management believes that if the discussion draft were adopted without modification it would not have a material impact on the Company. The model law is not scheduled for adoption by the NAIC until September, 1994. The investments of the Company are supervised by an investment committee of the Board of Directors of the Company, which includes one individual who is an officer of the Company. The bond portfolios for each of the subsidiaries are managed by an internal staff which is composed of employees of Employers Mutual. Investment expenses are based on actual expenses incurred by each of the Company's subsidiaries plus an allocation of other investment expenses incurred by Employers Mutual, which is based on a weighted average of total assets and investment transactions of each subsidiary. The following table shows the composition of the Company's investment portfolio (at amortized cost), by type of security, as of December 31, 1993. In the Company's consolidated financial statements, securities held-to-maturity are carried at amortized cost; securities available-for-sale are carried at market value. Amortized Cost Percent ------------ ------- Securities held-to-maturity: United States government agencies and authorities $109,895,914 36.4% States and political subdivisions ................ 18,374,003 6.1 Foreign governments .............................. 587,060 .2 Public utilities ................................. 8,813,202 2.9 Corporate securities ............................. 17,050,988 5.7 Mortgage-backed securities ....................... 36,289,456 12.0 ------------ ------- Total fixed maturity securities held-to-maturity 191,010,623 63.3 ------------ ------- Securities available-for-sale: States and political subdivisions ................ 58,431,008 19.4 Short-term investments ........................... 51,029,615 16.9 Other debt securities ............................ 486,941 .2 ------------ ------- Total fixed maturity securities available-for-sale ........................... 109,947,564 36.5 ------------ ------- Equity securities available-for-sale ............. 505,000 .2 ------------ ------- Total investments .......................... $301,463,187 100.0% ============ ======= The following table shows the composition of the Company's investment portfolio (at amortized cost), by type of security, as of December 31, 1992. In the Company's consolidated financial statements, fixed maturities are carried at amortized cost, equity securities are carried at market value and short-term investments are carried at cost. Amortized Cost Percent ------------ ------- Fixed maturity securities held-to-maturity: United States government agencies and authorities $144,419,244 46.4% States and political subdivisions ................ 51,188,090 16.4 Debt securities issued by foreign governments .... 590,502 .2 Public utilities ................................. 9,693,693 3.1 Corporate securities ............................. 16,560,387 5.3 Mortgage-backed securities ....................... 26,983,821 8.7 Other debt securities ............................ 1,117,121 .4 ------------ ------- Total fixed maturity securities held-to-maturity 250,552,858 80.5 ------------ ------- Equity securities available-for-sale ................. 1,560,000 .5 ------------ ------- Short-term investments ............................... 59,198,070 19.0 ------------ ------- Total investments .......................... $311,310,928 100.0% ============ ======= Fixed maturity investments held by the Company generally have an investment quality rating of "A" or better by independent rating agencies. The following table shows the composition of the Company's fixed maturity investments, by rating, as of December 31, 1993. Securities held-to-maturity are carried at amortized cost; securities available-for-sale are carried at market value. Securities Securities held-to-maturity available-for-sale --------------------- --------------------- Amount Percent Amount Percent ------------ ------- ------------ ------- Rating(1) Aaa ..................... $153,843,269 80.5% $ 60,876,041 53.8% Aa ...................... 6,221,433 3.3 36,855,004 32.6 A ....................... 24,733,496 12.9 15,350,535 13.6 Baa ..................... 5,714,089 3.0 - - Ba ...................... 498,336 .3 - - ------------ ------- ------------ ------- Total fixed maturities $191,010,623 100.0% $113,081,580 100.0% ============ ======= ============ ======= (1) Ratings for preferred stocks and fixed maturity securities with initial maturities greater than one year are assigned by Moody's Investor's Services, Inc. Moody's rating process seeks to evaluate the quality of a security by examining the factors that affect returns to investors. Moody's ratings are based on quantitative and qualitative factors, as well as the economic, social and political environment in which the issuing entity exists. The quantitative factors include debt coverage, sales and income growth, cash flows and liquidity ratios. Qualitative factors include management quality, access to capital markets and the quality of earnings and balance sheet items. Ratings for securities with initial maturities less than one year are based on an evaluation of the underlying assets or the credit rating of the issuer's parent company. The amortized cost and estimated market value of fixed maturity securities held-to-maturity and available-for-sale at December 31, 1993, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. Estimated Amortized Market Cost Value ------------ ------------ Fixed maturity securities held-to-maturity: Due in one year or less ................... $ 14,613,909 $ 14,887,469 Due after one year through five years ..... 55,951,990 61,054,939 Due after five years through ten years .... 73,944,312 80,286,921 Due after ten years ....................... 10,210,956 11,582,035 Mortgage-backed securities ................ 36,289,456 38,494,233 ------------ ------------ Totals .................................. $191,010,623 $206,305,597 ============ ============ Fixed maturity securities available-for-sale: Due in one year or less ................... $ 51,429,559 $ 51,599,338 Due after one year through five years ..... 10,168,440 10,476,611 Due after five years through ten years .... 31,194,883 33,453,428 Due after ten years ....................... 17,154,682 17,552,203 ------------ ------------ Totals .................................. $109,947,564 $113,081,580 ============ ============ The mortgage-backed securities shown on the above table include $14,616,836 of securities issued by government corporations and agencies and $21,672,620 of collateralized mortgage obligations ("CMOs"). CMOs are securities backed by mortgages on real estate which come due at various times. The Company has attempted to minimize the prepayment risks associated with mortgage-backed securities by not investing in "principal only" and "interest only" CMOs. The CMOs that the Company has invested in are designed to reduce the risk of prepayment by providing predictable principal payment schedules within a designated range of prepayments. Investment yields may vary from those anticipated due to changes in prepayment patterns of the underlying collateral. Investment results of the Company for the periods indicated are shown in the following table: Year Ended December 31, ---------------------------------------- 1993 1992 1991 ------------ ------------ ------------ Average invested assets (1) ........ $306,387,058 $288,433,650 $252,909,481 Investment income (2) .............. 20,779,951 21,539,597 20,201,993 Average yield ...................... 6.78% 7.47% 7.99% Realized investment gains .......... $ 684,445 $ 384,283 $ 64,418 (1) Average of the aggregate invested amounts (amortized cost) at the beginning and end of the year. (2) Investment income is net of investment expenses and does not include realized gains or provision for income taxes. EMPLOYEES - --------- EMC Insurance Group Inc. has no full-time employees, although approximately 12 employees of Employers Mutual perform administrative duties on a part-time basis. Otherwise, the Company's business activities are conducted by employees of Employers Mutual, Farm and City, and Illinois EMCASCO, which have 1,486 (plus 30 part-time), 14 (plus 1 part-time), and 60 (plus 1 part time) employees, respectively. Dakota Fire, EMCASCO, EMC Re and Underwriters, Ltd. have no employees of their own; they transact business through Employers Mutual and Illinois EMCASCO employees. The property and casualty insurance subsidiaries share the costs associated with the pooling agreement in accordance with their pool participation percentages. See "Property and Casualty Insurance -- Pooling Agreement" and "Property and Casualty Insurance - -- Services Provided by Employers Mutual". REGULATION - ---------- The Company's insurance subsidiaries are subject to extensive regulation and supervision by their home states, as well as those in which they do business. The purpose of such regulation and supervision is primarily to provide safeguards for policyholders rather than to protect the interests of stockholders. The insurance laws of the various states establish regulatory agencies with broad administrative powers, including the power to grant or revoke operating licenses and to regulate trade practices, investments, premium rates, deposits of securities, the form and content of financial statements and insurance policies, accounting practices and the maintenance of specified reserves and capital for the protection of policyholders. Premium rate regulation varies greatly among jurisdictions and lines of insurance. In most states in which the Company's subsidiaries write insurance, premium rates for their lines of insurance are subject to either prior approval or limited review upon implementation. States require rates for property and casualty insurance that are adequate, not excessive, and not unfairly discriminatory. The Company's insurance subsidiaries are required to file detailed annual reports with the appropriate regulatory agency in each state where they do business based on applicable statutory regulations, which differ from generally accepted accounting principles. Their businesses and accounts are subject to examination by such agencies at any time. Since EMC Insurance Group Inc. and Employers Mutual are domiciled in Iowa, the State of Iowa exercises principal regulatory supervision, and Iowa law requires periodic examination. The Company's subsidiaries are subject to examination by state insurance departments on a periodic basis as applicable law requires. State laws governing insurance holding companies also impose standards on certain transactions with related companies, which include, among other requirements, that all transactions be fair and reasonable and that an insurer's surplus as regards policyholders be reasonable and adequate in relation to its liabilities. Under Iowa law, dividends or distributions made by registered insurers are restricted in amount and may be subject to approval from the Iowa Commissioner of Insurance. "Extraordinary" dividends or distributions are subject to prior approval and are defined as dividends or distributions which exceed the greater of 10 percent of statutory surplus as regards policyholders as of the preceding December 31, or net income of the preceding calendar on a statutory basis. Both Illinois and North Dakota impose restrictions which are similar to those of Iowa on the payment of extraordinary dividends and restrictions. At December 31, 1993, $10,113,818 was available for distribution in 1994 to EMC Insurance Group Inc. without prior approval. See note 8 of Notes to Consolidated Financial Statements under Item 8 of this Form 10-K. Under the insurance laws of all states in which the Company's insurance subsidiaries and Employers Mutual operate, insurers can be assessed up to prescribed limits for policyholder losses occasioned by the insolvency or liquidation of other insurance companies. Under these laws, the extent of any future assessments against the Company is uncertain. Most laws do provide, however, that an assessment may be excused or deferred if it would threaten a solvent insurer's financial strength. Such assessments totaled $86,200, $132,996 and $41,736 in 1993, 1992 and 1991, respectively. The NAIC has recently adopted certain risk-based capital standards for property and casualty insurance companies which will be implemented in 1994. Risk-based capital requirements attempt to measure minimum statutory capital needs based upon the risks in a company's mix of products and investment portfolio. The formula has been designed to help state regulators assess capital adequacy of insurance companies and identify property/casualty insurers that are in (or are perceived as approaching) financial difficulty by establishing minimum capital needs based upon the risks applicable to the operations of the individual insurer. The formula takes into consideration industry performance and individual insurer financial characteristics by examining a number of financial criteria to test its perceived levels of risk against assets available to bear such risks. The model act adopted by the NAIC provides a minimum level of capital at which a State Commissioner of Insurance may act to place an insurer under certain restraints or in the worst case, to place an insurer under his or her control. These risk-based capital rules are a quantitative measurement technique which purport to quantify the minimum amount of capital necessary to match the degree of financial risk. It is a method for specifying how much minimum capital an insurer must have, based on the risks it has assumed, to assure that it maintains an acceptably low probability of financial impairment. The risk-based capital requirements for property and casualty insurance companies will measure three major areas of risk facing property and casualty insurers: asset risk, credit risk and underwriting risk. Companies having less statutory surplus than required by the risk-based capital requirements are subject to varying degrees of regulatory scrutiny and intervention, depending on the severity of the inadequacy. The Company's insurance subsidiaries' ratio of total adjusted capital to risk-based capital at December 31, 1993 is well in excess of the level which would prompt regulatory action. ITEM 2. ITEM 2. PROPERTIES. - ------- ----------- Lease costs of the Company's two office facilities in West Des Moines, Iowa total approximately $71,000 and $31,000 annually. These leases expire March 31, 1998 and November 30, 1995, respectively. Lease costs of the Company's office facilities in Oak Brook, Illinois, and Bismarck, North Dakota, which total approximately $187,000 and $137,000 annually, are included as expenses under the pooling agreement. See note 2 of Notes to Consolidated Financial Statements under Item 8 of this Form 10-K. Expenses of office facilities owned by Employers Mutual are borne by the parties to the pooling agreement, less the rent received from the space used and paid for by non-insurance subsidiaries and outside tenants. Expenses totaling $1,784,868, $1,699,591 and $1,457,824 for the three years ended December 31, 1993, 1992 and 1991, respectively, were charged to the pool in connection with the rental of 130,433 and 63,450 square feet located in Des Moines and Ames, Iowa, respectively. ITEM 3. ITEM 3. LEGAL PROCEEDINGS. - ------- ------------------ The Company and Employers Mutual and its other subsidiaries are parties to numerous lawsuits arising in the normal course of the insurance business. The Company believes that the resolution of these lawsuits will not have a material adverse effect on its financial condition or its results of operations. The companies involved have reserves which are believed adequate to cover any potential liabilities arising out of all such pending or threatened proceedings. 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 common stock is traded on the NASDAQ National Market System under the symbol EMCI. The following table shows the range of high and low bid quotations and dividends paid for each quarter within the two most recent years. 1993 1992 ---------------------------- ---------------------------- High Low Dividends High Low Dividends ------- ------- --------- ------- ------- --------- 1st Quarter $10 3/4 $ 8 $.13 $10 1/4 $ 8 3/4 $.13 2nd Quarter 11 1/4 9 1/2 .13 10 1/2 9 1/4 .13 3rd Quarter 10 1/4 9 1/4 .13 9 3/4 8 .13 4th Quarter 10 1/4 8 3/4 .13 8 3/4 7 7/8 .13 At December 31 9 1/2 8 1/2 On March 9, 1994, there were approximately 958 holders of record of the Company's common stock. There are certain regulatory restrictions relating to the payment of dividends (see note 8 of Notes to Consolidated Financial Statements under Item 8 of this Form 10-K). It is the present intention of the Company's Board of Directors to declare quarterly cash dividends. A dividend reinvestment and common stock purchase plan provides stockholders with the option of receiving additional shares of common stock instead of cash dividends. Participants may also purchase additional shares of common stock without incurring broker commissions by making optional cash contributions to the Plan. See note 6(c) of Notes to Consolidated Financial Statements under Item 8 of this Form 10-K. During 1993, Employers Mutual elected to receive 50 percent of it's dividends in common stock under this plan. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA. - ------- ------------------------ Year ended December 31,* -------------------------------------------- 1993 1992 1991 1990 1989 -------- -------- -------- -------- -------- (In thousands except per share amounts) Insurance premiums earned ...... $156,438 $147,410 $113,419 $101,323 $ 91,728 Investment income, net ......... 20,780 21,540 20,202 19,884 19,309 Realized investment gains ...... 684 384 65 48 257 Other income ................... 259 - - - - -------- -------- -------- -------- -------- Total revenues ............ 178,161 169,334 133,686 121,255 111,294 Losses and expenses ............ 169,142 168,359 123,254 110,415 102,517 -------- -------- -------- -------- -------- Income before income taxes ..... 9,019 975 10,432 10,840 8,777 Income taxes ................... 1,885 759 3,124 2,894 2,055 -------- -------- -------- -------- -------- Income from continuing operations ................... 7,134 216 7,308 7,946 6,722 Income from discontinued operations ................... - - 1,853 319 274 Income from accounting changes 2,621 - - - - -------- -------- -------- -------- -------- Net income ................ $ 9,755 $ 216 $ 9,161 $ 8,265 $ 6,996 ======== ======== ======== ======== ======== Earnings per common share: Income from continuing operations ................. $ .70 $ .02 $ .73 $ .80 $ .71 Income from discontinued operations ................. - - .18 .03 .03 Income from accounting changes .................... .26 - - - - -------- -------- -------- -------- -------- Net income ................ $ .96 $ .02 $ .91 $ .83 $ .74 ======== ======== ======== ======== ======== Premiums earned by segment: Property and casualty ........ $109,585 $109,139 $ 78,413 $ 70,597 $ 62,517 Reinsurance .................. 33,324 26,615 25,009 20,696 18,621 Nonstandard risk automobile .. 13,529 11,656 9,997 10,030 10,590 -------- -------- -------- -------- -------- Total ..................... $156,438 $147,410 $113,419 $101,323 $ 91,728 ======== ======== ======== ======== ======== Total assets ................... $368,936 $372,807 $311,001 $296,126 $284,396 ======== ======== ======== ======== ======== Stockholders' equity ........... $109,634 $100,911 $105,144 $100,615 $ 95,911 ======== ======== ======== ======== ======== Average return on equity ....... 9.3% .2% 8.9% 8.4% 7.5% ======== ======== ======== ======== ======== Book value per share ........... $ 10.63 $ 9.98 $ 10.47 $ 10.04 $ 9.82 ======== ======== ======== ======== ======== Cash dividends paid per share .. $ .52 $ .52 $ .52 $ .52 $ .52 ======== ======== ======== ======== ======== * Prior year assets have been restated to reflect the reporting of ceded reinsurance balances as assets in accordance with SFAS 113. See note 1 of Notes to Consolidated Financial Statements under Item 8 of this Form 10-K. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL - ------- ------------------------------------------------- CONDITION AND RESULTS OF OPERATIONS. ------------------------------------ OVERVIEW EMC Insurance Group Inc. (the "Company"), an approximately 67 percent owned subsidiary of Employers Mutual Casualty Company ("Employers Mutual"), is an insurance holding company with operations in property and casualty insurance, reinsurance, nonstandard risk automobile insurance and excess and surplus lines insurance management. Property and casualty insurance is the most significant segment, representing 70.1 percent of consolidated premium income. The three property and casualty insurance subsidiaries of the Company and two subsidiaries of Employers Mutual are parties to reinsurance pooling agreements with Employers Mutual (collectively the "pooling agreement"). Under the terms of the pooling agreement, each company cedes to Employers Mutual all of its insurance business and assumes from Employers Mutual an amount equal to its participation in the pool. All losses, settlement expenses and other underwriting and administrative expenses are prorated among the parties on the basis of participation in the pool. The investment programs and income tax liabilities of the pool participants are not subject to the pooling agreement. The purpose of the pooling agreement is to reduce the risk of an exposure insured by any of the pool participants by spreading it among all the companies. The pooling agreement produces a more uniform and stable underwriting result from year to year for all companies in the pool than might be experienced individually. In addition, each company benefits from the capacity of the entire pool, rather than being limited to policy exposures of a size commensurate with its own assets, and from the wide range of policy forms and lines of insurance written and the variety of rate filings and commission plans offered by each of the companies. A single set of reinsurance treaties is maintained for the protection of all six companies in the pool. Effective January 1, 1992, the aggregate participation of the property and casualty insurance subsidiaries was increased to 22 percent from 17 percent. In connection with this change in pool participation, the Company's liabilities increased $31,428,000 and invested assets increased $29,402,000. The Company reimbursed Employers Mutual $2,026,000 for commissions incurred to generate this business. Employers Mutual voluntarily assumes reinsurance business from nonaffiliated insurance companies and cedes 95 percent of this business to the Company's reinsurance subsidiary, exclusive of certain reinsurance contracts. Amounts not ceded to the reinsurance subsidiary have historically been retained by Employers Mutual and have been subject to cession to the pool members. Under the terms of the pooling agreement, the property and casualty insurance subsidiaries had a 22 percent (17 percent in 1991) participation in the amounts assumed from these nonaffiliated companies. Effective January 1, 1993, the pooling agreement was amended so that the voluntary assumed reinsurance business written by Employers Mutual is no longer subject to cession to the pool members. As a result, amounts assumed from nonaffiliates have declined from amounts assumed in prior years. In connection with this change in the pooling agreement, the Company's liabilities decreased $4,470,000 and invested assets decreased $4,427,000. Employers Mutual reimbursed the Company $43,000 for commissions incurred to generate this business. The parties to the pooling agreement have historically recorded amounts assumed from the National Workers' Compensation Reinsurance Pool on a net basis. Under this approach, reserves for outstanding losses and unearned premiums were reported as liabilities under "Indebtedness to Related Party" in the Company's consolidated financial statements. Effective December 31, 1993, the parties to the pooling agreement began recording these amounts as outstanding losses and unearned premiums. As a result, outstanding losses increased $11,437,000, unearned premiums increased $1,711,000 and indebtedness to related party decreased $13,148,000. There was no income effect from this reclassification. Prior year consolidated financial statements have been restated for comparative purposes. As noted above, the Company's reinsurance subsidiary assumes a 95 percent quota share portion of Employers Mutual's assumed reinsurance business, exclusive of certain reinsurance contracts. The reinsurance subsidiary receives 95 percent of all premiums and assumes 95 percent of all related losses and settlement expenses of this business. The reinsurance subsidiary does not reinsure any of Employers Mutual's direct insurance business, nor any "involuntary" facility or pool business that Employers Mutual assumes pursuant to state law. In addition, the reinsurance subsidiary is not liable for credit risk in connection with the insolvency of any reinsurers of Employers Mutual. The following changes were made to the quota share agreement during 1993: (1) Effective January 1, 1993, the quota share agreement was amended so that losses in excess of $1,000,000 per event are retained by Employers Mutual. The reinsurance subsidiary pays an annual override commission to Employers Mutual for this additional protection, which totaled $1,809,000 in 1993. In conjunction with this change in the quota share agreement, the reinsurance subsidiary terminated its catastrophe reinsurance contracts with Employers Mutual and other nonaffiliated reinsurers. Effective January 1, 1993, the reinsurance subsidiary no longer cedes reinsurance to nonaffiliated reinsurers and only cedes reinsurance to Employers Mutual under an aggregate "excess of loss" treaty. As a result, reinsurance receivables and prepaid reinsurance premiums for the Company have decreased from prior year amounts. Ceded reinsurance on the books at December 31, 1992 is being allowed to run-off. (2) Effective June 30, 1993, Employers Mutual commuted the portion of the quota share agreement that pertains to a casualty pool that is in a run- off position. In connection with this change in the quota share agreement, the Company's liabilities decreased $19,783,000 and invested assets decreased $17,806,000. The reserve discount amount of $1,977,000 was recorded as deferred income and is being amortized into operations over the estimated settlement period of the reserves, which is ten years. During 1993, $259,000 was recognized as income. (3) Effective October 31, 1993, Employers Mutual commuted the portion of the quota share agreement that pertains to a voluntary pool that handles large "highly protected" risks. This pool has experienced deteriorating underwriting results over the last several years and Employers Mutual is presently considering whether to continue its participation in the pool beyond 1994. In connection with this change in the quota share agreement, the Company's liabilities decreased $3,827,000 and invested assets decreased $2,620,000. Employers Mutual reimbursed the Company $1,207,000 for commissions incurred to generate this business. No reserve discount was calculated as this business involves short-tail property coverage. The Company sold its life insurance subsidiary to Employers Mutual on December 31, 1991. All information presented in this report reflects the life segment as a discontinued operation. RESULTS OF OPERATIONS Operating income before income taxes was $9,019,000 in 1993, $975,000 in 1992 and $10,432,000 in 1991. Results for 1992 were significantly affected by catastrophe losses, which totaled $16,569,000. This compares to catastrophe losses of $8,513,000 in 1993 (which includes $1,283,000 of development on Hurricane Andrew) and $3,652,000 in 1991. Results for 1993 and 1992 were negatively impacted by poor experience in the nonstandard risk automobile insurance subsidiary and declining production in the excess and surplus lines insurance management agency. Premiums earned totaled $156,438,000 in 1993, 147,410,000 in 1992 and $113,419,000 in 1991. The large increase in 1992 reflects the change in the property and casualty insurance subsidiaries' pool participation. Premium volume increased substantially in the reinsurance subsidiary and the nonstandard risk automobile insurance subsidiary in 1993 while the property and casualty insurance subsidiaries remained relatively flat. Net investment income totaled $20,780,000 in 1993, $21,540,000 in 1992 and $20,202,000 in 1991. The large increase in 1992 reflects investment income earned on $29,402,000 transferred to the property and casualty insurance subsidiaries in connection with the change in pool participation. The decrease in 1993 is primarily due to a decline in invested assets resulting from the transfer of $24,853,000 to Employers Mutual in connection with the change in the property and casualty insurance subsidiaries' pooling agreement relating to the voluntary assumed reinsurance business and the commutation of two reinsurance contracts under the reinsurance subsidiary's quota share agreement. Losses and expenses totaled $169,142,000 in 1993, $168,359,000 in 1992 and $123,254,000 in 1991. The large increase in 1992 reflects the change in the property and casualty insurance subsidiaries' pool participation and a record amount of catastrophe losses. The Company adopted four new accounting standards and implemented an accounting change in 1993. The net impact of these items was an increase in net income of $2,621,000 ($.26 per share). Following is a brief explanation of each item: * Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 106 (SFAS 106), "Employers' Accounting for Postretirement Benefits Other Than Pensions". The Company adopted SFAS 106 by recognizing the transition obligation as a cumulative effect adjustment to income. The Company's transition obligation amounted to $2,166,000 ($.21 per share), net of income tax benefits of $1,116,000. * Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 109 (SFAS 109), "Accounting for Income Taxes". The Company adopted SFAS 109 as a cumulative effect adjustment to income. The Company recognized a benefit of $5,595,000 ($.55 per share), net of a valuation allowance of $1,000,000. * Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 113 (SFAS 113), "Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts". SFAS 113 requires a gross (rather than net) balance sheet presentation for ceded reinsurance amounts and addresses the recognition of gain or loss resulting from reinsurance transactions and appropriate financial statement disclosure of reinsurance activities. Ceded reinsurance amounts previously reported on a net basis in the December 31, 1992 balance sheet have been reclassified for comparative purposes. Assets and liabilities increased $20,075,000 and $28,891,000 at December 31, 1993 and 1992, respectively, as a result of the gross-up of ceded balances related to reinsurance receivables on losses and settlement expenses and prepaid reinsurance premiums. Adoption of this statement had no effect on the income of the Company. * Effective January 1, 1993, the property and casualty insurance subsidiaries changed their method of calculating unearned premiums from the monthly pro rata method to the daily method. The property and casualty insurance subsidiaries changed their accounting method because of management's belief that the new method provides for a more accurate matching of revenues and expenses over the terms of the underlying insurance policies. This change resulted in a cumulative increase in unearned premiums of $1,110,000 and a decrease in income of $808,000 ($.08 per share), net of income tax benefits of $302,000. * Effective December 31, 1993, the Company adopted Statement of Financial Accounting Standards No. 115 (SFAS 115), "Accounting for Certain Investments in Debt and Equity Securities". SFAS 115 provides that investments in all debt securities and those equity securities with readily determinable market values are to be classified in one of three categories: held-to-maturity, trading or available-for-sale. Classification of investments is based upon management's current intent. Debt securities which management has a positive intent and ability to hold to maturity are classified as "securities held-to-maturity" and are carried at amortized cost. Unrealized holding gains and losses on securities held-to-maturity are not reflected in the consolidated financial statements. Debt and equity securities that are held for current resale are classified as "trading securities" and are reported at market value, with unrealized holding gains and losses included in earnings. All other debt and equity securities are classified as "securities available-for-sale" and are carried at market value, with unrealized holding gains and losses excluded from earnings and reported as a separate component of stockholders' equity, net of tax. The Company has historically held its investment portfolio to maturity and has classified the majority of its portfolio at December 31, 1993 (63.3 percent) as "securities held-to-maturity". The remainder of the portfolio has been classified as "securities available-for-sale". Adoption of this statement had no effect on the income of the Company. Net unrealized holding gains reflected in stockholders' equity at December 31, 1993 totaled $2,049,000, net of deferred income taxes of $1,055,000. SEGMENT RESULTS Property and Casualty Insurance Operating income before income taxes increased 59.6 percent to $9,835,000 in 1993, increased 2.1 percent to $6,164,000 in 1992 and decreased 17.3 percent to $6,037,000 in 1991. Underwriting loss decreased significantly in 1993. Results for 1992 reflect an increase in catastrophe losses, which was compounded by the increase in the pool participation. Results for 1991 reflect a substantial increase in reserves reported by the National Workers' Compensation Reinsurance Pool. Investment income increased 2.9 percent to $13,243,000 in 1993, 17.0 percent to $13,048,000 in 1992 and 9.6 percent to $11,153,000 in 1991. Results for 1993 reflect the transfer of $4,427,000 to Employers Mutual in connection with the change in the pooling agreement and the general decline in interest rates for current investments. The large increase in 1992 reflects investment income earned on $29,402,000 received from Employers Mutual in connection with the change in pool participation and $10,000,000 received from the parent company to support this increased participation. Premiums earned increased .4 percent to $109,585,000 in 1993, 39.2 percent to $109,139,000 in 1992 and 11.1 percent to $78,413,000 in 1991. The large increase in 1992 reflects $24,821,000 from the change in pool participation. Depressed rates caused by the soft market, a shift of large commercial insureds to alternative risk mechanisms and the generally weak economy contributed to the small increase in 1993. In addition to these factors, results for 1993 reflect the change in the pooling agreement whereby effective January 1, 1993, the voluntary assumed reinsurance business written by Employers Mutual is no longer subject to cession to the pool members. This business accounted for $1,442,000 of earned premiums (including reinstatement premiums) in 1992. Underwriting loss decreased 46.8 percent to $3,813,000 in 1993, increased 39.3 percent to $7,169,000 in 1992 and increased 76.5 percent to $5,147,000 in 1991. Catastrophe losses had a significant impact on these results, totaling $3,372,000 in 1993, $4,631,000 in 1992 and $2,980,000 in 1991. Results for the last three years have been negatively impacted by a strengthening of workers' compensation reserves. The Company had underestimated the cost of medical expenses associated with workers' compensation claims due to greater than expected increases in the price and usage of drugs, medical durables and medical services. Losses totaling $1,998,000, $1,026,000 and $1,272,000 were charged to operations during 1993, 1992 and 1991, respectively. Employers Mutual has assigned additional staff to supervise the reserving process for workers' compensation claims and to more closely monitor the development of such reserves. In addition, Employers Mutual now employs medically trained persons to assist in determining proper reserve levels based on the future medical needs of the insureds. All major claims have been reviewed and the Company believes that the reserves are now adequate. Results for 1993 reflect $880,000 of losses related to the Midwest summer floods and the change in the pooling agreement whereby effective January 1, 1993, the voluntary reinsurance business written by Employers Mutual is no longer subject to cession to the pool members. Underwriting losses associated with the voluntary reinsurance business (including catastrophe losses) amounted to $1,427,000 in 1992. Inadequate rate increases and the increasing burden of residual markets in some states reduces the profit potential for the workers' compensation line of business in those states. The parties to the pooling agreement have adjusted rates, policyholder dividends and underwriting standards in these problem states and have experienced a planned overall decline in writings for this line of business. Workers' compensation will continue to be an important line of business for the parties to the pooling agreement; however, the percentage of workers' compensation written premiums to total written premiums is expected to decline gradually as the parties to the pooling agreement refine their underwriting standards based on current conditions in each state. Reinsurance Operating income before income taxes increased 110.0 percent to $510,000 in 1993, decreased 332.8 percent to a loss of $5,089,000 in 1992 and increased 71.8 percent to $2,186,000 in 1991. Results for 1993 and 1992 were significantly impacted by catastrophe losses, poor experience in two voluntary pools and continued development in a casualty pool that is in a run-off position. Investment income declined 10.0 percent to $6,090,000 in 1993, 5.4 percent to $6,763,000 in 1992 and 2.6 percent to $7,149,000 in 1991. The large decline in 1993 is primarily attributable to the transfer of $20,426,000 to Employers Mutual in connection with the commutation of two reinsurance contracts. Declining interest rates for current investments contributed to the decline in 1992 and 1991. The following changes were implemented in 1993 to improve the future operating results of the reinsurance subsidiary: (1) the quota share agreement was amended so that effective January 1, 1993, losses in excess of $1,000,000 per event are retained by Employers Mutual; (2) management reduced the aggregate liability in hurricane prone areas by moving to a higher attachment point in nationally exposed programs and by terminating several reinsurance arrangements with other reinsurers that had severe hurricane losses; (3) Employers Mutual commuted two reinsurance contracts under the quota share agreement that have produced very poor results over the last several years. Premiums earned increased 25.2 percent to $33,324,000 in 1993, 6.4 percent to $26,615,000 in 1992 and 20.8 percent to $25,009,000 in 1991. Amounts earned in 1992 and 1991 reflect $1,220,000 and $1,286,000, respectively, in premiums ceded (excluding reinstatement premiums) to Employers Mutual for catastrophe reinsurance protection. This coverage was terminated in 1993 in conjunction with the change in the quota share agreement noted above. The reinsurance subsidiary pays Employers Mutual an annual override commission for retaining losses in excess of $1,000,000 per event, which totaled $1,809,000 in 1993. The amount earned in 1992 also reflects $3,859,000 of reinstatement premiums paid to reinsurers (including Employers Mutual) to reinstate reinsurance coverage which was exhausted by Hurricanes Andrew and Iniki. Results for 1993 reflect a shift from catastrophe "excess of loss" business to "pro rata" business and a general improvement in rates. Under catastrophe "excess of loss" contracts, the reinsurance subsidiary provided coverage for catastrophe losses which exceeded a specified amount. Premiums associated with this type of business are generally lower as the coverage provided is not often exposed. However, the last few years have demonstrated that the exposure under this type of business can far exceed the premiums received. With "pro rata" business, the reinsurance subsidiary receives a specified portion of all premiums on each contract and then shares in all losses in the same proportion as the premium. Although the reinsurance subsidiary has a share in each loss under this type of business, the premium received is believed to be more adequate. Underwriting loss decreased 49.3 percent to $6,040,000 in 1993, increased 138.5 percent to $11,904,000 in 1992 and decreased 17.9 percent to $4,991,000 in 1991. The large loss in 1992 is primarily related to catastrophe losses, which totaled $11,609,000. This compares to catastrophe losses of $5,141,000 in 1993 (including development on Hurricane Andrew of $1,283,000) and $2,403,000 in 1991. Operating results for the last three years have been significantly impacted by losses from two voluntary pools in which the subsidiary participates and by losses from a casualty pool that is in a run-off position. The voluntary pools reported combined losses of $2,425,000 in 1993, $2,007,000 in 1992 and $1,571,000 in 1991. Effective October 31, 1993, Employers Mutual commuted the portion of the quota share agreement that pertains to one of these pools. Losses associated with this pool totaled $2,017,000 in 1993 and $1,294,000 in 1992. No reserve discount was calculated as this business involves short-tail property coverage. Losses associated with the casualty pool that is in a run-off position totaled $868,000 in 1993, $952,000 in 1992 and $2,376,000 in 1991. Employers Mutual commuted the portion of the quota share agreement that pertains to this pool effective June 30, 1993. The reserve discount amount of $1,977,000 was recorded as deferred income and is being amortized into operations over the estimated settlement period of the reserves, which is ten years. During 1993, $259,000 was recognized as income. Results for 1993 also reflect $1,000,000 of losses associated with severe east coast winter storms and $398,000 of losses associated with the World Trade Center explosion. Nonstandard Risk Automobile Insurance Operating results before income taxes decreased 65.4 percent to a loss of $1,268,000 in 1993, decreased 153.1 percent to a loss of $767,000 in 1992 and increased 51.9 percent to a profit of $1,444,000 in 1991. Results for 1993 and 1992 were significantly impacted by increased loss frequency and severity associated with a new book of business and a strengthening of loss and settlement expense reserves. Investment income decreased 1.1 percent to $1,166,000 in 1993, 11.3 percent to $1,179,000 in 1992 and 2.1 percent to $1,329,000 in 1991 due to the declining interest rates available for current investments. The nonstandard risk marketplace is very competitive. Policies are written for relatively short periods of time and insureds continually search for the most attractive rates. In response to the favorable results achieved in 1991, the company began increasing market share in 1992 by offering more competitive rates. The company experienced adverse selection in this new business as the standard market began to accept marginal risks during this same time period. As a result, losses associated with this new business exceeded the premiums received. Premiums earned increased 16.1 percent to $13,528,000 in 1993, increased 16.6 percent to $11,656,000 in 1992 and decreased .3 percent to $9,997,000 in 1991. The large increases in 1993 and 1992 reflect the increase in market share discussed above. Underwriting results decreased 27.6 percent to a loss of $2,543,000 in 1993, decreased 1,911.8 percent to a loss of $1,993,000 in 1992 and increased 126.7 percent to a profit of $110,000 in 1991. In addition to the adverse selection experienced in 1993 and 1992, the company also strengthened its loss and expense reserves in each of these years. The company has applied for rate increases in all states and is currently reviewing its book of business to identify those risks with unacceptable loss experience. The company will take appropriate action, up to and including the cancellation of specific risks, to improve future loss experience. Rate increases are not expected to have a significant impact on the company's market share in 1994. Excess and Surplus Lines Insurance Management Agency Operating income before income taxes decreased 79.1 percent to $103,000 in 1993, 22.7 percent to $496,000 in 1992 and 12.3 percent to $641,000 in 1991. Operating results continue to be effected by the termination of business with a large agency that had previously represented over 50 percent of this segment's volume. Management continues to search for new business, but a large portion of excess and surplus lines insurance is currently being written by standard carriers due to the soft market conditions. Parent Company Operating income before income taxes decreased 194.1 percent to a loss of $161,000 in 1993, increased 39.2 percent to $171,000 in 1992 and decreased 79.1 percent to $123,000 in 1991. The loss in 1993 is primarily due to a decline in investment income. Invested assets decreased in 1993 as a result of a capital contribution made to the reinsurance subsidiary in December of 1992 and the payment of stockholder dividends. NEW ACCOUNTING STANDARD The Financial Accounting Standards Board has issued Statement of Financial Accounting Standards No. 112 (SFAS 112), "Employers' Accounting for Postemployment Benefits". SFAS 112 requires that the cost of certain postemployment benefits that vest or accumulate be accrued over the period of an employee's service. SFAS 112 is effective for fiscal years beginning after December 15, 1993. The Company will adopt this standard in the first quarter of 1994. Adoption of this standard is not expected to have a material effect on the income of the Company. LIQUIDITY AND CAPITAL RESOURCES The Company maintains a portion of the investment portfolio in relatively short-term and highly liquid investments to ensure the availability of funds to meet claims and expenses. The remainder of the investment portfolio is invested in securities with maturities that approximate the anticipated liabilities of the insurance issued. The major ongoing sources of the Company's liquidity are insurance premium income, investment income and cash provided from maturing or liquidated investments. The principal outflows of cash are payments of claims, commissions, premium taxes, operating expenses, income taxes, dividends and investment purchases. The Company has historically generated positive cash flows from operations. During 1993, the Company had a negative operating cash flow of $8,794,000, which reflects $24,853,000 paid to Employers Mutual in connection with the change in the property and casualty insurance subsidiaries' pooling agreement and the commutation of two reinsurance contracts under the reinsurance subsidiary's quota share agreement. This compares to operating cash flows of $50,826,000 for 1992, which included $29,402,000 received from Employers Mutual in connection with the increase in the property and casualty insurance subsidiaries' pool participation. The National Association of Insurance Commissioners (NAIC) has recently adopted certain risk-based capital standards for property and casualty insurance companies which will be implemented in 1994. Risk-based capital requirements attempt to measure minimum statutory capital needs based upon the risks in a company's mix of products and investment portfolio. The formula has been designed to help state regulators assess capital adequacy of insurance companies and identify property/casualty insurers that are in (or perceived as approaching) financial difficulty by establishing minimum capital needs based upon the risks applicable to the operations of the individual insurer. The formula takes into consideration industry performance and individual insurer financial characteristics by examining a number of financial criteria to test its perceived levels of risk against assets available to bear such risks. The model act adopted by the NAIC provides a minimum level of capital at which a State Commissioner of Insurance may act to place an insurer under certain restraints or in the worst case, to place an insurer under his or her control. These risk-based capital rules are a quantitative measurement technique which purport to quantify the minimum amount of capital necessary to match the degree of financial risk. It is a method for specifying how much minimum capital an insurer must have, based on the risks it has assumed, to assure that it maintains an acceptably low probability of financial impairment. The risk-based capital requirements for property and casualty insurance companies will measure three major areas of risk facing property and casualty insurers: asset risk, credit risk and underwriting risk. Companies having less statutory surplus than required by the risk-based capital requirements are subject to varying degrees of regulatory scrutiny and intervention, depending on the severity of the inadequacy. The Company's insurance subsidiaries' ratio of total adjusted capital to risk-based capital at December 31, 1993 is well in excess of the level which would prompt regulatory action. The majority of the Company's assets are invested in fixed maturities. These investments provide a substantial amount of income which offsets underwriting losses and contributes to net earnings. As these investments mature the proceeds will be reinvested at current rates, which are significantly lower than those now being earned; therefore, less investment income will be available to contribute to net earnings. The Company contributed $10,000,000 of the proceeds received from the sale of the life subsidiary to increase the surplus of the property and casualty insurance subsidiaries in 1992 in connection with the increase in pool participation. The Company contributed $3,000,000 to the surplus of the reinsurance subsidiary in 1992 in order to retain its status as an authorized reinsurance company in several states. As of December 31, 1993, the Company had no material commitments for capital expenditures. A source of cash flows for the holding company is dividend payments from its subsidiaries. State insurance regulations restrict the maximum amount of dividends insurance companies can pay without prior regulatory approval. See note 8 of Notes to Consolidated Financial Statements for additional information regarding dividend restrictions. The Company collected $860,000, $3,288,000 and $3,600,000 of dividends from its insurance subsidiaries in 1993, 1992 and 1991, respectively and $106,000 of dividends from its excess and surplus lines insurance agency in 1991. The Company paid cash dividends to stockholders totaling $3,443,000, $5,104,000 and $5,082,000 in 1993, 1992 and 1991, respectively. The decrease in 1993 is due to the fact that Employers Mutual received 50 percent of its dividends in common stock under the Company's dividend reinvestment and common stock purchase plan. Inflation has a widespread effect on the Company's results of operations, primarily through increased losses and settlement expenses. The Company considers inflation, including social inflation which reflects an increasingly litigious society and increasing jury awards, when setting reserve amounts. Premiums are also affected by inflation, although they are often restricted or delayed by competition and the regulatory rate-setting environment. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. - ------- -------------------------------------------- Management's Responsibility for Financial Reporting The consolidated financial statements and related financial information in this annual report are the responsibility of management. The consolidated financial statements have been prepared in accordance with generally accepted accounting principles and necessarily include certain amounts that are based on management's best estimates and judgments. In discharging its responsibility both for the integrity and fairness of these statements and the related financial information, and for the examination of the accounting systems from which they are derived, management maintains a system of internal control designed to provide reasonable assurance, weighing the costs with the benefits sought, that transactions are executed in accordance with management's authorization, assets are safeguarded, and proper records are maintained. Management believes that the system of internal control, which is subject to close scrutiny by management and by internal auditors and is revised as considered necessary, supports the integrity and reliability of the consolidated financial statements. Further, in accordance with generally accepted auditing standards, the independent certified public accountants obtained a sufficient understanding of the Company's internal control structure to plan their audit and determine the nature, timing and extent of tests to be performed. The Audit Committee of the Board of Directors, composed solely of outside directors, met during the year with management, the Company's internal auditors and the independent certified public accountants to review the scope of the audits, discuss the evaluation of internal accounting controls and discuss financial reporting matters. The independent auditors and internal auditors have free access to the Audit Committee and meet with it, without management present, to discuss any appropriate matters. The consolidated financial statements are examined by KPMG Peat Marwick, independent certified public accountants. Their report appears elsewhere in this annual report. /s/ E.H. Creese - ------------------------------------ E. H. Creese, C.P.A. Senior Vice President, Treasurer and Chief Financial Officer Independent Auditor's Report The Board of Directors and Stockholders EMC Insurance Group Inc.: We have audited the accompanying consolidated balance sheets of EMC Insurance Group 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 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 EMC Insurance Group Inc. and Subsidiaries 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. As discussed in notes 1, 10, 12 and 13 to the consolidated financial statements, the Company changed its method of computing unearned premiums in 1993 and implemented the provisions of the Financial Accounting Standards Board's Statements No. 106, "Employers Accounting for Postretirement Benefits Other Than Pensions", No. 109, "Accounting for Income Taxes", No. 113, "Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts" and No. 115, "Accounting for Certain Investments in Debt and Equity Securities". /s/ KPMG Peat Marwick Des Moines, Iowa February 21, 1994 EMC INSURANCE GROUP INC. AND SUBSIDIARIES Consolidated Balance Sheets December 31, -------------------------- 1993 1992 ------------ ------------ ASSETS Investments (note 10): Fixed maturities: Securities held-to-maturity, at amortized cost (market value $206,305,597 and $266,719,495) $191,010,623 $250,552,858 Securities available-for-sale, at market value (amortized cost $109,947,564) ............... 113,081,580 - Equity securities available-for-sale, at market value (cost $505,000 and $1,560,000) .......... 475,000 1,418,000 Short-term investments, at cost which approximates market value ..................... - 59,198,070 ------------ ------------ Total investments .......................... 304,567,203 311,168,928 ------------ ------------ Cash .............................................. 675,203 2,009,512 Indebtedness of related party (note 4) ............ 12,291,512 3,652,076 Accrued investment income ......................... 4,835,451 4,592,856 Accounts receivable ............................... 415,215 576,155 Deferred policy acquisition costs ................. 7,698,864 8,112,831 Deferred income taxes (note 13) ................... 13,040,693 7,065,221 Intangible assets, including goodwill, at cost less accumulated amortization of $1,540,130 and $1,405,617 ................................. 2,017,690 2,152,203 Reinsurance receivables (note 3) .................. 18,477,406 27,866,790 Prepaid reinsurance premiums (note 3) ............. 2,832,184 3,637,917 Other assets ...................................... 2,084,102 1,972,611 ------------ ------------ Total assets ............................... $368,935,523 $372,807,100 ============ ============ See accompanying Notes to Consolidated Financial Statements. EMC INSURANCE GROUP INC. AND SUBSIDIARIES Consolidated Balance Sheets December 31, -------------------------- 1993 1992 ------------ ------------ LIABILITIES Losses and settlement expenses (notes 2, 3 and 4) . $197,121,852 $215,388,865 Unearned premiums (notes 2, 3 and 4) .............. 45,941,056 45,984,474 Other policyholders' funds ........................ 2,854,793 3,695,397 Income taxes payable .............................. 550,000 668,000 Postretirement benefits (note 12) ................. 3,537,449 - Deferred income (note 2) .......................... 1,717,641 - Other liabilities ................................. 7,578,963 6,159,587 ------------ ------------ Total liabilities .......................... 259,301,754 271,896,323 ------------ ------------ STOCKHOLDERS' EQUITY (notes 6, 7, 8 and 10) Common stock, $1 par value, authorized 20,000,000 shares; issued and outstanding, 10,325,329 shares in 1993 and 10,161,760 shares in 1992 ........... 10,325,329 10,161,760 Additional paid-in capital ........................ 55,021,926 53,507,459 Unrealized holding gains on fixed maturity securities available-for-sale, net of tax ....... 2,068,451 - Unrealized holding losses on equity securities available-for-sale, net of tax .................. (19,800) (142,000) Retained earnings ................................. 42,319,249 37,866,902 Treasury stock, at cost (8,090 shares in 1993 and 49,392 shares in 1992) ...................... (81,386) (483,344) ------------ ------------ Total stockholders' equity ................. 109,633,769 100,910,777 ------------ ------------ Contingent liabilities (notes 3, 13 and 16) Total liabilities and stockholders' equity $368,935,523 $372,807,100 ============ ============ See accompanying Notes to Consolidated Financial Statements. EMC INSURANCE GROUP INC. AND SUBSIDIARIES Consolidated Statements of Income Year ended December 31, ---------------------------------------- 1993 1992 1991 ------------ ------------ ------------ Revenues: Premiums earned (notes 2 and 3) ... $156,437,538 $147,410,287 $113,419,238 Investment income, net (note 10) .. 20,779,951 21,539,597 20,201,993 Realized investment gains (note 10) 684,445 384,283 64,418 Other income (note 2) ............. 259,217 - - ------------ ------------ ------------ 178,161,151 169,334,167 133,685,649 ------------ ------------ ------------ Losses and expenses: Losses and settlement expenses (notes 2 and 3) ........ 120,355,299 122,087,833 88,104,919 Dividends to policyholders ........ 2,494,284 3,382,736 1,757,923 Amortization of deferred policy acquisition costs ........ 30,717,175 29,291,362 24,255,722 Other underwriting expenses ....... 15,575,257 13,597,179 9,135,247 ------------ ------------ ------------ 169,142,015 168,359,110 123,253,811 ------------ ------------ ------------ Income from continuing operations before income taxes and cumulative effect of changes in accounting principles ....... 9,019,136 975,057 10,431,838 ------------ ------------ ------------ Income taxes (note 13): Current ........................... 1,903,128 2,260,795 3,905,736 Deferred .......................... (18,027) (1,501,430) (781,719) ------------ ------------ ------------ 1,885,101 759,365 3,124,017 ------------ ------------ ------------ Income from continuing operations before cumulative effect of changes in accounting principles 7,134,035 215,692 7,307,821 Income from discontinued operations (note 5) ............... - - 1,853,234 ------------ ------------ ------------ Income before cumulative effect of changes in accounting principles 7,134,035 215,692 9,161,055 CUMULATIVE EFFECT OF CHANGES IN ACCOUNTING PRINCIPLES FOR: Income taxes (note 13) .......... 5,595,177 - - Postretirement benefits (note 12) (2,165,900) - - Unearned premiums (note 1) ...... (807,933) - - ------------ ------------ ------------ Net income ................. $ 9,755,379 $ 215,692 $ 9,161,055 ============ ============ ============ See accompanying Notes to Consolidated Financial Statements. EMC INSURANCE GROUP INC. AND SUBSIDIARIES Consolidated Statements of Income, Continued Year ended December 31, ---------------------------------------- 1993 1992 1991 ------------ ------------ ------------ EARNINGS PER COMMON SHARE: Income from continuing operations before cumulative effect of changes in accounting principles $ .70 $ .02 $ .73 Income from discontinued operations .................... - - .18 ------------ ------------ ------------ Income before cumulative effect of changes in accounting principles .70 .02 .91 Cumulative effect of changes in accounting principles for: Income taxes ................. .55 - - Postretirement benefits ...... (.21) - - Unearned premiums ............ (.08) - - ------------ ------------ ------------ Net income ................. $ .96 $ .02 $ .91 ============ ============ ============ Average number of shares outstanding 10,197,999 10,071,901 10,054,899 ============ ============ ============ Pro forma amounts, assuming retroactive application of new method of calculating unearned premiums: Net income ................. $ 10,563,312 $ 344,420 $ 8,971,387 ============ ============ ============ Earnings per common share ......... $1.04 $ .03 $ .89 ============ ============ ============ See accompanying Notes to Consolidated Financial Statements. EMC INSURANCE GROUP INC. AND SUBSIDIARIES Consolidated Statements of Stockholders' Equity Year ended December 31, ------------------------------------- 1993 1992 1991 ----------- ----------- ----------- Common stock, beginning of year ........ $10,161,760 $10,082,675 $10,023,435 Issuance of common stock: Stock option plans ................. 31,252 79,085 59,240 Dividend reinvestment plan ......... 132,317 - - ----------- ----------- ----------- Common stock, end of year .............. 10,325,329 10,161,760 10,082,675 ----------- ----------- ----------- Additional paid-in capital, beginning of year .................... 53,507,459 52,838,624 52,332,954 Additional paid-in capital from issuance of common stock: Stock option plans ................. 279,234 669,320 490,783 Dividend reinvestment plan ......... 1,211,972 - - Gain (loss) on sale of treasury stock .. 23,261 (485) 14,887 ----------- ----------- ----------- Additional paid-in capital, end of year 55,021,926 53,507,459 52,838,624 ----------- ----------- ----------- Unrealized holding gains on fixed maturity securities available-for- sale, beginning of year .............. - - - Unrealized holding gains on revaluation of fixed maturity securities available -for-sale, net of tax (note 10) ...... 2,068,451 - - ----------- ----------- ----------- Unrealized holding gains on fixed maturity securities available-for- sale, net of tax, end of year ........ 2,068,451 - - ----------- ----------- ----------- Unrealized holding losses on equity securities available-for-sale, net of tax, beginning of year ........ (142,000) (326,375) (625,000) Unrealized holding gains on revaluation of equity securities available-for- sale, net of tax ..................... 122,200 184,375 298,625 ----------- ----------- ----------- Unrealized holding losses on equity securities available-for-sale, net of tax, end of year .............. $ (19,800) $ (142,000) $ (326,375) ----------- ----------- ----------- EMC INSURANCE GROUP INC. AND SUBSIDIARIES Consolidated Statements of Stockholders' Equity, Continued Year ended December 31, ---------------------------------------- 1993 1992 1991 ------------ ------------ ------------ Retained earnings, beginning of year $ 37,866,902 $ 42,891,128 $ 38,947,265 Net income .......................... 9,755,379 215,692 9,161,055 Dividends on common stock ($.52 per share in 1993, 1992 and 1991): Cash dividends .................. (3,443,465) (5,103,890) (5,081,607) Dividends reinvested in shares of common stock .............. (1,859,567) (136,028) (135,585) ------------ ------------ ------------ Retained earnings, end of year ...... 42,319,249 37,866,902 42,891,128 ------------ ------------ ------------ Treasury stock at cost, beginning of year ................. (483,344) (341,616) (63,207) Purchase of shares for the treasury (126,948) (315,749) (420,799) Sale of shares from the treasury .... 528,906 174,021 142,390 ------------ ------------ ------------ Treasury stock at cost, end of year (81,386) (483,344) (341,616) ------------ ------------ ------------ Total stockholders' equity ..... $109,633,769 $100,910,777 $105,144,436 ============ ============ ============ See accompanying Notes to Consolidated Financial Statements. EMC INSURANCE GROUP INC. AND SUBSIDIARIES Consolidated Statements of Cash Flows Year ended December 31, ------------------------------------- 1993 1992 1991 ----------- ----------- ----------- Cash flows from operating activities: Income from continuing operations .... $ 9,755,379 $ 215,692 $ 7,307,821 ----------- ----------- ----------- Adjustments to reconcile income to net cash (used in) provided by operating activities: Cumulative effect of changes in accounting principles, net of tax (2,621,344) - - Losses and settlement expenses .... 8,010,617 33,143,232 7,571,843 Unearned premiums ................. 650,196 4,122,176 2,472,252 Other policyholders' funds ........ (840,604) 880,866 (217,686) Deferred policy acquisition costs 413,967 (2,189,375) (523,277) Indebtedness of related party ..... (8,639,436) 2,261,884 (5,269,702) Accrued investment income ......... (242,595) (168,511) 29,659 Accrued income taxes: Current ......................... (118,000) (2,390,000) 951,000 Deferred ........................ (18,027) (1,501,430) (781,719) Provision for amortization ........ (23,072) 23,660 65,284 Realized investment gains ......... (684,445) (384,283) (64,418) Postretirement benefits ........... 255,782 - - Reinsurance receivables ........... 9,389,384 (12,828,945) 3,004,446 Prepaid reinsurance premiums ...... 805,733 (945,813) (61,779) Amortization of deferred income ... (259,217) - - Other, net ........................ 225,040 1,184,844 (961,824) ----------- ----------- ----------- 6,303,979 21,208,305 6,214,079 Cash (used in) provided by the change in the property and casualty insurance subsidiaries' pooling agreement (note 2) ...... (4,426,945) 29,402,411 - Cash used in the commutation of two reinsurance contracts under the reinsurance subsidiary's quota share agreement (note 2) .. (20,425,955) - - ----------- ----------- ----------- Total adjustment .............. (18,548,921) 50,610,716 6,214,079 ----------- ----------- ----------- Net cash (used in) provided by operating activities ... $(8,793,542) $50,826,408 $13,521,900 ----------- ----------- ----------- EMC INSURANCE GROUP INC. AND SUBSIDIARIES Consolidated Statements of Cash Flows, continued Year ended December 31, ---------------------------------------- 1993 1992 1991 ------------ ------------ ------------ Cash flows from investing activities: Purchases of fixed maturities ..... $(55,851,708) $(62,701,348) $(35,475,949) Maturities of fixed maturities .... 57,329,956 37,285,914 31,844,948 Sale of equity securities ......... 1,043,068 - - Purchases of short-term investments (308,953,569) (357,300,319) (163,308,142) Sales of short-term investments ... 317,122,024 337,456,332 141,779,010 Sale of life subsidiary ........... - 474,356 15,500,000 ------------ ------------ ------------ Net cash provided by (used in) investing activities 10,689,771 (44,785,065) (9,660,133) ------------ ------------ ------------ Cash flows from financing activities: Issuance of common stock .......... 331,568 748,405 550,023 Dividends paid to stockholders (note 6(c)) ........ (3,443,465) (5,103,890) (5,081,607) Purchase of treasury stock, net ... (118,641) (278,241) (399,107) ------------ ------------ ------------ Net cash used in financing activities ............... (3,230,538) (4,633,726) (4,930,691) ------------ ------------ ------------ Net (decrease) increase in cash ..... (1,334,309) 1,407,617 (1,068,924) Cash at beginning of year ........... 2,009,512 601,895 1,670,819 ------------ ------------ ------------ Cash at end of year ................. $ 675,203 $ 2,009,512 $ 601,895 ============ ============ ============ Income taxes paid ................... $ 4,656,213 $ 4,650,795 $ 2,954,736 Interest paid ....................... 1,696 387,351 15,874 See accompanying Notes to Consolidated Financial Statements. EMC INSURANCE GROUP INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES PRINCIPLES OF CONSOLIDATION AND BASIS OF PRESENTATION EMC Insurance Group Inc., an approximately 67 percent owned subsidiary of Employers Mutual Casualty Company (Employers Mutual), is an insurance holding company with operations in property and casualty insurance, reinsurance, nonstandard risk automobile insurance and excess and surplus lines insurance management. EMC Insurance Group Inc. and its subsidiaries are referred to herein as the "Company". The Company's subsidiaries include EMCASCO Insurance Company, Illinois EMCASCO Insurance Company, Dakota Fire Insurance Company, EMC Reinsurance Company, Farm and City Insurance Company and EMC Underwriters, Ltd. The Company sold its life insurance subsidiary to Employers Mutual on December 31, 1991. All information presented in this report reflects the life segment as a discontinued operation (see note 5). The consolidated financial statements have been prepared on the basis of generally accepted accounting principles (GAAP) which differ in some respects from those followed in reports to insurance regulatory authorities. All significant intercompany balances and transactions have been eliminated. PROPERTY AND CASUALTY INSURANCE, REINSURANCE AND NONSTANDARD RISK AUTOMOBILE INSURANCE OPERATIONS Premiums are recognized as revenue ratably over the terms of the respective policies. Effective January 1, 1993, the property and casualty insurance subsidiaries changed their method of calculating unearned premiums from the monthly pro rata method to the daily pro rata method. The property and casualty insurance subsidiaries changed their accounting method because of management's belief that the new method provides for a more accurate matching of revenues and expenses over the terms of the underlying insurance policies. This change resulted in a cumulative increase in unearned premiums of $1,109,799 and a decrease in income of $807,933 ($.08 per share), net of income tax benefits of $301,866. Certain costs of acquiring new business, principally commissions, premium taxes and variable underwriting expenses, have been deferred. Such costs are being amortized as premium revenue is recognized. The method followed in computing deferred policy acquisition costs limits the amount of such deferred costs to their estimated realizable value, which gives effect to the premium to be earned, related investment income, losses and loss settlement expenses and certain other costs expected to be incurred as the premium is earned. Unpaid losses and settlement expenses are based on estimates of reported and unreported claims and related settlement expenses. Changes in estimates are reflected in current operating results. The provisions for losses and settlement expenses are considered adequate to cover the ultimate net cost of losses and claims incurred to date net of estimated salvage and subrogation recoverable. Since the provisions are necessarily based on estimates, the ultimate liability may be more or less than such provisions. EMC INSURANCE GROUP INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements, Continued EXCESS AND SURPLUS LINES OPERATIONS Income is derived from fees and commissions which are realized when earned. Costs of doing business are expensed as incurred. REINSURANCE CEDED Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 113 (SFAS 113), "Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts". SFAS 113 requires a gross (rather than net) balance sheet presentation for ceded reinsurance amounts and addresses the recognition of gain or loss resulting from reinsurance transactions and appropriate financial statement disclosure of reinsurance activities. Ceded reinsurance amounts previously reported on a net basis in the December 31, 1992 consolidated financial statements have been reclassified for comparative purposes. Assets and liabilities increased $20,074,607 and $28,891,424 at December 31, 1993 and 1992, respectively, as a result of the gross-up of ceded balances related to reinsurance receivables on losses and settlement expenses and prepaid reinsurance premiums. Adoption of this statement had no effect on the income of the Company. INVESTMENTS Effective December 31, 1993, the Company adopted Statement of Financial Accounting Standards No. 115 (SFAS 115) "Accounting for Certain Investments in Debt and Equity Securities." SFAS 115 requires that investments in all debt securities and those equity securities with readily determinable market values be classified into one of three categories: held-to-maturity, trading or available-for-sale. Classification of investments is based upon management's current intent. Debt securities which management has a positive intent and ability to hold until maturity are classified as securities held-to-maturity and are carried at amortized cost. Unrealized holding gains and losses on securities held-to-maturity are not reflected in the consolidated financial statements. Debt and equity securities that are purchased for short-term resale are classified as trading securities. Trading securities are carried at market value, with unrealized holding gains and losses included in earnings. All other debt and equity securities not included in the above two categories are classified as securities available-for-sale. Securities available-for-sale are carried at market value, with unrealized holding gains and losses reported as a separate component of stockholders' equity, net of tax. At December 31, 1993 the Company did not have any investments categorized as trading securities. Adoption of this statement had no effect on the income of the Company. Prior to December 31, 1993, investments in fixed maturities were carried at amortized cost, equity securities were carried at market value and short- term investments were carried at cost. Changes in unrealized holding gains and losses resulting from the revaluation of equity securities were reported as direct increases and decreases in stockholders' equity. Unrealized holding gains and losses on fixed maturities and short-term investments were not recognized in the consolidated financial statements. EMC INSURANCE GROUP INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements, Continued The Company's carrying value for investments in the held-to-maturity and available-for-sale categories is reduced to its estimated realizable value if a decline in the market value is deemed other than temporary. Such reductions in carrying value are recognized as realized losses and charged to income. Premiums and discounts on debt securities are amortized over the life of the security as an adjustment to yield using the effective interest method. Realized gains and losses on disposition of investments are included in net income. The cost of investments sold is determined on the first-in, first-out method. Included in investments at December 31, 1993 and 1992 are securities on deposit with various regulatory authorities as required by law amounting to $11,329,402 and $10,774,732, respectively. PENSION COSTS Net periodic pension cost relating to the Company's employee participation in Employers Mutual's Retirement Plan is computed on the basis of Statement of Financial Accounting Standards No. 87, "Employers' Accounting for Pensions", and includes the following components: service cost, interest cost, actual return on assets for the period and amortization of unrealized gain/loss from past experience. It is the Company's policy to fund pension costs according to regulations provided under the Internal Revenue Code. Assets held in the Plan are a mix of equity, debt and guaranteed interest securities. POSTRETIREMENT BENEFITS OTHER THAN PENSIONS Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 106 (SFAS 106), "Employers' Accounting for Postretirement Benefits Other Than Pensions". Under SFAS 106, the cost of postretirement benefits other than pensions must be recognized on an accrual basis as employees perform services to earn the benefits. Prior to 1993, the cost of retiree health care and life insurance benefits were recognized as expenses when paid. INCOME TAXES The Company files a consolidated Federal income tax return with its subsidiaries. Consolidated income taxes/benefit are allocated among the entities based upon separate tax liabilities. Deferred income taxes are provided for temporary differences between financial statement carrying values of assets and liabilities and their respective tax bases. Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 109 (SFAS 109), "Accounting for Income Taxes". Under SFAS 109, deferred tax assets are recognized for deductible temporary differences and operating loss and tax credit carryforwards, and then a valuation allowance is established to reduce that deferred tax asset if it is "more likely than not" that the related tax benefits will not be realized. 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. The effect on deferred tax assets and liabilities from a change in tax rates is recognized in income in the period that includes the enactment date. Prior to 1993, the Company computed deferred income taxes in accordance with Statement of Financial Accounting Standards No. 96. EMC INSURANCE GROUP INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements, Continued EARNINGS PER SHARE Earnings per common share are computed by dividing earnings by the weighted average number of common shares outstanding during each year. INTANGIBLE ASSETS Goodwill, which represents the excess of cost over the fair value of net assets of acquired subsidiaries, is being amortized on a straight-line basis over 25 years. RECLASSIFICATIONS Certain amounts previously reported in prior years' consolidated financial statements have been reclassified to conform to current year presentation. 2. AFFILIATION AND TRANSACTIONS WITH AFFILIATES Property and Casualty Insurance Subsidiaries The three property and casualty insurance subsidiaries of the Company and two subsidiaries of Employers Mutual are parties to reinsurance pooling agreements with Employers Mutual (collectively the "pooling agreement"). Under the terms of the pooling agreement, each company cedes to Employers Mutual all of its insurance business and assumes from Employers Mutual an amount equal to its participation in the pool. All losses, settlement expenses and other underwriting and administrative expenses are prorated among the parties on the basis of participation in the pool. The investment programs and income tax liabilities of the pool participants are not subject to the pooling agreement. Effective January 1, 1992, the aggregate participation of the property and casualty insurance subsidiaries was increased to 22 percent from 17 percent. In connection with this change in pool participation, the Company's liabilities increased $31,427,861 and invested assets increased $29,402,411. The Company reimbursed Employers Mutual $2,025,450 for commissions incurred to generate this business. Employers Mutual voluntarily assumes reinsurance from nonaffiliated insurance companies and cedes 95 percent of this business to the Company's reinsurance subsidiary, exclusive of certain reinsurance contracts. Amounts not ceded to the reinsurance subsidiary have historically been retained by Employers Mutual and have been subject to cession to the pool members. Under the terms of the pooling agreement, the property and casualty insurance subsidiaries had a 22 percent (17 percent in 1991) participation in the amounts assumed from these nonaffiliated companies. Effective January 1, 1993, the pooling agreement was amended so that the voluntary assumed reinsurance business written by Employers Mutual is no longer subject to cession to the pool members. As a result, amounts assumed from nonaffiliates have declined from amounts assumed in prior years. In connection with this change in the pooling agreement, the Company's liabilities decreased $4,470,204 and invested assets decreased $4,426,945. Employers Mutual reimbursed the Company $43,259 for commissions incurred to generate this business. EMC INSURANCE GROUP INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements, Continued Reinsurance Subsidiary As noted above, the reinsurance subsidiary assumes a 95 percent quota share portion of Employers Mutual's assumed reinsurance business, exclusive of certain reinsurance contracts. The reinsurance subsidiary receives 95 percent of all premiums and assumes 95 percent of all related losses and settlement expenses of this business. The reinsurance subsidiary does not reinsure any of Employers Mutual's direct insurance business, nor any "involuntary" facility or pool business that Employers Mutual assumes pursuant to state law. In addition, the reinsurance subsidiary is not liable for credit risk in connection with the insolvency of any reinsurers of Employers Mutual. Effective January 1, 1993, the quota share agreement was amended so that losses in excess of $1,000,000 per event are retained by Employers Mutual. EMC Re pays an annual override commission to Employers Mutual for this additional protection, which totaled $1,808,527 in 1993. Employers Mutual retained $615,000 of losses under this agreement in 1993. Effective June 30, 1993, Employers Mutual commuted the portion of the quota share agreement that pertains to a casualty pool that is in a run-off position. In connection with this change in the quota share agreement, the Company's liabilities decreased $19,783,037 and invested assets decreased $17,806,179. The reserve discount amount of $1,976,858 was recorded as deferred income and is being amortized into operations over the estimated settlement period of the reserves, which is ten years. During 1993, $259,217 was recognized as income. Effective October 31, 1993, Employers Mutual commuted the portion of the quota share agreement that pertains to a voluntary pool that handles large "highly protected" risks. This pool has experienced deteriorating underwriting results over the last several years and Employers Mutual is presently considering whether to continue its participation in the pool beyond 1994. In connection with this change in the quota share agreement, the Company's liabilities decreased $3,827,201 and invested assets decreased $2,619,776. Employers Mutual reimbursed the Company $1,207,425 for commissions incurred to generate this business. No reserve discount was calculated as this business involves short-tail property coverage. Premiums assumed by the reinsurance subsidiary from Employers Mutual amounted to $34,445,978, $35,777,710 and $29,291,685 in 1993, 1992 and 1991, respectively. It is customary in the reinsurance business for the assuming company to compensate the ceding company for the acquisition expenses it incurred in the generation of the business. Commissions paid by the reinsurance subsidiary to Employers Mutual amounted to $8,979,309, $10,242,650 and $8,873,078 in 1993, 1992 and 1991, respectively. In conjunction with the change in the quota share agreement noted above, the reinsurance subsidiary terminated its catastrophe reinsurance treaty with Employers Mutual. This treaty paid losses in excess of $1,000,000 resulting from any one catastrophe, subject to a maximum loss of $3,000,000. Maximum recovery was limited to $6,000,000. Ceded reinsurance on the books at December 31, 1992 is being allowed to run-off. The reinsurance subsidiary recovered $306,250, $4,125,000 and $485,000 under this treaty and paid reinstatement premiums of $0, $1,033,330 and $47,025 in 1993, 1992 and 1991, respectively. Total premiums paid to Employers Mutual amounted to $0, $2,253,579 and $1,332,957 in 1993, 1992 and 1991, respectively. EMC INSURANCE GROUP INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements, Continued The reinsurance subsidiary has an aggregate excess of loss treaty with Employers Mutual which provides protection from a large accumulation of retentions resulting from multiple catastrophes in any one calendar year. The coverage provided is $2,000,000 excess of $2,500,000 ($2,000,000 in 1991) aggregate losses retained, excess of $200,000 per event. Maximum recovery is limited to $4,000,000 per accident year. EMC Re recovered $143,501, $4,221,444 and $607,306 under this treaty and paid reinstatement premiums of $208,470, $744,561 and $0 in 1993, 1992 and 1991, respectively. Total premiums paid to Employers Mutual amounted to $708,445, $1,124,561 and $320,000 in 1993, 1992 and 1991, respectively. Nonstandard Risk Automobile Insurance Subsidiary The nonstandard risk automobile insurance subsidiary has a reinsurance treaty on an excess of loss basis with Employers Mutual which provides reinsurance for 100 percent of each loss in excess of $100,000, up to $1,000,000. No recoveries have been made under this treaty. Premiums paid to Employers Mutual amounted to $42,065, $35,377 and $34,827 in 1993, 1992 and 1991, respectively. 3. REINSURANCE CEDED The parties to the pooling agreement cede insurance business to other insurers in the ordinary course of business for the purpose of limiting their maximum loss exposure through diversification of their risks. In its consolidated financial statements, the Company treats risks to the extent they are reinsured as though they were risks for which the Company is not liable. Insurance ceded by the pool participants does not relieve their primary liability as the originating insurers. Employers Mutual evaluates the financial condition of the reinsurers of the parties to the pooling agreement and monitors concentrations of credit risk arising from similar geographic regions, activities, or economic characteristics of the reinsurers to minimize exposure to significant losses from reinsurer insolvencies. The parties to the pooling agreement also assume insurance from involuntary pools and associations in conjunction with direct business written in various states. Prior to 1993, the reinsurance subsidiary ceded reinsurance business to Employers Mutual and other nonaffiliated reinsurers in the ordinary course of business for the purpose of limiting its maximum loss exposure. Effective January 1, 1993, the quota share agreement with Employers Mutual was amended so that losses in excess of $1,000,000 per event are retained by Employers Mutual. In conjunction with this change in the quota share agreement, the reinsurance subsidiary terminated its catastrophe reinsurance contracts with Employers Mutual and the nonaffiliated reinsurers. Effective January 1, 1993, the reinsurance subsidiary no longer cedes reinsurance to unaffiliated reinsurers and only cedes reinsurance to Employers Mutual under an aggregate "excess of loss" treaty. As a result, reinsurance receivables and prepaid reinsurance premiums for the Company have decreased from prior year amounts. Ceded reinsurance on the books at December 31, 1992 is being allowed to run-off. EMC INSURANCE GROUP INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements, Continued As of December 31, 1993, deductions for reinsurance ceded to two unaffiliated reinsurers aggregated $12,191,018, which represented a significant portion of the total prepaid reinsurance premiums and reinsurance receivables for losses and settlement expenses. These amounts reflect the property and casualty insurance subsidiaries' pool participation percentage of amounts ceded by Employers Mutual to these organizations in connection with its role as "service carrier". Under these arrangements, Employers Mutual writes business for these organizations on a direct basis and then cedes 100 percent of this business to these organizations. Credit risk associated with these amounts is minimal as all companies writing direct business in the states that participate in these organizations are responsible for the liabilities of such organizations on a pro rata basis. The effect of reinsurance on premiums written and earned and losses and settlement expenses incurred for the years ended December 31, 1993, 1992 and 1991 is presented below. Amounts for the year ended December 31, 1993 reflect (1) the change in the property and casualty insurance subsidiaries' pooling agreement whereby effective January 1, 1993, the voluntary assumed reinsurance business written by Employers Mutual is no longer subject to cession to the pool members and (2) the change in the reinsurance subsidiary's quota share agreement whereby effective January 1, 1993, losses in excess of $1,000,000 per event are retained by Employers Mutual and the reinsurance subsidiary therefore no longer purchases catastrophe protection (see note 2). Year ended December 31, ---------------------------------------- 1993 1992 1991 ------------ ------------ ------------ Premiums written Direct ......................... $135,277,129 $138,829,576 $139,292,883 Assumed from nonaffiliates ..... 6,636,942 16,467,613 9,477,850 Assumed from affiliates ........ 147,620,705 150,070,741 108,847,230 Ceded to nonaffiliates ......... (10,701,482) (17,721,207) (11,113,238) Ceded to affiliates ............ (120,898,914) (129,826,840) (130,675,014) ------------ ------------ ------------ Net premiums written ......... $157,934,380 $157,819,883 $115,829,711 ============ ============ ============ Premiums earned Direct ......................... $137,141,457 $142,391,771 $134,675,865 Assumed from nonaffiliates ..... 6,758,364 14,980,642 9,056,890 Assumed from affiliates ........ 148,366,487 140,442,245 106,783,050 Ceded to nonaffiliates ......... (11,507,217) (16,775,394) (11,051,459) Ceded to affiliates ............ (124,321,553) (133,628,977) (126,045,108) ------------ ------------ ------------ Net premiums earned .......... $156,437,538 $147,410,287 $113,419,238 ============ ============ ============ Losses and settlement expenses incurred Direct ......................... $ 97,842,980 $112,579,261 $101,910,680 Assumed from nonaffiliates ..... 6,575,099 17,415,319 8,671,495 Assumed from affiliates ........ 107,369,274 114,359,445 77,845,953 Ceded to nonaffiliates ......... (5,845,414) (16,862,082) (4,735,272) Ceded to affiliates ............ (85,586,640) (105,404,110) (95,587,937) ------------ ------------ ------------ Net losses and settlement expenses incurred .......... $120,355,299 $122,087,833 $ 88,104,919 ============ ============ ============ EMC INSURANCE GROUP INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements, Continued 4. REINSURANCE ASSUMED The parties to the pooling agreement have historically recorded amounts assumed from the National Workers' Compensation Reinsurance Pool on a net basis. Under this approach, reserves for outstanding losses and unearned premiums were reported as liabilities under "Indebtedness to Related Party" in the Company's consolidated financial statements. Effective December 31, 1993, the parties to the pooling agreement began recording these amounts as outstanding losses and unearned premiums. As a result, outstanding losses increased $11,436,543, unearned premiums increased $1,711,288 and indebtedness to related party decreased $13,147,831. There was no income effect from this reclassification. Prior year consolidated financial statements have been restated for comparative purposes. 5. DISCONTINUED OPERATIONS On December 31, 1991 the Company's life insurance subsidiary was sold to Employers Mutual pursuant to a stock acquisition agreement dated December 9, 1991. The Company received $15,500,000 in cash on December 31, 1991 with final settlement of $474,356 on March 2, 1992 based on the GAAP book value on December 31, 1991, which totaled $15,974,356. No income statement gain was recognized on the sale. The consolidated financial statements report the life segment's results as discontinued operations on a separate line in the 1991 statement of income. Income from discontinued operations is net of applicable income tax benefit of $150,939. 6. COMMON STOCK (a) EMPLOYEE STOCK PURCHASE PLANS 1987 Employee Stock Purchase Plan Under the Employers Mutual 1987 Employee Stock Purchase Plan, Employers Mutual could purchase up to 200,000 shares of EMC Insurance Group Inc. common stock for resale to eligible employees. The plan provided for two option periods each calendar year; from January 1 until the last business day of June, and from July 1 until the last business day of December, with the last business day in each option period being the option exercise date. Any employee who was employed by Employers Mutual, its affiliates, or its subsidiaries on the first day of the month immediately preceding any option period was eligible to participate in the plan. Eligible employees could elect to participate in the plan either through payroll deduction or by lump sum contributions, but in no case could the participation level exceed 10 percent of the employee's base annual compensation amount. The option price was 85 percent of the fair market value of the stock on the exercise date. The plan was terminated in August of 1993 and the remaining shares were deregistered. For the first option period of 1993, 101 employees participated in the plan and exercised a total of 10,706 options at a price of $8.08. Activity under the plan was as follows: EMC INSURANCE GROUP INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements, Continued Year ended December 31, --------------------------- 1993 1992 1991 ------- ------- ------- Shares available for purchase, beginning of year 55,720 85,765 110,564 Shares purchased under plan ................... (10,706) (30,045) (24,799) Shares deregistered ........................... (45,014) - - ------- ------- ------- Shares available for purchase, end of year ...... - 55,720 85,765 ======= ======= ======= 1993 Employee Stock Purchase Plan On February 12, 1993, the Company filed a registration statement with the Securities and Exchange Commission authorizing the issuance of up to 500,000 shares of the Company's common stock for use in the Employers Mutual Casualty Company 1993 Employee Stock Purchase Plan. The plan provides for two option periods each calendar year; from January 1 until the last business day of June, and from July 1 until the last business day of December, with the last business day in each option period being the option exercise date. Any employee who is employed by Employers Mutual, its affiliates, or its subsidiaries on the first day of the month immediately preceding any option period is eligible to participate in the plan. Eligible employees may elect to participate in the plan either through payroll deduction or by lump sum contributions, but in no case can the participation level exceed 10 percent of the employee's base annual compensation amount. The option price is 85 percent of the fair market value of the stock on the exercise date. Upon exercise of an option, the Company shall issue a stock certificate evidencing the ownership of the participant in the shares of stock so purchased. The certificate, however, will be held in custody by the stock transfer agent for a period of one year from the exercise date. During such one year period, the participant shall have the rights and privileges of a shareholder, including the right to vote, to receive dividends, and to have such shares participate in the dividend reinvestment and common stock purchase plan. However, the participant shall not be able to sell, transfer, assign, pledge or otherwise encumber or dispose of such shares during such one year period. Upon expiration of the one year period or upon any earlier termination of employment of the participant for any reason, including death, such participant shall, within thirty days of such expiration or termination, receive the stock certificate(s) evidencing his or her shares of stock. The plan is administered by the Board of Directors of Employers Mutual and the Board has the right to amend or terminate the plan at any time; however, no such amendment or termination shall adversely affect the rights and privileges of participants with unexercised options. For the second option period of 1993, 104 employees participated in the plan and exercised a total of 13,454 options at a price of $8.19. Activity under the plan was as follows: Year ended December 31, ------------ Shares available for purchase, beginning of year .......... - Shares registered for use in plan ....................... 500,000 Shares purchased under plan ............................. (13,454) ------------ Shares available for purchase, end of year ................ 486,546 ============ EMC INSURANCE GROUP INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements, Continued (b) 1993 NON-EMPLOYEE DIRECTOR STOCK PURCHASE PLAN On February 12, 1993, the Company filed a registration statement with the Securities and Exchange Commission authorizing the issuance of up to 200,000 shares of the Company's common stock for use in the 1993 Employers Mutual Casualty Company Non-Employee Director Stock Purchase Plan. All non-employee directors of Employers Mutual and its subsidiaries and affiliates who are not serving on the "Disinterested Director Committee" of Employers Mutual's Board of Directors (the "Board") as of the beginning of the option period are eligible for participation in the plan. The option period is from the date of each eligible director's respective Annual Meeting to the day immediately prior to the next and subsequent Annual Meeting. Each eligible director is granted an option at the beginning of the option period to purchase stock at an option price equal to 75 percent of the fair market value of the stock on the option exercise date. The option may be exercised anytime during the option period. An eligible director can purchase shares of common stock in an amount equal to a minimum of 25 percent to a maximum of 100 percent of their annual cash retainer. Eligible directors may not have sold any of the Company's common stock in the six month period preceding the exercise date and may not sell any shares of the Company's common stock in the six month period following the exercise of an option. The plan is administered by the Disinterested Director Committee of the Board. The Board may amend or terminate the plan at any time; however, no such amendment or termination shall adversely affect the rights and privileges of participants with unexercised options. The plan will continue through the option period for options granted at the 2002 Annual Meeting. During 1993, five directors participated in the plan and exercised a total of 5,952 options at prices ranging from $6.56 to $7.69. Activity under the plan was as follows: Year ended December 31, ------------ Shares available for purchase, beginning of year .......... - Shares registered for use in plan ....................... 200,000 Shares purchased under plan ............................. (5,952) ------------ Shares available for purchase, end of year ................ 194,048 ============ EMC INSURANCE GROUP INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements, Continued (c) DIVIDEND REINVESTMENT PLAN The Company maintains a Dividend Reinvestment and Common Stock Purchase Plan which provides stockholders with the option of reinvesting cash dividends in additional shares of the Company's common stock. Participants may also purchase additional shares of common stock without incurring broker commissions by making optional cash contributions to the plan. Any holder of shares of common stock is eligible to participate in the plan. During 1993, Employers Mutual elected to participate in the Dividend Reinvestment Plan by reinvesting 50 percent of its dividends in additional shares of the Company's common stock. Activity under the plan was as follows: Year ended December 31, ------------------------- 1993 1992 1991 ------- ------- ------- Shares available for purchase, beginning of year 955,069 973,901 991,575 Shares purchased under plan ................... (186,187) (18,832) (17,674) ------- ------- ------- Shares available for purchase, end of year ...... 768,882 955,069 973,901 ======= ======= ======= Range of purchase prices ........................ $10.00 $8.00 $8.50 to to to $10.25 $10.25 $9.50 (d) TREASURY STOCK The Company from time to time repurchases shares of its outstanding common stock in the open market or through negotiated purchases for the purpose of providing shares for use in the Company's Dividend Reinvestment and Common Stock Purchase Plan. The Company repurchased 7,000 shares and 10,000 shares for this purpose during 1992 and 1991 at an average cost of $10.47 and $9.00, respectively. The Company also repurchases shares of its outstanding common stock in connection with the issuance of new shares under Employers Mutual's stock option plans. Treasury stock activity was as follows: Year ended December 31, ------------------------- 1993 1992 1991 ------- ------- ------- Treasury shares, beginning of year ............... 49,392 36,685 8,863 Repurchased shares ............................ 12,568 31,539 45,496 Reissued shares ............................... (53,870) (18,832) (17,674) ------- ------- ------- Treasury shares, end of year ..................... 8,090 49,392 36,685 ======= ======= ======= Average cost ..................................... $ 10.06 $ 9.79 $ 9.31 ======= ======= ======= Gain (loss) on sale .............................. $23,261 $ (485) $14,887 ======= ======= ======= EMC INSURANCE GROUP INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements, Continued 7. STOCK OPTIONS During 1993, Employers Mutual maintained three separate stock option plans which utilize the common stock of the Company. The Company receives the current fair market value for any shares issued under the plans and all costs of the plans are borne by Employers Mutual or the company employing the individual optionees. (a) 1979 STOCK OPTION PLAN Under Employers Mutual's 1979 Stock Option Plan, 480,000 shares of the Company's common stock were reserved for issuance to certain officers and key management employees of Employers Mutual and its subsidiaries as determined by its Board of Directors. Options were granted to 37 individuals. For the one remaining eligible participant at February 21, 1994 the option price is the greater of statutory book value or fair market value at the date of grant, which was $6.38 per share and which must be exercised by no later than March 14, 1994. The period for granting options under the plan expired on March 31, 1984. Options granted vest at an annual rate of 10 percent on a cumulative basis. Upon death, retirement, or permanent disability, all options granted become exercisable. During 1993, 960 options were exercised at a price of $6.38. Stock options under the plan were as follows: Year ended December 31, ------------------------ 1993 1992 1991 ------ ------ ------ Outstanding, beginning of year ............ 5,760 44,440 74,290 Exercised .............................. (960) (38,200) (29,850) Expired ................................ - (480) - ------ ------- ------- Outstanding, end of year .................. 4,800 5,760 44,440 ====== ======= ======= Shares exercisable, end of year ........... 4,800 3,840 40,600 ====== ======= ======= (b) 1982 INCENTIVE STOCK OPTION PLAN Under the terms of Employers Mutual's 1982 Incentive Stock Option Plan, 600,000 shares of the Company's common stock were reserved for issuance to officers and key employees of Employers Mutual and its subsidiaries. The Board of Directors of Employers Mutual is the administrator of the plan. Options have been granted to 57 individuals. For the 35 remaining eligible participants at February 21, 1994, the option price is the fair market value at dates of grant ranging from $7.81 to $10.25 per share. Options granted under the plan are for a term of two to ten years. Each option shall have a vesting period of two, three, four or five years, with such vesting to commence one year from the date of grant, except in the event of termination of employment when all such granted options are exercisable within three, six or twelve months depending upon the circumstances of such termination. The period for granting options under the plan expired on August 30, 1992. Once granted, the period for exercising the options can not exceed ten years from date of grant. The option price was determined by the Board of Directors but could not be less than the fair market value of the stock on the date of grant. During 1993, 24,820 options were exercised at prices ranging from $6.88 to $8.75. Stock options under the plan were as follows: EMC INSURANCE GROUP INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements, Continued Year ended December 31, ------------------------------- 1993 1992 1991 ------- ------- ------- Outstanding, beginning of year ............ 387,093 447,393 431,193 Granted ............................... - 82,900 62,500 Exercised ............................. (24,820) (58,540) (41,300) Expired ............................... (10,200) (84,660) (5,000) ------- ------- ------- Outstanding, end of year .................. 352,073 387,093 447,393 ======= ======= ======= Shares exercisable, end of year ........... 214,680 168,082 195,644 ======= ======= ======= (c) 1993 INCENTIVE STOCK OPTION PLAN On February 12, 1993 the Company filed a registration statement with the Securities and Exchange Commission authorizing the issuance of up to 500,000 shares of the Company's common stock for use in the 1993 Employers Mutual Casualty Company Incentive Stock Option Plan. Options granted under the plan will be for a term of two to ten years. Each option shall have a vesting period of two, three, four or five years, with such vesting to commence one year from the date of grant, with the exception of an option with a two year vesting period for which the vesting period shall commence on the date of grant. The time limit for granting options under the plan is December 31, 2002. The Senior Executive Compensation and Stock Option Committee of Employers Mutual's Board of Directors is the administrator of the plan. Options have been granted to 52 individuals under the plan. For the 51 eligible participants at February 21, 1994, the option price is the fair market value at dates of grant ranging from $9.38 to $9.56 per share. Option prices are determined by the Committee but can not be less than the fair market value of the stock on the date of grant. During 1993, 163,650 options were granted to eligible participants and no options were exercised. Stock options under the plan were as follows: Year ended December 31, ------------ Outstanding, beginning of year ............................ - Granted ................................................. 163,650 Exercised ............................................... - Expired ................................................. (2,500) ------------ Outstanding, end of year .................................. 161,150 ============ Shares exercisable, end of year ........................... - ============ EMC INSURANCE GROUP INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements, Continued (8) RETAINED EARNINGS Retained earnings of the Company's insurance subsidiaries available for distribution as dividends to EMC Insurance Group Inc. are limited by law to the statutory unassigned surplus of each of the subsidiaries as of the previous December 31, as determined in accordance with accounting practices prescribed by insurance regulatory authorities of the state of domicile of each subsidiary. Subject to this limitation, the maximum dividend that may be paid by Iowa corporations without prior approval of the insurance regulatory authorities is restricted to the greater of 10 percent of statutory surplus as regards policyholders as of the preceding December 31, or net income of the preceding calendar year on a statutory basis. Both Illinois and North Dakota impose restrictions which are similar to those of Iowa on the payment of extraordinary dividends and distributions. At December 31, 1993, $10,113,818 was available for distribution in 1994 to EMC Insurance Group Inc. without prior approval. Illinois and North Dakota are currently exploring changes to the definition of extraordinary dividends; however, no legislation has been finalized at this time. Statutory policyholders' surplus of the Company's insurance subsidiaries was $78,681,248 and $73,638,088 at December 31, 1993 and 1992, respectively. Statutory net income (loss) of the Company's insurance subsidiaries was $8,788,458, ($3,960,393) and $4,852,271 for the three years ended December 31, 1993. The Company contributed $10,000,000 of the proceeds received from the sale of the life subsidiary to increase the surplus of the property and casualty insurance subsidiaries in 1992 in connection with the increase in the pool participation. The Company contributed $3,000,000 to the surplus of the reinsurance subsidiary in 1992 in order to retain its status as an authorized reinsurance company in several states. EMC INSURANCE GROUP INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements, Continued (9) SEGMENT INCOME EMC INSURANCE GROUP INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements, Continued (10) INVESTMENTS As discussed in note 1, Summary of Significant Accounting Policies, the Company adopted SFAS 115 as of December 31, 1993. In conjunction with the adoption of SFAS 115, the Company changed its intent with respect to holding certain debt securities to maturity and reclassified $61,885,165 of securities held-to-maturity and $51,196,415 of short-term investments to securities available-for-sale. Unrealized holding gains related to this reclassification increased stockholders' equity by $2,068,451, net of deferred income taxes of $1,065,565. Unrealized holding losses associated with equity securities available-for-sale totaled $19,800, net of defered tax benefits of $10,200. The amortized cost and estimated market value of securities held-to- maturity and available-for-sale as of December 31, 1993 are as follows. The estimated market value is based on quoted market prices, where available, or on values obtained from independent pricing services. Gross Gross Estimated Amortized Unrealized Unrealized Market December 31, 1993 Cost Gains Losses Value ----------------- ------------ ----------- ----------- ------------ Securities held-to-maturity: U.S. Treasury securities and obligations of U.S. government corporations and agencies ........... $109,895,914 $ 9,931,812 $ (630) $119,827,096 Obligations of states and political subdivisions ........... 18,374,003 1,936,083 (2,129) 20,307,957 Debt securities issued by foreign governments 587,060 70,343 - 657,403 Public utilities ......... 8,813,202 336,199 (910) 9,148,491 Corporate securities ..... 17,050,988 819,896 (467) 17,870,417 Mortgage-backed securities 36,289,456 2,204,777 - 38,494,233 ------------ ----------- ----------- ------------ Total fixed maturity securities held-to- maturity ........... $191,010,623 $15,299,110 $ (4,136) $206,305,597 ============ =========== =========== ============ Securities available-for-sale: Obligations of states and political subdivisions ........... $ 58,431,008 $ 3,038,591 $ (74,084) $ 61,395,515 Other debt securities .... 486,941 4,779 (2,070) 489,650 Short-term investments ... 51,029,615 166,800 - 51,196,415 ------------ ----------- ----------- ------------ Total fixed maturity securities available-for-sale $109,947,564 $ 3,210,170 $ (76,154) $113,081,580 ============ =========== =========== ============ Equity securities available-for-sale $ 505,000 $ - $ (30,000) $ 475,000 ============ =========== =========== ============ EMC INSURANCE GROUP INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements, Continued The amortized cost and estimated market value of fixed maturity securities held-to-maturity and equity securities available-for-sale as of December 31, 1992 are as follows: Gross Gross Estimated Amortized Unrealized Unrealized Market December 31, 1992 Cost Gains Losses Value ----------------- ------------ ----------- ----------- ------------ U.S. Treasury securities and obligations of U.S. government corporations and agencies ............ $144,419,244 $ 9,242,068 $ (281,096) $153,380,216 Obligations of states and political subdivisions ............ 51,188,090 4,393,165 (99,395) 55,481,860 Debt securities issued by foreign governments .. 590,502 50,452 - 640,954 Public utilities .......... 9,693,693 191,934 (37,746) 9,847,881 Corporate securities ...... 16,560,387 405,443 (183,348) 16,782,482 Mortgage-backed securities 26,983,821 2,500,728 (309) 29,484,240 Other debt securities ..... 1,117,121 19,400 (34,659) 1,101,862 ------------ ----------- ----------- ------------ Total fixed maturity securities held-to- maturity ............ $250,552,858 $16,803,190 $ (636,553) $266,719,495 ============ =========== =========== ============ Equity securities available-for-sale .. $ 1,560,000 $ - $ (142,000) $ 1,418,000 ============ =========== =========== ============ The amortized cost and estimated market value of fixed maturity securities held-to-maturity and available-for-sale at December 31, 1993, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. Estimated Amortized Market Cost Value ------------ ------------ Fixed maturity securities held-to-maturity: Due in one year or less ................... $ 14,613,909 $ 14,887,469 Due after one year through five years ..... 55,951,990 61,054,939 Due after five years through ten years .... 73,944,312 80,286,921 Due after ten years ....................... 10,210,956 11,582,035 Mortgage-backed securities ................ 36,289,456 38,494,233 ------------ ------------ Totals .................................. $191,010,623 $206,305,597 ============ ============ Fixed maturity securities available-for-sale: Due in one year or less ................... $ 51,429,559 $ 51,599,338 Due after one year through five years ..... 10,168,440 10,476,611 Due after five years through ten years .... 31,194,883 33,453,428 Due after ten years ....................... 17,154,682 17,552,203 ------------ ------------ Totals .................................. $109,947,564 $113,081,580 ============ ============ EMC INSURANCE GROUP INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements, Continued Proceeds from calls and prepayments of fixed maturity securities and realized investment gains and losses were as follows: Year ended December 31, ------------------------------------- 1993 1992 1991 ----------- ----------- ----------- Proceeds from calls and prepayments ... $37,579,956 $18,640,915 $ 6,504,948 Gross realized investment gains ....... 706,059 388,692 64,514 Gross realized investment losses ...... 9,682 4,409 96 A summary of net investment income is as follows: Year ended December 31, ------------------------------------- 1993 1992 1991 ----------- ----------- ----------- Interest on fixed maturities .......... $19,701,641 $19,754,718 $19,297,727 Dividends on equity securities ........ 65,065 119,989 124,777 Interest on short-term investments .... 1,602,740 2,172,983 1,110,513 ----------- ----------- ----------- Total investment income ........... 21,369,446 22,047,690 20,533,017 Investment expense .................... 589,495 508,093 331,024 ----------- ----------- ----------- Net investment income ............. $20,779,951 $21,539,597 $20,201,993 =========== =========== =========== A summary of realized investment gains (losses) and net changes in unrealized holding gains (losses) is as follows: Year ended December 31, ------------------------------------- 1993 1992 1991 ----------- ----------- ----------- Realized investment gains (losses): Fixed maturities .................. $ 696,377 $ 384,283 $ 64,418 Equity securities ................. (11,932) - - ----------- ----------- ----------- Total realized investment gains 684,445 384,283 64,418 Applicable income taxes ........... (232,711) (130,656) (21,902) ----------- ----------- ----------- Net realized investment gains 451,734 253,627 42,516 ----------- ----------- ----------- Net changes in unrealized holding gains (losses): Fixed maturity securities held-to-maturity ................ (871,663) (2,088,038) 11,501,606 Fixed maturity securities available-for-sale .............. 3,134,016 - - Equity securities available-for-sale .............. 112,000 184,375 298,625 Applicable income taxes ........... (807,280) 647,245 (4,012,079) ----------- ----------- ----------- Net changes in unrealized holding gains (losses) ...... 1,567,073 (1,256,418) 7,788,152 ----------- ----------- ----------- Net realized investment gains and changes in unrealized holding gains (losses) ...................... $ 2,018,807 $(1,002,791) $ 7,830,668 =========== =========== =========== EMC INSURANCE GROUP INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements, Continued (11) EMPLOYEE RETIREMENT PLAN The Company participates in Employers Mutual's defined benefit retirement plan covering substantially all employees. The plan is funded by employer contributions and provides a monthly income for life upon retirement or upon total and permanent disability. The following table sets forth the funded status and the net periodic pension cost (benefit) for the Employers Mutual defined benefit retirement plan, based upon a measurement date of November 1, 1993, 1992 and 1991, respectively: Year ended December 31, ---------------------------------------- 1993 1992 1991 ------------ ------------ ------------ Actuarial present value of benefit obligations: Accumulated benefit obligation, including vested benefits of $27,245,933, $23,739,308 and $16,922,064 .................. $ 29,713,282 $ 24,695,567 $ 18,600,097 ============ ============ ============ Projected benefit obligation for service rendered to date ......... $(44,579,398) $(36,103,055) $(27,610,564) Plan assets at fair value .......... 51,625,386 48,365,122 46,915,274 ------------ ------------ ------------ Plan assets in excess of projected benefit obligation ............... 7,045,988 12,262,067 19,304,710 Unrecognized net loss (gain) from past experience different from that assumed and effects of changes in assumptions ........... 4,440,487 (754,346) (3,715,134) Prior service cost not yet recog- nized in net periodic pension cost 4,374,510 4,941,220 653,767 Unrecognized portion of initial net asset ........................ (7,182,692) (8,072,193) (9,123,946) ------------ ------------ ------------ Prepaid pension cost ........ $ 8,678,293 $ 8,376,748 $ 7,119,397 ============ ============ ============ Net periodic pension cost (benefit) included the following components: Year ended December 31, ------------------------------------- 1993 1992 1991 ----------- ----------- ----------- Service cost - benefits earned during the period ................... $ 2,347,984 $ 1,691,648 $ 1,368,932 Interest cost on projected benefit obligation .................. 2,533,587 2,053,584 1,818,023 Actual gain on plan assets ............ (5,229,721) (4,386,821) (9,440,576) Net amortization and deferral ......... 647,291 (615,762) 4,791,814 ----------- ----------- ----------- Net periodic pension cost (benefit) $ 299,141 $(1,257,351) $(1,461,807) =========== =========== =========== EMC INSURANCE GROUP INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements, Continued The unrecognized net asset is being recognized over 12.5 to 15.2 years beginning January 1, 1987. The weighted average discount rate used to measure the projected benefit obligation was 6.75 percent, 7.00 percent and 7.75 percent and the assumed long-term rate of return on plan assets was 8.00 percent, 8.00 percent and 8.75 percent for 1993, 1992 and 1991, respectively. The rate of increase in future compensation levels used in measuring the projected benefit obligation was 5.30 percent in 1993, 5.50 percent in 1992 and 6.00 percent in 1991. Pension expense (benefit) for the Company amounted to $103,846, ($622,177) and ($275,628) in 1993, 1992 and 1991, respectively. Effective November 1, 1992, the Plan was amended to comply with the requirements of the Tax Reform Act of 1986, which placed limits on the benefits for highly compensated employees. This change in the benefit formula represents a prior service cost of $4,354,553, which is being amortized over 12 to 14 years beginning January 1, 1993. The Company's share of this prior service cost amounted to $1,003,257. 12. POSTRETIREMENT BENEFITS OTHER THAN PENSIONS The Company participates in Employers Mutual's postretirement benefit plans which provide certain health care and life insurance benefits for retired employees. Substantially all of the Company's employees may become eligible for those benefits if they reach normal retirement age while working for the Company. The health care postretirement plan requires contributions from participants and contains certain cost sharing provisions such as coinsurance and deductibles. The life insurance plan is noncontributory. Both plans are unfunded and benefits provided are subject to change. As discussed in note 1, Summary of Significant Accounting Policies, the Company adopted SFAS 106 as of January 1, 1993. The Company's transition obligation as of January 1, 1993 amounted to $2,165,900 ($.21 per share), net of income tax benefits of $1,115,767, and was recorded as a cumulative effect adjustment to income. Prior year financial statements have not been restated to apply the provisions of SFAS 106. The following table sets forth the status and the net periodic postretirement benefit cost of the Employers Mutual postretirement benefit plans at December 31, 1993, based upon a measurement date of November 1, 1993: Actuarial present value of benefit obligations: Retirees ............................................... $ 7,874,628 Fully eligible active plan participants ................ 5,681,430 Other active plan participants ......................... 7,783,183 ----------- Total .............................................. 21,339,241 ----------- Unrecognized net loss from past experience different from that assumed and effects of changes in assumptions .. 447,778 Prior service cost not yet recognized in net periodic postretirement benefit cost .............................. 5,105,109 ----------- Postretirement benefit obligation .................. $15,786,354 =========== EMC INSURANCE GROUP INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements, Continued Net periodic postretirement benefit cost for the year ended December 31, 1993 included the following components: Service cost - benefits earned during the period ............ $ 596,498 Interest cost on accumulated postretirement benefit obligation ........................................ 999,526 ---------- Net periodic postretirement benefit cost ............ $1,596,024 ========== The assumed weighted average annual rate of increase in the per capita cost of covered health care benefits (i.e. the health care cost trend rate) is 12.5 percent for 1994 (compared to 13 percent assumed for 1993) and is assumed to decrease gradually to 6 percent in 2007 and remain at that level thereafter. The health care cost trend rate assumption has a significant effect on the amounts reported. For example, a one-percentage-point increase in the assumed health care cost trend rate for each future year would increase the accumulated postretirement benefit obligation as of December 31, 1993 by $3,269,053 and the aggregate of the service and interest cost components of net periodic postretirement benefit cost for the year ended December 31, 1993 by $281,964. The weighted average discount rate used in determining the accumulated postretirement benefit obligation at December 31, 1993 and January 1, 1993 was 6.75 percent and 7.00 percent, respectively. Effective January 1, 1993, the health care postretirement plan was amended to provide additional benefits under the prescription drug coverage. The amendment substantially reduced the retired employee's cost sharing provisions for prescription drug coverage. The amendment resulted in a prior service cost of $5,105,109, which will be amortized over 8.9 to 10.0 years beginning January 1, 1994. The Company's share of the prior service cost amounted to $1,156,028. The Company's net periodic postretirement benefit cost for the year ended December 31, 1993 was $359,747. The postretirement benefit cost of $78,807 and $53,180 for the years ended December 31, 1992 and 1991, respectively, which were recorded on a cash basis, have not been restated. (13) INCOME TAXES As discussed in note 1, Summary of Significant Accounting Policies, the Company adopted SFAS 109 as of January 1, 1993. The cumulative effect of this change in accounting for income taxes as of January 1, 1993 increased income by $5,595,177 ($.55 per share), net of a valuation allowance of $1,000,000, and is reported separately in the consolidated statement of income for the year ended December 31, 1993. Excluding the amount recognized as the cumulative effect of the change, the effect of applying SFAS 109 on net income for the year ended December 31, 1993 was a decrease of $174,483 ($.02 per share). Prior year consolidated financial statements have not been restated to apply the provisions of SFAS 109. EMC INSURANCE GROUP INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements, Continued Temporary differences between the consolidated financial statement carrying amount and tax basis of assets and liabilities that give rise to significant portions of the deferred tax asset at December 31, 1993 and 1992 relate to the following: Year ended December 31, ------------------------ 1993 1992 ----------- ----------- Loss reserve discounting .......................... $12,549,200 $ 7,239,227 Unearned premium reserve limitation ............... 2,953,491 2,886,863 Postretirement benefits ........................... 1,202,733 - Policyholder dividends payable .................... 970,630 1,209,346 Prepayment of tax on commutation of loss reserves 583,998 - Other, net ........................................ 617,529 201,763 ----------- ----------- Total gross deferred income tax asset ......... 18,877,581 11,537,199 Less valuation allowance .......................... (1,000,000) - ----------- ----------- Total deferred income tax asset ............... 17,877,581 11,537,199 ----------- ----------- Deferred policy acquisition costs ................. (2,617,614) (2,758,363) Net unrealized holding gains ...................... (1,055,365) - Other, net ........................................ (1,163,909) (1,713,615) ----------- ----------- Total gross deferred income tax liability ..... (4,836,888) (4,471,978) ----------- ----------- Net deferred income tax asset ............. $13,040,693 $ 7,065,221 =========== =========== The valuation allowance primarily relates to the tax benefit of future postretirement benefit deductions that are scheduled to reverse more than fifteen years into the future. The valuation allowance was established for these future deductions due to the uncertainty of the timing of these deductions. There was no change in the valuation allowance during the year ended December 31, 1993. Management believes the Company will generate sufficient taxable income in the future to recognize the benefits of future tax deductions. The Company has had cumulative taxable income in the five-year period of 1989 - 1993 of approximately $37,500,000. EMC INSURANCE GROUP INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements, Continued The actual income tax expense for the years ended December 31, 1993, 1992 and 1991 differed from the "expected" tax expense for those years (computed by applying the United States federal corporate tax rate of 34 percent to income from continuing operations before income taxes and cumulative effect of changes in accounting principles) as follows: Year ended December 31, ---------------------------------- 1993 1992 1991 ---------- ---------- ---------- Computed "expected" tax expense ......... $3,066,506 $ 331,519 $3,546,825 Increases (decreases) in taxes resulting from: Tax-exempt interest income .......... (1,171,612) (1,312,568) (1,464,296) Unrecognized future temporary differences ....................... - 1,745,003 480,042 (Under) over accrual ................ (252,839) - 620,500 Settlement of IRS examination ....... 117,497 - - Other, net .......................... 125,549 (4,589) (59,054) ---------- ---------- ---------- Income taxes ...................... $1,885,101 $ 759,365 $3,124,017 ========== ========== ========== The Internal Revenue Service is currently examining the Company's 1990 and 1991 tax returns. The Company does not expect any material assessments related to these examinations. EMC INSURANCE GROUP INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements, Continued (14) RECONCILIATION OF STATUTORY NET INCOME AND SURPLUS A reconciliation of net income and stockholders' equity from that reported on a statutory basis to that reported in the accompanying consolidated financial statements on a GAAP basis is as follows: Year ended December 31, ------------------------------------- 1993 1992 1991 ----------- ----------- ----------- Statutory net income (loss) ........... $ 8,761,472 $(3,118,589) $15,271,311 Change in deferred policy acquisition costs ................... (413,967) 2,189,375 523,277 Change in salvage and subrogation accrual ............................. (232,760) 742,233 81,119 Change in other policyholders' funds .. 840,604 (880,866) 217,686 Change in pension accrual ............. (103,846) 622,177 275,628 GAAP postretirement benefit cost in excess of statutory cost ......... (216,091) - - Deferred income tax benefit ........... 18,027 1,501,430 781,719 Income from discontinued operations (note 4) ................. - - 1,853,234 Statutory gain on sale of life subsidiary ..................... - (474,356) (9,900,000) Statutory reserve discount on commutation of reinsurance contract in excess of GAAP amortization ...... (1,717,641) - - Other, net ............................ 198,237 (365,712) 57,081 ----------- ----------- ----------- Income before cumulative effect of changes in accounting principles, GAAP basis .......................... 7,134,035 215,692 9,161,055 Cumulative effect of changes in accounting principles for: Income taxes ...................... 5,595,177 - - Postretirement benefits ........... (2,165,900) - - Unearned premiums ................. (807,933) - - ----------- ----------- ----------- Net income, GAAP basis ................ $ 9,755,379 $ 215,692 $ 9,161,055 =========== =========== =========== EMC INSURANCE GROUP INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements, Continued Year ended December 31, ---------------------------------------- 1993 1992 1991 ------------ ------------ ------------ Statutory stockholders' equity ..... $ 85,830,140 $ 83,331,013 $ 91,670,358 Deferred policy acquisition costs .. 7,698,864 8,112,831 5,923,456 Accrued salvage and subrogation .... 1,793,592 2,026,352 1,284,119 Other policyholders' funds payable (2,854,793) (3,695,397) (2,814,531) Pension asset ...................... 1,705,735 1,809,581 1,187,404 GAAP postretirement benefit liability in excess of statutory liability ........................ (1,358,197) - - Deferred income tax asset .......... 13,040,693 7,065,221 5,563,791 Goodwill ........................... 2,017,690 2,152,203 2,286,716 Statutory reserve discount on commutation of reinsurance contract in excess of GAAP amortization ..................... (1,717,641) - - Unrealized holding gains on fixed maturity securities available-for-sale ............... 3,134,016 - - Other .............................. 343,670 108,973 43,123 ------------ ------------ ------------ Stockholders' equity, GAAP basis ... $109,633,769 $100,910,777 $105,144,436 ============ ============ ============ (15) DISCLOSURES ABOUT THE FAIR VALUE OF FINANCIAL INSTRUMENTS The carrying amount of (1) cash, (2) accounts receivable, (3) indebtedness of related party, (4) accounts payable and (5) accrued expenses approximate fair value because of the short maturity of these instruments. The estimated fair value of the Company's investments at December 31, 1993 are summarized as follows. The estimated fair value is based on quoted market prices, where available, or on values obtained from independent pricing services (see note 10). Carrying Estimated Amount Fair Value ------------ ------------ Fixed maturity securities held-to-maturity ...... $191,010,623 $206,305,597 Fixed maturity securities available-for-sale .... $113,081,580 $113,081,580 Equity securities available-for-sale ............ $ 475,000 $ 475,000 (16) CONTINGENT LIABILITIES The Company and Employers Mutual and its other subsidiaries are parties to numerous lawsuits arising in the normal course of the insurance business. The Company believes that the resolution of these lawsuits will not have a material adverse effect on its financial condition or its results of operations. The companies involved have reserves which are believed adequate to cover any potential liabilities arising out of all such pending or threatened proceedings. EMC INSURANCE GROUP INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements, Continued Employers Mutual has entered into unsecured financing arrangements with several large commercial policyholders. The Company, under terms of the pooling agreement, is a 22 percent participant in these policies (note 2). At December 31, 1993, the Company is contingently liable for $1,738,000 of unsecured receivables held by Employers Mutual. (17) NEW ACCOUNTING STANDARD The Financial Accounting Standards Board has issued Statement of Financial Accounting Standards No 112 (SFAS 112), "Employers' Accounting for Postemployment Benefits". SFAS 112 requires that the cost of certain postemployment benefits that vest or accumulate be accrued over the period of an employee's service. SFAS 112 is effective for fiscal years beginning after December 31, 1993. The Company will adopt this standard in the first quarter of 1994. Adoption of this standard is not expected to have a material effect on the income of the Company. (18) UNAUDITED INTERIM FINANCIAL INFORMATION Three months ended, -------------------------------------------------- March 31 June 30 September 30 December 31 ----------- ----------- ----------- ----------- - ---- Total revenues ........... $42,369,391 $45,480,653 $45,386,046 $44,665,844 =========== =========== =========== =========== Income before income taxes (benefit) ........ $ 3,375,144 $ 476,062 $ 627,295 $ 4,540,635 Income taxes (benefit) ... 1,262,205 (963,626) 392,546 1,193,976 ----------- ----------- ----------- ----------- Income from operations ... 2,112,939 1,439,688 234,749 3,346,659 Income from accounting changes ................ 2,621,344 - - - ----------- ----------- ----------- ----------- Net income .......... $ 4,734,283 $ 1,439,688 $ 234,749 $ 3,346,659 =========== =========== =========== =========== Earnings per share:* Income from operations $ .21 $ .14 $ .02 $ .33 Income from accounting changes .............. .26 - - - ----------- ----------- ----------- ----------- Net income .......... $ .47 $ .14 $ .02 $ .33 =========== =========== =========== =========== EMC INSURANCE GROUP INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements, Continued Three months ended, -------------------------------------------------- March 31 June 30 September 30 December 31 ----------- ----------- ----------- ----------- - ---- Total revenues ........... $40,592,007 $41,298,060 $42,664,483 $44,779,617 =========== =========== =========== =========== Income (loss) before income taxes (benefit) $ 2,315,687 $ 1,015,692 $(2,472,573) $ 116,251 Income taxes (benefit) ... 299,983 516,923 (879,335) 821,794 ----------- ----------- ----------- ----------- Net income (loss) ... $ 2,015,704 $ 498,769 $(1,593,238) $ (705,543) =========== =========== =========== =========== Earnings (loss) per share* $ .20 $ .05 $ (.16) $ (.07) =========== =========== =========== =========== - ---- Total revenues ........... $31,545,776 $33,059,727 $34,818,761 $34,261,385 =========== =========== =========== =========== Income before income taxes $ 3,089,115 $ 773,182 $ 2,070,921 $ 4,498,620 Income taxes ............. 614,989 170,077 622,519 1,716,432 ----------- ----------- ----------- ----------- Income from continuing operations ............. 2,474,126 603,105 1,448,402 2,782,188 Income from discontinued operations ............. 458,529 469,056 637,317 288,332 ----------- ----------- ----------- ----------- Net income .......... $ 2,932,655 $ 1,072,161 $ 2,085,719 $ 3,070,520 =========== =========== =========== =========== Earnings per share:* Income from continuing operations ............. $ .25 $ .06 $ .15 $ .27 Income from discontinued operations ............. .04 .05 .06 .03 ----------- ----------- ----------- ----------- Net income .......... $ .29 $ .11 $ .21 $ .30 =========== =========== =========== =========== * Since the weighted average shares for the quarters are calculated independent of the weighted average shares for the year, quarterly earnings per share may not total to annual earnings 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. - -------- --------------------------------------------------- See the information under the caption "Election of Directors" in the Company's Proxy Statement in connection with its Annual meeting to be held on May 25, 1994, which information is incorporated herein by reference. The following sets forth information regarding all executive officers of the Company. NAME AGE POSITION Bruce G. Kelley 40 President and Chief Executive Officer of the Company and of Employers Mutual since 1992. He was elected President of the Company and Employers Mutual in 1991. Mr. Kelley was Executive Vice President of the Company and Employers Mutual from 1989 to 1991. He has been employed with Employers Mutual since 1985 and has been a Director since 1984. Fredrick A. Schiek 59 Executive Vice President and Chief Operating Officer of the Company and of Employers Mutual since 1992. He was Vice President of Employers Mutual from 1983 until 1992. He has been employed by Employers Mutual since 1959. E. H. Creese 62 Senior Vice President and Treasurer of the Company since 1993 and Senior Vice President and Treasurer of Employers Mutual since 1992. He was Vice President and Treasurer of the Company from 1983 until 1993 and of Employers Mutual from 1985 until 1992. He has been employed by Employers Mutual since 1984. Philip T. Van Ekeren 63 Senior Vice President and Secretary of the Company since 1993 and Senior Vice President and Secretary of Employers Mutual since 1992. He was Vice President and Secretary of the Company from 1978 until 1993 and of Employers Mutual from 1978 until 1992. He has been employed by Employers Mutual since 1961. David O. Narigon 41 Vice President of the Company since 1989. Vice President of Employers Mutual since 1989 and Assistant Secretary from 1986 to 1989. He has been employed by Employers Mutual since 1983. Raymond W. Davis 48 Vice President of the Company and Employers Mutual since 1985. He has been employed by Employers Mutual since 1979. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION. - -------- ----------------------- See the information under the caption "Compensation of Management" in the Company's Proxy Statement in connection with its Annual Meeting to be held on May 25, 1994, which information is incorporated herein by reference. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. - -------- --------------------------------------------------------------- See the information under the captions "Voting Securities and Principal Stockholder" and "Security Ownership of Management" in the Company's Proxy Statement in connection with its Annual Meeting to be held on May 25, 1994, which information is incorporated herein by reference. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. - -------- ----------------------------------------------- See the information under the caption "Certain Relationships and Related Transactions" in the Company's Proxy Statement in connection with its Annual Meeting to be held on May 25, 1994, which information is incorporated herein by reference. PART IV ------- ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. - -------- ----------------------------------------------------------------- (a) List of Financial Statements and Schedules. Form 10-K Page ------ 1. Financial Statements Independent Auditor's Report ................................ 44 Consolidated Balance Sheets, December 31, 1993 and 1992 ..... 45 Consolidated Statements of Income for the Years ended December 31, 1993, 1992 and 1991 ......................... 47 Consolidated Statements of Stockholders' Equity for the Years ended December 31, 1993, 1992 and 1991 ............. 49 Consolidated Statements of Cash Flows for the Years ended December 31, 1993, 1992 and 1991 ......................... 51 Notes to Consolidated Financial Statements .................. 53 2. Schedules Independent Auditor's Report on Schedules ................... 86 Schedule I - Summary of Investments ....................... 87 Schedule III - Condensed Financial Information of Registrant 88 Schedule V - Supplementary Insurance Information .......... 91 Schedule VI - Reinsurance .................................. 92 Schedule X - Supplemental Information Concerning Property-Casualty Insurance Operations ..... 93 All other schedules have been omitted for the reason that the items required by such schedules are not present in the consolidated financial statements, are covered in notes to consolidated financial statements or are not significant in amount. 3. Management contracts and compensatory plan arrangements Exhibit 10(b). Management Incentive Compensation Plan. Exhibit 10(d). Employers Mutual Casualty Company 1979 Stock Option Plan. Exhibit 10(e). Employers Mutual Casualty Company 1982 Incentive Stock Option Plan. Exhibit 10(g). Deferred Bonus Compensation Plans. Exhibit 10(h). EMC Reinsurance Company Executive Bonus Program. Exhibit 10(j). Employers Mutual Casualty Company Excess Retirement Benefit Agreement. Exhibit 10(l). Employers Mutual Casualty Company 1993 Employee Stock Purchase Plan. Exhibit 10(m). 1993 Employers Mutual Casualty Company Incentive Stock Option Plan. Exhibit 10(n). Employers Mutual Casualty Company Non-Employee Director Stock Option Plan. (b) Reports on Form 8-K. None. (c) Exhibits. 2. Plan of Acquisition, Reorganization, Arrangement, Liquidation, or Succession. (a) Stock Purchase Plan between Employers Mutual Casualty Company and EMC Insurance Group Inc. dated December 9, 1991. (Incorporated by reference to Exhibit 2.1 to the Company's December 31, 1991 Form 8-K on file with the Commission). 3. Articles of incorporation and bylaws: (a) Articles of Incorporation of the Company, as amended. (Incorporated by reference to the Company's Form 10-K for the calendar year ended December 31, 1988.) (b) Bylaws of the Company, as amended. (Incorporated by reference to the Company's Form 10-K for the calendar year ended December 31, 1992.) 10. Material contracts. (a) Quota Share Reinsurance Contract between Employers Mutual Casualty Company and EMC Reinsurance Company, as amended. (b) Management Incentive Compensation Plan. (Incorporated by reference to the Company's Form 10-K for the calendar year ended December 31, 1983.) (c) Employers Mutual Companies reinsurance pooling agreements between Employers Mutual Casualty Company and certain of its affiliated companies, as amended. (d) Employers Mutual Casualty Company 1979 Stock Option Plan. (Incorporated by reference to Registration No. 2-81486.) (e) Employers Mutual Casualty Company 1982 Incentive Stock Option Plan, as amended. (Incorporated by reference to the Company's Form 10-K for the calendar year ended December 31, 1986.) (f) Excess of loss reinsurance contract between Employers Mutual Casualty Company and Farm and City Insurance Company. (Incorporated by reference to the Company's Form 10-K for the calendar year ended December 31, 1985.) (g) Deferred Bonus Compensation Plans. (Incorporated by reference to the Company's Form 10-K for the calendar year ended December 31, 1986.) (h) EMC Reinsurance Company Executive Bonus Program. (Incorporated by reference to the Company's Form 10-K for the calendar year ended December 31, 1989.) (i) EMC Insurance Group Inc. Amended and Restated Dividend Reinvestment and Common Stock Purchase Plan. (Incorporated by reference to Registration No. 33-34499.) (j) Employers Mutual Casualty Company Excess Retirement Benefit Agreement. (Incorporated by reference to the Company's Form 10-K for the calendar year ended December 31, 1989.) (k) Aggregate Catastrophe Excess of Loss Retrocession Agreement between EMC Reinsurance Company and Employers Mutual Casualty Company. (Incorporated by reference to the Company's Form 10-K for the calendar year ended December 31, 1991.) (l) Employers Mutual Casualty Company 1993 Employee Stock Purchase Plan. (Incorporated by reference to Registration No. 33-49335.) (m) 1993 Employers Mutual Casualty Company Incentive Stock Option Plan. (Incorporated by reference to Registration No. 33-49337.) (n) Employers Mutual Casualty Company Non-Employee Director Stock Option Plan. (Incorporated by reference to Registration No. 33-49339.) 13. 1993 Annual Report to Stockholders. (All information called for by Parts I and II of this Form 10-K has been included in this document under the respective item numbers (Items 1 through 9). 18. Letter re change in calculation of unearned premiums. (Incorporated by reference to the Company's Form 10-Q for the quarter ended March 31, 1993.) 21. Subsidiaries of the Registrant. 23. Consent of KPMG Peat Marwick with respect to Forms S-8 (Registration No's. 2-81486, 2-93738, 33-49335, 33-49337 and 33-49339) and Form S-3 (Registration No. 33-34499). 24. Power of Attorney. 28. Consolidated Schedule P of Annual Statements provided to state regulatory authorities. (d) Financial statements required by Regulation S-X which are excluded from the Annual Report to Stockholders by Rule 14a-3(b)(1). 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, on March 25, 1994. EMC INSURANCE GROUP INC. /s/ E. H. Creese --------------------------- E. H. Creese Senior Vice President, Treasurer & 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 March 25, 1994. /s/ E. H. Creese ---------------------------------- Robb B. Kelley* Chairman of the Board and Director /s/ E. H. Creese ----------------------------------- Bruce G. Kelley* President and Director (Chief Executive Officer) /s/ E. H. Creese ----------------------------------- George C. Carpenter III* Director /s/ E. H. Creese ----------------------------------- David J. Fisher* Director /s/ E. H. Creese ----------------------------------- George W. Kochheiser* Director /s/ E. H. Creese ----------------------------------- Raymond A. Michel* Director /s/ E. H. Creese ----------------------------------- Therese M. Vaughan* Director /s/ E. H. Creese ----------------------------------- E. H. Creese Senior Vice President & Treasurer (Chief Financial and Accounting Officer) * by power of attorney INDEPENDENT AUDITORS' REPORT ON SCHEDULES The Board of Directors and Stockholders EMC Insurance Group Inc.: Under date of February 21, 1994, we reported on the consolidated balance sheets of EMC Insurance Group 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 years in the three-year period ended December 31, 1993, as contained in Part II, Item 8 of the Form 10-K. In connection with our audits of the aforementioned consolidated financial statements, we also audited the related supplementary financial statement schedules listed in Part IV, Item 14(a)2. These supplementary financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these supplementary financial statement schedules based on our audits. In our opinion, such supplementary 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 1, 10, 12 and 13 to the consolidated financial statements, the Company changed its method of computing unearned premiums in 1993 and implemented the provisions of the Financial Accounting Standards Board's Statements No. 106, "Employers Accounting for Postretirement Benefits Other Than Pensions", No. 109, "Accounting for Income Taxes", No. 113, "Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts" and No. 115, "Accounting for Certain Investments in Debt and Equity Securities". /s/ KPMG Peat Marwick Des Moines, Iowa February 21, 1994 EMC INSURANCE GROUP INC. AND SUBSIDIARIES Schedule I - Summary of Investments - Other Than Investments in Related Parties December 31, 1993 Amount at which shown Market in the Type of investment Cost value balance sheet ------------------ ------------ ------------ ------------ Fixed maturities: Securities held-to-maturity: United States Government and government agencies and authorities ............... $146,185,370 $158,321,329 $146,185,370 States, municipalities and political subdivisions ........ 18,374,003 20,307,957 18,374,003 Foreign governments ............. 587,060 657,403 587,060 Public utilities ................ 8,813,202 9,148,491 8,813,202 All other corporate bonds ....... 17,050,988 17,870,417 17,050,988 ------------ ------------ ------------ Total fixed maturity securities held-to-maturity 191,010,623 206,305,597 191,010,623 ------------ ------------ ------------ Securities available-for-sale: States, municipalities and political subdivisions ........ 58,431,008 61,395,515 61,395,515 Redeemable preferred stock ...... 486,941 489,650 489,650 Short-term investments .......... 51,029,615 51,196,415 51,196,415 ------------ ------------ ------------ Total fixed maturity securities available-for-sale 109,947,564 113,081,580 113,081,580 ------------ ------------ ------------ Equity securities available-for-sale: Nonredeemable preferred stock ..... 505,000 475,000 475,000 ------------ ------------ ------------ Total equity securities available-for-sale .......... 505,000 475,000 475,000 ------------ ------------ ------------ Total investments ....... $301,463,187 $319,862,177 $304,567,203 ============ ============ ============ EMC INSURANCE GROUP INC. AND SUBSIDIARIES Schedule III - Condensed Financial Information of Registrant Condensed Balance Sheets December 31, -------------------------- 1993 1992 ------------ ------------ ASSETS - ------ Investment in common stock of subsidiaries (equity method) .................. $104,350,390 $ 93,290,152 Fixed maturity securities available-for-sale, at market value ............................... 4,785,692 - Equity securities available-for-sale, at market value .................................. 475,000 882,500 Short-term investments, at cost which approximates market value ..................... - 6,723,101 Cash ............................................ 35,414 66,870 Accrued investment income ....................... 13,750 10,410 Income taxes recoverable ........................ 67,000 22,000 Indebtedness of related party ................... 4,624 - ------------ ------------ Total assets ............................... $109,731,870 $100,995,033 ============ ============ LIABILITIES - ----------- Accounts payable ................................ $ 98,101 $ 71,426 Indebtedness to related party ................... - 12,830 ------------ ------------ Total liabilities .......................... 98,101 84,256 ------------ ------------ STOCKHOLDERS' EQUITY - -------------------- Common stock, $1 par value, authorized 20,000,000 shares; issued and outstanding, 10,325,329 shares in 1993 and 10,161,760 shares in 1992 ......... 10,325,329 10,161,760 Additional paid-in capital ...................... 55,021,926 53,507,459 Unrealized holding losses on equity securities available-for-sale, net of tax ................ (19,800) (142,000) Retained earnings ............................... 44,387,700 37,866,902 Treasury stock, at cost (49,392 shares in 1993 and 36,685 shares in 1992) .................... (81,386) (483,344) ------------ ------------ Total stockholders' equity ................. 109,633,769 100,910,777 ------------ ------------ Total liabilities and stockholders' equity $109,731,870 $100,995,033 ============ ============ EMC INSURANCE GROUP INC. AND SUBSIDIARIES Condensed Statements of Income Years ended December 31, ------------------------------------- 1993 1992 1991 ----------- ----------- ----------- Equity in undistributed earnings (loss) $ 6,370,743 $(3,142,782) $ 3,505,464 Dividends received from consolidated subsidiaries ........... 860,000 3,288,010 3,706,016 Investment income ..................... 214,825 483,786 484,077 Loss on sale of stock ................. (30,000) - - ----------- ----------- ----------- 7,415,568 629,014 7,695,557 Operating expenses .................... 345,678 312,778 361,192 ----------- ----------- ----------- Income from continuing operations before income taxes (benefit) .... 7,069,890 316,236 7,334,365 Income taxes (benefit) ................ (64,145) 100,544 26,544 ----------- ----------- ----------- Income from continuing operations .. 7,134,035 215,692 7,307,821 Income from discontinued operations ... - - 1,853,234 Income from accounting changes ........ 2,621,344 - - ----------- ----------- ----------- Net income .............. $ 9,755,379 $ 215,692 $ 9,161,055 =========== =========== =========== EMC INSURANCE GROUP INC. AND SUBSIDIARIES Condensed Statements of Cash Flows Years ended December 31, ------------------------------------- 1993 1992 1991 ----------- ----------- ----------- Net cash provided by operating activities ................ $ 761,673 $ 3,370,212 $ 3,905,045 ----------- ----------- ----------- Cash flows from investing activities: Fixed maturities ................... - - 5,000,000 Short-term investments ............. 1,937,409 13,815,080 (19,449,054) Sale of life subsidiary ............ - 474,356 15,500,000 Sale of stock ...................... 500,000 - - ----------- ----------- ----------- Net cash provided by investing activities ........... 2,437,409 14,289,436 1,050,946 ----------- ----------- ----------- Cash flows from financing activities: Issuance of common stock ........... 331,568 748,405 550,023 Dividends paid to stockholders ..... (3,443,465) (5,103,890) (5,081,607) Capital contribution to subsidiaries - (13,000,000) - Purchase of treasury stock, net .... (118,641) (278,241) (399,107) ----------- ----------- ----------- Net cash used in financing activities ..................... ( 3,230,538) (17,633,726) (4,930,691) ----------- ----------- ----------- Net (decrease) increase in cash ....... (31,456) 25,922 25,300 Cash at beginning of year ............. 66,870 40,948 15,648 ----------- ----------- ----------- Cash at end of year ................... $ 35,414 $ 66,870 $ 40,948 =========== =========== =========== Income taxes paid ..................... $ 14,000 $ 86,544 $ 120,544 Interest paid ......................... - - - EMC INSURANCE GROUP INC. AND SUBSIDIARIES Schedule V - Supplementary Insurance Information For Years Ended December 31, 1993, 1992 and 1991 EMC INSURANCE GROUP INC. AND SUBSIDIARIES Schedule VI - Reinsurance For years ended December 31, 1993, 1992, and 1991 EMC INSURANCE GROUP INC. AND SUBSIDIARIES Schedule X - Supplemental Insurance Information Concerning Property-Casualty Insurance Operations For Years Ended December 31, 1993, 1992 and 1991 Differences between Electronic and Circulated 10-K's - ---------------------------------------------------- 1) The index to exhibits in the electronic format indicates if the exhibits are included in the direct transmission or are filed under Form SE. The circulated document contains the page numbers of the exhibits.

63541_1993.txt

63541_1993

1993

63541

Item 1. Business. Maytag Corporation (the "Company") was organized as a Delaware corporation in 1925. In 1989, the Company completed the acquisition of Chicago Pacific Corporation ("CPC"), a furniture and international home appliance company, through a cash tender offer followed by a stock merger. CPC operated in two segments, home appliances and furniture; however, the Company later sold the furniture companies segment. The Company is engaged in two industry segments: home appliances and vending equipment. Financial and other information relating to industry segment and geographic data is included in Part II, Item 7 and Item 8. HOME APPLIANCES The home appliances segment comprises approximately 95% of 1993 consolidated net sales. The Company, through its various business units, manufactures and distributes a broad line of home appliances including laundry equipment, gas and electric ranges, refrigerators, freezers, dishwashers, and floor care products. In 1992, the Company sold its microwave oven and dehumidifier manufacturing operations. The Company continues to distribute microwave ovens and dehumidifiers, as well as compactors. Maytag Customer Service (formerly Maycor Appliance Parts & Service Co.) provides product service and parts distribution in the United States and Canada for all of the Company's appliance brands, except Hoover. Maytag International Inc., the Company's international marketing subsidiary, handles the sales of appliances and licensing of certain home appliance brands in markets outside the United States and Canada. Maytag Financial Services Corporation provides financing programs primarily to certain customers of the Company in North America. The Company markets its home appliances to all major United States and many major international markets, including the replacement market, the commercial laundry market, the new home and apartment builder market, the manufactured housing (mobile home) market, the recreational vehicle market, the private label market and the household/commercial floor care market. Products are primarily sold directly to dealers but are also sold through independent distributors, mass merchandisers and large national department stores. Sales of appliances to manufacturers of mobile homes and recreational vehicles are made directly by specialized marketing personnel. Most home appliance sales are made within North America. A portion of the Company's operations and sales are outside the United States. The risks involved in foreign operations vary from country to country and include tariffs, trade restrictions, changes in currency values, economic conditions and international relations. Geographic information is included in Part II, Item 8, Page 29. The Company uses basic raw materials such as steel, copper, aluminum, rubber and plastic in its manufacturing process in addition to purchased motors, compressors, timers, valves and other components. These materials are supplied by established sources and the Company anticipates that such sources will, in general, be able to meets its future requirements. The Company holds a number of patents which are important in the manufacture of its products. The licenses it holds on other patents are not considered to be critical to its business. The Company holds a number of trademark registrations of which the most important are ADMIRAL, HOOVER, JENN-AIR, MAGIC CHEF, MAYTAG, NORGE and the associated corporate symbols. The Company's home appliance business is not seasonal. The Company is not dependent upon a single home appliance customer or a few customers. Therefore, the loss of any one customer would not have a material adverse effect on its business. The dollar amount of backlog orders of the Company is not considered significant for home appliances in relation to the total annual dollar volume of sales. Because it is the Company's practice to maintain a level of inventory sufficient to cover anticipated shipments and since orders are generally shipped upon receipt, a large backlog would be unusual. The home appliance market is highly competitive with the principal competitors being larger than the Company. Because of continued competitiveness within the industry, price increases continue to be difficult to implement. There were no significant increases in the costs of the Company's raw materials or components in 1993. Information regarding the Company's improvement in gross margin over 1992 is included in Part II, Item 7. The Company uses product quality, customer service, advertising and sales promotion, warranty and pricing as its principal methods of competition. Although the Company has many manufacturing sites with environmental concerns, compliance with laws and regulations regarding the discharge of materials into the environment or relating to the protection of the environment has not had a material effect on capital expenditures, earnings or the Company's competitive position. The scheduled phase-out of chlorofluorocarbons ("CFCs", an aerosol propellant and refrigerant) by the mid-1990s, mandated by government standards, continues to cause concern throughout the refrigeration industry. In addition, alternative washing machine designs to meet anticipated future government regulations dealing with energy and water usage are being evaluated by the Company and the industry. Because compliance with these current and anticipated laws and regulations is essentially prospective, it has not had a significant impact on current operations. It is anticipated that the industry and the Company will meet all final standards. The number of employees of the Company within the home appliances segment as of December 31, 1993 was 19,661. VENDING EQUIPMENT The vending equipment segment comprises approximately 5% of 1993 consolidated net sales. The Company manufactures, through its Dixie-Narco subsidiary, a variety of soft drink vending machines and money changers. The products are sold primarily to companies bottling soft drinks such as Coca-Cola, Dr. Pepper, Pepsi Cola, Royal Crown Cola and Seven-Up. The Company uses steel as a basic raw material in its manufacturing processes in addition to purchased motors, compressors and other components made of copper, aluminum, rubber and plastic. These materials are supplied by established sources and the Company anticipates that such sources will, in general, be able to meet its future requirements. The Company holds a number of patents which are important in the manufacture of its products. The Company holds a DIXIE-NARCO trademark registration and its associated corporate symbol. Vending equipment sales, though stronger in the first six months of the year, are considered by the Company to be essentially nonseasonal. The Company's vending equipment segment is dependent upon a few major soft drink suppliers. Therefore, the loss of one or more of these customers could have a material adverse effect on this segment. The Company manufactures and sells its vending machines in competition with a small number of other manufacturers and is the major manufacturer of such equipment. The principal methods of competition utilized by the vending equipment segment are product quality, customer service, delivery, warranty and price. Positive factors pertaining to the Company's competitive position include product design, manufacturing efficiency and superior service, while new product innovations by competitors and severe price competition negatively impact its position. The dollar amount of backlog orders of the Company is not considered significant for vending equipment in relation to the total annual dollar volume of sales. Because it is the Company's practice to maintain a level of inventory sufficient to cover shipments and since orders are generally shipped upon receipt, a large backlog would be unusual. Although the Company has manufacturing sites with environmental concerns, compliance with laws and regulations regarding the discharge of materials into the environment or relating to the protection of the environment has not had a material effect on capital expenditures, earnings or the Company's competitive position. The scheduled phase-out of chlorofluorocarbons ("CFCs', an aerosol propellant and refrigerant) by the mid-1990s, mandated by government standards, will also not affect the production technology in the vending equipment industry. This has not had a significant impact on current operations, and it is anticipated that the industry and the Company will meet all final standards. The number of employees of the Company within the vending equipment segment as of December 31, 1993 was 1,136. Item 2. Item 2. Properties. The Company's corporate headquarters is located in Newton, Iowa. Major offices and manufacturing facilities in the United States related to the home appliances segment are located at: Galesburg, Illinois; Jackson, Tennessee; Indianapolis, Indiana; Cleveland, Tennessee; Herrin, Illinois; Newton, Iowa; North Canton, Ohio; and El Paso, Texas. Maytag Customer Service, which is located in Cleveland, Tennessee, operates an automated national parts distribution center in Milan, Tennessee which services all of the Company's appliance brands, except Hoover. In addition to manufacturing facilities in the United States, the Company has three other North American manufacturing facilities located in Canada and Mexico. The Company also has five manufacturing facilities outside North America in Australia, Portugal and the United Kingdom. A sixth manufacturing facility in Dijon, France was closed in 1993. Major facilities related to the vending equipment segment are: Dixie-Narco, Inc., with offices and manufacturing facilities located in Williston, South Carolina and Eastlake, Ohio. The manufacturing facilities are well maintained, suitably equipped and in good operating condition. The facilities used in the production of home appliances and vending equipment had sufficient capacity to meet production needs in 1993, and the Company expects that such capacity will be adequate for planned production in 1994. The Company's 1993 capital expenditures and the planned 1994 capital expenditures include an ongoing program of product improvements and enhanced manufacturing efficiencies. The Company also owns or leases sales offices in many large metropolitan areas throughout the United States, Australia, Canada, the United Kingdom and Western Europe. Lease commitments were not material at December 31, 1993. Item 3. Item 3. Legal Proceedings. The Company is involved in contractual disputes, environmental, administrative and legal proceedings and investigations of various types. Although any litigation, proceeding or investigation has an element of uncertainty, the Company believes that the outcome of any proceeding, lawsuit or claim which is pending or threatened, or all of them combined, will not have a material adverse effect on its consolidated financial position. Item 4. Item 4. Submission of Matters to a Vote of Security Holders. The Company did not submit any matters to a vote of security holders during the fourth quarter of 1993 through a solicitation of proxies or otherwise. Executive Officers of the Registrant The following sets forth the names of all executive officers of the Company, the offices held by them, the year they first became an officer of the Company and their ages: First Became Name Office Held an Officer Age - ----------------- ----------------------- ------------ --- Leonard A. Hadley Chairman and Chief Executive Officer 1979 59 John P. Cunningham Executive Vice President and Chief Financial Officer 1994 56 Joseph F. Fogliano Executive Vice President and President North American Appliance Group 1993 54 Jon O. Nicholas Senior Vice President, Human Resources 1993 54 Carleton F. Zacheis Senior Vice President, Planning 1988 60 and Business Development Terry A. Carlson Vice President, Purchasing 1991 51 Janis C. Cooper Vice President, Public 1989 46 Affairs Randall J. Espeseth Vice President, Taxes 1992 47 Mark A. Garth Vice President - Controller and Chief Accounting Officer 1994 34 Edward H. Graham Vice President, General Counsel 1990 58 and Assistant Secretary Douglass C. Horstman Vice President, Government Affairs 1993 54 John H. Jansen Vice President, Technology 1992 54 Thomas C. Vice President and Treasurer 1989 55 Ringgenberg Steven H. Wood Vice President, Information Services 1992 36 E. James Bennett Secretary and Assistant General Counsel 1985 52 The executive officers were elected to serve in the indicated office until the organizational meeting of the Board of Directors following the annual meeting of shareholders on April 26, 1994 or until their successors are elected. Each of the executive officers has served the Company or an acquired company in various executive or administrative positions for at least five years except for: Name Company/Position Period - -------------------- ---------------------------- -------- Terry A. Carlson Estee Lauder, Inc - Vice President, Corporate Purchasing 1987-1991 John P. Cunningham IBM Corporation - Vice President and Assistant General Manager, Main Frame Division 1992-1993 - Vice President, Member Europe Executive Committee, Paris, 1990-1992 France - Vice President, Corporate 1988-1990 Controller Joseph F. Fogliano Thomson Consumer Electronics, Inc. 1988-1993 - President and CEO Douglass C. Horstman D. C. Horstman & Associates (government affairs consulting firm) 1973-1993 - Owner/Operator John H. Jansen Ridge Tool Company (a division of Emerson Electric Company) - Vice President, Engineering 1985-1992 Steven H. Wood Ernst & Young, Chicago, Illinois - Senior Manager 1985-1989 Part II Item 5. Item 5. Market for Registrant's Common Equity and Related Stockholder Matters. MARKET AND DIVIDEND INFORMATION - ------------------------------------------------------------------------------- Sales Price of Common Shares Dividends In Whole Dollars Per Share ------------------------------------------ ---------------- 1993 1992 1993 1992 ----------------- ----------------- ---- ---- Quarter High Low High Low - ------- ---- --- ---- --- First $16 $13 $20 $15 $.125 $.125 Second 16 13 21 16 .125 .125 Third 18 15 18 13 .125 .125 Fourth 19 15 16 13 .125 .125 The principal U.S. market in which the Company's common stock is traded is the New York Stock Exchange. As of March 1, 1994 the Company had 32,334 shareowners of record. Item 6. Item 6. Selected Financial Data. Thousands of Dollars Except Per Share Data (1) (2) (3) 1993 1992 1991 1990 1989 ---------- ---------- ---------- ---------- ---------- Net sales $2,987,054 $3,041,223 $2,970,626 $3,056,833 $3,088,753 Cost of sales 2,262,942 2,339,406 2,254,221 2,309,138 2,312,645 Income taxes 38,600 15,900 44,400 60,500 75,500 Income (loss) from continuing operations 51,270 (8,354) 79,017 98,905 131,472 Percent of income (loss) from continuing operations to net sales 1.7% (.3%) 2.7% 3.2% 4.3% Income (loss) from continuing operations per share $ .48 $ (.08) $ .75 $ .94 $ 1.27 Dividends paid per share .50 .50 .50 .95 .95 Average shares outstanding (in thousands) 106,252 106,077 105,761 105,617 103,694 Working capital $ 406,181 $ 452,626 $ 509,025 $ 612,802 $ 650,905 Depreciation of property, plant and equipment 102,459 94,032 83,352 76,836 68,077 Additions to property, plant and equipment 99,300 129,891 143,372 141,410 127,838 Total assets 2,469,498 2,501,490 2,535,068 2,586,541 2,436,319 Long-term debt 724,695 789,232 809,480 857,941 876,836 Total debt to capitalization 60.6% 58.7% 45.9% 47.7% 50.6% Shareowners' equity per share of Common stock $ 5.50 $ 5.62 $ 9.50 $ 9.60 $ 8.89 (1) Includes $60.4 million in pretax charges ($50 million in a special charge and $10.4 million in selling, general and administrative expenses) for additional costs associated with two Hoover Europe "free flights" promotion programs. (2) Includes a $95 million pretax charge relating to the reorganization of the North American and European business units and before cumulative effect of accounting changes. (3) These amounts reflect the acquisition of Hoover on January 26, 1989. Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. _____________________________________________________________________________ COMPARISON OF 1993 WITH 1992 The Company operates in two business segments, home appliances and vending equipment. The operations of the home appliance segment represented 95.0 percent of net sales in 1993 and 1992. Consolidated net sales decreased 1.8 percent in 1993 compared to 1992. Although sales volumes in the United States increased due to improved consumer confidence, the overall decline in sales resulted from a decrease in European sales, less favorable currency conversions of sales outside the United States, and the absence of sales from the microwave oven operation that was sold in June 1992. North American home appliance sales increased 3.1 percent in spite of the absence of sales from the microwave oven operation. European sales decreased 22.1 percent from 1992 due to less favorable currency conversions and lower sales volumes due to some market share declines. Lower sales volumes in Europe are expected in 1994 compared to 1993. Sales in the Company's vending equipment segment declined 5.3 percent from 1992 due to slow economic activity in Europe, cutbacks by domestic bottlers and increased competition. Gross profit as a percent of sales increased to 24.2 percent from 23.1 percent in 1992. The increase in margins resulted principally from improvements in the North American Appliance Group. The improvement in the North American Appliance Group was primarily due to production efficiencies, reductions of certain employee-related costs and some selective price increases. In addition, 1992 results for the North American Appliance Group included plant start-up costs. Gross margins in Hoover Europe declined primarily due to operating inefficiencies associated with previously announced plans to close a factory in Dijon, France and higher pension costs. Vending equipment margins improved in 1993 due to reductions in material, distribution and warranty costs from 1992. In 1994, although consolidated pension and postretirement medical costs are expected to increase due to a reduction in the discount rate assumption and lower pension assets, this is expected to be offset by other cost reductions. Selling, general and administrative (S,G&A) expenses decreased to 17.2 percent in 1993 from 17.4 percent in 1992. The decline was principally due to cost efficiencies resulting from the reorganization of the North American Appliance Group. Special charges consisted of a $50 million pretax charge in the first quarter of 1993 to cover anticipated additional costs associated with two "free flights" promotional programs in Europe and a $95 million pretax charge in the third quarter of 1992 for a reorganization of U.S. and European operations. Total pretax charges relating to the "free flights" promotion programs in 1993 were $60.4 million ($50 million in a special charge and $10.4 million in S,G&A) and in 1992 were $12.2 million. See the notes to the financial statements for a discussion of this matter. Offsetting a portion of the 1993 European "free flights" expenses in S,G&A was a $5 million reversal of excess reorganization reserves in Europe. Operating income for 1993 totaled $158.9 million compared to $78.6 million in 1992. Before special charges, operating income would have been $208.9 million or 7.0 percent of sales in 1993 compared to $173.6 million or 5.7 percent of sales in 1992. The decrease in the effective tax rate for 1993 was primarily due to the 1992 tax rate reflecting the impact of non-recoverable losses outside the MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - continued _____________________________________________________________________________ United States. The notes to the financial statements include a reconciliation between the statutory tax and the actual tax provided. Excluding special charges in 1993 and 1992 and the cumulative effect of accounting changes in 1992, net income would have been $81.3 million or $.76 per share in 1993 compared to net income of $65.4 million or $.62 per share in 1992. In November 1992, the Financial Accounting Standards Board issued Statement No. 112 (FAS 112), "Employers' Accounting for Postemployment Benefits." The new rules require recognition of specified postemployment benefits provided to former or inactive employees, such as severance pay, workers' compensation, supplemental unemployment benefits, disability benefits and continuation of healthcare and life insurance coverages. The Company has estimated that the cumulative effect of adopting FAS 112, which will be recorded in the first quarter of 1994, will be between $.02-$.04 per share. The ongoing expenses associated with the adoption of the new rules are not expected to be material. _____________________________________________________________________________ COMPARISON OF 1992 WITH 1991 The Company operates in two business segments, home appliances and vending equipment. The operations of the home appliance segment represented 95.0 percent of net sales in 1992 and 1991. Effective January 1, 1992, the Company adopted Statement of Financial Accounting Standards No. 106 (FAS106) "Employers' Accounting for Postretirement Benefits Other than Pensions." FAS 106 requires companies to recognize the cost of postretirement benefits over an employee's service period. The Company's previous practice had been to recognize these costs as claims were received. The one-time transitional cost for adopting FAS106 resulted in an aftertax charge of $222 million or $2.09 per share in the first quarter of 1992. FAS106 also resulted in an additional pretax charge of approximately $24 million in 1992. Implementation of FAS106 had no impact on cash flows and the Company continues to pay the cost of postretirement benefits as claims are received. Also effective January 1, 1992, the Company adopted Statement of Financial Accounting Standards No. 109 (FAS109) "Accounting for Income Taxes." The adoption of FAS109 required a one-time aftertax charge of $85 million or $.80 per share. However, there was no cash flow impact of adopting the pronouncement since deferred taxes changed by a like amount. The one-time cumulative impact of adopting both FAS106 and FAS109 totaled $307 million or $2.89 per share. Consolidated net sales increased 2.4 percent in 1992 compared to 1991. The overall sales increase, although partially offset by lower prices, was due to market share gains in most product categories and increased volume as a result of improved consumer confidence in the United States. Sales of the Company's home appliances within North America increased 2.7 percent from 1991. While European sales were 1.3 percent higher in 1992 compared to 1991, the majority of the increase is due to favorable currency translation with volume remaining flat. The Company's vending sales increased 10.4 percent in 1992, primarily due to increased volume within the United States. Gross profit as a percent of sales decreased to 23.1 percent from 24.1 percent in 1991. The deterioration in margins was principally caused by additional expenses arising from the use of FAS106 as well as expenses related to a plant start-up, new product introductions and price reductions. Excluding FAS106 charges, gross profit as a percent of sales would have been 23.8 percent for 1992. Selling, general and administrative expenses as a percent of sales and MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - continued _____________________________________________________________________________ before reorganization remained relatively level at 17.4 percent in 1992 and 17.7 percent in 1991. The slight decrease was caused primarily by increased sales in 1992. During the third quarter of 1992, the Company provided for the costs of reorganizing its North American and European operations. In North America, several manufacturing facilities are being realigned, effectively combining expertise in research, engineering and product development. In addition, sales forces were reorganized and streamlined. The Company was also implementing a centralized distribution and order system for its North American operations designed to enhance customer service and operational efficiency. The effort in Europe was aimed at downsizing production capacity and streamlining sales, marketing, administration and distribution activities. This special charge reduced income before income taxes by $95 million or $.70 per share after tax. Operating income for 1992 amounted to $78.6 million compared to $191.5 million in 1991. Before the special reorganization charge, 1992 operating income would have been $173.6 million or 5.7 percent of sales, down $17.9 million or 9.4 percent from 1991. The net operating loss of the Company's European operations in 1992 increased $66.2 million from 1991 primarily due to a provision of $55 million for reorganization expenses relating to plant closings and other organizational changes and the continuing recession in the United Kingdom. The increase in the effective tax rate was primarily due to the effect of non-recoverable losses outside of the United States. The notes to the financial statements contain a reconciliation between the statutory tax and the actual tax provided. Excluding the cumulative effect of accounting changes and reorganization expenses, for comparative purposes, net income would have been $65.4 million or $.62 per share compared to net income of $79 million or $.75 per share in 1991. _____________________________________________________________________________ LIQUIDITY AND CAPITAL RESOURCES Cash provided by operations in 1993 totaled $71.3 million compared to $183.1 million in 1992. The overall decrease resulted from the funding of expenditures relating to the reorganization of the North American and European operations, the Hoover Europe "free flights" promotions and working capital needs in the North American Appliance Group. Offsetting this decrease was a $42 million withdrawal from an over-funded pension plan in Europe and lower funding of an employee benefit trust. Current assets were 1.6 times current liabilities at December 31, 1993 and 1.8 times at December 31, 1992. Gross capital expenditures in 1993 were $99.3 million compared to $129.9 million in 1992. The expenditures in 1993 were mainly related to improvements in product design and manufacturing processes and increases in manufacturing capacity. Capital spending in 1992 was higher as it included major plant start-up projects. Planned capital expenditures for 1994 approximate $110 million and relate to ongoing production improvements and product enhancements. Depreciation expense increased to $102.5 million in 1993 from $94.0 million in 1992 resulting from major capital projects completed near the end of 1992. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - continued _____________________________________________________________________________ Significant investing and financing transactions related to capital expenditures, debt retirement and dividend payments were funded through operations and the issuance of $5.5 million in medium term notes and a $139.0 million increase in notes payable and commercial paper borrowings. The Company also reduced long term debt by $94.4 million during 1993. The Company has two credit facilities which support the Company's commercial paper program. Subject to certain exceptions, the credit agreements require the Company to maintain certain quarterly levels of consolidated tangible net worth, leverage ratios and interest coverage ratios. The Company was in compliance with all covenants at December 31, 1993 and expects to be in compliance with all covenants. The covenants become more stringent commencing in the first quarter of 1994. Additional funds available at December 31, 1993 under all credit agreements, applying the terms of the most restrictive covenant above, totaled $243 million. Dividend payments in both 1993 and 1992 amounted to $53 million or $.50 per share. Dividends amounted to nine percent of average shareowners' equity in 1993 and seven percent in 1992. Any funding requirements for future capital expenditures and other cash requirements in excess of cash generated from operations will be supplemented with issuance of debt securities and bank borrowings. _____________________________________________________________________________ IMPACT OF INFLATION The Company uses the LIFO method of accounting for approximately 79 percent of its inventories. Under this method, the cost of sales reported in the financial statements approximates current costs. The charges to operations for depreciation represent the allocation of historical costs incurred over past years and are significantly less than if they were based upon current costs of productive capacity being consumed. Assets acquired in prior years will, of course, be replaced at higher costs but this will take place over several years. New higher-cost assets will result in higher depreciation charges, but in many cases due to technological improvements, there will be operating cost savings as well. Item 8. Item 8. Financial Statements and Supplementary Data. Page ---- Report of Independent Auditors 13 Statements of Consolidated Income--Years ended December 31, 1993, 1992 and 1991 14 Statements of Consolidated Financial Condition-- December 31, 1993 and 1992 15 Statements of Consolidated Cash Flows--Years ended December 31, 1993, 1992 and 1991 17 Notes to Consolidated Financial Statements 18 Quarterly Results of Operations--Years 1993 and 1992 30 Report of Independent Auditors Shareowners and Board of Directors Maytag Corporation We have audited the accompanying statements of consolidated financial condition of Maytag Corporation and subsidiaries as of December 31, 1993 and 1992, and the related statements of consolidated income 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 Item 14(a). These financial statements and related schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and related schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. These 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 Maytag 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. 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 notes to consolidated financial statements, in 1992 the Company changed its method of accounting for postretirement benefits other than pensions and income taxes. Ernst & Young February 1, 1994 Chicago, Illinois STATEMENTS OF CONSOLIDATED INCOME (LOSS) Thousands of Dollars Except Per Share Data Year ended December 31 1993 1992 1991 --------- --------- --------- Net sales $2,987,054 $3,041,223 $2,970,626 Cost of Sales 2,262,942 2,339,406 2,254,221 --------- --------- --------- GROSS PROFIT 724,112 701,817 716,405 Selling, general and administrative expenses 515,234 528,250 524,898 Special charges 50,000 95,000 --------- --------- --------- OPERATING INCOME 158,878 78,567 191,507 Interest expense (75,364) (75,004) (75,159) Other--net 6,356 3,983 7,069 --------- --------- --------- INCOME BEFORE INCOME TAXES AND CUMULATIVE EFFECT OF ACCOUNTING CHANGES 89,870 7,546 123,417 Income taxes 38,600 15,900 44,400 --------- --------- --------- INCOME (LOSS) BEFORE CUMULATIVE EFFECT OF ACCOUNTING CHANGES 51,270 (8,354) 79,017 Cumulative effect of accounting changes for postretirement benefits other than pensions and income taxes (307,000) --------- --------- -------- NET INCOME (LOSS) $ 51,270 $ (315,354) $ 79,017 ========= ========= ======== Income (loss) per average share of Common stock: Income (loss) before cumulative effect of accounting changes $ .48 $ (.08) $ .75 Cumulative effect of accounting changes $ (2.89) Net income (loss) per Common share $ .48 $ (2.97) $ .75 See notes to consolidated financial statements. STATEMENTS OF CONSOLIDATED FINANCIAL CONDITION Thousands of Dollars December 31 -------------------- ASSETS 1993 1992 - ------ --------- --------- CURRENT ASSETS Cash and cash equivalents $ 31,730 $ 57,032 Accounts receivable, less allowance-- (1993--$15,629; 1992--$16,380) 532,353 476,850 Inventories 429,154 401,083 Deferred income taxes 46,695 52,261 Other current assets 16,919 28,309 ---------- ---------- Total current assets 1,056,851 1,015,535 NONCURRENT ASSETS Deferred income taxes 68,559 71,442 Pension investments 168,103 215,433 Intangibles, less allowance for amortization-- (1993--$46,936; 1992--$37,614) 319,657 328,980 Other noncurrent assets 35,266 35,989 ----------- ---------- Total noncurrent assets 591,585 651,844 PROPERTY, PLANT AND EQUIPMENT Land 46,149 47,370 Buildings and improvements 288,590 286,368 Machinery and equipment 1,068,199 962,006 Construction in progress 44,753 90,847 ---------- ---------- 1,447,691 1,386,591 Less allowance for depreciation 626,629 552,480 ---------- ---------- Total property, plant and equipment 821,062 834,111 ---------- ---------- TOTAL ASSETS $2,469,498 $2,501,490 ========== ========== December 31 ---------------------- LIABILITIES AND SHAREOWNERS' EQUITY 1993 1992 ---------- ---------- CURRENT LIABILITIES Notes payable $ 157,571 $ 19,886 Accounts payable 195,981 218,142 Compensation to employees 84,405 89,245 Accrued liabilities 178,015 180,894 Income taxes payable 16,193 11,323 Current maturities of long-term debt 18,505 43,419 --------- ---------- Total current liabilities 650,670 562,909 NONCURRENT LIABILITIES Deferred income taxes 44,882 89,011 Long-term debt 724,695 789,232 Postretirement benefits other than pensions 391,635 380,376 Other noncurrent liabilities 70,835 80,737 --------- ---------- Total noncurrent liabilities 1,232,047 1,339,356 SHAREOWNERS' EQUITY Common stock: Authorized--200,000,000 shares (par value $1.25) Issued--117,150,593 shares, including shares in treasury 146,438 146,438 Additional paid-in capital 480,067 478,463 Retained earnings 325,823 328,122 Cost of Common stock in treasury (1993--10,430,833 shares; 1992--10,545,915 shares) (232,510) (234,993) Employee stock plans (62,342) (65,638) Foreign currency translation (70,695) (53,167) --------- ---------- Total shareowners' equity 586,781 599,225 --------- ---------- TOTAL LIABILITIES AND SHAREOWNERS' EQUITY $2,469,498 $2,501,490 ========= ========= See notes to consolidated financial statements. STATEMENTS OF CONSOLIDATED CASH FLOWS Thousands of Dollars Year ended December 31 ------------------------------ 1993 1992 1991 -------- -------- -------- OPERATING ACTIVITIES Net income (loss) $ 51,270 $(315,354) $ 79,017 Adjustments to reconcile net income (loss) to net cash provided by operating activities: Cumulative effect of accounting changes 307,000 Depreciation and amortization 111,781 103,351 92,667 Deferred income taxes (35,833) (30,210) 1,700 Reorganization expenses (5,000) 95,000 "Free flights" promotion expenses 60,379 12,235 Changes in selected working capital items: Inventories (29,323) 80,731 37,075 Receivables and other current assets (48,609) (6,051) 12,867 Reorganization reserve (39,671) (15,530) "Free flights" promotion reserve (42,981) (1,604) Other current liabilities (17,383) (70,422) 46,623 Net change in pension assets and liabilities 43,513 (12,149) (22,385) Postretirement benefits 11,259 21,254 Other--net 11,913 14,814 (12,894) --------- -------- -------- NET CASH PROVIDED BY OPERATIONS 71,315 183,065 234,670 INVESTING ACTIVITIES Capital expenditures--net (95,990) (120,364) (138,100) --------- -------- -------- TOTAL INVESTING ACTIVITIES (95,990) (120,364) (138,100) FINANCING ACTIVITIES Proceeds from credit agreements and long-term borrowings 5,500 73,712 57,900 Increase (decrease) in notes payable 138,951 (2,378) (31,023) Reduction in long-term debt (94,449) (70,158) (92,832) Stock options exercised and other Common stock transactions 5,903 5,558 3,421 Dividends (53,569) (53,269) (53,150) --------- --------- -------- TOTAL FINANCING ACTIVITIES 2,336 (46,535) (115,684) Effect of exchange rates on cash (2,963) (7,886) (1,721) INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS (25,302) 8,280 (20,835) Cash and cash equivalents at beginning of year 57,032 48,752 69,587 --------- --------- -------- CASH AND CASH EQUIVALENTS AT END OF YEAR $ 31,730 $ 57,032 $ 48,752 ========= ======== ========= See notes to consolidated financial statements. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS ______________________________________________________________________ SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: Principles of Consolidation: The consolidated financial statements include the accounts and transactions of the Company and its wholly owned subsidiaries. Certain subsidiaries located outside the United States are consolidated as of a date one month earlier than subsidiaries in the United States. Intercompany accounts and transactions are eliminated in consolidation. Exchange rate fluctuations from translating the financial statements of subsidiaries located outside the United States into U.S. dollars and exchange gains and losses from designated foreign currency transactions are recorded in a separate component of shareowners' equity. All other foreign exchange gains and losses are included in income. Certain reclassifications have been made to prior years' financial statements to conform with the 1993 presentation. Cash Equivalents: Highly liquid investments with a maturity of 90 days or less when purchased are considered by the Company to be cash equivalents. Inventories: Inventories are stated at the lower of cost or market. Cost is determined by the last-in, first-out (LIFO) method for approximately 79% and 76% of the Company's inventories at December 31, 1993 and 1992. The remaining inventories, which are primarily outside the United States, are stated using the first-in, first-out (FIFO) method. Intangibles: Intangibles principally represent goodwill, which is the cost of business acquisitions in excess of the fair value of identifiable net tangible assets. Goodwill is amortized over 40 years on the straight-line basis and the carrying value is reviewed annually. If this review indicates that goodwill will not be recoverable as determined based on the undiscounted cash flows of the entity acquired over the remaining amortization period, the Company's carrying value of the goodwill will be reduced by the estimated shortfall of cash flows. Income Taxes: Certain expenses (principally related to accelerated tax depreciation, employee benefits and various other accruals) are recognized in different periods for financial reporting and income tax purposes. Property, Plant and Equipment: Property, plant and equipment is stated on the basis of cost. Depreciation expense is calculated principally on the straight-line method for financial reporting purposes. The depreciation methods are designed to amortize the cost of the assets over their estimated useful lives. Short and Long-Term Debt: The carrying amounts of the Company's borrowings under its short-term revolving credit agreements, including multicurrency loans, approximate their fair value. The fair values of the Company's long- term debt are estimated based on quoted market prices of comparable instruments. - ------------------------------------------------------------------------------ INVENTORIES In thousands 1993 1992 -------- -------- Finished products $282,841 $249,289 Work in process, raw materials and supplies 146,313 151,794 -------- -------- $429,154 $401,083 ======== ======== If the first-in, first-out (FIFO) method of inventory accounting, which approximates current cost, had been used for all inventories, they would have been $76.3 million and $78.1 million higher than reported at December 31, 1993 and 1992. ___________________________________________________________________________ PENSION BENEFITS The Company and its subsidiaries have noncontributory defined benefit pension plans covering most employees. Plans covering salaried and management employees generally provide pension benefits that are based on an average of the employee's earnings and credited service. Plans covering hourly employees generally provide benefits of stated amounts for each year of service. The Company's funding policy is to contribute amounts to the plans sufficient to meet minimum funding requirements. A summary of the components of net periodic pension expense (income) for the defined benefit plans is as follows: Year ended December 31 -------------------------------- In thousands 1993 1992 1991 --------- ---------- --------- Service cost--benefits earned during the period $ 24,067 $ 21,469 $ 23,520 Interest cost on projected benefit obligation 90,322 87,654 85,325 Actual return on plan assets (167,539) (87,263) (141,918) Net amortization and deferral 59,315 (25,239) 23,602 --------- --------- --------- Net pension expense (income) $ 6,165 $ (3,379) $ (9,471) ========= ========= ========= The change in pension expense (income) from 1992 to 1993 resulted from pension benefit improvements, a reduction in the discount rate and lower expected return on assets resulting from lower asset values at the beginning of the year. Assumptions used in determining net periodic pension expense (income) for the defined benefit plans in the United States were: 1993 1992 1991 ---- ---- ---- Discount rates 8.5% 9% 9% Rates of compensation increase 6 6 6 Expected long-term rates of return on assets 9.5 9.5 9.5 For the valuation of pension obligations at the end of 1993 and for determining pension expense in 1994, the discount rate and rate of compensation increase have been decreased to 7.5% and 5.0% respectively. Assumptions for defined benefit plans outside the United States are comparable to the above in all periods. As of December 31, 1993, approximately 87% of the plan assets are invested in listed stocks and bonds. The balance is invested in real estate and short term investments. Certain pension plans in the United States provide that in the event of a change of Company control and plan termination, any excess funding may be used only to provide pension benefits or to fund retirees' health care benefits. The use of all pension assets for anything other than providing employee benefits is either limited by legal restrictions or subject to severe taxation. The following table sets forth the funded status and amounts recognized in the statements of consolidated financial condition for the Company's defined benefit pension plans: Pension investments above of approximately $104 million and $142 million at December 31, 1993 and 1992, and pension income of $5.4 million, $10.9 million and $7.1 million in 1993, 1992 and 1991 relate to pension plans covering employees in Europe. In 1993 and 1992, the Company recorded $4.9 million and $4.5 million, respectively, to recognize the minimum pension liability required by the provisions of Statement of Financial Accounting Standards No. 87, "Employers' Accounting for Pensions." The transaction, which had no effect on income, was offset by recording an intangible asset of an equivalent amount. ____________________________________________________________________________ POSTRETIREMENT BENEFITS OTHER THAN PENSIONS In addition to providing pension benefits, the Company provides postretirement health care and life insurance benefits for its employees in the United States. Most of the postretirement plans are contributory, and contain certain other cost sharing features such as deductibles and coinsurance. The plans are unfunded. Employees are not vested and these benefits are subject to change. Death benefits for certain retired employees are funded as part of, and paid out of, pension plans. In 1992, the Company adopted Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," which requires employers to accrue the cost of such retirement benefits during the employee's service with the Company. Prior to 1992, the cost of providing these benefits to retired employees was recognized as a charge to income as claims were received. The transition obligation of $355 million as of January 1, 1992 was recorded as a one-time charge in the first quarter of 1992 and reduced net income by $222 million or $2.09 per share. The ongoing effect of adopting the new standard increased 1993 and 1992 periodic postretirement benefit cost by $11.3 and $23.9 million respectively. Postretirement benefit costs in 1991 of approximately $11.7 million were recorded on a cash basis and have not been restated. A summary of the components of net periodic postretirement benefit cost is as follows: In thousands 1993 1992 ------- ------- Service cost $10,225 $ 8,258 Interest cost 26,939 30,421 Net amortization and deferral (8,228) 2,106 ------- ------- Net periodic postretirement benefit cost $28,936 $40,785 ======= ======= Postretirement benefit costs for 1993 decreased primarily due to a plan amendment to eligibility requirements. Assumptions used in determining net periodic postretirement benefit cost were: 1993 1992 Health care cost trend rates (1): ---- ---- Current year 14% 15% Decreasing gradually to 6% 6% Until the year 2009 2009 Each year thereafter 6% 6% Discount rates 8.5% 9.0% (1) Weighted-average annual assumed rate of increase in the per capita cost of covered benefits. For the valuation of the accumulated benefit obligation at December 31, 1993 and for determining postretirement benefit costs in 1994, the health care cost trend rates were decreased. This results in a health care cost trend rate of 12.5 percent in 1994, decreasing gradually to 6 percent until 2001 and remaining at that level thereafter. In addition, the discount rate was reduced to 7.5 percent. The health care cost trend rate assumption has a significant impact on the amounts reported. For example, 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 $43.6 million and the aggregate of the service and interest cost components of net periodic postretirement benefit cost for 1993 by $5.9 million. The following table presents the status of the plans reconciled with amounts recognized in the statements of consolidated financial condition for the Company's postretirement benefits. December 31 ---------------- 1993 1992 In thousands ---- ---- Accumulated postretirement benefit obligation: Retirees $284,524 $189,764 Fully eligible active plan participants 58,709 60,236 Other active plan participants 56,465 76,587 -------- -------- 399,698 326,587 Unamortized plan amendment 54,248 62,476 Unrecognized net loss (62,311) (8,687) Postretirement benefit liability recognized in the -------- -------- the statements of consolidated financial condition $391,635 $380,376 ======== ======== __________________________________________________________________________ OTHER EMPLOYEE BENEFITS The Company has a leveraged employee stock ownership plan (ESOP) for eligible United States employees. The ESOP is designed to fund the Company's contribution to an existing salaried savings plan. The Company made contributions to the plan of $5.5 million, $5.2 million and $4.9 million for loan payments in 1993, 1992 and 1991, the majority of which represents interest on the ESOP debt. With each loan and interest payment, a portion of the Common stock in the ESOP becomes available for allocation to participating employees. The Company also sponsors other defined contribution plans. Contributions to these plans are generally based on employees' compensation. Expenses of the Company related to these plans, including the ESOP, amounted to $8.6 million in 1993, $7.9 million in 1992 and $7.8 million in 1991. In November 1992, the Financial Accounting Standards Board issued Statement No. 112 (FAS 112), "Employers' Accounting for Postemployment Benefits." The new rules require recognition of specified postemployment benefits provided to former or inactive employees, such as severance pay, workers' compensation, supplemental employment benefits, disability benefits and continuation of healthcare and life insurance coverages. The Company has estimated the cumulative effect of adopting FAS 112, which will be recorded in the first quarter of 1994, will not have a material impact on the annual results for 1994. The ongoing expenses associated with the new statement are not expected to be material. ______________________________________________________________________________ ACCRUED LIABILITIES In thousands 1993 1992 ------ ------ Warranties $ 46,281 $ 50,877 Advertising/sales promotion 51,946 30,054 Other 79,788 99,963 ------ ------ $178,015 $180,894 ======= ======= ______________________________________________________________________________ INCOME TAXES Effective January 1, 1992, the Company adopted Statement of Financial Accounting Standards 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 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. Prior to 1992, the provision for income taxes was based on income and expenses included in the accompanying consolidated statements of income. As permitted under the new rules, prior years' financial statements have not been restated. The cumulative effect of adopting Statement 109 was to decrease net income by $85 million or $.80 per share as of January 1, 1992. At December 31, 1993, the Company has available for tax purposes approximately $177 million of net operating loss carryforwards outside the United States, of which $38 million expire in various years through 1999 and $139 million is available indefinitely. Of this amount, $30 million relates to pre-acquisition net operating losses which will be used to reduce intangibles when utilized. Deferred income taxes reflect the net tax effects of temporary differences between the amount 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 December 31, 1993 and 1992 are as follows: In thousands 1993 1992 ---------- --------- Deferred tax assets (liabilities): Tax over book depreciation $(118,973) $(116,725) Postretirement benefit obligation 151,424 143,197 Product warranty accruals 20,021 20,221 Pensions and other employee benefits (38,753) (58,704) Reorganization accrual 8,856 23,586 Net operating loss carryforwards 48,817 23,178 Other 14,937 15,812 --------- --------- 86,329 50,565 Less valuation allowance for deferred tax assets (15,957) (15,873) --------- --------- Net deferred tax assets $ 70,372 $ 34,692 Recognized in statements of consolidated ========= ========= financial condition: Deferred tax assets-current $ 46,695 $ 52,261 Deferred tax assets-noncurrent 68,559 71,442 Deferred tax liabilities (44,882) (89,011) --------- --------- Net deferred tax assets $ 70,372 $ 34,692 ========= ========= Income (loss) before income taxes and cumulative effect of accounting changes consists of the following: Year ended December 31 ------------------------------- In thousands 1993 1992 1991 ------- ------ ------ United States $162,554 $ 80,013 $112,988 Non-United States (72,684) (72,467) 10,429 ------- ------- ------- $ 89,870 $ 7,546 $123,417 ======= ======= ======= Significant components of the provision for income taxes are as follows: Year ended December 31 ---------------------------- In thousands 1993 1992 1991 Current provision: ---- ---- ---- Federal $ 51,700 $ 37,000 $ 28,600 State 9,100 7,100 6,000 Non-United States 20,000 2,000 8,100 ------ ------ ------ 80,800 46,100 42,700 Deferred provision: Federal 400 (13,800) 7,600 State 700 (3,100) Non-United States (43,300) (13,300) (5,900) ------ ------ ------ (42,200) (30,200) 1,700 ------ ------ ------ Provision for income taxes $ 38,600 $ 15,900 $ 44,400 ====== ====== ====== Significant items impacting the effective income tax rate follow: Year ended December 31 ------------------------------- In thousands 1993 1992 1991 ------ ------ ------ Income before cumulative effect of accounting changes computed at the statutory United States income tax rate $31,500 $ 2,600 $42,000 Increase (reduction) resulting from: Acquisitions: Intangibles amortization 3,200 3,100 3,100 Depreciation 2,400 The effect of statutory rate differences outside the United States 2,500 2,600 600 Non-United States losses with no tax benefit 10,700 State income taxes, net of federal tax benefit 6,400 2,700 4,000 Tax credits arising outside the United States (800) (5,400) (7,300) Effect of tax rate changes on deferred taxes (2,500) Other-net (1,700) (400) (400) -------- ------- ------- Provision for income taxes $38,600 $15,900 $44,400 ======== ======= ======= Since the Company plans to continue to finance expansion and operating requirements of subsidiaries outside the United States through reinvestment of the undistributed earnings of these subsidiaries (approximately $81 million at December 31, 1993), taxes which would result from distribution have not been provided on such earnings. If such earnings were distributed, additional taxes payable would be significantly reduced by available tax credits arising from taxes paid outside the United States. Income taxes paid, net of refunds received, during 1993, 1992 and 1991 were $68.3 million, $28.5 million, and $34.5 million, respectively. ______________________________________________________________________________ LONG-TERM DEBT AND NOTES PAYABLE In thousands The following sets forth the long-term debt in the statements of consolidated financial condition: 1993 1992 Notes payable with interest payable semiannually: Due May 15, 2002 at 9.75% $200,000 $200,000 Due July 15, 1999 at 8.875% 175,000 175,000 Due July 1, 1997 at 8.875% 100,000 100,000 Medium-term notes, maturing from 1994 to 2010, from 7.69% to 9.03% with interest payable semiannually 177,750 197,250 Employee stock ownership plan notes payable semiannually through July 2, 2004 at 9.35% 59,129 60,307 Multicurrency loans at 5.4% to 9.475% 63,631 Other 31,321 36,463 --------- -------- 743,200 832,651 Less current portion 18,505 43,419 --------- -------- $724,695 $789,232 ========= ======== The 9.75% notes, the 8.875% notes due in 1999 and the medium-term notes grant the holders the right to require the Company to repurchase all or any portion of their notes at 100% of the principal amount thereof, together with accrued interest, following the occurrence of both a change in Company control and a credit rating decline. The Company has established a trust to administer a leveraged employee stock ownership plan (ESOP) within an existing employee savings plan. The Company has guaranteed the debt of the trust and will service the repayment of the notes, including interest, through the Company's employee savings plan contribution and from the quarterly dividends paid on stock held by the ESOP. Dividends paid by the Company on stock held by the ESOP totaled $1.4 million in 1993, 1992 and 1991. The ESOP notes are secured by the Common stock owned by the ESOP trust. The fair value of the Company's long-term debt, based on public quotes if available, exceeded the amount recorded in the statements of consolidated financial condition at December 31, 1993 and 1992 by $83.7 million and $50 million, respectively. Notes payable at December 31, 1993 and 1992 consisted of notes payable to banks, in addition to $112 million in commercial paper borrowings at December 31, 1993. The Company's commercial paper program is supported by two credit agreements totaling $300 million, which were entered into on June 25, 1993. The $100 million agreement expires June 24, 1994 and the $200 million agreement expires June 25, 1996. Subject to certain exceptions, the credit agreements require the Company to maintain certain quarterly levels of consolidated tangible net worth, leverage ratios and interest coverage ratios. At December 31, 1993, the Company was in compliance with all covenants. Additional funds available at December 31, 1993 under all credit agreements, applying the terms of the most restrictive covenant, totaled $243 million. Interest paid during 1993, 1992 and 1991 was $76.2 million, $77.4 million, and $78.4 million. The aggregate maturities of long-term debt in each of the next five fiscal years is as follows (in thousands): 1994- $18,505; 1995-$45,185; 1996-$5,308; 1997-$106,535; 1998-$7,147. ______________________________________________________________________________ STOCK PLANS In 1992, the shareowners approved the 1992 stock option plan for executives and key employees. The plan provides that options could be granted to key employees for not more than 3.6 million shares of the Common stock of the Company. The option price under the plan is the fair market value at the date of the grant. Options may not be exercised until one year after the date granted. Under the Company's 1986 plan which expired in 1991, options to purchase 1.6 million shares of Common stock were granted at the market value at the date of grant. Some options were also granted under this plan with stock appreciation rights (SAR) which entitle the employee to surrender the right to receive up to one-half of the shares covered by the option and to receive a cash payment equal to the difference between the option price and the market value of the shares being surrendered. Under a plan which expired in 1986, options to purchase 800,000 shares of Common stock were granted at the market value at date of grant. In April 1990, the Company's shareowners approved the Maytag Corporation 1989 Stock Option Plan for Non-Employee Directors which authorizes the issuance of up to 250,000 shares of Common stock to the Company's non-employee directors. Options under this plan are immediately exercisable upon grant. The following is a summary of certain information relating to these plans: Average Option Price Shares SAR ------- ------- ------- Outstanding December 31, 1990 $14.81 966,851 459,131 Granted 14.76 885,920 246,240 Exercised 10.49 (7,526) Canceled or expired 17.59 (18,450) (12,988) --------- ------- Outstanding December 31, 1991 14.76 1,826,795 692,383 Granted 14.54 411,910 Exercised 9.86 (179,736) (11,192) Exchanged for SAR 11.16 (11,192) Canceled or expired 12.63 (34,640) (93,242) --------- ------- Outstanding December 31, 1992 15.09 2,013,137 587,949 Granted 15.92 599,060 Exercised 12.89 (101,156) (5,360) Exchanged for SAR 12.53 (5,360) Canceled or expired 16.26 (147,080) (85,728) --------- ------- Outstanding December 31, 1993 15.33 2,358,601 496,861 ========= ======= Options for 1,777,361 shares, 1,623,227 shares and 964,875 shares were exercisable at December 31, 1993, 1992 and 1991. There were 2,784,030 shares available for future grants at December 31, 1993. In the event of a change in Company control, all stock options granted become immediately exercisable. In 1991, the shareowners approved the 1991 Stock Incentive Award Plan For Key Executives. This plan authorizes the issuance of up to 2.5 million shares of Common stock to certain key employees of the Company, of which 1,980,338 shares are available for future grants as of December 31, 1993. Under the terms of the plan, the granted stock vests three years after the award date and is contingent upon pre-established performance objectives. In the event of a change in Company control, all incentive stock awards become fully vested. No incentive stock awards may be granted under this plan on or after May 1, 1996. Incentive stock award shares outstanding at December 31, 1993 under a 1993 grant total 459,957, and $3.6 million has been expensed during 1993 for the the anticipated payout on these awards. Under a 1991 grant which expired in 1993, 53,068 shares are vested and outstanding and $1.1 million has been expensed during 1993. No amounts were expensed in 1992 and 1991 under these awards. ______________________________________________________________________________ SHAREOWNERS' EQUITY The Company has 24 million authorized shares of Preferred stock, par value $1 per share, none of which is issued. Pursuant to a Shareholder Rights Plan approved by the Company in 1988, each share of Common stock carries with it one Right. Until exercisable, the Rights will not be transferable apart from the Company's Common stock. When exercisable, each Right will entitle its holder to purchase one one-hundredth of a share of Preferred stock of the Company at a price of $75. The Rights will only become exercisable if a person or group acquires 20% or more of the Company's Common stock which may be reduced to not less than 10% at the discretion of the Board of Directors. In the event the Company is acquired in a merger or 50% or more of its consolidated assets or earnings power are sold, each Right entitles the holder to purchase Common stock of either the surviving or acquired company at one-half its market price. The Rights may be redeemed in whole by the Company at a purchase price of $.01 per Right. The Preferred shares will be entitled to 100 times the aggregate per share dividend payable on the Company's Common stock and to 100 votes on all matters submitted to a vote of shareowners. The Rights expire May 2, 1998. ______________________________________________________________________________ INDUSTRY SEGMENT AND GEOGRAPHIC INFORMATION Principal financial data by industry segment is as follows: In thousands 1993 1992 1991 Net Sales --------- --------- --------- Home appliances $2,830,457 $2,875,902 $2,820,828 Vending equipment 156,597 165,321 149,798 --------- --------- --------- Total $2,987,054 $3,041,223 $2,970,626 ========= ========= ========= Income (Loss) Before Income Taxes and Cumulative Effect of Accounting Changes Home appliances $ 160,431 $ 62,568 $ 187,018 Vending equipment 17,566 16,311 4,498 Corporate (including interest expense) (88,127) (71,333) (68,099) --------- --------- --------- Total $ 89,870 $ 7,546 $ 123,417 ========= ========= ========= Capital Expenditures-net Home appliances $ 92,194 $ 115,676 $ 133,504 Vending equipment 1,028 771 4,612 Corporate 2,768 3,917 (16) --------- --------- --------- Total $ 95,990 $ 120,364 $ 138,100 ========= ========= ========= Depreciation and Amortization Home appliances $ 105,916 $ 98,116 $ 86,928 Vending equipment 4,377 4,236 4,805 Corporate 1,488 999 934 --------- --------- --------- Total $ 111,781 $ 103,351 $ 92,667 ========= ========= ========= Identifiable Assets Home appliances $2,147,174 $2,135,961 $2,200,227 Vending equipment 103,765 104,119 119,752 Corporate 218,559 261,410 215,089 --------- --------- --------- Total $2,469,498 $2,501,490 $2,535,068 ========= ========= ========= Information about the Company's operations in different geographic locations is as follows: In thousands 1993 1992 1991 Net Sales --------- --------- --------- North America $2,468,374 $2,407,591 $2,332,365 Europe 390,761 501,857 495,517 Other 127,919 131,775 142,744 --------- --------- --------- Total $2,987,054 $3,041,223 $2,970,626 ========= ========= ========= Income (Loss) Before Income Taxes and Cumulative Effect of Accounting Changes North America $ 246,981 $ 145,991 $ 190,820 Europe (72,358) (67,061) (865) Other 3,374 (51) 1,561 Corporate (including interest expense) (88,127) (71,333) (68,099) --------- --------- --------- Total $ 89,870 $ 7,546 $ 123,417 ========= ========= ========= Identifiable Assets North America $1,794,271 $1,677,131 $1,681,304 Europe 359,323 452,995 507,746 Other 97,345 109,954 130,929 Corporate 218,559 261,410 215,089 --------- ---------- --------- Total $2,469,498 $2,501,490 $2,535,068 ========= ========= ========= Sales between affiliates of different geographic regions are not significant. The amount of exchange gain or loss included in operations in any of the years presented was not material. In 1993 the Company incurred $60.4 million in pretax charges for two "free flights" promotion programs in Europe ($50 million in a special charge and $10.4 million in selling, general and administrative expenses). In 1992 the Company incurred $95 million of reorganization expenses for marketing and distribution changes in North America and plant closings and other organizational changes in Europe. Of the $95 million allocated to Home Appliances, $40 million was allocated to North America and $55 million to Europe. _____________________________________________________________________________ CONTINGENT LIABILITIES In 1993 and 1992, the Company made provisions to cover the cost of two Hoover Europe "free flights" promotion programs, including a $50 million special charge in the first quarter of 1993. The promotions began in August, 1992 and included qualified purchases through January, 1993. The terms of the promotions require all flights to be completed by the end of the second quarter of 1994. The Company believes that it has made adequate provisions for any costs to be incurred relating to these promotions. Although the final costs of the promotions cannot be determined at this time, management does not believe that any additional costs that may be incurred will have a material adverse effect on the financial condition of the Company. At December 31, 1993, the Company is contingently liable for guarantees of indebtedness owed by a third party ("the borrower") of $21.3 million relating to the sale of one of its manufacturing facilities in 1992. The borrower is performing under the payment terms of the loan agreement; however, it had been out of compliance with certain financial covenants at December 31, 1993 for which it has requested a waiver from the lender involved. The indebtedness is collateralized by the assets of the borrower. Other contingent liabilities arising in the normal course of business, including guarantees, repurchase agreements, pending litigation, environmental issues, taxes and other claims are not considered to be material in relation to the Company's financial position. QUARTERLY RESULTS OF OPERATIONS (Unaudited) ________________________________________________________________________________ The following is a summary of unaudited quarterly results of operations for the years ended December 31, 1993 and 1992. December 31 September 30 June 30 March 31 ----------- ------------ ---------- --------- In thousands except per share data Net sales $746,723 $770,222 $753,256 $716,853 Gross profit 179,066 188,501 183,812 172,733 Net income (loss) 17,469 23,040 21,307 (10,546) Per average share $ .16 $ .22 $ .20 $ (.10) Net sales $782,446 $735,540 $770,060 $753,177 Gross profit 173,495 161,871 176,803 189,648 Income (loss) before cumulative effect of accounting change 11,238 (63,234) 18,937 24,705 Per average share .11 (.60) .18 .23 Net income (loss) 11,238 (63,234) 18,937 (282,295) Per average share $ .11 $ (.60) $ .18 $ (2.66) The quarter ended March 31, 1993 includes a $50 million pretax special charge for additional costs associated with two Hoover Europe "free flights" promotion programs. The quarter ended September 30, 1992 includes a nonrecurring $95 million pretax charge relating to the reorganization of the Company's North American and European operations. 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 directors and officers on pages 1 through 6 of the Proxy Statement of the Company is incorporated herein by reference. Additional information concerning executive officers of the Company is included under "Executive Officers of the Registrant" included in Part I,Item 4. Item 11. Item 11. Executive Compensation. Information concerning executive compensation on pages 7 through 12 of the Proxy Statement, is incorporated herein by reference; provided that the information contained in the Proxy Statement under the heading "Compensation Committee Report on Executive Compensation" is specifically not incorporated herein by reference. Information concerning director compensation on pages 15 and 16 of the Proxy Statement is incorporated herein by reference, provided that the information contained in the Proxy Statement under the headings "Shareholder Return Performance" and "Shareholder Proposal Concerning Chief Executive Officer Compensation" is specifically not incorporated herein by reference. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management. The security ownership of certain beneficial owners and management is incorporated herein by reference from pages 4 through 6 of the Proxy Statement. Item 13. Item 13. Certain Relationships and Related Transactions. Information concerning certain relationships and related transactions is incorporated herein by reference from pages 2 through 4 of the Proxy Statement. PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K. (a)(1) and (2) The response to this portion of Item 14 is submitted as a separate section of this report in the "List of Financial Statements and Financial Statement Schedules" on page 34. (3) The response to this portion of Item 14 is submitted as a separate section of this report in the "List of Exhibits" on pages 35 through 38. (b) No reports on Form 8-K were filed during the fourth quarter of 1993. (c) Exhibits--The response to this portion of Item 14 is submitted as a separate section of this report in the "List of Exhibits" on pages 35 through 38. (d) Financial Statement Schedules--The response to this portion of Item 14 is submitted as a separate section of this report in the "List of Financial Statements and Financial Statement Schedules" on page 34. 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. MAYTAG CORPORATION (Registrant) Leonard A. Hadley Leonard A. Hadley Chairman and Chief Executive Officer Director Pursuant to the requirement 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. John P. Cunningham John A. Sivright John P. Cunningham John A. Sivright Executive Vice President and Director Chief Financial Officer Mark A. Garth Lester Crown Mark A. Garth Lester Crown Vice President-Controller and Director Chief Accounting Officer Fred G. Steingraber Edward C. Cazier, Jr. Fred G. Steingraber Edward C. Cazier, Jr. Director Director Neele E. Stearns, Jr. Peter S. Willmott Neele E. Stearns, Jr. Peter S. Willmott Director Director Date: March 30, 1994 ANNUAL REPORT ON FORM 10-K Item 14(a)(1), (2) and (3), (c) and (d) LIST OF FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES LIST OF EXHIBITS FINANCIAL STATEMENT SCHEDULES Year Ended December 31, 1993 MAYTAG CORPORATION NEWTON, IOWA FORM 10-K--ITEM 14(a)(1) AND ITEM 14(d) MAYTAG CORPORATION LIST OF FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES The following consolidated financial statements and supplementary data of Maytag Corporation and subsidiaries are included in Part II, Item 8: Page ---- Statements of Consolidated Income--Years Ended December 31, 1993, 1992 and 1991 . . . . . . . . . . . . . 14 Statements of Consolidated Financial Condition-- December 31, 1993 and 1992 . . . . . . . . . . . . . . . . 15 Statements of Consolidated Cash Flows--Years Ended December 31, 1993, 1992 and 1991 . . . . . . . . . . . . . 17 Notes to Consolidated Financial Statements . . . . . . . . . 18 Quarterly Results of Operations--Years 1993 and 1992 . . . . 30 The following consolidated financial statement schedules of Maytag Corporation and subsidiaries are included in Item 14(d): Schedule V Property, Plant and Equipment . . . . . . . . . 39 Schedule VI Accumulated Depreciation, Depletion and Amortization of Property, Plant and Equipment . 40 Schedule VIII Valuation and Qualifying Accounts . . . . . . 41 Schedule IX Short-Term Borrowings . . . . . . . . . . . . . 42 Schedule X Supplementary Income Statement Information . . 43 All other 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. FORM 10-K--ITEM 14(a) (3) AND ITEM 14(c) MAYTAG CORPORATION LIST OF EXHIBITS The following exhibits are filed herewith or incorporated by reference. Items indicated by (1) are considered a compensatory plan or arrangement required to be filed pursuant to Item 14 of Form 10-K. Incorporated Filed with Exhibit Herein by Electronic Number Description of Document Reference to Submission - ------- ----------------------- ------------ ---------- 3(a) Restated Certificate of Incorporation of X Registrant. 3(b) Certificate of Designations of Series A 1988 Annual Junior Participating Preferred Stock of Report on Registrant. Form 10-K. 3(c) Certificate of Increase of Authorized 1988 Annual Number of Shares of Series A Junior Report on Participating Preferred Stock of Form 10-K. Registrant. 3(d) By-Laws of Registrant, as amended through X February 7, 1991. 4(a) Rights Agreement dated as of May 2, 1988 Current between Registrant and The First National Report on Bank of Boston. Form 8-K dated May 5, 1988, Exhibit 1. 4(b) Amendment, dated as of September 24, 1990 Current to the Rights Agreement, dated as of May Report on 2, 1988 between the Registrant and The Form 8-K First National Bank of Boston. dated October 3, 1990, Exhibit 1. 4(c) Indenture dated as of June 15, 1987 Quarterly between Registrant and The First National Report on Bank of Chicago. Form 10-Q for the quarter ended June 30, 1987. 4(d) First Supplemental Indenture dated as of Current September 1, 1989 between Registrant and Report on The First National Bank of Chicago. Form 8-K dated September 28, 1989, Exhibit 4.3. Incorporated Filed with Exhibit Herein by Electronic Number Description of Document Reference to Submission - ------ ----------------------- ------------ ---------- 4(e) Second Supplemental Indenture dated as of Current November 15, 1990 between Registrant and Report on The First National Bank of Chicago. Form 8-K dated November 29, 1990. 4(f) U.S. $100,000,000 Credit Agreement Dated X as of June 25, 1993 Among Registrant, the Banks Party Hereto and Bank of Montreal, Chicago Branch as Agent and Royal Bank of Canada. 4(g) U.S. $200,000,000 Credit Agreement Dated X as of June 25, 1993 Among Registrant, the Banks Party Hereto and Bank of Montreal, Chicago Branch as Agent and Royal Bank of Canada. 4(h) First Amendment, Dated as of March 4, X 1994 to the U.S. $100,000,000 Credit Agreement, Dated as of June 25, 1993 among Registrant, the Banks party Hereto and Bank of Montreal, Chicago Branch as Agent and Royal Bank of Canada as Co- Agent. 4(i) First Amendment, Dated as of March 4, X 1994 to the U.S. $200,000,000 Credit Agreement, dated as of June 25, 1993 among Registrant, the banks Party Hereto and Bank of Montreal, Chicago Branch as Agent and Royal Bank of Canada as Co- Agent. 4(j) Copies of instruments defining the rights of holders of long-term debt not required to be filed herewith or incorporated herein by reference will be furnished to the Commission upon request. 10(a) Annual Management Incentive Plan, as 1990 Annual amended through December 21, 1990 (1). Report on Form 10-K 10(b) Executive Severance Agreements (1). X 10(c) Corporate Severance Agreements (1). 1989 Annual Report on Form 10-K. 10(d) Termination Agreement with Harvey 1989 Annual Kapnick, Director and former Chief Report on Executive Officer of Chicago Pacific Form 10-K. Corporation (1). Incorporated Filed with Exhibit Herein by Electronic Number Description of Document Reference to Submission - ------- ----------------------- ------------ ---------- 10(e) 1989 Non-Employee Directors Stock Option Exhibit A to Plan (1). Registrant's Proxy Statement dated March 18, 1990. 10(f) 1981 Stock Option Plan for Executives 1992 Annual and Key Employees (1). Report on Form 10-K. 10(g) 1986 Stock Option Plan for Executives Exhibit A to and Key Employees (1). Registrant's Proxy Statement dated March 14, 1986. 10(h) 1992 Stock Option Plan for Executives Exhibit A to and Key Employees (1). Registrant's Proxy Statement dated March 16, 1992. 10(i) 1987 Stock Incentive Award Plan for Key Exhibit B to Executives (1). Registrant's Proxy Statement dated March 25, 1987. 10(j) 1991 Stock Incentive Award Plan for Key Exhibit A to Executives (1). Registrant's Proxy Statement dated March 15, 1991. 10(k) Directors Deferred Compensation Plan (1). Amendment No. 1 on Form 8 dated April 5, 1990 to 1989 Annual Report on Form 10-K. 10(l) 1988 Capital Accumulation Plan for Key Amendment No. Employees (1). 1 on Form 8 dated April 5, 1990 to 1989 Annual Report on Form 10-K. Incorporated Filed with Exhibit Herein by Electronic Number Description of Document Reference to Submission - ------- ----------------------- ------------ ---------- 10(m) Directors Retirement Plan (1). Amendment No. 1 on Form 8 dated April 5, 1990 to 1989 Annual Report on Form 10-K. 11 Computation of Per Share Earnings. X 12 Ratio of Earnings to Fixed Charges. X 21 List of Subsidiaries of the Registrant. X 23 Consent of Ernst & Young. X 99(a) Annual Report on Form 11-K of the Maytag X Corporation Salary Savings Plan. 99(b) Annual Report on Form 11-K of the Hoover X Company Retirement Savings Plan for Hourly-Rated Employees. SCHEDULE X--SUPPLEMENTARY INCOME STATEMENT INFORMATION Thousands of Dollars COL. A COL. B ITEM Charged to Costs and Expenses - ------------------------ ------------------------------------------------ 1993 1992 1991 ---- ---- ---- Maintenance and repairs $ 53,128 $ 54,982 $ 50,504 Advertising costs 136,452 134,024 119,391 NOTE - All other items are not stated as such amounts are less than 1% of total sales and revenues.

33656_1993.txt

33656_1993

1993

33656

Item 1. BUSINESS DESCRIPTION OF BUSINESS Ethyl Corporation (the "Company") is a major producer of per- formance chemicals including fuel and lubricant additives, brominated flame retardants, polymer intermediates and catalysts, detergent intermediates, agricultural chemical intermediates, pharmaceutical intermediates, electronic materials, and bromine chemicals. The Company also owns Whitby, Inc. ("Whitby"), which in turn owns Whitby Pharmaceuticals, Inc. ("Whitby Pharmaceuticals"), which markets pharmaceutical products that are contract manufactured for it. Incorporated in Virginia in 1887, the Company employs approximately 5,500 people. The following discussion of the Company's businesses as of December 31, 1993, should be read in conjunction with the information contained in the "1993 Financial Review" section of Ethyl's Annual Report as of December 31, 1993, referred to in Item 7 below. Chemicals The Company conducts its worldwide chemicals operations through the Petroleum Additives Division, which includes fuel additives and lubricant additives, and the Chemicals Businesses, which consist of three divisions - -- Olefins and Derivatives, Bromine Chemicals and Specialty Chemicals, which includes Electronic Materials. The Chemicals Businesses manufacture a broad range of chemicals, most of which are additives to or intermediates for detergents, plastics and elastomers, agricultural pesticides and herbicides, pharmaceuticals and electronic semiconductors. Most sales of the Chemicals Businesses products are made directly to manufacturers of such products, including chemical and polymer companies, pharmaceutical companies, and detergent manufacturers in the United States and throughout the world. The Petroleum Additives Division manufactures a broad range of additives for motor fuels and lubricating oils. Most sales of fuel additives for gasoline, diesel fuels and heating oils are sold directly to petroleum refiners and marketers, terminals and blenders, while lubricant additive packages are sold directly to companies producing finished oils and fluids in the United States and throughout the world. The Company produces a majority of its products in the United States and also has major production facilities in Belgium, Canada and France. The processes and technology for most of these products were developed in the Company's research and development laboratories. The Company's divisions operate in a highly competitive environment. Some market areas involve a significant number of competitors, while others involve only a few. The competitors are both larger and smaller than the Company in terms of resources and market shares. Competition in connection with all of the Company's products requires continuing investments in research and development of new products or leading technologies, in continuing product and process improvements and in providing specialized customer services. Principal Olefins and Derivatives products include linear alpha olefins and synthetic primary alcohols used as intermediates in the manufacture of detergents, plasticizers, polymers, synthetic lubricants and lubricant additives; poly alpha olefins used in the formulation of synthetic lubricants and personal-care products; and zeolite A, which is used as a builder in detergent formulations. Also produced are tertiary amines for disinfectants and sanitizers and alkenyl succinic anhydride for paper sizing. Bromine Chemicals products include brominated flame retardants for use in polymers, clear brine fluids for use in oil and gas well drilling and completion, and bromine-containing chemicals used in water purification, in soil fumigation and as chemical intermediates; and organic and inorganic brominated compounds used as pharmaceutical, photographic and agrichemical intermediates; and also high-purity caustic potash and potassium carbonate used in the glass, chemical and food industries. Specialty Chemicals include the active ingredient in ibuprofen pain relievers; aluminum alkyl polymerization co-catalysts, high-molecular-weight phenolic antioxidants for polymers, ortho-alkylated phenols, diamines and anilines used as polymer additive intermediates; polymer modifiers; herbicide intermediates; organophosphorus intermediates used in insecticides; and Electronic Materials. Electronic materials primarily include polycrystalline silicon, which is produced in the Company's polysilicon production facility by a unique process developed by the Company. The same polysilicon plant also produces silane gas. These products are used in the semiconductor industry. Products of the Petroleum Additives Division include additives for gasoline and diesel fuels, additives for passenger-car and diesel crankcase lubricants, gear lubricants, transmission fluids and hydraulic fluids, as well as railroad-engine oil additives. Gasoline fuel additive products include lead and manganese antiknock compounds to increase octane and prevent power loss due to early or late combustion (engine knock); hindered phenolic antioxidants to prevent thermal degradation during storage and transport; corrosion inhibitors to prevent fuel storage and pumping system failures; detergent packages to keep carbon deposits from forming on fuel injectors, intake valves or carburetors and in combustion chambers; and dyes to provide color differentiation. Lead antiknock compounds, which are sold worldwide by the Petroleum Additives Division to petroleum refiners, remain one of the Company's largest product lines. The Company estimates that it accounts for approximately one-third of the total worldwide sales of lead antiknock compounds. For a number of years, lead antiknock compounds have been subject to regulations restricting the amount of the product that can be used in gasoline in the United States. Similar restrictions have been in effect in Canada since 1990. The North American market for these products in motor vehicles has effectively been eliminated, but the market for their use in piston aircraft and certain other applications has remained at about the same level for years and is expected to remain stable. As the Company has forecasted and planned, the market for these products in other major markets, particularly Western Europe, continues to decline as the use of unleaded gasoline grows. The contribution of lead antiknock compounds to the Company's net sales has declined to about 13% in 1993 from about 16% in 1992 and about 19% in 1991. The lead antiknock profit contribution to the Company's operating profit, excluding allocation of corporate expenses, is estimated to have been 49% in 1993, 50% in 1992 and 44% in 1991. Excluding the costs related to the planned cessation of lead antiknock compound production at the Company's Canadian plant, the 1993 lead antiknock profit contribution would have been about 52%. In recent years, the Company has been able to offset a continuing decline in shipments of lead antiknock compounds with higher margins due primarily to significant increases in selling prices. Any further decline in the use of lead antiknocks would adversely affect such sales and profit contributions unless the Company can offset such declines with increased market share and/or higher selling prices. The Company currently produces some of its lead antiknock compounds in its subsidiary's Canadian plant and obtains additional quantities under a supply agreement with E.I. DuPont de Nemours & Company. On January 11, 1994, the Company announced an agreement with The Associated Octel Company Limited ("Octel") of London under which Octel has agreed to allocate a portion of its production capacity of lead antiknock compounds to the Company for sale and distribution through the Company's worldwide network. Ethyl also announced that its Canadian subsidiary would cease production of lead antiknock compounds by March 31, 1994. The agreement continues so long as the Company determines that a market continues to exist for lead antiknock compounds. Under the agreement with Octel, the Company has the right to purchase from Octel antiknock compounds which the Company estimates will be sufficient to cover its needs in any contract year. Purchases are at a fixed initial price per pound with periodic escalations and adjustments. In addition to the supply agreement, Octel and the Company have agreed that the Company will assume the distribution for Octel of any of its lead antiknock compounds that are shipped in bulk. The Company believes the agreements with Octel will assure it of an ongoing efficient source of supply for lead antiknock compounds as the worldwide demand for these products continues to decline. It does not anticipate that the cessation of its Canadian antiknock operations and the entry into the Octel supply agreement will adversely affect its relations with its customers, nor will these changes have a material effect on its future results of operations. The Company and Octel will continue to compete vigorously in sales and marketing of lead antiknock compounds. The Company also sells manganese-based antiknock compounds, HiTEC(R) 3000 (MMT), which are used in unleaded gasoline in Canada. The Company conducted extensive testing of this product prior to filing a request in 1990 for a fuel-additive waiver from the United States Environmental Protection Agency (the "EPA") required to begin marketing the additive for use in unleaded gasoline in the United States. The Company voluntarily withdrew its waiver application in November 1990 after public hearings and detailed exchanges of information with the EPA, when the EPA raised several health and environmental questions near the end of the 180-day statutory review period. The Company continued testing and filed a new waiver request in July 1991, followed by additional public hearings and detailed exchanges of information with the EPA. In January 1992, the EPA denied the Company's application for a waiver. An appeal was filed with the United States Court of Appeals for the District of Columbia Circuit contesting the EPA's denial of the application for a waiver for the use of the additive in unleaded gasoline. In April 1993, the Court remanded the case to the EPA for reconsideration within 180 days of its denial of the Company's waiver application, directing the EPA to consider new evidence and make a new decision. On November 30, 1993, the EPA determined that emissions data contained in the Company's application satisfy all Clean Air Act standards, but reported that it was not able to complete its assessment of the overall public health implications of manganese. The Company and the EPA mutually agreed to an 180-day extension, until May 29, 1994, to resolve this last remaining issue. The Petroleum Additives Division also produces diesel fuel additive products, including cetane improvers for consistent combustion and power delivery; amine stabilizers and hindered phenolic antioxidants to prevent degradation during storage and transport; cold flow improvers to enhance fuel pumping under cold-weather conditions; detergent packages to keep carbon deposits from forming on fuel injectors and in combustion chambers; dyes for fuel identification and leak detection; lubricity agents; and a conductivity modifier to neutralize static charge build-up in fuel and products for home heating oils. The division's lubricant additive products include (i) engine oil additive packages for passenger car motor oils for gasoline engines, heavy- duty diesel oils for diesel powered vehicles, diesel oils for locomotive, marine and stationary power engines and oils for two-cycle engines, (ii) specialty additive packages for automatic transmission fluids, automotive and industrial gear oils, hydraulic fluids and industrial oils, and (iii) components for engine oil and specialty additive packages such as antioxidants to resist high-temperature degradation, antiwear agents to protect metal surfaces from abrasion, detergents to prevent carbon and varnish deposits from forming on engine parts, dispersants to keep engine parts clean by suspending insoluble products of fuel combustion and oil oxidation, friction reducers to facilitate movement, pour point depressants to enable oils to flow at cold temperatures, corrosion inhibitors to protect metal parts, and viscosity-index improvers to control oils' rate of flow at low and high temperatures. Major raw materials used by the Company's operating chemical divisions include ethylene, polybutene, process oil, aluminum and sodium and lead metals, 2-ethyl- 1-hexanol, isobutylene, and phenol and bisphenol-A, as well as electricity and natural gas as fuels, which are purchased or provided under contracts at prices the Company believes are competitive. The Company also produces bromine from extensive brine reserves in Arkansas. With separate, sharpened focus on two distinctly different businesses the Chemicals Businesses and Petroleum Additives--Ethyl took steps in 1993 to reorganize the Baton Rouge-based Chemicals Businesses while continuing to consolidate the Petroleum Additives Division's administrative, sales and research activities in Richmond, Virginia. The February 8, 1993, acquisition of Potasse et Produits Chimiques added organic and inorganic brominated compounds and high-purity caustic potash and potassium carbonate product lines to the Company's existing businesses. Recent developments include economic recovery for Ethyl's poly alpha olefins businesses which began in late 1993, supported by the recent introduction by several major U.S. oil companies of full or partially synthetic passenger car motor oils requiring the use of poly alpha olefins. In 1993, new zeolite A capacity was added at the Houston Plant to support the product's continued market penetration as an environmentally accepted replacement for phosphate builders in laundry detergents. A line of polydecene emollients developed for nonoily personal-care end uses was commercialized and R&D developed new applications in detergents, stabilizers and cleansers for Ethyl's patented ADMOX(R) brand of low-water amine oxide. Commercialization of SAYTEX(R) 8010 flame retardant was accomplished in early 1993 followed by the successful start-up later in the year of a new production facility in Magnolia, Arkansas. The first commercial plant for SAYTEX(R) BT-93W flame retardant is scheduled for start-up in early 1994 in Magnolia. Also, in response to worldwide market demand for SAYTEX RB-100(R) flame retardant, used primarily in printed circuit boards, a multimillion-dollar investment program to increase capacity and improve quality has been completed at Magnolia. The Company is actively targeting the development of S(+)-ibuprofen (an enhanced version of ibuprofen). Construction of a new facility was completed in the fourth quarter of 1993 and is in the start-up phase. A plant expansion to increase production capability of ibuprofen also is in progress. All of these facilities are located at the Orangeburg, South Carolina plant. The late December 1992 acquisition of the marketing and sales activities of a lubricant additives business in Japan following the June 1992 acquisition of the petroleum additives products and technologies of Amoco Petroleum Additives Company and their subsequent integration into the Company's product lines also were part of a major ongoing effort to expand and improve the product lines and geographic coverage of the Petroleum Additives Division. As part of the consolidation of the Petroleum Additives Division, construction continues on a major Petroleum Additives research complex in Richmond, scheduled for completion in mid-1994. The market for lubricant additives has been experiencing significant changes as a result of market and regulatory demands. The demands for better fuel economy, reduced emissions and cleaner oils have led to new equipment design and more stringent performance requirements. Such requirements mean reformulation of many products, new product development and more product qualification tests. To maintain and enhance a responsive worldwide product supply network for its petroleum additives, Ethyl is partially replacing the manufacturing capacity of products produced under contract for Ethyl by Amoco Petroleum Additives Company through June of 1995, and expanding capacity for other products. Ethyl has had a supply arrangement with Amoco since mid-1992, when it acquired Amoco's petroleum additives business. The new, more efficient facilities are scheduled for start-up, primarily in 1995, at Houston, Texas; Sauget, Illinois; Feluy, Belgium; and Natchez, Mississippi. Pharmaceuticals Whitby offers a complete line of hydrocodone-based analgesic products, including LORTAB(R) products; VICON(R) products, which include prescription and over-the-counter vitamin and mineral products; and THEO- 24(R) products, which consist of a series of varying dosage bronchodilators. Other products include WINSOR(R) brand prescription dosage ibuprofen and over-the-counter products. Third-party manufacturers inspected by the United States Food and Drug Administration formulate and produce Whitby's products according to Whitby's specifications. Whitby sells its products to wholesalers, large pharmacy chains and institutional purchasers such as hospital chains and health maintenance organizations. In 1993, Whitby launched three new products: Duratuss(TM) prescription tablets for coughs and colds, Duratuss HD Elixir(TM) for the same indications, and a 400 mg product extension to its Theo-24 series of respiratory products. In December 1993, Ethyl decided to discontinue pharmaceutical research projects previously conducted by Whitby Research, Inc., a subsidiary of Whitby. This will allow Whitby to focus on the acquisition of new products through purchase, license or strategic alliance. Whitby will also conduct, through a network of outside contract organizations, drug-development work on projects driven by the marketing group. Research and Patents The Company spent approximately $76 million, $74 million and $69 million in 1993, 1992 and 1991, respectively, on research and development, which amounts qualified under the technical accounting definition of research and development. Total R&D and technical services support spending for 1993 was some $126 million, including $50 million related to technical services support to customers, testing of existing products, cost reduction, quality improvement and environmental studies. Substantially all of such activities were sponsored by the Company. Most research and development was related to the Company's chemical operations, but a portion was related to design and development of new drug molecules by Whitby Research prior to the decision to discontinue pharmaceutical research in December 1993. The Company owns more than 2200 active United States and foreign patents, including 113 U.S. patents and 178 foreign patents issued in 1993. Some of these patents are licensed to others. In addition, rights under the patents and inventions of others have been acquired by the Company through licenses. The Company's patent position is actively being managed and is deemed by it to be adequate for the conduct of its business. Environmental Requirements The Company is subject to Federal, state and local requirements regulating the handling, manufacture or use of materials (some of which are classified as hazardous or toxic by one or more regulatory agencies), the discharge of materials into the environment and the protection of the environment. It is the Company's policy to comply with these requirements and to provide workplaces for employees that are safe, healthy and environmentally sound and that will not adversely affect the safety, health or environment of communities in which the Company does business. The Company believes that as a general matter its policies, practices and procedures are properly designed to prevent any unreasonable risk of environmental damage, and of resulting financial liability, in connection with its business. The Clean Air Act Amendments of 1990 ("the Amendments") became Federal law on November 15, 1990. Because the EPA and the states are still in the process of completing and implementing definitive regulations, interpreting the Amendments and establishing detailed requirements, the Company is unable at this time to make any detailed assessment of the effect of the Amendments on its earnings or operations. Among other environmental requirements, the Company is subject to the Federal Comprehensive Environmental Response, Compensation and Liability Act ("Superfund"), and similar state laws, under which the Company has been designated as a potentially responsible party ("PRP") which may be liable for a share of the costs associated with cleaning up various hazardous waste sites, some of which are on the EPA's Superfund national priority list. Although, under some court interpretations of these laws, a PRP might have to bear more than its proportional share of the cleanup costs if appropriate contributions from other PRPs are not able to be obtained, the Company has been able to demonstrate it is only a de minimis participant at all but a few of the sites. Also, the Company has settled or resolved actions related to certain sites and generally has not had to bear significantly more than its proportional share in multiparty situations. Further, almost all of the sites represent environmental issues that are quite mature and that have been investigated, studied and in many cases settled. In de minimis PRP matters, the Company's policy generally is to negotiate a consent decree and to pay any apportioned settlement, enabling the Company to be effectively relieved of any further liability as a PRP, except for remote contingencies. In other than de minimis PRP matters, the Company's records indicate that unresolved exposures are expected to be immaterial. Because the Company's management has been actively involved in evaluating environmental matters, the Company is able to conclude that the outstanding environmental liabilities for unresolved PRP sites for which the Company would not be a de minimis participant should not be material. Compliance with government pollution-abatement and safety regulations usually increases operating costs and requires remediation costs and investment of capital that in some cases produces no monetary return. Operating and remediation costs charged to expense were $61 million in 1993 versus $51 million in 1992 and $38 million in 1991 (excluding depreciation of previous capital expenditures) and are expected to be somewhat higher in the next few years than in the past. Capital expenditures for pollution-abatement and safety projects, including such costs that are included in other projects, were about $30 million, $29 million and $25 million in 1993, 1992 and 1991, respectively. For each of the next few years, capital expenditures for these types of projects are likely to increase somewhat from current levels. Management's estimates of the effects of compliance with governmental pollution-abatement and safety regulations are subject to (i) the possibility of changes in the applicable statutes and regulations or in judicial or administrative construction of such statutes and regulations, and (ii) uncertainty as to whether anticipated solutions to pollution problems will be successful, or whether additional expenditures may prove necessary. FINANCIAL INFORMATION AS TO INDUSTRY SEGMENTS AND GEOGRAPHIC AREAS The Company's remaining operations are substantially all in the Chemicals Industry. Geographic area information for the Company's operations for the three years ended December 31, 1993, is presented in the Annual Report on pages 26 and 27 (and the related notes on page 28) and is incorporated herein by reference. FINANCIAL INFORMATION ABOUT FOREIGN AND DOMESTIC OPERATIONS AND EXPORT SALES Financial information about the Company's foreign and domestic operations and export sales for the three years ended December 31, 1993, is set forth in the Annual Report on pages 26 and 27 and in Notes 1, 3, 12, 14 and 15 of the Notes to the Financial Statements on pages 35, 36, 38, 39, 40, 41 and 42 and is incorporated herein by reference. See also information as to the Company's foreign lead antiknock compounds business under "DESCRIPTION OF BUSINESS - Chemicals" above. Domestic export sales to non-affiliates may be made worldwide but are made primarily in the Far East, Latin America and Europe. Foreign unaffiliated sales are made primarily in Europe, Canada, the Far East and the Middle East. Item 2. Item 2. PROPERTIES The following is a brief description of the principal plants and related facilities of the Company, all of which are owned except as stated below. LOCATION PRINCIPAL OPERATIONS Baton Rouge, Louisiana Research and product-development (2 facilities) activities Bracknell, Berkshire, Research and testing activities England Deer Park, Texas (leased land) Production of poly alpha olefins Elk Grove Village, Illinois Research and product-development (leased) activities Feluy, Belgium Production of aluminum alkyls, orthoalkylated anilines and phenols, lubricant additives, poly alpha olefins and linear alpha olefins Houston, Texas Production of aluminum alkyls, synthetic primary alcohols, linear alpha olefins, lubricant additive dispersants and blends, alkenyl succinic anhydride, orthoalkylated anilines and phenols, polycrystalline silicon, high-purity silane, zeolite A and other chemicals; research activities Louvain-la-Neuve, Belgium Research and customer technical service activities Magnolia, Arkansas Production of flame retardants, bromine, (2 facilities) ethylene dibromide, vinyl bromide, several inorganic bromides, agricultural chemical intermediates, tertiary amines, and polyimide foam; research activities Natchez, Mississippi Production of lubricant additives including mainly detergents Orangeburg, South Carolina Production of specialty chemicals, including pharmaceutical intermediates; and fuel additives, including antioxidants, diesel fuel cetane improver and manganese antiknocks; and orthoalkylated phenols, polymer modifiers and performance polymers; research activities St. Louis, Missouri Research and product-development activities Sarnia, Ontario, Canada Production of lead antiknock compounds1, lubricant additives, cold flow improvers and diesel fuel cetane improver Sauget, Illinois Production of lubricant additives, including detergents, dispersants, antioxidants, antiwear agents, crankcase packages, transmission and gear packages and friction reducers Thann, France Production of organic and inorganic brominated pharmaceutical, photographic and agrochemical intermediates, high- purity caustic potash and potassium carbonate; product development activities 1 The Company will cease production of lead antiknock compounds by March 31, 1994. The Company believes that its plants, including approved expansions, are more than adequate at projected sales levels. The Company currently has excess capacity in linear and poly alpha olefins and polysilicon. Operating rates of certain other plants vary with product mix and normal seasonal sales swings. The Company believes that its plants generally are well maintained and in good operating condition. The Company owns its corporate headquarters offices in Richmond, Virginia, and its regional offices in Bracknell, Berkshire, England. The Company leases its executive offices in New York, New York, and Baton Rouge, Louisiana, and its regional offices in Brussels, Belgium; Mississauga, Ontario, Canada; Singapore; and Tokyo, Japan, as well as various sales and other offices. Whitby leases office space in Richmond, Virginia. The Company's research laboratory at Louvain-la-Neuve, Belgium, was completed in mid-1993. The Company also began construction in late 1992 of a $70-million lubricant and fuel additives research and product-development facility in Richmond, Virginia, scheduled for start-up in the summer of 1994. At that time, research and product-development activities at St. Louis, Missouri, will be phased out. All expenses in connection with the discontinuance of the St. Louis operations have been fully provided for. The Company is partially replacing the manufacturing capacity of Amoco's Wood River, Illinois, lubricant and fuel additives plant from which the Company currently is receiving product under a supply agreement. The new, more efficient facilities are scheduled for start-up in 1995 at Houston, Texas; Sauget, Illinois; Feluy, Belgium; and Natchez, Mississippi. The Company is obtaining lubricant additives, including crankcase packages and certain components, under a long-term supply agreement with a subsidiary of Mitsubishi Kasei Corporation from its petroleum additives plant in Yokkaichi, Japan. The Company also has a long-term services agreement for research and product development and customer technical services activities at the research facility associated with the petroleum additives plant in Yokkaichi, Japan. Item 3. Item 3. LEGAL PROCEEDINGS The Company and its subsidiaries are involved from time to time in legal proceedings of types regarded as common in the Company's businesses, particularly administrative or judicial proceedings seeking remediation under environmental laws, such as Superfund, and products liability litigation. A 1992 products liability suit is pending in a Minnesota state court against the Company, another chemical company, and the owner and leasing agent of a residence in Minneapolis at which two children are claimed to have been injured by ingesting soil and dust containing lead from peeling paint and automotive emissions. In recent years, many suits have been brought against paint manufacturers and landlords alleging personal injury caused by ingesting lead from paint found in paint chips, dirt and dust. Like these suits, the Minnesota suit just mentioned involves alleged injury from paint lead in chips, dirt and dust, but also involves alleged injury from gasoline lead in dirt and dust, as well. The Company believes the Minnesota suit is without merit with respect to the Company, but since the suit partially rests on a theory of harm to children from eating dirt containing automotive lead emissions, the Company is vigorously defending it. While it is not possible to predict or determine the outcome of the proceedings presently pending, in the Company's opinion they will not ultimately result in any liability that would have a material adverse effect upon the results of operations or financial condition of the Company and its subsidiaries on a consolidated basis. Item 4. Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS The Company will be requesting that shareholders approve increasing the number of shares issuable pursuant to the stock option plan by 5.9 million shares. ADDITIONAL INFORMATION - EXECUTIVE OFFICERS OF THE COMPANY The names and ages of all executive officers of the Company, as of March 25, 1994, are set forth on the following pages. The term of office of each such officer is until the meeting of the Board of Directors following the next annual shareholders meeting (April 28, 1994). All of such officers have been employed by the Company for at least the last five years, with the exception of Thomas E. Gottwald, who rejoined the Company August 1, 1991, following two years as General Manager of Tredegar Film Products, a division of Tredegar Industries, Inc., which was spun off to Ethyl shareholders in mid-1989, following assignments with Ethyl in Corporate Business Development and Strategic Planning. Name Age Office *Bruce C. Gottwald 60 Chairman of the Board and of the Executive Committee, Chief Executive Officer, Director *Floyd D. Gottwald, Jr. 71 Vice Chairman of the Board, Director *Charles B. Walker 55 Vice Chairman of the Board, Chief Financial Officer and Treasurer, Director *Thomas E. Gottwald 33 President and Chief Operating Officer, Director *William M. Gottwald, MD 46 Senior Vice President and President of Whitby, Director E. Whitehead Elmore 55 Special Counsel to the Company's Executive Committee and Corporate Secretary Sampson H. Bass, Jr. 64 Vice President - Secretary to the Executive Committee David A. Fiorenza 44 Vice President - Finance and Controller C. S. Warren Huang 44 Vice President - Research and Development Donald R. Lynam 55 Vice President - Air Conservation Steven M. Mayer 51 Vice President and General Counsel Ian A. Nimmo 52 Vice President - Lubricant Additives Henry C. Page, Jr. 55 Vice President - Human Resources Newton A. Perry 51 Vice President - Fuel Additives A. Prescott Rowe 56 Vice President - External Affairs *Member of the Executive Committee Floyd D. Gottwald, Jr., and Bruce C. Gottwald are brothers. William M. Gottwald, MD, is a son of Floyd D. Gottwald, Jr. Thomas E. Gottwald is a son of Bruce C. Gottwald. Certain Agreements Between Albemarle and Ethyl The Chemicals Businesses have in the past engaged in numerous transactions with the Ethyl Businesses. Such transactions have included, among other things, the provision of various types of financial support by the Company. Although the Company will continue to provide certain support services to Albemarle and Albemarle will provide certain support services to the Company for a limited period of time, most of such services are expected ultimately to be discontinued. In addition to these services, for a more extended period of time, Albemarle will provide services to the Company at Orangeburg, South Carolina, and Feluy, Belgium, and Albemarle and the Company will exchange services at Houston, Texas. Orangeburg, South Carolina Agreements The Orangeburg, South Carolina plant consists of facilities for the production of petroleum additives and specialty chemicals. After the Distribution, Albemarle will operate for the Company the facilities that produce petroleum additives (the "Orangeburg Additives Facility") for a period of ten years, with an option by the Company to extend for an additional ten years. The operating agreement relating to the Orangeburg Additives Facility (the "Orangeburg Operating Agreement") provides that Albemarle will produce certain petroleum additive products meeting the Company's specifications and provide certain services and utilities customarily used by or reasonably necessary to maintain the Orangeburg Additives Facility in accordance with design capacity. At its option and upon 180 days' notice, the Company may assume responsibility for the operation of the Orangeburg Additives Facility, in which event Albemarle would continue to provide certain services and utilities for that facility. The Company will reimburse Albemarle for certain costs specified in the Orangeburg Operating Agreement and will pay to Albemarle a monthly operating fee based on a percentage of such reimbursable costs. Albemarle will produce under a supply contract MMT for the Company in facilities owned by Albemarle. Albemarle also will be licensed by the Company, subject to certain restrictions, to produce and sell MMT for its own account to the extent of any excess not set aside for the Company under the supply contract. Albemarle will own the land on which the Orangeburg Additives Facility is located. In conjunction with Albemarle's operation of the Orangeburg Additives Facility for the Company, Albemarle will lease the land to the Company for a period of ten years, with an option by the Company to extend for an additional ten years. Albemarle and the Company will have a separate blending services agreement (the "Orangeburg Blending Agreement"), pursuant to which Albemarle will provide storage, blending and packaging services to the Company in connection with the operation of the Orangeburg Additives Facility. The term of the Orangeburg Blending Agreement will be for ten years, and the Company will have the option to extend for an additional ten years. Pursuant to the Orangeburg Blending Agreement, the Company will reimburse Albemarle for specified costs associated with the blending operations and will pay to Albemarle a monthly operating fee based on a percentage of such reimbursable costs. Pursuant to an antioxidant supply agreement, Albemarle will produce antioxidants for the Company at the Orangeburg plant. The Company will reimburse Albemarle for specified production costs and pay a monthly fee. The antioxidant supply agreement will be for ten years, and the Company will have the option to extend for an additional ten years. Houston, Texas Agreement The Houston, Texas plant consists of facilities for the production of petroleum additives, olefins and derivatives and specialty chemicals. After the Distribution, the Company will own the petroleum additives facility at the Houston plant (the "Houston Additives Facilities"), and Albemarle will own the facilities that produce olefins and derivatives and specialty chemicals. Albemarle and the Company will have a reciprocal agreement (the "Houston Services Agreement"), with respect to the operation of the Company's Houston Additives Facilities and Albemarle's chemical operations adjoining the Houston Additives Facilities. Pursuant to the Houston Services Agreement, the Company will provide to Albemarle certain services and utilities related to Albemarle's chemicals operations in Houston, while Albemarle will provide to the Company certain services and utilities related to the Company's petroleum additives operations in Houston. The term of the Houston Services Agreement is ten years, but any party receiving services and utilities may terminate one or more of such services or utilities upon giving 60 days' notice to the other party or may terminate all of such services and utilities upon giving 180 days' notice to the other party. Each party also has the right to extend for an additional ten years the Houston Services Agreement with respect to the services and utilities that it is receiving. Each party providing services will receive from the other party reimbursement of specified costs and a monthly service fee based on a percentage of such reimbursable costs. Feluy, Belgium Agreement The Feluy, Belgium plant consists of facilities for the production of petroleum additives, olefins and derivatives and specialty chemicals. After the Distribution, the Company will own and operate the petroleum additives facility at the Feluy, Belgium plant (the "Feluy Additives Facility"), and Albemarle will own the facilities that produce olefins and derivatives and specialty chemicals at the Feluy plant. Albemarle and the Company will have an agreement (the "Feluy Services Agreement"), with respect to the operation of the Company's Feluy Additives Facility. Pursuant to the Feluy Services Agreement, Albemarle will provide to the Company certain services and utilities related to the Company's petroleum additives operation in Feluy. The term of the Feluy Services Agreement is ten years, but the Company may terminate one or more of such services or utilities upon giving 60 days' notice to Albemarle or may terminate all of such services and utilities upon giving 180 days' notice to Albemarle. The Company also has the right to extend the Feluy Services Agreement for an additional ten years. Albemarle will receive from the Company reimbursement of specified costs and a monthly service fee based on a percentage of such reimbursable costs. Indemnification and Tax-Sharing Agreements Pursuant to an indemnification agreement between the Company and Albemarle, the Company will indemnify Albemarle for losses to Albemarle after the Distribution Date resulting from the conduct of the Ethyl Businesses, including environmental liabilities, before and after the Distribution Date, and Albemarle will indemnify the Company for losses to the Company after the Distribution Date resulting from the conduct of the Chemicals Businesses, including environmental liabilities, before and after the Distribution Date. Tax liabilities, and related indemnification, are covered under a tax sharing agreement. Under that agreement the Company will be responsible for the taxes of the Ethyl Businesses and the Chemicals Businesses for periods prior to the Distribution, except with respect to taxes attributable to subsidiaries of the Company that will become subsidiaries of Albemarle in connection with the Distribution. Albemarle will be responsible for the taxes of the Chemicals Businesses for post-Distribution periods. PART II Item 5. Item 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The information contained on page 29 of the Annual Report under the captions "Dividend Information & Equity Per Common Share" and "Market Prices of Common Stock & Shareholder Data" and on pages 36 to 38 of the Annual Report in Notes 1, 10 and 11 of the Notes to Financial Statements is incorporated herein by reference. Item 6. Item 6. SELECTED FINANCIAL DATA The information for the five years ended December 31, 1993, contained in the Five-Year Summary on pages 14 and 15 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 textual and tabular information concerning the years 1993, 1992 and 1991 contained in the "1993 Financial Review" section on pages 16 through 27 of the Annual Report (and the related notes on page 28) are incorporated herein by reference. Additional information on restructuring costs from that included in the Annual Report is as follows: The major components of the $36.1 million in special charges in 1993 ($22.4 million after income taxes) included $14.2 million related to ceasing production at the Canadian lead antiknock facility of which $11.4 million was a noncash write-down of the remaining book value of the assets (which will reduce annual depreciation and amortization by about $1.5 million per year), $8.3 million for relocation of employees and other restructuring costs, $6.0 million covering manpower reductions of 55 employees and other costs in connection with discontinuing pharmaceutical research projects at Whitby Research, Inc., as well as $7.6 million for work force reductions of about 165 chemicals and corporate employees in the U.S. and Europe. Item 8. Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The consolidated financial statements contained on pages 30 through 34, the Notes to Financial Statements contained on pages 35 through 45, the Report of Independent Accountants on page 46 and the information under the caption "Selected Quarterly Financial Data (Unaudited)" on page 28 of the Annual Report are incorporated herein by reference. Item 9. Item 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Inapplicable. PART III Item 10. Item 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information contained in the Proxy Statement under the caption "Election of Directors" concerning directors and persons nominated to become directors of the Company is incorporated herein by reference. See "Additional Information -- Executive Officers of the Company" at the end of Part I above for information about the executive officers of the Company. Item 11. Item 11. EXECUTIVE COMPENSATION The information contained in the Proxy Statement under the caption "Compensation of Executive Officers and Directors" concerning executive compensation is incorporated herein by reference. Item 12. Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information contained in the Proxy Statement under the caption "Stock Ownership" is incorporated herein by reference. Item 13. Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information contained in the Proxy Statement under the caption "Election of Directors," specifically in the last several paragraphs of such section, is incorporated herein by reference. PART IV Item 14. Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) (1) The following consolidated financial statements of the registrant included on pages 30 to 46 in the Annual Report are incorporated herein by reference in Item 8: Consolidated balance sheets as of December 31, 1993 and December 31, Consolidated statements of income, shareholders' equity and cash flows for the years ended December 31, 1993, 1992, and 1991 Notes to financial statements Report of Independent Accountants (a) (2) See Index to Financial Statement Schedules of registrant and its consolidated subsidiaries at. (a) (3) Exhibits The following documents are filed as exhibits to this Form 10-K pursuant to Item 601 of Regulation S-K: 3.1 Restated Articles of Incorporation of the registrant (filed as Exhibit 3.1 to the registrant's Report on Form 10-K for the year ended December 31, 1992, and incorporated herein by reference thereto). 3.2 By-laws of the registrant. 4.1 $500 million Credit Agreement, dated as of February 16, 1994. 4.2 Indenture, dated as of June 15, 1985 (filed as Exhibit 4 to the registrant's Registration Statement on Form S-3 filed on June 27, 1985, and incorporated herein by reference thereto), as supplemented by the First Supplemental Indenture dated as of June 15, 1986 (filed as Exhibit 4.2 to the registrant's Registration Statement on Form S-3 filed on June 12, 1986, and incorporated herein by reference thereto), and the Prospectus Supplement, dated as of September 16, 1988, setting the terms for the public sale of $200,000,000 aggregate principal amount of its 9.8% Notes due September 15, 1998 (filed on September 16, 1988, and incorporated herein by reference thereto). 10.1 Bonus Plan of the registrant (filed as Exhibit 10.1 to the registrant's Report on Form 10-K for the year ended December 31, 1992, and incorporated herein by reference thereto). 10.2 Incentive Stock Option Plan of the registrant (filed as Exhibit 10.2 to the registrant's Report on Form 10-K for the year ended December 31, 1992, and incorporated herein by reference thereto). 10.3 Non-Employee Directors' Stock Acquisition Plan (filed as Exhibit A to the registrant's Proxy Statement for Annual Meeting of Shareholders filed on March 17, 1993, and incorporated herein by reference thereto). 10.4 Excess Benefit Plan of the registrant (filed as Exhibit 10.4 to the registrant's Report on Form 10-K for the year ended December 31, 1992, and incorporated herein by reference thereto). 10.5 Supply Agreement, dated as of December 22, 1993, between Ethyl Corporation and the Associated Octel Company Limited (filed as Exhibit 99 on the Registrant's Report on Form 8-K filed on February 17, 1994, and incorporated herein by reference thereto). 11 Computation of Earnings Per Share. 13 The registrant's Annual Report to Shareholders for the year ended December 31, 1993 (note 1). 22 List of subsidiaries of the registrant. 23 Consent of Independent Certified Public Accountants. __________________________ Note 1. With the exception of the information incorporated in this Form 10-K by reference thereto, the Annual Report shall not be deemed "filed" as part of this Form 10-K. 28 Trust Agreement Between Ethyl Corporation and NationsBank of Virginia, N.A. (filed as Exhibit 28 to the registrant's Report on Form 10-K for the year ended December 31, 1992, and incorporated herein by reference thereto). 99 Form 8-K filed on February 25, 1994. (b) Form 8-K as filed with the Commission on February 25, 1994. (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. ETHYL CORPORATION (Registrant) By: /s/ Bruce C Gottwald Bruce C. Gottwald, Chairman of the Board Dated: 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 indicated as of March 25, 1994. Signature Title /s/ Bruce C Gottwald Chairman of the Board, (Bruce C. Gottwald) Chairman of the Executive Committee, Chief Executive Officer and Director (Principal Executive Officer) /s/ Charles B Walker Vice Chairman of the Board, (Charles B. Walker) Treasurer, Chief Financial Officer and Director (Principal Financial Officer) Signature Title /s/ David A. Fiorenza Vice President - Finance and (David A. Fiorenza) Controller (Principal Accounting Officer) /s/ L B Andrew Director (Lloyd B. Andrew) /s/ Joseph C. Carter Jr Director (Joseph C. Carter, Jr.) /s/ Ronald V. Dolan Director (Ronald V. Dolan) /s/ Floyd D Gottwald Jr Vice Chairman of the Board (Floyd D. Gottwald, Jr.) and Director /s/ Bruce C. Gottwald Jr. Director (Bruce C. Gottwald, Jr.) /s/ Thomas E Gottwald President and Director (Thomas E. Gottwald) /s/ William M Gottwald Senior Vice President (William M. Gottwald) and Director Signature Title /s/ Gilbert M Grosvenor Director (Gilbert M. Grosvenor) /s/ Andre B. Lacy Director (Andre B. Lacy) /s/ Emmett J. Rice Director (Emmett J. Rice) INDEX TO FINANCIAL STATEMENT SCHEDULES OF REGISTRANT AND SUBSIDIARIES Pages Report of Independent Accountants on Financial Statement Schedules ETHYL CORPORATION AND SUBSIDIARIES Schedules: V - Property, Plant and Equipment for the years ended December 31, 1993, 1992 and 1991 VI - Accumulated Depreciation, Depletion and Amortization of Property, Plant & Equipment for the years ended December 31, 1993, 1992 and 1991 X - Supplementary income statement information for the years ended December 31, 1993, 1992 and 1991 Schedules other than those listed above are omitted as the information is either not applicable, not required or has been furnished in the financial statements or notes thereto. REPORT OF INDEPENDENT ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULES To the Board of Directors and Shareholders of Ethyl Corporation Our report on the consolidated financial statements of Ethyl Corporation and Subsidiaries has been incorporated by reference in this Form 10-k from page 46 46 of the 1993 Annual Report to Shareholders of Ethyl Corporation. In connection with our audits of such financial statements, we have also audited the related financial statement schedules listed in the index on page 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 COOPERS & LYBRAND Richmond, Virginia January 31, 1994 ETHYL CORPORATION AND SUBSIDIARIES SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION for the years ended December 31, 1993, 1992, and 1991 ( In Thousands ) Col. A Col. B Item Charged to Costs and Expenses 1993 1992 1991 ---- ---- ---- Maintenance and repairs: $96,851 $83,463 $80,991 ======= ======= ======= Amortization of intangible assets, taxes, other than payroll and income taxes, royalties and advertising costs are less than one percent of revenue as reported in the related income statements for 1993, 1992 and 1991. EXHIBIT INDEX Number and Name of Exhibit Page Number 3.1 Restated Articles of Incorporated by reference - Incorporation see Page 34 3.2 By-laws Pages 46 through 75 4.1 $500 million Credit Agreement, Pages 76 through 185 dated as of February 16, 1994 4.2 1988 $200,000,000 Debt Incorporated by reference - Offering see Page 35 10.1 Bonus Plan Incorporated by reference - see Page 35 10.2 Incentive Stock Option Incorporated by reference - Plan see Page 35 10.3 Non-Employee Directors' Stock Incorporated by reference - Acquisition Plan see Page 35 10.4 Excess Benefit Plan Incorporated by reference see Page 35 10.5 Supply Agreement between Ethyl Incorporated by reference Corporation and Associated see Page 35 Octel Company 11 Computation of Earnings Page 186 Per Share 13 Annual Report Pages 187 through 238 22 List of Subsidiaries Pages 239 23 Consent of Independent Page 240 Certified Public Accountants 28 Trust Agreement Incorporated by reference - see Page 36 99 Form 8K filed on February 25, 1994 Pages 241 through 261

63073_1993.txt

63073_1993

1993

63073

Item 1. BUSINESS THE SYSTEM SYSTEM ORGANIZATION New England Electric System (NEES) is a voluntary association created under Massachusetts law on January 2, 1926, and is a registered holding company under the Public Utility Holding Company Act of 1935 (the 1935 Act). NEES owns voting stock in the amounts indicated of the following companies, which together constitute the System. % Voting Securities State of Type of Owned by Name of Company Organization Business NEES --------------- ------------ --------- ---------- Subsidiaries: Granite State Electric Company N.H. Retail 100 (Granite State) Electric Massachusetts Electric Company Mass. Retail 100 (Mass. Electric) Electric The Narragansett Electric Company R.I. Retail 100 (Narragansett) Electric Narragansett Energy Resources R.I. Wholesale 100 Company (Resources) Electric Generation New England Electric Resources, Inc. Mass. Consulting 100 (NEERI) Services New England Electric Transmission N.H. Electric 100 Corporation (NEET) Transmission New England Energy Incorporated Mass. Oil and Gas 100 (NEEI) Exploration & Development New England Hydro-Transmission N.H. Electric 53.97(a) Corporation (N.H. Hydro) Transmission New England Hydro-Transmission Mass. Electric 53.97(a) Electric Company, Inc. Transmission (Mass. Hydro) New England Power Company (NEP) Mass. Wholesale 98.80(b) Electric Generation & Transmission New England Power Service Company Mass. Service 100 (Service Company) Company (a) The common stock of these subsidiaries is owned by NEES and certain participants (or their parent companies) in Phase II of the Hydro-Quebec project. See Interconnection with Quebec, page 21. (b) Holders of common stock and 6% Cumulative Preferred Stock of NEP have general voting rights. The 6% Cumulative Preferred Stock represents 1.20% of the total voting power. In 1993, the System was realigned into two strategic business units, a wholesale business unit and a retail business unit. The facilities of NEES' three retail electric subsidiaries, Mass. Electric, Narragansett, and Granite State (collectively referred to as the Retail Companies), and of its principal wholesale electric subsidiary, NEP, constitute a single integrated electric utility system that is directly interconnected with other utilities in New England and New York State, and indirectly interconnected with utilities in Canada. See ELECTRIC UTILITY OPERATIONS, page 3. NEET owns and operates a portion of an international transmission interconnection between the electric systems of Hydro-Quebec and New England. Mass. Hydro and N.H. Hydro own and operate facilities in connection with an expanded second phase of this interconnection. See Interconnection with Quebec, page 21. NEEI is engaged in various activities relating to fuel supply for the System. These activities presently include participation (principally through a partnership with a non-affiliated oil company) in domestic oil and gas exploration, development, and production (see OIL AND GAS OPERATIONS, page 43) and the sale to NEP of fuel purchased in the open market. Resources is a general partner, with a 20% interest, in each of two partnerships formed in connection with the Ocean State Power project. See Ocean State Power, page 21. The Service Company has contracted with NEES and its subsidiaries to provide, at cost, such administrative, engineering, construction, legal, and financial services as the companies request. The Service Company also provides maintenance and construction services under contract to certain non-affiliated utility customers. Profits from these contracts are used to reduce the cost of services to affiliated companies. NEERI is a wholly-owned, non-utility subsidiary of NEES which provides consulting services domestically and internationally to non-affiliates. EMPLOYEES As of December 31, 1993, NEES subsidiaries had approximately 5,000 employees. As of that date, the total number of employees was approximately 840 at NEP, 1,800 at Mass. Electric, 760 at Narragansett, 80 at Granite State, and 1,500 at the Service Company. Of the 5,000 employees, approximately 3,300 are members of labor organizations. Collective bargaining agreements with the Brotherhood of Utility Workers of New England, Inc., the International Brotherhood of Electrical Workers, and the Utility Workers Union of America, AFL-CIO expire in May 1995. FINANCIAL INFORMATION ABOUT BUSINESS SEGMENTS The business of the System is conducted in two primary business segments, electric utility operations and oil and gas operations. The financial information with respect to Electric Utility Operations is as follows: Year Ended December 31 (thousands of dollars) 1993 1992 1991 - ---------------------- ---- ---- ---- Operating revenues $2,187,040 $2,138,302 $2,056,798 Operating income 332,843 341,650 317,487 Total assets 4,460,652 4,177,781 3,964,569 Capital expenditures 304,659 241,872 209,674 The financial information with respect to Oil and Gas Operations is as follows: Year Ended December 31 (thousands of dollars) 1993 1992 1991 - ---------------------- ---- ---- ---- Operating revenues $ 46,938 $ 43,374 $ 37,580 Pre-tax loss passed (46,355) (54,607) (39,303) on to customers Total assets 335,226 407,015 485,508 Capital expenditures 18,965 21,262 32,969 ELECTRIC UTILITY OPERATIONS GENERAL NEP's business is principally generating, purchasing, transmitting, and selling electric energy in wholesale quantities. In 1993, 95% of NEP's revenue from the sale of electricity was derived from sales for resale to affiliated companies and 5% from sales for resale to municipal and other utilities. NEP is the wholesale supplier of the electric energy requirements of the Retail Companies. Narragansett, however, receives credits against its purchases of power from NEP for the cost of generation from its Providence units, which are integrated with NEP's facilities to achieve maximum economy and reliability. Discussions of NEP's generating properties, load growth, energy mix, and fuel supplies include the related properties of Narragansett. For details of sales of energy and operating revenue for the last five years, see OPERATING STATISTICS on page 28 of the New England Power Company 1993 Annual Report to Stockholders (the NEP 1993 Annual Report). The combined service area of the Retail Companies constitutes the retail service area of the System and covers more than 4,400 square miles with a population of about 3,000,000 (1990 census). See Map, page 17. The largest cities served are Worcester, Mass. (population 170,000) and Providence, R.I. (population 161,000). Mass. Electric and Narragansett are engaged principally in the distribution and sale of electricity at retail. Mass. Electric provides approximately 930,000 customers with electric service at retail in a service area comprising approximately 43% of the area of The Commonwealth of Massachusetts. The population of the service area is about 2,160,000 or 36% of the total population of the Commonwealth (1990 Census). Mass. Electric's territory consists of 149 cities and towns including rural, suburban, and urban communities with Worcester, Lawrence, Lowell, and Quincy being the largest cities served. The economy of the area is diversified. Principal industries served by Mass. Electric include electrical and industrial machinery, computer manufacturing and related products, plastic goods, fabricated metals and paper, and chemical products. In addition, a broad range of professional, banking, high-technology, medical, and educational concerns is served. During 1993, 41% of Mass. Electric's revenue from the sale of electricity was derived from residential customers, 36% from commercial customers, 22% from industrial customers, and 1% from others. In 1993, the 20 largest customers of Mass. Electric accounted for less than 8% of its electric revenue. For details of sales of energy and operating revenue for the last five years, see OPERATING STATISTICS on page 26 of Mass. Electric's 1993 Annual Report to Stockholders (the Mass. Electric 1993 Annual Report). Narragansett provides approximately 323,000 customers with electric service at retail. Its service territory, which includes urban, suburban, and rural areas, covers about 839 square miles or 80% of the area of Rhode Island, and encompasses 27 cities and towns including the cities of Providence, East Providence, Cranston, and Warwick. The population of the area is about 725,000 (1990 Census) which represents about 72% of the total population of the state. The economy of the territory is diversified. Principal industries served by Narragansett produce fabricated metal products, jewelry, silverware, electrical and industrial machinery, transportation equipment, textiles, and chemical and allied products. In addition, a broad range of professional, banking, medical, and educational institutions is served. During 1993, 42% of Narragansett's revenue from the sale of electricity was derived from residential customers, 40% from commercial customers, 16% from industrial customers, and 2% from others. In 1993, the 20 largest customers of Narragansett accounted for approximately 11% of its electric revenue. For details of sales of energy and operating revenue for the last five years see OPERATING STATISTICS on page 23 of Narragansett's 1993 Annual Report to Stockholders (the Narragansett 1993 Annual Report). Granite State provides approximately 35,000 customers with electric service at retail in the State of New Hampshire in an area having a population of about 73,000 (1990 Census), including the city of Lebanon and the towns of Hanover, Pelham, Salem and surrounding communities. During 1993, 48% of Granite State's revenue from the sale of electricity was derived from commercial customers, 39% from residential customers, 12% from industrial customers, and 1% from others. In 1993, the 10 largest customers of Granite State accounted for about 20% of its electric revenue. Granite State is not subject to the reporting requirements of the Securities Exchange Act of 1934, and its financial impact on the System is relatively small. Information on Granite State is provided herein solely for the purpose of furnishing a more complete description of System operations. The electric utility business of NEP and the Retail Companies is not highly seasonal. For NEP and the Retail Companies, industrial customers are broadly distributed among standardized industrial classifications. No single industrial classification exceeds 4% of operating revenue, and no single customer of the System contributes more than 1% of operating revenue. Kilowatthour (KWH) sales billed to ultimate customers in 1993 increased by 1.4% over 1992. A return to more normal weather conditions in 1993 was largely offset by the fact that 1992 included an extra day for leap year. KWH sales billed to ultimate customers increased 0.4% in 1992. COMPETITIVE CONDITIONS The electric utility business is being subjected to increasing competitive pressures, stemming from a combination of increasing electric rates, improved technologies and new regulations, and legislation intended to foster competition. Recently, this competition has been most prominent in the bulk power market in which non-utility generating sources have noticeably increased their market share. For example, in 1984, less than 1% of NEP's capacity was supplied by non-utility generation sources. By the end of 1993, non-utility power purchases accounted for 380 MW or 7% of NEP's total capacity. In addition to competition from non- utility generators, the presence of excess generating capacity in New England has resulted in the sale of bulk power by utilities at prices less than the total costs of owning and operating such generating capacity. Electric utilities are also facing increased competition in the retail market. Currently, retail competition comes from alternative fuel suppliers (principally natural gas companies) for heating and cooling, customer-owned generation to displace purchases from electric utilities, and direct competition among electric utilities to attract major new manufacturing facilities to their service territories. In the future, the potential exists for electric utilities and non-utility generators to sell electricity to retail customers of other electric utilities. The NEES companies are responding to current and anticipated competitive pressures in a variety of ways including cost control and a corporate reorganization into separate retail and wholesale business units. The wholesale business unit is positioning itself for increased competition through such means as terminating certain purchased power contracts, past and future shutdowns of uneconomic generating stations, and rapid amortization of certain plant assets. NEP's rates currently include approximately $100 million per year associated with the recovery of certain Seabrook Nuclear Generating Station Unit 1 (Seabrook 1) costs under a 1988 rate settlement and coal conversion expenditures at NEP's Salem Harbor station. The recovery of these costs will be completed prior to the end of 1995. The retail business unit's response to competition includes the development of value-added services for customers and the offering of economic development rates to encourage businesses to locate in our service territory. In its recent rate settlement, Mass. Electric was able to change the standard terms under which it offers service to commercial and industrial customers to extend the notice period a customer must give from one to two years before purchasing electricity from others or generating any additional electricity for the customer's own use. In addition, Mass. Electric began offering a discount from base rates in return for a contract requiring the customer to provide five years written notice before purchasing electricity from others or generating any additional electricity for the customer's own use. The discount is available to customers with average monthly peak demands over 500 kilowatts. Electric utility rates are generally based on a utility's costs. Therefore, electric utilities are subject to certain accounting standards that are not applicable to other business enterprises in general. These accounting rules allow regulated entities, in appropriate circumstances, to establish regulatory assets and to defer the income statement impact of certain costs that are expected to be recovered in future rates. The effects of competition could ultimately cause the operations of the NEES companies, or a portion thereof, to cease meeting the criteria for application of these accounting rules. While the NEES companies do not expect to cease meeting these criteria in the near future, if this were to occur, accounting standards of enterprises in general would apply and immediate recognition of any previously deferred costs would be necessary in the year in which these criteria were no longer applicable. RATES General In 1993, 74% of the System's electric utility revenues was attributable to NEP, whose rates are subject to regulation by the Federal Energy Regulatory Commission (FERC). The rates of Mass. Electric, Narragansett, and Granite State are subject to the respective jurisdictions of the state regulatory commissions in Massachusetts, Rhode Island, and New Hampshire. The rates of each of the Retail Companies contain a purchased power cost adjustment clause (PPCA). The PPCA is designed to allow the Retail Companies to pass on to their customers increases in purchased power expense resulting from increases allowed by the FERC in NEP's rates. The Retail Companies are also required to reflect rate decreases or refunds. PPCA changes become effective on the dates specified in the filing of the adjustments with the state regulatory commission (not earlier than 30 days after such filing) unless the state regulatory commission orders otherwise. There have been, on occasion, regulatory delays in permitting PPCA increases. Effective March 1, 1993, Narragansett and Granite State received approval for PPCA clauses that fully reconcile on an annual basis purchased power expenses incurred by the companies against purchased power related revenues. Under the doctrine of Narragansett v. Burke, a case decided by the Rhode Island Supreme Court in 1977, NEP's wholesale rates must be accepted as allowable expenses for rate-making purposes by state commissions in retail rate proceedings. In 1986 and 1988 the U.S. Supreme Court reaffirmed this doctrine in two cases that did not involve NEP. However, the Narragansett v. Burke doctrine has been indirectly challenged by a number of state regulatory commissions which have held that federal preemption of the regulation of wholesale electric rates does not preclude the state commission from reviewing the prudence of a utility's decision to purchase power under a FERC-approved rate, and from disallowing costs if it finds that the purchase was an imprudent choice among alternative sources. In a 1985 opinion, the New Hampshire Supreme Court took this position on the issue of state regulation of wholesale power purchases. Also, legislation has been filed from time to time in Congress that would have eroded or repealed the doctrine. If state commissions were to refuse to allow the Retail Companies to include the full cost of power purchased from NEP in their rates, System earnings could be adversely affected. The rates of NEP and the Retail Companies contain fuel adjustment clauses that allow the rates to be adjusted to reflect changes in the cost of fuel. NEP's fuel clause is on a current basis. Mass. Electric has a fuel clause billing procedure that provides for monthly billing of estimated quarterly fuel costs, while Narragansett's and Granite State's fuel costs are estimated on a semi-annual basis. Billings are adjusted in the subsequent period for any excess or deficiency in fuel cost recovery. The FERC rules allow up to 50% of construction work in progress (CWIP) to be included in rate base in addition to CWIP already allowed in rate base for fuel conversion projects or pollution control facilities. This rule allows NEP the option of recovering currently through rates a portion of the costs of financing its construction program, rather than recording allowance for funds used during construction (AFDC) on that portion. The FERC rules with regard to canceled plants provide that utilities may recover in rates only 50% of prudently incurred canceled plant costs. However, the FERC allows utilities to include the recoverable amount in rate base and earn a return on the unamortized balance. NEP is recovering the cost of the conversion to coal of three units at Salem Harbor Station by means of an oil conservation adjustment (OCA), a FERC-approved rate. The OCA is designed to amortize the conversion costs by the mid-1990s. Through 1993, NEP has recovered approximately 84% of the conversion costs. The Retail Companies have OCA provisions designed to pass on to their customers amounts billed through NEP's OCA, which totaled $24.6 million for 1993. NEP Rates No NEP rate cases were filed with the FERC during 1993. Seabrook 1 Nuclear Unit NEP owns approximately 10% of Seabrook 1, a 1,150 MW nuclear generating unit, that entered commercial service on June 30, 1990. NEP's rate recovery of its investment in Seabrook 1 was resolved through two separate rate settlement agreements. The pre-1988 portion of NEP's investment is being recovered over a period of seven years and five months ending in July 1995. NEP's investment in Seabrook 1 since January 1, 1988, which amounts to approximately $50 million at December 31, 1993, is being recovered over its useful life. W-92 Rate Case In May 1992, the FERC approved a settlement of NEP's W-92 rate case under which base rates were increased by $39.7 million, effective March 1992. The entire increase was attributable to costs associated with the commercial operation of Unit 2 of the Ocean State Power (OSP) generating facility. These costs had been collected through NEP's fuel clause since the unit entered service in late 1991. The settlement also incorporated new depreciation rates proposed in NEP's filing, which reduced NEP's overall revenue requirement by $18 million. Mass. Electric Rates Rate schedules applicable to electric services rendered by Mass. Electric are on file with the Massachusetts Department of Public Utilities (MDPU). In November 1993, the MDPU approved a rate agreement filed by Mass. Electric, the Massachusetts Attorney General, and two groups of large commercial and industrial customers. Under the agreement, Mass. Electric began implementing an 11- month general rate decrease effective December 1, 1993 of $26 million (on an annual basis) from the level of rates then in effect. This rate reduction will continue in effect until October 31, 1994, after which rates will increase to the previously approved levels. The agreement also provided for rate discounts of up to $4 million available for the period ending October 31, 1994 for large commercial and industrial customers who agree to give a five-year notice to Mass. Electric before they purchase power from another supplier or generate any additional power themselves. These discounts will increase after October 31, 1994 to a level of $11 million per year if all eligible customers participate. Mass. Electric also agreed not to increase its base rates above currently approved levels before October 1, 1995. The decrease in revenues will be offset by the recognition for accounting purposes of revenues for electricity delivered but not yet billed. The agreement also resolved all issues associated with providing funds and securing rate recovery for environmental cleanup costs of Massachusetts manufactured gas waste sites formerly owned by Mass. Electric and its affiliates, as well as certain other Mass. Electric environmental cleanup costs (see Hazardous Substances, page 30). The rate agreement allows for these costs to be met by establishing a special interest bearing fund on Mass. Electric's books. On a consolidated basis, the fund's initial balance of $30 million comes from previously recorded environmental reserves and is not recoverable from customers. The establishment of the fund's initial balance at Mass. Electric resulted in a one-time charge to fourth quarter earnings of $9 million, before tax. Annual contributions of $3 million, adjusted for inflation, will be added to the fund by Mass. Electric and will be recoverable in rates. In addition, any shortfalls in the fund will be paid by Mass. Electric and be recovered through rates over seven years, without interest. Lastly, the agreement provided for the rate recovery of $8 million of certain storm restoration and other costs previously charged to expense. Effective October 1992, the MDPU authorized a $45.6 million annual increase in rates for Mass. Electric. This general rate increase included $2.5 million representing the first step of a four-year phase-in of Mass. Electric's tax deductible costs associated with post-retirement benefits other than pensions (PBOPs). A second $2.5 million increase took effect October 1, 1993. Narragansett Rates Rate schedules applicable to electric services rendered by Narragansett are on file with the Rhode Island Public Utilities Commission (RIPUC) and the Rhode Island Division of Public Utilities and Carriers. Effective March 1993, Narragansett implemented a new rate design which reallocated costs among its various rate classes, but which are not expected to affect total revenues over a twelve month period. Among other things, the new rates reduced the seasonality of the rates applicable to Narragansett's larger commercial and industrial customers. This change will result in lower revenues in summer months and higher revenues in other months when compared to Narragansett's prior rate design. Effective May 1992, the RIPUC authorized a $3.5 million annual increase in rates for Narragansett. In addition, effective January 1993, the RIPUC approved a $1.5 million increase in rates for Narragansett representing the first step of a three-year phase-in of Narragansett's recovery of costs associated with PBOPs. A second $1.5 million increase took effect in January 1994. Effective April 1991, the RIPUC approved Narragansett's settlement of a $13 million rate increase. Granite State Rates Effective March 1993, the New Hampshire Public Utilities Commission (NHPUC) authorized a $2.0 million rate increase for Granite State, with a retroactive adjustment to September 15, 1992 to reflect the difference between the authorized amount and the $1.4 million Granite State had been collecting on an interim basis since September 15, 1992. Effective July 1, 1993, the NHPUC approved a $0.7 million increase in rates for Granite State to recover costs associated with PBOPs. Recovery of Demand-Side Management Expenditures The three Retail Companies offer conservation and load management programs, usually referred to in the industry as Demand- Side Management (DSM) programs, which are designed to help customers use electricity efficiently, as a part of meeting the System's future resource needs and customers' needs for energy services. See RESOURCE PLANNING, page 36. The Retail Companies file their DSM programs regularly with their respective regulatory agencies and have received approval to recover in rates estimated DSM expenditures on a current basis. The rates provide for reconciling estimated expenditures to actual DSM expenditures, with interest. Mass. Electric's expenditures subject to the reconciliation mechanism were $47 million, $44 million, and $55 million in 1993, 1992, and 1991, respectively. Narragansett's expenditures subject to the reconciliation mechanism were $12 million, $12 million, and $19 million in 1993, 1992, and 1991, respectively. Since 1990, the Retail Companies have been allowed to earn incentives based on the results of their DSM programs. The Retail Companies must be able to demonstrate the electricity savings produced by their DSM programs to their respective state regulatory agencies before incentives are recorded. Mass. Electric recorded $6.7 million, $8.6 million, and $6.0 million of before-tax incentives in 1993, 1992, and 1991, respectively. Narragansett recorded $0.5 million, $1.3 million, and $1.6 million of before-tax incentives in 1993, 1992, and 1991, respectively. The Retail Companies have received regulatory approvals that will give them the opportunity to continue to earn incentives based on 1994 DSM program results. GENERATION Energy Mix The following table displays the contributions of various fuel sources and other generation to total net generation of electricity by NEP during the past three years, as well as an estimate for 1994: % of Net Generation -------------------------- Estimated Actual --------- ---------------- 1994 1993 1992 1991 ---- ---- ---- ---- Coal 37 38 41 44 Nuclear 18 18 18 18 Gas (1) 16 16 15 11 Oil 11 11 10 11 Hydroelectric 6 6 6 7 Hydro-Quebec 6 5 4 3 Renewable Non-Utility Generation (2) 6 6 6 6 --- --- --- --- 100 100 100 100 (1) Gas includes both utility and non-utility generation. (2) Waste to energy and hydro. Electric Utility Properties The electric utility properties of the System companies consist of NEP's and Narragansett's fossil-fuel base load and intermediate load steam generating units, conventional and pumped storage hydroelectric stations, internal combustion peaking units, portions of fossil fuel and nuclear generating units, the ownership interests of NEET, Mass. Hydro, and N.H. Hydro in the Hydro-Quebec Interconnection, and an integrated system of transmission lines, substations, and distribution facilities. See MAP - ELECTRIC UTILITY PROPERTIES, page 17. NEP's integrated system consists of 2,290 circuit miles of transmission lines, 116 substations with an aggregate capacity of 13,265,588 kVA, and 7 pole or conduit miles of distribution lines. The properties of Mass. Electric and Narragansett include substations and distribution and transmission lines, which are interconnected with transmission and other facilities of NEP. At December 31, 1993, Mass. Electric owned 282 substations, which had an aggregate capacity of 2,859,309 kVA, 147,090 line transformers with the capacity of 7,489,447 kVA, and 15,948 pole or conduit miles of distribution lines. Mass. Electric also owns 81 circuit miles of transmission lines. At December 31, 1993, Narragansett owned 248 substations, which had an aggregate capacity of 2,838,927 kVA, 53,100 line transformers with the capacity of 2,239,554 kVA, and 4,492 pole or conduit miles of distribution lines. Narragansett, in addition, owns 325 circuit miles of transmission lines. Substantially all of the properties and franchises of Mass. Electric, Narragansett, and NEP are subject to the liens of indentures under which mortgage bonds have been issued. For details of the mortgage liens on these properties see the long-term debt note in Notes to Financial Statements in each of these companies' respective 1993 Annual Report. The properties of NEET are subject to a mortgage under its financing arrangements. (a) These units currently burn coal, but are also capable of burning oil. (b) For a discussion of the Manchester Street Station repowering project, see Manchester Street Station Repowering on page 37. (c) Includes (i) an interest in a jointly owned oil-fired unit in Yarmouth, Maine, and (ii) diesel units at various locations. (d) See Hydroelectric Project Licensing, page 28. (e) See Nuclear Units, page 21. (f) Capability includes contracted purchases (1,312 MW) less contract sales (164 MW). Net generation includes the effects of the above contracted purchases and economy interchanges through the New England Power Exchange (including Hydro-Quebec purchases and purchases from non-utility generation). For further information see Non-Utility Generation Sources, page 20. NEP and Narragansett are members of the New England Power Pool (NEPOOL), a group of over 90 New England utilities that comprises virtually all of New England's electric generation. Mass. Electric and Granite State participate in NEPOOL through NEP. The NEPOOL Agreement provides for coordination of the planning and operation of the generation and transmission facilities of its members. The NEPOOL Agreement incorporates generating capacity reserve obligations, provisions regarding the use of major transmission lines, and provisions for payment for facilities usage. The NEPOOL Agreement further provides for New England-wide central dispatch of generation through the New England Power Exchange. Through NEPOOL, operating and capital economies are achieved and reserves are established on a region-wide rather than an individual company basis. The electric energy available to NEES subsidiaries and other members is determined by the aggregate available to NEPOOL. The 1993 NEPOOL peak demand of 19,570 MW occurred on July 8, 1993. The maximum demand to date of 19,742 MW occurred on July 19, 1991. The 1993 summer peak for the System of 4,081 MW occurred on July 8, 1993. This was below the previous all time peak load of 4,250 MW which occurred on July 19, 1991. The 1993-1994 winter peak of 4,121 MW occurred on January 19, 1994. For a discussion of resource planning, see RESOURCE PLANNING, page 36. MAP (Displays electric utility properties of NEES subsidiaries) Fuel for Generation NEP burned the following amounts of coal, residual oil, and gas during the past three years: 1993 1992 1991 ---- ---- ---- Coal (in millions of tons) 3.2 3.3 3.6 Oil (in millions of barrels) 5.0 4.9 6.4 Natural Gas (in billions of cubic feet) 0.7 3.2 1.7 Coal Procurement Program Depending on coal-fired generating unit availability and the degree to which the units are dispatched, NEP's 1994 coal requirements should range between 3.0 and 3.2 million tons. NEP obtains its domestic coal under contracts of varying lengths and on a spot basis from domestic coal producers in Kentucky, West Virginia, and Pennsylvania, and from mines in Colombia and Venezuela. Three different rail systems (CSX, Norfolk Southern, and Conrail) transport coal from domestic sources to loading ports on the east coast. NEP's coal is transported from east coast ports by ocean-going collier to Brayton Point and Salem Harbor. NEP has a term charter with the Energy Independence, a self-unloading collier, which carries all of NEP's U.S. coal and a portion of foreign coal. NEP also charters other coal-carrying vessels for the balance of foreign coal. As protection against interruptions in coal deliveries, NEP maintained coal inventories at its generating stations during 1993 in the range of 40 to 60 days. A United Mine Workers strike lasting the second half of 1993 interrupted one long-term contract which was replaced prior to its 1994 expiration. To meet environmental requirements, NEP uses coal with a relatively low sulphur and ash content. NEP's average price for coal burned, including transportation costs, calculated on a 26 million Btu per ton basis, was $44.72 per ton in 1991, $44.15 in 1992, and $43.53 per ton in 1993. Based on a 42 gallon barrel of oil producing 6.3 million Btu's, these coal prices were equivalent to approximately $10.83 per barrel of oil in 1991, $10.70 in 1992 and $10.57 per barrel of oil in 1993. Oil Procurement Program The System's 1994 oil requirements are expected to be approximately 5.0 million barrels. The System obtains its oil requirements through contracts with oil suppliers and purchases on the spot market. Current contracts provide for minimum annual purchases of 2.6 million barrels at market related prices. The System currently has a total storage capacity for approximately 2.3 million barrels of residual and diesel fuel oil. The System's average cost of oil burned, calculated on a 6.3 million Btu per barrel basis, was $11.82 in 1991, $12.68 in 1992, and $13.30 in 1993. Natural Gas NEP uses natural gas at both Brayton 4 and Manchester Street Stations when gas is priced less than residual fuel oil. At Brayton 4, natural gas currently displaces 2.2% sulphur residual fuel oil. At Manchester Street Station, gas currently displaces 1.0% sulphur residual fuel oil. In 1993, approximately 0.7 billion cubic feet of gas were consumed at an average cost of $2.58 per thousand cubic feet excluding pipeline demand charges. This gas price was equivalent to approximately $16.25 per barrel of oil. Firm year-round gas deliveries to Manchester Street Station are planned as part of its repowering project. The repowered facility would use up to 95 million cubic feet of natural gas per day. See Manchester Street Station Repowering, page 37. NEP has contracted with six pipeline companies for transportation of natural gas from supply regions to these two generating stations: (1) 60 million cubic feet per day from Western Canada via TransCanada PipeLines, Ltd. (TransCanada), Iroquois Gas Transmission System, Tennessee Gas Pipeline Company and Algonquin Gas Transmission Company, and (2) 60 million cubic feet per day from the U.S. Mid-Continent region via ANR Pipeline Company, Columbia Gas Transmission Company and Algonquin. (a) NEP has entered into a firm service agreement with TransCanada. Service commenced on November 1, 1992. (b) NEP has entered into a firm service agreement with Iroquois. Service commenced on November 1, 1993. (c) NEP has entered into a firm service agreement with Tennessee. Service commenced on November 1, 1993. (d) NEP has entered into a firm service agreement with Algonquin for delivery of Canadian gas. Service commenced on November 1, 1993. Additional service for a portion of the domestic gas is expected to commence in December 1994. NEP has also entered into a firm service agreement for deliveries of gas to its Brayton Point Station. All facilities for this service have been constructed and in service since December of 1991. (e) ANR has constructed substantially all facilities necessary to serve NEP. NEP has entered into a firm service agreement with ANR. Service is expected to commence in December 1994. (f) Columbia has received and accepted a FERC certificate to construct facilities for service to NEP. NEP has entered into a firm service agreement with Columbia. Service is expected to commence in December 1994. NEP has also signed contracts with four Canadian gas suppliers for a total of 60 million cubic feet per day. NEP has not yet signed supply arrangements with Mid-Continent producers. The pipeline agreements require minimum fixed payments. NEP's minimum net payments are currently estimated to be approximately $45 million in 1994, $65 million in 1995, and $70 million each in 1996, 1997, and 1998. The amount of the fixed payments are subject to FERC regulation and will depend on FERC actions affecting the rates on each of the pipelines. As part of its W-12 rate settlement, NEP is recovering 50% of the fixed pipeline capacity payments through its current fuel clause and deferring the recovery of the remaining 50% until the Manchester Street repowering project is completed. NEP has deferred payments of approximately $13 million as of December 31, 1993. Nuclear Fuel Supply As noted above, NEP participates with other New England utilities in the ownership of several nuclear units. See Nuclear Units, page 21. The utilities responsible for supply for these units are not experiencing any difficulty in obtaining commitments for the supply of each element of the nuclear fuel cycle. Non-Utility Generation Sources The System companies purchase a portion of the electricity generated by, or provide back-up or standard service to, 139 small power producers or cogenerators (a total of 3,185,101 MWh of purchases in 1993). As of December 31, 1993, these non-utility generation sources include 32 low-head hydroelectric plants, 51 wind or solar generators, seven waste to energy facilities, and 49 cogenerators. The total capacity of these sources is as follows: In Service Future Projects (12/31/93) Under Contract Source (MW) (MW) ------ ---------- --------------- Hydro 43 - Wind - 20 Waste to Energy 169 33 Cogeneration 303 40 Independent Power Producers - 83* ---- --- Total 515 176 * Milford Power was accepted for dispatch by NEPOOL on January 20, 1994. The in-service amount includes 377 MW of capacity and 138 MW treated as load reductions and excludes the Ocean State Power contracts discussed below. Ocean State Power Ocean State Power (OSP) and Ocean State Power II (OSP II) are general partnerships that own and operate a two unit gas-fired combined cycle electric power plant in Burrillville, R.I. Resources is a general partner with a 20% interest in both OSP and OSP II and had an equity investment of approximately $40 million at December 31, 1993. The first unit began commercial operation on December 31, 1990 and the second unit went into service on October 1, 1991. The two units have a combined winter net electrical capability of approximately 562 MW. Each unit's capacity and energy output is sold under 20-year unit power agreements to a group of New England utilities, including NEP, which has contracts for 48.5% of the output of each unit. NEP is required to make certain minimum fixed payments to cover capital and fixed operating costs of these units in amounts estimated to be $70 million per year. Interconnection with Quebec NEET, Mass. Hydro, and New Hampshire Hydro own and operate, on behalf of NEPOOL participants in the project, a 450 kV direct current (DC) transmission line and related terminals to interconnect the New England and Quebec transmission systems (the Interconnection). The transfer capability of the Interconnection is 2,000 MW. NEPOOL members purchase from and sell energy to Hydro-Quebec pursuant to several agreements. The principal agreement calls for NEPOOL members to purchase 7 billion KWH of energy each year for ten years (the Firm Energy Contract). Purchases under the Firm Energy Contract totaled over 6.4 billion KWH in 1993. NEP is a participant in both the Phase I and Phase II projects of the Interconnection. NEP's participation percentage in both projects is approximately 18%. NEP and the other participants have entered into support agreements that end in 2020, to pay monthly their proportionate share of the total cost of constructing, owning, and operating the transmission facilities. NEP accounts for these support agreements as capital leases and accordingly recorded approximately $78 million in utility plant at December 31, 1993. Under the support agreements, NEP has agreed, in conjunction with any Phase II project debt financing, to guarantee its share of project debt. At December 31, 1993, NEP had guaranteed approximately $34 million. In the event any Interconnection facilities are abandoned for any reason, each participant is contractually committed to pay its pro-rata share of the net investment in the abandoned facilities. Nuclear Units General NEP is a stockholder of Yankee Atomic Electric Company (Yankee Atomic), Vermont Yankee Nuclear Power Corporation (Vermont Yankee), Maine Yankee Atomic Power Company (Maine Yankee), and Connecticut Yankee Atomic Power Company (Connecticut Yankee). Each of these companies (collectively referred to as the Yankee Companies) owns a single nuclear generating unit. In addition, NEP is a joint owner of the Millstone 3 nuclear generating unit in Connecticut and the Seabrook 1 nuclear generating unit in New Hampshire. Millstone 3 and Seabrook 1 are operated by subsidiaries of Northeast Utilities (NU). NEP pays its proportionate share of costs and receives its proportionate share of each unit's output. NEP's interest and investment in each of the Yankee Companies, Millstone 3, and Seabrook 1 and the net capability of each plant are as follows: Equity Net Investment Capability (12/31/93) Interest (MW) (in millions) -------- ---------- ------------- Yankee Atomic 30.0% * $ 7 Vermont Yankee 20.0% 93 10 Maine Yankee 20.0% 158 14 Connecticut Yankee 15.0% 87 15 ---- ---- Subtotal 338 $ 46 Net Investment in Plant** (12/31/93) (in millions) ------------- Millstone 3 12.2% 140 $405 Seabrook 1 9.9% 115 149 ---- Subtotal 255 ---- Total 593 ==== *Operations ceased **Excludes nuclear fuel NEP has a 30% ownership interest in Yankee Atomic which owns a 185 megawatt nuclear generating station in Rowe, Massachusetts. The station began commercial service in 1960. In February 1992, the Yankee Atomic board of directors decided to permanently cease power operation of, and in time, decommission the facility. In March 1993, the FERC approved a settlement agreement that allows Yankee Atomic to recover all but $3 million of its approximately $50 million remaining investment in the plant over the period extending to July 2000, when the plant's Nuclear Regulatory Commission (NRC) operating license would have expired. Yankee Atomic recorded the $3 million before-tax write-down in 1992. The settlement agreement also allows Yankee Atomic to earn a return on the unrecovered balance during the recovery period and to recover other costs, including an increased level of decommissioning costs, over this same period. Decommissioning cost recovery increased from $6 million per year to $27 million per year for the period 1993 to 1995. This level of recovery is subject to review in 1996. NEP has recorded an estimate of its entire future payment obligations to Yankee Atomic as a liability on its balance sheet and an offsetting regulatory asset reflecting its expected future rate recovery of such costs. This liability and related regulatory asset amounted to approximately $104 million each at December 31, 1993. NEP purchases the output of the other Yankee nuclear electric generating plants in the same percentages as its stock ownership of the Yankee Companies, less small entitlements taken by municipal utilities for Maine Yankee and Vermont Yankee. NEP has power contracts with each Yankee Company that require NEP to pay an amount equal to its share of total fixed and operating costs (including decommissioning costs) of the plant plus a return on equity. The stockholders of three Yankee Companies (Vermont Yankee, Maine Yankee and Connecticut Yankee) have agreed, subject to regulatory approval, to provide capital requirements in the same proportion as their ownership percentages of the particular Yankee Company. Pursuant to the terms of a lending agreement, Yankee Atomic will not pay dividends to its shareholders, including NEP, until such lender is paid in full. There is widespread concern about the safety of nuclear generating plants. The NRC regularly reviews the adequacy of its comprehensive requirements for nuclear plants. Many local, state, and national public officials have expressed their opposition to nuclear power in general and to the continued operation of nuclear power plants. It is possible that this controversy will result in cost increases and modifications to, or premature shutdown of, the operating nuclear units in which NEP has an interest. On three occasions (most recently in 1987), referenda appeared on the ballot in Maine that, if passed, would have required the prompt shutdown of Maine Yankee. All the referenda were defeated. There is no assurance that similar measures will not appear on future ballots. Pending before FERC is an initial decision of an administrative law judge disallowing full rate recovery for the unamortized portion of a nuclear plant to be retired before the end of its operating license. The decision, if affirmed, would result in rate recovery of less than the full investment in a nuclear plant retired from service prior to the end of its operating license. The amount of the disallowance would depend upon the plant's historic capacity factor and the number of years remaining on its operating license. Decommissioning Each of the Yankee Companies includes charges for all or a portion of decommissioning costs in its cost of energy. These charges vary depending upon rate treatment, the method of decommissioning assumed, economic assumptions, site and unit specific variables, and other factors. Any increase in these charges is subject to FERC approval. Each of the operating nuclear units has established decommissioning trust funds or escrow funds into which payments are being made to meet the projected cost of decommissioning its plant. If any of the units were shut down prior to the end of its operating license, the funds collected for decommissioning to that point would be insufficient. Estimates of NEP's pro-rata share (based on ownership) of decommissioning costs, NEP's share of the actual book values of decommissioning fund balances set aside for each unit at December 31, 1993 (in millions of dollars), and the expiration date of the operating license of each plant are as follows: NEP's share of ----------------------------- Estimated Decommissioning Fund License Costs Balances (1) Expiration Unit (in 1993 $) (12/31/93) Date ---- --------------- ------------ ---------- Yankee Atomic (2) $78 $26 -- Connecticut Yankee $49 $18 2007 Maine Yankee $63 $19 2008 Vermont Yankee $57 $20 2012 Millstone 3 $50 $10 2025 Seabrook 1 $36 $ 3 2026 (1) Certain additional amounts are anticipated to be available through tax deductions. (2) The estimated cost of decommissioning for Yankee Atomic does not reflect the benefit of the component removal project (CRP) for which decommissioning funds were spent in 1993. Additional expenditures for CRP will be made in 1994. NEP is currently collecting through rates amounts for decommissioning based upon cost estimates and funding methodologies authorized by FERC. Such estimates are determined periodically for each plant and may not reflect the current projected cost of decommissioning. There is no assurance that decommissioning costs actually incurred by the Yankee Companies, Millstone 3 or Seabrook 1 will not substantially exceed these amounts. For example, current decommissioning cost estimates assume the availability of permanent repositories for both low-level and high-level nuclear waste which do not currently exist. NRC rules require that reasonable assurance be provided that adequate funds will be available for the decommissioning of commercial nuclear power plants. The rule establishes minimum funding levels that licensees must satisfy. Each of the units in which NEP has an interest has filed a report with the NRC providing assurance that funds will be available to decommission the facility. A Maine statute provides that if both Maine Yankee and its decommissioning trust fund have insufficient assets to pay for the plant decommissioning, the owners of Maine Yankee are jointly and severally liable for the shortfall. The definition of owner under the statute covers NEP and may cover companies affiliated with it. NEP and the Retail Companies cannot determine, at this time, the constitutionality, applicability, or effect of this statute. If NEP or the Retail Companies were required to make payments under this statute, they would assess their legal remedies at that time. In any event, NEP and the Retail Companies would attempt to recover through rates any payments required. If any claim in excess of NEP's ownership share were enforced against a NEES company, that company would seek reimbursement from any other Maine Yankee stockholder which failed to pay its share of such costs. The Energy Policy Act of 1992 assesses the domestic nuclear power industry for a portion of costs associated with the decontamination and decommissioning of the Department of Energy's (DOE) uranium enrichment facilities. An annual assessment of $150 million (escalated for inflation) on the domestic nuclear power industry will be allocated to each plant based upon the amount of DOE uranium enrichment services utilized in the past. The total DOE assessment, which began in October 1992, will remain in place for up to 15 years and will amount to $2.25 billion (escalated). The Yankees, Millstone 3 and Seabrook have been assessed and initial billings indicate NEP's obligation for such costs over the next 14 years will be approximately $29 million. In accordance with the provisions of the Energy Policy Act, these costs are being recovered through NEP's fuel clause. High-Level Waste Disposal The Nuclear Waste Policy Act of 1982 provides a framework and timetable for selection of sites for repositories of high-level radioactive waste (spent nuclear fuel) from United States nuclear plants. The DOE has entered into contracts with the Yankee Companies, the Millstone 3 joint owners, and the Seabrook 1 joint owners for acceptance of title to, and transportation and storage of, this waste. Under these contracts, each operating unit will pay fees to the DOE to cover the development and creation of waste repositories. Fees for fuel burned since April 1983 have been collected by the DOE on an ongoing basis at the rate of one tenth of a cent per KWH of net generation. Fees for generation up through April 1983 were determined by the DOE as follows: $13.2 million for Yankee Atomic, $48.7 million for Connecticut Yankee, $50.4 million for Maine Yankee, and $39.3 million for Vermont Yankee. Neither Millstone 3 nor Seabrook 1 has been assessed any fees for fuel burned through April 1983, because they did not enter commercial operation until 1986 and 1990, respectively. The Yankee Companies had several options to pay these fees. Yankee Atomic paid its fee to the DOE for the period through April 1983. The other three Yankee Companies elected to defer payment until a future date, thereby incurring interest expense. However, payment to the DOE must occur prior to the first delivery of spent fuel. Connecticut, Maine, and Vermont Yankee have segregated a portion of their respective DOE obligations in external accounts. The remainder of the funds have been used to support general capital requirements. All expect to separately fund in full in external accounts their DOE obligation (including accrued interest) prior to payment to the DOE. To the extent that any of the three Yankee Companies is unable to fully meet its DOE obligation at the prescribed time, NEP might be required to provide additional funds. Prior to such time that the DOE takes delivery of a plant's spent nuclear fuel, it is stored on site in spent fuel pools. Connecticut Yankee and Maine Yankee have adequate existing storage through the late 1990's. Millstone 3 will be able to maintain a full core discharge capability through the end of its current license. Seabrook 1's current licensed storage capacity is adequate until at least 2010. Vermont Yankee is able to maintain a full core discharge capability until 2001. Yankee Atomic has adequate on-site storage capacity for all its spent fuel. Federal legislation enacted in December 1987 directed the DOE to proceed with the studies necessary to develop and operate a permanent high-level waste disposal site at Yucca Mountain, Nevada. There is local opposition to development of this site. Although originally scheduled to open in 1998, the DOE announced in November 1989 that the permanent disposal site is not expected to open before 2010, a date the DOE has defined as optimistic. The legislation also provides for the development of a Monitored Retrievable Storage (MRS) facility and abandons plans to identify and select a second, permanent disposal site. An MRS facility would provide temporary storage for high-level waste prior to eventual permanent disposal. It is not known when an MRS facility would begin accepting deliveries. Additional delays due to political and technical problems are likely. It is extremely unlikely deliveries would be accepted prior to 1999. Federal authorities have deferred indefinitely the commercial reprocessing of spent nuclear fuel. Low-Level Waste Disposal In 1986, the Low-Level Radioactive Waste Policy Amendments Act was enacted by Congress. This statute sets a time limit of December 31, 1992, beyond which disposal of low-level waste at any of the three existing sites is impermissible. Under the statute, individual states are responsible for finding local sites for disposal or forming regional disposal compacts by defined milestone dates. As of December 1991, all of the states in which NEP holds an interest in a nuclear facility had met the 1990 milestone which required the filing of a facility operating license application or Governor's certification that the state will provide for storage, disposal, and management of waste generated after 1992. Although New Hampshire met the 1990 milestone, the arrangements made by the state did not encompass low-level waste generated by Seabrook 1 and it is currently prohibited from shipping its low-level waste out of the state. Connecticut Yankee, Millstone 3, Vermont Yankee, Maine Yankee and Yankee Atomic are currently allowed to ship low-level radioactive waste to the existing disposal site in South Carolina. The 1992 milestone required each state to file a facility operating license application. None of the states in which NEP holds an interest in a nuclear facility has met this milestone. Failure to meet this milestone means that those states may be subject to surcharges on waste shipped out of state. Disposal costs could increase significantly. Since January 1, 1993, the South Carolina low-level waste disposal site has been the only site open to accept low-level waste from NEP's units. The South Carolina site will remain open until June 30, 1994 to generators whose states are making progress toward developing their own disposal facilities. Effective June 30, 1994, the South Carolina low-level waste disposal site will be closed permanently to non- regional wastes. However, all of the nuclear facilities in which NEP has an interest have temporary storage facilities on site to meet short-term low-level radioactive waste storage requirements. Price-Anderson Act The Price-Anderson Act limits the amount of liability claims that would have to be paid in the event of a single incident at a nuclear plant to $9.2 billion (based upon 114 licensed reactors). The maximum amount of commercially available insurance coverage to pay such claims is only $200 million. The remaining $9.0 billion would be provided by an assessment of up to $79.3 million per incident levied on each of the nuclear units in the United States, subject to a maximum assessment of $10 million per incident per nuclear unit in any year. The maximum assessment, which was most recently calculated in 1993, is to be adjusted at least every five years to reflect inflationary changes. NEP's current interest in the Yankees, Millstone 3, and Seabrook 1 would subject NEP to an $81.8 million maximum assessment per incident. NEP's payment of any such assessment would be limited to a maximum of $10.3 million per incident per year. As a result of the permanent cessation of power operation of the Yankee Atomic plant, Yankee Atomic has petitioned the NRC for an exemption from obligations under the Price-Anderson Act. Other Items Federal legislation requires emergency response plans, approved by federal authorities, for nuclear generating units. The Yankee Companies, Seabrook 1, and Millstone 3 are not currently experiencing difficulty in maintaining approval of their emergency response plans. REGULATORY AND ENVIRONMENTAL MATTERS Regulation Numerous activities of NEES and its subsidiaries are subject to regulation by various federal agencies. Under the 1935 Act, many transactions of NEES and its subsidiaries are subject to the jurisdiction of the Securities and Exchange Commission (SEC). Under the Federal Power Act, certain electric subsidiaries of NEES are subject to the jurisdiction of the FERC with respect to rates, accounting, and hydroelectric facilities. In addition, the NRC has broad jurisdiction over nuclear units and federal environmental agencies have broad jurisdiction over environmental matters. The electric utility subsidiaries of NEES are also subject to the jurisdiction of regulatory bodies of the states and municipalities in which they operate. For more information, see: RATES, page 8, Nuclear Units, page 21, RESOURCE PLANNING, page 36, Fuel for Generation, page 18, Environmental Requirements, page 29, and OIL AND GAS OPERATIONS, page 43. Hydroelectric Project Licensing NEP is the largest operator of conventional hydroelectric facilities in New England. NEP's hydroelectric projects are licensed by the FERC. These licenses expire periodically and the projects must be relicensed at that time. NEP's present licenses expire over a period from 2001 to 2020 excluding the Deerfield River Project discussed below. Upon expiration of a FERC license for a hydro project, the project may be taken over by the United States or licensed to the existing, or a new licensee. If the project were taken over, the existing licensee would receive an amount equal to the lesser of (i) fair value of the project or (ii) original cost less depreciation and amounts held in amortization reserves, plus in either case severance damages. The net book value of NEP's hydroelectric projects was $245 million as of December 31, 1993. In the event that a new license is not issued when the existing license expires, FERC must issue annual licenses to the existing licensee which will allow the project to continue operation until a new license is issued. A new license for a project may incorporate operational restrictions and requirements for additional non-power facilities (e.g., recreational facilities) that could affect operation of the project, and may also require additional capital investment. For example, NEP has previously received new licenses for projects on the Connecticut River that involved construction of an extensive system of fish ladders. The license for the 84 MW Deerfield River Project expired at the end of 1993. NEP filed an application for a new license in 1991, which is still under review. Several advocacy groups have intervened proposing operational modifications which would reduce the energy output of the project substantially. FERC has issued NEP an annual license to continue operation of the project under the terms and conditions of the expired license until a new license issues or other disposition of the project takes place. The next NEP project to require a new license will be the 368 MW Fifteen Mile Falls Project on the Connecticut River in New Hampshire and Vermont. This license expires in 2001. The formal process of preparing an application for a new license will begin in 1996. FERC has recently issued a Notice of Inquiry regarding the decommissioning of licensed hydroelectric projects. Responses to this notice are still under review at FERC. Some parties have advocated positions in this docket that would draw into question recovery of investment and severance damages in the event of project decommissioning. Depending upon the scope of any project decommissioning regulations, the associated costs could be substantial. Environmental Requirements Existing Operations The NEES subsidiaries are subject to federal, state, and local environmental regulation of, among other things: wetlands and flood plains; air and water quality; storage, transportation, and disposal of hazardous wastes and substances; underground storage tanks; and land-use. It is likely that the stringency of environmental regulation affecting the System and its operations will increase in the future. Siting and Construction Activities for New Facilities All New England states require, in certain circumstances, regulatory approval for site selection or construction of electric generating and major transmission facilities. Connecticut, Maine, Massachusetts, New Hampshire, and Rhode Island also have programs of coastal zone management that might restrict construction of power plants and other electrical facilities in, or potentially affecting, coastal areas. All agencies of the federal government must prepare a detailed statement of the environmental impact of all major federal actions significantly affecting the quality of the environment. The New England states have environmental laws which require project proponents to prepare reports of the environmental impact of certain proposed actions for review by various agencies. Except for the planned Manchester Street Repowering Project, the System is not currently constructing generating plants or major transmission facilities. Environmental Expenditures Total System capital expenditures for environmental protection facilities have been substantial. System capital expenditures for such facilities amounted to approximately $29 million in 1991, $31 million in 1992, and $23 million in 1993, including expenditures by NEP of $25 million, $28 million, and $14 million, respectively, for those years. The System estimates that total capital expenditures for environmental protection facilities will be approximately $65 million in 1994 ($50 million by NEP) and $25 million in 1995 ($15 million by NEP). Hazardous Substances The United States Environmental Protection Agency (EPA) has established a comprehensive program for the management of hazardous waste. The program allows individual states to establish their own programs in coordination with the EPA; Massachusetts, New Hampshire, Vermont, and Rhode Island have established such programs. Both the EPA and Massachusetts regulations cover certain operations at Brayton Point and Salem Harbor. Other System activities, including hydroelectric and transmission and distribution operations, also involve some wastes that are subject to EPA and state hazardous waste regulation. In addition, numerous System facilities are subject to federal and state underground storage tank regulations. The EPA regulates the manufacture, distribution, use, and disposal of polychlorinated biphenyls (PCB), which are found in dielectric fluid used in some electrical equipment. The System has completed the removal from service of all PCB transformers and capacitors. Some electrical equipment contaminated with PCBs remains in service. At sites where PCB equipment has been operated, removal, disposal, and replacement of contaminated soils may be required. The Federal Comprehensive Environmental Response, Compensation and Liability Act, more commonly known as the "Superfund" law, imposes strict, joint and several liability, regardless of fault, for remediation of property contaminated with hazardous substances. Parties liable include past and present site owners and operators, transporters that brought wastes to the site, and entities that generated or arranged for disposal or treatment of wastes ultimately disposed of at the site. A number of states, including Massachusetts, have enacted similar laws. The electric utility industry typically utilizes and/or generates in its operations a range of potentially hazardous products and by-products. These products or by-products may not have previously been considered hazardous, and may not currently be considered hazardous, but may be identified as such by federal, state, or local authorities in the future. NEES subsidiaries currently have in place an environmental audit program intended to enhance compliance with existing federal, state, and local requirements regarding the handling of potentially hazardous products and by-products. Federal and state environmental agencies, as well as private parties, have contacted or initiated legal proceedings against NEES and certain subsidiaries regarding liability for cleanup of sites alleged to contain hazardous waste or substances. NEES and/or its subsidiaries have been named as a potentially responsible party (PRP) by either the EPA or the Massachusetts Department of Environmental Protection (DEP) for 18 sites (6 for NEP, 13 for Mass. Electric, and 2 for Narragansett) at which hazardous waste is alleged to have been disposed. NEES and its subsidiaries are also aware of other sites which they may be held responsible for remediating and it is likely that, in the future, NEES and its subsidiaries will become involved in additional proceedings demanding contribution for the cost of remediating additional hazardous waste sites. The most prevalent types of hazardous waste sites that NEES and its subsidiaries have been connected with are former manufactured gas locations. Until the early 1970s, NEES was a combined electric and gas holding company system. Gas was manufactured from coal and oil until the early 1970s to supply areas in which natural gas was not yet available or for peaking purposes. Among the waste byproducts of that process were coal and oil tars. The NEES companies are currently aware of approximately 40 locations at which gas may have been manufactured and/or stored. Of the manufactured gas locations, 17 have been listed for investigation by the DEP. Two manufactured gas plant locations that have been the subject of extensive litigation are discussed in more detail below: the Pine Street Canal Superfund site in Burlington, Vermont and a site located in Lynn, Massachusetts. Approximately 18 parties, including NEES, have been notified by the EPA that they are PRPs for cleanup of the Pine Street Canal site, at which coal tar and other materials were deposited. Between 1931 and 1951, NEES and its predecessor owned all of the common stock of Green Mountain Power Corporation. Prior to, during, and after that time, gas was manufactured at the Pine Street Canal site. The EPA had brought a lawsuit against NEES and other parties to recover all of the EPA's past and future response costs at this site. In 1990, the litigation ended with the filing of a final consent decree with the court. Under the terms of the settlement, to which 14 entities were party, the EPA recovered its past response costs. NEES recorded its share of these costs in 1989. NEES remains a PRP for ongoing and future response costs. In November 1992, the EPA proposed a cleanup plan estimated by the EPA to cost $50 million. In June 1993, the EPA withdrew this cleanup plan in response to public concern about the plan and the cost. It is not known at this time what the ultimate cleanup plan will be, how much it will cost, or what portion NEES will have to pay. On May 26, 1993, the United States Court of Appeals for the First Circuit affirmed on appeal an earlier adverse decision against NEES and two of its subsidiaries, Mass. Electric and New England Power Service Company, with respect to the Lynn, Massachusetts site which was once owned by an electric and gas utility formerly owned by NEES. The electric operations of this subsidiary were merged into Mass. Electric. The decision held NEES and these subsidiaries liable for cleanup of the properties involved in the case. Although the circumstances differ from location to location, the Court of Appeals opinion has adverse implications for the potential liability of NEES and its subsidiaries with respect to other gas manufacturing locations operated by gas utilities once owned by NEES. In November 1993, the MDPU approved a rate agreement filed by Mass. Electric (see RATES, page 8) that resolved all rate recovery issues related to Massachusetts manufactured gas sites formerly owned by NEES or its subsidiaries as well as certain other Massachusetts hazardous waste sites. The agreement allows for these costs to be met by establishing a special fund on Mass. Electric's books. On a consolidated basis, the fund's initial balance of $30 million comes from previously recorded environmental reserves and is not recoverable from customers. NEES had previously established approximately $40 million of reserves related to Massachusetts manufactured gas locations earlier in 1993 and in prior years. The establishment of the fund's initial balance at Mass. Electric resulted in a one-time charge to fourth quarter earnings of $9 million, before tax. The agreement also provides that contributions of $3 million, adjusted for inflation, be added to the fund each year by Mass. Electric and be recoverable in rates. Under the agreement, any shortfalls in the fund will be paid by Mass. Electric and be recovered through rates over seven years, without interest. Predicting the potential costs to investigate and remediate hazardous waste sites continues to be difficult. Factors such as the evolving nature of remediation technology and regulatory requirements and the particular characteristics of each site, including, for example the size of the site, the nature and amount of waste disposed at the site, and the surrounding geography and land use, make precise estimates difficult. There are also significant uncertainties as to the portion, if any, of the investigation and remediation costs of any particular hazardous waste site that may ultimately be borne by NEES or its subsidiaries. At year end 1993, NEES had total reserves for environmental response costs of $56 million and a related regulatory asset of $19 million. NEES and each of its subsidiaries believe that hazardous waste liabilities for all sites of which each is aware, and which are not covered by a rate agreement, will not be material (10% of common equity) to their respective financial positions. Where appropriate, the NEES companies intend to seek recovery from their insurers and from other PRPs, but it is uncertain whether, and to what extent, such efforts would be successful. NEP, in burning coal and oil to produce electricity, produces approximately 308,000 tons per year of coal ash and other coal combustion by-products and 18,500 tons per year of oil ash. In August 1993, the EPA determined that coal combustion byproducts would not be regulated as a hazardous waste. The EPA is expected to issue regulations regarding oil ash treatment in 1997. The EPA and the New England states in which System companies operate regulate the removal and disposal of material containing asbestos. Asbestos insulation is found extensively on power plant equipment and, to a lesser extent, in buildings and underground electric cable. System companies routinely remove and dispose of asbestos insulation during equipment maintenance. Electric and Magnetic Fields (EMF) In recent years, concerns have been raised about whether EMF, which occur near transmission and distribution lines as well as near household wiring and appliances, cause or contribute to adverse health effects. Numerous studies on the effects of these fields, some of them sponsored by electric utilities (including NEES companies), have been conducted and are continuing. Some of the studies have suggested associations between certain EMF and various types of cancer, while other studies have not substantiated such associations. In February 1993, the EPA called for significant additional research on EMF. It is impossible to predict the ultimate impact on NEES subsidiaries and the electric utility industry if further investigations were to demonstrate that the present electricity delivery system is contributing to increased risk of cancer or other health problems. Several state courts have recognized a cause of action for damage to property values in transmission line condemnation cases based on the fear that power lines cause cancer. It is difficult to predict what impact there would be on the NEES companies if this cause of action is recognized in the states in which NEES companies operate and in contexts other than condemnation cases. Bills have been introduced in the Rhode Island Legislature to require transmission lines to be placed underground. In July 1993, two bills passed by the legislature restricting the construction of overhead transmission lines were vetoed by the governor. EMF- related legislation has also been introduced in Massachusetts. Air Under federal regulations, each New England state has issued a state implementation plan that limits air pollutants emitted from facilities such as generating stations. These implementation plans are intended to ensure continued maintenance of national and state ambient air quality standards, where such standards are currently met. The plans are also intended to bring areas not currently meeting standards into compliance. In 1985, the Massachusetts legislature enacted an acid rain law that requires that sulphur dioxide (SO2) emissions from fossil fuel generating stations be reduced. Regulations implementing the statute were adopted in 1989. Emission reductions required by the regulations must be fully implemented by January 1, 1995, and will require NEP to use more costly lower sulphur oil and coal and make capital expenditures. Use of natural gas at Brayton 4 is one of NEP's methods for helping to meet the requirements of the acid rain law. See Fuel for Generation - Natural Gas, page 19. NEP may also use emission credits for conservation from non-combustion energy sources and cogeneration technology toward meeting the law's requirements. NEP produces approximately 50% of its electricity at eight older thermal generating units located in Massachusetts. The 1990 amendments to the federal Clean Air Act require a significant reduction in the nation's SO2 and nitrogen oxide (NOx) emissions by the year 2000. Under the amendments, NEP is not subject to Phase 1 of the acid rain provisions of the federal law that will become effective in 1995. However, NEP is subject to the Massachusetts SO2 acid rain law that will become effective in 1995. Phase 2 of the federal acid rain requirements, effective in 2000, will apply to NEP and its units. Under the federal Clean Air Act, state environmental agencies in ozone non-attainment areas were required to develop regulations (also known as Reasonably Available Control Technology requirements, or RACT) that will become effective in 1995 to address the first phase of ozone air quality attainment. These regulations were adopted in Massachusetts in September 1993. The RACT regulations require control technologies (such as low NOx burners) to reduce NOx emissions, an ozone precursor. Additional control measures may be necessary to ensure attainment of the ozone standard. These measures would have to be developed by the states in 1994 and fully implemented no later than 1999. The extent of these additional control measures is unknown at this time, but could range from minor additions to the RACT requirements to extensive emission reduction requirements, such as costly add-on controls or fuel switching. To date, NEP has expended approximately $7 million of one-time operation and maintenance costs and $50 million of capital costs in connection with Massachusetts and federal Clean Air Act compliance requirements. NEP expects to incur additional one-time operation and maintenance costs of approximately $18 million and capital costs of approximately $70 million in 1994 and 1995 to comply with the federal and state clean air requirements that will become effective in 1995. In addition, as a result of federal and state clean air requirements, NEP will begin incurring increased fuel costs which are estimated to reach an annual level of $13 million by 1995. The generation of electricity from fossil fuels may emit trace amounts of hazardous air pollutants as defined in the Clean Air Act Amendments of 1990. The Act mandates a study of the potential dangers of hazardous air pollutant emissions from electric utility plants. Such research is currently under way and is expected to be complete in 1995. The study conclusions could result in new emission standards and the need for additional costly controls on NEP plants. At this time, NEES and its subsidiaries cannot estimate the impact that findings of this research might have on operations. The federal Clean Air Act Amendments of 1990 and the Rio Convention on global climate change have increased the public focus on industrial emissions to the air. Electric utilities' use of fossil fuels is a significant source of emissions which evoke concerns about such issues as acid rain, ozone levels, global warming, small particulates, and hazardous air pollutants. Should the 1999 ozone attainment requirements be extensive or additional Clean Air Act Amendments or other environmental requirements be imposed, continued operation of certain existing generating units of NEP beyond 1999 could be uneconomical. NEP believes that premature retirement of substantially all of its older thermal generating units would cause substantial rate increases. Water The federal Clean Water Act prohibits the discharge of any pollutant (including heat), except in compliance with a discharge permit issued by the states or the EPA for a term of no more than five years. NEP and Narragansett have received required permits for all their steam-generating plants. NEET has received its required surface water discharge permits for all of its current operations. Occasional violations of the terms of these permits have occurred. NEES facilities store substantial amounts of oil and are required to have spill prevention control and counter-measure (SPCC) plans. Currently, major System facilities such as Brayton Point and Salem Harbor have up-to-date SPCC plans. A comprehensive study of smaller facilities has been completed to determine the appropriate plans for these facilities and a five-year implementation plan has been developed. Nuclear The NRC, along with other federal and state agencies, has extensive regulations pertaining to environmental aspects of nuclear reactors. Safety aspects of nuclear reactors, including design controls and inspection programs to mitigate any possibility of nuclear accidents and to reduce any damages therefrom, are also subject to NRC regulation. See Nuclear Units, page 21. RESOURCE PLANNING Load Forecasts and History The Retail Companies currently forecast an increase in KWH sales of 1.4% in 1994. The System has been projecting that, in the absence of significant energy conservation by its customers, annual weather-normalized peak load growth over the next 15 years will average approximately 2.3%. Peak load growth would be limited to about 1.1% annually over this period if planned DSM programs described below are successfully implemented. These projections are being updated. During the late 1980s unusually high load growth caused a tight capacity situation to develop for both the System and the New England region. More recently, the sluggish regional economy plus the addition of new generating facilities in the region alleviated concerns about inadequate resources for the next several years. Future resource additions from the Manchester Street repowering project described below and contracts with non-utility generators along with the continued demand-side management programs are expected to meet NEP's resource needs until approximately 2000. Additional new capacity may be required in that time frame. A return to the high load growth of the late 1980s, the cancellation of future planned capacity, or the shutdown of existing capacity could necessitate additional generation or power purchase contracts on the supply-side, or demand-side conservation and load management programs, in order to meet customer demands. Corporate Plans NEES has a history of planning for change to meet resource requirements and other goals. NEES' current plan, called NEESPLAN 4, was completed in 1993. NEESPLAN 4 attempts to reconcile the increasing importance and cost of environmental impact mitigation and utilities' traditional obligation to serve, with growing competition at all levels in the industry. NEESPLAN 4 also addresses planning methodology and implements a resource strategy that restricts commitments to those necessary to meet highly certain loads, and develops options on future resources to meet less certain loads and meet future fuel diversity needs. The new plan also strengthens the emission reduction goals previously established by the System and calls for CO2, SOx, and NOx reductions by 2000 to 20%, 60%, and 60%, respectively, below 1990 levels. Most of this reduction will come from current plans and commitments, including demand-side management, the Manchester Street repowering, increased use of natural gas and lower sulphur fuels, the installation of emission control equipment, low NOx burners, combustion controls, and other new power sources entering the energy mix through the year 2000. Many of these actions are being taken to comply with state and federal environmental laws. See Environmental Requirements, page 29. The remaining improvement will come from actions beyond current commitments. They may include further fuel conversions or efficiency improvements in power plants and the transmission and distribution system, as well as competitively acquired renewable resources and greenhouse gas offsets. NEP is currently participating in an experimental project investigating greenhouse gas offsets which involves funding the use of improved forestry techniques in Malaysia to limit unnecessary destruction of forests. Past NEES plans have concerned similar challenging issues the System faced and continues to address. In 1979, NEES instituted NEESPLAN, the key objectives of which were to keep customer costs to a minimum and to reduce the System's reliance on foreign oil. In 1985, NEES announced an updated plan, NEESPLAN II, the objectives of which were to provide an adequate supply of electricity to customers at the lowest possible cost and to encourage customers to use electricity efficiently. NEESPLAN 3, announced in 1990, continued these objectives and directly addressed the environmental impacts of providing electricity service. Demand-Side Management As mentioned above, the System believes that DSM programs are an important part of meeting its resource goals. Since 1987, the System has put in place a series of customer programs for encouraging electric conservation and load management. Through these DSM programs, the System has achieved over 825,000 MWh of annual energy savings. During 1993, the System spent a total of $76 million on DSM programs and related expenses. The System has budgeted to spend up to $103 million in 1994. Recovery of these expenditures through rates on a current, as incurred, basis has been approved by the various regulatory commissions. See RATES, page 8. Manchester Street Station Repowering The NEES subsidiaries' major construction project is the repowering of the Manchester Street Station, a 140 MW electric generating station in Providence, R.I. During 1993, construction continued on the joint Narragansett/NEP project. The project began in 1992 and remains on schedule and within budget, with an expected in-service date of late 1995. Narragansett and NEP operate three steam electric generating units of approximately 50 MW each which went into service at Manchester Street Station in the 1940s. During 1992, NEP acquired a 90% interest in the site and the Station in anticipation of the repowering project. As part of the repowering project, three new combustion turbines and heat recovery steam generators will be added to the Station, replacing the existing boilers. The existing steam turbines will be replaced with new and more efficient turbines of slightly larger capacity. The fuel for generation, which is now primarily residual oil, will be replaced with natural gas, using distillate oil as an emergency backup. See Fuel for Generation, page 18. Repowering will more than triple the power generation capacity of Manchester Street Station, and substantially increase the plant's thermal efficiency. It is expected that the plant's capacity factor will also increase. Certain air emissions are projected to decrease relative to historical levels because of the change in fuels and the increase in efficiency. Substantial additions to Narragansett's high voltage transmission network will be necessary in order to accommodate the output of the plant. Two 7-mile 115 kV underground transmission cables (located primarily in public ways) are under construction to connect the repowered station to existing 115 kV lines at a new substation. Total cost for the generating station, scheduled for completion in late 1995, is estimated to be approximately $525 million, including AFDC. In addition, related transmission work, which is principally the responsibility of Narragansett, is estimated to cost approximately $75 million and is scheduled for completion in late 1994. At December 31, 1993, $161 million, including AFDC, has been spent on the project which includes the related transmission work. Substantial commitments have been made relative to future planned expenditures for this project. Regulation The activities and specific projects in the System's resource plans are subject to regulation by state and federal authorities. Approval by these agencies is necessary to site and license new facilities and to recover the costs for new DSM programs and non- utility resources. See Regulation, page 28. Research and Development Expenditures for the System's research and development activities totaled $9.5 million, $8.9 million, and $8.8 million in 1993, 1992, and 1991, respectively. Total expenditures are expected to be about $12 million in 1994. About 50% of these expenditures support the Electric Power Research Institute, which conducts research and development activities on behalf of its sponsors and provides NEES companies with access to a wide range of relevant research results at minimum cost. The System also directly funds research projects of a more site-specific concern to the System and its customers. These projects include: - creating options to allow the use of economically-priced fossil fuels without adversely affecting plant performance, and to insure safe, reliable and environmentally sound production of electric energy at the lowest cost; - developing and assessing new information and methods to understand and reduce the environmental impacts of System operations including investigation of offset methods for counterbalancing greenhouse gas emissions away from the source; - developing, assessing and demonstrating new generation technologies and fuels that will ensure economic, efficient and environmentally sound production of electric energy in the future; - creating options to maintain electric service quality and reliability for customers at the lowest cost; and - developing conservation, load control, and rate design measures that will help customers use electric energy more efficiently. Construction and Financing Estimated construction expenditures (including nuclear fuel) for the System's electric utility companies are shown below for 1994 through 1996. The System conducts a continuing review of its construction and financing programs. These programs and the estimates shown below are subject to revision based upon changes in assumptions as to System load growth, rates of inflation, receipt of adequate and timely rate relief, the availability and timing of regulatory approvals, new environmental and legal or regulatory requirements, total costs of major projects, and the availability and costs of external sources of capital. The anticipated capital requirements for oil and gas operations are not included in the table below. See OIL AND GAS OPERATIONS page 43. Estimated Construction Expenditures ----------------------------------- 1994 1995 1996 Total ---- ---- ---- ----- (In Millions - excluding AFDC) NEP - --- Manchester St. Station Generation $145 $ 95 $ 40 $ 280 Manchester St. Station Substation 10 0 0 10 Other Generation (1) 70 50 60 180 Other Transmission 15 15 20 50 ---- ---- ---- ------ Total NEP $240 $160 $120 $ 520 ---- ---- ---- ------ Mass. Electric - -------------- Distribution $ 90 $ 90 $ 95 $ 275 Narragansett - ------------ Manchester St. Station Generation $ 15 $ 15 $ 5 $ 35 Manchester St. Station Transmission/ 30 0 0 30 Substation Other Transmission 15 15 15 45 Distribution 20 25 25 70 ---- ---- ---- ------ Total Narragansett $ 80 $ 55 $ 45 $ 180 ---- ---- ---- ------ Granite State - ------------- Distribution $ 5 $ 5 $ 5 $ 15 ---- ---- ---- ------ Other $ 10 $ 0 $ 0 $ 10 - ----- ---- ---- ---- ------ Combined Total - -------------- Manchester St. Station Generation $160 $110 $ 45 $ 315 Manchester St. Station Transmission/ 40 0 0 40 Substation Other Generation (1) 70 50 60 180 Other Transmission 40 30 35 105 Distribution 115 120 125 360 ---- ---- ---- ------ Grand Total $425 $310 $265 $1,000 ---- ---- ---- ------ (1) Includes Nuclear Fuel Financing The proportion of construction expenditures estimated to be financed by internally generated funds during the period from 1994 to 1996 is: NEP 80% Mass. Electric 80% Narragansett 70% Granite State 80% The general practice of the operating subsidiaries of NEES has been to finance construction expenditures in excess of internally generated funds initially by issuing unsecured short-term debt. This short-term debt is subsequently reduced through sales by such subsidiaries of long-term debt securities and preferred stock, and through capital contributions from NEES to the subsidiaries. NEES, in turn, generally has financed capital contributions to the operating subsidiaries through retained earnings and the sale of additional NEES shares. Since April 1991, NEES has been meeting all of the requirements of its dividend reinvestment and common share purchase plan and employee share plans through open market purchases. Under these plans, NEES may revert to the issuance of new common shares at any time. The ability of NEP and the Retail Companies to issue short-term debt is limited by regulatory restrictions, by provisions contained in their charters, and by certain debt and other instruments. Under the charters or by-laws of NEP, Mass. Electric, and Narragansett, short-term debt is limited to 10% of capitalization. The preferred stockholders authorized these limitations to be increased to 20% of capitalization until the late 1990's, at which time the limits will revert to 10% of capitalization. The following table summarizes the short-term debt limits at December 31, 1993, and the amount of outstanding short-term debt at such date. ($ millions) Limit Outstanding ----- ----------- NEP 315 51 Mass. Electric 139 38 Narragansett 75 20 Granite State 10 - In order to issue additional long-term debt and preferred stock, NEP and the Retail Companies must comply with earnings coverage requirements contained in their respective mortgages, note agreements, and preference provisions. The most restrictive of these provisions in each instance generally requires (1) for the issuance of additional mortgage bonds by NEP, Mass. Electric, and Narragansett, for purposes other than the refunding of certain outstanding mortgage bonds, a minimum earnings coverage (before income tax) of twice the pro forma annual interest charges on mortgage bonds, and (2) for the issuance of additional preferred stock by NEP, Mass. Electric, and Narragansett, minimum gross income coverage (after income tax) of one and one-half times pro forma annual interest charges and preferred stock dividends, in each case for a period of twelve consecutive calendar months within the fifteen calendar months immediately preceding the proposed new issue. The respective long-term debt and preferred stock coverages of NEP and the Retail Companies under their respective mortgage indentures, note agreements, and preference provisions, are stated in the following table for the past three years: Coverage ----------------------- 1993 1992 1991 ---- ---- ---- NEP - --- General and Refunding Mortgage Bonds 4.66 4.15 4.02 Preferred Stock 2.76 2.80 2.71 Mass. Electric - -------------- First Mortgage Bonds 3.15 3.60 3.07 Preferred Stock 2.02 2.14 2.12 Narragansett - ------------ First Mortgage Bonds 2.47 3.79 2.98 Preferred Stock 1.78 2.52 2.06 Granite State - ------------- Notes (1) 2.41 2.53 1.98 (1) As defined under the most restrictive note agreement. OIL AND GAS OPERATIONS GENERAL Since 1974, NEEI has engaged in oil and gas exploration and development, primarily through a partnership with Samedan Oil Corporation (Samedan), a subsidiary of Noble Affiliates, Inc. NEEI's oil and gas activities are regulated by the SEC under the 1935 Act. Under the terms of the Samedan-NEEI partnership agreement, Samedan is the managing partner and oversees all partnership operations including the sale of production. Effective January 1, 1987, NEEI decided not to acquire new oil and gas prospects due to prevailing and expected oil and natural gas market conditions. This decision did not affect NEEI's interests and commitments in oil and gas properties owned as of December 31, 1986 by the Samedan-NEEI partnership. Samedan continues to explore, develop, and manage these properties on behalf of the partnership. Thus, the results of NEEI's operations are substantially affected by the performance of Samedan. Samedan may elect to terminate the partnership at the end of any calendar year upon one year's prior notice. NEEI is required to obtain SEC approval for further investment in these oil and gas properties. On December 21, 1993, the SEC issued an order authorizing NEEI to invest up to $10 million in its partnership with Samedan during 1994. The SEC has reserved jurisdiction over an additional $5 million of spending authority. NEEI is winding down its oil and gas program. The level of expenditures for exploration and development of existing properties has declined as a result of the decision not to acquire new oil and gas prospects after December 31, 1986. NEEI's activities are primarily rate-regulated and consist of all prospects entered into prior to 1984. Savings and losses from this rate-regulated program are being passed on to NEP and ultimately to retail customers, under an intercompany pricing policy (Pricing Policy) approved by the SEC. Due to precipitate declines in oil and gas prices, NEEI has incurred operating losses since 1986 and expects to generate substantial additional losses in the future. NEP's ability to pass such losses on to its customers was favorably resolved in NEP's 1988 FERC rate settlement. This settlement covered all costs incurred by or resulting from commitments made by NEEI through March 1, 1988. Other subsequent costs incurred by NEEI are subject to normal regulatory review. NEEI follows the full cost method of accounting for its oil and gas operations, under which capitalized costs (including interest paid to banks) relating to wells and leases determined to be either commercial or non-commercial are amortized using the unit of production method. Due to the Pricing Policy, NEEI's rate-regulated program has not been subject to certain SEC accounting rules, applicable to non-rate-regulated companies, which limit the costs of oil and gas property that can be capitalized. The Pricing Policy has allowed NEEI to capitalize all costs incurred in connection with fuel exploration activities of its rate regulated program, including interest paid to banks of which $9 million, $14 million, and $22 million was capitalized in 1993, 1992, and 1991, respectively. In the absence of the Pricing Policy, the SEC's full cost "ceiling test" rule requires non-rate regulated companies to write-down capitalized costs to a level which approximates the present value of their proved oil and gas reserves. Based on NEEI's 1993 average oil and gas selling prices and NEEI's proved reserves at December 31, 1993, if this test were applied, it would have resulted in a write-down of approximately $138 million after-tax. RESULTS OF OPERATIONS Revenues from natural gas sales were approximately 13% higher in 1993 than 1992 even though NEEI's natural gas production declined by about 9%. NEEI expects 1994 natural gas revenues to be slightly higher than 1993 revenues on slightly lower total production. NEEI's 1993 oil and gas exploration and development expenditures were $9 million. NEEI's estimated proved reserves decreased from 17.3 million barrels of oil and gas equivalent at December 31, 1992, to 15.1 million barrels of oil and gas equivalent at December 31, 1993. Production, primarily from offshore Gulf properties, decreased reserves by 3.8 million equivalent barrels. Additions and revisions primarily on offshore Gulf properties increased reserves by 1.6 million equivalent barrels. Prices received by NEEI for its natural gas varied considerably during 1993, from approximately $1.31/MCF to $2.90/MCF, due principally to seasonal fluctuations and regional variations in gas prices. NEEI's overall average gas price in 1993 was $1.96/MCF. The results of NEEI's oil and gas program will continue to be affected by developments in the world oil market and the domestic market for natural gas, including actions by the federal government and by foreign governments, which may affect the price of oil and gas, the terms of contracts under which gas is sold, and changes in regulation of the domestic interstate gas pipelines. The following table summarizes NEEI's crude oil and condensate production in barrels, natural gas production in MCF, and the average sales price per barrel of oil and per MCF of natural gas produced by NEEI during the years ended December 1993, 1992, and 1991, and the average production (lifting) cost per dollar of gross revenues. Years Ended December 31, ---------------------------------- 1993 1992 1991 ---- ---- ---- Crude oil and condensate production (barrels) 477,545 506,428 435,890 Natural gas production 19,696,944 21,514,986 17,904,015 (MCF) Average sales price per barrel of oil and $17.05 $19.34 $22.80 condensate Average sales price per MCF of natural gas $1.96 $1.59 $1.61 Average production cost (including severance taxes) per dollar of gross revenue $0.14 $0.17 $0.18 OIL AND GAS PROPERTIES During 1993, principal producing properties, representing 58% of NEEI's 1993 revenues, were (i) a 50% working interest in Brazos Blocks A-52, A-53, A-65, and A-37 located in federal waters offshore Texas, (ii) a 12% working interest in Main Pass Blocks 107 and 108, located in federal waters offshore Louisiana, (iii) a 25% working interest in Main Pass Blocks 93, 102, and 90, located in federal waters offshore Louisiana, (iv) a 20% working interest in Matagorda Island 587, located in federal waters offshore Texas, and (v) a 15% working interest in Eugene Island Block 28, located in federal waters offshore Louisiana. Other major producing properties during 1993 included a 20% working interest in Vermilion Block 114, located in federal waters offshore Louisiana, a 15% working interest in High Island Blocks 21, 22, and 34, located in federal waters offshore Texas, and a 15% working interest in West Delta 18/33, located in federal waters offshore Louisiana. As used in the tables below, (i) a productive well is an exploratory or a development well that is not a dry well, (ii) a dry well is an exploratory or development well found to be incapable of producing either oil or gas in commercial quantities, (iii) "gross" refers to the total acres or wells in which NEEI has a working interest, and (iv) "net," as applied to acres or wells, refers to gross acres or wells multiplied by the percentage working interest owned by NEEI. The following table shows the approximate undeveloped acreage held by NEEI as of December 31, 1993. Undeveloped acreage is acreage on which wells have not been drilled or completed to a point that would permit the production of commercial quantities of oil and gas, regardless of whether such acreage contains proved reserves. Location Gross Acres Net Acres -------- ----------- --------- Offshore-Gulf of Mexico 124,209 21,676 Other 278,203 49,756 ------- ------ Total 402,412 71,432 During the years ended December 31, 1993, 1992, and 1991 NEEI participated in the completion of the following net exploratory and development wells: Net Exploratory Wells Net Development Wells --------------------- --------------------- Year Ended Productive* Dry Productive* Dry ---------- ---------- --- ---------- --- December 31, 1993 0 2 0 0 December 31, 1992 2 0 0 0 December 31, 1991 1 4 3 5 * Includes depleted wells The following table summarizes the total gross and net productive wells and the approximate total gross and net developed acres, both as of December 31, 1993: Oil Gas Developed Acres --- --- --------------- Gross Net Gross Net Gross Net ----- --- ----- --- ----- --- 139 16 557 64 312,492 57,400 At December 31, 1993, NEEI was in the process of drilling or completing 4 gross and 0 net wells. CAPITAL REQUIREMENTS AND FINANCING Estimated expenditures in 1994 for NEEI's exploration and development program are approximately $10 million which is the amount authorized by the SEC. In addition, NEEI's estimated 1994 interest costs are approximately $10 million. Internal funds are expected to provide 100% of NEEI's capital requirements for 1994. In 1989, NEEI refinanced its outstanding borrowings through a credit agreement which currently provides for borrowings of up to $275 million. Borrowings under this credit agreement are principally secured by a pledge of NEEI's rights with respect to NEP under the Pricing Policy covering the rate-regulated program. The amount available for borrowing under the revolving credit agreement decreases by varying amounts annually, beginning December 31, 1995 and expiring December 31, 1998. NEEI MAP Major Oil and Gas Properties EXECUTIVE OFFICERS NEES - ---- All executive officers are elected to continue in office subject to Article 19 of the Agreement and Declaration of Trust until the first meeting of the Board of Directors following the next annual meeting of shareholders, or the special meeting of shareholders held in lieu of such annual meeting, and until their successors are chosen and qualified. The executive officers also serve as officers and/or directors of various subsidiary companies. John W. Rowe - Age: 48 - President and Chief Executive Officer since 1989 - Elected Chairman of NEP in 1993 - President of NEP from 1991 to 1993 - Chairman of NEP from 1989 to 1991 - President and Chief Executive Officer of Central Maine Power Company from 1984 to 1989. Frederic E. Greenman - Age: 57 - Senior Vice President since 1987 - General Counsel since 1985 - Secretary since 1984 - Vice President of NEP since 1979. Alfred D. Houston - Age: 53 - Elected Executive Vice President in 1994 - Senior Vice President-Finance from 1987 to 1994 - Vice President-Finance from 1985 to 1987 - Vice President of NEP since 1987 - Vice President of Narragansett since 1976 - Treasurer of Narragansett since 1977. John W. Newsham - Age 61 - Vice President since 1991 - Executive Vice President of NEP since 1993 - Vice President of NEP and Director of Thermal Production from 1987 to 1993. Richard P. Sergel - Age: 44 - Vice President since 1992 - Treasurer from 1990 to 1991 - Chairman of Mass. Electric and Narragansett since 1993 - Treasurer of NEP and Mass. Electric from 1990 to 1991 - Vice President of the Service Company since 1988 - Director of Rates from 1982 to 1990. Jeffrey D. Tranen - Age: 47 - Vice President since 1991 - President of NEP since 1993 - Vice President of NEP from 1984 to 1993 - Vice President of Mass. Hydro, N.H. Hydro, and NEET from 1987 to 1991 - President of Mass. Hydro, N.H. Hydro, and NEET since 1991. Michael E. Jesanis - Age: 37 - Treasurer since 1992 - Director of Corporate Finance from 1990 to 1991 - Manager, Financial Planning from 1986 to 1990. NEP - --- The Treasurer is elected by the stockholders to hold office until the next annual meeting of stockholders and until the successor is duly chosen and qualified. The other executive officers are elected by the Board of Directors to hold office subject to the pleasure of the directors and until the first meeting of directors after the next annual meeting of stockholders and until their successors are duly chosen and qualified. Certain officers of NEP are, or at various times in the past have been, officers and/or directors of the System companies with which NEP has entered into contracts and had other business relations. Jeffrey D. Tranen* - President since 1993 - Vice President from 1984 to 1993. John W. Rowe* - Chairman since 1993 - President from 1991 to 1993 - Chairman from 1989 to 1991. John W. Newsham* - Executive Vice President since 1993 - Vice President from 1987 to 1993. Lawrence E. Bailey - Age: 50 - Vice President since 1989 - Plant Manager of Brayton Point Station from 1987 to 1991. Jeffrey A. Donahue - Age: 35 - Vice President since 1993 - various engineering positions with the Service Company since 1983 - Director of Construction since 1992 - Chief Electrical Engineer since 1991. Frederic E. Greenman* - Vice President since 1979. Alfred D. Houston* - Vice President since 1987 - Treasurer from 1983 to 1987. John F. Malley - Age: 45 - Vice President since 1992 - Manager of Generation Planning for the Service Company from 1986 to 1991. Arnold H. Turner - Age: 53 - Vice President since 1989 - Director of Planning and Power Supply since 1985. Jeffrey W. VanSant - Age: 40 - Vice President since 1993 - Manager of Oil and Gas Exploration and Development for the Service Company from 1985 to 1993 - Manager of Oil and Gas Procurement from 1992 to 1993 - Manager of Natural Gas Supply from 1989 to 1992. Michael E. Jesanis* - Treasurer since 1992. Howard W. McDowell - Age: 50 - Controller since 1987 - Controller of Mass. Electric and Narragansett since 1987 - Treasurer of Granite State since 1984. *Please refer to the material supplied under the caption EXECUTIVE OFFICERS - NEES for other information regarding this officer. Mass. Electric - -------------- The Treasurer is elected by the stockholders to hold office until the next annual meeting of stockholders and until the successor is duly chosen and qualified. The other executive officers are elected by the board of directors to hold office subject to the pleasure of the directors and until the first meeting of the directors after the next annual meeting of stockholders. Certain officers of Mass. Electric are, or at various times in the past have been, officers and directors of System companies with which Mass. Electric has entered into contracts and had other business relations. Richard P. Sergel - Chairman since 1993 - Reference is made to the material supplied under the caption EXECUTIVE OFFICERS - NEES for other information regarding Mr. Sergel. John H. Dickson - Age: 51 - President since 1990 - Treasurer from 1985 to 1990 - Treasurer of NEES from 1985 to 1990 - Treasurer of NEP from 1987 to 1990 - Vice President of NEEI from 1982 to 1990 - Treasurer of NEEI from 1983 to 1990. David L. Holt - Age: 45 - Executive Vice President since 1993 - Vice President of NEP from 1992 to 1993 - Chief Engineer and Director of Engineering for the Service Company since 1991 - Chief Electrical Engineer for the Service Company from 1986 to 1991. John C. Amoroso - Age: 55 - Vice President since 1993 - District Manager, Southeast District from 1992 to 1993 - Manager, Southeast District from 1985 to 1992. Gregory A. Hale - Age: 43 - Vice President since 1993 - Senior Counsel for the Service Company from 1988 to 1993. Cheryl A. LaFleur - Age: 39 - Vice President since 1993 - Vice President of the Service Company from 1992 to 1993 - Assistant to the NEES Chairman and President from 1990 to 1991 - Senior Counsel for the Service Company from 1989 to 1991. Charles H. Moser - Age: 53 - Vice President since 1993 - Chief Protection and Planning Engineer for the Service Company from 1984 to 1993. Lydia M. Pastuszek - Age: 40 - Vice President since 1993 - Vice President of NEP from 1990 to 1993 - President of Granite State since 1990 - Assistant to the President of Granite State from 1989 to 1990 - Director of Demand Planning for the Service Company from 1985 to 1989. Anthony C. Pini - Age: 41 - Vice President since 1993 - Assistant Controller for the Service Company from 1985 to 1993. Nancy H. Sala - Age: 42 - Vice President since 1992 - Central District Manager since 1992 - Assistant to the President of Mass. Electric from 1990 to 1992 - Manager of the Central District for Mass. Electric from 1989 to 1990 - Manager of Petroleum Supply and NEEI Shipping for the Service Company from 1986 - 1989. Dennis E. Snay - Age: 52 - Vice President and Merrimack Valley District Manager since 1990 - Assistant to President of Mass. Electric from 1984 to 1990. Michael E. Jesanis - Treasurer since 1992 - Reference is made to the material supplied under the caption EXECUTIVE OFFICERS - NEES for other information regarding Mr. Jesanis. Howard W. McDowell - Controller since 1987 and Assistant Treasurer since 1977 - Reference is made to the material supplied under the caption EXECUTIVE OFFICERS - NEP for other information regarding Mr. McDowell. Narragansett - ------------ Officers are elected by the board of directors or appointed, as appropriate, to serve until the meeting of directors following the annual meeting of stockholders, and until their successors are chosen and qualified. Officers other than the President, Treasurer, and Secretary, serve also at the pleasure of the directors. Certain officers of Narragansett are, or at various times in the past have been, officers and directors of System companies with which Narragansett has entered into contracts and had other business relations. Richard P. Sergel - Chairman since 1993 - Reference is made to the material supplied under the caption EXECUTIVE OFFICERS - NEES for other information regarding Mr. Sergel. Robert L. McCabe - Age: 53 - President since 1986. William Watkins, Jr. - Age 61 - Executive Vice President since 1992 - Vice President of the Service Company from 1981 to 1992. Francis X. Beirne - Age: 50 - Vice President since 1993 - Manager, Southern District from 1988 to 1993 - District Manager, Customer Service from 1983 - 1988. Richard W. Frost - Age: 54 - Vice President since 1993 - Division Superintendent of Transmission and Distribution from 1986 to 1990 - District Manager - Southern District from 1990 to 1993. Alfred D. Houston - Vice President since 1976 - Treasurer since 1977 - Reference is made to the material supplied under the caption EXECUTIVE OFFICERS - NEES for other information regarding Mr. Houston. James V. Mahoney - Age: 48 - Vice President and Director of Business Services since 1993 - President of NEEI from 1992 to 1993 - Vice President of the Service Company from 1989 to 1993 - Director of Fuel Supply for the Service Company from 1985 to 1993. Howard W. McDowell - Controller since 1987 - Reference is made to the material supplied under the caption EXECUTIVE OFFICERS - NEP for other information regarding Mr. McDowell. Item 2. Item 2. PROPERTIES See Item 1. Business - ELECTRIC UTILITY PROPERTIES, page 13 and OIL AND GAS PROPERTIES, page 45. Item 3. Item 3. LEGAL PROCEEDINGS In February 1993, a jury in Salem Massachusetts Superior Court assessed damages of $7.5 million, including interest, against Mass. Electric in a case arising from the installation by Mass. Electric of an allegedly undersized transformer for the plaintiff's manufacturing facility. Mass. Electric settled this case with its general liability insurance carrier and the plaintiff in 1993. See Item 1. RATES, page 8; Nuclear Units, page 21; Hydro Electric Project Licensing, page 28; Environmental Requirements, page 29; OIL AND GAS OPERATIONS, page 43. 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 last quarter of 1993. PART II Item 5. Item 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED SECURITY HOLDER MATTERS NEES information in response to the disclosure requirements specified by this Item 5. appears under the captions in the NEES Annual Report indicated below: Required Information Annual Report Caption -------------------- --------------------- (a) Market Information Shareholder Information (b) Holders Shareholder Information (c) Dividends Financial Highlights The information referred to above is incorporated by reference in this Item 5. NEP, Mass. Electric, and Narragansett - The information required by this item is not applicable as the common stock of all these companies is held solely by NEES. Information pertaining to payment of dividends and restrictions on payment of dividends is incorporated herein by reference to each company's 1993 Annual Report. Item 6. Item 6. SELECTED FINANCIAL DATA NEES ---- The information required by this item is incorporated herein by reference to page 21 of the NEES 1993 Annual Report. NEP --- The information required by this item is incorporated herein by reference to page 29 of the NEP 1993 Annual Report. Mass. Electric -------------- The information required by this item is incorporated herein by reference to page 27 of the Mass. Electric 1993 Annual Report. Narragansett ------------ The information required by this item is incorporated herein by reference to page 24 of the Narragansett 1993 Annual Report. Item 7. Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. NEES ---- The information required by this item is incorporated herein by reference to pages 12 through 20 of the NEES 1993 Annual Report. NEP --- The information required by this item is incorporated herein by reference to pages 4 through 9 of the NEP 1993 Annual Report. Mass. Electric -------------- The information required by this item is incorporated herein by reference to pages 4 through 10 of the Mass. Electric 1993 Annual Report. Narragansett ------------ The information required by this item is incorporated herein by reference to pages 4 through 9 of the Narragansett 1993 Annual Report. Item 8. Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA NEES ---- The information required by this item is incorporated herein by reference to pages 21 through 40 of the NEES 1993 Annual Report. NEP --- The information required by this item is incorporated herein by reference to pages 3, 10 through 27, and 29 of the NEP 1993 Annual Report. Mass. Electric -------------- The information required by this item is incorporated herein by reference to pages 3, 11 through 25, and 27 of the Mass. Electric 1993 Annual Report. Narragansett ------------ The information required by this item is incorporated herein by reference to pages 3, 10 through 22, and 24 of the Narragansett 1993 Annual Report. Item 9. Item 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE NEES, NEP, Mass. Electric, and Narragansett - None. PART III Item 10. Item 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT NEES ---- The information required by this item is incorporated herein by reference to the material under the caption ELECTION OF DIRECTORS in the definitive proxy statement of NEES, dated March 10, 1994, for the 1994 Annual Meeting of Shareholders, provided that the information under the headings "Compensation Committee Report on Executive Compensation" and "Corporate Performance" are not so incorporated. Reference is also made to the information under the caption EXECUTIVE OFFICERS - NEES in Part I of this report. NEP --- The names of the directors of NEP, their ages, and a brief account of their business experience during the past five years appear below. Information required by this item for Executive Officers is provided under the caption EXECUTIVE OFFICERS - NEP in Part I of this report. Directors are elected to hold office until the next annual meeting of stockholders or special meeting held in lieu thereof and until their respective successors are chosen and qualified. Joan T. Bok - Director since 1979 - Age: 64 - Chairman of the Board of NEES - Vice Chairman of the Company from 1993 to 1994 - Chairman or Vice Chairman of the Company from 1988 to 1994 - Vice Chairman of the Company from 1989 to 1991 - Chairman of NEES from 1984 to 1994 (Chairman, President, and Chief Executive Officer from July 26, 1988 until February 13, 1989). Directorships of NEES System companies: New England Electric System, Massachusetts Electric Company, The Narragansett Electric Company, Narragansett Energy Resources Company, New England Electric Resources, Inc., New England Electric Transmission Corporation, New England Energy Incorporated, New England Hydro Finance Company, Inc., New England Hydro-Transmission Corporation, New England Hydro-Transmission Electric Company, Inc., and New England Power Service Company. Other directorships: Avery Dennison Corporation, John Hancock Mutual Life Insurance Company, Monsanto Company, and the Federal Reserve Bank of Boston. Frederic E. Greenman* - Director since 1986. Directorships of NEES System companies and affiliates: Narragansett Energy Resources Company, New England Electric Resources, Inc., New England Electric Transmission Corporation, New England Energy Incorporated, New England Hydro Finance Company, Inc., New England Hydro-Transmission Corporation, New England Hydro-Transmission Electric Company, Inc., New England Power Service Company, Yankee Atomic Electric Company, Connecticut Yankee Atomic Power Company, Maine Yankee Atomic Power Company, and Vermont Yankee Nuclear Power Corporation. Alfred D. Houston* - Director since 1984. Directorships of NEES System companies: Narragansett Energy Resources Company, New England Electric Transmission Corporation, New England Energy Incorporated, New England Hydro Finance Company, Inc., New England Hydro-Transmission Corporation, New England Hydro-Transmission Electric Company, Inc., and New England Power Service Company. John W. Newsham* - Director since 1991. Directorships of NEES System companies: Narragansett Energy Resources Company, New England Electric Resources, Inc., and New England Power Service Company. John W. Rowe* - Director since 1989. Directorships of NEES System companies and affiliates: New England Electric System, Massachusetts Electric Company, The Narragansett Electric Company, Narragansett Energy Resources Company, New England Electric Resources, Inc., New England Electric Transmission Corporation, New England Energy Incorporated, New England Hydro Finance Company, Inc., New England Hydro-Transmission Corporation, New England Hydro-Transmission Electric Company, Inc., New England Power Service Company, and Maine Yankee Atomic Power Company. Other directorships: Bank of Boston Corporation and UNUM Corporation. Jeffrey D. Tranen* - Director since 1991. Directorships of NEES System affiliates: Narragansett Energy Resources Company, New England Electric Resources, Inc., New England Electric Transmission Corporation, New England Energy Incorporated, New England Hydro Finance Company, Inc., New England Hydro-Transmission Corporation, New England Hydro-Transmission Electric Company, Inc., and New England Power Service Company. *Please refer to the material supplied under the caption EXECUTIVE OFFICERS - NEES and EXECUTIVE OFFICERS - NEP in Part I of this report for other information regarding this director. Mass. Electric -------------- The names of the directors of Mass. Electric, their ages, and a brief account of their business experience during the past five years appear below. Information required by this item for Executive Officers is provided under the caption EXECUTIVE OFFICERS - - Mass. Electric in Part I of this report. Directors are elected to hold office until the next annual meeting of stockholders or special meeting held in lieu thereof and until their respective successors are chosen and qualified. Urville J. Beaumont - Director since 1984 - Age: 61 - Treasurer and Director, law firm of Beaumont & Campbell, P.A. Joan T. Bok* - Director since 1979. Sally L. Collins - Director since 1976 - Age: 58 - Health Services Administrator at Kollmorgen Corporation EOD since January 1989 - Former Director of Medical Services at Oxbow Health Associates, Inc., Hadley, Mass. - Former member of Mass. Electric Customer Advisory Council. John H. Dickson - Director since 1990 - Reference is made to material supplied under the caption EXECUTIVE OFFICERS - Mass. Electric for other information regarding Mr. Dickson. Other directorship: Worcester Business Development Corporation. Charles B. Housen - Director since 1979 - Age: 61 - Chairman, President, and Director of Erving Industries, Inc., Erving, Mass. Dr. Kathryn A. McCarthy - Director since 1973 - Age: 69 - Research Professor of Physics at Tufts University, Medford, Mass. - Senior Vice President and Provost at Tufts from 1973 to 1979 - Other directorships: State Mutual Life Assurance Company of America. Patricia McGovern - Elected Director in 1994 - Age: 52 - Of Counsel to law firm of Goulston & Storrs, P.C. since 1993 - Massachusetts State Senator and Chair of the Senate Ways and Means Committee from 1984 to 1992. John F. Reilly - Director since 1988 - Age: 61 - President and CEO of Fred C. Church, Inc., Lowell, Mass. - Other as directorships: Colonial Gas Company and NE Insurance Co., Ltd. John W. Rowe* - Director since 1989. Richard P. Sergel* - Director since 1993. Richard M. Shribman - Director since 1979 - Age: 68 - Treasurer of Norick Realty Corporation, Salem, Mass. - President of Norick Realty Corporation until 1992 - Other directorships: Eastern Bank. Roslyn M. Watson - Director since 1992 - Age: 44 - President of Watson Ventures (commercial real estate development and management) Boston, Mass. - Vice President of the Gunwyn Company (commercial real estate development) Cambridge, Mass. from 1990 - 1993 and Project Manager from 1986 - 1990 - Other directorships: The Boston Company Funds. *Please refer to the material supplied under the caption EXECUTIVE OFFICERS - NEES in Part I of this report and/or the material supplied under the caption DIRECTORS AND OFFICERS OF THE REGISTRANT - NEP in this Item for other information regarding this director. Narragansett ------------ The names of the directors of Narragansett, their ages, and a brief account of their business experience during the past five years appear below. Information required by this item for Executive Officers is provided under the caption EXECUTIVE OFFICERS - - Narragansett in Part I of this report. Directors are elected to hold office until the next annual meeting of stockholders or special meeting held in lieu thereof and until their respective successors are chosen and qualified. Joan T. Bok* - Director since 1979. Stephen A. Cardi - Director since 1979 - Age: 52 - Treasurer and Director of Cardi Corporation (construction), Warwick, R.I. Frances H. Gammell - Director since 1992 - Age: 44 - Director, Vice President of Finance, and Secretary of Original Bradford Soap Works, Inc. Joseph J. Kirby - Director since 1988 - Age: 62 - President of Washington Trust Bancorp, Inc., Westerly, R.I. and President and Director of the Washington Trust Company. Robert L. McCabe - President and Director of Narragansett since 1986 - Other directorship: Citizens Savings Bank - Please refer to the material supplied under the caption EXECUTIVE OFFICERS - Narragansett in Part I of this report for other information regarding Mr. McCabe. John W. Rowe* - Director since 1989. Richard P. Sergel* - Chairman and Director since 1993. William E. Trueheart - Director since 1989 - Age: 50 - President of Bryant College, Smithfield, Rhode Island - Executive Vice President of Bryant College from 1986 to 1989 - Other directorships: Fleet National Bank. John A. Wilson, Jr. - Director since 1971 - Age: 62 - Former Consultant to and President of Wanskuck Co., Providence, R.I., - Former Consultant to Hinckley, Allen, Snyder & Comen (attorneys), Providence, R.I. *Please refer to the material supplied under the caption DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT - NEP in this Item for other information regarding this director. Section 16(a) of the Securities Exchange Act of 1934 requires the System's officers and directors, and persons who own more than 10% of a registered class of the System's equity securities, to file reports on Forms 3, 4, and 5 of share ownership and changes in share ownership with the SEC and the New York Stock Exchange and to furnish the System with copies of all Section 16(a) forms they file. Based solely on Mass. Electric's and Narragansett's review of the copies of such forms received by them, or written representations from certain reporting persons that such forms were not required for those persons, Mass. Electric and Narragansett believe that, during 1993, all filing requirements applicable to its officers, directors, and 10% beneficial owners were complied with, except that one report on Form 3 was filed late for each of Mr. Beirne, Mr. Frost, and Mr. Mahoney. Item 11. Item 11. EXECUTIVE COMPENSATION NEES ---- The information required by this item is incorporated herein by reference to the material under the captions BOARD STRUCTURE AND COMPENSATION, EXECUTIVE COMPENSATION, PAYMENTS UPON A CHANGE IN CONTROL, PLAN SUMMARIES, and RETIREMENT PLANS in the definitive proxy statement of NEES, dated March 10, 1994, for the 1994 Annual Meeting of Shareholders, provided that the information under the headings "Compensation Committee Report on Executive Compensation" and "Corporate Performance" are not so incorporated. NEP, MASS. ELECTRIC, AND NARRAGANSETT ------------------------------------- EXECUTIVE COMPENSATION The following tables give information with respect to all compensation (whether paid directly by NEP, Mass. Electric, or Narragansett or billed to it as hourly charges) for services in all capacities for NEP, Mass. Electric, or Narragansett for the years 1991 through 1993 to or for the benefit of the Chief Executive Officer and the four other most highly compensated executive officers for each company. NEP SUMMARY COMPENSATION TABLE Long-Term Compensa- Annual Compensation (b) tion -------------------------- --------- Other Name and Annual Restricted All Other Principal Compensa- Share Compensa- Position Year Salary Bonus tion Awards tion (a) ($) ($)(c) ($)(d) ($)(e) ($)(f) - ---------- ---- ------- ------ --------- ---------- --------- John W. 1993 181,269 112,095 2,318 54,256 2,386(g) Rowe 1992 184,532 69,205 2,318 56,479 2,340 Chairman 1991 160,202 67,618 2,188 58,394 2,153 Joan T. 1993 154,428 92,949 3,323 46,245 3,444(h) Bok 1992 157,705 59,310 2,899 48,274 3,326 Vice 1991 155,392 66,005 3,135 56,641 3,615 Chairman Jeffrey D. 1993 159,936 112,105 2,974 32,753 3,563(i) Tranen 1992 120,843 52,286 2,307 23,732 2,670 President 1991 129,725 45,832 2,240 20,970 2,595 Frederic E. 1993 123,648 75,058 2,131 22,811 3,110(j) Greenman 1992 133,223 50,258 2,361 26,960 3,298 Vice 1991 125,237 43,804 2,516 24,028 3,145 President Lawrence E. 1993 135,123 61,283 101 21,286 3,790(k) Bailey 1992 129,711 47,737 101 20,985 2,594 Vice 1991 122,928 32,588 102 14,474 2,459 President (a) Certain officers of NEP are also officers of NEES and various other System companies. (b) Includes deferred compensation in category and year earned. (c) The bonus figure represents cash bonuses under an incentive compensation plan, special bonuses, the goals program award, and the variable portion of the incentive thrift plan match by NEP. See description under Plan Summaries. (d) Includes amounts reimbursed by NEP for the payment of taxes. (e) These shares receive the same dividends as the other common shares of NEES. The shares become unrestricted after five years. See also Payments Upon a Change in Control, below. As of December 31, 1993, the following executive officers held the amount of restricted shares with the value indicated: Mr. Rowe 11,807 shares, $461,949 value; Mrs. Bok 10,241 shares, $400,679 value; Mr. Greenman 3,220 shares, $125,983 value; Mr. Tranen 2,193 shares, $85,019 value; and Mr. Bailey 1,369 shares, $53,562 value. These amounts do not include the restricted share awards for 1993 which were not determined until February 1994. The value was calculated by multiplying the closing market price on December 31, 1993 by the number of shares. (f) Includes NEP contributions to life insurance and the incentive thrift plan that are not bonus contributions. See description under Plan Summaries. The life insurance contribution is calculated based on the value of term life insurance for the named individuals. The premium costs for most of these policies have been or will be recovered by NEP. (g) For Mr. Rowe, the amount and type of compensation in 1993 is as follows: $1,879 for contributions to the thrift plan and $507 for life insurance. (h) For Mrs. Bok, the amount and type of compensation in 1993 is as follows: $1,937 for contributions to the thrift plan and $1,507 for life insurance. (i) For Mr. Tranen, the amount and type of compensation in 1993 is as follows: $3,198 for contributions to the thrift plan and $365 for life insurance. (j) For Mr. Greenman, the amount and type of compensation in 1993 is as follows: $2,478 for contributions to the thrift plan and $637 for life insurance. (k) For Mr. Bailey, the amount and type of compensation in 1993 is as follows: $2,702 for contributions to the thrift plan and $1,088 for life insurance. MASS. ELECTRIC SUMMARY COMPENSATION TABLE Long-Term Compensa- Annual Compensation (b) tion -------------------------- --------- Other Name and Annual Restricted All Other Principal Compensa- Share Compensa- Position Year Salary Bonus tion Awards tion (a) ($) ($)(c) ($)(d) ($)(e) ($)(f) - ---------- ---- ------- ------ --------- ---------- --------- Richard P. 1993 93,628 71,187 1,657 20,713 2,036(h) Sergel (g) Chairman John H. 1993 156,900 116,399 3,005 28,103 3,623(i) Dickson 1992 150,469 61,561 3,087 27,801 3,442 President 1991 141,720 51,451 2,389 23,606 3,255 and CEO Nancy H. 1993 102,860 43,386 103 13,370 2,378(j) Sala (g) 1992 96,785 20,508 103 8,326 1,936 Vice President Dennis E. 1993 105,768 29,175 101 11,173 3,025(k) Snay 1992 101,208 28,448 103 12,207 2,024 Vice 1991 94,862 23,320 103 10,001 1,897 President Cheryl A. 1993 71,488 43,373 68 13,206 1,575(l) LaFleur (g) Vice President (a) Certain officers of Mass. Electric are also officers of NEES and various other System companies. (b) Includes deferred compensation in category and year earned. (c) The bonus figure represents cash bonuses under an incentive compensation plan, special bonuses, the goals program award, and the variable portion of the incentive thrift plan match by Mass. Electric. See description under Plan Summaries. (d) Includes amounts reimbursed by Mass. Electric for the payment of taxes. (e) These shares receive the same dividends as the other common shares of NEES. The shares become unrestricted after five years. See also Payments Upon a Change in Control, below. As of December 31, 1993, the following executive officers held the amount of restricted shares with the value indicated: Mr. Sergel 2,022 shares, $79,110 value; Mr. Dickson 2,190 shares, $85,683 value; Ms. Sala 360 shares, $14,085 value; Mr. Snay 859 shares, $33,608 value; and Ms. LaFleur 824 shares, $32,239 value. These amounts do not include the restricted share awards for 1993 which were not determined until February 1994. The value was calculated by multiplying the closing market price on December 31, 1993 by the number of shares. (f) Includes Mass. Electric contributions to life insurance and the incentive thrift plan that are not bonus contributions. See description under Plan Summaries. The life insurance contribution is calculated based on the value of term life insurance for the named individuals. The premium costs for most of these policies have been or will be recovered by Mass. Electric. (g) Mr. Sergel and Ms. LaFleur were elected as officers of Mass. Electric in 1993, and Ms. Sala was elected in 1992. Compensation data is provided for the years in which they have served as officers. (h) For Mr. Sergel, the type and amount of compensation in 1993 is as follows: $1,873 for contributions to the thrift plan and $163 for life insurance. (i) For Mr. Dickson, the type and amount of compensation in 1993 is as follows: $3,138 for contributions to the thrift plan and $485 for life insurance. (j) For Ms. Sala, the type and amount of compensation in 1993 is as follows: $2,057 for contributions to the thrift plan and $321 for life insurance. (k) For Mr. Snay, the type and amount of compensation in 1993 is as follows: $2,115 for contributions to the thrift plan and $910 for life insurance. (l) For Ms. LaFleur, the type and amount of compensation in 1993 is as follows: $1,430 for contributions to the thrift plan and $145 for life insurance. NARRAGANSETT SUMMARY COMPENSATION TABLE Long-Term Compensa- Annual Compensation (b) tion -------------------------- --------- Other Name and Annual Restricted All Other Principal Compensa- Share Compensa- Position Year Salary Bonus tion Awards tion (a) ($) ($)(c) ($)(d) ($)(e) ($)(f) - ---------- ---- ------- ------ --------- ---------- --------- Richard P. 1993 48,207 36,653 854 10,665 1,048(h) Sergel (g) Chairman Robert L. 1993 139,632 98,654 2,408 22,617 3,771(i) McCabe 1992 134,536 54,109 2,041 25,076 2,603 President 1991 128,863 40,428 1,306 18,024 2,388 and CEO William 1993 118,501 39,403 101 13,370 5,847(j) Watkins, 1992 65,586 17,315 66 7,350 1,312 Jr. (g) Executive Vice President Richard W. 1993 96,408 28,667 103 11,211 2,628(k) Frost (g) Vice President Francis X. 1993 87,300 10,580 113 2,462 1,859(l) Beirne (g) Vice President (a) Certain officers of Narragansett are also officers of NEES and various other System companies. (b) Includes deferred compensation in category and year earned. (c) The bonus figure represents cash bonuses under an incentive compensation plan, special bonuses, the goals program award, and the variable portion of the incentive thrift plan match by Narragansett. See description under Plan Summaries. (d) Includes amounts reimbursed by Narragansett for the payment of taxes. (e) These shares receive the same dividends as the other common shares of NEES. The shares become unrestricted after five years. See also Payments Upon a Change in Control, below. As of December 31, 1993, the following executive officers held the amount of restricted shares with the value indicated: Mr. Sergel 2,022 shares, $79,110 value; Mr. McCabe 2,082 shares, $81,458 value; Mr. Watkins 954 shares, $37,325 value; Mr. Frost 942 shares, $36,855 value; and Mr. Beirne 206 shares, $8,059 value. These amounts do not include the restricted share awards for 1993 which were not determined until February 1994. The value was calculated by multiplying the closing market price on December 31, 1993 by the number of shares. (f) Includes Narragansett contributions to life insurance and the incentive thrift plan that are not bonus contributions. See description under Plan Summaries. The life insurance contribution is calculated based on the value of term life insurance for the named individuals. The premium costs for most of these policies have been or will be recovered by Narragansett. (g) Messrs. Sergel, Frost, and Beirne were elected as officers of Narragansett in 1993, and Mr. Watkins was elected in 1992. Compensation data is provided for the years in which they have served as officers. (h) For Mr. Sergel, the type and amount of compensation in 1993 is as follows: $964 for contributions to the thrift plan and $84 for life insurance. (i) For Mr. McCabe, the type and amount of compensation in 1993 is as follows: $2,682 for contributions to the thrift plan and $1,089 for life insurance. (j) For Mr. Watkins, the type and amount of compensation in 1993 is as follows: $2,370 for contributions to the thrift plan and $3,477 for life insurance. (k) For Mr. Frost, the type and amount of compensation in 1993 is as follows: $1,928 for contributions to the thrift plan and $700 for life insurance. (l) For Mr. Beirne, the type and amount of compensation in 1993 is as follows: $1,746 for contributions to the thrift plan and $113 for life insurance. Directors' Compensation Members of the Mass. Electric and Narragansett Boards of Directors, except Dickson, McCabe, Rowe, and Sergel receive a quarterly retainer of $1,250, a meeting fee of $600 plus expenses, and 50 NEES common shares each year. Since all members of the NEP Board are employees of NEES System companies, no fees are paid for service on the Board except as noted below for Mrs. Bok. Mrs. Bok retired as an employee of the NEES companies on January 1, 1994 (remaining as Chairman of NEES and a director for NEES subsidiaries). Mrs. Bok has agreed to waive the normal fees and annual retainers otherwise payable for services by non- employees on NEES subsidiary boards and will receive in lieu thereof a single annual stipend of $60,000. Mrs. Bok also became a consultant to NEES as of January 1, 1994. Under the terms of her contract, she will receive an annual retainer of $100,000. No payments were made in 1993 pursuant to these arrangements. Mass. Electric and Narragansett permit directors to defer all or a portion of their retainers and meeting fees. Special accounts are maintained on Mass. Electric's and Narragansett's books showing the amounts deferred and the interest accrued thereon. Other NEP, Mass. Electric, and Narragansett do not have any share option plans. The NEES Compensation Committee administers certain of the incentive compensation plans, and the Management Committee administers the others (including the incentive share plan). Retirement Plans The following table shows estimated annual benefits payable to executive officers under the qualified pension plan and the supplemental retirement plan, assuming retirement at age 65 in 1994. PENSION TABLE Five-Year Average 15 Years 20 Years 25 Years 30 Years 35 Years 40 Years Compensa- of of of of of of tion Service Service Service Service Service Service - --------- -------- -------- -------- -------- -------- -------- $100,000 28,000 36,600 45,000 53,400 58,900 61,600 $150,000 43,000 56,300 69,300 82,200 90,300 94,800 $200,000 58,000 76,000 93,500 111,000 122,100 128,100 $250,000 73,000 95,700 117,800 139,800 153,800 161,300 $300,000 88,100 115,400 142,000 168,600 185,500 194,500 $350,000 103,100 135,100 166,300 197,400 217,200 227,700 $400,000 118,100 154,800 190,500 226,200 249,000 261,000 $450,000 133,100 174,500 214,800 255,000 280,700 294,200 For purposes of the retirement plans, Messrs. Rowe, Tranen, Greenman, and Bailey currently have 16, 24, 30, and 25 credited years of service, respectively. Mr. Sergel, Mr. Dickson, Ms. Sala, Mr. Snay, and Ms. LaFleur currently have 15, 20, 24, 30, and 7 credited years of service, respectively. Messrs. McCabe, Watkins, Frost, and Beirne currently have 25, 21, 31, and 22 credited years of service, respectively. At the time she retired from NEP, Mrs. Bok had 38 credited years of service, and she commenced receiving the described benefits under the pension plans and the life insurance program. As a non-employee, she no longer accrues service credit or additional benefits under these plans. Benefits under the pension plans are computed using formulae based on percentages of highest average compensation computed over five consecutive years. The compensation covered by the pension plan includes salary, bonus, and restricted share awards. The benefits listed in the pension table are not subject to deduction for Social Security and are shown without any joint and survivor benefits. The Pension Table above does not include annuity payments to be received in lieu of life insurance. The policies are described above under Plan Summaries. In February 1993, NEP announced a voluntary early retirement program available to all non-union employees over age 55 with 10 or more years of service as of June 30, 1993. Mrs. Bok accepted the offer. The program offered either an annuity or a lump sum equal to the greater value of either one week's base pay times the number of years of service plus two weeks base pay or an additional five years of service and five years of age. In accordance with the terms of the offer, Mrs. Bok received an additional annuity of $12,611 from a supplemental pension plan and a lump sum of $110,896 from the qualified plan. Mrs. Bok had not been eligible for a bonus under the prior incentive compensation plan. In lieu thereof she will receive a limited cost of living (consumer price index) adjustment to her benefits from the qualified pension plan and the supplemental retirement plan. Since this plan serves to adjust the pension benefit only after retirement, there will be no supplement paid under the plan until at least 1995. Senior executives receive the same post-retirement health benefits as those offered non-union employees who retire with a combination of age and years of service equal to 85. PAYMENTS UPON A CHANGE OF CONTROL The incentive compensation plans would provide a payment of 40% of base compensation in the event of a "change in control" as defined in the plans. This payout would be made in lieu of any cash bonuses under the plans for the year in which the "change in control" occurs. A similar payment is provided for the previous plan year if awards for that year had not yet been distributed. A "change in control" is defined, generally, as an occurrence of certain events that either evidence a merger or acquisition of NEES or cause a significant change in the makeup of the NEES board of directors over a short period of time. Upon the occurrence of a "change in control," restrictions on all shares issued to participants under the incentive share plan would cease and the participants would receive an award of shares for that year, determined in the usual manner, based upon the cash awards described in the preceding paragraph. NEP, MASS. ELECTRIC, AND NARRAGANSETT PLAN SUMMARIES A brief description of the various plans through which compensation and benefits are provided to the named executive officers is presented below to better enable shareholders to understand the information presented in the tables shown earlier. The amounts of compensation and benefits provided to the named executive officers under the plans described below (and charged to NEP, Mass. Electric, or Narragansett) are presented in the Summary Compensation Tables. Goals Program The goals program covers all employees who have completed one year of service with any NEES subsidiary. Goals are established annually. For 1993, these goals related to earnings per share, customer costs, safety, absenteeism, conservation, generating station availability, transmission reliability, environmental and OSHA compliance, and customer favorability attitudes. Some goals apply to all employees, while others apply to particular functional groups. Depending upon the number of goals met, and provided the minimum goal for earnings per share is met, employees may earn a cash bonus of 1% to 4-1/2% of their compensation. Incentive Thrift Plan The incentive thrift plan (a 401(k) program) provides for a match of one-half of up to the first 4% of base compensation contributed to the System's incentive thrift plan (shown under All Other Compensation in the Summary Compensation Tables) and, based on an incentive formula tied to earnings per share, may fully match the first 4% of base compensation contributed (the additional amount, if any, is shown under Bonus in the Summary Compensation Tables). Under Federal law, contributions to these plans are restricted. In 1993, the salary reduction amount was limited to $8,994. Life Insurance NEES has established for certain senior executives life insurance plans funded by individual policies. The combined death benefit under these insurance plans is three times the participant's annual salary. After termination of employment, participants may elect, commencing at age 55 or later, to receive an annuity income equal to 40% of annual salary. In that event, the life insurance is reduced over fifteen years to an amount equal to the participant's final annual salary. Due to changes in the tax law, this plan was closed to new participants, and an alternative was established with only a life insurance benefit. The individuals listed in the NEP summary compensation table are in one or the other of these plans. Mass. Electric and Narragansett each have two executive officers eligible to participate in one or the other of these plans. Item 12. Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT NEES ---- The information required by this item is incorporated herein by reference to the material under the caption TOTAL COMMON EQUITY BASED HOLDINGS in the definitive proxy statement of NEES, dated March 10, 1994, for the 1994 Annual Meeting of Shareholders, provided that the information under the headings "Compensation Committee Report on Executive Compensation" and "Corporate Performance" are not so incorporated. NEP, Mass. Electric, and Narragansett ------------------------------------- NEES owns 100% of the voting securities of Mass. Electric and Narragansett. NEES owns 98.80% of the voting securities of NEP. SECURITY OWNERSHIP The following tables list the holdings of NEES common shares as of March 10, 1994 by NEP, Mass. Electric, and Narragansett directors, the executive officers named in the Summary Compensation Tables, and all directors and executive officers, as a group. NEP --- Name Shares Beneficially Owned (a) ---- ----------------------------- Lawrence E. Bailey 1,953 Joan T. Bok 25,162 Frederic E. Greenman 10,632 Alfred D. Houston 10,953 John W. Newsham 10,270 John W. Rowe 20,419 Richard P. Sergel 6,702 Jeffrey D. Tranen 6,604 All directors and executive officers, as a group (13 persons) 115,340 (b) (a) Includes restricted shares and allocated shares in employee benefit plans. (b) This is less than 1% of the total number of shares of NEES outstanding. Mass. Electric -------------- Name Shares Beneficially Owned ---- ------------------------- Urville J. Beaumont 104 (a) Joan T. Bok 25,162 (b) Sally L. Collins 105 John H. Dickson 7,883 (b) Charles B. Housen 52 Cheryl A. LaFleur 1,796 (b) Kathryn A. McCarthy 100 Patricia McGovern 0 John F. Reilly 105 John W. Rowe 20,419 (b) Nancy H. Sala 5,459 (b),(c) Richard P. Sergel 6,702 (b) Richard M. Shribman 105 Dennis E. Snay 3,720 (b) Roslyn M. Watson 205 All directors and executive officers, as a group (23 persons) 105,713 (d) (a) Mr. Beaumont disclaims a beneficial ownership interest in these shares held under an irrevocable trust. (b) Includes restricted shares and allocated shares in employee benefit plans. (c) Ms. Sala disclaims a beneficial ownership interest in 205 shares held under the Uniform Gift to Minors Act. (d) This is less than 1% of the total number of shares of NEES outstanding. Narragansett ------------ Name Shares Beneficially Owned ---- ------------------------- Francis X. Beirne 2,956 (a) Joan T. Bok 25,162 (a) Stephen A. Cardi 104 Richard W. Frost 4,521 (a) Frances H. Gammell 105 Joseph J. Kirby 105 Robert L. McCabe 7,671 (a) John W. Rowe 20,419 (a) Richard P. Sergel 6,702 (a) William E. Trueheart 105 William Watkins, Jr. 7,143 (a) John A. Wilson, Jr. 508 All directors and executive officers, as a group (15 persons) 95,477 (b) (a) Includes restricted shares and allocated shares in employee benefit plans. (b) This is less than 1% of the total number of shares of NEES outstanding. Item 13. Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The construction company of Mr. Stephen A. Cardi, a director of Narragansett, was awarded two contracts by New England Power Company for construction work at its Brayton Point Station. The contract amounts totalled $600,000 and $1,000,000, respectively. Reference is made to Item 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT and Item 11. EXECUTIVE COMPENSATION. PART IV Item 14. Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K List of Exhibits Unless otherwise indicated, the exhibits listed below are incorporated by reference to the appropriate exhibit numbers and the Commission file numbers indicated in parentheses. NEES ---- (3) Agreement and Declaration of Trust dated January 2, 1926, as amended through April 28, 1987 (Exhibit 3 to 1987 Form 10-K, File No. 1-3446). (4) Instruments Defining the Rights of Security Holders (a) Massachusetts Electric Company First Mortgage Indenture and Deed of Trust, dated as of July 1, 1949, and twenty supplements thereto (Exhibit 7-A, File No. 1-8019; Exhibit 7-B, File No. 2-8836; Exhibit 4-C, File No. 2-9593; Exhibit 4 to 1980 Form 10-K, File No. 2-8019; Exhibit 4 to 1982 Form 10-K, File No. 0-5464; Exhibit 4 to 1986 Form 10-K, File No. 0-5464; Exhibit 4(a) to 1988 Form 10-K, File No. 1-3446; Exhibit 4(a) to 1989 Form 10-K, File No. 1-3446; Exhibit 4(a) to 1992 Form 10-K, File No. 1-3446; Twentieth Supplemental Indenture dated as of September 1, 1993 (filed herewith). (b) The Narragansett Electric Company First Mortgage Indenture and Deed of Trust, dated as of September 1, 1944, and twenty-one supplements thereto (Exhibit 7-1, File No. 2-7042; Exhibit 7-B, File No. 2-7490; Exhibit 4-C, File No. 2-9423; Exhibit 4-D, File No. 2-10056; Exhibit 4 to 1980 Form 10-K, File No. 0-898; Exhibit 4 to 1982 Form 10-K, File No. 0-898; Exhibit 4 to 1983 Form 10-K, File No. 0-898; Exhibit 4 to 1985 Form 10-K, File No. 0-898; Exhibit 4 to 1986 Form 10-K, File No. 0-898; Exhibit 4 to 1987 Form 10-K, File No. 0-898; Exhibit 4 to 1991 Form 10-K, File No. 0-898); Exhibit 4(b) to 1992 Form 10-K, File No. 1-3446; Twenty-First Supplemental Indenture dated as of October 1, 1993 (filed herewith). (c) The Narragansett Electric Company Preference Provisions, as amended, dated March 23, 1993 (filed herewith). (d) New England Power Company Indentures General and Refunding Mortgage Indenture and Deed of Trust dated as of January 1, 1977 and nineteen supplements thereto (Exhibit 4(b) to 1980 Form 10-K, File No. 0-1229; Exhibit 4(b) to 1982 Form 10-K, File No. 0-1229; Exhibit 4(b) to 1983 Form 10-K, File No. 0-1229; Exhibit 4(b) to 1985 Form 10-K, File No. 0-1229; Exhibit 4(b) to 1986 Form 10-K, File No. 0-1229; Exhibit 4(c)(ii) to 1988 Form 10-K, File No. 1-3446; Exhibit 4(c)(ii) to 1989 Form 10-K, File No. 1-3446; Exhibit 4(c)(ii) to 1990 Form 10-K, File No. 1-3446; Exhibit 4(c)(ii) to 1991 Form 10-K, File No. 1-3446; Exhibit 4(c)(ii) to 1992 Form 10-K, File No. 1-3446; Nineteenth Supplemental Indenture dated as of August 1, 1993 (filed herewith). (10) Material Contracts (a) Boston Edison Company et al. and New England Power Company: Amended REMVEC Agreement dated August 12, 1977 (Exhibit 5-4(d), File No. 2-61881). (b) The Connecticut Light and Power Company et al. and New England Power Company: Sharing Agreement for Joint Ownership, Construction and Operation of Millstone Unit No. 3 dated as of September 1, 1973, and Amendment dated as of August 1, 1974 (Exhibit 10-5, File No. 2-52820); Amendments dated as of December 15, 1975 and April 1, 1986; (Exhibit 10(b), to 1990 Form 10-K, File No. 1-3446). Transmission Support Agreement dated August 9, 1974; Instrument of Transfer to NEP with respect to the 1979 Connecticut Nuclear Unit, and Assumption of Obligations, dated December 17, 1975 (Exhibit 10-6(b), File No. 2-57831). (c) Connecticut Yankee Atomic Power Company et al. and New England Power Company: Stockholders Agreement dated July 1, 1964 (Exhibit 13-9-A, File No. 2-23006); Power Purchase Contract dated July 1, 1964 (Exhibit 13-9-B, File No. 2-23006); Supplementary Power Contract dated as of April 1, 1987 (Exhibit 10(c) to 1987 Form 10-K, File No. 1-3446); Capital Funds Agreement dated September 1, 1964 (Exhibit 13-9-C, File No. 2-23006); Transmission Agreement dated October 1, 1964 (Exhibit 13-9-D, File No. 2-23006); Agreement revising Transmission Agreement dated July 1, 1979 (Exhibit to 1979 Form 10-K, File No. 1-3446); Guarantee Agreement dated as of November 13, 1981 (Exhibit 10(d) to 1981 Form 10-K, File No. 1-3446); Guarantee Agreement dated as of August 1, 1985 (Exhibit 10(c) to 1985 Form 10-K, File No. 1-3446). (d) Maine Yankee Atomic Power Company et al. and New England Power Company: Capital Funds Agreement dated May 20, 1968 and Power Purchase Contract dated May 20, 1968 (Exhibit 4-5, File No. 2-29145); Amendments dated as of January 1, 1984, March 1, 1984 (Exhibit 10(d) to 1983 Form 10-K, File No. 1-3446), October 1, 1984, and August 1, 1985 (Exhibit 10(d) to 1985 Form 10-K, File No. 1-3446); Stockholders Agreement dated May 20, 1968 (Exhibit 10-20, File No. 2-34267); Additional Power Contract dated as of February 1, 1984 (Exhibit 10(d) to 1985 Form 10-K, File No. 1-3446); Guarantee Agreement dated as of September 23, 1985 (Exhibit 10(d) to 1985 Form 10-K, File No. 1-3446). (e) New England Energy Incorporated Contracts (i) Capital Funds Agreement with NEES dated November 1, 1974 (Exhibit 10-29(b), File No. 2-52969); Amendment dated July 1, 1976, and Amendment dated July 26, 1979 (Exhibit 10(g)(i) to 1980 Form 10-K, File No. 1-3446); Amendment dated August 26, 1981 (Exhibit 10(f)(i) to 1981 Form 10-K, File No. 1-3446); Amendment dated March 26, 1985 (Exhibit 10(e)(i) to 1985 Form 10-K, File No. 1-3446); Amendment dated as of April 28, 1989 (Exhibit 10 (e)(i) to 1989 Form 10-K, File No. 1-3446); Amendment dated as of June 1, 1990 (Exhibit 10(e)(i) to 1990 Form 10-K, File No. 1-3446). (ii) Loan Agreement with NEES dated July 19, 1978 and effective November 1, 1974, and Amendment dated July 26, 1979 (Exhibit 10(g)(iii) to 1980 Form 10-K, File No. 1-3446); Amendment dated August 26, 1981 (Exhibit 10(f)(ii) to 1981 Form 10-K, File No. 1-3446); Amendment dated March 26, 1985 (Exhibit 10(e)(ii) to 1985 Form 10-K, File No. 1-3446); Amendment dated as of April 28, 1989 (Exhibit 10(e)(ii) to 1989 Form 10-K, File No. 1-3446); Amendment dated as of June 1, 1990 (Exhibit 10(e)(ii) to 1990 Form 10-K, File No. 1-3446). (iii) Fuel Purchase Contract with New England Power Company dated July 26, 1979, and Amendment dated August 26, 1981 (Exhibit 10(f)(iii) to 1981 Form 10-K, File No. 1-3446); Amendment dated March 26, 1985, and Amendment effective January 1, 1984 (Exhibit 10(e)(iii) to 1985 Form 10-K, File No. 1-3446); Amendment dated as of April 28, 1989 (Exhibit 10(e)(iii) to 1989 Form 10-K, File No. 1-3446). (iv) Partnership Agreement with Samedan Oil Corporation as Amended and Restated on February 5, 1985 (Exhibit 10(e)(iv) to 1984 Form 10-K, File No. 1-3446); Amendment dated as of January 14, 1992 (Exhibit 10(e)(iv) to 1991 Form 10-K, File No. 1-3446). (v) Credit Agreement dated as of April 28, 1989 (Exhibit 10(e)(v) to 1989 Form 10-K, File No. 1-3446); Amendment dated as of June 1, 1990 (Exhibit 10(e)(v) to 1990 Form 10-K, File No. 1-3446); Amendment dated as of August 1, 1992 (Exhibit 10(e)(v) to 1992 Form 10-K, File No. 1-3446). (vi) Capital Maintenance Agreement dated November 15, 1985, and Assignment and Security Agreement dated November 15, 1985 (Exhibit 10(e)(vi) to 1985 Form 10-K, File No. 1-3446); Amendment dated as of April 28, 1989 (Exhibit 10(e)(vi) to 1989 Form 10-K, File No. 1-3446). (f) New England Power Company and New England Electric Transmission Corporation et al.: Phase I Terminal Facility Support Agreement dated as of December 1, 1981 (Exhibit 10(g) to 1981 Form 10-K, File No. 1-3446); Amendments dated as of June 1, 1982, and November 1, 1982 (Exhibit 10(f) to 1982 Form 10-K, File No. 1-3446); Agreement with respect to Use of the Quebec Interconnection dated as of December 1, 1981 (Exhibit 10(g) to 1981 Form 10-K, File No. 1-3446); Amendments dated as of May 1, 1982, and November 1, 1982 (Exhibit 10(f) to 1982 Form 10-K, File No. 1-3446); Amendment dated as of January 1, 1986 (Exhibit (10)(f) 1986 Form 10-K, File No. 1-3446); Agreement for Reinforcement and Improvement of New England Power Company's Transmission System dated as of April 1, 1983 (Exhibit 10(f) to 1983 Form 10-K, File No. 1-3446); Lease dated as of May 16, 1983 (Exhibit 10(f) to 1983 Form 10-K, File No. 1-3446); Upper Development - Lower Development Transmission Line Support Agreement dated as of May 16, 1983 (Exhibit 10(f) to 1983 Form 10-K, File No. 1-3446). (g) New England Electric Transmission Corporation and PruCapital Management, Inc. et al: Note Agreement dated as of September 1, 1986 (Exhibit 10(g) to 1986 Form 10-K, File No. 1-3446); Mortgage, Deed of Trust and Security Agreement dated as of September 1, 1986 (Exhibit 10(g) to 1986 Form 10-K, File No. 1-3446); Equity Funding Agreement with New England Electric System dated as of December 1, 1985 (Exhibit 10(g) to 1991 Form 10-K, File No. 1-3446). (h) Vermont Electric Transmission Company, Inc. et al. and New England Power Company: Phase I Vermont Transmission Line Support Agreement dated as of December 1, 1981; Amendments dated as of June 1, 1982, and November 1, 1982 (Exhibit 10(g) to 1982 Form 10-K, File No. 1-3446); Amendment dated as of January 1, 1986 (Exhibit 10(h) to 1986 Form 10-K, File No. 1-3446). (i) New England Power Pool Agreement: (Exhibit 4(e), File No. 2-43025); Amendments dated July 1, 1972, and March 1, 1973 (Exhibit 10-15, File No. 2-48543); Amendment dated March 15, 1974 (Exhibit 10-5, File No. 2-52775); Amendment dated June 1, 1975 (Exhibit 10-14, File No. 2-57831); Amendment dated September 1, 1975 (Exhibit 10-13, File No. 2-59182); Amendments dated December 31, 1976, January 31, 1977, July 1, 1977, and August 1, 1977 (Exhibit 10-16, File No. 2-61881); Amendments dated August 15, 1978, January 3, 1980, and February 1980 (Exhibit 10-3, File No. 2-68283); Amendment dated September 1, 1981 (Exhibit 10(h) to 1981 Form 10-K, File No. 1-3446); Amendment dated as of December 1, 1981 (Exhibit 10(h) to 1982 Form 10-K, File No. 1-3446); Amendments dated June 1, 1982, June 15, 1983, and October 1, 1983 (Exhibit 10(i) to 1983 Form 10-K, File No. 1-3446); Amendments dated August 1, 1985, August 15, 1985, September 1, 1985, and January 1, 1986 (Exhibit 10(i) to 1985 Form 10-K, File No. 1-3446); Amendment dated September 1, 1986 (Exhibit 10(i) to 1986 Form 10-K, File No. 1-3446); Amendment dated April 30, 1987 (Exhibit 10(i) to 1987 Form 10-K, File No. 1-3446); Amendments dated March 1, 1988 and May 1, 1988 (Exhibit 10(i) to 1988 Form 10-K, File No. 1-3446); Amendment dated March 15, 1989 (Exhibit 10(i) to 1989 Form 10-K, File No. 1-3446); Amendment dated October 1, 1990 (Exhibit 10(i) to 1990 Form 10-K, File No. 1-3446); Amendment dated as of September 15, 1992 (Exhibit 10(i) to 1992 Form 10-K, File No. 1-3446). (j) Public Service Company of New Hampshire et al. and New England Power Company: Agreement for Joint Ownership, Construction and Operation of New Hampshire Nuclear Units dated as of May 1, 1973; Amendments dated May 24, 1974, June 21, 1974, September 25, 1974 and October 25, 1974 (Exhibit 10-18(b), File No. 2-52820); Amendment dated January 31, 1975 (Exhibit 10-16(b), File No. 2-57831); Amendments dated April 18, 1979, April 25, 1979, June 8, 1979, October 11, 1979, December 15, 1979, June 16, 1980, December 31, 1980 (Exhibit 10(i) to 1980 Form 10-K, File No. 1-3446); Amendments dated June 1, 1982, April 27, 1984, June 15, 1984 (Exhibit 10(j) to 1984 Form 10-K, File No. 1-3446); Amendments dated March 8, 1985, March 14, 1986, May 1, 1986 and September 19, 1986 (Exhibit 10(j) to 1986 Form 10-K, File No. 1-3446); Amendment dated November 12, 1987 (Exhibit 10(j) to 1987 Form 10-K, File No. 1-3446); Amendment dated January 13, 1989 (Exhibit 10(j) to 1989 Form 10-K, File No. 1-3446); Amendment dated as of November 1, 1990 (Exhibit 10(j) to 1991 Form 10-K, File No. 1- 3446). Transmission Support Agreement dated as of May 1, 1973 (Exhibit 10-23, File No. 2-49184); Instrument of Transfer to NEP with respect to the New Hampshire Nuclear Units and Assumptions of Obligations dated December 17, 1975 and Agreement Among Participants in New Hampshire Nuclear Units, certain Massachusetts Municipal Systems and Massachusetts Municipal Wholesale Electric Company dated May 28, 1976 (Exhibit 10-16(c), File No. 2-57831); Seventh Amendment To and Restated Agreement for Seabrook Project Disbursing Agent (Exhibit 10(j) to 1991 Form 10-K, File No. 1-3446); Amendments dated as of June 29, 1992 (Exhibit 10(j) to 1992 Form 10-K, File No. 1-3446); Seabrook Project Managing Agent Operating Agreement dated as of June 29, 1992, and amendment to Seabrook Project Managing Agent Agreement dated as of June 29, 1992 (Exhibit 10(j) to 1992 Form 10-K, File No. 1-3446). (k) Vermont Yankee Nuclear Power Corporation et al. and New England Power Company: Capital Funds Agreement dated February 1, 1968, Amendment dated March 12, 1968, and Power Purchase Contract dated February 1, 1968 (Exhibit 4-6, File No. 2-29145); Amendments dated as of June 1, 1972 and April 15, 1983 (Exhibit 10(k) to 1983 Form 10-K, File No. 1-3446) and April 24, 1985 (Exhibit 10(k) to 1985 Form 10-K, File No. 1-3446); Amendment dated as of June 1, 1985 (Exhibit 10(k) to 1987 Form 10-K, File No. 1-3446); Amendments dated as of May 6, 1988 (Exhibit 10(k) to 1988 Form 10-K, File No. 1-3446); Amendment dated as of June 15, 1989 (Exhibit 10(k) to 1989 Form 10-K, File No. 1-3446); Additional Power Contract dated as of February 1, 1984 (Exhibit 10(k) to 1983 Form 10-K, File No. 1-3446); Guarantee Agreement dated as of November 5, 1981 (Exhibit 10(j) to 1981 Form 10-K, File No. 1-3446). (l) Yankee Atomic Electric Company et al. and New England Power Company: Amended and Restated Power Contract dated April 1, 1985 (Exhibit 10(l) to 1985 Form 10-K, File No. 1-3446); Amendment dated May 6, 1988 (Exhibit 10(l) to 1988 Form 10-K, File No. 1-3446); Amendments dated as of June 26, 1989 and July 1, 1989 (Exhibit 10 (l) to 1989 Form 10-K, File No. 1-3446); Amendment dated as of February 1, 1992 (Exhibit 10(l) to 1992 Form 10-K, File No. 1- 3446). *(m) New England Electric Companies' Deferred Compensation Plan as amended dated December 8, 1986 (Exhibit 10(m) to 1986 Form 10-K, File No. 1-3446). *(n) New England Electric System Companies Retirement Supplement Plan as amended dated April 1, 1991 (Exhibit 10(n) to 1991 Form 10-K, File No. 1-3446). *(o) New England Electric Companies' Executive Supplemental Retirement Plan as amended dated April 1, 1991 (Exhibit 10(o) to 1991 Form 10-K, File No. 1-3446). *(p) New England Electric Companies' Incentive Compensation Plan as amended dated January 1, 1992 (Exhibit 10(q) to 1992 Form 10-K, File No. 1-3446). *(q) New England Electric Companies' Senior Incentive Compensation Plan as amended dated November 26, 1991 (Exhibit 10(q) to 1991 Form 10-K, File No. 1- 3446). *(r) New England Electric Companies' Incentive Compensation Plan II as amended dated September 3, 1992 (Exhibit 10(r) to 1992 Form 10-K, File No. 1-3446). *(s) New England Electric System Directors Deferred Compensation Plan as amended dated November 24, 1992 (Exhibit 10(s) to 1992 Form 10-K, File No. 1-3446). *(t) Forms of Life Insurance Program (Exhibit 10(s) to 1986 Form 10-K, File No. 1-3446); and Form of Life Insurance (Collateral Assignment) (Exhibit 10(t) to 1991 Form 10-K, File No. 1-3446). (u) New England Power Company and New England Hydro-Transmission Electric Company, Inc. et al: Phase II Massachusetts Transmission Facilities Support Agreement dated as of June 1, 1985 (Exhibit 10(t) to 1986 Form 10-K, File No. 1-3446); Amendment dated as of May 1, 1986 (Exhibit 10(t) to 1986 Form 10-K, File No. 1-3446); Amendments dated as of February 1, 1987, June 1, 1987, September 1, 1987, and October 1, 1987 (Exhibit 10(u) to 1987 Form 10-K, File No. 1-3446); Amendment dated as of August 1, 1988 (Exhibit 10(u) to 1988 Form 10-K, File No. 1-3446); Amendment dated January 1, 1989 (Exhibit 10(u) to 1990 Form 10-K, File No. 1-3446). (v) New England Power Company and New England Hydro-Transmission Corporation et al: Phase II New Hampshire Transmission Facilities Support Agreement dated as of June 1, 1985 (Exhibit 10(u) to 1986 Form 10-K, File No. 1-3446); Amendment dated as of May 1, 1986 (Exhibit 10(u) to 1986 Form 10-K, File No. 1-3446); Amendments dated as of February 1, 1987, June 1, 1987, September 1, 1987, and October 1, 1987 (Exhibit 10(v) to 1987 Form 10-K, File No. 1-3446); Amendment dated as of August 1,1988 (Exhibit 10(v) to 1988 Form 10-K, File No. 1-3446); Amendments dated January 1, 1989 and January 1, 1990 (Exhibit 10(v) to 1990 Form 10-K, File No. 1-3446). (w) New England Power Company et al: Phase II New England Power AC Facilities Support Agreement dated as of June 1, 1985 (Exhibit 10(v) to 1986 Form 10-K, File No. 1-3446); Amendment dated as of May 1, 1986 (Exhibit 10(v) to 1986 Form 10-K, File No. 1-3446); Amendments dated as of February 1, 1987, June 1, 1987, and September 1, 1987 (Exhibit 10(w) to 1987 Form 10-K, File No. 1-3446); Amendment dated as of August 1, 1988 (Exhibit 10(w) to 1988 Form 10-K, File No. 1-3446). (x) New England Hydro-Transmission Electric Company, Inc. and New England Electric System et al: Equity Funding Agreement dated as of June 1, 1985 (Exhibit 10(w) to 1986 Form 10-K, File No. 1-3446); Amendment dated as of May 1, 1986 (Exhibit 10(w) to 1986 Form 10-K, File No. 1-3446); Amendment dated as of September 1, 1987 (Exhibit 10(x) to 1987 Form 10-K, File No. 1-3446); Amendment dated as of August 1, 1988 (Exhibit 10(x) to 1988 Form 10-K, File No. 1-3446). (y) New England Hydro-Transmission Corporation and New England Electric System et al: Equity Funding Agreement dated as of June 1, 1985 (Exhibit 10(x) to 1986 Form 10-K, File No. 1-3446); Amendment dated as of May 1, 1986 (Exhibit 10(x) to 1986 Form 10-K, File No. 1-3446); Amendment dated as of September 1, 1987 (Exhibit 10(y) to 1987 Form 10-K, File No. 1-3446); Amendment dated as of August 1, 1988 (Exhibit 10(y) to 1988 Form 10-K, File No. 1-3446). (aa) Ocean State Power, et al., and Narragansett Energy Resources Company: Equity Contribution Agreement dated as of December 29, 1988 (Exhibit 10(aa) to 1988 Form 10-K, File No. 1-3446); Amendment dated as of September 29, 1989 (Exhibit 10 (aa) to 1989 Form 10-K File No. 1-3446); Ocean State Power, et al., and New England Electric System: Equity Contribution Support Agreement dated as of December 29, 1988 (Exhibit 10(aa) to 1988 Form 10-K, File No. 1-3446); Amendment dated as of September 29, 1989 (Exhibit 10 (aa) to 1989 Form 10-K, File No. 1-3446); Ocean State Power II, et al., and Narragansett Energy Resources Company:Equity Contribution Agreement dated as of September 29, 1989 (Exhibit 10 (aa) to 1989 Form 10-K File No. 1-3446); Ocean State Power II, et al., and New England Electric System: Equity Contribution Support Agreement dated as of September 29, 1989 (Exhibit 10 (aa) to 1989 Form 10-K File No. 1-3446). *(bb) New England Power Service Company and Joan T. Bok: Service Credit Letter dated October 21, 1982 (Exhibit 10(cc) to 1992 Form 10-K, File No. 1-3446). *(cc) New England Electric System and John W. Rowe: Service Credit Letter dated December 5, 1988 (Exhibit 10(dd) to 1992 Form 10-K, File No. 1-3446). *(dd) New England Power Service Company and the Company: Form of Supplemental Pension Service Credit Agreement (Exhibit 10(ee) to 1992 Form 10-K, File No. 1-3446). * Compensation related plan, contract, or arrangement. (13) 1993 Annual Report to Shareholders (filed herewith). (18) Coopers & Lybrand Preferability Letter dated February 25, 1994 (filed herewith). (22) Subsidiary list appears in Part I of this document. (25) Power of Attorney (filed herewith). NEP --- (3) (a) Articles of Organization as amended through June 27, 1987 (Exhibit 3(a) to 1988 Form 10-K, File No. 0-1229). (b) By-laws of the Company as amended June 25, 1987 (Exhibit 3 to 1987 Form 10-K, File No. 0-1229). (4) General and Refunding Mortgage Indenture and Deed of Trust dated as of January 1, 1977 and nineteen supplements thereto (Exhibit 4(b) to 1980 Form 10-K, File No. 0-1229; Exhibit 4(b) to 1982 Form 10-K, File No. 0-1229; Exhibit 4(b) to 1983 Form 10-K, File No. 0-1229; Exhibit 4(b) to 1985 Form 10-K, File No. 0-1229; Exhibit 4(b) to 1986 Form 10-K, File No. 0-1229; Exhibit 4(b) to 1986 Form 10-K, File No. 0-1229; Exhibit 4(b) to 1988 Form 10-K, File No. 0-1229; Exhibit 4(c)(ii) to 1989 NEES Form 10-K, File No. 1-3446; Exhibit 4(c)(ii) to 1990 NEES Form 10-K, File No. 1-3446; Exhibit 4(c)(ii) to 1991 NEES Form 10-K, File No. 1-3446; Exhibit 4(c)(ii) to 1992 NEES Form 10-K, File No. 1-3446; Exhibit 4(c) to 1993 NEES Form 10-K, File No. 1-3446). (10) Material Contracts (a) Boston Edison Company et al. and the Company: Amended REMVEC Agreement dated August 12, 1977 (Exhibit 5-4(d), File No. 2-61881). (b) The Connecticut Light and Power Company et al. and the Company: Sharing Agreement for Joint Ownership, Construction and Operation of Millstone Unit No. 3 dated as of September 1, 1973, and Amendment dated as of August 1, 1974 (Exhibit 10-5, File No. 2-52820); Amendments dated as of December 15, 1975 and April 1, 1986 (Exhibit 10(b) to NEES' 1990 Form 10-K File No. 1-3446). Transmission Support Agreement dated August 9, 1974; Instrument of Transfer to the Company with respect to the 1979 Connecticut Nuclear Unit, and Assumption of Obligations, dated December 17, 1975 (Exhibit 10-6(b), File No. 2-57831). (c) Connecticut Yankee Atomic Power Company et al. and the Company: Stockholders Agreement dated July 1, 1964 (Exhibit 13-9-A, File No. 2-2006); Power Purchase Contract dated July 1, 1964 (Exhibit 13-9-B, File No. 2-23006); Supplementary Power Contract dated as of April 1, 1987 (Exhibit 10(c) to 1987 Form 10-K, File No. 0-1229); Capital Funds Agreement dated September 1, 1964 (Exhibit 13-9-C, File No. 2-23006); Transmission Agreement dated October 1, 1964 (Exhibit 13-9-D, File No. 2-23006); Agreement revising Transmission Agreement dated July 1, 1979 (Exhibit to NEES' 1979 Form 10-K, File No. 1-3446); Five Year Capital Contribution Agreement dated November 1, 1980 (Exhibit 10(e) to NEES' 1980 Form 10-K, File No. 1-3446); Guarantee Agreement dated as of November 13, 1981 (Exhibit 10(d) to NEES' 1981 Form 10-K, File No. 1-3446); Guarantee Agreement dated as of August 1, 1985 (Exhibit 10(c) to NEES' 1985 Form 10-K, File No. 1-3446). (d) Maine Yankee Atomic Power Company et al. and the Company: Capital Funds Agreement dated May 20, 1968 and Power Purchase Contract dated May 20, 1968 (Exhibit 4-5, File No. 2-29145); Amendments dated as of January 1, 1984, March 1, 1984 (Exhibit 10(d) to NEES' 1983 Form 10-K, File No. 1-3446); October 1, 1984, and August 1, 1985 (Exhibit 10(d) to NEES' 1985 Form 10-K, File No. 1-3446); Stockholders Agreement dated May 20, 1968 (Exhibit 10-20; File No. 2-34267); Additional Power Contract dated as of February 1, 1984 (Exhibit 10(d) to NEES' 1985 Form 10-K, File No. 1-3446); Guarantee Agreement dated as of September 23, 1985 (Exhibit 10(d) to NEES' 1985 Form 10-K, File No. 1-3446). (e) Mass. Electric and the Company: Primary Service for Resale dated February 15, 1974 (Exhibit 5-17(a), File No. 2-52969); Amendment of Service Agreement dated June 22, 1983 (Exhibit 10(b) to Mass. Electric's 1986 Form 10-K, File No. 0-5464); Amendment of Service Agreement effective November 1, 1993 (filed herewith). (f) The Narragansett Electric Company and the Company: Primary Service for Resale dated February 15, 1974 (Exhibit 4-1(b), File No. 2-51292); Amendment of Service Agreement dated July 26, 1990 (Exhibit 4(f) to New England Power Company's 1990 Form 10-K, File No. 0-1229). Amendment of Service Agreement dated July 24, 1991 (Exhibit 10(f) to 1991 Form 10-K, File No. 0-1229); Amendment of Service Agreement effective November 1, 1993 (filed herewith). (g) Time Charter between Intercoastal Bulk Carriers, Inc., and New England Power Company dated as of December 27, 1989 (Exhibit 10(g) to 1989 Form 10-K, File No. 1-3446). (h) New England Electric Transmission Corporation et al. and the Company: Phase I Terminal Facility Support Agreement dated as of December 1, 1981 (Exhibit 10(g) to NEES' 1981 Form 10-K, File No. 1-3446); Amendments dated as of June 1, 1982 and November 1, 1982 (Exhibit 10(f) to NEES' 1982 Form 10-K, File No. 1-3446); Agreement with respect to Use of the Quebec Interconnection dated as of December 1, 1981 (Exhibit 10(g) to NEES' 1981 Form 10-K, File No. 1-3446); Amendments dated as of May 1, 1982 and November 1, 1982 (Exhibit 10(f) to NEES' 1982 Form 10-K, File No. 1-3446); Amendment dated as of January 1, 1986 (Exhibit 10(f) to NEES' 1986 Form 10-K, File No. 1-3446); Agreement for Reinforcement and Improvement of the Company's Transmission System dated as of April 1, 1983 (Exhibit 10(f) to NEES' 1983 Form 10-K, File No. 1-3446); Lease dated as of May 16, 1983 (Exhibit 10(f) to NEES' 1983 Form 10-K, File No. 1-3446); Upper Development-Lower Development Transmission Line Support Agreement dated as of May 16, 1983 (Exhibit 10(f) to NEES' 1983 Form 10-K, File No. 1-3446). (i) Vermont Electric Transmission Company, Inc. et al. and the Company: Phase I Vermont Transmission Line Support Agreement dated as of December 1, 1981; Amendments dated as of June 1, 1982 and November 1, 1982 (Exhibit 10(g) to NEES' 1982 Form 10-K, File No. 1-3446); Amendment dated as of January 1, 1986 (Exhibit 10(h) to NEES' 1986 Form 10-K, File No. 1-3446). (j) New England Energy Incorporated and the Company: Fuel Purchase Contract dated July 26, 1979, and Amendment dated August 26, 1981 (Exhibit 10(f)(iii) to NEES' 1981 Form 10-K, File No. 1-3446); Amendment dated March 26, 1985, and Amendment effective January 1, 1984 (Exhibit 10(e)(iii) to NEES' 1985 Form 10-K, File No. 1-3446); Amendment dated as of April 28, 1989 (Exhibit 10(e)(iii) to 1989 NEES Form 10-K, File No. 1-3446). (k) New England Power Pool Agreement: (Exhibit 4(e), File No. 2-43025); Amendments dated July 1, 1972, March 1, 1973 (Exhibit 10-15, File No. 2-48543);Amendment dated March 15, 1974 (Exhibit 10-5, File No. 2-52775); Amendment dated June 1, 1975 (Exhibit 10-14, File No. 2-57831); Amendment dated September 1, 1975 (Exhibit 10-13, File No. 2-59182); Amendments dated December 31, 1976, January 31, 1977, July 1, 1977, and August 1, 1977 (Exhibit 10-16, File No. 2-61881); Amendments dated August 15, 1978, January 3, 1980, and February 1980 (Exhibit 10-3, File No. 2-68283); Amendment dated September 1, 1981 (Exhibit 10(h) to NEES' 1981 Form 10-K, File No. 1-3446); Amendment dated December 1, 1981 (Exhibit 10(h) to NEES' 1982 Form 10-K, File No. 1-3446); Amendments dated June 1, 1982, June 15, 1983, and October 1, 1983 (Exhibit 10(i) to NEES' 1983 Form 10-K, File 1-3446); Amendments dated August 1, 1985, August 15, 1985, September 1, 1985, and January 1, 1986 (Exhibit 10(i) to NEES' 1985 Form 10-K, File No. 1-3446); Amendment dated September 1, 1986 (Exhibit 10(i) to NEES' 1986 Form 10-K, File No. 1-3446); Amendment dated April 30, 1987 (Exhibit 10(i) to NEES' 1987 Form 10-K, File No. 1-3446); Amendments dated March 1, 1988 and May 1, 1988 (Exhibit 10(i) to NEES' 1988 Form 10-K, File No. 1-3446); Amendment dated March 15, 1989 (Exhibit 10(i) to 1989 NEES Form 10-K, File No. 1-3446); Amendment dated October 1, 1990 (Exhibit 10 (i) to 1990 NEES Form 10-K, File No. 1-3446); Amendment dated October 1, 1990 Exhibit 10(i) to 1990 NEES Form 10-K, File No. 1-3446); Amendment dated as of September 15, 1992 (Exhibit 10(i) to 1992 NEES Form 10-K, File No. 1-3446). (l) New England Power Service Company and the Company: Specimen of Service Contract (Exhibit 10(l) to 1988 Form 10-K, File No. 0-1229). (m) Public Service Company of New Hampshire et al. and the Company: Agreement for Joint Ownership, Construction and Operation of New Hampshire Nuclear Units dated as of May 1, 1973; Amendments dated May 24, 1974, June 21, 1974, September 25, 1974 and October 25, 1974 (Exhibit 10-18(b), File No. 2-52820); Amendment dated January 31, 1975 (Exhibit 10-16(b), File No. 2-57831); Amendments dated April 18, 1979, April 25, 1979, June 8, 1979, October 11, 1979, December 15, 1979, June 16, 1980, and December 31, 1980 (Exhibit 10(i) to NEES' 1980 Form 10-K, File No. 1-3446); Amendments dated June 1, 1982, April 27, 1984, and June 15, 1984 (Exhibit 10(j) to NEES' 1984 Form 10-K, File No. 1-3446); Amendments dated March 8, 1985, March 14, 1986, May 1, 1986, and September 19, 1986 (Exhibit 10(j) to NEES' 1986 Form 10-K, File No. 1-3446); Amendment dated November 12, 1987 (Exhibit 10(j) to NEES' 1987 Form 10-K, File No. 1-3446); Amendment dated January 13, 1989 (Exhibit 10(j) to NEES' 1990 Form 10-K, File No. 1-3446); Seventh Amendment as of November 1, 1990 (Exhibit 10(m) to NEES' 1991 Form 10-K, File No. 1-3446). Transmission Support Agreement dated as of May 1, 1973 (Exhibit 10-23, File No. 2-49184); Instrument of Transfer to the Company with respect to the New Hampshire Nuclear Units and Assumptions of Obligations dated December 17, 1975 and Agreement Among Participants in New Hampshire Nuclear Units, certain Massachusetts Municipal Systems and Massachusetts Municipal Wholesale Electric Company dated May 28, 1976 (Exhibit 16(c), File No. 2-57831); Seventh Amendment To and Restated Agreement for Seabrook Project Disbursing Agent dated as of November 1, 1990 (Exhibit 10(m) to NEES' 1991 Form 10-K, File No. 1-3446); Amendments dated as of June 29, 1992 (Exhibit 10(j) to NEES' 1992 Form 10-K, File No. 1- 3446). Settlement Agreement dated as of July 19, 1990 between Northeast Utilities Service Company and the Company (Exhibit 10(m) to NEES' 1991 Form 10-K, File No. 1-3446). Seabrook Project Managing Agent Operating Agreement dated as of June 29, 1992, Amendment to Seabrook Project Managing Agent Operating Agreement dated as of June 29, 1992 (Exhibit 10(j) to NEES' 1992 Form 10-K, File No. 1- 3446). (n) Vermont Yankee Nuclear Power Corporation et al. and the Company: Capital Funds Agreement dated February 1, 1968, Amendment dated March 12, 1968 and Power Purchase Contract dated February 1, 1968 (Exhibit 4-6, File No. 2-29145); Amendments dated as of June 1, 1972, April 15, 1983 (Exhibit 10(k) to NEES' 1983 Form 10-K, File No. 0-1229) and April 24, 1985 (Exhibit 10(n) to NEES' 1985 Form 10-K, File No. 1-3446); Amendment dated as of June 1, 1985 (Exhibit 10(n) to 1988 Form 10-K, File No. 0-1229); Amendments dated May 6, 1988 (Exhibit 10(n) to 1988 Form 10-K, File No. 0-1229); Amendment dated as of June 15, 1989 (Exhibit 10(k) to 1989 NEES Form 10-K, File No. 1-3446); Additional Power Contract dated as of February 1, 1984 (Exhibit 10(k) to NEES' 1983 Form 10-K, File No. 1-3446); Guarantee Agreement dated as of November 5, 1981 (Exhibit 10(j) to NEES' 1981 Form 10-K, File No. 1-3446). (o) Yankee Atomic Electric Company et al. and the Company: Amended and Restated Power Contract dated April 1, 1985 (Exhibit 10(l) to NEES' 1985 Form 10-K, File No. 1-3446); Amendment dated May 6, 1988 (Exhibit 10(l) to NEES' 1988 Form 10-K, File No. 1-3446); Amendments dated as of June 26, 1989 and July 1, 1989 (Exhibit 10(l) to 1989 NEES Form 10-K, File No. 1-3446); Amendment dated as of February 1, 1992 (Exhibit 10(l) to 1992 NEES Form 10-K, File No. 1-3446). *(p) New England Electric Companies' Deferred Compensation Plan as amended dated December 8, 1986 (Exhibit 10(m) to NEES' 1986 Form 10-K, File No. 1-3446). *(q) New England Electric System Companies Retirement Supplement Plan as amended dated April 1, 1991 (Exhibit 10(n) to NEES' 1991 Form 10-K, File No. 1-3446). *(r) New England Electric Companies' Executive Supplemental Retirement Plan as amended dated April 1, 1991 (Exhibit 10(o) to NEES' 1991 Form 10-K, File No. 1-3446). *(s) New England Electric Companies' Incentive Compensation Plan as amended dated January 1, 1992 (Exhibit 10(p) to NEES' 1992 Form 10-K, File No. 1-3446); New England Electric Companies' Senior Incentive Compensation Plan as amended dated November 26, 1991 (Exhibit 10(q) to NEES' 1991 Form 10-K, File No. 1-3446). *(t) Forms of Life Insurance Program: (Exhibit 10(s) to NEES' 1986 Form 10-K, File No. 1-3446); and Form of Life Insurance (Collateral Assignment) (Exhibit 10(t) to NEES' 1991 Form 10-K, File No. 1-3446). *(u) New England Electric Companies' Incentive Compensation Plan II as amended dated September 1, 1992 (Exhibit 10 (r) to NEES' 1992 Form 10-K, File No. 1-3446). (v) New England Hydro-Transmission Electric Company, Inc. et al. and the Company: Phase II Massachusetts Transmission Facilities Support Agreement dated as of June 1, 1985 (Exhibit 10(t) to NEES' 1986 Form 10-K, File No. 1-3446); Amendment dated as of May 1, 1986 (Exhibit 10(t) to NEES' 1986 Form 10-K, File No. 1-3446); Amendments dated as of February 1, 1987, June 1, 1987, September 1, 1987, and October 1, 1987 (Exhibit 10(u) to NEES' 1987 Form 10-K, File No. 1-3446); Amendment dated as of August 1, 1988 (Exhibit 10(u) to NEES' 1988 Form 10-K, File No. 1-3446); Amendment dated January 1, 1989 (Exhibit 10 (u) to NEES' 1990 Form 10-K, File No. 1-3446). (w) New England Hydro-Transmission Corporation et al. and the Company: Phase II New Hampshire Transmission Facilities Support Agreement dated as of June 1, 1985 (Exhibit 10(u) to NEES' 1986 Form 10-K, File No. 1-3446); Amendment dated as of May 1, 1986 (Exhibit 10(u) to NEES' 1986 Form 10-K, File No. 1-3446); Amendments dated as of February 1, 1987, June 1, 1987, September 1, 1987, and October 1, 1987 (Exhibit 10(v) to NEES' 1987 Form 10-K, File No. 1-3446). Amendment dated as of August 1, 1988 (Exhibit 10(v) to NEES' 1988 Form 10-K, File No. 1-3446); Amendments dated January 1, 1989 and January 1, 1990 (Exhibit 10 (v) to NEES' 1990 Form 10-K, File No. 1-3446). (x) Vermont Electric Power Company et al. and the Company: Phase II New England Power AC Facilities Support Agreement dated as of June 1, 1985 (Exhibit 10(v) to NEES' 1986 Form 10-K, File No. 1-3446); Amendment dated as of May 1, 1986 (Exhibit 10(v) to NEES' 1986 Form 10-K, File No. 1-3446). Amendments dated as of February 1, 1987, June 1, 1987, and September 1, 1987 (Exhibit 10(w) to NEES' 1987 Form 10-K, File No. 1-3446); Amendment dated as of August 1, 1988 (Exhibit 10(w) to NEES' 1988 Form 10-K, File No. 1-3446). (y) TransCanada Pipelines Limited and the Company: Firm Service Contract for Firm Transportation Service for natural gas dated as of January 6, 1992; Amendments dated as of March 2, 1992 and October 30, 1992 (Exhibit 10(y) to 1992 Form 10-K, File No. 0-1229). (z) TransCanada Pipelines Limited and the Company: Firm Service Contract for Firm Transportation Service for natural gas dated as of October 30, 1992 (Exhibit 10(z) to 1992 Form 10-K, File No. 0-1229). (aa) Algonquin Gas Transmission Company and the Company: X-38 Service Agreement for Firm Transportation of natural gas dated July 3, 1992; Amendment dated July 31, 1992 (Exhibit 10(aa) to 1992 Form 10-K, File No. 0-1229). (bb) ANR Pipeline Company and the Company: Gas Transportation Agreement dated July 18, 1990 (Exhibit 10(bb) to 1992 Form 10-K, File No. 0-1229). (cc) Columbia Gas Transmission Corporation and the Company: Service Agreement for Service under FTS Rate Schedule dated June 13, 1991 (filed herewith). (dd) Iroquois Gas Transmission System, L.P. and the Company: Gas Transportation Contract for Firm Reserved Service dated as of June 5, 1991 (Exhibit 10(dd) to 1992 Form 10-K, File No. 0-1229). (ee) Tennessee Gas Pipeline Company and the Company: Firm Natural Gas Transportation Agreement dated July 9, 1992 (Exhibit 10(ee) to 1992 Form 10-K, File No. 0-1229). *(ff) New England Power Service Company and Joan T. Bok: Service Credit Letter dated October 21, 1982 (Exhibit 10(cc) to 1992 NEES Form 10-K, File No. 1-3446). *(gg) New England Electric System and John W. Rowe: Service Credit Letter dated December 5, 1988 (Exhibit 10(dd) to 1992 NEES Form 10-K, File No. 1-3446). *(hh) New England Power Service Company and the Company: Form of Supplemental Pension Service Credit Agreement (Exhibit 10(ee) to 1992 NEES Form 10-K, File No. 1-3446). * Compensation related plan, contract, or arrangement. (12) Statement re computation of ratios for incorporation by reference into NEP registration statements on Form S-3, Commission File Nos. 33-48257, 33-48897, and 33-49193 (filed herewith). (13) 1993 Annual Report to Stockholders (filed herewith). (22) Subsidiary list (filed herewith). (25) Power of Attorney (filed herewith). Mass. Electric -------------- (3) (a) Articles of Organization of the Company as amended March 5, 1993, August 11, 1993, September 20, 1993, and November 15, 1993 (filed herewith). (b) By-Laws of the Company as amended February 4, 1993, July 30, 1993, and September 15, 1993 (filed herewith). (4) First Mortgage Indenture and Deed of Trust, dated as of July 1, 1949, and twenty supplements thereto (Exhibit 7-A, File No. 1-8019; Exhibit 7-B, File No. 2-8836; Exhibit 4-C, File No. 2-9593; Exhibit 4 to 1980 Form 10-K, File No. 2-8019; Exhibit 4 to 1982 Form 10-K, File No. 0-5464; Exhibit 4 to 1986 Form 10-K, File No. 0-5464); Exhibit 4 to 1988 Form 10-K, File No. 0-5464; Exhibit 4(a) to 1989 NEES Form 10-K, File No. 1-3446; Exhibit 4(a) to 1992 NEES Form 10-K, File No. 1-3446; Exhibit 4(a) to 1993 NEES Form 10-K, File No. 1-3446). (10) Material Contracts (a) Boston Edison Company et al. and Company: Amended REMVEC Agreement dated August 12, 1977 (Exhibit 5-4(d), File No. 2-61881). (b) New England Power Company and the Company: Primary Service for Resale dated February 15, 1974 (Exhibit 5-17(a), File No. 2-52969); Amendment of Service Agreement dated July 22, 1983 (Exhibit 10(b) to 1986 Form 10-K, File No. 0-5464); Amendment of Service Agreement effective November 1, 1993 (Exhibit 10(e) to 1993 NEP Form 10-K, File No. 0- 1229). (c) New England Power Pool Agreement: (Exhibit 4(e), File No. 2-43025); Amendments dated July 1, 1972, and March 1, 1973 (Exhibit 10-15, File No. 2-48543); Amendment dated March 15, 1974 (Exhibit 10-5, File No. 2-52775); Amendment dated June 1, 1975 (Exhibit 10-14, File No. 2-57831); Amendment dated September 1, 1975 (Exhibit 10-13, File No. 2-59182); Amendments dated December 31, 1976, January 31, 1977, July 1, 1977, and August 1, 1977 (Exhibit 10-16, File No. 2-61881); Amendments dated August 15, 1978, January 3, 1980, and February 1980 (Exhibit 10-3, File No. 2-68283); Amendment dated September 1, 1981 (Exhibit 10(h) to NEES' 1981 Form 10-K, File No. 1-3446); Amendment dated as of December 1, 1981 (Exhibit 10(h) to NEES' 1982 Form 10-K, File No. 1-3446); Amendments dated June 1, 1982, June 15, 1983, and October 1, 1983 (Exhibit 10(i) to NEES' 1983 Form 10-K, File No. 1-3446); Amendments dated August 1, 1985, August 15, 1985, September 1, 1985, and January 1, 1986 (Exhibit 10(i) to NEES' 1985 Form 10-K, File No. 1-3446); Amendment dated September 1, 1986 (Exhibit 10(i) to NEES' 1986 Form 10-K, File No. 1-3446); Amendments dated April 30, 1987 (Exhibit 10(i) to NEES' 1987 Form 10-K, File No. 1-3446); Amendments dated March 1, 1988 and May 1, 1988 (Exhibit 10(i) to NEES' 1988 Form 10-K, File No. 1-3446); Amendment dated March 15, 1989 (Exhibit 10(i) to 1989 NEES Form 10-K, File No. 1-3446). Amendment dated October 1, 1990 (Exhibit 10(i) to 1990 NEES Form 10-K, File No. 1-3446); Amendment dated as of September 15, 1992 (Exhibit 10(i) to 1992 NEES Form 10-K, File No. 1-3446). (d) New England Power Service Company and the Company: Specimen of Service Contract (Exhibit 10(d) to 1988 Form 10-K, File No. 0-5464). (e) New England Telephone and Telegraph Company and the Company: Specimen of Joint Ownership Agreement for Wood Poles (Exhibit 4(e), File No. 2-24458). *(f) New England Electric Companies' Deferred Compensation Plan as amended dated December 8, 1986 (Exhibit 10(m) to NEES' 1986 Form 10-K, File No. 1-3446). *(g) New England Electric System Companies Retirement Supplement Plan as amended dated April 1, 1991 (Exhibit 10(n) to NEES' 1991 Form 10-K, File No. 1-3446). *(h) New England Electric Companies' Executive Supplemental Retirement Plan as amended dated April 1, 1991 (Exhibit 10(o) to NEES' 1991 Form 10-K, File No. 1-3446). *(i) New England Electric Companies' Incentive Compensation Plan as amended dated January 1, 1992 (Exhibit 10(p) to NEES' 1992 Form 10-K, File No. 1-3446). *(j) New England Electric Companies' Form of Deferred Compensation Agreement for Directors (Exhibit 10(p) to NEES' 1980 Form 10-K, File No. 1-3446). *(k) New England Electric Companies' Senior Incentive Compensation Plan as amended dated November 26, 1991 (Exhibit 10(q) to NEES' 1991 Form 10-K, File No. 1-3446). *(l) Forms of Life Insurance Program: (Exhibit 10(s) to NEES' 1986 Form 10-K, File No. 1-3446); and Form of Life Insurance (Collateral Assignment) (Exhibit 10(t) to NEES' 1991 Form 10-K, File No. 1-3446). *(m) New England Electric Companies' Incentive Compensation Plan II as amended dated September 1, 1992 (Exhibit 10(r) to NEES' 1992 Form 10-K, File No. 1-3446). *(n) New England Power Service Company and the Company: Form of Supplemental Pension Service Credit Agreement (Exhibit 10(ee) to 1992 NEES Form 10-K, File No. 1-3446). * Compensation related plan, contract, or arrangement. (12) Statement re computation of ratios for incorporation by reference into the Mass. Electric registration statement on Form S-3, Commission File No. 33-49251 (filed herewith). (13) 1993 Annual Report to Stockholders (filed herewith). (18) Coopers & Lybrand Preferability Letter dated February 25, 1994 (Exhibit 18 to 1993 NEES Form 10-K, File No. 1-3446). (25) Power of Attorney (filed herewith). Narragansett ------------ (3) (a) Articles of Incorporation as amended June 9, 1988 (Exhibit 3(a) to 1988 Form 10-K, File No. 0-898). (b) By-Laws of the Company (Exhibit 3 to 1980 Form 10-K, File No. 0-898). (4) (a) First Mortgage Indenture and Deed of Trust, dated as of September 1, 1944, and twenty-one supplements thereto (Exhibit 7-1, File No. 2-7042; Exhibit 7-B, File No. 2-7490; Exhibit 4-C, File No. 2-9423; Exhibit 4-D, File No. 2-10056; Exhibit 4 to 1980 Form 10-K, File No. 0-898; Exhibit 4 to 1982 Form 10-K, File No. 0-898; Exhibit 4 to 1983 Form 10-K, File No. 0-898; Exhibit 4 to 1985 Form 10-K, File No. 0-898; Exhibit 4 to 1986 Form 10-K, File No. 0-898; Exhibit 4 to 1987 Form 10-K, File No. 0-898; Exhibit 4(b) to 1991 NEES Form 10-K, File No. 1-3446; Exhibit 4(b) to 1992 NEES Form 10-K, File No. 1-3446; Exhibit 4(b) to 1993 NEES Form 10-K, File No. 1-3446). (b) The Narragansett Electric Company Preference Provisions, as amended, dated March 23, 1993 (Exhibit 4(c) to 1993 NEES Form 10-K, File No. 1- 3446). (10) Material Contracts (a) Boston Edison Company et al. and the Company: Amended REMVEC Agreement dated August 12, 1977 (Exhibit 5-4(d), File No. 2-61881). (b) New England Power Company and the Company: Primary Service for Resale dated February 15, 1974 (Exhibit 4-1(b), File No. 2-51292); Amendment of Service Agreement dated July 26, 1990 (Exhibit 10(f) to 1990 NEP Form 10-K, File No. 0-1229); Amendment of Service Agreement dated July 24, 1991 (Exhibit 4(f) to 1991 NEP Form 10-K, File No. 0-1229); Amendment of Service Agreement effective November 1, 1993 (Exhibit 10(f) to 1993 NEP Form 10-K, File No. 0-1229). (c) New England Power Pool Agreement: (Exhibit 4(e), File No. 2-43025); Amendments dated July 1, 1972, and March 1, 1973 (Exhibit 10-15, File No. 2-48543); Amendment dated March 15, 1974 (Exhibit 10-5, File No. 2-52775); Amendment dated June 1, 1975 (Exhibit 10-14, File No. 2-57831); Amendment dated September 1, 1975 (Exhibit 10-13, File No. 2-59182); Amendments dated December 31, 1976, January 31, 1977, July 1, 1977, and August 1, 1977 (Exhibit 10-16, File No. 2-61881); Amendments dated August 15, 1978, January 3, 1980, and February 1980 (Exhibit 10-3, File No. 2-68283); Amendment dated September 1, 1981 (Exhibit 10(h) to NEES' 1981 Form 10-K, File No. 1-3446); Amendment dated December 1, 1981 (Exhibit 10(h) to NEES' 1982 Form 10-K, File No. 1-3446); Amendments dated June 1, 1982, June 15, 1983, and October 1, 1983 (Exhibit 10(i) to NEES' 1983 Form 10-K, File No. 1-3446); Amendments dated August 1, 1985, August 15, 1985, September 1, 1985, and January 1, 1986 (Exhibit 10 (i) to NEES' 1985 Form 10-K, File No. 1-3446); Amendment dated September 1, 1986 (Exhibit 10(i) to NEES' 1986 Form 10-K, File No. 1-3446); Amendment dated April 30, 1987 (Exhibit 10(i) to NEES' 1987 Form 10-K, File No. 1-3446); Amendments dated March 1, 1988 and May 1, 1988 (Exhibit 10(i) to NEES' 1988 Form 10-K, File No. 1-3446); Amendment dated March 15, 1989 (Exhibit 10(i) to 1989 NEES Form 10-K, File No. 1-3446). Amendment dated October 1, 1990 (Exhibit 10(i) to 1990 NEES' Form 10-K, File No. 1-3446); Amendment dated as of September 15, 1992 (Exhibit 10(i) to NEES' 1992 Form 10-K, File No. 1-3446. (d) New England Power Service Company and the Company: Specimen of Service Contract (Exhibit 10(d) to 1989 Form 10-K, File No. 0-898). (e) New England Telephone and Telegraph Company and the Company: Specimen of Joint Ownership Agreement for Wood Poles (Exhibit 3(d), File No. 2-24458). *(f) New England Electric Companies' Deferred Compensation Plan for Officers, as amended December 8, 1986 (Exhibit 10(m) to NEES' 1986 Form 10-K, File No. 1-3446). *(g) New England Electric System Companies Retirement Supplement Plan, as amended April 1, 1991 (Exhibit 10(n) to NEES' 1991 Form 10-K, File No. 1-3446). *(h) New England Electric Companies' Executive Supplemental Retirement Plan, as amended dated April 1, 1991 (Exhibit 10(o) to NEES' 1991 Form 10-K, File No. 1-3446). *(i) New England Companies' Incentive Compensation Plan, as amended dated January 1, 1992 (Exhibit 10(p) to NEES' 1992 Form 10-K, File No. 1-3446). *(j) New England Electric Companies' Form of Deferred Compensation Agreement for Directors (Exhibit 10(p) to NEES' 1980 Form 10-K, File No. 1-3446). *(k) New England Electric Companies' Senior Incentive Compensation Plan as amended dated November 26, 1991 (Exhibit 10(q) to NEES' 1991 Form 10-K, File No. 1-3446). *(l) Forms of Life Insurance Program (Exhibit 10(s) to NEES' 1986 Form 10-K, File No. 1-3446); and Form of Life Insurance (Collateral Assignment) (Exhibit 10(t) to NEES' 1991 Form 10-K, File No. 1-3446). *(m) New England Electric Companies' Incentive Compensation Plan II as amended dated September 1, 1992 (Exhibit 10(r) to NEES' 1992 Form 10-K, File No. 1-3446). *(n) New England Power Service Company and the Company: Form of Supplemental Pension Service Credit Agreement (Exhibit 10(ee) to 1992 NEES Form 10-K, File No. 1-3446). * Compensation related plan, contract, or arrangement. (12) Statement re computation of ratios for incorporation by reference into the Narragansett registration statement on Form S-3, Commission File No. 33-45052 (filed herewith). (13) 1993 Annual Report to Stockholders (filed herewith). (25) Power of Attorney (filed herewith). Financial Statement Schedules See Index to Financial Statements and Financial Statement Schedules for NEES, NEP, Mass. Electric, and Narragansett on pages 100, 109, 115, and 121, respectively. Reports on Form 8-K NEES ---- NEES filed reports on Form 8-K dated October 14, 1993 and November 30, 1993, both of which contained Item 5. NEP --- None. Mass. Electric -------------- Mass. Electric filed reports on Form 8-K dated October 14, 1993 and November 30, 1993, both of which contained Item 5. Narragansett ------------ None. NEW ENGLAND ELECTRIC SYSTEM 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. NEW ENGLAND ELECTRIC SYSTEM* s/John W. Rowe John W. Rowe President and Chief Executive Officer 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. (Signature and Title) Principal Executive Officer s/John W. Rowe John W. Rowe President and Chief Executive Officer Principal Financial Officer s/Alfred D. Houston Alfred D. Houston Executive Vice President and Chief Financial Officer Principal Accounting Officer s/Michael E. Jesanis Michael E. Jesanis Treasurer Directors (a majority) Joan T. Bok Paul L. Joskow John M. Kucharski Edward H. Ladd Joshua A. McClure s/John G. Cochrane Malcolm McLane All by: Felix A. Mirando, Jr. John G. Cochrane John W. Rowe Attorney-in-fact George M. Sage Charles E. Soule Anne Wexler James Q. Wilson James R. Winoker Date (as to all signatures on this page) March 28, 1994 *The name "New England Electric System" means the trustee or trustees for the time being (as trustee or trustees but not personally) under an agreement and declaration of trust dated January 2, 1926, as amended, which is hereby referred to, and a copy of which as amended has been filed with the Secretary of the Commonwealth of Massachusetts. Any agreement, obligation or liability made, entered into or incurred by or on behalf of New England Electric System binds only its trust estate, and no shareholder, director, trustee, officer or agent thereof assumes or shall be held to any liability therefor. NEW ENGLAND POWER 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. NEW ENGLAND POWER COMPANY s/Jeffrey D. Tranen Jeffrey D. Tranen 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 date indicated. The signature of each of the undersigned shall be deemed to relate only to matters having reference to the above-named company. (Signature and Title) Principal Executive Officer s/Jeffrey D. Tranen Jeffrey D. Tranen President Principal Financial Officer s/Michael E. Jesanis Michael E. Jesanis Treasurer Principal Accounting Officer s/Howard W. McDowell Howard W. McDowell Controller Directors (a majority) Joan T. Bok Frederic E. Greenman Alfred D. Houston s/John G. Cochrane John W. Newsham All by: John W. Rowe John G. Cochrane Jeffrey D. Tranen Attorney-in-fact Date (as to all signatures on this page) March 28, 1994 MASSACHUSETTS ELECTRIC 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. MASSACHUSETTS ELECTRIC COMPANY s/John H. Dickson John H. Dickson 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 date indicated. The signature of each of the undersigned shall be deemed to relate only to matters having reference to the above-named company. (Signature and Title) Principal Executive Officer s/John H. Dickson John H. Dickson President Principal Financial Officer s/Michael E. Jesanis Michael E. Jesanis Treasurer Principal Accounting Officer s/Howard W. McDowell Howard W. McDowell Controller Directors (a majority) Urville J. Beaumont Joan T. Bok Sally L. Collins John H. Dickson s/John G. Cochrane Charles B. Housen All by: Kathryn A. McCarthy John G. Cochrane Patricia McGovern Attorney-in-fact John F. Reilly John W. Rowe Richard P. Sergel Richard M. Shribman Roslyn M. Watson Date (as to all signatures on this page) March 28, 1994 THE NARRAGANSETT ELECTRIC 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. THE NARRAGANSETT ELECTRIC COMPANY s/Robert L. McCabe Robert L. McCabe 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 date indicated. The signature of each of the undersigned shall be deemed to relate only to matters having reference to the above-named company. (Signature and Title) Principal Executive Officer s/Robert L. McCabe Robert L. McCabe President Principal Financial Officer s/Alfred D. Houston Alfred D. Houston Vice President and Treasurer Principal Accounting Officer s/Howard W. McDowell Howard W. McDowell Controller Directors (a majority) Joan T. Bok Stephen A. Cardi Frances H. Gammell s/John G. Cochrane Joseph J. Kirby All by: Robert L. McCabe John G. Cochrane John W. Rowe Attorney-in-fact Richard P. Sergel William E. Trueheart John A. Wilson, Jr. Date (as to all signatures on this page) March 28, 1994 CONSENT OF INDEPENDENT ACCOUNTANTS We consent to the incorporation by reference in the registration statements of New England Electric System on Form S-3 of the Dividend Reinvestment and Common Share Purchase Plan (File No. 33-12313) and on Forms S-8 of the New England Electric System Companies Employees' Share Ownership Plan (File No. 2-89648), the New England Electric System Companies Incentive Thrift Plan (File No. 33-26066), the New England Electric System Companies Incentive Thrift Plan II (File No. 33-35470), the NEES Goals Program (File No. 2-94447) and the Yankee Atomic Electric Company Thrift Plan (File No. 2-67531) of our reports dated February 25, 1994 on our audits of the consolidated financial statements and financial statement schedules of New England Electric System and subsidiaries as of December 31, 1993 and 1992 and for each of the three years in the period ended December 31, 1993, which reports are incorporated by reference or included in this Annual Report on Form 10-K. We also consent to the incorporation by reference in the registration statements of New England Power Company on Forms S-3 (File Nos. 33-48257, 33-48897, and 33-49193), Massachusetts Electric Company on Form S-3 (File No. 33-49251) and The Narragansett Electric Company on Form S-3 (File No. 33-45052) of our reports dated February 25, 1994 on our audits of the financial statements and financial statement schedules of New England Power Company, Massachusetts Electric Company and The Narragansett Electric Company, respectively, as of December 31, 1993 and 1992 and for each of the three years in the period ended December 31, 1993, which reports are incorporated by reference or included in this Annual Report on Form 10-K. s/ Coopers & Lybrand Boston, Massachusetts COOPERS & LYBRAND March 25, 1994 REPORT OF INDEPENDENT ACCOUNTANTS Our reports on the consolidated financial statements of New England Electric System and subsidiaries and on the financial statements of certain of its subsidiaries, listed in item 14 herein, which financial statements and reports are included in the respective 1993 Annual Reports to Shareholders, have been incorporated by reference in this Form 10K. In connection with our audits of such financial statements, we have also audited the related financial statement schedules listed in Item 14 herein. In our opinion, the financial statement schedules referred to above, when considered in relation to the corresponding basic financial statements taken as a whole, present fairly, in all material respects, the information required to be included therein. s/ Coopers & Lybrand Boston, Massachusetts COOPERS & LYBRAND February 25, 1994 NEW ENGLAND ELECTRIC SYSTEM AND SUBSIDIARIES CONSOLIDATED --------------------------------------------------------- SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION Year Ended December 31, 1993, 1992, and 1991

108703_1993.txt

108703_1993

1993

108703

ITEM 1. BUSINESS GENERAL Wyman-Gordon Company, founded in 1883, is a leading producer of highly engineered, technically advanced components, primarily for the aerospace industry. The Company uses forging and investment casting technologies to produce components to exacting customer specifications for demanding applications such as jet turbine engines and airframes. The Company also designs and produces prototype products using composite technologies. JET ENGINE COMPONENTS The Company manufactures numerous forged and cast components for jet engines for both commercial and defense aircraft produced by all of the major manufacturers, including General Electric, Pratt & Whitney, Rolls-Royce and CFM International. The Company's forged engine parts include fan discs, compressor discs, turbine discs, seals, spacers and cases. Cast engine parts include thrust reversers, valves and fuel system parts such as combustion chamber swirl guides. Jet engines may produce in excess of 100,000 pounds of thrust and may subject parts produced by the Company to temperatures reaching 1,350oF. Components for such extreme conditions require precision manufacturing and expertise with high-purity titanium and nickel-based superalloys. Rotating parts such as fan, compressor and turbine discs must be manufactured to precise quality specifications. AIRFRAME STRUCTURAL COMPONENTS The Company manufactures forged and cast structural parts for fixed-wing aircraft and helicopters. These products include wing spars, engine mounts, struts, landing gear beams, landing gear, wing hinges, wing and tail flaps, housings, and bulkheads. These parts may be made of titanium, steel, aluminum and other alloys, as well as composite materials. The Company also produces dynamic rotor forgings for helicopters. Forging is particularly well-suited for airframe parts because of its ability to impact greater proportional strength to metal than other manufacturing processes. Investment casting can produce complex shapes to precise, repeatable dimensions. The Company has been a major supplier for many years of the beams that support the main landing gear assemblies on the Boeing 747 and has begun shipment of main landing gear beams for the new Boeing 777 widebody. The Company forges landing gear and other airframe structural components for the Boeing 747, 757, 767 and 777, the McDonnell Douglas MD-11 and the Airbus A330 and A340. The Company produces structural forgings for the, and fighter aircraft and the Sikorsky Black Hawk helicopter. The Company also produces large, one-piece bulkheads for Lockheed and Boeing for the new advanced tactical fighter. OTHER PRODUCTS The Company produces steam turbine and gas turbine generator components for land-based power generation applications. The Company also manufactures shafts, cases, compressor and turbine discs for marine gas turbines. The Company's investment castings operations produces components for medical devices, power equipment, food processing equipment, land-based military equipment such as tanks, and various other applications. The Company derived approximately 5% of its 1993 and 1992 revenues from sales of non-aerospace products. In 1992, the Company received preliminary vendor qualification to provide components to a major producer of land-based gas turbines. The Company expects to receive final vendor qualifications in the second quarter of 1994 and has received an order to produce those components beginning in 1994. MARKETS COMMERCIAL AEROSPACE The Company manufactures high-technology forged and cast products for virtually all models of commercial aircraft produced. Forged and investment cast parts include a wide variety of components for both the jet engines and structural airframes of these aircraft. The Company's composite operation designs and produces aerospace prototypes. The Company also produces products utilized in general aviation and business jet aircraft. DEFENSE EQUIPMENT The Company is a supplier to builders of military aircraft and missiles, manufacturing forged and investment cast components for jet engines as well as structural components and systems for defense and defense related industries. The Company manufactures fan, compressor and turbine discs, seals and spacers for jet engines, structural components such as aluminum, steel and titanium bulkheads for military aircraft and various fittings, spars and landing gear components. The Company also produces weapon cases for missiles and rockets. For naval defense applications, the Company manufactures components for nuclear propulsion plants, as well as pump, valve, structural and non-nuclear propulsion forgings. OTHER MARKETS The Company also participates in a number of other markets, principally in the nuclear and non-nuclear power generation, marine and food processing industries. The Company is actively seeking to identify alternative applications for its capabilities, such as in the automotive and other commercial markets. CUSTOMERS The Company has approximately 100 active customers that purchase forgings, approximately 425 active customers that purchase investment castings and approximately ten active customers that purchase composite structures. The Company's principal customers are similar across all of these production processes. Five customers, General Electric Company, United Technologies Corporation (principally its Pratt & Whitney Division), Boeing Company, McDonnell Douglas Corporation and Mitsui & Company U.S.A., accounted for approximately 54% of the Company's revenues during 1993 and approximately 53% of the Company's revenues during 1992. General Electric and United Technologies each accounted for more than 10% of revenues for 1993 and 1992. The Company has organized its operations into product groups which focus on specific customers or groups of customers with similar needs. The Company has become actively involved with its aerospace customers through joint development relationships and cooperative research and development, engineering, quality control, just-in-time inventory control and computerized design programs. This involvement begins with the design of the tooling and processes to manufacture the customer's components to its precise specifications. The Company increasingly participates with its customers in joint development projects. The Company's plasma arc melting ("PAM") unit is being developed in cooperation with General Electric Company in order to develop new processing techniques and materials, including alloys for use in components for the new GE90 jet engine. In addition, General Electric has contracted with the Company to produce tooling for several components for the GE90 engine. Another customer partnership involves the creation of a joint venture with Pratt & Whitney and Australian investors to produce aerospace grade, nickel-based superalloy ingot in Perth, Australia. Pratt & Whitney has committed to purchase a portion of the joint venture's output, and the Company anticipates that a part of such commitment will be satisfied through orders of forgings produced by the Company. MARKETING AND SALES The Company markets its products principally through its own sales engineers and makes only limited use of manufacturers' representatives. Substantially all sales are made directly to original equipment manufacturers. The Company's sales are not subject to significant seasonal fluctuations, although production in the third quarter normally tends to be somewhat less than that of other quarters as a result of scheduled plant shutdowns. A substantial portion of the Company's revenues is derived from long-term, fixed price contracts with major engine and aircraft manufacturers. These contracts are typically "requirements" contracts under which the purchaser commits to purchase a given portion of its requirements of a particular component from the Company. Actual purchase quantities are typically not determined until shortly before the year in which products are to be delivered. BACKLOG The decreased level of backlog at December 31, 1993 is attributable primarily to (1) continuing lower levels of demand in the commercial aerospace and defense equipment markets, (2) the inclusion at December 31, 1992 of backlog of approximately $12.9 million related to the Company's Wyman-Gordon Composites, Inc. operation which was sold in November 1993 and (3) the continued effect of the implementation of just-in-time delivery schedules by customers. At December 31, 1993 approximately $153.0 million of total backlog was scheduled to be shipped within one year and the remainder in subsequent years, although there can be no assurances that products ordered will not be subject to schedule changes. The decreased level of backlog at December 31, 1992 is attributable primarily to (1) delays by the Company's two largest engine component customers releasing long-term supply agreements to their supplier base, (2) more rapid production cycle times which require shorter lead order times and (3) the implementation of just-in-time delivery schedules by customers. MANUFACTURING PROCESSES The Company employs three manufacturing processes: forging, investment casting and composites production. FORGING Forging is the process by which desired shapes, metallurgical characteristics, and mechanical properties are imparted to metal by heating and shaping it through hammering, pressing or ring-rolling. The Company forges alloys of titanium, aluminum and steel as well as high temperature nickel-based superalloys. The Company manufactures most of its forged aerospace components at its facilities in Grafton and Worcester, Massachusetts (although the Company continues to consolidate its forging operations at the Grafton facility). The Company has three large closed- die hydraulic forging presses rated at 18,000, 35,000 and 50,000 tons, an open-die cogging press rated at 2,000 tons and a hydraulic isothermal forging press rated at 8,000 tons. The Company also operates forging hammers rated up to 35,000 pounds, a 220-ton ring- roll and supporting facilities. The Company employs all major forging processes, including the following: Open-Die Forging. In this process, the metal is forged between dies that never completely surround the metal, thus allowing the metal to be observed during the process. Typically, open-die forging is used to create relatively simple, preliminary shapes. Closed-Die Forging. Closed-die forging involves hammering or pressing heated metal into the required shapes and size determined by machined impressions in specially prepared dies which exert three dimensional control on the metal. In hot-die forging, a type of closed-die process, the dies are heated to a temperature approaching the transformation temperature of the materials being forged so as to allow the metal to flow more easily within the die cavity, which enhances the repeatability of the part shapes and allows greater metallurgical control. Both titanium and nickel-based superalloys are forged using this process, in which the dies are heated to a temperature of approximately 1,300oF. Isothermal Forging. Isothermal forging is a closed-die process in which the dies are heated to the same temperature as the metal being forged, typically in excess of 1,900oF. The forged material typically consists of nickel-based superalloy powders. Because of the extreme temperatures necessary for forming these alloys, the dies must be made of refractory metal (such as molybdenum) so that the die retains its strength and shape during the forging process. Because the dies may oxidize at these elevated temperatures, the forging process is carried on in a vacuum or inert gas atmosphere. The Company's isothermal press also allows it to produce near-net shape components (requiring less machining by the customer) made from titanium alloys, which can be an important competitive advantage in times of high titanium prices. The Company carries on this process in its 8,000-ton isothermal press. Ring-Rolling. This process, conducted on the Company's 220-ton ring-roll, involves rotating heated metal rings between two rotating rolls to produce seamless metal rings for use as seals, cases, spacers and similar parts for jet turbine engines. The Company can produce rings up to 80 inches in diameter and 20 inches in height. Titanium and Superalloy Production. The Company has backward-integrated into the manufacturing of raw materials used in its forging processes. In 1987 the Company began to cast titanium scrap and "sponge" into ingot and convert the ingot to billet by forging the ingot in its forging presses. Such billet may be used as raw material for the Company's forgings or may be converted or sold for other uses. The Company markets titanium ingots, billets, engineered mults and open-die forgings for use outside the Company's forging activities. The Company's PAM unit produces high quality titanium and can also be modified for the manufacture of nickel-based superalloy powders through an atomization process. The Company expects that the PAM unit will be certified by certain customers for the manufacture of some of their components in late 1994 and will thereafter produce the high-purity materials required for future high performance jet engines. The Company entered into a joint venture with Pratt & Whitney and certain Australian investors to produce nickel-based superalloy ingots in Perth, Australia. The Company expects that these ingots will be utilized as raw materials for the Company's forging and casting products. See "Business - Customers". Support Operations. The Company manufactures its own forging dies out of high-strength steel and molybdenum. These dies can weigh in excess of 100 tons and can be up to 25 feet in length. In manufacturing its dies, the Company takes its customers' drawings and engineers the dies using CAD/CAM equipment and sophisticated metal flow computer models that simulate metal flow during the forging process. This activity improves die design and process control and permits the Company to enhance the metallurgical characteristics of the forging. The Company also has a large machine shop with computer aided profiling equipment, vertical turret lathes and other equipment that it employs to rough machine products to a shape required to allow inspection of the products. The Company also operates rotary and car-bottom heat treating furnaces that enhance the performance characteristics of the forgings. These furnaces have sufficient capacity to handle all the Company's forged products. The Company subjects its products to extensive quality inspection and contract qualification procedures involving zyglo, chemical etching, ultrasonic, red dye, and electrical conductivity testing facilities. INVESTMENT CASTINGS The Company's investment castings operations use modern, automated, high volume production equipment and both air-melt and vacuum-melt furnaces to produce a wide variety of complex investment castings. Castings are made of a range of metal alloys including aluminum, magnesium, steel, titanium and nickel-based superalloys. The Company's castings operations are conducted in facilities located in Connecticut, New Hampshire, Nevada and California. These plants house air and vacuum-melt furnaces, wax injection machines and investment dipping tanks. The Company's Groton, Connecticut facility was recently expanded to produce high quality titanium castings. Investment castings are produced in four major stages. First, aluminum molds, known as "tools," are fabricated in the shape of the component to the specifications of the customer. Tools are primarily purchased from outside die makers, although the Company maintains internal tool-making capabilities. Wax is injected into the mold from a heated reservoir to form a "pattern." In the second stage, the wax patterns are mechanically coated with a sand and silicate-bonded slurry. This forms a ceramic shell which is subsequently air-dried under controlled environmental conditions. The wax inside this shell is then melted and removed in a high temperature steam autoclave and the molten wax is recycled. In the third, or foundry stage, metal is melted in an electric furnace in either an air or vacuum environment and poured into the ceramic shell. After cooling, the ceramic shells are removed by vibration. The metal parts are then cleaned in a high temperature caustic bath, followed by water rinsing. In the fourth, or finishing stage, the castings are finished to remove excess metal. The final product then undergoes a lengthy series of inspections (radiography, fluorescent penetrant, magnetic particle and dimensional) to ensure quality and consistency. COMPOSITES The Company's composites operation, Scaled Composites, Inc., designs, fabricates and tests prototypes for aerospace, automotive and other customers. These customers include Lawrence Livermore Laboratories, Orbital Sciences Corp. and McDonnell Douglas. In November 1993, the Company sold substantially all of the net assets and business operations of its Wyman-Gordon Composites, Inc. operations. Accordingly, such operations are not included in the above discussion. RAW MATERIALS Raw materials used by the Company in its forgings and castings include alloys of titanium, nickel, steel, aluminum and other high-temperature alloys. The composites operation uses high strength fibers such as fiberglass or graphite, as well as materials such as foam and epoxy, to fabricate composite structures. The major portion of metal requirements for forged and cast products are purchased from major non-ferrous metal suppliers producing forging and casting quality material as needed to fill customer orders. The Company has two or more sources of supply for all significant raw materials. The Company satisfies some of its titanium requirements internally by producing titanium alloy from titanium scrap and "sponge." The Company's PAM unit will also produce high quality titanium and advanced nickel alloys. The titanium and nickel-based superalloys utilized by the Company have a high dollar value. Accordingly, the Company attempts to recover and recycle scrap materials such as machine turnings, forging flash, scrapped forgings, test pieces and casting sprues, risers and gates. In the event of customer cancellation, the Company may, under certain circumstances, obtain reimbursement from the customer if the material cannot be diverted to other uses. Costs of material already on hand, along with any conversion costs incurred, have generally been billed to the customer unless transferable to another order. ENERGY USAGE The Company is a large consumer of energy. Energy is required primarily for heating materials to be forged and cast, melting of ingots, heat-treating materials after forging and casting, operating forging hammers, forging presses, melting furnaces, ring-rolls, die-sinking, mechanical manipulation and pollution control equipment and space heating. The Company uses natural gas, oil and electricity in varying amounts at its manufacturing facilities. In recent years, the Company's production facilities experienced no energy shortages which caused them to curtail their operations. EMPLOYEES As of December 31, 1993, the Company had 1,853 employees of whom approximately 612 were executive, administrative, engineering, research, sales and clerical and 1,241 production and craft. Approximately 44% of the production and craft employees, consisting of employees in the forging business, are represented by a union. In April 1992, the Company entered into a new three year collective bargaining agreement with the forging operation's employees. RESEARCH AND PATENTS The Company maintains a research and development center at Millbury, Massachusetts which is engaged in applied research and development work primarily relating to the Company's forging operations. The Company works closely with customers, universities and government technical agencies in developing advanced forging materials and processes. The Company's composites operation conducts research and development related to aerospace composite structures at the Mojave, California facility. The Company expended approximately $2.8 million on applied research and development work during 1993. Although the Company owns patents covering certain of its processes, the Company does not consider that these patents are of material importance to the Company's business as a whole. All of the Company's products are manufactured to customer specifications and, consequently, there are no proprietary products. COMPETITION Most of the Company's production capabilities are possessed in varying degrees by other companies in the industry, including both domestic and foreign manufacturers. Competition is intense among the companies currently involved in the industry. Competitive advantages are afforded to those with high quality products, low cost manufacturing, excellent customer service and delivery and engineering and production expertise. ENVIRONMENTAL REGULATIONS The Company is subject to extensive, stringent and changing federal, state and local environmental laws and regulations, including those regulating the use, handling, storage, discharge and disposal of hazardous substances and the remediation of alleged environmental contamination. Accordingly, the Company is involved from time to time in administrative and judicial inquiries and proceedings regarding environmental matters. Nevertheless, the Company believes that compliance with these laws and regulations will not have a material adverse effect on the Company's operations as a whole. The Company continues to design and implement a system of programs and facilities for the management of its raw materials, production processes and industrial waste to promote compliance with environmental requirements. In the fourth quarter of 1991, the Company recorded a pre-tax charge of $7.0 million with respect to environmental investigation and remediation costs at the Grafton facility and a pre-tax charge of $5.0 million against potential environmental remediation costs upon the eventual sale of the Worcester facility. Pursuant to an agreement entered into with the U.S. Air Force upon the acquisition of the Grafton facility from the federal government in 1982, the Company has agreed to make additional expenditures of approximately $10.1 million for environmental management and remediation projects at that site during the period 1992 through 1999, including $4.4 million for new waste water treatment facilities to be constructed during 1993 and 1994 in accordance with an administrative compliance order entered into with the United States Environmental Protection Agency (the "EPA"). The Company, together with numerous other parties, has also been alleged to be a potentially responsible party ("PRP") at the following four federal or state superfund sites: Operating Industries, Monterey Park, California; Cedartown Municipal Landfill, Cedartown, Georgia; PSC Resources, Palmer, Massachusetts; and the Gemme site, Leicester, Massachusetts. The Company believes that any liability it may incur with respect to these sites will not be material. In view of the relatively small number of PRP's identified at the Gemme site, the possibility exists that the Company could ultimately be liable for remediation costs in excess of its pro rata share of the wastes disposed of at that site. Preliminary engineering studies of the potential remediation costs associated with this site estimate that such costs could range from $0.5 million to $9.9 million depending on the levels of toxicity ultimately found and the method or methods of remediation selected. No allocation of liability has yet been agreed upon by the PRPs. The Company's Grafton, Massachusetts plant location is one of 46 sites throughout the country included in the U.S. Nuclear Regulatory Commission's ("NRC") May 1992 Site Decommissioning Management Plan ("SDMP") for low-level radioactive waste. The SDMP identifies the Company's site as a "Priority C" (lowest priority) site. The NRC conducted a long-range dose assessment in 1992 to determine what action, if any, it would order with respect to the site; its draft report states that the site should be remediated. However, the Company believes that the NRC's draft assessment was flawed and has retained an environmental engineering firm to challenge that draft assessment. The Company has submitted the environmental engineering firm's Dose Assessment Review to the NRC for consideration but has had no response from the NRC to date. The Company has provided $1.5 million for the estimated cost of the remediation. The Company believes that it may have meritorious claims for reimbursement from the U.S. Air Force in respect of any liabilities it may have for such remediation. PRODUCT LIABILITY EXPOSURE The Company produces many critical engine and structural parts for commercial and military aircraft. As a result, the Company faces an inherent business risk of exposure to product liability claims. The Company maintains insurance against product liability claims, but there can be no assurance that such coverage will continue to be available on terms acceptable to the Company or that such coverage will be adequate for liabilities actually incurred. The Company has not experienced any material loss from product liability claims and believes that its insurance coverage is adequate to protect it against any claims to which it may be subject. LEGAL PROCEEDINGS At December 31, 1993, the Company was involved in certain legal proceedings arising in the normal course of its business. The Company believes the outcome of these matters will not have a material adverse effect on the Company. In December 1992, the Company made a number of modifications to the Company's retiree health plans to limit the Company's obligations thereunder. In 1993, two separate class action suits were filed by certain retirees from the Company's Massachusetts and Michigan facilities contesting the Company's actions. The Company believes that it has meritorious defenses to these lawsuits and intends to defend its actions vigorously. The Company further believes that the outcome of this litigation will not have a material adverse effect on the Company. EXECUTIVE OFFICERS OF THE REGISTRANT John M. Nelson was elected Chairman and Chief Executive Officer of the Company in May 1991. On the date of the Special Meeting to be held in lieu of the 1993 Annual Meeting of Shareholders of the Company, Mr. Nelson will turnover his duties as Chief Executive Officer to David P. Gruber, currently the President and Chief Operations Officer, but will continue as Chairman of the Board of Directors. Prior to election to his present position, he served for many years in a series of executive positions with Norton Company, a manufacturer of abrasives and ceramics based in Worcester, Massachusetts, and was Norton's Chairman and Chief Executive Officer from 1988 to 1990 and its President and Chief Operating Officer from 1986 to 1988. Mr. Nelson is also a Director of Brown & Sharpe Manufacturing Company, Cambridge Biotechnology, Inc., TSI Corporation, Commerce Holdings, Inc. and the TJX Companies, Inc., Vice President of the Worcester Art Museum and Chairman of the Worcester Area Chamber of Commerce. David P. Gruber was elected President and Chief Operating Officer of the Company in October 1991 and was elected a Director of the Company in August 1992. Mr. Gruber will become President and Chief Executive Officer of the Company on the date of the Special Meeting to be held in lieu of the 1993 Annual Meeting of Shareholders of the Company. Prior to joining the Company, Mr. Gruber served as Vice President, Advanced Ceramics, of Compagnie de Saint Gobain (which acquired Norton Company in 1990), a position he held with Norton Company since 1987. Mr. Gruber previously held various executive and technical positions with Norton Company since 1978. Luis E. Leon joined the Company as Vice President-Treasurer in May 1991. In May 1993, he was elected Vice President - Finance and Treasurer. Prior to joining the Company, he had served since 1986 as Treasurer of Milton Roy Company, a manufacturer of fluid control products. From 1983 to 1986 he served as Manager of Treasury Operations of Kerr-McGee Corporation, a diversified energy company. Sanjay N. Shah serves as Vice President and Assistant General Manager of the Company's Aerospace Forgings Division. Previously he had served as Vice President - Operations since 1990. He has held a number of research, engineering and manufacturing positions at the Company since joining the Company in 1975. Wallace F. Whitney, Jr. joined the Company in 1991. Prior to that time, he had been Vice President, General Counsel and Secretary of Norton Company since 1988, where he had been employed in various legal capacities since 1973. Frank J. Zugel joined the Company in June 1993 when he was elected Vice President - General Manager, Investment Castings. Prior to that time he had served as President of Stainless Steel Products, Inc., a metal fabricator for aerospace applications, since 1992 and before then as Vice President of Pacific Scientific Company, a supplier of components to the aerospace industry, since 1988. None of the executive officers has any family relationship with any other executive officer. All officers are elected annually. ITEM 2. ITEM 2. PROPERTIES The response to Item 2. - Properties incorporates by reference the paragraphs captioned "Facilities" included in Item 1. - Business. ITEM 3. ITEM 3. LEGAL PROCEEDINGS The response to Item 3. - Legal Proceedings incorporates by reference the paragraphs captioned "Environmental Regulations" and "Legal Proceedings" included in Item 1. - Business. 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 response to Item 5. - Market for the Registrant's Common Equity and Related Stockholder Matters incorporates by reference the "Market and Dividend Information" section of the Company's 1993 Annual Report to Stockholders. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The response to Item 6. - Selected Financial Data incorporates by reference the 1989 through 1993 columns of the following lines which are included in the "Consolidated Ten-Year Financial Review" section of the Company's 1993 Annual Report: revenue, total assets, long-term debt, income (loss) from continuing operations, net income (loss) per share - continuing operations and dividends paid (per share). Also incorporated by reference is the "Accounting and Tax Matters" section of the Company's 1993 Annual Report. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The response to Item 7. - Management's Discussion and Analysis of Financial Condition and Results of Operations incorporates by reference the "Management's Discussion" section of the Company's 1993 Annual Report. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The response to Item 8. - Financial Statements and Supplementary Data incorporates by reference the following sections of the Company's 1993 Annual Report: Consolidated Statements of Operations and Retained Earnings Consolidated Balance Sheets Consolidated Statements of Cash Flows Notes to Consolidated Financial Statements Report of Independent Auditors ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE On June 17, 1992, the Company changed its independent accountants from Coopers & Lybrand to Ernst & Young. Cooper & Lybrand's report for the year ended December 31, 1991 contained no adverse opinion, disclaimer or qualification as to uncertainty, audit scope or accounting principles. Through the date of dismissal, there were no disagreements between the Company and Coopers & Lybrand on any matter of accounting principles or practices, financial statement disclosures, or auditing scope or procedures that if not resolved to the satisfaction of Coopers & Lybrand would have caused such firm to make reference thereto in connection with its reports on the financial statements of the Company. The Company's decision to change its independent accountants was approved by the Audit Committee of the Company's Board of Directors and by the full Board. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information regarding executive officers is incorporated by reference to PART I, Item 1. BUSINESS, under the caption "Executive Officers of the Registrant." ELECTION OF DIRECTORS Four directors will be elected at the Special Meeting in lieu of the Annual Meeting of Shareholders (the "Meeting") each to hold office until the 1997 annual meeting of shareholders and until his or her successor is elected and qualified. All of the nominees are currently directors of the Company. Unless authority to do so has been withheld or limited in the proxy, it is the intention of the persons named as proxies to vote the Shares to which the proxy relates for the election to the Board of Directors the four nominees listed below. The affirmative vote of a majority of the Shares of common stock, par value $1.00 per share, of the Company ("Shares") voting at the Meeting is required for election. Edouard C. Thys, a director since 1988, retired from the Company in October 1993 and, in accordance with Company policy regarding employee directors, no longer serves as a member of the Board of Directors. NOMINEES FOR THREE-YEAR TERM The following is certain information about the directors of the Company who are standing for reelection at the Meeting. Robert G. Foster, age 55, President and Director of Commonwealth BioVentures, Inc., Worcester, Massachusetts (a venture capital company engaged in biotechnology). Director of the Company since 1989. Member of the Management Resources and Compensation Committee. Term expires in 1994. Mr. Foster was President and Chairman of Ventrex Laboratories, Inc. from 1976 to 1987, when he assumed his present position. He is also a Director of United Timber Corp. Judith S. King, age 59, Community Volunteer, Personal Investments. Director of the Company since 1990. Member of the Audit, Directors and Management Resources and Compensation Committees. Term expires in 1994. Mrs. King is also a Trustee and Treasurer of the Stoddard Charitable Trust. Jon C. Strauss, age 54, President of Worcester Polytechnic Institute, Worcester, Massachusetts. Director of the Company since 1989. Member of the Audit and Finance Committees. Term expires in 1994. Prior to assuming his current position in 1985, Dr. Strauss was Chief Administrative Officer at the University of Southern California and, before that, Chief Financial Officer at the University of Pennsylvania. He is a Director of Computervision Corporation, a Regional Director of Shawmut Bank, a Trustee of the Massachusetts Biotechnology Research Institute and a Trustee of The Medical Center of Central Massachusetts. Charles A. Zraket, age 70, Adjunct Research Scholar, Kennedy School of Government, Harvard University. Trustee and Former President and Chief Executive Officer of the MITRE Corporation, Bedford, Massachusetts (a not-for-profit corporation engaged in systems engineering and research primarily for United States government departments and agencies). Director of the Company since 1990. Chairman of the Management Resources and Compensation Committee and member of the Directors Committee. Term expires in 1994. Mr. Zraket was President and Chief Executive Officer of the MITRE Corporation from 1986 to 1990 after having served as Executive Vice President and Chief Operating Officer. He is a Director of Bank of Boston, Boston Edison Company, Advanced Photovoltaics Systems, Inc. and Aspect Medical Systems. Mr. Zraket also serves as a Trustee of Northeastern University, Beth Israel Hospital and the Hudson Institute. CONTINUING DIRECTORS The following is certain information about the directors of the Company who are continuing in office. E. Paul Casey, age 64, Chairman and General Partner, Metapoint Partners, Peabody, Massachusetts (an investment partnership). Director of the Company since 1993. Member of the Audit and Management Resources and Compensation Committees. Term expires in 1996. Mr. Casey established Metapoint Partners in 1988. He served as Vice Chairman of Textron, Inc. from 1986 to 1987 and as Chief Executive Officer and President of Ex-Cell-O Corporation during 1978 to 1986. Mr. Casey is a Director of Comerica, Inc. and Hood Enterprises, Inc. and is a Trustee of the Henry Ford Health Care System. Warner S. Fletcher, age 49, Attorney and Director of the law firm of Fletcher, Tilton & Whipple, P.C., Worcester, Massachusetts. Director of the Company since 1987. Chairman of the Finance Committee and member of the Audit Committee. Term expires in 1996. Mr. Fletcher is a Director of Mechanics Bank. He is also Chairman of The Stoddard Charitable Trust and a Trustee of the Fletcher Foundation, the Worcester Foundation for Experimental Biology, the Bancroft School and the Worcester Art Museum. M Howard Jacobson, age 60, Senior Advisor, Bankers Trust, New York. Director of the Company since 1993. Member of the Finance and Directors Committees. Term expires in 1996. Mr. Jacobson was for many years Chief Executive Officer, President, Treasurer and a Director of Idle Wild Foods, Inc. until that company was sold in 1986. From 1989 to 1991 he was a Senior Advisor to Prudential Bache Capital Funding. Mr. Jacobson is a Director of Allmerica Property & Casualty Cos. Inc., Immulogic Pharmaceutical Corporation, Stoneyfield Farm, Inc., Cyplex, and Boston Chicken, Inc. He is Chairman of the Board of Trustees of Worcester Polytechnic Institute, Chairman of the Board of Directors of the Foundation of The Medical Center of Central Massachusetts, an Overseer of WGBH/National Public Broadcasting and a Trustee of the Worcester Foundation for Experimental Biology. George S. Mumford, Jr., age 65, Professor, Department of Physics and Astronomy, Tufts University. Director of the Company since 1968. Chairman of the Audit Committee and member of the Finance Committee. Term expires in 1996. Mr. Mumford formerly served as Dean of the Graduate School of Arts and Sciences at Tufts University. He was President and a Director of The Manufacturers Company until 1986, and he is a former member of the Board of Directors of the Council of Graduate Schools in the United States and Past President of the Northeast Association of Graduate Schools. Russell E. Fuller, age 67, Chairman of REFCO, INC., Boylston, Massachusetts (a supplier of specialty industrial products). Director of the Company since 1988. Chairman of the Directors Committee and member of the Finance Committee. Term expires in 1995. Mr. Fuller is Chairman and Treasurer of The George F. and Sybil H. Fuller Foundation and a Trustee of The Medical Center of Central Massachusetts. He is also a Trustee of the Massachusetts Biotechnology Research Institute and the Worcester County Horticultural Society. John M. Nelson, age 62, Chairman and Chief Executive Officer of the Company. Director of the Company since 1991. Member (ex officio) of the Audit, Finance and Directors Committees. Term expires in 1995. Mr. Nelson will become Chairman of the Board of Directors of the Company on the date of the Meeting. He was elected to his present position in May 1991. Prior to that time, he served for many years in a series of executive positions with Norton Company (a manufacturer of abrasives and ceramics) and was that company's Chairman and Chief Executive Officer from 1988 to 1990 and its President and Chief Operating Officer from 1986 to 1988. Mr. Nelson is also a Director of Brown & Sharpe Manufacturing Company, Cambridge Biotechnology, Inc., TSI Corporation, Commerce Holdings, Inc. and the TJX Companies, Inc. He is also President of the Greater Worcester Community Foundation, Vice President of the Worcester Art Museum and Chairman of the Worcester Area Chamber of Commerce. At the time of his election to his present position, Mr. Nelson and the Company entered into an agreement that provides for a five-year term of employment, defined pension benefits upon completion of such term and certain other employee benefits. The agreement also provides for accelerated vesting of stock options and pension benefits and continuation of employee benefits in the event of termination of his employment under specified conditions. David P. Gruber, age 52, President and Chief Operating Officer of the Company. Director of the Company since 1992. Term expires in 1995. In addition to retaining his present office as President of the Company, Mr. Gruber will become Chief Executive Officer of the Company on the date of the Meeting. He was elected to his current position in October 1991. He was previously employed by Norton Company since 1978 and served as its Vice President, Advanced Ceramics from 1987 to 1991 and Vice President- Coated Abrasives from 1986 to 1987. Mr. Fletcher and Mrs. King are cousins. None of the other Directors has any family relationships. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION MEETINGS OF THE BOARD The Board of Directors held nine meetings during 1993. Non-employee directors of the Company received annual remuneration of $10,000 for their services plus a fee of $600 for each Board meeting attended. Those non-employee directors who are also members of the Audit, Finance, Management Resources and Compensation or Directors Committees of the Board receive additional compensation of $600 for each Committee meeting attended. Each director attended at least seventy-five percent of the total number of Board and Committee meetings held while he or she served as a director or member of a Committee. COMPENSATION COMMITTEE REPORT OVERALL POLICY The Management Resources and Compensation Committee (the "Committee") of the Board of Directors is composed entirely of independent outside directors. The Committee is responsible for setting and administering the policies which govern the Company's executive compensation and stock ownership programs. The Company's executive compensation program is designed to be closely linked to corporate performance and return to stockholders. To this end, the Company maintains an overall compensation policy and specific compensation plans that tie a significant portion of executive compensation to the Company's success in meeting specified annual performance goals and to appreciation in the price of Shares. To overall objectives of this strategy are to attract and retain talented executives, to motivate those executives to achieve the goals inherent in the Company's business strategy, to link executive and stockholder interests through equity based incentive plans and, finally, to provide a compensation package that recognizes individual contributions as well as overall business results. The Committee approves the compensation of John M. Nelson, the Company's Chief Executive Officer, and Messrs. Gruber, Leon and Whitney, the three corporate executives who report directly to Mr. Nelson. Each of these officers' compensation is detailed below. The Committee also sets policies in order to ensure consistency throughout the executive compensation program. In reviewing the individual performance of the executives whose compensation is determined by the Committee (other than Mr. Nelson), the Committee takes into account Mr. Nelson's evaluation of their performance. There are three principal elements of the Company's executive compensation program: base salary, annual bonus and stock options. The Committee's policies with respect to each of these elements, including the bases for the compensation awarded to Mr. Nelson, are discussed below. In addition, while the elements of compensation described below are considered separately, the Committee takes into account the full compensation package provided by the Company to the individual, including pension benefits, supplemental retirement benefits, savings plans, severance plans, insurance and other benefits, as well as the programs described below. The Committee did not rely on compensation surveys or the services of consultants in making its determinations regarding compensation amounts or the relative proportions of fixed and variable compensation; rather its decision was based on its own judgment as to the most efficient manner of achieving the Company's compensation objective specified above. BASE SALARIES Base salaries for new executive officers are initially determined by evaluating the responsibilities of the position held and the experience of the individual, taking into account the competitive marketplace. Annual salary adjustments are determined by evaluating the performance of the Company and of each executive officer, and also take into account changed responsibilities. The Committee, where appropriate, also considers non-financial performance measures such as increase in market share, manufacturing efficiency gains, improvements in product quality and improvements in relations with customers, suppliers and employees. Mr. Nelson serves as Chief Executive Officer of the Company pursuant to a May 21, 1991 employment agreement. Mr. Nelson's employment agreement calls for the payment of an annual base salary of $300,000 during his service as the Company's Chief Executive Officer. In determining Mr. Nelson's base salary, the Committee took into account a comparison of base salaries of chief executive officers of other companies, the Company's financial situation and Mr. Nelson's experience as chief executive officer of a Fortune 500 company. Mr. Nelson's base salary is approximately 35% lower than that of his predecessor. Pursuant to his employment agreement, the Committee granted Mr. Nelson an option in 1991 to purchase 300,000 Shares at a price of $6.625 per Share. This mix of compensation was determined by the Committee based on its philosophy that executive compensation should be variable as much as possible. ANNUAL BONUS The Company maintains a Management Incentive Plan ("MIP") under which executive officers (as well as other key employees) are eligible for an annual cash bonus. The Committee establishes individual and corporate performance objectives at the beginning of each year. Eligible executives are assigned threshold, target and maximum bonus levels. The Committee determines the corporate performance targets for bonus payments based on the corporate financial plan for the ensuing year and may use such measures as operating income and cash generation. If minimum objectives are not met, no bonuses are paid. As in the case of base salary, the Committee may consider individual non-financial performance measures and, where appropriate, unit performance measures, in determining bonus amounts. The Committee has final authority in interpreting the MIP and discretion in making any awards under the MIP. In 1993, as in 1992, the Committee determined that in view of the Company's financial condition, it would be inappropriate to adopt a bonus plan under the MIP and thus no bonuses have been or will be paid under the MIP for 1993 performance. At the recommendation of Mr. Nelson, the Committee authorized the grant of special bonuses in 1993 to Messrs. Gruber, Leon and Whitney to recognize their efforts in successfully refinancing the Company's debt in adverse circumstances during the year. Such bonuses were granted apart from the operation of the MIP and are reported in the Summary Compensation Table following this report. STOCK OPTIONS Under the Company's Long-Term Incentive Plan, options with respect to Shares may be granted to the Company's key employees, including executive officers. The Committee sets guidelines for the size of stock option awards based on factors similar to those used to determine base salaries and annual bonus. Stock options are designed to align the interests of executives with those of the shareholders. Stock options may be exercised over a ten-year period at an exercise price equal to the market price of the Shares on the date of grant and vest over three years. This approach is designed to provide an incentive for the creation of shareholder value over the long-term since the full benefit of the compensation package cannot be realized unless appreciation of the price of Shares occurs over a number of years. In 1993 the Committee granted options to a total of 48 key employees; the Committee believes that broad dissemination of options within the Company enhances the benefits to the Company of stock-based incentives. In 1993, Mr. Nelson was granted options to purchase 25,000 Shares with an exercise price of $5.125 per Share and now has options to purchase a total of 375,000 Shares. The 1993 grant was made to further the Committee's view that executive compensation ought to be dependent in large measure on the performance of the Company and the Shares. Mr. Nelson now beneficially owns 52,000 Shares that he purchased on the open market since he became Chief Executive Officer. The Committee believes that significant equity interests in the Company held by the Company's management better align the interests of shareholders and management. CONCLUSION Through the incentive and stock option programs described above, a significant portion of the Company's executive compensation is linked directly to individual and corporate performances and stock price appreciation. The Committee intends to continue the policy of linking executive compensation to corporate performance and returns to stockholders, recognizing that the ups and downs of the business cycle from time to time may result in an imbalance for a particular period. Charles A. Zraket, Chairman E. Paul Casey Robert G. Foster Judith S. King EXECUTIVE COMPENSATION The remuneration of the Company's Chief Executive Officer and each of the four most highly compensated executive officers at December 31, 1993 for services rendered to the Company during 1993, 1992 and 1991 is reported in the table set forth below. The remuneration of Edouard C. Thys, who retired from the Company in October 1993, is also reported. PENSION BENEFITS All salaried employees and executive officers of the Company participate in a defined benefit pension plan (the "Pension Plan"). Under the terms of the Pension Plan each eligible employee receives a retirement benefit based on the number of years of his or her credited service (to a maximum 35 years) and average annual total earnings (salary plus incentive bonus only) for the five consecutive most highly paid years during the ten years preceding retirement. In addition, with the exception of Messrs. Nelson and Thys, the executive officers covered by the Summary Compensation Table and certain other key executives designated by the Committee are eligible to receive benefits under the Supplemental Retirement Plan for Senior Executives (the "Supplemental Pension Plan"). Under the Supplemental Pension Plan, participants who have been employed by the Company for at least 15 years and who retire on or after their 62nd birthday receive an annual pension which, when added to other retirement benefits received from the Company, totals 50% of their highest average annual earnings during any preceding 60-consecutive-month period. This supplemental benefit is reduced if the participant has been employed for less than 15 years or retires prior to age 62 and may be further reduced by certain other income benefits payable to participants. Benefits under the Pension Plan are not offset for Social Security payments but Supplemental Pension Plan benefits are offset for such payments. If the Committee so determines, payments under the Supplemental Pension Plan may be terminated if a retired participant becomes "substantively employed," as defined in the Supplemental Pension Plan, by another employer before age 65. The following table indicates the aggregate estimated annual benefits payable, as single life annuity amounts, under both the Pension Plan and the Supplemental Pension Plan to participants retiring in various categories of earnings and years of service. To the extent that an annual retirement benefit exceeds the limit imposed by the Code, the difference will be paid from the general operating funds of the Company. As of December 31, 1993, the individuals named in the Summary Compensation Table had full credited years of service with the Company as follows: Mr. Nelson, 2; Mr. Gruber, 2; Mr. Leon, 2; Mr. Whitney, 2; Mr. Shah, 18; and Mr. Thys, 35. SAVINGS/INVESTMENT PLAN All full-time salaried employees with at least one year's service with the Company may participate in the Savings/Investment Plan (the "S/I Plan"). Participating employees may through payroll deductions make a basic contribution of up to five percent of their covered compensation and a supplemental contribution of up to an additional ten percent of their covered compensation. The Company currently contributes an amount equal to 50% of participant's basic contribution. The Company's contributions are made in the form of Shares. The right of a participant with less than five years of Company service to such Company contributions vests at the rate of 20% per year. Supplemental employee contributions beyond the five percent limit, when made, receive no matching Company contributions. The S/I Plan allows participants to take advantage of Section 401(k) of the Internal Revenue Code by realizing a federal income tax deferral through a voluntary salary reduction and equivalent contribution by the Company to the participant's special S/I Plan account for that purpose. Such tax-deferred savings are not available for withdrawal by an employee before age 59 1/2 except in circumstances of financial hardship. A participant may elect deductions for regular savings and tax-deferred savings in any combination not exceeding fifteen percent of the participant's covered compensation, provided, however, that tax-deferred savings may not exceed $9,240 in 1994. Participants currently have a choice of six investment funds and may allocate both their personal and Company contributions and earnings as they wish among them. They include Income Accumulation, Growth Stock, S&P 500 Stock, U.S. Treasury and Asset Allocation Funds and a Wyman-Gordon Stock Fund that invests primarily in Shares. A participant retiring under a Company retirement income plan may elect among several methods of distribution of his S/I Plan account. The S/I Plan is administered by the Savings/Investment Plan Committee, whose members are appointed by the Chief Executive Officer. AGREEMENTS WITH MANAGEMENT In addition to the employment agreement with John M. Nelson described in "- Compensation Committee Report - Base Salaries," the Company has entered into agreements with each of its executive officers, other than Messrs. Nelson and Thys, that would provide such officers with specified benefits in the event of termination of employment within three years following a change of control of the Company when both employment termination and such change in control occur under conditions defined in the agreements. Such benefits include a payment equal to a maximum of 250% of the executive officer's annual compensation, continuation of insurance coverages for up to twenty-four months following termination and accelerated vesting of existing options and stock appreciation rights. No benefits are payable under the agreements in the event of an executive officer's termination for cause, in the event of retirement, disability or death or in cases of voluntary termination in circumstances other than those specified in the agreements that would entitle an executive officer to benefits. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The response to Item 12. - Security Ownership of Certain Beneficial Owners and Management incorporates by reference the information under the caption "Executive Compensation" included in the Company's response to Item 11 above. [FN] (5) Russell E. Fuller is one of seven trustees of the George F. and Sybil H. Fuller Foundation (the "Fuller Foundation") and the Shares beneficially owned by the Fuller Foundation are therefore reported in the above table. Mr. Fuller disclaims any beneficial ownership in the Shares beneficially owned by the Foundation. (6) Mr. Thys has retired from the Company and is no longer a director. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The response to Item 13. - Certain Relationships and Related Transactions incorporates by reference the information under the captions "Nominees for Three-Year Term" and "Continuing Directors" included in the Company's response to Item 10 above and the information under the captions "Compensation Committee Report" and "Agreements with Management" included in the Company's response to Item 11 above. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K EXHIBITS The exhibit listing required by Item 601 of Regulation S-K is included on page E-1. FINANCIAL STATEMENTS The following financial statements, together with the report thereon of Ernst & Young dated February 11, 1994 appearing in the 1993 Annual Report are incorporated by reference in this Form 10-K: Consolidated Statements of Operations and Retained Earnings Consolidated Balance Sheets Consolidated Statements of Cash Flows Notes to Consolidated Financial Statements REPORTS ON FORM 8-K No reports on Form 8-K were filed with the Commission during the fourth quarter of 1993. CONSENT OF INDEPENDENT AUDITORS We consent to the incorporation by reference in this Annual Report (Form 10-K) of Wyman-Gordon Company and Subsidiaries of our report dated February 11, 1994, included in the 1993 Annual Report. Our audits also included the financial statement schedules of Wyman-Gordon Company listed in Item 14. 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 the Registration Statements (Form S-8, File Numbers 2-56547, 2-75980, 33-26980 and 33-48068) pertaining to the Wyman-Gordon Company Executive Long-Term Incentive Program (1975) - Amendment No. 6, the Wyman-Gordon Company Stock Purchase Plan, the Wyman-Gordon Company Savings/Investment Plan and the Wyman-Gordon Company Long-Term Incentive Plan and in the related Prospectuses of our report dated February 11, 1994, with respect to the consolidated financial statements of Wyman-Gordon Company and Subsidiaries incorporated by reference in the Annual Report (Form 10-K) for the years ended December 31, 1993 and 1992. Worcester, Massachusetts ERNST & YOUNG March 28, 1994 REPORT OF INDEPENDENT ACCOUNTANTS Our report on the consolidated financial statements of Wyman-Gordon Company and Subsidiaries has been incorporated by reference in this Form 10-K from page 18 of the 1991 Annual Report to Shareholders of Wyman-Gordon Company. In connection with our audits of such financial statements, we have also audited the related financial statement schedules listed in Item 14 on page 22 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. Boston, Massachusetts COOPERS & LYBRAND February 19, 1992 CONSENT OF INDEPENDENT ACCOUNTANTS We consent to the incorporation by reference in the registration statements of Wyman-Gordon Company on Forms S-8 (File Numbers 2-56547, 2-75980, 33-26980 and 33-48068) of our report dated February 19, 1992, on our audit of the consolidated financial statements and financial statement schedules of Wyman-Gordon Company as of December 31, 1991, and for the year then ended, which report is included or incorporated by reference in this Annual Report on Form 10-K. Boston, Massachusetts COOPERS & LYBRAND March 28, 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. Wyman-Gordon Company (REGISTRANT) By /s/ LUIS E. LEON March 30, 1994 --------------------------------------- -------------- Luis E. Leon Date Vice President - Finance and Treasurer S-1 S-2 S-3 Commercial paper represents paper sold by Wyman-Gordon Company. Bank loans are evidenced by renewable 90-day notes bearing interest at money market rates. The maximum and average amounts outstanding during the period were computed using month-end balances. The weighted average interest rates during 1992 and 1991 were calculated based upon the weighted average interest cost of borrowings throughout the year. Additional information is included in Note C to the 1993 Annual Report. S-4 E-1 NOTE: Exhibits not physically located in this Form 10-K can be obtained from the Company upon written request to the Assistant Clerk at the address on the cover of this Form 10-K at a cost of $.25 per page. E-2

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ITEM 1. BUSINESS The company was founded in 1918 and has been a leader in consumer electronics, first in radio and later in monochrome and color television and other video products. The company's operations involve a dominant industry segment, the design, development, and manufacture of video products (including color television sets and other consumer products) along with parts and accessories for such products. These products along with purchased video cassette recorders are sold principally to retail dealers and wholesale distributors in the United States, Canada and other foreign countries. Independently owned and operated distributors sell to retail dealers who, in turn, sell to consumers. The company sells directly to retail dealers, buying groups, private label customers and the lodging, health care and rent-to-own industries. Also included in the company's video products business are color picture tubes that are produced for and sold to other manufacturers; video monitors which are primarily produced for and sold to computer manufacturers; and cable and subscription television products which are sold primarily to cable television operators. The company also makes power supplies and high-security electronic equipment. During 1993, the monochrome video monitor business was sold and the company reached an agreement (subject to certain contingencies) to sell the power supply business in early 1994. Raw Materials Many materials, such as copper, plastic, steel, wood, glass, aluminum and zinc, are essential to the business. The company experienced shortages in 1993 of picture tube glass and certain other components. Shortages may possibly recur in 1994. Patents The company is licensed under a number of patents which are of importance to its business, and holds numerous patents that expire at various times through 2010. The company has patents and patent applications for numerous high-definition television (HDTV) related inventions. To the extent these inventions are incorporated into the HDTV standard adopted by the Federal Communications Commission, any royalties resulting from these patents would be pooled and shared with the other participants of the Grand Alliance formed in 1993 by the company and other proponents of various HDTV systems. Non-HDTV applications of these patents could produce royalties which would accrue entirely to the company. In addition, major manufacturers of televisions and video cassette recorders agreed during 1992 to take licenses under some of the company's U.S. tuning system patents (the licenses expire in 2003). Based on 1993 U.S. industry unit sales levels and technology, more than $20 million in annual royalty income is expected. While in the aggregate its patents and licenses are valuable, the business of the company is not materially dependent on them. Seasonal Variations in Business Sales of the company's consumer electronics products are generally at a higher level during the second half of the year. Sales of consumer electronics products typically increase in the fall, as the summer vacation season ends and people spend more time indoors, with the new fall programming on the television networks, and during the Christmas holiday season. During 1993, 1992 and 1991, approximately 54 percent, 56 percent and 56 percent, respectively, of the company's net sales were recorded in the second half of the year and approximately 30 percent of the company's net sales were recorded in the fourth quarter of each of the three years ended December 31, 1993. Competitive Conditions Competitive factors in North America include price, performance, quality, variety of products and features offered, marketing and sales capabilities, manufacturing costs, and service and support. The company believes it competes well with respect to each of these factors. The company's major product areas, including the color television market, are highly competitive. The company's major competitors are foreign-owned global giants, generally with greater worldwide television volume and overall resources. In efforts to increase market share or achieve higher production volumes, the company's competitors have aggressively lowered their selling prices in the past several years. Some of the company's foreign competitors have been capable of offsetting the effects of U.S. price reductions through sales at higher margins in their home markets and through direct governmental supports. During 1993, the company continued to pursue efforts to reduce unfair competition from television imports. Research and Development During 1993, expenditures, net of outside funding, for company-sponsored engineering and research relating to new products and services and to improvements of existing products and services amounted to $47.8 million. Amounts expended in 1992 and 1991 were $55.4 million and $54.1 million, respectively. Environmental Issues Compliance with Federal, State and local environmental protection provisions is not expected to have a material effect on capital expenditures, earnings or the competitive position of the company. Further information regarding environmental compliance is set forth under Item 3 of this report. Number of Employees At the end of December 1993, the company employed approximately 22,100 people, of whom approximately 15,600 are hourly workers covered by collective bargaining agreements. Approximately 4,400 of the company's employees are located in the Chicago, Illinois area, of whom approximately 2,800 are represented by unions. Approximately 16,700 of the company's employees are located in Mexico, of whom approximately 12,400 are represented by unions. Mexican labor contracts expire every two years and wages are renegotiated annually. The company believes that its relations with its employees are good. Financial Information about Foreign and Domestic Operations and Export Sales The North American Free Trade Agreement (NAFTA), which took effect on January 1, 1994, will significantly reduce duty costs in 1994 and beyond. This should improve the company's ability to compete against Asian imports in North America and is expected to increase sales of the company's color television receivers in Mexico and Canada and color picture tube production in the U.S. Since the passage of the NAFTA, the company has added more than 300 U.S. jobs that are directly related to increased demand for U.S. picture tubes. Information regarding foreign operations is included in "Note Five - Geographic Segment Data" on page 36 of this report. Export sales are less than 10% of consolidated net sales. The company's product lines are dependent on the continuing operations of the company's manufacturing and assembly facilities located in Mexico. ITEM 2. ITEM 2. PROPERTIES The company utilizes a total of approximately 6.7 million square feet for manufacturing, warehousing, engineering and research, administration and distribution, as described below. In addition, the company owns 95 acres of vacant land adjacent to its Glenview, Illinois headquarters, which is available for sale. Square Feet Location Nature of Operation (in millions) - ------------------- ------------------------------------- ------------ Domestic: - ------------------- Chicago, Illinois Six locations - production of color 2.7 (1) (including suburban picture tubes; parts and service; engi- locations) neering and research, marketing and administration activities; and assembly of electronic components Springfield, Missouri Production of plastic cabinets for 1.0 (2) color television and other plastic parts; and warehouses and distribution McAllen, El Paso and Four locations - warehouses .2 Brownsville, Texas; Douglas, Arizona Various Nine locations - domestic distribution .2 Foreign: - ------------------- Mexico Fourteen manufacturing and warehouse 2.4 (3) locations - sub-assembly production of television chassis, tuners, wooden television cabinets and other components and final assembly of color television, color video monitors and cable products; and assembly of power supplies Canada Three locations - distribution of .2 consumer electronics products Taiwan One location - purchasing office - ------- Total 6.7 ======= (1) The company owns a 500,000 square foot warehouse in Northlake, Illinois of which 100,000 square feet is used for storage (included in the above table) with the remainder leased to another company (not included in the above table). A contract is currently pending to sell the entire facility to this lessee and to thereafter vacate that portion currently occupied by the company. (2) The company owns a 400,000 square foot warehouse in Springfield, Missouri which is being leased to another company and as such is not included in the above table. A contract is currently pending to sell the entire 1.7 million square foot facility to this lessee and to leaseback that portion the company is currently utilizing. The company expects to vacate this space by mid - 1995. (3) The company owns, and has offered for sale or lease, 230,000 square feet of manufacturing and warehousing space in Chihuahua, Mexico. Currently this space is not being utilized by the company and as such is not included in the above table. The company's facilities are suitable and adequate to meet current and anticipated requirements. Substantially all of the total square footage of property used is owned by the company. ITEM 3. ITEM 3. LEGAL PROCEEDINGS The company is involved in various legal actions, environmental matters, patent claims, and other proceedings relating to a wide range of matters that are incidental to the conduct of its business. The company believes, after reviewing such matters with the company's counsel, that any liability which may ultimately be incurred with respect to these matters is not expected to have a material effect on either the company's consolidated financial position or results of operations. The company and other potentially responsible parties have completed negotiations with the United States and the State of Indiana with respect to settlement of certain natural resources claims for environmental damage that were not disposed of in settlement of the so-called Midco environmental litigation at Gary, Indiana. On March 26, 1993, the company signed the Amendment to Consent Decree and the Midco Natural Resources Participation Agreement. The company's share of the settlement was approximately $100,000 which was paid during 1993. On April 27, 1993, the U.S. Environmental Protection Agency sent written notices to all potentially responsible parties, advising the parties of the EPA's proposed plan of remediation at the American Chemical Services site near Griffith, Indiana. The EPA notified the parties that they would be expected to make a good faith offer to perform the remedial action and thereafter to negotiate and enter into a consent decree with the agency. The EPA estimates that the cost of remedial action could range from $38 to $64 million, depending upon the type of remedy actually needed to effect the cleanup. The company is alleged to have contributed less than one-tenth of one percent of the hazardous waste identified at the site. The company and other de minimus waste generators intend to seek a separate de minimus settlement with the EPA. In October 1989, the EPA filed a civil action against certain generator and owner/operator defendants under CERCLA seeking reimbursement for its response costs in connection with an environmental cleanup at a site located at Collegeville, Pennsylvania. One of the original defendants to the EPA case brought a third party action for contribution against a number of third party defendants, including Ford Electronics and Refrigeration Corporation ("FERCO"). FERCO is now seeking $600,000 in contribution from the company on the ground that FERCO is being held liable in part because it hauled certain waste from the company's former Lansdale, Pennsylvania picture tube plant. The claim is now under investigation. Numerous lawsuits against major computer and peripheral equipment manufacturers are pending in the U.S. District Court, Eastern District of New York, the U.S. District Court of New Jersey as well as in the New York State courts. These lawsuits seek several billion dollars in damages from various defendants for repetitive stress injuries claimed to have been caused by the use of word processor equipment. The company has been named as a defendant in sixteen of these cases which relate to keyboards allegedly manufactured by the company for its former subsidiary, Zenith Data Systems Corporation. Plaintiffs in the company's cases seek to recover $22 million actual and $230 million punitive damages from the company. The company believes it has meritorious defenses to the cases. In April, 1993, a group of 47 plaintiffs, individually and on behalf of certain minors and decedents, filed suit in the District Court of Cameron County, Texas against 130 defendants, including the company's subsidiaries, Zenith Electronics Corporation of Texas and Electro Partes de Matamoros, S.A. de C.V., alleging that plaintiffs suffered injuries or death as a result of defendants' negligence, negligent design for and implemented practices of managing, handling, storage, transportation, utilization and disposal of toxic compounds. Plaintiffs seek judgment for actual and exemplary damages against defendants, jointly and severally, in an unspecified amount. The company's two subsidiaries filed answers denying the material allegations of the complaint. 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 1993, through the solicitation of proxies or otherwise. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS The New York Stock Exchange is the principal United States market in which the company's common stock is traded. The number of stockholders of record was 16,636 as of February 18, 1994. No dividends were paid to stockholders during the two years ended December 31, 1993. The high and low price range by quarter for the past two years is listed below: ITEM 6. ITEM 6. SELECTED FINANCIAL DATA Five-Year Summary of Selected Financial Data ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Analysis of Operations Operating Results -- 1993 vs. 1992 The operating loss before special charges for restructuring and other actions was $51 million in 1993 and $61 million in 1992. Consolidated sales in 1993 were $1,228 million, down 1% from $1,244 million in 1992. The decline was principally due to lower sales in the noncore product areas and lower consumer product pricing, largely offset by higher unit volume in the consumer product line. The effect on operating results of unit volume increases in consumer products was offset by volume declines in the non-core product areas. Substantial cost reductions in all product areas of about $75 million resulted from process and design improvements, consolidation of operations in Mexico, headcount reductions and other operating changes. These cost reductions were offset by $42 million in consumer products price reductions that had been implemented throughout 1992 and early 1993, and $20 million of inflationary cost increases, primarily labor costs in Mexico. Despite the adverse impact of an industry glass shortage, industry color TV unit sales to dealers rose 11 percent in 1993 (following an 11 percent increase in 1992) to set a new record. Zenith's unit sales increase outpaced the industry growth, leading to an increase in market share. While industry unit sales to dealers of video cassette recorder decks remained about equal to 1992, Zenith's volume increased. Unit sales of color picture tubes to other TV manufacturers decreased in 1993 because the company used more of its capacity to support increased sales of Zenith color TVs and because of an industry glass shortage, which also adversely impacted Zenith color TV sales. Additional picture tube capacity became available in late 1993 when the dedicated FTM tube production line was converted to be able to produce both television and monitor picture tubes. Operating results were improved by the full year effect of certain manufacturing operations that were consolidated in Mexico during 1992, as well as continued efforts to reduce headcounts and product costs. These programs, together with new manufacturing process improvements that were initiated in late 1993, should have a positive effect on 1994 operations. Sales of cable products declined in 1993 as a new product for a major contract manufacturing customer was delayed. However, due to major cost savings associated with headcount reductions and consolidations of manufacturing operations, operating results improved compared to 1992. Sales of other products decreased in 1993 as Zenith downsized its non- core magnetics and monitor product areas. However, the cost structures of these areas were improved so that operating results in 1993 were somewhat better than 1992. During the year, the monochrome monitor business was sold (production ended in early 1994) and the company reached an agreement (subject to certain contingencies) to sell the power supply business in early 1994. Operating results in 1994 should benefit from these actions. Engineering and research expenses were $48 million in 1993, compared to $55 million in 1992, with reductions principally in non-core product areas. Selling, general, and administrative expenses declined slightly to $93 million in 1993 from $94 million. These improvements were primarily the result of headcount reductions initiated in late 1992. Other operating income (net) increased to $25 million from $24 million in 1993, as a result of increased royalty income from new licensing activities. Royalty income arising from licensing of Zenith patented tuning-system technology to other color TV and VCR manufacturers was about $26 million in both 1993 and 1992 and is included in Other operating income (net). Based on 1993 U.S. industry unit sales levels and technology, more than $20 million in annual royalty income is expected. Interest expense (net) of $15 million in 1993 was higher than 1992's $13 million as a result of increased average borrowings. The income tax credit in 1992 consisted principally of the reversal of previously accrued tax reserves no longer required in connection with earnings of a foreign subsidiary, and net operating loss carryback applications. Operating Results - 1992 vs. 1991 The operating loss before special charges for restructuring and other actions was $61 million in 1992, compared with $42 million in 1991. Consolidated sales in 1992 were $1,244 million, down 6% from $1,322 million in 1991. The decline was principally due to price reductions and lower unit shipments of consumer electronics products. Cost reductions of about $50 million in 1992 were more than offset by the price reductions and lower consumer electronics unit sales volumes, by sales declines in other categories, and by the effect of increases in the costs of labor, material and services. After two years of declines (approximately 4 percent in both 1990 and 1991), industry color TV unit sales to dealers rose 11 percent in 1992 to a new record level. However, unit shipments of Zenith color TVs declined in 1992, principally as a result of delayed responses to price reductions initiated by competitors during the year. Pricing declined by $21 million in 1992, compared with 1991. Industry sales to dealers of video cassette recorder products increased in 1992. Zenith shipments declined, partially as a result of the company's planned phaseout of camcorders due to inadequate margins. Zenith unit sales of color picture tubes to other TV manufacturers increased in 1992 as the domestic industry increased. The benefits of transferring certain consumer electronics manufacturing operations to Mexico began to be realized in 1992, but were offset in part by startup costs. Sales and operating results for cable products declined in 1992 due to the continuing deferral of equipment purchases by U.S. cable operators. Computer monitor sales increased in 1992, compared with 1991, but operating results were adversely affected by costly new-product start-up and by costs associated with moving monochrome monitor operations from Taiwan to Mexico. Sales of other products declined in 1992 from the prior year, primarily due to reduced lighting products requirements by a customer and the phasing out of several low-margin products. Selling, general and administrative expenses declined to $94 million in 1992 from $101 million in 1991 as a result of reduced compensation and other costs. Engineering and research expenses were $55 million in 1992, compared with $54 million in 1991. Other operating income (net) increased sharply to $24 million in 1992 from $0.5 expense in 1991, principally as a result of $26 million of royalty income arising from licensing of Zenith patented tuning-system technology to other color TV and VCR manufacturers. Interest expense (net) of $13 million in 1992 was higher than 1991's $9 million as a result of increased average borrowings. The income tax credit in 1992 consisted principally of the reversal of previously accrued tax reserves no longer required in connection with earnings of a foreign subsidiary, and net operating loss carryback applications. Operating results for 1991 include a gain on the sale of Zenith's Taiwan monochrome monitor plant which was offset by restructuring charges related to the consolidations of color TV and monitor assembly operations in Mexico. Restructuring and Other Charges In the fourth quarter of 1993, the company initiated major restructuring, re-engineering and other actions designed to reduce ongoing operating expenses and to revalue certain assets. Special charges for these actions were $31 million. The computer monitor and magnetics product areas were restructured in order to downsize production capacity to be more in line with expected reduced levels of business. The charge includes the anticipated expenses of the major efforts to re-engineer processes in all areas of the core business's operations. Major elements of this charge were the non-cash writedown of fixed assets and inventory ($23 million) as well as re-engineering and severance costs ($6 million) to be paid during 1994 and early 1995. The restructuring actions are expected to reduce 1994 operating expenses including reduced compensation expense of about $10 million and reduced depreciation of about $4 million. The 1992 results also included special charges for restructuring and other actions of $48 million. Included in the actions were manufacturing consolidations and related employment reductions in Mexico; consolidation of company-owned distribution; and salaried employment reductions throughout the company. In addition to valuation reserves for inventories and manufacturing equipment ($22 million) and severance and relocation costs ($18 million) of which $11 million was paid in 1993, the special charges also provided for trade-receivable write-offs ($6 million). Liquidity and Capital Resources Following is a three-year summary of cash provided and used: Liquidity Cash decreased $35 million during the three year period of 1991-1993. The decrease consisted of $53 million of cash used by operating activities and $75 million , net , used to purchase fixed assets. These uses of cash were offset by $93 million of cash provided from financing activities which included the issuance of long-term debt and sales of the company's common stock. Operating activities: In 1993, $28 million of cash was used by operating activities mainly to fund $45 million of net losses from operations as adjusted for depreciation and fixed asset write downs as a part of restructuring and other charges. A decrease in current accounts provided $3 million of cash and was composed of a $15 million decrease in receivables offset by a $8 million increase in inventories and a $4 million decrease in accounts payable and accrued expenses. The decrease in receivables was due to lower sales. Also, the company reduced cash used by operating activities by issuing common stock to the profit-sharing retirement plans to fulfill both the 1992 obligation to salaried employees and the 1993 obligation to salaried employees and a portion of the hourly employees. These issuances increased stockholders' equity by $15 million. In 1992, $16 million of cash was used by operating activities mainly to fund $64 million of net losses from operations as adjusted for depreciation, fixed asset write downs as a part of a restructuring and a loss on the disposition of properties. This was offset by cash provided from a $41 million decrease in current accounts composed of a $39 million decrease in inventories and a $21 million decrease in receivables, offset by a $15 million decrease in net income taxes payable and a $4 million decrease in accounts payable and accrued expenses. Also, the company reduced cash used by operating activities by issuing common stock to the profit-sharing retirement plan to fulfill the 1991 obligation to salaried employees, increasing stockholders' equity by $6 million. In 1991, $9 million of cash was used by operating activities mainly to fund $23 million of net losses from operations, as adjusted for depreciation and a gain on the sale of properties. This was offset by cash provided from a $13 million decrease in current accounts which consisted mainly of a $12 million decrease in inventories. Investing activities: In 1993, investing activities used $26 million of cash for capital additions. In 1992, $25 million of cash was used which consisted of capital additions of $32 million offset by $7 million of proceeds from a 1991 property sale. In 1991, $24 million of cash was used which consisted of capital additions of $37 million offset by $13 million of proceeds from property sales. Financing activities: In 1993, financing activities provided $69 million of cash which included $55 million provided from the sale of 8.5% senior subordinated convertible debentures and $24 million provided from sales of the company's common stock (including option exercises). This was offset by $10 million of cash used to repay borrowings under the company's working capital Credit Agreement with a lending group led by General Electric Capital Corporation (the "Credit Agreement"). In 1992, financing activities provided $11 million of cash which included $10 million provided from borrowings under the company's revolving credit and security agreement and $1 million provided from the exercise of stock options. In 1991, financing activities provided $13 million of cash which included $15 million provided from the sale of common stock to GoldStar Co. Ltd., offset by $2 million used to repurchase a portion of the 12 1/8% notes in a private transaction. Capital Resources As of December 31, 1993, total interest-bearing obligations of the company consisted of $170 million of long-term debt , $35 million of long-term debt classified as current and $9 million of extended-term payables with a foreign supplier. The company's long-term debt is composed of $115 million of convertible subordinated debentures due 2011 that require annual sinking fund payments of $6 million beginning in 1997 and $55 million aggregate principal amount of 8.5% senior subordinated convertible debentures due 2000 that were issued and sold during 1993 in a private placement. The $35 million of long-term debt classified as current represents notes due January 1995 that were redeemed by the company in January 1994. In May 1993, the company entered into the Credit Agreement. The maximum commitment for funds available for borrowing under the Credit Agreement is $90 million, but is defined by a defined borrowing base formula related to eligible accounts receivable and inventory. The company used the initial advance under the agreement to repay all amounts outstanding under its former bank agreement, which was simultaneously terminated. The Credit Agreement contains restrictive financial covenants that must be maintained as of the end of each fiscal quarter, including a liabilities to net worth ratio and a minimum net worth amount. As a result of the company's fourth quarter 1993 restructuring charge of $31 million the agreement was amended in January 1994 to relax these financial covenants as of December 31, 1993. The Credit Agreement terminates on December 31, 1994 (unless extended by agreement of the lenders), at which time all outstanding indebtedness under the agreement would have to be refinanced. There can be no assurance that the Credit Agreement will be extended or refinanced. As of December 31, 1993, no borrowings were outstanding under the Credit Agreement in keeping with the seasonal nature of the company's working capital needs. A Registration Statement filed with the Securities and Exchange Commission covering 5 million shares of common stock became effective in May 1993. During 1993, the company sold approximately 3.4 million shares of authorized but unissued shares of common stock to investors under this shelf registration for approximately $23 million, net of expenses. Subsequent to December 31, 1993, the company sold the remaining shares available under the shelf registration. Thereafter, in order to take advantage of favorable market conditions, the company determined to file another Registration Statement with the Securities and Exchange Commission covering an additional 2 million shares of common stock. The new Registration Statement became effective in February 1994, and the company subsequently sold the 2 million shares registered thereunder to investors on the open market. The 1994 common stock sales under both registration statements generated approximately $34 million, net of expenses. On March 1, 1994, the company announced its intention to file a Registration Statement for 5 million shares of the company's common stock to be sold by means of a prospectus. In addition, during January 1994, the company issued and sold $12 million aggregate principal amount of 8.5% senior subordinated convertible debentures due 2001 (similar to the $55 million sold during 1993) in a private placement and, as indicated above, also redeemed the $35 million of notes due January 1995 at a redemption price equal to par value plus accrued interest. Although the company believes that the Credit Agreement, together with extended-term payables expected to be available from a foreign supplier and its continuing efforts to obtain other financing sources, will be adequate to meet its seasonal working capital and other needs in 1994, there can be no assurance that the company will not experience liquidity problems in the future because of adverse market conditions or other unfavorable events. In such event, the company would be required to seek other sources of liquidity, if available. Outlook The company's major product areas, including the color television market, are highly competitive. The company's major competitors are foreign-owned global giants, generally with greater worldwide television volume and overall resources. In efforts to increase market share or achieve higher production volumes, the company's competitors have aggressively lowered their selling prices in the past several years. Some of the company's foreign competitors have been capable of offsetting the effects of U.S. price reductions through sales at higher margins in their home markets and through direct governmental supports. There can be no assurance that such competition will not continue to adversely affect the company's performance or that the company will be able to maintain its market share in the face of such competition. Price competition continued in the first quarter of 1994, and the company selectively reduced color television prices to maintain its historical competitive price position. The North American Free Trade Agreement (NAFTA), which took effect on January 1, 1994, will significantly reduce duty costs in 1994 and beyond. This should improve the company's ability to compete against Asian imports in North America and is expected to increase sales of the company's color television receivers in Mexico and Canada and color picture tube production in the U.S. In light of the company's losses from continuing operations, competitive environment and inflationary cost pressures (including labor costs in Mexico where labor contracts expire every two years and wages are renegotiated annually), the company has undertaken major cost reduction programs each year. In 1994, the company expects to reduce costs by about $50 million from continued process and design improvements, headcount reductions and other operating changes. The company continues to seek additional cost reduction opportunities for 1994 and beyond, although there can be no assurance that any such cost reductions will be achieved. Also, as in 1993, the company may experience an adverse impact as industry shortages of picture tube glass or other components continue in 1994. The goals of the company's business strategy are to improve profitability, to introduce new products (such as home theater TVs), to develop new products (such as digital cable products incorporating the company-developed transmission technology selected in February 1994 by the HDTV Grand Alliance and the FCC Advisory Committee review panel), and to re-engineer operations. This strategy is expected to continue to involve significant expenditures by the company in 1994 and beyond. There can be no assurance that the company will achieve the goals of its business strategy, including an expected improvement in financial results. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The financial information required by Item 8 is contained in Item 14 of Part IV (page 15) 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 AND EXECUTIVE OFFICERS OF THE REGISTRANT Information concerning directors is incorporated herein by reference from the sections entitled "Election of Directors", "Nominees for Election as Directors" and "Board of Directors, Committees and Directors' Compensation" from the company's definitive Proxy Statement, copies of which will be electronically transmitted to the Commission via EDGAR. EXECUTIVE OFFICERS OF THE REGISTRANT Name Office Held Age - -------------------- ------------------------------------------ --------- Jerry K. Pearlman Chairman and Chief Executive 55 Officer since 1983; Chairman, President and Chief Executive Officer 1983-1993 Gerald M. McCarthy Executive Vice President and 52 member of the Office of the Chairman since 1993; Senior Vice President, Sales and Marketing and member of the Office of the President 1991 - 1993. President, Zenith Sales Company Division since 1983 Albin F. Moschner President and Chief Operating Officer 41 and member of the Office of the Chairman since 1993; Senior Vice President, Operations and member of the Office of the President 1991 - Kell B. Benson Vice President-Finance and Chief 46 Financial Officer since 7/89; Vice President-Controller 1989; Corporate Controller 1987-1989; Director, Financial Control- Consumer and Cable Products 1983-1987 Michael J. Kaplan Vice President-Human Resources since 54 1993; Vice President-Human Resources and Public Affairs 1988 - 1993; Director of Personnel and Industrial Relations 1982-1988 John Borst, Jr. Vice President-General Counsel 66 since 1985 ITEM 11. ITEM 11. EXECUTIVE COMPENSATION Incorporated by reference from the sections entitled "Summary Compensation Table", "Employment Agreement", "Termination and Change of Control Agreements", "Option Grants in 1993", "Option Exercises in 1993 and Year-End Option Values" and "Compensation Committee Report on Executive Compensation" from the company's definitive Proxy Statement, copies of which will be electronically transmitted to the Commission via EDGAR. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Incorporated by reference from the sections entitled "Security Ownership of Certain Beneficial Owners" and "Security Ownership of Management" from the company's definitive Proxy Statement, copies of which will be electronically transmitted to the Commission via EDGAR. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS No material transactions occurred during 1993. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) 1. The following Consolidated Financial Statements of Zenith Electronics Corporation, the Report of Independent Public Accountants, and the Unaudited Quarterly Financial Data are included in this report on pages 30 through 42: Statements of Consolidated Operations and Retained Earnings - Years ended December 31, 1993, 1992 and 1991 Consolidated Balance Sheets - December 31, 1993 and 1992 Statements of Consolidated Cash Flows - Years ended December 31, 1993, 1992 and 1991 Notes to Consolidated Financial Statements Report of Independent Public Accountants Unaudited Quarterly Financial Data (a) 2. The following consolidated financial statement schedules for Zenith Electronics Corporation are included in this report on pages 25 through 29: Schedule V - Property, Plant and Equipment Schedule VI - 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 The Report of Independent Public Accountants on Financial Statement Schedules is included in this report on page 24. All other schedules for which provision is made in Regulation S-X of the Securities and Exchange Commission, are not required under the related instructions or are inapplicable and, therefore, have been omitted. 3. Exhibits: (3a) Restated Certificate of Incorporation of the company, as amended (incorporated by reference to Exhibit 3a of the company's Report on Form 10-K for the year ended December 31, 1992) (3b) Certificate of Amendment to Restated Certificate of Incorporation of the company dated May 4, 1993 (incorporated by reference to Exhibit 4l of the company's Quarterly Report on Form 10-Q for the quarter ended April 3, 1993) (3c) By-Laws of the company, as amended (incorporated by reference to Exhibit 3 of the company's Current Report on Form 8-K, dated January 31, 1994) (4a) Indenture, dated as of January 15, 1985, for 12-1/8% Notes due 1995 with the Irving Trust Company (incorporated by reference to Exhibit 2 of the company's Report on Form 10-K for the year ended December 31, 1989) (4b) Indenture, dated as of April 1, 1986, for 6-1/4% Convertible Subordinated Debentures due 2011 with The First National Bank of Boston, Trustee (incorporated by reference to Exhibit 1 of the company's Quarterly Report on Form 10-Q for the quarter ended March 30, 1991) (4c) Stockholder Rights Agreement dated as of October 3, 1986 (incorporated by reference to Exhibit 4c of the company's Quarterly Report on Form 10-Q for the quarter ended September 28, 1991) (4d) Amendment, dated April 26, 1988, to Stockholder Rights Agreement (incorporated by reference to Exhibit 4d of the company's Quarterly Report on Form 10-Q for the quarter ended April 3, 1993) (4e) Amended and Restated Summary of Rights to Purchase Common Stock (incorporated by reference to Exhibit 4e of the company's Quarterly Report on Form 10-Q for the quarter ended July 3, 1993) (4f) Amendment, dated July 7, 1988, to Stockholder Rights Agreement (incorporated by reference to Exhibit 4f of the company's Quarterly Report on Form 10-Q for the quarter ended July 3, 1993) (4g) Agreement, dated May 23, 1991, among Zenith Electronics Corporation, The First National Bank of Boston and Harris Trust and Savings Bank (incorporated by reference to Exhibit 1 of Form 8, dated May 30, 1991) (4h) Amendment, dated May 24, 1991, to Stockholder Rights Agreement (incorporated by reference to Exhibit 2 of Form 8 dated May 30, 1991) (4i) Agreement, dated as of February 1, 1993, among Zenith Electronics Corporation, Harris Trust and Savings Bank and The Bank of New York (incorporated by reference to Exhibit 1 of Form 8 dated March 25, 1993) (4j) Credit Agreement, dated as of May 21, 1993, with General Electric Capital Corporation, as agent and lender, and the other lenders named therein (incorporated by reference to Exhibit 4 of the company's Current Report on Form 8-K dated May 21, 1993) (4k) Amendment No. 1 dated November 8, 1993 to the Credit Agreement dated May 21, 1993, with General Electric Capital Corporation, as agent and lender, and the other lenders named therein (incorporated by reference to Exhibit 4(b) of the company's Current Report on Form 8-K, dated November 19, 1993) (4l) Amendment No. 3 dated January 7, 1994 to the Credit Agreement dated May 21, 1993, with General Electric Capital Corporation, as agent and lender, The Bank of New York Commercial Corporation, as lender, and Congress Financial Corporation, as lender (incorporated by reference to Exhibit 4(b) of the company's Current Report on Form 8-K dated January 11, 1994) (4m) Fourth Amendment dated January 28, 1994 to the Credit Agreement dated May 21, 1993, with General Electric Capital Corporation, as agent and lender, The Bank of New York Commercial Corporation, as lender, and Congress Financial Corporation, as lender (incorporated by reference to Exhibit 4 of the company's Current Report on Form 8-K dated January 31, 1994) (4n) Debenture Purchase Agreement dated as of November 19, 1993 with the institutional investors named therein (incorporated by reference to Exhibit 4(a) of the company's Current Report on Form 8-K dated November 19, 1993) (4o) Amendment No. 1 dated November 24, 1993 to the Debenture Purchase Agreement dated as of November 19, 1993 with the institutional investor named therein (incorporated by reference to Exhibit 4(a) of the company's Current Report on Form 8-K dated November 24, 1993) (4p) Amendment No. 2 dated January 11, 1994 to the Debenture Purchase Agreement dated as of November 19, 1993 (incorporated by reference to Exhibit 4(c) of the company's Current Report on Form 8-K dated January 11, 1994) (4q) Debenture Purchase Agreement dated as of January 11, 1994 with the institutional investor named therein (incorporated by reference to Exhibit 4(a) of the company's Current Report on Form 8-K dated January 11, 1994) *(10a) 1987 Zenith Stock Incentive Plan (as amended subject to shareholder approval on April 28, 1992) (incorporated by reference to Exhibit A of the company's definitive Proxy Statement dated March 13, 1992) *(10b) Form of Amended and Restated Employment Agreement with Jerry K. Pearlman, Gerald M. McCarthy, Albin F. Moschner, Kell B. Benson and John Borst, Jr. (incorporated by reference to Exhibit 2 of the company's Report on Form 10-K for the year ended December 31, 1990) *(10c) Restricted Stock Agreement, dated December 3, 1986, of Jerry K. Pearlman (incorporated by reference to Exhibit 10c of the company's Report on Form 10-K for the year ended December 31, 1991) *(10d) Amendment, dated May 27, 1987, to Restricted Stock Agreement of Jerry K. Pearlman (incorporated by reference to Exhibit 10d of the company's Report on Form 10-K for the year ended December 31, 1992) *(10e) Amendment, dated March 28, 1988, to Restricted Stock Agreement of Jerry K. Pearlman *(10f) Amendments, dated October 1, 1990, and January 23, 1991, to Restricted Stock Agreement of Jerry K. Pearlman (incorporated by reference to Exhibit 3 of the company's Report on Form 10-K for the year ended December 31, 1990) *(10g) Restricted Stock Agreement, dated March 31, 1987, with Gerald M. McCarthy, and Amendments thereto dated December 2, 1987, March 28, 1988, August 22, 1988, and January 23, 1991 (incorporated by reference to Exhibit 10b of the company's Quarterly Report on Form 10-Q for the quarter ended June 29, 1991) *(10h) Forms of Amendments, dated as of July 24, 1991, to Restricted Stock Agreement dated December 3, 1986, with Jerry K. Pearlman and to Restricted Stock Agreement dated March 31, 1987, with Gerald M. McCarthy (incorporated by reference to Exhibit 10c of the company's Quarterly Report on Form 10-Q for the Quarter ended June 29, 1991) *(10i) Supplemental Agreement, dated September 12, 1986, with Jerry K. Pearlman (incorporated by reference to Exhibit 10m of the company's Report on Form 10-K for the year ended December 31, 1991) *(10j) Amendment to Supplemental Agreement with Jerry K. Pearlman (incorporated by reference to Exhibit 10j of the company's Report on Form 10-K for the year ended December 31, 1992) *(10k) Form of Amendment, dated as of May 19, 1989, to Supplemental Agreement with Jerry K. Pearlman, (incorporated by reference to Exhibit 6 of the company's Report on Form 10-K for the year ended December 31, 1989) *(10l) Form of Amendment, dated as of July 24, 1991, to Supplemental Agreement with Jerry K. Pearlman (incorporated by reference to Exhibit 10a of the company's Quarterly Report on Form 10-Q for the Quarter ended June 29, 1991) *(10m) Form of Supplemental Agreement with Gerald M. McCarthy, Albin F. Moschner, Kell B. Benson and John Borst, Jr. (incorporated by reference to Exhibit 10q of the company's Report on Form 10-K for the year ended December 31, 1991) *(10n) Form of Stock Indemnification Rights Grant with Jerry K. Pearlman and Kell B. Benson *(10o) Form of Amendment to Stock Indemnification Rights Grant with Jerry K. Pearlman and Kell B. Benson (incorporated by reference to Exhibit 7 of the company's Report on Form 10-K for the year ended December 31, 1989) *(10p) Letter Agreement, dated October 21, 1991, with Albin F. Moschner (incorporated by reference to Exhibit 10u of the company's Report on Form 10-K for the year ended December 31, 1991) *(10q) Form of Indemnification Agreement with Officers and Directors (incorporated by reference to Exhibit 8 of the company's Report on Form 10-K for the year ended December 31, 1989) *(10r) Form of Directors Stock Units Compensation Agreement with Harry G. Beckner (2,000 units) and with G. Ralph Guthrie (1,000 units) (incorporated by reference to Exhibit 10r of the company's Report on Form 10-K for the year ended December 31, 1992) *(10s) Form of Directors 1989 Stock Units Compensation Agreement with Harry G. Beckner, T. Kimball Brooker and G. Ralph Guthrie (1000 units each) (incorporated by reference to Exhibit 9 of the company's Report on Form 10-K for the year ended December 31, 1989) *(10t) Form of Directors 1990 Stock Units Compensation Agreement with Harry G. Beckner, G. Ralph Guthrie, T. Kimball Brooker, David H. Cohen, Charles Marshall, Andrew McNally IV and Peter S. Willmott (1000 units each) (incorporated by reference to Exhibit 6 of the company's Report on Form 10-K for the year ended December 31, 1990) *(10u) Form of Directors 1991 Stock Units Compensation Agreement with Harry G. Beckner, T. Kimball Brooker, David H. Cohen, G. Ralph Guthrie, Charles Marshall, Andrew McNally IV and Peter S. Willmott (1,000 units each) (incorporated by reference to Exhibit 10d of the company's Quarterly Report on Form 10-Q for the Quarter ended June 29, 1991) *(10v) Form of Amendment, dated as of July 24, 1991, to Directors Stock Units Compensation Agreements for 1987, 1988, 1990 and 1991 (incorporated by reference to Exhibit 10e of the company's Quarterly Report on Form 10-Q for the Quarter ended June 29, 1991) *(10w) Directors Retirement Plan and form of Agreement (incorporated by reference to Exhibit 10 of the company's Report on Form 10-K for the year ended December 31, 1989) *(10x) Form of Amendment, dated as of July 24, 1991, to Directors Retirement Plan and form of Agreement (incorporated by reference to Exhibit 10f of the company's quarterly Report on Form 10-Q for the Quarter ended June 29, 1991) (10y) Investment Agreement, dated as of February 25, 1991, with GoldStar Co., Ltd. (incorporated by reference to Exhibit 1 of the company's Current Report on Form 8-K, dated February 25, 1991) (10z) Registration Rights Agreement, dated as of February 25, 1991, with GoldStar Co., Ltd. (incorporated by reference to Exhibit 2 of the company's Current Report on Form 8-K, dated February 25, 1991) (10aa) Investment Agreement dated as of March 25, 1993 between Zenith Electronics Corporation and Fletcher Capital Markets, Inc. (incorporated by reference to Exhibit 1 of the company's Current Report on Form 8-K dated March 26, 1993) (10bb) Investment Agreement dated as of July 29, 1993 between Zenith Electronics Corporation and Fletcher Capital Markets, Inc. (incorporated reference to Exhibit 5(a) of the company's Current Report on Form 8-K dated July 29, 1993) (21) Subsidiaries of the company (23) Consent of Independent Public Accountants * Represents a management contract, compensation plan or arrangement. (b) Reports on Form 8-K The following reports on Form 8-K were filed during the quarter ended December 31, 1993. A report on Form 8-K dated October 21, 1993 was filed by the company stating under Item 5 that Zenith had issued a press release which reported third quarter 1993 financial results. A report on Form 8-K dated November 19, 1993 was filed by the company stating under Item 5 that Zenith had sold to certain institutional investors $42 million principal amount of its 8.5% Senior Subordinated Convertible Debentures due November 19, 2000, pursuant to a Debenture Purchase Agreement dated November 19, 1993, entered into by the company and the purchasers. A report on Form 8-K dated November 24, 1993 was filed by the company stating under Item 5 that Zenith had agreed to sell to certain institutional investors an additional $13 million principal amount of its 8.5% Senior Subordinated Convertible Debentures due November 19, 2000, pursuant to a Debenture Purchase Agreement dated November 19, 1993 entered into by the company and amended on November 24, 1993 to add the additional purchasers. A report on Form 8-K dated December 14, 1993 was filed by the company stating under Item 5 that Zenith had issued a press release announcing that it has called for redemption of its outstanding 12 1/8% Notes due on January 13, 1994. A report on Form 8-K dated December 15, 1993 was filed by the company stating under Item 5 that Zenith had issued a press release announcing that it is planning to restructure its computer monitor and magnetics areas and re-engineer its core consumer electronics and cable business which will result in a fourth quarter special charge of up to $30 million. (c) and (d) Exhibits and Financial Statement Schedules Certain exhibits and financial statement schedules required by this portion of Item 14 are filed 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. ZENITH ELECTRONICS CORPORATION (Registrant) By: /S/ Jerry K. Pearlman --------------------- Jerry K. Pearlman Chairman, and Chief Executive Officer Date March 1, 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 Title Date ------------------------- ---------------------- ------------------ Director - -------------------------- Harry G. Beckner /s/ T. Kimball Brooker Director March 1, 1994 - ------------------------- T. Kimball Brooker /s/ David H. Cohen Director March 1, 1994 - ------------------------- David H. Cohen /s/ Charles Marshall Director March 1, 1994 - ------------------------ Charles Marshall /s/ Gerald M. McCarthy Director, Executive Vice March 1, 1994 - ----------------------- President - Sales and Marketing, Gerald M. McCarthy and President - Zenith Sales Company /s/ Andrew McNally IV Director March 1, 1994 - ---------------------- Andrew McNally IV /s/ Albin F. Moschner Director, President and Chief March 1, 1994 - ---------------------- Operating Officer Albin F. Moschner /s/ Jerry K. Pearlman Director, Chairman and Chief March 1, 1994 - --------------------- Executive Officer Jerry K. Pearlman (Principal Executive Officer) /s/ Peter S. Willmott Director March 1, 1994 - --------------------- Peter S. Willmott /s/ Kell B. Benson Vice President - Finance and March 1, 1994 - -------------------- Chief Financial Officer Kell B. Benson (Principal Financial Officer) INDEX TO FINANCIAL STATEMENT SCHEDULES AND EXHIBITS Page Number ------ Report of Independent Public Accountants on Financial Statement Schedules 24 Financial Statement Schedules: Schedule V - Property, Plant and Equipment 25 Schedule VI - Accumulated Depreciation, Depletion and Amortization of Property, Plant and Equipment 26 Schedule VIII - Valuation and Qualifying Accounts 27 Schedule IX - Short-Term Borrowings 28 Schedule X - Supplementary Income Statement Information 29 Consolidated Financial Statements 30 Notes to Consolidated Financial Statements 33 Report of Independent Public Accountants 41 Unaudited Quarterly Financial Data 42 Exhibits: (10e) Amendment, dated March 28, 1988, to Restricted Stock Agreement of Jerry K. Pearlman 43 (10n) Form of Stock Indemnification Rights Grant with Jerry K. Pearlman and Kell B. Benson 46 (21) Subsidiaries of the company 50 (23) Consent of Independent Public Accountants 51 REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS ON ------------------------------------------- FINANCIAL STATEMENT SCHEDULES ----------------------------- To the Stockholders of Zenith Electronics Corporation: We have audited, in accordance with generally accepted auditing standards, the consolidated financial statements included in ZENITH ELECTRONICS CORPORATION's annual report to stockholders included in this Fork 10-K, and have issued our report thereon dated February 14, 1994. Our audit was made for the purpose of forming an opinion on those statements taken as a whole. The schedules listed in the preceding index 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. /s/ARTHUR ANDERSEN & CO. ------------------------ ARTHUR ANDERSEN & CO. Chicago, Illinois, February 14, 1994 FINANCIAL STATEMENT SCHEDULES --------------------------------------------------- ZENITH ELECTRONICS CORPORATION SCHEDULE V-PROPERTY, PLANT AND EQUIPMENT (Amounts in millions) ZENITH ELECTRONICS CORPORATION SCHEDULE VI-ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT (Amounts in millions) ZENITH ELECTRONICS CORPORATION SCHEDULE VIII-VALUATION AND QUALIFYING ACCOUNTS (Amounts in millions) ZENITH ELECTRONICS CORPORATION SCHEDULE IX-SHORT-TERM BORROWINGS (Amounts in millions) ZENITH ELECTRONICS CORPORATION SCHEDULE X-SUPPLEMENTARY INCOME STATEMENT INFORMATION (Amounts in millions) Amounts for royalties; depreciation and amortization of intangible assets, pre-operating costs and similar deferrals; and taxes other than payroll and income taxes are not presented as such amounts are less 1% of total sales and revenues. CONSOLIDATED FINANCIAL STATEMENTS ----------------------------------------------------------------- Statements of Consolidated operations and retained earnings In millions, except per share amounts The accompanying Notes to Consolidated Financial Statements are an integral part of these statements. Consolidated balance sheets In millions The accompanying Notes to Consolidated Financial Statements are an integral part of these statements. Statements of Consolidated cash flows In millions The accompanying Notes to Consolidated Financial Statements are an integral part of these statements. Notes to Consolidated Financial Statements --------------------------------------------------------- Note One - Significant Accounting Policies: Principles of consolidation: The consolidated financial statements include the accounts of Zenith Electronics Corporation and all domestic and foreign subsidiaries (the company). All significant intercompany balances and transactions have been eliminated. Statements of consolidated cash flows: The company considers time deposits, certificates of deposit and all highly liquid investments purchased with an original maturity of three months or less to be cash. Inventories: Inventories are stated at the lower of cost or market. Costs are determined for all inventories except picture tube inventories using the first-in, first-out (FIFO) method. Picture tube inventories are valued using the last-in, first-out (LIFO) method. Properties and depreciation: Additions of plant and equipment with lives of eight years or more are depreciated by the straight-line method over their useful lives. Accelerated methods are used for depreciation of virtually all other plant and equipment items, including high technology equipment that may be subject to rapid economic obsolescence. Property held for disposal is stated at the lower of cost or estimated net realizable value. As of December 31, 1993, $5.9 million of property held for disposal was included in Other Noncurrent Assets and included certain facilities and land no longer used in the company's operations. Most tooling expenditures are charged to expense in the year acquired, except for picture tube tooling which is amortized over four years. Certain production fixtures are capitalized as machinery and equipment. Rental expenses under operating leases were $9.0 million, $8.8 million and $8.9 million in 1993, 1992 and 1991, respectively. Commitments for lease payments in future years are not material. The company capitalizes interest on major capital projects. Such interest has not been material. Engineering, research, product warranty and other costs: Engineering and research costs are expensed as incurred. Estimated costs for product warranties are provided at the time of sale based on experience factors. The costs of co-op advertising and merchandising programs are also provided at the time of sale. Foreign currency: The company uses the U.S. dollar as the functional currency for all foreign subsidiaries. Foreign exchange gains and losses are included in Other Operating Expense (Income) and were not material in 1993, 1992 and 1991. Earnings per share: Primary earnings per share are based upon the weighted average number of shares outstanding and common stock equivalents, if dilutive. Fully diluted earnings per share, assuming conversion of the 6 1/4% convertible subordinated debentures and the 8.5% convertible senior subordinated debentures, are not presented because the effect of the assumed conversion is antidilutive. The number of shares used in the computation were 32.3 million, 29.5 million and 28.8 million in 1993, 1992 and 1991, respectively. Note Two - Financial Results and Liquidity: The company has incurred losses from operations of $97.0 million, $105.9 million and $51.6 million in 1993, 1992 and 1991, respectively. For many years the company's major competitors, many with greater resources, have aggressively lowered their selling prices in an attempt to increase market share. Although the company has benefited from cost reduction programs, these lower color television prices together with inflationary cost increases have more than offset such cost reduction benefits. The company's 1994 operating plan is designed to improve financial results through cost reductions, repositioning of product lines and intensified asset management. The plan also seeks to improve the profitability of the core business and contemplates the introduction of new products such as home theater TVs. These efforts along with continued investments in the development of new technologies (such as high definition television and new digital cable products) are expected to involve significant expenditures by the company in 1994 and beyond. The company's Credit Agreement (see Note Nine) expires on December 31, 1994. The maximum commitment for funds available for borrowing under the Credit Agreement is $90 million, but is limited by a defined borrowing base formula related to eligible accounts receivable and inventory. Although the company believes that the Credit Agreement, together with extended-term payables expected to be available from a foreign supplier and its continuing efforts to obtain other financing sources, will be adequate to meet its seasonal working capital needs in 1994, there can be no assurances that the company will not experience liquidity problems in the future because of adverse market conditions or other unfavorable events. Note Three - Restructuring and Other Charges: During the fourth quarter of 1993, the company recorded a charge of $31.0 million primarily to restructure certain product areas and re-engineer its core consumer electronics and cable business. The restructuring will affect computer monitors and magnetics, product areas in which the company is bringing its production capacity more in line with expected reduced levels of business. The fourth-quarter charge was primarily for non-cash fixed asset and inventory write-downs, as well as severance costs, and is designed to reduce fixed costs and operating expenses. During 1992, the company recorded $48.1 million of restructuring and other charges. These included provisions for severance, inventory valuation and other restructuring costs, along with writeoffs of trade receivables. Designed to reduce fixed costs and operating expenses, the restructuring actions include manufacturing consolidations and related employment reductions in Mexico, consolidation of company-owned distribution and other activities, and salaried employment reductions throughout the company. During 1991, the company initiated certain restructuring actions. Integral to the restructuring was the sale and leaseback of the land and building in Taiwan and the consolidation of the color television final assembly operation into Mexico. Taken as a whole, the restructuring actions had no impact on the operating results of the company as the $8.9 million net gain on the sale of the Taiwan property was offset by charges relating to the restructuring. Note Four - Income Taxes: In the fourth quarter of 1992, the company elected early adoption of Statement of Financial Accounting Standards (SFAS) No. 109, "Accounting for Income Taxes", which requires the use of the liability method in accounting for income taxes. This statement superseded SFAS No. 96, which the company adopted retroactively in October 1989. The adoption of SFAS No. 109 had no effect on the financial statements of the company because the related net deferred tax assets were offset by a valuation allowance. The valuation allowance was established since the realization of these assets cannot be reasonably assured, given the company's recurring losses. The components of income taxes (credit) were: The $15.9 million income tax credit in 1992, resulted from the reversal of $10.0 million of previously accrued tax reserves no longer required in connection with earnings of a foreign subsidiary and $5.9 million of net operating loss carryback applications which resulted in cash refunds. The statutory federal income tax rate and the effective tax rate are compared below: Deferred tax assets (liabilities) are comprised of the following: As of December 31, 1993, the company had $383.5 million of net operating loss carryforwards (NOLs) available for financial statement purposes. For federal income tax purposes, the company had net operating loss carryforwards of $365.5 million and unused tax credits of $4.6 million, (which expire from 2000 through 2008). The company expects these NOLs and tax credits to be available in the future to reduce the Federal income tax liability of the company. However, should there occur a 50% "ownership change" of the company as defined under section 382 of the Internal Revenue Code of 1986, the company's ability to utilize the NOLs and available tax credits would be restricted to a prescribed annual amount (currently 5.06% of the market value of the company at the time of the ownership change). The company has knowledge of equity holdings and stock options which must be counted as changes in the ownership of the company aggregating about 37 percent as of the three years ended December 31, 1993. As of the three years ended February 28, 1994, this percentage has decreased to about 33 percent. Additional equity-related transactions initiated by the company as well as investment decisions made independently by investors may increase this percentage in the future. Note Five - Geographic Segment Data: The company's operations involve a dominant industry segment-the design, development, manufacture and sale of video products, including color television sets, video cassette recorders and other consumer electronics products, color picture tubes, computer monitors, cable TV products, and parts and accessories for these products. Financial information, summarized by geographic area, is as follows: Foreign operations consist of manufacturing and sales subsidiaries in Mexico and distribution subsidiaries in Canada and Taiwan. Sales to affiliates are principally accounted for at amounts based on local costs of production plus a reasonable return. Note Six -- Other Operating Expense (Income): Major manufacturers of televisions and video cassette recorders agreed during 1992 to take licenses under some of the company's U.S. tuning system patents (the licenses expire in 2003). Royalty income related to the tuning system patents (after deducting legal expenses) was $25.7 million and $26.0 million in 1993 and 1992, respectively, and is included in Other Operating Expense (Income). The $26.0 million in 1992 included $5.3 million of past royalties. Note Seven - Inventories: Inventories consisted of the following: As of December 31, 1993 and 1992, inventories of $24.1 million and $19.6 million, respectively, were valued using the LIFO method. Note Eight - Property, Plant and Equipment: Property, plant and equipment consisted of the following: Note Nine - Short-term Debt and Credit Arrangements: The company entered into a Credit Agreement dated as of May 21, 1993, with a lending group led by General Electric Capital Corporation, for working capital purposes. Borrowings under the Credit Agreement are secured by accounts receivable, inventory, general intangibles, trademarks and the tuning system patent license agreements of the company and certain of its domestic subsidiaries. The Credit Agreement is scheduled to expire on December 31, 1994. The maximum commitment of funds available for borrowing under the Credit Agreement is $90 million, but is limited by a defined borrowing base formula related to eligible receivables and eligible inventory. Net proceeds arising from material asset transactions will result in a partial reduction in the maximum commitment of the lenders thereunder. Interest on borrowing is based on market rates with a commitment fee of 1/2 % per annum payable monthly on the unused balance of the facility. As of December 31, 1993, no borrowings were outstanding under the Credit Agreement. The Credit Agreement contains restrictive financial covenants that must be maintained as of the end of each fiscal quarter, including a liabilities to net worth ratio and a minimum net worth amount. As amended, the ratio of liabilities to net worth, as of December 31, 1993, was required to be not greater than 3.70 to 1.0 and was actually 2.67 to 1.0, and net worth was required to be equal to or greater than 140.0 million and was actually 152.4 million. At the end of each of the first three fiscal quarters of 1994, the liabilities to net worth ratio is required to be maintained at various levels ranging from a high of 4.95 to 1.0 to a low of 3.70 to 1.0 and minimum net worth is required to be maintained at amounts ranging from a high of $120.0 million to a low of $101.0 million. In addition, there are restrictions regarding capital expenditures, specified dollar limits on the amount of inventory for certain of the company's products, investments, acquisitions, guaranties, transactions with affiliates, sales of assets, mergers and additional borrowings, along with limitations on liens. The Credit Agreement prohibits dividend payments on the company's common stock, restricts dividend payments on any of its preferred stock, if issued, and prohibits the redemption or repurchase of stock. As of December 31, 1992, the company had $10.1 million outstanding under its previous $60 million revolving credit and security agreement. The agreement, which was terminated by the company on May 21, 1993, contained restrictive covenants similar in nature to the current Credit Agreement. Borrowings and interest rates on short-term debt were: Contracts with certain foreign suppliers permit the company to elect interest-bearing extended-payment terms. As of December 31, 1993 and 1992, $8.5 million and $10.8 million, respectively, of these obligations were outstanding and shown as accounts payable. Note Ten - Long-term Debt: The components of long-term debt were: Subsequent to December 31, 1993, the company redeemed its outstanding 12 1/8% notes due 1995 at a redemption price equal to par value, totaling $34.5 million plus accrued interest. The 6 1/4% convertible subordinated debentures are unsecured general obligations, subordinate in right of payment to certain other debt obligations, and are convertible into common stock at $31.25 per share. Terms of the debenture agreement include annual sinking-fund payments of $5.8 million beginning in 1997. The debentures are redeemable at the option of the company, in whole or in part, at specified redemption prices at par or above. In November 1993, the company sold to certain institutional investors $55 million of 8.5% senior subordinated convertible debentures due 2000. The debentures are unsecured general obligations, subordinate in right of payment to certain other debt obligations, and are convertible into shares of common stock at an initial conversion price of $9.76 per share. The debentures are redeemable at the option of the company, in whole or in part, at any time on or after November 19, 1997, at specified redemption prices at par or above. The fair value of long-term debt is $134.4 million as of December 31, 1993, as compared to the carrying amount of $170.0 million. The fair value of the company's 6 1/4% convertible subordinated debentures is based on the quoted market price from the New York Stock Exchange. The fair value of the 8.5% convertible senior subordinated debentures is based on the quoted price obtained from third party financial institutions. Currently, the company's Credit Agreement would not allow the company to extinguish the long-term debt through purchase and thereby realize the gain. Note Eleven - Stockholders' Equity: Changes in stockholders' equity accounts are shown below: A Registration Statement filed with the Securities and Exchange Commission covering 5 million shares of common stock became effective in May 1993. The company sold 3.4 million shares of authorized but unissued shares of common stock to investors under this shelf registration during 1993. Subsequent to December 31, 1993, the company sold the remaining 1.6 million shares under this registration and an additional 2.0 million shares under a new shelf registration and intends to file a shelf registration for an additional 5.0 million shares. On February 25, 1991, the company entered into investment and technology agreements with GoldStar Co. Ltd. Under the investment agreement, the company sold to GoldStar 1,450,000 shares of previously authorized but unissued common stock for $15.0 million. Pursuant to a Rights Agreement (as amended), a "right" entitling the holder thereof to purchase under certain conditions, one-half of one share of common stock at an exercise price of $37.50, subject to adjustment, was distributed with respect to each outstanding share of common stock in 1986, and with respect to each additional share of common stock that has become outstanding since then. The rights will become exercisable upon the earlier to occur of (i) the 10th day after a public announcement that a third party has become the beneficial owner of 25% or more of the outstanding common stock (an "acquiring person") or (ii) the 10th day after the commencement of, or the announcement of an intention to commence, an offer the consummation of which would result in a third party beneficially owning 25% or more of the common stock. In the event any person becomes an acquiring person, each holder of a right (other than the acquiring person) will thereafter have the right to receive upon exercise that number of shares of common stock having a market value of two times the exercise price of the right. The rights, which have no voting rights, expire in 1996. The rights may be redeemed at the option of the company at any time prior to such time as any person becomes an acquiring person. Under certain conditions and following a stockholder vote, the rights shall be redeemed by the company. In either case, the redemption price will be $.05 per right, subject to adjustment. The Rights Agreement also provides that under certain circumstances at any time after any person has become an acquiring person, the Board of Directors may exchange the rights (other than rights owned by such person) in whole or in part, for common stock at an exchange ratio of one- half of a share of common stock per right, subject to adjustment. At the company's Annual Meeting of Stockholders in May 1993, the stockholders approved the authorization of 8 million shares of preferred stock of which none are issued or outstanding as of December 31, 1993. The Board of Directors of the company is authorized to issue the preferred stock from time to time in one or more series and to determine all relevant terms of each such series, including but not limited to the following (i) whether and upon what terms, the shares of such series would be redeemable; (ii) whether a sinking fund would be provided for the redemption of the shares of such series and, if so, the terms thereof; and (iii) the preference, if any, to which shares of such series would be entitled in the event of voluntary or involuntary liquidation of the company. Note Twelve - Stock Options and Awards: The 1987 Stock Incentive Plan authorizes the granting of incentive and non-qualified stock options, restricted stock awards and stock appreciation rights to key management personnel. The purchase price of shares under option is the market price of the shares on the date of grant. Options expire 10 years from the date granted. Transactions in 1993 and 1992 are summarized below: The company had 63,837 and 69,836 restricted stock awards issued and outstanding as of December 31, 1993 and 1992, respectively. The market value of the restricted shares is deferred in the additional paid-in capital account and amortized over the years the restrictions lapse. Total compensation expense in 1993 and 1992, related to these awards, was not material. Note Thirteen - Retirement Plans and Employee Benefits: Virtually all employees in the United States and Canada are eligible to participate in noncontributory profit-sharing retirement plans after completing one full year of service. The plans provide for a minimum annual contribution of 6% of employees' eligible compensation. Contributions above the minimum could be required based upon profits in excess of a specified return on net worth. Profit-sharing contributions were $9.7 million, $11.1 million and $11.5 million in 1993, 1992 and 1991, respectively. The 1993, 1992 and 1991 contributions were partially funded through the issuance of approximately 1,021,000, 982,000 and 1,000,000 shares, respectively, of the company's common stock. Employees in Mexico and Taiwan are covered by government- mandated plans, the costs of which are accrued by the company. In the fourth quarter of 1993, the company elected early adoption of Statement of Financial Accounting Standards (SFAS) No.112, "Employers' Accounting for Postemployment Benefits." This statement requires that the company follow an accrual method of accounting for the benefits payable to employees when they leave the company other than by reason of retirement. Since most of these benefits were already accounted for by the company by the accrual method, adoption of SFAS No 112 did not have a material effect on the financial statements of the company, nor is it expected to have a material effect on future results of operations. Presently, the company does not offer any postretirement benefits; as a result, the 1992 adoption of SFAS No. 106 did not have any effect on the financial statements of the company. Note Fourteen - Contingencies: The company is involved in various legal actions, environmental matters, patent claims, and other proceedings relating to a wide range of matters that are incidental to the conduct of its business. In addition, the company remains liable for certain retained obligations of a discontinued business, principally income and other taxes prior to the closing of the sale. The company believes, after reviewing such matters and consulting with the company's counsel, that any liability which may ultimately be incurred with respect to these matters is not expected to have a material effect on either the company's consolidated financial position or results of operations. Note Fifteen - Reclassifications: Certain prior-year amounts have been reclassified to conform with the presentation used in the current year. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS -------------------------------------------------------------- To the Stockholders of Zenith Electronics Corporation: We have audited the accompanying consolidated balance sheets of Zenith Electronics Corporation (a Delaware corporation) and subsidiaries as of December 31, 1993 and 1992, and the related statements of consolidated operations and 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 consolidated financial statements referred to above present fairly, in all material respects, the financial position of Zenith Electronics 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. /S/ARTHUR ANDERSEN & CO. ------------------------ ARTHUR ANDERSEN & CO. Chicago, Illinois, February 14, 1994 UNAUDITED QUARTERLY FINANCIAL INFORMATION ----------------------------------------------------- In millions, except per share amounts

5187_1993.txt

5187_1993

1993

5187

ITEM 1. DESCRIPTION OF BUSINESS General American Home Products Corporation (the "Company"), a Delaware corporation organized in 1926, is a leading manufacturer and marketer of health care products (in- cluding pharmaceuticals, consumer health care products, medical supplies and diagnostic products) and food products. Unless stated to the contrary, or unless the context otherwise requires, references to the Company in this report include American Home Products Corporation, its divisions and subsidiaries. Information relating to acquisitions and certain other transactions is set forth in Note 2 of the Notes to Consolidated Financial Statements in the Company's 1993 Annual Report to Shareholders, and is incorporated herein by reference. Industry Segments Financial information, by geographic location and by the industry segments of the Company, for the three years ended December 31, 1993 is set forth on page 38 of the Company's 1993 Annual Report to Shareholders and is incorporated herein by reference. The Company is not dependent on any single or major group of customers for its sales. The Company currently manufactures, distributes and sells a diversified line of products in two business segments(*): 1. HEALTH CARE PRODUCTS - Pharmaceuticals - This sector includes a wide variety of ethical pharmaceuticals and biological products for human and veterinary use which are promoted and sold worldwide primarily to wholesalers, pharmacies, hospitals and doctors. Some of these sales are made through large buying groups representing certain of these customers. Principal product categories for human use include female health care products, infant nutritionals, cardiovascular and metabolic disease therapies, mental health products, anti-inflammatory products, anti-infectives and vaccines. Principal veterinary product categories include vaccine products, antibiotics and analgesics. The Company manufactures these products in the United States and Puerto Rico, and in eighteen foreign countries. *The product designations appearing in differentiated type herein are trademarks. Except for the female health care category, no single category of products accounted for more than 10% of Health Care Products segment sales in 1993. Within the female health care category, no single product or line of products accounted for more than 10% of Health Care Products segment sales in 1993. The operating income from the female health care category in the aggregate, and PREMARIN, individually, accounted for more than 10% of the Company's consolidated operating income before and after taxes. Consumer health care - The Company's over-the-counter health care products include analgesics, cough/cold/allergy remedies, hemorrhoidal and asthma relief items, oral health care and in-home diagnostic test products. These products are generally sold to wholesalers and retailers, and are primarily promoted to consumers through advertising. These products are manufactured in the United States and Puerto Rico, and in seven foreign countries. No single consumer health care product or line of products accounted for more than 10% of Health Care Products segment sales in 1993. Medical supplies and diagnostic products - Principal products in this segment include medical supplies, medical and diagnostic instrumentation, disposable laparoscopic and endoscopic surgical instruments and other hospital products which are promoted and sold principally to doctors, hospi- tals, other health care institutions and wholesalers. Buying groups also represent certain of these customers. In addi- tion to the United States, these products are manufactured in five foreign countries. No single product or line of products in this sector accounted for more than 10% of Health Care Products segment sales in 1993. Further information regarding the principal products in the Health Care Products segment and the principal markets served therein is included in the text on pages 13 through 23 of the Company's 1993 Annual Report to Shareholders, which is incorporated herein by reference. 2. FOOD PRODUCTS - Products in this segment include prepared pastas and specialty food, condiments, snack products, and jams, which are promoted to consumers through advertising and generally sold directly to wholesalers and retailers. Product line sales in 1993 under the CHEF BOYARDEE trademark exceeded 10% of Food Products segment sales but did not exceed 10% of total consolidated sales. Further information regarding the principal products in the Food Products segment and the principal markets served therein is included on page 24 of the Company's 1993 Annual Report to Shareholders, which is incorporated herein by reference. Sources and Availability of Raw Materials Generally, raw materials and packaging supplies are purchased in the open market from various outside vendors. The loss of any one source of supply would not have a material adverse effect on the Company's financial position or results of operations. Patents and Trademarks The Company owns, has applications pending for, and is licensed under many patents relating to a wide variety of products. The Company believes that its patents and licenses are important to its business, but no one patent or license (or group of related patents or licenses) currently is of material importance in relation to its business as a whole. In the pharmaceuticals area, substantially all of the Company's major products are no longer patent protected. The oral contraceptive brand TRIPHASIL lost its patent protection in the United States in May 1993 as did SECTRAL and CORDARONE. The non-steroidal anti-inflammatory ("NSAID") LODINE remains under patent protection in the United States until early 1997. Other prescription products, such as the cardiovasculars INDERAL LA and INDERIDE LA remain patent protected until early 1996. EFFEXOR, a recently approved antidepressant, will have patent protection into 2007. Sales in the consumer health care and medical supplies and diagnostic products businesses are largely supported by the Company's trademarks and brand names, as are food product sales. These trademarks and brand names are a significant part of the Company's business and have a perpetual life as long as they remain in use. See the Competition section of this Annual Report regarding generic and store brands competition in the consumer health care business. Seasonality Sales of consumer health care products are affected by seasonal demand for cold/flu season products. On a comparable basis, second quarter results have historically been lower than results in other quarters due primarily to the lower demand for cold/flu season products. Competition Each of the industry segments in which the Company is engaged is highly competitive. The Health Care Products segment faces competitive pressures in the United States from branded and generic forms of both prescription and non-prescription products, as well as new product introductions. For prescription products, the growth of generic substitutes is further promoted by legislation, regulation and various incentives enacted and promulgated in both the public and private sectors. The growth of managed care organizations, such as health maintenance organizations ("HMOs") and pharmaceutical benefit management companies, has resulted in further competitive pressures on health care products. While naturally sourced PREMARIN no longer has patent pro- tection, it is not presently subject to generic competition in the United States. The Company cannot presently predict the timing of regulatory approval of generic conjugated estrogens products and their potential impact on the market. However, the FDA has issued a bioequivalence guidance to facilitate the development of such generic products. While it is very likely that some generic companies are attempting to develop and obtain approval of such products, information on the status of drugs (including generic drugs) under FDA's approval processes is not publicly available prior to approval being obtained. In addition, PREMARIN has been subject to increased competition from certain synthetic estrogen products (though not conjugated estrogens products) that have been approved for many of the same uses as PREMARIN. The growth of consumer health care generic and store brands continued to impact some of the Company's branded product line categories in 1993. The debate regarding U.S. health care reform and its uncertainty continued during 1993. The proposals by the Clinton Administration have been formalized and were presented to Congress in October 1993. Other health care reform proposals from members of Congress are being introduced with varied agendas on issues such as Medicaid and Medicare rebates, price controls, governmental alliances and other matters. Similarly, in international markets, health care spending is subject to increasing governmental scrutiny, much of which is focused on pharmaceutical prices. While we cannot predict the impact proposed health care legislation will have on the Company's worldwide results of operations, we believe the pharmaceutical industry will continue to play a very positive role in helping to contain global health care costs through the development of innovative products. However, it is expected that global market forces will continue to constrain price growth regardless of the outcome of health care reform. A federal law that became effective in January 1991 requires drug manufacturers to pay rebates to state Medicaid programs, in order for their products to be eligible for federal matching funds under the Social Security Act. Additionally, a number of states are, or may be, pursuing similar initiatives for rebates to Pharmaceutical Assistance to the Elderly programs and other strategies, to contain the cost of pharmaceutical products. Federal and state rebate programs as well as infant nutritional products rebates under the federally sponsored Women, Infants and Children program are expected to continue. Other significant competitive factors in the Health Care Products segment are scientific and technological advances, product quality, price and effective communication of product information to physicians, pharmacists, hospitals and trade customers. Competition is particularly severe in the hospital supply industry, principally in the needle and syringe business and in the generic hospital injectable products business. In the Food Products segment, product quality, price and relevance to contemporary family needs are important competitive factors. Advertising and promotional expenditures are significant costs to the Company, and are necessary to effectively communicate information concerning the Company's products to health professionals, to the trade and to consumers. Research and Development Worldwide research and development activities are focused on developing and bringing to market new drugs to treat and/or prevent some of the most serious health care problems. The Company employs over 5,600 professionals worldwide who are committed to this effort. Research and development expend- itures totaled $662,689,000 in 1993, $552,450,000 in 1992 and $430,519,000 in 1991, with approximately 85% of these expenditures in the ethical pharmaceutical area. The Company received FDA approval in 1993 for EFFEXOR, ORUVAIL and LODINE 400 mg tablets. The Company's Wyeth-Ayerst Laboratories Division currently has three New Drug Applications ("NDA") filed with the FDA for review and 23 active Investigational New Drug applications pending. In addition, in 1993 a NDA to switch a lower dose of ORUDIS to a non-prescription status was filed. During 1993, several major collaborative research and development arrangements continued with other pharmaceutical and biotechnology companies. Research and development projects continued at Genetics Institute, Inc. and at the Company's other health care operations. It is not anticipated, however, that the products from these activities will contribute significantly to revenues and operating profit in the near future. The extent, if any, of subsequent contributions cannot presently be predicted. Regulation The Company's various health care and food products are subject to regulation by government agencies throughout the world. The primary emphasis of these requirements is to assure the safety and effectiveness of the Company's products. In the United States, the FDA, under the federal Food, Drug and Cosmetic Act (the "Act"), including several recent amendments to the Act, regulates the Company's human and animal pharmaceuticals, consumer health care, medical supplies and diagnostic products and food products businesses. FDA's powers include the imposition of criminal and civil sanctions against companies, including seizures of regulated products and criminal sanctions against individuals. To facilitate compliance, the Company from time to time may institute voluntary compliance actions such as product recalls when it believes it advisable to do so. In addition, many states have similar regulatory requirements. Most of the Company's pharmaceutical products, and an increasing number of its consumer health care products, are regulated under the FDA's new drug approval processes, which mandate pre-market approval of all new drugs. Such require- ments continue to increase the amount of time, testing and documentation needed for approval, resulting in a corres- ponding increase in the cost of new product introductions. FDA has exercised its enforcement powers more aggressively in recent years, increasing both the number and intensity of its factory inspections. The Company's pharmaceutical business is also affected by the Controlled Substances Act, administered by the Drug Enforcement Administration, which regulates strictly all narcotic and habit-forming drug substances. The Company devotes significant resources to dealing with the extensive federal and state regulatory requirements applicable to its products. With respect to the Company's food products, the Nutrition Labeling and Education Act of 1990 and FDA regulations issued thereunder will, in the future, affect the consumer nutritional information and any health claims appearing on the labels of the Company's food products. Environmental Certain of the Company's operations are affected by a variety of federal, state and local environmental protection laws and regulations and the Company has, in a number of instances, been notified of its potential responsibility relating to the generation, storage, treatment and disposal of hazardous waste. In addition, the Company has been advised that it may be a responsible party in several sites on the National Priority List created by the Comprehensive Environmental Response, Compensation, and Liability Act ("CERCLA"). (See Item 3. Legal Proceedings.) The Company provides for the estimated costs of remediation for all known environ- mental liabilities. Employees At the end of 1993, the Company had 51,399 employees world- wide, with 29,028 employed in the United States including Puerto Rico. Financial Information about the Company's Foreign and Domestic Operations Financial information about foreign and domestic operations for the three years ended December 31, 1993, as set forth on page 38 of the Company's 1993 Annual Report to Shareholders, is incorporated herein by reference. ITEM 2. ITEM 2. PROPERTIES In the fourth quarter of 1993, the Company relocated its executive offices and the headquarters for its domestic consumer health care and food products businesses to a new facility in Giralda Farms, Madison, New Jersey. The former headquarters facility, a 31-story office building located at 685 Third Avenue, New York, New York, is being marketed for sale or lease. The Company's domestic and international pharmaceutical operations and its international consumer health care business are headquartered in three executive/administrative buildings in Radnor and St. Davids, Pennsylvania. Sherwood, the Company's principal medical supplies and diagnostic operation, maintains its headquarters in St. Louis, Missouri. The following are the principal domestic manufacturing plants (M) and research laboratories (R) of the Company's operating units: Floor Area INDUSTRY SEGMENT (Sq. Ft.) Health Care Products: Deland, Florida (M) 342,000 Fort Dodge, Iowa (M,R) 498,000 Andover, Massachusetts (M,R) 270,000 Cambridge, Massachusetts (M,R) 220,000 Mason, Michigan (M) 299,000 Norfolk, Nebraska (M) 204,000 Hammonton, New Jersey (M,R) 467,000 Monmouth Junction, New Jersey (R) 285,000 Rouses Point, New York (M,R) 833,000 Malvern, Pennsylvania (M) 816,000 Marietta, Pennsylvania (M,R) 225,000 Radnor, Pennsylvania (R) 418,000 West Chester, Pennsylvania (M) 421,000 Guayama, Puerto Rico (M) 1,079,000 Georgia, Vermont (M) 288,000 Richmond, Virginia (M) 273,000 Richmond, Virginia (M) 321,000 Food Products: Vacaville, California (M,R) 527,000 Milton, Pennsylvania (M,R) 1,020,000 Fort Worth, Texas (M) 205,000 All of the above properties are owned except the land and a 757,000 sq. ft. facility in Guayama, Puerto Rico, which are under lease expiring in 2007 with options for renewal and purchase, 105,000 sq. ft. facility in Georgia, Vermont which is under lease expiring in 2006, and 177,000 sq. ft. in Cambridge, Massachusetts, which is under leases expiring in 1999 and 2009. The Company also owns or leases a number of other smaller properties in the United States which are used for manufacturing, warehousing and office space. During 1993, the Company's St. Joseph, Missouri manufacturing facility (224,000 sq. ft.) was severely damaged by floods. Production from this facility was shifted to other plants and this facility was closed. In addition to the domestic properties, foreign subsidiaries and affiliates of the Company, which generally own their properties, have manufacturing facilities in nineteen countries outside the United States, the principal facilities of which are located in Ireland, Italy, Germany, Brazil, Mexico and the United Kingdom. ITEM 3. ITEM 3. LEGAL PROCEEDINGS The Company is involved in various legal proceedings, including product liability suits of a nature considered normal to its business. There are approximately 1,700 cases pending, predominantly in the United Kingdom, based primarily on alleged dependence on the tranquilizer ATIVAN. Substantially all of the cases in the United Kingdom have been supported by governmental legal aid funding. The Legal Aid Board in England, where more than 1,100 cases are pending, has determined to discontinue funding of these cases. If this decision is upheld on appeal, these cases will be dismissed and the other legally- aided cases in Scotland and Northern Ireland (approximately 340 cases) may be discontinued as well. The Company is self-insured against ordinary product liability risks and, other than for the years 1986 to 1988, has liability coverage in excess of certain limits from various insurance carriers. As discussed in Item 1, the Company is a party to a number of proceedings brought under CERCLA and similar state laws. These proceedings seek to require the owners or operators of facilities at which hazardous wastes are alleged to have been disposed, transporters of waste to the sites and generators of hazardous waste disposed of at the sites, to clean up the sites or to reimburse the government for cleanup costs. Although joint and several liability is alleged in these cases where multiple entities have been named as responsible parties, these proceedings are frequently resolved on the basis of the quantity of hazardous waste disposed of at the site by the generator. The Company's potential liability varies greatly from site to site. For some sites, the potential liability is de minimis and, for others, the final costs of cleanup have not yet been determined. In 1992, the New York Department of Environmental Conservation imposed a $750,000 penalty on the Company relating to air emissions at a New York State facility. The Company appealed the amount of the penalty to the Supreme Court of New York, claiming that the maximum penalty permitted under New York law is $97,000. The Supreme Court affirmed the penalty and an appeal to the Appellate Division of the New York Supreme Court, Third Department, is pending. The United States Environmental Protection Agency ("USEPA") filed an action against Ekco Housewares ("Ekco"), a former subsidiary of the Company, in the U.S. District Court for the Northern District of Ohio alleging violation of federal and state financial assurance regulations in connection with the required closure of a lagoon at Ekco's Massillon, Ohio facility. AHPC assumed the defense of the action pursuant to an indemnification agreement. On January 28, 1994, the court entered judgment against Ekco in the amount of $4,606,000, concluding that Ekco had violated regulations governing the posting of financial assurance for closure, post-closure and liability coverage. An appeal will be filed and pursued vigorously, with judgment stayed during the pendency of the appeal. The Company has been involved in various antitrust suits and government investigations relating to its marketing and sale of infant formula. The antitrust lawsuits, which were commenced in various federal and state courts, allege in general that the Company conspired with one or more of its competitors to fix prices of infant formula and to monopolize the market for infant formula products. The Company has settled most of the cases as well as a Federal Trade Commission proceeding. Each of these settlements was entered into by the Company in order to avoid the burden and expense of protracted litigation and did not involve any admission of wrongdoing by the Company. The Company is currently a defendant in litigation brought in federal court by the State of Louisiana and in purported class actions in Alabama and Texas (under the Texas Deceptive Trade Practices Act) state courts on behalf of indirect purchasers of infant formula in those states. In addition to the Federal Trade Commission, the government agencies that have been conducting investigations of pricing and marketing practices in the infant formula industry include three state attorneys general. The Company has been advised that two other state attorneys general have terminated their investigations of the Company without any action. In addition, the Bureau of Competition Policy in Canada is conducting an investigation of infant formula pricing and marketing practices in Canada. On October 14, 1993, Rite Aid Corporation, Revco D.S. Inc. and other retail drug chains and retail pharmacies filed an action in the U.S. District Court for the Middle District of Pennsylvania against the Company, other pharmaceutical manufacturers and a pharmacy benefit management company. The complaint alleges that the Company and other defendants provided discriminatory price and promotional allowances to managed care organizations and others in violation of the Robinson-Patman Act. The complaint further alleges collusive conduct among the defendants related to the alleged discriminatory pricing in violation of the Sherman Antitrust Act as well as certain other violations of common law principles of unfair competition. Subsequently, numerous other cases, many of which are purported class actions brought on behalf of retail pharmacies and retail drug and grocery chains, were filed in various federal courts and in various California state courts against the Company as well as other pharmaceutical manufacturers and wholesalers. These cases make one or more similar allegations of violations of federal or state antitrust or unfair competition laws. All of the federal actions have been consolidated for pretrial purposes in the U.S. District Court for the Northern District of Illinois. The above actions seek treble damages, injunctive and other relief. For information concerning certain litigation involving Genetics Institute, Inc., see Part I, Item 3 of Genetics Institute, Inc's. Annual Report on Form 10-K for the fiscal year ended November 30, 1993, which Item is incorporated herein by reference. In the opinion of the Company, although the outcome of any litigation cannot be predicted with certainty, the ultimate liability of the Company in connection with pending litigation and other matters described above will not have a material adverse effect on the Company's financial position or results of operations. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. EXECUTIVE OFFICERS OF THE REGISTRANT AS OF MARCH 24, 1994 Each officer is elected to hold office until his successor is chosen or until his earlier removal or resignation. None of the executive officers is related to another: Elected to Name Age Offices and Positions Office John R. Stafford 56 Chairman of the Board, December 1986 President and Chief Executive Officer, Chairman of Executive, Finance and Operations Committees Business Experience: 1989 to date, Chairman of the Board, President and Chief Executive Officer (President to May 1990 and from February 1994) Robert G. Blount 55 Executive Vice President, August 1987 Director, Member of Finance and Operations Committees Business Experience: 1989 to date, Executive Vice President Stanley F. Barshay 54 Senior Vice President August 1987 Member of Finance and Oper- ations Committees Business Experience: 1989 to date, Senior Vice President Joseph R. Bock 64 Senior Vice President February 1990 Member of Finance and Operations Committees Business Experience: 1989 to February 1990, Vice President - Industrial Relations February 1990 to date, Senior Vice President Elected to Name Age Offices and Positions Office Louis L. Hoynes, Jr. 58 Senior Vice President and November 1990 General Counsel Member of Finance and Operations Committees Business Experience: 1989 to 1990, Partner, Willkie Farr & Gallagher November 1990 to date, Senior Vice President and General Counsel Joseph J. Carr 51 Senior Vice President May 1993 Member of Finance and Oper- ations Committees Business Experience: To November 1989, Executive Vice President - Operations, Wyeth-Ayerst Laboratories Division November 1989 to April 1991, Vice President April 1991 to May 1993, Group Vice President May 1993 to date, Senior Vice President Fred Hassan 48 Senior Vice President May 1993 Member of Finance and Oper- ations Committees Business Experience: February 1989 to March 1993, President of Wyeth-Ayerst Laboratories Division March 1993 to May 1993, Group Vice President, May 1993 to date, Senior Vice President John R. Considine 43 Vice President - Finance February 1992 Member of Finance and Oper- ations Committees Business Experience: To February 1989, Vice President and Comptroller February 1989 to February 1992, Vice President and Treasurer February 1992 to date, Vice President - Finance Elected to Name Age Offices and Positions Office Thomas M. Nee 54 Vice President - Taxes May 1986 Member of Finance Committee Business Experience: 1989 to date, Vice President - Taxes PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED SHAREHOLDER MATTERS The New York Stock Exchange is the principal market on which the Company's common stock is traded. Tables showing the high and low sales price for the stock, as reported in the consolidated transaction reporting system, and the dividends paid per common share for each quarterly period during the past two years, as shown on page 40 of the Company's 1993 Annual Report to Shareholders, are incorporated herein by reference. There were 72,422 holders of record of the Company's common stock as of March 1, 1994. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The data with respect to the last five fiscal years, appearing in the Ten-Year Selected Financial Data presented on pages 26 and 27 of the Company's 1993 Annual Report to Shareholders, are 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, appearing on pages 41 through 43 of the Company's 1993 Annual Report to Shareholders, is incorporated herein by reference. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The Consolidated Financial Statements and Notes on pages 28 through 38 of the Company's 1993 Annual Report to Share- holders, the Report of Independent Public Accountants and the Management Report on Financial Statements on page 39, and Quarterly Financial Data on page 40, 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) Information relating to the Company's directors is incorporated herein by reference to pages 3 through 7 and page 24 of a definitive proxy statement filed with the Securities and Exchange Commission on March 17, 1994 ("the 1994 Proxy Statement"). (b) Information relating to the Company's executive officers as of March 24, 1994 is furnished in Part I hereof under a separate unnumbered caption ("Executive Officers of the Registrant"). ITEM 11. ITEM 11. EXECUTIVE COMPENSATION Information relating to executive compensation is in- corporated herein by reference to pages 11 through 16 of the 1994 Proxy Statement. Information with respect to compensation of directors is incorporated herein by reference to pages 8 and 9 of that proxy statement. Information relating to the Compensation Committee Interlocks and Insider Participation is incorporated by reference to pages 23 and 24 of the 1994 Proxy Statement. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Information relating to security ownership is incorporated by reference to pages 9 and 10 of the 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) 1. Financial Statements The following Consolidated Financial Statements, related Notes and Report of Independent Public Accountants, included on pages 28 through 39 of the Company's 1993 Annual Report to Shareholders, are incorporated herein by reference. Pages Consolidated Balance Sheets as of December 31, 1993 and 1992 28 Consolidated Statements of Income for the years ended December 31, 1993, 1992 and 1991 29 Consolidated Statements of Retained Earnings and Additional Paid-in Capital for the years ended December 31, 1993, 1992 and 1991 30 Consolidated Statements of Cash Flows for the years ended December 31, 1993, 1992 and 1991 31 Notes to Consolidated Financial Statements 32-38 Report of Independent Public Accountants 39 (a) 2. Financial Statement Schedules The following consolidated financial information is included in Part IV of this report: Pages Report of Independent Public Accountants on Supplemental Schedules IV-6 For the years ended December 31, 1993, 1992 and 1991: Schedule V - Property, Plant and Equipment IV-7 Schedule VI - Accumulated Depreciation of Property, Plant and Equipment IV-8 Schedule VIII - Valuation and Qualifying Accounts IV-9 ITEM 14. (Continued) Pages Schedule IX - Short-term Borrowings IV-10 Schedule X - Supplementary Income Statement Information IV-11 Schedules other than those listed above are omitted because they are either not applicable or the required information is included through incorporation by reference to pages 28 through 38 of the Company's 1993 Annual Report to Shareholders. (a) 3. Exhibits Exhibit No. Description (3.1) Restated Certificate of Incorporation, as amended to date, is incorporated herein by reference to Exhibit (3.1) of the Registrant's Form 10-K for the year ended December 31, 1990. (3.2) By-Laws, as amended to date is incorporated herein by reference to Exhibit (3.2) of the Registrant's Form 10-K for the year ended December 31, 1992. (4.1) Indenture, dated as of April 10, 1992, between AHPC and Chemical Bank (as successor by merger to Manufacturers Hanover Trust Company), as Trustee, is incorporated by reference to Registrant's Form 8-A dated August 25, 1992. (4.2) Supplemental Indenture, dated October 13, 1992, between AHPC and Chemical Bank (as successor by merger to Manufacturers Hanover Trust Company) as Trustee, incorporated by reference to Registrant's Form 10-Q for the quarter ended September 30, 1992. (10.1) Credit Agreement dated as of April 29, 1993 among Registrant, the Lenders Parties thereto and Chemical Bank. (10.2) * 1978 Stock Option Plan, as amended to date, is incorporated herein by reference to Exhibit (10.2) of the Registrant's Form 10-K for the year ended December 31, 1990. (10.3) * 1980 Stock Option Plan, as amended to date is incorporated by reference to Exhibit (10.3) of the Registrant's Form 10-K for the year ended December 31, 1991. *Denotes management contract or compensatory plan or arrangement required to be filed as an exhibit hereto. ITEM 14. (Continued) (a) 3. Exhibits Exhibit No. Description (10.4) * 1985 Stock Option Plan, as amended to date is incorporated by reference to Exhibit (10.4) of the Registrant's Form 10-K for the year ended December 31, 1991. (10.5) * Management Incentive Plan, as amended to date, is incorporated herein by reference to Exhibit (10.5) of the Registrant's Form 10-K for the year ended December 31, 1990. (10.6) * Supplemental Executive Retirement Plan is incorporated herein by reference to Exhibit (10.6) of the Registrant's Form 10-K for the year ended December 31, 1990. (10.7) * 1990 Stock Incentive Plan is incorporated herein by reference to Exhibit (28) of the Registrant's Form S-8 Registration Statement File No. 33-41434 under the Securities and Exchange Act of 1933, filed June 28, 1991. (10.8) * 1993 Stock Incentive Plan is incorporated herein by reference to Exhibit I of the Registrant's Proxy Statement filed March 17, 1994. (10.9) * 1994 Restricted Stock Plan for Non-Employee Directors is incorporated herein by reference to Exhibit II of the Registrant's Proxy Statement filed March 17, 1994. (10.10)* Form of Deferred Compensation Agreement. (10.11)* American Home Products Savings Plan, as amended, is incorporated herein by reference to Exhibit 99 of the Registrant's Form S-8 Registration Statement File No. 33-50149 under the Securities and Exchange Act of 1933, filed September 1, 1993. (10.12)* American Home Products Corporation Retirement Plan for Outside Directors, as amended on January 27, 1994. (10.13) Sixth Amended and Restated Disclosure Statement Pursuant to Section 1125 of the Bankruptcy Code, dated March 28, 1988, among A.H. Robins Company, Incorporated, Registrant and AHP Subsidiary (9) Corporation is incorporated herein by reference to Exhibit (2) of Registrant's Form 8-K dated December 15, 1989, filed December 30, 1989. ITEM 14. (Continued) (a) 3. Exhibits Exhibit No. Description (10.14) Purchase Agreement, dated as of April 6, 1990, between Reckitt & Colman plc and Registrant is incorporated herein by reference to Exhibit (2.1) of Registrant's Form 8-K dated June 29, 1990, filed July 12, 1990. (10.15) First Amendment, dated as of June 28, 1990, to the Purchase Agreement is incorporated herein by reference to Exhibit (2.2) of Registrant's Form 8-K dated June 29, 1990, filed July 12, 1990. (10.16) Second Amendment, dated as of July 3, 1990, to the Purchase Agreement is incorporated herein by reference to Exhibit (2.3) of Registrant's Form 8-K dated June 29, 1990, filed July 12, 1990. (10.17) Agreement and Plan of Merger dated as of September 19, 1991 among Genetics Institute, Inc. ("G.I."), Registrant, AHP Biotech Holdings, Inc. and AHP Merger Subsidiary Corporation, is incorporated herein by reference to Exhibit (I) of Registrant's Schedule 13D dated January 24, 1992 filed with respect to the common stock of G.I. ("Schedule 13D"). (10.18) Depositary Agreement dated as of January 16, 1992 among Registrant, AHP Biotech Holdings, Inc., G.I. and The First National Bank of Boston, as Depositary, is incorporated herein by reference to Exhibit (II) of the Registrant's Schedule 13D. (10.19) Governance Agreement dated as of January 16, 1992 among Registrant, AHP Biotech Holdings, Inc. and G.I., is incorporated herein by reference to Exhibit (III) of the Registrant's Schedule 13D. (11) Calculation of per share earnings as reported in Note 10 to Consolidated Financial Statements on page 37 of the Company's 1993 Annual Report to Shareholders is incorporated herein by reference. (13) 1993 Annual Report to Shareholders. Such report, except for those portions thereof which are expressly incorporated by reference herein, is furnished solely for the information of the Commission and is not to be deemed "filed" as part of this filing. (21) Subsidiaries of the Registrant. ITEM 14. (Continued) (a) 3. Exhibits Exhibit No. Description (23) Consent of Independent Public Accountants relating to their report dated January 18, 1994, consenting to the incorporation thereof in Registration Statements on Form S-3 (File No. 33-45324) and on Form S-8 (File No., 33-24068, 33-41434, 33-50149 and 33-55456) by reference to the Form 10-K of the Registrant filed for the year ended December 31, 1993. (99) Part I Item 3 of Genetics Institute, Inc.'s Annual Report on Form 10-K (SEC File No. 0-14587) for the year ended November 30, 1993 is incorporated herein by reference. (b) Reports on Form 8-K No reports on Form 8-K were filed during the fourth quarter of the year ended December 31, 1993. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To American Home Products Corporation: We have audited in accordance with generally accepted auditing standards, the consolidated financial statements included in American Home Products Corporation's Annual Report to Shareholders incorporated by reference in this Form 10-K, and have issued our report thereon dated January 18, 1994. Our audit was made for the purpose of forming an opinion on those statements taken as a whole. The schedules listed in the accompanying index 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. New York, New York January 18, 1994 SCHEDULE V American Home Products Corporation and Subsidiaries Schedule V -- Property, Plant and Equipment For the Years Ended December 31, 1993, 1992 and 1991 (Dollars in thousands) Column A Column B Column C Column D Column E Column F Currency Balance Translation Balance at Adjustment at Beginning Additions Retire- Add End of Classification of Period at Cost ments (Deduct) Period Year Ended 12/31/93: Land $79,881 $17,463 $8,186 $217 $89,375 Buildings 1,292,741 218,779 20,310 (17,797) 1,473,413 Machinery and Equipment 1,460,538 212,716 32,846 (20,872) 1,619,536 Furniture and Fixtures 223,733 68,954 12,542 (2,104) 278,041 ---------- -------- -------- -------- ---------- $3,056,893 $517,912 $73,884 ($40,556) $3,460,365 ========== ======== ======== ======== ========== Year Ended 12/31/92: Land $61,433 $20,338 $683 ($1,207) $79,881 Buildings 1,076,708 276,776 36,606 (24,137) 1,292,741 Machinery and Equipment 1,327,571 218,666 63,652 (22,047) 1,460,538 Furniture and Fixtures 193,520 39,508 6,566 (2,729) 223,733 ---------- -------- -------- -------- ---------- $2,659,232 $555,288 $107,507 ($50,120) $3,056,893 ========== ======== ======== ======== ========== Year Ended 12/31/91: Land $51,787 $11,388 $1,030 ($712) $61,433 Buildings 1,046,677 69,130 26,631 (12,468) 1,076,708 Machinery and Equipment 1,264,319 123,284 47,231 (12,801) 1,327,571 Furniture and Fixtures 170,039 34,336 8,734 (2,121) 193,520 ---------- -------- ------- -------- ---------- $2,532,822 $238,138 $83,626 ($28,102) $2,659,232 ========== ======== ======= ======== ========== SCHEDULE VI American Home Products Corporation and Subsidiaries Schedule VI -- Accumulated Depreciation of Property, Plant and Equipment For the Years Ended December 31, 1993, 1992 and 1991 (Dollars in thousands) Column A Column B Column C Column D Column E Column F Additions Currency Balance Charged Translation Balance at to Costs Adjustment at Beginning and Retire- Add End of Description of Period Expenses ments (Deduct) Period Year Ended 12/31/93: Buildings $378,776 $50,091 $14,499 ($3,085) $411,283 Machinery and Equipment 774,893 108,103 29,745 (9,466) 843,785 Furniture and Fixtures 125,433 32,722 11,457 (1,186) 145,512 ---------- -------- ------- -------- ---------- $1,279,102 $190,916 $55,701 ($13,737) $1,400,580 ========== ======== ======= ======== ========== Year Ended 12/31/92: Buildings $354,574 $49,805 $20,325 ($5,278) $378,776 Machinery and Equipment 723,762 105,485 43,048 (11,306) 774,893 Furniture and Fixtures 104,055 28,291 5,424 (1,489) 125,433 ---------- -------- ------- -------- ---------- $1,182,391 $183,581 $68,797 ($18,073) $1,279,102 ========== ======== ======= ======== ========== Year Ended 12/31/91: Buildings $332,841 $34,730 $8,652 ($4,345) $354,574 Machinery and Equipment 671,207 95,968 36,022 (7,391) 723,762 Furniture and Fixtures 91,384 22,248 8,293 (1,284) 104,055 ---------- -------- ------- -------- ---------- $1,095,432 $152,946 $52,967 ($13,020) $1,182,391 ========== ======== ======= ======== ========== Rates of depreciation range from 2 to 20 percent for buildings, 6 2/3 to 33 1/3 percent for machinery and equipment and 5 to 33 1/3 percent for furniture and fixtures. SCHEDULE VIII American Home Products Corporation and Subsidiaries Schedule VIII -- Valuation and Qualifying Accounts For the Years Ended December 31, 1993, 1992 and 1991 (Dollars in thousands) Column A Column B Column C Column D Column E Additions Balance Charged Balance at to Costs at Beginning and Deductions End of Description of Period Expenses (A) Period Year ended 12/31/93: Valuation and qualifying accounts - Allowance for doubtful accounts $23,702 $7,101 $5,172 $25,631 Allowance for cash discounts 15,203 148,013 142,898 20,318 Allowance for deferred tax assets 101,324 -- 9,961 91,363 ---------- -------- -------- ---------- $140,229 $155,114 $158,031 $137,312 ========== ======== ======== ========== Liability for loss contin- gencies and additional taxes $511,679 $41,899 $138,050 $415,528 Liability for self-insurance claims 269,413 38,284 38,302 269,395 Accrued postretirement benefit obligation 250,355 37,754 23,556 264,553 ---------- -------- -------- ---------- $1,031,447 $117,937 $199,908 $949,476 ========== ======== ======== ========== Year ended 12/31/92: Valuation and qualifying accounts - Allowance for doubtful accounts $25,865 $5,147 $7,310 $23,702 Allowance for cash discounts 11,554 132,227 128,578 15,203 Allowance for deferred tax assets -- 101,324(B) -- 101,324 ---------- -------- -------- ---------- $37,419 $238,698 $135,888 $140,229 ========== ======== ======== ========== Liability for loss contin- gencies and additional taxes $550,734 $90,295 $129,350 $511,679 Liability for self-insurance claims 258,436 32,129 21,152 269,413 Accrued postretirement benefit obligation 129,084 121,271(C) -- 250,355 ---------- -------- -------- ---------- $938,254 $243,695 $150,502 $1,031,447 ========== ======== ======== ========== cont'd Column A Column B Column C Column D Column E Additions Balance Charged Balance at to Costs at Beginning and Deductions End of Description of Period Expenses (A) Period Year ended 12/31/91: Valuation and qualifying accounts - Allowance for doubtful accounts $26,591 $7,066 $7,792 $25,865 Allowance for cash discounts 7,657 119,839 115,942 11,554 ---------- -------- -------- ---------- $34,248 $126,905 $123,734 $37,419 ========== ======== ======== ========== Liability for loss contin- gencies and additional taxes $458,628 $157,304 $65,198 $550,734 Liability for self-insurance claims 268,449 21,984 31,997 258,436 Accrued postretirement benefit obligation 103,500 25,584 -- 129,084 ---------- -------- -------- ---------- $830,577 $204,872 $97,195 $938,254 ========== ======== ======== ========== (A) Represents amounts used for the purposes for which the accounts were created and reversal of amounts no longer required. (B) Established upon the adoption of Statement of Financial Accounting Standards ("SFAS") No. 109, "Accounting for Income Taxes" as disclosed in Note 9 on pages 36 and 37 of the Company's 1993 Annual Report to Shareholders. (C) Includes the cumulative effect of adopting SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" as disclosed in Note 4 on pages 33, 34 and 35 of the Company's 1993 Annual Report to Shareholders. SCHEDULE IX American Home Products Corporation and Subsidiaries Schedule IX -- Short-term Borrowings For the Years Ended December 31, 1993, 1992 and 1991 (Dollars in thousands) Column A Column B Column C Column D Column E Column F Average Weighted Maximum Amount Average Amount Out- Interest Category Out- standing Rate of Weighted standing During During Aggregate Balance Average During the the Short-term at End Interest the Period Period Borrowings Of Period Rate Period (A) (B) Commercial Paper 1993 $0 -- -- -- -- 1992 0 -- $159,500 $17,361 3.2% 1991 0 -- 665,157 214,695 5.9% (A) Average daily amount outstanding. (B) Weighted as to principal amount and days outstanding. SCHEDULE X American Home Products Corporation and Subsidiaries Schedule X -- Supplementary Income Statement Information For the Years Ended December 31, 1993, 1992 and 1991 (Dollars in thousands) Item Charged to Costs and Expenses 1993 1992 1991 Maintenance and repairs $159,630 $153,001 $142,939 ======== ======== ======== Amortization of intangible assets, pre-operating costs and similar deferrals (A) * $246,632 * ======== ======== ======== Taxes, other than payroll and income taxes * * * ======== ======== ======== Royalties $94,475 $97,499 $84,708 ======== ======== ======== Advertising costs $613,576 $601,798 $553,641 ======== ======== ======== *Less than 1% of sales (A) Amortization of intangible assets in 1992 reflects the special charge of $220,000 discussed in Note 2 on page 32 of the Company's 1993 Annual Report to Shareholders. 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 HOME PRODUCTS CORPORATION (Registrant) March 24, 1994 By /S/ Robert G. Blount Robert G. Blount Executive 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. Signatures Title Date Principal Executive Officer: /S/ John R. Stafford Chairman, President March 24, 1994 John R. Stafford and Chief Executive Officer Principal Financial Officer: /S/ Robert G. Blount Executive Vice President March 24, 1994 Robert G. Blount and Director Principal Accounting Officer: /S/ John R. Considine Vice President - Finance March 24, 1994 John R. Considine A Majority of Directors: /S/ Clifford L. Alexander, Jr. Director March 24, 1994 Clifford L. Alexander, Jr. /S/ Frank A. Bennack, Jr. Director March 24, 1994 Frank A. Bennack, Jr. /S/ K. Roald Bergethon Director March 24, 1994 K. Roald Bergethon SIGNATURES (continued) Signatures Title Date /S/ John W. Culligan Director March 24, 1994 John W. Culligan /S/ Robin Chandler Duke Director March 24, 1994 Robin Chandler Duke /S/ John D. Feerick Director March 24, 1994 John D. Feerick /S/ Edwin A. Gee Director March 24, 1994 Edwin A. Gee /S/ William F. Laporte Director March 24, 1994 William F. Laporte /S/ Robert W. Sarnoff Director March 24, 1994 Robert W. Sarnoff /S/ John R. Torell III Director March 24, 1994 John R. Torell III /S/ William Wrigley Director March 24, 1994 William Wrigley EXHIBIT (21) SUBSIDIARIES OF THE REGISTRANT DECEMBER 31, 1993 State or Country of Name Incorporation Domestic AH Investments Ltd. Delaware A.H. Robins Company, Inc. Virginia A.H. Robins International Company Nevada AHP Subsidiary Holding Corporation Delaware AHP Subsidiary (10) Corporation Delaware American Home Food Products, Inc. Delaware Ayerst Laboratories Incorporated New York Ayerst-Wyeth Pharmaceuticals Inc. Delaware Corometrics Medical Systems, Inc. Delaware Genetics Institute, Inc. Delaware Quinton Instrument Company Washington Route 24 Holdings, Inc. Delaware Sherwood Medical Company Delaware Symbiosis Corp. Florida Vermont Whey Company Vermont Viobin Corporation Illinois Whitehall Laboratories Inc. Delaware Wyeth-Ayerst International Inc. New York Wyeth Laboratories Inc. New York Wyeth Nutritionals Inc. Delaware Wyeth-Ayerst (Asia) Limited Delaware Foreign AHP Holdings B.V. Netherlands American Drug Corporation Panama American Home Investments (Hong Kong) Limited Hong Kong Ayerst International S.A. France Brenner-EFEKA Pharma G.m.b.H. Germany Whitehall Italia SpA Italy Laboratorios Wyeth Whitehall Ltda. Brazil Much Pharma A.G. Germany Sherwood Medical Industries Limited England Sherwood Medical Industries of Ireland Ltd. Ireland Whitehall Laboratories Limited England Whitehall-Robins Canada, Inc. Canada Wyeth (Japan) Corporation Japan John Wyeth & Brother Limited England Wyeth-Ayerst Canada, Inc. Canada Wyeth Hong Kong, Ltd. Hong Kong Wyeth-Pharma G.m.b.H. Germany Wyeth Pharmaceuticals Pty. Limited Australia Wyeth S.A. de C.V. Mexico Wyeth S.p.A. Italy Wyeth-Philippines Inc. Philippines There have been omitted from the above list the names of subsidiaries which, considered in the aggregate as a single subsidiary, would not constitute a significant subsidiary.

29669_1993.txt

29669_1993

1993

29669

ITEM 1. BUSINESS R. R. Donnelley & Sons Company (the company), incorporated in the state of Delaware in 1956 as the successor to a business founded in 1864, is a major participant in the information industry, providing a broad range of services in print and digital media. The company believes it is the largest supplier of commercial print and print-related services in the United States. It is a major supplier in the United Kingdom and also provides services in Mexico, other locations in Europe and in Asia. Services provided to customers include presswork and binding, including on-demand customized publications; conventional and digital pre-press operations, including desktop publishing and filmless color imaging, necessary to create a printed image; software replication, translation and localization; list, list enhancement, database management and mail production services (provided primarily through Metromail); design and related creative services (provided through Mobium); cartographic services; electronic communication networks for simultaneous worldwide product releases; digital services to publishers; and, through R. R. Donnelley Logistic Services, the planning for and fulfillment of truck, rail, mail and air distribution for products of the company and its customers, as well as third parties. The company's pre-press, presswork and binding operations have accounted for over 90% of the company's revenues for each of the last five years. In 1990, the company acquired the Meredith/Burda companies, thereby enhancing the company's service capabilities by adding four printing plants. The company provides these services to more than 4,000 customers, including publishers of consumer and trade magazines, books and telephone and other directories; direct mail (catalog) and in-store merchandisers; software publishers and computer hardware manufacturers; and financial institutions and other firms requiring substantial amounts of printing and other related information services. Due to the range of services it provides, the company believes it is uniquely positioned to meet the information and communication needs of its customers. The relative contribution of each of the company's major product areas to its total sales for the five-year period ended December 31, 1993, is presented in the table below. In 1993, international printing operations represented less than 9% of consolidated results and assets. Most of the company's sales are made pursuant to term contracts with customers, with the remainder being made on a single-order basis. For some customers, the company prints and provides related services for several different publications under different contracts. The company's contracts with its larger customers normally run for a period of years (usually three to five years but longer in the case of contracts requiring significant capital investment) or for an indefinite period subject to termination on specified notice by either party. Such sales contracts generally provide for timely price adjustments to reflect price changes for materials, wages and utilities. No single customer has a relationship with the company that accounted for 3% or more of the company's sales in 1993. The company's dependence for sales from its ten largest customers has declined in the past eleven years to approximately 22% of sales in 1993, down from 35% of sales in 1983. The various phases of the information industry in which the company is involved are highly competitive. While the company has contracts with its customers as indicated above, there are numerous competing companies and renewal of such contracts is dependent, in part, on the ability of the company to continue to differentiate itself from the competition. Differentiation results, in part, from the company's broad range of value-added services, which include Selectronic(R) imaging and gathering; list maintenance, database management and targeted mail programs; expansive mailing and distribution services; in-plant reception from customer desktop publishing systems; fulfillment and returned books inventory management; replication of magnetic media products; electronic data management and distribution; and design. Although the company believes it is the largest commercial printer in the United States, it estimates that its revenues represent approximately 7% of the total sales in the industry. Although the company's plants are well located for the national or regional distribution of its products, competitors in some areas of the United States have a competitive advantage in some instances due to such factors as freight rates, wage scales and customer preference for local services. In addition to location, other important competitive factors are price and quality as well as the range of available services. An excess of supply versus demand exists for most grades of paper. The list price of paper remains stable, although discounting is prevalent for certain grades of paper. Existing paper supply contracts (at prevailing market prices) will cover the company's requirements through 1994, and management believes that extensions and renewals of these purchase contracts will provide adequate paper supplies in the future. Ink and ink materials are currently available in sufficient amounts, and the company believes that it will have adequate supplies in the future. The company estimates that its capital expenditures in 1994 and 1995 to comply with federal, state and local provisions for environmental controls, as well as expenditures, if any, for the company's share of costs to clean hazardous waste sites that have received waste from the company, will not be material and will not have a material effect upon its earnings or its competitive position. The company employed an average of approximately 32,100 persons in 1993 (34,000 persons at December 31, 1993), of whom more than 11,000 had been with the company for more than 10 years and over 2,700 for 25 years or longer. ITEM 2. ITEM 2. PROPERTIES R. R. Donnelley & Sons Company's corporate office is located in leased facilities in Chicago, Illinois. Production facilities leased by the company are listed in the chart beginning on page 6. Printing and other plants that are owned and operated by the company (or through wholly owned subsidiaries) are listed below and continuing on the next page. The company has historically followed the practice of adding capacity to meet customer requirements, and has retained a substantial portion of its earnings for reinvestment in plant and equipment for this purpose. Management believes that growth in 1994 will be financed in large part by internally-generated funds. The amount of capital expenditures in future years will depend upon the requirements of the company's existing and future customers. ITEM 3. ITEM 3. LEGAL PROCEEDINGS On July 13, 1990, the Federal Trade Commission ("FTC") filed a complaint in the U.S. District Court for the District of Columbia ("District Court") seeking a preliminary injunction enjoining the company from consummating its acquisition of the Meredith/Burda companies. The complaint alleged that consummation of the acquisition might substantially lessen competition in certain alleged rotogravure printing markets. The District Court denied the motion of the FTC for an injunction as well as a further motion for injunction pending appeal. The acquisition was closed on September 4, 1990. On October 11, 1990, the FTC Staff initiated its administrative action challenging the acquisition of the Meredith/Burda companies. The complaint alleged the same issues as did the complaint before the District Court. Trial before an administrative law judge ("ALJ") of the FTC concluded in June, 1993. On December 30, 1993, the FTC's ALJ issued his initial decision upholding the position of the FTC Staff. The ALJ found that the acquisition by the company of the Meredith/Burda companies created a "dominant firm" and significantly increased concentration in a "high-volume publication rotogravure market," thus increasing the likelihood of anti-competitive conduct and actual or tacit collusion among the firms participating in that market. The ALJ ordered the divestiture of the Meredith/Burda companies and prohibited the acquisition by the company of any other firms participating in the U.S. "rotogravure market" without FTC approval for a period of ten years. The company has filed its appeal of the ALJ's decision, asking the FTC Commissioners to dismiss the FTC complaint. The appeal has the effect of staying the ALJ's order. If the appeal by the company is not granted, the company intends to file a further appeal to a U.S. Court of Appeals. The company continues to believe that the acquisition of the Meredith/Burda companies was legally proper and will ultimately be upheld. 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 quarter ended December 31, 1993. EXECUTIVE OFFICERS OF R. R. DONNELLEY & SONS COMPANY (1) Each officer named has carried on his principal occupation and employment in R. R. Donnelley & Sons Company for more than five years with the exception of S. J. Baumgartner and E. P. Duffy as noted in the above table. (2) Member of the company's management committee. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The common stock is listed and traded on the New York Stock Exchange, Chicago Stock Exchange and Pacific Stock Exchange and is accorded unlisted trading privileges on the Boston and Cincinnati Stock Exchanges. As of March 1, 1994 there were approximately 10,400 stockholders of record. Information about the quarterly prices of the common stock, as reported on the New York Stock Exchange-Composite Transactions, and dividends paid during the two years ended December 31, 1993, is contained in the chart below: 1992 reflects the 2 for 1 stock split effective September 1, 1992. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA SELECTED FINANCIAL DATA (NOT COVERED BY AUDITORS' REPORT) (THOUSANDS OF DOLLARS, EXCEPT SHARE DATA) - -------- * 1993 earnings from operations includes the one-time adjustment for a restructuring charge ($90 million). ** 1993 net income and net income per share include one-time adjustments for the restructuring charge ($60.8 million or $0.39 per share); the net cumulative effect of accounting changes ($69.5 million or $0.45 per share); and the deferred income tax charge related to the federal income tax rate increase ($6.2 million or $0.04 per share). *** Reflects the 2 for 1 stock split effective September 1, 1992. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS COMPARISON OF 1993 WITH 1992 Net sales grew at a rate of 4.6% (first half growth was 0.5%; second half growth was 8.2%). The year-to-year growth was due to an increased volume of services provided to customers, including volume added through the company's global expansion into new areas. Strong demand for global software services, financial printing services and services for book publishers and volume increases associated with recent acquisitions in new product areas, including specialty products and special interest magazines, were partially offset by the negative effects of a stronger dollar (lower translation of foreign revenues, particularly those of the company's U.K. operations) and lower catalog volume primarily associated with the decision by Sears, Roebuck & Co., a customer, to discontinue its catalog operations. Gross profit grew at a greater rate than net sales, 6.3%, reflecting better coverage of fixed costs through higher volume, a more favorable mix of sales and a favorable LIFO inventory credit. Earnings from operations included a $90 million restructuring charge recorded during the first quarter (an after-tax charge of $0.39 per share) related primarily to the closing of the company's Chicago manufacturing facility following the decision by Sears to discontinue its catalog operations. Excluding this charge, earnings from operations would have been $415.6 million, a 2.5% increase over the prior year, reflecting the gross profit improvement partially offset by higher selling and administrative expenses (10.1% increase) resulting primarily from the additional costs associated with newly acquired and start-up operations and the expansion of the company's global sales presence. The $4.6 million increase in total other expense-net resulted from higher interest expense (higher outstanding debt balances due to recent acquisitions, investments in joint ventures and additional VEBA funding for employee benefits) and increased expenses associated with life insurance programs, which were partially offset by improved earnings on investments. The 1993 provision for income taxes included the one-time effect of the new, higher federal statutory income tax rate on deferred taxes, which reduced net income $6.2 million (equivalent to $0.04 per share); excluding this one-time charge, the 1993 effective tax rate of 33.1% would have been lower than the 1992 rate of 35.0%, reflecting the benefits associated with life insurance programs and credits associated with affordable housing investments, partially offset by the impact of the higher federal statutory income tax rate on current year earnings ($2.8 million). Net income from operations before cumulative effects of accounting changes reflected the restructuring charge and increased selling and administrative expenses partially offset by the favorable factors discussed above with respect to gross profit. Excluding the restructuring charge and deferred income tax charge, net income from operations before cumulative effects of accounting changes would have been $245.9 million (equivalent to $1.59 per common share). During the first quarter of 1993, the company adopted two new accounting standards for postretirement benefits and income taxes. The one-time charge for postretirement benefits, net of associated tax benefits of $80.1 million, was $127.7 million (equivalent to $0.82 per share). Ongoing annual expense increases resulting from this new accounting requirement have been mitigated through an investment program to partially prefund the related postretirement liabilities. Nevertheless, in 1993, the new accounting standard for postretirement benefits resulted in additional expenses which reduced operating income by $0.05 per share. The new accounting standard for income taxes resulted in a one-time credit of $58.2 million (equivalent to $0.37 per share). As discussed above, the new income tax standard also required the company to increase its 1993 income tax provision by $6.2 million. This new standard will not have an ongoing material effect as long as statutory income tax rates remain at current levels. COMPARISON OF 1992 WITH 1991 The growth in net sales (7.1% higher than 1991) is represented by an increased volume of services provided to customers, including volume added through the company's global expansion into new markets. A large portion of this increase was due to the introduction of new products by documentation services customers and the strong demand for financial printing services resulting from favorable capital market conditions in 1992. Gross profit grew at a greater rate than net sales, 12.5%, reflecting several factors: higher volume, a more favorable mix of sales, improved productivity and cost control, lower start-up costs and a LIFO inventory credit. Higher depreciation expense, increased reserve provisions and expenses related to the companywide stock purchase plan and incentive compensation plans partially offset the favorable factors. Selling and administrative expenses increased 13.4% over 1991 as a result of higher volume-related commission expenses, a higher provision for doubtful accounts receivable, the increased costs of expanding the company's global sales presence and expenses related to the companywide stock purchase plan and incentive compensation plans. Earnings from operations also grew at a rate greater than net sales, 11.7%, reflecting the gross profit improvement partially offset by the higher selling and administrative expenses. The $1.5 million increase in total other expense-net resulted from lower interest expense (lower interest rates and outstanding debt balances) which was more than offset by start-up expenses associated with recent international and domestic joint venture investments. The effective tax rate of 35.0% in 1992 was lower than the 36.0% in 1991 reflecting the benefits associated with a life insurance program. Net income for the full year increased 14.5%, as a consequence of the net favorable factors discussed above. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION The Consolidated Balance Sheet presents the company's financial position at the end of each of the last two years. The statement lists the company's assets and liabilities, and the equity of its shareholders. Major changes in the company's financial position are summarized in the Consolidated Statement of Cash Flows which appears on page. The Cash Flows Statement summarizes the changes in the Company's cash and equivalents balance for each of the last three years and helps to show the relationship between operations (presented in the Consolidated Statement of Income) and liquidity and financial resources (presented in the Consolidated Balance Sheet). With the growth in cash flow and the credit facilities and shelf registration discussed below, management believes the company has the financial flexibility to fund current operations and growth. In 1993, net income from operations before cumulative effect of accounting changes plus depreciation and amortization represented $453.7 million of the net cash provided by operating activities. Excluding the restructuring charge and the charge related to the impact of higher income tax rates on deferred income tax balances, net income from operations before cumulative effect of accounting changes plus depreciation and amortization would have been $520.7 million, compared to $492.8 million in 1992. Cash flow from operations was used primarily to fund capital investments and pay dividends. The company's working capital continued to be adequate for the operation and expansion of the business. Working capital--particularly cash, accounts receivable and inventories--is closely controlled and continually monitored. Emphasis continues on overall balance sheet management. Working capital increased by $14.6 million from December 31, 1992, due to working capital balances of newly acquired businesses, the additional funding of the Voluntary Employee's Beneficiary Associations, increase in inventory resulting from the reduced LIFO reserve, as well as increased inventory quantities to support revenue growth and the reclassification of short-term debt (which reflects management's estimate of near-term repayments). Other noncurrent liabilities and deferred income tax balances at December 31, 1993 reflect the impacts of the adoption of new accounting standards for postretirement benefits and income taxes. A valuation allowance has not been provided on deferred tax asset balances due to the company's projection of future taxable income (supported by existing long-term customer contracts that are expected to provide future revenues and earnings) in excess of such tax assets. In 1993, capital expenditures totaled $307 million ($228 million in 1992) and an additional $178 million ($84 million in 1992) was invested in various acquisitions and joint ventures. This capital investment reflects the company's continued program to expand and upgrade operations, including new equipment and operations to meet the growing needs of present and new customers. The expenditures were financed by internally generated funds and the issuance of debt. Management currently estimates capital investment in 1994 will be approximately $375 million, and, once again, capital investment will be substantially financed through operating cash flows. Other expenditures in 1994 are expected to be in line with the growth in sales, earnings and cash flows. At December 31, 1993, the company had revolving credit facilities totaling $550 million with a number of banks (see the Notes to Consolidated Financial Statements). These credit facilities provide support for the issuance of commercial paper and other credit needs. Under an effective shelf registration, in January, 1993, the company issued $110 million of 7.0% (7.2% effective rate after consideration of placement costs and discounts) notes due January, 2003. As of December 31, 1993, the company had effective shelf registration statements permitting it to issue, from time to time, up to $500 million in additional debt securities. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The financial information required by Item 8 is contained in Item 14 of Part IV and listed on page. 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 directors and officers of the company is contained on pages 2-5 and 8 of the company's definitive Proxy Statement dated February 17, 1994 and is incorporated herein by reference. See also the list of the company's executive officers and related information under "Executive Officers of R. R. Donnelley & Sons Company" at the end of Part I of this Report. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION Information concerning executive compensation for the year ended December 31, 1993, and, with respect to certain of such information, prior years, is contained on pages 8-14 of the company's definitive Proxy Statement dated February 17, 1994 and is incorporated herein by reference (excluding the information on page 14 under the caption, "Compensation Committee Report on Executive Compensation"). ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Information concerning the beneficial ownership of the company's common stock is contained on pages 5-8 of the company's definitive Proxy Statement dated February 17, 1994 and is incorporated herein by reference. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Information concerning certain relationships and related transactions for the year ended December 31, 1993, is contained on pages 5 and 14 of the company's definitive Proxy Statement dated February 17, 1994 and is incorporated herein by reference (excluding the information on page 14 under the caption, "Compensation Committee Report on Executive Compensation"). 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 (page) to the financial statements are filed as part of this annual report. 2. Financial Statement Schedules The financial statement schedules listed in the accompanying index (page) to the financial statements are filed as part of this annual report. 3. Exhibits The exhibits listed on the accompanying index to exhibits (pages E-1 through E-2) are filed as part of this annual report. (b)Reports on Form 8-K None (c)Exhibits The exhibits listed on the accompanying index (Pages E-1 through E-2) are filed as part of this annual report. (d)Financial Statements omitted-- Separate financial statements of the parent company have been omitted since it is primarily an operating company and the minority interest and indebtedness to persons other than the parent of the subsidiaries included in the consolidated financial statements are less than 5% of total consolidated assets. Certain schedules have been omitted because the required information is included in the consolidated financial statements or notes thereto or because they are not applicable or not 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, ON THE 28TH DAY OF MARCH, 1994. R. R. DONNELLEY & SONS COMPANY William L. White By __________________________________ William L. White, Vice President, Controller 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 28TH DAY OF MARCH, 1994. SIGNATURE AND TITLE SIGNATURE AND TITLE John R. Walter Robert A. Hanson - ------------------------------------- ------------------------------------- John R. Walter Robert A. Hanson Chairman of the Board, Director Chief Executive Officer and Director (Principal Executive Officer) Thomas S. Johnson ------------------------------------- Frank R. Jarc Thomas S. Johnson - ------------------------------------- Director Frank R. Jarc Executive Vice President and Richard M. Morrow Chief Financial Officer ------------------------------------- (Principal Financial Officer) Richard M. Morrow Director William L. White - ------------------------------------- John M. Richman William L. White ------------------------------------- Vice President, Controller John M. Richman (Principal Accounting Officer) Director Martha Layne Collins William D. Sanders - ------------------------------------- ------------------------------------- Martha Layne Collins William D. Sanders Director Director James R. Donnelley Jerre L. Stead - ------------------------------------- ------------------------------------- James R. Donnelley Jerre L. Stead Director Director Charles C. Haffner III Bide L. Thomas - ------------------------------------- ------------------------------------- Charles C. Haffner III Bide L. Thomas Director Director H. Blair White ------------------------------------- H. Blair White Director ITEM 14(A). INDEX TO FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES R.R. DONNELLEY & SONS COMPANY AND SUBSIDIARIES CONSOLIDATED STATEMENT OF INCOME See accompanying Notes to Consolidated Financial Statements. R.R. DONNELLEY & SONS COMPANY AND SUBSIDIARIES CONSOLIDATED BALANCE SHEET Assets See accompanying Notes to Consolidated Financial Statements. R.R. DONNELLEY & SONS COMPANY AND SUBSIDIARIES CONSOLIDATED STATEMENT OF CASH FLOWS See accompanying Notes to Consolidated Financial Statements. R.R. DONNELLEY & SONS COMPANY AND SUBSIDIARIES CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY (THOUSANDS OF DOLLARS) See accompanying Notes to Consolidated Financial Statements. R.R. DONNELLEY & SONS COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Basis of Consolidation-- The consolidated financial statements include the accounts of the company and its subsidiaries. Intercompany items and transactions are eliminated in consolidation. Nature of Operations-- The operations of the company are in the information industry. The company produces a wide variety of print and print-related services for specific customers, virtually always under contract. Some contracts provide for progress payments from customers as certain phases of the work are completed; however, revenue is not recognized until the production process has been completed in accordance with the terms of the contracts. Some customers furnish paper for their work, while in other cases the company purchases and sells the paper. International operations represent less than 9% of consolidated results and of consolidated assets. Cash and Equivalents-- The company considers all highly liquid debt instruments purchased with original maturities of three months or less to be cash equivalents. Inventories-- Inventories include material, labor and factory overhead and are substantially carried at Last-In, First-Out (LIFO) cost. This method reflects the effect of inventory replacement costs in earnings; accordingly, charges to cost of sales reflect recent costs of material, labor and factory overhead. Foreign Currency Translation-- Gains and losses arising from the translation of the company's international subsidiaries' financial statements are reflected in Retained Earnings. Net Income Per Share of Common Stock-- Net income per share is computed on the basis of average shares outstanding during each year. No material dilution would result if effect were given to the exercise of outstanding stock options and the vesting of stock units. Benefit Plans-- The company's Retirement Benefit Plan (the Plan) is a non-contributory defined benefit plan covering substantially all employees. Normal retirement age is 65 but provision is made for earlier retirement. As required, the company uses the projected unit credit actuarial cost method to determine pension cost for financial reporting purposes. In conjunction with this method, the company amortizes deferred gains and losses (using the corridor method), prior service costs and the transition credit (the excess of Plan assets plus balance sheet accruals over the projected obligation, as of January 1, 1987) over 19 years, representing the average remaining service life of its active employee population. For tax and funding purposes, the attained age normal actuarial cost method is used. Compared to the projected unit credit method, the attained age normal method attributes a greater proportion of the total retirement obligation to an employee's early years of service. R.R. DONNELLEY & SONS COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) Capitalization, Depreciation and Amortization-- Property, plant and equipment are stated at cost. Depreciation is computed principally on the straight-line method. Maintenance and repair costs are charged to expense as incurred. Major overhauls are capitalized as reductions to accumulated depreciation. When properties are retired or disposed, the costs and related depreciation reserves are eliminated and the resulting profit or loss is recognized in income. Goodwill and other intangible assets are amortized principally over periods ranging from 10 to 40 years. Income Taxes-- Deferred income taxes relate principally to the use of accelerated depreciation methods for tax reporting purposes, the investment in safe harbor leases, pension costs, net postretirement medical and death benefit costs and contributions to fund the Voluntary Employees' Beneficiary Associations (VEBAs). RESTRUCTURING CHARGE On January 25, 1993, Sears Roebuck and Co., a customer, announced its decision to discontinue catalog operations during 1993. In response to Sears' announcement, the company incurred a one-time charge of $60.8 million (net of the associated tax benefit) in the first quarter of 1993. The charge primarily covered the costs associated with closing the company's manufacturing facility in Chicago, Illinois, where the company printed the Sears catalogs. The loss of this work will have no ongoing material effect on operating results. INVENTORIES The components of the company's inventories as of December 31, 1993 and 1992, were as follows: VOLUNTARY EMPLOYEES' BENEFICIARY ASSOCIATIONS The company maintains two Voluntary Employees' Beneficiary Associations to fund employee welfare benefits and postretirement medical and death benefits. The balances of the VEBAs (net of associated liabilities) in the accompanying Consolidated Balance Sheet are classified as either current or noncurrent depending on the ultimate expected payment date of the underlying liabilities. As of December 31, 1993, a net current asset of $9.8 million was included in Prepaid Assets representing the current position of the company's employee welfare benefit plans funded by one of the VEBAs ($33.2 million included in Other Accrued Liabilities at December 31, 1992). The VEBA established to partially fund the company's liability for postretirement medical and death benefits ($135 million at December 31, 1993) is included in other noncurrent liabilities as an offset to the related liability. (The initial VEBA fund of $104 million was recorded as a Noncurrent Asset at December 31, 1992). For additional information, refer to the notes on "Other Retirement Benefits." R.R. DONNELLEY & SONS COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) PROPERTY, PLANT AND EQUIPMENT The following table summarizes the components of Property, Plant and Equipment (at cost): COMMITMENTS AND CONTINGENCIES Authorized expenditures on incomplete projects for the purchase of property, plant and equipment, as of December 31, 1993, totaled $418.8 million. Of this total, $143.9 million has been paid and an additional $120.7 million has been committed for payment upon completion of the contracts. The company has a variety of commitments with suppliers for the purchase of paper, ink and other materials for delivery in future years at prevailing market prices. The company has operating lease commitments approximating $390.2 million extending through various periods to 2066. The lease commitment is $60.8 million for 1994, and ranges from $26.8 million to $47.4 million in each of the years 1995-1998 and totals $186.1 million for future periods. The company does not believe an accounts receivable credit risk exists due to the diversity of industry classification, distribution channels and geographic location of its customers. In addition, the company is a party to certain litigation (other than the FTC matter described below) arising in the ordinary course of business which, in the opinion of management, will not have a material adverse effect on the operations of the company. The company also has future annual commitments to invest in various affordable housing limited partnerships which provide annual tax benefits and credits in amounts greater than the annual investments. The company has appealed a recent decision in the Federal Trade Commission (FTC) challenge to the company's 1990 acquisition of the Meredith/Burda companies. An FTC administrative law judge found the acquisition has or may substantially lessen competition in an alleged "high-volume publication gravure printing" market and ordered the divestiture of the Meredith/Burda companies. The company's appeal has the effect of staying the divestiture order. The ruling is contrary to an earlier ruling by a Federal District Court which allowed the acquisition to be consummated. Company management continues to believe this acquisition was legally proper. RETIREMENT BENEFIT PLAN Net pension credits included in operating results for the Retirement Benefit Plan (the Plan) were: R.R. DONNELLEY & SONS COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) For financial reporting purposes the actuarial computations that derived the above amounts assumed a discount rate on projected benefit obligations of 7.5% (7.8% at December 31, 1992 and December 31, 1991), an expected long-term rate of return on Plan assets of 9.5% and annual salary increases of 5%. Plan assets include primarily government and corporate debt securities and marketable equity securities, and, to a lesser extent, commingled funds, real estate and a group annuity contract purchased from a life insurance company. The funded status and prepaid pension cost (included in Other Assets on the accompanying Consolidated Balance Sheet) are as follows: In the event of Plan termination, the Plan provides that no funds can revert to the company and any excess assets over Plan liabilities must be used to fund retirement benefits. OTHER RETIREMENT BENEFITS In addition to pension benefits, the company provides certain health care and life insurance benefits for retired employees. Substantially all of the company's domestic, full-time employees become eligible for those benefits upon reaching age 55 while working for the company and having ten years continuous service at retirement. Beginning in 1992, the company began a program to partially fund the liabilities associated with these plans through a tax-exempt trust. The trust is invested in various assets, primarily life insurance covering some of the company's employees. Effective January 1, 1993, the company adopted Statement of Financial Accounting Standards No. 106 (SFAS 106), "Employers' Accounting for Postretirement Benefits Other Than Pensions." SFAS 106 requires companies to charge to expense the expected costs of postretirement health care and life insurance (and similar benefits) during the years that the employees render service. Previously, such costs were expensed as actual claims were paid (cash basis). The company elected to immediately recognize the transition obligation for future benefits to be paid related to past employee services, resulting in a noncash charge of $207.8 million before deferred income tax benefits ($127.7 million after-tax or $0.82 per share) that represents the cumulative effect of the change in accounting for the years prior to 1993. R.R. DONNELLEY & SONS COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) The net accrual-basis expense for postretirement benefits during 1993 included the following components: The above table does not include a $23 million charge for postretirement medical benefits associated with the closing of the company's Chicago manufacturing facility; such amount was included in the restructuring charge (see separate note above). The expense for postretirement medical and death benefits for 1992 and 1991 (recognized on a cash basis) was $12.4 million and $9.8 million, respectively. The liability (included in Other Noncurrent Liabilities on the accompanying Consolidated Balance Sheet at December 31, 1993) for postretirement benefits, net of the partial funding, is as follows: For financial reporting purposes the 1993 actuarial computations assumed a discount rate of 7.5% to determine the accumulated postretirement benefit obligation, an expected long-term rate of return on plan assets of 9.0% and a health care cost trend rate of 8.4% initially, declining gradually to 5.4% in 2053, to measure the accumulated postretirement benefit obligation. Effective January 1, 1993, certain features of the plan were amended. For future retirees, the company introduced retiree cost-sharing and implemented programs intended to stem rising costs. Also, the company has adopted a provision which limits its future obligation to absorb health care cost inflation. The features of the new plan provisions have been reflected in the assumed health care cost trend rate disclosed above. However, a one-percentage- point increase in the assumed health care cost trend rate would increase the 1993 postretirement benefit expense (service cost and interest cost) by $1.6 million and the accumulated postretirement benefit obligations as of December 31, 1993 by $10.4 million. INCOME TAXES Effective January 1, 1993, the company adopted Statement of Financial Accounting Standards No. 109 (SFAS 109), "Accounting for Income Taxes." SFAS 109 requires, among other things, the application of current statutory income tax rates to deferred income tax balances. In the first quarter of 1993, the company recognized the cumulative effect, through January 1, 1993, of the accounting change, reflecting the difference between current statutory tax rates and the generally higher rates that were used to establish the deferred income tax balances, resulting in noncash income of $58.2 million (equivalent to $0.37 per share). R.R. DONNELLEY & SONS COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) Cash payments for income taxes were $75.2 million, $105.9 million and $106.2 million in 1993, 1992 and 1991, respectively. The components of income tax expense for the years ending December 31, 1993, 1992 and 1991, were as follows: - -------- *The 1993 deferred income tax expense includes $6.2 million for the one-time adjustment of previously recorded deferred taxes due to the increase in the U.S. statutory rate. The significant deferred tax assets and liabilities at December 31, 1993 and January 1, 1993, were as follows: The following table reconciles the difference between the U.S. statutory tax rates and the rates used by the company in the determination of net income: R.R. DONNELLEY & SONS COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) DEBT FINANCING AND INTEREST EXPENSE The company's debt at December 31, consisted of the following: Based upon the interest rates currently available to the company for borrowings with similar terms and maturities, the fair value of the company's debt is approximately $788 million. The company's debentures are not actively traded and contain no call provisions. The company's other financial instruments are either carried at fair value or do not materially differ from fair value. At December 31, 1993, the company had available credit facilities of $550 with a group of domestic and foreign banks. The credit arrangements provide support for the issuance of commercial paper and other credit needs. Borrowings under the facilities (none during the past three years) bear interest at various rates not exceeding the banks' prime rates. The company pays annual fees ranging from 0.1% to 0.15% on the total unused credit facilities. At December 31, 1993, the company had $233.0 million of commercial paper and short-term debt outstanding, of which $37.4 million represents management's current estimate of 1994 net repayment. The remaining $195.6 million is classified as long term since the company has the ability and intent to maintain such debt on a long term basis. The weighted average interest rate on all commercial paper debt outstanding during 1993 was 3.2% (3.3% at December 31, 1993). The following table summarizes interest expenses included in the Consolidated Statement of Income: Interest paid, net of capitalized interest, was $42.9 million, $38.4 million, $51.8 million in 1993, 1992 and 1991, respectively. As of December 31, 1993, the company had effective shelf registrations permitting it to issue, from time to time, up to $500 million of debt securities. The proceeds of any debt securities issued would be used for general corporate purposes. R.R. DONNELLEY & SONS COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) STOCK AND INCENTIVE PROGRAMS FOR MANAGEMENT EMPLOYEES Stock Unit Awards and Restricted Stock Awards--At December 31, 1993 and 1992, the company had outstanding 80,000 and 171,000 stock units, respectively, which had been granted to officers and selected managers prior to 1990. Certain of these units are payable upon or subsequent to termination of employment and others are payable upon vesting, normally five years after the date of grant. Payment of these awards will be made in shares of common stock equal to the number of units awarded, in cash equal to the market value at the date of distribution, or a combination thereof, at the company's option. The expense for these grants was recognized in the year granted. When an award of stock units is paid, the recipient will receive an additional amount in cash equal to dividends paid on an equivalent number of shares of common stock during the vesting period, plus interest. The values of the dividends and interest accounts, were $232 thousand and $409 thousand at December 31, 1993 and 1992, respectively. At December 31, 1993 and 1992, the company had outstanding 275,000 and 223,000, respectively, restricted shares granted to certain officers. These shares are registered in the names of the recipients, but are subject to conditions of forfeiture and restrictions on sale or transfer for five years from the grant date. Dividends on the restricted shares are paid currently to the recipients and, accordingly, the restricted shares are treated as outstanding shares. The expense of the grant is recognized evenly over the vesting period. The value of the stock units and restricted stock awards was $11.0 million and $12.9 million based upon the closing price of the company's stock price at each year end ($31.13 and $32.75 at December 31, 1993 and 1992, respectively). Charges to expense for both stock plans were $1.1 million, $1.2 million, and $0.9 million in 1993, 1992 and 1991, respectively. Stock Purchase Plan-- The company has a stock purchase plan for selected managers and key staff employees. Under the plan, the company is required to contribute an amount equal to 70% of participants' contributions, of which 50% is applied to the purchase of stock and 20% is paid in cash. The number of shares required for the plan for the year 1993 will depend upon the extent to which eligible participants subscribe during the subscription period in the first quarter of 1994 and the price of the stock on March 16, 1994. Amounts charged to expense for this plan were $6.2 million in 1993 and $5.8 million in 1992. No amounts were charged to expense for the 1991 plan year since participation was not allowed according to the plan terms because the company's earnings did not meet the required performance goal under the plan. Incentive Compensation Plans-- The company has incentive compensation plans covering selected officers. Amounts charged to expense for supplementary compensation, which is determined from participants' base salaries and factors relating to various performance measures, were $2.6 million in 1993, $2.7 million in 1992 and $0.7 million in 1991. Stock Options-- The company has granted stock options annually from 1983 to 1993. Exercise prices are 100% of the market price of common stock on the date of grant. The options vest over four or five years and may be exercised, once vested, up to ten years from the date of grant. Under the 1991 Stock Incentive Plan, a maximum of 2.9 million shares were available for future grants of stock options and restricted stock awards as of December 31, 1993. Information relating to stock options for the years ended December 31 is shown on the following table. R.R. DONNELLEY & SONS COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) Other Information-- Under the stock programs, authorized unissued shares or treasury shares may be used. If authorized unissued shares are used, not more than 11.3 million shares may be issued in the aggregate. The company intends to reacquire shares of its common stock to meet the stock requirements of these programs in the future. EMPLOYEE STOCK OWNERSHIP PLAN Contributions to the company's Employee Stock Ownership Plan were discontinued in response to the change in tax law that eliminated the previously available tax credit. Under this plan, 1.2 million shares are held in trust as of December 31, 1993, for formerly eligible employees. There are no charges to operations for this plan, except for certain administrative expenses. STOCK SPLIT On July 23, 1992, the Board of Directors declared a 2-for-1 common stock split. The split was completed on September 1, 1992, by the distribution of one share of common stock, par value $1.25 per share, for each share held by stockholders of record on August 7, 1992. Information relating to stock options, stock units rights, reacquired common stock, the Shareholders Rights Plan, and the net income and dividends per share included in the Consolidated Financial Statements and related footnotes reflect the stock split. PREFERRED STOCK The company has two million shares of $1.00 par value preferred stock authorized for issuance. The Board of Directors may divide the preferred stock into one or more series and fix the redemption, dividend, voting, conversion, sinking fund, liquidation and other rights. The company has no present plans to issue any preferred stock. One million of the shares are reserved for issuance under the Shareholder Rights Plan discussed below. SHAREHOLDER RIGHTS PLAN The company maintains a Shareholder Rights Plan (the Plan) designed to deter coercive or unfair takeover tactics, to prevent a person or group from gaining control of the company without offering fair value to all shareholders and to deter other abusive takeover tactics which are not in the best interest of shareholders. Under the terms of the Plan, each share of common stock is accompanied by one-quarter of a right; each full right entitles the shareholder to purchase from the company, one one-hundredth of a newly issued share of Series A Junior Preferred Stock at an exercise price of $225. R.R. DONNELLEY & SONS COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONCLUDED) The rights become exercisable ten days after a public announcement that an acquiring person (as defined in the Plan) has acquired 20% or more of the outstanding common stock of the company (the Stock Acquisition Date) or ten days after the commencement of a tender offer of which would result in a person owning 30% or more of such shares. The company can redeem the rights for $.05 per right at any time until twenty days following the Stock Acquisition Date (the 20-day period can be shortened or lengthened by the company). The rights will expire on August 8, 1996 unless redeemed earlier by the company. If, subsequent to the rights becoming exercisable, the company is acquired in a merger or other business combination at any time when there is a 20% or more holder, the rights will then entitle a holder to buy shares of the acquiring company with a market value equal to twice the exercise price of each right. Alternatively, if a 20% holder acquires the company by means of a merger in which the company and its stock survives, or if any person acquires 30% or more of the company's common stock, each right not owned by a 20% or more shareholder, would become exercisable for common stock of the company (or, in certain circumstances, other consideration) having a market value equal to twice the exercise price of the right. ACQUISITIONS The company made several acquisitions, joint venture and equity investments in 1993, 1992 and 1991, none of which, either individually or in the aggregate, were material to the company's financial statements. The acquisitions were accounted for using the purchase method; accordingly, the assets and liabilities of the acquired entities have been recorded at their estimated fair values at their respective dates of acquisition. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Stockholders of R.R. Donnelley & Sons Company: We have audited the accompanying consolidated balance sheets of R. R. Donnelley & Sons Company (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 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 R. R. Donnelley & Sons Company 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 ended December 31, 1993, in conformity with generally accepted accounting principles. As explained in the Notes to Consolidated Financial Statements, effective January 1, 1993, the company changed its method of accounting for postretirement benefits other than pensions and its method of accounting for income taxes. Arthur Andersen & Co. Chicago, Illinois January 27, 1994 UNAUDITED INTERIM FINANCIAL INFORMATION THOUSANDS OF DOLLARS EXCEPT PER SHARE DATA REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULES To the Stockholders of R.R. Donnelley & Sons Company: We have audited, in accordance with generally accepted auditing standards, the financial statements included in the Company's Annual Report to Shareholders included in this Form 10-K, and have issued our report thereon dated January 27, 1994. Our audit was made for the purpose of forming an opinion on those statements taken as a whole. The schedules listed in the index to the financial statements and financial statement schedules 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. Chicago, Illinois, January 27, 1994 SCHEDULE V PROPERTY, PLANT AND EQUIPMENT Depreciation of plant and equipment is computed principally on the straight- line basis primarily at the following rates: buildings, 3%-5% and machinery and equipment, 6 2/3%-33 1/3%. SCHEDULE VI ACCUMULATED DEPRECIATION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT SCHEDULE VIII VALUATION AND QUALIFYING ACCOUNTS Transactions affecting the allowances for doubtful accounts during the years ended December 31, 1993, 1992 and 1991 were as follows: SCHEDULE IX SHORT-TERM BORROWINGS - -------- *At December 31, 1993 the Company had $218.7 million of commercial paper ($176.0 million and $215.7 million at December 31, 1992 and December 31, 1991, respectively) of which the $23.1 million represents management's current estimate of 1994 repayments. The remaining $195.6 million, at December 31, 1993, is classified as long term since the Company has the ability and intent to maintain such debt on a long term basis. SCHEDULE X SUPPLEMENTARY INCOME STATEMENT INFORMATION Amounts charged to expense for the years ended December 31, 1993, 1992 and 1991 were as follows: INDEX TO EXHIBITS* - -------- *Filed with the Securities and Exchange Commission. Each such exhibit may be obtained by a shareholder of the Company upon payment of $5.00 per exhibit. **Management contract or compensatory plan or arrangement. (1) Instruments, other than that described in 4(d), defining the rights of holders of long-term debt not registered under the Securities Exchange Act of 1934 of the registrant and of all subsidiaries for which consolidated or unconsolidated financial statements are required to be filed are being omitted pursuant to paragraph (4)(iii)(A) of Item 601 of Regulation S-K. Registrant agrees to furnish a copy of any such instrument to the Commission upon request. E-1 (2) Filed as Exhibit with Form SE filed on July 31, 1986, and incorporated herein by reference. (3) Filed as Exhibit with Form SE filed on March 24, 1988, and incorporated herein by reference. (4) Filed as Exhibit with Form SE filed on May 10, 1988, and incorporated herein by reference. (5) Filed as Exhibit with Form SE filed on March 23, 1990, and incorporated herein by reference. (6) Filed as Exhibit with Form SE filed on March 25, 1991, and incorporated herein by reference. (7) Filed as Exhibit with Form SE filed on May 9, 1991 and incorporated herein by reference. (8) Filed as Exhibit with Form SE filed on March 26, 1992 and incorporated herein by reference. (9) Filed as Exhibit with Form SE filed on March 30, 1993 and incorporated herein by reference. (10) Filed on May 14, 1993 as Exhibit to Quarterly Report on Form 10-Q for the quarterly period ended March 31, 1993. (11) Filed on November 12, 1993 as Exhibit to Quarterly Report on Form 10-Q for the quarterly period ended September 30, 1993. E-2

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312667

ITEM 1. BUSINESS INTRODUCTION Spelling Entertainment Group Inc. (the "Company") is a fully- integrated producer and distributor of filmed entertainment and has an extensive library of television series, mini-series, movies-for-television, pilots and feature films (collectively referred to hereinafter as "film product"), which are licensed for viewing both in the United States and international markets. The Company also licenses music and merchandising rights associated with its film product. The Company's current entertainment operations are conducted through subsidiaries of Spelling Entertainment Inc. ("SEI"). The Company acquired 82% of SEI in the first half of 1991 and the remainder in July 1992 (see Note 2 to the Company's Consolidated Financial Statements; references to Notes hereinafter refer to the notes to such financial statements). The Company's production operations are conducted by Spelling Television and Laurel Entertainment ("Laurel"); distribution activities are conducted primarily through Worldvision Enterprises, Inc. ("Worldvision") and Spelling Films International ("SFI"); licensing and merchandising activities are conducted by Hamilton Projects. Unless the context indicates otherwise, "Spelling" or the "Company" refers to Spelling Entertainment Group Inc. and its subsidiaries. The Company's former petroleum operations have been sold and are classified as discontinued operations in the accompanying financial statements (see "Discontinued Operations" and Note 11). Approximately 48% of the Company's Common Stock was owned by American Financial Corporation and its subsidiaries ("AFC") until March 31, 1993, when AFC sold the Common Stock it owned to Blockbuster Entertainment Corporation and its subsidiaries ("BEC"). BEC acquired additional Common Stock during 1993, both from third parties and from the Company (see Note 7). As of March 25, 1994 BEC owned approximately 70.5% of the Company's outstanding stock. In September 1993, the Company and Republic Pictures Corporation ("Republic") entered into an agreement in principle pursuant to which the Company agreed to acquire by merger all of the outstanding shares of common stock of Republic for $13 per share in cash (the "Republic Merger"), including the approximate 35% interest in Republic held by BEC. Additionally, options and warrants to acquire Republic common stock will be converted into the right to receive, upon payment of the exercise price, 1.6508 shares of the Company's Common Stock for each share of Republic common stock into which such option or warrant was exercisable. Republic common stock will be converted into options to acquire the Company's Common Stock. In December 1993, the Company and Republic entered into a definitive agreement covering the Republic Merger, which is expected to be consummated in the second quarter of 1994. In January 1994, BEC entered into a merger agreement pursuant to which BEC has agreed to merge with and into Viacom Inc. ("Viacom"), with Viacom being the surviving corporation. Upon the closing of the merger, which closing is subject to customary conditions, including approval of the merger by BEC's shareholders, Viacom would own a majority of the Company's Common Stock. Spelling Entertainment Group Inc. (formerly the Charter Company) was incorporated in Florida in 1959 and has its principal executive offices at 5700 Wilshire Boulevard, Los Angeles, California 90036, telephone (213) 965-5700. PRODUCTION Originally established in 1965 as Aaron Spelling Productions, Spelling Television has a history of successful network television production, including nearly 3,000 hours of television series, movies-for-television, mini-series and pilots, as well as feature films. In association with a variety of partnerships, Aaron Spelling has been one of the industry's most creative and profitable producers of network programming, producing such successful series as "Beverly Hills, 90210," "Melrose Place," "Love Boat," "Dynasty," "Hotel," "Vegas," "Matt Houston," "Fantasy Island," "Charlie's Angels," "Starsky and Hutch," "Family" and "Hart to Hart." Laurel, which was acquired by SEI in 1989, had been engaged primarily in the development and production of first-run syndicated series (see below) and feature films. In recent years however, it has diversified its activities to include the development and production of network mini-series and movies-for-television. Laurel has pursued a strategy of lower cost productions outside of the traditional Hollywood system and showcasing new or emerging talent. Laurel has produced or is producing several projects based on books or materials by author Stephen King. Worldvision finances third party production through the payment of guaranteed advances in exchange for certain distribution rights. See "Distribution - Acquiring Distribution Rights." SFI also finances third party production through the payment of guaranteed advances payable to producers in exchange for international distribution rights. See "Distribution." DEVELOPMENT The Company (primarily through Spelling Television and Laurel) is continually developing concepts and acquiring properties on which it can base pilots (and ultimately series), movies-for-television, mini-series and feature films. The Company may conduct such development internally, or in conjunction with a television network or motion picture studio/distributor. The development costs include property acquisition costs and the costs associated with writing a screenplay or teleplay. The Company has projects in development with a number of successful writers, producers, and/or individuals including Eric Roth, Joel Schumacher, Charles Rosen and Kareem Abdul-Jabbar. NETWORK PROGRAMMING Scripts for television programming are submitted to the network for review. If the network accepts the script, it will typically order production of a pilot or a prototype episode, for which it will pay the Company a negotiated fixed license fee. The Company's cost of producing such a pilot or prototype usually exceeds the network license fee. As of March 25, 1994, the Company had received orders for two new series projects. One is an eight episode order of a one-hour series for the Fox Broadcasting Company ("Fox") network tentatively titled "Models, Inc." Another is a six episode order of a one-hour series, for the Fox network, tentatively entitled "Shock Rock". The Company has other projects under consideration at the networks including an half-hour comedy tentatively titled "Madmen of the People." If the network decides to order a series, the license agreement generally provides for a minimum number of episodes to be delivered, with the network having certain rights to order additional episodes. The license agreement normally grants the network the right to exhibit the series in the United States during the license period and all other distribution rights are retained by the Company, subject to certain network-related holdback periods. The episodic license fee is normally less than the Company's costs of producing each series episode. In recent years, the size of the series deficits incurred by the Company has generally increased; however, in many cases the Company has been successful in obtaining international sales through Worldvision to substantially offset such production deficits. The Company is currently producing the television series "Beverly Hills, 90210" and "Melrose Place," both of which are being aired on the Fox television network. "Beverly Hills, 90210" is in its fourth season and has been renewed for the 1994-95 television season. "Melrose Place," which debuted during the summer of 1992 as a spin-off of "Beverly Hills, 90210," is in its second season, and has also been renewed for the 1994-95 television season. The Company is also producing the television series "Winnetka Road" and "Burke's Law," both mid-season replacements. The Company has received an order for an additional 13 episodes of "Burke's Law" from CBS for the 1994-95 television season. In 1993, Laurel produced "The Stand," an eight-hour mini-series based on one of Stephen King's best selling books, which was delivered to the ABC network in December 1993 and is scheduled to air in May 1994. The Company has recently received orders for two four hour mini-series from the ABC network, one based on James Michener's novel, "Texas" and the other based on Stephen King's novel, "The Langoliers." Laurel also produced a movie-for-television, "Precious Victims," which aired on the CBS network in September 1993. As with television series, the network license fees received for mini-series and movies-for-television are normally less than the costs of production, and the deficit must be covered by revenue from other markets, primarily through the exploitation of international rights. The Company had revenue from the Fox network in 1993, 1992 and 1991 representing 22%, 22% and 13% of revenue, respectively. FIRST-RUN SYNDICATED PROGRAMMING First-run syndicated television series are produced and sold directly to television stations in the United States without any prior network broadcast. These programs are licensed to individual or groups of television stations, on a market by market basis, in contrast to network distribution, which provides centralized access to a national audience. In first-run snydication, the Company licenses its film product in exchange for cash payments, advertising time (barter) or a combination of both. In cash licensing, a broadcaster normally agrees to pay a fixed licensing fee in one or more installments in exchange for the right to broadcast the product a specified number of times over an agreed upon set period of time. Where product is licensed in exchange for advertising time, through what are known as "barter agreements," a broadcaster agrees to give the Company a specified amount of advertising time, which the Company subsequently sells. Particularly in the initial years of such programming revenue can be less than the Company's costs of producing the programming. Worldvision is currently marketing for first-run barter syndication 22 episodes each of two series, currently titled "Robin's Hoods" and "Heaven Help Us," to be produced by Spelling Television. Worldvision has also begun to market these programs to international television markets for cash license fees. In first-run syndication, the Company retains greater control over creative and production decisions than is the case with network programming; however, there is a greater financial risk associated with such programming. Fixed license fees paid by the networks usually cover approximately 75% of the Company's production costs. Barter revenue is not fixed but is dependent on achieving specific ratings in targeted demographic areas. If a show's ratings are high, the advertising revenue received by the Company through its barter arrangements could be substantial. Laurel has produced for first-run syndication a movie-for-television, "The Vernon Johns Story," starring James Earl Jones, and two television series, "Tales From The Darkside" and "Monsters," both of which are anthology format one-half hour programs. The libraries of 90 and 72 episodes of "Tales From The Darkside" and "Monsters," respectively, represent a sufficient number of episodes to permit repeat syndication. "Tales From The Darkside" is currently licensed in the basic cable market by Worldvision. FEATURE FILMS The Company or certain of its employees act as producer or executive producer for feature films. Because of the significant amounts of capital required to finance the production and distribution of feature films, the Company generally has not sought to finance feature films entirely on its own, but rather has arranged for both financing and distribution from a major studio or other third party. This strategy limits the financial risks and rewards associated with any single film. The Company's potential to realize profits from a successful motion picture is also limited since as a producer it receives a fixed fee and only a contingent profit participation after the film is released. The Company's aggregate receipts from profit participations in the feature films it has produced have not been substantial to date. See "Distribution" for the acquisition of international distribution rights by SFI. OTHER MARKETS As noted above, network licensing fees and first-run syndication revenue are normally less than the associated costs of production. As a result, successful exploitation of the Company's television programming in other media and markets is a key to the profitability of the Company's production activities. Programming produced by the Company prior to its March 1989 acquisition of Worldvision is distributed under various distribution arrangements with third parties such as Warner Brothers or Twentieth Century-Fox. Distribution of product produced subsequent to the acquisition has been handled primarily through Worldvision. See "Distribution." As of December 31, 1993, the Company had contractual agreements with licensees covering film product which provide for approximately $145,000,000 in future gross license fees (revenue), approximately half of which are expected to be recognized after 1994. DISTRIBUTION Worldvision has been engaged in the distribution of filmed entertainment for over thirty-five years, originally serving as the distribution arm of the ABC network. Today, Worldvision is a leading worldwide distributor for the Company and other independent producers, with rights to more than 4,000 hours of television programming available for domestic distribution and more than 12,000 hours of television programming for international distribution. Worldvision currently distributes such programming in 110 countries through offices in New York, Chicago, Atlanta, Los Angeles, London, Paris, Rome, Toronto, Sydney, Tokyo and Rio de Janeiro. SFI was formed in 1990 to engage in the international distribution of feature films. SFI typically acquires all international distribution rights to such films by agreeing to pay a guaranteed advance to the producer against the producer's share of distribution receipts. Such advances are normally payable by SFI upon completion and delivery of the films by the producers. SFI then sells or licenses the films to various international subdistributors in each territory in exchange for a guaranteed advance plus, in most cases, a share of future profits. In certain international territories Worldvision handles television and home video distribution of SFI's films. SFI has, on a limited basis, developed feature film projects internally. SFI's revenue during 1993 was primarily generated by its distribution of "Short Cuts," directed by Robert Altman, and "Shadowlands," starring Anthony Hopkins and Debra Winger. ACQUIRING DISTRIBUTION RIGHTS A substantial portion of Worldvision's revenue is derived from fees earned from the distribution and licensing of television programming produced by the Company. See "Production." In addition, since 1989, Worldvision has invested approximately $150 million in the acquisition of distribution rights to film product from third parties. Worldvision acquires the exhibition rights to film product through contracts with the producers or other owners of such product. These contracts generally give Worldvision the exclusive distribution rights to license an unlimited number of exhibitions of the film product over a period of time, typically in excess of twenty years. Worldvision also acquires distribution rights from third party producers through advances to such producers which are recovered by Worldvision from revenue earned from distribution. Usually Worldvision recovers its distribution fees, expenses and advances before the producers or owners receive any additional proceeds. As an example, Worldvision contributed certain funding to "Twin Peaks," a first-run network series aired by ABC during the 1989-90 and 1990-91 television seasons. Worldvision also advanced funds for thirteen episodes of "Land of the Lost," aired by ABC during the 1992-93 season, and 52 half-hour episodes of the animated first-run syndicated series "Camp Candy," featuring the cartoon image of John Candy. Worldvision has also funded the production of various home video projects, including "Golf My Way" and "Golf My Way (II)," starring Jack Nicklaus. Over 350,000 units of these two programs have been distributed in the home video market. Recently, Worldvision began acquiring domestic distribution rights to made-for-video feature-length films. Films acquired for release in 1994 were "Breaking Point," a suspense-thriller starring Gary Busey and Kim Cattrall; "Crackerjack," featuring Thomas Ian Griffin, Nastassja Kinski and Christopher Plummer; and "Bulletproof Heart" with Mimi Rogers and Anthony LaPaglia. In September 1992, Worldvision purchased from Carolco Television Inc. ("Carolco") the domestic television rights to a library of more than 150 feature films, together with certain related receivables. The library includes box-office hits such as "Terminator 2," "Basic Instinct," "the Rambo trilogy," "L.A. Story," "Red Heat," "Total Recall," "Platoon," "The Last Emperor" and "Universal Soldier." Due to pre-existing licensing agreements covering these films, Worldvision will not recognize significant revenue from the exploitation of these rights until after 1996. MARKETS The Company generates revenue in addition to the revenue generated from the initial network or first-run syndicated market by licensing its film product in the following markets: (i) international television distribution, (ii) domestic off-network distribution (repeat airings on domestic broadcast television stations), (iii) worldwide cable and pay television, (iv) worldwide home video and (v) worldwide licensing and merchandising. INTERNATIONAL TELEVISION DISTRIBUTION. Demand for American-made film product in international markets has increased in recent years due to the increase in the number of television stations in those markets and, in some territories, the privatization of the local television industry. The Company typically begins to earn international television revenue from television programming during the same season such programming is originally broadcast on domestic television, or soon thereafter. Substantially all of the Company's television programming is presently being distributed in international television markets, including "Beverly Hills, 90210" and "Melrose Place," which are currently licensed in over seventy countries around the world. Television revenue from the distribution of feature films is normally delayed until after the films have been exploited in the theatrical and home video markets in each territory. See "Governmental Regulation" for restrictions placed on exhibition of the Company's film product in certain markets. DOMESTIC OFF-NETWORK DISTRIBUTION. The profitability of the Company's network television programming continues to depend substantially on its ability to distribute such programming in the domestic syndication television market after the initial network airing. However, in recent years the license fees obtainable from this market have declined and are expected to continue to decline, due in part to the increase in original programming available to independent stations from the emergence of the Fox network and the increased production of programming produced specifically for first-run syndication. Expected revenue per episode in this market normally increases for longer running series. In the Company's experience, a minimum of 65 episodes (normally three seasons) is generally required to successfully market repeat showings of a network series in the syndication market. Therefore, it is important to produce series which are aired over at least several broadcast seasons. Episodes from a network series normally become available for off-network syndication distribution four or five years after the series' initial network telecast. In 1992, Worldvision began to market "Beverly Hills, 90210" for off-network syndication telecast on a combined cash-and-barter basis for delivery in the third quarter of 1994. The series "Vegas" and "Little House on the Prairie" and several Worldvision feature film packages were aired in domestic repeat syndication during 1993. See also "Production - First-Run Syndicated Programming." BASIC CABLE TELEVISION. Domestic basic cable television represents an increasingly significant market for the Company's film product. The series "Tales From The Darkside," "The Love Boat," "Hotel" and "HeartBeat," among others, have been licensed to cable television systems. In the past, licensing a program to a cable exhibitor generally only reduced the amount of license fees that could be obtained from domestic off-network syndication distribution; in recent years, cable exhibition has effectively developed as an alternate market to domestic syndication. Cable exhibitors in some instances have purchased rights to short-running television series which do not include sufficient episodes to allow for traditional off-network syndication distribution. Cable television operations outside the U.S., while still in the early stages of development in many countries, have also been growing rapidly. See "Distribution - Spelling Satellite Networks" regarding the international cable and satellite television operations conducted by the Company. HOME VIDEO. Worldvision also distributes the Company's film product in the worldwide home video market, generally in the lower-priced sell-through market. "Monsters," "Tales From The Darkside" and the two-hour pilot and an episode of "Beverly Hills, 90210" have been successfully distributed in the home video market. Additionally, the Company distributes third party film product in this market. "Happily Ever After," an animated feature film, began distribution in late 1993. Also, by paying a guaranteed advance, the Company has acquired distribution rights for three films, "Breaking Point," "Crackerjack," and "Bulletproof Heart," which are intended for initial domestic distribution in the home video market. Generally, the budget for these pictures is under $2,000,000, and the Company puts up less than one-half of the budget in exchange for all domestic rights. LICENSING AND MERCHANDISING. Hamilton Projects merchandises products and licenses music associated with the Company's television properties, including "Beverly Hills, 90210," and "Melrose Place." Hamilton Projects is a full- service licensing and merchandising company, providing strategic planning, concept development and program execution to third parties, including those outside the entertainment industry. SPELLING SATELLITE NETWORKS (SSN) SSN was formed in January 1993 to capitalize on the increased global demand for American film product and the rapidly expanding technologies and exhibition outlets in the cable and satellite arena. SSN launched its first cable channel, TeleUNO, in March 1993. TeleUNO currently reaches more than two million homes in Latin America, including Mexico, Argentina and Brazil. TeleUNO generates revenue from both subscription fees and advertising through multi-year contracts with cable operators throughout Latin America. TeleUNO conducts its operations in association with Multivision, Mexico's largest multi-point, multi-channel distribution systems (MMDS). The Company is responsible for providing the film product which will air on the channel and for all sales and marketing activities. Multivision is responsible for all technical operations, including supplying the satellite transponder. The Company and Multivision will share revenue generated through licensing of the channel or sale of advertising on the channel. SSN is also currently exploring the possibility of launching additional channels in partnership with programmers or others in other markets around the world. PROGRAMMING LIBRARY The following tables provide a sampling of significant titles in the programming library which contains more than 400 titles and over 12,000 hours of programming to which the Company has certain distribution rights. TELEVISION SERIES: FEATURE FILMS: (a) These ten productions in the aggregate accounted for approximately 53% of the Company's 1993 revenue. (b) Represents programming owned by the Company. (c) Acquired in the 1992 purchase of the Carolco film library. (d) Distribution rights are for varying terms. COMPETITION The motion picture and television industry is highly competitive with respect to access to the available literary properties, creative personnel, talent, production personnel, television acceptance, distribution commitments and financing which are essential to produce and sell film product. Certain of the Company's competitors have greater financial resources and more people engaged in the acquisition, development, production and distribution of both television programming and feature films. The Company's arrangements with the networks provide it with pilot, series and movies-for-television commitments; however, the networks are under no obligation to actually broadcast the Company's product. The Company's successful domestic repeat syndication of a network series generally depends upon the ratings achieved through network exhibition of such a series over a number of years sufficient to generate a minimum of 65 episodes. In turn, the Company's overall success in achieving multiple years of network exhibition of a series is dependent upon factors such as the viewing public's taste (as reflected in the ratings) and critical reviews. In addition, see the discussion in "Government Regulation" regarding the relaxation of certain government regulations which may permit the television networks to acquire financial interests in, and syndication rights to, television programs. The Company must continue to acquire distribution rights to television programming and feature films to maintain its competitive position. In order to acquire rights to distribute new third party film product, the Company may be required to increase its advances to producers or to reduce its distribution fees. Licensing television programming to broadcasters and cable networks has also become increasingly competitive as new products continually enter the syndication market and certain producers attempt to develop an additional network to distribute their product. Likewise, SFI is competing with numerous well-financed, experienced companies engaged in feature film production and international feature film distribution. The Company's relative lack of experience and financial strength in distributing feature films in the international market may hinder its ability to compete effectively with companies which are more experienced and have greater financial capabilities. TRADEMARKS AND SERVICE MARKS The Company or its subsidiaries own various United States federal trademark or service mark registrations including SPELLING(R), BEVERLY HILLS, 90210(R), MELROSE PLACE(R), and has applied for registration for numerous other marks relating to its film product in the United States and foreign countries. The Company or its subsidiaries own various foreign trademark or service mark registrations or have applied for trademark or service mark registrations include TELE UNO(R). Certain of the Company's trademark and service marks may offer significant merchandising opportunities. See "Licensing and Merchandising." GOVERNMENT REGULATION The production and distribution of television programming by independent producers is not directly regulated by the federal or state governments, but the marketplace for television programming is substantially affected by regulations of the Federal Communications Commission ("FCC") applicable to television stations, television networks and cable television systems. The FCC's syndicated program exclusivity rules affect the sale of programming to commercial television stations, regional superstations, and cable networks. Pursuant to these rules, commercial television stations can bargain for the right to exclusive showing of programming within a 35-mile radius and to require cable television systems with 1,000 or more subscribers to black out showings of the same programming on certain television stations they carry in order to preserve contracted exclusivity. The FCC also allows regional superstations (such as WTBS in Atlanta and WGN in Chicago) and group owners to purchase rights to programming on a nationwide basis. In addition, distributors of syndicated programming may exercise such rights for a period of one year after first licensing a particular syndicated program or package in areas where that programming has not yet been licensed. The Cable Television Consumer Protection and Competition Act of 1992 ("Cable Act") prohibits certain unfair or discriminatory practices in the distribution of satellite superstations or in the sale of satellite cable programming by entities affiliated with cable operators. The Cable Act also strictly limits entities affiliated with cable operators in offering exclusive contracts for satellite cable programming or superstations. Furthermore, the Cable Act prohibits certain coercive and discriminatory acts by cable operators and other multichannel video program distributors against program vendors. In addition, the Cable Act provides all commercial television stations with the right to bargain for and withhold consent to the retransmission of their signals by cable television systems, and certain local stations have the option to demand carriage on cable systems. These provisions are subject to interpretation by the FCC, and various entities have petitioned the Commission to reconsider certain aspects of the rules it has adopted to enforce these requirements. Moreover, judicial appeals relating to various aspects of these rules are pending. Accordingly, the Company cannot predict the specific impact of the Cable Act on its business. In 1989, the twelve-member European Community ("EC") adopted a "directive" that its member states ensure that more than 50% of the programming shown on their television stations be European-produced "where practicable." These guidelines could restrict the amount of American television programming and feature films that are shown on European television. In the recently-concluded General Agreement on Trade & Tariffs, the EC refused to make any commitment to modify these guidelines or to refrain from adopting additional barriers. Because of significant questions regarding the interpretation and enforcement of the guidelines, the Company cannot predict what effect they may have on its business. In addition, certain European countries have adopted individual national restrictions on broadcasting of programming based on origin. Other countries in which the Company distributes its programming may adopt similar restrictions, which may have an adverse effect on its ability to distribute its programs or create stronger incentives for the Company to establish ventures with international firms. The effect of the foregoing regulations on the Company's operations cannot be accurately assessed at this time. In 1993, the FCC further relaxed its rules governing financial interests in and syndication of programming by the broadcast television networks (known as the "fin syn" rules). The relaxed rules still prohibit the three largest broadcast networks from holding or acquiring financial interests and syndication rights in any first-run non-network program or series they have not solely produced; from domestically syndicating any prime time network first-run non-network program; and from withholding a prime time network program from syndication for more than a specified period. However, these remaining restrictions on program syndication by the networks are set to expire in November of 1995, and are currently the subject of judicial review. In 1993, a Federal district court vacated certain provisions of consent decrees which prohibited television networks from acquiring financial interests and syndication rights in television programming produced by non-network suppliers such as the Company. The effect of the relaxed fin syn rules and the court's action on the operations of the Company is as yet unclear; however, these regulatory changes could have a material adverse effect on the operations of the Company. EMPLOYEES At December 31, 1993, Spelling employed or had service agreements with approximately 223 employees who are employed in administrative or other positions which are relatively independent of the Company's current level of production activities. In addition, the Company employs individuals for particular production projects. As a result, the number of employees and production project employees providing services to the Company can vary substantially during the course of a year depending upon the number and scheduling of its productions. The Company's union representation, wage scales and fringe benefits follow prevailing industry standards. Certain subsidiaries of the Company are signatories to collective bargaining agreements relating to the various types of employees and independent contractors required to produce television programming and feature films. These employees include writers, directors, actors, musicians and studio craftsmen. The following table sets forth the union contracts to which certain Spelling subsidiaries are parties and the relevant expiration dates: (*) Cancelable by either party subject to one year's notice. Although the Company considers all employee relations to be satisfactory at present, the renewal of union contracts does not depend on its activities or decisions alone. If the relevant union and the motion picture and television industry were unable to come to a new agreement prior to these expiration dates, any resulting work stoppage could adversely affect the Company's production activities. DISCONTINUED OPERATIONS The Company, formerly known as The Charter Company, was engaged in petroleum marketing operations, but in 1991 and 1992 sold substantially all of such operations. Additional information relating to discontinued operations including information regarding environmental contingencies is provided in the accompanying financial statements (see Note 11). PETROLEUM MARKETING. Revenue from the Company's petroleum marketing operations had been derived primarily from sales of commercial grade fuel oils such as residual fuel oil and other petroleum products. These operations were conducted by its wholly-owned subsidiaries, New England Petroleum Corporation ("NEPCO") and Penndel Energy Corporation ("Penndel"). The major portion of petroleum marketing sales was made under term and spot contracts for the sale of residual fuel oil to electric utilities and other commercial customers. During July and August 1992, the Company sold the "Penndel Group," consisting of two subsidiaries and a terminal facility, for approximately $17.7 million in cash. In December 1992 and January 1993, NEPCO's major utility supply contracts were sold. These utility supply contacts comprised the remainder of the Company's oil operations. OIL PRODUCING CONCESSION. In April 1991, the Company completed the sale of its 24.5% interest in an oil producing concession located in the Persian Gulf (the "Concession") to two Concession partners. The Company received approximately $23.9 million in cash, including the repayment of $6.1 million in advances made to the Concession in 1991. MARKETING GROUP AND INVESTMENT IN CIRCLE K. In 1988, the Company sold its Marketing Group of convenience stores to The Circle K Corporation ("Circle K"), a former affiliate of the Company's former principal shareholder, for $130 million in cash plus preferred stock originally valued at $50 million. In May 1990, Circle K and its principal subsidiaries filed for protection under Chapter 11 of the United States Bankruptcy Code ("Chapter 11") and suspended dividends on its preferred stock held by the Company. ITEM 2. ITEM 2. PROPERTIES The Company leases office space of approximately 51,000 square feet in Los Angeles and 63,000 square feet in New York. In addition, the Company leases offices in other cities in the United States and in various other countries throughout the world in connection with its international distribution activities. The Company also rents facilities on a short-term basis for the production of its film product, including a facility in Vancouver, British Columbia. Management believes comparable space is readily available should any lease expire without renewal. ITEM 3. ITEM 3. LEGAL PROCEEDINGS The Company has become subject to various lawsuits, claims and other legal matters in the course of conducting its business. The Company believes such lawsuits, claims and other legal matters should not have a material adverse effect on the Company's consolidated results of operations or financial condition. In September 1993, five purported class action lawsuits were filed in the Delaware Chancery Court against the Company, Republic, BEC and the members of the Board of Directors of Republic. The complaints seek preliminary and permanent injunctive relief against BEC's offer for acquisition and damages caused to Republic's public stockholders. On March 24, 1994, all parties to the litigation entered into a Memorandum of Understanding that contemplates the negotiation of a definitive settlement agreement and a hearing pursuant to the Delaware Chancery Court Rules to consider the fairness of the settlement. At such hearing, attorneys for the plaintiff class will apply for fees and expenses in an amount not to exceed $225,000, and defendants will not oppose such application. The Company is also involved in a number of legal actions including threatened claims, pending lawsuits and contract disputes, environmental clean-up assessments, damages from alleged dioxin contamination and other matters. While the outcome of these suits and claims cannot be predicted with certainty, the Company believes based upon its knowledge of the facts and circumstances and applicable law that the ultimate resolution of such suits and claims will not have a material adverse effect on the Company's results of operations or financial condition. This belief is also based upon allowances that have been established for estimated losses on disposal of former operations and remaining Chapter 11 disputed claims, and an insurance-type indemnity agreement which covers up to $35,000,000 of certain such liabilities in excess of a threshold amount of $25,000,000, subject to certain adjustments. Substantial portions of such allowances are intended to cover environmental costs associated with the Company's former operations. See Note 11 for information regarding the environmental and remaining Chapter 11 contingencies relating to the Company's discontinued operations. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of security holders. ______________________________________________ PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The Company's Common Stock is traded on the New York and Pacific Stock Exchanges under the symbol SP. The table below sets forth the high and low sales prices for the Common Stock as reported on the Composite Tape. The number of holders of record of the Company's Common Stock as of March 25, 1994, was approximately 64,605,268. In the fourth quarter of 1991, the Company declared and paid an annual cash dividend of $.05 per common share. In the first quarter of 1992, the Company began paying quarterly cash dividends of $.02 per common share. There are no restrictions that materially limit the Company's ability to pay dividends. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The following table sets forth certain data for the years ended December 31 (in thousands, except per share data): (a) Due to the acquisition of SEI in the second quarter of 1991, amounts are not comparable to prior years. (b) Per share amounts are calculated after preferred dividends of $810,000, except for 1993 which is $724,000. 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 the Consolidated Financial Statements of the Company and the related Notes. BUSINESS COMBINATIONS AND ACQUISITIONS The Company makes its decisions to acquire or invest in businesses based on financial and strategic considerations. The Company may from time to time invest in or acquire businesses or assets in addition to those described below. In May 1991, the Company acquired ownership of approximately 82% of the common stock of SEI for approximately $166,800,000 in cash and $22,745,000 principal amount of ten-year notes. This acquisition was accounted for using the purchase method of accounting and, accordingly, the operations of SEI have been included in the Company's financial statements from the date of acquisition. In July 1992, the Company acquired the remaining minority interest (see Note 2). In December 1991, the Company acquired Hamilton Projects and ownership of certain television programming, and received $24,000,000 in cash, in exchange for its distribution rights to Hanna-Barbera's animated programming (see Note 2). In September 1992, the Company purchased from Carolco domestic television distribution rights for more than 150 feature films, together with certain related receivables. The purchase price for these assets included $50,000,000 in cash and the assumption of approximately $14,000,000 in related liabilities. The cash portion of the purchase price was funded through SEI's bank facility (see Notes 3 and 4). In September 1993, the Company and Republic entered into an agreement in principle pursuant to which the Company agreed to acquire by merger all of the outstanding shares of common stock of Republic for $13 per share in cash, including the approximate 35% interest in Republic held by BEC. Additionally, certain options to acquire Republic common stock will be converted into options to acquire the Company's Common Stock. In December 1993, the Company and Republic entered into a definitive agreement covering the Republic Merger, which is expected to be consummated in the second quarter of 1994. The aggregate cash payments to the shareholders of Republic will be approximately $100,000,000, which will be funded through borrowings under the Company's credit arrangements with BEC (see Note 4 and "Financial Condition" below). RESULTS OF CONTINUING OPERATIONS The results of operations for any period are significantly affected by the quantity and performance of the Company's film product which is licensed to, and available for exhibition by, licensees in various media and territories. Consequently, results of operations may vary significantly between periods, and the results of operations in any one period may not be indicative of results of operations in future periods. The success of the Company's business depends, in part, upon the network exhibition of its television series over several years to allow for more profitable licensing and syndication arrangements. During the initial years of a television series, network and international license fees normally approximate the production costs of the series, and accordingly the Company recognizes only minimal profit or loss during this period. If a sufficient number of episodes of a series are produced, the Company is reasonably assured that it will also be able to sell the series in the domestic off-network market, and the Company would then expect to be able to realize a more substantial profit with respect to the series. The Company's business in general may also be affected by the public taste, which is unpredictable and subject to change, and by conditions within the filmed entertainment industry, including, but not limited to, the quality and availability of creative talent and the negotiation and renewal of union contracts relating to writers, directors, actors, musicians and studio craftsmen as well as any changes in the law and governmental regulation. In 1993, a Federal district court vacated certain provisions of consent decrees which prohibited television networks from acquiring financial interests and syndication rights in television programming produced by non-network suppliers such as the Company. Accordingly, subject to certain restrictions imposed by the Federal Communications Commission, the networks will be able to negotiate with program suppliers to acquire financial interests and syndication rights in television programs that air on the networks and therefore could become competitors of the Company. The following paragraphs discuss significant items in the Consolidated Statements of Operations for the three years ended December 31, 1993. REVENUE The following table sets forth the components of revenue from the Company's major markets for the years ended December 31 (in thousands): * Includes only the eight months following the acquisition of SEI. Network revenue remained at approximately the same level in 1993 as in 1992, as opposed to the significant increase in such revenue in 1992. In 1993, the Company delivered fewer hours of programming than in 1992, but the effect of this decrease was offset by an increase in the average license fee per hour or episode of programming. The increase in 1992 was attributable to (i) the fact that the results of operations include SEI's operations for only eight months in 1991 as compared to 12 months in 1992; and (ii) the delivery of additional programming in 1992. Network revenue in all three periods included license fees attributable to "Beverly Hills, 90210." The license fees from "Melrose Place" began in the fall of 1992. Both of these series have been ordered by the Fox network for the 1994/1995 season, and "Beverly Hills, 90210" is also expected to be released in the domestic off-network marketplace in the fall of 1994. The Company has received orders for two new series, "Burke's Law" (13 episodes) and "Winnetka Road" (six episodes), for the current season, as well as an order for two four hour mini-series, one based on James Michener's novel "Texas" and the other based on Stephen King's novel "The Langoliers." The CBS network has also ordered an additional 13 episodes of "Burke's Law" for the 1994/1995 season. Home video revenue increased $14,161,000 or 103%, in 1993 as compared to 1992. This increase was primarily due to the distribution of "Happily Ever After," an animated feature film, and the international licensing of "The Stand." The increase in such revenue in 1992 was $8,097,000, or 142%, as compared to 1991, primarily due to (i) the significant efforts by the Company to increase its presence in the home video distribution market, and (ii) the fact that SEI's operations were only included for eight months in 1991. International film distribution revenue decreased $5,024,000, or 24%, in 1993 as compared to 1992. During 1993, the Company delivered two feature films, "Short Cuts" and "Shadowlands," as compared to four during 1992, including "The Player." There were no comparable distribution activities in 1991. Licensing and merchandising revenue remained relatively constant in 1993, but increased $13,535,000 or 530%, in 1992 as compared to 1991. The increase from 1991 to 1992 was primarily due to the successful licensing of "Beverly Hills, 90210," and the acquisition of Hamilton Projects in December 1991. Other distribution revenue includes revenue from the licensing of the Company's extensive library of feature films and television programming in worldwide free and pay television markets other than domestic network television. The revenue from these markets remained relatively stable between 1993 and 1992. The increase between 1992 and 1991 was primarily due to the inclusion of SEI's operations for only eight months in 1991. Generally, the future growth in these markets is expected to occur in the international area rather than the domestic market; see Item 1. "Business - Distribution." FILM AND TELEVISION COSTS Film and television costs consist primarily of the amortization of capitalized product costs and the accrual of third party participations and residuals. Such costs in 1993 increased $4,457,000, or 2%, as compared to 1992, primarily as a result of the overall increase in revenue in 1993, although the percentage relationship between such costs and the related revenue decreased to 73% in 1993 from 76% in 1992. Such costs increased $106,924,000, or 119%, in 1992 as compared to 1991; this increase also resulted primarily from the increases in the Company's revenue. Additionally, the percentage relationship between these costs and the related revenue increased from 73% in 1991 to 76% in 1992. This percentage relationship is a function of (i) the mix of film product generating revenue in each period and (ii) changes in the projected profitability of individual film product based on the Company's estimates of such product's ultimate revenue and costs. SELLING, GENERAL AND ADMINISTRATIVE Selling, general and administrative costs in 1993 decreased $1,516,000, or 4%, as compared to 1992. This decrease primarily resulted from a decrease in management fees charged to the Company by the Company's former principal shareholder in 1993 following BEC's acquisition of a majority interest in the Company. Selling, general and administrative costs in 1992 increased $11,392,000, or 48%, as compared to 1991, primarily due to the inclusion of SEI's costs for only the last eight months of 1991 as compared to a full twelve months for 1992. In addition, a subsidiary recorded a nonrecurring gain from the relocation of its offices in 1991. INTEREST INCOME Interest income increased $1,347,000 in 1993 as compared to 1992, following an increase of $890,000 in 1992 as compared to 1991. These increases were principally due to the amortization of discount on receivables acquired from Carolco for the full year 1993 and from the date of acquisition in 1992. INTEREST EXPENSE Interest expense in 1993 decreased $2,019,000, or 20%, despite the Company's increased level of borrowings during the first three quarters of 1993. This decrease was primarily due to (i) the lower effective interest rates during the year and (ii) the repayment or redemption of a substantial amount of the Company's debt during the fourth quarter of 1993 (see Note 4 and "Financial Condition" below). Interest expense increased $2,890,000, or 41%, in 1992 due to the Company's increased level of borrowings during the year. The Company's borrowings will increase in 1994 as a result of the amounts borrowed to fund the aquisition of Republic (see Note 15). MINORITY INTEREST During 1992 the Company had minority interest expense of $1,327,000 related to the earnings of SEI for the period up to the date of the Company's acquisition of the minority interest. In 1991 the similar charge was $932,000. There was no such charge in 1993. PROVISION FOR INCOME TAXES During 1993, the Company's provision for income taxes increased $3,871,000, or 42%, over the provision in 1992. This increase was primarily due to the increase in pre-tax income in 1993, as described in the foregoing paragraphs. The effective tax rate decreased significantly in 1993, largely as a result of the effect of a reduction in the valuation allowance against the realizability of certain tax loss and credit ("tax attribute") carryforwards. Tax benefits from the utilization of certain tax attribute carryforwards in 1992 and 1991 were recorded as extraordinary items under then applicable accounting rules. (See Note 10). The Company adopted Statement of Financial Accounting Standards No. 109 ("SFAS 109") effective January 1, 1993. The cumulative effect of adopting SFAS 109 was not material. During 1992, the provision for income taxes increased by $6,350,000, or 224%, as compared to 1991. This increase is primarily due to the increase in pre-tax income, partially offset by a decrease in the overall effective tax rate for the year, as a result of the reduced effect of non-deductible intangible expenses. DISCONTINUED OPERATIONS The Company, formerly known as The Charter Company, was engaged in petroleum marketing operations, but in 1991 and 1992 sold substantially all of the remaining such operations. (See Note 11.) In April 1991, the Company completed the sale of its interest in an oil producing concession to two of its partners in the concession. The Company recognized a net gain of $8,848,000 after a provision for income taxes of $4,556,000. During July and August 1992, the Company sold two subsidiaries and a terminal facility. In December 1992 and January 1993, the Company sold its remaining utility supply contracts. No material gain or loss resulted from the overall disposition of these operations. The Company continues to sell the few remaining assets of the discontinued operations whenever possible and to settle remaining obligations associated with the discontinued operations. The financial position of discontinued operations is presented in the Balance Sheets under the caption "Net liabilities related to discontinued operations." Included in such amounts are certain allowances for estimated losses on disposal of the remaining oil operations and disputed claims relating to the reorganization in 1986 under Chapter 11 of the Bankruptcy Code. These allowances totaled approximately $29,621,000 and $30,587,000 at December 31, 1993 and 1992, respectively. See Note 11 regarding the insurance-type indemnity agreement the Company entered into in early 1993 which covers up to $35,000,000 in such claims over a threshold of $25,000,000. The Company is involved in a number of legal actions including threatened claims, pending lawsuits and contract disputes, environmental clean-up assessments, damages from alleged dioxin contamination and other matters. Some of the parties involved in such actions seek significant amounts of damages. While the outcome of these suits and claims cannot be predicted with certainty, the Company believes based upon its knowledge of the facts and circumstances and applicable law that the ultimate resolution of such suits and claims will not have a material adverse effect on the Company's results of operations or financial condition. This belief is also based upon allowances that have been established for estimated losses on disposal of former operations and remaining Chapter 11 disputed claims and an insurance-type indemnity agreement which covers up to $35,000,000 of certain such liabilities in excess of a threshold amount of $25,000,000, subject to certain adjustments. Substantial portions of such allowances are intended to cover environmental costs associated with the Company's former operations. Although there are significant uncertainties inherent in estimating environmental liabilities, based upon the Company's experience it is considered unlikely that the amount of possible environmental liabilities and Chapter 11 disputed claims would exceed the amount of the allowances by more than $50 million. In 1993, the Company had a net loss from discontinued operations of $3,971,000 after an income tax benefit of $2,529,000. This loss resulted primarily from the premium paid for the insurance-type indemnity described above. EXTRAORDINARY ITEMS In connection with the early extinguishment of certain indebtedness, the Company in 1993 recorded an extraordinary loss of $2,022,000 (net of a tax benefit of $1,287,000) from the write-off of unamortized discount and debt issuance costs relating to such debt. During 1992 and 1991, the Company had extraordinary income of $3,948,000 and $4,572,000, respectively, from tax benefits relating to utilization of certain tax attribute carryforwards; a similar benefit in 1993 was included in the Company's provision for income taxes in accordance with the provisions of SFAS 109. FINANCIAL CONDITION The Company's operations require the production of film product and the acquisition of rights to distribute film product produced by others. The Company's expenditures in this regard totalled $150,648,000 and $154,607,000 in 1993 and 1992, respectively. The cost of producing network television programming is largely funded through the receipt of the related network license fees. The cost of other production and acquisition activities is funded through the Company's operating cash flow and borrowings under its various credit arrangements. In connection with the Republic Merger, the Company in October 1993 issued 13,362,215 shares of the Company's Common Stock to BEC in exchange for 3,652,542 shares of BEC common stock. The BEC shares were subsequently resold, with the Company realizing approximately $100,445,000 in proceeds. The Company subsequently used these proceeds to prepay or redeem (i) all of the outstanding principal amount of its 10% Senior Subordinated Notes and 12% Subordinated Debentures, (ii) approximately $39,500,000 of SEI's bank debt and (iii) all of its outstanding Preferred Stock. (See Notes 4 and 6). As a result, the Company will borrow under its credit facilities to fund the completion of the Republic Merger in the second quarter of 1994. In January 1994, the Company terminated its existing bank credit agreement and entered into a three-year credit agreement with BEC (the "BEC Facility") (see Note 4). The BEC Facility provides for a three-year term loan facility of $100,000,000 to fund the Company's acquisition of Republic and a revolving credit facility of $75,000,000 to fund the Company's working capital and other requirements. The entire amount outstanding under the BEC Facility may be accelerated if BEC's indebtedness is accelerated by its banks. The events which might result in such an acceleration include the consummation of BEC's merger with Viacom (see Note 15) without the receipt of a waiver from BEC's banks. The Company has not been informed as to whether such waiver will be granted by BEC's lenders. However, the Company is currently exploring and believes it can obtain credit arrangements with third parties under terms and conditions which are not materially different from those contained in the BEC Facility. The Company believes that its financial condition remains strong and that it has the financial resources necessary to meet its anticipated capital requirements. In addition to cash provided by operating activities, and the issuance of Common Stock, the Company has sufficient resources available under its credit facility to meet its ongoing plans for the production and acquisition of film product and to take advantage of internal and external development and acquisition opportunities. INFLATION The Company anticipates that its business will be affected by general economic trends. During a period of high inflation, the Company believes that if costs increase, it should be able to pass such increases on to its customers. RECENTLY ISSUED ACCOUNTING STANDARDS Effective January 1994, the Company adopted SFAS No. 112, "Employers' Accounting for Postemployment Benefits," and SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities." SFAS No. 112 will not have an effect on the Company's results of operations or financial condition because the Company does not provide such benefits. However, the adoption of SFAS No. 115 will require the Company to adjust the carrying value of a common stock investment to fair market value with a corresponding adjustment to its Shareholders' Equity (see Note 1). ITEM 8: ITEM 8: FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA INDEX REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS TO SPELLING ENTERTAINMENT GROUP INC. We have audited the accompanying consolidated balance sheet of Spelling Entertainment Group Inc. (a Florida Corporation) and subsidiaries as of December 31, 1993, and the related consolidated statements of operations, shareholders' equity, and cash flows for the year then ended. These financial statements and the schedules for the year ended December 31, 1993 listed in the index at Item 14(a) are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and the 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 Spelling Entertainment Group Inc. and subsidiaries as of December 31, 1993, and the results of their operations and their cash flows for the year then ended 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 for the year ended December 31, 1993 listed in the index at Item 14(a) 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. Los Angeles, California February 1, 1994 REPORT OF INDEPENDENT AUDITORS BOARD OF DIRECTORS SPELLING ENTERTAINMENT GROUP INC. We have audited the accompanying consolidated balance sheet of Spelling Entertainment Group Inc. and subsidiaries (formerly The Charter Company) as of December 31, 1992 and the related consolidated statements of operations, changes in shareholders' 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 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 Spelling Entertainment Group Inc. and subsidiaries at December 31, 1992, and the consolidated results of their operations and their 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, 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 Cincinnati, Ohio March 19, 1993 SPELLING ENTERTAINMENT GROUP INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (IN THOUSANDS, EXCEPT SHARE DATA) The accompanying Notes to Consolidated Financial Statements are an integral part of these statements. SPELLING ENTERTAINMENT GROUP INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS (IN THOUSANDS, EXCEPT PER SHARE DATA) The accompanying Notes to Consolidated Financial Statements are an integral part of these statements. SPELLING ENTERTAINMENT GROUP INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY (IN THOUSANDS, EXCEPT NUMBER OF SHARES) The accompanying Notes to Consolidated Financial Statements are an integral part of these statements. SPELLING ENTERTAINMENT GROUP INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS) The accompanying Notes to Consolidated Financial Statements are an integral part of these statements. SPELLING ENTERTAINMENT GROUP INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES BASIS OF PRESENTATION. The consolidated financial statements present the consolidated financial position and results of operations of Spelling Entertainment Group Inc. and subsidiaries (the "Company" or "Spelling"). All material intercompany accounts and transactions have been eliminated. Certain reclassifications have been made to prior periods to conform to the current year's presentation. In May 1991, the Company acquired ownership of approximately 82% of the common stock of Spelling Entertainment Inc. ("SEI"). The acquisition of SEI has been accounted for as a purchase, and, accordingly, the results of SEI's operations since its acquisition are included in the accompanying consolidated financial statements (see Note 2). In July 1992 the Company acquired the remaining minority interest. Until March 31, 1993 American Financial Corporation and subsidiaries ("AFC") owned 24,594,215 shares (48%) of the Company's common stock, $.10 par value ("Common Stock"), and 9,000 shares (100%) of the preferred stock, $.10 par value ("Preferred Stock"); at that date, AFC sold the shares of Common Stock to Blockbuster Entertainment Corporation ("BEC"). Subsequently, BEC increased its ownership to 45,658,640 shares (approximately 70.5%) of the Company's Common Stock during 1993. (See Note 7). CASH AND CASH EQUIVALENTS. Cash equivalents consist of interest-bearing securities with original maturities of less than ninety days. ACCOUNTS RECEIVABLES, NET. Accounts receivable are net of allowance of $4,983,000 and $3,974,000 at December 31, 1993 and 1992, respectively. ACCOUNTING FOR FILM AND TELEVISION COSTS. Film and television costs include production or acquisition costs (including advance payments to producers), capitalized overhead and interest, prints and advertising expected to benefit future periods. These costs are amortized, and third party participations and residuals are accrued, on an individual product basis in the ratio that current year gross revenue bears to estimated future gross revenue. Film and television costs are stated at the lower of cost less amortization or estimated net realizable value on an individual film product basis. Estimates of total gross revenue, costs and participations are reviewed quarterly and revised as necessary. When estimates of total revenue and costs indicate that a television program or feature film will result in an ultimate loss, additional amortization is provided to fully recognize such loss in that period. PROPERTY, PLANT AND EQUIPMENT, NET. The carrying values of property, plant and equipment are based on cost, and provision for depreciation is made principally on the straight-line method over estimated useful lives. Property, plant and equipment are net of accumulated depreciation of $5,003,000 and $4,828,000 at December 31, 1993 and 1992, respectively. OTHER ASSETS. Included in other assets is a common stock investment at a carrying value (at cost) of $1,963,000 at December 31, 1993. The fair value of such investment, based on the closing over-the-counter market price on December 31, 1993, was $20,797,000. It is not clear that the Company could realize such a value if the investment were to be sold due to the relatively low trading volume of such shares relative to the number of shares owned by the Company. The Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards ("SFAS") No. 115, "Accounting for Certain Investments in Debt and Equity Securities," which will be effective in 1994. This statement will require the Company to adjust the carrying value of this asset, which will be classified as "available for sale" under the applicable provisions of SFAS No. 115, to fair market value with a corresponding adjustment to Shareholders' Equity. INTANGIBLE ASSETS, NET. Intangible assets represent the acquisition cost of SEI in excess of the market value of its identified net assets. This cost is being amortized on a straight-line basis over 40 years. Amortization expense relating to such intangible assets was $3,825,000, $4,086,000 and $2,626,000 for the years ended December 31, 1993 and 1992, and the eight months ended December 31, 1991, respectively. Intangible assets are net of accumulated amortization of $10,527,000 and $6,713,000 at December 31, 1993 and 1992, respectively. SPELLING ENTERTAINMENT GROUP INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) DEFERRED REVENUE. A substantial portion of the network license fees related to television programming are received prior to the time the programming is completed or delivered to the network. Such fees, and other fees received prior to the time that the related television programming or feature film (collectively, "film product") is available to the licensee, are recorded on the balance sheet as deferred revenue. Such amounts are normally repayable by the Company only if it fails to deliver the related film product to the licensee. REVENUE RECOGNITION. Revenue from licensing agreements covering film product owned by the Company is recognized when the film product is available to the licensee for telecast, exhibition or distribution, and other conditions of the licensing agreements have been met. Long-term noninterest-bearing receivables arising from such agreements are discounted to present value. Revenue from television distribution of film product which is not owned by the Company is recognized when billed. Revenue from direct home video distribution is recognized, net of an allowance for estimated returns, together with related costs, in the period in which the product is available for rental or sale by the Company's customers. ACCOUNTING FOR ENVIRONMENTAL MATTERS. The allowances for estimated losses on disposal and disputed claims reported in Note 11 include accruals for environmental liabilities, including anticipated remediation costs of properties held for sale. Such accruals are determined independently of the estimated net realizable value of any related asset, and are recorded without discount or offset for either (i) time value of money prior to the anticipated date of payment, or (ii) expected recoveries from insurance or contribution claims against unaffiliated entities. The allowances are reviewed quarterly and revised as necessary. DEBT DISCOUNT. Debt discount is amortized over the lives of the respective borrowings, generally on the interest method. There was no unamortized debt discount at December 31, 1993. NET INCOME PER COMMON SHARE. Net income per common share amounts are based on the weighted average common shares outstanding during the respective period. Primary and fully-diluted net income per common share are not presented as they result in a dilution of less than 3% from basic net income per common share. SPELLING ENTERTAINMENT GROUP INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 2. BUSINESS COMBINATIONS AND ACQUISITIONS In May 1991, the Company acquired approximately 27,200,000 shares (82%) of the common stock and all of the preferred stock ($25,000,000 liquidation value) of SEI for approximately $166,800,000 in cash and $22,745,000 principal amount of ten-year, 10% notes (see Note 4 ). The preferred stock and 14,000,000 of the common shares were purchased from Great American Communications Company ("GACC", an AFC affiliate) for approximately $107,500,000 in cash. In July 1992, the Company issued approximately $43,820,000 (5,843,000 shares) of Common Stock in exchange for the remaining publicly held SEI common shares. If the Company had owned 100% of SEI effective at the beginning of 1992, the unaudited pro forma results of operations of the Company for 1992 would have been as follows (in thousands, except per share amount): The pro forma results are not necessarily indicative of the results that would have been realized had the acquisition actually taken place on that date or of the results which may occur in the future. In December 1991, the Company acquired Hamilton Projects (a licensing and merchandising company) and ownership of certain television programming, and received $24,000,000 in cash, from GACC in exchange for its distribution rights to Hanna-Barbera's animated programming. No gain or loss was recognized from this transaction. See Note 4 regarding the acquisition of film distribution rights from Carolco Television, Inc. ("Carolco"), Note 11 regarding the disposition of assets related to the Company's discontinued operations and Note 15 regarding the Company's agreement to acquire Republic Pictures Corporation ("Republic"). SPELLING ENTERTAINMENT GROUP INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 3. FILM AND TELEVISION COSTS Film and television costs are comprised of the following at December 31 (in thousands): Film and television rights include the Company's acquisition from Carolco in September 1992 of the domestic television rights to more than 150 of Carolco's feature films. The purchase price for these rights, plus certain related receivables, was $50,000,000 in cash plus the assumption of approximately $14,000,000 of related liabilities. Film and television rights also include advances to producers for distribution rights and other film product not produced by the Company. Based on the Company's estimates of future gross revenue as of December 31, 1993, approximately 60% of unamortized released television costs and film and television rights will be amortized during the three years ending December 31, 1996. 4. DEBT Debt consisted of the following at December 31 (in thousands): SPELLING ENTERTAINMENT GROUP INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) In July 1992, SEI entered into a five-year bank credit agreement (the "Bank Agreement") which replaced a prior banking arrangement. The Bank Agreement provided for a term loan facility and a revolving credit facility, with a maximum aggregate availability of $90,000,000. The Bank Agreement contained certain restrictions on the ability of SEI to pay dividends to the parent company. The Bank Agreement was repaid and terminated in January 1994. In January 1994, the Company entered into a three-year credit agreement with BEC (the "BEC Facility"). The BEC Facility provides for (i) a three-year term loan facility of $100,000,000 to fund the Company's acquisition of Republic (see Note 15) and (ii) a revolving credit facility of $75,000,000 to fund the Company's working capital and other requirements. Under the BEC Facility, the Company pays an annual fee of 0.175 % of the unused portion of the revolving credit facility and certain facility and administration fees; interest on the revolving facility is payable at LIBOR plus 1.0%; and interest on the term loan will be at 6.625%. Borrowings under the BEC Facility are secured by all of the assets of the Company. In addition, the Company has agreed to guarantee the obligations of BEC under BEC's credit facility to the extent of the Company's borrowings from BEC under the BEC Facility. The fees and interest rate applicable to the revolving credit portion of the BEC Facility are subject to renegotiation should BEC's facility be terminated, repaid or restructured, and the entire amount outstanding under the BEC Facility may be accelerated if BEC's facility is accelerated by its lenders. The events which might result in an acceleration of BEC's facility include the consummation of BEC's merger with Viacom (see Note 15) without the receipt of a waiver from BEC's lenders. The Company has not been informed as to whether such waiver will be granted by BEC's lenders. However, the Company is currently exploring and believes it can obtain arrangements with third parties under terms and conditions which are not materially different from those contained in the BEC Facility. In February 1993, the Company redeemed its 12-1/4% Subordinated Notes. The Company prepaid all of the outstanding principal amount of its 10% Senior Subordinated Notes and paid or prepaid a substantial portion of its bank debt in October 1993, and redeemed all of the outstanding principal amount of its 12% Subordinated Debentures in November 1993. The Company made cash interest payments of $7,800,000 in 1993, $8,800,000 in 1992 and $7,000,000 in 1991. At December 31, 1993, the carrying value of all of the Company's term loans approximated fair value. SPELLING ENTERTAINMENT GROUP INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 5. EXTRAORDINARY ITEMS Details of the extraordinary items for the three years ended December 31 were as follows (in thousands): In connection with the early extinguishment of certain indebtedness in 1993 (see Note 4), the Company recorded an extraordinary loss from the write-off of unamortized discount and debt issuance costs relating to such debt. See Note 10 regarding the change in 1993 in the Company's method of accounting for income taxes. 6. PREFERRED STOCK At December 31, 1993, there were 20,000,000 shares of Preferred Stock authorized. 9,000 shares of Series A Preferred Stock had been issued by the Company with a dividend yield of 9% and a liquidation value of $1,000 per share. The Company redeemed all of the Series A Preferred Stock in November 1993. 7. COMMON STOCK The Company declared and paid cash dividends on its Common Stock of $.08, $.08 and $.05 for the years ended December 31, 1993, 1992 and 1991, respectively. SALE OF COMMON STOCK. In October 1993, in connection with the negotiation of the Republic merger (see Note 15), the Company sold 13,362,215 shares of its Common Stock to BEC in exchange for 3,652,542 shares of BEC's common stock. The BEC shares were subsequently sold, with the Company realizing approximately $100,445,000 in cash. STOCK OPTION PLAN. The Company has a stock option plan under which both incentive and nonqualified stock options may be granted to certain key employees and directors to purchase up to five million shares of Common Stock. Options may be granted at a price not less than the fair value of the underlying Common Stock on the date of grant, in the case of incentive stock options, or 50% thereof, in the case of nonqualified options. Each SPELLING ENTERTAINMENT GROUP INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) option may be granted subject to various terms and conditions established on the date of grant, including exercise and expiration dates; provided, however, that all options will expire no later than ten years from their date of grant. The options typically become exercisable at the rate of 20% to 25% annually, beginning one year after date of grant. In October 1992, the Company's shareholders approved amendments that provided for the issuance of options to purchase approximately one million shares of Common Stock to replace options to purchase an identical number of SEI common shares. Stock option data follows: 8. BENEFIT PLANS The Company maintained two defined contribution employee retirement plans which covered substantially all non-union employees of SEI. Contributions by SEI were discretionary or set by formula. Effective January 1, 1993, SEI adopted a new 401(k) Contribution Plan that replaced the two prior plans. Expenses under the various employee retirement plans were $463,000, $586,000 and $355,000 for the years ended December 31, 1993 and 1992 and eight months ended December 31, 1991, respectively. A significant number of the Company's production employees are covered by union sponsored, collectively bargained, multi-employer pension plans. The Company contributed approximately $4,259,000, $3,714,000, $1,383,000 for the years ended December 31, 1993 and 1992 and the eight months ended December 31, 1991, respectively. The FASB issued SFAS No. 106, "Employers' Accounting for Postretirement Benefits other than Pensions" (effective in 1993) and SFAS No. 112 "Employers' Accounting for Postemployment Benefits" (effective in 1994). The Company does not have any postretirement or postemployment benefits. SPELLING ENTERTAINMENT GROUP INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 9. RELATED PARTY TRANSACTIONS See Note 4 regarding the Company's credit facility with BEC and Note 7 regarding the Company's sale of Common Stock to BEC. From their issuance in May 1991 until their prepayment in October 1993 (see Note 4), a director of the Company held $18,287,500 principal amount of the Company's 10% Senior Subordinated Notes. The Company paid $1,791,000, $1,828,000, and $914,000 in interest (at 10%) on these obligations during 1993, 1992 and 1991, respectively. During 1993, the Company recorded revenue of approximately $3,100,000 from the sale of home videocassettes to BEC. During 1993 the Company paid AFC a premium of $5,000,000 for an insurance-type indemnity against up to $35,000,000 of certain costs it may have to pay (in excess of $25,000,000) in resolving environmental and bankruptcy related claims over a twelve year period. (See Note 11). BEC and AFC provided the Company with management services for which the Company was charged by AFC $1,283,000, $1,493,000 and $928,000 for the years ended December 31, 1993, 1992 and 1991, respectively. The amount charged by BEC in 1993 was $380,000. As of December 31, 1993 the Company had a net receivable from BEC of $1,930,000. 10. INCOME TAXES The provision for income taxes for continuing operations, discontinued operations and extraordinary items for each of the three years ending December 31 include (in thousands): SPELLING ENTERTAINMENT GROUP INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) Effective January 1, 1993, the Company adopted SFAS No. 109, "Accounting for Income Taxes" ("SFAS 109"). SFAS 109 requires an asset and liability approach in accounting for income taxes. Under this method, deferred income taxes are recognized, at enacted rates, to reflect the future effects of tax loss and credit ("tax attribute") carryforwards and temporary differences arising between the tax bases of assets and liabilities and their financial reporting amounts at each year-end. Deferred tax assets and liabilities are adjusted for tax rate changes when they occur. This statement also eliminated the concept of recognizing the benefits of subsequent period utilization of tax attribute carryforwards as extraordinary items, by requiring the immediate recognition of attributes in the year incurred, subject to realization. The cumulative effect of adopting SFAS 109 was not material. The temporary differences and tax attribute carryforwards which gave rise to deferred tax assets and liabilities at December 31, 1993 were as follows (in thousands): The components of income from continuing operations before the provision for income taxes in 1993 were as follows (in thousands): SPELLING ENTERTAINMENT GROUP INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) The primary reasons for the effective tax rates on the income from continuing operations differing from the statutory federal tax rates for each of the three years ended December 31 are summarized as follows: SPELLING ENTERTAINMENT GROUP INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) In connection with adopting SFAS 109, the Company established a valuation allowance against certain of its tax attribute carryforwards. During the year, the Company reassessed (under the criteria of SFAS 109) the realizability of the tax attribute carryforwards in light of factors arising from, or related to, the acquisition of a majority of the Company's Common Stock by BEC. Based on this reassessment, the Company reduced the valuation reserve by approximately $4,200,000 and reflected a corresponding benefit in its provision for income taxes for the third quarter of 1993. Under the "deferred" method previously used by the Company, income tax expense was determined giving effect to differences between income and expense for financial reporting and tax return purposes. The provision for income taxes in 1992 and 1991 included provisions for deferred taxes (primarily related to timing differences in the recognition of film revenue and costs) that would be required in the absence of tax attribute carryforwards. The tax benefit from utilization of such carryforwards was reflected as an extraordinary item in such years. Total cash income tax payments were $6,300,000, $4,100,000 and $5,200,000, respectively for 1993, 1992 and 1991. As of December 31, 1993, the Company had available net operating loss carryforwards of approximately $54,500,000, capital loss carryforwards of $9,500,000, foreign tax credit carryforwards of $3,401,000, investment tax credit carryforwards of $1,773,000 and AMT credit carryforwards of $2,147,000. The use of these attributes, which except for the AMT credit will expire in 1994 through 2007, is subject to certain limitations as a result of BEC's acquisition of a majority interest in the Company during 1993. SPELLING ENTERTAINMENT GROUP INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 11. DISCONTINUED OPERATIONS All of the Company's former business segments are reported as discontinued. A summary of financial data for discontinued operations for each of the three years ended December 31 follows (in thousands, except per share data): (a) Interest expense incurred prior to the acquisition of SEI which is attributable to discontinued operations. SPELLING ENTERTAINMENT GROUP INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) Net assets (liabilities) of discontinued operations which are held for disposition consisted of the following at December 31 (in thousands): In April 1991, the Company completed the sale of its 24.5% interest in an oil producing concession located in the Persian Gulf (the "Concession") to two Concession partners. The Company recognized a pretax gain of $13.4 million on the sale and received approximately $23.9 million in cash, which included the repayment of $6.1 million in advances made to the Concession in 1991. In December 1991, the Company's Board of Directors authorized management to sell the remaining oil operations. During July and August 1992, the Company sold the "Penndel Group", consisting of two oil group subsidiaries and its Philadelphia terminal facility, for approximately $17.7 million in cash. During December 1992 and January 1993, the Company's major utility supply contracts were sold. No material gain or loss resulted from the overall disposition of these operations. The Company received $50 million in preferred stock of the Circle K Corporation as partial consideration for the sale of its Marketing Group to Circle K in 1988. In May 1990, Circle K and its principal subsidiaries filed for protection under Chapter 11 of the United States Bankruptcy Code. The Company recorded a provision for impairment of $25 million in 1989 and an additional provision of $20 million in 1990. In December 1991, the Company sold the stock and recorded a $4.9 million pretax loss. CONTINGENCIES. The Company continues to be involved in a number of legal and other actions, including threatened claims and pending litigation from matters such as contract disputes, remaining disputed claims under the joint plan of reorganization of the Company and certain of its subsidiaries (the "Joint Plan"), environmental clean-up assessments, damages from alleged dioxin contamination and others. Some of these parties seek damages from the Company in very large amounts. The allowances for estimated losses on disposal and disputed claims set forth above include accruals with respect to these actions. While the results of such actions cannot be predicted with certainty, based upon its knowledge of the facts and circumstances and applicable laws, the Company believes the ultimate resolution of these matters should not have a material adverse effect on its financial condition and its results of operations. This belief is also based upon (i) allowances that have been established for SPELLING ENTERTAINMENT GROUP INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) estimated losses on disposal of former operations and remaining Chapter 11 disputed claims (see table above), and (ii) an insurance-type indemnity agreement with AFC. Substantial portions of such allowances are intended to cover environmental liabilities associated with the Company's former operations. Although there are significant uncertainties inherent in estimating environmental-related liabilities, based upon the Company's experience it is considered unlikely that the amount of possible environmental liabilities and Joint Plan disputed claims would exceed the amount of allowances by more than $50 million. The AFC indemnity, which was agreed to in exchange for a one-time payment of $5 million expensed by the Company as part of discontinued operations in the first quarter of 1993, provides for the reimbursement to the Company of certain costs it may have to pay in resolving environmental and bankruptcy related claims over a twelve year period. The indemnity covers up to $35 million of such liabilities in excess of a threshold amount of $25 million, subject to certain adjustments. (A) In December 1986, the Bankruptcy Court for the Middle District of Florida, Jacksonville Division, confirmed a Joint Plan of Reorganization under Chapter 11 of the Bankruptcy Code for the Company and four of its subsidiaries. There were $13.2 million of remaining Chapter 11 claims pending at December 31, 1993 (reduced from $111 million at December 31, 1986). To the extent such claims are allowed by the Bankruptcy Court, additional payments will be required under the Joint Plan. (B) A subsidiary of the Company, Independent Petrochemical Corporation ("IPC"), has been named as a defendant in a number of personal injury and property damage actions arising from the alleged improper disposal in 1971 of waste material, which was later determined to contain dioxin, at a number of sites in Missouri. These actions were brought by approximately 2,450 individual plaintiffs, the United States (U.S. v. Bliss, et al., U.S. District Court for the Eastern District of Missouri, filed January 20, 1984), the State of Missouri and certain codefendants. Substantially all of the claims by individuals against IPC have been settled by its insurers for an aggregate of approximately $33 million. Although IPC settled with United States and Missouri in 1993, agreeing to liability of $106 million plus future costs, the settlements provide that such amounts are collectible only from insurance potentially available to IPC. The Company has written off its investment in IPC. The Company and two other subsidiaries, Charter Oil Company ("Charter Oil") and Charter International Oil Company were joined as defendants in many of these actions and have settled the claims of (i) substantially all the individuals for $9.5 million, (ii) the United States for $5 million, and (iii) the State of Missouri for $1 million, principally to assure the feasibility of the Joint Plan of Reorganization at the time of its confirmation by the Bankruptcy Court in 1986. The Company, Charter Oil and IPC brought an action against their insurers to secure coverage for the dioxin claims (IPC v. Aetna, et al., U.S. District Court for the District of Columbia, SPELLING ENTERTAINMENT GROUP INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) filed November 9, 1983). On January 10, 1994, the court granted the insurers' motion for summary judgment based upon pollution exclusion language in their policies. Unless this decision is reversed on reconsideration or appeal, there will be no further insurance coverage for the dioxin claims. The only counterclaims that were filed in the coverage case, by two insurers seeking recovery of certain defense costs and $12 million of the settlement amounts they paid to individuals, have been dismissed voluntarily with prejudice. (C) The Company has had contact with various governmental agencies regarding possible contamination of soil and groundwater at eight properties that are or have been owned or leased by Company's subsidiaries. Private actions also have been brought or threatened with respect to such possible contamination at an additional five locations. The Company may be assessed for cleanup costs under relevant local, state or federal environmental laws, and future claims could be asserted with respect to other formerly owned or leased properties. Notification of possible responsibility has also been received regarding twelve other sites where waste materials allegedly were delivered. The Company's liability insurers have been placed on notice of many of these claims and have taken the position that there is no coverage under their policies. While the Company does not agree that coverage is not available under its past policies, there is no assurance that pending or future claims will be covered by such insurance. Although comprehensive evaluations of liability and of the extent of contamination have not been performed in all cases, the following claims are believed by the Company at this time to be the most significant. A subsidiary has begun the cleanup of a petroleum terminal property owned by the subsidiary in Tiverton, Rhode Island. The estimated remaining cost is $8 million, which has been fully accrued. The subsidiary is investigating whether former owners or insurers may be liable for a portion of the cost. In 1990, a subsidiary declined to join a settlement agreement among the United States, a state government and 15 companies regarding the Sullivan's Ledge superfund site in New Bedford, Massachusetts, based upon certain legal defenses and the belief that any liability the subsidiary may have should be less than a pro rata allocation among the settling parties. Under the proposed agreement, the subsidiary would have been obligated to pay between $2 million and $3 million in cleanup costs. The subsidiary subsequently has agreed with the United States to settle its potential liability for $215,000, subject to court approval. The settlement, which is being objected to by members of the prior settling group, will be asserted by the subsidiary as a defense to any private cost recovery action filed by the group. A subsidiary has been informed that it is one of thirteen identified potentially responsible parties at the Sikes superfund site in Crosby, Texas, and that a cleanup plan estimated to cost approximately $89 million has been selected and is being implemented by the EPA. Although joint and several liability is possible with respect to such sites, and there is little relevant information presently available, management believes that there are meritorious defenses against any material liability. SPELLING ENTERTAINMENT GROUP INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) An unaffiliated company has suggested that a subsidiary of the Company is one of 18 potentially responsible parties at the Petro-chemical Systems superfund site in Liberty County, Texas, at which the EPA has selected a cleanup plan estimated to cost approximately $26 million. Bankruptcy defenses will be relevant to possible cost recovery actions by the EPA or other parties concerning this site. PENSION PLAN. The Company has a noncontributory, defined benefit pension plan which covers employees of the discontinued operations, a significant number of which have vested benefits. Contributions are made on an actuarial basis in amounts primarily based on employees' years of service and average salary when employed. At December 31, 1992 and 1991, the plan assets exceeded the projected benefit obligation by $2.5 million and $2.3 million, respectively. In 1993, the Company recorded an additional minimum pension liability of $5,217,000 (net of a tax benefit of $3,321,000), with an offsetting charge to Shareholders' Equity, to reflect the adjustment to pension liability resulting from the reduction in the discount rate from 8.5% in 1992 to 7% in 1993. The following table sets forth the plan's funded status and amounts recognized as of December 31, 1993 (in thousands): Net pension cost for 1993 which was charged against net liabilities related to discontinued operations in the balance sheet (in thousands): The weighted-average discount rate and the rate of increase in future compensation levels used in determining the actuarial present value of the projected benefit obligation were 7% and 6.25%, respectively. The expected long-term rate of return on assets was 9%. The plan assets are invested primarily in fixed income securities. Included in the plan assets at December 31, 1993 and 1992, was $5.5 million principal amount of AFC 12.25% debentures due 2003. SPELLING ENTERTAINMENT GROUP INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 12. COMMITMENTS AND CONTINGENCIES The Company continues to be involved in a number of legal and other actions including threatened claims and pending litigation. While the results of such actions cannot be predicted with certainty, based upon its knowledge of the facts and circumstances and applicable laws, the Company believes that the ultimate resolution of all disputed claims, pending litigation and threatened claims will not have a material adverse effect on its financial condition or its results of operations. See Note 11 for contingencies relating to discontinued operations. As of December 31, 1993, SEI had operating leases for offices and equipment. The rental expense for the years ended December 31, 1993 and 1992, and eight months ended December 31, 1991, was $4.5 million, $4.0 million and $1.8 million, respectively. The future minimum annual rental commitments under non-cancelable operating leases, excluding renewal options, for the subsequent five years and thereafter for continuing operations are as follow (in thousands): SPELLING ENTERTAINMENT GROUP INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 13. QUARTERLY OPERATING RESULTS (UNAUDITED) The following table presents quarterly results of operations for the years ended December 31, 1993 and 1992 (in thousands, except per share data). (a) Certain reclassifications have been made in the financial statements to the prior presentations of revenue; selling, general and administrative expense; interest income; and other expense. In this table, only revenue is affected by these reclassifications. SPELLING ENTERTAINMENT GROUP INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 14. BUSINESS SEGMENTS The Company's continuing business activities consist of one business segment. The Company had revenue from one customer in 1993, 1992 and 1991 representing 22%, 22% and 13% of revenue, respectively. Net assets, capital expenditures and depreciation outside the United States were not material in relation to consolidated amounts. International revenue is earned primarily from television and theatrical distribution and home video sales; substantially all of such revenue is earned under license agreements denominated in U.S. dollars. International export revenue by major geographic area follows for the years ended December 31 (as a percentage of total revenue): (*) Specific sources not available 15. SUBSEQUENT EVENTS On September 12, 1993, the Company and Republic entered into an agreement in principle pursuant to which the Company agreed to acquire by merger all of Republic's outstanding common stock for $13 per share in cash. Additionally, options and warrants to acquire Republic common stock outstanding prior to the merger will be converted into the right to receive, upon payment of the exercise price, 1.6508 shares of the Company's Common Stock for each share of Republic common stock into which such option or warrant was exercisable. The definitive merger agreement was signed by the Company and Republic on December 7, 1993. The actual merger is expected to be consummated in the second quarter of 1994, with the shareholders of Republic receiving a total consideration of approximately $100,000,000 in cash. In January 1994, BEC entered into a merger agreement pursuant to which BEC has agreed to merge with and into Viacom, Inc. ("Viacom") with Viacom being the surviving corporation. Under the terms of the agreement each share of BEC's common stock shall be converted into the right to receive .08 shares of Viacom Class A common stock, .60615 shares of Viacom Class B common stock and under certain circumstances, up to an additional .13829 shares of Viacom Class B common stock. Upon the closing of the merger, which closing is subject to customary conditions including approval of the merger by the BEC's shareholders, Viacom would own a majority of the Company's Common Stock. The Company entered into a credit facility with BEC in January 1994; see Note 4. SPELLING ENTERTAINMENT GROUP INC. SCHEDULE II -- AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS AND EMPLOYEES OTHER THAN RELATED PARTIES THREE YEARS ENDED DECEMBER 31, 1993 (IN THOUSANDS) (a) Individual ceased being an employee during the year. (b) Represents secured receivables of SEI acquired in 1991. Represents loans made for the purchase of personal residences in connection with relocations. The notes bear interest at 8% and each was secured by trust deeds on the property. SPELLING ENTERTAINMENT GROUP INC. SCHEDULE VIII--VALUATION AND QUALIFYING ACCOUNTS YEAR ENDED DECEMBER 31, (IN THOUSANDS) (a) During 1993, all reserves for disputed claims and other items were reclassed into losses on disposal and disputed claims. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE On June 1, 1993, the Company replaced Ernst & Young with Arthur Andersen & Co. as its independent accountants. The decision to replace Ernst & Young was approved by the Board of Directors of the Company. The report of Ernst & Young dated March 19, 1993 relating to the Consolidated Financial Statements of the Company for the two years ended December 31, 1992 contained no adverse opinion or disclaimer of opinion and was not qualified or modified as to uncertainty, audit scope or accounting principle. In connection with its audit of the Company for the year ended December 31, 1992 and through May 31, 1993, there have been no disagreements with Ernst & Young on any matter of accounting principles or practices, financial statement disclosure or auditing scope or procedure, which disagreement if not resolved to the satisfaction of Ernst & Young would have caused them to make reference thereto in their financial report on the financial statements for such years. _____________________________________________ PART III The information required by the following items will be included in the Company's definitive Proxy Statement, which will be filed with the Securities and Exchange Commission in connection with the 1994 Annual Meeting of Shareholders, and is incorporated herein by reference: 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 _____________________________________________ 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 are included in Part II, Item 8. 2. Financial Statement Schedules: A. Selected Quarterly Financial Data is included in Note 13 to the Company's Consolidated Financial Statements B. Schedules filed herewith for 1993, 1992 and 1991: All other schedules for which provisions are made in the applicable regulation of the Securities and Exchange Commission have been omitted as they are not applicable, not required, or the information required thereby is set forth in the Consolidated Financial Statements or the notes thereto. 3. Exhibits - see Exhibit Index on page 61. (b) Reports on Form 8-K: (1) Form 8-K dated October 5, 1993 related to the consummation of the sale of 13,362,215 shares of the Company's Common Stock to a subsidiary of Blockbuster Entertainment Corporation. (2) Form 8-K dated December 8, 1993 related to the Definitive Agreement and Plan of Merger with Republic Pictures Corporation. (3) Form 8-K dated January 31, 1994 related to the Credit Agreement with Blockbuster Entertainment 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. SPELLING ENTERTAINMENT GROUP INC. Date: By: /s/ H. STEVEN R. BERRARD ------------------------------- Steven R. Berrard 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. Date: By: /s/ H. WAYNE HUIZENGA ------------------------------- H. Wayne Huizenga Chairman of the Board By: /s/ AARON SPELLING ------------------------------- Aaron Spelling Vice Chairman of the Board By: /s/ STEVEN R. BERRARD ------------------------------- Steven R. Berrard President and Chief Executive Officer (Principal Executive Officer) By: /s/ THOMAS P. CARSON ------------------------------- Thomas P. Carson Senior Vice President, Treasurer and Chief Financial Officer (Principal Financial Officer) By: /s/ KATHLEEN COUGHLAN -------------------------------- Kathleen Coughlan Vice President and Corporate Controller (Principal Accounting Officer) By: /s/ JOHN T. LAWRENCE -------------------------------- John T. Lawrence Director By: /s/ S. CRAIG LINDNER -------------------------------- S. Craig Lindner Director By: /s/ ALFRED W. MARTINELLI -------------------------------- Alfred W. Martinelli Director By: /s/ JOHN L. MEUTHING -------------------------------- John L. Meuthing Director SPELLING ENTERTAINMENT GROUP INC. INDEX TO EXHIBITS

40834_1993.txt

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ITEM 1. Business General Developments General Signal Corporation, incorporated in New York in 1904, produces instrumentation and controls and related systems and equipment for industrial automation, management of electrical energy, telecommunications transmission, transportation, and test and measurement equipment. The company serves these markets through three product sectors: Process Controls, Electrical Controls and Industrial Technology. During 1993, the company issued 4.1 million additional shares of common stock, completed a two-for-one split of common stock, acquired Revco Scientific, Inc. by issuing 2.6 million shares of common stock and completed the divestiture of substantially all of the semiconductor equipment operations. During the last five years, the company expended approximately $224 million in cash and common stock (2.6 million shares) to acquire 20 businesses and/or product lines. The notes to the financial statements on pages 29 and 30 of the Shareholders' Report provide additional information for acquisitions during the last three years and is incorporated herein by reference. Financial Information about Business Segments Selected business segment information for the last five fiscal years is summarized on page 31 of the Shareholders' Report and is incorporated herein by reference. In addition to the information disclosed with respect to business segments, the Securities and Exchange Commission requires the disclosure of any class of similar products or services that exceeds 10 percent of consolidated sales. During 1992 and 1991, sales of the company's semiconductor equipment group (including sales of units held for disposition) were approximately $135.0 million or 8 percent and $180.2 million or 11 percent of consolidated sales, respectively. A summary of information by geographic area for the last five fiscal years is included on page 32 of the Shareholders' Report and is incorporated herein by reference. Narrative Description of Business Major Markets and Products and Method of Distribution A narrative description of the registrant's business is included on pages 4 through 13 of the Shareholders' Report and is incorporated herein by reference. The company's products are sold by its own sales organization and through distributors and manufacturers' representatives. Materials and Supplies The company manufactures many of the components used in its products but it also purchases a variety of basic materials and component parts. Although some basic materials and components have been and may be in short supply from time to time, the company believes that generally it will be able to obtain adequate supplies of major items or reasonable substitutes. Patents The company holds many patents and has continued to secure other patents that cover many of its products. While patents are important in the aggregate to the company's competitive position, the loss of any single patent, patent application or patent license agreement, or group thereof, would not materially affect the conduct of its business as a whole. The company is both a licensor and licensee of patents, and overall, recognizes more income than expense from such arrangements. Working Capital A discussion of working capital is included on pages 16 and 17 of the Shareholders' Report and is incorporated herein by reference. Backlog The amount of unfilled orders was approximately $380.5 million in 1993 and $407.5 million in 1992 (excluding unfilled orders of businesses sold or discontinued). All unfilled orders are expected to be filled within the next succeeding year. Competition Although the businesses of the company are highly competitive, the competitive position cannot be determined accurately in the aggregate since none of its competitors offer all of the same product lines or serve all of the same markets, nor are reliable comparative figures available for its competitors. Competition for computer-directed control systems comes primarily from a relatively small number of large and well established concerns. In the other product groups, competition comes from numerous concerns, both large and small. The principal methods of competition are price, service, product performance and technical innovation. These methods vary with the type of product sold. The company believes that it can compete effectively on the basis of each of these factors as they apply to the various products offered. Research and Development Research and development expenditures for the last three years are included on page 33 of the Shareholders' Report and are incorporated herein by reference. Environmental Matters The company is involved in various stages of investigation and remediation relative to environmental protection matters, arising from its own initiative, from indemnification of purchasers of divested operations, or from legal or administrative proceedings, some of which include waste disposal sites. In certain instances, the company may be exposed to joint and several liability for remedial action or damages. The company, along with several other entities, has been named as a Potentially Responsible Party for remedial costs at certain third-party sites listed on the National Priorities List under CERCLA. The potential costs related to such matters and the possible impact on future operations are uncertain due in part to the complexity of government laws and regulations and their interpretations, the varying costs and effectiveness of cleanup technologies, the uncertain level of insurance or other types of recovery, and the questionable level of the company's responsibility. In management's opinion, after considering reserves established for such purposes, remedial actions for compliance with the present laws and regulations governing the protection of the environment are not expected to have a material adverse impact on the company's results of operations or financial position. Employees At December 31, 1993, the company had approximately 12,900 employees, excluding employees of businesses held for sale. Approximately 3,600 employees are represented by 23 different collective bargaining units. The company has generally experienced satisfactory labor relations at its various locations. Executive Officers of the Registrant Name, Position, and Other Information Age Edmund M. Carpenter, Chairman and Chief Executive Officer 53 since May 1, 1988. Previously, Director, President and Chief Operating Officer of ITT Corporation since 1985. Prior to joining ITT Corporation in 1981, President of Kelsey-Hayes Company, a subsidiary of Fruehauf Corporation. Joel S. Friedman, Senior Vice President - Operations since 57 March 1, 1987. Previously, Group Executive and President of Lightnin, a unit of General Signal, since 1984 and President of O-Z/Gedney, a unit of General Signal, since 1975. Peter A. Laing, Senior Vice President - Operations since 54 March 1, 1987. Previously, Group Executive and President of the Edwards Company, a unit of General Signal, since 1984, President of the Edwards Company since 1978, and Vice President - Finance of General Railway Signal, since 1974. Stephen W. Nagy, Senior Vice President - Finance and Chief 54 Financial Officer since October 1, 1989. Previously, Vice President - Finance and Chief Financial Officer of Trinova Corporation since 1983. George Falconer, Vice President - Human Resources since 62 October 23, 1986. Previously, Director of Human Resources since 1981, Director of Industrial Relations since 1977, and Corporate Director of Personnel Relations since 1976. Associated with Metal Forge, a unit of General Signal, since 1970, most recently as Vice President - Employee Relations. Nino J. Fernandez, Vice President - Investor Relations 53 since May 1, 1987. Previously, Director of Communications since 1974. Philip A. Goodrich, Vice President - Corporate Development 38 since December 12, 1991. Previously, Director of Corporate Development since May, 1989 and Assistant Treasurer since May, 1987. Prior to joining the company, associated with Joseph E. Seagram & Sons, Inc. since 1981 most recently as Assistant Treasurer. Darryl A. Littleton, Vice President - Manufacturing since 45 February 5, 1992. Previously, Senior Partner and Director of Ingersoll Engineers, Inc. since 1984. Terry J. Mortimer, Vice President and Controller since May 25, 49 1990. Previously Director - Finance and Chief Accountant for Apple Computer since June, 1988. Previously with Becton Dickinson and Company from January, 1981 to June, 1988, most recently as Medical Sector Controller. Edgar J. Smith, Jr., Vice President, General Counsel, and 60 Secretary since April 19, 1984, Vice President and General Counsel since January 1, 1980. Previously Assistant General Counsel since 1967. Thomas E. Taylor, Vice President-Taxes since September 1, 1993. 48 Previously with Elf Aquitaine, Inc. as Vice President-Taxes since 1985. Julian B. Twombly, Vice President and Treasurer since December 48 17, 1991. Prior to joining the company, associated with United Dominion Industries, Ltd. since 1974, most recently as Senior Vice President and Treasurer. The executive officers are elected annually by the Board of Directors. There are no family relationships between any of the directors or executive officers of the company. ITEM 2. ITEM 2. Properties The Process Controls sector's operations consist of 40 manufacturing facilities in 16 states and 9 foreign countries, containing approximately 4.5 million square feet, of which 86% is owned and 14% is leased. The Electrical Controls sector's operations consist of 34 manufacturing facilities in 15 states and 5 foreign countries, containing approximately 2.5 million square feet, of which approximately 69% is owned and 31% is leased. The Industrial Technology sector's operations consist of 10 manufacturing facilities in 8 states, containing approximately 1.0 million square feet, of which approximately 80% is owned and 20% is leased. In addition to manufacturing plants, the company as lessee occupies executive offices in Stamford, Connecticut, and various sales and service locations throughout the world. All of these properties, as well as the related machinery and equipment, are considered to be well-maintained, suitable and adequate for their intended purposes. Assets subject to lien are not significant. As a result of recent business divestitures and restructuring activities, the company holds 1.1 million square feet of idle facilities for sale or sublease. ITEM 3. ITEM 3. Legal Proceedings The company and certain of its subsidiaries are defendants in legal proceedings incidental to its business. Although the ultimate disposition of these proceedings is not presently determinable, management does not expect the outcome to have a material adverse impact on the company's financial position. 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 Stock and Related Shareholder Matters The company's common stock is listed on the New York and Pacific stock exchanges under the symbol "GSX". Information as to quarterly prices for the last two years, and dividends paid is included on page 33 of the Shareholders' Report and is incorporated herein by reference. There were approximately 9,434 holders of record of the company's common stock on March 7, 1994. ITEM 6. ITEM 6. Selected Financial Data Selected financial data of the company for the last five fiscal years are incorporated herein by reference to pages 34 and 35 of the Shareholders' Report. 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" appears on pages 14 through 17 of the Shareholders' Report and is incorporated herein by reference. ITEM 8. ITEM 8. Financial Statements and Supplementary Data The financial statements and related notes are incorporated herein by reference to pages 19 through 33 of the Shareholders' Report. Quarterly financial information is incorporated herein by reference to page 32 of the Shareholders' Report. The Report of Independent Auditors, dated January 25, 1994, is incorporated herein by reference to page 18 of the Shareholders' Report. 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 This information is incorporated herein by reference to pages 5 through 7 of the Proxy Statement for the 1994 annual meeting of shareholders. Also see page 2 of this 10-K as to information related to executive officers. ITEM 11. ITEM 11. Executive Compensation This information is incorporated by reference to pages 13 through 14 of the Proxy Statement for the 1994 annual meeting of shareholders. ITEM 12. ITEM 12. Security Ownership of Certain Beneficial Owners and Management This information is incorporated by reference to pages 2 through 4 of the Proxy Statement for the 1994 annual meeting of shareholders. ITEM 13. ITEM 13. Certain Relationships and Related Transactions Not applicable. PART IV ITEM 14. ITEM 14. Exhibits, Financial Statements, Schedules, and Reports on Form 8-K (a) (1) Financial Statements and Other Financial Data. The financial statements of the company and consolidated subsidiaries are incorporated herein by reference to pages 19 through 33 of the Shareholders' Report. The Independent Auditors' Report of Ernst & Young, dated January 25, 1994, is incorporated herein by reference to page 18 of the Shareholders' Report. (2) Schedules and Report of Independent Auditors. Page Report of KPMG Peat Marwick . . . . . . . . . . . . . 6 Schedule VIII- Valuation and Qualifying Accounts . . 7 Schedule IX - Short Term Borrowings . . . . . . . . . 7 All other schedules are omitted as the required information is not applicable or the information is presented in the financial statements or related notes. (3) Exhibits. 3.1 Restated Certificate of Incorporation of General Signal Corporation, as amended through April 27, 1988, is incorporated herein by reference to Exhibit 3.1 of the registrant's 1988 Form 10-K filed March 17, 1989. 3.2 By-laws of General Signal Corporation, as amended through February 3, 1994. 4.1 Copies of the instruments with respect to the company's long-term debt are available to the Securities and Exchange Commission upon request. 4.2 Copies of the Credit Agreements among General Signal Corporation and Various Commercial Banking Institutions, as amended through January 12, 1994, as described in the Notes to Financial Statements incorporated herein by reference in (a)(1) above, are available to the Securities and Exchanges Commission upon request. 10.1 Description of General Signal Corporation Incentive Compensation Plan is incorporated herein by reference to Exhibit 10.1 of the registrant's 1991 Form 10-K filed March 25, 1992. 10.2 Retirement Plan for Directors of General Signal Corporation is incorporated herein by reference to Exhibit 10.7 of the registrant's 1988 Form 10-K filed March 17, 1989. 10.3 General Signal Corporation Change in Control Severance Pay Plan, as amended, is incorporated herein by reference to Exhibit 10.8 of the registrant's 1989 Form 10-K filed March 16, 1990. 10.4 General Signal Corporation Deferred Compensation Plan dated October 14, 1993. 10.5 General Signal Corporation Benefit Equalization Plan as amended and restated October 14, 1993. 10.6 General Signal Corporation 1992 Stock Incentive Plan as amended and restated July 7, 1993. 10.7 General Signal Corporation 1989 Stock Option and Incentive Plan as amended July 7, 1993. 10.8 General Signal Corporation 1985 Stock Option Plan as amended and restated July 7, 1993. 10.9 General Signal Corporation 1981 Stock Option Plan as amended and restated July 7, 1993. 10.10 Consulting Agreement with Nathan R. Owen is incorporated herein by reference to Exhibit 10.10 of the registrant's 1986 Form 10-K filed March 30, 1987. 10.11 Employment agreement between Edmund M. Carpenter and the registrant dated April 15, 1988 is incorporated herein by reference to Exhibit 10.12 of the registrant's 1988 Form 10-K filed March 17, 1989. 10.12 Employment agreement between Stephen W. Nagy and the registrant dated August 17, 1989 is incorporated herein by reference to Exhibit 10.11 of the registrant's 1989 Form 10-K filed March 16, 1990. 11.0 Computation of Earnings per Share. See page 8 of this report. 12.0 Calculation of Ratios of Earnings to Fixed Charges. See page 9 of this report. 13.0 1993 Annual Report to Shareholders. Except for those portions specifically incorporated herein by reference, the company's 1993 Annual Report to Shareholders is furnished for the information of the Commission and is not deemed to be "filed." Pages 14 through 35, including the Independent Auditors' Report on page 18, are specifically incorporated herein by reference. 21.0 Subsidiaries. See pages 9 through 11 of this report. 23.0 Consent of Ernst & Young. See page 12 of this report. 24.1 Consent of KPMG Peat Marwick. See page 12 of this report. (b) Reports on Form 8-K. 1. A report on Form 8-K was filed on June 17, 1993, reporting the July 7, 1993 two-for-one stock split of the company's common stock in the form of a 100 percent stock distribution. 2. A report on Form 8-K was filed on February 4, 1994, reporting the company's results of operations for the quarter and year ended December 31, 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. GENERAL SIGNAL CORPORATION /s/ Edmund M. Carpenter (Edmund M. Carpenter, Chairman) March 17, 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 /s/ Edmund M. Carpenter (Edmund M. Carpenter) Chairman and Director March 17, 1994 (Principal Executive Officer) /s/ Stephen W. Nagy (Stephen W. Nagy) Senior Vice President March 17, 1994 and Chief Financial Officer /s/ Terry J. Mortimer (Terry J. Mortimer) Vice President and March 17, 1994 Controller (Chief Accounting Officer) /s/ Ralph E. Bailey (Ralph E. Bailey) Director March 17, 1994 /s/ Van C. Campbell Van C. Campbell) Director March 17, 1994 /s/ Ronald E. Ferguson (Ronald E. Ferguson) Director March 17, 1994 /s/ John P. Horgan (John P. Horgan) Director March 17, 1994 /s/ C. Robert Kidder (C. Robert Kidder) Director March 17, 1994 /s/ Richard J. Kogan (Richard J. Kogan) Director March 17, 1994 /s/ Nathan R. Owen (Nathan R. Owen) Director March 17, 1994 /s/ Roland W. Schmitt (Roland W. Schmitt) Director March 17, 1994 /s/ John R. Selby (John R. Selby) Director March 17, 1994 INDEPENDENT AUDITORS' REPORT The Board of Directors and Shareholders General Signal Corporation We have audited the accompanying statements of earnings, shareholders' equity, and cash flows of General Signal Corporation and consolidated subsidiaries for the year ended December 31, 1991 (prior to the acquisition of Revco Scientific, Inc.) 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 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 included 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 the cash flows of General Signal Corporation and consolidated subsidiaries for the year ended December 31, 1991 (prior to the acquisition of Revco Scientific, Inc.) in conformity with generally accepted accounting principles. /s/ KPMG Peat Marwick Stamford, Connecticut January 24, 1992 GENERAL SIGNAL CORPORATION AND CONSOLIDATED SUBSIDIARIES Schedule VIII - Valuation and Qualifying Accounts Years Ended December 31, 1993, 1992 and 1991 ($ in thousands) Additions charged Balance at(credited) to Balance at beginning cost and end of of period expense Deductions period Reserves deducted from assets: Allowance for doubtful accounts $8,882 $4,608 $2,968(1) $10,522 Assets held for sale 18,600 -- 4,223(3) 14,377 Dispositions and re- structuring: Transaction and consol- idation of Revco -- 13,200 4,416(4) 8,784 Semiconductor 57,301 (53,200) 38,400(4) 13,348 (47,647)(5) Restructuring -- 30,500 17,489 (4) 13,011 57,301 (9,500) 12,658 35,143 Reserves deducted from assets: Allowance for 6,445(1) doubtful accounts $11,074 5,502 1,249(2) $8,882 Assets held for sale -- 18,600 -- 18,600 Dispositions and restructuring -- 67,000 9,699(4) 57,301 Reserves deducted from assets: Allowance for doubtful accounts $10,662 5,748 5,336(1) $11,074 (1) Write-off of bad debts, net of recoveries. (2) Transfer of semiconductor equipment operations allowance for doubtful accounts to assets held for sale at October 1, 1992. (3) Charges to reserve related to businesses divested during 1993. (4) Charges to reserve for related costs incurred during the year. (5) Represents primarily gain on disposal of businesses divested during 1993. (1) Actual interest expense on short-term borrowings for the year divided by average short-term borrowings outstanding during the year. (2) Annual interest expense on short-term borrowing divided by the year-end balance. Exhibit (11.0) GENERAL SIGNAL CORPORATION AND CONSOLIDATED SUBSIDIARIES Computation of Earnings Per Share (Amounts in thousands, except per share data) Year Ended December 31, 1993 1992 1991 I. Earnings (loss) per share of common stock (used for financial reporting): Net earnings (loss): Continuing operations $ 66,596 $ 12,465 $63,957 Loss on disposal of discontinued operations --- --- (9,800) Extraordinary charges (6,576) (330) --- Cumulative effect of accounting changes (25,300) (92,400) --- Net Earnings (loss) $34,720 $(80,265) $54,157 Average number of common shares outstanding (a) 45,205 41,753 38,572 Earnings (loss) per average share of common stock: Continuing operations $1.47 $.30 $1.66 Loss on disposal of discontinued operations --- --- (.26) Extraordinary charges (0.14) (0.01) --- Cumulative effect of accounting changes (0.56) (2.21) --- $0.77 $(1.92) $1.40 II. Primary earnings per share (b) (including common stock equivalents): Average number of common shares outstanding 45,205 41,753 38,572 Dilutive effect of outstanding options (as determined by application of the treasury stock method) 263 298 38 Total shares used in calculation of primary earnings per share 45,468 42,051 38,610 Primary earnings (loss) per share: Continuing operations $1.46 $.30 $1.66 Loss on disposal of discontinued operations --- --- (.26) Extraordinary charges (.14) (.01) --- Cumulative effect of accounting changes (.56) (2.20) --- $0.76 $(1.91) $1.40 III. Fully diluted earnings per share (b): Average number of shares used in calculation of primary earnings per share above 45,468 42,051 38,610 Additional dilutive effect of outstanding options (as determined application of the treasury stock method) 36 74 190 Total shares used in calculation of fully diluted earnings per share 45,504 42,125 38,800 Fully diluted earnings (loss) per share: Continuing operations $1.46 $0.30 $1.65 Loss on disposal of discontinued operations --- --- (0.25) Extraordinary charges (0.14) (0.01) --- Cumulative effect of accounting changes (0.56) (2.19) --- $0.76 $(1.90) $1.40 (a) Excludes common stock equivalents in accordance with provisions of APB Opinion No. 15 because such equivalent shares result in dilution of less than 3%. (b) This calculation is presented in accordance with Regulation S-K although the effect of the options deemed to be common stock equivalents is antidilutive in 1992. Exhibit (12.0) GENERAL SIGNAL CORPORATION Calculation of Ratios of Earnings to Fixed Charges ($ in thousands) Year Ended December 31, 1989 1990 1991 1992 1993 Earnings: Earnings (loss) from continuing operations before income taxes and extraordinary items $108,482 $(25,193) $89,451 $18,786 $94,398 Add: fixed charges 54,526 47,724 40,626 37,029 23,440 $163,008 $22,531 $130,077 $55,815 $117,838 Fixed charges: Interest expense $44,759 $37,557 $32,193 $28,629 $18,240 One-third of rent expense 9,767 10,167 8,433 8,400 5,200 $54,526 $47,724 $40,626 $37,029 $23,440 Ratio 2.99 .47 (1)3.20 1.51 5.03 (1) Earnings are inadequate to cover fixed charges by an amount of approximately $25 million. Exhibit (21.0) SUBSIDIARIES OF REGISTRANT Percent Organized Under the 1. Consolidated Subsidiaries Owned Laws of Subsidiaries of General Signal Corporation: Aurora/Hydromatic Pumps Inc. 100 Delaware Borri Elettronica Industriale S.p.A. 100 Italy Subsidiary of Borri Elettronica Industriale S.p.A. Borri Stromversorgunanlagen GMBH 100 Germany DeZurik of Australia Proprietary Ltd. 100 Australia GCA Europa S.A. 100 France GCA International Corporation 100 New Jersey G. S. Building Systems Corporation 100 Connecticut Subsidiaries of G. S. Building Systems Corporation: Dual-Lite Manufacturing, Inc. 100 Delaware General Signal FSC Corp 100 Virgin Islands General Signal Holdings Company 100 Delaware Subsidiary of General Signal Holdings Company General Signal Technology Corporation 100 Delaware Subsidiaries of General Signal Technology Corporation: Assembly Technologies - AP, Inc. 100 Delaware General Farebox Service of Atlanta, Inc. 100 Delaware GFI Service of Chicago, Inc. 100 Delaware GFI Service of New York, Inc. 100 Delaware General Signal Japan Corporation 100 Japan General Signal SEG Korea 100 Korea Revco Scientific, Inc. 100 Delaware General Signal Kabushiki Kaisha 100 Japan General Signal Limited 100 Canada General Signal SEG Asia, Ltd. 100 Hong Kong General Signal S.E.G. SARL 100 France General Signal UK Limited 100 England Subsidiaries of General Signal UK Limited: DeZurik International Ltd. 100 England GCA Limited 100 England G.S. Iona Ltd. 100 England General Signal SEG, Ltd. 100 England Leeds & Northrup Limited 100 England Lightnin Europe Limited 100 England Lightnin Mixers Limited 100 England Subsidiaries of Lightnin Mixers Ltd.: Deutsche Lightnin Jesse Mischtechnik Verwaltungsgesellschaft mbH 90 Germany (Remaining 10% owned by General Signal Corporation Inc.) Turbo - Maschinenbau G.m.b.H. 100 Germany Turbo - Lightnin Mischtechnik GmbH & Co. KG 100 Germany Sola (UK) Limited 75 England Tau-Tron (UK) Limited 100 England Telenex Europe Limited 100 England Leeds & Northrup Company 100 Delaware Subsidiaries of Leeds & Northrup Company: Leeds & Northrup Australia Pty., Ltd. 100 Australia Subsidiary of Leeds & Northrup Australia Pty., Ltd.: Leeds & Northrup(New Zealand)Ltd. 100 New Zealand Leeds & Northrup GmbH 100 Germany Leeds & Northrup Mexicana, S.A. 100 Mexico Leeds & Northrup S.A. 100 Spain LDN, Ltd. 100 Delaware Subsidiary of LDN, Ltd. Leeds & Northrup S.A.R.L. 100 France L.D.N. Netherlands, B.V. 100 Netherlands L&N Singapore, Pte., Ltd. 100 Singapore Leeds & Northrup Italy, S.p.A. 53 Italy (47% owned by Leeds & Northrup Company; Lightnin Mixers Pty. Ltd. 60 Australia (Remaining 40% owned by General Signal Ltd.) Lightnin Pte. Ltd. 100 Singapore Metal Forge Company, Inc. 100 Delaware Shenyang Stock Electric Power Equipment Company, Limited 100 China Sola Australia, Limited 100 Australia Sola Electric AG 100 Switzerland Stock Japan, Ltd. 100 Japan Telenex Corporation 100 New Jersey 2.Other Subsidiaries The following minor foreign subsidiaries and the investment in 50-percent-or-less owned companies, which are not material individually or in the aggregate in relation to the financial statements, are carried at cost plus equity in undistributed earnings since acquisition. Subsidiaries of General Signal Corporation: DeZurik - India 40 India DeZurik Japan Co., Ltd. 48 Japan DeZurik Mexico, S.A. de C.V. 49 Mexico General Signal Acquisition Corporation 100 Delaware General Signal Corporation 100 Delaware General Signal International Corporation 100 Delaware HMS Ventures Ltd. 14 California High Ridge Company, Limited 100 Bermuda Industrias Sola Basic, S.A. 49 Mexico Koyo Lindberg Ltd. 50 Japan New Signal, Inc. 100 Delaware Solamex, S.A. de C.V. 48 Mexico Subsidiary of Solamex, S.A. de C.V.: Industrial GESCA S.A.deC.V. 99 Mexico Inmobiliaria S-Tres, S.A.deC.V. 99 Mexico Inmobiliaria S-Dos, S.A.deC.V. 99 Mexico Inmobiliaria Solamex, S.A. de C.V. 99 Mexico Productora Y Maquiladora Queretana S.A.deC.V. 99 Mexico Solenergy Corporation 30 Massachusetts Terasaki Nelson Ltd. 50 Japan Exhibit (23.0) CONSENT OF ERNST & YOUNG The Board of Directors and Shareholders General Signal Corporation We consent to the incorporation by reference in this Annual Report (Form 10-K) of General Signal Corporation of our report dated January 25, 1994, included in the 1993 Annual Report to Shareholders of General Signal Corporation. Our audit also included the 1993 and 1992 financial statement schedules of General Signal Corporation and consolidated 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 1993 and 1992 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 the Registration Statements (Form S-3 No. 33-33929), (Form S-8 No. 33-46613) pertaining to the General Signal Corporation Savings and Stock Ownership Plan, (Form S-8 No. 33-47495) pertaining to General Signal Corporation's stock incentive plans, (Form S-3 No. 33-50081) pertaining to the merger agreement with Revco Scientific, Inc. and related prospectuses of our report dated January 25, 1994, with respect to the 1993 and 1992 financial statements incorporated herein by reference, and our report included in the preceding paragraph with respect to the 1993 and 1992 financial statement schedules included in this Annual Report (Form 10-K) of General Signal Corporation. /s/ Ernst & Young Stamford, Connecticut March 18, 1994 Exhibit (23.1) CONSENT OF KPMG PEAT MARWICK The Board of Directors and Shareholders General Signal Corporation We consent to incorporation by reference in the Registration Statements on Forms S-3 (No. 33-33929 and 33-50081) and on Forms S-8 (Nos. 33-46613 and 33-47495) of General Signal Corporation of our report dated January 24, 1992, relating to the balance sheet of General Signal Corporation and consolidated subsidiaries as of December 31, 1991 and the related statements of earnings, shareholders' equity and cash flows and related schedules for the years ended December 31, 1991 and 1990, which report appears in the December 31, 1992 Annual Report on Form 10-K of General Signal Corporation. /s/ KPMG Peat Marwick Stamford, Connecticut March 18, 1994

12927_1993.txt

12927_1993

1993

12927

Item 1. Business The Boeing Company, together with its subsidiaries (herein referred to as the "Company"), is one of the world's major aerospace firms. The Company operates primarily in two industry segments: Commercial Aircraft, and Defense and Space. Commercial Aircraft operations - conducted principally through Boeing Commercial Airplane Group - involve development, production and marketing of commercial jet transports and providing related support services, principally to commercial customers. Defense and Space operations - conducted principally through Boeing Defense & Space Group - involve research, development, production, modification and support of military aircraft and helicopters and related systems, space systems and missile systems. Defense and Space operations are principally with the U.S. Government. With respect to the Commercial Aircraft segment, the Company is a leading producer of commercial transport aircraft and offers a family of commercial jetliners designed to meet a broad spectrum of passenger and cargo requirements of domestic and foreign airlines. This family of jet transport aircraft currently includes the 737 and 757 standard-body models series and the 747 and 767 wide-body models series. In early 1992, the Company sold the de Havilland division of Boeing of Canada, which produced turboprop commuter aircraft. The Company continues development of the 777 twinjet, a new jet transport which will seat from 375 to 400 passengers in two classes and will fill a market segment between the 767-300 and 747-400 models. It will feature a new wing, wide-body fuselage and the latest high-efficiency turbofan engines. This new twinjet will continue to require substantial investments in development, tooling and inventory, leading up to initial deliveries in mid-1995. Principal ongoing activities in the Defense and Space segment include Space Station development and other space related activities, production and remanufacturing of CH-47 helicopters, fighter aircraft engineering and manufacturing development activities, B-2 bomber subcontract work, V-22 Osprey tiltrotor transport development and test activities, E-3 Airborne Warning and Control System (AWACS) updates and the new 767-based AWACS, RAH-66 Comanche helicopter development activities, Avenger air defense system deliveries, updating and modifying various military aircraft and systems, and classified projects. The Space Station, fighter, RAH-66 Comanche helicopter, and V-22 Osprey tiltrotor transport are developmental programs currently being conducted primarily under cost-reimbursement-type contracts. The Company's activities on the, RAH-66, and V-22 programs are under joint venture teaming arrangements with other companies. The Company conducts various other activities representing only a small portion of the Company's total activities, primarily developing large-scale information systems and conducting management services, principally for government agencies. In 1993, the Company discontinued its involvement with the U.S. Government's strategic petroleum reserve. Commercial jet transports are normally sold on a firm fixed-price basis with an indexed price escalation clause. Defense and space developmental programs are normally performed under cost-reimbursement-type contracts, but certain developmental programs have been under fixed-price arrangements in the recent past. Developmental contracts often contain incentives related to cost performance and/or awards for other contract milestone accomplishments. Defense and space production programs are generally performed under firm fixed-price contracts or fixed-price contracts containing incentive provisions related to costs. 2 of 109 Revenues, operating profits and other financial data of the Company's major industry segments for the three years ended December 31, 1993, are set forth on pages 51 and 52 of the Company's 1993 Annual Report to Shareholders and are incorporated herein by reference. The worldwide market for commercial jet transports is predominantly driven by long-term trends in airline passenger traffic. The principal factors in long-term traffic growth are sustained economic growth in developed and emerging markets and political stability. Demand for the Company's products is further influenced by profitability of the airline industry, the globalization and consolidation of the industry, airport and air traffic control infrastructure, noise regulations, product development and strategy, and price and other competitive factors. The Company's ability to deliver jet transports on schedule is dependent upon a variety of factors, including availability of raw materials, performance of suppliers and subcontractors, and certifications by the Federal Aviation Administration. The introduction of new commercial aircraft programs and major derivatives involves increased risks associated with meeting development, production and certification schedules. The Company experienced no significant shortages of raw materials essential to its business during 1993 and does not anticipate any shortages of critical commodities over the longer term, although this is difficult to assess because many factors causing such possible shortages are outside its control. The Company is highly dependent on its suppliers and subcontractors in order to meet commitments to its customers. Many major components and equipment items for the Company's products are procured from or subcontracted to various domestic and foreign companies. Although the Company has periodically experienced certain problems with supplier and subcontractor performance, these situations have been manageable. While the Company owns numerous patents and has licenses under patents owned by others relating to its products and their manufacture, it does not believe that its business would be materially affected by the expiration of any patents or termination of any patent license agreements. The Company has no trademarks, franchises or concessions that are considered to be of material importance to the conduct of its business. The Company is a major supplier to U.S. Government agencies, principally the Department of Defense (DoD) and the National Aeronautics and Space Administration (NASA). This portion of the Company's business is highly sen- sitive to shifts in the national economy, changing national priorities, fluc- tuations in the defense and space budgets, and Government procurement policies. The Company's backlog of firm contractual orders (in billions) at December 31 follows: 1993 1992 ---- ---- Commercial Aircraft $69.0 $82.0 Defense and Space 4.2 5.6 Other industries .3 .3 ----- ----- Total $73.5 $87.9 ===== ===== 3 of 109 Not included in firm contractual backlog are purchase options and announced orders for which definitive contracts have not been executed and orders from customers which have filed for bankruptcy protection. Additionally, U.S. Government and foreign military firm backlog is limited to amounts obligated to contracts. Unobligated U.S. Government contract values not included in backlog totaled $6.9 billion and $7.6 billion as of December 31, 1993 and 1992. In evaluating the Company's contractual backlog for commercial customers, certain risk factors should be considered. Many of the orders extend out several years, with approximately 60% of the contractual backlog for commercial jet airplanes scheduled to be delivered after 1995. Changes in the economic environment and the financial condition of airlines can result in customer requests for rescheduling or cancellation of contractual orders. Contracts with the U.S. Government are subject to termination for default or for convenience by the Government if deemed in its best interests. Contracts which are terminated for convenience generally provide for payments to a contractor for its costs and a proportionate share of profit for work accomplished through the date of termination. Contracts which are terminated for default generally provide that the Government pays only for the work it has accepted, can require the contractor to pay the difference between the original contract price and the cost to reprocure the contract items net of the value of the work accepted from the original contractor, and can hold a contractor liable for damages. (See Item 3 - Legal Proceedings regarding the Government's partial termination of the Peace Shield program for alleged default.) A termination for default, if upheld, also may adversely affect a contractor's ability to compete successfully for other Government contracts. The Commercial Aircraft segment is highly competitive. The Company's commercial aircraft sales are subject to intense competition from aircraft manufactured by other companies, both foreign and domestic, including foreign companies which are nationally owned or subsidized. To meet competition, the Company maintains a continuous program directed toward enhancing the performance and capability of its products and has a family of commercial aircraft to meet varied and changing airline requirements. The Company continually evaluates opportunities to improve current models, and conducts ongoing marketplace assessments to ensure that its family of jet transports is well positioned to meet future requirements of the airline industry. The fundamental strategy is to maintain a broad product line responsive to changing market conditions by maximizing commonality within and across the Boeing family of airplanes. The major focus of development activities over the past three years has been the 777 wide-body twinjet which is scheduled to enter airline service in mid-1995. The 777 is designed to meet airline requirements for an efficient, comfortable, high-capacity airplane to be used in domestic and intra-regional markets. A long-range version of the 777 is being offered for delivery in late 1996, and the aircraft could be further developed for greater capability including additional range and a stretched fuselage. During 1993 the Company began development activities on the next generation of the 737 family of short-to-medium-range jetliners that will provide greater range, increased speed, and reduced noise and emissions while maintaining 737 family commonality. The first next-generation 737, designated the 737-700, is the middle-sized member of the 737 family. Customer orders will determine the sequence and timing of the introduction of the smaller 737-600 and the larger 737-800. The Company continues to assess the market potential for new or derivative aircraft that are larger and have more range than the 747-400. Because of a relatively limited market and the heavy resource investment levels required, the Company signed an agreement with four European aerospace companies in 1993 to study the feasibility of developing a new aircraft capable of carrying between 550 and 800 passengers. 4 of 109 While product development activities are principally oriented toward maintaining and enhancing the competitiveness of the Boeing subsonic fleet, the Company is also involved in studies to understand the technological and economic issues associated with development of commercial supersonic aircraft. During 1993, announced new orders for the Company's commercial jet transports totaled 247 aircraft, which represented approximately 75% of the dollar value of total new announced orders during the year. In terms of revenue, the Company's commercial jet transport deliveries represented approximately 60% of total market deliveries during the five-year period ended December 31, 1993. The U.S. Government defense market environment is one in which continued intense competition among defense contractors can be expected, especially in light of the shrinking defense budget. The Company's ability to successfully retain and compete for such business is highly dependent on its technical excellence, demonstrated management proficiency, strategic alliances, and cost-effective performance. Company-sponsored research and development not recoverable under contracts and charged directly to earnings as incurred amounted to $1,661 million, $1,846 million, and $1,417 million in 1993, 1992 and 1991, respectively. In 1994, research and development expense is projected to increase somewhat relative to 1993, principally in support of the 777, the 737-700, and other commercial jet transport programs and research. The Company is subject to federal, state and local laws and regulations designed to protect the environment and to regulate the discharge of materials into the environment. The Company believes its policies, practices and procedures are properly designed to prevent unreasonable risk of environmental damage and the consequent financial liability to the Company. Compliance with environmental laws and regulations requires continuing management effort and expenditures by the Company. Compliance with environmental laws and regulations has not had in the past, and, the Company believes, will not have in the future, material effects on the capital expenditures, earnings, or competitive position of the Company. The Company had approximately 123,000 employees at January 31, 1994, including approximately 1,600 in Canada. Sales outside the United States (principally export sales from domestic operations) by geographic area are included on page 51 of the Company's 1993 Annual Report to Shareholders and incorporated herein by reference. Less than 3% of total sales were derived from non-U.S. operations of the Company for each of the three years in the period ended December 31, 1993. Approximately 62% of the Company's contractual backlog at December 31, 1993, in terms of dollar value was with non-U.S. customers. Sales outside the United States are influenced by international relationships and U.S. Government foreign policy. Relative profitability is not significantly different from that experienced in the domestic market. Approximately 18% of accounts receivable and customer financing combined consisted of amounts due from customers outside the United States. These amounts are payable in U.S. dollars, and, in management's opinion, related risks are adequately covered by allowance for losses. The Company has not experienced materially adverse financial consequences as a result of sales and financing activities outside the United States. 5 of 109 Item 2. Item 2. Properties The locations and approximate floor areas of the Company's principal operating properties at year end 1993, are indicated in the following table. The table also indicates the approximate portions which are Company-owned or leased from others. Floor area (thousands of square feet) -------------------------- Company- owned Leased --------- ------ United States: Seattle, Washington, and surrounding area 44,811 8,742 Wichita, Kansas 11,669 1,144 Philadelphia, Pennsylvania 3,166 497 Portland, Oregon 1,007 70 Huntsville, Alabama 641 157 Oakridge, Tennessee 490 0 Sunnyvale, California 461 357 Corinth & Irving, Texas 433 33 Macon, Georgia 399 0 Spokane, Washington 394 0 Vienna, Virginia 335 99 Moses Lake, Washington 252 484 Glasgow, Montana 180 0 Canada: Winnipeg, Manitoba 522 40 Arnprior, Ontario 162 57 With the exception of the Glasgow Industrial Airport located in Glasgow, Montana, which is Company-owned, runways and taxiways used by the Company are located on airport properties owned by others and are used by the Company jointly with others. The Company's rights to use such facilities are provided for under long-term leases with municipal, county or other government authorities. In addition, the U.S. Government furnishes the Company certain office space, installations and equipment at Government bases for use in connection with various activities. Facilities at the principal locations support both major industry segments. Work related to a given program may be assigned to various locations, based upon periodic review of shop loads and production capability. During 1993, net additions to property, plant and equipment totaled $1,317 million. Annual plant and equipment additions over the next two years are projected to be substantially below the 1993 expenditure level. The Company's properties are generally well maintained and in good operating condition. There are no significant unused facilities. Existing facilities are sufficient to meet the Company's near-term operating requirements. 6 of 109 Item 3. Item 3. Legal Proceedings Various legal proceedings, claims and investigations are pending against the Company related to products, contracts and other matters. Except for the items discussed below, most of these legal proceedings are related to matters covered by insurance. In January 1991, the Company received from the U.S. Government a notice of partial termination for default which terminated most of the work required un- der contracts to develop and install a new air defense system for Saudi Arabia, known as the Peace Shield program. The Government has filed with the Company a demand for repayment of $605 million of Peace Shield unliquidated progress pay- ments plus interest commencing January 25, 1991. In February 1991, the Company submitted a request for a deferred payment agreement which, if granted, would formally defer the Company's potential obligation to repay the $605 million of unliquidated progress payments until the conclusion of the appeal process. In June 1991, the Government selected another contractor to perform the work which is the subject of the contracts that have been terminated for default, and the Government will likely assert claims related to the reprocurement. The Company does not expect the Government to assert such claims prior to completion of the reprocurement contract, which was originally scheduled for late 1995. Management's position, supported by outside legal counsel which specializes in government procurement law, is that the grounds for default asserted by the Government in the Peace Shield termination are not legally supportable. Accordingly, management and counsel are of the opinion that on appeal the termination for default has a substantial probability of being converted to termination for the convenience of the Government, which would eliminate any Government claim for cost of reprocurement or other damages. Additionally, the Company has a legal basis for a claim for equitable adjustment to the prices and schedules of the contracts (the "Contract Claim"). Many of the same facts underlie both the Contract Claim and the Company's appeal of the Government's termination action. The Company has filed its complaint in the United States Claims Court to overturn the default termination in order to obtain payment of the Contract Claim. The parties are currently litigating jurisdictional issues related to the complaint, and are engaged in discovery. Trial is currently scheduled for March 1997. The Company expects that its position will ultimately be upheld with respect to the termination action and that it will prevail on the Contract Claim. The Company's financial statements have been prepared on the basis of a conservative estimate of the revised values of the Peace Shield contracts including the Contract Claim and the Company's position that the termination was for the convenience of the Government. At this time, the Company cannot reasonably estimate the length of time that will be required to resolve the termination appeal and the Contract Claim. In the event that the Company's appeal of the termination for default is not successful, the Company could realize a pre-tax loss on the program approximating the value of the unliquidated progress payments plus related interest and potential damages assessed by the Government. 7 of 109 The Company is subject to several U.S. Government investigations of business and cost classification practices. One investigation involves a grand jury proceeding as to whether or not certain costs were charged to the proper overhead accounts. No charges have been filed in this matter, and based on the facts known to it, the Company believes it would have defenses if any were filed. The investigations could result in civil, criminal or administrative proceedings. Such proceedings, if any, could involve claims by the Government for fines, penalties, compensatory and treble damages, restitution and/or for- feitures. Based upon Government procurement regulations, a contractor, or one or more of its operating divisions or subdivisions, can also be suspended or debarred from Government contracts if proceedings result from the inves- tigations. The Company believes, based upon all available information, that the outcome of Government investigations will not have a materially adverse effect on its financial position or results of operations. The Company is subject to federal and state requirements for protection of the environment, including those for discharge of hazardous materials and remediation of contaminated sites. Due in part to their complexity and pervasiveness, such requirements have resulted in the Company being involved with related legal proceedings, claims and remediation obligations over the past 10 years. The Company routinely assesses, based on in-depth studies, expert analyses and legal reviews, its contingencies, obligations and commitments for remediation of contaminated sites, including assessments of ranges and probabilities of recoveries from other responsible parties who have and have not agreed to a settlement and recoveries from insurance carriers. The Company's policy is to immediately accrue and charge to current expense identified exposures related to environmental remediation sites based on conservative estimates of investigation, cleanup and monitoring costs to be incurred. The costs incurred and expected to be incurred in connection with such activities have not had, and are not expected to have, a material impact to the Company's financial position. With respect to results of operations, related charges have averaged less than 2% of annual net earnings. Such accruals as of December 31, 1993, without consideration for the related contingent recoveries from insurance carriers, are less than 2% of total liabilities. Based on all known facts and expert analyses, the Company believes it is not reasonably likely that identified environmental contingencies will result in additional costs that would have a materially adverse impact to the Company's financial position or operating results and cash flow trends. 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 quarter ended December 31, 1993. 8 of 109 PART II Item 5. Item 5. Market for Registrant's Common Equity and Related Stockholder Matters Information required by this item is included on page 56 and the inside back cover of the Company's 1993 Annual Report to Shareholders and is incorporated herein by reference. Item 6. Item 6. Selected Financial Data Information required by this item is included on page 55 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 Information required by this item is included on pages 25-36 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 following consolidated financial statements and supplementary data, included in the Company's 1993 Annual Report to Shareholders at the pages indicated, are incorporated herein by reference: Consolidated Statements of Net Earnings - years ended December 31, 1993, 1992 and 1991: Page 38. Consolidated Statements of Financial Position - December 31, 1993 and 1992: Page 39. Consolidated Statements of Cash Flows - years ended December 31, 1993, 1992 and 1991: Page 40. Notes to Consolidated Financial Statements: Pages 41-53. Independent Auditors' Report: Page 37. Supplementary data regarding quarterly results of operations: Page 54. Item 9. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure None. 9 of 109 PART III Item 10. Item 10. Directors and Executive Officers of the Registrant Executive Officers No family relationships exist between any of the executive officers listed below, or directors or director nominees. Age Name (at 2/28/94) Positions and offices held and business experience ---- ------------ ------------------------------------------------- F. A. Shrontz 62 Chairman of the Board since 1988. Chief Executive Officer since 1986; Director since 1985. President from 1985 until 1988. P. M. Condit 52 President since 1992. Prior thereto Executive Vice President and General Manager - 777 Division, Boeing Commercial Airplane Group from 1989. Prior thereto Executive Vice President of Boeing Commercial Airplane Group from 1986. D. P. Beighle 61 Senior Vice President since 1986. Secretary from 1981 until 1991. L. W. Clarkson 55 Corporate Vice President - Planning & International Development since 1992. Prior thereto Senior Vice President - Government & International Affairs of Boeing Commercial Airplane Group from 1988. D. D. Cruze 63 Senior Vice President - Operations since 1990. Prior thereto Vice President - Operations from 1985. B. E. Givan 57 Senior Vice President and Chief Financial Officer since 1990. Prior thereto Vice President - Finance from 1988. Prior thereto Vice President - Financial Operations and Treasurer from 1986. C. G. King 59 President - Boeing Defense & Space Group since May 1993. Prior thereto Executive Vice President - Boeing Defense & Space Group since 1991. Prior thereto Executive Vice President - Military Airplane Division of Boeing Defense & Space Group since April 1990. Prior thereto President - Boeing Advanced Systems since January 1990. Prior thereto Executive Vice President - Boeing Advanced Systems since 1987. 10 of 109 Age Name (at 2/28/94) Positions and offices held and business experience ---- ------------ ------------------------------------------------- L. G. McKean 58 Vice President - Human Resources since 1990. Prior thereto Staff Vice President - Human Resources from 1989. Prior thereto Staff Vice President - Labor Relations from 1988. Prior thereto Director - Labor Relations from 1987. J. D. Warner 54 President - Boeing Computer Services since July 1993. Prior thereto Executive Vice President - Boeing Computer Services since March 1993. Prior thereto Vice President, Computing - Boeing Commercial Airplane Group since 1991. Prior thereto Vice President - Engineering Division of Boeing Commercial Airplane Group since 1989. Prior thereto Program Manager - B-2 Program of Boeing Advanced Systems since 1987. A. D. Welliver 60 Senior Vice President - Engineering and Technology since 1990. Prior thereto Vice President - Engineering and Technology from 1986. R. B. Woodard 51 President - Boeing Commercial Airplane Group since December 1993. Prior thereto Executive Vice President - Boeing Commercial Airplane Group since March 1993. Prior thereto Vice President and General Manager - Renton Division of Boeing Commercial Airplane Group since 1991. Prior thereto President - de Havilland division of Boeing of Canada since 1987. Other information required by Item 10 involving the identification and election of directors and Section 16(a) compliance is incorporated by reference from the registrant's definitive proxy statement, which will be filed with the Commission within 120 days after the close of the fiscal year. 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 required by Items 11, 12, and 13 is incorporated by reference from the registrant's definitive proxy statement, which will be filed with the Commission within 120 days after the close of the fiscal year. 11 of 109 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 All consolidated financial statements of the Company as set forth under Item 8 of this report on Form l0-K. 2. Financial Statement Schedules Schedule Description Page -------- ----------- ---- V Property, Plant and Equipment 17 VI Accumulated Depreciation of Property, Plant and Equipment 18 VIII Valuation and Qualifying Accounts 19 X Supplementary Income Statement Information 20 The auditors' report with respect to the above-listed financial statement schedules appears on page 16 of this report. All other financial statements and schedules not listed are omitted either because they are not applicable, not required, or the required information is included in the consolidated financial statements. 12 of 109 3. Exhibits (3) Articles of Incorporation and By-Laws. (i) Restated Certificate of Incorporation. (Exhibit (3) of the Form 10-K of the Company for the year ended December 31, 1991 (herein referred to as "1991 Form 10-K").) (ii) By-Laws, as amended and restated on October 25, 1993. Filed herewith. (4) Instruments Defining the Rights of Security Holders, Including Indentures. (i) Indenture, dated as of March 1, 1986, between the Company and The Chase Manhattan Bank (National Association), Trustee. (Exhibit (4) of the 1991 Form 10-K.) (ii) Indenture, dated as of August 15, 1991, between the Company and The Chase Manhattan Bank (National Association), Trustee. (Exhibit (4) to the Company's Current Report on Form 8-K dated August 27, 1991.) (iii) Rights Agreement, dated as of July 27, 1987, between the Company and The First National Bank of Boston, Rights Agent. Incorporated by reference to the Company's Registration Statement on Form 8-A filed July 20, 1987. (File No. 1-442.) (10) Material Contracts. o The Boeing Company Bank Credit Agreement. (i) Agreement Amended and Restated as of June 30, 1993. (Exhibit (10) of the Form 10-Q of the Company for the quarter ended September 30, 1993.) o Management Contracts and Compensatory Plans. (ii) 1984 Stock Option Plan. (a) Plan, as amended. (Exhibit (19) of the Form l0-Q of the Company for the quarter ended September 30, 1989.) (b) Forms of stock option agreements. (Exhibit (10)(vi)(b) of the 1992 Form 10-K.) (iii) 1988 Stock Option Plan. (a) Plan, as amended on December 14, 1992. (Exhibit (10)(vii)(a) of the 1992 Form 10-K.) (b) Form of Notice of Terms of Stock Option Grant. (Exhibit (10)(vii)(b) of the 1992 Form 10-K.) (iv) 1992 Stock Option Plan for Nonemployee Directors. (a) Plan. (Exhibit (19) of the Form 10-Q of the Company for the quarter ended March 31, 1992.) (b) Form of Stock Option Agreement. (Exhibit (10)(viii)(b) of the 1992 Form 10-K.) (v) Supplemental Benefit Plan for Employees of the Company. Plan, as amended. (Exhibit (10)(iii)(d) of the 1991 Form 10-K.) (vi) Supplemental Retirement Plan for Executives of the Company. Plan, as amended. (Exhibit (10)(iii)(e) of the 1990 Form 10-K.) 13 of 109 (vii) Deferred Compensation Plan for Employees of The Boeing Company. Plan, as amended on October 25, 1993. Filed herewith. (viii) Deferred Compensation Plan for Directors of The Boeing Company. Plan, as amended on October 25, 1993. Filed herewith. (ix) 1993 Incentive Stock Plan for Employees (a) Plan, as amended on December 13, 1993. Filed herewith. (b) Form of Notice of Stock Option Grant. (i) Regular Annual Grant. Filed herewith. (ii) Supplemental Grant. Filed herewith. (x) Incentive Compensation Plan for Officers and Employees of the Company and Subsidiaries. Plan, as amended. (Exhibit (19) of the Form l0-Q of the Company for the quarter ended September 30, 1990.) (xi) SAR Deferral Arrangements of the Company. (a) Form of SAR Deferral Agreement. (Exhibit (10)(iii)(i) of the 1990 Form 10-K.) (b) Plan for Employees, as amended. (Exhibit (19) of the Form 10-Q of the Company for the quarter ended September 30, 1989.) (c) Form of SAR deferral election notice. (Exhibit (10)(xiv)(c) of the 1992 Form 10-K.) (12) Computation of Ratio of Earnings to Fixed Charges. Page 21. (13) Portions of the 1993 Annual Report to Shareholders incorporated by reference herein. Filed herewith. (22) List of Company Subsidiaries. Filed herewith. (24) Independent Auditors' Consent and Report on Schedules for use in connection with filings of Form S-8 under the Securities Act of 1933. Page 16. (b) Reports on Form 8-K filed during quarter ended December 31, 1993: On November 2, 1993, the Company filed a Current Report on Form 8-K, including as an exhibit under Item 7, the Terms Agreement dated October 12, 1993, among The Boeing Company, CS First Boston Corporation, Merrill Lynch, Pierce, Fenner & Smith and Salomon Brothers Inc, as Representatives of the Underwriters, in connection with the issuance of $125,000,000 aggregate principal amount of 6-7/8% Debentures Due 2043. 14 of 109 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 the date indicated. THE BOEING COMPANY (Registrant) By: /s/ Frank Shrontz By: /s/ B. E. Givan ------------------------------- ------------------------------ Frank Shrontz - Chairman of the B. E. Givan - Senior Vice Board, Chief Executive Officer President and Chief Financial and Director Officer By: /s/ T. M. Budinich ------------------------------- T. M. Budinich - Vice President and Controller 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 date indicated. /s/ Robert A. Beck /s/ Stanley Hiller, Jr. - --------------------------- --------------------------------- Robert A. Beck - Director Stanley Hiller, Jr. - Director /s/ Philip M. Condit /s/ George M. Keller - --------------------------- --------------------------------- Philip M. Condit - Director and President George M. Keller - Director /s/ John B. Fery /s/ Donald E. Petersen - --------------------------- --------------------------------- John B. Fery - Director Donald E. Petersen - Director /s/ Paul E. Gray /s/ Charles M. Pigott - --------------------------- --------------------------------- Paul E. Gray - Director Charles M. Pigott - Director /s/ Harold J. Haynes /s/ Rozanne L. Ridgway - --------------------------- --------------------------------- Harold J. Haynes - Director Rozanne L. Ridgway - Director --------------------------------- Date: February 28, 1994 George H. Weyerhaeuser - Director 15 of 109 Independent Auditors' Consent and Report on Schedules Board of Directors and Shareholders The Boeing Company: We consent to the incorporation by reference in Registration Statement Nos. 2-48576, 2-93923, 33-25332, 33-31434, 33-43854, and 33-58798 on Form S-8 of our report dated January 24, 1994, on the consolidated financial statements of The Boeing Company and subsidiaries, in The Boeing Company's 1993 Annual Report to Shareholders and incorporated by reference in this Annual Report on Form 10-K for the year ended December 31, 1993. We also consent to the incorporation of the following report on schedules and the reference to us appearing under the heading "Experts" in the Registration Statements. Our audits of the financial statements referred to in our aforementioned report also included the financial statement schedules of The Boeing Company, listed in Item 14 (a) 2 in this Annual Report on Form 10-K for the year ended December 31, 1993. 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 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. /s/ Deloitte & Touche Deloitte & Touche Seattle, Washington March 10, 1994 16 of 109 SCHEDULE V - Property, Plant and Equipment The Boeing Company and Subsidiaries Years ended December 31, 1993, 1992 and 1991 (Dollars in millions) Column A Column B Column C Column D Column E Column F - -------------- ---------- --------- ----------- -------- ----------- Balance at Additions Other Balance at Classification January 1 at Cost Retirements Changes* December 31 - -------------- ---------- --------- ----------- -------- ----------- - ---- Land $ 399 $ 3 $ (5) $ - $ 397 Buildings and fixtures 4,192 1,125 (31) - 5,286 Machinery and equipment 6,085 788 (373) - 6,500 Construction in progress 1,617 (568) - - 1,049 ------- ------ ------ ----- ------- $12,293 $1,348 $(409) $ - $13,232 ======= ====== ===== ===== ======= - ---- Land $ 415 $ 2 $ - $ (18) $ 399 Buildings and fixtures 3,487 798 (29) (64) 4,192 Machinery and equipment 5,533 960 (345) (63) 6,085 Construction in progress 1,165 452 - - 1,617 ------- ------ ----- ----- ------- $10,600 $2,212 $(374) $(145) $12,293 ======= ====== ===== ===== ======= - ---- Land $ 380 $ 35 $ - $ - $ 415 Buildings and fixtures 3,147 376 (36) - 3,487 Machinery and equipment 4,817 949 (233) - 5,533 Construction in progress 647 518 - - 1,165 ------- ------ ----- ----- ------- $ 8,991 $1,878 $(269) $ - $10,600 ======= ====== ===== ===== ======= *Sale of the de Havilland division of Boeing of Canada. DEPRECIATION Property, plant and equipment are recorded at cost and depreciated over useful lives, principally on accelerated methods. Amortization of leasehold improvements is based on the shorter of the physical life of the improvements or the period of the lease. The asset lives used for depreciation computation are as follows: Buildings and fixtures 5 to 45 years Machinery and equipment 3 to 11 years 17 of 109 SCHEDULE VI - Accumulated Depreciation of Property, Plant and Equipment The Boeing Company and Subsidiaries Years ended December 31, 1993, 1992 and 1991 (Dollars in millions) Column A Column B Column C Column D Column E Column F - -------------- ---------- ---------- ----------- -------- ----------- Additions charged to Balance at costs and Other Balance at Classification January 1 expenses Retirements Changes* December 31 - -------------- ---------- ---------- ----------- -------- ----------- - ---- Buildings and fixtures $1,455 $224 $ (21) $ - $1,658 Machinery and equipment 4,114 729 (357) - 4,486 ------ ---- ----- ----- ------ $5,569 $953 $(378) $ - $6,144 ====== ==== ===== ===== ====== - ---- Buildings and fixtures $1,326 $162 $ (16) $ (17) $1,455 Machinery and equipment 3,744 708 (306) (32) 4,114 ------ ---- ----- ----- ------ $5,070 $870 $(322) $ (49) $5,569 ====== ==== ===== ===== ====== - ---- Buildings and fixtures $1,206 $149 $ (29) $ - $1,326 Machinery and equipment 3,337 619 (212) - 3,744 ------ ---- ----- ----- ------ $4,543 $768 $(241) $ - $5,070 ====== ==== ===== ===== ====== *Sale of the de Havilland division of Boeing of Canada. 18 of 109 SCHEDULE VIII - Valuation and Qualifying Accounts The Boeing Company and Subsidiaries Allowance for Doubtful Accounts and Customer Financing (Deducted from assets to which they apply) Years ended December 31, 1993, 1992 and 1991 (Dollars in millions) Column A Column B Column C Column D Column E - ----------- ---------- ------------------------ ----------- ----------- Additions ------------------------ (1) (2) Deductions Collection from Charged to of accounts reserves Balance at costs and previously (accounts Balance at Description January 1 expenses charged off charged off) December 31 - ----------- ---------- ---------- ----------- ----------- ----------- 1993 $103 $31 $ - $ 8 $126 1992 83 30 - 10 103 1991 52 38 - 7 83 19 of 109 SCHEDULE X - Supplementary Income Statement Information The Boeing Company and Subsidiaries Years ended December 31, 1993, 1992 and 1991 (Dollars in millions) Column A Column B -------- -------- Item Charged to costs and expenses ---- ----------------------------- 1993 1992 1991 ---- ---- ---- 1. Maintenance and repairs $513 $583 $658 3. Taxes, other than payroll and income taxes 414 374 386 Items omitted are less than 1% of total sales. 20 of 109 EXHIBIT (12) - Computation of Ratio of Earnings to Fixed Charges The Boeing Company and Subsidiaries (Dollars in millions) Year ended December 31, -------------------------------------------- 1993 1992 1991 1990 1989 ------ ------ ------ ------ ---- Earnings before federal taxes on income $1,821 $2,256 $2,204 $1,972 $922 Fixed charges excluding capitalized interest 75 62 66 58 49 Amortization of previously capitalized interest 31 22 13 13 12 Less undistributed earnings of affiliates 1 1 (1) (5) (15) Plus distributed earnings of affiliates - - - 5 21 ------ ------ ------ ------ ---- Earnings available for fixed charges $1,928 $2,341 $2,282 $2,043 $989 ====== ====== ====== ====== ==== Fixed charges: Interest expense $ 39 $ 14 $ 13 $ 6 $ 6 Interest capitalized during the period 150 119 44 22 18 Rentals deemed representative of an interest factor 36 48 53 52 43 ------ ------ ------ ------ ---- Total fixed charges $ 225 $ 181 $ 110 $ 80 $ 67 ====== ====== ====== ====== ==== Ratio of earnings to fixed charges 8.6 12.9 20.8 25.5 14.8 ====== ====== ====== ====== ==== 21 of 109 EXHIBITS FILED WITH THIS REPORT ON FORM 10-K Commission File Number 1-442 THE BOEING COMPANY Exhibit Index Annual Report to Share- Form holders 10-K Exhibit Description Page Page - -------------- ------------------------------------------------- ------- ---- (3)(ii) By-Laws, as amended and restated October 25, 1993 63 (10)(vii) Deferred Compensation Plan for Employees of The Boeing Company, as amended October 25, 1993 82 (10)(viii) Deferred Compensation Plan for Directors of The Boeing Company, as amended October 25, 1993 88 (10)(ix)(a) 1993 Incentive Stock Plan for Employees, as amended on December 13, 1993 93 (10)(ix)(b)(i) 1993 Incentive Stock Plan for Employees - Notice of Stock Option Grant for Regular Annual Grant 99 (10)(ix)(b)(ii) 1993 Incentive Stock Plan for Employees - Notice of Stock Option Grant for Supplemental Grant 102 (12) Computation of Ratio of Earnings to Fixed Charges 21 (13) Portions of the 1993 Annual Report to Shareholders incorporated by reference in Part I and Part II Market for Registrant's Common Equity and Related Stockholder Matters * 62 Selected Financial Data 55 61 Management's Discussion and Analysis of Financial Position and Results of Operations 25 23 Consolidated Statements of Net Earnings 38 39 Consolidated Statements of Financial Position 39 40 Consolidated Statements of Cash Flows 40 41 Notes to Consolidated Financial Statements 41 42 Independent Auditors' Report 37 38 Supplementary Data Regarding Quarterly Results of Operations 54 60 (22) List of Company Subsidiaries 105 (24) Independent Auditors' Consent and Report on Schedules for use in connection with Filings of Form S-8 under the Securities Act of 1933. 16 Appendix of graphic and image material pursuant to Rule 304(a) of Regulation S-T 107 *Listed on inside back cover of annual report 22 of 109 Exhibit (13) Portions of the 1993 Annual Report to Shareholders incorporated by reference in Part I and Part II 23 of 109 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS RESULTS OF OPERATIONS - --------------------- REVENUES Operating revenues for 1993 were $25.4 billion compared to $30.2 billion and $29.3 billion for 1992 and 1991. Commercial aircraft products and services accounted for 81%, 80% and 78% of total operating revenues for the years 1993, 1992 and 1991. The Company's commercial jet transport market share was approximately 60% in terms of sales value for each of the three years. Commercial jet transport deliveries by model: 1993 1992 1991 - ------------------------------------------------- 737 152 218 215 747 56 61 64 757 71 99 80 767 51 63 62 - ------------------------------------------------- Total 330 441 421 ================================================= Commercial production rates were at 32 1/2 aircraft per month at the beginning of 1993 and ended the year at 23 per month. In early 1994, the 747 production rate was reduced from 5 to 3 per month. Based on current production schedules, the 737 rate will be reduced from 10 to 8 1/2 per month in the fourth quarter of 1994, the 757 rate will be reduced from 5 to 4 per month in the first quarter of 1995, the 767 rate will be increased from 3 to 4 per month in the first quarter of 1995, and the 747 rate will be reduced from 3 to 2 per month in January 1995. Planned production rates will continue to be adjusted as necessary to match customer orders. Production of the new 777 model is on schedule to support the flight test program starting in mid-1994, and production activity will continue to build until initial deliveries begin in mid-1995. Commercial jet transport deliveries for 1994 are currently projected to be in the 260 range. Commercial transportation sales trends are discussed further in the Commercial Aircraft Market Environment section on pages 29-32. Sales by industry segment: [Graphic and image material item Number 1 See appendix on page 107 for description.] Sales by type of customer: [Graphic and image material item Number 2 See appendix on page 107 for description.] 24 of 109 Defense and space segment revenues were $4.4 billion for 1993, down from $5.4 billion and $5.8 billion for 1992 and 1991, respectively. Reduced B-2 bomber subcontract work was the major contributor to the lower sales in 1993. Several program terminations that occurred in 1991 and 1992 contributed to the decline in sales in 1992 compared with 1991, partially offset by increased sales in the B-2 program and the fighter aircraft program. The Company's defense and space business is broadly diversified, and no program other than B-2 accounted for more than 10% of total 1991-1993 defense and space revenues. B-2 bomber subcontract work, which accounted for less than 20% of total 1991-1993 defense and space business revenues, will continue to decline over the next few years. The principal contributors to 1993 defense and space sales included B-2 bomber subcontract work, production and remanufacturing of CH-47 helicopters, fighter aircraft engineering and manufacturing development activities, Space Station work packages, E-3 Airborne Warning and Control System (AWACS) updates, A-6 composite wing production (terminated for convenience by the Government during 1993), RAH-66 Comanche helicopter development activities, KC-135 tanker update modifications, V-22 Osprey tiltrotor transport development and test activities, Avenger air-defense system deliveries, and B-1B bomber avionics. U.S. Government classified projects also continued to contribute to defense and space segment revenues. The Company's activities on the, RAH-66 and V-22 programs are under joint venture teaming arrangements with other companies. NASA's selection of Boeing Defense & Space Group as the prime contractor for the restructured Space Station program will result in an increase of approximately 10% in defense and space segment sales in 1994 compared with 1993, based on current programs and schedules. However, U.S. Government defense and space programs continue to be subject to funding constraints, and further program stretch-outs or curtailments are possible. Defense and space sales trends are discussed further in the Defense and Space Market Environment section on page 32. Based on current programs and schedules, the Company projects total 1994 sales to be in the $21 billion range. EARNINGS Net earnings for 1993 on a comparable basis with the prior two years were as follows: (dollars in millions) 1993 1992 1991 - ------------------------------------------------------------------------- Net earnings as reported $1,244 $552 $1,567 Effect of SFAS No. 106 accounting change for retiree health care: - Cumulative adjustment for transition obligation 1,002 - Pro-forma current period cost (70) - ------------------------------------------------------------------------- Net earnings on a comparable basis $1,244 $1,554 $1,497 ========================================================================= 25 of 109 The Company elected to implement Statement of Financial Accounting Standards (SFAS) No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," in the fourth quarter of 1992, resulting in the accrual of a cumulative adjustment for retiree health care costs for active employees. The Company's previous practice was to accrue retiree health care liability upon an employee's retirement. Although the new accounting standard results in a higher level of retiree health care costs being recognized, there is no impact on the Company's cash flow requirements as there are no current plans to fund the accrued obligation. The $310 million decrease in net earnings for 1993 compared to 1992, excluding the cumulative effect of the SFAS No. 106 accounting change, was primarily due to lower commercial aircraft sales, together with lower corporate investment income and continued high levels of research and development expenditures, principally for the new 777 jet transport program. These factors were partially offset by improved defense and space earnings despite lower sales, and increased income from customer financing. The $57 million increase in net earnings for 1992 compared to 1991, on a comparable basis adjusted for the SFAS No. 106 accounting change, was primarily due to increased commercial aircraft sales and improved cost performance, particularly in the defense and space segment. These factors were partially offset by higher research and development expense (principally increased 777 program expenditures), lower corporate investment income and a higher effective federal income tax rate. Net earnings for 1991 were $182 million higher than 1990 earnings, primarily due to increased commercial aircraft sales, a lower defense and space segment operating loss and a lower effective federal income tax rate. These factors were partially offset by higher research and development expense (principally increased 777 program expenditures) and lower corporate investment income. The effective federal income tax rates were 31.7%, 31.1% and 28.9% for 1993, 1992 and 1991, respectively. Relative to the statutory rates, the lower effective tax rates for the three years were due primarily to tax-exempt income benefits from export sales, and research and development benefits in 1991. (See Note 6 to the Consolidated Financial Statements.) Essentially all of the Company's business is performed under contract, and therefore operating results trends are not significantly influenced by the effect of changing prices. Additional information relating to sales and earnings contributions by business segment can be found in Note 14 to the Consolidated Financial Statements. Although 1994 sales are projected to be lower than 1993 sales, operating profit margins, exclusive of research and development expenditures for new and derivative jet transport models, are expected to be substantially maintained through the efficiencies gained by process improvements in all aspects of the Company's operations. However, because of the impact of commercial aircraft research and development expenditures discussed below together with the lower sales level, there will be a significant decline in net earnings as a percent of sales for 1994. 26 of 109 RESEARCH AND DEVELOPMENT ACTIVITIES Research and development expenditures charged directly to earnings include design, developmental and related test activities for new and derivative commercial jet transports, other company-sponsored product development, and basic defense and space research and development not recoverable under U.S. Government flexibly priced contracts. Research and development expensed: [Graphic and image material item Number 3 See appendix on page 107 for description.] The principal commercial developmental program during the 1991-1993 time period has been the new 777 wide-body twinjet. Structural design activities on the 777 program peaked in 1992, resulting in the lower level of research and development charges in 1993 compared to 1992. The 777 development program has now transitioned from primarily structural and systems design activities to primarily systems integration and test activities. Flight testing will begin in mid-1994, leading to initial deliveries in mid-1995. The principal commercial developmental projects with significant expenditures in 1994 include the 777 base model, the extended-range version of the 777 for which deliveries begin in late 1996, initial structural design activities on the 737-700 for which deliveries begin in late 1997, and the freighter version of the 767 to be delivered in the fourth quarter of 1995. The first freighter version of the 747-400, in development since 1989, was delivered in the fourth quarter of 1993. The major developmental programs in the defense and space segment, funded principally under cost-reimbursement-type contracts, include Space Station work packages, fighter aircraft, V-22 Osprey tiltrotor transport and RAH-66 Comanche helicopter. The total amount of research and development expenditures charged to expense is projected to increase somewhat in 1994 from the $1.7 billion level in 1993. CONTINUOUS QUALITY IMPROVEMENT The Company remains strongly committed to continuous quality improvement in all aspects of its business and to maintaining a strong focus on customer needs, including product capabilities, technology, in-service economics and product support. Major long-term productivity gains are being aggressively pursued as substantial resources have been and will continue to be invested in training, restructuring of processes, technology, and organizational realignment. 27 of 109 In connection with the 777 developmental program, such measures have included early application of substantial resources for integrated product teams, design interface with customer representatives, use of advanced three-dimensional digital product definition and digital pre-assembly computer applications, and increased use of automated manufacturing processes. Although these measures have required significant current investments, substantial long-term benefits are anticipated from reductions in design changes, less rework, and improved quality of internally manufactured and supplier parts. Major process improvements and promising pilot projects are also being pursued on other commercial and military programs to improve quality, reduce inventory and shorten cycle times. BACKLOG Contractual backlog: [Graphic and image material item Number 4 See appendix on page 107 for description.] Total contractual backlog of unfilled orders at December 31, 1993, was $73.5 billion, compared with $87.9 billion at the end of 1992. Of the total 1993 backlog, $70.5 billion or 96% was for commercial customers (including foreign governments) and $3.0 billion or 4% was for the U.S. Government. Comparable figures at the end of 1992 were $82.6 billion or 94% commercial, and $5.3 billion or 6% U.S. Government. Not included in contractual backlog are purchase options and announced orders for which definitive contracts have not been executed and orders from customers which have filed for bankruptcy protection. U.S. Government and foreign military backlog is limited to amounts obligated to contracts. Unobligated U.S. Government contract values not included in backlog at December 31, 1993 and 1992, totaled $6.9 billion and $7.6 billion. In evaluating the Company's contractual backlog for commercial customers, certain risk factors should be considered. Many of the orders extend out several years, with approximately 60% of the contractual backlog for commercial jet airplanes scheduled to be delivered after 1995. Continuation of the weak economic environment in many areas of the world could result in additional customer requests for rescheduling or possible cancellation of contractual orders. COMMERCIAL AIRCRAFT MARKET ENVIRONMENT - -------------------------------------- The worldwide market for commercial jet transports is predominantly driven by long-term trends in airline passenger traffic. The principal factors in long-term traffic growth are sustained economic growth in developed and emerging markets and political stability. Demand for the Company's products is further influenced by profitability of the airline industry, the globalization and consolidation of the industry, limitations of airport and air traffic control infrastructure, noise regulations, product development and strategy, and price and other competitive factors. 28 of 109 PASSENGER TRAFFIC TRENDS Worldwide airline passenger traffic declined in 1991 - the first annual decline since the start of the jet era - due principally to the economic and political impacts of the Persian Gulf conflict. Passenger traffic in 1992 was approximately 8% higher than the depressed levels of 1991 for the airline industry worldwide, excluding Aeroflot of the Commonwealth of Independent States (CIS). Relative to 1990 levels, 1992 worldwide airline passenger traffic represented an increase of approximately 5%. The growth in worldwide airline passenger traffic in 1993 over 1992 was approximately 3 1/2%. For the three- year period 1991-1993, the average annual growth rate for worldwide passenger traffic was approximately 3%, significantly below the long-term historical growth rate. Worldwide economic growth rates in general were similarly below long-term historical averages during this period. Passenger traffic gains by U.S. airlines in 1992 were approximately 6 1/2%, largely due to aggressive price discounting that resulted in no revenue growth and significant operating losses in the aggregate. In 1993 passenger traffic of U.S. carriers increased approximately 3 1/2%; however, revenue was up approximately 7%. As a result, U.S. airlines realized an operating profit in the aggregate for 1993, in contrast to their significant operating losses in 1992 and 1991. European airline passenger traffic increased approximately 8% in 1993, but revenue yields remained weak, reflecting current economic conditions. With the exception of Japan, which experienced no growth in airline passenger traffic in 1993, Asia continues to experience high traffic growth. Passenger traffic growth in Asian countries other than Japan grew approximately 7% in 1993. World air travel: [Graphic and image material item Number 5 See appendix on page 108 for description.] The above graph shows the growth in world air travel, excluding traffic of former Soviet Union airlines, as measured by revenue passenger miles from 1970 through 1993, and the Company's forecast of world air travel through the year 2010. The forecasted revenue passenger miles represent an average annual growth rate of somewhat over 5%, compared with the long-term historical annual growth rate of nearly 7% through 1993. The forecasted average annual growth rate, although lower than the historical rate, results in greater annual increases in the absolute number of revenue passenger miles because of the growing volume to which the annual growth rates apply. Based on this long-term forecast of air traffic growth - taking into consideration increasing utilization levels of the worldwide fleet and requirements to replace older aircraft - the Company estimates the total commercial jet transport market through the year 2010, including existing aircraft orders, at approximately $800 billion in 1994 dollars. However, the realization of this market forecast under economically rational circumstances depends on the customer airlines' ability to achieve and sustain reasonable levels of profits over the long term. 29 of 109 AIRLINE PROFITABILITY The domestic and international airline industry in aggregate achieved a general long-term growth trend of positive operating profits from 1970 through 1989, although with significantly reduced operating profits or operating losses during the 1979-1983 period. That long-term profitability trend has again been seriously disrupted, especially with respect to the major U.S. airlines. From 1990-1992, the U.S. airline industry incurred very substantial losses. Additionally, the major non-U.S. airlines experienced operating losses in the aggregate during 1992. Through a combination of passenger traffic growth, improved revenue yields, lower fuel costs, aggressive cost reduction measures and other productivity improvements, both U.S. and non-U.S. airlines realized positive operating profits in 1993 in the aggregate. Net profits, which include interest expense on debt obligations, however, were negative for the fourth consecutive year for the U.S. airline industry. Until the airline industry can achieve sustained levels of acceptable profitability, future orders of the Company's commercial jet transports will be restricted. Many airlines have taken aggressive cost reduction measures, and the airline industry has continued to move toward more consolidation and integration of operations. These actions, coupled with rational fare structures and continued passenger traffic growth, are important factors in returning the airline industry to profitability and improved financial health. Airline industry profits - for core airline operations: [Graphic and image material item Number 6 See appendix on page 108 for description.] INDUSTRY COMPETITIVENESS As all jet transport manufacturers face declining production rates, competitive pressures for new orders continue to be intense in terms of pricing and other conditions. With respect to pricing pressures, the Company's continuous quality improvement and cost reduction efforts are intended to enable the Company to maintain market share at satisfactory margins. In July 1992 the U.S. Government and the European Community announced agreement on interpreting the commercial aircraft code of the General Agreement on Tariffs and Trade (GATT). The 1992 agreement limits direct European government development support subsidies to 33% and prohibits government production loans and government-subsidized sales arrangements. While Boeing would have preferred a ban on all government subsidies for commercial airplane programs, the controls embodied in the 1992 agreement were considered important in limiting future government support to the Company's European competitor. A new multi-lateral subsidies code was incorporated in the GATT agreement reached in December 1993 limiting government subsidies by all countries covered by the GATT. The more restrictive 1992 bilateral agreement remains in effect for the European Community. Further limiting of government subsidies to foreign aircraft manufacturing companies remains a primary goal of Boeing to ensure fair competition. 30 of 109 The aircraft manufacturing industry in the former Soviet Union (FSU) can be expected to capture the predominant share of the future FSU market, although current instability makes that market environment unpredictable. However, the Company believes the FSU market is large and diverse, and presents significant sales opportunities over the longer term. With regard to the commercial jet transport market outside the FSU, the FSU aircraft manufacturing industry, as well as those in certain Asian countries, has the potential of increasing competition, either independently or through alliances. Although this represents an added degree of uncertainty, the Company believes it will be able to maintain its long-term favorable market share through its wide range of product offerings and technological improvements, its broad-based network of domestic and international suppliers and program participants, its extensive customer service system, opportunities for strategic alliances, and continued emphasis on quality and continuous process improvements. WORLD AIRCRAFT FLEET Excess capacity in the worldwide aircraft fleet has contributed to the decline in sales and backlog. Approximately 800 commercial jet transports on average were in storage status during 1993. However, due to noise constraints and the inferior operating economics of older aircraft, only about one-half of the stored aircraft are expected to be put back into commercial service. More than 70% of the inactive aircraft do not meet the Federal Aviation Administration's more stringent Stage III noise requirements and have an average age of well over 20 years. The average age of the inactive aircraft meeting Stage III noise requirements is approximately 10 years. Nearly 40% of the 10,500 jet aircraft in the non-FSU worldwide commercial fleet do not meet noise requirements scheduled to come into effect by the end of the decade. Compliance with the new requirements, where feasible, requires modifications to older aircraft. The costs of these modifications, coupled with increasing maintenance costs and inferior operating economics associated with older aircraft, are projected to result in the retirement of up to 3,500 commercial jet transports by the year 2010 and therefore create substantial new aircraft demand. PRODUCT OFFERINGS The Company continually evaluates opportunities to improve current models, and conducts ongoing marketplace assessments to ensure that its family of jet transports is well positioned to meet future requirements of the airline industry. The fundamental strategy is to maintain a broad product line responsive to changing market conditions by maximizing commonality within and across the Boeing family of airplanes. The Company expects to continue leading the industry in customer satisfaction by offering products that exhibit the highest standards of quality, safety, technical excellence, economic performance, and in-service support. The major focus of development activities over the past three years has been the 777 wide-body twinjet which is scheduled to enter airline service in mid-1995. The new 777 model is designed to meet airline requirements for an efficient, comfortable, high-capacity airplane to be used in domestic and intra-regional markets. An extended-range version of the 777 is being offered for delivery in late 1996, and the aircraft could be further developed for greater capability, including additional range and a stretched fuselage. Orders for 147 and options for 108 777s had been announced by 16 customers as of year end 1993. 31 of 109 During 1993 the Company began development activities on the next generation of the 737 family of short-to-medium-range jetliners that will provide greater range, increased speed, and reduced noise and emissions while maintaining 737 family commonality. The first next-generation 737, designated the 737-700, is the middle-sized member of the 737 family. Customer orders will determine the sequence and timing of the introduction of the smaller 737-600 and the larger 737-800. Approximately 40% of the dollar value of the projected commercial jet transport deliveries through the year 2010 is expected to be in the size category that includes the 737 family. The improved operational capabilities and commonality benefits should give the new 737s significant competitive advantages. Initial 737-700 deliveries are scheduled for late 1997. Other derivatives recently developed or presently in development include the freighter version of the 747-400, in development since 1989 and first delivered in 1993, and the freighter version of the 767 for which deliveries begin in 1995. The Company continues to assess the market potential for new or derivative aircraft that are larger and have more range than the 747-400. Because of a relatively limited market and the heavy resource investment levels required, the Company signed an agreement with four European aerospace companies in 1993 to study the feasibility of developing a new aircraft capable of carrying between 550 and 800 passengers. While product development activities are principally oriented toward maintaining and enhancing the competitiveness of the Boeing subsonic fleet, the Company is also involved in studies to understand the technological and economic issues associated with development of commercial supersonic aircraft. At this time, environmental issues such as takeoff noise and emissions at high altitude appear manageable. SUMMARY Although significant market uncertainties exist - especially with respect to near-term economic conditions, the airline industry's profitability and financial health, and the intense competitive environment - the long-term market outlook remains favorable. The Company is well positioned in all segments of the commercial jet transport market, and intends to remain the airline industry's preferred supplier through emphasis on quality processes, customer satisfaction and product offerings. DEFENSE AND SPACE MARKET ENVIRONMENT - ------------------------------------ Changing defense priorities and severe federal government budget pressures have significantly changed the market environment for the defense and space segment. Over the three-year period 1991-1993, total U.S. Government defense and space funding declined approximately 20% in inflation-adjusted dollars, and further declines are projected over the next few years. As a consequence, some of the Company's programs have been subject to stretch-out, curtailment or termination. Although a number of programs remain subject to future stretch-out and curtailment, the Company's defense and space business is broadly diversified and includes a number of priority developmental programs and candidate programs for system upgrade or modification. Internationally, defense budgets have also moderated; however, there continue to be opportunities for the sale of Boeing systems to foreign governments. 32 of 109 Major defense and space contract awards during 1993 included NASA's selection of Boeing as the prime contractor for the restructured Space Station program, and the initial contract for two 767 Airborne Warning and Control Systems (AWACS) for the government of Japan. The selection as prime contractor for the Space Station program is an acknowledgment of Boeing Defense & Space Group's ability to effectively manage large, complex integration projects, and represents an assignment of great importance to both the Company and the country's manned space program. Boeing will be responsible for the design, development, physical integration, test and launch preparation of the Space Station, as well as completing the original work package to build the habitat and laboratory modules. The 767 AWACS program is expected to provide substantial business opportunities over the long term. Japanese officials have indicated they intend to seek funding for two additional 767 AWACS in 1994, and the Company continues to discuss 767 AWACS requirements with other countries. In addition to the 767 AWACS, other longer-term defense and space business opportunities associated with the Company's commercial aircraft include U.S. military airlift and tankers. The Pentagon's Defense Acquisition Board is presently evaluating potential future acquisition of commercial wide-body aircraft such as the 747 and 767 to supplement the military airlift fleet. A larger percentage of the Company's defense and space business was under cost-reimbursement-type contracts in 1993 compared to 1991 and 1992. The current major developmental programs, principally the Space Station, fighter, RAH-66 Comanche helicopter and V-22 Osprey tiltrotor aircraft, primarily involve cost-reimbursement-type contracts. In addition to the developmental programs mentioned above, the major revenue-producing programs for 1994 include production and remanufacturing of CH-47 helicopters, continuing B-2 bomber subcontract work, production of the Avenger air-defense system, updating and modifying various military aircraft and systems, 767 AWACS, other program support and classified project activities. The current defense and space market is characterized by aggressive competition for the fewer opportunities that remain and significant restructuring throughout the industry in the form of consolidations, acquisitions, relocations and organizational realignment. The Company continues to examine whether its long-term strategy is best pursued through internal means or through acquisitions, dispositions or alliances. During 1991 and 1992, a major organizational consolidation and restructuring of the Company's various defense and space divisions was accomplished, positioning the new Defense & Space Group to effectively compete in this new market environment. Joint venture arrangements with other companies are expected to continue to be common for major developmental programs and the follow-on production activities. Currently, the Company's activities in the, V-22 and RAH-66 developmental programs are under joint venture arrangements. OTHER BUSINESS ACTIVITIES - ------------------------- Other business activities include developing large-scale information systems and conducting management services through Boeing Computer Services, principally for government agencies. An information systems contract to enhance the readiness of the Army Reserve and National Guard units is projected to be the single largest contributor to other business sales for the next few years. In early 1993, the Company elected to discontinue its involvement with the U.S. Government's strategic petroleum reserve program. 33 of 109 LIQUIDITY AND CAPITAL RESOURCES - ------------------------------- The primary factors that affect the Company's investment requirements and liquidity position, other than operating results associated with current sales activity, include the timing of new and derivative commercial jet transport programs which require both high developmental expenditures and initial inventory buildup; cyclical growth and expansion requirements; requirements to provide customer financing assistance; and the timing of federal income tax payments. CASH FLOW SUMMARY Following is a summary of cash flow (based on changes in cash and short- term investments) to highlight and facilitate discussion of the principal cash flow elements. (dollars in billions) 1993 1992 1991 - ------------------------------------------------------------------------- Cash flow from earnings (a) $ 2.4 $ 2.7 $ 2.4 Facilities and equipment expenditures (b) (1.3) (2.2) (1.9) Net decrease in gross inventory 0.6 2.0 1.0 Reductions in customer advances (1.3) (2.1) (0.6) ------------------------- Net inventory change (c) (0.7) (0.1) 0.4 Net changes in receivables, liabilities, and deferred income taxes (d) (0.4) 1.0 (0.9) Pension funding in excess of expense (0.1) (0.2) (0.4) Net increase in customer financing (e) (0.9) (1.1) (0.1) Disbursement for cash dividends and treasury stock acquisition (0.3) (0.4) (0.4) - ------------------------------------------------------------------------- Net cash flow before new debt (1.3) (0.3) (0.9) Long-term debt issued 0.8 0.5 1.0 - ------------------------------------------------------------------------- (Decrease) Increase in cash and short-term investments (0.5) 0.2 0.1 ========================================================================= Cash and short-term investments at end of year $ 3.1 $ 3.6 $ 3.4 ========================================================================= (a) Cash flows from earnings as presented here are adjusted for non-cash charges for depreciation and retiree health care accruals. The Company has not funded Statement of Financial Accounting Standards No. 106 retiree health care accruals and at this time has no plan to fund these accruals in the future. 34 of 109 (b) Facilities and equipment expenditures were at historic highs during 1991 and 1992, primarily in support of the new 777 program. Additionally, productivity investments and facilities expansions in support of the record commercial production rate levels in the 1991-1992 time period contributed substantially to these capital asset expenditures. Expenditures in 1993 were down sharply as the 777 program facilities expansions were substantially completed. Facilities and equipment expenditures are projected to continue to decline over the next two years. (c) The reduction in gross inventory in 1991 was primarily attributable to defense and space activities. During both 1992 and 1993, inventory balances on the 737, 747, 757 and 767 commercial jet transport programs declined substan- tially due to production rate reductions and improvements in production inven- tory flow times, offset by substantial inventory and tooling buildup on the new 777 program. Defense and space segment inventories also declined in 1993. Pri- marily because of declining delivery rates, slower order activity, and program buildup on the 777 program during 1992 and 1993, the ratio of commercial cus- tomer advances to commercial gross inventory declined. Consequently, the reduc- tions in commercial gross inventory were more than offset by reductions in cus- tomer advances, resulting in a net cash requirement. With regard to defense and space contract activity, the ratio of progress billings to gross inventory did not significantly change during this period. Inventory buildup for the 777 pro- gram is projected to continue through mid-1995 when deliveries of the new 777 begin, partially offset by further reductions on the other commercial programs. (d) Over the three-year period 1991-1993, changes in accounts receivable, accounts payable, other liabilities and deferred taxes required $0.3 billion in cash flows in the aggregate. Reductions in customer advances in excess of related costs of $0.9 billion over that three-year period represented the largest individual negative cash flow factor. As of year end 1990, excess customer advances totaled $1.1 billion, primarily associated with commercial aircraft order activity, and have been declining since that time. Offsetting this principal negative cash flow factor were the effects of reductions in accounts receivable and increases in accounts payable and other liabilities. Cash generated from reductions in accounts receivable totaled $0.4 billion, principally associated with U.S. Government contract activity in 1992. Increases in accounts payable and other liabilities provided $0.7 billion over the three-year period, primarily due to increased levels of lease and other deposits from customers. Federal income tax payments over the past several years have substantially exceeded the tax provisions on book income, due principally to certain tax law changes previously enacted, resulting in the acceleration of the recognition of taxable income related to long-term contracts and inventory costing. Federal income tax payments for the 1994-1995 time period are projected to exceed income tax expense by approximately $1 billion as remaining contracts executed under prior tax regulations are completed. (e) The increase in customer financing has been largely driven by the commercial aircraft market conditions discussed above. The Company has outstanding commitments of approximately $4.0 billion to arrange or provide financing related to aircraft on order or under option. However, not all these commitments are likely to be utilized. The Company will sell a portion of customer financing assets from time to time when capital markets are favorable in order to maintain maximum capital resource flexibility. Outstanding loans and commitments are secured by the underlying aircraft. 35 of 109 Property, plant and equipment - net additions: [Graphic and image material item Number 7 See appendix on page 109 for description.] Customer financing - net additions: [Graphic and image material item Number 8 See appendix on page 109 for description.] LIQUIDITY AND CAPITAL RESOURCES SUMMARY The $2.3 billion of long-term debt added over the prior three years is unsecured, with maturities ranging from 10 to 50 years. Total borrowings as of year end 1993 amounted to 23% of total book capital (shareholders' equity plus borrowings), and the Company believes that it has substantial additional long-term borrowing capability. A $3.0 billion revolving credit line agreement with a group of major banks remains available, but unused. In aggregate, cash and short-term investments are projected to decrease through mid-1995 due principally to the inventory buildup on the new 777 jet transport, customer financing commitments, and federal income tax payments. No additional debt issuances are anticipated at this time. The Company believes its internally generated liquidity, together with access to external capital resources, will be sufficient to satisfy existing commitments and plans, and to provide adequate financial flexibility to take advantage of potential strategic business opportunities should they arise. _______ CONTINGENT ITEMS As discussed in Note 13 to the Consolidated Financial Statements, the U.S. Government has terminated for alleged default most of the work required under contracts for a new Saudi Arabia air defense system known as the Peace Shield program. The Government has demanded that the Company repay $605 million of Peace Shield unliquidated progress payments and has selected another contractor to perform the terminated work. Management believes that the Government's grounds for default are not legally supportable, and on appeal the Government's position will be overturned. The Company has filed its complaint in the United States Claims Court to overturn the default termination, submitted a Contract Claim for equitable adjustment to the contract prices and schedules, and requested that repayment of $605 million of unliquidated progress payments be deferred. The Company's financial statements assume that the termination for default will be overturned and that the Contract Claim will be settled in the Company's favor. If the Company's appeal of the termination for default is not successful, the Company could realize a pre-tax loss on the program approximating the value of the unliquidated progress payments plus related interest and potential damages. The Company continues to be subject to ongoing U.S. Government investigations of business practices and cost classifications. These proceedings could involve claims by the Government for damages, and under certain circumstances a contractor can be suspended or debarred from Government contracts. The Company believes, based upon all available information, that the outcome of the Government investigations will not have a materially adverse effect on its financial position or results of operations. 36 of 109 The Company is subject to federal and state requirements for protection of the environment, including those for discharge of hazardous materials and remediation of contaminated sites. Due in part to their complexity and pervasiveness, such requirements have resulted in the Company being involved with related legal proceedings, claims and remediation obligations over the past 10 years. The costs incurred and expected to be incurred in connection with such activities have not had, and are not expected to have, a material impact to the Company's financial position. With respect to results of operations, related charges have averaged less than 2% of annual net earnings, and have not exceeded 3 1/2% in any given year. The Company routinely assesses, based on in-depth studies, expert analyses and legal reviews, its contingencies, obligations and commitments to clean up sites, including assessments of the probability of recoveries from other responsible parties who have and have not agreed to a settlement and recoveries from insurance carriers. The Company's policy is to immediately recognize identified exposures related to environmental cleanup sites based on conservative estimates of investigation, cleanup, and monitoring costs to be incurred. Based on all known facts and expert analyses, the Company believes it is not reasonably likely that identified environmental contingencies will result in a materially adverse impact on the Company's financial position or operating results and cash flow trends. 37 of 109 INDEPENDENT AUDITORS' REPORT January 24, 1994 Board of Directors and Shareholders The Boeing Company Seattle, Washington We have audited the accompanying consolidated statements of financial position of The Boeing Company and subsidiaries as of December 31, 1993 and 1992, and the related statements of net 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, such consolidated financial statements present fairly, in all material respects, the financial position of The Boeing 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 in Note 1 to the financial statements, in 1992 the Company changed its method of accounting for postretirement benefits other than pensions. /s/ Deloitte & Touche Deloitte & Touche Seattle, Washington 38 of 109 THE BOEING COMPANY AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF NET EARNINGS (Dollars in millions except per share data) Year ended December 31, 1993 1992 1991 - ------------------------------------------------------------------------------ Sales and other operating revenues $25,438 $30,184 $29,314 Costs and expenses 23,747 28,144 27,360 - ------------------------------------------------------------------------------ Earnings from operations 1,691 2,040 1,954 Other income, principally interest 169 230 263 Interest and debt expense (39) (14) (13) - ------------------------------------------------------------------------------ Earnings before federal taxes on income and cumulative effect of change in accounting 1,821 2,256 2,204 Federal taxes on income 577 702 637 - ------------------------------------------------------------------------------ Earnings before cumulative effect of change in accounting 1,244 1,554 1,567 Cumulative effect to January 1, 1992, of change in accounting for postretirement benefits other than pensions (1,002) - ------------------------------------------------------------------------------ Net earnings $ 1,244 $ 552 $ 1,567 ============================================================================== Earnings per share: Before cumulative effect of change in accounting $3.66 $ 4.57 $4.56 Cumulative effect to January 1, 1992, of change in accounting for postretirement benefits other than pensions (2.95) - ------------------------------------------------------------------------------ $3.66 $ 1.62 $4.56 ============================================================================== Cash dividends per share $1.00 $ 1.00 $1.00 ============================================================================== See notes to consolidated financial statements. 39 of 109 THE BOEING COMPANY AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF FINANCIAL POSITION (Dollars in millions except per share data) December 31, 1993 1992 - ------------------------------------------------------------------------------ Assets Cash and cash equivalents $ 2,342 $ 2,711 Short-term investments 766 903 Accounts receivable 1,615 1,428 Current portion of customer financing 218 229 Deferred income taxes 800 115 Inventories 10,485 11,073 Less advances and progress billings (7,051) (8,372) - ------------------------------------------------------------------------------ Total current assets 9,175 8,087 Customer financing 2,959 2,066 Property, plant and equipment, at cost 13,232 12,293 Less accumulated depreciation (6,144) (5,569) Deferred income taxes 63 212 Other assets 1,165 1,058 - ------------------------------------------------------------------------------ $20,450 $18,147 ============================================================================== Liabilities and Shareholders' Equity Accounts payable and other liabilities $ 5,854 $ 5,248 Advances in excess of related costs 226 639 Income taxes payable 434 232 Current portion of long-term debt 17 21 - ------------------------------------------------------------------------------ Total current liabilities 6,531 6,140 Accrued retiree health care 2,148 2,004 Long-term debt 2,613 1,772 Contingent stock repurchase commitment 175 175 Shareholders' equity: Common shares, par value $5.00 - 600,000,000 shares authorized; 349,256,792 shares issued 1,746 1,746 Additional paid-in capital 413 418 Retained earnings 7,180 6,276 Less treasury shares, at cost - 1993 - 9,118,995; 1992 - 9,836,313 (356) (384) - ------------------------------------------------------------------------------ Total Shareholders' equity 8,983 8,056 - ------------------------------------------------------------------------------ $20,450 $18,147 ============================================================================== See notes to consolidated financial statements. 40 of 109 THE BOEING COMPANY AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (Dollars in millions) Year ended December 31, 1993 1992 1991 - ------------------------------------------------------------------------------ Cash flows - operating activities: Net earnings $ 1,244 $ 552 $ 1,567 Adjustments to reconcile net earnings to net cash provided by operating activities: Effect of cumulative change in accounting for postretirement benefits other than pensions 1,002 Depreciation and amortization - Plant and equipment 953 870 768 Leased aircraft, other 72 91 58 Deferred income taxes (536) (26) 95 Gain/undistributed earnings - affiliates (1) (13) 1 Changes in operating assets and liabilities - Accounts receivable (187) 635 (41) Inventories, net of advances and progress billings (733) (138) 458 Accounts payable and other liabilities 606 229 (140) Advances in excess of related costs (413) (28) (416) Federal taxes on income 202 206 (453) Change in prepaid pension expense (134) (202) (403) Change in accrued retiree health care 144 184 40 - ------------------------------------------------------------------------------ Net cash provided by operating activities 1,217 3,362 1,534 - ------------------------------------------------------------------------------ Cash flows - investing activities: Short-term investments 137 (388) 623 Customer financing additions (1,560) (1,156) (223) Customer financing reductions 626 16 123 Plant and equipment, net additions (1,317) (2,160) (1,850) Proceeds from sale of affiliate 50 Other 8 (19) (3) - ------------------------------------------------------------------------------ Net cash used by investing activities (2,106) (3,657) (1,330) - ------------------------------------------------------------------------------ Cash flows - financing activities: Debt financing 837 482 993 Shareholders' equity - Cash dividends paid (340) (340) (343) Treasury shares acquired (109) (127) Stock options exercised, other 23 35 23 - ------------------------------------------------------------------------------ Net cash provided by financing activities 520 68 546 - ------------------------------------------------------------------------------ Net increase (decrease) in cash and cash equivalents (369) (227) 750 Cash and cash equivalents at beginning of year 2,711 2,938 2,188 - ------------------------------------------------------------------------------ Cash and cash equivalents at end of year $ 2,342 $ 2,711 $ 2,938 ============================================================================== See notes to consolidated financial statements. 41 of 109 THE BOEING COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Years ended December 31, 1993, 1992 and 1991 (Dollars in millions except per share data) Note 1 - Summary of Significant Accounting Policies Principles of consolidation The consolidated financial statements include the accounts of all sub- sidiaries. Intercompany profits, transactions and balances have been eliminated in consolidation. Sales and other operating revenues Sales under commercial programs and U.S. Government and foreign military fixed-price contracts are generally recorded as deliveries are made. For certain fixed-price contracts that require substantial performance over a long time period before deliveries begin, sales are recorded based upon attainment of scheduled performance milestones. Sales under cost-reimbursement contracts are recorded as costs are incurred and fees are earned. Certain U.S. Government contracts contain profit incentives based upon performance as compared to predetermined targets. Incentives based on cost are recorded currently. Other incentives are included in revenues when awards or penalties are established, or when amounts can reasonably be determined. Income associated with customer financing activities is included in sales and other operating revenues. Inventories and cost of deliveries Inventoried costs on long-term commercial programs and U.S. Government and foreign military contracts include direct engineering, production and tooling costs, and applicable overhead. In addition, for U.S. Government fixed-price- incentive contracts, inventoried costs include research and development and general and administrative expenses estimated to be recoverable. Inventoried costs are generally reduced by the estimated average cost of deliveries. For mature commercial programs, average cost of deliveries is based on the estimated total cost of units committed to production. For commercial programs in the early production stages, average cost of deliveries is based on the estimated total cost of units representing what is believed to be a conservative market projection. For U.S. Government and foreign military contracts, average cost of deliveries is based on the estimated total cost of contractual units. To the extent the total of such costs is expected to exceed the total estimated sales price, charges are made to current earnings to reduce inventoried costs to estimated realizable value. In accordance with industry practice, inventoried costs include amounts relating to programs and contracts with long production cycles, a portion of which is not expected to be realized within one year. 42 of 109 Commercial spare parts and general stock materials are stated at average cost not in excess of realizable value. Research and development, general and administrative expenses Research and development (including the Company-sponsored share of research and development activity conducted in connection with cost-share contracts) and general and administrative expenses are charged directly to earnings as incurred except to the extent estimated to be directly recoverable under U.S. Government flexibly priced contracts. Interest expense Interest and debt expense is presented net of amounts capitalized. Interest expense is subject to capitalization as a construction-period cost of property, plant and equipment and major commercial program tooling. Postretirement benefits The Company's funding policy for pension plans is to contribute, at a minimum, the statutorily required amount to an irrevocable trust. Benefits under the plans are generally based on years of credited service, age at retirement and average of last five years' earnings. The actuarial cost method used in determining the net periodic pension cost is the projected unit credit method. In the fourth quarter of 1992, the Company adopted retroactive to January 1, 1992, the provisions of Statement of Financial Accounting Standards (SFAS) No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," using the immediate recognition transition option. SFAS No. 106 requires accrual of these benefits during an employee's service period. Prior to 1992, post- retirement benefits consisting of retiree health care were accrued for eligible retirees and qualifying dependents. The effect of the immediate recognition of the transition obligation was a decrease to 1992 earnings on an after-tax basis of $1,002, or $2.95 per share based on the annual average shares outstanding. This accounting change increased 1992 pre-tax costs by $123. The retiree health care obligation is unfunded. Taxes on income In 1992, the Company adopted the provisions of Statement of Financial Accounting Standards (SFAS) No. 109, "Accounting for Income Taxes." Under the asset and liability method prescribed by SFAS No. 109, deferred income taxes are provided for the temporary differences between the financial reporting basis and the tax basis of assets and liabilities. These deferred taxes are measured by the provisions of currently enacted tax laws. Because the Company had previously adopted SFAS No. 96, the adoption of SFAS No. 109 does not have a material effect on the Consolidated Statements of Net Earnings. State taxes on income, which are relatively minor in amount, are included in general and administrative expense. 43 of 109 Cash and short-term investments Cash and cash equivalents consist of highly liquid instruments such as certificates of deposit, time deposits, treasury notes and other money market instruments which generally have maturities of less than three months. Short- term investments are carried at cost, which approximates market value. Capital assets Property, plant and equipment are recorded at cost and depreciated over useful lives, principally by accelerated methods. Applicable interest costs are capitalized with respect to plant and equipment additions. Contingent stock repurchase commitment The Company has issued put options on 5,000,000 shares of its stock, exercisable on specific dates in 1994, giving another party the right to sell shares of Boeing stock to the Company at contractually specified prices. The balance of the temporary equity account is the amount the Company would be obligated to pay if all the put options were exercised. The proceeds from the issuance of the put options were accounted for as paid-in capital. Per share data Net earnings per share are computed based on the weighted average number of shares outstanding of 339,736,640, 340,217,888 and 343,355,917 for the years ended December 31, 1993, 1992 and 1991, respectively. There is no material dilutive effect on net earnings per share due to common stock equivalents. Note 2 - Accounts Receivable Accounts receivable at December 31 consisted of the following: 1993 1992 - ------------------------------------------------------------------------------ Amounts receivable under U.S. Government contracts $1,182 $1,035 Accounts receivable from commercial and foreign military customers 433 393 - ------------------------------------------------------------------------------ $1,615 $1,428 ============================================================================== Accounts receivable included the following as of December 31, 1993 and 1992, respectively: amounts not currently billable of $325 and $209 ($192 and $132 not expected to be collected in one year) relating primarily to sales values recorded upon attainment of performance milestones that differ from contractual billing milestones and withholds on U.S. Government contracts; $271 and $241 ($240 and $192 not expected to be collected in one year) relating to claims and other amounts on U.S. Government contracts subject to future settlement; and $57 and $33 of other receivables not expected to be collected in one year. 44 of 109 Note 3 - Inventories Inventories at December 31, 1993 and 1992, consisted of $9,557 and $10,141 relating to long-term commercial programs and U.S. Government and foreign military contracts, and $928 and $932 relating to commercial spare parts, general stock materials and other inventories. General and administrative and research and development expenses included in inventories represented approximately 1% of total inventories. All commercial jet transport programs except the 777 are being accounted for as mature programs as described in Note 1. As of December 31, 1993, there were no significant deferred production costs not recoverable from existing firm orders. Inventory costs relating to long-term commercial jet transport programs included net unamortized tooling of $2,887 and $1,646 at December 31, 1993 and 1992; of these amounts, $2,299 and $867 related to the 777 program. For mature commercial programs, substantially all of such costs will be amortized over existing firm orders. For the 777 program, the number of units for determining production costs in excess of aggregate estimated average cost and over which total tooling costs will be amortized and absorbed in cost of sales will be established when deliveries commence. As of January 24, 1994, 134 777s were under firm contract. Additionally, as of December 31, 1993 and 1992, inventory balances included $457 and $581 subject to claims or other uncertainties related to U.S. Government contracts, principally for the Peace Shield program. (See Note 13.) Interest capitalized as construction-period tooling costs amounted to $50 and $53 in 1993 and 1992. Note 4 - Customer Financing Long-term customer financing, less current portion, at December 31 consisted of the following: 1993 1992 - ------------------------------------------------------------------------------ Notes receivable $1,396 $1,305 Investment in sales-type/financing leases 768 111 Operating lease aircraft, at cost, less accumulated depreciation of $220 and $168 895 720 - ------------------------------------------------------------------------------ 3,059 2,136 Less valuation allowance (100) (70) - ------------------------------------------------------------------------------ $2,959 $2,066 ============================================================================== Financing for aircraft is collateralized by security in the related asset, and historically the Company has not experienced a problem in accessing such collateral. The operating lease aircraft category includes new and used jet and commuter aircraft, spare engines and spare parts. 45 of 109 Principal payments from notes receivable and sales-type/financing leases for the next five years are as follows: 1994 1995 1996 1997 1998 ------------------------------------ $218 $377 $86 $46 $55 ==================================== Certain notes currently bear interest at fixed rates of 7.9% to 10.3%, while the remainder are at variable interest rates up to 1.75% above the prime rate. Sales and other operating revenues included interest income associated with notes receivable and sales-type/financing leases of $153, $57 and $46 for 1993, 1992 and 1991, respectively. Note 5 - Property, Plant and Equipment Property, plant and equipment at December 31 consisted of the following: 1993 1992 - ------------------------------------------------------------------------------ Land $ 397 $ 399 Buildings 5,286 4,193 Machinery and equipment 6,500 6,084 Construction in progress 1,049 1,617 - ------------------------------------------------------------------------------ $13,232 $12,293 ============================================================================== Interest capitalized as construction-period property, plant and equipment costs amounted to $100, $66 and $44 in 1993, 1992 and 1991, respectively. Note 6 - Taxes on Income In 1992, the Company adopted the provisions of Statement of Financial Accounting Standards (SFAS) No. 109, "Accounting for Income Taxes." State taxes on income, which are relatively minor in amount, are included in general and administrative expense. The provision for federal taxes on income consisted of the following: Year ended December 31, 1993 1992 1991 - ------------------------------------------------------------------------------ Taxes paid or currently payable $1,113 $728 $542 Change in deferred taxes other than SFAS No. 106 cumulative transition effect (536) (26) 109 Amortization of investment credit (14) - ------------------------------------------------------------------------------ $ 577 $702 $637 ============================================================================== 46 of 109 The provisions for federal taxes on income were less than those which result from application of the statutory corporate tax rates due to the following: 1993 1992 1991 - ------------------------------------------------------------------------------ Statutory tax rate 35.0 % 34.0 % 34.0 % Foreign Sales Corporation tax benefit (3.3) (3.8) (3.2) Rate change impact on deferred balances (0.5) Research benefit (1.8) Amortization of investment credit (0.6) Other 0.5 0.9 0.5 - ------------------------------------------------------------------------------ Effective tax rate 31.7 % 31.1 % 28.9 % ============================================================================== The research benefit recognized in 1991 related to benefits earned in prior years. The net deferred tax assets (liabilities) resulted from temporary tax differences associated with the following: Year ended December 31, 1993 1992 1991 - ------------------------------------------------------------------------------ Inventory and long-term contract methods of income recognition $ 381 $(182) $(199) Postretirement benefits accruals 429 393 (118) Employee benefits accruals 223 215 203 Customer financing (158) (76) (67) Domestic International Sales Corporation (12) (23) (34) - ------------------------------------------------------------------------------ $ 863 $ 327 $(215) ============================================================================== The temporary tax difference associated with inventory and long-term contract methods of income recognition encompasses related costing differences, including timing and depreciation differences. A valuation allowance was not required due to the nature of and circumstances associated with the temporary tax differences. Income taxes have been settled with the Internal Revenue Service for all years through 1978. It is the Company's position that adequate provision has been made for all amounts due for the years 1979 through 1993. Federal income tax payments and transfers were $908, $518 and $993 in 1993, 1992 and 1991, respectively. Note 7 - Other Assets Other assets at December 31 consisted of the following: 1993 1992 - ------------------------------------------------------------------------------ Prepaid pension expense $ 981 $ 847 Investments and other assets 184 211 - ------------------------------------------------------------------------------ $1,165 $1,058 ============================================================================== 47 of 109 Note 8 - Accounts Payable and Other Liabilities Accounts payable and other liabilities at December 31 consisted of the following: 1993 1992 - ------------------------------------------------------------------------------ Accounts payable $2,731 $2,869 Employee compensation and benefits 1,005 997 Lease and other deposits 708 275 Other 1,410 1,107 - ------------------------------------------------------------------------------ $5,854 $5,248 ============================================================================== Note 9 - Long-Term Debt Long-term debt at December 31 consisted of the following: 1993 1992 - ------------------------------------------------------------------------------ Unsecured debentures and notes: 8 3/8% due Mar. 1, 1996 $ 249 $ 249 6.35% due Jun. 15, 2003 299 8 1/10% due Nov. 15, 2006 175 175 8 3/4% due Aug. 15, 2021 398 398 7.95% due Aug. 15, 2024 300 300 7 1/4% due Jun. 15, 2025 247 8 3/4% due Sep. 15, 2031 248 248 8 5/8% due Nov. 15, 2031 173 173 7.865% due Aug. 15, 2042 100 100 7 7/8% due Apr. 15, 2043 173 6 7/8% due Oct. 15, 2043 125 Other notes 143 150 Less current portion (17) (21) - ------------------------------------------------------------------------------ $2,613 $1,772 ============================================================================== The $300 debentures due August 15, 2024, are redeemable at the holder's option on August 15, 2012. All other debentures and notes are not redeemable prior to maturity. The $100 notes due August 15, 2042, were issued to a private investor, and the interest rate of 7.865% is a synthetic rate reflecting the effect of interest rate swaps simultaneously entered into with the private investor. Maturities of long-term debt for the next five years are as follows: 1994 1995 1996 1997 1998 ------------------------------------ $17 $13 $269 $9 $11 ==================================== Interest payments were $175, $120 and $32 in 1993, 1992 and 1991, respectively. The Company has a $3,000 credit line currently available under an agreement with a group of commercial banks. Under this agreement, there are compensating balance arrangements, and retained earnings totaling $1,186 are free from dividend restrictions. The Company has complied with restrictive covenants contained in the various debt agreements. 48 of 109 Note 10 - Postretirement Plans Pensions The Company has various noncontributory plans covering substantially all employees. All major plans are funded and have plan assets that exceed accumulated benefit obligations. The following table reconciles the plans' funded status to the prepaid expense balance at December 31. 1993 1992 - ------------------------------------------------------------------------------ Actuarial present value of benefit obligations: Vested $(7,196) $(6,081) Nonvested (547) (436) - ------------------------------------------------------------------------------ Accumulated benefit obligation (7,743) (6,517) Effect of projected future salary increases (1,299) (1,397) - ------------------------------------------------------------------------------ Projected benefit obligation (9,042) (7,914) Plan assets at fair value - primarily equities, fixed income obligations and cash equivalents 9,180 8,326 - ------------------------------------------------------------------------------ Plan assets in excess of projected benefit obligation 138 412 Unrecognized net actuarial loss 467 139 Unrecognized prior service cost 476 410 Unrecognized net asset at January 1, 1987, being recognized over the plans' average remaining service lives (100) (114) - ------------------------------------------------------------------------------ Prepaid pension expense recognized in the Consolidated Statements of Financial Position $ 981 $ 847 ============================================================================== The pension provision included the following components: Year ended December 31, 1993 1992 1991 - ------------------------------------------------------------------------------ Service cost (current period attribution) $ 307 $ 293 $ 299 Interest accretion on projected benefit obligation 632 594 561 Actual return on plan assets (923) (483) (972) Net deferral and amortization of actuarial losses (gains) 257 (140) 427 - ------------------------------------------------------------------------------ Net pension provision $ 273 $ 264 $ 315 ============================================================================== The actuarial present value of the projected benefit obligation at December 31, 1993, 1992 and 1991, respectively, was determined using a weighted average discount rate of 7.25%, 8.25% and 8.25%, and a rate of increase in future compensation levels of 5.0%, 6.0% and 6.0%. The expected long-term rate of return on plan assets was 8.5% at December 31, 1993, 1992 and 1991. 49 of 109 The pension plans have been amended to provide that, in the event there is a change in control of the Company which is not approved by the Board of Directors and the plans are terminated within five years thereafter, the assets in the plans first will be used to provide the level of retirement benefits required by the Employee Retirement Income Security Act, and then any surplus will be used to fund a trust to continue present and future payments under the post- retirement medical and life insurance benefits in the Company's group insurance programs. Although the Company has no intention of doing so, should it terminate certain of its pension plans under conditions where the plan's assets exceed the plan's obligations, the Company has an agreement with the Government whereby the Government is entitled to a fair allocation of any of the plan's reverted assets based on plan contributions that were reimbursed under Government contracts. Also, the Revenue Reconciliation Act of 1990 imposes a 20% non- deductible excise tax on the gross assets reverted if the Company establishes a qualified replacement plan or amends the terminating plan to provide for benefit increases; otherwise, a 50% tax is applied. Any net amount retained by the Company is treated as taxable income. The Company has certain unfunded and partially funded plans with a projected benefit obligation of $169 and $109; plan assets of $23 and $0; and unrecog- nized prior service costs and actuarial losses of $70 and $46 as of December 31, 1993 and 1992, respectively, based on actuarial assumptions consistent with the funded plans. The net provision for the unfunded plans was $22 and $15 for 1993 and 1992. The principal defined contribution plans are the Company-sponsored 401(k) plans and a funded plan for unused sick leave. Under the terms of the Company- sponsored 401(k) plans, eligible employees are allowed to contribute up to 12% of their base pay. The Company contributes amounts equal to 50% of the employee's contribution to a maximum of 4% of the employee's pay, subject to statutory limitations. The provision for these defined contribution plans in 1993, 1992 and 1991 was $213, $221 and $205, respectively. Other postretirement benefits In the fourth quarter of 1992, the Company adopted retroactive to January 1, 1992, the provisions of Statement of Financial Accounting Standards (SFAS) No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," using the immediate recognition transition option. SFAS No. 106 requires accrual of these benefits during an employee's service period. Prior to 1992, postretirement benefits were accrued for eligible retirees upon retirement. The Company's postretirement benefits other than pensions consist of health care coverage for eligible retirees and qualifying dependents. Except for employees covered by the United Auto Workers bargaining agreement for whom lifetime benefits are provided, retiree health care is provided principally until age 65. At January 1, 1992, the accumulated postretirement benefit obligation was $1,819; however, $301 of this obligation had been previously accrued, resulting in a pre-tax transition obligation adjustment of $1,518. The effect of the immediate recognition of the transition obligation was a decrease to first quarter 1992 net earnings of $1,002 and a deferred tax benefit of $516. 50 of 109 The retiree health care cost provision was $230, $257 and $105 for 1993, 1992 and 1991, respectively. The components of expense for 1993 and 1992 were as follows: Year ended December 31, 1993 1992 - ------------------------------------------------------------------------------ Service cost (current period attribution) $ 92 $110 Interest accretion on accumulated postretirement benefit obligation 144 147 Net deferral and amortization of actuarial gains (6) - ------------------------------------------------------------------------------ Net provision for retiree health care $230 $257 ============================================================================== Benefit costs were calculated based on assumed cost growth for retiree health care costs of a 12.0% annual rate for 1994, decreasing to a 5.25% annual growth rate by the year 2003. A 1% increase or decrease in the assumed annual trend rates would increase or decrease the accumulated postretirement benefit ob- ligation by $218 and $227 as of December 31, 1993 and 1992, with a corresponding effect on the postretirement benefit expense of $39 and $43 for 1993 and 1992. The accumulated postretirement benefit obligation at December 31, 1993 and 1992, was determined using a weighted average discount rate of 7.25% and 8.25%. The accumulated postretirement benefit obligation at December 31 consisted of the following components: 1993 1992 - ------------------------------------------------------------------------------ Retirees and dependents $ 534 $ 485 Fully eligible active plan participants 364 358 Other active plan participants 923 872 - ------------------------------------------------------------------------------ Total accumulated postretirement benefit obligation 1,821 1,715 Unrecognized net actuarial gain 327 289 - ------------------------------------------------------------------------------ Accrued postretirement benefit obligation $2,148 $2,004 ============================================================================== Note 11 - Research and Development, General and Administrative Expenses Expenses charged directly to earnings as incurred included the following: Year ended December 31, 1993 1992 1991 - ------------------------------------------------------------------------------ Research and development $1,661 $1,846 $1,417 General and administrative 1,102 1,232 1,291 ============================================================================== 51 of 109 In July 1987, the Company adopted a Stockholder Rights Plan and declared a dividend distribution of one Right for each outstanding share of common stock. Under certain conditions, each Right may be exercised to purchase one one- hundredth of a share of Series A Junior Participating Preferred Stock at a purchase price of $150, subject to adjustment. The Rights will be exercisable only if a person or group has acquired, or obtained the right to acquire, 20% or more of the outstanding shares of common stock; following the commencement of a tender or exchange offer for 30% or more of such outstanding shares of 52 of 109 common stock; or after the Board of Directors of the Company declares any person, alone or together with affiliates and associates, to be an Adverse Person. If the Board of Directors declares an Adverse Person, or a person or group acquires more than 30% of the then outstanding shares of common stock (except pursuant to an offer which the independent Directors determine to be fair to and otherwise in the best interests of the Company and its share- holders), each Right will entitle its holder to receive, upon exercise, common stock (or, in certain circumstances, cash, property or other securities of the Company) having a value equal to two times the exercise price of the Right. The Company will be entitled to redeem the Rights at 5 cents per Right at any time prior to the earlier of the expiration of the Rights in August 1997 or ten days following the time that a person has acquired or obtained the right to acquire a 20% position. The Company may not redeem the Rights if the Board of Directors has previously declared a person to be an Adverse Person. The Rights do not have voting or dividend rights, and until they become exercisable, have no dilutive effect on the earnings of the Company. Changes in stock options and stock appreciation rights (SARs), issued to officers and other employees at exercise prices equal to market value of the stock at grant date, consisted of the following: (Shares in thousands) Year ended December 31, 1993 1992 1991 - ------------------------------------------------------------------------------ Number of shares under option: Outstanding at beginning of year 12,001 8,123 7,526 Granted 2,531 4,748 1,597 Exercised (743) (630) (630) Cancelled or expired (278) (98) (69) Exercised as SARs (246) (142) (301) - ------------------------------------------------------------------------------ Outstanding at end of year 13,265 12,001 8,123 ============================================================================== Exercisable at end of year 5,715 4,985 4,488 ============================================================================== Stock appreciation rights: Outstanding at end of year 1,703 2,174 2,398 Exercisable at end of year 1,480 1,658 1,660 ============================================================================== Number of shares authorized for future stock option grants at end of year 16,695 5,513 10,166 ============================================================================== The ranges of exercise prices per share for options outstanding were as follows: December 31, 1993 1992 1991 - ------------------------------------------------------------------------------ High $60.06 $60.06 $60.06 Low $12.63 $10.70 $ 5.56 ============================================================================== The Company has authorized 10,000,000 shares of $1 par preferred stock, none of which has been issued. 53 of 109 Note 13 - Contingencies Various legal proceedings, claims and investigations are pending against the Company related to products, contracts and other matters. Except for the items discussed below, most of these legal proceedings are related to matters covered by insurance. In January 1991, the Company received from the U.S. Government a notice of partial termination for default which terminated most of the work required under contracts to develop and install a new air defense system for Saudi Arabia, known as the Peace Shield program. The Government has filed with the Company a demand for repayment of $605 of Peace Shield unliquidated progress payments plus interest commencing January 25, 1991. In February 1991, the Company submitted a request for a deferred payment agreement which, if granted, would formally defer the Company's potential obligation to repay the $605 of unliquidated progress payments until the conclusion of the appeal process. In June 1991, the Government selected another contractor to perform the work which is the subject of the contracts that have been terminated for default, and the Government will likely assert claims related to the reprocurement. The Company does not expect the Government to assert such claims prior to completion of the reprocurement contract, which was originally scheduled for late 1995. Management's position, supported by outside legal counsel which specializes in government procurement law, is that the grounds for default asserted by the Government in the Peace Shield termination are not legally supportable. Accordingly, management and counsel are of the opinion that on appeal the termination for default has a substantial probability of being converted to termination for the convenience of the Government, which would eliminate any Government claim for cost of reprocurement or other damages. Additionally, the Company has a legal basis for a claim for equitable adjustment to the prices and schedules of the contracts (the "Contract Claim"). Many of the same facts underlie both the Contract Claim and the Company's appeal of the Government's termination action. The Company has filed its complaint in the United States Claims Court to overturn the default termination in order to obtain payment of the Contract Claim. The parties are currently litigating jurisdictional issues related to the complaint, and are engaged in discovery. Trial is currently scheduled for March 1997. The Company expects that its position will ultimately be upheld with respect to the termination action and that it will prevail on the Contract Claim. The Company's financial statements have been prepared on the basis of a conservative estimate of the revised values of the Peace Shield contracts including the Contract Claim and the Company's position that the termination was for the convenience of the Government. At this time, the Company cannot reasonably estimate the length of time that will be required to resolve the termination appeal and the Contract Claim. In the event that the Company's appeal of the termination for default is not successful, the Company could realize a pre-tax loss on the program approximating the value of the unliquidated progress payments plus related interest and potential damages assessed by the Government. 54 of 109 The Company is subject to several U.S. Government investigations of business and cost classification practices. One investigation involves a grand jury proceeding as to whether or not certain costs were charged to the proper overhead accounts. No charges have been filed in this matter, and based on the facts known to it, the Company believes it would have defenses if any were filed. The investigations could result in civil, criminal or administrative proceedings. Such proceedings, if any, could involve claims by the Government for fines, penalties, compensatory and treble damages, restitution and/or forfeitures. Based upon Government procurement regulations, a contractor, or one or more of its operating divisions or subdivisions, can also be suspended or debarred from Government contracts if proceedings result from the inves- tigations. The Company believes, based upon all available information, that the outcome of Government investigations will not have a materially adverse effect on its financial position or results of operations. The Company is subject to federal and state requirements for protection of the environment, including those for discharge of hazardous materials and remediation of contaminated sites. Due in part to their complexity and per- vasiveness, such requirements have resulted in the Company being involved with related legal proceedings, claims and remediation obligations over the past 10 years. The Company routinely assesses, based on in-depth studies, expert analyses and legal reviews, its contingencies, obligations and commitments for remedi- ation of contaminated sites, including assessments of ranges and probabilities of recoveries from other responsible parties who have and have not agreed to a settlement and recoveries from insurance carriers. The Company's policy is to immediately accrue and charge to current expense identified exposures related to environmental remediation sites based on conservative estimates of inves- tigation, cleanup and monitoring costs to be incurred. The costs incurred and expected to be incurred in connection with such activities have not had, and are not expected to have, a material impact to the Company's financial position. With respect to results of operations, related charges have averaged less than 2% of annual net earnings. Such accruals as of December 31, 1993, without consideration for the related contingent recoveries from insurance carriers, are less than 2% of total liabilities. Based on all known facts and expert analyses, the Company believes it is not reasonably likely that identified environmental contingencies will result in additional costs that would have a materially adverse impact to the Company's financial position or operating results and cash flow trends. 55 of 109 Note 14 - Industry Segment Information The Company operates in two principal industries: Commercial Aircraft, and Defense and Space. Commercial Aircraft operations principally involve develop- ment, production and marketing of commercial jet transports and providing related support services, principally to the commercial airline industry. Defense and Space operations involve research, development, production, mod- ification and support of military aircraft and related systems, space systems and missile systems. No single product line in the Defense and Space segment represented more than 10% of consolidated revenues, operating profits or identifiable assets. Foreign sales by geographic area consisted of the following: Year ended December 31, 1993 1992 1991 - ------------------------------------------------------------------------------ Asia $ 8,870 $ 7,108 $ 5,458 Europe 4,698 7,165 8,745 Oceania 635 1,911 1,659 Africa 264 430 558 Western Hemisphere 149 872 1,436 - ------------------------------------------------------------------------------ $14,616 $17,486 $17,856 ============================================================================== Defense sales were approximately 6%, 3% and 5% of total sales in Europe for 1993, 1992 and 1991, respectively. Defense sales were approximately 2%, 5% and 5% of total sales in Asia for 1993, 1992 and 1991, respectively. Exclusive of these amounts, Defense and Space sales were principally to the U.S. Government. Financial information by segment for the three years ended December 31, 1993, is summarized on page 57. Corporate income consists principally of interest income from corporate investments. Corporate expense consists of noncapitalized interest on debt and other general corporate expenses. Corporate assets consist principally of cash, cash equivalents, short-term investments and deferred income taxes. 56 of 109 Year ended December 31, 1993 1992 1991 - ------------------------------------------------------------------------------ Revenues Commercial Aircraft $20,568 $24,133 $22,970 Defense and Space 4,407 5,429 5,846 Other industries 463 622 498 - ------------------------------------------------------------------------------ Operating revenues 25,438 30,184 29,314 Corporate income 169 230 263 - ------------------------------------------------------------------------------ Total revenues $25,607 $30,414 $29,577 ============================================================================== Operating profit Commercial Aircraft $ 1,646 $ 1,990 $ 2,246 Defense and Space 219 204 (102) Other industries 16 27 (2) - ------------------------------------------------------------------------------ Operating profit 1,881 2,221 2,142 Corporate income 169 230 263 Corporate expense (229) (195) (201) - ------------------------------------------------------------------------------ Earnings before taxes $ 1,821 $ 2,256 $ 2,204 ============================================================================== Identifiable assets at December 31 Commercial Aircraft $12,686 $10,178 $ 7,806 Defense and Space 3,525 3,687 4,262 Other industries 202 264 196 - ------------------------------------------------------------------------------ 16,413 14,129 12,264 Corporate 4,037 4,018 3,660 - ------------------------------------------------------------------------------ Consolidated assets $20,450 $18,147 $15,924 ============================================================================== Depreciation Commercial Aircraft $ 710 $ 598 $ 484 Defense and Space 230 241 269 Other industries 67 73 51 - ------------------------------------------------------------------------------ Total depreciation $ 1,007 $ 912 $ 804 ============================================================================== Capital expenditures, net Commercial Aircraft $ 1,120 $ 1,890 $ 1,445 Defense and Space 164 212 317 Other industries 33 58 88 - ------------------------------------------------------------------------------ Total capital expenditures, net $ 1,317 $ 2,160 $ 1,850 ============================================================================== 57 of 109 Note 15 - 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, principally relating to customer financing activities. Off-balance-sheet risk items include financing commitments, extensions of credit, credit guarantees, tax benefit transfers, foreign govern- ment expropriation guarantees, interest rate swaps, and agreements with other financing parties to participate in long-term receivables with interest rate terms different from those of the related receivable. Irrevocable financing commitments related to aircraft on order, including options, scheduled for delivery through 2002 totaled $3,963 as of December 31, 1993. The Company anticipates that not all of these commitments will be utilized and that it will be able to arrange for third-party investors to assume a portion of the remaining commitments, if necessary. The Company's exposure to credit and market-related losses related to credit guarantees, tax benefit transfers, and foreign government expropriation guarantees totaled $28 as of December 31, 1993. The Company has entered into interest rate swaps with third-party investors whereby the interest rate terms differ from those of the original receivable. These interest rate swaps related to $458 of customer financing receivables as of December 31, 1993. In addition, participation in customer financing receivables by third-party investors with interest rate terms different from the original receivable totaled $83. Note 16 - Significant Group Concentrations of Credit Risk Substantially all financial instruments are with commercial airline customers and the U.S. Government. As of December 31, 1993, virtually all off-balance- sheet financial instruments described in Note 15 related to commercial aircraft customers. Of the $3,897 in accounts receivable and customer financing receivables included in the Consolidated Statements of Financial Position, $2,583 related to commercial aircraft customers and $1,182 related to the U.S. Government. Financing for aircraft is collateralized by security in the related asset, and historically, the Company has not experienced a problem in accessing such collateral. 58 of 109 Note 17 - Disclosures about Fair Value of Financial Instruments The carrying values of cash equivalents and short-term investments are representative of fair value because of the short maturity of those instruments. Certain receivable balances will be collected over an extended period; consequently, the fair value of accounts receivable is estimated to be lower than the carrying value by $60 and $50 as of December 31, 1993 and 1992, reflecting a discounted value due to deferred collection. The carrying value of accounts payable is estimated to approximate fair value. There are generally no quoted market prices available for customer financing notes receivable. The net fair value of such notes is estimated to approximate the net carrying value based upon interest rates and risk-related rate spreads as of December 31, 1993. The carrying amount of long-term debt was $2,630 and $1,793 as of December 31, 1993 and 1992. The fair value of long-term debt, based on current market rates for debt of the same risk and maturities, was estimated at $2,870 and $1,880 as of December 31, 1993 and 1992. The Company's long-term debt, however, is generally not callable until maturity. With regard to financial instruments with off-balance-sheet risk, it is not practicable to estimate the fair value of future financing commitments, and all other off-balance-sheet financial instruments are estimated to have only a nominal fair value. The terms and conditions reflected in the outstanding guarantees and commitments for financing assistance are not materially different from those that would have been negotiated as of December 31, 1993. 59 of 109 60 of 109 Five Year Summary (Dollars in millions except per share data) (Share data restated for applicable stock splits) OPERATIONS 1993 1992 1991 1990 1989 Sales and other operating revenues Commercial Aircraft $20,568 $24,133 $22,970 $21,230 $14,305 Defense and Space 4,407 5,429 5,846 5,862 5,429 Other industries 463 622 498 503 542 - --------------------------------------------------------------------------- Total 25,438 30,184 29,314 27,595 20,276 - --------------------------------------------------------------------------- Net earnings 1,244 1,554** 1,567 1,385 675* Per share 3.66 4.57** 4.56 4.01 1.96* Percent of sales 4.9% 5.2% 5.3% 5.0% 3.3% - --------------------------------------------------------------------------- Cash dividends paid $ 340 $ 340 $ 343 $ 328 $ 269 Per share 1.00 1.00 1.00 .95 .77 7/9 - --------------------------------------------------------------------------- Other income, principally interest 169 230 263 448 347 - --------------------------------------------------------------------------- Research and development expensed 1,661 1,846 1,417 827 754 General and administrative expensed 1,102 1,232 1,291 1,246 1,066 - --------------------------------------------------------------------------- Additions to plant and equipment 1,317 2,160 1,850 1,586 1,362 Depreciation of plant and equipment 953 870 768 636 584 - --------------------------------------------------------------------------- Salaries and wages 5,766 6,318 6,502 6,487 6,082 Average employment 134,400 148,600 159,100 161,700 159,200 =========================================================================== FINANCIAL POSITION AT DECEMBER 31 Total assets $20,450 $18,147 $15,924 $14,591 $13,278 Working capital 2,601 1,947 2,462 1,396 1,689 Net plant and equipment 7,088 6,724 5,530 4,448 3,481 - --------------------------------------------------------------------------- Cash and short-term investments 3,108 3,614 3,453 3,326 1,863 Total debt 2,630 1,793 1,317 315 280 Customer financing 3,177 2,295 1,197 1,133 868 - --------------------------------------------------------------------------- Shareholders' equity 8,983 8,056 8,093 6,973 6,131 Per share 26.41 23.74 23.71 20.30 17.73 Common shares outstanding in millions 340.1 339.4 341.3 343.6 345.8 =========================================================================== CONTRACTUAL BACKLOG Commercial $70,497 $82,649 $92,826 $91,475 $73,974 U.S. Government 3,031 5,281 5,090 5,719 6,589 - --------------------------------------------------------------------------- Total $73,528 $87,930 $97,916 $97,194 $80,563 =========================================================================== * Exclusive of the cumulative effect of adopting Statement of Financial Accounting Standards No. 96, "Accounting for Income Taxes." Net earnings including the effect were $973 or $2.82 per share. ** Exclusive of the cumulative effect of adopting Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions." Net earnings including the effect were $552 or $1.62 per share. Cash dividends have been paid on common stock every year since 1942. 61 of 109 Market for Registrant's Common Equity and Related Stockholder Matters Shareholder & Investor Information The Boeing Company General Offices 7755 East Marginal Way South Seattle, Washington 98108 (206) 655-2121 Shareholder Inquires Transfer Agent and Registrar The First National Bank of Boston Our transfer agent is responsible for our shareholder records, issuance of stock certificates, and distribution of our dividends and IRS Form 1099. Requests concerning these matters are most efficiently answered by corresponding directly with The First National Bank of Boston at the following address: The Boeing Company c/o The First National Bank of Boston Mail Stop 45-02-09 P.O. Box 644 Boston, Massachusetts 02102-0644 Telephone:(617) 575-2900 or (800) 442-2001 Pre-recorded information concerning various shareholder account matters is available toll-free from Boeing Shareholder Services at (800) 457-7723. Written inquiries may be sent to The Boeing Company Shareholder Services Mrs. Michelle Hayes P.O. Box 3707, Mail Stop 10-13 Seattle, Washington 98124-2207 Annual Meeting The annual meeting of Boeing shareholders will be held in the auditorium of the Company's 2-22 building, located at 7755 East Marginal Way South, Seattle, Washington, on April 25, 1994. Formal notice of the meeting, proxy statement, form of proxy and annual report were mailed to shareholders starting about March 15, 1994. Stock Exchange Listings The company's common stock is traded principally on the New York Stock Exchange; the trading symbol is BA. Boeing common stock is also listed on the Amsterdam, Brussels, London, Swiss and Tokyo stock exchanges. Ad- ditionally, the stock is traded on the Boston, Cincinnati, Midwest and Philadelphia exchanges. The number of shareholders of record as of January 31, 1994, was 101,219. General Auditors Deloitte and Touche 700 Fifth Avenue, Suite 4500 Seattle, Washington 98104-5044 (206) 292-1800 62 of 109 Exhibit (3) By-Laws, as amended and restated October 25, 1993 63 of 109 BY-LAWS OF THE BOEING COMPANY ARTICLE I Stockholders' Meetings SECTION 1. Annual Meetings. The Annual Meeting of the stockholders shall be held on the last Monday in the month of April in each year, or, if that day be a legal holiday, on the next succeeding day not a legal holiday, at 11:00 a.m., for the election of directors and the transaction of such other business as may come before the meeting. SECTION 2. Special Meetings. A special meeting of the stockholders may be called at any time by the Board of Directors, or by stockholders holding together at least twenty-five percent of the outstanding shares of stock entitled to vote, except as otherwise provided by statute or by the Certificate of Incorporation or any amendment thereto. SECTION 3. Place of Meeting. All meetings of the stockholders of the Corporation shall be held at such place or places within or without the State of Delaware as may from time to time be fixed by the Board of Directors or as shall be specified or fixed in the respective notices or waivers of notice thereof. SECTION 4. Notice of Meetings. Except as otherwise required by statute and as set forth below, notice of each annual or special meeting of stockholders shall be given to each stockholder of record entitled to vote at such meeting not less than thirty nor more than sixty (or the maximum number permitted by applicable law) days before the meeting date. If the Corporation has an Interested Stockholder as defined in Article EIGHTH of the Certificate of Incorporation, notice of each special meeting of stockholders shall be given to each stockholder of record entitled to vote at such meeting not less than fifty-five nor more than sixty (or the maximum number permitted by applicable law) days before the meeting date, unless the calling of such meeting is ratified by the affirmative vote of a majority of the Continuing Directors as defined in Article EIGHTH of the Certificate of Incorporation, in which case notice of such special meeting shall be given to each stockholder of record entitled to vote at such meeting not less than thirty nor more than sixty (or the maximum number permitted by applicable law) days before the meeting date. Such notice shall be given by delivering to each stockholder a written or printed notice thereof either personally or by mailing such notice in a postage-prepaid envelope addressed to the stockholder's address as it appears on the stock books of the Corporation. Except as otherwise required by statute, no publication of any notice of a meeting of stockholders shall be required. Every notice of a meeting of stockholders shall state the place, date, and hour of the meeting and, in the case of a special meeting, the purpose or purposes for which the meeting is called. 64 of 109 SECTION 5. Waivers of Notice. Whenever any notice is required to be given to any stockholder under the provisions of these By-Laws, the Certificate of Incorporation, or the Delaware General Corporation Law, a waiver thereof in writing, signed by the person or persons entitled to such notice, whether before or after the time stated therein, shall be deemed equivalent to the giving of such notice. The attendance of a stockholder at a meeting, in person or by proxy, shall constitute a waiver of notice of such meeting, except when a stockholder attends a meeting for the express purpose of objecting, at the beginning of the meeting, to the transaction of any business because the meeting is not lawfully called or convened. SECTION 6. Quorum. At all meetings of stockholders, except when otherwise provided by statute or by the Certificate of Incorporation or any amendment thereto, or by the By-Laws, the presence, in person or by proxy duly authorized, of the holders of one-third of the outstanding shares of stock entitled to vote shall constitute a quorum for the transaction of business; and except as otherwise provided by statute or rule of law, or by the Certificate of Incorporation or any amendment thereto, or by the By-Laws, the vote, in person or by proxy, of the holders of a majority of the shares constituting such quorum shall be binding upon all stockholders of the Corporation. In the absence of a quorum, a majority of the shares present in person or by proxy and entitled to vote may adjourn any meeting, from time to time but not for a period of more than thirty days at any one time, until a quorum shall attend. At any such adjourned meeting at which a quorum shall be present, any business may be transacted which might have been transacted at the meeting as originally called. Unless otherwise provided by statute, no notice of an adjourned meeting need be given. SECTION 7. Proxies. 7.1 Appointment. Each stockholder entitled to vote at a meeting of stockholders or to express consent or dissent to corporate action in writing without a meeting may authorize another person or persons to act for such stockholder by proxy. Such authorization may be accomplished by (a) the stockholder or such stockholder's authorized officer, director, employee, or agent executing a writing or causing his or her signature to be affixed to such writing by any reasonable means, including facsimile signature, or (b) by transmitting or authorizing the transmission of a telegram, cablegram, or other means of electronic transmission to the intended holder of the proxy or to a proxy solicitation firm, proxy support service, or similar agent duly authorized by the intended proxy holder to receive such transmission; provided, that any such telegram, cablegram, or other electronic transmission must either set forth or be accompanied by information from which it can be determined that the telegram, cablegram, or other electronic transmission was authorized by the stockholder. Any copy, facsimile telecommunication, or other reliable reproduction of the writing or transmission by which a stockholder has authorized another person to act as proxy for such stockholder may be substituted or used in lieu of the original writing or transmission for any and all purposes for which the original writing or transmission could be used, provided that such copy, facsimile telecommunication, or other reproduction shall be a complete reproduction of the entire original writing or transmission. 65 of 109 7.2 Delivery to Corporation; Duration. A proxy shall be filed with the Secretary of the Corporation before or at the time of the meeting or the delivery to the Corporation of the consent to corporate action in writing. A proxy shall become invalid three years after the date of its execution, unless otherwise provided in the proxy. A proxy with respect to a specified meeting shall entitle the holder thereof to vote at any reconvened meeting following adjournment of such meeting but shall not be valid after the final adjournment thereof. SECTION 8. Inspectors of Election. 8.1 Appointment. In advance of any meeting of stockholders, the Board of Directors of the Corporation shall appoint one or more persons to act as inspectors of election at such meeting and to make a written report thereof. The Board of Directors may designate one or more persons to serve as alternate inspectors to serve in place of any inspector who is unable or fails to act. If no inspector or alternate is able to act at a meeting of stockholders, the chairman of such meeting shall appoint one or more persons to act as inspector of elections at such meeting. 8.2 Duties. The inspectors shall: (a) ascertain the number of shares of the Corporation outstanding and the voting power of each such share; (b) determine the shares represented at the meeting and the validity of proxies and ballots; (c) count all votes and ballots; (d) determine and retain for a reasonable period of time a record of the disposition of any challenges made to any determination by them; and (e) certify their determination of the number of shares represented at the meeting and their count of the votes and ballots. Each inspector of election shall, before entering upon the discharge of his or her duties, take and sign an oath to faithfully execute the duties of inspector with strict impartiality and according to the best of his or her ability. The inspectors of election may appoint or retain other persons or entities to assist them in the performance of their duties. 8.3 Determination of Proxy Validity. The validity of any proxy or ballot executed for a meeting of stockholders shall be determined by the inspectors of election in accordance with the applicable provisions of the Delaware General Corporation Law as then in effect. In determining the validity of any proxy transmitted by telegram, cablegram, or other electronic transmission, the inspectors shall record in writing the information upon which they relied in making such determination. SECTION 9. Fixing the Record Date. 9.1 Meetings. For the purpose of determining stockholders entitled to notice of and to vote at any meeting of stockholders or any adjournment thereof, the Board of Directors may fix a record date, which record date shall not precede the date on which the resolution fixing the record date is adopted by the Board of Directors, and which record date shall be not fewer than thirty nor more than sixty (or the maximum number permitted by applicable law) days before the date of such meeting. If the corporation has an Interested Stockholder as defined in Article EIGHTH of the Certificate of Incorporation, the record date for each special meeting of stockholders shall be not fewer than fifty-five nor more than sixty (or the 66 of 109 maximum number permitted by applicable law) days before the meeting date, unless the calling of such meeting is ratified by the affirmative vote of a majority of the Continuing Directors, as defined in Article EIGHTH of the Certificate of Incorporation. If no record date is fixed by the Board of Directors, the record date for determining stockholders entitled to notice of and to vote at a meeting of stockholders shall be at the close of business on the day next preceding the day on which notice is given, or, if notice is waived, at the close of business on the day next preceding the day on which the meeting is held. A determination of stockholders of record entitled to notice of and 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. 9.2 Consent to Corporate Action Without a Meeting. For the purpose of determining the stockholders entitled to consent to corporate action in writing without a meeting, the Board of Directors may fix a record date, which record date shall not precede the date on which the resolution fixing the record date is adopted by the Board of Directors, and which date shall not be more than ten (or the maximum number permitted by applicable law) days after the date on which the resolution fixing the record date is adopted by the Board of Directors. If no record date has been fixed by the Board of Directors, the record date for determining stockholders entitled to consent to corporate action in writing without a meeting, when no prior action by the Board of Directors is required by Chapter 1 of the Delaware General Corporation Law as now or hereafter amended, shall be the first date on which a signed written consent setting forth the action taken or proposed to be taken is delivered to the Corporation by delivery to its registered office in the State of Delaware, its principal place of business, or an officer or agent of the Corporation having custody of the records of proceedings of meetings of stockholders. Delivery made to the Corporation's registered office shall be by hand or by certified or registered mail, return receipt requested. If no record date has been fixed by the Board of Directors and prior action by the Board of Directors is required by Chapter 1 of the Delaware General Corporation Law as now or hereafter amended, the record date for determining stockholders entitled to consent to corporate action in writing without a meeting shall be at the close of business on the day on which the Board of Directors adopts the resolution taking such prior action. 9.3 Dividends, Distributions, and Other Rights. For the purpose of determining the stockholders entitled to receive payment of any dividend or other distribution or allotment of any rights or the stockholders 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 a record date, which record date shall not precede the date on which the resolution fixing the record date is adopted, and which record date shall be not more than sixty (or the maximum number permitted by applicable law) days prior to such action. If no record date is fixed, the record date for determining stockholders for any such purpose shall be at the close of business on the day on which the Board of Directors adopts the resolution relating thereto. 67 of 109 9.4. Voting List. At least ten days before each meeting of stockholders, a complete list of the stockholders entitled to vote at such meeting shall be made, arranged in alphabetical order, and showing the address of each stockholder and the number of shares registered in the name of each stockholder. This list shall be open to examination by any stockholder, for any purpose germane to the meeting, during ordinary business hours, for a period of ten days prior to the meeting, either at a place within the city where the meeting is to be held, which place shall be specified in the notice of the meeting, or, if not so specified, at the place where the meeting is to be held. The list shall also be produced and kept at such meeting for inspection by any stockholder who is present. SECTION 10. Action by Stockholders Without a Meeting. Subject to the provisions of Article NINTH of the Certificate of Incorporation, any action which could be taken at any annual or special meeting of stockholders may be taken without a meeting, without prior notice, and without a vote, if a consent or consents in writing, setting forth the action so taken, are (a) signed by the holders of outstanding stock having not fewer than the minimum number of votes that would be necessary to authorize or take such action at a meeting at which all shares entitled to vote thereon were present and voted and (b) delivered to the Corporation by delivery to its registered office in the State of Delaware, its principal place of business, or an officer or agent of the Corporation having custody of the records of proceedings of meetings of stockholders. Delivery made to the Corporation's registered office shall be by hand or by certified mail or registered mail, return receipt requested. Every written consent shall bear the date of signature of each stockholder who signs the consent and no written consent shall be effective to take the corporate action referred to therein unless written consents signed by a sufficient number of stockholders to take such action are delivered to the Corporation, in the manner required by this section, within sixty (or the maximum number permitted by applicable law) days of the date of the earliest dated consent delivered to the Corporation in the manner required by this section. The validity of any consent executed by a proxy for a stockholder pursuant to a telegram, cablegram, or other means of electronic transmission transmitted to such proxy holder by or upon the authorization of the stockholder shall be determined by or at the direction of the Secretary of the Corporation. A written record of the information upon which the person making such determination relied shall be made and kept in the records of the proceedings of the stockholders. Any such consent shall be inserted in the minute book as if it were the minutes of a meeting of the stockholders. 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. SECTION 11. Business for Stockholders' Meetings. 11.1 Business at Annual Meetings. In addition to the election of directors, other proper business may be transacted at the annual meeting of stockholders, provided that such business is properly brought before such meeting. To be properly brought before an annual meeting, business must be (a) brought by or at the direction of the Board of Directors, or (b) brought before the meeting by a stockholder pursuant to written notice thereof, in accordance with Section 12 of this Article I, and received by the Secretary 68 of 109 not fewer than sixty nor more than ninety days prior to the date specified in Section 1 of this Article I for such annual meeting. Any such stockholder notice shall set forth (i) the name and address of the stockholder proposing such business; (ii) a representation that the stockholder is entitled to vote at such meeting and a statement of the number of shares of the Corporation which are beneficially owned by the stockholder; (iii) a representation that the stockholder intends to appear in person or by proxy at the meeting to propose such business; and (iv) as to each matter the stockholder proposes to bring before the meeting, a brief description of the business desired to be brought before the meeting, the reasons for conducting such business at the meeting, the language of the business matter (if appropriate), and any material interest of the stockholder in such business. No business shall be conducted at any annual meeting of stockholders except in accordance with this Section 11.1. If the facts warrant, the Board of Directors, or the chairman of an annual meeting of stockholders, shall determine and declare (a) that a proposal does not constitute proper business to be transacted at the meeting or (b) that business was not properly brought before the meeting in accordance with the provisions of this Section 11.1 and, if, in either case, it is so determined, any such business shall not be transacted. The procedures set forth in this Section 11.1 for business to be properly brought before an annual meeting by a stockholder are in addition to, and not in lieu of, the requirements set forth in Rule 14a-8 under Section 14 of the Securities Exchange Act of 1934, or any successor provision. 11.2 Business at Special Meetings. At any special meeting of the stockholders, only such business as is specified in the notice of such special meeting given by or at the direction of the person or persons calling such meeting, in accordance with Section 2 of this Article I, shall come before such meeting. SECTION 12. Notice to Corporation. Any written notice required to be delivered by a stockholder to the Corporation pursuant to Section 11.1 of this Article I or Section 2.1 of Article II must be given, either by personal delivery or by registered or certified mail, postage prepaid, to the Secretary at the Corporation's executive offices in the City of Seattle, State of Washington. ARTICLE II Board of Directors SECTION 1. Number and Term of Office. The number of directors shall be thirteen, but the number may be increased, or decreased to not less than three, from time to time, either by the directors by adoption of a resolution to such effect or by the stockholders by amendment of the By-Laws in accordance with Article VIII hereof. The directors shall be divided into three classes, each of which shall be composed as nearly as possible of one-third of the directors. Each director shall serve for the term to which the director was elected, and until a successor shall have been elected and qualified or until the director's prior death, resignation, or removal. At each annual election, directors shall be chosen for a full three-year term to succeed those whose terms expire. 69 of 109 SECTION 2. Nomination and Election. 2.1 Nomination. Only persons who are nominated in accordance with the following procedures shall be eligible for election as directors. Nominations for the election of directors may be made (a) by or at the direction of the Board of Directors, or (b) by any stockholder of record entitled to vote for the election of directors at such meeting; provided, however, that a stockholder may nominate persons for election as directors only if written notice (in accordance with Section 12 of Article I) of such stockholder's intention to make such nominations is received by the Secretary not later than (i) with respect to an election to be held at an annual meeting of the stockholders, not fewer than sixty nor more than ninety days prior to the date specified in Section 1 of Article I for such annual meeting, and (ii) with respect to an election to be held at a special meeting of the stockholders for the election of directors, the close of business on the seventh business day following the date on which notice of such meeting is first given to stockholders. Any such stockholders' notice shall set forth (a) the name and address of the stockholder who intends to make a nomination; (b) a representation that the stockholder is entitled to vote at such meeting and a statement of the number of shares of the Corporation which are beneficially owned by the stockholder; (c) a representation that the stockholder intends to appear in person or by proxy at the meeting to nominate the person or persons specified in the notice; (d) as to each person the stockholder proposes to nominate for election or re-election as a director, the name and address of such person and such other information regarding such nominee as would be required in a proxy statement filed pursuant to the proxy rules of the Securities and Exchange Commission had such nominee been nominated by the Board of Directors, and a description of any arrangements or understandings, between the stockholder and such nominee and any other persons (including their names), pursuant to which the nomination is to be made; and (e) the consent of each such nominee to serve as a director if elected. If the facts warrant, the Board of Directors, or the chairman of a stockholders meeting at which directors are to be elected, shall determine and declare that a nomination was not made in accordance with the foregoing procedure and, if it is so determined, the defective nomination shall be disregarded. The right of stockholders to make nominations pursuant to the foregoing procedure is subject to the rights of the holders of any class or series of stock having a preference over the Common Stock as to dividends or upon liquidation. The procedures set forth in this Section 2.1 for nomination for the election of directors by stockholders are in addition to, and not in lieu or limitation of, (a) any procedures now in effect or hereafter adopted by or at the direction of the Board of Directors or any committee thereof and (b) the requirements set forth in Rule 14a-11 under Section 14 of the Securities Exchange Act of 1934, or any successor provision. 2.2 Election. At each election of directors, the persons receiving the greatest number of votes shall be the directors. SECTION 3. Place of Meeting. Meetings of the Board of Directors, or of any committee thereof, may be held either within or without the State of Delaware. 70 of 109 SECTION 4. Annual Meeting. Each year the Board of Directors shall meet in connection with the annual meeting of stockholders for the purpose of electing officers and for the transaction of other business. No notice of such meeting is required. Such annual meeting may be held at any other time or place which shall be specified in a notice given as hereinafter provided for special meetings of the Board, or in a consent and waiver of notice thereof, signed by all the directors. SECTION 5. Stated Meetings. The Board of Directors may, by resolution adopted by affirmative vote of a majority of the whole Board, from time to time appoint the time and place for holding stated meetings of the Board, if by it deemed advisable; and such stated meetings shall thereupon be held at the time and place so appointed, without the giving of any special notice with regard thereto. In case the day appointed for a stated meeting shall fall upon a legal holiday, such meeting shall be held on the next following day, not a legal holiday, at the regularly appointed hour. Except as otherwise provided in the By- Laws, any and all business may be transacted at any stated meeting. SECTION 6. Special Meetings. 6.1 Convenors and Notice. Special meetings of the Board of Directors may be called by or at the request of the Chairman of the Board or any two directors. Notice of a special meeting of the Board of Directors, stating the place, day, and hour of the meeting, shall be given to each director in writing (by mail, wire, facsimile, or personal delivery) or orally (by telephone or in person). 6.2 Waiver of Notice. With respect to a special meeting of the Board of Directors, a written waiver, signed by a director, shall be deemed equivalent to notice to that director. A director's attendance at a meeting shall constitute that director's waiver of notice of such meeting, except when the director attends a meeting for the express purpose of objecting, at the beginning of the meeting, to the transaction of any business because the meeting was not lawfully called or convened. Neither the business to be transacted at, nor the purpose of, any regular or special meeting of the Board of Directors need be specified in the waiver of notice of such meeting. SECTION 7. Quorum and Manner of Acting. Except as herein otherwise provided, forty percent of the total number of directors fixed by or in the manner provided in these By-Laws at the time of any stated or special meeting of the Board or, if vacancies exist on the Board of Directors, forty percent of such number of directors then in office, provided, however, that such number may not be less than one-third of the total number of directors fixed by or in the manner provided in these By-Laws, shall constitute a quorum for the transaction of business; and, except as otherwise required by statute or by the Certificate of Incorporation or any amendment thereto, or by the By-Laws, the act of a majority of the directors present at any such meeting at which a quorum is present shall be the act of the Board of Directors. In the absence of a quorum, a majority of the directors present may adjourn any meeting, from time to time, until a quorum is present. No notice of any adjourned meeting need be given. 71 of 109 SECTION 8. Chairman of the Board. The Chairman of the Board shall preside, when present, at all meetings of the Board, except as otherwise provided by law. SECTION 9. Resignations. Any director of the Corporation may resign at any time by giving written notice thereof to the Secretary. Such resignation shall take effect at the time specified therefor or if the time is not specified, upon delivery thereof; and, unless otherwise specified with respect thereto, the acceptance of such resignation shall not be necessary to make it effective. SECTION 10. Removal of Directors. Any director may be removed solely for cause by the affirmative vote of the holders of record of a majority of the outstanding shares of stock entitled to vote, at a meeting of the stockholders called for the purpose; and the vacancy on the Board caused by any such removal may be filled by the stockholders at such meeting or at any subsequent meeting. SECTION 11. Filling of Vacancies Not Caused by Removal. In case of any increase in the number of directors, or of any vacancy created by death or resignation, the additional director or directors may be elected or, as the case may be, the vacancy or vacancies may be filled, either (a) by the Board of Directors at any meeting, (i) if the Corporation has an Interested Stockholder as defined in Article EIGHTH of the Certificate of Incorporation, by the affirmative vote of a majority of the Continuing Directors, as defined in Article EIGHTH, or (ii) if the Corporation does not have an Interested Stockholder, by the affirmative vote of a majority of the remaining directors, though less than a quorum; or (b) by the stockholders entitled to vote, either at an annual meeting or at a special meeting thereof called for the purpose, by the affirmative vote of a majority of the outstanding shares entitled to vote at such meeting. SECTION 12. Directors' Fees. The Board of Directors shall have authority to determine from time to time the amount of compensation which shall be paid to its members for attendance at meetings of the Board or of any committee of the Board. SECTION 13. Action Without a Meeting. Any action required or permitted to be taken at any meeting of the Board of Directors or any committee thereof may be taken without a meeting if all members of the Board or 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. 72 of 109 ARTICLE III Board Committees SECTION 1. Audit Committee. In addition to any committees appointed pursuant to Section 2 of this Article, there shall be an Audit Committee, appointed annually by the Board of Directors, consisting of at least three directors who are not members of management. It shall be the responsibility of the Audit Committee to review the scope and results of the annual independent audit of books and records of the Corporation and its subsidiaries, to review compliance with all corporate policies which have been approved by the Board of Directors, and to discharge such other responsibilities as may from time to time be assigned to it by the Board of Directors. The Audit Committee shall meet at such times and places as the members deem advisable, and shall make such recommendations to the Board of Directors as they consider appropriate. SECTION 2. Other Committees. The Board of Directors may appoint standing or temporary committees and invest such committees with such powers as it may see fit, with power to subdelegate such powers if deemed desirable by the Board of Directors; but no such committee shall have the power or authority of the Board of Directors to (a) amend the Certificate of Incorporation, (b) adopt a plan of merger or consolidation, (c) recommend to the stockholders the sale, lease, or exchange or other disposition of all or substantially all of the property and assets of the Corporation other than in the usual and regular course of business, (d) recommend to the stockholders a voluntary dissolution or a revocation thereof, (e) amend these By-Laws, (f) declare a dividend, or (g) authorize the issuance of stock. The Board of Directors may designate one or more directors as alternate members of any committee, who may replace any absent or disqualified member at any meeting of the committee. In the absence or disqualification of a member of a committee, the member or members thereof present at any meeting and not disqualified from voting, whether or not such member or members constitute a quorum, may unanimously appoint another member of the Board of Directors to act at the meeting in the place of any such absent or disqualified member. SECTION 3. Quorum and Manner of Acting. A majority of the number of directors composing any committee of the Board of Directors, as established and fixed by resolution of the Board of Directors, shall constitute a quorum for the transaction of business at any meeting of such committee but, if less than a majority are present at a meeting, a majority of such directors present may adjourn the meeting from time to time without further notice. The act of a majority of the members of a committee present at a meeting at which a quorum is present shall be the act of such committee. 73 of 109 ARTICLE IV Officers and Agents: Terms, Compensation, Removal, Vacancies SECTION 1. Officers. The elected officers of the Corporation shall be a Chairman of the Board (who shall be a director), a President (who shall be a director), and one or more Vice Presidents (each of whom may be assigned by the Board of Directors or the Chief Executive Officer an additional title descriptive of the functions assigned to such officer and one or more of whom may be designated Executive or Senior Vice President). The Board may also elect one or more Vice Chairmen. The Board of Directors shall also designate either the Chairman of the Board or the President as the Chief Executive Officer of the Corporation. The Board of Directors shall appoint a Controller, a Secretary, and a Treasurer. Any number of offices, whether elective or appointive, may be held by the same person. The Chief Executive Officer may, by a writing filed with the Secretary, designate titles as officers for employees and agents and appoint Assistant Secretaries and Assistant Treasurers, as, from time to time, may appear to be necessary or advisable in the conduct of the affairs of the Corporation and may, in the same manner, terminate or change such titles. SECTION 2. Term of Office. So far as practicable, all elected officers shall be elected at the annual meeting of the Board in each year, and shall hold office until the annual meeting of the Board in the next subsequent year and until their respective successors are chosen. The Controller, Secretary, and Treasurer shall hold office at the pleasure of the Board. SECTION 3. Salaries of Elected Officers. The salaries paid to the elected officers of the Corporation shall be authorized or approved by the Board of Directors. SECTION 4. Bonuses. None of the officers, directors, or employees of the Corporation or any of its subsidiary corporations shall at any time be paid any bonus or share in the earnings or profits of the Corporation or any of its subsidiary corporations except pursuant to a plan approved by affirmative vote of two- thirds of the members of the Board of Directors. SECTION 5. Removal of Elected and Appointed Officers. Any elected or appointed officer may be removed at any time, either for or without cause, by affirmative vote of a majority of the whole Board of Directors, at any meeting called for the purpose. SECTION 6. Vacancies. If any vacancy occurs in any office, the Board of Directors may elect or appoint a successor to fill such vacancy for the remainder of the term. 74 of 109 ARTICLE V Officers' Duties and Powers SECTION 1. Chairman of the Board. The Chairman of the Board shall preside, when present, at all meetings of the stockholders (except as otherwise provided by statute) and at all meetings of the Board of Directors. The Chairman shall have general power to execute bonds, deeds, and contracts in the name of the Corporation; to affix the corporate seal; to sign stock certificates; and to perform such other duties and services as shall be assigned to or required of the Chairman by the Board of Directors. SECTION 2. President. The President shall have general power to execute bonds, deeds, and contracts in the name of the Corporation and to affix the corporate seal; to sign stock certificates; during the absence or disability of the Chairman of the Board to exercise the Chairman's powers and to perform the Chairman's duties; and to per- form such other duties and services as shall be assigned to or required of the President by the Board of Directors; provided, that if the office of President is vacant, the Chairman shall exercise the duties ordinarily exercised by the President until such time as a President is elected or appointed. SECTION 3. Chief Executive Officer. The officer designated by the Board of Directors as the Chief Executive Officer of the Corporation shall have general and active control of its business and affairs. The Chief Executive Officer shall have general power to appoint or designate all employees and agents of the Corporation whose appointment or designation is not otherwise provided for and to fix the compensation thereof, subject to the provisions of these By-Laws; to remove or suspend any employee or agent who shall not have been elected or appointed by the Board of Directors or other body; to suspend for cause any employee, agent, or officer, other than an elected officer, pending final action by the body which shall have appointed such employee, agent, or officer; and to exercise all the powers usually pertaining to the office held by the Chief Executive Officer of a corporation. SECTION 4. Vice Presidents and Controller. The several Vice Presidents and the Controller shall perform all such duties and services as shall be assigned to or required of them, from time to time, by the Board of Directors or the Chief Executive Officer, respectively. SECTION 5. Secretary. The Secretary shall attend to the giving of notice of all meetings of stock- holders and of the Board of Directors and shall keep and attest true records of all proceedings thereat. The Secretary shall have charge of the corporate seal and have authority to attest any and all instruments or writings to which the same may be affixed and shall keep and account for all books, documents, papers, and records of the Corporation relating to its corporate organization. The Secretary shall have authority to sign stock certificates and shall generally perform all the duties usually appertaining to the office of secretary of a corporation. In the absence of the Secretary, an Assistant Secretary or Secretary pro tempore shall perform the duties of the Secretary. 75 of 109 SECTION 6. Treasurer. The Treasurer shall have the care and custody of all moneys, funds, and securities of the Corporation, and shall deposit or cause to be deposited all funds of the Corporation in accordance with directions or authorizations of the Board of Directors or the Chief Executive Officer. The Treasurer shall have power to sign stock certificates, to indorse for deposit or collection, or otherwise, all checks, drafts, notes, bills of exchange, or other commercial paper payable to the Corporation, and to give proper receipts or discharges therefor. In the absence of the Treasurer, an Assistant Treasurer shall perform the duties of the Treasurer. SECTION 7. Additional Powers and Duties. In addition to the foregoing especially enumerated duties and powers, the several officers of the Corporation shall perform such other duties and exercise such further powers as may be provided in these By-Laws or as the Board of Directors may from time to time determine, or as may be assigned to them by any superior officer. SECTION 8. Disaster Emergency Powers of Acting Officers. If, as a result of a disaster or other state of emergency, the Chief Executive Officer is unable to perform the duties of that office, (a) the powers and duties of the Chief Executive Officer shall be performed by the employee with the highest base salary who shall be available and capable of performing such powers and duties and, if more than one such employee has the same base salary, by the employee whose surname begins with the earliest letter of the alphabet among the group of those employees with the same base salary; and (b) the officer performing such duties shall continue to perform such powers and duties until the Chief Executive Officer becomes capable of performing those duties or until the Board of Directors shall have elected a new Chief Executive Officer or designated another individual as Acting Chief Executive Officer; and (c) such officer shall have the power in addition to all other powers granted to the Chief Executive Officer by these By-Laws and by the Board of Directors to appoint an acting President, acting Vice President - Finance, acting Controller, acting Secretary, and acting Treasurer, if any of the persons duly elected to any such office is not by reason of such disaster or emergency able to perform the duties of such office, each of such acting appointees to serve in such capacities until the officer for whom the appointee is acting becomes capable of performing the duties of such office or until the Board of Directors shall have designated another individual to perform such duties or have elected another person to fill such office; and (d) any such acting officer so appointed shall be entitled to exercise all powers vested by the By-Laws or the Board of Directors in the duly elected officer for whom the acting officer is acting; and (e) anyone transacting business with this Corporation may rely upon a certification by any two officers of the Corporation that a specified individual has succeeded to the powers of the Chief Executive Officer and that such person has appointed other acting officers as herein provided and any person, firm, corporation, or other entity to which such certification has been delivered by such officers may continue to rely upon it until notified of a change in writing signed by two officers of this Corporation. 76 of 109 ARTICLE VI Stock and Transfers of Stock SECTION 1. Stock Certificates. Every stockholder shall be entitled to a certificate, signed by the Chairman of the Board or the President or a Vice President and the Treasurer or an Assistant Treasurer or the Secretary or an Assistant Secretary, certifying the number of shares owned by the stockholder in the Corporation. Any and all of the signatures on a certificate may be a facsimile. If any officer, transfer agent, or registrar who has signed or whose facsimile signature has been placed upon a certificate shall have ceased to be such officer, transfer agent, or registrar before such certificate is issued, it may be issued by the Corporation with the same effect as if he or she were such officer, transfer agent, or registrar at the date of issue. SECTION 2. Transfer Agents and Registrars. The Board of Directors may, in its discretion, appoint responsible banks or trust companies in the Borough of Manhattan, in the City of New York, State of New York, and in such other city or cities as the Board may deem advisable, from time to time, to act as transfer agents and registrars of the stock of the Corporation; and, when such appointments shall have been made, no stock certificate shall be valid until countersigned by one of such transfer agents and registered by one of such registrars. SECTION 3. Transfers of Stock. Shares of stock may be transferred by delivery of the certificates therefor, accompanied either by an assignment in writing on the back of the certificates or by written power of attorney to sell, assign, and transfer the same, signed by the record holder thereof; but no transfer shall affect the right of the Corporation to pay any dividend upon the stock to the holder of record thereof, or to treat the holder of record as the holder in fact thereof for all purposes, and no transfer shall be valid, except between the parties thereto, until such transfer shall have been made upon the books of the Corporation. SECTION 4. Lost Certificates. The Board of Directors may provide for the issuance of new certificates of stock to replace certificates of stock lost, stolen, mutilated, or destroyed, or alleged to be lost, stolen, mutilated, or destroyed, upon such terms and in accordance with such procedures as the Board of Directors shall deem proper and prescribe. ARTICLE VII Miscellaneous SECTION 1. Fiscal Year. The fiscal year of the Corporation shall be the calendar year. SECTION 2. (Repealed in its entirety by vote of the stockholders, May 5, 1975.) 77 of 109 SECTION 3. Signing of Negotiable Instruments. All bills, notes, checks, or other instruments for the payment of money shall be signed or countersigned by such officer or officers and in such manner as from time to time may be prescribed by resolution (whether general or special) of the Board of Directors. SECTION 4. Indemnification of Directors and Officers. 4.1 Right to Indemnification. Each person who was or is made a party or is threatened to be made a party to or is otherwise involved (including, without limitation, as a witness) in any actual or threatened action, suit, or proceeding, whether civil, criminal, administrative, or investigative (hereinafter a "proceeding"), by reason of the fact that he or she is or was a director or officer of the Corporation or that, being or having been such a director or officer or an employee of the Corporation, he or she is or was serving at the request of an executive officer of the Corporation as a director, officer, employee, or agent of another corporation or of a partnership, joint venture, trust, or other enterprise, including service with respect to an employee benefit plan (hereinafter an "indemnitee"), whether the basis of such proceeding is alleged action in an official capacity as such a director, officer, employee, or agent or in any other capacity while serving as such a director, officer, employee, or agent, shall be indemnified and held harmless by the Corporation to the full extent permitted 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 permitted prior thereto), or by other applicable law as then in effect, against all expense, liability, and loss (including attorneys' fees, judgments, fines, ERISA excise taxes or penalties, and amounts paid in settlement) actually and reasonably incurred or suffered by such indemnitee in connection therewith and such indemnification shall continue as to an indemnitee who has ceased to be a director, officer, employee, or agent and shall inure to the benefit of the indemnitee's heirs, executors, and administrators; provided, however, that except as provided in Section 4.2 with respect to proceedings seeking to enforce rights to indemnification, the Corporation shall indemnify any such indemnitee in connection with a proceeding (or part thereof) initiated by such indemnitee only if such proceeding (or part thereof) was authorized or ratified by the Board of Directors of the Corporation. The right to indemnification conferred in this Section 4.1 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 (hereinafter an "advancement of expenses"); provided, however, that an advancement of expenses incurred by an indemnitee in his her capacity as a director or officer (and not in any other capacity in which service was or is rendered by such indemnitee, including, without limitation, service to an employee benefit plan) shall be made only upon delivery to the Corporation of an undertaking (hereinafter an "undertaking"), by or on behalf of such indemnitee, to repay all amounts so advanced if it shall ultimately be determined by final judicial decision from which there is no further right to appeal that such indemnitee is not entitled to be indemnified for such expenses under this Section 4.1 or otherwise; and provided, further, that an advancement of expenses shall not be made if the Corporation's Board of Directors makes a good faith determination that such payment would violate law or public policy. 78 of 109 4.2 Right of Indemnitee to Bring Suit. If a claim under Section 4.1 is not paid in full by the Corporation within sixty days after a written claim has been received by the Corporation, except in the case of a claim for an advancement of expenses, in which case the applicable period shall be twenty days, the indemnitee may at any time thereafter bring suit against the Corporation to recover the unpaid amount of the claim. If successful in whole or in part in any such suit, or in a suit brought by the Corporation to recover an advancement of expenses pursuant to the terms of an undertaking, the indemnitee shall also be entitled to be paid the expense of prosecuting or defending such suit. The indemnitee shall be presumed to be entitled to indemnification under this Section 4 upon submission of a written claim (and, in an action brought to enforce a claim for an advancement of expenses, where the required undertaking has been tendered to the Corporation), and thereafter the Corporation shall have the burden of proof to overcome the presumption that the indemnitee is not so entitled. Neither the failure of the Corporation (including its Board of Directors, independent legal counsel, or its stockholders) to have made a determination prior to the commencement of such suit that indemnification of the indemnitee is proper in the circumstances, nor an actual determination by the Corporation (including its Board of Directors, independent legal counsel, or its stockholders) that the indemnitee is not entitled to indemnification shall be a defense to the suit or create a presumption that the indemnitee is not so entitled. 4.3 Nonexclusivity of Rights. The rights to indemnification and to the advancement of expenses conferred in this Section 4 shall not be exclusive of any other right which any person may have or hereafter acquire under any statute, provisions of the Certificate of Incorporation, By-Laws, agreement, vote of stockholders or disinterested directors, or otherwise. Notwithstanding any amendment to or repeal of this Section 4, or of any of the procedures established by the Board of Directors pursuant to Section 4.7, any indemnitee shall be entitled to indemnification in accordance with the provisions hereof and thereof with respect to any acts or omissions of such indemnitee occurring prior to such amendment or repeal. 4.4 Insurance, Contracts, and Funding. 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 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 Corporation may, without further stockholder approval, enter into contracts with any indemnitee in furtherance of the provisions of this Section 4 and may create a trust fund, grant a security interest, or use other means (including, without limitation, a letter of credit) to ensure the payment of such amounts as may be necessary to effect indemnification as provided in this Section 4. 4.5 Persons Serving Other Entities. Any person who is or was a director, of- ficer, or employee of the Corporation who is or was serving (i) as a director or officer of another corporation of which a majority of the shares entitled to vote in the election of its directors is held by the Corporation or (ii) in an executive or management capacity in a partnership, joint venture, trust, or other enterprise of which the Corporation or a wholly owned subsidiary of the Corporation is a general partner or has a majority ownership shall be deemed to be so serving at the request of an executive officer of the Corporation and entitled to indemnification and advancement of expenses under Section 4.1. 79 of 109 4.6 Indemnification of Employees and Agents of the Corporation. The Corporation may, by action of its Board of Directors, authorize one or more executive officers to grant rights to advancement of expenses to employees or agents of the Corporation on such terms and conditions as such officer or officers deem appropriate under the circumstances. The Corporation may, by action of its Board of Directors, grant rights to indemnification and advancement of expenses to employees or agents or groups of employees or agents of the Corporation with the same scope and effect as the provisions of this Section 4 with respect to the indemnification and advancement of expenses of directors and officers of the Corporation; provided, however, that an undertaking shall be made by an employee or agent only if required by the Board of Directors. 4.7 Procedures for the Submission of Claims. The Board of Directors may establish reasonable procedures for the submission of claims for indemnification pursuant to this Section 4, determination of the entitlement of any person thereto, and review of any such determination. Such procedures shall be set forth in an appendix to these By-Laws and shall be deemed for all purposes to be a part hereof. ARTICLE VIII Amendments SECTION 1. Amendment of the By-Laws: General. Except as herein otherwise expressly provided, the By-Laws of the Corporation may be altered or repealed in any particular and new By-Laws, not inconsistent with any provision of the Certificate of Incorporation or any provision of law, may be adopted, either by the affirmative vote of the holders of record of a majority in number of the shares present in person or by proxy and entitled to vote at an annual meeting of stockholders or at a special meeting thereof, the notice of which special meeting shall include the form of the proposed alteration or repeal or of the proposed new By- Laws, or a summary thereof; or either (a) by the affirmative vote of a majority of the whole Board of Directors at any meeting thereof, or (b) by the affirmative vote of all the directors present at any meeting at which a quorum, less than a majority, is present; provided, in either of the latter cases, that the notice of such meeting shall include the form of the proposed alteration or repeal or of the proposed new By-Laws, or a summary thereof. SECTION 2. Amendments as to Compensation and Removal of Officers. Notwithstanding anything contained in these By-Laws to the contrary, the affirmative vote of the holders of record of a majority of the Voting Stock, as defined in Article EIGHTH of the Certificate of Incorporation, at a meeting of the stockholders called for the purpose, shall be required to alter, amend, repeal, or adopt any provision inconsistent with Sections 3,. 4 and 5 of Article IV hereof, notice of which meeting shall include the form of the proposed amendment, or a summary thereof. 80 of 109 SECTION 3. Amendments as to Shareholder Meetings, Directors. Notwithstanding anything contained in these By-Laws to the contrary, either (a) the affirmative vote of a majority of the Continuing Directors, as defined in Article EIGHTH of the Certificate of Incorporation, or (b) the affirmative vote of the holders of record of at least seventy-five percent of the Voting Stock, as defined in Article EIGHTH of the Certificate of Incorporation, shall be required to alter, amend, repeal, or adopt any provision inconsistent with Sections 1, 2, and 4 of Article I and Sections 1, 10, and 11 of Article II. SECTION 4. Amendment of this Article VIII. Notwithstanding anything contained in these By-Laws to the contrary, either (a) the recommendation of a majority of the Continuing Directors, as defined in Article EIGHTH of the Certificate of Incorporation, together with the affirmative vote of the holders of record of a majority of the Voting Stock, as defined in Article EIGHTH of the Certificate of Incorporation, or (b) the affirmative vote of the holders of record of at least seventy-five percent of the Voting Stock, as defined in Article EIGHTH of the Certificate of Incorporation, shall be required to alter, amend, repeal, or adopt any provision inconsistent with this Article VIII. 81 of 109 Exhibit (10)(vii) Deferred Compensation Plan for Employees of The Boeing Company as amended October 25, 1993 82 of 109 DEFERRED COMPENSATION PLAN FOR EMPLOYEES OF THE BOEING COMPANY 1. Purpose. The purpose of the Deferred Compensation Plan for Employees of The Boeing Company (the "Plan") is to provide for deferment of payment of all or a portion of awards made to an employee under the Company's Incentive Compensation and Performance Award Plans. 2. Eligibility. Any employee eligible to receive an award under the Incentive Compensation Plan or the Performance Award Plan is eligible to elect to participate in this Plan. 3. Election to Participate. An eligible employee may elect to defer awards made thereafter, by executing and delivering to the Company a notice which shall state the percentage of the award to be deferred, and the method for crediting investment earnings on deferred amounts. An election to participate will remain in effect until participation in the Plan terminates, or until the election is changed by a notice to the Company increasing or decreasing the percentage of future awards to be deferred, or changing the method for crediting investment earnings on future deferrals. An election or change in election must be made by December 1 to be effective for an award made under the Incentive Compensation Plan in the following year, and by on or before December 1 of the year preceding the year in which the service is performed for which a Participant may earn an award under the Performance Award Plan. If a Participant terminates participation in this Plan, all amounts accumulated in the Participant's account prior to termination will continue to be held subject to the Plan. For purposes of the Plan, a "Participant" means an employee or former employee having an account under the Plan. 4. Earnings Credits on Deferred Amounts. All amounts deferred under the Plan shall be credited to the Participant's Plan account at the time an award is made. Each account shall be credited with earnings thereon, under the Interest Credit method or the Stock Unit method, at the election of the Participant, such election to be irrevocable once made. In the absence of an election, the Interest Credit method shall be used. Interest Credit Method. As of March 31, June 30, September 30, and December 31 each year, a Participant's account shall be credited with interest on all amounts in that account during the preceding quarter. Interest will be computed during each calendar year at the mean between the high and the low during the first eleven months of the preceding year of yields on Aa-rated Industrial Bonds as reported by Moody's Investors Service, Inc., rounded to the nearest 1/4th of one percent. The Company will notify Participants annually of the established interest rate. 83 of 109 Stock Unit Method. At the time an award is made, the Participant's Stock Unit account shall be credited with the number of shares of the Company's common stock that could be purchased with the award, based on the Fair Market Value of such stock on the day of the award (or on the next business day on which the Exchange is open, if the Exchange is closed on the day of the award) excluding commissions, taxes, and other charges; and such number (carried to two decimal places) shall be recorded as stock units in the Participant's account, for bookkeeping purposes only. For purposes of the Plan, "Fair Market Value" equals the mean of the high and low per share trading prices for the common stock of the Company as reported in The Wall Street Journal for the "New York Stock Exchange - Composite Transactions" for a single trading day. The number of stock units in an account shall be appropriately adjusted to reflect stock splits, stock dividends, and other like adjustments in the Company's common stock. Each Participant's Stock Unit account periodically shall be credited with the number of shares of the Company's common stock that could be purchased, as set forth in the preceding paragraph, by an amount equal to the cash dividends that would be payable on the number of shares of the Company's common stock that equals the number of stock units in a Participant's Stock Unit account. The Company will notify Participants annually of the number of stock units, and the dividend equivalents, credited to their Stock Unit account. The Committee may authorize an irrevocable one-time election by Participants, to elect the Stock Unit method for Plan balances as of December 31, 1993. 5. Payment. The timing and manner of distribution of amounts held under the Plan shall be determined by the Committee in its sole discretion, but distributions shall commence no later than the January 15 immediately following the year in which the Participant reaches age 70-1/2. For Participants subject to Section 16 of the Securities Exchange Act of 1934 and the rules and regulations thereunder ("Section 16"), distributions shall commence no earlier than as set forth in this section. A Participant may submit an election to the Committee, stating the number of years over which the Participant requests that payment be made (which shall be between 1 and 15 years), the initial year of payment , and the payment option (in the case of payments to be made over 2 or more years). The election shall be submitted to the Committee by not later than December 1 of the year following the year of termination of the Participant's employment by the Company. Distributions shall be made in accordance with the election unless the Committee determines that the distribution should be made at some different time or in some different manner. The payment options (in the case of payments to be made over 2 or more years) shall be as follows: Approximately Equal Option. The amount payable to the Participant each year shall be computed by the Company so that the aggregate amount of cash or stock in a Participant's account under the Plan shall be distributed in approximately equal installments in each year for which deferred compensation payments are to be made; or 84 of 109 Fractional Option. The amount payable to the Participant each year shall be computed by multiplying a fraction, the numerator of which is one and the denominator of which is the number of years remaining in the distribution period, by the balance in the account on January 1 of such year. Under either option, the Participant's account shall be debited at the time of payment, which shall be on or before January 15 of each year. An approved payment period and payment option shall be applicable to the Participant's total aggregate deferred compensation accounts under the Plan, including any accounts previously maintained that have been combined into an account under this Plan. Participants who have filed elections prior to January 1, 1993, may by December 1, 1993, revise such elections (subject to Committee approval) to reflect the payment periods and payment options permitted by the foregoing provisions, or may cancel such elections and defer making an election until such time as is permitted by the foregoing provisions. Distributions from a Participant's Stock Unit account shall be paid in cash. Following a Participant's termination of employment (or for Participants subject to Section 16 , following the period the Participant is so subject and for any required Section 16 reporting period thereafter), distributions may be made in stock at the written election of the Participant, subject to Committee approval. The cash distribution shall equal the cash value, on the date as of which the distribution is calculated (which shall be the first business day in January unless some other date is prescribed by the Committee), of the number of whole shares of Company common stock then distributable to such Participant, based on the Fair Market Value of such stock on that date, or the next day on which the Exchange is open, if the Exchange is closed on the date the distribution is calculated. Any distribution in stock shall be in whole shares of the Company's common stock equal in number to the whole number of stock units credited to the Participant's account under the Stock Unit method. No fractional shares shall be distributed and any account balance remaining after a stock distribution shall be paid in cash. Except as provided below with respect to the Stock Unit accounts of Participants subject to Section 16, a Participant may request that amounts credited to his account under the Plan be distributed prior to the termination of his employment with the Company, or that an approved method of payment of his Plan account be changed. Any such request shall set forth the reason therefor, and is subject to approval by the Committee in its sole and absolute discretion. Any request for a distribution prior to termination of employment must be submitted to the Committee by no later than December 1 of the year prior to the year in which the distribution is requested to be made. No request for distribution prior to termination of employment will be approved if the Participant also has elected to defer any portion of an award under the Company's Incentive Compensation or Performance Award Plans to be made in the calendar year in which the requested distribution is to be made. A Participant may request that any or all amounts accumulated under this Plan be distributed except for any amounts, and any interest or dividend equivalents credited thereon, which were deferred in the calendar year 85 of 109 in which the request for distribution is submitted. To the extent required for exemption from Section 16, distributions prior to termination of employment shall not be permitted under this Plan from amounts deferred to a Stock Unit account by a Participant who is subject to Section 16, except in the case of the Participant's disability. Disability, for these purposes, shall mean a condition entitling the Participant to Disability Retirement under the Company's Retirement Plan. For Participants subject to Section 16, no change to the timing of or payment option for payments from a Stock Unit account shall be considered or allowed during the period the Participant is subject to Section 16 and for any required Section 16 reporting period thereafter. The Committee may establish guidelines for its own use in considering any such request or any other request or election under the Plan, but such guidelines shall not in any way limit the Committee's discretion in acting upon a request or election, or in determining the timing and manner of any distributions to be made under the Plan. Distributions under the Plan shall be subject to withholding for taxes and other charges, as required by law, and the Company shall deduct from any such distribution any amounts owed by the Participant to the Company. For those distributions in stock, required withholding will be taken from the common stock which would have been received. 6. Beneficiaries. A Participant may designate one or more beneficiaries to receive distributions from the Plan, upon the death of the Participant. If no beneficiary has been designated, all such amounts shall be paid to the personal representative of the Participant. Except as provided in the following paragraph, the death of a Participant shall not affect the timing or manner of distributions from the Participant's account. A Participant may elect that one or more fixed payments be made from his account under the Plan, to his personal representative or designated beneficiary, following his death. Such payments, if approved by the Committee, shall be made within 15 months after the Participant's death. Any amounts thereafter remaining in the account will be distributed at the time and in the manner approved by the Committee. 7. Termination or Amendment of the Plan. This Plan may be terminated, modified, or amended from time to time by resolution of the Board of Directors. If the Plan is terminated, all amounts accumulated prior to termination will continue to remain subject to the provisions of the Plan as if the Plan had not been terminated. 86 of 109 8. Participant's Rights. Amounts deferred and accumulated under the Plan remain the property of the Company, and no Participant or other person shall acquire any property interest in the account or any other assets of the Company on account of participation in the Plan, the Participant's rights being limited to receiving from the Company the payments provided for in the Plan. The Plan is unfunded, and to the extent that any Participant acquires a right to receive payments from the Plan, such right shall be no greater than the right of an unsecured creditor of the Company. Except to the extent provided in the final paragraph of Section 5 of the Plan, the right of a Participant, his legal representative or beneficiary to receive payments from the Plan shall not be subject to anticipation, sale, assignment, pledge, encumbrance or charge, nor shall such right be liable for or subject to the debts, contracts, liabilities or torts of the Participant, his legal representative or beneficiaries. 9. Powers of Compensation Committee. The Compensation Committee of the Board of Directors (the "Committee") shall have full power and authority to construe and interpret this Plan. Decisions of the Committee shall be final and binding upon the Participants, their legal representatives and beneficiaries. Approval by the Committee of any election or request made by a Participant pursuant to the Plan shall be subject to the sole discretion of the Committee. 87 of 109 Exhibit (10)(viii) Deferred Compensation Plan for Directors of The Boeing Company as amended October 25, 1993 88 of 109 DEFERRED COMPENSATION PLAN FOR DIRECTORS OF THE BOEING COMPANY 1. Purpose. The purpose of the Deferred Compensation Plan for Directors of The Boeing Company (the "Plan") is to provide for deferral of payment of all or a portion of any annual fees, meeting fees, or both, payable to members of the Board of Directors of The Boeing Company (the "Company"). 2. Eligibility. Any member of the Company's Board of Directors entitled to compensation as a director is eligible to elect to participate in the Plan. 3. Election to Participate. A director may elect to defer all or a specified percentage of annual fees, meeting fees, or both, that may thereafter become payable, by executing and delivering to the Company a notice which states the percentage of the fees to be deferred and the deferral account to which the fees are to be credited. An election or change in election must be made by December 1 to be effective for fees to be paid in the following year. An election to participate will remain in effect until participation in the Plan terminates, or until the election is changed by a notice to the Company increasing or decreasing the percentage of fees to be deferred, or changing the account for future deferrals. If a Director or former Director having an account under the Plan (a "Participant") terminates participation in the Plan, all amounts accumulated in the Participant's account(s) prior to termination will continue to be held subject to the Plan. 4. Deferral Accounts. All fees deferred under the Plan shall be credited to the Participant either in an Interest Credit deferral account or in a Stock Unit deferral account, at the election of the Participant, such election to be irrevocable once made. In the absence of an election, the Interest Credit deferral account shall be credited. Fees shall be credited at the time the fees otherwise are payable. Each Participant's account(s) shall be credited with earnings thereon as follows: Interest Credit Deferral Account. As of March 31, June 30, September 30, and December 31 each year, a Participant's Interest Credit deferral account shall be credited with interest on all amounts in that account during the preceding quarter. Interest will be computed during each calendar year at the mean between the high and the low during the first eleven months of the preceding year of yields on Aa-rated Industrial Bonds as reported by Moody's Investors Service, Inc., rounded to the nearest 1/4th of one percent. The Company will notify Participants annually of the established interest rate. Stock Unit Deferral Account. At the time the fee is credited, the Participant's Stock Unit deferral account shall be credited with the number of shares of the Company's common stock that could be purchased with the fee, based on the Fair Market Value of such stock on the day the fee is credited (or on the next business day on which the Exchange 89 of 109 is open, if the Exchange is closed on the day the fee is credited), excluding commissions, taxes, and other charges; and such number (carried to two decimal places) shall be recorded as stock units in the Participant's account, for bookkeeping purposes only. For purposes of the Plan, "Fair Market Value" equals the mean of the high and low per share trading prices for the common stock of the Company as reported in The Wall Street Journal for the "New York Stock Exchange - Composite Transactions" for a single trading day. The number of stock units in an account shall be appropriately adjusted to reflect stock splits, stock dividends, and other like adjustments in the Company's common stock. Each Participant's Stock Unit deferral account periodically shall be credited with the number of shares of the Company's common stock that could be purchased, as set forth in the preceding paragraph, by an amount equal to the cash dividends that would be payable on the number of shares of the Company's common stock that equals the number of stock units in a Participant's Stock Unit deferral account. The Company will notify Participants annually of the number of stock units, and the dividend equivalents, credited to their Stock Unit deferral account. The Committee may authorize an irrevocable one-time election by Participants to elect the Stock Unit deferral account for Plan balances as of December 31, 1993. 5. Payment. The timing and manner of distribution of amounts held under the Plan shall be determined by the Committee in its sole discretion, but distributions shall commence no earlier than as set forth in this section. Distributions must commence no later than the January 15 immediately following: (a) the year in which the Participant reaches age 70-1/2 or, (b) if the Participant continues service on the Board beyond such age, the year the Participant retires from the Board or otherwise terminates service from the Board. A Participant may submit an election to the Committee, stating the number of years over which the Participant requests that payment be made (which shall be between 1 and 15 years), the initial year of payment, and the payment option (in the case of payments to be made over 2 or more years). The election shall be submitted to the Committee by not later than December 1 of the year in which the Participant retires from the Board or otherwise terminates service from the Board. The distribution shall be made in accordance with the election unless the Committee determines that the distribution should be made at some different time or in some different manner. The payment options (in the case of payments to be made over 2 or more years) shall be as follows: Approximately Equal Option. The amount payable to the Participant each year shall be computed so that the aggregate amount of cash or stock in a Participant's account(s) under the Plan shall be distributed in approximately equal installments in each year for which deferred compensation payments are to be made; or Fractional Option. The amount payable to the Participant each year shall be computed by multiplying a fraction, the numerator of which is one and the denominator of which is the number of years remaining in the distribution period, by the balance in the account(s) on January 1 of such year. 90 of 109 Under either option, the Participant's account(s) shall be debited at the time of payment, which shall be on or before January 15 of each year. An approved payment period and payment option shall be applicable to the Participant's total aggregate deferred compensation accounts under the Plan, including any accounts previously maintained that have been combined into an account under this Plan. Participants who have filed elections prior to January 1, 1993, may by December 1, 1993, revise such elections (subject to Committee approval) to reflect the payment periods and payment options permitted by the foregoing provisions, or may cancel such elections and defer making an election until such time as is permitted by the foregoing provisions. Distributions of amounts from a Stock Unit deferral account shall be paid in cash during any period in which the Participant is subject to Section 16 of the Securities Exchange Act of 1934 and the rules and regulations thereunder ("Section 16"), and for any required Section 16 reporting period thereafter. Following such period, distributions from the Stock Unit deferral account may be made in stock at the written election of the Participant, subject to Committee approval. Any cash distribution shall equal the cash value, on the date as of which the distribution is calculated (which shall be the first business day in January unless some other date is prescribed by the Committee), of the number of whole shares of Company common stock then distributable to such Participant, based on the Fair Market Value of such stock on that date or the next day on which the Exchange is open, if the Exchange is closed on the date the distribution is calculated. Any distributions in stock shall be in whole shares of the Company's common stock equal to the whole number of stock units credited to the Participant's Stock Unit deferral account. No fractional shares shall be distributed and any account balance remaining after a stock distribution shall be paid in cash. A Participant may request that amounts (except for any amounts, and any interest credited thereon, which were deferred in the calendar year in which the request for distribution is submitted) credited to the Participant's Interest Credit deferral account be distributed during the Participant's term of office as a director of the Company, or that an approved method of payment of the account be changed. Any such request must be submitted to the Committee by no later than December 1 of the year prior to the year in which the distribution is requested to be made, must set forth the reason therefor, and is subject to approval by the Committee in its sole and absolute discretion. Distributions during a Participant's term of office as a director of the Company shall not be permitted under the Plan from amounts deferred to a Stock Unit deferral account, except in the case of the Participant's disability. Disability, for these purposes, shall mean a condition entitling the Participant to Disability Retirement under the Company's Retirement Plan as if such Retirement Plan were applicable to the Participant. No change to the timing of or payment option for payments from the Stock Unit deferral account shall be considered or allowed during the period the Participant is subject to Section 16 and for any required Section 16 reporting period thereafter. 91 of 109 The Committee may establish guidelines for its own use in considering any such request or any other request or election under the Plan, but such guidelines shall not in any way limit the Committee's discretion in acting upon a request or election, or in determining the timing and manner of any distributions to be made under the Plan. 6. Beneficiaries. A Participant may designate one or more beneficiaries to receive distributions from the Plan, upon the death of the Participant. If no beneficiary has been designated, all such amounts shall be paid to the personal representative of the Participant. Except as provided in the following paragraph, the death of a Participant shall not affect the timing or manner of distributions from the Participant's account(s). A Participant may elect that one or more fixed payments be made from the Participant's account(s) under the Plan, to the Participant's personal representative or designated beneficiary, following the Participant's death. Such payments, if approved by the Committee, shall be made within 15 months after the Participant's death. Any amounts thereafter remaining in the account(s) will be distributed at the time and in the manner approved by the Committee. 7. Termination or Amendment of the Plan. The Plan may be terminated, modified, or amended from time to time by resolution of the Board of Directors. If the Plan is terminated, all amounts accumulated prior to termination will continue to remain subject to the provisions of the Plan as if the Plan had not been terminated. 8. Participants' Rights. Amounts deferred and accumulated under the Plan remain the property of the Company, and no Participant or other person shall acquire any property interest in the account(s) or any other assets of the Company on account of participation in the Plan, a Participant's rights being limited to receiving from the Company the payments provided for in the Plan. The Plan is unfunded, and to the extent that any Participant acquires a right to receive payments from the Plan, such right shall be no greater than the right of an unsecured creditor of the Company. Except to the extent provided in the final paragraph of Section 5 of the Plan, the right of a Participant, the Participant's legal representative or beneficiary to receive payments from the Plan shall not be subject to anticipation, sale, assignment, pledge, encumbrance or charge, nor shall such right be liable for or subject to the debts, contracts, liabilities or torts of the Participant, or the Participant's legal representative or beneficiaries. 9. Powers of Compensation Committee. The Compensation Committee of the Board of Directors (the "Committee") shall have full power and authority to construe and interpret the Plan. No member of the Committee shall act on any matter concerning such member's participation in the Plan or such member's account(s) under the Plan. Decisions of the Committee shall be final and binding upon the Participants, their legal representatives and beneficiaries. Approval by the Committee of any election or request made by a Participant pursuant to the Plan shall be subject to the sole discretion of the Committee. 92 of 109 Exhibit (10)(ix)(a) 1993 Incentive Stock Plan for Employees as amended on December 13, 1993 93 of 109 THE BOEING COMPANY 1993 Incentive Stock Plan for Employees As Amended December 13, 1993 1. Purpose. The purpose of this 1993 Incentive Stock Plan for Employees (the "Plan") is to attract, retain and motivate key employees by providing them the opportunity to acquire a proprietary interest in the The Boeing Company (the "Company") and to link their interests and efforts to the long-term interests of the Company's shareholders. 2. Plan Administration. 2.1 The Plan shall be administered by the Compensation Committee (the "Committee") of the Company's Board of Directors (the "Board"). Except for the terms and conditions explicitly set forth in the Plan, the Committee shall have the authority, in its discretion, to determine all matters relating to awards under the Plan, including selection of the individuals to be granted awards, the type of awards, the number of shares of the Company's Common Stock (the "Common Stock") subject to an award, all terms, conditions, restrictions and limitations, if any, of an award and the terms of any award agreement or notice. 2.2 The Committee shall also have the authority to grant awards in fulfillment of commitments previously made for stock-based awards under the "Incentive Compensation Plan for Officers and Employees of The Boeing Company and Subsidiaries." 2.3 Except for the power to amend the Plan as provided in Section 12, the Board or the Committee, in its discretion, may delegate the Committee's authority and duties under the Plan to a committee appointed by the Board consisting of one or more senior executive officers of the Company who are also members of the Board, under such conditions and limitations as the Board or the Committee may establish, except that only the Committee may make any determinations regarding grants or awards to participants who are subject to Section 16 of the Securities Exchange Act of 1934 (the "1934 Act"). 2.4 All decisions made by the Committee or its delegate pursuant to the provisions of the Plan and all determinations and selections made by the Committee or its delegate pursuant to such provisions and related orders or resolutions of the Board shall be final and conclusive. 3. Eligibility. Any employee of the Company shall be eligible to receive an award under the Plan. For purposes of this Section 3, the "Company," with respect to all awards under the Plan other than Incentive Stock Options, includes any entity that is directly or indirectly controlled by the Company or any entity in which the Company has a significant equity interest, as determined by the Committee. With respect to Incentive Stock Options, the "Company" includes any parent or subsidiary of the Company in accordance with Section 422 of the Internal Revenue Code of 1986, as amended (the "Code"). 94 of 109 4. Shares Subject to the Plan. 4.1 The stock offered under the Plan shall be shares of Common Stock and may be unissued shares or shares now held or subsequently acquired by the Company as treasury shares, as the Board may from time to time determine. Subject to adjustment as provided in Sections 4.3 and 5, the aggregate number of shares to be delivered under the Plan shall not exceed fourteen million (14,000,000) shares, of which no more than an aggregate of two million (2,000,000) shares shall be available for issuance pursuant to stock awards granted under Section 6.4. 4.2 Any shares subject to any award granted under the Plan which is forfeited, is terminated or expires unexercised shall again be available for award under the Plan, subject to the limitations contained in applicable laws and regulations. 4.3 The Board, in its sole discretion, may increase the aggregate number of shares of Common Stock to be delivered under Section 4.1 by up to two million (2,000,000) shares in the event that the Company acquires any other corporation or business entity and the Company agrees to assume outstanding employee stock options or stock grant commitments of the acquired entity or otherwise grants awards to employees in connection with such acquisition. 5. Adjustment of Shares Available. The aggregate number of shares available for awards under the Plan, the number of shares covered by each outstanding award, and the exercise price per share thereof (but not the total price) of each such award shall all be proportionately adjusted for any increase or decrease in the number of issued shares of Common Stock resulting from any split-up or consolidation of shares or any like capital adjustment or the payment of any stock dividend. 6. Awards. 6.1 The Committee shall have the authority, in its sole discretion, to determine the type or types of award(s) to be granted to employees. Such awards may include, but are not limited to, Incentive Stock Options, Nonqualified Stock Options, Stock Appreciation Rights granted in tandem with all or a portion of related stock options under the Plan or Stock Awards. Subject to adjustment as provided in Section 5 hereof, no more than 3% of the number of shares authorized by Section 4.1, which equates to 420,000 shares, may be issued to any one individual in any one year. 6.2 Stock Options. The Committee may grant stock options designated as "Incentive Stock Options," which comply with the provisions of Section 422 of the Code or any successor statutory provision, or "Nonqualified Stock Options." The price at which shares may be purchased upon exercise of a particular option shall be determined by the Committee but shall be no less than 100% of the Fair Market Value of such shares at the time such option is granted. For purposes of the Plan, "Fair Market Value" equals the mean of the high and low per share trading prices for the Common Stock as reported in The Wall Street Journal for the New York Stock Exchange Composite Transactions for a single trading day. The term of each stock option shall be set by the Committee, but no Incentive 95 of 109 Stock Option shall be exercisable more than ten years after the date such stock option is granted and, to the extent the aggregate Fair Market Value (determined as of the date the option is granted) of Common Stock with respect to which Incentive Stock Options are exercisable for the first time during any calendar year (under this Plan and all other stock option plans of the Company) exceeds $100,000, such options shall be treated as Nonqualified Stock Options. 6.3 Stock Appreciation Rights. The Committee may grant "Stock Appreciation Rights" to employees who have been or are granted stock options under the Plan. In exchange for the surrender in whole or in part of the privilege of exercising the related option to purchase shares of the Common Stock, the granted Stock Appreciation Right shall entitle an employee to payment of an amount equal to the appreciation in value of the surrendered option (the excess of the Fair Market Value of such option at the time of surrender over its aggregate exercise price). Such payment may be made in cash or in shares of Common Stock valued at the Fair Market Value as of the date of the surrender, or partly in cash and partly in shares of Common Stock, as determined by the Committee in its sole discretion. The Committee may establish an arrangement under which employees may defer any such cash payment to a future date or dates under terms similar to the terms of the Company's Deferred Compensation Plan (including the accrual of interest on deferred amounts), provided that an employee's election to defer under any such arrangement shall be made (a) on or before the date of grant of the Stock Appreciation Right being surrendered or (b) subject to approval by the Committee, before the date on which the employee becomes vested in the related option being surrendered. The Committee may establish a maximum appreciation value payable for Stock Appreciation Rights. For Stock Appreciation Rights exercised during any ten-day window period following the Company's release of quarterly financial information, the Committee may, in its sole discretion, establish a uniform Fair Market Value of the Common Stock for such period. The uniform Fair Market Value shall not be less than the Fair Market Value otherwise available to an optionee and shall not be greater than the highest daily mean price during such ten-day period of the sales prices of the Common Stock as reported in The Wall Street Journal; provided, however, that with respect to Stock Appreciation Rights granted in connection with Incentive Stock Options, the Fair Market Value shall not exceed the maximum fair market value permissible under Section 422 of the Code. 6.4 Stock Awards. The Committee may grant "Stock Awards" under the Plan in Common Stock or denominated in units of Common Stock. Such awards may be granted either alone, in addition to, or in tandem with any other type of award granted under the Plan. The Committee, in its discretion, may make such awards either noncontingent or contingent upon attainment of certain performance objectives to be achieved during a period of time, or upon continuous service with the Company. The measure of whether and to what degree such objectives have been attained and the resulting awards will be determined by the Committee. The Committee may choose, at the time of the grant of the award or any time thereafter up to the time of payment of the award, to include as part of such award an entitlement to receive dividends or dividend equivalents, subject to such terms as the Committee may establish. All dividends or dividend equivalents which are not paid currently may, at the Committee's discretion, accrue interest and be paid to the participant if and when and to the extent that such award is paid. 96 of 109 7. Option Exercise. 7.1 Each award agreement or notice for a stock option or Stock Appreciation Right shall contain a provision that the option or right shall not be exercisable unless the optionee remains in the employ of the Company at least twelve months after the granting of the option. 7.2 No shares shall be delivered pursuant to the exercise of any option or Stock Appreciation Right, in whole or in part, until qualified for delivery under such securities laws and regulations as may be deemed by the Committee to be applicable thereto and until, in the case of the exercise of an option, payment in full of the option price thereof (in cash or stock as provided in Section 7.4) is received by the Company. No holder of an option or Stock Appreciation Right, legal representative, legatee, or distributee shall be or be deemed to be a holder of any shares subject to such option or Stock Appreciation Right unless and until such person or entity has received a certificate or certificates therefor. 7.3 No option may at any time be exercised with respect to a fractional share. In the event that shares are issued pursuant to the exercise of a Stock Appreciation Right, no fractional share shall be issued; however, a fractional Stock Appreciation Right may be exercised for cash. 7.4 An employee who owns shares of Common Stock may use the previously acquired shares, whose value shall be determined as the Fair Market Value of such shares on the date the stock option is exercised, as a form of payment to exercise stock options under the Plan. The Committee, in its discretion, may restrict or rescind this right by notice to a participant in the Plan. An option may be exercised with stock only by surrendering to the Company whole shares of Common Stock having a Fair Market Value equal to or less than the exercise price. If an option is exercised by surrender of stock having a Fair Market Value less than the exercise price, the employee must pay the difference in cash. 8. Transferability. The right of any award recipient to exercise an award granted under the Plan shall, during the lifetime of such award recipient, be exercisable only by such award recipient and shall not be assignable or transferable by such award recipient other than by will or the laws of descent and distribution. 9. Withholding Taxes. The Company shall have the right to deduct from any settlement of an award made under the Plan, including the delivery or vesting of shares, an amount sufficient to cover with-holding required by law for any federal, state or local taxes or to take such other action as may be necessary to satisfy any such withholding obligations, including the withholding from any other cash amounts due or to become due from the Company to the participant an amount equal to such taxes. 97 of 109 10. Termination of Employment. The terms and conditions under which an award may be exercised following termination of a participant's employment with the Company shall be determined by the Committee, provided, that if a participant's employment with the Company terminates for any reason within twelve months of the date of grant of a stock option or Stock Appreciation Right, such option or right shall expire as of the date of such termination of employment and the participant and the participant's legal representative shall forfeit any and all rights pertaining to such award. 11. Term of the Plan. The Plan shall become effective as of May 1, 1993 and shall remain in full force and effect through April 30, 1998 unless sooner terminated by the Board. After termination of the Plan, no future awards may be granted but awards previously granted shall remain outstanding in accordance with their applicable terms and conditions and the terms and conditions of the Plan. 12. Plan Amendment. The Committee or the Board may amend, suspend or terminate the Plan at any time, provided that no such amendment shall be made without approval of the Company's stockholders if such approval is required to comply with Rule 16b-3 under the 1934 Act or the Delaware General Corporation Law or, with respect to Incentive Stock Options, Section 422 of the Code or any successor provision. 13. Section 16(b) Compliance. It is the intention of the Company that the Plan shall comply in all respects with Rule 16b-3 under the 1934 Act and, if any Plan provision is later found not to be in compliance with Section 16 of the 1934 Act, the provision shall be deemed null and void, and in all events the Plan shall be construed in favor of its meeting the requirements of Rule 16b-3. Notwithstanding anything in the Plan to the contrary, the Board, in its absolute discretion, may bifurcate the Plan so as to restrict, limit or condition the use of any provision of the Plan to participants who are officers subject to Section 16 of the 1934 Act without so restricting, limiting or conditioning the Plan with respect to other participants. 98 of 109 Exhibit (10)(ix)(b)(i) 1993 Incentive Stock Plan for Employees - Notice of Stock Option Grant for Regular Annual Grant 99 of 109 NOTICE OF TERMS OF STOCK OPTION GRANT ________ _, 1993 To: __________________ SSN: __________________ We are pleased to inform you that you have been selected by the Compensation Committee of the Board of Directors of The Boeing Company ("the Compensation Committee") to receive an option to purchase ________ shares of the Company's common stock at an exercise price of $______ per share. The grant of this option is made pursuant to The Boeing Company 1993 Incentive Stock Plan for Employees of The Boeing Company, (the "Plan"). A copy of the Plan is attached and incorporated into this notice by reference. The terms and conditions of the option grant are set forth in the Plan and in this notice. Exercise of all or part of this stock option constitutes acceptance of all the terms and conditions of the option grant. For purposes of this notice the term "Company" means The Boeing Company and/or any subsidiary company designated by the Compensation Committee as eligible to participate in the Plan. The term "retirement" means retirement under conditions which satisfy the terms in the Company retirement plan or the applicable subsidiary plan. Type of Option: Of this option, _______ shares are granted as Incentive Stock Options and subject to the rules governing Incentive Stock Options; and, ____ shares are granted as a Non-Qualified Stock Options. Date of Grant: The date of the grant of the stock option is , 1993 Term of the Stock Option: 1. The stock option will terminate and all rights to exercise the stock option will terminate completely if you do not remain employed by the Company for at least one year from the date of grant regardless of the reason for your termination. 2. If you remain employed by the Company for at least one year from the date of grant, this stock option will terminate and all rights to exercise this stock option will terminate at the earliest of the following dates: a. 24 months from the date of termination, if you terminate your employment prior to age 62 because of disability, retirement, or death; b. 48 months from the date of termination, if you terminate your employment at or after age 62 because of disability, retirement, or death; c. On the day after you terminate your employment with the Company, if you terminate for reasons other than disability, retirement, or death; or d. 10 years from the date of grant. 100 of 109 Vesting Rules: If you do not remain employed by the Company for one year after the date of grant, the stock option does not vest and may not be exercised. If you remain employed by the Company for one year from the date of grant, and the stock option has not otherwise terminated, the stock option shall vest and may be exercised according to the following schedule: Date After Which Stock Option Portion of Grant That Incentive Non-Qualified May be Exercised Becomes Exercisable Stock Option Stock Option - ----------------------------- --------------------- ------------ ------------- One year after the date of grant 40% _____ _____ Three years after date of grant 30% _____ _____ Five years after date of grant 30% _____ _____ If you terminate your employment with the Company one year or more after the date the option was granted (and your termination is due to retirement, disability, or death), any nonexercisable portion of the Incentive Stock Option or the Non-Qualified Stock Option covered by this notice will become 100% exercisable one day after your termination date; provided, however, that the total option exercise price of the Incentive Stock Options which became exercisable during the calendar year in which you terminate (including any Incentive Stock Options which became exercisable in that year from previous stock option grants you may have received) may not exceed $100,000 (or such greater amount as established by the Internal Revenue Service) and the balance will be exercisable as non-qualified stock options. Exercise: During your lifetime only you, your guardian or your legal representative may exercise the stock option. The Plan permits exercise of the stock option by the personal representative of your estate or the beneficiary thereof following your death. Transfer: The stock option is not transferable except by will or the applicable laws of descent and distribution. Method of Exercise of Stock Option: The stock option or any part thereof may be exercised by giving written notice of exercise to the Secretary of the Com- pany, which notice shall (a) state the number of full shares to be purchased, and (b) be accompanied by payment in full for the number of shares to be pur- chased. The date such notice and payment are received by the office of the Secretary shall be the date of exercise of shares. Payment may be made either in the form of cash, check, Company stock, or any combination thereof unless otherwise restricted by the Compensation Committee. The Company will issue and deliver to you or in accordance with your instructions at the earliest practicable date after exercise a certificate or certificates for the number of shares purchased; provided, however, that if any federal or state law or regulation or a securities exchange listing the Company's shares requires the Company to take any action with respect to the exercised shares before issuance thereof, then the date for issuance and delivery of such shares shall be extended for the period of time necessary to take such action. Very truly yours, THE BOEING COMPANY Secretary 101 of 109 Exhibit (10)(ix)(b)(ii) 1993 Incentive Stock Plan for Employees - Notice of Stock Option Grant for Supplemental Grant 102 of 109 NOTICE OF TERMS OF STOCK OPTION GRANT ________ _, 1993 To: __________________ SSN: __________________ We are pleased to inform you that you have been selected by the Compensation Committee of the Board of Directors of The Boeing Company ("the Compensation Committee") to receive an option to purchase ______ shares of the Company's common stock at an exercise price of $__.____ per share. The grant of this option is made pursuant to The Boeing Company 1993 Incentive Stock Plan for Employees, as amended (the "Plan"). A copy of the Plan is attached and incorporated into this notice by reference. The terms and conditions of the option grant are set forth in the Plan and in this notice. Exercise of all or part of this stock option constitutes acceptance of all the terms and conditions of the option grant. Type of Option: All of these stock option shares are granted as Non-Qualified Stock Options. Date of Grant: The date of the grant of the stock option is ___________, 1993. Term of the Stock Option: 1. The stock option will terminate and all rights to exercise the stock option will terminate completely if you do not remain employed by the Company for at least one year from the date of grant regardless of the reason for your termination. 2. If you remain employed by the Company for at least one year from the date of grant, this stock option will terminate and all rights to exercise this stock option will terminate upon the earlier of: (a) 5 years from the date of grant, or (b) the date you terminate employment if such termination is for reasons other than disability, death or retirement under conditions which satisfy the terms of the Company retirement plan. 3. This stock option shall automatically terminate if the Compensation Committee determines, in its sole and absolute discretion, that such option is included in "applicable employee remuneration" within the meaning of Section 13211 of Public Law 103-66. 103 of 109 Vesting Rules: If you do not remain employed by the Company for one year after the date of grant, the stock option does not vest and may not be exercised. If you remain employed by the Company for one year from the date of grant, and the stock option has not otherwise terminated, the stock option shall vest and may be exercised according to the following schedule: Cumulative When Stock Option Total of Stock May be Exercised Option Grant When the stock reaches $_____ a share* _______ stock options are exercisable. ______ When the stock reaches $_____ a share* _______ stock options are exercisable. ______ When the stock reaches $_____ a share* _______ stock options are exercisable. ______ * Over any 20 consecutive trading days, the closing price of Boeing Common Stock must average a value equal to or exceeding the applicable share price. (The share price of Boeing Common Stock will be the daily closing price as reported in The Wall Street Journal for the New York Stock Exchange Composite Transactions.) Exercise: During your lifetime only you, your guardian or your legal representative may exercise the stock option. The Plan permits exercise of the stock option by the personal representative of your estate or the beneficiary thereof following your death. Transfer: The stock option is not transferable except by will or the applicable laws of descent and distribution. Method of Exercise of Stock Option: The stock option or any part thereof may be exercised by giving written notice of exercise to the Secretary of the Company, which notice shall (a) state the number of full shares to be purchased, and (b) be accompanied by payment in full for the number of shares to be purchased. The date such notice and payment are received by the office of the Secretary shall be the date of exercise of the stock option as to such number of shares. Payment may be made either in the form of cash, check, Company stock, or any combination thereof unless otherwise restricted by the Compensation Committee. The Company will issue and deliver to you or in accordance with your instructions at the earliest practicable date after exercise a certificate or certificates for the number of shares purchased; provided, however, that if any federal or state law or regulation or a securities exchange listing the Company's shares requires the Company to take any action with respect to the exercised shares before issuance thereof, then the date for issuance and delivery of such shares shall be extended for the period of time necessary to take such action. Very truly yours, THE BOEING COMPANY Secretary 104 of 109 Exhibit (22) List of Company Subsidiaries THE BOEING COMPANY SUBSIDIARIES (ALL WHOLLY-OWNED) Page 1 of 2 Place of Date Name Incorporation Incorporated - ------------------------------------------------------------------------------ Aileron Inc. Delaware 1989 *Aldford Limited Bermuda 1993 Aldford-1 Corporation Delaware 1993 *Amwell Limited Bermuda 1993 Amwell-1 Corporation Delaware 1993 *Andsell Limited Bermuda 1993 Andsell-1 Corporation Delaware 1993 ARGOSystems, Inc. California 1969 *Arneway Limited Bermuda 1993 Arneway-1 Corporation Delaware 1993 *A.S.I. Electronics (in process of dissolution) California 1977 Astro Limited Bermuda 1975 Astro-II, Inc. Vermont 1984 *Beaufoy Limited Bermuda 1993 Beaufoy-1 Corporation Delaware 1993 BCS Richland, Inc. Washington 1975 BE&C Engineers, Inc. Delaware 1978 BOECON Corporation Washington 1973 Boeing Aerospace Operations, Inc. Washington 1972 Boeing Agri-Industrial Company Oregon 1973 *Boeing Canada Technology Ltd. Ontario 1929 Boeing China, Inc. Delaware 1986 Boeing Commercial Space Development Company Delaware 1987 BOEING DEFENSE & SPACE-CORINTH CO. Delaware 1987 BOEING DEFENSE & SPACE-IRVING CO. Delaware 1979 Boeing Defense & Space - Oak Ridge, Inc. Delaware 1980 Boeing Domestic Sales Corporation Washington 1974 Boeing Equipment Holding Company Washington 1968 Boeing Financial Corporation Washington 1965 Boeing Georgia, Inc. Delaware 1980 Boeing Information Services, Inc. Delaware 1981 Boeing International Corporation Delaware 1953 Boeing International Sales Corporation Washington 1971 Boeing Investment Company, Inc. Delaware 1985 Boeing Leasing Company Delaware 1988 Boeing Louisiana, Inc. Delaware 1986 Boeing Middle East Limited Delaware 1982 Boeing Mississippi, Inc. Delaware 1985 Boeing Nevada, Inc. Delaware 1989 *Second-tier subsidiaries **Third-tier subsidiaries 105 of 109 THE BOEING COMPANY SUBSIDIARIES (ALL WHOLLY-OWNED) Page 2 of 2 Place of Date Name Incorporation Incorporated - ------------------------------------------------------------------------------ Boeing of Canada Ltd. Delaware 1986 Boeing Offset Company, Inc. Delaware 1985 Boeing Operations International, Incorporated Delaware 1981 Boeing Petroleum Services, Inc. Delaware 1984 Boeing Sales Corporation Guam 1984 Boeing Sales Corporation, Limited Bermuda 1993 Boeing Technology International, Inc. Washington 1973 *Braham Limited Bermuda 1993 Braham-1 Corporation Delaware 1993 Energy Enterprises, Inc. Delaware 1991 *Gainford Limited Bermuda 1993 Gainford-1 Corporation Delaware 1993 Gaucho-1 Inc. Delaware 1994 *Grape Limited Bermuda 1993 Grape Corporation Delaware 1993 Hanway Corporation Delaware 1993 Longacres Park, Inc. Washington 1948 Mandarin-1 Corporation Delaware 1993 Mandarin-2 Corporation Delaware 1993 Mandarin-3 Corporation Delaware 1993 Mandarin-4 Corporation Delaware 1993 Mandarin-5 Corporation Delaware 1993 Mandarin-6 Corporation Delaware 1993 Montana Aviation Research Company Delaware 1991 RGL-1 Corporation Delaware 1993 RGL-2 Corporation Delaware 1993 RGL-3 Corporation Delaware 1993 RGL-4 Corporation Delaware 1993 RGL-5 Corporation Delaware 1993 RGL-6 Corporation Delaware 1993 Rainier Aircraft Leasing, Inc. Delaware 1992 *UTL Canada, Inc. (in process of dissolution) Canada 1987 **2433265 Manitoba Ltd. Manitoba 1989 *692567 Ontario Limited Ontario 1986 *757UA, Inc. Delaware 1989 *767ER, Inc. Delaware 1987 *Second-tier subsidiaries **Third-tier subsidiaries 106 of 109 Appendix of graphic and image material pursuant to Rule 304(a) of Regulation S-T Graphic and image material item Number 1 A bar chart for the five years 1989-1993 indicating sales by industry segment (dollars in billions): 1989 1990 1991 1992 1993 Commercial Aircraft 14.305 21.230 22.970 24.133 20.568 Defense and Space 5.429 5.862 5.846 5.429 4.407 Other 0.542 0.503 0.498 0.622 0.463 Total 20.276 27.595 29.314 30.184 25.438 Graphic and image material item Number 2 A bar chart for the five years 1989-1993 indicating sales by type of customer (dollars in billions): 1989 1990 1991 1992 1993 Foreign 11.029 16.109 17.856 17.486 14.616 Domestic Commercial 3.965 6.049 5.896 7.245 6.413 U. S. Government 5.282 5.437 5.562 5.453 4.409 Total 20.276 27.595 29.314 30.184 25.438 Graphic and image material item Number 3 A bar chart of research and development expensed for the five years 1989-1993 (dollars in billions): 1989 - 0.754; 1990 - 0.827; 1991 - 1.417; 1992 - 1.846; 1993 - 1.661 Graphic and image material item Number 4 A bar chart for the five years 1989-1993 indicating contractual backlog by type of customer (dollars in billions): 1989 1990 1991 1992 1993 Commercial 73.974 91.475 92.826 82.649 70.497 U. S. Government 6.589 5.719 5.090 5.281 3.031 Total 80.563 97.194 97.916 87.930 73.528 107 of 109 Graphic and image material item Number 5 A line chart plotting world air travel - as measured by revenue passenger miles in billions, excluding former Soviet Union airlines - for the years 1970-2010. Years 1970-1993 are designated as historical, years 1994-2010 are designated as forecast. The two lines graphed are total revenue passenger miles and U.S. revenue passenger miles. Relevant plot points (revenue passenger miles in billions): U.S. Total U.S. Total Revenue Revenue Revenue Revenue Passenger Passenger Passenger Passenger Year Miles Miles Year Miles Miles -------- --------- --------- -------- --------- --------- 1970 148.3 284.0 1993 513.6 1270.2 1975 173.3 427.9 1994 520.8 1343.0 1980 260.6 652.0 1995 568.3 1427.8 1985 351.1 831.1 2000 706.5 1894.3 1990 472.3 1158.3 2005 896.1 2428.9 1991 463.2 1131.1 2010 1073.4 3070.3 1992 493.8 1224.2 Graphic and image material item Number 6 A bar chart for the twenty-four years 1970-1993 indicating airline industry profits for core airline operations for both U.S. major airlines and non-U.S. airlines (Inflation-adjusted dollars in billions): U.S. major Non-U.S. U.S. major Non-U.S. Year Airlines Airlines Year Airlines Airlines -------- ---------- -------- -------- ---------- -------- 1970 0.169 1.442 1982 (1.022) 0.781 1971 1.065 0.996 1983 0.498 2.612 1972 1.788 0.820 1984 2.898 4.206 1973 1.673 1.953 1985 1.699 3.825 1974 1.973 0.235 1986 1.105 4.613 1975 0.285 1.565 1987 2.326 6.790 1976 1.659 3.477 1988 3.266 9.164 1977 1.954 3.919 1989 1.506 7.382 1978 2.718 3.738 1990 (2.587) 0.902 1979 0.411 1.062 1991 (2.346) 1.261 1980 (0.390) (0.722) 1992 (2.402) (0.477) 1981 (0.720) (0.387) 1993 0.800 1.858 1993 is indicated to be an estimate 108 of 109 Graphic and image material item Number 7 A bar chart for the five years 1989-1993 indicating both (1) property, plant and equipment - net additions and (2) depreciation (dollars in billions): 1989 1990 1991 1992 1993 Net additions 1.362 1.586 1.850 2.160 1.317 Depreciation 0.584 0.636 0.768 0.870 0.953 Graphic and image material item Number 8 A bar chart for the five years 1989-1993 indicating both customer financing - net additions (dollars in billions): 1989 - (.263); 1990 - 0.264; 1991 - 0.065; 1992 - 1.098; 1993 - 0.881 109 of 109

93410_1993.txt

93410_1993

1993

93410

ITEM 1. BUSINESS (a) GENERAL DEVELOPMENT OF BUSINESS SUMMARY DESCRIPTION OF CHEVRON - ------------------------------ Chevron Corporation (1), a Delaware corporation, is a major international oil company. It provides administrative, financial and management support for, and manages its investments in, domestic and foreign subsidiaries and affiliates, which engage in fully integrated petroleum operations, chemical operations, real estate development and other mineral and energy related activities in the United States and approximately 100 other countries. Petroleum operations consist of exploring for, developing and producing crude oil and natural gas; transporting crude oil, natural gas and petroleum products by pipelines, marine vessels and motor equipment; refining crude oil into finished petroleum products; and marketing crude oil, natural gas and the many products derived from petroleum. Chemical operations include the manufacture and marketing of a wide range of chemicals for industrial uses. Incorporated in Delaware in 1926 as Standard Oil Company of California, the company adopted the name Chevron Corporation in 1984. Domestic integrated petroleum operations are conducted primarily through three divisions of the company's wholly owned Chevron U.S.A. Inc. subsidiary. Exploration and production operations in the United States are carried out through Chevron U.S.A. Production Company. U.S. refining and marketing activities are performed by Chevron U.S.A. Products Company. Warren Petroleum Company engages in all phases of the domestic natural gas liquids business. A list of the company's major subsidiaries is presented on page 40 of this Annual Report on Form 10-K. As of December 31, 1993, Chevron had 47,576 employees, 78 percent of whom were employed in U.S. operations. OVERVIEW OF PETROLEUM INDUSTRY - ------------------------------ Petroleum industry operations and profitability are influenced by a large number of factors, over some of which individual oil and gas companies have little control. Governmental attitudes and policies, particularly in the areas of taxation, energy and the environment, have a significant impact on petroleum activities, regulating where and how companies conduct their operations and formulate their products and, in some cases, limiting their profits directly. Prices for crude oil and natural gas, petroleum products and petrochemicals are determined by supply and demand for these commodities. OPEC member countries are the world's swing producers of crude oil and their production levels are the primary driver in determining worldwide supply. Demand for crude oil and its products is largely driven by the health of local, national and worldwide economies, although weather patterns and taxation relative to other energy sources also play a significant part. Natural gas is generally produced and consumed on a country or regional basis. Its largest use is for electrical generation, where it competes with other energy fuels. CURRENT OPERATING ENVIRONMENT - ----------------------------- Crude oil prices rose slightly in the first quarter of 1993 and remained steady through the second quarter before trending downward for the remainder of the year. The decline was particularly prominent during the last two months of 1993, with prices reaching their lowest level in five years by year end. The weak global economy has dampened the demand for petroleum and petroleum related products. Increased production from non-OPEC countries, particularly from the North Sea, and OPEC's failure to adjust their production levels accordingly has further exacerbated the decline in crude oil prices. Partially mitigating the effects of - ------------------ (1) As used in this report, the term "Chevron" and such terms as "the company," "the corporation," "our," "we," and "us" may refer to Chevron Corporation, one or more of its consolidated subsidiaries, or to all of them taken as a whole, but unless the context clearly indicates otherwise, should not be read to include "affiliates" of Chevron (those companies owned approximately 50 percent or less). As used in this report, the term "Caltex" may refer to the Caltex Group of companies, any one company of the group, any of their consolidated subsidiaries, or to all of them taken as a whole and also includes the "affiliates" of Caltex. All of these terms are used for convenience only, and are not intended as a precise description of any of the separate companies, each of which manages its own affairs. - 1 - lower crude oil prices were higher natural gas prices. Unseasonable weather patterns, low gas storage levels, the loss of three nuclear power plants in the Southeast for a portion of the year, and the environmentally preferred attributes of natural gas all contributed to the stronger natural gas prices. In the United States, the Henry Hub, Louisiana spot price for natural gas, a common benchmark for natural gas prices, averaged $2.21 per thousand cubic feet (MCF) in 1993, an increase of $.41 per MCF over 1992. Strong refined product prices, which did not decline as rapidly as crude oil prices, also helped to dampen the effects of lower crude oil prices. However, product prices in the United States fell late in the year and have remained low into 1994. If both crude oil and refined product prices continue at their low levels, the company's earnings and cash flow from ongoing operations may be negatively affected. Widely fluctuating prices have become characteristic of the petroleum industry for the past several years. Chevron's average realization from U.S. crude oil production declined from $16.50 per barrel in 1992 to $14.58 per barrel in 1993 while average liquids realizations from international liftings, including equity affiliates, declined by $1.84 per barrel to $16.09 per barrel. Average U.S. natural gas realizations from production increased to $1.99 per MCF in 1993 from $1.70 per MCF in 1992. The following table compares the high, low and average company posted prices for West Texas Intermediate (WTI), an industry benchmark light crude oil, for each of the quarters during 1993 and for the full years of 1993, 1992, and 1991: - ---------------------------------------------------------------------- WEST TEXAS INTERMEDIATE CRUDE OIL CHEVRON POSTED PRICES (Dollars per Barrel) ------------------------------------- 1st Q 2nd Q 3rd Q 4th Q Year 1992 1991 ----- ----- ----- ----- ----- ----- ----- High 20.25 19.75 18.00 18.00 20.25 21.75 29.50 Low 17.50 18.00 16.00 13.00 13.00 16.50 16.75 Average 19.09 19.10 17.01 15.58 17.68 19.71 20.20 - ---------------------------------------------------------------------- For the first two months of 1994, average natural gas realizations for the company's U.S. operations were $2.14 per MCF. During this period, the company's posted price for WTI ranged from $13.00 per barrel to $15.00 with an average of $13.86. On March 21, 1994, the company's posted price for WTI was $14.25 per barrel. CHEVRON STRATEGIC DIRECTION - --------------------------- To improve financial performance and to compete more effectively, Chevron developed and began implementing seven "strategic intents" in 1992. These are to: - - SHIFT EXPLORATION AND PRODUCTION EMPHASIS TO INTERNATIONAL OPPORTUNITIES. The company believes opportunities to discover and develop major new reserves in the United States are limited due to regulatory barriers and drilling prohibitions on many of the most promising areas of development. In 1993, 68 percent of the exploration and production capital spending, including affiliates, was allocated to international operations. In 1994, that number is expected to increase to 75 percent. As recently as 1990, U.S. exploration and production capital spending was approximately 50 percent of the total. As an important example of this new emphasis, in April 1993, the company entered into a joint venture agreement with the Republic of Kazakhstan to develop the massive Tengiz oil field in that country. - 2 - - - GENERATE $1 BILLION IN CASH ANNUALLY FROM U.S. EXPLORATION AND PRODUCTION OPERATIONS. Chevron is emphasizing a steady cash flow from a core group of approximately 400 oil and gas fields concentrated in California, Texas, the Rocky Mountains and the Gulf of Mexico. In 1993, net cash flow after capital and exploratory expenditures for U.S. exploration and production operations was more than $1.2 billion. Lower operating expenses and an improved natural gas market helped to mitigate the effects of lower crude oil prices. If crude oil prices do not rebound, this goal may be difficult to achieve in 1994. - - RESHAPE THE U.S. REFINING AND MARKETING COMPANY INTO A TOP COMPETITOR. Chevron is currently the leading U.S. marketer of refined products and has the largest refining capacity in the nation. The company is seeking to strengthen its competitive position by investing in core refineries, reducing the size of its refining system and concentrating on specific marketing regions. Major projects are continuing at the company's Richmond and El Segundo, California refineries in order to produce reformulated fuels to meet the January 1995 emission requirements of the Clean Air Act Amendments of 1990 and the 1996 requirements of the California Air Resources Board. The company expects to complete the sale of its Philadelphia, Pennsylvania and Port Arthur, Texas refineries in 1994, thereby reducing its refining capacity about 25 percent. - - GROW CALTEX IN ATTRACTIVE MARKETS. Management believes that the demand for petroleum products will continue to grow in the Asia Pacific region and Chevron's 50 percent owned Caltex affiliate, a leading competitor in these areas, has made significant capital investments to expand and upgrade its refining capacity. Refinery upgrade projects are currently underway in Singapore and Korea, as well as the construction of a new refinery in Thailand. - - EXPLOIT COMPETITIVE STRENGTHS IN CHEMICALS. The petrochemical industry is highly cyclical. In order to improve its competitive position, the company is concentrating on areas of the petrochemical business in which it holds a competitive advantage, such as in its proprietary Aromax (R) process used to produce high value benzene from low value by-products of the oil refining process. The first Aromax (R) plant in the U.S., located at the company's Pascagoula, Mississippi, refinery, was completed in 1993. The company also announced, in January 1994, a cost reduction plan intended to reduce annual operating expense by approximately $100 million by 1996. An integral part of the plan is to divest or close non-core assets and sharpen the company's focus on the remaining core businesses. - - BE SELECTIVE IN NON-CORE BUSINESSES. In 1993, Chevron continued to dispose of marginally performing or non-strategic assets, including various oil and gas properties located in the United States and Indonesia. The company also divested its ORTHO lawn and garden products business, retail marketing operations in Guatemala, Nicaragua and El Salvador, certain undeveloped coal properties in the U.S., and its Vinwood Cellars Winery in California. Properties currently for sale include the company's 52.5 percent interest in some zinc-lead prospects in Ireland, refineries located in Philadelphia, Pennsylvania and Port Arthur, Texas, and the company's headquarters building located in San Francisco, California. - - FOCUS ON REDUCING COSTS ACROSS ALL ACTIVITIES. Chevron undertook an extensive cost-cutting and work force reduction program in early 1992. These efforts, in combination with the company's continuing program to dispose of non-core or underperforming assets, reduced 1993 operating costs, adjusted for special items, by approximately 5 percent or 40 cents a barrel from 1992 levels. When compared to the base year of 1991, ongoing operating, selling and administrative expenses have dropped by 11 percent, or 94 cents a barrel. To remain competitive, the company's management has set a number of new goals, including a new cost-reduction target of an additional 25 cents a barrel by the end of 1994. In 1993, the company established a new "strategic intent:" - - BUILD A COMMITTED TEAM TO ACCOMPLISH THE CORPORATE MISSION. The company believes the success of the other seven strategic intents is dependent on the commitment and dedication that Chevron employees bring to their jobs. In a 1992 employee survey and a 1993 update, Chevron measured employee - 3 - commitment using a model that assesses employee's willingness to expend discretionary effort on the job, combined with how strongly they feel the company deserves that effort. The surveys highlighted employee concerns on issues that the company is addressing. Due, in part, to the results of the survey, the company has initiated a number of work and family programs to help employees improve their productivity and commitment, such as flexible schedules, part-time work, job sharing and various leave programs. The company also presented commemorative wristwatches to its employees and a one time cash bonus equal to 5 percent of their annual salaries in appreciation for their efforts in meeting the company's five year goal, established in 1989, to be number one in stockholders' return among five peer U.S. oil companies. In February 1994, the company took delivery of a new vessel, the Chevron Employee Pride, named in honor of its worldwide workforce. (b) INDUSTRY SEGMENT AND GEOGRAPHIC AREA INFORMATION The company's primary business is its integrated petroleum operations. Secondary operations include chemicals and minerals. The petroleum activities of the company are widely distributed geographically, with major operations in the United States, Australia, United Kingdom, Canada, Nigeria, Angola, Papua New Guinea, China, Indonesia and Zaire. The company's Caltex affiliate, through its subsidiaries and affiliates, conducts exploration and production operations in Indonesia and refining and marketing activities in the Eastern Hemisphere, with major operations in Japan, Korea, Australia, the Philippines, Thailand and South Africa. Tengizchevroil (TCO), a 50/50 joint venture with a subsidiary of the national oil company of the Republic of Kazakhstan conducts production activities in Kazakhstan, a former Soviet republic. The company's and its affiliates' chemicals operations are concentrated in the United States, but include operating facilities in France, Japan and Brazil. The company's and its affiliates' principal minerals activities include both coal and platinum and palladium operations in the United States. Tabulations setting forth three years' identifiable assets, operating income, sales and other operating revenues for the company's three industry segments, by United States and International geographic areas, may be found in Note 9 to the Consolidated Financial Statements beginning on page FS-22 of this Annual Report on Form 10-K. (c) DESCRIPTION OF BUSINESS AND PROPERTIES The petroleum industry is highly competitive in the United States and throughout most of the world. This industry also competes with other industries in supplying the energy needs of various types of consumers. The company's operations can be affected significantly by changing economic, regulatory and political environments in the various countries, including the United States, in which it operates. The company evaluates the economic and political risk of initiating, maintaining or expanding operations in any geographical area. In the United States, environmental regulations and federal, state and local actions and policies concerning economic development, energy and taxation may have a significant effect on the company's operations. Internationally, the company is monitoring closely the civil unrest in Angola and the political uncertainty in Nigeria and Zaire and the possible threat these may pose to the company's oil and gas exploration and production operations and the safety of the company's employees located in those countries. The company attempts to avoid unnecessary involvement in partisan politics in the communities in which it operates but participates in the political process to safeguard its assets and to ensure that the community benefits from its operations and remains receptive to its continued presence. - 4 - CAPITAL AND EXPLORATORY EXPENDITURES Chevron's capital and exploratory expenditures during 1993 and 1992 are summarized in the following table: ------------------------------------------------------- CAPITAL AND EXPLORATORY EXPENDITURES (Millions of Dollars) 1993 1992 ------ ------ Exploration and Production $2,217 $2,097 Refining, Marketing and Transportation 1,166 1,263 Chemicals 224 251 Coal and Other Minerals 42 79 All Others 90 112 ------ ------ Total Consolidated Companies 3,739 3,802 Equity in Affiliates 701 621 ------ ------ Total Including Affiliates $4,440 $4,423 ====== ====== ------------------------------------------------------- Total consolidated expenditures in 1993 were essentially flat when compared to 1992, declining less than 2 percent between periods. An increase in exploration and production (E&P) expenditures of $120 million was more than offset by lower expenditures in the company's other operations. Exploration and production expenditures amounted to 59 percent of the company's consolidated expenditures, a 4 percent increase over 1992 levels. The increase was due solely to increased expenditures in international E&P as U.S. E&P expenditures continued to decline, down 4 percentage points to 34 percent of consolidated E&P expenditures in 1993. This decrease reflects the continued shift in the company's emphasis from U.S. exploration and production activities to international opportunities. Major international E&P expenditures in 1993 included development of the Alba Field in the U.K. North Sea, the North West Shelf Project in Australia, the Hibernia Project offshore Newfoundland, the Duri steamflood project in Indonesia, Areas B and C in Angola and the Tengiz project in Kazakhstan. Refining, marketing and transportation outlays in 1993 included expenditures for upgrading U.S. refineries to produce fuels, such as low aromatics and ultra low sulfur diesel fuel and reformulated gasoline, to comply with current and future federal, state and local air quality regulations. In 1994, the company expects to spend approximately $4.9 billion, including its share of equity affiliates' expenditures, an increase of approximately 11 percent over 1993 levels. Equity affiliate spending, primarily Caltex expenditures in the high growth Pacific Rim areas, account for this increase as consolidated expenditures in 1994 are expected to remain flat at $3.7 billion. E&P expenditures are expected to total $2.4 billion, of which approximately 75 percent will be for international projects such as the continued development of the Hibernia Field, expansion of the North West Shelf Project, enhanced recovery projects in Indonesia, the Tengiz project in Kazakhstan, and other development projects in West Africa. Refining, marketing and transportation expenditures are estimated at $2.1 billion, with U.S. expenditures of about $1 billion, including continued upgrades to U.S. refineries to produce reformulated gasoline in order to comply with the Clean Air Act Amendments of 1990 and California Air Resources Board regulations. The actual expenditures for 1994 will depend on various conditions affecting the company's operations and may differ significantly from the company's forecast. If low oil prices persist, expenditures, particularly for exploration and production, may be lower than forecast. Significant expenditures are expected over the next few years at the company's manufacturing facilities to comply with federal, state and local environmental regulations and to enable these facilities to produce cleaner fuels for industrial and consumer use. - 5 - PETROLEUM - EXPLORATION The following table summarizes the company's net interests in productive and dry exploratory wells completed in each of the last three years and the number of exploratory wells drilling at December 31, 1993. "Exploratory wells" include delineation wells, which are wells drilled to find a new reservoir in a field previously found to be productive of oil or gas in another reservoir or to extend a known reservoir beyond the proved area. "Wells drilling" include wells temporarily suspended. - ----------------------------------------------------------------------------- EXPLORATORY WELL ACTIVITY NET WELLS COMPLETED (1) WELLS DRILLING --------------------------------------- AT 12/31/93 1993 1992 1991 ------------------- ----------- ---------- ----------- GROSS (2) NET (2) PROD. DRY PROD. DRY PROD. DRY --------- ------- ---- ---- ---- ---- ---- ---- United States 37 33 32 14 42 16 39 25 --------- ------- ---- ---- ---- ---- ---- ---- Canada 13 11 27 26 10 - 24 21 Africa 13 5 3 4 3 3 2 5 Other International 35 10 - 9 5 4 1 5 --------- ------- ---- ---- ---- ---- ---- ---- Total International 61 26 30 39 18 7 27 31 --------- ------- ---- ---- ---- ---- ---- ---- Total Consolidated Companies 98 59 62 53 60 23 66 56 Equity in Affiliate - - 1 1 1 - 1 1 --------- ------- ---- ---- ---- ---- ---- ---- Total Including Affiliates 98 59 63 54 61 23 67 57 ========= ======= ==== ==== ==== ==== ==== ==== (1) Indicates the number of wells completed during the year regardless of when drilling was initiated. Completion refers to the installation of permanent equipment for the production of oil or gas or, in the case of a dry well, the reporting of abandonment to the appropriate agency. (2) Gross wells include the total number of wells in which the company has an interest. Net wells are the sum of the company's fractional interests in gross wells. - ----------------------------------------------------------------------------- At December 31, 1993, the company owned or had under lease or similar agree- ments undeveloped and developed oil and gas properties located throughout the world. Undeveloped acreage includes undeveloped proved acreage. The geo- graphical distribution of the company's acreage is shown in the next table. - ----------------------------------------------------------------------------- ACREAGE* AT DECEMBER 31, 1993 (Thousands of Acres) DEVELOPED UNDEVELOPED DEVELOPED AND UNDEVELOPED ---------------- -------------- ---------------- GROSS NET GROSS NET GROSS NET ------- ------ ----- ----- ------- ------ United States 3,994 3,123 4,626 2,841 8,620 5,964 ------- ------ ----- ----- ------- ------ Canada 18,213 10,374 528 383 18,741 10,757 Africa 17,147 12,726 135 53 17,282 12,779 Asia 54,297 23,944 61 21 54,358 23,965 Europe 3,231 1,195 58 11 3,289 1,206 Other International 9,656 3,257 57 16 9,713 3,273 ------- ------ ----- ----- ------- ------ Total International 102,544 51,496 839 484 103,383 51,980 ------- ------ ----- ----- ------- ------ Total Consolidated Companies 106,538 54,619 5,465 3,325 112,003 57,944 Equity in Affiliates 3,202 1,601 233 116 3,435 1,717 ------- ------ ----- ----- ------- ------ Total Including Affiliates 109,740 56,220 5,698 3,441 115,438 59,661 ======= ====== ===== ===== ======= ====== * Gross acreage includes the total number of acres in all tracts in which the company has an interest. Net acreage is the sum of the company's fractional interests in gross acreage. - ----------------------------------------------------------------------------- - 6 - The company had $222 million of suspended exploratory wells included in properties, plant and equipment at year-end 1993. The wells are suspended pending drilling of additional wells to determine if commercially producible quantities of oil or gas reserves are present. The ultimate disposition of these well costs is dependent on the results of this future activity. During 1993, the company explored for oil and gas in the United States and about 21 other countries. The company's 1993 exploratory expenditures, including affiliated companies' expenditures but excluding unproved property acquisitions, were $533 million compared with $547 million in 1992, a 3 percent decrease. Domestic expenditures represented approximately 34 percent of the consolidated companies' worldwide exploration expenditures, essentially unchanged from the prior year. Significant activities in Chevron's exploration program during 1993 include the following (number of wells are on a "gross" basis): UNITED STATES: Domestic exploratory expenditures, excluding unproved property acquisitions, were $183 million in 1993, compared to $189 million spent in 1992. In addition, the company incurred costs of $11 million for unproved property acquisitions in 1993. The company continued to focus its 1993 exploratory efforts in the Gulf of Mexico and in other areas where it has existing production. Fifteen exploratory wells were initiated in 1993. Seven of these exploratory wells were completed in 1993, resulting in two discoveries located in the Houston Salt Basin and in the Gulf of Mexico. Plans to spud a well in the Norphlet Trend prospect in Destin Dome 97, located in the Gulf of Mexico, were deferred until March 1994 due to delays in the permit process. Exploration efforts in high-potential areas, including Alaska's Arctic National Wildlife Refuge (ANWR) and parts of offshore Florida, California and North Carolina have been blocked by legal restrictions and drilling moratoria. Chevron and other oil companies have sued the Department of Interior to recover bonus payments, lease rentals and certain geophysical costs for federal offshore leases that remain undrilled due to state, federal, and private objections to drilling. The company is seeking to recover approximately $126 million, plus interest, spent on leases off Florida, North Carolina and Alaska. AFRICA: In Africa, the company spent $104 million during 1993 on exploratory efforts, excluding the acquisition of unproved properties, compared with $108 million in 1992. The company also acquired $9 million of unproved properties in 1993. In Nigeria, the company drilled six exploratory and appraisal wells in 1993, with all six either having proved reserves assigned or assignment deferred pending further exploration or evaluation work. The company also acquired 3-D seismic data covering Nigerian acreage of 1,410 square kilometers in 1993 and separately entered into a farm-in arrangement for the exploration of three offshore concessions. In Angola, the company is the operator of a 7,000 square kilometer concession off the coast of Angola's Cabinda exclave. The concession is divided into Areas A, B, and C, with Area A generating all current production. One successful exploration well was drilled in Area A during 1993 resulting in the discovery of the Numbi South East field which was brought on stream in 1993 by linking it to the existing Numbi Field facilities. Two exploratory wells were drilled in Areas B and C and a third was drilled at the end of the year. These resulted in the discovery of the M'Bili Field in Area C and a non-commercial accumulation in Area B. The third well was tested in Area B as a discovery well, N'Sangui, in January 1994. Options for the development of M'Bili are currently being evaluated. The current Exploration Period for Areas B and C was to expire at the end of February 1994 with a provision to fulfill all obligations by the end of August 1994. The company has requested an extension of the Exploration Period. Under the existing agreement, two exploratory wells will be drilled in Areas B and C in 1994. An additional well may be drilled if the extension is granted. Chevron (operator) and its partners are currently negotiating a Production Sharing Agreement for the recently awarded Deepwater Block 14, located due west of Areas B and C. The agreement is expected to be completed and signed in 1994. In the Congo, a regional 3-D survey was acquired in 1993 covering the southern part of the Marine VII Block which includes both the Kitina and Kitina South discoveries, as well as several additional exploration prospects. In Namibia, the company has been conducting a detailed seismic evaluation of the offshore Namibia Block 2815, where Chevron is the operator. In 1993, Chevron farmed-out a portion of its interest in the concession, reducing its share from 60 percent to 40 percent. - 7 - OTHER INTERNATIONAL INCLUDING AFFILIATED COMPANIES: Exploration expenditures, excluding unproved property acquisitions, were $246 million in 1993, a decrease of $4 million from the 1992 amount of $250 million. In addition, unproved properties of $430 million, primarily related to the company's investment in Tengizchevroil (TCO), were acquired in 1993. In the North Sea, Chevron participated in four wildcat wells in the U.K. sector in 1993. A discovery was made in the Paleocene Parliament prospect, to the northeast of Alba and Britannia, thereby establishing area potential. During the U.K.'s 14th licensing round, the company was awarded operatorship of four blocks in the coastal waters to the west of Britain. In Canada, exploration efforts in 1993 continued to be concentrated in the western part of the country. A total of 23 wildcat wells were drilled in 1993 which reflected an increase in drilling activity as a share of total exploratory expenditures. In Indonesia, Chevron and its partners drilled nine exploratory wells in 1993, three of which resulted in oil discoveries. In Australia, Chevron and its partners in West Australia Petroleum Pty., Ltd. (WAPET) participated in the drilling of the North West Shelf exploration well West Dixon-1, which proved unsuccessful. A preliminary interpretation of the Gorgon 3-D seismic survey was completed in 1993 and WAPET has approved the exploratory drilling for gas of North Gorgon-2 in 1994. WAPET also acquired a 519,000 acre block north of Gorgon in 1993. The new permit, WA-253-P, will be issued to WAPET in early 1994. In Papua New Guinea, the government has agreed to grant Chevron and its partners an extension of its exploratory license. The extension significantly extends the time remaining for exploration of a large area of the Papuan Fold and Thrust Belt. Exploration efforts continue to be concentrated near the Kutubu project facilities and export system. The Gobe 4X well was drilled before year-end at a location approximately 15 kilometers northwest of the SE Gobe field, resulting in an additional oil and gas discovery on this 40 kilometer-long anticline. In China, Chevron was awarded sole interest in Block 33/08 in the East China Sea in December. Seismic studies are planned for the second quarter 1994 to determine the optimum location for exploratory drilling. All exploration and drilling activities will be coordinated from Chevron's newly-opened Shanghai office. The HZ/32-4-1 exploratory well in the Pearl River Mouth Basin of the South China Sea was abandoned as a dry hole in 1993. Other areas where exploration activities occurred in 1993 include Bolivia where the first exploratory well (Cuevo West) was completed in March 1994 as a dry hole, Trinidad and Tobago where the first of four exploratory wells (Rocky Palace #1) was spudded in late 1993, Colombia where evaluation of the Rio Blanco Block in the Llanos foothills continued in 1993 with the acquisition of a seismic program, Yemen where the exploratory well Al Harsh #1 was unsuccessful, and Azerbaijan where Chevron and the State Oil Company of the Azerbaijan Republic (SOCAR) signed an agreement to jointly study oil and gas reserve potential in the southern third of the Caspian Sea. - 8 - PETROLEUM - OIL AND NATURAL GAS PRODUCTION The following table summarizes the company's and its affiliate's 1993 net production of crude oil, natural gas liquids and natural gas. - ----------------------------------------------------------------------------- 1993 NET PRODUCTION* OF CRUDE OIL AND NATURAL GAS LIQUIDS AND NATURAL GAS CRUDE OIL & NATURAL GAS NATURAL GAS LIQUIDS (THOUSANDS OF (BARRELS PER DAY) CUBIC FEET PER DAY) ----------------- ------------------- United States -California 130,330 139,110 -Gulf of Mexico 127,500 1,134,910 -Texas 73,420 403,620 -Louisiana 5,790 30,060 -Wyoming 10,610 155,120 -Colorado 16,560 - -New Mexico 8,630 94,720 -Other States 21,380 98,460 ------- --------- Total United States 394,220 2,056,000 ------- --------- Africa 217,600 - Canada 49,510 217,650 United Kingdom (North Sea) 49,430 27,670 Indonesia 31,730 1,050 Australia 17,780 163,580 Papua New Guinea 31,040 - China 8,200 - Other International 7,750 6,110 ------- --------- Total International 413,040 416,060 ------- --------- Total Consolidated Companies 807,260 2,472,060 ------- --------- Equity in Affiliates 142,890 53,370 ------- --------- Total Including Affiliates 950,150 2,525,430 ======= ========= * Net production excludes royalties owned by others. - ----------------------------------------------------------------------------- PRODUCTION LEVELS: In 1993, net crude oil and natural gas liquids production, including affiliates, increased by about one percent to 950,150 barrels per day from 943,940 barrels per day in 1992. Production increases were noted in Papua New Guinea due to full year production and additional wells being brought on stream in 1993 from the Kutubu project, in Kazakhstan due to the startup of a new joint venture partnership in April 1993, and in Indonesia due to production increases as the result of application of enhanced recovery methods in certain fields. These production increases were partially offset by production declines in the United States due to divestments of producing properties in 1992 and normal field declines. Net production of natural gas, including affiliates, declined 250,920 thousand cubic feet per day, or 9 percent, in 1993 from 1992. The decrease was primarily due to normal field declines and 1992 divestitures of producing properties in the United States and the Netherlands. The decline was partially offset by production from the startup of the company's new joint venture in Kazakhstan. In the United States, natural gas producers have traditionally sold their production to pipeline companies, who in turn distribute the product to their customers. As a result of FERC Order 636, producers now can sell directly to customers and provide many of the services previously provided by the pipeline companies. Chevron has concentrated its natural gas marketing efforts on the longer term contract market. These customers, which include local distribution companies and industrials, require premium bearing services and marketing arrangements that Chevron can fulfill. The company's sales to these customers have risen significantly, while sales to pipeline companies have correspondingly declined. - 9 - Data on the company's average sales price per unit of oil and gas produced, as well as the average production cost per unit for 1993, 1992 and 1991 are reported in Table III on pages FS-32 to FS-33 of this Annual Report on Form 10-K. The following table summarizes the company's and its affiliates' gross and net productive wells at year-end 1993. - ----------------------------------------------------------------------------- PRODUCTIVE OIL AND GAS WELLS AT DECEMBER 31, 1993 PRODUCTIVE (1) PRODUCTIVE (1) OIL WELLS GAS WELLS ------------------ ------------------- GROSS (2) NET(2) GROSS (2) NET (2) --------- ------ --------- ------- United States 27,155 12,460 3,164 1,569 --------- ------ --------- ------- Canada 2,042 1,017 330 146 Africa 830 320 4 2 United Kingdom (North Sea) 180 24 - - Other International 968 350 54 15 --------- ------ --------- ------- Total International 4,020 1,711 388 163 --------- ------ --------- ------- Total Consolidated Companies 31,175 14,171 3,552 1,732 Equity in Affiliates 4,311 2,156 28 14 Total Including Affiliates 35,486 16,327 3,580 1,746 ========= ====== ========= ======= Multiple completion wells included above: 388 183 20 14 (1) Includes wells producing or capable of producing. Wells that produce both oil and gas are classified as oil wells. (2) Gross wells include the total number of wells in which the company has an interest. Net wells are the sum of the company's fractional interests in gross wells. - ----------------------------------------------------------------------------- DEVELOPMENT ACTIVITIES: The company's development expenditures, including affiliated companies but excluding proved property acquisitions, were $1,451 million in 1993 and $1,525 million in 1992. The table below summarizes the company's net interest in productive and dry development wells completed in each of the past three years and the status of the company's developmental wells drilling at December 31, 1993. (A "development well" is a well drilled within the proved area of an oil or gas reservoir to the depth of a stratigraphic horizon known to be productive. "Wells drilling" include wells temporarily suspended.) - ----------------------------------------------------------------------------- DEVELOPMENT WELL ACTIVITY NET WELLS COMPLETED (1) WELLS DRILLING -------------------------------------- AT 12/31/93 1993 1992 1991 ------------------- ----------- ---------- ----------- GROSS (2) NET (2) PROD. DRY PROD. DRY PROD. DRY --------- ------- ---- ---- ---- ---- ---- ---- United States 97 80 293 11 217 5 445 6 --------- ------- ---- ---- ---- ---- ---- ---- Canada 14 12 41 12 45 4 66 5 Africa 6 2 10 - 10 1 13 1 Other International 51 16 16 - 10 - 17 1 --------- ------- ---- ---- ---- ---- ---- ---- Total International 71 30 67 12 65 5 96 7 --------- ------- ---- ---- ---- ---- ---- ---- Total Consolidated Companies 168 110 360 23 282 10 541 13 Equity in Affiliates 45 22 93 - 159 5 171 10 --------- ------- ---- ---- ---- ---- ---- ---- Total Including Affiliates 213 132 453 23 441 15 712 23 ========= ======= ==== ==== ==== ==== ==== ==== (1) Indicates the number of wells completed during the year regardless of when drilling was initiated. Completion refers to the installation of permanent equipment for the production of oil or gas or, in the case of a dry well, the reporting of abandonment to the appropriate agency. (2) Gross wells include the total number of wells in which the company has an interest. Net wells are the sum of the company's fractional interests in gross wells. - ----------------------------------------------------------------------------- - 10 - Significant 1993 development activities include the following: UNITED STATES: Chevron's U.S. development expenditures were $475 million in 1993, a decrease of $8 million from the 1992 figure of $483 million. Additions to proved reserves during 1993 from extensions, discoveries and improved recovery, before revisions, were 98 million barrels of crude oil and natural gas liquids and 356 billion cubic feet of natural gas. The development of the San Joaquin Valley diatomite reserves in California continued in 1993. Forty one new wells were drilled and 45 older wells were reworked using reservoir fracturing techniques. A four year water injection project, initiated in 1992, to sustain reservoir pressure and further boost production continued into its second year with the drilling of 42 injection wells and the conversion of 18 producing wells to injection. The combination of reservoir fracturing and water injection is expected to increase both the production rate and the amount of oil ultimately recoverable from this resource. Production in the Point Arguello project, offshore California, averaged 74,000 barrels of oil per day in 1993. Chevron owns approximately 25 percent of the project and operates two offshore platforms (Hermosa and Hidalgo), the onshore Gaviota oil and gas plant and the interconnecting pipelines. A workover and drilling program, designed to add proved reserves and abate the decline in production rate, commenced in August 1993 on the two offshore platforms. Five workovers and two new wells, improving Chevron's lease production by 4,300 barrels of oil per day, were completed in 1993. Three additional wells are planned to be drilled in 1994. Chevron and its partners began double-hulled tankering to Los Angeles of some 250,000 barrels of oil three to four times per month from the field's processing plant at Gaviota in August 1993 under an agreement with the California Coastal Commission. Previously, production was limited to approximately 60,000 barrels per day or 70 percent of full capacity of 85,000 barrels per day due to limited onshore pipeline capacity. Fourth quarter production averaged 80,700 barrels per day. The terms of the permit granted by the California Coastal Commission allowed tankering to continue until January 1, 1996 but required suspension of tankering from February 1, 1994 until such time that Chevron and its partners sign an agreement with a pipeline developer that the developer could use to finance construction of a new line. In late January 1994, Chevron approached the California Coastal Commission to permit short-term tankering beyond February 1 due to damage to a key crude oil pipeline system to Los Angeles caused by the Northridge earthquake. The request was not acted upon by January 31 and short-term tankering was subsequently suspended on February 1. Although production was initially maintained by routing to alternate markets, the shortage of adequate transportation facilities has subsequently resulted in reduced production. In March 1994, the company announced that an agreement had been reached on building a new 130 mile pipeline in Southern California that would carry Point Arguello oil production to Los Angeles. The company anticipates construction on the Pacific Pipeline will commence in early 1995 and be operational in early 1996. Pending the construction of this new pipeline, the company is seeking to resume limited tanker shipments through 1995. Natural gas production from Garden Banks Block 191 in the Gulf of Mexico started in late 1993. Daily production should reach 150 million cubic feet per day during the first quarter of 1994. During 1994, six additional wells will be drilled under simultaneous drilling and production operations. Chevron is the operator and holds a 50 percent interest in this block. In the Gulf of Mexico's Norphlet Trend, which stretches some 80 miles from the Destin Dome area (offshore Florida) to the Mobile Block 861 area (offshore Mississippi), two wells, Mobile Block 861 #8 (Chevron 50 percent interest) and Mobile Block 917 #2 (Chevron 91.3 percent interest), were completed and tested in 1993. Production from 861 #8, which tested at 57 million cubic feet per day (total), commenced in February 1994 while production from 917 #2, which tested at 46 million cubic feet per day (total), will commence in 1995. The company and its partners are currently drilling or planning to drill additional exploratory wells in Mobile Blocks 863, 864, and 916 and Destin Dome 97 in 1994. A new platform was installed in Chevron's wholly owned Main Pass 299 Field in July 1993. Ten development wells are planned with three wells having been completed and placed in production in December 1993. Production is expected to peak at 3,000 barrels per day late in 1994. - 11 - Chevron continued to aggressively develop "tight gas" (gas which is produced from a tight, low-permeability formation) in the Laredo, Texas area. In 1993, twenty-five wells were drilled with twenty-three successes, adding net proved reserves of 70 billion cubic feet of gas. Production averaged 135 million cubic feet of gas per day in 1993. The S. Uribe No. 11 well was completed in 1993 with a sustained flow rate of 23 million cubic feet of gas per day. AFRICA: Developmental expenditures in Africa were $239 million in 1993, compared to $189 million in 1992. Additions to proved reserves were 105 million barrels of crude oil and natural gas liquids. In Angola, where Chevron's equity interest is 39 percent, ten development wells were added in Area A fields in 1993. In order to sustain production, six existing wells in Area A were reworked and three offshore processing platforms in the Malongo and Takula Fields were revamped and modernized in 1993. Production from the N'Sano Field, discovered in 1992, was tied back to existing Takula facilities. A new production platform to fully develop N'Sano reserves is under construction for installation later this year. Areas B and C continued to be the major focus of development programs in 1993. The first phase of development in these areas involves the installation of two integrated drilling and production platforms in the Kokongo Field. The East Kokongo platform will also be the hub for future phases of development for Areas B and C. A thirty-eight mile pipeline linking the platforms to onshore terminal facilities was completed in the fourth quarter of 1993. Platform construction will be completed in Brazil and delivered to Angola with oil production scheduled to begin in late 1994. The second phase of development is scheduled for the Sanha and N'Dola fields and will consist of two production platforms and related pipelines and facilities for which contracts were awarded in 1993. Commencement of work has been delayed by partner financing issues. Preliminary development plans for the third phase involving development of the Nemba and Lomba fields have been submitted for governmental approval. In Nigeria, Chevron is operator and has a 40 percent interest in concessions totalling 2.3 million acres in onshore and offshore regions in the Niger Delta. Producing facilities for three new fields, Opuekeba, Idama and Inda, were completed and the fields came on stream during the second half of 1993. Combined production from these new fields, along with production from the Belma and Belma North unitized field development which began in October 1993, is expected to add 60,000 barrels per day to the total production capacity in 1994. Upgrade construction work on two production platforms, Tapa and Delta South, were completed in 1993. This is the beginning of a multi-year program which will include all existing platforms in order to extend the useful life of these facilities and also enhance safety and environmental performance. Work on the Escravos Gas Project, Phase I, continued in 1993. This first phase will utilize gas that is currently being flared in the Okan and Mefa fields. The project will include offshore gas compression facilities, an onshore Liquified Petroleum Gas (LPG) extraction plant, and a floating LPG storage unit anchored offshore. The project will sell gas under a long term contract to the Nigerian Gas Company in addition to producing approximately fifteen thousand barrels per day of hydrocarbon liquids for export. The project is scheduled for start-up in 1997. At year-end, discussions were underway on the assignment of Chevron as the developer of a West African Gas Pipeline which would deliver gas to Ghana via Benin and Togo. The company has an additional subsidiary in Nigeria that holds a 20 percent interest in five offshore oil fields operated by another partner. In Zaire, where the company has a 50 percent interest in a 390 square mile concession off the coast, development and exploration activities resumed in 1993 as political unrest subsided. Two developmental wells and four well workovers in the Mibale, Motoba and Libwa fields were completed in 1993. In the Congo, where Chevron has a 29.3 percent interest, the 1991 Kitina discovery in the offshore Marine VII Block was successfully delineated with a second appraisal well. Engineering studies are currently underway to determine the optimal development and reservoir management plan for this field. OTHER INTERNATIONAL INCLUDING AFFILIATED COMPANIES: Development expenditures in 1993 were $737 million compared to $853 million in 1992. Additions to proved reserves from extensions, discoveries and improved - 12 - recoveries were 66 million barrels of crude oil and natural gas liquids and 46 billion cubic feet of natural gas. Additions to proved reserves from acquisitions were approximately 1.1 billion barrels of crude oil and natural gas liquids and 1.5 trillion cubic feet of natural gas. In the United Kingdom, the company has interests in over 50 blocks on the U.K. Continental Shelf which totals approximately 1.7 million gross acres. Chevron held interests, varying from 4.9 to 33.3 percent, in five producing fields in the North Sea during 1993. A sixth field, Alba, started production in January 1994. At the Ninian Field in the U.K. North Sea, Chevron increased its interest by 6.5 percent to 23.6 percent in December 1993. Chevron and its partners began processing third party oil and gas in 1992 using available processing capacity at the Ninian facilities. The Ninian partners receive tariffs for processing and exporting the production from three subsea produced satellite fields - Staffa, Lyell and Strathspey. Staffa production was brought on stream in 1992, followed by production from Lyell (Chevron owns a 33.3 percent interest) in March 1993 and Strathspey in December 1993. Lyell production peaked at 31,000 barrels per day and has stabilized at a daily average of 19,000 barrels per day. Strathspey production is currently averaging 17,000 barrels per day, with an expected peak of 41,000 barrels per day. In 1993, Chevron and its partners announced a commercial framework for bringing on future satellite fields through Ninian. Direct drilling from Ninian Northern platform into the first of four potential satellite prospects began in December. At the Alba Field in the North Sea, development of the first phase of that project was successfully completed with the installation and hook-up of the Alba Northern platform and the Alba floating storage unit (FSU) in November. Initial production, expected to peak at 70,000 barrels per day later this year, began in January 1994 after the FSU was fully commissioned. Work also began in 1993 on plans for the second phase of Alba which will develop the southern area of the reservoir. The Alba Field, in which Chevron has a 33 percent interest, is estimated to contain up to 400 million barrels of recoverable reserves. At the Britannia Field in the North Sea, a 3-D seismic survey was completed in 1992 and analyzed in 1993 as a guide for field mapping and development drilling. Delineation drilling results and technical studies indicate that approximately two and one-half trillion cubic feet of gas, 175 million barrels of condensate and up to 30 million barrels of crude oil will be recoverable, with Chevron's share equating to approximately 30 percent. Preliminary facility engineering studies are nearing completion and a firm decision on development options and commercial arrangements is expected in 1994. In Canada, the company continues to concentrate its development efforts in six core producing areas in Alberta and one in Manitoba where operating efficiencies and lower operating costs can be realized using existing infrastructure. Chevron increased its ownership in the Hibernia Field, located approximately 200 miles offshore Newfoundland, by 5 percent to about 27 percent in January 1993 after one of the four original project partners withdrew. In 1993, construction on the project continued with the awarding of the supermodule fabrication contracts, the pouring of the base slab for the Gravity Base Structure, and the completion of supermodule and hook-up engineering. Hibernia investment is projected to be about $200 million in 1994, an increase of $54 million over 1993 levels. Initial production is scheduled for 1997. The company's capitalized investment in this project was $375 million at year-end 1993. In Indonesia, Chevron's interests in 14 contract areas are managed by its 50 percent owned P.T. Caltex Pacific Indonesia and Amoseas Indonesia affiliates. The Duri Steamflood project, begun in 1985 to assist the difficult production process for the relatively heavy, waxy Duri crude, is being completed in 12 stages (Areas 1-12). Development of Area 7 is currently underway. More than three billion additional barrels of oil are expected to be recovered from the Duri Field as a result of steamflooding. Total production at Duri averaged 247,000 barrels per day in 1993 and is expected to peak at just over 300,000 barrels per day by the late 1990s. A waterflood project involving 21 fields in Central Sumatra, including the Minas field, continued in 1993. Water injection at Minas was initiated in December 1993 as part of the conversion of the peripheral waterflood to a pattern waterflood which is designed to improve oil recovery. Chevron sold its 17.5 percent share in the South Natuna Sea Block B effective January 1, 1994. Chevron's net share of production from this block averaged approximately 11,300 barrels of oil and natural gas liquids per day in 1993. - 13 - In Kazakhstan, the company formed a 50/50 joint venture with Tengizmunaigaz, a subsidiary of Kazakhstanmunaigaz - the national oil company of the Republic of Kazakhstan, to develop the Tengiz and Korolev oil fields on the northeast coast of the Caspian Sea. This joint venture affiliate, Tengizchevroil (TCO), began operations in April 1993, adding net proved reserves to Chevron of 1.1 billion barrels of crude oil and natural gas liquids and 1.5 trillion cubic feet of natural gas. Current production has averaged about 30,000 barrels per day, which is approximately 46 percent of the rated crude oil production capacity of 65,000 barrels per day. Production is restricted by limited treatment and transportation facilities currently available to TCO to bring the oil to world markets. Tengiz crude oil production is currently exchanged for Russian crude which is then exported from Russia to world markets. Natural gas, natural gas liquids and sulfur are being sold into local markets. Over the next three to five years, plans call for TCO to spend about $1.5 billion on expanding production capacity and infrastructure. Current capacity is expected to double to 130,000 barrels per day by 1995 and could reach 260,000 barrels per day by the late 1990s. The pace of field development from 130,000 to 260,000 barrels per day is predicated on the construction of an export pipeline system capable of handling the full production from the fields. Negotiations to agree on terms for a pipeline project, which would be separate from the TCO joint venture's Tengiz development project, have proved to be very difficult, and it is currently impossible to predict the eventual outcome or its impact on the joint venture. In Australia, the Goodwyn Field, being developed as part of the North West Shelf Project in which Chevron holds a one-sixth interest, is scheduled to start production in 1994. Completion of the offshore platform, originally scheduled for 1993, was delayed due to repair work on the piles. Upon completion of the repair work, in first quarter 1994, the topside modules will be installed and commissioned. Production will flow by a 30 inch diameter pipeline to the nearby North Rankin platform and then by trunkline to shore. The participants in the North West Shelf Project approved, in 1993, the development of the Wanaea Field, the Cossack Field, and an LPG extraction and export project. Combined initial production from the two oilfields is forecast at 115,000 barrels per day starting in late 1995. The liquids-rich gas from Wanaea will be combined with gas from the North Rankin and Goodwyn fields and processed at the onshore gas plant at Karratha, which is being modified to allow the export sale of LPG. Two new LPG storage tanks and a second product loading jetty are currently under construction to handle the extra production. Following start-up in early 1996, LPG exports are expected to average 25,000 barrels per day. Drilling and construction for the Roller/Skate oilfield development progressed according to schedule in 1993. Production is scheduled to commence in 1994 at a peak rate of 32,000 barrels per day. Associated gas from the Roller/Skate and Saladin fields will be piped to shore and either sold in the Perth market or stored in the Dongara field for future sales. The Roller/Skate development, in which Chevron holds about a 26 percent interest, is a project of the West Australian Petroleum Pty., Ltd. In Papua New Guinea, Chevron (19 percent interest) and its partners are reviewing the feasibility of developing the SE Gobe Field with possible production commencing in 1994. In China, projects to develop the HZ/32-2 and HZ/32-3 Fields in the South China Sea were initiated in 1993 with the awarding of the major contract. The plan includes two platforms, 12 additional wells and a tie-in to the existing production facility at the HZ/21-1 Field. Initial production, expected to peak at 45,000 barrels per day, is scheduled for 1995. Chevron holds a 16 percent interest in the venture. Other development projects included the completion of the expanded development of the Chichimene Field in the Llanos Basin area of Colombia. The project included development drilling, production facilities and a 35 kilometer pipeline. Expected peak production of 10,000 barrels of oil per day is expected in 1994. Chevron holds a 50 percent interest in the field. - 14 - PETROLEUM - NATURAL GAS LIQUIDS Chevron's wholly owned Warren Petroleum Company is engaged in all phases of the domestic natural gas liquids (NGL's) business and is the largest U.S. wholesale marketer of natural gas liquids, selling to customers in 46 states. Warren also conducts Chevron's international liquefied petroleum gas (LPG) trading and sales activities. Sales in 1993 totaled 287 thousand barrels per day (includes sales of 79,000 barrels per day to Chevron subsidiaries). Warren's business encompasses: EXTRACTION - Warren operates 18 gas processing plants in Oklahoma, Texas, Louisiana and New Mexico and holds equity interests in another 25 plants. Natural gas from Chevron's and other producers' wells is piped to these plants, where the various liquids are extracted. Gas liquids production from these plants was 64,000 barrels per day in 1993. FRACTIONATION - Raw natural gas liquids are collected from Warren's processing plants, third-party purchases and Warren's gas liquids import facility on the Houston Ship Channel and transported via pipelines to Warren's fractionation plant at Mont Belvieu, Texas. The 220,000 barrel per day capacity facility fractionates raw NGL's into ethane, propane, normal butane, iso-butane and natural gasoline products. The Mont Belvieu complex includes a 45 million barrel capacity underground gas liquids storage facility. DISTRIBUTION - Gas liquids are distributed to refineries, chemical producers and independent distributors via terminals supplied by pipelines, barges, tank cars and trucks. NGL imports and exports are handled at Warren's marine terminal, the Warrengas Terminal, located on the Houston Ship Channel and linked to the Mont Belvieu complex by dedicated pipelines. In 1993, Warren continued its activities in international LPG business development, marketing LPG for other Chevron companies in Canada, West Africa, the U.K., and Australia. International sales more than doubled from 13,000 barrels per day in 1992 to 28,000 barrels per day in 1993. Warren completed the construction of an underground natural gas salt dome storage facility at Hattiesburg, Mississippi, on behalf of Chevron U.S.A. Production Company. The five billion cubic feet storage terminal began receiving gas deliveries in December 1993. A major expansion of the Mont Belvieu fractionator was also completed in 1993. A new butane hydrotreating and isomerization unit was added, increasing its fractionation capacity by 20,000 barrels per day. The company's total third-party natural gas liquids sales volumes over the last three years are reported in the following table. --------------------------------------------------- NATURAL GAS LIQUIDS SALES VOLUMES (Thousands of barrels per day) 1993 1992 1991 ---- ---- ---- United States - Warren 208 191 172 United States - Other 3 3 3 ---- ---- ---- Total United States 211 194 175 Canada 30 26 21 Other International 7 7 8 ---- ---- ---- Total Consolidated Companies 248 227 204 ==== ==== ==== --------------------------------------------------- - 15 - PETROLEUM - RESERVES AND CONTRACT OBLIGATIONS Table IV on pages FS-33 to FS-34 of this Annual Report on Form 10-K sets forth the company's net proved oil and gas reserves, by geographic area, as of December 31, 1993, 1992, and 1991. During 1993, the company filed estimates of oil and gas reserves with the Department of Energy, Energy Information Agency. These estimates were consistent with the reserve data reported on page FS-34 of this Annual Report on Form 10-K. The quantities of crude oil that the company is obligated to deliver in the future under existing contracts in the United States and internationally, which specify delivery of fixed and determinable quantities, are not significant in relation to the quantities available from production of the company's proved developed reserves in those areas. The company sells gas from its producing operations under a variety of contractual arrangements. Most contracts generally commit the company to sell quantities based on production from specified properties but certain gas sales contracts specify delivery of fixed and determinable quantities. In the United States, the quantities of natural gas the company is obligated to deliver in the future under existing contracts is not significant in relation to the quantities available from the production of the company's proved developed U.S. reserves in these areas. Outside the United States, the company has contracts, principally with the State Energy Commission of Western Australia, which have remaining obligations to deliver 269 billion cubic feet of natural gas through 2005. The company believes it can satisfy these contracts from quantities available from production of the company's proved developed Australian natural gas reserves. PETROLEUM - REFINING The daily refinery inputs over the last three years for the company's and its affiliate's refineries are shown in the following table. - ----------------------------------------------------------------------------- PETROLEUM REFINERIES: LOCATIONS, CAPACITIES AND INPUTS (Inputs and Capacities are in Thousands of Barrels Per Day) DECEMBER 31, 1993 ------------------ REFINERY INPUTS OPERABLE -------------------- LOCATIONS NUMBER CAPACITY 1993 1992 1991 - ---------------------------- ------ -------- ---- ---- ---- Pascagoula, Mississippi 1 295 283 294 306 Port Arthur, Texas 1 185 177 189 195 Richmond, California 1 235 228 228 221 El Segundo, California 1 226 233 235 180 Philadelphia, Pennsylvania 1 172 184 164 162 Other* 6 282 202 201 214 -- ----- ----- ----- ----- Total United States 11 1,395 1,307 1,311 1,278 -- ----- ----- ----- ----- Burnaby, B.C., Canada 1 45 43 41 41 Milford Haven, Wales United Kingdom 1 115 120 103 107 -- ----- ----- ----- ----- Total International 2 160 163 144 148 -- ----- ----- ----- ----- Total Consolidated Companies 13 1,555 1,470 1,455 1,426 Equity in Various Affiliate Locations 14 492 435 399 369 -- ----- ----- ----- ----- Total Including Affiliate 27 2,047 1,905 1,854 1,795 == ===== ===== ===== ===== * Refineries in El Paso, Texas; Barber's Point, Hawaii; Salt Lake City, Utah; Perth Amboy, New Jersey; Willbridge, Oregon; and Richmond Beach, Washington. Inputs for the company's Nikiski, Alaska, refinery, closed in 1991, are included in the above data for 1991. - ----------------------------------------------------------------------------- - 16 - Based on refinery statistics published in the December 20, 1993 issue of The Oil and Gas Journal, Chevron had the largest U.S. refining capacity and had the fifth largest worldwide refining capacity including its share of affiliate's refining capacity. The company wholly owns and operates 11 refineries in the United States and one each in Canada and the United Kingdom. The company's Caltex Petroleum Corporation affiliate owns or has interests in 14 operating refineries in Japan (4), Korea, the Philippines, Australia, New Zealand, Bahrain, Singapore, Pakistan, Thailand, Kenya and South Africa. The company also owns closed refineries in Nikiski, Alaska; Cincinnati, Ohio; and Baltimore, Maryland. Excluded from the affiliate's refineries are 3 closed refineries in Japan. Production records were set at all locations in 1993 as refineries focused on maximizing unit utilization. In 1993, distillation operating capacity utilization averaged 94 percent in the United States and 95 percent worldwide (including affiliate), compared with 90 percent in the United States and 92 percent worldwide in 1992. Chevron's capacity utilization of its domestic cracking and coking facilities, which are the primary facilities used to convert heavier products to gasoline and other light products, averaged 88 percent in 1993, unchanged from 1992. During 1993, the company completed the first facility to use Chevron's patented Aromax (R) technology at the Pascagoula, Mississippi refinery. This process produces high value benzene from lower valued refining feed stock and will facilitate the company's ability to comply with the requirement to reduce the benzene content in motor gasoline mandated by the Clean Air Act Amendments of 1990. At the El Paso, Texas refinery, the company entered into an operating agreement with a neighboring refinery which allowed Chevron, as operator, to combine the most efficient units from each refinery in order to lower costs and increase yields. The company also completed a $40 million facility at the Salt Lake City, Utah refinery which will allow the company to economically manufacture ultra low sulfur diesel fuel, one of the few such facilities in that area. In August 1993, the company installed its proprietary Isodewaxing (R) technology at the Richmond lube oil refining plant. This process, which uses a new catalyst developed by the company, boosted lube oil production by 1,500 barrels per day. The U.S. downstream industry is going through massive recapitalization in order to meet stringent new environmental regulations. This led to the 1993 announcement of a major restructuring of the company's downstream operations. An integral part of this plan is to divest refineries in Philadelphia, Pennsylvania and Port Arthur, Texas since these refineries no longer fit in Chevron's long term plans to have a more strategically focused U.S. refining operation and will reduce the capital expenditures that would have been required under the 1990 amendments to the Clean Air Act. In 1993, the company established an $837 million pre-tax provision for the divestment of these two refineries. This charge was composed primarily of a write-down of the refineries' facilities and related inventories to their estimated realizable values. Also included in the charges were provisions for environmental site assessments and employee severance. The company has taken into account probable environmental cleanup obligations in estimating the realizable value of the refineries. Responsibility for these obligations will be negotiated with potential buyers. While negotiations for the refinery sales are ongoing, it is expected that the reserve will be sufficient to complete the restructuring. In late February 1994, the company signed a letter of intent with Sun Company, Inc. for the sale of the Philadelphia refinery. In late March 1994, the company announced it has entered into exclusive negotiations with Clark Refining & Marketing, Inc. regarding the sale of its Port Arthur, Texas, refinery. The company will invest nearly $1 billion in its Richmond and El Segundo, California refineries over the next three years to produce reformulated gasoline. In addition, a $300 million investment to upgrade key processing units to improve yields of high value light products is underway at the Richmond refinery. At the company's Milford Haven, Wales refinery, a new isomerization unit was brought on stream in 1993. This $54 million unit will enable the refinery to produce a higher octane blend stock in response to increased demand for lead-free gasoline and anticipated benzene reduction in European gasoline. - 17 - In March 1994, the company announced that it will license technology and provide engineering design for a major upgrade to the Kirishi Refinery, operated by Kirishinefteexport, in Russia. The key refining process unit covered by the agreement is a new hydrocracker, scheduled for startup in mid-1999, which will use Chevron's Isocracking technology to maximize production of middistillates such as diesel fuel and jet fuel. The company will also provide technology to remove ammonia and hydrogen sulfide from water used in the refining process, yielding clean water for reuse. Caltex and its partners completed front-end engineering design of a grassroots, 130,000 barrels per day refinery in Thailand. The engineering, procurement and construction contract was awarded in October and the project is on target for completion in 1996. Work continued on the expansion/upgrade project at the Singapore export refinery. Completion of the project, scheduled for mid-1995, will increase refining capacity by 60,000 barrels per day, increase yield of light products by 33,000 barrels per day, and enable the refinery to produce oxygenated unleaded gasoline and low sulfur diesel fuel. A Japanese affiliate of Caltex placed a new residuum desulfurizer into service at the Negishi, Japan refinery. This unit, along with the cracker unit installed last year, will allow the refinery to increase yields of higher-value products and reduce dependence on low sulfur crudes. PETROLEUM - REFINED PRODUCTS MARKETING PRODUCT SALES: The company and its affiliates, primarily Caltex Petroleum Corporation, sell petroleum products throughout much of the world. The principal trademarks for identifying these products are "Chevron", "Gulf" (principally in the United Kingdom) and "Caltex". Domestic sales volumes of refined products by the company during 1993 amounted to 1,423 thousand barrels per day, equivalent to approximately nine percent of total U.S. consumption. Worldwide sales volumes, including the company's share of affiliates' sales, averaged 2,346 thousand barrels per day in 1993, an increase of about one percent over 1992. The following table shows the company's and its affiliates' refined product sales volumes, excluding intercompany sales, over the past three years. -------------------------------------------------------- REFINED PRODUCTS SALES VOLUMES (Thousands of Barrels Per Day) 1993 1992 1991 ----- ----- ----- UNITED STATES Gasolines 652 646 632 Gas Oils and Kerosene 325 347 312 Jet Fuel 247 252 249 Residual Fuel Oil 94 110 145 Other Petroleum Products* 105 115 106 ----- ----- ----- Total United States 1,423 1,470 1,444 ----- ----- ----- INTERNATIONAL United Kingdom 111 108 110 Canada 50 39 38 Other International 168 147 142 ----- ----- ----- Total International 329 294 290 ----- ----- ----- Total Consolidated Companies 1,752 1,764 1,734 Equity in Affiliate 594 565 533 ----- ----- ----- Total Including Affiliate 2,346 2,329 2,267 ===== ===== ===== * Principally naphtha, lubes, asphalt and coke. -------------------------------------------------------- - 18 - The company's Canadian sales volumes consist of refined product sales in British Columbia and Alberta by the company's Chevron Canada Ltd. subsidiary. In the United Kingdom, the sales volumes reported comprise a full range of product sales by the company's Gulf Oil (Great Britain) Ltd. subsidiary. The 1993 volumes reported for "Other International" relate primarily to international sales of aviation, marine fuels, and refined products in Latin America, the Far East and elsewhere. The equity in affiliates' sales in 1993 consist primarily of the company's interest in Caltex Petroleum Corporation, which operates in 63 countries including Australia, the Philippines, New Zealand, South Africa and, through Caltex affiliates, in Japan and Korea. The company introduced several new products in 1993. In September, the company began delivering JP-8, a kerosene-based jet fuel, to the U.S. military. Over the next two years, JP-8, a safer and more versatile fuel, capable of powering tanks, trucks and other military vehicles, will phase out naphtha-based JP-4. In October, low aromatics diesel fuel in California and ultra low sulfur diesel fuel in the rest of the country were introduced to comply with various federal and state air quality regulations. Reformulated heavy duty motor oils that meet the needs of low sulfur diesel fuel users were also introduced nationwide in October. RETAIL OUTLETS: In the United States, the company supplies, directly or through jobbers, over 9,000 motor vehicle, aircraft and marine retail outlets, including more than 2,400 company-owned or -leased motor vehicle service stations. The company's gasoline market area is concentrated in the Southeastern, South Central and Western states. Chevron is among the top three marketers in 16 states. During 1993, the company completed the acquisition and brand conversion of 55 service stations in south Florida that were acquired from Exxon in exchange for comparable properties in the Baltimore-Washington D.C.-Eastern Virginia areas. Chevron branded retail fuel sales in Arkansas, Western Kentucky and Western Tennessee were discontinued in 1993. In 1993, Chevron introduced a "Direct Mail Marketing" and a "Premium Card" program to credit card customers. The company also expanded its "Fast Pay" system by approximately 400 stations in 1993, to a total of over 1,300 stations nationwide. This automated system allows credit card customers to pay at the pump with credit approvals processed in about five seconds using satellite data transmission. During 1993, the company outsourced purchasing, warehousing and distribution responsibilities for its Tire, Batteries and Accessories business (TBA). Internationally, the company's branded products are sold in 214 owned or leased stations in British Columbia, Canada and in 467 (230 owned or leased) stations in the United Kingdom. In 1993, the company completed the sale of its retail marketing operations in Guatemala, El Salvador and Nicaragua. PETROLEUM - TRANSPORTATION TANKERS: Chevron's controlled seagoing fleet at December 31, 1993 is summarized in the following table. All controlled tankers were utilized in 1993. - ----------------------------------------------------------------------------- CONTROLLED TANKERS AT DECEMBER 31, 1993 U.S. FLAG FOREIGN FLAG ----------------------------- ------------------------------ CARGO CAPACITY CARGO CAPACITY NUMBER (millions of barrels) NUMBER (millions of barrels) ------ --------------------- ------ --------------------- Owned - - 26 27 Bareboat Charter 7 2 6 11 Time Charter - - 9 5 ---- ---- ---- ---- Total 7 2 41 43 ==== ==== ==== ==== - ----------------------------------------------------------------------------- - 19 - Federal law requires that cargo transported between domestic ports be carried in ships built and registered in the United States, owned and operated by U.S. entities and manned by U.S. crews. At year-end 1993, the company's U.S. flag fleet was engaged primarily in transporting crude oil from Alaska and California terminals to refineries on the West Coast and Hawaii, refined products between the Gulf Coast and East Coast, and refined products from California refineries to terminals on the West Coast, Alaska and Hawaii. At year-end 1993, two of the company's controlled international flag vessels were being used for floating storage. The remaining international flag vessels were engaged primarily in transporting crude oil from the Middle East, Indonesia, Mexico, West Africa and the North Sea to ports in the United States, Europe, the United Kingdom, and Asia. Refined products also were transported worldwide. In addition to the tanker fleet summarized in the table on page 19, the company owns a one-sixth undivided interest in each of five liquefied natural gas (LNG) ships that are bareboat chartered to the Australian North West Shelf Project. These ships, along with two time chartered LNG vessels, transport LNG from Australia to eight Japanese gas and electric utilities. One additional LNG ship has been ordered with delivery expected in late 1994. In 1993, the company took delivery of one 1.1 million and two 1.0 million barrel capacity, double hull tankers and sold two 1.2 million and two 3.2 million barrel capacity tankers. The company also took delivery of a 1.0 million barrel capacity tanker, the Chevron Employee Pride, in February 1994 and expects to take delivery of an additional 1.0 million barrel capacity tanker in October 1994. During 1993, the company reduced its time chartered fleet by a net one tanker and 1.0 million barrels of capacity. Page 24 of this Annual Report on Form 10-K contains a discussion of the effects of the Federal Oil Pollution Act on the company's shipping operations. PIPELINES: Chevron owns and operates an extensive system of domestic crude oil, refined products and natural gas pipelines. The company also has direct or indirect interests in other domestic and international pipelines. The company's ownership interests in pipelines are summarized in the following table: ----------------------------------------------------------- PIPELINE MILEAGE AT DECEMBER 31, 1993 WHOLLY PARTIALLY OWNED OWNED (1) TOTAL ----- ----- ------ UNITED STATES: Crude oil (2) 5,696 624 6,320 Natural gas 569 44 613 Petroleum products 3,709 1,610 5,319 ----- ----- ------ Total United States 9,974 2,278 12,252 ----- ----- ------ INTERNATIONAL: Crude oil (2) - 747 747 Natural gas - 197 197 Petroleum products 12 130 142 ----- ----- ------ Total International 12 1,074 1,086 ----- ----- ------ Worldwide 9,986 3,352 13,338 ===== ===== ====== (1) Reflects equity interest in lines. (2) Includes gathering lines related to the transportation function. Excludes gathering lines related to the production function. ----------------------------------------------------------- - 20 - CHEMICALS The company's Chevron Chemical Company subsidiary manufactures and markets chemical products for industrial use. The chemical industry, historically, has been cyclical and is highly competitive. Since its last peak in the late 1980s, industry conditions have deteriorated as ample supplies, caused by production overcapacity, have exerted downward pressure on prices. In the past four years, weak demand due to U.S. and worldwide recessions has further weakened prices. At year-end 1993, Chevron Chemical Company owned and operated 24 U.S. manufacturing facilities in 12 states, owned manufacturing facilities in Brazil and France, and owned a majority interest in a manufacturing facility in Japan. The principal domestic plants are located at Cedar Bayou, Orange and Port Arthur, Texas; St. James and Belle Chasse, Louisiana; Philadelphia, Pennsylvania; Marietta, Ohio; Pascagoula, Mississippi; St. Helens, Oregon; and Richmond, California. The following table shows, by chemical division, 1993 revenues and the number of owned or majority owned chemical manufacturing facilities and combined operating capacities as of December 31, 1993. - ----------------------------------------------------------------------------- CHEMICAL OPERATIONS MANUFACTURING FACILITIES 1993 ------------------- ANNUAL REVENUE (1) DIVISION U.S. INTERNATIONAL CAPACITY ($ MILLIONS) - --------------------- ---- ------------- ------------------- ------------ Olefins and Derivatives 12 - 6,990 million lbs. $1,003 Aromatics and Derivatives 7 - 6,570 million lbs. 718 Oronite Additives 2 3 160 million gal. 746 Fertilizers 2 - (2) 86 Consumer Products 1 - (2) 133 Other (including excise taxes) - - (2) 37 -- - ------ Totals 24 3 $2,723 == = ====== (1) Excludes intercompany sales. (2) No meaningful common measurement. - ----------------------------------------------------------------------------- The company divested its last major asset in the agricultural-related chemical business with the sale of its ORTHO consumer products division, a leading supplier of lawn and garden products in the United States, to Monsanto Company in 1993. The sale was the result of studies that concluded that the company's agricultural-related businesses were non-competitive or were non-core. The company decided to divest those businesses and focus its attention on areas of strength - petrochemicals, plastics and additives. Construction was completed during 1993 on the first U.S. benzene manufacturing plant using the company's proprietary Aromax (R) technology at the Pascagoula, Mississippi refinery. This technology will enable Chevron to produce high-value benzene from certain low-value by-products of the oil refining process. Benzene is a prime building block for a wide range of consumer products such as sporting goods, nylon, laundry detergent, children's toys and automobile tires. In March 1993, the company announced that a letter of intent had been signed with the Saudi Venture Capital Group, a consortium of Saudi Arabian business leaders, to develop an aromatics facility in Jubail, Saudi Arabia, if necessary Saudi government approval can be obtained. The planned facility would be owned and operated by a newly formed joint venture company. This joint company, owned on an equal basis by Chevron and the Saudi group, would market within Saudi Arabia, while Chevron would market all products outside Saudi Arabia. The facility will utilize Chevron's patented Aromax (R) reforming technology and have a capacity of 420,000 tons of benzene per year and 270,000 tons of cyclohexanes per year. The project is currently delayed while the Saudi government revises its petrochemical investment policy. The company is also in the early stages of examining opportunities to employ the Aromax (R) technology in Asia, where chemical demand is growing rapidly. - 21 - In January 1994, the company announced a cost-reduction plan intended to reduce annual operating expense by approximately $100 million by 1996. Major elements of the plan include completing the divestiture of the company's agricultural businesses, including the closing of the consumer products plant in Maryland Heights, Missouri and the sale of the fertilizer plant in St. Helens, Oregon; the sale of Chevron's asphalt business in Brazil; closing of the company's oil-field chemical business; reorganizing the Oronite Additives Division into global regions; and streamlining and reducing costs at the company's three largest plants in Cedar Bayou and Orange, Texas, and Belle Chasse, Louisiana. An agreement was reached in March 1994 with Institut Francais du Petrole to jointly develop a new high-purity paraxylene technology called Eluxyl. If the demonstration unit using this new technology, to be constructed and operated at Chevron's Pascagoula, Mississippi, refinery, proves successful, the company plans to integrate the technology at Pascagoula and expand its paraxylene activities worldwide. COAL AND OTHER MINERALS COAL: The company's wholly-owned coal mining and marketing subsidiary, The Pittsburg and Midway Coal Mining Co. (P&M), owned and operated four surface and three underground mines at year-end 1993. Three of the mines are located in New Mexico and one each in Alabama, Wyoming, Kentucky and Colorado. All of the mines produce steam coal used primarily for electric power generation. P&M's strategy is to focus on regional markets in the United States, capitalizing on major utility growth markets in the West and Southeast. Approximately 88 percent of P&M's coal sales are made to electric utilities. Sales of coal from P&M's wholly-owned mines and from its 50 percent interest in Black Beauty Coal Company were 20.8 million tons in 1993, an increase of 26 percent over 1992. About 57 percent of these sales came from two mines, the McKinley Mine in New Mexico and the Kemmerer Mine in Wyoming. The average selling price for coal from mines owned and operated by P&M was $24.62 per ton in 1993, contributing $426 million to Chevron's consolidated sales and other operating revenues. At year-end 1993, P&M controlled approximately 560 million tons of developed and undeveloped coal reserves. Demand growth for coal in the U.S. remains largely dependent on the demand for electric power, which in turn depends on regional and national economic conditions and on competition from other fuel sources. Although coal-fired generation of electricity grew during 1993, competition among coal producers kept downward pressure on regional coal prices during much of the year. However, in the East, a prolonged strike by United Mine Workers of America restricted coal production, tightening coal supplies and driving up spot market prices in the latter half of the year. P&M sells about 88 percent of its coal production under multi-year supply agreements, so it is not particularly exposed to short-term fluctuations in market prices. P&M controls a significant inventory of low-sulfur coal reserves, and the company expects demand for this type of coal to grow as utilities start to implement programs to comply with the air quality emission standards of the Clean Air Act Amendments of 1990. In addition, P&M anticipates that the Energy Policy Act of 1992 will increase competition in the electric power market and will provide new market opportunities for low-cost coal producers. OTHER MINERALS: P&M manages the company's investments in non-coal minerals. The company expressed its long-term intention to exit the non-coal minerals business, and most such assets have been sold in recent years. The principal assets remaining are a 50 percent interest in the Stillwater Mining Company, a Montana platinum-palladium mining operation, and a 52.5 percent interest in some zinc-lead prospects in Ireland. The company's share of sales and other revenues from non-coal operations was approximately $21 million in 1993. The sale of the company's 52.5 percent holding in the Irish zinc-lead prospects has been delayed due to legal challenges. The company expects these challenges to be resolved and the sale completed during 1994. REAL ESTATE The company's real estate activities are carried out primarily through its wholly owned subsidiaries, Chevron Land and Development Company and Huntington Beach Company (collectively, Chevron Land). - 22 - Their activities have concentrated on converting Chevron's surplus fee production properties in California into residential and commercial real estate. After making major infrastructure improvements, the properties are sold to third parties or jointly developed. At the end of 1993, Chevron Land managed over 26,000 acres of real estate in California. Chevron Land participates in residential developments through partnerships with home builders. During 1993, the company sold approximately 160 homes in California. Although this represents a 78 percent increase from the 90 homes sold in 1992, the California housing market continues to be weak as California lags the rest of the nation in realizing significant renewed economic growth. The company anticipates that the California real estate market will not begin to recover until late 1994 at the earliest and is currently positioning itself to take advantage of the recovery when it occurs by developing properties at a pace that meets market demand while preserving current real estate development entitlements. Ten residential housing projects were actively being developed at year-end, eight through joint venture partnerships. Although Chevron's current development emphasis is on the residential sector, the Company also participates in commercial real estate investment and development activities. The Montebello Town Square in Southern California, a 250,000 square foot community shopping center situated on 20 acres of a former oil field, was sold by the company in 1993. The company also leases approximately 70,000 acres of irrigated farmland and 160,000 acres of rangeland to local growers and ranchers in California's San Joaquin Valley. In 1993, Chevron Land restructured its organization by reducing its workforce 20 percent and closing or consolidating 5 of its offices. Currently, Chevron Land's activities are predominately handled by the company's offices in Newport Beach and San Francisco, California. RESEARCH AND ENVIRONMENTAL PROTECTION RESEARCH: The company's principal research laboratories are at Richmond and La Habra, California. The Richmond facility engages in research on new and improved refinery processes, develops petroleum and chemical products, and provides technical services for the company and its customers. The La Habra facility conducts research and provides technical support in geology, geophysics and other exploration science, as well as oil production methods such as hydraulics, assisted recovery programs and drilling, including offshore drilling. Employees in subsidiaries engaged primarily in research activities at year-end 1993 numbered approximately 2,400. In January 1994, the company signed an agreement with China National Petroleum Corporation to provide enhanced oil recovery technology for testing in Daqing, China's largest oil field. The technology, called "microbial profile modification," consists of pumping bacterial spores and nutrients into a reservoir to plug off highly permeable zones in order to improve the sweep efficiency of a waterflood. The agreement calls for 15 months of testing in Chevron Petroleum Technology Company's labs in La Habra, California, followed by a two year pilot program in Daqing. Chevron's research and development expenses were $206, $229, and $250 million for the years 1993, 1992, and 1991, respectively. The company owns, controls, or is licensed under numerous patents, but its business is not dependent upon patents. Licenses under the company's patents are generally made available to others in the petroleum and chemical industries. ENVIRONMENTAL PROTECTION: One of Chevron's ongoing corporate strategies is to give high priority to environmental, public and governmental concerns. Chevron's revised corporate policy on Health, Environment and Safety was approved by the Stockholders in 1991. In 1992, a comprehensive series of 101 management practices was approved by senior management to strengthen the implementation of the policy. The program is called "Protecting People and the Environment" and is modeled after the Chemical Manufacturers Associations' program called "Responsible Care." It is also similar to the American Petroleum Institute's program called "Strategies for Today's Environmental Partnership." The program also encompasses previous company programs to control pollution such as the SMART (Save Money and Reduce Toxics) program which focuses on routine, process related, hazardous waste. - 23 - The company's oil and gas exploration activities, along with many other petroleum companies, have been hampered by drilling moratoria, imposed because of environmental concerns, in areas where the company has leasehold interests, particularly Alaska, offshore Florida and offshore California. Difficulties and delays in obtaining necessary permits because of environmental concerns, such as those experienced by Chevron and its partners in the Point Arguello Field offshore California, can delay or restrict oil and gas development projects. While events such as these can impact current and future earnings, either directly or through lost opportunities, the company does not believe they will have a material effect on the company's consolidated financial position, its liquidity, or its competitive position relative to other domestic or international petroleum concerns. The situation has, however, been a factor, among others, in the shift of the company's exploration efforts to areas outside of the United States. The company will spend an estimated $1.1 billion in capital expenditures over the next 5 years on its refining facilities in order to comply with federal and state clean air regulations and to provide consumers with fuels that reduce air pollution and air toxicity. The Clean Air Act Amendments of 1990 (CAAA) requires the production of reformulated gasoline (RFG). Beginning in January 1995, only RFG may be sold in the nine worst ozone areas in the United States. In addition, the California Air Resources Board (CARB) requires a more stringent reformulated gasoline to be sold statewide beginning in March 1996. CAAA required a significant decrease in the sulfur content of diesel fuel sold in U.S. markets beginning October 1993. CARB, in addition to the federal requirements, also mandated a reduction in the aromatics content of diesel fuel sold in California. Chevron introduced low aromatics diesel fuel in California and ultra low sulfur diesel fuel in the rest of the nation in October 1993. The Federal Oil Pollution Act of 1990 (OPA) expanded federal authority to direct responses to oil spills to improve preparedness and response capabilities and to impose penalties on spillers for restoration costs and loss of use of the resources during restoration. OPA also requires the phase out of single hull tankers and the phase in of double hull tankers for trading to U.S. ports. Many of the coastal states have enacted or are preparing legislation in these same areas. In 1990, the company began a fleet modernization program, which included seven double hull tankers for delivery during the 1992-1994 period. Six of these tankers have been delivered through the first week of March 1994. The company has been actively involved in the Marine Preservation Association, a non-profit organization that funds the Marine Spill Recovery Corporation (MSRC). MSRC owns the largest stockpile of oil spill response equipment in the nation and operates five strategically located U.S. coastal regional centers. The company expects the enactment of additional federal and state regulations addressing the issue of waste management and disposal and effluent emission limitations for offshore oil and gas operations. While the costs of operating in an environmentally responsible manner and complying with existing and anticipated environmental legislation and regulations, including loss contingencies for prior operations, are expected to be significant, the company anticipates that these costs will not have a material impact on its consolidated financial position, its liquidity, or its competitive position in the industry. During 1993, the company's U.S. capitalized environmental expenditures were $620 million, representing approximately 31 percent of the company's total consolidated U.S. capital and exploratory expenditures. The company's U.S. capitalized environmental expenditures were $430 million and $284 million in 1992 and 1991, respectively. These environmental expenditures include capital outlays to retrofit existing facilities, as well as those associated with new facilities. The expenditures are predominantly in the petroleum segment and relate mostly to air and water quality projects and activities at the company's refineries, oil and gas producing facilities and service stations. For 1994, the company estimates that capital expenditures for environmental control facilities will be approximately $637 million. The actual expenditures for 1994 will depend on various conditions affecting the company's operations and may differ significantly from the company's forecast. The company is committed to protecting the environment wherever it operates, including strict compliance with all governmental regulations. The future annual capital costs of fulfilling this commitment are uncertain, but for the next several years are expected to continue at current levels. - 24 - Under provisions of the Superfund law, Chevron has been designated as a potentially responsible party (PRP) for remediation of a portion of 223 hazardous waste sites. Since remediation costs will vary from site to site as well as the company's share of responsibility for each site, the number of sites in which the company has been identified as a PRP should not be used as a relevant measure of total liability. At year-end 1993, the company's environmental remediation reserve related to Superfund sites amounted to $56 million. The largest of these sites, located in California, accounts for approximately 20 percent of the reserve. The company's 1993 environmental expenditures, remediation provisions and year-end environmental reserves are discussed on pages FS-3 through FS-4 of this Annual Report on Form 10-K. These pages also contain additional discussion of the company's liabilities and exposure under the Superfund law and additional discussion of the effects of the Clean Air Act Amendments of 1990. ITEM 2. ITEM 2. PROPERTIES The location and character of the company's oil and gas and minerals and real estate properties and its refining, marketing, transportation and chemical facilities are described above under Item 1. Business and Properties. Information in response to the Securities Exchange Act Industry Guide No. 2 ("Disclosure of Oil and Gas Operations") is also contained in Item 1 and in Tables I through VI on pages FS-30 to FS-35 of this Annual Report on Form 10-K. Note 12 "Properties, Plant and Equipment" to the company's financial statements contained on page FS-24 of this Annual Report on Form 10-K presents information on the company's gross and net properties, plant and equipment, and related additions and depreciation expenses, by geographic area and industry segment, for 1993, 1992 and 1991. ITEM 3. ITEM 3. LEGAL PROCEEDINGS A. Cities Service Tender Offer Cases. The complaint by Cities Service Co. ("Cities Services") and two individual plaintiffs was originally filed in August 1982 in Oklahoma state court in Tulsa. Prior proceedings have effectively eliminated the two individual plaintiffs as parties. The defendants were initially Gulf Oil Corporation and GOC Acquisition Corporation. Subsequent filings have identified Chevron U.S.A. Inc. as the successor in interest to Gulf Oil Corporation. In the original complaint Cities Service pleaded for damages of not less than $2.7 billion together with legal interest for breach of contract and misrepresentation. The great bulk of the damages were related to claims on behalf of shareholders of Cities Service. All of the claims by Cities Service shareholders have now been resolved and will ultimately be dismissed. Plaintiff Cities Service has now made new claims by way of a motion to amend the petition, which motion was submitted for ruling on February 28, 1994, but has not yet been ruled on by the court. The amended pleading adds Oxy U.S.A. as the successor to plaintiff Cities Service, adds Chevron U.S.A. Inc. (as successor to Gulf Oil Corporation) and adds Chevron Corporation as a new defendant. In addition to the existing claims for breach of contract and fraud, the amendments add the following causes of action: for willful and malicious breach of contract, negligent misrepresentation, interference with prospective economic advantage in connection with the 1989 proposed Oxy-Cities DOE settlement, and adds the claimed DOE liability as additional contract damages and as additional fraud damages. The proposed amendment also adds a claim for punitive damages based upon the alleged fraud, negligent misrepresentation, willful breach and interference claims. The new claim requests not less than $100 million on each of the several claims, together with pre-judgment interest and punitive damages. It also requests $12 million plus prejudgment interest for Cities' costs in defending against DOE proceedings since 1989, and an order entitling Cities Services to recover such "restitutionary obligation" amounts ultimately paid by Oxy U.S.A. to the DOE in excess of its proposed 1989 DOE settlement, and punitive damages. - 25 - B. In re Gulf Pension Litigation. In two lawsuits, which were commenced on December 2, 1986 and April 24, 1987 and consolidated on July 17, 1987 in the U.S. District Court for the Southern District of Texas as In re Gulf Pension Litigation, former employees of Gulf Oil Corporation who were participants in the Gulf Pension Plan contend that a partial termination of the Gulf Pension Plan has occurred and they are entitled to immediate vesting and distribution of plan benefits and to distribution of alleged excess plan assets, which it is alleged have been unlawfully seized by Gulf or Chevron. The action is brought under the Employee Retirement Income Security Act of 1974 and common law, and is primarily an action for damages. Defendants have filed an answer denying plaintiffs' allegations. On August 21, 1987, the Court certified a class on these issues consisting of "all former members of the Gulf Pension Plan and the spouses or the beneficiaries of such members." On January 4, 1990, the Court certified a subclass of plaintiffs who also contend that Chevron unlawfully denied them benefits due upon their alleged involuntary termination. A partial settlement agreement was reached during trial on November 19, 1990 and approved by the court at a January 25, 1991 hearing. On April 10, 1991, the Court issued its opinion on the remaining issues in the case. The Court ruled that partial terminations of the Gulf Pension Plan occurred, and ordered all participants in the plan as of July 1, 1986 to be vested in their benefits under the plan. The Court also ruled that participants in the Gulf Contributory Retirement Plan ("CRP") and the Supplemental Annuity Plan of Mene Grande Oil Company ("SAP") were entitled to the surplus assets of those plans. However, the Court ruled that Chevron, otherwise, has the right to retain surplus funds remaining in the Gulf Pension Plan after all obligations to the Plan Participants have been satisfied. Accordingly, the Court found no impropriety in the merger of the Gulf Pension Plan into the Chevron Retirement Plan or the use of plan assets to fund a special early retirement program and pension supplement. However, the Court did rule that Gulf and Chevron had incorrectly paid certain investment management fees out of plan assets and had incorrectly received a benefit from the use of pension plan assets in the negotiation of a divestiture sale agreement. On October 15, 1991, the court approved the terms of a second partial settlement agreement. As a part of the second partial settlement, the parties agreed not to appeal the partial termination issues except as relevant to plaintiff's claim that they are entitled to surplus Gulf Pension Plan assets that are not attributable to CRP/SAP. The second partial settlement does not affect the court's ruling that the plaintiffs are not entitled to approximately $620 million in surplus funds in the Gulf Pension Plan. Plaintiffs have appealed this part of the case to the Fifth Circuit Court of Appeals. Chevron has appealed the ruling that it incorrectly paid management fees out of the plan's assets and that it received a benefit from the use of pension funds. On April 29, 1993 Chevron reached a settlement with the Internal Revenue Service regarding these issues, which included a payment to the Chevron Retirement Plan and a payment of excise taxes. Subsequently, Chevron's appeal was dismissed by the court, although the underlying judgement was not vacated. C. Clean Water Act Violations. On September 23, 1993, the Environmental Protection Agency (EPA) instituted an administrative proceeding seeking civil penalties in excess of $100,000 from the company for its self-reported violations of the Clean Water Act since July 1986 at production facilities located on the Outer Continental Shelf of the Gulf of Mexico. The company has agreed with the EPA to settle this matter for $121,000. D. Premanufacture Notifications for Detergent Additives. On September 30, 1993, the EPA instituted an administrative proceeding seeking civil penalties of about $17 million from the company for alleged violations of the Toxic Substances Control Act (TSCA). The EPA contends that the company was required to file Premanufacture Notifications (PMNs) with regard to six chemical substances manufactured or imported since 1990. The company believes that no PMNs were required because the chemicals were within the scope of existing TSCA inventory listings. Nevertheless, the company reported the situation to the EPA when it was advised by a third party that the EPA may, without public notice, have revised its interpretation of TSCA regulations to require PMNs to be filed in such circumstances. Thereafter, under protest, the company suspended the production and importation of the - 26 - chemicals and filed PMNs for them, continuing the suspension for the 90-day period contemplated by TSCA. The detergents in question are very similar to common detergents and intermediates used in their production, and the EPA does not appear to claim that failure to file a PMN resulted in any health or safety risk. The EPA permitted the company to dispose of its current stocks of the chemicals during the period that the company suspended their production and importation. E. El Segundo Refinery Reformulated Gasoline Project. On September 22, 1993, the EPA instituted an administrative proceeding contending that the company had not received a permit required under the Clean Air Act Amendments of 1990 (CAAA) for field activities at the El Segundo refinery relating to the production of reformulated gasolines, which will be federally mandated by 1995 under other provisions of the CAAA. All company activities had been conducted in accordance with authorization by the South Coast Air Quality Management District (SCAQMD), the primary enforcing agency of the rule that the EPA contends the company violated. EPA efforts to cause the company to cease all construction activities were stayed by the Ninth Circuit Court of Appeals, and SCAQMD has since issued the company a formal permit to construct. However, the EPA may continue to seek civil penalties from the company for activities conducted prior to the issuance of the permit. Other previously reported legal proceedings have been settled or the issues resolved so as not to merit further reporting. - 27 - ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matter was submitted during the fourth quarter of 1993 to a vote of security holders through the solicitation of proxies or otherwise. EXECUTIVE OFFICERS OF THE REGISTRANT AT MARCH 1, 1994 MAJOR AREA OF NAME AND AGE EXECUTIVE OFFICE HELD RESPONSIBILITY - ------------------- -------------------------------- ---------------------- K.T. Derr 57 Chairman of the Board since 1989 Chief Executive Director since 1981 Officer Executive Committee Member since 1986 J.D. Bonney 63 Vice-Chairman of the Board Worldwide Exploration since 1987 and Production Director and Executive Activities, Pipe- Committee Member since 1986 lines, Coal and Other Minerals, Administrative Services, Aircraft Services J.N. Sullivan 56 Vice-Chairman of the Board Worldwide Refining, since 1989 Marketing and Trans- Director since 1988 portation Activities, Executive Committee Member Chemicals, since 1986 Real Estate, Environmental, Human Resources, Research W.E. Crain 64 Vice-President since 1986 Worldwide Exploration Director and Executive and Production Committee Member since 1988 R.E. Galvin 62 Vice-President since 1988 U.S. Exploration President of Chevron U.S.A. and Production Production Company since 1992 Executive Committee Member since 1993 D.R. Hoyer 62 Vice-President since 1987 U.S. Refining, President of Chevron U.S.A. Marketing and Products Company since 1992 Supply Executive Committee Member since 1993 M.R. Klitten 49 Vice-President since 1989 Finance Executive Committee Member since 1989 R.H. Matzke 57 Vice-President since 1990 Overseas Exploration President of Chevron Overseas and Production Petroleum Inc. since 1989 Executive Committee Member since 1993 J.E. Peppercorn 56 Vice-President since 1990 Chemicals President of Chevron Chemical Company since 1989 Executive Committee Member since 1993 H.D. Hinman 53 Vice-President and General Law Counsel since 1993 Executive Committee Member since 1993 - 28 - The Executive Officers of the Corporation consist of the Chairman of the Board, the Vice-Chairmen of the Board, and such other officers of the Corporation who are either Directors or members of the Executive Committee, or are chief executive officers of principal business units. Except as noted below, all of the Corporation's Executive Officers have held one or more of such positions for more than five years. Messrs. Galvin, Hoyer, Matzke and Peppercorn are rotating members of the Executive Committee, with two serving at any one time. R.E. Galvin - Regional Vice-President, Exploration, Land and Production, Chevron U.S.A. Inc. - 1985 - Vice-President, Chevron Corporation and Senior Vice-President, Exploration, Land and Production, Chevron U.S.A. Inc. - 1988 - President, Chevron U.S.A. Production Company (a Division of Chevron U.S.A. Inc.) - 1992 H.D. Hinman - Partner, Law Firm of Pillsbury Madison & Sutro - 1973 - Vice-President and General Counsel, Chevron Corporation - 1993 M.R. Klitten - Comptroller, Chevron U.S.A. Inc. - 1985 - President, Chevron Information Technology Company - 1987 - Vice-President for Finance, Chevron Corporation - 1989 R.H. Matzke - President, Chevron Canada Resources Limited - 1986 - President, Chevron Overseas Petroleum Inc. - 1989 - Vice-President, Chevron Corporation and President, Chevron Overseas Petroleum Inc. - 1990 J.E. Peppercorn - Senior Vice-President, Chevron Chemical Company - 1986 - President, Chevron Chemical Company - 1989 - Vice-President, Chevron Corporation and President, Chevron Chemical Company - 1990 - 29 - PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The information on Chevron's common stock market prices, dividends, principal exchanges on which the stock is traded and number of stockholders of record is contained in the Quarterly Results and Stock Market Data tabulations, on page FS-12 of this Annual Report on Form 10-K. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The selected financial data for years 1989 through 1993 are presented on page FS-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 Indexes to Financial Statements, Supplementary Data and Management's Discussion and Analysis of Financial Condition and Results of Operations are presented on page 41 of this Annual Report on Form 10-K. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Indexes to Financial Statements, Supplementary Data and Management's Discussion and Analysis of Financial Condition and Results of Operations are presented on page 41 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 The information on Directors on page 4 through 6 of the Notice of Annual Meeting of Stockholders and Proxy Statement dated March 25, 1994, is incorporated herein by reference in this Annual Report on Form 10-K. See Executive Officers of the Registrant on pages 28 and 29 of this Annual Report on Form 10-K for information about executive officers of the company. There was no late filing or failure by an insider to file a report required by section 16 of the Exchange Act. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The information on pages 15 through 17 of the Notice of Annual Meeting of Stockholders and Proxy Statement dated March 25, 1994, is incorporated herein by reference in this Annual Report on Form 10-K. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information on pages 2 and 3 of the Notice of Annual Meeting of Stockholders and Proxy Statement dated March 25, 1994, is incorporated herein by reference in this Annual Report on Form 10-K. ITEM 13. ITEM 13.CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS There were no relationships or related transactions requiring disclosure under Item 404 of Regulation S-K. - 30 - 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 (S) -------- Report of Independent Accountants FS-13 Consolidated Statement of Income for the three years ended December 31, 1993 FS-14 Consolidated Balance Sheet at December 31, 1993 and 1992 FS-15 Consolidated Statement of Cash Flows for the three years ended December 31, 1993 FS-16 Consolidated Statement of Stockholders' Equity for the three years ended December 31, 1993 FS-17 Notes to Consolidated Financial Statements FS-18 to FS-29 (2) FINANCIAL STATEMENT SCHEDULES: Report of Independent Accountants on Financial Statement Schedules 35 Schedule V - Property, Plant and Equipment 36 Schedule VI - Accumulated Depreciation, 37 Depletion and Amortization of Property, Plant and Equipment Caltex Group of Companies Combined Financial Statements and Schedules C-1 to C-21 The Combined Financial Statements and Schedules of the Caltex Group of Companies are filed as part of this report and follow the Five-Year Financial Summary (page FS-36). 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: The Exhibit Index on pages 33 and 34 of this Annual Report on Form 10-K lists the exhibits that are filed as part of this report. (b) REPORTS ON FORM 8-K: The company filed no reports on Form 8-K during the fourth quarter of 1993 and through March 30, 1994. - 31 - 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 30th day of March 1994. Chevron Corporation By KENNETH T. DERR* ------------------------------------ Kenneth T. Derr, 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 the 30th day of March 1994. PRINCIPAL EXECUTIVE OFFICERS DIRECTORS (AND DIRECTORS) KENNETH T. DERR* SAMUEL H. ARMACOST* - ------------------------------------- -------------------------------------- Kenneth T. Derr, Samuel H. Armacost Chairman of the Board J. DENNIS BONNEY* WILLIAM E. CRAIN* - ------------------------------------- -------------------------------------- J. Dennis Bonney, William E. Crain Vice-Chairman of the Board JAMES N. SULLIVAN* SAM GINN* - ------------------------------------- -------------------------------------- James N. Sullivan, Sam Ginn Vice-Chairman of the Board CONDOLEEZZA RICE* -------------------------------------- PRINCIPAL FINANCIAL OFFICER Condoleezza Rice MARTIN R. KLITTEN* S. BRUCE SMART, JR.* - ------------------------------------- -------------------------------------- Martin R. Klitten, S. Bruce Smart, Jr. Vice-President, Finance JOHN A. YOUNG* -------------------------------------- John A. Young PRINCIPAL ACCOUNTING OFFICER DONALD G. HENDERSON* GEORGE H. WEYERHAEUSER* - ------------------------------------- -------------------------------------- Donald G. Henderson, George H. Weyerhaeuser Vice-President and Comptroller *By: MALCOLM J. McAULEY -------------------------------- Malcolm J. McAuley, Attorney-in-Fact - 32 - EXHIBIT INDEX EXHIBIT NO. DESCRIPTION - ------- -------------------------------------------------------------------- 3.1 Restated Certificate of Incorporation of Chevron Corporation, dated November 23, 1988, filed as Exhibit 3.1 to Chevron Corporation's Annual Report on Form 10-K for 1989, and incorporated herein by reference. 3.2 By-Laws of Chevron Corporation, as amended December 7, 1989, including provisions giving attorneys-in-fact authority to sign on behalf of officers of the corporation, filed as Exhibit 3.2 to Chevron Corporation's Annual Report on Form 10-K for 1989, and incorporated herein by reference. 4.1 Rights Agreement dated as of November 22, 1988 between Chevron Corporation and Manufacturers Hanover Trust Company of California, as Rights Agent, filed as Exhibit 4.0 to Chevron Corporation's Current Report on Form 8-K dated November 22, 1988, and incorporated herein by reference. 4.2 Amendment No. 1 dated as of December 7, 1989 to Rights Agreement dated as of November 22, 1988 between Chevron Corporation and Manufacturers Hanover Trust Company of California, as Rights Agent, filed as Exhibit 4.0 to Chevron Corporation's Current Report on Form 8-K dated December 7, 1989, and incorporated herein by reference. Pursuant to the Instructions to Exhibits, certain instruments defining the rights of holders of long-term debt securities of the corporation and its consolidated subsidiaries are not filed because the total amount of securities authorized under any such instrument does not exceed 10 percent of the total assets of the corporation and its subsidiaries on a consolidated basis. A copy of such instrument will be furnished to the Commission upon request. 10.1 Management Incentive Plan of Chevron Corporation, as amended and restated effective January 1, 1990, filed as Exhibit 10.1 to Chevron Corporation's Annual Report on Form 10-K for 1990, and incorporated herein by reference. 10.2 Management Contingent Incentive Plan of Chevron Corporation, as amended May 2, 1989, filed as Exhibit 10.2 to Chevron Corporation's Annual Report on Form 10-K for 1989, and incorporated herein by reference. 10.3 Chevron Corporation Excess Benefit Plan, amended and restated as of July 1, 1990, filed as Exhibit 10.3 to Chevron Corporation's Annual Report on Form 10-K for 1990, and incorporated herein by reference. 10.4 Supplemental Pension Plan of Gulf Oil Corporation, amended as of June 30, 1986, filed as Exhibit 10.4 to Chevron Corporation's Annual Report on Form 10-K for 1986 and incorporated herein by reference. 10.5 Chevron Restricted Stock Plan for Non-Employee Directors, as amended and restated effective January 29, 1992, filed as Appendix A to Chevron Corporation's Notice of Annual Meeting of Stockholders and Proxy Statement dated March 16, 1992, and incorporated herein by reference. 10.6 Chevron Corporation Long-Term Incentive Plan, filed as Appendix A to Chevron Corporation's Notice of Annual Meeting of Stockholders and Proxy Statement dated March 19, 1990, and incorporated herein by reference. 12.1 Definitions of Selected Financial Terms (page 38). 12.2 Computation of Ratio of Earnings to Fixed Charges (page 39). 22.1 Subsidiaries of Chevron Corporation (page 40). 24.1 Consent of Price Waterhouse (page 35). 24.2 Consent of KPMG Peat Marwick (page C-5 of financial statements for the Caltex Group of Companies). - 33 - EXHIBIT INDEX (continued) EXHIBIT NO. DESCRIPTION - ------- -------------------------------------------------------------------- 25.1 Powers of Attorney for directors and certain officers of Chevron Corporation, authorizing, among other things, the signing of reports on their behalf, filed as Exhibit 25.1 to Chevron Corporation's Annual Report on Form 10-K for 1988 and incorporated herein by reference. 25.2 Power of Attorney for a certain director of Chevron Corporation, authorizing, among other things, the signing of reports on his behalf, filed as Exhibit 25 to Chevron Corporation's Quarterly Report on Form 10-Q for the quarter ended June 30, 1989, and incorporated herein by reference. 25.3 Power of Attorney for a certain officer of Chevron Corporation, authorizing, among other things, the signing of reports on his behalf, filed as Exhibit 25.3 to Chevron Corporation's Annual Report on Form 10-K for 1989 and incorporated herein by reference. 25.4 Power of Attorney for a certain director of Chevron Corporation, authorizing, among other things, the signing of reports on her behalf, filed as Exhibit 25 to Chevron Corporation's Quarterly Report on Form 10-Q for the quarter ended June 30, 1991, and incorporated herein by reference. 25.5 Power of Attorney for a certain director of Chevron Corporation, authorizing, among other things, the signing of reports on her behalf, filed as Exhibit 25 to Chevron Corporation's Quarterly Report on Form 10-Q for the quarter ended March 31, 1993, and incorporated herein by reference. Copies of above exhibits not contained herein are available, at a fee of $2 per document, to any security holder upon written request to the Secretary's Department, Chevron Corporation, 225 Bush Street, San Francisco, California 94104. - 34 - REPORT OF INDEPENDENT ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULES To the Board of Directors of Chevron Corporation Our audits of the consolidated financial statements referred to in our report dated February 25, 1994 appearing on page FS-13 of 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. PRICE WATERHOUSE San Francisco, California February 25, 1994 CONSENT OF INDEPENDENT ACCOUNTANTS We hereby consent to the incorporation by reference in the Prospectuses constituting part of the Registration Statements on Form S-3 (No. 2-98466) and Form S-8 (Nos. 33-3899, 33-34039 and 33-35283) of Chevron Corporation, and to the incorporation by reference in the Prospectus constituting part of the Registration Statement on Form S-3 (No. 33-14307) of Chevron Capital U.S.A. Inc. and Chevron Corporation, and to the incorporation by reference in the Registration Statement on Form S-3 (No. 33-58838) of Chevron Canada Finance Limited and Chevron Corporation, and to the incorporation by reference in the Prospectus constituting part of the Registration Statement on Form S-8 (No. 2-90907) of Caltex Petroleum Corporation of our report dated February 25, 1994 appearing on page FS-13 of 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. PRICE WATERHOUSE San Francisco, California March 30, 1994 - 35 - SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT (INCLUDING CAPITAL LEASES) (Millions of Dollars) - 36 - SCHEDULE VI - ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT (INCLUDING CAPITAL LEASES) (1) (Millions of Dollars) - 37 - EXHIBIT 12.1 DEFINITIONS OF SELECTED FINANCIAL TERMS RETURN ON AVERAGE STOCKHOLDERS' EQUITY Net income divided by average stockholders' equity. Average stockholders' equity is computed by averaging the sum of the beginning of year and end of year balances. RETURN ON AVERAGE CAPITAL EMPLOYED Net income plus after-tax interest expense divided by average capital employed. Capital employed is stockholders' equity plus short-term debt plus long-term debt plus capital lease obligations plus minority interests. Average capital employed is computed by averaging the sum of capital employed at the beginning of the year and at the end of the year. TOTAL DEBT-TO-TOTAL DEBT PLUS EQUITY RATIO Total debt, including capital lease obligations, divided by total debt plus stockholders' equity. CURRENT RATIO Current assets divided by current liabilities. INTEREST COVERAGE RATIO Income before income tax expense and cumulative effect of change in accounting principle, plus interest and debt expense and amortization of capitalized interest, divided by before-tax interest costs. - 38 - EXHIBIT 12.2 CHEVRON CORPORATION - TOTAL ENTERPRISE BASIS COMPUTATION OF RATIO OF EARNINGS TO FIXED CHARGES (Dollars in Millions) Year Ended December 31, ------------------------------------------ 1993 1992(1) 1991 1990 1989 ------ ------ ------ ------ ------ Net Income before Cumulative Effect of Changes in Accounting Principles $1,265 $2,210 $1,293 $2,157 $ 251 Income Tax Expense 1,389 1,508 1,302 2,387 1,322 Distributions Greater Than (Less Than) Equity in Earnings of Less Than 50% Owned Affiliates 6 (9) (20) (6) (9) Minority Interest (2) 2 2 6 3 Previously Capitalized Interest Charged to Earnings During Period 20 18 17 15 15 Interest and Debt Expense 390 490 585 707 718 Interest Portion of Rentals (2) 169 152 153 163 118 ------ ------ ------ ------ ------ EARNINGS BEFORE PROVISION FOR TAXES AND FIXED CHARGES $3,237 $4,371 $3,332 $5,429 $2,418 ====== ====== ====== ====== ====== Interest and Debt Expense $ 390 $ 490 $ 585 $ 707 $ 718 Interest Portion of Rentals (2) 169 152 153 163 118 Capitalized Interest 60 46 30 24 42 ------ ------ ------ ------ ------ TOTAL FIXED CHARGES $ 619 $ 688 $ 768 $ 894 $ 878 ====== ====== ====== ====== ====== - ---------------------------------------------------------------------------- RATIO OF EARNINGS TO FIXED CHARGES 5.23 6.35 4.34 6.07 2.75 - ---------------------------------------------------------------------------- (1) The information for 1992 reflects the company's adoption of the Financial Accounting Standards Board Statements No. 106, "Employers' Accounting for Postretirement Benefits Other than pensions" and No. 109, "Accounting for Income Taxes," effective January 1, 1992. (2) Calculated as one-third of rentals. - 39 - EXHIBIT 22.1 SUBSIDIARIES OF CHEVRON CORPORATION* Name of Subsidiary State or Country (Reported by Principal Area of Operation) in Which Organized - ----------------------------------------- ------------------ UNITED STATES Chevron U.S.A. Inc. Pennsylvania Principal Divisions: Chevron U.S.A. Production Company Chevron U.S.A. Products Company Warren Petroleum Company Chevron Capital U.S.A. Inc. Delaware Chevron Chemical Company Delaware Chevron Investment Management Company Delaware Chevron Land and Development Company Delaware Chevron Oil Finance Company Delaware Chevron Pipe Line Company Delaware Huntington Beach Company California The Pittsburg & Midway Coal Mining Co. Missouri INTERNATIONAL Bermaco Insurance Company Limited Bermuda Cabinda Gulf Oil Company Limited Bermuda Chevron Asiatic Limited Delaware Chevron Canada Limited Canada Chevron Canada Enterprises Limited Canada Chevron Canada Resources Canada Chevron International Limited Liberia Chevron International Oil Company, Inc. Delaware Chevron Niugini Pty. Limited Papua New Guinea Chevron Overseas Petroleum Inc. Delaware Chevron Standard Limited Delaware Chevron U.K. Limited United Kingdom Chevron Transport Corporation Liberia Chevron Nigeria Limited Nigeria Gulf Oil (Great Britain) Limited United Kingdom Insco Limited Bermuda Transocean Chevron Company Delaware *All of the subsidiaries in the above list are wholly owned, either directly or indirectly, by Chevron Corporation. Certain subsidiaries are not listed since, considered in the aggregate as a single subsidiary, they would not constitute a significant subsidiary at December 31, 1993. - 40 - INDEX TO MANAGEMENT'S DISCUSSION AND ANALYSIS, CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA PAGE(S) -------------- Management's Discussion and Analysis . . . . . . . . . . . . . FS-1 to FS-12 Quarterly Results and Stock Market Data . . . . . . . . . . . FS-12 Report of Management . . . . . . . . . . . . . . . . . . . . . FS-13 Report of Independent Accountants . . . . . . . . . . . . . . FS-13 Consolidated Statement of Income . . . . . . . . . . . . . . . FS-14 Consolidated Balance Sheet . . . . . . . . . . . . . . . . . . FS-15 Consolidated Statement of Cash Flows . . . . . . . . . . . . . FS-16 Consolidated Statement of Stockholder's Equity . . . . . . . . FS-17 Notes to Consolidated Financial Statements . . . . . . . . . . FS-18 to FS-29 Supplemental Information on Oil and Gas Producing Activities . FS-30 to FS-35 Five-Year Financial Summary . . . . . . . . . . . . . . . . . FS-36 - 41 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS KEY FINANCIAL RESULTS Millions of dollars, except per-share amounts 1993 1992 1991 - ----------------------------------------------------------------------------- Sales and Other Operating Revenues $36,191 $38,212 $38,118 Income Before Cumulative Effect of Changes in Accounting Principles $ 1,265 $ 2,210 $ 1,293 Cumulative Effect of Changes in Accounting Principles - $ (641) - Net Income $ 1,265 $ 1,569 $ 1,293 Special (Charges) Credits Included in Income* $ (883) $ 651 $ (66) Per Share: Income Before Cumulative Effect of Changes in Accounting Principles $ 3.89 $ 6.52 $ 3.69 Net Income $ 3.89 $ 4.63 $ 3.69 Dividends $ 3.50 $ 3.30 $ 3.25 ============================================================================= *Before cumulative effect of changes in accounting principles Chevron's worldwide net income for 1993 was $1.265 billion, down 19 and 2 percent from 1992 and 1991, respectively. However, special items in all years and the cumulative effect of adopting two new accounting standards in 1992 affected the comparability of the company's reported results. Special items, after related tax effects, decreased 1993 earnings $883 million, increased 1992 earnings $651 million and decreased 1991 earnings $66 million. Also, the cumulative effect of adopting the two new accounting standards reduced 1992 earnings $641 million. Excluding the effects of special items and the accounting changes, 1993 earnings of $2.148 billion were up 38 percent from $1.559 billion in 1992 and increased 58 percent from $1.359 billion in 1991. OPERATING ENVIRONMENT AND OUTLOOK. Crude oil prices began trending downward at midyear. The decline accelerated during the last two months of 1993, with prices reaching their lowest level in over five years by year-end. During the year, Chevron's posted price for West Texas Intermediate (WTI), a benchmark crude, declined $5.50 per barrel to $13.25 at year-end 1993. Worldwide demand for crude oil has been dampened by the weak global economy; production in the non-OPEC countries has increased, particularly in the North Sea; and the OPEC producers have not adjusted their production levels accordingly. On the other hand, natural gas prices in the United States remained strong in 1993, with the company's average realization of $1.99 per thousand cubic feet nearly 30 cents higher than in 1992. For most of 1993, refined product prices did not decline as quickly as crude oil prices, resulting in strong worldwide sales margins. However, late in the year, the decline accelerated in the United States and product prices have remained at lower levels into early 1994. Economic indicators show evidence that the U.S. economy is improving; however, recessionary conditions continue in other major countries. Bitter cold weather in the U.S. Midwest and East strengthened crude oil prices somewhat in early 1994 but by February 25 Chevron's posted price for WTI had fallen back to the year-end 1993 level. Natural gas prices remained firm, with average U.S. natural gas realizations in January 1994 of $2.03 per thousand cubic feet. If both crude oil and refined product prices continue at their low levels, the company's earnings from ongoing operations may be negatively affected. Widely fluctuating prices have become characteristic of the petroleum industry for the past several years. The company has made significant progress in streamlining its businesses and reducing costs in recent years and believes it has improved its ability to operate more competitively and profitably. YEAR-END 1993 MARKED THE END OF A FIVE-YEAR PERIOD, FOR WHICH AGGRESSIVE MANAGEMENT PERFORMANCE OBJECTIVES HAD BEEN SET IN EARLY 1989. The company declared its mission was to provide superior financial results for the company's stockholders. The objective was set to have a higher total stockholder return - stock appreciation plus reinvested dividends - than five other major U.S. oil companies against which the company measures its performance. To achieve this, the company embarked upon an aggressive program to restructure its businesses, improve management decision making and accountability, shed marginal and non-core assets, reduce operating costs, improve work processes, and through selective investments, position the company for long-term growth. Over the 1989-1993 period, Chevron's total annual stockholder return averaged 18.9 percent, the best among its peer group. The company disposed of marginal and non-core assets, generating almost $4 billion in cash proceeds during this period, and reduced its annual cost structure by about $1 billion in 1993 from FS-1 1991 levels. Using the company's method of measuring cost performance, costs were reduced from $7.45 per barrel in 1991 to $6.51 in 1993, a reduction of $.94 per barrel, or nearly 13 percent. IN EARLY 1994, THE COMPANY ANNOUNCED A NEW FIVE-YEAR GOAL OF MAINTAINING ITS POSITION AS THE NO. 1 MAJOR U.S. OIL COMPANY IN TOTAL STOCKHOLDER RETURN. Key elements include targeting a further $.25 per barrel reduction in operating and administrative costs by the end of 1994; attaining a 12 percent return on capital employed, after adjusting for special items; and pursuing growth opportunities - particularly in international exploration and production and, through its Caltex affiliate, in refining and marketing activities in the fast growing Asia-Pacific region. UNITED STATES REFINING AND MARKETING DEVELOPMENTS. The company announced a major restructuring of its U.S. refining and marketing business in May 1993. The company's refineries at Port Arthur, Texas, and Philadelphia, Pennsylvania, will be sold and investments in retail marketing activities in the East will be concentrated in the Gulf Coast states. As a result, the company's U.S. refining capacity will decrease about 350,000 barrels per day, or 25 percent, and U.S. refined product sales volumes may decline about 250,000 barrels per day, or about 17 percent from 1993 volumes. However, the new refining organization, while smaller, is expected to be more efficient, with improved cash flow and return on capital employed. It will also eliminate the large capital investments that would have been required for these facilities under the Clean Air Act and other environmental regulations. A provision of $543 million was recorded for the financial effects of the restructuring. In late February 1994, the company signed a letter of intent to sell the Philadelphia refinery to Sun Company, Inc. While negotiations for the refinery sales are ongoing, it is expected that the reserve will be sufficient to complete the restructuring. UNITED STATES EXPLORATION AND PRODUCTION DEVELOPMENTS. The interim tankering permit issued by the California Coastal Commission required the Point Arguello partners to have signed an agreement by February 1, 1994 that would allow a pipeline developer to secure financing for construction of a pipeline to the Los Angeles area. Because of ongoing negotiations, the deadline was not met and tankering was suspended. With tankering, the project had been producing over 80,000 barrels per day. The partners have thus far maintained production volumes by routing the oil to alternate markets, pending resolution of the negotiations and resumption of tankering. Chevron is operator and owns approximately 25 percent of the project. INTERNATIONAL EXPLORATION AND PRODUCTION DEVELOPMENTS. Tengizchevroil (TCO), the company's joint venture with the Republic of Kazakhstan to develop the Tengiz and Korolev oil fields on the northeastern coast of the Caspian Sea, began operations in April 1993. The oil is being exported into world markets under a transportation/exchange agreement with Russia, whereby TCO receives and exports crude oil from Russia in exchange for providing Russia with comparable amounts of Tengiz crude. Natural gas, natural gas liquids and sulfur are being sold into local markets. Upon formation of the joint venture, Chevron's net proved reserves of crude oil and natural gas liquids increased 1.1 billion barrels and net proved reserves of natural gas increased 1.5 trillion cubic feet, representing the company's share of TCO's current net proved reserves. Crude oil production capacity is 65,000 barrels per day; however, because of pipeline transportation constraints, production has averaged approximately 30,000 barrels per day since April. At year-end 1993, the company's cash investment in TCO was about $220 million. In addition, the company has accrued future field development obligations and amounts payable after completion and demonstrated operability of an export pipeline system. Over the next three to five years, plans call for TCO to spend about $1.5 billion to reach a production capacity of 260,000 barrels per day by the late 1990s. Current capacity is expected to double to 130,000 barrels per day by 1995. The pace of field development from 130,000 to 260,000 barrels per day is dependent on the ability to export the full production capacity. This will ultimately require the construction of an export pipeline system, which is separate from the TCO joint venture's Tengiz development project. Negotiations to agree on terms for a pipeline project have proved to be very difficult, and it is currently impossible to predict the eventual outcome or its impact on the joint venture. In January 1994, production began from the Alba oil field in the United Kingdom North Sea. Chevron is operator and owns one-third of this project. Production should peak at about 70,000 barrels per day later in 1994. FS-2 Chevron has significant oil and gas exploration and production operations in Nigeria and in the Angolan exclave of Cabinda, where its share of net production is about 100,000 barrels of crude oil per day from each of these countries. Angola has experienced civil unrest following its 1992 elections; separately, elements seeking independence of Cabinda from Angola have periodically created civil unrest in the area of the company's operations. Also, the nullification of the Nigerian elections in 1993 has been followed by a period of political uncertainty. To date, none of these events has had a significant impact on the company's operations, but the company is closely monitoring developments. ENVIRONMENTAL MATTERS. Virtually all aspects of the businesses in which the company engages are subject to various federal, state and local environmental, health and safety laws and regulations. These regulatory requirements continue to increase in both number and complexity and govern not only the manner in which the company conducts its operations, but also the products it sells. Most of the costs of complying with myriad laws and regulations pertaining to its operations and products are embedded in the normal costs of conducting its business. Using definitions and guidelines established by the American Petroleum Institute, Chevron estimates its worldwide environmental spending in 1993 was nearly $1.5 billion, of which $675 million were capital expenditures. These amounts do not include non-cash provisions recorded for environmental remediation programs, but include spending charged against such reserves. In addition to the various federal, state and local environmental laws and regulations governing its ongoing operations and products, the company (as well as other companies engaged in the petroleum or chemicals industries) is required to incur expenses for corrective actions at various facilities and waste disposal sites. An obligation to take remedial action may be incurred as a result of the enactment of laws, such as the federal Superfund law, or the issuance of new regulations or as the result of accidental leaks and spills in the ordinary course of business. In addition, an obligation may arise when a facility is closed or sold. Most of the expenditures to fulfill these obligations relate to facilities and sites where past operations followed practices and procedures that were considered acceptable under regulations existing at the time performed, but now will require investigatory and/or remedial work to ensure adequate protection to the environment. During 1993, the company recorded $215 million of before-tax provisions to provide for environmental remediation efforts, including Superfund sites. Actual expenditures charged against these provisions and other previously established reserves amounted to $183 million in 1993. At year-end 1993, the company's environmental remediation reserve was $746 million, including $56 million related to Superfund sites. Receivables of $18 million have been recorded for expected reimbursements of expenditures for environmental cleanup. Under provisions of the Superfund law, the Environmental Protection Agency (EPA), as well as certain state agencies, have designated Chevron a potentially responsible party (PRP) for remediation of a portion of 223 hazardous waste sites. At year-end 1993, the company's cumulative share of costs and settlements for approximately 145 of these sites, for which payments or provisions have been made in 1993 and prior years, was about $89 million, including a provision of $6 million during 1993. For the remaining sites, investigations are not yet at a stage where the company is able to quantify a probable liability or determine a range of possible exposure. The Superfund law provides for joint and several liability. Any future actions by the EPA and other regulatory agencies to require Chevron to assume other responsible parties' costs at designated hazardous waste sites are not expected to have a material effect on the company's consolidated financial position or liquidity. Provisions are recorded for work at identified sites where an assessment or remediation plan has been developed and for which costs can reasonably be estimated. It is likely the company will continue to incur additional charges for environmental programs relating to past operations. These future costs are indeterminable due to such factors as the unknown magnitude of possible contamination, the unknown timing and extent of the corrective actions that may be required, the determination of the company's liability in proportion to other responsible parties and the extent to which such costs are recoverable from insurance or other sources. While the amounts of future costs may be material to the company's results of operations in the period in which they are recognized, the company does not expect these costs to have a material effect on Chevron's consolidated financial position or liquidity. Also, the company does not believe its obligations to make such expenditures have had or will have any significant impact on the company's competitive position relative to other domestic or FS-3 international petroleum or chemicals concerns. Although environmental compliance costs are substantial, the company has no reason to believe they vary significantly from similar costs incurred by other companies engaged in similar businesses in similar areas. The company believes that such costs ultimately are reflected in the petroleum and chemicals industries' prices for products and services. The 1990 amendments to the Clean Air Act will require significant capital expenditures for the industry to meet clean-air regulations. The company's capital expenditures related to air quality were $434 million in 1993. Estimated 1994 total capital environmental expenditures are $686 million, of which $478 million will be spent to meet federal and state clean-air regulations for its products and facilities. This is in addition to the ongoing costs of complying with other environmental regulations. In addition to the reserves for environmental remediation discussed above, the company maintains reserves for dismantlement, abandonment and restoration of its worldwide oil, gas and mineral properties at the end of their productive lives. Most such costs are environmentally related. Provisions are recognized through depreciation expense as the properties are produced. The amount of these reserves at year-end 1993 was about $1.5 billion. For the company's other ongoing operating assets, such as refineries, no provisions are made for exit or cleanup costs that may be required when such assets reach the end of their useful lives. OTHER CONTINGENCIES. At year-end 1993 the company had $222 million of suspended exploratory wells included in properties, plant and equipment. The wells are suspended pending drilling of additional wells to determine if commercially producible quantities of oil or gas reserves are present. The ultimate disposition of these well costs is dependent on the results of this future activity. The company is the subject of various lawsuits and claims and other contingent liabilities. These are discussed in the notes to the accompanying consolidated financial statements. The company believes that the resolution of these matters will not materially affect its financial position or liquidity. 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 established accounting standards for employers who provide benefits to former or inactive employees after termination but before retirement. In May 1993, the FASB issued SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities." The company's current accounting practices are substantially in compliance with the new standards. Accordingly, the adoption of these two standards in the first quarter of 1994 will not have a material effect on the company's consolidated financial statements and will not affect its liquidity. SPECIAL ITEMS. Net income is affected by transactions that are unrelated to, or are not representative of, the company's ongoing operations for the periods presented. These transactions, defined by management and designated "special items," can obscure the underlying results of operations for a year as well as affect comparability between years. The adjacent table summarizes the (losses) gains, on an after-tax basis, from special items included in the company's reported net income. Millions of dollars 1993 1992 1991 - ----------------------------------------------------------------------------- Asset Dispositions $ 122 $757 $149 Restructurings and Reorganizations (554) (40) (185) Prior-Year Tax Adjustments (130) 72 173 Environmental Remediation Provisions (90) (44) (160) Asset Write-Offs and Revaluations (71) (133) (24) LIFO Inventory (Losses) Gains (46) (26) 16 Other (114) 65 (35) - ----------------------------------------------------------------------------- Total Special Items $(883) $651 $(66) ============================================================================= ASSET DISPOSITIONS in 1993 resulted from the company's continuing program to dispose of marginal and non-strategic assets. The Ortho lawn and garden products business was the major asset sold in 1993, generating a $130 million gain. In addition, oil and gas properties in the United States and Indonesia, undeveloped coal properties in the United States and marketing assets in Central America were sold during the year resulting in a net loss of $8 million. In 1992, assets sold included oil and gas properties in the United States, United Kingdom, Canada and Sudan; a U.S. fertilizer business; and a copper interest in Chile. In addition, the stock of a U.S. oil and gas subsidiary was exchanged with Pennzoil Company for 15,750,000 shares of Chevron stock, a transaction valued at $1.1 billion. The FS-4 combination of these and other smaller sales resulted in after-tax gains of $757 million. In 1991, sales of producing properties in the United States, Oman and Spain; non-producing properties in the United Kingdom; certain U.S. geothermal properties; an agricultural chemicals interest, together with the company's share of the gain on an asset sale by its Caltex affiliate, resulted in net gains of $149 million. RESTRUCTURINGS AND REORGANIZATIONS charges in 1993 amounted to $554 million, primarily the second quarter provision to restructure Chevron's U.S. refining and marketing business. This charge, totaling $543 million, was composed primarily of a write-down of the refineries' facilities and related inventories to their estimated realizable values. Also included in the charges were provisions for environmental site assessments and employee severance. The company has taken into account probable environmental cleanup obligations in estimating the realizable value of the refineries. Responsibility for these obligations will be negotiated with potential buyers. In 1992, Chevron recorded a net charge of $40 million associated with restructuring and work-force reductions - provisions of $105 million for work-force reductions were offset by $65 million of pension settlement gains in connection with the company's enhanced early retirement program. During 1991, charges of $185 million were recorded for the reconfiguration of the Port Arthur refinery and companywide work-force reductions. PRIOR-YEAR TAX ADJUSTMENTS are generally the result of issues in open tax years being settled with taxing authorities or being re-evaluated by the company as a result of new developments. Also, adjustments are required for the effect on deferred income taxes of changes in statutory tax rates. ENVIRONMENTAL REMEDIATION PROVISIONS pertain to estimated future costs for environmental remediation programs at certain of the company's U.S. service stations, marketing terminals, refineries, chemical plants and other locations; divested operations in which Chevron has liability for future remediation costs; and sites, commonly referred to as Superfund sites, for which the company is a PRP. In addition to an amount included in the 1993 restructuring charge discussed above, such provisions amounted to $90 million in 1993, $44 million in 1992 and $160 million in 1991. ASSET WRITE-OFFS AND REVALUATIONS in 1993 comprised certain U.S. refinery assets, U.S. and Canadian production assets, and miscellaneous corporate assets. Asset write-offs in 1992 consisted of a $110 million write-down of the company's Canadian Beaufort Sea properties and a net $23 million charge related to certain U.S. refining, marketing and chemical fertilizer assets. Certain U.S. refinery assets of $24 million were written off in 1991. LIFO INVENTORY GAINS AND LOSSES result from the reduction of inventories in certain inventory pools valued under the Last-In, First-Out (LIFO) accounting method. LIFO losses decreased 1993 net income $46 million and 1992 net income $26 million. However, drawdowns of LIFO-valued inventories increased net income in 1991 by $16 million as low-cost inventories, relative to then-current costs, were liquidated. These amounts include the company's equity share of Caltex LIFO inventory effects. Chevron's consolidated petroleum inventories were 99 million barrels at year-end 1993, 105 million barrels at year-end 1992 and 121 million barrels at year-end 1991. OTHER SPECIAL ITEMS in 1993 included net additions of $70 million to reserves for various litigation and regulatory issues and a one-time cash bonus award to employees totaling $60 million, offset by a favorable inventory adjustment of $16 million. In 1992, insurance recoveries and chemical products licensing agreements of $76 million were partially offset by $11 million of net additions to reserves for various litigation and regulatory issues. In 1991, additions of $35 million were made to litigation and regulatory reserves. RESULTS OF OPERATIONS. Strong worldwide refined product sales margins and higher U.S. natural gas prices mitigated the effects of lower crude oil prices in 1993, but the most important contributor to the company's improved operating performance was the large reduction in its operating and administrative costs. Also, lower interest and exploration expenses helped earnings. Chemicals operations continued at depressed levels. Similar to 1993, the increase in 1992 operating earnings from 1991 levels reflected reduced operating and administrative costs, higher U.S. natural gas prices and improved U.S. refined product sales margins. These benefits were partly offset by lower earnings in international refining and marketing and worldwide chemicals operations as weak global economic conditions held down product prices, shrinking sales margins. FS-5 SALES AND OTHER OPERATING REVENUES were $36.2 billion, down from $38.2 billion in 1992 and $38.1 billion in 1991. Revenues declined from 1992 and 1991 levels primarily due to lower crude oil and refined products prices partly offset by higher natural gas prices. The $.6 billion decline in OTHER INCOME in 1993 was due to lower asset sales gains. OPERATING EXPENSES, adjusted for special items, declined significantly as a result of the company's extensive cost-reduction programs initiated in early 1992. Operating expenses and administrative costs in 1993, adjusted for special items, declined $358 million from 1992. Coupled with the $512 million reduction in 1992 from 1991 levels, the two-year reduction in costs totaled $870 million, an 11 percent decrease from 1991. The company believes it has achieved a significant reduction in its cost structure and that most of the cost savings will be sustainable. Millions of dollars 1993 1992 1991 - ----------------------------------------------------------------------------- Reported Operating Expenses* $6,267 $6,145 $6,933 Reported Selling, General and Administrative Expenses 1,530 1,761 1,704 - ----------------------------------------------------------------------------- Total Operational Costs 7,797 7,906 8,637 Eliminate Special Charges Before Tax (531) (282) (501) - ----------------------------------------------------------------------------- Adjusted Ongoing Operational Costs $7,266 $7,624 $8,136 ============================================================================= *Operations are charged at market rates for consumption of the company's own fuel. These "costs" are eliminated in the consolidated financial statements. For cost performance measurement, such costs are included and amounted to $1,017, $1,251 and $1,272 in 1993, 1992 and 1991, respectively. TAXES on income were $1.2 billion in 1993, $1.3 billion in 1992 and $959 million in 1991, equating to effective income tax rates of 47.9 percent, 36.2 percent and 42.6 percent for each of the three years, respectively. The increase in the 1993 tax rate is due primarily to unfavorable prior-year tax adjustments, including an increase in deferred income taxes resulting from the 1 percent increase in the U.S. corporate income tax rate. The lower effective tax rate for 1992 is primarily attributable to a low overall tax cost on property dispositions, primarily the tax-free exchange with Pennzoil. Partially offsetting these effects were lower favorable prior-year tax adjustments in 1992 and proportionately lower equity affiliate income that is recorded on an after-tax basis. The 1991 effective tax rate benefited from favorable prior-year tax adjustments. CURRENCY TRANSACTIONS increased net income $46 million in 1993 and $90 million in 1992 compared with a decrease of $4 million in 1991. These amounts include the company's share of affiliates' currency transactions. The gain on currency transactions in 1993 resulted primarily from fluctuations in the value of Nigerian currency relative to the U.S. dollar. In 1992, gains resulted from fluctuations in currencies in the United Kingdom, Canada, Australia and Nigeria. RESULTS BY MAJOR OPERATING AREAS Millions of dollars 1993 1992 1991 - ----------------------------------------------------------------------------- Exploration and Production United States $ 566 $1,043 $ 285 International 580 594 717 - ----------------------------------------------------------------------------- Total Exploration and Production 1,146 1,637 1,002 - ----------------------------------------------------------------------------- Refining, Marketing and Transportation United States (170) 297 (153) International 252 111 486 - ----------------------------------------------------------------------------- Total Refining, Marketing and Transportation 82 408 333 - ----------------------------------------------------------------------------- Total Petroleum 1,228 2,045 1,335 Chemicals 143 89 151 Coal and Other Minerals 44 198 7 Corporate and Other (150) (122) (200) - ----------------------------------------------------------------------------- Income Before Cumulative Effect of Changes in Accounting Principles $1,265 $2,210 $1,293 Cumulative Effect of Changes in Accounting Principles - (641) - - ----------------------------------------------------------------------------- Net Income $1,265 $1,569 $1,293 ============================================================================= FS-6 SPECIAL ITEMS BY MAJOR OPERATING AREAS Millions of dollars 1993 1992 1991 - ----------------------------------------------------------------------------- Exploration and Production United States $(136) $413 $(46) International (61) 14 138 - ----------------------------------------------------------------------------- Total Exploration and Production (197) 427 92 - ----------------------------------------------------------------------------- Refining, Marketing and Transportation United States (725) (53) (335) International 1 (3) 133 - ----------------------------------------------------------------------------- Total Refining, Marketing and Transportation (724) (56) (202) - ----------------------------------------------------------------------------- Total Petroleum (921) 371 (110) Chemicals 112 53 34 Coal and Other Minerals - 159 (4) Corporate and Other (74) 68 14 - ----------------------------------------------------------------------------- Total Special Items Included in Net Income $(883) $651 $(66) ============================================================================= U.S. EXPLORATION AND PRODUCTION earnings in 1993, excluding special items, improved 11 percent from 1992 levels and more than doubled from 1991 results. In 1993, the effects of lower average crude oil prices and lower crude oil and natural gas production volumes were more than offset by lower operating expenses and higher natural gas prices. Also, natural gas contract settlements contributed to the earnings improvement. While the company's average crude oil realization declined $1.92 per barrel to $14.58 in 1993, average natural gas prices increased to $1.99 per thousand cubic feet compared with $1.70 for 1992. Because of the company's extensive cost cutting efforts and disposition of higher-cost oil and gas properties, 1993 earnings per equivalent barrel, excluding special items, increased $.18 to $.95. Millions of dollars 1993 1992 1991 - ----------------------------------------------------------------------------- Earnings Excluding Special Items $702 $ 630 $331 - ----------------------------------------------------------------------------- Asset Dispositions (54) 419 (49) Prior-Year Tax Adjustments (40) 5 (50) Environmental Remediation Provisions (13) (2) (3) Asset Write-Offs and Revaluations (13) - - Restructurings and Reorganizations (2) (35) - LIFO Inventory Gains 1 5 1 Other (15) 21 55 - ----------------------------------------------------------------------------- Total Special Items (136) 413 (46) - ----------------------------------------------------------------------------- Reported Earnings $566 $1,043 $285 ============================================================================= Cost cutting efforts and higher natural gas prices were also the major factors in 1992's earnings improvement over 1991, offsetting lower crude oil prices and lower production levels. Exploration expense declined over the three-year period, and depreciation expense dropped in line with lower production volumes. Net liquids production for 1993 averaged 394,000 barrels per day, down from 432,000 in 1992 and 454,000 in 1991. Net natural gas production for 1993 was about 2.1 billion cubic feet per day, down from approximately 2.3 billion cubic feet per day in 1992 and 1991. The production declines in liquids and natural gas were due primarily to the disposition of producing properties in late 1992. INTERNATIONAL EXPLORATION AND PRODUCTION earnings, excluding special items, improved 11 percent over the levels of 1992 and 1991 when crude oil prices were much higher. Because of the terms of the operating agreements in some of the countries in which the company produces, fluctuations in crude oil prices have less impact on earnings than in the United States. Contributing factors to the higher 1993 earnings included lower operating expenses, lower exploration expenses and higher production volumes. Millions of dollars 1993 1992 1991 - ----------------------------------------------------------------------------- Earnings Excluding Special Items $641 $580 $579 - ----------------------------------------------------------------------------- Prior-Year Tax Adjustments (63) (27) 45 Asset Dispositions 29 166 93 Asset Write-Offs and Revaluations (19) (110) - Restructurings and Reorganizations (2) (9) - LIFO Inventory Losses (1) (1) - Other (5) (5) - - ----------------------------------------------------------------------------- Total Special Items (61) 14 138 - ----------------------------------------------------------------------------- Reported Earnings $580 $594 $717 ============================================================================= FS-7 Both net liquids and natural gas production have increased steadily over the three-year period. Ongoing development projects in Indonesia and West Africa, the mid-1992 start up of production in Papua New Guinea and the second quarter 1993 start up of the Tengiz joint venture all contributed to the increase in net liquids production. Increases in net natural gas production have occurred primarily in Australia's North West Shelf Project and in Canada. Net liquids production in 1993 was 10 percent higher than in 1991, and net natural gas production increased 5 percent over this same three-year period. Foreign currency transaction gains were $57 million in 1993, compared with $80 million in 1992 and $19 million in 1991. SELECTED OPERATING DATA 1993 1992 1991 - ----------------------------------------------------------------------------- U.S. EXPLORATION AND PRODUCTION Net Crude Oil and Natural Gas Liquids Production (MBPD) 394 432 454 Net Natural Gas Production (MMCFPD) 2,056 2,313 2,359 Natural Gas Liquids Sales (MBPD) 211 194 175 Revenues from Net Production Crude Oil ($/bbl.) $14.58 $16.50 $17.10 Natural Gas ($/MCF) $ 1.99 $ 1.70 $ 1.53 INTERNATIONAL EXPLORATION AND PRODUCTION (1) Net Crude Oil and Natural Gas Liquids Production (MBPD) 556 512 504 Net Natural Gas Production (MMCFPD) 469 463 447 Natural Gas Liquids Sales (MBPD) 37 33 29 Revenues from Liftings Liquids ($/bbl.) $16.09 $17.93 $18.36 Natural Gas ($/MCF) $ 2.08 $ 2.07 $ 2.28 U.S. REFINING AND MARKETING Gasoline Sales (MBPD) 652 646 632 Other Refined Product Sales (MBPD) 771 824 812 Refinery Input (MBPD) 1,307 1,311 1,278 Average Refined Product Sales Price ($/bbl.) $25.35 $25.96 $26.40 INTERNATIONAL REFINING AND MARKETING (1) Refined Product Sales (MBPD) 923 859 823 Refinery Input (MBPD) 598 543 517 CHEMICALS SALES AND OTHER OPERATING REVENUES (2) United States $2,694 $2,929 $3,217 International 602 566 550 -------------------------------- Worldwide $3,296 $3,495 $3,767 ============================================================================= (1) Includes equity in affiliates for all years. Per unit revenues from net production for 1992 and 1991 have been restated to include equity affiliates. Refinery input in 1993 includes South Africa, where local government restrictions prohibited this disclosure in 1992 and prior years. (2) Millions of dollars. Includes sales to other Chevron companies. MBPD=thousands of barrels per day; MMCFPD=millions of cubic feet per day; bbl.=barrel; MCF=thousands of cubic feet U.S. REFINING AND MARKETING earnings, excluding special items, improved 59 percent from 1992 levels and more than tripled from 1991 results when weak demand and ample supplies depressed refined products margins. Although average product prices in 1993 declined from the prior year, lower crude oil prices, lower operating costs and stronger markets resulted in higher average sales margins compared with 1992. Late in 1993, margins declined somewhat as product prices fell faster than crude oil prices. Total product sales volumes declined 3 percent from 1992's level, although sales of higher-valued motor fuels increased about 1 percent. FS-8 Millions of dollars 1993 1992 1991 - ----------------------------------------------------------------------------- Earnings Excluding Special Items $ 555 $350 $ 182 - ----------------------------------------------------------------------------- Restructurings and Reorganizations (543) (1) (83) Environmental Remediation Provisions (77) (42) (157) LIFO Inventory (Losses) Gains (44) (22) 10 Prior-Year Tax Adjustments (38) 7 (33) Asset Write-Offs and Revaluations (25) (31) (24) Asset Dispositions (1) - - Other 3 36 (48) - ----------------------------------------------------------------------------- Total Special Items (725) (53) (335) - ----------------------------------------------------------------------------- Reported Earnings $(170) $297 $(153) ============================================================================= Industry conditions and operating problems that plagued the company's U.S. refining and marketing business in 1991 largely turned around in 1992. Cost-cutting programs, operating efficiencies generated by downsizing the Port Arthur refinery and improved operations at other refineries all contributed to the improved earnings in 1992. Sales of refined products increased 2 percent over 1991 levels. Refinery operating problems in 1991 reduced product yields while increasing maintenance costs and the requirement for outside product purchases. INTERNATIONAL REFINING AND MARKETING earnings include international marine results and equity earnings of the company's Caltex Petroleum Corporation affiliate. Excluding special items, 1993 earnings more than doubled from the weak level of 1992, but were still below 1991's strong results. Millions of dollars 1993 1992 1991 - ----------------------------------------------------------------------------- Earnings Excluding Special Items $251 $114 $353 - ----------------------------------------------------------------------------- Asset Dispositions 13 - 59 Prior-Year Tax Adjustments (4) 7 76 LIFO Inventory Losses (3) (9) (2) Asset Write-Offs and Revaluations (1) - - Restructurings and Reorganizations (1) (1) - Other (3) - - - ----------------------------------------------------------------------------- Total Special Items 1 (3) 133 - ----------------------------------------------------------------------------- Reported Earnings $252 $111 $486 - ----------------------------------------------------------------------------- International downstream operations improved significantly as product sales margins recovered from the prior year's weak levels in all the company's marketing areas - Canada, the United Kingdom and in the Caltex areas of operations, especially South Africa and Singapore. Lower crude oil and operating costs coupled with stronger markets boosted sales margins in 1993. Also, the company's international trading results improved significantly. Equity earnings of Caltex were $227 million, $180 million and $259 million for 1993, 1992, and 1991, respectively. In 1993, earnings were reduced $52 million for Chevron's share of Caltex ongoing adjustments to the carrying value of its petroleum inventories to reflect market values; earnings in 1991 included a special gain of $59 million from an asset sale. Total refined product sales volumes increased 7 percent from 1992 and 12 percent from 1991. Caltex volumes increased 6 percent in each year, continuing its average annual 6 percent growth of the past several years. Earnings in 1992 fell from 1991 levels as weak global economic conditions held down product prices, shrinking sales margins in all the company's areas of operations. In 1991, operating earnings benefited from strong sales margins, particularly in the first quarter of that year when product prices did not fall as quickly as crude oil prices in the aftermath of the Persian Gulf War. CHEMICALS earnings, excluding special items, fell 14 percent from 1992 levels and 74 percent from 1991 results. Millions of dollars 1993 1992 1991 - ----------------------------------------------------------------------------- Earnings Excluding Special Items $ 31 $36 $117 - ----------------------------------------------------------------------------- Asset Dispositions 130 13 27 Prior-Year Tax Adjustments (5) (2) - Restructurings and Reorganizations (5) (1) - LIFO Inventory Gains 1 1 7 Asset Write-Offs and Revaluations - 8 - Other (9) 34 - - ----------------------------------------------------------------------------- Total Special Items 112 53 34 - ----------------------------------------------------------------------------- Reported Earnings $143 $89 $151 - ----------------------------------------------------------------------------- Results in the company's chemicals business reflected the continued depressed state of the commodity chemicals industry. The industry has suffered several years of depressed prices and demand due to overcapacity coupled with weak worldwide economies. In early 1994, the company announced additional measures to improve profitability and competitiveness of its chemicals business, including work-force reductions, cost reductions and reorganizations. Provisions for the expected cost of these measures were recorded in 1993. FS-9 In 1992, in addition to industry conditions, plant shutdowns for maintenance and Hurricane Andrew also contributed to the earnings decline from 1991. Foreign currency transactions, mainly related to Brazil, resulted in losses of $10 million in 1993 and 1992 compared with losses of $6 million in 1991. COAL AND OTHER MINERALS earnings, excluding special items, improved 13 percent from 1992 levels and quadrupled from 1991 results. Operationally, a decline in coal earnings for 1993 was more than offset by lower non-coal exploration expenses, due to prior-year property dispositions. Annual coal sales in 1993 exceeded 20 million tons for the first time, but margins declined on lower prices. Millions of dollars 1993 1992 1991 - ----------------------------------------------------------------------------- Earnings Excluding Special Items $44 $ 39 $11 - ----------------------------------------------------------------------------- Asset Dispositions 5 159 19 Prior-Year Tax Adjustments (2) - (4) Other (3) - (19) - ----------------------------------------------------------------------------- Total Special Items - 159 (4) - ----------------------------------------------------------------------------- Reported Earnings $44 $198 $ 7 ============================================================================= Operating earnings in 1992 were up more than threefold from 1991 levels, primarily from higher coal production that increased 10 percent over the prior year. Additionally, expenses in non-coal minerals operations were lower as the company continued its withdrawal from those businesses. The pending sale of lead and zinc deposits in Ireland is expected to be completed in 1994. The sale will result in a gain. CORPORATE AND OTHER activities include interest expense, interest income on cash and marketable securities, real estate and insurance operations, and other activities of a corporate nature not allocated to the business segments. Excluding the effects of special items, the lower costs in 1993 and 1992 primarily reflected the continued decline in interest expense, due to lower average interest rates and, in 1993, lower average debt levels. Millions of dollars 1993 1992 1991 - ----------------------------------------------------------------------------- Results Excluding Special Items $ (76) $(190) $(214) - ----------------------------------------------------------------------------- Prior-Year Tax Adjustments 22 82 139 Asset Write-offs and Revaluations (13) - - Restructurings and Reorganizations (1) 7 (102) Other (82) (21) (23) - ----------------------------------------------------------------------------- Total Special Items (74) 68 14 - ----------------------------------------------------------------------------- Reported Earnings $(150) $(122) $(200) ============================================================================= Reported earnings in 1992 and 1991 included provisions of $41 million and $102 million for a companywide, voluntary enhanced early retirement program. In 1992, $65 million of pension settlement gains were recognized in connection with the program. These amounts were considered to be corporate items not properly allocable to the company's business segments. LIQUIDITY AND CAPITAL RESOURCES. Cash, cash equivalents and marketable securities increased $321 million to $2.0 billion at year-end 1993. Cash provided by operating activities increased $307 million in 1993 to $4.2 billion, compared with $3.9 billion in 1992 and $3.3 billion in 1991. The 1993 increase reflects higher operational earnings, adjusted for non-cash charges, and decreased working capital requirements. Cash from operations and proceeds from asset sales were used to fund the company's capital expenditures, dividend payments to stockholders and retirement of debt. AT YEAR-END 1993, THE COMPANY CLASSIFIED $1.9 BILLION OF SHORT-TERM OBLIGATIONS AS LONG-TERM DEBT. Settlement of these obligations, primarily commercial paper, is not expected to require the use of working capital in 1994 because the company has the intent and the ability to refinance them on a long-term basis. Commercial paper not reclassified to long-term debt also is intended to be reissued continuously or refinanced on a long-term basis. ON DECEMBER 31, 1993, CHEVRON HAD $3.6 BILLION IN COMMITTED CREDIT FACILITIES WITH VARIOUS MAJOR BANKS. These facilities support commercial paper borrowing and also can be used for general credit requirements. No borrowings were outstanding under these facilities during the year or at year-end 1993. FS-10 Chevron and one of its subsidiaries each have existing "shelf" registrations on file with the Securities and Exchange Commission that would permit registered offerings of up to approximately $1.05 billion of debt securities. DURING 1993, THE COMPANY PREPAID TWO FIXED-TERM U.S. PUBLIC DEBT ISSUES TOTALING $600 MILLION. In early 1994, an additional $200 million of fixed-term U.S. public debt was called for early repayment. The debt issues were refinanced with short-term commercial paper. The company has pursued an aggressive debt management strategy focused on short-term and variable-rate financing. This strategy, together with the general decline in interest rates, has reduced the company's annual average before-tax interest rate from 7.6 percent in 1991, to 5.7 percent in 1992 and to 4.6 percent in 1993. The variable-rate component of total debt was 68 percent at the end of 1993. Chevron's total debt was $7.538 billion at year-end 1993, down $303 million from $7.841 billion at year-end 1992. THE COMPANY'S FUTURE DEBT LEVEL IS PRIMARILY DEPENDENT ON ITS CAPITAL SPENDING PROGRAM AND ITS BUSINESS OUTLOOK. While the company does not currently expect its debt level to increase significantly during 1994, it believes it has substantial borrowing capacity to meet unanticipated cash requirements. In light of currently low crude oil prices, the company intends to monitor its capital spending and may make adjustments as the year progresses. FINANCIAL RATIOS 1993 1992 1991 - ----------------------------------------------------------------------------- Current Ratio 0.8 0.9 0.9 Interest Coverage Ratio 7.4 8.2 5.1 Total Debt/Total Debt Plus Equity 35.0% 36.4% 34.3% ============================================================================= The CURRENT RATIO is the ratio of current assets to current liabilities at year-end. Two items affect the current ratio negatively, which in the company's opinion do not affect its liquidity. Included in current assets in all years are inventories valued on a LIFO basis, which at year-end 1993 were lower than current costs by $671 million. Also at year-end 1993, $2.5 billion of commercial paper included in current liabilities is planned to be refinanced continuously. Chevron's INTEREST COVERAGE RATIO decreased in 1993 due to lower before-tax income. The interest coverage ratio is defined as income before income tax expense, plus interest and debt expense and amortization of capitalized interest, divided by before-tax interest costs. The company's DEBT RATIO (total debt to total debt plus equity) decreased to 35.0 percent, due primarily to a net reduction in debt of $303 million. The company's senior debt is rated AA by Standard & Poor's Corporation and Aa2 by Moody's Investors Service. Chevron's U.S. commercial paper is rated A-1+ by Standard & Poor's and Prime-1 by Moody's, and Chevron's Canadian commercial paper is rated R-1 (middle) by Dominion Bond Rating Service. All these ratings denote high-quality, investment-grade securities. IN JANUARY 1994, THE COMPANY INCREASED ITS QUARTERLY DIVIDEND 5 CENTS PER SHARE TO $.925, AN ANNUALIZED RATE OF $3.70 PER SHARE, AND PROPOSED A TWO-FOR-ONE SPLIT OF ITS ISSUED COMMON STOCK. Stockholders will be asked to approve an increase in the number of authorized shares of common stock from 500 million to 1 billion to accommodate the split and also to approve the stock split at the annual meeting on May 3, 1994. CAPITAL AND EXPLORATORY EXPENDITURES 1993 1992 1991 - ---------------------------------- -------------------- --------------------- Millions Interna- Interna- Interna- of dollars U.S. tional Total U.S. tional Total U.S. tional Total - ----------------------------------------------------------------------------- Exploration and Production $ 763 $1,599 $2,362 $ 792 $1,458 $2,250 $1,121 $1,408 $2,529 Refining, Marketing and Transportation 949 748 1,697 962 749 1,711 974 775 1,749 Chemicals 199 34 233 224 37 261 195 34 229 Coal and Other Minerals 47 10 57 65 20 85 99 14 113 All Other 91 - 91 116 - 116 166 1 167 - ----------------------------------------------------------------------------- Total $2,049 $2,391 $4,440 $2,159 $2,264 $4,423 $2,555 $2,232 $4,787 - ----------------------------------------------------------------------------- Total Excluding Equity in Affili- ates $2,029 $1,710 $3,739 $2,136 $1,666 $3,802 $2,540 $1,749 $4,289 ============================================================================= FS-11 WORLDWIDE CAPITAL AND EXPLORATORY EXPENDITURES FOR 1993, INCLUDING THE COMPANY'S EQUITY SHARE OF AFFILIATES' EXPENDITURES, TOTALED $4.4 BILLION. Expenditures for exploration and production accounted for 53 percent of total outlays in 1993, 51 percent in 1992 and 53 percent in 1991. U.S. exploration and production spending declined to 32 percent of worldwide exploration and production expenditures in 1993, down from 35 percent in 1992 and 44 percent in 1991, reflecting the company's increasing focus on international exploration and production activities. THE COMPANY PROJECTS 1994 CAPITAL AND EXPLORATORY EXPENDITURES AT APPROXIMATELY $4.9 BILLION, including Chevron's share of spending by affiliates. Excluding affiliates, spending will be essentially flat at $3.7 billion. The 1994 program provides $2.4 billion in exploration and production investments, of which about 75 percent is for international projects. The company is participating in several significant oil and gas development projects. These projects include the development of the Hibernia field off the coast of Newfoundland; the Tengiz project in Kazakhstan; steam and waterflood projects in Indonesia; expansion of the North West Shelf liquefied natural gas project in Australia; additional development in the North Sea, Nigeria and Angola; continuing enhanced oil recovery projects in California; and a natural gas development project in the Norphlet Trend in the Gulf of Mexico. Refining, marketing and transportation expenditures are estimated at about $2.1 billion, with $1 billion of that planned for the U.S., including upgrading U.S. refineries to produce reformulated gasolines needed to comply with the Clean Air Act. Most of the balance will be focused on high growth Asia Pacific Rim countries, where the company's Caltex affiliate has several major refinery projects under way to increase capacity and meet rising demand. QUARTERLY RESULTS AND STOCK MARKET DATA Unaudited FS-12 REPORT OF MANAGEMENT TO THE STOCKHOLDERS OF CHEVRON CORPORATION Management of Chevron is responsible for preparing the accompanying financial statements and for assuring their integrity and objectivity. The statements were prepared in accordance with generally accepted accounting principles and fairly represent the transactions and financial position of the company. The financial statements include amounts that are based on management's best estimates and judgments. The company's statements have been audited by Price Waterhouse, independent accountants, selected by the Audit Committee and approved by the stockholders. Management has made available to Price Waterhouse all the company's financial records and related data, as well as the minutes of stockholders' and directors' meetings. Management of the company has established and maintains a system of internal accounting controls that is designed to provide reasonable assurance that assets are safeguarded, transactions are properly recorded and executed in accordance with management's authorization, and the books and records accurately reflect the disposition of assets. The system of internal controls includes appropriate division of responsibility. The company maintains an internal audit department that conducts an extensive program of internal audits and independently assesses the effectiveness of the internal controls. The Audit Committee is composed of directors who are not officers or employees of the company. It meets regularly with members of management, the internal auditors and the independent accountants to discuss the adequacy of the company's internal controls, financial statements and the nature, extent and results of the audit effort. Both the internal auditors and the independent accountants have free and direct access to the Audit Committee without the presence of management. Kenneth T. Derr Martin R. Klitten Donald G. Henderson Chairman of the Board and Vice President, Finance Vice President and Chief Executive Officer Comptroller February 25, 1994 REPORT OF INDEPENDENT ACCOUNTANTS TO THE STOCKHOLDERS AND THE BOARD OF DIRECTORS OF CHEVRON CORPORATION In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of income, stockholders' equity and cash flows present fairly, in all material respects, the financial position of Chevron 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 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, 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, effective January 1, 1992, the company changed its methods of accounting for postretirement benefits other than pensions and for income taxes. Price Waterhouse San Francisco, California February 25, 1994 FS-13 CONSOLIDATED STATEMENT OF INCOME Year Ended December 31 Millions of dollars, ------------------------------------- except per-share amounts 1993 1992 (1) 1991 (1) - ----------------------------------------------------------------------------- REVENUES Sales and other operating revenues (2) $36,191 $38,212 $38,118 Equity in net income of affiliated companies 440 406 491 Other income 451 1,059 334 - ----------------------------------------------------------------------------- TOTAL REVENUES 37,082 39,677 38,943 - ----------------------------------------------------------------------------- COSTS AND OTHER DEDUCTIONS Purchased crude oil and products 18,007 19,872 19,693 Operating expenses 6,267 6,145 6,933 Provision for U.S. refining and marketing restructuring 837 - - Exploration expenses 360 507 629 Selling, general and administrative expenses 1,530 1,761 1,704 Depreciation, depletion and amortization 2,452 2,594 2,616 Taxes other than on income (2) 4,886 4,899 4,597 Interest and debt expense 317 436 519 - ----------------------------------------------------------------------------- TOTAL COSTS AND OTHER DEDUCTIONS 34,656 36,214 36,691 - ----------------------------------------------------------------------------- INCOME BEFORE INCOME TAX EXPENSE AND CUMULATIVE EFFECT OF CHANGES IN ACCOUNTING PRINCIPLES 2,426 3,463 2,252 INCOME TAX EXPENSE 1,161 1,253 959 ============================================================================= INCOME BEFORE CUMULATIVE EFFECT OF CHANGES IN ACCOUNTING PRINCIPLES $ 1,265 $ 2,210 $ 1,293 CUMULATIVE EFFECT OF CHANGES IN ACCOUNTING PRINCIPLES - (641) - ============================================================================= NET INCOME $1,265 $1,569 $1,293 ============================================================================= PER SHARE OF COMMON STOCK: INCOME BEFORE CUMULATIVE EFFECT OF CHANGES IN ACCOUNTING PRINCIPLES $3.89 $6.52 $3.69 CUMULATIVE EFFECT OF CHANGES IN ACCOUNTING PRINCIPLES - (1.89) - --------------------------------- NET INCOME PER SHARE OF COMMON STOCK $3.89 $4.63 $3.69 WEIGHTED AVERAGE NUMBER OF SHARES OUTSTANDING 325,478,876 338,977,414 350,174,450 ============================================================================= (1) Reclassified. See Note 1. (2) Includes consumer excise taxes. $4,068 $3,964 $3,659 See accompanying notes to consolidated financial statements. FS-14 CONSOLIDATED BALANCE SHEET At December 31 -------------------- Millions of dollars 1993 1992 - ----------------------------------------------------------------------------- ASSETS Cash and cash equivalents $ 1,644 $ 1,292 Marketable securities, at cost 372 403 Accounts and notes receivable (less allowance: 1993 - $66; 1992 - $66) 3,808 4,115 Inventories: Crude oil and petroleum products 1,108 1,276 Chemicals 423 497 Materials and supplies 252 292 Other merchandise 18 70 -------------------- 1,801 2,135 Prepaid expenses and other current assets 1,057 827 - ----------------------------------------------------------------------------- TOTAL CURRENT ASSETS 8,682 8,772 Long-term receivables 94 127 Investments and advances 3,623 2,451 Properties, plant and equipment, at cost 44,807 44,010 Less: accumulated depreciation, depletion and amortization 22,942 21,822 -------------------- 21,865 22,188 Deferred charges and other assets 472 432 - ----------------------------------------------------------------------------- TOTAL ASSETS $34,736 $33,970 ============================================================================= - ----------------------------------------------------------------------------- LIABILITIES AND STOCKHOLDERS' EQUITY Accounts payable $3,325 $3,469 Accrued liabilities 2,538 2,009 Short-term debt 3,456 2,888 Federal and other taxes on income 782 967 Other taxes payable 505 502 - ----------------------------------------------------------------------------- TOTAL CURRENT LIABILITIES 10,606 9,835 Long-term debt and capital lease obligations 4,082 4,953 Non-current deferred income taxes 2,916 2,894 Reserves for employee benefit plans 1,458 1,400 Deferred credits and other non-current obligations 1,677 1,160 - ----------------------------------------------------------------------------- TOTAL LIABILITIES 20,739 20,242 - ----------------------------------------------------------------------------- Preferred stock (authorized 100,000,000 shares, $1.00 par value, none issued) - - Common stock (authorized 500,000,000 shares, $3.00 par value, 356,243,534 shares issued) 1,069 1,069 Capital in excess of par value 1,855 1,840 Deferred compensation - Employee Stock Ownership Plan (ESOP) (920) (954) Currency translation adjustment and other 108 56 Retained earnings 13,955 13,814 Treasury stock, at cost (1993 - 30,504,429 shares; 1992 - 31,069,745 shares) (2,070) (2,097) - ----------------------------------------------------------------------------- TOTAL STOCKHOLDERS' EQUITY 13,997 13,728 - ----------------------------------------------------------------------------- TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $34,736 $33,970 ============================================================================= See accompanying notes to consolidated financial statements. FS-15 CONSOLIDATED STATEMENT OF CASH FLOWS Year Ended December 31 ---------------------------- Millions of dollars 1993 1992 1991 - ----------------------------------------------------------------------------- OPERATING ACTIVITIES Net income $1,265 $1,569 $1,293 Adjustments Depreciation, depletion and amortization 2,452 2,594 2,616 Dry hole expense related to prior years' expenditures 29 57 35 Distributions less than equity in affiliates' income (173) (144) (220) Net before-tax losses (gains) on asset retirements and sales 373 (568) 25 Net currency translation (gains) losses (27) (66) 4 Deferred income tax provision (160) (176) (183) Cumulative effect of changes in accounting principles - 641 - Net decrease (increase) in operating working capital (1) 463 82 (249) Other (1) (75) (43) - ----------------------------------------------------------------------------- NET CASH PROVIDED BY OPERATING ACTIVITIES (2) 4,221 3,914 3,278 - ----------------------------------------------------------------------------- INVESTING ACTIVITIES Capital expenditures (3,323) (3,352) (3,693) Proceeds from asset sales 908 1,043 768 Net sales of marketable securities (3) 30 45 18 - ----------------------------------------------------------------------------- NET CASH USED FOR INVESTING ACTIVITIES (2,385) (2,264) (2,907) - ----------------------------------------------------------------------------- FINANCING ACTIVITIES Net borrowings of short-term obligations 293 1,333 1,564 Proceeds from issuance of long-term debt 199 23 35 Repayments of long-term debt and other financing obligations (854) (1,260) (711) Cash dividends paid (1,139) (1,115) (1,139) Purchases of treasury shares (4) (382) (286) - ----------------------------------------------------------------------------- NET CASH USED FOR FINANCING ACTIVITIES (1,505) (1,401) (537) - ----------------------------------------------------------------------------- EFFECT OF EXCHANGE RATE CHANGES ON CASH AND CASH EQUIVALENTS 21 3 (20) - ----------------------------------------------------------------------------- NET CHANGE IN CASH AND CASH EQUIVALENTS 352 252 (186) CASH AND CASH EQUIVALENTS AT BEGINNING OF YEAR 1,292 1,040 1,226 - ----------------------------------------------------------------------------- CASH AND CASH EQUIVALENTS AT YEAR-END $1,644 $1,292 $1,040 ============================================================================= (1) The "Net decrease (increase) in operating working capital" is composed of the following: Decrease in accounts and notes receivable $ 187 $ 97 $ 692 Decrease in inventories 288 292 312 (Increase) decrease in prepaid expenses and other current assets (52) 85 (151) Increase (decrease) in accounts payable and accrued liabilities 214 (567) (880) (Decrease) increase in income and other taxes payable (174) 175 (222) - ----------------------------------------------------------------------------- Net decrease (increase) in operating working capital $ 463 $ 82 $ (249) ============================================================================= (2) "Net Cash Provided by Operating Activities" includes the following cash payments for interest and income taxes: Interest paid on debt (net of capitalized interest) $ 309 $ 392 $ 453 Income taxes paid $1,505 $1,236 $1,460 ============================================================================= (3) "Net sales of marketable securities" consists of the following gross amounts: Marketable securities purchased $(1,855) $(2,633) $(4,104) Marketable securities sold 1,885 2,678 4,122 - ----------------------------------------------------------------------------- Net sales of marketable securities $ 30 $ 45 $ 18 ============================================================================= See accompanying notes to consolidated financial statements. FS-16 CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY FS-17 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Millions of dollars NOTE 1: SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Chevron Corporation and its consolidated subsidiaries (the company) employ accounting policies that are in accordance with generally accepted accounting principles in the United States. SUBSIDIARY AND AFFILIATED COMPANIES. The consolidated financial statements include the accounts of subsidiary companies more than 50 percent owned. Investments in and advances to affiliates in which the company has a substantial ownership interest of approximately 20 to 50 percent, or for which the company participates in policy decisions, are accounted for by the equity method. Under this accounting, remaining unamortized cost is increased or decreased by the company's share of earnings or losses after dividends. OIL AND GAS ACCOUNTING. The successful efforts method of accounting is used for oil and gas exploration and production activities. SHORT-TERM INVESTMENTS. Short-term investments that are part of the company's cash management portfolio are classified as cash equivalents. These investments are highly liquid and generally have original maturities of three months or less. All other short-term investments are classified as marketable securities. INVENTORIES. Crude oil, petroleum products, chemicals and other merchandise are stated at cost, using a Last-In, First-Out (LIFO) method. In the aggregate, these costs are below market. Materials and supplies inventories generally are stated at average cost. PROPERTIES, PLANT AND EQUIPMENT. All costs for development wells, related plant and equipment (including carbon dioxide and certain other injected materials used in enhanced recovery projects), and mineral interests in oil and gas properties are capitalized. Costs of exploratory wells are capitalized pending determination of whether the wells found proved reserves. Costs of wells that are assigned proved reserves remain capitalized. All other exploratory wells and costs are expensed. Proved oil and gas properties are regularly assessed for possible impairment on an aggregate worldwide portfolio basis, applying the informal "ceiling test" of the Securities and Exchange Commission. Under this method, the possibility of an impairment may exist if the aggregate net book carrying value of these properties, net of applicable deferred income taxes, exceeds the aggregate undiscounted future cash flows, after tax, from the properties, as calculated in accordance with accounting rules for supplemental information on oil and gas producing activities. In addition, high-cost, long-lead-time oil and gas projects are individually assessed prior to production start-up by comparing the recorded investment in the project with its fair market or economic value, as appropriate. Economic values are generally based on management's expectations of discounted future after-tax cash flows from the project at the time of assessment. Depreciation and depletion (including provisions for future abandonment and restoration costs) of all capitalized costs of proved oil and gas producing properties, except mineral interests, are expensed using the unit-of-production method by individual fields as the proved developed reserves are produced. Depletion expenses for capitalized costs of proved mineral interests are determined using the unit-of-production method by individual fields as the related proved reserves are produced. Periodic valuation provisions for impairment of capitalized costs of unproved mineral interests are expensed. Depreciation and depletion expenses for coal and other mineral assets are determined using the unit-of-production method as the proved reserves are produced. The capitalized costs of all other plant and equipment are depreciated or amortized over estimated useful lives. In general, the declining-balance method is used to depreciate plant and equipment in the United States; the straight-line method generally is used to depreciate international plant and equipment and to amortize all capitalized leased assets. Gains or losses are not recognized for normal retirements of properties, plant and equipment subject to composite group amortization or depreciation. Gains or losses from abnormal retirements or sales are included in income. Expenditures for maintenance, repairs and minor renewals to maintain facilities in operating condition are expensed. Major replacements and renewals are capitalized. ENVIRONMENTAL EXPENDITURES. Environmental expenditures that relate to current ongoing operations or to an existing condition caused by past operations are expensed. Expenditures that create future benefits or contribute to future revenue generation are capitalized. Liabilities related to future remediation costs are recorded when environmental assessments and/or cleanups are probable, and the costs can be reasonably estimated. Other than for assessments, the timing of these accruals coincides with the company's commitment to a formal plan of action, such as an approved remediation plan or the sale or disposal of an asset. For oil and gas and coal producing properties, a provision is made through depreciation expense for anticipated abandonment and restoration costs at the end of the property's useful life. For Superfund sites, the company records a liability for its share of costs when it has been named as a Potentially Responsible Party (PRP) and when an assessment or cleanup plan has been developed. This liability includes the company's own portion of the costs and also the company's portion of amounts for other PRPs when it is probable that they will not be able to pay their share of the cleanup obligation. The company records the gross amount of its liability based on its best estimate of future costs in current dollars and using currently available technology and applying current regulations as well as the company's own internal environmental policies. Future amounts are not discounted. Probable recoveries or reimbursements are recorded as an asset. FS-18 NOTE 1: SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - Continued CURRENCY TRANSLATION. The U.S. dollar is the functional currency for the company's consolidated operations as well as for substantially all operations of its equity method companies. For those operations, all gains or losses from currency transactions are included in income currently. The cumulative translation effects for the few equity affiliates using functional currencies other than the U.S. dollar are included in the currency translation adjustment in stockholders' equity. TAXES. Effective 1992, the company accounts for income taxes in accordance with Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes." In 1991, the company accounted for income taxes in accordance with Statement No. 96, "Accounting for Income Taxes." Income taxes are accrued for retained earnings of international subsidiaries and corporate joint ventures intended to be remitted. Income taxes are not accrued for unremitted earnings of international operations that have been, or are intended to be, reinvested indefinitely. RECLASSIFICATION OF CERTAIN REVENUES AND PURCHASES. To conform to the presentation in 1993, the years 1992 and 1991 in the consolidated income statement were reclassified to net certain offsetting forward crude oil purchases and sales contracts. This reclassification had no effect on net income for any period. Sales and other operating revenues, and purchased crude oil and products, decreased $3,216 for 1992 and $2,002 for 1991, from the amounts previously reported. NOTE 2: ADOPTION OF STATEMENTS OF FINANCIAL ACCOUNTING STANDARDS NO. 106, "EMPLOYERS' ACCOUNTING FOR POSTRETIREMENT BENEFITS OTHER THAN PENSIONS" (SFAS 106) AND NO. 109, "ACCOUNTING FOR INCOME TAXES" (SFAS 109) Effective January 1, 1992, the company adopted SFAS 106 and SFAS 109, issued by the Financial Accounting Standards Board. The effects of these statements on 1992 net income included a charge of $641, or $1.89 per share, attributable to the cumulative effect of adoption, including the company's share of equity affiliates. This net charge was composed of $833, after related tax benefits of $423, for the recognition of liabilities for retiree benefits (primarily health and life insurance), partially offset by a credit of $192 for deferred income tax benefits and other changes stipulated by the new income tax accounting rules. Apart from the cumulative effect, adoption of the statements increased earnings for 1992 by $163 after tax, or $.48 per share. Under the new income tax accounting, benefits of $200 were recorded, largely due to the strengthening of the dollar in 1992, which resulted in lower foreign deferred tax liabilities. These benefits were partly offset by $37 of additional after-tax expense for retiree benefits, when compared to the previous practice of expensing these costs when paid. NOTE 3: SPECIAL ITEMS AND OTHER FINANCIAL INFORMATION Net income is affected by transactions that are unrelated to or are not representative of the company's ongoing operations for the periods presented. These transactions, defined by management and designated "special items," can obscure the underlying results of operations for a year as well as affect comparability of results between years. Listed below are categories of special items and their net increase (decrease) to net income, after related tax effects: Year Ended December 31 ----------------------------- 1993 1992 1991 - ----------------------------------------------------------------------------- Asset dispositions, net Ortho lawn and garden products $ 130 $ - $ - Oil and gas properties (25) 209 44 Stock exchange with Pennzoil Company - 376 - Copper interest in Chile - 159 - Other 17 13 105 ----------------------------- 122 757 149 - ----------------------------------------------------------------------------- Asset write-offs and revaluations Oil and gas properties (31) (110) - Refining and marketing assets (24) (31) (24) Other (16) 8 - ----------------------------- (71) (133) (24) - ----------------------------------------------------------------------------- Prior-year tax adjustments (130) 72 173 - ----------------------------------------------------------------------------- Environmental remediation provisions (90) (44) (160) - ----------------------------------------------------------------------------- Restructurings and reorganizations Work-force reductions, net (11) (40) (102) U.S. Refining and marketing (543) - (83) ----------------------------- (554) (40) (185) - ----------------------------------------------------------------------------- LIFO inventory (losses) gains (46) (26) 16 - ----------------------------------------------------------------------------- Other, net Litigation and regulatory issues (70) (11) (35) One-time employee bonus (60) - - Chemicals products license agreements - 32 - Other adjustments 16 44 - ----------------------------- (114) 65 (35) - ----------------------------------------------------------------------------- Total special items, after tax* $(883) $651 $(66) ============================================================================= *Amounts include the company's share of equity affiliates' transactions. The U.S. refining and marketing restructuring charge of $543 was primarily composed of a writedown of two refineries and their related inventories to estimated realizable values. Also included in the charge were provisions for environmental site assessments and employee severance. The estimated realizable value of the refineries took into account probable environmental cleanup obligations. Responsibility for these obligations will be negotiated with potential buyers. The refineries are located in Port Arthur, Texas, and Philadelphia, Pennsylvania, and have a combined refinery capacity of about 350,000 barrels per day. FS-19 NOTE 3: SPECIAL ITEMS AND OTHER FINANCIAL INFORMATION - Continued Other financial information is as follows: Year Ended December 31 ----------------------------- 1993 1992 1991 - ----------------------------------------------------------------------------- Total financing interest and debt costs $371 $478 $546 Less: capitalized interest 54 42 27 - ----------------------------------------------------------------------------- Interest and debt expense 317 436 519 Research and development expenses 206 229 250 Currency transaction gains (losses)* $ 46 $ 90 $ (4) ============================================================================= *Includes $18 and $24 in 1993 and 1992, respectively, for the company's share of affiliates' currency transaction effects; in 1991 the net effect was zero. The excess of current cost (based on average acquisition costs for the year) over the carrying value of inventories for which the LIFO method is used was $671 and $803 at December 31, 1993 and 1992, respectively. NOTE 4. INFORMATION RELATING TO THE CONSOLIDATED STATEMENT OF CASH FLOWS The Consolidated Statement of Cash Flows excludes the following non-cash transactions: In 1993, the company acquired a 50 percent interest in the Tengizchevroil joint venture (TCO) in the Republic of Kazakhstan through a series of cash and non-cash transactions. The company's interest in TCO is accounted for using the equity method of accounting and is recorded in "Investments and advances" in the consolidated balance sheet. The cash expended in connection with the formation of TCO and subsequent advances to TCO have been included in the consolidated statement of cash flows in "Capital expenditures." The deferred payment portion of the TCO investment totaled $709 at year-end 1993 and is recorded in "Accrued liabilities" and "Deferred credits and other non-current obligations" in the consolidated balance sheet. The timing of these payments is dependent on the occurrence of certain future events, including the pace of field development and the completion and successful operation of an export pipeline system. During 1993, payments related to the deferred portion of the TCO investment were classified as Repayments of long-term debt and other financing obligations" in the consolidated statement of cash flows. The company's Employee Stock Ownership Plan (ESOP) repaid $30 and $20 of matured debt guaranteed by Chevron Corporation in 1993 and 1991, respectively. The company reflected this payment as reductions in debt outstanding and in Deferred Compensation - ESOP. The company refinanced an aggregate amount of $334 and $57 in tax exempt long-term debt and capital lease obligations in 1993 and 1992, respectively. In 1991, the company refinanced $970 of long-term bank notes of the ESOP with the public issuance of SEC registered long-term notes of a like amount. These refinancings are not reflected in the consolidated statement of cash flows. In 1992, the company received 15,750,000 shares of its common stock held by a stockholder in exchange for the stock of a subsidiary owning certain U.S. oil and gas producing properties and related facilities, cash and other current assets and current liabilities. The value attributed to the treasury shares received was $1,100. The property exchanged consisted of properties, plant and equipment with a carrying value of $790 and, excluding cash, net current liabilities of $1. Cash of $57 was included as a reduction of proceeds from asset sales. In 1992, the company acquired an additional ownership interest in an affiliate, accounted for under the equity method, in a non-cash transaction. This increase in ownership required the consolidation of the affiliate into the company's financial statements. The principal result of this consolidation was to increase non-current assets and liabilities by approximately $64. There have been other non-cash transactions that have occurred during the years presented. These include the reissuance of treasury shares for management compensation plans, acquisitions of properties, plant and equipment through capital lease transactions, and changes in stockholders' equity, long-term debt and other liabilities resulting from the accounting for the company's ESOP. The amounts for these transactions have not been material in the aggregate in relation to the company's financial position. The major components of "Capital expenditures," and the reconciliation of this amount to the capital and exploratory expenditures, excluding equity in affiliates, presented in "Management's Discussion and Analysis of Financial Condition and Results of Operations," are presented below: Year Ended December 31 ----------------------------- 1993 1992 1991 - ----------------------------------------------------------------------------- Additions to properties, plant and equipment $3,214 $3,342 $3,698 Additions to investments 179 47 48 Payments for other (liabilities) and assets, net (70) (37) (53) - ----------------------------------------------------------------------------- Capital expenditures 3,323 3,352 3,693 Expensed exploration expenditures 330 450 594 Equipment acquired through a non-cash capital lease transaction - - 2 Repayments of long-term debt and other financing obligations 86 - - - ----------------------------------------------------------------------------- Capital and exploratory expenditures, excluding equity companies $3,739 $3,802 $4,289 ============================================================================= NOTE 5. STOCKHOLDERS' EQUITY Retained earnings at December 31, 1993, include $2,087 for the company's share of undistributed earnings of equity affiliates. In 1988, the company declared a dividend distribution of one Right for each outstanding share of common stock. The Rights will be exercisable, unless redeemed earlier by the company, if a person or group acquires, or obtains the right to acquire, 10 percent or more of the outstanding shares of common stock or commences a tender or exchange offer that would result in acquiring 10 percent or more of the outstanding shares of common stock, either event occurring without the prior consent of the company. Each Right entitles its holder to purchase stock having a value equal to two times the exercise price of the Right. The person or group who had acquired 10 percent FS-20 NOTE 5. STOCKHOLDERS' EQUITY - Continued or more of the outstanding shares of common stock without the prior consent of the company would not be entitled to this purchase opportunity. The Rights will expire in November 1998, or they may be redeemed by the company at 5 cents per share prior to that date. The Rights do not have voting or dividend rights and, until they become exercisable, have no dilutive effect on the earnings of the company. Five million shares of the company's preferred stock have been designated Series A participating preferred stock and reserved for issuance upon exercise of the Rights. No event during 1993 made the Rights exercisable. The Board of Directors has proposed a two-for-one split of the company's issued common stock. Stockholders have been asked to approve the split and an increase in authorized shares of common stock from 500 million to 1 billion to accommodate the split at the annual stockholders' meeting on May 3, 1994. If approved, the split will be effective May 11, 1994 for stockholders of record on that date. NOTE 6. FINANCIAL INSTRUMENTS OFF-BALANCE SHEET RISK. The company enters into forward exchange contracts, generally with terms of 90 days or less, as a hedge against some of its foreign currency exposures. Offsetting gains and losses on these contracts are recognized concurrently with the exchange gains and losses stemming from the associated commitments. At December 31, 1993 and 1992, the company had not recognized gains or losses on forward contracts with a carrying and approximate fair value of $114 and $119, respectively. CONCENTRATIONS OF CREDIT RISK. The company's financial instruments that are exposed to concentrations of credit risk consist primarily of its cash equivalents, marketable securities and trade receivables. The company's cash equivalents and marketable securities are in high-quality securities placed with a wide array of institutions with high credit ratings. This investment policy limits the company's exposure to concentrations of credit risk. The trade receivable balances, reflecting the company's diversified sources of revenue, are dispersed among the company's broad customer base worldwide. As a consequence, concentrations of credit risk are limited. The company routinely assesses the financial strength of its customers. Letters of credit are the principal security obtained to support lines of credit or negotiated contracts when the financial strength of a customer is not considered sufficient. FAIR VALUE. At December 31, 1993, the company's long-term debt of $2,057 had an estimated fair value of $2,238. The fair value is based on quoted market prices at December 31, 1993, or the present value of expected cash flows when a quoted market price was not available. The reported amounts of financial instruments such as Cash equivalents, Marketable securities and Short-term debt approximate fair value because of their short maturity. NOTE 7. SUMMARIZED FINANCIAL DATA - CHEVRON U.S.A. INC. At December 31, 1993, Chevron U.S.A. Inc. was Chevron Corporation's principal operating company, consisting primarily of the company's U.S. integrated petroleum operations (excluding most of the domestic pipeline operations). These operations are conducted by three divisions: Chevron U.S.A. Production Company, Chevron U.S.A. Products Company and Warren Petroleum Company. Summarized financial information for Chevron U.S.A. Inc. and its consolidated subsidiaries is presented below: Year Ended December 31 ----------------------------- 1993 1992* 1991* - ----------------------------------------------------------------------------- Sales and other operating revenues $28,092 $29,454 $29,073 Total costs and other deductions 27,588 28,410 28,861 Income before cumulative effect of changes in accounting principles 325 811 90 Cumulative effect of changes in accounting principles - (573) - Net income 325 238 90 ============================================================================= At December 31 ---------------- 1993 1992 - ----------------------------------------------------------------------------- Current assets $3,661 $4,200 Other assets 14,099 14,587 Current liabilities 5,936 5,528 Other liabilities 5,738 6,795 Net equity 6,086 6,464 ============================================================================= *To conform to the presentation adopted in 1993, the 1992 and 1991 periods have been reclassified to net certain offsetting crude oil purchases and sales contracts. The reclassification had no effect on net income. See Note 1. NOTE 8. LITIGATION The company is a defendant in numerous lawsuits, in addition to those mentioned in this note. Plaintiffs may seek to recover large and sometimes unspecified amounts, and some matters may remain unresolved for several years. In April 1991, a United States District Court in Texas ruled favorably on claims brought by former employees of Gulf and participants in the Gulf Pension Plan that a partial termination of the plan had occurred. However, the court denied plaintiffs' claims to a share of any surplus plan assets. In October 1991, the district court approved a partial settlement in which the parties agreed not to appeal the partial termination claims except as relevant to plaintiffs' claims for a share of surplus plan assets. These claims are now before the Fifth Circuit Court of Appeals. A second partial settlement was implemented in 1993, resulting in a charge to earnings of $48. A lawsuit brought against the company by OXY USA Inc., the successor in interest to Cities Service Company, remains pending in an Oklahoma state court. The suit involves claims for breach of contract and misrepresentation related to the termination of Gulf Oil Corporation's offer to purchase Cities' stock in 1982. (Gulf was acquired by Chevron in 1984.) FS-21 NOTE 8. LITIGATION - Continued Management is of the opinion that resolution of the lawsuits will not result in any significant liability to the company in relation to its consolidated financial position or liquidity. NOTE 9. GEOGRAPHIC AND SEGMENT DATA The geographic and segment distributions of the company's identifiable assets, operating income and sales and other operating revenues are summarized in the following tables. The company's primary business is its integrated petroleum operations. Secondary operations include chemicals and coal. The company's real estate and insurance operations and worldwide cash management and financing activities are in "Corporate and Other." At December 31 ----------------------------- 1993 1992 1991 - ----------------------------------------------------------------------------- IDENTIFIABLE ASSETS United States Petroleum $16,443 $18,508 $20,056 Chemicals 2,045 2,165 2,210 Coal and Other Minerals 744 762 767 ---------------------------- Total United States 19,232 21,435 23,033 ----------------------------- International Petroleum 12,202 9,671 9,018 Chemicals 412 390 402 Coal and Other Minerals 13 10 12 - ----------------------------------------------------------------------------- Total International 12,627 10,071 9,432 - ----------------------------------------------------------------------------- TOTAL IDENTIFIABLE ASSETS 31,859 31,506 32,465 Corporate and Other 2,877 2,464 2,171 - ----------------------------------------------------------------------------- TOTAL ASSETS $34,736 $33,970 $34,636 - ----------------------------------------------------------------------------- Year Ended December 31 ----------------------------- 1993 1992 1991 - ----------------------------------------------------------------------------- OPERATING INCOME United States Petroleum $ 692 $ 1,693 $ 289 Chemicals 162 46 149 Coal and Other Minerals 59 68 27 ----------------------------- Total United States 913 1,807 465 ----------------------------- International Petroleum 1,772 1,731 2,205 Chemicals 63 70 47 Coal and Other Minerals (3) 177 (26) ----------------------------- Total International 1,832 1,978 2,226 - ----------------------------------------------------------------------------- TOTAL OPERATING INCOME 2,745 3,785 2,691 Corporate and Other (319) (322) (439) Income Tax Expense (1,161) (1,253) (959) - ----------------------------------------------------------------------------- Income Before Cumulative Effect of Changes in Accounting Principles $ 1,265 $ 2,210 $ 1,293 Cumulative Effect of Changes in Accounting Principles - (641) - - ----------------------------------------------------------------------------- NET INCOME $ 1,265 $ 1,569 $ 1,293 ============================================================================= Year Ended December 31 ----------------------------- 1993 1992* 1991* ----------------------------- SALES AND OTHER OPERATING REVENUES United States Petroleum-Refined products $13,169 $13,964 $13,921 -Crude oil 4,086 5,138 6,649 -Natural gas 1,776 1,631 1,502 -Natural gas liquids 1,098 1,075 1,043 -Other petroleum revenues 682 700 611 -Excise taxes 2,554 2,458 2,267 -Intersegment 924 1,052 1,226 ----------------------------- Total Petroleum 24,289 26,018 27,219 ----------------------------- Chemicals-Products 2,211 2,409 2,652 -Intersegment 248 266 252 ----------------------------- Total Chemicals 2,459 2,675 2,904 ----------------------------- Coal and Other Minerals-Products 447 395 417 ----------------------------- Total United States 27,195 29,088 30,540 - ----------------------------------------------------------------------------- International Petroleum-Refined products 2,920 2,857 2,873 -Crude oil 4,415 4,893 3,627 -Natural gas 380 364 367 -Natural gas liquids 137 115 122 -Other petroleum revenues 285 227 201 -Excise taxes 1,499 1,490 1,374 -Intersegment 1 10 13 ----------------------------- Total Petroleum 9,637 9,956 8,577 ----------------------------- Chemicals-Products 497 463 446 -Excise taxes 15 16 18 -Intersegment 6 5 4 ----------------------------- Total Chemicals 518 484 468 ----------------------------- Coal and Other Minerals-Products - 2 10 ----------------------------- Total International 10,155 10,442 9,055 - ----------------------------------------------------------------------------- Intersegment sales elimination (1,179) (1,333) (1,495) - ----------------------------------------------------------------------------- Corporate and Other 20 15 18 - ----------------------------------------------------------------------------- TOTAL SALES AND OTHER OPERATING REVENUES $36,191 $38,212 $38,118 ============================================================================= Memo: Intergeographic Sales United States $ 266 $ 309 $ 361 International 4,418 3,823 3,497 - ----------------------------------------------------------------------------- *To conform to the presentation adopted in 1993, the 1992 and 1991 periods have been reclassified to net certain offsetting crude oil purchases and sales contracts. The reclassification had no effect on net income. See Note 1. Operating income for the geographic areas includes allocated corporate overhead. In 1992 and 1991, the operating income for the business segments excluded corporate charges of $63 and $154 for a companywide voluntary enhanced early retirement program. In 1992, $103 of pension settlement gains were recognized in connection with the program. These amounts are included in "Corporate and Other." Identifiable assets include all assets associated with operations in the indicated geographic areas, including investments in affiliates. Sales and other operating revenues for the petroleum segment are derived from the production and sale of crude oil, FS-22 NOTE 9. GEOGRAPHIC AND SEGMENT DATA - Continued natural gas and natural gas liquids, and from the refining and marketing of petroleum products. The company also obtains revenues from the transportation and trading of crude oil and refined products. Chemicals revenues result primarily from the sale of petrochemicals, plastic resins, and lube oil and fuel additives. Coal and other minerals revenues relate primarily to coal sales. Sales and other operating revenues in the above table include both sales to unaffiliated customers and sales from the transfer of products between segments. Sales from the transfer of products between segments and geographic areas are generally at estimated market prices. Transfers between geographic areas are presented as memo items below the table. Equity in earnings of affiliated companies has been associated with the segments in which the affiliates operate. Sales to the Caltex Group are included in the International petroleum segment. Information on these affiliates is presented in Note 11. Other affiliates are either not material or not vertically integrated with a segment's operations. NOTE 10. LEASE COMMITMENTS Certain non-cancelable leases are classified as capital leases, and the leased assets are included as part of properties, plant and equipment. Other leases are classified as operating leases and are not capitalized. Details of the capitalized leased assets are as follows: At December 31 ----------------- 1993 1992 - ----------------------------------------------------------------------------- Petroleum Exploration and Production $ 50 $ 50 Refining, Marketing and Transportation 554 553 - ----------------------------------------------------------------------------- 604 603 Less: accumulated amortization 409 381 - ----------------------------------------------------------------------------- Net capitalized leased assets $195 $222 ============================================================================= At December 31, 1993, the future minimum lease payments under operating and capital leases are as follows: At December 31 -------------------- Operating Capital Year Leases Leases - ----------------------------------------------------------------------------- 1994 $174 $ 41 1995 143 48 1996 128 43 1997 110 41 1998 100 42 Thereafter 220 500 - ----------------------------------------------------------------------------- Total $875 715 - ------------------------------------------------------------------ Less: amounts representing interest and executory costs (292) - ----------------------------------------------------------------------------- Net present value 423 Less: capital lease obligations included in short-term debt (278) - ----------------------------------------------------------------------------- Long-term capital lease obligations $145 ============================================================================= Future sublease rental income $ 46 $ - ============================================================================= Rental expenses incurred for operating leases during 1993, 1992 and 1991 were as follows: At December 31 ----------------------------- 1993 1992 1991 - ----------------------------------------------------------------------------- Minimum rentals $452 $408 $472 Contingent rentals 9 10 11 - ----------------------------------------------------------------------------- Total 461 418 483 Less: sublease rental income 15 14 49 - ----------------------------------------------------------------------------- Net rental expense $446 $404 $434 ============================================================================= Contingent rentals are based on factors other than the passage of time, principally sales volumes at leased service stations. Certain leases include escalation clauses for adjusting rentals to reflect changes in price indices, renewal options ranging from one to 25 years and/or options to purchase the leased property during or at the end of the initial lease period for the fair market value at that time. NOTE 11. INVESTMENTS AND ADVANCES Investments in and advances to companies accounted for using the equity method, and other investments accounted for at or below cost, are as follows: At December 31 ----------------- 1993 1992 - ----------------------------------------------------------------------------- Equity Method Affiliates Caltex Group $2,147 $1,905 Other affiliates 1,353 450 - ----------------------------------------------------------------------------- 3,500 2,355 Other, at or below cost 123 96 - ----------------------------------------------------------------------------- Total investments and advances $3,623 $2,451 ============================================================================= Chevron owns 50 percent each of P.T. Caltex Pacific Indonesia, an exploration and production company operating in Indonesia; Caltex Petroleum Corporation, which, through its subsidiaries and affiliates, conducts refining and marketing activities in Asia, Africa, Australia and New Zealand; and American Overseas Petroleum Limited, which, through its subsidiaries, manages certain of the company's exploration and production operations in Indonesia. These companies and their subsidiaries and affiliates are collectively called the Caltex Group. Other affiliates includes Tengizchevroil, a 50 percent owned joint venture formed in 1993 with the Republic of Kazakhstan, to develop the Tengiz oil field. Equity in earnings of companies accounted for by the equity method, together with dividends and similar distributions received from equity method companies for the years 1993, 1992 and 1991, are as follows: Year Ended December 31 - ---------------------------------------------------------------------------- Equity in Earnings Dividends ------------------------ ------------------------- 1993 1992 1991 1993 1992 1991 - ---------------------------------------------------------------------------- Caltex Group $361 $334* $422 $172 $183 $202 Other affiliates 79 72 69 95 79 68 - ---------------------------------------------------------------------------- Total $440 $406 $491 $267 $262 $270 ============================================================================ *Before cumulative effect of changes in accounting principles. FS-23 NOTE 11. INVESTMENTS AND ADVANCES - Continued The company's transactions with affiliated companies, primarily for the purchase of Indonesian crude oil from P.T. Caltex Pacific Indonesia and the sale of crude oil and products to Caltex Petroleum Corporation's refining and marketing companies, are summarized in the following table. Year Ended December 31 ---------------------------- 1993 1992 1991 - ----------------------------------------------------------------------------- Sales to Caltex Group $1,739 $1,784 $1,537 Sales to other affiliates 5 5 66 - ----------------------------------------------------------------------------- Total sales to affiliates $1,744 $1,789 $1,603 ============================================================================= Purchases from Caltex Group $ 842 $ 797 $ 821 Purchases from other affiliates 101 56 23 - ----------------------------------------------------------------------------- Total purchases from affiliates $943 $853 $844 - ----------------------------------------------------------------------------- Accounts and notes receivable in the consolidated balance sheet include $156 and $215 at December 31, 1993 and 1992, respectively, of amounts due from affiliated companies. Accounts payable include $35 and $33 at December 31, 1993 and 1992, respectively, of amounts due to affiliated companies. The following tables summarize the combined financial information for the Caltex Group and substantially all of the other equity method companies together with Chevron's share. Amounts shown for the affiliates are 100 percent. NOTE 12. PROPERTIES, PLANT AND EQUIPMENT Expenses for maintenance and repairs were $875, $1,045 and $1,229 in 1993, 1992 and 1991, respectively. FS-24 NOTE 13.TAXES Year Ended December 31 --------------------------- 1993 1992 1991 - ----------------------------------------------------------------------------- Taxes Other Than on Income United States Taxes on production $ 135 $ 140 $ 153 Import duties 21 18 17 Excise taxes on products and merchandise 2,554 2,458 2,267 Property and other miscellaneous taxes (excluding payroll taxes) 380 416 428 --------------------------- 3,090 3,032 2,865 Payroll taxes 122 141 145 - ----------------------------------------------------------------------------- Total United States 3,212 3,173 3,010 - ----------------------------------------------------------------------------- International Taxes on production 7 30 14 Import duties 22 55 50 Excise taxes on products and merchandise 1,514 1,506 1,392 Property and other miscellaneous taxes (excluding payroll taxes) 112 114 111 --------------------------- 1,655 1,705 1,567 Payroll taxes 19 21 20 - ----------------------------------------------------------------------------- Total international 1,674 1,726 1,587 - ----------------------------------------------------------------------------- Total taxes other than on income $4,886 $4,899 $4,597 ============================================================================= Year Ended December 31 --------------------------- 1993 1992 1991 - ----------------------------------------------------------------------------- Taxes on Income U.S. federal Current $ 394 $ 329 $ 163 Deferred (241) (129) (185) Deferred - Adjustment for enacted changes in tax laws/rates 54 - - State and local 63 54 16 - ----------------------------------------------------------------------------- Total United States 270 254 (6) - ----------------------------------------------------------------------------- International Current 864 1,046 963 Deferred 48 (47) 2 Deferred - Adjustment for enacted changes in tax laws/rates (21) - - - ----------------------------------------------------------------------------- Total international 891 999 965 - ----------------------------------------------------------------------------- Total taxes on income $1,161 $1,253 $ 959 ============================================================================= U.S. federal income tax expense was reduced by $57, $49 and $27 in 1993, 1992 and 1991, respectively, for low-income housing and other business tax credits. In 1993, before-tax income for U.S. operations was $687, compared with $1,592 in 1992 and $157 in 1991. Before-tax income for international operations was $1,739, $1,871 and $2,095 in 1993, 1992 and 1991, respectively. The deferred income tax provisions included benefits of $98, $163 and $67 related to properties, plant and equipment in 1993, 1992 and 1991, respectively. U.S. benefits were recorded in 1993 related to the U.S. refining and marketing restructuring provision. The 1991 U.S. deferred tax provision included benefits accrued from the reserves established for the Port Arthur reconfiguration and the corporate severance program. In 1992, the tax related to the cumulative effect of adopting SFAS 106 (Note 2) was $423, representing deferred income tax benefits approximating the statutory tax rate. The company's effective income tax rate varied from the U.S. statutory federal income tax rate because of the following: Year Ended December 31 --------------------------- 1993 1992 1991 - ----------------------------------------------------------------------------- Statutory U.S. federal income tax rate 35.0% 34.0% 34.0% Effects of income taxes on international operations in excess of taxes at the U.S. statutory rate 15.6 15.2 23.7 Effects of asset dispositions (0.6) (8.0) (2.0) State and local taxes on income, net of U.S. federal income tax benefit 2.2 1.1 0.6 Prior-year tax adjustments 3.0 (0.6) (4.2) Effects of enacted changes in tax laws/rates on deferred tax liabilities 1.3 - - Tax credits (2.4) (1.4) (1.2) All others (0.9) (0.9) (1.8) - ----------------------------------------------------------------------------- Consolidated companies 53.2 39.4 49.1 Effect of recording equity in income of certain affiliated companies on an after-tax basis (5.3) (3.2) (6.5) - ----------------------------------------------------------------------------- Effective tax rate 47.9% 36.2% 42.6% ============================================================================= The company records its deferred taxes on a tax jurisdiction basis and classifies those net amounts as current or noncurrent based on the balance sheet classification of the related assets or liabilities. At December 31, 1993 and 1992, deferred taxes were classified in the consolidated balance sheet, as follows: Year Ended December 31 ---------------------- 1993 1992 - ----------------------------------------------------------------------------- Prepaid expenses and other current assets $ (495) $ (313) Deferred charges and other assets (146) (132) Federal and other taxes on income 27 24 Non-current deferred income taxes 2,916 2,894 - ----------------------------------------------------------------------------- Total deferred taxes, net $2,302 $2,473 - ----------------------------------------------------------------------------- The reported deferred tax balances are composed of the following deferred tax liabilities (assets): Year Ended December 31 ---------------------- 1993 1992 - ----------------------------------------------------------------------------- Properties, plant and equipment $3,933 $3,869 Inventory 293 318 Miscellaneous 237 195 - ----------------------------------------------------------------------------- Deferred tax liabilities 4,463 4,382 - ----------------------------------------------------------------------------- Abandonment/environmental reserves (910) (792) Employee benefits (535) (492) AMT/other tax credits (486) (580) Other accrued liabilities (472) (338) Miscellaneous (255) (159) - ----------------------------------------------------------------------------- Deferred tax assets (2,658) (2,361) - ----------------------------------------------------------------------------- Deferred tax assets valuation allowance 497 452 - ----------------------------------------------------------------------------- Total deferred taxes, net $2,302 $2,473 ============================================================================= FS-25 NOTE 13. TAXES - Continued It is the company's policy for subsidiaries included in the U.S. consolidated tax return to record income tax expense as though they filed separately, with the parent recording the adjustment to income tax expense for the effects of consolidation. Undistributed earnings of international consolidated subsidiaries and affiliates for which no deferred income tax provision has been made for possible future remittances totaled approximately $3,300 at December 31, 1993. Substantially all of this amount represents earnings reinvested as part of the company's ongoing business. It is not practical to estimate the amount of taxes that might be payable on the eventual remittance of such earnings. On remittance, certain countries impose withholding taxes that, subject to certain limitations, are then available for use as tax credits against a U.S. tax liability, if any. The company estimates withholding taxes of approximately $247 would be payable upon remittance of these earnings. NOTE 14. SHORT-TERM DEBT At December 31 ----------------- 1993 1992 - ----------------------------------------------------------------------------- Commercial paper $4,391 $4,023 Current maturities of long-term debt 167 89 Current maturities of long-term capital leases 23 24 Redeemable long-term obligations Long-term debt 297 320 Capital leases 255 255 Notes payable 203 277 - ----------------------------------------------------------------------------- 5,336 4,988 Reclassified to long-term debt (1,880) (2,100) - ----------------------------------------------------------------------------- Total short-term debt $3,456 $2,888 ============================================================================= Redeemable long-term obligations consist primarily of tax-exempt variable-rate put bonds that are included as current liabilities because they become redeemable at the option of the bondholders during the year following the balance sheet date. Selected data on the company's commercial paper activities are shown below: Weighted Weighted Average Maximum Average Interest Outstanding Average Interest Balance at Rate at at Any Amount Rate for Year December 31 December 31 Month End Outstanding the Year - ----------------------------------------------------------------------------- 1993 $4,390 3.3% $4,891 $4,445 3.1% 1992 $4,023 3.5% $4,441 $3,958 3.6% 1991 $2,748 4.8% $2,748 $1,863 5.7% ============================================================================= The average amounts outstanding and weighted average interest rates during each year are based on average daily balances outstanding. Amounts used in the above computations include amounts that have been classified as long-term debt during 1993, 1992 and 1991. NOTE 15. LONG-TERM DEBT At December 31 ----------------- 1993 1992 - ----------------------------------------------------------------------------- 8.11% amortizing notes due 2004 (1) $ 750 $ 750 8.25% notes due 1996 (2) - 301 8.75% notes due 1996 (2) - 300 9.375% sinking-fund debentures due 2016 278 292 6.76% serial notes due 1994-1997 (1), (3) 190 220 7.875% notes due 1997 (4) 200 199 5.6% notes due 1998 190 - 9.75% sinking-fund debentures due 2017 179 190 4.625% 200 million Swiss franc issue due 1997 136 137 Other long-term obligations (6.88%) (3) (less than $50 individually) 223 318 Other foreign currency obligations (6.81%) (3) 78 66 - ----------------------------------------------------------------------------- Total including debt due within one year 2,224 2,773 Debt due within one year (167) (89) Reclassified from short-term debt (3.17%) (3) 1,880 2,100 - ----------------------------------------------------------------------------- Total long-term debt $3,937 $4,784 ============================================================================= (1) Guarantee of ESOP debt. (2) Debt retired before maturity date. (3) Weighted average interest rate at December 31, 1993. (4) Called in early 1994. Chevron and one of its wholly owned subsidiaries have "shelf" registrations on file with the Securities and Exchange Commission (SEC) that would permit the issuance of $1,050 of debt securities pursuant to Rule 415 of the Securities Act of 1933. At year-end 1993, the company had $3,595 of committed credit facilities with banks worldwide, $1,880 of which had termination dates beyond one year. These credit agreements provide commitments for term loans of up to $3,280 and revolving credit for short-term advances of up to $315. The facilities also support the company's commercial paper borrowings. Interest on any borrowings under the agreements is based on either the London Interbank Offered Rate or the Reserve Adjusted Domestic Certificate of Deposit Rate. No amounts were outstanding under these credit agreements during the year nor at year-end. At December 31, 1993 and 1992, the company classified $1,880 and $2,100, respectively, of short-term debt as long-term. Settlement of these obligations is not expected to require the use of working capital in 1994, as the company has both the intent and ability to refinance this debt on a long-term basis. Consolidated long-term debt maturing in each of the five years after December 31, 1993, is as follows: 1994-$167, 1995-$89, 1996-$93, 1997-$435 and 1998-$198. NOTE 16. EMPLOYEE BENEFIT PLANS PENSION PLANS. The company has defined benefit pension plans for most employees. The principal plans provide for automatic membership on a non-contributory basis. The retirement benefits provided by these plans are based primarily on years of service and on average career earnings or the highest consecutive three years' average earnings. The company's policy is to fund at least the minimum necessary to satisfy requirements of the Employee Retirement Income Security Act. FS-26 NOTE 16. EMPLOYEE BENEFIT PLANS - Continued The net pension expense (credit) for all of the company's pension plans for the years 1993, 1992 and 1991 consisted of: 1993 1992 1991 - ----------------------------------------------------------------------------- Cost of benefits earned during the year $103 $106 $100 Interest cost on projected benefit obligations 276 302 295 Actual return on plan assets (472) (309) (799) Net amortization and deferral 101 (134) 346 - ----------------------------------------------------------------------------- Net pension expense (credits) $ 8 $(35) $(58) ============================================================================= In addition to the net pension expense in 1993, the company recognized a net settlement loss of $63 and a curtailment loss of $4 reflecting the termination of a former Gulf pension plan and lump-sum payments from other company pension plans. In 1992, the company recorded charges of $65 and a curtailment loss of $7, offset by net lump-sum settlement gains of $101 related to an early retirement program offered to employees of its U.S. and certain Canadian subsidiaries. In 1991, charges of $154 related to the early retirement programs and lump sum settlement gains of $25 were recognized. At December 31, 1993 and 1992, the weighted average discount rates and long-term rates for compensation increases used for estimating the benefit obligations and the expected rates of return on plan assets were as follows: 1993 1992 - ----------------------------------------------------------------------------- Assumed discount rates 7.4% 8.1% Assumed rates for compensation increases 5.1% 5.5% Expected return on plan assets 9.1% 9.2% - ----------------------------------------------------------------------------- The pension plans' assets consist primarily of common stocks, bonds, cash equivalents and interests in real estate investment funds. The funded status for the company's combined plans at December 31, 1993 and 1992, was as follows: Plans with Plans with Assets Accumulated in Excess of Benefits Accumulated in Excess of Benefits Plan Assets ------------------- ----------------- At December 31 1993 1992 1993 1992 - ----------------------------------------------------------------------------- Actuarial present value of: Vested benefit obligations $(2,854) $(2,869) $(183) $(161) ============================================================================= Accumulated benefit obligations $(2,949) $(2,947) $(194) $(168) ============================================================================= Projected benefit obligations $(3,456) $(3,395) $(229) $(184) Plan assets at fair values 3,831 3,893 1 6 - ----------------------------------------------------------------------------- Plan assets greater (less) than projected benefit obligations 375 498 (228) (178) Unrecognized net transition (assets) liabilities (349) (426) 20 22 Unrecognized net losses 41 17 74 34 Unrecognized prior service costs 84 85 7 - Minimum liability adjustment - - (52) (52) - ----------------------------------------------------------------------------- Net pension cost prepaid (accrued) $ 151 $ 174 $(179) $(174) - ----------------------------------------------------------------------------- The net transition assets and liabilities generally are being amortized by the straight-line method over 15 years. PROFIT SHARING/SAVINGS PLAN AND SAVINGS PLUS PLAN. Eligible employees of the company and certain of its subsidiaries who have completed one year of service may participate in the Profit Sharing/Savings Plan and the Savings Plus Plan. Charges to expense for the profit sharing part of the Profit Sharing/Savings Plan and the Savings Plus Plan were $95, $84 and $104 in 1993, 1992 and 1991, respectively. EMPLOYEE STOCK OWNERSHIP PLAN (ESOP). In December 1989, the company established an ESOP as part of the Profit Sharing/Savings Plan. The ESOP Trust Fund borrowed $1,000 and purchased 14.1 million previously unissued shares of the company's common stock. The ESOP provides a partial pre-funding of the company's future commitments to the profit sharing part of the plan, which will result in annual income tax savings for the company. As interest and principal payments are made on the ESOP debt, shares are released from a suspense account and allocated to profit sharing accounts of plan participants. The ESOP is expected to satisfy most of the company's obligations to the profit sharing part of the Profit Sharing/Savings Plan during the next 11 years. Other company obligations to the profit sharing part of the plan will be satisfied by cash contributions. The company recorded expense for the ESOP of $60, $50 and $44 in 1993, 1992 and 1991, respectively, including $74, $75 and $69 of interest expense related to the ESOP loan. All dividends paid on the shares held by the ESOP will be used to service the ESOP debt. The dividends used were $47, $35 and $40 in 1993, 1992 and 1991, respectively. MANAGEMENT INCENTIVE PLANS. The company has two incentive plans, the Management Incentive Plan (MIP) and the Long-Term Incentive Plan (LTIP) for officers and other regular salaried employees of the company and its subsidiaries who hold positions of significant responsibility. The MIP makes outright distributions of cash for services rendered or deferred awards in the form of stock units. Awards under LTIP may take the form of, but are not limited to, stock options, restricted stock, stock units and non-stock grants. Stock options become exercisable not earlier than one year and not later than 10 years from the date of grant. The maximum number of shares of common stock that may be granted each year is 1 percent of the total outstanding shares of common stock as of January 1 of such year. As of December 31, 1993, 2,151,505 shares were under option at exercise prices ranging from $63.875 to $87.75 per share. Stock option transactions for 1993 and 1992 are as follows: FS-27 NOTE 16. EMPLOYEE BENEFIT PLANS - Continued At December 31 ---------------- Thousands of shares 1993 1992 - ----------------------------------------------------------------------------- Outstanding January 1 1,967 1,265 Granted 706 725 Exercised (509) (6) Forfeited (12) (17) - ----------------------------------------------------------------------------- Outstanding December 31 2,152 1,967 ============================================================================= Exercisable December 31 1,456 1,250 ============================================================================= Charges to expense for the combined management incentive plans were $36, $20 and $37 in 1993, 1992 and 1991, respectively. OTHER BENEFIT PLANS. In addition to providing pension benefits, the company makes contributions toward certain health care and life insurance plans for active and qualifying retired employees. Substantially all employees in the United States and in certain international locations may become eligible for coverage under these benefit plans. The company's annual contributions for medical and dental benefits are limited to the lesser of actual medical and dental claims or a defined fixed per capita amount. Life insurance benefits are paid by the company and annual contributions are based on actual plan experience. Under SFAS 106, adopted effective January 1, 1992, the company's net postretirement benefits expense was as follows: 1993 1992 --------------------- -------------------- Health Life Total Health Life Total - ----------------------------------------------------------------------------- Cost of benefits earned during the year $23 $ 3 $ 26 $23 $ 4 $ 27 Interest cost on benefit obligation 76 30 106 70 30 100 - ----------------------------------------------------------------------------- Net postretirement benefits expense $99 $33 $132 $93 $34 $127 ============================================================================= 1991 expense under the cash method was $60. Non-pension postretirement benefits are funded by the company when incurred. A reconciliation of the funded status of these benefit plans is as follows: At December 31, 1993 At December 31, 1992 ------------------------ ----------------------- Health Life Total Health Life Total - ----------------------------------------------------------------------------- Accumulated postretirement benefit obligation (APBO) Retirees $ (593) $(320) $ (913) $(598) $(281) $ (879) Fully eligible active participants (139) (64) (203) (109) (47) (156) Other active participants (271) (56) (327) (272) (49) (321) - ----------------------------------------------------------------------------- Total APBO (1,003) (440) (1,443) (979) (377) (1,356) Fair value of plan assets - - - - - - - ----------------------------------------------------------------------------- APBO (greater) than plan assets (1,003) (440) (1,443) (979) (377) (1,356) Unrecognized net loss (gain) 63 25 88 69 (12) 57 - ----------------------------------------------------------------------------- Accrued postretirement benefit costs $ (940) $(415) $(1,355) $(910) $(389) $(1,299) ============================================================================= For measurement purposes, separate health care cost-trend rates were utilized for pre-age 65 and post-age 65 retirees. The 1994 annual rates of increase were assumed to be 8.0 percent and 8.9 percent, respectively, decreasing to average ultimate rates of 5.9 percent in 1997 for pre-age 65 and 5.4 percent in 1997 for post-age 65. An increase in the assumed health care cost-trend rates of 1 percent in each year would increase the aggregate of service and interest cost for the year 1993 by $19 and would increase the December 31, 1993 accumulated postretirement benefit obligation (APBO) by $166. At December 31, 1993 the weighted average discount rate was 7.25 percent and the assumed rate of compensation increase related to the measurement of the life insurance benefit was 5.0 percent. FS-28 NOTE 17. OTHER CONTINGENT LIABILITIES AND COMMITMENTS The U.S. federal income tax and California franchise tax liabilities of the company have been settled through 1976 and 1987, respectively. Settlement of open tax matters is not expected to have a material effect on the consolidated financial position of the company and, in the opinion of management, adequate provision has been made for income and franchise taxes for all years either under examination or subject to future examination. The Internal Revenue Service (IRS) has asserted tax deficiencies against the other three stockholders of Arabian American Oil Co. (Aramco) regarding the pricing of crude oil purchased from Saudi Arabia during the period 1979 through 1981. In December 1993, the U.S. Tax Court ruled in favor of Exxon and Texaco on this issue. It is not known if the IRS will appeal this decision. The IRS may have until late 1995 to appeal since other tax issues related to the 1979-81 period must be resolved. Chevron has not received any proposed tax deficiency concerning this issue. In July 1991, the IRS issued a "Designated Summons" that requires Chevron to produce additional documents in connection with the Saudi pricing issue. The Designated Summons extends the statutory period for assessing additional tax. As directed by the District Court, Chevron completed production of documents before year-end 1993. Further motions regarding compliance with the Summons are expected in 1994. After Chevron complies with the Summons, the IRS may propose tax deficiencies similar to those asserted against other Aramco stockholders. The company believes that it properly accounted for the Saudi crude in its tax return and that it owes no additional U.S. taxes. At December 31, 1993, the company and its subsidiaries, as direct or indirect guarantors, had contingent liabilities of $234 for notes of affiliated companies and $45 for notes of others. The company and its subsidiaries have certain other contingent liabilities with respect to guarantees and claims and has long-term commitments under various agreements, the payments and future commitments for which are not material in the aggregate. In September 1990, the Minerals Management Service of the U.S. Department of the Interior (the Service) issued a preliminary determination letter to the effect that the company owed additional royalty payments on natural gas the company produced from federal leasehold interests and sold under long-term supply contracts. The company made royalty payments based on the contract price received, rather than on the basis of published weighted average gas prices, which were higher. The company has submitted an answer refuting the preliminary determination. The Service has the matter under review and has not rendered an order directing payment. However, the parties are continuing to explore settlement. In March 1992, an agency within the Department of Energy (DOE) issued a Proposed Remedial Order (PRO) claiming Chevron failed to comply with DOE regulations in the course of its participation in the Tertiary Incentive Program. Although the DOE regulations involved were rescinded in March 1981, following decontrol of crude oil prices in January 1981, and the statute authorizing the regulations expired in September 1981, the PRO purports to be for the period April 1980 through April 1990. The DOE claims the company overrecouped under the regulations by $125 during the period in question. Including interest through December 1993, the total claim amounted to $273. The company asserts that in fact it incurred a loss through participation in the DOE program. The Office of Hearings and Appeals has granted Chevron's motion for evidentiary hearing and discovery. No date has yet been set for the evidentiary hearing. The company is subject to loss contingencies pursuant to environmental laws and regulations that in the future may require the company to take action to correct or ameliorate the effects on the environment of prior disposal or release of chemical or petroleum substances by the company or other parties. Such contingencies may exist for various sites including, but not limited to: Superfund sites, operating refineries, closed refineries, oil fields, service stations, terminals and land development areas. The amount of such future cost is indeterminable due to such factors as the unknown magnitude of possible contamination, the unknown timing and extent of the corrective actions that may be required, the determination of the company's liability in proportion to other responsible parties and the extent to which such costs are recoverable from insurance. The company's operations, particularly oil and gas exploration and production, can be affected by changing economic, regulatory and political environments in the various countries, including the United States, in which it operates. In certain locations, host governments have imposed restrictions, controls and taxes, and, in others, political conditions have existed that may threaten the safety of employees and the company's continued presence in those countries. Internal unrest or strained relations between a host government and the company or other governments may affect the company's operations. Those developments have, at times, significantly affected the company's related operations and results, and are carefully considered by management when evaluating the level of current and future activity in such countries. Areas in which the company has significant operations include the United States, Australia, United Kingdom, Canada, Nigeria, Angola, Papua New Guinea, China, Indonesia and Zaire. The company's Caltex affiliates have significant operations in Indonesia, Japan, Korea, Australia, the Philippines, Thailand and South Africa. The company's Tengizchevroil affiliate operates in Kazakhstan. FS-29 SUPPLEMENTAL INFORMATION ON OIL AND GAS PRODUCING ACTIVITIES Unaudited In accordance with Statement of Financial Accounting Standards No. 69, "Disclosures about Oil and Gas Producing Activities" (SFAS 69), this section provides supplemental information on oil and gas exploration and producing activities of the company in six separate tables. The first three tables provide historical cost information pertaining to costs incurred in exploration, property acquisitions and development; capitalized costs; and results of operations. Tables IV through VI present information on the company's estimated net proved reserve quantities, standardized measure of estimated discounted future net cash flows related to proved reserves, and changes in estimated discounted future net cash flows. The other geographic category includes activities in the United Kingdom North Sea, Canada, Papua New Guinea, Australia and other countries. Amounts shown for affiliated companies are Chevron's 50 percent equity share in each of P.T. Caltex Pacific Indonesia (CPI), an exploration and production company operating in Indonesia, and Tengizchevroil (TCO), an exploration and production company operating in the Republic of Kazakhstan, which began operations in April 1993. TABLE I - COSTS INCURRED IN EXPLORATION, PROPERTY ACQUISITIONS AND DEVELOPMENT (1) Consolidated Companies - ------------------------------------------------------ Millions of Affiliated dollars U.S. Africa Other Total Companies Worldwide - ----------------------------------------------------------------------------- YEAR ENDED DECEMBER 31, 1993 Exploration Wells $ 123 $ 57 $126 $ 306 $ 1 $ 307 Geological and geophysical 12 40 40 92 9 101 Rentals and other 48 7 70 125 - 125 - ----------------------------------------------------------------------------- Total exploration 183 104 236 523 10 533 - ----------------------------------------------------------------------------- Property acquisitions (2) Proved (3) 12 - 14 26 276 302 Unproved 11 9 10 30 420 450 - ----------------------------------------------------------------------------- Total property acquisitions 23 9 24 56 696 752 - ----------------------------------------------------------------------------- Development 475 239 566 1,280 171 1,451 - ----------------------------------------------------------------------------- Total Costs Incurred $ 681 $352 $826 $1,859 $877(4) $2,736 ============================================================================= YEAR ENDED DECEMBER 31, 1992 Exploration Wells $ 96 $ 59 $ 83 $ 238 $ 1 $ 239 Geological and geophysical 84 48 137 269 8 277 Rentals and other 9 1 21 31 - 31 - ----------------------------------------------------------------------------- Total exploration 189 108 241 538 9 547 - ----------------------------------------------------------------------------- Property acquisitions (2) Proved (3) 19 - 36 55 - 55 Unproved 16 1 10 27 - 27 - ----------------------------------------------------------------------------- Total property acquisitions 35 1 46 82 - 82 - ----------------------------------------------------------------------------- Development 483 189 682 1,354 171 1,525 - ----------------------------------------------------------------------------- Total Costs Incurred $ 707 $298 $969 $1,974 $180 $2,154 ============================================================================= YEAR ENDED DECEMBER 31, 1991 Exploration Wells $ 205 $ 65 $150 $ 420 $ 1 $ 421 Geological and geophysical 98 45 164 307 8 315 Rentals and other 18 2 8 28 2 30 - ----------------------------------------------------------------------------- Total exploration 321 112 322 755 11 766 - ----------------------------------------------------------------------------- Property acquisitions (2) Proved (3) - 1 4 5 - 5 Unproved 59 8 33 100 - 100 - ----------------------------------------------------------------------------- Total property acquisitions 59 9 37 105 - 105 - ----------------------------------------------------------------------------- Development 665 152 569 1,386 164 1,550 - ----------------------------------------------------------------------------- Total Costs Incurred $1,045 $273 $928 $2,246 $175 $2,421 - ----------------------------------------------------------------------------- (1) Includes costs incurred whether capitalized or charged to earnings. Excludes support equipment expenditures. (2) Proved amounts include wells, equipment and facilities associated with proved reserves; unproved represents amounts for equipment and facilities not associated with the production of proved reserves. (3) Does not include properties acquired through property exchanges. (4) In 1993, Total Costs Incurred for affiliated companies includes $146 for CPI. FS-30 TABLE II - CAPITALIZED COSTS RELATING TO OIL AND GAS PRODUCING ACTIVITIES Consolidated Companies - ------------------------------------------------------- Affiliated Millions of dollars U.S. Africa Other Total Companies Worldwide - ----------------------------------------------------------------------------- AT DECEMBER 31, 1993 Unproved properties $ 404 $ 31 $ 206 $ 641 $ 420 $ 1,061 Proved properties and related producing assets 15,655 1,528 4,646 21,829 1,005 22,834 Support equipment 750 105 303 1,158 546 1,704 Deferred exploratory wells 139 23 60 222 - 222 Other uncompleted projects 269 296 879 1,444 466 1,910 - ----------------------------------------------------------------------------- Gross capitalized costs 17,217 1,983 6,094 25,294 2,437 27,731 - ----------------------------------------------------------------------------- Unproved properties valuation 280 20 103 403 - 403 Proved producing properties - Depreciation and depletion 9,645 799 2,467 12,911 386 13,297 Future abandonment and restoration 1,002 195 276 1,473 13 1,486 Support equipment depreciation 338 52 149 539 238 777 - ----------------------------------------------------------------------------- Accumulated provisions 11,265 1,066 2,995 15,326 637 15,963 - ----------------------------------------------------------------------------- Net Capitalized Costs $ 5,952 $ 917 $3,099 $ 9,968 $1,800* $11,768 ============================================================================= AT DECEMBER 31, 1992 Unproved properties $ 481 $ 23 $ 217 $ 721 $ - $ 721 Proved properties and related producing assets 15,682 1,358 4,087 21,127 622 21,749 Support equipment 685 92 270 1,047 374 1,421 Deferred exploratory wells 100 30 66 196 1 197 Other uncompleted projects 443 203 910 1,556 368 1,924 - ----------------------------------------------------------------------------- Gross capitalized costs 17,391 1,706 5,550 24,647 1,365 26,012 - ----------------------------------------------------------------------------- Unproved properties valuation 327 17 110 454 - 454 Proved producing properties - Depreciation and depletion 9,276 700 2,225 12,201 335 12,536 Future abandonment and restoration 967 168 226 1,361 13 1,374 Support equipment depreciation 296 50 133 479 218 697 - ----------------------------------------------------------------------------- Accumulated provisions 10,866 935 2,694 14,495 566 15,061 - ----------------------------------------------------------------------------- Net Capitalized Costs $ 6,525 $ 771 $ 2,856 $10,152 $ 799 $10,951 ============================================================================= AT DECEMBER 31, 1991 Unproved properties $ 658 $ 24 $ 389 $ 1,071 $ - $ 1,071 Proved properties and related producing assets 18,088 1,212 3,925 23,225 534 23,759 Support equipment 658 90 212 960 347 1,307 Deferred exploratory wells 109 50 124 283 1 284 Other uncompleted projects 528 179 656 1,363 322 1,685 - ----------------------------------------------------------------------------- Gross capitalized costs 20,041 1,555 5,306 26,902 1,204 28,106 - ----------------------------------------------------------------------------- Unproved properties valuation 429 12 110 551 - 551 Proved producing properties - Depreciation and depletion 10,322 613 2,166 13,101 299 13,400 Future abandonment and restoration 1,024 147 216 1,387 12 1,399 Support equipment depreciation 262 60 117 439 203 642 - ----------------------------------------------------------------------------- Accumulated Provisions 12,037 832 2,609 15,478 514 15,992 - ----------------------------------------------------------------------------- Net Capitalized Costs $ 8,004 $ 723 $2,697 $11,424 $ 690 $12,114 ============================================================================= *At December 31, 1993, Net Capitalized Costs for affiliated companies includes $860 for CPI. FS-31 Unaudited TABLE III - RESULTS OF OPERATIONS FOR OIL AND GAS PRODUCING ACTIVITIES (1) The company's results of operations from oil and gas producing activities for the years 1993, 1992 and 1991 are shown below. Net income from exploration and production activities as reported on Page FS-6 includes the allocation of corporate overhead and income taxes computed on an effective rate basis. In accordance with SFAS 69, allocated corporate overhead is excluded from the results below, and income taxes are based on statutory tax rates, reflecting allowable deductions and tax credits. Interest expense is excluded from both reported results. Consolidated Companies - ------------------------------------------------------- Affiliated Millions of dollars U.S. Africa Other Total Companies Worldwide - ----------------------------------------------------------------------------- YEAR ENDED DECEMBER 31, 1993 Revenues from net production Sales $1,539 $ 247 $ 779 $2,565 $ 63 $2,628 Transfers 1,912 1,040 661 3,613 487 4,100 - ----------------------------------------------------------------------------- Total 3,451 1,287 1,440 6,178 550 6,728 Production expenses (1,274) (208) (402) (1,884) (204) (2,088) Proved producing properties depreciation, depletion and abandonment provision (958) (126) (311) (1,395) (58) (1,453) Exploration expenses (99) (79) (174) (352) (9) (361) Unproved properties valuation (31) (4) (12) (47) - (47) Other income (expense) (2) 20 - 8 28 6 34 - ----------------------------------------------------------------------------- Results before income taxes 1,109 870 549 2,528 285 2,813 Income tax expense (422) (625) (243) (1,290) (152) (1,442) - ----------------------------------------------------------------------------- RESULTS OF PRODUCING OPERATIONS $ 687 $ 245 $ 306 $1,238 $133* $1,371 ============================================================================= YEAR ENDED DECEMBER 31, 1992 Revenues from net production Sales $1,558 $ 365 $ 816 $2,739 $ 19 $2,758 Transfers 2,301 1,097 580 3,978 519 4,497 - ----------------------------------------------------------------------------- Total 3,859 1,462 1,396 6,717 538 7,255 Production expenses (1,477) (194) (508) (2,179) (153) (2,332) Proved producing properties depreciation, depletion and abandonment provision (1,126) (110) (301) (1,537) (38) (1,575) Exploration expenses (182) (79) (226) (487) (8) (495) Unproved properties valuation (38) (5) (17) (60) - (60) Other income (expense) (2) 431 27 72 530 (15) 515 - ----------------------------------------------------------------------------- Results before income taxes 1,467 1,101 416 2,984 324 3,308 Income tax expense (420) (856) (231) (1,507) (170) (1,677) - ----------------------------------------------------------------------------- Results of Producing Operations $1,047 $ 245 $ 185 $1,477 $154 $1,631 ============================================================================= YEAR ENDED DECEMBER 31, 1991 Revenues from net production Sales $1,609 $ 268 $ 694 $2,571 $ 20 $2,591 Transfers 2,364 1,138 778 4,280 563 4,843 - ----------------------------------------------------------------------------- Total 3,973 1,406 1,472 6,851 583 7,434 Production expenses (1,870) (149) (439) (2,458) (148) (2,606) Proved producing properties depreciation, depletion and abandonment provision (1,259) (100) (252) (1,611) (35) (1,646) Exploration expenses (220) (92) (298) (610) (10) (620) Unproved properties valuation (77) (3) (21) (101) - (101) Other income (expense) (2) 107 (5) 117 219 (15) 204 - ----------------------------------------------------------------------------- Results before income taxes 654 1,057 579 2,290 375 2,665 Income tax expense (246) (894) (403) (1,543) (212) (1,755) - ----------------------------------------------------------------------------- Results of Producing Operations $ 408 $ 163 $ 176 $ 747 $163 $ 910 ============================================================================= *For 1993, Results of Producing Operations for affiliated companies includes $134 for CPI. FS-32 TABLE III - RESULTS OF OPERATIONS FOR OIL AND GAS PRODUCING ACTIVITIES (1) - Continued Per Unit Average Consolidated Companies Sales Price and ------------------------------ Production Affiliated Cost (1), (3) U.S. Africa Other Total Companies Worldwide - ----------------------------------------------------------------------------- YEAR ENDED DECEMBER 31, 1993 Average sales prices Liquids, per barrel $14.48 $16.21 $16.06 $15.33 $13.06 $15.05 Natural gas, per thousand cubic feet 1.98 - 2.08 2.00 .13 1.99 Average production costs, per barrel 4.91 2.62 4.22 4.34 4.77 4.38 ============================================================================= YEAR ENDED DECEMBER 31, 1992 Average sales prices Liquids, per barrel $16.02 $18.40 $17.66 $17.00 $14.87 $16.77 Natural gas, per thousand cubic feet 1.69 - 1.96 1.73 - 1.73 Average production costs, per barrel 5.11 2.44 5.85 4.78 4.23 4.74 ============================================================================= YEAR ENDED DECEMBER 31, 1991 Average sales prices Liquids, per barrel $16.73 $19.00 $18.36 $17.63 $15.25 $17.36 Natural gas, per thousand cubic feet 1.53 - 2.24 1.63 - 1.63 Average production costs, per barrel 6.29 2.01 5.10 5.37 3.87 5.26 ============================================================================= Average sales price for liquids ($/bbl.) DECEMBER 1993 $10.73 $12.94 $13.63 $12.05 $10.46 $11.82 December 1992 15.22 17.60 17.26 16.35 14.15 16.07 December 1991 15.08 17.39 18.76 16.43 14.38 16.19 ============================================================================= Average sales price for natural gas ($/MCF) DECEMBER 1993 $ 2.19 $ - $ 2.34 $ 2.21 $ .26 $ 2.20 December 1992 2.17 - 1.99 2.14 - 2.14 December 1991 1.93 - 2.51 2.00 - 2.00 ============================================================================= (1) The value of owned production consumed as fuel has been eliminated from revenues and production expenses, and the related volumes have been deducted from net production in calculating the per unit average sales price and production cost. This has no effect on the amount of Results of Producing Operations. (2) Includes gas-processing fees, net sulfur income, natural gas contract settlements, currency transaction gains and losses, miscellaneous expenses, etc. In 1993, the United States includes before-tax losses on property dispositions and other special charges totaling $150. In 1992, before-tax gains on property dispositions of $326 in the United States were offset partially by net charges of $44 for severance programs, regulatory issues and other adjustments; Other includes $192 of before-tax gains on sales of producing and nonproducing properties, partially offset by a before-tax charge of $165 for the write-down of Beaufort Sea properties. In 1991, losses and property dispositions in the United States were offset by favorable adjustments to litigation and other reserves; the Other geographic segment included $89 of before-tax gains on property dispositions. (3) Natural gas converted to crude oil equivalent gas (OEG) barrels at a rate of 6 MCF=1 OEG barrel. TABLE IV - RESERVE QUANTITIES INFORMATION The company's estimated net proved underground oil and gas reserves and changes thereto for the years 1993, 1992 and 1991 are shown in the following table. These quantities are estimated by the company's reserves engineers and reviewed by the company's Reserves Advisory Committee using reserve definitions prescribed by the Securities and Exchange Commission. Proved reserves are the estimated quantities that geologic and engineering data demonstrate with reasonable certainty to be recoverable in future years from known reservoirs under existing economic and operating conditions. Due to the inherent uncertainties and the limited nature of reservoir data, estimates of underground reserves are subject to change over time as additional information becomes available. Proved reserves do not include additional quantities recoverable beyond the term of lease or contract unless renewal is reasonably certain, or that may result from extensions of currently proved areas, or from application of secondary or tertiary recovery processes not yet tested and determined to be economic. Proved developed reserves are the quantities expected to be recovered through existing wells with existing equipment and operating methods. "Net" reserves exclude royalties and interests owned by others and reflect contractual arrangements and royalty obligations in effect at the time of the estimate. Upon formation of the Tengizchevroil joint venture in April 1993, the company recognized 1.1 billion barrels of net proved crude oil and natural gas liquids reserves and 1.5 trillion cubic feet of net natural gas reserves, which represented its 50 percent ownership. FS-33 Unaudited TABLE IV - RESERVE QUANTITIES INFORMATION - Continued TABLE V - STANDARDIZED MEASURE OF DISCOUNTED FUTURE NET CASH FLOWS RELATED TO PROVED OIL AND GAS RESERVES The standardized measure of discounted future net cash flows, related to the above proved oil and gas reserves, is calculated in accordance with the requirements of SFAS 69. Estimated future cash inflows from production are computed by applying year-end prices for oil and gas to year-end quantities of estimated net proved reserves. Future price changes are limited to those provided by contractual arrangements in existence at the end of each reporting year. Future development and production costs are those estimated future expenditures necessary to develop and produce year-end estimated proved reserves based on year-end cost indices, assuming continuation of year-end economic conditions. Estimated future income taxes are calculated by applying appropriate year-end statutory tax rates. These rates reflect allowable deductions and tax credits and are applied to estimated future pre-tax net cash flows, less the tax basis of related assets. Discounted future net cash flows are calculated using 10 percent midperiod discount factors. This discounting requires a year-by-year estimate of when the future expenditures will be incurred and when the reserves will be produced. The information provided does not represent management's estimate of the company's expected future cash flows or value of proved oil and gas reserves. Estimates of proved reserve quantities are imprecise and change over time as new information becomes available. Moreover, probable and possible reserves, which may become proved in the future, are excluded from the calculations. The arbitrary valuation prescribed under SFAS 69 requires assumptions as to the timing of future production from proved reserves and the timing and amount of future development and production costs. The calculations are made as of December 31 each year and should not be relied upon as an indication of the company's future cash flows or value of its oil and gas reserves. FS-34 Unaudited TABLE V - STANDARDIZED MEASURE OF DISCOUNTED FUTURE NET CASH FLOWS RELATED TO PROVED OIL AND GAS RESERVES - CONTINUED TABLE VI - CHANGES IN THE STANDARDIZED MEASURE OF DISCOUNTED FUTURE NET CASH FLOWS FROM PROVED RESERVES FS-35 FIVE-YEAR FINANCIAL SUMMARY (1) FS-36 CALTEX GROUP OF COMPANIES COMBINED FINANCIAL STATEMENTS AND SCHEDULES December 31, 1993 C-1 CALTEX GROUP OF COMPANIES COMBINED FINANCIAL STATEMENTS AND SCHEDULES DECEMBER 31, 1993 INDEX SCHEDULE NUMBER PAGE(S) -------- ----------- General Information . . . . . . . . . . . . . . . . . . C-3 to C-4 Independent Auditors' Report . . . . . . . . . . . . . C-5 Combined Balance Sheet . . . . . . . . . . . . . . . . C-6 to C-7 Combined Statement of Income . . . . . . . . . . . . . C-8 Combined Statement of Retained Earnings . . . . . . . C-9 Combined Statement of Cash Flows . . . . . . . . . . . C-9 Notes to Combined Financial Statements . . . . . . . . C-10 to C-19 Property, Plant and Equipment . . . . . . . . . . . . V C-20 Accumulated Depreciation, Depletion and Amortization . VI C-21 NOTE: All other schedules are omitted as permitted by Rule 4.03 and Rule 5.04 of Regulation S-X. C-2 CALTEX GROUP OF COMPANIES GENERAL INFORMATION The Caltex Group of Companies (Group) is jointly owned 50% each by Chevron Corporation and Texaco Inc. The private joint venture was created in Bahrain in 1936 by its two owners to produce, refine and market crude oil and refined products. Headquartered in Irving, Texas, the Group is comprised of the following companies: Caltex Petroleum Corporation, a company incorporated in Delaware, that through its many subsidiaries and affiliates, conducts refining and marketing activities in the Eastern Hemisphere; P. T. Caltex Pacific Indonesia, an exploration and production company incorporated and operating in Indonesia; American Overseas Petroleum Limited, a company incorporated in the Bahamas, that, through its subsidiaries, manages certain exploration and production operations in Indonesia in which Chevron and Texaco have interests, but not necessarily jointly nor in the same properties. A brief description of each company's operations and the Group's environmental activities follows: CALTEX PETROLEUM CORPORATION (CALTEX) - ------------------------------------- Through its subsidiaries and affiliates, Caltex operates in 63 countries with some of the highest economic and petroleum growth rates in the world, principally in Africa, Asia, the Middle East, New Zealand and Australia. Certain refining and marketing operations are conducted through joint ventures, with equity interests in 14 refineries in 11 countries. Caltex' share of refinery inputs approximated 869,000 barrels per day in 1993. Caltex continues to improve its refineries with investments designed to provide higher yields and meet environmental regulations. Construction of a new 130,000 barrels per day refinery in Thailand is progressing with completion anticipated in 1996. At year end 1993, Caltex had over 7,800 employees, of which about 3% were located in the United States. With a strong presence in its principal operating areas, Caltex has an average market share of 17.3% with refined product sales of approximately 1.3 million barrels per day in 1993. Caltex built 130 new branded retail outlets during 1993 and refurbished 294 existing locations in its aim to upgrade its retail distribution network. Caltex conducts international crude oil and refined product logistics and trading operations from a subsidiary in Singapore. Other offices are located in London, Bahrain and Tokyo. The company has an interest in a fleet of vessels and owns or has equity interests in numerous pipelines, terminals and depots. Currently, Caltex is active in the petrochemical business, particularly in Japan and South Korea. P. T. CALTEX PACIFIC INDONESIA (CPI) - ------------------------------------ CPI holds a Production Sharing Contract in Central Sumatra for which the Indonesian government granted an extension to the year 2021 during 1992. CPI also acts as operator for four other petroleum contract areas in Sumatra, which are jointly held by Chevron and Texaco. Exploration is pursued throughout an area comprising 2.446 million acres with production established in the giant Minas and Duri fields, along with more than 80 smaller fields. Gross production from fields operated by CPI for 1993 was 674,000 barrels per day. CPI entitlements are sold to its shareholders, who use it in their systems or sell it to third parties. In addition, during 1993 CPI began gas exploration activities in the Nias block held jointly by Chevron and Texaco. At year end 1993, CPI had over 6,400 employees, all located in Indonesia. C-3 CALTEX GROUP OF COMPANIES GENERAL INFORMATION AMERICAN OVERSEAS PETROLEUM LIMITED (AOPL) - ------------------------------------------ In addition to coordinating the CPI activities, AOPL, through its subsidiary Amoseas Indonesia Inc., manages Texaco's and Chevron's undivided interest holdings which include ten contract areas in Indonesia, excluding Sumatra. Production is currently established in two contract areas, while exploration is being pursued in seven others. One in Darajat in West Java contains geothermal reserves sufficient to supply a 55-megawatt power generating plant for over 30 years. Production of the geothermal reserves is expected to begin in 1994 while the state owned utility company completes construction of an associated power station. AOPL's 1993 share of production amounted to 38,400 barrels per day. At year end, AOPL had 281 employees, of which about 15% were located in the United States. ENVIRONMENTAL ACTIVITIES - ------------------------ The Group's activities are subject to environmental, health and safety regulations in each of the countries in which it operates. Such regulations vary significantly in degree of scope, standards and enforcement. The Group's policy is to comply with all applicable environmental, health and safety laws and regulations. The Group has an active program to ensure its environmental standards are maintained, which includes closely monitoring applicable statutory and regulatory requirements, as well as enforcement policies, in each of the countries in which it operates, and conducting periodic environmental compliance audits. At December 31, 1993, the Group had accrued $12 million for various remediation activities. The environmental guidelines and definitions promulgated by the American Petroleum Institute provide the basis for reporting the Group's expenditures. For the year ended December 31, 1993, the Group, including its equity share of nonsubsidiary companies, incurred capital costs of $147 million and nonremediation related operating expenses of $92 million. The major component of the Group's expenditures is for the prevention of air pollution. Based upon existing statutory and regulatory requirements, investment and operating plans and known exposures, the Group believes environmental expenditures will not materially affect its liquidity, financial position or results of operations. C-4 INDEPENDENT AUDITORS' REPORT TO THE STOCKHOLDERS THE CALTEX GROUP OF COMPANIES: We have audited the accompanying combined balance sheets of the Caltex Group of Companies as of December 31, 1993 and 1992, and the related combined statements of income, retained earnings, and cash flows for each of the years in the three-year period ended December 31, 1993. In connection with our audits of the combined financial statements, we also have audited the financial statement schedules as listed in the accompanying index. These combined financial statements and financial statement schedules are the responsibility of the Group's management. Our responsibility is to express an opinion on these combined 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 combined financial statements referred to above present fairly, in all material respects, the financial position of the Caltex Group of Companies as of December 31, 1993 and 1992 and the results of its operations and its 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 combined financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. As discussed in Notes 1 and 6 to the combined financial statements, effective January 1, 1992, the Group adopted the provisions of the Financial Accounting Standards Board's Statements of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" and No. 109, "Accounting for Income Taxes." KPMG PEAT MARWICK Dallas, Texas February 15, 1994 CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS We hereby consent to the incorporation by reference in the Prospectuses constituting part of the Registration Statements on Form S-3 (No. 2-98466) and Form S-8 (Nos. 33-3899, 33-34039 and 33-35283) of Chevron Corporation, and to the incorporation by reference in the Prospectus constituting part of the Registration Statement on Form S-3 (No. 33-14307) of Chevron Capital U.S.A. Inc. and Chevron Corporation, and to the incorporation by reference in the Registration Statement on Form S-3 (No. 33-58838) of Chevron Canada Finance Limited and Chevron Corporation, and to the incorporation by reference in the Registration Statement on Form S-8 (No. 2-90907) of Caltex Petroleum Corporation of our report dated February 15, 1994, relating to the combined balance sheets of the Caltex Group of Companies as of December 31, 1993 and 1992 and the related combined statements of income, retained earnings and cash flows and related financial statement schedules for each of the years in the three-year period ended December 31, 1993, which report appears in the December 31, 1993 Annual Report on Form 10-K of Chevron Corporation. KPMG PEAT MARWICK Dallas, Texas March 25, 1994 C-5 CALTEX GROUP OF COMPANIES COMBINED BALANCE SHEET - DECEMBER 31, 1993 AND 1992 (MILLIONS OF DOLLARS) ASSETS 1993 1992 CURRENT ASSETS: ------ ------ Cash and cash equivalents (including time deposits of $64 in 1993 and $121 in 1992) $ 166 $ 239 Notes and accounts receivable, less allowance for doubtful accounts of $14 in 1993 and $15 in 1992: Trade 950 1,020 Other 155 115 Nonsubsidiary companies 112 173 ------ ------ 1,217 1,308 Inventories: Crude oil 148 239 Refined products 532 512 Materials and supplies 56 55 ------ ------ 736 806 Deferred income taxes 4 25 ------ ------ Total current assets 2,123 2,378 INVESTMENTS AND ADVANCES: Nonsubsidiary companies at equity 1,796 1,427 Miscellaneous investments and long-term receivables, less allowance of $7 in 1993 and 1992 195 173 ------ ------ 1,991 1,600 PROPERTY, PLANT AND EQUIPMENT, AT COST: Producing 3,027 2,783 Refining 1,483 1,259 Marketing 2,252 2,107 Marine 35 35 Capitalized leases 119 113 ------ ------ 6,916 6,297 Less: Accumulated depreciation, depletion and amortization 2,878 2,628 ------ ------ 4,038 3,669 PREPAID AND DEFERRED CHARGES 237 216 ------ ------ Total assets $8,389 $7,863 ====== ====== See accompanying Notes to Combined Financial Statements. C-6 CALTEX GROUP OF COMPANIES COMBINED BALANCE SHEET - DECEMBER 31, 1993 AND 1992 (MILLIONS OF DOLLARS) LIABILITIES AND STOCKHOLDERS' EQUITY 1993 1992 ------ ------ CURRENT LIABILITIES: Notes payable to banks and other financial institutions $ 966 $ 830 Long-term debt due within one year 51 51 Accounts payable: Trade and other 967 1,081 Stockholder companies 87 229 Nonsubsidiary companies 149 76 ------ ------ 1,203 1,386 Accrued liabilities 86 91 Estimated income taxes 105 95 ------ ------ Total current liabilities 2,411 2,453 LONG-TERM DEBT AND CAPITAL LEASE OBLIGATIONS 530 486 ACCRUED LIABILITY FOR EMPLOYEE BENEFITS 98 92 DEFERRED CREDITS 646 605 DEFERRED INCOME TAXES 263 270 MINORITY INTEREST IN SUBSIDIARY COMPANIES 146 138 STOCKHOLDERS' EQUITY: Common stock 355 355 Additional paid-in capital 2 2 Retained earnings 3,688 3,310 Currency translation adjustment 250 152 ------ ------ Total stockholders' equity 4,295 3,819 COMMITMENTS AND CONTINGENT LIABILITIES ------ ------ Total liabilities and stockholders' equity $8,389 $7,863 ====== ====== See accompanying Notes to Combined Financial Statements. C-7 CALTEX GROUP OF COMPANIES COMBINED STATEMENT OF INCOME FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (MILLIONS OF DOLLARS) 1993 1992 1991 ------- ------- ------- SALES AND OTHER OPERATING REVENUES (1) $15,409 $17,281 $15,445 OPERATING CHARGES: Cost of sales and operating expenses (2) 13,431 15,348 13,394 Selling, general and administrative expenses 496 479 444 Depreciation, depletion and amortization 295 263 257 Maintenance and repairs 170 165 156 ------- ------- ------- 14,392 16,255 14,251 ------- ------- ------- Operating income 1,017 1,026 1,194 OTHER INCOME (DEDUCTIONS): Equity in net income of nonsubsidiary companies 140 163 188 Dividends, interest and other income 99 83 288 Foreign exchange, net 23 21 (5) Interest expense (93) (102) (131) Minority interest in subsidiary companies (8) (13) (8) ------- ------- ------- 161 152 332 ------- ------- ------- Income before provision for income taxes and cumulative effects of changes in accounting principles 1,178 1,178 1,526 ------- ------- ------- PROVISION FOR INCOME TAXES: Current 433 456 649 Deferred 25 53 38 ------- ------- ------- Total provision for income taxes 458 509 687 ------- ------- ------- Income before cumulative effects of changes in accounting principles 720 669 839 Cumulative effects of changes in accounting principles - 51 - ------- ------- ------- Net income $ 720 $ 720 $ 839 ======= ======= ======= (1) Includes sales to: Stockholder companies $ 907 $ 835 $1,124 Nonsubsidiary companies $2,684 $3,075 $2,610 (2) Includes purchases from: Stockholder companies $3,333 $3,917 $3,181 Nonsubsidiary companies $2,618 $2,198 $2,217 See accompanying Notes to Combined Financial Statements. C-8 CALTEX GROUP OF COMPANIES COMBINED STATEMENT OF RETAINED EARNINGS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (MILLIONS OF DOLLARS) 1993 1992 1991 ------- ------- ------- Balance at beginning of year $3,310 $2,955 $2,518 Net income 720 720 839 Cash dividends (342) (365) (402) ------- ------- ------- Balance at end of year $3,688 $3,310 $2,955 ======= ======= ======= COMBINED STATEMENT OF CASH FLOWS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (MILLIONS OF DOLLARS) 1993 1992 1991 ------- ------- ------- OPERATING ACTIVITIES: Net income $ 720 $ 720 $ 839 Adjustments to reconcile net income to net cash provided by operating activities: Cumulative effects of changes in accounting principles - (51) - Depreciation, depletion and amortization 295 263 257 Dividends from nonsubsidiary companies, less than equity in net income (103) (133) (162) Asset sales (4) (4) (200) Deferred income taxes 25 53 38 Prepaid charges and deferred credits (41) 25 45 Changes in operating working capital 31 (58) 127 Other 10 (46) 5 ------- ------- ------- Net cash provided by operating activities 933 769 949 ------- ------- ------- INVESTING ACTIVITIES: Capital expenditures (763) (711) (640) Investments in and advances to nonsubsidiary companies (149) (17) (1) Net purchases of investment instruments (21) (11) (14) Proceeds from asset sales 73 144 85 ------- ------- ------- Net cash used in investing activities (860) (595) (570) ------- ------- ------- FINANCING ACTIVITIES: Proceeds from borrowings having original terms in excess of three months 745 831 643 Repayments of borrowings having original terms in excess of three months (704) (857) (553) Net increase (decrease) in other borrowings 140 94 (37) Dividends paid, including minority interest (342) (365) (407) ------- ------- ------- Net cash used in financing activities (161) (297) (354) ------- ------- ------- Effect of exchange rate changes on cash and cash equivalents 15 (8) (17) ------- ------- ------- NET CHANGE IN CASH AND CASH EQUIVALENTS (73) (131) 8 CASH AND CASH EQUIVALENTS AT BEGINNING OF YEAR 239 370 362 ------- ------- ------- CASH AND CASH EQUIVALENTS AT END OF YEAR $ 166 $ 239 $ 370 ======= ======= ======= See accompanying Notes to Combined Financial Statements. C-9 CALTEX GROUP OF COMPANIES NOTES TO COMBINED FINANCIAL STATEMENTS (1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES PRINCIPLES OF COMBINATION The combined financial statements of the Caltex Group of Companies (Group) include the accounts of Caltex Petroleum Corporation and subsidiaries, American Overseas Petroleum Limited and subsidiaries and P.T. Caltex Pacific Indonesia after the elimination of intercompany balances and transactions. A subsidiary of Chevron Corporation and two subsidiaries of Texaco Inc. (stockholders) each own 50% of the outstanding common shares. The Group is primarily engaged in exploring, producing, refining and marketing crude oil and refined products in the Eastern Hemisphere. The Group employs accounting policies that are in accordance with generally accepted accounting principles in the United States. TRANSLATION OF FOREIGN CURRENCIES The U.S. dollar is the functional currency for all principal subsidiary operations. Nonsubsidiary companies in Japan and Korea use the local currency as the functional currency. INVENTORIES Crude oil and refined product inventories are stated at the lower of cost (primarily determined on the last-in, first-out (LIFO) method) or current market value. Costs include applicable purchase and refining costs, duties, import taxes, freight, etc. Materials and supplies are valued at average cost. INVESTMENTS AND ADVANCES Investments in and advances to nonsubsidiary companies in which 20% to 50% of the voting stock is owned by the Group, or in which the Group has the ability to exercise significant influence, are accounted for by the equity method. Under this method, the Group's equity in the earnings or losses of these companies is included in current results, and the related investments reflect the equity in the book value of underlying net assets. Investments in other nonsubsidiary companies are carried at cost and related dividends are reported as income. PROPERTY, PLANT AND EQUIPMENT Exploration and production activities are accounted for under the "successful efforts" method. Depreciation, depletion and amortization expenses for capitalized costs relating to the producing area, including intangible development costs, are computed using the unit-of-production method. All other assets are depreciated by class on a uniform straight line basis. Depreciation rates are based upon the estimated useful life of each class of property. In view of the numerous depreciation classifications, it is not practical to provide a schedule of depreciation rates. Maintenance and repairs necessary to maintain facilities in operating condition are charged to income as incurred. Additions and betterments that materially extend the life of properties are capitalized. Upon disposal of properties, any net gain or loss is included in other income. C-10 CALTEX GROUP OF COMPANIES NOTES TO COMBINED FINANCIAL STATEMENTS (1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - CONTINUED DEFERRED INCOME TAXES Effective January 1, 1992, deferred income taxes are recognized according to the asset and liability method specified in Statement of Financial Accounting Standards (SFAS) No. 109 "Accounting for Income Taxes" by applying individual jurisdiction tax rates applicable to future years to differences between the financial statement and tax basis carrying amounts of assets and liabilities. The effect of tax rate changes on previously recorded deferred taxes is recognized in the current year. Deferred income taxes for 1991 were recognized under the method specified in SFAS No. 96. No provision has been made for possible income taxes that might be payable if accumulated earnings of subsidiary companies and nonsubsidiary companies accounted for by the equity method were distributed, since such earnings have been or are intended to be indefinitely reinvested. ENVIRONMENTAL MATTERS Compliance with environmental regulations is determined in relation to the existing laws in each of the countries in which the Group operates and the Group's own internal standards. The Group capitalizes expenditures that create future benefits or contribute to future revenue generation. Remediation costs are accrued based on estimates of known environmental exposure even if uncertainties exist about the ultimate cost of the remediation. Such accruals are based on the best available nondiscounted estimated costs using data developed by third party experts. Costs of environmental compliance for past and ongoing operations, including maintenance and monitoring, are expensed as incurred. Recoveries from third parties are recorded as assets when realization is determined to be probable. RECLASSIFICATIONS Certain amounts have been reclassified for preceding periods to conform with the current year's presentation. (2) INVENTORIES The excess of current cost over the stated value of inventory maintained on the LIFO basis was approximately $40 million and $91 million at December 31, 1993 and 1992, respectively. The reduction of LIFO inventories in certain countries resulted in an increase in the earnings of consolidated subsidiaries and nonsubsidiary companies at equity of approximately $1 million in 1993. Previous reductions in LIFO inventories resulted in a decrease in earnings of $2 million in 1992 and an increase in earnings of $4 million in 1991. Charges of $104 million and $25 million reduced income in 1993 and 1991, respectively, to reflect a market value of certain inventories lower than their LIFO carrying value. Earnings of $14 million were recorded in 1992 to reflect a partial recovery of the 1991 charge. C-11 CALTEX GROUP OF COMPANIES NOTES TO COMBINED FINANCIAL STATEMENTS (3) NONSUBSIDIARY COMPANIES AT EQUITY Investments in and advances to nonsubsidiary companies at equity at December 31 include the following (in millions): Equity Share 1993 1992 ------------ ------ ------ Nippon Petroleum Refining Company, Ltd. 50% $ 829 $ 727 Koa Oil Company, Ltd. 50% 310 268 Honam Oil Refinery Company, Ltd. 50% 423 357 All other Various 234 75 ------ ------ $1,796 $1,427 ====== ====== Shown below is summarized combined financial information for these non- subsidiary companies (in millions): 100% Equity Share ---------------- ----------------- 1993 1992 1993 1992 ------ ------ ------ ------ Current assets $4,680 $5,149 $2,316 $2,564 Other assets 6,147 4,851 2,975 2,410 Current liabilities 4,900 4,946 2,349 2,470 Other liabilities 2,306 2,173 1,146 1,078 Net worth 3,621 2,881 1,796 1,426 100% Equity Share ------------------------- ---------------------- 1993 1992 1991 1993 1992 1991 ------- ------- ------- ------ ------ ------ Operating revenues $10,679 $10,502 $10,267 $5,304 $5,216 $5,102 Operating income 494 645 839 242 319 416 Net income 281 326 380 140 163 188 Retained earnings at December 31, 1993, includes $1.2 billion representing the Group's share of undistributed earnings of nonsubsidiary companies at equity. Cash dividends received from these nonsubsidiary companies were $37 million, $30 million, and $26 million in 1993, 1992 and 1991, respectively. Sales to the other 50 percent owner of Nippon Petroleum Refining Company, Ltd. of products refined by Nippon Petroleum Refining Company, Ltd. and Koa Oil Company, Ltd. were approximately $1.9 billion, $2 billion, and $2.1 billion in 1993, 1992, and 1991, respectively. C-12 CALTEX GROUP OF COMPANIES NOTES TO COMBINED FINANCIAL STATEMENTS (4) NOTES PAYABLE Information regarding short-term financing, consisting primarily of demand loans, promissory notes, acceptance credits and overdrafts, is shown below (dollars in millions): Weighted Maximum Weighted Average Average Outstanding Average Interest Rate Borrowings At Interest Rate At Any Amount On Average Year End At Year End Month End Outstanding Outstanding ------------- ------------- ---------- ----------- -------------- 1993 $966 4.7% $1,041 $902 4.6% 1992 830 5.0 1,063 898 5.7 1991 907 7.2 996 875 9.9 Unutilized lines of credit available for short-term financing totaled $814 million at December 31, 1993. (5) LONG-TERM DEBT AND CAPITAL LEASE OBLIGATIONS Long-term debt and capital lease obligations, with related interest rates at December 31, 1993, consist of the following (in millions): 1993 1992 U.S. dollars: ---- ---- Variable interest rate term loans $173 $155 Fixed interest rate term loans with 7.6% average rate 220 205 Australian dollars: Debentures with interest rates at 12.5% due 1995 - 1996 8 11 Promissory notes payable with 4.9% average rate 76 65 Capital lease obligations 33 33 New Zealand dollars: Term loans with interest rates 6 - 6.35% due 1996-1997 14 - Other 6 17 ---- ---- $530 $486 ==== ==== At December 31, 1993 and 1992, $101 million and $110 million, respectively, of notes payable were classified as long-term debt. Settlement of these obligations is not expected to require the use of working capital in 1994, as the Group has both the intent and ability to refinance this debt on a long- term basis. At December 31, 1993 and 1992, $101 million and $110 million, respectively, of long-term committed credit facilities were available with major banks to support notes payable classified as long-term debt. Maturities subsequent to December 31, 1993 follow (in millions): 1994 - $51 (included on the combined balance sheet as a current liability); 1995 - $151; 1996 - $147; 1997 - $37; 1998 - $86; 1999 and thereafter - $109. C-13 CALTEX GROUP OF COMPANIES NOTES TO COMBINED FINANCIAL STATEMENTS (6) EMPLOYEE BENEFITS The Group has retirement plans covering substantially all eligible employees. Generally, these plans provide defined benefits based on final or final average pay, as defined. The benefit levels, vesting terms and funding practices vary among plans. The funded status of retirement plans, primarily foreign and inclusive of nonsubsidiary companies at equity, at December 31 follows (in millions): Assets Exceed Accumulated Accumulated Benefits FUNDING STATUS Benefits Exceed Assets ------------ ------------- 1993 1992 1993 1992 ---- ---- ---- ---- Actuarial present value of: Vested benefit obligation $280 $240 $117 $100 Accumulated benefit obligation 309 264 137 117 Projected benefit obligation 484 432 195 170 Amount of assets available for benefits: Funded assets at fair value $450 $403 $ 39 $ 26 Net pension (asset) liability recorded (11) (8) 128 123 ---- ---- ---- ---- Total assets $439 $395 $167 $149 ==== ==== ==== ==== Assets less than projected benefit obligation $(45) $(37) $(28) $(21) Consisting of: Unrecognized transition net assets (liabilities) 31 38 (2) (4) Unrecognized net losses (44) (42) (23) (16) Unrecognized prior service costs (32) (33) (3) (1) Weighted average rate assumptions: Discount rate 9.5% 11.1% 6.5% 6.5% Rate of increase in compensation 7.4% 9.0% 4.7% 4.7% Expected return on plan assets 10.3% 11.4% 5.5% 4.9% EXPENSES (Funded & Unfunded Combined) 1993 1992 1991 ---- ---- ---- Cost of benefits earned during the year $ 27 $ 26 $ 21 Interest cost on projected benefit obligation 58 54 49 Actual return on plan assets (59) (9) (64) Net amortization and deferral 16 (38) 22 ---- ---- ---- $ 42 $ 33 $ 28 ==== ==== ==== The Group adopted SFAS No. 106 "Employers' Accounting for Postretirement Benefits Other Than Pensions" effective January 1, 1992, using the immediate recognition option. SFAS No. 106 requires accrual, during the employees' service with the Group, of the cost of their retiree health and life insurance benefits. Prior to 1992, postretirement benefits were included in expense as the benefits were paid. C-14 CALTEX GROUP OF COMPANIES NOTES TO COMBINED FINANCIAL STATEMENTS (6) EMPLOYEE BENEFITS - Continued Certain companies within the Group provide health care and life insurance benefits to retired employees. The plans which provide these benefits are unfunded. As of December 31, 1993 and 1992, the accumulated postretirement benefit obligation amounted to $47 million and $43 million, respectively, with related accruals of $44 million and $43 million, respectively. The net periodic postretirement benefit costs amounted to $6 million for each of the years ending December 31, 1993 and 1992. In November 1992 the Financial Accounting Standards Board issued SFAS No. 112 "Employers' Accounting for Postemployment Benefits." This new standard requires companies to accrue, no later than 1994, for the cost for benefits provided to former or inactive employees after employment but prior to retirement. Adoption of this new standard is not expected to materially impact the combined financial statements of the Group. (7) OPERATING LEASES The Group has various operating leases involving service stations, equipment and other facilities for which net rental expense was $110 million, $95 million, and $53 million in 1993, 1992 and 1991, respectively. Future net minimum rental commitments under operating leases having noncancelable terms in excess of one year are as follows (in millions): 1994 - $42; 1995 - $42; 1996 - $42; 1997 - $37; 1998 - $31; 1999 and thereafter - $146. (8) CONTINGENT LIABILITIES On January 25, 1990, Caltex Petroleum Corporation and certain of its subsidiaries were named as defendants, along with privately held Philippine ferry and shipping companies and the shipping company's insurer, in a lawsuit filed in Houston, Texas State Court. After removal to Federal District Court in Houston, the litigation's disposition turned on questions of federal court jurisdiction and whether the case should be dismissed for forum non conveniens. The plaintiffs' petition purported to be a class action on behalf of at least 3,350 parties, who were either survivors of, or next of kin of persons deceased in a collision in Philippine waters on December 20, 1987. One vessel involved in the collision was carrying Group products in connection with a freight contract. Although the Group had no direct or indirect ownership or operational responsibility for either vessel, various theories of liability were alleged against the Group. No specific monetary recovery was sought although the petition contained a variety of demands for various categories of compensatory as well as punitive damages. These issues were resolved in the Group's favor by the Federal District Court in March 1992, and that decision is now final. However, the plaintiffs had separately filed another lawsuit, alleging the same causes of action as in the Texas litigation, in Louisiana State Court in New Orleans in late 1988 but never served the Group until late December of 1993, after the decision in the Texas litigation became final. Subsequent to receipt of the service, the Group has removed this case to Federal District Court in New Orleans and has moved for its dismissal. Management is contesting this case vigorously. It is not possible to estimate the amount of damages involved, if any. The Group may be subject to loss contingencies pursuant to environmental laws and regulations in each of the countries in which it operates that, in the future, may require the Group to take action to correct or remediate the effects on the environment of prior disposal or release of petroleum substances by the Group. The amount of such future cost is indeterminable due to such factors as the nature of the new regulations, the unknown magnitude of any possible contamination, the unknown timing and extent of the corrective actions that may be required, and the extent to which such costs are recoverable from third party insurance. C-15 CALTEX GROUP OF COMPANIES NOTES TO COMBINED FINANCIAL STATEMENTS (8) CONTINGENT LIABILITIES - Continued The Group is also involved in certain other litigation and Internal Revenue Service tax audits that could involve significant payments if such items are all ultimately resolved adversely to the Group. While it is impossible to ascertain the ultimate legal and financial liability with respect to the above mentioned contingent liabilities, the aggregate amount that may arise from such liabilities is not anticipated to be material in relation to the Group's combined financial position, results of operations, or liquidity. (9)FINANCIAL INSTRUMENTS Certain Group companies are parties to financial instruments with off-balance sheet credit and market risk, principally interest rate risk. As of December 31, the Group had commitments outstanding for interest rate swaps and foreign currency transactions for which the notional or contractual amounts are as follows (in millions): 1993 1992 ---- ---- Interest rate swaps $344 $317 Commitments to purchase foreign currencies $338 $141 Commitments to sell foreign currencies $ 89 $ 20 The interest rate swaps are intended to hedge against fluctuations in interest rates on debt, and their effects are recognized in the statement of income at the same time as the interest expense on the debt to which they relate. Commitments to purchase and sell foreign currencies are made to provide exchange rate protection for specific transactions and to maximize economic benefit based on expected currency movements. The above purchase and sale commitments are at year end exchange rates and mature during the following year. These commitments are marked to market and the resulting gains and losses are recognized in current year income unless the contract is a specific hedge of an identifiable transaction. There were no material differences between the notional and estimated fair value for these commitments. The Group's long-term debt, excluding capital lease obligations, of $497 million and $453 million at December 31, 1993 and 1992, respectively, had fair values of $511 million and $462 million at December 31, 1993 and 1992, respectively. The fair value estimates were based on the present value of expected cash flows discounted at current market rates for similar obligations. The reported amounts of financial instruments such as Cash and cash equivalents, Notes and accounts receivable, and all current liabilities approximate fair value because of their short maturity. Certain Group companies were contingently liable as guarantors for $7 million and $12 million at December 31, 1993 and 1992, respectively. The Group also had commitments of $36 million and $96 million at December 31, 1993 and 1992, respectively, in the form of letters of credit which have been issued on behalf of Group companies to facilitate either the Group's or other parties' ability to trade in the normal course of business. Financial instruments exposed to credit risk consist primarily of trade receivables. These receivables are dispersed among the countries in which the Group operates, thus limiting concentrations of such risk. The Group performs ongoing credit evaluations of its customers and generally does not require collateral. Letters of credit are the principal security obtained to support lines of credit when the financial strength of a customer or country is not considered sufficient. Credit losses have been historically within management's expectations. C-16 CALTEX GROUP OF COMPANIES NOTES TO COMBINED FINANCIAL STATEMENTS (10) OTHER INCOME/DEDUCTIONS In 1991, dividends, interest and other income included gains from asset sales on a before and after tax basis of $200 million and $120 million, respectively. Asset sales in 1993 and 1992 were not significant. Net foreign exchange (exclusive of the currency translation adjustment) for consolidated subsidiaries and nonsubsidiary companies at equity, after applicable income taxes, amounted to gains of $32 million and $43 million in 1993 and 1992, respectively. The gain in 1991 was less than $1 million. (11) TAXES Taxes charged to income consist of the following (in millions): 1993 1992 1991 ------ ------ ------ Taxes other than income taxes: Duties, import and excise taxes $1,978 $1,891 $1,802 Other 29 29 29 ------ ------ ------ Total taxes other than income taxes 2,007 1,920 1,831 Provision for income taxes 458 509 687 ------ ------ ------ $2,465 $2,429 $2,518 ====== ====== ====== The provision for income taxes, substantially all foreign, has been computed on an individual company basis at rates in effect in the various countries of operation. The actual tax expense differs from the "expected" tax expense (computed by applying the U.S. Federal corporate tax rate to income before provision for income taxes) as follows: 1993 1992 1991 ----- ----- ----- Computed "expected" tax expense 35.0% 34.0% 34.0% Effect of recording equity in net income of nonsubsidiary companies on an after tax basis (4.2) (4.9) (4.2) Effect of dividends received from subsidiary and nonsubsidiary companies 4.2 3.8 3.3 Foreign income subject to foreign taxes in excess of U.S. statutory tax rate 7.4 11.6 10.4 Decrease in deferred tax asset valuation allowance (3.1) (.4) - Other (.4) (.9) 1.5 ----- ----- ----- 38.9% 43.2% 45.0% ===== ===== ===== C-17 CALTEX GROUP OF COMPANIES NOTES TO COMBINED FINANCIAL STATEMENTS (11) TAXES - Continued Deferred income taxes are provided for the temporary differences between the financial reporting basis and the tax basis of assets and liabilities. Temporary differences and tax loss carryforwards which give rise to deferred tax assets and liabilities at December 31, 1993 and 1992 are as follows (in millions): Deferred Deferred Tax Assets Tax Liabilities --------------- -------------- 1993 1992 1993 1992 ---- ---- ---- ---- Inventory $ 10 $ 27 $ 18 $ 17 Depreciation - - 298 275 Retirement plans 33 28 3 2 Tax loss carryforwards 29 36 - - Other 28 30 34 30 ---- ---- ---- ---- 100 121 353 324 Valuation allowance (6) (42) - - ---- ---- ---- ---- Total deferred taxes $ 94 $ 79 $353 $324 ==== ==== ==== ==== The valuation allowance has been established to record deferred tax assets at amounts where recoverability is more likely than not. Net income was increased by $36 million and $5 million for changes in the deferred tax asset valuation allowance during 1993 and 1992, respectively. Undistributed earnings for which no deferred income tax provision has been made approximated $3.6 billion at December 31, 1993. Such earnings have been or are intended to be indefinitely reinvested. These earnings would become taxable in the U.S. only upon remittance as dividends. It is not practical to estimate the amount of tax that might be payable on the eventual remittance of such earnings. On remittance, certain foreign countries impose withholding taxes which, subject to certain limitations, are then available for use as tax credits against a U.S. tax liability, if any. (12) CASH FLOWS For purposes of the statement of cash flows, all highly liquid debt instruments with original maturities of three months or less are considered cash equivalents. The "Changes in Operating Working Capital" consists of the following (in millions): 1993 1992 1991 ---- ---- ---- Notes and accounts receivable $ 82 $(45) $418 Inventories 66 (114) 62 Accounts payable (147) 212 (317) Accrued liabilities 16 (27) (2) Estimated income taxes 14 (84) (34) ---- ---- ---- Total $ 31 $(58) $127 ==== ==== ==== C-18 CALTEX GROUP OF COMPANIES NOTES TO COMBINED FINANCIAL STATEMENTS (12) CASH FLOWS - Continued "Net Cash Provided by Operating Activities" includes the following cash payments for interest and income taxes (in millions): 1993 1992 1991 ---- ---- ---- Interest paid (net of capitalized interest) $ 92 $106 $132 Income taxes paid $391 $528 $662 In 1991, an asset sale was funded with receivables of $120 million, which were subsequently collected in 1992. No other significant non-cash investing or financing transactions occurred in 1993, 1992 or 1991. (13) INVESTMENTS IN DEBT AND EQUITY SECURITIES In May 1993, the Financial Accounting Standards Board issued SFAS No. 115 "Accounting For Certain Investments in Debt and Equity Securities." This new standard requires companies, no later than 1994, to classify debt and equity securities into one of three categories: held-to-maturity, available-for-sale, or trading. Debt which will be held to maturity will be carried at amortized cost. Certain securities considered available-for-sale shall be carried at fair value and unrealized holding gains and losses shall be carried as a net amount in a separate component of stockholders' equity until realized. Securities classified as trading shall be carried at fair value and unrealized holding gains and losses shall be included in earnings. Adoption of this new standard will not materially impact the combined financial position or the results of operations of the Group. (14) OIL AND GAS EXPLORATION, DEVELOPMENT AND PRODUCING ACTIVITIES The financial statements of Chevron Corporation and Texaco Inc. contain required supplementary information on oil and gas producing activities, including disclosures on equity affiliates. Accordingly, such disclosures are not presented herein. C-19 CALTEX GROUP OF COMPANIES SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (MILLIONS OF DOLLARS) OTHER BALANCE AT ADDI- RETIRE- CHANGES BALANCE BEGINNING TIONS MENTS ADD AT END CLASSIFICATION OF PERIOD AT COST OR SALES (DEDUCT) OF PERIOD - ------------------------------------------------------------------------------- Year ended December 31, 1993 Producing $2,783 $247 $ 3 $ - $3,027 Refining 1,259 237 6 (7) (1) 1,483 Marketing 2,107 262 108 (9) (2) 2,252 Marine 35 - - - 35 Capitalized leases 113 8 2 - 119 ------ ---- ---- ---- ------ Total $6,297 $754 $119 $(16) $6,916 ====== ==== ==== ==== ====== Year ended December 31, 1992 Producing $2,462 $322 $ 1 $ - $2,783 Refining 1,111 166 18 - 1,259 Marketing 1,915 253 46 (15) (3) 2,107 Marine 55 - 20 - 35 Capitalized leases 113 - - - 113 ------ ---- ---- ---- ------ Total $5,656 $741 $ 85 $(15) $6,297 ====== ==== ==== ==== ====== Year ended December 31, 1991 Producing $2,179 $284 $ 1 $ - $2,462 Refining 1,008 105 2 - 1,111 Marketing 1,689 243 39 22 (1) 1,915 Marine 54 1 - - 55 Capitalized leases 111 3 1 - 113 ------ ---- ---- ---- ------ Total $5,041 $636 $ 43 $ 22 $5,656 ====== ==== ==== ==== ====== (1) Reclassification (2) Currency translation adjustment $(4) and reclassification $(5) (3) Currency translation adjustment C-20 CALTEX GROUP OF COMPANIES SCHEDULE VI - ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (MILLIONS OF DOLLARS) ADDITIONS OTHER BALANCE AT CHARGED TO RETIRE- CHANGES BALANCE BEGINNING COSTS AND MENTS ADD AT END CLASSIFICATION OF PERIOD EXPENSES OR SALES (DEDUCT) OF PERIOD - ------------------------------------------------------------------------------- Year ended December 31, 1993 Producing $1,158 $128 $ 1 $ - $1,285 Refining 646 51 6 (2) (1) 689 Marketing 736 104 32 (2) (2) 806 Marine 7 2 - - 9 Capitalized leases 81 10 2 - 89 ------ ---- --- ---- ------ Total $2,628 $295 $41 $(4) $2,878 ====== ==== === ==== ====== Year ended December 31, 1992 Producing $1,051 $106 $(1) $ - $1,158 Refining 614 47 15 - 646 Marketing 672 98 25 (9) (3) 736 Marine 23 2 18 - 7 Capitalized leases 73 10 2 - 81 ------ ---- --- ---- ------ Total $2,433 $263 $59 $(9) $2,628 ====== ==== === ==== ====== Year ended December 31, 1991 Producing $ 940 $111 $ - $ - $1,051 Refining 567 49 2 - 614 Marketing 609 85 22 - 672 Marine 21 2 - - 23 Capitalized leases 64 10 1 - 73 ------ ---- --- ---- ------ Total $2,201 $257 $25 $ - $2,433 ====== ==== === ==== ====== (1) Reclassification (2) Currency translation adjustment $(1) and reclassification $(1) (3) Currency translation adjustment C-21

103392_1993.txt

103392_1993

1993

103392

ITEM 1. BUSINESS ----------------- (a) General Development of Business ------------------------------- Continental Can Company, Inc. (the Company) is a publicly traded company incorporated in Delaware in 1970 under the name Viatech, Inc. The name of the Company was changed to Continental Can Company, Inc. in October 1992. The Company is engaged in the packaging business through a number of consolidated operating subsidiaries. The Company's packaging business consists of (i) its 50%-owned domestic subsidiary, Plastic Containers, Inc. (PCI), which owns Continental Plastic Containers, Inc. and Continental Caribbean Containers, Inc. (collectively, CPC), (ii) its wholly owned German operating subsidiary, Dixie Union Verpackungen GmbH (Dixie Union) and (iii) its majority-owned European operating subsidiaries, Ferembal S.A. (Ferembal), which in turn owns 51% of Obalex, A.S. (Obalex), Onena Bolsas de Papel, S.A. (Onena) and Industrias Gomariz, S.A. (Ingosa). PCI is a leading manufacturer of extrusion blow-molded containers in the United States. Ferembal is a manufacturer of rigid packaging, primarily food cans, of which it is the second largest supplier in France. Obalex is a manufacturer of metal cans in the Czech Republic. Dixie Union manufactures plastic films and packaging machines, primarily for the food and pharmaceutical industries. Onena manufactures film, and Onena and Ingosa laminate and print plastic, paper and foil packaging materials for the food and snack food industries in Spain. The Company also owns Lockwood, Kessler & Bartlett, Inc. (LKB) which provides services principally in the fields of mapping and survey, civil and structural engineering, mechanical and electrical engineering, and construction administration and inspection. (b) Financial Information About Industry Segments --------------------------------------------- The Company has one reportable industry segment - packaging, as determined in accordance with the Financial Accounting Standards Board Statement of Financial Accounting Standards No. 13. (c) Narrative Description of Business --------------------------------- The Company manufactures packaging which accounted for 97.5%, 97.3%, and 95.8% of its consolidated revenues in 1993, 1992 and 1991, respectively. CPC - The Company's 50%-owned subsidiary, PCI, acquired CPC in --- November 1991. CPC, headquartered in Norwalk, Connecticut, has fourteen manufacturing plants in the continental United States and one in Puerto Rico. CPC is a leader in the development, manufacture and sale of a wide range of extrusion blow-molded plastic containers for household chemicals, food and beverages, automotive products and motor oil, industrial and agricultural chemicals and cosmetics and toiletries. CPC manufactures single and multi- layer containers, primarily from high density polyethylene and polypropylene resins, ranging in size from two ounces to five gallons. Some of these multi- layer containers include a barrier layer of ethyl vinyl alcohol which renders the container oxygen tight and makes it suitable for use in food products which are subject to spoilage or deterioration if exposed to oxygen. CPC sells containers to national consumer products companies, including Clorox Company, Coca-Cola Foods, Colgate-Palmolive Company, Lever Brothers, Mobil Oil Corp., Pennzoil Products Company, Procter & Gamble Company, Quaker Oats Company and Quaker State Oil Refining Corporation. CPC, in many cases, manufactures substantially all of a customer's container requirements for specific product categories or for particular container sizes. CPC has long- standing relationships with most of its customers and has contracts or agreements of two to seven years in duration with customers representing approximately 70% of its dollar sales volume. Ferembal - The Company acquired a 68% interest in Ferembal in the fourth -------- quarter of 1989, increased its interest to 84% in August, 1991 and at December 31, 1993 owned 85% of Ferembal. Ferembal, headquartered in Paris, has five manufacturing plants located in each of the main agricultural regions of France. The Roye plant, located in Picardie, was built in 1964 and expanded substantially in 1968. Its three main divisions include coil cutting, printing and varnishing; the manufacture of ends and bodies; and assembly. There are five welded lines in operation at Roye and all industrial products are manufactured at this plant. The Moelan plant, located in Brittany, is set up along similar lines as the Roye plant with five welded lines. The Ludres plant, in eastern France, is Ferembal's largest facility. In addition to twelve presses and two easy-open end manufacturing units, Ludres has nine body assembly lines. Ferembal's research and development and technical service departments are also located at Ludres. The Veauche plant was built in 1982 to service southern France. Approximately 50% of the output of the two welded lines is "passed through the wall" to a customer for the canning of pet food. The Ville Neuve sur Lot plant was built in 1991 and went into production with a three piece can line in early 1992. A two piece can line went into production at this facility in mid-1992. Ferembal is the second largest producer of food cans in France and also produces cans for pet foods and industrial products. Ferembal's products include three piece cans for food with over two hundred sets of specifications, two piece cans in several different diameters, easy open ends, stylized and "hi-white enamel" cans, and a large number of can products for industrial end uses. Ferembal's production for the food and pet food markets accounts for approximately 80% of its sales with remaining sales coming from cans produced for industrial products. Ferembal's customers are primarily vegetable and prepared food processors, pet food processors, and paint and other industrial can users. Obalex - The Company, through Ferembal, owns 51% of the outstanding stock ------ of Obalex. Obalex is headquartered in a three building complex on a 5 acre site in Znojmo, Czech Republic, which also serves as its sole manufacturing facility. Obalex manufacturers both two and three piece cans for food which account for approximately 80% of its sales and a number of can products for industrial end users. Dixie Union - The Company, through its wholly owned subsidiary, Viatech ----------- Holding GmbH, owns all of the outstanding stock of Dixie Union. Dixie Union is headquartered in Kempten, Germany and has subsidiary companies in France and the United Kingdom, which function as a sales, distribution and customer service network. Dixie Union manufactures three main product lines for the packaging industry: multi-layer shrink bags, composite plastic films and packaging machines and slicers. Most of Dixie Union's customers are in the food and pharmaceutical industries. Onena - The Company owns 80% of the stock of Onena located in Pamplona, ----- Spain. Onena manufactures plastic film and prints and laminates paper, plastic and foil packaging material for the food and snack food industries in Spain. Ingosa - The Company owns 99.97% of the stock of Ingosa located in ------ Pamplona, Spain. Ingosa prints and laminates paper, plastic and foil packaging material for the food and snack food industries in Spain. During 1994 the Company intends to merge Onena and Ingosa and locate all of their operations at Ingosa's current manufacturing facility. See Note 2(a) of the Notes to the Consolidated Financial Statements. LKB - The Company owns 100% of LKB, a consulting engineering firm, --- located in Syosset, New York. LKB provides services to clients in the fields of transportation, site, municipal, electrical and mechanical, and environmental engineering. Most of LKB's clients are public sector state and municipal agencies, utilities, financial institutions and developers. Most of its projects involve infra-structure design and rehabilitation, environmental reports and services, and utility substation design. Other Matters - The primary users of products manufactured by the ------------- Company are firms in the food and snack food, pet food, household chemical, motor oil and pharmaceutical industries. The raw materials used in the production of plastic containers, cans and packaging films are readily available commodity materials and chemicals produced by a large number of manufacturers. It is the practice of the Company to obtain these raw materials from several sources in order to ensure an economical, adequate and timely supply. Some of the products manufactured by the Company are manufactured pursuant to license. With regard to composite films, a fully paid up license from the American National Can Company is in effect. With regard to shrink bags and film, a license from the American National Can Company is in effect. Present patents under this license expire at various times through 2000. The license will expire on the date the last of the licensed patents expire. This license is non-exclusive as to manufacture and sale of shrink bags and film in Europe and non-exclusive as to sales to the rest of the world. Sales may not be made in the Western Hemisphere. The Company does not believe these licenses are material to its packaging business taken as a whole. The Company's business is seasonal insofar as the sales of Ferembal and Obalex to the vegetable packaging industry is dependent on agricultural production and occurs primarily in the second and third quarters. The Company's remaining products are not seasonal. The Company is not dependent upon a single customer or a few customers. Sales to no single customer exceeded 10% of the Company's consolidated revenues in 1993. As of December 31, 1993, the Company's backlog was approximately $19,868,000 (compared to $19,149,000, at December 31, 1992). All backlog is expected to be filled within the current fiscal year. Ferembal, Obalex, and Plastic Containers, Inc. produce most of their products under open orders. As a result, none of the foregoing backlog is attributable to them. The Company's business in total is highly competitive with a large number of competitors. The main competitors include Owens Illinois, Inc. and Graham Packaging with regard to plastic containers, CMB Packaging with regard to cans, W. R. Grace & Co. with regard to barrier shrink films, and Multi-Vac with regard to packaging machinery. The principal methods of competition are price, quality and service. The amount spent on research and development activities amounted to approximately $12,862,000 in 1993, $14,603,000 in 1992, and $4,194,000 in 1991. The number of persons employed by the Company as of December 31, 1993 and 1992 was 3,712 and 3,182, respectively. (d) Foreign and Domestic Operations ------------------------------- Sales to unaffiliated customers are set out below: Information regarding the operating profit and the identifiable assets attributable to the Company's foreign operations is incorporated herein by reference to Note 16 of the Consolidated Financial Statements appearing in the Annual Report to Stockholders for the year ended December 31, 1993. ITEM 2. ITEM 2. PROPERTIES ------------------- The Company believes its facilities are suitable, adequate, and properly sized to provide the capacity necessary to meet its sales. The Company's production facilities are utilized for the manufacture and storage of the Company's products. The extent of utilization in each of the Company's facilities varies based on a number of factors but primarily on sales and inventory levels for specific products. The location of the customer also affects utilization since shipment costs beyond a certain distance can make production of some products at a remote facility uneconomic. Seasonality affects utilization substantially at Ferembal and Obalex with very high utilization in the pre-harvest and harvest season and substantially lower utilization during the late fall and winter. The Company adjusts labor levels and capital investment at each of its facilities in order to optimize their utilization. The Company's general corporate offices and the main production facility for LKB are located in Syosset, New York in a 25,000 square foot building owned by the Company. This steel and concrete block building was constructed in 1955 on a 2-1/2 acre lot. CPC is headquartered in 10,415 square feet of leased office space in Norwalk, Connecticut. CPC also leases its technical center in Elk Grove, Illinois (78,840 sq. ft.) and sales offices in Montvale, New Jersey (2,042 sq. ft.), Cincinnati, Ohio (1,266 sq. ft.), Houston, Texas (703 sq. ft.) and Des Plaines, Illinois (1,655 sq. ft.). The following table sets forth the location and square footage of CPC's production facilities which are used for both manufacture and warehousing of finished goods: CPC owns the plants in Santa Ana, Fairfield, Oil City, Baltimore and Puerto Rico; all others are leased. Ferembal is headquartered in 20,000 square feet of office space subject to a capital lease in Clichy, a suburb of Paris. Ferembal operates five manufacturing facilities in five locations in France. Ferembal owns a 384,000 square foot manufacturing facility on a 21 acre site in Roye for the production of food and industrial cans. Ferembal owns a 42,000 square foot manufacturing facility for the production of food cans at Veauche on a 5 acre site. The facility at Veauche is located next to a customer's plant and food can production is "passed through the wall" to the customer. Ferembal has a capital lease with regard to several buildings totaling 229,000 square feet on a 23 acre site in Ludres. In addition, Ferembal owns a 29,000 square foot building on a 3 acre site. These facilities are used for the manufacture of food cans and for research and development activities. Ferembal has a capital lease with regard to several buildings totaling 252,000 square feet on an 18 acre site in Moelan which are used for the manufacture of food cans. Ferembal operates a manufacturing facility for food cans in a 42,000 square foot building on a 4 acre site in Villeneuve sur Lot under a rental agreement. Each of the manufacturing facilities utilizes a portion of its building space for warehousing its finished goods. Obalex is located in several buildings with approximately 182,000 square feet on an 8.4 acre site in Znojmo, Czech Republic. This facility is the sole manufacturing site for Obalex which also uses the complex for the storage of its finished goods. Dixie Union is headquartered in a three-story, 108,000 square foot manufacturing facility on a 5 acre site in Kempten, Germany, leased through 2004. In addition, two small facilities are leased as sales and distribution centers in Milton Keynes, England and Redon, France. Onena is headquartered in a manufacturing facility in Pamplona, Spain consisting of several owned buildings encompassing 89,200 square feet on a 3.7 acre site. Ingosa owns two buildings totaling 358,000 square feet located on a 3.5 acre site in Pamplona, Spain, which also serve as its headquarters, manufacturing and warehousing facility. The Company intends to merge the operations of Ingosa and Onena in 1994 and it is expected that Ingosa's manufacturing facility will be expanded by approximately 96,000 square feet at a cost of approximately $1 million during 1994. After the merger the Company intends to sell Onena's facility. ITEM 3. ITEM 3. LEGAL PROCEEDINGS -------------------------- The Company's subsidiaries are defendants in a number of actions which arose in the normal course of business. In the opinion of management, the eventual outcome of these actions will not have a significant effect on the Company's financial position. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS ------------------------------------------------------------ On November 29, 1993 a Special Meeting of Stockholders was held to consider a proposal to approve the possible issuance of 887,500 shares of the Company's Common Stock to Merrywood, Inc. pursuant to an Agreement dated September 10, 1992, as amended, among the Company, Plastic Containers, Inc., Merrywood Inc., and Plaza, Inc. Such proposal was approved by a vote of 1,321,713 shares (86%) cast in favor, 84,390 shares (5%) cast against and 126,754 shares (9%) abstaining. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER -------------------------------------------------------------------------- MATTERS ------- The information required by this item is incorporated herein by reference to the section entitled "Common Stock Prices and Related Matters" of the Annual Report to Stockholders for the year ended December 31, 1993. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA(1) ----------------------------------- (1) In thousands, except per share amounts and current ratio. (2) In 1993, includes sales of $10,682 and net income of $238 related to the purchase of Obalex. In 1991, includes sales of $17,030 and a net loss of $1,045 related to the purchase of PCI. In 1989, includes sales of $34,538 and net income of $150 related to the purchase of Ferembal. (3) Includes income for the cumulative effect of accounting change of $460 ($.15 per share primary and $.14 per share fully-diluted) and an extraordinary charge of $1,502 ($.49 per share primary and $.44 per share fully-diluted) in 1992. Includes income for an extraordinary item of $22 ($.01 per share both primary and fully-diluted), and $127 ($.10 per share primary and $.08 per share fully-diluted) in 1990 and 1989, respectively. (4) The 1991 weighted average shares outstanding include 1,020 shares and 255 warrants to purchase shares sold in June 1991 for net proceeds of $29,453. The 1990 weighted average shares outstanding include 460 shares sold in January 1990 for net proceeds of $6,756. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND ------------------------------------------------------------------------ RESULTS OF OPERATIONS --------------------- The information required by this item is incorporated herein by reference to the section entitled "Management's Discussion and Analysis of Financial Condition and Results of Operations" in the Annual Report to Stockholders for the year ended December 31, 1993. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA ---------------------------------------------------- The information required by this item is incorporated by reference to the Company's consolidated financial statements and related notes, together with the independent auditors' report in the Annual Report to Stockholders for the year ended December 31, 1993. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND ------------------------------------------------------------------------ FINANCIAL DISCLOSURE -------------------- There have been no changes in nor disagreements with the Company's accountants on accounting and financial disclosure during the twenty-four month period ended December 31, 1993. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT ----------------------------------------------------------- The information required by this item, with respect to directors of the registrant, will be included under the caption "Election of Directors" of a definitive Proxy Statement to be dated March 28, 1994 which will be filed with the Commission pursuant to Regulation 14A and is hereby incorporated into this report by this reference. Executive officers of the registrant include Messrs. Donald J. Bainton and Abdo Yazgi who are also directors of the registrant and for whom information required by this item is included in the Proxy Statement as previously mentioned. Information for other executive officers, is as follows: (1) The term of office of all executive officers is indefinite, at the pleasure of the Board of Directors. The business experience of each executive officer is as follows: Mr. Andreas has served as Vice President of Manufacturing since April 1992. Prior to that time, he was an independent business consultant. Prior to his retirement in 1988, Mr. Andreas was employed by the former Continental Can Company, Inc. for 33 years, most recently as General Manager. Mr. L'Hommedieu has served as Treasurer or Assistant Treasurer of the Company and its subsidiary, Lockwood, Kessler & Bartlett, Inc., since 1963. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION -------------------------------- The information required by this item is included under the caption "Executive Compensation" of a definitive Proxy Statement to be dated March 28, 1994 which will be filed with the Commission pursuant to Regulation 14A and is hereby incorporated into this report by this reference. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT ----------------------------------------------------------------------- The information required by this item is included under the caption "Stock Ownership" of a definitive Proxy Statement to be dated March 28, 1994 which will be filed with the Commission pursuant to Regulation 14A and is hereby incorporated into this report by this reference. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS ------------------------------------------------------- The information required by this item is included under the caption "Transactions with Management" of a definitive Proxy Statement to be dated March 28, 1994 which will be filed with the Commission pursuant to Regulation 14A and is hereby incorporated into this report by this reference. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K -------------------------------------------------------------------------- (a) 1. Financial Statements: Consolidated Balance Sheets as of December 31, 1993 and 1992 Consolidated Statements of Earnings for the years ended December 31, 1993, 1992, and 1991 Consolidated Statements of Stockholders' Equity 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 Notes to Consolidated Financial Statements for the years ended December 31, 1993, 1992 and 1991 Independent Auditors' Report The above financial statements are included under Item 8 of Part II of this report. 2. Financial Statement Schedules: See index to financial statement schedules for Continental Can Company, Inc. and subsidiaries on page 11. * Management contract or compensatory plan or arrangement. (1) These documents have been previously filed with the Commission as Exhibits to 1992 Quarterly Reports on Form 10-Q for Plastic Containers, Inc. (2) These documents have previously been filed with the Commission as Exhibits to 1993 Quarterly Reports on Form 10-Q for Continental Can Company, Inc. All other items for which provision is made in the applicable regulations of the Securities and Exchange Commission have been omitted as they are not required under the related instructions or they are inapplicable. (b) Reports on Form 8-K 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. CONTINENTAL CAN COMPANY, INC. By: /s/ Abdo Yazgi Date: March 18, 1994 ------------------------------------------ -------------- Abdo Yazgi, Executive Vice President (Principal Financial & 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. /s/ Donald J. Bainton Date: March 18, 1994 ------------------------------------------ -------------- Donald J. Bainton, Chairman of the Board of Directors and Chief Executive Officer (Principal Executive Officer) Date: ------------------------------------------ -------------- Kenneth Bainton, Director /s/ Robert L.. Bainton Date: March 18, 1994 ------------------------------------------ -------------- Robert L. Bainton, Director /s/ Nils E. Benson Date: March 18, 1994 ------------------------------------------ -------------- Nils E. Benson, Director /s/ Rainer N. Greeven Date: March 18, 1994 ------------------------------------------ -------------- Rainer N. Greeven, Director /s/ Ronald H. Hoenig Date: March 18, 1994 ------------------------------------------ -------------- Ronald H. Hoenig, Director /s/ Ferdinand W. Metternich Date: March 18, 1994 ------------------------------------------ -------------- Ferdinand W. Metternich, Director /s/ Charles M. Marquardt Date: March 18, 1994 ------------------------------------------ -------------- Charles M. Marquardt, Director Date: ------------------------------------------ -------------- Donald F. Othmer, Director /s/ V. Henry O'Neill Date: March 18, 1994 ------------------------------------------ -------------- V. Henry O'Neill, Director /s/ John J. Serrell Date: March 18, 1994 ------------------------------------------ -------------- John J. Serrell, Director /s/ Robert A. Utting Date: March 18, 1994 ------------------------------------------ -------------- Robert A. Utting, Director /s/ Abdo Yazgi Date: March 18, 1994 ------------------------------------------ -------------- Abdo Yazgi, Director /s/ Cayo Zapata Date: March 18, 1994 ------------------------------------------ -------------- Cayo Zapata, Director /s/ Jose Luis Zapata Date: March 18, 1994 ------------------------------------------ -------------- Jose Luis Zapata, Director Index to Financial Statement Schedules for Continental Can Company, Inc. and Subsidiaries Years ended December 31, 1993, 1992 and 1991 Subsidiaries of the Registrant Page 12 Independent Auditors' Report on Schedules Page 13 Consent of Independent Auditors Page 14 FINANCIAL STATEMENT SCHEDULES: ----------------------------- II - Amounts Receivable from Related Parties and Underwriters, Promoters, and Employees other than Related Parties Page 15 III - Condensed Financial Information of Registrant Page 16 V - Property, Plant and Equipment Page 18 VI - Accumulated Depreciation and Amortization of Property, Plant and Equipment Page 19 VIII - Allowance for Doubtful Accounts Page 19 IX - Short-Term Borrowings Page 20 X - Supplementary Income Statement Information Page 20 All other schedules are omitted because they are not applicable, not required, or the information is given in the financial statements or the notes thereto. EXHIBITS ATTACHED: - - ----------------- 1993 Annual Report to Stockholders Page 21 (22) Subsidiaries of the Registrant The following listed companies represent the significant subsidiaries of the Company, all of which are included in the Company's consolidated financial statements: (1) Subsidiary of Ferembal (2) Subsidiary of Viatech Holding GmbH (3) Subsidiary of Plastic Containers, Inc. * The Company, pursuant to a proxy, has voting rights over 51% of the shares of Plastic Containers, Inc. INDEPENDENT AUDITORS' REPORT ON SCHEDULES ----------------------------------------- The Board of Directors and Stockholders Continental Can Company, Inc.: Under date of March 9, 1994, we reported on the consolidated balance sheets of Continental Can Company, Inc. 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 years in the three-year period ended December 31, 1993, as contained in the 1993 Annual Report to Stockholders. In connection with our audits of the aforementioned consolidated financial statements, we also audited the related consolidated financial statement schedules as listed in the accompanying index. 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 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 1 (h) and 13 and notes 1 (d) and 10 to the consolidated financial statements, the Company adopted the provisions of Financial Accounting Standards Nos. 106, "Employer's Accounting for Post-Retirement Benefits Other Than Pensions" and 109, "Accounting for Income Taxes", respectively, on a prospective basis in 1992. /s/ KPMG PEAT MARWICK Jericho, New York March 9, 1994 CONSENT OF INDEPENDENT AUDITORS ------------------------------- The Board of Directors Continental Can Company, Inc.: We consent to incorporation by reference in the Registration Statements Nos. 33-7783, 33-37163, 33-37164 and 33-37165 on Form S-8 of Viatech, Inc. (now known as Continental Can Company, Inc.) of our reports dated March 9, 1994 relating to the consolidated balance sheets of Continental Can Company, Inc. and subsidiaries as of December 31, 1993 and 1992, and the consolidated statements of earnings, stockholders' equity and cash flows and related schedules for each of the years in the three year period ended December 31, 1993, which reports are either incorporated by reference or appear in the December 31, 1993 Annual Report on Form 10-K of Continental Can Company, Inc. As discussed in notes 1 (h) and 13 and notes 1 (d) and 10 to the consolidated financial statements, the Company adopted the provisions of Financial Accounting Standards Nos. 106, "Employer's Accounting for Post-Retirement Benefits Other Than Pensions" and 109, "Accounting for Income Taxes", respectively, on a prospective basis in 1992. /s/ KPMG PEAT MARWICK Jericho, New York March 21, 1994 Continental Can Company, Inc. and Subsidiaries Schedule II - Amounts Receivable from Related Parties and Underwriters, Promoters, and Employees other than Related Parties Years ended December 31, 1993, 1992 and 1991 All balances shown reflect loans by the Company to Mr. Donald J. Bainton, Chairman of the Board and Chief Executive Officer. Schedule III - Condensed Financial Information of Registrant Continental Can Company, Inc. Balance Sheets Years Ended December 31, 1993 and 1992 (in thousands) (a) See Note 9, Items (a) and (b) of Notes to Consolidated Financial Statements of Continental Can Company, Inc. and Subsidiaries. At December 31, 1993, current liabilities include $1,164 of Convertible Subordinated Debentures due in 1994. Continental Can Company, Inc. Statements of Earnings Years Ended December 31, 1993, 1992 and 1991 Schedule III - Condensed Financial Information of Registrant (Continued) Continental Can Company, Inc. Statements of Cash Flows Years Ended December 31, 1993, 1992 and 1991 Continental Can Company, Inc. and Subsidiaries Schedule V - Property, Plant and Equipment Years Ended December 31, 1993, 1992 and 1991 Continental Can Company, Inc. and Subsidiaries Schedule VI - Accumulated Depreciation and Amortization of Property, Plant and Equipment Years Ended December 31, 1993, 1992 and 1991 Continental Can Company, Inc. and Subsidiaries Schedule VIII - Allowance for Doubtful Accounts Years Ended December 31, 1993, 1992 and 1991 (1) Represents uncollectible accounts written-off. (2) Represents $1,411 from the consolidation of acquired subsidiary in 1991. (3) Represents $418 from the consolidation of acquired subsidiary in 1993. Continental Can Company, Inc. and Subsidiaries Schedule IX - Short-Term Borrowings Years ended December 31, 1993, 1992 and 1991 Amounts payable to banks for short term borrowings: Continental Can Company, Inc. and Subsidiaries Schedule X - Supplementary Income Statement Information Years ended December 31, 1993, 1992 and 1991 CONTINENTAL CAN COMPANY, INC. 1993 ANNUAL REPORT CORPORATE PROFILE Continental Can Company, Inc., through its subsidiaries, manufactures extrusion blow-molded plastic containers, metal cans, films and equipment for the packaging industry, and prints and laminates flexible packaging for the food and snack food industries. The Company also owns Lockwood, Kessler & Bartlett, Inc., an engineering firm located in the United States. REPORT TO STOCKHOLDERS: - - ----------------------- Last year was a challenging one for our company. European economies failed to emerge from their recessionary slump which had a negative impact on the sales and profitability of our subsidiaries in Europe. Since most of our sales are generated in Europe, the ongoing recession had a significant impact. Due to high levels of inventory, several of Ferembal's vegetable-can customers shuttered their packing plants for the season, thereby reducing orders for food cans. Finally, the dollar strengthened against European currencies throughout 1993, resulting in a $19.8 million reduction in reported sales due to currency translation rate differences. To partially offset the declines resulting from sluggish European economies, cost-cutting measures were implemented at each of our European subsidiaries. These actions served to reduce somewhat the negative impact of the recession. In addition, this cost-cutting program has placed our Company in a good position to increase profitability when the European economic situation improves. On the domestic side the performance of Plastic Containers, Inc., (PCI) improved with an increase in sales and an improvement in overall results. In 1993, sales rose by $6.3 million over 1992. This improvement was a result of the renewed sales and marketing efforts which began in 1992 and are continuing. These marketing efforts were coupled with a detailed examination of our manufacturing operations which has enabled us to respond quickly to changing customer demands. This is a crucial component in our ability to introduce new products quickly, keep up with our increasing sales volume, and to provide "just-in-time" delivery to our customers. Because we believe that carefully chosen acquisitions are of vital strategic importance to the growth of our Company, we have continued to acquire those companies that can increase our sales and profitability. In 1993, we increased our stake in Obalex, A.S., our Czech can manufacturer in which we had purchased a 34% interest at the end of 1992. Obalex had sales of $10.7 million and net income of approximately $677,000 which added $238,000 in net income to our 1993 consolidated results. In addition to the increased position in Obalex, we acquired Industrias Gomariz S.A. (Ingosa) for a nominal consideration in late 1993. Like Onena, Ingosa is located in Pamplona, Spain, and is a flexible packaging manufacturer. Because both companies share similar products and markets, we intend to merge these companies into one operating entity in 1994. Once these companies are merged, we anticipate a boost in sales and an enhancement of profitability. Our agreement with the Spanish provincial government to exchange amounts due it by Ingosa for a portion of the equity of the merged entity, and other favorable terms of that agreement, significantly strengthens the financial condition of the new firm. The formation of this new entity will allow us to expand our current markets and to weather more easily the difficult economic conditions which continue in Spain. In 1993, our cash flow remained strong, enabling our Company to reduce debt while continuing to invest in machinery and equipment to expand our manufacturing capacity, capability, and efficiency. In 1994, we look forward to increases in our sales, profitability, and cash flow. We believe that European economies will improve somewhat during the coming year. Foreign currency rates, while potentially still negative, are not expected to be a major factor in our reported results in 1994. Given the swings between the dollar and European currencies, PCI's improving performance is an important factor both for the Company's revenues and for its long-term growth and profitability. For 1994 and beyond, we expect PCI to continue to build on the base it has established, to increase its sales, and to improve its operating results. During the ten rewarding years that I have been Chairman and CEO of Continental Can Company, Inc. (formerly Viatech, Inc.), our Company has enjoyed tremendous growth and success by nearly every financial measure. However, change is inevitable and growth essential, especially in today's marketplace. We are committed to continuing our growth internally and through acquisitions, so that the next ten years will prove to be as successful and rewarding as the last ten years have been. Donald J. Bainton Chairman & Chief Executive Officer March 18, 1994 DESCRIPTION OF BUSINESS Continental Can Company, Inc. is a holding company primarily engaged in the packaging business through a number of consolidated operating subsidiaries. The Company's packaging business consists of its 50%-owned domestic subsidiary, Plastic Containers, Inc. (PCI), which owns Continental Plastic Containers, Inc. and Continental Caribbean Containers, Inc. (collectively, CPC), which is a leading manufacturer of extrusion blow-molded containers in the United States. Its wholly-owned German operating subsidiary is Dixie Union Verpackungen GmbH (Dixie Union) and its majority-owned European operating subsidiaries are Ferembal S.A. (Ferembal), Obalex A.S. (Obalex), Onena Bolsas de Papel, S.A. (Onena) and Industrias Gomariz, S.A. (Ingosa). Ferembal is a manufacturer of rigid packaging, primarily food cans, of which it is the second largest supplier in France. Obalex also manufactures rigid packaging, primarily food cans, in the Czech Republic. Dixie Union manufactures plastic films and packaging machines, primarily for the food and pharmaceutical industries. Onena manufactures film, and Onena and Ingosa laminate and print plastic, paper and foil packaging materials for the food and snack food industries primarily in Spain. The Company also owns Lockwood, Kessler & Bartlett, Inc. (LKB) which provides services principally in the northeastern United States in the fields of survey, civil, environmental and structural engineering, mechanical and electrical engineering, and construction administration and inspection. CPC - The Company's 50%-owned subsidiary, PCI, acquired CPC in November --- 1991. CPC, headquartered in Norwalk, Connecticut, develops, manufactures and sells a wide range of extrusion blow-molded plastic containers through its national network of fifteen manufacturing plants (including one in Puerto Rico). CPC supplies containers for household chemicals, food and beverages, automotive products and motor oil, industrial and agricultural chemicals and cosmetics and toiletries. CPC produces both single and multi-layer containers, manufactured primarily from high density polyethylene and polypropylene resins, ranging in size from two ounces to five gallons. Some of these multi-layer containers include a barrier layer to protect food products which are subject to spoilage or deterioration if exposed to oxygen. Besides being fully recyclable, in many instances, these containers can be, and are, produced using a significant amount of post-consumer recycled plastic. Its customers include some of the largest consumer products companies in the United States, such as Clorox Company, Coca- Cola Foods, Colgate-Palmolive Company, Mobil Oil Corporation, Pennzoil Products Company, Procter & Gamble Company, Quaker Oats Company and Quaker State Oil Refining Corporation. CPC, in many cases, manufactures substantially all of a customer's container requirements for specific product categories or for particular container sizes. CPC has long-standing relationships with most of its customers and has long-term contracts with customers representing approximately 70% of its dollar sales volume. FEREMBAL - The Company owns an 85% interest in Ferembal, the second -------- largest food can manufacturer in France and the fourth largest in Europe. Ferembal, headquartered in Paris, has five manufacturing plants located in each of the main agricultural regions of France. The most recent plant was built in 1991 and went into full production with both two and three-piece can lines by mid-1992. Besides food cans for such products as vegetables, mushrooms, fruits, prepared meals and pet foods, Ferembal also manufactures cans for industrial products such as paint, automotive products and motor oil. Ferembal's products include both two and three-piece cans for food, easy-open ends, stylized and "hi-white enamel" cans, and a large number of can products for industrial end uses, all in a number of different diameters. Ferembal's production for the food and pet food markets accounts for approximately 80% of its sales with remaining sales coming from cans produced for industrial products. Ferembal's customers include many leading French and European vegetable and prepared food processors, pet food processors, and paint and other industrial can users. OBALEX - The Company, through Ferembal, owns 51% of the outstanding stock ------ of Obalex. Obalex, located in the Czech Republic, manufacturers both two and three-piece cans for food which account for approximately 80% of its sales and a number of can products for industrial end users. DIXIE UNION - The Company, through its wholly-owned subsidiary, Viatech ----------- Holding GmbH, owns all of the outstanding stock of Dixie Union. Dixie Union is headquartered in Kempten, Germany and has subsidiary companies in France and the United Kingdom, which function as a sales, distribution and customer service network. Dixie Union manufactures three main product lines for the packaging industry: multi-layer shrink bags, composite plastic films and packaging machines and slicers. Dixie Union is one of a few companies in Europe which manufacture both packaging films and packaging equipment. Dixie Union's customers are primarily processors of meats, cheeses, poultry and fish products, although Dixie Union also produces packaging and machinery for suppliers of technical and medical products. Most of Dixie Union's sales are generated in Europe; however, a number of Dixie Union's packaging machines are sold in the United States through an exclusive distributor, and through agents and distributors on a worldwide basis. ONENA AND INGOSA - The Company also owns an 80% interest in Onena and a ---------------- 99.97% interest in Ingosa, which are located in Pamplona, Spain. Onena manufactures plastic film, and Onena and Ingosa laminate and print a variety of paper, foil and plastic film products. Their major customers are primarily in the food and snack food industries in Spain. During 1994, the Company intends to merge Onena and Ingosa and locate all of the operations at Ingosa's current manufacturing facility, which will be expanded. See Note 2(a) of the Notes to the Consolidated Financial Statements. SELECTED FINANCIAL DATA(1) (1) In thousands, except per share amounts and current ratio. (2) In 1993, includes sales of $10,682 and net income of $238 related to the purchase of Obalex. In 1991, includes sales of $17,030 and a net loss of $1,045 related to the purchase of PCI. In 1989, includes sales of $34,538 and net income of $150 related to the purchase of Ferembal. (3) Includes income for the cumulative effect of accounting change of $460 ($.15 per share primary and $.14 per share fully-diluted) and an extraordinary charge of $1,502 ($.49 per share primary and $.44 per share fully-diluted) in 1992. Includes income for an extraordinary item of $22 ($.01 per share both primary and fully-diluted), and $127 ($.10 per share primary and $.08 per share fully-diluted) in 1990 and 1989, respectively. (4) The 1991 weighted average shares outstanding include 1,020 shares and 255 warrants to purchase shares sold in June 1991 for net proceeds of $29,453. The 1990 weighted average shares outstanding include 460 shares sold in January 1990 for net proceeds of $6,756. (5) Earnings before interest, taxes, depreciation and amortization. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS 1993 VS. 1992 Sales declined 5.8% in 1993 to $481,842,000 as compared to $511,241,000 in 1992. The decrease resulted primarily from changes in foreign currency translation rates which reduced reported sales by $19.8 million as compared to the prior year. A reduction in vegetable can sales in France as a result of inventory reductions by Ferembal's customers (approximately $10 million) and an economic recession in Europe accounted for the remainder of the decline. Increased sales at PCI ($6.3 million) and sales of Obalex ($10.7 million) offset a portion of the decline. Management believes that currency translation rate differences and economic weakness in Europe will continue to negatively impact reported sales in 1994, although less severely than in 1993. Backlog amounted to approximately $19,868,000 at December 31, 1993 as compared to $19,149,000 at December 31, 1992. The increase in backlog is not expected to have a material effect on the Company's sales in 1994. Gross profit declined 10% to $87,164,000 as compared to $96,872,000 in 1992. Gross profit margin declined to 18.1% in 1993 from 18.9% in 1992. The decline in gross profit related primarily to the Company's European operations for the reasons noted above. Selling, general and administrative expenses remained at approximately 13% as a percentage of sales in both 1993 and 1992. As a result of these various factors, operating income was $24,871,000 in 1993 and $29,600,000 in 1992 while the operating income margin amounted to 5.2% in 1993 from 5.8% in 1992. Net interest expense declined during 1993 to $22,942,000 from $26,023,000 in 1992 as a result of changes in foreign currency translation rates, lower average outstanding debt balances and lower interest rates primarily in the Company's European operations. The Company's consolidated effective tax rate amounted to approximately 153% in 1993 compared to 87% in 1992. The higher effective tax rate reflects the low level of tax benefits accrued at the Company's loss operations offset by the provision for taxes applicable to the Company's profitable operations. Minority interest in each of 1993 and 1992 reflects the interests of other shareholders in PCI, Ferembal and Onena, and of Obalex in 1993. Net income amounted to $988,000 ($.33 per share) in 1993 as compared to $2,063,000 ($.67 per share) in 1992. Included in net income in 1992 was the cumulative effect of an accounting change relating to the adoption of FASB No. 109 amounting to $460,000 ($.15 per share) and an extraordinary loss related to the write-off of a deferred financing fee of $1,502,000 ($.49 per share). 1992 VS. 1991 Sales increased 65% in 1992 to $511,241,000 as compared to $310,654,000 in 1991. This increase resulted primarily from the acquisition of CPC in November 1991 ($183,712,000 in 1992 and $17,030,000 in 1991) and from an approximately 6% improvement in foreign currency translation rates over the prior year. Sales in 1992 were negatively impacted by a poor harvest in France for some crops because of adverse weather conditions and general economic weakness in both the United States and Europe. Management believes the negative impact of the poor harvest amounted to about $2,000,000 and about $3,000,000 related to weak economies. Gross profit increased by 40% or $27.5 million to $96.9 million in 1992. The increase in gross profit also related to the acquisition of CPC ($28,388,000 in 1992 and $1,568,000 in 1991) and foreign currency translation rates. Gross profit as a percentage of sales declined to 18.9% in 1992 from 22.3% in 1991. The percentage decline relates to a generally lower gross profit margin at CPC than at the Company's other operating subsidiaries primarily because of CPC's substantially higher depreciation charges relating to the write-up of its assets at acquisition. However, the Company's other operations also reported a decline in gross profit margin to 21.6% in 1992 from 23.1% in 1991. Other factors reducing gross profit margins were pricing pressures in the packaging machine business at Dixie Union which is expected to continue so long as Europe remains in a recession, and increased raw material costs at Ferembal which are not expected to continue to increase so long as Europe remains in a recession. Backlog declined approximately $7.9 million from December 31, 1991 to December 31, 1992. Of this amount approximately $1.7 million related to currency translation rates. Economic weakness, primarily in Europe, accounted for approximately $5.8 million while economic weakness in the United States accounted for approximately $.4 million. Approximately 80% of the decline related to Dixie Union with most of the remainder attributable to reduced backlog at Onena. The declining backlog could be expected to result in lower sales at Dixie Union and Onena during the first half of 1993 compared to the same period of 1992. Selling, general and administrative expenses remained at approximately 13% in each of 1992 and 1991. As a result of these factors operating income amounted to $29,600,000 in 1992 as compared to $27,356,000 in 1991. Operating income increased $2,883,000 in 1992 and declined $1,214,000 in 1991 as a result of the acquisition. The operating income margin declined from 8.8% in 1991 to 5.8% in 1992, again primarily resulting from a lower level of the operating income margin at PCI than at the remainder of the Company's operations. However, the operating profit margin in the remainder of the Company's operations also declined from 9.7% in 1991 to 9.0% in 1992. Net interest expense rose substantially in 1992 to $26,023,000. Besides the increase resulting from the acquisition of CPC ($10,095,000 in 1992 and $884,000 in 1991), European interest rates were higher during 1992 than 1991. Additionally, the Company earned substantial interest income during 1991 from the proceeds of a stock offering. Foreign currency exchange losses were also higher in 1992 than 1991 primarily as a result of the devaluation of the pound. The Company's consolidated effective tax rate in 1992 amounted to 87% as compared to 42% in 1991. The higher effective tax rate in 1992 reflects the effect of offsetting relatively low levels of tax benefits to pre-tax losses recognized by CPC against the provision for taxes applicable primarily to Ferembal's pre-tax income. Minority interest in each of 1992 and 1991 reflects the interest of other shareholders in PCI, Ferembal, and Onena, and of Dixie Union in 1991. The change in minority interests results principally because the minority shareholder of PCI absorbed 50% of PCI's losses, which were greater in 1992 than in 1991. Income before cumulative effect of accounting change and extraordinary item amounted to $3,105,000 ($1.01 per share) in 1992 as compared to $7,394,000 ($2.92 per share) in 1991. Cumulative effect of accounting change related to the adoption of FASB No. 109 on January 1, 1992 and amounted to $460,000 ($.15 per share) in 1992. The extraordinary loss related to the write-off of a deferred financing fee from the acquisition of CPC and amounted to $1,502,000 ($.49 per share) in 1992. As a result, net income amounted to $2,063,000 ($.67 per share) in 1992 and $7,394,000 ($2.92 per share) in 1991. FINANCIAL CONDITION Capital Requirements The packaging business utilizes relatively large amounts of specialized machinery and equipment which are periodically upgraded or replaced. Capital expenditures in 1993 amounted to $22,154,000 primarily for the purchase of machinery and equipment. During 1993, major capital expenditures included the purchase of extrusion blow-molding lines and line changes for barrier containers for food products and an easy-open end line for cans. Expenditures in 1994 are expected to amount to approximately $25,500,000 and be similar in character to those in 1993. Approximately $1 million is expected to be spent on a building addition at Ingosa during 1994. During 1993, Ferembal increased its ownership interest in Obalex to 51% through the issuance by Obalex of an additional 17% of its shares for a capital contribution by Ferembal of approximately $3,000,000. See Note 2(b). During 1993 the Company purchased substantially all of the shares of Ingosa for nominal consideration. The Company intends to merge the operations of Onena and Ingosa during 1994 and has entered into an agreement with the Spanish provincial government to capitalize certain amounts due it by Ingosa for 41% of the equity of the merged entity. The merger is expected to be completed by June 30, 1994 and to be legally effective as of January 1, 1994. See Note 2(a). The Company has actively pursued acquisition possibilities in 1993 and intends to continue to do so in 1994 and later years. It is presently the Company's intention to finance any acquisitions by leveraging the assets of the company to be acquired or, possibly, through the issuance of stock. There are no plans presently to utilize any substantial portion of the existing capital resources of the Company in an acquisition. The Company met its 1993 capital requirements with cash generated from operations, from existing funds, and through borrowings. It is anticipated that most expenditures in 1994 will be financed in a similar manner. LIQUIDITY The Company's liquidity position at December 31, 1993 remained essentially unchanged from the prior year end. Working capital decreased to $66.1 million at December 31, 1993 from $69.2 million at December 31, 1992. The current ratio was 1.67 at December 31, 1993 and 1.69 at December 31, 1992. The Company's cash position decreased by approximately $1.5 million between December 31, 1993 and 1992. Cash flows from operating activities provided $28.9 million for the Company in 1993 most of which related to depreciation and amortization. Of the cash provided by operating activities, the Company invested a substantial portion of such funds in capital expenditures amounting to $22.2 million. Additionally, the Company used a net amount of $9.0 million in financing activities primarily for the repayment of short and long-term borrowings. At December 31, 1993, the Company had available a credit line of $3,150,000 under a Revolving Credit Facility. The Company's packaging subsidiaries had available various credit facilities of $42.7 million at December 31, 1993. However, the Company's ability to draw upon these lines for other than certain subsidiary purposes is restricted. The Company expects that cash from operations and its existing banking facilities will be sufficient to meet its needs in 1994 and on a long-term basis. RECENT ACCOUNTING PRONOUNCEMENTS The Company and its subsidiaries account for income taxes in accordance with Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" (FAS No. 109) issued in February 1992. This statement requires, among other things, recognition of future tax benefits, measured by enacted tax rates, attributable to deductible temporary differences between financial statement and income tax bases of assets and liabilities and to tax net operating loss carryforwards, to the extent that realization of such benefits is more likely than not. As discussed in Note 10, PCI has tax net operating loss carryforwards (NOL's) totaling approximately $45,000,000 which expire between 2006 and 2008. FAS No. 109 requires that the tax benefit of such NOL's be recorded as an asset to the extent that management assesses the utilization of such NOL's to be "more likely than not". Management has determined, based on the Continental Plastic Container Company's history of prior operating earnings and its expectations for the future, that operating income of PCI will more likely than not be sufficient to utilize at least $28,500,000 of the $45,000,000 of NOL's prior to their ultimate expiration in the year 2008. The NOL's available for future utilization were generated principally by an operating loss in the short period following the November 1991 purchase and additional interest expense on debt incurred in connection with the purchase. Additionally, in the year ended December 31, 1992, an extraordinary loss was incurred due to the write-off of deferred financing costs relating to a short- term note which was refinanced. The operations of the Continental Plastic Container Companies have historically been profitable (excluding non-recurring items). In assessing the likelihood of utilization of existing NOL's, management considered the historical results of the Continental Plastic Container Companies' operations both prior to the purchase and as subsidiaries of PCI subsequent to the purchase, and the current operating environment. In 1992, PCI adopted Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Post-retirement Benefits Other than Pensions". There was no cumulative effect of the change in accounting for post-retirement benefits, as the accumulated post-retirement benefit obligation (APBO) existing at January 1, 1992 equaled the amount recorded in the prior year as part of the purchase accounting adjustments. PCI continues to fund benefit costs on a pay-as-you-go basis. See Note 13 for more information. NEW ACCOUNTING STANDARD NOT ADOPTED PCI provides certain post-employment benefits to former and inactive employees, their beneficiaries and covered dependents. These benefits include disability related benefits, continuation of health care benefits and life insurance coverage. In November 1992, the Financial Accounting Standards Board issued SFAS No. 112, "Employers' Accounting for Post-Employment Benefits", which requires employers to recognize the obligation to provide post-employment benefits and an allocation of the cost of those benefits to the periods the employees render service. Implementation of SFAS No. 112 will be required of PCI in 1994. The effect of the implementation of this Statement has not been determined. However, management believes the impact will not be significant to the consolidated financial statements. INFLATION AND CHANGING PRICES Costs and revenues are subject to inflation and changing prices in the packaging business. Since all competitors are similarly affected, product selling prices generally reflect cost increases resulting from inflation. Inflation has not been a material factor in the Company's revenues and earnings in the past three-years. CONTINENTAL CAN COMPANY, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS DECEMBER 31, 1993 AND 1992 See accompanying notes to consolidated financial statements. CONTINENTAL CAN COMPANY, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (CONTINUED) See accompanying notes to consolidated financial statements. CONTINENTAL CAN COMPANY, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF EARNINGS YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 See accompanying notes to consolidated financial statements. CONTINENTAL CAN COMPANY, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 See accompanying notes to consolidated financial statements. CONTINENTAL CAN COMPANY, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 See accompanying notes to consolidated financial statements. CONTINENTAL CAN COMPANY, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (1) Accounting Policies and Other Matters (a) Principles of Consolidation The accompanying consolidated financial statements include the accounts of Continental Can Company, Inc. (the Company), its majority-owned foreign and domestic subsidiaries and, subsequent to acquisition on November 21, 1991, its 50% interest in Plastic Containers, Inc. (PCI). During 1992, the Company entered into an agreement which gave the Company a proxy to vote an additional 1% of the shares of PCI (see Note 2(c)). The proxy provides the Company with effective control over PCI and, accordingly, the Company's interest in PCI is reflected on a consolidated basis. At December 31, 1993, the Company owned the following packaging related businesses: 85% of Ferembal S.A. (Ferembal), located in France which in turn owns 51% of Obalex A.S. (Obalex) located in the Czech Republic; 100% of Viatech Holding GmbH (Holding), which in turn owns all of the outstanding shares of Dixie Union Verpackungen GmbH (Dixie Union), located in the Federal Republic of Germany; and 80% of Onena Bolsas de Papel, S.A. (Onena), and 99.97% of Industrias Gomariz, S.A. (Ingosa), both located in Spain. As mentioned above, the Company also owns 50% of PCI, which in turn owns 100% of Continental Plastic Containers, Inc. and Continental Caribbean Containers, Inc. (collectively, CPC). In addition, the Company owns 100% of an engineering firm, Lockwood, Kessler & Bartlett, Inc. At December 31, 1992 the Company's then 34% interest in Obalex was reflected on the equity method of accounting. In 1993, the Company increased its interest in Obalex to 51% and accordingly the Company's interest is now reflected on a consolidated basis. Minority interests reflected in consolidation represent the portions of Ferembal, Holding, Onena, Ingosa and PCI not owned by the Company. See Note 2. All significant intercompany balances and transactions have been eliminated. (b) Inventories Inventories consist principally of packaging materials, repair parts and supplies. The manufacturing inventories of PCI are stated at the lower of cost applied on the last-in, first-out (LIFO) method, which is not in excess of market. Inventories of the Company's other subsidiaries and the repair parts and supplies inventories of PCI are stated at the lower of cost on a first-in, first-out (FIFO) basis or market. (c) Depreciation and Amortization Depreciation and amortization of property, plant and equipment are computed on a straight-line basis over the estimated useful lives of the assets, as follows: Leasehold improvements are amortized over their estimated useful lives or the term of the lease, whichever is less. Provision for amortization of intangible assets is based upon the estimated useful lives of the related assets and is computed using the straight-line method. Intangible assets resulting from the acquisitions of (a) PCI consist of (i) a non-compete agreement and acquisition and financing costs (amortized over five-years), and (ii) customer contracts (amortized over ten years); and (b) Ferembal consist of patents (amortized on a straight-line basis over their estimated useful lives) and goodwill (amortized on a straight line basis over forty years). (d) Income Taxes The Company files a consolidated tax return for U.S. purposes for itself and its domestic subsidiaries (to the extent it owns at least 80% of such subsidiaries). Separate returns are filed for all other subsidiaries. U.S. deferred income taxes have not been provided on the unremitted earnings of the Company's foreign subsidiaries to the extent that such earnings have been invested in the business, as any taxes on dividends would be substantially offset by foreign and other tax credits. Effective January 1, 1992, the Company implemented the provisions of Statement of Financial Accounting Standards (SFAS) No. 109, "Accounting for Income Taxes" (see Note 10). The cumulative effect of adopting SFAS No. 109 is reflected in the consolidated statement of earnings. SFAS No. 109 utilizes the liability method and deferred taxes are determined based on the estimated future tax effects of differences between the financial statement and tax bases of assets and liabilities given the provisions of enacted tax laws. Prior to the implementation of SFAS No. 109, the Company accounted for income taxes using Accounting Principles Board Opinion No. 11. (e) Foreign Currency Translation The accounts of Ferembal and its subsidiary, Obalex, Holding and its subsidiary, Dixie Union, Onena and Ingosa have been converted to U.S. dollars utilizing SFAS No. 52, "Foreign Currency Translation", under which assets and liabilities are translated at the exchange rate in effect at the balance sheet date, while revenues, costs and expenses are translated at the average exchange rate for the reporting period. Resulting unrealized net gains or losses are recorded as a separate component of stockholders' equity. Realized foreign exchange gains or losses are reflected in operations. (f) Statement of Cash Flows The Company considers securities purchased within three months of their maturity date to be cash equivalents. Cash equivalents consist of short-term investments in government securities and bonds. Cash paid for interest and income taxes was as follows: As partial consideration for the purchase of CPC, PCI gave a secured promissory note for $100,000,000 effective November 22, 1991. See Note 2(c). (g) Research and Development Research and development costs are charged to expense as incurred. Such costs amounted to approximately $12,862,000, $14,603,000, and $4,194,000 in 1993, 1992, and 1991, respectively. (h) Accounting for Post-retirement Benefits Other Than Pensions In 1992, the Company adopted SFAS No. 106, "Employer's Accounting for Post- retirement Benefits Other Than Pensions", which requires a calculation of the actuarial present value of expected benefits to be paid to or for employees after their retirement and an allocation of the cost of those benefits to the periods the employees render service (see Note 13). (i) Insurance Prior to November 21, 1991, CPC was self-insured for the purposes of providing workers' compensation, general liability and property and casualty insurance coverages up to varying deductible amounts. CPC's former owner's risk management consulting services determined CPC's required reserves for asserted and unasserted claims based on actuarially determined loss experience. Subsequent to November 21, 1991, PCI purchased commercial insurance policies, but remained self-insured for coverages up to varying deductible amounts. PCI's self- insurance reserves are included in other liabilities in the consolidated balance sheets. Costs charged to operations for self-insurance for the years ended December 31, 1993 and 1992 were $2,268,000 and $2,078,000, respectively, and for the period from November 22, 1991 through December 31, 1991 were $222,000. (j) Plant Rationalization and Realignment PCI records an estimate of the liabilities associated with the closing of specific manufacturing facilities. Costs (income) charged to operations for these programs were $(135,000), and $159,000 for the years ended December 31, 1993 and 1992 respectively, and $32,000 for the period from November 22, 1991 through December 31, 1991. Net income was recognized in 1993 due to a sublease of the related facilities. Included in other current liabilities at December 31, 1993 is $472,000 ($1,734,000 at December 31, 1992) related to accruals for plant rationalization and realignment. (k) Earnings Per Share Earnings per common share is based on the weighted average number of common and common equivalent shares outstanding. Common equivalent shares include dilutive stock options (using the treasury stock method) exercisable under the Company's option plans and warrants. Weighted average shares outstanding in 1993, 1992, and 1991 were 3,023,062, 3,078,387, and 2,532,967, respectively. Earnings per common share, assuming full dilution, gives effect to the conversion of the Company's outstanding 10-3/4% Convertible Subordinated Debentures as if such Debentures had been converted, after elimination of related interest expense, net of income tax benefit. (l) Reclassifications Certain reclassifications have been made to conform prior year financial statements to the 1993 presentation. (2) Acquisitions (a) Ingosa On November 30, 1993, the Company purchased substantially all of the shares of Ingosa for nominal consideration. Ingosa, located in Pamplona, Spain, is a flexible packaging manufacturer which laminates and prints plastic, paper and foil materials primarily for the food industry in Spain. The acquisition is being accounted for under the purchase method. In connection with this transaction the excess of the fair value of the net assets acquired over the purchase price was allocated to property, plant and equipment. Such allocation has been based on preliminary estimates which may be revised at a later date. In addition, the Company entered into an agreement with the provincial government through SODENA, an economic development corporation owned by the government. The agreement, which was subsequently legislatively ratified in 1994, contemplates that Onena will be merged into Ingosa. SODENA will receive 41% of the equity in the combined entity in exchange for the elimination of $3,736,000 (534 million pesetas) in overdue local taxes owed by Ingosa. In addition, SODENA will provide the merged entity with a $2,100,000 (300 million pesetas) interest free loan for a period of up to 4 years secured by Onena's existing land and building and provide certain other incentives to the merged entity. The Company has agreed to invest $700,000 (100 million pesetas) in the merged entity as additional equity. The various transactions contemplated pursuant to this agreement are expected to be completed during the second quarter of 1994 and to be legally effective as of January 1, 1994. (b) Obalex On November 27, 1992, Ferembal acquired 34% of the stock of Obalex A.S., a producer of food cans in the Czech Republic, for approximately $3,021,000 and simultaneously entered into two agreements to provide Obalex with training, a technology license, and certain equipment, which approximates Ferembal's estimated cost of providing such training, technology and equipment. Ferembal paid approximately $1,086,000, with a balance of $1,935,000, paid in December 1993. In 1993, Ferembal, pursuant to a pre-emptive right, subscribed to a share issue which gave Ferembal an additional 17% interest in the common stock of Obalex for approximately $3,000,000. These transactions have been accounted for under the purchase method with the purchase price allocated to the fair value of the net assets acquired. (c) PCI During 1991, the Company and Merrywood, Inc. (Merrywood) each invested $30,000,000 for respective 50% interests in PCI. On November 21, 1991, PCI purchased all of the outstanding stock of CPC, manufacturer of a wide range of blow-molded plastic containers for the food, automotive, personal care and household, industrial and agricultural chemical markets. The purchase price of approximately $153,450,000 included $135,450,000 as the purchase price for the stock acquired, $15,000,000 as consideration for a non-competition agreement, and $3,000,000 as fees for providing financing. Of the total consideration, $53,450,000 was paid in cash and $100,000,000 was represented by a secured promissory note of PCI, guaranteed by CPC. PCI's results are reflected in the Company's consolidated financial statements after consideration of purchase accounting adjustments recorded by PCI. In 1992, PCI issued $110,000,000 in senior secured notes, the proceeds of which were used to retire the secured promissory note of PCI (see Note 9(c)). In connection with the retirement of the promissory note, PCI incurred an extraordinary loss of $3,005,000 on the write-off of capitalized financing costs. The Company has reflected this item in its consolidated statement of earnings, net of the portion attributable to the minority interest in PCI. In addition to the foregoing amounts to purchase CPC, PCI had agreed to pay the seller an amount equal to 30% of the amount by which CPC's sales (adjusted to reflect resin prices in effect on August 31, 1991) for 1992 and 1993 exceeded $218,000,000 and $224,000,000, respectively. No additional payments were required. During 1992, the Company entered into an agreement with Merrywood pursuant to which Merrywood granted the Company a proxy, irrevocable until August 6, 1998, to vote an additional 1% of the PCI common stock. The agreement also provides (i) that Merrywood has the right to require the Company to purchase its 50% interest in PCI for $30,000,000, plus interest at 1% over the prime rate from November 21, 1991, and (ii) that after July 1, 1994, Merrywood has the right to exchange its 50% interest in PCI for 887,500 shares of the Company's common stock (adjusted for any future stock split, stock combination or reclassification) representing approximately 31% of the total number of shares currently outstanding. In addition, pursuant to the agreement, the Company gave Merrywood three voting and one non-voting position on the Company's board of directors. If Merrywood has not elected to require the Company to purchase its interests in PCI for cash by August 7, 1998, then Merrywood's PCI shares are required to be exchanged for shares of the Company's Common Stock. (d) Minority Interest in Dixie Union In July 1991, the Company purchased the 49% minority interest in the equity of Viatech Holding GmbH owned by the Dow Chemical Company (Dow) for $5,804,000 in a transaction accounted for under the purchase method. In connection with this transaction, the excess of the fair value of the net assets acquired over the purchase price was allocated to property, plant and equipment. In addition, the Company entered into a new technology transfer agreement with Dow with regard to certain extrusion and polymer technology. The effective period is five-years, commencing 1991, and the annual royalty paid is $280,000. (e) Ferembal During the two-year period ended December 31, 1993, the Company purchased approximately 1% of the outstanding shares of Ferembal for $333,000. In August 1991, the Company purchased approximately 16% of the outstanding shares of Ferembal from Citicorp Capital Investors Europe Limited and certain of its affiliates for an aggregate consideration of $6,051,000. As a result of these transactions, the Company's equity interest in Ferembal increased from 68% (as acquired during 1989) to 85%. These transactions have been accounted for under the purchase method, with the excess of cost over the fair value of the net assets acquired (approximately $3.6 million) being amortized on a straight-line basis over forty years. As part of the 1989 purchase of Ferembal, goodwill of approximately $10.0 million (amortized over 40 years) was recorded and a junior subordinated convertible bond was issued which, if converted at December 31, 1993, would reduce the Company's percentage ownership of Ferembal to 64%. (See Note 9(d)). The accumulated amortization of goodwill relating to Ferembal amounted to $1,442,000 and $1,083,000 at December 31, 1993 and 1992, respectively. During the year ended December 31, 1991, Ferembal created Ferembal Investissement S.A. (Investissement) for the purpose of holding a subsidiary, Ferembal Sud Ouest S.A. (Sud Ouest). Investissement was capitalized with 150,000 shares of 100 francs par value. Ferembal holds 80,000 shares and two banks, Credit du Nord and Societe Generale, hold the remaining 70,000 shares. Ferembal has entered into an agreement with the banks whereby it has guaranteed to purchase the shares between the dates of May 1, 1995 and December 31, 1996. (3) Investments At December 31, 1993 and 1992, short-term investments consisted principally of U.S. treasury bills and government agency securities. All investments are recorded at cost, which approximates market. (4) Accounts Receivable and Business/Credit Concentrations Most of the Company's customers are located in the United States and Europe. Sales to two customers in 1993, two customers in 1992 and three customers in 1991 accounted for 15%, 15% and 24% of the Company's sales, respectively; accounts receivable from two customers at December 31, 1993 and from three customers at December 31, 1992 amounted to 19%, and 24%, respectively, of the Company's total stockholders' equity. Included in other accounts receivable at December 31, 1993 are $3,024,000 due from a customer for equipment purchases, engineering fees billed of $2,250,000 ($3,297,000 at December 31, 1992), recoverable value added taxes of $686,000 ($2,993,000 at December 31, 1992) related to Ferembal, and a loan aggregating $34,986 ($166,060 at December 31, 1992) to the Company's Chairman. The loan bears interest at prime + 1% and matures no later than December 31, 1994. (5) Inventories Inventories consist principally of packaging materials. The components of inventory at December 31 were as follows: (6) Prepaid Expenses and Other Current Assets The components of prepaid expenses and other current assets at December 31, were as follows: Ferembal entered into an agreement with a local municipality in France for the sale, at cost, of land and buildings under construction at December 31, 1991. Ferembal then agreed to lease the land and buildings from the municipality under a 20-year operating lease. Ferembal may terminate the lease at any time in the first six-years, without penalty, and upon agreement thereafter. Rental payments to the municipality will be determined on the cost of the land and buildings, less any government subsidies received, plus interest, and will be payable over the 20-year term. At December 31, 1992, the construction of the buildings was complete and the cost of such land and buildings were considered to be assets held for sale and were presented as other current assets in the amount of $1,560,000. The sale of the land and buildings occurred on January 11, 1993 at cost. Payment is due in the second quarter of 1994. (7) Other Assets The components of other assets at December 31 were as follows: (8) Short-term Borrowings At December 31, 1993 and 1992, approximately $6,378,000 and $3,986,000, respectively, were outstanding representing amounts drawn to cover bank overdrafts. Interest is to be paid at rates ranging from 7.14% to 14%. At December 31, 1993, Ferembal had short-term unsecured borrowing agreements of approximately $21,000,000, substantially all of which were unused. At December 31, 1993, Holding had total lines of credit available under short-term unsecured borrowing agreements of approximately $9,100,000. (9) Long-Term Debt, Capital Leases and Other Long-Term Liabilities Long-term debt and capital leases at December 31, 1993 and 1992 are summarized as follows: (a) In May 1987, the Company issued $1,612,875 of 10.75% Convertible Subordinated Debentures due in 1994. Interest payments are payable every six months. Each $15.00 face amount of Debenture, with the payment of an additional $15.00 in cash, is convertible into four shares of Common Stock. The Debentures are callable at the option of the Company. Shares issuable upon conversion of the Debentures amounted to 310,450 at December 31, 1993. (b) The Company's Revolving Credit Facility provides for borrowings of up to $4 million. A commitment fee of .75% is payable on the unused portion of the facility. There are provisions regarding the maintenance of minimum net worth and demand deposits averaging at least $400,000. The facility is secured by all of the Company's tangible and intangible assets. Subject to certain conditions precedent, the Revolving Credit Facility may be converted into a five-year term note when due. (c) PCI is required to make four annual sinking fund payments of $22 million each, commencing April 1, 1997 and continuing through April 1, 2000. The notes are redeemable, in whole or in part, at the option of PCI at prices decreasing from 105% of par at April 1, 1997 to par on April 1, 2000. In the event of a change of control of PCI as defined in the indenture, PCI is obligated to offer to purchase all outstanding Senior Secured Notes at a redemption price of 101% of the principal amount thereof, plus accrued interest. In addition, PCI is obligated in certain instances to offer to purchase Senior Secured Notes at a redemption price of 100% of the principal amount thereof, plus accrued interest with the net cash proceeds of certain sales or dispositions of PCI's assets. The indenture places certain restrictions on PCI concerning payment of dividends, additional liens, disposition of the proceeds from asset sales, sale-leaseback transactions and additional borrowings. At December 31, 1993, PCI was in compliance with these restrictions. (d) In 1989, Ferembal issued a subordinated bond convertible into 100,000 shares of capital stock at the option of the holders at any time prior to October 28, 1999. If exercised, the Company's ownership interest in Ferembal will decrease from the present 85% interest to a 64% interest. If the conversion right is not exercised, the bond becomes due in two equal annual installments beginning in 1999. (e) The capital lease obligations represent lease payments due through 2005 which are capitalized according to FASB Statement No. 13. The following is a schedule of future minimum lease payments under the capitalized leases together with the present value of the net minimum lease payments as of December 31, 1993: In January 1991, Ferembal entered into a sale and lease-back agreement relating to land and buildings at one of its manufacturing facilities with a net book value of approximately $2,394,000. The transaction resulted in a net gain of $284,000. The gain on this transaction was deferred and is being amortized over the lives of the leased assets. The proceeds were used to retire an equivalent amount of senior long-term debt. (f) In June 1988, Onena settled an outstanding dispute regarding the amount of turnover tax due to the Spanish provincial government. A mortgage on Onena's property, plant and equipment secures the obligation, which amounts to $822,000 (118 million pesetas) at December 31, 1993 and 1992 and is repayable in installments over a six-year term. Also included is $3,736,000 (534 million pesetas) at December 31, 1993 which is due to the Spanish provincial government by Ingosa and which is expected to be capitalized in 1994. See Note 2(a). (g) In 1992, Onena reached an agreement with regard to sums due to social security which amounts to $2,626,000 (375 million pesetas) at December 31, 1993 (385 million pesetas at December 31, 1992). The agreement provides for a five-year repayment schedule. Also included is $686,000 (98 million pesetas) at December 31, 1993 relating to amounts due to social security by Ingosa which will be repaid over a three-year period beginning in 1994. Maturities of long-term debt are as follows: During 1992, PCI obtained a $15 million credit facility with Citibank, N.A. ("Citibank") under which PCI is able to borrow, on a revolving basis, up to an amount representing specified percentages of PCI's eligible accounts receivable and eligible inventory, not to exceed $15 million outstanding at any time. The facility will mature on its fifth anniversary. The revolving credit loans bear interest at the rate, selected at PCI's option, of 1.5% per annum over the fluctuating alternative base rate of Citibank or 2.75% per annum over the London Inter Bank offering rate of Citibank. Borrowings under the revolving credit facility are guaranteed by CPC and secured by accounts receivable and inventories and a secondary lien on the outstanding stock of CPC. PCI is required to pay Citibank an annual commitment fee of 1/2% of the average daily unused portion of the revolving credit facility. Commitment fees totaled $72,000 and $43,000 for the years ended December 31, 1993 and 1992, respectively. There were no outstanding borrowings under this credit facility at December 31, 1993 and 1992. This revolving credit facility contains covenants covering, among other things, leverage, cash flow, minimum fixed charge coverage, minimum interest coverage and net worth, and restrictions on capital expenditures, additional indebtedness, sale-leaseback transactions, dividends and other corporate transactions of PCI and its subsidiaries. At December 31, 1993, PCI was in compliance with the covenants. PCI is required to have no outstanding borrowings under the revolving credit facility for at least 30 consecutive days during each 12-month period, other than borrowings used to finance permitted acquisitions, dividends and letters of credit. The agreement provides for the issuance of letters of credit by Citibank on PCI's behalf. At December 31, 1993, $1,084,000 of such letters of credit had been issued, guaranteeing obligations carried in the consolidated balance sheet. The revolving credit facility agreement also requires a reserve by PCI of $1,800,000 for automatic clearing house (ACH) float. The letter of credit and ACH reserve reduce the total amount available under the revolving credit facility. At December 31, 1993, no other funds had been drawn on the revolving credit facility. Additional letters of credit totaling $652,000 were obtained from another banking facility. The Company has a $625,000 unused standby letter of credit available, which expires on January 28, 1996, bears interest at 1.5% per annum and is secured by U.S. Treasury bills worth $510,000. Other long-term liabilities at December 31, 1993 primarily include pension and profit sharing amounts related to PCI and Ferembal of $17,447,000 ($16,275,000 at December 31, 1992), insurance reserves at PCI of $7,688,000 ($7,625,000 at December 31, 1992), and accrued post-retirement benefits at PCI of $6,008,000 ($5,832,000 at December 31, 1992). (10) Income Taxes As discussed in note 1(d), The Company adopted SFAS No. 109 as of January 1, 1992. The cumulative effect of this change in accounting for income taxes of $460,000, exclusive of the portion allocated to minority interest ($85,000), was determined as of January 1, 1992 and is reported separately in the consolidated statement of earnings for the year ended December 31, 1992. As a result of applying SFAS No. 109 in 1992, pre-tax income before minority interest, extraordinary item and cumulative effect of accounting change for the year ended December 31, 1992 increased by $884,000. Prior years' financial statements have not been restated to apply the provisions of SFAS No. 109. The components of the provision for income taxes for the years ended December 31, 1993, 1992 and 1991 are as follows: The Company's total income tax provision differs from the provision that would result from applying the U.S. Federal statutory income tax rate to income before provision for income taxes, minority interest, extraordinary item and cumulative effect of accounting change due to the following: The significant components of deferred income tax benefit attributable to income from continuing operations for the years ended December 31, 1993 and 1992 are as follows: For the year ended December 31, 1991, deferred income tax expense of $53,000 results from timing differences in the recognition of income and expense reported in the financial statements and that reported for tax purposes. The source of the differences between income and expense for tax purposes as compared to related amounts reported in the financial statements and the tax effect of each is as follows: 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 1992 are presented below: The valuation allowance for deferred tax assets as of January 1, 1992 was $2,211,000. The net change in the total valuation allowance for the years ended December 31, 1993 and 1992 was an increase of $1,671,000 and $2,409,000, respectively. Due to different tax jurisdictions of the Company's subsidiaries, net deferred tax liabilities of $32,000 at December 31, 1993, and $1,728,000 at December 31, 1992 shown above are reflected in the consolidated balance sheets as: At December 31, 1993, PCI has operating loss carry forwards for Federal income tax purposes of approximately $45,000,000 which are available to offset future Federal taxable income through 2008. (11) Common Stock (a) Sales of Common Stock In June 1991, the Company received net proceeds of $29,453,000 from the sale of 1,020,000 shares of its Common Stock and 255,000 Warrants to purchase its Common Stock. Each Warrant, for a period of two years, entitled the holder thereof to purchase one share of the Company's Common Stock for $30.875. At December 31, 1993, no Warrants remained outstanding. (b) Options The 1981 Incentive Stock Option Plan, as amended, (the Incentive Plan) provided for the issuance of up to 120,000 shares of the Company's Common Stock upon the exercise of options at prices not less than 100% of the fair market value of the shares. Options were exercisable for up to 10 years. During 1992, 3,000 options were exercised under the Plan. As of December 31, 1993, no options remained unexercised and no further options could be granted under the Incentive Plan. The 1988 Restricted Stock Option Plan, as amended, (the Restricted Plan) provides for the issuance of up to 500,000 shares of Common Stock upon the exercise of options at an exercise price determined by the Personnel Committee of the Board of Directors (the Committee), but no less than $1.00 per share. The Committee may determine the exercise period of the option up to a maximum of twenty years from the date of the grant and may determine a restricted period during which any portion of the option may not be exercised. On March 4, 1993, an employee was granted an option to purchase up to 5,000 shares of common stock at a price of $22.00 per share. The option expires five-years from its grant and had not been exercised as of December 31, 1993. As of December 31, 1993, the Chairman and the Executive Vice President had received (i) restricted options (granted in March 1992) to purchase 30,000 and 20,000 shares, respectively, vesting over a five- year period, at $26.75 per share, such price being the fair market value at date of grant; (ii) unrestricted options to purchase 140,000 and 60,000 shares, respectively, under the Restricted Plan at $8.625 to $17.00 per share, such prices being the fair market value of a share of the Company's Common Stock at the date of the grant; and (iii) restricted options (granted in April 1991) to purchase 10,000 and 6,000 shares, respectively, at an exercise price of $1.00 per share which vest at a rate of 20% per year subject to their continued employment. Concerning the 16,000 restricted options granted in April 1991, compensation to be recognized over the five-year vesting period will aggregate $520,000, of which $104,000, $104,000 and $78,000 was charged to expense in 1993, 1992 and 1991, respectively. As of December 31, 1993, 28,100 shares were reserved for future options under the Restricted Plan. The Chairman was granted, pursuant to a prior employment agreement, an option to purchase 40,000 shares of the Company's Common Stock at an exercise price of $2.94 per share being the fair market value of a share of the Company's stock on the date this option was approved by the Company's shareholders. This option is not under any of the Company's option plans, had not been exercised as of December 31, 1993 and expires on December 31, 1998. Pursuant to the 1988 Director Stock Option Plan (the Retainer Plan), directors may elect to receive a stock option in lieu of cash as an annual retainer. Each electing director will receive an option equal to the nearest number of whole shares determined by dividing the annual retainer by the fair market value of the stock less one dollar. The option price is one dollar per share and an option may not be exercised prior to the first anniversary of the date it was granted nor more than ten years after such date. During 1993, nine electing directors each received an option to purchase 316 shares of Common Stock under the Retainer Plan. During 1992 and 1991, nine and eight electing directors each received an option to purchase 241 and 100 shares of Common Stock, respectively, pursuant to the Retainer Plan. In 1993, 1992, and 1991, a total of $58,500, $41,250, and $24,000, respectively, was charged to compensation expense with respect to the Retainer Plan. In 1992, pursuant to an agreement (see Note 2(c)), each of three directors and an advisory director were granted options to purchase 10,000 shares of the Company's Common Stock at $25.75 per share, being its fair market value on the date of the grant. The options expire in 2002 and had not been exercised as of December 31, 1993. Pursuant to the 1992 Restricted Stock Plan for Non-Employee Directors (the "Stock Plan"), each non-employee director of the Company receives an award of 300 shares of Company Common Stock during each year of service beginning in 1992. Such shares are restricted from transfer while such recipient remains a member of the Board of Directors and the shares are subject to forfeiture under certain circumstances including resignation or failure to stand for reelection prior to age 70. The Company issued 8,400 shares under the Stock Plan in 1993 for the 1992 and 1993 plan years; the Company has expensed $103,425 in 1993 and $79,500 in 1992 for shares which were issued. In March 1990, a director received an option to purchase 10,000 shares of the Company's Common Stock at an exercise price of $17.00 per share, being the fair market value of a share of the Company's Common Stock on the date the option was granted. The option is not under any of the Company's option plans, had not been exercised as of December 31, 1993 and expires on March 13, 1995. The 1990 Stock Option Plan for Non-Employee Directors (the Director Plan) provides for the issuance of up to 200,000 shares of Common Stock to directors who are not employees of the Company or its subsidiaries. The Director Plan is administered by a Board Committee. The Director Plan provides for the grant to each non-employee director, at the commencement of his initial term, of an option to purchase up to 10,000 shares of Common Stock at a price equal to the fair market value of a share of Common Stock on the date of the grant. The options become exercisable as to one-tenth of the shares subject to option on the date of the grant and on the nine successive anniversaries of such date. The term of the options is 10 years provided that any option holder who ceases to be a member of the Board of Directors forfeits any part of the option grant which has not become exercisable as of such date. During 1990, each member of the Board of Directors who was not an employee (10 individuals) received an option to purchase 10,000 shares of Common Stock at prices ranging from $17.00 to $17.50 per share, being the fair market value of a share of Common Stock on the date of the grant. No options have been exercised pursuant to the Director Plan. There are currently 100,000 shares available for grant under the Director Plan. Additionally, on November 9, 1993, an individual was awarded an option to purchase up to 5,000 shares of Common Stock at an exercise price of $20.00 per share being the fair market value of a share of the Company's stock on such date. The option expires five-years from its grant and had not been exercised at December 31, 1993. (12) Pension and Profit Sharing Plan PCI provides a defined benefit pension plan for substantially all salaried employees (which was amended in 1993) and a noncontributory defined benefit pension plan for substantially all hourly workers who have attained 21 years of age. The following table sets forth the plans' funded status at December 31, 1993 and 1992 based primarily on January 1, 1993 participant data and plan assets: Net pension costs under the above mentioned PCI plans included the following components for the years ended December 31, 1993 and 1992 and the period from November 22, 1991 to December 31, 1991: During 1992, negotiated benefit increases were made for certain hourly plan participants and early retirement (window plan) was accepted by certain salaried plan participants. The effects of these changes were to increase the hourly plan's PBO by $576,000 and increase the salaried plan's PBO and total periodic pension expense by $814,000 and $581,000, respectively. Assumptions used in the accounting were: Ferembal provides retirement benefits pursuant to an industry-wide labor agreement. The plan is not funded. Amounts charged to expense amounted to $250,000 in 1993, $94,000 in 1992 and $35,000 in 1991. Other non-current liabilities at December 31, 1993 include $1,425,000 ($1,230,000 at December 31, 1992) for this plan. Ferembal also provides an employee profit-sharing plan, the annual contributions to which are determined by a prescribed formula. Amounts charged to expense amounted to $954,000 in 1993, $1,287,000 in 1992 and $1,450,000 in 1991. Amounts are paid to employees after five-years with accrued interest. Other non-current liabilities at December 31, 1993 include $5,951,000($4,557,000 at December 31, 1992) for the plan. Holding provides selected managers of a subsidiary company with pension and disability benefits. Amounts charged to expense amounted to $161,000 in 1993, $154,000 in 1992 and $326,000 in 1991. (13) Post-Retirement Benefits Other Than Pensions and Post-Employment Benefits PCI provides certain health care and life insurance benefits for retired PCI employees. Certain of PCI's hourly and salaried employees become eligible for these benefits when they become eligible for an immediate pension under a formal company pension plan. In 1993, the plan was amended to eliminate health care benefits for employees hired after January 1, 1993. Expenses for benefits provided to retired employees were $710,000, $490,000 and $132,000 for the years ended December 31, 1993 and 1992 and the period from November 22, 1991 through December 31, 1991, respectively. In 1992, PCI adopted SFAS No. 106, "Employers' Accounting for Post-Retirement Benefits Other Than Pensions". There was no cumulative effect of the change in accounting for post-retirement benefits, as the accumulated post-retirement benefit obligation (APBO) existing at January 1, 1992 equaled the amount recorded in the prior year as part of the purchase accounting adjustments. PCI continues to fund benefit costs on a pay-as-you-go basis. Summary information on PCI's plan at December 31, 1993 and 1992 is as follows: As of December 31, 1993, the discount rate used in determining the APBO was 7.5%. The assumed health care cost trend rate used in measuring the accumulated post-retirement benefit obligation was 10.95% for 1993, declining gradually with each succeeding year on an ultimate rate of 5.0% beginning in calendar year 2002. As of December 31, 1992, the discount rate used in determining the APBO was 8.5%. The assumed health care cost trend rate used in measuring the accumulated post-retirement benefit obligation was 10% for 1992, declining gradually with each succeeding year on an ultimate rate of 6.2% beginning in calendar year 2020. The effect of a one percentage-point increase in the assumed health care cost trend rates in each year would increase the accumulated post- retirement benefit obligation as of December 31, 1993 by $851,000 and the aggregate of the service and interest cost components of net periodic post- retirement benefit cost for the year then ended by $90,000. PCI provides certain post-employment benefits to former and inactive employees, their beneficiaries and covered dependents. These benefits include disability related benefits, continuation of health care benefits and life insurance coverage. In November 1992, the Financial Accounting Standards Board issued SFAS No. 112, "Employers' Accounting for Post-Employment Benefits", which requires employers to recognize the obligation to provide post-employment benefits and an allocation of the cost of those benefits to the periods the employees render service. Implementation of the Statement will be required of PCI in 1994. The effect of the implementation of the Statement has not been determined. However, management believes the impact will not be significant to the consolidated financial statements. (14) Executive Compensation The Company entered into employment agreements with its Chairman and former Vice-Chairman. The contract with the former Vice-Chairman, who died in January 1989, provided for compensation of $135,000 per annum and was to expire on December 31, 1998. Also, the contract provided that in the event of his death prior to December 31, 1998, his spouse will receive one-half of the amounts which would otherwise have been paid to him until her death or until December 31, 1998, whichever occurs first. The Company has included the present value of this obligation in accrued liabilities. At December 31, 1993, the contract with the Chairman, as amended, provides for base compensation of $400,000 per annum and expires on December 31, 1999. The contract also provides that, in the event of his death before December 31, 1999, his spouse will receive one-half of the amount paid to him annually as base compensation until her death, or until ten years after the date of his death, whichever occurs first. (15) Net Interest Expense The details of net interest expense were as follows: (16) Foreign and Domestic Operations The Company performs services principally in the packaging industry. Manufacturing operations are performed domestically through PCI, whereas manufacturing operations are performed overseas in Europe through Ferembal, Holding and Onena. Information about the Company's foreign and domestic operations follows. (17) Fair Value of Financial Instruments The carrying amounts of cash and cash equivalents, investments, accounts receivable, other current assets, accounts payable and short-term borrowings approximate fair value because of the short maturity of these instruments. 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, and approximates the carrying amount as of December 31, 1993. (18) Commitments and Contingencies The Company and its subsidiaries occupy offices and use equipment under various lease arrangements. The rent expense under non-cancellable long- term operating leases for the years ended December 31, 1993, 1992 and 1991 was approximately $7,082,000, $4,968,000, and $758,000, respectively. Total commitments under such arrangements are payable in annual installments of $4,627,000 in 1994, $4,311,000 in 1995, $3,887,000 in 1996, $2,699,000 in 1997 and $1,435,000 in 1998 and $502,000 thereafter. The Company also rents certain equipment and facilities on a month-to-month basis or through short-term leases. The rent expense under such arrangements amounted to approximately $1,317,000 in 1993, $969,000 in 1992, and $711,000 in 1991. Ferembal is contingently liable for receivables sold with recourse of $9,859,000 at December 31, 1993. At December 31, 1993, Holding has commitments for the purchase or construction of capital assets amounting to $136,000. The Company's subsidiaries are defendants in several actions which arose in the normal course of business and, in the opinion of management, the eventual outcome of these actions will not have a material adverse effect on the Company's financial position. (19) Quarterly Financial Data (Unaudited) Summarized quarterly financial data for 1993 and 1992 (in thousands, except per share amounts) is as follows: INDEPENDENT AUDITORS' REPORT ---------------------------- THE BOARD OF DIRECTORS AND STOCKHOLDERS CONTINENTAL CAN COMPANY, INC. We have audited the consolidated balance sheets of Continental Can Company, Inc. 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 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 aforementioned consolidated financial statements present fairly, in all material respects, the financial position of Continental Can Company, Inc. and subsidiaries 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. As discussed in notes 1 (h) and 13 and notes 1 (d) and 10 to the consolidated financial statements, the Company adopted the provisions of Financial Accounting Standards Nos. 106, "Employer's Accounting for Post-Retirement Benefits Other Than Pensions" and 109, "Accounting for Income Taxes", respectively, on a prospective basis in 1992. /s/ KPMG PEAT MARWICK Jericho, New York March 9, 1994 GENERAL INFORMATION ANNUAL MEETING May 18, 1994 at 10:00 a.m. at The Union League Club, 38 East 37th Street, New York, New York. AVAILABILITY OF FORM 10-K Stockholders may receive, without charge, a copy of the Company's 1993 Annual Report filed with the Securities and Exchange Commission on Form 10-K, including the financial statements and schedules thereto, by directing their written inquiries to Abdo Yazgi, Secretary, Continental Can Company, Inc., One Aerial Way, Syosset, New York 11791. CONTINENTAL CAN COMPANY, INC. COMMON STOCK PRICES AND RELATED MATTERS The common stock of Continental Can Company, Inc. is traded on the New York Stock Exchange. The following table indicates the quarterly high and low sales prices for Continental Can Company, Inc. (CAN) common stock for the last two years. No dividends were paid to the holders of common stock for the years 1993, 1992 and 1991. The Company has no present intention to pay dividends on its common stock. There were 422 stockholders of record as of March 21, 1994. DIRECTORS PRINCIPAL OCCUPATION Donald J. Bainton Chairman of the Board and Chief Executive Officer of the Company Kenneth Bainton Registered Architect with the firm of Alexander Kouzmanoff in New York City Robert L. Bainton Former President of B & B Beverage Co. (Retired 1991) Nils E. Benson Former President of Penn Elastic Co. (Retired 1989) Rainer N. Greeven Partner, Greeven & Ercklentz (Attorneys) Ronald H. Hoenig President of Hoenig & Company, Inc. Charles H. Marquardt Former Chief Operating Officer of Plastic Containers, Inc. (Retired 1993) Ferdinand W. Metternich Managing partner in St. Gallen Consulting Group, a management consulting firm based in Switzerland V. Henry O'Neill Private investor in real estate Donald F. Othmer Distinguished Professor of Chemical Engineering Polytechnic University John J. Serrell President of Kinetic Development Inc. Robert A. Utting President of R.A. Utting & Associates, Inc. Abdo Yazgi Executive Vice President, Chief Administrative Officer, and Secretary of the Company Cayo Zapata Director of Tapas Tapones, a division of Taenza, S.A. DE C.V. Jose Luis Zapata Director of Corporate Finance of Taenza, S.A. DE C.V. OFFICERS PRINCIPAL OCCUPATION Donald J. Bainton Chairman of the Board & Chief Executive Officer Abdo Yazgi Executive Vice President, Chief Administrative Officer, and Secretary John Andreas Vice President - Manufacturing Marcial B. L'Hommedieu Treasurer Linda Driscoll Assistant Secretary CONTINENTAL CAN COMPANY, INC. General Offices: Syosset, New York SUBSIDIARIES AND OFFICERS: PLASTIC CONTAINERS, INC, Syosset, New York CONTINENTAL PLASTIC CONTAINERS, INC. Norwalk, Connecticut Charles DiGiovanna, Chief Executive Officer and President Jay Hereford, Chief Financial Officer Frank Kalisik, Vice President - Research & Development John E. Farrell, Vice President - Marketing CONTINENTAL CARIBBEAN CONTAINERS, INC. Caugus, Puerto Rico FEREMBAL S.A. Clichy, France Rene Faber, Managing Director Christian Bonnet, Financial Director Pierre Lichtenberger, Divisional Director Roland Montaclair, Purchasing Director Jean-Marie Desautard, Personnel Director OBALEX, A.S. Znojmo, Czech Republic Jiri Nekvasil, Chairman Lubos Kadlec, Managing Director VIATECH HOLDING GMBH Kempten, Federal Republic of Germany DIXIE UNION VERPACKUNGEN GMBH Kempten, Federal Republic of Germany Hans H. Schwaebe, Executive Director Peter Epp, Chief Financial Officer ONENA BOLSAS DE PAPEL S.A. INDUSTRIAS GOMARIZ S.A. Pamplona, Spain Carlos Paredes, Executive Director LOCKWOOD, KESSLER & BARTLETT, INC. Syosset, New York John A. Eaton, President Sylvester A. Celebrini, Vice President Ralph A. Cuomo, Vice President George Gross, Vice President Steven Hanuszek, Vice President John P. Lekstutis, Vice President Martin Solomon, Vice President TRANSFER AGENT AND REGISTRAR American Stock Transfer & Trust Company New York, New York AUDITORS KPMG Peat Marwick Jericho, New York GENERAL COUNSEL Carter, Ledyard & Milburn New York, New York

761860_1993.txt

761860_1993

1993

761860

ITEM 1. BUSINESS GENERAL IP Timberlands, Ltd. (the 'Registrant') is a Texas limited partnership formed by International Paper Company ('International Paper') to succeed to substantially all of International Paper's forest resources business. The Registrant's forest resources business includes the marketing and sale of forest products for use as sawlogs, poles and pulpwood. In addition, the Registrant may sell or exchange portions of its forestlands and may acquire additional properties for cash, additional units or other consideration. The Registrant operates through IP Timberlands Operating Company, Ltd., a Texas limited partnership ('IPTO'), in which the Registrant holds a 99% limited partner's interest. IP Forest Resources Company ('IPFR'), a wholly owned subsidiary of International Paper, is the managing general partner of the Registrant and IPTO, and lnternational Paper is the special general partner of both. A further discussion of the Registrant's organization appears on the inside front cover and page 14 of the Annual Report to Unitholders (the 'Annual Report'), which information is incorporated herein by reference. DESCRIPTION OF PRINCIPAL PRODUCTS The Registrant's forestlands include merchantable forest products inventory, approximately 60% of which consists of commercial softwoods, principally Douglas fir in the Pacific Northwest, southern pine in the South, and spruce and fir in the Northeast. A variety of hardwoods account for the remaining 40% of the inventory. The Registrant sells forest products to International Paper for use in its pulp mills and wood products plants and to third party customers. A discussion of the Registrant's harvest plan is presented on page 8 of the Annual Report, which information is incorporated herein by reference. COMPETITION AND COSTS Log and wood fiber consuming facilities tend to purchase raw materials within relatively small geographic areas, generally within a 100-mile radius. Competitive factors within a market area generally include price, species, grade and proximity to wood-consuming facilities. The Registrant competes in the log and wood fiber market with numerous private industrial and nonindustrial forestland owners as well as with the U.S. government, principally the U.S. Forest Service and the Bureau of Land Management. Litigation involving endangered species and environmental concerns has caused a decline in government forest products sales volumes and market share in recent years and has resulted in additional demand and higher prices for private forestland owners. Many factors influence the Registrant's competitive position, including costs, prices, product quality and services. MARKETING Consistent with International Paper's experience prior to the contribution of its forestlands to the Registrant, the Registrant has annually sold forest products from its lands to more than 800 purchasers other than International Paper. No customer accounted for more than 10% of annual revenues for the years 1993 and 1991. In 1992, total revenues included $91 million in sales to a west coast forest products company due principally to bulk sales and forestland sales. During 1993, 1992 and 1991, International Paper's facilities consumed approximately 30%, 27% and 28%, respectively, of the logs and wood fiber harvested from the Registrant's forestlands, which represented approximately 12%, 10% and 11%, respectively, of its manufacturing facilities' requirements during such periods. International Paper does not anticipate any change in its policy of relying on the Registrant's forestlands as an important source of raw material for its manufacturing facilities, although it is unable to predict what portion of its requirements will be purchased from the Registrant in the future. In addition to sales to International Paper for use in its manufacturing facilities, the Registrant sells trees to International Paper that are harvested and resold by International Paper to unaffiliated purchasers as logs, poles or pulpwood. Additional information on marketing activities, including related parties and major customers, appears on pages 8 and 15 of the Annual Report, which information is incorporated herein by reference. ENVIRONMENTAL PROTECTION Management of the Registrant's forestlands to protect the environment is a continuing commitment of the Registrant. The Registrant expends considerable efforts to comply with regulatory requirements for the use of pesticides, protection of wetlands, and minimization of stream sedimentation and soil erosion. From time to time the Registrant volunteers to or may be required to clean up certain dump sites on its forestlands created by the general public. Environmental protection costs and capital expenditures have not been significant and are not expected to be significant in the future. EMPLOYEES The Registrant does not have officers or directors. Instead, officers and directors of IPFR perform all management functions for the Registrant. In most respects, the Registrant conducts the business formerly conducted by the Forest Products Division of International Paper. Consequently, the employees of International Paper or its subsidiaries formerly assigned to such division continue to carry out the activities of the Registrant. These employees continue to be employees of International Paper and in some cases are employed solely for the conduct of the Registrant's business. ITEM 2. ITEM 2. PROPERTIES FORESTLANDS Forestlands include approximately 5.5 million acres owned in fee (excluding any interest in underlying minerals) and approximately 507,000 acres held under long-term deeds and leases (terms of three years or longer). These forestlands are located in 14 states in three major regions of the United States. In the Pacific Northwest, forestlands are located in Oregon and Washington, including approximately 311,000 acres owned in fee and approximately 3,200 acres covered by deeds and leases. In the southern and southeastern United States, forestlands are located in seven states, including approximately 3,689,000 acres owned in fee and approximately 500,400 acres held under long-term deeds and leases. In the Northeast, forestlands are located in Maine, New York, Pennsylvania, Vermont and New Hampshire, including approximately 1,531,000 acres owned in fee and approximately 3,300 acres held under long-term deeds and leases. The deeds and leases held by the Registrant generally do not include deeds and leases on government lands in the western United States nor deeds and leases with terms of less than three years, which are generally managed by International Paper in connection with short-term wood procurement for its manufacturing facilities. CAPITAL INVESTMENTS Discussion of the Registrant's capital investments can be found on pages 9 and 10 of the Annual Report, which information is incorporated herein by reference. ITEM 3. ITEM 3. LEGAL PROCEEDINGS IPTO and International Paper are parties to two lawsuits involving long-term leases on approximately 212,000 acres of forestlands in Louisiana and Mississippi. Successors in interest to the original lessors are seeking to have the two leases terminated and IPTO enjoined from further operation on the land covered by the leases, as well as seeking approximately $52 million in alleged damages, plus alleged statutory and trebling penalties and punitive damages in excess of $450 million. A jury trial in the Louisiana state court case resulted in a verdict in favor of IPTO and International Paper on January 24, 1992. Appeals are pending. Trial in the Mississippi state court case has been stayed while the parties litigate certain issues relating to the purchase option exercise by IPTO. IPTO and International Paper plan to vigorously contest any remaining allegations. The Registrant is a party to various legal proceedings incidental to its business. While any proceeding or litigation has an element of uncertainty, the Registrant believes that the outcome of any lawsuit or claim that is pending or threatened, or all of them combined, will not 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 No matters were submitted to a vote of security holders during the fourth quarter of the fiscal year ended December 31, 1993. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The market and cash distribution data on the Registrant's Class A Depositary Units are set forth below and on the inside front cover and page 18 of the Annual Report and are incorporated herein by reference. As of March 25, 1994, there were 3,947 holders of record of the Registrant's Class A Depositary Units. Set forth below are the market price ranges for each quarter of 1993 and 1992 for the Class A Depositary Units on the New York Stock Exchange Composite Index. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA Selected financial data for 1993, 1992 and 1991 is set forth on page 1 of the Annual Report and is incorporated herein by reference. Selected financial data for 1990 and 1989 is as follows (in thousands, except per unit data): ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Management's review and comments on the consolidated financial statements are set forth on pages 8, 9 and 10 of the Annual Report and are incorporated herein by reference. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The Registrant's consolidated financial statements, the notes thereto and the report of independent public accountants are set forth on pages 11 through 17 and 19 of the Annual Report and 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 The directors and executive officers of IPFR* and their business experiences are as set forth below: **WILLIAM M. ELLINGHAUS, 72, former President, Chief Operating Officer and director of American Telephone & Telegraph Company, having retired in 1984. He was Executive Vice Chairman of The New York Stock Exchange until 1986. He is a director of International Paper Company and Textron Inc. Director since April 8, 1986. JOHN A. GEORGES, 63, Chairman and Chief Executive Officer of IPFR since 1985. He has been Chairman and Chief Executive Officer of International Paper Company since 1985. He was elected Chief Executive Officer of International Paper in 1984 and President in 1981. He is a director of International Paper Company, Ryder Systems, Inc., Scitex Corporation Ltd. and Warner-Lambert Company. He is a member of The Business Council and the Policy Committee of the Business Roundtable. He is a Board member of The Business Council of New York State, a member of the Trilateral Commission, the President's Advisory Committee for Trade Policy and Negotiations, and a trustee of Drexel University. Director since January 8, 1985. **ARTHUR G. HANSEN, 69, Educational Consultant. He was Director of Research of the Hudson Institute from 1987 to 1988, Chancellor of the Texas A&M University System from 1982 to 1986, President of Purdue University from 1971 to 1982 and President of Georgia Institute of Technology from 1969 to 1971. He is a director of American Electric Power Company, Inc., The Interlake Corporation, International Paper Company and Navistar International Corporation. He is a member of the National Academy of Engineering, Chairman of the Corporation for Educational Technology and a fellow of the American Association for the Advancement of Science. Director since February 1, 1990. **WILLIAM G. KUHNS, 72, former Chairman of General Public Utilities Corporation (a public utility holding company). He is a director of Ingersoll-Rand Company and International Paper Company. Director since April 14, 1987. **JANE C. PFEIFFER, 61, Management Consultant. She is a director of Ashland Oil, Inc., International Paper Company, J.C. Penney Company, Inc. and The Mutual Life Insurance Company of New York. She is a trustee of the Conference Board, The University of Notre Dame, the Overseas Development Council and a member of The Council on Foreign Relations. Director since January 13, 1988. - ------------------ * Managing General Partner of the Registrant. ** Member of the Audit Committee of IPFR. The Audit Committee reviews policies and practices of the Registrant dealing with various matters (including accounting and financial practices) as to which conflicts of interest with the special general partner may arise. The Audit Committee consists of nonemployee directors of IPFR. EXECUTIVE OFFICERS AS OF MARCH 31, 1994 INCLUDING NAME, AGE, OFFICES AND POSITIONS HELD*, AND BUSINESS EXPERIENCE DURING THE PAST FIVE YEARS EDWARD J. KOBACKER, 55, president since August, 1992. He was general manager and group executive of the kraft paper group of International Paper from 1987 to 1992, when he assumed his current position and was elected vice president and general manager--forest products of International Paper. FREDERICK L. BLEIER, 45, treasurer and controller since July, 1993; controller from 1991. He has been sector controller--forest products of International Paper since July, 1993. He was director-corporate accounting of International Paper from 1990 to 1993. He joined International Paper as manager-financial reporting in 1988. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The four nonemployee directors of IPFR receive a retainer of $7,000 per year plus a fee of $1,100 for each IPFR Board and committee meeting attended. These fees are paid by IPFR. The Registrant has no employees. All management and services are performed by International Paper on behalf of the Registrant. International Paper pays the personnel used in the Registrant's business with certain expenses reimbursed to it by the Registrant. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The Registrant knows of no one owning beneficially more than five percent (5%) of the Registrant's Class A Depositary Units except International Paper, which owns approximately eighty-four percent (84%). The following table shows, as of March 25, 1994, the number of Class A Depositary Units in the Registrant beneficially owned (as defined by the Securities and Exchange Commission) or otherwise claimed by current IPFR directors and by all IPFR directors and executive officers as a group (if no name appears, no Class A Depositary Units are owned or claimed). - ------------------ (1) Ownership shown includes securities over which the individual has or shares, directly or indirectly, voting or investment powers, including units owned by a spouse or relatives and ownership by trusts for the benefit of such relatives, as required to be reported by the Securities and Exchange Commission. Certain individuals may disclaim beneficial ownership of some of these units, but they are included for the purpose of computing the holdings and the percentages of Class A Depositary Units owned. The certificate of incorporation of IPFR ('IPFR Charter') provides for two classes of common stock: Class A Common Stock and Class B Common Stock, of which International Paper is the sole owner. The Class B Common Stock possesses exclusive voting rights and the holder or holders thereof are entitled to cumulative voting for the election of directors of IPFR. Except with respect to voting rights, the Class B Common Stock of IPFR is equal in all other respects to the Class A Common Stock of IPFR. However, the Class B Common Stock represents only .00005 of 1% of the total authorized Common Stock of IPFR, all of which has been issued and is outstanding. The IPFR Charter further provides that in the event International Paper owns, or as a result of certain events would own, less than 50% of either the outstanding Class A Depositary Units or Class B Depositary Units, then - ------------------ * Officers of IPFR are elected to hold office until the next annual meeting of the board of directors and until election of successors, subject to removal by the board. (i) International Paper must sell all of the shares of Class B Common Stock to the directors of IPFR, on a pro rata basis, at a price equal to $100.00 per share in cash; (ii) any director who does not purchase his pro rata shares of Class B Common Stock must resign; and (iii) the directors of IPFR are then required, as soon as practicable but not later than the next annual meeting of stockholders of IPFR, to vote or cause their shares of Class B Common Stock to be voted to elect a Board of Directors of IPFR comprised entirely of persons who are not employees, officers, directors or affiliates of International Paper or of any affiliate of International Paper (other than IPFR). Each director of IPFR is further required to execute a voting trust agreement, pursuant to which the Class B Common Stock will be held and voted, and a stockholders agreement, pursuant to which transfer of ownership in the Class B Common Stock is restricted to persons who are directors of IPFR. In order to maintain the independence of IPFR's Board of Directors, the IPFR Charter further provides that (i) each director, upon resigning as a director of IPFR, must sell his shares of Class B Common Stock to IPFR, and (ii) each subsequent director elected to replace any director so resigning must similarly purchase shares of Class B Common Stock and enter into the voting trust agreement and stockholders agreement described above. International Paper believes that the foregoing arrangement for the possible ownership of the Class B Common Stock of IPFR assists in reducing the potential for conflicts of interests should International Paper's ownership of units decrease significantly. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS A description of certain relationships and related transactions is set forth on pages 14 through 17 of the Annual Report and is incorporated herein by reference. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K EXHIBITS (13) 1993 Annual Report to Unitholders of the Registrant (24) Power of Attorney REPORTS ON FORM 8-K No reports on Form 8-K were filed by the Registrant for the fourth quarter of 1993. FINANCIAL STATEMENT SCHEDULES The consolidated balance sheets 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 31, 1993, together with the report thereon of Arthur Andersen & Co., dated February 4, 1994, appearing on pages 11 through 17 and 19 of the Annual Report, are incorporated herein by reference. With the exception of the aforementioned information and the information incorporated by reference in Items 1, 2, 5 through 8, and 13, the Annual Report is not to be deemed filed as part of this report. The following additional financial data should be read in conjunction with the financial statements in the Annual Report. 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. ADDITIONAL FINANCIAL DATA 1993, 1992 AND 1991 REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULES TO THE PARTNERS OF IP TIMBERLANDS, LTD.: We have audited in accordance with generally accepted auditing standards, the consolidated financial statements included in IP Timberlands, Ltd.'s 1993 Annual Report to Unitholders incorporated by reference in this Form 10-K, and have issued our report thereon dated February 4, 1994. Our audits were made for the purpose of forming an opinion on those statements taken as a whole. The schedules listed in the accompanying index are the responsibility of the Partnership'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 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 York, N. Y. February 4, 1994 SCHEDULE II IP TIMBERLANDS, LTD. SCHEDULE II--AMOUNTS RECEIVABLE FROM RELATED PARTIES (IN THOUSANDS) FOR THE YEAR ENDED DECEMBER 31, 1993 FOR THE YEAR ENDED DECEMBER 31, 1992 FOR THE YEAR ENDED DECEMBER 31, 1991 - ------------------ (a) Consists of notes with due dates of up to 90 days; weighted average interest rates of 3.5% at December 31, 1993, 3.68% at December 31, 1992, and 5.28% at December 31, 1991. (b) Consisted of notes with annual due dates through 1995; weighted average interest rates of 9.75% at December 31, 1990. SCHEDULE V IP TIMBERLANDS, LTD. SCHEDULE V--PROPERTY, PLANT AND EQUIPMENT (IN THOUSANDS) FOR THE YEAR ENDED DECEMBER 31, 1993 FOR THE YEAR ENDED DECEMBER 31, 1992 FOR THE YEAR ENDED DECEMBER 31, 1991 - ------------------ (a) Represents depletion credited directly to the asset. SCHEDULE VI IP TIMBERLANDS, LTD. SCHEDULE VI--ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT (IN THOUSANDS) FOR THE YEAR ENDED DECEMBER 31, 1993 FOR THE YEAR ENDED DECEMBER 31, 1992 FOR THE YEAR ENDED DECEMBER 31, 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. IP TIMBERLANDS, LTD. By: IP Forest Resources Company (as managing general partner) By: JAMES W. GUEDRY ------------------------------- JAMES W. GUEDRY, VICE PRESIDENT AND SECRETARY 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: ( IP TIMBERLANDS, LTD. LOGO ) PRINTED ON HAMMERMILL PAPERS, ACCENT OPAQUE, 50 LBS. HAMMERMILL PAPERS IS A DIVISION OF INTERNATIONAL PAPER EXHIBIT INDEX Exhibits Page No. -------- -------- (13) 1993 Annual Report to Unitholders of the Registrant (24) Power of Attorney

787250_1993.txt

787250_1993

1993

787250

Item 1 - BUSINESS* DPL INC. DPL Inc. was organized in 1985 under the laws of the State of Ohio to engage in the acquisition and holding of securities of corporations for investment purposes. The executive offices of DPL Inc. are located at Courthouse Plaza Southwest, Dayton, Ohio 45402 - telephone (513) 224-6000. DPL Inc.'s principal subsidiary is The Dayton Power and Light Company ("DP&L"). DP&L is a public utility incorporated under the laws of Ohio in 1911. Located in West Central Ohio, it furnishes electric service to 464,000 retail customers in a 24 county service area of approximately 6,000 square miles and furnishes natural gas service to 286,000 customers in 16 counties. In addition, DP&L provides steam heating service in downtown Dayton, Ohio. DP&L serves an estimated population of 1.2 million. Principal industries served include electrical machinery, automotive and other transportation equipment, non-electrical machinery, agriculture, paper, rubber and plastic products. DP&L's sales reflect the general economic conditions and seasonal weather patterns of the area. The solid performance of the economy of West Central Ohio and seasonal summer and winter weather in 1993 contributed to increased energy sales for the year. Electric sales to business customers were up 4% for the year while total electric and natural gas sales increased 4% and 3%, respectively, as compared to 1992. During 1993, cooling degree days were 4% above the twenty year average and 35% above 1992. Heating degree days in 1993 were 3% above the thirty year average and 6% above 1992. Sales patterns will change in future years as weather and the economy fluctuate. Subsidiaries of DP&L include MacGregor Park Inc., an owner and developer of real estate; and DP&L Community Urban Redevelopment Corporation, the owner of a downtown Dayton office building. Other subsidiaries of DPL Inc. include Miami Valley CTC, Inc., which provides transportation services to DP&L and another unaffiliated Dayton-based company; Miami Valley Leasing, which leases vehicles and miscellaneous communications equipment, owns real estate and has a financial investment in an unaffiliated energy development company; Miami Valley Resources, Inc. ("MVR"), a natural gas supply management company; Miami Valley Lighting, Inc., a street lighting business; Miami Valley Insurance Company, an insurance company for DPL Inc. and its subsidiaries; and Miami Valley Development Company, which is engaged in the business of technology research and development. * Unless otherwise indicated, the information given in "Item 1 - BUSINESS" is current as of March 11, 1994. No representation is made that there have not been subsequent changes to such information. I-1 DPL Inc. and its subsidiaries are exempt from registration with the Securities and Exchange Commission under the Public Utility Holding Company Act of 1935 because its utility business operates solely in the State of Ohio. DPL Inc. and its subsidiaries employed 3,147 persons as of December 31, 1993, of which 2,653 are full-time employees and 494 are part-time employees. Information relating to industry segments is contained in Note 11 of Notes to Consolidated Financial Statements on page 26 of the registrant's 1993 Annual Report to Shareholders ("1993 Annual Report"), which Note is incorporated herein by reference. COMPETITION DPL Inc. competes through its principal subsidiary, DP&L, with privately and municipally owned electric utilities and rural electric cooperatives, natural gas suppliers and other alternate fuel suppliers. DP&L competes on the basis of price and service. Like other utilities, DP&L from time to time may have electric generating capacity available for sale to other utilities. DP&L competes with other utilities to sell electricity provided by such capacity. The ability of DP&L to sell this electricity will depend on how DP&L's price, terms and conditions compare to those of other utilities. In addition, from time to time, DP&L also makes power purchases from neighboring utilities. In an increasingly competitive energy environment, cogenerated power may be used by customers to meet their own power needs. Cogeneration is the dual use of a form of energy, typically steam, for an industrial process and for the generation of electricity. The Public Utilities Regulatory Policies Act of 1978 ("PURPA") provides regulations covering when an electric utility is required to offer to purchase excess electric energy from cogeneration and small power production facilities that have obtained qualifying status under PURPA. The National Energy Policy Act of 1992 which reformed the Public Utilities Holding Company Act of 1935 allows the federal government to mandate access by others to a utility's electric transmission system and may accelerate competition in the supply of electricity. General deregulation of the natural gas industry has continued to prompt the influence of market competition as the driving force behind natural gas procurement. The maturation of the natural gas spot market in combination with open access I-2 interstate transportation provided by pipelines has provided DP&L, as well as its end-use customers, with an array of procurement options. Customers with alternate fuel capability can continue to choose between natural gas and their alternate fuel based upon overall economics. Therefore, demand for natural gas purchased from DP&L or purchased elsewhere and transported to the end-use customer by DP&L could fluctuate based on the economics of each in comparison with changes in alternate fuel prices. For DP&L, price competition and reliability among both natural gas suppliers and interstate pipeline sources are major factors affecting procurement decisions. In April 1992, FERC issued Order No. 636 ("Order 636") amending its regulations governing the service obligations, rate design and cost recovery of interstate pipelines. DP&L's interstate pipeline suppliers have received approval from FERC to implement their restructuring plans to comply with the regulations. The Public Utilities Commission of Ohio ("PUCO") has held roundtable discussions and meetings regarding the implications of Order 636 for local distribution companies, producers and consumers. The PUCO has issued interim guidelines allowing utilities to file revised natural gas transportation tariffs to comply with the Order, and is continuing efforts to examine the impact via roundtable discussions. DP&L's natural gas tariffs and operations comply with the PUCO's interim guidelines and the requirements of Order 636. In January 1994, DP&L, the Staff of the PUCO and the Office of the Ohio Consumers' Counsel (the "OCC") submitted to the PUCO an agreement which resolves issues relating to the recovery of Order 636 "transition costs" to be billed to DP&L by natural gas interstate pipeline companies. The agreement, which is subject to PUCO approval, provides for the full recovery of these transition costs from DP&L customers. The interstate pipelines will file with the FERC for authority to recover these transition costs, the exact magnitude of which has not been established. MVR, established in 1986 as a subsidiary of DPL Inc., acts as a broker in arranging and managing natural gas supplies for business and industry. Deliveries of natural gas to MVR customers can be made through DP&L's transportation system, or another transportation system, on the same basis as deliveries to customers of other gas brokerage firms. Customers with alternate fuel capability can continue to choose between natural gas and their alternate fuel based upon overall economics. I-3 DP&L provides service to 12 municipal customers which distribute electricity within their corporate limits. One municipality has signed a contract for DP&L to provide 95% of its requirements. In addition to these municipal customers, DP&L maintains an interconnection agreement with one municipality which can generate all or a portion of its energy requirements. Sales to municipalities represented 1.3% of total electricity sales in 1993. DP&L maintains discussions with these municipalities concerning potential energy agreements. CONSTRUCTION AND FINANCING PROGRAM OF DPL INC. 1994-1998 Construction Program - ------------------------------ The estimated construction additions for the years 1994-1998 are set forth below: Estimated 1994 1995 1996 1997 1998 1994-1998 ---- ---- ---- ---- ---- --------- millions Electric generation and transmission commonly owned with neighboring utilities................ $ 22 $ 28 $ 24 $ 41 $ 23 $138 Other electric generation and transmission facilities.. 43 33 34 18 13 141 Electric distribution...... 24 26 31 34 37 152 General.................... 3 3 2 1 1 10 Gas, steam and other facilities............... 17 16 14 15 15 77 --- --- --- --- --- --- Total construction..... $109 $106 $105 $109 $ 89 $518 Estimated construction costs over the next five years average $104 million annually which is approximately equal to the projected depreciation expense over the same period. The construction additions for the period include plans to construct a series of 70 MW combustion turbine generating units scheduled to be completed at varying intervals dependent upon need. The first unit is scheduled for completion in June 1995. I-4 Construction plans are subject to continuing review and are expected to be revised in light of changes in financial and economic conditions, load forecasts, legislative and regulatory developments and changing environmental standards, among other factors. DP&L's ability to complete its capital projects and the reliability of future service will be affected by its financial condition, the availability of external funds at reasonable cost and adequate and timely rate increases. See ENVIRONMENTAL CONSIDERATIONS for a description of environmental control projects and regulatory proceedings which may change the level of future construction additions. The potential impact of these events on DP&L's operations cannot be estimated at this time. 1994-1998 Financing Program - --------------------------- DP&L will require a total of $106 million during the next five years for bond maturities and preferred stock and bond sinking funds in addition to any funds needed for the construction program. DPL Inc. will require an additional $5 million for mandatory redemptions. At year-end 1993, DPL Inc. had a cash and temporary investment balance of $82 million. Proceeds from temporary cash investments, together with internally generated cash and future outside financings, will provide for the funding of the construction program, sinking funds and general corporate requirements. In mid-March 1994, DPL Inc. plans to file a registration statement with the Securities and Exchange Commission for the issuance and sale of approximately three-and-a-half million common shares. The net proceeds from the planned sale of shares, estimated to equal approximately $65 million, would be contributed to DP&L which would use the funds, along with temporary cash investments and/or short-term borrowings, to redeem in May 1994 all of the outstanding shares of its Preferred Stock, Series D, E, F, H and I, which have an average dividend rate of 8.1%. During late 1992 and early 1993, DP&L took advantage of favorable market conditions to reduce its cost of debt and extend maturities through early refundings. Three new series of First Mortgage Bonds were issued in 1992 in the aggregate principal amount of $320 million at an average interest rate of 7.8% to finance the redemption of a similar principal amount of debt securities. Additionally, in early 1993, DP&L issued two new series of First Mortgage Bonds in the aggregate principal amount of $446 million at an average interest rate of 8.0% to finance the redemption of a similar principal amount of six series of First Mortgage Bonds. The amounts and timings of future financings will depend upon market and other conditions, rate increases, levels of sales and construction plans. I-5 In November 1989, DPL Inc. entered into a revolving credit agreement ("the Credit Agreement") with a consortium of banks renewable through 1998 which allows total borrowings by DPL Inc. and its subsidiaries of $200 million. DP&L has authority from the PUCO to issue short term debt up to $200 million with a maximum debt limit of $300 million including loans from DPL Inc. under the terms of the Credit Agreement. At December 31, 1993, DPL Inc. had no outstanding borrowings under this Credit Agreement. At December 31, 1992, DPL Inc. had $90 million outstanding under the Credit Agreement which was used to fund share purchases for DPL Inc.'s Employee Stock Ownership Plan. These borrowings were repaid in January 1993 with the proceeds from the issuance of $90 million of DPL Inc.'s 7.83% Notes due 2007. DP&L also has $97 million available in short term informal lines of credit At year-end, DP&L had $10 million outstanding from these lines of credit and $15 million in commercial paper outstanding. Under DP&L's First and Refunding Mortgage, First Mortgage Bonds may be issued on the basis of (i) 60% of unfunded property additions, subject to net earnings, as defined, being at least two times interest on all First Mortgage Bonds outstanding and to be outstanding, and (ii) 100% of retired First Mortgage Bonds. DP&L anticipates that, during 1994-98, it will be able to issue sufficient First Mortgage Bonds to satisfy its long-term debt requirements in connection with the financing of its construction and refunding programs discussed above. The maximum amount of First Mortgage Bonds which may be issued in the future will fluctuate depending upon interest rates, the amounts of bondable property additions, earnings and retired First Mortgage Bonds. There are no coverage tests for the issuance of preferred stock under DP&L's Amended Articles of Incorporation. ELECTRIC OPERATIONS AND FUEL SUPPLY DP&L's present winter generating capability is 3,053,000 KW. Of this capability, 2,843,000 KW (approximately 93%) is derived from coal-fired steam generating stations and the balance consists of combustion turbine and diesel-powered peaking units. Approximately 87% (2,472,000 KW) of the existing steam generating capability is provided by certain units owned as tenants in common with the Cincinnati Gas & Electric Company ("CG&E") or with CG&E and Columbus Southern Power Company ("CSP"). Under the agreements among the companies, each company owns a specified undivided share of each facility, is entitled to its share of capacity and energy output, and has a capital and operating cost responsibility proportionate to its ownership share. I-6 A merger agreement between CG&E and PSI Resources is currently pending. DP&L has intervened in the merger proceeding currently pending at the FERC so that the operations of its commonly owned generating units will not be materially impacted by the merger. The remaining steam generating capability (371,000 KW) is derived from a generating station owned solely by DP&L. DP&L's all time net peak load was 2,765,000 KW, which occurred in July 1993. The present summer generating capability is 3,017,000 KW. GENERATING FACILITIES --------------------- MW Rating -------------- Owner- Operating DP&L Station ship* Company Location Portion Total - ----------- ----- --------- ------------ ------- ----- Coal Units - ---------- Hutchings W DP&L Miamisburg, OH 371 371 Killen C DP&L Wrightsville, OH 402 600 Stuart C DP&L Aberdeen, OH 820 2,340 Conesville-Unit 4 C CSP Conesville, OH 129 780 Beckjord-Unit 6 C CG&E New Richmond, OH 210 420 Miami Fort- Units 7&8 C CG&E North Bend, OH 360 1,000 East Bend-Unit 2 C CG&E Rabbit Hash, KY 186 600 Zimmer C CG&E Moscow, OH 365 1,300 Combustion Turbines or Diesel - ----------------------------- Hutchings W DP&L Miamisburg, OH 32 32 Yankee Street W DP&L Centerville, OH 144 144 Monument W DP&L Dayton, OH 12 12 Tait W DP&L Dayton, OH 10 10 Sidney W DP&L Sidney, OH 12 12 * W = Wholly Owned; C = Commonly Owned I-7 In order to transmit energy to their respective systems from their commonly-owned generating units, the companies have constructed and own, as tenants in common, 847 circuit miles of 345,000-volt transmission lines. DP&L has several interconnections with other companies for the purchase, sale and interchange of electricity. DP&L derived over 99% of its electric output from coal-fired units in 1993. The remainder was derived from units burning oil or natural gas which were used to meet peak demands. DP&L estimates that approximately 65-85% of its coal requirements for the period 1994-1998 will be obtained through long term contracts, with the balance to be obtained by spot market purchases. DP&L has been informed by CG&E and CSP through the procurement plans for the commonly owned units operated by them that sufficient coal supplies will be available during the same planning horizon. The prices to be paid by DP&L under its long term coal contracts are subject to adjustment in accordance with various indices. Each contract has features that will limit price escalations in any given year. The total average price per million British Thermal Units ("MMBTU") of coal received in each of 1993 and 1992 was $1.46/MMBTU and $1.56/MMBTU in 1991. The average fuel cost per kWh generated of all fuel burned for electric generation (coal, gas and oil) for the year was 1.43 cents which represents a decrease from 1.48 cents in 1992 and 1.60 cents in 1991. Through the operation of a fuel cost adjustment clause applicable to electric sales, the increases and decreases in fuel costs are reflected in customer rates on a timely basis. See RATE REGULATION AND GOVERNMENT LEGISLATION and ENVIRONMENTAL CONSIDERATIONS. GAS OPERATIONS AND GAS SUPPLY DP&L has long term firm pipeline transportation agreements with ANR Gas Pipeline Company ("ANR") through 1997 and Columbia Gas Transmission Corporation ("Columbia"), Columbia Gulf Transmission Corporation, Texas Gas Transmission Corporation ("Texas Gas") and Panhandle Eastern Pipe Line Company ("Panhandle") through 2004. Along with the firm transportation services DP&L has approximately 16 billion cubic feet of storage service with the various pipelines. DP&L also maintains and operates four propane-air plants with a daily rated capacity of approximately 67,500 thousand cubic feet ("MCF") of natural gas. I-8 Coordinated with the pipeline service agreements, DP&L has 14 firm natural gas supply agreements with various natural gas producers. DP&L purchased approximately 90% of its 1993 supply under these producer agreements and the remaining supplies on the spot/short term market. DP&L purchased natural gas during 1993 at an average price of $3.65 per MCF, compared to $3.31 per MCF and $2.70 per MCF in 1992 and 1991, respectively. Through the operation of a natural gas cost adjustment clause applicable to gas sales, increases and decreases in DP&L's natural gas costs are reflected in customer rates on a timely basis. See RATE REGULATION AND GOVERNMENT LEGISLATION. DP&L is also interconnected with CNG Transmission Corporation and Texas Eastern Transmission Corporation. Several interconnections with various interstate pipelines provide DP&L the opportunity to purchase competitively-priced natural gas supplies and pipeline services. During 1993, DP&L implemented requirements of Order 636 with all of its natural gas interstate pipeline suppliers. As a result of FERC's mandate that pipelines no longer bundle the product of natural gas with pipeline transportation into one package, DP&L purchased the majority of its natural gas in 1993 under direct market purchases. Additionally, the implementation of Order 636 required DP&L to purchase certain volumes of natural gas from interstate pipelines to fill storage. In the future, DP&L will obtain all its natural gas from direct market purchases or pipelines based on cost and reliability. DP&L has natural gas agreements that meet 90% of its requirements. The remainder will be purchased to meet seasonal requirements under short term purchase agreements. The PUCO continues to support open access, nondiscriminatory transportation of natural gas by the state's local distribution companies for end-use customers. The PUCO has guidelines to provide a standardized structure for end-use transportation programs which requires a tariff providing the prices, terms and conditions for such service. DP&L has filed a transportation tariff to comply with these guidelines and approval is pending. During 1993, DP&L provided transportation service to 185 end-use customers, delivering a total quantity of 13,401,229 MCF. Columbia and Panhandle have obtained conditional approval from FERC to recover take-or-pay and contract reformation costs from DP&L through fixed demand surcharges pursuant to revised FERC rules. The validity of the revisions was reviewed and dismissed by the U.S. Court of Appeals for the District of Columbia Circuit. Pursuant to a settlement approved by the PUCO, DP&L may recover take-or-pay costs from its retail and transportation customers. I-9 On April 30, 1990, Columbia filed an application with FERC to implement a general rate increase in order to recover, among other things, costs associated with construction of certain "Global Settlement" facilities. The rates were accepted to become effective November 1, 1990. A partial offer of settlement was accepted on April 16, 1992, and an initial decision on the remaining issues was issued on November 13, 1992. On May 31, 1991, Columbia filed a second application with FERC to implement a general rate increase which was partially accepted effective December 1, 1991. On October 1, 1991, Columbia filed a third application to implement a general rate increase which was partially accepted to become effective April 1, 1992. The second and third applications were subsequently consolidated into one rate proceeding, and rate design, cost classification and cost allocations were further consolidated into Columbia's restructuring proceeding referenced in following paragraphs. A settlement dated November 9, 1992, regarding the remaining cost of service and throughput issues was approved by FERC April 2, 1993. On April 27, 1990, Texas Gas filed an application with FERC to implement a general rate increase which was accepted to become effective November 1, 1990. This docket was consolidated into the Texas Gas restructuring proceeding which was made effective November 1, 1993. On May 1, 1992, Panhandle filed an application with FERC to implement a general rate increase which rates were accepted effective November 1, 1992. A hearing on this matter is set for May 17, 1994. On April 29, 1993 Texas Gas filed a second application with FERC to implement a rate increase which was accepted effective November 1, 1993. A hearing on this matter is set for June 28, 1994. On November 1, 1993, ANR filed an application with FERC to implement a rate increase which was accepted effective May 2, 1994. Through the operation of a natural gas cost adjustment clause applicable to gas sales, increases and decreases in DP&L's natural gas costs are reflected in customer rates on a timely basis. On July 31, 1991, Columbia Gas System Inc. and Columbia, one of DP&L's major pipeline suppliers, filed separate Chapter 11 petitions in U.S. Bankruptcy Court. The bankruptcy court permitted Columbia to break approximately 4,500 long term natural gas contracts with upstream suppliers on August 22, 1991, January 6, 1992, and January 8, 1992. The bankruptcy court issued an order on March 18, 1992, granting approval of an agreement between the customers and Columbia which assures the continuation of all firm service agreements (including storage) through the winter of 1993, with year-to-year continuation unless adequate notice is provided. On February 13, 1992, the bankruptcy court ruled on a motion by Columbia to flow through to its customers all appropriate refunds, including take-or-pay refunds which were received from its upstream suppliers and I-10 excessive rate refunds except for approximately $18 million of pre-petition take-or-pay refunds. However, on July 6, 1992, the United States District Court for Delaware reversed the bankruptcy court. On July 8, 1993, the Third Circuit Court of Appeals reversed the District Court for Delaware and reinstated the U.S. Bankruptcy Court's ruling that Columbia may flow through to its customers all post petition take-or-pay refunds which were received from its upstream suppliers. The U.S. Supreme Court denied an appeal on February 18, 1994 of the Third Circuit Court of Appeals'1decision. DP&L expects full recovery of all take-or-pay refunds received by Columbia post petition. The parties to the bankruptcy are currently evaluating Columbia's proposed plan of reorganization. Based upon a July 1993 FERC Order disallowing the recovery of natural gas producer contracts rejected in the bankruptcy case, DP&L does not expect the bankruptcy proceedings to have a material adverse effect on its earnings or competitive position. In April 1992 FERC issued Order 636 which amended its regulations governing the service obligations of interstate pipelines. Some of the major changes enacted include unbundling of pipeline sales from transportation, the creation of a "no-notice" transportation service, pre-granted abandonment for all interruptible and short term firm transportation subject to a right-of-first refusal, capacity brokering, rate design and transition costs. All interstate pipeline filings were made effective by November 1, 1993. In response to Order 636 issued by FERC, the PUCO has initiated roundtable discussions with natural gas utilities and other interested parties to discuss the impact of the Order and the state regulation of natural gas utilities. The PUCO has issued interim guidelines allowing utilities to file revised natural gas transportation tariffs to comply with Order 636, and is continuing to examine the impact via ongoing roundtable discussions that run concurrently with the interstate pipelines' restructuring proceedings. The interim guidelines also require each natural gas utility to file plans for peak day operations. DP&L's operations comply with all interim guidelines and DP&L expects full recovery of all Order 636 transition costs. RATE REGULATION AND GOVERNMENT LEGISLATION DPL Inc. and its subsidiaries are exempt from registration with the Securities and Exchange Commission under the Public Utility Holding Company Act of 1935 because its utility business operates solely in the State of Ohio. DP&L's sales of electricity, natural gas and steam to retail customers are subject to rate regulation by the PUCO and various municipalities. DP&L's wholesale electric rates to municipal corporations and other distributors of electric energy are subject to regulation by FERC under the Federal Power Act. I-11 Ohio law establishes the process for determining rates charged by public utilities. Regulation of rates encompasses the timing of applications, the effective date of rate increases, the cost basis upon which the rates are based and other related matters. Ohio law also established the Office of the OCC, which is authorized to represent residential consumers in state and federal judicial and administrative rate proceedings. DP&L's electric and natural gas rate schedules contain certain recovery and adjustment clauses subject to periodic audits by, and proceedings before, the PUCO. Electric fuel and gas costs are expensed as recovered through rates. Ohio legislation extends the jurisdiction of the PUCO to the records and accounts of certain public utility holding company systems, including DPL Inc. The legislation extends the PUCO's supervisory powers to a holding company system's general condition and capitalization, among other matters, to the extent that they relate to the costs associated with the provision of public utility service. Additionally, the legislation requires PUCO approval of (i) certain transactions and transfers of assets between public utilities and entities within the same holding company system, and (ii) prohibits investments by a holding company in subsidiaries which are not public utilities in an amount in excess of 15% of the aggregate capitalization of the holding company on a consolidated basis at the time such investments are made. In April 1991, DP&L filed an application with the PUCO to increase its electric rates to recover costs associated with the construction of the William H. Zimmer Generating Station ("Zimmer"), earn a return on DP&L's investment and recover the current costs of providing electric service to its customers. In November 1991, DP&L entered into a settlement agreement with various consumer groups resolving all issues in the case. The PUCO approved the agreement on January 22, 1992. Pursuant to that agreement, new electric rates took effect February 1, 1992, January 2, 1993 and January 3, 1994. The agreement also established a baseline return on equity of 13% (subject to upward adjustment) until DP&L's next electric rate case. In the event that DP&L's return exceeds the allowed return by between one and two percent, then one half of the excess return will be used to reduce the cost of demand-side management ("DSM") programs. Any return that exceeds the allowed return by more than two percent will be entirely credited to these programs. Amounts deferred during the phase-in period, including carrying charges, will be capitalized and recovered over seven years commencing in 1994. Deferrals were $58 million in 1992 and $28 million in 1993. The recovery expected in 1994, net of additional carrying cost deferrals, is $10 million. The phase-in plan meets the requirements of the Financial Accounting Standards Board ("FASB") Statement No. 92. I-12 In addition, DP&L agreed to undertake cost-effective DSM programs with an average annual cost of $15 million for four years commencing in 1992. The amount recovered in rates was $4.6 million in 1992. This amount increased to $7.8 million in 1993 and will remain at that level in subsequent years. The difference between expenditures and amounts recovered through rates is deferred and is eligible for recovery in future rates in accordance with existing PUCO rulings. In March 1991, the PUCO granted DP&L the authority to defer interest charges, net of income tax, on its 28.1% ownership investment in Zimmer from the March 30, 1991, commercial in-service date through January 31, 1992. Deferred interest charges on the investment in Zimmer have been adjusted to a before tax basis in 1993 as a result of FASB Statement No. 109. Amounts deferred are being amortized over the life of the plant. Regulatory deferrals on the balance sheet were: Dec. 31 Dec. 31 1993 1992 -------- -------- --millions-- Phase-in $ 85.8 $ 57.7 DSM 23.3 2.2 Deferred interest - Zimmer 63.7 43.9 ------ ------ Total $172.8 $103.8 ====== ====== In 1989 the PUCO approved rules for the implementation of a comprehensive Integrated Resource Planning ("IRP") program for all investor-owned electric utilities in Ohio. Under this program, each utility is required to file an IRP as part of its Long Term Forecast Report ("LTFR"). The IRP requires each utility to evaluate available demand-side resource options in addition to supply-side options to determine the most cost-effective means for satisfying customer requirements. The rules currently allow a utility to apply for deferred recovery of DSM program expenditures and lost revenues between LTFR proceedings. Ultimate recovery of deferred expenditures is contingent on review and approval of such programs as cost-effective and consistent with the most recent IRP proceeding. The rules also allow utilities to submit alternative proposals for the recovery of DSM programs and related costs. I-13 In 1991 the PUCO ruled that DP&L's 1991 LTFR be consolidated and reviewed in conjunction with DP&L's 1992 LTFR proceeding. DP&L filed its 1992 LTFR in June 1992. DP&L also filed its environmental compliance plan in June 1992, and asked the PUCO to consolidate the environmental compliance plan proceeding with the LTFR proceeding. The PUCO granted DP&L's request to consolidate the cases. The evidentiary hearing on DP&L's 1991/1992 LTFR and environmental compliance plan was held on February 17, 1993. The parties entered into a stipulation in settlement of all issues which continues DP&L's commitment to DSM programs. The stipulation was approved by the PUCO on May 6, 1993. DP&L has in place a percentage of income payment plan ("PIPP") for eligible low-income households as required by the PUCO. This plan prohibits disconnections for nonpayment of customer bills if eligible low-income households pay a specified percentage of their household income toward their utility bill. The PUCO has approved a surcharge by way of a temporary base rate tariff rider which allows companies to recover arrearages accumulated under PIPP. In 1993 DP&L reached a settlement with the PUCO staff, the Office of the OCC and the Legal Aid Society to provide new and expanded programs for PIPP eligible customers. The expanded programs include greater arrears crediting, lower monthly payments, educational programs and information reports. In exchange, DP&L may accelerate recovery of PIPP and pre-PIPP arrearages and recover program costs. The settlement also established a four year moratorium on changes to the program. The PUCO approved the settlement on December 2, 1993. Pursuant to the terms of the settlement, DP&L filed an application on January 21, 1994 to lower its PIPP rate. To date, the PUCO has not acted on DP&L's application. In 1991 the PUCO issued a Finding and Order which encourages electric utilities to undertake the competitive bidding of new supply-side energy projects. The policy also encourages utilities to provide transmission grid access to those supply-side energy providers awarded bids by utilities. Electric utilities are permitted to bid on their own proposals. The PUCO has issued for comment proposed rules for competitive bidding but has not issued final rules at this time. DP&L initiated a competitive bidding process in January 1993 for the construction of up to 140 MW of electric peaking capacity and energy by 1997. Through an Ohio Power Siting Board ("OPSB") investigative process, DP&L's self-built option was evaluated to be the least cost option. On March 7, 1994, the OPSB approved DP&L's applications for up to three 70 MW combustion turbines and two natural gas supply lines for the proposed site. I-14 The OPSB issued rules on March 22, 1993 to provide electric and magnetic field information in applications for construction of major generating and transmission facilities. DP&L has addressed the topics covered by the new rules in all recent projects. One utility requested a rehearing on the rules which was denied by the OPSB on May 24, 1993. At this time DP&L cannot predict the ultimate impact associated with the siting of new transmission lines. On March 25, 1993, the PUCO adopted guidelines for the treatment of emission allowances created by the Clean Air Act Amendments of 1990. Under the guidelines, DP&L's emission allowance trading plans, procedures, practices, activity and associated costs will be reviewed in its annual electric fuel component audit proceeding. The PUCO guidelines are being appealed by an industrial consumer group. In its Entry on emission allowances, the PUCO directed its Staff to develop proposed accounting guidelines for allowance trading programs in accordance with FERC rulemaking efforts. According to FERC Order No. 552 issued on March 23, 1993, DP&L will value allowances based on a weighted average cost methodology. On May 26, 1993, the Senate of the State of Ohio approved the appointment of Mr. David W. Johnson as PUCO commissioner. On January 12, 1994, the Ohio Consumers' Counsel Governing Board appointed Robert S. Tongren, a former assistant attorney general, to the position of Consumers' Counsel. Mr. Tongren replaced William A. Spratley, whose resignation from this position became effective September 30, 1993. On February 22, 1994 a bill was introduced in the State of Ohio House of Representatives which, if approved, would give electric consumers the opportunity to obtain "retail" and "wholesale at retail" services from electric suppliers other than their current supplier at competitive rates. The ultimate disposition of the bill or its effect on DP&L cannot be determined at this time. ENVIRONMENTAL CONSIDERATIONS The operations of DP&L, including the commonly owned facilities operated by DP&L, CG&E and CSP, are subject to federal, state, and local regulation as to air and water quality, disposal of solid waste and other environmental matters, including the location, construction and initial operation of new electric generating facilities and most electric transmission lines. DP&L expended $6 million for environmental control facilities during 1993. The possibility exists that current environmental regulations could be revised which could change the level of estimated 1994-1998 construction expenditures. See CONSTRUCTION AND FINANCING PROGRAM OF DPL INC. I-15 Air Quality - ----------- In July 1985, the United States Environmental Protection Agency ("U.S. EPA") adopted final stack height rules which could result in the lowering of emission limits for sulfur dioxide and particulate matter from affected units. DP&L operates one unit (Killen Station) potentially affected by these rules. The Ohio Environmental Protection Agency ("Ohio EPA") has determined that Killen Station is not impacting air quality and, therefore, no further action is needed at this time. CSP has informed DP&L that Conesville Unit 4 is not affected by the rules. CG&E has informed DP&L that Miami Fort Unit 7 is "grandfathered" from regulation and that Miami Fort Unit 8 is not affected by the rules because Miami Fort Unit 5 is picking up the necessary emission reductions. On June 17 and July 12, 1988, DP&L and others filed with the U.S. Supreme Court two petitions for a Writ of Certiorari seeking a review of the D.C. Circuit Court of Appeals decision that addressed the 1985 stack height rules. Those petitions were denied in October 1988 and, as a result, the U.S. EPA planned to begin a remand rulemaking to address issues arising from a lower Court's opinion. The U.S. EPA continues to work on a remand rulemaking. In December 1988, the U.S. EPA notified the State of Ohio that the portion of its State Implementation Plan ("SIP") dealing with sulfur dioxide emission limitations for Hamilton County (in southwestern Ohio) was deficient and required the Ohio EPA to develop a new SIP within 18 months. The notice affects industrial and utility sources and could require significant reductions in sulfur dioxide emission limitations at CG&E's Miami Fort Units 7 and 8 which are jointly owned with DP&L. In February 1989, CG&E, together with other industrial sources affected by the notice, filed a petition for review in the U.S. Court of Appeals for the Sixth Circuit of the U.S. EPA's issuance of the notice. In July 1989, the Court of Appeals dismissed the petition for review. In April 1990, the Ohio EPA published its proposed revised SIP for comment. In June 1990, CG&E submitted its comments challenging the revisions, arguing that the proposed SIP is based on a computer model which is unsuitable and invalid for the hilly terrain of Hamilton County, and that in the last ten years, no violation of the National Ambient Air Quality Standards for SO2 has ever been monitored. In order to support its position, CG&E is taking part in an air monitoring program designed to prove that the present SIP adequately protects the ambient air quality. In October 1991, the Ohio EPA adopted new SO2 regulations for Hamilton County. These regulations do not change the preexisting requirements for Miami Fort Units 7 and 8. The new regulations have been submitted to the U.S. EPA. On January 27, 1994, the I-16 U.S. EPA provided notice in the Federal Register that the new regulations for the Ohio SIP for Hamilton County were conditionally approved. Changing environmental regulations continue to increase the cost of providing service in the utility industry. The Clean Air Act Amendments of 1990 (the "Act") will limit sulfur dioxide and nitrogen oxide emissions nationwide. The Act will restrict emissions in two phases with Phase I compliance completed by 1995 and Phase II completed by 2000. Final regulations were issued by the U.S. EPA on January 11, 1993. These regulations are consistent with earlier Act restrictions and do not change the expected costs of compliance of DP&L. DP&L's preliminary compliance plan was filed with the PUCO in June 1992 and consolidated with the 1991/1992 LTFR proceeding. DP&L anticipates meeting the requirements of Phase I by switching to lower sulfur coal at several commonly owned electric generating facilities and increasing existing scrubber removal efficiency. Cost estimates to comply with Phase I of the Act are approximately $10 million in capital expenditures. Phase I compliance is expected to have a minimal 1% to 2% price impact. Phase II requirements can be met primarily by switching to lower sulfur coal at all non-scrubbed coal-fired electric generating units. The stipulation entered into on February 17, 1993 with regards to the LTFR, including the environmental compliance plan, was approved by the PUCO on May 6, 1993. DP&L anticipates that costs to comply with the Act will be eligible for recovery in future fuel hearings and other regulatory proceedings. On March 16, 1993, DP&L received a Finding of Violation from the U.S. EPA regarding opacity standards at Killen Station and, on March 17, 1993, a Notice of Violation from the U.S. EPA regarding opacity standards at Stuart Station. DP&L has subsequently conducted conferences with the U.S. EPA to discuss the Finding and Notice. On October 11, 1993, DP&L entered into negotiated Consent Orders with the U.S. EPA for the alleged violations at Killen and Stuart Stations. The Consent Orders do not require payment of any penalty but require DP&L to formalize emissions control measures. Land Use - -------- DP&L and numerous other parties have been notified by the U.S. EPA that it considers them Potentially Responsible Parties ("PRPs") for clean-up at three superfund sites in Ohio - the Sanitary Landfill Site on Cardington Road in Montgomery County Ohio, the United Scrap Lead Site in Miami County, Ohio, and the Powell Road Landfill in Huber Heights, Montgomery County, Ohio. I-17 DP&L received notification from the U.S. EPA in July 1987, for the Cardington Road site. DP&L has not joined the PRP group formed at that site because of the absence of any known evidence that DP&L contributed hazardous substances to this site. The Record of Decision issued by the U.S. EPA identifies the chosen clean-up alternative at a cost estimate of $8.1 million. DP&L received notification from the U.S. EPA in September 1987, for the United Scrap Lead Site. DP&L has joined a PRP group for this site, which is actively conferring with the U.S. EPA. The Record of Decision issued by the U.S. EPA estimates clean-up costs at $27.1 million. DP&L is one of over 200 parties to this site, and its estimated contribution to the site is less than .01%. Nearly 60 PRPs are actively working to settle the case. DP&L is participating in the sponsorship of a study to evaluate alternatives to the U.S. EPA's clean-up plan. The final resolution of these investigations will not have a material effect on DP&L's financial position or earnings. DP&L and numerous other parties received notification from the U.S. EPA on May 21, 1993 that it considers them PRPs for clean-up of hazardous substances at the Powell Road Landfill Site in Huber Heights, Ohio. DP&L has joined the PRP group for the site. On October 1, 1993, the U.S. EPA issued its Record of Decision identifying a cost estimate of $20.5 million for the chosen remedy. DP&L is one of over 200 PRPs to this site, and its estimated contribution is less than 1%. The final resolution will not have a material effect on DP&L's financial position or earnings. I-18 I-19 I-20 I-21 I-22 Item 2 Item 2 - PROPERTIES Electric - -------- Information relating to DP&L's electric properties is contained in Item 1 - BUSINESS, DPL INC. (pages I-1 and I-2), CONSTRUCTION AND FINANCING PROGRAM OF DPL INC. (pages I-4 through I-6) and ELECTRIC OPERATIONS AND FUEL SUPPLY (pages I-6 through I-8) and Item 8 - Notes 2 and 7 of Notes to Consolidated Financial Statements on pages 21 and 23, respectively, of the registrant's 1993 Annual Report, which pages are incorporated herein by reference. Natural Gas - ----------- Information relating to DP&L's gas properties is contained in Item 1 - - BUSINESS, DPL INC. (pages I-1 and I-2) and GAS OPERATIONS AND GAS SUPPLY (pages I-8 through I-11), which pages are incorporated herein by reference. Steam - ----- DP&L owns two steam generating plants and the steam distribution facility serving downtown Dayton, Ohio. Other - ----- DP&L owns a number of area service buildings located in various operating centers. Substantially all property and plant of DP&L is subject to the lien of the Mortgage securing DP&L's First Mortgage Bonds. Item 3 Item 3 - LEGAL PROCEEDINGS Information relating to legal proceedings involving DP&L is contained in Item 1 - BUSINESS, DPL INC. (pages I-1 and I-2), GAS OPERATIONS AND GAS SUPPLY (pages I-8 through I-11), RATE REGULATION AND GOVERNMENT LEGISLATION (pages I-11 through I-15) and ENVIRONMENTAL CONSIDERATIONS (pages I-15 through I-18) and Item 8 - Note 2 of Notes of Consolidated Financial Statements on page 21 of the registrant's 1993 Annual Report, which pages are incorporated herein by reference. Item 4 Item 4 - SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS At DPL Inc.'s Annual Meeting of Shareholders ("Annual Meeting") held on April 20, 1993, shareholders approved a proposal to increase the number of authorized common shares of DPL Inc. from 120 million to 250 million. The proposal was approved with 81,668,678 shares voting FOR, 5,395,660 shares AGAINST and 1,770,393 shares ABSTAINED. Three directors of DPL Inc. were elected at the Annual Meeting, each of whom will serve a three year term expiring in 1996. The nominees were elected as follows: James F. Dicke, II, 87,896,326 shares FOR, 938,405 shares WITHHELD; Peter H. Forster, 87,838,970 shares FOR, 995,761 shares WITHHELD; and Jane G. Haley, 87,860,952 shares FOR, 973,779 shares WITHHELD. I-23 PART II - ------- Item 5 Item 5 - MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The information required by this item of Form 10-K is set forth on pages 14, 27 and 28 of the registrant's 1993 Annual Report, which pages are incorporated herein by reference. As of December 31, 1993, there were 53,275 holders of record of DPL Inc. common equity, excluding individual participants in security position listings. DP&L's Mortgage restricts the payment of dividends on DP&L's Common Stock under certain conditions. In addition, so long as any Preferred Stock is outstanding, DP&L's Amended Articles of Incorporation contain provisions restricting the payment of cash dividends on any of its Common Stock if, after giving effect to such dividend, the aggregate of all such dividends distributed subsequent to December 31, 1946 exceeds the net income of DP&L available for dividends on its Common Stock subsequent to December 31, 1946, plus $1,200,000. As of year end, all earnings reinvested in the business of DP&L were available for Common Stock dividends. The Credit Agreement requires that the aggregate assets of DP&L and its subsidiaries (if any) constitute not less than 60% of the total consolidated assets of DPL Inc., and that DP&L maintain common shareholder's equity (as defined in the Credit Agreement) at least equal to $550 million. Item 6 Item 6 - SELECTED FINANCIAL DATA The information required by this item of Form 10-K is set forth on page 14 of the registrant's 1993 Annual Report, which page 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 of Form 10-K is set forth in Note 2 of Notes to Consolidated Financial Statements on page 21 and on pages 1, 13, 15 and 16 of the registrant's 1993 Annual Report, which pages are incorporated herein by reference. Item 8 Item 8 - FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The information required by this item of Form 10-K is set forth on page 14 and on pages 17 through 27 of the registrant's 1993 Annual Report, which pages are incorporated herein by reference. II-1 Report of Independent Accountants on Financial Statement Schedules -------------------------------- To The Board of Directors of DPL Inc. Our audits of the consolidated financial statements referred to in our report dated January 25, 1994 appearing on page 27 of the 1993 Annual Report to Shareholders of DPL 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. Price Waterhouse Dayton, Ohio January 25, 1994 II-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 EXECUTIVE OFFICERS OF THE REGISTRANT Directors of the Registrant - --------------------------- The information required by this item of Form 10-K is set forth on pages 2 through 5 of DPL Inc.'s definitive Proxy Statement dated March 2, 1994, relating to the 1994 Annual Meeting of Shareholders ("1994 Proxy Statement"), which pages are incorporated herein by reference, and on pages I-21 and I-22 of this Form 10-K. Item 11 Item 11 - EXECUTIVE COMPENSATION The information required by this item of Form 10-K is set forth on pages 9 through 15 of the 1994 Proxy Statement, which pages are incorporated herein by reference. Item 12 Item 12 - SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information required by this item of Form 10-K is set forth on pages 3 through 6 and on pages 14 and 15 of the 1994 Proxy Statement, which pages are incorporated herein by reference. Item 13 Item 13 - CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS None. III-1 PART IV - ------- Item 14 Item 14 - EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K Pages of 1993 Form 10-K Incorporated by Reference ------------------ Report of Independent Accountants..................... II-2 (a) Documents filed as part of the Form 10-K 1. Financial Statements Pages of 1993 Annual -------------------- Report Incorporated by Reference -------------------- Consolidated Statement of Results of Operations for the three years in the period ended December 31, 1993..................................... 17 Consolidated Statement of Cash Flows for the three years in the period ended December 31, 1993..... 18 Consolidated Balance Sheet as of December 31, 1993 and 1992......................................... 19 Notes to Consolidated Financial Statements............ 20 - 26 Report of Independent Accountants..................... 27 2. Financial Statement Schedules ----------------------------- For the three years in the period ended December 31, 1993: Page No. ------------- Schedule V - Property and plant IV-7 - IV-9 Schedule VI - Accumulated depreciation and amortization IV-10 - IV-12 Schedule VII - Obligations relating to securities of other issuers IV-13 Schedule VIII - Valuation and qualifying accounts IV-14 Schedule IX - Short-term borrowings IV-15 Schedule X - Supplementary income statement information IV-16 The information required to be submitted in schedules I, II, III, IV, XI, XII and XIII is omitted as not applicable or not required under rules of Regulation S-X. IV-1 3. Exhibits -------- The following exhibits have been filed with the Securities and Exchange Commission and are incorporated herein by reference. Incorporation by Reference ----------------- 2 Copy of the Agreement of Merger among Exhibit A to the DPL Inc., Holding Sub Inc. and DP&L 1986 Proxy Statement dated January 6, 1986.................. (File No. 1-2385) 3(a) Copy of Amended Articles of Exhibit 3 to Report on Incorporation of DPL Inc. dated Form 10-K for year ended January 4, 1991, and amendment dated December 31, 1991 December 3, 1991....................... (File No. 1-9052) 4(a) Copy of Composite Indenture dated as of Exhibit 4(a) to October 1, 1935, between DP&L and Report on Form 10-K The Bank of New York, Trustee with all for year ended amendments through the Twenty-Ninth December 31, 1985 Supplemental Indenture................. (File No. 1-2385) 4(b) Copy of the Thirtieth Supplemental Exhibit 4(h) to Indenture dated as of March 1, 1982, Registration Statement and The Bank of New York, Trustee...... No. 33-53906 4(c) Copy of the Thirty-First Supplemental Exhibit 4(h) to Indenture dated as of November 1, 1982, Registration Statement between DP&L and The Bank of New York, No. 33-56162 Trustee................................ 4(d) Copy of the Thirty-Second Supplemental Exhibit 4(i) to Indenture dated as of November 1, 1982, Registration Statement between DP&L and The Bank of New York, No. 33-56162 Trustee................................ 4(e) Copy of the Thirty-Third Supplemental Exhibit 4(e) to Indenture dated as of December 1, 1985, Report on Form 10-K between DP&L and The Bank of New York, for year ended Trustee................................ December 31, 1985 (File No. 1-2385) 4(f) Copy of the Thirty-Fourth Supplemental Exhibit 4 to Report Indenture dated as of April 1, 1986, on Form 10-Q for between DP&L and The Bank of New York, quarter ended Trustee................................ June 30, 1986 (File No. 1-2385) 4(g) Copy of the Thirty-Fifth Supplemental Exhibit 4(h) to Indenture dated as of December 1, 1986, report on Form 10-K between DP&L and The Bank of New York, for the year ended Trustee................................ December 31, 1986 (File No. 1-9052) IV-2 4(h) Copy of the Thirty-Sixth Supplemental Exhibit 4(i) to Indenture dated as of August 15, 1992, Registration Statement between DP&L and The Bank of New York, No. 33-53906 Trustee............................... 4(i) Copy of the Thirty-Seventh Supplemental Exhibit 4(j) to Indenture dated as of November 15, 1992, Registration Statement between DP&L and The Bank of New York, No. 33-56162 Trustee............................... 4(j) Copy of the Thirty-Eighth Supplemental Exhibit 4(k) to Indenture dated as of November 15, 1992, Registration Statement between DP&L and The Bank of New York, No. 33-56162 Trustee............................... 4(k) Copy of the Thirty-Ninth Suplemental Exhibit 4(k) to Indenture dated as of January 15, 1993, Registration Statement between DP&L and The Bank of New York, No. 33-57928 Trustee................................ 4(l) Copy of the Fortieth Supplemental Exhibit 4(m) to Report Indenture dated as of February 15, 1993, on Form 10-K for the between DP&L and The Bank of New York, year ended December 31, Trustee................................ 1992 (File No. 1-2385) 4(m) Copy of the Credit Agreement dated as Exhibit 4(k) to DPL of November 2, 1989 between DPL Inc., Inc.'s Registration the Bank of New York, as agent, and Statement on Form S-3 the banks named therein................ (File No. 33-32348) 4(n) Copy of Shareholder Rights Agreement Exhibit 4 to Report between DPL Inc. and The First on Form 8-K dated National Bank of Boston................ December 13, 1991 (File No. 1-9052) 10(a) Description of Management Incentive Exhibit 10(c) to Compensation Program for Certain Report on Form 10-K Executive Officers..................... for the year ended December 31, 1986 (File No. 1-9052) 10(b) Copy of Severance Pay Agreement Exhibit 10(f) to Report with Certain Executive Officers........ on Form 10-K for the year ended December 31, 1987 (File No. 1-9052) 10(c) Copy of Supplemental Executive Exhibit 10(e) to Report Retirement Plan amended August 6, on Form 10-K for the 1991................................... year ended December 31, 1991 (File No. 1-9052) IV-3 18 Copy of preferability letter relating Exhibit 18 to Report on to change in accounting for unbilled Form 10-K for the year revenues from Price Waterhouse......... ended December 31, 1987 (File No. 1-9052) The following exhibits are filed herewith: Page No. ---------------------- 3(b) Copy of Amendment dated April 20, 1993 to DPL Inc.'s Amended Articles of Incorporation.......................... 10(d) Amended description of Directors' Deferred Stock Compensation Plan effective January 1, 1993.............. 10(e) Amended description of Deferred Compensation Plan for Non-Employee Directors effective January 1, 1993.... 10(f) Copy of Management Stock Incentive Plan amended January 1, 1993........... 13 Copy of DPL Inc.'s 1993 Annual Report to Shareholders........................ 21 Copy of List of Subsidiaries of DPL Inc................................ 23 Consent of Price Waterhouse............ Pursuant to paragraph (b)(4)(iii)(A) of Item 601 of Regulation S-K, the Company has not filed as an exhibit to this Form 10-K certain instruments with respect to long-term debt if the total amount of securities authorized thereunder does not exceed 10% of the total assets of the Company and its subsidiaries on a consolidated basis, but hereby agrees to furnish to the SEC on request any such instruments. (b) Reports on Form 8-K ------------------- None IV-4 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. DPL Inc. Registrant March 15, 1994 Peter H. Forster --------------------------------- Peter H. Forster Chairman, President 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. T. J. Danis Director March 15, 1994 - ------------------------- (T. J. Danis) Director March , 1994 - ------------------------- (J. F. Dicke, II) P. H. Forster Director and Chairman March 15, 1994 - ------------------------- (principal executive (P. H. Forster) officer) Ernie Green Director March 15, 1994 - ------------------------- (E. Green) J. G. Haley Director March 15, 1994 - ------------------------- (J. G. Haley) IV-5 A. M. Hill Director March 15, 1994 - ------------------------- (A. M. Hill) Director March , 1994 - ------------------------- (W A. Hillenbrand) T. M. Jenkins Group Vice President March 15, 1994 - ------------------------- and Treasurer (T. M. Jenkins) (principal financial and accounting officer) Director March , 1994 - ------------------------- (R. J. Kegerreis) Director March , 1994 - ------------------------- (B. R. Roberts) IV-6 IV-7 IV-8 IV-9 IV-10 IV-11 IV-12 IV-13 IV-14 IV-15 IV-16 EXHIBIT INDEX ------------- Exhibit - ------- 3(b) Copy of Amendment dated April 20, 1993 to DPL Inc.'s Amended Articles of Incorporation.......................... 10(d) Amended description of Directors' Deferred Stock Compensation Plan effective January 1, 1993.............. 10(e) Amended description of Deferred Compensation Plan for Non-Employee Directors effective January 1, 1993.... 10(f) Copy of Management Stock Incentive Plan amended January 1, 1993........... 13 Copy of DPL Inc.'s 1993 Annual Report to Shareholders........................ 21 Copy of List of Subsidiaries of DPL Inc................................ 23 Consent of Price Waterhouse............

73918_1993.txt

73918_1993

1993

73918

ITEM 1. BUSINESS A. GENERAL - INDUSTRY SEGMENTS The Registrant, which was incorporated in Delaware in 1931, its wholly owned subsidiaries and its predecessor organizations have been engaged in the transportation, mining and sale of industrial minerals, iron ore and coal since 1854. The principal offices of the Registrant are located at 1100 Superior Avenue, Cleveland, Ohio 44114-2598. The information regarding the approximate amounts of consolidated sales and revenues (including sales commissions, royalties and management fees), consolidated profit from operations and consolidated identifiable assets for the three years ended December 31, 1993, attributable to each of the Registrant's industry segments, appears on pages 39 through 42 of this Annual Report on Form 10-K. B. PRINCIPAL PRODUCTS AND SERVICES 1. MARINE TRANSPORTATION The Registrant, through its Columbia Transportation Division and Pringle Transit Company, a wholly owned subsidiary, operates self-unloading vessels engaged in the transportation of iron ore, coal, limestone and other dry bulk cargo on the Great Lakes. The self-unloader fleet consists of fifteen (15) vessels, of which thirteen (13) are operated by the Columbia Transportation Division and two (2) are operated by Pringle Transit Company. The Registrant has commenced steps to transfer the Pringle operations to its Columbia Transportation Division and anticipates the transfer to be completed early in the second quarter. Twelve (12) of the vessels are owned by the Registrant and three (3) are leased as described below. The vessels' cargo capacities range in size from 13,500 tons to 60,000 tons. The newest vessel was commissioned in 1981 and the oldest in 1925. The relatively long life of Great Lakes vessels is due to a scheduled program of regular winter maintenance and periodic rebuilding and to the lack of corrosion because of freshwater operations. One of the owned vessels, the "Columbia Star", a 1000-foot Great Lakes self-unloading bulk carrier, has been financed through the use of bonds issued pursuant to Title XI of the Merchant Marine Act of 1936, as amended. See - 2 - Note F of the Notes to Consolidated Financial Statements for disclosure of financial data with respect to these bonds. One leased vessel, the Wolverine, is leased and operated by the Registrant under a bareboat charter agreement which expires in 1999 and is renewable thereafter for up to ten years. The agreement provides an option to purchase the equity position in the vessel on the charter hire payment date in each year and an option to purchase the vessel at the end of the charter period. The two other leased vessels, the Roesch and the Thayer, are leased and operated by Pringle Transit Company under bareboat subcharter and charter agreements which expire in 1998 and provide options to purchase the vessels at the end of the subcharter and charter terms, respectively. The standard annual Great Lakes vessel season of navigation is 260 days. In 1993, the Registrant operated eleven (11) vessels during the season. The Registrant's fleet carried approximately 3% more tons of commodities than in 1992. 2. INDUSTRIAL MINERALS IRON ORE The Registrant held iron ore mining rights located near Eveleth, Minnesota, which were assigned in exchange for an overriding royalty to Eveleth Taconite Company ("Taconite Company") and Eveleth Expansion Company ("Expansion Com- pany"), in which the Registrant and its wholly owned subsidiary, ONCO Eveleth Company, hold 15% and 20.5% interests, respectively ("Eveleth Mines"). The Eveleth Mines reserves are sufficient to support the normal level of operations for 40 years. The Registrant also has a contract to serve, on a fee basis, as Manager of the Eveleth Mines operations. In addition to the mine, the Eveleth facility consists of a concentrating and pellet production plant, located approximately eight miles south of the mine. In 1993, 3,138,945 long tons of taconite pellets were produced. The Registrant sold its share of Eveleth pellets, approximately 700,000 long tons, under contracts or on the open market. Eveleth Mines is a cost-sharing operation. The basic agreements, entered into as of December 1, 1974, govern the operation for the life of the mine. Under the basic agreements, Eveleth Mines is required to operate at full capacity, with participants sharing fixed and variable costs in proportion to their respective equity interests. These agreements were modified, effective as of January 1, - 3 - 1991, to permit the participants greater production flexibility and to alter the cost-sharing arrangements through December 31, 1996. Under the modified agreements, each of the participants pays fixed costs in proportion to its equity interest and variable costs in proportion to the amount of iron ore nominated by it. Eveleth Mines reached agreement on a new labor contract with the United Steelworkers of America in the fourth quarter of 1993. The agreement, which has been ratified by the work force, will expire on August 1, 1999. One of the participants, with a 35% equity interest, has not taken any iron ore from Eveleth Mines since September 1992. That participant continues to pay its share of fixed costs. Preliminary discussions have been held regarding that participant's possible exit from Eveleth Mines. No agreement has been reached regarding the terms or timing of any such exit. Until those terms have been set, it is impossible to predict how any such exit might affect the continued viability of Eveleth Mines. INDUSTRIAL SANDS The Registrant has three wholly owned subsidiaries engaged in the production of industrial sands. These subsidiaries are listed in the following table. - 4 - The Registrant's three silica sand subsidiaries produced approximately 1,265,650 tons of sand in 1993. The finished products produced by the Registrant's industrial sand business move by truck and rail to consumers. 3. MANUFACTURING The Registrant's manufacturing operations consist of the design, manufacturing and marketing of hot topping products and continuous casting refractories used in molten steel processing and the custom blending of metallurgical powders used in the treatment of molten steel. The briquetting plant produces fluorspar briquettes and dries fluorspar purchased from Mexico. The following subsidiaries and two divisions make up the Registrant's manufacturing operations. Ferro Engineering Division(1) Cleveland, Ohio Canadian Ferro Hot Metal Specialties Limited(2) Hamilton, Ontario, Canada Indiana Manufacturing Company Inc.(2) Dunkirk, Indiana Tuscarawas Manufacturing Company(2) Uhrichsville, Ohio West Minerals Division ONCO Minerals, Inc.(2) Warren, Ohio Brownsville Briquetting Plant(1) Brownsville, Texas (1) A division of the Registrant. (2) A wholly owned subsidiary of the Registrant. Canadian Ferro Hot Metal Specialties Limited, Indiana Manufacturing Company Inc., ONCO Minerals, Inc. and Tuscarawas Manufacturing Company own the plants and properties on which the plants are located. The Registrant owns the Ferro Engineering Division plant site in Cleveland, Ohio. The Brownsville plant is held under a lease which expires July 31, 1999. 4. OTHER The Registrant owns a coal transfer facility at Ceredo, West Virginia, on the Ohio River. This facility transferred 4,137,071 tons of coal in 1993, which is approximately 27% less than 1992 due to a nine-month, nationwide strike by the United Mine Workers of America - 5 - during 1993. The Registrant has entered into an agreement for the sale of this facility which, subject to the fulfillment of certain conditions, will be concluded in the third quarter of 1994. The Registrant sold substantially all of the assets of its Licking River Terminal facility located at Wilder, Kentucky, to Newport Steel Corporation on December 31, 1993. This facility had not operated since July 1992. The Registrant's wholly owned subsidiary, National Perlite Products Company, became inactive as of January 31, 1994. Prior to the cessation of operations, National Perlite had not been mining perlite ore from its reserves near Malad City, Idaho. It had continued to expand perlite until its closure. C. COMPETITION The Registrant experiences intense competition in all of its business segments from both foreign and domestic companies with which it competes in supplying products and services or which offer alternative choices as to modes of transportation. Vessel rates are an important factor as to the ability of the Registrant's Great Lakes fleet to compete with other independent and captive fleets, railroads and other providers of surface transportation. The Registrant believes that product quality, differentiation and customer service are significant competitive considerations for all of its business segments. D. ENVIRONMENTAL, HEALTH AND SAFETY CONSIDERATIONS The Registrant is subject to various other environmental laws and regulations imposed by federal, state and local governments. The Registrant cannot reasonably estimate future costs, if any, related to compliance with these laws and regulations. However, costs incurred to comply with environmental regulations have not been significant in 1993 and prior years. Although it is possible that the Registrant's future operating results could be affected by future costs of environmental compliance, it is management's belief that such costs will not have a material effect on the Registrant's consolidated financial position. The Registrant is unable at this time to predict the effects of recently enacted amendments to the Clean Air Act upon its business. E. PRINCIPAL CUSTOMERS More than 10% of the Registrant's 1993 sales and revenues was attributable to each of Armco Steel Company, L.P. and LTV Steel Company, Inc. A long-term vessel transportation contract and a contract for iron ore pellets were the primary sources of - 6 - revenues from Armco Steel Company, L.P. In the case of LTV Steel Company, Inc., revenues were largely attributable to coal-loading and vessel transportation services and manufactured products sold in 1993. F. EMPLOYEES At December 31, 1993, the Registrant and its subsidiaries employed 1,390 persons. ITEM 2. ITEM 2. PROPERTIES The Registrant's principal operating properties are described in response to Item 1. The Registrant's executive offices are located at 1100 Superior Avenue, Cleveland, Ohio, under a sublease expiring on March 31, 2003. The total area involved is approximately 55,000 square feet. ITEM 3. ITEM 3. LEGAL PROCEEDINGS (1) The suit filed by Ray W. Bauman to recover royalties and profits and for punitive damages against Laxare, Inc. for allegedly unlawfully mining coal was dismissed by the Circuit Court of Boone County, West Virginia, on January 21, 1994. (2) The Registrant's subsidiary, Laxare, Inc., was named in a Complaint dated December 27, 1988, along with Cannelton Industries, Inc. and Thomas G. Williams, Jr., a Lessor of Laxare, Inc., in the Circuit Court of Boone County, West Virginia. The Plaintiffs, Mary Catherine Marks and Josephine W. Luther, allege that defendant Thomas Williams has unlawfully withheld royalties from coal mined from the leased premises and that Laxare, Inc. was negligent in its verification of the title to the leased premises, which has resulted in Plaintiffs not receiving royalties. (3) On January 9, 1989, Laxare, Inc. was served with an Action for Declaratory Judgment filed by Thomas G. Williams, Jr. and his sister, Sarah M. Williams, against John Chesley Williams, Mary Catherine Marks, Josephine W. Luther, Cannelton Industries, Inc. and Laxare, Inc. in the Circuit Court of Kanawha County, West Virginia, in which Mr. Williams asked the Court to interpret various documents related to the above-described suit. Both actions have been combined in the Circuit Court of Kanawha County, West Virginia. On October 1, 1993, the Court denied Laxare, Inc.'s Motion for Summary Judgment on the question of the leasehold's legal validity and required it to submit briefs in support of all of its affirmative defenses. A joint scheduling order is being drafted by the parties for submission to the Court. Trial is anticipated for - 7 - later in 1994. The Registrant has not been able to assess the extent of damages in the event of an adverse decision in this case. (4) The Registrant; its wholly owned subsidiary, Oglebay Norton Taconite Company; Eveleth Taconite Company; Eveleth Expansion Company and The United Steel Workers of America, Local 6860, have been named Defendants in a Complaint filed on August 16, 1988, in Federal District Court, 5th District of Minnesota, by Lois E. Jenson and Patricia S. Kosmach, in their own behalf and on behalf of all others similarly situated. The Complaint alleges both sexual harassment and sexual discrimination under Title VII of the Civil Rights Act of 1964 (the Act), Title 42, United States Code, 2000e et seq., and under the provision of the Minnesota Human Rights Act, Minnesota Statutes, Section 363.01 et seq. (5) On November 22, 1988, Kathleen P. O'Brien Anderson, a former employee of Eveleth Mines, filed a Notice of Charge of Discrimination with the Equal Employment Opportunity Commission, alleging sexual harassment and sexual discrimination. Ms. Anderson was issued, by the Equal Employment Opportunity Commission, a Notice of Right to Sue, which has been consolidated with the preceding Federal Court proceeding. These proceedings have been certified as a class action. This matter was tried in December 1992 and February 1993. On May 14, 1993, the Court issued its decision, dismissing seven of Plaintiffs' nine claims of discrimination and harassment against Defendants, Oglebay Norton Taconite Company and the Registrant. In addition, it was determined that as Eveleth Taconite Company, Eveleth Expansion Company and Eveleth Expansion Financing Corporation were not "employers", as defined under the Act, they were dismissed as parties defendant. This dismissal, however, does not relieve them of their contractual obligations to the Registrant and Oglebay Norton Taconite Company. The Registrant and Oglebay Norton Taconite Company received unfavorable decisions on the remaining two claims, one involving discrimination in the promotion of hourly employees to step-up foreman and the other harassment. Proceedings continue with regard to the two remaining counts against the Registrant and its subsidiary. As final orders have not been issued, the opportunity for appeal is not yet available. No assessment of potential loss can be predicted at this time. All or a portion of any loss in respect of this litigation may be covered by insurance, although at this time no assessment can be made as to the ultimate scope of insurance coverage available. (6) On February 26, 1993, a Complaint was filed by Lois E. Jenson and Kathleen O'Brien Anderson in the United States District Court, District of Minnesota, Fifth Division, naming the Registrant; its wholly owned subsidiary, Oglebay Norton Taconite Company; Eveleth Taconite Company; Eveleth Expansion Company; and The United Steel - 8 - Workers of America, Local 6860, Defendants. The Complaint alleges violations of Title VII of the Civil Rights Act of 1964, Title 42, United States Code, Section 2000e et seq., as amended by the Civil Rights Act of 1991, and the Minnesota Human Rights Act, Minnesota Statutes, Section 363.01 et seq. The Plaintiffs seek injunctive relief, back pay, with triple damages, and compensatory and punitive damages in unspecified amounts. This suit is considered by counsel to be superfluous and barred by the doctrine of res judicata due to the fact that these same Plaintiffs filed a related suit in 1988, which was tried in December 1992 and February 1993 and for which a ruling was rendered on May 14, 1993. An answer has been filed to this Complaint. No assessment of potential loss can be predicted at this time. (7) The Registrant and certain of its subsidiaries are involved in various other claims and ordinary routine litigation incidental to their businesses, including claims relating to the exposure of persons to asbestos and silica. The full impact of these claims and proceedings in the aggregate continues to be unknown. The Registrant continues to monitor this situation. (8) The Registrant, as Manager of Eveleth Mines, has received a number of demands for arbitration with respect to management of Eveleth Mines and the allocation of certain costs, including the right of the Registrant to allocate the cost of the litigation referred to above in paragraphs (4) and (5) among the participants, submitted by a participant with a 35% equity interest. Arbitration panels have not been selected to date, and no discovery has taken place. As noted above under the heading "Iron Ore" beginning on page 3, the 35% owner has not taken any iron ore from Eveleth Mines since September 1992 and has expressed an interest in exiting from Eveleth Mines. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matter was submitted to a vote of the Registrant's security holders, through the solicitation of proxies or otherwise, during the fourth quarter of the fiscal year covered by this report. EXECUTIVE OFFICERS OF THE REGISTRANT (Included pursuant to Instruction 3 to paragraph (b) of Item 401 of Regulation S-K) The executive officers of the Registrant as of March 7, 1994, unless otherwise indicated, were as follows. - 9 - Two executive officers, August F. Bradfish, Vice President- Industrial Minerals, and Frank A. Castle, Vice President-General Manager of Columbia Transportation Division, retired as of January 31, 1994, and December 31, 1993, respectively. Except as noted above, all executive officers of the Registrant have served in the capacities indicated, respectively, during the past five years. All executive officers serve at the pleasure of the Board of Directors, with no fixed term of office. - 10 - Part II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The Company's Common Stock, par value $1 per share, as reported by NASDAQ is traded on the Over-The-Counter Market. The following is a summary of the market ranges and dividends declared for each quarterly period in 1993 and 1992 for the Common Stock. As of December 31, 1993, there were 543 stockholders of record. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS FINANCIAL CONDITION The Company's operating activities provided cash of $7,764,000 in 1993 as compared to $22,109,000 in 1992 and $24,891,000 in 1991. The increased cash provided from operations the past two years resulted from the timing of certain transactions at the end of 1991 and 1990. At the end of 1991, the Company sold its Licking River Terminal long-term coal dumping contract to a third party for $12,500,000. The proceeds from the sale were collected at the beginning of 1992 reducing accounts receivable, established at the time of the sale, and increasing cash from operations. At the beginning of 1991, the Company sold inventories and collected related accounts receivable for certain iron ore transactions which occurred at the end of 1990, increasing cash from operations by $14,295,000. In 1993, accounts receivable included $1,500,000 related to the sale of assets which caused a decline in cash provided by operating activities. In November 1993, the Company repaid $10,000,000 outstanding on its revolving credit and reborrowed $10,000,000 in December 1993. The Company repaid a total of $20,000,000 of borrowings under its revolving credit in January and September 1992 and borrowed a total of $15,000,000 in February and October 1992. In May 1991, the Company borrowed $6,000,000 under its revolving credit for working capital purposes and repaid the amount borrowed in July and August. In December 1993, the Company refinanced its Title XI Ship Financing Bonds at a cost of $652,000, reducing the fixed interest rate from 9.65% to 5.3%. The reduction in interest will result in cumulative savings approximating $3,200,000 over the life of the Bonds. In 1993 and 1991, the Company purchased 9,000 and 4,227 shares, respectively, of its Common Stock on the open market for $189,000 and $118,000, respectively, and placed these shares in treasury. The Company declared and paid dividends on a quarterly basis amounting to $.80 per share in 1993, $1.40 per share in 1992 and $1.60 per share in 1991. Dividends paid were $2,009,000 in 1993 compared to $3,518,000 and $4,022,000 in 1992 and 1991, respectively. In the fourth quarter of 1992, the Company's Board of Directors approved a reduction of the quarterly dividend from $.40 per share of Common Stock to $.20 per share. The equivalent dollars resulting from this action will be used to help advance the Company's strategic businesses. Expenditures for property and equipment amounted to $2,921,000 in 1993 compared to $8,727,000 and $3,506,000 in 1992 and 1991, respectively. Vessel inspection costs of $364,000 and $2,782,000 are included in 1993 and 1992 expenditures, respectively, capitalized as a result of a change in accounting for such costs, as further described in Note A to the consolidated financial statements. Expenditures for 1992 also include $2,400,000 of property and equipment acquired as a part of West Minerals, Inc. No significant capital expenditures for 1994 are currently anticipated. LTV Steel Company, Inc. (LTV) sought protection from its creditors under Chapter 11 of the Bankruptcy Code in 1986; and the U. S. bankruptcy court authorized LTV to reject the Company's long-term iron ore sales and vessel transportation contracts. In 1991, an agreement with LTV regarding the Company's unsecured bankruptcy claim was approved by the Court. In 1993, the Company sold for cash its claim against LTV, resulting in a $2,653,000 pretax gain after the retirement of $4,412,000 of long-term receivables. As previously mentioned, the Company sold its Licking River Terminal long-term dumping contract in 1991. In 1993, the Company sold the assets of the Terminal resulting in a $1,326,000 pretax gain. The Company's wholly-owned subsidiary, Saginaw Mining Company, ceased operation of its St. Clairsville, Ohio coal mine and began the mine closing process in 1992. Operation of the mine was discontinued as a result of a decision by a major public utility customer to terminate its long-term contract with the Company which provided for the sale of substantially all the mine's high-sulphur coal to that customer. Upon termination of the contract, the utility customer paid the Company $1,952,000 which was recognized as a gain on shutdown of this discontinued operation. Permanent closure of the mine was completed in 1993. Final settlement and customer funding of the closure costs has been extended to July 31, 1994, at the request of the customer. The Company's wholly-owned subsidiary, T & B Foundry, was disposed of in 1992 resulting in a $3,300,000 pretax loss. The above dispositions are further described in Note G to the consolidated financial statements. The Company is subject to various environmental laws and regulations imposed by federal, state and local governments. Also, in the normal course of business, the Company is involved in various pending or threatened legal actions. The Company cannot reasonably estimate future costs, if any, related to these matters. However, costs incurred to comply with environmental regulations and to settle litigation have not been significant in 1993 and prior years. Although it is possible that the Company's future operating results could be affected by future costs of environmental compliance or litigation, it is management's belief that such costs will not have a material adverse effect on the Company's consolidated financial position. Anticipated cash flows from operations and current financial resources are expected to meet the Company's needs during 1994. As was demonstrated by the Company's 1993 refinancing of its Title XI Bonds, all financing alternatives are under constant review to determine their ability to provide sufficient funding at the least possible cost. RESULTS OF OPERATIONS Net sales, operating revenues, sales commissions, royalties and management fees from continuing operations amounted to $163,446,000 in 1993 as compared to $154,011,000 and $148,843,000 in 1992 and 1991, respectively. Income from continuing operations before taxes was $9,554,000 in 1993 as compared to a loss from continuing operations of $49,761,000 in 1992 and income of $3,839,000 in 1991. Net income for 1993 was $7,262,000 or $2.89 per share on 2,511,545 average shares as compared to a net loss of $56,693,000 or $22.56 per share in 1992 on 2,512,926 average shares and net income of $5,127,000 or $2.04 per share in 1991 on 2,513,767 average shares. Included in 1993 revenues is the $2,653,000 gain on the sale of the Company's unsecured bankruptcy claim and the $1,326,000 gain on the sale of the Company's Licking River Terminal assets. Notes G and K to the consolidated financial statements further describe these 1993 transactions. Revenues include a $1,544,000 gain in 1992 on the disposal of certain undeveloped Iron Ore and Industrial Sands properties and a $5,777,000 gain in 1991 on the sale of the Company's Licking River Terminal long-term coal dumping contract. Included in interest, dividends and other income in 1991 is interest income of $2,728,000 attributable to a federal income tax refund. Income from continuing operations before taxes for 1993 was reduced $1,700,000 as the result of a reserve against doubtful coal customer accounts receivable and $652,000 related to the Company's refinancing of its Title XI Bonds. The loss from continuing operations for 1992 was increased $47,912,000 for a provision for capacity rationalization, asset impairment charges and a loss on the disposal of a business. Notes G, H and K to the consolidated financial statements further describe these charges. In 1991, income from continuing operations before taxes was reduced $1,593,000 related to asset impairment charges, as further described in Note H to the consolidated financial statements. In 1992 the Company adopted Statement of Financial Accounting Standards (SFAS) No. 106 "Employers' Accounting for Postretirement Benefits Other than Pensions." As a part of adopting SFAS No. 106, the Company recorded a one-time, non-cash charge of $17,541,000 or $6.98 per share in 1992. The Company also changed its method of accounting for vessel inspection costs from expensing such costs over one shipping season to deferring these costs and amortizing them over five shipping seasons between required inspections. This change in accounting has resulted in a cumulative adjustment which decreased the 1992 net loss by $534,000 or $.21 per share. Note A to the consolidated financial statements further describes these changes in accounting. The net loss for 1992 was increased $9,978,000 or $3.97 per share for an extraordinary provision for the Coal Industry Retiree Health Benefit Act of 1992. This 1992 legislation requires former coal mining companies to assume certain health care benefit obligations for retired coal miners and their dependents, as further described in Note I to the consolidated financial statements. In 1993, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities," which the Company must adopt in 1994. Under the new rules, the Company's marketable equity investments will be classified as available-for-sale and carried at fair value. Unrealized holding gains and losses on investments classified as available-for-sale are carried as a separate component of stockholders' equity, net of taxes. Presently, the Company reports such investments at the lower of cost or market and as long-term in the consolidated balance sheet. The Company will adopt the new standard in the first quarter of 1994, which will result in an approximate $2,972,000 increase in stockholders' equity as of January 1, 1994. In 1993, the Company reevaluated assumptions used in determining postretirement pension and health care benefits. The weighted-average discount rates were adjusted from 8.5% to 7.25% to better reflect market rates. The assumed health care cost trend rate will decline by 1.25% and the expected long-term rate of return on assets will be adjusted from 9.5% to 9% in 1994. The change in assumptions did not affect 1993 net income and will not have a significant effect on net income in 1994. Postretirement benefits are further described in Note D to the consolidated financial statements. Depressed economic conditions in the steel industry and the previously mentioned charges adversely affected the Company's 1992 operating results. In 1993, strong order levels experienced by the Company's steel industry customers as well as effective cost management have contributed significantly to 1993 operating results. The Company continues to stress quality products, cost reductions and improved marketing practices for its products and services in order to remain competitive within the industries served. The operating results of the Company's business segments for the three years ended December 31, 1993 are discussed below. Segments were redefined in 1993 resulting in an insignificant reclassification of prior years' information. It is the policy of the Company to allocate certain corporate general and administrative expenses to its business segments. MARINE TRANSPORTATION - Operating revenues amounted to $73,143,000 in 1993 which was 4% greater than revenues of $70,654,000 in 1992, and was comparable to revenues of $73,090,000 in 1991. Operating profit was $10,791,000 in 1993 which was a 13% and 26% increase over 1992 and 1991 levels of $9,538,000 and $8,571,000, respectively. Income from continuing operations before taxes was $5,492,000 in 1993 compared to $2,228,000 and $1,498,000 in 1992 and 1991, respectively. Revenues improved in 1993 for the Company's Great Lakes vessel fleet as operating days increased 6% from an extended sailing season and a 1% increase in the average rate per ton was realized due to a better commodity mix, compared to 1992 levels. The 1993 average rate per ton declined 5% compared to the 1991 rate. The fleet experienced 3% and 5% increases in tonnage carried in 1993, representing a record level, compared to 1992 and 1991 tonnage, respectively. Transportation of iron ore increased, while coal and stone shipments declined. Coal shipments were adversely affected by coal industry labor disputes. Ten vessels sailed for the full season and one vessel sailed for part of the season in 1993 compared to eleven and thirteen vessels operating for almost full seasons in 1992 and 1991, respectively. The 1993 operating profit improvement compared to prior years was primarily the result of improved revenues and lower operating costs. Asset impairment charges in 1992 relate primarily to adjusted carrying values of certain vessels in the Company's fleet based on market conditions in this industry. Depreciation expense declined in 1993 as a result of the prior year asset impairment charges. Depreciation was greater in 1992 compared to 1991 expense due to the acquisition of two vessels at the end of 1990. Interest expense declined in 1993 compared to prior years, as a result of lower interest rates and reductions in outstanding debt. The Title XI Bonds fixed interest rate reduction from 9.65% to 5.3% at the end of 1993, as further described in Note F to the consolidated financial statements, will reduce interest expense in 1994. A new four-year labor agreement was signed in the fourth quarter of 1993 covering the licensed officers and engineers in the Company's fleet. This agreement helps assure uninterrupted operation of this important segment of the Company's business. INDUSTRIAL MINERALS IRON ORE - Net sales, royalties and management fees for iron ore amounted to $23,634,000 in 1993, a 26% and 24% increase over 1992 and 1991 levels of $18,821,000 and $18,998,000, respectively. Operating profit contribution was $4,031,000 compared to operating losses of $2,832,000 in 1992 and $1,741,000 in 1991. Income from continuing operations was $3,405,000 in 1993 compared to losses of $38,206,000 in 1992 and $2,911,000 in 1991. The Company, in addition to its sales to long-term contract customers, attempts to sell the balance of its share of Eveleth Mines' iron ore production each year on the open spot market to steel producers. Iron ore spot market demand has been depressed the past three years; therefore, the Company has not been successful in selling its iron ore at competitive prices. Price pressure from the Company's customers continues as a result of excess capacity in the iron ore industry. The Company is continuing its efforts in responding to this pressure through increased productivity, managed cost reduction and more aggressive marketing. In 1992, the Company recorded a provision for capacity rationalization of $34,694,000, and asset impairment charges of $330,000, as disclosed in Note H to the consolidated financial statements. The charges resulted from depressed economic conditions in the steel industry and Eveleth's high costs, which caused certain partners in Eveleth Mines to continue to acquire their iron ore requirements from other sources rather than produce them at Eveleth. While the Company might conclude otherwise at a later date, the treatment of its Eveleth investment should not be viewed as an abandonment of its iron ore business. Preliminary discussions have been held regarding one of the partners possible exit from Eveleth Mines. No agreement has been reached regarding the terms or timing of any such exit. Until those terms have been set, it is impossible to predict how this event may affect the continued viability of Eveleth Mines. Revenues increased in 1993 primarily due to a 65% and 74% increase in iron ore pellet tonnage sold compared to 1992 and 1991, respectively. Spot market sales to long-term contract customers and other new customers accounted for the increase in 1993. Eveleth Mines was shut down for part of 1992. The improvement was partially offset by a 14% and 21% decline in the average selling price per ton in 1993 compared to 1992 and 1991 average prices, respectively. Capacity rationalization steps taken in 1992 improved operating profit in 1993 by $5,220,000. In addition, increased revenues and productivity and reduced costs contributed to the 1993 improvement. A $550,000 gain on the sale of certain undeveloped iron ore properties reduced the loss from continuing operations in 1992. Interest expense declined in 1993, compared to prior years, due to reductions in outstanding debt. Late in the fourth quarter of 1993, the Company reached a new collective bargaining agreement with members of the United Steel Workers of America at Eveleth Mines. Early in 1994, the six-year agreement was ratified by the Eveleth work force. INDUSTRIAL SANDS - Net sales for 1993 amounted to $26,606,000 compared to $24,447,000 and $23,326,000 in 1992 and 1991, respectively. Operating profit was $1,827,000 in 1993 compared to $944,000 and $910,000 in 1992 and 1991, respectively. Income from continuing operations before taxes was $1,846,000 in 1993 compared to a loss of $2,699,000 in 1992 and income of $537,000 in 1991. Included in 1992 is a gain on the sale of certain undeveloped sand properties which reduced the loss by $993,000. Asset impairment charges of $4,640,000 and $400,000 were recorded at the end of 1992 and 1991, respectively. These charges resulted from changes in market conditions and circumstances that have impaired certain asset carrying values at the Company's Texas Mining Company and California Silica Products Company. Central Silica Company, the Company's Ohio sand producer, experienced 13% and 29% increases in sales in 1993 compared to 1992 and 1991, respectively. Central's 1993 operating profit improved 29% and 53% compared to 1992 and 1991, respectively. Tonnage sold in 1993 declined 13% compared to 1992 and increased 10% compared to the 1991 level. The gross margin on sand products sold improved in 1993 by 54% and 44% compared to 1992 and 1991, respectively. The 1993 sales and profit improvements were principally due to a magnetic separation process implemented in the fourth quarter of 1992 which enabled Central to obtain new business. The improvements were partially offset by reductions in plant capacity for certain Central Silica customers in 1993. Texas Mining Company sales in 1993 were comparable to 1992 sales, while operating profit improved 21% in 1993, compared to 1992. Although tonnage shipped decreased 6%, gross margin increased 44% in 1993 compared to 1992. The improvement was primarily the result of a better mix of products sold, partially offset by greater health care costs. Sales in 1993 were 8% less than in 1991; however, operating profit more than tripled in 1993 compared to 1991. The sales decline reflects a lower level of oil well drilling due to lower market prices, partially offset by improved sales in the gas extraction market. The substantial profit improvement is the result of a 6% reduction in the average operating cost per ton sold and the expiration of a non-compete covenant, partially offset by greater health care costs. California Silica Products sales improved by 20% and 27% in 1993 compared to 1992 and 1991, respectively. Operating profit in 1993 improved $630,000 and $890,000 over 1992 and 1991 losses, respectively. The 1993 sales improvement reflects a 20% and 24% increase in tonnage shipped compared to 1992 and 1991 levels, respectively, primarily to recreational markets. The 1993 operating profit improvement is attributable to increased sales and lower depreciation expense due to asset impairment charges recognized in 1992. MANUFACTURING - Net sales for 1993 amounted to $35,756,000 which was 4% and 67% greater than 1992 and 1991 levels of $34,422,000 and $21,363,000, respectively. Operating profit was $2,809,000 in 1993 compared to a profit of $257,000 in 1992 and a loss of $1,154,000 in 1991. Income from continuing operations before taxes was $2,608,000 in 1993 compared to losses of $4,077,000 and $1,559,000 in 1992 and 1991, respectively. The loss from continuing operations before taxes in 1992 includes a $3,300,000 loss on the disposal of T & B Foundry, as disclosed in Note G to the consolidated financial statements. Asset impairment charges of $755,000 and $411,000 are included in 1992 and 1991, respectively, representing changes in market conditions and circumstances that impaired certain asset carrying values at the Company's Ferro Engineering Division. The increase in net sales in 1993 compared to 1992 is attributable to new business in the tundish coatings, shapes, hot tops and metal powders product lines. An 11% increase in net sales in 1993 related to this new business was partially offset by the loss of T & B Foundry revenues which was disposed of at the end of 1992. T & B Foundry accounted for 16% and 31% of the Manufacturing segment net sales in 1992 and 1991, respectively. Fluorspar product line net sales in 1993 were comparable to 1992, but declined 25% compared to the 1991 sales level. The increase in net sales in 1992 compared to 1991 is primarily attributable to the acquisition of the West Minerals metal powders product line at the beginning of 1992. Operating profit improved in 1993 compared to 1992 as a result of the new business and cost reductions in the tundish coatings, shapes and hot top product lines. Operating profit improved in 1992 compared to 1991 as a result of the West Mineral acquisition and improved tundish coatings and shapes revenues. Interest expense declined in 1993 compared to 1992 due to lower interest rates and a reduction in outstanding debt. Increases in depreciation, expenditures for properties and equipment and interest expense in 1992 compared to 1991 were related principally to the acquisition. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA REPORT OF INDEPENDENT AUDITORS Board of Directors Oglebay Norton Company We have audited the accompanying consolidated balance sheet of Oglebay Norton Company and subsidiaries 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 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 Oglebay Norton Company and subsidiaries at December 31, 1993 and 1992, and the consolidated results of its operations and 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 A to the consolidated financial statements, in 1992 the Company changed its method of accounting for postretirement benefits other than pensions and vessel inspection costs. ERNST & YOUNG Cleveland, Ohio February 18, 1994 See notes to consolidated financial statements. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS OGLEBAY NORTON COMPANY AND SUBSIDIARIES December 31, 1993, 1992, and 1991 NOTE A - ACCOUNTING POLICIES PRINCIPLES OF CONSOLIDATION: The consolidated financial statements include the accounts of the Company and its majority owned subsidiaries. Intercompany transactions and accounts have been eliminated upon consolidation. CASH EQUIVALENTS: The Company considers all highly liquid investments with a maturity of three months or less to be cash equivalents. Cash equivalents are stated at cost which approximates market value. INVENTORIES: Inventories are stated at the lower of average cost or market. INVESTMENTS: The Company holds an investment in Eveleth Mines through a 15 percent interest in Eveleth Taconite Company (ETC) and a 20.5 percent interest in Eveleth Expansion Company (EEC). Other long-term investments held by the Company have a carrying value of $3,172,000 and a fair value, based on quoted market prices, of $7,675,000 at December 31, 1993. In 1993, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities," which the Company must adopt in 1994. Under the new rules, the Company's marketable equity investments will be classified as available-for-sale and carried at fair value. Unrealized holding gains and losses on investments classified as available-for-sale are carried as a separate component of stockholders' equity, net of taxes. Presently, the Company reports such investments at the lower of cost or market and as long-term in the consolidated balance sheet. The Company will adopt the new standard in the first quarter of 1994, which will result in an approximate $2,972,000 increase in stockholders' equity as of January 1, 1994. PROPERTIES AND EQUIPMENT: Properties and equipment are carried at cost. DEPRECIATION AND AMORTIZATION: The Company provides depreciation on the straight-line method over the estimated useful lives of the assets. The amortization of advances to Eveleth Mines equivalent to the Company's share of depreciation of the underlying plant is computed on the units-of-production method adjusted for levels of operation. Such adjustment provides for a minimum of 75% of depreciation calculated on a straight-line basis. INCOME TAXES: 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. NOTE A - ACCOUNTING POLICIES - (CONTINUED) NET INCOME (LOSS) PER SHARE: Net income (loss) per share of Common Stock is based on the average number of shares outstanding. ACCOUNTING CHANGES AND RECLASSIFICATION: In 1992, the Company adopted the accounting provisions of Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other than Pensions." This standard requires that the expected cost of retiree health benefits be charged to expense during the years that employees render service rather than recognizing these costs on a cash basis. As a part of adopting the standard, the Company recorded a one-time, non-cash charge of $17,540,830 (net of income taxes of $9,037,000), or $6.98 per share. This cumulative adjustment represents the discounted present value of expected future retiree health benefits attributed to employees' service rendered prior to that date. In 1992, the Company changed its method of accounting for vessel inspection costs from expensing such costs over one shipping season to deferring these costs and amortizing them over the five shipping seasons between required inspections. This change results in a better matching of these expenses with revenues generated during the periods benefited and improves financial reporting. This change in accounting has been applied retroactively to vessel inspection costs incurred in prior years and has resulted in a cumulative adjustment of $534,415 (net of income taxes of $275,000), or $.21 per share. Pro forma effects of the accounting change are not significant. Consolidated financial statements for years prior to 1992 have not been restated for the above accounting changes. Certain amounts in prior years have been reclassified to conform with the 1993 consolidated financial statement presentation. NOTE B - STOCKHOLDERS' EQUITY The Preferred Stock is issuable in series and the Board of Directors is authorized to fix the number of shares and designate the terms of each issue. Certain shares of Series C $10.00 Preferred Stock and Common Stock have been reserved for issuance upon exercise of Rights under a Stockholders' Rights Plan. The Rights should not interfere with any merger or other business combination approved by the Board of Directors, because the Board, at its option, may redeem the Rights at their redemption price. The Company has a noncontributory Employee Stock Ownership Plan (ESOP) and Trust for the benefit of certain salaried employees. In prior years, the Trust financed the purchase of 250,000 shares of the Company's Common Stock. The Company has guaranteed the financing and is obligated to make annual contributions to enable the Trust to repay the loans, including interest. The Company, as guarantor, has recorded the loans as long-term debt and a like amount as a reduction of stockholders' equity. NOTE C - INCOME TAXES The Company made income tax payments of $40,000, $2,483,000, and $2,641,000 during 1993, 1992 and 1991, respectively. The Company received income tax refunds of $222,000, $106,000, and $1,377,000 during those same periods. The 1991 refund, representing prior years' minimum taxes paid, allowed the Company to reinstate and use investment tax credits previously reduced under the Tax Reform Act of 1986. In addition, the Company received $2,728,000 of interest income on the 1991 tax refund. The U.S. current tax liability was reduced in 1991 by $821,000, reflecting the use of investment tax credits previously utilized for financial accounting purposes. The Company has no remaining investment tax credit carryforward. NOTE C - INCOME TAXES (CONTINUED) NOTE D - POSTRETIREMENT BENEFITS The Company has a number of noncontributory defined benefit pension plans covering certain employees. The plans provide benefits based on the participants' years of service and compensation or stated amounts for each year of service. The Company's funding policy is to contribute amounts to the plans sufficient to meet the minimum funding required by applicable regulations. NOTE D - POSTRETIREMENT BENEFITS - (CONTINUED) Defined contribution plans are maintained for certain employees and Company contributions are based on specified percentages of employee contributions, except for the ESOP. The expense for these plans was $1,434,000, $1,321,000 and $1,333,000 for 1993, 1992 and 1991, respectively. The Company also pays into certain defined benefit multi-employer plans under various union agreements which provide pension and other benefits for various classes of employees. Payments are based upon negotiated contract rates and the expense amounted to $1,348,000, $1,088,000, and $1,397,000 for 1993, 1992 and 1991, respectively. In addition to providing pension benefits, the Company provides health care and life insurance benefits for certain retired employees. Substantially all of the Company's employees are eligible for these benefits when they reach normal retirement age. The Company's policy is to fund these postretirement benefit costs principally on a cash basis as claims are incurred. In 1992, the Company adopted Statement of Financial Accounting Standards No. 106, as further disclosed in Note A. Postretirement benefit costs for 1991 were recorded on a cash basis and have not been restated. NOTE D - POSTRETIREMENT BENEFITS - (CONTINUED) The weighted-average discount rate used in determining the accumulated postretirement benefit obligation was 7.25% and 8.5% at December 31, 1993 and 1992, respectively. The weighted-average annual assumed rate of increase in the health care cost trend rate for 1994 is 9% (11% in 1993) for retirees age 65 and over and 12% (14% in 1993) for retirees under age 65, and both are assumed to decrease gradually to 5.25% in 2001 and 2007, respectively, (6% in 1993) 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% in each year would increase the accumulated postretirement benefits obligation as of December 31, 1993 by approximately $2,791,000 and the aggregate of the service and interest cost components of net periodic postretirement benefits cost for 1993 by approximately $534,000. NOTE E - COMMITMENTS Future minimum payments at December 31, 1993, under noncancellable operating leases, primarily vessel charters, are $4,530,000 in 1994, $4,440,000 in 1995, $4,218,000 in 1996, $4,035,000 in 1997, $3,996,000 in 1998, $1,790,000 in 1999 and $1,938,000 thereafter. Rental expense was $5,162,000, $5,181,000 and $5,337,000 in 1993, 1992 and 1991 respectively. In general, the leases are renewable or contain purchase options at the end of the lease term. The purchase price or renewal lease payment is based on the fair market value of the asset at the date of purchase or renewal. The Company and its partners in Eveleth Mines have guaranteed to reimburse ETC and EEC for all costs incurred in production of iron ore pellets, including EEC's debt service. Each partner of Eveleth Mines pays its share of costs based upon its share of production or ownership interest, whichever is applicable. Purchases by the Company under a take-or-pay contract, associated with Eveleth Mines long-term debt, amounted to $24,800,000, $21,764,000 and $19,166,000 for the years ended December 31, 1993, 1992 and 1991, respectively. Maturities on the long-term debt are $2,813,000 in 1994 and 1995 and are included in the reserve for capacity rationalization on the consolidated balance sheet. Accrued taxes and other expenses on the consolidated balance sheet include $4,955,000 and $146,000 payable in 1993 and 1992, respectively, for ETC's working capital requirements. NOTE F - LONG-TERM DEBT NOTE F - LONG-TERM DEBT (CONTINUED) The Title XI Ship Financing Bonds are guaranteed by the U.S. Government under the Federal Ship Financing Program. During the fourth quarter of 1993 the Company refinanced the Title XI Bonds at a cost of $652,000, reducing the fixed interest rate from 9.65% to 5.3%. The reduction in interest will result in cumulative savings approximating $3,200,000 over the life of the Bonds. The Bonds mature in 2001 and require sinking fund redemptions of $1,250,000 semiannually. In connection with the Title XI Bonds and a vessel charter agreement, the Company may be required, under certain conditions, to make deposits to a Title XI reserve fund, maintain specified levels of stockholders' equity or obtain prior written consent from the Maritime Administrator, U.S. Department of Transportation, for certain designated financial transactions. No approval was required through 1993 and the Company does not anticipate any such consent will be required in the future. The Company has mandatory payments under the Term Loan of $7,000,000 in 1994, $8,000,000 in 1995, 1996 and 1997 and $13,750,000 in 1998. The Revolving Credit terminates on December 31, 1996 subject to annual renewals to December 31, 1998 under certain conditions. The Company has an additional $24,000,000 of borrowing available under the Revolving Credit at December 31, 1993. Collateral for the Title XI Ship Financing Bonds and the Term Loan is in the form of first preferred ship mortgages on five of the Company's vessels with a net book value of $111,953,000. The Company, in separate agreements which expire in 1995, entered into interest rate swaps with major financial institutions to substitute fixed rates for LIBOR-based interest rates on notional amounts totaling $32,684,000 at December 31, 1993. The interest rate differential is recognized over the lives of the agreements as an adjustment to interest expense. The weighted average interest rate was 10.1% on the amounts covered by the swap agreements during 1993. Market risks associated with the swap agreements are mitigated since increased interest payments under the agreements resulting from a decrease in LIBOR-based interest rates are effectively offset by decreased variable rate interest payments under the debt obligations. The Company's debt agreements, as amended, contain various covenants with the most restrictive covenant requiring the Company to maintain specified levels of tangible net worth during each year. The Company's tangible net worth was $65,231,000 at December 31, 1993, compared to a minimum specified level of $60,631,000. Long-term debt maturities are $11,190,000 in 1994, $11,976,000 in 1995, 1996 and 1997 and $26,976,000 in 1998. The Company made interest payments of $7,973,000, $7,279,000 and $9,069,000 during 1993, 1992 and 1991, respectively. The fair value of the Company's long-term debt and interest rate swap liabilities is estimated to be $80,000,000 and $1,100,000, respectively, at December 31, 1993. Such fair values were estimated using discounted cash flow analysis based on the Company's current incremental borrowing rates for similar types of arrangements. NOTE G - DISPOSITIONS In July 1986, LTV Steel Company, Inc. (LTV) sought protection from its creditors under Chapter 11 of the Bankruptcy Code and the U.S. Bankruptcy Court authorized LTV to reject the Company's long-term iron ore sales and vessel transportation contracts. In May 1991, an agreement with LTV regarding the Company's unsecured bankruptcy claim was approved by the Court. During the second quarter of 1993 the Company sold for cash its claim against LTV, resulting in a $2,653,000 pretax gain after the retirement of $4,412,000 of long-term receivables. During the fourth quarter of 1991, the Company sold a long-term coal dumping contract held by its wholly owned subsidiary, Licking River Terminal (LRT) for $12,500,000. Since this contract represented the majority of LRT's business, the Company recorded asset impairment charges of $6,723,000 in 1991. This transaction, including the net gain on the sale of the contract of $5,777,000, is reflected in the 1991 consolidated financial statements. During the second quarter of 1992, the Company determined that the facility no longer served the objectives of the Company's strategic goals and was shut down. Amounts accrued in 1991 adequately covered shutdown costs incurred in 1992. During the fourth quarter of 1993, the Company sold its LRT assets resulting in a $1,326,000 pretax gain. The Company's wholly owned subsidiary, Saginaw Mining Company, ceased operation of its St. Clairsville, Ohio coal mine in August 1992 and began the mine closing process. The decision to terminate the operation of the mine followed a decision by a major public utility customer to terminate its long-term contract with the Company which provided for the sale of substantially all the mine's high-sulphur coal to that customer. Upon termination of the contract, the utility customer paid the Company $1,951,791 which was recognized as a gain on shutdown of discontinued operation of $1,287,791 (net of income taxes of $664,000), or $.51 per share. The contract was due to expire in 1994. NOTE G - DISPOSITIONS - (CONTINUED) Permanent closure of the mine was completed in 1993. Closure costs of this discontinued operation are being funded by the public utility customer, as required by the contract. Final settlement and funding of the closure costs has been extended to July 31, 1994, at the request of the customer. Remaining net liabilities of the discontinued operation consist primarily of employee benefit costs. The Company's wholly owned subsidiary, T & B Foundry, was disposed of effective December 31, 1992 resulting in a $3,300,000 pretax loss. The Foundry is included in the Company's Manufacturing segment in 1992 and 1991. NOTE H - ASSET IMPAIRMENTS AND RESERVES During the fourth quarter of 1992, the Company recorded a $34,693,983 provision for capacity rationalization. The charge includes a $12,256,183 write down of the Company's investment in Eveleth Mines and the establishment of a $22,437,800 reserve for certain fixed obligations, including the Company's share of Eveleth's long-term debt. The charge resulted from economic conditions in the steel industry and Eveleth's high costs, which caused certain partners in Eveleth Mines to continue to acquire their iron ore requirements from other sources rather than produce them at Eveleth. During the fourth quarter of 1992 and 1991, the Company recorded asset impairment charges of $9,918,497 and $1,592,725, respectively. These charges relate primarily to changed market conditions and circumstances that have impaired certain asset carrying values. The Company has established reserves and written down several under performing assets at its Ferro Engineering Division, National Perlite Products Company and Texas Mining Company in both 1992 and 1991. In addition, certain under performing assets primarily at the Company's Columbia Transportation Division and California Silica Products Company were written down in 1992. Ferro is included in the Company's Manufacturing segment, while Columbia is included in the Marine Transportation segment. Texas Mining and California Silica are included in the Company's Industrial Sands segment. NOTE I - EXTRAORDINARY PROVISION During the fourth quarter of 1992, the Coal Industry Retiree Health Benefit Act of 1992 was enacted by the U.S. Congress. This legislation requires coal mining companies to assume certain health care benefit obligations for retired coal miners and their dependents. Some of these coal miners never worked for the companies now required by this law to pay these health care benefits. In other cases, the companies have had no relationship or obligation to these miners for decades. While the exact amount of the liability is difficult to determine, the Company recorded a, non-cash, extraordinary charge of $9,977,900 (net of income taxes of $5,140,000), or $3.97 per share, to accrue for this obligation in 1992. At December 31, 1993 and 1992, the Coal Act liability amounted to $14,320,000 and $15,117,900, respectively. The change in the liability in 1993 is a result of interest accretion, changes in actuarial assumptions and payments of $379,000. In 1994, interest accretion is expected to reduce net income by approximately $685,000. NOTE J - INDUSTRY SEGMENTS AND MAJOR CUSTOMERS Oglebay Norton Company is a Cleveland-based raw materials and Great Lakes marine transportation company serving the steel, ceramic, chemical, electric utility and oil-and gas-well service industries with industrial minerals and supplying manufactured products used in hot metal processing. The Company's major industry segments are as follows: MARINE TRANSPORTATION Through its Columbia Transportation Division, the Company operates a fleet of vessels engaged in the transportation of iron ore, coal, limestone and other dry bulk cargoes on the Great Lakes. INDUSTRIAL MINERALS IRON ORE The Company owns interests in and manages the taconite mining and pelletizing operations of Eveleth Mines owned by Eveleth Taconite Company and Eveleth Expansion Company located on the Mesabi Range near Eveleth, Minnesota. INDUSTRIAL SANDS Company subsidiaries engaged in natural resource operations include: Central Silica Company, headquartered in Zanesville, Ohio, which produces silica sand for the glass, paint, ceramic and foundry industries; Texas Mining Company which produces sand products at Brady, Texas and Riverside, California for the oil-well service, construction and foundry industries; and California Silica Products Company near San Juan Capistrano, California, which produces silica products for the construction, recreation and other industries. MANUFACTURING The Ferro Engineering Division of the Company in Cleveland, Ohio, and the Company's Canadian, Indiana and Ohio subsidiaries, Canadian Ferro Hot Metal Specialties Limited, Indiana Manufacturing Company and Tuscarawas Manufacturing Company, produce a wide variety of ingot and tundish refractory products used in iron and steel making. West Minerals, whose assets were acquired by the Company's ONCo Minerals, Inc., retained its recognized name, continuing to engineer and custom blend metallurgical powders for the treatment of molten steel and steel making slags. The Company also operates a plant at Brownsville, Texas, which processes fluorspar for the fiberglass, glass, ceramics and steel industries. NOTE K - QUARTERLY RESULTS OF OPERATIONS (UNAUDITED) Per share amounts are based on the average number of shares outstanding during each quarter. Certain quarterly amounts for 1992 are different from amounts reported in the prior year as a result of reallocations made for postretirement benefit costs and reserves for doubtful accounts. Second quarter income before extraordinary provision and changes in accounting and net income for 1993 increased $1,751,000 ($.70 per share) related to the sale of an unsecured bankruptcy claim, as further disclosed in Note G, and declined $792,000 ($.32 per share) as a result of a reserve against doubtful coal customer accounts receivable. Fourth quarter income before extraordinary provision and changes in accounting and net income for 1993 increased $875,000 ($.35 per share) related to the sale of assets, as further disclosed in Note G, and declined $760,000 ($.30 per share) related to bond refinancing costs, as further disclosed in Note F, and an additional reserve against remaining doubtful coal customer accounts receivable. The fourth quarter loss before extraordinary provision and changes in accounting and the net loss for 1992 was increased $31,622,000 ($12.58 per share) for a provision for capacity rationalization, asset impairment charges and a loss on the disposal of a business. See Notes G and H for further disclosure. The fourth quarter net loss for 1992 was also increased $9,978,000 ($3.97 per share) for an extraordinary provision for the Coal Industry Retiree Health Benefit Act of 1992 as further disclosed in Note I. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None PART III Information in this Part III required by Item 10 ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a)(1) LIST OF FINANCIAL STATEMENTS: The response to this portion of Item 14 is submitted as a separate section of this Annual Report on Form 10-K. (a)(2) LIST OF FINANCIAL STATEMENT SCHEDULES: The response to this portion of Item 14 is submitted as a separate section of this Annual Report on Form 10-K. (a)(3) LIST OF EXHIBITS: See the Exhibit Index beginning at sequential page of this Annual Report on Form 10-K. (b) REPORTS ON FORM 8-K: The Registrant did not file any reports on Form 8-K in 1993. (c) EXHIBITS: The response to this portion of Item 14 is submitted as a separate section of this Annual Report on Form 10-K beginning at sequential page . (d) FINANCIAL STATEMENT SCHEDULES: The response to this portion of Item 14 is submitted as a separate section of this Annual Report on Form 10-K beginning at sequential page . - 44 - 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. OGLEBAY NORTON COMPANY /S/ Richard J. Kessler -------------------------- Richard J. Kessler Vice President-Finance and Development and Treasurer March 29, 1994 - 45 - Pursuant to the requirements of the Securities Exchange Act of 1934, this Annual Report has been signed below by the Principal Executive Officer, the Principal Financial Officer, the Principal Accounting Officer and a majority of the Directors of the Registrant on March 29, 1994. Chairman of the Board, /S/ R. Thomas Green, Jr. President and Chief Executive - ------------------------ Officer and Director; Principal R. Thomas Green, Jr. Executive Officer Vice President-Finance and /S/ Richard J. Kessler Development and Treasurer; - ------------------------ Principal Financial and Richard J. Kessler Accounting Officer /S/ Brent D. Baird - ------------------------ Brent D. Baird Director /S/ Malvin E. Bank - ------------------------ Malvin E. Bank Director /S/ William G. Bares - ------------------------ William G. Bares Director /S/ Albert C. Bersticker - ------------------------ Albert C. Bersticker Director /S/ John J. Dwyer - ------------------------ John J. Dwyer Director /S/ Ralph D. Ketchum - ------------------------ Ralph D. Ketchum Director /S/ Herbert S. Richey - ------------------------ Herbert S. Richey Director /S/ Renold D. Thompson - ------------------------- Vice Chairman of the Board and Renold D. Thompson Director /S/ John D. Weil - ------------------------ John D. Weil Director /S/ Fred R. White, Jr. - ------------------------ Fred R. White, Jr. Director ANNUAL REPORT ON FORM 10-K ITEM 14(a) (1) AND (2), 14(c) AND 14(d) LIST OF FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES CERTAIN EXHIBITS FINANCIAL STATEMENT SCHEDULES YEAR ENDED DECEMBER 31, 1993 OGLEBAY NORTON COMPANY AND SUBSIDIARIES CLEVELAND, OHIO FORM 10-K ITEM 14(a) (1) AND (2) LIST OF FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES OGLEBAY NORTON COMPANY AND SUBSIDIARIES The following consolidated financial statements of the Registrant and its subsidiaries are included in Item 8: Consolidated Balance Sheet - December 31, 1993 and 1992 Consolidated Statement of Operations - Years ended December 31, 1993, 1992, and 1991 Consolidated Statement of Cash Flows - Years ended December 31, 1993, 1992 and 1991 Consolidated Statement of Stockholders' Equity - Years ended December 31, 1993, 1992 and 1991 Notes to Consolidated Financial Statements The following consolidated financial statement schedules of the Registrant and its subsidiaries are included in Item 14(d): Schedule I - Marketable Securities - Other Investments Schedule V - Property, Plant and Equipment Schedule VI - 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 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 V - PROPERTY, PLANT AND EQUIPMENT - CONTINUED OGLEBAY NORTON COMPANY AND SUBSIDIARIES Years Ended December 31, 1993, 1992 and 1991 Note 1 - Capitalization of the Registrant's five year vessel inspection costs. Note 2 - Expansion and replacement of equipment at the Registrant's Texas Mining Company, California Silica Products Company and Central Silica Company. Note 3 - Expansion and replacement of equipment at the Registrant's Ferro Engineering Plant, ONCo Minerals, Inc., Indiana Manufacturing Company and Tuscarawas Manufacturing Company. Note 4 - Leasehold improvements and equipment replacement at the Registrant's corporate offices. Note 5 - Sale of Registrant's Licking River Terminal assets and the sale of the property owned by the Registrant in Ohio. Note 6 - Capitalization of Registrant's five year vessel inspection costs and boiler rework to one of Registrant's vessels. Note 7 - Expansion and replacement of equipment at the Registrant's Texas Mining Company, Central Silica Company, and California Silica Company. Note 8 - Purchase of West Minerals and expansion and replacement at the Registrant's Ferro Engineering Plant, T & B Foundry Company, Indiana Manufacturing Company and the Brownsville Briquetting Plant. Note 9 - Retirement of equipment primarily at Registrant's Central Silica Company. Note 10 - Sale of North Carolina sand property and retirement of equipment and furniture at the Registrant's corporate offices. Note 11 - Write-off of properties and equipment in connection with the disposal of the Registrant's T & B Foundry Company and write down of equipment principally at the Registrant's Canadian Ferro Hot Top Specialty LTD. Note 12 - Reclassification of properties and equipment of the Registrant's discontinued operation, Saginaw Mining Company, amounting to $13,381,675 and the write-off of land owned by the Registrant in Tennessee and Minnesota. Note 13 - Expansion and replacement of equipment at the Registrant's Texas Mining Company, California Silica Products Company and Central Silica Company. SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT - CONTINUED OGLEBAY NORTON COMPANY AND SUBSIDIARIES Years Ended December 31, 1993, 1992 and 1991 Note 14 - Expansion and replacement of equipment principally at the Registrant's Ferro Engineering Plant, Indiana Manufacturing Company, Tuscarawas Manufacturing Company and T & B Foundry Company. Note 15 - Expansion and replacement of equipment and furniture at Registrant's corporate offices, National Perlite Products Company and Ceredo Dock Note 16 - Retirement of equipment at the Registrant's Texas Mining Company, and Central Silica Company. Note 17 - Write-down of equipment principally at the Registrant's Texas Mining Company. SCHEDULE VI - ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT - CONTINUED OGLEBAY NORTON COMPANY AND SUBSIDIARIES Years Ended December 31, 1993, 1992 and 1991 Note 1 - Sale of Registrant's Licking River Terminal assets. Note 2 - Write down of vessels and related equipment of the Registrant's Columbia Transportation Division. Note 3 - Write down of assets principally at the Registrant's California Silica Company and Texas Mining Company. Note 4 - Disposal of T & B Foundry Company assets. Note 5 - Reclassification of properties and equipment of the Registrant's discontinued operation, Saginaw Mining Company, amounting to $13,133,003 and write down of assets principally at the Registrant's Saginaw Mining Company and National Perlite Products Company. Note 6 - Write down of assets at the Registrant's Licking River Terminal Division and National Perlite Products Company. SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS OGLEBAY NORTON COMPANY AND SUBSIDIARIES SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT OGLEBAY NORTON COMPANY AND SUBSIDIARIES

20286_1993.txt

20286_1993

1993

20286

ITEM 1. BUSINESS -------- Cincinnati Financial Corporation ("CFC") was incorporated on September 20, 1968 under the laws of the State of Delaware. On April 4, 1992, the shareholders voted to adopt an Agreement of Merger by means of which the reincorporation of the Corporation from the State of Delaware to the State of Ohio was accomplished. CFC owns 100% of The Cincinnati Insurance Company ("CIC") and 100% of CFC Investment Company ("CFC-I"). The principal purpose of CFC is to be a holding company for CIC and CFC-I and in addition for the purpose of acquiring other companies. CIC, incorporated in August, 1950, is an insurance carrier presently licensed to conduct multiple line underwriting in accordance with Section 3941.02 of the Revised Code of Ohio. This includes the sale of fire, automobile, casualty, bonds, and all related forms of property and casualty insurance in 50 states and the District of Columbia. CIC is not authorized to write any other forms of insurance. CIC is in a highly competitive industry and competes in varying degrees with a large number of stock and mutual companies. CIC also owns 100% of the stock of the following insurance companies. 1. The Cincinnati Life Insurance Company ("CLIC") incorporated in 1987 under the laws of Ohio for the purpose of acquiring the business of Inter-Ocean and The Life Insurance Company of Cincinnati. CLIC acquired The Life Insurance Company of Cincinnati and Inter-Ocean Insurance Company on February 1, 1988. CLIC is engaged in the sale of life insurance and accident and health insurance in 45 states and the District of Columbia. 2. The Cincinnati Casualty Company ("CCC") (formerly the Queen City Indemnity Company), incorporated in 1972 under the laws of Ohio, is engaged in the fire and casualty insurance business on a direct billing basis in 26 states. The business of CIC and CCC is conducted separately, and there are no plans for combining the business of said companies. 3. The Cincinnati Indemnity Company ("CID"), incorporated in 1988 under the laws of Ohio, is engaged in the writing of nonpreferred personal and casualty lines of insurance in 20 states. The business of CIC and CID is conducted separately, and there are no plans for combining the business of said companies. CFC-I, organized in 1970, owns certain real estate in the Greater Cincinnati area and is in the business of leasing or financing various items, principally automobiles, trucks, computer equipment, machine tools, construction equipment, and office equipment. Industry segment information for revenue, operating profits, and identifiable assets is included on page 30 of the Company's Annual Report to Shareholders and is incorporated herein by reference (see Exhibit 13 to this filing). As more fully discussed in pages 7 and 9 to 12 in the Company's Annual Report to Shareholders, incorporated herein by reference (see Exhibit 13 to this filing), the company sells insurance primarily in the Midwest and Southeast through a network of a limited number (965 in 23 states at December 31, 1993) of selectively appointed independent agents, most of whom own stock in the Company. Gross written premiums by property/ casualty lines for 1993 are shown in the table on page 9 of the Annual Report to Shareholders (see Exhibit 13 to this filing). As indicated therein, the Company's mix of property/casualty business did not change significantly in 1993. Life and accident and health insurance (which constituted only 4% of the Company's premium income for 1993) is also sold primarily through property/casualty agencies and did not change significantly in 1993. The consolidated financial statements include the estimated liability for unpaid losses and loss adjustment expenses ("LAE") of the Company's property/casualty ("P/C") insurance subsidiaries. The subsidiaries write property and casualty insurance in 50 states and the District of Columbia. The liabilities for losses and LAE are determined using case-basis evaluations and statistical projections and represent estimates of the ultimate net cost of all unpaid losses and LAE incurred through December 31 of each year. These estimates are subject to the effect of trends in future claim severity and frequency. These estimates are continually reviewed; and as experience develops and new information becomes known, the liability is adjusted as necessary. Such adjustments, if any, are reflected in current operations. The Company does not discount any of its property/casualty liabilities for unpaid losses and unpaid loss adjustment expenses. The accompanying tables present an analysis of losses and LAE. The following table provides a reconciliation of beginning and ending liability balances for 1993, 1992, and 1991. The next table shows the development of the estimated liability for the ten years prior to 1993. The reconciliation shows a 1993 recognition of $39,769,000 redundancy in the December 31, 1992 liability. This redundancy is due in part to the effects of settling case reserves established in prior years for less than expected and also in part to the over estimation of the severity of IBNR losses. Average severity continues to increase primarily because of increases in medical costs related to workers' compensation and auto liability insurance. Also, litigation expenses for recent court cases on pending liability claims continue to be very costly; and judgments continue to be high and difficult to estimate. The anticipated effect of inflation is implicitly considered when estimating liabilities for losses and LAE. While anticipated price increases due to inflation are considered in estimating the ultimate claim costs, the increase in average severities of claims is caused by a number of factors that vary with the individual type of policy written. Future average severities are projected based on historical trends adjusted for anticipated changes in underwriting standards, policy provisions, and general economic trends. These trends are monitored based on actual development and are modified if necessary. The limits on risks retained by the Company vary by type of policy, and risks in excess of the retention limits are reinsured. Because of the growth in the Company's capacity to underwrite risks and reinsurance market conditions, in 1987, the Company raised its retention limits from $500,000 to $750,000 for casualty lines of insurance. In 1989, the casualty and property lines retention limits were further raised to $1,000,000. There are no differences between the liability reported in the accompanying consolidated financial statements in accordance with generally accepted accounting principles ("GAAP") and that reported in the annual statement filed with state insurance departments in accordance with statutory accounting practices ("SAP"). The table above presents the development of balance sheet liabilities for 1983 through 1993. The top line of the table shows the estimated liability for unpaid losses and LAE recorded at the balance sheet date for each of the indicated years. This liability represents the estimated amount of losses and LAE for claims arising in all prior years that are unpaid at the balance sheet date, including losses that had been incurred but not yet reported to the Company. The upper portion of the table shows the reestimated amount of the previously recorded liability based on experience as of the end of each succeeding year. The estimate is increased or decreased as more information becomes known about the frequency and severity of claims for individual years. The "cumulative redundancy (deficiency)" represents the aggregate change in the estimates over all prior years. For example, the 1987 liability has developed a $26,000,000 redundancy over six years and has been reflected in income over the six years. The effects on income of the past three years of changes in estimates of the liabilities for losses and LAE for all accident years is shown in the reconciliation table. The lower section of the table shows the cumulative amount paid with respect to the previously recorded liability as of the end of each succeeding year. For example, as of December 31, 1992, the Company had paid $441,000,000 of the currently estimated $508,000,000 of losses and LAE that have been incurred as of the end of 1987; thus an estimated $67,000,000 of losses incurred as of the end of 1987 remain unpaid as of the current financial statement date. In evaluating this information, it should be noted that each amount includes the effects of all changes in amounts for prior periods. For example, the amount of deficiency or redundancy related to losses settled in 1992, but incurred in 1987, will be included in the cumulative deficiency or redundancy amount for 1987 and each subsequent year. This table does not present accident or policy year development data which readers may be more accustomed to analyzing. Conditions and trends that have affected development of the liability in the past may not necessarily occur in the future. Accordingly, it may not be appropriate to extrapolate future redundancies or deficiencies based on this table. The Company limits the maximum net loss that can arise by large risks or risks concentrated in areas of exposure by reinsuring (ceding) with other insurers or reinsurers. Related thereto, the Company's retention levels were last increased from $750,000 to $1,000,000 during 1989. Management does not presently intend to raise such retention levels in 1994. The Company reinsures with only financially sound companies. The composition of its reinsurers has not changed, and the Company has not experienced any uncollectible reinsurance amounts or coverage disputes with its reinsurers in more than ten years. Information concerning the Company's investment strategy and philosophy is contained in page 32 of the Annual Report to Shareholders, incorporated herein by reference (see Exhibit 13 to this filing). The Company's primary strategy is to maintain liquidity to meet both its immediate and long-range insurance obligations through the purchase and maintenance of medium-risk fixed maturity and equity securities, while earning optimal returns on medium-risk equity securities which offer growing dividends and capital appreciation. The Company usually holds these securities to maturity unless there is a change in credit risk or the securities are called by the issuer. Historically, municipal bonds (with concentrations in the essential services, i.e. schools, sewer, water, etc.) have been attractive to the Company due to their tax exempt features. Because of Alternative Mininum Tax matters, the Company uses a blend of tax-exempt and taxable fixed maturity securities. Investments in common stocks have been made with an emphasis on securities with an annual dividend yield of at least 4 to 5 percent and annual dividend increases. The Company's strategy in equity investments is to identify approximately 10 to 12 companies in which it can accumulate 10 to 20 percent of their common stock. As a long-term investor, a buy and hold strategy has been followed for many years, resulting in an accumulation of a significant amount of unrealized appreciation on equity securities. As of December 31, 1993, CFC employed 1,975 persons. ITEM 2. ITEM 2. PROPERTIES ---------- CFC-I owns a fully leased 85,000 square feet office building in downtown Cincinnati that is currently leased to Proctor and Gamble Company, a non-affiliated company, on a net, net, net lease basis. This property is carried in the financial statements at $747,782 as of December 31, 1993. CFC-I also owns the Home Office building located on 75 acres of land in Fairfield, Ohio. This building contains approximately 380,000 square feet. The John J. and Thomas R. Schiff & Company occupies approximately 5,300 square feet, and the balance of the building is occupied by CFC and its subsidiaries. The property is carried in the financial statements at $13,024,736 as of December 31, 1993. CFC-I also owns the Fairfield Executive Center which is located on the northwest corner of the home office property in Fairfield, Ohio. This is a four-story office building containing approximately 124,000 square feet. CFC and its subsidiaries occupy approximately 9% of the building, unaffiliated tenants occupy approximately 78% of the building, and the balance is currently available for lease. The property is carried in the financial statements at $10,415,112 as of December 31, 1993. The CLIC owns a four-story office building in the Tri-County area of Cincinnati containing approximately 127,000 square feet. At the present time, 100% of the building is currently being leased. This property is carried in the financial statements at $5,650,634 as of December 31, 1993. ITEM 3. ITEM 3. LEGAL PROCEEDINGS ----------------- The Company is involved in no material litigation other than routine litigation incident to the nature of the insurance industry. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS --------------------------------------------------- CFC filed with the commission on February 25, 1994, definitive proxy statements and annual reports pursuant to Regulation 14A. Material filed was the same as that described in Item 4 and is incorporated herein by reference. No matters were submitted during the fourth quarter. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER ----------------------------------------------------------------- MATTERS ------- This information is included in the Annual Report of the Registrant to its shareholders on page 5 for the year ended December 31, 1993 and is incorporated herein by reference (see Exhibit 13 to this filing). ITEM 6. ITEM 6. SELECTED FINANCIAL DATA ----------------------- This information is included in the Annual Report of the Registrant to its shareholders on pages 18 and 19 for the year ended December 31, 1993 and is incorporated herein by reference (see Exhibit 13 to this filing). ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITIONS AND ---------------------------------------------------------------- RESULTS OF OPERATIONS --------------------- This information is included in the Annual Report of the Registrant to its shareholders on pages 31 and 32 for the year ended December 31, 1993 and is incorporated herein by reference (see Exhibit 13 to this filing). ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA --------- ---------- --- ------------- ---- (a) Financial Statements The following consolidated financial statements of the Registrant and its subsidiaries, included in the Annual Report of the Registrant to its shareholders on pages 19 to 29 for the year ended December 31, 1993, are incorporated herein by reference (see Exhibit 13 to this filing). Independent Auditors' Report 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 Shareholders' Equity--Years ended December 31, 1993, 1992, and 1991 Notes to Consolidated Financial Statements (b) Supplementary Data Selected quarterly financial data, included in the Annual Report of the Registrant to its shareholders on Page 1 for the year ended December 31, 1993, is incorporated herein by reference (see Exhibit 13 to this filing). ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING ------------------------------------------------------------ AND FINANCIAL DISCLOSURE ------------------------ There were no disagreements on accounting and financial disclosure requirements with accountants within the last 24 months prior to December 31, 1993. PART III CFC filed with the Commission on February 25, 1994 definitive proxy statements pursuant to regulation 14-A. Material filed was the same as that described in Item 10, Directors and Executive Officers of the Registrant; Item 11, Executive Compensation; Item 12, Security Ownership of Certain Beneficial Owners and Management; Item 13, Certain Relationships and Related Transactions, and is incorporated herein by reference. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K ---------------------------------------------------------------- (a) Filed Documents. The following documents are filed as part of this report: 1. Financial Statements--incorporated herein by reference (see Exhibit 13 to this filing) as listed in Part II of this Report. 2. Financial Statement Schedules and Independent Auditors' Report: Independent Auditors' Report Schedule I--Summary of Investments Other than Investments in Related Parties Schedule V--Supplementary Insurance Information Schedule VI--Reinsurance Schedule IX--Short-Term Borrowings Schedule X--Supplemental Information Concerning Property-Casualty Insurance Operations All other schedules are omitted because they are not required, inapplicable or the information is included in the financial statements or notes thereto. 3. Exhibits: --------- Exhibit 11--Statement re computation of per share earnings for years ended December 31, 1993, 1992, and 1991 Exhibit 13--Material incorporated by reference from the annual report of the registrant to its shareholders for the year ended December 31, 1993 Exhibit 21--Subsidiaries of the registrant--information contained in Part I of this report. Exhibit 22--Notice of Annual Meeting of Shareholders and Proxy Statement dated February 26, 1994 filed with Securities and Exchange Commission, Washington, D.C., 20549 Exhibit 23--Independent Auditors' Consent Exhibit 28--Information from reports furnished to state insurance regulatory authorities (b) Reports on Form 8-K--NONE INDEPENDENT AUDITORS' REPORT To The Shareholders and Board of Directors of Cincinnati Financial Corporation We have audited the consolidated financial statements of Cincinnati Financial Corporation and its 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 14, 1994; 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 Cincinnati Financial Corporation and its subsidiaries listed in Item 14(a)(2). 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 /s/ Deloitte & Touche Cincinnati, Ohio February 14, 1994 S I G N A T U R E S 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. CINCINNATI FINANCIAL CORPORATION Index of Exhibits Exhibit 11-- Statement re computation of per share earnings for the years ended December 31, 1993, 1992, and 1991. Exhibit 13-- Material incorporated by reference from the annual report of the registrant to the shareholders for the year ended December 31, 1993. Segment information from page 30 (incorporated into Item 1). Text data from pages 7, 9, 10, 11 and 12 (incorporated into Item 1). 1993 Premium chart from page 9 (incorporated into Item 1). "Price range of Common Stock" section from page 5 (incorporated into Item 5). "Selected Financial Information" from pages 18 and 19 (incorporated into Item 6). "Management Discussion" from pages 31 and 32 (incorporated into Items 1 and 7). Independent Auditors' Report and Financial Statements from pages 19 thru 29 (incorporated into Item 8). "Selected Quarterly Financial Data" from page 1 (incorporated into Item 8). Exhibit 23-- Independent Auditors' Consent Exhibit 28-- Information from reports furnished to state insurance regulatory authorities.

815917_1993.txt

815917_1993

1993

815917

ITEM 1. BUSINESS The Jones Financial Companies, a Limited Partnership (the "Registrant" and also referred to herein as the "Partnership") is organized under the Revised Uniform Limited Partnership Act of the State of Missouri. The terms "Registrant" and "Partnership" used throughout, refer to The Jones Financial Companies, a Limited Partnership and any or all of its consolidated subsidiaries. The Partnership is the successor to Whitaker & Co., which was established in 1871 and dissolved on October 1, 1943, said date representing the organization date of Edward D. Jones & Co., L.P. ("EDJ"), the Partnership's principal subsidiary. EDJ was reorganized on August 28, 1987, which date represents the organization date of The Jones Financial Companies, a Limited Partnership. The Partnership is engaged in business as a broker/dealer in listed and unlisted securities, including governmental issues, acts as an investment banker, and is a distributor of mutual fund shares. In addition, the Partnership engages in sales of various insurance products and renders investment advisory services. The Partnership is heavily oriented towards serving individual retail customers. The Partnership is a member firm of the New York, American and Midwest exchanges, and is a registered broker/dealer with the National Association of Securities Dealers, Inc. As of February 25, 1994, the Partnership was comprised of 111 general partners, 2,000 limited partners and 54 subordinated limited partners. The Partnership employed 8,086 persons, including 2,013 part-time employees. As of said date, the Partnership employed 2,776 full-time investment representatives actively engaged in sales in 2,704 offices in 48 states. The Partnership anticipates opening its first offices in Hawaii and Ontario, Canada in 1994. The Partnership owns 100 percent of the outstanding common stock of EDJ Holding Company, Inc., a Missouri corporation and 100 percent of the outstanding common stock of LHC, Inc., a Missouri corporation. The Partnership also holds all of the partnership equity of Edward D. Jones & Co., L.P., a Missouri limited partnership and EDJ Leasing Co., L.P. a Missouri limited partnership. EDJ Holding Company, Inc. and LHC, Inc. are the general partners of Edward D. Jones & Co., L.P. and EDJ Leasing Co., L.P., respectively. In addition, the Partnership owns 100 percent of the outstanding common stock of Conestoga Securities, Inc., a Missouri corporation and also owns, as a limited partner, 49.5 percent of Passport Research Ltd., a Pennsylvania limited partnership, which acts as an investment advisor to a money market mutual fund. The Partnership owns 100% of the equity of Edward D. Jones & Co., an Ontario limited partnership and the general partner is Edward D. Jones & Co. Canada Holding Co. Inc., which is wholly owned by the Partnership. The Partnership has an equity position in several entities formed to act as general partners of various direct participation programs sponsored by the Nooney Corporation as follows: Nooney Capital Corp. (a Missouri corporation), 66-2/3% of outstanding Class B non-voting stock; Nooney-Five Capital Corp. (a Missouri Corporation), 100% of outstanding Class B non-voting stock; Nooney-Six Capital Corp. (a Missouri corporation), 100% of outstanding Class B non-voting stock; Nooney-Seven Capital Corp. (a Missouri corporation), 100% of outstanding Class B non-voting stock; Nooney Income Investments, Inc. (a Missouri corporation), 100% of outstanding Class B non-voting stock; Nooney Income Investments Two, Inc. (a Missouri corporation), 100% of outstanding Class B non-voting stock; Nooney Income Investment Three, Inc., (a Missouri corporation), 100% of outstanding Class B non-voting stock. The Partnership holds all of the partnership equity in a Missouri limited partnership, EDJ Ventures, Ltd., which acts as a partner and renders advisory and other management services to direct participation program partnerships. Conestoga Securities, Inc. is the general partner of EDJ Ventures, Ltd. The Partnership is the sole shareholder of Tempus Corporation, a Missouri corporation, which was formed strictly to facilitate the issuance of certain debt securities of the Partnership in a private transaction. The Partnership is a limited partner of EDJ Insurance Agency of New Jersey, L.P., a New Jersey limited partnership; EDJ Insurance Agency of Arkansas, an Arkansas limited partnership; EDJ Insurance Agency of Montana, a Montana limited partnership; EDJ Insurance Agency of New Mexico, a New Mexico limited partnership; EDJ Insurance Agency of Utah, a Utah limited partnership; and is a general partner in EDJ Insurance Agency of California, a California general partnership; each of which engage in general insurance brokerage activities. The Partnership owns all of the outstanding stock of EDJ Insurance Agency of Ohio, Inc., which is also engaged in insurance brokerage activities. Affiliates of the partner include EDJ Insurance Agency of Nevada, EDJ Insurance Agency of Texas, EDJ Insurance Agency of Alabama, EDJ Insurance Agency of Florida, EDJ Insurance Agency of Wyoming, EDJ Insurance Agency of Arizona and EDJ Insurance Agency of Massachusetts. The Partnership holds all of the Partnership equity of Unison Investment Trusts, L.P., d/b/a Unison Investment Trusts, Ltd., a Missouri limited partnership, which sponsors unit investment trust programs. The general partner of Unison Investment Trusts, L.P. is Unison Capital Corp., Inc., a Missouri corporation wholly owned by the Partnership. The Partnership owns 100% of the outstanding common stock of Edward D. Jones Homeowners, Inc., a Missouri corporation which, in turn, serves as the general partner of EDJ Residential Mortgage Services, a Missouri limited partnership wholly owned by the Partnership, which formerly provided mortgage brokerage and ancillary services. The Partnership owns 100% of the outstanding common stock of Cornerstone Mortgage Investment Group, Inc., a Delaware limited purpose corporation which has issued and sold collateralized mortgage obligation bonds, and Cornerstone Mortgage Investment Group II, Inc., a Delaware limited purpose corporation which has structured and sold secured mortgage bonds. The Partnership owns 100% of the outstanding stock of CIP Management, Inc., which is the managing general partner of CIP Management, L.P. CIP Management, L.P. is the managing general partner of Community Investment Partners, L.P. and Community Investment Partners II, L.P., business development companies. Other affiliates of the Partnership include Patronus, Inc. and EDJ Investment Advisory Services. Neither has conducted an active business. The Partnership owns as a general partner, 1/3 of Commonwealth Pacific Limited Partnership, a Washington limited partnership, which formerly operated as a syndicator of various real estate limited partnership programs, for which the Partnership had served as an underwriter and distributor. Revenues by Source. The following table sets forth, for the past three years the sources of the Partnership's revenues by dollar amounts, (all amounts in thousands): 1993 1992 1991 Commissions Listed $ 70,634 $ 59,256 $ 44,115 Mutual Funds 272,020 187,411 110,499 O-T-C 20,786 14,424 10,136 Insurance 64,424 42,585 34,964 Other 596 274 60 Principal Transactions 92,471 131,366 104,426 Investment Banking 45,001 60,635 67,376 Interest & Dividends 38,084 30,520 25,533 Money-Market Fees 10,048 10,751 9,320 IRA Custodial Service Fees 4,387 3,310 999 Other Revenues 13,001 9,080 4,160 _________ _________ _________ Total Revenue $ 631,452 $ 549,612 $411,588 Because of the interdependence of the activities and departments of the Partnership's investment business and the arbitrary assumptions involved in allocating overhead, it is impractical to identify and specify expenses applicable to each aspect of the Partnership's operations. Furthermore, the net income of firms principally engaged in the securities business, including the Partnership's, is effected by interest savings as a result of customer and other credit balances and interest earned on customer margin accounts. Listed Brokerage Transactions. A large portion of the Partnership's revenue is derived from customers' transactions in which the Partnership acts as agent in the purchase and sale of listed corporate securities. These securities include common and preferred stocks and corporate debt securities traded on and off the securities exchanges. Revenue from brokerage transactions is highly influenced by the volume of business and securities prices. Customers' transactions in securities are effected on either a cash or a margin basis. In a margin account, the Partnership lends the customer a portion of the purchase price up to the limits imposed by the margin regulations of the Federal Reserve Board (Regulation T), New York Stock Exchange (NYSE) margin requirements, or the Partnership's internal policies, which may be more stringent than the regulatory minimum requirements. Such loans are secured by the securities held in customers' margin accounts. These loans provide a source of income to the Partnership since it is able to lend to customers at rates which are higher than the rates at which it is able to borrow on a secured basis. The Partnership is permitted to use as collateral for the borrowings, securities owned by margin customers having an aggregate market value generally up to 140 percent of the debit balance in margin accounts. The Partnership may also use the interest-free funds provided by free credit balances in customers' accounts to finance customers' margin account borrowings. In permitting customers to purchase securities on margin, the Partnership assumes the risk of a market decline which could reduce the value of its collateral below a customer's indebtedness before the collateral is sold. Under the NYSE rules, the Partnership is required in the event of a decline in the market value of the securities in a margin account to require the customer to deposit additional securities or cash so that at all times the loan to the customer is no greater than 75 percent of the value of the securities in the account ( or to sell a sufficient amount of securities in order to maintain this percentage). The Partnership, however, imposes a more stringent maintenance requirement. Variations in revenues from listed brokerage commissions between periods is largely a function of market conditions; however, some portion of the overall increases in recent years is due to the growth in the number of registered representatives over these periods. Mutual Funds. The Partnership distributes mutual fund shares in continuous offerings and new underwritings. As a dealer in mutual fund shares, the Partnership receives a dealers' discount which generally ranges from 1 percent to 5 3/4 percent of the purchase price of the shares, depending on the terms of the dealer agreement and the amount of the purchase. The Partnership also earns service fees which are generally based on 15 to 25 basis points of its customers' assets which are held by the mutual funds. The Partnership does not manage any mutual fund, although it is a limited partner of Passport Research, Ltd., an advisor to a money market mutual fund. Over-the-Counter and Principal Transactions. Partnership activities in unlisted (over-the-counter) transactions are essentially similar to its activities as a broker in listed securities. In connection with customers' orders to buy or sell securities on an agency basis, the Partnership charges a commission. In dealing on a principal basis, the Partnership charges its customers a net price approximately equal to the current inter-dealer market price plus or minus a mark-up or mark-down from such market price. The National Association of Securities Dealers (NASD) Rules of Fair Practice require that such mark-up (or mark-down) be fair and reasonable. The Partnership has executed several agency agreements with various national insurance companies. Through its approximately 2,056 investment representatives who hold insurance sales licenses, EDJ is able to offer term life insurance, health insurance, and fixed and variable annuities to its customers. The sale of annuities is the primary product. Revenues from the sale of insurance products approximated 10% of total revenues in 1993, and this area has experienced growth in recent years largely as a result of the growth in the number of representatives licensed to engage in insurance sales. The Partnership makes a market in over-the-counter corporate securities, municipal obligations, including general obligations and revenue bonds, unit investment trusts and mortgage-backed securities. The Partnership's market-making activities are conducted with other dealers in the "wholesale" market and "retail" market wherein the Partnership acts as a dealer buying from and selling to its customers. In making markets in over-the-counter securities, the Partnership exposes its capital to the risk of fluctuation in the market value of its security positions. It is the Partnership's policy not to trade for its own account. As in the case of listed brokerage transactions, revenue from over- the-counter and principal transactions is highly influenced by the volume of business and securities prices, as well as by the varying number of registered representatives employed by the Partnership over the periods indicated. Investment Banking. The Partnership's investment banking activities are carried on through its Syndicate and Underwriting Departments. The principal service which the Partnership renders as an investment banker is the underwriting and distribution of securities either in a primary distribution on behalf of the issuer of such securities or in a secondary distribution on behalf of a holder of such securities. The distributions of corporate and municipal securities are, in most cases, underwritten by a group or syndicate of underwriters. Each underwriter has a participation in the offering. Unlike many larger firms against which the Partnership competes, the Partnership does not presently engage in other investment banking activities such as assisting in mergers and acquisitions, arranging private placement of securities issues with institutions or providing consulting and financial advisory services to corporations. The Syndicate and Underwriting Departments are responsible for the largest portion of the Partnership's investment banking business. In the case of an underwritten offering managed by the Partnership, the Departments may form underwriting syndicates and work closely with the branch office system for sales of the Partnership's own participation and with other members of the syndicate in the pricing and negotiation of other terms. In offerings managed by others in which the Partnership participates as a syndicate member, the Departments serve as active coordinators between the managing underwriter and the Partnership's branch office system. The underwriting activity of the Partnership involves substantial risks. An underwriter may incur losses if it is unable to resell the securities it is committed to purchase or if it is forced to liquidate all or part of its commitment at less than the agreed purchase price. Furthermore, the commitment of capital to underwriting may adversely affect the Partnership's capital position and, as such, its participation in an underwriting may be limited by the requirement that it must at all times be in compliance with the net capital rule. The Securities Act of 1933 and other applicable laws and regulations impose substantial potential liabilities on underwriters for material misstatements or omissions in the prospectus used to describe the offered securities. In addition, there exists a potential for possible conflict of interest between an underwriter's desire to sell its securities and its obligation to its customers not to recommend unsuitable securities. In recent years there has been an increasing incidence of litigation in these areas. These lawsuits are frequently brought for the benefit of large classes of purchasers of underwritten securities. Such lawsuits often name underwriters as defendants and typically seek substantial amounts in damages. Interest and dividend income is earned on securities held and margin account balances. Other revenue sources include money market management fees and IRA custodial services fees, accommodation transfer fees, gains from sales of certain assets, and other product and service fees. The Partnership has an interest in the investment advisor to its money market fund, Daily Passport Cash Trust. Revenue from this source has increased over the periods due to growth in the fund, both in dollars invested and number of accounts. In 1991 EDJ became the trustee for its IRA accounts. Each account is charged an annual service fee for services rendered to it by the Partnership. The Partnership has registered an investment advisory program with the SEC under the Investment Advisors Act of 1940. This service is offered firmwide and involves income and estate tax planning and analysis for clients. Revenues from this source are insignificant and included under "Other Revenues." Also included in the category "Other Revenues" are accommodation transfer fees, gains from sales of certain assets, other non-recurring gains and revenue from management fees charged by mutual funds. Research Department. The Partnership maintains a Research Department to provide specific investment recommendations and market information for retail customers. The Department supplements its own research with the services of various independent research services. The Partnership competes with many other securities firms with substantially larger research staffs in its research activities. Customer Account Administration and Operations. Operations employees are responsible for activities relating to customers' securities and the processing of transactions with other broker/dealers. These activities include receipt, identification, and delivery of funds and securities, internal financial controls, accounting and personnel functions, office services, storage of customer securities and the handling of margin accounts. The Partnership processes substantially all of its own transactions. It is important that the Partnership maintains current and accurate books and records from both a profit viewpoint as well as for regulatory compliance. To expedite the processing of orders, the Partnership's branch office system is linked to the St. Louis headquarters office through an extensive communications network. Orders for all securities are centralized in St. Louis and executed there. The Partnership's processing of paperwork following the execution of a security transaction is automated, and operations are generally on a current basis. There is considerable fluctuation during any one year and from year to year in the volume of transactions the Partnership processes. The Partnership records transactions and posts its books on a daily basis. Operations' personnel monitor day-to-day operations to determine compliance with applicable laws, rules and regulations. Failure to keep current and accurate books and records can render the Partnership liable to disciplinary action by governmental and self-regulatory organizations. The Partnership has a computerized branch office communication system which is principally utilized for entry of security orders, quotations, messages between offices and cash receipts functions. The Partnership clears and settles virtually all of its listed transactions through the National Securities Clearing Corporation ("NSCC"), New York, New York. NSCC effects clearing of securities on the New York, American and Midwest Stock Exchanges. In conjunction with clearing and settling transactions with NSCC the Partnership holds customers' securities on deposit with Depository Trust Company ("DTC") in lieu of maintaining physical custody of the certificates. The Partnership is substantially dependent upon the operational capacity and ability of NSCC/DTC. Any serious delays in the processing of securities transactions encountered by NSCC/DTC may result in delays of delivery of cash or securities to the Partnership's customers. These services are performed for the Partnership under contracts which may be changed or terminated at will by either party. Automated Data Processing, Inc., ("ADP") provides automated data processing services for customer account activity and records. The Partnership does not employ its own floor broker for transactions on exchanges. The Partnership has arrangements with other brokers to execute the Partnership's transactions in return for a commission based on the size and type of trade. If for any reason any of the Partnership's clearing, settling or executing agents were to fail, the Partnership and its customers would be subject to possible loss. While the coverages provided by the Securities Investors Protection Corporation (SIPC) and protection in excess of SIPC limits would be available to customers of the Partnership, to the extent that the Partnership would not be able to meet the obligations of the customers, such customers might experience delays in obtaining the protections afforded them by the SIPC and the Partnership's insurance carrier. The Partnership believes that its internal controls and safeguards concerning the risks of securities thefts are adequate. Although the possibility of securities thefts is a risk of the industry, the Partnership has not had, to date, a significant problem with such thefts. The Partnership maintains fidelity bonding insurance which, in the opinion of management, provides adequate coverage. Employees. Including its general partners, the Partnership has approximately 8,086 full and part-time employees, including 2,776 who are registered salespeople as of February 25, 1994. The Partnership's salespersons are compensated on a commission basis and may, in addition, be entitled to bonus compensation based on their respective branch office profitability and the profitability of the Partnership. The Partnership has no formal bonus plan for its non-registered employees. The Partnership has, however, in the past paid bonuses to its non-registered employees on an informal basis, but there can be no assurance that such bonuses will be paid for any given period or will be within any specific range of amounts. Employees of the Partnership are bonded under a blanket policy as required by NYSE rules. The annual aggregate amount of coverage is $30,000,000 subject to a $2,000,000 deductible provision, per occurrence. The Partnership maintains a training program for prospective salespeople which includes eight weeks of concentrated instruction and on-the-job training in a branch office. The first phase of training is spent reviewing Series 7 examination materials and preparing for and taking the examination. The first week of the training after passing the examination is spent in a comprehensive training program in St. Louis. The next five weeks include on-the-job training in branch locations reviewing products, office procedures and sales techniques. The broker is then sent to a designated location to establish the EDJ office, conduct market research and prepare for opening the office. After the salesperson has opened a branch office, one final week is spent in a central location to complete the initial training program. Three and nine months later, the investment representative attends additional training classes in St. Louis, and subsequently, EDJ offers periodic continuing training mechanisms to its seasoned sales force. Although the Partnership pays the broker during the transition period, the broker must fulfill special tasks before being awarded full branch status. EDJ's basic brokerage payout is similar to its competitors. A bonus may also be paid based on the profitability of the branch and the profitability of the Partnership. The Partnership considers its employee relations to be good and believes that its compensation and employee benefits which include medical, life, and disability insurance plans and profit sharing and deferred compensation retirement plans, are competitive with those offered by other firms principally engaged in the securities business. Competition. The Partnership is subject to intensive competition in all phases of its business from other securities firms, many of which are substantially larger than the Partnership in terms of capital, brokerage volume and underwriting activities. In addition, the Partnership encounters competition from other financially oriented organizations such as banks, insurance companies, and others offering financial services and advice. In recent periods, many regulatory requirements prohibiting non-securities firms from engaging in certain aspects of brokerage firms' business have been eliminated and further removal of such prohibitions is anticipated. With minor exceptions, customers are free to transfer their business to competing organizations at any time. There is intense competition among securities firms for salespeople with good sales production records. In recent periods, the Partnership has experienced increasing efforts by competing firms to hire away its registered representatives although the Partnership believes that its rate of turnover of investment representatives is not higher than that of other firms comparable to the Partnership. Regulation. The securities industry in the United States is subject to extensive regulation under both federal and state laws. The SEC is the federal agency responsible for the administration of the federal securities laws. The Partnership's principal subsidiary is registered as a broker-dealer and investment advisor with the SEC. Much of the regulation of broker-dealers has been delegated to self-regulatory organizations, principally the NASD and national securities exchanges such as the NYSE, which has been designated by the SEC as the Partnership's primary regulator. These self-regulatory organizations adopt rules (which are subject to approval by the SEC) that govern the industry and conduct periodic examinations of the Partnership's operations. Securities firms are also subject to regulation by state securities administrators in those states in which they conduct business. The Partnership is registered as a broker-dealer in 50 states and Puerto Rico. Broker-dealers are subject to regulations which cover all aspects of the securities business, including sales methods, trade practices among broker-dealers, use and safekeeping of customers' funds and securities, capital structure of securities firms, record-keeping and the conduct of directors, officers and employees. Additional legislation, changes in rules promulgated by the SEC and self- regulatory organizations, or changes in the interpretation or enforcement of existing laws and rules, may directly affect the mode of operation and profitability of broker-dealers. The SEC, self- regulatory organizations and state securities commissions may conduct administrative proceedings which can result in censure, fine, suspension or expulsion of a broker-dealer, its officers or employees. The principal purpose of regulation and discipline of broker-dealers is the protection of customers and the securities markets, rather than protection of the creditors and stockholders of broker-dealers. Uniform Net Capital Rule. As a broker-dealer and a member firm of the NYSE, the Partnership is subject to the Uniform Net Capital Rule (Rule) promulgated by the SEC. The Rule is designed to measure the general financial integrity and liquidity of a broker-dealer and the minimum net capital deemed necessary to meet the broker-dealer's continuing commitments to its customers. The Rule provides for two methods of computing net capital and the Partnership has adopted what is generally referred to as the alternative method. Minimum required net capital under the alternative method is equal to 2% of the customer debit balances, as defined. The Rule prohibits withdrawal of equity capital whether by payment of dividends, repurchase of stock or other means, if net capital would thereafter be less than 5% of customer debit balances. Additionally, certain withdrawals require the consent of the SEC to the extent they exceed defined levels even though such withdrawals would not cause net capital to be less than 5% of aggregate debit items. In computing net capital, various adjustments are made to exclude assets which are not readily convertible into cash and to provide a conservative statement of other assets such as a company's inventories. Failure to maintain the required net capital may subject a firm to suspension or expulsion by the NYSE, the SEC and other regulatory bodies and may ultimately require its liquidation. The Partnership has, at all times, been in compliance with the net capital rules. ITEM 2. ITEM 2. PROPERTIES All of its headquarter offices are owned by the Partnership. The Partnership conducts its headquarters operations from St. Louis County, Missouri. The headquarters facilities are comprised of 17 separate buildings containing approximately 822,000 usable square feet. One additional building on the campus is leased. The Partnership acquired an existing 397,000 square foot building in St. Louis County in December, 1992, of which 170,000 square feet is occupied at December 31, 1993. This building was substantially renovated in 1993. The Partnership plans to use the unoccupied space for growth in future headquarters personnel which is planned to parallel the growth of the salesforce. The Partnership also maintains facilities in 2,655 branch locations which (as of December 31, 1993) are predominantly rented under cancellable leases. Further information concerning leased computer equipment, branch satellite equipment and other obligations of the Partnership is given in the Notes to the Consolidated Financial Statements appearing elsewhere herein. ITEM 3. ITEM 3. LEGAL PROCEEDINGS In recent years there has been an increasing incidence of litigation involving the securities industry. Such suits often seek to benefit large classes of industry customers; many name securities dealers as defendants along with exchanges in which they hold membership and seek large sums as damages under federal and state securities laws, anti- trust laws, and common law. There are various actions pending against the Partnership which have arisen in the normal course of business. In view of the number and diversity of claims against the Partnership, the number of jurisdictions in which litigation is pending and the inherent difficulty of predicting the outcome of litigation and other claims, the Partnership cannot definitely state what the eventual outcome of these pending claims will be. However, in the opinion of management, after consultation with legal counsel, the impact of this litigation will not have a material adverse affect on the Partnership's financial position or results of operations. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS There is no market for the Limited or Subordinated Limited Partnership interests and their assignment is prohibited. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The following information sets forth, for the past five years, selected financial data. (All amounts in thousands, except per unit information.) Summary Income Statement Data: 1993 1992 1991 1990 1989 Revenues $631,452 $549,612 $411,588 $316,503 $280,429 Net income 66,211 62,282 40,875 22,553 15,703 Net income per weighted average $1,000 equivalent limited partnership unit outstanding $194.62 $238.41 $185.92 $130.52 $82.50 Weighted average $1,000 equivalent limited partnership units outstanding 50,381 41,160 42,616 25,874 27,274 Net income per weighted average $1,000 equivalent subordinated limited partnership unit outstanding $350.32 $418.21 $322.38 $212.86 $154.82 Weighted average $1,000 equivalent subordinated limited partnership units outstanding 16,936 12,941 10,624 10,190 9,779 Summary Balance Sheet Data: 1993 1992 1991 1990 1989 Total assets $800,478 $653,253 $513,730 $422,257 $387,618 ======= ======= ======= ======= ======= Long-term debt $ 33,317 $ 23,847 $ 24,769 $ 19,977 $ 20,075 Other liabilities, exclusive of subordinated liabilities 514,386 414,110 326,229 250,772 234,732 Subordinated liabilities 73,000 78,000 48,000 50,400 52,800 Total partnership capital 179,775 137,296 114,732 101,108 80,011 ________ ________ ________ ________ ________ Total liabilities and partnership capital $800,478 $653,253 $513,730 $422,257 $387,618 ======== ======== ======== ======== ======== ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following table summarizes the changes in major categories of revenues and expenses for the last two years (Dollar amounts in thousands.) 1993 vs. 1992 1992 vs. 1991 Increase - (Decrease) Amount % Amount % Revenues Commissions $ 124,510 41 $ 104,176 52% Principal transactions (38,895) (30) 26,940 26 Investment banking (15,634) (26) (6,741) (10) Interest and dividends 7,564 25 4,987 20 Other 4,295 19 8,662 60 _________ ___ _________ ___ 81,840 15 138,024 34 _________ ___ _________ ___ Expenses Employee and partner compensation and benefits 53,859 16 88,142 37 Occupancy and equipment 10,069 20 3,867 8 Communications and data processing 4,898 17 3,556 14 Interest 3,632 23 2,155 16 Payroll and other taxes 1,767 11 3,192 24 Floor brokerage and clearance fees 781 15 691 15 Other operating expenses 2,905 7 15,014 53 ________ ___ ________ ___ 77,911 16 116,617 31 ________ ___ ________ ___ Net income $ 3,929 6% $ 21,407 52% ======== === ======== === RESULTS OF OPERATIONS (1993 VERSUS 1992) Revenues increased 15% ($82 million) over 1992 to $631 million. Expenses increased by 16% ($78 million) resulting in net income of $66 million, an increase of 6% ($4 million) over 1992. These results were significantly influenced by the Partnership's activities in connection with the expansion of its salesforce. The number of investment representatives increased 24% in 1993 to 2,745. By comparison, 1992's growth in investment representatives was 22%. The vast majority of these new investment representatives are beginners in the industry who generally achieve profitability after about 30 months. In the interim, the Partnership incurs significant training, salary and support costs. The net impact of these direct expenses amounted to nearly $21 million during 1993 ($14 million in 1992). Additionally, the Partnership made significant increases in home office overhead to support the increased salesforce. Commission revenues increased $125 million fueled by a $85 million (45%) increase in mutual fund commissions and service fees. Listed and over-the-counter agency commissions increased $18 million or 24% over 1992. Insurance commissions increased 51%, with variable annuity commissions increasing $20.6 million and fixed annuities decreasing by $5 million. The increasing level of securities prices along with lower interest rates turned individual investors to equity markets and equity based investments in search of more attractive returns. The continued strength of the securities markets led to solid increases in commission generated from the sales of securities products. Principal transaction revenues decreased 30% ($39 million). Collateralized mortgage obligations (CMOs) revenues decreased $11.3 million, government and municipal bond revenues decreased by $9.7 million and $3.7 million, respectively. Prior to 1993, municipal bond syndicate revenues were included in principal transaction revenues. In 1993, these revenues, totalling $10.3 million, were included in investment banking revenues. The majority of the principal transaction revenue decreases largely resulted from historically low interest rates and the resulting popularity of equity based investments. Investment banking revenues declined $15.6 million resulting from decreases in certificate of deposit revenues ($8 million), CMO revenues ($11 million), and equity and debt originations. Interest and dividend revenues increased 25% or $7.6 million. Customers' margin loan balances increased 36% in 1993 ($120 million) ending the year at $451 million. The increase in customers' loan balances was attributable to higher securities prices, continuation of marketing efforts targeting individuals to view their securities as access to a personal line of credit and lower interest rates. The increase in loan balances more than offset the decline in short term interest rates during the year resulting in increased interest earnings. Other revenues increased $4 million (19%) over 1992. Revenues from non-bank custodian IRA accounts resulted in an increase of $1 million in 1993. Overall expenses increased 16% ($78 million). The Partnership's compensation structure for its investment representatives is designed to expand or contract substantially as a result of changes in revenues, net income and profit margins. Similarly, non-sales personnel compensation from bonuses and profit sharing contributions expands and contracts in relation to net income. The Partnership's non-compensation related expenses are less responsive to changes in revenues and net income. Rather, these expenses are influenced by the number of salespeople, growth of the salesforce, the number of customer accounts and, to a lesser extent, the volume of transactions. As a result of its expense structure, the Partnership's compensation expense increase of 16% matched the overall increase in expenses of 16%. The Partnership's expenses other than compensation increased 15%. The increase in other expenses resulted from several items. Increased expense levels related to supporting a larger number of investment representatives and branch offices were primarily responsible for the increase in operating expenses. RESULTS OF OPERATIONS (1992 VERSUS 1991) Revenues increased 34% ($138 million) over 1991 to $550 million. Expenses increased by 31% ($117 million) resulting in net income of $62 million, an increase of 52% ($21 million) over 1991. The number of investment representatives increased 22% in 1992 to 2,216. By comparison, 1991's growth in investment representatives was 9%. The increased size of the salesforce and higher securities prices along with a very steeply sloped yield curve were significant factors contributing to 1992's financial results. Commission revenues increased $104 million fueled by a $77 million (70%) increase in mutual fund commissions and service fees. Listed and over-the-counter agency commissions increased $19 million or 36% over 1991. Insurance commissions increased 22%, with variable annuity commissions increasing $10 million and fixed annuities decreasing by $4 million. The increasing level of securities prices along with lower interest rates turned individual investors to equity markets and equity based investments in search of more attractive returns. Principal transaction revenues increased 26% ($27 million) with taxable and tax free fixed income securities increasing $21 million. At the same time, O-T-C principal stock sales increased by $3 million. Individual investors were attracted to longer term fixed income products to increase or maintain their returns compared to other shorter term alternatives. Additionally, tax free bonds experienced relatively high yields during the year when compared to treasury securities with similar maturities. The increase in O-T-C stock sales resulted from higher equity prices and investors directing their investment dollars into smaller capitalization companies. The returns experienced during the year from investing in smaller capitalization companies was higher than the investment returns of larger exchange listed securities. Investment banking revenues declined $6.7 million from substantial decreases in certificate of deposit revenues ($6 million) and CMOs revenues ($4 million). These decreases were partially offset by equity originations and syndicate equity participation increases of $3 million. Initial public offerings continued to be popular during the year along with investor interest in utility unit investment trust underwritings. The decrease in investment banking CMO revenues was partially offset by increased sales of CMOs on a principal basis. Interest and dividend revenues increased 20% or $5 million. Customers' margin loan balances increased 66% in 1992 ($132 million) ending the year at $331 million. The increase in customers' loan balances was attributable to higher securities prices, continuation of marketing efforts targeting individuals to view their securities as access to a personal line of credit and lower interest rates. The increase in loan balances more than offsets the decline in short term interest rates during the year resulting in increased interest earnings. Other revenues increased $9 million (60%) over 1991. During the last quarter of 1991, the Partnership qualified as a non-bank custodian for its IRA accounts resulting in an increase of $2.3 million in 1992 from IRA service fee revenues. Revenues for fees and services received from the Edward D. Jones & Co. Daily Passport Cash Trust money market account and a related tax free money market account offered through Edward D. Jones & Co. increased $1.4 million over 1991. Overall expenses increased 31% ($117 million). The Partnership's compensation structure for its investment representatives is designed to expand or contract substantially as a result of changes in revenues, net income and profit margins. Similarly, non-sales personnel compensation from bonuses and profit sharing contributions expands and contracts in relation to net income. The Partnership's non-compensation related expenses tend to be less responsive to changes in revenues and net income. Rather, these expenses tend to be more influenced by the number of salespeople, growth of the salesforce, the number of customer accounts and, to a lesser extent, the volume of transactions. As a result of its expense structure, the Partnership's compensation expense increase of 37% exceeded the overall increase in expenses of 31%. The Partnership's expenses other than compensation increased 22%. Other operating expenses increased 53% or $15 million over 1991. The increase in other operating expenses resulted from several items. Increased expense levels related to supporting a larger number of investment representatives and branch offices were primarily responsible for the increase in operating expenses. THE EFFECTS OF INFLATION The Partnership's net assets are primarily monetary, consisting of cash, securities inventories and receivables less liabilities. Monetary net assets are primarily liquid in nature and would not be significantly affected by inflation. Inflation and future expectations of inflation influence securities prices, as well as activity levels in the securities markets. As a result, profitability and capital may be impacted by inflation and inflationary expectations. Additionally, inflation's impact on the Partnership's operating expenses may affect profitability to the extent that additional costs are not recoverable through increased prices of services offered by the Partnership. LIQUIDITY AND CAPITAL ADEQUACY The Partnership's equity capital at December 31, 1993, was $179.8 million compared to $137.3 million at December 31, 1992. Overall, equity capital increased 31%, primarily due to the retention of earnings and issuance of partnership interests. The Partnership issued additional limited partnership interests in August 1993 of $24.8 million and additional subordinated limited partnership interest of $4.4 million in January 1993. At December 31, 1993, the Partnership had a $28.8 million balance of cash and cash equivalents. Lines of credit are in place at nine banks aggregating $445 million ($420 million of which are through uncommitted lines of credit), of which $310 million was available at December 31, 1993. The Partnership believes that the liquidity provided by existing cash balances and borrowing arrangements will be sufficient to meet the Partnership capital and liquidity requirements. As a result of its activities as a broker/dealer, EDJ, the Partnership's principal subsidiary, is subject to the Net Capital provisions of Rule 15c3-1 of the Securities Exchange Act of 1934 and the capital rules of the New York Stock Exchange. Under the alternative method permitted by the rules, EDJ must maintain minimum Net Capital, as defined, equal to the greater of $150,000 or 2% of aggregate debit items arising from customer transactions. The Net Capital rule also provides the partnership capital may not be withdrawn if resulting Net Capital would be less than 5% of aggregate debit items. Additionally, certain withdrawals require the consent of the SEC to the extent they exceed defined levels even though such withdrawals would not cause Net Capital to be less than 5% of aggregate debit items. At December 31, 1993, EDJ's Net Capital of $89,790,000 was 20% of aggregate debit items and its net capital in excess of the minimum required was $80,681,000. Net Capital and the related capital percentage may fluctuate on a daily basis. CASH FLOWS Cash and cash equivalents decreased $8,932,000 from December 31, 1992, to December 31, 1993. Cash flows were primarily provided from net income, decreases in securities owned, short and long term bank loans and the issuance of partnership interests. Cash flows were primarily used to increase net receivables from customers and brokers, purchase equipment, property and improvements, and fund withdrawals and distributions. Cash and cash equivalents increased $5,308,000 from December 31, 1991, to December 31, 1992. Cash flows were primarily provided from net income, short term bank loans and the issuance of subordinated debt. Cash flows were primarily used to increase net receivables from customers, increase securities owned, purchase equipment, property and improvements, and fund withdrawals and distributions. Cash and cash equivalents increased $5,078,000 from December 31, 1990, to December 31, 1991. Cash flows were primarily provided from net income, an increase in accounts payable and accrued expenses, short term bank loans and the issuance of long term debt. Cash flows were primarily used to increase net receivables from customers, increase securities owned, purchase equipment, property and improvements, and fund withdrawals and distributions. There were no material changes in the Partnership's overall financial condition during the year ended December 31, 1993, compared with the year ended December 31, 1992. The Partnership's consolidated statement of financial condition is comprised primarily of cash and assets readily convertible into cash. Securities inventories are carried at market value and are readily marketable. The firm carried lower trading inventory levels in 1993 as compared to 1992. Customer margin accounts are collateralized by marketable securities. Other customer receivables and receivables and payables with other broker/dealers normally settle on a current basis. Liabilities, including amounts payable to customers, checks and accounts payable and accrued expenses are non-interest bearing sources of funds to the Partnership. These liabilities, to the extent not utilized to finance assets, are available to meet liquidity needs and provide funds for short term investments, which favorably impacts profitability. The Partnership's growth in recent years has been financed through sales of limited partnership interest to its employees, retention of earnings and private placements of long-term and subordinated debt. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Financial Statements Included in this Item Page No. Report of Independent Public Accountants Consolidated Statements of Financial Condition as of 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 Changes in Partnership Capital for the years ended December 31, 1993, 1992 and 1991 Notes to Consolidated Financial Statements REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To The Jones Financial Companies, a Limited Partnership: We have audited the accompanying consolidated statements of financial condition of The Jones Financial Companies, a Limited Partnership (a Missouri limited partnership) and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income, cash flows and changes in partnership capital for each of the three years in the period ended December 31, 1993. 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 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 Jones Financial Companies, a Limited Partnership and subsidiaries as of December 31, 1993 and 1992, and the results of their operations, their cash flows and the changes in their partnership capital for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. ARTHUR ANDERSEN & CO. St. Louis, Missouri, February 22, 1994 THE JONES FINANCIAL COMPANIES, A LIMITED PARTNERSHIP CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION ASSETS December 31, December 31, (Amounts in thousands) 1993 1992 Cash and cash equivalents $ 28,798 $ 37,730 Receivable from: Customers (Note 2) 464,760 352,686 Brokers or dealers and clearing organizations (Note 3) 32,550 13,880 Securities owned, at market value (Note 4): Inventory securities 60,371 67,873 Investment securities 73,575 78,797 Office equipment, property and improvements, at cost, net of accumulated depreciation and amortization of $79,903 and $69,989, respectively 102,434 72,125 Other assets 37,990 30,162 __________ __________ $ 800,478 $ 653,253 ========== ========== The accompanying notes are an integral part of these statements. THE JONES FINANCIAL COMPANIES, A LIMITED PARTNERSHIP CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION LIABILITIES AND PARTNERSHIP CAPITAL December 31, December 31, (Amounts in thousands) 1993 1992 Bank loans (Note 5) $ 139,261 $ 123,000 Payable to: Customers (Note 2) 242,584 167,884 Brokers or dealers and clearing organizations (Note 3) 8,092 13,915 Securities sold but not yet purchased, at market value (Note 4) 17,766 9,588 Accounts payable and accrued expenses 37,419 37,600 Accrued compensation and employee benefits 69,264 62,123 Long-term debt (Note 6) 33,317 23,847 ____________ __________ 547,703 437,957 Liabilities subordinated to claims of general creditors (Note 7) 73,000 78,000 Partnership capital (Notes 8 and 9): Limited partners 71,222 47,328 Subordinated limited partners 19,163 14,716 General partners 89,390 75,252 ____________ __________ 179,775 137,296 ____________ __________ $ 800,478 $ 653,253 ========== ========== The accompanying notes are an integral part of these statements. THE JONES FINANCIAL COMPANIES, A LIMITED PARTNERSHIP CONSOLIDATED STATEMENTS OF INCOME Years Ended (Amounts in thousands, Dec. 31, Dec. 31, Dec. 31, except per unit information) 1993 1992 1991 Revenues: Commissions $ 428,460 $ 303,950 $199,774 Principal transactions 92,471 131,366 104,426 Investment banking 45,001 60,635 67,376 Interest and dividends 38,084 30,520 25,533 Other 27,436 23,141 14,479 _________ _________ _________ 631,452 549,612 411,588 _________ _________ _________ Expenses: Employee and partner compensation and benefits (Note 10) 381,805 327,946 239,804 Occupancy and equipment (Note 11) 59,549 49,480 45,613 Communications and data processing 34,167 29,269 25,713 Interest (Notes 5, 6 and 7) 19,128 15,496 13,341 Payroll and other taxes 18,180 16,413 13,221 Floor brokerage and clearance fees 6,141 5,360 4,669 Other operating expenses 46,271 43,366 28,352 _________ _________ _________ 565,241 487,330 370,713 _________ _________ _________ Net income $ 66,211 $ 62,282 $ 40,875 ======== ======== ======== Net income allocated to: Limited partners $ 9,805 $ 9,813 $ 7,923 Subordinated limited partners 5,933 5,412 3,425 General partners 50,473 47,057 29,527 _________ _________ _________ 66,211 $ 62,282 $ 40,875 ======== ======== ======== Net income per weighted average $1,000 equivalent partnership units outstanding: Limited partners $ 194.62 $ 238.41 $ 185.92 ======== ======== ======== Subordinated limited partners $ 350.32 $ 418.21 $ 322.38 ======== ======== ======== Weighted average $1,000 equivalent partnership units outstanding: Limited partners 50,381 41,160 42,616 ======== ======== ======== Subordinated limited partners 16,936 12,941 10,624 ======== ======== ======== The accompanying notes are an integral part of these statements. THE JONES FINANCIAL COMPANIES, A LIMITED PARTNERSHIP CONSOLIDATED STATEMENTS OF CASH FLOWS Years Ended Dec. 31, Dec. 31, Dec. 31, (Amounts in thousands) 1993 1992 1991 CASH FLOWS PROVIDED (USED) BY OPERATING ACTIVITIES: Net income $ 66,211 $ 62,282 $ 40,875 Adjustments to reconcile net income to net cash provided (used) by operating activities: Depreciation and amortization 16,800 14,728 11,203 Increase in net receivable from/payable to customers (37,374) (90,526) (82,200) (Increase) decrease in net receivable from/payable to brokers or dealers and clearing organizations (24,493) 13,401 9,939 Decrease (increase) in securities owned, net 20,902 2,573 (27,365) Increase in accounts payable and other accrued expenses 6,960 106 37,069 Increase in other assets (7,828) (7,744) (2,700) _________ _________ _________ Net cash provided (used) by operating activities 41,178 (5,180) (13,179) _________ _________ _________ CASH FLOWS USED BY INVESTING ACTIVITIES: Purchase of office equipment, property and improvements (47,109) (28,872) (20,284) _________ _________ _________ CASH FLOWS (USED) PROVIDED BY FINANCING ACTIVITIES: Increase in bank loans, net 16,261 50,000 63,400 Issuance of long-term debt 11,700 - 13,300 Repayment of long-term debt (2,230) (922) (8,508) (Repayment) issuance of subordinated liabilities (5,000) 30,000 (2,400) Issuance of partnership interests 29,195 2,396 802 Redemption of partnership interests (1,193) (1,326) (2,176) Withdrawals and distributions from partnership capital (51,734) (40,788) (25,877) _________ _________ _________ Net cash (used) provided by financing activities (3,001) 39,360 38,541 Net (decrease) increase in cash _________ _________ _________ and cash equivalents (8,932) 5,308 5,078 CASH AND CASH EQUIVALENTS, beginning of year 37,730 32,422 27,344 _________ _________ _________ end of year $ 28,798 $ 37,730 $ 32,422 ======== ======== ======== The accompanying notes are an integral part of these statements. THE JONES FINANCIAL COMPANIES, A LIMITED PARTNERSHIP CONSOLIDATED STATEMENTS OF CHANGES IN PARTNERSHIP CAPITAL YEARS ENDED DECEMBER 31, 1993, 1992 and 1991 Subordinated Limited Limited General Partnership Partnership Partnership (Amounts in thousands) Capital Capital Capital Total Balance, December 31, 1990 $ 46,173 $ 10,635 $ 44,300 $101,108 Issuance of partnership interests - 802 - 802 Redemption of partnership interests (2,044) (132) - (2,176) Net income 7,923 3,425 29,527 40,875 Withdrawals and distributions (5,365) (2,942) (17,570) (25,877) _________ _________ _________ _________ Balance, December 31, 1991 $ 46,687 $ 11,788 $ 56,257 $114,732 Issuance of partnership interests - 2,396 - 2,396 Redemption of partnership interests (1,175) (151) - (1,326) Net income 9,813 5,412 47,057 62,282 Withdrawals and distributions (7,997) (4,729) (28,062) (40,788) _________ _________ _________ _________ Balance, December 31, 1992 $ 47,328 $ 14,716 $ 75,252 $137,296 Issuance of partnership interests 24,763 4,432 - 29,195 Redemption of partnership interests (1,193) - - (1,193) Net income 9,805 5,933 50,473 66,211 Withdrawals and distributions (9,481) (5,918) (36,335) (51,734) _________ _________ _________ _________ Balance, December 31, 1993 $ 71,222 $ 19,163 $ 89,390 $179,775 ======== ======== ======== ======== The accompanying notes are an integral part of these statements. THE JONES FINANCIAL COMPANIES, A LIMITED PARTNERSHIP NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993, 1992 AND 1991 NOTE 1 - SUMMARY OF ACCOUNTING POLICIES The Partnership's Business and Basis of Accounting. The accompanying consolidated financial statements include the accounts of The Jones Financial Companies, a Limited Partnership, and all wholly owned subsidiaries (the "Partnership"). All material intercompany balances and transactions have been eliminated. The Partnership conducts business throughout the United States with its customers, various brokers and dealers, clearing organizations, depositories and banks. The Partnership's principal operating subsidiary is Edward D. Jones & Co., L.P. (EDJ), a registered broker/dealer. Cash and Cash Equivalents. The Partnership considers all short-term investments with original maturities of three months or less, which are not held for sale to customers, to be cash equivalents. Securities Transactions. The Partnership's securities activities involve execution, settlement and financing of various securities transactions for customers. These transactions (and related revenue and expense) are recorded on a settlement date basis, generally representing the fifth business day following the transaction date, which is not materially different than a trade date basis. They may expose the Partnership to risk in the event customers, other brokers and dealers, banks, depositories or clearing organizations are unable to fulfill contractual obligations. For transactions in which it extends credit to customers, the Partnership seeks to control the risks associated with these activities by requiring customers to maintain margin collateral in compliance with various regulatory and internal guidelines. Securities Owned. Securities owned are valued at current market prices. Unrealized gains or losses are reflected in revenues as "principal transactions." Office Equipment, Property and Improvements. Office equipment is depreciated using straight-line and accelerated methods over estimated useful lives of five to eight years. Buildings are depreciated using the straight-line method over estimated useful lives approximating thirty to forty years. Amortization of property improvements is computed based on the remaining life of the property or economic useful life of the improvement, whichever is less. When assets are retired or otherwise disposed of, the cost and related accumulated depreciation or amortization are removed from the accounts, and any resulting gain or loss is reflected in income for the period. The cost of maintenance and repairs is charged to income as incurred, whereas significant renewals and betterments are capitalized. Segregated Cash Equivalents and Securities Owned. Rule 15c3-3 of the Securities and Exchange Commission requires deposits of cash or securities to a special reserve bank account for the benefit of customers if total customer related credits exceed total customer related debits, as defined. No deposits of cash or securities were required as of December 31, 1993 or 1992. Income Taxes. Income taxes have not been provided for in the consolidated financial statements since the Partnership is organized as a partnership, and each partner is liable for its own tax payments. Reclassifications. Certain 1992 and 1991 amounts have been reclassified to conform to the 1993 financial statement presentation. Fiscal Year End Change. The Partnership changed its year end from the last Friday in September to December 31, effective December 31, 1992, for various reporting purposes. The 1991 amounts have been restated on a calendar year basis. NOTE 2 - RECEIVABLE FROM AND PAYABLE TO CUSTOMERS Accounts receivable from and payable to customers include margin balances and amounts due on uncompleted transactions. Values of securities owned by customers and held as collateral for these receivables are not reflected in the financial statements. Substantially all amounts payable to customers are subject to withdrawal upon customer request. NOTE 3 - RECEIVABLE FROM AND PAYABLE TO BROKERS OR DEALERS AND CLEARING ORGANIZATIONS The components of receivable from and payable to brokers or dealers and clearing organizations are as follows: (Amounts in thousands) 1993 1992 Securities failed to deliver $ 7,030 $ 2,485 Deposits paid for securities borrowed 22,048 9,255 Deposits with clearing organizations 2,446 1,971 Other 1,026 169 __________ __________ Total receivable from brokers or dealers and clearing organizations $ 32,550 $ 13,880 ========== ========== Securities failed to receive $ 6,580 $ 10,434 Deposits received for securities loaned 1,239 3,481 Other 273 - __________ __________ Total payable to brokers or dealers and clearing organizations $ 8,092 $ 13,915 ========== ========== "Fails" represent the contract value of securities which have not been received or delivered by settlement date. NOTE 4 - SECURITIES OWNED Security positions are summarized as follows (at market value): 1993 1992 ____________________ ___________________ Securities Securities Sold but Sold but Securities not yet Securities not yet Owned Purchased Owned Purchased Inventory Securities: Certificates of deposit $ 3,691 $ 49 $ 2,498 $ 86 U.S. government and agency obligations 4,123 15,070 5,702 7,299 State and municipal obligations 34,306 839 45,708 284 Corporate bonds and notes 10,045 818 11,108 566 Corporate stocks 8,206 990 2,857 1,353 _________ _________ _________ _________ $ 60,371 $ 17,766 $ 67,873 $ 9,588 ======== ======== ======== ======== Investment Securities: U.S. government and agency obligations $ 73,575 $ 78,797 ======== ======== NOTE 5 - BANK LOANS The Partnership borrows from banks primarily to finance customer margin balances and firm trading securities. Interest is at a fluctuating rate (weighted average rate of 4.17%, 4.35% and 4.97%at December 31, 1993, 1992 and 1991, respectively) based on short-term lending rates. The average of the aggregate short-term bank loans outstanding was $99,100,000, $57,794,000, and $23,257,000 and the average interest rate (computed on the basis of the average aggregate loans outstanding) was 4.04%, 4.40%, and 6.35% for the years ended December 31, 1993, 1992 and 1991, respectively. The highest month-end borrowing was $154,500,000, $142,000,000 and $96,200,000 during the years ended December 31, 1993, 1992 and 1991, respectively. Short-term bank loans outstanding at December 31, 1993, 1992 and 1991, consist of $139,261,000, $109,000,000 and $73,000,000 of loans collateralized by securities owned by the Partnership and customers' margin securities with a market value of $363,740,000, $197,514,000 and $140,000,000, respectively. At December 31, 1992, the Partnership had a $14,000,000 short term loan secured by property with a carrying value of $16,198,000. Cash paid during the year for interest on bank loans, capital notes and other liabilities was $14,059,000, $10,956,000, and $8,956,000 for the years ended December 31, 1993, 1992 and 1991, respectively. NOTE 6 - LONG-TERM DEBT Long-term debt is comprised of the following: (Amounts in thousands) 1993 1992 Note payable, secured by property, interest at 9.0% per annum, interest due in monthly installments, principal due on June 1, 1994. $ 9,600 $ 9,600 Note payable, secured by property, interest at 9.875% per annum, principal and interest due in monthly installments of $141,907 with a final installment of $6,840,192 due on August 5, 2001. 12,282 12,747 Note payable, secured by property, interest at 8.5% per annum, principal and interest due in monthly installments of $115,215 through April 5, 2008. 11,435 - Note payable, secured by property, interest at prime rate per annum, interest due in monthly installments. - 1,500 __________ __________ $ 33,317 $ 23,847 ========== ========== Required annual principal payments, as of December 31, 1993, are as follows: Principal Payment Year (Amounts in thousands) _____ ___________________ 1994 $ 10,540 1995 1,031 1996 1,130 1997 1,239 1998 1,359 Thereafter 18,018 __________ $ 33,317 ========== The Partnership has land and buildings with a carrying value of $45,971,000 at December 31, 1993, which are subject to security agreements that collateralize various real estate related notes payable. The Partnership has estimated the fair value of the long- term debt to be approximately $36,493,000 and $25,368,000 as of December 31, 1993 and 1992, respectively. Subsequent to December 31, 1993, the Partnership arranged to refinance its long-term debt. After the refinancing is complete, the Partnership will have a $21,759,000 8.72% note due in monthly installments of approximately $290,000 through May 5, 2003, and a $14,900,000 8.23% note due in monthly installments of $150,000 through April 5, 2008. These notes replace all long-term debt which existed as of December 31, 1993, and will have the same underlying collateral. NOTE 7 - LIABILITIES SUBORDINATED TO CLAIMS OF GENERAL CREDITORS Liabilities subordinated to the claims of general creditors consist of: (Amounts in thousands) 1993 1992 Capital notes, 10.6%, due in annual installments of $7,000,000 commencing on March 15, 1994, with a final installment on March 15, 1997 $ 28,000 $ 28,000 Capital notes, 9.375%, due in annual installments of $5,000,000 commencing on July 1, 1993, with a final installment on April 1, 1996 15,000 20,000 Capital notes, 8.96%, due in annual installments of $6,000,000 commencing on May 1, 1998, with a final installment on May 1, 2002 30,000 30,000 __________ __________ $ 73,000 $ 78,000 ========== ========== The capital note agreements contain restrictions which, among other things, require maintenance of certain financial ratios, restrict encumbrance of assets and creation of indebtedness and limit the withdrawal of partnership capital. As of December 31, 1993, the Partnership was required, under the note agreements, to maintain minimum partnership capital of $65,000,000 and Net Capital as computed in accordance with the uniform Net Capital rule of 7.5% of aggregate debit items (See Note 9). The subordinated liabilities are subject to cash subordination agreements approved by the New York Stock Exchange and, therefore, are included in the Partnership's computation of Net Capital under the Securities and Exchange Commission's uniform Net Capital rule. The Partnership has estimated the fair value of the subordinated capital notes to be approximately $76,726,000 and $81,300,000 as of December 31, 1993 and 1992, respectively. Subsequent to year end the Partnership intends to exercise its right to repay $17,000,000 of the capital notes prior to maturity. NOTE 8 - PARTNERSHIP CAPITAL The limited partnership capital, consisting of 64,280 and 40,710 $1,000 units at December 31, 1993 and 1992, respectively, is held by current and former employees and general partners. Each limited partner receives interest at seven and one-half percent on the principal amount of capital contributed and a varying percentage of the net income of the Partnership. Interest expense includes $ 3,781,000, $3,090,000, and $3,198,000 for the years ended December 31, 1993, 1992 and 1991, respectively, paid to limited partners on capital contributed. The subordinated limited partnership capital, consisting of 17,290 and 12,858 $1,000 units at December 31, 1993 and 1992, respectively, is held by current and former general partners. Each subordinated limited partner receives a varying percentage of the net income of the Partnership. The subordinated limited partner capital is subordinated to the limited partnership capital. Included in partnership capital at December 31, 1993 and 1992, are undistributed profits of $17,964,000 and $18,438,000, respectively, that will be withdrawn by the partners. NOTE 9 - NET CAPITAL REQUIREMENTS As a result of its activities as a broker/dealer, EDJ, is subject to the Net Capital provisions of Rule 15c3-1 of the Securities Exchange Act of 1934 and the capital rules of the New York Stock Exchange. Under the alternative method permitted by the rules, EDJ must maintain minimum Net Capital, as defined, equal to the greater of $150,000 or 2% of aggregate debit items arising from customer transactions. The Net Capital rule also provides that partnership capital may not be withdrawn if resulting Net Capital would be less than 5% of aggregate debit items. Additionally, certain withdrawals require the consent of the SEC to the extent they exceed defined levels even though such withdrawals would not cause Net Capital to be less than 5% of aggregate debit items. At December 31, 1993, EDJ's Net Capital of $89,790,000 was 20% of aggregate debit items and its Net Capital in excess of the minimum required was $80,681,000. Net Capital as a percentage of aggregate debits after anticipated capital withdrawals was 17%. Net Capital and the related capital percentage may fluctuate on a daily basis. EDJ's Net Capital excludes $19,782,000 of undistributed profits which will be withdrawn by the partners and $27,254,000 of cash capital contributions that were pending New York Stock Exchange approval. Subsequent to December 31, 1993, EDJ received approval from the New York Stock Exchange to add $27,254,000 of cash capital contributions that were made during 1993 as allowable Net Capital. EDJ also received permission to prepay in advance of its scheduled maturity $17,000,000 of subordinated debt. The effect of these approvals would have been to increase Net Capital to $117,044,000 and excess Net Capital to $107,935,000 as of December 31, 1993. The percentage of Net Capital to aggregate debits and the percentage of Net Capital to aggregate debits after anticipated capital withdrawals, would have been 26% and 19%, respectively. Net Capital in excess of 5% of aggregate debit items would have been $94,272,000. NOTE 10 - EMPLOYEE BENEFIT PLAN The Partnership maintains a profit sharing plan covering all eligible employees. Contributions to the plan are at the discretion of the Partnership. However, participants may contribute on a voluntary basis. Approximately $16,716,000, $15,625,000, and $10,347,000 were provided by the Partnership for its contributions to the plan for the years ended December 31, 1993, 1992 and 1991, respectively. No post retirement benefits are provided. NOTE 11 - COMMITMENTS Branch office facilities, computer system equipment and branch satellite equipment are rented under various operating leases. Additionally, branch offices are leased on a three to five year basis, and are cancellable at the option of the Partnership. The Partnership's computer system equipment and branch satellite equipment lease commitments are $10,823,000 in 1994, $5,321,000 in 1995, $3,661,000 in 1996, and $2,770,000 in 1997 and $1,221,000 in 1998 and thereafter. Rent expense was $28,385,000, $24,837,000, and $24,703,000 for the years ended December 31, 1993, 1992 and 1991, respectively. NOTE 12 - CONTINGENCIES Various legal actions, primarily relating to the distribution of securities, are pending against the Partnership. Certain cases are class actions (or purported class actions) claiming substantial damages. These actions are in various stages and the results of such actions cannot be predicted with certainty. In the opinion of management, after consultation with legal counsel, the ultimate resolution of these actions will not have a material adverse impact on the Partnership's financial condition. ITEM 9. ITEM 9. CHANGE IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The Jones Financial Companies, a Limited Partnership, being organized as a partnership, does not have individuals associated with it designated as officers or directors. Presently, the Partnership is comprised of 111 general partners, 2,000 limited partners and 54 subordinated limited partners. Under the terms of the Partnership Agreement, John W. Bachmann is designated Managing Partner and in said capacity has primary responsibility for administering its business, determining its policies, controlling the management and conduct of the Partnership's business and has the power to appoint and dismiss general partners of the Partnership and to fix the proportion of their respective interests in the Partnership. Subject to the foregoing, the Partnership is managed by its 111 general partners. The Executive Committee of the Partnership is comprised of John W. Bachmann, James W. Harrod, Douglas E. Hill, Charles R. Larimore, Richie L. Malone, Darryl L. Pope, Ray L. Robbins, Jr., Edward Soule and James D. Weddle. The purpose of the Executive Committee is to provide counsel and advice to the Managing Partner in discharging his functions. Furthermore, in the event the position of Managing Partner is vacant, the Executive Committee shall succeed to all of the powers and duties of the managing partner. None of the general partners are appointed for any specific term nor are there any special arrangements or understandings pursuant to their appointment other than as contained in the Partnership Agreement. No general partner is or has been individually, nor in association with any prior business, the subject of any action under any insolvency law or criminal proceeding or has ever been enjoined temporarily or permanently from engaging in any business or business practice. A listing of the names, ages, dates of becoming a general partner and area of responsibility for each general partner follows: BECAME NAME AGE G.P. AREA OF RESPONSIBILITY Warren K. Akerson 51 1974 Sales Allan J. Anderson 51 1992 Sales Management John W. Bachmann 55 1970 Managing Partner Thomas M. Bartow 44 1989 Sales Training James D. Bashor 39 1990 Regional Sales Leader Robert J. Beck 39 1983 Municipal Trading John D. Beuerlein 40 1979 Sales Management John S. Borota 53 1978 Sales Hiring William H. Broderick, III 41 1986 Syndicate Morton L. Brown 47 1978 Managed Investments Alan J. Bubalo 40 1984 Regional Sales Leader Spencer B. Burke 45 1987 Investment Banking Daniel A. Burkhardt 46 1979 Investment Banking Jack L. Cahill 44 1980 Sales Management Brett A. Campbell 35 1993 Marketing Donald H. Carter 50 1994 Regional Sales Leader John J. Caruso 47 1988 Data Processing Guy R. Cascella 36 1992 Regional Sales Leader Craig E. Christell 37 1994 Regional Sales Leader Richard A. Christensen, Jr.46 1978 Mutual Funds Processing Robert J. Ciapciak 38 1988 Market Research David W. Clapp 44 1978 Sales Management Stephen P. Clement 44 1990 Video Communications Loyola A. Cronin 36 1987 Branch Staff Training Harry J. Daily, Jr. 47 1985 Regional Sales Leader A. Randal Dickinson 42 1984 Regional Sales Leader Terry A. Doyle 44 1992 Regional Sales Leader William T. Dwyer, Jr. 38 1994 Regional Sales Leader Abe W. Dye 49 1984 Sales Management Allen R. Eaker 47 1989 Regional Sales Leader Norman L. Eaker 37 1984 Securities Processing Kevin Eberle 43 1993 Regional Sales Leader Michael J. Esser 45 1983 Advanced Sales Training Kevin N. Flatt 45 1989 Fixed Income/Equity Trading John A. Fowler 46 1979 Customer Tax Support Steve Fraser 38 1993 Securities Processing Chris A. Gilkison 40 1994 Branch Locations Barbara G. Gilman 55 1988 Trust Marketing Steven L. Goldberg 35 1987 Central Services James R. Gonso 38 1986 Regional Sales Leader Ronald Gorgen 44 1993 Field Services Robert L. Gregory 51 1974 Sales Hiring Patricia F. Hannum 33 1988 Financial Services Stephen P. Harrison 45 1990 Regional Sales Leader James W. Harrod 58 1974 Sales Training David L. Hayes 38 1994 Regional Sales Leader Randy K. Haynes 38 1994 Operations John M. Hess 46 1992 Regional Sales Leader Mary Beth Heying 36 1994 Communications Douglas E. Hill 49 1974 Product Management Stephen M. Hull 49 1994 Regional Sales Leader Earl H. Hull, Jr. 48 1990 Regional Sales Leader Glennon D. Hunn 51 1984 Data Processing Gary R. Hunziker 53 1994 Regional Sales Leader Paul C. Husted 40 1990 Regional Sales Leader Thomas G. Iorio 33 1994 Regional Sales Leader Mellany F. Isom 40 1984 Sales Hiring Myles P. Kelly 40 1989 Accounting Loren G. Kolpin 48 1985 Regional Sales Leader Charles R. Larimore 53 1981 Branch Administration Ronald E. Lemonds 57 1972 Equity Marketing Michele Liebman 37 1994 Data Processing Steven F. Litchfield 38 1983 Regional Sales Leader Richie L. Malone 45 1979 Data Processing Richard G. McCarty 54 1990 Regional Sales Leader James A. McKenzie 49 1977 Regional Sales Leader Thomas Migneron 33 1993 Internal Audit Richard G. Miller, Jr. 38 1991 Regional Sales Leader Thomas W. Miltenberger 46 1985 Mutual Funds Marketing Merry L. Mosbacher 35 1986 Investment Banking Joseph M. Mott, III 36 1989 Insurance/Annuities Marketing William D. Murphy 53 1980 Regional Sales Leader Matt B. Myre 37 1988 Regional Sales Leader Rodger W. Naugle 52 1992 Regional Sales Leader Steven Novik 44 1983 Accounting Cynthia Paquette 33 1993 Data Processing Robert K. Pearce 44 1989 Human Resources Darryl L. Pope 54 1971 Operations Gary D. Reamey 38 1984 Canada Division James L. Regnier 36 1994 Sales Training Ray L. Robbins, Jr. 49 1975 Research Stephen T. Roberts 41 1981 Compliance Wann V. Robinson 43 1992 Regional Sales Leader Douglas Rosen 33 1993 Regional Sales Leader Harry John Sauer, III 36 1988 Dividend Processing Philip R. Schwab 45 1978 Syndicate Darrell G. Seibel 59 1985 Regional Sales Leader Robert D. Seibel 59 1974 Regional Sales Leader Festus W. Shaughnessy, III 38 1988 Sales Training Connie M. Silverstein 38 1988 Sales Hiring Alan F. Skrainka 32 1989 Research John S. Sloop 45 1990 Sales Management Ronald H. Smith 54 1984 Regional Sales Leader Lawrence R. Sobol 43 1977 General Counsel Edward Soule 41 1986 Accounting Lawrence E. Thomas 38 1983 Government Bond Trading Terry R. Tucker 39 1988 Data Processing Richard G. Unnerstall 38 1989 Data Processing Robert Virgil, Jr. 59 1994 Headquarters Administration JoAnn Von Bergen 44 1986 Cash Processing John R. Wagner 46 1987 Regional Sales Leader Donald E. Walter 48 1983 Compliance Director Bradley T. Wastler 41 1989 Sales Management James D. Weddle 40 1984 Sales Management Vicki Westall 34 1993 Product Review Thomas J. Westphal 35 1989 Customer Statements Heidi Whitfield 33 1993 Product Review Robert D. Williams 32 1994 Regional Sales Leader A. Thomas Woodward 47 1985 Sales Management Price P. Woodward 31 1993 Regional Sales Leader Alan T. Wright 47 1994 Investment Banking Except as indicated below, each of the General Partners has been a general partner of the Partnership for more than the preceding five years. Allan J. Anderson, joined the Partnership in 1984 as a registered representative and became a general partner in 1992. James D. Bashor, joined the Partnership in 1983 as a registered representative and became a general partner in 1990. Brett A. Campbell, joined the Partnership in 1984 as a registered representative and became a general partner in January 1993. Donald H. Carter, joined the Partnership in 1982 as a registered representative and became a general partner in January 1994. Guy Cascella, joined the Partnership in 1983 as a registered representative and became a general partner in 1992. Stephen P. Clement, joined the Partnership in 1987 as Video manager and became a general partner in 1990. Prior to this, he was a news director for an ABC affiliate television station. Craig E. Christell, joined the Partnership in 1982 as a registered representative and became a general partner in January 1994. Terry Doyle, joined the Partnership in 1981 as a registered representative and became a general partner in 1992. William T. Dwyer, joined the Partnership in 1982 as a registered representative and became a general partner in January 1994. Kevin Eberle, joined the Partnership in 1985 as a registered representative and became a general partner in 1993. Steve Fraser, joined the Partnership in 1985 in the Operations Department and became a general partner in January, 1993. Prior to this, he was employed by Automated Data Processing Inc. Chris A. Gilkison, joined the Partnership in 1987 as a registered representative and became a general partner in January 1994. Ron Gorgen, joined the Partnership in 1980 as a registered representative and became a general partner in January 1993. David L. Hayes, joined the Partnership in 1977 active in hiring and training and became a general partner in January 1994. Stephen P. Harrison, joined the Partnership in 1978 as a registered representative and became a general partner in 1990. Randy K. Haynes, joined the Partnership in 1984 as a registered representative and became a general partner in January 1994. John Hess, joined the Partnership in 1982 as a registered representative and became a general partner in 1992. Mary Beth Heying, joined the Partnership in 1984 in the Communications Department and became a general partner in January 1994. Earl H. Hull, Jr., joined the Partnership in 1975 as a registered representative and became a general partner in 1990. Steven M. Hull, joined the Partnership in 1973 as a registered representative and became a general partner in 1994. Gary R. Hunziker, joined the Partnership in 1986 as a registered representative and became a general partner in January 1994. Paul C. Husted, joined the Partnership in 1982 as a registered representative and became a general partner in 1990. Thomas G. Iorio, joined the Partnership in 1982 as a registered representative and became a general partner in January 1994. Michele M. Liebman, joined the Partnership in 1985 in the Data Processing Department and became a general partner in January 1994. Richard G. McCarty, joined the Partnership in 1980 as a registered representative and became a general partner in 1990. Thomas Migneron, joined the Partnership in 1985 as an internal auditor and became a general partner in January, 1993. Richard G. Miller, Jr., joined the Partnership in 1981 as a registered representative and became a general partner in 1991. Rodger Naugle, joined the Partnership in 1981 as a registered representative and became a general partner in 1992. Cynthia Paquette, joined the Partnership in 1985 in the Data Processing Department and became a general partner in January 1993. James L. Regnier, joined the Partnership in 1983 as a registered representative and became a general partner in January 1994. Wann V. Robinson, joined the Partnership in 1985 as a registered representative and became a general partner in 1992. Douglas Rosen, joined the Partnership in 1982 as a registered representative and became a general partner in January 1993. John S. Sloop, joined the Partnership in 1983 as a registered representative and became a general partner in 1990. Robert Virgil, Jr., joined the Partnership in 1993 as a general partner. Prior to this, he served as dean of the John M. Olin School of Business at Washington University. Vicki Westall, joined the Partnership in 1984 in the Product Review Department and became a general partner in January, 1993. Prior to this, she was an accountant with Peat, Marwick, Mitchell & Co. Heidi Whitfield, joined the Partnership in 1982 as an equity analyst and became a general partner in January 1993. Robert D. Williams, joined the Partnership in 1986 as a registered representative and became a general partner in 1994. Price P. Woodward, joined the Partnership in 1984 as a registered representative and became a general partner in January 1993. Alan T. Wright, joined the Partnership in 1985 in Investment Banking Department and became a general partner in January 1994. Daniel A. Burkhardt is a director of Essex County Gas Company, Amsebury, Massachusetts; Galaxy Cablevision Management, Inc., Sikeston, Missouri; Dial Reit, Omaha, Nebraska; Met Life Farm & Ranch Properties, Kansas City, Missouri; Southeastern MI Gas Enterprises, Port Huron, Michigan; and Community Investment Partners, L.P. John C. Heisler, Philip R. Schwab and John D. Beuerlein are directors of Cornerstone Mortgage Investment Group, Inc. and Cornerstone Mortgage Investment Group II, Inc. Ray L. Robbins, Jr. is a director of Community Investment Partners, L.P. Robert Virgil, Jr. is a director of CPI Corp., St. Louis, Missouri; Angelica Corp., St. Louis, Missouri; and Allied Healthcare Products, Inc., St. Louis, Missouri. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The following table sets forth all compensation paid by the Partnership during the three most recent years to the five general partners receiving the greatest compensation (including respective shares of profit participation). Returns to General Partner Capital _____________________ (1) (2) (3) & (4) General Net income Partner Deferred allocated invested Total Compen-to General Capital at (1) (2) Year Salaries sation Partners 12/31/93 (3) John W. Bachmann1993 120,000 10,707 2,350,562 3,213,597 2,481,269 1992 120,000 11,306 2,298,834 3,408,360 2,430,140 1991 120,000 10,111 1,556,853 2,752,555 1,686,964 Douglas E. Hill 1993 118,000 10,707 1,994,416 2,726,688 2,123,123 1992 118,000 11,306 1,948,536 2,888,991 2,077,842 1991 115,000 10,111 1,318,416 2,330,993 1,443,527 Ron Larimore 1993 118,000 10,707 1,994,416 2,726,688 2,123,123 1992 118,000 11,306 1,992,323 2,953,912 2,121,629 1991 115,000 10,111 1,346,468 2,380,588 1,471,579 Richie L. Malone1993 118,000 10,707 1,899,444 2,596,846 2,028,151 1992 118,000 11,306 1,810,493 2,596,846 1,939,799 1991 115,000 10,111 1,122,057 1,983,823 1,247,168 Darryl W. Pope 1993 118,000 10,707 1,994,416 2,726,688 2,123,123 1992 118,000 11,306 1,926,642 2,856,530 2,055,948 1991 115,000 10,111 1,304,391 2,306,195 1,429,502 (1) Each non-selling general partner receives a salary presently ranging from $78,000 - $120,000 annually. Selling general partners do not receive a specified salary, rather, they receive the net sales commissions earned by them (none of the five individuals listed above earned any such commissions). Additionally, general partners who are principally engaged in sales are entitled to office bonuses based on the profitability of their respective branch office, on the same basis as the office bonus program established for all investment representative employees. (2) Each general partner is a participant in the Partnership's profit sharing plan which covers all eligible employees. Contributions to the plan, which are within the discretion of the Partnership, are made annually and have historically been determined based on approximately twenty-four percent of the Partnership's net income. Allocation of the Partnership's contribution among participants is determined by each participant's relative level of eligible earnings, including in the case of general partners, their profit participation. (3) Each general partner is entitled to participate in the annual net income of the Partnership based upon the respective percentage interest in the Partnership of each partner. These interests in the Partnership held by each general partner currently range from 1/10 of 1% to 4.95% in 1993. (1/10 of 1% to 5.25% in 1992 and 1/10 of 1% to 5.55% in 1991). At the discretion of the Managing Partner, the partnership agreement provides that, generally, the first five percent of net income allocable to general partners be distributed on the basis of individual merit as determined by the Managing Partner. Thereafter, the remaining net income allocable to general partners is distributed based upon each individual's percentage interest in the Partnership. In 1993, 6% of net income was distributed on the basis of individual merit. (4) Net income allocable to general partners is the amount remaining after payment of interest and earnings on capital invested to limited partners and subordinated limited partners. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Being organized as a limited partnership, management is vested in the general partners thereof and there are no other outstanding "voting" or "equity" securities. It is the opinion of the Partnership that the general partnership interests are not securities within the meaning of federal and state securities laws primarily because each of the general partners participates in the management and conduct of the business. In connection with outstanding limited and subordinated limited partnership interests (non-voting securities), 82 of the general partners also own limited partnership interests and 37 of the general partners also own subordinated limited partnership interests, as noted in the table below. As of February 25, 1994: Name of Amount of Beneficial Beneficial Percent of Title of Class Owner Ownership Class Limited Partnership All General Interests Partners as a Group $ 5,448,000 8% Subordinated All General Limited Partnership Partners as Interests a Group $13,715,000 64% ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS In the ordinary course of its business the Partnership has extended credit to certain of its partners and employees in connection with their purchase of securities. Such extensions of credit have been made on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with non-affiliated persons, and did not involve more than the normal risk of collectibility or present other unfavorable features. The Partnership also, from time to time and in the ordinary course of business, enters into transactions involving the purchase or sale of securities from or to partners or employees and members of their immediate families, as principal. Such purchases and sales of securities on a principal basis are effected on substantially the same terms as similar transactions with unaffiliated third parties. ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K INDEX (a) (1) The following financial statements are included in Part II, Item 8: Page No. Report of Independent Public Accountants Consolidated Statements of Financial Condition as of 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 Changes in Partnership Capital for the years ended December 31, 1993, 1992 and 1991 Notes to Consolidated Financial Statements All schedules are omitted because they are not required, inapplicable, or the information is otherwise shown in the financial statements or notes thereto. (b) Report on Form 8-K No reports on Form 8-K were filed in the fourth quarter of 1993. (c) Exhibits Reference is made to the Exhibit Index hereinafter contained. EXHIBIT INDEX TO ANNUAL REPORT ON FORM 10-K FOR THE YEAR ENDED DECEMBER 31, 1993 Exhibit Number Page Description 3.1 * Amended and Restated Agreement and Certificate of Limited Partnership of Registrant dated October 1, 1993. 3.2 * Form of Limited Partnership Agreement of Edward D. Jones & Co., L.P., dated November 1, 10.1 * Form of Cash Subordination Agreement between the Registrant and Edward D. Jones & Co., incorporated herein by reference to Exhibit 10.1 to the Company's registration statement of Form S-1 (Reg. No. 33-14955). 10.2(a) * Note Purchase Agreement between Tempus Corporation and Edward D. Jones & Co. dated as of April 15, 1986, incorporated herein by reference to Exhibit 10(a) to the Company's Quarterly Report on Form 10-Q for the quarter ended March 28, 1986. 10.2(b) * Note Purchase Agreement between Tempus Corporation and Edward D. Jones & Co., L.P. dated as of March 15, 1988, incorporated herein by reference to Exhibit 10.1 to the Company's Quarterly Report on Form 10-Q for the quarter ended March 25, 1988. 10.3 * Complaint for Permanent Injunction and Other Equitable Relief and Final Judgment of Permanent Injunction in re: SEC v. Edward D. Jones & Co. (U.S. Dist. Ct. for Dist. of Columbia; Civil Action No. 85-3078), incorporated herein by reference to Exhibit 10(i) to the Company's current report on Form 8-K dated September 24, 1985. 10.4 * Volume Discount Agreement dated May 27, 1987, between Digital Equipment Corporation and Edward D. Jones & Co., incorporated herein by reference to Exhibit 10.13(c) to the Company's registration statement on Form S-1 (Reg. No. 33-14955). 10.5 * Master Lease Agreement dated as of May 29, 1987, between Digital Equipment Corporation and Edward D. Jones & Co., incorporated herein by reference to Exhibit 10.13(b) to the Company's registration statement on Form S-1 (Reg. No. 33-14955). 10.6 * Master Lease Agreement dated as of October 17, 1988, between Edward D. Jones & Co., L.P., and BancBoston Leasing, incorporated herein by reference to Exhibit 10.1 to the Company's Annual Report on Form 10-K for the year ended September 30, 1988. 10.7 * Satellite Communications Agreement dated as of September 12, 1988, between Hughes Network Systems and Edward D. Jones & Co., L.P., incorporated herein by reference to Exhibit 10.1 to the Company's Annual Report on Form 10-K for the year ended September 30, 1988. 10.8 * Agreements of Lease between EDJ Leasing Company and Edward D. Jones & Co., L.P., dated August 1, 1991, incorporated herein by reference to Exhibit 10.18 to the Company's Annual Report or Form 10-K for the year ended September 27, 1991. 10.9 * Loan Agreement between EDJ Leasing Co., L.P. and Nationwide Insurance Company dated August 2, 1991, incorporated herein by reference to Exhibit 10.19 to the Company's Annual Report or Form 10-K for the year ended September 27, 1991. 10.10 * Edward D. Jones & Co., L.P. Note Purchase Agreement dated as of May 8, 1992, incorporated herein by reference to Exhibit 10.1 to the Company's Quarterly Report on Form 10-Q for the quarter ended June 26, 1992. 10.11 * Purchase and Sale Agreement by and between EDJ Leasing Co., L.P. and the Resolution Trust Corporation incorporated herein by reference to Exhibit 10.21 to the Company's Annual Report or Form 10-K for the year ended December 31, 1992. 10.12 Master Lease Agreement between EDJ Leasing Company and Edward D. Jones & Co., L.P., dated March 9, 1993, and First Amendment to Lease dated March 9, 1994. 10.13 Purchase Agreement by and between Edward D. Jones & Co., L.P. and Genicom Corporation dated November 25, 1992. 10.14 Mortgage Note and Deed of Trust and Security Agreement between EDJ Leasing Co., L.P. and Nationwide Insurance Company dated March 9, 1993. 10.15 Mortgage Note and Amendment to Deed of Trust between EDJ Leasing Co., L.P. and Nationwide Insurance Company dated March 9, 1994. 24.1 Consent of Independent Public Accountants 25 * Delegation of Power of Attorney to Managing Partner contained within Exhibit 3.1. ________________________________________________________________________ * - 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: (Registrant) THE JONES FINANCIAL COMPANIES, A LIMITED PARTNERSHIP ___________________________________________________ By (Signature and Title) /s/ John W. Bachmann __________________________________ John W. Bachmann, Managing Partner Date March 28, 1994 __________________________________ Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following person on behalf of the registrant and in the capacity and on the date indicated. (Registrant) THE JONES FINANCIAL COMPANIES, A LIMITED PARTNERSHIP ___________________________________________________ By (Signature and Title) /s/ John W. Bachmann __________________________________ John W. Bachmann, Managing Partner Date March 28, 1994 __________________________________ SUPPLEMENTAL INFORMATION TO BE FURNISHED WITH REPORTS FILED PURSUANT TO SECTION 15(D) OF THE ACT BY REGISTRANTS WHICH HAVE NOT REGISTERED SECURITIES PURSUANT TO SECTION 12 OF THE ACT. There have been no annual reports sent to security holders covering the registrant's last fiscal year nor have there been any proxy statements, form of proxy or other proxy soliciting material sent to any of registrant's security holders.

352949_1993.txt

352949_1993

1993

352949

ITEM 1. BUSINESS Fleming Companies, Inc. (hereinafter referred to as "Fleming," the "registrant" or the "company") was incorporated in Kansas in 1915 and in 1981 was reincorporated as an Oklahoma corporation. Fleming is engaged primarily in the wholesale distribution of food and related products. The company currently serves as the principal source of supply for 4,700 retail food stores, including 2,900 supermarkets, in 36 states in the U.S. and several foreign countries. These supermarkets have a total area of 80 million square feet. These are predominantly independent stores, many of which operate and advertise under a common name to promote greater consumer recognition. Fleming's retail customers (hereinafter referred to as "customers") also include national and regional corporate chains. The company distributes a wide variety of both national and private brand groceries, meats, dairy and delicatessen products, frozen foods, fresh produce, and a variety of general merchandise and related items. In addition, Fleming offers a full range of support services, including collateralized long-term financing of certain customers, which enables the customers to compete with other types of food stores in their respective market areas. The company also owns and operates 72 supermarkets. See "Company- Operated Retail Stores". The company's wholesale distribution of food and related products is its dominant business as defined by Statement of Financial Accounting Standards No. 14; therefore, segment information is not required. On January 18, 1994, the company announced the details of a plan to consolidate facilities and restructure its organizational alignment and operations. Management's objective is to improve company performance by eliminating functions and operations that do not add economic value. As a result, registrant has closed five regional offices and also will close five distribution centers and relocate two operations. When completed, these actions will reduce employment by about 2,000, or 9% of the company's work force, and lower operating costs by approximately $65 million annually. The plan resulted from a thorough review, which began in October 1993, of all operations and business strategies. The 1993 fourth quarter results reflect a charge of $101.3 million resulting directly from facilities consolidation restructuring. This is in addition to $6.5 million provided for a facilities consolidation in the second quarter. The plan consists of four categories: facilities consolidation, re-engineering, retail-related assets and elimination of regional operations. The actions contemplated by the plan will affect the company's food and general merchandise wholesaling operations as well as certain retailing assets. In early 1994, the company announced that it would close its Fort Worth, Joplin and Tupelo facilities as part of the plan. The pending closing of the Topeka food distribution facility was previously announced. See "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations." DISTRIBUTION FACILITIES. Fleming currently operates 28 food distribution divisions which handle food and related products including groceries, meat, produce, frozen foods, dairy products and certain nonfood items. Five general merchandise divisions distribute general merchandise, health and beauty care items, prescription drug products, and other nonfood items. Two additional divisions distribute dairy, delicatessen and fresh meat products. All are equipped with modern materials handling equipment for receiving, storing and shipping large quantities of merchandise. In total, the company's distribution facilities, including outside storage, comprise approximately 21 million square feet of warehouse space. See "Recent Developments." PRODUCTS. The company purchases its inventory requirements from numerous processors, manufacturers and growers, and believes it generally has adequate and alternate sources of supply for most of the products handled. Fleming purchases product on a volume basis and strives to maintain optimum inventory turnover rates while optimizing service levels. Most grocery purchases are subject to a cash discount if paid within specified days of receipt of merchandise. Fleming operates a central procurement program for fresh meats and produce and for products sold primarily under private brands, including canned goods, frozen foods, general merchandise and dairy products. Private brands include Bonnie Hubbard-R-, Captain's Cove-R-, Fleming's-R-, Hyde Park-R-, IGA-R-, Marquee-R-, Montco-R-, P.S. - Personally Selected-R-, Piggly Wiggly-R-, Rainbow-R-, Royal-TM-, Sentry-R-, Sunrise-TM- and TV-R-. Private brands are an important source of sales and are slightly more profitable to Fleming than national brands. Billings to customers for merchandise are generally based on an agreed price that includes Fleming's defined cost, to which is added a fee determined by the volume of the customer's purchases. A delivery charge is usually added based on order size and mileage. In some geographic areas, billings are determined by percentage mark-up. Payment may be received upon delivery of the order, or within credit terms that generally are weekly or semiweekly. A cash deposit from the customer may be required. RETAIL STORES SERVED. The retail stores served by Fleming range in size from small convenience outlets to conventional supermarkets to large superstores, combination units and price impact stores. Fleming's principal customers are supermarkets carrying a wide variety of grocery, meat, produce, frozen food and dairy products. Most customers also handle an assortment of nonfood items, including health and beauty care, and general merchandise such as housewares, soft goods and stationery. Many supermarkets also operate one or more specialty departments such as in-store bakeries, delicatessens, seafood and floral departments. Fleming seeks to expand its customer base through a variety of means. See "Services to Customers" and "Capital Invested in Customers". Sales by store format are comprised of: conventional - 46%; superstore - 23%; price impact - 17%; and combination 14%. Sales for 1993 by the company's operating regions are dispersed as follows: Mid-South - 25%; Western - 24%; Mid-America - 20%; Southern - 19%; and Eastern - 12%. Sales by customer type are comprised of: single-store independents - 20%; multiple-store independents - - 33%; voluntary chains - 5%; corporate chains - 35%; and company-operated locations - 7%. The mix of product sales for 1993 was: groceries - 52%; perishables - 42%; and general merchandise - 6%. Voluntary chains are retail stores licensed to do business under a common trade name and generally participate in group advertising and promotional activities. See "Franchise Operations." The company considers a chain as 11 or more stores under common ownership. At 1993 year end, Fleming was serving 810 corporate chain stores, compared to 840 a year ago. Many of the customers served by Fleming have entered into sales service plan agreements with Fleming which are terminable upon notice by either party. Certain customers also have signed mid-term or long-term supply agreements. The agreements set forth the terms under which Fleming provides products and services to the stores. SERVICES TO CUSTOMERS. In addition to supplying retail stores with their inventory requirements, Fleming offers a wide variety of services designed to enhance the customer's ability to compete and to attract new retailers. Such services include merchandising and marketing assistance, advertising, consumer education programs, retail electronic services and employee training. The costs of some of these services are included in the fees charged by Fleming in connection with its sale of food products and related items. Charges are made separately for services such as retail accounting, electronic services, leasing and financing. Another important service that Fleming offers is assistance in the development and expansion of retail stores. Fleming provides, for a fee, site selection and market surveys; store design, layout and decor assistance; and equipment and fixture planning. Fleming also develops sales promotions for customers including travel, continuity and other incentive programs. CAPITAL INVESTED IN CUSTOMERS. As part of its services to retailers, Fleming executes prime leases on store locations for sublease to certain customers. Sublease rentals are generally higher than the base rental to Fleming. At the end of 1993, Fleming was the primary lessee of 770 retail store locations subleased to and operated by customers. In certain circumstances, the company has also guaranteed the lease obligations of certain customers. In addition to extending credit for inventory purchases, Fleming also assists customers by making capital available in the form of loans and equity investments. The composition of Fleming's portfolio of loans to (including current portion) and investments in customers is presented below. Amounts are in millions. Fleming makes equity investments in certain customers under its equity store program or as business development ventures. Fleming also makes secured loans to these customers. These investments and loans decreased from $209 million to $190 million during 1993. Losses of $12 million were recorded under the equity method associated with such investments in 1993, compared to $16 million recorded in 1992. Equity investments in customers totaled $55 million and $46 million at year end 1993 and 1992, including $12 million and $10 million in 1993 and 1992, respectively, invested in company-owned retail stores held for resale to qualified buyers. Loans to customers in whom the company held an equity interest totaled approximately $135 million at year-end 1993, compared to $163 million at year-end 1992. During 1993, $68 million of notes evidencing loans were sold, compared to $45 million sold in 1992. The loan portfolio is net of reserves of $18 million in 1993 and 1992. Through its equity store program, the company invests capital in customers. The customer is permitted to purchase the company's investment over a five to ten year period. At year-end 1993, equity investments in 51 customers under this program totaled $15 million compared to $18 million at year end 1992. Loans to these customers were $55 million in 1993 and $49 million in 1992. Upon review and approval by its board of directors, the company invests in strategic multi-store customers as business development ventures. These customers, many of whom are highly leveraged, are usually medium-sized retail chains who have entered into long-term supply agreements with the company. At year-end 1993, the company had equity investments of approximately $28 million in 10 business development ventures compared to investments of $18 million in 12 ventures in 1992. At the end of 1993, the company had secured loans totaling approximately $78 million to these entities compared to $114 million in 1992. In addition, the company has guaranteed $35 million of loans to one such venture. The company also makes loans to customers in which it has no equity investment, primarily for store expansions or improvements. These loans are generally secured by inventory and store fixtures, bear interest at rates at or above prime, and are for terms of up to ten years. Such loans totaled approximately $178 million and $193 million at year-end 1993 and 1992, respectively. Fleming does not believe its loans to customers would be investment grade if rated. Furthermore, its equity investments are highly illiquid. However, the company has systems and controls in place to monitor the performance of its equity investments and the more than 800 outstanding loans to customers totaling $313 million and $356 million in 1993 and 1992, respectively. For equity stores and business development ventures, the company has active representation on the customer's board of directors. The company also conducts periodic credit reviews and receives and analyzes the customers' financial statements. Retail counselors visit the customers' locations regularly. On an ongoing basis, senior management reviews the company's largest investments and credit exposures. In making credit and investment decisions, the company considers many factors including anticipated risk, expected return on capital utilized and the benefits to be derived from sustained or increased product sales. Sales to stores served by the company through the equity store program and business development ventures were approximately $1.6 billion in 1993, or approximately 12% of total net sales. Although the company has in the past and may in the future sustain operating losses associated with capital investments in customers, management believes that on balance the economic benefit to the company including the benefit of increased product sales outweighs the increased risk of making such capital investments. COMPANY-OPERATED RETAIL STORES. At year end, the company operated 72 supermarkets located in four states. The average size of these stores is 38,000 square feet. Company-operated stores do business in a variety of formats, from conventional supermarkets to price impact stores. All locations are served by Fleming distribution divisions. The number of company-operated stores increased during 1993 and 1992 due to purchases of retail locations in both years. Management intends to continue to increase ownership of company-operated stores. The growth plan includes evaluating markets currently served as well as identifying appropriate acquisition candidates in specific niche markets. INTERNATIONAL ACTIVITIES. The company has a 49% interest in a joint venture with one of Mexico's largest retailers, Grupo Gigante, to develop and operate price impact supermarkets in Mexico. Four stores were in operation at the end of 1993 and two stores are planned for opening in 1994. The company's pro-rata investment in the venture is $13 million. In the fall of 1993 the company (35%) and an affiliate of a leading Australian food wholesaler (65%) capitalized a Singapore corporation in order to acquire and develop food distribution businesses throughout Asia. The company has an option to purchase and the Australian shareholder has a right to require the company to purchase an additional 14%. The Singapore corporation holding minority interests has formed joint ventures to operate food distribution centers with local supermarket operators in each of Singapore and Malaysia and plans additional joint ventures in other Pacific Rim countries. The company's committed investment, including the additional 14% interest in the Singapore corporation, is approximately $7.5 million. The company has export sales aggregating $212 million in 1993. International sales activities have been consolidated under Fleming International, Ltd., a wholly owned subsidiary. Principal areas in which these sales were made are: the Caribbean, Central America, Japan, Mexico, the Pacific Rim, and South America. The company will continue to explore expansion of its international activities. Fleming currently exports both private label and branded products, and has established working alliances with many companies to expand their international sales through Fleming. FRANCHISE OPERATIONS. The company offers its customers the opportunity to franchise a concept or license a common trade name. This program helps the customer compete by providing, as part of the franchise or license program, state-of-the-art business concepts, group advertising, private label products and other benefits. Fleming is the franchisor or has the right to license retailers to use certain trade names such as Big Star-R-, Big T-R-, Checkers-R-, Food 4 Less-R-, IGA-R-, MEGA MARKET-R-, Minimax-R-, Piggly Wiggly-R-, Sentry-R-, Shop 'n Bag-R-, Shop 'n Kart-R-, Super 1 Foods-R-, Super Save-R-, Thriftway-R-, United Supers-R- and Value King-R-. While these rights are collectively significant, none of the individual trade names is considered material to the company's operation. At year end 1993, the company franchised or licensed approximately 1,700 stores. RELATED ACTIVITIES. The company operates dairy facilities in Nashville, Tenn., and Baton Rouge, La. These automated facilities process milk products, including regular and low fat milk, as well as cultured items such as cottage cheeses, sour cream and dips marketed under private and national brands, In addition, these facilites process fruit juices and soft drinks. The company owns an 80% interest in a limited assortment retail format, Sav-U-Foods-R-. These are small stores located in Southern California that carry fewer varieties of products than conventional stores while offering very competitive pricing. There are currently 20 stores in operation with plans to have at least 50 open by the end of 1994. These stores are supplied from a separate distribution center. Fleming owns and operates two drug stores, two retail liquor stores and a bakery, all located in Wisconsin. Most distribution divisions operate a truck fleet to deliver products to customers. The company increases the utilization of its truck fleet by backhauling products from many suppliers, thereby reducing the number of empty miles traveled. To further increase its fleet utilization, the company has made its truck fleet available to other firms on a for-hire carriage basis. COMPETITION. Fleming competes with several other wholesale food distributors in most of its market areas on the basis of product price, quality and assortment, schedules and reliability of deliveries, the range and quality of services provided and its willingness to invest capital in customers. The sales volume of wholesale food distributors is dependent on the level of sales achieved by the retail food stores they serve. Retail stores served by Fleming compete with other retail food outlets in their areas on the basis of product price, quality and assortment, store location, sales promotions, advertising, availability of parking, hours of operation, cleanliness and attractiveness. Fleming believes that the designs and locations of its distribution divisions enable it to serve its customers in an efficient manner and that its purchasing systems and standards enable it to provide such customers with a wide assortment of products at competitive prices. EMPLOYEES. Fleming had approximately 23,300 associates at year end 1993. RECENT DEVELOPMENTS. In January 1994, the company announced that it has signed a letter of intent to sell substantially all the assets of its Royal Foods dairy and deli products distribution business located in Woodbridge, New Jersey, to DiGiorgio Corporation. The transaction, at March 24, 1994 is subject to execution of a definitive agreement and receipt of certain third party consents. The company expects to record a pre-tax gain of approximately $3 million on the transaction, $3 million less than the original estimate. Annual sales of the operation are approximately $300 million and future financial results will not be adversely affected as a result of the transaction. The company's Royal Foods distribution center located in Maryland is not part of the proposed sale and will continue to supply perishable products to customers of the Philadelphia division. ITEM 2. ITEM 2. PROPERTIES The following table sets forth information with respect to Fleming's major distribution facilities. OUTSIDE STORAGE Outside storage facilities - typically rented on a short-term basis. 5,160 ----- Total square feet 20,895 ------ ------ (1) Comprise the Lubbock distribution operation. (2) The company has announced that it will close this facility in 1994 and transfer its customers to other company-operated facilities. (3) Comprise the Royal distribution operation. At the end of 1993, Fleming operated a delivery fleet consisting of approximately 1,800 power units and 3,700 trailers. Most of this equipment is owned by the company. Company-operated retail stores occupy approximately 2.7 million square feet which is primarily leased. ITEM 3. ITEM 3. LEGAL PROCEEDINGS TROPIN V. THENEN ET AL., (INCLUDING MALONE & HYDE, INC., AND FLEMING COMPANIES, INC.) CASE NO. 93-1092-CIV-MORENO. UNITED STATES DISTRICT COURT, SOUTHERN DISTRICT OF FLORIDA. WALCO INVESTMENTS, INC., ET AL. V. THENEN, ET AL., (INCLUDING MALONE & HYDE, INC., AND FLEMING COMPANIES, INC.) CASE NO. 93-1092-CIV-MORENO, UNITED STATES DISTRICT COURT, SOUTHERN DISTRICT OF FLORIDA. On December 21, 1993, these cases were filed in the United States District Court for the Southern District of Florida. Both cases name numerous defendants, including registrant, its subsidiary Malone & Hyde, Inc., and four former associates of subsidiaries of registrant. These cases contain similar factual allegations. As to registrant, Malone & Hyde, and the former associates, plaintiffs allege, among other things, that the former associates participated in fraudulent activities by taking money for confirming diverting transactions which had not occurred and that, in so doing, the former associates acted within the scope of their employment. Plaintiffs also allege that Malone & Hyde allowed its name to be used in furtherance of the alleged fraud. The allegations against registrant and Malone & Hyde include common law fraud, breach of contract, aiding and abetting a violation of Section 10(b) of the Securities and Exchange Act of 1934, negligence, and demand for repayment of monies allegedly received by the confirmers. In addition, allegations were made against Malone & Hyde claiming it violated the federal Racketeer Influenced and Corrupt Organizations Act and comparable state law. Plaintiffs seek damages, treble damages, attorneys fees, costs, expenses and other appropriate relief. While the amount of damages sought under most claims is not specified, plaintiffs allege that hundreds of millions of dollars were lost as the result of the matters complained of. Registrant and Malone & Hyde, Inc. deny the allegations of the complaints and will vigorously defend the actions. See "Item 7. Management's Discussion and Analysis of Financial Condition and 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 table sets forth certain information concerning the executive officers of the company as of March 24, 1994: No family relationship exists among any of the executive officers listed above. Executive officers are elected by the board of directors for a term of one year beginning with the annual meeting of shareholders held in April or May of each year. Each of the executive officers has been employed by the company or its subsidiaries for the preceding five years except for Messrs. Devening, Almond and Anderson. Mr. Devening returned to the company in June 1989 as executive vice president and chief financial officer and was elected to his present position in 1993. From 1979 to January 1987, he was associated with the company, being elected executive vice president-finance and administration in 1982. From January 1987 to June 1989, he was vice president and chief financial officer of Genentech, Inc., a pharmaceutical products company. Mr. Almond joined the company in May 1989 as senior vice president-general counsel. He assumed the additional role of corporate secretary in 1992. Since 1985 until joining the company, he was senior vice president-general counsel and administration of Wilson Foods Corp., a processor of meat products. In 1990, Wilson Foods Corp. filed for protection under Chapter 11 of the United States Bankruptcy Code and subsequently had a reorganization plan approved by the court. Mr. Anderson joined the company in his present position in July 1993. Since 1986, until joining the company, he was vice president of McKesson Corporation, a distributor of pharmaceutical and related products, where he was responsible for its service merchandising division. Mr. Werries will retire effective April 27, 1994 as chairman of the board. Mr. Stauth will then become chairman, president and chief executive officer. Mr. Stuard will retire effective December 1, 1994. PART II ------- ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED SHAREHOLDER MATTERS Fleming common stock is traded on the New York, Chicago and Pacific stock exchanges. The ticker symbol is FLM. As of December 31, 1993, the 36.9 million outstanding shares were owned by 11,200 shareholders of record and approximately 19,300 beneficial owners whose shares are held in street name by brokerage firms and financial institutions. According to the New York Stock Exchange Composite Transactions tables, the high and low prices of Fleming common stock during each calendar quarter of the past two years are shown below. Cash dividends on Fleming common stock have been paid for 77 consecutive years. Dividends are generally declared on a quarterly basis with holders as of the record date being entitled to receive the cash dividend on the payment date. Record and payment dates are normally as shown below: Cash dividends of $.30 per share were paid on each of the above four payment dates in 1992 and 1993. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA (a) In 1993 and 1992, the company recorded an after-tax loss of $2.3 million and $5.9 million, respectively, for early retirement of debt. In 1991, the company changed its method of accounting for postretirement health care benefits, resulting in a charge to net earnings of $9.3 million. The results in 1993 include an after-tax charge of approximately $62 million for additional facilities consolidations, re-engineering, impairment of retail-related assets and elimination of regional operations. The company instituted a plan late in 1991 to reduce costs and increase operating efficiency by consolidating four distribution centers into larger, higher volume and more efficient facilities. The after-tax charge was $41.4 million. During 1989, the company sold all of its preferred stock investment and approximately 60% of its common stock investment in the purchaser of White Swan, Inc., resulting in an after-tax gain of $8.2 million. The remaining common stock investment was sold in 1990, resulting in an after-tax gain of approximately $3.6 million. See notes to consolidated financial statements and the financial review included in Item 7 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS LIQUIDITY AND CAPITAL RESOURCES Fleming continues to experience excellent access to the capital markets. The company refinanced at lower interest rates $28 million of term debt through borrowings on bank lines and the issuance of medium-term notes. Also, proceeds from the sale of $68 million of long-term retailer notes receivable were applied to the early redemption of $63 million of 9.5% debentures purchased at the required premium. Additional customer notes receivable may be sold in the future with the proceeds used to reduce debt. The company registered an additional $264 million of debt securities with the Securities and Exchange Commission. Medium-term notes in the amount of $61 million were issued in 1993 with maturities ranging from four to seven years with an average interest rate of 5.9%. The remaining $290 million of registered securities are available for sale from time to time and allow the company to maintain adequate access to the debt capital markets. In addition, three-year loans totaling $65 million were consummated with three banks. In January 1994, a similar $20 million loan was closed and a maturing loan was extended for 2.5 years. The company has established public and private commercial paper programs. Two revolving credit agreements, $400 million maturing in October 1997 and $200 million maturing in October 1994, serve as backup lines for the company's commercial paper programs and for borrowings under uncommitted lines, assuring adequate liquidity. These credit facilities, with a strong group of banks led by Morgan Bank, were established in October to replace a similar $500 million facility which was scheduled to expire in November 1994. During 1993, the company made no borrowings under any of its committed agreements. The interest rate for the facilities is based on various money market rates selected by the company at the time of borrowing. Management intends to renew the $200 million credit agreement prior to its maturity. The committed credit agreements and seven term bank loans contain various covenants, including restrictions on additional indebtedness, payment of cash dividends and acquisition of the company's common stock. None of these covenants negatively impact the company's liquidity or capital resources at this time. Reinvested earnings of approximately $92 million were available at year end for cash dividends and acquisition of the company's stock. Each of these credit agreements may be terminated in the event of a defined change of control of the company. Uncommitted bank lines were used during the year when their rates were lower than commercial paper rates. During 1993, borrowings under these lines averaged $170 million, ranging from $81 million to $435 million, and were $145 million at year-end 1993. Commercial paper borrowings averaged $151 million, ranging from $15 million to $226 million, and were $166 million at year end. The company's long-term debt and commercial paper continue to carry investment grade ratings of BBB/Baa2 and A-2/P-2, respectively. However, the ratings of Baa2 and P-2 were put under review with negative implications in January 1994 by Moody's Investors Service. Fleming makes investments in and loans to its retail customers, primarily in conjunction with the establishment of long-term supply agreements. Such investments and loans were made at a lesser rate in 1993 than in 1992. At year end these investments and loans of $379 million, combined with total trade receivables of $232 million, were $611 million, an $83 million net decrease from 1992. After a $68 million sale of notes, net investments and loans decreased $33 million. In addition, net trade receivables decreased $50 million. Cash flow from operations, one of the company's primary sources of liquidity, was $209 million in 1993, up $119 million from 1992. The increase is attributable to reduced trade receivables and inventories. Trade receivables in 1993 had a turnover rate of 45.3 times, up from 43.1 times the prior year. Inventory turns increased slightly to 13.1 times in 1993, compared to 12.8 times the year before. Capital expenditures were $53 million in 1993 compared to $62 million in 1992. In both years these were for normal additions and replacements of warehouse and transportation equipment and leasehold improvements. Capital expenditures in 1994 are expected to be approximately $100 million, excluding any possible acquisitions. The increase is primarily attributable to expansion projects at several distribution centers to accommodate new customers, including Kmart. The company's capital structure is as presented below. Amounts include current maturities of long-term debt and current obligations under capital leases. Long-term debt and capital lease obligations decreased $8 million to $1.08 billion during 1993. Shareholders' equity at the end of 1993 remained $1.06 billion, unchanged from the prior year. The year-end debt-to-capital ratio decreased to 50.4%, slightly below last year's ratio of 50.6%. The company's long-term target ratio is approximately 50%. Total capital was $2.14 billion at year end, essentially unchanged from the prior year. The composite interest rate of total debt (excluding capital lease obligations) before the effect of interest rate swaps was 4.8% at year end, a reduction from 5.8% a year earlier, principally due to lower short-term rates and to a lesser extent the company's refinancing activities in the first half of 1993. Including the effect of interest rate swaps, the composite interest rate of debt was 4.9% and 5.9% at the end of 1993 and 1992, respectively. The dividend payments of $1.20 per common share in 1993 and 1992 were 125% and 38% of primary net earnings per common share in 1993 and 1992, respectively. The payout ratio would have been 44% in 1993 before fourth quarter charges for facilities consolidation and restructuring and debt prepayment and 36% in 1992 before fourth quarter charges for debt prepayment. The company's policy toward cash dividends is to pay out approximately one-third of trailing 12 months earnings. The company has adequate liquidity to provide for cash needs of approximately $83 million for the facilities consolidation and restructuring plan. RESULTS OF OPERATIONS NET SALES Sales increased 1.5% in 1993 over 1992 compared to a .3% increase in 1992 over 1991. The 1993 sales increase is primarily due to a full year of Baker's in 1993, compared to 12 weeks in 1992, and the addition of the Garland facility in August. Also contributing to the increase were new customers, including Kmart. For 1993, the company again experienced food price deflation of .1% compared to deflation of 1% in 1992 and inflation of .8% in 1991. The company's outlook for 1994 is for a low level of food price inflation. Tonnage of food product sold in 1993 was essentially the same as 1992. In 1992, tonnage of food product sold versus 1991 increased 1.6%, compared to a 6.1% increase achieved in 1991. The lower tonnage growth rates experienced in 1993 and 1992 reflect sluggish retail food industry sales and the lack of net expansion of the company's customer base as new business was roughly matched by business lost. Sales for 1994 will be positively affected by the addition of the recently acquired retail stores in Florida, a full year of operation at the Garland facility and new business resulting in part from the supply agreement signed with Kmart. These sales gains will be offset by the expiration of a contract with Albertson's in Florida in early 1994 and declining business with Wal-Mart. COMPONENTS OF EARNINGS Components of earnings, before the early debt retirement in 1993 and 1992, and before the accounting change in 1991, expressed as a percent of sales are: GROSS MARGIN Gross margin as a percent of sales improved by 21 basis points, rising to 5.85% in 1993 compared to 5.64% in 1992. The increase in gross margin in 1993 was due to retail operations, which accounted for a 44 point favorable comparison. Retail food operations typically have a higher gross margin than wholesale operations. The margin increase is principally the effect of a full year of Baker's operations compared to only fourth quarter operations in 1992 and, to a lesser extent, the Florida operations acquired late in 1993. Gross margin comparisons for the first three quarters of 1994 will continue to benefit from the effects of the Florida operations. Product handling expense was nine basis points better. Higher product cost accounted for the rest of the difference. The 18 basis point decrease in gross margin in 1992 compared to 1991 is due to several factors. The absence of company-operated retail stores sold in December 1991 and the presence of Baker's stores acquired at the beginning of the fourth quarter of 1992 caused 14 basis points of the decrease. Increased transportation expenses in 1992 contributed 10 basis points to the decrease in gross margin. This was due principally to the company's facilities consolidation program that resulted in trucks driving farther to deliver product. Gross margin in the fourth quarter of 1992 was increased by $4.9 million, or four basis points (annual effect) from the favorable resolution of certain litigation. The LIFO method of inventory valuation increased gross margin by $9.3 million, an increase of $4.5 million or four basis points from 1991. SELLING AND ADMINISTRATIVE Selling and administrative expenses in 1993 were 4.27% of sales, compared to 3.84% in 1992. Retail operations have higher selling expenses than wholesale operations, and this was the main reason for the $63.4 million increase. Reductions in other selling and administrative categories were more than offset by the increase in credit loss expense discussed below. During the second quarter of 1993, selling and administrative expenses were affected by several nonrecurring items. The company recorded $11.2 million of pretax income resulting from cash received in the favorable resolution of a litigation matter and a $1.2 million accrual for expected settlements in other legal proceedings. Management estimated that the company's previously disclosed contingent liability for lease obligations exceeded previously established reserves by $2 million and recorded this amount as an expense. A $4.6 million gain from a real estate transaction was also recorded during the quarter. Selling and administrative expenses in 1991 were increased by $15 million due to unusual charges related to litigation settlements and the write-down of a nonoperating asset. Comparing 1992 to 1991, selling and administrative expenses were reduced by $42.1 million. In addition to the unusual charges, the absence of selling expenses related to company-operated retail stores sold at the end of 1991 and additional selling expenses related to Baker's operation led to a net reduction of $25 million. Also contributing to the positive result in 1992 compared to 1991 were the effects of cost controls and the benefits of certain completed facilities consolidations. Gains on the sales of customer notes receivable were reductions to selling and administrative expenses of $3.2 million, $2.5 million and $2.7 million in 1993, 1992 and 1991, respectively. The company invests a significant amount of capital in its customers through various methods consisting of customary or extended credit terms for inventory purchases, secured loans with terms up to ten years, and minority equity investments in qualifying customers under the company's equity store program. In addition, the company may guarantee debt and lease obligations of certain customers. Usually, such capital investments are made in and guarantees are extended to customers with whom the company enjoys long-term supply agreements. A significant portion of the company's net trade receivables and investments in customer notes receivable is related to multi-store, medium-sized retail chains in which the company holds an equity interest, referred to as business development ventures. Selling and administrative expenses include credit loss expense of $52 million in 1993, $28.3 million in 1992, and $17.3 million in 1991. The increases in 1993 and 1992 are due to the combined effect on customers' financial conditions of sluggish retail sales, intensified retail competition and lack of food price inflation. Credit losses increased in the fourth quarter of 1993, due to adverse developments in certain of the company's equity store program investments. Management monitors the status of credit and investment exposure and believes it has provided adequate allowances for potential losses. However, due to the nature of its customers and the highly competitive retail grocery environment, there is no assurance that future losses will not occur. INTEREST EXPENSE Interest expense in 1993 declined $3.1 million to $78 million. The improvement is due to lower short-term rates and refinancings in late 1992 and the first half of 1993. The company's borrowing strategy seeks to minimize interest expense while achieving a target range of exposure to floating interest rates and balancing its debt instruments across a range of maturities. The company enters into interest rate hedge agreements to manage interest costs and exposure to changing interest rates. Interest expense in 1992 improved over 1991, dropping by $12.3 million to $81.1 million as a result of lower interest rates. As a percent of sales, interest expense was .60%, .63% and .73% in 1993, 1992 and 1991, respectively. INTEREST INCOME Interest income consists primarily of interest earned on notes receivable from customers. Also included is income generated from direct financing leases of retail stores and related equipment. In 1993, 1992 and 1991, interest income was $62.9 million, $59.5 million and $61.4 million, respectively. The increase in 1993 results from higher outstanding notes receivable and direct financing leases, partially offset by a slight decline in the interest rate. The decrease in 1992 compared to 1991 was due to lower interest rates prevailing in 1992 versus 1991, partially offset by the effect of higher average notes receivable balances. EQUITY INVESTMENT RESULTS Losses resulting from investments in certain customers accounted for under the equity method were $11.9 million in 1993 compared to $15.1 million in 1992 and $7.7 million in 1991. The improvement in 1993 is due to improved operating performance by certain of the company's business development ventures. Such ventures were responsible for equity method losses of $6 million in 1993, compared to $11 million in 1992 and $4.1 million in 1991. The increase from 1991 to 1992 resulted from poor performance by certain of the company's business development ventures. For 1994, the continued effects on customers of a lack of food price inflation and intense competition may result in higher losses. However, the benefits to the company outweigh these losses. FACILITIES CONSOLIDATION AND RESTRUCTURING On January 18, 1994, the company announced the details of a plan to consolidate facilities and restructure its organizational alignment and operations. Management's objective is to improve company performance by eliminating functions and operations that do not add economic value. The plan resulted from a thorough review, which began in October 1993, of all operations and business strategies. The 1993 fourth quarter results reflect a charge of $101.3 million resulting directly from facilities consolidation and restructuring. This is in addition to $6.5 million provided for a facilities consolidation in the second quarter. The plan consists of four categories: facilities consolidation, re-engineering, retail-related assets and elimination of regional operations. The actions contemplated by the plan will affect the company's food and general merchandise wholesaling operations as well as certain retailing assets. Cash requirements related to the charge are estimated to be $31 million in 1994 and $52 million in 1995 and thereafter. The cash requirements are expected to be provided by internally generated cash flows and through capital raised in the debt markets. Facilities consolidations will result in the closure of five distribution centers, the relocation of two operations, consolidation of one center's administrative function, and completion of the 1991 facilities consolidation actions. Disclosures of specific facilities affected are made as closing actions commence. Approximately 400 associate positions are expected to be eliminated through facilities consolidations. The closures and relocations are anticipated to be completed primarily in 1994. Expected losses on disposition of the related property through sale or sublease are provided for through the estimated disposal dates. The total provision for facilities consolidation is approximately $60 million. Detail components include: severance costs - $15 million, impaired property and equipment - $13 million, other related asset impairments and obligations - $11 million, lease and holding costs - $10 million, completion of actions contemplated in the 1991 restructure charge - $7 million and product handling and damage - $4 million. The actions are not expected to result in a material reduction of revenues. Increased transportation expense likely will result due to trucks driving farther to serve customers, although expected savings due to administrative expenses, working capital and productivity improvements will be far more significant. The costs to complete activities contemplated in the 1991 restructure charge result principally from the deterioration of the California bay area commercial real estate market. Management's 1991 estimate of real estate values and demand has been adversely affected by the decline in sales values and increase in available competing properties. Increased costs in the consolidation were partially offset by a change in management's plans regarding the originally planned construction of a large, new facility in the Kansas City area. The revised plan calls for enlarging and utilizing existing facilities with a lower associated capital outlay. It is not practical to separately estimate reduced depreciation and amortization, labor or operating costs. Management does anticipate that, in the aggregate, a positive annual pretax earnings impact of approximately $20 million will result once the facilities consolidation plan is fully implemented. The re-engineering component of the charge provides for the cash costs associated with terminating an expected 1,500 associates displaced by the re-engineering plan, which will be implemented beginning in 1994. Annual payroll savings are projected to be approximately $40 million. The provision for re-engineering is approximately $25 million. Certain retail supermarket locations leased or owned by the company have been deemed to no longer represent viable strategic sites for stores due to size, location or age. The charge includes the present value of lease payments on these locations, as well as holding costs until disposition, the write-off of capital lease assets recorded for certain of the locations, and the expected loss on a location closed in 1994. The charge consists principally of cash costs for lease payments and write-down of property. Annual savings from these actions are expected to be $1 million. The provision for retail-related assets is approximately $15 million. Elimination of the company's regional operations in early 1994 will result in cash severance payments to approximately 100 associates, as well as transferring approximately 60 associates. Completion of the actions is expected in mid-1994. The annual savings are expected to be $4 million, principally in payroll costs. The provision for eliminating regions is approximately $8 million, including the write-down to estimated fair value of certain related assets. The 1991 restructuring plan was initiated to reduce costs and increase future operating efficiency by consolidating several distribution centers into larger, higher volume and more efficient facilities. The charge of $67 million included severance benefits, lease terminations, asset disposals and the impairment of related assets. The plan has resulted in the closing or consolidation of four facilities whose operations were assimilated into other distribution centers. Cash expenditures related to the 1991 facilities consolidation charge were $12 million and $22 million in 1993 and 1992, respectively. It is not practical to specifically quantify the operating efficiencies and economies of scale that resulted from the 1991 consolidation actions. Additional estimated costs, related primarily to asset dispositions in process, were made in the 1993 charge as discussed. EARLY DEBT RETIREMENT In the fourth quarters of 1993 and 1992, the company recorded extraordinary losses for early retirement of debt. In 1993, the company retired $63 million of 9.5% debentures at a cost of $2.3 million, after tax benefits of $2.1 million. In 1992, the company recorded a charge of $5.9 million, after tax benefits of $3.7 million. The 1992 costs related to retiring the $172.5 million of convertible notes, $30 million of the 9.5% debentures and certain other debt. Lower future interest costs will result from the actions in both years, as well as the elimination of the dilutive effect associated with the potential issuance of common shares into which the notes were convertible. TAXES ON INCOME The effective income tax rates were 48%, 39% and 38.3% in 1993, 1992 and 1991, respectively. The 1993 rate was higher than previous years because of the significance of the facilities consolidation and restructuring charge. Pretax income was reduced, resulting in nondeductible items for tax purposes having a much larger impact on the effective rate. In addition, the federal rate increased by 1% because of the new tax law enacted in 1993. The combined state income tax rate increased by 1% in 1993 compared to 1992 for the same reasons as the federal rate. The 1992 effective rate was reduced because of favorable settlements of possible tax assessments recorded in prior years. The 1991 rate was lower primarily due to one-time benefits related to the difference in the financial and tax basis in an insurance subsidiary sold in 1991 and a lower combined state income tax rate. The expected 1994 effective rate is 44%. OTHER In 1993, the company reduced the discount rate assumption used to determine its obligations for defined benefit pension plans and postretirement benefits. The 1% decline will cause pension and postretirement benefit expense recognized in 1994 to increase by approximately $3 million compared to 1993. Considering the various factors discussed above, management does not anticipate that 1994 earnings from core operations will be improved over those of 1993. In December 1993, the company and numerous other defendants were named in two lawsuits filed in U. S. District Court in Miami. Because the litigation is in its preliminary stages, management has been unable to conclude that an adverse resolution is not reasonably likely or predict the potential liability, if any, to the company. However, management does not believe that an adverse outcome is likely that would materially affect the company's consolidated financial position. Statement of Financial Accounting Standards No. 114 - Accounting by Creditors for Impairment of a Loan will be effective for the first quarter of the company's 1995 fiscal year. This statement requires that loans determined to be impaired be measured by the present value of expected future cash flows discounted at the loan's effective interest rate. Management has not yet determined the impact, if any, on the consolidated statements of earnings or financial position. Statement of Financial Accounting Standards No. 112 - Employers' Accounting for Postemployment Benefits is not applicable to benefits offered to company associates. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA See Part IV, Item 14(a) 1. Financial Statements. 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 Incorporated herein by reference to pages 3 through 6 of the company's proxy statement dated March 14, 1994, in connection with its annual meeting of shareholders to be held on April 27, 1994. Information concerning Executive Officers of the company is included in Part I herein which is incorporated in this Part III by reference. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION Incorporated herein by reference to pages 12 through 20 of the company's proxy statement dated March 14, 1994, in connection with its annual meeting of shareholders to be held on April 27, 1994. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Incorporated herein by reference to pages 9 through 11 of the company's proxy statement dated March 14, 1994, in connection with its annual meeting of shareholders to be held on April 27, 1994. 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 PAGE NUMBER IN FORM 10-K (a) 1. Financial Statements: o Consolidated Statements of Earnings - For the years ended December 25, 1993, December 26, 1992, and December 28, 1991 30 o Consolidated Balance Sheets - At December 25, 1993, and December 26, 1992 31 o Consolidated Statements of Shareholders' Equity - For the years ended December 25, 1993, December 26, 1992, and December 28, 1991 33 o Consolidated Statements of Cash Flows - For the years ended December 25, 1993, December 26, 1992, and December 28, 1991 34 o Notes to Consolidated Financial Statements - For the years ended December 25, 1993, December 26, 1992, and December 28, 1991 35 o Independent Auditors' Report 52 o Quarterly Financial Information (Unaudited) 53 (a) 2. Financial Statement Schedules: o Independent Auditors' Report on Schedules 52 o Schedule V - Property and Equipment 55 o Schedule VI - Accumulated Depreciation and Amortization of Property and Equipment 56 o Schedule VIII - Valuation and Qualifying Accounts 57 All other financial statement 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. (a), (c) 3. Exhibits: PAGE NUMBER OR EXHIBIT INCORPORATION BY NUMBER REFERENCE TO 3.1 Certificate of Incorporation Exhibit 3.1 to Report on Form 10-K for year ended December 28, 1991. 3.2 By-Laws Exhibit 28.2 to Report on Form 8-K dated August 22, 1989. 4.1 $400,000,000 Credit Agreement Exhibit 4.1 to dated as of October 21, 1993, among Report on Form 10-Q the Registrant, the banks listed for the quarter ended in the Agreement and Morgan October 2, 1993. Guaranty Trust Company of New York, as Agent 4.2 Amendment No. 1, dated January 12, 58 1994, to $400,000,000 Credit Agreement 4.3 $200,000,000 Credit Agreement dated Exhibit 4.2 to Report as of October 21, 1993, among the on Form 10-Q for the Registrant, the banks listed in the quarter ended Agreement and Morgan Guaranty Trust October 2, 1993. Company of New York, as Agent 4.4 Amendment No. 1, dated January 17, 63 1994, to $200,000,000 Credit Agreement 4.5 Agreement to furnish copies of 69 other long-term debt instruments 4.6 Rights Agreement dated as of Exhibit 28 to July 7, 1986, between the Report on Form Registrant and Morgan 8-K dated June 24, Guaranty Trust Company of New York 1986. 4.7 Amendment to Rights Agreement Exhibit 28.1 to dated as of August 22, 1989, Report on Form 8-K between the Registrant dated August 22, and First Chicago Trust Company 1989. of New York, as Rights Agent 4.8 Indenture dated as of December 1, Exhibit 4 to 1989, between the Registrant and Registration Morgan Guaranty Trust Company of Statement New York, as trustee No. 33-29633. PAGE NUMBER OR EXHIBIT INCORPORATION BY NUMBER REFERENCE TO 10.1 Investment Advisor Agreement Exhibit 10.17 to between the Registrant and The Form 10-K for year First Boston Corporation dated ended December 30, November 27, 1989 1989. 10.2 Investment Advisor Agreement Exhibit 10.18 to between the Registrant and Merrill Form 10-K for year Lynch, Pierce, Fenner & Smith ended December 30, Incorporated dated December 5, 1989 1989. 10.3 Agreement and Plan of Exhibit 2.1 to Reorganization by and among Registration Fleming Companies, Inc., Statement No. Cornhusker Acquisition and 33-51312. Baker's Supermarkets, Inc. dated August 25, 1992 10.4 Dividend Reinvestment and Exhibit 28.1 to Stock Purchase Plan, as Registration amended Statement No. 33-26648 and Exhibit 28.3 to Registration Statement No. 33-45190. 10.5* 1985 Stock Option Plan Exhibit 28(a) to Registration Statement No. 2-98602. 10.6* Form of Award Agreement for 70 1985 Stock Option Plan (1994) 10.7* 1990 Stock Option Plan Exhibit 28.2 to Registration Statement No. 33-36586. 10.8* Form of Award Agreement for 74 1990 Stock Option Plan (1994) 10.9* Fleming Management Incentive Exhibit 10.4 to Compensation Plan Registration Statement No. 33-51312. 10.10* Directors' Deferred Exhibit 10.5 to Compensation Plan Registration Statement No. 33-51312. 10.11* Supplemental Retirement Plan Exhibit 10.7 to Registration Statement No. 33-51312. PAGE NUMBER OR EXHIBIT INCORPORATION BY NUMBER REFERENCE TO 10.12* Godfrey Company 1984 Non- Appendix II to qualified Stock Option Plan Registration Statement No. 33-18867. 10.13* Form of Severance Agreement Exhibit 10.14 to between the Registrant and Form 10-K for year certain of its officers ended December 31, 1988. 10.14* Fleming Companies, Inc. 1990 Exhibit B to Stock Incentive Plan dated Proxy Statement February 20, 1990 for year ended December 30, 1989. 10.15* Phase I of Fleming Companies, Inc. Exhibit 10.16 to Stock Incentive Plan and Form of Form 10-K for year Awards Agreement ended December 30, 1989. 10.16* Phase II of Fleming Companies, Inc. Exhibit 10.12 to Form Stock Incentive Plan 10-K for year ended December 26, 1992. 10.17* Phase III of Fleming Companies, Inc. 80 Stock Incentive Plan 10.18* Fleming Companies, Inc. Directors' Exhibit 10.14 to Stock Equivalent Plan Form 10-K for year ended December 28, 1991. 10.19* Agreement between the Registrant 84 and E. Dean Werries 10.20* Agreement between the Registrant 85 and James E. Stuard 10.21* Agreement between the Registrant 87 Robert F. Harris 11 Earnings per share computation 93 12 Computation of ratio of earnings to 97 fixed charges 21 Subsidiaries of the Registrant 98 23 Consent of Deloitte & Touche 99 PAGE NUMBER OR EXHIBIT INCORPORATION BY NUMBER REFERENCE TO 24 Power of attorney instruments signed 100 by certain directors and officers of the Registrant appointing R. Randolph Devening, Vice Chairman and Chief Financial Officer, as attorney-in-fact and agent to sign the Annual Report on Form 10-K on behalf of said directors and officers 99 Company Undertaking 102 * Management contract, compensatory plan or arrangement. (b) Reports on Form 8-K: Form 8-K filed December 16, 1993 disclosed that the company's fourth quarter and full year 1993 results will be below expectations. Reasons for the less than expected results include an increase in the provision for credit losses, a significant LIFO charge and weak sales. Form 8-K filed January 20, 1994 disclosed the press release made by the company on January 18, 1994 announcing details of its planned restructuring. Registrant recorded a pre-tax charge of approximately $101 million in the fourth quarter of 1993 resulting from the restructuring. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, Fleming has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized on the 24th day of March 1994. FLEMING COMPANIES, INC. /S/ ROBERT E. STAUTH ---------------------------------------- By: Robert E. Stauth (President and Chief Executive Officer) /S/ R. RANDOLPH DEVENING ---------------------------------------- By: R. Randolph Devening (Vice Chairman and Chief Financial Officer) /S/ DONALD N. EYLER --------------------------------------------- By: Donald N. Eyler (Senior Vice President and Controller) (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 indicated on the 25th day of March 1994. /S/ E. DEAN WERRIES * /S/ ROBERT E. STAUTH * /S/ R. RANDOLPH DEVENING * - ------------------------- ------------------------- -------------------------- E. Dean Werries Robert E. Stauth R. Randolph Devening (Chairman of the Board) (Director) (Director) /S/ ARCHIE R. DYKES * /S/ CAROL B. HALLETT * /S/ JAMES G. HARLOW, JR. * - ------------------------- ------------------------- -------------------------- Archie R. Dykes Carol B. Hallett James G. Harlow, Jr. (Director) (Director) (Director) /S/ R. D. HARRISON * /S/ LAWRENCE M. JONES * /S/ EDWARD C. JOULLIAN III* - ------------------------- ------------------------- --------------------------- R. D. Harrison Lawrence M. Jones Edward C. Joullian III (Director) (Director) (Director) /S/ HOWARD H. LEACH * /S/ JOHN A. MCMILLAN * /S/ GUY O. OSBORN * - ------------------------- -------------------------- ------------------------- Howard H. Leach John A. McMillan Guy O. Osborn (Director) (Director) (Director) /S/ R. RANDOLPH DEVENING - --------------------------- *By: R. Randolph Devening (Attorney-in-Fact) *A Power of Attorney authorizing R. Randolph Devening to sign the Annual Report on Form 10-K on behalf of each of the indicated directors of Fleming Companies, Inc. has been filed herein as Exhibit 25. CONSOLIDATED STATEMENTS OF EARNINGS For the years ended December 25, 1993, December 26, 1992, and December 28, 1991 (In thousands, except per share amounts) Sales to customers accounted for under the equity method were approximately $1.6 billion, $1.3 billion and $1 billion in 1993, 1992 and 1991, respectively. See notes to consolidated financial statements. CONSOLIDATED BALANCE SHEETS At December 25, 1993, and December 26, 1992 (In thousands, execept per share amounts) LIABILITIES AND SHAREHOLDERS' EQUITY Receivables include $48.3 million and $48.9 million in 1993 and 1992, respectively, due from customers accounted for under the equity method. See notes to consolidated financial statements. CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY For the years ended December 25, 1993, December 26, 1992, and December 28, 1991 (In thousands) See notes to consolidated financial statements. CONSOLIDATED STATEMENTS OF CASH FLOWS For the years ended December 25, 1993, December 26, 1992, and December 28, 1991 (In thousands) See notes to consolidated financial statements. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES FISCAL YEAR: The company's fiscal year ends on the last Saturday in December. PRINCIPLES OF CONSOLIDATION: The consolidated financial statements include all material subsidiaries. Material intercompany items have been eliminated. The equity method of accounting is used for investments in certain customers. CASH AND CASH EQUIVALENTS: Cash equivalents consist of liquid investments readily convertible to cash with a maturity of three months or less. The carrying amount for cash equivalents is a reasonable estimate of fair value. RECEIVABLES: Receivables include the current portion of customer notes receivable of $69.9 million (1993) and $67.8 million (1992). Receivables are shown net of allowance for credit losses of $44.3 million (1993) and $25.3 million (1992). The company extends credit to its retail customers located over a broad geographic base. Regional concentrations of credit risk are limited. INVENTORIES: Inventories are valued at the lower of cost or market. Most grocery and certain perishable inventories are valued on a last-in, first-out (LIFO) method. Other inventories are valued on a first-in, first-out (FIFO) method. PROPERTY AND EQUIPMENT: Property and equipment are recorded at cost or, for leased assets under capital leases, at the present value of minimum lease payments. Depreciation, as well as amortization of assets under capital leases, are based on the estimated useful asset lives using the straight-line method. GOODWILL: The excess of purchase price over the value of net assets of businesses acquired is amortized on the straight-line method over periods not exceeding 40 years. Goodwill is shown net of accumulated amortization of $74.2 million (1993) and $60 million (1992). Goodwill is written down if it is probable that estimated operating income generated by the related assets will be less than the carrying amount. ACCOUNTS PAYABLE: Accounts payable include $8.8 million (1993) and $11.2 million (1992) of issued checks that have not yet cleared the company's bank accounts, less deposits in transit. FINANCIAL INSTRUMENTS: Interest rate hedge transactions and other financial instruments are utilized to manage interest rate exposure. The difference between amounts to be paid or received is accrued and recognized over the life of the contracts. TAXES ON INCOME: Deferred income taxes arise from temporary differences between financial and tax bases of certain assets and liabilities. DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS: The methods and assumptions used to estimate the fair value of significant financial instruments are discussed in the Investments and Notes Receivable, and Long-Term Debt notes. FOREIGN CURRENCY TRANSLATION: Net exchange gains or losses resulting from the translation of assets and liabilities of an international investment are included in shareholders' equity. NET EARNINGS PER COMMON SHARE: Primary earnings per common share are computed based on net earnings, less dividends on preferred stock in 1991, divided by the weighted average common shares outstanding. The impact of common stock options on primary earnings per common share is not materially dilutive. Fully diluted earnings per common share assume conversion of the convertible subordinated notes that were redeemed during 1992. RECLASSIFICATIONS: Certain reclassifications have been made to prior year amounts to conform to current year classifications. INVENTORIES Inventories are valued as follows: Current replacement cost of LIFO inventories were greater than the carrying amounts by approximately $12.5 million at December 25, 1993, and $19.3 million at December 26, 1992. INVESTMENTS AND NOTES RECEIVABLE Investments and notes receivable consist of the following: The company extends long-term credit to certain retail customers it serves. Loans are primarily collateralized by inventory and fixtures. Investments and notes receivable are shown net of allowance for credit losses of $18.3 million and $18.2 million in 1993 and 1992, respectively. Interest rates are above prime with terms up to 10 years. The carrying amount of notes receivable approximates fair value because of the variable interest rates charged on the notes. The Financial Accounting Standards Board has issued Statement of Financial Accounting Standards (SFAS) No. 114 - Accounting by Creditors for Impairment of a Loan. This new statement requires that loans determined to be impaired be measured by the present value of expected future cash flows discounted at the loan's effective interest rate. The new standard is effective for the first quarter of the company's 1995 fiscal year. The company has not yet determined the impact, if any, on the consolidated statements of earnings or financial position. The company has sold certain notes receivable at face value with limited recourse. The outstanding balance at year end 1993 on all notes sold is $155.4 million, of which the company is contingently liable for $31.3 million should all the notes become uncollectible. The company guarantees bank debt of $35 million for a customer. LONG-TERM DEBT Long-term debt consists of the following: Aggregate maturities of long-term debt for the next five years are as follows: 1994-$61.3 million; 1995-$140.3 million; 1996-$69 million; 1997-$13.8 million and 1998-$27.8 million. In 1993 and 1992, the company recorded extraordinary losses for early retirement of debt. In 1993, the company retired $63 million of the 9.5% debentures. The extraordinary loss was $2.3 million, after income tax benefits of $2.1 million, or $.06 per share. The funding source for the early redemption was the sale of notes receivable. In 1992, the company retired the $172.5 million of convertible subordinated notes, $30 million of the 9.5% debentures and certain other debt. The extraordinary loss was $5.9 million, after income tax benefits of $3.7 million, or $.15 per share. Funding sources related to the 1992 early retirement were bank lines, medium-term notes, sale of notes receivable and commercial paper. The company has two commercial paper programs supported by committed $400 million and $200 million revolving credit agreements with a group of banks. Currently, the company limits the amount of commercial paper issued at any time plus the amount of borrowing under uncommitted credit lines to the unused credit available through the committed credit agreements. The $400 million credit agreement matures in October 1997. The $200 million credit agreement matures in October 1994, but the company intends to renew the agreement prior to maturity. At year end, the company had no borrowings under the agreements which carry combined annual facility and commitment fees of .25% and .15% for the $400 million agreement and the $200 million agreement, respectively. The interest rate is based on various money market rates selected by the company at the time of borrowing. The credit agreements contain various covenants, including restrictions on additional indebtedness, payment of cash dividends and acquisition of the company's common stock. None of these covenants negatively impact the company's liquidity or capital resources at this time. Reinvested earnings of approximately $92 million were available at year end for cash dividends and acquisition of the company's stock. The agreements contain a provision that, in the event of a defined change of control, the credit agreements may be terminated. The company has registered $565 million in medium-term notes. Of this, the remaining $289.6 million may be issued from time to time, at fixed or floating interest rates, as determined at the time of issuance. The unsecured term bank loans have original maturities of three years and bear interest at floating rates. Unsecured credit lines have original maturities of generally less than one year and bear interest at floating rates. The loans contain essentially the same covenants as the revolving credit agreements and are prepayable without penalty. The carrying value of assets collateralized under mortgaged real estate notes and other debt was approximately $9.4 million and $123 million at year end 1993 and 1992, respectively. Components of interest expense are as follows: The company's employee stock ownership plan (ESOP) allows substantially all associates to participate. The ESOP purchased 640,000 shares of common stock from the company at $31.25 per share, resulting in proceeds of $20 million. The ESOP borrowed the money from a bank. The company guaranteed the bank loan. The loan balance is presented in long-term debt with an offset as a reduction of shareholders' equity. The ESOP will repay the loan with proceeds from company contributions. The company makes contributions based on fixed debt service requirements of the ESOP loan. The ESOP used $.6 million of common stock dividends for debt service in each of 1993, 1992 and 1991. During 1993, 1992 and 1991, the company recognized $1.1 million, $.9 million and $.8 million, respectively, in compensation expense. Interest expense of $.5 million, $.7 million and $1.3 million was recognized at average rates of 3.7%, 4.4% and 7.7% in 1993, 1992 and 1991, respectively. The company enters into interest rate hedge agreements to manage interest costs and exposure to changing interest rates. At year end 1993 and 1992, agreements were in place that effectively fixed rates on $70 million and $270 million, respectively, of the company's floating rate debt. Additionally, for both years, $60 million of agreements convert fixed rate debt to floating and a $100 million transaction hedges the company's risk of fluctuation between prime rate and LIBOR. The maturities for such agreements range from 1995 to 1998. The counterparties to these agreements are major national and international financial institutions. The fair value of long-term debt as of year end 1993 and 1992 was determined using valuation techniques that considered cash flows discounted at current market rates and management's best estimate for instruments without quoted market prices. At year end 1993 and 1992, the fair value of debt exceeded the carrying amount by $13.8 million and $16.5 million, respectively. For interest rate swap agreements, the fair value was estimated using termination cash values. At year end 1993, swap agreements had no fair value. At year end 1992, swap agreements had a fair value of $1.7 million. The company does not have any financial basis in the hedge agreements other than accrued interest payable or receivable. LEASE AGREEMENTS CAPITAL AND OPERATING LEASES: The company leases certain distribution facilities with terms generally ranging from 20 to 30 years, while lease terms for other operating facilities range from 1 to 15 years. The leases normally provide for minimum annual rentals plus executory costs and usually include provisions for one to five renewal options of five years. The company leases company-operated retail store facilities with terms generally ranging from 3 to 20 years. These agreements normally provide for contingent rentals based on sales performance in excess of specified minimums. The leases usually include provisions for one to three renewal options of two to five years. Certain equipment is leased under agreements ranging from 2 to 8 years with no renewal options. Accumulated amortization related to leased assets under capital leases was $41.7 million and $59.5 million at year end 1993 and 1992, respectively. Future minimum lease payment obligations for leased assets under capital leases as of year end 1993 are set forth below: Future minimum lease payments required at year end 1993 under operating leases that have initial noncancelable lease terms exceeding one year are presented in the following table: The following table shows the composition of total annual rental expense under noncancelable operating leases and subleases with initial terms of one year or greater: At year end 1993, the company is contingently liable for future minimum rental commitments of $335 million. DIRECT FINANCING LEASES: The company leases retail store facilities for sublease to customers with terms generally ranging from 5 to 25 years. Most leases provide for a contingent rental based on sales performance in excess of specified minimums. Sublease rentals are generally higher than the rental paid. The leases and subleases usually contain provisions for one to four renewal options of two to five years. The following table shows the future minimum rentals to be received under direct financing leases and future minimum lease payment obligations under capital leases in effect at December 25, 1993: Contingent rental income and contingent rental expense were not material in 1993, 1992 or 1991. FACILITIES CONSOLIDATION AND RESTRUCTURING The results in 1993 include a charge of $107.8 million for additional facilities consolidations, re-engineering, impairment of retail-related assets and elimination of regional operations. Facilities consolidations will result in the closure of five distribution centers, the relocation of two operations, the consolidation of a center's administrative function and completion of the 1991 facilities consolidation actions. The related charge provides for severance costs, impaired property and equipment, product handling and damage, and impaired other assets. The re-engineering component of the charge provides for severance costs of terminating associates displaced by the re-engineering plan. Impairment of retail-related assets provides for the present value of lease payments and assets associated with certain retail supermarket locations leased or owned by the company. These sites are no longer strategically viable due to size, location or age. Elimination of regional operations in early 1994 will result in cash severance payments to affected associates. The 1991 restructuring plan was initiated to reduce costs and increase operating efficiency by consolidating four distribution centers into larger, higher volume and more efficient facilities. The $67 million charge included associate severance, lease terminations and impairment of related assets. The plan has resulted in the closing or consolidation of four facilities whose operations were assimilated into other distribution centers. Additional estimated costs, related primarily to asset dispositions in process, were made in the 1993 charge. TAXES ON INCOME Components of taxes on income (tax benefit) are as follows: Deferred tax expense (benefit) relating to temporary differences includes the following components: Temporary differences that give rise to deferred tax assets and liabilities as of December 25, 1993, are as follows: The effect of the increase in the federal statutory rate to 35% on deferred tax assets and liabilities was immaterial. The valuation allowance contains $4.5 million of acquired loss carryforwards that, if utilized, will be reversed to goodwill in future years. The effective income tax rates are different from the statutory federal income tax rates for the following reasons: SHAREHOLDER'S EQUITY The company offers a Dividend Reinvestment and Stock Purchase Plan which offers shareholders the opportunity to automatically reinvest their dividends in common stock at a 5% discount from market value. Shareholders also may purchase shares at market value by making cash payments up to $5,000 per calendar quarter. Shareholders reinvested dividends in 174,000 and 157,000 new shares in 1993 and 1992, respectively. Additional shares totaling 9,000 and 13,000 in 1993 and 1992, respectively, were purchased at market value by shareholders. The company has a shareholder rights plan designed to protect shareholders should the company become the target of coercive and unfair takeover tactics. Shareholders have one right for each share of stock held. When exercisable, each right entitles shareholders to buy one share of common stock at a specific price in the event of certain defined actions that constitute a change of control. The rights expire on July 6, 1996. The company has severance agreements with certain management associates. The agreements generally provide two years' salary to these associates if the associate's employment terminates within two years after a change of control. In the event of a change of control, a supplemental trust will be funded to provide these salary obligations. INCENTIVE STOCK PLANS The company's stock option plans allow the granting of nonqualified stock options and incentive stock options, with or without stock appreciation rights (SARs), to key associates. In 1993 and 1992, options with SARs were exercisable for 35,000 and 46,000 shares, respectively. Options without SARs were exercisable for 841,000 shares in 1993 and 805,000 shares in 1992. At year end 1993, there were 1.5 million shares available for grant under the stock option plans. Stock option transactions are as follows: The company has a stock incentive plan that allows awards to key associates of up to 400,000 restricted shares of common stock and phantom stock units. The company has issued 133,000 restricted common shares, net of 10,000 shares forfeited in 1993. These shares were recorded at the market value when issued, $4.4 million, and are amortized to expense as earned. The unamortized portion, $1.8 million and $2.1 million in 1993 and 1992, respectively, is netted against capital in excess of par value within shareholders' equity. In the event of a change of control, the company may accelerate the vesting and payment of any award or make a payment in lieu of an award. ASSOCIATE RETIREMENT PLANS The company sponsors retirement and profit sharing plans for substantially all nonunion and some union associates. The company also has nonqualified, unfunded supplemental retirement plans for selected associates. These plans comprise the company's defined benefit pension plans. Contributory profit sharing plans maintained by the company are for associates who meet certain types of employment and length of service requirements. Company contributions under these defined contribution plans are made at the discretion of the board of directors. Expenses for these plans were $2 million, $1.1 million and $.8 million in 1993, 1992 and 1991, respectively. Benefit calculations for the company's defined benefit pension plans are primarily a function of years of service and final average earnings at the time of retirement. Final average earnings are the average of the highest five years of compensation during the last 10 years of employment. The company funds these plans by contributing the actuarially computed amounts that meet funding requirements. The following table sets forth the company's defined benefit pension plans' funded status and the amounts recognized in the statements of earnings. Substantially all the plans' assets are invested in listed stocks, short-term investments and bonds. The significant actuarial assumptions used in the calculation of funded status for 1993 and 1992 are: discount rate - 7.5% and 8.5%, respectively; compensation increases - 4% and 5%, respectively; and return on assets - 9.5% and 10%, respectively. Net pension expense includes the following components: Certain associates have pension and health care benefits provided under collectively bargained multiemployer agreements. Expenses for these benefits were $44 million, $40 million and $37.1 million for 1993, 1992 and 1991, respectively. ASSOCIATE POSTRETIREMENT HEALTH CARE BENEFITS In 1991, the company adopted SFAS No. 106 - Employers' Accounting for Postretirement Benefits Other Than Pensions. The company elected to recognize immediately the accumulated postretirement benefit obligation, resulting in a charge to net earnings of $9.3 million. The effect of the change on 1991 net earnings, excluding the cumulative effect upon adoption, was not material. The company offers a comprehensive major medical plan to eligible retired associates who meet certain age and years of service requirements. This unfunded defined benefit plan generally provides medical benefits until Medicare insurance commences. Components of postretirement benefits expense are as follows: The composition of the accumulated postretirement benefit obligation (APBO) and the amounts recognized in the balance sheets are presented below. During 1993, a postretirement benefit obligation was settled. No additional benefit payments will be made for this terminated obligation. The weighted average discount rate used in determining the APBO was 7.5% and 9.5% for 1993 and 1992, respectively. For measurement purposes in 1993 and 1992, a 14% and 15%, respectively, annual rate of increase in the per capita cost of covered medical care benefits was assumed. In 1993, the rate was assumed to decrease to 8% by 2000, then to 7.5% in 2001 and thereafter. In 1992, the rate was assumed to decrease to 8% by 1999 and remain at 8% thereafter. If the assumed health care cost increased by 1% for each future year, the current cost and the APBO would have increased by 3% to 5% for all periods presented. The company also provides other benefits for certain inactive associates. Expenses related to these benefits are immaterial. SUPPLEMENTAL CASH FLOWS INFORMATION In 1993, the company acquired the assets or common stock of three businesses. In August, the company purchased distribution center assets located in Garland, Texas. In September and November, the company purchased certain assets and the common stock, respectively, of two supermarket operators in southern Florida. The acquisitions were accounted for as purchases. The results of these entities are not material to the company. Cash paid for the acquisitions, net of cash acquired, was $51.1 million. The fair value of assets acquired was $111.1 million, with liabilities assumed or created of $9 million. In 1992, the company acquired the common stock of Baker's Supermarkets, the operator of 10 supermarkets located in Omaha, Neb. The acquisition was accounted for as a purchase. The results of Baker's operations are not material to the company. The company issued 1,073,512 shares of common stock at a price of $31.79 per share, or $34.1 million. The fair value of assets acquired was $88.7 million, with liabilities assumed or created of $39.8 million. Cash paid for the acquisition, net of cash acquired, was $8.2 million. LITIGATION AND CONTINGENCIES In December 1993, the company and numerous other defendants were named in two suits filed in U.S. District Court in Miami. The plaintiffs allege liability on the part of the company as a consequence of an alleged fraudulent scheme conducted by Premium Sales Corporation and others in which unspecified but large losses in the Premium-related entities occurred to the detriment of a purported class of investors which has brought one of the suits. The other suit is by the receiver/trustee of the estates of Premium and certain of its affiliated entities. Because the litigation is in its preliminary stages, management has been unable to conclude that an adverse resolution is not reasonably likely and its ultimate outcome cannot presently be determined. Accordingly, management cannot predict the potential liability, if any, to the company. However, the company has begun an investigation and, based on available information, management does not believe that an adverse outcome is likely that would materially affect the company's consolidated financial position. The company intends to vigorously defend against the suits. The company's facilities are subject to various laws and regulations regarding the discharge of materials into the environment. In conformity with these provisions, the company has a comprehensive program for testing and removal, replacement or repair of its underground fuel storage tanks and for site remediation where necessary. The company has established reserves that it believes will be sufficient to satisfy anticipated costs of all known remediation requirements. In addition, the company is addressing several other environmental cleanup matters involving its properties, all of which the company believes are immaterial. From time to time the company is named as a potentially responsible party, with others, with respect to EPA-designated superfund sites. Under current law, the company's liability for remediation of such sites may be joint and several with other responsible parties, regardless of the extent of the company's use of the sites in relation to other users. However, the company believes that, to the extent it is ultimately determined to be liable for hazardous waste deposited at any site, such liability will not result in a material adverse effect on its consolidated financial position or results of operations. The company is committed to maintaining the environment and protecting natural resources and to achieving full compliance with all applicable laws and regulations. The company is a party to various other litigation, possible tax assessments and other matters, some of which are for substantial amounts, arising in the ordinary course of business. While the ultimate effect of such actions cannot be predicted with certainty, the company expects that the outcome of these matters will not result in a material adverse effect on its consolidated financial position or results of operations. To the Board of Directors and Shareholders Fleming Companies, Inc. We have audited the accompanying consolidated balance sheets of Fleming Companies, Inc. and subsidiaries as of December 25, 1993 and December 26, 1992, and the related consolidated statements of earnings, shareholders' equity, and cash flows for each of the three years in the period ended December 25, 1993. Our audits also included the financial statement schedules listed in the Index at Item 14. 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 Fleming Companies, Inc. and subsidiaries as of December 25, 1993 and December 26, 1992, and the 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. Also, in our opinion, such financial statement schedules when considered in relation to the basic consolidated statements taken as a whole, present fairly in all material respects the information set forth therein. /s/ Deloitte & Touche Oklahoma City, Oklahoma February 10, 1994 QUARTERLY FINANCIAL INFORMATION (In thousands, except per share amounts) (Unaudited) The first quarter of both years consists of 16 weeks, all other quarters are 12 weeks. The second quarter of 1993 includes $11.2 million of pretax income resulting from the favorable resolution of a litigation matter and a $1.2 million accrual for charges in other legal proceedings. Also included is a $2 million charge for an increase to previously established reserves related to the company's contingent liability for lease obligations. The company also recorded a $4.6 million gain from a real estate transaction during the second quarter of 1993. The effective tax rate was increased in the third quarter of 1993 due to the new tax law enacted in August 1993. See discussion of facilities consolidation and restructuring charges in the notes to consolidated financial statements. QUARTERLY FINANCIAL INFORMATION (In thousands, except per share amounts) (Unaudited) The fourth quarter of 1992 reflects $4.9 million of income related to litigation settlement. SCHEDULE V ---------- FLEMING COMPANIES, INC. AND CONSOLIDATED SUBSIDIARIES ----------------------------- SCHEDULE V - PROPERTY AND EQUIPMENT ----------------------------------- YEARS ENDED DECEMBER 25, 1993, DECEMBER 26, 1992, AND DECEMBER 28, 1991 ---------------------------------------- (In thousands) In general, the estimated useful lives used in computing depreciation and amortization are: buildings and major improvements - 20 to 40 years; warehouse, transportation and other equipment - 3 to 10 years; mechanized warehouse equipment - 15 years; and data processing equipment - 5 to 7 years. Impairments in 1993 includes $16.7 million of property writedown recognized through facilities consolidation and restructuring charge. SCHEDULE VI ----------- FLEMING COMPANIES, INC. AND CONSOLIDATED SUBSIDIARIES ----------------------------- SCHEDULE VI - ACCUMULATED DEPRECIATION AND AMORTIZATION OF PROPERTY AND EQUIPMENT ------------------------------------------ YEARS ENDED DECEMBER 25, 1993, DECEMBER 26, 1992 AND DECEMBER 28, 1991 --------------------------------------- (In thousands) Impairments in 1993 includes $1.3 million of accumulated amortization written off through facilities consolidation and restructuring charge. SCHEDULE VIII ------------- FLEMING COMPANIES, INC. AND CONSOLIDATED SUBSIDIARIES ----------------------------- SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS ------------------------------------------------- YEARS ENDED DECEMBER 25, 1993, DECEMBER 26, 1992, AND DECEMBER 28, 1991 ---------------------------------------- (In thousands)

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Item 3 -- "Claims Relating To Waste Disposal Sites". Item 3. Legal Proceedings General In connection with the transfer of assets and liabilities from ARCO to Lyondell, Lyondell agreed to assume certain liabilities arising out of the operation of the Company's integrated petrochemical and petroleum processing business prior to July 1, 1988. At that time, the Company and ARCO entered into an agreement (Cross-Indemnity Agreement) whereby the Company agreed to defend and indemnify ARCO against certain uninsured claims and liabilities which ARCO may incur relating to the operation of the business of the Company prior to July 1, 1988, including liabilities which may arise out of certain of the legal proceedings described in this Item 3. See Item 13 -- "Certain Relationships and Related Transactions". Prior to November 20, 1990, ARCO's insurance carriers had assumed the defense of most of the lawsuits described in this Item 3. Since that date, ARCO's insurance carriers have refused to advance defense costs in those lawsuits relating to certain of the waste disposal sites. See "Claims Relating To Waste Disposal Sites - ARCO Insurance Litigation". In addition to the proceedings specifically described in this Item 3, ARCO, the Company and its subsidiaries are defendants in other suits, some of which are not covered by insurance. Many of these additional suits involve smaller amounts than the matters described herein, or make no specific claim for relief. Although final determination of legal liability and the resulting financial impact with respect to the litigation described in this Item 3, as well as the other litigation affecting the Company, cannot be ascertained with any degree of certainty, the Company does not believe that any ultimate uninsured liability resulting from the legal proceedings in which it currently is involved (directly or indirectly) will individually, or in the aggregate, have a material adverse effect on the business or financial condition of the Company. See Note 18 of "NOTES TO CONSOLIDATED FINANCIAL STATEMENTS". Although Lyondell is involved in numerous and varied legal proceedings, a significant portion of its litigation arises in three contexts: (1) claims for personal injury or death allegedly arising out of exposure to the Company's products; (2) claims for personal injury or death, and/or property damage allegedly arising out of the generation and disposal of chemical wastes at Superfund and other waste disposal sites; and (3) claims for personal injury and/or property damage and air and noise pollution allegedly arising out of the operation of the Company's facilities. The following sections of this Item 3 describe these types of pending proceedings. Lyondell (either directly or through ARCO as its indemnitee) is the real party at interest in these proceedings. Claims Related To Company Products ARCO and the Company are involved in numerous suits arising in whole or in part from the operation of the Company's, including LCR, petrochemical and petroleum processing businesses and the assets related thereto in which the plaintiffs allege damages arising from exposure to allegedly toxic chemical products, such as benzene and butadiene. Plaintiffs in these cases usually worked at a manufacturing facility as employees of one of Lyondell's customers, were employees of the Company's contractors, or were employees of companies involved in the transportation of the Company's products to its customers. These suits allege toxic effects of exposure to chemicals sold in the ordinary course of business to third parties by various industrial concerns, including ARCO or the Company, or allege toxic chemical exposures at the Company's manufacturing facilities. Issues common to these cases include: (1) whether the plaintiff can identify a specific product to which he was allegedly exposed; (2) whether the Company supplied the identified product to which plaintiff claims he was exposed; (3) whether the plaintiff has a medical condition which, based upon competent scientific and medical evidence, is causally related to the identified product; (4) whether, and under what conditions, the plaintiff was exposed to the identified product; and (5) if the plaintiff was exposed, whether the Company has any legal defenses to the plaintiff's claims and whether there are other parties or defendants to whom the Company can turn for contribution or indemnification. The Company believes that it has always followed a policy of not only complying with all mandated standards related to product warnings and exposure levels but also of complying with Company specific standards that were more strict than those imposed by the law. As a result, the Company believes that it has a basis to avail itself of legal defenses against claims regarding its products due to exposures by employees and by claims of exposures from third parties to whom the Company sold its products. The vast majority of chemical exposure cases name a large number of industrial concerns, in addition to the Company, as defendants and are at various stages of discovery. Although the Company does not believe that the pending chemical exposure cases will have a material adverse effect on its business or financial condition, it is difficult to determine the potential outcome of this type of case. The majority of the plaintiffs in chemical exposure legal proceedings request relief in the form of unspecified monetary damages. Furthermore, when specific amounts are requested they often bear no objective relation to the merits of the case. Notwithstanding the foregoing, it is possible that if one or more of the presently pending chemical exposure cases were resolved against ARCO or the Company, the resulting damage award could be material to the Company without giving effect to contribution or indemnification obligations of co- defendants or others, or to the effect of any insurance coverage that may be available to offset the effects of any such award. Claims Relating To Waste Disposal Sites Wastes generated from products produced by facilities transferred from ARCO and now owned by the Company or LCR have, from time to time, been disposed of at third-party landfills. Two of these facilities, known as the "French Ltd." and the "Brio" Sites, both of which are located near Houston, Texas, have been classified as "Superfund" sites under the Comprehensive Environmental Response, Compensation and Liability Act of 1980 (CERCLA). The Environmental Protection Agency (EPA) has named many potentially responsible parties (PRPs) at each site from whom wastes were allegedly received. Based on the current law, the Company does not believe that its obligation to ARCO related to ARCO's share of clean-up costs at either of these sites will result in a liability that will have, individually or in the aggregate, a material adverse effect on the business or financial condition of the Company. It is possible, however, that the Company may be involved in future CERCLA and comparable state law investigations and clean-ups. The current presidential administration recently proposed a plan to significantly revise the Superfund law which is scheduled for reauthorization this year. Because the proposal is so recent and because it is expected to generate strong reactions from business, insurance companies, lenders, municipalities and environmentalists, the Company is not able to predict whether the administration's plan will be enacted or to determine with specificity what the impact would be on the Company. French Ltd. Site Remediation -- At the French Ltd. site, ARCO and the other PRPs have entered into a settlement agreement relating to the allocation of clean-up costs. The EPA approved the clean-up plan and a Consent Decree was entered in the Federal District Court for the Southern District of Texas in the first quarter of 1990. An amendment to the Consent Decree relating to natural resource damage has been negotiated and submitted to the court for approval. The total costs associated with the Consent Decree are currently estimated to be approximately $90 million. The Company believes that its share of clean-up costs (as allocated pursuant to the Cross-Indemnity Agreement) will be no more than five percent of total costs recovered without giving effect to any insurance coverage which may be available to offset these costs. French Ltd. Site Litigation -- Approximately 2,500 plaintiffs have made claims related to wastes in the French Ltd. Superfund site. In each of these cases, ARCO is one of many defendants. These suits generally allege that unspecified chemical waste sent to the site by the defendants caused a decrease in property value, a decrease in plaintiffs' ability to enjoy their property, and unspecified adverse effects on plaintiffs' health. Although some of the lawsuits request relief in the form of unspecified monetary damages, the aggregate amount of actual damages sought in those cases where damages are specified exceeds $5 billion. The aggregate amount of punitive damages sought in those cases where damages are specified exceeds $20 billion. In December, 1992, after mediation, ARCO, along with several other defendants, entered into a preliminary agreement to settle claims of approximately 2,200 plaintiffs. The remaining claims are in pretrial discovery. The Company's obligation to reimburse ARCO for defense costs and settlements related to French Ltd. has not been determined. Brio Site Remediation -- At the Brio site, a definitive agreement allocating these remedial costs among ARCO and other PRPs has been reached. The EPA approved the plan and a Consent Decree between the Department of Justice and a group of PRPs (including ARCO on behalf of its former divisions and subsidiaries) was entered in Federal District Court for the Southern District of Texas, in April, 1991 and remediation work is ongoing. In 1991, various parties filed an appeal to the entering of the Consent Decree after the denial of their motions to intervene in the proceedings. This appeal was denied in December, 1991. The total clean-up cost is currently estimated to be approximately $60 million. The Company believes that its share of the clean-up costs (as allocated pursuant to the Cross-Indemnity Agreement) will be no more than one percent of total costs without giving effect to any insurance coverage which may be available to offset these costs. Brio Site Litigation -- There currently are eight separate pending legal proceedings filed against ARCO or its affiliates and numerous others in connection with the Brio Superfund site. In these proceedings, there are approximately 600 plaintiffs, many of whom are suing in their capacity as next friend of minor children. In each of these cases, ARCO is one of many defendants. Plaintiffs allege personal injury as a result of exposure to various substances that were disposed of or stored at the Brio site. These suits generally allege that defendants were negligent in sending chemical substances to the site and also contain allegations of nuisance and strict liability. The suits involve: a school district alleging damages as a result of the closing of Weber Elementary; employees of the various entities who operated the refining and reprocessing facilities at Brio; and other plaintiffs. All of the lawsuits request relief in the form of unspecified compensatory and exemplary damages. These suits are in pretrial discovery. ARCO (or its affiliate) is the named defendant in the above proceedings. Under the provisions of the Cross-Indemnity Agreement, Lyondell is not obligated to indemnify ARCO for costs arising out of this litigation for which ARCO is insured. Although ARCO is currently litigating the nature and extent of its coverage with its insurance carriers (see "ARCO Insurance Litigation"), Lyondell believes that the ultimate resolution of the above described lawsuits, ARCO's insurance litigation and related issues will not result in any material obligation on the part of Lyondell to ARCO with respect to the Brio and the French Ltd. Superfund Sites. Other Waste Disposal Site Litigation -- The Company and ARCO are named defendants in three of four presently pending lawsuits filed on behalf of 73 plaintiffs in the state district court in Galveston County, Texas involving the alleged release of toxic and hazardous substances from the Hall's Bayou Ranch. LCR sends and, prior to July 1, 1993, Lyondell and its predecessor sent surface water runoff and process waste water from the Refinery to Gulf Coast Waste Disposal Authority (GCWDA) and a portion of the solids output from GCWDA is sent for storage to the Hall's Bayou Ranch site. Plaintiffs claim personal injury, diminution of property value and loss of use and enjoyment of the property. They are seeking $7 billion in actual damages and $28 billion in punitive damages. In March 1993, the Company and ARCO entered a preliminary settlement agreement to resolve these proceedings with all plaintiffs. The proposed settlement is not expected to have a material adverse effect on the Company's financial position. ARCO Insurance Litigation -- On November 21, 1990, ARCO filed suit against certain of its insurers with respect to insurance policies in effect at times during past years. This litigation involves claims for reimbursement of defense costs and environmental expenses incurred by ARCO in connection with ARCO's activities at sites and locations throughout the United States. ARCO's insurers had been participating in the defense of the Company and ARCO for the Mont Belvieu proceedings (see "Claims Related To Company Operations -- Mont Belvieu Litigation") as well as the litigation involving the French Ltd. and the Brio Superfund sites; however, subsequent to the filing of ARCO's lawsuit, the insurers have refused to advance defense costs for these proceedings (and certain other proceedings relating to the Company's products) until the coverage dispute has been resolved. ARCO is currently paying the defense costs in these proceedings, as well as other waste disposal site litigation, pending the resolution of the coverage dispute. It has not been determined whether or not the Company has an obligation to reimburse ARCO for defense costs related to the coverage dispute. Claims Related To Company Operations Mont Belvieu Litigation -- Several organizations and groups of citizens who own property in the vicinity of Mont Belvieu, Texas, have instituted suits for monetary damages and injunctive relief against ARCO and others who own underground storage and transportation facilities in the city of Mont Belvieu. In September, 1980, Warren Petroleum Company (Warren) experienced a leak in one of its underground hydrocarbon storage wells in Mont Belvieu. On March 18, 1983, suit was brought by 34 plaintiffs, naming Warren, ARCO and other companies with operations in Mont Belvieu as defendants. These plaintiffs claimed property damage, and, in some instances, personal injuries allegedly resulting from storage operations in Mont Belvieu. Later, 83 additional plaintiffs joined the suit. Because of the number of plaintiffs, the court divided this lawsuit into three separate lawsuits. In February, 1986, ARCO was granted a directed verdict as to all of the claims of the plaintiffs in the first of the three lawsuits to be tried which had the effect of dismissing all the pending claims without the ability to refile. Thereafter, the plaintiffs in the two remaining cases dropped their claims against ARCO. ARCO remains in these two cases as a result of cross claims for contribution filed by other defendants. These suits have not been set for trial. In 1986, a number of companies that operated facilities in Mont Belvieu, including ARCO, instituted a program to make offers to purchase certain properties in Mont Belvieu. The purpose of the purchase program was to give persons within a certain area the opportunity to move, if they so desired. A number of residents and litigants participated in the program. The implementation of the purchase program described above led to the filing of a new set of lawsuits. There are two separate legal proceedings which have resulted from eight lawsuits filed against ARCO, the Company, and a number of other companies that operate facilities in Mont Belvieu. These claims are made by persons outside of the area designated by the purchase program and are pending in state and federal court. The lawsuits name ARCO and the Company as well as every other company that participated in the purchase program as defendants. In six of the cases, which involve a total of 94 plaintiffs, the city of Mont Belvieu also is named as a defendant. These plaintiffs claim that industry operations, together with incidents that occurred at certain facilities, and the publicity surrounding those incidents, destroyed the value of their property. The plaintiffs also assert that they were discriminated against by the purchase program and that their civil rights were violated since they did not receive an offer to buy their property. The plaintiffs further claim that the purchase violated antitrust provisions of state law, and that the defendants were negligent in their operations and trespassed onto plaintiffs' properties. In December, 1991, the trial court in the lawsuit pending in state district court entered a take nothing summary judgment in favor of ARCO, the Company and other companies who were named as defendants in that lawsuit. The plaintiff sought injunctive relief, recovery of more than $9 million in actual damages and more than $28 million in punitive damages in this case. The plaintiff appealed the adverse ruling. In July, 1992, the state court of appeals in Houston reversed and remanded the case for retrial in a different county based on its interpretation of proper venue. In September, 1993, a summary judgment in the state district court in the new county was granted in favor of all defendants in this matter. An appeal is pending. All other Mont Belvieu cases were consolidated in the Federal District Court in the Southern District of Texas. In addition to unspecified damages, the aggregate amount of actual damages sought from all defendants in all of these Mont Belvieu cases exceeds $241 million. The aggregate amount of punitive damages sought exceeds $675 million. These lawsuits went to trial on December 1, 1992. On January 11, 1993, after the plaintiffs concluded their offer of evidence, the trial court granted the defendants' motion for directed verdict which dismissed plaintiffs' claims without the ability to refile. An appeal is pending. ARCO is paying all defense costs in all of the Mont Belvieu litigation and the Company does not expect that a claim will be made under the Cross-Indemnity Agreement. Channelview Nuisance Litigation -- In 1992 and 1993, the Company, together with two other corporate defendants, was named as a defendant in two separate lawsuits that were filed in two state district courts in Harris County, Texas. In the first suit, the 15 plaintiffs allege that one or all of the named defendants' facilities emit loud noises, bright lights and noxious fumes in proximity to the plaintiffs' homes. The 15 plaintiffs in the second lawsuit make these same allegations. Some of these latter plaintiffs also allege a diminished quality of the water in their water wells. The two lawsuits have been consolidated. The plaintiffs are claiming, among other things, diminution in property value, interference with the use and enjoyment of their property and personal injuries. The consolidated lawsuits seek unspecified actual damages in excess of $5 million and punitive damages in excess of $20 million. Arceneaux Litigation -- In November, 1993, multiple lawsuits were filed in state district court on behalf of approximately 70,000 plaintiffs residing or doing business in the vicinity of the lower San Jacinto River against hundreds of named businesses, including the Company, owning or operating facilities situated in the vicinity of the Houston Ship Channel alleging, among other things, pollution to the San Jacinto River watershed below the Ship Channel and requesting damages in the aggregate in excess of $1.5 trillion. In January, 1994, one of the suits against a single defendant was non-suited and the three remaining suits were dismissed on the defendants' motion without the ability to refile. Other Matters In April, 1993 the City of Houston, Texas (joining the Texas Air Control Board as a necessary party) filed suit in the state district court of Harris County, Texas against the Company, alleging violations of the Texas Clean Air Act and the Texas Administrative Code and seeking maximum civil penalties and appropriate injunctive relief. In July, 1993 the City of Houston filed an amended and restated petition which added as causes of action certain allegations made by the Texas Air Control Board, now the TNRCC, following its April, 1993 state inspection plan (SIP) inspection. The Company filed a general denial to all allegations of the lawsuit in July, 1993 and is engaged in settlement negotiations with the City and the State. In the fourth quarter of 1992, the Refinery underwent an EPA multi-media inspection and an Occupational Safety and Health Administration (OSHA) Process Quality Verification Audit. The OSHA inspection of the Refinery was resolved in an informal settlement agreement in April, 1993. At this time, the EPA has not formally notified the Company of the enforcement action to be taken, if any. In addition to the matters reported herein, from time to time the Company receives notices from federal, state or local governmental entities of alleged violations of environmental laws and regulations pertaining to, among other things, the disposal, emission and storage of chemical and petroleum substances, including hazardous wastes. Although the Company has not been the subject of significant penalties to date, such alleged violations may become the subject of enforcement actions or other legal proceedings and may (individually or in the aggregate) involve monetary sanctions of $100,000 or more (exclusive of interest and costs). 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 Set forth below are the executive officers of Registrant as of March 1, 1994. Name, Age and Present Business Experience During Past Position with Lyondell Five Years and Period Served as Officer(s) - ---------------------- ------------------------------------------ John R. Beard, 41................. Mr. Beard became Vice President Quality, Vice President, Supply and Planning on July 1, 1993. Quality, Supply and Planning Mr. Beard was appointed Vice President, Planning and Evaluations in May, 1992. He served as the Site Manager of Lyondell's Houston Refinery from 1988 until April, 1992. From 1985 until 1988, he served in management assignments in evaluations, marketing and manufacturing. Prior to 1985, he served in various management positions for ARCO Products Company and the ARCO Chemical Division. He originally joined ARCO in 1974. Bob G. Gower, 56.................. Mr. Gower was elected Chief Executive Officer Chief Executive Officer, of the Company on October 24, 1988 and President and Director Director and President of the Company on June 27, 1988. He has been President of Lyondell and its predecessor, the Lyondell Division, since formation of the Lyondell Division in April, 1985. Mr. Gower was a Senior Vice President of ARCO from June, 1984 until his resignation as an officer of ARCO in January, 1989. Prior to 1984, he served in various capacities with the then ARCO Chemical Division. He originally joined ARCO in 1963. Robert H. Ise, 59................. Mr. Ise was appointed Vice President, Vice President, Marketing, Supply and Evaluations of Lyondell Petrochemical Company LYONDELL-CITGO Refining Company Ltd. on Vice President, July 1, 1993. He previously served Lyondell Marketing, Supply and Evaluations as Vice President, Marketing and Sales, LYONDELL-CITGO Refining Polymers and Petroleum Products from April, Company Ltd. 1992 until June, 1993 and continues to serve as a Vice President of Lyondell. He served as Vice President, Marketing and Sales, Petroleum Products, from December, 1988 until April, 1992. He served as Vice President of Industrial Products Marketing of the Lyondell Division from June, 1987 to December, 1988. From May, 1985 to June, 1987 he served as Director, Industrial Products Marketing for the Lyondell Division. Prior thereto, he served in various marketing capacities for the ARCO Products Division. He originally joined ARCO in 1959. Richard W. Park, 54............... Mr. Park was elected Vice President, Human Vice President, Resources on June 27, 1988. He previously Human Resources served as Vice President of Employee Relations of the Lyondell Division since February, 1987. From 1985 to 1987 he served as Manager of Personnel for the then ARCO Chemical Division's Specialty Chemicals and International Units. Prior to 1985 he held other employee relations positions with divisions of ARCO. He originally joined ARCO in 1965. Name, Age and Present Business Experience During Past Position with Lyondell Five Years and Period Served as Officer(s) - ---------------------- ------------------------------------------ Jeffrey R. Pendergraft, 45........ Mr. Pendergraft was named Senior Vice Senior Vice President, President on May 6, 1993. Mr. Pendergraft Secretary and General Counsel was elected Vice President and General Counsel on June 27, 1988 and Secretary on October 24, 1988. From September, 1985 to June, 1988, he served as General Attorney of the Lyondell Division. Prior to September, 1985, he served as an attorney for various operating divisions and corporate units of ARCO at increasing levels of responsibility. He originally joined ARCO in 1972. W. Norman Phillips, Jr., 39....... Mr. Phillips was elected Vice President, Vice President, Channelview Operations on May 6, 1993. From Channelview Operations May 22, 1992 until May 6, 1993, he served as Site Manager of Channelview Operations. He previously served as Manager, Planning from August, 1991 until May, 1992. Prior to August, 1991, he served in various positions in manufacturing and marketing for ARCO and Lyondell, including Sales Manager in the Petroleum Products Marketing Department from September, 1987 until August, 1991. He originally joined ARCO in 1977. Joseph M. Putz, 53................ Mr. Putz was elected Vice President and Vice President Controller on October 24, 1988. Previously and Controller he was Vice President, Control and Administration of Lyondell, and its predecessor, the Lyondell Division, from June, 1987 to October, 1988. From 1986 to 1987 he served as Director, Internal Control of ARCO. From 1985 to 1986 he served as Manager of Special Projects for ARCO. Prior to 1985, he held various financial positions with divisions of ARCO. He originally joined ARCO in 1965. Dan F. Smith, 47.................. Mr. Smith was elected a Director of the Executive Vice President and Company on October 24, 1988. He was elected Chief Operating Officer Executive Vice President and Chief Operating Officer on May 6, 1993. He served as Vice President Corporate Planning of ARCO from October, 1991 until May, 1993. He previously served as Executive Vice President and Chief Financial Officer of the Company from October, 1988 to October, 1991 and as Senior Vice President of Manufacturing of Lyondell, and its predecessor, the Lyondell Division, from June, 1986 to October 1988. From August, 1985 to June, 1986, Mr. Smith served as Vice President of Manufacturing for the Lyondell Division. He joined the Lyondell division in April, 1985 as Vice President, Control and Administration. Prior to 1985, he served in various financial, planning and manufacturing positions with ARCO. He originally joined ARCO in 1968. Name, Age and Present Business Experience During Past Position with Lyondell Five Years and Period Served as Officer(s) ---------------------- ------------------------------------------ Debra L. Starnes, 41.............. Ms. Starnes was appointed Vice President, Vice President, Petrochemicals Business Management and Petrochemicals Business Management Marketing on July 1, 1993. She previously and Marketing served as Vice President, Petrochemicals Business Management from May 22, 1992 to July, 1993. She served as Vice President, Corporate Planning from September, 1991 until May, 1992. From January, 1989 to September, 1991, she served as Director, Planning. Prior to 1989, she held various manufacturing, marketing and planning positions with ARCO and Lyondell. She originally joined ARCO in 1975. Russell S. Young, 45.............. Mr. Young was elected Senior Vice President, Senior Vice President, Chief Financial Officer and Treasurer on Chief Financial Officer May 7, 1992. He previously served as Vice and Treasurer President and Treasurer from November, 1988 until May, 1992. Mr. Young served as Controller of the ARCO Products Division from September, 1986 to January, 1989. From July, 1984 to September, 1986 he served as Assistant Treasurer of ARCO. Prior thereto he served in corporate finance positions for ARCO. He originally joined ARCO in 1980. (a) The By-Laws of the Company provide that each officer shall hold office until the officer's successor is elected or appointed and qualified or until the officer's death, resignation or removal by the Board of Directors. DESCRIPTION OF CAPITAL STOCK The authorized capital stock of the Company currently consists of 250,000,000 shares of common stock, par value $1 per share. The following summary description of the capital stock of the Company is qualified in its entirety by reference to the Certificate of Incorporation and By-Laws of the Company, copies of which are filed as exhibits to the Company's Registration Statement on Form S-1 (No. 33-25407) and incorporated herein by reference. Common Stock The Company is currently authorized to issue 250,000,000 shares of common stock, of which 80,000,000 shares of common stock are outstanding at the date hereof. Holders of common stock (Stockholders) are entitled (i) to receive such dividends as may from time to time be declared by the Board of Directors of the Company; (ii) to one vote per share on all matters on which the Stockholders are entitled to vote; (iii) to act by written consent in lieu of voting at a meeting of stockholders; and (iv) to share ratably in all assets of the Company available for distribution to the Stockholders, in the event of liquidation, dissolution or winding up of the Company. For additional information regarding the Company's dividend policy, see Item 5 Item 5. Market for Registrant's Common Equity and Related Stockholder Matters The common stock is listed on the New York Stock Exchange. ARCO has advised the Company that, as of March 1, 1994, ARCO owned 39,921,400 shares of the common stock, which represented 49.9 percent of the outstanding shares. The reported high and low sale prices of the common stock on the New York Stock Exchange (New York Stock Exchange Composite Tape) for each quarter from January 1, 1992 through December 31, 1993, inclusive, were: On March 1, 1994 the closing price of the common stock was $22-3/4 and there were 2,976 record holders of the common stock. On January 21, 1994 the Board of Directors declared a quarterly dividend in the amount of $0.225 per share payable on March 15, 1994 to stockholders of record on February 18, 1994. During the last two years, Lyondell has declared per share quarterly cash dividends (which were paid in the subsequent quarter) as follows: * On July 23, 1993, the Board of Directors decreased the amount of the regular quarterly dividend from $0.45 to $0.225 per share. The declaration and payment of dividends is at the discretion of the Board of Directors of the Company. The future declaration and payment of dividends and the amount thereof will be dependent upon the Company's results of operations, financial condition, cash position and requirements, investment opportunities, future prospects and other factors deemed relevant by the Board of Directors. Subject to these considerations and to the legal considerations discussed in the following paragraph, the Company currently intends to distribute to its stockholders cash dividends on its common stock at a quarterly rate of $0.225 per share. In order to declare and pay dividends in the future, the Company's Board of Directors will have to make the determination that for purposes of the General Corporation Law of the State of Delaware (Delaware Law) there is a sufficient amount of surplus (the amount by which its assets exceed its liabilities and capital) at that time or sufficient net profits. In determining the amount of surplus of the Company for purposes of Delaware Law, the Company's assets, including the stock of any of its subsidiaries, may be valued by the Board of Directors at their current market value. If prior to or as a result of any future dividend the Company had a negative stockholders' equity, the Company's Board of Directors would have to make the determination that, based upon its familiarity with the Company's business, prospects and financial condition, the Company's recent earnings history and forecast, an appraisal of the Company's assets and discussions with the Company's executive officers, legal department and accountants, the dividend was a permitted dividend under Delaware Law. As detailed on page 12 herein, certain of the Company's debt instruments contain provisions that generally provide that the holders of such debt may, under certain limited circumstances, require the Company to repurchase the debt (Put Rights). In addition to the occurrences described on page 12 herein, the Put Rights may be triggered by the making of certain unearned distributions to stockholders, other than regular dividends, that are followed by a specified decline in public ratings on such debt. Regular dividends are those quarterly cash dividends determined in good faith by the Company's Board of Directors (whose determination is conclusive) to be appropriate in light of the Company's results of operations and capable of being sustained. The determinations described in the paragraphs above were made prior to the declaration of $0.225 per share dividend to be made on March 15, 1994. The Company's $400 million Facility also could limit the Company's ability to pay dividends under certain circumstances. See "Items 1 and 2 -- Finance Matters". During 1993, the Company paid $108 million in dividends. Total dividends paid during the year exceeded cumulative earnings and profits, as computed for federal income tax purposes. Subject to final determination by the Internal Revenue Service, 100 percent of each of the 1993 quarterly dividend payments was considered a return of capital. The operation of certain of the Company's employee benefit plans may result in the issuance of common stock upon the exercise of options granted to employees of the Company, including its officers. Although the terms of these plans provide that additional shares may be issued to satisfy the Company's obligations under the options, the Company from time to time may cause common stock to be repurchased in the market in order to satisfy these obligations. Item 6. Item 6. Selected Financial Data The following table sets forth selected financial information for the Company: (1) The 1993 increase in net income from the cumulative effect of the accounting change for turnarounds was $22 million, or $0.27 per share. See Note 4 to Notes to Consolidated Financial Statements. The 1992 reduction in net income from the cumulative effect of the accounting change for postretirement benefits other than pensions was $18 million, or $.22 per share. See Notes 4 and 16 of Notes to Consolidated Financial Statements. The 1992 increase in net income from the cumulative effect of the accounting change for income taxes was $8 million, or $.10 per share. See Notes 4 and 17 of Notes to Consolidated Financial Statements. (2) Distributions to ARCO were made prior to the initial public offering of the Company's common stock on January 25, 1989. Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations General As discussed in Note 3 of Notes to Consolidated Financial Statements, on July 1, 1993, the Company and CITGO Petroleum Corporation (CITGO) announced the commencement of operations of LYONDELL-CITGO Refining Company Ltd. (LCR), a new entity owned by subsidiaries of the Company and CITGO. LCR owns and operates the refining business, formerly owned by the Company, including the full- conversion refinery (Refinery). LCR is undertaking a major upgrade project at the Refinery to enable the facility to process substantial additional volumes of very heavy crude oil. CITGO will provide a major portion of the funds for the upgrade project as well as the funding of certain capital projects. On July 1, 1993, LCR entered into a long-term crude oil supply contract (Crude Supply Contract) with LAGOVEN, S.A., an affiliate of CITGO. In addition, under terms of a long-term product sales agreement (Products Agreement), CITGO will purchase a substantial portion of the refined products produced at the Refinery. Both LAGOVEN and CITGO are subsidiaries of Petroleos de Venezuela, S.A., the national oil company of Venezuela. The Company believes that the principal benefit from its participation in LCR will be stabilized earnings and cash flow from the refining business. During 1993, the Refinery increased the volumes of heavy Venezuelan crude oil processed and it is anticipated that the Refinery will continue to achieve increased benefits from processing heavy Venezuelan crude oil as it achieves improved operating efficiency. Prior to July 1, 1993, the petrochemical and refining operations of the Company were considered to be a single segment due to the integrated nature of their operations. However, these operations are now considered to be separate segments due to the formation of LCR and the related separate management and operations of that entity. See Note 19 - Segment Information, of Notes to Consolidated Financial Statements. The Petrochemical segment consists of olefins, including ethylene, propylene, butadiene, butylenes and specialty products; polyolefins, including polypropylene and low density polyethylene; aromatics produced at the Channelview Petrochemical Complex, including benzene and toluene; methanol and refinery blending stocks. The Refining segment consists of refined petroleum products, including gasoline, heating oil and jet fuel; aromatics produced at the Refinery, including benzene, toluene, paraxylene and orthoxylene; lubricants; olefins feedstocks and crude oil resales. The following table sets forth sales volumes for the Company's major products, excluding intersegment sales volumes, for the periods indicated. Sales volumes include production, purchases of products for resale, propylene production from the product flexibility unit and draws from inventory. The following table sets forth the Company's sales and other revenues, excluding intersegment sales, for the periods indicated: (*) Crude oil resales consist of revenues from the resale of previously purchased crude oil and from locational exchanges of crude oil that are settled on a cash basis. Crude oil exchanges and resales facilitate the operation of the Company's petroleum processing business by allowing the Company to optimize the crude oil feedstock mix in response to market conditions and refinery maintenance turnarounds and also to reduce transportation costs. RESULTS OF OPERATIONS Overview Net income for 1993 was $26 million or $.33 per share compared with $16 million or $.20 per share in 1992 and $222 million or $2.78 per share in 1991. Earnings for 1993 included a net $13 million after-tax benefit associated with a change in accounting for major maintenance turnarounds consisting of a $22 million favorable adjustment for the cumulative effect related to prior periods, partially offset by a $9 million charge to current operations. Earnings for 1992 reflect a net after-tax charge of $10 million for the cumulative effect related to prior periods of adopting Financial Accounting Standards Board mandated accounting standards for postretirement benefits and income taxes. Excluding the effect of these accounting changes, the earnings decline was primarily due to lower ethylene sales volumes and lower polyolefins margins, partially offset by higher refined products margins. The decrease in 1992 versus 1991 resulted primarily from lower refining and ethylene margins as well as higher maintenance expenses for scheduled and unscheduled downtime at the Refinery. The 1993 results included after-tax charges of $11 million consisting of the cancellation of a capital project, an increase in the environmental reserve and a workforce reduction and realignment and an additional charge of $3 million for an adjustment to deferred income taxes associated with an increase in the federal income tax rate. These charges were partially offset by a benefit of $7 million due to a contract adjustment and LIFO inventory profits. Net income in 1992 included a benefit of $3 million due to an insurance recovery. This compares to a benefit of $25 million in 1991 primarily associated with insurance and litigation settlements and LIFO inventory profits. Refining Segment Revenues Sales and other operating revenues, including intersegment sales, were $2.8 billion in 1993 compared to $3.7 billion in 1992 and $4.5 billion in 1991. The 1993 decrease of $973 million compared to 1992 was due to lower crude oil resale volumes, lower sales prices for refined products and lower resale volumes of purchased light products. Crude oil resale volumes were lower due to reduced logistical purchases required to meet refinery feedstock requirements which were impacted by higher Venezuelan crude oil volumes purchased under the Crude Supply Contract. Refined products sales prices were lower as additional industry supply exceeded demand growth due to additions of oxygenates, primarily MTBE, to meet stricter environmental standards, as well as new industry conversion capacity. The purchase and resale activity for light refined products conducted for logistic and other reasons was curtailed during the current period because, effective with the beginning of LCR operations on July 1, 1993, a majority of the refined products produced at the Refinery are now sold to CITGO under the Products Agreement. The 1992 decrease in sales and other operating revenues of $790 million versus 1991 was primarily due to lower crude oil resales and to lower sales prices and volumes for refined products. The price premium that existed for refined products during 1991 that was caused by the 1990-1991 Gulf War dissipated in 1992 resulting in lower prices. Refined products sales volumes were lower primarily due to lower production resulting from scheduled and unscheduled downtime of major units. Cost of Sales Cost of sales was $2.6 billion in 1993, compared to $3.6 billion in 1992 and $4.2 billion in 1991. The 1993 decrease compared to 1992 of $1,010 million was principally due to lower quantities of crude oil purchased, lower light refined products purchased and lower crude oil prices. Crude oil purchases were lower due to the reduced logistical purchases. Purchases of light refined products were lower primarily due to lower purchases for resale activity. Lower crude oil prices were due to generally lower industry-wide crude oil prices and to the processing of higher volumes of lower priced, heavy Venezuelan crude oil purchased under the Crude Supply Contract. The 1992 decrease compared to 1991 of $605 million was principally due to lower crude oil purchases that were resold and to lower refining feedstock costs. Refining feedstock costs were lower primarily due to lower production resulting from the scheduled and unscheduled downtime and a reduction in crude oil runs due to unfavorable margins. Partially offsetting this decrease were higher maintenance expenses related to the scheduled and unscheduled downtime. Cost of sales was reduced in 1991 by $8 million relating to LIFO inventory profits. Selling, General and Administrative Expenses Selling, general and administrative expenses were $48 million in 1993, compared to $43 million in 1992 and $42 million in 1991. The increase in 1993 compared to 1992 of $5 million resulted primarily from higher personnel and realignment expenses associated with ongoing operations of LCR starting on July 1, 1993. Operating Income Operating income amounted to $81 million in 1993, compared to $49 million in 1992 and $235 million in 1991. The $32 million increase in 1993 compared to 1992 was primarily due to improved refined products margins, partially offset by higher selling, general and administrative expenses. Refined products margins were higher due to processing higher volumes of heavy, low cost Venezuelan crude oil purchased under the Crude Supply Contract. The decrease in operating income of $186 million in 1992 compared to 1991 resulted primarily from lower refined products margins and to higher maintenance expenses. Refined products margins were lower primarily because decreasing product prices more than offset reductions in crude oil costs. Product prices were lower due to the dissipation during 1992 of the Gulf War related price premium created in 1990 and 1991. Higher maintenance expenses and the reduced ability to process higher margin heavy crude oils which resulted from the scheduled and unscheduled downtime of major units during 1992 contributed to lower operating profits. Also contributing to the decrease in operating income during 1992 compared to 1991 was a net reduction in benefits of $11 million from insurance settlements and lower LIFO inventory profits of $8 million. Petrochemical Segment Revenues Sales and other operating revenues, including intersegment sales, were $1.5 billion in 1993 compared to $1.7 billion in 1992 and $2.0 billion in 1991. The 1993 decrease of $169 million compared to 1992 was primarily due to lower olefins and polyolefins sales volumes and prices caused by continued weak demand associated with poor worldwide industry conditions and higher industry production due to reduced maintenance downtime during 1993. The 1992 decrease in sales and other operating revenues of $284 million versus 1991 was primarily due to lower sales prices for olefins and methanol. Olefins sales prices were negatively affected by the continued weak worldwide economy and by additional industry production capability due to capacity additions. Cost of Sales Cost of sales was $1.4 billion in 1993 compared to $1.5 billion in 1992 and $1.7 billion in 1991. The 1993 decrease of $124 million compared to 1992 and the 1992 decrease of $175 million compared to 1991 were principally due to lower olefins feedstock costs due to the curtailment of production resulting from the poor economic conditions and to a lesser extent to lower feedstock prices. Cost of sales was reduced in 1993 and 1992 by $5 million and $2 million, respectively, and was increased $2 million in 1991 relating to LIFO inventory adjustments. Operating Income Operating income amounted to $57 million in 1993 compared to $102 million in 1992 and $213 million in 1991. The decrease of $45 million in operating income in 1993 compared to 1992 was primarily due to lower ethylene sales volumes and lower polyolefins margins. Ethylene sales volumes and polyolefins margins were lower primarily due to poor industry and economic conditions. The decrease of $111 million in operating income in 1992 compared to 1991 was primarily due to lower ethylene and methanol margins. Ethylene margins were negatively affected by the continued weak worldwide economy and by industry capacity additions. Methanol sales prices were lower due to the dissipation during 1992 of the Gulf War related price premium created during 1990 and 1991. Contributing to the decrease in operating income was the absence of a $12 million one-time gain recorded in 1991 for proceeds received from an out-of- period settlement of litigation. Unallocated and Headquarters Selling, General and Administrative General and administrative expenses were $45 million in 1993, $47 million in 1992 and $49 million in 1991. The reduction of $2 million in general and administrative expenses in 1993 compared to 1992 and in 1992 compared to 1991 primarily resulted from lower personnel related costs. Interest Expense and Interest Income Interest expense was $74 million in 1993 compared to $79 million in 1992 and $74 million in 1991. The $5 million reduction in interest expense in 1993 compared to 1992 was primarily caused by a reduction of outstanding debt due to the prepayment of amounts due under capitalized leases during April, 1992. The $5 million increase in 1992 compared to 1991 resulted from higher average debt outstanding in 1992 which more than offset lower interest rates. Interest income was $2 million in 1993 compared to $10 million in 1992 and $14 million in 1991. The $8 million decrease in 1993 versus 1992 was primarily due to lower amounts of cash available for investment. The $4 million decrease in 1992 versus 1991 was primarily due to lower interest rates and to a lesser extent to lower amounts of cash available for investment. Minority Interest in LYONDELL-CITGO Refining Company Ltd. Minority interest was $5 million in 1993 representing CITGO's allocation of LCR's income. Income Tax The effective income tax rate during 1993 from continuing operations was 73.1 percent compared to 27.3 percent for 1992 and 34.6 percent for 1991. The difference for 1993, between the effective tax rate and the federal statutory rate was primarily due to a charge to state deferred taxes related to Texas franchise taxes and the unfavorable impact on federal deferred taxes of the increase in the federal tax rate. The difference for 1992 was primarily due to a state income tax adjustment, tax exempt income related to company owned life insurance and tax exempt interest. FINANCIAL CONDITION Investing Activities Cash flows associated with investing activities during 1993 included capital expenditures of $60 million, excluding $9 million related to the Refinery upgrade project, of which $38 million was for environmentally related projects at the Refinery and the Channelview Complex. During 1992, capital expenditures were $97 million, of which $57 million was for environmentally related projects. The 1994 capital expenditures budget, excluding the Refinery upgrade project, has been set at $90 million. The budget provides $60 million for refinery projects, $26 million of which are to be funded by Lyondell according to the terms of the agreement with LCR and $34 million to be funded from the restricted cash balance which was created by CITGO's 1993 contributions to LCR. The remaining $30 million is for petrochemical projects at the Channelview Complex. In addition to the capital expenditures budget, $150 million of spending, funded by CITGO, is planned for the Refinery upgrade project designed to increase the Refinery's ability to process larger volumes of very heavy Venezuelan crude oil. As of December 31, 1993, $73 million of cash and $6 million of short-term investments were restricted for use in LCR capital projects, including the Refinery upgrade project and other expenditures as determined by the LCR owners. Financing Activities Cash flows associated with financing activities during 1993 included $108 million of dividend payments, $29 million for scheduled repayments of Medium-Term Notes and $4 million of net proceeds from short-term debt. In December 1993, the Company completed a five-year, $400 million revolving credit facility with a group of banks, representing an increase in amount and term compared to the Company's previous $300 million bank credit facility, which was scheduled to terminate in July, 1994. Borrowings under the new credit facility bear interest based on Euro-Dollar, CD or Prime rates, at the Company's option. The facility is available for working capital and general corporate purposes as needed. This credit facility contains covenants relating to dividend payments, debt incurrence, liens, disposition of assets, mergers and consolidations, fixed charge and leverage ratios and certain payments to LCR. At December 31, 1993, no amounts were outstanding under this credit facility. See Note 11 of Notes to Consolidated Financial Statements. Effective July 1, 1993, LCR entered into a 364 day unsecured $100 million revolving credit facility with a group of banks. Under terms of the credit facility, LCR may borrow with interest based on prime, LIBOR or CD rates at LCR's option or have letters of credit issued on its behalf. The facility is available for working capital and general corporate purposes as needed. At December 31, 1993, no amounts were outstanding under this credit facility. See Note 11 of Notes to Consolidated Financial Statements. On January 21, 1994, the Board of Directors declared a quarterly dividend in the amount of $.225 per share of common stock, payable March 15, 1994 to stockholders of record on February 18, 1994. During 1993, all of the $108 million of dividend payments exceeded cumulative earnings and profits in 1993, as computed for federal income tax purposes subject to final determination by the Internal Revenue Service, and will be considered a return of capital to all stockholders. See Note 13 of Notes to Consolidated Financial Statements. Environmental Matters Various environmental laws and regulations impose substantial requirements upon the operations of the Company. The Company's policy is to be in compliance with such laws and regulations, which include, among others, the Comprehensive Environmental Response, Compensation and Liability Act of 1980 (CERCLA), as amended, the Resource Conservation and Recovery Act (RCRA) and the Clean Air Act and Clean Air Act Amendments of 1990. ARCO, along with many other companies, has been named a potentially responsible party (PRP) under CERCLA in connection with the past disposal of waste at third party waste sites. The Company may have an obligation to reimburse ARCO for a portion of the remediation costs for two of those sites pursuant to the Cross-Indemnity Agreement. The Company reserves for contingencies, including those based upon unasserted claims, that are probable and reasonably estimable. In connection with environmental matters, the Company established reserves based upon known facts and circumstances. Based on current environmental laws and regulations, the Company believes that it has adequately reserved for the matters described above and, based upon such reserves, does not anticipate any material adverse effect upon its earnings, operations or competitive position, although the resolution in any reporting period of one or more of these matters could have a material impact on the Company's results of operations for that period. The environmental reserve on December 31, 1993 was $24 million. The environmental reserve includes $0.5 million of estimated advances to ARCO for remediation costs associated with CERCLA waste disposal sites and $23.5 million of estimated remediation costs related to waste disposal sites located within the Company's facilities associated with RCRA. The Company spent $627,000, $593,000 and $1 million in 1993, 1992 and 1991, respectively, relating to CERCLA matters. The Company also spent $2 million, $158,000 and $224,000 in 1993, 1992 and 1991, respectively, in conjunction with RCRA matters. The Company estimates it will incur approximately $7 million of costs in conjunction with CERCLA and RCRA matters in 1994 which is included in the December 31, 1993 environmental reserve. Current Business Outlook The year 1993 was difficult for the petrochemical and refining industries which are sensitive to economic cycles. Downward pressure on petrochemical sales prices continued during 1993 due to significant increases in manufacturing capacity, which has occurred since early 1991, coupled with weak worldwide demand growth. Profitability and cash flows for the petrochemical and refining businesses are affected by market conditions, feedstock cost volatility, capital expenditures required to meet increasing environmental standards, repair and maintenance costs, and downtime of production units due to turnarounds. Turnarounds on major units can have significant financial impacts due to the repair and maintenance costs incurred as well as loss of production, ultimately resulting in lower profitability. Turnarounds on certain of the Company's major production units are scheduled for 1994; however, the timing of such turnarounds can be accelerated or delayed because of numerous factors, many of which are beyond the Company's control. In view of the above factors, the Company, during 1993, took actions to improve near-term earnings and cash flows and to position the Company for better results as the business environment improves. Those actions included the completion of the refining venture with CITGO, a significant reduction in capital expenditures from the budgeted amount, implementation of a cost reduction program which the Company expects will reduce overhead costs by approximately $30 to $50 million on an annual basis and the reduction of regular quarterly dividends from $.45 per share to $.225 per share beginning with the dividend paid in the third quarter of 1993. The Company's Board of Directors' decision to reduce the dividend reflects the Company's belief that payment of quarterly dividends at the previous level was no longer appropriate in light of current business conditions. The actions taken to conserve cash, including the dividend reduction, were consistent with the Company's objective of maximizing total return to stockholders. The Company believes that its ability to maintain suitable debt ratings, to fund a capital program appropriate to its asset base and to position the Company to benefit from an upturn in the business cycle are critical factors in maintaining and increasing future stockholder value. Progress was made during 1993 in achieving the cost reduction targets, which are reflected primarily within the operating incomes of the Refining and Petrochemical segments. Continued efforts are planned during 1994 to fully achieve these savings. Although future industry conditions cannot be known with certainty, the Company believes that the business climate necessary for improved profitability within its petrochemical segment has begun to stabilize. U.S. ethylene demand grew approximately three percent during 1993 and was particularly strong in the fourth quarter. The rapid increase in world capacity in recent years, which caused a contraction of U.S. exports, has slowed. Domestically, new capacity over the next two years is expected to be relatively in balance with demand growth and there are no additional capacity expansions currently announced for the U. S. after 1995. The Company significantly improved the performance and outlook for its refining business in 1993 with the completion of the refining venture with CITGO. This agreement has stabilized refining margins and improved cash flows. The refining segment began to see the economic benefits from the venture in 1993 and results should further improve through increased utilization of heavy Venezuelan crude oil and recent efficiency improvements. Although the future economic environment cannot be known with certainty, the Company believes that the cash flow management, cost reduction and other steps recently taken have positioned it to capitalize on the anticipated improvement in the business environment. Further, the Company believes that business conditions will be such that cash balances, cash generated from operating activities and existing lines of credit will be adequate to meet future cash requirements for scheduled debt repayments, necessary capital expenditures and to sustain for the reasonably foreseeable future the revised regular quarterly dividend. However, the Company continually evaluates its cash requirements and allocates cash in order to maximize stockholder returns. --------------------- Management cautions against projecting any future results based on present or prior earnings levels because of the cyclical nature of the refining and petrochemical industries and uncertainties associated with the United States and worldwide economies and United States governmental regulatory actions. Item 8. Item 8. Financial Statements and Supplementary Data Index to Consolidated Financial Statements and Financial Statement Schedules Financial statement schedules other than those listed above have been omitted because they are either not applicable or the required information is shown in the financial statements or related notes. REPORT OF INDEPENDENT ACCOUNTANTS To the Stockholders and Board of Directors of Lyondell Petrochemical Company We have audited the accompanying consolidated balance sheet of Lyondell Petrochemical Company as of December 31, 1993 and 1992, and the related consolidated statements of income and accumulated deficit and cash flows for each of the three years in the period ended December 31, 1993, and the related financial statement schedules. 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 Lyondell Petrochemical Company 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. 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 4 to the consolidated financial statements, during 1993 the Company changed its method of accounting for the cost of repairs and maintenance incurred in connection with turnarounds of major units at its manufacturing facilities, and in 1992, the Company changed its method of accounting for income taxes and for postretirement benefits other than pensions. COOPERS & LYBRAND Houston, Texas February 11, 1994 LYONDELL PETROCHEMICAL COMPANY CONSOLIDATED STATEMENT OF INCOME AND ACCUMULATED DEFICIT See notes to consolidated financial statements. LYONDELL PETROCHEMICAL COMPANY CONSOLIDATED BALANCE SHEET See notes to consolidated financial statements. LYONDELL PETROCHEMICAL COMPANY CONSOLIDATED STATEMENT OF CASH FLOWS See notes to consolidated financial statements. LYONDELL PETROCHEMICAL COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. Formation of the Company and Operations In 1985, Atlantic Richfield Company (ARCO) established the Lyondell Petrochemical Company as a division of ARCO (Lyondell Division). Lyondell Petrochemical Corporation, a wholly-owned subsidiary of ARCO, was incorporated in the state of Delaware in 1985 and subsequently changed its name to Lyondell Petrochemical Company (Company). Effective July 1, 1988, ARCO transferred substantially all the assets and liabilities relating to the integrated petrochemical and petroleum processing business of the Lyondell Division to the Company. In addition, certain pipeline assets were transferred to the Company. For financial reporting purposes, the transfer of these assets and liabilities was recorded at the historical net book value of $127 million as of July 1, 1988. On January 25, 1989, ARCO completed an initial public offering of 43,000,000 shares of the Company's 80,000,000 shares of common stock owned by ARCO. The Company received none of the proceeds from the sale. As of December 31, 1993, ARCO owned 39,921,400 shares, which represents 49.9 percent of the outstanding common stock. The Company and LYONDELL-CITGO Refining Company Ltd. (LCR) operate in two business segments: petrochemicals and refining. The Company generally sells its petrochemical products to customers for use primarily in the manufacture of other chemicals and products, which in turn are used in the production of a wide variety of consumer and end-use products. LCR sells its principal refined products primarily to CITGO Petroleum Corporation (CITGO) and to a lesser extent, other marketers of petroleum products. See Note 3. 2. Summary of Significant Accounting Policies Basis of Presentation - The consolidated financial statements include the accounts of the Company and its subsidiaries. All significant transactions between the entities of the Company have been eliminated from the consolidated financial statements. Certain amounts from prior years have been reclassified to conform to current year presentation. Cash, Cash Equivalents and Short-Term Investments - Cash equivalents consist of highly liquid debt instruments such as certificates of deposit, commercial paper and money market accounts purchased with an original maturity date of three months or less. Short-term investments consist of similar investments maturing in more than three months from purchase. The Company's policy is to invest cash in conservative, highly rated instruments and limit the amount of credit exposure to any one institution. The Company performs periodic evaluations of the relative credit standing of these financial institutions which are considered in the Company's investment strategy. Cash equivalents and short- term investments are stated at cost which approximates market value because of the short maturity of these instruments. The Company has no requirements for compensating balances in a specific amount at a specific point in time. The Company does maintain compensating balances for some of its banking services and products. Such balances are maintained on an average basis and are solely at the Company's discretion, so that effectively on any given date, none of the Company's cash is restricted with the exception of cash held for use in connection with LCR capital projects and other expenditures as determined by the LCR owners (see Note 3). LYONDELL PETROCHEMICAL COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) 2. Summary of Significant Accounting Policies - (continued) Accounts Receivable - The Company sells its products primarily to companies in the petrochemical and refining industries. The Company performs ongoing credit evaluations of its customers' financial condition and in certain circumstances requires letters of credit from them. The Company's allowance for doubtful accounts receivable, which is reflected in the consolidated balance sheet as a reduction in accounts receivable, totaled $2 million at December 31, 1993 and 1992. Inventories - Inventories are stated at the lower of cost or market. Cost is determined on the last-in, first-out (LIFO) basis except for materials and supplies, which are valued at average cost. Fixed Assets - Fixed assets are recorded at cost. Depreciation of fixed assets is computed using the straight-line method over the estimated useful lives of the related assets as follows: Manufacturing facilities and equipment - 5 to 30 years Leased assets and improvements - 5 to 20 years Upon retirement or sale, the Company removes the cost of the assets and the related accumulated depreciation from the accounts and reflects any resulting gains or losses in income. Environmental Remediation Costs - Expenditures related to investigation and remediation of contaminated sites which include operating facilities and waste disposal sites, are accrued when it is probable that a liability has been incurred and the amount of that liability can reasonably be estimated. These costs are expensed or capitalized in accordance with generally accepted accounting principles. Futures Contracts - The Company executes futures contracts primarily to hedge fluctuations in product prices and feedstock costs. Changes in the market value of hedging contracts are reported as an adjustment to cost of sales upon completion of the hedged transaction. Exchanges - Crude oil and finished product exchange transactions, which are of a homogeneous nature of commodities in the same line of business, that do not involve the payment or receipt of cash, are not accounted for as purchases and sales. Any resulting volumetric exchange balances are accounted for as inventory in accordance with the normal LIFO valuation policy. Exchanges that are settled through payment and receipt of cash are accounted for as purchases and sales. Income Taxes - Deferred taxes result from temporary differences in the recognition of revenues and expenses for tax and financial reporting purposes and are calculated, effective in 1992 with the adoption of Statement of Financial Accounting Standards (SFAS) No. 109, "Accounting for Income Taxes", based upon cumulative book/tax differences in the balance sheet. 3. Formation of LYONDELL-CITGO Refining Company Ltd. On July 1, 1993, the Company and CITGO announced the commencement of operations of LCR, a new entity formed and owned by the Company and CITGO in order to own and operate the Company's refining business, including the full-conversion Houston refinery (Refinery). LCR is undertaking a major upgrade project at the Refinery to enable the facility to process substantial additional volumes of very heavy crude oil. LCR is a limited liability company organized under the laws of the state of Texas. The Company owns its interest in LCR through a wholly-owned subsidiary, Lyondell Refining Company. CITGO holds its interest through CITGO Refining Investment Company, a wholly-owned subsidiary of CITGO. CITGO has committed to reinvest its share of operating cash flow during the upgrade project, while the Company has unrestricted access to its share of operating cash flow from LCR. LYONDELL PETROCHEMICAL COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) 3. Formation of LYONDELL-CITGO Refining Company Ltd. - (continued) Under the terms of the transaction, CITGO will provide a major portion of the funds for the upgrade project, as well as certain funds for general refinery capital projects. Project engineering for the upgrade is currently underway and at the present time, LCR management anticipates the cost over the next three to four years to be approximately $800 million. Funding for the upgrade project will occur in three phases. The first phase, the initial $300 million, will be funded by CITGO. The second phase will be funded by an LCR borrowing of $200 million. The third phase, which is expected to occur toward the end of the upgrade project, will be a combination of LCR borrowing and contributions from CITGO and the Company. Prior to completion of the upgrade project, the financing costs for the upgrade project loans will be funded by CITGO. The timing of the third phase and the level of contributions from the Company and CITGO will be dependent upon the total cost of the upgrade project. It is currently anticipated that the Company will contribute, in the form of a subordinated loan, 25 percent of the cost of the upgrade project in excess of $500 million ($75 million if the cost of the upgrade project equals $800 million). On July 1, 1993, the Company contributed its refining assets (including the lube oil blending and packaging plant in Birmingport, Alabama) and refining working capital to LCR and retained an approximate 95 percent interest in LCR. CITGO contributed $50 million for future capital projects of LCR and in exchange received an approximate five percent interest in LCR. CITGO also made an additional $50 million contribution for future capital projects of LCR on December 31, 1993. At December 31, 1993, CITGO had an approximate 10 percent interest in LCR. In addition to the funding related to the upgrade project described in the prior paragraph, CITGO has one additional contribution commitment of $30 million to be made upon completion of the upgrade project and it has an option to make an additional equity contribution sufficient to increase its interest to 50 percent. On July 1, 1993, LCR entered into a long-term crude oil supply agreement with LAGOVEN, S.A., an affiliate of CITGO. In addition, under the terms of a long- term product sales agreement, CITGO will purchase a majority of the refined products produced at the Refinery. Both LAGOVEN and CITGO are subsidiaries of Petroleos de Venezuela, S.A., the national oil company of Venezuela. Also effective July 1, 1993, the parties entered into multiple agreements for feedstock and product sales between LCR and the Company. These agreements generally are aimed at preserving much of the synergy that previously existed between the Company's refining and petrochemical businesses. LCR and the Company also have entered into a tolling agreement, pursuant to which alkylate and MTBE will be produced at the Channelview Complex for LCR, and various administrative services agreements. With respect to liabilities associated with LCR, the Company generally has retained liability for events that occurred prior to July 1, 1993 and certain on-going environmental projects at the Refinery. LCR generally is responsible for liabilities associated with events occurring after June 30, 1993 and on- going environmental compliance inherent to the operation of the Refinery. At December 31, 1993, $73 million of cash and $6 million of short-term investments were restricted for use in connection with LCR capital projects, including the Refinery upgrade project and other expenditures as determined by the LCR owners. LYONDELL PETROCHEMICAL COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) 4. Accounting Changes In the first quarter of 1993, effective January 1, 1993, the Company changed its method of accounting for the cost of repairs and maintenance incurred in connection with turnarounds of major units at its manufacturing facilities. Under the new method, turnaround costs exceeding $5 million are deferred and amortized on a straight-line basis until the next planned turnaround, generally four to six years. In prior years, all turnaround costs were expensed as incurred. The Company believes that the new method of accounting is preferable in that it provides for a better matching of turnaround costs with future product revenues. The cumulative effect of this accounting change for years prior to 1993 resulted in a benefit of $33 million ($22 million or $.27 per share after income taxes), and was included in first quarter income. The change resulted in $9 million after-tax (or $.11 per share) of additional amortization expenses during the year ended December 31, 1993. In the fourth quarter of 1992, the Company adopted, effective January 1, 1992, the provisions of SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions", requiring the accrual of postretirement benefits. The applicable postretirement benefits include medical and life benefit plans. In prior years, expenses for these plans were recognized on a pay-as-you-go basis. The change resulted in a decrease of 1992 net income before cumulative effect of accounting changes of approximately $3 million (or $.04 per share). The unfavorable effect of this accounting change through December 31, 1991 amounted to $28 million before taxes or $18 million (or $.22 per share) net of tax and was charged against 1992 income. In the fourth quarter of 1992, the Company adopted, effective January 1, 1992, the provisions of SFAS No. 109, "Accounting for Income Taxes". The Statement requires, among other things, a change from the deferred to the liability method of computing deferred income taxes. The favorable cumulative effect of this accounting change on years prior to 1992 was an $8 million (or $.10 per share) reduction in the Company's deferred tax liability and was included in 1992 income. The favorable effect of the change on 1992 net income, excluding the cumulative effect upon adoption, was $2 million (or $.02 per share). Effective January 1, 1992, the Company adopted SFAS No. 112, "Employers' Accounting for Postemployment Benefits". The standard requires companies to accrue the cost of postemployment (prior to retirement) benefits either during the years that the employee renders the necessary service or at the date of the event giving rise to the benefit, depending upon whether certain conditions are met. The effect of adoption did not have a material impact on 1992 net income. 5. Related Party Transactions Related party transactions with ARCO are summarized as follows: In addition, sales to an affiliate, ARCO Chemical Company, consisting of benzene, ethylene, propylene, butylene, methanol and other products and services, were $263 million, $296 million and $355 million for the years ended December 31, 1993, 1992 and 1991, respectively. LYONDELL PETROCHEMICAL COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) 6. Supplemental Cash Flow Information Supplemental cash flow information is summarized as follows: As of December 31, 1993, fixed assets included $16 million of non-cash additions of which $14 million related to accounts payable accruals. 7. Inventories The categories of inventory and their book values at December 31, 1993 and 1992, were as follows: For the years ended December 31, 1993, 1992 and 1991, the Company reduced cost of sales by approximately $6 million, $1 million and $6 million, respectively, associated with the reduction in LIFO inventories. The excess of the current cost of inventories over book value was approximately $56 million and $135 million at December 31, 1993 and 1992, respectively. 8. Fixed Assets The components of fixed assets at December 31, 1993 and 1992, were as follows: 9. Deferred Charges and Other Assets Deferred charges and other assets at December 31, 1993 and 1992, was comprised of the following: LYONDELL PETROCHEMICAL COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) 10. Other Accrued Liabilities Other accrued liabilities at December 31, 1993 and 1992, were as follows: 11. Long-Term Debt and Financing Arrangements Long-term debt at December 31, 1993 and 1992, was comprised of the following: Aggregate maturities of long-term debt during the five years subsequent to December 31, 1993 are as follows: 1994-$8 million; 1995-$10 million; 1996-$150 million; 1997-$112 million; 1998-$32 million. Effective July 1, 1993, LCR entered into a 364 day unsecured revolving credit facility with a group of banks with Continental Bank, N.A., as agent. Under terms of the credit facility, LCR may borrow a maximum of $100 million in the form of cash or letters of credit with interest based on prime, LIBOR or CD rates at LCR's option. The credit facility may be extended at the request of LCR upon consent of the bank group. The credit facility contains covenants that limit LCR's ability to modify certain significant contracts, dispose of assets or merge or consolidate with other entities. At December 31, 1993, no amounts were outstanding under this credit facility. During December, 1993, the Company finalized a five year, $400 million unsecured revolving credit facility (Credit Facility) which replaced its existing $300 million credit facility which was due to expire in July, 1994. In connection with the Credit Facility, the Company paid administrative, arrangement and commitment fees totaling $3.2 million. At December 31, 1993, no amounts were outstanding under the Credit Facility. Under the terms of the Credit Facility, the interest rate is based on Euro- Dollar or CD rates, at the Company's option, and also is dependent upon the Credit Facility utilization rate and the Company's debt ratings. The Credit Facility contains restrictive covenants regarding the incurrence of additional debt, the maintenance of certain fixed charge coverage and leverage ratios and the making of contributions to LCR, as well as the payment of dividends to the extent that the Company's net income after January 1, 1994 generally does not exceed, over time, dividends declared or paid after that date. The Credit Facility's debt incurrence covenant restricts the incurrence by the Company of additional debt, including debt under the Credit Facility, unless, immediately after giving effect to the additional borrowing, the ratio of earnings before depreciation, amortization, interest and income taxes, to interest expense exceeds the limits set forth in the Credit Facility. However, the debt incurrence covenant does not become applicable until the debt incurred by the Company after December 31, 1993 exceeds $75 million. LYONDELL PETROCHEMICAL COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) 11. Long-Term Debt and Financing Arrangements- (continued) During March, 1992, the Company completed the placement of $200 million of Notes consisting of $100 million of 8.25 percent Notes due 1997 and $100 million of 9.125 percent Notes due 2002. A majority of the proceeds was used in April, 1992 to prepay amounts due under capitalized leases relating to the olefins plants, which allowed the Company to terminate the leases and acquire ownership of the plants. The Company's Medium-Term Notes mature at various dates from 1994 to 2005 and have a weighted average interest rate at December 31, 1993 and 1992 of 9.85 percent. The Notes due 1996 and 1999, and the Medium-Term Notes contain provisions that would allow the holders to require the Company to repurchase the debt upon the occurrence of certain events together with specified declines in public ratings on the Notes due 1996 and 1999. Certain events include acquisitions by persons other than ARCO or the Company of more than 20 percent of the Company's common stock, any merger or transfer of substantially all of the Company's assets, in connection with which the Company's common stock is changed into or exchanged for cash, securities or other property and payment of certain "special" dividends. At December 31, 1993, the Company had letters of credit outstanding totaling $33.8 million. Based on the borrowing rates currently available to the Company for debt with terms and average maturities similar to the Company's debt portfolio, the fair value of long-term debt is $776 million. 12. Earnings Per Share Earnings per share were computed based on the weighted average number of shares outstanding of 80,000,000 for the years ended December 31, 1993, 1992 and 1991. 13. Stockholders' Equity (Deficit) Dividends - During 1993, the Company paid a regular dividend to stockholders in the amount of $.45 per share during the first and second quarters and a regular dividend to stockholders in the amount of $.225 per share during each of the remaining two quarters. During 1992, the Company paid regular quarterly dividends of $.45 per share. During 1991, the Company paid a regular dividend to stockholders in the amount of $.40 per share during the first quarter and $.45 per share during each of the remaining three quarters. Return of Capital - During 1993, the Company paid $108 million in dividends. Total dividends paid during the year exceeded cumulative earnings and profits, as computed for federal income tax purposes. Subject to final determination by the Internal Revenue Service, 100 percent of each of the 1993 quarterly dividend payments was considered a return of capital. Stock Options - The Company's Executive Long-Term Incentive Plan (LTI Plan), became effective November 7, 1988. The LTI Plan provides, among other things, for the granting to officers and other key management employees of non-qualified stock options for the purchase of up to 1,295,000 shares of the Company's common stock. The number of options exercisable each year is equal to 25 percent of the number granted after each year of continuous service starting one year from the date of grant. The LTI Plan provides that the option price per share will not be less than 100 percent of the fair market value of the stock on the effective date of the grant. As of December 31, 1993, options covering 761,732 shares were outstanding under the LTI Plan of which 283,056 were exercisable at a weighted average price of $22.10 per share. LYONDELL PETROCHEMICAL COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued) 13. Stockholders' Equity (Deficit) - (continued) The Company's Incentive Stock Option Plan (ISO Plan) became effective January 12, 1989. The ISO Plan is a qualified plan which provides for the granting of stock options for the purchase of up to 550,000 shares of the Company's common stock. All employees of the Company who are not on the executive payroll are eligible to participate in the ISO Plan, subject to certain restrictions. Various restrictions apply as to when and to the number of stock options that may be exercised during any year. In no event, however, may a stock option be exercised prior to the first anniversary of the date the stock option was granted. As of December 31, 1993, options covering 476,665 shares were outstanding at an average exercise price of $29.35 per share. These options were held by 2,053 eligible employees. At December 31, 1993, no stock options were exercisable. The following summarizes stock option activity for the ISO Plan: LYONDELL PETROCHEMICAL COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued) 14. Leases At December 31, 1993, future minimum rental payments for operating leases with noncancelable lease terms in excess of one year were as follows: LYONDELL PETROCHEMICAL COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued) 14. Leases-(Continued) Operating lease net rental expenses for 1993, 1992 and 1991 were $43 million, $35 million and $33 million, respectively. 15. Retirement Plans All Lyondell and LCR employees are covered by defined benefit pension plans. Retirement benefits are based on years of service and the employee's compensation primarily during the last three years of service. The funding policy for these plans is to make periodic contributions as required by applicable regulations. Lyondell and LCR accrue pension costs based on an actuarial valuation and fund the plans through contributions to separate trust funds that are kept apart from Lyondell or LCR's funds. Lyondell and LCR also have unfunded supplemental nonqualified retirement plans which provide pension benefits for certain employees in excess of the qualified plans' limits. The following table sets forth the funded status of Lyondell and LCR's retirement plans and the amounts recognized in the Company's consolidated balance sheet at December 31, 1993 and 1992: The Company's net pension cost for 1993, 1992 and 1991 included the following components: LYONDELL PETROCHEMICAL COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) 15. RETIREMENT PLANS - (CONTINUED) The assumptions used as of December 31, 1993, 1992 and 1991, in determining the pension costs and pension liability shown above were as follows: Lyondell and LCR also maintain voluntary defined contribution Capital Accumulation and Savings plans for eligible employees. Under provisions of the plans, Lyondell and LCR contribute an amount equal to 150 percent of employee contributions up to a maximum Lyondell or LCR contribution of 6 percent of the employee's base salary for the Capital Accumulation plans and 200 percent of employee contributions up to a maximum Lyondell or LCR contribution of 2 percent of the employee's base salary for the Savings plans. Lyondell and LCR contributions to these plans totaled $8 million in 1993, $7 million in 1992 and $7 million in 1991. 16. Postretirement Benefits Other Than Pensions Lyondell and LCR sponsor unfunded defined benefit postretirement plans other than pensions that cover both salaried and non-salaried employees which provide medical and life insurance benefits. The postretirement health care plans are contributory while the life insurance plans are non-contributory. Currently, Lyondell and LCR pay approximately 80 percent of the cost of the health care plans, but reserve the right to modify the cost-sharing provisions at any time. The following table sets forth the plans' separate postretirement benefit liabilities as of December 31, 1993 and 1992: Net periodic postretirement benefit costs for 1993 and 1992 included the following components: LYONDELL PETROCHEMICAL COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) 16. POSTRETIREMENT BENEFITS OTHER THAN PENSIONS - (continued) For measurement purposes, the assumed annual rate of increase in the per capita cost of covered health care benefits was 13 percent for 1993-1996, 9 percent for 1997-2001, and 6 percent thereafter. The health care cost trend rate assumption has a significant effect on the amounts reported. To illustrate, increasing the assumed health care cost trend rates by one percentage point in each year would increase the accumulated postretirement benefit liability as of December 31, 1993 by $10 million and the net periodic postretirement benefit cost for the year then ended by $1 million. The accumulated postretirement benefit obligation was calculated utilizing a weighted-average discount rate of 7.25 percent and 8.75 percent at December 31, 1993 and 1992, respectively, and an average rate of salary progression of 5 percent in each year. Lyondell and LCR's current policy is to fund the postretirement health care and life insurance plans on a pay-as-you-go basis. 17. 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 SFAS No. 109, "Accounting for Income Taxes" (see Note 4). As permitted under the new standard, prior years' financial statements have not been restated. During 1993, the Company increased its provision for deferred income taxes by $3 million due to an increase in the federal corporate income tax rate from 34 percent to 35 percent effective January 1, 1993. Significant components of the Company's provision for income taxes attributable to continuing operations follows: Prior to the change in accounting methods, the components of the Company's provision for deferred income taxes for the year ended December 31, 1991 were as follows (millions of dollars): LYONDELL PETROCHEMICAL COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) 17. 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 liabilities and assets as of December 31, 1993 and 1992 are as follows: Pretax income from continuing operations for the years ended December 31, 1993, 1992 and 1991 was taxed under domestic jurisdictions only. The reconciliation of income tax attributable to continuing operations computed at the U.S. federal statutory tax rates to the Company's effective tax rates follows: 18. COMMITMENTS AND CONTINGENCIES The Company has various purchase commitments for materials, supplies and services incident to the ordinary conduct of business. In the aggregate, such commitments are not at prices in excess of current market. In connection with the transfer of assets and liabilities from ARCO to the Company, the Company agreed to assume certain liabilities arising out of the operation of the Company's integrated petrochemical and petroleum processing business prior to July 1, 1988. In connection with the transfer of such liabilities, the Company and ARCO entered into an agreement (Cross-Indemnity Agreement) whereby the Company has agreed to defend and indemnify ARCO against certain uninsured claims and liabilities which ARCO may incur relating to the operation of the business of the Company prior to July 1, 1988, including certain liabilities which may arise out of pending and future lawsuits. LYONDELL PETROCHEMICAL COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) 18. COMMITMENTS AND CONTINGENCIES - (CONTINUED) ARCO indemnified the Company under the Cross-Indemnity Agreement with respect to other claims or liabilities and other matters of litigation not related to the assets or business included in the consolidated financial statements. ARCO has also indemnified the Company for all federal taxes which might be assessed upon audit of the operations of the Company included in the consolidated financial statements prior to January 12, 1989, and for all state and local taxes for the period prior to July 1, 1988. In addition to lawsuits for which the Company has indemnified ARCO, the Company is also subject to various lawsuits and proceedings. Subject to the uncertainty inherent in all litigation, management believes the resolution of these proceedings will not have a material adverse effect upon the Company's operations. The Company's policy is to be in compliance with all applicable environmental laws. The Company is subject to extensive environmental laws and regulations concerning emissions to the air, discharges to surface and subsurface waters and the generation, handling, storage, transportation, treatment and disposal of waste materials. Some of these laws and regulations are subject to varying and conflicting interpretations. In addition, the Company cannot accurately predict future developments, such as increasingly strict requirements of environmental laws, inspection and enforcement policies and compliance costs therefrom which might affect the handling, manufacture, use, emission or disposal of products, other materials or hazardous and non-hazardous waste. Subject to the terms of the Cross-Indemnity Agreement, the Company is currently contributing funds to the cleanup of two waste sites (French Ltd. and Brio, both of which are located near Houston, Texas) under the Comprehensive Environmental Response, Compensation and Liability Act (CERCLA) as amended and the Superfund Amendments and Reauthorization Act of 1986. The Company is also subject to certain assessment and remedial actions at the Refinery under the Resource Conservation and Recovery Act (RCRA). In addition, the Company has negotiated an order with the Texas Water Commission, now the Texas Natural Resource Conservation Commission (TNRCC), for assessment and remediation of groundwater and soil contamination at the Refinery. The Company has accrued $24 million related to future CERCLA, RCRA and TNRCC assessment and remediation costs, of which $7 million is included in current liabilities while the remaining amounts are expected to be incurred over the next three to seven years. However, it is possible that new information about the sites for which the reserve has been established, or future developments such as involvement in other CERCLA, RCRA, TNRCC or other comparable state law investigations could require the Company to reassess its potential exposure related to environmental matters. In the opinion of management, any liability arising from these matters will not have a material adverse effect on the consolidated financial condition of the Company, although the resolution in any reporting period of one or more of these matters could have a material impact on the Company's results of operations for that period. 19. SEGMENT INFORMATION As discussed in Note 3, the refining operations of the Company were contributed to LCR effective July 1, 1993. Prior to July 1, 1993, the petrochemical and refining operations of the Company were considered to be a single segment due to the integrated nature of their operations. However, these operations are now considered to be separate segments due to the formation of LCR and the related separate management and operations of that entity. The Petrochemical segment consists of olefins, including ethylene, propylene, butadiene, butylenes and specialty products; polyolefins, including polypropylene and low density polyethylene; aromatics produced at the Channelview Complex, including benzene and toluene; methanol and refinery blending stocks. LYONDELL PETROCHEMICAL COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) 19. SEGMENT INFORMATION - (CONTINUED) The refining segment is primarily composed of the LCR venture (see Note 3) and consists of refined petroleum products, including gasoline, heating oil and jet fuel; aromatics produced at the Refinery, including benzene, toluene, paraxylene and orthoxylene; lubricants; olefins feedstocks and crude oil resales. Crude oil resales consist of revenues from the resale of previously purchased crude oil and from locational exchanges of crude oil that are settled on a cash basis. Crude oil exchanges and resales facilitate the operation of the Company's petroleum processing business by allowing the Company to optimize the crude oil feedstock mix in response to market conditions and refinery maintenance turnarounds and also to reduce transportation costs. Crude oil resales amounted to $401 million, $893 million and $1,308 million for years ended December 31, 1993, 1992 and 1991, respectively. Consolidated sales to CITGO totaled $864 million in 1993, $282 million in 1992 and $181 million in 1991. No other customer accounted for 10 percent or more of consolidated sales. Summarized below is the segment data for the Company which includes certain pro forma adjustments necessary to present the petrochemical and refining operations as individual segments for periods prior to the formation of LCR. These adjustments relate principally to allocations of costs and expenses between the two segments and are based on current operating agreements between the Company and LCR. Intersegment sales between petrochemical and refining segments include olefins feedstocks produced at the Refinery and gasoline and fuel oil blending stocks produced at the Channelview Complex and were made at prices based on current market values. LYONDELL PETROCHEMICAL COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) 19. SEGMENT INFORMATION - (CONTINUED) LYONDELL PETROCHEMICAL COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) 20. Unaudited Quarterly Results (*) The 1992 quarterly results have been restated to reflect the adoption during the fourth quarter of 1992, of accounting changes which were effective January 1, 1992. In addition, the first two quarters of 1993 and all four quarters of 1992 include certain pro forma adjustments necessary to present the petrochemical and refining operations as individual segments for periods prior to the formation of LCR effective July 1, 1993. 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 Set forth below are the directors of the Registrant as of March 1, 1994. The executive officers of the Registrant are listed on page 19 herein. Mike R. Bowlin, 51............ Mr. Bowlin was elected a Director of the Chairman of the Board Company on July 23, 1993 and Chairman of the Board on August 13, 1993. He has been President and Chief Operating Officer of ARCO since June 1, 1993 and a director of ARCO since June, 1992. He was an Executive Vice President of ARCO from June, 1992 to May, 1993. He was a Senior Vice President of ARCO from August, 1985 to June, 1992 and President of ARCO International Oil and Gas Company from November, 1987 to June, 1992. He was Senior Vice President of International Oil and Gas Acquisitions from July, 1987 to November, 1987. He was President of ARCO Coal Company from August, 1985 to July, 1987. He was a Vice President of ARCO from October, 1984 to July, 1985. From April, 1981 to December, 1984, he was Vice President of ARCO Oil and Gas Company. He has been an officer of ARCO since October, 1984. He originally joined ARCO in 1969. William T. Butler, 61....... Dr. Butler was elected a Director of the Company on December 21, 1988, effective as of January 25, 1989. He has held his current position as President and Chief Executive Officer of Baylor College of Medicine (education and research) since 1979. He is also a director of First City Bancorporation of Texas, Inc., C. R. Bard, Inc. and Browning-Ferris Industries Inc. Allan L. Comstock, 50........ Mr. Comstock was elected a Director of the Company on July 23, 1993. He has been a Vice President and Controller of ARCO since June, 1993. He was a Vice President of ARCO Chemical from October, 1989 through May, 1993. From November, 1985 to September, 1989 he was General Auditor of ARCO. He originally joined ARCO in 1969. Terry G. Dallas, 43.......... Mr. Dallas was elected a Director of the Company on July 23, 1993. He has been a Vice President of ARCO since June, 1993 and Treasurer of ARCO since January 24, 1994. He was Vice President, Corporate Planning of ARCO from June, 1993 to January, 1994. He served as Assistant Treasurer for ARCO Corporate Finance from 1990 to 1993. He was Vice President of Finance, Control and Planning for ARCO British, Ltd. from 1988 to 1990 and Manager of International Acquisitions for ARCO International Oil and Gas Company from 1986 to 1988. He originally joined ARCO in 1979. Bob G. Gower, 56............. Mr. Gower was elected Chief Executive Officer President and Chief of the Company on October 24, 1988 and a Executive Officer Director and President of the Company on June 27, 1988. He has been President of Lyondell and its predecessor, the Lyondell Division, since the formation of the Lyondell Division in April, 1985. Mr. Gower was a Senior Vice President of ARCO from June, 1984 until his resignation as an officer of ARCO in January, 1989. Prior to 1984 he served in various capacities with the then ARCO Chemical Division. He originally joined ARCO in 1963. Mr. Gower is also a director of Texas Commerce Bank-Houston and Keystone International Inc. Stephen F. Hinchliffe, Jr. 60. Mr. Hinchliffe was elected a Director of the Company on March 1, 1991. Since 1988, he has held his current position of Chairman of the Board and Chief Executive Officer of BHH Management, Inc., the managing partner of Leisure Group, Inc. Previously, he served as Chairman of the Board of Leisure Group, Inc. (a manufacturer of consumer products), which he founded in 1964. Dudley C. Mecum II, 59....... Mr. Mecum was elected a Director of the Company on November 28, 1988, effective as of January 25, 1989. He has held his current position as a partner with G. L. Ohrstrom & Company (merchant banking) since August, 1989. Previously he was Chairman of Mecum Associates, Inc. (management consulting) from December, 1987 to August, 1989. He served as Group Vice President and director of Combustion Engineering Inc. from 1985 to December, 1987, and as a managing partner of the New York region of Peat, Marwick, Mitchell & Co. from 1979 to 1985. He is also a director of The Travelers, Inc., Dyncorp, VICORP Restaurants, Inc., Fingerhut Companies, Inc. and Roper Industries, Inc. William C. Rusnack, 49...... Mr. Rusnack was elected a Director of the Company on October 24, 1988. He has been a Senior Vice President of ARCO since July 1990 and President of ARCO Products Company since June, 1993. He was President of ARCO Transportation Company from July, 1990 to May, 1993. He was Vice President, Corporate Planning, of ARCO from July, 1987 to July, 1990. He was Senior Vice President, Marketing and Employee Relations, of the ARCO Oil and Gas Division from August, 1985 to July, 1987 and Vice President, Manufacturing, of the ARCO Products Division from July, 1984 to August, 1985. From June 1983 to July, 1984 he was Vice President, Planning and Control, of the ARCO Products Division. He originally joined ARCO in 1966. Mr. Rusnack is also a director of BWIP Holding, Inc. Dan F. Smith, 47.............. Mr. Smith was elected a Director of the Executive Vice President Company on October 24, 1988. He was elected and Chief Operating Officer Executive Vice President and Chief Operating Officer on May 6, 1993. He served as Vice President Corporate Planning of ARCO from October, 1991 until May, 1993. He previously served as Executive Vice President and Chief Financial Officer of the Company from October, 1988 to October, 1991 and as Senior Vice President of Manufacturing of Lyondell, and its predecessor, the Lyondell Division, from June, 1986 to October, 1988. From August, 1985 to June, 1986 Mr. Smith served as Vice President of Manufacturing for the Lyondell Division. He joined the Lyondell Division in April, 1985 as Vice President, Control and Administration. Prior to 1985, he served in various financial, planning and manufacturing positions with ARCO. He originally joined ARCO in 1968. Paul R. Staley, 64........... Mr. Staley was elected a Director of the Company on November 28, 1988, effective as of January 25, 1989. He has held his current position as Chairman of the Executive Committee of the Board of Directors of P. Q. Corporation (an industry supplier of silicates) since January, 1991. He held the positions of President and Chief Executive Officer of P.Q. Corporation from 1973 and 1981, respectively, until January, 1991. William E. Wade, Jr., 51..... Mr. Wade was elected a director of the Company on August 13, 1993. He has been Executive Vice President of ARCO since June 1, 1993 and a director of ARCO since June 1, 1993. He was a Senior Vice President of ARCO from May, 1987 to May, 1993 and President of ARCO Oil and Gas Company from October, 1990 to May, 1993. He was President of ARCO Alaska, Inc. from July, 1987 to July, 1990. He was a Vice President of ARCO from 1985 to May, 1987. From 1981 to 1985, he was Vice President of ARCO Exploration Company. He has been an officer of ARCO since 1985. He originally joined ARCO in 1968. ITEM 11. ITEM 11. Executive Compensation EXECUTIVE COMPENSATION The following table sets forth information as to the Chief Executive Officer and the next four most highly compensated executive officers of the Company. SUMMARY COMPENSATION TABLE - ----------- In accordance with the transition provisions applicable to the revised proxy rules covering disclosure of executive compensation adopted under the Securities Exchange Act of 1934 (the "Proxy Rules"), amounts of other annual compensation and all other compensation are excluded for the Company's 1991 fiscal year. (a) Special bonuses were paid in 1993 in recognition of the executive officers' and other key employees' significant contributions during 1992 and 1993 to the successful completion of the Company's refining venture with CITGO Petroleum Corporation and Lagoven S.A. (b) Includes imputed income in respect of the Long-Term Disability Plan, tax gross-ups in respect of financial counseling reimbursements and in respect of other miscellaneous items, and the amount of incremental interest accrued under the Executive Deferral Plan that exceeds 120 percent of a specified IRS rate. "Tax gross-ups" refers to the additional reimbursement paid to a recipient to cover the federal income tax obligations associated with the underlying benefit, including an additional amount, based on maximum applicable income tax rates. (c) Amounts shown in the LTIP Payouts column represent payment of performance units (including associated dividend share credits) awarded under the Company's Executive Long-Term Incentive Plan (the "LTIP"). The LTIP provides for the granting of stock options and the right to receive performance units under certain circumstances and a cash payment in respect of dividend share credits as described in this footnote. Dividend share credits are allocated to an optionee's account whenever dividends are declared on shares of common stock. The number of dividend share credits to be allocated on each record date to an optionee's account is computed by multiplying the dividend rate per share of Common Stock by the sum of (i) the number of shares subject to outstanding options, (ii) the number of performance units and (iii) the number of dividend share credits then credited to the optionee's account and dividing the resulting figure by the fair market value of a share of Common Stock ("FMV") on such dividend record date. As future dividends are declared, the participant will receive dividend share credits not only on the number of shares covered by unexercised options and the number of performance units but also on the number of dividend share credits in the participant's account. The dividend crediting mechanism will continue to operate in this manner (i) with respect to options, until the participant exercises such options or the options expire, and (ii) with respect to performance units, until payment is made (or not made, as the case may be) in respect of performance units. Dividend share credits do not represent earned compensation and have no definite value, if any, until the date on which the options or performance units, as applicable, in respect of which such credits have been allocated, are exercised or paid. See footnote (b) to the Aggregated Option Exercises and Fiscal Year-End Option Values Table. Dividend share credits are canceled upon an optionee's termination of employment under certain specified circumstances. In addition to the dollar amounts shown in the LTIP Payouts column, the number of dividend share credits accrued to the accounts of the named executives during 1993 and 1992, respectively, is as follows: Mr. Gower: 13,819 and 13,200; Mr. Smith: 2,405 and 4,399; Mr. Pendergraft: 3,414 and 2,885; Mr. Young: 2,625 and 2,311; and Mr. Ise: 3,384 and 2,900. (d) Includes contributions to the Executive Supplementary Savings Plan, incremental executive medical plan premiums, financial counseling reimbursements and certain amounts in respect of the Executive Life Insurance Plan, as follows: (e) In 1993 a revised methodology was adopted to calculate certain amounts in respect of the Executive Life Insurance Plan; accordingly, 1992 amounts have been restated to reflect this methodology. The effect of this restatement is not material to the overall figure previously reported. (f) Mr. Smith was elected Executive Vice President and Chief Operating Officer on May 6, 1993. The salary figure for 1993 is the amount paid to Mr. Smith for his service from that date. Prior to that he served as Vice President Corporate Planning of ARCO from October, 1991. He previously served as Executive Vice President and Chief Financial Officer of the Company from October, 1988 to October, 1991. The salary figure for 1991 is the amount paid to Mr. Smith for that portion of the year he was employed by the Company. (g) Includes relocation expenses in connection with his relocation to Houston of $540,000 for the loss from the sale of a home. Mr. Smith also received $370,000 as a tax gross-up in connection with that loss, which is included in this column. (h) Mr. Ise served as Vice President, Marketing and Sales, Polymers and Petroleum Products through June 30, 1993. Effective as of July 1, 1993, Mr. Ise began providing services as a loaned executive as a Vice President of LYONDELL-CITGO Refining Company Ltd., a limited liability company in which the Company currently owns an approximate 90% interest and CITGO Petroleum Corporation owns an approximate 10% interest. LYONDELL-CITGO Refining Company Ltd. reimburses the Company for the cost of salary and other compensation paid to Mr. Ise. Mr. Ise continues to serve as a Vice President of Lyondell. EXECUTIVE LONG-TERM INCENTIVE PLAN The LTIP provides for the granting of stock options, the right to receive performance units under certain circumstances and a cash payment in respect of dividend share credits. The following table describes the grants to the named executive officers of stock options and certain other information with respect to the exercise of stock options. No performance units were granted in 1993. Additional information with respect to payouts of performance units under the LTIP is contained in the Summary Compensation Table. OPTIONS OPTION GRANTS IN LAST FISCAL YEAR The following table provides information regarding stock options granted to the named executive officers during 1993. The values assigned to each reported option are shown using the Black-Scholes option pricing model. In assessing these values it should be kept in mind that no matter what theoretical value is placed on a stock option on the date of grant, its ultimate value will be dependent on the market value of the company's stock at a future date. - ----------- (a) The ten-year options were granted on March 5, 1993 pursuant to the LTIP at an exercise price equal to the FMV on the date of grant. The options become exercisable in four equal annual installments beginning March, 1994. Options and the dividend share credits associated with such options are canceled upon an optionee's termination of employment under certain specified circumstances. Stock options also carry eligibility for dividend share credits as described in footnote (c) to the Summary Compensation Table. (b) The values shown reflect a variation of the Black-Scholes pricing model. The pricing model used by the Company includes the following assumptions: options are exercised at the end of the 10-year term; no premium for risk is assigned; the dividend yield is assumed to be the current yield on the date of grant; and a long-term (200 days) historical volatility rate is applied. The values relate solely to stock options (and not performance units) and do not take into account risk factors such as nontransferability and limits on exercisability. The values do take into account the fact that dividend share credits are allocated to an optionee's account whenever dividends are declared on shares of common stock. (c) Mr. Smith was not an executive officer when options were granted in 1993. See footnote (f) to the Summary Compensation Table. The following table shows the number of shares of Common Stock represented by outstanding stock options held by each of the named executive officers as of December 31, 1993. Also reported are the values for "in-the-money" options which represent the positive spread between the exercise price of any such existing stock options and the year end price of common stock. AGGREGATED OPTION EXERCISES IN 1993 AND FISCAL YEAR-END OPTION VALUES - ---------- (a) The FMV of Lyondell Common Stock on December 31, 1993 was $21.25 (b) Each option carries with it the right to dividend share credits, as described in footnote (c) to the Summary Compensation Table. Set forth below is a calculation of the value of accrued dividend share credits, assuming exercise at December 31, 1993, of the in-the-money options. These hypothetical values have been calculated for illustration purposes only. ANNUAL PENSION BENEFITS The following table shows estimated annual pension benefits payable to the Company's employees, including executive officers of the Company, upon retirement on January 1, 1994 at age 65 under the provisions of the Lyondell Retirement Plan and the Executive Supplementary Retirement Plan. PENSION PLAN TABLE - --------- (a) The amounts shown in the above table are necessarily based upon certain assumptions, including retirement of the employee on January 1, 1994 and payment of the benefit under the basic form of allowance provided under the Lyondell Retirement Plan (payment for the life of the employee only with a guaranteed minimum payment period of 60 months). The amounts will change if the payment is made under any other form of allowance permitted by the Lyondell Retirement Plan, or if an employee's retirement occurs after January 1, 1994, since the "annual covered compensation level" of such employee (one of the factors used in computing the annual retirement benefits) may change during the employee's subsequent years of membership service. The benefits shown are not subject to deduction for Social Security benefits or other offset amounts. The plans, however, provide a higher level of benefits for the portion of compensation above the compensation levels on which Social Security benefits are based. (b) As of December 31, 1993, the credited years of service (rounded to the nearest whole number) under the Lyondell Retirement Plan for the named executive officers are: Mr. Gower, 30; Mr. Smith, 17; Mr. Pendergraft, 21; Mr. Young, 13; and Mr. Ise, 34. (c) All employees' (including executive officers') years of service with ARCO prior to the creation of Lyondell have been credited under the Company's retirement plans. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT PRINCIPAL STOCKHOLDERS The Company's principal stockholder, ARCO, is one of the nation's leading integrated oil companies and maintains its headquarters at 515 South Flower Street, Los Angeles, California 90071. At March 1, 1994 ARCO owned 39,921,400 shares of Lyondell's Common Stock, which represent 49.9 percent of the outstanding stock. ARCO has consistently maintained an ownership position of just under 50 percent of Lyondell's Common Stock from the date of the Company's public offering of stock; however, there is no assurance that ARCO will maintain such ownership position in the future. ARCO officers and directors do not constitute a majority of the Board of Directors; however, ARCO officers and directors hold five of eleven directorships. Beginning in 1989, the Company was not included as a consolidated subsidiary in ARCO's financial statements; however, for certain securities laws purposes, ARCO could be deemed to be a "control" person or an "affiliate" of Lyondell. The table below sets forth certain information as of December 31, 1993 (the most recent date as of which the Company has information) regarding the beneficial ownership of the Common Stock by persons other than ARCO known by the Company to own beneficially more than five percent of its outstanding shares of Common Stock. - ---------- (a) Wellington Management Company ("WMC") (together with its wholly-owned subsidiary, Wellington Trust Company, National Association) may be deemed a beneficial owner of the 5,356,300 shares by virtue of the direct or indirect investment and/or voting discretion they possess pursuant to the provisions of investment advisory agreements with clients. WMC has shared dispositive power over the 5,356,300 shares of Common Stock, including the 5,083,900 shares beneficially owned by Vanguard/Windsor Fund Inc., an investment advisory client of WMC. SECURITY OWNERSHIP OF MANAGEMENT The following table sets forth the number of shares of Common Stock owned beneficially as of March 1, 1994 by each director, each of the executive officers named on the Summary Compensation Table and by all current directors and officers as a group. As of March 1, 1994, the percentage of shares of Common Stock beneficially owned by any director, named executive officers or by all directors and officers as a group, did not exceed one percent of the issued and outstanding Common Stock. Unless otherwise noted, each individual has sole voting and investment power. (a) Includes shares held by the trustees under the Lyondell Capital Accumulation Plan and the Lyondell Savings Investment Plan for the accounts of participants as of December 31, 1993. (b) The amounts shown include shares that may be acquired within 60 days following March 1, 1994 through the exercise of stock options, as follows: Mr. Gower, 112,137; Mr. Smith, 20,366; Mr. Pendergraft, 23,285; Mr. Young, 20,704; Mr. Ise, 25,879 and all directors and officers as a group, including those just named, 272,984. (c) Does not include 1,000 shares held by a trust of which Mr. Hinchliffe is a trustee, as to which shares he disclaims beneficial ownership. (d) Does not include 1,100 shares owned by Mr. Young's spouse, as to which shares he disclaims beneficial ownership. (e) Does not include 5,059 shares owned by spouses and a trust, as to which shares beneficial ownership is disclaimed. Compliance with Section 16(a) of the Securities Exchange Act of 1934 Section 16(a) of the Securities Exchange Act of 1934 requires the Company's directors and executive officers, and persons who own more than eleven percent of a registered class of the Company's equity securities, to file with the Securities and Exchange Commission ("SEC") and the New York Stock Exchange initial reports of ownership and reports of changes in ownership of Common Stock of the Company. 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. To the Company's knowledge, based solely on review of the copies of such reports furnished to the Company and written representations that such reports accurately reflect all reportable transactions and holdings, during the fiscal year ended December 31, 1993 all Section 16(a) filing requirements applicable to its officers, directors and greater than ten-percent beneficial owners were complied with. ITEM 13. ITEM 13. Certain Relationships and Related Transactions TRANSACTIONS BETWEEN THE COMPANY AND ARCO In connection with the transfer of assets and liabilities to Lyondell, the Company and ARCO entered into a number of agreements for the purpose of defining their ongoing relationships. In addition, in July 1987 the Lyondell Division and ARCO Chemical Company ("ARCO Chemical"), then a wholly owned subsidiary of ARCO, entered into a number of agreements in connection with the organization of ARCO Chemical. None of these agreements was the result of arm's-length negotiations between independent parties. It was the intention of the Company, ARCO and ARCO Chemical that such agreements and the transactions provided for therein, taken as a whole, accommodate the parties' interests in a manner that was fair to the parties, while continuing certain mutually beneficial joint arrangements. The Audit Committee of the Board of Directors of the Company, none of the members of which are affiliated with the Company (including LCR), ARCO or ARCO Chemical has determined that such agreements, taken as a whole, were fair to the Company and its stockholders. Because of the complexity of the various relationships between the Company, ARCO and its direct and indirect subsidiaries, including ARCO Chemical (together, "ARCO Affiliates"), however, there can be no assurance that each of such agreements, or the transactions provided for therein, has been effected on terms at least as favorable to the Company as could have been obtained from unaffiliated third parties. The terms and provisions of many of those initial agreements have been modified subsequently or supplemented and additional or modified agreements, arrangements and transactions have been and will continue to be entered into by the Company and ARCO Affiliates. Any such future agreements, arrangements and transactions will be determined through negotiation between the Company and ARCO Affiliates and it is possible that conflicts of interest will be involved. Future contractual relations among the Company and ARCO Affiliates will be subject to certain provisions of the Company's Certificate of Incorporation. See "Certificate of Incorporation Provisions Relating to Corporate Conflicts of Interest." In addition, the Audit Committee of the Board of Directors has adopted a set of guidelines for the review of all agreements entered into between the Company and ARCO Affiliates. These guidelines include a provision that, at least annually, the Audit Committee will review such agreements, or the transactions provided for therein, to assure that such agreements are, in its opinion, fair to the Company and its stockholders. For the year ended December 31, 1993, Lyondell (including LCR) paid ARCO Affiliates an aggregate of approximately $80 million. For the year ended December 31, 1993, Lyondell recorded revenues of approximately $278 million from sales to ARCO Affiliates, of which $263 million represented sales to ARCO Chemical. THE FOLLOWING IS A SUMMARY OF CERTAIN AGREEMENTS, ARRANGEMENTS AND TRANSACTIONS AMONG THE COMPANY AND ARCO AFFILIATES EFFECTIVE DURING THE PAST FISCAL YEAR, AS WELL AS CERTAIN AGREEMENTS, ARRANGEMENTS AND TRANSACTIONS THAT ARE CURRENTLY PROPOSED. TECHNOLOGY TRANSFERS AND LICENSES Effective July 1, 1988, ARCO assigned to the Company numerous domestic and foreign trademarks and certain U.S. and foreign patents and granted the Company a nonexclusive license to use other trademarks which contain the word "ARCO," to use ARCO's spark symbol as a logo and to use ARCO's color striping scheme, which license was royalty-free for a period of four years. The Company paid ARCO approximately $80,000 under the terms of this license in 1993. In connection with the transfer of assets and liabilities relating to the Lyondell Division from ARCO to the Company, the Company and ARCO, effective July 1, 1988, entered into (i) a License Agreement pursuant to which ARCO licensed to the Company on a nonexclusive, royalty-free basis certain rights (including Lyondell's right to sublicense to third parties, in some cases without accounting to ARCO) to ARCO's technology and intellectual property related to certain operations or assets of the Company, (ii) a technology assignment agreement pursuant to which legal title to certain other technology and intellectual property useful in the Company's business (including, without limitation, technology relating to olefins, including product flexibility) was transferred to the Company; provided, however, that except for technology relating to the product flexibility unit, ARCO retained a nonexclusive license to use the technology and property rights in ARCO's other operations, and (iii) an immunity from suit agreement in respect of the Company's right to practice all remaining technology in the possession of the Company prior to July 1, 1988. During 1990, the Company and ARCO entered into a series of amendments to these agreements designed to clarify the parties' rights under the original technology transfer. In addition, Lyondell and ARCO executed a patent maintenance agreement pursuant to which ARCO agreed to maintain certain patents licensed to Lyondell. Lyondell and ARCO also entered into a letter agreement granting Lyondell the right to obtain additional licensing rights. CROSS-INDEMNITY AGREEMENT In connection with the transfer by ARCO of substantially all of the assets and liabilities of its Lyondell Division to the Company, the Company and ARCO executed a Cross-Indemnification Agreement (the "Cross-Indemnity Agreement"). In the Cross-Indemnity Agreement, the Company agreed generally to indemnify ARCO against substantially all fixed and contingent liabilities relating to the integrated petrochemical and petroleum processing business and certain assets of the Lyondell Division. The liabilities assumed by the Company include the following, to the extent not covered by ARCO's insurance: (a) all liabilities and obligations of the Company and its combined subsidiaries, as of July 1, 1988; (b) all liabilities and obligations under contracts and commitments relating to the business of the Lyondell Division and certain assets relating thereto; (c) employment and collective bargaining agreements affecting the Company's employees; (d) specified pending litigation and other proceedings; (e) federal, state, foreign and local income taxes to the extent provided in the Cross-Indemnity Agreement; (f) liabilities for other taxes associated with the Lyondell Division's business and certain assets relating thereto; (g) liabilities for any past, present or future violations of federal, state or other laws (including environmental laws), rules, regulations or other requirements of any governmental authority in connection with the business of the Lyondell Division and certain assets relating thereto; (h) existing or future liabilities for claims based on breach of contract, breach of warranty, personal or other injury or other torts relating to such integrated petrochemical and petroleum processing businesses and certain assets relating thereto; and (i) any other liabilities relating to the assets transferred to the Company or its subsidiaries. ARCO has indemnified the Company with respect to other claims or liabilities and other matters of litigation not related to the assets or business transferred by ARCO to the Company. The Cross-Indemnity Agreement includes procedures for notice and payment of indemnification claims and provides that a party entitled to indemnification for a claim or suit brought by a third party may require the other party to assume the defense of such claim. The Cross-Indemnity Agreement also includes a defense cost-sharing agreement, whereby the Company will bear its allocated defense costs for certain lawsuits. DISPUTE RESOLUTION AGREEMENT In April 1993, the Company, ARCO and ARCO Chemical entered into a Dispute Resolution Agreement that mandates a procedure for negotiation and binding arbitration of significant commercial disputes among any two or more of the parties. SERVICES AGREEMENTS The Company and ARCO entered into an agreement effective January 1, 1991 and amended as of February, 1992 (the "Administrative Services Agreement") under which ARCO agreed to continue to provide various transitional services to the Company that ARCO had been providing pursuant to previous administrative service agreements. The services which ARCO agreed to provide the Company in the Administrative Services Agreement included employee benefits administration services, payroll, telecommunications and certain computer-related services. The Administrative Services Agreement terminates no later than December 31, 1997 although it may be terminated in its entirety earlier than such date upon the terminating party providing the other party with at least one year's prior notice, and a party may elect to terminate some of the services it is receiving upon 30 days prior notice to the other party. The Administrative Services Agreement provides for an annual renegotiation of fees. ARCO earned a fee of approximately $2 million during 1993 for all of the services which it provided under the Administrative Services Agreement. Effective January 1, 1991, the Company and ARCO entered into an agreement (the "Insurance Termination Agreement") which terminated the insurance coverage previously provided by ARCO and established procedures for the resolution of pending and future claims that are or will be covered under ARCO's policies in effect prior to January 1, 1991. OTHER AGREEMENTS BETWEEN THE COMPANY AND ARCO Lyondell has purchased and LCR continues to purchase certain of its crude oil requirements from ARCO Oil and Gas ("AOGC") under short-term arrangements at prices based on market values at the time of delivery. LCR also purchases crude oil from AOGC from time to time on the spot market at then-current spot market prices. The Company and LCR also purchased natural gas and natural gas liquids from AOGC during 1993 on the spot market at then-current spot market prices. The Company (including LCR) also sold products to ARCO Affiliates, including crude oil resales and sales of heating oil and lube oil at market-based prices. The Company has entered into several contracts with ARCO Pipe Line Company (ARCO Pipe Line) pursuant to which the Company (i) leased certain pipelines and pipeline segments from ARCO Pipe Line at annual rental rates which include recovery of operating costs, return on capital investment and inflation escalators (ii) acquired the services of ARCO Pipe Line to operate various groups of pipelines owned by the Company, (iii) entered into a throughput and deficiency commitment for volumes at tariff rates for transportation of crude oil and other products. Certain of these contracts that relate to the refining business were assigned to LCR as of July 1, 1993. The Company and LCR paid ARCO Pipe Line approximately $20 million during 1993 for rental fees and services under these contracts. ARCO Pipe Line and LCR have agreed to use jointly a control room owned by LCR and located at the Houston Refinery. ARCO Pipe Line also owns various easements and licenses for its pipelines and related equipment located on the property of the Company or LCR and has performed services relating to the pipeline systems. The Company (including LCR) also ships products over common carrier pipelines owned and operated by ARCO Pipe Line pursuant to filed tariffs on the same basis as other non-affiliated customers. AGREEMENTS BETWEEN THE COMPANY AND ARCO CHEMICAL COMPANY Lyondell provides to ARCO Chemical a large portion of the feedstocks purchased by ARCO Chemical for its manufacturing facilities located at Channelview, Texas. Pricing arrangements under these contracts are generally representative of prevailing market prices. Lyondell also provides certain nominal plant services at the aforementioned plants. ARCO Chemical in turn provides certain feedstocks and supplies to Lyondell at market-based prices. The Company processes MTBE (using one of the Company's two MTBE units) for ARCO Chemical, and ARCO Chemical markets this product for its own account. The term of this agreement extends through June 30, 1997. ARCO Chemical purchases certain base feedstocks for this processing agreement from Lyondell at market based prices. A processing fee is paid by ARCO Chemical to Lyondell to cover variable and fixed operating costs, as well as capital costs. In addition, the Company has agreed to sell to ARCO Chemical MTBE produced at the Company's second MTBE unit that is in excess of the Company's requirements at market-based prices. CERTIFICATE OF INCORPORATION PROVISIONS RELATING TO CORPORATE CONFLICTS OF INTEREST In order to address certain potential conflicts of interest between the Company and ARCO (for purposes of this section the term "ARCO" also includes ARCO's successors and any corporation, partnership or other entity in which ARCO owns fifty percent or more of the voting securities or other interest), the Company's Certificate of Incorporation contains provisions regulating and defining the conduct of certain affairs of the Company as they may involve ARCO and its officers and directors, and the powers, rights, duties and liabilities of the Company and its officers, directors and stockholders in connection therewith. In general, these provisions recognize that from time to time the Company and ARCO may engage in the same or similar activities or lines of business and have an interest in the same areas of corporate opportunities. The Certificate of Incorporation provides that ARCO has no duty to refrain from (1) engaging in business activities or lines of business that are the same as or similar to those of the Company, (2) doing business with any customer of the Company or (3) employing any officer or employee of the Company. The Certificate of Incorporation provides that ARCO is not under any duty to present any corporate opportunity to the Company which may be a corporate opportunity for both ARCO and the Company, and that ARCO will not be liable to the Company or its stockholders for breach of any fiduciary duty as a stockholder of the Company by reason of the fact that ARCO pursues or acquires such corporate opportunity for itself, directs such corporate opportunity to another person or does not present the corporate opportunity to the Company. ARCO currently owns interests in certain chemical companies and refiners (other than the Company) and has advised the Company that it may continue to acquire additional interests in chemical companies and refiners. The Certificate of Incorporation provides that directors and officers of the Company will not be liable to the Company or its stockholders for breach of any fiduciary duty if they comply with the following provisions of the Certificate of Incorporation. When a corporate opportunity is offered in writing to an officer or an officer and a director of the Company who is also an officer or an officer and a director of ARCO, solely in his or her designated capacity with one of the two companies, such opportunity shall be first presented to whichever company was so designated. No person is currently in this category. Otherwise, (i) a corporate opportunity offered to any person who is an officer or officer and director of the Company and who is also a director of ARCO, shall be first presented to the Company, (ii) a corporate opportunity offered to a person who is a director of the Company and who is also an officer or officer and director of ARCO shall be first presented to ARCO, (iii) in all other cases, a corporate opportunity offered to any person who is an officer and/or a director of both the Company and ARCO shall be first presented to the Company. Mr. Bowlin, Mr. Comstock, Mr. Dallas, Mr. Rusnack and Mr. Wade are in category (ii) and no persons currently are in categories (i) and (iii). Another section of the Certificate of Incorporation provides that no contract, agreement, arrangement or transaction between the Company and ARCO or between the Company and a director or officer of the Company or of ARCO would be void or voidable for the reason that ARCO or any director or officer of the Company or of ARCO are parties thereto or because any such director or officer were present or participated in the meeting of the Board of Directors which authorized the contract if the material facts about the contract, agreement, arrangement or transaction were disclosed or known to the Board of Directors or the stockholders and the Board of Directors in good faith authorizes the contract by a vote of a majority of the disinterested directors or the majority of stockholders approves such contract, agreement, arrangement or transaction. The foregoing Certificate of Incorporation provisions describe the obligations of officers and directors of the Company with respect to presentation of corporate opportunities, but do not limit the ability of the Company or of ARCO to consider and act upon such opportunities whether or not such provisions have been followed. CERTAIN OTHER TRANSACTIONS During the 1993 fiscal year, Dan F. Smith, a director and the Company's Executive Vice President and Chief Operating Officer, was indebted to the Company in the amount of $349,000. This interest-free loan, which was repaid within seven months and was not outstanding at the end of the year, was made in connection with his relocation to Houston. 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 and 2 -- Consolidated Financial Statements and Financial Statement Schedules: these documents are listed in the Index to Consolidated Financial Statements and Financial Statement Schedules. Exhibits: 3.1 -- Restated Certificate of Incorporation of the Registrant filed with the State of Delaware on November 2, 1988.* 3.2 -- By-Laws of the Registrant.* 4.1 -- Indenture, dated as of May 31, 1989, as supplemented by a First Supplemental Indenture dated as of May 31, 1989, between the Registrant and Texas Commerce Bank National Association, as Trustee.** 4.2 -- Indenture, dated as of March 10, 1992, as supplemented by a First Supplemental Indenture dated as of March 10, 1992, between the Registrant and Continental Bank, National Association, as Trustee.***** 4.3 -- Specimen certificate.* 4.4 -- Form of Medium-Term Note.** 10.1 -- Lyondell Petrochemical Company Amended & Restated Annual Incentive Plan. 10.2 -- Lyondell Petrochemical Company Executive Supplementary Savings Plan.** 10.3 -- Lyondell Petrochemical Company Executive Long-Term Incentive Plan as amended and restated as of October 19, 1990.*** 10.4 -- Lyondell Petrochemical Company Supplementary Executive Retirement Plan, effective October 1, 1990.*** 10.5 -- Lyondell Petrochemical Company Executive Medical Insurance Plan - Summary Plan Description.*** 10.6 -- Lyondell Petrochemical Company Executive Deferral Plan, effective October 1, 1990.**** 10.7 -- Lyondell Petrochemical Company Executive Long-Term Disability Plan, effective October 1, 1990.***** 10.8 -- Lyondell Petrochemical Company Executive Life Insurance Plan, effective October 1, 1990.***** 10.9 -- Lyondell Petrochemical Company Elective Deferral Plan for Outside Directors.**** 10.10 -- Lyondell Petrochemical Company Retirement Plan for Outside Directors, as amended and restated.**** 10.11 -- Lyondell Petrochemical Company Supplemental Executive Benefit Plans Trust Agreement.**** 10.12 -- Form of Registrant's Indemnity Agreement with Officers and Directors.* 10.13 -- Asset Purchase Agreement (conformed without exhibits), dated as of December 19, 1989, between the Registrant and Rexene Products Company.** 10.14 -- Conveyance (conformed without exhibits), dated as of July 1, 1988 between the Registrant and ARCO.* 10.15(a) -- Cross-Indemnification Agreement, dated as of July 1, 1988, between the Registrant and ARCO and Amendment No. 1 to the Cross- Indemnification Agreement effective as of July 1, 1988.* 10.15(b) -- Dispute Resolution Agreement, dated as of April, 1993, between the Registrant, ARCO and ARCO Chemical Company. 10.16(a) -- Administrative Services Agreement, dated as of January 1, 1991, between the Registrant and ARCO.**** 10.16(b) -- Letter Agreement regarding Administrative Services Agreement, between the Registrant and ARCO dated as of February 26, 1992.***** 10.17 -- Agreements Implementing Transfer of Pipeline Rights from ARCO Pipe Line Company to Registrant.* 10.18(a) -- Amended and Restated Limited Liability Company Regulations of LYONDELL-CITGO Refining Company Ltd. dated as of July 1, 1993.****** 10.18(b) -- Contribution Agreement between Lyondell Petrochemical Company and LYONDELL-CITGO Refining Company Ltd. dated as of July 1, 1993.****** 10.18(c) -- Crude oil Supply Agreement between LYONDELL-CITGO Refining Company Ltd. and Lagoven, S.A. dated as of May 5, 1993****** 10.19(a) -- Immunity From Suit Agreement, effective July 1, 1988, between ARCO and the Registrant.* 10.19(b) -- Amendment to Immunity From Suit Agreement, effective July 1, 1988, between ARCO and the Registrant.*** 10.20(a) -- License Agreement, effective July 1, 1988, between ARCO and the Registrant.* 10.20(b) -- License Agreement Amendment, effective July 1, 1988, between ARCO and the Registrant.*** 10.21(a) -- Technology Agreement, effective as of July 1, 1988, between ARCO and the Registrant, as amended.** 10.21(b) -- Technology Agreement Amendment dated September 14, 1990, effective July 1, 1988 between ARCO and the Registrant.*** 10.22 -- Assignment of Common Law Trademark(s), dated October 3, 1988, between ARCO and the Registrant.* 10.23 -- Assignment of U.S. Trademark(s), dated October 3, 1988, between ARCO and the Registrant.* 10.24 -- Crystalline Polymers License and Block Copolymer License dated February 14, 1990 between Phillips Petroleum Co. and the Registrant.** 10.25(a) -- Assignment of Foreign Trademarks, dated October 3, 1988, as amended February 14, 1988, between ARCO and the Registrant.** 10.25(b) -- Assignment of Foreign Trademarks, dated October 24, 1990, between ARCO and the Registrant.*** 10.26 -- Assignment of Patents and Patent Applications, dated December 27, 1988, between ARCO and the Registrant.** 10.27 -- Assignment of Technology Agreement, dated July 1, 1988, as amended, between ARCO and the Registrant.** 10.28 -- Trademark License Agreement, dated October 7, 1988 between, ARCO and the Registrant.** 10.29 -- Trademark License Agreement Amendment, dated October 7, 1991, between ARCO and the Registrant.**** 10.30 -- Symbol Agreement dated July 1, 1988 between ARCO and the Registrant.** 10.31 -- Joint Pipeline Use Agreement, dated July 1, 1987, between ARCO Chemical Company and the Registrant.* 10.32 -- MTBE Purchase, Transportation & Storage Agreement, dated July 1, 1987, between ARCO Chemical Company and the Registrant.* 10.33(a) -- Isobutylene Purchase and MTBE Tolling Agreement, dated July 1, 1987 and amended May 2, 1988, between the Registrant and ARCO Chemical Company.* 10.33(b) -- Amendment No. 1 to Isobutylene Purchase and MTBE Tolling Agreement.***** 10.34 -- LYONDELL-CITGO Refining Company Ltd. $100,000,000 Credit Agreement dated as of July 1, 1993. 10.35 -- Lyondell Petrochemical Company $400,000,000 Credit Agreement dated as of December 6, 1993 22 -- Subsidiaries of the Registrant. 24 -- Consent of Coopers & Lybrand. 25 -- Powers of Attorney * Filed as an exhibit to Registrant's Registration Statement on Form S-1 (No. 33-25407) and incorporated herein by reference. ** Filed as an exhibit to Registrant's Annual Report on Form 10-K Report for the year ended December 31, 1989 and incorporated herein by reference. *** Filed as an exhibit to Registrant's Annual Report on Form 10-K Report for the year ended December 31, 1990 and incorporated herein by reference. **** Filed as an exhibit to Registrant's Annual Report on Form 10-K Report for the year ended December, 31, 1991 and incorporated herein by reference. ***** Filed as an exhibit to Registrant's Annual Report on Form 10-K Report for the year ended December 31, 1992 and incorporated herein by reference. ****** Filed as an exhibit to Registrant's Form 8-K dated as of July 1, 1993 and incorporated herein by reference. (b) Consolidated Financial Statements and Financial Statement Schedules (1) Consolidated Financial Statements Consolidated Financial Statements and Financial Statement Schedules filed as part of this Annual Report on Form 10-K are listed in the Index to Consolidated Financial Statements and Financial Statement Schedules on page 34. (2) Financial Statement Schedules For years ended 1993, 1992, and 1991. V. -- Property, Plant and Equipment. VI. -- Accumulated Depreciation and Amortization of Property, Plant and Equipment. IX. -- Short-Term Borrowings X. -- Supplementary Income Statement Information All other schedules are omitted because they are not applicable or the required information is contained in the Financial Statements or notes thereto. Copies of exhibits will be furnished upon prepayment of 25 cents per page. Requests should be addressed to the Secretary. (c) Reports on Form 8-K: No Current Reports on Form 8-K were filed during the quarter ended December 31, 1993 or thereafter through March 16, 1994. 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. LYONDELL PETROCHEMICAL COMPANY By: BOB G. GOWER ------------------------------------------- Bob G. Gower 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. SCHEDULE V LYONDELL PETROCHEMICAL COMPANY PROPERTY, PLANT AND EQUIPMENT MILLIONS OF DOLLARS SCHEDULE VI LYONDELL PETROCHEMICAL COMPANY ACCUMULATED DEPRECIATION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT MILLIONS OF DOLLARS SCHEDULE IX LYONDELL PETROCHEMICAL COMPANY SHORT-TERM BORROWINGS MILLIONS OF DOLLARS (a) Total of daily outstanding principal divided by the actual number of days in the period (365 days). (b) Actual interest expense on short-term borrowing divided by the average amount outstanding during the period, based upon a 365-day year. SCHEDULE X LYONDELL PETROCHEMICAL COMPANY SUPPLEMENTARY INCOME STATEMENT INFORMATION MILLIONS OF DOLLARS (a) Includes amortization of deferred turnaround costs. See Note 4 of Notes to Consolidated Financial Statements. (b) Includes property, superfund and other taxes. EXHIBIT INDEX

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1993

52795

ITEM 1. BUSINESS OF THE COMPANY. GENERAL Itel Corporation (the "Company" or "Itel"), which was incorporated in Delaware in 1967, is engaged in (i) the distribution of wiring systems products for voice, data and video networks and electrical power applications by Anixter Inc. and its subsidiaries (collectively "Anixter"), (ii) the development and distribution of products used in the cable television industry by ANTEC Corporation and its subsidiaries (collectively "ANTEC"), and (iii) rail car leasing by Itel Rail Corporation and its subsidiaries (collectively "Rail") (see discussion below of the 1992 rail car transaction for the limited nature of the Company's continuing interest in this business). In 1993, ANTEC was changed from a division of Anixter to a subsidiary of the Company and the Company's interest in ANTEC was later reduced to 53% following a public offering of ANTEC common stock. In 1993 and 1992, the Company sold substantially all of its other transportation services assets, except for one short-line railroad which is currently being held for sale. In 1991, the Company sold the distribution services business previously conducted by Itel Distribution Systems, Inc. ("Itel Distribution") and all the stock of Great Lakes International, Inc. which together with its subsidiaries (collectively "Great Lakes") was engaged in heavy marine construction, primarily dredging. At the end of 1990, the Company sold substantially all of its intermodal container leasing assets. For information about these sales see Item 7 -- Financial Liquidity and Capital Resources -- Asset Sales and Other Dispositions and Note 3 of the Notes to the Consolidated Financial Statements. At December 31, 1993, the Company also had investments in securities of other companies, including approximately 9% of the common stock of Santa Fe Energy Resources, Inc. ("Energy") and approximately 9% of the common stock of Catellus Development Corporation ("Real Estate"). In 1991, the Company sold its 15% investment in the common stock of Santa Fe Pacific Corporation ("Santa Fe") and its 21% investment in the common stock of American President Companies, Ltd. ("APC"). The financing operations of Signal Capital Corporation and its subsidiaries (collectively "Signal Capital") and certain remaining other transportation services assets are being held for sale. See Note 3 of the Notes to the Consolidated Financial Statements. As of December 31, 1993, the Company had cumulative net operating loss ("NOL") carryforwards for Federal income tax purposes of approximately $345 million expiring primarily in 1995 through 2007, and investment tax credit ("ITC") carryforwards of approximately $16 million that expire between 1994 and 2001. Certain of these carryforwards have not been examined by the Internal Revenue Service ("IRS") and, therefore, may be subject to adjustment. The availability of tax benefits of NOL and ITC carryforwards to reduce the Company's future Federal income tax liability is subject to various limitations under the Internal Revenue Code of 1986, as amended. These carryforwards are not applicable to ANTEC's results after September 1993. In addition, at December 31, 1993, various foreign subsidiaries of Itel had aggregate cumulative NOL carryforwards for foreign income tax purposes of approximately $50 million which are subject to various tax provisions of each respective country and expire primarily between 1995 and 2003. At December 31, 1993, the Company and its subsidiaries employed approximately 4,600 persons. For information on segment and geographic data see Note 14 of the Notes to the Consolidated Financial Statements. ANIXTER Anixter is a leading supplier of wiring systems, networking and internetworking products for voice, data and video networks and electrical power applications in the United States, Canada, Europe and parts of Asia. Anixter stocks and sells a full line of these products from a network of 87 locations in the United States, 21 in Canada, 20 in the United Kingdom, 23 in Continental Europe, 2 in Mexico, 2 in Australia and single locations in Singapore, Hong Kong and Ireland. Anixter sells approximately 80,000 products to over 60,000 active customers and works with over 2,000 suppliers. Its customers include international, national, regional and local companies that are end users of these products and engage in manufacturing, communications, finance, education, health care, transportation, utilities and government. Also, Anixter sells products to resellers such as contractors, installers, system integrators, value added resellers, architects, engineers and wholesale distributors. The average order size is about $1,000. The products sold by Anixter fall into two broad categories. The first category is communication (voice, data and video) products used to connect personal computers, peripheral equipment, mainframe equipment and various networks to each other. The products include an assortment of transmission media (copper and fiber optic cable) and components, such as adapters, outlets, cable assemblies, crossconnect systems, connectors, terminals, tools, test equipment and power protection devices. Active data components for networking applications include concentrators, intelligent hubs, multiplexers, transceivers, routers and servers. Anixter sells products that are incorporated in local area networks ("LANs"), the internetworking of LANs to form wide area networks ("WANs") and the increased use of fiber optic products in private networks, including factory environments. It is expected that these markets will continue to grow at double digit rates, with international growth somewhat outpacing U.S. growth. Anixter has followed a strategy of regularly expanding its product lines and the services that it provides to its customers. During 1993, Anixter began selling and providing technological support for internetworking products, including routers, as well as video-conferencing and network access products. The second major product category is electrical wiring systems products used for the transmission of electrical energy and control/monitoring of industrial processes. These products include power cables, high temperature or other critical environment cables, armored and control cable, instrumentation and thermalcouple cable, portable power cable, shielded electronic process cables and accessory products. Anixter is not a significant distributor to the residential or commercial construction industries. Prior to 1989, Anixter's operations were limited to the United States, Canada, the United Kingdom and Belgium. In 1989, Anixter made a major commitment to expand its operations into the international voice, data and video communications markets. Since then, Anixter has opened businesses in France, Germany, Italy, Norway, Spain, Sweden, Switzerland, Australia, Mexico, Portugal, Singapore, The Netherlands, Austria and Hong Kong. Anixter also has resident salespersons in Greece and Malaysia along with technical representatives in the Czech Republic, Hungary and Poland. While several of these expansion businesses achieved an operating profit in 1993 and 1992, the international expansion program is still considered to be in the startup mode. Since 1988, Anixter has experienced operating losses relating to the expansion program totalling approximately $33 million. An important element of Anixter's business strategy is to develop and maintain close relationships with its key suppliers, which include the world's leading manufacturers of networking and electrical wiring systems products. Such relationships stress joint product planning, inventory management, technical support, advertising and marketing. In support of this strategy, Anixter does not compete with its suppliers in product design or manufacturing activities. Anixter has developed a competitive advantage through its proprietary computer system which connects all of its warehouses and sales offices throughout the world. The system is designed for sales support, order entry, inventory status, order tracking, credit review and material management. This fully integrated system connects Anixter's 158 worldwide service centers through more than 2,600 terminals. The computer system enables the sales staff to locate products at any location and ship them within 24 hours. Anixter provides a high level of customer service while maintaining a reasonable level of investment in inventory and facilities. Anixter competes with distributors and manufacturers who sell products directly or through existing distribution channels to end users or other resellers. In addition, Anixter's future performance could be subject to economic downturns and possibly rapid changes in applicable technologies. To guard against inventory obsolescence, Anixter has negotiated various return and price protection agreements with its key suppliers. Although Anixter's relationships with its suppliers are good, the loss of a major supplier could have a temporary adverse effect on Anixter's business but would not have a lasting impact since such products are available from alternate sources. ANTEC ANTEC is a leading developer and supplier of optical transmission, construction, rebuild and maintenance equipment for the broadband communications industry. The ANTEC business was originally formed as a division of Anixter in 1969 and, in 1993, ANTEC became a separate subsidiary of Itel. ANTEC's role in the development of new products is to identify new product needs in the broadband communications industry and to work with strategic allies that generally contribute extensive engineering and design services in conjunction with ANTEC's engineers and then manufacture the product for sale by ANTEC. These alliances allow ANTEC to develop innovative products while minimizing its investment in engineering, facilities and equipment. ANTEC is one of the leading suppliers to the cable market for fiber optic products. ANTEC also supplies cable system operators with almost all of the products required in a cable television system, including headend, distribution, drop and in-home subscriber products. ANTEC serves its customers through an efficient delivery network consisting of 23 sales and stocking locations in North America. ANTEC maintains complete inventories and is able to provide overnight as well as staged delivery of product on an "as needed" basis. More than 95% of ANTEC's consolidated sales for the year ended December 31, 1993 came from sales to the cable industry. Demand for these products depends primarily on capital spending by cable operators for constructing, rebuilding, maintaining or upgrading their systems. The amount of capital spending and, therefore, ANTEC's sales and profitability, are affected by a variety of factors, including general economic conditions, access by cable operators to financing, government regulation of cable operators, demand for cable services and technological developments in the broadband communications industry. Technological developments are occurring rapidly in the communications industry and, while the effects of such developments are uncertain, they may have a material adverse effect on the demand for ANTEC products and on the cable industry as a whole. For example, technologies are being implemented that bypass existing cable systems and permit the transmission of signals directly into households. Cable operators are subject to extensive regulation. For example, pursuant to the Cable Act of 1992, the Federal Communications Commission (the "FCC") has adopted regulations that govern cable operators. The regulations generally provide, among other things, for rate rollbacks for basic tier cable service, further rate reductions under certain circumstances and limitations on future rate increases. In addition, the Cable Act of 1992 provides that commercial broadcasting stations may elect (i) to require cable operators to carry their stations, or (ii) to bar cable operators from carrying their stations unless the cable operator agrees to pay to the station a "re-transmission consent fee." Also in 1992, the FCC issued its "video dialtone" ruling which, among other things, allows local telephone companies to transmit all types of enhanced services, including interactive voice, video and data delivery in competition with cable operators. Additionally, in February 1994, the FCC announced that it intends to impose another rate cut of 7% for basic services. These regulations, among others, could limit capital expenditures by cable operators and, thus, could limit or reduce ANTEC's profitability. Moreover, changes in current regulation are possible and could have a similar effect. On August 24, 1993, a Federal district court judge in Alexandria, Virginia declared unconstitutional, on First Amendment grounds, restrictions, as applied to Bell Atlantic Corporation and six other regional phone companies, under the 1984 Cable Act that prevent local exchange telephone companies from providing video programming to subscribers in their own telephone service area. It is uncertain whether this ruling will be upheld on appeal, and it is unclear what long-term effect, if any, this decision and related developments may have on the cable industry in general or ANTEC's business prospects. Similar uncertainty is created by proposed federal legislation to permit competition among cable operators, telephone companies and other companies. Almost all of the products supplied by ANTEC are manufactured for it by domestic and foreign manufacturers. Approximately 23% of ANTEC's aggregate purchases in 1993 were of products manufactured by AT&T, and many ANTEC customers have demonstrated loyalty to AT&T products. In addition, approximately 57% of ANTEC's purchases in 1993 were from its ten largest suppliers. The loss of a significant manufacturing source, such as AT&T, could adversely affect ANTEC's business, although management believes that any such loss is unlikely to have a lasting impact on its business, since such products are generally available from alternate sources. There can be no assurance that the technology applications under development by ANTEC and its strategic partners will be successfully developed or, if they are successfully developed, that they will be widely used by cable operators or that ANTEC will otherwise be able to successfully exploit these technology applications. Furthermore, ANTEC's competitors may develop similar or alternative new technology applications which, if successful, could have a material adverse effect on ANTEC. ANTEC relies on strategic alliances with various manufacturers for the development and production of new technology applications. These strategic alliances are based on business relationships and generally are not subject of written agreements expressly providing for the alliance to continue for a significant period of time. The loss of a strategic partner could have a material adverse effect on the development of the new products under development with that partner. The cable industry is highly concentrated with over 75% of U.S. domestic subscribers being served by approximately twenty-five major multi-system operators ("MSO's"). In 1993, approximately 58% of ANTEC's revenues were obtained from sales to the twenty-five largest MSO's. A significant portion of ANTEC's revenue is derived from sales to Tele-Communications, Inc. (together with its affiliates, "TCI") aggregating $146.1 million, $86.7 million and $58.0 million for the years ended December 31, 1993, 1992 and 1991. In October, 1993, TCI and Bell Atlantic Corporation jointly announced their agreement for the acquisition of TCI and Bell Atlantic. In February, 1994, TCI and Bell Atlantic jointly announced the termination of their acquisition agreement. A variety of factors were identified, including the FCC rate cut, as the reasons for such termination. In the termination announcement, TCI also indicated that it plans to suspend its capital expenditure budget for 1994 by one-half pending clarification of the FCC action. It is not known what effect, if any, the recent FCC and TCI announcements will have on capital spending increases in general, or on ANTEC's performance in particular. However, ANTEC believes that while capital expenditures for some products by some operators may be adversely effected, capital spending for infrastructure improvements and upgrades will continue and, therefore, ANTEC does not anticipate a material adverse impact on its performance as a result of these recent announcements. All aspects of ANTEC's business are highly competitive. ANTEC competes with national, regional and local manufacturers, distributors and wholesalers, including companies larger than ANTEC, such as General Instrument Corporation and Scientific-Atlanta, Inc. Various manufacturers who are suppliers to ANTEC sell directly as well as through distributors into the cable marketplace. In addition, because of the convergence of the cable, telecommunications and computer industries and rapid technological development, new competitors may seek to enter the cable market. Many of ANTEC's competitors or potential competitors are substantially larger and have greater resources than ANTEC. The principal methods of competition are product differentiation, performance and quality; price and terms; and service, technical and administrative support. The future success of ANTEC depends in part on its ability to attract and retain key executive, marketing and sales personnel. Competition for qualified personnel in the cable industry is intense, and the loss of certain key personnel could have a material adverse effect on ANTEC. ANTEC has entered into employment contracts with its executive officers. ANTEC also has a stock option program designed to provide substantial incentives for its employees to remain with ANTEC. RAIL CAR LEASING In June 1992, Itel and Rail completed a transaction with General Electric Capital Corporation and certain of its affiliates ("GECC") pursuant to which Rail contributed substantially all of its owned rail cars, subject to approximately $170 million of debt, to a trust (the "Trust") of which Rail is a 99% beneficiary and the Trust contributed these rail cars, subject to the debt, along with other rail cars the Trust received as a contribution from its 1% beneficiary, to a partnership (the "Partnership") of which the Trust is a 99% partner. The Partnership assumed the Rail debt and leased all of these contributed rail cars, along with other rail cars it received as a contribution from its other partners, to a subsidiary of GECC (the "Lessee"). These leases (the "Leases") expire in 2004, with fixed rentals of approximately $153 million annually. The Leases include the grant to the Lessee of an assignable fixed price purchase option at the end of the term of the leases for all, but not less than all, of the rail cars for approximately $500 million. The Leases are net leases under which the Lessee is responsible for maintenance and other expenses of the rail cars and all obligations of the Lessee are unconditionally guaranteed by GECC. Rail also assigned to GECC, for certain consideration, substantially all of its contracts to lease rail cars from others. Prior to the rail car transaction, most of Rail's cars, other than boxcars, were leased to major railroads and shippers under fixed-rate leases which were typically one to five years in length. The majority of these leases required Rail to maintain the cars and provide other administrative services. The utilization of grain hoppers was affected by, among other things, export demand, domestic trade policies and weather. Prior to the rail car transaction, most of Rail's boxcars were leased to small railroads and used primarily for transportation by the paper and forest product industries. A majority of these leases were long-term "per diem" leases. Per diem leases did not require fixed rental payments. Instead, the rental paid by the lessee was a percentage of the use charges ("car hire") earned by the lessee railroad for the use of the leased equipment on the tracks of other railroads. STOCK INVESTMENTS At December 31, 1993, as the result of September 1988 acquisitions, other purchases and Santa Fe's 1990 restructuring and related spin-offs of Energy and Real Estate common stock, the Company owned 8,064,005 shares or approximately 9% of Energy's common stock and 6,687,575 shares or approximately 9% of Real Estate's common stock, both of which are listed on the New York Stock Exchange (the "NYSE"). Energy and Real Estate are subject to the informational filing requirements of the Securities Exchange Act of 1934 and, in accordance therewith, are required to file reports and other information with the Securities and Exchange Commission. In 1993, 1992 and 1991, the Company wrote down the value of its investments in marketable equity securities by $25 million, $25 million and $50 million, respectively. ASSETS HELD FOR SALE The principal assets held for sale at December 31, 1993 are those of Signal Capital. The Company acquired Signal Capital in connection with the purchase of a major rail car fleet in 1988. The finance business of Signal Capital has been classified as assets held for sale in the Company's consolidated financial statements since its acquisition. The finance business is being liquidated and no material amounts of new loans or investments are being made by Signal Capital. Since the date of acquisition the portfolio has been reduced from $1.44 billion to $175 million at December 31, 1993, including reductions of $82 million, $82 million and $157 million in 1993, 1992 and 1991, respectively. All cash proceeds were used to reduce indebtedness. ITEM 2. ITEM 2. PROPERTIES. See Item 1 - -Business of the Company--Rail Car Leasing and the Consolidated Financial Statements. The Company's rail cars have been leased to GECC under the Leases. Most of Anixter and ANTEC's facilities are leased. Certain of the debt agreements of the Company's subsidiaries are secured by their assets (see Note 9 of the Notes to the Consolidated Financial Statements). ITEM 3. ITEM 3. LEGAL PROCEEDINGS. In the ordinary course of business, the Company and its subsidiaries became involved as plaintiffs or defendants in various legal proceedings. The claims and counterclaims in such litigation, including those for punitive damages, individually in certain cases and in the aggregate, involve amounts which may be material. However, it is the opinion of the Company's management, based upon the advice of its counsel, that the ultimate disposition of pending litigation will not be material. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. During the fourth quarter of 1993, no matters were submitted to a vote of the security holders. EXECUTIVE OFFICERS OF THE REGISTRANT The following table lists the name, age as of March 25, 1994, position, offices and certain other information with respect to the executive officers of the Company. The term of office of each executive officer will expire upon the appointment of his successor by the Board of Directors. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS. A. MARKET INFORMATION Itel Corporation's Common Stock is traded on the NYSE. B. STOCK PRICES The following table sets forth the high and low sales prices for the Common Stock on the NYSE. C. DIVIDENDS ON COMMON STOCK The Company has not paid dividends on its Common Stock since 1979 and does not anticipate declaring any such cash dividends in the foreseeable future. Certain loan agreements and indentures require that the Company maintain a minimum net worth or otherwise limit the Company's ability to declare dividends or make any distribution to holders of any shares of capital stock, or redeem or otherwise acquire such shares of the Company. Approximately $30 million is available for such distributions under the most restrictive of these covenants. D. NUMBER OF HOLDERS OF COMMON STOCK There were approximately 6,000 holders of record of the Common Stock as of March 25, 1994. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA. - --------------- Notes: (a) Operating income in 1992 includes $21.8 million of non-recurring operating costs relating to severance and transition costs due to the rail car transaction (see Note 7 of the Notes to the Consolidated Financial Statements). (b) Non-recurring items include an $84.5 million pre-tax gain on ANTEC Offering in 1993 relating to the September 1993 initial public offering of shares of common stock of ANTEC (see Note 4 of the Notes to the Consolidated Financial Statements). (c) The non-recurring pre-tax loss of $20.5 million in 1993 principally relates to the write-down of miscellaneous investments and certain non-operating assets to net realizable value. (d) In 1993, 1992 and 1991, the Company wrote down the value of its investments in marketable equity securities by $25.0 million, $25.0 million and $50.0 million, respectively. The remaining $29.4 million pre-tax charge in 1991 relates to the loss on sale of the Company's investment in Santa Fe. The $31.7 million pre-tax charge in 1990 primarily relates to the recognized loss in market value on other marketable equity securities. (e) Extraordinary items in 1993, 1992 and 1991 represent the gain/(loss) net of related income taxes on early extinguishment of senior and subordinated debt at Itel and its subsidiaries. (f) Weighted average common and common equivalent shares outstanding decreased substantially from 1989 to 1992 primarily as a result of Itel's large treasury stock purchases in 1992, 1991 and 1990. Consequently, the loss per share in 1992 and 1991 was adversely impacted. In 1993, weighted average common and common equivalent shares increased slightly due primarily to the conversion of Series C convertible preferred stock into approximately 3.8 million shares of Common Stock in August 1993. (g) Stockholders' equity reflects treasury stock purchases of $.3 million, $114.3 million, $147.4 million, $187.6 million and $6.5 million in 1993, 1992, 1991, 1990 and 1989, respectively. No dividends on common stock were declared or paid during any of the periods shown. (h) Stockholders' equity includes unrealized losses on marketable equity securities available-for-sale, net of deferred income tax benefit of $23.7 million, $49.1 million, $47.8 million, $112.9 million and $24.9 million at December 31, 1993, 1992, 1991, 1990 and 1989, respectively. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. FINANCIAL LIQUIDITY AND CAPITAL RESOURCES Asset Sales and Other Dispositions Recapitalization Program: In 1990, the Company began a program of modifying its capital structure by reducing certain senior and subordinated debt at Itel and its subsidiaries and purchasing Common Stock. Over the last several years, the Company also implemented a program of selling or otherwise monetizing certain assets to fund the recapitalization program. Since the program began, the Company has used proceeds to substantially reduce debt at the holding company and subsidiary level and to repurchase approximately $450 million of outstanding Common Stock. The financial liquidity and capital resources in 1993 and 1992 reflect the impact of Itel's recapitalization program. ANTEC Separation: In July 1993, ANTEC, formerly a business division of Anixter, was established as a separate and independent corporation through Anixter's contribution of assets and liabilities of its ANTEC business division to ANTEC and Anixter's distribution of 100% of the outstanding common stock of ANTEC to Itel. In September 1993, Itel and ANTEC completed a public offering (the "Offering") of shares of common stock of ANTEC. Net proceeds from the Offering were approximately $157 million of which Itel, after considering the redemption by ANTEC of preferred shares owned by Itel, received approximately $97 million. Proceeds were used to reduce indebtedness. As a result of the Offering, Itel's ownership of ANTEC common stock was reduced to 53%. Liquidation of Signal Capital: Signal Capital has been classified as assets held for sale since acquisition in connection with the purchase of a major rail car fleet in 1988. The finance business is being liquidated and no material amounts of new loans or investments are being made by Signal Capital. Since the date of acquisition the portfolio has been reduced from $1.44 billion to $175 million at December 31, 1993, including reductions of $82 million, $82 million and $157 million in 1993, 1992 and 1991, respectively. Rail Car Transaction: In June 1992, Itel and Rail completed a transaction with GECC pursuant to which Rail contributed substantially all of its owned rail cars, subject to approximately $170 million of debt, to a Trust of which Rail is a 99% beneficiary and the Trust contributed these rail cars, subject to the debt, along with other rail cars the Trust received as a contribution from its 1% beneficiary, to a partnership (the "Partnership") of which the Trust is a 99% partner. The Partnership assumed the Rail debt and leased all of these contributed rail cars, along with other rail cars it received as a contribution from its other partners, to a subsidiary of GECC (the "Lessee"). The Leases expire in 2004, with fixed rentals of approximately $153 million annually. The Leases include the grant to the Lessee of an assignable fixed price purchase option at the end of the term of the Leases for all, but not less than all, of the rail cars for approximately $500 million. The Leases are net leases under which the Lessee is responsible for maintenance and other expenses of the rail cars and all obligations of the Lessee are unconditionally guaranteed by GECC. Rail also assigned to GECC, for certain consideration, substantially all of its contracts to lease rail cars from others. In June 1992, the Trust issued $998 million of 7 3/4% Notes (the "Trust Notes") secured by the Trust's ownership interest in the Partnership. The net proceeds were used to repay certain debt of Rail and Itel. The Trust Notes are non-recourse to Itel. Other Dispositions: In 1993 and 1992, the Company sold substantially all of its other transportation services assets, except for one short-line railroad which is currently being held for sale. In 1991, the Company sold its investments in American President Companies, Ltd. ("APC"), its third party distribution business, Great Lakes International, Inc. ("Great Lakes") and Santa Fe for aggregate cash proceeds in excess of $500 million. Proceeds from the sales were used to reduce debt or to purchase Common Stock. Cash Flow Consolidated net cash provided (used) by continuing operating activities was $21.3 million for the year ended December 31, 1993 compared to ($5.5) million in 1992. Cash provided (used) by continuing operating activities increased due to higher operating income and lower interest costs caused by debt reductions somewhat offset by higher investment in net working capital attributable to Anixter and ANTEC sales volume increases. Consolidated cash provided (used) by net investing activities was $11.7 million in 1993 versus ($18.7) million in 1992. Consolidated investing activities in 1993 primarily reflect net receipts from Itel's investment in Q-TEL (formerly Quadrum) of $23.7 million and proceeds from the sale of miscellaneous marketable securities and other investments somewhat offset by two ANTEC acquisitions aggregating $9.9 million and capital expenditures required at Anixter and ANTEC. Consolidated cash used for net financing activities was ($141.4) million for the year ended 1993 in comparison to ($50.4) million for the year ended 1992. The 1993 period includes approximately $156.6 million of proceeds from the Offering and the paydown of a substantial amount of subordinated debt. Consolidated net financing activities in 1992 reflect the issuance of $998 million of Trust Notes and subsequent paydown of substantial amounts of other debt. Cash from discontinued operations, net was $117.4 million in 1993 versus $68.0 million in 1992. Discontinued operations in 1993 and 1992 include net proceeds from the sale of most of the Company's other transportation services assets of $46 million and $8 million, respectively, and cash received from the reduction of assets at Signal Capital of $82 million in both years. Consolidated net cash provided (used) by continuing operating activities was ($5.5) million for the year ended December 31, 1992 compared to $34.4 million in 1991. This decrease was due primarily to higher investment in net working capital attributable to Anixter and ANTEC sales volume increases and severance and transition payments due to the rail car transaction. Consolidated cash provided (used) by net investing activities was ($18.7) million in 1992 versus $209.4 million in 1991. Consolidated cash provided from net investing activities in 1991 reflects significant proceeds from marketable securities sales, primarily Santa Fe. Consolidated investing activities in 1992 reflect significantly lower purchases of rail equipment due to the rail car transaction. Consolidated cash used for net financing activities was ($50.4) million for the year ended 1992 in comparison to ($442.0) million for the year ended 1991. Consolidated net financing activities in 1992 reflect the issuance of $998 million of Trust Notes and subsequent paydown of substantial amounts of other debt. Cash used for net financing activities in 1991 reflects the use of proceeds from significant asset sales to repay debt. The consolidated cash used for net financing activities in both years reflects large purchases of treasury stock, principally from Henley. Cash from discontinued operations, net was $68.0 million in 1992 versus $170.7 million in 1991. Discontinued operations in 1992 includes net proceeds from the sale of certain of the Company's other transportation services assets and cash received from the reduction of assets at Signal Capital. Discontinued operations in 1991 include net proceeds from the sales of the Company's investments in Great Lakes, APC and the third party distribution business aggregating $183 million and cash received from the reduction of assets at Signal Capital of $157 million. Based upon discussions with financial analysts and similar disclosures provided by competitors of Itel's businesses, the Company considers operating income before amortization of goodwill and operating income plus depreciation and amortization of goodwill ("cash flow") to be meaningful and readily comparable measures of Itel's relative performance. However, with the completion of the rail car transaction in June 1992, the ongoing fixed cash flow of Rail car leasing is available only to service interest and principal on the debt of the Trust and the Partnership. Cash flow by the Company's major business segments is presented in the following table. The decline in 1992 is due to the rail car transaction. Consolidated net interest expense was $151.1 million, $181.7 million and $179.7 million for the years ended December 31, 1993, 1992 and 1991, respectively. The Company has entered into interest rate agreements which effectively fix or cap, for a period of time, the interest rate on a portion of its floating rate obligations. As a result, the interest rate on substantially all debt obligations at December 31, 1993 is fixed or capped. Financings On December 13, 1993, the Company obtained a $250 million senior bank term loan ("Term Loan") from a group of banks. The Term Loan is secured by the Company's investments in the capital stock of Anixter, ANTEC and Signal Capital and its common shares of Energy and Real Estate aggregating $730 million at net book value at December 31, 1993. The Term Loan matures in 1996. The net proceeds from the Term Loan were used exclusively to repay other debt of Itel. In August 1993, Itel's Series C convertible preferred stock was converted into approximately 3.8 million shares of Common Stock. In July 1993, ANTEC executed an agreement with a group of banks for a new $100 million revolving credit facility. The revolving line of credit, which matures in 1997 and is extendible at the banks' option for one additional year, was reduced to $50 million upon completion of the Offering. Part of the proceeds from the new ANTEC revolving credit facility were used to repay a portion of a secured revolving line of credit of Anixter. The ANTEC revolving credit facility is non-recourse to Itel. In May 1993, the Anixter secured revolving line of credit was extended to 1996 and was increased to $300 million. The revolving line of credit may be extended for two additional one-year periods at the option of the lenders. Upon completion of the new ANTEC revolving credit facility in July, Anixter's secured revolving line of credit was reduced to $210 million. In November, the Company increased the revolving line of credit to $220 million. At December 31, 1993, $88.6 million was available under the bank revolving lines of credit at Anixter, most of which was available to Itel for general corporate purposes. Debt Maturities and Repayments Current maturities of non-recourse debt of $67.8 million at December 31, 1993 represent senior debt related to the Rail car leasing business to be serviced from Rail car leasing cash flow. In 1993 and 1992, Rail car leasing retired at maturity approximately $62.2 million and $17.9 million of non-recourse debt, respectively. In 1993, the Company retired or called for redemption approximately $558 million of the face value of subordinated debt at Itel (including $180 million of 13% Senior Subordinated Notes ("13% Notes") called on December 17, 1993 for January 18, 1994 redemption and $41 million of 13% Notes called on January 27, 1994 for February 28, 1994 redemption). In 1992 and 1991, respectively, the Company retired $688 million and $79 million of the face value of senior and subordinated debt at Itel and its subsidiaries. NOL Carryforwards To the extent of certain taxable income realized by the Company, liquidity is enhanced by potential tax benefits. As of December 31, 1993, the Company had cumulative NOL carryforwards for Federal income tax purposes of approximately $345 million expiring principally in 1995 through 2007, and ITC carryforwards of approximately $16 million expiring in 1994 through 2001. Certain of these carryforwards have not been examined by the IRS and, therefore, may be subject to adjustment. The availability of tax benefits of NOL and ITC carryforwards to reduce the Company's future Federal income tax liability is subject to various limitations under the Internal Revenue Code of 1986, as amended (the "Code"), which may limit their use in the event of substantial ownership changes of Itel's stock as defined in the Code. Such ownership changes may not be within the control of the Company. In addition, at December 31, 1993, various foreign subsidiaries of Itel had aggregate cumulative NOL carryforwards for foreign income tax purposes of approximately $50 million which are subject to various provisions of each respective country and expire between 1995 and 2003. The Company accounts for income taxes in accordance with Statement of Financial Accounting Standards No. 109 ("SFAS No. 109"). Among other things, SFAS No. 109 requires recognition of deferred tax liability on the temporary differences between financial statement and income tax bases of assets and liabilities, measured at enacted tax rates, and the reduction of the liability for deferred taxes for NOL and ITC carryforwards, to the extent that realization of such carryforwards are more likely than not. Accordingly, the Company has reduced its deferred tax liability for its Federal and state NOL and ITC carryforwards in its consolidated financial statements. The Company's partial recognition of Federal and state future tax benefits is due to the expected utilization of those benefits based upon future receipt of substantial taxable income, specifically resulting from (a) over $546 million of existing temporary differences at December 31, 1993, primarily rail car depreciation, which will reverse prior to 2005 and (b) projected consolidated taxable income including the guaranteed minimum future rentals from the Leases of $153 million annually through 2004 and the discontinuance of the substantial capital expenditure program that gave rise to a significant portion of the NOL. Management anticipates that increases in taxable income during the carryforward period will arise primarily as a result of the factors mentioned above. The following table presents the Company's, exclusive of ANTEC, scheduled reversal of existing temporary differences and the expiration dates and amounts of the Company's, exclusive of ANTEC, domestic NOL and ITC carryforwards at December 31, 1993. At December 31, 1993, 1992 and 1991, consolidated valuation allowances for its tax carryforwards are $55.4 million, $58.4 million and $62.1 million, respectively, including valuation allowances on its foreign NOLs at December 31, 1993, 1992, 1991. The effect of the Revenue Reconciliation Act of 1993 enacted in August 1993 was not significant to the Company's consolidated results of operations. Liquidity Considerations and Other Certain debt agreements entered into by Itel's subsidiaries contain various restrictions including restrictions on payments to Itel. Such restrictions have not had nor are expected to have an adverse impact on Itel's ability to meet its cash obligations. At December 31, 1993, the market value of the Company's investment in marketable equity securities was below cost by $36.5 million. In accordance with generally accepted accounting principles, the Company's investment in marketable equity securities has been reflected at market value in the consolidated balance sheet. The Company continuously evaluates the market value of its marketable securities held for investment in relation to its historical cost to determine whether a decline in market value is "other than temporary". When such decline in market value is deemed to be other than temporary, the Company records such decline as a charge against income. In 1993, 1992 and 1991, the Company wrote down the value of its investments in marketable equity securities by $25.0 million, $25.0 million and $50.0 million, respectively. CAPITAL EXPENDITURES Consolidated capital expenditures were $13.4 million, $17.0 million and $75.1 million for 1993, 1992 and 1991, respectively. Anixter capital expenditures were $11.4 million, $6.3 million and $8.4 million for 1993, 1992 and 1991, respectively. ANTEC capital expenditures were $2.0 million, $1.7 million and $2.0 million for 1993, 1992 and 1991, respectively. Rail car leasing capital expenditures were zero, $9.0 million and $64.7 million for 1993, 1992 and 1991, respectively. Due to the rail car transaction, future rail car leasing capital expenditures, if any, will be funded from the proceeds of any dispositions of the rail cars involved in that transaction. RESULTS OF OPERATIONS As a result of the rail car transaction with GECC in June 1992, the revenues and operating income of Rail car leasing, though essentially fixed, are lower than such results prior to the rail car transaction. Further, the ongoing fixed cash flow of Rail car leasing is available only to service interest and principal on the Trust Notes and the debt of the Partnership. Earnings Per Share: Weighted average common and common equivalent shares outstanding decreased substantially from 1989 to 1992 primarily as a result of Itel's large treasury stock purchases in 1992, 1991 and 1990. Consequently, the loss per share in 1992 and 1991 was adversely impacted. In 1993, weighted average common and common equivalent shares increased slightly due primarily to the conversion of Series C convertible preferred stock into approximately 3.8 million shares of Common Stock in August 1993. Quarter ended December 31, 1993: Loss from continuing operations for the fourth quarter of 1993 was ($17.5) million compared with ($29.2) million in the fourth quarter of 1992. The fourth quarter of 1993 and 1992 each include pre-tax charges associated with the write-down of marketable equity securities of $25.0 million. Net loss was ($22.6) million and ($53.6) million in the fourth quarter of 1993 and 1992, respectively. The Company retired or called for redemption approximately $206.0 million and $65.3 million of its subordinated and senior debt resulting in an extraordinary net loss of ($5.1) million and ($2.4) million in the fourth quarters of 1993 and 1992, respectively. The loss from discontinued operations in the fourth quarter of 1992 includes a ($16.1) million net loss from the discontinuance of the other transportation services segment. Consolidated revenues during the period, which includes revenues of Rail car leasing, increased 24% to $508.5 million, primarily reflecting increased volume at Anixter and ANTEC. Anixter revenues increased 21% to $359.7 million from $296.7 million reflecting increased volume in its U.S. wiring systems business and significantly higher volume in its European operations. ANTEC revenues increased 48% to $110.6 million in the fourth quarter of 1993 compared to $74.7 million in 1992 due to the upswing in spending by cable system operators and the acceptance of products developed by ANTEC. Consolidated operating income, including Rail car leasing, increased 27% to $39.4 million from $31.1 million in the fourth quarter of 1992 and consolidated operating income before amortization of goodwill increased 23% to $45.0 million from $36.5 million in the fourth quarter of 1992. Anixter's operating income before amortization of goodwill increased 78% to $16.4 million from $9.2 million in the fourth quarter of 1992 due to stronger European and U.S. Distribution earnings. The 1992 period also contained special charges related to a terminated equity participation plan. ANTEC's operating income before amortization of goodwill more than doubled to $7.1 million from $3.3 million in 1992 reflecting significantly increased volume. Consolidated net interest expense and other for the fourth quarter declined to $36.5 million from $48.8 million in 1992 due to the use of proceeds from the continued monetization of Itel's non-core assets to significantly reduce high-cost debt. Year ended December 31, 1993: Income (loss) from continuing operations was $16.1 million in 1993 compared with ($59.8) million in 1992. Results of continuing operations in 1993 include an $84.5 million pre-tax gain on the Offering and a ($20.5) million non-recurring pre-tax loss principally relating to the write-down of miscellaneous investments and certain non-operating assets to net realizable value. Operating income in 1992 includes a $21.8 million non-recurring operating charge related to the rail car transaction. Results of continuing operations in both 1993 and 1992 include pre-tax charges associated with the write-down of marketable equity securities of $25.0 million. Net loss was ($1.2) million and ($104.3) million for the years ended December 31, 1993 and 1992, respectively. The loss from discontinued operations in 1992 includes a ($16.1) million net loss on the discontinuance of the other transportation services segment. The Company retired or called for redemption a significant amount of its subordinated and senior debt resulting in an extraordinary net loss of ($16.0) million and ($20.4) million in 1993 and 1992, respectively. Consolidated revenues for the year ended December 31, 1993, which includes Rail car leasing, increased 14% to approximately $1.9 billion from $1.7 billion in 1992 primarily reflecting increased volume at Anixter and ANTEC. Anixter revenues rose 14% to $1.3 billion resulting from the continued growth of the U.S. wiring systems business and the continuing worldwide expansion. ANTEC revenues increased 42% to $427.6 million in 1993 compared to 1992 due to the upswing in spending by cable system operators and the acceptance of products developed by ANTEC. More than 95% of ANTEC's consolidated sales for the year ended December 31, 1993 came from sales to the cable industry. Demand for these products depends primarily on capital spending by cable operators for constructing, rebuilding, maintaining or upgrading their systems. In February 1994, the FCC announced its intention to impose a 7% rate reduction for basic cable services and ANTEC's largest customers announced it may reduce its capital expenditure budget for 1994. However, the Company believes that while capital expenditures for some products by some operators may be adversely affected, capital spending for infrastructure improvements and upgrades will continue and, therefore, the Company does not anticipate a material adverse impact on its performance as a result of these recent announcements. Rail car leasing revenue in 1993 decreased to $153.0 million from $217.5 million due to the effect of the rail car transaction in June 1992. Consolidated operating income, including Rail car leasing, was $157.9 million compared with $148.7 million (before the $21.8 million non-recurring operating charge) in 1992. Consolidated operating income before amortization of goodwill and the non-recurring operating charge increased to $179.4 million from $166.3 million in 1992. Anixter operating income before amortization of goodwill for 1993 increased 36% to $61.1 million due to improved margins and volume at U.S. distribution offset slightly by increased spending in international markets. Net start-up losses from recently established foreign operations were ($4.4) million in 1993 compared to ($2.5) million in 1992. The 1992 period also contained special charges related to a terminated equity participation plan. ANTEC's operating income before amortization of goodwill increased 70% to $25.2 million in 1993 from $14.8 million in 1992 reflecting significantly increased volume. Rail car leasing operating income before amortization of goodwill increased to $102.4 million from $93.5 million in 1992. Rail car leasing results in 1992 include a $21.8 million non-recurring operating charge relating to the rail car transaction. Consolidated net interest expense and other for 1993 declined to $151.1 million from $181.7 million in 1992 due to the use of proceeds from the 1992 rail car transaction and the continued monetization of Itel's non-core assets to significantly reduce high-cost debt. Year ended December 31, 1992: Loss from continuing operations was ($59.8) million in 1992 compared with ($57.7) million in 1991. Operating income in 1992 includes a $21.8 million non-recurring operating charge related to the rail car transaction. Results of continuing operations in 1992 and 1991 include pre-tax charges associated with the sale and write-down of marketable equity securities of $25.0 million and $79.4 million, respectively. Net loss was ($104.3) million and ($55.7) million for the years ended December 31, 1992 and 1991, respectively. The loss from discontinued operations in 1992 includes a ($16.1) million net loss on the disposition of certain other transportation services assets. The loss from discontinued operations in 1991 includes a ($14.6) million net loss on the sale of APC and Great Lakes. The Company retired a significant amount of its subordinated and senior debt resulting in an extraordinary net gain (loss) of ($20.4) million and $8.8 million in 1992 and 1991, respectively. Consolidated revenues for the year ended December 31, 1992, which includes revenues of Rail car leasing, increased 6% to approximately $1.7 billion from $1.6 billion in 1991 primarily reflecting increased volume at Anixter and ANTEC. Anixter revenues increased 13% to $1.2 billion reflecting strong U.S. data markets and significantly higher European volume. ANTEC revenues increased 17% to $301.0 million due to stronger fiber optics sales. Rail car leasing revenues decreased to $217.5 million from $307.0 million primarily due to the effect of the June 1992 rail car transaction. Consolidated operating income before the $21.8 million non-recurring operating charge was $148.7 million compared with $165.3 million in 1991. Consolidated operating income before the non-recurring operating charge and amortization of goodwill decreased to $166.3 million from $177.8 million in 1991. Anixter operating income before amortization of goodwill for 1992 increased 7% to $44.8 million due to lower European losses and stronger U.K. results partially offset by lower Canadian earnings. Net start-up losses from recently established foreign operations decreased to ($2.5) million in 1992 from ($9.6) million in 1991. ANTEC's operating income before amortization of goodwill increased 48% to $14.8 million in 1992 from $10.0 million in 1991 reflecting significantly increased volume. Rail car leasing operating income before amortization of goodwill decreased to $93.5 million in 1992 from $136.4 million in 1991 reflecting the rail car transaction. Consolidated net interest expense and other for 1992 was $181.7 million compared to $179.7 million in 1991. Results in 1992 reflect the effects of debt reduction and lower interest costs following the 1991 sales of the Company's investments in APC, Santa Fe and Great Lakes, and the 1992 rail car transaction offset by the effect of the Company's treasury stock purchases and lower investment income. Net interest expense includes the carrying costs on the remaining marketable equity securities of approximately $25 million for the year ended December 31, 1992. Year ended December 31, 1991: Loss from continuing operations was ($57.7) million compared with ($32.4) million in 1990. Results in both years include pre-tax charges associated with the sale and write-down of marketable equity securities of $79.4 million and $31.7 million in 1991 and 1990, respectively. Net income (loss) was ($55.7) million and $128.7 million for the years ended December 31, 1991 and 1990, respectively. The loss from discontinued operations in 1991 includes a ($14.6) million net loss on the sales of APC and Great Lakes. Income from discontinued operations in 1990 primarily reflects a $154.9 million net gain on the sale of the Company's container leasing assets. In 1991, the Company retired approximately $78.9 million of the face value of its subordinated debt resulting in an extraordinary net gain of $8.8 million. Consolidated revenues for the year ended December 31, 1991 decreased slightly to approximately $1.6 billion. Anixter revenues, which included the start-up operations in Europe, increased 5% over 1990. ANTEC revenues declined 21% from 1990 due to significantly lower cable industry spending. Rail car leasing revenue was $307.0 million, slightly lower than 1990 primarily due to continued softness in the grain car leasing market. Consolidated operating income was $165.3 million compared with $168.2 million in 1990. Consolidated operating income before amortization of goodwill was $177.8 million compared with $180.8 million in 1990. Anixter operating income before amortization of goodwill for 1991 increased 14% to $42.0 million. Net start-up losses from recently established foreign operations were ($9.6) million and ($10.1) million in 1991 and 1990, respectively. ANTEC's operating income before amortization of goodwill decreased to $10.0 million in 1991 from $22.0 million in 1990 due to the poor cable television market. Rail car leasing operating income before amortization of goodwill was $136.4 million, up slightly from 1990 due to lower maintenance costs, partially offset by lower rental revenues. Net interest expense and other for the year was $179.7 million compared to $174.7 million in 1990 as the effect of the Company's treasury stock purchases was partially offset by the effects of debt reduction following the 1991 sales of the Company's investments in APC, Santa Fe and Great Lakes and excess proceeds from the sale of the Company's container leasing assets at the end of 1990. Net interest expense includes the carrying costs on marketable equity securities of approximately $60 million and $70 million for the years ended December 31, 1991 and 1990, respectively. Impact of Inflation: Inflation has slowed in recent years and is currently not an important determinant of Anixter and ANTEC's results of operations due, in part, to rapid inventory turnover. Due to the rail car transaction, inflation is currently not a determinant of the Company's rail car leasing business results of operations. ITEM 8. ITEM 8. CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. Not applicable. [This page left intentionally blank] REPORT OF INDEPENDENT AUDITORS The Board of Directors and Stockholders Itel Corporation We have audited the accompanying consolidated balance sheets of Itel Corporation 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 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 Itel Corporation 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. Our audits were conducted for the purpose of forming an opinion on the consolidated financial statements taken as a whole. The accompanying supplemental balance sheets at December 31, 1993 (page 22) and supplemental statements of operations for the years ended December 31, 1993 and 1992 (page 24) and supplemental statements of cash flows for the year ended December 31, 1993 (page 26) are presented for purposes of additional analysis and are not a required part of the consolidated financial statements. Such information has been subjected to the auditing procedures applied in our audits of the consolidated financial statements and, in our opinion, is fairly stated in all material respects in relation to the consolidated financial statements taken as a whole. ERNST & YOUNG Chicago, Illinois February 8, 1994 ITEL CORPORATION CONSOLIDATED BALANCE SHEETS (IN THOUSANDS, EXCEPT SHARE AMOUNTS) See accompanying notes to the consolidated financial statements. ITEL CORPORATION SUPPLEMENTAL BALANCE SHEETS (IN THOUSANDS) Supplemental consolidating data are shown for Anixter, ANTEC, Rail car leasing and All other. Transactions between Anixter, ANTEC, Rail car leasing and All other have been eliminated from the consolidated column. ITEL CORPORATION CONSOLIDATED STATEMENTS OF OPERATIONS (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) See accompanying notes to the consolidated financial statements. ITEL CORPORATION SUPPLEMENTAL STATEMENTS OF OPERATIONS (IN THOUSANDS) Supplemental consolidating data are shown for Anixter, ANTEC, Rail car leasing and All other. Transactions between Anixter, ANTEC, Rail car leasing and All other have been eliminated from the consolidated columns. ITEL CORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS) See accompanying notes to the consolidated financial statements. ITEL CORPORATION SUPPLEMENTAL STATEMENTS OF CASH FLOWS (IN THOUSANDS) Supplemental consolidating data are shown for Anixter, ANTEC, Rail car leasing and All other. Transactions between Anixter, ANTEC, Rail car leasing and All other have been eliminated from the consolidated column. ITEL CORPORATION CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (IN THOUSANDS) See accompanying notes to the consolidated financial statements. ITEL CORPORATION NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Consolidation: The consolidated financial statements include the accounts of Itel Corporation ("Itel") and its majority-owned subsidiaries (collectively "the Company") after elimination of intercompany transactions. Minority interests of $98.2 million at December 31, 1993 primarily relate to the 47% public ownership in ANTEC (see Note 4) and the 1% external ownership interests in the Trust and Partnership, respectively (see Note 7). Reclassifications: The 1992 and 1991 consolidated financial statements and related notes have been reclassified to reflect the 1993 presentation. The Company adopted the Statements of Financial Accounting Standards No. 114, "Accounting by Creditors for Impairment of a Loan" and No. 115, "Accounting for Certain Investments in Debt and Equity Securities" at December 31, 1993. The effect on the consolidated financial statements was immaterial. Cash and equivalents and restricted cash: The Company considers all highly liquid investments with an original maturity of three months or less to be cash equivalents. The carrying amount of cash and equivalents approximates fair value because of the short maturity of those instruments. Restricted cash consists primarily of cash to be used for interest and principal on the debt related to Rail car leasing (see Note 9). Inventories: Inventories are valued principally at the lower of average, approximating first-in, first-out, cost or market. Depreciation: The Company provides for depreciation of property principally on the straight-line basis over various useful lives including the term of the Leases (see Note 7) for rental equipment--rail cars, 25 to 40 years for buildings and improvements, 3 to 10 years for machinery and equipment and the term of the lease for leasehold improvements. Goodwill: Goodwill relates to the excess of cost over net tangible assets of businesses acquired. The Company at each balance sheet date evaluates, for recognition of potential impairment, its recorded goodwill against the current and undiscounted expected future operating income before goodwill amortization expense of the entities to which goodwill relates. In the opinion of management, goodwill at Anixter Inc. and its subsidiaries (collectively "Anixter") and ANTEC Corporation and its subsidiaries (collectively "ANTEC") has not diminished in value since their date of acquisition, and, having an indefinite life, is not subject to amortization. However, in accordance with Opinion 17 of the Accounting Principles Board of the American Institute of Certified Public Accountants, goodwill is being amortized over a period of 40 years using the straight-line method. The remaining goodwill relates to the purchase of Pullman Leasing Company in 1988 and is being amortized over the term of the Leases (see Note 7). Marketable equity securities available-for-sale: Marketable equity securities available-for-sale are reflected in the balance sheet at the quoted market price as of the balance sheet date. The difference between cost and market is reflected in stockholders' equity net of deferred tax benefit. Realized gains on dispositions of securities are determined using the average cost method. Realized pre-tax gains, before related interest carrying costs, were $.3 million, zero and $5.5 million in 1993, 1992 and 1991, respectively. Aggregate unrealized pre-tax loss on marketable equity securities available-for-sale amounted to $36.6 million at December 31, 1993 (see Note 5). Investment in and advances to Q-TEL S.A. de C.V. of Mexico ("Q-TEL"): Investment in and advances to Q-TEL, formerly Quadrum, include a 19% equity interest in Q-TEL and at December 31, 1993 a $6.6 million loan. Interest rate agreements: The Company has entered into interest rate agreements which effectively fix or cap, for a period of time, the interest rate on a portion of its floating rate obligations. As a result, the interest rate on substantially all debt obligations at December 31, 1993 is fixed or capped. The net effects of such ITEL CORPORATION NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) agreements are included in interest expense. Revenue recognition: Sales and related cost of sales are recognized primarily upon shipment of products. Advertising and sales promotion: Advertising and sales promotion costs are expensed as incurred. Income taxes: Provisions for income taxes include deferred taxes resulting from temporary differences in determining income for financial and tax purposes using the liability method. Such temporary differences result primarily from differences in the carrying value of assets and liabilities. Income (loss) per common share: Income (loss) per share amounts are based upon results from operations after deducting preferred dividends earned and the amortization of preferred stock discounts. Weighted average common and common equivalent shares were 30,132,000, 29,085,000 and 34,440,000 for 1993, 1992 and 1991, respectively. NOTE 2. SUPPLEMENTAL CASH FLOW INFORMATION Continuing operations of the Company paid interest, including interest allocated to discontinued operations, of approximately $187.9 million, $232.5 million and $248.6 million for the years ended December 31, 1993, 1992 and 1991, respectively. Approximately $7.0 million, $1.5 million and $3.3 million was paid principally for foreign and certain state income taxes for the years ended December 31, 1993, 1992 and 1991, respectively. In a non-cash transaction Itel's Series C convertible preferred stock ("Preferred Stock") was converted into approximately 3.8 million shares of common stock in August 1993. NOTE 3. DISCONTINUED AND ASSETS HELD FOR SALE The finance business of Signal Capital Corporation ("Signal Capital") has been included as assets held for sale since acquisition in connection with the purchase of a major railcar fleet in 1988. The finance business is being liquidated and no material amounts of new loans or investments are being made by Signal Capital. Since the date of acquisition the portfolio has been reduced from $1.44 billion to $175 million at December 31, 1993, including reductions of $82 million, $82 million and $157 million in 1993, 1992 and 1991 respectively. Proceeds were used to repay indebtedness. In 1993 and 1992, the Company sold substantially all of its other transportation services assets, except for one short-line railroad which is currently being held for sale, for aggregate net cash proceeds of $54 million. The Company recorded a $26 million pre-tax loss in 1992 in discontinued operations to reflect the disposal of this segment. In 1991, the Company sold its investments in various other businesses for aggregate cash proceeds in excess of $250 million. These 1991 sales resulted in pre-tax losses totaling $65 million which was reflected in discontinued operations. ITEL CORPORATION NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) The results of operations of the other transportation services segment, other previously sold businesses and Signal Capital have been included in discontinued operations net of allocated corporate interest expense. Allocated corporate interest expense amounted to $19.0 million, $38.1 million and $53.6 million for the years ended December 31, 1993, 1992 and 1991, respectively. Summarized financial results of discontinued operations were as follows: The composition of remaining discontinued and assets held for sale, net consisted of the following: NOTE 4. GAIN ON ANTEC OFFERING AND NON-RECURRING ITEMS The pre-tax gain on ANTEC Offering relates to the September 1993 initial public offering of shares of common stock of ANTEC (the "Offering"). Itel provided deferred taxes relating to the recognized pre-tax book gain. Itel and ANTEC sold approximately 4.0 million and 5.4 million shares of ANTEC common stock, respectively, at $18 per share. Net proceeds from the Offering were approximately $157 million of which Itel, after considering the redemption by ANTEC of preferred shares owned by Itel, received approximately $97 million. As a result of the Offering, Itel's ownership of ANTEC common stock was reduced to 53%. The non-recurring pre-tax loss in 1993 principally relates to the write-down of miscellaneous investments and certain non-operating assets to net realizable value. ITEL CORPORATION NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 5. MARKETABLE EQUITY SECURITIES AVAILABLE-FOR-SALE In 1993, 1992 and 1991, the Company wrote down the value of its investments in marketable equity securities by $25.0 million, $25.0 million and $50.0 million, respectively. Also in 1991, the Company recorded a pre-tax loss of $29.4 million on the sale of its investment in Santa Fe Pacific Corporation ("Santa Fe"). The Company has reduced the pre-tax unrealized losses on marketable equity securities available-for-sale included in stockholders' equity by $12.9 million at December 31, 1993 to reflect a deferred tax benefit due to the Company's current ability to either (a) carryback all December 31, 1993 unrealized capital losses to previously generated capital gains or (b) generate capital gains by the future sale of capital assets to offset December 31, 1993 unrealized capital losses. NOTE 6. EXTRAORDINARY ITEMS In 1993, 1992 and 1991, the Company retired or called for redemption senior and subordinated debt resulting in a pre-tax extraordinary gain (loss) of ($26.2) million, ($32.9) million and $13.3 million, respectively. NOTE 7. RAIL CAR TRANSACTION In 1992, a 98% owned affiliate of Itel leased all of the rail cars owned by the Company to an affiliate of General Electric Capital Corporation ("GECC") for twelve years with fixed annual rentals of approximately $153 million. The leases (the "Leases") include an option for GECC to purchase all, but not less than all, of the rail cars for approximately $500 million at the end of the term of the Leases. GECC is responsible for the maintenance and other expenses of the rail cars and has unconditionally guaranteed all obligations of its affiliate. Operating income in 1992 includes $21.8 million of non-recurring operating expense relating to severance and transition costs due to the rail car transaction. NOTE 8. ACCRUED EXPENSES Accrued expenses consists of the following: ITEL CORPORATION NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 9. DEBT Debt is summarized below. Subsequent to December 31, 1993, the Company retired $221.0 million of the 13% Senior Subordinated Notes ("13% Notes") primarily using a $250 million senior bank term loan ("Term Loan") at Itel (see discussion below). The pro forma column reflects such redemption of 13% Notes as if it occurred on December 31, 1993. Itel-- 13% Notes: On December 17, 1993, Itel called $180 million of the 13% Notes for redemption on January 18, 1994. Itel called the remaining $41 million of 13% Notes on January 27, 1994 for redemption on February 28, 1994. 10.2% Senior Subordinated Extendible Notes ("Extendible Notes"): The Extendible Notes are callable in January 1995 and may be extended for periods of one to five years after January 1995 at an interest rate and period established by Itel. Unless repurchased by Itel at the option of the holder at the end of any interest period, the Extendible Notes mature in 2001. ITEL CORPORATION NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) Term Loan: On December 13, 1993, the Company obtained a $250 million Term Loan from a group of banks. The Term Loan is secured by the Company's investments in the capital stock of Anixter, ANTEC and Signal Capital and its common shares of Santa Fe Energy Resources, Inc. ("Energy") and Catellus Development Corporation ("Real Estate") aggregating $730 million at net book value at December 31, 1993. The Term Loan matures in 1996. Various interest rate options are available. The interest rate at December 31, 1993 was 4 3/4%. The net proceeds from the Term Loan were used exclusively to repay other debt of Itel. Anixter-- Bank revolving lines of credit: Anixter has various secured revolving bank lines of credit worldwide which provide for up to $281 million of borrowings contingent on the level of certain assets. At December 31, 1993, $184.7 million was borrowed and $88.6 million was available under the bank revolving lines of credit at Anixter, most of which was available for general corporate purposes. These lines of credit reduce or mature at various dates from 1994 through 1996. The $220.0 million domestic revolving line of credit, which matures in 1996, may be extended for two additional one-year periods at the option of the lender. Various interest rate options are available under these facilities and the average interest rate at December 31, 1993 was 6.0%. Commitment fees of 1/2% are payable on the unused portion of these revolving lines of credit. The 1993 commitment fees paid were insignificant. ANTEC-- Bank revolving line of credit: ANTEC has a revolving line of credit which provides for up to $50.0 million in borrowings. The line of credit is non-recourse to Itel, matures in 1997 and is extendible at the banks' option for one additional year. Various interest rate options are available. The interest rate at December 31, 1993 was 4.5%. Commitment fees of 1/2% are payable on the unused portion of the revolving line of credit. The 1993 commitment fees paid were insignificant. Rail car leasing-- In connection with the completion of the rail car transaction (see Note 7), a trust (the "Trust") issued $998 million of 7 3/4% Notes (the "Trust Notes"). The Trust Notes are non-recourse to Itel, mature through 2004 and are secured by the Trust's ownership interest in a partnership, which holds substantially all of the rail cars formerly operated by Itel Rail Corporation and its subsidiaries (collectively "Rail"). The net proceeds from the Trust Notes were used to repay certain senior indebtedness of Rail and other debt of Itel. Equipment Trust Certificates ("ETCs") and other secured indebtedness of the Partnership are non-recourse to Itel, have interest rates ranging from 9.5% to 11.1% and mature through 2003. The ETCs have annual sinking fund requirements. With the completion of the rail car transaction in June 1992, the ongoing fixed cash flow of the Company's Rail car leasing business is available only to service interest and principal on the debt of the Rail car leasing business. Other-- Certain debt agreements entered into by Itel's subsidiaries contain various restrictions including restrictions on payments to Itel. These debt agreements are secured by certain assets of the subsidiaries aggregating approximately $1.6 billion at December 31, 1993. Itel has guaranteed certain debt and other obligations of Anixter. Restricted net assets of subsidiaries were approximately $600 million at December 31, 1993. Certain of Itel's loan agreements or indentures require that Itel maintain a minimum net worth and interest coverage, use the proceeds of certain asset sales to repay debt, and limit Itel's ability to make capital investments, incur debt, declare dividends or make distributions to holders of any shares of capital stock, or ITEL CORPORATION NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) redeem or otherwise acquire such shares of the Company. Approximately $30 million is available for such distributions under the most restrictive of these covenants. At December 31, 1993, the Company had four outstanding interest swap agreements having a total notional principal amount of $193.0 million and an average fixed rate of approximately 8.4%. The swap agreements expire in 1994. The Company also had five future interest swap agreements having a total notional principal amount of $150.0 million and an average fixed rate of 6.8%. These swap agreements begin in the latter half of 1994 and expire in 1995 and 1996. Aggregate annual maturities of debt, after consideration of early 1994 retirements of the 13% Notes, are as follows: The fair value of the Company's debt and interest rate swaps is presented below. The fair value of the Company's debt is estimated based on the quoted market prices. The fair value of interest rate swaps is the estimated amount that the Company would be required to pay to terminate the swap agreements at the reporting date, taking into account current interest rates. NOTE 10. INCOME TAXES Itel and its U.S. subsidiaries (other than ANTEC for periods after September 1993) file their Federal income tax return on a consolidated basis. As of December 31, 1993, the Company had cumulative net operating loss ("NOL") carryforwards for Federal income tax purposes of approximately $345 million expiring principally in 1995 through 2007, and investment tax credit ("ITC") carryforwards of approximately $16 million expiring in 1994 through 2001. Certain of these carryforwards have not been examined by the Internal Revenue Service and, therefore, may be subject to adjustment. The availability of NOL and ITC carryforwards to reduce the Company's future Federal income tax liability is subject to various limitations under the Internal Revenue Code of 1986, as amended (the "Code"), which may limit their use in the event of substantial ownership changes of Itel's stock as defined in the Code. Such ownership changes may not be within the control of the Company. In addition, at December 31, 1993, various foreign subsidiaries of Itel had aggregate cumulative NOL carryforwards for foreign income tax purposes of approximately $50 million which are subject to various provisions of each respective country and expire primarily between 1995 and 2003. ITEL CORPORATION NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) In accordance with generally accepted accounting principles, the Company has reduced its deferred tax liability to reflect its Federal and state NOL and ITC carryforwards. The Company's partial recognition of Federal and state future tax benefits is based on the expected utilization of those benefits based upon future receipt of substantial taxable income, specifically resulting from (a) over $546 million of existing temporary differences at December 31, 1993, primarily rail car depreciation, which will reverse prior to 2005 and (b) projected consolidated taxable income including the receipt of guaranteed minimum future rentals from the Leases of $153 million annually through 2004 and the discontinuance of the substantial capital expenditure programs that gave rise to a significant portion of the NOL. Management anticipates that increases in taxable income during the carryforward period will arise primarily as a result of the factors mentioned above. Domestic income (loss) from continuing operations before income taxes was $58.6 million, ($68.5) million and ($79.9) million for the years ended December 31, 1993, 1992 and 1991, respectively. Foreign loss from continuing operations before income taxes was ($12.8) million, ($11.3) million and ($13.9) million for the years ended December 31, 1993, 1992 and 1991, respectively. Deferred income taxes reflect the impact of temporary differences between amounts of assets and liabilities for financial reporting purposes and such amounts as measured by tax laws. Deferred income taxes also result from differences between the fair value of assets acquired in business combinations accounted for as purchases and their tax bases. Significant components of the Company's deferred tax liabilities and assets were as follows: At December 31, 1993, 1992 and 1991, consolidated valuation allowances for its tax carryforwards were $55.4 million, $58.4 million and $62.1 million, respectively, including valuation allowances on its foreign NOLs at December 31, 1993, 1992 and 1991. ITEL CORPORATION NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) Income tax (expense) benefit relating to operations was comprised of: Reconciliations of income tax (expense) benefit in continuing operations to the statutory corporate Federal tax rate, 35% in 1993 and 34% in 1992 and 1991, were as follows: ITEL CORPORATION NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) The income tax effects of items comprising the deferred income tax (expense) benefit were as follows: NOTE 11. CONTINGENCIES AND LITIGATION In the ordinary course of business, Itel and its subsidiaries become involved as plaintiffs or defendants in various legal proceedings. The claims and counterclaims in such litigation, including those for punitive damages, individually in certain cases and in the aggregate, involve amounts which may be material. However, it is the opinion of the Company's management, based upon the advice of its counsel, that the ultimate disposition of pending litigation will not be material. NOTE 12. PENSION PLANS, POST-RETIREMENT BENEFITS AND OTHER BENEFITS The Company's various pension plans are non-contributory and cover substantially all full-time domestic employees. Retirement benefits are provided based on compensation as defined in the plans. The Company's policy is to fund these plans as required by ERISA and the Code. Assets of the Company's plans at fair value were $44.0 million and $40.1 million at December 31, 1993 and 1992, respectively. Projected benefit obligations of the Company's plans were $57.2 million and $48.3 million at December 31, 1993 and 1992, respectively. The accumulated benefit obligations of the Company's plans were $44.5 million and $33.5 million at December 31, 1993 and 1992, respectively. The weighted-average assumed discount rate used to measure the projected benefit obligation was 6.8% and 7.3% at December 31, 1993 and 1992, respectively. Pension expense, including the cost of 401(k) plans, for 1993, 1992 and 1991 was insignificant. The Company's liability for post-retirement benefits other than pensions is insignificant. NOTE 13. PREFERRED STOCK AND COMMON STOCK Itel has authorized 15 million shares of Preferred Stock, par value $1.00 per share. In August 1993, the Preferred Stock was converted into approximately 3.8 million shares of Common Stock. At December 31, 1993, 1992 and 1991, 33,010,000, 28,080,000 and 32,140,000 shares of Common Stock, respectively, were issued and outstanding. In connection with all Itel employee stock plans described below, 2,998,485 shares were reserved for issuance at December 31, 1993. Stock options and stock grants-- Itel has Employee Stock Incentive Plans ("ESIP") authorizing an aggregate of 5.7 million stock options or restricted grants. In addition, Itel has a Director Stock Option Plan ("DSOP") authorizing an aggregate of .2 million stock options. Substantially all options and grants under these plans have been at fair market value or higher. The exercise price of certain options increase at a specified fixed rate. One-third of the options granted become exercisable each year after the year of grant (except in the case of director options which vest fully in six months) and the options expire seven to ten years after the date of grant. ITEL CORPORATION NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) Additionally, Itel has an Employee Stock Purchase Plan ("ESPP") covering most employees, excluding ANTEC after September 1993. Participants can request that up to 10% of their base compensation be applied toward the purchase of Common Stock under Itel's ESPP. The exercise price is the lower of 85% of the fair market value of the Common Stock at the date of grant or at the later exercise date (currently one year). Under the ESIP, DSOP and ESPP, total options currently exercisable at December 31, 1993 and 1992 were 763,336 and 1,374,030, respectively. The following table summarizes the 1993 activity under the ESIP, DSOP and ESPP. Total stock options exercised for the years ended December 31, 1992 and 1991 were 1,438,316 and 353,103, respectively. The purchase price per share for all stock options exercised ranged from $4.44 to $21.88 in 1992 and $3.38 to $16.50 in 1991. Stock option plans of subsidiaries-- In 1993, Anixter adopted the Anixter Employee Stock Incentive Plan and options to purchase approximately 2.1 million shares of Anixter common stock were granted with an exercise price of $9.00 per share to key employees of Anixter. Substantially, all options and grants under these plans have been at fair market value. These options vest immediately to three years and terminate one to seven years from the date of grant. At December 31, 1993, Itel owned all of the 29.0 million shares of outstanding Anixter common stock. In 1993, ANTEC adopted the ANTEC Employee Stock Incentive Plan and options to purchase approximately 1.5 million shares of ANTEC common stock were granted with exercise prices of $10.00 to $18.00 per share to key employees of ANTEC. All options and grants under these plans have been at fair market value or higher. These options vest over four years beginning in January 1995 and terminate seven years from the date of grant. At December 31, 1993, Itel owned 53% of the 20.1 million shares of outstanding ANTEC common stock. In 1993, ANTEC also adopted the ANTEC Employee Stock Purchase Plan, with terms identical to Itel's ESPP described above, and the ANTEC Director Stock Option Plan. Options to purchase 56,000 shares of ANTEC common stock were granted under the ANTEC Employee Stock Purchase Plan at $15.30 per share. At December 31, 1993, no options were outstanding under the ANTEC Director Stock Option Plan. In connection with all ANTEC option plans, 2.3 million ANTEC shares were reserved for issuance at December 31, 1993. Warrants-- The Company has issued warrants to directors, which are currently exercisable, to purchase 130,000 shares of Common Stock at prices ranging from $10.13 to $24.25 per share expiring between 1995 and the year 2000. In 1992, Itel acquired warrants to purchase 4.675 million shares of Common Stock held by an affiliate of Samuel Zell, the chairman of the board of directors of Itel. In connection with the warrant purchase, a $15.0 million note receivable was cancelled. ITEL CORPORATION NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) Common Stock-- In a series of transactions in 1992, 1991 and 1990, the Company purchased from the Henley Group, Inc. ("Henley") 18.7 million shares of the Company's Common Stock for an aggregate price of $377 million. In addition to the Common Stock purchased from Henley, in 1992 and 1991, Itel purchased 2,046,000 and 1,605,300 shares of Common Stock, respectively. All treasury stock was retired. There are restrictions in several of Itel's debt agreements which limit the payment of dividends and the repurchases or redemption of Common Stock (see Note 9). NOTE 14. BUSINESS SEGMENTS The Company is engaged in three principal areas of business: distribution of wiring systems products for voice, data and video networks and electrical power applications (Anixter), the development and distribution of products used in the cable television industry (ANTEC) and rail car leasing operations through the Leases. Itel Corporate obtains and coordinates financing, legal and other related services, certain of which are rebilled to these segments. Information for the years ended December 31, 1993, 1992 and 1991 regarding the Company's major business segments is presented in the following table. The business segments of Itel have been reclassified to reflect ANTEC as a separate segment. - --------------- (a) Identifiable assets are principally comprised of marketable equity securities (including Energy and Real Estate) and discontinued and assets held for sale. (b) Reflects $9.0 million of expenses relating to a terminated equity participation plan. (c) Includes $21.8 million of non-recurring operating costs relating to severance and transition costs due to the rail car transaction. ITEL CORPORATION NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) The classification of the Company's 1993, 1992 and 1991 foreign operations in the following table includes all revenues and related items of the Company's non-U.S. operations. Export sales are insignificant. SUMMARY QUARTERLY FINANCIAL INFORMATION (UNAUDITED) The following tables summarize the Company's quarterly financial information. - --------------- (a) The third quarter of 1993 has been restated from amounts previously reported to reflect a $4.6 million reclassification from non-recurring items to extraordinary items relating to the write-off of deferred financing fees on early extinguishment of debt. (b) The second quarter of 1992 includes a $21.8 million non-recurring operating charge relating to severance and transition costs due to the rail car transaction. (c) Continuing operations in the third quarter of 1993 include an $84.5 million pre-tax gain on the Offering and a ($20.5) million non-recurring pre-tax loss principally relating to the write-down of miscellaneous investments and certain non-operating assets to net realizable value. Continuing operations in the fourth quarter of 1993 and 1992 include pre-tax charges of $25.0 million associated with the write-down of the Company's marketable equity securities. (d) Discontinued operations in the fourth quarter of 1992 include a $26.0 million pre-tax loss on the discontinuance of the other transportation services segment. (e) The extraordinary items in 1993 and 1992 reflect a pre-tax loss of ($26.2) million and ($32.9) million, respectively, on the early extinguishment of the Company's subordinated and senior debt. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF REGISTRANT. See Registrant's Proxy Statement for the 1994 Annual Meeting of Stockholders -- "Election of Directors" and "Timeliness of Certain Filings." ITEM 11. ITEM 11. EXECUTIVE COMPENSATION. See Registrant's Proxy Statement for the 1994 Annual Meeting of Stockholders -- "Summary Compensation Table," "Option Grants in Last Fiscal Year," "Aggregated Option Exercised in Last Fiscal Year and FY-End Option Value," "Pension Plan Table," "Compensation of Directors," "Employment Contracts and Termination of Employment and Changes in Control Arrangements," and "Compensation Committee Interlocks and Insider Participation." ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. See Registrant's Proxy Statement for the 1994 Annual Meeting of Stockholders -- "Security Ownership of Management" and "Security Ownership of Principal Stockholders." ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. See Registrant's Proxy Statement for the 1994 Annual Meeting of Stockholders -- "Certain Relationships and Related Transactions." PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K. (a) Exhibits. The exhibits listed below in Item 14(a)1, 2 and 3 are filed as part of this annual report. Each management contract or compensatory plan required to be filed as an exhibit is identified by an asterisk(*). (b) Reports on Form 8-K. None. ITEM 14(A)1 AND 2. INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES. Financial Statements. The following Consolidated Financial Statements of Itel Corporation and Report of Independent Auditors are filed as part of this report. Financial Statement Schedules. The following financial statement schedules of Itel Corporation are filed as part of this Report and should be read in conjunction with the Consolidated Financial Statements of Itel Corporation. Consolidated Schedules for the years ended December 31, 1993, 1992 and 1991, except as noted: All other schedules are omitted because they are not required or are not applicable, or the required information is shown in the consolidated financial statements or notes thereto. ITEM 14(A)3. EXHIBIT LIST. Each management contract or compensation plan required to be filed as an exhibit is identified by an asterisk(*). (28) Additional exhibits. This Annual Report on Form 10-K includes the following Financial Statement Schedules: ITEL CORPORATION AND SUBSIDIARIES-- FINANCIAL SCHEDULES All other schedules are omitted because they are not required or are not applicable, or the required information is included in the consolidated financial statements or notes thereto. - --------------- + Copies of other instruments defining the rights of holders of long-term debt of Itel Corporation and its subsidiaries not filed pursuant to Item 601(b)(4)(iii) of Regulation S-K and omitted copies of attachments to plans and material contracts will be furnished to the Securities and Exchange Commission upon request. 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, as amended, the Registrant hereby undertakes as follows, which undertaking shall be incorporated by reference into the Registrant's Registration Statement on Form S-8 Nos. 2-93173 (filed September 30, 1987), 33-13486 (filed April 15, 1987), 33-21656 (filed May 3, 1988) and 33-60676 (filed April 5, 1993): 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 provision, 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. ITEL CORPORATION SCHEDULE I--MARKETABLE SECURITIES--OTHER INVESTMENTS DECEMBER 31, 1993 (IN THOUSANDS, EXCEPT SHARE AMOUNTS) - --------------- (a) At December 31, 1993, the Company wrote down its investment in marketable equity securities by $25 million. ITEL CORPORATION SCHEDULE II--AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS, AND EMPLOYEES OTHER THAN RELATED PARTIES YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (IN THOUSANDS) - --------------- (a) In 1992, Itel acquired warrants to purchase 4.675 million shares of Common Stock held by an affiliate of Samuel Zell, a director of Itel. In connection with the warrant purchase, a $15.0 million note receivable was cancelled. ITEL CORPORATION SCHEDULE III--CONDENSED FINANCIAL INFORMATION OF REGISTRANT ITEL CORPORATION (PARENT COMPANY) BALANCE SHEETS (IN THOUSANDS) ITEL CORPORATION SCHEDULE III--CONDENSED FINANCIAL INFORMATION OF REGISTRANT ITEL CORPORATION (PARENT COMPANY) STATEMENTS OF OPERATIONS (IN THOUSANDS) ITEL CORPORATION SCHEDULE III--CONDENSED FINANCIAL INFORMATION OF REGISTRANT ITEL CORPORATION (PARENT COMPANY) STATEMENTS OF CASH FLOWS (IN THOUSANDS) ITEL CORPORATION SCHEDULE V--PROPERTY AND EQUIPMENT YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (IN THOUSANDS) ITEL CORPORATION SCHEDULE VI--ACCUMULATED DEPRECIATION YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (IN THOUSANDS) ITEL CORPORATION SCHEDULE VIII--VALUATION AND QUALIFYING ACCOUNTS AND RESERVES YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (IN THOUSANDS) - --------------- (a) At December 31, 1993, 1992 and 1991, the Company wrote down its investment in marketable equity securities by $25.0 million, $25.0 million and $50.0 million, respectively. The remaining deduction of $29.4 million in 1991 relates to the loss on sale of the Company's investment in Santa Fe. 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 THE 25TH DAY OF MARCH, 1994. ITEL CORPORATION JAMES E. KNOX ---------------------------------------- James E. Knox 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 DATES INDICATED. CONSENT OF INDEPENDENT AUDITORS We consent to the incorporation by reference in the Registration Statement (Form S-8 No. 2-93173) pertaining to the Itel Corporation 1983 Stock Incentive Plan, the Registration Statement (Form S-8 No. 33-13486) pertaining to the Itel Corporation Key Executive Equity Plan, the Registration Statement (Form S-8 No. 33-21656) pertaining to the Itel Corporation 1988 Employee Stock Purchase Plan, the Registration Statement (Form S-8 No. 33-38364) pertaining to the Itel Corporation 1989 Employee Stock Incentive Plan and the Registration Statement (Form S-8 No. 33-60676) pertaining to the Itel Corporation 1993 Director Stock Option Plan and in the related Prospectuses of our report dated February 8, 1994 with respect to the consolidated financial statements and schedules of Itel Corporation included in this Annual Report (Form 10-K) for the year ended December 31, 1993. ERNST & YOUNG Chicago, Illinois March 25, 1994

29989_1993.txt

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Item 1. Business Omnicom Group Inc., through its wholly and partially-owned companies (hereinafter collectively referred to as the "Agency" or "Company"), operates advertising agencies which plan, create, produce and place advertising in various media such as television, radio, newspaper and magazines. The Agency offers its clients such additional services as marketing consultation, consumer market research, design and production of merchandising and sales promotion programs and materials, direct mail advertising, corporate identification, and public relations. The Agency offers these services to clients worldwide on a local, national, pan-regional or global basis. Operations cover the major regions of North America, the United Kingdom, Continental Europe, the Middle East, Africa, Latin America, the Far East and Australia. In both 1993 and 1992, 52% of the Agency's billings came from its non-U.S. operations. (See "Financial Statements and Supplementary Data") According to the unaudited industry-wide figures published in the trade journal, Advertising Age, in 1993 Omnicom Group Inc. was ranked as the third largest advertising agency group worldwide. The Agency operates three separate, independent agency networks: The BBDO Worldwide Network, the DDB Needham Worldwide Network and the TBWA International Network. The Agency also operates independent agencies, Altschiller Reitzfeld, and Goodby, Berlin and Silverstein, and certain marketing service and specialty advertising companies through Diversified Agency Services ("DAS"). The BBDO Worldwide, DDB Needham Worldwide and TBWA International Networks General BBDO Worldwide, DDB Needham Worldwide and TBWA International, by themselves and through their respective subsidiaries and affiliates, independently operate advertising agency networks worldwide. Their primary business is to create marketing communications for their clients' goods and services across the total spectrum of advertising and promotion media. Each of the agency networks has its own clients and competes with each other in the same markets. The BBDO Worldwide, DDB Needham Worldwide and TBWA International agencies typically assign to each client a group of advertising specialists which may include account managers, copywriters, art directors and research, media and production personnel. The account manager works with the client to establish an overall advertising strategy for the client based on an analysis of the client's products or services and its market. The group then creates and arranges for the production of the advertising and/or promotion and purchases time, space or access in the relevant media in accordance with the client's budget. BBDO Worldwide Network The BBDO Worldwide Network operates in the United States through BBDO Worldwide which is headquartered in New York and has full-service offices in Los Angeles and San Francisco, California; Atlanta, Georgia; Chicago, Illinois; Detroit, Michigan; and Minneapolis, Minnesota. The BBDO Worldwide Network operates internationally through subsidiaries in Austria, Belgium, Brazil, Canada, Finland, France, Germany, Greece, Hong Kong, Italy, Malaysia, Mexico, the Netherlands, Peru, Poland, Portugal, Puerto Rico, Russia, Singapore, Spain, Sweden, Switzerland, Taiwan and the United Kingdom; and through affiliates located in Argentina, Australia, Chile, Croatia, the Czech Republic, Denmark, Egypt, El Salvador, Guatemala, Honduras, Hungary, India, Lebanon, Kuwait, New Zealand, Norway, Panama, the Philippines, Romania, Saudi Arabia, the Slovak Republic, Sweden, Turkey, the United Kingdom, United Arab Emirates, Uruguay, and Venezuela; and through joint ventures in China and Japan. The BBDO Worldwide Network uses the services of associate agencies in Colombia, Ecuador, Indonesia, Korea, Pakistan and Thailand. DDB Needham Worldwide Network The DDB Needham Worldwide Network operates in the United States through DDB Needham Worldwide which is headquartered in New York and has full-service offices in Los Angeles, California; Dallas, Texas; Honolulu, Hawaii; Chicago, Illinois; and Seattle, Washington. The DDB Needham Worldwide Network operates internationally through subsidiaries in Australia, Austria, Belgium, Canada, China, the Czech Republic, Denmark, France, Germany, Greece, Hong Kong, Hungary, Italy, Japan, Mexico, the Netherlands, New Zealand, Norway, Poland, Portugal, Singapore, the Slovak Republic, Spain, Sweden, Thailand and the United Kingdom; and through affiliates located in Brazil, Estonia, Finland, Germany, India, Korea, Malaysia, the Philippines, Switzerland, Taiwan and Thailand. The DDB Needham Worldwide Network uses the services of associate agencies in Argentina, Chile, Colombia, Costa Rica, Egypt, Indonesia, Ireland, Peru, Saudi Arabia, Turkey, United Arab Emirates, Venezuela and in Denver, Colorado. TBWA International Network The TBWA International Network operates in the United States through TBWA Advertising which is headquartered in New York and through TBWA Switzer Wolfe Advertising in St. Louis, Missouri. The TBWA International Network operates internationally through subsidiaries in Belgium, France, Germany, Italy, the Netherlands, Spain, Switzerland, and the United Kingdom; and through affiliates located in Denmark, South Africa and Sweden. The TBWA International Network uses the services of associate agencies in Austria, Canada, Finland, Greece, Japan, Korea, Mexico, Norway, Portugal and Turkey. Diversified Agency Services DAS is the Company's Marketing Services and Specialty Advertising division whose agencies' mission is to provide customer driven marketing communications coordinated to the client's benefit. The division offers marketing services including sales promotion, public relations, direct and database marketing, corporate and brand identity, graphic arts, merchandising/point-of-purchase; and specialty advertising including financial, healthcare and recruitment advertising. DAS agencies headquartered in the United States include: Harrison, Star, Wiener & Beitler, Inc., The Schechter Group, Inc., Kallir, Philips, Ross, Inc., RC Communications, Inc., Merkley Newman Harty Inc. and Lavey/Wolff/Swift, Inc., in New York; Doremus & Company, Gavin Anderson & Company Worldwide, Inc., Porter Novelli, Inc., Bernard Hodes Advertising, Inc., and Rapp Collins Worldwide Inc., all in various cities and headquartered in New York; Baxter, Gurian & Mazzei, Inc., in Beverly Hills, California; Frank J. Corbett, Inc., in Chicago, Illinois; Thomas A. Schutz Co., Inc. in Morton Grove, Illinois; Rainoldi, Kerzner & Radcliffe, Inc. in San Francisco, California and Alcone Sims O'Brien, Inc., in Irvine, California and Mahwah, New Jersey. DAS operates in the United Kingdom through subsidiaries which include Countrywide Communications Group Ltd., CPM Field Marketing Ltd., Granby Marketing Services Ltd., Headway, Home and Law Publishing Group Ltd., Interbrand Ltd., Product Plus London Ltd., Specialist Publications (UK) Ltd., The Anvil Consultancy Ltd. and Colour Solutions Ltd. In addition, DAS operates internationally with subsidiaries and affiliates in Australia, Belgium, Canada, France, Germany, Hong Kong, Ireland, Italy, Japan, Mexico, Scotland, Spain, Sweden and Switzerland. Omnicom Group Inc. As the parent company of BBDO Worldwide, DDB Needham Worldwide, TBWA International, the DAS Group, Goodby, Berlin and Silverstein, Inc., and Altschiller Reitzfeld, Inc., the Company, through its wholly-owned subsidiary Omnicom Management Inc., provides a common financial and administrative base for the operating groups. The Company oversees the operations of each group through regular meetings with their respective top-level management. The Company sets operational goals for each of the groups and evaluates performance through the review of monthly operational and financial reports. The Company provides its groups with centralized services designed to coordinate financial reporting and controls, real estate planning and to focus corporate development objectives. The Company develops consolidated services for its agencies and their clients. For example, the Company participated in forming The Media Partnership, which consolidates certain media buying activities in Europe in order to obtain cost savings for clients. Clients The clients of the Agency include major industrial, financial and service industry companies as well as smaller, local clients. Among its clients are Anheuser-Busch, Apple Computer, Chrysler Corporation, Delta Airlines, General Mills, Gillette, GTE, Henkel, McDonald's, PepsiCo., Volkswagen and The Wm. Wrigley Jr. Company. The Agency's ten largest clients accounted for approximately 18% of 1993 billings. The majority of these have been clients for more than ten years. The Agency's largest client accounted for less than 5% of 1993 billings. Revenues Commissions charged on media billings are the primary source of revenues for the Agency. Commission rates are not uniform and are negotiated with the client. In accordance with industry practice, the media source typically bills the Agency for the time or space purchased and the Agency bills its client for this amount plus the commission. The Agency typically requires that payment for media charges be received from the client before the Agency makes payments to the media. In some instances a member of the Omnicom Group, like other advertising agencies, is at risk in the event that its client is unable to pay the media. The Agency's advertising networks also generate revenues in arranging for the production of advertisements and commercials. Although, as a general matter, the Agency does not itself produce the advertisements and commercials, the Agency's creative and production staff directs and supervises the production company. The Agency bills the client for production costs plus a commission. In some circumstances, certain production work is done by the Agency's personnel. In some cases, fees are generated in lieu of commissions. Several different fee arrangements are used depending on client and individual agency needs. In general, fee charges relate to the cost of providing services plus a markup. The DAS Group primarily charges fees for its various specialty services, which vary in type and scale, depending upon the service rendered and the client's requirements. Advertising agency revenues are dependent upon the marketing requirements of clients and tend to be highest in the second and fourth quarters of the fiscal year. Other Information For additional information concerning the contribution of international operations to commissions and fees and net income see Note 5 of the Notes to Consolidated Financial Statements. The Agency is continuously developing new methods of improving its research capabilities, to analyze specific client requirements and to assess the impact of advertising. In the United States, approximately 136 people on the Agency's staff were employed in research during the year and the Agency's domestic research expenses approximated $13,137,000. Substantially all such expenses were incurred in connection with contemporaneous servicing of clients. The advertising business is highly competitive and accounts may shift agencies with comparative ease, usually on 90 days' notice. Clients may also reduce advertising budgets at any time for any reason. An agency's ability to compete for new clients is affected in some instances by the policy, which many advertisers follow, of not permitting their agencies to represent competitive accounts in the same market. As a result, increasing size may limit an agency's potential for securing certain new clients. In the vast majority of cases, however, the separate, independent identities of BBDO Worldwide, DDB Needham Worldwide and TBWA International and the independent agencies within the DAS Group have enabled the Agency to represent competing clients. BBDO Worldwide, DDB Needham Worldwide, TBWA International and the DAS Group have sought, and as part of the Agency's operating segments will seek, new business by showing potential clients examples of advertising campaigns produced and by explaining the variety of related services offered. The Agency competes in the United States and abroad with a multitude of full service and special service agencies. In addition to the usual risks of the advertising agency business, international operations are subject to the risk of currency exchange fluctuations, exchange control restrictions and to actions of governmental authorities. Employees The business success of the Agency is, and will continue to be, highly dependent upon the skills and creativity of its creative, research, media and account personnel and their relationships with clients. The Agency believes its operating groups have established reputations for creativity and marketing expertise which attract, retain and stimulate talented personnel. There is substantial competition among advertising agencies for talented personnel and all agencies are vulnerable to adverse consequences from the loss of key individuals. Employees are generally not under employment contracts and are free to move to competitors of the Agency. The Company believes that its compensation arrangements for its key employees, which include stock options, restricted stock and retirement plans, are highly competitive with those of other advertising agencies. As of December 31, 1993, the Agency, excluding unconsolidated companies, employed approximately 14,400 persons, of which approximately 6,100 were employed in the United States and approximately 8,300 were employed in its international offices. Government Regulation The advertising business is subject to government regulation, both within and outside the United States. In the United States, federal, state and local governments and their agencies and various consumer groups have directly or indirectly affected or attempted to affect the scope, content and manner of presentation of advertising. The continued activity by government and by consumer groups regarding advertising may cause further change in domestic advertising practices in the coming years. While the Company is unable to estimate the effect of these developments on its U.S. business, management believes the total volume of advertising in general media in the United States will not be materially reduced due to future legislation or regulation, even though the form, content, and manner of presentation of advertising may be modified. In addition, the Company will continue to assure that its management and operating personnel are aware of and are responsive to the possible implications of such developments. Item 2. Item 2. Properties Substantially all of the Company's offices are located in leased premises. The Company has continued a program to consolidate leased premises. Management has obtained subleases for most of the premises vacated. Where appropriate, management has established reserves for the difference between the cost of the leased premises that were vacated and anticipated sublease income. Domestic The Company's corporate office occupies approximately 25,000 sq. ft. of space at 437 Madison Avenue, New York, New York under a lease expiring in the year 2010. BBDO Worldwide occupies approximately 265,000 sq. ft. of space at 1285 Avenue of the Americas, New York, New York under a lease expiring in the year 2012, which includes options for additional growth of the agency. DDB Needham Worldwide occupies approximately 211,000 sq. ft. of space at 437 Madison Avenue, New York, New York under leases expiring in the year 2010, which include options for additional growth of the agency. TBWA International occupies approximately 51,000 sq. ft. of space at 292 Madison Avenue, New York, New York under a lease expiring in the year 2004, which includes options for additional growth of the agency. The Agency's other full-service offices in Atlanta, Beverly Hills, Chicago, Dallas, Detroit, Honolulu, Irvine, Los Angeles, Mahwah, Minneapolis, Morton Grove, New York, San Francisco, Seattle and St. Louis and service offices at various other locations occupy approximately 1,780,000 sq. ft. of space under leases with varying expiration dates. International The Company's international subsidiaries in Australia, Austria, Belgium, Brazil, Canada, China, the Czech Republic, Denmark, Finland, France, Germany, Greece, Hong Kong, Hungary, Italy, Japan, Malaysia, Mexico, the Netherlands, New Zealand, Norway, Poland, Portugal, Puerto Rico, Russia, Singapore, the Slovak Republic, Spain, Sweden, Switzerland, Taiwan, Thailand and the United Kingdom occupy premises under leases with various expiration dates. Item 3. Item 3. Legal Proceedings The Agency has no material pending legal proceedings, other than ordinary routine litigation incidental to its business. 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 last quarter of 1993. Executive Officers of the Company The individuals named below are Executive Officers of the Company: John L. Bernbach, Martin Boase and Peter I. Jones ceased to be Executive Officers of the Company in 1993 by reason of a change in their responsibilities. Effective January 1, 1994, Keith L. Bremer resigned his position as Treasurer of the Company to become Chief Financial Officer of DDB Needham Worldwide Inc. Effective January 1, 1994, Dennis E. Hewitt was promoted to Treasurer of the Company. Mr. Hewitt joined the Company in May 1988 as Assistant Treasurer. William G. Tragos became an Executive Officer of the Company upon the Company's acquisition of TBWA International B.V. in May 1993. Mr. Tragos is one of the founding partners of TBWA International B.V. and has served as the Chairman and Chief Executive Officer since its formation. John D. Wren became an Executive Officer of the Company upon his appointment as Chief Executive Officer of Diversified Agency Services in May 1993. Mr. Wren had served as President of Diversified Agency Services since February 1992, having previously served as its Executive Vice President and General Manager from January 1991 through February 1992, and as its Senior Vice President and Chief Financial Officer from September 1986 through December 1990. Dale A. Adams was promoted to Controller of the Company in July 1992. Mr. Adams joined the Company in July 1991 after ten years with Coopers & Lybrand, where he served as a general practice manager from 1987 until joining the Company. Raymond E. McGovern has served as Secretary and General Counsel of the Company since September 1986, having previously served as Secretary and General Counsel of BBDO Worldwide Inc. (then named BBDO International, Inc.) for more than 10 years. Similar information with respect to the remaining Executive Officers of the Company will be found in the Company's definitive proxy statement expected to be filed April 8, 1994. The Executive Officers of the Company are elected annually following the Annual Meeting of the Shareholders of their respective employers. PART II Item 5. Item 5. Market for Registrant's Common Equity and Related Stockholder Matters Price Range of Common Stock and Dividend History The Company's Common Stock is listed on the New York Stock Exchange under the symbol "OMC". The table below shows the range of reported last sale prices on the New York Stock Exchange Composite Tape for the Company's common stock for the periods indicated and the dividends paid per share on the common stock for such periods. Dividends Paid Per Share of High Low Common Stock ---- --- ------------ First Quarter .............. $36 3/4 $31 1/4 $.275 Second Quarter ............. 36 5/8 32 .310 Third Quarter .............. 35 7/8 32 .310 Fourth Quarter ............. 41 7/8 34 3/4 .310 First Quarter .............. 47 1/2 38 3/8 .310 Second Quarter ............. 47 1/4 38 1/4 .310 Third Quarter .............. 46 1/4 37 .310 Fourth Quarter ............. 46 1/2 41 1/2 .310 The Company is not aware of any restrictions on its present or future ability to pay dividends. However, in connection with certain borrowing facilities entered into by the Company and its subsidiaries (see Note 7 of the Notes to Consolidated Financial Statements), the Company is subject to certain restrictions on its current ratio, tangible net worth, and the ratio of net cash flow to consolidated indebtedness. On January 24, 1994 the Board of Directors declared a regular quarterly dividend of $.31 per share of common stock, payable April 1, 1994 to holders of record on March 18, 1994. Approximate Number of Equity Security Holders Approximate Number of Record Holders Title of Class on March 15, 1994 -------------- --------------------- Common Stock, $.50 par value ............. 2,672 Preferred Stock, $1.00 par value ......... None Item 6. Item 6. Selected Financial Data The following table sets forth selected financial data of the Company and should be read in conjunction with the consolidated financial statements which begin on page. Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Results of Operations In 1993, domestic revenues from commissions and fees increased 9 percent. The effect of acquisitions, net of divestitures, accounted for a 4 percent increase. The remaining 5 percent increase was due to net new business gains and higher spending from existing clients. Domestic revenues increased 2 percent in both 1992 and 1991, primarily as a result of net new business gains and higher spending from existing clients. In 1993, international revenues increased 10 percent. The effect of the acquisition of TBWA International B.V. and several marketing services companies in the United Kingdom, net of divestitures, accounted for an 18 percent increase in international revenues. The strengthening of the U.S. dollar against several major international currencies relevant to the Company's non-U.S. operations decreased revenues by 12 percent. The increase in revenues, due to net new business gains and higher spending from existing clients, was 4 percent. In 1992, international revenues increased 25 percent, of which the effect of the acquisition of McKim Baker Lovick BBDO in Canada and the purchase of additional shares in several companies which were previously affiliates of the Company accounted for 14 percent. The remaining increase was due to net new business gains and higher spending from existing clients. The fourth quarter strengthening of the U.S. dollar did not significantly impact the revenues for the year. In 1991, international revenues increased 9 percent, of which the effect of the acquisition of Valin Pollen in the United Kingdom, the purchase of additional shares in several companies which were previously affiliates of the Company, offset by the merger of BBDO's agency in the United Kingdom into Abbott Mead Vickers. BBDO Ltd., accounted for 4 percent. The strengthening of the U.S. dollar decreased international revenues by 3 percent in 1991. The remaining increase was due to net new business gains and higher spending from existing clients. In 1993, worldwide operating expenses increased 9 percent. Acquisitions, net of divestitures during the year, accounted for a 12 percent increase in worldwide operating expenses. The strengthening of the U.S. dollar against several international currencies decreased worldwide operating expenses by 6 percent. The remaining increase was caused by normal salary increases and growth in out-of-pocket expenditures to service the increased revenue base. Net foreign exchange gains did not significantly impact operating expenses for the year. In 1992, worldwide operating expenses, before the special charge, increased 12 percent. Acquisitions, net of divestitures during the year, accounted for 5 percent of the increase. The remaining increase was caused by normal salary increases and growth in out-of-pocket expenditures to service the increased revenue base. Foreign exchange gains did not significantly impact total operating expenses for the year. The ratio of worldwide operating expenses, before the special charge, as a percent of commissions and fees improved slightly over 1991. In 1991, worldwide operating expenses, increased 5 percent over 1990 levels. The ratio of worldwide operating expenses, excluding non-recurring items, as a percent of commissions and fees did not change significantly in 1991. Foreign exchange gains were comparable to those reported in 1990. Gains, net of losses, from the sales of equity interests in certain companies, together with other non-recurring items did not have a significant effect on the 1991 results. Interest expense in 1993 is comparable to 1992. Interest and dividend income decreased in 1993 by $2.2 million. This decrease was primarily due to lower average amounts of cash and marketable securities invested during the year and lower average interest rates on amounts invested. Interest expense in 1992 is comparable to 1991. Interest and dividend income decreased by $1.4 million in 1992. This decrease was primarily due to lower average funds available for investment during the year and declining interest rates in certain countries. Interest expense increased in 1991 by $1.3 million. Interest and dividend income increased by $2.8 million in 1991. This increase was primarily due to an increase of funds available for investment overseas in markets where interest rates were generally above those in the United States. In 1993, the effective tax rate decreased to 42.0%. This decrease primarily reflects a lower international effective tax rate caused by fewer international operating losses with no associated tax benefit, partially offset by an increased domestic federal tax rate. In 1992, the effective tax rate of 43.6% was comparable to the 1991 effective tax rate of 44%. In 1993, consolidated net income increased 23 percent. This increase is the result of revenue growth, margin improvement, an increase in equity income and a decrease in minority interest expense. Operating margin increased to 11.2 percent in 1993 from 11.1 percent in 1992. This increase was the result of greater growth in commission and fee revenue than the growth in operating expenses. The increase in equity income is the result of improved net income at companies which are less than 50 percent owned. The decrease in minority interest expense is primarily due to the acquisition of certain minority interests in 1993 and lower earnings by companies in which minority interests exist. In 1993, the incremental impact of acquisitions, net of divestitures, accounted for 1 percent of the increase in consolidated net income, while the strengthening of the U.S. dollar against several international currencies decreased consolidated net income by 6 percent. Consolidated net income increased 21 percent in 1992. This increase is a result of revenue growth and margin improvement. Operating margin, before the first quarter special charge discussed below, increased to 11.1 percent in 1992 from 10.9 percent in 1991. This increase was the result of greater growth in commissions and fees than the growth in operating expenses. In 1992, the incremental impact of acquisitions, net of divestitures, accounted for 6 percent of the increase in consolidated net income. Consolidated net income increased 10 percent in 1991. This increase is a result of revenue growth, margin improvement, lower net interest costs and a reduction in the effective tax rate. Operating margin, which excludes net interest expense, increased to 10.9 percent in 1991 from 10.8 percent in 1990, reflecting the greater growth of commissions and fees as compared to operating expenses. The reduction in net interest expense also contributed to an increase in the Net Income Before Tax margin from 8.7 percent to 9.1 percent. The impact of net non-recurring items in 1991 did not contribute towards net income growth. In 1991, the incremental effect of acquisitions net of dispositions had an adverse effect of 5 percent on net income. At December 31, 1993, accounts payable increased by $131.3 million from December 31, 1992. This increase was primarily due to an increased volume of activity resulting from business growth and acquisitions during the year and differences in the dates on which payments to media and other suppliers became due in 1993 compared to 1992. In 1992, the Company adopted two new accounting principles which had a net favorable cumulative after tax effect of $3.8 million. At the same time, the Company recorded a special charge to provide for future losses related to certain leased property. The combination of the favorable impact of the adoption of the new accounting principles and the after tax impact of the special charge had no effect on 1992 consolidated net income. Effective January 1, 1994, the Company will adopt Statement of Financial Accounting Standards No. 112 "Employers' Accounting for Postemployment Benefits" ("SFAS No. 112"). The Company estimates that the adoption of SFAS No. 112 will result in an unfavorable after tax effect on net income of approximately $27 million. The current economic conditions in the Company's major markets would indicate varying growth rates in advertising expenditures in 1994. The Company anticipates slow growth rates in certain European economies and improved growth rates in the United States, the United Kingdom and Australia. However, the Company believes that it is properly positioned should the anticipated improved growth rates not occur. Capital Resources and Liquidity Cash and cash equivalents increased $62 million during 1993 to $175 million at December 31, 1993. The Company's positive net cash flow provided by operating activities was enhanced by an improvement in the relationship between the collection of accounts receivable and the payment of obligations to media and other suppliers. After annual cash outlays for dividends paid to shareholders and minority interests and the repurchase of the Company's common stock for employee programs, the balance of the cash flow was used to fund acquisitions, make capital expenditures, repay debt obligations and invest in marketable securities. Cash was also raised from the issuance of $144 million of 4.5%/6.25% Step-Up Convertible Subordinated Debentures due 2000, the net proceeds of which were used for general corporate purposes, including, to reduce borrowings under the Company's commercial paper program. On August 9, 1993, the Company issued a Notice of Redemption for the outstanding $85 million of its 7% Convertible Subordinated Debentures due 2013. Prior to the October 8, 1993 redemption date, debenture holders elected to convert all of their outstanding debentures into common stock of the Company at a conversion price of $25.75 per common share. The Company maintains relationships with a number of banks worldwide, which have extended unsecured committed lines of credit in amounts sufficient to meet the Company's cash needs. At December 31, 1993, the Company had $359 million in committed lines of credit, comprised of a $200 million, two and one-half year revolving credit agreement and $159 million in unsecured credit lines, principally outside of the United States. Of the $359 million in committed lines, $27 million were used at December 31, 1993. Management believes the aggregate lines of credit available to the Company are adequate to support its short-term cash requirements for dividends, capital expenditures and maintenance of working capital. The Company anticipates that the year end cash position, together with the future cash flows from operations and funds available under existing credit facilities will be adequate to meet its long-term cash requirements as presently contemplated. Item 8. Item 8. Financial Statements and Supplementary Data The financial statements and supplementary data required by this item appear beginning on page. 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 with respect to the directors of the Company is incorporated by reference to the Company's definitive proxy statement expected to be filed by April 8, 1994. Information regarding the Company's executive officers is set forth in Part I of this Form 10-K. Item 11. Item 11. Executive Compensation Incorporated by reference to the Company's definitive proxy statement expected to be filed by April 8, 1994. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management Incorporated by reference to the Company's definitive proxy statement expected to be filed by April 8, 1994. Item 13. Item 13. Certain Relationships and Related Transactions Incorporated by reference to the Company's definitive proxy statement expected to be filed by April 8, 1994. PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K Page ---- (a) 1.Financial Statements: Report of Management ............................................ Report of Independent Public Accountants ........................ Consolidated Statements of Income for the three years ended December 31, 1993 ...................................... Consolidated Balance Sheets at December 31, 1993 and 1992 ....... Consolidated Statements of Shareholders' Equity for the three years ended December 31, 1993 .......................... Consolidated Statements of Cash Flows for the three years ended December 31, 1993 ...................................... Notes to Consolidated Financial Statements ...................... Quarterly Results of Operations (Unaudited) ..................... 2.Financial Statement Schedules: For the three years ended December 31, 1993: Schedule II--Amounts Receivable from Related Parties, Underwriters, Promoters, and Employees Other Than Related Parties .................................. S-1 Schedule VIII--Valuation and Qualifying Accounts ............... S-3 Schedule IX--Short-Term Borrowings ............................. S-4 Schedule X--Supplementary Income Statement Information ......... S-5 All other schedules are omitted because they are not applicable or the required information is shown in the consolidated financial statements or notes thereto. 3. Exhibits: (3)(i) Articles of Incorporation. Incorporated by reference to the 1986 Annual Report on Form 10-K filed with the Securities and Exchange Commission on March 31, 1987. (ii) By-laws. Incorporated by reference to the 1987 Annual Report on Form 10-K filed with the Securities and Exchange Commission on March 31, 1988. (4) Instruments Defining the Rights of Security Holders, Including Indentures. 4.1 Copy of Registrant's 6 1/2% Convertible Subordinated Debentures due 2004, including the indenture, filed as Exhibit 4.2 to Omnicom Group Inc.'s Annual Report on Form 10-K for the fiscal year ended December 31, 1989, is incorporated herein by reference. 4.2 Copy of Registrant's 4.5%/6.25% Step-Up Convertible Subordinated Debentures due 2000, filed as Exhibit 4.3 to Omnicom Group Inc.'s Quarterly Report on Form 10-Q for the quarter ended September 30, 1993, is incorporated herein by reference. (10) Material Contracts. Management Contracts, Compensatory Plans, Contracts or Arrangements. 10.1 Standard Form of Severance Compensation Agreement incorporated by reference to BBDO International Inc.'s Form S-1 Registration Statement filed with the Securities and Exchange Commission on September 28, 1973, is incorporated herein by reference. 10.2 Copy of Registrant's 1987 Stock Plan, filed as Exhibit 10.26 to Omnicom Group Inc.'s Annual Report on Form 10-K for the fiscal year ended December 31, 1987, is incorporated herein by reference. 10.3 Copy of Registrant's Profit-Sharing Retirement Plan dated May 16, 1988, filed as Exhibit 10.24 to Omnicom Group Inc.'s Annual Report on Form 10-K for the fiscal year ended December 31, 1988, is incorporated herein by reference. 10.4 Copy of Employment Agreement dated March 20, 1989, between Peter I. Jones and Boase Massimi Pollitt plc, filed as Exhibit 10.22 to Omnicom Group Inc.'s Annual Report on Form 10-K for the fiscal year ended December 31, 1989, is incorporated herein by reference. 10.5 Standard Form of the Registrant's 1988 Executive Salary Continuation Plan Agreement, filed as Exhibit 10.24 to Omnicom Group Inc.'s Annual Report on Form 10-K for the fiscal year ended December 31, 1989, is incorporated herein by reference. 10.6 Standard Form of the Registrant's Indemnification Agreement with members of Registrant's Board of Directors, filed as Exhibit 10.25 to Omnicom Group Inc.'s Annual Report on Form 10-K for the fiscal year ended December 31, 1989, is incorporated herein by reference. 10.7 Copy of DDB Needham Worldwide Joint Savings Plan, effective as of May 1, 1989, filed as Exhibit 10.26 to Omnicom Group Inc.'s Annual Report on Form 10-K for the fiscal year ended December 31, 1989, is incorporated herein by reference. 10.8 Amendment to Registrant's Profit-Sharing Retirement Plan, listed as Exhibit 10.3 above, adopted February 4, 1991, filed as Exhibit 10.28 to Omnicom Group Inc.'s Annual Report on Form 10-K for the fiscal year ended December 31, 1990, is incorporated herein by reference. 10.9 Amendment to Registrant's Profit-Sharing Retirement Plan listed as Exhibit 10.3 above, adopted on December 7, 1992, filed as Exhibit 10.13 to Omnicom Group Inc.'s Annual Report on Form 10-K for the fiscal year ended December 31, 1992, is incorporated herein by reference. 10.10 Amendment to Registrant's Profit-Sharing Retirement Plan listed as Exhibit 10.3 above, adopted on July 1, 1993. 10.11 Copy of Severance Agreement dated July 6, 1993, between Keith Reinhard and DDB Needham Worldwide Inc. 10.12 Copy of Severance Agreement dated July 6, 1993, between John L. Bernbach and DDB Needham Worldwide Inc. 10.13 Copy of Employment Agreement dated May 26, 1993, between William G. Tragos and TBWA International B.V. 10.14 Copy of Deferred Compensation Agreement dated October 12, 1984, between William G. Tragos and TBWA Advertising Inc. Other Material Contracts. 10.15 Copy of $200,000,000 Amended and Restated Credit Agreement, dated January 1, 1993, between Omnicom Finance Inc., Swiss Bank Corporation and the financial institutions party thereto, filed as Exhibit 10.12 to Omnicom Group Inc.'s Annual Report on Form 10-K for the fiscal year ended December 31, 1992, is incorporated herein by reference. (21) Subsidiaries of the Registrant....................... S-6 (23) Consents of Experts and Counsel. 23.1 Consent of Independent Public Accountants............ S-16 (24) Powers of Attorney from Bernard Brochand, Robert J. Callander, Leonard S. Coleman, Jr., John R. Purcell, Gary L. Roubos, Quentin I. Smith, Jr., Robin B. Smith, William G. Tragos, and Egon P. S. Zehnder. (b) Reports on Form 8-K: No reports on Form 8-K were filed during the fourth 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, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. Omnicom Group Inc. Date: March 28, 1994 By: /s/ Fred J. Meyer ------------------------------- Fred J. Meyer 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. REPORT OF MANAGEMENT The management of Omnicom Group Inc. is responsible for the integrity of the financial data reported by Omnicom Group and its subsidiaries. Management uses its best judgment to ensure that the financial statements present fairly, in all material respects, the consolidated financial position and results of operations of Omnicom Group. These financial statements have been prepared in accordance with generally accepted accounting principles. The system of internal controls of Omnicom Group, augmented by a program of internal audits, is designed to provide reasonable assurance that assets are safeguarded and records are maintained to substantiate the preparation of accurate financial information. Underlying this concept of reasonable assurance is the premise that the cost of control should not exceed the benefits derived therefrom. The financial statements have been audited by independent public accountants. Their report expresses an independent informed judgment as to the fairness of management's reported operating results and financial position. This judgment is based on the procedures described in the second paragraph of their report. The Audit Committee meets periodically with representatives of financial management, internal audit and the independent public accountants to assure that each is properly discharging their responsibilities. In order to ensure complete independence, the Audit Committee communicates directly with the independent public accountants, internal audit and financial management to discuss the results of their audits, the adequacy of internal accounting controls and the quality of financial reporting. /s/ Bruce Crawford /s/ Fred J. Meyer - ----------------------------------- ---------------------------------- Bruce Crawford Fred J. Meyer President and Chief Executive Officer Chief Financial Officer REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Board of Directors and Shareholders of Omnicom Group Inc.: We have audited the accompanying consolidated balance sheets of Omnicom Group Inc. (a New York 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 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 Omnicom Group Inc. 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 Note 12 to the consolidated financial statements, effective January 1, 1992, the Company changed its methods of accounting for income taxes and postretirement benefits other than pensions. Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. The schedules on pages S-1 through S-5 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 York, New York February 22, 1994 OMNICOM GROUP INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME The accompanying notes to consolidated financial statements are an integral part of these statements. OMNICOM GROUP INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS A S S E T S The accompanying notes to consolidated financial statements are an integral part of these balance sheets. OMNICOM GROUP INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY Three Years Ended December 31, 1993 (Dollars in Thousands) The accompanying notes to consolidated financial statements are an integral part of these statements. OMNICOM GROUP INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS The accompanying notes to consolidated financial statements are an integral part of these statements. OMNICOM GROUP INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. Summary of Significant Accounting Policies Recognition of Commission and Fee Revenue. Substantially all revenues are derived from commissions for placement of advertisements in various media and from fees for manpower and for production of advertisements. Revenue is generally recognized when billed. Billings are generally rendered upon presentation date for media, when manpower is used, when costs are incurred for radio and television production and when print production is completed. Principles of Consolidation. The accompanying consolidated financial statements include the accounts of Omnicom Group Inc. and its domestic and international subsidiaries (the "Company"). All significant intercompany balances and transactions have been eliminated. Reclassifications. Certain prior year amounts have been reclassified to conform with the 1993 presentation. Billable Production. Billable production orders in process consist principally of costs incurred in producing advertisements and marketing communications for clients. Such amounts are generally billed to clients when costs are incurred for radio and television production and when print production is completed. Treasury Stock. The Company accounts for treasury share purchases at cost. The reissuance of treasury shares is accounted for at the average cost. Gains or losses on the reissuance of treasury shares are generally accounted for as additional paid-in capital. Foreign Currency Translation. The Company's financial statements were prepared in accordance with the requirements of Statement of Financial Accounting Standards No. 52, "Foreign Currency Translation." Under this method, net transaction gains of $5.0 million, $8.1 million and $5.3 million are included in 1993, 1992 and 1991 net income, respectively. Net Income Per Common Share. Primary earnings per share is based upon the weighted average number of common shares and common share equivalents outstanding during each year. Fully diluted earnings per share is based on the above adjusted for the assumed conversion of the Company's Convertible Subordinated Debentures and the assumed increase in net income for the after tax interest cost of these debentures. For the year ended December 31, 1993, the 6.5% Convertible Subordinated Debentures were assumed to be converted for the full year; the 7% Convertible Subordinated Debentures were assumed to be converted through October 8, 1993 when they were converted into common stock; and the 4.5%/6.25% Step-Up Convertible Subordinated Debentures were assumed to be converted from their September 1, 1993 issuance date. For the years ended December 31, 1992 and 1991, the 6.5% and 7% Convertible Subordinated Debentures were assumed to be converted for the full year. The number of shares used in the computations were as follows: 1993 1992 1991 ---- ---- ---- Primary EPS computation ....... 30,607,900 28,320,400 27,415,000 Fully diluted EPS computation . 37,563,500 35,332,400 34,384,400 Severance Agreements. Arrangements with certain present and former employees provide for continuing payments for periods up to 10 years after cessation of their full-time employment in consideration for agreements by the employees not to compete and to render consulting services in the post employment period. Such payments, which are determined, subject to certain conditions and limitations, by earnings in subsequent periods, are expensed in such periods. Depreciation of Furniture and Equipment and Amortization of Leasehold Improvements. Depreciation charges are computed on a straight-line basis or declining balance method over the estimated useful lives of furniture and equipment, up to 10 years. Leasehold improvements are amortized on a straight-line basis over the lesser of the terms of the related lease or the useful life of these assets. Intangibles. Intangibles represent acquisition costs in excess of the fair value of tangible net assets of purchased subsidiaries which are being amortized on a straight-line basis over periods not exceeding forty years. Deferred Taxes. Deferred tax liabilities and tax benefits relate to the recognition of certain revenues and expenses in different years for financial statement and tax purposes. OMNICOM GROUP INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Cash Flows. The Company's cash equivalents are primarily comprised of investments in overnight interest-bearing deposits and money market instruments with maturity dates of three months or less. The following supplemental schedule summarizes the fair value of assets acquired, cash paid, common shares issued and the liabilities assumed in conjunction with the acquisition of equity interests in subsidiaries and affiliates, for each of the three years ended December 31: (Dollars in thousands) 1993 1992 1991 Fair value of non-cash assets acquired .. $ 287,177 $ 173,974 $ 89,384 Cash paid, net of cash acquired ......... (80,577) (59,651) (77,129) Common shares issued .................... (21,906) 5,596 (10,610) --------- --------- --------- Liabilities assumed ..................... $ 184,694 $ 119,919 $ 1,645 ========= ========= ========= During 1993, the Company issued 3,334,079 shares of common stock upon conversion of $85.9 million of its 7% Convertible Subordinated Debentures. Concentration of Credit Risk. The Company provides advertising and marketing services to a wide range of clients who operate in many industry sectors around the world. The Company grants credit to all qualified clients, but does not believe it is exposed to any undue concentration of credit risk to any significant degree. 2. Acquisitions During 1993 the Company made several acquisitions whose aggregate cost, in cash or by issuance of the Company's common stock, totaled $132.8 million for net assets, which included intangible assets of $149.7 million. Included in both figures are contingent payments related to prior year acquisitions totaling $16.2 million. Pro forma combined results of operations of the Company as if the acquisitions had occurred on January 1, 1992 do not materially differ from the reported amounts in the consolidated statements of income for each of the two years in the period ended December 31, 1993. Certain acquisitions entered into in 1993 require payments in future years if certain results are achieved. Formulas for these contingent future payments differ from acquisition to acquisition. In May 1993, the Company completed its acquisition of a third agency network, TBWA International B.V. The acquisition was accounted for as a pooling of interests and, accordingly, the results of operations for TBWA International B.V. have been included in these consolidated financial statements since January 1, 1993. Prior year consolidated financial statements were not restated as the impact on such years was not material. 3. Bank Loans and Lines of Credit Bank loans generally resulted from bank overdrafts of international subsidiaries which are treated as loans pursuant to bank agreements. At December 31, 1993 and 1992, the Company had unsecured committed lines of credit aggregating $359 million and $266 million, respectively. The unused portion of credit lines was $332 million and $237 million at December 31, 1993 and 1992, respectively. The lines of credit are generally extended at the banks' lending rates to their most credit worthy borrowers. Material compensating balances are not required within the terms of these credit agreements. At December 31, 1992, the committed lines of credit included $125 million under a two year revolving credit agreement. Due to the long term nature of this credit agreement, borrowings under the agreement were classified as long-term debt. As of January 1, 1993, the $125 million credit agreement was replaced by a $200 million, two and one-half year revolving credit agreement. Borrowings under this credit agreement are also classified as long-term debt. There were no borrowings under these credit agreements at December 31, 1993 and 1992. 4. Employee Stock Plans Under the terms of the Company's 1987 Stock Plan, as amended (the "1987 Plan"), 4,750,000 shares of common stock of the Company are reserved for restricted stock awards and non-qualified stock options to key employees of the Company. OMNICOM GROUP INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Under the terms of the 1987 Plan, the option price may not be less than 100% of the market value of the stock at the date of the grant. Options become exercisable 30% on each of the first two anniversary dates of the grant date with the final 40% becoming exercisable three years from the grant date. Under the 1987 Plan, 285,000, 242,500 and 175,000 non-qualified options were granted in 1993, 1992 and 1991, respectively. A summary of changes in outstanding options for the three years ended December 31, 1993 is as follows: Years Ended December 31, --------------------------------- 1993 1992 1991 ---- ---- ---- Shares under option (at prices ranging from $16.50 to $35.0625) -- Beginning of year ..................... 998,000 1,043,900 1,076,416 Options granted (at prices ranging from $23.50 to $40.0625) ................... 285,000 242,500 175,000 Options exercised (at prices ranging from $16.50 to $35.0625) .............. (197,800) (274,200) (203,600) Options forfeited ....................... (12,800) (14,200) (3,916) --------- ------- --------- Shares under option (at prices ranging from $16.875 to $40.0625)-- End of year 1,072,400 998,000 1,043,900 ========= ======= ========= Shares exercisable ...................... 562,650 443,400 371,749 Shares reserved ......................... 1,502,882 589,422 1,099,902 Under the 1987 Plan, 337,200 shares, 314,775 shares and 278,250 shares of restricted stock of the Company were awarded in 1993, 1992 and 1991, respectively. All restricted shares granted under the 1987 Plan were sold at a price per share equal to their par value. The difference between par value and market value on the date of the sale is charged to shareholders' equity and then amortized to expense over the period of restriction. Under the 1987 Plan, the restricted shares become transferable to the employee in 20% annual increments provided the employee remains in the employ of the Company. Restricted shares may not be sold, transferred, pledged or otherwise encumbered until the restrictions lapse. Under most circumstances, the employee must resell the shares to the Company at par value if the employee ceases employment prior to the end of the period of restriction. A summary of changes in outstanding shares of restricted stock for the three years ended December 31, 1993 is as follows: Years Ended December 31, ----------------------------------- 1993 1992 1991 ---- ---- ---- Beginning balance ........... 629,752 619,024 765,763 Amount granted ............ 337,200 314,775 278,250 Amount vested ............. (201,712) (278,942) (394,085) Amount forfeited .......... (24,804) (25,105) (30,904) ------- ------- ------- Ending balance .............. 740,436 629,752 619,024 ======= ======= ======= The charge to operations in connection with these restricted stock awards for the years ended December 31, 1993, 1992 and 1991 amounted to $7.1 million, $6.0 million and $6.2 million, respectively. OMNICOM GROUP INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) 5. Segment Reporting The Company operates advertising agencies and offers its clients additional marketing services and specialty advertising through its wholly-owned and partially-owned businesses. 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: (Dollars in Thousands) United States International Consolidated ---------- ------------- ------------ Commissions and Fees ........ $ 770,611 $ 745,864 $1,516,475 Operating Profit ............ 92,095 77,104 169,199 Net Income .................. 40,814 44,531 85,345 Identifiable Assets ......... 827,032 1,462,831 2,289,863 Commissions and Fees ........ 706,902 678,259 1,385,161 Operating Profit ............ 70,558 75,816 146,374 Net Income .................. 33,223 36,075 69,298 Identifiable Assets ......... 675,508 1,276,442 1,951,950 Commissions and Fees ........ 692,642 543,516 1,236,158 Operating Profit ............ 65,981 69,136 135,117 Net Income .................. 25,078 31,974 57,052 Identifiable Assets ......... 659,583 1,226,311 1,885,894 6. Investments in Affiliates The Company has approximately 45 unconsolidated affiliates with equity ownership ranging from 20% to 50%. The following table summarizes the balance sheets and income statements of the Company's unconsolidated affiliates, primarily in Europe, Australia, Asia and Canada, as of December 31, 1993, 1992, 1991, and for the years then ended: (Dollars in Thousands) 1993 1992 1991 ---- ---- ---- Current assets ................. $308,741 $312,423 $408,376 Non-current assets ............. 73,772 64,901 54,474 Current liabilities ............ 235,389 259,508 321,777 Non-current liabilities ........ 29,596 8,302 11,456 Minority interests ............. 1,149 1,110 275 Gross revenues ................. 290,814 288,416 374,760 Costs and expenses ............. 238,039 243,661 326,076 Net income ..................... 33,574 27,752 28,933 The Company's equity in the net income of these affiliates amounted to $13.2 million, $9.6 million and $9.3 million for 1993, 1992 and 1991, respectively. The Company's equity in the net tangible assets of these affiliated companies was approximately $58.1 million, $56.2 million and $54.5 million at December 31, 1993, 1992 and 1991, respectively. Included in the Company's investments in affiliates is the excess of acquisition costs over the fair value of tangible net assets acquired. These acquisitions costs are being amortized on a straight-line basis over periods not exceeding forty years. OMNICOM GROUP INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) 7. Long-Term Debt and Financial Instruments Long-term debt outstanding as of December 31, 1993 and 1992 consisted of the following: During the third quarter of 1993, the Company issued $143,750,000 of 4.5%/6.25% Step-Up Convertible Subordinated Debentures with a scheduled maturity in 2000. The average annual interest rate through the year 2000 is 5.42%. The debentures are convertible into common stock of the Company at a conversion price of $54.88 per share subject to adjustment in certain events. The debentures are not redeemable prior to September 1, 1996. Thereafter, the Company may redeem the debentures initially at 102.984% and at decreasing prices thereafter to 100% at maturity, in each case together with accrued interest. The debentures also may be repaid at the option of the holder at anytime prior to September 1, 2000 if there is a Fundamental Change, as defined in the debenture agreement, at the repayment prices set forth in the debenture agreement, subject to adjustment, together with accrued interest. On August 9, 1993, the Company issued a Notice of Redemption for its 7% Convertible Subordinated Debentures with a scheduled maturity in 2013. Prior to the October 1993 redemption date, debenture holders elected to convert all of their outstanding debentures into common stock of the Company at a conversion price of $25.75 per common share. During the third quarter of 1989, the Company issued $100,000,000 of 6.5% Convertible Subordinated Debentures with a scheduled maturity in 2004. The debentures are convertible into common stock of the Company at a conversion price of $28.00 per share subject to adjustment in certain events. Debenture holders have the right to require the Company to redeem the debentures on July 26, 1996 at a price of 123.001%, or upon the occurrence of a Fundamental Change, as defined in the debenture agreement, at the prevailing redemption price. The Company may redeem the debentures on or after July 27, 1994, initially at 118.808%, from July 27, 1995 to and including July 26, 1996 at 123.001%, and thereafter at 100%, together in each case with accrued interest. The debentures may also be redeemed in whole at any time, at par together with accrued interest, if any, in the event of certain developments regarding United States tax laws or the imposition of certain certification or identification requirements. Also in the third quarter of 1989, a wholly-owned subsidiary of the Company issued interest bearing Loan Notes in connection with the acquisition of Boase Massimi Pollitt plc. The Loan Notes are unsecured obligations guaranteed by the Company and bear interest at a yearly rate of 1/8 percent below the average of the six month London Inter-Bank Offered Rate for the three business days preceding the commencement of the relevant interest period. The Loan Notes are redeemable, at the option of the holder in whole or in part at their nominal amount, together with interest accrued to the date of redemption, on any interest payment date. Under certain conditions the Company may redeem the Loan OMNICOM GROUP INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Notes, at their nominal amount plus accrued interest, on any interest payment date on or after December 31, 1992. Unless earlier redeemed or purchased and cancelled, the Loan Notes will be repaid on December 31, 1994 at their nominal amount together with accrued interest. In January 1993, the Company amended and restated the revolving credit agreement originally entered into in 1988. This $200,000,000 revolving credit agreement is with a consortium of banks having an initial term of two and one-half years. This credit agreement includes a facility for issuing commercial paper backed by bank letters of credit. The agreement contains certain financial covenants regarding minimum tangible net worth, current ratio, ratio of net cash flow to consolidated indebtedness, limitation on foreign indebtedness, limitation on employee loans, and limitation on investments in and loans to affiliates and unconsolidated subsidiaries. At December 31, 1993 the Company was in compliance with all of these covenants. Aggregate maturities of long-term debt in the next five years are as follows: (Dollars in Thousands) ---------------------- 1994 ........................ $21,892 1995 ........................ 18,906 1996 ........................ 9,622 1997 ........................ 4,373 1998 ........................ 1,526 Periodically, the Company enters into swap agreements and other derivative financial instruments primarily to reduce the impact of changes in foreign exchange rates on net assets and liabilities denominated in foreign currencies and to reduce the impact of changes in interest rates on floating rate debt. At December 31, 1993, the Company had foreign currency and interest rate swap agreements outstanding with commercial banks having a notional principal amount of $70.6 million. These agreements effectively change a portion of the Company's foreign currency denominated debt to U.S. dollar denominated debt. The change from foreign currency denominated debt reduces the exposure to foreign currency fluctuations. The Company also has entered into U.S. dollar interest rate swap agreements which convert its floating rate debt to a fixed rate. These agreements have varying notional principal amounts, starting dates and maturity dates. The aggregate maximum notional principal amount outstanding through October 2003 is $50 million. 8. Income Taxes Income before income taxes and the provision for taxes on income consisted of the amounts shown below: Years Ended December 31, (Dollars in Thousands) ----------------------------------- 1993 1992 1991 --------- --------- --------- Income before income taxes: Domestic ......................... $ 65,571 $ 47,535 $ 44,937 International .................... 77,053 74,761 66,987 --------- --------- --------- Totals ......................... $ 142,624 $ 122,296 $ 111,924 Provision for taxes on income: Current: Federal ........................ $ 16,428 $ 17,143 $ 15,140 State and local ................ 6,531 6,215 2,765 International .................. 35,071 29,067 29,980 --------- --------- --------- 58,030 52,425 47,885 --------- --------- --------- Deferred: Federal ........................ 2,979 (3,702) 1,170 State and local ................ 139 (1,375) 239 International .................. (1,277) 5,920 (46) --------- --------- --------- 1,841 843 1,363 --------- --------- --------- Totals ......................... $ 59,871 $ 53,268 $ 49,248 ========= ========= ========= OMNICOM GROUP INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) The Company's effective income tax rate varied from the statutory federal income tax rate as a result of the following factors: 1993 1992 1991 ---- ---- ---- Statutory federal income tax rate ..... 35.0% 34.0% 34.0% State and local taxes on income, net of federal income tax benefit .......... 3.0 2.6 1.8 International subsidiaries' tax rate in excess of federal statutory rate .... 0.1 1.3 2.7 Losses of international subsidiaries without tax benefit ................. 0.2 1.0 0.3 Non-deductible amortization of goodwill 3.9 3.7 3.3 Other ................................. (0.2) 1.0 1.9 ---- ---- ---- Effective rate ........................ 42.0% 43.6% 44.0% ==== ==== ==== The Company accounts for income taxes in accordance with the provisions of Statement of Financial Accounting Standards No. 109 "Accounting for Income Taxes," which was adopted effective January 1, 1992. Deferred income taxes are provided for the temporary difference between the financial reporting basis and tax basis of the Company's assets and liabilities. Deferred tax benefits result principally from recording certain expenses in the financial statements which are not currently deductible for tax purposes. Deferred tax liabilities result principally from expenses which are currently deductible for tax purposes, but have not yet been expensed in the financial statements. The Company has recorded deferred tax benefits as of December 31, 1993 and 1992 of $56.7 million and $21.9 million, respectively, related principally to leasehold amortization, restricted stock amortization, foreign exchange transactions, and accrued expenses. The Company has recorded deferred tax liabilities as of December 31, 1993 and 1992 of $29.3 million and $21.9 million, respectively, related principally to furniture and equipment depreciation and tax lease recognition. In 1993, legislation was enacted which increased the U.S. statutory tax rate from 34% to 35%. The effect of this rate change and other statutory rate changes in various state, local and international jurisdictions was not material to net income. A provision has been made for additional income and withholding taxes on the earnings of international subsidiaries and affiliates that will be distributed. 9. Employee Retirement Plans The Company's international and domestic subsidiaries provide retirement benefits for their employees primarily through profit sharing plans. Company contributions to the plans, which are determined by the boards of directors of the subsidiaries, have been in amounts up to 15% (the maximum amount deductible for federal income tax purposes) of total eligible compensation of participating employees. Profit sharing expense amounted to $25.8 million in 1993, $20.8 million in 1992 and $24.4 million in 1991. Some of the Company's international subsidiaries have pension plans. These plans are not required to report to governmental agencies pursuant to the Employee Retirement Income Security Act of 1974 (ERISA). Substantially all of these plans are funded by fixed premium payments to insurance companies who undertake legal obligations to provide specific benefits to the individuals covered. Pension expense amounted to $2.4 million in 1993, $2.7 million in 1992 and $2.5 million in 1991. Certain subsidiaries of the Company have an executive retirement program under which benefits will be paid to participants or their beneficiaries over 15 years from age 65 or death. In addition, other subsidiaries have individual deferred compensation arrangements with certain executives which provide for payments over varying terms upon retirement, cessation of employment or death. OMNICOM GROUP INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Some of the Company's domestic subsidiaries provide life insurance and medical benefits for retired employees. Eligibility requirements vary by subsidiary, but generally include attainment of a specified combined age plus years of service factor. In 1991 the cost of these benefits was expensed as paid and was not material to the consolidated results of operations. Effective January 1, 1992, the Company adopted the provisions of Statement of Financial Accounting Standards No. 106 "Employers' Accounting For Post- retirement Benefits Other Than Pensions" ("SFAS No. 106"). SFAS No. 106 requires that the expected cost of post retirement benefits be charged to expense during the years that the eligible employees render service. The after tax cumulative effect of the adoption of SFAS No. 106 was not material to the net worth of the Company and the expense for the year was not material to the 1993 and 1992 consolidated results of operations. 10. Commitments At December 31, 1993, the Company was committed under operating leases, principally for office space. Certain leases are subject to rent reviews and require payment of expenses under escalation clauses. Rent expense was $128.8 million in 1993, $117.3 million in 1992 and $101.7 million in 1991 after reduction by rents received from subleases of $10.0 million, $14.1 million and $17.9 million, respectively. Future minimum base rents under terms of noncancellable operating leases, reduced by rents to be received from existing noncancellable subleases, are as follows: (Dollars in Thousands) Gross Rent Sublease Rent Net Rent ---------- ------------- -------- 1994 .................... $103,531 $ 9,297 $ 94,234 1995 .................... 94,594 7,698 86,896 1996 .................... 85,395 6,459 78,936 1997 .................... 77,229 4,305 72,924 1998 .................... 66,330 2,927 63,403 Thereafter .............. 414,201 10,944 403,257 Where appropriate, management has established reserves for the difference between the cost of leased premises that were vacated and anticipated sublease income. 11. Fair Value of Financial Instruments SFAS No. 107 "Disclosures about Fair Value of Financial Instruments," which was adopted by the Company in 1992, requires all entities to disclose the fair value of financial instruments for which it is practicable to estimate fair value. 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 and marketable securities: Marketable securities consist principally of investments in short-term, interest bearing instruments. The carrying amount approximates fair value. Long-term investments: Included in deferred charges and other assets are long-term investments which consist principally of an investment in Aegis Group plc., a publicly traded company, carried at fair market value and related stock warrants carried at cost. The fair value of the warrants was determined using an option pricing model. The remaining amounts, carried at cost, approximate estimated fair value. Long-term debt: The fair value of the Company's convertible subordinated debenture issues was determined by reference to quotations available in markets where those issues are traded. These quotations primarily reflect the conversion value of the debentures into the Company's common stock. These debentures are redeemable OMNICOM GROUP INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) by the Company, at prices explained in Note 7, which are significantly less than the quoted market prices used in determining the fair value. The fair value of the Company's remaining long-term debt was estimated based on the current rates offered to the Company for debt with the same remaining maturities. Swap agreements and forward contracts: The fair value of interest rate swaps and forward contracts is the estimated amount that the Company would receive or pay to terminate the agreements at December 31, 1993. The estimated fair value of the Company's financial instruments at December 31, 1993 is as follows: (Dollars in Thousands) Carrying Fair Amount Value --------- --------- Cash and marketable securities ......... $ 212,836 $ 212,836 Long-term investments .................. 26,015 27,672 Long-term debt ......................... 300,204 370,941 Other financial instruments: Interest rate swaps ................. -- (2,457) Forward contracts ................... (288) (288) 12. Special Charge and Adoption of New Accounting Principles Effective January 1, 1992, the Company adopted SFAS No. 106 and SFAS No. 109. The cumulative after tax effect of the adoption of these Statements increased net income by $3.8 million, substantially all of which related to SFAS No. 109. Due to the continued weakening of the commercial real estate market in certain domestic and international locations and the reorganization of certain operations, the Company provided a special charge of $6.7 million pretax for losses related to future lease costs. Effective January 1, 1994, the Company will adopt SFAS No. 112, "Employers' Accounting for Postemployment Benefits" ("SFAS No. 112"). The Company estimates that the adoption of SFAS No. 112 will result in an unfavorable after tax effect on net income of approximately $27 million. OMNICOM GROUP INC. AND SUBSIDIARIES QUARTERLY RESULTS OF OPERATIONS (Unaudited) The following table sets forth a summary of the unaudited quarterly results of operations for the two years ended December 31, 1993 and 1992, in thousands of dollars except for per share amounts. First Second Third Fourth --------- --------- --------- --------- Commissions & Fees 1993 ....................... $ 339,139 $ 381,758 $ 339,531 $ 456,047 1992 ....................... 308,888 347,561 327,750 400,962 Income Before Special Charge and Income Taxes 1993 ....................... 24,738 49,274 19,581 49,031 1992 ....................... 24,093 39,441 23,042 42,434 Special Charge 1993 ....................... -- -- -- -- 1992 ....................... 6,714 -- -- -- Income Before Income Taxes 1993 ....................... 24,738 49,274 19,581 49,031 1992 ....................... 17,379 39,441 23,042 42,434 Income Taxes 1993 ....................... 10,390 20,678 8,228 20,575 1992 ....................... 7,678 16,993 10,633 17,964 Income After Income Taxes 1993 ....................... 14,348 28,596 11,353 28,456 1992 ....................... 9,701 22,448 12,409 24,470 Equity in Affiliates 1993 ....................... 1,692 2,674 1,769 7,045 1992 ....................... 2,103 4,081 125 3,289 Minority Interests 1993 ....................... (1,584) (4,008) (276) (4,720) 1992 ....................... (2,876) (4,172) (2,157) (3,923) Cumulative Effect of Change in Accounting Principles 1993 ....................... -- -- -- -- 1992 ....................... 3,800 -- -- -- Net Income 1993 ....................... 14,456 27,262 12,846 30,781 1992 ....................... 12,728 22,357 10,377 23,836 Primary Earnings Per Share 1993 ....................... 0.50 0.90 0.43 0.95 1992 ....................... 0.45 0.78 0.37 0.84 Fully Diluted Earnings Per Share 1993 ....................... 0.49 0.82 0.43 0.87 1992 ....................... 0.45 0.72 0.37 0.76 Schedule II OMNICOM GROUP INC. AND SUBSIDIARIES SCHEDULE II--AMOUNTS RECEIVABLE FROM RELATED PARTIES, UNDERWRITERS, PROMOTERS, AND EMPLOYEES OTHER THAN RELATED PARTIES For the Three Years Ended December 31, 1993 - ----------- (1) See footnote on Page S-2 S-1 Schedule II OMNICOM GROUP INC. AND SUBSIDIARIES SCHEDULE II--AMOUNTS RECEIVABLE FROM RELATED PARTIES, UNDERWRITERS, PROMOTERS, AND EMPLOYEES OTHER THAN RELATED PARTIES (Continued) For the Three Years Ended December 31, 1993 S-2 Schedule VIII OMNICOM GROUP INC. AND SUBSIDIARIES SCHEDULE VIII--VALUATION AND QUALIFYING ACCOUNTS For the Three Years Ended December 31, 1993 S-3 Schedule IX OMNICOM GROUP INC. AND SUBSIDIARIES SCHEDULE IX--SHORT-TERM BORROWINGS For the Three Years Ended December 31, 1993 S-4 Schedule X OMNICOM GROUP INC. AND SUBSIDIARIES SCHEDULE X--SUPPLEMENTARY INCOME STATEMENT INFORMATION For the Three Years Ended December 31, 1993 S-5

318300_1993.txt

318300_1993

1993

318300

ITEM 1. BUSINESS. INTRODUCTION Peoples Bancorp Inc. (the "Company") was incorporated under the laws of the State of Delaware on April 1, 1980. The Company was merged, following Shareholder approval, into the Peoples Bancorp Inc., an Ohio corporation, effective April 6, 1993, pursuant to a reincorporation proceeding. Its principal business is to act as a multi-bank holding company. Its wholly-owned subsidiaries are The Peoples Banking and Trust Company, Marietta, Ohio ("Peoples Bank"), The First National Bank of Southeastern Ohio ("First National Bank") and The Northwest Territory Life Insurance Company, an Arizona corporation ("Northwest Territory"). At December 31, 1993 Peoples Bancorp Inc. (parent company only) had 23 full-time equivalent employees. PEOPLES BANK Peoples Bank was chartered as an Ohio banking corporation under its present name in Marietta, Ohio, in 1902. On August 1, 1990, Peoples Bank and The Peoples Bank, Nelsonville and Athens, were combined to provide efficiency in banking operations. On December 30, 1991, an office was opened at The Plains, a growing community in Athens County, Ohio. The Middleport office of Peoples Bank was acquired on January 2, 1992. This is a full-service branch located in Meigs County, Ohio. Peoples Bank acquired some of the assets and some of the liabilities of Liberty Savings Bank, Marietta, Ohio, from the RTC on February 1, 1992. During 1993 Peoples Bank opened a business production office in Newark, Ohio. As of December 31, 1993, Peoples Bank was one of the largest of 13 banks in Washington and Athens Counties, Ohio, and held 29.2% of total assets of all banks in those two counties. At December 31, 1993, it had assets of $400,000,000; deposits of $336,187,000; and net loans of $277,281,000. Peoples Bank is a full-service commercial bank. It provides checking accounts, NOW accounts, Super NOW accounts, money market deposit accounts, savings accounts, time certificates of deposit, commercial loans, installment loans, commercial and residential real estate mortgage loans, credit cards, automatic teller machines, banking by phone, lease financing, corporate and personal trust services and safe deposit rental facilities. Peoples Bank also sells travelers checks, money orders and cashier's checks. Services are provided through ordinary walk-in offices, automated teller facilities called "SuperTeller", and automobile drive-in facilities called "Motor Bank". At December 31, 1993, the Trust Department of Peoples Bank held approximately $326 million in trust and custodial accounts apart from the assets of the Bank. With all of its offices located in Ohio, Peoples Bank serves principally Washington, Athens and Meigs Counties, together with portions of Hocking, Perry and Vinton Counties in Ohio and adjacent parts of Northern West Virginia. The business production office in Newark, Ohio, serves that immediate area in Licking County. Peoples Bank provides services to its customers at its main office in downtown Marietta and through SuperTeller and other banking facilities. Full-service branches and SuperTellers are located at the Frontier Shopping Center and inside a grocery store at Pike and Acme Streets in Marietta. A full-service branch, two Motor Banks and a Super- /PAGE 2 Teller are operated in Belpre, Ohio. Full-service branches with Motor Banks are located in Lowell, Reno and Nelsonville, Ohio. A full-service branch is located at One North Court Street and at the Athens Mall in Athens, Ohio. The One North Court Street office also has a SuperTeller machine. In 1993, Peoples Bank added three SuperTeller machines on the campus of Ohio University in Athens, Ohio. These locations were operated by another local bank prior to Peoples Bank assuming operation of these machines. A full-service bank is located at Middleport, Ohio. At December 31, 1993, Peoples Bank had 217 full-time equivalent employees. THE FIRST NATIONAL BANK OF SOUTHEASTERN OHIO First National Bank is a national banking association chartered in 1900. It provides services and products that are substantially the same as those of Peoples Bank. It operates a commercial bank and motor bank at one location at 415 Main Street, Caldwell, Ohio. It also has a full-service office on Marion Street in Chesterhill, Ohio. On January 2, 1991, it acquired a full-service office on Kennebec Street, McConnelsville, Ohio. Its market area is comprised of Caldwell, Chesterhill, McConnelsville and the surrounding area in Noble and Morgan Counties, Ohio. At December 31, 1993, it had assets of $61,650,000, deposits of $49,723,000 and net loans of $38,089,000. At December 31, 1993, it had 29 full-time equivalent employees. During 1989, The First National Bank of Caldwell and The First National Bank of Chesterhill were merged to form The First National Bank of Southeastern Ohio. THE NORTHWEST TERRITORY LIFE INSURANCE COMPANY Northwest Territory was organized under Arizona law in 1983 and was issued a Certificate of Authority to act as a reinsurance company by the State of Arizona on February 8, 1984. Northwest Territory reinsures credit life and disability insurance issued to customers of banking subsidiaries of the Company by another insurance company. At November 30, 1993, Northwest Territory had total assets of $1,137,000 and had gross premium income of $231,000 in 1993, $230,000 in 1992 and $199,000 in 1991. Northwest Territory reinsures risks (currently not exceeding $15,000 per insured on a present value basis) within limits established by governmental regulations and management policy. Northwest Territory has no employees. CUSTOMERS AND MARKETS The Company's service area has a diverse economic structure. Principal industries in the area include metals, plastics and petrochemical manufacturing; oil, gas and coal production and related support industries. In addition, tourism, education and other service-related industries are important and growing industries. Excellent transportation facilities, including highway, river and rail, are available and have helped the area to develop. Consequently, the Company is not dependent upon any one industry segment for its business opportunities. /PAGE 3 COMPETITION The banking subsidiaries of the Company experience significant competition in attracting depositors and borrowers. Competition in lending activities comes principally from other commercial banks in the lending areas of the banks and, to a lesser extent, from savings associations, insurance companies, governmental agencies, credit union, brokerage firms and pension funds. The primary factors in competing for loans are interest rate and overall lending services. Competition for deposits comes from other commercial banks, savings and loan associations, money market funds and credit unions as well as from insurance companies and brokerage firms. The primary factors in competing for deposits are interest rates paid on deposits, account liquidity, convenience of office location and overall financial condition. The Company believes that its size, overall banking services and financial condition place it in a favorable competitive position. NORTHWEST TERRITORY LIFE INSURANCE COMPANY Northwest Territory Life Insurance Company operates in the highly competitive industry of credit life and disability insurance. A large number of stock and mutual insurance companies also operating in this industry have been in existence for longer periods of time and have substantially greater financial resources than does Northwest Territory Life Insurance Company. The principal methods of competition in the credit life and disability insurance industry are the availability of coverages, premium rates and a competitive advantage due to the fact that the business of Northwest Territory Life Insurance Company is limited to the accepting of life and disability reinsurance ceded in part by Northwest Territory Life Insurance Company from the credit life and disability insurance purchased by loan customers of Peoples Bank and First National Bank. SUPERVISION AND REGULATION The following is a summary of certain statutes and regulations affecting the Corporation and its subsidiaries. The summary is qualified in its entirety by reference to such statutes and regulations. The Corporation is a bank holding company under the Bank Holding Company Act of 1956, as amended, which restricts the activities of the Corporation and the acquisition by the Corporation of voting stock or assets of any bank, savings association or other company. The Corporation is also subject to the reporting requirements of, and examination and regulation by, the Board of Governors of the Federal Reserve System (the "Federal Reserve Board"). Subsidiary banks of a bank holding company are subject to certain restrictions imposed by the Federal Reserve Act on transactions with affiliates, including any loans or extensions of credit to the bank holding company or any of its subsidiaries, investments in the stock or other securities thereof and the taking of such stock or securities as collateral for loans to any borrower; the issuance of guarantees, acceptances or letters of credit on behalf of the bank holding company and its subsidiaries; purchases or sales of securities or other assets; and the payment of money or furnishing of services to the bank holding companies are prohibited from engaging in certain tie-in arrangements in connection with extensions of credit or provision of property or services. /PAGE 4 Bank holding companies are also restricted in acquiring shares or substantially all of the assets of any bank located outside the state in which the operations of the holding company's banking subsidiaries are principally conducted. Such an acquisition must be specifically authorized by statute of the state of the bank whose shares or assets are to be acquired. Ohio laws permit interstate banking on a reciprocal basis. Bank holding companies and banks located in Ohio may acquire or organize bank holding companies and banks in other states; conversely, bank holding companies and banks in such states may acquire or organize bank holding companies or acquire or charter banks in Ohio if the other state enacts effective reciprocal legislation granting Ohio bank holding companies and banks the same or greater authority. As a national bank, The First National Bank of Southeastern Ohio is supervised and regulated by the Comptroller of the Currency. As Ohio state-chartered banks, The Peoples Banking and Trust Company and The First National Bank of Southeastern Ohio are insured by the Federal Deposit Insurance Corporation ("FDIC") and those entities are subject to the applicable provisions of the Federal Deposit Insurance Act. A subsidiary of a bank holding company can be liable to reimburse the FDIC if the FDIC incurs or anticipates a loss because of a default of another FDIC-insured subsidiary of the bank holding company or FDIC assistance provided to such subsidiary in danger of default. Various requirements and restrictions under the laws of the United States and the State of Ohio affect the operations of The Peoples Banking and Trust Company and The First National Bank of Southeastern Ohio, including requirements to maintain reserves against deposits, restrictions on the nature and amount of loans which may be made and the interest that may be charged thereon, restrictions relating to investments and other activities, limitations on credit exposure to correspondent banks, limitations on activities based on capital and surplus, limitations on payment of dividends and limitations on branching. The Federal Reserve Board has adopted risk-based capital guidelines for bank holding companies and for state member banks. The risk-based capital guidelines include both a definition of capital and a framework for calculating weighted-risk assets by assigning assets and off-balance sheet items to risk weights (including certain off-balance sheet items, such as standby letters of credit). The minimum supervisory risk-based capital ratio is 8%. At least half of the total capital is to be comprised of common stockholder's equity (including retained earnings), noncumulative perpetual preferred stock, a limited amount of cumulative perpetual preferred stock and minority interest in equity accounts of consolidated subsidiaries, less goodwill ("Tier 1 capital"). The remainder ("Tier 2 capital") may consist, among other things, of mandatory convertible debt securities, a limited amount of subordinated debt, other preferred stock and a limited amount of allowance for loan and lease losses. The Federal Reserve Board also imposes a minimum leverage ratio (Tier 1 capital to total assets) of 4% for bank holding companies and state member banks that meet certain specified condition, including no operational, financial or supervisory deficiencies and including having the highest regulatory rating. The minimum leverage ratio is 1.0-2.0% higher for other bank holding companies and state member banks based on their particular circumstances and risk profiles and those experiencing or anticipating significant growth. /PAGE 5 National bank subsidiaries, such as The First National Bank of Southeastern Ohio, are subject to similar capital requirements adopted by the Comptroller of the Currency, and state non-member bank subsidiaries, such as The Peoples Banking and Trust Company, are subject to similar capital requirements adopted by the FDIC. The Corporation and it subsidiaries currently satisfy all capital requirements. Failure to meet the capital guidelines could subject a banking institution to a variety of enforcement remedies available to federal and state regulatory authorities, including the termination of deposit insurance by the FDIC. The ability of a bank holding company to obtain funds for the payment of dividends and for other cash requirements is largely dependent on the amount of dividends which may be declared by its subsidiary banks. The Peoples Banking and Trust Company and The First National Bank of Southeastern Ohio may not pay dividends to the Corporation if, after paying such dividends, they would fail to meet the required minimum levels under the risk-based capital guideline and the minimum leverage ratio requirements. The Peoples Banking and Trust Company and The First National Bank of Southeastern Ohio must have the approval of their respective regulative authorities if a dividend in any year would cause the total dividends for that year to exceed the sum of the current year's net profits and the retained net profits for the preceding two years, less required transfers to surplus. Payment of dividend by the bank subsidiaries may be restricted at any time at the discretion of the regulatory authorities, if they deem such dividends to constitute an unsafe and/or unsound banking practice. These provisions could have the effect of limiting the Corporation's ability to pay dividends on its outstanding common shares. Northwest Territory Life Insurance Company is chartered by the State of Arizona and is subject to regulation, supervision and examination by the Arizona Department of Insurance. The powers of regulation and supervision of the Arizona Department of Insurance relate generally to such matters a minimum capitalization, the grant and revocation of certificates of authority to transact business, the nature of and limitations on investments, the maintenance of reserves, the form and content of required financial statements, reporting requirements and other matters pertaining to life and disability insurance companies. MONETARY POLICY AND ECONOMIC CONDITIONS The commercial banking business is affected not only by general economic conditions, but also by the policies of various governmental regulatory agencies, including the Federal Reserve Board. The Federal Reserve regulates money and credit conditions and interest rates in order to influence general economic conditions primarily through open-market operations in United States Government securities, changes in the discount rate on bank borrowings, and changes in the reserve requirements against bank deposits. These policies and regulations significantly affect the overall growth and distribution of bank loans, investments and deposits, and the interest rates charged on loans, as well as the interest rates paid on deposits and accounts. The monetary policies of the Federal Reserve Board have had a /PAGE 6 significant effect on the operating results of commercial banks in the past and are expected to continue to have significant effects in the future. In view of the changing conditions in the economy and the money markets and the activities of monetary and fiscal authorities, no definitive predictions can be made as to future changes in interest rates, credit availability or deposit levels. STATISTICAL FINANCIAL INFORMATION REGARDING THE COMPANY The following listing of statistical financial information, which is included in the Company's Annual Report to Stockholders, provides comparative data for the Company over the past three and five years, as appropriate. These tables should be read in conjunction with "Management's Discussion and Analysis" and the Consolidated Financial Statements of the Company and its subsidiaries found at pages 26 through 30 and 6 through 19, respectively, of the Company's Annual Report to Stockholders. AVERAGE BALANCES AND ANALYSIS OF NET INTEREST INCOME Please refer to page 22 of the Company's Annual Report to Stockholders. RATE VOLUME ANALYSIS Please refer to page 23 of the Company's Annual Report to Stockholders. LOAN MATURITIES Please refer to page 23 of the Company's Annual Report to Stockholders. AVERAGE DEPOSITS Please refer to "Average Balances and Analysis of Net Interest Income" on page 22 of the Company's Annual Report to Stockholders. MATURITIES SCHEDULE OF LARGE CERTIFICATES OF DEPOSIT Please refer to page 23 of the Company's Annual Report to Stockholders. LOAN PORTFOLIO ANALYSIS Please refer to pages 24 and 25 of the Company's Annual Report to Stockholders. SECURITIES ANALYSIS Please refer to page 27 of the Company's Annual Report to Stockholders. /PAGE 7 RETURN RATIOS Please refer to page 5 of the Company's Annual Report to Stockholders. ITEM 2. ITEM 2. PROPERTIES The principal office of the Company and Peoples Bank is located at 138 Putnam Street, Marietta, Ohio. This location consists of a five-story, stone-block building and one other smaller building attached by interior corridors. Peoples Bank also owns several nearby vacant lots for parking and a nearby Motor Bank. Peoples Bank owns property on which three additional full-service and two additional Motor Banks are located, leases the land on which one full-service branch is located and leases its other full-service branch. Peoples Bank also owns a two-story, block building on the Public Square in Nelsonville, Ohio, an additional office in Nelsonville, together with an office consisting of a two-story concrete structure at One North Court Street, Athens, Ohio, and a brick full-service office in the Athens Mall. The building in the Mall is owned by the Bank on leased real property. First National Bank owns a three-story office building of brick and stone at 415 Main Street in Caldwell, Ohio, and a one-story masonry and brick building constructed in 1969 located on Marion Street in Chesterhill, Morgan County, Ohio, together with a two-story brick structure in McConnelsville, Morgan County, Ohio, located on Kennebec Street. In 1993, Peoples Bank completed construction of a five-story addition to its primary facility in downtown Marietta. The Company and its subsidiaries own other real property which, when considered in the aggregate, is not material to their operations. Management believes that these properties are in satisfactory condition and adequate. Due to growth and acquisitions, the Company expanded its space for some customer services and data processing. Please refer to Note 6 to the Consolidated Financial Statements on page 14 of the Company's Annual Report to Stockholders for a discussion of lease commitments. ITEM 3. ITEM 3. LEGAL PROCEEDINGS. There are no pending legal proceedings to which the Company or its subsidiaries are a party or to which any of their property is subject other than ordinary routine litigation incidental to their business, none of which is material. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. Please refer to this Company's Annual Proxy Statement for a discussion of items submitted to a vote of security holders. /PAGE 8 PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. Please refer to page 21 of the Company's Annual Report to Stockholders, which is incorporated by reference herein. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA. The table of Selected Financial Data on page 5 of the Company's Annual Report to Stockholders is incorporated herein by reference. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION. Please refer to Pages 26 through 30 of the Company's Annual Report to Stockholders, which are incorporated herein by reference. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. The Consolidated Financial Statements of Peoples Bancorp Inc. and it subsidiaries, included on pages 6 through 19 of its Annual Report to Stockholders for the fiscal year ended December 31, 1993, and the Report of Coopers & Lybrand included therein are incorporated herein by reference. Following is an index to the financial statements included in the Annual Report to Stockholders for the fiscal year ended December 31, 1993: FINANCIAL STATEMENTS: Peoples Bancorp Inc. and Subsidiaries: Report of Independent Accountants: Annual Report Page 20 Consolidated Balance Sheet December 31, 1993 and 1992: Annual Report Page 6 Consolidated Statement of Income for the Three Years Ended December 31, 1993: Annual Report Page 7 Consolidated Statement of Stockholders' Equity for the Three Years Ended December 31, 1993: Annual Report Page 8 Consolidated Statement of Cash Flows for the Three Years Ended December 31, 1993: Annual Report Page 9 Notes to the Consolidated Financial Statements: Annual Report Pages 10 - 19 Peoples Bancorp Inc.: (Parent Company Only Financial Statements are included in Note 18 to the Financial Statements): Annual Report Pages 18 - 19 Statistical Financial Information of the Company: Annual Report Pages 21 - 25 /PAGE 9 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. Directors and Executive Officers of the Company include those persons enumerated under "Election of Directors" on pages 5 through 10 of the Company's definitive Proxy Statement relating to the Company's Annual Meeting of Stockholders to be held April 5, 1994, which section is expressly incorporated by reference. Other Executive Officers are Carol A. Schneeberger (37), Vice President/Operations, John T. Underwood (54) Vice President/Business Development, John (Jack) W. Conlon (48), Chief Financial Officer and Jeffrey D. Welch (39), Treasurer. Ms. Schneeberger became Vice President/Operations of the Company in October, 1988. Prior to her above election she was Auditor of the Company since August, 1987 and Auditor of Peoples Bank from January, 1986. She was Assistant Auditor of Peoples Bank from January, 1979. Mr. Underwood joined Peoples Bancorp Inc. in October, 1993. Mr. Underwood was Executive Vice President/Operations for Peoples Bank and has 31 years of banking experience. Mr. Conlon has been Chief Financial Officer since April, 1991. He is also Chief Financial Officer and Treasurer of Peoples Bank. Mr. Welch has been Treasurer since 1985. He was Assistant Treasurer from 1984 to 1985. Certain other information called for in this Item 10 is incorporated herein by reference to the Company's definitive Proxy Statement under the caption "Security Ownership of Certain Beneficial Owners and Management" on pages 2 through 5. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION. See "Compensation Committee Interlocks and Insider Participation" and "Compensation of Executive Officers and Directors" on pages 13 and 14, and 14 through 18, respectively, of the Proxy Statement relating to the Company's Annual Meeting of Stockholders to be held April 5, 1994, which are expressly incorporated by reference. Neither the report on executive compensation nor the performance graph included in the Company's definitive Proxy Statement relating to the Company's Annual Meeting of Stockholders to be held on April 5, 1994, shall be deemed to be incorporated herein by reference. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT See "Security Ownership of Certain Beneficial Owners and Management" on pages 2 through 5 of the Company's definitive Proxy Statement relating to the Company's Annual Meeting of Stockholders to be held April 5, 1994, which section is expressly incorporated by reference. /PAGE 10 ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS See "Transactions Involving Management" on page 11 of the Company's definitive Proxy Statement relating to the Company's Annual Meeting of Stockholders to be held April 5, 1994, which section is expressly incorporated by reference. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K a) (1) Financial Statements For a list of all financial statements incorporated by reference in this Annual Report on Form 10-K, see "Index to Financial Statements" at Page 13. b) (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. c) (3) Exhibits Exhibits filed with this Annual Report on Form 10-K are attached hereto. For a list of such exhibits, see "Exhibit Index" at page 15. The following table provides certain information concerning executive compensation plans and arrangements required to be filed as exhibits to this Annual Report on Form 10-K. /PAGE 11 (b) Reports on Form 8-K During 1993, an Agreement of Merger of Peoples Bancorp (Delaware) with Peoples Bancorp (Ohio) was filed on Form 8-K, dated May 3, 1993 (File No. 0-16772). There were no current reports on Form 8-K filed during the fiscal quarter ended December 31, 1993. (c) Exhibits Exhibits filed with this Annual Report on Form 10-K are attached hereto. For a list of such exhibits, see "Exhibit Index" at page 15. (d) Financial Statement Schedules None /PAGE 12 PEOPLES BANCORP INC. FINANCIAL STATEMENTS: Peoples Bancorp Inc. and Subsidiaries: Report of Independent Accountants: Annual Report Page 20 Consolidated Balance Sheet as of December 31, 1993 and 1992: Annual Report Page 6 Consolidated Statement of Income for the Three Years Ended December 31, 1993: Annual Report Page 7 Consolidated Statement of Stockholders' Equity for the Three Years Ended December 31, 1993: Annual Report Page 8 Consolidated Statement of Cash Flows for the Three Years Ended December 31, 1993: Annual Report Page 9 Notes to the Consolidated Financial Statements: Annual Report Pages 10 - 19 Peoples Bancorp Inc.: (Parent Company Only Financial Statements are included in Note 18 to the Financial Statements): Annual Report Pages 18 - 19 Statistical Financial Information of the Company: Annual Report Pages 21 - 25 /PAGE 13 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. PEOPLES BANCORP INC. Date: March 24, 1994 By ROBERT E. EVANS Robert E. Evans, 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. /PAGE 14 EXHIBIT LIST AND INDEX PEOPLES BANCORP INC. FORM 10-K FOR YEAR ENDED DECEMBER 31, 1993 /PAGE 15 EXHIBIT LIST AND INDEX (Continued) PEOPLES BANCORP INC. FORM 10-K FOR YEAR ENDED DECEMBER 31, 1993 /PAGE 16 [DESCRIPTION] ACTUAL PROXY STATEMENT [TEXT] NOTICE OF ANNUAL MEETING OF SHAREHOLDERS PEOPLES BANCORP INC. Marietta, Ohio March 7, 1994 To the Shareholders of Peoples Bancorp Inc.: You are cordially invited to attend the Annual Meeting of Shareholders (the "Annual Meeting") of Peoples Bancorp Inc. (the "Company") to be held at 10:00 a.m., local time, on Tuesday, April 5, 1994, in the Conference Room of The Peoples Banking and Trust Company, 235 Second Street, Marietta, Ohio, for the following purposes: 1. To elect the following Directors for terms of three years each: 2. To consider and vote upon a proposal to adopt an amendment to Article FOURTH of the Company's Amended Articles of Incorporation which would increase the authorized number of shares of the Company from 4,000,000 shares to 6,000,000 shares, all of which will be common shares, without par value. 3. To transact such other business as may properly come before the Annual Meeting and any adjournment or adjournments thereof. Shareholders of record at the close of business on February 15, 1994, will be entitled to notice of and to vote at the Annual Meeting and any adjournment or adjournments thereof. You are cordially invited to attend the Annual Meeting. The vote of each shareholder is important, whatever the number of common shares held. Whether or not you plan to attend the Annual Meeting, please sign, date and return your Proxy promptly in the enclosed envelope. The Company's Annual Report to Shareholders for the fiscal year ended December 31, 1993 accompanies this Notice and Proxy Statement. By Order of the Board of Directors RUTH I. OTTO Ruth I. Otto Corporate Secretary PEOPLES BANCORP INC. 138 Putnam Street Marietta, Ohio 45750 (614) 373-3155 PROXY STATEMENT This Proxy Statement and the accompanying proxy are being mailed to shareholders of Peoples Bancorp Inc., an Ohio corporation (the "Company"), on or about March 7, 1994, in connection with the solicitation of proxies by the Board of Directors of the Company for use at the Annual Meeting of Shareholders of the Company (the "Annual Meeting") called to be held on Tuesday, April 5, 1994, or at any adjournment or adjournments thereof. The Annual Meeting will be held at 10:00 a.m., local time, in the Conference Room of The Peoples Banking and Trust Company, 235 Second Street, Marietta, Ohio. The Company has three wholly-owned subsidiaries. They include The Peoples Banking and Trust Company ("Peoples Bank"), The First National Bank of Southeastern Ohio ("First National") and The Northwest Territory Life Insurance Company ("Northwest Territory"). A proxy for use at the Annual Meeting accompanies this Proxy Statement and is solicited by the Board of Directors of the Company. Shareholders of the Company may use their proxies if they are unable to attend the Annual Meeting in person or wish to have their common shares of the Company voted by proxy even if they do attend the Annual Meeting. Without affecting any vote previously taken, any shareholder executing a proxy may revoke it at any time before it is voted by filing with the Secretary of the Company, at the address of the Company set forth on the cover page of this Proxy Statement, written notice of such revocation; by executing a later-dated proxy which is received by the Company prior to the Annual Meeting; or by attending the Annual Meeting and giving notice of such revocation in person. Attendance at the Annual Meeting will not, in and of itself, constitute revocation of a proxy. Only shareholders of the Company of record at the close of business on February 15, 1994 (the "Record Date"), are entitled to receive notice of and to vote at the Annual Meeting and any adjournment or adjournments thereof. At the close of business on the Record Date, 1,457,432 common shares were outstanding and entitled to vote. Each common share entitles the holder thereof to one vote on each matter to be submitted to shareholders at the Annual Meeting. A quorum for the Annual Meeting is a majority of the common shares outstanding. There is no cumulative voting with respect to the election of directors. As of the date of this Proxy Statement, the Board of Directors of the Company does not know of any business to be brought before the Annual Meeting except as set forth in this Proxy Statement. However, if any matters other than those referred to in this Proxy Statement should properly come before such Annual Meeting, or any adjournment or adjournments thereof, it is intended that the persons named as proxies in the enclosed proxy may vote the common shares represented by said proxy on such matters in accordance with their best judgment in light of the conditions then prevailing. The Company will bear the costs of preparing and mailing this Proxy Statement, the accompanying proxy and any other related materials and all other costs incurred in connection with the solicitation of proxies on behalf of the Board of Directors. Proxies will be solicited by mail and may be further solicited, for no additional compensation, by officers, directors, or employees of the Company and its subsidiaries by further mailing, by telephone, or by personal contact. The Company will also pay the standard charges and expenses of brokerage houses, voting trustees, banks, associations and other custodians, nominees, and fiduciaries, who are record holders of common shares not beneficially owned by them, for forwarding such materials to and obtaining proxies from the beneficial owners of common shares entitled to vote at the Annual Meeting. The Annual Report to the Shareholders of the Company for the fiscal year ended December 31, 1993 (the "1993 fiscal year") is enclosed herewith. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The following table sets forth, as of the Record Date, certain information concerning the beneficial ownership of common shares by the only person known to the Company to be the beneficial owner of more than 5% of the outstanding common shares: The following table sets forth, as of the Record Date, certain information with respect to the common shares beneficially owned by each director of the Company, by each nominee for election as a director of the Company, by the executive officer of the Company named in the Summary Compensation Table and by all executive officers and directors of the Company as a group: To the Company's knowledge, based solely on a review of the copies of the reports furnished to the Company and written representations that no other reports were required, during the 1993 fiscal year, all filing requirements applicable to officers, directors and greater than 10% beneficial owners of the Company under Section 16(a) of the Securities Exchange Act of 1934, as amended (the "Exchange Act"), were complied with. ELECTION OF DIRECTORS (Item 1 on Proxy) In accordance with Section 2.02 of the Regulations of the Company, four directors of Class II are to be elected to hold office for terms of three years each, in each case until their respective successors are duly elected and qualified. It is the intention of the persons named in the accompanying proxy to vote the common shares represented by the proxies received pursuant to this solicitation for the nominees named below who have been designated by the Board of Directors, unless otherwise instructed on the proxy. The following table gives certain information concerning each nominee for election as a director of the Company. Unless otherwise indicated, each person has held his principal occupation for more than five years. While it is contemplated that all nominees will stand for election, if one or more nominees at the time of the Annual Meeting should be unavailable or unable to serve as a candidate for election as a director, the proxies reserve full discretion to vote the common shares represented by the proxies for the election of the remaining nominees and for the election of any substitute nominee or nominees designated by the Board of Directors. The Board of Directors knows of no reason why any of the above-mentioned persons will be unavailable or unable to serve if elected to the Board. Under Ohio law and the Company's Regulations, the four nominees for election as Class II directors receiving the greatest number of votes will be elected as directors. Common shares as to which the authority to vote is withheld and broker non-votes will be counted for quorum purposes but will not be counted toward the election of directors, or toward the election of the individual nominees specified on the form of proxy. The following table gives certain information concerning the current directors who will continue to serve after the Annual Meeting. Unless otherwise indicated, each person has held his or her principal occupation for more than five years. George W. Broughton, a nominee for election as a director of the Company, is the son of Carl L. Broughton who currently serves as a director of the Company. Mr. Broughton has chosen not to stand for reelection and will cease to serve on April 5, 1994. The Board of Directors of the Company held a total of thirteen (13) meetings during the Company's 1993 fiscal year. Each incumbent director attended 75% or more of the aggregate of the total number of meetings held by the Board of Directors during the period he or she served as a director and the total number of meetings held by all committees of the Board of Directors on which he or she served during the period he or she served except Jewell Baker (50%) and Fred R. Price (35%). The Board of Directors of the Company has an Audit Committee comprised of Jewell Baker, Dennis D. Blauser, Wilford D. Dimit, Barton S. Holl, Norman J. Murray, Fred R. Price, James B. Stowe and Joseph H. Wesel (Mr. Wesel serves as an ex-officio member). The function of the Audit Committee is to assist the Audit Department of the Company in the annual review of the loan portfolio of each subsidiary bank, to review the work schedule of the Audit Department as to when audits of the subsidiaries are to be conducted and the adequacy of such audits, to review the adequacy of the Company's system of internal controls, to investigate the scope and adequacy of the work of the Company's independent public accountants, and to recommend to the Board of Directors a firm of accountants to serve as the Company's independent public accountants. The Audit Committee met seven (7) times during the Company's 1993 fiscal year. The Board of Directors of the Company has a Compensation Committee comprised of Carl L. Broughton, Norman J. Murray, Paul T. Theisen and Joseph H. Wesel. The function of the Compensation Committee is to review and recommend for approval by the Board of Directors salaries, bonuses, employment agreements and employee benefit plans for officers and employees, to supervise the operation of the Company's compensation plans, to select those eligible employees who may participate in each plan (where selection is required) and to prescribe (where permitted under the terms of the plan) the terms of any stock options granted under any stock option plan of the Company. The Compensation Committee met one (1) time during the Company's 1993 fiscal year. The Board of Directors does not have a standing nominating committee or committee performing similar functions. TRANSACTIONS INVOLVING MANAGEMENT Paul T. Theisen is President and a shareholder in the law firm of Theisen, Brock, Frye, Erb & Leeper Co., L.P.A. which rendered legal services to the Company and its subsidiaries during the Company's 1993 fiscal year and is expected to render legal services to the Company and its subsidiaries during the Company's 1994 fiscal year. During the Company's 1993 fiscal year, its subsidiaries, Peoples Bank and First National, entered into banking transactions, in the ordinary course of their respective businesses, with certain executive officers and directors of the Company, with members of their immediate families and with corporations for which directors of the Company serve as executive officers. It is expected that similar banking transactions will be entered into in the future. Loans to such persons have been made on substantially the same terms, including the interest rate charged and the collateral required, as those prevailing at the time for comparable transactions with persons not affiliated with the Company or its subsidiaries. These loans have been subject to, and are presently subject to, no more than a normal risk of uncollectibility and present no other unfavorable features. The aggregate amount of loans to directors and executive officers of the Company and their associates as a group at December 31, 1993, was $9,085,162.68. As of the date hereof, all of such loans are performing loans. REPORT OF THE COMPENSATION COMMITTEE OF THE BOARD OF DIRECTORS ON EXECUTIVE COMPENSATION Notwithstanding anything to the contrary set forth in any of the Company's previous filings under the Securities Act of 1933, as amended, or the Exchange Act that might incorporate future filings, including this Proxy Statement, in whole or in part, this Report and the graph set forth on page 19 shall not be incorporated by reference into any such filings. In November of 1992, a sub-committee of the Executive Committee of the Company's Board of Directors was given additional duties by the Board to act as the Board's Compensation Committee (the "Committee"). The members of the Committee are Carl L. Broughton, Norman J. Murray, Paul T. Theisen and Joseph H. Wesel, none of whom are compensated executive officers or employees of the Company or its subsidiaries. Mr. Murray is Chairman of the Board of Peoples Bank. The Committee is to meet periodically to review and recommend for approval by the Board of Directors salaries, bonuses, employment agreements and employee benefits plans for officers and employees, including executive officers of the Company. Prior to the establishment of the Committee, the Board of Directors functioned in the same capacity. The Committee also supervises the operation of the Company's compensation plans, selects those eligible employees who may participate in each plan (where selection is permitted) and prescribes (where permitted under the terms of the plan) the terms of any stock options granted under any stock option plan of the Company. Section 162(m) of the Internal Revenue Code of 1986, as amended, prohibits a publicly held corporation, such as the Company, from claiming a deduction on its federal income tax return for compensation in excess of $1 million paid for a given fiscal year to the chief executive officer (or person acting in that capacity) at the close of the corporation's fiscal year and the four most highly compensated officers of the corporation, other than the chief executive officer, at the end of the corporation's fiscal year. The $1 million compensation deduction limitation does not apply to "performance-based compensation". The proposed regulations issued by the Internal Revenue Service under Section 162(m) on December 15, 1993 (the "Proposed IRS Regulations") set forth a number of provisions which compensatory plans, such as the Incentive Bonus Plan and the Company's Stock Option Plan, must contain if the compensation paid under such plans is to qualify as performance-based for the purposes of Section 162(m). In order to qualify as "performance-based" under IRS Regulations, the compensation must be paid solely on account of the attainment of one or more performance goals set by a compensation committee comprised solely of two (2) or more outside directors. The performance goals must be approved by a majority of shareholders prior to payment of the remuneration and the compensation committee must certify to the satisfaction of the goals. Due to the fact that all executive officers of the Company receive compensation at levels substantially below the deductibility limit, the Committee does not propose at this time to present for shareholder approval performance goals such as those provided in the Incentive Compensation Plan discussed below. The Committee will rely from time to time upon advice of the Company's General Counsel regarding the appropriateness of presenting the Incentive Bonus Plan, or any similar plan, to Shareholders. The Committee operates under the principle that the compensation of executive officers should be directly and significantly related to the financial performance of the Company. The compensation philosophy of the Company reflects a commitment to reward executive officers for performance through cash compensation and through plans designed to enhance the long-term commitment of officers and employees to the Company and its subsidiaries. The cash compensation program for executive officers consists of two elements, a base salary component and an incentive component payable under the Incentive Bonus Plan. The combination of base salary and incentive compensation is designed to relate total cash compensation levels to the performance of the Company, its subsidiaries and the individual executive officer. The salaries of executive officers of the Company, including Mr. Evans' salary, have remained without substantial adjustment for a number of years, except for limited increases reflecting cost of living rises and special meritorious increases or adjustments reflecting increased responsibilities and promotions. This philosophy was reflected in Mr. Evans' 1993 salary, which increased only 4.3% from the prior year. This adjustment was designed to reflect cost of living increases. Primary reliance has been placed on the Incentive Bonus Plan for compensation adjustments. The Incentive Bonus Plan was established in 1988 for certain senior officers of the Company and its subsidiaries, including Mr. Evans and the other executive officers of the Company. The purpose of the Plan is to base, in part, compensation on the profit performance of the Company. Each year, in January, the Committee establishes minimum levels of return on equity and net income which must be met before any incentive bonus is paid. In 1993 the Incentive Bonus Plan required the attainment of a minimum return on equity of 10.00% and income growth based on the highest dollar net income from either the preceding year or any of the four years prior to 1993 increasing such year by a 5% compounding factor. If such minimum levels are met, each officer receives an incentive bonus equal to a predetermined percentage of salary, based on the amount by which net income exceeds the minimum level, up to an approximate maximum of 23% of salary. Consequently, higher net income creates higher incentive bonuses. The goals set for 1993 were exceeded and Mr. Evans' incentive bonus was approximately 20.8% of his salary. The Company's long-term compensation program consists primarily of stock options granted under the Company's 1993 Stock Option Plan (the "1993 Plan"). The Committee believes that stock ownership by members of the Company's management and stock-based performance compensation arrangements are important in aligning the interests of management with those of shareholders generally in the enhancement of shareholder value. Options are granted under the 1993 Plan with an exercise price equal to the market value of the Company's common shares on the date of grant. If there is no appreciation in the market value of the Company's common shares, the options are valueless. The Committee granted options based upon its subjective determination of the relative current and future contribution each officer has or may contribute to the long-term welfare of the Company. In order to further enhance Mr. Evans' long-term commitment to the Company, Peoples Bank entered in a Deferred Compensation Agreement with him in 1976. Under this Agreement, Mr. Evans agreed to serve the Bank as an employee until he reaches age 65 or until his earlier retirement, disability or death and agreed not to engage in activities in competition with Peoples Bank. The amount of $5,000 is automatically accrued to Mr. Evans' account upon the completion of each year of service to Peoples Bank until he reaches normal retirement age. At various times in the past, the Company has adopted certain broad-based employee benefit plans in which the Company's executive officers are permitted to participate on the same terms as non-executive officer employees who meet applicable eligibility criteria, subject to legal limitations on the amounts that may be contributed or the benefits that may be payable under the plans. To enhance the long-term commitment of the officers and employees of the Company and its subsidiaries, the Company established the Peoples Bancorp Inc. Retirement Savings Plan (the "Peoples 401(k) Plan") on December 31, 1985. Mr. Evans, as well as all officers and employees of the Company and its subsidiaries, may participate in the Peoples 401(k) Plan. Company matching contributions and participant contributions may be invested in common shares providing each participant with motivation toward safe and sound long-term growth of the Company. Company matching contributions may vary at the discretion of the Board of Directors. Submitted by the Compensation Committee of the Company's Board of Directors: Carl L. Broughton, Norman J. Murray, Paul T. Theisen and Joseph H. Wesel. COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION Carl L. Broughton, who served as Chairman of the Board of the Company from 1988 to 1990, serves as a member of the Compensation Committee. Norman J. Murray, Chairman of the Board of Peoples Bank, also serves as a member of the Compensation Committee. Paul T. Theisen, who is President and a shareholder in the law firm of Theisen, Brock, Frye, Erb & Leeper Co., L.P.A. which rendered legal services to the Company and its subsidiaries during the Company's 1993 fiscal year and is expected to render legal services to the Company and its subsidiaries during the Company's 1994 fiscal year, also serves as a member of the Compensation Committee. COMPENSATION OF EXECUTIVE OFFICERS AND DIRECTORS Summary of Cash and Certain Other Compensation The following table shows for the last three fiscal years, the cash compensation paid by the Company and its subsidiaries, as well as certain other compensation paid or accrued for those years, to Robert E. Evans, the Chief Executive Officer of the Company and the only executive officer of the Company whose total annual salary and bonus for the 1993 fiscal year exceeded $100,000. GRANT OF OPTIONS The following table sets forth information concerning individual grants of options made under the Peoples Bancorp Inc. 1993 Stock Option Plan (the "1993 Plan") during the 1993 fiscal year to the named executive officer. The Company has never granted stock appreciation rights. OPTION EXERCISES AND HOLDINGS The following table sets forth information with respect to unexercised options held as of the end of the 1993 fiscal year by the named executive officer. No options were exercised during the 1993 fiscal year. PENSION PLAN The following table shows the estimated annual pension benefits payable upon retirement at age 65 on a lifetime annuity basis under the Peoples Bancorp Inc. Retirement Plan, a funded, noncontributory pension plan (the "Pension Plan"), to a covered participant in specified compensation and years of service classifications. Benefits listed in the Pension Plan Table are not subject to deduction for Social Security benefits or other amounts and are computed on a lifetime annuity basis. Monthly benefits upon normal retirement (age 65) are based upon 40% of "average monthly compensation" plus 17% of the excess, if any, of "average monthly compensation" over "covered compensation." For purposes of the Pension Plan, "average monthly compensation" is based upon the monthly compensation (including regular salary and wages, overtime pay, bonuses and commissions) of an employee averaged over the five consecutive credited years of service which produce the highest monthly average within the last ten years preceding retirement and "covered compensation" is the average of the 35 years of social security wage bases prior to social security retirement age ("covered compensation" for Robert E. Evans as of the end of the 1993 fiscal year was $42,000.) 1993 annual compensation, to the extent determinable, for purposes of the Pension Plan for Mr. Evans was $183,500. As of the end of 1993 fiscal year, Mr. Evans had 23 credited years of service. DEFERRED COMPENSATION AGREEMENTS On November 18, 1976, Peoples Bank entered into a Deferred Compensation Agreement with Mr. Evans and an executive officer since retired. Under this Deferred Compensation Agreement, Mr. Evans agreed to serve Peoples Bank as an employee until he reaches age 65 or until his earlier retirement, disability or death and agreed not to engage in activities in competition with Peoples Bank. Under this Agreement, Mr. Evans or his beneficiaries are entitled to receive specified amounts upon Mr. Evans' retirement, disability or death, which amounts are payable monthly for ten years (with interest) or in one lump sum at the election of Peoples Bank. The principal amount payable to Mr. Evans is based upon the sum of the amount accrued for his account during his years of employment with Peoples Bank. During the Company's 1993 fiscal year, the amount of $5,000 was accrued for Mr. Evans' account pursuant to his Deferred Compensation Agreement and as of December 31, 1993, a total of $100,000 had been accrued to his account. The amount of $5,000 will be accrued to Mr. Evans' account upon the completion of each year of service to Peoples Bank until he reaches normal retirement age. DIRECTORS COMPENSATION Each director of the Company receives $250 per calendar quarter and $250 for each meeting attended. Effective January 1, 1991, the Company established the Peoples Bancorp Inc. Deferred Compensation Plan for Directors (the "Directors Deferred Compensation Plan"). Voluntary participation in the Directors Deferred Compensation Plan enables a director of the Company, or of one of its subsidiaries, to defer all or a part of his or her director's fees, including federal income tax thereon. Such deferred fees earn interest as provided in the Directors Deferred Compensation Plan. Distribution of the deferred funds is paid in a lump sum or annual installments beginning in the first year in which the person is no longer a director. Directors, other than those employed by the Company (the "Non-Employee Directors"), are automatically granted options on the date they are first elected or appointed as a director of the Company to purchase 550 common shares at an option price equal to 100% of the fair market value of the common shares on the date of grant. In addition, every other year at the Board meeting immediately following the annual shareholders meeting, commencing in 1993, all Non-Employee Directors then serving on the Board of Directors, other than a Non-Employee Director who was first elected as a director at such annual shareholders meeting or first appointed as a director at the Board meeting immediately following such annual shareholders meeting will receive an automatic grant of options to purchase 550 common shares; provided that the number of common shares subject to options granted to Non-Employee Directors who have not served a full two years on the Board will be prorated such that those Non-Employee Directors will receive options to purchase only a percentage of 550 common shares commensurate with the actual portion of the two years that such Non-Employee Directors served on the Board. Options granted to Non-Employee Directors have terms of ten years and become exercisable with respect to 20% of the common shares subject thereto on the date of grant and 20% on each of the first, second, third and fourth anniversaries of the date of grant. If a Non-Employee Director ceases to be a director for reasons other than his or her death, the options may be exercised for a period of three months, subject to the term of the options. If a Non-Employee Director ceases to be a director by reason of his or her death, the options may be exercised for a period of one year, subject to the term of the options. PERFORMANCE GRAPH The following line graph compares the yearly percentage change in the Company's cumulative total shareholder return (as measured by dividing (i) the sum of (A) the cumulative amount of dividends for the measurement period, assuming dividend reinvestment, and (B) the difference between the price of the Company's common shares at the end and the beginning of the measurement period; by (ii) the price of the Company's common shares at the beginning of the measurement period) against the cumulative return for an index for NASDAQ Stock Market (U.S. Companies) comprised of all domestic common shares traded on the NASDAQ National Market System and the NASDAQ Small-Cap Market and an index for NASDAQ Bank Stocks comprised of all depository institutions (SIC Code #602) and depository institutions holding companies (SIC Code #671) that are traded on the NASDAQ National Market System and the NASDAQ Small-Cap Market ("NASDAQ Bank Stocks"), for the five-year period ended December 31, 1993. PLEASE SEE FORM SE FOR PERFORMANCE GRAPH IN PAPER FORM DELIVERED TO THE SEC ON MARCH 7, 1994 PROPOSED AMENDMENT OF AMENDED ARTICLES OF INCORPORATION TO INCREASE AUTHORIZED NUMBER OF COMMON SHARES (Item 2 on Proxy) The Amended Articles of Incorporation (the "Amended Articles") of the Company presently authorize 4,000,000 shares, all of which are common shares, without par value. The Company's Board of Directors unanimously adopted a resolution proposing and declaring it advisable that Article FOURTH of the Company's Amended Articles be amended in order to increase the authorized number of shares of the Company to 6,000,000 shares, all of which will be common shares, without par value, and recommending to the shareholders of the Company the approval of the proposed amendment. Of the Company's presently authorized 4,000,000 common shares, 1,457,432 were outstanding as of February 15, 1994, 110,000 common shares were reserved for issuance upon the exercise of options granted and to be granted under the Company's 1993 Plan and 2,432,568 were available for issuance. In addition, common shares may be acquired by participants in the Peoples 401(k) Plan if they direct that their contributions and Company matching contributions under the Peoples 401(k) Plan be invested in the investment fund consisting of common shares. The proposed increase in the authorized number of common shares of the Company would be accomplished by amending Article FOURTH of the Company's Amended Articles to read as follows: FOURTH: The authorized number of shares of the Corporation shall be 6,000,000, all of which shall be common shares, each without par value. The Board of Directors believes that it is desirable and in the best interests of the Company and its shareholders to increase the number of common shares that the Company is authorized to issue in order to ensure that the Company will have a sufficient number of authorized common shares available in the future to provide it with the desired flexibility to meet its business needs. If this proposal is approved by the shareholders, the additional common shares could be available for a variety of corporate purposes, including, for example, the declaration and payment of share dividends to the Company's shareholders; share splits; use in the financing of expansion or future acquisitions; issuance pursuant to a dividend reinvestment plan; issuance pursuant to the terms of employee stock option plans and other employee benefit plans, including the Peoples 401(k) Plan and the 1993 Plan; and use in other possible future transactions of a currently undetermined nature. If the proposed amendment is adopted, the Company would be permitted to issue the additional authorized common shares without further shareholder approval, except to the extent otherwise required by the Company's Amended Articles, by law or by NASDAQ or any securities exchange on which the common shares may be listed at the time (the common shares are currently reported on the NASDAQ National Market System). The authorization of additional common shares will enable the Company, as the need may arise, to take timely advantage of market conditions and the availability of favorable opportunities without the delay and expense associated with the holding of a special meeting of its shareholders. It is the belief of the Board of Directors that the delay necessary for shareholder approval of a specific issuance could be to the detriment of the Company and its shareholders. The Board of Directors does not intend to issue any common shares except on terms which the Board deems to be in the best interests of the Company and its shareholders. Existing shareholders of the Company will have no pre-emptive rights to purchase any common shares issued in the future. Depending on the terms thereof, the issuance of the common shares may or may not have a dilutive effect on the Company's then-existing shareholders. From time to time the Company's Board of Directors has declared a share split with respect to the Company's outstanding common shares. As of the date hereof, the Board has not yet determined to declare such a share split. If the Board of Directors should authorize at a future date such a share split, the issuance of the common shares pursuant to the share split will not have a dilutive effect on the equity interest of the Company's existing shareholders. Shareholders of the Company should understand that they are not being asked to approve or disapprove a proposed share split. A vote in favor of the proposal to adopt the amendment to Article FOURTH of the Amended Articles should not be deemed to be a vote to approve a share split. If the proposed amendment is not approved by the shareholders, the Company anticipates that share splits will still take place from time to time notwithstanding the disapproval. The Board of Directors of the Company is considering the adoption of a dividend reinvestment plan (a "DRIP") pursuant to which common shares of the Company may be issued; however, the terms under which such a DRIP would be operated have not been determined. The issuance of common shares pursuant to the DRIP may or may not have a dilutive effect on the equity interest of the Company's then-existing shareholders, depending on the terms thereof. Shareholders of the Company should understand that they are not being asked to approve or disapprove the adoption of a DRIP. A vote in favor of the proposal to adopt the amendment to Article FOURTH of the Amended Articles should not be deemed to be a vote to approve the DRIP. If the proposed amendment is not approved by the shareholders, the Company anticipates that the DRIP will still be adopted. Other than the common shares which would be acquired as a result of a share split, the common shares which may be acquired pursuant to the Peoples 401(k) Plan, the 110,000 common shares which may be issued under the 1993 Plan and the common shares which may be issued if a DRIP is adopted by the Board of Directors, the Company presently has no plans, agreements or understandings to issue any of the newly authorized common shares. Although the Company has no such intentions, the proposed increase in the authorized and unissued common shares might be considered as having the effect of discouraging an attempt by another person or entity, through the acquisition of a substantial number of common shares, to acquire control of the Company with a view to imposing a merger, sale of all or any part of its assets, or a similar transaction, since the issuance of new common shares, in a public or private sale, merger or similar transaction, could be used to dilute the share ownership of a person or entity seeking to obtain control of the Company. Furthermore, since Article SEVENTH of the Amended Articles requires, if three members of the Board of Directors of the Company votes against the approval of such amendments or transactions, the affirmative vote of holders of shares entitling them to exercise not less than 75% of the voting power of the Company to: (i) adopt amendments to the Amended Articles or the Regulations of the Company (including the provisions of the Amended Articles and the Regulations pertaining to the right of a shareholder to nominate an individual for election as a director of the Company, the number of directors, the right of shareholders to remove directors from office and fill vacancies in the Board of Directors, or the classified Board); (ii) adopt any proposal to fix or change the number of directors of the Company by action of the shareholders; or (iii) adopt mergers, consolidations, a proposal to sell, lease, exchange, transfer or otherwise dispose of all or substantially all of the Company's property or assets, combinations or majority share acquisitions involving the issuance of common shares and requiring shareholder approval, and a proposal to dissolve the Company; the Board could (within the limits imposed by Ohio law) issue new common shares to purchasers who, together with other shareholders of the Company, might block such a 75% vote. The Board has no present knowledge of any present or past efforts to gain control of the Company and has not received any indication from any party that such party is interested in acquiring the Company. As of February 15, 1994, the Company's executive officers and directors, their respective associates and the Trust Department of Peoples Bank held approximately 22.2% of the Company's common shares and corresponding voting power. The Company's Amended Articles and Regulations contain other provisions which could potentially make a change of control of the Company more difficult. These include (a) the classification of the Board of Directors of the Company into three classes of directors so that each director serves for three years, with one class being elected each year; (b) the requirement that shareholder nominations for election to the Board of Directors be made in writing and delivered or mailed to the Secretary of the Company within the time frames specified in the Company's Regulations; and (c) the requirement that holders of shares entitling them to exercise not less than 75% of the voting power of the Company vote in favor of the removal of a director from office and that such removal only be for cause. UNDER ARTICLE SEVENTH OF THE AMENDED ARTICLES, THE AFFIRMATIVE VOTE OF THE HOLDERS OF SHARES ENTITLING THEM TO EXERCISE NOT LESS THAN A MAJORITY OF THE VOTING POWER OF THE COMPANY IS REQUIRED TO ADOPT THE PROPOSED AMENDMENT TO ARTICLE FOURTH OF THE COMPANY'S AMENDED ARTICLES. Under Ohio law and the Company's Regulations, abstentions and broker non-votes are counted as present; the effect of an abstention or a broker non-vote on the proposal is the same as a "no" vote. If the amendment is approved, it will become effective upon the filing of a Certificate of Amendment to the Company's Amended Articles with the Ohio Secretary of State, which is expected to be accomplished as promptly as practicable after such approval is obtained. The Board of Directors recommends that the shareholders vote FOR the proposed amendment to Article FOURTH of the Company's Amended Articles. Unless otherwise directed, the persons named in the enclosed proxy will vote the common shares represented by all proxies received prior to the Annual Meeting, and not properly revoked, in favor of the proposed amendment to Article FOURTH. SHAREHOLDER PROPOSALS FOR 1995 ANNUAL MEETING Any qualified shareholder who desires to present a proposal for consideration at the 1995 Annual Meeting of Shareholders must submit the proposal in writing to the Company. If the proposal is received by the Company on or before November 15, 1994 and otherwise meets the requirements of applicable state and federal law, it will be included in the proxy statement and form of proxy of the Company relating to its 1995 Annual Meeting of Shareholders. NOTIFICATION OF APPOINTMENT OF INDEPENDENT PUBLIC ACCOUNTANTS The Board of Directors of the Company appointed the accounting firm of Coopers & Lybrand to serve as independent public accountants of the Company for the 1993 fiscal year. The firm has served as independent public accountants for the Company since 1980. Accountants for the 1994 fiscal year have not been selected. The Board of Directors has historically appointed accountants at the meeting held immediately following the Annual Meeting and intends to do so this year. The Board of Directors expects that representatives of Coopers & Lybrand will be present at the Annual Meeting, will have the opportunity to make a statement if they desire to do so, and will be available to respond to appropriate questions. OTHER MATTERS As of the date of this Proxy Statement, the Board of Directors knows of no other business to be presented for action by the shareholders at the 1994 Annual Meeting of Shareholders other than as set forth in this Proxy Statement. However, if any other matter is properly presented at the Annual Meeting, or at any adjournment or adjournments thereof, it is intended that the persons named in the enclosed proxy may vote the common shares represented by such proxy on such matters in accordance with their best judgment in light of the conditions then prevailing. It is important that proxies be voted and returned promptly; therefore, shareholders who do not expect to attend the Annual Meeting in person are urged to fill in, sign and return the enclosed proxy in the self-addressed envelope furnished herewith. By Order of the Board of Directors ROBERT E. EVANS Robert E. Evans President and Chief Executive Officer March 7, 1994

787977_1993.txt

787977_1993

1993

787977

Item 1. Business. General. Alex. Brown Incorporated (together with its subsidiaries, the "Company"), incorporated in 1986, is a holding company which is the successor to the investment banking business founded in 1800 by Alexander Brown. The firm began operating in partnership form in approximately 1805 and continued in that form until 1984 when the firm's investment banking business was transferred to Alex. Brown & Sons Incorporated ("Alex. Brown"), the Company's principal operating subsidiary. The Company's real estate advisory and investment management businesses are operated through various entities. In some instances, non-affiliated third parties or the professionals in such businesses hold equity interests in such entities. In certain of those instances, the equity interests of non-affiliated third parties are equal to or greater than the Company's. Through Alex. Brown, the Company provides investment services to individual and institutional investors, and investment banking services to corporate and municipal clients. To support the investment services provided to individual and institutional investors, the Company effects transactions in equity and debt securities as both agent and principal. In addition, the Company's Research Division supplies investment advice to individual and institutional investors regarding corporate securities in selected industry sectors. The Company provides investment banking services to corporate clients primarily in the industry sectors selected for research coverage. The Company also provides investment banking services to municipal clients, including states, counties, cities, transportation authorities, sewer and water authorities, and housing and health and higher education agencies. The Company's operations are conducted from 28 offices in 15 states and the District of Columbia and from representative offices in London, England and Geneva, Switzerland. The Company's principal office is in Baltimore, with other offices in major cities including New York, San Francisco, Los Angeles, Boston, Chicago, Dallas, Atlanta, Philadelphia and Washington, D.C. Alex. Brown is a member of the New York Stock Exchange, Inc. ("NYSE"), the American Stock Exchange, Inc., the Chicago Board Options Exchange, Inc., other regional securities exchanges and the National Association of Securities Dealers, Inc. (the "NASD"). Alex. Brown is also a member of the Securities Investor Protection Corporation ("SIPC"), and with respect to its representative offices in London, the Securities and Futures Authority. Investment Services. The Company provides investment services to individual and institutional customers. The Company's investment services to individual customers primarily involve transactions in corporate equity and debt and state and local government securities, including securities followed by the Company's research analysts and underwritten on a managed or co-managed basis by the Company. In addition to executing transactions, the Company provides portfolio strategy, investment advice and research services to individual investors. The Company targets its investment services to individuals of high net worth or high annual income. The Company's institutional customers include banks, retirement funds, mutual funds, investment advisers and insurance companies. Services to these customers generally include investment advisory and other services. The majority of the Company's institutional brokerage revenues are generated by the purchase and sale of corporate equity securities, including securities followed by the Company's research analysts and securities underwritten on a managed or co-managed basis by the Company. Institutional investors typically purchase and sell securities in block transactions. Revenues from securities transactions with institutional customers are based on negotiated rates which typically represent a significant discount from the Company's commission schedule. Research. The Company's Research Division develops investment recommendations and market information in the consumer, environmental, financial services, health care, media/ communications, technology and transportathe consumer, environmental, financial services, health care, media/ communications, technology and transportation industries. Within these industries, the Company follows approximately 600 companies. Research reports are made available generally to customers. Research activities include the review and analysis of general market conditions, industries and specific companies; recommendations of specific actions with regard to industries and specific companies; the furnishing of information to retail and institutional customers; and responses to inquiries from customers and investment representatives. Additionally, the Company hosts periodic seminars in a number of industry areas at which Company representatives and industry authorities make presentations with respect to specific companies, the industry and its trends. These seminars are open to the Company's investment services customers and investment banking clients. The Company believes that its research activities have contributed to attracting and retaining its investment services customers and investment banking clients. Securities Commissions. Securities transactions for individual and institutional investors where the Company acts as agent generate securities commission revenues. Commissions are charged on both exchange and over-the-counter agency transactions for individual customers in accordance with a schedule formulated by the Company, which may change from time to time. In certain cases, discounts from the schedule may be granted. The Company's securities commissions result primarily from executing transactions in listed stocks and bonds. The Company also realizes commission revenues when it executes a trade in an over-the-counter security in which it does not make a market. A substantial portion of the commission revenues generated by the Company is attributable to individual and institutional investors who receive who receive the Company's research services. Principal Transactions. In addition to executing trades as agent, the Company regularly acts as a principal in executing trades in equity and convertible securities, municipal bonds, corporate debt, mortgage and asset-backed securities and United States government and government agency securities. When transactions are executed by the Company on a principal basis, the Company, in lieu of commissions, marks up or marks down securities and records the resulting net gains or losses in revenues from principal transactions. Inventories of various securities are carried to facilitate sales to customers and other dealers. Principal transactions are effected for both individual and institutional customers. As of December 31, 1993, the Company made markets, buying and selling as a principal, in approximately 375 common stocks and other securities traded on the NASD's Automated Quotations System or otherwise in the over-the-counter market and approximately 300 listed securities. The majority of the equity securities in which the Company makes a market are in the industry areas followed by the Company's research analysts. The Company buys and sells as principal a wide range of fixed income securities and variable rate debt obligations, including municipal securities, collateralized mortgage obligations, corporate fixed income securities and U.S. government and agency obligations. Municipal securities include general obligation and revenue bonds and notes issued by states, counties, cities and state and local government agencies and authorities. Corporate fixed income securities include high yield (non-rated and non-investment grade) obligations, convertible debentures and other bonds, notes and preferred stocks. U.S. government and agency obligations include direct U.S. government obligations and government-guaranteed securities and agency obligations. Information regarding the Company's long and short trading securities positions as of December 31, 1993 and 1992 is set forth in Management's Discussion and Analysis of Financial Condition and Results of Operations and Notes 4 and 8 of Notes to Consolidated Financial Statements, incorporated herein by reference to pages 32-35, 42 and 44, respectively, of the 1993 Annual Report to Stockholders. The level of positions carried in the Company's trading accounts fluctuates significantly. The size of the securities positions on any one date may not be representative of the Company's exposure on any other date because securities positions vary substantially depending upon economic and market conditions, the allocation of capital among types of inventories, underwriting commitments, customer demand and trading volume. The Company may have large positions within its inventories from time to time which increase the Company's exposure to specific credit, event, market or liquidity risks. The aggregate value of inventories that the Company may carry is limited by certain requirements of Rule 15c3-1 (the "Net Capital Rule") of the Securities and Exchange Commission ("SEC"). See "Net Capital Requirements." The Company's principal transactions expose the Company to risk because securities positions are subject to fluctuations in market value and certain inventory positions are in thinly traded securities. High yield securities can be extremely volatile. Each trading department is subject to internal position limits. The Company also participates as a market maker in the NASD's Small Order Small Order Execution System ("SOES"), an automated trading system through which participating firms can execute customer orders of limited size against market makers in eligible securities through computer terminal entries. Participating market makers are required to honor such transactions; therefore, SOES participation puts an affirmative obligation on the Company to monitor trading activity in SOES securities in which it makes a market and maintain commensurate control of its positions. SOES participation is mandatory for market makers in all NASDAQ National Market System ("NMS") securities, and imposes upon market makers a penalty of 20 business days during which they may not make a market at all in any NMS security in which an unexcused withdrawal has occurred. Withdrawal is excused only in limited circumstances. The NASD is authorized to establish the maximum size of SOES orders at either 200 or 500 shares, depending on the trading characteristics of the particular security. Although the Company does not believe that SOES participation dramatically affects its market making activities, there can be no assurance that SOES participation will not in the future increase the Company's exposure to loss from principal transactions. Investment Banking. As an investment banking firm, the Company provides financial advice to, and raises capital for, a broad range of corporate clients primarily in industry areas which have been selected by the Company for research coverage. The Company manages and participates in public offerings and arranges the private placement of equity and debt securities directly with institutional and individual investors. The Company is a major underwriter of corporate and municipal securities. The management of an underwriting syndicate is generally more profitable than participation as a syndicate member because the managing underwriter receives a management fee and a greater amount of securities for distribution. Certain risks are involved in the underwriting of securities. Underwriting syndicates agree to purchase securities at a discount from the initial public offering price. If the securities must be sold below the syndicate cost, an underwriter is exposed to losses on the securities that it has committed to purchase. In the last several years, investment banking firms have increasingly underwritten corporate and municipal offerings with fewer syndicate participants or, in some cases, without an underwriting syndicate. In such cases the underwriter assumes a larger part or all of the risk of an underwriting transaction. Under federal securities laws, other laws and court decisions, an underwriter is exposed to substantial potential liability for material misstatements or omissions of fact in the prospectus used to describe the securities being offered. While municipal securities are exempt from the registration requirements of the Securities Act of 1933, as amended (the "Securities Act"), underwriters of municipal securities nevertheless are exposed to substantial potential liability in connection with material misstatements or omissions of fact in the offering documents prepared in connection with offerings of such securities. In the past five years, approximately 53% (45% in 1993) of the public offerings of equity and corporate debt securities managed or co-managed by the Company have been initial public offerings. Generally, a strong market for new issues occurs when overall market and economic conditions are favorable. New issues are perceived to have a higher degree of risk for investors and investor receptivity to new issues tends to vary as a function of overall market conditions. The Company also provides advice to clients on a wide range of financial matters, including mergers and acquisitions, divestitures, financial planning, financial restructuring and recapitalizations. In connection with mergers and acquisitions, the Company often provides opinion letters and valuations and renders various other services. The Company's traditional clients for such services are companies for which the Company has raised capital or which are followed by the Company's Research Division. The Company also provides these services to companies which are not Corporate Finance clients or covered by the Company's Research Division but which are, or have subsidiaries or divisions, in industries followed by the Company's Research Division. Historically, the core of the Company's mergers and acquisitions business has been the representation of sellers in negotiated transactions. Fees for these services are negotiated and are generally related to the value of the transaction for which the service is provided. The Company also engages in merchant banking investments. In most cases, these investments are made with the management of such companies. The Company may also co-invest with other financial groups in larger transactions where its specific industry expertise may create additional value. Merchant banking business has the potential of generating substantial fees and investment returns but involves a significant degree of risk due to the concentrated investment of capital in securities that generally lack liquidity. As of December 31, 1993, the Company had outstanding $16.6 million of merchant banking investments and a commitment to invest $23 million in a merchant banking partnership in which the Company and certain of its employees are general partners over a period of up to five years. In addition to its corporate investment banking activities, the Company provides financial advice to, and raises capital for, many types of issuers of tax-exempt securities, including states, counties, cities, transportation authorities, sewer and water authorities and housing and health and higher education agencies. Most of these issuers are located in the eastern U.S. The Company manages public offerings of securities and distributes these securities to individual and institutional investors. Investment Management Services. The Company provides investment advisory, administrative and distribution services to a variety of clients, domestic and international. These services are typically provided for a fee generally based on the value of the assets for which such services are rendered. Investment advisory services are provided to high net worth individuals, institutional investors, foundations, endowments, mutual funds and private investment funds. As of December 31, 1993, the Company provided investment advisory, administrative and/or distribution services with respect to $9.2 billion of assets. Advisory, administrative and distribution services are provided to the "Flag" family of mutual funds, which are Company sponsored, as well as to mutual funds and investment partnerships sponsored by unaffiliated third liated third parties. Most investment advisory services are provided pursuant to contracts which provide for termination by either party at any time. Advisory fees are generally charged as a percentage of assets managed. Other than with respect to advisory services provided to mutual funds, the Company's largest advisory service is Alex. Brown Investment Management ("ABIM"), a partnership in which the Company has a 50% interest and its associated investment advisory professionals have the remaining 50% interest. ABIM manages equity and balanced accounts for institutions and individuals. The Company has a 50% interest in Brown & Glenmede Holdings, Inc., a holding company which owns all of the outstanding shares of Brown Advisory & Trust Company, a Maryland nondepository trust company that was founded in March, 1993. As of December 31, 1993, Brown Advisory & Trust Company managed assets of $170 million. Real Estate Advisory. Through a 48.7% ownership of the Common Stock of Alex. Brown Kleinwort Benson Realty Advisors Corporation, ("ABKB"), a joint venture among the Company, Kleinwort Benson Group plc and management of ABKB, the Company provides real estate consulting and advisory services to institutional investors. As of December 31, 1993, ABKB had approximately 20 real estate advisory clients with real estate assets under management aggregating approximately $2.94 billion. Typically, advisory contracts may be cancelled by either party upon 30 days notice. Correspondent Services. The Company provides administrative, execution, operational and clearing services to other securities firms on a fully disclosed basis. In addition to commissions and other transaction related fees, the Company receives interest revenue in those instances where it extends margin credit directly to customers of its correspondent brokers. The Company may extend credit directly to its correspondent firms to finance their operations or securities positions which such firms hold for their own accounts. The Company relies on the general credit of its correspondent brokers and may be exposed to risk of loss if any of its correspondents or their customers are unable to meet their financial commitments. The ratio of capital to the level of business of the Company's correspondent brokers may be less than that of the Company. From time to time the Company makes unsecured subordinated loans to correspondent brokers. Such loans are funded through general working capital sources. As of December 31, 1993, the Company provided correspondent services to 38 securities firms. The Company intends to continue to expand its correspondent services activities. Margin Accounts and Interest Income. The Company extends margin financing to its customers and to the customers of correspondent brokers for whom the Company provides clearing and execution services. Margin loans are collateralized by securities and cash in customer accounts. Customers are charged for margin financing at interest rates based upon the broker call rate (the prevailing interest rate charged by banks on secured loans to broker-dealers), plus an additional amount of up to 2.5%. The amount of the Company's interest revenue is affected by the volume of customer borrowing and by prevailing interest rates. The average volume of customer borrowing has increased in each of the last five years. Margin lending by the Company is subject to the margin rules of the Board of Governors of the Federal Reserve System, NYSE margin requirements and the Company's internal policies, which in most instances are more stringent than ringent than the NYSE requirements. In permitting customers to purchase on margin, the Company assumes the risk that a market decline may reduce the value of the collateral it holds below the customer's indebtedness before the collateral can be sold. The proceeds realizable upon the sale of such collateral can be adversely affected by the liquidity of the market for the security, applicable restrictions on the sale of the security or the size of the collateral position as compared to the trading volume of the security. Under applicable NYSE rules, in the event of a significant decline in the market value of the securities in a margin account, the Company is obligated to require the customer to deposit additional securities or cash in the account or to sell securities to reduce or eliminate the customer's indebtedness to the Company. Credit balances and securities in customers' accounts, to the extent not required to be segregated pursuant to rules of the SEC, may be used in the conduct of the Company's business, including the extensions of margin credit. Customer lending activities may influence the basis on which net capital requirements of Alex. Brown are determined under the Net Capital Rule. As these activities expand, the Company's net capital requirements increase. See "Net Capital Requirements." Accounting, Administration and Operations. Accounting, administration and operations personnel are responsible for the processing of securities transactions; receipt, identification and delivery of funds and securities; custody of customer securities; internal financial control; accounting functions; office services; personnel services and compliance with regulatory and legal requirements. There is a considerable fluctuation in the volume of transactions which a securities firm must process. In the past, when the volume of trading in securities reached record levels, the securities industry has experienced operating problems. The Company has not experienced any material operating difficulties during periods of record heavy trading volume; however, extraordinarily heavy trading volume in the future could result in clearance and processing difficulties. The Company utilizes its own facilities and the services of Automatic Data Processing Inc. for the electronic processing related to recording data pertinent to securities transactions and general accounting. The Company believes that its internal controls and safeguards against securities theft, including use of depositories and periodic securities counts, are adequate. As required by the NYSE and certain other authorities, the Company carries fidelity bonds covering loss or theft of securities as well as employee dishonesty, forgery and alteration of checks and similar items, and securities forgery. The amounts of coverage provided by the bonds are believed to be adequate. The Company posts its books and records daily. Periodic reviews of certain controls are conducted, and administrative and operations personnel meet with management to review operational conditions in the Company to assure compliance with applicable laws, rules and regulations. Competition. The Company encounters intense competition in all aspects of the securities business and competes directly with other securities firms, a significant number of which have substantially greater capital and other resources and many of which offer a wider range of financial services than the Company. Other securities firms, oriented primarily to the market for market for individual investors, charge commissions that are significantly discounted from those in the range generally charged by the Company to its individual customers. In addition to competition from firms currently in the securities business, there is increasing competition from other sources, such as commercial banks and insurance companies offering financial services, and from other investment alternatives. The Company believes that the principal competitive factors in the securities industry are the quality and ability of professional personnel and relative prices of services and products offered. The Company and its competitors directly solicit potential customers, and many of the Company's competitors engage in advertising programs which the Company does not use to any significant degree. The Company and its competitors also furnish investment research publications in an effort to hold and attract existing and potential clients. Employees. As of December 31, 1993, the Company had approximately 2,175 full-time employees. None of the Company's employees are covered by a collective bargaining arrangement. Regulation. The securities industry in the United States is subject to extensive regulation under both federal and state laws. The SEC is the federal agency responsible for the administration of the federal securities laws. Alex. Brown is registered as a broker-dealer with the SEC. Alex. Brown as well as other investment advisers in which the Company has an equity interest are registered as investment advisers with the SEC. Much of the regulation of broker-dealers has been delegated to self-regulatory organizations, principally the NASD and national securities exchanges such as the NYSE, which has been designated by the SEC as Alex. Brown's primary regulator. These self-regulatory organizations adopt rules (subject to approval by the SEC) that govern the industry and conduct periodic examinations of Alex. Brown's operations. Securities firms are also subject to regulation by state securities administrators in those states in which they conduct business. Alex. Brown is registered as a broker-dealer in all 50 states, the District of Columbia and Puerto Rico. Broker-dealers are subject to regulations covering all aspects of the securities business, including sales methods, trade practices among broker-dealers, use and safekeeping of customers' funds and securities, capital structure of securities firms, record-keeping and the conduct of directors, officers and employees. Additional legislation, changes in rules promulgated by the SEC and self-regulatory organizations, or changes in the interpretation or enforcement of existing laws and rules may directly affect the mode of operation and profitability of broker-dealers. The SEC, self-regulatory organizations and state securities commissions may conduct administrative proceedings which can result in censure, fine, the issuance of cease-and-desist orders or the suspension or expulsion of a broker-dealer, its officers or employees. The principal purpose of regulation and discipline of broker-dealers is the protection of customers and the securities markets, rather than protection of creditors and stockholders of broker-dealers. From time to time, the Company has been subject to disciplinary actions, none of which, to date, has had a material adverse effect on the operations of the Company. Alex. Brown is a member of SIPC, which provides, in the event of the liquidation of a broker-dealer, protection for customers' accounts held by Alex. Brown of up to $500,000 for each customer, subject to a limitation of $100,000 for claims for cash balances. In addition, Alex. Brown has obtained protection in excess of SIPC coverage of $2,000,000 for each account and up to $9,500,000 for specified accounts. Alex. Brown & Sons Limited and Alex. Brown & Sons Investments Limited, through which the Company operates representative offices in London, England, are subject to the United Kingdom Financial Services Act of 1986, which governs all aspects of United Kingdom investment business and to the rules of the Securities and Futures Authority. Certain subsidiaries and employees of the Company are engaged in the insurance business and are subject to regulation and supervision by appropriate authorities in the states in which they conduct their business. Net Capital Requirements. As a registered broker-dealer and a member firm of the NYSE, Alex. Brown is subject to the Net Capital Rule, which has also been adopted through incorporation by reference in NYSE Rule 325. The Net Capital Rule, which specifies minimum net capital requirements for registered brokers and dealers, is designed to measure the general financial integrity and liquidity of a broker-dealer and requires that at least a minimum part of its assets be kept in relatively liquid form. Alex. Brown is also subject to the net capital requirements of the Commodities Futures Trading Commission ("CFTC") and various commodity exchanges, which generally require that Alex. Brown, as an introducing broker, maintain a minimum net capital equal to the alternative net capital requirements discussed below. Alex. Brown has elected to compute net capital under the alternative method of calculation permitted by the Net Capital Rule. Under the alternative method, Alex. Brown is required to maintain minimum net capital, as defined in the Net Capital Rule, equal to the greater of $1,000,000 or 2% of the amount of its "aggregate debit items" computed in accordance with the Formula for Determination of Reserve Requirements for Brokers and Dealers (SEC Rule 15c3-3). The "aggregate debit items" are assets that have as their source transactions with customers, primarily margin loans. Failure to maintain the required net capital may subject a firm to suspension or revocation of registration by the SEC and suspension or expulsion by the NYSE and other regulatory bodies and ultimately may require its liquidation. The Net Capital Rule and NYSE Rule 326 prohibit payments of dividends, redemption of stock, the prepayment of subordinated indebtedness, and making any unsecured advance or loan to a stockholder, employee or affiliate, if net capital thereafter would be less than 5% of aggregate debit items. The Net Capital Rule also provides that the SEC may restrict for up to twenty business days any withdrawal of equity capital, or unsecured loan or advance to a stockholder, employee or affiliate ("capital withdrawal") if such capital withdrawal, together with all other net capital withdrawals during a thirty day period, exceeds 30% of excess net capital and the SEC concludes that the capital withdrawal may be detrimental to the financial integrity of the broker-dealer. The Net Capital Rule also provides that the total outstanding principal amount of a broker-dealer's indebtedness under certain subordination agreements, the proceeds of which are included in its net capital, may not exceed 70% of the sum of the outstanding principal amount of all subordinated indebtedness included in net capital, par or stated value of capital stock, paid in capital in excess of par, retained earnings and other capital accounts for a period in a period in excess of 90 days. Under NYSE Rule 326, a member firm is required to reduce its business if its net capital is less than 4% of aggregate debit items. NYSE Rule 326 also prohibits the expansion of business if net capital is less than 5% of aggregate debit items for 15 consecutive days. The provisions of Rule 326 also become operative if capital withdrawals (including scheduled maturities of subordinated indebtedness during the following six months, charges relating to lending on control and restricted securities under NYSE Rule 431 and discretionary liabilities which are included in capital under the Net Capital Rule) would result in a reduction of a firm's net capital to the levels indicated. Net capital is essentially defined as net worth (assets minus liabilities), plus qualifying subordinated borrowings and certain discretionary liabilities, and less certain mandatory deductions that result from excluding assets that are not readily convertible into cash and from valuing conservatively certain other assets, such as a firm's positions in securities. Among these deductions are adjustments (called "haircuts") to the market value of firm securities to reflect the possibility of a market decline prior to disposition. A change in the Net Capital Rule, the imposition of new rules or any unusually large charge against net capital could limit those operations of Alex. Brown that require the intensive use of capital, such as underwriting and trading activities and the financing of customer account balances, and also could restrict the Company's ability to withdraw capital from Alex. Brown which in turn could limit the Company's ability to pay dividends, repay debt and redeem or purchase shares of its outstanding stock. Alex. Brown has been in compliance at all times with all aspects of the Net Capital Rule and CFTC net capital requirements applicable to it. As of December 31, 1993, Alex. Brown was required to maintain minimum net capital, in accordance with SEC and CFTC rules, of $15,873,000 and had total net capital (as so computed) of $227,468,000 or $211,595,000 in excess of 2% of aggregate debit items and $187,785,000 in excess of 5% of aggregate debit items. Item 1(d). Financial Information about Foreign and Domestic Operations and Export Sales. Not Applicable. Item 2. Item 2. Properties. The Company conducts business from offices in the following U.S. cities: Annapolis, Maryland Los Angeles, California Atlanta, Georgia Memphis, Tennessee Baltimore, Maryland Naples, Florida Boston, Massachusetts New Orleans, Louisiana Burlingame, California New York, New York Charlotte, North Carolina Philadelphia, Pennsylvania Chicago, Illinois Richmond, Virginia Dallas, Texas San Francisco, California Durham, North Carolina Timonium, Maryland Fishkill, New York Towson, Maryland Frederick, Maryland Washington, D.C. Greenwich, Connecticut West Palm Beach, Florida Houston, Texas Wilmington, Delaware Jacksonville, Florida Winston-Salem, North Carolina In addition, wholly-owned subsidiaries of Alex. Brown lease offices in London, England and Geneva, Switzerland. The Company occupies an aggregate of approximately 200,000 square feet of space in downtown Baltimore under leases expiring on various dates from 1995 through 2002. The Company is a limited partner in a partnership which owns a building in downtown Baltimore where it leases approximately 90,000 square feet. The Company's other offices, including the separate offices of Alex. Brown Investment Management, the Company's operations and data center and offices in 27 U.S. cities, London and Geneva, occupy an aggregate of approximately 560,000 square feet under leases that expire at various dates through 2004. Future minimum rental commitments under existing leases are set forth in Note 10 of Notes to Consolidated Financial Statements incorporated herein by reference to pages 44 and 45 of the 1993 Annual Report to Stockholders. Alex. Brown Partners, a Maryland limited partnership (the "Partnership"), the partners of which include certain Directors of the Company and other Managing Directors and Principals of Alex. Brown, and certain partners thereof have ownership interests in some of the properties occupied by the Company in downtown Baltimore. Item 3. Item 3. Legal Proceedings. Alex. Brown is a defendant in a number of lawsuits relating to its Investment Banking and securities brokerage business. The Company is also a member of a defendant class of underwriters in a number of lawsuits relating to its participation in underwritings and, in addition, may be required to contribute to any adverse final judgments or settlements in actions arising out of its participation in the underwritings of certain issues in which it is not a defendant. Approximately 30 underwritten public offerings in which Alex. Brown has participated are the subject of litigation. The Company cannot state what the eventual outcome of these pending actions will be. The following are descriptions of certain lawsuits filed as class actions involving or affecting the Company. A substantial settlement or judgment in any of these cases could have a material adverse effect on the Company. While there can be no assurances of a favorable determination of these actions, the Company believes there are meritorious defenses to all of the cases described herein, and intends to defend each action vigorously. Exide Electronics Group, Inc. On May 3, 1990, a suit captioned Bernard M. d Bernard M. Branson v. Exide Electronics Corporation, et al., Index No. 11536 was filed in Delaware Chancery Court, New Castle County, in which the Company was named as a defendant. The action pertained to the December, 1989 public offering (the "Offering") of 1.2 million shares of the Common Stock of Exide Electronics Group, Inc. ("Exide") at $12.50 per share. The Company was lead manager of the offering and directly underwrote 224,000 shares. Plaintiff purported to represent a class consisting of all persons who purchased shares of Exide in the Offering. The complaint alleged violations of the Securities Act and of Delaware common law in connection with alleged untrue statements and omissions of material facts in the registration statement and prospectus prepared in connection with the Offering. In particular, the complaint alleged that the prospectus failed to properly disclose Exide's exposure with respect to litigation that had been pending against Exide in a California court and in which a jury returned a verdict against Exide, in April, 1990, in the amount of $14.9 million. Immediately following the verdict, Exide shares traded in the range of $7-8 per share. Plaintiff sought unspecified compensatory damages, costs, and fees. On September 14, 1992, the Court granted the Company's motion to dismiss the complaint. However, plaintiffs have appealed the Court's order, and such appeal remains pending. Industrial Funding Corp. On January 16, 1992, the Company was named as a defendant in an action pending before the United States District Court for the Northern District of California, entitled Wade v. Industrial Funding Corp., et al., Index No. C-92-0343. The litigation pertains to the December 8, 1989 public offering of shares of Industrial Funding Corp. ("IFC"), for which the Company served as co-lead underwriter. Plaintiffs sue as representatives of a purported class consisting of all persons who purchased IFC shares between December 8, 1989 and February 28, 1991. Plaintiffs allege violations of the federal securities laws in connection with alleged untrue statements and omissions of material facts in connection with the offering. In particular, Plaintiffs allege that Defendants failed to disclose material adverse facts regarding IFC's financial condition. Plaintiffs seek compensatory and punitive damages in an unspecified amount. In-Store Advertising, Inc. The Company has been named as a defendant in several purported class action lawsuits, as well as one shareholder derivative lawsuit, pertaining to the July 19, 1990 public offering of Common Stock of In-Store Advertising, Inc. ("In-Store Advertising"), at $19 per share (the "Offering"). The Company co-managed the Offering and directly underwrote 414,000 shares. The lawsuits are pending in the United States District Court for the Southern District of New York, and have been consolidated under the caption In-Store Advertising, Inc. Securities Litigation, No. 90 Civ. 5594. Collectively, plaintiffs purport to represent all persons who purchased shares of In-Store Advertising in the Offering, and all persons who purchased shares in the open market during the period from the date of the Offering to August 28, 1990. Plaintiffs allege, among other things, that the prospectus for the Offering contained material misstatements of fact and omitted material facts and that the defendants, including the Company, made untrue statements of material fact and omitted material facts concerning In-Store Advertising's anticipated revenues and earnings. The Plaintiffs allege violations of the federal securities laws and the common law, and seek unspecified actual and punitive damages, rescission, costs, fees and other relief. On July 8, 1993, uly 8, 1993, In-Store Advertising filed for protection under the Bankruptcy Code, and on August 6, 1993, its plan of reorganization was approved. As a result thereof, In-Store Advertising has been discharged from any liability relating to this litigation. Pretrial discovery is proceeding. Taxable Municipal Bond Securities Litigation. In August, 1990, the Company was named as a defendant in three lawsuits brought on behalf of certain municipal bond investors. The actions have now been consolidated before the United States District Court for the Eastern District of Louisiana, under the caption In re: Taxable Municipal Bond Securities Litigation, Index No. MDL-863. The actions pertain to the 1986 public offerings of (i) $300 million taxable public purpose bonds by the Board of County Commissioners of Adams County, Colorado, (ii) $400 million taxable public purpose bonds by the Health, Educational and Housing Facility Board of the City of Memphis and (iii) $200 million taxable public purpose bonds by the El Paso Housing Finance Corporation. The Company participated as a member of the underwriting syndicate for each of these offerings, underwriting approximately .66% of the Adams County offering, approximately 2.5% of the City of Memphis offering and approximately 3% of the El Paso offering. The Plaintiffs in all three actions purport to represent a class of all persons who purchased bonds in the original offerings and who held the bonds until on or about January 25, 1990. The complaints allege various violations of the federal securities laws, the RICO statute and common law as a result of alleged untrue statements and omissions of material facts in connection with the bond offerings. In particular, the complaints allege that the defendants failed to disclose that the proceeds from the bond offerings were to be placed with Executive Life Insurance Company, a California insurance company, which would in turn invest the funds in high risk "junk bonds," the values of which are alleged to have declined significantly. The plaintiffs seek actual and punitive damages, rescission, trebling of actual damage pursuant to the RICO statute and other relief. The Company has joined with other members of the respective underwriting syndicates in retaining counsel to jointly represent the interests of the members of the syndicates. URCARCO, Inc. In 1990, the Company was named as a defendant in several suits that have been consolidated under the caption Melder v. Morris, Index No. 3:90-CV-1737-X, and are pending in the United States District Court for the Northern District of Texas, Dallas Division. Plaintiffs' allegations with respect to the Company pertain to the May, 1990 public offering (the "Offering") of 5 million shares of the common stock of URCARCO, Inc. ("URCARCO") (now known as Americredit Corp.) at $19 7/8 per share. The Company was the lead managing underwriter of the Offering, and directly underwrote 783,334 shares. Collectively, plaintiffs purport to represent a class consisting of all persons who purchased shares of URCARCO in the Offering, and all persons who purchased URCARCO shares on the open market during the period from November 15, 1989 to July 25, 1990. URCARCO operates a chain of retail used car lots in Texas and typically finances the purchases of its customers, many of whom would be unable to obtain traditional credit terms. From time to time, the Company provided investment banking services to URCARCO, and was the lead managing underwriter of its initial public offering. Plaintiffs allege violations of federal securities statutes and common law in connection with alleged untrue statements and omissions of material fact in the prospectus e prospectus issued in connection with the Offering and in other reports issued by URCARCO. In particular, the complaint alleges that URCARCO failed to disclose material adverse facts about its earnings, financial condition and loss reserves. Plaintiffs seek unspecified compensatory and punitive damages, costs and fees. On May 18, 1993, the Court dismissed Plaintiffs' claims under the federal securities laws on the grounds that the complaint failed to state a claim. However, Plaintiffs have appealed the Court's order to the United States Court of Appeals for the Fifth Circuit, and such appeal remains pending. Item 4. Item 4. Submission of Matters to a Vote of Security Holders. None. Executive Officers of the Registrant The following information regarding the persons who function as executive officers of the Company is included herein pursuant to Instruction 3 to Item 401(b) of Regulation S-K: Name Age Position with the Company Benjamin H. Griswold IV ....... 53 Chairman and Director A. B. Krongard ................ 57 Vice Chairman, Chief Executive Officer and Director Robert F. Price ............... 46 Secretary and General Counsel Mayo A. Shattuck III .......... 39 President, Chief Operating Officer and Director Beverly L. Wright ............. 45 Treasurer and Chief Financial Officer Officers serve at the discretion of the Board of Directors. There is no family relationship among any of the directors or executive officers of the Company. Mr. Griswold was first employed by the Partnership in 1967 and became a general partner in 1972. Mr. Griswold was Vice-Chairman of Alex. Brown from 1984 until February 1987 when he became Chairman of Alex. Brown and the Company. Mr. Krongard was first employed by the Partnership in 1971 and became a general partner in 1980. He has been a Managing Director of Alex. Brown since 1984 and was elected Chief Executive Officer and Vice Chairman of the Company and Alex. Brown in July 1991. Mr. Price was first employed by the Partnership in 1976 and became a Managing Director of Alex. Brown in 1987. He served as Secretary and General Counsel from 1984 until 1989 when he resigned from the Company. Upon his return to the Company in September, 1991, he became Secretary and General Counsel. Mr. Shattuck was first employed by the Company in 1985. He became a Managing Director of Alex. Brown in 1989, and was elected President and Chief Operating Officer in July 1991. Ms. Wright was first employed by the Partnership in 1978 and became a general partner in 1984. She has been a Managing Director of Alex. Brown since 1984 and was named Treasurer and Chief Financial Officer of the Company and Company and Alex. Brown in July 1986. There is no arrangement or understanding between any of the above-listed officers and any other person pursuant to which any such officer was elected as an officer. PART II Item 5. Item 5. Market for Registrant's Common Equity and Related Stockholder Matters. Information required by Item 5 is incorporated herein by reference to page 55 of the 1993 Annual Report to Stockholders attached hereto. Item 6. Item 6. Selected Financial Data. Information required by Item 6 is incorporated herein by reference to page 51 of the 1993 Annual Report to Stockholders attached hereto. 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 pages 32 through 35 of the 1993 Annual Report to Stockholders attached hereto. Item 8. Item 8. Financial Statements and Supplementary Data. Financial Statements required by Item 8 are listed in the Index to Financial Statements and Schedules on page 24. Supplementary data are incorporated herein by reference to page 52 of the 1993 Annual Report to Stockholders attached hereto. Item 9. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure. None. PART III The information required by Items 10, 11, 12, and 13 (except that information regarding executive officers called for by Item 10 Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K. (a) Exhibits: Reference is made to the Exhibit Index. Financial Statement Schedules: Reference is made to the Index to Financial Statements and Schedules on page 24. (b) Reports on Form 8-K. None. Other Matters For the purposes of complying with the amendments to the rules governing Form S-8 under the Securities Act of 1933, the undersigned registrant hereby undertakes as follows, which undertaking shall be incorporated by reference into registrant's Registration Statements on Forms S-8 Nos. 33-23789, 33-26988, 33-40618, 33-40619, 33-45715, 33-46282 and 33-67050. 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. ALEX. BROWN INCORPORATED By: s/ A. B. Krongard ------------------------------------ A. B. Krongard 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/ Benjamin H. Griswold IV Chairman of the Board of March 25, 1994 - ---------------------------- Directors Benjamin H. Griswold IV s/ A. B. Krongard Chief Executive Officer; March 25, 1994 - ---------------------------- Director (Principal A. B. Krongard Executive Officer) s/ Mayo A. Shattuck III President; Chief Operating March 25, 1994 - ---------------------------- Officer; Director Mayo A. Shattuck III s/ Beverly L. Wright Treasurer and Chief March 25, 1994 - ---------------------------- Financial Officer (Principal Beverly L. Wright Financial and Accounting Officer) s/ Lee A. Ault III Director March 25, 1994 - ---------------------------- Lee A. Ault III s/ Thomas C. Barry Director March 25, 1994 - ---------------------------- Thomas C. Barry s/ Andre W. Brewster Director March 25, 1994 - ---------------------------- Andre W. Brewster s/ Donald B. Hebb, Jr. Director March 25, 1994 - ---------------------------- Donald B. Hebb, Jr. s/ Steven Muller Director March 25, 1994 - ---------------------------- Steven Muller s/ David M. Norman Director March 25, 1994 - ---------------------------- David M. Norman s/ Frank E. Richardson Director March 25, 1994 - ---------------------------- Frank E. Richardson ALEX. BROWN INCORPORATED AND SUBSIDIARIES Index to Financial Statements and Schedules Page Financial Statements: Alex. Brown Incorporated and Subsidiaries included on pages 37 through 50 of the 1993 Annual Report to Stockholders, incorporated herein by reference and attached hereto: Consolidated Statements of Earnings 37 Consolidated Statements of Financial Condition 38 Consolidated Statements of Stockholders' Equity 39 Consolidated Statements of Cash Flows 40 Notes to Consolidated Financial Statements 41-49 Report of Independent Auditors 50 Schedules: Report of Independent Auditors S-1 Alex. Brown Incorporated and Subsidiaries for the years ended December 31, 1991, 1992 and 1993: Schedule II--Amounts Receivable from Related Parties and Underwriters, Promoters and Employees other than Related Parties .................................... S-2 Schedule IX--Short Term Borrowings .............................. S-6 All other schedules are omitted because they are not applicable, or not required, or because the required information is included in the financial statements or notes thereto. REPORT OF INDEPENDENT AUDITORS The Board of Directors Alex. Brown Incorporated: Under date of January 26, 1994, we reported on the consolidated statements of financial condition of Alex. Brown Incorporated and subsidiaries as of iaries as of December 31, 1993 and 1992 and the related consolidated statements of earnings, stockholders' 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 stockholders. These consolidated financial statements and our report thereon are incorporated by reference in the annual report on Form 10-K for 1993. In connection with our audits of the aforementioned consolidated financial statements, we also audited the related consolidated financial statement schedules as listed in the accompanying index. 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 Baltimore, Maryland March 25, 1994 Commission File No. 0-14199 SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 ----------------------------------------------------------------------------- EXHIBITS TO ANNUAL REPORT ON FORM 10-K UNDER SECURITIES EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED DECEMBER 31, 1993 - ------------------------------------------------------------------------------ ALEX. BROWN INCORPORATED ALEX. BROWN INCORPORATED Annual Report on Form 10-K Index to Exhibits Exhibit No. Exhibit Page - ------------- --------------------------------------------------- -------- 3.1 Charter of the Registrant, as amended (4) 3.2 By-Laws of the Registrant, as amended (2) 4.1 Indenture dated as of June 12, 1986 between Alex. Brown Incorporated and Bankers Trust Company, Trustee, relating to the Company's 5 3/4% convertible Subordinated Debentures due 2001 (2) 4.2 Agreement to furnish Loan Agreements -------- 10.1 Lease dated as of January 1, 1984 by and between Alex. Brown Partners, a Maryland Limited Partnership and Alex. Brown & Sons Incorporated (1) 10.1(a) First Amendment to Lease dated July 29, 1993 -------- 10.2 Lease dated as of January 1, 1985 by and between Brown Realty Company and Alex. Brown & Sons Incorporated (1) 10.2(a) Amendment to Lease dated July 29, 1993 -------- 10.3 Lease dated as of July 2, 1987 by and between Alex. Brown & Sons Incorporated and Calvert-Baltimore Associates Limited Partnership (3) 10.3(a) First Amendment to Lease dated March 8, 1988 by and between Calvert-Baltimore Associates Limited Partnership and Alex. Brown & Sons Incorporated (5) 10.3(b) Second Amendment to Lease dated August 10, 1989 by and between Calvert-Baltimore Associates Limited Partnership and Alex. Brown & Sons Incorporated (5) 10.4 Purchase and Sale Agreement regarding the name "Alex. Brown" -------- 10.5 First Amended and Restated Stockholders' Agreement dated June 23, 1989 among the Registrant and certain stock- holders of the Registrant, as amended (9) 10.6* Alex. Brown Incorporated 1991 Equity Incentive Plan (7) 10.7* Alex. Brown Incorporated 1991 Non-Employee Director Equity Plan (6) 10.8* Donald B. Hebb, Jr. Employment Agreement (8) 10.9* Mayo A. Shattuck III Employment Agreement (8) 10.10* Benjamin H. Griswold IV Employment Agreement -------- 11 Statement on Computation of per share earnings -------- 13 Pages 32 through 35, 37 through 52 and 55 of the Registrant's Annual Report to Stockholders for the Year Ended December 31, 1993 (10) 21 Subsidiaries of the Registrant (2) 23 Consent of KPMG Peat Marwick -------- *Connotes a management contract or compensatory plan or other arrangement in which a director or executive officer of the Registrant participates. (1) Incorporated by reference to the corresponding Exhibit to Registration Statement No. 33-2687 on Form S-1 of the Company filed on January 15, 1986. (2) Incorporated by reference to the corresponding Exhibit to Registration Statement No. 33-13289 on Form S-1 of the Company filed on April 9, 1987. (3) Incorporated by reference to the corresponding Exhibit to the Registration's Annual Report on Form 10-K for the year ended December 31, 1987. (4) Incorporated by reference to the corresponding Exhibit to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1988. (5) Incorporated by reference to the corresponding Exhibit to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1989. (6) Incorporated by reference to the corresponding Exhibit to Registration Statement No. 33-40618 on Form S-8 of the Company filed on May 16, 1991. (7) Incorporated by reference to the corresponding Exhibit to Registration Statement No. 33-40619 on Form S-8 of the Company filed on May 16, 1991. (8) Incorporated by reference to the corresponding Exhibit to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1991. (9) Incorporated by reference to the corresponding Exhibit the Registrant's Annual Report on Form 10-K for the year ended December 31, 1992. (10) Incorporated by reference to the corresponding Exibit to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1993.

310431_1993.txt

310431_1993

1993

310431

Item 1. Business (a) The Registrant, CBI Industries, Inc. and its subsidiaries (CBI), classifies its operations in three major business segments: Contracting Services, Industrial Gases and Investments. CBI was incorporated in Delaware in 1979, as a holding company. CBI's Contracting Services segment is comprised of a number of separate companies, including the original Chicago Bridge & Iron Company which was founded in 1889. The Industrial Gases segment of CBI is comprised of Liquid Carbonic Industries Corporation, and its subsidiaries, which was founded in 1888 and acquired by CBI in 1984. The Investments segment of CBI includes CBI Investments, Inc. and its subsidiaries which have interests in oil and refined product storage, blending, and transport; real estate; and financial investments. (b) Financial information by business segment appears under Financial Summary in CBI's 1993 Annual Report to Shareholders and is incorporated herein by reference. (c) The percentage of revenues contributed by each business segment over the past three years was: 1993 1992 1991 ____ ____ ____ Contracting Services 44% 47% 48% Industrial Gases 49 45 43 Investments 7 8 9 ____ ____ ____ 100% 100% 100% ==== ==== ==== A description of the business done by each of CBI's industry segments follows. Items that are not considered material to an understanding of the business taken as a whole have been omitted. CBI holds patents and licenses for certain items incorporated into its products. However, none are so essential that their loss would materially affect the businesses of CBI. For information regarding working capital practices, refer to Financial Review - Financial Condition - Liquidity and Capital Resources in CBI's 1993 Annual Report to Shareholders which is incorporated herein by reference. CBI has incurred expenses during the year for the purpose of complying with environmental regulations, but their impact on the financial statements has not been material. Contracting Services Chicago Bridge & Iron Company (Chicago Bridge) is the parent company of the Contracting Services segment companies. Chicago Bridge is organized as a worldwide construction group that provides, through separate subsidiaries, a broad range of services, including design, engineering, fabrication, project management, general contracting and specialty construction services, including non-destructive inspection and post-weld heat treatment. The traditional products constructed by the Chicago Bridge companies have been a wide variety of fabricated metal plate structures including, but not limited to, elevated water tanks, penstocks and tunnel liners for hydroelectric dams, low temperature and cryogenic vessels and systems, and flat-bottom tanks, pressure vessels, and other vessels and structures utilized in the chemical, petroleum refining and petrochemical industries. In recent years, Chicago Bridge companies have broadened their capabilities so as to be in a better position to provide additional products and services to address a more diverse base of customers. Other products and services include the construction of experimental test facilities, environmental chambers, advanced energy systems and structures, power plant maintenance and repair, turnkey water and wastewater treatment facilities, turnkey woodyard facilities for the forest products industry, non-destructive testing, post-weld heat treating and refractory bakeouts, and vessels, tanks and other structures for corrosion- resistant applications. Chicago Bridge conducts these activities through various separate companies, the major of which are mentioned on the following page. CBI Na-Con, Inc. provides domestic construction-related services which include, but are not limited to, the construction of commercial and municipal water and wastewater treatment plants, defense-related facilities, industrial expansion projects, refinery turnarounds and turnkey storage terminals. CBI Na-Con, Inc. has district offices located in Norcross, Georgia; Houston, Texas; Fontana, California; and Plainfield, Illinois. It also has metal plate fabrication capabilities at its Houston and Fontana facilities. CBI Services, Inc. provides fabricated metal plate products and other specialized domestic construction services for the power generation industries, the government and other industrial customers. The product lines of CBI Services, Inc. include, but are not limited to, petroleum, petrochemical and chemical storage tanks; pressure, cryogenic and low temperature vessels; and miscellaneous metal plate structures. CBI Services has district offices located in New Castle, Delaware; Fremont, California; and Kankakee, Illinois. It also has metal plate fabrication capabilities at its Kankakee facility. Chicago Bridge & Iron Company, incorporated in Illinois, is the original company which was formed in 1889 and is the parent company for Contracting Services companies which operate outside the United States. Regional offices of international subsidiaries are located in London (England), Singapore, Fort Erie (Canada), and Houston, Texas. Other subsidiary offices and facilities are located in Caracas (Venezuela), Dammam (Saudi Arabia), Dubai (U.A.E.), Blacktown (Australia), Johannesburg (South Africa), Kuala Lumpur (Malaysia), Manila (Philippines), Jakarta (Indonesia), Bangkok (Thailand) and Tokyo (Japan). Other Chicago Bridge companies include: CBI Walker, Inc., which designs and supplies equipment used to treat municipal and industrial water and wastewater; FMP/Rauma Company (a partnership owned 50.1% by Fibre Making Processes, Inc., a wholly-owned subsidiary of Chicago Bridge) which designs, manufactures and/or supplies equipment and turnkey woodyards to the forest products industry; Chicago Bridge and Iron Technical Services Company, which provides engineering and research services for the Chicago Bridge subsidiaries and for outside parties; MQS Inspection, Inc., which provides non-destructive examination and inspection services; Cooperheat, Inc. which provides post-weld heat treating and refractory bake-outs as field services and sells associated equipment; and Ershigs, Inc. (acquired May 1993), which is an engineering, manufacturing and construction company which specializes in fiberglass reinforced plastic and dual-laminate vessels, tanks and other structures for corrosion-resistant applications. The principal raw materials used by the Contracting Services segment are metal plate and structural steel. These materials are available from various domestic and international mills. Chicago Bridge does not anticipate having difficulty in obtaining adequate amounts of raw materials. This segment is not dependent upon any single customer or group of customers and the loss of any single customer would not have any material adverse effect on the business. This segment had a backlog of work to be completed on contracts of $424,900,000 at December 31, 1993 and $325,200,000 at December 31, 1992. Approximately 86% of the backlog as of December 31, 1993 is expected to be completed in 1994. Adequate industry statistics relating to this segment of the business in which CBI competes are not available. Several large companies offer metal plate products that compete with some, but not all, of those of Chicago Bridge. Local and regional companies offer strong competition in one or more geographical areas, but not in other areas where Chicago Bridge operates. Therefore, it is impossible to state Chicago Bridge's position in the industry. Quality, reputation, delivery, and price are the principal methods of competition within the industry. Competition is based primarily on performance and the ability to provide the design, engineering, fabrication, project management and construction required to complete projects in a timely and cost-efficient manner. Chicago Bridge believes its position is among the top in the field. As of December 31, 1993, this segment employed 45 people engaged full-time in the research and development of new products and services or the improvement of existing products and services. This is comparable to 40 people employed at December 31, 1992 and 43 at December 31, 1991. This segment incurred expenses of approximately $3,078,000 in 1993, $2,961,000 in 1992 and $2,824,000 in 1991 for its research and development activities. This segment also performs certain research and development activities for customers. Approximately 7,100 people were employed by this segment at the end of 1993. Industrial Gases Liquid Carbonic Industries Corporation (Liquid Carbonic) is the parent company of the Industrial Gases segment companies. CBI believes Liquid Carbonic is the world's largest supplier of carbon dioxide in its various forms. Liquid Carbonic also produces, processes and markets a wide variety of other industrial/medical and specialty gases, including oxygen, nitrogen, argon, hydrogen, acetylene, carbon monoxide, liquified natural gas and nitrous oxide. The segment also assembles and sells industrial gas-related equipment. Liquid Carbonic conducts its business through various separate companies, each of which either generally provides different products or services or conducts business in a different geographical area than the other companies. The business of Liquid Carbonic is generally broken down into units which engage in domestic carbon dioxide processing and sales; domestic bulk air gas production and sales; domestic cylinder gas products production and sales; domestic carbon monoxide and hydrogen gas production and pipeline sales; Canadian carbon dioxide processing and industrial gas production and sales; and international business outside of the United States and Canada, which involves primarily the processing and sale of carbon dioxide and other gases and chemicals in 21 other countries. The major Liquid Carbonic business units are the following: Liquid Carbonic Carbon Dioxide is engaged in the domestic processing and sale of carbon dioxide in all its forms. Carbon dioxide is used in the refrigeration, freezing, processing and preservation of food, beverage carbonation, chemical production, water treatment and the enhancement of oil and gas production. Liquid Carbonic Carbon Dioxide operates carbon dioxide plants and receives by-product carbon dioxide from other plants operated by suppliers. It also owns and operates plants to produce dry ice. It sells carbon dioxide to its bulk customers through a network of sales offices nationwide. Liquid Carbonic Bulk Gases produces and sells industrial/medical gases domestically. It sells oxygen, nitrogen and argon to industrial customers for refrigeration, as a pressure medium and for other applications; and to medical customers for resuscitative and therapeutic purposes. This unit operates air separation plants for the production of these gases. It sells industrial gases mainly to small and medium sized "merchant" accounts near supply sources and sells medical gases primarily to group purchasing organizations and individual medical centers. Liquid Carbonic Cylinder Gas Products is engaged in the domestic production and sale of specialty gases. It sells highly purified gases, acetylene, cylinder oxygen, nitrogen, argon and nitrous oxide. The highly purified gases are produced and distributed from regional gas laboratories and sold to universities, research centers, clinics and industry. Liquid Carbonic Process Plants produce and sell gaseous and liquid carbon monoxide and gaseous hydrogen. These gases are mainly sold by pipeline to customers located in Louisiana, Ohio and West Virginia. Liquid Carbonic Corporation is the parent company for the Liquid Carbonic companies which operate outside the United States. The principal subsidiaries are in Argentina, Belize, Bolivia, Brazil, Canada, Chile, Colombia, Mexico, Peru, Poland (acquired April 1993), Spain, Thailand and Venezuela. Liquid Carbonic Corporation also owns a non-majority interest in a number of affiliated companies located in Barbados, Guyana, Haiti, Jamaica, Japan, Korea, Trinidad, Turkey and Uruguay. Most of these companies process and sell carbon dioxide and produce industrial/medical gases, chemicals (including precipitated calcium carbonate, a chemical ingredient used in the manufacture of a variety of consumer and industrial products) and other products. These companies operate by-product and combustion plants for the processing of carbon dioxide, dry ice plants and air separation plants. Liquid Carbonic's strength in the carbon dioxide market is in part due to its ability over the years to secure adequate supplies of product from diverse sources. Most carbon dioxide sold by Liquid Carbonic is purchased from by- product sources. By-product carbon dioxide is obtained from various sources, including chemical plants, refineries, and industrial processes, or from carbon dioxide wells, and is processed in Liquid Carbonic's own plants to produce commercial carbon dioxide. Liquid Carbonic also purchases commercial carbon dioxide from by-product sources having their own carbon dioxide plants. Liquid Carbonic has supply contracts which require the purchase of specified minimum quantities of carbon dioxide. Generally, these contracts do not obligate the supplier to continue to produce carbon dioxide or to supply specified minimum quantities; however, these provisions have historically had no material adverse effect on Liquid Carbonic's source of supply. This segment is not dependent upon any single customer or group of customers and the loss of any single customer would not have a material adverse effect on the business. Liquid Carbonic's principal competitors in North America are the Airco subsidiary of the BOC Group, Air Products and Chemicals, Inc., the Cardox subsidiary of L'Air Liquide, and Praxair, Inc. It also faces competition from a number of regional and local competitors. As of December 31, 1993, Liquid Carbonic employed 98 people engaged full- time in the research and development of new products and services or the improvement of existing products and services. This is comparable to 106 people employed at December 31, 1992 and 88 at December 31, 1991. This segment incurred expenses of approximately $10,616,000 in 1993, $8,765,000 in 1992 and $7,246,000 in 1991 for its research and development activities. This segment also performs certain research and development activities for customers. Approximately 6,600 people were employed by this segment at the end of 1993. Investments CBI Investments, Inc. is the parent company of the Investments segment companies. The Investments segment includes Statia Terminals (Statia), which operates fuel oil and refined petroleum products storage and blending facilities and provides bunkering services in the Caribbean, and operates a special products terminal in Brownsville, Texas. On October 20, 1993, Statia purchased the other outstanding interests in, and became 100% owner of, Point Tupper Terminals Corporation, a Canadian terminal company. The Point Tupper operation, in which Statia initially became an equity investor in August 1992, is strategically located to service global oil producing and trading customers which market their products in the northeastern part of North America. Investments are also held in Petroterminal de Panama, S.A., a crude oil pipeline and transport facility in Panama; Tankstore Pte. Ltd., a fuel oil and petroleum product storage and terminal facility and bunkering operation in Singapore; and real estate. In addition, CBI Investments, Inc. has interests in several other companies. The businesses in this segment primarily provide services and therefore do not depend heavily on raw materials. Approximately 220 people were employed by Statia at the end of 1993. (d) Financial information by geographic area of operation is shown in Notes and Reports - Note 13 - Operations by Business Segment and Geographic Area in CBI's 1993 Annual Report to Shareholders and is incorporated herein by reference. Item 2. Item 2. Properties Contracting Services Chicago Bridge owns or leases the properties used to conduct its business. The capacities of these facilities depend upon the mix of products being manufactured. As the product mix is constantly changing, the extent of utilization of these facilities cannot be accurately stated. Chicago Bridge believes that these facilities are adequate to meet its requirements. The following list summarizes the principal owned properties: Type of Square Location Facility Footage ________ __________ _______ United States Fontana, California fabrication plant, warehouse and office 36,000 Fremont, California warehouse and office 85,000 Houston, Texas fabrication plant, warehouse and office 253,000 Kankakee, Illinois fabrication plant, warehouse and office 396,000 New Castle, Delaware warehouse and office 143,000 Norcross, Georgia warehouse and office 36,000 Plainfield, Illinois engineering and research center 176,000 warehouse and office 12,000 International Blacktown, New South Wales, Australia fabrication plant, warehouse and office 134,000 Fort Erie, Ontario, Canada fabrication plant, warehouse and office 208,000 In addition to the above, Chicago Bridge has interests in other fabrication facilities in Saudi Arabia, Thailand, Indonesia, Venezuela, South Africa and Australia. Chicago Bridge also owns or leases a number of field construction offices, warehouses and equipment maintenance centers strategically located throughout the world. In April 1993, Chicago Bridge announced a decision to close a fabrication facility located in Cordova, Alabama. Industrial Gases Liquid Carbonic owns or leases the facilities used in its business. Liquid Carbonic believes these facilities are adequately utilized and sufficient to meet its customer needs. The following list summarizes the principal properties: Type of Facility by Number of Facilities Geographic Area Owned or Leased ___________________ ____________________ United States By-product CO2 22 owned Air separation 3 owned, 3 leased Carbon monoxide/hydrogen 3 owned Research center 1 leased International By-product CO2 58 owned, 1 leased Combustion 31 owned Air separation 20 owned Research center 2 owned Investments The total storage capacity for Statia is, in millions of barrels, as follows: Caribbean (island of St. Eustatius, Netherlands Antilles) terminal 6.3 United States (Brownsville, Texas) terminal 1.6 Canada (Cape Breton Island, Nova Scotia) terminal 7.6 Approximately 30% of the total storage capacity at the Canadian terminal is currently being utilized. The remaining storage is scheduled to be reactivated by mid-1994. In November 1993, Statia Terminals entered into an agreement with an independent third-party to lease and operate five million barrels of new storage capacity, together with a related single-point mooring buoy, on the island of St. Eustatius. These additional facilities, which are scheduled to be on-line by the end of the first quarter of 1995, will permit Statia Terminals to service a new long-term contract with a major oil producer, and to discharge and re-load shipments from very large crude oil carriers. Petroterminal de Panama, S.A., in which CBI has a 21.25% interest, owns a pipeline and terminal facility in Panama. The pipeline is 81 miles in length and has a maximum capacity of 755,000 barrels of oil per day. The terminal facility occupies approximately 1,694 acres, of which 8 acres are owned by Petroterminal de Panama and the balance is owned by the Republic of Panama. Tankstore Pte. Ltd., in which CBI has a 20% interest, owns a storage and terminal facility on approximately 84 acres of land leased from the Republic of Singapore. The total storage capacity in Singapore is 5.2 million barrels. CBI currently owns approximately 2,300 acres of undeveloped real estate in Virginia, Texas and Utah. CBI also owns its corporate headquarters located in Oak Brook, Illinois. The buildings have approximately 196,000 square feet of space. Item 3. Item 3. Legal Proceedings On October 30, 1987, CBI Na-Con, Inc. was working in the Marathon Petroleum Company (Marathon) refinery in Texas City, Texas. While a lift was being made by a crane supplied and operated by others, the crane became unstable, causing the operator to drop the load on a hydrofluoric acid tank which released part of its contents into the atmosphere. The community surrounding the refinery was evacuated after the incident, and a substantial number of persons evacuated sought medical attention. CBI Na-Con, Inc. has reached settlements with all but 15 of the 4,300 (approximate) third-party plaintiffs who brought suit as a result of the incident. CBI Na-Con, Inc. is also defending a lawsuit brought by Marathon originally seeking contractual indemnity which has been amended to seek reimbursement for Marathon's expenditures relating to the incident, including property damage, emergency response costs, third-party claim payments and legal fees. CBI filed suit against its insurers seeking insurance coverage and other recourse as a result of the denial of coverage or reservation of rights by the insurers for the incident based on certain pollution exclusions in the policies. The trial court granted summary judgment in favor of the insurers in April 1991. CBI appealed the trial court's judgment, and the Texas Appellate Court reversed and remanded the case back to the trial court in August 1993 to allow CBI to conduct discovery. The insurers are seeking review by the Texas Supreme Court. Chicago Bridge & Iron Company (Chicago Bridge) was a minority shareholder from 1934 to 1954 in a company which owned or operated at various times several wood treating facilities at sites in the United States, some of which are currently under investigation, monitoring or remediation under various environmental laws. Chicago Bridge is involved in litigation concerning environmental liabilities, which are currently undeterminable, in connection with certain of those sites. Chicago Bridge denies any liability for each site and believes that the successors to the wood treating business are responsible for any cost of remediation at the sites. Chicago Bridge has now reached settlements for environmental liabilities at most of the sites. The company believes that any remaining potential liability will not have a materially adverse effect on its operations or financial condition. A subsidiary of the company, Liquid Carbonic Industries Corporation (Liquid Carbonic), has been or is currently involved in civil litigation and governmental proceedings relating to antitrust matters. In this regard, since April 1992, several lawsuits have been filed against Liquid Carbonic and various competitors. These cases have been consolidated in the United States District Court for the Middle District of Florida, Orlando Division. The lawsuits allege generally that, beginning not later than 1968 and continuing through the present, defendants conspired to allocate customers, fix prices and rig bids for carbon dioxide in the United States in violation of the antitrust laws. On April 19, 1993, the court certified a class in the consolidated cases consisting of direct purchasers of carbon dioxide from defendants in the continental United States for the period from January 1, 1968 to and including October 26, 1992. Plaintiffs seek from defendants unspecified treble damages, civil penalties, injunctive relief, costs and attorneys' fees. In addition, a suit has been brought against Liquid Carbonic and others under the antitrust laws of the State of Alabama based upon the foregoing allegations. The company believes that the allegations made against Liquid Carbonic in these lawsuits are without merit, and Liquid Carbonic intends to defend itself vigorously. Liquid Carbonic and its subsidiaries also from time to time furnish documents and witnesses in connection with governmental investigations of alleged violations of the antitrust laws. While the outcome of any particular lawsuit or governmental investigation cannot be predicted with certainty, the company believes that these antitrust matters will not have a materially adverse effect on its operations or financial condition. In addition to the above lawsuits, CBI is a defendant in a number of lawsuits arising from the conduct of its business. While it is impossible at this time to determine with certainty the ultimate outcome of any litigation or matters referred to above, CBI's management believes that adequate provisions have been made for probable losses with respect thereto as best as can be determined at this time and that the ultimate outcome, after provisions therefor, will not have a material adverse effect on the financial position of CBI. The adequacy of reserves applicable to the potential costs of being engaged in litigation and potential liabilities resulting from litigation are reviewed as developments in the litigation warrant. Item 3. Legal Proceedings (Continued) CBI also is jointly and severally liable for some liabilities of partnerships and joint ventures and has also given certain guarantees in connection with the performance of contracts and repayment of obligations by its subsidiaries and other ventures in which CBI has a financial interest. CBI's management believes that the aggregate liability, if any, for these matters will not be material to its 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 ended December 31, 1993. PART II Item 5. Item 5. Market for the Registrant's Common Equity and Related Stockholder Matters CBI's common stock is listed on the New York Stock Exchange (symbol CBH). The approximate number of holders of record of common stock at February 16, 1994, was 7,700. Information appearing under Quarterly Financial Data - Quarterly Operating Results, Common Stock Prices and Dividends in CBI's 1993 Annual Report to Shareholders is incorporated herein by reference. Item 6. Item 6. Selected Financial Data The summary of selected financial data appearing under Financial Summary in CBI'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 Information appearing under Financial Review in CBI's 1993 Annual Report to Shareholders is incorporated herein by reference. Item 8. Item 8. Financial Statements and Supplementary Data The financial statements consisting of Statements of Income, Balance Sheets, Statements of Cash Flows, Statements of Common Shareholders' Investment, Notes and Report of Independent Public Accountants in CBI's 1993 Annual Report to Shareholders is incorporated herein by reference. The supplemental financial information appearing under Quarterly Financial Data - Quarterly Operating Results, Common Stock Prices and Dividends in CBI's 1993 Annual Report to Shareholders is incorporated herein by reference. Additional financial information and schedules can be found in Part IV of this report. Item 9. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosures CBI has neither changed its independent accountants nor had any disagreements on accounting and financial disclosure with its independent accountants during the two most recent fiscal years. PART III Item 10. Item 10. Directors and Executive Officers of the Registrant (a) Information appearing under Election of Directors in CBI's 1994 Proxy Statement is incorporated herein by reference. (b) The executive officers of CBI as of March 15, 1994 are as follows: Served as Executive Officer Name Age Title of CBI Since John E. Jones 59 Chairman of the Board, President and Chief Executive Officer 1980 Lewis E. Akin 56 Executive Vice President 1986 Robert J. Daniels 60 Executive Vice President 1988 George L. Schueppert 55 Executive Vice President-Finance and Chief Financial Officer 1987 Charles O. Ziemer 54 Senior Vice President and General Counsel 1984 Buel T. Adams 61 Vice President and Treasurer 1983 Stephen M. Duffy 44 Vice President-Human Resources 1993 Carl T. Haller 50 Vice President-Administration 1993 Alan J. Schneider 48 Vice President and Controller 1991 (d) There are no family relationships between any executive officers and directors. Executive officers are usually elected at the meeting of the Board of Directors immediately preceding the Annual Meeting of Shareholders and serve until successors are elected. (e) With the exceptions of Stephen M. Duffy and Carl T. Haller, all of the above named officers have been employed by CBI in an executive or management capacity for more than five years. Stephen M. Duffy was formerly a Vice President with Sunbeam Appliance Company. Carl T. Haller was formerly a Vice President with Signode Corporation, a wholly owned subsidiary of Illinois Tool Works Inc. Information with respect to compliance with Section 16(a) of the Securities Exchange Act of 1934 appears under Compliance with Section 16 of the Exchange Act in CBI's 1994 Proxy Statement and is incorporated herein by reference. Item 11. Item 11. Executive Compensation Information appearing under Executive Compensation in CBI's 1994 Proxy Statement is incorporated herein by reference. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management Information appearing under Common Stock Ownership By Certain Persons and Management in CBI's 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 (a) 1. Financial Statements The following financial statements and Report of Independent Public Accountants previously incorporated by reference under Item 8 of Part II of this report. Financial Statements: Statements of Income - For the years ended December 31, 1993, 1992 and 1991 Balance Sheets - For the years ended December 31, 1993, 1992 and 1991 Statements of Cash Flows - For the years ended December 31, 1993, 1992 and 1991 Statements of Common Shareholders' Investment - For the years ended December 31, 1993, 1992 and 1991 Notes Report of Independent Public Accountants 2. Financial Statement Schedules The following Supplemental Schedules to Financial Statements are included herein on pages 12 through 15 of this report: Schedule V - Property and Equipment - For the years ended December 31, 1993, 1992 and 1991 Schedule VI - Accumulated Depreciation of Property and Equipment - For the years ended December 31, 1993, 1992 and 1991 Schedule VIII - Valuation and Qualifying Accounts and Reserves - For the years ended December 31, 1993, 1992 and 1991 Report of Independent Public Accountants on Supplemental Schedules to Consolidated Financial Statements Schedules other than those listed have been omitted because the schedules are either not applicable or the required information is shown in the financial statements or notes thereto incorporated by reference under Item 8 of Part II of this report. Quarterly financial data for the years ended December 31, 1993 and 1992 is shown in the supplemental financial information incorporated by reference under Item 8 of Part II of this report. CBI's interest in 50 percent or less owned affiliates, when considered in the aggregate, constitute a significant subsidiary. Summarized financial information is shown in Notes and Reports - Note 14 - Unconsolidated Affiliates previously incorporated by reference under Item 8 of Part II of this report. 3. Exhibits The Exhibit Index on page 16 and Exhibits being filed are submitted as a separate section of this report. (b) Reports on Form 8-K There were no reports on Form 8-K filed during the fourth 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. CBI INDUSTRIES, INC. Date: March 15, 1994 By: /s/ George L. Schueppert _____________________________ George L. Schueppert Executive Vice President-Finance, Chief Financial 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 indicated on March 15, 1994. Signature Title /s/ John E. Jones Chairman of the Board, President, _______________________________ Chief Executive Officer (Principal Executive Officer) and Director /s/ Lewis E. Akin Executive Vice President and Director _______________________________ Lewis E. Akin /s/ Robert J. Daniels Executive Vice President and Director _______________________________ Robert J. Daniels /s/ George L. Schueppert Executive Vice President-Finance, _______________________________ Chief Financial Officer (Principal George L. Schueppert Financial Officer) and Director /s/ Wiley N. Caldwell Director and Chairman of the Audit _______________________________ Committee Wiley N. Caldwell /s/ E.H. Clark, Jr. Director and Member of the Audit Committee _______________________________ E.H. Clark, Jr. /s/ John F. Riordan Director and Member of the Audit Committee _______________________________ John F. Riordan /s/ Robert G. Wallace Director and Member of the Audit Committee _______________________________ Robert G. Wallace /s/ Alan J. Schneider Vice President and Controller _______________________________ (Principal Accounting Officer) Alan J. Schneider REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS ON SUPPLEMENTAL SCHEDULES TO CONSOLIDATED FINANCIAL STATEMENTS To the Shareholders and Board of Directors, CBI Industries, Inc.: We have audited in accordance with generally accepted auditing standards, the financial statements of CBI Industries, Inc. and Subsidiaries included in the company's 1993 Annual Report to Shareholders incorporated by reference in this Form 10-K, and have issued our report thereon dated February 17, 1994. Our report on these financial statements includes an explanatory paragraph with respect to the change in methods of accounting for income taxes and for postretirement benefits other than pensions in 1992 as discussed in Notes 11 and 12 to the financial statements. Our audit was made for the purpose of forming an opinion on those statements taken as a whole. The supplemental schedules to financial statements listed in the index to Item 14 on page 10 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 supplemental 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. /s/ ARTHUR ANDERSEN & CO. _________________________ ARTHUR ANDERSEN & CO. Chicago, Illinois February 17, 1994 CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS WITH RESPECT TO FORM S-8 AND FORM S-3 As independent public accountants, we hereby consent to the incorporation of our reports included and incorporated by reference in this Form 10-K, into the company's previously filed Registration Statements on Form S-8 (Nos. 33-46962, 33-14906 and 33-37246) and on Form S-3 (Nos. 33-65122 and 33-51595). /s/ ARTHUR ANDERSEN & CO. _________________________ ARTHUR ANDERSEN & CO. Chicago, Illinois March 15, 1994 1993 FORM 10-K ANNUAL REPORT EXHIBIT INDEX Item 14 (a) 3 Exhibit (3) Articles of Incorporation and By-Laws. (i) Articles of Incorporation. - Certificate of Incorporation as amended can be found in CBI's Form 10-Q dated November 13, 1992 and is incorporated herein by reference. (ii) By-Laws. - By-laws as amended can be found in CBI's Form 10-K dated March 29, 1991 and are incorporated herein by reference. (4) Instruments Defining the Rights of Security Holders, Including Indentures. - 6 1/4% Notes due June 30, 2000. The indenture can be found in CBI's Form S-3 dated June 22, 1993 and is incorporated herein by reference. - 6 5/8% Notes due March 15, 2003. The indenture can be found in CBI's Form S-3 dated February 26, 1993 and is incorporated herein by reference. - Series A Preferred Stock Purchase Rights Agreement as amended can be found in CBI's Form 8-K dated August 8, 1989 and is incorporated herein by reference. - Description of Convertible Voting Preferred Stock, Series C can be found in CBI's Form 8-K dated April 19, 1988 and is incorporated herein by reference. (10) Material Contracts. (iii) Executive Contracts and Compensation Plans. (a) Directors' Deferred Fee Plan, as amended, can be found in CBI's Form 10-K dated March 30, 1993 and is incorporated herein by reference. (b) Agreement between John E. Jones and CBI can be found in CBI's Form 10-K dated March 29, 1983 and is incorporated herein by reference. (c) A summary of the Termination Agreements can be found in CBI's Form 8-K dated October 10, 1986 and is incorporated herein by reference. (d) Agreement between George L. Schueppert and CBI can be found in CBI's Form 10-K dated March 29, 1989 and is incorporated herein by reference. (e) CBI Industries Stock Option Plan, as amended, can be found in CBI's Form S-8 dated October 10, 1990 and is incorporated herein by reference. (f) CBI Executive Life Insurance Plan can be found in CBI's Form 10-K dated March 30, 1993 and is incorporated herein by reference. (11) Computation of Per Share Earnings. (13) Portions of the 1993 Annual Report to Shareholders expressly incorporated by reference into this report. (21) Subsidiaries of the Registrant.

73124_1993.txt

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Item 1 - -Business NORTHERN TRUST CORPORATION Northern Trust Corporation is a bank holding company within the meaning of the Bank Holding Company Act of 1956, as amended. The Corporation was organized in Delaware in 1971 and on December 1 of that year became the owner of all of the outstanding capital stock, except directors' qualifying shares, of The Northern Trust Company (Bank), an Illinois banking corporation located in the Chicago financial district. The Corporation also owns three other banks in the Chicago metropolitan area, a bank in each of Florida, Arizona, California and Texas, and various other nonbank subsidiaries, including a securities brokerage firm and a futures commission merchant. The Corporation expects that although the operations of other subsidiaries will be of increasing significance, the Bank will in the foreseeable future continue to be the major source of the Corporation's assets, revenues and net income. Except where the context otherwise requires, the term "Corporation" refers to Northern Trust Corporation and its consolidated subsidiaries. At December 31, 1993, the Corporation had consolidated total assets of approximately $16.9 billion and stockholders' equity of $1.2 billion. At June 30, 1993 the Corporation was the third largest bank holding company headquartered in Illinois and the 40th largest in the United States, based on consolidated total assets of approximately $16.3 billion on that date. THE NORTHERN TRUST COMPANY The Bank was founded by Byron L. Smith in 1889 to provide banking and trust services to the public. Currently in its one hundred and fifth year, the Bank's growth has come from internal sources rather than through merger or acquisition. At December 31, 1993, the Bank had consolidated assets of approximately $13.5 billion. At June 30, 1993, the Bank was the third largest bank in Illinois and the 38th largest in the United States, based on consolidated total assets of approximately $13.1 billion on that date. At December 31,1993 the Bank had seven active wholly owned subsidiaries: The Northern Trust International Banking Corporation, NorLease, Inc., The Northern Trust Safe Deposit Company, MFC Company, Inc., Nortrust Nominees Ltd., The Northern Trust Company U.K. Pension Plan Limited and The Northern Trust Company, Canada. The Northern Trust International Banking Corporation, located in New York, was organized under the Edge Act for the purpose of conducting international business. NorLease, Inc. was established by the Bank to enable it to broaden its leasing and leasing-related lending activities. The Northern Trust Safe Deposit Company was established in order to offer safe deposit facilities to the public. MFC Company, Inc. holds properties that are received from the Bank in connection with certain problem loans. Nortrust Nominees Ltd., located in London, is a U.K. trust corporation organized to hold U.K. real estate for fiduciary accounts. The Northern Trust Company U.K. Pension Plan Limited was established in connection with the pension plan for the Bank's London branch. The Northern Trust Company, Canada was established to offer institutional trust products and services to Canadian entities. OTHER NORTHERN TRUST CORPORATION SUBSIDIARIES The Corporation has three banking subsidiaries in the Chicago metropolitan area: Northern Trust Bank/O'Hare N.A., Northern Trust Bank/DuPage, and Northern Trust Bank/Lake Forest N.A. At December 31, 1993, the three Illinois banking subsidiaries had nine office locations with combined total assets of approximately $1.5 billion. The Corporation's Florida banking subsidiary, Northern Trust Bank of Florida N.A., is headquartered in Miami and at December 31, 1993, had fifteen offices located throughout Florida, with total assets of approximately $1.3 billion. The Corporation's Arizona banking subsidiary, Northern Trust Bank of Arizona N.A., is headquartered in Phoenix and at December 31, 1993 had total assets of approximately $214 million and serviced clients from four office locations. The Corporation has a Texas banking subsidiary, Northern Trust Bank of Texas N.A., headquartered in Dallas. It had four office locations and total assets of $152 million at December 31, 1993. The Corporation has one banking subsidiary in California, Northern Trust Bank of California N.A., headquartered in Santa Barbara. At December 31, 1993, it had six office locations and total assets of $141 million. The Corporation has several nonbank subsidiaries. Among them are Northern Trust Services, Inc., which provides management consulting services to nonaffiliated financial institutions. Northern Trust Securities, Inc. provides full brokerage services to clients of the Bank and the Corporation's other banking and trust subsidiaries and selectively underwrites general obligation tax-exempt securities. Northern Futures Corporation is a futures commission merchant. Northern Investment Corporation holds certain investments, including a loan made to a developer of a property in which - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- the Bank is the principal tenant. The Northern Trust Company of New York provides security clearance services for all nondepository eligible securities held by trust, agency, and fiduciary accounts administered by the Corporation's subsidiaries. Berry, Hartell, Evers & Osborne, Inc. is an investment management firm in San Francisco. Northern Trust Cayman International, Ltd. provides fiduciary services to clients residing outside of the U.S. CORPORATION'S INTERNAL ORGANIZATION The Corporation is organized into three principal business units: Corporate Financial Services and Personal Financial Services report to President and Chief Operating Officer William A. Osborn, who also heads the Commercial Banking and Corporate Management Services unit. In addition, the Corporation's Risk Management Unit focuses on financial and risk management. The following is a brief summary of the Corporation's business activities. CORPORATE FINANCIAL SERVICES John S. Sutfin, Vice Chairman of the Corporation, is head of Corporate Financial Services (CFS) which encompasses domestic and global custody trust- related services for securities traded in the United States and foreign markets, as well as securities lending, asset management, and cash management services. Master Trust/Master Custody is the principal product of CFS in the United States. Global Custody, the extension of domestic Master Custody to securities traded in markets foreign to the client, has been provided primarily through the Bank's London branch and Banque Scandinave en Suisse (BSS), in which the Bank has an investment of approximately 21%. The Corporation expects to transition most accounts custodied at BSS to the London branch during 1994. Related foreign exchange activities are conducted at the London branch. As measured by number of clients, the Corporation is a leading provider of Master Trust/Master Custody services in various market segments. At December 31, 1993 total assets under administration were $426.5 billion. The major market segments served are Corporate ERISA (pension and profit sharing funds subject to regulation under the Employment Retirement Income Security Act of 1974); public funds; taxable asset portfolios (foundations, endowments and insurance companies); and international asset portfolios (global assets of domestic and foreign institutions). To broaden the services provided to the defined contribution market, the Corporation signed a definitive agreement in December 1993 to acquire Hazlehurst & Associates, Inc., a privately-held retirement benefit plan services company based in Atlanta, Georgia. Hazlehurst's well established capabilities in retirement plan design, participant record keeping, and actuarial and consulting services will complement the Corporation's custody, fiduciary and investment management capabilities. The agreement is expected to close in the second quarter of 1994 subject to the approval of Hazlehurst shareholders and to regulatory approval. CFS also includes a correspondent trust market segment which provides custody, systems and investment services to smaller bank trust departments. Trust operations, The Northern Trust Company of New York and The Northern Trust Company, Canada are also included in CFS. PERSONAL FINANCIAL SERVICES Services to individuals is another major dimension of the Corporation's trust business. Barry G. Hastings, Vice Chairman of the Corporation, is head of Personal Financial Services (PFS) which encompasses personal trust and investment management services, estate administration, personal banking and mortgage lending. The Corporation's personal trust strategy combines private banking and trust services to targeted high net worth individuals in rapidly growing areas of wealth concentration. PFS is one of the largest bank managers of personal trust assets in the United States, with total assets under administration of $50.0 billion at December 31, 1993. The Corporation has created a broad national presence in the delivery of specialized private banking and personal trust services through the Bank and a network of banking subsidiaries located in Florida, Arizona, California, Texas and suburban Chicago. These full service banking subsidiaries are predominantly private banking and personal trust oriented and are included in PFS. In December 1993 the Corporation entered into a definitive agreement to acquire Beach One Financial Services, Inc., parent of The Beach Bank of Vero Beach in Florida. The agreement is expected to close in the third quarter of 1994 subject to the approval of Beach One shareholders and to regulatory approval. The Northern Trust Safe Deposit Company, Berry, Hartell, Evers & Osborne, Inc., and Northern Trust Securities, Inc. are also part of PFS. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- COMMERCIAL BANKING AND CORPORATE MANAGEMENT SERVICES Commercial Banking is headed by Gregg D. Behrens, Executive Vice President of the Bank. Commercial Banking offers a full range of banking services through the Bank and places special emphasis on developing institutional relationships in three target markets: middle market and small business companies in the Chicago and Midwest area, large domestic corporations, and financial institutions (both domestic and international). Credit services are administered in three groups: a Metropolitan Group, a Special Industries Group, and a Corporate and Correspondent Group. NorLease, Inc. and The Northern Trust International Banking Corporation are also part of Commercial Banking. Corporate Management Services (CMS), headed by J. David Brock, Executive Vice President of the Corporation, encompasses the treasury management products and services offered by the Corporation. This business serves the treasury needs of major corporations and financial institutions by providing products and services to accelerate cash collections, control disbursement outflows, and generate information to manage their cash positions. Treasury management products and services, including lockbox collection, controlled disbursement products and electronic banking, are developed and marketed in the Banking Services Group within CMS. CMS also includes banking operations and building management. RISK MANAGEMENT UNIT The Risk Management Unit, headed by Senior Executive Vice President and Chief Financial Officer Perry R. Pero, includes the Credit Policy function and the Bank's Treasury Department. The Credit Policy function is described fully on pages 16 to 17 of this report. The Treasury Department is responsible for managing the Bank's wholesale funding and interest rate risk, as well as the portfolio of interest rate risk management instruments under the direction of the Corporate Asset and Liability Policy Committee. It is also responsible for the investment portfolios of the Corporation and the Bank and provides investment advice and management services to the subsidiary banks. The Risk Management Unit also includes the Corporate Controller, Corporate Treasurer and Economic Research functions. GOVERNMENT POLICIES The earnings of the Bank, other banking subsidiaries, and the Corporation are affected by numerous external influences, principally general economic conditions, both domestic and international, and actions that the United States and foreign governments and their central banks take in managing their economies. These general conditions affect all of the Corporation's businesses, as well as the quality and volume of the loan and investment portfolios. An important regulator of domestic economic conditions is the Board of Governors of the Federal Reserve System, which has the general objective of promoting orderly economic growth in the United States. Implementation of this objective is accomplished by its open market operations in United States government securities, the discount rate at which member banks may borrow from Federal Reserve Banks and changes in the reserve requirements for deposits. The policies adopted by the Federal Reserve may strongly influence interest rates and hence what banks earn on their loans and investments and what they pay on their savings and time deposits and other purchased funds. Fiscal policies in the United States and abroad also affect the composition and use of the Corporation's resources. COMPETITION The Corporation's principal business strategy is to provide quality financial services to targeted market segments in which it believes it has a competitive advantage and favorable growth prospects. As part of this strategy, the Corporation seeks to deliver a level of service to its clients that distinguishes it from its competitors. The Corporation emphasizes the development and growth of recurring sources of fee-based income and is one of only eight major bank holding companies in the United States that generates more revenues from fee-based services than from net interest income. The Corporation seeks to develop and expand its recurring fee-based revenue by identifying selected market niches and providing a high level of individualized service to its clients in such markets. The Corporation also seeks to preserve its asset quality through established credit review procedures and to maintain a conservative balance sheet. Finally, the Corporation seeks to maintain a strong management team with senior officers having broad experience and long tenure with the Corporation. Active competition exists in all principal areas in which the subsidiaries of the Corporation are presently engaged. The Corporate and Personal Financial Services business units compete with domestic and foreign financial institutions, trust companies, financial companies, personal loan companies, mutual funds and investment advisors. The Corporation is a leading provider of Master Trust/Master Custody services and has the leading market share in the Chicago area personal trust market. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- The Commercial Banking and Corporate Management Services business unit competes with domestic and foreign financial institutions, finance companies and leasing companies. Its products also face increased competition due to the general trend among corporations and other institutions to rely more upon direct access to the credit and capital markets (such as through the direct issuance of commercial paper) and less upon commercial banks and other traditional financial intermediaries. The chief local competitors of the Bank for trust and banking business are Continental Bank N.A., The First National Bank of Chicago and its affiliate American National Bank and Trust Company of Chicago, Harris Trust and Savings Bank, and LaSalle National Bank. The chief national competitors of the Bank for Master Trust/Master Custody services are Mellon Bank Corporation, State Street Boston Corporation, Bankers Trust New York Corporation, Chase Manhattan Corporation and Bank of New York Company, Inc. REGULATION AND SUPERVISION The Corporation is a bank holding company subject to the Bank Holding Company Act of 1956, as amended (Act), and to regulation by the Board of Governors of the Federal Reserve System. The Act limits the activities which may be engaged in by the Corporation and its nonbanking subsidiaries to those so closely related to banking or managing or controlling banks as to be a proper incident thereto. Also, under section 106 of the 1970 amendments to the Act and the Federal Reserve Board's regulations, a bank holding company, as well as certain of its subsidiaries, is prohibited from engaging in certain tie-in arrangements in connection with any extension of credit or provision of any property or services. The Act also prohibits bank holding companies from acquiring substantially all the assets of or owning more than 5% of the voting shares of any bank or nonbanking company which is not already majority owned without prior approval of the Board of Governors. No application to acquire shares or assets of a bank located outside the state in which the operations of a bank holding company's banking subsidiaries are principally conducted may be approved by the Federal Reserve Board unless such acquisition is specifically authorized by a statute of the state in which the bank to be acquired is located. Illinois law permits bank holding companies located in any state of the United States to acquire banks or bank holding companies located in Illinois subject to regulatory determinations that the laws of the other state permit Illinois bank holding companies to acquire banks and bank holding companies within that state on qualifications and conditions not unduly restrictive compared to those imposed by Illinois law. Subject to these regulatory determinations, the Corporation may acquire banks and bank holding companies in such states, and bank holding companies in those states may acquire banks and bank holding companies in Illinois. Applicable laws also permit the Corporation to acquire banks or bank holding companies in Arizona, California, Texas, Florida and certain other states. Illinois law permits an Illinois bank holding company to acquire banks anywhere in the state. Illinois legislation also now allows Illinois banks to open branches anywhere within Illinois. The Financial Institutions Reform, Recovery and Enforcement Act of 1989 (FIRREA) amended the Act to authorize the Federal Reserve Board to allow bank holding companies to acquire any savings association (whether healthy, failed or failing) and removed "tandem operations" restrictions, which previously prohibited savings associations from being operated in tandem with a bank holding company's other subsidiaries. As a result, bank holding companies, including the Corporation, now have expanded opportunities to acquire thrift institutions. Under FIRREA, an insured depository institution which is commonly controlled with another insured depository institution shall generally be liable for any loss incurred, or reasonably anticipated to be incurred, by the Federal Deposit Insurance Corporation (FDIC) in connection with the default of such commonly controlled institution, or for any assistance provided by the FDIC to such commonly controlled institution, which is in danger of default. The term "default" is defined to mean the appointment of a conservator or receiver for such institution. Thus, any of the Corporation's banking subsidiaries could incur liability to the FDIC pursuant to this statutory provision in the event of a loss suffered by the FDIC in connection with any of the Corporation's other banking subsidiaries (whether due to a default or the provision of FDIC assistance). Although neither the Corporation nor any of its nonbanking subsidiaries may be assessed for such loss under FIRREA, the Corporation has agreed to indemnify each of its banking subsidiaries, other than the Bank, for any payments a banking subsidiary may be liable to pay to the FDIC pursuant to the provisions of FIRREA. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- The Bank is a member of the Federal Reserve System, its deposits are insured by the FDIC and it is subject to regulation by both these entities, as well as by the Illinois Commissioner of Banks and Trust Companies. The Bank is also a member of and subject to the rules of the Chicago Clearinghouse Association, and is registered as a government securities dealer in accordance with the Government Securities Act of 1986. As a government securities dealer its activities are subject to the rules and regulations of the Department of the Treasury. The Bank is registered as a transfer agent with the Federal Reserve and is therefore subject to the rules and regulations of the Federal Reserve. The Corporation's national bank subsidiaries are members of the Federal Reserve System and the FDIC and are subject to regulation by the Comptroller of the Currency. Northern Trust Bank/DuPage, a state chartered institution that is not a member of the Federal Reserve System, is regulated by the FDIC and the Illinois Commissioner of Banks and Trust Companies. The Corporation's nonbanking affiliates are all subject to examination by the Federal Reserve. In addition, The Northern Trust Company of New York is subject to regulation by the Banking Department of the State of New York. Northern Futures Corporation is registered as a futures commission merchant with the Commodity Futures Trading Commission, is a member of the National Futures Association, the Chicago Board of Trade and the Board of Trade Clearing Corporation, and is a clearing member of the Chicago Mercantile Exchange. Northern Trust Securities, Inc. is registered with the Securities and Exchange Commission and is a member of the National Association of Securities Dealers, Inc., and, as such, is subject to the rules and regulations of both these bodies. Berry, Hartell, Evers & Osborne, Inc. is registered with the Securities and Exchange Commission under the Investment Advisers Act of 1940 and is subject to that Act and the rules and regulations of the Commission promulgated thereunder. Various other subsidiaries and branches conduct business in other states and foreign countries and, therefore, may be subject to their regulations and restrictions. The Corporation and its subsidiaries are affiliates within the meaning of the Federal Reserve Act so that the banking subsidiaries are subject to certain restrictions with respect to loans to the Corporation or its nonbanking subsidiaries and certain other transactions with them or involving their securities. Information regarding dividend restrictions on the Corporation's banking subsidiaries is incorporated herein by reference to Note 12 titled Restrictions on Subsidiary Dividends and Loans or Advances on page 53 of the Corporation's Annual Report to Stockholders for the year ended December 31, 1993. Under the FDIC's risk-based insurance assessment system, each insured bank is placed in one of nine risk categories based on its level of capital and other relevant information. Each insured bank's insurance assessment rate is then determined by the risk category in which it has been classified by the FDIC. There is an eight basis point spread between the highest and lowest assessment rates, so that banks classified as strongest by the FDIC are subject to a rate of .23%, and banks classified as weakest by the FDIC are subject to a rate of .31%. The FDIC is prohibited from lowering the average assessment rate below .23% until the Bank Insurance Fund (Fund) has reached a reserve ratio of 1.25%. The FDIC currently estimates the Fund will achieve the designated reserve ratio in the first half of 2002. The Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA) substantially revised the bank regulatory and funding provisions of the Federal Deposit Insurance Act and made revisions to several other federal banking statutes. In general, FDICIA subjects banks to significantly increased regulation and supervision. Among other things, FDICIA requires federal bank regulatory authorities to take "prompt corrective action" with respect to banks that do not meet minimum capital requirements, and imposes certain restrictions upon banks which meet minimum capital requirements but are not "well capitalized" for purposes of FDICIA. FDICIA and the regulations adopted under it establish five capital categories as follows, with the category for any institution determined by the lowest of any of these ratios: *3% for banks with the highest CAMEL (supervisory) rating. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- An insured depository institution may be deemed to be in a capitalization category that is lower than is indicated by the capital position reflected on its statement of condition if it receives an unsatisfactory rating by its examiners with respect to its assets, management, earnings or liquidity. Although a bank's capital categorization thus depends upon factors other than the statement of condition ratios in the table above, the Corporation has set capital goals for each of its subsidiary banks that would allow each bank to meet the minimum ratios that are one of the conditions for it to be considered to be well capitalized. At December 31, 1993, the Bank and each of the Corporation's other subsidiary banks met or exceeded these goals. The Corporation's capital ratios are disclosed and discussed on page 39 of the Corporation's Annual Report to Stockholders for the year ended December 31, 1993. Under FDICIA, a bank that is not well capitalized is generally prohibited from accepting or renewing brokered deposits and offering interest rates on deposits significantly higher than the prevailing rate in its normal market area or nationally (depending upon where the deposits are solicited); in addition, "pass-through" insurance coverage may not be available for certain employee benefit accounts. 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 banks are subject to limitations on growth and are required to submit a capital restoration plan, which must be guaranteed by the institution's parent company. Institutions that fail to submit an acceptable plan, or that are significantly undercapitalized, are subject to a host of more drastic regulatory restrictions and measures. FDICIA directs that each federal banking agency prescribe standards for depository institutions or depository institutions' 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 and other standards as they deem appropriate. Many regulations implementing these directives have been proposed and adopted by the agencies. FDICIA also contains a variety of other provisions that may affect the operations of a bank, including new reporting requirements, regulatory standards for real estate lending, "truth in savings" provisions and a requirement that a depository institution give 90 days' prior notice to customers and regulatory authorities before closing any branch. STAFF The Corporation and its subsidiaries employed 6,259 full-time equivalent officers and staff members as of December 31, 1993, approximately 4,600 of whom were employed by the Bank. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- STATISTICAL DISCLOSURES The following statistical disclosures, included in the Corporation's Annual Report to Stockholders for the year ended December 31, 1993, are incorporated herein by reference. - -------------------------------------------------------------------------------- Additional statistical information as to the Corporation on a consolidated basis is set forth below. INVESTMENT SECURITIES REMAINING MATURITY AND AVERAGE YIELD OF INVESTMENT SECURITIES (Yield on a taxable equivalent basis giving effect of the federal and state tax rates) - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- LOANS AND LEASES BY TYPE Loans were classified based on credit risk exposure for 1993, 1992, 1991 and 1990. Loan breakdowns prior to 1990 were based on industry classifications defined by the Federal Reserve. - -------------------------------------------------------------------------------- REMAINING MATURITY OF SELECTED LOANS AND LEASES - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- AVERAGE DEPOSITS BY TYPE - -------------------------------------------------------------------------------- AVERAGE RATES PAID ON TIME DEPOSITS BY TYPE - ------------------------------------------------------------------------------- REMAINING MATURITY OF TIME DEPOSITS $100,000 AND MORE - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - ------------------------------------------------------------------------------- PURCHASED FUNDS - ------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- CHANGES IN NET INTEREST INCOME Note: Changes not due only to volume changes or rate changes are included in the change due to volume column. - -------------------------------------------------------------------------------- INTERNATIONAL OPERATIONS (BASED ON OBLIGOR'S DOMICILE) See also Note 20 titled International Operations on pages 57 and 58 of the Corporation's Annual Report to Stockholders for the year ended December 31, 1993, which is incorporated herein by reference. SELECTED AVERAGE ASSETS AND LIABILITIES ATTRIBUTABLE TO INTERNATIONAL OPERATIONS - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- PERCENT OF INTERNATIONAL RELATED AVERAGE ASSETS AND LIABILITIES TO TOTAL CONSOLIDATED AVERAGE ASSETS - -------------------------------------------------------------------------------- RESERVE FOR CREDIT LOSSES RELATING TO INTERNATIONAL OPERATIONS The Securities and Exchange Commission requires the Corporation to disclose a reserve for credit losses that is applicable to international operations. The above table has been prepared in compliance with this disclosure requirement and is used in determining international operating performance. In 1989, $51.5 million and in 1990 the remaining $13.1 million of the reserve designated for loans to less developed countries was transferred to the general unallocated portion of the reserve for credit losses. The amounts shown in the table should not be construed as being the only amounts that are available for international loan charge-offs, since the entire reserve for credit losses is available to absorb losses on both domestic and international loans. In addition, these amounts are not intended to be indicative of future charge-off trends. - -------------------------------------------------------------------------------- DISTRIBUTION OF INTERNATIONAL LOANS AND DEPOSITS BY TYPE - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- CREDIT RISK MANAGEMENT OVERVIEW The Credit Policy function reports to the Chief Financial Officer. Credit Policy provides a system of checks and balances for the Corporation's diverse credit-related activities by establishing and monitoring all credit-related policies and practices throughout the Corporation and ensuring their uniform application. These activities are designed to ensure that credit exposure is diversified on an industry and client basis, thus lessening the overall credit risk to the Corporation. Individual credit authority within the Commercial Banking and Personal Financial Services business units is limited to specified amounts and maturities. Credit decisions involving commitment exposure in excess of the specified individual limits are submitted to the appropriate Group Credit Approval Committee (Committee). Each Committee is chaired by the executive in charge of the area and has a Credit Policy officer as a voting participant. Each Committee's credit approval authority is specified, based on commitment levels, credit ratings and maturities. Credits involving commitment exposure in excess of these group credit limits require, dependent upon the internal credit rating, the approval of the Credit Policy Credit Approval Committee, the head of Credit Policy, or the business unit head. Credit Policy established the Counterparty Risk Management Committee in order to manage the Corporation's counterparty risk more effectively. This committee has sole credit authority for exposure to all foreign banks, certain domestic banks which Credit Policy deems to be counterparties and which do not have commercial credit relationships within the Corporation, and other organizations which Credit Policy deems to be counterparties. Under the auspices of Credit Policy, country exposure limits are reviewed and approved on a country-by-country basis. As part of the Corporation's ongoing credit granting process, internal credit ratings are assigned to each client and credit before credit is extended, based on creditworthiness. Credit Policy performs a semi-annual review of selected significant credit exposures which is designed to identify at the earliest possible stages clients who might be facing financial difficulties. Internal credit ratings are also reviewed during this process. Above average risk loans, which will vary from time to time, receive special attention by both lending officers and Credit Policy. This approach allows management to take remedial action in an effort to deal with potential problems. An integral part of the Credit Policy function is a monthly formal review of all past due and potential problem loans to determine which credits, if any, need to be placed on nonaccrual status or charged off. The provision is reviewed quarterly to determine the amount necessary to maintain an adequate reserve for credit losses. The Corporation's management of credit risk is reviewed by various bank regulatory agencies. The Corporation's independent auditors also perform a review of credit-related procedures, the loan portfolio and other extensions of credit, and the reserve for credit losses as part of their audit of the Corporation's annual financial statements. ALLOCATION OF THE RESERVE FOR CREDIT LOSSES The reserve for credit losses is established and maintained on an overall portfolio basis. However, bank disclosure guidelines issued by the Securities and Exchange Commission request management to furnish a breakdown of the reserve for credit losses by loan category. Thus, in accordance with these disclosure guidelines, breakdowns are provided for the major domestic and foreign loan categories as follows: Allocated Reserve. Credit Policy estimates the amount that is necessary to provide for potential losses relating to specific nonperforming loans. The allocated portion of the reserve totaled $0.2 million at December 31, 1993, which related entirely to specific nonperforming loans. Total nonperforming loans were $27.3 million at December 31, 1993. Unallocated Reserve. The unallocated portion of the reserve is available for unknown losses that are inherent not only in the loan portfolio, but also in other extensions of credit. While the unallocated portion serves to cover specific groups of loans and other extensions of credit that entail higher than average risk, it is considered a general reserve available to absorb all credit- related losses. The unallocated portion of the reserve totaled $145.3 million at December 31, 1993 compared with $134.5 million at December 31, 1992. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- In connection with management's assessment of the unallocated portion of the reserve for credit losses at December 31, 1993, the following groups of loans with specific risk elements were considered: . Management's ongoing review process identified loans with above average credit risk, including nonperforming loans with no specific reserve allocation, which totaled $336.3 million at December 31, 1993. Management assigns risk factors of either 5% to 10% or 5% to 20% to loan categories in this group and ascribed $16.8 million to $49.7 million of the unallocated reserve to this group. . Another risk group identified is composed of commercial real estate loans. Management believes that this group, which totaled $369.4 million at December 31, 1993 (not including $137.1 million of loans with above average credit risk just described), represented a general risk factor of 5% to 10% at year-end and accordingly $18.5 million to $36.9 million of the unallocated reserve was ascribed to this group of loans. . Another risk group identified is composed of highly leveraged credit transactions (HLTs). At December 31, 1993, HLTs, as defined by bank regulatory agencies and not included in the groups of loans discussed above, totaled $42.0 million. Management assigned a general risk factor of 3% to 5% and ascribed $1.3 million to $2.1 million of the unallocated reserve to HLTs. Based on this analysis, $36.6 million to $88.7 million of the unallocated portion of the reserve for credit losses at December 31, 1993 has been ascribed to the above three groups of loans. Management believes the amount of the remaining reserve is adequate to cover both the remaining loan portfolio and other credit-related activities. As required by the Securities and Exchange Commission, the breakdown of the reserve for credit losses at December 31, 1989 through 1993 is presented below. RESERVE FOR CREDIT LOSSES - -------------------------------------------------------------------------------- Loan categories as a percent of total loans as of December 31, 1989 through 1993, are presented below. LOAN CATEGORY TO TOTAL LOANS Loans were classified based on credit risk exposure for 1993, 1992, 1991 and 1990. Loan breakdowns for 1989 were based on industry classifications defined by the Federal Reserve. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- The information presented in the Credit Risk Management" section should be read in conjunction with the following information that is incorporated herein by reference to the Corporation's Annual Report to Stockholders for the year ended December 31, 1993: In addition, the following schedules on page 15 of this Form 10-K should be read in conjunction with the Credit Risk Management section: Reserve for Credit Losses Relating to International Operations Distribution of International Loans and Deposits by Type - -------------------------------------------------------------------------------- - ------------------------------------------------------------------------------- INTEREST RATE SENSITIVITY ANALYSIS As described in the Management's Discussion and Analysis of Financial Condition and Results of Operations, in the section titled Liquidity and Rate Sensitivity on pages 37 through 39 of the Corporation's Annual Report to Stockholders for the year ended December 31, 1993, rate sensitivity arises when interest rates on assets change in a different time period or in a different proportion from that of interest rates on liabilities. The objective of interest rate sensitivity management is to prudently structure the balance sheet so that movements of interest rates on assets and liabilities (adjusted for off-balance sheet hedges) are highly correlated and produce a reasonable net interest margin even in periods of volatile interest rates. Proactive rate sensitivity management for the Corporation is presently focused on the Bank. Other subsidiary banks and foreign offices of the Bank operate under policies that limit the risk of a significant mismatch in their interest sensitivity gap. The Corporate Asset and Liability Policy Committee meets at least monthly to review and determine these rate sensitivity policies. Rate sensitivity management procedures consist of performing net interest income simulations as well as monitoring assets and liabilities that are rate-sensitive within 90 days, 182 days and one year. As a matter of policy, a reasonable balance of rate-sensitive assets and liabilities on a cumulative one year basis is maintained, thus minimizing the risk related to a sustained change in interest rates. Because of daily volatility in our balance sheet items, day-to-day interest sensitivity gaps are not necessarily indicative of the desired position at a specific time or the average experience in the surrounding time period. A negative rate sensitivity gap generally indicates a timing mismatch in that more liabilities than earning assets will be repriced within the period. The economic impact of creating a negative rate sensitivity position depends on the magnitude of actual changes in interest rates relative to the anticipated interest rates. If mismatches are created in a market that anticipates rising interest rates, but the actual increase in rates is lower than expected, net interest income is enhanced by taking the negative rate sensitivity gap. As a result of positions taken as of December 31, 1993, the Corporation's net interest income would be enhanced by not only a decline in interest rates but also by a modest increase. The table below reflects the Corporation's consolidated rate sensitivity position at December 31, 1993. INTEREST RATE SENSITIVITY ANALYSIS - -------------------------------------------------------------------------------- Allocations were made to specific interest sensitivity periods based primarily on the earlier of the repricing or maturity date, with the exception of the net noninterest-related funds component. In this case, the temporary difference between the actual volume at December 31, 1993 and the trend volume was allocated to the "91 Days or Less" interest sensitivity period. The trend volume of net noninterest-related funds was allocated to the "Not Rate Sensitive Within One Year" category. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- The following unaudited Consolidated Statement of Condition and Consolidated Statement of Income for The Northern Trust Company were prepared in accordance with generally accepted accounting principles and are provided here for informational purposes. These financial statements should be read in conjunction with the footnotes accompanying the consolidated financial statements of the Corporation, included in the Corporation's Annual Report to Stockholders for the year ended December 31, 1993, and incorporated herein by reference on page 24 of this report. THE NORTHERN TRUST COMPANY CONSOLIDATED STATEMENT OF CONDITION - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- THE NORTHERN TRUST COMPANY CONSOLIDATED STATEMENT OF INCOME - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- SUPPLEMENTAL ITEM--EXECUTIVE OFFICERS OF THE REGISTRANT DAVID W. FOX Mr. Fox was elected Chairman of the Board of the Corporation and the Bank on April 17, 1990, and Chief Executive Officer of the Corporation and the Bank on December 19, 1989. He held the title of President of the Corporation and the Bank from 1987 through 1993. Mr. Fox, 62, joined the Bank in 1955. J. DAVID BROCK Mr. Brock became an Executive Vice President of the Corporation and the Bank in April 1990. He was Deputy Head of the Subsidiary Banks Group from 1987 to 1989. Currently he is head of Corporate Management Services. Mr. Brock, 49, joined the Bank in 1966. ROBERT G. DEDERICK Mr. Dederick returned to the Corporation and the Bank as an Executive Vice President and Chief Economist in October 1983, after serving as Undersecretary of Commerce for Economic Affairs at the Department of Commerce from 1981 to 1983. Mr. Dederick, 64, first joined the Bank in 1964. DAVID L. EDDY Mr. Eddy became a Senior Vice President of the Corporation and the Bank and Treasurer of the Corporation in 1986. Mr. Eddy, 57, joined the Bank in 1960. BARRY G. HASTINGS Mr. Hastings was elected Vice Chairman of the Corporation and the Bank effective January 1, 1994, and is currently head of Personal Financial Services. He was a Senior Executive Vice President of the Corporation and the Bank from 1992 through 1993 and prior to that time had served as an Executive Vice President of the Bank since 1987, and of the Corporation since 1990. Mr. Hastings, 46, began his career with the Corporation in 1974. JOHN V. N. MCCLURE Mr. McClure was appointed an Executive Vice President of the Corporation and the Bank effective February 15, 1994, and is currently responsible for Strategic Planning and Marketing. Previously, he served as head of the Private Banking Division of Personal Financial Services from 1989 to 1991. He had been a Senior Vice President of the Bank since 1986 and of the Corporation since 1991. Mr. McClure, 42, joined the Bank in 1973. WILLIAM A. OSBORN Mr. Osborn was elected President and Chief Operating Officer of the Corporation and the Bank effective January 1, 1994. He was a Senior Executive Vice President of the Corporation and the Bank from 1992 through 1993 and prior to that time had served as an Executive Vice President of the Bank since 1987, and of the Corporation since 1989. Mr. Osborn, 46, began his career with the Bank in 1970. PERRY R. PERO Mr. Pero is Chief Financial Officer of the Corporation and the Bank and Cashier of the Bank. Mr. Pero is also head of the Risk Management Unit and Chairman of the Corporate Asset and Liability Policy Committee. He became a Senior Executive Vice President of the Corporation and the Bank in 1992 after serving as an Executive Vice President of the Corporation and the Bank since 1987. He was Chairman of the Credit Policy Committee from 1984 to 1988. Mr. Pero, 54, joined the Bank in 1964. JOHN H. ROBINSON Mr. Robinson was appointed Controller of the Bank in 1981 and of the Corporation in 1985. He has been a Senior Vice President of the Bank since 1984 and of the Corporation since 1985. Mr. Robinson, 59, joined the Bank in 1960. PETER L. ROSSITER Mr. Rossiter was appointed General Counsel of the Corporation and the Bank in April 1993. He joined the Corporation and the Bank in 1992 as an Executive Vice President and Associate General Counsel. Mr. Rossiter, 45, had been a partner in the law firm of Schiff Hardin & Waite from 1979 to 1992. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- JOHN S. SUTFIN Mr. Sutfin was elected Vice Chairman of the Corporation and the Bank effective January 1, 1994, and is currently head of Corporate Financial Services. He was a Senior Executive Vice President of the Corporation and the Bank from 1992 through 1993. He was Chief Financial Officer of the Corporation and the Bank in 1987 and 1988. He became an Executive Vice President of the Corporation and the Bank in 1982. Mr. Sutfin, 54, joined the Bank in 1961. WILLIAM S. TRUKENBROD Mr. Trukenbrod was appointed an Executive Vice President of the Corporation and the Bank effective February 15, 1994, and is currently Chairman of the Credit Policy Committee. Previously, he served as head of the U.S. Corporate Group of Commercial Banking from 1987 to 1992. He had been a Senior Vice President of the Bank since 1980 and of the Corporation since 1992. Mr. Trukenbrod, 54, joined the Bank in 1962. There is no family relationship between any of the above executive officers and directors. The positions of Chairman of the Board and Chief Executive Officer, President and Vice Chairman are elected annually by the Board of Directors at the first meeting of the Board of Directors held after each annual meeting of stockholders. The other officers are appointed annually. Officers continue to hold office until their successors are duly elected or unless removed by the Board. ITEM 2 ITEM 2 - -PROPERTIES The executive offices of the Corporation and the Bank are located at 50 South LaSalle Street in the financial district of Chicago. This Bank-owned building is occupied by various divisions of the Corporation's business units and the Bank's safe deposit and leasing companies. Financial services are provided by the Bank at this location. Adjacent to this building are two office buildings in which the Bank leases approximately 316,000 square feet of space for staff divisions of the business units. The Bank also leases approximately 112,000 square feet of a building at 125 South Wacker Drive in Chicago for computer facilities, banking operations and personal banking services. Financial services are also provided by the Bank at two other Chicago area locations, one of which is owned and one of which is leased. In April 1994, the Bank is planning to open a branch office in a leased facility in Highland Park, Illinois. The Bank's trust and banking operations are located in a 465,000 square foot facility at 801 South Canal Street in Chicago. The building is owned by a developer and leased by the Corporation. Space for the Bank's London branch, Edge Act subsidiary and The Northern Company, Canada are leased. The Corporation's other subsidiaries operate from forty locations in Florida, Illinois, Arizona, California, New York and Texas. Of these locations, nine are owned and thirty-one are leased. Detailed information regarding the addresses of these locations can be found on pages 70 and 71 in the Corporation's Annual Report to Stockholders for the year ended December 31, 1993, which is incorporated herein by reference. The Corporation believes that the facilities which are owned or leased are suitable and adequate for its business needs. For additional information relating to the Corporation's properties and lease commitments, refer to Note 6 titled Buildings and Equipment and Note 7 titled Lease Commitments on page 50 of the Corporation's Annual Report to Stockholders for the year ended December 31, 1993, which is incorporated herein by reference. ITEM 3 ITEM 3 - -LEGAL PROCEEDINGS The information called for by this item is incorporated herein by reference to Note 15 titled Contingent Liabilities on page 55 of the Corporation's Annual Report to Stockholders for the year ended December 31, 1993. In late November, 1993, the U.S. Department of Justice informed the Corporation that the Department is investigating the mortgage lending practices of the Bank and the Corporation's three other Illinois banking subsidiaries, as part of its responsibility to investigate possible discrimination on the basis of race or national origin under the Equal Credit Opportunity Act and the Fair Housing Act. The Corporation intends to cooperate fully in the investigation and has so informed the Department of Justice. 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 information called for by this item is incorporated herein by reference to the section of the Consolidated Financial Statistics titled Common Stock Dividend and Market Price on pages 66 and 67 of the Corporation's Annual Report to Stockholders for the year ended December 31, 1993. Information regarding dividend restrictions of the Corporation's banking subsidiaries is incorporated herein by reference to Note 12 titled Restrictions on Subsidiary Dividends and Loans or Advances on page 53 of the Corporation's Annual Report to Stockholders for the year ended December 31, 1993. ITEM 6 ITEM 6 - -SELECTED FINANCIAL DATA The information called for by this item is incorporated herein by reference to the table titled Summary of Selected Financial Data on page 24 of the Corporation'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 The information called for by this item is incorporated herein by reference to Management's Discussion and Analysis of Financial Condition and Results of Operations on pages 24 through 39 of the Corporation's Annual Report to Stockholders for the year ended December 31, 1993. ITEM 8 ITEM 8 - -FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The following financial statements of the Corporation and its subsidiaries included in the Corporation's Annual Report to Stockholders for the year ended December 31, 1993, are incorporated herein by reference. The section titled Quarterly Financial Data on pages 66 and 67 of the Corporation's Annual Report to Stockholders 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 None - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- PART III ITEM 10 ITEM 10 - -DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information called for by Item 10, relating to Directors and Nominees for election to the Board of Directors, is incorporated herein by reference to pages 2 through 5 of the Corporation's definitive Proxy Statement and Notice of Meeting filed in connection with the solicitation of proxies for the Annual Meeting of Stockholders to be held April 19, 1994. The information called for by Item 10 relating to Executive Officers is set forth in Part I of this Annual Report on Form 10K. ITEM 11 ITEM 11 - -EXECUTIVE COMPENSATION The information called for by this item is incorporated herein by reference to pages 8 and 9 and pages 10 through 16 of the Corporation's definitive Proxy Statement and Notice of Meeting filed in connection with the solicitation of proxies for the Annual Meeting of Stockholders to be held April 19, 1994. ITEM 12 ITEM 12 - -SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information called for by this item is incorporated herein by reference to pages 6 through 8 of the Corporation's definitive Proxy Statement and Notice of Meeting filed in connection with the solicitation of proxies for the Annual Meeting of Stockholders to be held April 19, 1994. ITEM 13 ITEM 13 - -CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information called for by this item is incorporated herein by reference to page 9 of the Corporation's definitive Proxy Statement and Notice of Meeting filed in connection with the solicitation of proxies for the Annual Meeting of Stockholders to be held April 19, 1994. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- PART IV Item 14 Item 14 - -Exhibits, Financial Statement Schedules, and Reports on Form 8K Item 14(a)(1) and (2)--Northern Trust Corporation and Subsidiaries List of Financial Statements and Financial Statement Schedules The following financial information is submitted in Item 1 for informational purposes only: Financial Information of The Northern Trust Company (Bank Only): Unaudited Consolidated Statement of Condition--December 31, 1993 and 1992. Unaudited Consolidated Statement of Income--Years Ended December 31, 1993, 1992 and 1991. The following consolidated financial statements of the Corporation and its subsidiaries are submitted in Item 8: Consolidated Financial Statements of Northern Trust Corporation and Subsidiaries: Consolidated Statement of Condition--December 31, 1993 and 1992. Consolidated Statement of Income--Years Ended December 31, 1993, 1992 and 1991. Statement of Changes in Stockholders' Equity--Years Ended December 31, 1993, 1992 and 1991. Consolidated Statement of Cash Flows--Years Ended December 31, 1993, 1992 and 1991. The following financial information is submitted in Item 8: Financial Statements of Northern Trust Corporation (Parent Company Only): Statement of Condition--December 31, 1993 and 1992. Statement of Income--Years Ended December 31, 1993, 1992 and 1991. Statement of Changes in Stockholders' Equity--Years Ended December 31, 1993, 1992 and 1991. Statement of Cash Flows--Years Ended December 31, 1993, 1992 and 1991. The Notes to Financial Statements as of December 31, 1993, submitted in Item 8, pertain to the Bank only information, consolidated financial statements and parent company only information listed above. The Report of Independent Public Accountants submitted in Item 8 pertains to the consolidated financial statements and parent company only information listed above. Financial statement schedules have been omitted for the reason that they are not required or are not applicable. ITEM 14(a)3--EXHIBITS The exhibits listed on the Exhibit Index beginning on page 28 of this Form 10K are filed herewith or are incorporated herein by reference to other filings. ITEM 14(b)--REPORTS ON FORM 8K No reports on Form 8-K were filed by the Corporation 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, as amended, the Registrant has duly caused this Form 10-K Report to be signed on its behalf by the undersigned, thereunto duly authorized. Date: March 15,1994 Northern Trust Corporation (Registrant) By: David W. Fox ----------------------------------- DAVID W. FOX Chairman of the Board Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, this Form 10-K 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 --------- ----- David W. Fox Chairman of the Board, --------------------------- David W. Fox Chief Executive Officer and Director Perry R. Pero Senior Executive Vice President --------------------------- Perry R. Pero and Chief Financial Officer John H. Robinson Senior Vice President and Controller --------------------------- John H. Robinson (Chief Accounting Officer) -------- Worley H. Clark Director Robert S. Hamada Director Barry G. Hastings Director Robert A. Helman Director Arthur L. Kelly Director Ardis Krainik Director Robert D. Krebs Director Frederick A. Krehbiel Director ---- By: Peter L. Rossiter ------------------------- William G. Mitchell Director Peter L. Rossiter Attorney-in-Fact William A. Osborn Director William A. Pogue Director Harold B. Smith Director William D. Smithburg Director John S. Sutfin Director Bide L. Thomas Director --------- Date: March 15,1994 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- EXHIBIT INDEX The following Exhibits are filed herewith or are incorporated herein by reference. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- *Prior Filings (File No. 0-5965, except as noted) ------------------------------------------------ (1) Annual Report on Form 10-K for the year ended December 31, 1992 (2) Registration Statement on Form S-4 dated February 10, 1994 (Reg. No. 33-52219) (3) Quarterly Report on Form 10-Q for the quarter ended March 31, 1993 (4) Quarterly Report on Form 10-Q for the quarter ended September 30, 1986 (5) Annual Report on Form 10-K for the year ended December 31, 1986 (6) Annual Report on Form 10-K for the year ended December 31, 1988 (7) Form 8-K dated January 26, 1989 (8) Annual Report on Form 10-K for the year ended December 31, 1989 (9) Form 8-A dated October 30, 1989 (10) Annual Report on Form 10-K for the year ended December 31, 1990 (11) Annual Report on Form 10-K for the year ended December 31, 1991 (12) Quarterly Report on Form 10-Q for the quarter ended March 31,1992 (13) Form 8-K dated February 20, 1991 Upon written request to Peter L. Rossiter, Secretary, Northern Trust Corporation, 50 South LaSalle Street, Chicago, Illinois 60675, copies of exhibits listed above are available to Northern Trust Corporation stockholders by specifically identifying each exhibit desired in the request. Pursuant to Item 601(b)(4)(iii) of Regulation S-K, the Corporation hereby agrees to furnish the Commission, upon request, any instrument defining the rights of holders of long-term debt of the Corporation not filed as an exhibit herein. No such instrument authorizes long-term debt securities in excess of 10% of the total assets of the Corporation and its subsidiaries on a consolidated basis. - --------------------------------------------------------------------------------

711054_1993.txt

711054_1993

1993

711054

Item 1. Business The Company DCS Capital Corporation (the "Corporation") was incorporated in November 1982 under Delaware law. The Corporation was organized to assist DCS Capital Partnership (the "Partnership") in raising funds in connection with the Partnership's contractual obligation to finance approximately 76% of the construction and start-up costs, and certain deferred costs, of an ethylene plant designed and constructed by Dow Chemical Canada Inc. near Joffre, Alberta, Canada, for Novacor Chemicals Ltd. The ethylene plant was completed in 1984 at a cost of approximately S337 million and is designed to produce 1.5 billion pounds per year of polymer grade ethylene using ethane as feedstock. The Corporation's only business is to arrange financing for the Partnership through the issuance of debt securities to obtain funds for lending to the Partnership and to refinance prior borrowings. The interest cost charged to the Partnership is an amount that equals the interest cost incurred by the Corporation on its borrowings. In addition, the Partnership reimburses the Corporation for all its other costs. For this reason, the Corporation's revenues are always equal to its expenses. See also Notes 1 and 2 to the financial statements included elsewhere in this Annual Report for a further discussion of the business of the Corporation and the Partnership. Item 2. Item 2. Properties The Corporation has no plants or other physical properties. Item 3. Item 3. Legal Proceedings There are no claims or other legal proceedings against the Corporation. Item 4. Item 4. Submission of Matters to a Vote of Security Holders Omitted pursuant to General Instruction J of Form 10-K. PART II Item 5. Item 5. Market for the Registrant's Common Stock and Related Stockholder Matters The common stock of the Corporation is wholly owned by the Partnership and does not trade in any securities market. The Corporation does not pay dividends and does not intend to pay dividends in the foreseeable future. Item 6. Item 6. Selected Financial Data Omitted pursuant to General Instruction J of Form 10-K. Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operation The Corporation's only business has been to issue debt securities and either loan the proceeds to the Partnership or use the proceeds to refinance commercial paper notes issued by the Corporation. On February 15, 1984, the Corporation issued $150,000,000 of 12.20% Series A Notes due 1994 and on October 15, 1984, issued $100,000,000 of 12.375% Series B Notes due 1996. The proceeds of these debt issues were used to repay maturing commercial paper notes and make loans to the Partnership. During 1992, the Corporation redeemed $21,615,000 of the outstanding principal amounts of the 12.375% Series B notes, which was funded through short-term borrowings from a Bank. A $3,197,940 extraordinary loss on early redemption resulted from this transaction. During 1991 the Corporation redeemed all of the outstanding principal amounts of the 12.2% Series A notes, and borrowed $70,000,000 from Swiss Bank Corporation, New York. The corporation borrowed and repaid $80,000,000 under a bridge loan used to provide financing between the redemption of the Series A notes and the receipt of proceeds from the Swiss Bank Corporation note. Novacor Chemicals Ltd. continued repaying its loans from DCS Capital Partnership, which in turn made long-term debt and demand note payments to DCS Capital Corporation. Administrative expenses decreased by approximatley $308,000 and $240,000 in 1993 and 1992, respectively, from the 1991 administrative expense due primarily to debt issuance costs on the bridge loan and Swiss Bank note. The Corporation believes that it has ample liquidity for its business. In addition, the terms of its agreement with the Partnership and the Partnership's relationship with its general partners as described in Note 1 to the financial statements included elsewhere in this Annual Report assure that the Corporation's fixed charge coverage ratio will be maintained at 1.0. Item 8. Item 8. Financial Statements and Supplementary Data (a) Index to financial statements presented elsewhere in this Annual Report: Independent Auditors' Report Balance Sheets, December 31, 1993 and 1992 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 (b) Selected Quarterly Financial Data - Unaudited (in thousands): 1993 1st Qtr 2nd Qtr 3rdQtr 4th Qtr Year Interest on Partnership advances $2,820 $2,855 $2,831 $2,767 $11,273 Interest expense $2,820 $2,855 $2,831 $2,767 $11,273 1992 1st Qtr 2nd Qtr 3rdQtr 4th Otr Year Interest on Partnership advances $3,827 $3,230 $2,989 $2,910 $12,956 Reimbursement for early debt redemption(*) $ 0 $3,198 $ 0 $ 0 $3,198 Interest expense $3,827 $3,230 $2,989 $2,910 $12,956 Extraordinary loss on early debt redemption(*) $ 0 $3,198 $ 0 $ 0 $3,198 (*) See note 4 to the financial statements. No dividends were paid and the Corporation's common stock does not trade in any securities market. Note - other supplementary data is omitted because it is not applicable. Item 9. Item 9. Changes In and Disagreements with Accountants on Accounting and Financial Disclosure There have been no reported disagreements on any matter of accounting principles, procedures or financial disclosures in 1993 with the independent auditors. PART III Item 10. Item 10. Directors and Executive Officers of the Registrant Omitted pursuant to the provisions of General Instruction J of Form 10-K. Item 11. Item 11. Executive Compensation Omitted pursuant to the provisions of General Instruction J of Form 10-K. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management Omitted pursuant to the provisions of General Instruction J of Form 10-K. Item 13. Item 13. Certain Relationships and Related Transactions Omitted pursuant to the provisions of General Instruction J of Form 10-K. 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 and independent auditors' report: See Item 8 of this Annual Report. 2. Financial statement schedules: Schedules are omitted because of the absence of the conditions under which they are required or because the information called for is included in the financial statements. 3. Exhibits - See the Exhibit Index on page 16 of this Annual Report. The Corporation will provide a copy of any exhibit upon receipt of a written request for the particular exhibit or exhibits desired and upon receipt of payment of an amount equal to a charge of twenty-five cents for each exhibit page, with a minimum charge of two dollars per request. All requests should be addressed to the Secretary of the Corporation at the address of the Corporation's principal executive offices. (b) Reports on Form 8-K 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 annual report to be signed on its behalf by the undersigned, thereunto duly authorized, on the 16th day of March, 1994. DCS CAPITAL CORPORATION By J. P. Reinhard J. P. Reinhard, President Pursuant to the requirements of the Securities Exchange Act of 1934, this annual report has been signed by the following persons in the capacities and on the dates indicated. Signatures Title Date R. C. Bass Director C. L. Williams Director B. Taylorson Director J. P. Reinhard President (Principal Financial Officer, Principal Accounting Officer) INDEPENDENT AUDITORS' REPORT DCS Capital Corporation: We have audited the accompanying balance sheets of DCS Capital Corporation as of December 31, 1993 and 1992, and the related statements of income and expenses, and cash flows for each of the three years in the period ended December 31, 1993. 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 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 DCS Capital Corporation 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. Deloitte & Touche DELOITTE & TOUCHE Midland, Michigan March 7, 1994 DCS CAPITAL CORPORATION BALANCE SHEETS December 31, 1993 1992 ASSETS CURRENT ASSETS: Cash $300 $300 Receivables from DCS Capital Partership Current (Note 2) 46,387,812 45,608,007 Total Current Assets 46,388,112 45,608,307 Receivables from DCS Capital Partership Long-term (Note 2) 95,022,269 108,999,799 TOTAL ASSETS $141,410,381 $154,608,106 LIABILITIES AND STOCKHOLDER'S EQUITY CURRENT LIABILITIES: Accounts Payable $3,500 $ 0 Notes Payable (Note 3) 30,388,000 29,520,000 Long-term debt due within one year (Note 4) 14,000,000 14,000,000 Accrued Interest 1,996,312 2,088,007 Total Current Liabilities 46,387,812 45,608,007 LONG-TERM DEBT (Note 4) 95,022,269 108,999,799 STOCKHOLDER'S EQUITY: Common stock ($1 par value; authorized, issued and outstanding, 300 shares) (Note 1) 300 300 TOTAL LIABILITIES AND STOCKHOLDER'S EQUITY 141,410,381 154,608,106 See notes to financial statements. DCS CAPITAL CORPORATION STATEMENTS OF INCOME AND EXPENSES Year Ended Year Ended Year Ended December 31 December 31 December 31 1993 1992 1991 INTEREST AND OTHER INCOME: Interest earned on advances to DCS Capital Partnership (Note 1) 11,273,404 12,955,574 17,208,990 Reimbursement for early debt redemption 3,197,940 Administrative service fees from DCS Capital Partnership 140,636 208,899 449,033 TOTAL INCOME $11,414,040 $16,362,413 $17,658,023 INTEREST AND OTHER EXPENSES: Interest on short-term debt $1,060,018 $861,240 $3,030,632 Interest on long-term debt 10,213,386 12,094,334 14,178,358 Administrative expenses (Note 5) 140,636 208,899 449,033 Total Expenses before extraordinary loss 11,414,040 13,164,473 17,658,023 Extraordinary loss on early redemption of debt (Note 4) 0 3,197,940 0 TOTAL EXPENSES $11,414,040 $16,362,413 $17,658,023 See notes to financial statements. DCS CAPITAL CORPORATION STATEMENTS OF CASH FLOWS Year Ended Year Ended Year Ended December 31 December 31 December 31 1993 1992 1991 Net Income $ 0 $ 0 $ 0 Cash Flows from Operating Activities: Amortization of Discount on Notes 22,470 24,245 29,567 Decrease (Increase) in Accounts Receivable (779,805) (21,861,883) 3,143,427 Increase (Decrease) in Accounts Payable 3,500 0 (13,840) Decrease in Accrued Interest (91,695) (1,108,117) (3,029,587) Net Cash Provided/(Used) in Operations (845,530) (22,945,755) 129,567 Cash Flows from Financing Activities: Proceeds of Bank of America Notes 407,108,000 324,355,000 124,626,000 Repayment of Bank of America Notes (406,240,000) (301,385,000) (131,226,000) Proceeds from bridge loan 0 0 80,000,000 Repayment of bridge loan 0 0 (80,000,000) Proceeds from long-term debt 0 0 70,000,000 Repayment of long-term debt (14,000,000) (38,812,940) (77,082,000) Discount on Notes Repaid 0 32,228 0 Loss on Early Redemption 0 3,197,940 0 Net Cash Used by Financing Activities (13,132,000) (12,612,772) (13,682,000) Cash Flows from Investing Activities: Decrease in Long-term Receivables 13,977,530 35,558,528 13,552,433 Net Change in Cash 0 0 0 Cash at Beginning of Year 300 300 300 Cash at End of Year $ 300 $ 300 $ 300 See notes to financial statements. DCS CAPITAL CORPORATION NOTES TO FINANCIAL STATEMENTS 1. ORGANIZATION DCS Capital Corporation (the "Corporation") is a Delaware corporation wholly owned by DCS Capital Partnership (the "Partnership"), a Delaware partnership, the general partners of which are Dofinco Inc., Prentiss Glycol Company and Scotlene, Inc. The general partners are wholly owned subsidiaries of The Dow Chemical Company ("Dow"), Union Carbide Chemicals and Plastics Company, Inc., and Shell Canada Limited, respectively. The Corporation was incorporated on November 22, 1982, and was organized to assist the Partnership in raising fund to finance approximately 76 percent of the construction and start-up costs and certain deferred costs of an ethylene plant near Joffre, Alberta, Canada for Novacor Chemicals Ltd. ("Novacor"), an unrelated party. The Corporation's only business is to arrange financing for the Partnership through the issuance of debt securities to obtain funds for lending to the Partnership and to refinance prior borrowings. The interest cost charged to the Partnership is an amount that equals the interest cost incurred by the Corporation on its borrowings. In addition, the Partnership reimburses the Corporation for its administrative expenses as further discussed in Note 5 below. The Partnership in turn is reimbursed for its net expenses by Novacor. 2. RECEIVABLES FROM DCS CAPITAL PARTNERSHIP Receivables from the Partnership represent the net proceeds from the Corporation's borrowings that have been loaned to the Partnership, related accrued interest and other amounts for reimbursement of expenses. Advances and accrued interest thereon are evidenced by Partnership notes that are due at the same times and in the same amounts as principal, earned discount, interest and premium, if any, on the Corporation's borrowings. The Partnership notes bear interest at a variable interest rate based on the aggregate interest and amortization of discount on the Corporation's borrowings, which was approximately 7.87 percent at December 31, 1993 and 8.03 percent at December 31, 1992 and 9.86 at December 31, 1991. The Partnership notes are secured by certain rights of the Partnership under a Cash Deficiency Agreement among the partners and the Partnership. In addition, the performance of each partner pursuant to the Cash Deficiency Agreement has been guaranteed by each Partner's respective parent company (see Note 1). The Partnership notes are pledged as security for repayment of the Corporation's borrowings. The summarized financial statements of the Partnership are as follows: BALANCE SHEET December 31 December 31 1993 1992 Assets: Cash and Time Deposits $ 783 $ 3,1921 Due from Novacor Chemicals, Ltd.: Note receivable 140,512,391 153,789,153 Accrued interest 923,134 815,761 Investment in DCS Capital Corporation 300 300 Total $141,436,608 $154,608,406 Liabilities and Partners' Capital: Accounts Payable 25,927 Payable to DCS Capital Corporation: Notes and accrued interest $ 141,410,081 $154,607,806 Total liabilities 141,436,008 154,607,806 Partners' Capital 600 600 Total $ 141,436,608 $154,608,406 STATEMENTS OF INCOME AND EXPENSE Year Ended Year Ended Year Ended December 31 December 31 December 31 1993 1992 1991 Interest Income: Interest on Time Deposits $ 0 $ 0 $ 8,700 Interest on loans to Novacor Chemicals Company Ltd. 11,427,708 16,369,133 17,662,208 TOTAL INCOME $11,427,708 $16,369,133 $17,670,908 Expenses: Reimbursement for Loss on early debt redemption by DCS Capital Corporation $ 0 $ 3,197,940 $ 0 Interest on advances from DCS Capital Corporation 11,273,404 12,955,574 17,208,990 Administrative expenses: Paid to DCS Capital Corp. 140,636 208,899 449,033 Paid to others 13,668 6,720 12,885 TOTAL EXPENSES $11,427,708 $16,369,133 $17,670,908 3. NOTES PAYABLE During 1993, 1992 and 1991, the Corporation borrowed and repaid several short- term bank loans. The outstanding balances were $30,388,000, $29,520,000, and $6,550,000 at December 31, 1993, 1992 and 1991, respectively. The interest rates on outstanding loans were 3.56%, 3.75% and 5.09% at December 31, 1993, 199 and 1991, respectively. The maximum amount of short-term notes payable outstanding at any month-end during the year was $34,300,000, $36,325,000, and $82,640,000 for 1993, 1992 and 1991, respectively. The month-end average amount outstanding during the year was $29,195,200, $22,755,833, and $33,742,844 for 1993, 1992 and 1991, respectively. The weighted average interest rate during the year was 3.46%, 4.08%, and 7.01% for 1993, 1992 and 1991 respectively. 4. LONG-TERM DEBT Long-term debt is comprised of the following: December 31 December 31 1993 1992 12.375% Series B Notes, due in 1996 67,085,000 67,085,000 Swiss Bank Corp., N.Y. 28,000,000 42,000,000 95,085,000 109,085,000 Less unamortized debt discount (62,731) (85,201) Total $95,022,269 $108,999,799 The notes are secured by related Partnership notes receivable which are in turn secured by the Cash Deficiency Agreement referred to in Note 2 above. The long term debt of the Corporation had a fair value of approximately $14.0 million and $8.8 million more than the book value at December 31, 1993 and December 31, 1992, respectively, based upon current market rates on those dates. During 1991 the Corporation entered into a new long-term variable rate borrowing of $70,000,000 from Swiss Bank Corporation, N.Y. in order to redeem the 12.20% Series A notes. This long-term borrowing is payable in semi-annual installments of $7,000,000 due April and October. The interest rate at December 31, 1993 and 1992 was 3.75% and 3.5% respectively. During 1992 the Corporation redeemed $21,615,000 of the outstanding principal amounts of the 12.375% Series B notes, which was funded through short-term borrowings from a Bank. A $3,197,940 extraordinary loss on early redemption resulted from this transaction. 5. RELATED PARTY TRANSACTIONS The Corporation and the Partnership have no salaried employees and their officers are employees of Dow. Dow performs management services for both and is reimbursed for actual cash expenditures, including an allocation of general overhead and administrative expenses, none of which are material to the Corporation. 6. CASH FLOW Prior years statement of cash flows have been restated to conform with current year presentations. Additionally, the cash payments for interest for the years ended December 31, 1993, 1992 and 1991 were $11,365,099; $14,063,691 and $20,238,577, respectively. EXHIBIT INDEX 3.1 Certificate of Incorporation of the Corporation (incorporated by reference to Registration Statement No. 2-85622, Exhibit 3.1) 3.2 By-laws of the Corporation (incorporated by reference to Registration Statement No. 2-85622, Exhibit 3.2) 4.1 Form of Series B Notes (incorporated by reference to Registration Statement No. 2-93612, Exhibit A to Exhibit 4.3) 4.2 Indenture dated as of February 15, 1984 between the Corporation and The Royal Bank and Trust Company, trustee (the "Trustee")(incorporated by reference to Registration Statement No. 2-85622,Exhibit 4.2) 4.3 Form of Supplement No. 2 to Indenture (incorporated by reference to Registration Statement No. 2-93612, Exhibit 4.3) 4.4 Form of Partnership Note of the Partnership (incorporated by reference to Registration Statement No. 2-85622, exhibit A to Exhibit 4.9) 4.5 Cash Deficiency Agreement dated as of March 1, 1983, among Dofinco, Inc., Pretiss Glycol Company and Scotlene, Inc. (the "Partners") and the Partnership (incorporated by reference to Registration Statement No. 2-85622, Exhibit 4.5) 4.6 Guarantee Agreement dated as of March 1, 1983, between Dow and the Partnership (incorporated by reference to Registration Statement No. 2-85622, Exhibit 4.6) 4.7 Guarantee Agreement dated as of March 1, 1983, between Union Carbide Corporation and the Partnership (incorporated by reference to Registration Statement No. 2-85622, Exhibit 4.7) 4.8 Guarantee Agreement dated as of March 1, 1983, between Shell Canada Limited and the Partnership (incorporated by reference to Registration Statement No. 2-85622, Exhibit 4.8) 4.9 Financing Agreement dated as of February 15, 1984 between the Corporation and the Partnership (incorporated by reference to Registration Statement No. 2-85622, Exhibit 4.9) 4.10 Form of Consent Assignment and Agreement among the Partners, the Partnership and the Trustee (incorporated by reference to Registration Statement No. 2-85622, Exhibit 4.9) 4.11 Partnership Agreement dated as of February 9, 1983, among the Partners (incorporated by reference to Registration Statement No. 2-85622, Exhibit 4.11) 26 Form T-l Statement of of Eligibility and Qualification under the Trust Indenture Act of 1939 of the Trustee (incorporated by reference to Registration Statement No. 2-93612, Exhibit 26)

837579_1993.txt

837579_1993

1993

837579

ITEM 2. PROPERTIES UTILITY SERVICES MichCon operates natural gas distribution, transmission and storage facilities in the state of Michigan. At December 31, 1993, MichCon's distribution system included 14,680 miles of distribution mains, 1,021,739 service lines and 1,145,687 active meters. MichCon owns 2,502 miles of transmission and production lines which deliver natural gas to the distribution districts and interconnect its storage fields with the sources of supply and the market areas. MichCon also owns properties relating to five underground storage fields with an aggregate storage capacity of approximately 130 Bcf. Additionally, MichCon owns district office buildings, service buildings and gas receiving and metering stations. MichCon occupies its principal office buildings, located in Detroit and Grand Rapids, Michigan under long-term leases. Portions of these buildings are subleased. Most of MichCon's properties are held in fee, by easement, or under lease agreements. The principal plants and properties of MichCon are held subject to the lien of MichCon's Indenture of Mortgage and Deed of Trust under which MichCon's First Mortgage Bonds are issued. Some existing properties are being fully utilized and new properties are being added to meet the requirements of expansion into new areas. Citizens owns all of the properties used in the conduct of its utility business. Included in these properties is a gas distribution system, a two-story office building in downtown Adrian and a one-story service center. NONUTILITY SERVICES The Saginaw Bay partnerships own substantially all of the properties used in the conduct of their business, primarily a 126-mile transmission line and related lateral lines. The Supply Development Group has interest in properties used for gas production, including compressor facilities and gathering lines. Genix owns certain properties including land, buildings and computer equipment located in Pittsburgh, Pennsylvania and the metropolitan Detroit area. MCN's facilities are suitable and adequate for their intended use. ITEM 3. ITEM 3. LEGAL PROCEEDINGS In addition to utility services' regulatory proceedings and other matters described in Item 1, "Business", MCN is also involved in a number of law suits and administrative proceedings in the ordinary course of business with respect to taxes, environmental matters, personal injury, property damage claims and other matters. The management of MCN believes that the resolution of these matters will not have a material adverse effect on the financial condition of MCN. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. EXECUTIVE OFFICERS OF THE REGISTRANT Information with respect to all executive officers of MCN, as of February 28, 1994, is set forth below. Such officers are appointed by the Board of Directors for terms expiring at the next annual meeting of shareholders scheduled to be held on April 28, 1994. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS MCN Common Stock is traded on the New York Stock Exchange. On March 1, 1994 there were 26,248 holders of record of MCN Common Stock. Information regarding the market price of MCN Common Stock and related security holder matters is incorporated by reference herein from the section entitled "Supplementary Financial Information" in MCN's 1993 Annual Report to Shareholders, pages 52 and 53. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA Information required pursuant to this item is incorporated by reference herein from the section entitled "Supplementary Financial Information" in MCN's 1993 Annual Report to Shareholders, pages 52 and 53. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Information required pursuant to this item is incorporated by reference herein from the section entitled "Management's Discussion and Analysis" in MCN's 1993 Annual Report to Shareholders, pages 30 through 35. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Information required pursuant to this item is incorporated by reference herein from the following sections of MCN's 1993 Annual Report to Shareholders. The consolidated statement of income, cash flows and capitalization are for each of the years ended December 31, 1993, 1992 and 1991 and the consolidated statement of financial position is as of December 31, 1993 and 1992. Consolidated Statement of Income, page 36; Consolidated Statement of Financial Position, page 37; Consolidated Statement of Capitalization, page 38; Consolidated Statement of Cash Flows, page 39; Summary of Accounting Policies, page 40; Notes to Consolidated Financial Statements, pages 41 through 49; Independent Auditors' Report, page 50; and Supplementary Financial Information, pages 52 and 53. 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 set forth in the section entitled "Election of Directors" in MCN's March 1994 definitive Proxy Statement is incorporated by reference herein. Information concerning the executive officers of MCN is set forth in the section entitled "Executive Officers of the Registrant" on page 12 in Part I of this Report. COMPLIANCE WITH SECTION 16(A) OF THE SECURITIES EXCHANGE ACT OF 1934, AS AMENDED The information set forth in the section entitled "Filings Under Section 16(a)" in MCN's March 1994 definitive Proxy Statement is incorporated by reference herein. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The information set forth in the sections entitled "Directors' Compensation," "Executive Compensation," "Change of Control Employment Agreements," "Retirement Plans" and "Compensation Committee Interlocks and Insider Participation" in MCN's March 1994 definitive Proxy Statement is incorporated by reference herein. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information set forth in the section entitled "Election of Directors" in MCN's March 1994 definitive Proxy Statement is incorporated by reference herein. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information set forth in the section entitled "Executive Compensation" in MCN's March 1994 definitive Proxy Statement is incorporated by reference herein. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (A) LIST OF DOCUMENTS FILED AS PART OF THE REPORT: 1. For a list of financial statements incorporated by reference, see the section entitled "Financial Statements and Supplementary Data", on page 13 in Part II, Item 8 of this Report. 2. Financial Statement Schedules for each of the three years in the period ended December 31, 1993, unless otherwise noted, are included herein in response to Part II, Item 8: Independent Auditors' Report Schedules other than those referred to above are omitted as not applicable or not required, or the required information is shown in the financial statements or notes thereto. INDEPENDENT AUDITORS' REPORT MCN Corporation: We have audited the consolidated financial statements of MCN 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 8, 1994; 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 MCN Corporation and subsidiaries, listed in 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 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 Detroit, Michigan February 8, 1994 SCHEDULE II MCN CORPORATION AND SUBSIDIARIES SCHEDULE II -- AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS AND EMPLOYEES OTHER THAN RELATED PARTIES (THOUSANDS OF DOLLARS) - ------------------------ NOTES: (1) Represents unsecured promissory note payable, due August 2004, plus accrued interest thereon. Interest on the promissory note accrues at 9% per annum. The interest is payable upon maturity of the promissory note, but has been paid annually in recent years. (2) Represents notes payable, due various dates through May 2008, plus accrued interest thereon. Interest on the notes accrues at 16% per annum, compounded at the end of each calendar year. The interest is payable upon maturity of the notes. (3) Represents note payable, due June 1996, plus accrued interest thereon. Interest on the note accrues at 8 3/4% per annum. The interest is payable upon maturity of the note. (4) Represents note payable, due June 1992, to temporarily support the construction of gas storage facilities. The note accrued interest at a variable interest rate based on the prime rate, payable quarterly and upon maturity. SCHEDULE V MCN CORPORATION AND SUBSIDIARIES SCHEDULE V -- PROPERTY, PLANT AND EQUIPMENT (THOUSANDS OF DOLLARS) SCHEDULE V MCN CORPORATION AND SUBSIDIARIES SCHEDULE V -- PROPERTY, PLANT AND EQUIPMENT -- (CONCLUDED) (THOUSANDS OF DOLLARS) - ------------------------ NOTES: SCHEDULE VI MCN CORPORATION AND SUBSIDIARIES SCHEDULE VI -- ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT (THOUSANDS OF DOLLARS) SCHEDULE VI MCN CORPORATION AND SUBSIDIARIES SCHEDULE VI -- ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT -- (CONCLUDED) (THOUSANDS OF DOLLARS) - ------------------------ NOTES: SCHEDULE VII MCN CORPORATION AND SUBSIDIARIES SCHEDULE VII -- GUARANTEES OF SECURITIES OF OTHER ISSUERS DECEMBER 31, 1993 (THOUSANDS OF DOLLARS) - --------------------- NOTES: (1) Reference is made to Note 5a to the Consolidated Financial Statements in the 1993 Annual Report to Shareholders of MCN Corporation, page 43. SCHEDULE VIII MCN CORPORATION AND SUBSIDIARIES SCHEDULE VIII -- VALUATION AND QUALIFYING ACCOUNTS (THOUSANDS OF DOLLARS) SCHEDULE VIII MCN CORPORATION AND SUBSIDIARIES SCHEDULE VIII -- VALUATION AND QUALIFYING ACCOUNTS -- (CONCLUDED) - ------------------------ NOTES: (1) Reference is made to Note 5b to the Consolidated Financial Statements in the 1993 Annual Report to Shareholders of MCN Corporation, page 44. During the year ended December 31, 1993, $6,575,000 was transferred from Deferred Credits and Other Liabilities -- Other to Current Liabilities -- Other. Similarly, $2,000,000 was transferred during the year ended December 31, 1992. Actual expenditures deducted against the reserve in 1993 and 1992 were $2,073,000 and $781,000, respectively. (2) During 1991, MCN established a reserve relating to the restructuring of the gas technology business where MCN entered into a partnership with a third party to more effectively market its natural gas torch products. SCHEDULE IX MCN CORPORATION AND SUBSIDIARIES SCHEDULE IX -- SHORT-TERM BORROWINGS (THOUSANDS OF DOLLARS) - ------------------------ NOTES: (1) Reference is made to Note 4 to the Consolidated Financial Statements in the 1993 Annual Report to Shareholders of MCN Corporation, page 43. Fees are paid to compensate banks for lines of credit. (2) Represents amounts payable, net of any discount. (3) Weighted average effective interest rates were calculated on the net proceeds basis and do not include the effect of line of credit fees. SCHEDULE X MCN CORPORATION AND SUBSIDIARIES SCHEDULE X -- SUPPLEMENTARY INCOME STATEMENT INFORMATION (THOUSANDS OF DOLLARS) 3. Exhibits, Including Those Incorporated By Reference (B) REPORTS ON FORM 8-K: None. - ------------------------- * Indicates document filed herewith. References are to MCN (File No. 1-10070) for 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 Annual Report to be signed on its behalf by the undersigned, thereunto duly authorized. MCN CORPORATION (Registrant) By: /s/ Patrick Zurlinden Patrick Zurlinden Controller and Chief Accounting Officer 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 date indicated.

23533_1993.txt

23533_1993

1993

23533

ITEM 1. BUSINESS GENERAL DEVELOPMENT OF BUSINESS CalMat Co. (the "Company" or "Registrant") has its corporate headquarters in Los Angeles, California and has operations throughout the state of California, and in Phoenix and Tucson, Arizona, and Albuquerque, New Mexico. The Company was formed in 1984 by the business combination of California Portland Cement Company ("CPC") and Conrock Co. ("Conrock"). Following its formation, the Company operated CPC as its Cement Division. CalMat subsequently disposed of the Cement Division in an exchange transaction with Onoda California, Inc. in 1990. Two of its business segments involve the manufacture, production, distribution and sale of construction materials: hot-mix asphalt, and aggregates (crushed stone, sand and gravel) and ready mixed concrete. The business segments which supply materials to the construction industry experience fluctuations with general levels of activity in the industry and with weather-related construction delays, which normally occur during the first and fourth quarters each year. A third business segment is engaged in the ownership, leasing and management of industrial and office buildings, the ownership and leasing of undeveloped real property and sales of real property. FINANCIAL INFORMATION ABOUT INDUSTRY SEGMENTS Information about the Company's business segments for the years ended December 31, 1993, 1992 and 1991 is incorporated in Note 13 of the "Notes to Consolidated Financial Statements," located on pages 30 and 31 of this Annual Report on Form 10-K. NARRATIVE DESCRIPTION OF BUSINESS CONCRETE AND AGGREGATES DIVISION The Concrete and Aggregates Division produces and sells construction aggregates (sand and gravel and crushed rock) and supplies ready mixed concrete for use in most types of construction including homes, schools, shopping centers, office buildings and industrial parks as well as roads, freeways, bridges, dams and rail-based transit systems. Projects to which the Company is currently supplying aggregates include a remote aircraft parking facility at the Los Angeles International Airport, airport runway reconstruction at the John Wayne International Airport in Orange County, California, State Farm Insurance's Regional Office in Bakersfield, California, a major Intel Corporation complex in Albuquerque, New Mexico and several projects related to the expansion of the Sky Harbor International Airport in Phoenix, Arizona. The Division operates aggregates processing plants at 34 locations primarily in Los Angeles, San Francisco, San Diego and Orange County, California, in Phoenix and Tucson, Arizona, and in Albuquerque, New Mexico. Plants at three of these locations have been temporarily idled but are expected to return to operation when demand increases. The Division operates 16 plants in southern California, and the Company believes it is the largest supplier of construction aggregates to the greater Los Angeles area. During 1993 the Company sold 25.4 million tons of aggregates, representing less than half of the Company's annual maximum production capacity. As of December 31, 1993, the Company had approximately 1.8 billion tons of estimated aggregates reserves, located near the major urban centers of the markets it serves. The Company owns (or has long-term leases for) all of the properties on which its reserves are located, and in all cases the Company obtains permits from various governmental authorities prior to the commencement of its mining activities. Approximately 70% of the Company's total reserves are either fully permitted or in the process of being permitted. As is typical of major aggregates producers with a number of production facilities, the currently permitted reserves at the Company's quarries, expressed in terms of years of production at historical rates, varies widely, in the Company's case from approximately two to three years at several older facilities to in excess of 20 years at many others. The Company has permitting or alternative production plans to deal with all of its sites where reserves could be depleted in less than 10 years, and believes that its current reserves position provides it with a significant long-term competitive advantage. To further assure sufficient reserves and adequate facilities to meet future demand, CalMat continues to add new aggregates reserves. In March 1994 the Company added to its strategic aggregates base by acquiring the mining rights to approximately 17 million tons of permitted rock and sand located at Irvine Lake in Orange County, California where commercial aggregates production is expected to commence in 1994. In addition, the Company permitted more than 50 million tons of sand and gravel near San Bernardino, California in 1993 which should allow the Company to meet its needs in that region for several decades. In December 1992, the Company acquired substantially all of the assets of The Jamieson Company, a privately-held aggregates producer located in Pleasanton, California. This acquisition, which includes approximately 100 million tons of permitted reserves, enabled the Company to expand its aggregates business into the growing San Francisco Bay area and complemented the Company's existing asphalt operations in that market. The Division also operates 28 ready mixed concrete batch plants, generally at locations adjacent to the Division's aggregates processing plants (with the exception of the Los Angeles and San Francisco areas, where the Company does not produce ready mixed concrete). Ready mixed concrete consists by volume of approximately 80% aggregates and 20% cement, water and other. The Company's fleet of approximately 375 mixer trucks delivers ready mixed concrete to the customer's job site. The Company has vertically integrated into the ready mixed concrete business primarily in those geographic areas where it has been necessary from a competitive standpoint to provide an outlet for the Company's aggregates production. The Division has numerous competitors in each of its markets, but generally has fewer competitors in the aggregates market than in the ready mixed concrete market. A majority of the ready mixed concrete business is obtained by competitive bid. In addition to competitive pricing, the Division's other methods of meeting competition include providing higher levels of service and higher quality products to its customers. Most of the Company's aggregates are delivered to customers by third-party truckers. The Division consumes a portion of its aggregates production in the manufacturing of ready mixed concrete, and supplies a portion of its production to the Asphalt Division for use in the production of hot mix asphalt. Other sources of raw materials, such as cement used in ready mixed concrete, are readily available. The Division has labor agreements with various unions at most of the locations at which it operates. During 1993, new contracts were negotiated with all union employees at the Company's Bakersfield and Fresno locations which expire in 1996. ASPHALT DIVISION CalMat's Asphalt Division is the third largest supplier of hot mix asphalt to the construction industry nationwide and believes it is the largest such supplier in California. The Company produces and supplies asphalt and related specialty products. Unlike some asphalt producers, the Company does not undertake paving work, and thus does not compete with its customers, which are principally contractors engaged in the paving business. The Division's primary source of revenue is from sales of hot mix asphalt. Hot mix asphalt consists by volume of approximately 95% aggregates and 5% liquid asphalt (a petroleum refining by-product). The Division currently operates asphalt plants in 36 locations primarily in metropolitan Los Angeles, San Diego and Orange County and the San Francisco Bay and San Joaquin Valley areas of California, as well as Phoenix and Tucson, Arizona, and Albuquerque, New Mexico. Of the 36 locations, 21 are sites which also have aggregates- processing plants operated by the Concrete and Aggregates Division. This proximity provides the Company with a competitive advantage in those markets due to the availability of aggregates and transportation cost savings. At all other asphalt plants, more than one source of aggregates is available, and at all asphalt plants, more than one source of liquid asphalt is available. In addition, the Division operates nine asphalt recycling systems at its major plants which recover aggregates and oil from asphalt that has been salvaged from roads and other surfaces. Used in the production of new asphalt paving, the recovered aggregates and oil offer substantial cost savings, strengthen the Company's ability to secure public projects, and provide a high return on investment. Three additional recycling systems are planned for 1994. The Division manufactures related specialty products including GUARDTOP(R), a coating material used for sealing asphalt paving to prevent water damage and surface erosion, and under a license agreement the Division is the exclusive distributor in metropolitan Los Angeles of a polypropylene reinforcing fabric used in the resurfacing of pavement. The Division also maintains a fleet of paving machines and specialty paving equipment which it rents, along with qualified operators, to contractors. The Division has more than one competitor in each of its markets and has several competitors in most of its markets. The Division competes for business through price, quality and service to customers. The Division has labor agreements with the Operating Engineers and Laborers Unions which expire during 1994 for its Fresno and Sacramento locations and during 1995 for its southern California locations. In 1987 the Company entered into a ten-year consent decree with the Justice Department limiting its ability to acquire additional asphalt operations in Los Angeles, San Diego and other specified areas of southern California. PROPERTIES DIVISION The Properties Division manages the Company's extensive holdings of over 34,000 owned and leased acres and is responsible for land acquisitions, permitting, reclamation, sales and leasing activities. Due to economies of scale and the Company's experience and expertise in the permitting process, the Company believes it has a significant advantage over most of its smaller competitors in obtaining permits for its mining and other operations. CalMat maintains substantial property holdings near the major urban centers of the markets it serves and leases land containing aggregates reserves prior to commencement of mining activities. During 1993, approximately 120 leases covering more than 1,200 acres were in effect. These leaseholds were used for farming, storage locations and other uses. CalMat's land management cycle includes acquiring property, developing a master plan, obtaining land use entitlements, extracting aggregates, and then reclaiming the mined property and preparing it for development. The Company has generally been able to recycle previously mined properties due in part to the efforts of its land management professionals. CalMat reclaims land for a wide variety of uses such as agriculture, native habitat restoration, water conservation and commercial, residential and industrial development. Reclaimed property may be subdivided into lots and sold to developers after obtaining the necessary zoning and permits. As part of the Company's restructuring in 1988, the Company decided to discontinue its business of developing industrial and office buildings. Since that time, the Company has sold 30 industrial buildings (totalling approximately 1.5 million square feet). As market conditions permit, the Company intends to dispose of its remaining commercial and industrial developments except for certain industrial buildings which serve to buffer the Company's mining and production operations. The Company currently owns approximately 1.1 million square feet of commercial and industrial buildings, approximately 550,000 square feet of which are located in close proximity to aggregates mining sites and buffer the adjacent mining and processing operations. The Company currently operates 4 landfills and expects to develop 3 additional landfill sites in 1994 and 1995. All of the Company's existing and planned landfills are designed and have permits to accept only nonhazardous construction rubble. During 1993, the Division negotiated a new three-year labor agreement with the Operating Engineers Union at its Los Angeles landfill facility. REGULATIONS AND EMPLOYEES A substantial amount of time and resources is expended by CalMat to comply with local, state and federal regulations for land use, health and safety, air pollution and other environmental matters. This is essential, because changes in the enforcement of existing regulations or the addition of new laws and regulations may require the Company to modify, supplement or replace equipment or facilities. During the normal course of its operations, the Company uses and disposes of materials, such as solvents and lubricants used in equipment maintenance, which are classified as hazardous by some government agencies. The Company makes every attempt to minimize the generation of such waste material and recycles most of it. A small amount of remaining wastes are disposed of in fully permitted off-site landfills. Because of the nature of the Company's business, both the Occupational Safety and Health Administration (OSHA) and the Mine Safety and Health Administration (MSHA) have jurisdiction over its safety standards and controls. Considerable effort is expended to train, inspect, report and enforce according to OSHA and MSHA requirements. The Company continued to be successful in obtaining zoning approvals and other required permits from local governing bodies allowing the mining of aggregates and the conducting of the Company's other businesses. The state, county and city governing bodies within California, Arizona and New Mexico continue to adopt new laws and regulations relating to land use. These actions may, in some instances, reduce or restrict some uses of the Company's properties. CalMat had 1,574 full-time employees as of December 31, 1993. Of these, 451 were salaried and 1,123 were hourly. The Company is party to 29 collective bargaining agreements covering 884 employees; 16 of these agreements covering an aggregate of 593 employees are due for renegotiation during 1994. Although no assurance can be given as to the outcome of these negotiations, the Company believes it has good labor relations and is not presently anticipating any material work stoppages. OTHER In 1990, Onoda California, Inc., ("Onoda") and the Company consummated a transaction whereby the Company distributed to Onoda all of its shares of stock in California Portland Cement Company ("CPC") in exchange for certain shares of stock of the Company that were then held by Onoda. In addition, prior to 1990, certain other related transactions were accomplished, including the Company's contribution of certain assets to CPC and CPC's distribution of all of its shares of stock in one of its subsidiaries to the Company (along with the Company's distribution of the CPC stock to Onoda, the "Onoda Transactions"). The Onoda Transactions were reported as tax-free transactions for federal income tax purposes. Based on an analysis of the tax law in effect at the time of the Onoda Transactions, the Company believes that this treatment of the Onoda Transactions is correct, and has not established financial statement reserves for this matter. The Internal Revenue Services (the "IRS"), however, has yet to examine the Onoda Transactions. As a result, there can be no assurance that the IRS will not challenge the Company's position regarding the proper tax treatment of the Onoda Transactions. If the IRS were ultimately successful in denying the Company's treatment of the Onoda Transactions, the resulting tax liability would have a material adverse effect on the Company's financial position. As is the case with other companies in the same industries, the Company's products contain varying amounts of crystalline silica, a common mineral that is a component of most sands. Excessive, prolonged inhalation of very small particles (principally those less than 10 microns in size) of crystalline silica has been associated with non-malignant lung disease. In 1987, the carcinogenic potential of crystalline silica was evaluated by the International Agency for Research on Cancer and later by the National Toxicology Program. The International Agency found limited evidence of carcinogenicity in humans but sufficient evidence of carcinogenicity in animals. The National Toxicology Program concluded in 1991 that crystalline silica is "reasonably anticipated to be a carcinogen." At present, the State of California does not require warning notices concerning the carcinogenicity, if any, of crystalline silica pursuant to California Proposition 65, but this policy is subject to change in the future. In addition, future research results could tend to implicate crystalline silica as a carcinogen or could fail to show any association between crystalline silica and cancer. The Company is not a party to any litigation regarding crystalline silica. ITEM 2. ITEM 2. PROPERTIES PLANT FACILITIES See "Item 1. Business" on page 1 of this Annual Report on Form 10-K for additional information relating to these properties. The Company makes a practice of leasing idle land which has been obtained for its aggregates reserves during periods when the land is not used for operations. During 1993, approximately 120 leases covering more than 1,200 acres were in effect. These leaseholds were used for farming, storage locations and other uses. Additionally, the Company owns approximately 1.1 million square feet of commercial and industrial buildings, approximately 550,000 square feet of which are located in close proximity to aggregates operations and buffer the adjacent mining and processing operations. A total of 34,011 acres are owned or leased by the Company. See Schedule V, "CalMat Co. Property, Plant, and Equipment," on page 32 for additional information relating to these properties. ITEM 3. ITEM 3. LEGAL PROCEEDINGS The Company and its subsidiaries are involved in various lawsuits and claims which the Company considers ordinary and routine in view of its size and the nature of its business. The Company does not believe that any ultimate liability resulting from any such lawsuits will have a material adverse effect on the operations or financial position of the Company. During 1990, the lawsuits which had been pending against the Company and its directors in connection with actions taken by the Company which involved Brierley Investments Limited and Onoda U.S.A., Inc. ("Onoda USA") were settled and dismissed, with the court permitting stockholders not wishing to participate in the settlement to "opt out". An appeal challenging the settlement was also dismissed and the time for filing further appeals has lapsed. In November, 1990, a lawsuit was filed against the Company and its directors in Delaware Chancery Court by a stockholder who had opted out of the settlement, purporting to represent a class of similarly situated stockholders and alleging misrepresentations and breach of fiduciary duty in connection with the matters which were the subject of the original lawsuits. No specific damages were stated. During 1991, the Company filed a motion to stay discovery, which was granted by the Court, and a motion to dismiss the complaint, which was denied in April 1992. The Company filed a further motion to dismiss the complaint and a motion for summary judgment. As a result of rulings of the Court made in October 1993, the stay of discovery has been vacated and the action will proceed as an individual action against the Company only, and only on the claim of misrepresentation. While the ultimate outcome of this lawsuit cannot be predicted with certainty at this time, management does not expect that this matter will have a material adverse effect on the consolidated financial position or results of operations of the Company. During the third quarter of 1992, the Company received a letter from CPC, Onoda and Onoda USA, purporting to assert a claim for indemnification with respect to certain environmental matters, pursuant to certain provisions of the agreement, dated July 19, 1988, under which Onoda acquired the stock of CPC. The Company has notified these companies that it believes that it has no liability with respect to the matters identified in the letter. No dollar amount of damages was specified, but the July 19, 1988 agreement limits any potential liability with respect to such matters to a maximum of $16,000,000. Operating Industries, Inc. Landfill Site The U.S. Environmental Protection Agency ("EPA"), the State of California and the California Hazardous Substance Account have named the Company and over 200 other parties defendants in a civil action pursuant to certain California statutes and the Comprehensive Environmental Response, Compensation and Liability Act ("CERCLA") in connection with the cleanup of the former Operating Industries, Inc. landfill site in Monterey Park, California. The EPA alleges that the Company disposed of hazardous substances representing 0.078 percent of the total volume of waste at the site. The Company believes, however, that the substances attributed to it at the site were not hazardous. To date, the Company has contributed approximately $300,000 to fund certain interim remedial actions at the site, as part of two partial settlements of this matter (which in part remain subject to court approval). The EPA will select a final remedy for the site based on a "Remedial Investigation/Feasibility Study," which is not expected to be released before early 1994. Because, among other things, the EPA has yet to select a final remedy for the site and the Company's share of any liability is undetermined, the ultimate outcome of this action cannot be predicted with certainty. The Company believes, however, that this matter will be resolved without a material adverse effect on its financial position. The Company's belief is based on its position that the wastes attributed to it at the site were not hazardous, its extremely small share of the waste at the site and the large number of other defendants, and its belief that it has recourse to insurance coverage for at least a substantial portion of any resulting liability. San Gabriel Valley Superfund Area The EPA has named the Company and more than 300 other entities as "potentially responsible parties" ("PRPs") under CERCLA in connection with alleged groundwater contamination at four sites designated as San Gabriel Valley Areas 1 to 4 in Los Angeles County, California (the "Sites"). The EPA has advised the Company and the other PRPs that they may be jointly and severally liable for releases of hazardous substances, not only from properties they owned or operated, but also for area-wide groundwater contamination. The Company's corporate predecessor previously leased property the Company no longer owns to Aerojet Electrosystem's corporate predecessor, which burned solid waste propellant on the property. Because no legal proceedings have been initiated by the EPA and the investigation of the Sites is ongoing, the amount that may ultimately be required for investigation and/or remediation with respect to any contamination at the Sites or in the affected areas is presently unknown and is unlikely to be determined for some time. In addition, as a result of uncertainty regarding the source and scope of contamination, the large number of PRPs and the likelihood of varying degrees of responsibility among various classes of PRPs, the Company's potential share of liability, if any, cannot be determined at this time. San Fernando Valley Superfund Area The EPA has named the Company a PRP under CERCLA in connection with ongoing containment and remediation being conducted pursuant to an EPA Record of Decision issued in 1987 for the San Fernando Valley Area 1 Superfund Site, North Hollywood Operable Unit. The EPA advised the Company that, as an alleged past owner of a property formerly operated by another party as a landfill and alleged to be connected with the contamination, the Company may be jointly and severally liable, with at least fifteen (15) other PRP's, including Allied-Signal, Inc., Lockheed Corporation and Waste Management Disposal Services of California, Inc., for $17,213,355 in evaluation and containment costs incurred by the EPA. Because of, among other things, uncertainty regarding the scope and source of the contamination and the likelihood of varying degrees of responsibility among the various PRP's, the Company has not determined what portion, if any, of these costs it may be liable for, should these costs be allocated among the various PRP's. The property in question was sold to a third party in 1988. That party has also been named as a PRP. No legal proceedings have been initiated by the EPA at this time. The Company has, at this time, no detailed information concerning actual contributions to the contamination, if any, from the site in question, has not yet had an opportunity to make a determination as to possible defenses or insurance coverage which may be available to it or as to the possibility of recovery from other PRP's or third parties not named by the EPA as PRP's. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. EXECUTIVE OFFICERS OF THE COMPANY Executive officers are elected by the Board of Directors annually, and serve at the pleasure of the Board or until their successors are qualified and elected. The following is a list of executive officers of the Company: NAME OFFICE ------ -------- A. FREDERICK GERSTELL Chairman of the Board, President, Chief Executive Officer and Chief Operating Officer Mr. Gerstell, 56, became Chairman of the Board in January 1991. He served as President and Chief Executive Officer from 1988 through 1990. From 1984 to 1988, he served as President and Chief Operating Officer. Prior to the formation of CalMat by the merger of Conrock and CPC in 1984, he was President and Chief Operating Officer of CPC and employed by CPC from 1975. DELBERT H. TANNER Executive Vice President - Construction Materials Mr. Tanner, 42, was elected to his current position in June 1993. From July 1987 to June 1993, he served as Regional Vice President of Apac, Inc., a division of Ashland Oil, and President of its Florida and Georgia divisions. Prior to his service at Apac, he was employed for 14 years by the Tanner Companies, Phoenix, Arizona, a large construction materials producer and contractor, where he served as President and Chief Executive Officer. SCOTT J WILCOTT Executive Vice President, Law and Property Mr. Wilcott, 56, was elected to his current position in August 1990. He was elected Executive Vice President in 1989. He served as Senior Vice President, Legal Counsel and Secretary from 1984 to 1989. He has been employed by the Company since 1968. Prior to his service at Apac, he was employed for 14 years by the Tanner Companies, Phoenix, Arizona, a large construction materials producer and contractor, where he served as President and Chief Executive Officer. H. JAMES GALLAGHER Executive Vice President - Finance, Chief Financial Officer Mr. Gallagher, 47, was elected to his current position in August 1993. Prior to that he served concurrently as Executive Vice President, Chief Financial Officer and Director of Pacific Enterprises Oil Co., and Senior Vice President, Chief Financial Officer and Director of Pacific Interstate Company. He previously served as Vice President, Controller and Chief Financial Officer of Pacific Interstate Company from 1979 and Manager of Internal Audits of Pacific Enterprises, Inc. from 1975. PAUL STANFORD Senior Vice President - Administration, General Counsel and Secretary Mr. Stanford, 51, was elected to his current position in June 1993. From August 1990 until June 1993, he served as Vice President, General Counsel and Secretary. Before joining the Company, from 1981, he was engaged in the practice of business law with the firm of Paul, Hastings, Janofsky & Walker. EDWARD J. KELLY Senior Vice President, Treasurer and Chief Accounting Officer Mr. Kelly, 38, was elected to his current position in January 1994. Since June 1993, he served as Senior Vice President, Controller, and Chief Accounting Officer. From December 1990 until June 1993, he served as Vice President, Controller. He was employed by Superior Industries International, Inc., a manufacturer of automotive products, as Vice President, Corporate Controller and Secretary from 1985 to 1990. WALTER Q. LUKKARILA Vice President, Operations Mr. Lukkarila, 58, was elected to his current position in June 1993. Prior to that, in February 1991, he served as Vice President - Development, Construction Materials. He served as Vice President, Operations, Conrock Division from 1984 to 1991, and has been employed by the Company since 1980. CARLOS S. HERNANDEZ Vice President and General Manager, Asphalt Division Mr. Hernandez, 57, was elected to his current position in February 1990. He served as an Area Manager of Industrial Asphalt (now the Asphalt Division) from 1984 to 1989, then as Managing Director of the Asphalt Division from 1989 to 1990. He has been employed by the Company and Industrial Asphalt since 1968. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The Company's common stock is traded on the New York, Pacific and Chicago Stock Exchanges under the trading symbol "CZM." The following table sets forth the high and low sales prices of the Common Stock of the Company as reported on the New York Stock Exchange Composite Tape for the periods indicated and the cash dividends declared on the Company's Common Stock during each quarter presented. At February 25, 1994, there were 1,375 holders of record of the Company's Common Stock $1 par value. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA (a) 1992 includes $26.1 million of special charges related to the consolidation of certain construction materials operations ($11.1 million) and the write down of the book value of certain developed real estate ($15.0 million). Excluding these charges, income (loss) from continuing operations before income taxes and cumulative effect of change in accounting principle would have been $8.6 million. (b) In 1990, Onoda California, Inc. (Onoda), an indirect, wholly-owned subsidiary of Onoda Cement Co., Ltd. of Japan, acquired from CalMat all of the outstanding stock of California Portland Cement Company (CPC), a wholly-owned subsidiary, in exchange for 5,834,000 shares of CalMat's common stock held by Onoda. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS This discussion should be read in conjunction with the consolidated financial statements. RESULTS OF OPERATIONS The Arizona and New Mexico markets where the Company operated showed definite signs of recovery in 1993. California, however, experienced its fourth straight year of significant decline in residential and non-residential construction activity. Unit sales volumes for the Company's hot-mix asphalt increased in 1993, however, the higher cost of purchased liquid asphalt more than offset the improved sales volumes resulting in lower earnings for the year. The Concrete and Aggregates Division experienced higher prices and lower costs resulting in a significant increase in earnings in 1993. The Properties Division earnings for 1993 were slightly lower than in 1992, largely due to lower income from landfill operations. The Company reported net income of $9.2 million, or $0.40 per share, for the year ended December 31, 1993, which includes an after-tax credit of $0.9 million, or $0.04 per share, resulting from the adoption of the new accounting standard for accounting for income taxes and a provision to income tax expense of $0.7 million, or $0.03 per share, to adjust deferred taxes due primarily to the recent increase in the federal tax rate. Excluding these items, earnings for 1993 would have been $9.0 million, or $0.39 per share. The net loss reported of $16.5 million, or $0.71 per share, for the year ended December 31, 1992, includes after-tax charges totaling $21.8 million, or $0.94 per share. These after-tax charges consisted of $6.0 million, or $0.26 per share, arising from the adoption of the new accounting standard for postretirement benefits other than pensions, $9.0 million, or $0.39 per share, to write down the book value of certain developed real estate and $6.7 million, or $0.29 per share, related to consolidation of certain construction material operations. Excluding these charges, earnings for the year would have been $5.3 million, or $0.23 per share. REVENUES AND EARNINGS CONSOLIDATED Total revenues amounted to $353.5 million, $350.3 million and $378.3 million in 1993, 1992 and 1991, respectively. Net sales and operating revenues, which excludes gains on sale of real estate and other income, of $348.4 million in 1993 were up slightly from $347.3 million in 1992. Net sales and operating revenues were down $17.7 million, or 4.8%, in 1992 compared with 1991, the decrease occurring in the Asphalt Division, which was down 13.1%. Total revenues includes gains from ongoing land sales of $2.1 million, $0.5 million and $9.6 million in 1993, 1992 and 1991, respectively. Cost of goods sold on a consolidated basis as a percentage of net sales and operating revenues declined to 82.8% in 1993 compared with 84.0% in 1992, mainly due to higher average unit prices and a change in product mix in the Concrete and Aggregates Division offset by higher average costs in the Asphalt Division. This percentage was 80.1% in 1991. Income (loss) before incomes taxes and cumulative effect of change in accounting principle was $14.9 million in 1993, up from a loss of $17.5 million in 1992, which in turn was down from income of $31.4 million in 1991. The 1992 amount includes special charges of $26.1 million related to the consolidation of certain construction materials operations ($11.1 million) and to write down the book value of certain developed real estate ($15.0 million). Excluding these special charges, income (loss) before income taxes and cumulative effect of change in accounting principle increased 73.3% to $14.9 million compared with $8.6 million for 1992. This increase consists primarily of improved earnings of the Concrete and Aggregates Division of $9.3 million offset by a $2.2 million decrease in earnings of the Asphalt Division. Excluding special charges, income (loss) before income taxes and cumulative effect of change in accounting principle would have been $8.6 million in 1992 compared with $31.4 million in 1991. This drop consists primarily of declines in earnings of the Asphalt Division and the Concrete and Aggregates Division of $10.1 million and $6.8 million, respectively, and $9.1 million less in gains from land sales. Selling, general and administrative expenses decreased $2.8 million, or 6.3%, in 1993 compared with 1992, which in turn was reduced 7.2% from the 1991 level. This reflects management's continuing efforts to reduce these expenses. During the past three years, the Company has reduced selling, general and administrative expenses by $6.8 million, or 14.0%. The effective tax rate in 1993 increased with 44.3% compared with 40.0% in 1992 and 1991. Excluding the adjustment to deferred taxes in 1993 to account for the increase in the federal tax rate, the effective tax rate was 36.7%. The decrease compared with 1992 and 1991 is due primarily to the benefit of percentage depletion. OPERATING DIVISIONS ASPHALT DIVISION The Asphalt Division's principal business involves the production and sale of hot-mix asphalt. Hot-mix asphalt is comprised physically of approximately 95% aggregates (sand and gravel) and 5% liquid asphalt. In 1993, aggregates and liquid asphalt represented approximately 39% and 36% of the total production costs, respectively. The division has plants at 36 locations in metropolitan Los Angeles and San Diego, the San Francisco Bay and San Joaquin Valley areas of California; Phoenix and Tucson, Arizona; and Albuquerque, New Mexico. Of the 36 locations, 21 are sites which also have aggregates processing plants and/or ready mixed concrete plants operated by the Concrete and Aggregates Division. Division revenues of $153.9 million were up $7.4 million, or 5.1%, from 1992's revenues of $146.5 million, which in turn were down $22.0 million, or 13.1%, from 1991's revenues of $168.5 million. The increase in 1993 resulted from higher prices and higher volume, while the reduction in 1992 was due to lower prices and lower volume. Income from operations dropped to $8.8 million in 1993 from $11.0 million in 1992, which in turn dropped from $21.1 million in 1991. Unit sales volume of hot-mix asphalt was 7,830,000 tons in 1993, up 4.8% from 7,474,000 tons sold in 1992, which in turn was down 9.3% from 1991's volume of 8,241,000 tons. Substantially all of the volume improvement in 1993 occurred during the fourth quarter and was, in part, a result of less rainfall during the current year's fourth quarter. A slight increase in average sales prices and a 4.8% increase in unit sales volume was more than offset by the higher cost of purchased liquid asphalt during 1993, resulting in a 9.1% decline in gross profit per ton. Selling, general and administrative expenses increased 3.6% in 1993 due primarily to management's decision to further strengthen bad debt reserves. Competitive pricing in the division's primary markets during 1992 resulted in a drop in prices in excess of a slight reduction in costs versus 1991. The resulting gross profit per ton dropped 23.2%. Selling, general and administrative expenses increased 4.3% in 1992 compared with 1991 due primarily to wage increases and increased corporate support costs. Between 6.0% and 9.0% of the division's total gross profit was from the miscellaneous products and services category during 1993, 1992 and 1991. CONCRETE AND AGGREGATES DIVISION The Concrete and Aggregates Division produces and sells construction aggregates and supplies ready mixed concrete for use in commercial and residential construction, public construction projects and projects to build, expand and repair roads and highways. The division operates aggregates processing plants at 34 locations in the major markets of southern and central California, the San Francisco Bay area; Phoenix and Tucson, Arizona; and Albuquerque, New Mexico. Ready mixed concrete batch plants are operated at 28 locations in these markets except for the Los Angeles and San Francisco Bay areas. Of the 28 ready mixed concrete locations, 15 are sites which also have aggregates processing plants. The overall decline in construction activity in southern California in residential and non-residential building in recent years continues to have a negative impact on the Concrete and Aggregates Division's volumes compared to historical levels. However, as shown in the following table, 1993 aggregates volumes increased slightly from 1992 due primarily to volumes of the San Francisco Bay Area operations which were acquired in December, 1992. Volumes in 1992 increased slightly from 1991, due primarily to volume increases at the New Mexico operation as the local economy strengthened. CONSTRUCTION AGGREGATES - TONS SOLD Ready mixed concrete sales volume decreased 15% to 1,818,000 cubic yards in 1993 from 2,146,000 cubic yards in 1992, which in turn had increased from 1,860,000 cubic yards in 1991. Overall division revenue of $201.1 million was down 2.2% from 1992's revenue of $205.7 million, while 1992's revenue was up slightly from 1991's revenue of $203.6 million. The decrease in 1993's revenue was due to a decline in ready mixed concrete sales volume offset by higher average sales prices for both aggregates and ready mixed concrete. Although total division revenue in 1992 was comparable to 1991, aggregates revenue was lower due to lower prices on similar volume, offset by ready mixed concrete revenue which was higher, due to higher volume, but at lower prices. The result was similar total revenue but lower income from operations due to the lower average prices. In 1993, the average sales price of aggregates increased 4.3% compared with 1992. Including aggregates used in ready mixed concrete, overall aggregates gross profit increased $4.0 million in 1993. The average price of ready mixed concrete increased 4.8% while costs per cubic yard were essentially unchanged. The higher average sales prices for both aggregates and ready mixed concrete more than offset the impact of flat aggregates volume and lower ready mixed volume, resulting in a $7.1 million increase in gross profit from 1992's gross profit. The overall average sales price of aggregates fell 7.2% in 1992 compared with 1991, while costs increased 3.2% on a per ton basis. Including aggregates used in ready mixed concrete, overall aggregates gross profit fell $7.2 million in 1992. The overall average price of ready mixed concrete also declined 7.2% while costs per cubic yard were lower by 5.4%. Despite increased volume, lower prices resulted in a loss at the gross margin level for ready mixed concrete and a $1.7 million decline from 1991's gross profit. Selling, general and administrative expenses were reduced 9.9% in 1993 from the 1992 level, which in turn had decreased 11.7% from 1991. Income from operations recovered to $10.5 million in 1993 from $1.3 million in 1992 after dropping from 1991's level of $8.1 million. PROPERTIES DIVISION The Properties Division manages the Company's real estate and is responsible for acquisitions, permitting, reclamation, sales and leasing activities. Income from operations was $8.8 million compared with $9.0 million in 1992. Included in 1993 are gains from ongoing property sales of $2.1 million versus gains of $0.5 million in 1992. Also included in 1993 is a charge of $1.3 million related to anticipated settlements of certain property disputes. Excluding the gains from ongoing property sales and the $1.3 million charge, the Properties Division income was $8.0 million in 1993 compared with $8.5 million in 1992. The decline is largely due to lower income from landfill operations. Income from operations was $9.0 million in 1992 compared with $15.5 million in 1991. The large decline in income in 1992 is a result of fewer real estate transactions being completed. Gains from ongoing property sales were $0.5 million in 1992 compared with gains of $9.6 million in 1991. ENVIRONMENTAL MATTERS The Company is subject to federal, state and local environmental laws and regulations which require the Company to remove or mitigate the effect on the environment of the disposal or release of certain chemical, mineral and petroleum substances at various sites. Generally, the Company's exposure has been limited to soil contamination from underground fuel tanks rather than exposure resulting from generation of hazardous waste, although it is a "named party" or "potentially responsible party" at three federal Superfund sites. The Company conducts annual environmental assessments of each of its operating sites. Liabilities are recorded when environmental assessments and/or remedial efforts are probable, and the costs can be reasonably estimated. Generally, the timing of these accruals coincides with completion of a feasibility study or the Company's commitment to a formal plan of action. As investigation or remediation proceeds, and as the scope of the Company's obligations become more clearly defined, there may be changes to estimated costs, which might result in future charges to earnings. During 1993, the Company charged to income $1.1 million before tax for environmental remediation costs and made related payments of $0.3 million. At December 31, 1993, the reserve for environmental remediation costs totaled $3.5 million. The amount reserved represents the estimated undiscounted costs which the Company will incur to remediate sites with known contamination. No potential insurance recoveries have been offset against the reserve. Substantially all amounts accrued in the reserve are expected to be paid out over the next 5 years. OTHER There were no gains or losses on disposition of assets held for sale in 1993 compared with gains of $1.8 million and $2.9 million in 1992 and 1991, respectively. LIQUIDITY AND CAPITAL RESOURCES CASH FLOWS Cash and cash equivalents increased $10.6 million during 1993 to a balance at year end of $10.6 million compared with a balance of zero at the end of 1992, which in turn was a decrease of $12.1 million from 1991. Operating activities are the principal source of CalMat's cash flows. Over the past three years, operating activities have provided $115.2 million in cash. Net cash of $43.9 million generated from operating activities in 1993 was $15.8 million more than 1992's $28.1 million, which was $15.2 million less than in 1991. Cash used for investing activities totaled $4.3 million in 1993, a $58.3 million decrease from the 1992 level. The primary reasons for this change were $20.7 million less in spending on property, plant and equipment in 1993 and the use of $34.1 million for a business acquisition in 1992. Cash used for investing activities totaled $62.6 million in 1992, a $52.8 million increase from the 1991 level. The primary reason for this change was the $34.1 million spent for a business acquisition in 1992. In addition, there was $10.3 million less in proceeds from sales of real estate in 1992 and $9.4 million less in receipts on installment notes receivable. Net cash used for financing activities amounted to $29.0 million in 1993, a $51.5 million change from the $22.5 million provided by financing activities during 1992. The primary reasons for this change were $50.7 million in net payments on notes payable to banks in 1993, compared with $39.0 million in net proceeds in 1992; offset by $35.0 million in proceeds from issuance of senior notes in 1993, $4.2 million less in payments of cash dividends and $2.2 million less in common stock repurchases. Also included in 1993 is $2.1 million in payments for hedge costs and other loan fees. Net cash provided by financing activities amounted to $22.5 million in 1992, a $47.2 million change from the $24.8 million used for financing activities in 1991. The primary reasons for this change were $38.7 million less in principal payments on notes and bonds payable, $2.5 million more in net proceeds from notes payable to banks and $5.7 million less in common stock repurchases. During 1993, the Company retricted capital expenditures in order to conserve cash. Capital expenditures in 1994 are expected to be in excess of $40 million, due in part to equipment replacements and the commencement of expansion projects including the construction of mining facilities located at Irvine Lake in Orange County, California which is scheduled to begin production by the end of 1994 and Azusa Rock, located near Los Angeles, California. Management believes that cash provided by operations and existing borrowing arrangements will provide adequate funds for current commitments and expected working capital requirements during 1994. During 1993, the Company expended $10.6 million in cash dividends. In order to conserve cash, the Company reduced its quarterly dividend from $0.16 per share to $0.10 per share in February 1993. WORKING CAPITAL Working capital totaled $39.9 million at December 31, 1993, an increase of $5.9 million from the 1992 level of $34.0 million. This increase was primarily due to the $10.6 million increase in cash and cash equivalents. Working capital totaled $34.0 million at December 31, 1992, a decrease of $9.4 million from the 1991 level of $43.4 million. This decrease was primarily due to the $12.1 million decrease in cash and cash equivalents. Current ratios were 1.7 at December 31, 1993 and 1992. OTHER Total consolidated long-term and short-term borrowings at December 31, 1993 and 1992 were $115.5 million and $132.1 million, respectively. This $16.7 million decrease in debt was paid from cash flows from operations. Total consolidated long-term and short-term borrowings at December 31, 1992 of $132.1 million had increased $39.0 million over 1991 primarily due to $34.1 million used to finance the Jamieson Co. acquisition in 1992. Debt as a percent of total capitalization was 24.8% and 27.4%, at December 31, 1993 and 1992, respectively. During 1989, the Company announced its intention to repurchase a significant amount of its common stock using the net proceeds, after taxes and related debt, from the sale of real estate assets held for sale as the source of funding. Under this program, the Company repurchased on the open market approximately 309,000 shares at a cost of $7.5 million during 1991. The Company's commitment to repurchase shares pursuant to the settlement of stockholder litigation has been fulfilled. During November 1991, the Company announced its intention to expend up to $5.0 million over a twelve-month period to repurchase shares of its common stock. During 1992 and 1991, 91,000 shares and 17,000 shares, respectively, were acquired at a total cost of $2.4 million under the program. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The Company's Consolidated Financial Statements, Financial Statement Schedules and Selected Quarterly Financial Data are set forth in the "Index" on page 17 hereof. INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES Schedules other than those listed above are omitted since they are not applicable, not required, or the information required to be set forth therein is included in the financial statements, or in notes thereto. REPORT OF INDEPENDENT ACCOUNTANTS To the Stockholders and Board of Directors CalMat Co. Los Angeles, California We have audited the accompanying consolidated balance sheets of CalMat Co. and subsidiaries 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, and the related financial statement schedules as listed in the index on page 17 of this Form 10-K. 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 consolidated 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 consolidated financial position of CalMat Co. 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 Notes 4 and 9 to the consolidated financial statements, effective January 1, 1993, the Company changed its method of accounting for income taxes, and effective January 1, 1992, the Company changed its method of accounting for postretirement benefits other than pensions. COOPERS & LYBRAND Los Angeles, California February 21, 1994 CALMAT CO. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS The accompanying notes are an integral part of these financial statements. CALMAT CO. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS The accompanying notes are an integral part of these financial statements. CALMAT CO. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOW The accompanying notes are an integral part of these financial statements. CALMAT CO. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY The accompanying notes are an integral part of these financial statements. CALMAT CO. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1: SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES PRINCIPLES OF CONSOLIDATION The consolidated financial statements include the accounts of CalMat Co. (the Company) and all of its majority-owned subsidiaries. All significant intercompany accounts and transactions have been eliminated in consolidation. The Company uses the equity method of accounting for companies where ownership is between 20 and 50 percent. CASH AND CASH EQUIVALENTS Cash and cash equivalents include all cash balances and highly liquid investments with a maturity of three months or less when purchased. COSTS IN EXCESS OF NET ASSETS OF SUBSIDIARIES Costs in excess of the fair value of net assets of purchased subsidiaries are amortized on a straight-line basis over periods not exceeding 40 years. Accumulated amortization of such costs was $7.7 million and $6.0 million at December 31, 1993 and 1992, respectively. PROPERTY, PLANT AND EQUIPMENT Property, plant and equipment is carried at cost. Depreciation is computed using primarily straight-line rates over estimated useful lives (5 to 35 years for plant structures and components and 4 to 25 years for machinery and equipment). Depletion of rock and sand deposits is computed by the unit-of-production method based upon estimated recoverable quantities of rock and sand. Significant expenditures which add materially to the utility or useful lives of property, plant and equipment are capitalized. All other maintenance and repair costs are charged to current operations. The cost and related accumulated depreciation of assets replaced, retired or otherwise disposed of are eliminated from the property accounts, and any gain or loss is reflected in income. ENVIRONMENTAL 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 environmental assessments and/or remedial efforts are probable, and the costs can be reasonably estimated. Estimated liabilities are not discounted to present value. Generally, the timing of these accruals coincides with completion of a feasibility study or the Company's commitment to a formal plan of action. The reserve for environmental remediation costs was $3.5 million and $2.7 million at December 31, 1993 and December 31, 1992, respectively. REVENUE RECOGNITION Sales and operating revenues are recorded upon shipment of product, net of discounts, if any, and include revenue earned pursuant to the terms of property leasing contracts. Gains and losses on real estate are recorded upon consummation of the transaction. Other income relates primarily to interest and dividend income, miscellaneous rental income and gains on sale of fixed assets which are recognized in accordance with the terms of various contractual arrangements or upon receipt (as applicable). RECLASSIFICATION Certain prior year amounts have been reclassified to conform with the present presentation. CALMAT CO. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 2: ASSETS HELD FOR SALE During 1988, the Company announced its intention to dispose of a substantial portion of its developed and developable properties, and these properties were classified as assets held for sale. Due to the continued depressed condition of the commercial real estate market in southern California, combined with the lack of conventional financing available to buyers, the Company in 1992 conducted a review of the properties included in assets held for sale. As a result of this review, substantially all the properties were reclassified to operating assets. During 1993, the remaining properties were reclassified to operating assets. Prior period information has been restated to reflect the reclassifications. NOTE 3: ACCRUED LIABILITIES Accrued liabilities consist of the following at December 31: NOTE 4: FEDERAL AND STATE TAXES Income (loss) before income taxes and the related income tax expense (benefit) are as follows: CALMAT CO. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Deferred tax liabilities (assets) are comprised of the following at December 31, 1993 and January 1, 1993: A reconciliation of the provision for income taxes to the federal statutory income tax rate is as follows: In January 1993, the Company adopted Statement of Financial Accounting Standards (SFAS) No. 109, "Accounting for Income Taxes." The adoption of SFAS 109 changes the Company's method of accounting for income taxes from the deferred method (APB 11) to an asset and liability approach. Previously, the Company deferred the 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 assets and liabilities. Under SFAS 109, assets and liabilities acquired in purchase business combinations are assigned their fair values and deferred taxes are established for lower or higher tax bases. Under APB 11, values assigned were net of tax. In adopting SFAS 109, the Company adjusted the carrying amounts of assets purchased in business acquisitions which increased primarily net property, plant and equipment and deferred taxes by $13.5 million. Pre-tax income from operations for the year ended December 31, 1993 was reduced by $0.6 million, representing primarily the increase in depreciation expense resulting from these higher carrying amounts. The adjustments to the January 1, 1993 balance sheet to adopt SFAS 109 netted to a credit of $0.9 million. This amount, recorded in the first quarter, was reflected in 1993 net income as the cumulative effect of a change in accounting principle. It primarily represents the impact of adjusting deferred taxes to reflect the enacted tax rate in effect as of January 1, 1993 of 34.0% as opposed to the higher tax rates that were in effect when the deferred taxes originated. The Company increased its deferred tax liability in 1993 as a result of legislation enacted during 1993 increasing the corporate rate from 34.0% to 35.0%. CALMAT CO. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS At December 31, 1993, the Company had alternative minimum tax credit carryforwards of approximately $2.0 million available to offset regular tax in future years. The Company's federal consolidated income tax returns have been examined and settled by the Internal Revenue Service through 1985. NOTE 5: NOTES AND BONDS PAYABLE Notes and bonds payable consist of the following at December 31: During 1993, the Company replaced $35.0 million of borrowings under its revolving credit facilities with senior notes. The senior notes bear interest at 6.7% and require principal payments beginning in 1997 through 2000. At December 31, 1993, the Company had formal committed revolving credit facilities with a number of banks totaling $135.0 million which will expire in 1994 and beyond. At December 31, 1993, the Company had various unused lines of credit totaling approximately $81.0 million on which the Company pays commitment fees of .375%. Short-term bank borrowings made under these various credit facilities and included in notes payable to banks were $54.0 million and $113.0 million at December 31, 1993 and 1992, respectively, and bore rates equal to or less than the prime bank lending rate which was 6.0% at December 31, 1993 and 1992. Committed credit available under the revolving credit facilities provides management with the ability to refinance the short-term bank borrowings on a long-term basis and, as it is management's intention to do so, these borrowings have been classified as long-term debt. The credit agreements contain restrictions with respect to the incurring of additional debt, creation of liens and guarantees, and maintenance of minimum working capital, stockholders' equity and financial ratios. The Company has complied with all of these restrictions. Maturities of notes payable during the next five years are as follows: 1994, $5.9 million; 1995, $3.7 million; 1996, $2.0 million; 1997, $63.1 million; and 1998, $9.1 million. CALMAT CO. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 6: STOCK OPTIONS AND RIGHTS The Company has stock option plans that provide for granting incentive and non-qualified options on common stock to officers and key employees. During 1993, the Board of Directors adopted, subject to stockholder approval at the 1994 Annual Meeting of Stockholders, the 1993 Stock Option Plan for Executive and Key Employees of CalMat Co. which authorized the issuance of options covering 900,000 shares of common stock. Certain information relative to stock options follows: Prices per share of common stock under option range from $12.75 to $30.50 at December 31, 1993. Options expire from 1995 to 2003. Prices per share of options exercised range from $7.095 to $19.375 in 1993, $7.095 to $22.50 in 1992 and $7.095 to $19.125 in 1991. Stock options may be issued to executives and certain key employees as determined by the Management Development and Compensation Committee of the Board of Directors. The price of the shares subject to each option is set by the Committee but may not be less than the fair market value of the shares at the date of grant. Options generally become exercisable in installments beginning one year after the date of grant and expire 10 years after grant date. No options expired in 1993, 1992 or 1991. In September 1987, the Company declared a dividend distribution of one common share purchase right on each outstanding share of common stock. When exercisable, each right will entitle its holder to buy one share of the Company's stock at a price of $90 per share until September 1997. The rights will become exercisable if a person acquires 25.0% or more of the Company's stock or makes an offer, the consummation of which will result in the person's owning 30.0% or more of the Company's stock. In the event the Company is acquired in a merger, each right entitles the holder to purchase common stock of the surviving company having a market value twice the exercise price of the right. The rights may be redeemed by the Company at a price of $0.05 per right at any time prior to a person acquiring 25.0% of the Company's common stock. NOTE 7: STOCKHOLDERS' EQUITY Earnings per common equivalent share (common shares adjusted for dilutive effect of common stock options) have been computed by dividing net income for each period by the weighted-average shares of common stock outstanding. Weighted-average shares used for 1993, 1992 and 1991 totaled 23,117,000, 23,242,000 and 23,319,000, respectively. NOTE 8: FINANCIAL INSTRUMENTS AND CONCENTRATIONS OF CREDIT RISK The Company enters into interest rate swap agreements to effectively convert a portion of its floating-rate borrowings into fixed-rate obligations. The interest rate differential to be received or paid is recognized over the lives of the agreements as an adjustment to interest expense. Counterparties to these agreements are high credit quality financial institutions, and nonperformance is considered remote. In the unlikely event that a counterparty fails to meet the terms of an agreement, the Company's exposure is limited to the interest rate differential. CALMAT CO. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS The Company had outstanding interest rate swap agreements that effectively converted $25.0 million and $35.0 million of variable rate debt to fixed rate borrowings at December 31, 1993 and 1992, respectively. Financial instruments which potentially subject the Company to concentrations of credit risk consist principally of temporary cash investments and trade receivables. The Company places its temporary cash investments with high credit quality financial institutions. At times, such investments may be in excess of the FDIC insurance limit. A significant portion of the Company's sales are to customers in the construction industry, and, as such, the Company is directly affected by the well-being of that industry. However, the credit risk associated with trade receivables is minimal due to the Company's large customer base and ongoing control procedures which monitor the credit worthiness of customers. The Company generally obtains lien rights on all major projects. Historically, the Company has not experienced significant losses on trade receivables. The following disclosure of the estimated fair value of financial instruments is made in accordance with the requirements of Statement of Accounting Financial Standards (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 valuation methodologies described below. However, considerable judgements are required in interpreting market data to develop the estimates of fair value. Accordingly, the estimates presented herein may not be indicative of the amounts that the Company could realize in a current market exchange. The use of different market assumptions or valuation methodologies may have a material effect on the estimated fair value amounts. The carrying values of cash and cash equivalents, trade receivables and accounts payable approximate fair values due to the short-term maturities of these instruments. The carrying amounts and estimated fair values of the Company's other financial instruments at December 31, 1993 are as follows: The fair value of notes receivable has been estimated using the expected future cash flows discounted at market interest rates. The fair value of notes and bonds payable was estimated by discounting the future cash flows using rates currently available for debt of similar terms and maturity. The carrying values of short-term bank loans were assumed to approximate fair values due to their short-term maturities. Interest rate swaps fair value is the amount at which they could be settled, based on estimates from dealers. NOTE 9: RETIREMENT PLANS The Company has a trusteed thrift and profit-sharing retirement plan and a money purchase pension plan to provide funds from which retirement benefits are paid to substantially all salaried employees of the Company and its wholly-owned subsidiaries, including officers and directors who are also employees. Annual contributions to these plans made by the Company approximate 15.0% of the aggregate compensation paid or accrued each year to participants in the plan. The Company also contributes to various union pension plans, as specified by certain union agreements, and non-union pension plans which cover substantially all hourly employees. Contributions to all retirement plans charged to income totaled $8.6 million in 1993, $7.6 million in 1992 and $8.7 million in 1991. The Company provides certain health care and life insurance benefits to eligible retired employees. Salaried and non-union hourly participants generally become eligible after reaching age 62 with 20 years of service or after reaching age 65 with 15 years of service. The health care plan is contributory and the life insurance plan is noncontributory. The plans are unfunded. CALMAT CO. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS In the third quarter of 1992, the Company adopted Statement of Financial Accounting Standards (SFAS) No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions." These benefits are now accrued over the period the employee provides services to the Company. Prior to the change, costs were charged to expense as incurred. The Company elected to immediately recognize the Accumulated Postretirement Benefit Obligation valued as of January 1, 1992, as of the beginning of the year and recorded an after-tax charge of $6.0 million, or $0.26 per share ($10.0 million net of deferred taxes of $4.0 million), as a change in accounting principle. The following table sets forth the plans' funded status reconciled with the amount included in the caption other liabilities and deferred credits in the Company's balance sheets at December 31, 1993 and 1992: The net periodic postretirement benefit cost for 1993 and 1992 included the following components: For measurement purposes, a 12.0% annual rate of increase in the per capita cost of covered health care benefits was assumed for 1994; the rate was assumed to decrease gradually to 6.0% by 2012 and remain at that level thereafter. The weighted-average discount rate used in determining the Accumulated Postretirement Benefit Obligation in 1993 and 1992 was 7.0%. The health care cost trend rate assumption has a significant effect on the amounts reported. To illustrate, 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 $0.8 million and the aggregate of the service and interest cost components of net periodic postretirement benefit cost for the year then ended by $0.1 million. NOTE 10: ACQUISITION On December 8, 1992, the Company purchased substantially all of the assets of the Jamieson Company, a major San Francisco Bay area producer of aggregates. The Company paid $34.1 million for an aggregates production facility, mining equipment, related real estate and the exclusive right to mine significant aggregates reserves. The purchase was financed using the Company's existing lines of credit. The acquisition has been accounted for using the purchase method of accounting. Accordingly, the purchase price was allocated to assets based on their estimated fair values as of the date of the acquisition. The cost in excess of net assets acquired was approximately $10.4 million and is being amortized on a straight-line basis over 28 years, which approximates the estimated life of the aggregates reserves. The Jamieson Company's results of operations have been included in the Company's consolidated financial statements beginning December 8, 1992. The Jamieson Company's operations are not CALMAT CO. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS material in relation to the consolidated financial statements, and proforma financial information has, therefore, not been presented. NOTE 11: SPECIAL CHARGES Based upon an evaluation of certain developed real estate and due primarily to market conditions, the Company recorded a non-cash special charge of $15.0 million in the third quarter of 1992 representing the excess of net book value over the estimated fair market value. The net after-tax effect of this charge was $9.0 million, or $0.39 per share. Fourth quarter results for 1992 include a non-cash special charge of $11.1 million, of which $5.4 million is related to write downs of excess plant and equipment and severance payments related to the consolidation of certain construction materials operations, and $5.7 million is to write off accumulated costs incurred in connection with seeking permits for additional aggregates sources and for other valuation allowances. These costs relate to projects where completion is uncertain in the near term because of economic conditions and increased regulation. The Company believes it has adequate aggregates reserves and productive capacity to serve indicated demand in the Company's markets. The net after-tax effect of this charge was $6.7 million, or $0.29 per share. NOTE 12: COMMITMENTS AND CONTINGENCIES The Company had letters of credit and performance bonds outstanding totaling approximately $22.0 million at December 31, 1993 which guarantee various insurance and financing activities. The Company has been named by the U.S. Environmental Protection Agency ("EPA") as a defendant in a civil action involving one "Superfund" cleanup site and as a "potentially responsible party ("PRP") with respect to two other such sites. In each instance the Company is one of many entities so named. Because, in the case of the site involved in ongoing litigation, no final remedy has been selected, and with respect to the other two sites, investigation is ongoing, the Company's share of total liability, if any, is unable to be quantified at this time. In the case of the site involved in ongoing litigation, the Company believes that the wastes attributed to it were not hazardous. In addition, the waste attributed to the Company represents an extremely small (less than one-tenth of one percent) percentage of the total volume of waste at this site. The Company is subject to various legal proceedings, claims and liabilities, which arise in the ordinary course of its business. In the opinion of management, the amount of ultimate liability with respect to these actions will not materially affect the financial position of the Company. NOTE 13: BUSINESS SEGMENT INFORMATION The Company operates principally in three business segments: Asphalt, Concrete and Aggregates, and Properties. Operations in the Asphalt Division principally involve the manufacture and sale of hot-mix asphalt. In addition to supplying asphalt to customers at its various plants, the Asphalt Division maintains a fleet of specialty paving equipment which it rents to customers. It also markets Guardtop, an asphalt surface sealer, and is a distributor of paving reinforcement fabric. The division operates asphalt plants at 36 locations in metropolitan Los Angeles and San Diego, the San Francisco Bay and San Joaquin Valley areas of California; Phoenix and Tucson, Arizona; and Albuquerque, New Mexico. Of the 36 locations, 21 are sites which also have aggregates processing plants and/or ready mixed concrete plants operated by the Concrete and Aggregates Division. Operations in the Concrete and Aggregates Division include the mining and sale of aggregates (rock, sand and gravel) and the manufacture and sale of ready mixed concrete. The division operates aggregates production plants at 34 locations serving the Los Angeles, San Diego, Bakersfield, Fresno, Ventura, Santa Barbara and San Francisco Bay areas of California; Phoenix and Tucson, Arizona; and Albuquerque, New Mexico. Ready mixed concrete batch plants are operated at 28 locations in these markets except for the Los Angeles and San Francisco Bay areas. Of the 28 ready mixed concrete locations, 15 are sites which also have aggregates processing plants. CALMAT CO. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS The Properties Division manages the Company's real estate and is responsible for acquisition, permitting, reclamation, sales and leasing activities. These activities take place principally in Los Angeles and San Diego, California and Phoenix, Arizona. Business segment information for the years ended December 31, is as follows: Total revenues by segment include both sales to unaffiliated customers, as reported in the Company's consolidated statements of operations, and intersegment sales. Income from operations by segment represents total revenues less direct operating expenses, segment selling, general and administrative expenses and certain allocated corporate general and administrative expenses. Corporate and unallocated expenses include corporate administrative expenses and support expenses not allocated to business segments. Assets classified as corporate and other consist primarily of general office facilities, cash and cash equivalents and other assets. CALMAT CO. AND SUBSIDIARIES SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (AMOUNTS IN THOUSANDS) _______________________ Notes: (a) Includes $2,960, $1,105, and $21,369 related to reclassifications of completed construction projects for 1993, 1992 and 1991, respectively; $3,935 related to the adoption of SFAS 109 in 1993; $3,679 related to assets of acquired company for 1992; and other reclassifications to other accounts in 1993, 1992 and 1991. (b) Includes $11,142, $18,573 and $37,753 related to reclassifications of completed construction projects for 1993, 1992 and 1991, respectively; $13,085 related to the adoption of SFAS 109 in 1993; $12,662 related to assets of acquired company for 1992; ($15,000) related to the write down of the book value of certain developed real estate in 1992; ($1,545) related to asset write offs for 1992; and other reclassifications to other accounts in 1993, 1992 and 1991. (c) Includes $(14,102), ($19,678) and ($59,122) related to reclassifications of completed construction projects for 1993, 1992 and 1991, respectively; ($3,948) related to asset write offs for 1992; and other reclassifications to other accounts in 1993, 1992 and 1991. (d) Certain prior year amounts have been reclassified to conform with the present presentation. CALMAT CO. AND SUBSIDIARIES SCHEDULE VI - ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT For the Years Ended December 31, 1993, 1992 and 1991 (Amounts in Thousands) _______________________ Notes: (a) Includes $4,505 related to the adoption of SFAS 109 in 1993; ($1,436) related to asset write offs for 1992; and other reclassifications to other accounts in 1993, 1992 and 1991. (b) Certain prior year amounts have been reclassified to conform with the present presentation. CALMAT CO. AND SUBSIDIARIES SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (AMOUNTS IN THOUSANDS) ______________________ Notes: (a) Write offs of uncollectible accounts, less recoveries. (b) Cash discounts allowed. (c) Payments made. (d) Certain prior year amounts have been reclassified to conform with the present presentation. CALMAT CO. AND SUBSIDIARIES SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (AMOUNTS IN THOUSANDS) ______________________ Notes: (a) Amounts do not exceed one percent of total sales and revenue as reported in the related statements of operation. CALMAT CO. AND SUBSIDIARIES SELECTED QUARTERLY FINANCIAL DATA (Unaudited) (a) Reflects the cumulative effect to January 1, 1993, to adopt the new accounting standard for income taxes of $0.9 million, or $0.04 per share. (b) Reflects the cumulative effect to January 1, 1992, of the change in accounting for postretirement benefits of $6.0 million, or $0.26 per share. (c) Includes charge of $9.0 million, or $0.39 per share, to write down the book value of certain developed real estate. (d) Includes charge of $6.7 million, or $0.29 per share, related to the consolidation of certain construction materials operations. (e) Includes charge of $0.8 million, or $0.03 per share, related to anticipated settlements of certain property disputes. (f) Reflects the restatement for assets held for sale which increased revenues by $0.9 million and increased gross profit by $0.2 million from amounts originally reported. (g) The sum of the quarterly net income per share amounts may not equal the year because quarterly and annual figures are required to be independently calculated. 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 REGISTRANT Except for information as to identification and business experience of executive officers which is set forth in Part I of this report, the information called for by Item 10 is incorporated herein by reference to the information included under the caption "Election of Directors" on pages 3 through 12 of the Company's Proxy Statement dated March 17, 1994 for the April 27, 1994 Annual Meeting of Stockholders ("Proxy Statement"). ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The information called for by Item 11 is incorporated herein by reference to the information included under the caption "Management Remuneration" on pages 6 through 12 in the Company's Proxy Statement. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information called for by this Item 12 is incorporated herein by reference to the information included under the captions "Stock Ownership of Certain Beneficial Owners" and "Election of Directors" on pages 2 through 12 of the Company's Proxy Statement. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information called for by this Item 13 is incorporated herein by reference to the information included under the caption "Election of Directors" on pages 3 through 12 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: See Index to Consolidated Financial Statements and Financial Statement Schedules on page 17 of this Annual Report on Form 10-K. (2) Financial Statement Schedules: See Index to Consolidated Financial Statements and Financial Statement Schedules on page 17 of this Annual Report on Form 10-K. (3) Exhibits: The following exhibits are included as part of the Company's 1993 Annual Report on Form 10-K Report as required by Item 601 of Regulation S-K. The exhibits identified by asterisks are the management contracts and compensatory plans or arrangements required to be filed as exhibits to this Annual Report on Form 10-K. Stockholders may obtain copies of the exhibits not presented herein upon written request to: Secretary, CalMat Co., 3200 San Fernando Road, Los Angeles, CA 90065. Exhibit 3.1: CalMat Co. Certificate of Incorporation, as amended, filed as Exhibit 3.1 to the Company's 1987 Annual Report on Form 10-K, is incorporated herein by reference. Exhibit 3.2: Certificate of Amendment of Certificate of Incorporation, filed May 20, 1992, with Delaware Secretary of State, filed as Exhibit 3.2 to the Company's 1992 Annual Report on Form 10-K, is incorporated herein by reference. Exhibit 3.3: CalMat Co. By-Laws. Exhibit 4.1: Rights Agreement, dated as of September 22, 1987, between CalMat Co. and Security Pacific National Bank, filed as Exhibit 1 to the Company's Form 8-K dated October 5, 1987, is incorporated herein by reference. Exhibit 4.2: First Amendment to Rights Agreement, dated as of October 26, 1992, between CalMat Co. and Bank of America, N.T.&S.A., formerly known as Security Pacific National Bank, filed as Exhibit 4.2 to the Company's 1992 Annual Report on Form 10-K, is incorporated herein by reference. Exhibit 10.1: Credit Agreement among CalMat Co. and "The Banks Listed Herein" and Morgan Guaranty Trust Company of New York, as Agent, dated as of August 1, 1988, filed as Exhibit E - 10.2 to Registrant's 1991 Annual Report on Form 10-K, is incorporated herein by reference. Exhibit 10.2: Credit Agreement among CalMat Co., "Lenders Parties Hereto" and the First National Bank of Chicago, as Agent, dated as of August 20, 1991, filed as Exhibit F - 10.3 to the Company's 1991 Annual Report on Form 10-K, is incorporated herein by reference. Exhibit 10.3: Amendment No. One dated October 16, 1992 to Credit Agreement among CalMat Co., "Lenders Parties Hereto" and the First National Bank of Chicago, as Agent, dated as of August 20, 1991. Exhibit 10.4: Amendment No. Two dated December 28, 1992 to Credit Agreement among CalMat Co., "Lenders Parties Hereto" and the First National Bank of Chicago, as Agent, dated as of August 20, 1991. Exhibit 10.5: Waiver/Amendment No. Three dated February 5, 1993 to Credit Agreement among CalMat Co., "Lenders Parties Hereto" and the First National Bank of Chicago, as Agent, dated as of August 20, 1991. Exhibit 10.6: Amendment No. Four dated February 26, 1993 to Credit Agreement among CalMat Co., "Lenders Parties Hereto" and the First National Bank of Chicago, as Agent, dated as of August 20, 1991. Exhibit 10.7: Credit Agreement dated as of June 30, 1992, among CalMat Co., as the Borrower, The Financial Institutions Listed On The Signature Pages Hereof, as the Lenders, and Bank of America National Trust and Savings Association, as the Agent, filed as Exhibit 10.3 to the Company's 1992 Annual Report on Form 10-K, is incorporated herein by reference. Exhibit 10.8: First Amendment dated January 14, 1993 to Credit Agreement dated as of June 30, 1992, among CalMat Co., as the Borrower, The Financial Institutions Listed on the Signature Pages Hereof, as the Lenders, and Bank of America National Trust and Savings Association, as the Agent. Exhibit 10.9: Waiver dated February 5, 1993 to Credit Agreement dated as of June 30, 1992, among CalMat Co., as the Borrower, The Financial Institutions Listed on the Signature Pages Hereof, as the Lenders, and Bank of America National Trust and Savings Association, as the Agent. Exhibit 10.10: Second Amendment dated February 26, 1993 to Credit Agreement dated as of June 30, 1992, among CalMat Co., as the Borrower, The Financial Institutions Listed on the Signature Pages Hereof, as the Lenders, and Bank of America National Trust and Savings Association, as the Agent. Exhibit 10.11: Note Purchase Agreement dated as of July 23, 1993 between CalMat Co. and Metropolitan Life Insurance Company, et al. Exhibit 10.12: Amended Employment Agreement between the Company and A. Frederick Gerstell, filed as Exhibit 10.2 to the Company's 1990 Annual Report on Form 10-K, is incorporated herein by reference. Exhibit 10.13: Supplemental Executive Retirement Plan between the Company and A. Frederick Gerstell, filed as Exhibit 10.3 to the Company's 1990 Annual Report on Form 10-K, is incorporated herein by reference. Exhibit 10.14: Amended Employment Agreement between the Company and Scott J Wilcott, filed as Exhibit 10.6 to the Company's 1990 Annual Report on Form 10-K, is incorporated herein by reference. Exhibit 10.15: Amended Employment Agreement between the Company and Paul Stanford, filed as Exhibit 10.9 to the Company's 1992 Annual Report Form 10-K, is incorporated herein by reference. Exhibit 10.16: Letter Agreement Regarding Employment between the Company and Delbert H. Tanner, executed May 27, 1993. Exhibit 10.17: Letter Agreement Regarding Employment between the Company and H. James Gallagher, executed August 12, 1993. Exhibit 10.18: Thrift and Profit Sharing Retirement Plan and Money Purchase Pension Plan for Employees of CalMat Co., dated January 1, 1989, filed as Exhibit 10.8 to the Company's 1989 Annual Report on Form 10-K, is incorporated herein by reference. Exhibit 10.19: Trust Agreement pursuant to the Thrift and Profit Sharing Retirement Plan and the Money Purchase Pension Plan for Employees of CalMat Co., dated October 24, 1989, filed as Exhibit 10.9 to the Company's 1989 Annual Report on Form 10-K, is incorporated herein by reference. Exhibit 10.20: Stock Option Plan for Executive and Key Employees of CalMat Co., filed as Exhibit 4 to the Company's Form S-8 Registration Statement (#33-8770) effective October 6, 1986, is incorporated herein by reference. Exhibit 10.21: 1987 Stock Option Plan for Executive and Key Employees of CalMat Co., as amended, filed as Exhibit 4 to the Company's Form S-8 Registration Statement (#33-18760) effective December 19, 1987, is incorporated herein by reference. Exhibit 10.22: Non-qualified Deferred Compensation Plan for Selected Executives of CalMat Co, filed as Exhibit 10.12 to the Company's 1990 Annual Report on Form 10-K, is incorporated herein by reference. Exhibit 10.23: 1990 Stock Option Plan for Executive and Key Employees of CalMat Co., filed as Exhibit 4.1 to the Company's Form S-8 Registration Statement (#33-43558) effective October 28, 1991, is incorporated herein by reference. Exhibit 10.24: Amended and Restated 1993 Stock Option Plan for Officers, Directors and Key Employees of CalMat Co. filed as Exhibit A to the Company's Proxy Statement dated March 17, 1994, is incorporated herein by reference. Exhibit 21.1: Subsidiaries of the Company. Exhibit 22.1: The Company's definitive Proxy Statement filed with the Commission on March 16, 1994 and mailed to the Company's stockholders on March 17, 1994, is incorporated herein by reference. Exhibit 23.1: Consent of Coopers & Lybrand, certified public accountants, to incorporation by reference in the Registration Statements on Form S-8 (#33-8770, #33-18760 and #33-43558) and the related prospectuses pertaining to the Stock Option Plan for Executive and Key Employees of CalMat Co., the 1987 Stock Option Plan for Executive and Key Employees of CalMat Co. and the 1990 Stock Option Plan for Executive and Key Employees of CalMat Co., respectively, is on page 43 of this Annual Report on Form 10-K. (b) Reports on Form 8-K: There were no Form 8-K reports filed by the Company during the fourth quarter of 1993. CALMAT CO. PROPERTY OWNED AND LEASED AS OF DECEMBER 31, 1993 ______________________ (a) The Company's continuing program of evaluating the best use of property may result in reclassification of properties between categories from time to time. (b) Certain land in the Concrete and Aggregates Division is leased on a short-term basis as undeveloped property and the revenues generated are reported in the Properties Division. (c) Consists of numerous parcels which have limited access and of which approximately 59% are located in the Mojave Desert, Kern County, California. CALMAT CO. SCHEDULE OF ESTIMATED AGGREGATES RESERVES AS OF DECEMBER 31, 1993 (AMOUNTS IN MILLIONS) CONSENT OF INDEPENDENT ACCOUNTANTS We consent to the incorporation by reference in the Registration Statements of CalMat Co. and subsidiaries on Form S-8 (File Numbers 33-8770, 33-18760 and 33-43558) of our report dated February 21, 1994, on our audits of the consolidated financial statements and financial statement schedules of CalMat Co. and subsidiaries as of December 31, 1993 and 1992, and for the years ended December 31, 1993, 1992 and 1991, which report is included in this Annual Report on Form 10-K. COOPERS & LYBRAND Los Angeles, California March 17, 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. CalMat Co. By /s/ A. FREDERICK GERSTELL -------------------------------------- A. Frederick Gerstell, Chairman of the Board, President, Chief Executive Officer and Chief Operating Officer 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 date indicated.

72243_1993.txt

72243_1993

1993

72243

Item 1 Business (1) (a) A Virginia corporation founded in 1915, Noland Company is a distributor of Plumbing/Heating, Electrical, Industrial and Air Conditioning/Refrigeration supplies, with branch facilities in fourteen Southern states. While most of its sales are wholesale, the Company plays a modest retail role through product showrooms and other marketing efforts of certain items. It handles products of over 6,000 vendors and sells to thousands of customers, largely in the industrial and construction sectors of the Southern United States. There have been no significant changes in the Company's methods of operation during the last five years. However, the growing demand for computer-based, fully automated procurement systems for MRO (Maintenance, repair and operating) products is attracting new business and widening the scope and possibilities for potential sales growth in this market. Noland Properties, Inc., a wholly owned subsidiary, holds and manages the real estate holdings of the Company and acquires sites and provides facilities to house the Company's various branches as required. (b) The Company operates in only one industry segment, the distribution of mechanical equipment and supplies. Markets for these products are all areas of construction -- residential, nonresidential (commercial, institutional, and industrial), and non-building (highways, sewers, water, and utilities); manufacturing; domestic water systems; and maintenance/repair/modernization. (c) During the last five years, the Company has continued to serve essentially the same markets described in Item 1 (1) (b). Current plans call for the continuation of this policy. The Company does not manufacture any products. (i) Total sales of each class of similar products for the last five years are as follows: 1993 1992 1991 1990 1989 (In thousands) Plumbing/Heating $220,879 $225,239 $220,179 $247,805 $265,351 Electrical 43,363 49,090 47,498 57,539 62,860 Industrial 54,099 54,851 52,644 59,442 61,528 Air Conditioning/Refrigeration 84,600 82,906 64,214 63,687 64,890 $402,941 $412,086 $384,535 $428,473 $454,629 Not all branches have all four departments. If a product department does not exist in a particular branch, any sales of that department's products are attributed to the department that makes the sale. (ii) The Company continues to market new products introduced by its suppliers/manufacturers. None will require the investment of a material amount of the assets of the Company. (iii) The Company does not use or market raw materials. (iv) The Company holds several sales franchises and has produced a variety of copyrighted materials and systems used in the normal conduct of its business. It is virtually impossible to dollar- quantify their significance. None are reflected as assets in the Company's Balance Sheet. The Company has no patents. (v) The business in general is seasonal to the extent of the construction industry it supplies. (vi) It is the practice of the Company to carry a full line of inventory items for rapid delivery to customers. At times, advance buying is necessary to ensure the availability of products for sale. The Company also extends credit, and this and the necessity for an adequate supply of merchandise ordinarily absorbs most of the Company's working capital. (vii) The Company sells products to many thousands of customers. Although there is no customer which accounts for 10% or more of the Company's sales, there are several customers of which the loss of any one could have a material adverse effect on the Company's business. (viii)The dollar amount of the Company's backlog of orders believed to be firm was approximately $29,715,000 at December 31, 1993, and $30,073,000 at December 31, 1992. (ix) The portion of the Company's business with the Government and subject to renegotiation is not considered material. (x) The wholesale distribution of all products in which the Company is engaged is highly competitive. Competition results primarily from price, service and the availability of goods. Industry statistics indicate that Noland Company is one of the larger companies in its field. (xi) Company-sponsored research and development activities expenditures in 1993, 1992 and 1991 were immaterial. (xii) The Company believes it is in full compliance with Federal, State and local provisions which have been enacted or adopted regulating the discharge of materials into the environment. The effects of compliance are not material with respect to capital expenditures, earnings and competitive position of the Company. No material capital expenditures are anticipated for environmental control facilities during the remainder of the current year and the succeeding year. (xiii) As of December 31, 1993, the Company employed 1,683 persons. (d) From its founding in 1915 and continuing through 1993, the Company confined its operations to the Southern area of the United States. Item 2 Item 2 Properties The main properties of the Company consist of 94 facilities, including warehouses, offices, showrooms, paved outside storage areas and covered pipe storage sheds. These are located throughout the South: in Alabama, Arkansas, Delaware, Florida, Georgia, Kentucky, Maryland, Mississippi, North Carolina, South Carolina, Tennessee, Texas, Virginia and West Virginia. Twelve are held under leases and the remaining eighty-two are owned by the Company. All but one of the owned properties is free of any related debt. The executive office of the Company is located at 2700 Warwick Boulevard, Newport News, Virginia 23607. In the opinion of management, the aforementioned facilities are suitable for the purposes for which they are used, are adequate for the needs of the business and are in continuous use in the day-to-day course of operations. The Company's policy is to maintain, repair and renovate its properties on a continuing basis, replacing older structures with new buildings and yard facilities as the need for such replacement arises. In addition, reference is made to Note 2 (c), page 16 of the Annual Report to Stockholders filed as an exhibit hereto, with respect to property excess to current needs. Item 3 Item 3 Legal Proceeding None of material consequence. Item 4 Item 4 Submission of Matters to a Vote of Security Holders None Additional Item Executive Officers of the Registrant Positions and Offices Business Experience Name Age Held with Registrant During the Past 5 Years Lloyd U. Noland, III 50 Chairman of the Board, Chief Executive Officer President and Director of the Registrant. Donald G. Hurley 61 Vice President-Marketing Chief Marketing Officer. and Director Previously, Vice President Manager of Operations-Select Branch/Complexes. A. P. Henderson, Jr. 50 Vice President-Finance Chief Financial Officer and Director of the Registrant. Charles A. Harvey 54 Vice President-Corporate Responsible for the Data Registrant's Corporate Data Division. John E. Gullett 52 Vice President-Corporate Responsible for the Communications Registrant's Corporate Communications Dept. James E. Sykes, Jr. 50 Treasurer/Secretary Responsible for Regis- trant's treasury functions and secretarial duties. William G. Overman 53 Vice President-Purchases Responsible for Corporate Purchases Division. Prev. purchasing agent for plumbing and heating. Ronald K. Binger 47 Vice President-General Responsible for adminis- Credit Manager tering the Registrant's credit related activites. Previously, General Credit Manager (1991-1992), and Manager Internal Audit Department. David E. Gregg 47 Vice President-Manager Responsible for electric- of Merchandising, al and industrial market- Electrical/Industrial ing activities. Prev. Manager of Merchandising, Plumbing and Heating (1990-1991) and Complex Manager. All executive officers were elected for a term of one year beginning May 1, 1993 and/or until their successors are elected and qualified. None of the executive officers are related by blood, marriage or adoption. Service has been continuous since the date elected to their present positions. There are no arrangements or understandings between any officer and any other person pursuant to which he was elected an officer. Mr. Noland III has served as an officer since 1981, Mr. Henderson since 1983, Mr. Harvey since 1980, Mr. Gullett since 1982, Mr. Hurley since 1988, Mr. Overman since 1988 and Mr. Sykes since 1982. Messrs Binger and Gregg were elected officers during the April 1993 Board of Directors meeting. PART II Item 5 Item 5 Market for the Registrant's Common Stock and Related Security Holder Matters The information set forth on the inside back cover of the Annual Report to Stockholders contains information concerning the market price of Noland Company's common stock for the past two years, the number of holders thereof and the dividend record with respect thereto for the past two years. This information is incorporated herein by reference. Item 6 Item 6 Selected Financial Data The information set forth under the caption "Ten-Year Review of Selected Financial Data" relating to sales, net income, total assets, long-term debt, net income per share and dividends per share for the years 1989 through 1993 is incorporated herein by reference from pages 20 and 21 of the enclosed Noland Company 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 The information set forth under the above caption is incorporated herein by reference from pages 10 and 11 of the enclosed Noland Company Annual Report to Stockholders for the year ended December 31, 1993. Item 8 Item 8 Financial Statements and Supplementary Data The following consolidated financial statements of Noland Company, included in the Annual Report to Stockholders for the year ended December 31, 1993, are incorporated herein by reference: Annual Report to Stockholders (page) Report of Independent Accountants 12 Consolidated Statement of Income and Retained Earnings-- Years ended December 31, 1993, 1992 and 1991 13 Consolidated Balance Sheet--December 31, 1993, 1992 and 1991 14 Consolidated Statement of Cash Flows -- Years ended December 31, 1993, 1992 and 1991 15 Notes to Consolidated Financial Statements 16-19 Item 9 Item 9 Disagreements on Accounting and Financial Disclosure None PART III Item 10 Item 10 Directors and Executive Officers of the Registrant Data relating to Directors is incorporated herein by reference from pages 2 and 3 of the 1994 Noland Company Proxy Statement for the April 20, 1994 Annual Meeting of Stockholders. Data relating to Executive Officers is included in Part I of this report. Item 11 Item 11 Executive Compensation The information set forth under the caption "Compensation of Executive Officers" on page 4 of the 1994 Noland Company Proxy Statement for the April 20, 1994, Annual Meeting of Stockholders is incorporated herein by reference. Item 12 Item 12 Security Ownership of Certain Beneficial Owners and Management The information set forth under the captions "Voting Securities and Principal Holders Thereof" and "Nominees for Director" on pages 1, 2 and 3 of the 1994 Noland Company Proxy Statement for the April 20, 1994, Annual Meeting of Stockholders is incorporated herein by reference. Item 13 Item 13 Certain Relationships and Related Transactions (a) There were no material direct or indirect transactions with management and others. (b) Not applicable. (c) Not applicable. (d) Not applicable. PART IV Item 14 Item 14 Exhibits, Financial Statement Schedules and Reports on Form 8-K (a) 1. Consolidated Financial Statements Included in PART II, Item 8 of this report: Report of Independent Accountants Consolidated Statement of Income and Retained Earnings--Years Ended December 31, 1993, 1992 and 1991 Consolidated Balance Sheet--December 31, 1993, 1992 and 1991 Consolidated Statement of Cash Flows --Years ended December 31, 1993, 1992 and 1991 Notes to Consolidated Financial Statements With the exception of the aforementioned information incorporated by reference and the information in the 1993 Annual Report to Stockholders on the inside back cover and pages 11, 12, 20 and 21 incorporated in response to Items 5, 6 and 7 in this Form 10-K Annual Report, the 1993 Annual Report to Stockholders is not to be deemed "filed" as part of this report. The individual financial statements of the registrant have not been filed because consolidated financial statements are filed. The registrant is an operating company and the subsidiary is wholly owned. 2. Financial Statement Schedules Included in PART IV of this report: For the three years ended December 31, 1993 Form 10-K Page(s) Schedule V Property and Equipment 10 Schedule VI Accumulated Depreciation and Amortization of Property and Equipment 12 Schedule VIII Valuation and Qualifying Accounts 13 Schedule IX Short-Term Borrowings 14 Other financial statement schedules are omitted because of the absence of conditions under which they are required or because the required information is given in the consolidated financial statements or notes thereto. Report of Independent Accountants on Consolidated Financial Statement schedules 16 3. The exhibits are listed in the Index of Exhibits required by Item 601 of Regulation S-K at item (c) below. (b) Reports on Form 8-K No reports on Form 8-K for the three months ended December 31, 1993, were required to be filed. (c) The Index of Exhibits and any required Exhibits are included beginning at page 17 of this report. (d) Not applicable. Item 14(a)(2) Financial Statement Schedules [FN] See Notes to Schedule V on page 11 FORM 10-K Notes to Schedule V (1) For financial reporting purposes, depreciation is computed by the straight-line method based on estimated useful lives of properties (e.g., buildings, 40 years; equipment and fixtures, 3-10 years; and leasehold improvements, over the life of the lease). For tax reporting purposes, depreciation is computed by the straight- line method for buildings placed in service after 1986 and by accelerated methods on buildings placed in service prior to 1987 and equipment. Property in excess of current needs consists primarily of land held for possible future expansion and branch facilities not currently in use. (2) Includes reclassifications among the accounts shown. Also includes reclassification to assets held for resale. [FN] (1) Includes reclassifications among the accounts shown. [FN] Note: The interest rate at December 31, 1993 was 3.48%. 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. NOLAND COMPANY March 25, 1994 By Lloyd U. Noland III 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 on behalf of the Registrant and in the capacities and on the dates indicated. Chairman of the Board, Lloyd U. Noland, III President and Director March 25, 1994 Lloyd U. Noland, III Vice President-Finance, Chief Financial Officer Arthur P. Henderson, Jr. and Director March 25, 1994 Arthur P. Henderson, Jr. Vice President-Marketing March 25, 1994 Donald G. Hurley and Director Donald G. Hurley James E, Sykes, Jr. Treasurer/Secretary March 25, 1994 James E. Sykes, Jr. COOPERS & LYBRAND REPORT OF INDEPENDENT ACCOUNTANTS ON CONSOLIDATED FINANCIAL STATEMENT SCHEDULES _______________________ Our report on the consolidated financial statements of Noland Company and Subsidiary has been incorporated by reference in this Form 10-K from page 12 of the 1993 Annual Report to Stockholders of Noland Company. In connection with our audits of such consolidated financial statements, we have also audited the related consolidated financial statement schedules listed in Item 14 (a) 2 on page 7 of this Form 10-K. In our opinion, the consolidated 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 required to be included therein. COOPERS & LYBRAND Newport News, Virginia March 4, 1994 EXHIBIT INDEX Exhibit Number Exhibit Page (3) Articles of Incorporation and Bylaws Previously Filed (4) Instruments defining the rights of Security holders, including indentures Not Applicable (9) Voting trust agreement Not Applicable (10) Material contracts Not Applicable (11) Statement regarding computation of per share earnings--clearly determinable Not Applicable (12) Statement regarding computation of ratios Not Applicable (13) Portions of Annual Report to Portions Incorporated Stockholders By Reference (18) Letter regarding change in accounting principles Not Applicable (19) Previously unfiled documents Not Applicable (22) Subsidiary of the Registrant Previously Filed (23) Published report regarding matters submitted to vote of security holders Not Applicable (24) Consents of experts and counsel Not Applicable (25) Power of attorney Not Applicable (28) Additional exhibits Not Applicable (29) Information from reports furnished to state insurance regulatory authorities Not Applicable As to any security holder requesting a copy of the Form 10-K, the Company will furnish any exhibit indicated in the above list as filed with the Form 10-K upon payment to it of its expenses in furnishing such exhibit. This page intentionally left blank. EXHIBIT 13 Page Inside back cover 20 - 21 Ten Year Review 22 - 23 Management Discussions 24 - 27 Report of Independent Accountants 28 Consolidated Statement of Income 29 Consolidated Balance Sheet 30 Consolidated Statement of Cash Flows 31 Notes to Consolidated Financial Statements 32 - 42 Inside Back Cover Info ______________________ Shareholder and Investor Information Corporate Information Corporate Headquarters: Noland Company 2700 Warwick Boulevard Newport News, Virginia 23607 (804) 928-9000 Wholly Owned Subsidiary: Noland Properties, Inc. 2501 Washington Avenue Newport News, Virginia 23607 (804) 247-8200 Investor Inquiries or Request for Form 10-K: Call or write: Richard L. Welborn Assistant Vice President-Finance and Tax Administrator 2700 Warwick Boulevard Newport News, Virginia 23607 (804) 928-9000 Auditors: Coopers & Lybrand 11832 Rock Landing Drive Newport News, Virginia 23606 Legal Counsel: Hunton & Williams P.O. Box 1535 Richmond, Virginia 23212 Stock Information The Company's common stock is traded over the counter as part of NASDAQ's National Market System (symbol: NOLD). On March 15, 1994, the approximate number of holders of record of the Company's common stock was 2,800. Market Prices: The following table sets forth the reported high and low prices for the common stock on the NASDAQ system: _________________________________ High Low - --------------------------------- Qtr. 4 $17.25 $15.00 Qtr. 3 $18.00 $15.25 Qtr. 2 18.50 15.00 Qtr. 1 18.75 15.00 Qtr. 4 $16.50 $14.13 Qtr. 3 16.50 14.50 Qtr. 2 16.00 14.50 Qtr. 1 15.50 12.50 _________________________________ P/E Ratio: _________________________________ High Low - --------------------------------- 1993 21 17 1992 15 11 _________________________________ Dividend Policy: Noland has paid regular cash dividends for 61 consecutive years; and, while there can be no assurance as to future dividends because they are dependent on earnings, capital requirements and financial condition, the Company intends to continue that policy. Dividend payments are subject to the restrictions described in the Notes to the Consolidated Financial Statements. Dividends Paid: The Company paid quarterly dividends of $.06 per share in each quarter of 1992 and 1993. Registrar: Noland Company Transfer Agent: Mellon Financial Services Four Station Square Pittsburgh, Pennsylvania 15219-1173 (412) 236-8000 Annual Meeting: April 20, 1994, 2:00 p.m. Noland's Corporate Headquarters Newport News, Virginia Annual Report Pages 10-11 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Net income for 1993 was $3.3 million compared to $4.1 million for 1992. Business conditions were weaker than expected in the first six months of the year, resulting in a net loss for that period. However, increased demand for our products in the second half, along with continued improvements in profit margins, credit and inventory during the year, helped offset the mid-year loss and report a net profit for the year. Results of Operations Sales for 1993 were $402.9 million, compared to 1992's sales of $412.1 million or a 2.2 percent decline. The decline in sales was centered in six of the fourteen states in which Noland operates. Sales for 1992, as compared with 1991, increased $27.5 million, or 7.2 percent. Sales in three of the four product departments declined in 1993, with only Air Conditioning/ Refrigeration showing an increase over the prior year. The mix of sales between stock items and direct shipment items was 86 percent and 14 percent, respectively, for both 1993 and 1992. Gross profit, as a percent of sales, was 19.2 percent for 1993, 18.7 percent for 1992 and 18.5 percent for 1991. The higher gross profit percentages for 1993 and 1992 represent the continuing efforts of the Company to improve margins. The increased profit margin caused gross profit dollars to equal the year-earlier period despite $9 million in less sales. Gross profit for 1992 and 1991 includes the beneficial effect of the liquidation of certain LIFO inventory layers. Operating expenses increased 2.0 percent over 1992 to a total of $74.7 million. Operating expenses, as a percent of sales, were 18.5 percent, 17.8 percent, and 19.3 percent in 1993, 1992, and 1991, respectively. The 1993 increase in operating expenses is principally due to higher personnel-related costs which include a $548,000 charge for the adoption of Statement of Financial Accounting Standards No. 106 "Employers' Accounting for Postretirement Benefits Other than Pensions." SFAS No. 106 requires the Company to accrue annually the net periodic postretirement benefit cost rather than recognizing the cost when benefits are paid. The $548,000 charge reduced net income by nine cents per share. The Accumulated Postretirement Benefit Obligation at January 1, 1993 was $4.1 million and is being amortized over 20 years. The increased personnel - related costs were largely offset by a $2 million reduction in net bad debts. This was on top of a $900,000 reduction in bad debts in 1992. The Company's 1993 credit losses of $816,000 were less than three- tenths of one percent of sales, the ratio that has been our goal since the beginning of our credit crisis in the early 1990's. Interest expense decreased for the fourth consecutive year to a total of $2.4 million. This is $636,000 or 20.8 percent less than 1992. These declines are due largely to lower average short- term borrowings and continued low interest rates. Adversely affecting earnings for the year was a $419,000 loss on the sale of the Company's former North Little Rock, Ark. property, which reduced net income seven cents per share. The Company sells products to many thousands of customers. Although there is no customer which accounts for 10 percent or more of the Company's sales, there are several customers of which the loss of any one could have a material adverse effect on the Company's business. The growing demand for computer-based, fully automated procurement systems for MRO (maintenance, repair and operating) products is attracting new business and widening the scope and possibilities for potential sales growth in this market. As a result, an increased percentage of Company resources are being dedicated to developing comprehensive working relationships with large industrial customers. Looking ahead, the Company believes homebuilding, home remodeling, and manufacturing all should improve in 1994. These better market conditions, coupled with a better-trained sales force and a new year-long sales and marketing program, give reason to believe that sales growth should resume in 1994. In November 1992, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits." This Statement will not have a material effect on the Company's financial condition or results of operations. The Statement was adopted January 1, 1994. Liquidity and Capital Resources The Company maintains its liquidity through: (1) cash flow from operations; (2) short-term financings; (3) bank line of credit arrangements, when needed; and (4) additional long-term debt. During 1993 the Company generated $5.9 million in cash flow from operations, down from $14.7 million in 1992. The $5.9 million from operations along with additional borrowings of $1.4 million was used to purchase $7.6 million in capital assets and pay dividends. The Company's financial position remains strong with working capital of $65.2 million and a current ratio of 2.6 to 1. Management believes the Company's liquidity, working capital and capital resources are sufficient to meet the needs of the foreseeable future. Impact of Inflation Reported results, for the most part, are net of the impact of inflation because of the Company's use of the LIFO (last-in, first-out) inventory method. During inflationary periods, this method removes artificial profits induced by inflation and presents operating results in truer, more absolute terms. Since adopting LIFO in 1974, the Company has avoided both the recognition of these inflationary profits and the unnecessary payment of related taxes on such income. At approximate replacement cost, the Company's inventory investment was $86.9 million at year-end 1993, while the LIFO inventory balance was $55.5 million -- a difference accumulated since 1974 of $31.4 million. For purposes of financial reporting, the depreciation charge to earnings for the use of capital assets is reflected on the straight-line basis which does not necessarily keep pace with rising replacement costs of those assets. Annual Report Page 12 REPORT OF INDEPENDENT ACCOUNTANTS - ------------------------------------------------------------------------------- certified public accountants COOPERS & LYBRAND To the Board of Directors and Stockholders of Noland Company: We have audited the accompanying consolidated balance sheets of Noland Company and Subsidiary as of December 31, 1993, 1992 and 1991, 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 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 consolidated 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 consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Noland Company and Subsidiary as of December 31, 1993, 1992 and 1991, 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. Newport News, Virginia Coopers & Lybrand March 4, 1994 Annual Report Page 13 CONSOLIDATED STATEMENT OF INCOME AND RETAINED EARNINGS NOLAND COMPANY AND SUBSIDIARY For the years ended December 31, 1993, 1992, and 1991 Sales $402,941 $412,086 $384,535 Cost of Goods Sold: Purchases and freight in 330,244 333,848 313,486 Inventory, January 1 50,866 51,839 51,888 Inventory, December 31 (55,475) (50,866) (51,839) Cost of Goods Sold 325,635 334,821 313,535 Gross Profit on Sales 77,306 77,265 71,000 Operating Expenses 74,692 73,227 74,355 Operating Profit (Loss) 2,614 4,038 (3,355) Other Income: Cash discounts, net 3,340 3,445 3,244 Service charges 1,383 1,692 2,229 Miscellaneous 376 493 403 Total Other Income 5,099 5,630 5,876 Interest Expense 2,422 3,058 3,724 Income (Loss) Before Income Taxes 5,291 6,610 (1,203) Income Taxes 1,996 2,518 (478) Net Income (Loss) $ 3,295 $ 4,092 $(725) Retained Earnings, January 1 61,916 58,712 61,139 Cash Dividends Paid (1993 and 1992--$.24 per share; 1991--$.46 per share) (888) (888) (1,702) Retained Earnings, December 31 $64,323 $ 61,916 $58,712 Net Income (Loss) Per Share $ .89 $ 1.11 $ (.20) [FN] The accompanying notes are an integral part of the financial statements. Annual Report Page 14 [FN] The accompanying notes are an integral part of the financial statements. Annual Report Page 15 [FN] The accompanying notes are an integral part of the financial statements. Annual Report Pages 16-19 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOLAND COMPANY AND SUBSIDIARY 1. Principal Business of the Company Noland Company is a wholesale distributor of mechanical equipment and supplies. These products are categorized under plumbing/heating, electrical, industrial and air conditioning/refrigeration. Markets for these products are all areas of construction-- residential, nonresidential (commercial, institutional and industrial) and non-building (highways, sewer, water and utilities); manufacturing; domestic water systems; and maintenance /repair /modernization. Noland Properties, Inc., a wholly owned subsidiary, holds and manages the real estate holdings of the Company and acquires sites and provides facilities to house the Company's various branches as required. 2. Summary of Significant Accounting Policies a. Principles of Consolidation The consolidated financial statements include the accounts of Noland Company and its wholly owned subsidiary, Noland Properties, Inc. All material intercompany transactions have been eliminated. b. Inventory Inventory is stated at the lower of cost or market, with market being current replacement cost. The cost of inventory has been principally determined by the last-in, first-out (LIFO) method since 1974. c. Property and Equipment Property and equipment are valued at cost less accumulated depreciation. Depreciation is computed by the straight-line method based on estimated useful lives of properties and equipment. Expenditures for maintenance and repairs are charged to earnings as incurred. Upon disposition, the cost and related accumulated depreciation are removed and the resulting gain or loss is reflected in income for the period. For tax reporting purposes, depreciation is computed by the straight-line method for buildings placed in service after 1986 and by accelerated methods on equipment and on buildings placed in service prior to 1987. Property in excess of current needs consists primarily of land held for possible future expansion and branch facilities not currently in use. d. Retirement Plan The Company has a noncontributory retirement plan that covers all employees with one year or more of service. Benefits are based on years of service and compensation during active employment. The Company's policy is to fund annually the minimum funding requirements under the Employee Retirement Income Security Act of 1974. e. Postretirement Benefit Plans The Company offers postretirement health and life benefits to substantially all employees who retire with the required years of service. Health care benefits provided to the retirees and spouses consist of a reimbursement towards the purchase of the retirees' health plan of choice. The amount of reimbursement is based on years of service. Life insurance in the amount of $3,000 is provided to all retirees. Additional coverage may be purchased in an amount up to a total of fifty percent of final earnings. The Company pays a share of the cost of such additional coverage. The cost of these benefits is funded on a pay-as-you-go-basis. Net periodic postretirement cost for 1993 was based on the provisions of Statement of Financial Accounting Standards No. 106 "Employers' Accounting For Postretirement Benefits Other Than Pensions." In 1992 and 1991, postretirement benefit costs were recognized as claims were paid. f. Income Taxes Income tax expense was based on the provisions of Statement of Financial Accounting Standards No. 109 for 1993 and 1992. For 1991, income tax expense was based on the provisions of Statement of Financial Accounting Standards No. 96. A deferred tax asset or liability is recognized for the deferred tax consequences of all temporary differences. g. Cash and Cash Equivalents The Company considers all highly liquid debt instruments purchased with an original maturity of three months or less to be cash equivalents. Due to the short maturity period of cash and cash equivalents, the carrying amount approximates the fair value. The Company has no requirements for compensating balances. The Company maintains its cash in bank deposit accounts which, at times, may exceed federally insured limits. The Company has not experienced any losses in such accounts. The Company believes it is not exposed to any significant credit risk on cash and cash equivalents. h. Extra Compensation All employees with at least one year of service participate in one or more of the Company's extra compensation plans which are based on earnings before income taxes and certain adjustments. The cost of these plans was $1,658,000 in 1993, $1,280,000 in 1992 and $856,000 in 1991. 3. Accounts Receivable Accounts receivable shown as of December 31, 1993, 1992, and 1991 are net of an allowance for doubtful accounts of $968,000, $2,206,000, and $2,196,000, respectively. Bad debt charges, net of recoveries, were $816,000 for 1993, $2,800,000 for 1992, and $3,691,000 for 1991. 4. Inventory Comparative year-end inventories are as follows: 1993 1992 1991 (In thousands) - ------------------------------------------------------------- Inventory, at approximate replacement cost $86,879 $82,258 $83,954 Reduction to LIFO 31,404 31,392 32,115 LIFO inventory $55,475 $50,866 $51,839 Liquidation of certain inventory layers carried at lower costs which prevailed in prior years as compared with costs of 1992 purchases had the effect of increasing 1992 net income $429,000 ($.12 per share). In 1991 the liquidation decreased net loss $588,000 ($.16 per share). 5. Notes Payable a. Short-term Borrowings: Amounts payable to banks were $7,000,000, $3,500,000, and $10,000,000 at December 31, 1993, 1992, and 1991, respectively. The interest rate, which is based on existing Federal Funds rates, at December 31, 1993 was 3.48 percent. The carrying amount of these short-term borrowings approximates fair value because of the short maturity of the borrowings. The Company had unused lines of credit totaling $26,500,000 at December 31, 1993. b. Long-term Debt: 1993 1992 1991 (In thousands) Promissory note, 9.60% interest payable quarterly, $600,000 due annually June 1994 through 1995, $1,850,000 due annually June 1996 through 2000 with balance due June 2001. (1) $12,400 $13,000 $13,000 Promissory note, 10.15% interest payable quarterly, $1,250,000 due annually each January through 1994 with balance due January 1995. (1) 2,625 3,875 5,125 Promissory note, variable interest payable weekly (3.90% at December 31, 1993), fully revolving basis through June 1, 1995. (1) 10,000 10,000 10,000 Industrial revenue financings, variable interest payable quarterly (3.21% to 7.50% at December 31, 1993) with varying maturities from 1994 to 2004. (1)(2) 15,460 15,690 16,120 Other - 32 54 $40,485 $42,597 $44,299 Less current maturities 1,980 2,086 1,401 $38,505 $40,511 $42,898 (1) Subject to agreements that require the Company to maintain not less than $55,000,000 in working capital and not less than a 1.75-to-1 year-end current ratio. Cash dividends cannot exceed 50 percent of earnings, excluding net gains on disposition of capital assets, reckoned accumulatively from January 1, 1986. Earnings retained since that date not restricted under this provision amount to $5,640,000. (2) Industrial Development Revenue Refunding Bonds are callable at the option of the bondholders upon giving seven days notice to the Trustee. The carrying value of these bonds is a reasonable estimate of fair value as interest rates are based on prevailing market rates. At December 31, 1993, property and equipment with a net book value of $859,000 was pledged as collateral. In addition, to ensure payment of the long-term refunding bonds the Company has caused to be delivered to the Trustee an irrevocable, direct pay letter of credit in favor of the Trustee in the amount of $15,615,000. The contract amount of the letter of credit is a reasonable estimate of its fair value as the value is fixed over the life of the commitment. No material loss is anticipated due to nonperformance by the counterparties to those agreements. The fair value of the remaining $25 million of long-term debt is estimated based on the borrowing rates currently available to the Company for loans with similar terms and average maturities. The fair value of this long-term debt is $26.5 million for 1993. Annual maturities of long-term debt for the five years subsequent to December 31, 1993, are as follows: 1994, $1,980,000; 1995, $2,105,000; 1996, $3,635,000; 1997, $3,215,000, 1998, $1,850,000. 6. Postretirement Health Care and Life Insurance Benefits Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions." The Accumulated Postretirement Benefit Obligation (APBO) is being amortized over twenty years. The APBO was determined using a 7.5 percent discount rate. The change in accounting reduced 1993 net income $342,000 or nine cents per share. Net postretirement benefit cost reflects the impact of a plan amendment which reduced 1993 cost by approximately $400,000. There are no plan assets. The components of net periodic postretirement benefit costs for 1993 are: (In thousands) - ------------------------------------------------------------------ Service cost - benefits earned during the period $ 53 Interest cost on accumulated postretirement benefit obligation 292 Net amortization and deferral 203 Net postretirement benefit cost $ 548 Postretirement benefit costs for 1992 and 1991 were recognized as claims were paid and totaled $287,000 and $277,000, respectively. The following table sets forth the plans' combined postretirement benefit liability as of December 31, 1993: (In thousands) Accumulated postretirement benefit obligation: Retirees $(2,288) Fully eligible active employees (863) Other active plan participants (898) (4,049) Unrecognized transition obligation 3,863 Unrecognized net loss 66 Postretirement liability recognized in the balance sheet $ (120) 7. Retirement Plan The components of the provision for net periodic pension cost were as follows: 1993 1992 1991 (In thousands) - ----------------------------------------------------------------- Service cost - benefits earned during the period $ 749 $ 847 $ 738 Interest cost on projected benefit obligation 2,128 2,038 1,963 Actual return on assets (4,272) (1,877) (7,652) Net amortization and deferral 339 (2,051) 4,203 Net pension cost $(1,056) $(1,043) $( 748) Assumptions used in the accounting were: 1993 1992 1991 Discount rate 7.5% 8.0% 7.0% Rate of increase in future compensation levels 4.0% 4.0% 4.0% Long-term rate of return 8.0% 8.0% 8.0% The following table sets forth the Plan's funded status and the related amounts recognized in the Company's balance sheet at December 31, 1993, 1992, and 1991. 1993 1992 1991 (In thousands) - ----------------------------------------------------------------------- Actuarial present value of projected benefit obligation, based on employment service to date and current salary levels: Vested benefits $(27,501) $(25,076) $(26,886) Nonvested benefits (494) (426) (398) Accumulated benefit obligation (27,995) (25,502) (27,284) Additional amounts related to projected salary increases (2,219) (2,228) (2,437) Projected benefit obligation (30,214) (27,730) (29,721) Plan assets at fair value; primarily U.S. Government and corporate bonds and equity securities 42,733 40,339 40,187 Plan assets in excess of projected benefit obligation 12,519 12,609 10,466 Unrecognized net loss/(gain) from past experience different from that assumed (245) (256) 1,979 Unrecognized net asset at January 1, 1986, being recognized principally over 8.5 years (568) (1,703) (2,838) Prepaid pension $ 11,706 $10,650 $ 9,607 In February 1991, the Company made changes to its retirement plan which had the effect of increasing net pension cost $1,121,000 in 1991. 8. Income Taxes The Company adopted Statement of Financial Accounting Standards No. 109 "Accounting for Income Taxes" effective January 1, 1992. There was no effect on 1992 or prior years' net income due to this change in accounting. Tax expense (benefit): 1993 1992 1991 (In thousands) - --------------------------------------------------------------------------- Federal: Current $1,310 $2,127 $ (189) Deferred 436 24 (224) State: Current 239 363 (27) Deferred 11 4 (38) Total $1,996 $2,518 $ (478) The components of the net deferred tax liability are: 1993 1992 1991 (In thousands) Current deferred (assets) Accounts receivable $ (365) $ (830) $ (826) Inventory (875) (1,004) (999) Accrued vacation (523) (509) (490) Total net current deferred (asset) (1,763) (2,343) (2,315) Noncurrent deferred (assets) liabilities Property and equipment 4,706 4,900 5,243 Pension asset 4,405 4,007 3,615 Postretirement benefit liability (206) - - Other (501) (108) (115) Total net noncurrent deferred liability 8,404 8,799 8,743 Net deferred liability $6,641 $6,456 $6,428 The reasons for the difference between total tax expense (benefit) and the amount computed by applying the statutory federal income tax rate to income (loss) before income taxes are as follows: 1993 1992 1991 (In thousands) Statutory rate applied to pretax income $1,799 $2,248 $ (409) State income taxes, net of federal tax benefit 158 240 (36) Other 39 30 (33) Total tax expense (benefit) $1,996 $2,518 $ (478) 9. Postemployment Benefits In November 1992, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits." The Statement was adopted on January 1, 1994. This Statement is not material to the Company's financial condition or results of operations. 10. Lease Commitments The Company leases various assets used in its business, notably some of the warehouse and office facilities and equipment. These leases have varying expiration dates and often include renewal and purchase options. Certain leases require the Company to pay escalations in cost over base amounts for taxes, insurance, or other operating expenses incurred by lessor. Rental expense under operating leases for 1993, 1992, and 1991 was $792,000, $764,000, and $631,000, respectively. Minimum payments due for years after 1993 under noncancelable operating leases are $550,000 in 1994, $251,000 in 1995, $186,000 in 1996, $61,000 in 1997 and $94,000 thereafter. 11. Concentration of Credit Risk The Company sells its products to all major areas of construction and manufacturing markets throughout the Southern United States. When the Company grants credit, it is primarily to customers whose ability to pay is dependent upon the construction and manufacturing industry economics prevailing in the Southern United States; however, concentrations of credit risk with respect to trade accounts receivable are limited due to the large number of customers comprising the Company's customer base. The Company performs ongoing credit evaluations of its customers and in certain situations requires collateral. The Company maintains reserves for potential credit losses, and such losses have been within management's expectations. 12. Contingencies The Company is a defendant in various lawsuits arising in the normal course of business. In the opinion of management, the outcome of these lawsuits will not have a material adverse effect on the Company's financial position.

865937_1993.txt

865937_1993

1993

865937

ITEM 3. LEGAL PROCEEDINGS Catellus, its subsidiaries and other related companies are named defendants in several lawsuits arising from normal business activities, are named parties in certain governmental proceedings (including environmental actions) and are the subject of various environmental remediation orders of local governmental agencies arising in the ordinary course of its business. The matters described below may involve substantial claims for damages. While the outcome of these lawsuits or other proceedings against the Company and the cost of compliance with any governmental order cannot be predicted with certainty, management does not expect any of these matters to have a material adverse effect on the business or financial condition of the Company. Reference is made to Items 1 and 2 above for additional information on environmental matters, which information is incorporated herein by reference. CITY OF RICHMOND, ET AL. V. UNITED STATES OF AMERICA, ET AL. (United States District Court, Northern District of California; filed August 1989) is an action brought by the City of Richmond and Richmond Redevelopment Agency (collectively, "Richmond") and various developers against the Company and others, claiming that property, formerly Richmond Shipyard Number 2, purchased by Richmond in 1977 from the Company's predecessor, Santa Fe Land Improvement Company ("SFLI"), is contaminated. The United States and United States Maritime Administration are also named defendants. By third-party complaint, the Company has sued Kaiser Aluminum and Chemical Corporation ("Kaiser") and James L. Ferry & Son, Inc. ("Ferry") for indemnity. The plaintiffs seek damages exceeding $48.6 million for environmental response costs, natural resources damages and declaratory relief under the Comprehensive Environmental Response, Compensation, and Liability Act of 1980, as amended ("CERCLA"), compensatory damages under state law theories of negligence and strict liability, compensatory and punitive damages for alleged fraudulent concealment and indemnity, and also seek declaratory relief. The plaintiffs estimate that their environmental response costs will total approximately $16 million. Evidence to date indicates that the contamination at the property was the result of World War II shipbuilding operations by Kaiser between approxi- mately 1941 and 1945. As the owner of the property at that time, the Company is a potential responsible party ("PRP") under CERCLA, as is Kaiser, the tenant and operator on the property. The United States also may be considered a PRP inasmuch as Kaiser's wartime operations on the property were apparently controlled by the government. Richmond and the plaintiff developers are PRPs because they currently own and operate the property, and Ferry, a Richmond dredging contractor, may be considered a PRP because it was responsible for spreading contaminated soils on the site. The Company has substantial defenses to state common law claims, including the fraudulent concealment claim, and also believes that it has substantial contribution and indemnity claims against Kaiser and Ferry. The California Environmental Protection Agency's Department of Toxic Substances Control has issued a remedial action plan regarding the clean-up activities at this property. The plan contains a preliminary non-binding allocation of responsibility allocating an 11 percent share to the Company. Plaintiffs recently reached a settlement agreement in principle with the United States. The terms of the settlement have not been disclosed. Settlement discussions between plaintiffs and the Company have occurred over a period of more than one year and are expected to resume after terms of the settlement with the United States have been revealed. The Company estimates that it will recoup all or some portion of its costs and damages through its contribution and indemnity claims. However, it is not possible now to predict reliably the amount of the Company's recovery. The Company tendered defense of this action to its insurer, Employers Casualty Insurance Company (Employers). On November 16, 1993, Employers filed a declaratory relief action in Contra Costa Superior Court against the Company, seeking a declaration that it has no duty to defend or indemnify with respect to the contamination at issue. The Company removed the action to federal court and filed a counterclaim and motion for summary judgment on December 20, 1993. Subsequently, Employers placed $1.3 million into escrow, the approximate amount of the Company's claimed past defense costs, some or all of which may be paid to the Company. On January 6, 1994, Employers was placed into receivership. The Company, Employers and its receiver entered into a settlement agreement pursuant to which the Company will receive $300,000 of the escrow fund and the receiver and Employers stipulate that the Company has a valid claim for an additional $700,000 for past defense costs against Employers' assets in the receivership. The agreement is subject to receivership court approval. The Company does not know the extent of other claims which will be made against the assets in receivership or the extent of the assets which will be available to satisfy such claims. Therefore, the Company does not know how much, if any, of the $700,000 or future defense costs will be paid out of the assets in receivership. THE ATCHISON, TOPEKA & SANTA FE RAILWAY CO. V. THE TESTATE AND INTESTATE SUCCESSORS OF GRACE RICHARDS, ET AL. (Superior Court of California, County of San Diego; filed May 1983) and HERBERT LINCOLN HUBBARD, ET AL. V. THE ATCHISON, TOPEKA & SANTA FE RAILWAY COMPANY, SANTA FE LAND IMPROVEMENT COMPANY, ET AL. (Superior Court of California, County of San Diego; filed January 1988) are consolidated cases in which both the Company and the litigants claim title to a 550 foot by 75 foot strip of property located on and along the Santa Fe Depot site in downtown San Diego. The opposing litigants also seek damages for alleged fraud, interference with prospective economic advantage, and inverse condemnation. The trial court ruled that the Company and some of the opposing litigants each own an undivided one-half fee interest in the property, subject to a perpetual railroad easement in favor of The Atchison, Topeka & Santa Fe Railway Company. The trial court also rejected all of the opposing litigants' damage claims. The Company has appealed the portion of the trial court's judgment granting the opposing litigants a one-half undivided fee interest in the property and the opposing litigants have appealed all other aspects of the judgment. The cases are awaiting oral argument before the California Court of Appeal. GRUBB & ELLIS REALTY INCOME TRUST, LIQUIDATING TRUST V. CATELLUS DEVELOPMENT CORPORATION, ET AL. (United States District Court, Northern District of California; filed February 1993) is an action brought by Grubb & Ellis Realty Income Trust, Liquidating Trust ("Grubb & Ellis"), against the Company, among others, to recover the costs of environmental investigation and cleanup and other compensatory damages at the Livermore Arcade Shopping Center located in Northern California. Grubb & Ellis, the current owner of the site, claims that perchlorethylene (PCE) was released to soil and groundwater from a leaking sewer pipe carrying discharge from the operations of a dry cleaning establishment, whose tenancy at the shopping center includes a period when the property was owned by a predecessor of the Company. In February 1994, the Company reached a settlement with plaintiffs and all of the other defendants in this action pursuant to which the Company will pay $67,650 into a fund to cover certain past and future remediation costs in exchange for a qualified release of liability. KHACHATURIAN V. CATELLUS DEVELOPMENT CORPORATION, ET AL. (Superior Court of California, County of Alameda; filed April 1991) is an action by an auto dealer who contracted to purchase land from the Company in an auto mall in Fremont, California, in June 1990. The complaint alleged the Company had reneged on an oral agreement to pay the plaintiff a 3% commission on each land transaction in the auto mall, and stated breach of contract, fraud, false promise, bad faith denial of contract, and quantum meruit causes of action. The Company asserted, among other things, that no such agreement existed and that it denied plaintiff's claim in good faith and with probable cause. In November 1993, a jury found for plaintiff on his breach of contract and bad faith denial claims, awarding him $441,780.87 in damages and $7.6 million in punitive damages. The Company believes these verdicts are not supported by the evidence or the law, and that numerous errors at trial substantially prejudiced it. The Company filed its notice of appeal on February 3, 1994. TRUCK INSURANCE EXCHANGE V. CITY OF ONTARIO, ET AL. (Superior Court of California, San Bernardino County, Case No. RCY050056) involves a subrogation claim by insurance companies for the Ontario Auto Center dealerships against adjacent property owners, including the Company, for damages of approximately $4.5 million caused by sand blowing onto auto dealers' properties. As described above, the Company's insurer in this matter, Employers, has filed for receivership. At this time, the Company is unable to ascertain what impact, if any, the receivership will have upon the Company's coverage for indemnification and defense costs in this matter. 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 quarter ended December 31, 1993. EXECUTIVE OFFICERS OF THE COMPANY - --------------------------------- The following persons are the executive officers of Catellus. NAME AGE POSITION - ---- --- -------- Vernon B. Schwartz 43 Chairman, President and Chief Executive Officer James G. O'Gara 44 Senior Vice President David A. Smith 49 Senior Vice President and Chief Financial Officer James W. Augustino 45 Vice President Development J. Todd Bender 37 Vice President Development Faye A. Beverett 36 Vice President Financial Planning and Analysis Mary Burczyk 40 Vice President Corporate Communications Thomas W. Gille 45 Vice President Asset Management Daniel M. Gonzales 48 Vice President Human Resources and Administration John W. Greer 38 Vice President Development Jeffrey K. Gwin 55 Vice President Development William C. Matheson 41 Vice President Sales and Land Management Douglas B. Stimpson 37 Vice President Finance Maureen Sullivan 39 Vice President Law, General Counsel and Secretary Theodore L. Tanner 46 Vice President Development David M. Perna 41 Controller Additional information concerning the business background of each executive officer of Catellus is set forth below: Mr. Schwartz has served as President and Chief Executive Officer and a Director of Catellus since April 1989, and as Chairman since December 1989. Prior to joining Catellus, Mr. Schwartz served for eight years as the Executive Vice President and Chief Operating Officer of The Hahn Company, a major real estate developer. Mr. Schwartz has resigned from the Company effective June 30, 1994. The Board of Directors has undertaken a search for his successor. Mr. O'Gara was elected Senior Vice President in September 1992. He had served as Senior Vice President Development from December 1989 and Vice President Special Real Estate Projects of Catellus from 1984. Mr. Smith was elected Senior Vice President and Chief Financial Officer in March 1993. From November 1990 to March 1993, he was Vice President and Chief Financial Officer. Mr. Smith served as Vice President Finance from November 1989 to November 1990. Prior to that, he was Assistant Vice President Finance and Director of Finance for SFP. Mr. Augustino was elected Vice President Development in February 1990. For more than five years prior to such time, he served as Project Director and Assistant Vice President Special Projects of Catellus. Mr. Bender was elected Vice President Development in April 1990. Mr. Bender joined Catellus as Director of Development in July 1989. For more than five years prior to such time, he served as Vice President Development of Fifield Development Corporation, a Chicago-based real estate development firm. Ms. Beverett was elected Vice President Financial Planning and Analysis in February 1994. From April 1990 through January 1994, Ms. Beverett served as Director of Financial Analysis. For four years prior to that, she was a manager in the real estate consulting division of Deloitte, Haskins, & Sells in San Francisco. Ms. Burczyk was elected Vice President Corporate Communications in March 1990. From 1986 through March 1990, she was Senior Vice President of OLC Corporation, a Chicago-based investor relations consulting firm. Mr. Gille was elected Vice President Asset Management in April 1990. For more than five years prior to such time, he was Senior Vice President of Hogland, Bogart and Bertero, a commercial property management and consulting firm in San Francisco. Mr. Gonzales was elected Vice President Human Resources and Administration in April 1990. Mr. Gonzales served as Catellus' Director of Administration & Human Resources from May 1988 and its Director of Human Resources from September 1984. Mr. Greer was elected Vice President Development in February 1994. From January 1990 through January 1994, Mr. Greer served as Director of Development of Catellus. Prior to joining Catellus, he was Development Partner in the Industrial Division of Lincoln Properties, a real-estate development firm in Foster City, California. Mr. Gwin was elected Vice President Development in June 1988. From January 1985 through May 1988, Mr. Gwin served as a Regional Director of Catellus. Mr. Matheson was elected Vice President Sales and Land Management in April 1990. Mr. Matheson served as Catellus' Director of Sales & Land Management from July 1989; Regional Manager, Property Sales from November 1986; and Director of Outlying Lands from January 1985. Mr. Stimpson was elected Vice President Finance in February 1992. Mr. Stimpson served as Assistant Vice President Finance from February 1990; Director of Finance and Planning from June 1988; and Director of Planning from February 1986. Ms. Sullivan was elected Vice President Law, General Counsel and Secretary in March 1990. For five years prior to that, Ms. Sullivan was a partner in the real estate department of the law firm of Brobeck, Phleger and Harrison. Mr. Tanner was elected Vice President Development in February 1992. Mr. Tanner served as Director of Development from September 1989 to February 1992. From March 1988 through August 1989, he was Vice President of Cal Fed Enterprises, a real estate subsidiary of Cal Fed, Inc. Mr. Tanner served as Regional Project Manager of Catellus from February 1986 through March 1988. Mr. Perna joined Catellus as Controller in March 1990. He had served as Director of Internal Audit for SFP from 1988 to 1990, and as Audit Manager for SFP from 1985 to 1988. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The common stock commenced trading on December 5, 1990 and is traded on the New York Stock Exchange, the Midwest Stock Exchange and the Pacific Stock Exchange under the symbol "CDX." The following table sets forth the high and low sale prices of the common stock, as reported on the New York Stock Exchange Composite Tape, during the periods indicated. No cash dividends were paid in 1993 or 1992 on the Company's common stock and the Company does not anticipate paying any cash dividends on its common stock in the foreseeable future. At March 1, 1994, there were approximately 64,995 holders of record of common stock. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA (IN THOUSANDS, EXCEPT PER SHARE DATA) The following selected income statement and balance sheet data with respect to each of the years in the five-year period ended December 31, 1993 have been derived from the annual Consolidated Financial Statements. The operating and cash flow data have been derived from the Company's underlying financial and management records and are unaudited. This information should be read in conjunction with the Consolidated Financial Statements and related Notes thereto. See "Management's Discussion and Analysis of Financial Condition and Results of Operations" for a discussion of results of operations for 1993, 1992 and 1991. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS LIQUIDITY AND CAPITAL RESOURCES COMPANY STRATEGIES The Company's operations are guided by two key strategies: converting its land portfolio into operating properties and cash and creating maximum cash flow from the Company's existing income properties. A major advantage in pursuing these strategies is that a significant portion of the Company's undeveloped land is unleveraged and a significant portion of its developable holdings are fully entitled. This provides considerable flexibility in the timing of development activities. Catellus has limited its speculative development, focusing instead on built-to-suit opportunities. In 1991, 90% of all construction starts were build- to-suit, reaching 100% in 1992 and 1993. While Catellus expects the focus on build-to-suit to continue for the near term, it could return to speculative development if the market conditions warrant. In 1992, Catellus also began to pursue "build-to-sell" opportunities with building users or pre-arranged investors. These arrangements allow the Company to monetize the value of the land and receive a development fee. Property sales have consisted principally of surplus properties, and have also included selected income producing and developable properties. The level of sales and revenue generated by these sales fluctuates from period to period and cannot be predicted with certainty. Due to the lack of demand caused by a weak real estate market in California and the difficulty in obtaining financing for land acquisitions, land sales have declined over the past three years. Over that period, the Company has increased its sales of income producing properties and developable land. Income producing properties are often subject to debt, and the sale of such properties therefore generates relatively low cash flow because of the required debt paydowns. Overall, property sales represent a key element of the Company's cash flow, and provide flexibility necessary to respond to continued tightness in credit markets and the increased equity required in financings. The Company currently expects property sales of $50 million to $100 million for 1994; actual sales will depend on prevailing market conditions and the Company's anticipated level of capital expenditures. Any significant decrease in the sales level or cash flow generated by sales could impact the Company's ability to meet its obligations for fixed charges, capital expenditures and preferred stock dividends. Cash flow from operations is used to support income producing proper- ties, including improvements to these properties which are not financed. It also supports corporate activities and pre-development work. Catellus' financial strategy is to increase operating cash flow so that, combined with the proceeds from the sale of income producing properties, it will continue to cover all operating activities and unfinanced investing activities. The Company's objective is for future cash flow to also cover the equity required for construction and long-term financing. Development activities require significant investments of capital. In 1993, 1992 and 1991, the Company's capital expenditures for developable and income producing properties were $61.1 million, $87.9 million and $150.7 million. This capital comes from various sources, including funds provided by operating properties, financing activities, build-to-sell projects and property sales. Funds generated by operating properties, excluding property sales, have increased each year since 1991 as the Company has developed properties and increased its total leased square footage. Although credit markets have tightened increasingly over the past few years, and the Company must now contribute more cash equity for new development and refinancings, Catellus has been able to finance its requirements at reasonable terms. In response to the changing real estate markets, the Company has been reducing capital expenditures, generally limiting development projects to build-to-suit and build-to-sell projects, and providing funding for pre-devel- opment of selected long-term mixed-use projects. The Company believes that capital spending could be reduced further if, for a limited period of time, Catellus were unable to generate sufficient funds from property sales to cover planned expenditures. COMPARISON OF 1993, 1992 AND 1991 Cash provided by operating activities decreased $26.4 million from 1991 to 1993. The key factors in the decline were an overall decrease in net cash from surplus property sales, offset in part by an overall improvement in operating results of the Company's rental operations. Net cash from sales of land was $18.9 million, $48.1 million and $55.9 million in 1993, 1992 and 1991. These amounts do not reflect the net proceeds from the sale of income producing properties (including joint ventures) totalling $45 million and $30.7 million in 1993 and 1992. The increase in cash from rental operations is due principally to higher occupancy, as well as slightly higher average rental rates, from existing buildings. Although average rental rates are higher because of scheduled rent increases, rates on releasing and to new tenants are lower than existing rates. Although it is difficult to make meaningful direct comparisons of portfolio-wide rental rates because of the numerous factors affecting rates, including the term of each lease, rental concessions, size of space and the disparity among the Company's various markets, rental rates in 1993 for renewal leases and new tenants in existing industrial buildings were generally 10% to 15% below the final rate on the former lease for the same space. At December 31, 1993, the Company's total building portfolio was 93.6% leased compared to 90.9% and 85.1% at December 31, 1992 and 1991. For the four years from 1994 through 1997, leases for 11.1%, 11.1%, 18.1%, and 10.8% of total square footage is scheduled to expire. Net cash used for investing activities was $15 million, $55.6 million and $150.4 million in 1993, 1992 and 1991. The decrease in 1993 results from a $26.8 million reduction in capital expenditures and a $14.3 million increase in the net proceeds from the sale of income producing properties. The decrease in 1992 reflects both a $62.8 million decrease in capital expenditures and net proceeds from the sale of income producing properties and a joint venture interest of $30.7 million. In 1993, the Company invested $61.1 million to develop its land and improve its income producing properties. These funds were used for building construction and improvements, as well as entitlement efforts and pre-constru- ction activities. They were financed through borrowings from revolving construction facilities, property sales, funds generated from operations and cash on hand. During 1993, the Company completed 392,000 square feet for two build-to-suit projects that were 100% pre-leased and an additional 151,000 square feet that was built for and sold to users. In addition, the Company had under construction an additional 577,000 square feet which is 92.6% pre-leased. Net cash provided by financing activities was $120.2 million, $7.7 million and $100.9 million in 1993, 1992 and 1991, respectively. The 1993 amounts reflect principally the net proceeds from the Series A and B preferred stock offerings. These amounts also reflect the use of a portion of those proceeds to repay debt, to purchase investments held for future repayment of the $388.2 million mortgage loan with The Prudential Insurance Company of America (Prudential), and to pay dividends on the Series A preferred stock. In 1993, the Company renewed an unsecured revolving facility as a two-year $75 million unsecured revolving facility and a three-year $46 million unsecured term facility. The Company also renewed its construction facility for a one-year revolving period, with maximum borrowings at any time of $75.5 million. The Company also obtained a separate two-year $25.4 million con- struction facility for the East Baybridge Center project. CONVERSION OF DEBENTURE AND ISSUANCE OF SERIES A AND SERIES B PREFERRED STOCK During 1993, the Company completed a major restructuring of its debt with Bay Area Real Estate Investment Associates L.P. (BAREIA). On February 11, 1993, BAREIA converted a convertible debenture (accreted value of $111.4 million) into common stock with a value of $141 million. Concurrently with the conversion, the Company issued 3,449,999 shares of Series A preferred stock for $172.5 million. BAREIA purchased 40.7% of the Series A preferred stock sold, the same percentage as its common stock ownership. The net proceeds of the Series A preferred stock issuance were approximately $164.4 million. These proceeds were used to repay $69 million of an unsecured revolving credit facility and to invest $50 million in securities which were held for the benefit of The Prudential Insurance Company of America (Prudential) and committed to the paydown and refinancing of the Company's $388.2 million loan with Prudential. The balance of the proceeds were invested in short-term marketable securities until February 1994 when the refinancing of this loan with Prudential was completed. On November 4, 1993, the Company completed a private placement of 3,000,000 shares of Series B preferred stock for $150 million. The net proceeds of $143.5 million were used to repay $24 million of an unsecured term facility, with the remainder to be used to repay debt that matures from 1994 through 1997, and for general corporate purposes. The conversion of the debenture and the application of the net proceeds of the preferred stock issuances significantly reduced the Company's debt. The Company believes that the increased equity provided by the conversion of the debenture and the issuance of the Series A and Series B preferred stock will significantly increase its financial flexibility. At December 31, 1993, cash and cash equivalents totalled $146.6 million and restricted cash totalled $67.4 million. Assuming the refinancing and paydown of the Prudential loans, as described below, cash and cash equivalents at December 31, 1993 would have totalled $85.8 million. In addition, the Company had available $69.3 million under its working capital facility, $68.5 million under its construction facilities, and $1.9 million under its intermediate term loan facilities. REFINANCING OF PRUDENTIAL MORTGAGE LOAN On February 18, 1994, the Company refinanced its $388.2 million mortgage loan with Prudential with a $280 million mortgage loan due March 1, 2004 and bearing an average interest rate of 8.71%. The new loan reflects a paydown of $108.2 million, of which $81 million was required to meet current loan underwriting standards and $27.2 million was paid to release selected properties from the loan. In connection with this refinancing, the Company also paid down $10 million of another mortgage loan with Prudential due January 1, 1996, and incurred an extraordinary expense of $11.9 million ($7.4 million, net of income tax benefits). This extraordinary expense consisted of a redemption premium paid to Prudential and the write-off of deferred financing costs associated with the $388.2 million loan. COMPARISON OF 1993 TO 1992 The Company had a 1993 net loss of $52.8 million, after non-recurring expenses, property write-downs and extraordinary expense. The 1993 net loss per share was $.97 after preferred stock dividends of $16.1 million. This compares to net income of $1.2 million or $.02 per share in 1992. Before non-recurring expenses, property write-downs and extraordinary expense, the Company had 1993 net income of $7.7 million after tax, or a net loss of $.12 per share (after preferred stock dividends of $16.1 million). This compares to net income of $1.2 million, or $.02 per share, in 1992. Income before taxes was $17 million (before the non-recurring expenses, property write- downs and extraordinary expense) in 1993 compared to $2.4 million in 1992. The significant improvement in 1993 operating performance is due to a combination of factors. Income from operating properties increased, interest income increased from investments of the cash proceeds from equity offerings, and interest expense decreased from conversion of the Debenture and repayment of debt. This was partially offset by lower gross profit from property sales. Net income for 1993 also reflects a $3 million charge for income taxes related to the 1993 increase in the federal corporate tax rate. The decrease in gross profit from property sales resulted from a combination of lower sales and higher cost basis in properties sold. Property sales in 1993 included $46.9 million from sales of income producing properties, which generated gross profit of $23 million. For 1992, gross profit included $14.9 million from the sale of income producing properties and a $6.4 million loss on the sale of a joint venture interest. The income producing properties were sold in 1993 in conjunction with the Company's build-to-sell activities and the Prudential refinancing. The Prudential refinancing allowed the Company to sell certain buildings and ground leases which were subject to the mortgage, without paying a prepayment penalty. Land sales have decreased since 1992 because of a lack of demand caused by a weak real estate market in California and the limited financing available for land acquisitions. Property sales and related gross profit will continue to fluctuate from period to period. This fluctuation results from both changing market conditions and the Company's approach to selling property when it can obtain attractive prices. The factors in the decision to sell property include the attractiveness of the price, the property's future value potential and, in the case of income producing properties, the loss of rental revenue. Cost of sales may also vary widely because it is determined by the Company's historical cost basis in the underlying land sold. Income from operating properties increased 18% due to higher rental revenue coupled with only a slight increase in operating expenses. Nearly 85% of the growth in rental revenue came from existing properties, with the remainder coming from rents from buildings completed over the past twelve months. Over 80% of the increase in rental revenue from existing buildings was the result of higher occupancy and the remainder from higher rental rates. The increase in rental rates is from automatic rental increases, offset in part by decreases in rates for renewal leases and new tenants. The increase in taxes other than income resulted primarily from increases in property taxes from completed buildings and improvements, coupled with a reduction of property taxes in 1992 due to a reassessment of the Chicago Railway Exchange office building. The increase in interest income resulted from the investment of the net proceeds of the Series A and Series B preferred stock issuances. The increase in equity in earnings of joint ventures in 1993 was caused primarily by the suspension in recording losses incurred by Pacific Design Center. The suspension of losses began when the Company's interest in cumulative losses of that joint venture exceeded its interest in cumulative earnings. The equity in earnings of joint ventures was also affected by the 1992 sale of the Company's interest in a joint venture in a San Francisco office building. The Company's other joint ventures, as a group, are performing well and showed an overall improvement in operating results compared to 1992. Other revenue was lower than 1992 mainly due to the receipt of a non-refundable option deposit and an arbitration settlement in 1992. This was partially offset by increased revenue from early lease terminations and developers' fees earned in 1993. Interest expense decreased as a result of the conversion of the Debenture as well as paydowns on the working capital facility. This decrease, however, was partially offset by borrowings on intermediate secured term loans and by reduced capitalized interest due mainly to decreased construction activity. In 1993, the Company recorded a $32.5 million ($19.5 million net of income tax benefits) write-down of certain properties where carrying costs exceeded estimated net realizable value. As required by SFAS No. 109, the Company increased its tax expense and related deferred tax liability by $3 million during the third quarter of 1993 as a result of legislation enacted on August 10, 1993 increasing the federal corporate tax rate from 34% to 35% effective January 1, 1993. Excluding this, tax expense before the extraordinary item decreased $12.2 million due to lower pre-tax income ($21.2 million), offset by charges attributable to the conversion of the Debenture ($9 million). COMPARISON OF 1992 TO 1991 The Company had 1992 net income of $1.2 million, or $.02 per share, compared to $5 million, or $.09 per share, in 1991. Income before taxes was $2.4 million in 1992 compared to $8.3 million in 1991. The declines in 1992 were due to increases in interest and depreciation expenses and lower income from property sales. These increases were only partially offset by higher income from operating properties. The decrease in gross profit from property sales was due to an overall increase in the cost basis of properties sold in 1992 and a $6.4 million loss on the sale of a joint venture interest. The loss resulted from a decline in the value of the office building held by the venture and the Company's high cost basis in the interest sold. In addition to the joint venture sale, property sales in 1992 included $18.5 million from the sale of income producing properties which generated gross profit of $14.9 million, the sale of land and easements to the Southern California Rapid Transit District, and a number of smaller transactions, including the recognition of previously deferred revenue from installment sales. As described above, property sales and cost of sales will fluctuate from period to period. Income from operating properties increased 29% due to higher rental revenue, offset slightly by a marginal increase in operating expenses. Higher rental revenue from existing buildings contributed two-thirds of this increase, with the remainder from rents on buildings completed during 1992. Almost 60% of the increase in rental revenue from existing buildings was the result of higher occupancy. The rest came from higher rental rates. The increase in rental rates in existing buildings resulted from automatic increases in leases, offset in part by decreases in rates for renewal leases and new tenants. The increase in taxes other than income resulted principally from supplemental property tax billings for improvements on certain Southern California properties and for properties acquired in 1991 through a land exchange program with The Atchison, Topeka and Santa Fe Railway Company. These increases were partially offset by the reduction in property taxes due to a reassessment of an office building the Company owns in Chicago. Equity in losses of joint ventures increased due principally to higher losses from the Pacific Design Center. The Company's other joint ventures, as a group, performed well and had improved operating results compared to 1991. A reduction in general and administrative expenses resulted mainly from staff reductions and lower cost of outside professional services. The increased depreciation expense is due to buildings placed in service during 1992 and new tenant improvements in existing buildings. Interest expense increased as a result of lower interest capitalized due to reduced capital expenditures and compounding interest on the Debenture and new borrowings. Income tax expense decreased $2.1 million in 1992 primarily as a result of lower pre-tax income. INCOME TAXES The Company 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 1989. Adoption of SFAS No. 109 required no adjustment to the Company's balance sheet or statement of income. At December 31, 1993, the Company had gross deferred tax assets total- ling $83 million. This included $20 million relating to net operating loss carryforwards (NOLs) of $21.3 million, $16.9 million and $13.3 million, which expire in 2006, 2007 and 2008, respectively. The Company's other deferred tax assets of $63 million relate primarily to differences between book and tax basis of properties. These deferred tax assets are not subject to expiration and will be realized at the time of taxable dispositions of the properties. Deferred tax liabilities in excess of deferred tax assets are often associated with the same property, with the result that the deferred tax asset will be realized in a taxable disposition, without regard to other taxable income. The Company believes it is more likely than not that it will realize the benefit of its deferred tax assets, and that no valuation allowance is required. In making this determination, the Company considered: the nature of its deferred tax assets (and liabilities); the amounts and expiration dates of its NOLs; the historical levels of taxable income; the significant unrealized appreciation of its properties, including surplus properties likely to be sold during the NOL carryforward periods; and its ability to control the timing of property sales in order to assure that deferred tax assets will be offset by deferred tax liabilities or realized appreciation. ENVIRONMENTAL MATTERS Many of the Company's properties are in urban and industrial areas, and many properties may have been leased to commercial or industrial tenants who may have discharged hazardous materials. From 1991 to 1993, expensed and capitalized environmental costs, including legal fees, totalled $19.4 million. The Company expects to spend $5.9 million for environmental investigation and remediation costs in 1994, including related legal costs. The Company's environmental remediation costs are expected to increase as the Company develops its major mixed-use projects. While the Company or outside consultants have evaluated the environmental liabilities associated with most of the Company's properties, any evaluation necessarily is based on the prevailing law and identified site conditions at that time. Although the Company closely monitors its environmental costs, the size of the portfolio precludes extensive review of every property on a regular basis. Since the Company generally takes properties from an undeveloped to developed state, it may be obligated to achieve compliance with environmental laws only as they apply to the undeveloped property. Further remediation would only be required if the property were to be developed. The property would not be developed unless the scope and potential value justified the clean-up costs. Environmental costs incurred in connection with income producing properties and properties previously sold are expensed. Costs relating to undeveloped properties are capitalized as part of development costs. At December 31, 1993, the Company's estimate of its potential liability for identified environmental costs ranged from $2 million to $24 million for properties where costs would be charged to operations. These costs are expected to be incurred over an estimated ten-year period, with a substantial portion incurred over the next five years. At December 31, 1993, the Company's estimate of its potential liability for identified environmental costs relating to developable properties ranged from $18 million to $63 million. These costs generally will be capitalized as they are incurred, over the course of the estimated development period of approximately 20 years. The Company maintains a reserve for the known, probable costs of environmental remediation to be incurred in connection with income producing properties and properties previously sold. Although an unexpected event could have a material impact on the results of operations for any period, the Company does not believe that such costs for identified liabilities will have a material adverse effect on its financial condition. See Note 4 to the Consolidated Financial Statements. SUPPLEMENTAL CURRENT VALUE Since management believes that the current value of its properties is an important financial measure, the Company annually provides a current value balance sheet. Presented in addition to historical cost financial statements, the Company believes current value provides meaningful information regarding the financial condition and the value of its properties in today's real estate market. Current value does not contemplate liquidation or a distressed sale of the Company's assets. It is a measure of the value in the intended use of the property. It is determined through analyzing the economy, market trends and operating results affecting each property, direct sales comparisons and discussions with knowledgeable independent real estate professionals. Therefore, aggregate current value of the Company's assets will reflect increases and declines in the value of the Company's portfolio, which are not reflected in historical cost accounting. Management determines the valuation methods used to develop the current value balance sheets. These methods, as well as other relevant information, are discussed in Note 2 to the Consolidated Financial Statements. At December 31, 1993, stockholders' equity on a current value basis was $1 billion or $9.31 per share, compared to $964 million or $14.52 per share at December 31, 1992, after giving effect in each year to the 1993 conversion of the convertible debenture and the issuance of Series A and B preferred stock. Also assuming conversion of all Series A and B preferred stock in each year, at their respective $9.06 and $9.80 conversion prices, stockholders' equity per share on a current value basis would have been $9.34 and $12.88 at December 31, 1993 and 1992. At December 31, 1993, the current value of the Company's real estate assets was $1.7 billion, compared to $2.1 billion and $2.5 billion in 1992 and 1991. These represent declines of $411.6 million (19.4%) and $364.6 million (14.7%) in 1993 and 1992. Both the 1993 and 1992 declines were largely the result of a general decline in real estate values, particularly with respect to land held for development. The table below identifies the components of the change in current value, by property type, from December 31, 1992 to December 31, 1993: VALUE CHANGE BY COMPONENT AND PROPERTY TYPE (IN MILLIONS) The value of the developable portfolio declined 20.5% overall in 1993. The portfolio declined 19.5% solely as the result of market conditions caused by decreased demand for new real estate product. Continued poor economic conditions in the western United States has further reduced demand for new commercial real estate. This lack of demand has depressed rental rates for new development and in turn, resulted in falling land values in most markets. The value of income producing properties decreased 17.2% overall, again due to a general decline in real estate values. Approximately 11.5% of the decline was market related, after adjusting for sales, exchanges and trans- fers. This decline in value was caused principally by a general decline in the economy which reduced rents and increased investor yield requirements. Two other factors which affected value were sales of certain ground leases and buildings, offset by transfers of completed buildings from the developable portfolio. The value of surplus developable properties decreased 38%, of which 32.9% was market related, after adjusting for sales, exchanges and transfers. The value of agricultural and other properties declined 7.7%, of which 2% was related to current market conditions only, with the remaining decline due to sales and exchanges. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The financial statements and schedules required under Regulation S-X promulgated under the Securities Act of 1933 are identified in Item 14 and 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 the information relating to the executive officers of the Company set forth in Part I of this Annual Report on Form 10-K, the information required by the following items will be included in the Company's definitive Proxy Statement ("1994 Proxy Statement") which will be filed with the Securities and Exchange Commission in connection with the 1994 Annual Meeting of Stockholders. ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information in the section captioned "Election of Directors" in the 1994 Proxy Statement is incorporated herein by reference. The information in the section captioned "Compliance with Section 16(a) of the Securities Exchange Act of 1934" in the 1994 Proxy Statement is incorporated herein by reference. The information in the section captioned "Security Ownership of Certain Beneficial Owners" in the 1994 Proxy Statement is incorporated herein by reference. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The information in the sections captioned "Election of Directors-- Directors' Compensation" and "Compensation of Executive Officers" included in the 1994 Proxy Statement is incorporated herein by reference. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information in the sections captioned "Security Ownership of Directors and Officers" and "Security Ownership of Certain Beneficial Owners" in the 1994 Proxy Statement are incorporated herein by reference. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information in the section captioned "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) FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES See Index to Financial Statements and Financial Statement Schedules at herein. All other Schedules are omitted because they are not applicable or the required information is shown in the financial statements or notes thereto. (a)(3) EXHIBITS Exhibit No. - ------- 3.1 Form of Restated Certificate of Incorporation of the Registrant (1) 3.1A Amendment to Restated Certificate of Incorporation of the Registrant * 3.3 Form of Certificate of Designations, Preferences and Rights of $3.25 Series A Cumulative Convertible Preferred Stock (2) 3.4 Form of Restated By-Laws (3) 3.5 Form of Certificate of Designations, Preferences and Rights of $3.625 Series B Cumulative Convertible Exchangeable Preferred Stock (9) 4.1 Form of stock certificate representing Common Stock (1) 4.2 13 1/2% Convertible Debenture of the Registrant due December 28, 1994 (4) 4.3 Credit Agreement dated December 17, 1988, as amended December 28, 1989, between the Registrant and The Prudential Insurance Company of America ("Prudential") (1) 4.4 Term Loan Agreement dated December 6, 1988 between Security Pacific National Bank ("Security Pacific") and the Registrant (1) 4.5 Revolving Credit Agreement dated as of December 6, 1988 between Security Pacific and the Registrant (1) 4.6 Loan Agreement dated as of December 29, 1989 between the Registrant and The Chase Manhattan Bank, N.A. ("Chase") (1) 4.7 Amended and Restated Loan Agreement dated December 31, 1990 between Chase and the Registrant (5) 4.8 Extension and Modification Agreement dated November 6, 1991 between Chase and the Registrant (6) 4.9 Form of stock certificate representing $3.75 Series A Cumulative Convertible Preferred Stock (2) 4.10 Form of stock certificate representing $3.625 Series B Cumulative Convertible Exchangeable Preferred Stock * 4.11 Loan Agreement dated as of February 16, 1994 between the Registrant and Prudential ** 10.1 Exploration Agreement and Option to Lease dated December 28, 1989 between the Registrant and Santa Fe Pacific Minerals Corporation (1) 10.2 Agreement to Exchange Real Property dated as of December 29, 1989 ("Exchange Agreement") between the Registrant and The Atchison, Topeka and Santa Fe Railway Company ("ATSF") (1) 10.2A First Amendment to Exchange Agreement dated December 4, 1990 between the Registrant and ATSF (5) 10.3 Long-Term Stockholders Agreement dated as of December 29, 1989 among the Registrant, Bay Area Real Estate Investment Associates L.P. ("BAREIA"), Olympia & York SF Holdings Corporation ("O&Y") and Itel Corporation ("Itel") (1) 10.4 Registration Rights Agreement dated as of December 29, 1989 among the Registrant, BAREIA, O&Y and Itel (1) 10.6 Restated Tax Allocation and Indemnity Agreement dated December 29, 1989 among the Registrant and certain of its subsidiaries and Santa Fe Pacific Corporation ("SFP") (1) Exhibit No. Exhibits - ------- -------- 10.7 State Tax Allocation and Indemnity Agreement dated December 29, 1989 among the Registrant and certain of its subsidiaries and SFP (1) 10.8 Executive Employment Agreement dated April 1, 1989 between Vernon B. Schwartz and the Registrant(4) 10.9 Registrant's Annual Performance Bonus Program (4) 10.10 Registrant's Stock Purchase Program (4) 10.11 Registrant's Profit Sharing & Savings Plan and Trust (4) 10.12 Registrant's Long-Term Incentive Compensation Program (4) 10.12A Registrant's Long-Term Incentive Compensation Program, as amended and restated effective February 27, 1992 (3) 10.13 Registrant's Incentive Stock Compensation Plan (4) 10.14 Management Agreement between ATSF and Catellus Management Corporation dated December 1, 1990 (5) 10.15 Termination, Substitution and Guarantee Agreement between ATSF and the Registrant dated December 21, 1990 (5) 10.16 Registrant's Stock Option Plan (5) 10.17 Development Agreement dated April 1, 1991 between the Registrant and the San Francisco Board of Supervisors (7) 10.18 Development Agreement dated May 9, 1983, by and between the City of San Diego and the Registrant (5) 10.19 Owner Participation Agreement dated June 16, 1983, by and between Redevelopment Agency of The City of San Diego and the Registrant (5) 10.20 Development Agreement dated October 30, 1991, by and between The Southern California Rapid Transit District and the Registrant (6) 10.21 Executive Stock Option Plan (3) 10.21A Amended and Restated Executive Stock Option Plan * 10.22 Amended and Restated Development Agreement between the City of Fremont and the Registrant effective March 19, 1992 (3) 10.22A First Amendment to Amended and Restated Development Agreement between the City of Fremont and the Registrant effective July 1, 1993 * 10.23 First Amendment to Development Agreement between the Southern California Rapid Transit District ("RTD") and the Registrant (3) 10.24 Letter Agreement dated June 30, 1992 between RTD and the Registrant (3) 10.25 Agreement dated as of January 14, 1993 between the Registrant and BAREIA (8) 10.26 Form of First Amendment to Registration Rights Agreement among the Registrant, BAREIA, O&Y and Itel(8) 10.27 Form of Stockholders Agreement among the Registrant, BAREIA, O&Y and Itel (8) 10.28 Agreement dated February 22, 1994 between Registrant and Vernon B. Schwartz * 21.1 Subsidiaries of Registrant (3) 23.1 Consent of Independent Accountants * 23.2 Consent of Independent Real Estate Appraisers * 24.1 Powers of Attorney from directors with respect to the filing of the Form 10-K * The Registrant has omitted instruments with respect to long-term debt where the total amount of the securities authorized thereunder does not exceed 10 percent of the assets of the Registrant and its subsidiaries on a consoli- dated basis. The Registrant agrees to furnish a copy of such instrument to the Commission upon request. MANAGEMENT'S CONTRACTS AND COMPENSATORY PLANS - Exhibits 10.9, 10.11, 10.12, 10.13, 10.16, 10.21A and 10.28 are current management contracts or compensatory plans. (b) Reports on Form 8-K During the quarter ended December 31, 1993, the Registrant filed a Current Report on Form 8-K dated October 19, 1993 to file, under Item 5, the Company's earnings release for the quarter and nine months ended September 30, 1993. - --------------- * Filed with this report on Form 10-K. ** To be filed by amendment. (1) Incorporated by reference to Exhibit of the same number of the Registration Statement on Form 10 (Commission File No. 0-18694) as filed with the Commission on July 18, 1990 ("Form 10"). (2) Incorporated by reference to Exhibit of the same number on the Form 8 constituting a Post-Effective Amendment No. 1 to the Form 8-A as filed with the Commission on February 19, 1993. (3) Incorporated by reference to Exhibit of the same number of Registration Statement on Form S-3 (Commission File No. 33-56082) as filed with the Commission on December 21, 1992 ("Form S-3"). (4) Incorporated by reference to Exhibit of the same number of the Form 8 constituting Post-Effective Amendment No. 1 to the Form 10 as filed with the Commission on November 20, 1990. (5) Incorporated by reference to Exhibit of the same number on the Form 10-K for the year ended December 31, 1990. (6) Incorporated by reference to Exhibit of the same number on the Form 10-K for the year ended December 31, 1991. (7) Incorporated by reference to Exhibit of the same number on the Form 10-K for the year ended December 31, 1990, referred to therein as "Development Agreement dated February 19, 1991 between the Registrant and the San Francisco Board of Supervisors". (8) Incorporated by reference to Exhibit of the same number of Amendment No. 2 to Form S-3 as filed with the Commission on February 4, 1993. (9) Incorporated by reference to Exhibit of the same number on the Form 10-Q for the quarter ended September 30, 1993. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, Catellus Development Corporation has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. CATELLUS DEVELOPMENT CORPORATION By /s/ Vernon B. Schwartz ------------------------------ Vernon B. Schwartz Chairman, President and Chief Executive Officer Dated: 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 Catellus Development Corporation and in the capacities and on the date indicated. Signature Title Date - --------- ----- ----- /s/Vernon B. Schwartz Chairman, President, March 25, 1994 - -------------------------- Chief Executive Vernon B. Schwartz Officer and Director Principal Executive Officer /s/ David A. Smith Senior Vice President and March 25, 1994 - -------------------------- Chief Financial Officer David A. Smith Principal Financial Officer /s/ David M. Perna Controller March 25, 1994 - -------------------------- Principal Accounting David M. Perna Officer Signature Title Date - --------- ----- ----- * Director - -------------------------- Joseph F. Alibrandi * Director - -------------------------- Darla Totusek Flanagan * Director - -------------------------- Gary M. Goodman * Director - -------------------------- Robert D. Krebs * Director - -------------------------- Judd D. Malkin * Director - -------------------------- John E. Neal * Director - -------------------------- Joseph R. Seiger * Director - -------------------------- Jacqueline R. Slater * Director - -------------------------- Tom C. Stickel * Director - -------------------------- John E. Zuccotti By /s/ David M. Perna March 25, 1994 -------------------------- David M. Perna Attorney-in-fact AND FINANCIAL STATEMENT SCHEDULES (ITEM 14(A)(1) AND (A)(2)) Page ---- (A)(1) FINANCIAL STATEMENTS Report of Independent Accountants dated February 18, 1994, Report of Independent Real Estate Appraisers dated February 17, 1994 Consolidated Balance Sheet - Historical Cost Basis and Supplemental Current Value Basis at December 31, 1993 and 1992 Consolidated Statement of Income - Historical Cost Basis for the years ended December 31, 1993, 1992 and 1991 Consolidated Statement of Stockholders' Equity - Historical Cost Basis for the years ended December 31, 1993, 1992 and 1991 Consolidated Statement of Cash Flows - Historical Cost Basis for the years ended December 31, 1993, 1992 and 1991 Consolidated Statement of Changes in Revaluation Equity-Supplemental Current Value Basis for the years ended December 31, 1993 and 1992 Notes to Consolidated Financial Statements Summarized Quarterly Results (Unaudited) (A)(2) FINANCIAL STATEMENT SCHEDULES Page ---- Report of Independent Accountants dated February 18, 1994 S-1 Schedule V - Property, Plant and Equipment S-2 Schedule VI - Accumulated Depreciation, Depletion and Amortization S-3 Schedule VII - Guarantees of Securities of Other Issuers S-4 Schedule VIII - Valuation and Qualifying Accounts S-5 Schedule IX - Short-Term Borrowings S-6 Schedule X - Supplementary Income Statement Information S-7 Schedule XI - Real Estate and Accumulated Depreciation S-8 Attachment A to Schedule XI S-9 REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors and Stockholders of Catellus Development Corporation We have audited the accompanying historical cost basis consolidated balance sheet of Catellus Development Corporation and its subsidiaries (the Company) as of December 31, 1993 and 1992, and the related historical cost basis consolidated statements of income, of stockholders' equity and of cash flows for each of the three years in the period ended December 31, 1993. We have also audited the supplemental current value basis consolidated balance sheet of the Company as of December 31, 1993 and 1992 and the related supplemental current value basis consolidated statement of changes in revaluation equity for the years ended December 31, 1993 and 1992. 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 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 provide a reasonable basis for our opinion. In our opinion, the historical cost basis consolidated financial statements referred to above present fairly, in all material respects, the financial position of Catellus Development Corporation 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 described in Note 2, the supplemental current value basis consoli- dated balance sheets have been prepared by management to present relevant financial information that is not provided by the historical cost basis finan- cial statements and are not intended to be a presentation in conformity with generally accepted accounting principles. In addition, the supplemental current value basis consolidated balance sheets do not purport to present net realiz- able, liquidation, or market value of the Company as a whole. Current values of real estate are estimated by management in accor- dance with the procedures described in Note 2, which included receipt of an appraisers' concurrence report from Landauer Associates, Inc. We have tested the procedures used by management in arriving at their estimate of current value and have tested the underlying documentation. In the circumstances, we believe the procedures are reasonable and the documentation appropriate. Because of the subjectivity inherent in any estimate of current value of real estate, and because, generally, the Company's real estate assets are held for long-term operation and appreciation and thus are not presently for sale, amounts realized by the Company from the operation and ultimate disposition of real estate assets may vary significantly from the current values presented. In our opinion, the supplemental consolidated current value basis financial statements referred to above present fairly, in all material re- spects, the information set forth therein on the basis of accounting described in Note 2. /s/ Price Waterhouse Price Waterhouse San Francisco, CA February 18, 1994 REPORT OF INDEPENDENT REAL ESTATE APPRAISERS To the Board of Directors and Stockholders of Catellus Development Corporation and Price Waterhouse We have reviewed the estimate of aggregate current value of the portfolio of real estate holdings of Catellus Development Corporation (the Company) as of December 31, 1993 and 1992. The property interests at December 31, 1993 include approximately 277 income producing buildings; approximately 7,811 acres of land planned for near-term development; approximately 20,485 acres of land held for long-term development or sale; 73 ground lease positions; approximately 16,130 acres of agricultural land; approximately 857,185 acres of mountain and desert land; and 9 joint venture interests. The property interests were valued subject to tenants' leases, but before debt. The aggregate current value of the interests, estimated by the Company as of December 31, 1993 and 1992, was $1,712,217,000 and $2,123,816,000, respectively. These totals represent the Company's estimate of the aggregate current value of the interests in the entire property portfolio and assume that the individual assets are marketable and would be disposed of in an orderly manner, allowing a sufficient time period for exposure of each property interest to potential purchasers. The current valuation of the portfolio has applied neither a premium nor a discount with regard to a bulk sale of the entire portfolio. Based upon our review, we concur with the Company's estimates of aggregate current value of the portfolio. By this we mean it is our opinion that the current value estimates by the Company are within ten percent (10%) of the aggregate value which we would estimate in a full and complete appraisal of the same interests. A variation of less than ten percent (10%) between apprais- ers implies substantial agreement as to the most probable current value of such property interests. The data used in our review were supplied to us in summary form by the Company. We have had complete and unrestricted access to all underlying documents. We have relied upon the Company's interpretation and summaries of leases, operating agreements, estimate of environmental remediation costs, etc. During 1992 and 1993, we physically inspected Company properties with combined individual current value estimates representing approximately 86% of the aggregate current value estimate. We certify that neither Landauer Associates, Inc. nor the undersigned have any present or prospective interest in the Company's properties, and we have no personal interest or bias with respect to the parties involved. To the best of our knowledge and belief, the facts upon which the analysis and conclu- sion were based are materially true and correct. No one other than the under- signed, assisted by members of our staff, performed the analyses and reached the conclusions resulting in the opinion expressed in this letter. Our fee for this assignment was not contingent on any action or event resulting from the analy- ses, opinions, or conclusions in, or the use of, this review. This review has been prepared in conformity with the Code of Ethics and Standards of Professional Practice of the Appraisal Institute. As of the date of this letter, James C. Kafes has completed the requirements of the continuing education program of the Appraisal Institute. Respectfully submitted, Landauer Associates, Inc. Real Estate Counselors /s/ James C. Kafes /s/ John F. Brengelman James C. Kafes, MAI, CRE John F. Brengelman Managing Director Senior Vice President New York, NY February 17, 1994 CATELLUS DEVELOPMENT CORPORATION CONSOLIDATED BALANCE SHEET -- HISTORICAL COST BASIS AND SUPPLEMENTAL CURRENT VALUE BASIS (IN THOUSANDS, EXCEPT SHARE DATA) See notes to consolidated financial statements. CATELLUS DEVELOPMENT CORPORATION CONSOLIDATED STATEMENT OF INCOME -- HISTORICAL COST BASIS (IN THOUSANDS, EXCEPT PER SHARE DATA) See notes to consolidated financial statements. CATELLUS DEVELOPMENT CORPORATION CONSOLIDATED STATEMENT OF INCOME -- HISTORICAL COST BASIS (CONTINUED) (IN THOUSANDS, EXCEPT PER SHARE DATA) See notes to consolidated financial statements. CATELLUS DEVELOPMENT CORPORATION CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY -- HISTORICAL COST BASIS (IN THOUSANDS) See notes to consolidated financial statements. CATELLUS DEVELOPMENT CORPORATION CONSOLIDATED STATEMENT OF CASH FLOWS -- HISTORICAL COST BASIS (IN THOUSANDS) See notes to consolidated financial statements. CATELLUS DEVELOPMENT CORPORATION CONSOLIDATED STATEMENT OF CASH FLOWS -- HISTORICAL COST BASIS--(CONTINUED) (IN THOUSANDS) See notes to consolidated financial statements. CATELLUS DEVELOPMENT CORPORATION CONSOLIDATED STATEMENT OF CHANGES IN REVALUATION EQUITY - SUPPLEMENTAL CURRENT VALUE BASIS (IN THOUSANDS) See notes to consolidated financial statements. CATELLUS DEVELOPMENT CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1. DESCRIPTION OF BUSINESS Catellus Development Corporation (the Company) is a diversified real estate company which owns substantial property interests principally in Califor- nia, and in 10 other states in the West, Southwest and Midwest. The Company develops and manages its income producing properties which consist primarily of industrial facilities and a limited number of office and retail buildings located in California, Illinois and Texas. The Company has substantial undevel- oped land holdings primarily in California, Texas, New Mexico and Utah. NOTE 2. CURRENT VALUE PRESENTATION CURRENT VALUE REPORTING Current value basis consolidated balance sheets presented as of December 31, 1993 and 1992 provide supplemental information about the economic condition of the Company. Because of the low historical cost basis of the Company's real estate assets, management believes that the historical cost basis presentation used in customary financial statements does not reflect the true economic value of the Company's holdings. Current value reporting provides recognition that, over time, real property generally appreciates in value, and that value may be realized through the development process and effective management of income producing assets. It does not represent the net realizable value of the Company as a whole, nor does it contemplate liquidation or a distressed sale of the Company's assets. Management believes that current value information provides meaningful information regarding the Company's economic condition and the value of its holdings in today's real estate market. Current value accounting continues to represent an experimental ap- proach; authoritative criteria have not been established for its preparation and presentation. As experimentation continues, preparation and presentation methods may be modified in future reporting periods. BASIS OF VALUATION The following methods for estimating current value are based on management's best judgments regarding the economy, market trends and operating results. Such factors, along with the capitalization or discount rates used to estimate current values, cannot be precisely quantified and verified. In addition, they may change based on ongoing evaluation of future economic trends. DEVELOPABLE PROPERTIES--These properties, which have been designated by the Company for development, are located primarily in the San Francisco, Los Angeles, San Diego and Chicago metropolitan areas. Estimates of current value are made primarily using the direct sales comparison method. However, in cases where relevant comparable sales data is not available, current value is estimat- ed using the residual land analysis method. Under the direct sales comparison approach, recent sales of similar properties are used as a basis for estimating current value. The resulting values are adjusted to reflect the estimated costs to remediate known environ- mental contamination. In 1993, current value estimates for large contiguous parcels include a discount to reflect current market absorption rates for undeveloped land; no such discount was included in the corresponding 1992 values. Under the residual land analysis approach, current value is derived based on anticipated future cash flows associated with the Company's intended development plan, which considers the needs and opportunities of the market. Infrastructure costs, development costs (including costs to remediate known environmental contamination), operating cash flow and a residual sales amount are projected over an assumed period of development and operation. Such amounts are then discounted to the balance sheet date using a discount rate the Company believes is appropriate given the level of project risk. CATELLUS DEVELOPMENT CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) INCOME PRODUCING PROPERTIES (BUILDINGS)--The Company estimates the current value of buildings, which are located primarily in California, Arizona and Illinois, using the discounted cash flow method. Operating cash flows were projected based on current lease terms and management's estimate of potential future rents, operating costs, tenant improvement costs, leasing commissions and structural repairs. Buildings were assumed sold after 10 to 16 years; sales prices were determined using direct capitalization at capitalization rates ranging from 9% to 13% in 1993 and 9% to 14.5% in 1992. Operating cash flows and cash from property sales were discount- ed back to the balance sheet date at discount rates ranging from 10% to 14% in 1993 and a discount rate of 11.5% in 1992. INCOME PRODUCING PROPERTIES (GROUND LEASES)--The majority of the Company's land under lease is located in California. The Company generally estimates current value using discounted cash flow where annual cash flows are calculated based on existing lease agreements. In 1993, land subject to ground leases was assumed sold at conclusion of the existing lease and renewal options. Land values were based on the direct sales comparison approach and were project- ed to increase at an annual rate of 3% through the date of sale. In 1992, land subject to ground leases expiring within 10 years was assumed sold at conclusion of the existing lease. Land values were based on the direct sales comparison approach and were projected to increase at an annual rate of 4% through the date of sale. Existing leases with terms greater than 10 years were assumed to be renewed and the underlying land sold at the end of 20 years. Land values were based on direct capitalization of income projected for the year following sales using a rate of 9%. The projected cash flow for each lease together with the projected sales price, less estimated costs to ready the property for sale, were discount- ed back to the balance sheet date using a discount rate of 10% for both 1993 and 1992. INCOME PRODUCING PROPERTIES (JOINT VENTURE INVESTMENTS)--Current values for investments in joint ventures represent the Company's proportionate equity in the underlying net assets of the ventures. The current values of assets and liabilities of joint ventures were based on methods and assumptions similar to those used to estimate the current values of similar assets and liabilities of the Company. SURPLUS DEVELOPABLE PROPERTIES--These are properties which have development potential but are not currently scheduled for development. The Company estimates current values using direct sales comparisons. The properties are located primarily in California, New Mexico, Utah and Texas. AGRICULTURAL AND OTHER PROPERTIES--The Company's agricultural property holdings, which are in the process of being sold, are located in the San Joaquin Valley of California. Current values for these properties were determined using direct sales comparisons. Other properties consist of mountain and desert lands located in California. Current values for these properties were determined using direct sales comparisons supplemented by estimates made by management. ESTIMATED DISPOSITION COSTS--Selling commissions and other estimated disposition costs have been provided at 2.5% of the current value of the Company's properties and joint venture investments. CATELLUS DEVELOPMENT CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) DEFERRED INCOME TAXES--Deferred income taxes on a current value basis represent the present value of estimated income tax payments based on projec- tions of taxable income through the year 2028. The differences between the current value and historical cost bases of the Company's properties should be realized over an extended, indefinite period of time through future operations or sales. The Company has no current intention of selling any significant portion of its operating properties and fully expects that current values will be realized through operations. The projections of taxable income are based on cash flow assumptions and include anticipated sales of currently owned proper- ties, as well as projected investment in properties currently planned for development. The projections reflect deductions for anticipated depreciation on developed properties and other holding costs. These projections are based on the current provisions of the Internal Revenue Code. The discount rate used to compute the present value of income taxes is similar to the rate used to compute the current values of real estate assets which are the source of the taxable income. OTHER ASSETS AND LIABILITIES--Certain deferred assets and liabilities have been excluded from the current value balance sheet because they are already considered in the current value of real estate assets or have no current value. The remaining other assets and liabilities are carried in the current value balance sheet at historical costs which approximate current value. Projected property tax assessments for municipal debt are reflected in the current values of related properties. As a result, current value has been reduced by the municipal debt principal and no current value amount has been reflected in the caption "mortgage and other debt." REVALUATION EQUITY--The difference between the current value basis and historical cost basis of the Company's assets and liabilities is reported as revaluation equity in the stockholders' equity section of the consolidated current value basis balance sheet. The components of revaluation equity at December 31, 1993 and 1992 are as follows (in thousands): NOTE 3. CAPITAL STRUCTURE Prior to December 29, 1989, the Company was wholly owned by Santa Fe Pacific Corporation (SFP). On December 29, 1989, the Company issued 19.9% of its common stock to Bay Area Real Estate Investment Associates L.P. (BAREIA) for $398 million cash. In connection with the stock issuance, BAREIA also purchased from the CATELLUS DEVELOPMENT CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) Company, at par, a $75 million convertible debenture (Debenture). BAREIA is a California limited partnership whose general partner is JMB/Bay Area Partners and whose limited partner is the California Public Employees' Retirement System. On December 4, 1990, SFP distributed, in the form of a stock dividend, its remaining 80.1% interest in the Company to its stockholders (Distribution). On February 11, 1993, BAREIA converted the Debenture (accreted value of $111.4 million) into common stock with a value of $141 million. This is treated as a non-cash item in the statement of cash flows. After the conver- sion, BAREIA owned 40.7% of the outstanding common stock. At that time, the Company incurred a non-recurring non-cash expense of $29.6 million ($28.3 million net of income tax benefit), representing the excess of the value of the common stock issued over the accreted value of the Debenture at the date of conversion. Concurrently with the conversion of the Debenture, the Company issued 3,449,999 shares (of a total 3,500,000 authorized) of $3.75 Series A Cumulative Convertible Preferred Stock (Series A preferred stock) for $172.5 million, of which BAREIA purchased 1,405,702 shares (approximately 40.7% of the total). The Series A preferred stock has an annual dividend of $3.75 per share and a stated value and liquidation preference of $50 per share (plus accrued and unpaid dividends). It is convertible into common stock at a price of $9.06 per share, subject to adjustment in certain events. It is also redeemable, at the option of the Company, at any time after February 16, 1996, at $52.625 per share and thereafter at prices declining to $50 per share on or after February 16, 2003. The net proceeds of the Series A preferred stock issuance were used to repay $69 million of the working capital facility and to invest $50 million in securities to be held for the benefit of The Prudential Insurance Company of America (Prudential) and committed to the paydown and refinancing of the Company's $388.2 million first mortgage loan with Prudential (Note 5). The balance of the proceeds were invested in short-term marketable securities. On November 4, 1993, the Company sold, in a private placement, 3,000,000 shares (of a total 4,600,000 authorized) of $3.625 Series B Cumulative Convertible Exchangeable Preferred Stock (Series B preferred stock) for $150 million. The Series B preferred stock has an annual dividend of $3.625 per share and a stated value and liquidation preference of $50 per share (plus accrued and unpaid dividends). It is convertible into the Company's common stock at a price of $9.80 per share, subject to adjustment in certain events. The Series B preferred stock is exchangeable, at the Company's option, at any time after November 15, 1995, into 7.25% Convertible Subordinated Debentures due November 15, 2018, at a rate of $50 principal amount of debentures for each share of Series B preferred stock. It is also redeemable, at the option of the Company, at any time after November 15, 1996, at $52.5375 per share and thereaf- ter at prices declining to $50 per share on or after November 15, 2003. The proceeds of the Series B preferred stock issuance will be used to repay debt that matures from 1994 through 1997, and for general corporate purposes. The Company has reserved 19,039,735 and 15,306,000 shares of common stock for issuance on conversion of the Series A and Series B preferred stock, respectively, and 2,400,000 shares for issuance pursuant to various compensation programs. NOTE 4. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES PRINCIPLES OF CONSOLIDATION--The accompanying financial statements include the accounts of the Company and investees over 50% owned which are controlled by the Company. All other investees are accounted for using the equity method. CATELLUS DEVELOPMENT CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) REVENUE RECOGNITION--Rental revenue, in general, is recognized when due from tenants; however, revenue from leases with rent concessions are recog- nized on a straight-line basis over the initial term of the lease. Direct costs of negotiating and consummating a lease are deferred and amortized over the term of the related lease. The Company recognizes revenue from the sale of properties using the accrual method. Sales not qualifying for full recognition at the time of sale are accounted for under the installment method. In general, specific identi- fication is used to determine the cost of sales. Estimated future costs to be incurred by the Company after completion of each sale are included in cost of sales. CASH EQUIVALENTS--The Company considers all highly liquid investments with a maturity of three months or less at time of purchase to be cash equiva- lents. PROPERTY AND DEFERRED COSTS--Real estate is stated at the lower of cost or estimated net realizable value. In cases where the Company determines that the carrying costs for properties held for sale exceeds estimated net realizable value, or an impairment has been sustained, a write-down to estimated net realizable value is recorded. A property is considered impaired when it is probable that the property's estimated undiscounted future cash flow is less than its book value. The Company capitalizes construction and development costs. Costs associated with financing or leasing projects are also capitalized and amortized over the period benefitted by those expenditures. Depreciation is computed using the straight-line method. Buildings and improvements are depreciated using lives of between 20 and 40 years. Tenant improvements are depreciated over the primary terms of the leases (generally 3- 15 years), while furniture and equipment are depreciated using lives ranging between 3 and 10 years. Maintenance and repair costs are charged to operations as incurred, while significant improvements, replacements and major renovations are capital- ized. ALLOWANCE FOR UNCOLLECTIBLE ACCOUNTS--Accounts receivable are present- ed net of an allowance for uncollectible accounts totalling $1.9 million and $3.3 million at December 31, 1993 and 1992. The provision for uncollectible accounts in 1993, 1992 and 1991 totalled $.1 million, $.9 million and $2.0 million, respectively. ENVIRONMENTAL COSTS--The Company incurs on-going environmental remediation costs, including clean-up costs, consulting fees for environmental studies and investigations, monitoring costs, and legal costs relating to clean- up, litigation defense, and the pursuit of responsible third parties. Costs incurred in connection with income producing properties and properties previous- ly sold are expensed. Costs relating to undeveloped properties are capitalized as part of development costs. Environmental costs charged to operations for 1993, 1992 and 1991 were $5.5 million, $4.9 million and $3.5 million. Environ- mental costs capitalized in 1993, 1992 and 1991 were $1.4 million, $2.2 million and $2.5 million. The Company maintains a reserve for known, probable costs of environmental remediation to be incurred in connection with income producing properties and properties previously sold. This reserve was $5.6 million and $3.8 million at December 31, 1993 and 1992. When there is a legal requirement for environmental remediation of developable property, the Company will accrue for the estimated cost of remediation and capitalize that amount. Where there is no legal requirement for remediation, costs will be capitalized, as incurred, as part of the project costs. The Company also considers potential future costs of environmental remediation relating to individual development properties in conjunction with its analysis of current value and net realizable value. The current value of the Company's properties reflect the Company's best estimate of possible remediation costs. Based on this analysis, no loss has been recognized relating to environmental remediation because management believes that no material recoverability issues exist. CATELLUS DEVELOPMENT CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) INCOME TAXES--The Company 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 1989. The primary change from SFAS No. 96 is to allow for the possible earlier recognition of tax benefits. Adoption of SFAS No. 109 required no adjustment to the Company's balance sheet or statement of income. EARNINGS PER SHARE--Net income (loss) per share of common stock is computed by dividing net income (loss), after reduction for preferred stock dividends, by the weighted average number of shares of common stock outstanding during the year. Fully diluted earnings per share amounts have not been presented because assumed conversion of the Series A and Series B preferred stock would be anti-dilutive for all relevant periods. Assuming conversion of the Debenture on January 1, 1993, the net loss and loss before extraordinary item for 1993 would have been $.93 and $.84 per share. RECLASSIFICATIONS--Certain prior year amounts have been reclassified to conform with the current year financial statement presentation. NOTE 5. MORTGAGE AND OTHER DEBT Mortgage and other debt at December 31, 1993 and 1992 consisted of the following (in thousands): (a) This first mortgage loan with The Prudential Insurance Company of America (Prudential) is collateralized by a majority of the Company's income producing properties and by an assignment of rents generated by the underlying properties. The Company refinanced this loan on February 18, 1994 with a $280 million mortgageloan due March 1, 2004 and bearing an average interest rate of 8.71%. The new loan reflects a paydown of $108.2 million, of which $81 million was required to meet current loan underwriting standards CATELLUS DEVELOPMENT CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) and $27.2 million was paid to release selected properties from the loan. In connection with this refinancing, the Company incurred an extraordinary expense of $11.9 million ($7.4 million, net of income tax benefits). This extraordinary expense consisted primarily of a redemption premium paid to Prudential and the write-off of deferred financing costs associated with the $388.2 million loan. (b) These first mortgage loans are collateralized by certain of the Company's income producing properties and by an assignment of rents generated by the underlying properties. A majority of these loans have penalties if paid prior to maturity. In conjunction with the Prudential refinancing described in (a) above, a $10 million principal payment was made in February 1994 on a $54.4 million loan. The remaining principal balance of this loan is due January 1, 1996. Monthly payments on the remaining $64.1 million of these loans require principal payments through 2007. (c) The Company has a three-year $24 million secured term loan agreement of which none was available for future borrowings and a two-year $46.9 million secured term loan agreement of which $1.9 million was available for future borrowings. (d) The Company had a $155 million unsecured revolving credit agreement which allowed borrowings to be converted at either the lender's or the Company's option to a collateralized four-year term loan. Proceeds from the Series A preferred stock issuance (Note 3) were applied to reduce the amounts outstanding under the facility from $115 million to $46 million. On March 18, 1993, this facility was renewed as a $75 million unsecured revolving facility and a $46 million unsecured term facility. The term facility was paid down to $22 million in November 1993. The revolving facility expires on December 31, 1994; if the facility is not renewed by that date, the amount then outstanding will convert to a three-year term loan payable in installments. In June 1993, $5.7 million of this facility was used to provide a letter of credit, leaving $69.3 million available at December 31, 1993 for future borrowings. (e) The Company's construction loans are used to finance development projects and are secured by the related land and buildings. On May 4, 1993, the Company renewed its $100 million construction facility for a one-year revolving period to March 31, 1994, with maximum borrowings at any time of $75.5 million. If the construction facility is not renewed, the Company will be able to borrow up to $.9 million to complete projects already approved under the facility. Based on current discussions, the Company expects that the construction facility will be renewed for a one-year revolving period with maximum borrowings at any time of approximately $75 million. At December 31, 1993, $68.5 million was available under all construction loans for future borrowings. (f) The Debenture was convertible at any time into common stock of the Company at the market price per share when converted. Interest at the rate of 13.5% per year was compounded annually and payable at maturity. On February 11, 1993, the Debenture was converted into common stock with a value of $141 million (Note 3). (g) The assessment district bonds are issued by local municipalities to fund the construction of public infrastructure and improvements which benefit the Company's properties. These bonds are secured by certain of the Company's properties. CATELLUS DEVELOPMENT CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) Certain debt agreements include covenants which place limitations on the amount of indebtedness that may be incurred and dividends which may be paid by the Company. The Company was in compliance with all such covenants at December 31, 1993. Currently, the most restrictive of these covenants limit annual dividends to $27.6 million and total debt to $1.6 billion; up to $180 million of this debt may be for non-property related activities. Other covenants require stockholders' equity on a current value basis to be no less than $800 million and on a historical cost basis to be no less than $500 million, accelerate payment upon certain change of control events, and contain negative pledges with respect to certain of the Company's properties. The maturities of mortgage and other debt outstanding as of December 31, 1993 and pro forma as of December 31, 1993, reflecting the paydown and refinancing of the first mortgage loans described in (a) and (b) above, are summarized as follows (in thousands): Interest costs incurred during 1993, 1992 and 1991 relating to mortgage and other debt totalled $64.0 million, $78.3 million and $76.8 million. Total interest costs, which also includes loan fee amortization and other interest costs, amounted to $69.6 million, $82.6 million and $80.6 million in 1993, 1992 and 1991. Of these amounts, $25.6 million, $29.3 million and $35.9 million were capitalized during 1993, 1992 and 1991. NOTE 6. INCOME TAXES Total income taxes (benefit) reflected in the consolidated statement of income differ from the amounts computed by applying the federal statutory rate (35% in 1993 and 34% in 1992 and 1991) to income (loss) before extraordi- nary item as follows (in thousands): CATELLUS DEVELOPMENT CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) Deferred income taxes are provided for the temporary differences between the financial reporting basis and the tax basis of the Company's assets and liabilities and for operating loss and tax credit carryforwards. Signifi- cant components of the Company's net deferred tax liability as of December 31, 1993 are as follows (in thousands): During 1993, 1992 and 1991, the Company generated net operating loss carryforwards of $13.3 million, $16.9 million and $21.3 million for tax purposes which expire in 2008, 2007 and 2006. Deferred income tax expense was reduced to reflect the benefit of these amounts. The Company increased its tax expense and related deferred tax liability by $3 million in 1993 as a result of legislation enacted in August 1993 increasing the federal tax rate from 34% to 35% commencing January 1, 1993. NOTE 7. JOINT VENTURE INVESTMENTS The Company is involved in a variety of real estate-oriented joint venture activities. At December 31, 1993, these included two hotels, one office building, a 900,000 square foot trade mart center for the contract and home furnishing industries, an apartment complex and other projects in the early stages of development. The Company loaned a total of $.3 million in 1992 and $1.9 million in 1991 to one of its joint ventures and a joint venture partner. The loans bear interest at one percentage point over the rate payable under the joint venture's note to its creditor bank (6.3% at December 31, 1993) and are secured either by a second lien on the joint venture property or by the partner's interest in the joint venture. Principal and interest are due on or before February 1, 1996 on the loan to the joint venture. The loan to the joint venture partner matured on January 28, 1993. The Company has the right to foreclose on the partner's interest in the joint venture if the loan is not repaid. CATELLUS DEVELOPMENT CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) In the fourth quarter of 1992, the Company sold its 50% interest in an office building joint venture. The Company recognized a $6.4 million loss on the sale, attributable to the decline in value of the building and the high cost basis in the Company's interest in the joint venture. The condensed combined balance sheets and statements of income of the joint ventures, along with the Company's proportionate share, are summarized as follows (in thousands): The Company's proportionate share of venturers' deficit is an aggre- gate amount for all ventures. Because the Company's ownership percentage differs from venture to venture, and certain ventures have accumulated deficits while others have accumulated equity, the Company's percentage of venturers' deficit is not reflective of the Company's ownership percentage of the ventures. NOTE 8. PROPERTY Property and capitalized property costs at December 31, 1993 and 1992 consisted of the following (in thousands): CATELLUS DEVELOPMENT CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 9. LEASES The Company, as lessor, has entered into noncancelable operating leases expiring at various dates through 2052. Rental revenue under these leases totalled $105.1 million in 1993, $94.7 million in 1992 and $83.2 million in 1991. Included in this revenue are rentals contingent on lease operations of $3.2 million in 1993, $3.9 million in 1992 and $4.2 million in 1991. Future minimum rental revenues under existing noncancelable operating leases as of December 31, 1993 are summarized as follows (in thousands): The Company, as lessor, had income producing property under operating leases or held for rent as of December 31, 1993 and 1992 in the following amounts (in thousands): The Company, as lessee, has entered into noncancelable operating leases expiring at various dates through 2033. Rental expense and related sublease income under these leases totalled $4 million and $1.3 million in 1993, $5.9 million and $1.9 million in 1992 and $6.1 million and $2.2 million in 1991. Future minimum lease payments as of December 31, 1993 are summarized as follows (in thousands): CATELLUS DEVELOPMENT CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 10. TRANSACTIONS WITH AFFILIATES The Company has a management agreement with The Atchison, Topeka & Santa Fe Railway Company (ATSF), a subsidiary of SFP, under which the Company acts as exclusive management and selling agent for ATSF's nonoperating railroad properties. This agreement is in effect until October 31, 1994 but is subject to termination at any time on 180 days' notice. Fees of $4.8 million, $5.7 million and $6.2 million were earned in 1993, 1992 and 1991, respectively, under this agreement. The Company had an agreement to exchange certain desert properties for certain ATSF properties with comparable market value. The Company transferred approximately 154,000 acres ($10.3 million market value) and 174,000 acres ($12.2 million market value) of primarily desert land in exchange for five and six developable properties in 1992 and 1991, respectively. These exchanges had no impact on the historical cost of the Company's total assets. The Company concluded the exchange agreement during 1992 by selling an additional 169,000 acres of desert land and 4,000 acres of mineral rights to an affiliate of ATSF and recognized a gain of $6.3 million. NOTE 11. EMPLOYEE BENEFIT AND STOCK OPTION PLANS The Company has a profit sharing and savings plan for all employees. Funding consists of employee contributions along with matching and discretionary contributions by the Company. Total expense for the Company under this plan was $.6 million, $.7 million and $.7 million in 1993, 1992 and 1991, respectively. The Company has various plans through which employees may purchase common stock of the Company or receive common stock as incentive compensation. The Incentive Stock Compensation Plan (Substitute Plan) was adopted to provide substitute awards to employees whose awards under certain SFP plans were forfeited as a result of the Distribution. The number of shares, exercise price and expiration dates of these awards were set so the participant retained the full unrealized potential value of the original SFP grant. Options are exercis- able after March 5, 1992 and expire from 1997 through 1999. The Company also has a Stock Option Plan under which the Board of Directors may issue options to purchase up to 250,000 shares of common stock at a price not less than the fair market value at the date of grant. Options are exercisable no earlier than six months from the date of grant and generally expire ten years after the date of grant. All options granted to date are exercisable in installments on a cumulative basis at a rate of 25% each year commencing on the first anniversary of the date of grant. Under the Executive Stock Option Plan, the Board of Directors may issue non-qualified stock options to purchase up to 1,250,000 shares of common stock at a price not less than fair market value at the date of grant. Options are exercisable no earlier than six months from the date of grant and generally expire ten years after the date of grant. Each non-management director is automatically granted an option, upon initial election to the Board of Direc- tors, to purchase 5,000 shares of common stock at a price of 127.63% of the fair market value on the date of grant, increasing 5% on each anniversary of the grant date commencing on the sixth anniversary. The options are exercisable in installments on a cumulative basis at a rate of 20% each year. Unless otherwise provided at the time of grant, the exercise price for all other options will be the fair market value on the date of grant, increasing 5% on each anniversary of the grant date, and the options are exercisable in full on the fifth anniversary of the grant date. CATELLUS DEVELOPMENT CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) Transactions under these plans during 1992 and 1993 are summarized below: In addition, in 1992 restrictions lapsed on a total of 4,781 shares of common stock awarded under the Substitute Plan to holders of SFP restricted stock. Under the Long-Term Incentive Compensation Program (LICP), partici- pants will share a percentage of the increase in stockholders' equity (on a current value basis) over the five-year period ending December 31, 1996. The amount of the LICP award pool may range from one-quarter of one percent of the increase (if the annual compound growth over the period exceeds 5%) to 1% of the increase (if the annual compound growth exceeds 20%). All of the Company's executive officers are participants in the LICP. Certain executive officers will receive a portion of their awards in cash (equal to the amount of income tax payable on the award) and the balance in the Company's common stock; all other awards are payable in cash. There will be no LICP award pool if the annual compound growth is less than 5%; accordingly, there has been no accrual for the plan as of December 31, 1993. NOTE 12. COMMITMENTS AND CONTINGENCIES In April 1991, a lawsuit was brought against the Company alleging breach of contract for a finder's fee in connection with an August 1990 sale of land in Fremont, California. On November 1, 1993, the jury returned a verdict in favor of the plaintiff and made an award of approximately $440,000 which, together with pre-judgment interest, totals approximately $600,000. Addition- ally, the jury awarded approximately $7.7 million in punitive damages for what it found was the Company's bad faith denial of an alleged contract. While the Company intends to vigorously pursue an appeal, it has provided $8.3 million as a non-recurring expense in the consolidated statement of income for the year ended December 31, 1993. The Company has obtained standby letters of credit and surety bonds in favor of local municipalities to guarantee performance obligations on real property improvements. As of December 31, 1993, $29.2 million was outstanding. The Company, as a partner in certain joint ventures, has made certain financing guarantees which do not individually or collectively represent a material commitment. CATELLUS DEVELOPMENT CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) The Company is a party to a number of legal actions arising in the ordinary course of business. While the Company cannot predict with certainty the final outcome of these proceedings, considering the substantial legal defenses available, management believes that none of these actions, when finally resolved, will have a material adverse effect on the consolidated financial position or results of operations of the Company. Inherent in the operations of the real estate business is the possi- bility that environmental pollution conditions may exist on or relate to proper- ties owned or previously owned. The Company may be required in the future to take action to correct or reduce the effects on the environment of prior disposal or release of hazardous substances by third parties, the Company, or its corporate predecessors. The amount of such future cost is difficult to estimate with a high degree of accuracy due to such factors as the unknown magnitude of possible contamination, the unknown timing and extent of the corrective actions which may be required, the determination of the Company's liability in proportion to other responsible parties, and the extent to which such costs are recoverable from insurance. At December 31, 1993, management estimates that future costs for remediation of identified or suspected environmental contamination which will be treated as an expense may be in the range of $2 to $24 million. It is antici- pated that such costs will be incurred over the next ten years. The Company has provided a reserve for such costs (Note 4). Management also estimates that similar costs relating to the Company's developable properties may range from $18 million to $63 million. These amounts generally will be capitalized as components of development costs when incurred. It is anticipated that environ- mental remediation costs relating to property developments will be incurred over a period of twenty years. These estimates were developed based on extensive reviews which took place over several years based upon then prevailing law and identified site conditions. Because of the breadth of its portfolio, the Company is unable to review extensively each property on a regular basis. Such estimates are not precise and are always subject to the availability of further information about the prevailing conditions at the site, the future requirements of regulatory agencies and the availability of other parties to pay some or all of such costs. SUMMARIZED QUARTERLY RESULTS (UNAUDITED) The Company's earnings and cash flow are determined to a large extent by property sales. While the Company's commercial and industrial rental revenue has increased steadily, particularly in recent years, the Company's sales and net income have fluctuated significantly from quarter to quarter, as evidenced by the following summary of unaudited quarterly consolidated results of opera- tions. Property sales fluctuate from quarter to quarter, reflecting general market conditions and the Company's intent to sell property when it can obtain attractive prices. Cost of sales may also vary widely because it is determined by the Company's historical cost basis in the underlying land. Historically, sales in the fourth quarter have been high, reflecting the Company's experience that both buyers and sellers attempt to complete pending transactions prior to a calendar year-end. REPORT OF INDEPENDENT ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULES To the Board of Directors of Catellus Development Corporation Our audits of the consolidated historical cost basis financial state- ments referred to in our report dated February 18, 1994, appearing on page of this Form 10-K of Catellus Development Corporation, also included an audit of the Financial Statement Schedules listed in Item 14(a)(2) 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 historical cost basis financial statements. /s/ Price Waterhouse Price Waterhouse San Francisco, CA February 18, 1994 S-1 CATELLUS DEVELOPMENT CORPORATION SCHEDULE V--PROPERTY, PLANT AND EQUIPMENT THREE YEARS ENDED DECEMBER 31, 1993 (IN THOUSANDS) S-2 CATELLUS DEVELOPMENT CORPORATION SCHEDULE VI--ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION THREE YEARS ENDED DECEMBER 31, 1993 (IN THOUSANDS) S-3 CATELLUS DEVELOPMENT CORPORATION SCHEDULE VII--GUARANTEES OF SECURITIES OF OTHER ISSUERS DECEMBER 31, 1993 S-4 CATELLUS DEVELOPMENT CORPORATION SCHEDULE VIII--VALUATION AND QUALIFYING ACCOUNTS THREE YEARS ENDED DECEMBER 31, 1993 (IN THOUSANDS) S-5 CATELLUS DEVELOPMENT CORPORATION SCHEDULE IX--SHORT-TERM BORROWINGS THREE YEARS ENDED DECEMBER 31, 1993 (DOLLARS IN THOUSANDS) S-6 CATELLUS DEVELOPMENT CORPORATION SCHEDULE X--SUPPLEMENTARY INCOME STATEMENT INFORMATION FOR THE THREE YEARS ENDED DECEMBER 31, 1993 (IN THOUSANDS) S-7 CATELLUS DEVELOPMENT CORPORATION SCHEDULE XI -- REAL ESTATE AND ACCUMULATED DEPRECIATION DECEMBER 31, 1993 (DOLLARS IN THOUSANDS) S-8 CATELLUS DEVELOPMENT CORPORATION ATTACHMENT A TO SCHEDULE XI RECONCILIATION OF COST OF REAL ESTATE AT BEGINNING OF PERIOD WITH TOTAL AT END OF PERIOD (IN THOUSANDS) RECONCILIATION OF REAL ESTATE ACCUMULATED DEPRECIATION AT BEGINNING OF PERIOD WITH TOTAL AT END OF PERIOD (IN THOUSANDS) S-9

355069_1993.txt

355069_1993

1993

355069

Item 1. Business. (a) General Development of Business. Continental Cablevision, Inc. (the "Company," which term, as used herein, includes its consolidated subsidiaries unless the context indicates otherwise) is the third largest cable television system operator in the United States based on its number of basic subscribers and that of its affiliates on December 31, 1993. The Company was organized in 1963 and, through its subsidiaries, has been providing basic and pay cable television services since its inception. Developments in the Cable Television Business. During the year ended December 31, 1993, the Company's basic subscribers increased due to marketing of its basic and premium services and to line extensions within its existing franchise areas. The Company's revenues increased due to subscriber growth and an increase in monthly revenue per average basic subscriber, which included growth in ancillary revenue sources such as advertising and pay-per-view movies and events. (See "Description of Business--Service Charges; Alternate Sources of Revenues" and "Management's Discussion and Analysis of Financial Condition and Results of Operations--Liquidity and Capital Resources".) Through its continuous deployment of advanced technology, the Company believes that it maintains technical standards among the highest in the cable television industry. As of December 31, 1993, the Company provided at least 54-channel capacity and addressable technology in Systems serving approximately 75% and 79% of its basic subscribers, respectively. Addressable technology enables the Company to electronically determine the services to be delivered to each subscriber. (See "Description of Business--Technological Developments".) During the fiscal year ended December 31, 1993, the Company adjusted rates charged to customers for regulated services, realigned some channels and reconfigured its service offerings in order to comply with the Cable Television Consumer Protection and Competition Act of 1992 (the "1992 Cable Act") and the regulations adopted by the Federal Communications Commission (the "FCC") to implement the 1992 Cable Act. The 1992 Cable Act significantly changed the regulatory framework under which cable television systems operate, including the oversight of certain rates charged to subscribers and carriage rules for certain broadcast stations. The FCC's original rate regulations under the 1992 Cable Act were adopted on April 1, 1993 and went into effect on September 1, 1993. On February 22, 1994, after reconsideration, the FCC adopted a revised regulatory scheme with the purpose of further reducing the rates charged by cable television systems for regulated tiers of service. The final text of such rules has not yet been issued. In general, the regulations require that charges for cable television services (other than programming on a per-channel or per-program basis) be reduced to rates established either by application of FCC "benchmarks" or based upon a "cost-of-service" showing. The Company made permitted rate adjustments according to the original April 1, 1993 FCC benchmarks for Systems representing a majority of the Company's subscribers. (See "Description of Business--The Systems" for a definition of "System".) Substantially all of the remaining Systems have chosen cost-of-service to justify current rates. (See "Management's Discussion and Analysis of Financial Condition and Results Of Operations--Liquidity and Capital Resources" and "Description of Business--Legislation and Regulation".) Development of New Services; Alternate Access. In May 1993, the Company purchased a 20% interest in Teleport Communications Group Inc. and a 20% interest in TCG Partners, a related partnership (together, "TCG"). (See "Management's Discussion and Analysis of Financial Position and Results of Operations--Liquidity and Capital Resources--Investments".) TCG is currently owned by four cable operators (including the Company) and has entered into an agreement in principle to add Time Warner Entertainment Company as a fifth owner. TCG is an alternate access company which provides a variety of non-residential, local telecommunications services over high-capacity fiber optic networks to meet the voice, data and video transmission needs of its customers in major metropolitan areas. TCG and other alternate access providers offer telecommunications services as an alternative to the Bell Operating Companies and local exchange carriers. Alternate access providers such as TCG provide both dedicated services (digital private line circuits that carry voice, data and video transmissions from one point to another fixed point) and switched services (digital switches that interconnect circuits). The Company is currently providing directly or through joint ventures (primarily joint ventures with TCG and its owners), alternate access local telecommunications services over a portion of its fiber optic networks in a variety of locations. (See "Description of Business--Legislation and Regulation--Regulation of Telecommunications Activities".) In 1993 the Company entered into an agreement in principle with other cable operators to form a joint venture for the development of certain other telecommunications services, including personal communications services ("PCS"), which is the provision of wireless voice circuits for individual and business customers; video telephony services ("VT"); and utility communications services ("UCS"), which is the provision of two-way communications services between utility companies and their customers. Although the Company believes that alternate access, PCS, VT, UCS and other new telecommunications services could provide potential sources of revenues in time, there can be no assurances in this regard or that the joint venture described above for the development of PCS, VT and UCS will be formed. (b) Description of Business. Cable Television Service. Cable television service delivers a wide variety of channels of television programming, consisting primarily of video entertainment, sports and news, as well as informational services, locally originated programming and digital radio programming to the homes of subscribers who pay a monthly fee for the service. Television and radio signals are received by off-air antennas, microwave relay systems and satellite earth stations and then are modulated, amplified and distributed to subscribers' homes over networks of coaxial and fiber optic cables. Cable television systems typically are constructed and operated under nonexclusive franchises awarded by local governmental authorities for defined periods of time. The Company's Systems offer subscribers choices of packages, any of which may include television signals available off-air in any locality, television signals from distant cities (so called "superstations"), non-broadcast channels (such as Entertainment and Sports Programming Network ("ESPN"), Cable News Network ("CNN"), Cable Satellite Public Affairs Network ("C-SPAN") and Music Television ("MTV")), displays of information such as time, news, weather and stock market reports and public, governmental and educational access channels. The Company's Systems also provide premium television services to basic subscribers for an extra monthly charge (including Home Box Office, Cinemax, Showtime, The Movie Channel, The Disney Channel and certain regional sports channels). Certain of the Company's Systems also carry "multiplexed" premium services which are available on a limited basis from certain premium service suppliers. A premium service supplier, such as Home Box Office or Cinemax, uses multiplexing to offer its programming on two or more channels simultaneously but scheduled differently so as to provide the subscriber with a choice of programs at any given time. Although services vary from System to System because of differences in channel capacity and viewer interest, each of the Company's Systems offers as the lowest-priced tier a "basic" service package (consisting generally of broadcast television signals available off-air locally, local origination and public, educational and governmental access channels), one or more "cable programming service" packages (including satellite-delivered cable programming services), and several premium or pay-per-view services, all of which are paid for on a monthly basis. Subscribers may choose various combinations of such services. (See "Legislation and Regulation" for a description of recent legislation and pending regulation which limits the Company's ability to price and tier its programming services.) Service Charges; Alternate Sources of Revenues. The Company's revenues are derived principally from monthly subscription fees for basic and premium services. Rates charged to subscribers vary from market to market. In addition, the Company generally charges a one-time installation fee to new subscribers. Subscribers are free to terminate services at any time without additional charge, but are charged a reconnection fee to resume service. In recent years the Company has begun to receive revenues from additional sources. The Company derives revenues from the sale of advertising time on advertising-supported, satellite-delivered networks such as ESPN, MTV and CNN, as well as on locally originated programming. The Company's advertising revenues increased from $18,000,000 for the year ended December 31, 1989 to $53,000,000 for the year ended December 31, 1993 (representing a 31% compound annual growth rate in advertising revenues), and accounted for over 4% of total Company revenues during the year ended December 31, 1993. Another source of revenues is the sale of pay-per-view programming, which generally consists of recently released movies and special events (such as boxing matches, other sporting events or concerts), offered to subscribers on an individual event basis. The Company realized 19% compound annual growth in pay-per-view revenues during the period from January 1, 1990 to December 31, 1993; for the year ended December 31, 1993, pay-per-view revenues accounted for over 2% of total Company revenues. As of December 31, 1993, 79% of the Company's subscribers were served by Systems with addressable technology (see "Technological Developments"), which the Company believes positions it well to realize continued growth in such revenues. In addition, with future increased channel capacity and the further deployment of addressable technology in its Systems, the Company will be able to offer subscribers additional pay-per-view movies and events. The Company also receives a percentage of the proceeds from subscribers' purchases of merchandise offered on home shopping programs such as QVC and Home Shopping Network. Although the Company believes that these and other services could become substantial sources of revenue over time, there can be no assurance in this regard. Subscriber Data. The following table summarizes selected operating statistics of the Company and its affiliates since December 31, 1989. The Systems. The Company currently operates 143 Systems, located principally in suburban areas, in 16 states. A "System" is defined to include all areas served from a single "headend". (See "Properties".) Thus, a System may include one or more communities or franchise areas. The Company's Systems and those of its affiliates provided basic service to approximately 2,915,000 subscribers and passed approximately 5,192,000 occupied dwelling units ("Homes") on December 31, 1993. The following table sets forth certain information related to the Systems of the Company and of certain Affiliated Companies, as of December 31, 1993. Franchises. The Company's franchises establish the terms and conditions under which the Systems are operated. Typically, they establish certain performance and safety standards related to the Company's construction and maintenance of facilities in, under and over public streets and rights of way in the franchise areas. Some, but not all, of these franchises specify the services to be offered. Nearly all of the Company's franchises provide for the payment of fees to the issuing authority, which currently average approximately 3% of gross revenues. The Company's franchises are usually issued for fixed terms ranging from 10 to 15 years and must periodically be renewed. Most of such franchises can be terminated prior to their stated expirations for breach of material provisions. Franchises representing approximately 1,266,000 basic subscribers (approximately 43% of total basic subscribers of the Company and its affiliates as of December 31, 1993) are scheduled to expire over the next 5 years (1994-1998). To date, all of the Company's franchises have been renewed or extended at or prior to their stated expirations, frequently on modified but satisfactory terms. The Cable Communications Policy Act of 1984 (the "1984 Cable Act") establishes comprehensive renewal procedures which require that an incumbent franchisee's renewal application be assessed on its own merit and not as part of a comparative process with competing applications. (See "Legislation and Regulation--Cable Communications Policy Act of 1984".) Programming. The Company provides programming to its subscribers pursuant to contracts with programming suppliers. The Company generally pays either a monthly fee per subscriber or a percentage of the Company's gross receipts for programming on its basic and premium services. Some programming suppliers provide volume discount pricing structures and/or offer marketing support to the Company. The Company's programming contracts are generally for fixed periods of time ranging from 3 to 10 years and are subject to negotiated renewal. The costs to the Company to provide cable programming have increased in recent years and are expected to continue to increase due to additional programming being provided to basic subscribers, increased costs to produce or purchase cable programming, inflationary increases and other factors. In Systems where the Company has elected to base its rates on the FCC's benchmark methodology, it will be allowed to increase the rates for its regulated services in response to certain increases in programming costs. (See "Legislation and Regulation".) Under the 1992 Cable Act, local broadcasting stations may require cable television operators to pay a fee for the right to carry their local television signals. Alternatively, a local broadcaster may demand carriage under the 1992 Cable Act's "must-carry" provisions, although in such event the cable television operator is not required to compensate the local broadcaster for carriage. Historically, the Company has not paid fees for retransmission of local broadcast signals, other than mandatory copyright fees (see "Legislation and Regulation--Copyright"). A substantial number of local broadcast stations carried by the Company's Systems elected to require their consent to the carriage of their local television signals. Some local broadcast stations requested compensation from the Company for the right to carry local television signals; however, the Company's policy regarding retransmission arrangements is that it will not pay cash compensation to carry signals which are otherwise available over the air at no charge to viewers. The Company has been successful at reaching agreements, for terms ranging from 3 to 7 years, with virtually all the local broadcast stations that elected retransmission consent without payment of cash compensation. In some instances the Company has agreed to carry new programming networks created by broadcasters, such as ESPN 2, a national sports programming network owned by Capital Cities/ABC and Hearst. The Company has only in a very few instances been forced to drop a local broadcast signal from its programming. At this time, the Company cannot predict the outcome of any future retransmission consent negotiations with local broadcasters. The Company is an investor in various national cable programming suppliers, including Turner Broadcasting System, Inc. (the supplier of CNN and other cable programming services), QVC Network, Inc. (a home shopping channel), Viewers Choice, Inc. (a pay-per-view movie service), The Food Channel (a 24-hour channel offering programs on cooking and food preparation) and E! (a 24-hour channel following an entertainment/news format covering feature films, television, music and theater). The Company is also a joint owner of a regional news channel, New England Cable News. Technological Developments. Through its continuous deployment of advanced technology, the Company believes that it maintains technical standards among the highest in the cable television industry. As of December 31, 1993, the Company provided at least 54-channel capacity and addressable technology in Systems serving approximately 75% and 79% of its basic subscribers, respectively. Addressable technology enables the Company to electronically determine the services to be delivered to each subscriber, and, as a result, the Company can modify subscriber services without dispatching a technician to the home. Such technology also reduces service theft and is an effective enforcement tool in collecting delinquent payments. In addition, through the use of addressable technology, the Company is able to offer pay-per-view services and tiered services more effectively than would otherwise be possible. The Company expects to increase channel capacity and to deploy addressable technology further through the ongoing rebuilding and upgrading of its plant and anticipates that substantially all of its basic subscribers will be served by Systems with addressable technology and at least 54-channel capacity by the end of 1995. The use of fiber optic cable, which is capable of carrying hundreds of video, data and voice channels, as an alterna- tive to coaxial cable is playing a major role in expanding channel capacity and improving signal quality and transmission reliability of the Company's plant. The Company finds it cost-effective to deploy fiber optic cable when building new cable plant or rebuilding existing cable plant. The Company has been closely monitoring developments in the area of digital compression, a technology which is expected to enable cable television operators to increase the channel capacity of cable television systems by permitting a significantly increased number of video signals to be transmitted over a cable television system's existing bandwidth. Although this technology is still in the developmental stage and has not yet been widely implemented by cable television operators, the Company believes that it may be a cost-effective method of increasing channel capacity in some of its Systems. The use of digital compression in these Systems also could expand the number and types of services they offer and enhance the development of current and future revenue sources of these Systems. At this time, it is not possible to predict the impact that this technology will have on the Company's operations. The Company was one of the founders of Cable Television Laboratories, Inc., the cable industry's technological research consortium which is presently involved in, among other things, the development of digital compression, high-definition television and interactive television applications. Management Regions; Employees. The Company's Systems are clustered in nine management regions to maximize marketing and operating effectiveness. Each area is managed by a Senior Vice President, to whom the Company has delegated broad operating authority. Engineering, hiring and training, purchasing and accounting are all performed at the regional level. The Boston office, with approximately 80 people, provides staff support in the areas of corporate planning, finance, financial reporting, marketing, program acquisition, training and benefit administration and government relations. The Company currently has approximately 7,000 full-time employees. None of the Company's employees is represented by a union or is covered by a collective bargaining agreement. The Company believes that its relations with its employees are good. Competition. The Company's Systems compete with other communications and entertainment media, including conventional off-air television broadcasting service. Cable television service was first offered as a means of improving television reception in markets where terrain factors or remoteness from major cities limited the availability of off-air television. In some of the areas served by the Systems, a substantial variety of broadcast television programming can be received off-air. The extent to which cable television service is competitive with broadcast stations depends in significant part upon the cable television system's ability to provide an even greater variety of programming than that available off-air. Cable television systems also are susceptible to competition from other video programming delivery systems, from other forms of home entertainment such as video cassette recorders, and, in varying degrees, from sources of entertainment in the community, including motion picture theaters, live theater and sporting events. Reasonably priced earth stations designed for private home use now enable individual households to receive many of the satellite-delivered programming services formerly available only to cable television subscribers. Many satellite programmers now encode their signals in order to allow reception only by means of authorized decoding equipment. Cable television systems also may compete with wireless program distribution services such as multichannel, multipoint distribution service ("MMDS"). MMDS uses low power microwave frequencies to transmit television programming over the air to its subscribers. The ability of MMDS to compete with cable television systems has been limited in the past by its limited amount of channel capacity. In 1991, the FCC amended its regulations to enable MMDS systems to compete more effectively with cable television systems by making available additional channel capacity to the MMDS industry under certain conditions. (See "Legislation and Regulation--1992 Cable Act".) The Company currently competes with MMDS systems in some of its markets, but to date such competition has not had a material adverse effect on the Company's operations. Additional competition exists from private cable television systems serving condominiums, apartment complexes and other private residential developments. The operators of these private systems, known as Master Antenna Television ("MATV") and Satellite Master Antenna Television ("SMATV"), often enter into exclusive agreements with apartment building owners or homeowners' associations that preclude operators of franchised cable television systems from serving residents of such private complexes. Due to the widespread availability of reasonably priced earth stations, such private cable television systems now can offer both improved reception of local television stations and many of the same satellite-delivered programming services that are offered by franchised cable television systems. In February 1991, the FCC adopted regulations that would permit SMATV operators to use point-to-point microwave service to distribute video entertainment programming. Moreover, a private cable television system normally is free of the regulatory burdens imposed on franchised cable television systems. Although a number of states and some municipalities have enacted laws and ordinances to afford operators of franchised cable television systems access to private complexes, the United States Supreme Court has held that cable companies cannot have such access without compensating the property owner. The access statutes of several states and the ordinance of one municipality in which the Company operates have been challenged successfully in the courts, and other such laws are under attack. Since the Company has generally been able to enter into access agreements with owners of private complexes, in the opinion of management, successful challenges to these access statutes and municipal ordinances would not have a material effect on the Company's operations. Since the Company's Systems operate under nonexclusive franchises, other operators (including municipal franchising authorities themselves) may obtain permission to build cable television systems in competition with the Systems in areas in which they presently operate. To date, the extent of actual overbuilding in the Company's franchise areas has been negligible. The Company is unaware of any pending applications for franchises which would result in overbuilding in communities served by the Systems. The 1992 Cable Act may facilitate the franchising of second cable television systems and municipally owned cable television systems. Although the Company is unable to predict the extent to which it would be adversely affected as a result of overbuilds, management sees little likelihood at this time that, in the aggregate, overbuilds will have a material adverse effect on the Company's operations. (See "Legislation and Regulation--1992 Cable Act".) In recent years, the FCC has adopted policies for authorizing new technologies and providing a more favorable operating environment for certain existing technologies. Such policies have the potential to create substantial additional competition to cable television systems. These technologies include, among others, direct broadcast satellite to home services ("DBS") whereby signals are transmitted by satellite to receiving facilities located on the premises of the subscribers. Although programming is currently available to the owners of backyard earth stations through conventional and medium-powered satellites, in the very near future programming will be delivered by high-powered direct-to-home satellites and will be available to individuals on a wide-scale basis. The Company is a partner in Primestar Partners, L.P. ("Primestar"), a limited partnership formed to operate a DBS system which began operations with a medium-powered satellite in 1990 and plans to launch two high-powered replacement satellites in 1996. Several other companies are preparing to have high-powered DBS systems in place by the middle of this decade. Hughes Communications launched a satellite in December 1993 and plans to have its system operational by April 1994. It is expected that these DBS operators (including Primestar, which expects to offer up to 70 channels in 1994) will use digital compression technology to increase the channel capacity of their systems to provide a package of movies and other programming services competitive with those of cable television systems. High-powered DBS service will be able to be received virtually anywhere in the United States using a compact rooftop or wall-mounted receiving dish. DBS companies may be able to offer new and highly specialized services using a national base of subscribers that are not available to the cable television industry, but as channel capacity and addressability increases, the cable industry will have the ability to offer additional services as well. Because DBS systems will deliver their services using satellite technology, they may not be able to provide services that are of local interest to their subscribers, and may not be able to maintain a local presence, which is an advantage in developing and maintaining subscriber support. The extent to which DBS systems will be competitive with the service provided by cable television systems will depend, among other things, on the ability of DBS operators to convince subscribers to purchase or lease the more expensive equipment (relative to cable) necessary to receive their signals and to offer a comparable level of programming, customer service and marketing. The 1992 Cable Act requires cable programmers under certain circumstances to offer their programming to operators of DBS, MMDS and other multichannel video systems at not unreasonably discriminatory prices. (See "Legislation and Regulation--1992 Cable Act".) Advances in communications technology and changes in the marketplace are constantly occurring. Therefore, it is not possible to predict the effect which ongoing or future developments might have on the Company's Systems or operations. Telephone Company Competition. The 1984 Cable Act, FCC regulations and the 1982 federal court consent decree (the "Modified Final Judgment") that settled the 1974 antitrust suit against AT&T all limit in various ways the provision of video programming and other information services by telephone companies. The 1984 Cable Act codified FCC cross-ownership regulations which, among other things, prohibit local telephone exchange companies, including the seven Bell Operating Companies ("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. These statutory provisions 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 conduits, associated rights-of-way and connections to the home. In July 1991, the federal district court responsible for the Modified Final Judgment issued an opinion lifting the Modified Final Judgment prohibition on the provision of information services, including broadband video services, by the BOCs. This decision was sustained on appeal. As a result, the BOCs may now acquire or construct cable television systems outside of their own service areas subject to appropriate waivers from such federal district court. Several BOCs have purchased or made investments in cable television systems outside their service areas in reliance on this decision. The Company does not expect such purchases of existing cable television systems by BOCs outside their service areas to have a material adverse impact on the Company's operations. In July 1992, the FCC voted to authorize additional competition to cable television systems 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. Several telephone companies have sought approval from the FCC to build such "video dialtone" systems in various communities in their service areas, including communities in which the Company currently holds cable franchises. The FCC also has concluded that under the 1984 Cable Act neither a local exchange carrier providing such a video dialtone service nor its programming suppliers who lease the dialtone service are required to obtain a cable television franchise. This ruling is now on appeal. Cable television systems could be placed at a competitive disadvantage if this ruling is sustained and video dialtone services become widespread in the future since cable television systems are required to obtain local franchises to provide cable television service and must comply with a variety of obligations under such franchises including the payment of franchise fees. One telephone company has successfully challenged the constitutionality of the statutory ban in the 1984 Cable Act on unrestricted telephone company ownership of cable television systems within their own service areas. A federal district court in Virginia, a state in which the Company owns Systems, struck down the ban on grounds that it violated the First Amendment rights of the telephone company. This decision is currently pending before an intermediate federal appeals court. Other telephone companies have filed similar suits in other states where the Company also operates. With respect to petitions for waivers from the current cross-ownership prohibitions under FCC regulations and the 1984 Cable Act, the FCC in one instance has tentatively concluded that construction and operation of technologically advanced, integrated broadband networks by local exchange carriers for the purpose of providing video programming and other services would constitute good cause for waiver. In July 1989, the FCC granted a California telephone company a waiver of the cross-ownership restrictions based on a showing of "good cause", but the FCC's decision was reversed on appeal. As a result of this decision, however, the affected telephone company has now challenged the cross-ownership ban on constitutional grounds before an intermediate federal appeals court. Legislation has been introduced before both the United States House of Representatives and the United States Senate that would alter the relationships between telephone companies and cable television operators in various ways. Provisions in these pending bills, and in legislative initiatives that have been proposed by the Clinton administration, would: (1) set ground rules for BOC provision of information services, including video services, outside of their regional service areas; (2) repeal the 1984 Cable Act ban on the provision of video programming by telephone companies within their service areas under certain conditions (under some versions of this legislation, telephone companies would still be prohibited from purchasing, or entering into joint ventures with, existing cable television companies within their service areas); (3) require local telephone companies to provide potential competitors, including cable television companies and alternate access providers such as TCG, with interconnection to local telephone networks; and (4) reduce and/or eliminate state barriers to entry by TCG, the Company and other similar providers of alternative voice and data services. If the current restrictions on telephone company ownership of cable television systems are removed or relaxed further by the courts or Congress, the Company is likely to face increased competition from telephone companies, which have greater financial resources than the Company. Legislation and Regulation. The cable television industry is subject to extensive governmental regulation at the federal, state and local level. In addition, various legislative and regulatory proposals, such as tax reform proposals and proposals to revise the Copyright Act of 1976, may materially affect the cable television industry. The following is a summary of federal laws and regulations that currently materially affect the growth and operation of the cable television industry, and a description of certain state and local laws. Cable Communications Policy Act of 1984. The 1984 Cable Act created uniform national standards and guidelines for the regulation of cable television systems. Among other things, the 1984 Cable Act affirmed the right of franchising authorities (state or local, depending on the practice in individual states) to award one or more franchises within their jurisdictions. It also prohibited post-1984 Cable Act cable television systems from operating without a franchise in such jurisdictions. In connection with new franchises, the 1984 Cable Act provides that in granting or renewing franchises, franchising authorities may establish requirements for cable-related facilities and equipment, but may not specify requirements for video programming or information services other than in broad categories. The 1984 Cable Act preempted local control over rates for premium channels and optional program tiers, and deregulated rates for basic cable services in areas where the cable operator was subject to "effective competition" as then defined by the FCC. This scheme was altered significantly by the 1992 Cable Act, discussed below. Although franchising authorities may impose franchise fees under the 1984 Cable Act, such payments cannot exceed 5% of a cable television system's annual gross revenues. In those communities in which franchise fees are required, the Company currently pays franchise fees ranging from flat annual fees equal to less than 1% of gross revenues to fees of 5% of gross revenues. Franchising authorities are also empowered to require cable operators to provide cable-related facilities, equipment and, in the case of pre-1984 Cable Act franchises, services to the public and to enforce compliance with such franchise requirements and voluntary commitments. When changed circumstances render such compliance commercially impracticable, however, the 1984 Cable Act requires franchising authorities to renegotiate franchise requirements and, under certain circumstances, permits the cable operator to make changes in programming without local approval. The 1984 Cable Act established renewal procedures designed to protect incumbent franchisees against arbitrary denials of renewal. This statute requires that franchising authorities consider a franchisee's past performance and renewal proposal on their own merits in light of community needs and without comparison to competing applicants. Nevertheless, renewal is by no means assured, as the franchisee must meet certain statutory standards. Moreover, even if a franchise is renewed, a franchising authority may impose new and more onerous requirements such as upgrading of facilities and equipment, although the municipality must take into account the cost of meeting such requirements. Also, the franchising authority may require higher franchise fees, up to the 5% of annual gross revenues cap established by the 1984 Cable Act, as a condition of renewal. The 1984 Cable Act permits local franchising authorities to require cable television operators to set aside certain channels for public, educational, and governmental access programming. The 1984 Cable Act further requires cable television systems with 36 or more channels to designate a portion of their channel capacity for commercially leased access by third parties. Although there has been little activity in this area nationally, it is possible that such leased access will result in competition to services offered over the cable system, particularly since the 1992 Cable Act, discussed below, empowers the FCC to set the rates and conditions for such licensed access channels. Questions concerning the right of a municipality to award de facto exclusive cable television franchises and to restrict cable television operations have been at issue in Preferred Communications, Inc. v. City of Los Angeles, involving a proposed applicant for a franchise in one of the Company's service areas, in which the United States Supreme Court declared that cable television operators have First Amendment rights which cannot be abridged in the absence of overriding governmental interests. In this case, an intermediate federal appeals court recently reaffirmed that a municipality may not constitutionally restrict the award of a cable franchise to a single entity, but did not rule on the constitutionality of other franchise provisions. 1992 Cable Act. On October 5, 1992, Congress enacted the 1992 Cable Act, which represented a significant change in the regulatory framework under which cable television systems operate. Since the effectiveness of the 1984 Cable Act, and prior to the enactment of the 1992 Cable Act, rates for cable television service 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 television systems in the United States, including substantially all of the Company's Systems. The 1992 Cable Act requires each cable television system to establish a basic service tier (the "Basic Service Tier") consisting, at a minimum, of all broadcast signals carried by such system (except those signals imported by satellite from another market (i.e., superstations)) and all public, educational and governmental access programming. On April 1, 1993, the FCC adopted regulations governing the rates for the Basic Service Tier. Under the FCC's regulations, municipalities were originally authorized to reduce the rates for the Basic Service Tier by up to 10% from rates in effect on September 30, 1992 if those rates exceeded a per-channel benchmark established by the FCC. On February 22, 1994, after reconsideration, the FCC significantly revised the regulatory framework it adopted on April 1, 1993 and established a new benchmark formula. The final text of the rules implementing this revised regulatory framework has not yet been issued. In creating the new benchmark formula, the FCC authorized a further reduction in the rates for the Basic Service Tier in effect on September 30, 1992. As a result, such rates may be reduced by up to 17% if they exceed the new per-channel benchmark. If a cable television system's rates for the Basic Service Tier do not need to be reduced by 17% in order to reach the new benchmark, such rates may nonetheless be subject to further reduction, up to a maximum reduction of 17% from the rates in effect on September 30, 1992, based upon the results of a pending FCC study of the operating costs of such cable television systems. Pending resolution of the FCC's cost study, such systems will be required to calculate the extent to which their rate reduction falls short of 17%. This reduction "differential" will then be offset against any inflation adjustment pending completion of the cost study. Municipalities are also empowered to regulate the rates charged for installation and lease of the equipment used by subscribers to receive the Basic Service Tier (including a converter unit, a remote control unit and, if requested by a subscriber, an addressable converter unit or other equipment required to access programming offered on a per-channel or per-program basis) and the installation and monthly use of connections for additional television sets. The FCC's regulations require municipalities to regulate these rates on the basis of actual cost standards developed by the FCC. Under the regulations adopted by the FCC on April 1, 1993, the FCC may, in response to complaints by a subscriber, municipality or other governmental entity, reduce the rate for tiers of service other than the Basic Service Tier. This authority does not extend to any services offered on a per-channel or per-program basis. The original maximum reduction was set at 10% from the rates in effect on September 30, 1992, if those rates exceeded a per-channel benchmark established by the FCC. On February 22, 1994, the FCC determined on reconsideration to authorize a reduction of up to 17% from rates in effect on September 30, 1992 for regulated tiers of service other than the Basic Service Tier if those rates exceed a new per-channel benchmark established by the FCC. As with the potential reduction in rates for the Basic Service Tier, if a cable television operator's rates for these higher regulated service tiers do not need to be reduced by 17% in order to reach the new benchmark, such rates may nonetheless be subject to further reduction, up to a maximum reduction of 17% from the rates in effect on September 30, 1992, based upon the results of the FCC's cost study. Pending resolution of this study, these systems will be required to calculate the extent to which their rate reduction falls short of 17%. This reduction "differential" will then be offset against any inflation adjustment pending completion of the cost study. In response to complaints, the FCC will also regulate, on the basis of actual cost, the rates for equipment used only to receive these higher regulated service tiers of service. The regulations adopted by the FCC on April 1, 1993, including the original rate benchmarks, became effective on September 1, 1993. The final rules reflecting the new rate regulations adopted by the FCC on February 22, 1994 are expected to be issued before March 31, 1994 and become effective in May 1994. Until the new rate regulations become effective, rates will continue to be governed by the April 1, 1993 FCC rules. In connection with the adoption of the original regulations on April 1, 1993, the FCC announced its intention to investigate cable television systems whose rates for regulated services are substantially above the per-channel benchmarks. These cable television systems could be subject to rate reductions in excess of the maximum percentage reduction of 10% established in the original regulations. It is unclear what effect, if any, the actions of the FCC on February 22, 1994 will have on the FCC's previously announced intention to investigate such cable systems. Under the FCC's rules, as indicated above, municipalities and the FCC will use rates in effect on September 30, 1992 as the basis for any required reductions in the rates for the Basic Service Tier and other regulated service tiers. Accordingly, cable television systems that implemented rate increases subsequent to September 30, 1992, including certain of the Company's Systems, are subject to effective rate reductions in excess of 10%, and may be subject to effective rate reductions in excess of 17%. The regulations provide that future increases in service rates may not exceed an inflation-indexed amount, which may include a "productivity offset feature" (see discussion below), plus increases in certain costs beyond the cable operator's control, such as taxes, copyright fees, franchise fees and increased programming costs imposed by non-affiliated programmers that exceed an inflation index. The FCC will not allow amounts paid prior to October 6, 1994 to broadcast stations for retransmission of their signals to be passed through to customers in the form of increased rates, but will allow the pass-through of subsequent increases in such amounts. As part of the implementation of the new regulations, the FCC has frozen all rates in effect on April 5, 1993 until May 15, 1994 except rates for premium and pay-per-view program services and equipment or for any entirely new tier of services offered to customers. On February 22, 1994, the FCC also 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 final text of such rules has not yet been issued. In connection with the rate regulations adopted on April 1, 1993, the FCC suggested that cable television operators follow general ratemaking principles for cost-of-service showings. On February 22, 1994, the FCC adopted interim cost-of-service standards that establish a regulatory framework pursuant to which a cable television operator may attempt to justify rates in excess of the new 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 "rate base"). The interim standards (1) create a rebuttable presumption that excludes from a cable television operator's rate base 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%, presumably 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. The FCC has not yet issued the final text of its interim standards for cost-of-service proceedings or for any of the other actions taken on February 22, 1994. Thus, the Company is unable at this time to assess the impact of these actions on the Company's operations. On June 17, 1993, local commercial broadcast stations were required to make an election between the guarantee of mandatory carriage on cable television systems, without compensation, and requesting payment from cable television systems for "retransmission consent", which election is binding for three years. Since October 6, 1993, a cable television system has not been allowed to carry a local broadcast station that has elected to require retransmission consent without the station's express authorization. (See "Programming".) Under the 1992 Cable Act, cable television systems may not require subscribers to purchase any service tier other than the Basic Service Tier as a condition of access to video programming offered on a per-channel or per-program basis. Cable television systems are allowed up to ten years, to the extent necessary, to implement the technology to facilitate this access. In addition, the 1992 Cable Act (i) requires cable television programmers under certain circumstances to offer their programming to present and future competitors of cable television such as MMDS, SMATV and DBS operators at not unreasonably discriminatory prices, (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 and prohibits new exclusive contracts with program suppliers without FCC approval, (iii) bars municipalities from unreasonably refusing to grant additional competitive franchises, and (iv) regulates the ownership by cable television operators of other media such as MMDS and SMATV. The FCC has imposed or will impose new regulations under the 1992 Cable Act in the areas of customer service, technical standards, compatibility with other consumer electronic equipment such as "cable ready" television sets and video cassette recorders, equal employment opportunity, privacy, obscenity and indecency, rates for leased access channels, and disposition of a customer's home wiring. The FCC adopted a 40% limit on the number of channels that may be occupied by programming services in which a particular cable television operator has an attributable interest, and a national limit of 30% on the number of homes passed that any one entity can reach through its cable television systems. The latter rule was stayed by the FCC pending the outcome of an appeal from a federal district court decision holding such limits unconstitutional. The extent and materiality of the effects of the 1992 Cable Act on the Company's operations are described elsewhere in this report. (See "Management's Discussion and Analysis of Financial Condition and Results of Operations--Liquidity and Capital Resources--Recent Legislation" and "Programming".) A number of lawsuits have been filed challenging the constitutionality of various provisions of the 1992 Cable Act. Challenges to the rate regulations, leased access, program access and other sections of the 1992 Cable Act were rejected by a federal district court. This decision is currently on appeal to the D.C. Circuit Court of Appeals. Other challenges to the current rate freeze and other portions of the FCC's rate regulation scheme have been separately brought directly to the D.C. Circuit Court of Appeals. In another proceeding, such court has invalidated the leased access channel and public, educational and governmental access channel "indecency" restrictions in the 1992 Cable Act. A challenge to the constitutionality of the 1992 Cable Act's must-carry rules was denied by a federal district court in April 1993. A stay of the rules was denied by the United States Supreme Court pending the appeal which has been argued before that Court. The Company cannot predict the outcome of this appeal or of the remaining suits. Other Federal Regulation. The FCC, the principal federal regulatory agency with jurisdiction over cable television, is responsible for implementing federal policies such as cable television system relations with other communications media, cross-ownership, signal carriage, equal employment opportunity and technical performance. In 1989, the FCC issued new syndicated exclusivity and network non-duplication rules which enable local television broadcasters to compel cable television operators to delete certain programming on distant broadcast signals. Those rules took effect January 1, 1990. Under the rules, all television broadcasters, including independent stations, can compel cable television operators to delete syndicated programming from distant signals if the local broadcaster negotiated exclusive rights to such programming. Local network affiliates may insist that a cable television operator delete a network broadcast on a distant signal. The rules make certain distant signals a less attractive source of programming for the Company's Systems, since much of such distant signals' programming may have to be deleted. The FCC currently regulates the rates and conditions imposed by public utilities for use of their poles, unless, under the Federal Pole Attachments Act, state public service commissions are able to demonstrate that they regulate the cable television pole attachment rates (as is true in certain states in which the Company does business). In the absence of state regulation, the FCC administers pole attachment rates through the use of a formula which it has devised. The validity of this FCC function was upheld by the United States Supreme Court. Copyright. Cable television systems are subject to federal copyright licensing, covering carriage of television broadcast signals. In exchange for contributing a percentage of their revenues to a federal copyright royalty pool, cable television operators obtain a compulsory license to retransmit copyrighted materials from broadcast signals. Existing Copyright Office regulations require that compulsory copyright payments be calculated on the basis of revenue derived from any service tier containing broadcast retransmissions. Although the FCC has no formal jurisdiction over this area, it has recommended to Congress to eliminate the compulsory copyright scheme altogether. The United States Copyright Office has similarly recommended such a repeal. Without the compulsory license, cable television operators would need to negotiate rights from the copyright owners for each program carried on each broadcast station in the channel lineup. Such negotiated agreements could increase the cost to cable television operators of carrying broadcast signals. Thus, given the uncertain but possible adoption of this type of copyright legislation in the future, the nature or amount of the Company's future payments for broadcast signal carriage cannot be predicted at this time. Cable Television Cross-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 telephone companies' ownership of cable television systems operating in their service areas, with limited exceptions for rural areas. The FCC has discretionary authority to expand the rural area exception for telephone companies offering cable television service within their service areas and is currently considering increasing such authority. As discussed above under "Telephone Company Competition", the cable-telephone company cross-ownership ban contained in the 1984 Cable Act has been struck down as unconstitutional by one federal district court, and similar suits are pending in many other jurisdictions in which the Company operates. The FCC has modified its rule that formerly barred the commercial broadcasting networks (NBC, CBS and ABC) from owning cable television systems. The new FCC rule does not allow the network to acquire cable television 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 television systems. The 1992 Cable Act bars future common ownership of cable television systems and MMDS or SMATV systems in the same franchise area, but grandfathered existing combinations. There is no Federal prohibition of newspaper ownership of cable television systems, or cable television system ownership of radio stations. The Company does not have any prohibited cross-ownership interests. State and Local Regulation. Cable television systems are generally operated pursuant to franchises, permits or licenses issued by a municipality or other local governmental entity. Franchises are usually issued for fixed terms and must periodically be renewed. Most of the franchises for the Company's Systems were granted on a nonexclusive basis. Each franchise generally contains some provisions governing subscriber charges for basic cable television services, fees to be paid to the franchising authority, length of the franchise term, renewal and sale or transfer of the franchise, territory of the franchise, design and technical performance of the system, use and occupancy of public streets and number and types of cable television services provided. (See "Franchises".) Though the 1984 Cable Act provides for certain procedural protections, there can be no assurance that renewals will be granted or that renewals will be made on similar terms and conditions. (See "Cable Communications Policy Act of 1984".) Various proposals have been introduced at the state and local levels with regard to the regulation of cable television systems, and a number of states have adopted legislation subjecting cable systems to the jurisdiction of state governmental agencies. States where the Company operates Systems, including California, Connecticut, Massachusetts, Minnesota and New York, have enacted legislation with respect to the regulation of cable television systems. Regulation of Telecommunications Activities. As noted above, under "General Development of Business-Development of New Services; Alternate Access", the Company provides in certain of its Systems alternate access local telecommunications services over a portion of its fiber optic cable facilities, either directly or through joint ventures (primarily joint ventures with TCG and its owners). Local telecommunications activities are regulated by either the FCC or state public utility commissions, or both. In some instances, the Company or TCG may be required to obtain regulatory permission to offer such services, and may be required to file tariffs for its service offerings, depending on whether particular alternative access activities of the Company or TCG are classified as common carriage or private carriage. * * * * The foregoing does not purport to be a summary of all present and proposed federal, state and local regulations and legislation relating to the cable television industry. Other existing federal regulations, copyright licensing, and, in many jurisdictions, state and local franchise requirements, currently are the subject of a variety of judicial proceedings, legislative hearings, and administrative and legislative proposals which could change, in varying degrees, the manner in which cable television systems operate. Neither the outcome of these proceedings nor their impact upon the cable industry or the Company can be predicted at this time. Item 2. Item 2. Properties. The Company's principal physical assets consist of cable television systems, including signal receiving, encoding and decoding apparatus, headends, distribution systems, and subscriber house drop equipment for each of its Systems. The signal receiving apparatus typically includes a tower, antenna, ancillary electronic equipment, and earth stations for reception of satellite signals. Headends, consisting of associated electronic equipment necessary for the reception, amplification and modulation of signals, are located near the receiving devices. The Company's distribution systems consist of coaxial and fiber optic cables and related electronic equipment. Subscriber equipment consists of taps, house drops and converters. The Company owns its distribution system, various office and studio fixtures, test equipment and service vehicles. The physical components of the Systems require maintenance and periodic upgrading to keep pace with technological advances. The Company considers all of its properties to be in excellent condition. The Company's coaxial and fiber optic cables are generally attached to utility poles under pole rental agreements with local public utilities, although in some areas the distribution cable is buried in underground ducts or trenches. The FCC regulates pole attachment rates under the Federal Pole Attachments Act. (See "Descriptions of Business--Legislation and Regulation--Other Federal Regulation".) The Company owns or leases parcels of real property for signal reception sites (antenna towers and headends), microwave facilities and business offices. The Company owns the building which houses its offices in Boston, Massachusetts. Item 3. Item 3. Legal Proceedings. There are no material pending legal proceedings against the Company. The Company is subject to legal proceedings and claims which arise in the ordinary course of business, none of which is material in the opinion of management. Item 4. Item 4. Submission of Matters to a Vote of Security Holders. There were no matters submitted to a vote of security holders of the Company during the fourth quarter of the fiscal year ended December 31, 1993. PART II Item 5. Item 5. Market for the Registrant's Common Stock and Related Stockholder Matters. No established public trading market exists for the Company's Class A Common Stock, $.01 par value per share (the "Class A Common Stock"), or Class B Common Stock, $.01 par value per share (the "Class B Common Stock"; together with the Class A Common Stock, the "Common Stock"), and accordingly no high and low bid information or quotations are available with respect to the Company's Common Stock. As of March 21, 1994 there were 388 holders of record of its Common Stock. The Company has not paid dividends on its Common Stock and has no present intention of so doing. Certain agreements, pursuant to which the Company has borrowed funds, contain provisions that limit the amount of dividends and stock repurchases that the Company may make. (See Note 7 to the Company's Consolidated Financial Statements.) Item 6. Item 6. Selected Financial Data. The following tables present selected information relating to the financial condition and results of operations of the Company over the past five years, and should be read in conjunction with the Consolidated Financial Statements of the Company for the year ended December 31, 1993 set forth in Item 8 hereof. (In Thousands, Except Ratios and Subscriber Amounts) Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. The following table sets forth for the years indicated (i) certain items in the Selected Financial Data as a percentage of total revenues from continuing operations and (ii) the percentage changes in the amount of such items compared to the comparable prior year. Results of Operations. The Company has generated increases in revenues and EBITDA in each of the past three fiscal years primarily through basic subscriber growth and increases in monthly revenue per average basic subscriber. During the period from January 1, 1991 through December 31, 1993, revenues and EBITDA increased at annual compound growth rates of 8% and 11%, respectively. The high level of depreciation and amortization associated with the Company's acquisitions and capital expenditures related to continued System construction and routine replacements and interest costs related to its financing activities have caused the Company to report net losses. The Company believes that such net losses are common for cable television companies. 1991--Revenues increased 11% to $1,039,163,000 and EBITDA increased 14% to $444,708,000. The increase in revenues resulted from a 3% increase in basic subscribers to 2,804,000 and an increase in monthly revenue per average basic subscriber from $31.29 to $32.98. The $1.69 increase reflected primarily (i) an increase of $1.81 due to basic rate increases and revenue growth from other services, (ii) an increase of $.43 in advertising and pay-per-view revenue and (iii) a decrease of $.55 in premium subscription revenue, which was due to the decrease in the pay-to-basic percentage from 99.7% to 92.9%, reflecting industry-wide trends. The total number of premium subscriptions decreased from 2,702,000 to 2,603,000 in 1991. Operating, selling and general and administrative expenses increased 9% to $594,455,000, a rate of growth less than that of revenues reflecting operating efficiencies. Such efficiencies contributed to the 14% growth in EBITDA to $444,708,000. Depreciation and amortization expenses increased 2% to $269,363,000 as a result of reduced levels of acquisitions and capital expenditures as compared to prior years. Non-cash stock compensation increased 46% to $10,067,000 due to the vesting of a greater percentage of shares issued under the Company's Restricted Stock Purchase Program as compared to 1990. Operating income increased 38% to $165,278,000. Interest expense increased 3% to $323,123,000 in 1991 principally due to the increased debt incurred to finance the redemption of the remaining outstanding shares of the Company's redeemable Preferred Stock, offset in part by lower effective interest rates during 1991. As a result of such factors, 1991 net loss decreased by $33,809,000 to $161,642,000. 1992--Revenues increased 7% to $1,113,475,000 and EBITDA increased 10% to $488,330,000. The increase in revenues resulted from a 3% increase in basic subscribers to 2,876,000 and an increase in monthly revenue per average basic subscriber from $32.98 to $34.46. The $1.48 increase reflected primarily (i) an increase of $1.79 due to basic rate increases and revenue growth from other services, (ii) an increase of $.34 in advertising revenue, (iii) a decrease of $.08 in pay-per-view revenue due to the lack of availability of high-profile sporting events which could be offered as compared to 1991, a condition that prevailed industry-wide in 1992, and (iv) a decrease of $.57 in premium subscription revenue due to the decrease in the pay-to-basic percentage from 92.9% to 88.5%, again reflecting industry-wide trends. The total number of premium subscriptions decreased from 2,603,000 to 2,545,000 in 1992. Operating, selling and general and administrative expenses increased 5% to $625,145,000, a rate of growth less than that of revenues, reflecting continued operating efficiencies. Such efficiencies contributed to the 10% growth in EBITDA. Depreciation and amortization expenses increased 4% to $279,403,000 primarily as a result of the write-off of previously deferred financing costs in connection with the refinancing in 1992 of certain indebtedness. Non-cash stock compensation decreased 4% to $9,683,000 due to the vesting of a reduced percentage of shares issued under the Company's Restricted Stock Purchase Program as compared to 1991. Operating income increased 21% to $199,244,000. Interest expense decreased 10% to $289,479,000 due to a reduction in debt of $326,612,000 and lower effective interest rates. Other (income) expenses included a preliminary gain on the sale of the Company's interest in North Central Cable Communications Corporation of $10,253,000, before post-closing adjustments. Also included was a charge of $10,280,000 due to litigation arising from the redemption of the limited partnership interests in the American Partnerships. As a result of such factors, 1992 net loss decreased $58,682,000 to $102,960,000. 1993--Revenues increased 6% to $1,177,163,000 and EBITDA increased 8% to $527,592,000. The increase in revenues resulted from a 1% increase in basic subscribers to 2,915,000 and an increase in monthly revenue per average basic subscriber from $34.46 to $35.76. The $1.30 increase reflected primarily (i) an increase of $1.34 due to basic rate increases made prior to the imposition of the FCC's rate regulation and revenue growth from other services, (ii) an increase of $.29 in advertising and pay-per-view revenue, and (iii) a decrease of $.33 in premium subscription revenue, which was due to the decrease in the pay-to-basic percentage from 88.5% to 84.2%, again reflecting industry-wide trends. The total number of premium subscriptions decreased from 2,545,000 to 2,454,000 in 1993. Operating, selling and general and administrative expenses increased 4% to $649,571,000, a rate of growth less than that of revenues, reflecting continued operating efficiencies. Such efficiencies contributed to the 8% growth in EBITDA. Depreciation and amortization expenses increased 2% to $284,563,000. Non-cash stock compensation increased 14% to $11,004,000 due to the vesting of a greater percentage of shares issued under the Company's Restricted Stock Purchase Program as compared to 1992. Operating income increased 16% to $232,025,000. Interest expense decreased 4% to $276,698,000 due to a reduction in the average debt outstanding and lower effective interest rates. Other (income) expense included a gain of $4,322,000 on the sale of marketable equity securities and a gain of $17,067,000 on the sale of investments, which consisted of a gain of $15,919,000 due to the exchange of the Company's equity interest in Insight Communications Company U.K., L.P. for stock representing a minority interest in International CableTel, Incorporated and a gain of $1,148,000 due to a post-closing adjustment in connection with the sale of the Company's interest in North Central Cable Communications Corporation. Also included in other (income) expense was a gain of $2,325,000 relating to the reversal of previously accrued liabilities recorded in connection with the American Partnerships litigation, which was settled in 1993. Equity in net loss of affiliates increased to $12,827,000 primarily due to the Company recording its proportionate share of losses from TCG and its affiliates. Financial Accounting Standards No. 109, "Accounting for Income Taxes" ("SFAS 109"), which the Company implemented as of January 1, 1993, required a change from the deferred to the liability method for computing deferred income taxes. The cumulative effect of this change, which was made as of January 1, 1993, was a non-recurring increase in net loss of $184,996,000. The cumulative change resulted from net deferred tax liabilities recognized for the difference between the financial reporting and tax bases of assets and liabilities. Income tax expense (benefit) changed from an expense of $1,654,000 in 1992 to a benefit of $7,921,000 in 1993 due to deferred tax benefits recognized under SFAS 109. The income tax benefit for 1993 was decreased by $4,182,000 as a result of applying the newly enacted federal tax rates to deferred tax balances as of January 1, 1993. As a result of such factors, net loss before cumulative effect of change in accounting for income taxes for the year ended December 31, 1993 decreased by $77,186,000 to $25,774,000. * * * * * The Company expects that advertising and home shopping revenues (which currently represent approximately 5% of the Company's total revenues) may become a larger percentage of total revenues. These sources of revenues tend to be cyclical and seasonal in nature and could introduce cyclicality and seasonality to the Company's total revenues and EBITDA. Inflation. Certain of the Company's expenses, such as those for wages and benefits, for equipment repair and replacement, and for billing and marketing, increase with general inflation. However, the Company does not believe that its financial results have been, or will be, adversely affected by inflation, provided that it is able to increase its service rates periodically. (See "Business--Description of Business--Legislation and Regulation" for a description of recent legislation and pending regulation that may limit the Company's ability to raise its rates.) Recent Accounting Pronouncements. In May 1993, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities" ("SFAS 115"), which is effective for fiscal years beginning after December 15, 1993. SFAS 115 establishes standards for the accounting and reporting for investments in equity securities that have readily determinable fair values and for all investments in debt securities. The Company plans to implement SFAS 115 as of January 1, 1994. Upon such implementation, the Company believes it will recognize an additional asset of approximately $140,920,000 and a deferred tax liability of $56,367,000, which will increase shareholders' equity. In May 1993, the FASB issued Statement of Financial Accounting Standards No. 114, "Accounting by Creditors for Impairment of a Loan" ("SFAS 114"), which is effective for fiscal years beginning after December 15, 1994. SFAS 114 addresses the accounting for certain loans made by the Company to affiliates and certain employees if such loans are deemed impaired. The effect of implementing this statement will be immaterial to the Company's financial position and results of operations. In November 1992, the FASB issued Financial Accounting Standards No. 112, "Employer's Accounting for Postemployment Benefits" ("SFAS 112"), which is effective for fiscal years beginning after December 15, 1993. SFAS 112 establishes standards for accounting for benefits provided to former or inactive employees and their dependents and beneficiaries before retirement. The effect of implementing this statement will not be significant on the Company's financial position and results of operations. Liquidity and Capital Resources. The cable television business requires substantial financing for construction, expansion and maintenance of plant and for acquisitions. The Company has historically financed its capital needs and acquisitions through long-term debt and, to a lesser extent, through private issuances of equity and cash provided from operating activities. The Company's ability to generate cash adequate to meet its needs depends generally on its results of operations and on the availability of external financing. The following table sets forth for the years indicated certain items from the Statements of Consolidated Cash Flows. Year Ended December 31, 1991 1992 1993 (In Thousands) NET CASH PROVIDED FROM OPERATING ACTIVITIES $ 123,543 $ 215,045 $ 250,504 NET CASH PROVIDED FROM (USED FOR) FINANCING ACTIVITIES: Net Borrowings (Repayments) $ 210,934 $(374,712) 165,509 Stock Repurchased and Dividends Paid (163,888) (233,984) (31,232) Issuance of Stock -- 548,189 46,500 Other (1,765) 389 (2,580) Total $ 45,281 $ (60,118) $ 178,197 NET CASH PROVIDED FROM (USED FOR) INVESTING ACTIVITIES: Acquisitions, Net of Liabilities Assumed $ (5,490) $ -- $ -- Property, Plant and Equipment (145,846) (145,189) (185,691) Investments (9,077) (17,908) (106,819) Other Assets (4,523) (12,996) (39,728) Purchase of Marketable Equity Securities -- -- (8,042) Proceeds from Sale of Marketable Equity Securities -- -- 5,719 Proceeds from Sale of Investments -- 34,253 1,148 Total $(164,936) $(141,840) $(333,413) 1993 Transactions. On June 3, 1993, the Company publicly issued (the "June 1993 Offering") $100,000,000 in aggregate principal amount of 8-5/8% Senior Notes Due 2003 and $300,000,000 in aggregate principal amount of 9% Senior Debentures Due 2008. On August 16, 1993, the Company publicly issued (the "August 1993 Offering"; together with the June 1993 Offering, the "1993 Offerings") $200,000,000 in aggregate principal amount of 8-1/2% Senior Notes Due 2001, $275,000,000 in aggregate principal amount of 8-7/8% Senior Debentures Due 2005 and $525,000,000 in aggregate principal amount of 9-1/2% Senior Debentures Due 2013 (all of the foregoing securities are sometimes collectively referred to as the "Senior Unsecured Debt Securities"). The Company used the net proceeds from the issuance of the Senior Unsecured Debt Securities, which totalled approximately $1,372,617,000, primarily to: (i) prepay in its entirety $184,500,000 of outstanding senior indebtedness, plus accrued interest thereon, of American Cablesystems of California, Inc., an indirectly wholly owned subsidiary of the Company; (ii) repay the entire $149,950,000 then outstanding under the Company's reducing revolving credit facility (the "Reducing Revolver"); (iii) prepay $770,000,000 of the term loans (the "Term Loans") outstanding under the Company's Credit Agreement (the "Credit Agreement"), plus accrued interest thereon; (iv) prepay in its entirety the $100,000,000 term loan outstanding under the Company's 1992 Credit Agreement (the "1992 Credit Facility"), plus accrued interest thereon; and (v) prepay in their entirety the $31,208,000 of the Company's outstanding Series A/B Senior Secured Notes due January 15, 1999, plus accrued interest thereon. The Company used the remainder of the net proceeds for general corporate purposes. As a result of the application of the net proceeds described above, the Company extended the average life of its total indebtedness by approximately 4 years to over 11 years. The Company also increased its borrowing availability under the Reducing Revolver from $400,000,000 to $500,000,000, none of which was outstanding as of December 31, 1993. During the period from January 1, 1991 through December 31, 1993, the Company committed substantial capital resources for (i) construction and expansion of existing Systems, (ii) routine replacement of cable television plant, (iii) an increase in the channel capacity of certain Systems, (iv) construction of new Systems, and (v) an increase in the percentage of Systems which are equipped with addressable technology. In 1991, 1992 and 1993, capital expenditures totaled $145,846,000, $145,189,000 and $185,691,000, respectively. The Company has budgeted approximately $355,000,000 for capital expenditures for the Systems during 1994 which includes $257,000,000 for the cost to rebuild and expand channel capacity of, and to further deploy addressable technology in, several of its Systems, $60,000,000 for line extensions and customer connections and $38,000,000 primarily for routine replacement of its equipment. The Company's 1994 budget is not yet final due to uncertainty caused by the FCC's proposed rulemakings released on February 22, 1994, and will not become final until the Company can assess the impact of such regulations on the Company's business. (See "Business--Description of Business--Legislation and Regulation--1992 Cable Act".) The anticipated increase in capital expenditures during 1994 as compared to 1993 is due principally to the Company's intention to further expand channel capacity and to deploy addressable technology more extensively in its Systems. (See "Business--Description of Business--Technological Developments".) During the year ended December 31, 1993, the Company made investments in an aggregate amount of $106,819,000, which related primarily to its ownership interests in TCG and Primestar. (See "Investments" and "Business--Description of Business--Competition".) The Company engaged in several other transactions reflected in Net Cash Provided From (Used For) Investing Activities in 1993. The Company exercised options for shares of common stock of Home Shopping Network, Inc. at a price of $8,042,000 and then sold a portion of the shares for $5,719,000. In addition, the Company received a post-closing adjustment of $1,148,000 from the disposition in 1992 of its interest in North Central Cable Communications Corporation. Finally, other assets increased by $39,728,000 primarily due to underwriting fees and expenses relating to the issuance of the Senior Unsecured Debt Securities and the capitalization of a termination fee of an interest rate protection agreement. In November 1993, the Company issued and sold to a group of private investors 95,876 shares of Class A Common Stock for $46,500,000. The Company invested such net proceeds in cash equivalents which were later used in part to fund a repurchase of shares of Class A Common Stock from the partners of an investment limited partnership managed by Burr, Egan, Deleage & Co. (the "BED Partnership"). A condition to such repurchase by the Company was the release by the BED Partnership of all rights under the Stock Liquidation Agreement, described below, as to any shares not sold by such partnership and its partners. On December 21, 1993, the Company repurchased 64,176 shares from such partners for an aggregate purchase price of approximately $31,125,000, or $485 per share, which was the same per share price that investors paid in the November private placement. In March 1994, the Company repurchased 3,316 shares of Class B Common Stock from two other investment limited partnerships managed by Burr, Egan, Deleage & Co. for $485 per share. As a result of such repurchases and the release by the BED Partnership, the Company reduced its future obligations to repurchase shares pursuant to the 1998-1999 Share Repurchase Program, described below, by 83,939 shares. 1998-1999 Share Repurchase Program. In 1989, following various discussions with shareholders concerning the lack of a public trading market for the Company's Common Stock, the Company entered into a liquidity agreement (the "Stock Liquidation Agreement") with certain major shareholders, including H. Irving Grousbeck, MD Co. and Burr, Egan, Deleage & Co. (collectively, the "Subject Shareholders"), who together held 1,684,116 shares of Common Stock (or approximately 26% of the then outstanding shares of Common Stock). Shortly thereafter, the Company extended to its other shareholders the opportunity to participate in such program. The Stock Liquidation Agreement provided for various liquidity arrangements, of which the only remaining one is the Company's obligation to repurchase the remaining shares of Common Stock held by the Subject Shareholders (other than MD Co., a large portion of whose shares were purchased in 1992), as well as by other shareholders who elected to participate in this aspect of the liquidity program (collectively, the "Selling Shareholders"), on December 15, 1998 (or January 15, 1999, at each Selling Shareholder's election) at the purchase price equal to the greater of (i) the dollar amount that a holder of Common Stock would receive per share of Common Stock upon a sale of the Company as a whole pursuant to a merger or a sale of stock or, if greater, the dollar amount a holder of Common Stock would then receive per share of Common Stock derived from the sale of the Company's assets and subsequent distribution of the proceeds therefrom (net of corporate taxes, including sales and capital gains taxes in connection with such sale of assets), in either case less a discount of 22.5% or (ii) the dollar amount equal to the net proceeds which would be expected to be received by a shareholder of the Company from the sale of a share of the Company's Common Stock in an underwritten public offering after, under certain circumstances, being reduced by pro forma expenses and underwriting discounts. None of the Officers or Directors of the Company elected to participate in the 1998-1999 Share Repurchase Program. The Selling Shareholders have agreed not to acquire any additional shares of the Company's Common Stock (or securities convertible into or granting the right to purchase shares of Common Stock). The maximum number of shares of Common Stock that the Company will be required to repurchase is 667,366 (currently representing approximately 11.70% of its outstanding shares of Common Stock, on a fully diluted basis assuming conversion of the Company's outstanding Convertible Preferred Stock into shares of Common Stock on a share-for-share basis). The obligations of the Company to repurchase shares of Common Stock pursuant to the 1998-1999 Share Repurchase Program are subject to applicable requirements of law, including the relevant Delaware corporate statutes relating to impairment of capital. Section 160 of the Delaware General Corporation Law provides that, for the purpose of redeeming or otherwise acquiring outstanding shares of its capital stock, a corporation may use only those surplus funds which represent the amount by which the value of its net assets exceeds the aggregate amount represented by all the shares of its capital stock; to the extent funds used for redemption purposes exceed this amount, a corporation is deemed to have impaired its capital in violation of Section 160. If the Company's financial position is such that it is unable to fulfill its obligations under the Stock Liquidation Agreement in compliance with this statutory requirement, the Company will be prohibited from consummating such transactions. The Company's obligations under the 1998-1999 Share Repurchase Program are also subject to existing and future agreements of the Company, including all existing and future financing agreements. Provisions in such agreements restricting the Company's ability to incur indebtedness or to make distributions to, or redeem or repurchase shares of capital stock from, its shareholders may prevent the Company from consummating the 1998-1999 Share Repurchase Program. (See Note 7 to the Company's Consolidated Financial Statements.) To the extent such program is thus prohibited, the Stock Liquidation Agreement provides that the Company's obligation to consummate the relevant repurchase or portion thereof will be deferred until such time as the consummation of such repurchase or portion thereof would be in compliance with such requirements of law and agreements. In the event the Company is unable to perform its obligations to complete the 1998-1999 Share Repurchase Program within six months of the payment date therefor, the Company is obligated, at the request made within such six month period of any one or more Subject Shareholders (other than MD Co.) or transferees holding an aggregate of at least 100,000 shares of such transferred shares of Common Stock, to use its best efforts (subject to compliance with applicable laws and regulations) to cause the sale of all or substantially all of the assets of the Company and, following the consummation of such sale, to liquidate the Company. Credit Arrangements of the Company. On December 31, 1993, the Company had cash on hand of $122,640,000 and the following credit arrangements: (i) the Credit Agreement, which provided for term loans in the aggregate principal amount of $754,550,000 as of such date; (ii) the 1992 Credit Facility, which provided for the Reducing Revolver in an amount of up to $500,000,000 (all of which was available as of such date); (iii) $171,500,000 of 10.12% Senior Notes Due 1999 to The Prudential Life Insurance Company; (iv) the Senior Unsecured Debt Securities (see "1993 Transactions" above); (v) $100,000,000 of 10-5/8% Senior Subordinated Notes Due 2002; (vi) $325,000,000 of 12-7/8% Senior Subordinated Debentures Due 2004; (vii) $100,000,000 of Senior Subordinated Floating Rate Debentures Due 2004; and (viii) $300,000,000 of 11% Senior Subordinated Debentures Due 2007. Other miscellaneous debt was $26,128,000 on December 31, 1993. The annual maturities of the Company's indebtedness for the years ending December 31, 1994, 1995, 1996, 1997 and 1998 will be $65,626,000, $92,550,000, $99,350,000, $145,250,000 and $175,350,000, respectively. The Company's subsidiaries are divided into Restricted Subsidiaries and Unrestricted Subsidiaries for purposes of its credit arrangements. Restricted Subsidiaries are the operating subsidiaries which own and operate the Company's Systems and which as a group are bound, to the same extent as the Company, by the covenants and obligations of substantially all of the Company's credit agreements. All subsidiaries of the Company that currently own and operate Systems have been designated Restricted Subsidiaries. An Unrestricted Subsidiary currently guarantees up to $34,375,000 of Primestar's indebtedness. Primestar is incurring such indebtedness in connection with the construction of a successor satellite system. (See "Business--Description of Business--Competition".) The Company anticipates that the obligations under such guarantee will increase over the next three years up to a maximum of $70,625,000. This guarantee is currently secured by a pledge of certain marketable securities held by such Unrestricted Subsidiary, including shares of Common Stock of Turner Broadcasting System, Inc. In addition, the Company loaned approximately $9,000,000 to Primestar in 1993 to assist Primestar in its financing of its successor satellite system, which loans (plus accrued interest thereon) were repaid in the first quarter of 1994. Investments. In 1993, the Company purchased 20% of TCG for a purchase price of $66,020,000. (See "Business-- Description of Business--Development of New Services; Alternate Access".) In addition, the Company has committed to loan up to $17,300,000 to TCG through 1997, of which $5,000,000 was advanced as of December 31, 1993. The Company anticipates that its funding commitments to TCG will increase over time. The Company has also invested $19,640,000 in joint ventures involving TCG and other cable operators and expects in the future to make additional investments in TCG and joint ventures involving TCG. Such future possible investments cannot be quantified at this time and will be evaluated by the Company on a project-by-project basis. The Company funded its investment in TCG and joint ventures involving TCG through borrowings under the Reducing Revolver and cash from operating activities. As of the date hereof, the Company has committed to spend approximately $135,000,000 for acquisitions of and investments in cable television systems in 1994. Of such amount, an Unrestricted Subsidiary of the Company advanced $80,000,000 in the first quarter of 1994 as a loan which is convertible into a 50% equity interest in a company which owns and operates cable television systems. The Company funded such investment with cash and cash equivalents. In addition, the Company anticipates that in the second quarter of 1994 it will close the acquisition of another cable television system for approximately $55,000,000. The Company expects to fund the purchase price for such system from borrowings under the Reducing Revolver. Capital Resources. The Company's ability to generate cash adequate to meet its needs depends generally on its results of operations and on the availability of external financing. The Company believes that cash from operating activities, future borrowings under existing and new credit facilities and future equity issuances will be sufficient to fund its debt service obligations as well as anticipated capital expenditures, investments and its obligations under the 1998-1999 Share Repurchase Program. Although in the past the Company has been successful in refinancing its indebtedness and obtaining new financing, there can be no assurance that the Company will continue to be able to do so in the future or that the terms available will be favorable to the Company. Recent Legislation. On October 5, 1992, Congress passed the 1992 Cable Act, which, among other things, authorizes the FCC to set standards for governmental authorities to regulate the rates for certain cable television services and equipment, and gives local broadcast stations the option to elect mandatory carriage or require retransmission consent. (See "Business--Description of Business--Legislation and Regulation--1992 Cable Act".) Pursuant to authority granted under the 1992 Cable Act, the FCC in April 1993 promulgated rate regulations that establish maximum allowable rates for cable television services, except for services offered on a per-channel or per-program basis. On February 22, 1994 the FCC adopted a revised regulatory scheme which included, among other things, interim cost-of-service standards and a new benchmark formula. In creating the new benchmark formula, the FCC authorized a further reduction in rates for certain regulated services. As a result, rates for certain regulated services in effect on September 30, 1992 may now be reduced by up to 17% if they exceed the new per-channel benchmark. The old benchmark formula called for a reduction of up to 10%. As part of the implementation of the regulations, the FCC has frozen rates for regulated services from April 1, 1993 through May 15, 1994. The FCC's regulations require rates for equipment to be cost-based, and require reasonable rates for regulated cable television services to be established based on, at the election of the cable television operator, either application of the FCC's benchmarks or a cost-of-service showing pursuant to standards adopted by the FCC. To the extent that a cable television system's rates are found to exceed the reasonable rate determined by the methodology selected by the cable television operator, the rates will be subject to "rollbacks" and, in some cases, refunds. In addition, if a cable television system's rates for regulated services do not need to be reduced by 17% in order to reach the new benchmark adopted on February 22, 1994, such rates may nonetheless be subject to further reduction, up to a maximum reduction of 17% from the rates in effect on September 30, 1992, based upon the results of a pending FCC study of the operating costs of such cable television systems. The timing and amount of such rollbacks, refunds and further reductions, if any, for any system will depend on a number of factors, including the method of rate determination selected by the cable television operator, further clarification of the benchmark and cost-of-service methodologies adopted on February 22, 1994, the capacity of the FCC to efficiently process cost-of-service showings submitted by cable television operators, the success on the merits of such cost-of-service showings and the outcome of pending litigation challenging various aspects of the 1992 Cable Act. In complying with the original FCC rate regulations promulgated on April 1, 1993 (which remain in effect until the new regulations become effective), the Company made permitted rate adjustments according to the original FCC benchmarks for regulated services in Systems serving a majority of the Company's basic subscribers. Substantially all of the remaining Systems have chosen a cost-of-service methodology to justify current rates. The Company believes that resolution of pending rate cases filed pursuant to the FCC's regulations will not have a material adverse effect upon the Company's operations for the year ended December 31, 1993. The final text of the rules adopted by the FCC on February 22, 1994 has not yet been released. In addition, such rules relating to cost-of-service showings may be subject to further revisions. As a result, it is impossible to predict the exact impact of the rate regulations upon existing and future rates charged by the Company for its regulated tiers of service. It is, however, possible that such rate regulation could have a material adverse impact upon the future results of operations of the Company. Item 8. Item 8. Financial Statements and Supplementary Data. The financial statements of the Company and related notes thereto, together with the Independent Auditors' Report of Deloitte & Touche, independent certified public accountants, follows beginning on page 20. INDEPENDENT AUDITORS' REPORT Continental Cablevision, Inc.: We have audited the accompanying consolidated balance sheets of Continental Cablevision, Inc. and its subsidiaries as of December 31, 1992 and 1993 and the related statements of consolidated operations, consolidated shareholders' equity (deficiency) and consolidated 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, such consolidated financial statements of Continental Cablevision, Inc. and its subsidiaries present fairly, in all material respects, the financial position of the companies at December 31, 1992 and 1993 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 Note 12 to the financial statements, the Company changed its method of accounting for income taxes in 1993. DELOITTE & TOUCHE Boston, Massachusetts February 10, 1994 (March 9, 1994 as to Notes 5 and 15 to the consolidated financial statements) Continental Cablevision, Inc. and Subsidiaries Consolidated Balance Sheets See Notes to Consolidated Financial Statements. Continental Cablevision, Inc. and Subsidiaries Statements of Consolidated Operations See Notes to Consolidated Financial Statements. Continental Cablevision, Inc. and Subsidiaries Statements of Consolidated Shareholders' Equity (Deficiency) See Notes to Consolidated Financial Statements. Continental Cablevision, Inc. and Subsidiaries Statements of Consolidated Cash Flows See Notes to Consolidated Financial Statements. Continental Cablevision, Inc. and Subsidiaries Notes to Consolidated Financial Statements 1. Summary of Significant Accounting Policies Principles of Consolidation The accompanying consolidated financial statements include the accounts of Continental Cablevision, Inc. (the Company) and its subsidiaries. All significant intercompany accounts and transactions have been eliminated. Cash and Cash Equivalents The Company considers all highly liquid investments purchased with a maturity of three months or less to be cash equivalents. The carrying amount of cash and cash equivalents approximates fair value due to the short maturity of these investments. Supplies and Property, Plant and Equipment Supplies are stated at the lower of cost (first-in, first-out method) or market. Property, plant and equipment are stated at cost and include capitalized interest of $396,000, $766,000 and $908,000 in 1991, 1992 and 1993, respectively. Depreciation is provided using the straight-line group method over estimated useful lives as follows: buildings, 25 to 40 years; reception and distribution facilities, 3 to 15 years; and equipment and fixtures, 4 to 12-1/2 years. (See Note 6) Franchise Costs Franchise costs represent amounts allocated to franchises in various acquisitions and costs deferred in connection with successful franchise applications. Such amounts are amortized over the lives of the related franchises, generally 10 to 15 years. Accumulated amortization aggregated $466,456,000 and $561,244,000 at December 31, 1992 and 1993, respectively. Other Assets Other assets are principally composed of goodwill, deferred financing costs and loans to employees (see Note 11). Goodwill represents the excess of the Company's purchase price over the fair value of identifiable assets acquired in various transactions, and is amortized over 40 years. Accumulated amortization aggregated $54,625,000 and $61,209,000 at December 31, 1992 and 1993, respectively. Investments Investments in 20-50% owned affiliates are generally accounted for using the equity method. Investments in less than 20% owned companies are generally accounted for using the cost method. (See Note 5) Allowance for Doubtful Accounts The allowance for doubtful accounts at December 31, 1992 and 1993 is $9,072,000 and $9,435,000, respectively. Income Taxes The Company implemented Statement of Financial Accounting Standards No. 109, Accounting for Income Taxes (SFAS 109) as of January 1, 1993. SFAS 109 requires the recognition of deferred tax liabilities and assets for the future tax consequences of temporary differences between the financial reporting and tax bases of existing assets and liabilities. In addition, future tax benefits, such as net operating loss and investment tax credit carryforwards are recognized to the extent realization of such benefits is more likely than not. (See Note 12) Fair Value of Financial Instruments The estimated fair value of financial instruments has been determined by the Company using available market information and appropriate valuation methodologies. However, considerable judgment is required in interpreting 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 fair value estimates presented herein are based on pertinent information available to management as of December 31, 1992 and 1993. 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. (See Notes 4, 5, 7 and 9) Loss per Common Share Loss per common share is calculated by dividing the loss available to common shareholders by the weighted average number of common shares outstanding of 4,701,000, 4,782,000 and 4,562,000 for the years ended December 31, 1991, 1992 and 1993, respectively. Shares of Convertible Preferred Stock were not assumed to be converted into shares of common stock since the result would be anti-dilutive by decreasing the loss per share for the years ended December 31, 1992 and 1993. Recent Accounting Pronouncements In May 1993, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 115, Accounting for Certain Investments in Debt and Equity Continental Cablevision, Inc. and Subsidiaries Notes to Consolidated Financial Statements (Continued) Securities (SFAS 115), which, is effective for fiscal years beginning after December 15, 1993. SFAS 115 establishes standards for the accounting and reporting for investments in equity securities that have readily determinable fair values and for all investments in debt securities. The Company plans to implement SFAS 115 as of January 1, 1994. Upon such implementation, the Company believes it will recognize an additional asset of approximately $140,920,000 and a deferred tax liability of $56,367,000, which will increase shareholders' equity. 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), which is effective for fiscal years beginning after December 15, 1994. SFAS 114 addresses the accounting for certain loans made by the Company to affiliates and certain employees, if such loans are deemed impaired. The effect of implementing this statement will not be significant to the Company's financial position and results of operations. In November 1992, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 112, Employers' Accounting for Post-Employment Benefits (SFAS 112). SFAS 112 establishes standards for accounting for benefits provided to former or inactive employees and their dependents and beneficiaries before retirement. SFAS 112 is effective for fiscal years beginning after December 15, 1993. The effect of implementing this statement will not be significant to the Company's financial position and results of operations. Reclassifications Certain amounts have been reclassified from previous presentation in the accompanying consolidated financial statements. 2. Supplemental Disclosure of Cash Flows The following represents non-cash investing and financing activities and cash paid for interest and income taxes during the years ended December 31, 1991, 1992 and 1993. December 31, 1991 1992 1993 (In Thousands) Acquisition: Fair Value of Assets Acquired $ 6,401 $ - $ - Common Stock Issued for Acquisition (6,401) - - Total $ - $ - $ - Dispositions: Gain on Sale of Investment (See Note 5) $ - $ 10,253 $ 15,919 Deferred Gain on Sale of Investment - - 165 Bases of Assets Sold - - 429 Gain on Sale of Marketable Equity Securities - - 3,471 Bases of Properties Received - - (19,984) Promissory Note Issued to Buyer - 24,000 - Proceeds Received from Disposition $ - $ 34,253 $ - Accretion of Redeemable Common Stock $ 8,763 $ 13,806 $ 14,766 Accretion of Series A Convertible Preferred Stock $ - $ 16,861 $ 34,115 Cash Paid During the Year for Interest $334,209 $301,210 $261,846 Cash Paid During the Year for Income Taxes $ 1,801 $ 1,259 $ 2,370 3. Acquisitions During 1991, the Company purchased cable television systems for approximately $5,490,000 and also purchased for stock the non-owned interest in a partnership managed by the Company for approximately $6,401,000. This investment was previously accounted for using the equity method. The effect of these acquisitions on the Company's results of operations was not material. The accompanying financial statements reflect the results of operations commencing on the acquisition dates. 4. Marketable Equity Securities Marketable equity securities are carried at cost and have an aggregate market value of $142,538,000 and $199,596,000 at December 31, 1992 and 1993, respectively. 5. Investments In October 1993, the Company exchanged its equity interest in Insight Communications Company U.K., L.P. for stock representing less than a 5% interest in International CableTel, Incorporated (CableTel), a telecommunications company operating in the United Kingdom. The Company has accounted for the investment in CableTel as a marketable equity security and recorded a gain of $15,919,000. Continental Cablevision, Inc. and Subsidiaries Notes to Consolidated Financial Statements (Continued) In May 1993, the Company purchased a 20% interest in Teleport Communications Group Inc. (TCG) for $60,020,000 and has contributed $6,000,000 for a 20% interest in TCG Partners, a related partnership. In addition, the Company has made commitments to TCG to loan up to $17,300,000 through 1997, of which $5,000,000 was borrowed as of December 31, 1993. The Company also has invested $19,640,000 in various partnerships with TCG Partners. TCG and its affiliates are telecommunications companies which operate fiber optic networks in the United States. In September 1992, the Company completed the disposition of its 50% interest in North Central Cable Communications Corporation (NCCC) to Meredith/New Heritage Strategic Partners, L.P. (Meredith) and simultaneously purchased an ownership interest in Meredith. The Company sold a portion of its interest in NCCC for $48,253,000 in cash and simultaneously invested $14,000,000 of the proceeds in Meredith. In addition, the Company exchanged its remaining interest in NCCC and issued a $24,000,000 promissory note to Meredith and, as a result, currently has approximately a one-third ownership interest in Meredith. The $10,253,000 preliminary gain represented the proceeds received less the basis in NCCC, the cash investment in Meredith and the promissory note. In April 1993, an additional gain of $1,148,000 was recorded due to the receipt of previously escrowed funds. The Company also received $14,000,000 from Meredith as a prepayment for services provided by the Company which was recorded in accrued and other liabilities on the balance sheet. Meredith operates several cable systems in Minnesota and North Dakota. In January 1992, the Company purchased an ownership interest in N-Com Limited Partnership II (N-Com) for approximately $4,465,000. N-Com operates several cable systems located in Michigan. The Company also has various investments in cable television companies which are not individually material to the Company. The Company has approximately a one-third ownership interest in these companies and therefore accounts for these investments using the equity method. The major components of these companies' combined financial position as of the balance sheet dates and the results of operations for the years then ended were as follows (reflects the Company's proportionate share for the periods which the investments were owned): December 31, 1992 1993 (In Thousands) Property, Plant and Equipment $ 49,000 $106,000 Total Assets 165,000 253,000 Total Liabilities 165,000 196,000 Equity - 57,000 December 31, 1991 1992 1993 (In Thousands) Revenues $ 39,000 $ 49,000 $ 63,000 Depreciation and Amortization 20,000 20,000 22,000 Operating Loss (4,000) (4,000) (5,000) Net Loss (15,000) (21,000) (19,000) At December 31, 1993, the Company has $10,626,000 of investments and $8,895,000 of advances in Primestar Partners, L.P. (Primestar), a limited partnership that provides direct broadcast satellite services. This investment represents approximately a 10% interest, is carried at cost and quoted market prices are not available. Due to the excessive cost involved in performing alternative valuation methodologies it was not practicable to estimate the fair value of the investment as of December 31, 1993. As of December 31, 1992, it was estimated that the carrying value of the investment in Primestar of $6,986,000 approximated fair value. Subsequent to December 31, 1993, Primestar repaid the outstanding advances and a wholly owned subsidiary of the Company issued a standby letter of credit of $34,375,000 on behalf of Primestar, which guaranteed a portion of the financing received for the construction of a successor satellite system. The letter of credit is secured by certain marketable equity securities with a market value of $89,709,000 as of December 31, 1993. Other investments, none of which were individually material to the Company, were carried at an aggregate cost of $22,629,000 and $27,741,000 at December 31, 1992 and 1993, respectively. These other investments are valued by management at $36,634,000 and $40,543,000 as of December 31, 1992 and 1993, respectively, primarily based on recent private transactions or other valuation methods. Subsequent to December 31, 1993, the Company advanced $80,000,000 as a loan, convertible into a 50% equity interest in a company which owns and operates cable systems. Continental Cablevision, Inc. and Subsidiaries Notes to Consolidated Financial Statements (Continued) 6. Property, Plant and Equipment The components of property, plant and equipment are as follows: December 31, 1992 1993 (In Thousands) Land and Buildings $ 48,806 $ 50,040 Reception and Distribution Facilities 1,834,816 1,893,925 Equipment and Fixtures 223,345 249,192 Total 2,106,967 2,193,157 Less--Accumulated Depreciation 893,119 981,650 Property, Plant and Equipment--net $1,213,848 $1,211,507 7. Debt Total debt outstanding is as follows: December 31, 1992 1993 (In Thousands) Bank Indebtedness: The Company $1,717,425 $ 754,550 Unrestricted Subsidiary 195,875 - Total Bank Indebtedness 1,913,300 754,550 Insurance Company Notes 191,000 171,500 Senior Secured Notes 31,231 - Senior Notes and Debentures - 1,400,000 Subordinated Debt 850,000 825,000 Other 26,138 26,128 Total $3,011,669 $3,177,178 At December 31, 1993, the Company's Bank Indebtedness includes the Term Loan and the Credit Agreement. The Term Loan of $754,550,000 bears interest at a rate between the agent bank's prime rate (6% at December 31, 1993) and prime plus l%, depending on certain financial tests. The Term Loan requires increasing quarterly installments through 2000. Prepayments are required if the Restricted Group sells assets, incurs certain indebtedness, or has excess cash flow, as defined in the Term Loan. At December 31, 1993, the Credit Agreement consists of a $500,000,000 revolving credit facility, of which none is outstanding. Credit availability under the revolving credit facility will decrease quarterly commencing April 1994, with a final maturity in December 2000. Borrowings under the Credit Agreement bear interest at a rate between the agent bank's prime rate (6% at December 31, 1993) plus 1/2% and prime plus 1-1/4%, depending on certain financial tests. At the Company's option, the interest rates under the Term Loan and Credit Agreement may be fixed at a spread over certain money market rates for various terms up to five years. The Insurance Company Notes bear interest at 10.12%, require increasing semi-annual repayments through July 1, 1999 and rank pari passu in right of payment with the Company's Bank Indebtedness (collectively, Senior Secured Debt). The stock of the Company's Restricted Subsidiaries is pledged as collateral for the Senior Secured Debt. The Company's unsecured Senior Notes and Debentures (Senior Unsecured Debt) rank pari passu in right of payment with the Senior Secured Debt and are non-redeemable prior to maturity, except for the 9-1/2% Senior Debentures. The 9-1/2% Senior Debentures are redeemable at the Company's option at par plus declining premiums beginning in 2005. In addition, at any time prior to August 1996, the Company may redeem a portion of the 9-1/2% Senior Debentures at a premium with the proceeds from any offering by the Company of its capital stock. No sinking fund is required for any of the Senior Unsecured Debt. The Senior Unsecured Debt consists of the following: December 31, (In Thousands) 8-1/2% Senior Notes, Due September 15, 2001 $ 200,000 8-5/8% Senior Notes, Due August 15, 2003 100,000 8-7/8% Senior Debentures, Due September 15, 2005 275,000 9% Senior Debentures, Due September 1, 2008 300,000 9-1/2% Senior Debentures, Due August 1, 2013 525,000 Total $1,400,000 The Company's Senior Unsecured Debt and Senior Secured Debt (collectively, Senior Debt) limit the Restricted Group with respect to, among other things, (i) dividends and repurchases of capital stock and subordinated debt in an aggregate amount in excess of $864,000,000, (ii) the creation of liens and additional indebtedness, (iii) property dispositions, and (iv) investments and leases, and require certain minimum ratios of cash flow to debt and to related fixed charges. The Company's Subordinated Debt is redeemable at the Company's option at par plus declining premiums at various dates, and is subordinated to the Company's Senior Debt. Subordinated Debt consists of the following: December 31, 1992 1993 (In Thousands) 10-5/8% Senior Subordinated Notes, Due June 15, 2002 $100,000 $100,000 12-7/8% Senior Subordinated Debentures, Due November 1, 2004 350,000 325,000 Senior Subordinated Floating Rate Debentures, Due November 1, 2004 100,000 100,000 11% Senior Subordinated Debentures, Due June 1, 2007 300,000 300,000 Total $850,000 $825,000 Continental Cablevision, Inc. and Subsidiaries Notes to Consolidated Financial Statements (Continued) The 12-7/8% Senior Subordinated Debentures have mandatory annual sinking fund payments on November 1, 2002 and 2003 which will retire 50% of such debentures prior to maturity. In December 1993, the Company repurchased $25,000,000 of these debentures at a premium of $3,075,000, which was recorded as interest expense. The Senior Subordinated Floating Rate Debentures bear interest at LIBOR plus 3% through November 1996, increasing to LIBOR plus 6.5% through maturity. The Company currently has Interest Rate Exchange Agreements (Swaps) pursuant to which it pays fixed interest rates averaging 8.1% on notional amounts of $1,100,000,000 (expiring 1994 through 2000) and variable interest rates on notional amounts of $1,775,000,000 (expiring 1994 through 2003). The variable interest rates currently range from 3.4% to 3.5%. In addition, the Company has $300,000,000 of Interest Rate Cap Agreements (Caps) which limit six month LIBOR to 8% and expire in 1995. The Company's exposure, if the other parties fail to perform under the agreements, would be limited to the impact of variable interest rate fluctuations and the periodic settlement of amounts due under these agreements. Subsequent to December 31, 1993, the Company entered into additional Caps of $100,000,000 and $200,000,000 which limit six month LIBOR to 8% and 5.15%, respectively, and expire in 1996 and 1995, respectively. The fair value of total debt is estimated to be $3,137,955,000 and $3,510,020,000 as of December 31, 1992 and 1993, respectively. The fair value is based on recent trades and dealer quotes, adjusted for an unrealized loss of $101,178,000 and $94,547,000, respectively, which represents the fair value of interest rate exchange agreements based on estimates obtained from dealers. Annual maturities of debt for the five years subsequent to December 31, 1993, are as follows: (In Thousands) 1994 $ 65,626 1995 92,550 1996 99,350 1997 145,250 1998 175,350 Thereafter 2,599,052 $3,177,178 8. Commitments The Company and its subsidiaries have entered into various operating lease agreements, with total commitments of $37,463,000 as of December 31, 1993. Commitments under such agreements for the years 1994-1998 approximate $8,191,000, $7,403,000, $6,538,000, $4,315,000 and $3,519,000, respectively. The Company and its subsidiaries also rent pole space from various companies under agreements which are generally terminable on short notice. Lease and rental costs charged to operations for the years ended December 31, 1991, 1992, and 1993 were $16,500,000 $17,876,000 and $18,378,000, respectively. The Company has entered into a purchase and sale agreement to purchase a cable television system for approximately $55,000,000. This transaction is expected to close in the second quarter of 1994. 9. Redeemable Stock Pursuant to a Stock Liquidation Agreement with certain shareholders (the Selling Shareholders), the Company committed to repurchase 1,228,193 shares of its common stock in December 1998 or January 1999 at a defined purchase price (Purchase Price). The Purchase Price is the greater of the estimated amount of net proceeds per share from an underwritten public offering of the Company's common stock or, the net proceeds per share from the liquidation of the Company less a 22.5% discount. The Stock Liquidation Agreement also required the Company to offer to repurchase up to 300,000 shares from all shareholders by October 15, 1993 (the Mandatory Tender Offer). The initial estimated repurchase cost for the entire 1,528,193 shares of Redeemable Common Stock has been adjusted by periodic accretions through the repurchase dates, based on the interest method, of the difference between the initial estimate and the subsequent estimates of the Purchase Price. The fair value of the Redeemable Common Stock is estimated at $286,721,000 and $339,365,000 as of December 31, 1992 and 1993, respectively, based on the estimate of the Purchase Price at these dates of $382 and $506 per share, respectively, as determined by the Company's investment banker. In the event the Company is unable to meet its commitments under the Stock Liquidation Agreement, the Selling Shareholders may cause the sale of all or substantially all of the assets of the Company. Pursuant to the Company's August 1992 Tender Offer, the Company repurchased 319,022 Redeemable Common shares, 159,437 Class A shares, and 237,302 Class B shares in October 1992 for approximately $239,852,000, of which $5,868,000 was paid in January 1993. This transaction satisfied the Mandatory Tender Offer and, together with agreements with certain shareholders to withdraw Continental Cablevision, Inc. and Subsidiaries Notes to Consolidated Financial Statements (Continued) from the 1998-1999 Share Repurchase, reduced the number of Redeemable Common shares to 751,305 shares. In December 1993, the Company repurchased 64,176 Redeemable Common shares for approximately $31,125,000. This transaction, together with an agreement with a certain shareholder to withdraw from the 1998-1999 Share Repurchase, reduced the number of Redeemable Common shares to 670,682 shares. The effect of these transactions on certain accounts is as follows: Redeemable Additional Common Common Paid-In Stock Stock Capital (In Thousands) Repurchase of 715,761 Shares (319,022 were Redeemable Shares) $ (93,591) $ (4) $(146,257) Reclassification of 457,866 Shares to Common Stock (141,962) 4 141,958 Total for the Year Ended December 31, 1992 $(235,553) $ - $ (4,299) Repurchase of 64,176 Redeemable Shares $ (19,848) $ - $ (11,277) Reclassification of 16,447 Shares to Common Stock (5,085) - 5,085 Total for the Year Ended December 31, 1993 $ (24,933) $ - $ (6,192) During 1991, the Company redeemed the remaining outstanding shares of Redeemable Preferred Stock for approximately $163,606,000. 10. Shareholders' Equity (Deficiency) In May 1992, the Company adopted amendments to its Certificate of Incorporation and By-laws which reclassified the Company's outstanding common stock, which has one vote per share, as Class A Common Stock, and created a new class of common stock, Class B Common Stock, which has ten votes per share. At December 31, 1993, there were 250,244 and 4,320,918 Class A and Class B shares of common stock outstanding, respectively. Shareholders' Equity (Deficiency) reflects only 248,060 and 3,652,420 Class A and Class B shares of common stock outstanding, respectively, due to the classification of 670,682 shares as Redeemable Common Stock. In November 1993, the Company sold 95,876 shares of Class A Common Stock for approximately $46,500,000. During 1992, the Company sold 469,275 shares of Class B Common Stock for approximately $153,839,000 after $1,161,000 of expenses related to the offerings. In June 1992, the Company sold 1,142,858 shares of Series A Convertible Preferred Stock (Convertible Preferred), $.01 par value, for $350 per share. Net proceeds were approximately $394,349,000 after expenses related to the offering. Each Convertible Preferred share is entitled to ten votes per share, shares equally with each common share in all dividends and distributions, and is convertible into one share of common stock, at any time, at the option of the holder. The Convertible Preferred stockholders have the right, at any time after the third anniversary of the purchase date, to sell their shares in a public offering by causing the Company to register such shares under the Securities Act of 1933. Certain other shareholders of the Company have similar registration rights. The Convertible Preferred has a liquidation preference equal to the greater of its Accreted Value or the amount which would be distributed to common stockholders assuming conversion of the Convertible Preferred. The Accreted Value assumes a yield of 8% per annum, compounded semi-annually in arrears on the $350 purchase price per share. The carrying value of the Convertible Preferred has been increased by $34,115,000 to reflect the Accreted Value of $450,976,000 as of December 31, 1993. After the fifth anniversary of the purchase date, if the value of the common stock is greater than 137.5% of the then Accreted Value, the Company will have the right to convert each outstanding share of Convertible Preferred into one share of common stock. On the tenth anniversary of the purchase date, each outstanding share of Convertible Preferred may be converted at the option of the holder or the Company into a number of common shares which will have a value equal to the Accreted Value. The Company may, at its sole option, purchase for cash at the Accreted Value all or part of the Convertible Preferred instead of accepting or requiring conversion. In connection with the above-referenced sale of shares of Convertible Preferred Stock and Class B Common Stock, the issuance of subordinated debt, senior notes, and debentures, and certain other investment banking services, the Company paid aggregate fees and underwriting discounts to Lazard Freres & Company (Lazard) of approximately $9,000,000 and $7,700,000 in 1992 and 1993, respectively. Two directors of the Company are general partners of Lazard and are managing directors of Corporate Partners, L.P., which purchased 728,953 shares of Convertible Preferred on the same terms as all other purchasers of Convertible Preferred. 11. Restricted Stock Purchase Program The Company maintains a Restricted Stock Purchase Program under which certain employees of the Company, selected by the Board of Directors, are permitted to buy Continental Cablevision, Inc. and Subsidiaries Notes to Consolidated Financial Statements (Continued) shares of the Company's common stock at the par value of one cent per share. The shares remain wholly or partly subject to forfeiture for five years, during which a pro rata portion of the shares becomes "vested" at six-month intervals. Upon termination of employment with the Company, an employee must resell to the Company, for the price paid by the employee, the employee's shares which are not then vested. For financial statement presentation, the difference between the purchase price and the fair market value at the date of issuance (as determined by the Board of Directors) is recorded as additional paid-in capital and unearned compensation, and charged to operations through 1996 as the shares vest. Shares of common stock issued under the program for the years ended December 31, 1991, 1992, and 1993 were 1,200 and 108,450 and 1,600, respectively. At December 31, 1992 and 1993, 119,728 and 78,327 shares, respectively, were not yet vested. In connection with the Restricted Stock Purchase Program, a wholly-owned subsidiary of the Company has loaned approximately $20,580,000 and $14,035,000 at December 31, 1992 and 1993, respectively, to the participating employees to fund their individual tax liabilities. These loans are due through 1996, bear interest at a range from 5% to 8% , and are included in Other Assets in the accompanying financial statements. 12. Income Taxes At December 31, 1993, the Company and its subsidiaries have net operating loss carryforwards of approximately $959,000,000 for federal income tax purposes expiring through 2008, and investment tax credit carryforwards of approximately $60,000,000 expiring through 2005. Effective January 1, 1993, the Company implemented the provisions of SFAS 109 and recognized an additional charge of $184,996,000 for deferred income taxes. Such amount has been reflected in the consolidated financial statements as the cumulative effect of change in accounting for income taxes. During 1993, the Company revised its estimated annual effective tax rate to reflect a change in the federal statutory rate from 34% to 35%. The income tax benefit for the year decreased approximately $4,182,000 as a result of applying the newly enacted federal tax rates to deferred tax balances as of January 1, 1993. The provision (benefit) for income taxes is comprised of: Year Ended December 31, 1991 1992 1993 (In Thousands) Current: Federal $ - $ - $ 647 State 1,861 1,654 1,220 Deferred: Federal - - (7,968) State - - (1,820) Total $1,861 $1,654 $(7,921) Differences between the effective income tax rate and the federal statutory rates are summarized as follows: Year Ended December 31, 1991 1992 1993 Federal Statutory Rate (34.0)% (34.0)% (35.0)% Enacted Tax Rate Change - - 12.4 Net Operating Losses without Current Income Tax Benefit 16.8 14.8 - Depreciation and Amortization Not Deductible for Tax Purposes 11.1 17.4 - Gain on Sale of Investment 6.9 - - State Income Tax, Net of Federal Income Tax Benefit .8 1.1 (1.2) Other (.4) 2.3 .3 Total 1.2% 1.6% (23.5)% Deferred income taxes prior to the implementation of SFAS 109 resulted primarily from timing differences in the recognition of certain expense items for tax and financial reporting purposes. The tax effect of each major component is as follows: Year Ended December 31, 1991 1992 (In Thousands) Accelerated Depreciation and Amortization $13,051 $ 7,811 Restricted Stock Purchase Program (3,301) 7,469 Gain on Sale of Investment (4,080) 3,486 Deferred Income - (4,555) Utilization of Accounting Net Operating Losses (1,561) (7,669) Other (4,109) (6,542) Total $ - $ - Continental Cablevision, Inc. and Subsidiaries Notes to Consolidated Financial Statements (Continued) The tax effects of temporary differences and carryforwards that give rise to significant portions of deferred tax assets and liabilities consist of the following: December 31, (In Thousands) Deferred Tax Liabilities: Depreciation and Amortization $(533,242) Other (14,989) Deferred Tax Assets: Net Operating Loss Carryforwards 490,499 Tax Credit Carryforwards 60,304 Other 49,858 Valuation Allowance (157,471) Net Deferred Tax Liability $(105,041) Valuation allowances have been established for uncertainties in realizing transitional investment tax credit carryforwards and the tax benefit of certain limited use net operating losses for federal and state income tax purposes. If in future periods the realization of tax credit and net operating loss carryforwards acquired as a result of business combinations becomes more likely than not, $27,000,000 of the valuation allowance will be allocated to reduce goodwill and other intangible assets. The net change of the valuation allowance from the beginning of the year was an increase of $34,971,000 relating to current state net operating loss carryforwards that are not expected to be realized. A recently affirmed tax court decision affecting the cable television industry ratified the deductibility of certain franchise cost amortization. As a result, the Company revised the estimated tax bases of certain intangible assets. This resulted in the Company adjusting the carrying values of goodwill, franchise costs and deferred tax relating to specific acquisitions by $16,287,000, $54,506,000 and $70,793,000, respectively. 13. Retirement and Matched Savings Plans The Company has a non-contributory defined benefit plan covering substantially all employees. Benefits under the plan are determined based on formulas which reflect employees' years of service and the average of the five consecutive years of highest compensation. The Company's policy is to make contributions sufficient to meet the minimum funding requirements of ERISA. The components of net periodic pension expense are as follows: Year Ended December 31, 1991 1992 1993 (In Thousands) Service Cost--Benefits Earned During the Year $ 2,241 $2,479 $2,584 Interest Cost on Projected Benefit Obligations 856 1,118 1,336 Actual Return on Plan Assets (1,231) (179) (136) Other Items 802 (422) (615) Total $ 2,668 $2,996 $3,169 The following table sets forth the funded status and amounts recognized in the Company's balance sheet: December 31, 1992 1993 (In Thousands) Actuarial Present Value of: Vested Benefit Obligation $ (5,757) $ (8,384) Non-Vested Benefit Obligation (1,390) (1,647) Accumulated Benefit Obligation (7,147) (10,031) Effect of Projected Salary Increases (9,285) (10,553) Projected Benefit Obligation (16,432) (20,584) Plan Assets at Market Value 8,735 11,350 Funded Status (7,697) (9,234) Deferred Transition Loss 1,335 1,264 Unrecognized Prior Service Cost (95) (89) Unrecognized Net Loss 790 1,884 Accrued Pension Cost $ (5,667) $ (6,175) The actuarial assumptions as of the year-end measurement date are as follows: December 31, 1992 1993 Discount Rate 8.5% 7.75% Expected Long-Term Rate of Return 9.0% 9.0 % Rate of Increase in Future Salary Levels 5.5% 4.75% At December 31, 1993, plan assets consist of equity and debt securities, U.S. Government obligations and cash equivalents. The Company sponsors a defined contribution Matched Savings Plan covering substantially all of its employees. The Company's contribution for this plan is based on a percentage of each participant's salary. Total costs for the years ended December 31, 1991, 1992 and 1993 were $1,961,000, $2,418,000 and $2,550,000, respectively. Continental Cablevision, Inc. and Subsidiaries Notes to Consolidated Financial Statements (Continued) 14. Contingencies On March 18, 1993, the Company received a favorable jury verdict in federal district court in Massachusetts determining that the Company properly discharged its fiduciary duties in connection with the redemption of the limited partnership interests in the four limited partnerships acquired in 1989 for an aggregate purchase price of approximately $380,000,000. The plaintiff limited partners had alleged that the Company had acquired the partnership interests at unfairly low prices. The jury also found that the Company had not misrepresented any fact or opinion in making the offers to acquire the partnership interests. An unspecified fact, however, was found to have been omitted. The Company entered into a settlement agreement on May 14, 1993, settling all claims and counterclaims in the suit, which was subsequently approved by the court. Pursuant to the settlement agreement, the Company has contributed to a settlement fund of $6,158,554. The Company is subject to legal proceedings and claims which arise in the ordinary course of business. In the opinion of management, the ultimate resolution of such legal proceedings and claims will not have a material effect on the consolidated financial position and results of operations of the Company. 15. Legislation and Regulation Pursuant to the Cable Television Consumer Protection and Competition Act of 1992, the FCC promulgated rate regulations on April 1, 1993 that establish maximum permitted rates for cable television services, except for services offered on a per-channel or per-program basis. Such regulations took effect on September 1, 1993. On February 22, 1994, after reconsideration, the FCC significantly revised the regulatory framework it adopted on April 1, 1993. The final rules reflecting the new rate regulations are expected to be issued before March 31, 1994 and to become effective in May 1994. See page 19 (Liquidity and Capital Resources--Recent Legislation) of the Company's December 31, 1993 Annual Report on Form 10-K for a discussion of the effect of rate regulation on the Company. 16. Quarterly Financial Information (Unaudited) Quarterly results of operations for 1992 and 1993 are summarized below: First Second Third Fourth Quarter Quarter Quarter Quarter (In Thousands, Except Per Share Amounts) Revenues $ 267,840 $277,887 $280,877 $286,871 Depreciation and Amortization 67,124 70,208 69,965 72,106 Restricted Stock Purchase Program 2,441 2,427 2,405 2,410 Operating Income 47,008 49,573 52,171 50,492 Net Loss (30,802) (27,597) (15,139) (29,422) Loss Applicable to Common Shareholders (30,802) (28,298) (23,205) (37,516) Loss Per Common Share (6.43) (5.90) (4.58) (8.38) Revenues $ 287,542 $297,238 $295,458 $296,925 Depreciation and Amortization 69,024 69,882 72,044 73,613 Restricted Stock Purchase Program 2,690 2,689 2,690 2,935 Operating Income 57,766 62,648 55,512 56,099 Loss Before Cumulative Effect of Change in Accounting for Income Taxes (5,397) (1,491) (13,487) (5,399) Cumulative Effect of Change in Accounting for Income Taxes (184,996) - - - Net Loss (190,393) (1,491) (13,487) (5,399) Loss Applicable to Common Shareholders (198,602) (9,819) (22,305) (14,159) Loss Per Common Share: Loss Before Cumulative Effect of Change in Accounting for Income Taxes (2.99) (2.16) (4.90) (3.08) Cumulative Effect of Change in Accounting for Income Taxes (40.61) - - - Net Loss (43.60) (2.16) (4.90) (3.08) 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 positions held by each Director and Officer of the Company are shown below. There are no family relationships among the following persons. Name of Director or Executive Officer Position with the Company Amos B. Hostetter, Jr. (1) Chairman of the Board, Chief Executive Officer and Director Timothy P. Neher Vice Chairman of the Board and Director Michael J. Ritter President, Chief Operating Officer and Director Roy F. Coppedge III Director C. Alexander Howard Director Jonathan H. Kagan (1) Director Robert B. Luick Director and Secretary Henry F. McCance Director Lester Pollack Director Vincent J. Ryan (1) Director William T. Schleyer Executive Vice President Jeffrey T. DeLorme Executive Vice President Nancy Hawthorne Chief Financial Officer and Senior Vice President Name of Other Officers Position with the Company Andrew L. Dixon, Jr Senior Vice President-Human Resources David M. Fellows Senior Vice President-Engineering and Technology Richard A. Hoffstein Senior Vice President and Corporate Controller Frederick C. Livingston Senior Vice President-Marketing Robert J. Sachs Senior Vice President-Corporate and Legal Affairs Robert A. Stengel Senior Vice President-Programming P. Eric Krauss Treasurer Nancy B. Larkin Vice President-Community Relations Jon W. Lunsford Director of Corporate Finance W. Lee H. Dunham Assistant Secretary Patrick K. Miehe Assistant Secretary (1) Members of the Executive Committee. The Company has a classified Board composed of three classes. Each class serves for three years, with one class being elected each year. The term of the Class B Directors, Messrs. Neher, Ryan and Kagan, will expire at the 1994 annual meeting of shareholders; the term of the Class C Directors, Messrs. Hostetter, McCance, Pollack and Coppedge, will expire at the 1995 annual meeting of shareholders; and the term of the Class A Directors, Messrs. Ritter, Howard and Luick, will expire at the 1996 annual meeting of shareholders. Under the terms of stock purchase agreements with the Company, Corporate Advisors, L.P., on behalf of the investors (the "Preferred Stock Investors") who purchased Series A Convertible Preferred Stock, $.01 par value of the Company (the "Convertible Preferred Stock"), has the right to designate two persons, and Boston Ventures Limited Partnership III, on behalf of itself and Boston Ventures Limited Partnership IIIA, Boston Ventures Limited Partnership IV and Boston Ventures Limited Partnership IVA (collectively, the "Boston Ventures Investors"), has the right to designate one person, to be nominated as members of the Board of Directors. Lester Pollack and Jonathan H. Kagan are the designees of the Preferred Stock Investors, and Roy F. Coppedge III is the designee of the Boston Ventures Investors. The Executive Officers and other Officers were elected by the Board of Directors on May 20, 1993, except that P. Eric Krauss was elected Treasurer effective December 31, 1993. All Executive Officers and other Officers hold office until the first meeting of the Board following the next annual meeting of shareholders and until their successors are chosen and qualified. The following is a description of the business experience during the past five years of each Director and Officer and includes, as to Directors, other directorships held in companies required to file periodic reports with the Securities and Exchange Commission (the "Commission") and registered investment companies. Directors and Executive Officers. Amos B. Hostetter, Jr. (57), a cofounder of the Company, is the Chairman of the Board and Chief Executive Officer of the Company. He has been a Director since 1963. Mr. Hostetter is a past Chairman of the National Cable Television Association (NCTA) and currently serves on NCTA's Board and Executive Committee. He is past Chairman and serves on the Executive Committee of the Board of Directors of both Cable in the Classroom and the Cable Satellite Public Affairs Network (C-SPAN) and currently serves on the Board of Directors of Children's Television Workshop. Timothy P. Neher (46) is the Vice Chairman of the Board of the Company. He has been a Director since 1982 and has been employed by the Company since 1974. Prior to 1991 he was President and Chief Operating Officer of the Company, prior to 1986 he was an Executive Vice President of the Company, and prior to 1982 he was Vice President and Treasurer of the Company. He currently is on the Board of Directors of Turner Broadcasting System, Inc. Michael J. Ritter (53) is the President and Chief Operating Officer of the Company. He has been a Director since 1991 and has been employed by the Company since 1980. Prior to 1991 he was an Executive Vice President, and prior to 1988 he was the Senior Vice President and General Manager of the Company's Michigan management region. Roy F. Coppedge III (45) has been a director of Boston Ventures Management, Inc. since 1983. He currently is on the Board of Directors of Enquirer/Star Group Inc. and Dial Page, Inc. He was elected to serve as a Director of the Company in 1992. C. Alexander Howard (61) was until 1989 an officer and Director of R.C. Crisler & Co., Inc., brokers of communications properties. He is currently engaged in private investment activities. He had been affiliated with the Crisler organization since 1962. Mr. Howard has been a Director of the Company since 1964. Jonathan H. Kagan (37) is Managing Director of Corporate Advisors, L.P. and, since 1987, has been a General Partner of Lazard Freres & Co. He has been associated with Lazard Freres & Co. since 1980. He was elected to serve as a Director of the Company in 1992. Robert B. Luick (82) is of counsel to the law firm of Sullivan & Worcester, which firm has acted as counsel to the Company since its inception. Mr. Luick has been with Sullivan & Worcester since 1943. He is a member of the Board of Directors of Ionics, Incorporated, a diversified water treatment company. He has been Secretary and a Director of the Company since 1963. Henry F. McCance (51) has been general partner of the following venture capital partnerships since their formation: Greylock Ventures Limited Partnership (1983), Greylock Investments Limited Partnership (1985), Greylock Capital Limited Partnership (1987) and Greylock Limited Partnership (1990). He is also President and Treasurer of Greylock Management Corporation, an investment services organization, and a Director of Immulogic Pharmaceutical Corporation, Brookstone and Manugistics. Prior to 1990, Mr. McCance was a Vice President and Treasurer of Greylock Management Corporation. Mr. McCance has been a Director of the Company since 1972. Lester Pollack (60) is Senior Managing Director of Corporate Advisors, L.P. and Chief Executive Officer of Centre Partners, L.P., investment partnerships affiliated with Lazard Freres & Co., as well as a General Partner of Lazard Freres & Co. He currently is on the Board of Directors of SunAmerica Inc., CNA Financial Corporation, Kaufman & Broad Home Corporation, Tidewater, Inc., Loews Corporation, Parlex Corporation and Polaroid Corporation. He was elected to serve as a Director of the Company in June 1992. Vincent J. Ryan (58) has been Chairman of the Board and a Director of Schooner Capital Corporation, a venture capital organization, since 1971. Mr. Ryan is also Chairman of the Board of Iron Mountain Information Management Company, Inc., an information management company. He has been a Director of the Company since 1980. William T. Schleyer (42) is an Executive Vice President of the Company. Prior to 1989 he was the Senior Vice President and General Manager of the Company's New England management region. He is a member of the Boards of Directors of Cable Television Laboratories, Inc., the research and development arm of the cable industry, and TCG. He has been employed by the Company since 1978. Jeffrey T. DeLorme (41) is an Executive Vice President of the Company. Prior to March 1993, he was the Senior Vice President and General Manager of the Company's Florida/Georgia management region. He was formerly the Director of Corporate Services in the Company's Michigan management region. He has been employed by the Company since 1980. Nancy Hawthorne (42) is the Chief Financial Officer and a Senior Vice President of the Company. Prior to December 1993, she was also the Treasurer of the Company, in addition to being Chief Financial Officer and a Senior Vice President. Prior to December 1992, she was a Senior Vice President and the Treasurer of the Company. Prior to 1988, she was a Vice President and the Treasurer of the Company. She is a member of the Boards of Directors of Perini Corporation, a construction company, and TCG. She has been employed by the Company since 1982. Other Officers Andrew L. Dixon Jr. (51) is a Senior Vice President of the Company. From 1985 to 1991, he was the Vice President of Human Resources of the Company. He has been employed by the Company since 1982. David M. Fellows (41) is a Senior Vice President of the Company. Prior to December 1992, he was the Vice President of Strategic Operations and then the President of Scientific Atlanta's Transmissions Systems Business Division, where he was responsible for the company's head end, fiber and digital compression products. Richard A. Hoffstein (46) is a Senior Vice President and the Corporate Controller of the Company. Prior to 1986, he was the Corporate Controller, Assistant Treasurer and Assistant Secretary of the Company. He has been employed by the Company since 1976. Frederick C. Livingston (48) is a Senior Vice President of the Company. Prior to 1988, he was a Vice President of the Company, and prior to 1984 he was the Director of Marketing for the Company. He has been employed by the Company since 1979. Robert J. Sachs (45) is a Senior Vice President of the Company. Prior to 1988, he was a Vice President of the Com- pany, and prior to 1983 he was the Company's Director of Corporate Development. He has been employed by the Company since 1979. Robert A. Stengel (51) is a Senior Vice President of the Company. Prior to 1988, he was a Vice President of Programming of the Company. He has been employed by the Company since 1980. P. Eric Krauss (30) is the Treasurer of the Company. Prior to December 1993, he was the Assistant Treasurer of the Company. He has been employed by the Company since January 1, 1990. He was formerly employed by The First National Bank of Boston since 1986, most recently as an Assistant Vice President. Nancy B. Larkin (43) is a Vice President of the Company. She has been employed by the Company since February 1988. She was formerly employed by American Cablesystems Corporation, most recently as Vice President of Corporate Communications and Training. Jon W. Lunsford (34) is the Director of Corporate Finance for the Company. He has been employed by the Company since January 1, 1991. He was formerly employed by Crestar Bank since 1982, most recently as a Vice President. W. Lee. H. Dunham (52) is an Assistant Secretary of the Company. He has been a partner of the law firm of Sullivan & Worcester since 1974. Patrick K. Miehe (46) is an Assistant Secretary of the Company. He has been a partner of the law firm of Sullivan & Worcester since 1990. Biographical information concerning the Directors, Executive Officers and other Officers is as of March 21, 1994. Item 11. Item 11. Executive Compensation. The following table (the "Summary Compensation Table") discloses compensation received by the Company's Chief Executive Officer and the four most highly compensated other Executive Officers for the three fiscal years ended December 31, 1991, 1992 and 1993. Compensation Committee Interlocks and Insider Participation. Base annual compensation for Executive Officers was determined during the last fiscal year by the Chairman, the Vice Chairman and the President of the Company. Pursuant to authority delegated by the Board of Directors, the Chairman also awarded grants of restricted stock during the last fiscal year to key employees designated by the Board in accordance with the Company's Restricted Stock Purchase Program. Amos B. Hostetter, Jr., Timothy P. Neher and Michael J. Ritter--the Chairman, Vice Chairman and President of the Company, respectively--are Directors and participate in deliberations concerning Executive Officer compensation. An Unrestricted Subsidiary of the Company has made loans to these three Executive Officers and other persons in amounts equal to the income taxes incurred by them as a result of their restricted stock purchases. Such loans were financed through cash provided from operating activities and long-term borrowings. The Company charges interest on these loans generally at rates ranging from 5% to 8% per annum and declares bonuses to each of these persons in the amount of the interest due each year. As of March 21, 1994, the amounts of the loans outstanding to the three Executive Officers named above were as follows: Amos B. Hostetter, Jr. ($1,662,750), Timothy P. Neher ($2,669,856) and Michael J. Ritter ($1,689,612). During the fiscal year ended December 31, 1993, the largest aggregate amounts of indebtedness of such Executive Officers were as follows: Amos B. Hostetter, Jr. ($3,134,686), Timothy P. Neher ($4,057,356) and Michael J. Ritter ($2,020,797). The outstanding principal balance of each such loan is generally payable upon the earlier to occur of (i) the fifth anniversary of such loan or (ii) the termination of such person's employment with the Company. (For information regarding loans to other Executive Officers, see footnote (1) to the Summary Compensation Table.) On December 31, 1993, the Company accepted payment for loans incurred in connection with restricted stock purchases pursuant to the Company's 1989 Restricted Stock Purchase Agreement III ("RSPA III") which became due on such date by (i) transfer to the Company and cancellation of shares of Common Stock with a value equal to the loan outstanding, valued at $485 per share (the "Stock-for-Loan Exchange"), (ii) payment in cash or (iii) a combination of the two. The Company also made an offer (the "Offer") in January 1994 to purchase shares of Common Stock up to a maximum of 53,399 shares at a purchase price of $485 per share. The persons who were eligible to participate in the Stock-for-Loan Exchange and to accept the Offer were persons who held shares of Common Stock issued pursuant to RSPA III (current or former employees and family members of employees and former employees). The valuation of the shares at $485 was equal to the price last paid in a private placement of shares of Common Stock, which was consummated in November 1993. (See "Management's Discussion and Analysis of Financial Position and Results of Operations--Liquidity and Capital Resources".) The three Executive Officers named above repaid the following loan amounts in shares of Common Stock in the Stock-for-Loan Exchange: Amos B. Hostetter, Jr. ($1,471,936), Timothy P. Neher ($1,387,500) and Michael J. Ritter ($331,185), and sold the following numbers of shares to the Company pursuant to the Offer: Amos B. Hostetter, Jr. (0), Timothy P. Neher (1,192) and Michael J. Ritter (397). (For information regarding other Executive Officers, see "Certain Relationships and Related Transactions".) In addition, the Hostetter Foundation, an entity controlled by Mr. Hostetter, sold 1,184 shares of Class B Common Stock to the Company in January 1994 for a purchase price of $485 per share. Retirement Plan. The following table sets forth, as to the Company's Retirement Plan, the estimated annual benefits payable upon retirement to all employees of the Company and its subsidiaries in the following compensation and years-of-service classifications. Such benefits are offset in recognition of the employer contribution toward social security benefits. The compensation covered by the Retirement Plan includes salary and cash bonuses and is limited by section 401 of the Internal Revenue Code of 1986, as amended. The covered compensation for each Executive Officer named in the Summary Compensation Table is based upon the amounts shown in the "Salary" column of the Summary Compensation Table. For each Executive Officer, the current compensation covered by the Retirement Plan does not differ substantially (by more than 10%) from the aggregate compensation set forth in the Summary Compensation Table. As of January 1, 1994, covered compensation is limited to $150,000. The Executive Officers named in the Summary Compensation Table have been credited with the following years of service: Mr. Hostetter, 31 years; Mr. Ritter, 13 years; Mr. Schleyer, 16 years; Mr. DeLorme, 14 years; and Ms. Hawthorne, 12 years. Benefits are computed on the basis of (1) .95% of the employee's average annual compensation less .37% of average annual compensation (limited to social security covered compensation) multiplied by (2) the number of years of service (not to exceed thirty years). Average annual compensation is the average of a participant's compensation for the five consecutive years in which compensation was the highest. Compensation of Directors. The members of the Board of Directors who are not Officers of the Company currently receive an annual retainer of $10,000 and a fee of $2,500 for each meeting attended. In addition, Directors who reside outside the Greater Boston Area are reimbursed for their travel expenses incurred in connection with attendance at meetings of the Board of Directors. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management. The following table provides information as of March 21, 1994 with respect to the shares of Common Stock and the Convertible Preferred Stock beneficially owned by each person known by the Company to own more than 5% of the outstanding Common Stock or Convertible Preferred Stock, each Director of the Company, each Executive Officer named in the Summary Compensation Table and by all Directors and Executive Officers of the Company as a group. The number of shares beneficially owned by each Director or Executive Officer is determined according to rules of the Commission, and the information is not necessarily indicative of beneficial ownership for any other purpose. Under such rules, beneficial ownership includes any shares as to which the individual or entity has sole or shared voting power or investment power and also any shares which the individual or entity has the right to acquire within 60 days of March 21, 1994 through the exercise of an option, conversion feature or similar right. Except as noted below, each holder has sole voting and investment power with respect to all shares of Common Stock or Convertible Preferred Stock listed as owned by such person or entity. Item 13. Item 13. Certain Relationships and Related Transactions. Lazard Freres & Co. ("Lazard") received fees and underwriting discounts from the Company in an aggregate amount of $7,748,400 for its services as an underwriter of the 1993 Offerings. A wholly owned subsidiary of Lazard is the sole general partner of Corporate Advisors, which in turn is the sole general partner of Corporate Partners and Corporate Offshore Partners. Corporate Advisors is also an investment manager for The State Board of Administration of Florida ("SBA"). Corporate Partners, Corporate Offshore Partners and SBA collectively own 857,144 shares of Convertible Preferred Stock. Certain entities controlled by Lazard also own limited partnership interests in Corporate Partners and Corporate Advisors. Lester Pollack, a Director of the Company, is Senior Managing Director of Corporate Partners and a General Partner of Lazard. Jonathan H. Kagan, a Director of the Company, is Managing Director of Corporate Partners and a General Partner of Lazard. Robert B. Luick, a Director and the Secretary of the Company, is of counsel to the law firm of Sullivan & Worcester, counsel to the Company. The Company paid legal fees in the amount of approximately $1,450,000 to Sullivan & Worcester in the year ended December 31, 1993. For a discussion of loans made to Executive Officers of the Company in connection with the Company's Restricted Stock Purchase Program, see footnote (1) to the Summary Compensation Table and "Compensation Committee Interlocks and Insider Participation" under the caption "Executive Compensation". For a description of the Company's Stock-for-Loan Exchange and an Offer to repurchase shares of Common Stock, and information regarding certain Executive Officers participating therein, see "Compensation Committee Interlocks and Insider Participation" under the caption "Executive Compensation". The following Executive Officers participated in the Stock-for-Loan Exchange in the following amounts: William T. Schleyer ($291,000), Jeffrey T. DeLorme ($155,000) and Nancy Hawthorne ($274,464). In addition, William T. Schleyer paid the remaining $141,063 of his outstanding loan incurred in connection with restricted stock purchases pursuant to RSPA III in cash and Jeffrey T. DeLorme sold 218 shares to the Company pursuant to the Offer. PART IV Item 14. Item 14. Exhibits, Financial Statements, Schedules and Reports on Form 8-K. (a)(1) Financial Statements. The following consolidated financial statements of the Company and the Independent Auditors' Report relating thereto are filed under Item 8 in Part II of this report: Independent Auditors' Report Consolidated Balance Sheets as of December 31, 1992 and 1993 Statements of Consolidated Operations for the years ended December 31, 1991, 1992 and 1993 Statements of Consolidated Shareholders' Equity (Deficiency) for the years ended December 31, 1991, 1992 and 1993 Statements of Consolidated Cash Flows for the years ended December 31, 1991, 1992 and 1993 Notes to Consolidated Financial Statements (a)(2) Financial Statement Schedules. The following financial statement schedules of the Company and the Independent Auditors' Report relating thereto are filed as part of this report: Schedule I --Marketable Securities-Other Investments Schedule II --Accounts Receivable from Related Parties Schedule V --Property, Plant and Equipment Schedule VI --Accumulated Depreciation of Property, Plant and Equipment Schedule VIII --Valuation and Qualifying Accounts and Reserves Schedule X --Supplementary Income Statement Information Schedule I presents financial information as of December 31, 1993. All other Schedules present financial information for the years ended December 31, 1991, 1992 and 1993. Financial Statement Schedules not included are omitted due to the lack of conditions under which they are required. (a)(3) Exhibits Listed below are the exhibits which are filed as part of this report (according to the number assigned to them in Item 601 of Regulation S-K). Each exhibit marked by an asterisk (*) is incorporated by reference to the Company's Registration Statement No. 33-46510 (as amended), declared effective by the Securities and Exchange Commission on June 15, 1992, each exhibit marked by two asterisks (**) is incorporated by reference to the Company's Registration Statement No. 33-59806, declared effective by the Securities and Exchange Commission on May 27, 1993, and each exhibit marked by three asterisks (***) is incorporated by reference to the Company's Registration Statement No. 33-65798, declared effective by the Securities and Exchange Commission on August 6, 1993. Exhibit numbers in parentheses refer to the exhibit numbers in Registration Statements. Each exhibit marked by a pound sign (#) is a management contract or compensatory plan. 3.1A Restated Certificate of Incorporation of the Company.* (3.1) 3.1B Form of Certificate of Designation of the Company relating to the Convertible Preferred Stock.* (3.1A) 3.2 By-Laws of the Company.* (3.2) 4.1 Indenture dated as of June 22, 1992 between the Company and Morgan Guaranty Trust Company of New York as Trustee, pertaining to the Company's 10-5/8% Senior Subordinated Notes due 2002.* (4.1) 4.2 Indenture, dated as of June 22, 1992 between the Company and Morgan Guaranty Trust Company of New York as Trustee, pertaining to the Company's 11% Senior Subordinated Debentures due 2007.* (4.2) 4.3 Indenture dated as of November 1, 1989 between the Company and The Connecticut National Bank as successor trustee, pertaining to the Company's 12-7/8% Senior Subordinated Debentures due November 1, 2004.* (4.5) 4.4 Indenture dated as of November 1, 1989 between the Company and The Connecticut National Bank as successor trustee, pertaining to the Company's Senior Subordinated Floating Rate Debentures due November 1, 2004.* (4.6) 4.5 Credit Agreement dated as of May 1, 1989, as amended and restated as of July 30, 1990, among the Company and certain of its direct and indirect Subsidiaries as Guarantors and The First National Bank of Boston, for itself and as Agent, and certain financial institutions named therein.* (4.7) 4.5A Amendment to Credit Agreement dated as of May 15, 1992 among the Company and certain of its direct and indirect Subsidiaries as Guarantors and The First National Bank of Boston, for itself and as Agent, and certain financial institutions named therein.* (4.7A) 4.5B Amendment No. 2 to Credit Agreement dated as of March 1, 1993 among the Company and certain of its direct and indirect Subsidiaries as Guarantors, The First National Bank of Boston, for itself and as Agent, and certain financial institutions named therein.** (4.5B) 4.5C Amendment No. 3 to Credit Agreement dated as of July 1, 1993 among the Company, certain of its direct and indirect Subsidiaries as Guarantors, and The First National Bank of Boston, for itself and as Agent.*** (4.5C) 4.5D Amendment No. 4 to Credit Agreement dated as of August 30, 1993 among the Company, certain of its direct and indirect Subsidiaries as Guarantors, and The First National Bank of Boston, for itself and as Agent. 4.6 Note Agreement dated as of September 20, 1989, as amended as of February 15, 1991, by and among the Company and certain of its direct and indirect Subsidiaries as Guarantors and The Prudential Insurance Company of America.* (4.8) 4.6A Amendment to Note Agreement dated as of April 30, 1992 by and among the Company and certain of its direct and indirect Subsidiaries as Guarantors and The Prudential Insurance Company of America.* (4.8A) 4.7 Credit Agreement dated as of May 15, 1992 among the Company and certain of its direct and indirect subsidiaries, The First National Bank of Boston, for itself and as Agent, The Bank of New York, for itself and as Arranging Agent, and certain financial institutions named therein.* (4.11) 4.7A Amendment No. 1 to 1992 Credit Agreement dated as of March 1, 1993 among the Company and certain of its direct and indirect Subsidiaries as Guarantors, The First National Bank of Boston, for itself and as Agent, and certain financial institutions named therein.** (4.9A) 4.7B Amendment No. 2 to 1992 Credit Agreement dated as of July 1, 1993 among the Company, certain of its direct and indirect Subsidiaries as Guarantors, The First National Bank of Boston, for itself and as Agent, and The Bank of New York, for itself and as Arranging Agent.*** (4.8B) 4.7C Amendment No. 3 to 1992 Credit Agreement dated as of August 30, 1993 among the Company and certain of its direct and indirect Subsidiaries as Guarantors, The FirstNational Bank of Boston, for itself and as Agent, and certain financial institutions named therein. 4.7D Amendment No. 4 to 1992 Credit Agreement dated as of August 30, 1993 among the Company, certain of its direct and indirect Subsidiaries as Guarantors, The First National Bank of Boston, for itself and as Agent, and The Bank of New York, for itself and as Arranging Agent. 4.8 Indenture dated as of June 1, 1993 between the Company and The First National Bank of Chicago, as Trustee, pertaining to the Company's 8-5/8% Senior Notes due 2003.** (4.10) 4.9 Indenture dated as of June 1, 1993 between the Company and The First National Bank of Chicago, as Trustee, pertaining to the Company's 9% Senior Debentures due 2008.** (4.11) 4.10 Indenture dated as of August 1, 1993 between the Company and the Bank of New York, as Trustee, pertaining to the Company's 8-7/8% Senior Debentures due 2005.*** (4.11) 4.11 Indenture dated as of August 1, 1993 between the Company and the Bank of New York, as Trustee, pertaining to the Company's 9-1/2% Senior Debentures due 2013.*** (4.12) 4.13 Indenture dated as of August 1, 1993 between the Company and the Bank of New York, as Trustee, pertaining to the Company's 8-1/2% Senior Notes due 2001.*** (4.13) 10.1 Stock Liquidation Agreement dated as of March 6, 1989, as amended as of September 28, 1990, replacing and restating the Stock Acquisition Agreement made as of December 19, 1988 by and among the Company, H. Irving Grousbeck, MD Co., Burr, Egan, Deleage & Co., Roderick A. MacLeod and Amos B. Hostetter, Jr.* (10.2) 10.2 Second Amendment to Stock Liquidation Agreement dated as of July 7, 1992 by and among the Company, Amos B. Hostetter, Jr., H. Irving Grousbeck, MD Co., Burr, Egan, Deleage & Co. and Roderick A. MacLeod.** (10.2) 10.3 Form of Restricted Stock Purchase Agreement.*# (10.3) 10.4 Stock Purchase Agreement dated April 27, 1992 among the Company, Corporate Partners, L.P., Corporate Offshore Partners, L.P., The State Board of Administration of Florida, Chemical Equity Associates, Mellon Bank, N.A. as Trustee for First Plaza Group Trust, Vencap Holdings (1992) Pte Ltd and Corporate Advisors, L.P.* (10.4) 10.5 Registration Rights Agreement dated June 22, 1992 among the Company, Corporate Partners, L.P., Corporate Offshore Partners, L.P., The State Board of Administration of Florida, Chemical Equity Associates, Mellon Bank, N.A. as Trustee for First Plaza Group Trust, Vencap Holdings (1992) Pte Ltd and Corporate Advisors, L.P.* (10.5) 10.6 Amendment to Registration Rights Agreement dated July 15, 1992 among the Company and Corporate Advisors, L.P. on behalf of Corporate Partners, L.P., Corporate Offshore Partners, L.P., The State Board of Administration of Florida, ContCable Co-Investors, L.P., Mellon Bank, N.A., as Trustee for First Plaza Group Trust, and Vencap Holdings (1992) PTE Ltd.** (10.6) 10.7 Stock Purchase Agreement dated July 15, 1992, as amended on November 17, 1992, among the Company, Boston Ventures Limited Partnership III, Boston Ventures Limited Partnership IIIA, Boston Ventures Limited Partnership IV and Boston Ventures Limited Partnership IVA.** (10.7) 10.8 Stock Purchase Agreement dated July 15, 1992 among the Company, Thomas H. Lee Equity Partners, L.P., THL-CCI Investors Limited Partnership, Providence Media Partners L.P., Alta V Limited Partnership, Customs House Partners and Ontario Teachers' Pension Plan Board.** (10.8) 10.9 Registration Rights Agreement dated July 15, 1992 among the Company, Boston Ventures Limited Partnership III, Boston Ventures Limited Partnership IIIA, Boston Ventures Limited Partnership IV, Boston Ventures Limited Partnership IVA, Thomas H. Lee Equity Partners, L.P., THL-CCI Investors Limited Partnership, Providence Media Partners L.P., Alta V Limited Partnership, Customs House Partners and Ontario Teachers' Pension Plan Board.** (10.9) 10.10 Liquidation Rights Agreement dated as of July 7, 1992 by and between the Company and MD Co.** (10.10) 10.11 Stock Purchase Agreement dated as of December 17, 1992 by and among Teleport Communications Group Inc., Comcast Corporation, Comcast Teleport, Inc., the Company and Continental Teleport, Inc.** (10.11) 11.1 Schedule of computation of earnings per share. 12.1 Computation of ratio of earnings to fixed charges. 21 Subsidiaries of the Company. (b) Reports on Form 8-K. 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. CONTINENTAL CABLEVISION, INC. By: /s/ Amos B. Hostetter, Jr. Amos B. Hostetter, Jr. Chairman of the Board Dated: 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. Supplemental Information to be Furnished With Reports Filed Pursuant to Section 15(d) to the Act by Registrants Which Have Not Registered Securities Pursuant to Section 12 of the Act. As of the date hereof, the Company has not sent proxy materials or its annual report for the fiscal year ending December 31, 1993 to security holders. At such time as the Company sends such proxy materials and annual report to its security holders, it will furnish four copies thereof to the Securities and Exchange Commission for its information. _________________________ Requests for copies of exhibits filed with this Annual Report on Form 10-K may be directed to Mr. P. Eric Krauss, Treasurer, Continental Cablevision, Inc., The Pilot House, Lewis Wharf, Boston, Massachusetts 02110. INDEX TO FINANCIAL STATEMENT SCHEDULES Financial Statement Schedules Listed below are Financial Statement Schedules of the Company which are filed as part of this report INDEPENDENT AUDITOR'S REPORT Continental Cablevision, Inc.: We have audited the consolidated financial statements of Continental Cablevision, Inc. and its subsidiaries as of December 31, 1992 and 1993, and for each of the three years in the period ended December 31, 1993, and have issued our report thereon dual dated February 10, 1994 and March 9, 1994; such consolidated financial statements and report are included elsewhere in this Form 10-K. Our audits also included the financial statement schedules of Continental Cablevision, Inc. and its subsidiaries, listed in 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 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 Boston, Massachusetts February 10, 1994 (March 9, 1994 as to Notes 5 and 15 to the consolidated financial statements) SCHEDULE I CONTINENTAL CABLEVISION, INC. AND SUBSIDIARIES MARKETABLE SECURITIES--OTHER INVESTMENTS December 31, 1993 See Notes to Consolidated Financial Statements. SCHEDULE II CONTINENTAL CABLEVISION, INC. AND SUBSIDIARIES ACCOUNTS RECEIVABLE FROM RELATED PARTIES Year Ended December 31, 1991 See Notes to Consolidated Financial Statements. SCHEDULE II (continued) CONTINENTAL CABLEVISION, INC. AND SUBSIDIARIES ACCOUNTS RECEIVABLE FROM RELATED PARTIES (CONTINUED) Year Ended December 31, 1992 See Notes to Consolidated Financial Statements. SCHEDULE II (Continued) CONTINENTAL CABLEVISION, INC. AND SUBSIDIARIES ACCOUNTS RECEIVABLE FROM RELATED PARTIES Year Ended December 31, 1993 See Notes to Consolidated Financial Statements. SCHEDULE V CONTINENTAL CABLEVISION, INC. AND SUBSIDIARIES PROPERTY, PLANT AND EQUIPMENT Years Ended December 31, 1991, 1992 and 1993 See Notes to Consolidated Financial Statements. SCHEDULE VI CONTINENTAL CABLEVISION, INC. AND SUBSIDIARIES ACCUMULATED DEPRECIATION OF PROPERTY, PLANT AND EQUIPMENT Years Ended December 31, 1991, 1992 and 1993 See Notes to Consolidated Financial Statements. SCHEDULE VIII CONTINENTAL CABLEVISION, INC. AND SUBSIDIARIES VALUATION AND QUALIFYING ACCOUNTS AND RESERVES Years Ended December 31, 1991, 1992 and 1993 See Notes to Consolidated Financial Statements. SCHEDULE X CONTINENTAL CABLEVISION, INC. AND SUBSIDIARIES SUPPLEMENTARY INCOME STATEMENT INFORMATION Years Ended December 31, 1991, 1992 and 1993 See Notes to Consolidated Financial Statements. INDEX TO EXHIBITS Listed below are the exhibits which are filed as part of this report (according to the number assigned to them in Item 601 of Regulation S-K). Each exhibit marked by an asterisk (*) is incorporated by reference to the Company's Registration Statement No. 33-46510 (as amended), declared effective by the Securities and Exchange Commission on June 15, 1992, each exhibit marked by two asterisks (**) is incorporated by reference to the Company's Registration Statement No. 33-59806, declared effective by the Securities and Exchange Commission on May 27, 1993, and each exhibit marked by three asterisks (***) is incorporated by reference to the Company's Registration Statement No. 33-65798, declared effective by the Securities and Exchange Commission on August 6, 1993. Exhibit numbers in parentheses refer to the exhibit numbers in Registration Statements. Each exhibit marked by a pound sign (#) is a management contract or compensatory plan.

912238_1993.txt

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912238

Item 1. Business. Household International Netherlands B.V. (the "Company") was organized under the Dutch Civil Code on September 14, 1990. All of the outstanding voting securities of the Company are owned by Household Overseas Limited, which is a wholly-owned subsidiary of Household International (U.K.) Limited ("HIUK"). The Company was created solely to act as a non-operating special purpose financing subsidiary of HIUK. The Company will only enter into agreements or arrangements to obtain funds for, or to provide financing options to, HFC Bank plc ("HFC Bank"), also a wholly- owned subsidiary of HIUK. The Company will not engage in any other type of business activity. Item 2. Item 2. Properties. The Company does not and will not have any material physical properties. Item 3. Item 3. Legal Proceedings. There is no litigation pending against 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 the Registrant's Common Equity and Related Stockholder Matters. All voting securities of the Company are owned by Household Overseas Limited. Item 6. Item 6. Selected Financial Data. In thousands. 1993 1992 1991 1990* - ---------------------------------------------------------------- STATEMENTS OF OPERATIONS YEAR ENDED DECEMBER 31: Net interest margin $93.9 - - - General and administrative expenses 13.7 $ 3.1 $ 3.0 $ 0.7 Income taxes 32.1 - - - - ----------------------------------------------------------------- Net income (loss) $48.1 $(3.1) $(3.0) $(0.7) ================================================================= BALANCE SHEET DATA AS OF DECEMBER 31: Total assets $126,187.4 $20.0 $20.0 $20.0 Senior notes payable 124,711.7 - - - Shareholder's equity 61.3 13.2 16.3 19.3 - ----------------------------------------------------------------- *Household International Netherlands B.V. was incorporated on September 14, 1990. Therefore, there is no operating data for 1989. Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. In October, 1993 the Company issued $125 million of 5.25% Senior Notes Due October 15, 1998 (the "Notes"). The Notes are unconditionally guaranteed, as to the payment of principal and interest, by Household International, Inc., a Delaware Corporation ("Household International"). Household International may, at any time, assume all the obligations of the Company with respect to Notes without the consent of any holder of the Notes. Household International files periodic reports under the Securities Exchange Act of 1934, as amended, with the Securities and Exchange Commission (File No. 1-8198), including audited financial statements which include the financial results of HIUK and its subsidiaries, including the Company. The Company loaned the proceeds of the above referenced Notes to HFC Bank pursuant to an intercompany loan agreement at the semi-annual rate of 5.50%. The Company anticipates that it will have no other source of income other than a lending relationship with HFC Bank. Item 8. Item 8. Financial Statements and Supplementary Data. STATEMENTS OF OPERATIONS In thousands. - -------------------------------------------------------------- YEAR ENDED DECEMBER 31 1993 1992 1991 - -------------------------------------------------------------- Interest income $1,499.5 - - Interest expense 1,405.6 - - - -------------------------------------------------------------- Net interest margin 93.9 - - General and administrative expenses 13.7 $ 3.1 $ 3.0 - -------------------------------------------------------------- Net income (loss) before income taxes 80.2 (3.1) (3.0) Income taxes 32.1 - - - -------------------------------------------------------------- Net income (loss) $ 48.1 $(3.1) $(3.0) ============================================================== The accompanying notes are an integral part of these financial statements. BALANCE SHEETS In thousands. - --------------------------------------------------------------- DECEMBER 31 1993 1992 - --------------------------------------------------------------- ASSETS Cash $ 14.7 $20.0 Accrued interest receivable 1,461.1 - Intercompany loan 124,050.9 - Deferred issuance costs 660.7 - - --------------------------------------------------------------- Total assets $126,187.4 $20.0 =============================================================== LIABILITIES AND SHAREHOLDER'S EQUITY Accrued interest payable and accrued liabilities $ 1,414.4 $ 6.8 Senior notes payable 124,711.7 0 - --------------------------------------------------------------- Total liabilities 126,126.1 6.8 Shareholder's equity 61.3 13.2 - --------------------------------------------------------------- Total liabilities and shareholder's equity $126,187.4 $20.0 =============================================================== The accompanying notes are an integral part of these financial statements. STATEMENTS OF CASH FLOWS In thousands. - --------------------------------------------------------------- YEAR ENDED DECEMBER 31 1993 1992 1991 - --------------------------------------------------------------- CASH PROVIDED BY OPERATIONS Net income (loss) $ 48.1 $(3.1) $(3.0) Adjustments to reconcile net income to net cash provided by operations: Accrued interest receivable (1,461.1) - - Arrangement fee 987.5 - - Deferred issuance costs (687.5) - - Accrued interest payable and accrued liabilities 1,407.7 3.1 3.0 - --------------------------------------------------------------- Cash provided by operations 294.7 0.0 0.0 - --------------------------------------------------------------- INVESTMENT IN OPERATIONS Intercompany loan originated (125,000.0) - - - --------------------------------------------------------------- Cash decrease from investments in operations (125,000.0) - - - --------------------------------------------------------------- FINANCING TRANSACTIONS Senior notes payable issued 124,700.0 - - - --------------------------------------------------------------- Cash increase from financing transactions 124,700.0 - - - --------------------------------------------------------------- Decrease in cash (5.3) 0.0 0.0 CASH AT JANUARY 1 20.0 20.0 20.0 - --------------------------------------------------------------- Cash at December 31 $ 14.7 $20.0 $20.0 =============================================================== The accompanying notes are an integral part of these financial statements. STATEMENTS OF CHANGES IN SHAREHOLDER'S EQUITY All dollar amounts are stated in thousands. - --------------------------------------------------------------- Issued Number and Accumu- of Paid-in lated Shares Capital Deficit Total - --------------------------------------------------------------- Balance at December 31, 1990 400 $20.0 $ (.7) $19.3 Net loss - - (3.0) (3.0) - --------------------------------------------------------------- Balance at December 31, 1991 400 20.0 (3.7) 16.3 Net loss - - (3.1) (3.1) - --------------------------------------------------------------- Balance at December 31, 1992 400 20.0 (6.8) 13.2 Net income - - 48.1 48.1 - --------------------------------------------------------------- Balance at December 31, 1993 400 $20.0 $41.3 $61.3 =============================================================== The accompanying notes are an integral part of these financial statements. Notes to Financial Statements Household International Netherlands B.V. (the "Company") was organized under the Dutch Civil Code on September 14, 1990. All of the outstanding voting securities of the company are owned by Household Overseas Limited, which is a wholly-owned subsidiary of Household International (U.K.) Limited ("HIUK"). The ultimate parent company is Household International, Inc. ("Household International"), a Delaware corporation. The Company was organized solely to serve as a source of financing, directly or indirectly, for HFC Bank plc ("HFC Bank"), also a wholly-owned subsidiary of HIUK. The Company's functional currency is the U.S. dollar, as the majority of the Company's activities are denominated in U.S. dollars. 1. EXPLANATION ADDED TO FINANCIAL STATEMENTS PREPARED FOR USE IN THE UNITED STATES The Company maintains its accounts in accordance with accounting principles and practices employed by enterprises in the Netherlands. The accompanying financial statements reflect certain adjustments not recorded on the Company's books, to present these statements in accordance with generally accepted accounting principles of the U.S., and therefore differ from the statements prepared for use in the Netherlands. These adjustments, which only affect 1993 and had no impact on either net income for the year ended December 31, 1993 or shareholder's equity at that date, were as follows: A. Deferral of a $987,500 loan arrangement fee. This amount has been netted against the intercompany loan and is being amortized over the expected term of the loan. The amortization was included in interest income in the accompanying statements of operations. B. Deferral of $687,500 in senior notes payable issuance costs. These costs have been recorded as an asset and are being amortized over the expected term of the notes. The amortization was included in interest expense in the accompanying statements of operations. C. Deferral of $300,000 in senior notes payable discount. The discount has been netted against the senior notes payable and is being amortized over the expected term of the notes. The amortization was included in interest expense in the accompanying statements of operations. 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Debt discount and deferred issuance costs - Debt discount and deferred issuance costs are amortized using a method which approximates the effective yield method over the expected term of the related senior notes payable. Income taxes - The Company has obtained a ruling from the tax authorities of the Netherlands. Under this ruling a certain minimum taxable income is to be reported during the year. Income tax expense as included in the accompanying statements of operations has been calculated in accordance with this tax ruling. 3. INTERCOMPANY LOANS In thousands. --------------------------------------------------------- AT DECEMBER 31 1993 1992 --------------------------------------------------------- Due from HFC Bank plc $125,000.0 - Unamortized arrangement fee (949.1) - --------------------------------------------------------- Total $124,050.9 - ========================================================= The Company granted a long-term loan to HFC Bank. The loan bears an annual interest rate of 5.50 percent and matures on October 15, 1998. HFC Bank has entered into an agreement ("arrangement fee") to reimburse the Company for the discount on the senior notes payable and issuance costs. This arrangement fee is netted against the principal balance and is amortized into interest income using a method which approximates the effective yield method over the expected term of the loan. 4. SENIOR NOTES PAYABLE In thousands. --------------------------------------------------------- AT DECEMBER 31 1993 1992 --------------------------------------------------------- Notes payable, 5.25% due October 15, 1998 $125,000.0 - Unamortized discounted (288.3) - --------------------------------------------------------- Total notes payable $124,711.7 - ========================================================= The senior notes payable, which were issued in the U.S., are guaranteed as to the payment of principal and interest until maturity by Household International. 5. SHAREHOLDER'S EQUITY The Company is authorized to issue 2,000 shares of common stock with a stated par value of 100 Netherland guilders. At December 31, 1993 and 1992, 400 shares were issued and outstanding. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS Household International Netherlands B.V.: We have audited the accompanying balance sheets of Household International Netherlands B.V. (a Netherlands corporation) as of December 31, 1993 and 1992, and the related statements of operations, changes in shareholder'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 Household International Netherlands B.V. 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 (see Note 1). ARTHUR ANDERSEN & CO. Chicago, Illinois, February 25, 1994 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 individuals are executive officers and/or directors of the Company: John W. Blenke, age 38, is President, Chairman of the Board, Chief Executive Officer and Secretary of the Company since March 1994. Mr. Blenke was elected Secretary in October 1993. Mr. Blenke is also currently an Assistant General Counsel and Secretary of Household International, having been appointed Secretary in 1993. Mr. Blenke joined Household International in 1989 as Corporate Finance Counsel, was promoted to Assistant General Counsel-Securities & Corporate Law and Assistant Secretary in 1991. Prior to joining Household, Mr. Blenke was employed with a subsidiary of Transamerica Corporation. Joseph P. Hoff, age 43, was appointed the Vice President, Treasurer and Chief Financial Officer, as well as a Director of the Company on September 8, 1993. Mr. Hoff is also currently an Assistant Treasurer of Household International and a Vice President and Assistant Treasurer of Household Finance Corporation, also a subsidiary of Household, positions which he has held since 1989. Prior to 1989, Mr. Hoff was a Senior Vice President of Household Commercial Financial Services. David A. Schoenholz, age 42, was appointed Vice President, Controller and Chief Accounting Officer of the Company on September 8, 1993. Mr. Schoenholz is also currently the Vice President-Chief Accounting Officer of Household International, having been so appointed in 1993. Mr. Schoenholz was appointed Vice President in 1989 and Controller in 1987. He joined Household International in 1985 as Director-Internal Audit. Prior to joining Household International, Mr. Schoenholz was employed by the Commodore Corporation, a manufacturer of mobile homes, as Vice President/Controller from 1983 to 1985. ABN-AMRO Trust Company (Nederland) B.V. was apppointed a Director of the Company on September 8, 1993, and is a limited liability company incorporated on August 27, 1991 in Amsterdam, Netherlands. ABN-AMRO Trust Company (Nederland) B.V. and its subsidiaries serve as director to approximately 1,000 Netherlands incorporated holding and finance companies. ABN-AMRO Trust Company (Nederland) B.V. acts as a manager, administrator and advisor with respect to various financial and commercial activities of companies located or operating in the Netherlands. Item 11. Item 11. Executive Compensation. None of the officers of the Company receive compensation for serving as officers of the Company. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management. Not applicable. 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. (a) Financial Statements. The following financial statements, together with the report of Arthur Andersen & Co., dated February 25, 1994, appearing on pages 4 through 10 hereof. Household International Netherlands B.V.: Statements of Operations for the Three Years Ended December 31, 1993. Balance Sheets, December 31, 1993 and 1992. Statements of Cash Flows for the Three Years Ended December 31, 1993. Statements of Changes in Shareholder's Equity for the Three Years Ended December 31, 1993. Notes to Financial Statements. (b) Reports on Form 8-K. During the three months ended December 31, 1993, the Company filed no Reports on Form 8-K. (c) Exhibits. 3(a) Articles of Incorporation of the Company. 4(a) Indenture dated as of September 9, 1993, between the Company, Household and The First National Bank of Boston, as Trustee (incorporated by reference to Exhibit 4(a) of the Company's Registration Statement on Form S-3 (No. 33-50351), filed on September 21, 1993). 10(a) Loan Agreement dated October 21, 1993 between the Company and HFC Bank plc. 12(a) Statement on the Computation of Ratio of Earnings to Fixed Charges of the Company. 12(b) Statement on the Computation of Ratio of Earnings to Fixed Charges and to Combined Fixed Charges and Preferred Stock Dividends of Household International (incorporated by reference to Exhibit 12 of Household International's Annual Report on Form 10-K for the fiscal year ended December 31, 1993). 23 Consent of Independent Public Accountants (d) Schedules. None. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, Household International Netherlands B.V. has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. HOUSEHOLD INTERNATIONAL NETHERLANDS B.V. Dated: March 31, 1994 By: /s/ John W. Blenke -------------------------------- President, Chairman of the Board and Chief Executive 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 Household International Netherlands B.V. and in the capacities and on the dates indicated. Signature Title Date --------- ----- ---- /s/ John W. Blenke President, March 31, 1994 - ----------------------- Chairman of the Board (John W. Blenke) and Chief Executive Officer /s/ Joseph W. Hoff Vice President, March 31, 1994 - ----------------------- Treasurer, Chief (Joseph W. Hoff) Financial Officer and Director /s/ David A. Schoenholz Vice President, March 31, 1994 - ----------------------- Controller and (David A. Schoenholz) Chief Accounting Officer Director March 31, 1994 - ----------------------- ABN-AMRO Trust Company (Nederland) B.V. EXHIBIT INDEX EXHIBIT NO. DESCRIPTION - ------- ----------- 3(a) Articles of Incorporation of the Company. 4(a) Indenture dated as of September 9, 1993, between the Company, Household and The First National Bank of Boston, as Trustee (incorporated by reference to Exhibit 4(a) of the Company's Registration Statement on Form S-3 (No. 33-50351), filed on September 21, 1993). 10(a) Loan Agreement dated October 21, 1993 between the Company and HFC Bank plc. 12(a) Statement on the Computation of Ratio of Earnings to Fixed Charges of the Company. 12(b) Statement on the Computation of Ratio of Earnings to Fixed Charges and to Combined Fixed Charges and Preferred Stock Dividends of Household International (incorporated by reference to Exhibit 12 of Household International's Annual Report on Form 10-K for the fiscal year ended December 31, 1993). 23 Consent of Independent Public Accountants

84613_1993.txt

84613_1993

1993

84613

ITEM 1. Business General Development of Business: Rockland Electric Company (the "Company") is a New Jersey corporation which was incorporated in 1899 under an Act of the Legislature of New Jersey and is engaged in the transmission, distribution and sale of electricity. Its principal New Jersey office is located at 82 East Allendale Road, Saddle River, New Jersey 07458. The Company has a wholly owned non-utility subsidiary, Saddle River Holdings Corp. ("SRH"), a Delaware corporation. SRH has two wholly owned non-utility subsidiaries, O&R Energy, Inc. and Atlantic Morris Broadcasting, Inc., both Delaware corporations. O&R Energy, Inc. has a wholly owned non-utility subsidiary, Millbrook Holdings, Inc., also a Delaware corporation. All of the Company's outstanding common stock is owned by Orange and Rockland Utilities, Inc. (the "Parent"). The Parent is a New York corporation, with its principal office at One Blue Hill Plaza, Pearl River, New York 10965. The Parent has two wholly owned utility subsidiaries, the Company and Pike County Light & Power Company ("Pike"), a Pennsylvania corporation, as well as three non-utility subsidiaries. Financial Information about Industry Segments: Consolidated financial information regarding the Company's principal business segments, Electric Utility Operations and Diversified Activities, is contained in Note 11 of the Notes to Consolidated Financial Statements - "Segments of Business" in Part II, Item 8 of this Form 10-K Annual Report. Narrative Description of Business: Principal Business The Company serves a territory with a population of approximately 155,000, located in parts of northern Bergen and Passaic Counties in the northeastern corner of New Jersey (adjacent to the southeastern portion of the territory served by its Parent in New York) and a small area in Sussex County in the northwestern corner of New Jersey along the Delaware River. At December 31, 1993, the Company served approximately 64,000 customers in 26 communities. There have been no significant changes in either the population of the Company's service territory or in the number of customers served since December 31, 1992. At that time, service was provided to approximately 63,000 customers in 26 communities with an estimated population of 155,000. While the territory served is predominantly residential, the Company also serves a number of commercial and industrial customers in diversified lines of business activities, from which significant electric revenues are received. No customer accounts for more than 10% of sales. The business of the Company is seasonal to the extent that sales of electricity are higher during the summer, mainly due to air conditioning requirements. Events Affecting the Company On August 16, 1993, the Rockland County, New York District Attorney charged a then Vice President of the Parent and the Company with grand larceny, commercial bribery and making illegal political contributions and commenced a related investigation of the Parent. Two other former employees of the Parent, who had reported to the Vice President were also charged with grand larceny. On August 20, 1993, the Parent's Board of Directors created a Special Committee (the "Special Committee") of the Board, consisting entirely of outside Directors, to conduct an independent investigation of the issues raised by the Rockland County District Attorney and any other matters discovered in the course of the investigation as the Special Committee deems necessary or desirable. The Special Committee was granted full and complete power and authority to take whatever steps it deems necessary or desirable, including retention of counsel and other advisors, presenting to the Parent's Board of Directors periodic reports regarding its activities and at the appropriate time its full findings, and making recommendations to the Parent's Board of Directors with respect to any remedial measures it deems appropriate to prevent a recurrence of any improprieties or irregularities discovered by the investigation. The Special Committee has retained the law firm of Stier, Anderson & Malone as investigative counsel, and Price Waterhouse & Co. as accounting experts, to assist it in conducting its independent investigation. The Special Committee will present preliminary conclusions of its investigation at the Parent's Annual Meeting of Shareholders on May 11, 1994. The Special Committee intends to complete its investigation as promptly as practicable after the Annual Meeting and will report its final conclusions and recommendations to the Parent's Board of Directors at that time. In addition, during the fourth quarter, James F. Smith was terminated for cause as Chief Executive Officer of the Parent and the Company and removed as Chairman of the Parent's and the Company's Board of Directors. President and Chief Operating Officer of the Parent and the Company, Victor J. Blanchet, Jr. was appointed to serve as acting Chief Executive Officer of the Parent and the Company. Details concerning these events, including the cost incurred for legal counsel, accounting services, and other professional and consultative services related to the ongoing investigations and their effect of the Company's Results of Operations are contained in the "Management's Discussion and Analysis of Financial Condition and Results of Operations" under the caption "Events Affecting the Company" and in Note 10 of the Notes to Consolidated Financial Statements under the caption "Legal Proceedings" in this Form 10-K Annual Report. Reference is also made to Item 3, "Legal Proceedings", of this Form 10-K Annual Report. Electric Operations The Company's electricity supply requirements, together with all operating and service personnel, are furnished by its Parent pursuant to contracts. The contract for the supply of electricity has been approved by the Federal Energy Regulatory Commission (the "FERC") and the contract for provision of operating and service personnel has been approved by the New Jersey Board of Regulatory Commissioners (the "NJBRC"). Such contracts provide, in general, for the reimbursement to the Parent, by the Company, of costs allocable to electricity and services furnished to the Company, and require additional payments to the Parent of an amount sufficient to yield specified returns on its investment in plant and other assets allocable to the Company under certain formulae. During 1992, the Parent was a party to a proceeding initiated by the FERC to determine the rate of return authorized for use in establishing wholesale rates between the Parent, the Company and Pike. Pursuant to an agreement which was approved by the FERC on February 19, 1993, the Parent has been authorized to earn an 11.7% return on equity effective as of January 1, 1993, which is a decrease from the previously authorized 12.25% return on equity. Generating Capacity and Purchased Power. As described more fully in Item 2, "Properties", of this Form 10-K Annual Report, the capacity of the Parent's plants provides the Parent and its utility subsidiaries with a net generating capability of 1,032 megawatts ("Mw") in the winter and 1,020 Mw in the summer. The maximum historical one-hour demand for the Parent and its utility subsidiaries of 1,037 Mw occurred on July 8, 1993. During 1993, the Parent's purchased power accounted for approximately 42% of the total energy supply of the Company and its utility subsidiaries. Purchased power is available to the Parent primarily through its membership in the New York Power Pool (the "NYPP"), through which member companies are able to coordinate inter- utility transfers of bulk power in order to achieve economy and efficiency. Through the NYPP control center, the Parent is able to purchase power in order to optimize its generation/purchase mix, using the lowest cost energy available to its interconnected system at any time. During 1993, the Parent purchased 464,334 megawatt hours ("Mwh") from or through the NYPP, which represents approximately 23% of the total purchased power. By agreement with the NYPP, the Parent must maintain capacity reserves including firm capacity purchases of not less than 18% of its peak load. In addition, the Parent has agreements with the New York Power Authority (the "NYPA") and certain other utilities for the purchase of firm power. During 1993, an agreement with the NYPA provided for firm purchases of 25 Mw of year-round capacity from the Blenheim-Gilboa pumped-storage generating facility ("Gilboa Facility") and firm power purchase agreements with Central Hudson Gas & Electric Corporation ("Central Hudson") and Pennsylvania Power & Light Company ("PP&L"), provided for an additional 225 Mw of capacity. Other agreements were in effect from time to time throughout 1993 with several other utilities, including an agreement with Philadelphia Electric Company pursuant to which significant economy purchases were made during 1993, which provided for short-term, firm purchases on an as-available, as-needed basis. The NYPA agreement for firm purchases from the Gilboa Facility, which provides for 25 Mw of year-round capacity, will be in effect through April 2015. The firm purchase agreement with Central Hudson will provide 50 Mw of capacity through April 1994, and the agreement with PP&L will provide capacity ranging between 10 Mw and 125 Mw through October 1995. In addition, a firm purchase power agreement with Public Service Electric & Gas Company ("PSE&G") will provide between 75 Mw and 300 Mw of capacity during the base contract term which extends from May 1994 through April 1998, with an additional 100 MW available throughout the base contract term at the option of the Parent. The contract also provides that at the option of the Parent 100 Mw of additional capacity would be available to the Parent between May 1992 and April 1994 and 400 Mw of additional capacity will be available from May 1998 through October 2000. During 1994, the Company expects to purchase 50 Mw of capacity above the base contract amount under these options. Other agreements will continue to be in effect which will enable the Company to take advantage of economic power purchases on an as available, as- needed basis. Additional information regarding the Parent's future power supply, particularly capacity purchase contracts with Independent Power Producers and Qualifying Facilities, is contained under the caption "Future Energy Supply and Demand" in this Item I. The Parent also maintains interconnections with Central Hudson, PSE&G and Consolidated Edison Company of New York, Inc. ("Con Ed"). Through these interconnections, and as a member of the NYPP, the Parent can exchange power directly with the above utilities and, through the facilities of other members of the NYPP, the Parent can exchange power with all members of the NYPP and with utilities in pools in neighboring states. Fuel Supply. The Parent's 1,032 Mw winter generating capacity is available from various fuel sources including gas, coal, oil and hydro power. Electricity available for sale is a mix of Company generation by various fuel types, supplemented by purchased power when such power is available at a price lower than the price of generation or is needed to meet load requirements. Details for the years 1989 through 1993 are as follows: 1989 1990 1991 1992 1993 Gas 25% 27% 22% 21% 16% Coal 29 32 36 33 33 Oil 28 19 14 10 5 Hydro 3 4 3 3 4 Purchased Power 15 18 25 33 42 Total 100% 100% 100% 100% 100% Gas - During 1993, the Parent was able to use significant volumes of natural gas for boiler fuel at both its Lovett Plant and the Bowline Point Plant. It also expects to be able to use natural gas in the Lovett Plant and Bowline Point Plant during 1994, whenever such gas is more economical than alternative fuels. In 1993, the Parent used 2.1 billion cubic feet ("Bcf") and 6.0 Bcf of gas, respectively, at the Lovett Plant and the Bowline Point Plant. The annual average cost per thousand cubic feet ("Mcf") of natural gas burned in the Parent's generating plants during the years ended December 31, 1989 through 1993 was $2.79, $2.78, $2.64, $2.82 and $3.01, respectively. This is equivalent to $2.71, $2.69, $2.56, $2.74 and $2.92, respectively, per million British Thermal Unit ("MMBTU"). Coal - The low sulfur coal (1.0 lbs. SO2 per MMBTU) used in the Parent's Lovett Plant Units 4 and 5 is supplied to the Parent primarily through long term contracts with Massey Coal Sales, Inc. ("Massey") and the Pittston Coal Sales Co., ("Pittston") as well as through spot market purchases, which accounted for approximately 22% of the Parent's 1993 coal requirements. The Parent has the right, under the coal purchase contracts, to suspend the purchase of coal if alternative fuel sources become less expensive. The coal is fully washed and, as such, is low in ash (typically 7%) and high in BTU content (26 MMBTU's per ton). The annual average cost per ton of coal consumed at the Lovett Plant during each of the years ended December 31, 1989 through 1993 was $58.53, $58.40, $56.57, $55.95 and $55.25, respectively. This is equivalent to $2.26, $2.25, $2.18, $2.16 and $2.14, respectively, per MMBTU. During 1993 coal was the predominant fuel burned at the Lovett Plant, and the Parent expects it to be the predominant fuel burned during 1994. In February 1994, the contract with Pittston was terminated by the Parent because of Pittston's failure to meet the coal quality specification of its contract. Alternative supplies have been obtained and arrangements for longer term replacement coal are under review. Oil - The Parent does not anticipate purchasing any significant quantity of fuel oil for its Lovett Plant. Con Ed has undertaken the supply of #6 fuel oil (0.37% maximum sulfur content by weight) to the Bowline Point Plant, which is supplied under a contract between Con Ed and the Parent. Pursuant to that contract, Con Ed has also undertaken to provide a backup oil supply for the Company's Lovett Plant under certain conditions. The Parent believes that it will be able to secure sufficient oil supplies to meet the total requirements of #6 fuel oil for the calendar year 1994. The annual average cost per barrel of oil burned in the Parent's generating plants during the years ended December 31, 1989 through 1993 was $19.21, $23.73, $21.23, $20.43 and $21.27, respectively. This is equivalent to $3.09, $3.81, $3.40, $3.26 and $3.39, respectively, per MMBTU. Hydro - Water for the operation of the Parent's Mongaup River Hydro Plants is controlled by the Parent through the ownership of the necessary land in fee or through easements. In the case of the Parent's Grahamsville Plant, water is obtained under contract with the City of New York Board of Water Supply. This contract, which expires in 2005, entitles the Parent to 8.1 Bcf of free water each year. Water in excess of the 8.1 Bcf, which amounted to 9.0 Bcf during 1993, is billed at varying rates based on an average cost of all fuels used in power generation. Purchased Power - the Parent's practice regarding purchased power is to supplement the Parent's electric generation by purchasing both capacity and energy when needed to meet load and reserve requirements and also when such power is available at a price lower than the cost of production. Details regarding purchased power are contained under the captions "Generating Capacity and Purchased Power" and "Future Energy Supply and Demand" in this Item 1. In addition, information regarding the cost of electric energy is contained under the caption "Energy Costs" in the "Management's Discussion and Analysis of Financial Condition and Results of Operations" in this Form 10-K Annual Report. Future Energy Supply and Demand. The Parent and the Company continue to be committed to meeting customer energy needs by providing reliable energy service at the lowest prudent cost and in an environmentally sound manner. Through the Integrated Resource Plan the Parent and the Company have responded to the changes that have occurred in the utility industry and have incorporated a significant number of conservation and demand reduction alternatives as well as purchased power from both utility and non-utility generators, into their energy strategy. The Demand-Side Management ("DSM") program involves efforts to control electric peak demand and energy usage, and addresses the need to improve plant utilization by making customer demand more complementary over time to the available capacity. DSM programs are available to all market segments. Through December 31, 1993, DSM efforts have reduced the annual need for increased generating capacity and energy by 97.9 Mw and 173,104 Mwh, respectively, both through programs administered by the Parent and the Company as well as through contracts with outside consultants pursuant to the competitive bidding program. The New York State Public Service Commission ("NYPSC") has consistently authorized the recovery of DSM costs, and in New Jersey, the Company's DSM costs are recoverable on a current basis. The Parent's Supply-Side Management program involves the acquisition of future increments of capacity and energy from both investor-owned utilities and from non-utility generators. The Parent has entered into several agreements in this regard. In 1990, the Parent entered into a power supply agreement ("Wallkill Agreement") with Wallkill Generating, L.P. ("Wallkill Generating"). The Wallkill Agreement was approved by the NJBRC in October 1991, and in July 1991 the FERC approved the rates contained in the Wallkill Agreement. Pursuant to the agreement, Wallkill Generating, a limited partnership formed by PG&E/Bechtel Generating Company (now U.S. Generating Company), has contracted to construct and operate a gas- fired combined cycle generating facility in the Town of Wallkill, N.Y. and sell 95 Mw of capacity and associated energy to the Parent. The original target date for commercial operation of this project as set forth in the Wallkill Agreement was April, 1994. Wallkill Generating has reported that construction of the project will begin in the spring of 1994 and it will be available for commercial operation in late 1995. In 1990, the Parent entered into a long-term power supply agreement ("State Line Agreement") with State Line Power Associates Limited Partnership ("State Line"). Under the terms of the State Line Agreement, State Line contracted to construct and operate a gas-fired combined cycle generating facility in the Borough of Ringwood, New Jersey and sell 100 Mw of capacity and associated energy to the Parent. In July 1992, the State Line Agreement was terminated by the Parent for, among other things, State Line's failure to make a required milestone payment pursuant to specified contract terms. On August 3, 1992, State Line filed suit against the Parent in the United States District Court for the Southern District of New York claiming that the Parent had wrongfully terminated the State Line Agreement. On January 7, 1994, State Line and the Parent settled all litigation relating to the State Line Agreement. In addition to the Wallkill Agreement, future increments of purchased capacity and energy have been contracted from investor owned utilities and the NYPA as previously described under the caption "Generating Capacity and Purchased Power" in this Item 1. In addition, the Parent has contracted to purchase approximately 90 Mw of capacity and associated energy from various Public Utility Regulatory Policies Act ("PURPA") Qualifying Facilities. These contracts include a contract between the Parent and Harriman Energy Partners, Ltd., ("Harriman Energy") a limited partnership, the general partner of which is Destec Holding, Inc. (formerly PSE, Inc.). This contract provides for the construction of a project that upon commercial operation, which Harriman Energy has reported to be in late 1996, would provide the Parent with approximately 57 Mw of capacity and associated energy for a period of 25 years. This contract has been approved by the NYPSC and the New Jersey Board of Regulatory Commissioners ("NJBRC"). Construction has not been commenced on either the Wallkill Generating or Harriman Energy projects and the Parent cannot predict whether either of these projects will be constructed. If either or both of these projects are not constructed, other economic sources of capacity and energy should be available to the Parent and the Company. Diversified Activities The Company's wholly owned non-utility subsidiary, Saddle River Holdings Corp. ("SRH"), was established for the purpose of investing in non-utility business ventures and, through subsidiaries, is currently engaged in natural gas marketing and radio broadcasting. Capital contributions to SRH are borne by the Company's shareholder. Any losses or profits from investments in SRH accrue to the shareholder and are not included in the cost of service for ratemaking purposes. Gas marketing activities are conducted through a subsidiary, O&R Energy, Inc., which provides natural gas to industrial, commercial and institutional end users, gas distribution companies and electric generating facilities in 38 states. A subsidiary of O&R Energy, Inc., Millbrook Holdings, Inc., holds approximately twelve acres of non-utility real estate in Morris County, New Jersey. Broadcasting activities are conducted through Atlantic Morris Broadcasting, Inc., a subsidiary of SRH, which owns radio stations WKTU (FM) in Ocean City, New Jersey, WABT (FM) in Dundee, Illinois, WALL (AM) and WKOJ (FM) in Middletown, New York and WCSO (FM) and WLPZ (AM) in Portland, Maine. The Company's Consolidated Financial Statements include the results of operations of all diversified activities. The diversified activities, which consist primarily of gas marketing activities, are considered to be a reportable business segment. However, the net earnings realized from diversified activities are less than 10% of total net earnings and the identifiable assets of the diversified activities consist primarily of gas marketing receivables which generally have corresponding gas marketing payables. Based on these factors, the disclosure related to the Company's diversified activities, as prescribed by Regulation S-K, has, with few exceptions, been omitted from other sections of this Form 10-K Annual Report. Construction Program and Financing Construction Program. The construction expenditures, excluding allowance for funds used during construction ("AFDC"), of the Company for the period 1994 through 1998 are presently estimated at approximately $37 million, as set forth in the table below. The Company's construction program is under continuous review and the estimated construction expenditures are, therefore, subject to periodic revision to reflect, among other things, changes in energy demands, economic conditions, environmental regulations, construction delays, the level of internally generated funds and other modifications to the construction program. Forecasted Construction Expenditures (000's) 1994 1995 1996 1997 1998 Transmission & Substations $ 805 $1,270 $1,520 $3,565 $3,255 Electric Distribution 4,480 4,960 5,450 5,300 5,315 Electric General 115 25 25 25 530 Total Construction $5,400 $6,255 $6,995 $8,890 $9,100 The Company's forecasted construction expenditures for the five year period 1994 through 1998 consists primarily of routine transmission and distribution projects for capital replacements or system betterments. Information regarding the Company's construction program is contained under the caption "Liquidity and Capital Resources" in the "Management's Discussion and Analysis of Financial Condition and Results of Operations" in Part II, Item 7 of this Form 10-K Annual Report, as well as in Note 10 of the Notes to Consolidated Financial Statements - "Construction Program" in Part IV, Item 14 of this Form 10-K Annual Report. Financing. During the three year period 1991-1993, the Company's total construction expenditures were financed with internally generated funds. It is expected that the construction expenditures for the years 1994-1998 will also be financed with internally generated funds. Additional information regarding the Company's financing activities is contained under the caption "Liquidity and Capital Resources" in the "Management's Discussion and Analysis of Financial Condition and Results of Operations" in Part I, Item 7 as well as in Note 7 of the Notes to Consolidated Financial Statements - "Cash and Short-Term Debt" of this Form 10-K Annual Report. Regulatory Matters Regulation. The Company is subject to the jurisdiction of the NJBRC with respect to, among other things, rates, services, the issuance of securities, and accounting and depreciation procedures. In addition, approval by the NYPSC is required for the purchase of any securities of the Company by the Parent or for any capital contribution made to the Company by the Parent. The Company is also subject to the jurisdiction of the FERC with respect to the interstate transmission of electricity and certain other matters, including accounting, recordkeeping and reporting. The Company is also subject to regulation by various other Federal, state, county and local agencies under numerous regulations dealing with, among other things, environmental matters, energy conservation, long-range planning, fuel use, plant siting and gas pricing. Current Rate Activities. Information regarding the Company's rate activities is contained under the caption "Rate Activities" in the "Management's Discussion and Analysis of Financial Condition and Results of Operations" in Part II, Item 7, as well as in "Legal Proceedings" in Part I, Item 3 of this Form 10-K Annual Report. Rate Relief. The amounts of rate relief approved by the NJBRC during the last five years are set forth in the following table: Historical Rate Relief 1989 - 1993 Annual Amount Overall Rate Return on ($000's) of Return Equity Effective Date Requested Granted Granted (%) Granted (%) 1989-1991 - - - - 1/24/92 12,863 5,100 10.17 12.00 1/01/93 (A) 1,685 (A) (A) (A) Rate increase as ordered by the NJBRC to reflect the effect of revised legislation regarding gross receipts and franchise taxes. Rate recovery with interest is permitted over a ten year period. Information regarding possible rate impacts of certain events described under the caption "Events Affecting the Company" in this Item 1 is contained in Item 3 "Legal Proceedings", of this Form 10-K Annual Report. Utility Industry Risk Factors The electric utility industry is exposed to risks relating to increases in fuel costs, numerous regulatory and environmental restrictions, delays in obtaining adequate rate relief, increases in the costs of construction and construction delays, the effects of energy conservation, the effect of weather-related sales and revenue fluctuations and meeting the growth of energy sales. The Company is, to some extent, experiencing all of these challenges. However, the impact on the Company has been less than for the utility industry in general, principally due to the Company's relatively low construction expenditures and low external financing requirements. The problems associated with nuclear energy have not affected the Company, as its Parent has no operating nuclear plants, nor any under construction, and has no plans for future participation in nuclear projects. Additional information on the recovery by the Company of its investment in the Parent's cancelled Sterling Nuclear Project, is contained in Note 3 of the Notes to Consolidated Financial Statements - "Sterling Nuclear Project" in Part IV, Item 14 of this Form 10-K Annual Report. Competition There are competitive factors present in the industry which affect utility companies in varying degrees. Among these are the use by interruptible or dual-fuel customers of lower priced alternative fuels; the establishment of municipal distribution agencies; the presence of cogenerating systems, small power producers and independent power producers; and the increasing interest in, and research on, the development of energy sources other than those now in use. In recent years, changing laws and governmental regulation, combined with growing interest in self-generation and an increase in nonregulated energy suppliers has served to intensify the level of competition experienced by regulated utilities. The National Energy Policy Act of 1992 ("Energy Policy Act") is expected to bring major changes to the electric utility industry, including increased competition from a new category of wholesale electric generators which are exempt from the Public Utility Holding Company Act of 1935. The Energy Policy Act also empowers the FERC to require utilities, under certain circumstances, to provide open access to electric wholesalers for use of the utility's transmission systems. The Parent and the Company recognize the changes in the regulated utility environment and are committed to remain competitive in the core business. The Parent's and the Company's five year strategic plan has put forth as a corporate objective the achievement of a competitive edge by providing the most economical and effective energy service to customers. Such competitive factors are not expected to have a material effect on either the Parent or the Company for the foreseeable future. Marketing The primary focus of the Company's marketing efforts is the efficient use of energy by the Company's residential, commercial and industrial customers. Existing programs being marketed include all state approved DSM programs as well as other energy conservation programs. The Company is also marketing the Job Development Rates authorized by the NJBRC. These rates offer discounts to firms locating to vacant buildings or expanding their operations. Environmental Matters The Parent and the Company are subject to regulation by Federal, state, county and, to some extent, local authorities with respect to the environmental effects of its operations, including regulations relating to air and water quality, aesthetics, levels of noise, hazardous wastes, toxic substances, protection of vegetation and wildlife and limitations on land use. In connection with such regulation, various permits are required with respect to the Parent's and the Company's facilities. Generally, the principal environmental areas and requirements to which the Parent is subject are as follows: Water Quality. The Parent is required to comply with Federal and state water quality statutes and regulations including the Federal Clean Water Act ("Clean Water Act"). The Clean Water Act requires that the Parent's generating stations be in compliance with state issued State Pollutant Discharge Elimination System Permits ("SPDES Permits"), which prescribe applicable conditions to protect water quality. On May 18, 1992, the Parent applied to the State of New York Department of Environmental Conservation (the "NYDEC") for the renewal of its SPDES Permit for the Lovett Coal Ash Management Facility. The existing permit expired on December 1, 1992, but remains in effect until issuance of a new permit. The Parent also has an SPDES Permit, effective October 1, 1991 for its Lovett generating station. The Parent's Bowline Point generating station currently operates under a SPDES permit which expired on October 1, 1992. This permit remains in effect since a permit renewal application was filed on April 3, 1992, which was within the statutory deadline for renewal application. The Parent is now proceeding with the State Environmental Quality Review Act process as part of the permit renewal procedure. The Parent entered into a settlement with the United States Environmental Protection Agency (the "EPA") and others that relieved the Parent for at least 10 years from a regulatory agency requirement that, in effect, would have required that cooling towers be installed at the Bowline Point generating station. In return, the Parent agreed to certain plant modifications, operating restrictions and other measures. The settlement expired in May, 1991. On May 15, 1991, the Parent and others entered into an Interim Agreement with the NYDEC to continue specific operating conditions and other measures for a period from May 15, 1991 to September 30, 1992. Several interveners to the original settlement filed a civil action challenging the Interim Agreement's legality. On March 23, 1992, the parties to the Interim Agreement and interveners signed a Consent Order terminating litigation and agreeing to certain operating limitations and biological monitoring requirements. The Consent Order was due to expire on September 1, 1993. On August 5, 1993, the parties executed the First Amended Consent Order which extends the agreement through September 1, 1994. Air Quality. Under the Federal Clean Air Act, the EPA has promulgated national primary and secondary air quality standards for certain pollutants, including sulfur oxides, particulate matter and nitrogen oxides. The NYDEC has adopted, and the EPA has approved, the New York State Implementation Plan ("SIP") for the attainment, maintenance and enforcement of these standards. In order to comply with the SIP, the Parent burns #6 fuel oil at its Lovett and Bowline Point generating stations with a 0.37% maximum sulfur content by weight. Pursuant to the SIP, the Parent is governed by the following limitations when it is burning coal at Lovett Units 4 and 5: if one unit is burning, the Parent may emit sulfur dioxide at a rate not to exceed 1.5 lb/MMBTU, and if two units are burning, the Parent may emit sulfur dioxide at a rate not to exceed 1.0 lb/MMBTU per unit. The Clean Air Act Amendments of 1990, which became law on November 15, 1990, could restrict the Parent's ability to meet increased electric energy demand after the year 2000 or could substantially increase the cost to meet such demand. Regulations pertaining to nitrogen oxide reduction and continuous emissions monitoring systems will require increased capital expenditures by the Parent totaling $26.2 million during 1994 through 1996 as follows: $8.2 million in 1994, $12.0 million in 1995 and $6.0 million in 1996. The Parent will continue to assess the impact of the Clean Air Act Amendments of 1990 on its power generating operations as additional regulations implementing these Amendments are promulgated. The NYDEC has proposed to revise the SIP to meet ozone attainment standards and to provide a mechanism for Title V emissions fee billing. Under the proposed fee revision, beginning in 1994, Title V sources which include the Parent's Lovett Plant and Bowline Point Plant will be required to pay an emission fee based upon actual air emissions reported to NYDEC at a rate of approximately $25 per ton of air emissions. The effect of the proposed revision, based on 1992 emissions would have been approximately $450,000. Toxic Substances and Hazardous Wastes. The Federal Comprehensive Environmental Response, Compensation and Liability Act of 1980, as amended by the Superfund Amendments and Reauthorization Act of 1986 ("Superfund"), provides that both the owners and operators of facilities where releases of hazardous substances into the environment have occurred or are imminent, and the generators and transporters of hazardous substances disposed of at the facilities, are, regardless of fault, jointly and severally liable for all response, removal and remedial action costs and also for damages to natural resources. As part of its operations, the Parent generates materials which are deemed to be hazardous substances under Superfund. These materials include asbestos and dielectric fluids containing polychlorinated biphenyls ("PCB's"), both of which are disposed of at licensed, off-site locations not owned by the Parent. Other hazardous substances may be generated in the course of the Parent's operations or may be present at Parent-owned locations. The Parent has from time to time, received process or notice of claims under Superfund or similar state statutes relating to sites at which it is alleged that hazardous substances generated by the Parent (and, in most instances, by a large number of other potentially responsible parties) were disposed of. Similar claims may be asserted from time to time hereafter, involving additional sites. Typically, many months, and sometimes years, are required to determine fully the probable magnitude of the cleanup costs for a site, the extent, if any, of the Parent's responsibility, the number and responsibility of other parties involved, the financial ability of the other parties to pay their proportionate share of any costs, and the probable ultimate liability exposure, if any, of the Parent. This process is still under way at most of the sites of which the Parent has notice, and the costs at some of these sites may be substantial. However, based on the information and relevant circumstances known to the Parent at this time, the Parent's share of these costs is not expected to be material. Environmental Expenditures. The Parent estimates that its expenditures attributable, in whole or in substantial part, to environmental considerations totaled $13.7 million in 1993. Compliance with Federal, state and local laws and regulations which have been enacted or adopted regulating the discharge of materials into the environment or otherwise relating to the protection of the environment is not anticipated to have a material financial impact on the Parent or the Company. Projected environmental expenditures are under continuous review and are revised periodically to reflect changes in environmental regulations, inflation, technology and other factors which are beyond the control of the Parent. Although the Parent and the Company are unable to predict the ultimate impact of environmental regulations on existing or proposed facilities or on the operations of the Parent or the Company, the Company believes that its expenditures for compliance with environmental regulations will be given appropriate rate treatment. Research and Development The Company and its Parent support research and development agencies involved in utility research, provide funds for joint utility research projects and the Parent conducts its own internal program. Electric research and development expenditures of the Parent, a portion of which were borne by the Company based on the Company's use of the consolidated electric system capacity, amounted to approximately $4.0 million in 1993, $3.1 million in 1992, and $2.7 million in 1991. The Parent and the Company provide support to national agencies such as the Electric Power Research Institute. At the state level, the Parent and the Company support the Empire State Electric Energy Research Corporation and the New York State Energy Research and Development Authority. Generally, the Parent's internal research and development program concentrates on projects which uphold the corporate goal of providing safe and reliable electric and gas service to customers at a minimum price and in an environmentally acceptable manner. The program includes projects which seek improvement of generation and distribution systems, mitigation of environmental impacts of electric power generation, and advancement in customer utilization and conservation. Current projects include a demonstration of magnetic bearings on a power plant fan and motor, the development of a new technique for locating faults in underground cables, and the development of a methodology for measuring the impact of commercial and industrial demand-side management programs. Franchises The Company has municipal consents or franchises covering substantially all the territory in which it operates, which consents or franchises have been approved by the NJBRC in every case in which such approval is required. In certain areas served by the Company, the original franchises were granted for limited periods, and have since expired. The Company, however, has operated in these areas for many years with the acquiescence of the municipal authorities and, in the opinion of outside counsel, its continued operation in these areas is lawful. None of the municipal consents or franchises held by the Company are exclusive. Under the present provisions of the public utility law of the State of New Jersey, no other private corporation can commence public utility operations in any part of the territory now served by the Company without obtaining a certificate of public convenience and necessity from the NJBRC. Such certificate would not be required with respect to a municipality furnishing electric service under the provisions of the statutes pertaining to municipalities. Municipal corporations, upon compliance with the provisions of the municipal law, are authorized to acquire the public utility service of any public utility company by purchase or by condemnation. Employee Relations The Company does not have any employees other than officers. Personnel for Company operations are furnished by the Parent on a reimbursement basis. The Parent's current contract with Local 503 of the International Brotherhood of Electrical Workers ("IBEW"), representing 977 production, maintenance, commercial and service employees of the Parent became effective June 1, 1991 and expires June 1, 1994. This contract does not include supervisory employees. At December 31, 1993, the Company's non-utility subsidiary had 198 employees of which 51 were part-time employees, none of whom were covered by the Parent's contract with the IBEW or any other collective bargaining agreement. ITEM 2. ITEM 2. Properties The Company's property consists primarily of electric transmission and distribution facilities. These properties are required for the continued operation of the Company's major business segment. In addition, the Company maintains certain miscellaneous utility and non- utility property. The Company's facilities are in satisfactory condition, are suitable for the particular purpose for which they were acquired, and are adequate for the Company's present operations. Electric Generating Facilities. The Parent's generating plants, all of which are located in New York State, are as follows: Maximum Percent Summer of Net Mwh Net MW Total Generated Plant Name Units Energy Source Capability Capability In 1993 Swinging Bridge, 8 Mongaup & Rio Hydroelectric 25.8 2.5% 60,437 Grahamsville 1 Hydroelectric 18.0 1.8 103,941 Hillburn 1 Jet Fuel/Gas 37.0 3.6 2,509 Shoemaker 1 Jet Fuel/Gas 37.0 3.6 5,048 Lovett 5 Coal/Oil/Gas 501.7 49.2 1,869,967 Bowline Point 2 Oil/Gas 400.6 (1) 39.3 850,930 1,020.1 100.0% 2,892,832 (1) Parent's share of maximum summer net megawatt capability. Electric Transmission and Distribution Facilities. The Company owns and operates 93 miles of transmission lines, 16 substations, 17,910 in-service line transformers and 1,160 miles of distribution lines. The electric transmission and distribution facilities of the Company are located within the Company's New Jersey service territory, which is described under the caption "Principal Business" in Item 1 of this Form 10-K. Miscellaneous Properties. The Company owns structures at different locations within the Company's service territory which are used as offices, service buildings, store houses and garages. The Company leases its principal office in Saddle River, New Jersey, as well as office space at other locations. Character of Ownership. The Company's major electric substations are located on land owned by the Company in fee. Electric transmission facilities of the Company (including substations) are, with minor exceptions, located on land owned in fee or occupied pursuant to perpetual easements. Electric distribution lines are located in, on or under public highways or private lands pursuant to lease, easement, permit, municipal consent, agreement or license, express or implied through use by the Company without objection by the owners. In the case of distribution lines, the Company owns approximately 60% of the poles upon which its wires are installed and has a joint right of use in the remaining poles on which its wires are installed, which poles are owned, in most cases, by telephone companies. The Parent's electric and gas plants are owned by the Parent except for the gas turbines at Hillburn and Shoemaker which are leased and the Bowline Point Plant which is jointly owned with Consolidated Edison Company of New York, Inc. and operated by the Parent. Substantially all of the utility plant and other physical property owned by the Company are subject to the lien of the indenture securing the first mortgage bonds of the Company. ITEM 3. ITEM 3. Legal Proceedings Investigations and Related Litigation: On August 16, 1993, Linda Winikow, then a Vice President of the Parent and the Company, was arrested by the Rockland County (New York) District Attorney and charged with grand larceny, commercial bribery and making campaign contributions under a false name. In essence, the District Attorney alleged that Ms. Winikow (1) had been coercing or inducing certain vendors of goods or services to the Parent to make contributions to political candidates or causes, while arranging for some of those contributions to be, in effect, reimbursed by means of false or inflated invoices paid by the Parent, and (2) had used advertising contracts to try to influence news reports about the Parent. Two other former employees of the Parent who reported to Ms. Winikow were charged with grand larceny. Ms. Winikow was immediately placed on leave of absence by the Parent and the Company. The District Attorney also announced that he would commence an investigation of the Parent and the Parent announced that it would undertake its own investigation into the matters cited by the District Attorney. The Company's Board of Directors terminated Ms. Winikow's employment as of August 26, 1993. On the same day, the Parent's Board of Directors terminated Ms. Winikow's employment with the Parent. On October 5, 1993, the independent Directors of the Parent determined to terminate for cause the employment of James F. Smith as Chief Executive Officer of the Parent and to remove him as Chairman of the Board. On October 7, 1993, notice of such termination was delivered to Mr. Smith and he was suspended from all duties effective immediately. On the same day, the Board of Directors of the Parent appointed Victor J. Blanchet, Jr. to serve as Acting Chief Executive Officer of the Parent. Mr. Smith had certain rights under his employment agreement with the Parent to take corrective action with respect to his termination for cause which lapsed, without such action being taken, on December 6, 1993. Mr. Smith also has the right to contest his termination for cause in an arbitration proceeding. Also effective as of October 7, 1993, the Parent, acting as sole shareholder of the Company, removed Mr. Smith as a Director of the Company and the Company's Board of Directors removed Mr. Smith from the offices of Chairman of the Board of Directors and Chief Executive Officer of the Company and appointed Mr. Blanchet to serve as Acting Chief Executive Officer of the Company. On October 6, 1993, Ms. Winikow pleaded guilty in the Supreme Court of the State of New York, County of Rockland, to grand larceny (a class D felony), commercial bribery (a class A misdemeanor) and making a campaign contribution under a false name (an unclassified misdemeanor) and, on November 10, 1993, the two former employees pleaded guilty to grand larceny (a class D felony). In pleading guilty to the felony count, Ms. Winikow stated she had been acting on behalf of the Parent. The presiding judge informed Ms. Winikow that her sentence would be based on her assistance to the prosecution in its investigation. Ms. Winikow's sentencing on these pleas is currently scheduled for April 7, 1994. On March 22 1994, a Rockland County Grand Jury indictment was returned charging Mr. Smith with eight felony counts of grand larceny and two misdemeanor counts of petit larceny. According to the press release issued by the Rockland County District Attorney on March 22, 1994, the ten count indictment charges Mr. Smith with stealing from the Parent by charging personal expenses to the Parent, including (i) approximately $7,300 to rent four vans and a panel truck that were used by Mr. Smith's son's film production company, including approximately $780 worth of parking summonses issued to the rental van and a car owned by the Parent that was being used by Mr. Smith's son' (ii) approximately $3,037 in moving costs to have Mr. Smith's daughter's belongings moved to Westchester County on two separate occasions and to have other belongings moved to Mr. Smith's summer home in Kennebunkport, Maine; (iii) approximately $4,600 for assorted graphic printing, consisting of engagement invitations for both of his children, a hand-colored wedding program for his daughter, as well as printed directions to his Kennebunkport, Maine summer home; (iv) approximately $7,000 for holiday baskets for Mr. Smith's family members, friends and his Maine Realtor; (v) approximately $1,100 for assorted holiday plants delivered to Mr. Smith's home; (vi) approximately $1,760 to have Mr. Smith's home cleaned following a boiler replacement; (vii) approximately $1,098 for printed materials associated with Mr. Smith's wife's election campaign for village trustee (which Mr. Smith subsequently repaid to the Parent after Ms. Winikow's arrest); (viii) approximately $2,000 for a surprise 50th birthday party for Mr. Smith's wife at the Parent's conference center facilities; (ix) approximately $300 worth of auto repairs made to Mr. Smith's son-in-law's automobile; and (x) approximately $600 worth of watches given by Mr. Smith to his children and their spouses. Mr. Smith was arraigned in Rockland County Supreme Court on March 22, 1994, and entered a plea of not guilty. On November 3, 1993, the Parent and the District Attorney executed a Joint Cooperation Agreement (the "Agreement"). As part of the Agreement, the District Attorney confirmed that, in light of the Parent's cooperation, as reflected by its undertakings in the Agreement, and in light of the clear demonstration by the Parent's Board of Directors of its determination to uncover all past improper activities of the types being investigated by the District Attorney and the New York State Public Service Commission ("NYPSC"), no criminal charge of any kind will be filed against the Parent or any of its affiliates or subsidiaries in connection with the District Attorney's investigation. The Agreement is annexed as Exhibit 99.1 to the Parent's Form 10-Q Quarterly Report for the quarter ended September 30, 1993. On November 3, 1993, the New Jersey Board of Regulatory Commissioners ("NJBRC") commenced its periodic management audit of the Company. As a result of the events and investigations described above, the NJBRC audit includes, in addition to a standard review of operating procedures, policies and practices, a review of the posture of Company management regarding business ethics and a determination regarding the effect of such events on Company ratepayers. Under an agreement with the NJBRC to return to customers funds misappropriated by employees in connection with the events described above, the Company refunded to New Jersey ratepayers $94,100 through reductions in the applicable fuel adjustment charges in February and March 1994. The Parent has also pledged to return any other funds that are discovered to have been misappropriated. On August 18, 1993, Feiner v. Orange and Rockland Utilities, Inc., a purported ratepayer class action complaint against the Parent, the Company, Ms. Winikow and others was filed in the United States District Court, Southern District of New York. The complaint names a number of "John Does" who are described as officers and directors of the Parent but does not identify any current or former officer or director by name except Ms. Winikow. The Feiner complaint alleges that the defendants violated RICO and New York common law by using false and misleading testimony to obtain rate increases from the NYPSC and used funds obtained from ratepayers in furtherance of an alleged scheme to make illegal campaign contributions and other illegal payments. Plaintiffs seek damages in the amount of $900 million (which they seek to treble pursuant to the RICO statute). The Parent and the Company intend to vigorously contest these claims and the Parent filed a motion to dismiss them on February 19, 1994. On August 31, 1993, Patents Management Corporation v. Orange and Rockland Utilities, Inc., et al. ("Patents Management"), a purported shareholder derivative complaint, was filed in the Supreme Court of the State of New York, County of New York, against the Parent, all but one of the Directors and several other named defendants by an alleged shareholder of the Parent. Plaintiff claims that the named Directors breached their fiduciary duties by condoning the wrongful acts of Ms. Winikow or failing to exercise appropriate supervisory control over Ms. Winikow. Plaintiff requests that the Court require each Director to indemnify the Parent against all losses sustained by the Parent as a result of these alleged wrongful acts of Ms. Winikow. The defendants intend to vigorously contest these claims. On November 23, 1993, Gross v. Orange and Rockland Utilities, Inc. ("Gross"), a purported shareholder class action complaint, was filed in the United States District Court, Southern District of New York. Plaintiff alleges that various Securities and Exchange Commission filings of the Parent during the period March 2, and November 4, 1993, contained false and misleading information, and thereby violated Sections 11 and 12(2) of the Securities Act of 1933, by failing to disclose what the plaintiff alleges was a "scheme" by the Parent to make illegal political payments and campaign contributions to various public officials and politicians. As a result, plaintiff claims, during such period persons who purchased the Parent's stock through the Company's Dividend Reinvestment and Stock Purchase Plan did so at artificially inflated prices. The complaint seeks unspecified money damages. The Parent intends to vigorously contest these claims. On July 31, 1992, State Line Power Associates, Limited Partnership v. Orange and Rockland Utilities, Inc., a complaint brought by a New Jersey partnership, was filed against the Parent in the United States District Court, Southern District of New York. The plaintiff had, pursuant to an Agreement dated October 11, 1990 (the Agreement), agreed to build a gas-fired combined cycle generating facility in Ringwood, New Jersey and sell 100 Mw of capacity and associated energy to the Parent. The complaint, which alleged that the Parent had improperly terminated the Agreement, sought compensatory damages in excess of $50 million and a declaratory judgment to the effect that the Parent remained obligated to purchase 100 Mw of capacity and associated energy from the plaintiff pursuant to the terms of the Agreement. In its answer to the complaint, the Parent denied the plaintiff's allegations. On January 7, 1994, the parties entered into a settlement agreement pursuant to which the Parent, without any admission of liability, paid to the plaintiff an amount that is not material to the financial condition of the Parent, and the plaintiff delivered to the Parent a release of all outstanding claims against the Parent. The Company will be responsible for payment of a portion of the settlement and related costs pursuant to the Power Supply Agreement. Environmental The Federal Comprehensive Environmental Response, Compensation and Liability Act of 1980 and certain similar state statutes authorize various governmental authorities to issue orders compelling responsible parties to take cleanup action at sites determined to present an imminent and substantial danger to the public and to the environment because of an actual or threatened release of hazardous substances. The Parent is a party to a number of administrative proceedings involving potential impact on the environment. Such proceedings arise out of, without limitation, the operation and maintenance of facilities for the generation, transmission and distribution of electricity and natural gas. Such proceedings are not, in the aggregate, material to the business or financial condition of the Parent or the Company. Pursuant to the Clean Air Act Amendments of 1990, which became law on November 15, 1990, a permanent nationwide reduction of 10 million tons in sulfur dioxide emissions from 1980 levels, as well as a permanent reduction of 2 million tons of nitrogen oxide emissions from 1980 levels must be achieved by January 1, 2000. In addition, continuous emission monitoring systems will be required at all affected facilities. The Parent has two base load generating stations that burn fossil fuels that will be impacted by the legislation in the year 2000. These generating facilities already burn low sulfur fuels, so additional capital costs are not anticipated for compliance with the sulfur dioxide emission requirements. However, installation of low nitogren oxide burners at Lovett Plant and operational modifications at Bowline Plant are expected to be required. Additional emission monitoring systems will be installed at both facilities. The Parent's construction expenditures for this work is estimated to be approximately $28.2 million from 1993 to 1996. Beginning with calendar year 1994, Title V sources (Bowline Point and Lovett) will be required to pay an emission fee. Each facility's fee will be based upon actual air emissions reported to NYSDEC at a rate of approximately $25 per ton of air emissions. (If this fee was in effect in 1992, the Parent's obligation would have been approximately $.5 million). The Company will continue to assess the impact of the Clean Air Act Amendments of 1990 on its power generating operations as the regulations implementing these Amendments are promulgated. The Company will be responsible for a portion of the costs to comply with such regulations. Regulatory Matters: On December 30, 1992, in connection with the Company's 1991 electric rate case (Docket No. ER910303565), the NJBRC issued a Decision and Order dealing with the appropriateness of additional tax liability placed on New Jersey utilities pursuant to New Jersey's June 1, 1991 tax legislation. Pursuant to this legislation the Company will be required to pay an additional combined approximate $16 million of gross receipts and franchise taxes in 1993 and 1994. In its Decision and Order, the NJBRC allowed the Company to recover this amount over a ten year period with interest on the unamortized balance at an annual rate of 7.5%. On February 26, 1993, Rate Counsel filed a Notice of Appeal from the NJBRC Decision and Order with the Superior Court of New Jersey, Appellate Division, stating as grounds for the appeal that the Decision is arbitrary and capricious and would result in unjust and unreasonable rates. On August 9, 1993, Rate Counsel filed its initial brief with regard to its appeal. Thereafter, on October 12, 1993, the Company filed its initial brief and on October 27, 1993 Rate Counsel filed its reply brief in this matter. Oral argument was held on March 7, 1994, on March 21, 1994 the Superior Court affirmed the NJBRC's December 20, 1992 Decision and Order. 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 As more fully described in Part III, Item 12, "Security Ownership of Certain Beneficial Owners and Management" of this Form 10-K Annual Report, all of the outstanding common stock of the Company is owned by the Parent. There is no trading in any market for such common stock. As described in Note 4 of the Notes to Consolidated Financial Statements - "Retained Earnings" in Part IV, Item 14 of this Form 10-K Annual Report, the Company has various restrictions on the use of retained earnings for cash dividends, which are contained in or result from covenants in the Company's Mortgage Trust Indenture dated as of July 1, 1954, as supplemented. As of December 31, 1993 and 1992, approximately $7,501,600 was so restricted. It has not been the practice of the Company to pay quarterly common stock dividends to the Parent since 1984 although the Company has had sufficient unrestricted retained earnings and cash available for the payment of such dividends. ITEM 6. ITEM 6. Selected Consolidated Financial Data ITEM 7. ITEM 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Financial Condition Financial Performance. In 1993, the Company's consolidated net income was $4.7 million, an increase of $.3 million from the $4.4 million earned in 1992. Earnings in 1992 decreased by $2.0 million, from the $6.4 million earned in 1991. Earnings per average common share outstanding in 1993 were $42.12, an increase of $2.46 from the $39.66 earned in 1992. Earnings per average common share for 1992 were $17.36 lower than 1991 earnings per share of $57.02. A discussion of the items causing the change in earnings is contained in the "Results of Operations." The Company's interest coverage, as computed under the terms of its mortgage indenture, was 3.3 times for the current year as compared to 2.9 times in 1992 and 3.6 times in 1991. The after tax interest and preferred dividend coverage was 2.42 times in 1993 as compared to 2.29 times in 1992 and 2.82 times in 1991. Events Affecting the Company. During the third quarter of 1993, the Rockland County (NY) District Attorney charged a then Vice President of the Parent and the Company with grand larceny, commercial bribery and making illegal political contributions and commenced a related investigation of the Parent. Two other former employees of the Parent reporting to the Vice President were charged with grand larceny. The Board of Directors of the Parent promptly formed a Special Committee of outside directors (Special Committee), with authority to take any steps deemed necessary or desirable, to conduct an independent investigation into such matters, in order to determine to what extent there were any other improprieties and to make recommendations as to any necessary remedial measures. The Special Committee has retained investigative counsel and an accounting firm to assist its inquiry. The New Jersey Board of Regulatory Commission (NJBRC) also began an investigation to determine the impact of these events on the Company's ratepayers. The Company is cooperating fully in the inquiries and has pledged to return to customers any funds that are discovered to have been misappropriated. Under an agreement reached with the NJBRC, the Company agreed to refund $94,100 to New Jersey ratepayers in February and March 1994 through reductions in the applicable fuel adjustment charges. On November 4, 1993 the Parent signed a Joint Cooperation Agreement with the Rockland County District Attorney's office which creates an Inspector General's office within the Parent to monitor its efforts to implement and maintain programs to ensure the highest ethical standards of business conduct. The agreement also specified a number of other steps the Parent will undertake to aid in the on-going investigation and prevent any recurrence. As a result of the agreement and the Parent's continued cooperation with the inquiry, the District Attorney has agreed not to file any criminal charges against the Parent or any of its subsidiaries in connection with the current investigation. The former officer of the Parent and the Company and two former employees of the Parent charged by the District Attorney subsequently pleaded guilty to all counts. The District Attorney's Office has identified $374,124 as representing the amount of consolidated funds misappropriated by these individuals. As part of their plea, the two former employees of the Parent agreed to a partial restitution agreement pursuant to which they will reimburse to the Parent and its subsidiaries a sum of $199,709 prior to their sentencing, scheduled for May 4, 1994. The investigations being conducted by the Special Committee of the Board of Directors of the Parent and the District Attorney, along with those of the NJBRC, are still under way. The Parent and the Company intend to take all appropriate actions to protect the interests of its customers and shareholders. It is not possible to predict at this time the extent of additional refunds that may be required by the NJBRC, if any. During 1993 the Company incurred expenses of $1.3 million for legal counsel, accountants, and other consultants in connection with the investigation and related matters. These activities are currently anticipated to continue through the first half of 1994. It is currently estimated that the Company will incur from $.7 to $1.3 million of expenses in 1994 to conclude the investigation. These expenditures are not recoverable from ratepayers. The Company will attempt to offset these costs to the extent possible by achieving savings in the cost of operations during the year. During the fourth quarter, James F. Smith was terminated for cause as Chief Executive Officer of the Parent and the Company and removed as Chairman of the Board of Directors of the Parent, and Victor J. Blanchet, Jr. was appointed to serve as Acting Chief Executive Officer of the Parent and the Company. In order to fully protect its interests the Parent, has initiated lawsuits in federal and state courts to recover misappropriated funds. In related activities, two lawsuits have been brought by shareholders and another by ratepayers seeking damages resulting from these events. For more information on these legal proceedings, refer to Note 10 of the Notes to Consolidated Financial Statements. Rate Activities. In January 1992, an increase in electric rates of $5.1 million was granted by the NJBRC in response to the Company's March 18, 1991 petition requesting a $12.9 million increase in base rates. This increase includes a 12% rate of return on equity. In addition, the NJBRC initiated a Phase II proceeding in this case to address the effect of tax legislation adopted June 1, 1991. That legislation changed the procedure under which certain taxes are collected from the State's utilities. Previously, the Company had been subject to an effective gross receipts and franchise tax of 12.5%, which the utilities paid in lieu of property taxes. The new tax is based upon the number of units of energy (kwh or therms) delivered by a utility rather than revenues. The legislation also requires that utilities accelerate payment to the State of New Jersey of the taxes collected. As a result, the Company is required to make additional tax payments of approximately $16 million during the period 1993-1994. On November 12, 1992, the NJBRC approved the recovery of the additional tax over a ten-year period. A carrying charge of 7.5% on the unamortized balance was also approved. The amount of unamortized accelerated payments is included in Deferred Revenue Taxes in the accompanying financial statements. On February 26, 1993 the New Jersey Department of Public Advocate, Division of Rate Counsel ("Rate Counsel") filed a Notice of Appeal from the NJBRC Decision and Order with the Superior Court of New Jersey Appellate Division, stating as grounds for the appeal that the Decision is arbitrary and capricious and would result in unjust and unreasonable rates. On August 9, 1993, Rate Counsel filed its initial brief with regard to its appeal. Thereafter, on October 12, 1993, the Company filed its initial brief and on October 27, 1993, Rate Counsel filed its reply brief with regard to this matter. Oral argument was held on March 7, 1994, and on March 21, 1994 the Superior Court affirmed the NJBRC's December 30, 1992 Decision and Order. Results of Operations The discussion which follows identifies the principal causes of significant changes in the amount of revenues and expenses affecting net income, by comparing 1993 to 1992 and 1992 to 1991. The discussion should be read in conjunction with the Notes to Consolidated Financial Statements which immediately follow the financial statements contained in this Form 10-K Annual Report. Changes in net income during the periods presented in the accompanying Consolidated Statements of Income and Retained Earnings are highlighted as follows: Increase (Decrease) From Prior Year 1993 1992 (Thousands of Dollars) Utility Operations: Operating revenues $ 6,926 $ (385) Energy Costs (522) (2,720) Net revenues from utility operations 7,448 2,335 Other utility operating expenses 5,751 4,008 Diversified activities-net (661) (198) Income from Operations 1,036 (1,871) Other income and deductions (845) (49) Interest charges net of AFDC (84) 25 Net Income $ 275 $(1,945) Utility Revenues. Revenues increased by 5.5% or $6.9 million, in 1993, after decreasing 0.3% or $0.4 million in 1992. These changes were attributable to the following factors: Increase (Decrease) From Prior Year 1993 1992 (Thousands of Dollars) Retail Sales: Base rates $ 4,847 $ 4,259 Fuel recoveries (1,311) (3,071) Sales volume 3,492 (1,566) Other operating revenues (102) (7) Total $ 6,926 $ (385) Fuel recovery revenues represent amounts collected pursuant to the levelized fuel adjustment clause included in the Company's tariff schedule, as authorized by the NJBRC. During 1993, the fuel recovery rate fell to approximately 2.74 cents per kilowatt hour from the 2.94 cents per kilowatt hour recovered during 1992 and 3.23 cents per kilowatt hour during 1991. Revenue increases due to higher sales volumes reflect an increase in kilowatt hour sales during 1993 of 3.6%. Total sales in 1993 amounted to 1,239.6 million kilowatt hours. During 1992 sales volumes totaled 1,196.2 million kilowatt hours or a 1.7% decrease over the 1991 level of 1,219.6 million kilowatt hours. The increase in 1993 was the result of the warmer weather during the summer months of 1993 compared to the same period of 1992, coupled with an increase in the average number of customers. The decrease in 1992 was primarily attributable to cooler summer weather, partially offset by the increase in number of customers compared to 1991. Energy Costs. All of the energy requirements of the Company are furnished by its Parent pursuant to a contract approved by the FERC. Energy costs are adjusted to match revenues recovered through the operation of the levelized electric energy adjustment clause. The cost of power purchased from the Parent decreased by .8% and 3.9% for the years 1993 and 1992, respectively. The components of the changes in electric energy costs are as follows: Increase (Decrease) From Prior Year 1993 1992 (Thousands of Dollars) Prices paid for purchased power $ (548) $ 2,259 Changes in kilowatt hours purchased 1,791 (1,462) Deferred fuel charges (1,765) (3,517) Total $ (522) $(2,720) The average price paid per kilowatt hour purchased during 1993 amounted to 5.12 cents compared to 5.16 cents during 1992 and 4.99 cents during 1991. Any fluctuations in the price paid per kilowatt hour are reflective of the Parent's costs to generate or purchase electricity, particularly the cost of fuel used in electric production. Other Utility Operating Expenses. The increases (decreases) in other operating expenses are presented in the following table: Increase (Decrease) From Prior Year 1993 1992 (Thousands of Dollars) Other operation & maintenance $ 2,994 $ 5,055 Depreciation 151 321 Taxes 2,606 (1,368) Total $ 5,751 $ 4,008 Other Operation and Maintenance. The cost of conservation programs increased other operation and maintenance expenses in 1993 by $2.9 million and 1992 by $3.1 million. These costs are recoverable in revenues on a current basis. The remaining increase in 1993 was the result of higher operation expenses associated with inflation. The increase in 1992 is primarily the result of an increase in the Company's circuit maintenance programs along with inflationary increases. Depreciation. Depreciation expenses increased $0.2 million and $0.3 million in 1993 and 1992, respectively. These increases are the result of plant additions in both years. Taxes. The Company's tax expense increased by $2.6 million in 1993 after decreasing by $1.4 million in 1992. Taxes other than income taxes increased $1.4 million in 1993 after a decrease of $0.4 million in 1992. The 1993 increase is the result of increases in gross receipts and franchise tax. Federal income tax expense increased by $1.2 million in 1993 following a $1.0 million decrease the year before. Changes in Federal income taxes are detailed in Note 2 of the Notes to Consolidated Financial Statements under the caption "Federal Income Taxes" in Part IV, Item 14 of this Form 10-K Annual Report. Diversified Activities. The Company's diversified activities, which are conducted through it's wholly owned non-utility subsidiaries, consist of natural gas marketing and radio broadcasting activities. Revenues from diversified activities increased $87.6 million and $88.4 million in 1993 and 1992, respectively. The increased revenues in both years is primarily the result of increased sales volumes from gas marketing activities. However, an extremely competitive market for non- utility gas sales in 1993 resulted in significantly lower gross profit margins on these sales when compared to 1992. This resulted in a decrease in operating income of $0.7 million in 1993 after a decrease of $0.2 million in 1992. The increase in gas marketing payables and receivables are directly related to the favorable increase in customers and higher sales volumes. Gas marketing payables increase proportionately to gas marketing receivables. A description of the non-utility subsidiaries of the Company is included in Part I, Item 1 of this Form 10-K Annual Report under the caption "Diversified Activities." The Company will continue to look to its gas marketing activities to increase operating results in the future while the Company's radio broadcasting activities have been, and will continue to be, affected by the economy. Other Income, Deductions and Interest Charges. Other nonoperating income, net of deductions and interest charges, decreased by $0.9 million during 1993 after decreasing by $0.3 million during 1992. The most significant reason for the decrease was the cost of the investigation and related matters described under the caption "Events Affecting the Company" in this Item 7, which amounted to $1.3 million. The fluctuation in net nonoperating income is also a result of fluctuations in interest expense items as well as the change in allowance for funds used during construction from the previous year. Liquidity and Capital Resources Utility construction expenditures, net of AFDC, amounted to $6.5 million, $7.6 million and $8.5 million during 1993, 1992 and 1991, respectively. The expenditures represent fixed asset replacements and are predominantly associated with the Company's transmission and distribution systems. During that three year period, the total construction expenditures, including those from diversified activities, were financed with internally generated funds. The Company estimates that its 1994-1998 capital requirements, which include construction expenditures and funds required for debt maturities, will be as follows: 1994 - $6,291,000; 1995 - $9,220,000; 1996 - $8,007,000; 1997 - $8,890,000; and 1998 -$9,100,000. It is expected that these capital requirements will be financed with internally generated funds. Information regarding the Company's construction program is contained in Part 1, Item 1 of this Form 10-K Annual Report under the caption Construction Program and in Note 10 of the Notes to Consolidated Financial Statements - under the caption "Construction Program" in Part IV, Item 14 of this Form 10-K Annual Report. At December 31, 1993, the Company had available bank lines of credit of $10.0 million, against which no short-term borrowings were outstanding. For additional information regarding the Company's short- term borrowings, see Note 7 of the Notes to Consolidated Financial Statements under the caption "Cash and Short Term Debt" in Part IV, Item 14 of this Form 10-K Annual Report. The Company's capital structure at the end of 1993 was 67% common equity and 33% long-term debt. The Company was required under the terms of its Sixth Supplemental Indenture to make an annual sinking fund payment on June 14 of each year of $240,000 with respect to its Series "F" Bonds and, pursuant to its Seventh Supplemental Indenture, to make sinking fund payments of $333,000 on January 31 of each year with respect to its Series "G" Bonds. During 1992 and 1991 cash payments were made to satisfy both requirements and during 1993 both issues were redeemed. On February 25, 1993 the Company sold $20 million of First Mortgage 6% Bonds, Series I due 2000 (Series I Bonds). The Series I Bonds were sold at a discount to yield 6.11% to the public. The net proceeds to the Company from the sale of the Series I bonds were used to pay the principal and redemption premium on an aggregate of $16,017,000 of the Company's outstanding First Mortgage Bonds and for other corporate purposes. The principal amount and series of First Mortgage Bonds refunded on March 27, 1993 were: $5,000,000 of 9 1/8% bonds, Series D due 2000; $6,000,000 of 7 7/8% Bonds, Series E due 2001; $3,680,000 of 8.95% Bonds, Series F due 2004; and $1,337,000 of 10% Bonds, Series G due 1997. Cash payments totaling $333,000 were made to satisfy the Series G sinking fund requirement of the Company in 1993. SRH and its subsidiaries also maintain certain lines of credit and undertake long and short-term borrowings or make investments from time to time. At December 31, 1993 SRH and its' subsidiaries had outstanding loans aggregating $2.9 million, the proceeds of which were used to make investments in broadcasting properties. In addition, O&R Energy, Inc., a subsidiary of SRH had an available line of credit and standby letters of credit which together amounted to $15.0 million and under which $1.2 million was outstanding at December 31, 1993. Non-utility temporary cash investments amounted to $685,000 at year end. Credit Ratings The credit ratings of the Company's First Mortgage Bonds are as follows: Company First Mortgage Agency Bonds Moody's Investors Service, Inc. A2 Standard & Poor's Corporation A+ The Company's First Mortgage Bonds are not rated on a stand-alone basis. They are reviewed annually in conjunction with the debt, preferred stock and commercial paper ratings of the Parent. The ratings assigned to the Company's securities by the rating agencies are not a recommendation to buy, sell or hold the Company's securities, but rather are assessments of the credit-worthiness of the Company's securities by the rating agencies. Other Developments SFAS No. 112. In November 1992 the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 112 "Employers Accounting for Postemployment Benefits", (SFAS No. 112), which requires the recognition of postemployment benefits, such as salary continuation, severance pay, and disability benefits, provided to former or inactive employees on an accrual basis. The Company currently recognizes the cost of such benefits as they are paid. Adoption of SFAS No. 112 is mandatory for fiscal years beginning after December 15, 1993. The Company anticipates adopting this accounting standard in 1994; however, it does not expect adoption to have a material adverse effect on the Company's results of operations. Inflation The Company's utility revenues are based on rate regulation, which provides for recovery of operating costs and a return on rate base. Inflation affects the Company's construction costs, operating expenses and interest charges and can impact the Company's financial performance if rate relief is not granted on a timely basis. Financial statements, which are prepared in accordance with generally accepted accounting principles, report operating results in terms of historic costs and do not recognize the impact of inflation. ITEM 8. ITEM 8. Financial Statements and Supplementary Data The financial statements and schedules required by this Item are contained on pages 41 through 65 of this Form 10-K Annual Report. Such information is listed in Item 14(a)(1) "Financial Statements" on page 37 of this Form 10-K Annual Report. ITEM 9. ITEM 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure On February 10, 1994, the Executive Committee of the Board of Directors of the Parent appointed the accounting firm of Arthur Andersen & Co. to audit the books, records and accounts of the Parent and the Company for the 1994 fiscal year. The appointment of Arthur Andersen & Co. is subject to the approval of the Parent's shareholders at the Annual Meeting to be held on May 11, 1994. The accounting firm of Grant Thornton audited the Company's consolidated financial statements for 1993 and prior years. Upon recommendation of the Audit Committee, the Board of Directors of the Parent decided to solicit bids for the performance of auditing services for the Parent and the Company for 1994. Bids were received from six public accounting firms, including Grant Thornton. Based on a review of the competing bids, the Audit Committee believed that the selection of Arthur Andersen & Co. would be in the best interests of the Parent and the Company and recommended such selection to the Parents Board of Directors. The reports of Grant Thornton on the Company's consolidated financial statements for the past two fiscal years did not contain an adverse opinion or a disclaimer of opinion and the reports were not qualified or modified as to uncertainty, audit scope or accounting principals, except that the report for 1993 was modified by inclusion of an explanatory paragraph regarding the uncertainty of the pending investigations of the Parent and related litigation described in the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1993. Since January 1, 1992, there have been no disagreements with Grant Thornton on any matter of accounting principles or practices, financial statement disclosure or auditing scope or procedure, which if not resolved to the satisfaction of Grant Thornton, would have caused Grant Thornton to make reference to the subject matter of such disagreements in connection with its report. PART III ITEM 10. ITEM 10. Directors and Executive Officers of the Registrant Directors The persons listed below are the Directors of the Company; Messrs. Blanchet and Chambers were elected to the Board in April 1993, and Mr. Vanderhoef was elected to the Board in March 1994, by the Parent, as sole holder of the Company's common stock, to hold office for one year or until their successors are elected and qualified. Principal Occupation; Business Experience Name Age Past Five Years Since (2) Victor J. Blanchet 52 President, Chief Operating 1991 Officer and Director of the Company, the Parent and Pike. Acting Chief Executive Officer (1) Patrick J. Chambers, Jr. 59 Senior Vice President, 1980 Chief Financial Officer and Director of the Company, the Parent and Pike (1) H. Kent Vanderhoef 71 Acting Chairman of the Parent's 1994 Board of Directors; Director of the Company and Pike; Director and former Chairman of the Board of Directors and Chief Executive Officer, Kay-Fries, Inc., Rockleigh, New Jersey, a chemical manufacturer. Mr. Vanderhoef was president of Kay-Fries until 1981 and, from 1983 until 1990, was a consultant to that company. Director, Rockland Country Club Foundation. Chairman, Executive Committee of the Parent's Board of Directors and Member, Audit Committee of the Parent's Board of Directors. (1) The business experience of this director is contained under the heading "Identification of Executive Officers and Business Experience" in this Item 10. (2) Denotes date of election to the Board of Directors. Identification of Executive Officers and Business Experience The executive officers of the Company are also officers of the Parent and Pike. All of the executive officers of the Company are appointed on an annual basis at the first Board of Directors' meeting following the annual meeting. Officer, Age and Title Business Experience Past Five Years of Victor J. Blanchet, Jr., 52 Acting Chief Executive Officer since Acting Chief Executive Officer, October 7, 1993. President and Chief Operating President and Chief Operating Officer Officer since January 1991. Executive Vice President from April 1990 until January 1991. Vice President from 1977 to April 1990. Patrick J. Chambers, Jr., 59 Senior Vice President since 1978 and Senior Vice President and Chief Financial Officer since 1979. Chief Financial Officer Robert J. Biederman, Jr., 41 Vice President since April 1990. Vice President, Transmission Director of Operations from 1986 and Distribution until April 1990. Terry L. Dittrich, 48 Acting Controller since Acting Controller March 18, 1994. Director of Accounting since April 1990. Manager of Accounting from 1985 to April 1990. Frank E. Fischer, 60 Vice President since 1978. Vice President, Engineering and Production Gerard A. Maher, 59 Assistant Secretary since April 1989. Assistant Secretary and Assistant Treasurer since April 1990. Assistant Treasurer Assistant General Counsel from April 1989 to August 1991. Partner, Nixon, Hargrave, Devans & Doyle from November 1986 to March 1989. Robert J. McBennett, 51 Treasurer since April 1984. Treasurer Victor A. Roque, 47 General Counsel since April 1989. Vice President, General Counsel Vice President and Secretary since and Secretary January 1987. Senior Attorney from 1981 to January 1987. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The table below shows all compensation awarded to, earned by or paid to persons serving as Chief Executive Officer in 1993 for services rendered in all capacities to the Company and its subsidiary during the fiscal years ended December 31, 1993, December 31, 1992 and December 31, 1991. There were no other executive officers during 1993 whose total annual salary and bonus exceeded $100,000: (1) Pursuant to the Incentive Plan (described in the following section), the amount of annual awards depends upon the level of achievement of one-year goals. If performance is below a minimum level, no award is earned. Actual amounts of annual awards earned under the Plan are shown. All decisions with regard to payments for the achievement of 1993 goals have been deferred until after the investigation has been concluded. Mr. Smith will not receive a payment. (2) Interest in excess of 120% of the long-term federal rate, with compounding, prescribed under section 1274(d) of the Internal Revenue Code, paid or payable on compensation deferred at the officer's election. (3) At the end of the last fiscal year, the Company had no program or plan that awards restricted stock, stock options or stock appreciation rights. (4) Pursuant to the Incentive Plan, the amount of long-term awards depends upon the achievement of long-term goals. If performance is below a minimal level, no award is earned. Installments of long- term incentive awards earned for the period 1986-1988 which were paid or payable in 1991, and awards earned for the period 1989-1991 which were paid or payable in 1992 are shown. (5) The long-term incentive award earned for the period 1989-1991 is payable in three annual installments beginning in 1992. The first installment was paid in February 1992. The second installment, which ordinarily would have been made in February 1993, was approved by the Parent's Board of Directors for payout in December 1992. Consequently, no payment of the long-term incentive award was made in 1993. (6) Interest earned on long-term incentive awards which were deferred under the terms of the Incentive Plan and not at the election of the officer. In 1993, the amounts were: Mr. Smith, $9,570; and Mr. Blanchet $3,842. In addition, Mr. Smith's compensation reflects the average annual premium of $1,334 for a supplemental long-term disability insurance policy purchased for him in 1991. (7) Upon notice of his termination for cause, Mr. Smith was suspended from all duties with pay during the period in which he was entitled to take corrective action with respect to his termination for cause, which lapsed on December 6, 1993. However, the Company ceased paying Mr Smith's salary effective November 30, 1993 after Mr. Smith filed an election to commence receiving his pension plan benefits as of such date. Incentive Plan. The Parent has an Incentive Compensation Plan ("Incentive Plan") for officers and certain other key executives, as specified on an annual basis. The Incentive Plan established a system of awards for the achievement of one-year goals and three-year goals. Payment of the three-year award is made over a three-year period beginning the year following the end of the cycle. The current three- year award cycle is for the period 1992 through 1994. The Compensation Committee of the Parent's Board of Directors approves the setting of goals and objectives upon which incentive compensation awards are based and submits these goals and objectives to the Parent's Board of Directors for approval. The three-year goals for the three-year period 1992 through 1994 include the attainment of a target return on equity, retail price comparisons for electric and gas operations and the achievement of demand-side management objectives. At the end of each Incentive Plan year an amount is accrued towards the payment of incentive compensation based upon the three-year goals. The incentive compensation based upon the three-year goals may be more or less than the portion so set aside, depending upon the level of achievement actually attained. A portion of the three-year award may be deferred at the discretion of the Parent's Board of Directors until the participant's retirement, death, disability or severe hardship. The following table sets forth the dollar value of the range of the estimated payouts under the Incentive Plan. The amounts reported in columns (d), (e) and (f) of the following table represent amounts estimated for fiscal year 1993 assuming, respectively, (i) the achievement of a minimally acceptable level of performance under the Incentive Plan (if performance is below this minimal level, no award will be paid); (ii) the achievement of certain goals which are formulated in each case to be attainable during the calendar year, absent major changes in external factors over which the Company may have little control; or (iii) the achievement of certain goals at a level which theoretically can be attained during the calendar year, but cannot be attained if any external factors adversely affect the achievement of the goals. Subsidiary Performance Plan. In 1992, a Performance Unit Incentive Plan (the "Performance Unit Incentive Plan") was adopted by the Parent and certain of its wholly-owned non-utility subsidiaries. The Performance Unit Incentive Plan, administered by the Compensation Committee, was designed to provide incentive awards to certain qualifying individuals in the Company and its subsidiaries, including O&R Energy, Inc. and Atlantic Morris Broadcasting, Inc. (together, the "Participating Companies"). Pursuant to the Performance Unit Incentive Plan, in 1992 certain key employees of the Participating Companies, including Messrs. Smith and Chambers ("Participants"), were granted awards entitling each of them to certain rights, measured as Performance Units. Each Performance Unit gives each Participant the opportunity to receive up to 1% of the combined net gain in value of the Participating Companies over a starting net value measured as the combined initial investment in each of the Participating Companies ("Starting Value"). If the percentage of net gain over the Starting Value does not exceed the average corporate bond rate, Participants will not be entitled to any payout under the Performance Unit Incentive Plan. Under the terms of the Performance Unit Incentive Plan, the award held by Mr. Smith has been cancelled as a result of his termination for cause. With respect to the Performance Unit Plan, the following table sets forth in column (b) the number of Performance Units awarded, while the amounts reported in columns (d) and (e) represent amounts, including those attributable to the Company estimated, respectively, (i) assuming no gain in net value over the Starting Value and (ii) based on an average 1992 quarterly corporate bond rate of 8.13%. _____________ (1) Estimated long-term awards under the Parent's Incentive Plan. (2) Rights under the Performance Unit Incentive Plan and the Incentive Compensation Plan were canceled as a result of Mr. Smith's termination for cause. ITEM 12. ITEM 12. Security Ownership of Certain Beneficial Owners and Management Amount and Nature of Name of Beneficial Percent Title of Class Beneficial Owner Ownership of Class Common Stock - Orange and Rockland $100 Par Value Utilities, Inc. 112,000 100% (Parent) 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 following consolidated financial statements of the Company are included in Part II, Item 8. Page Report of Independent Certified Public Accountants. 42 Consolidated Balance Sheets as of December 31, 1993 and 1992. 44 Consolidated Statements of Income and Retained Earnings 46 for the Years Ended December 31, 1993, 1992 and 1991. Consolidated Cash Flow Statements for the Years Ended December 31, 1993, 1992 and 1991. 47 Notes to Consolidated Financial Statements. 48 (a)(2) Financial Statement Schedules: Page Property, Plant and Equipment and Non-utility Property for the Years Ended December 31, 1993, 1992 and 1991. (Schedule V). 66 Accumulated Depreciation, Depletion and Amortization of Property, Plant and Equipment and Non-utility Property for the Years Ended December 31, 1993, 1992 and 1991 (Schedule VI). 69 Valuation and Qualifying Accounts and Reserves for the Years Ended December 31, 1993, 1992 and 1991 (Schedule VIII). 72 Supplementary Income Statement Information for the Years Ended December 31, 1993, 1992 and 1991 (Schedule X). 73 All other schedules are omitted because they are either not applicable or the required information is shown in the financial statements or notes thereto. (a) (3) Exhibits *3.1 Certificate of Incorporation, as amended through November 5, 1987. (Exhibit 3.1 to Form 10-K for the fiscal year ended December 31, 1992, File No. 2-36005). 3.5 By-Laws, as amended through October 7, 1993. *4.1 Mortgage Trust Indenture of Rockland Electric Company, dated as of July 1, 1954. (Exhibit 2.16 to Registration Statement No. 2-14159). *4.4 Third Supplemental Indenture of Rockland Electric Company, dated as of August 15, 1965. (Exhibit 4.23 to Registration Statement No. 2-24682). *4.10 Ninth Supplemental Indenture of Rockland Electric Company, dated as of March 1, 1993. (Exhibit 4.10 to Form 10-K for the fiscal year ended December 31, 1992, File No. 2-36005). *10.0 Joint Operating Agreement, dated as of February 5, 1976 between Orange and Rockland Utilities, Inc. and the Company. (Exhibit 10.0 to Form 10-K for Fiscal year ended December 31, 1989, File No. 2-36005). 10.1 Power Supply Agreement, dated as of January 1, 1993 between Orange and Rockland Utilities, Inc. and the Company, as filed with the Federal Energy Regulatory Commission. *+10.3 Performance Unit Incentive Plan effective December 3, 1992. (Exhibit 10.3 to Form 10-K for the fiscal year ended December 31, 1992, File No. 2-36005). *+10.4 Award Agreement under the Performance Unit Incentive Plan applicable to P. J. Chambers, Jr. dated December 3, 1992. (Exhibit 10.4 to Form 10-K for the fiscal year ended December 31, 1992, File No. 2-36005). *+10.5 Award Agreement under the Performance Unit Incentive Plan applicable to J. F. Smith dated December 3, 1992. (Exhibit 10.5 to Form 10-K for the fiscal year ended December 31, 1992, File No. 2-36005). *22 Subsidiaries of the Company. (Exhibit 22 to Form 10-K for the fiscal year ended December 31, 1992, File No. 2-36005). *Incorporated by reference to the indicated filings. +Denotes Executive Compensation Plans and Arrangements (b) Reports on Form 8-K On February 17, 1994, the Company filed a Current Report on Form 8-K, dated February 10, 1994, reporting, under Item 4. "Changes in Registrant's Certifying Accountant", the appointment by the Executive Committee of the Parent's Board of Directors of the accounting firm of Arthur Andersen & Co. to audit the books, records and accounts of the Company and its subsidiaries for the 1994 fiscal year. On February 22, 1994, the Company filed a Form 8-K/A dated February 22, 1994, amending the February 10, 1994 Form 8-K to include as Exhibit 16, a letter from the accounting firm of Grant Thornton, which firm audited the Company's consolidated financial statements for the 1993 fiscal year and prior years. 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. ROCKLAND ELECTRIC COMPANY (Registrant) By VICTOR J. BLANCHET JR. (Victor J. Blanchet, Jr. Acting Chief Executive Officer, President, Chief Operating Officer and Director) 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. Signature and Title Capacity in Which Signing VICTOR J. BLANCHET, JR. Chief Operating (Victor J. Blanchet, Jr., Officer; Director Acting Chief Executive Officer, President and Chief Operating Officer) PATRICK J. CHAMBERS, JR. Principal Financial (Patrick J. Chambers, Jr., Officer; Director Senior Vice President and Chief Financial Officer) TERRY L. DITTRICH Principal Accounting (Terry L. Dittrich, Officer - Acting Acting Controller) Date: March 25, 1994 ROCKLAND ELECTRIC COMPANY (A WHOLLY OWNED SUBSIDIARY OF ORANGE AND ROCKLAND UTILITIES, INC.) CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTAL SCHEDULES WITH REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS Prepared for filing as part of Annual Report (Form 10-K) to the Securities and Exchange Commission REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS Board of Directors of Rockland Electric Company and Subsidiary We have audited the accompanying consolidated balance sheets of Rockland Electric Company (a wholly owned subsidiary of Orange and Rockland Utilities, Inc.) and Subsidiary 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. 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 Rockland Electric Company and Subsidiary as of December 31, 1993 and 1992, and the consolidated results of their operations and their consolidated cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. As more fully discussed in Note 10 (Legal Proceedings) to the Consolidated Financial Statements, the Company, Orange and Rockland Utilities, Inc. and various state regulatory authorities are currently investigating misappropriations of funds by certain former employees of Orange and Rockland Utilities, Inc. and the impact on ratepayers. As a result of these improprieties, several class action and derivative complaints have been filed against the Company, Orange and Rockland Utilities, Inc. and others. Although Orange and Rockland Utilities, Inc. and the Company have agreed to refund certain amounts to ratepayers as of December 31, 1993, the ultimate outcome of the investigations and litigation cannot presently be determined. Accordingly, no provision for any additional liability that may result from these matters has been made in the accompanying financial statements. As discussed in Notes 2 and 9 of the Consolidated Financial Statements, the Company changed its method of accounting for income taxes and postretirement benefits in 1993. We have also audited the schedules listed in the Index at Item 14(a)(2). In our opinion, these schedules present fairly, in all material respects, the information required to be set forth therein. GRANT THORNTON New York, New York February 16, 1994 ROCKLAND ELECTRIC COMPANY AND SUBSIDIARY ROCKLAND ELECTRIC COMPANY AND SUBSIDIARY (A Wholly Owned Subsidiary of Orange and Rockland Utilities, Inc.) Notes to Consolidated Financial Statements NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES. General: Rockland Electric Company (the "Company"), a New Jersey corporation, is a wholly owned subsidiary of Orange and Rockland Utilities, Inc. (the "Parent"), a New York corporation. The Company is subject to regulation by the Federal Energy Regulatory Commission (the "FERC") and the State of New Jersey Board of Regulatory Commissioners (the "NJBRC") with respect to its rates and accounting. The Company's accounting policies conform to generally accepted accounting principles, as applied in the case of regulated public utilities, and are in accordance with the accounting requirements and rate-making practices of the regulatory authority having jurisdiction. A description of the Company's significant accounting policies follows. Principles of Consolidation: The consolidated financial statements include the accounts of the Company and its wholly owned non-utility subsidiary. All intercompany balances and transactions have been eliminated. The Company's non-utility subsidiary is engaged in gas marketing and radio broadcasting activities. Utility Revenues: Utility Revenues are recorded on the basis of cycle billings rendered to certain customers monthly and others bimonthly. Unbilled revenues are accrued at the end of each month for estimated energy usage since the last meter reading. Electric Fuel Costs: The tariff schedules of the Company contain adjustment clauses which utilize estimated prospective energy costs based on a twelve-month period beginning on the first of January each year. The recovery of such estimated costs is made through monthly charges per kilowatt hour over the year of projection. Any over or under recoveries are deferred and refunded or charged to customers during the subsequent twelve-month period. Utility Plant: Utility plant is stated at original cost. The cost of additions to and replacements of utility plant includes contracted work, direct labor and material, allocable overheads, allowance for funds used during construction ("AFDC") and indirect charges for engineering and supervision. Replacement of minor items of property and the cost of repairs is charged to maintenance expense. At the time depreciable plant is retired or otherwise disposed of, the original cost together with removal cost, less salvage, are charged to accumulated provision for depreciation. Depreciation: For financial reporting purposes depreciation is computed on the straight-line method based on estimated useful lives of the various classes of property. Provisions for depreciation were equivalent to the composite rates based on the average depreciable property balances at the beginning and end of the year; 2.84% in 1993, 1992 and 1991. Federal Income Taxes: The Parent and its subsidiaries file a consolidated Federal income tax return and income taxes are allocated, for financial reporting purposes, to the Parent and its subsidiaries, based on the taxable income or loss of each. Investment tax credits, which were available prior to the Tax Reform Act of 1986, have been fully normalized and are being amortized over the remaining useful life of the related property for financial statement reporting purposes. The Company adopted Statement of Financial Accounting Standards No. 109 (SFAS No. 109) "Accounting for Income Taxes" on January 1, 1993, which requires a change from the deferred method to the asset and liability method of accounting for income taxes. SFAS No. 109 retains the requirement to record deferred income taxes for temporary differences that are reported in different years for financial reporting and tax purposes. The statement also requires that deferred tax liabilities or assets be adjusted for the future effects of any changes in tax laws or rates and that regulated enterprises recognize an offsetting regulatory asset representing the probable future rate recoveries for additional deferred tax liabilities. The probable future rate recoveries (revenues) to be recorded take into consideration the additional future taxes which will be generated by that revenue. Deferred taxes are also provided on temporary differences of the Company's non-regulated subsidiaries, which are charged to expense rather than offset by regulatory assets. Deferred Revenue Taxes: Deferred revenue taxes represent the unamortized balance of an accelerated payment of New Jersey Gross Receipts and Franchise Tax required by legislation enacted effective June 1, 1991. In accordance with an order by the New Jersey Board of Regulatory Commissioners (NJBRC) the expenditure has been deferred and is being recovered in rates, with a carrying charge of 7.5% on the unamortized balance, over a ten-year period. Allowance for Funds Used During Construction: AFDC is a non-cash income item and is defined in the approved Uniform System of Accounts as the net cost, during the period of construction, of borrowed funds used for construction purposes and a reasonable rate upon other funds when so used. AFDC is considered a cost of utility plant. In accordance with the order issued by the FERC, AFDC is segregated, in the accompanying financial statements, into two components related to the source of funds from which the credits are derived. The annual rates used by the Company to record AFDC are as follows: Year Ended Borrowed Other December 31, Funds Funds 1993 4.23% 5.55% 1992 4.42% 5.54% 1991 8.06% 3.17% AFDC amounted to 1.6%, 3.6% and 4.5% of net income applicable to common stock for the years 1993, 1992 and 1991, respectively. Reserves for Claims and Damages: Costs arising from worker's compensation claims, property damages and general liability are partially self-funded. Provisions for the reserves are based on experience, risk of loss and the rate-making practices of the regulatory authority. Intercompany Transactions: A comparative summary of the significant intercompany transactions (other than those relating to Federal income taxes - Notes 1 and 2) between the Company and its Parent is as follows: Year Ended December 31, 1993 1992 1991 (Thousands of Dollars) Purchase of electricity $67,266 $65,903 $63,567 Rents paid $ 1,977 $ 1,882 $ 1,680 Investigation costs $ 1,300 - - Interest paid $ 47 $ 10 $ 2 The Company purchases 100 percent of its electric energy requirements from its Parent under a FERC approved purchased power agreement. This agreement is cancelable by either party on six (6) months written notice with no penalties or minimum payments required under termination of the agreement. Reclassifications: Certain amounts from prior years have been reclassified to conform with the current year presentation. These reclassifications had no effect on previously recorded net income. NOTE 2 - FEDERAL INCOME TAXES. The Internal Revenue Service (IRS) concluded its audit of the Parent's Consolidated Federal Income tax returns through 1987. Presently, the IRS is examining tax returns for 1988 and 1989. Notification of their findings for these years has not yet been received. The components of Federal income taxes are as follows: Year Ended December 31, 1993 1992 1991 (Thousands of Dollars) Charged to Operations: Current $1,237 $2,578 $5,252 Deferred - net 1,734 (469) (2,076) Deferred investment tax credit (121) (137) (132) 2,850 1,972 3,044 Charged to Other Income: Current (506) (131) (97) Deferred - net 89 168 144 (417) 37 47 Total $2,433 $2,009 $3,091 Effective January 1, 1993, the Company adopted the provisions of SFAS No. 109, which required the recording of an additional deferred tax liability of approximately $6.4 million. The adoption of SFAS No. 109 did not have a significant impact on the results of current operations because of the recording of offsetting regulatory assets for utility operations and the relatively minor impact from diversified operations. The resultant cumulative effect of a change in accounting principle of $(.1) million is included in current operations. The fiscal years 1992 and 1991 were not restated to apply the provisions of SFAS No. 109. The tax effect of temporary differences which gave rise to deferred tax assets and liabilities as of December 31, 1993 are as follows: (Thousands of Dollars) Liabilities: Accelerated depreciation $19,930 Other 4,650 Total liabilities 24,580 Assets: Employee benefits (3,113) Deferred fuel costs (478) Other (4,388) Total assets (7,979) Total $16,601 Reconciliation of the difference between Federal income tax expenses and the amount computed by applying the prevailing statutory income tax rate to income before income taxes for the years ended December 31, 1993, 1992 and 1991 is as follows: % of Pre-Tax Income 1993 1992 1991 Statutory tax rate 35% 34% 34% Increase (decrease) in computed taxes resulting from: Amortization of investment tax credits (2) (2) (1) Amortization of Sterling Reserve (2) (2) (1) Additional depreciation deducted for book purposes 2 3 2 Other 1 (2) (1) Effective Tax Rate 34% 31% 33% On August 10, 1993 the Budget Reconciliation Act of 1993 was signed into law. Among other things, the Act increased the corporate federal income tax rate to 35% from 34% retroactive to January 1, 1993. Pursuant to the provisions of SFAS No. 109, the Company adjusted its deferred tax and regulatory asset balances during 1993 to reflect the higher rate. The impact of this rate change was to increase the deferred tax liability by $.7 million, however, because of the recording of offsetting regulatory assets the increase in income tax expense was less than $.1 million. NOTE 3 - STERLING NUCLEAR PROJECT. Costs associated with the Sterling Nuclear Project, which was abandoned in 1980, and in which the Company's Parent was a 33% participant, are recorded in Deferred Debits - Extraordinary Property Loss. The Company's allocated costs amount to 29% of the Parent's costs. The NJBRC has approved a twenty-year amortization, which commenced June 23, 1982, for costs (excluding a return on the unamortized balance) attributable to the Company. At December 31, 1993 and 1992, the unamortized Sterling Nuclear Project costs, which have been approved for amortization and recovery, before reduction for deferred taxes, amounted to $5,585,000 and $5,942,000, respectively. Such costs are not subject to an earned return on the unamortized balance. NOTE 4 - RETAINED EARNINGS. The Company has various restrictions on the availability of retained earnings for cash dividends, which are contained in or result from covenants in the indentures supplemental to the Mortgage Trust Indenture. Approximately $7,501,600 at December 31, 1993 and 1992 was so restricted. NOTE 5 - COMMON STOCK. All of the Company's common stock, $100 par value, outstanding is owned by the Parent and has been pledged as collateral for the first mortgage bonds of the Parent. NOTE 6 - LONG-TERM DEBT. Details of long-term debt are shown below: Year Ended December 31, 1993 1992 (Thousands of Dollars) First Mortgage Bonds: Series C, 4 5/8% due August 15, 1995 $ 2,000 $ 2,000 Series D, 9 1/8% due February 15, 2000 - 5,000 Series E, 7 7/8% due April 15, 2001 - 6,000 Series F, 8.95% due June 15, 2004 - 3,680 Series G, 10% due February 1, 1997 - 1,670 Series H, 9.59% due July 1, 2020 20,000 20,000 Series I, 6% due July 1, 2000 20,000 - Diversified Activities: Secured Notes, 6-7% due through August 31, 1996 2,868 3,511 Total 44,868 41,861 Less: Amount due within one year 891 1,255 43,977 40,606 Unamortized discount on long-term debt (111) - Total Long-Term Debt $43,866 $40,606 The Company was required under the terms of the Sixth Supplemental Indenture to its Mortgage Trust Indenture dated as of July 1, 1954, as supplemented, to make an annual sinking fund payment of $240,000 with respect to the Series F bonds on June 14 of each year. Similarly, pursuant to the Seventh Supplemental Indenture to such Mortgage Trust Indenture, the Company was required to make annual sinking fund payments of $333,000 with respect to the Series G bonds on January 31 of each year. In March 1993, both Series F and G bonds were redeemed. During 1993, a cash payment of $333,000 was made to satisfy the Series G requirement. The aggregate amount of maturities and sinking fund requirements for each of the five years following 1993 is as follows: 1994 - $891,000; 1995 - $2,965,000; and 1996 - $1,012,000. There are no sinking fund requirements for 1997 and 1998. Substantially all of the utility plant and non-utility property of the Company is subject to the lien of the indenture securing the first mortgage bonds of the Company. On March 10, 1993 the Company sold $20 million of First Mortgage 6% Bonds, Series I due 2000 ("Series I Bonds"). The Series I Bonds were sold at a discount to yield 6.11% to the public. The net proceeds to the Company from the sale of the Series I Bonds were used to pay the principal of and redemption premium on an aggregate of $16,017,000 of the Company's First Mortgage Bonds outstanding and for other corporate purposes. The principal amount and series of First Mortgage Bonds refunded are: $5,000,000 of 9 1/8% Bonds, Series D due 2000; $6,000,000 of 7 7/8% Bonds, Series E due 2001; $3,680,000 of 8.95% Bonds, Series F due 2004; and $1,337,000 of 10%, Bonds Series G due 1997. NOTE 7 - CASH AND SHORT-TERM DEBT. The Company considers all cash and highly liquid debt instruments purchased with a maturity date of three months or less to be cash and cash equivalents for the purpose of the Consolidated Statements of Cash Flows. At December 31, 1993 and 1992, the Company held $3,000,000 and $2,000,000 of commercial paper issued by the Parent. At December 31, 1993, the Company had unsecured lines of credit with two commercial banks aggregating $10 million. Annual fees equal to one-eighth of one percent are paid to the Banks for such lines of credit. The Company may borrow under the lines of credit through the issuance of promissory notes to the banks at their prevailing interest rate for prime commercial borrowers. The aggregate amount of promissory notes outstanding at any time cannot exceed the total combined lines of credit. In addition, O&R Energy, Inc., a non-utility wholly owned subsidiary of Saddle River Holdings Corporation (which is a wholly owned subsidiary of the Company) has an outstanding line of credit and standby letters of credit which together amount to $15.0 million. Amounts advanced under the line of credit bear interest equal to one-half of one percent above the bank's prime rate. As of December 31, 1993, $1.2 million was outstanding and in 1992 there were no such borrowings outstanding. Additional information regarding the Company's short-term borrowings is as follows: Year Ended December 31, 1993 1992 1991 Weighted average interest rate at year-end 6.5% -% -% Amount outstanding at year-end $1,200,000 - - Average amount outstanding for year $1,077,973 $310,274 $20,274 Daily weighted interest rate during year 6.47% 4.75% 9.13% Maximum amount outstanding at any month end $1,200,000 - - NOTE 8 - FAIR VALUE OF FINANCIAL INSTRUMENTS. Financial Accounting Standards No. 107 ("SFAS No. 107"), "Fair Value of Financial Instruments", required disclosure of the estimated fair value of an entity's financial instrument assets and liabilities. For the Company, financial instruments consist principally of cash and cash equivalents, temporary cash investments, long-term debt and notes payable. 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 and cash equivalents and Temporary cash investments -- The carrying amount reasonably approximates fair value because of the short maturity of those instruments. 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. Notes Payable -- reasonably approximates fair value of the short maturity of those instruments. 1993 1992 Carrying Fair Carrying Fair Amount Amount Amount Amount (Thousands of Dollars) Cash and cash equivalents $13,813 $13,813 $14,827 $14,827 Temporary cash investments 685 685 128 128 Long-term debt 44,868 47,006 41,861 43,986 Notes payable 1,200 1,200 - - In addition, off balance sheet financial instruments, which consist of non-utility natural gas futures contracts used to hedge firm and anticipated gas sales commitments, had a fair value of $3,856,000 at December 31, 1993 compared to an acquisition cost of $3,944,000. NOTE 9 - PENSION AND POSTRETIREMENT BENEFITS. Pension Benefits The Parent maintains a non-contributory defined benefit retirement plan, covering substantially all employees. The plan calls for benefits to be paid to eligible employees at retirement, based primarily on years of service and average career compensation. Pension costs are accounted for in accordance with the requirements of Statement of Financial Accounting Standards No. 87 - "Employers Accounting for Pensions" (SFAS No. 87). SFAS No. 87 results in a difference in the method of determining pension costs for financial reporting and funding purposes. Plan valuation for funding and income tax purposes is prepared on the unit credit method, which makes no assumptions as to future years of service or compensation levels. In contrast, the projected unit of credit cost method required for accounting purposes by SFAS No. 87 reflects assumptions as to future years of employee service and compensation levels. The Parent's policy is to fund the pension costs determined by the unit credit method subject to the IRS funding limitation rules. For rate-making purposes, pension expense determined under SFAS No. 87 is reconciled with the amount provided in rates for pensions. The Parent's net periodic pension cost in 1993, 1992 and 1991 includes the following components: December 31, 1993 1992 1991 (Thousands of Dollars) Service cost-benefits earned during year $ 5,690 $ 5,896 $ 5,114 Interest cost on projected benefit obligation 12,915 10,301 9,396 Actual return on plan assets (19,383) (15,135) (32,839) Net amortization and deferral 5,014 4,397 22,635 Net Pension Expense $ 4,236 $ 5,459 $ 4,306 The following table sets forth the funded status of the Parent's Plan and amounts recognized in the Parent's Consolidated Balance Sheets at December 31, 1993 and 1992. Plan assets are stated at fair market value and are comprised primarily of common stock and investment grade debt securities. December 31, 1993 1992 (Thousands of Dollars) Actuarial present value of benefit obligations: Vested $(153,730) $(128,611) Non-vested (9,758) ( 16,281) Accumulated benefit obligation $(163,488) $(144,892) Projected benefit obligation $(180,176) $(162,371) Plan assets at fair market value 182,810 169,842 Excess of plan assets over projected benefit obligation 2,634 7,471 Unamortized net transition asset at adoption of SFAS No. 87 being amortized over 15 years (8,909) (10,022) Unrecognized prior service cost 28,528 8,514 Unrecognized net gain (47,960) (27,434) Accrued Pension Cost $ (25,707) $ (21,471) The expected long term rate of return on plan assets, the weighted average discount rate and the annual rate of increase in future compensation assumed in determining the projected benefit obligation were 8%, 7.75% and 4%, respectively for 1993. For the year 1992 the expected long term rate of return on plan assets, the discount rate and the annual rate of increase in future compensation assumed in determining the projected benefit obligation were 7.5%, 7% and 5%, respectively. Postretirement Benefits In addition to providing pension benefits, the Parent provides certain health care and life insurance benefits for retired employees. Employees retiring from the Company on or after having attained age 55 who have rendered at least 5 years of service are entitled to postretirement health care coverage. Prior to January 1, 1993 the Parent recognized the cost of providing these benefits by expending the annual insurance premiums, which amounted to $2.4 million and $1.9 million for retiree benefits during 1992 and 1991 respectively. Effective January 1, 1993 the Company adopted the provisions of Statement of Financial Accounting Standards No. 106 (SFAS No. 106), "Employers Accounting for Postretirement Benefits Other than Pensions", which established revised accounting and financial reporting standards for postretirement benefits other than pensions. SFAS No. 106 requires the Company to accrue the estimated future cost of postretirement health and non-pension benefits during the years that the employee renders the necessary service, rather than recognizing the cost of such benefits after the employee has retired and when the benefits are actually paid. Deferred accounting for any difference between the expense charge required under SFAS No. 106 and the current rate allowance has been authorized by the NJBRC. Rate recovery of SFAS No. 106 costs applicable to the Company's operations will be addressed in the next rate filing. The Emerging Issues Task Force (EITF) Committee of the FASB addressed implementation issues of SFAS No. 106 for regulated industries in EITF Issue No. 92-12. A consensus was reached that deferral of the difference between SFAS No. 106 costs and amounts allowed in rates was proper so long as the subsequent recovery period was within approximately 20 years. Accordingly, this change in accounting did not have a material impact on the Company's results of operations in that the Company was able to record a regulatory asset relating to the difference between SFAS No. 106 costs and amounts allowed in rates in its service jurisdiction. In order to provide funding for active employees' postretirement benefits as well as benefits paid to current retirees, the Company has established Voluntary Employees' Beneficiary Association (VEBA) trusts for collectively bargained employees and management employees. Contributions to the VEBA trusts are tax deductible, subject to limitations contained in the Internal Revenue Code. No contributions to the trusts have been made as of December 31, 1993. The Company's policy is to fund the SFAS 106 postretirement health and life insurance costs to the extent of rate recoveries realized for these costs. As permitted by SFAS No. 106, the Parent has elected to amortize the postretirement benefit obligation at the date of adoption of the accounting standards, January 1, 1993, over a 20 year period. This transition obligation totaled $57.2 million. The following table sets forth the plan's funded status, reconciled with amounts recognized in the Parent's financial statements at December 31, 1993: Accumulated postretirement benefit obligation: Fully eligible active employees $(18,386) Other active employees (27,073) Retirees (20,337) Total benefit obligation (65,796) Plan assets at fair value - Accumulated postretirement obligation in excess of plan asset (65,796) Unrecognized experience net (gain) loss 4,694 Unrecognized transition obligation 54,383 Accrued postretirement benefit cost $( 6,719) The components of net periodic postretirement benefit cost for the year ended December 31, 1993 are as follows: Service cost $ 1,535 Interest cost 4,598 Return on plan assets - Amortization of transition obligation 2,861 Deferred and capitalized (6,719) Net Expense $ 2,275 Of the plan totals, $1,454 of the accrued postretirement benefit cost and $492 of the net expense have been allocated to the Company. The calculation of the actuarial present value of benefit obligations at December 31, 1993 assumes a discount rate of 7.75% and health care cost trend rates of 9.0% for medical costs and 14% for prescription drugs in 1994 decreasing through 2003 to a rate of 5.0%. If the health care trend rate assumptions were increased by 1 percent, the Parent's accumulated postretirement benefit obligation would be increased by approximately $7.2 million. The effect of this change on the sum of the service cost and interest cost would be an increase of $.8 million. Other In addition to the plans described above, the Parent sponsors a 401(k) savings plan (Savings Plan) for its employees. Eligible employees may contribute up to a combined 20% of their compensation, subject to IRS restrictions, on a before-tax and after-tax basis. The Parent makes no contributions to the Savings Plan. The Parent also has an unfunded non-contributory supplemental retirement plan covering certain management employees. As of December 31, 1993, the Parent's obligation under this plan is fully provided for. The Parent has established a Subsidiary Equity Incentive Plan in which plan participants are entitled to certain rights measured as Performance Units. Each Performance Unit gives the plan participant the opportunity to receive an incentive award of up to 1% of the net gain, subject to certain restrictions, in the value of the Parent's investment in the participating subsidiaries over its initial investment. As of December 31, 1993 no incentive awards have been granted under the plan. In November 1992, the FASB issued Statement of Financial Accounting Standards No. 112 "Employers Accounting for Postemployment Benefits," (SFAS No. 112), which requires the recognition of postemployment benefits, including health and welfare benefits, provided to former or inactive employees on an accrual basis. The Company currently recognizes the cost of such benefits as they are paid. As of December 31, 1993, the effect of adopting SFAS 112 will require the recognition of a liability of approximately $.8 million. SFAS No. 112 will not have a material adverse impact on the Company's results of operations because the Parent expects to record an offsetting regulatory asset. The Parent adopted SFAS No. 112 on January 1, 1994. NOTE 10 - COMMITMENTS AND CONTINGENCIES. CONSTRUCTION PROGRAM Under the Company's construction program, it is estimated that expenditures (excluding AFDC) of approximately $36,640,000 will be incurred during the years 1994 through 1998. The estimated amounts by year are: $5,400,000, $6,255,000, $6,995,000, $8,890,000 and $9,100,000, respectively. CONCENTRATION OF CREDIT RISK Financial instruments which potentially subject the Company to concentrations of credit risk, as defined by Statement of Financial Accounting Standards No. 105 "Financial Instruments with Concentrations of Credit Risk", consist principally of temporary cash investments, accounts receivable and gas marketing accounts receivable. The Company places its temporary cash investments with high quality financial institutions. Concentrations of credit risk with respect to accounts receivable are limited due to the Company's large, diverse customer base within its service territory. With respect to gas marketing operations, the customer base consists of a large, diverse group of users of natural gas across the United States, with the Company's credit risk being dependent on overall economic conditions. As of December 31, 1993, the Company had no significant concentrations of credit risk. GAS FUTURES CONTRACTS O&R Energy, Inc., a non-utility subsidiary of the Company, has entered into futures contracts that have been designated as hedges against firm fixed-price, fixed-quantity and anticipated sales commitments. The gain and losses on future contracts are included in the cost of gas sold when the physical delivery of gas occurs. The aggregate amount of these commitments is approximately $4.7 million. LONG-TERM PERFORMANCE AWARDS The Company and its non-utility subsidiary have granted awards to certain key officers, whereby they will be entitled to receive a specified percentage of the incremental net value of the gas marketing and broadcasting subsidiaries over the initial investment in such subsidiaries, as defined. The awards expire December 31, 1997 or with the occurrence of certain events. POWER SUPPLY AGREEMENT On January 1, 1993, Orange and Rockland Utilities, Inc. (the Parent) and the Company entered into an agreement to sell and deliver the Company's entire requirements of electricity in quantities sufficient for the Company's own use and for resale in the Company's franchise territory located in New Jersey. The rate for all electricity delivered shall reimburse the Parent for the cost of rendering service, including return on investment. The Parent renders bills monthly and payment is due on or before the last day of the month following the month in which service is rendered. Simple interest shall accrue from the due date until the date of payment. This agreement shall remain in effect unless cancelled by either party by written notice given not less than six months prior to the proposed date of cancellation. LEGAL PROCEEDINGS During the third quarter of 1993, the Rockland County (NY) District Attorney charged a then Vice President of the Company with grand larceny, commercial bribery and making illegal political contributions and commenced a related investigation of the Company. Two other former employees reporting to the Vice President were charged with grand larceny. The Board of Directors promptly formed a Special Committee of outside directors (the Special Committee), with authority to take any steps deemed necessary or desirable, to conduct an independent investigation into such matters, in order to determine to what extent there were any other improprieties and to make recommendations as to any necessary remedial measures. The Special Committee has retained investigative counsel and an accounting firm to assist its inquiry. The New Jersey Board of Regulatory Commission (NJBRC) also began an investigation to determine the impact of these events on the Company's ratepayers. The Company is cooperating fully in the inquiries and has pledged to return to customers any funds that are discovered to have been misappropriated. The Company agreed to refund $94,100 in February and March 1994 through reductions in the applicable fuel adjustment charges. On November 4, 1993 the Parent signed a Joint Cooperation Agreement with the Rockland County District Attorney's office which creates an Inspector General's office within the Company to monitor its efforts to implement and maintain programs to ensure the highest ethical standards of business conduct. The agreement also specified a number of other steps the Company will undertake to aid in the on-going investigation and prevent any recurrence. As a result of the agreement and the Company's continued cooperation with the inquiry, the District Attorney has agreed not to file any criminal charges against the Company or any of its subsidiaries in connection with the current investigation. The former Company officer and two former employees charged by the District Attorney subsequently pleaded guilty to all counts. The District Attorney's Office has identified $374,124 as representing the amount of consolidated funds misappropriated by these individuals. As part of their plea, the two former employees agreed to a partial restitution agreement pursuant to which they will reimburse to the Parent and its subsidiaries a sum of $199,709 prior to their sentencing, scheduled for May 4, 1994. The investigations being conducted by the Special Committee of the Board of Directors and the District Attorney, along with the NJBRC, are still under way. The Company intends to take all appropriate actions to protect the interests of its customers and shareholders. It is not possible to predict at this time the extent of additional refunds that may be required by the NJBRC, if any. During the fourth quarter, James F. Smith was terminated for cause as Chief Executive Officer and removed as Chairman of the Board of Directors, and Victor J. Blanchet, Jr. was appointed to serve as Acting Chief Executive Officer. On March 22 1994, a Rockland County Grand Jury indictment was returned charging Mr. Smith with eight felony counts of grand larceny and two misdemeanor counts of petit larceny. According to the press release issued by the Rockland County District Attorney on March 22, 1994, the ten count indictment charges Mr. Smith with stealing from the Parent by charging personal expenses to the Parent, including (i) approximately $7,300 to rent four vans and a panel truck that were used by Mr. Smith's son's film production company, including approximately $780 worth of parking summonses issued to the rental van and a car owned by the Parent that was being used by Mr. Smith's son (ii) approximately $3,037 in moving costs to have Mr. Smith's daughter's belongings moved to Westchester County on two separate occasions and to have other belongings moved to Mr. Smith's summer home in Kennebunkport, Maine; (iii) approximately $4,600 for assorted graphic printing, consisting of engagement invitations for both of his children, a hand-colored wedding program for his daughter, as well as printed directions to his Kennebunkport Maine summer home; (iv) approximately $7,000 for holiday baskets for Mr. Smith's family members, friends and his Maine Realtor; (v) approximately $1,100 for assorted holiday plants delivered to Mr. Smith's home; (vi) approximately $1,760 to have Mr. Smith's home cleaned following a boiler replacement; (vii) approximately $1,098 for printed materials associated with Mr. Smith's wife's election campaign for village trustee (which Mr. Smith subsequently repaid to the Parent after Ms. Winikow's arrest); (viii) approximately $2,000 for a surprise 50th birthday party for Mr. Smith's wife at the Parent's conference center facilities; (ix) approximately $300 worth of auto repairs made to Mr. Smith's son-in-law's automobile; and (x) approximately $600 worth of watches given by Mr. Smith to his children and their spouses. Mr. Smith was arraigned in Rockland County Supreme Court on March 22, 1994, and entered a plea of not guilty. In order to fully protect its interests, the Company, has initiated lawsuits in federal and state courts to recover misappropriated funds. In related activities, two lawsuits have been brought by shareholders and another by ratepayers seeking damages resulting from these events. On August 18, 1993, Feiner v. Orange and Rockland Utilities, Inc., a purported ratepayer class action complaint against the Parent, the Company, former Vice President of the Parent and the Company Linda Winikow and others, was filed in the United States District Court, Southern District of New York. Plaintiffs allege that the defendants violated the Federal Racketeer Influenced and Corrupt Organizations Act (RICO) and New York common law by using false and misleading testimony to obtain rate increases from the NYPSC and used funds obtained from ratepayers in furtherance of an alleged scheme to make illegal campaign contributions and other illegal payments. Plaintiffs seek damages in the amount of $900 million (which they seek to treble pursuant to the RICO statute). The Parent and the Company intend to vigorously contest these claims. On August 31, 1993, Patents Management Corp. v. Orange and Rockland Utilities, Inc., a purported shareholder derivative complaint, was filed in the Supreme Court of the State of New York, County of New York, against the Parent, all but one of the Parent's Directors and several other named defendants by an alleged shareholder of the Parent. Plaintiff claims that the Parent's Directors breached their fiduciary duties by condoning the alleged wrongful acts of Mrs. Winikow or failing to exercise appropriate supervisory control over Mrs. Winikow. Plaintiff requests that the Court require each Director to indemnify the Parent against all losses sustained by the Parent as a result of these alleged wrongful acts of Mrs. Winikow. The Parent intends to vigorously contest these claims. On November 23, 1993, Gross v. Orange and Rockland Utilities, Inc., a purported shareholder class action complaint, was filed in the United States District Court, Southern District of New York. Plaintiff alleges that various Securities and Exchange Commission filings of the Parent during the period between March 2, 1993 and November 4, 1993, contained false and misleading information, and thereby violated Sections 11 and 12(2) of the Securities Act of 1933, by failing to disclose what the plaintiff alleges was a "scheme" by the Parent to make illegal political payments and campaign contributions to various public officials and politicians. As a result, plaintiff claims, during such period persons who purchased the Company's stock through the Parent's Dividend Reinvestment Plan did so at artificially inflated prices. The complaint seeks unspecified money damages. The Parent intends to vigorously contest these claims. The costs of outside professional and consultant firms associated with the investigation of the misuse of Company funds by former employees of the Parent amounted to $1.3 million for the year ending December 31, 1993. These investigations are currently anticipated to continue through the first half of 1994. The Company currently estimates it will incur from $.7 to $1.3 million of expenses in 1994 to conclude the investigation. These expenditures are not recoverable from ratepayers. The Company will attempt to offset these costs to the extent possible by achieving savings in the cost of operations during the year. On July 31, 1992, State Line Power Associates, Limited Partnership v. Orange and Rockland Utilities, Inc., a complaint brought by a New Jersey partnership, was filed against the Parent in the United States District Court, Southern District of New York. The plaintiff had, pursuant to an Agreement dated October 11, 1990 (the Agreement), agreed to build a gas- fired combined cycle generating facility in Ringwood, New Jersey and sell 100 Mw of capacity and associated energy to the Parent. The complaint, which alleged that the Parent had improperly terminated the Agreement, sought compensatory damages in excess of $50 million and a declaratory judgment to the effect that the Parent remained obligated to purchase 100 Mw of capacity and associated energy from the plaintiff pursuant to the terms of the Agreement. In its answer to the complaint, the Parent denied the plaintiff's allegations. On January 7, 1994, the parties entered into a settlement agreement pursuant to which the Parent, without any admission of liability, paid to the plaintiff an amount that is not material to the financial condition of the Parent, and the plaintiff delivered to the Parent a release of all outstanding claims against the Parent. The Company will be responsible for payment of a portion of the settlement and related costs pursuant to the Power Supply Agreement. Environmental The Federal Comprehensive Environmental Response, Compensation and Liability Act of 1980 and certain similar state statutes authorize various governmental authorities to issue orders compelling responsible parties to take cleanup action at sites determined to present an imminent and substantial danger to the public and to the environment because of an actual or threatened release of hazardous substances. The Parent is a party to a number of administrative proceedings involving potential impact on the environment. Such proceedings arise out of, without limitation, the operation and maintenance of facilities for the generation, transmission and distribution of electricity and natural gas. Such proceedings are not, in the aggregate, material to the business or financial condition of the Parent or the Company. Pursuant to the Clean Air Act Amendments of 1990, which became law on November 15, 1990, a permanent nationwide reduction of 10 million tons in sulfur dioxide emissions from 1980 levels, as well as a permanent reduction of 2 million tons of nitrogen oxide emissions from 1980 levels must be achieved by January 1, 2000. In addition, continuous emission monitoring systems will be required at all affected facilities. The Parent has two base load generating stations that burn fossil fuels that will be impacted by the legislation in the year 2000. These generating facilities already burn low sulfur fuels, so additional capital costs are not anticipated for compliance with the sulfur dioxide emission requirements. However, installation of low nitogren oxide burners at Lovett Plant and operational modifications at Bowline Plant are expected to be required. Additional emission monitoring systems will be installed at both facilities. The Parent's construction expenditures for this work is estimated to be approximately $28.2 million from 1993 to 1996. Beginning with calendar year 1994, Title V sources (Bowline Point and Lovett) will be required to pay an emission fee. Each facility's fee will be based upon actual air emissions reported to NYSDEC at a rate of approximately $25 per ton of air emissions. (If this fee was in effect in 1992, the Parent's obligation would have been approximately $.5 million). The Company will continue to assess the impact of the Clean Air Act Amendments of 1990 on its power generating operations as the regulations implementing these Amendments are promulgated. The Company will be responsible for a portion of the costs to comply with such regulations. NOTE 11 - SEGMENTS OF BUSINESS The Company defines its principal business segment as electric utility operations and diversified activities. The diversified activities include gas marketing and radio broadcasting. Total electric operating revenues as reported in the Consolidated Statements of Income include sales to unaffiliated customers, which are billed at a tariff rate. Income from operations is total operating revenues less total operating expenses. Identifiable assets by segment are those assets that are used in the distribution and sales operations in each segment. Corporate assets are principally property, cash, sundry receivables and unamortized debt expense. Schedule V ROCKLAND ELECTRIC COMPANY Property, Plant and Equipment and Nonutility Property For the Year Ended December 31, 1993 (Thousands of Dollars) Column A Column F Total Utility Nonutility Balance at Classification Plant Property End of Period Transmission Plant $ 32,163 $ - $ 32,163 Distribution Plant 104,259 - 104,259 General Plant 3,149 25 3,174 Plant Held for Future Use 1,007 - 1,007 Other 6 7,372 7,378 140,584 7,397 147,981 Construction Work In Progress 2,815 - 2,815 Total $143,399 $7,397 $150,796 Neither the total additions nor the total deductions during the year ended December 31, 1993 amounted to more than 10% of the closing balance of total utility plant and other physical property, and the information required by Columns B, C, D and E is, therefore, omitted. A summary of Columns C, D and E for the year ended December 31, 1993 is as follows: Column C - Additions at cost $ 6,590 Column D - Retirements 705 Column E - Other changes 320* Net Change $ 6,205 * Other changes represent transfers of property between the respondent and the Parent amounting to $320. For information concerning depreciation procedures, see Note 1 of Notes to Consolidated Financial Statements. Schedule V ROCKLAND ELECTRIC COMPANY Property, Plant and Equipment and Nonutility Property For the Year Ended December 31, 1992 (Thousands of Dollars) Column A Column F Total Utility Nonutility Balance at Classification Plant Property End of Period Transmission Plant $ 31,711 $ - $ 31,711 Distribution Plant 98,626 - 98,626 General Plant 3,015 25 3,040 Plant Held for Future Use 1,007 - 1,007 Other 6 6,585 6,591 134,365 6,610 140,975 Construction Work In Progress 3,616 - 3,616 Total $137,981 $6,610 $144,591 Neither the total additions nor the total deductions during the year ended December 31, 1992 amounted to more than 10% of the closing balance of total utility plant and other physical property, and the information required by Columns B, C, D and E is, therefore, omitted. A summary of Columns C, D and E for the year ended December 31, 1992 is as follows: Column C - Additions at cost $ 7,728 Column D - Retirements 1,399 Column E - Other changes 429* Net Change $ 6,758 * Other changes represent transfers of property between the respondent and the Parent amounting to $429. For information concerning depreciation procedures, see Note 1 of Notes to Consolidated Financial Statements. Schedule V ROCKLAND ELECTRIC COMPANY Property, Plant and Equipment and Nonutility Property For the Year Ended December 31, 1991 (Thousands of Dollars) Column A Column F Total Utility Nonutility Balance at Classification Plant Property End of Period Transmission Plant $ 31,487 $ - $ 31,487 Distribution Plant 93,772 - 93,772 General Plant 2,871 25 2,896 Plant Held for Future Use 1,007 - 1,007 Other 6 6,072 6,078 129,143 6,097 135,240 Construction Work In Progress 2,593 - 2,593 Total $131,736 $6,097 $137,833 Neither the total additions nor the total deductions during the year ended December 31, 1991 amounted to more than 10% of the closing balance of total utility plant and other physical property, and the information required by Columns B, C, D and E is, therefore, omitted. A summary of Columns C, D and E for the year ended December 31, 1991 is as follows: Column C - Additions at cost $10,348 Column D - Retirements 690 Column E - Other changes 81* Net Change $ 9,739 * Other changes represent transfers of property between the respondent and the Parent amounting to $81. For information concerning depreciation procedures, see Note 1 of Notes to Consolidated Financial Statements. Schedule VI ROCKLAND ELECTRIC COMPANY Accumulated Depreciation and Amortization of Property, Plant and Equipment and Nonutility Property For the Year Ended December 31, 1993 (Thousands of Dollars) Column A Column B Column C Column D Column E Column F Additions Balance at charged to Other Balance at beginning costs and changes-add end of Description of period expenses Retirements (deduct) period Accumulated deprecia- tion of utility plant $34,530 $3,757 $ 786 $ (148)(A) $37,353 Accumulated deprecia- tion of nonutility property $ 1,692 $ 510 $ - $ - $ 2,202 (A) Other changes include the following: additions of $135 materials salvaged, $12 charged to other accounts, and net miscellaneous additions of $109 less deductions of $404 for removal costs. Schedule VI ROCKLAND ELECTRIC COMPANY Accumulated Depreciation and Amortization of Property, Plant and Equipment and Nonutility Property For the Year Ended December 31, 1992 (Thousands of Dollars) Column A Column B Column C Column D Column E Column F Additions Balance at charged to Other Balance at beginning costs and changes-add end of Description of period expenses Retirements (deduct) period Accumulated deprecia- tion of utility plant $32,796 $3,606 $1,627 $ (245)(A) $34,530 Accumulated deprecia- tion of nonutility property $ 1,312 $ 380 $ - $ - $ 1,692 (A) Other changes include the following: additions of $146 materials salvaged, $12 charged to other accounts, and net miscellaneous additions of $92 less deductions of $495 for removal costs. Schedule VI ROCKLAND ELECTRIC COMPANY Accumulated Depreciation and Amortization of Property, Plant and Equipment and Nonutility Property For the Year Ended December 31, 1991 (Thousands of Dollars) Column A Column B Column C Column D Column E Column F Additions Balance at charged to Other Balance at beginning costs and changes-add end of Description of period expenses Retirements (deduct) period Accumulated depre- ciation of utility plant $26,554 $3,285 $ 811 $3,768(A) $32,796 Accumulated depre- ciation of non- utility property $ 982 $ 330 $ - $ - $ 1,312 (A) Other changes include the following: additions of $4,073 materials salvaged, $13 charged to other accounts, and net miscellaneous additions of $21 less deductions of $339 for removal costs. Schedule VIII ROCKLAND ELECTRIC COMPANY Valuation and Qualifying Accounts and Reserves Years Ended December 31, 1993, 1992 and 1991 (Thousands of Dollars) Column A Column B Column C Column D Column E Additions (1) (2) Balance at Charged to Charged Balance at beginning costs and to other end of Description of period expenses accounts Deductions period December 31, 1993 Allowance for Uncollectible Accounts: Customer accounts $190 $220 $39 $239 $210 Other accounts 35 91 - 73 52 Gas marketing accounts 75 548 - 153 471 $300 $859 $39(A) $465(B) $733 Reserve for Claims and Damages $223 $122 $ - $ 77(C) $268 December 31, 1992 Allowance for Uncollectible Accounts: Customer accounts $196 $251 $29 $286 $190 Other accounts 59 77 - 102 35 Gas marketing accounts 40 43 - 8 75 $295 $371 $29(A) $396(B) $300 Reserve for Claims and Damages $387 $ 9 $93 $266(C) $223 December 31, 1991 Allowance for Uncollectible Accounts: Customer accounts $205 $470 $23 $502 $196 Other accounts 50 130 6 127 59 Gas marketing accounts 0 41 - 1 40 $255 $641 $29(A) $630(B) $295 Reserve for Claims and Damages $475 $ 124 $ - $212(C) $387 (A) Collection of accounts previously written off. (B) Accounts considered uncollectible and written off. (C) Payment of damage claims. Schedule X ROCKLAND ELECTRIC COMPANY Supplementary Income Statement Information (Thousands of Dollars) Column B Column A Charged to Costs and Expenses Year Ended December 31, Item 1993 1992 1991 1. Maintenance $ 5,430 $ 5,396 $ 4,816 2. Taxes other than income taxes: Miscellaneous Federal taxes $ 1,230 $ 1,297 $ 1,259 Municipal property taxes 236 215 203 State gross earnings (franchise) 6,161 5,775 5,699 State unemployment 71 44 17 State utility gross receipts 11,412 10,380 10,672 State sales, use and capital stock 166 284 260 19,276 17,995 18,110 Less: charged to construction work in progress accounts 399 402 414 Total $18,877 $17,593 $17,696 Other items not shown are less than one percent of revenues. UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-K EXHIBITS ROCKLAND ELECTRIC COMPANY (Exact name of Registrant as Specified in its Charter) Fiscal Year Ended December 31, 1993 Commission File Number 2-36005 ROCKLAND ELECTRIC COMPANY EXHIBIT LIST 1993 Form 10-K Exhibit * 3.1 Certificate of Incorporation, as amended through November 5, 1987. (Exhibit 3.1 to Form 10-K for the fiscal year ended December 31, 1992, File No. 2-36005). 3.5 By-Laws, as amended through October 7, 1993. * 4.1 Mortgage Trust Indenture of Rockland Electric Company, dated as of July 1, 1954. (Exhibit 2.16 to Registration Statement No. 2-14159). * 4.4 Third Supplemental Indenture of Rockland Electric Company, dated as of August 15, 1965. (Exhibit 4.23 to Registration Statement No. 2-24682). *4.10 Ninth Supplemental Indenture of Rockland Electric Company, dated March 1, 1993. (Exhibit 4.10 to Form 10-K for the fiscal year ended December 31, 1992, File No. 2-36005). *10.0 Joint Operating Agreement, dated as of February 5, 1976 between Orange and Rockland Utilities, Inc. and the Company. (Exhibit 10.0 to Form 10-K for fiscal year ended December 31, 1989). 10.1 Power Supply Agreement, dated as of January 1, 1993 between Orange and Rockland Utilities, Inc. and the Company, as filed with the Federal Energy Regulatory Commission. * +10.3 Performance Unit Incentive Plan effective December 3, 1992. (Exhibit 10.3 to Form 10-K for the fiscal year ended December 31, 1992, File No. 2-36005). ROCKLAND ELECTRIC COMPANY EXHIBIT LIST 1993 Form 10-K Exhibit * +10.4 Award Agreement under the Performance Unit Incentive Plan applicable to P. J. Chambers, Jr. dated December 3, 1992. (Exhibit 10.4 to Form 10-K for the fiscal year ended December 31, 1992, File No. 2-36005). * 22 Subsidiaries of the Company. (Exhibit 22 to Form 10-K for the fiscal year ended December 31, 1992, File No. 2-36005). *Incorporated by reference to the indicated filings. +Denotes Executive Compensation Plans and Arrangements.

54045_1993.txt

54045_1993

1993

54045

Item 1. BUSINESS 1(a) GENERAL DEVELOPMENT OF BUSINESS Joslyn Corporation, an Illinois corporation (together with its subsidiaries, the "Registrant") is a holding company formed in 1988 in connection with a share exchange with its principal operating subsidiary, Joslyn Manufacturing Co. Joslyn Manufacturing Co., founded by Marcellus L. Joslyn, was incorporated in Illinois on December 6, 1902 as the Independent Arm and Pin Co. The Registrant is a holding company for a number of subsidiaries which are engaged primarily in the manufacturing and supplying of electrical hardware, apparatus, protective equipment, air pressurization and dehydration products and services used in the construction and maintenance of transmission and distribution facilities to electric power and telephone companies. The Registrant's subsidiaries also manufacture and supply vacuum switchgear and electrical controls to commercial and industrial markets as well as protective equipment, connector backshells, and air and gas dehydration systems to aerospace and defense companies. The Registrant has eleven wholly owned operating subsidiaries: * JOSLYN MANUFACTURING CO., a Delaware corporation, manufactures and supplies electrical hardware, apparatus, and protective equipment used in the construction and maintenance of electric power transmission and distribution facilities and telephone and cable television communication lines. * JOSLYN CLARK CONTROLS, INC., a Delaware corporation, manufactures electrical controls, fire pump controllers, general purpose contactors and starters for industrial and commercial markets. * JOSLYN CANADA INC., organized under the laws of the Province of Ontario, Canada, supplies electrical apparatus and protective equipment, high-voltage vacuum and sulfur hexaflouride (SF-6) switching equipment for commercial, heavy industrial and electrical utility markets within Canada. * JOSLYN HI-VOLTAGE CORPORATION, a Delaware corporation, manufactures and supplies high-voltage vacuum and air switching equipment for commercial, heavy industrial and electrical utility markets. * JOSLYN ELECTRONIC SYSTEMS CORPORATION, a Delaware corporation, manufactures and supplies electric power equipment, electronic protection equipment, and field test equipment designed and produced primarily for the telecommunications, industrial, aerospace and defense industries. * JOSLYN POWER PRODUCTS CORPORATION, a Delaware corporation, manufactures and supplies sulfur hexaflouride (SF-6) fuses and medium voltage switchgear for commercial, industrial and electrical utility markets. * JOSLYN JENNINGS CORPORATION, a Delaware corporation, manufacturers and supplies vacuum capacitors for aerospace and defense markets and vacuum interrupters for industrial, commercial and electrical utility markets. * JOSLYN RESEARCH AND DEVELOPMENT CORPORATION, a Delaware corporation, conducts research and product development jointly with other Joslyn subsidiaries. * ADK PRESSURE EQUIPMENT CORPORATION, a Delaware corporation, manufactures and distributes air dehydrators and associated equipment to provide and monitor pressurized dry air. Most products are used to prevent moisture intrusion in telephone cables, antenna lines and wave guides and are sold to telephone markets worldwide. * The SUNBANK FAMILY OF COMPANIES,INC., a California holding corporation, and its two subsidiaries, SUNBANK ELECTRONICS,INC., and AIR-DRY CORPORATION OF AMERICA, Delaware corporations, supply custom designed electrical connector accessories and flexible conduits, multi-conductor cable and air and gas dehydration systems for aerospace and defense markets. * JOSLYN FOREIGN SALES CORPORATION, organized under the laws of the Virgin Islands of the United States, exports the Registrant's products throughout the world. 1(b) FINANCIAL INFORMATION ABOUT BUSINESS SEGMENTS Note 12, Segment of Business Reporting, on page 22 of the Annual Report is incorporated herein by reference. 1(c) NARRATIVE DESCRIPTION OF BUSINESS The Registrant's business is composed of two business segments: Utility Systems and Electrical Technologies. The products and services of Registrant's subsidiaries have been grouped as business segments based upon and in a manner consistent with the types of markets existing for the products and services. UTILITY SYSTEMS SEGMENT (a) PRINCIPAL PRODUCTS AND SERVICES The Registrant designs and manufactures construction, maintenance materials and electric power protection equipment principally for electric power distribution and overhead telephone and cable television communication lines. These products are manufactured from metal, rubber and porcelain and include pole line hardware, earth anchors, power surge arresters, power distribution cut-outs, cable termination devices and other products. Sales of these materials and products by Registrant's subsidiaries are made directly to ultimate users, distributors for resale to ultimate users, contractors, and to original equipment manufacturers by a direct sales force of approximately twenty people. Distribution is made directly from manufacturing plants or through a network of distribution centers operated by Registrant's subsidiaries. (b) RAW MATERIALS Materials used in the manufacture of the products of this segment are basic commodities, primarily various types of steel, rubber, porcelain, zinc, zinc oxide powder and components which are readily available and are purchased by Registrant's subsidiaries from numerous sources, none of which is material to the business of this segment as a whole. (c) PATENTS, LICENSES AND TRADEMARKS The Registrant does not consider that the business of the Utility Systems segment is dependent to a material extent upon patent and trademark protection, although certain features of the products of this segment are protected by patents and trademarks. Licensing of these products to others plays no material role in the Registrant's earnings. (d) SEASONAL ASPECTS OF BUSINESS Although the level of business of the Utility Systems segment varies modestly throughout the year, the business of this segment is not seasonal. (e) CUSTOMERS The business of this segment is not dependent upon any single customer or a few customers, the loss of which would have a material adverse effect on this segment as a whole. (f) BACKLOG ORDERS The Registrant does not believe information related to backlog orders to be material to the understanding of the business of this segment. (g) RENEGOTIATION OF PROFITS The business of the Utility Systems segment is not subject to renegotiation of profits or termination of contracts or subcontracts at the election of the Government. (h) COMPETITION There are several competitors in every product line of this segment resulting in strong competition. Because of the range of products manufactured by Registrant's subsidiaries, it is difficult to determine accurately its overall competitive position in these lines. The Registrant believes, however, that it is one of the principal suppliers of transmission, distribution and communication hardware, electric power surge arresters, electric power distribution cutouts and terminating devices in the United States and Canada. Some of the products manufactured by this segment, however, are commodity products with respect to which the Registrant experiences competition with directly competing products. The Registrant competes on the basis of its service, product quality, marketing technique and price and believes that its ability in these areas permits it to compete effectively. ELECTRICAL TECHNOLOGIES SEGMENT (a) PRINCIPAL PRODUCTS AND SERVICES Electric power and electronic protection equipment and switchgear are designed and produced primarily for use by the telecommunications, industrial, aerospace, defense, electric utility and petrochemical industries. These products include communication transient voltage suppression devices, communication test equipment, vacuum interrupters for power switching, starters and contactors, air dryers, and sulfur hexaflouride switches. The Registrant's defense products include electrical flexible conduits, vacuum capacitors, air and gas dehydration systems, electromagnetic pulse protection applications, and specialty products. Such products are primarily sold by Registrant's subsidiaries own sales force or through sales representatives directly to end users or to original equipment manufacturers, although some sales are made to distributors for resale. (b) RAW MATERIALS Materials used in the manufacture of the products of the Electrical Technologies segment are basic commodities and components which are readily available and are purchased by Registrant's subsidiaries from numerous sources, none of which is material to the business of this segment as a whole. (c) PATENTS, LICENSES AND TRADEMARKS The Registrant does not consider that the business of the Electrical Technologies segment is dependent to a material extent upon patent and trademark protection, although certain features of the products of the segment are protected by patents and trademarks. Licensing of these products to others is not material to the Registrant's earnings. The Registrant has obtained licenses to utilize various patents in some of the lines of business of this segment. However, no product manufactured by the Electrical Technologies segment under licenses from others makes a material contribution to sales or earnings. (d) SEASONAL ASPECTS OF BUSINESS Although the level of the business of the Electrical Technologies segment varies modestly throughout the year, the business of this segment is not seasonal. (e) CUSTOMER The business of this segment is not dependent upon any single customer or a few customers, the loss of which would have a material adverse effect on the segment as a whole. (f) BACKLOG ORDERS The Registrant does not believe information related to backlog orders to be material to the understanding of the business of this segment. (g) RENEGOTIATION OF PROFITS The business of the Electrical Technologies segment is not subject to renegotiation of profits or termination of contracts or subcontracts at the election of the Government. (h) COMPETITION There are several competitors in most product lines of this segment resulting in competition. Because of the range of products manufactured by the Registrant's subsidiaries, it is difficult to determine accurately its overall competitive position in these lines. The Registrant believes, however, that it is one of the principal U.S. suppliers of electrical power switching systems using vacuum and SF-6 technologies. Some of the electrical products manufactured by this segment are high technology products with respect to which Registrant's subsidiaries experience competition with products utilizing competing technology. The Registrant competes on the basis of its advanced technology, services, product quality, marketing technique and price and believes that its ability in these areas permits it to compete effectively. EFFECT OF ENVIRONMENTAL PROTECTION Compliance with federal, state and local provisions which have been enacted or adopted regulating the discharge of materials into the environment, or otherwise relating to the protection of the environment, has had no material adverse impact upon capital expenditures, earnings and the competitive position of the Registrant and its subsidiaries, except to the extent as described in Item 3, "Legal Proceedings." The Registrant regularly makes provision in its budgeted capital expenditures for environmental control facilities; however, for the current fiscal year ending December 31, 1993, and for future periods, the Registrant has not planned any capital expenditures for environmental control facilities which are expected to be material to current operations. See also Item 3, "Legal Proceedings." NUMBER OF EMPLOYEES As of March 1, 1994, the Registrant had approximately 2,025 employees. 1(d) FINANCIAL INFORMATION ABOUT FOREIGN AND DOMESTIC OPERATIONS AND EXPORT SALES Note 12, Segment of Business Reporting, on page 22 of the Annual Report is incorporated herein by reference. Item 2. Item 2. PROPERTIES EXPIRATION OF TERM PLANT OR FACILITY AND LOCATION GENERAL CHARACTER IF LEASED ______________________________ _________________ __________ (a) CORPORATE HEADQUARTERS Allen County, Indiana Undeveloped Property Bonner County, Idaho Undeveloped Property Chicago, Illinois Office 4/30/05 Goleta, California Undeveloped Property Santa Maria, California Undeveloped Property (b) UTILITY SYSTEMS Birmingham, Alabama Distribution Center and Undeveloped Property Brooklyn Center, Minnesota Undeveloped Property Chicago, Illinois Manufacturing Plant and Distribution Center Chicago, Illinois Manufacturing Plant Franklin Park, Illinois Office, Manufacturing Plant Franklin Park, Illinois Undeveloped Property Richmond, Virginia Distribution Center and 9/1/96 Sales Office Vernon, California Distribution Center 10/30/94 (c) ELECTRICAL TECHNOLOGIES Alsip, Illinois Manufacturing Plant Cleveland, Ohio (116th Street) Manufacturing Plant Cleveland, Ohio (Harvard Avenue) Manufacturing Plant Goleta, California Manufacturing Plant Lachine, Quebec Manufacturing Plant and Office 12/31/96 Lancaster, South Carolina Manufacturing Plant Maui, Hawaii Investment Property Moorpark, California Manufacturing Plant 1/31/98 Paso Robles, California Manufacturing Plant 1/31/98 San Dimas, California Service Center Month to Month San Jose, California Manufacturing Plant Spokane, Washington Manufacturing Plant 9/30/94 Somerset, New Jersey Distribution Center and Sales Office Month to Month Woodstock, Illinois Office, Manufacturing Plant and Test Facility The Registrant believes that its properties are in good condition and are adequate to meet its current and reasonably anticipated needs. Item 3. Item 3. LEGAL PROCEEDINGS Registrant's subsidiary, Joslyn Manufacturing Co. (the "Company") previously operated wood treating facilities that chemically preserved utility poles, pilings and railroad ties. An environmental reserve for estimated additional, future remedial actions and clean-up costs for known sites currently under investigation pursuant to environmental laws and regulations has been made. Note 6, Environmental Matters, on page 19 of the Annual Report is incorporated herein by reference. Joslyn Manufacturing Co. executed a Consent Order effective May 30, 1985, with the Minnesota Pollution Control Agency pertaining to a former wood treating facility owned by the Company located in Brooklyn Center, Minnesota. The Consent Order requires the Company to undertake soil and groundwater investigation and clean-up of the site. The Company is currently performing its obligations under the Consent Order and is continuing the clean-up of the site. Registrant has completed a significant portion of the clean-up at the site. The Louisiana Department of Environmental Quality issued administrative orders against potentially responsible parties, including Joslyn Manufacturing Co., to perform a clean-up at a former wood treating facility located in Bossier City, Louisiana. The Company is complying with the administrative order and has unilaterally implemented a remedial action plan for remediating the site. Additional offsite soil remediation may be required. The Company has begun preliminary investigation of offsite areas. The site has recently been proposed for listing on the National Priorities List by the U.S. Environmental Protection Agency. The Company is opposing the proposed listing. The Company is currently appealing adverse decisions against other potentially responsible parties as well as its insurance carrier for allocation, contribution and indemnification for remediation efforts which have been or will be performed by the Company. The Company is a defendant in a purported class action lawsuit entitled, JOHNSON ET AL. V. LINCOLN CREOSOTE CO., INC., filed with the 26th Judicial Court for Bossier Parish, Louisiana, No. 70481 on February 23, 1987, . Plaintiffs are seeking damages allegedly sustained from the disposal of materials on the former wood treating site previously owned and operated by the Company prior to 1970 and located in Bossier City, Louisiana. The damages sought are unspecified. The Court held a hearing for the purpose of determining class certification but no decision has yet been made by the judge. The Company has tendered the defense of the suit to its insurance carrier. On November 20, 1986, the Illinois Environmental Protection Agency issued an Immediate Removal Order for the Company's former wood treating facility in Franklin Park, Illinois. In compliance with that Order, Registrant has completed a significant portion of the clean-up at the site. In 1990, the Company entered into a Consent Order with the current property owner and the Oregon Department of Environmental Quality pertaining to a former wood treating facility located in Portland, Oregon. The Consent Order requires an investigation of the site which is continuing. It is anticipated that a feasibility study for remediating the site will be completed in 1994. The Company has been named as a third party defendant in a suit filed on September 11, 1992 entitled UNITED STATES OF AMERICA, ET AL. VS. SCA SERVICES OF INDIANA V. OMNISOURCE CORP.,-29, U.S. District Court Northern District Indiana (Ft. Wayne Division). The suit seeks contribution for the remediation of the Ft. Wayne Reduction Superfund Site. The Company is one of over 65 potentially responsible parties. The Company is defending the suit. Item 4. Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. EXECUTIVE OFFICERS OF THE REGISTRANT Listed below are the names, titles, offices, positions and ages of all executive officers of the Registrant. There are no family relationships between them. The officers' terms in office expire on April 27, 1994, the date of the meeting of the Board of Directors, which is held immediately before the 1994 Annual Meeting of Shareholders. DONALD B. HAMISTER Chairman of the Board - Age 73 Experience 1992 Retired as Chief Executive Officer 1991 Re-elected Chief Executive Officer 1987 Retired as Chief Executive Officer RAYMOND E. MICHELETTI President, Chief Executive Officer and a Director - Age 68 Experience 1992 Elected President, Chief Executive Officer and Director 1991 Elected President, Chief Operating Officer and Director 1988 Elected Senior Vice President; Elected President, Joslyn Hi-Voltage Corporation LAWRENCE G. WOLSKI Director, Executive Vice President, Chief Financial Officer, and Utility Systems Group Director - Age 49 Experience 1993 Elected Executive Vice President 1987 Elected Senior Vice President GEORGE W. DIEHL Vice President, Power Switching and Controls Group Director and a Director - Age 54 Experience 1991 Appointed Vice President; Elected President and Chief Operating Officer, Joslyn Hi-Voltage Corporation 1988 General Manager, Joslyn Hi-Voltage Corporation DANIEL DUMONT Vice President - Age 46 Experience 1990 Appointed Vice President; Elected President and Chief Operating Officer, Joslyn Canada Inc. 1987 General Manager, Joslyn Canada Inc. WAYNE M. KOPROWSKI Vice President, General Counsel and Secretary - Age 47 Experience 1990 Elected Vice President 1986 Elected General Counsel and Secretary, Joslyn Corporation STEVEN L. THUNANDER Vice President - Age 43 Experience 1988 Appointed Vice President; Elected President and Chief Operating Officer, Joslyn Manufacturing Co. PART II Item 5. Item 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS Information regarding the price of Registrant's common stock, dividend payments and numbers of shareholders is included in Common Stock Prices and Dividends on page 10 of the Annual Report which is incorporated herein by reference. Item 6. Item 6. SELECTED FINANCIAL DATA Selected financial data, which is included in the Five-Year Comparative Financial Data on page 10 of the Annual Report, is incorporated herein by reference. Item 7. Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION Management's Discussion and Analysis of Financial Condition and Results of Operations on pages 4 through 9 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 in the Annual Report, are incorporated herein by reference: ANNUAL REPORT PAGE NO. _____________ Consolidated Statement of Income for the Years Ended December 31, 1993, 1992 and 1991 11 Consolidated Balance Sheet -- December 31, 1993 and 1992 12 Consolidated Statement of Shareholders' Equity for the Years Ended December 31, 1993, 1992 and 1991 13 Consolidated Statement of Cash Flows for the Years Ended December 31, 1993, 1992 and 1991 14 Notes to Consolidated Financial Statements 15-23 Report of Independent Public Accountants 23 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) Information regarding directors of the Registrant required by this Item 10 is contained under the caption "Nominees For Election As Director" on pages 2 and 3 of the Proxy Statement, and is incorporated herein by reference. (b) Information regarding executive officers of the Registrant required by this Item 10 is included on pages 10 and 11 in Part I of this Report pursuant to General Instruction G of Form 10-K. Item 11. Item 11. EXECUTIVE COMPENSATION Information concerning executive compensation required by this Item 11 is contained under the following captions in the Proxy Statement, and is incorporated herein by reference: PROXY Statement Page No. _________ Compensation of Directors 5 Summary Compensation Table 6 Stock Option/SAR Grants in 1993 7 Defined Benefit Pension Plan 7 Employment Agreements 8 Item 12. Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information required by this Item 12 is contained in the Proxy Statement under the captions "Principal Holders of Voting Securities" on page 4 and "Security Ownership of Management on March 3, 1994" on page 3 and is incorporated herein by reference. PART IV Item 13. Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS None. Item 14. Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a)1. Financial Statements Included in Part II of this report: Consolidated Statement of Income for the years ended December 31, 1993, 1992 and 1991 Consolidated Balance Sheet as of December 31, 1993 and 1992 Consolidated Statement of Shareholders' 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 Included in Part IV of this Report: PAGE Report of Independent Public Accountants on Consolidated Financial Statement Schedules 16 Schedule II - Amounts Receivable From Related Parties And Underwriters, Promoters and Employees 17 Schedule V - Property, Plant and Equipment 18 Schedule VI - Accumulated Depreciation of Property, Plant and Equipment 19 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. 3. Exhibits The exhibits filed in response to Item 601 of Regulation S-K and Item 14(c) of Form 10-K are listed in the Exhibit Index on page 20. Management contracts or compensatory plans or arrangements are identified in the Exhibit Index by a "+". (b) Reports on Form 8-K No reports on Form 8-K were filed during the fourth quarter of the period 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. March 30, 1994 JOSLYN CORPORATION By:/s/ Raymond E. Micheletti ________________________________ Raymond E. Micheletti 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 /s/Donald B. Hamister Chairman of the Board March 30, 1994 ________________________ Donald B. Hamister /s/Raymond E. Micheletti President, Chief Executive ________________________ Officer, Director March 30, 1994 Raymond E. Micheletti /s/Lawrence G. Wolski Executive Vice President, March 30, 1994 ________________________ Chief Financial Officer, Chief Lawrence G. Wolski Accounting Officer, Director /s/William E. Bendix Director March 30, 1994 ________________________ William E. Bendix /s/John H. Deininger Director March 30, 1994 ________________________ John H. Deininger /s/Richard C. Osborne Director March 30, 1994 ________________________ Richard C. Osborne /s/Walter W. Schoenholz Director March 30, 1994 ________________________ Walter W. Schoenholz REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS ON CONSOLIDATED FINANCIAL STATEMENT SCHEDULES ___________________________________________ We have audited, in accordance with generally accepted auditing standards, the consolidated financial statements included in Joslyn Corporation's annual report incorporated by reference in this Form 10-K, and have issued our report thereon dated February 9, 1994. 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 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 consolidated financial data required to be set forth therein in relation to the basic consolidated financial statements taken as a whole. ARTHUR ANDERSEN & CO. Chicago, Illinois February 9, 1994. SCHEDULE II AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS AND EMPLOYEES _________________________________________ Balance at End of Period _____________ Balance at Name of Beginning Amounts Amounts Not Debtor of Period Additions Collected Written Off Current Current ______________________________________________________________________________ Year Ended December 31, 1993 A.R. Gray(1)$175,000 $0 $5,000 $0 $0 $170,000 Year Ended December 31, 1992 A. R. Gray $185,000 $0 $10,000 $0 $0 $175,000 Year Ended December 31, 1991 A. R. Gray $195,000 $0 $10,000 $0 $0 $185,000 ____________________________ (1) Mr. Gray is Vice President and a Director of Joslyn Electronic Systems Corporation. The above debt relates to his relocation to California from Spokane, Washington, and is a second mortgage on his primary residence of 0% interest, payable in annual installments of the lesser of $10,000 or his annual bonus. The Balance at the end of the period for the current portion is not determinable until annual bonus payments are granted. A balloon payment equal to the unpaid balance of the loan is due March 1, 1997. (a) 1993 includes the transfer of $438 of long-term assets, previously held for resale, to land and buildings, $280 of a tax agents reclassification within fixed asset categories and $193 of equipment to the acquisition for cash of the EEV vacuum capacitor product line. (b) 1992 includes $8,018 of property, plant and equipment relating to the acquisition for cash of Lear Siegler Jennings Corp. Depreciation is computed using the straight-line method for financial statement purposes. Generally the rates of depreciation range from 2.5% to 4% for buildings and 6.67% to 20% for machinery and equipment. EXHIBIT INDEX Page 3(i) Articles of Incorporation (Exhibit D to Registrant's Form S-4 Registration Statement filed March 17, 1988)* 3(ii) By-Laws (Exhibit D to Registrant's Form S-4 Registration Statement filed March 17, 1988)* 4 Rights Agreement with the First National Bank of Chicago dated February 10, 1988 (Exhibit 4 to Registrant's 1987 Form 10-K)* 10 (a) Form of Employment Agreement with Mr. Micheletti (Exhibit 10(c) to Registrant's 1991 Form 10-K)*+ (b) Form of Employment Agreement with Mr. Wolski (Exhibit 10(c) to Registrant's 1991 Form 10-K)*+ (c) Joslyn Corporation Long Term Incentive Compensation Plan (Exhibit 10(c) to Registrant's 1989 Form 10-K)*+ (d) Joslyn Corporation Parity Compensation Plan (Exhibit 10(c) to Registrant's 1989 Form 10-K)*+ (e) Joslyn Mfg. and Supply Co. Employee Stock Benefit Plan, as amended (Exhibit A to Registrant's Proxy Statement dated March 25, 1983)*+ (f) Joslyn Corporation Stock Option Plan (Exhibit A to Registrant's Proxy Statement dated March 28, 1989)*+ 13 Portions of the Annual Report for the year ended December 31, 1993 incorporated by reference 21 21 Subsidiaries of the Registrant 41 23 Consent of Independent Public Accountants 42 99 Proxy Statement dated March 25, 1994 43 * Incorporated by reference. + Management contract or compensatory plan or arrangement. EXHIBIT 13 PORTIONS OF THE ANNUAL REPORT FOR THE YEAR ENDED DECEMBER 31, 1993 INCORPORATED BY REFERENCE Management's Discussion and Analysis of Financial Condition and Results of Operations LIQUIDITY AND CAPITAL RESOURCES The financial condition of the Corporation remains strong with a working capital ratio of 2.8 to 1 at December 31, 1993 compared to a restated 2.5 to 1 at December 31, 1992. Net deferred tax assets and retained earnings were reduced and restated by $3.1 million due to the adoption of Statement of Financial Accounting Standards (SFAS) No. 109, "Accounting for Income Taxes", as discussed in Note 4 of the Notes to Consolidated Financial Statements. Joslyn Corporation has no long-term debt. The $41.1 million of cash and cash equivalents, together with internally generated funds and unused lines of credit with a bank, should provide adequate liquidity and financial flexibility for 1994 and beyond to fund planned operations, environmental remedial expenditures, normal capital expansion and acquisitions. The sources and uses of cash flows are summarized in the Consolidated Statement of Cash Flows. The Balance Sheet was comparable from December 31, 1992 to December 31, 1993. Inventories increased $3.7 million or 11.5% from the prior year end, reflecting increased inventory levels at several subsidiaries to provide more Page 21 4 responsiveness to customer demand and because of new products. Despite the higher year-end inventory levels, the average monthly inventory turnover during 1993 improved compared to 1992. Also, Accounts Payable increased $1.2 million, or 10.8%, due to the timing of payments while Accrued Liabilities decreased $3.0 million, or 10.4%, due to 1) a decreased current accrual for environmental matters, 2) payments made for the relocation or discontinuance of product lines and 3) a reduction in advance payments. Environmental accruals are discussed more fully in Note 6 of the Notes to Consolidated Financial Statements. Expenditures for environmental clean-up activities were $2.7 million in 1993 compared to $15.0 million in 1992. The 1992 expenditures were partially offset by cash recoveries from an insurance carrier and other third parties which resulted in approximately $9.6 million being credited to the environmental accruals. The Corporation anticipates that it may spend up to approximately $2.0 million in 1994. The expenditures are expected to continue to decrease in the future years. Although inflation has not been a significant factor in the last several years, the Corporation continually seeks to minimize its effects by controlling costs and improving productivity. Costs are passed on by increasing selling prices when competitive conditions permit. Page 22 5 RESULTS OF OPERATIONS 1993 Net income of $14.9 million was 4% higher than in 1992 and was $2.10 per share, a new Joslyn record. In 1993, sales of $217.7 million and income from business segments of $27.8 million were flat compared to 1992. Increases in the Electrical Technologies segment of business offset decreases in the Utility Systems segment. The Electrical Technologies business segment sales of $142.7 million were $6.5 million or 4.7% greater than in 1992 and operating income of $22.8 million was $1.5 million or 7.1% greater than in 1992. Joslyn Jennings, acquired during the second quarter of 1992, made a significant contribution not only because it was included for the entire year in 1993, but also because its operating results improved. Joslyn Electronic Systems had an excellent year by increasing sales more than 14% and improving profit margins. New products helped these increases. Joslyn Hi-Voltage, Joslyn Clark Controls and Joslyn Sunbank had increased sales and earnings. Joslyn Power Products' sales and earnings were lower due to changes in product mix, decreased volume related to significant competition and because of delays in obtaining new orders. The integration of the Air-Dry and ADK Pressure Equipment operations resulted in lower combined sales and earnings because of distractions associated with this merger, as well as continued softness in defense and some areas of the telecommunications markets. The Utility Systems business segment had a difficult year with sales down $6.6 million from $81.7 million in 1992 and operating income down $1.7 million from $6.7 million in the prior Page 23 6 year. The segment's markets were weak, which led to reduced sales and increased competition. In addition, operating inefficiencies and start-up problems were encountered due to closing the Birmingham, Alabama hardware plant and relocating the production to the Chicago, Illinois hardware plant. The gross profit margin improved to 27.3% in 1993 from 26.3% in 1992 by selling higher margin products and reducing certain production costs. Selling, distribution and administrative expense of $29.5 million increased $2.8 million over 1992 primarily because of the inclusion of Joslyn Jennings and Sierra for the entire year in 1993 versus a partial year in 1992 and increased research and development expense. Other expense, net in 1993 includes charges related to plant consolidations and certain postemployment costs, as well as other miscellaneous charges of a non-operating nature. In the third quarter of 1993, Congress enacted the Revenue Reconciliation Act of 1993 (RRA) which, among other things, increased the federal statutory tax rate to 35% retroactive to January 1, 1993. Statement of Financial Accounting Standards No. 109 requires companies to recompute their tax assets if there are changes in tax laws or tax rates and to record the effects of the change in net income. In the third quarter of 1993, the Corporation recorded the effects of the RRA which increased net income and earnings per share by approximately two cents ($.02) per share because the Corporation has significant net deferred tax assets. The related tax benefit contributed to a portion of the improvement in the Corporation's effective income tax rate from 36.2% in 1992 to 34.7% in 1993. Page 24 7 RESULTS OF OPERATIONS 1992 Sales of $217.9 million were $14.2 million or 7.0% greater and income from business segments of $28.0 million was $3.1 million or 12.3% greater in 1992 than in 1991. The Electrical Technologies business segment sales of $136.2 million in 1992 increased 13.8% over 1991. The 1992 sales include approximately $14 million by Joslyn Jennings Corporation since its acquisition in April 1992. All business units within this segment had increased sales except for the defense businesses which decreased 3%. Increased sales of the SF-6 Switch products and ADK Pressure Equipment's dryers and Adam-720 monitor system were particularly strong. Operating income from this segment of $21.3 million in 1992 increased 10.6% compared to 1991. Increased income from the SF-6 Switches, Joslyn Clark Controls and ADK Pressure Equipment, along with continued strong performance by Joslyn Hi- Voltage Corporation and contributions from Joslyn Jennings, more than offset decreased income from Joslyn Electronic Systems and the defense businesses. The Utility Systems business segment sales of $81.7 million in 1992 decreased 2.8% from 1991, but operating income of $6.7 million in Page 25 8 1992 was 17.9% higher than in 1991. Operating income improved due to product mix, including the divestiture of a marginally profitable product line, and reduced operating costs related to actions taken in the last half of 1991. The Utility Systems segment had inventory reductions that also contributed to improved earnings performance. The gross profit margins improved to 26.3% for 1992 from 25.6% in 1991 due to changes in product mix, cost reductions and new products, combined with the ongoing process of reviewing and pruning marginal product lines. Selling, distribution and administrative expense of $26.7 million increased $1.6 million or 6.2% in 1992 compared to 1991 primarily because 1) the inclusion of Joslyn Jennings expenses, 2) increased direct costs related to higher sales and 3) greater spending for research and development, more than offset other expense reductions. Investment income of $1.2 million decreased 7.2% compared to 1991 because lower interest rates more than offset the increased average amount of funds invested. Other expense, net in 1992 includes primarily charges for plant consolidations, as well as miscellaneous other non-operating expenses and gains. Page 26 9 FIVE-YEAR COMPARATIVE DATA Joslyn Corporation and Subsidiaries *The Corporation adopted SFAS No. 109, "Accounting for Income Taxes", (See Note 4) in 1993 and elected to apply it retroactively to 1990. Accordingly, income and per share amounts in 1990 and certain balance sheet amounts for 1990, 1991 and 1992 were restated. **Relates to accounting change for postretirement medical benefits in 1991. See Note 7. ***Includes non-recurring charges of $23.5 million before taxes and $21.5 million after taxes primarily related to a write-down of goodwill and other intangibles. ****Includes non-operating items that net to $8.0 million pretax income. COMMON STOCK PRICES AND DIVIDENDS Shares Traded on the NASDAQ National Market System The bid market price quotations were obtained from the NASDAQ National Market System. The bid prices represent prices between broker-dealers, do not include retail markups and markdowns or any commission to the broker-dealers and may not reflect prices in actual transactions. The approximate number of holders of the Corporation's common stock at March 1, 1994 was 3,200 (including employee shareholders under the Employees' Savings and Profit Sharing Plan, but excluding the number of shareholders of record whose shares are held in "nominee" or "street" name). Page 27 10 CONSOLIDATED STATEMENT OF INCOME Joslyn Corporation and Subsidiaries The accompanying Notes to Consolidated Financial Statements are an integral part of this statement. Page 28 11 CONSOLIDATED BALANCE SHEET Joslyn Corporation and Subsidiaries *Restated to reflect Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes". See Note 4 in the Notes to Consolidated Financial Statements. The accompanying Notes to Consolidated Financial Statements are an integral part of this balance sheet. Page 29 12 CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY Joslyn Corporation and Subsidiaries The accompanying Notes to Consolidated Financial Statements are an integral part of this statement. Page 30 13 CONSOLIDATED STATEMENT OF CASH FLOWS Joslyn Corporation and Subsidiaries The accompanying Notes to Consolidated Financial Statements are an integral part of this statement. Page 31 14 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Joslyn Corporation and Subsidiaries 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: Principles of Consolidation: The Consolidated Financial Statements include the accounts of the Corporation and all subsidiaries, after elimination of intercompany accounts and transactions. Cash and Cash Equivalents: Cash and cash equivalents of $41,102,000 and $38,228,000 at December 31, 1993 and 1992, respectively, include cash equivalents which are highly liquid investments with original maturities or put dates of three months or less. They are recorded at cost which approximates market. Also included in this balance sheet caption are equity securities having an aggregate cost of $4,089,000 and $4,199,000 on December 31, 1993 and 1992 and an aggregate market value of $4,704,000 and $4,671,000, respectively. At December 31, 1993, gross unrealized gains were $633,000 and there were immaterial gross unrealized losses. At December 31, 1992, gross unrealized gains were $504,000 and there were immaterial unrealized losses. There were $124,000 net realized gains on the sale of equity securities in 1993, immaterial net realized gains on the sale of equity securities in 1992 and no realized gains or losses on equity securities in 1991. At December 31, 1993, cash and cash equivalents also included $608,000 of restricted funds used to guarantee a self-insurance program with an insurance company. Inventories: At December 31, 1993 and 1992, inventories of $18,424,000 and $17,646,000, respectively, are valued using the last-in, first-out (LIFO) method. The remaining inventories are valued at the lower of first-in, first-out (FIFO) cost or market. If FIFO inventory methods had been used for all inventories, the December 31, 1993 and 1992 inventories would have been $9,069,000 and $9,068,000 higher, respectively. During 1993, 1992 and 1991, certain inventories were reduced, which resulted in a liquidation of some LIFO inventories valued at lower costs prevailing in prior years. These liquidations resulted in increasing income before taxes by an immaterial amount in 1993, $875,000 in 1992 and $903,000 in 1991. Property, Plant and Equipment: Property, plant and equipment are stated at cost. Depreciation is computed using the straight-line method for financial statement purposes and accelerated methods for income tax purposes. When properties are retired or otherwise disposed of, the related cost and accumulated depreciation are removed from the respective accounts and any gain or loss from disposition is recognized. Maintenance and repair costs are expensed when incurred and were $4,261,000, $3,650,000 and $3,403,000 in 1993, 1992 and 1991, respectively. Research and Development: Costs related to research and development activities are charged against income as incurred. These costs were approximately $6,200,000 in 1993, $5,000,000 in 1992 and $4,100,000 in 1991. Cash Flow Information: Cash paid for interest was $135,000 in 1993, $212,000 in 1992 and $199,000 in 1991. Cash paid for income taxes was $7,999,000 in 1993, $5,737,000 in 1992 and $6,626,000 in 1991. Equity Adjustments: Included in Equity Adjustments are Cumulative Currency Translation Adjustments with debit balances of $260,000 and $131,000 at December 31,1993 and 1992, respectively, and Pension Liability Adjustments with debit balances of $509,000 and $445,000 at December 31, 1993 and 1992, respectively. Net Income Per Share: Net income per share of common stock was computed based on weighted average shares of 7,086,000 in 1993, 7,045,000 in 1992 and 7,047,000 in 1991. 2. FINANCING ARRANGEMENTS: At December 31, 1993, 1992 and 1991, the Corporation had unused lines of credit established with banks of $15.0 million, $17.5 million and $24.0 million, respectively, that may be drawn as needed. The lines of credit were not used during 1993, 1992 or 1991. In connection with the line of credit agreements, the Corporation was not required to maintain compensating cash balances in 1993. In 1992 and 1991, the Corporation maintained cash balances of 5% on certain unused credit lines and paid fees on certain other unused credit lines. At December 31, 1992, cash in the consolidated balance sheet included $125,000 used for compensating cash balances. The Corporation has complied with the compensating cash balance requirements of all credit agreements with banks. Page 32 15 3. PROFIT SHARING AND PENSION BENEFITS: Most domestic subsidiaries of Joslyn participate in one of two Profit Sharing Plans. The plans distribute Unit Contributions primarily in relationship to covered compensation and years of service. For both plans, Company Unit Contributions are at the discretion of the Board of Directors of each participating Corporation and are related to profit sharing income, as defined, for each Company Unit. Company Unit Contributions are made partly in cash and partly in common stock of Joslyn Corporation. The plans have similar provisions requiring one year of service for eligibility and five years of service for vesting. Each member of the Profit Sharing Plans is entitled to vote the number of Joslyn Corporation shares allocated to that member's account. Additionally, a 401(k) savings feature is part of the plans which provides proportionate, fully-vested, Company matching contributions. Profit Sharing Expense for both plans was $2,191,000 in 1993, $2,596,000 in 1992 and $2,023,000 in 1991. Additional retirement benefits are provided through a frozen non-contributory, defined benefit pension plan for eligible domestic, salaried employees of participating units. Benefits are based on years of service and an average of the five highest consecutive years of defined compensation, both before the plan freeze date. Effective December 31, 1988, this plan was frozen and no employees may qualify for participation in the plan thereafter. No amounts were contributed in 1993, 1992 and 1991 because of the full funding limitation in the 1974 Employee Retirement Income Security Act (ERISA). If a qualified defined benefit pension plan is terminated and all accrued liabilities to employees and their beneficiaries are satisfied, in general, all remaining assets in the plan's trust may revert to the employer as income, subject to significant excise and income taxes. Joslyn Clark Controls, Inc. and Joslyn Jennings Corporation each also has a non-contributory, defined benefit pension plan for eligible hourly employees. The benefits are based on negotiated amounts per year of service. The Corporation's funding policy is to make the contribution required by ERISA. The three pension plans include provisions limiting benefits in accordance with the Internal Revenue Code and ERISA. The assets of the three pension plans consist primarily of stocks and bonds in a Master Trust account which is managed by an independent investment manager. Following is a schedule reconciling the aggregate funded status of the pension plans with the amounts included in the applicable consolidated balance sheet: *Actuarial present values Page 33 16 The discount rate used in determining the actuarial present value of the projected benefit obligation as of October 1, 1993 and 1992 was 6.25% and, as of October 1, 1991 was 7.25%. The expected long-term rate of return on assets for 1993, 1992 and 1991 was 8.0%. The components of net pension income (cost) in 1993, 1992 and 1991 are as follows: (in thousands) - ----------------------------------------------------------------- 1993 1992 1991 - ----------------------------------------------------------------- Service Costs-Benefits Earned During the Period $ (218) $ (314) $ (124) Interest Cost on Projected Benefit Obligation (2,231) (2,187) (1,736) Actual Return on Plan Assets 3,004 4,189 4,918 Net Amortization and Deferrals (549) (1,664) (3,081) - ----------------------------------------------------------------- Net Pension Income (Cost) $ 6 $ 24 $ (23) ================================================================= 4. INCOME TAXES: The Corporation adopted Statement of Financial Accounting Standards (SFAS) No. 109, "Accounting for Income Taxes", in the first quarter of 1993 and elected to apply the provisions retroactively to the calendar year ended December 31, 1990. SFAS No. 109 requires the adjustment of deferred taxes for changes in tax rates and tax laws using the liability method. The adoption of SFAS No. 109 resulted in a $3.1 million, or $.43 per share, "Cumulative Effect of Change in Accounting" charge against 1990 net income and 1990 retained earnings. Net deferred tax assets also were reduced by $3.1 million. There was no effect on income or earnings per share for 1991, 1992 or for the first two quarters of 1993. In the third quarter of 1993, Congress enacted the Revenue Reconciliation Act of 1993 (RRA) which, among other things, increased the federal statutory rate from 34% to 35% retroactively to January 1, 1993. In the third quarter, the Corporation recorded the tax effects of the RRA which increased net income and earnings per share by approximately two cents ($.02) per share. The increase reflects the benefits related to the Corporation's significant net deferred tax assets. Income before income taxes consists of the following: (in thousands) - --------------------------------------------------------------- 1993 1992 1991 - --------------------------------------------------------------- Domestic $20,409 $20,467 $19,540 Foreign 2,361 1,941 940 - --------------------------------------------------------------- $22,770 $22,408 $20,480 =============================================================== The provision for income taxes consists of the following: (in thousands) - --------------------------------------------------------------- 1993 1992 1991 - --------------------------------------------------------------- Current: U.S. Federal $ 5,801 $ 5,318 $ 5,918 Foreign 787 594 322 State and Local 1,305 1,143 1,393 - --------------------------------------------------------------- $ 7,893 $ 7,055 $ 7,633 - --------------------------------------------------------------- Deferred: U.S. Federal $ (6) $ 822 $ (283) Foreign 15 46 (12) State and Local (2) 177 (63) - --------------------------------------------------------------- $ 7 $ 1,045 $ (358) - --------------------------------------------------------------- Total Income Tax Provision $ 7,900 $ 8,100 $ 7,275 =============================================================== Page 34 17 A reconciliation of the statutory U.S. federal income tax rates to the Corporation's effective income tax rates is as follows: - ----------------------------------------------------------------- 1993 1992 1991 - ----------------------------------------------------------------- Expected Tax Rates 35.0% 34.0% 34.0% State Income Taxes, Net of Federal Income Tax 3.9 4.1 4.3 Tax Reductions Related to: Foreign Sales Corporation (1.5) (1.4) (1.4) U.S. Tax-exempt Interest (1.2) (1.2) (1.4) Research and Development Credit (0.5) (0.4) (0.7) U.S. Taxes on Foreign Operations 0.2 0.1 0.2 All Other, Net (1.2) 1.0 0.5 - ---------------------------------------------------------------- Effective Tax Rates 34.7% 36.2% 35.5% ================================================================ Deferred tax assets and liabilities arise from the tax effects of timing differences in the recognition of income and expenses for financial statement and tax purposes. Significant deferred tax assets and liabilities as of December 31, 1993 and 1992 are as follows: (in thousands) - ---------------------------------------------------------------- 1993 1992 - ---------------------------------------------------------------- Assets: Postretirement Medical $ 5,077 $ 4,650 Environmental Matters 3,705 4,034 Other Employee Benefits 1,868 1,604 Warranties 1,421 1,545 All Other 4,063 4,008 - ---------------------------------------------------------------- Gross Deferred Tax Assets $16,134 $15,841 Valuation Allowance (200) (200) - ---------------------------------------------------------------- $15,934 $15,641 ================================================================ Liabilities: Depreciation $ 4,552 $ 4,476 Pension 1,246 1,113 Other - 43 - ---------------------------------------------------------------- Gross Deferred Tax Liabilities $ 5,798 $ 5,632 ================================================================ The Corporation's policy is to provide deferred U.S. federal income taxes on the undistributed cumulative income of its foreign operating subsidiaries, to the extent that foreign tax credits are not available. The Corporation's tax credit carry-forwards are not significant. In 1991, the Corporation recorded a pretax charge of $10.2 million for the cumulative effect to January 1, 1991 of a change in accounting for postretirement medical benefits. This charge resulted in related deferred federal and state income taxes of $3.2 million and $0.7 million, respectively. 5. STOCK OPTIONS: The shareholders have approved two stock option plans for key employees which include Incentive Stock Options (ISOs), non- qualified stock options and non-qualified stock options with tandem stock appreciation rights. Stock options granted after 1991 and ISOs do not have tandem stock appreciation rights. These plans provided for a maximum of 2,081,250 shares that could be delivered upon exercise of stock options and stock appreciation rights (SARs). Stock options and SARs are granted at the market value of the Corporation's stock on the date of grant. Options granted prior to 1990 are exercisable not less than six months nor more than ten years after the date of the grant. Options granted subsequent to 1989 are exercisable not less than six months nor more than five years after the date of the grant. An SAR entitles an option holder to elect to receive, in lieu of the exercise of an option and without payment to the Corporation, an amount equal to the difference between the option price and the market value of the common stock on the date the right is exercised. This amount may be paid in cash, in common shares, or in a combination thereof, subject to approval of a committee of non-participants. An immaterial expense in 1993 and expenses of $282,000 in 1992, $208,000 in 1991 are included in Other Expense, Net with respect to SARs. The Corporation made payments or issued stock related to the exercise of SARs as follows: - ------------------------------------------------------------------ Year Number of Rights Option Price - ------------------------------------------------------------------ 1993 12,435 $15.29 to 21.17 1992 45,764 14.92 to 21.17 1991 28,748 15.29 to 18.25 ================================================================== Page 35 18 A summary of activity in the plans is presented below: 6. ENVIRONMENTAL AND LEGAL MATTERS: The Corporation previously operated wood treating facilities that chemically preserved utility poles, pilings and railroad ties. All such treating operations were discontinued or sold prior to 1982. These facilities used wood preservatives that included creosote, pentachlorophenol and chromium-arsenic-copper. While preservatives were handled in accordance with all appropriate procedures called for at the time, subsequent changes in environmental laws now require the generators of these spent preservatives to be responsible for the cost of remedial actions at the sites where spent preservatives have been deposited. The Corporation has environmental accruals of approximately $10 million as of December 31, 1993. It is anticipated that approximately $2 million may be spent in 1994 on clean-up and related activities. Consequently, approximately $2 million is classified as a current liability and the remaining $8 million of the reserve is classified as a long-term liability at December 31, 1993. Net expenditures of $2.7 million, $5.4 million and $2.9 million were made during 1993, 1992 and 1991, respectively, on environmental clean-up and related activities, of former wood treating sites. The expenditures for 1992 are net of $9.6 million proceeds received from an insurance settlement and from other parties. No charges to expense were recorded in 1993, 1992 and 1991 related to the environmental accruals. While it is difficult to estimate the timing or amount of expenditures, the Corporation believes that this reserve is adequate for clean-up of known sites currently under investigation by various state and federal environmental agencies. The reserve is based on facts known at the current time; however, changes in EPA standards, possible future listing on the National Priorities List, improvements in clean-up technology and discovery of additional information concerning these sites and other sites could affect the estimated costs in the future. The Corporation has notified its insurance carrier of the sites being investigated and has submitted claims against it for the cost of clean-up at several sites. Recoveries, if any, from the carrier are uncertain at this time. Additionally, there are other potentially responsible parties who also operated certain of the sites. The reserve reflects an estimate of the allocation of remediation costs between the various parties. Page 36 19 Joslyn Manufacturing Co., a subsidiary of the Corporation, is a defendant in a purported class action tort suit. The suit alleges exposure to chemicals and property devaluation resulting from wood treating operations previously conducted at a Louisiana site. Both the size of the class and the damages are unspecified. The Corporation has tendered the defense of the suit to its insurance carrier. The Corporation believes that it may have adequate insurance coverage for the litigation, however, because of the above uncertainties, the Corporation is unable to determine at this time the potential liability, if any. The Corporation is involved in various other claims, legal actions and complaints arising in the normal course of business. It is the opinion of Management that such actions and claims will not have a material adverse effect on the results of operations or financial condition of the Corporation. 7. POSTRETIREMENT MEDICAL BENEFITS: The Corporation and its participating domestic subsidiaries provide optional health care benefits for retired employees under a frozen contributory plan. Employees may become eligible for these benefits if they were employed by the Corporation at the defined retirement age, were employed at least ten years and were hired prior to January 1, 1989. The benefits are subject to deductibles, co-payment provisions and other limitations, which are amended periodically. Also, the Corporation assumed a frozen retiree medical coverage plan as a result of its acquisition of the Jennings business in 1992. The following data is for these coverages in aggregate. These benefits are discretionary and are not a commitment to long-term benefit payments. The plans are funded as claims are paid. In 1991, Joslyn Corporation adopted Statement of Financial Accounting Standards (SFAS) No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions", on the immediate recognition basis. As a result of the adoption of SFAS No. 106, the Corporation recorded charges of $10,963,000 for optional postretirement medical benefits. The after-tax charge of $6,763,000, or $.95 per share, had two components: $6,268,000, or $.89 per share, was a one-time cumulative non-operating adjustment to January 1, 1991 and $495,000, or $.06 per share, was a charge for 1991, in addition to normal claims paid. The net periodic postretirement medical benefit cost for 1993, 1992 and 1991 was as follows: (in thousands) - ---------------------------------------------------------------- 1993 1992 1991 - ---------------------------------------------------------------- Service Cost $ 434 $ 486 $ 514 Interest Cost 762 889 868 Other (93) (25) - - ---------------------------------------------------------------- Net Medical Benefit Cost $1,103 $ 1,350 $ 1,382 ================================================================ The accumulated postretirement medical benefit obligation at December 31, 1993 and 1992 was as follows: (in thousands) - ---------------------------------------------------------------- 1993 1992 - ---------------------------------------------------------------- Retirees $ 4,129 $ 3,651 Fully Eligible Active Plan Participants 1,138 1,308 Other Active Plan Participants 6,049 7,103 - ---------------------------------------------------------------- Total Accumulated Medical Obligation $11,316 $12,062 Unrecognized Net Gain 2,816 1,334 - ---------------------------------------------------------------- Accrued Medical Benefit Cost $14,132 $13,396 ================================================================ The assumed health care cost trend rate used in the calculation for measuring the accumulated postretirement medical benefit obligation was 15.4% in 1993 and 17.7% in 1992. This rate was assumed to decrease by 2.3% per year to 8.5% in 1996 and remain at that level thereafter. The effect on the accumulated medical benefit obligation at January 1, 1993 of a one-percentage-point increase for each year in the health care cost trend rate used would result in an increase of $2,114,000 in the total obligation and a $211,000 increase in the aggregate service and interest cost components of the 1993 expense. The weighted average discount rates used to determine the accumulated postretirement medical benefit obligation as of December 31, 1993 and 1992 were 7% and 8%, respectively. Page 37 20 8. ACQUISITIONS: In the second quarter of 1993, Joslyn Jennings Corporation purchased a vacuum capacitor product line from EEV Limited in Chelmsford, England. The product line was relocated to Joslyn Jennings' facility in San Jose, California. The purchase price was not material. In April 1992, Joslyn Corporation purchased, for cash, the stock of Lear Siegler Jennings Corp., a San Jose, California based manufacturer of high-voltage vacuum products and telecommunications test instrumentation. A wholly-owned subsidiary of Joslyn Corporation also purchased certain real estate, some of which is being used in the business and some of which was sold in 1993. The Corporation paid $9.9 million for this acquisition, which was accounted for by the purchase method. The operating results of this acquisition are included in the Corporation's consolidated financial statements from the date of acquisition. In March 1991, Joslyn Clark Controls, Inc. acquired a product line of photoelectric sensing and control devices that was relocated to Joslyn Clark Controls' plant in Lancaster, South Carolina. The purchase price was not material. 9. SHAREHOLDERS' RIGHTS: The Corporation has a Shareholders' Right attached to each share of common stock. Each Right entitles the holder to buy from the Corporation one newly issued share of common stock at an exercise price of $60. The Rights become exercisable upon the acquisition of a certain percentage of Corporation stock or a tender offer or exchange offer for Corporation stock by a person or group. The Corporation is entitled to redeem the Rights at $.05 per Right at any time prior to fifteen days after a public announcement that a person or group has acquired a certain percentage of the Corporation's common stock. Depending on the occurrence of certain specific events, each exercisable Right, other than Rights held by the acquiring party, either entitles the holder to purchase the Corporation's common stock at an adjusted per-share price equal to 20% of the then market price or entitles the holder to purchase a share of the acquiring company common stock at a 50% discount. The Rights will expire on March 3, 1998. 10. OTHER EXPENSE, NET: Other Expense, Net in 1993, 1992 and 1991 includes primarily charges related to plant consolidations and to actions to eliminate marginal products as part of Management's continuing effort to simplify the organization, reduce costs and improve efficiencies. Also included are certain post-employment benefit expenses and other miscellaneous non-operating items. In 1992 and 1991, respectively, the expenses were partially offset by a gain on the sale of certain property and a $4 million gain from the settlement of a patent infringement lawsuit. 11. DETAILS OF CONSOLIDATED BALANCE SHEET: (in thousands) - ------------------------------------------------------------ 1993 1992 - ------------------------------------------------------------ Inventories: Finished Goods $ 6,788 $ 6,826 Work in Process 11,407 9,685 Raw Materials 18,165 16,113 - ------------------------------------------------------------ $36,360 $32,624 ============================================================ Prepaid Income Taxes and Other Current Assets: Prepaid Income Taxes $ 8,693 $ 8,308 * Other 2,267 2,337 - ------------------------------------------------------------ $10,960 $10,645 ============================================================ Net Property, Plant and Equipment: Land $ 7,525 $ 6,920 Buildings 24,510 24,317 Machinery and Equipment 47,768 45,566 Construction in Progress 486 635 - ------------------------------------------------------------ $80,289 $77,438 Less Accumulated Depreciation 40,305 35,888 - ------------------------------------------------------------ $39,984 $41,550 ============================================================ Accrued Liabilities: Reserve for Environmental Matters $ 1,889 $ 2,560 Accrued Wages, Bonuses and Vacation Expenses 3,616 3,486 Accrued Taxes, Other than Income Taxes 1,543 1,425 Accrued Warranties and Workers' Compensation 6,088 5,694 Advance Payments 2,279 3,065 Reserve for Relocation or Discontinuance of Product Lines 1,007 2,488 Other Accrued Liabilities 9,032 9,702 - ------------------------------------------------------------ $25,454 $28,420 ============================================================ * Restated. See Note 4. Page 38 21 12. SEGMENT OF BUSINESS REPORTING: The operations of the Corporation are divided into the following business segments for financial reporting purposes: Electrical Technologies: Electronic protection equipment, high voltage vacuum products, connector accessories and switchgear are designed and produced for use by the telecommunications, industrial, aerospace, defense, electric utility and petrochemical industries. These products include communication electronic transient suppression devices, telecommunications test instrumentation, electric switching and interrupting systems, capacitors, relays, starters, contactors, fire pump controllers, sulfur hexafluoride switches and air pressurization and dehydration products for insulated cables, antenna lines and waveguides and similar systems. Utility Systems: Construction and maintenance materials and electric power protection equipment are designed and produced principally for electric power distribution and for overhead telephone communication lines. These products are manufactured and assembled from metal, rubber and porcelain and include hardware, earth anchors, power surge arresters, cable accessories, electrical terminating devices and other products. In addition, the Corporation sells complementary goods produced by other manufacturers. Inter-segment sales are not material. Foreign operations of the Corporation, which are not material, are located in Canada and primarily serve markets in that country. No single customer accounts for 10% or more of the Corporation's sales. General Corporate assets are principally cash and cash equivalents, prepaid expenses and land. Export sales from the Corporation's United States operations to unaffiliated customers were as follows: Page 39 22 13. QUARTERLY FINACIAL INFORMATION (Unaudited): The following table sets forth certain unaudited quarterly financial information for 1993 and 1992: REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Shareholders and Board of Directors of Joslyn Corporation: We have audited the accompanying consolidated balance sheets of Joslyn Corporation (an Illinois 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 fiscal years in the period ended December 31, 1993. 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 amounts and disclosures in the consolidated 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 Joslyn Corporation and Subsidiaries as of December 31, 1993 and 1992, and the results of its operations and its cash flows for each of the three fiscal years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. As explained in Note 7 to the consolidated financial statements, effective January 1, 1991, the Corporation changed its method of accounting for postretirement benefits other than pensions. As explained in Note 4 to the consolidated financial statements, the Corporation has given retroactive effect to the change in accounting for the method of calculating the provision for income taxes. Chicago, Illinois ARTHUR ANDERSEN & CO. February 9, 1994 Page 40 23 EXHIBIT 21 Subsidiaries of the Registrant * JOSLYN MANUFACTURING CO., a Delaware corporation * JOSLYN CLARK CONTROLS, INC., a Delaware corporation * JOSLYN CANADA, INC., organized under the laws of the Province of Ontario, Canada * JOSLYN HI-VOLTAGE CORPORATION, a Delaware corporation * JOSLYN ELECTRONIC SYSTEMS CORPORATION, a Delaware corporation * JOSLYN JENNINGS CORPORATION, a Delaware corporation * JOSLYN RESEARCH AND DEVELOPMENT CORPORATION, a Delaware corporation * THE SUNBANK FAMILY OF COMPANIES, INC., a California holding corporation, and its two subsidiaries, SUNBANK ELECTRONICS, INC., and AIR-DRY CORPORATION OF AMERICA, Delaware corporations * JOSLYN FOREIGN SALES CORPORATION, organized under the laws of the Virgin Islands of the United States. EXHIBIT 23 CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS _________________________________________ As independent public accountants, we hereby consent to the incorporation by reference in Registration Statement File No. 33-50686 of our report dated February 9, 1994, included or incorporated by reference in the Joslyn Corporation and subsidiaries Form 10-K and to all references to our firm included in that Registration Statement. ARTHUR ANDERSEN & CO. Chicago, Illinois March 23, 1994. EXHIBIT 99 PROXY STATEMENT DATED MARCH 25, 1994 JOSLYN Joslyn Corporation CORPORATION 30 South Wacker Drive Chicago, Illinois 60606 Telephone: (312) 454-2900 Telecopier: (312) 454-2930 Notice of Annual Meeting of Shareholders To Be Held April 27, 1994 ______________________________________________________________________________ The Secretary of Joslyn Corporation hereby gives notice that the Annual Meeting of Shareholders of Joslyn Corporation will be held in the Assembly Room, 6th Floor, The Northern Trust Company Building, 50 South LaSalle Street, Chicago, Illinois 60675 on Wednesday, April 27, 1994, at 10:00 o'clock a.m., for the following purposes: (1) the election of six Directors; (2) the ratification of the appointment of Arthur Andersen & Co. as independent public accountants for the year 1994; (3) the amendment of the Joslyn Corporation Articles of Incorporation to limit the personal liability of the Corporation's directors; and (4) the transaction of such other business as may properly come before the meeting or any adjournment thereof. Only Shareholders of record at the close of business on March 1, 1994 will be entitled to vote at the meeting. The Annual Report of the Corporation for the year 1993, including financial statements, accompanies this Proxy Statement. Each Shareholder, whether or not he or she expects to be present at the meeting, is requested to sign, date and return the enclosed Proxy in the envelope which is supplied with this Notice. By order of the Board of Directors, Joslyn Corporation Wayne M. Koprowski Secretary ______________________________________________________________________________ JOSLYN CORPORATION 30 South Wacker Drive Chicago, Illinois 60606 PROXY STATEMENT This Proxy Statement is furnished in connection with the solicitation of proxies on behalf of the Board of Directors of Joslyn Corporation (the "Corporation") for the Annual Meeting of Shareholders to be held in the Assembly Room, 6th Floor, The Northern Trust Company Building, 50 South LaSalle Street, Chicago, Illinois 60675 on Wednesday, April 27, 1994, at 10:00 o'clock a.m., or any adjournment thereof. On or before March 25, 1994, this Proxy Statement and the enclosed Proxy were first sent or given to the Corporation's Shareholders. The 1993 Annual Report to Shareholders, including financial statements for the fiscal year ended December 31, 1993, accompanies this Proxy Statement. The executive offices of the Corporation are located at 30 South Wacker Drive, Chicago, Illinois 60606. The only voting securities of the Corporation are its Common Shares, of which there were 7,108,141 shares outstanding on March 1, 1994, the record date. A majority of such shares will constitute a quorum for the transaction of business at the Annual Meeting. Shareholders are entitled to one vote for each Common Share of the Corporation held. The Board of Directors is soliciting discretionary authority to accumulate votes. In the election of the Board of Directors, shareholders have the right to vote the number of shares owned by them for each of the six nominees, or they may cumulate their votes and give six votes to one nominee for each share owned, or they may distribute their votes on the same principle among as many nominees as they choose. No act need be done or notice given prior to the exercise of such cumulative voting rights. An affirmative vote of the shareholders of at least two-thirds of the outstanding shares entitled to vote is required to approve the amendment to the Articles of Incorporation. For the purpose of counting votes, abstentions, broker non-votes and other shares not voted have the same effect as a vote against the proposal. Each proxy received by the Board of Directors of the Corporation will be voted as specified by the Shareholder thereon. Any Shareholder may revoke their proxy at any time prior to the voting thereof by (1) giving written notice of such revocation to the Secretary of the Corporation, (2) properly submitting to the Corporation a duly executed proxy bearing a later date or (3) appearing in person at the 1994 Annual Meeting and voting in person. The cost of preparation of proxy solicitation materials and solicitation of proxies will be paid by the Corporation. In addition to use of the mails, proxies may be solicited by any Director, Officer, or employee of the Corporation either personally or by such other means as he may choose, and any such solicitation shall be made without additional compensation. The Corporation may reimburse brokers and others for their expenses in forwarding proxy solicitation materials to beneficial owners. The Corporation has retained Morrow & Co., Inc. to assist in the solicitation of proxies at an estimated fee of less than $10,000, plus reasonable expenses. Page 44 1 NOMINEES FOR ELECTION AS DIRECTOR The Board of Directors has designated the six persons hereinafter listed to be nominees for election as Directors of the Corporation at the Annual Meeting. Proxies solicited by the Board of Directors will be voted as directed therein with respect to the election of Directors; but if no choice is specified in any proxy, then such proxies will be voted for such nominees. The entire Board of Directors is elected annually and each Director is elected to serve until his successor is duly elected and qualified unless the Directorship is eliminated, in which case the Directorship will expire at the next Annual Meeting. Each of the nominees has consented to serve as a Director if he is elected. If for any reason any such nominee for election should become unavailable for election, a circumstance the Board of Directors does not anticipate, discretionary authority may be exercised for a substitute nominee. The persons named in proxies hereby solicited reserve the right, exercisable in their sole discretion, to vote proxies cumulatively so as to elect all or as many as possible of such nominees depending upon circumstances at the meeting. NOMINEES FOR REELECTION AS DIRECTOR: William E. Bendix Mr. Bendix is President, Chief Executive Officer and a Director of Mark Controls Corporation, a NASDAQ listed company, and has held this position since 1987. Mark Controls Corporation is a manufacturer of industrial valves, liquid temperature control devices and electronic controllers. Prior to that, Mr. Bendix was Group Vice President and a Director and was responsible for five of the company's business units. Mr. Bendix joined Mark Controls as Vice President of Manufacturing in 1969, was subsequently named Vice President of Operations and was elected a Director in 1973. Prior to joining Mark Controls, Mr. Bendix was a principal at Theodore Barry and Associates, a management consulting firm with a practice emphasizing operations management. Mr. Bendix is a Director of DEP Corporation, the former Chairman of the Valve Manufacturers Association of America, and a former Director of Sargent-Welch Scientific Company. Mr. Bendix is 59 years of age. John H. Deininger Mr. Deininger is Chief Executive Officer and President of Union City Body Company, L.P., a manufacturer of truck bodies. He is a retired Executive Vice President of Illinois Tool Works, Inc., a manufacturer of engineered components and industrial systems. He was formerly President, Chief Operating Officer and a Director of Signode Industries, Inc., now a wholly-owned subsidiary of Illinois Tool Works, Inc. Mr. Deininger is currently a Director of Eljer Industries, a New York Stock Exchange listed company which manufactures and markets plumbing and heating ventilation products. Mr. Deininger is also a Director of Life Fitness, Inc., a maker of exercise and fitness equipment and a Director of Wayn-Tex, Inc., a manufacturer of plastic woven for the carpet and food packaging industries. He formerly was a Director for Allied Tube & Conduit, a manufacturer of metal tubing for plumbing and electrical use. He is also a part-time consultant on industrial business operations. Mr. Deininger is 62 years of age. Page 45 2 Donald B. Hamister Mr. Hamister is Chairman of Joslyn Corporation's Board of Directors. Mr. Hamister joined Joslyn in 1939. He became an Operating Manager of the Corporation in 1958 and was elected a Vice President and Director of the Corporation in 1973. He was elected President and Chief Executive Officer in 1978 and Chairman of the Board in 1979. He retired as President and Chief Executive Officer of the Corporation in 1985, was reelected to the position of Chief Executive Officer in 1986, and held that position until 1987. He was reelected as Chief Executive Officer in 1991 and held that position through December, 1992. Mr. Hamister served in the United States Navy from 1942 to 1946 attaining the rank of lieutenant. He is a member of the Institute of Electrical and Electronics Engineers and the Airline Avionics Institute. He served as Chairman of the Airline Avionics Institute from 1972 to 1974. Mr. Hamister is 73 years of age. Raymond E. Micheletti Mr. Micheletti is President and Chief Executive Officer of Joslyn Corporation. He joined Joslyn in 1966, became General Manager of the Joslyn Hi-Voltage Equipment Division in 1972, was named Vice President of the Corporation in 1976, and assumed the additional responsibility of Joslyn's Wood Products Group. In 1984, he led the acquisition of a new business unit, Joslyn Clark Controls, Inc. He was named a Senior Vice President of the Corporation in 1988 with responsibility for the Industrial Controls business segment. In 1991, Mr. Micheletti was elected President and a Director of the Corporation. He led the acquisition of a new business unit, Joslyn Jennings Corporation, in 1992 and later that year was elected to his current position with the Company. He is a graduate electrical engineer and a member of the Institute of Electrical and Electronics Engineers. Mr. Micheletti is 68 years of age. Richard C. Osborne Mr. Osborne is President, Chief Executive Officer and Chairman of the Board of Scotsman Industries, Inc., a New York Stock Exchange listed company. Scotsman is a leading manufacturer of refrigeration products primarily serving the foodservice, hospitality, beverage, bakery and healthcare industries, with a secondary focus on luxury appliances for the consumer market. Mr. Osborne previously held the position of Executive Vice President of Household Manufacturing, Inc. from 1982 to 1989, and from 1979 to 1982 was President of Structo and Halsey Taylor, a division of Household Manufacturing, Inc. Mr. Osborne was the Director of Manufacturing of Pillsbury Company from 1967 to 1979, and began his career as an Engineer with the Chevrolet Division of General Motors. Mr. Osborne is 50 years of age. Lawrence G. Wolski Mr. Wolski is Executive Vice President, Chief Financial Officer, and Director of the Utility Systems Group. He joined Joslyn in 1974 as Controller, having been employed previously by Arthur Andersen & Co. for eight years, his last position being that of Audit Manager. In 1976, he was elected Vice President, Finance, of the Corporation. He was elected Chief Financial Officer of the Corporation in 1980, Senior Vice President in 1987, and Executive Vice President in 1993. Mr. Wolski was elected a Director of the Corporation in 1981. Mr. Wolski is 49 years of age. SECURITY OWNERSHIP OF MANAGEMENT ON MARCH 3, 1994 The following table sets forth information about the beneficial ownership of Common Stock for each Director and nominees for Director, each Executive Officer named in the Summary Compensation Table in this Proxy Statement, and all Directors and Executive Officers of the Corporation as a group as of March 3, 1994. Page 46 3 Directors and Number Nominees of Shares(a) ______________ _____________ William E. Bendix . . . . . . . . . . . . . . . . . . 2,000 John H. Deininger . . . . . . . . . . . . . . . . . . 900 Donald B. Hamister . . . . . . . . . . . . . . . . . 12,000 Raymond E. Micheletti . . . . . . . . . . . . . . . . 25,937 Richard C. Osborne . . . . . . . . . . . . . . . . . 750 Lawrence G. Wolski . . . . . . . . . . . . . . . . . 36,664 Certain Executive Officers _________________ Wayne M. Koprowski . . . . . . . . . . . . . . . . . 20,044 Steven L. Thunander . . . . . . . . . . . . . . . . . 21,645 A. Russell Gray . . . . . . . . . . . . . . . . . . 11,541 Directors and Officers as a Group . . . . . . . . . . 155,897 ____________ (a) Includes shares Executive Officers have the right to acquire pursuant to the Corporation's Employee Stock Benefit and Stock Option Plans. The number of shares which each of the above individuals have the right to acquire are: Mr. Micheletti 12,253 shares; Mr. Wolski 22,664 shares; Mr. Koprowski 15,044 shares; Mr. Thunander 18,356 shares; and Mr. Gray 6,136 shares. In addition to the shares shown as owned by the nominees in the preceding table, the following approximate number of shares are held by the Profit Sharing Plan in which the individuals named have shared voting power as to those shares: Mr. Micheletti 1,698 shares; Mr. Wolski 1,451 shares; Mr. Koprowski 800 shares; Mr. Thunander 1,125 shares; and Mr. Gray 539 shares. None of the Director nominees or Executive Officers hold 1.0% or more of the outstanding shares of the Corporation. PRINCIPAL HOLDERS OF VOTING SECURITIES The following table sets forth certain information regarding the beneficial ownership of the Corporation's Common Shares on December 31, 1993, by each person known by management to be the beneficial owner of more than 5% of the outstanding shares of the Corporation: Name and Address of Amount and Nature of Percent Beneficial Owner Beneficial Ownership of Class ____________________ ____________________ _________ Robert D. MacDonald, James H. Ingersoll & . . . . . 659,438(a) 9.3% David L. Everhart, Trustees 150 N. Michigan Avenue, Suite 2500 Chicago, Illinois 60601 Joslyn Retirement Plans' Company Stock Trust . . . . 454,472(b) 6.4% 30 South Wacker Drive Chicago, Illinois 60606 Pioneering Management Corporation . . . . . . . . . 430,337(c) 6.1% 60 State Street Boston, Massachusetts 02109 Page 47 4 ___________________ (a) Includes 515,645 shares held by Messrs. MacDonald, Ingersoll and Everhart as co-trustees of the Alice Newell Joslyn Trust and the Marcellus Lindsey Joslyn Trust. These trusts have sole voting and dispositive power with respect to the shares in each trust. In addition to the 515,645 shares held with co-trustees Messrs. Ingersoll and Everhart, Mr. MacDonald holds 143,793 shares as a trustee of four other trusts. (b) Joslyn Retirement Plans' Company Stock Trust ("Trust") has sole voting and investment power for 43,173 of such shares and shared voting and investment power for 411,299 of such shares. The Trust beneficially owns certain of the above shares for the Corporation's Employees' Savings and Profit Sharing Plan ("Profit Sharing Plan") and the Trustee has power to dispose of such shares; provided, however, that in the event of a tender or exchange offer, the participants generally have the right to direct the Trustee on how to respond to the tender or exchange offer. (c) Pioneering Management Corporation has reported in its Form 13G that it has sole voting power as to 430,337 shares and shared dispositive power as to 430,337 shares. BOARD OF DIRECTORS AND COMMITTEES The Board of Directors has standing Audit, Compensation and Nominating Committees. Messrs. William E. Bendix, Donald B. Hamister, Richard C. Osborne and Walter W. Schoenholz were the members of the Audit Committee during 1993. Messrs. John H. Deininger, Hamister, Osborne and Schoenholz were members of the Compensation Committee during 1993. Messrs. Raymond E. Micheletti, Bendix, Deininger, and Hamister were members of the Nominating Committee during 1993. In addition, the Board of Directors formed an ad hoc Succession Committee for the purpose of identifying candidates for the position of President and Chief Executive Officer to succeed Mr. Micheletti upon his retirement. Messrs. Bendix, Deininger, Hamister, Osborne and Schoenholz were members of the Succession Committee in 1993. Among other responsibilities, the Audit Committee recommends the selection of the independent public accountants, reviews the scope and procedures of the planned audit activities and reviews the results of the audits. The Audit Committee considers and approves in advance non-audit services performed by the independent public accountants to determine that such services do not compromise their independence. The Compensation Committee recommends the compensation to be paid for the services of the Directors and Executive Officers of the Corporation. The Nominating Committee develops criteria for Directors, evaluates the qualifications of and interviews prospective candidates for the Board of Directors of the Corporation and makes recommendations to the Directors of nominees for election to the Board of Directors of the Corporation. During 1993, there were two meetings for each of the Audit and Compensation Committees and one meeting of the Succession Committee. There were five meetings of the Board of Directors in 1993. All members of the Board attended all of the meetings of the Board, and all members of the Committees attended all meetings of the Committees of the Board. COMPENSATION OF DIRECTORS Directors of the Corporation who are employees serve without additional compensation. Directors of the Corporation who are not employees of the Corporation each receive an annual compensation payment of $19,000. These Directors also receive $700 for each meeting of the Board of Directors or a Committee thereof attended and $700 for each day or fraction thereof spent in the conduct of the Corporation's business other than Board or Board Committee meetings. The Chairman of the Board of Directors receives an additional $10,000 per year to serve in that capacity. Page 48 5 Directors who are not employees may elect to become participants in the Deferred Compensation Plan in order to defer all or a portion of their fees. Deferred fees otherwise payable are credited to a participant's Deferred Fee Account bearing an annual interest rate. Upon termination of their services, payment from the Deferred Fee Account will be paid to the former Directors in installments. SUMMARY COMPENSATION TABLE The following table sets forth the compensation paid or to be paid for the fiscal year 1993 to the Chief Executive Officer and to the four most highly compensated Executive Officers of the Corporation. A more detailed explanation follows the table. Name and Principal Fiscal All Other Position Year Salary(1) Bonus Compensation(2) ____________________ _______ _________ _______ _______________ Raymond E. Micheletti 1993 $299,224 $91,125 $15,485 President and Chief 1992 250,557 107,800 16,078 Executive Officer 1991 219,657 76,223 14,812 Lawrence G. Wolski 1993 $237,548 $73,552 $15,485 Exec. Vice President, 1992 233,001 82,854 16,078 Chief Financial Officer 1991 220,534 71,320 14,812 Wayne M. Koprowski 1993 $148,610 $32,400 $10,716 Vice President 1992 145,157 40,625 13,845 1991 136,718 36,963 9,849 Steven L. Thunander 1993 $164,882 $25,000 $5,839 Vice President 1992 163,800 28,529 7,997 1991 163,132 10,000 4,796 A. Russell Gray 1993 $134,000 $25,746 $10,727 Dir., Communications 1992 130,000 7,450 8,536 & Defense Group 1991 125,000 18,237 10,751 ______________________ 1) Salary includes base compensation and contributions made under the Joslyn Corporation Retirement Parity Compensation Plan ("Parity Plan"). Certain Executive Officers of Joslyn Corporation are participants in the Parity Plan. The Parity Plan provides annual payments to eligible employees who may elect to deposit their payments in an individual trust. Each trust provides for distribution upon: (1) retirement after attaining age 60, (2) disability or death, (3) attaining age 65, or (4) termination of employment prior to age 60. The 1993 Parity Plan amount for eligible individuals listed in the Summary Compensation Table were: Mr. Micheletti $29,224; Mr. Wolski $23,548; Mr. Koprowski $13,610; and Mr. Thunander $14,882. 2) "All Other Compensation" is comprised of contributions on behalf of the Executive Officers to the Corporation's Profit Sharing Plan, a defined plan, except that it also includes a $1,000 director fee for Messrs. Gray and Thunander for being subsidiary company board members. Page 49 6 STOCK OPTION/SAR GRANTS IN 1993 The following tables show, as to the Chief Executive Officer and the four most highly compensated Executive Officers of the Corporation, information with respect to grants of non-qualified stock options and stock exercises for the period January 1, 1993 to December 31, 1993. Non-Qualified Option grants awarded December 31, 1993 _______________________ (1) All options were granted on December 31, 1993, and first become exercisable on June 29, 1994. (2) The Base Price equals the average of the last reported high and low transactions of Common Shares on the NASDAQ National Market System on the date of the grant of options. Aggregated Option/SAR Exercises in 1993 and Fiscal Year-end Option/SAR Values This table provides the number of shares acquired by stock option exercise during 1993. The value realized is the difference between the market price on the date of exercise and the base price multiplied by the number of shares exercised. The table also provides the year-end value of all stock options and Stock Appreciation Rights ("SARs") granted to but not yet exercised by each executive. The value represents the difference of the market price on December 31, 1993 and the base price multiplied by the number of outstanding options. This value may go up or down as the stock price fluctuates and is not realized until exercised. DEFINED BENEFIT PENSION PLAN Salaried employees participated in the Employees' Supplemental Retirement Plan of Joslyn Corporation ("Pension Plan") until December 31, 1988 when the Pension Plan was frozen. Therefore, no additional benefit accruals for either additional employment service or compensation increases will be incurred. The estimated annual benefits payable upon retirement at age 65 for each of the individuals named in the Summary Compensation Table are as follows: Mr. Micheletti $40,158; Mr.Wolski $76,068; Mr. Koprowski $13,687; Mr. Thunander $34,976 and Mr. Gray $0. Page 50 7 EMPLOYMENT AGREEMENTS The Corporation has entered into separate employment agreements with the following individuals: Messrs. Raymond E. Micheletti (President, Chief Executive Officer and a Director) and Lawrence G. Wolski (Executive Vice President, Chief Financial Officer and a Director). Each agreement provides for an annual salary to be paid to the employee at least equal to that being received at the date of the agreement. The agreements expire on March 31, 1994 as to Mr. Micheletti, and on December 31, 1996 as to Mr. Wolski. These agreements may be earlier terminated by Joslyn upon 180 days written notice. Messrs. Micheletti and Wolski each are entitled to receive salary at the rate in effect at the date of notice for a period of 18 months following termination of employment conditioned upon their rendition of consulting services to Joslyn for the remaining term of their Agreement. However, Joslyn may terminate an agreement within such period if the employee accepts other employment prior to the expiration of the period, and Joslyn reasonably determines the new employment to be in conflict or competition with Joslyn. Upon the death of any such employee, his legal representative is entitled to receive his salary payable to the end of the month following the month in which death occurs, plus incentive compensation for the fiscal year extended to the last day of the month following date of death, plus an amount equal to the monthly base salary in effect at the time of death multiplied by three. Mr. Micheletti has announced his intention to retire at the end of 1994 from his position of President and Chief Executive Officer and therefore his agreement will not be extended. JOSLYN CORPORATION STOCK PERFORMANCE GRAPH The graph provided below compares Joslyn Corporation's cumulative shareholder total return with that of the NASDAQ Composite Index and the Dow Jones Electrical Equipment Group. The comparison is made by calculating the difference in share price from December 31, 1988, and December 31, 1993 and including the cumulative amount of dividends, assuming reinvestment, during this five year period. An initial investment of $100.00 has been used as a common point of reference. Comparative Five Year Cumulative Total Return - GRAPH - Page 51 8 For ease of comparison, the table below provides the data utilized in the graph. The table assumes an investment of $100.00 on December 31, 1988 and indicates the appreciation or depreciation of each investment over a five year period. REPORT OF THE COMPENSATION COMMITTEE ON EXECUTIVE COMPENSATION The Compensation Committee of the Board of Directors is responsible for reviewing and approving to the Board compensation for the Executive Officers of the Corporation, including the Chief Executive Officer and the four most highly compensated Executive Officers. The Committee reviews base salaries and corporate and individual bonus goals of the Chief Executive Officer and of the Executive Officers as recommended by the Chief Executive Officer. The Committee also approves all grants of stock options under the Corporation's Stock Option Plan. All Committee members are non-employee, outside directors of the Corporation. Compensation Philosophy The Corporation seeks to link Executive Officer compensation to profitability resulting in enhanced shareholder value. The compensation philosophy has the following objectives: - to attract and retain quality management - to encourage and reward performance on an individual, business unit and corporate basis - to reward both short term and long term performance - to tie executive compensation to long term growth of shareholder value The Corporation's executive compensation program is comprised of a base salary, an annual incentive bonus program and a long term incentive compensation plan in the form of stock options. In addition, Executive Officers are eligible to participate in various benefit plans, including medical insurance coverage and profit sharing, which are available to all employees. Base Salary Base salaries for Executive Officers are determined in consideration of each Executive Officer's position, responsibilities, experience and performance. In setting compensation, the Committee takes into account the national marketplace for a group of companies consisting of Page 52 9 electrical and electronics manufacturing companies of similar size (annual sales between $100 and $600 million) in the Corporation's labor market ("Labor Market Group"). The Committee decided against using the companies in the industry peer group as reflected in the Performance Graph because the Committee believes that the comparatively large size of many of the peer group companies distorts compensation levels for similar positions. Each Executive Officer's base salary is initially set at the median for similar positions within the Labor Market Group. The Committee annually reviews and may adjust individual salaries of all Executive Officers including the Chief Executive Officer and the four highest compensated Executive Officers taking into account compensation guidelines (utilizing executive compensation surveys, outside compensation specialists, or both), business performance and individual performance. Business performance is evaluated in reference to both actual corporate earnings results and comparative results of the companies in the Corporation's industry peer group as reflected in the Performance Graph. The factors impacting base salary are not independently assigned specific weights. Rather, the Committee reviews all the factors and makes salary recommendations which reflect the Committee's analysis of the aggregate impact of these factors. Mr. Micheletti's 1992 base salary of $220,000 was increased to $270,000 in 1993 in recognition of his promotion to Chief Executive Officer, the additional responsibilities that would be imposed on him in that capacity, and the Corporation's record earnings performance in 1992. The Committee used market comparisons obtained from compensation surveys for comparably sized manufacturing companies in setting his 1993 base salary. Mr. Micheletti's base salary places him about 20% below the median for chief executive officers in the Labor Market Group. Annual Incentive Bonus Program In addition to base salary, each Executive Officer is eligible for an annual incentive cash bonus award under the Executive Management Incentive Plan. The Compensation Committee believes that the plan provides an additional short term incentive to those executives who have a greater potential impact on business performance by having a larger portion of their total compensation in variable bonus opportunities. Annual cash bonuses are paid based on formulas which take into consideration attainment of corporate and business unit earnings goals and individual goals designed to improve the Corporation's overall performance. Individual performance goals are taylored to each Executive Officer's position and vary from person to person. For Executive Officers, excluding the Chief Executive Officer, potential bonus payments range from 0% to a maximum of 50% of base salary depending on the Executive Officer's position with half of the bonus potential based upon corporate or business unit earnings performance and the other half based upon individual performance. However, since actual payouts are dependent on achieving pre-determined performance goals, failure to attain those goals could result in no bonus. During 1993, the Corporation achieved its business plan earnings goals for the year and the Executive Officers, including the Chief Executive Officer and the four highest compensated Executive Officers, received cash bonuses for achieving the business plan earnings goal. For 1993, Mr. Micheletti's potential bonus ranges from 0% to 70% of base salary with a target payment of 35% of base salary. Over 70% of his annual potential bonus was based upon the attainment targeted net income goals for the plan year, with the remaining bonus based upon the achievement of individual goals. For 1993, Mr. Micheletti was awarded a bonus of $91,125, which is 33.8% of base salary based in part upon the Committee's achievement of its 1993 business plan earnings goal. Page 53 10 Long Term Incentive Compensation Plan (Stock Option Plan) The Compensation Committee believes that by providing key employees, including the Chief Executive Officer and the four highest compensated Executive Officers, who have substantial responsibility over the management and growth of the Corporation, with an opportunity to increase their ownership of the Corporation's stock, the interests of the shareholders and key employees, including Executive Officers, will be more closely aligned. The Stock Option Plan meets this objective by permitting the Corporation through the Compensation Committee to make annual grants of non-qualified stock options to key employees, including the Chief Executive Officer and the four highest paid Executive Officers. Stock options are granted with an exercise price equal to the fair market value of the Corporation's common stock on the date of grant and typically may be exercised over a period of five years. This approach is intended to motivate the key employees to contribute to the creation and growth of shareholder value over the long term. Value to the optionee is dependent upon an increase in the stock price above the exercise price. The size of each person's stock option grant is based upon a formula, originally recommended by an outside compensation consultant, which provides a range of possible grants utilizing a multiple of the optionee's base salary. The formula for determining the number of stock option grants is the base salary times a multiplier (ranging from 0.3 to 1.0), divided by the then market price of the Corporation's stock. Currently, the stock option grants awarded by the Committee place optionees approximately 66% below the median compared to optionees in the Labor Market Group. The Compensation Committee also considers previous options granted but unexercised as well as actual ownership in the Corporation's stock in making additional grants of options. In 1993, Mr. Micheletti was granted 9,273 options at an exercise price of $24.75. The option grant was below the median compared to grants typically made to chief executive officers in the Labor Market Group. Richard C. Osborne, Chairman John H. Deininger Donald B. Hamister Walter W. Schoenholz PROPOSAL TO AMEND THE ARTICLES OF INCORPORATION TO LIMIT DIRECTOR LIABILITY The proposed amendment would limit the personal liability of the Directors to the Corporation or its shareholders for monetary damages arising from breach of fiduciary duty. The proposed amendment is authorized by a change to the Illinois Business Corporation Act of 1983 that became effective January 1, 1994 and will assist the Corporation in attracting and retaining qualified individuals to serve as Directors of the Corporation. Background Until the amendment of the Illinois Business Corporation Act in July 1993, Illinois was one of the few states that had not taken action to protect corporate directors who acted in good faith but were nevertheless threatened with substantial liability from negligence claims. As a result of the change in the law, an Illinois corporation is now able to provide its directors with liability protection similar to that available to companies incorporated in a vast majority of other states, including Delaware. Liability is not limited under Illinois law if the acts or omissions of directors are in bad faith, involve intentional wrongdoing, violate certain statutory provisions, or result in profit or other advantage to which the director is not legally entitled. Page 54 11 Text of Proposed Amendment The text of the proposed amendment to be added to the Corporation's Articles of Incorporation as Article Nine is as follows: The Directors of the Corporation shall not be liable to the Corporation or to its shareholders for monetary damages for breach of fiduciary duties as a Director, provided that this provision shall not eliminate or limit the liability of a Director (i) for any breach of the Director's duty of loyalty to the Corporation or its shareholders, (ii) for acts or omissions not in good faith or that involve intentional misconduct or a knowing violation of the law, (iii) under Section 8.65 of the Illinois Business Corporation Act or (iv) for any transaction from which the Director derived an improper personal benefit. Reasons for the Proposed Amendment Directors of Illinois corporations are required, under Illinois law, to perform their duties in good faith and with that degree of care that an ordinarily prudent person in a like position would use under similar circumstances. A director may rely upon information, opinions and reports prepared by certain officers or employees, professional advisors, or committees of the Board. Decisions made on that basis are protected by the "business judgment rule" and should not be questioned by a court in the event of a lawsuit challenging such decisions. However, the expense of defending such lawsuits and the inevitable uncertainties of applying the business judgment rule to particular facts and circumstances mean, as a practical matter, that directors are not relieved of the threat of monetary damage awards. The Board of Directors of the Corporation, therefore, believes that the proposed amendment should be adopted in order to ensure that the Corporation will continue to be able to attract and retain competent, qualified and talented persons to serve as directors. Effect of the Proposed Amendment The proposed amendment would protect the Corporation's Directors against personal liability to the Corporation or its shareholders for any breach of duty unless a judgment or other final adjudication adverse to them establishes (i) a breach of the duty of loyalty to the Corporation, (ii) acts or omissions in bad faith or involving intentional misconduct or a knowing violation of the law, (iii) acts violating the prohibitions contained in Section 8.65 of the Illinois Business Corporation Act against certain improper distributions of assets, or (iv) an improper personal benefit to a Director to which he or she was not legally entitled. No claim of the type which would be affected by the proposed amendment is presently pending or, to the knowledge of management of the Corporation, threatened. The amendment as proposed would not reduce the fiduciary duty of a Director, it merely limits monetary damage awards to the Corporation and its shareholders arising from certain breaches of that duty. It does not affect the availability of equitable remedies, such as the right to enjoin or rescind a transaction, based upon a Director's breach of fiduciary duty. The amendment also does not affect a Director's liability for acts taken or omitted prior to the time it becomes effective (after shareholder approval and upon filing with the Illinois Secretary of State). The limitation of liability afforded by the proposed amendment affects only actions brought by the Corporation or its shareholders, and does not preclude or limit recovery of damages by third parties. With respect to this proposal, shareholders may direct that their votes be cast for or against such proposal, or may abstain, by marking the proper box on the Proxy. THE BOARD OF DIRECTORS RECOMMENDS A VOTE "FOR" THE PROPOSED AMENDMENT. Proxies solicited by management will be so voted unless shareholders specify a contrary choice in their proxies. For approval, the proposed requires the affirmative vote of at least two-thirds of the outstanding shares of Common Stock of the Corporation. Abstentions and broker non-votes will have the effect of a vote against the proposal. Page 55 12 RATIFICATION OF INDEPENDENT PUBLIC ACCOUNTANTS Shareholders will be asked to ratify the appointment by the Board of Directors of Arthur Andersen & Co. as independent public accountants for the Corporation and its subsidiary companies for the year 1994. Arthur Andersen & Co. served in this capacity in 1993, and has been retained by the Corporation in this capacity since 1933. THE BOARD OF DIRECTORS RECOMMENDS THAT YOU VOTE "FOR" THE RATIFICATION OF THE APPOINTMENT BY THE BOARD OF DIRECTORS OF ARTHUR ANDERSEN & CO. AS INDEPENDENT ACCOUNTANTS FOR THE YEAR 1994. Representatives of Arthur Andersen & Co. are expected to be present at the Annual Meeting. They will have an opportunity to make a statement if they wish and will be available to respond to any questions at the Annual Meeting. The Chairman of the Meeting will refer appropriate questions from Shareholders to the representatives of Arthur Andersen & Co. for response. SHAREHOLDER PROPOSAL FOR 1995 ANNUAL MEETING The 1995 Annual Meeting of the Shareholders of the Corporation is expected to be held on April 26, 1995. If any Shareholder wishes a proposal to be considered for presentation at the 1995 Annual Meeting, such proposal must be received by the Corporation at its offices at 30 South Wacker Drive, Chicago, Illinois 60606 not later than November 29, 1994. OTHER MATTERS The Board of Directors does not know of any matters to be presented at the meeting other than those mentioned in the Notice of Annual Meeting of Shareholders. However, if other matters come before the meeting, it is the intention of each person named in the accompanying Proxy to vote said Proxy in accordance with his judgment of such matters. The Notice of Annual Meeting of Shareholders and Proxy Statement are hereby sent by order of the Board of Directors. Chicago, Illinois March 25, 1994 Page 56 13

85408_1993.txt

85408_1993

1993

85408

ITEM 1. BUSINESS Rowan Companies, Inc.(the "Company"), organized in 1947 as a Delaware corporation and a successor to a contract drilling business conducted since 1923 under the name Rowan Drilling Company, Inc., is engaged principally in the contract drilling of oil and gas wells in domestic and foreign areas. As noted below, it also provides aircraft services and, since February, 1994, has operated a mini-steel mill, a heavy equipment manufacturing operation and a marine rig construction yard through the purchase of the net assets of Marathon LeTourneau Company. Offshore operations of the Company consist primarily of contract drilling services utilizing mobile rigs, principally a fleet of 20 self-elevating drilling platforms ("jack-up rigs"), including three heavy duty cantilever jack-up rigs ("Gorilla Class rigs") delivered in the 1984-86 period. Beginning in 1992, the Company has moved towards Total Project Management, an approach to drilling operations which emphasizes drilling and completing wells on a turnkey basis. In that same year it began providing offshore platform installation and removal services. The Company provides contract and charter helicopter and fixed-wing aircraft services. In Alaska and in the Gulf of Mexico, services provided are primarily to support oil and gas related operations, with the Company's fleet consisting on March 1, 1994 of 94 helicopters and 15 fixed-wing aircraft. Since 1991, the Company has owned a 49% interest in a Dutch-based joint venture company, KLM ERA Helicopters B.V. ("KLM ERA"), which owns a fleet consisting of 10 helicopters in the Dutch and British sectors of the North Sea and one helicopter in Canada. On February 11, 1994, the Company purchased through its wholly-owned subsidiary, LeTourneau, Inc., the net assets of Marathon LeTourneau Company for $52.1 million with $10.4 million cash paid at the time of the purchase and the balance being seller-financed by promissory notes bearing interest at 7% and payable at the end of five years. LeTourneau, Inc. operates a mini-steel mill that recycles scrap and produces alloy steel and steel plate; a manufacturing facility that produces heavy equipment for the mining, timber and material handling industries including, among other things, front-end loaders up to 50 ton-capacity and trucks under the registered trademark, Titan, up to 240 ton capacity; and a marine division that has built over one-third of all mobile offshore jack-up drilling rigs, including all 20 operated by Rowan. Information regarding revenues, operating profit, identifiable assets and export sales of the Company's industry segments and foreign and domestic operations for each of the three years in the period ended December 31, 1993, is incorporated by reference herein and provided in Footnote 10 of the Notes to Consolidated Financial Statements on page 25 of the Company's Annual Report to Stockholders for the fiscal year ended December 31, 1993 ("Annual Report"), incorporated portions of which are filed as Exhibit 13 hereto. Information on the Company's manufacturing segment is not provided since the purchase occurred after year-end 1993. In the years 1991, 1992 and 1993, the Company had revenues from individual customers representing more than 10% of consolidated revenues as follows: Conoco, Inc. - 23% and 11% for 1991 and 1992, respectively; and Shell Oil Company - 12% for 1991 and Phillips Petroleum Company - 17% for 1993. Such revenues were primarily from drilling operations. For a discussion of the Company's availability of funds for future operations and estimated capital expenditures for 1994 which would be in addition to the $52.1 million purchase of the net assets of Marathon LeTourneau, see "Liquidity and Capital Resources" under "Management's Discussion and Analysis of Financial Condition and Results of Operations" on page 14 of the Annual Report, which information is incorporated herein by reference. CONTRACT DRILLING In 1993, drilling operations generated an operating profit (income from operations before deducting general and administrative expenses) of $19.1 million. Offshore Operations At December 31, 1993, the Company's drilling fleet consisted of 20 deep-water jack-up rigs (eight conventional and twelve cantilever, including three Gorilla Class rigs in the latter category), one semi-submersible rig and three submersible barge rigs. The Company owns all of the rigs comprising its fleet except for two cantilever jack-up rigs leased under sale/leaseback arrangements expiring in 1999 and 2000. Since completing a major drilling rig expansion program conducted in the early to mid-1980s, the Company's capital expenditures have been primarily for improvements to existing drilling rigs and the purchase of aircraft. Adding to these capital expenditures was the November 1991 acquisition of the 49% interest in KLM ERA and the February 1994 purchase of the net assets of Marathon LeTourneau. See ITEM 2. ITEM 2. PROPERTIES The Company leases as its corporate headquarters 57,800 square feet of space in an office tower located at 2800 Post Oak Boulevard in Houston, Texas. DRILLING RIGS The following is a summary of the principal drilling equipment owned or operated by the Company and in service at March 31, 1994. See "Liquidity and Capital Resources" as appearing in "Management's Discussion and Analysis of Financial Condition and Results of Operations" on page 14 in the Annual Report which page is incorporated herein by reference. OFFSHORE ITEM 2. PROPERTIES OFFSHORE(Continued) ITEM 2. PROPERTIES (Continued) ______________________ (a) Classes 200-C ("Gorilla"), 116-C, 116, 84 and 52 are nomenclature assigned by LeTourneau, Inc. to jack-ups of its design and construction. (b) Indicates rated water depth in current location and rated drilling depth, respectively. (c) Unit modified to increase operating capability in hostile environments. (d) Gorilla Class unit designed for hostile environment capability. (e) Unit equipped with a "top drive" drilling system. (f) Unit equipped with a "skid base" unit. (g) Unit equipped with drilling/heavy-lift crane option. (h) Unit equipped with leg extensions. (i) Rig sold December 1984 and leased back for 15 years. (j) Rig sold December 1985 and leased back for 15 years. (k) Onshore rigs, including the three used rigs purchased in 1991, were constructed at various dates between 1960 and 1982, utilizing, in some instances, new as well as used equipment. Most of the older rigs have been substantially rebuilt subsequent to their respective dates of construction. (l) Refer to "Contracts" on page 4 of this Form 10-K for definition of types of contracts. (m) Indicates estimated completion date of work to be performed. (n) Currently under tow from Alaska. (o) Rigs currently being shipped to the United States. The Company's Drilling Division leases and, in some cases, owns various operating and administrative facilities generally consisting of office, maintenance and storage space in the states of Alaska, Texas and Louisiana and, on a foreign basis, in the countries of Canada, Venezuela, England, Scotland, The Netherlands, and Trinidad. AIRCRAFT At March 1, 1994 the U.S.-based Company-owned helicopter fleet consisted of 14 twin-engine turbine IFR rated Bell 212 helicopters (14 passenger), 16 twin-engine turbine IFR rated Bell 412 helicopters (14 passenger), 31 twin-engine turbine MBB BO-105CBS helicopters (five passenger), two Aerospatiale 332L Super Puma helicopters (19 passenger) and 31 various single-engine turbine helicopters (four to six passenger). The U.S.-based fixed-wing fleet of Company-owned aircraft consisted of four Convair 580s (44 passenger), nine DeHavilland Twin Otters (9-19 passenger), one DeHavilland Dash 8 (37 passenger), one Lear Jet 35A (six passenger) and one Beechcraft King Air 200C (six passenger). Helicopters owned by KLM ERA on March 1, 1994 consisted of six twin-engine turbine IFR rated Sikorsky S-61N helicopters (26 passenger) and five twin-engine turbine IFR rated Sikorsky S-76B helicopters (13 passenger). The Company's principal aircraft bases in Alaska, all located on leased property, are a fixed-wing air service center (57,000 square feet of hangar, repair and office facilities) at Anchorage International Airport, with an adjacent helicopter hangar facility (14,800 square feet) and hangar, office and repair facilities at Fairbanks International Airport (13,000 square feet). The Company also maintains similar, smaller helicopter facilities in Alaska at Deadhorse, Juneau, Valdez and Yakutat. The Company's principal facilities to accommodate its Gulf of Mexico operations are located on leased property at Lake Charles Regional Airport.The facilities, comprising 53,000 square feet, include helicopter hangars, a repair facility and an operations and administrative building. The Company also operates a helicopter facility (20,700 square feet of hangar, repair and office facilities) located on leased property at the Terrebonne Airport in Houma, Louisiana and a helicopter facility (5,700 square feet of hangar, repair and office facilities) located on leased property in New Iberia, Louisiana. KLM ERA's principal facilities to accommodate its operations in the Dutch sector of the North Sea include bases in Amsterdam and Den Helder. The Amsterdam facility, comprising 149,000 square feet leased and 17,000 square feet subleased, includes helicopter hangars, a repair facility, an operations/administrative building and a passenger waiting area. The Den Helder facility, comprising 35,000 square feet, includes a helicopter hangar, a repair facility and an operations/administrative building. The Amsterdam operations are scheduled for shutdown and consolidation with the Den Helder operations by the fourth quarter of 1994. Manufacturing Facilities LeTourneau's principal manufacturing facility and headquarters are located in Longview, Texas on approximately 2,400 acres with approximately 1.2 million square feet under roof. Included within the facility are: A mini-steel mill having approximately 330,000 square feet of covered work space and housing two 25-ton electric arc furnaces having an aggregate 120,000 tons per year capacity; a fabrication shop having approximately 300,000 square feet of covered work space and housing a 3,000 ton vertical bender for making roll-ups or flattening materials up to 2 1/2 inches thick by 11 feet wide; a machine shop having approximately 140,000 square feel of covered work space and housing various types of machinery; and an assembly shop have approximately 124,000 square feel and housing various types of machinery. The marine division's facility located in Vicksburg, Mississippi is located on 1,850 acres of land and has approximately 476,000 square feet of covered work space. This facility is currently closed and the businesses formerly carried on at this location have been relocated to the Longview, Texas facility. The LeTourneau Portland Division's distributor for forest products in the Northwestern United States, is located on a six acre site in Troutdale, Oregon with approximately 22,000 square feet of building space. The Western Mining Division of LeTourneau located in Tucson, Arizona is housed in a 20,000 square foot leased facility. It functions as the distributor for LeTourneau's mining equipment products in the Western United States. ITEM 3. ITEM 3. LEGAL PROCEEDINGS The Company is involved from time to time in litigation arising out of the conduct of the Company's operations and other matters, not all the potential liabilities with respect to which are covered by the terms of the Company's insurance policies. While the Company is unable to predict the ultimate liabilities which may result from such litigation, the Company believes that no such litigation in which the Company was involved as of March 31, 1994 will have a material adverse effect on the financial position or results of operations of the Company. 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 common stockholders during the fourth quarter of the fiscal year ended December 31, 1993. ADDITIONAL ITEM. EXECUTIVE OFFICERS OF THE REGISTRANT The names, positions, years of accredited service and ages of the officers of the Company and certain officers of the Company's wholly-owned subsidiary, Era Aviation, Inc., as of March 24, 1994 are listed below. Officers of both entities are normally appointed annually by the entities' Board of Directors at the bylaws prescribed meetings held in the spring and serve at the discretion of the Board of Directors. There are no family relationships among these officers, nor any arrangements or understandings between any officer and any other person pursuant to which the officer was selected. Years of Accredited Name Position Service Age - -------------------- -------------------------------- ---------- ----- Executive Officers of the Registrant: C. R. Palmer Chairman of the Board, President 34 59 and Chief Executive Officer R. G. Croyle Executive Vice President 20 51 D. F. McNease Senior Vice President, Drilling 19 42 John L. Buvens Vice President, Legal 13 38 James B. Davis Vice President, Engineering 20 43 Paul L. Kelly Vice President, Special Projects 11 54 Bill S. Person Vice President, Industrial Relations 26 45 William C. Provine Vice President, Investor Relations 7 47 E. E. Thiele Vice President, Finance, Adminis- 24 54 tration and Treasurer Other Officers of the Registrant: Mark H. Hay Secretary and Assistant Treasurer 15 49 P. G. Wheeler Assistant Treasurer 19 46 Lynda A. Aycock Assistant Treasurer 22 47 Certain Officers of Era Aviation, Inc.: C. W. Johnson President and Chief Operating Officer 16 50 James Vande Voorde Vice President 20 54 Each of the executive officers and other officers of the Company and the two officers of Era Aviation, Inc. listed above continuously served in the position shown above for more than the past five years except as noted in the following paragraphs. Since October 1993, Mr. Croyle's principal occupation has been in the position set forth. For more than five years prior to that time, Mr. Croyle served as Vice President, Legal of the Company. Since October 1993, Mr. McNease's principal occupation has been in the position set forth. From April 1991 to October 1993, Mr. McNease served as Vice President, Drilling of the Company. For more than five years prior to that time, he served as Vice President of Rowandrill, Inc., a subsidiary of the Company. Since October 1993, Mr. Buvens' principal occupation has been in the position set forth. For more than five years prior to that time, Mr. Buvens served as an Attorney for the Company. Since October 1993, Mr. Davis' principal occupation has been in the position set forth. From January 1990 to October 1993, Mr. Davis served as Manager of Engineering/Purchasing & Chief Engineer of the Company. From June 1989 to January 1990, he served as, he served as an Engineer for the Company. For more than five years prior to that time, he served as a Tool Pusher for the Company. Since October 1993, Mr. Person's principal occupation has been in the position set forth. From April 1990 to October 1993, Mr. Person served as Director of British American Offshore Limited, a subsidiary of the Company. For more than five years prior to that time, he served as Manager of Industrial Relations of the Company. Since October 1993, Mr. Provine's principal occupation has been in the position set forth. For more than five years prior to that time, Mr. Provine served as Vice President of Rowandrill, Inc., a subsidiary of the Company. Since January 1994, Mr. Thiele's principal occupation has been in the position set forth. From February 1989 to January 1994, Mr. Thiele served as Vice President, Administration and Finance. Since October 1993, Ms. Aycock's principal position has been in the position set forth. For more than five years prior to that time, Ms. Aycock served as an Accountant for the Company. Since December 1993, Mr. Johnson's principal occupation has been in the position set forth. For more than five years prior to that time, Mr. Johnson served as Executive Vice President of Era Aviation, Inc., a subsidiary of the Company. In addition to serving in the position shown above, Mr. Wheeler has also served as Corporate Tax Director of the Company for more than five years. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS The information required hereunder regarding the Common Stock price range and cash dividend information for 1993 and 1992 and the number of holders of Common Stock is set forth on page 26 of the Company's Annual Report under the title "Common Stock Price Range, Cash Dividends and Stock Splits", and is incorporated herein by reference, except for the final two paragraphs under such title. Also incorporated herein by reference to the Annual Report is the first paragraph in the right hand column appearing on page 14 within "Management's Discussion and Analysis of Financial Condition and Results of Operations", such paragraph providing information pertinent to the Company's ability to pay cash dividends subject to certain restrictions. The Company's Common Stock is listed on the New York Stock Exchange and the Pacific Stock Exchange. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The information required hereunder is set forth on pages 10 and 11 of the Company's Annual Report under the title "Twelve Year Financial Review" and is incorporated herein by reference except for the information for the years 1988, 1987, 1986, 1985, 1984, 1983, and 1982. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The information required hereunder is set forth on pages 12, 13 and 14 under the title "Management's Discussion and Analysis of Financial Condition and Results of Operations" in the Company's Annual Report and is incorporated herein by reference. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Refer to ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K on page 21 of this Form 10-K for a listing of financial statements of the registrant and its subsidiaries, all of which financial statements are incorporated by reference under this item. 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 provided under the columns entitled Name, Principal Occupation for the Past Five Years, Age and Year First Became Director in the table on pages 5 and 6, in footnotes (1) and (3) on page 6 and in the paragraph following footnote (5) on page 4 of the Proxy Statement for the Company's 1994 Annual Meeting of Stockholders (the "Proxy Statement") is incorporated herein by reference. There are no family relationships among the directors or nominees for directors and the executive officers of the Company, nor any arrangements or understandings between any director or nominee for director and any other person pursuant to which such director or nominee for director was selected. Except as otherwise indicated, each director or nominee for director of the Company has been employed or engaged for the past five years in the principal occupation set forth opposite his name in the information incorporated by reference. See ADDITIONAL ITEM. EXECUTIVE OFFICERS OF THE REGISTRANT on pages 18 and 19 of this Form 10-K for information relating to executive officers. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The standard arrangement for compensating directors described in footnote (2) on page 6 of the Proxy Statement and the information appearing under the titles "Summary Compensation Table", "Option Grants in Last Fiscal Year", Aggregated Option Exercises in Last Fiscal Year and Fiscal Year-End Option Values", "Option Plans", "Convertible Debenture Incentive Plan" and "Pension Plans" on pages 8 through 11 of the Proxy Statement are incorporated herein by reference. In accordance with the instructions to Item 402 of Regulation S-K, the information contained in the Proxy Statement under the titles "Board Compensation Committee Report on Executive Compensation" and "Stockholder Return Performance Presentation" shall not be deemed to be filed as part of this Form 10-K. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information regarding security ownership of certain beneficial owners and management of the Company set forth under the headings "Voting Securities Outstanding" appearing on page 2 and "Security Ownership of Management and Principal Stockholders" appearing on pages 2 through 4 of the Proxy Statement is incorporated herein by reference. The business address of all directors is the principal executive offices of the Company as set forth on the facing page of this Form 10-K. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Information regarding certain business relationships and transactions between the Company and certain of the directors of the Company under the heading "Certain Transactions" appearing on page 14 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 financial statements and independent auditors' report, included in the Annual Report, are incorporated herein by reference: Page of 1993 Annual Report ------------- Independent Auditors' Report............................. 15 Consolidated Balance Sheet, December 31, 1993 and 1992.............................. 16 Consolidated Statement of Operations for the Years Ended December 31, 1993, 1992 and 1991............ 17 Consolidated Statement of Changes in Stockholders' Equity for the Years Ended December 31, 1993, 1992 and 1991................................................ 18 Consolidated Statement of Cash Flows for the Years Ended December 31, 1993, 1992 and 1991........ 19 Notes to Consolidated Financial Statements............... 20 Selected Quarterly Financial Data (Unaudited) for the Quarters Ended March 31, June 30, September 30 and December 31, 1993 and 1992.......................... 26 2. Financial Statement Schedules Page of This Report ----------- Independent Auditors' Report.............................. 27 V - Property and Equipment for the Years Ended December 31, 1993, 1992 and 1991.................... 28 VI - Accumulated Depreciation and Amortization of Property and Equipment for the Years Ended December 31, 1993, 1992 and 1991.............. 30 IX - Short-Term Borrowings for the Years Ended December 31, 1993, 1992 and 1991.................... 31 Financial Statement Schedules I, II, III, IV, VII, VIII, X, XI, XII, XIII and XIV have been omitted as not required, not significant or because the required information is shown in Notes to the Consolidated Financial Statements of the Company's Annual Report. 3. Exhibits: Unless otherwise indicated below as being incorporated by reference to another filing of the Company with the Securities and Exchange Commission, each of the following exhibits is filed herewith: 3a Restated Certificate of Incorporation of the Company, dated February 17, 1984, incorporated by reference to: Exhibit 3a to the Company's Form 10-K for the fiscal year ended December 31, 1983 (File No. 1-5491); Exhibit 4.2 to the Company's Registration Statement on Form S-3 (Registration No. 33-13544); and Exhibits 4a, 4b, 4c and 4d below. 3b Bylaws of the Company amended as of April 23, 1993, incorporated by reference to Exhibit 3 to the Company's Form 10Q for the quarter ended March 31, 1993 (File No. 1-5491). 4a Certificate of Designation of the Company's $2.125 Convertible Exchangeable Preferred Stock incorporated by reference to Exhibit 4.2 to the Company's Registration Statement on Form S-3 (Registration No. 33-6476). 4b Certificate of Designation of the Company's Series I Preferred Stock incorporated by reference to Exhibit 4b to the Company's Form 10-K for the fiscal year ended December 31, 1986 (File No.1-5491). 4c Certificate of Designation of the Company's Series II Preferred Stock incorporated by reference to Exhibit 4c to the Company's Form 10-K for the fiscal year ended December 31, 1987 (File No.1-5491). 4d Certificate of Designation of the Company's Series A Junior Preferred Stock dated March 2, 1992 incorporated by reference to Exhibit 4d to the Company's Form 10-K for the fiscal year ended December 31, 1991 (File No. 1-5491). 4e Rights Agreement dated as of February 25, 1992 between the Company and Citibank, N.A. as Rights Agent incorporated by reference to Exhibit 1 to the Company's Current Report on Form 8-K dated March 2, 1992 (File No. 1-5491). 4f Indenture dated December 1, 1991 between the Company and Bankers Trust Company, as Trustee, relating to the Company's 11-7/8% Senior Notes due 2001 incorporated by reference to Exhibit 28.1 to the Company's Current Report on Form 8-K dated December 12, 1991 (File No. 1-5491). 4g Specimen Common Stock certificate, incorporated by reference to Exhibit 4g to the Company's Form 10-K for the fiscal year ended December 31, 1992 (File No. 1-5491). 10a 1980 Nonqualified Stock Option Plan of the Company together with form of Stock Option Agreement related thereto incorporated by reference to Exhibit 5.10 to the Company's Registration Statement on Form S-7 (Registration No. 2-68622). 10b 1988 Nonqualified Stock Option Plan of the Company as amended together with form of Stock Option Agreement related thereto incorporated by reference to Exhibit 10b of the Company's Form 10-K for the fiscal year ended December 31, 1992 (File No. 1-5491). 10c Amendment No. 1 dated October 25, 1990, to all then outstanding Stock Option Agreements related to the 1980 Nonqualified Stock Option Plan of the Company incorporated by reference to Exhibit 10c to the Company's Form 10-K for the fiscal year ended December 31, 1990 (File No. 1-5491). 10d Amendment No. 2 dated May 23, 1991, to all then outstanding Stock Option Agreements related to the 1980 Nonqualified Stock Option Plan of the Company incorporated by reference to Exhibit 10d to the Company's Form 10-K for the fiscal year ended December 31, 1991 (File No. 1-5491). 10e Amendment No. 1 dated October 25, 1990, to all then outstanding Stock Option Agreements related to the 1988 Nonqualified Stock Option Plan of the Company incorporated by reference to Exhibit 10d to the Company's Form 10-K for the fiscal year ended December 31, 1990 (File No. 1-5491). 10f Amendment No. 2 dated May 23, 1991, to all then outstanding Stock Option Agreements related to the 1988 Nonqualified Stock Option Plan of the Company incorporated by reference to Exhibit 10f to the Company's Form 10-K for the fiscal year ended December 31, 1991 (File No. 1-5491). 10g 1986 Convertible Debenture Incentive Plan of the Company incorporated by reference to Exhibit 10b to the Company's Form 10-K for the fiscal year ended December 31, 1986 (File No.1-5491). 10h Pension Restoration Plan of the Company incorporated by reference to Exhibit 10h to the Company's Form 10-K for the fiscal year ended December 31, 1992 (File No. 1-5491). 10i Credit Agreement dated September 22, 1986 (including amendatory letter dated March 25, 1987) and First Preferred Ship Mortgage dated November 7, 1986 between the Company and Marathon LeTourneau Company incorporated by reference to Exhibit 10c to the Company's Form 10-K for the fiscal year ended December 31, 1986 and amendatory letter dated February 21, 1992 incorporated by reference to Exhibit 10h to the Company's Form 10-K for the fiscal year ended December 31, 1991 (File No. 1-5491). 10j Participation Agreement dated December 1, 1984 between the Company and Textron Financial Corporation et al. and Bareboat Charter dated December 1, 1984 between the Company and Textron Financial Corporation et al. incorporated by reference to Exhibit 10c to the Company's Form 10-K for the fiscal year ended December 31, 1985 (File No. 1-5491). 10k Participation Agreement dated December 1, 1985 between the Company and Eaton Leasing Corporation et. al. and Bareboat Charter dated December 1, 1985 between the Company and Eaton Leasing Corporation et. al. incorporated by reference to Exhibit 10d to the Company's Form 10-K for the fiscal year ended December 31, 1985 (File No.1-5491). 10l Corporate Continuing Guaranty dated December 31, 1986 between Shearson Lehman Brothers Holdings Inc. and the Company incorporated by reference to Exhibit 10h to the Company's Form 10-K for the fiscal year ended December 31, 1986 (File No.1-5491). 10m Corporate Continuing Guaranty dated September 10, 1987 between Shearson Lehman Brothers Holdings Inc. and the Company incorporated by reference to Exhibit 10i to the Company's Form 10-K for the fiscal year ended December 31, 1987 (File No.1-5491). 10n Cross-Border Corporate Continuing Guaranty dated May 29, 1991 between Citicorp and the Company's wholly-owned subsidiary, Rowan International, Inc. incorporated by reference to Exhibit 10o to the Company's Form 10-K for the fiscal year ended December 31, 1991 (File No. 1-5491). 10o Consulting Agreement dated March 1, 1991 between the Company and C. W. Yeargain incorporated by reference to Exhibit 10K to the Company's Form 10-K for the fiscal year ended December 31, 1990 (File No. 1-5491). 10p Acquisition Agreement dated as of November 7, 1991, among KLM Royal Dutch Airlines, Blue Yonder I B.V., KLM Helikopters B.V. and Rowan Aviation (Netherlands) B.V. incorporated by reference to Exhibit 28.1 to the Company's Current Report on Form 8-K dated November 7, 1991 (File No. 1-5491). 10q Business Loan Agreement dated January 27, 1993 between Key Bank of Alaska and the Company's wholly-owned subsidiary, Era Aviation, Inc. incorporated by reference to Exhibit 10s to the Company's Form 10-K for the fiscal year ended December 31, 1992 (File No. 1-5491). 10r Asset Purchase Agreement dated as of November 12, 1993, among Rowan Companies, Inc., Rowan Equipment, Inc., General Cable Corporation, Marathon LeTourneau Company, Marathon LeTourneau Sales & Service Company and Marathon LeTourneau Australia Pty. Ltd. incorporated by reference to the Company's Current Report on Form 8-K dated February 11, 1994 (File No. 1-5491). 11 Computation of Primary and Fully Diluted Earnings (Loss) Per Share for the years ended December 31, 1993, 1992 and 1991 appearing on page 32 in this Form 10-K. *13 Annual Report to Stockholders for fiscal year ended December 31, 1993. 21 Subsidiaries of the Registrant as of March 31, 1994. 23 Independent Auditors' Consent. 24 Powers of Attorney pursuant to which names were affixed to this Form 10-K for the fiscal year ended December 31, 1993. The Company agrees to furnish to the Commission upon request a copy of all instruments defining the rights of holders of long-term debt of the Company and its subsidiaries. ________________________________ * Only portions specifically incorporated herein are deemed to be filed. EXECUTIVE COMPENSATION PLANS AND ARRANGEMENTS Compensatory plans in which directors and executive officers of the Company participate are listed as follows: . 1980 Nonqualified Stock Option Plan of the Company together with form of Stock Option Agreement related thereto incorporated by reference to Exhibit 5.10 to the Company's Registration Statement on Form S-7 (Registration No. 2-68622); Amendment No. 1 dated October 25, 1990, to all then outstanding Stock Option Agreements related to such Plan incorporated by reference to Exhibit 10c to the Company's Form 10-K for the fiscal year ended December 31, 1990 (File No. 1-5491); and Amendment No. 2 dated May 23, 1991, to all then outstanding Stock Option Agreements related to such Plan incorporated by reference to Exhibit 10d to the Company's Form 10-K for the fiscal year ended December 31, 1991 (File No. 1-5491). . 1988 Nonqualified Stock Option Plan of the Company as amended together with form of Stock Option Agreement related thereto incorporated by reference to Exhibit 10b to the Company's Form 10-K for the fiscal year ended December 31, 1992 (File No. 1-5491; Amendment No. 1 dated October 25, 1990, to all then outstanding Stock Option Agreements related to such Plan incorporated by reference to Exhibit 10d to the Company's Form 10-K for the fiscal year ended December 31, 1990 (File No. 1-5491); and Amendment No. 2 dated May 23, 1991, to all then outstanding Stock Option Agreements related to such Plan incorporated by reference to Exhibit 10f to the Company's Form 10-K for the fiscal year ended December 31, 1991 (File No. 1-5491). . 1986 Convertible Debenture Incentive Plan of the Company incorporated by reference to Exhibit 10b to the Company's Form 10-K for the fiscal year ended December 31, 1986 (File No. 1-5491). . Pension Restoration Plan of the Company incorporated by reference to Exhibit 10h to the Company's Form 10-K for the fiscal year ended December 31, 1992 (File 1-5491). (b) Reports on Form 8-K: . No reports on Form 8-K were filed by the Registrant during the fourth quarter of fiscal year 1993. . Subsequent to December 31, 1993, the Company filed a Current Report on Form 8-K as follows: A report dated February 21, 1994 under ITEM 2. ACQUISITION OR DISPOSITION OF ASSETS in which the Company reported the acquisition of substantially all of the assets, and assumption of certain related liabilities, of Marathon LeTourneau Company and two of its subsidiaries. Marathon LeTourneau is a wholly-owned subsidiary of General Cable Corporation. Filed by amendment on Form 8-K/A dated March 31, 1994 were related financial statements of the Company on a pro forma basis and financial statements of Marathon LeTourneau Company on a historical basis. 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 into registrant Registration Statements on Form S-8 Nos. 2-67866 (filed May 22, 1980), 2-58700, as amended by Post-Effective Amendment No. 4 (June 11, 1980), 33-33755, as amended by Amendment No. 1 (filed March 29, 1990), 33-61444 (filed April 23, 1993), 33-51103 (filed November 18, 1993) 33-51105 (filed November 18, 1993) and 33-51109 (filed November 18, 1993): 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. ROWAN COMPANIES, INC. By: C. R. PALMER (C. R. Palmer, Chairman of the Board, President and Chief Executive Officer) Date: March 31, 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. Signature Title Date C. R. PALMER Chairman of the Board, President March 31, 1994 (C. R. Palmer) and Chief Executive Officer E. E. THIELE Principal Financial Officer and March 31, 1994 (E. E. Thiele) Principal Accounting Officer Director - ------------------------ (Ralph E. Bailey) * HENRY O. BOSWELL Director March 31, 1994 (Henry O. Boswell) * H. E. LENTZ Director March 31, 1994 (H. E. Lentz) * WILFRED P. SCHMOE Director March 31, 1994 (Wilfred P. Schmoe) * CHARLES P. SIESS, JR. Director March 31, 1994 (Charles P. Siess, Jr.) * PETER SIMONIS Director March 31, 1994 (Peter Simonis) * C. W. YEARGAIN Director March 31, 1994 (C. W. Yeargain) * BY C. R. PALMER March 31, 1994 (C. R. Palmer, Attorney-in-fact) INDEPENDENT AUDITORS' REPORT Rowan Companies, Inc. and Subsidiaries: We have audited the consolidated financial statements of Rowan Companies, 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 March 7, 1994; such financial statements and report are included in your 1993 Annual Report to Stockholders and are incorporated herein by reference. Our audits also included the financial statement schedules of Rowan Companies, Inc. and Subsidiaries, listed in 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 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. DELOITTE & TOUCHE DELOITTE & TOUCHE Houston, Texas March 7, 1994 ROWAN COMPANIES, INC. AND SUBSIDIARIES SCHEDULE V PROPERTY AND EQUIPMENT (In Thousands) ROWAN COMPANIES, INC. AND SUBSIDIARIES SCHEDULE V PROPERTY AND EQUIPMENT (In Thousands) SCHEDULE VI ROWAN COMPANIES, INC. AND SUBSIDIARIES ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY AND EQUIPMENT (In Thousands) SCHEDULE IX ROWAN COMPANIES, INC. AND SUBSIDIARIES SHORT-TERM BORROWINGS (In thousands) (A) The only borrowing during the period was for $10,000,000. The proceeds were received on March 31, 1993, and the loan was repaid on June 18, 1993. The borrowing carried a weighted average interest rate of 4.67%. (B) The only borrowing during the period was for $15,000,000. The proceeds were received on November 27, 1991, and the loan was repaid on December 17, 1991. The borrowing carried a fixed interest rate of 6.31%. EXHIBIT 11 ROWAN COMPANIES, INC. AND SUBSIDIARIES COMPUTATION OF PRIMARY AND FULLY DILUTED EARNINGS (LOSS) PER SHARE (in thousands except per share amounts) Note: Reference is made to Note 1 to Consolidated Financial Statements regarding computation of per share amounts. (A) Included in accordance with Regulation S-K Item 601 (b)(11) although not required to be provided for by Accounting Principles Board Opinion No. 15 because the effect is insignificant. (B) This calculation is submitted in accordance with regulation S-K Item 601(b)(11) although it is contrary to paragraph 40 of APB Opinion No. 15 because it produces an antidilutive result. EXHIBIT INDEX Page 1 of 4 EXHIBIT INDEX Page 2 of 4 EXHIBIT INDEX Page 3 of 4 EXHIBIT INDEX Page 4 of 4 ________________________________________________ (1) Incorporated herein by reference to another filing of the Company with the Securities and Exchange Commission as indicated. (2) Included herein. (3) Included in Form 10-K on page 32. (4) Included herein. See Item 1, Items 5-8 and Subpart (a)1. of ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K on page 20 and page 21, respectively, on Form 10-K for specific portions incorporated herein by reference.

10497_1993.txt

10497_1993

1993

10497

ITEM 1. BUSINESS GENERAL COMPANY INFORMATION As used herein, the "Company" means BayBanks, Inc. alone or BayBanks, Inc. together with its consolidated subsidiaries, depending on the context, and the "BayBanks" means the Company's three bank subsidiaries. BayBanks, Inc., established in 1928, is one of the largest bank holding companies in Massachusetts and is headquartered in Boston, Massachusetts. At December 31, 1993, the Company had total assets of $10.1 billion, total deposits of $8.8 billion, total stockholders' equity of $703 million, and 5,571 full-time equivalent employees. The Company's largest subsidiary is BayBank, a Massachusetts commercial bank based in Burlington, Massachusetts, that had total assets of $9.2 billion at December 31, 1993. BayBank Boston, N.A. is based in the Company's headquarter's city and BayBank Connecticut, N.A. is located in Hartford, Connecticut. The Company also maintains a loan production office in Portland, Maine. The Company has an extensive banking network with 201 full-service offices and 356 automated banking facilities serving 156 cities and towns in Massachusetts and two in Connecticut. The Company uses state-of-the-art computer and telecommunications technology to process customer transactions, provide customer information, and increase the efficiency of its data processing activities. BayBank Systems, Inc., a nonbank subsidiary of the Company, engages in data processing, product and systems development, and other technologically oriented operations, principally for the Company but also for franchisees and correspondents. In particular, BayBank Systems, Inc., operates the Company's proprietary X-Press 24(R) automated teller machine ("ATM") network. BayBanks Credit Corp. (a subsidiary of BayBank Systems, Inc.) and BayBanks Mortgage Corp. (a subsidiary of BayBank) provide instalment loan, credit card, and mortgage loan operations and services, and BayBanks Mortgage Corp. also services approximately $2.0 billion of residential mortgage loans originated by the BayBanks and placed in the secondary market. Other subsidiaries provide brokerage, investment management, and general management services to the BayBanks and other affiliates. The following presents selected financial information for the Company's three banking subsidiaries: GENERAL BANKING BUSINESS The Company provides a complete range of banking and related financial services, with particular emphasis on retail and middle market business customers. In addition to its normal deposit and lending activities, the Company aggressively pursues fee income opportunities, both in traditional and automated banking services and in the investment field, including acting as investment adviser and shareholder servicing agent for BayFunds(R), a proprietary mutual fund family. Retail Banking The Company -- a recognized leader in consumer banking -- has the largest retail market share in Massachusetts. More households in Massachusetts do business with the BayBanks than with any other banking organization. The Company offers a wide variety of retail banking products, including FDIC-insured checking, money market, savings, and time deposit accounts; credit cards; home mortgages and home equity financing; instalment loans; and trust and private banking services. The Company's proprietary X-Press 24 network, the 11th largest ATM network in the country, operates over 1,000 ATMs in Massachusetts and Connecticut and produces approximately 11 million transactions per month; the Company has approximately 1 million ATM cards in use. In addition, the BayBank X-Press 24 Cash(R) network operates cash machines located in major retail stores in Massachusetts. Approximately 88 nonaffiliated financial institutions are X-Press 24 network members. X-Press 24 cardholders can perform automated banking transactions at over 65,000 CIRRUS(R) and NYCE(R) terminals worldwide. Qualifying cardholders can also use their cards to make point-of-sale purchases at retail establishments worldwide, including Mobil(R) stations, grocery stores and, through BayBank X-Press Check(R), anywhere MasterCard(R) is accepted. The Company provides a broad range of support and maintenance services to the X-Press 24 network member institutions. In addition to its branch and ATM networks, the Company operates a customer service center twenty-four hours a day, seven days a week, that provides customer service and product information, opens consumer banking accounts, and fills customer orders, including those from its catalog of banking services. Corporate Banking The Company provides a comprehensive range of cash management, credit, deposit, international banking, and related services to businesses, hospitals, educational institutions, and local governments, with particular emphasis on the Massachusetts middle market. Specialized products available to BayBanks' business and governmental customers include personal computer-based cash management services with which a customer may perform a range of deposit account transactions; X-Press Trade(R), offering automated international letter of credit services; BayBank X-Press Tax(R) for automated payroll tax depositing; a Collateralized Municipal Money Market Account; and the Escrow Client Account Service. BayBank also acts as corporate trustee for bond offerings and as trustee or custodian for employee benefit and pension plans. Specific lending groups focus on healthcare and educational institutions, municipalities, retailers, automobile dealers, and emerging technology companies. The Company also provides secured financing, in the form of asset-based lending, leasing, and real estate lending, for commercial customers. The Company's general corporate lending activities are directed toward small and middle market companies in the New England region, with a primary emphasis on Massachusetts enterprises. Investment Services The Company's subsidiaries offer a wide range of investment services to individuals and business customers. The government and municipal securities dealerships at BayBank Boston, N.A., participate in the underwriting of Massachusetts municipal obligations and engage in private placement activities. BayBanks Brokerage Services, Inc., provides retail brokerage services. BayBanks Investment Management, Inc., a registered investment adviser, provides portfolio advice and asset management for individuals and businesses and manages the BayBank trust department's common and collective trust funds. As of December 31, 1993, the BayBank trust department had total assets of $5.2 billion under management or in custody. BayBanks Investment Management, Inc., acts as investment adviser to several portfolios of BayFunds, a proprietary mutual fund family, and BayBank Boston, N.A. acts as investment adviser to one other BayFunds portfolio. BayFunds added equity and bond portfolios to its existing money market portfolio during the first quarter of 1993. COMPETITION The BayBanks operate in a highly competitive banking market. All of the banks compete with other commercial banks in their respective service areas, with several large commercial banks located in the City of Boston, and with a number of large regional and national commercial banks located throughout the country. Legislation enacted in recent years and changing regulatory interpretations have substantially increased the geographic and product competition among commercial banks, thrift institutions, mortgage companies, leasing companies, credit unions, finance companies, and nonbanking institutions, including mutual funds, insurance companies, brokerage firms, investment banks, and a variety of financial services and advisory companies. In the international business, the BayBanks compete with other domestic banks having foreign operations and with major foreign banks and other financial institutions. GOVERNMENT MONETARY POLICY The earnings and growth of the banking industry in general are affected by the policies of regulatory authorities, including the Board of Governors of the Federal Reserve System ("Federal Reserve Board"). An important function of the Federal Reserve Board is to regulate the national money supply. Among the instruments of monetary policy used by the Federal Reserve Board to implement its objectives are open market operations in U.S. Government securities, changes in the discount rates on member bank borrowings, and changes in amount or methods of calculating reserve requirements against member banks' deposits. These means, used in varying combinations, influence the overall growth of bank loans, investments, and deposits as well as the rates charged on loans or paid for deposits. The monetary policies of the Federal Reserve Board have had a significant effect on the operating results of commercial banks in the past and are expected to continue to have such an effect in the future. The effect of such policies upon the future business and earnings of the Company cannot be predicted. GENERAL BANKING REGULATION The Company is a bank holding company subject to supervision and regulation by the Federal Reserve Board under the Bank Holding Company Act of 1956. As a bank holding company, the activities of the Company and its bank and nonbank subsidiaries are limited to the business of banking and activities closely related or incidental to banking. The Company may not acquire the ownership or control of more than 5% of any class of voting shares or substantially all of the assets of any company, including a bank, without the prior approval of the Federal Reserve Board. The Company is also subject to the Massachusetts and Connecticut bank holding company laws that, respectively require the Company to obtain the prior approval of the Massachusetts Board of Bank Incorporation and the Connecticut Banking Commissioner for holding company mergers and bank acquisitions. The Company's largest subsidiary bank, BayBank, is subject to supervision and examination by the Federal Deposit Insurance Corporation ("FDIC") and the Commissioner of Banks of the Commonwealth of Massachusetts ("Bank Commissioner"). BayBank Boston, N.A. and BayBank Connecticut, N.A., are national banking associations subject to supervision and examination by the Office of the Comptroller of the Currency ("OCC"). All of the Company's subsidiary banks are insured by and subject to certain regulations of the FDIC. They are also subject to various requirements and restrictions under federal and state law, which include requirements to obtain regulatory approval of certain business transactions, including establishing and closing bank branches; requirements to maintain reserves against deposits; restrictions on the types and amounts of loans that may be granted and the interest that may be charged thereon; and limitations on the types of investments that may be made and the types of services that may be offered. Various consumer laws and regulations also affect the operations of the Company's subsidiary banks. Under the Financial Institutions Reform, Recovery and Enforcement Act of 1989, 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 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. Because the Company is a holding company, its right to participate in the assets of any subsidiary upon the latter's liquidation or reorganization will be subject to the prior claims of the subsidiary's creditors (including depositors in the case of bank subsidiaries), except to the extent that the Company may itself be a creditor with recognized claims against the subsidiary. The Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA") provided for increased funding for FDIC deposit insurance and for expanded regulation of the banking industry. Among other things, FDICIA requires the federal banking regulators to take prompt corrective action with respect to depository institutions that do not meet minimum capital requirements. FDICIA establishes five capital ratio categories: "well capitalized," "adequately capitalized," "undercapitalized," "significantly undercapitalized," and "critically undercapitalized." A depository institution is 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. The critical capital level must be a level of tangible equity equal to at least 2% of total assets, but may be fixed at a higher level by regulation. A depository 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 and may be reclassified to a lower category by action based on other supervisory criteria. For an institution to be well capitalized it must have a total risk-based capital ratio of at least 10%, a Tier 1 risk-based capital ratio of at least 6%, and a 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 1 risk-based capital ratio of at least 4%, and a leverage ratio of at least 4% (3% in some cases). 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 increased regulatory monitoring and growth limitations and are required to submit capital restoration plans. A depository institution's holding company must guarantee the capital plan, up to an amount equal to the lesser of 5% of the depository institution's assets at the time it becomes undercapitalized or the amount needed to comply with the 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. 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 depository institutions are subject to appointment of a receiver or conservator. Each of the bank subsidiaries of the Company exceeds current minimum regulatory capital requirements and qualify as well capitalized under the regulations relating to prompt corrective action (see "Regulatory Capital Requirements"). The FDIC has adopted regulations governing the receipt of brokered deposits that require certain banks, depending on their capital ratios and other factors, to obtain a waiver from the FDIC before they may accept brokered deposits, and that limit the interest rates certain banks can offer on deposits. Although the Company does not solicit brokered deposits, all of its bank subsidiaries are free to do so without restraint under the regulation. Under FDIC's risk-based deposit insurance premium system for the Bank Insurance Fund ("BIF"), which went into effect on January 1, 1993, banks currently pay within a range of 23 cents per $100 of domestic deposits (the prior rate for all institutions) to 31 cents per $100 of domestic deposits, depending on their risk classification. To arrive at a risk-based assessment for each bank, the FDIC places the bank in one of nine risk categories, using a two-step process based first on capital ratios and then on other relevant supervisory information. Each institution is assigned to one of three groups (well capitalized, adequately capitalized, or undercapitalized) based on its capital ratios. For these purposes, 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 must 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 is one that does not meet either of the foregoing definitions. Each institution is also assigned to one of three supervisory subgroups based on an evaluation of the risk posed by the institution to the BIF. Well capitalized banks presenting the lowest risk to the BIF pay the lowest assessment rate, while undercapitalized banks presenting the highest risk pay the highest rate. The BayBanks' capital ratios at December 31, 1993, placed them in the well capitalized category for assessment purposes. The assessment will depend upon the level of deposit balances and the BayBanks' applicable risk categories (see "Regulatory Capital Requirements"). Other significant provisions of FDICIA require federal banking regulators to draft standards in a number of areas to assure bank safety and soundness, including internal controls; credit underwriting; asset growth; management compensation; ratios of classified assets to capital; and earnings. The legislation also contains provisions that require the adoption of capital guidelines applicable to interest rate risks; tighten independent auditing requirements; restrict the activities and investments of state-chartered insured banks; strengthen various consumer banking laws; limit the ability of undercapitalized banks to borrow from the Federal Reserve's discount window; and require regulators to perform annual on-site bank examinations and set standards for real estate lending. The full impact of FDICIA will not be completely known until the adoption by the various federal banking agencies of all of the implementing regulations. However, FDICIA has resulted in increased costs for the banking industry due to higher FDIC assessments and increased compliance burdens. Otherwise, FDICIA has not had an adverse effect on the Company's operations. REGULATORY CAPITAL REQUIREMENTS Under the three federal banking regulators' risk-based capital measures for banks and bank holding companies a banking organization's reported balance sheet is converted to risk-based amounts by assigning each asset to a risk category, which is then multiplied by the risk weight for that category. Off-balance sheet exposures are converted to risk-based amounts through a two-step process. First, off-balance sheet assets and credit equivalent amounts (e.g., interest rate swaps) are multiplied by a credit conversion factor depending on the defined categorization of the particular item. Then the converted items are assigned to a risk category that weights the items according to their relative risk. The total of the risk-weighted on-and off-balance sheet amounts represents a banking organization's risk-adjusted assets for purposes of determining capital ratios under the risk-based guidelines. Risk-adjusted assets can either exceed or be less than reported assets, depending on the risk profile of the banking organization. Risk-adjusted assets for institutions such as the Company will generally be less than reported assets because retail banking activities include proportionally more residential real estate loans with a lower risk rating and a relatively small off-balance sheet position. A banking organization's total qualifying capital includes two components, core capital (Tier 1 capital) and supplementary capital (Tier 2 capital). Core capital, which must comprise at least half of total capital, includes common stockholders' equity, qualifying perpetual preferred stock, and minority interests, less goodwill. Supplementary capital includes the allowance for loan losses (subject to certain limitations), other perpetual preferred stock, certain other capital instruments, and term subordinated debt, which is discounted at 20% a year during its final five years of maturity. The Company's major capital components include stockholders' equity in core capital, and the allowance for loan losses and grandfathered floating rate notes, subject to a 40% discounting in the fourth quarter of 1993, in supplementary capital. At December 31, 1993, the minimum risk-based capital requirements were 4.00% for core capital and 8.00% for total capital. Federal banking regulators have also adopted leverage capital guidelines to supplement the risk-based measures. The leverage ratio is determined by dividing Tier 1 capital as defined under the risk-based guidelines by average total assets (not risk-adjusted) for the preceding quarter. The minimum leverage ratio is 3.00%, although banking organizations are expected to exceed that amount by 100 or 200 basis points or more, depending upon their circumstances. At December 31, 1993, the Company's consolidated risk-based capital ratios were 10.68% for core capital and 12.40% for total capital, and at December 31, 1992, were 10.37% and 12.30%, respectively. The Company's consolidated leverage ratio was 7.26% at December 31, 1993, and 6.79% at December 31, 1992. These ratios exceeded the minimum regulatory guidelines. During the fourth quarter of 1992, the Company completed a public offering of 2.3 million shares of common stock that raised $79.3 million in capital. The Company contributed $8 million in capital to its subsidiaries during 1992 and $22 million during 1993, with the remaining funds held in the parent company's cash and securities portfolios. The Company reinstated its quarterly cash dividend in the first quarter of 1993 at an initial rate of $.20 per share; an equal amount was paid in the second quarter. In the third quarter of 1993, the Company increased its quarterly cash dividend to $.25 per share, which dividend was also paid in the fourth quarter. Total dividends declared for 1993 were $.90 per share. On January 27, 1994, the Board of Directors raised the quarterly dividend amount when it declared a dividend of $.35 per share paid on March 1, 1994. The following table presents the risk-based and leverage capital ratios required for depository institutions to be considered well capitalized under applicable federal regulations and the reported capital ratios of the Company and its bank subsidiaries at December 31, 1993: - --------------- (1) Under Federal Prompt Corrective Action and Risk-based Deposit Insurance Assessment Regulations. n/a -- not applicable The Company and its bank subsidiaries are not subject to any agreements or understandings with their regulatory authorities and all prior regulatory commitments made have been fulfilled. STATISTICAL DISCLOSURES Securities Act Guide 3, Statistical Disclosure by Bank Holding Companies, requires certain statistical disclosures. The statistical information required is either incorporated by reference from the Company's 1993 Annual Report as indicated in the index below, presented in statistical tables within this section, or is not applicable. This information should be read in conjunction with the Financial Review incorporated by reference in Item 7 and the consolidated financial statements and related notes incorporated by reference in Item 8 in this report. - --------------- n/a -- not applicable * The dividend payout ratio was 25.2% in 1993 and 45.6% in 1989; the dividend payout ratio was not meaningful in 1990. There were no dividends paid in 1991 or 1992. ** The average equity to average assets ratio was 7.01% in 1993, 5.67% in 1992, 5.10% in 1991, 5.55% in 1990, and 6.05% in 1989. ANALYSIS OF NET INTEREST INCOME - --------------- (1) The rate/volume variance is allocated to the average balance category. (2) Presented on a tax equivalent basis at the combined effective federal and state tax rate of 43.2% for 1993 and 42.3% for 1992. (3) Loan income includes loan fees, primarily related to commercial and residential real estate loans, of $6.2 million in 1993, $6.8 million in 1992, and $7.4 million in 1991. Nonperforming loans (nonaccrual loans) are included in average loan balances. Interest income is recorded on an accrual basis. Thus, nonperforming loans do not contribute to net interest income and affect the net interest margin. SECURITIES AVAILABLE FOR SALE (1) AT DECEMBER 31 - --------------- (1) There were no securities available for sale as of December 31, 1991. INVESTMENT SECURITIES AT DECEMBER 31 MATURITY DISTRIBUTION OF COMMERCIAL AND COMMERCIAL REAL ESTATE LOANS AT DECEMBER 31, 1993 - --------------- (1) Of the total commercial and commercial real estate loans above with remaining maturities in excess of one year, 50% have adjustable rates of interest. (2) Excludes $47,751 of commercial and $49,014 of commercial real estate nonperforming loans. SUMMARY OF LOAN LOSS EXPERIENCE DISTRIBUTION OF ALLOWANCE FOR LOAN LOSSES (1) - --------------- (1) The distribution of the allowance for loan losses is based on an assessment of an aggregate potential for future losses in the respective year-end loan portfolios. While the allowance has been distributed to individual loan categories, it is available to absorb losses in the total portfolio. The distribution of the allowance includes both allocations assigned to specifically identified problem loans and unallocated amounts that are not specifically identified as to any individual loan. The unallocated amounts related to commercial and commercial real estate loans were $85 million as of December 31, 1993, as described in the CREDIT QUALITY section incorporated by reference in Item 7 (see 1993 Annual Report, "Allowance for Loan Losses," page 15). REMAINING MATURITIES OF TIME DEPOSITS -- $100,000 OR MORE AT DECEMBER 31, 1993 - --------------- (1) Included in this amount are $35 million of large certificates of deposits and $45 million of consumer certificates of deposit of $100,000 or more. SHORT-TERM BORROWINGS ITEM 2. ITEM 2. PROPERTIES. BayBanks, Inc., and its subsidiaries occupy both owned and leased premises. The offices occupied by the Company in Boston, Massachusetts, include its principal executive offices and are leased from nonaffiliated companies. Property occupied by the three subsidiary banks represents the majority of the Company's property, and is generally considered to be in good condition and adequate for the purpose for which it is used. Bank properties include bank buildings and branches, and free-standing automated banking facilities. The Company owns the 11-story 208,000 square foot headquarters building of BayBank, its principal bank subsidiary, of which 5% is leased to nonaffiliates. Of the 201 branch offices of the subsidiary banks at December 31, 1993, 98 were located in owned buildings and 103 were located in leased buildings. In addition, the Company leases sites for 356 automated banking facilities. In 1992, BayBank Systems, Inc., the Company's principal nonbank subsidiary, occupied a new $38 million, 185,000 square foot owned technology center that enabled the Company to consolidate personnel located in various leased and owned locations, thereby increasing operating efficiency. Also during 1992, BayBank Systems updated an adjoining 121,000 square foot owned facility that houses its principal data processing equipment. At December 31, 1993, there was an aggregate $38 million mortgage on these facilities to an affiliated bank at market terms and in conformity with banking regulations that cover transactions between affiliated parties. ITEM 3. ITEM 3. LEGAL PROCEEDINGS. There were no material pending legal proceedings other than ordinary routine litigation incidental to the conduct of the Company's business. 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 THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. (a) The stock of BayBanks, Inc. is traded over the counter through the NASDAQ National Market System under the symbol BBNK. The Quarterly Share Data information that appears on page 38 in the Company's 1993 Annual Report is incorporated herein by reference. (b) As of March 10, 1994, there were approximately 4,500 holders of record of the Company's common stock. (c) The Company paid dividends of $.90 per share during 1993. The Company paid a dividend quarterly from 1928 through 1990. During 1991 and 1992, the Company did not pay any dividends. For additional information on dividend payments, reference is made to the CAPITAL AND DIVIDENDS section that is incorporated by reference from pages 15 and 16 of the Company's 1993 Annual Report, and Note 1 to the consolidated financial statements, incorporated by reference under Item 8. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA. The Average Balances and Summary of Operations* appearing on pages 34 and 35 of the Company's 1993 Annual Report are incorporated herein by reference. * The caption "Dividends paid per share" in the Summary of operations should read "Dividends declared per share." ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS. The Financial Review appearing on pages 4 through 16 of the Company's 1993 Annual Report is incorporated herein by reference. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. The following consolidated financial statements and notes thereto of the Company and its subsidiaries appearing on pages 17 through 32 of the Company's 1993 Annual Report are incorporated herein by reference: ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. There have been no changes in or matters of disagreement on accounting and financial disclosure with the Company's independent auditors. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. Information concerning directors on pages 1 through 4 of the Company's proxy statement dated March 21, 1994, is incorporated herein by reference. The following are the executive officers of the registrant as of March 15, 1994: Mr. Crozier has been an officer of BayBanks, Inc. since 1967 and was elected Chairman of the Board and Director in 1974. In 1977, Mr. Crozier was elected to the additional post of President. Mr. Arena has been a director since 1977 and was elected Vice Chairman in 1992 when he joined the Company to head its investment, private banking, and personal trust services activities. Prior to joining the Company, Mr. Arena was an independent investment management consultant from 1990 to 1992 and a trustee of an investment management firm from 1987 to 1990. Mr. Isaacs was elected Vice Chairman in 1992, Executive Vice President in 1985, Senior Vice President in 1979, and Vice President in 1978, and joined the Company in 1974. Mr. Isaacs is also the Chairman and CEO of BayBank Systems, Inc., the Company's technology subsidiary. Mr. Pollard was elected Vice Chairman and Director in 1983 and Executive Vice President in 1979 and had been a Senior Vice President since 1976. Mr. Pollard is also President and CEO of BayBank Boston, N.A., and is the senior lending officer of the Company. Ms. Beal was elected Executive Vice President in 1985, Senior Vice President in 1979, and Vice President in 1977, and has been with the Company since 1972. Mr. Vasily was elected Chief Financial Officer in 1991, Executive Vice President in 1987, Senior Vice President in 1980, and Vice President upon joining the Company in 1978, and was the Controller of the Company from 1983 to 1989. Ms. Tonra was elected Senior Vice President of BayBanks, Inc., in 1985 and Controller in 1989, and joined the Company in 1985. She is the Principal Accounting Officer of the Company. Information concerning reports of transactions in BayBanks, Inc. stock on page 12 of the Company's proxy statement dated March 21, 1994 is incorporated herein by reference. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION. Information concerning management remuneration and transactions on pages 5 through 7 of the Company's proxy statement dated March 21, 1994, is incorporated herein by reference. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. Information concerning securities ownership of management on pages 1 and 2, and concerning securities ownership of certain beneficial owners on page 12, of the Company's proxy statement dated March 21, 1994, is incorporated herein by reference. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. Information concerning relationships and transactions of the Company's executive officers and directors on page 4 of the Company's proxy statement dated March 21, 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 The following financial statements of the Company and its subsidiaries included in its 1993 Annual Report are incorporated by reference in Item 8: Independent Auditors' Report Consolidated Balance Sheet-December 31, 1993 and 1992 Consolidated Statement of Income-Years Ended December 31, 1993, 1992, and 1991 Consolidated Statement of Changes in 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 Financial Statements 2. Financial Statement Schedules All schedules are omitted because either the required information is shown in the financial statements or notes incorporated by reference, or they are not applicable, or the data is not significant. 3. Appendix containing narrative descriptions of graphical and image material omitted from text of Form 10-K and from Exhibit 13 thereto. 4. Exhibits See the Exhibit List and Index on pages 17 and 18. (b) Reports on Form 8-K There were no reports on Form 8-K 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. BAYBANKS, INC. (Registrant) By: /s/ MICHAEL W. VASILY MICHAEL W. VASILY Executive Vice President March 24, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below on March 24, 1994, by the following persons on behalf of the registrant and in the capacities indicated. BAYBANKS, INC. EXHIBIT LIST AND INDEX - --------------- * Incorporated by reference to the document indicated in parentheses.

906933_1993.txt

906933_1993

1993

906933

764241_1993.txt

764241_1993

1993

764241

ITEM 1. BUSINESS National City Bancshares, Inc., (hereinafter referred to as the Corporation), is an Indiana Corporation organized in 1985 to engage in the business of a bank holding company. Based in Evansville, Indiana, the Corporation has eleven wholly owned subsidiaries, ten commercial banks serving twenty towns and cities with a total of thirty banking centers and an insurance agency. Each subsidiary, its locations, number of offices, year founded and date of merger is shown below. In addition to these mergers, Chandler State Bank was acquired by the Corporation in August 1986 and merged into The National City Bank of Evansville in June 1987. The Corporation's subsidiary banks provide a wide range of financial services to the communities they serve in southwestern Indiana, western Kentucky and southeastern Illinois. These services include various types of deposit accounts; safe deposit boxes; safekeeping of securities; automated teller machines; consumer, mortgage and commercial loans; mortgage loan sales and servicing; letters of credit; accounts receivable management (financing, accounting, billing and collecting); and complete personal and corporate trust services. All banks are members of the Federal Deposit Insurance Corporation. The Corporation's nonbank subsidiary, Ayer-Wagoner-Deal Insurance Agency, Inc., operates as an insurance agency offering various insurance products through several insurance companies or underwriters and sells the following types of insurance: life, casualty, property, homeowners, business, disability and automobile. At December 31, 1993, the Corporation and its subsidiaries had 388 full-time equivalent employees. The subsidiaries provide a wide range of employee benefits and consider employee relations to be excellent. COMPETITION The Corporation has active competition in all areas in which it presently engages in business. Each subsidiary bank competes for commercial and individual deposits and loans with commercial banks, savings and loan associations, credit unions connected with local businesses and other non-banking institutions. The Corporation's insurance agency competes with several other insurance agencies in Rockport, Indiana, and neighboring communities. FOREIGN OPERATIONS The Corporation and its subsidiaries have no foreign branches or significant business with foreign obligers or depositors. REGULATION AND SUPERVISION The Corporation, as a bank holding company registered under the Bank Holding Company Act of 1956, as amended ("Act"), is subject to regulation by the Board of Governors of the Federal Reserve System ("Board"). Under the Act, the Corporation is required to obtain the prior approval of the Board before acquiring direct or indirect ownership or control of more than 5% of the voting shares of any bank which is not already majority owned. In addition, the Corporation is prohibited under the Act, with certain exceptions, from acquiring direct or indirect ownership or control of 5% or more of the voting shares of any company which is not a bank. The Corporation may engage in, and may own shares of companies engaged in, certain activities found by the Board to be so closely related to banking as to be a proper incident thereto. The Act prohibits the acquisition by a bank holding company of shares of a bank located outside the state in which the operations of its banking subsidiaries are principally conducted, unless such an acquisition is specifically authorized by statute of the state in which the bank to be acquired is located. The Corporation is required by the Act to file annual reports of its operations with the Board and such additional information as they may require pursuant to the Act, and the Corporation and its subsidiaries are subject to examination by the Board. Further, under the Act and the regulations of the Board, the Corporation and its subsidiaries are prohibited from engaging in certain tie-in arrangements with respect to any extension of credit or provision of property or services. The Board has adopted "capital adequacy guidelines" for its use in examining and supervising bank holding companies. A bank holding company's ability to pay dividends and expand its business through the acquisition of additional subsidiaries can be restricted if its capital falls below levels established by these guidelines. The primary supervisory authority of The National City Bank of Evansville and The Peoples National Bank of Grayville is the Comptroller of the Currency, who regularly examines such areas as reserves, loans, investments, management practices and other aspects of bank operations. The Comptroller of the Currency has the authority to prevent a national bank from engaging in an unsafe or an unsound practice in conducting its business. The payment of dividends, depending upon the financial condition of a bank, could be deemed such a practice. In addition, both banks are members of, and subject to regulation by, the Federal Deposit Insurance Corporation. As state banks, Poole Deposit Bank and Farmers State Bank are supervised and regulated by the Commonwealth of Kentucky Department of Financial Institutions. The Farmers and Merchants Bank, Lincolnland Bank, The Bank of Mitchell, Pike County Bank, The Spurgeon State Bank and The State Bank of Washington are supervised and regulated by the State of Indiana Department of Financial Institutions. In addition, all eight banks are members of, and subject to regulation by, the Federal Deposit Insurance Corporation. Federal and state banking laws and regulations govern, among other things, the scope of the bank's business, the investments it may make, the reserves against deposits it must maintain, loans the bank makes and collateral it takes, activities with respect to mergers and consolidations and the establishment of branches. The Financial Institutions Reform, Recovery and Enforcement Act of 1989 ("FIRREA") was enacted on August 9, 1989, primarily in an attempt to address problems in the savings and loan industry. However, the Act has had a substantial effect on the environment in which commercial banks operate. The annual assessment rates for banks insured by the Federal Deposit Insurance Corporation were to increase from .083% of deposits to .12% in 1990, and to .15% in 1991. However, such rates were increased by the FDIC to .195% effective January 1, 1991 and .23% effective July 1, 1991. The Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA") was enacted in 1991. Among other things, FDICIA, requires federal bank regulatory authorities to take "prompt corrective action" with respect to banks that do not meet minimum capital requirements. For these purposes, FDICIA established five capital tiers: well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized, and critically undercapitalized. The Corporation and each of the Corporation's Banks currently exceed the regulatory definition of a "well capitalized" financial institution. The Ayer-Wagoner-Deal Insurance Agency, Inc. is regulated by the Indiana Department of Insurance. STATISTICAL DISCLOSURE The statistical disclosure on the Corporation and its subsidiaries, on a consolidated basis, included on pages 1, 3 through 13 and 33 of the Corporation's Annual Report to Shareholders for the fiscal year ended December 31, 1993, is hereby incorporated by reference herein. ITEM 2. ITEM 2. PROPERTIES The net investment of the Corporation and its subsidiaries in real estate and equipment at December 31, 1993, was $10,439,166. The Corporation's offices are located in a building owned by The National City Bank of Evansville (hereinafter referred to as the Bank), in which the Bank's main office is located. The main office of the Bank is located at 227 Main Street in downtown Evansville, Indiana. This building is owned in fee by the Bank. The other subsidiary banks, all branches and the insurance agency are located on premises either owned or leased. None of the property is subject to any major encumbrance. ITEM 3. ITEM 3. LEGAL PROCEEDINGS None ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS During the fourth quarter of 1993, two matters were submitted to a vote of shareholders. On December 14, 1993, a special meeting of the shareholders was held to consider and take action on proposals to approve and adopt two Merger Agreements. The first Merger Agreement dated July 1, 1993, by and between the Corporation and Lincolnland Bancorp, Inc. ("Lincolnland") provided for, among other things, the merger of Lincolnland with and into the Corporation. This proposal was approved with 2,003,763.1085 shares voted affirmatively, 3,614.0000 negatively and 31,460.8022 abstaining. The second Merger Agreement dated June 25, 1993, by and between the Corporation and Sure Financial Corporation, ("Sure") provided for, among other things, the merger of Sure with and into the Corporation. This proposal was approved with 2,024,601.1085 shares voted affirmatively, 288,160.7531 negatively and 9,532.8022 abstaining. Both mergers were consummated December 17, 1993. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED SHAREHOLDER MATTERS Pages 1 and 33 of the Corporation's Annual Report to Shareholders for the fiscal year ended December 31, 1993, is hereby incorporated by reference herein. Dividends are restricted by earnings and the need to maintain adequate capital. Management intends to continue its current dividend policy subject to these restrictions. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA Page 1 of the Corporation's Annual Report to Shareholders for the fiscal year ended December 31, 1993, is hereby incorporated by reference herein. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION Pages 1, 3 through 13 and 33 of the Corporation's Annual Report to Shareholders for the fiscal year ended December 31, 1993, are incorporated by reference herein. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Pages 15 through 30 of the Corporation's Annual Report to Shareholders for the fiscal year ended December 31, 1993, are incorporated by reference herein. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE The Board of Directors approved the appointment of McGladrey & Pullen, Certified Public Accountants and Consultants, as independent accountants to audit the financial statements of the Corporation and its subsidiaries for the year 1993. Gaither Rutherford & Co., formerly Gaither Koewler Rohlfer Luckett & Co., ("Gaither") audited the books and records of the Corporation and its subsidiaries from 1985 through 1992. The Board of Directors had determined it to be in the best interest of the Corporation to change independent accountants for 1993. This change was ratified by the Corporation's shareholders at the 1993 annual meeting. The financial statements provided by Gaither in 1992 and 1991 did not contain any adverse opinions or any disclaimers of opinions, nor were they qualified or modified as to uncertainty, audit scope or accounting reasons. Further, there have been no disagreements between Gaither and the Corporation. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT (a) Directors of the Corporation This information under the heading "Election of Directors and Information with Respect to Directors and Officers" on pages 3 to 6 of the Corporation's Proxy Statement for its Annual Meeting of Shareholders to be held April 19, 1994, is hereby incorporated by reference herein. (b) Executive Officers of the Corporation The Executive Officers of the Corporation, most of whom are also Executive Officers of The National City Bank of Evansville (hereinafter referred to as the Bank) are as follows: ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The information under the heading "Compensation of Executive Officers" on pages 7 through 11 of the Corporation's Proxy Statement for its Annual Meeting of Shareholders to be held April 19, 1994, is hereby incorporated by reference herein. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information under the heading "Voting Securities" on pages 1 through 3 of the Corporation's Proxy Statement for its Annual Meeting of Shareholders to be held April 19, 1994, is hereby incorporated by reference herein. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information under the heading "Transactions with Management" on page 11 of the Corporation's Proxy Statement for its Annual Meeting of Shareholders to be held April 19, 1994, is hereby incorporated by reference herein. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K FINANCIAL STATEMENTS The following consolidated financial statements of the Corporation and its subsidiaries, included on pages 15 through 30 of the Corporation's Annual Report to Shareholders for the fiscal year ended December 31, 1993, are hereby incorporated by reference: Independent Auditor's Report Consolidated Statements of Financial Position, at 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 FINANCIAL STATEMENT SCHEDULES All schedules are omitted because they are not applicable or not required or because the required information is included in the consolidated financial statements or related notes. EXHIBITS The following exhibits are submitted herewith: 3 - Articles of Incorporation, as amended 13 - Annual Report to Shareholders for the year ended December 31, 1993 (Incorporated by Reference) 22 - Subsidiaries of the Registrant 28 - Proxy Statement for the Annual Meeting of Shareholders to be held on April 19, 1994 (Incorporated by Reference) REPORTS ON FORM 8-K Form 8-K dated December 29, 1993, reported that on December 17, 1993, the Registrant completed its acquisition of Sure Financial Corporation ("Sure") and Lincolnland Bancorp, Inc. ("Lincolnland"). The transactions were structured as statutory mergers, pursuant to which each of Sure and Lincolnland were merged with and into National City Bancshares, Inc. Sure was a multibank holding company with approximately $130 million in assets and Lincolnland was a one-bank holding company with approximately $108 million in total assets. Shareholders of Lincolnland received shares of Registrant valued at $23.5 million and shareholders of Sure received shares of Registrant valued at $16 million in the transactions. The former subsidiaries of Lincolnland and Sure will be operated as wholly owned subsidiaries of Registrant. The consolidated entity will have approximately $711 million in total assets. In other matters, Michael F. Elliott was appointed Executive Vice President of the Registrant on December 21, 1993. Mr. Elliott was President of Sure. 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 dates indicated. NATIONAL CITY BANCSHARES, INC. By /s/ JOHN D. LIPPERT 3/15/94 John D. Lippert Date Chairman of the Board and Chief Executive Officer By /s/ ROBERT A. KEIL 3/15/94 Robert A. Keil Date President and Chief Financial Officer By /s/ HAROLD A. MANN 3/15/94 Harold A. Mann Date Secretary and Treasurer (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. Donald B. Cox Date Director /s/ SUSANNE R. EMGE 3/15/94 Mrs. N. Keith Emge Date Director /s/ MICHAEL D. GALLAGHER 3/15/94 Michael D. Gallagher Date Director /s/ DONALD G. HARRIS 3/15/94 Donald G. Harris Date Director /s/ ROBERT H. HARTMANN 3/15/94 Robert H. Hartmann Date Director /s/ C. MARK HUBBARD 3/15/94 C. Mark Hubbard Date Director /s/ EDGAR P. HUGHES 3/15/94 Edgar P. Hughes Date Director /s/ R. EUGENE JOHNSON 3/15/94 R. Eugene Johnson Date Director /s/ EDWIN F. KARGES, JR. 3/15/94 Edwin F. Karges, Jr. Date Director /s/ ROBERT A. KEIL 3/15/94 Robert A. Keil Date Director /s/ JOHN D. LIPPERT 3/15/94 John D. Lippert Date Director /s/ JOHN LEE NEWMAN 3/15/94 John Lee Newman Date Director /s/ RONALD G. REHERMAN 3/15/94 Ronald G. Reherman Date Director Laurence R. Steenberg Date Director /s/ C. WAYNE WORTHINGTON 3/15/94 C. Wayne Worthington Date Director /s/ GEORGE A. WRIGHT 3/15/94 George A. Wright Date Director EXHIBIT INDEX Reg. S-K EXHIBIT NUMBER DESCRIPTION OF EXHIBIT 3 Articles of Incorporation, as amended 13 Annual Report to Shareholders for the year ended December 31, 1993 22 Subisdiaries of the Registrant 28 Proxy Statement for the Annual Meeting of Shareholders to be held on April 19, 1994

40865_1993.txt

40865_1993

1993

40865

Item 1. Business GTE Florida Incorporated (the Company) (formerly General Telephone Company of Florida, formerly Peninsular Telephone Company) was incorporated on June 20, 1901, as a corporation for profit pursuant to the general corporation laws of the state of Florida. The Company is a wholly-owned subsidiary of GTE Corporation (GTE). The Company has a wholly-owned subsidiary, GTE Communications Corporation (GTECC). In 1989, the assets of another subsidiary, GTE Ventures (GTEV), were sold to affiliated companies at net book value. GTECC contains the majority of the Company's nonregulated operations including the provision of terminal equipment to business and residential customers, cellular mobile phones and other nonregulated telecommunication services. The Company provides local telephone service within its franchise area and intraLATA (Local Access Transport Area) long distance service between the Company's facilities and the facilities of other telephone companies within the Company's LATAs. InterLATA service to other points in and out of Florida is provided through connection with interexchange (long distance) common carriers. These common carriers are charged fees (access charges) for interconnection to the Company's local facilities. End user business and residential customers are also charged access charges for access to the facilities of the long distance carrier. The Company also earns other revenues by leasing interexchange plant facilities and providing such services as billing and collection and operator services to interexchange carriers, primarily the American Telephone and Telegraph Company (AT&T). The number of access lines served has grown steadily from 1,623,994 on January 1, 1989 to 1,978,220 on December 31, 1993. The Company's principal line of business is providing telecommunication services. These services fall into five major classes: local network, network access, long distance, equipment sales and services and other. Revenues from each of these classes over the last three years are as follows: Years Ended December 31 ---------------------------------------- 1993 1992 1991 ---- ---- ---- (Thousands of Dollars) Local Network Services $ 537,446 $ 498,151 $ 450,489 % of Total Revenues 44% 40% 37% Network Access Services $ 406,244 $ 425,860 $ 419,628 % of Total Revenues 34% 34% 34% Long Distance Services $ 74,646 $ 110,101 $ 161,412 % of Total Revenues 6% 9% 13% Equipment Sales and Services $ 91,536 $ 89,436 $ 92,267 % of Total Revenues 8% 7% 7% Other $ 101,243 $ 130,993 $ 105,483 % of Total Revenues 8% 10% 9% At December 31, 1993, the Company had 8,210 employees, both bargaining and non-bargaining unit members. In 1993, an agreement was reached on one contract with the international Brotherhood of Electrical Workers (IBEW). During 1994, there are no contracts which will expire. Telephone Competition The Company holds franchises, licenses and permits adequate for the conduct of its business in the territories which it serves. The Company is subject to regulation by the Florida Public Service Commission (FPSC) as to its intrastate business operations and the Federal Communications Commission (FCC) as to its interstate business operations. Information regarding the Company's activities with the various regulatory agencies and revenue arrangements with other telephone companies can be found in Note 10 of the Company's Annual Report to Shareholders for the year ended December 31, 1993, incorporated herein and filed as Exhibit 13. The year was marked by important changes in the U.S. telecommunications industry. Rapid advances in technology, together with government and industry initiatives to eliminate certain legal and regulatory barriers are accelerating and expanding the level of competition and opportunities available to the Company. As a result, the Company faces increasing competition in virtually all aspects of its business. Specialized communications companies have constructed new systems in certain markets to bypass the local-exchange network. Additional competition from interexchange carriers as well as wireless companies continues to evolve for both intrastate and interstate communications. During 1994, the Company will begin implementation of a re-engineering plan that will redesign and streamline processes. Implementation of its re- engineering plan will allow the Company to continue to respond aggressively to these competitive and regulatory developments through reduced costs, improved service quality, competitive prices and new product offerings. Moreover, implementation of this program will position the Company to accelerate delivery of a full array of voice, video and data services. The re- engineering program will be implemented over three years. During the year, the Company continued to introduce new business and consumer services utilizing advanced technology, offering new features and pricing options while at the same time reducing costs and prices. In 1993, GTE also continued to make progress in advanced telecommunications technology. In Tampa, Florida, GTE concluded the largest market trial of residential personal communication services (PCS) in the United States. The knowledge and experience gained during this trial will enhance GTE's ability to compete in this emerging market. During 1993, the FCC announced its decision to auction licenses during 1994 in 51 major markets and 492 basic trading areas across the United States to encourage the development of a new generation of wireless PCS. These services will both complement and compete with the Company's traditional wireline services. The Company will be permitted to fully participate in the license auctions in areas outside of GTE's existing cellular service areas. Limited participation will be permitted in areas in which GTE has an existing cellular presence. In 1992, the FCC issued a "video dialtone" ruling that allows telephone companies to transmit video signals over their networks. The FCC also recommended that Congress amend the Cable Act of 1984 to permit telephone companies to supply video programming in their service areas. Activity directed toward changing the traditional cost-based rate of return regulatory framework for intrastate and interstate telephone services has continued. Legislative activity to change the Florida regulatory scheme is expected to evolve within the next year. The Company is continuing to pursue favorable pricing arrangements through the FPSC. In September 1993, the FCC released an order allowing competing carriers to interconnect to the local-exchange network for the purpose of providing switched access transport services. This ruling complements similar interconnect arrangements for private line services ordered during 1992. The order encourages competition for the transport of telecommunications traffic between local exchange carriers' (LECs) switching offices and interexchange carrier locations. In addition, the order allows LECs flexibility in pricing competitive services. The GTE Consent Decree, which was issued in connection with the 1983 acquisition of GTE Sprint (since divested) and GTE Spacenet, prohibits GTE's domestic telephone operating subsidiaries from providing long distance service beyond the boundaries of the LATA. This prohibition restricts their direct provision of long distance service to relatively short distances. The degree of competition allowed in the intraLATA market is subject to state regulation. However, regulatory constraints on intraLATA competition are gradually being relaxed. In fact, some form of intraLATA competition is authorized in Florida. These and other actions to eliminate the existing legal and regulatory barriers, together with rapid advances in technology, are facilitating a convergence of the computer, media and telecommunications industries. In addition to allowing new forms of competition, these developments are also creating new opportunities to develop interactive communications networks. The Company supports these initiatives to assure greater competition in telecommunications, provided that overall the changes allow an opportunity for all service providers to participate equally in a competitive marketplace under comparable conditions. Item 2. Item 2. Properties The Company's property consists of network facilities (82%), company facilities (13%), customer premises equipment (1%) and other (4%). From January 1, 1989 to December 31, 1993, the Company made gross property additions of $1.5 billion and property retirements of $1.3 billion. Substantially all of the Company's property is subject to liens securing long-term debt. In the opinion of management, the Company's telephone plant is substantially in good repair. Item 3. Item 3. Legal Proceedings There are no pending legal proceedings, either for or against the Company, which would have a material impact on the Company's financial statements. 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 Shareholder Matters Market information is omitted since the Company's common stock is wholly-owned by GTE Corporation. Item 6. Item 6. Selected Financial Data Reference is made to the Registrant's Annual Report to Shareholders, page 28, for the year ended December 31, 1993, incorporated herein and filed as Exhibit 13. Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Reference is made to the Registrant's Annual Report to Shareholders, pages 24 to 27, for the year ended December 31, 1993, incorporated herein and filed as Exhibit 13. Item 8. Item 8. Financial Statements and Supplementary Data Reference is made to the Registrant's Annual Report to Shareholders, pages 5 to 22, for the year ended December 31, 1993, incorporated herein and filed as Exhibit 13. 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 names, ages and positions of all the directors and executive officers of the Company as of March 7, 1994 are listed below along with their business experience during the past five years. a. Identification of Directors Director Name Age Since Business Experience - ------------------ --- -------- ---------------------------------------- Peter A. Daks 48 1994 State President - Florida; various positions with GTE including Regional Vice president-General Manager, Florida- GTE South Area; Vice President- Information Management, GTE Telephone Operations; Assistant Vice President- Business Systems Planning at GTE Service Corporation in Stamford, CT; Vice President-Information Management and Information Management; Director-GTE Southeast and Manager-System Development at GTE Products Corporation. Kent B. Foster 50 1994 Vice Chairman of the Board of Directors of GTE Corporation, October 1993. President, GTE Telephone Operations, 1989; Director, GTE Corporation, 1992; Director, all GTE domestic telephone subsidiaries, 1993; Director, BC Telecom, Inc.; Director, Compania Anonima Nacional Telefonos de Venezuela; Director, National Bank of Texas. Richard M. Cahill 55 1994 Vice President - General Counsel of GTE Telephone Operations, 1988; Director, all GTE domestic telephone subsidiaries, 1993; Director, GTE Vantage Incorporated, 1991; Director, GTE Intelligent Network Services Incorporated, 1993. Gerald K. Dinsmore 44 1992 Senior Vice President - Finance and Planning for GTE Telephone Operations, 1994. Vice President - Finance, GTE Telephone Operations, 1993; Vice President - Intermediary Customer Markets, GTE Telephone Operations, 1991. President, South Area, GTE Telephone Operations, 1992; Director, all GTE domestic telephone subsidiaries, 1993. Michael B. Esstman 47 1994 Executive Vice President-Operations, GTE Telephone Operations, 1993; President, Central Area, GTE Telephone Operations, 1991. President, Contel Eastern Region, Telephone Operations Sector, 1983; Director, AG Communications System; Director, all GTE domestic telephone subsidiaries, 1993. Thomas W. White 47 1994 Executive Vice President of GTE Telephone Operations, 1993; Senior Vice President - General Office Staff, GTE Telephone Operations, 1989; Director, all GTE domestic telephone subsidiaries, 1993; Director, Quebec-Telephone. Directors are elected annually. The term of each director expires on the date of the next annual meeting of shareholders, which may be held on any day during May, as specified in the notice of the meeting. There are no family relationships between any of the directors or executive officers of the Company. All of the directors, with the exception of Mr. Dinsmore, were elected January 1, 1994, following the resignations from the Board of Marsha Lewis Brown, Raleigh W. Greene, Mia C. Hardcastle, A. Lamar Matthews Jr., Richard D. Pope, Jr., T. Terrell Sessums, Jan E. Smith and Gus A. Stavros. b. Identification of Executive Officers Year Assumed Present Name Age Position Position with Company - ---------------------- --- ------------ ---------------------------- Peter A. Daks (1) 48 1994 President James D. Bennett (2) 48 1994 State Vice President - Sales M. Michael Foster (3) 50 1994 State Vice President - Operations Fassil Gabremariam (4) 49 1994 State Vice President - Finance Donald W. McLeod (5) 53 1994 State Vice President - External Affairs Marceil Morrell (6) 44 1994 State Vice President - General Counsel David H. Richter (7) 44 1994 State Vice President - Human Resources Charles J. Somes (8) 48 1994 Secretary Position with GTE Telephone Operations (9) ----------------------------- Kent B. Foster 50 1989 President Michael B. Esstman (10) 47 1993 Executive Vice President - Operations Thomas W. White 47 1989 Executive Vice President Guillermo Amore 55 1990 Senior Vice President - International Gerald K. Dinsmore (1) 44 1993 Senior Vice President - Finance and Planning Robert C. Calafell (11) 52 1993 Vice President - Video Services A. T. Jones 54 1992 Vice President - International Brad M. Krall (12) 52 1993 Vice President - Centralized Services Donald A. Hayes 56 1992 Vice President - Information Technology Richard L. Schaulin 51 1989 Vice President - Human Resources Clarence F. Bercher 50 1991 Vice President - Sales Mark S. Feighner 45 1991 Vice President - Product Management Geoff C. Gould 41 1989 Vice President - Regulatory and Governmental Affairs G. Bruce Redditt 43 1991 Vice President - Public Affairs Richard M. Cahill 55 1989 Vice President and General Counsel Leland W. Schmidt 60 1989 Vice President - Industry Affairs Paul E. Miner 49 1990 Vice President - Regional Operations Support Katherine J. Harless 43 1992 Vice President - Intermediary Markets William M. Edwards, III (13) 45 1993 Controller Each of these executive officers has been an employee of the Company or an affiliated company for the last five years. Except for duly elected officers and directors, no other employees had a significant role in decision making. All officers are appointed for a term of one year. NOTES: (1) Peter A. Daks, previously Regional Vice President - General Manager/Florida, was appointed President for GTE Florida Inc. replacing Gerald K. Dinsmore who was appointed Senior Vice President - Finance and Planning for GTE Telephone Operations effective March 7, 1994, replacing John L. Hume who retired. (2) James D. Bennett, previously Area Vice President - Sales, was appointed State Vice President - Sales effective March 7, 1994. (3) M. Michael Foster, previously Regional Vice President - General Manager - Michigan, was appointed State Vice President - Operations replacing Peter A. Daks who was appointed President. (4) Fassil Gabremariam, previously Area Vice President - Finance was appointed State Vice President - Finance effective March 7, 1994. (5) Donald W. McLeod was appointed State Vice President - External Affairs replacing Bruce M. Holmberg who retired and Jorge Jackson who was appointed Area Vice President - Public Affairs - West. (6) Marceil Morrell was appointed State Vice President - General Counsel replacing James V. Carideo who retired effective March 7, 1994. (7) David H. Richter was appointed State Vice President - Human Resources replacing Margaret B. Haight who was appointed State Vice President - General Manager - Kentucky for GTE South Incorporated effective March 7, 1994. (8) Charles J. Somes was appointed Secretary replacing Jerry L. Austin who retired effective March 7, 1994. (9) Position is with, and duties are performed at, the GTE Telephone Operations Headquarters in Irving, Texas. (10) Michael B. Esstman was appointed Executive Vice President - Operations effective April 25, 1993 replacing Charles A. Crain who retired on April 1, 1993. (11) Robert C. Calafell was appointed Vice President - Video Services effective March 28, 1993. (12) Brad M. Krall was appointed Vice President - Centralized Services effective November 7, 1993. (13) William M. Edwards, III, was appointed Controller effective November 21, 1993 replacing John D. Utzinger. William E. Starkey retired November 21, 1993, George N. King retired May 21, 1993 and Clark W. Barlow retired August 21, 1993. Stephen A. Inkrott accepted a position with GTE Telephone Operations as Assistant Vice President - Network Planning. The Federal securities laws require the Company's directors and executive officers, and persons who own more than 10% of a registered class of the Company's equity securities, to file with the Securities and Exchange Commission initial reports of ownership and reports of changes in ownership of any equity securities of the Company. To the Company's knowledge, none of the persons subject to these reporting requirements filed the required initial statement of beneficial ownership of securities on a timely basis, but the Company has determined that each of its current directors and executive officers is in the process of completing this filing. All of the Company's common stock is owned by GTE and, to the Company's knowledge, none of South directors or executive officers currently owns, or has ever owned, any shares of the Company's registered preferred stock. Item 11. Item 11. Executive Compensation Executive Compensation Tables The following tables provide information about executive compensation. Long-Term Incentive Plan - Awards in Last Fiscal Year The GTE Long-Term Incentive Plan (LTIP) provides for awards, currently in the form of stock options with tandem stock appreciation rights and cash bonuses, to participating employees. The stock options and stock appreciation rights awarded under the LTIP to the five most highly compensated individuals in 1993 are shown in the table on page 11. Under the LTIP, performance bonuses are paid in cash based on the achievement of pre-established goals for GTE's return on equity (ROE) over a three-year award cycle. Performance bonuses are denominated in units of GTE Common Stock ("Common Stock Units") and are maintained in a Common Stock Unit Account. At the time performance targets are established for the three-year cycle, a Common Stock Unit Account is set up for each participant who is eligible to receive a cash award under the LTIP. An initial dollar amount for each account is determined based on the competitive performance bonus grant practices of other major companies in the telecommunications industry and with other selected corporations that are comparable to GTE in terms of revenue, market value and other quantitative measures. That amount is then divided by the average market price of GTE Common Stock for the calendar week preceding the day the account is established to determine the number of Common Stock Units in the account. The value of the account increases or decreases based on the market price of the GTE Common Stock. An amount equal to the dividends declared on an equivalent number of shares of GTE Common Stock is added each time a dividend is paid. This amount is then converted into the number of Common Stock Units obtained by dividing the amount of the dividend by the average price of the GTE Common Stock on the composite tape of the New York Stock Exchange on the dividend payment date and added to the Common Stock Unit Account. Messrs. Dinsmore, Daks and Foster are the only individuals of the five most highly compensated individuals eligible to receive a cash award under the LTIP. The number of Common Stock Units initially allocated in 1993 to their accounts and estimated future payouts under the LTIP are shown in the following table. Executive Agreements GTE has entered into agreements (the Agreements) with Messrs. Dinsmore, Daks and Foster regarding benefits to be paid in the event of a change in control of GTE (a "Change in Control"). A Change in Control is deemed to have occurred if a majority of the members of the Board do not consist of members of the incumbent Board (as defined in the Agreements) or if, in any 12-month period, three or more directors are elected without the approval of the incumbent Board. An individual whose initial assumption of office occurred pursuant to an agreement to avoid or settle a proxy or other election contest is not considered a member of the incumbent Board. In addition, a director who is elected pursuant to such a settlement agreement will not be deemed a director who is elected or nominated by the incumbent Board for purposes of determining whether a Change in Control has occurred. A Change in Control will not occur in the following situations: (1) certain merger transactions in which there is at least 50% GTE shareholder continuity in the surviving corporation, at least a majority of the members of the board of directors of the surviving corporation consists of members of the Board of GTE and no person owns more than 20% (or under certain circumstances, a lower percentage, not less than 10%) of the voting power of the surviving corporation following the transaction, and (2) transactions in which GTE's securities are acquired directly from GTE. The Agreements provide for benefits to be paid in the event this individual separates from service and has a "good reason" for leaving or is terminated without "cause" within two years after a Change in Control of GTE. Good reason for leaving includes but is not limited to the following events: demotion, relocation or a reduction in total compensation or benefits, or the new entity's failure to expressly assume obligations under the Agreements. Termination for cause includes certain unlawful acts on the part of the executive or a material violation of his or her responsibilities to the Corporation resulting in material injury to the Corporation. An executive who experiences a qualifying separation from service will be entitled to receive up to two times the sum of (i) base salary and (ii) the average of his or her other percentage awards under the EIP for the previous three years. The executive will also continue to receive medical and life insurance coverage for up to two years and will be provided with financial and outplacement counseling. In addition, the Agreements with Messrs. Dinsmore, Daks and Foster provide that in the event of a separation from service, they will receive service credit in the following amounts: two times years of service otherwise credited if the executive has five or fewer years of credited service; 10 years if credited service is more than five and not more than 10 years; and, if the executive's credited service exceeds 10 years, the actual number of credited years of service. These additional years of service will apply towards vesting, retirement eligibility, benefit accrual and all other purposes under the Supplemental Executive Retirement Plan and the Executive Retired Life Insurance Plan. In addition, each executive will be considered to have not less than 76 points and 15 years of accredited service for the purpose of determining his or her eligibility for early retirement benefits. However, there will be no duplication of benefits. The Agreements remain in effect until the earlier of July 1 of each successive year or the date on which the executive reaches age 65, unless the Agreement is terminated earlier pursuant to its terms. The Agreements will be automatically renewed on each successive July 1 unless, not later than December 31 of the preceding year, one of the parties notifies the other that he does not wish to extend the Agreement. If a Change in Control occurs, the Agreements will remain in effect until the obligations of GTE (or its successor) under the Agreements have been satisfied. Retirement Programs Pension Plans The estimated annual benefits payable, calculated on a single life annuity basis, under GTE's defined benefit pension plans at normal retirement at age 65, based upon final average earnings and years of employment, are illustrated in the table below: PENSION PLAN TABLE Years of Service Final Average ----------------------------------------------------------- Earnings 15 20 25 30 35 - ------------- ----------------------------------------------------------- $ 150,000 $ 31,604 $ 42,138 $ 52,672 $ 63,207 $ 73,742 200,000 42,479 56,638 70,797 84,957 99,117 300,000 64,229 85,638 107,048 128,457 149,867 400,000 85,979 114,638 143,298 172,957 200,617 500,000 107,729 143,638 179,548 215,457 251,367 600,000 129,479 172,638 215,798 258,957 302,117 700,000 151,229 201,638 252,048 302,457 352,867 800,000 172,979 230,638 288,298 345,957 403,617 900,000 194,729 259,638 324,548 389,457 454,367 1,000,000 216,479 288,638 360,798 432,957 505,117 1,200,000 259,979 346,638 433,298 519,957 606,617 GTE Service Corporation, a wholly-owned subsidiary of GTE, maintains a noncontributory pension plan for the benefit of GTE employees based on years of service. Pension benefits to be paid from this plan and contributions to this plan are related to basic salary exclusive of overtime, differentials, incentive compensation (except as otherwise described) and other similar types of payment. Under this plan, pensions are computed on a two-rate formula basis of 1.15% and 1.45% for each year of service, with the 1.15% service credit being applied to that portion of the average annual salary for the five highest consecutive years that does not exceed the Social Security Integration Level (the portion of salary subject to the Federal Security Act), and the 1.45% service credit being applied to that portion of the average annual salary that exceeds said level. As of March 7, 1993, the credited years of service under the plan for Messrs. Dinsmore, Daks, Foster, Inkrott and Gabremariam are 18, 14, 23, 28 and 20, respectively. Under Federal law, an employee's benefits under a qualified pension plan such as the GTE Service Corporation plan are limited to certain maximum amounts. GTE maintains a Supplemental Executive Retirement Plan (SERP), which supplements the benefits of any participant in the qualified pension plan by direct payment of a lump sum or by an annuity, on an unfunded basis, of the amount by which any participant's benefits under the GTE Service Corporation pension plan are limited by law. In addition, the SERP includes a provision permitting the payment of additional retirement benefits determined in a similar manner as under the qualified pension plan on remuneration accrued under management incentive plans as determined by the Executive Compensation and Organizational Structure Committee. Executive Retired Life Insurance Plan The Executive Retired Life Insurance Plan (ERLIP) provides Messrs. Dinsmore, Daks, Foster, Inkrott and Gabremariam a maximum postretirement life insurance benefit of three times final base salary. Upon retirement, ERLIP benefits may be paid as life insurance or optionally, an equivalent amount may be paid as a lump sum payment equal to the present value of the life insurance amount (based on actuarial factors and the interest rate then in effect), as an annuity or as installment payments. If an optional payment method is selected, the ERLIP benefit will be based on the actuarial equivalent of the present value of the insurance amount. Directors' Compensation The current directors, all of whom are employees of GTE, are not paid any fees of renumeration, as such, for services on the Board. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management (a) Security Ownership of Certain Beneficial Owners as of February 28, 1994: Name and Shares of Title Address of Beneficial Percent of Class Beneficial Owner Ownership of Class - ---------------- --------------------- ----------- --------- Common Stock of GTE Corporation 23,400,000 100% GTE Florida One Stamford Forum shares of Incorporated Stamford, Connecticut record (b) Security Ownership of Management as of December 31, 1993: Common Stock of Name of Director or Nominee (1) GTE Corporation ------------------------------- No director Kent B. Foster 168,299 or nominee or Thomas W. White 83,071 executive Michael B. Esstman 54,051 officer owns Richard M. Cahill 37,188 as much as Gerald K. Dinsmore 18,503 1/10 of Peter A. Daks 9,606 1 percent ------- 370,718 ======= Executive Officers(1)(2) ------------------------ Gerald K. Dinsmore 18,503 Peter A. Daks 9,606 Kent B. Foster 168,299 Stephen A. Inkrott 21,102 Fassil Gabremariam 15,733 ------- 233,243 ======= All directors and executive Represents officers as a group(1)(2) 743,055 less than 1/10 ======= of 1 percent of outstanding common stock. (1) Includes shares acquired through participation in GTE's Consolidated Employee Stock Ownership Plan and/or the GTE Savings Plan. (2) Included in the number of shares beneficially owned by Messrs. Dinsmore, Daks, Foster, Inkrott and Gabremariam and all directors and executive officers as a group are 16,798; 5,166; 115,583; 13,232; 6,500; and 509,655 shares, respectively, which such persons have the right to acquire within 60 days pursuant to stock options. (c) There were no changes in control of the Company during 1993. Item 13. Item 13. Certain Relationships and Related Transactions The Company's executive officers or directors were not materially indebted to the Company or involved in any material transaction in which they had a direct or indirect material interest. PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K (a)(1) Financial Statements - Reference is made to the Registrant's Annual Report to Shareholders, pages 5 - 22, for the year ended December 31, 1993, incorporated herein and filed as Exhibit 13. Report of Independent Public Accountants. Consolidated Balance Sheets - December 31, 1993 and 1992. Consolidated Statements of Income for the years ended December 31, 1993-1991. Consolidated Statements of Reinvested Earnings for the years ended December 31, 1993-1991. Consolidated Statements of Cash Flows for the years ended December 31, 1993-1991. Notes to Consolidated Financial Statements. (2) Financial Statement Schedules - Included in Part IV of this report for the years ended December 31, 1993-1991: Page(s) ------- Report of Independent Public Accountants 21 Schedules: V - Property, Plant and Equipment 22-24 VI - Accumulated Depreciation and Amortization of Property, Plant and Equipment 25 VIII - Valuation and Qualifying Accounts 26 X - Supplementary Income Statement Information 27 Note: Schedules other than those listed above are omitted as not applicable, not required, or the information is included in the financial statements or notes thereto. (3) Exhibits - Included in this report or incorporated by reference. 3-1* Restated Articles of Incorporation dated May 1, 1989 (Exhibit 3-2 of 1989 Form 10-K, File No. 1-3090). 3-2* By-Laws (Exhibit 3-2, File No. 2-52735). 4* Indenture with Index, dated November 1, 1950, between the Company and Chemical Bank and NCNB National Bank of Florida (formerly Exchange Bank and Trust Company of Florida), Trustees, as supplemented by 28 Supplemental Indentures (Exhibits 1 and 2, File No. 1-3090; Exhibit 4(e), File No. 2-10839; Exhibit 4(f), File No. 2-11521; Exhibit 4-18a, File No. 2-13958; Exhibit 4-21, File No. 2-14633; Exhibit 2-3, File No. 2-16152; Exhibits 2-3 and 2-4, File No. 2-23625; Exhibits 2-3 and 2-4, File No. 2-27412; Exhibit 2-3, File No. 2-30311; Exhibit 4-3, File No. 2-39215; Exhibit 2-3, File No. 2-45015; Exhibit 2-3, File No. 2-49304; Exhibit 4-3, File No. 2-51282; Exhibits 4-3 and 4-4, File No. 2-52735; Exhibit 2-3, File No. 2-57428; Exhibits 2-3, 2-4, and 2-5, File No. 2-68285; Exhibit 20 of the 1980 Form 10-K, File No. 1-3090; Exhibit 15, File No. 33-4557; and File No. 33-20998). 13 Annual Report to Shareholders for the year ended December 31, 1993, filed herein as Exhibit 13. (b) Reports on Form 8-K - No reports on Form 8-K were filed during the fourth quarter of 1993. * Denotes exhibits incorporated herein by reference to previous filings with the Securities and Exchange Commission as designated. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To GTE Florida Incorporated: We have audited in accordance with generally accepted auditing standards, the consolidated financial statements included in GTE Florida Incorporated and subsidiary's annual report to shareholders incorporated by reference in this Form 10-K, and have issued our report thereon dated January 28, 1994. Our report on the consolidated financial statements includes an explanatory paragraph with respect to the change in the method of accounting for income taxes in 1992 as discussed in Note 1 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 under 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. Dallas, Texas January 28, 1994. GTE FLORIDA INCORPORATED AND SUBSIDIARY SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (Thousands of Dollars) Column A Column B ----------------- ---------------------------------------------- Item Charged to Operating Expenses - ------------------------------------------------------------------------------- 1993 1992 1991 -------- -------- -------- Maintenance and repairs $211,504 $188,653 $217,290 ======== ======== ======== Taxes, other than payroll and income taxes, are as follows: Real and personal property $ 46,402 $ 41,012 $ 46,064 State gross receipts 15,944 15,961 12,793 Other 4,794 4,667 5,807 Portion of above taxes charged to plant and other accounts (3,612) (4,006) (3,494) -------- -------- -------- Total $ 63,528 $ 57,634 $ 61,170 ======== ======== ======== 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. GTE FLORIDA INCORPORATED ----------------------------------- (Registrant) Date March 21, 1994 By PETER A. DAKS -------------------- ------------------------------- PETER A. DAKS President 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 and in the capacities and on the dates indicated. PETER A. DAKS President and Director March 21, 1994 - ----------------------- (Principal Executive Officer) PETER A. DAKS GERALD K. DINSMORE Senior Vice President - Finance March 21, 1994 - ------------------------ and Planning and Director GERALD K. DINSMORE (Principal Financial Officer) WILLIAM M. EDWARDS, III Controller March 21, 1994 - ------------------------ (Principal Accounting Officer) WILLIAM M. EDWARDS, III RICHARD M. CAHILL Director March 21, 1994 - ------------------------ RICHARD M. CAHILL MICHAEL B. ESSTMAN Director March 21, 1994 - ------------------------ MICHAEL B. ESSTMAN KENT B. FOSTER Director March 21, 1994 - ------------------------- KENT B. FOSTER THOMAS W. WHITE Director March 21, 1994 - ------------------------- THOMAS W. WHITE

732350_1993.txt

732350_1993

1993

732350

Item 1. Business Balcor Pension Investors-V (the "Registrant") is a limited partnership formed in 1983 under the laws of the State of Illinois. The Registrant raised $219,652,500 from sales of Limited Partnership Interests. The Registrant's operations currently consist of investment in wrap-around mortgage loans and first mortgage loans and, to a lesser extent, other junior mortgage loans. The Registrant is also currently operating eight properties acquired through foreclosure. All information included in this report relates to this industry segment. The Registrant originally funded a net of thirty-four loans. During 1993, two of these loans were prepaid in full, and prior to 1993, sixteen of these loans were prepaid in full, two were partially prepaid and one was partially prepaid and partially written-off. A portion of the Mortgage Reductions generated by the prepayments was reinvested by the Registrant in five mortgage loans and an additional funding on an existing loan, and a portion was distributed to Limited Partners. The remainder was added to the Registrant's working capital reserves. The Registrant acquired three properties through foreclosure during 1993 and six in prior years, one of which was subsequently sold. The Registrant also reclassified a loan as an investment in joint venture - affiliate in prior years. As of December 31, 1993, the Registrant has eleven loans in its investment portfolio, an investment in joint venture - affiliate and owns the eight properties described under Item 2. Item 2. Properties As of December 31, 1993, the Registrant owns the eight properties described below: Location Description of Property Dallas, Texas Comerica Plaza: two four-story office buildings containing approximately 113,000 square feet. Tampa, Florida Granada Apartments: a 110-unit apartment complex located on approximately 8 acres. Arlington, Texas Huntington Meadows: a 250-unit apartment complex located on approximately 11.4 acres. Alameda County, California International Teleport: a two-story office building containing approximately 120,000 square feet. Temple Terrace, Florida Plantation Apartments: a 126-unit apartment complex located on approximately 7.9 acres. Largo, Florida The Glades on Ulmerton: a 304-unit apartment complex located on approximately 18.3 acres. Lakewood, Colorado Union Tower: a fourteen-story office building containing approximately 196,000 square feet. Orlando, Florida Waldengreen Apartments: a 276-unit apartment complex located on approximately 15 acres. The Registrant also holds a minority joint venture interest in the Whispering Hills Apartments located in Overland Park, Kansas. 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 these properties. Item 3. Item 3. Legal Proceedings (a & b) Williams proposed class action In February 1990, a proposed class-action complaint was filed, Paul Williams and Beverly Kennedy, et al. vs. Balcor Pension Investors, et al., Case No.: 90- C-0726 (U. S. District Court, Northern District of Illinois) against the Registrant, the General Partner, The Balcor Company, Shearson Lehman Hutton, Inc., American Express Company, other affiliates, and seven affiliated limited partnerships (the "Related Partnerships") as defendants. Several parties have since been joined as additional named plaintiffs. The complaint alleges that the defendants violated Federal securities laws with regard to the adequacy and accuracy of disclosure of information in respect of the offering of limited partnership interests of the Registrant and the Related Partnerships and also alleges breach of fiduciary duty, fraud, negligence and violations under the Racketeer Influenced and Corrupt Organizations Act. The complaint seeks compensatory and punitive damages. The defendants filed their answer, affirmative defenses and a counterclaim to the complaint. The defendants' counterclaim asserts claims of fraud and breach of warranty against plaintiffs, as well as a request for declaratory relief regarding certain defendants' rights under their partnership agreements to be indemnified for their expenses incurred in defending the litigation. The defendants seek to recover damages to their reputations and business as well as costs and attorneys' fees in defending against the claims brought by plaintiffs. In May 1993, the Court issued an opinion and order denying the plaintiffs' motion for class certification based in part on the inadequacy of the individual plaintiffs representing the proposed class. Further, the Court granted defendants' motion for sanctions and ordered that plaintiffs' counsel pay the defendants' attorneys fees incurred with the class certification motion. The defendants have filed a petition for reimbursement of their fees and costs from plaintiffs' counsel, which remains pending. A motion filed by the plaintiffs is currently pending seeking to dismiss the defendants' counterclaim for fraud. In July 1993, the Court gave the plaintiffs leave to retain new counsel. In September 1993, the plaintiffs retained new counsel and filed a new amended complaint and motion for class certification which named three new class representatives. The defendants have conducted discovery with respect to the new representatives and, on February 16, 1994, filed a response to the plaintiffs' latest motion for class certification. The motion is expected to be briefed by March 30, 1994. The defendants intend to continue vigorously contesting this action. As of this time, no plaintiff class has been certified. Management of each of the defendants believes they have meritorious defenses to contest the claims. Whispering Hills Apartments Balcor Mortgage Advisors, Inc. ("BMA"), acting as nominee for the Registrant and an affiliate (together, the "Participants"), previously funded a $15,700,000 first mortgage loan (the "Loan") to three individuals (jointly, the "Borrower"), collateralized by a first mortgage on the Whispering Hills Apartments, Overland Park, Kansas. The Registrant funded $3,925,000 (25%) of the Loan. In March 1988, the Borrower filed suit against the entities from whom they bought the property (the "Seller"), alleging negligence, breach of warranty and fraudulent misrepresentation arising from construction defects at the property, and requesting either monetary damages or rescission of the Borrower's purchase of the property (the "Construction Case"). During May 1988, BMA intervened in the Construction Case and asserted claims for damages. In January 1992, the Court awarded BMA and the Borrower $4,586,844 and $3,897,522, respectively, but did not order rescission of the property. The Seller appealed the Court's decision and, additionally, in April 1992, the Seller and its general partner each filed for protection under Chapter 11 of the U.S. Bankruptcy Code in the U.S. Bankruptcy Court for the Eastern District of California, In re Catwil Corporation (Case No.: 92-91348) and In re Sixty-Ninth Street Associates (Case No.:92-91349) (together, the "Bankruptcy Case"). Due to these bankruptcy proceedings, the Participants have been unable to collect on the judgment and have filed a proof of claim in the Bankruptcy Case. In October 1989, two insurance carriers for the Seller filed a petition for declaratory judgment (the "Insurance Case") in the District Court of Johnson County, Kansas, Civil Court Department, Case No. 89-C-11370, Industrial Indemnity Insurance Company, et al. v. Catwil Corporation, et al., claiming no obligation to pay any portion of the judgment in the Construction Case. BMA and the Borrower intervened in this action and filed a motion for summary judgment against the insurance companies which was granted in part in February 1993. In December 1993, BMA and the Borrower reached a settlement with the insurance companies pursuant to which one of them will pay BMA and the Borrower a total of $1,000,000. As part of the settlement, the Participants and the Borrower have agreed to dismiss the Construction Case and withdraw their claims in the Bankruptcy Case. The settlement is subject to the approval of the Bankruptcy Court and is expected to be finalized during the second quarter of 1994. The entire $1,000,000 settlement will be paid to BMA, and applied to the outstanding amount due under the Loan. Additionally, in December 1991, BMA and the Borrower filed a suit against the Seller and additional related parties, in the Superior Court of California, San Joaquin County, Balcor Mortgage Advisors, Inc., et al. vs. Sixty Ninth Street Associates, et. al. Case No. 239584, alleging fraudulent transfers of assets and seeking $2,000,000 in compensatory damages, a return of the improperly transferred funds, punitive damages and costs. In November 1993, BMA and the Borrower entered into a settlement agreement with the defendants whereby the defendants paid BMA the sum of $125,000 in full satisfaction of BMA's claims against them, and the case was dismissed. This amount was applied to the amount due under the Loan. Villa Medici Apartments The Registrant previously funded a $10,850,000 loan ("Loan") to Wiston XXIV Limited Partnership (the "Borrower"), collateralized by a first mortgage on Villa Medici Apartments. In February 1991, the Loan was placed in default. In March 1991, the Borrower filed for protection under Chapter 11 of the U.S. Bankruptcy Code in the U.S. Bankruptcy Court for the District of Kansas, In re Wiston XXIV Limited Partnership (Case No.: 91-40410-11). The Registrant filed a motion to proceed with a foreclosure of the property, which was granted by the Bankruptcy Court. In October 1992, the Registrant commenced foreclosure proceedings against the Borrower in the District Court of Johnson County, Kansas, Balcor Pension Investors-V vs. Wiston XXIV Limited Partnership, et al., Case No. 92-C-11570, and a receiver was appointed by the court to manage the property. In April 1993, the Bankruptcy Court denied confirmation of the borrower's plan of reorganization and the borrower appealed. Subsequently, the Bankruptcy Court issued an order preventing the Registrant from proceeding with the foreclosure action while the appeal is pending. A ruling on the appeal is not expected until the latter half of 1994. Additionally, in November 1991, the Registrant filed an action against the general partners of the Borrower ("Principals"), for misappropriation of property funds, in the Circuit Court of Cook County, Illinois, Balcor Pension Investors-V v. Robert L. Thompson and Wiston Management, Inc., (Case No.: 91 L 18444). Pursuant to a court order, the Registrant received the amount initially sought and is now receiving net cash flow from the property on a current basis. The Registrant continues to review materials to determine whether all property funds are accounted for. Springwells Park Apartments In April 1985, the Registrant funded a $12,500,000 loan collateralized by a first mortgage on Springwells Park Apartments (the "Property"). Upon the partial repayment of the loan in 1990, the Registrant received three promissory notes evidencing the remaining balance of $3,300,000. In February 1993, one of the notes, in the amount of $2,300,000 which is collateralized by a second mortgage on the Property, was placed in default and, in May 1993, the Registrant commenced foreclosure proceedings in the Circuit Court of Wayne County, Michigan, Balcor Pension Investors-V vs. Springwells Properties Limited Partnership, et. al., Case No.: 93-313288CH, and filed a claim against the borrower and a principal of the borrower (the "Guarantor") to enforce a guarantee by the Guarantor. In May 1993, the borrower filed a counterclaim against the Registrant alleging lender liability claims and requesting unspecified damages. The terms of the Registrant's note require the consent of the new first mortgage holder prior to a foreclosure of the Property by the Registrant. The first mortgage holder would not grant its consent, and as a result, in July 1993, the Registrant withdrew its request for foreclosure and the appointment of a receiver. However, the complaint filed on the guarantee was not released and the Registrant continues to pursue the Guarantor under the $2,300,000 note. Proceedings on these matters continue and are in the discovery phase. The new first mortgage holder commenced non-judicial foreclosure proceedings in October 1993. On December 6, 1993, the borrower filed for protection under Chapter 11 of the U.S. Bankruptcy Code (In re Springwell Properties Limited Partnership, U.S. Bankruptcy Court for the Eastern District of Michigan, Case No.: 93-53186-G). The new first mortgage holder has filed a motion to lift the stay imposed by the bankruptcy court on the foreclosure proceedings. No hearing on this motion has been scheduled at this time. The remaining two notes held by the Registrant aggregate approximately $700,000. The Registrant commenced litigation in November 1992 against the Guarantor under these two notes, which are collateralized by a second mortgage on other real property owned by an affiliate of the borrower ("Affiliate") and which have been in default since 1990, to enforce a guarantee by the Guarantor (Balcor Pension Investors-V vs. Springwell Properties Limited Partnership and Anthony S. Brown, Circuit Court of Cook County, Case No.: 92-L-13994). This litigation is currently in the discovery phase. The Affiliate then filed for protection in March 1993, under Chapter 11 of the U.S. Bankruptcy Code (In re Aspen Hotel Partners Limited Partnership, U.S. Bankruptcy Court for the Eastern District of Michigan, Case No.: 93-42354). The Registrant has filed a proof of claim in this case. In February 1994, a plan of reorganization was confirmed by the court. The Registrant received $45,000 in February 1994, and is scheduled to receive $55,000 by May 1, 1994. Upon receipt of this payment, the Registrant will release the notes and its lien on this parcel of property. This settlement will have no impact, however, on the other cases described above. 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. For information regarding previous distributions, see Financial Statements, Statements of Partner's Capital and Management's Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources. As of December 31, 1993, the number of record holders of Limited Partnership Interests of the Registrant was 41,645. Item 6. Item 6. Selected Financial Data Year ended December 31, 1993 1992 1991 1990 1989 Net interest income on loans receivable $10,736,753 $10,625,873 $10,505,134 $12,098,301 $13,490,294 Income from operations of real estate held for sale 1,845,385 1,815,619 2,928,056 1,587,139 1,565,534 Provision for po- tential losses on loans, real estate and accrued inter- est receivable 8,055,000 4,000,000 5,749,082 5,500,000 4,000,000 Interest on short- term investments 928,837 935,793 1,413,189 2,874,943 2,040,460 Administrative expenses 1,494,536 1,351,578 1,163,259 683,714 643,494 Net income 10,335,746 7,982,124 8,022,644 9,921,710 11,993,388 Net income per Limited Partner- ship Interest 21.17 16.35 16.44 20.33 24.57 Cash and cash equivalents 23,623,906 24,859,520 19,611,150 29,469,908 28,506,412 Net investment in loans receivable 38,952,112 53,961,219 75,462,395 97,371,771 124,405,045 Loans in substan- tive foreclosure 11,548,672 22,100,734 15,361,590 17,485,030 24,909,686 Real estate held for sale 41,430,697 37,121,109 42,699,025 35,024,205 20,541,371 Investment in joint venture - affiliate 3,222,981 3,222,705 2,964,048 2,213,075 1,794,646 Total assets 120,700,542 144,257,526 158,402,349 167,064,706 178,283,565 Distributions to Limited Partners 28,664,651 14,277,412 21,635,771 24,381,428 22,887,790 Distributions per Limited Partner- ship Interest 65.25 32.50 49.25 55.50 52.10 Number of loans 11 15 18 20 22 Properties owned 8 6 5 4 3 Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Balcor Pension Investors-V (the "Partnership") is a limited partnership formed in 1983 to invest in wrap-around mortgage loans and first mortgage loans and, to a lesser extent, other junior mortgage loans. The Partnership raised $219,652,500 from sales of Limited Partnership Interests and utilized these proceeds to fund a net of thirty-four loans. Currently, there are eleven loans outstanding in the Partnership's portfolio, and the Partnership is operating eight properties acquired through foreclosure and one investment in a joint venture with an affiliate. Operations Summary of Operations In March 1993, the borrower of the wrap-around mortgage collateralized by the Valley West Shopping Center prepaid the loan in full. In connection with this prepayment, the Partnership received additional interest and participation income of $7,910,750. As a result, net income increased during 1993 as compared to 1992. However, the provision for potential losses on loans and real estate increased during 1993 to provide for further declines in the fair value of certain properties in the Partnership's portfolio, which partially offset the increase in net income. During 1992, the provision for potential losses on loans, real estate and accrued interest receivable declined as compared to 1991. This was partially offset by a decrease in income from operations of real estate held for sale resulting primarily from the sale of the Northland Park Industrial building in January 1992, which had generated significant income from operations during 1991, and the acquisition of The Glades on Ulmerton apartment complex through foreclosure in December 1991, which was generating a significant deficit after debt service payments. Further discussion of the Partnership's operations is summarized below. 1993 Compared to 1992 Interest income on loans receivable decreased during 1993 as compared to 1992 as a result of a decrease in the total amount of loans outstanding, due to the foreclosure on the International Teleport office building in October 1992, and the prepayment of the Imperial Gardens loan in December 1992, the Valley West loan in March 1993 and the Lake Worth loan in April 1993. This was partially offset by additional interest income received as a result of the Valley West and Lake Worth loan prepayments. The Partnership also received significant participation income from the Valley West loan prepayment in 1993. Interest expense on loans payable decreased during 1993 as compared to 1992 due to the prepayment of the Valley West loan and the concurrent repayment of the underlying mortgage loan. The Partnership's four non-accrual loans at December 31, 1993 are collateralized by the 45 West 45th Street Office Building located in New York, New York; Fairview Plaza I and II Office Building located in Charlotte, North Carolina; Villa Medici Apartments located in Overland Park, Kansas; and Springwells Park Apartments located in Dearborn, Michigan. For non-accrual loans, income is recorded only as cash payments are received from the borrowers. The funds advanced by the Partnership for these non-accrual loans totaled approximately $23,830,000, representing approximately 12% of the original funds advanced. Certain of these non-accrual loans are collateralized by properties located in areas which are experiencing weak rental markets due to various factors, including adverse local economic conditions, which have resulted in declining rental and occupancy rates. The reduced cash flows from these properties have adversely affected the borrowers' abilities to make mortgage payments to the Partnership on a timely basis. During 1993, the Partnership received cash payments totaling approximately $1,771,000 of net interest income on these four loans. Under the terms of the original loan agreements, the Partnership would have received approximately $2,568,000 of net interest income during 1993. Of the loans on non-accrual status at December 31, 1993, those collateralized by the 45 West 45th Street Office Building, Springwells Park Apartments and Villa Medici Apartments are also classified in substantive foreclosure. Loans are classified in substantive foreclosure when a determination has been made that the borrower has little or no equity remaining in the collateral property in consideration of its current fair value, or the Partnership has taken certain actions which result in taking effective control of operations of the collateral property. Income from operations of real estate held for sale represents net property operations generated by the eight properties the Partnership has acquired through foreclosure. These eight properties comprise approximately 35% of the Partnership's portfolio based on original funds advanced. The increase in income generated in 1993 resulting from the foreclosures of the International Teleport office building in 1992 and the Plantation, Granada and Waldengreen apartment complexes in 1993, was substantially offset by higher property operating expenses due to the repair and renovation program at The Glades on Ulmerton apartment complex and by higher leasing activity at the Union Tower office building. The allowance for potential losses provides for potential loan losses and is based upon loan loss experience for similar loans and for the industry, upon prevailing economic conditions and the General Partner's analysis of specific loans in the Partnership's portfolio. While actual losses may vary from time to time because of changes in circumstances (such as occupancy rates, rental rates, and other economic factors), the General Partner believes that adequate recognition has been given to loss exposure in the portfolio at December 31, 1993. The Partnership recognized a provision for potential losses of $2,000,000 for its loans during 1993. In addition, in 1993 a provision of $6,055,000 was recognized related to the Partnership's real estate held for sale to provide for further declines in the fair value of certain properties in the Partnership's portfolio. As a result of the sale of the Northland Park Industrial building in January 1992, deferred expenses related to this property were fully amortized resulting in a decrease in amortization expense during 1993 as compared to 1992. Due to the loan foreclosures and prepayments during 1992 and 1993, the total amount of loans outstanding decreased, resulting in decreased mortgage servicing fees during 1993 as compared to 1992. Higher foreclosure related costs incurred during 1993 were the primary reason administrative expenses increased during 1993 as compared to 1992. 1992 Compared to 1991 Interest income on loans receivable decreased slightly during 1992 as compared to 1991. Decreased collections from certain of the loans currently on non-accrual status and decreased interest income as a result of the foreclosure of International Teleport in October 1992 were partially offset by the additional interest income received as a result of the prepayment on the Imperial Gardens loan in December 1992. The Partnership also received a prepayment premium in 1992 in connection with this loan. Interest expense on loans payable decreased primarily due to the reclassification of the interest expense related to The Glades on Ulmerton Apartments mortgage note payable to operations of real estate acquired through foreclosure beginning in December 1991. The Partnership's five non-accrual loans at December 31, 1992 were collateralized by the 45 West 45th Street and Fairview Plaza I and II office buildings and the Granada, Villa Medici and Waldengreen apartment complexes. The funds advanced by the Partnership for these non-accrual loans totaled approximately $30,425,000, representing approximately 16% of the original funds advanced. During the year ended December 31, 1992, the Partnership received cash payments totaling approximately $2,182,000 of net interest income on these five loans. Under the terms of the original loan agreements, the Partnership would have received approximately $3,724,000 of net interest income during the year ended December 31, 1992. Of the loans on non-accrual status at December 31, 1992, the loans collateralized by the 45 West 45th Street Office Building and the Granada, Villa Medici and Waldengreen apartment complexes were classified in substantive foreclosure. As a result of the sale of the Northland Park Industrial building in January 1992, which had generated significant income from operations during 1991, and the acquisition of The Glades on Ulmerton apartment complex through foreclosure in December 1991, which was generating a significant deficit after debt service payments, income from operations of real estate held for sale decreased during 1992 as compared to 1991. These decreases were partially offset by higher rental income at the Union Tower office building as a result of higher occupancy levels in 1992 as compared to 1991. In addition, the Partnership recognized a gain in 1992 in connection with the sale of the Northland Park Industrial building. Primarily as a result of lower interest rates during 1992, interest income on short-term investments decreased during 1992 as compared to 1991. The Partnership recognized a provision for potential losses of $4,000,000 for its loans and real estate during 1992. As a result of the sale of the Northland Park Industrial building in January 1992, deferred expenses related to this property were fully amortized resulting in an increase in amortization expense during 1992 as compared to 1991. As a result of higher legal expenses relating to the Partnership's loans in default and on non-accrual status, administrative expenses increased during 1992 as compared to 1991. Participation in income of joint venture - affiliate represents the Partnership's 25% share of the income of the Whispering Hills Apartments. The property was vacant during 1990 and early 1991 while repairs were being made to the property. Leasing commenced in February 1991, and as of December 31, 1992, the property's occupancy rate had increased to 99%. Property operations during 1992 generated income as compared to a slight loss in 1991. In addition, the provision for potential losses related to the property was higher in 1992. The increase in the provision for potential losses resulted in decreased net income during 1992 as compared to 1991 which decrease was partially offset by improved property operations during 1992. Liquidity and Capital Resources The Partnership's cash flow provided by operating activities during 1993 was generated by additional interest and participation income received from the Valley West Shopping Center and the Lake Worth Mobile Home Park loan prepayments, interest income received from the Partnership's loans receivable and short-term investments, and cash flow from the operation of the Partnership's properties held for sale. This cash flow was partially offset by the payment of administrative expenses and mortgage servicing fees. This cash flow, as well as cash received from investing activities generated primarily from the prepayment on the Valley West Shopping Center loan, was mostly utilized for financing activities consisting of distributions to Limited Partners and the General Partner, the prepayment of the underlying mortgage loans on the Valley West Shopping Center and Plantation Apartments, and the purchase of the underlying mortgage loan on Waldengreen Apartments prior to acquisition of the property through foreclosure. As of December 31, 1993, the Partnership had undistributed Mortgage Reductions of approximately $13,513,000, which have been retained while the Partnership determines its working capital needs. The Partnership's cash or near cash position also fluctuates during each quarter, initially decreasing with the payment of Partnership distributions for the previous quarter, and then gradually increasing each month in the quarter as mortgage payments and cash flow from property operations are received. The Partnership classifies the cash flow performance of its properties as either positive, a marginal deficit or a significant deficit, each after consideration of debt service payments unless otherwise indicated. A deficit is considered to be significant once it exceeds $250,000 annually or 20% of the property's rental and service income. Seven of the eight properties held by the Partnership at December 31, 1993, are generating positive cash flow, as compared to four of the five properties held by the Partnership at December 31, 1992. The Union Tower, Comerica Plaza and International Teleport office buildings and the Huntington Meadows, Plantation, Granada and Waldengreen apartment complexes have occupancy rates of 98%, 100%, 69%, 94%, 94%, 95% and 99% respectively, which, except for International Teleport which was foreclosed upon in October 1992, exceed the average occupancy rates in their respective markets. The average occupancy rate for office buildings in the Alameda, California area is approximately 81%. 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. The General Partner will also examine the terms of any mortgage loans collateralized by its properties, and may refinance or, in certain instances, use Partnership reserves to repay such loans. The General Partner is taking steps at the International Teleport office building to improve occupancy, which declined prior to the foreclosure by the Partnership due to the loss of several large tenants during 1992. The Glades on Ulmerton apartment complex, located in Largo, Florida, was acquired through foreclosure in December 1991 and generated a significant cash flow deficit after debt service payments during 1993 and 1992. The Partnership has completed a major repair and renovation program for the property aimed at arresting the deterioration of the property's value and improving the asset's performance. Approximately $1,172,000 and $458,000 was spent during 1993 and 1992, respectively, for non-recurring repair and maintenance expenditures which were completed during the fourth quarter of 1993. As of December 31, 1993, the property had an occupancy rate of 95% while the average occupancy rate for apartment complexes in the Largo, Florida area is 93%. Because of the current weak real estate markets in certain cities and regions of the country, attributable to local and regional market conditions such as overbuilding and recessions in local economies and specific industry segments, certain borrowers have requested that the Partnership allow prepayment of mortgage loans. The Partnership has allowed some of these borrowers to prepay such loans, in some cases without assessing prepayment premiums, under circumstances where the General Partner believed that refusing to allow such prepayment would ultimately prove detrimental to the Partnership in light of the probable inability of the properties to generate sufficient revenues to keep loan payments current. In other cases, borrowers have requested prepayment in order to take advantage of lower available interest rates. In these cases, the General Partner evaluates the request for prepayment along with the market conditions on a case by case basis, and in some cases the Partnership collects substantial prepayment premiums. In addition, certain borrowers have failed to make payments when due to the Partnership for more than ninety days and, accordingly, these loans have been placed on non-accrual status (income is recorded only as cash payments are received). The General Partner has negotiated with some of these borrowers regarding modifications of the loan terms and has instituted foreclosure proceedings under certain circumstances. Such foreclosure proceedings may be delayed by factors beyond the General Partner's control such as bankruptcy filings by borrowers and state law procedures regarding foreclosures. Further, certain loans made by the Partnership have been restructured to defer and/or reduce interest payments where the properties collateralizing the loans were generating insufficient cash flow to support property operations and debt service. In the case of most loan restructurings, the Partnership receives concessions, such as increased participations or additional interest accruals, in return for modifications, such as deferral or reduction of basic interest payments. There can be no assurance, however, that the Partnership will receive actual benefits from the concessions. In March 1993, the Partnership made a successful bid for the Plantation Apartments at a foreclosure sale, and, in April 1993, received title to the property. As part of this transaction, the Partnership assumed the underlying mortgage note, and repaid this loan in full in August 1993. In addition, in June 1993, the Partnership made a successful bid for the Granada Apartments at a foreclosure sale and received title to the property. The underlying mortgage note of $9,220 was repaid in June 1993. Also, in September 1993, the Partnership made a successful bid for the Waldengreen Apartments at a foreclosure sale and received title to the property. See Note 7 of Notes to Financial Statements for additional information on all of these properties. In July 1993, the Partnership purchased the first mortgage loan collateralized by the Waldengreen Apartments, leaving the Partnership with a senior lien on the property. The purchase price was $2,269,702, comprised of the principal ($2,000,000) and accrued interest ($344,576) less the balance of the tax escrow held by the lender ($74,874). In March 1993, the borrower of the wrap-around mortgage collateralized by Valley West Shopping Center located in West Des Moines, Iowa prepaid the loan in full in the amount of $21,834,548, comprised of the funds advanced on the loan ($10,472,551), accrued and unpaid interest thereon ($34,032), additional interest ($1,710,750), the amount representing the difference between the funds advanced by the Partnership and the outstanding principal balance due on the underlying loan ($3,417,215) and participation in the appreciation of the property ($6,200,000). The funds advanced by the Partnership represented the difference between the wrap-around loan receivable of $36,000,000 and the original balance of the underlying mortgage note payable of $25,527,449. The underlying mortgage note payable which had a current balance of $22,110,234 was also prepaid. In April 1993, the Partnership received $3,150,000 from the borrower on the Lake Worth Mobile Home Park loan as settlement in full on amounts owed to the Partnership. In September 1989, the borrower had prepaid the original principal balance of the loan and a portion of the accrual interest. The Partnership also received a $5,000,000 second mortgage note from the borrower which represented additional accrual interest and prepayment premiums due at the prepayment date. The Partnership had previously recorded $1,000,000 of this note in the financial statements which represented the balance of accrual interest recognized prior to the date of the prepayment. In December 1993, the Partnership purchased a 4.75 acre unimproved parcel of land adjacent to Granada Apartments in Tampa, Florida from unaffiliated parties for a purchase price of $52,873. The General Partner believes this parcel will enhance the sale potential of Granada Apartments. In February 1994, the Seven Trails West Apartments loan matured and was placed in default when the borrower failed to repay the loan. The General Partner is negotiating a two year extension of this loan on substantially the same terms as the previously modified loan. In addition, during February 1994, the Partnership prepaid the underlying mortgage on The Glades on Ulmerton Apartments. The loan collateralized by the Villa Medici apartment complex was placed in default by the Partnership in 1991. The borrower subsequently filed for protection under the U.S. Bankruptcy Code. In addition, in April 1993, the Partnership accelerated the second mortgage loan collateralized by the Springwells Park Apartments. During December 1993, the borrower filed for protection under the U.S. Bankruptcy Code. See Item 3. Legal Proceedings for additional information. The Partnership and three affiliated partnerships (together, the "Participants"), previously funded a $23,000,000 loan to 45 West 45th Street Office Building, New York, New York (the "Property"), of which the Partnership's share is $5,000,000 (approximately 22%). In September 1991, the loan was placed in default. Pursuant to a cash management agreement entered into between the Participants and the borrower, cash flow from property operations is received by the Participants and recognized as interest income. In May 1993, the Participants cashed a letter of credit which provided partial collateral for the loan, of which the Partnership's share was approximately $105,000. The Participants intend to file foreclosure proceedings during 1994. The loan collateralized by the Noland Fashion Square shopping center located in Independence, Missouri, is recorded by the Partnership as an investment in an acquisition loan. The Partnership has recorded its share of the collateral property's operations as equity in loss from investment in acquisition loan. The Partnership's share of operations has no effect on the cash flow of the Partnership. Amounts representing contractually required debt service are recorded as interest income. Distributions to Limited Partners can be expected to fluctuate for various reasons. Generally, distributions are made from Cash Flow generated by interest and other payments made by borrowers under the Partnership's mortgage loans and by the operations of the Partnership's properties. Loan prepayments and repayments can initially cause Cash Flow to increase as prepayment premiums and participations are paid; however, thereafter, prepayments and repayments will have the effect of reducing Cash Flow. If such proceeds are distributed, Limited Partners will receive a return of capital and the dollar amount of Cash Flow available for distribution thereafter can be expected to decrease. Distribution levels can also vary as loans are placed on non-accrual status, modified or restructured and, if the Partnership has taken title to properties through foreclosure or otherwise, as a result of property operations. The Partnership made distributions totaling $65.25 per Interest during 1993 as compared to $32.50 per Interest during 1992 and $49.25 per Interest in 1991. See Statements of Partners' Capital. Distributions were comprised of $42.00 of Cash Flow and $23.25 of Mortgage Reductions in 1993, $30.00 of Cash Flow and $2.50 of Mortgage Reductions in 1992 and $24.75 of Cash Flow and $24.50 of Mortgage Reductions in 1991. Cash Flow distributions increased in 1993 as compared to 1992 and 1991 due to two loan prepayments in 1993 and one loan prepayment and one property sale in 1992. Total distributions increased between 1993 and 1992 and decreased between 1992 and 1991 due to the distribution to Limited Partners of the Mortgage Reductions received from loan prepayments and the property sale. To date, including the distribution in January 1994, Limited Partners have received cumulative cash distributions of $438.60 per $500 Interest. Of this amount, $333.25 has been cash flow from operations and $105.35 represents a return of original capital. In January 1994, the Partnership made a distribution of $3,953,745 ($9.00 per Interest) to the holders of Limited Partnership Interests for the fourth quarter of 1993. This distribution includes a regular quarterly distribution of $4.00 per Interest from Cash Flow and a special distribution of $5.00 per Interest from Cash Flow. The level of the regular quarterly distribution remained the same as the third quarter of 1993. In addition, during October 1993, the Partnership paid $146,435 to the General Partner as its distributive share of the Cash Flow distributed for the third quarter of 1993 and made a contribution of $48,812 to the Early Investment Incentive Fund. The General Partner presently expects to continue making cash distributions from the Cash Flow generated from property operations and by the receipt of mortgage payments, less payments on the underlying loans, fees to the General Partner and administrative expenses. The General Partner believes it has retained, on behalf of the Partnership, an appropriate amount of working capital to meet current cash or liquidity requirements which may occur. In 1993, the Financial Accounting Standards Board issued Statement No. 114, "Accounting by Creditors for Impairment of a Loan." This statement addresses accounting by creditors for impairment of loans and also eliminates the classification of loans as "in substantive foreclosure." This statement has been adopted by the Partnership as of January 1, 1994, and will not have a material impact on the financial position or results of operations of the Partnership. 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 and/or sales prices, depending on general or local economic conditions. In the long-term, inflation can be expected to increase operating costs and replacement costs and may lead to increased rental revenues and real estate values. The Partnership's use of participations for loans receivable is intended to provide a hedge against the impact of inflation; sharing in cash flow or rental income and/or the capital appreciation of the properties securing the loans should result in increases in the total yields on the loans as inflation rises. Item 8. Item 8. Financial Statements and Supplementary Data See Index to Financial Statements and Financial Statement Schedules in this Form 10-K. The supplemental financial information specified by Item 302 of Regulation S-K is not applicable. 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) Neither the Registrant nor Balcor Mortgage Advisors-V, its General Partner, has a Board of Directors. (b, c & e) The names, ages and business experience of the executive officers 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 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. (d) There is no family relationship between any of the foregoing officers. (f) None of the foregoing officers 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 (a, b, c, d & e) 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 most 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 Mortgage Advisors-V and its officers and partners own as a group through the Early Investment Incentive Fund and otherwise the following Limited Partnership Interests of the Registrant: Amount Beneficially Title of Class Owned Percent of Class Limited Partnership 15,332 Interests 3.49% Interests Relatives and affiliates of the officers and partners of the General Partner do not own any additional 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 9 of Notes to Financial Statements for information relating to transactions with affiliates. See Note 2 of Notes to Financial Statements for information relating to the Partnership Agreement and the allocation of distributions and profits and losses. (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 Financial Statement Schedules in this Form 10-K. (3) Exhibits: (3) The Amended and Restated Agreement of Limited Partnership and Amended and Restated Certificate of Limited Partnership of Balcor Pension Investors-V previously filed as Exhibit 3 and 4.1, respectively, to Amendment No. 1 dated January 16, 1984 to the Registrant's Registration Statement on Form S-11 (Registration No. 2-87662) are incorporated herein by reference. (4) 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. 0-13233) is 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 Financial Statement Schedules in this Form 10-K. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of l934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized. BALCOR PENSION INVESTORS-V By: /s/ Allan Wood Allan Wood Executive Vice President, and Chief Accounting and Financial Officer (Principal Accounting and Financial Officer) of Balcor Mortgage Advisors-V, the General Partner 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. Signature Title Date President and Chief Executive Officer (Principal Executive Officer) of Balcor Mortgage /s/ Thomas E. Meador Advisors-V, the General Partner March 30, 1994 Thomas E. Meador Executive Vice President, and Chief Accounting and Financial Officer (Principal Accounting and Financial Officer) of Balcor Mortgage /s/ Allan Wood Advisors-V, the General Partner March 30, 1994 Allan Wood INDEX TO FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES Report of Independent Auditors 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 Schedules: I - Marketable Securities - Other Investments, as of December 31, 1993 X - Supplementary Income Statement Information, for the years ended December 31, 1993, 1992 and 1991 Schedules, other than those listed, are omitted for the reason that they are inapplicable or equivalent information has been included elsewhere herein. REPORT OF INDEPENDENT AUDITORS To the Partners of Balcor Pension Investors-V We have audited the accompanying balance sheets of Balcor Pension Investors-V (An Illinois Limited Partnership) as of December 31, 1993 and 1992, and the related statements of partners' capital, income and expenses 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 Partnership'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 Balcor Pension Investors-V 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, 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. /s/ Ernst & Young Ernst & Young Chicago, Illinois March 17, 1994 BALCOR PENSION INVESTORS-V (An Illinois Limited Partnership) BALANCE SHEETS December 31, 1993 and 1992 ASSETS 1993 1992 ------------- ------------- Cash and cash equivalents $ 23,623,906 $ 24,859,520 Escrow deposits - restricted 379,685 122,381 Accounts and accrued interest receivable 1,285,486 2,723,712 Deferred expenses, net of accumulated amortization of $172,787 in 1993 and $137,053 in 1992 257,003 146,146 ------------- ------------- 25,546,080 27,851,759 ------------- ------------- Investment in loans receivable: Loans receivable - wrap-around and first mortgages 45,482,975 83,770,927 Investment in acquisition loan 8,587,042 8,664,085 Less: Loans payable - underlying mortgages 9,160,291 32,082,793 Allowance for potential loan losses 5,957,614 6,391,000 ------------- ------------- Net investment in loans receivable 38,952,112 53,961,219 Loans in substantive foreclosure (net of allowance of $1,200,000 in 1993) 11,548,672 22,100,734 Real estate held for sale (net of allowance of $6,055,000 in 1993) 41,430,697 37,121,109 Investment in joint venture - affiliate 3,222,981 3,222,705 ------------- ------------- 95,154,462 116,405,767 ------------- ------------- $120,700,542 $144,257,526 ============= ============= LIABILITIES AND PARTNERS' CAPITAL Accounts and accrued interest payable $ 266,687 $ 219,349 Due to affiliates 136,721 89,601 Other liabilities, principally escrow deposits and accrued real estate taxes 927,341 658,933 Security deposits 290,169 236,327 Mortgage notes payable 2,245,353 5,840,049 ------------- ------------- Total liabilities 3,866,271 7,044,259 Partners' capital (439,305 Limited Partnership Interests issued and outstanding) 116,834,271 137,213,267 ------------- ------------- $120,700,542 $144,257,526 ============= ============= The accompanying notes are an integral part of the financial statements. BALCOR PENSION INVESTORS-V (An Illinois Limited Partnership) STATEMENTS OF PARTNERS' CAPITAL for the years ended December 31, 1993, 1992 and 1991 Partners' Capital Accounts ----------------------------------------- General Limited Total Partner Partners ------------- ------------- ------------- Balance at December 31, 1990 $159,794,121 $ (1,430,612) $161,224,733 Cash distributions (A) (22,843,860) (1,208,089) (21,635,771) Net income for the year ended December 31, 1991 8,022,644 802,264 7,220,380 ------------- ------------- ------------- Balance at December 31, 1991 144,972,905 (1,836,437) 146,809,342 Cash distributions (A) (15,741,762) (1,464,350) (14,277,412) Net income for the year ended December 31, 1992 7,982,124 798,212 7,183,912 ------------- ------------- ------------- Balance at December 31, 1992 137,213,267 (2,502,575) 139,715,842 Cash distributions (A) (30,714,742) (2,050,091) (28,664,651) Net income for the year ended December 31, 1993 10,335,746 1,033,575 9,302,171 ------------- ------------- ------------- Balance at December 31, 1993 $116,834,271 $ (3,519,091) $120,353,362 ============= ============= ============= (A) Summary of cash distributions paid per Limited Partnership Interest: 1993 1992 1991 ------------- ------------- ------------- First quarter $ 6.25 $ 6.25 $ 11.00 Second quarter 46.00 11.25 10.75 Third quarter 9.00 8.75 21.25 Fourth quarter 4.00 6.25 6.25 The accompanying notes are an integral part of the financial statements. BALCOR PENSION INVESTORS-V (An Illinois Limited Partnership) STATEMENTS OF INCOME AND EXPENSES for the years ended December 31, 1993, 1992 and 1991 1993 1992 1991 ------------- ------------- ------------- Income: Interest on loans receivable, loans in substantive foreclosure and from investment in acquisition loans $ 12,035,758 $ 13,990,146 $ 14,221,182 Less interest on loans payable - underlying mortgages 1,299,005 3,364,273 3,716,048 ------------- ------------- ------------- Net interest income on loans receivable 10,736,753 10,625,873 10,505,134 Income from operations of real estate held for sale 1,845,385 1,815,619 2,928,056 Interest on short-term investments 928,837 935,793 1,413,189 Participation income 6,277,197 48,224 Participation in income of joint venture - affiliate 358,755 368,723 471,015 ------------- ------------- ------------- Total income 20,146,927 13,794,232 15,317,394 ------------- ------------- ------------- Expenses: Provision for potential losses on loans, real estate and accrued interest receivable 8,055,000 4,000,000 5,749,082 Amortization of deferred expenses 35,734 95,646 48,391 Mortgage servicing fees 148,867 218,359 241,228 Administrative 1,494,536 1,351,578 1,163,259 ------------- ------------- ------------- Total expenses 9,734,137 5,665,583 7,201,960 ------------- ------------- ------------- Income before equity in loss from investment in acquisition loans 10,412,790 8,128,649 8,115,434 Equity in loss from investment in acquisition loans (77,044) (146,525) (92,790) ------------- ------------- ------------- Net income $ 10,335,746 $ 7,982,124 $ 8,022,644 ============= ============= ============= Net income allocated to General Partner $ 1,033,575 $ 798,212 $ 802,264 ============= ============= ============= Net income allocated to Limited Partners $ 9,302,171 $ 7,183,912 $ 7,220,380 ============= ============= ============= Net income per Limited Partnership Interest (439,305 issued and outstanding) $ 21.17 $ 16.35 $ 16.44 ============= ============= ============= The accompanying notes are an integral part of the financial statements. BALCOR PENSION INVESTORS-V (An Illinois Limited Partnership) STATEMENTS OF CASH FLOWS for the years ended December 31, 1993, 1992 and 1991 1993 1992 1991 ------------- ------------- ------------- Operating activities: Net income $ 10,335,746 $ 7,982,124 $ 8,022,644 Adjustments to reconcile net income to net cash provided by operating activities: Equity in loss from investment in acquisition loans 77,044 146,525 92,790 Participation in income of joint venture - affiliate (358,755) (368,723) (471,015) Provision for potential losses on loans, real estate and accrued interest receivable 8,055,000 4,000,000 5,749,082 Amortization of deferred expenses 35,734 95,646 48,391 Accrued interest income due at maturity (837,826) (737,769) (744,530) Collection of interest income due at maturity 616,266 581,287 Net change in: Escrow deposits - restricted (257,304) 411,475 575,142 Accounts and accrued interest receivable 1,438,226 (1,408,076) 58,073 Accounts and accrued interest payable 47,338 (2,145,149) 2,194,868 Due to affiliates 47,120 3,346 8,045 Other liabilities 268,408 (500,726) (68,471) Security deposits 53,842 73,378 97,509 ------------- ------------- ------------- Net cash provided by operating activities 19,520,839 8,133,338 15,562,528 ------------- ------------- ------------- Investing activities: Capital contributions to joint venture - affiliate (5,625) (56,689) (279,958) Distributions from joint venture - affiliate 364,104 166,755 Collection of principal payments on loans receivable and loans in substantive foreclosure 37,341,491 6,213,222 136,141 Additions to real estate (733,315) (390,320) (874,354) Payment of expenses on real estate held for sale (344,577) (108,561) (148,721) Proceeds from sale of real estate 15,075,828 ------------- ------------- ------------- Net cash provided by or used in investing activities 36,622,078 20,900,235 (1,166,892) ------------- ------------- ------------- Financing activities: Distributions to Limited Partners (28,664,651) (14,277,412) (21,635,771) Distributions to General Partner (2,050,091) (1,464,350) (1,208,089) Principal payments on loans payable - underlying mortgages (812,268) (2,731,218) (1,180,984) Repayment of loans payable - underlying mortgages (22,110,234) Principal payments on mortgage notes payable (99,776) (123,664) (229,550) Repayment of mortgage notes payable (3,494,920) (5,088,361) Payment of deferred expenses (146,591) (100,198) ------------- ------------- ------------- Net cash used in financing activities (57,378,531) (23,785,203) (24,254,394) ------------- ------------- ------------- Net change in cash and cash equivalents (1,235,614) 5,248,370 (9,858,758) Cash and cash equivalents at beginning of period 24,859,520 19,611,150 29,469,908 ------------- ------------- ------------- Cash and cash equivalents at end of period $ 23,623,906 $ 24,859,520 $ 19,611,150 ============= ============= ============= The accompanying notes are an integral part of the financial statements. BALCOR PENSION INVESTORS-V (An Illinois Limited Partnership) NOTES TO FINANCIAL STATEMENTS 1. Accounting Policies: (a) The Partnership records wrap-around mortgage loans at the face amount of the mortgage instrument which includes the outstanding indebtedness of the borrower under the terms of the underlying mortgage obligation(s). The underlying mortgage obligation(s) are recorded as a reduction of the wrap-around mortgage loan and the resulting balance represents the Partnership's net advance to the borrower. The Partnership is responsible for making periodic payments to the underlying mortgage lender(s) only to the extent that payments as required by the wrap-around mortgage agreement are received by the Partnership from the borrower. (b) Net interest income on the Partnership's wrap-around mortgage loans is primarily comprised of the difference between the interest portion of the monthly payment received from the borrower and the interest portion of the underlying debt service paid to the mortgage lender(s). This interest is recorded in the period that it is earned as determined by the terms of the mortgage loan agreements. Certain mortgage loans also contain provisions for specific amounts of interest to accrue on a periodic basis and to be paid to the Partnership upon maturity of the loans. Interest of this type is recognized only to the extent of the net present value of the total amount due to date. The accrual of interest is discontinued when payments become contractually delinquent for ninety days or more unless the loan is in process of collection. Once a loan has been placed on non-accrual status, income is recorded only as cash payments are received from the borrower until such time as the borrower has demonstrated an ability to make payments under the terms of the original or renegotiated loan agreement. (c) The Partnership provides for potential loan losses based upon past loss experience for similar loans and prevailing economic conditions in the geographic area in which the collateral is located, delinquencies with respect to repayment terms and the valuation of specific loans in the Partnership's portfolio. (d) Under certain circumstances, the Partnership may accept promissory notes in satisfaction of a borrower's obligations for certain fees upon prepayment of a loan as required by the loan agreement. These fees include, among other things, prepayment penalties and participations in the borrower's appreciation in the collateral property. The Partnership's policy is to record such income on a cash basis as payments required under the terms of the promissory notes are received. (e) Deferred expenses consist of mortgage brokerage fees which are amortized on a straight-line basis over the term to maturity of the loans and leasing commissions which are amortized on a straight-line basis over the average term of the leases to which they apply. (f) Loans are classified in substantive foreclosure when a determination has been made that the borrower has little or no equity remaining in the collateral property in consideration of its current fair value, or the Partnership has taken certain actions which result in taking effective control of operations of the collateral property. These loans are on non-accrual status; therefore, income is recorded only as cash payments are received from the borrower. (g) Investment in acquisition loans represents first mortgage loans which, because the loan agreements include certain specified terms, must be accounted for as an investment in a real estate venture. The investment is therefore reflected in the accompanying financial statements using the equity method of accounting. Under this method, the Partnership records its investment at cost (representing total loan fundings) and subsequently adjusts its investment for its share of property income or loss. Amounts representing contractually required debt service are recorded in the accompanying statements of income and expenses as interest income and participation income. Equity from investment in acquisition loan represents the Partnership's share of the collateral properties' operations, including depreciation and interest expense. The Partnership's share of operations has no effect on cash flow of the Partnership. (h) Real estate held for sale and loans in substantive foreclosure are recorded at the lower of fair value less estimated costs to sell, or cost at the foreclosure date or substantive foreclosure date, respectively. Any future declines in fair value will be charged to income and recognized as a valuation allowance, while subsequent increases in value will reduce the valuation allowance, but not below zero. (i) In 1993, the Financial Accounting Standards Board issued Statement No. 114, "Accounting by Creditors for Impairment of a Loan." This statement addresses accounting by creditors for impairment of loans and also eliminates the classification of loans as "in substantive foreclosure." This statement has been adopted by the Partnership as of January 1, 1994, and will not have a material impact on the financial position or results of operations of the Partnership. (j) Investment in joint venture - affiliate represents the Partnership's 25% interest, under the equity method of accounting, in a joint venture with an affiliated partnership. Under the equity method of accounting, the Partnership records its initial investment at cost and adjusts its investment account for additional capital contributions, distributions and its share of joint venture income or loss. (k) Cash equivalents include all highly liquid investments with a maturity of three months or less when purchased. (l) 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. (m) Several reclassifications have been made to the previously reported 1992 and 1991 statements in order to provide comparability with the 1993 statements. 2. Partnership Agreement: The Partnership was organized in October 1983. The Partnership Agreement provides for Balcor Mortgage Advisors-V to be the General Partner and for the admission of Limited Partners through the sale of Limited Partnership Interests at $500 per Interest, 439,305 of which were sold on or prior to August 31, 1984, the termination date of the offering. Pursuant to the Partnership Agreement, all income of the Partnership will be allocated 90% to the Limited Partners and 10% to the General Partner and all losses will be allocated 99% to the Limited Partners and 1% to the General Partner. To the extent that Cash Flow is generated, distributions will be made as follows: (i) 90% of such Cash Flow will be distributed to the Limited Partners, (ii) 7.5% of such Cash Flow will be distributed to the General Partner, and (iii) an additional 2.5% of such Cash Flow will be distributed to the General Partner and shall constitute the Early Investment Incentive Fund (the "Fund"). Upon the liquidation of the Partnership, the General Partner will return to the Partnership for distribution to Early Investors an amount not to exceed the 2.5% share, if necessary for Early Investors to receive a return of their Original Capital plus a specified Cumulative Return based on the date of investment. At the sole discretion of the General Partner, subject to certain limitations, amounts placed in the Fund have become available to repurchase Interests from existing Limited Partners. During 1993, the Fund repurchased 4,497 Interests at a total cost of $1,431,452. The amounts of the repurchases are as follows: Date Number of Repurchased Interests Cost First Quarter 1993 751 $264,099 Second Quarter 1993 140 43,883 Third Quarter 1993 2,371 729,541 Fourth Quarter 1993 1,235 393,929 Distributions of Cash Flow and Mortgage Reductions pertaining to such repurchased Interests will be paid to the Fund and will be available to repurchase additional Interests. 3. Investment in Loans Receivable Loans receivable and loans payable at December 31, 1993 consisted of the following: Loans Receivable Current Current Original Due Mortgage Monthly Interest Funding Date of Additional Property Balances(A) Payments Rate Date Loan Interest Apartments: Glen Apartments Falls Church, VA $5,142,293 $41,250 10.00% 2-86 12-97 (B,C,D) Meadow Run Fairborn, OH 5,264,258 43,063 13.25% 6-84 7-96 (B,C,D,E) Seven Trails West West St. Louis County, MO 15,250,823 (F) (F) 9-84 (F) (B,D) Office Building: Fairview Plaza I & II Charlotte, NC (G) 7,389,345 (H) (H) 6-84 6-97 Mobile Home Parks: Club Wildwood Hudson, FL 5,262,701 49,000 14.00% 9-84 10-96 (B,D) Four Seasons Estates Largo, FL 3,208,258 34,375 13.75% 9-84 10-96 (B,D) Pointe West Largo, FL 3,965,297 37,125 13.50% 9-84 10-96 (B,D) ----------- Total $45,482,975 =========== Loans Payable Underlying Current Current Due Mortgage Monthly Interest Date of Property Balances Payments Rate Loan Apartments: Glen Apartments Falls Church, VA $2,614,517 $19,235 7.50% 12-97 Seven Trails West West St. Louis County, MO 4,734,753 58,585 8.375% (I) Office Building: Fairview Plaza I & II Charlotte, NC 663,028 23,613 8.75% 7-96 Mobile Home Parks: Club Wildwood Hudson, FL 33,237 4,754 9.00% 9-94 Four Seasons Estates Largo, FL 842,335 12,857 10.125% 10-96 Pointe West Largo, FL 272,421 7,224 9.00% 10-96 ---------- Total $9,160,291 ========== (A) All loans are wrap-around mortgage loans except for Meadow Run which is a first mortgage loan. The notes receivable balance of the wrap-around mortgage loans includes the underlying loan balances. (B) An additional amount of interest accrues on a monthly basis and is payable to the Partnership upon maturity of the loan, prepayment or upon sale of the property. This interest is included in the loan balance. (C) The Partnership will receive participation income in the form of a share of gross or net income or cash flow of the property above specified levels. (D) The Partnership will receive a share in the future appreciation of the property by sharing in the sales price of the property, if it is sold, and/or by sharing in a percentage of the increase in the appraised value at maturity over the appraised value on the funding date or the date of the most recent previous sale. (E) The Partnership will receive a percentage of the reserve fund at any time reserve interest is due. The reserve fund is a fund held by the Partnership pursuant to a pledge agreement, into which the borrower is required to make monthly payments. (F) In July 1991, the terms of the loan were modified effective March 1991, and basic interest was reduced from 12.5% to 10.0%. Under the original terms of the loan agreement, the Partnership would have earned and received approximately $2,021,000, $1,883,000 and $1,838,000 during 1993, 1992 and 1991, respectively. The borrower made interest payments of approximately $1,470,000, $1,470,000 and $1,531,000 during 1993, 1992 and 1991, respectively, which were recorded as interest income. The loan matured in February 1994 and was subsequently placed in default when the borrower failed to pay the amounts due to the Partnership. The General Partner is currently negotiating an extension with the borrower on substantially the same terms as the modified loan. (G) This loan is on non-accrual status; therefore, income is recorded only as cash payments are received from the borrower. (H) In January 1992, a modification of this loan was executed. As part of the modification, the borrower made a principal payment of $1,600,000, and the Partnership forgave $1,000,000 from the outstanding principal balance. The new basic interest rate is 9.5% with monthly installments of principal and interest based on a 30 year amortization schedule through June 1, 1997, the new maturity date. This loan also originally provided for several types of additional interest. Under the terms of the modification, the Partnership has waived the payment of all outstanding accrued interest due to date. Under the original terms of the loan agreement (adjusted for the $1,600,000 principal payment in 1992), the Partnership would have earned and received approximately $1,045,000, $1,045,000 and $1,265,000 of interest income during 1993, 1992 and 1991, respectively. The borrower made interest payments of approximately $625,000, $638,000 and $1,156,000 during 1993, 1992 and 1991, respectively, which were recorded as interest income. (I) The underlying loan matured in February 1994. The Partnership expects to purchase this loan from the underlying lender on or about March 31, 1994. 4. Loans in Substantive Foreclosure: Loans in substantive foreclosure at December 31, 1993 consisted of the following: Carrying Property Value 45 West 45th Street Office Building New York, NY (A) $ 1,949,672 Springwells Park Apartments Dearborn, MI (B) 100,000 Villa Medici Apartments Overland Park, KS 9,499,000 ------------ Total $ 11,548,672 ============ (A) The Partnership and three affiliated partnerships entered into a participation agreement to fund a $23,000,000 first mortgage loan collateralized by this property. The Partnership participates ratably in approximately 22% of the original loan amount and interest income. The loan had been classified as an acquisition loan, therefore the balance includes the Partnership's share of the cumulative net loss of the property through December 31, 1992 and is shown net of its adjustment to fair value. (B) During 1993, $1,133,386 of the allowance for loan losses was used to reduce the carrying value of the loan to $100,000. Subsequent to this write-down, the loan was reclassified to loans in substantive foreclosure. The Partnership received $45,000 from the borrower in February 1994 and is scheduled to receive $55,000 in May 1994. 5. Investment in Acquisition Loan: The Partnership and two affiliated partnerships entered into a participation agreement to fund a $23,300,000 first mortgage loan collateralized by the Noland Fashion Square Shopping Center. The Partnership participates ratably in approximately 41% of the original loan amount, interest income and participation income. As of December 31, 1993, the balance of the loan was $8,587,042, which includes the partnership's share of the cumulative net loss of the property after the loan was funded. Current monthly payments of $74,061 are interest only with the entire principal balance due in December 1999. This loan also provides for several types of additional interest which include a percentage of the adjusted gross cash flow of the property, a percentage of the sale price over certain stated amounts and a percentage of the increase in the appraised value at maturity over the appraised value at funding. Additional interest amounts payable to the Partnership upon maturity of the loan or sale of the property are contingent upon certain conditions and, therefore, such interest has not been accrued. 6. Mortgage Notes Payable: Mortgage notes payable at December 31, 1993 and 1992 consisted of the following: Balance Balance Current Current Due at at Monthly Interest Date of Balloon Property 12/31/93 12/31/92 Payments Rate Loan Payment Real estate held for sale: The Glades on Ulmerton Apartments (carrying value $4,743,466)(A) $2,245,353 $2,291,079 $21,312 9.25% 7/99 $2,241,349 Granada Apartments (carrying value $2,848,979) (B) 54,050 Plantation Apartments (carrying value $3,414,738) (C) 1,494,920 Waldengreen Apartments (carrying value $6,035,166) (D) 2,000,000 ---------- ---------- Total $2,245,353 $5,840,049 ========== ========== (A) This loan was modified during April 1992, effective January 1992. The Partnership assumed the loan based on the existing terms except the interest rate was increased from 8% to 9.25%. In February 1994, the loan was prepaid. (B) The Partnership acquired title to this property through foreclosure in June 1993, and the loan fully amortized in June 1993. (C) The Partnership acquired title to this property through foreclosure in April 1993. The underlying mortgage was scheduled to mature in August 1992. Pursuant to negotiations with the lender, the maturity date was extended to August 1993, at which time the Partnership repaid the loan in full. (D) The Partnership acquired title to this property through foreclosure in September 1993. The Partnership purchased the first mortgage loan in July 1993 for $2,269,702, comprised of the principal ($2,000,000) and accrued interest ($344,576) less the balance of the tax escrow held by the lender ($74,874). During the years ended December 31, 1993, 1992 and 1991, the Partnership incurred interest expense on mortgage notes payable for properties held during the year of $275,882, $226,726 and $505,122, and paid interest expense on the mortgage notes payable of $275,882, $249,357 and $505,122, respectively. 7. Real Estate Held for Sale: (a) In September 1993, the Partnership received title to Waldengreen Apartments located in Orlando, Florida. The carrying value of the loan of $5,990,589 has been capitalized to the basis of the property, as well as expenses incurred in connection with the foreclosure of $344,577. (b) In June 1993, the Partnership received title to Granada Apartments located in Hillsborough County, Florida. The carrying value of the loan of $3,296,106 has been capitalized to the basis of the property, as well as $52,873 used to acquire vacant land adjacent to the property. (c) In April 1993, the Partnership received title to Plantation Apartments located in Temple Terrace, Florida, as a result of the foreclosure sale in March 1993. The $3,708,168 outstanding loan balance and accounts receivable of $3,860 were capitalized as part of the basis of the property upon foreclosure. The Partnership used $56,706 held in escrow to reduce the basis of the property upon foreclosure. As part of this transaction, the Partnership assumed the obligation to pay the underlying mortgage note. This property was classified as real estate held for sale at December 31, 1992. (d) In October 1992, the Partnership received title to the International Teleport office building located in Alameda County, California. The $14,000,000 outstanding loan balance and accrued interest of $313,055, together with other expenses incurred of $104,701 were capitalized as part of the basis of the property upon foreclosure. The Partnership used $96,274 held in escrow to reduce the basis of the property upon foreclosure. (e) In December 1991, the Partnership received title to The Glades on Ulmerton Apartments located in Largo, Florida. The $6,350,000 outstanding loan balance and accrued interest due at maturity of $285,030, together with other expenses paid of $148,721 were capitalized as part of the basis of the property upon foreclosure. The Partnership used $258,285 held in escrow to reduce the basis of the property upon foreclosure. As part of this transaction, the Partnership assumed the obligation to pay the underlying mortgage note. 8. Investment in Joint Venture - Affiliate: The Partnership has classified the first mortgage loan investment collateralized by the Whispering Hills Apartments as an equity investment in joint venture - affiliate. This investment represents a joint venture between the Partnership and an affiliated partnership. Profits and losses are allocated 25% to the Partnership and 75% to the affiliate. 9. 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 Mortgage servicing fees $153,658 $10,951 $222,651 $15,742 $242,046 $20,034 Property management fees 361,175 39,167 277,401 23,888 135,534 20,576 Reimbursement of expenses to the General Partner, at cost: Accounting 75,896 6,300 76,751 6,197 66,344 8,867 Data processing 150,141 41,698 158,957 12,800 174,991 14,002 Investor communica- tions 11,381 945 36,557 2,945 23,522 3,144 Legal 12,197 1,012 19,911 1,608 17,136 2,290 Portfolio management 104,608 33,724 89,851 25,716 67,284 16,927 Other 35,224 2,924 9,394 705 3,104 415 10. Property Sale: In January 1992, the Partnership sold the Northland Park Industrial building, located in North Kansas City, Missouri for a sale price of $15,350,000. The carrying basis of the property at the date of sale was $15,063,040. The Partnership incurred selling expenses of $21,749, and paid a real estate commission of $150,000 to an unaffiliated broker in connection with the sale. A portion of the proceeds from the sale were used to prepay the three underlying mortgage loans totaling $5,088,361 and prepayment fees of $102,423 incurred in connection with the prepayment of the underlying mortgages. The Partnership recognized a gain on the sale of the property of $12,788. 11. Contingency: The Partnership is currently involved in a lawsuit whereby the Partnership and certain affiliates have been named as defendants alleging certain federal securities law violations with regard to the adequacy and accuracy of disclosures of information concerning the offering of the Limited Partnership Interests of the Partnership. The defendants continue to vigorously contest this action. As of this time, no plaintiff class has been certified and no judicial determination has been made. Although the outcome of these matters is not presently determinable, it is management's opinion that the ultimate outcome should not have a material adverse affect on the financial position of the Partnership. Management of the defendants believes they have meritorious defenses to contest the claims. 12. Subsequent Event: In January 1994, the Partnership made a distribution of $3,953,745 ($9.00 per Interest) to the holders of Limited Partnership Interests for the fourth quarter of 1993. This distribution includes a regular quarterly distribution of $4.00 per Interest from Cash Flow and a special distribution of $5.00 per Interest from Cash Flow. BALCOR PENSION INVESTORS-V (An Illinois Limited Partnership) SCHEDULE I - MARKETABLE SECURITIES - OTHER INVESTMENTS as of December 31, 1993 Col. A Col. B Col. C Col. D Col. E Amount at Which Each Number Portfolio of of Shares Equity Security or Units - Market Issues and Each Principal Value of Other Security Name of Issuer and Amounts Cost Each Issue Issue Carried Title of Each Issue of Bonds of Each at Balance in the and Notes Issue Sheet Date Balance Sheet Marketable Securities(A) Commercial Paper: ABB Treasury Centre Inc. 3.27% due 01/03/94 $1,000,000 $ 998,744 $ 998,744 $ 998,744 Cargill Financial Services Inc. 6.00% due 01/03/94 5,000,000 4,997,500 4,997,500 4,997,500 A.I. Credit Corp. 3.22% due 01/07/94 1,800,000 1,795,331 1,795,331 1,795,331 A.I. Credit Corp. 3.35% due 01/10/94 250,000 248,534 248,534 248,534 Consolidated Natural Gas 3.30% due 01/18/94 2,000,000 1,989,733 1,989,733 1,989,733 American Cyanamid Co. 3.18% due 01/19/94 1,000,000 996,997 996,997 996,997 USAA Capital Corp. 3.22% due 01/19/94 2,000,000 1,992,666 1,992,666 1,992,666 Cincinnati Bell Inc. 3.20% due 01/20/94 2,000,000 1,994,845 1,994,845 1,994,845 AIG Funding Inc. 3.19% due 01/21/94 4,000,000 3,986,531 3,986,531 3,986,531 Canadian Wheat Bread 3.08% due 01/21/94 2,000,000 1,994,011 1,994,011 1,994,011 Metropolitan Life Funding Inc. 3.20% due 01/31/94 2,000,000 1,990,756 1,990,756 1,990,756 ----------- ----------- ----------- ----------- Total $23,050,000 $22,985,648 $22,985,648 $22,985,648 =========== =========== =========== =========== (A) Marketable securities are included in cash and cash equivalents on the balance sheet. Cash of $638,258 is also included in this catagory. BALCOR PENSION INVESTORS - V (An Illinois Limited Partnership) SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION for the years ended December 31, 1993, 1992 and 1991 Column A Column B Item Charged to Costs and Expenses 1993 1992 1991 Maintenance and repairs $2,430,025 $1,142,678 $ 527,451 Real estate taxes 918,190 632,507 727,245

352541_1993.txt

352541_1993

1993

352541

ITEM 1. BUSINESS WPL Holdings, Inc. (herein sometimes referred to as the "company") was incorporated under the laws of the State of Wisconsin on April 22, 1981 and operates as a holding company with both utility and nonregulated businesses. It is the parent company of a public utility, Wisconsin Power and Light Company (WP&L) and its related subsidiaries, and of Heartland Development Corporation ("HDC"), the parent corporation for the company's nonregulated businesses. WP&L WP&L incorporated in Wisconsin on February 21, 1917, as the Eastern Wisconsin Electric Company, is a public utility predominately engaged in the transmission and distribution of electric energy and the generation and bulk purchase of electric energy for sale. It also transports, distributes and sells natural gas purchased from gas suppliers. Nearly all of the WP&L's customers are located in south and central Wisconsin. WP&L operates in municipalities pursuant to permits of indefinite duration which are regulated by Wisconsin law. WP&L does not derive a material portion of its revenues from any one customer. WP&L owns all of the outstanding capital stock of South Beloit Water, Gas and Electric Company ("South Beloit"), a public utility supplying electric, gas and water service, principally in Winnebago County, Illinois, which was incorporated on July 23, 1908. WP&L also owns varying interests in several other subsidiaries and investments which are not material to WP&L's operations. Regulation The company and WP&L are subject to regulation by the Public Service Commission of Wisconsin ("PSCW") as to retail utility rates and service, accounts, issuance and use of proceeds of securities, certain additions and extensions to facilities, and in other respects. South Beloit is subject to regulation by the Illinois Commerce Commission ("ICC") for similar items. The Federal Energy Regulatory Commission ("FERC") has jurisdiction under the Federal Power Act over certain of the electric utility facilities and operations, wholesale rates and accounting practices of WP&L and in certain other respects. Certain of WP&L's natural gas facilities and operations are subject to the jurisdiction of the FERC under the Natural Gas Act. The company is presently exempt from all provisions of the Public Utility Holding Company Act of 1935, except provisions relating to the acquisition of securities of other public utility companies. An anticipated change in the regulatory environment is the movement towards the deregulation of certain aspects of utility operations. WP&L is in the process of evaluating the impacts of such deregulation. With respect to environmental matters, the United States Environmental Protection Agency administers certain federal statutes; others are delegated to the Wisconsin Department of Natural Resources ("DNR"). In addition, the DNR has jurisdiction over air and water quality standards associated with fossil fuel fired electric generation and the level and flow of water, safety and other matters pertaining to hydroelectric generation. WP&L is subject to the jurisdiction of the Nuclear Regulatory Commission ("NRC") with respect to the Kewaunee nuclear plant and to the jurisdiction of the United States Department of Energy ("DOE") with respect to the disposal of nuclear fuel and other radioactive wastes from the Kewaunee Nuclear Power Plant ("Kewaunee"). Employees At year-end 1993, WP&L employed 2,673 persons, of whom 2,136 were considered electric utility employees, 387 were considered gas utility employees and 150 were considered other utility employees. WP&L has a three-year contract with members of the International Brotherhood of Electrical Workers, Local 965, that is in effect until June 1, 1996. The contract covers 1,742 of WP&L's employees. ELECTRIC OPERATIONS: General The company, through WP&L provides electricity in a service territory of approximately 16,000 square miles in 35 counties in southern and central Wisconsin and four counties in northern Illinois. As of December 31, 1993, the company provided retail electric service to approximately 360,000 customers in 609 cities, villages and towns, and wholesale service to 25 municipal utilities, 1 privately owned utility, three rural electric cooperatives and to Wisconsin Public Power, Inc. System, which provides retail service to nine communities. WP&L owns 21,579 miles of electric transmission and distribution lines and 351 substations located adjacent to the communities served. WP&L's electric sales are seasonal to some extent with the yearly peak normally occurring in July or August. WP&L also experiences a smaller winter peak in December or January. Fuel In 1993, approximately 80 percent of WP&L's net kilowatthour generation of electricity was fueled by coal and 17 percent by nuclear fuel (provided by WP&L's 41 percent ownership interest in Kewaunee). The remaining electricity generated was produced by hydroelectric, oil-fired and natural gas generation. Coal WP&L anticipates that its average fuel costs will increase in the future, due to cost escalation provisions in existing coal and transportation contracts and increases in the costs of new coal contracts due to emission requirements under federal and state laws. The estimated coal requirements of WP&L's generating units (including jointly-owned facilities) for the years 1994 through 2013 total about 166 million tons. Present coal supply contracts and transportation contracts (excluding extension options) cover approximately 25 percent and 24 percent, respectively, of this estimated requirement. WP&L will seek renewals of existing contracts or additional sources of supply and negotiate new or additional transportation contracts to satisfy the requirements of approved environmental regulations. Nuclear Kewaunee is jointly owned by WP&L (41%), Wisconsin Public Service Corporation (41.2%) and Madison Gas & Electric Company (17.8%). Wisconsin Public Service Corporation is the operating partner. The plant began commercial operation in 1974. The supply of fuel for Kewaunee involves the mining and milling of uranium ore to uranium concentrates, the conversion of uranium concentrates to uranium hexafluoride, enrichment of the uranium hexafluoride and fabrication of the enriched uranium into usable fuel assemblies. The following narrative discusses the nuclear fuel supplies for Kewaunee which requires approximately 250,000 pounds of uranium concentrates per year. Additionally, WP&L and the other Kewaunee co-owners formed a limited partnership of subsidiaries in the mid-1970's to secure uranium reserves and maintain a long-term uranium concentrates supply capability. (a) Requirements for uranium are met through spot market purchases of uranium. In general a four-year supply of uranium is maintained. (b) Uranium hexafluoride, from inventory and from spot market purchases, was used to satisfy converted material requirements in 1993. Such conversion services will be purchased on the spot market in the future. (c) In 1993, enriched uranium was procured from COGEMA, Inc. pursuant to a contract last amended in 1991. The partnership is obligated to take delivery of additional enriched uranium contracted from COGEMA in 1993 and 1994. The partnership also purchased enriched uranium on the spot market in 1993. Enrichment services were purchased from the DOE under the terms of the utility services contract. This contract is in effect for the life of Kewaunee. The partnership is committed to take 70 percent of its annual requirements in 1994 and 1995, and in alternate years thereafter from the DOE. (d) Fuel fabrication requirements through 1995 are covered by contract. This contract contains an option to allow the partnership to extend the contract through 1998. (e) Beyond the stated periods for Kewaunee, additional contracts for uranium concentrates, conversion to uranium hexafluoride, fabrication and spent fuel storage will have to be procured. The prices for the foregoing are expected to increase. The National Energy Policy Act of 1992 provides that both the Federal government and the nuclear utilities fund the decontamination and decommissioning of the three federal gaseous diffusion plants in the United States. This will require the owners of Kewaunee to pay approximately $15 million, in current dollars over a period of 15 years. WP&L's share amounts to an annual payment of approximately $410,000. The steam generator tubes at Kewaunee are susceptible to corrosion characteristics seen throughout the nuclear industry. Annual inspections are performed to identify degraded tubes. Degraded tubes are either repaired by sleeving or are plugged with approximately 15 percent heat transfer margin, meaning that full power should be sustainable with the equivalent of 15 percent of the steam generator tubes plugged. Currently, the equivalent of 10 percent of the tubes in the steam generators are plugged. WP&L and the other joint owners continue to evaluate appropriate strategies, including replacement, as well as continued operation of the steam generators without replacement. WP&L and the joint owners intend to operate Kewaunee until at least 2013, the expiration of the present operating license. WP&L and the joint owners are also evaluating initiatives to improve the performance of Kewaunee. These initiatives include funding of the development of welded repair technology for steam generator tubes and numerous cost reduction measures such as the conversion from a 12-month to an 18-month fuel cycle. If the steam generators are not replaced, and excluding the possible affect of the aforementioned repair strategies, a gradual power reduction of approximately 1 percent per year may begin as soon as 1995. Physical decommissioning is expected to occur during the period 2014 to 2021 with additional expenditures being incurred during the period 2022 to 2050 related to the storage of spent nuclear fuel at the site. WP&L's share of the decommissioning costs of this plant is estimated to be $149 million (in 1993 dollars) based on a site specific study, performed in 1992, using immediate dismantlement as the method of decommissioning. Wisconsin utilities operating nuclear generating plants are required by the PSCW to establish external trust funds to provide for the decommissioning of such plants. The market value of the investments in the funds established by WP&L at December 31, 1993 totaled $45.1 million. Pursuant to the Nuclear Waste Policy Act of 1982, the DOE has entered into a contract with WP&L to accept, transport and dispose of spent nuclear fuel beginning not later than January 31, 1998. It is likely that the DOE will delay the acceptance of spent nuclear fuel beyond 1998. A fee to offset the costs of the DOE's disposal for all spent fuel used since April 7, 1983 has been assessed by the DOE at one mill per net kilowatthour of electricity generated and sold by the Kewaunee nuclear power plant. An additional one-time fee was paid for the disposal of spent nuclear fuel used to generate electricity prior to April 7, 1983. Spent fuel is currently stored at Kewaunee. The existing capacity of the spent fuel storage facility will enable storage of the projected quantities of spent fuel through April 2001. WP&L is currently evaluating options for the storage of additional quantities beyond 2001. Several technologies are available. It is expected that the larger capacity requirements for spent nuclear fuel storage will require a capital investment in the late 2000's. The Low-Level Radioactive Waste Policy Act of 1980 as amended in 1985 provides that states may enter into compacts to provide for regional low-level waste disposal facilities. The amended Act provides that after January 1, 1993, compact members may restrict the use of regional disposal facilities to waste generated within the region. Wisconsin is a member of the Midwest Interstate Low-Level Radioactive Waste Compact which includes six Midwestern states and was ratified by Congress. A Midwest disposal facility is not expected to be operational until the late 1990's. Presently, the state of Ohio has been selected as the host state for the Midwest Compact and is proceeding with the preliminary phases of site selection. In the meantime, WP&L has access to an existing low level waste storage space to temporarily store low level waste generated. Recovery of Electric Fuel Costs WP&L does not automatically pass changes in electric fuel cost through to its Wisconsin retail electric customers. Instead, rates are based on estimated per unit fuel costs established during rate proceedings and are not subject to change by fuel cost fluctuations unless actual costs are outside specified limits. If actual fuel costs vary from the estimated costs by more than +10 percent in a month or by more than +3 percent for the test year to date, projected annual variances are then estimated. If the projected annual variance is more than +3 percent, rates are subject to hearings and increase or decrease by the PSCW. WP&L's wholesale rates and South Beloit's retail rates contain fuel adjustment clauses pursuant to which rates are adjusted monthly to reflect changes in the costs of fuel. Environmental Matters WP&L cannot precisely forecast the effect of future environmental regulations by federal, state and local authorities upon its generating, transmission and other facilities, or its operations, but has taken steps to anticipate the future while meeting the requirements of approved environmental regulations of today. The Clean Air Act Amendments of 1977 and subsequent amendments to the Clean Air Act, as well as the new laws affecting the handling and disposal of solid and hazardous wastes along with clean air legislation passed in 1990 by Congress, could affect the siting, construction and operating costs of both present and future generating units (see "Item 3. Legal Proceedings"). Under the Federal Clean Water Act, National Pollutant Discharge Elimination System permits for generating station discharge into water ways are required to be obtained from the DNR, to which the permit program has been delegated. These permits must be periodically renewed. WP&L has obtained such permits for all of its generating stations or has filed timely applications for renewals of such permits. Air quality regulations promulgated by the DNR in accordance with Federal standards impose statewide restrictions on the emission of particulates, sulfur dioxide, nitrogen oxides and other air pollutants and require permits from the DNR for the operation of emission sources. WP&L currently has the necessary permits to operate its fossil-fueled generating facilities. However, new permits will be required for all major facilities in Wisconsin beginning in 1994. The schedule for application of these new permits has been staggered by the DNR to accomodate staffing at the DNR. WP&L's Columbia Generating facility is required to submit a permit application on May 1, 1994. The remaining facilities will be addressed later in 1994 and early 1995. Pursuant to Wisconsin statutes 144.386(2), WP&L has submitted data and plans for 1993 sulfur dioxide emissions compliance. WP&L will make any necessary operational changes in fuel types and power plant dispatch to comply with the Plan. WP&L's compliance strategy for Wisconsin's 1993 sulfur dioxide law and the Federal Clean Air Act Amendments required plant upgrades at its generating facilities. The majority of these projects were completed in 1993. WP&L has installed continuous emissions monitoring systems at all of its coal fired boilers (Edgewater and Nelson Dewey facilities) in 1993 and will complete the installation of these monitors at the remaining facilities in 1994. No additional costs for compliance with these acid rain requirements are anticipated at this time. WP&L maintains licenses for all its ash disposal facilities and regularly reports to the DNR groundwater data and quantities of ash landfilled or reused. The landfills are operated according to a Plan of Operation approved by the DNR. WP&L's accumulated pollution abatement expenditures through December 31, 1993, totaled approximately $122 million. The major expenditures consist of about $60 million for the installation of electrostatic precipitators for the purpose of reducing particulate emissions from WP&L's coal-fired generating stations and approximately $62 million for other pollution abatement equipment at the Columbia, Edge- water, Kewaunee, Nelson Dewey, Rock River and Blackhawk plants. Expenditures during 1993 totaled approximately $6 million. Estimated pollution abatement expenditures total $.7 million through 1995. WP&L's estimated pollution abatement expenditures are subject to continuing review and are revised from time to time due to escalation of construction costs, changes in construction plans and changes in environmental regulations. See "Electric Operations - Fuel" for information concerning the disposal of spent nuclear fuel and high level nuclear waste. GAS OPERATIONS: General As of December 31, 1993, the company, through its subsidiary WP&L, provided retail natural gas service to approximately 136,000 customers in 217 cities, villages and towns in 22 counties in southern and central Wisconsin and one county in northern Illinois. WP&L's gas sales follow a seasonal pattern. There is an annual base load of gas used for heating, cooking, water heating and other purposes, with a large peak occurring during the heating season. In 1993, WP&L purchased significant volumes of lower cost gas directly from producers and marketers and transported those volumes over its two major pipeline supplier's systems. This replaced higher cost gas historically purchased directly from the major pipeline systems. WP&L transported gas for 85 end users at year-end 1993. Gas Supplies In 1992 the FERC issued Order No. 636 and 636-A which requires interstate pipelines to restructure their services. Under these orders, existing pipeline sales service would be "unbundled" such that gas supplies would be sold separately from interstate transportation services. Both of the interstate pipelines which serve WP&L, ANR Pipeline and Northern Natural Pipeline, completed their transition to unbundled services as mandated by the FERC in its Order 636 during 1993. As a result, WP&L now contracts with these two parties for various unbundled services such as firm and interruptible transportation, firm and interruptible storage service and "no-notice" service. WP&L has benefited from enhanced access to competitively priced gas supplies, and from more flexible transportation services. Pipelines are, however, seeking to recover from their customers certain transition costs associated with restructuring. Any such recovery is subject to prudence hearings at the FERC and state regulatory commissions. With the pipelines exiting their historic role of selling gas to WP&L, the utility has increased its contracting activity with producers and marketers of natural gas correspondingly. WP&L's portfolio of gas supply contracts are designed to meet the needs of gas customers and extend from one month to 10 years in term. The most significant change in WP&L's mix of gas contracts for 1993 are: 1) a significant increase in the volume of Canadian gas contracted for, and 2) a large increase in firm storage service from the pipelines. The new Canadian contract commitments represent WP&L's successful negotiations to minimize the "transition costs" of moving to the unbundled, post-Order 636 environment. In mid 1993, WP&L was faced with the decision of whether to negotiate with the Canadians to reform the terms of long-term contracts which were in place with the two pipelines and assume the contracts on the renegotiated terms, or pay the pipelines to buy out of these contract commitments with the Canadians. WP&L opted for the latter approach at an estimated savings of over $16 million to WP&L's customers. In 1993, WP&L increased its peak-day entitlements on ANR pipeline by 16,000 dekatherms per day reflecting the need for additional firm capacity in order to meet the load growth of firm customers. WP&L maintains gas storage agreements with ANR Pipeline and a third party storage service provider. The storage agreements allow WP&L to purchase a portion of its gas supply between April and October, when natural gas costs usually are lower. The less expensive gas is stored in the storage fields and is withdrawn between November and March when gas costs typically are higher. The agreements have terms extending through March 31, 1995 and March 31, 1997. WP&L's current portfolio of contracts is as follows: The future cost of natural gas is expected to be market sensitive. WP&L's rate schedules applicable to all retail gas customers provide for adjustments of its rates, upon notice by WP&L to the PSCW, to reflect all increases or decreases in the cost of gas purchased for resale. Increases or decreases in such costs are reflected automatically by adjustments to customers' bills commencing with meters read following the effective date of any changes in such costs. One of the biggest changes which WP&L faces in the post-Order 636 environment is dealing with the heightened emphasis placed upon daily balancing of the economic utilization of WP&L's two pipelines. As the natural gas market continues to evolve, WP&L continuously evaluates products and services provided by pipelines and gas suppliers to meet the changing needs of its firm and interruptible gas customers. Environmental Matters Manufactured Gas Plant Sites. Historically, WP&L has owned 11 properties that have been associated with the production of manufactured gas. Currently, WP&L owns five of these sites, three are owned by municipalities, and the remaining three are owned by private companies. In 1989, WP&L initiated investigation of these manufactured gas plant sites. The Wisconsin Department of Natural Resources ("DNR") has been involved in reviewing preliminary investigation plans and has received reports regarding these investigations. Based on the results of WP&L's preliminary investigations, WP&L recorded an estimated liability and corresponding deferred charge of approximately $15 million as of December 31, 1991. In 1992, and into the beginning of 1993, WP&L continued its investigations and studies. WP&L confirmed that there was no contamination at two of the sites and received a close out letter from the DNR related to one of those sites and requested a close out letter for the other site. Additionally, the investigation of historical records at a third site indicated a minimal likelihood of any significant environmental impacts. In February 1993, WP&L completed more current cost estimates for the environmental remediation of the eight remaining sites. The results of this more current analysis indicated that during the next 35 years, WP&L will expend approximately $81 million for feasibility studies, data collection, soil remediation activities, groundwater research and groundwater remediation activities, including construction of slurry containment walls and the installation of groundwater pump and treatment facilities. This estimate was based on various assumptions, and is subject to continuous review and revision by management. Based on the cost estimate set forth above, which assumes a 4 percent average inflation over the 35 year period, WP&L will spend approximately $4.2 million, $1.5 million, $2.1 million, $4.4 million and $4.2 million in 1994 through 1998, respectively. The cost estimate also contemplates that primarily groundwater pump and treatment activities will take place after 1998 through and including 2027. During this time, WP&L estimates that it will incur average annual costs of $2.0 million to complete the planned groundwater remediation activities. With respect to rate recovery of these costs, the PSCW has approved a five year amortization of the unamortized balance of incurred environmental costs deferred to date. Based on the present regulatory record at the PSCW, management believes that future costs of remediating these manufactured gas plant sites will be recovered in rates. HDC Incorporated in 1988, HDC is the parent company of all nonutility companies within the holding company system. HDC and its principal subsidiaries are engaged in business development in three major areas: (1) environmental engineering and consulting through the Environmental Holding Company ("EHC") which is the parent company of RMT, Inc. ("RMT"), Jones and Neuse, Inc. ("J & N"), Hydroscience, Inc. ("Hydroscience") and Four Nines, Inc. ("Four Nines"), (2) affordable housing and historic rehabilitation properties through Heartland Properties, Inc. ("HPI"), and (3) energy related products and services which includes, in addition to Enserv, Inc., the recent acquisition of A&C Enercom, EcoGroup, and Entec Consulting, Inc. At year-end 1993, HDC employed 1,391 persons, of whom 830 were considered environmental engineering and consulting employees. ENVIRONMENTAL ENGINEERING AND CONSULTING: RMT was acquired by WP&L on July 30, 1983 and became a wholly owned subsidiary of HDC in March 1988. In 1992, HDC transferred to EHC its ownership of RMT. RMT is a Madison, Wisconsin-based environmental and engineering consulting company that serves clients nationwide in a variety of industrial segment markets. The most significant of these are foundries, chemical companies, pulp and paper processors and other manufacturers. RMT specializes in solid and hazardous waste management, ground water quality protection, industrial design and hygiene engineering, laboratory services, and air and water pollution control. RMT owns and operates chemical and soil-testing laboratories in Madison, Wisconsin and leases biological-testing laboratories in Greenville, South Carolina. The company believes that RMT will be favorably impacted by the enforcement of current environmental regulations and programs, and legislation and regulations being developed or implemented to address ground-water protection, acid rain, and air and water toxics legislation and regulations. During 1993, HDC acquired three environmental consulting and engineering service companies J & N, Hydroscience and Four Nines which are being treated as operating subsidiaries of RMT. J & N is operating out of Austin, Texas as RMT's Gulf Coast Region. J & N also has four additional Texas offices, a Louisiana office and a Mexican subsidiary, ABC Estudios y Projectos. It provides full capabilities in air quality, water quality, hazardous and solid waste engineering, and remedial projects. Hydroscience is a South Carolina based consulting engineering firm specializing in wastewater treatment and toxicity assessments to industrial and municipal entities. Four Nines is a Philadelphia based company specializing in air pollution control engineering. See "Item 8. Financial Statements and Supplementary Data", Notes to Consolidated Financial Statements, Note 12, for financial information related to business segments. OTHER NONREGULATED Formed by HDC on June 24, 1988, HPI is responsible for the development and management of the company's real estate and housing investments. HPI's primary focus has been the development, construction and management of affordable housing and historic rehabilitation properties in selected Wisconsin communities. As of December 31, 1993, HPI's level of investment in housing was approximately $91 million, providing nearly 2,175 units to a diverse group of residents. As in prior years, long-term financing on many new investments has been structured with the cooperation of municipal housing and community development authorities. In 1993, HPI enhanced its operations with the organization of two new subsidiaries: (1) Toolkit Property Management Systems, Inc. ("Toolkit") and Heartland Retirement Services, Inc. ("HRS"). Toolkit provides property management services for many of HPI's housing investments, aiming to attract and maintain good residents. HRS provides a comprehensive range of housing related products for the fastest growing segment of the American population, older adults. To facilitate HPI's development and financing efforts, HDC incorporated Capital Square Financial Corporation ("Capital Square") in 1992 to provide mortgage banking services to the affordable housing market. Capital Square has become a Federal National Mortgage Association ("FNMA") single and multi-family seller-servicer. This designation enables Capital Square to underwrite first mortgages on affordable housing investments to be packaged by FNMA for resale to the secondary markets as mortgaged backed securities. ENSERV has historically focused its efforts on the commercialization of a coal-benefication process called "K-Fuel". "K-Fuel" is a registered trademark for a low-sulfur, high-energy content processed coal. ENSERV is continuing to pursue commercialization of the "K-Fuel" process, but there is no assurance that this commercialization can be successfully completed. HDC acquired A&C Enercom ("A&C") in February 1993. A&C is based out of Atlanta, Georgia, and provides marketing and demand side management services primarily to public electric and gas utility companies. They have 13 offices spread throughout the United States. During 1993, HDC also acquired Entec Consulting, Inc. ("Entec"), a Madison, Wisconsin based firm, to act as a subsidiary of A&C. Entec provides full-service consulting to the utility industry for power generation computer software programs. A&C acquired EcoGroup, a Phoenix, Arizona based company during 1993. EcoGroup provides energy and environmental programs primarily for the electric and gas utility industry. All references to the company or WPL Holdings, Inc. herein include the company and its subsidiaries, except where the context otherwise indicates. ITEM 2. ITEM 2. PROPERTIES WP&L The following table gives information with respect to electric generating facilities of WP&L (including WP&L's portion of those facilities jointly owned). The maximum net hourly peak load on WP&L's electric system was 1,971,000 kwh's and occurred on August 26, 1993. At the time of such peak load, 2,310,000 kwh's were produced by generating facilities operated by WP&L (including other company shared jointly owned facilities) and WP&L delivered 812,000 kwh's of power and received 473,000 kwh's of power from external sources. During the year ended December 31, 1993, about 86.4 percent of WP&L's total kilowatthour requirements was generated by company-owned and jointly-owned facilities and the remaining 13.6 percent was purchased. Substantially all of WP&L's facilities are subject to the lien of its first mortgage bond indenture. HDC: The following table gives information with respect to rental properties associated with HDC's affordable housing and historic rehabilitation project developments (through its subsidiary, HPI) as of December 31, 1993. Occupancy rates in the 66 properties/investments owned by HPI averaged 92 percent during 1993. This occupancy percentage excludes properties in the first six months of initial occupancy. Substantially all of these properties are pledged as security for HDC's mortgage notes and bonds payable. See page 3 of "Item 1. Business-HDC", for a discussion of additional properties owned by HDC's subsidiaries. ITEM 3. ITEM 3. LEGAL PROCEEDINGS There are no material pending legal proceedings, other than ordinary routine litigation incidental to the business, to which the company or any of its subsidiaries is a party or to which any of their property is subject. ENVIRONMENTAL MATTERS The information required by Item 3 is included in this Form 10-K as Item 8 - Notes to Consolidated Financial Statements, Note 10c, incorporated herein by reference. RATE MATTERS The information required by Item 3 is included in Item 7 of this Form 10-K within the Management's Discussion and Analysis of Financial Condition and Results of Operations narrative under the caption "Rates and Regulatory Matters." ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. EXECUTIVE OFFICERS OF THE REGISTRANT Erroll B. Davis, Jr, 49, was elected President on January 17, 1990 and Chief Executive Officer, effective July 1, 1990. He has served as President and Chief Executive Officer of WP&L since August 1, 1988. Prior positions held with WP&L include, Executive Vice President, May 1984, Vice President - Finance and Public Affairs, November 1982 and Vice President - Finance, August 1978. Mr. Davis was elected President of WPL Holdings, Inc. on January 17, 1990. He has served as a director of WPL Holdings, Inc. since March 1988. Daniel A. Doyle, 35, was appointed controller and treasurer of WP&L effective October 3, 1993. He previously served as controller of WP&L since July 1992. Prior to joining the company, he was Controller of Central Vermont Public Service Corporation since December 1988. During the period 1981 to 1988, he was employed by Arthur Andersen & Co. as an Audit Staff Assistant, Audit Senior and Audit Manager with primary responsibilities of auditing and providing financial consulting services to large publicly held corporations. Mr. Doyle functions as the principal accounting officer of the company. Edward M. Gleason, 53, was elected Vice President, Treasurer and Corporate Secretary effective October 3, 1993. He previously served as Vice President-Finance and Treasurer of WP&L since May 1986, Controller and Treasurer of WP&L since October 1985 and Treasurer of WP&L since May 1983. Mr. Gleason functions as the principal financial officer of the company. Steve F. Price, 41, was appointed Assistant Corporate Secretary and Assistant Treasurer on April 15, 1992. He had been Cash Management Supervisor since December 1987. He was also appointed Assistant Corporate Secretary of WP&L on April 15, 1992. NOTE: All ages are as of December 31, 1993. None of the executive officers listed above is related to any director of the Board or nominee for director of the company. Executive officers of the company have no definite terms of office and serve at the pleasure of the Board of Directors. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS At December 31, 1993, there were approximately 38,626 holders of record of the company's Common Stock including underlying holders in the company's Employee Stock Ownership Plan and the company's Dividend Reinvestment and Stock Purchase Plan. Cash dividends paid per share of common stock during 1993 and 1992 were 47.5 cents and 46.5 cents, respectively, for each quarter, for a total of $1.90 and $1.86 per share, respectively for each year. ITEMS 6 and 7. SELECTED FINANCIAL DATA AND MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION WPL HOLDINGS, INC. Management's Discussion and Analysis of Financial Condition and Results of Operations 1993 COMPARED WITH 1992 OVERVIEW Earnings per share of WPL Holdings, Inc. (the "company") common stock increased to $2.11 in 1993 compared with $2.10 in 1992. The increase in earnings primarily reflects an increase in earnings from the company's utility subsidiary, Wisconsin Power and Light Company ("WP&L"). The principle factors leading to increased earnings include warmer summer weather and lower electric fuel costs per kilowatthour ("kWh") which yielded higher electric gross margins for WP&L. These increases were somewhat offset by increased depreciation expense resulting from additional investment in utility plant and property additions, a change in the mix of gas sales from higher margin sales to lower margin sales, the increase in the Federal corporate tax rate from 34% to 35% and a one-time 4-cent-per-share charge associated with a voluntary separation program for the executive management group at the utility. The company's nonregulated subsidiary, Heartland Development Corporation ("HDC"), contributed to earnings through its principal businesses: (1) environmental engineering and consulting, (2) affordable housing and (3) energy products and services. Electric Operations WP&L's electric margin in dollars increased during 1993 compared with 1992 due to increased demand for electricity brought on by warmer summer weather. Residential customers, being the most weather sensitive, experienced the most significant increases. Wisconsin's strong economy kept the Commercial and Industrial classes growing steadily. These increases were coupled with declining electric production fuel costs per kWh. The decrease in electric production fuels is due to WP&L's aggressive pursuit of additional spot coal purchase opportunities as its longer term contracts begin to expire. Additionally, a highly competitive rail transportation environment has significantly reduced the cost of transporting the coal. Also, lower cost purchased power became available due to excess capacity in the bulk power market. Gas Operations WP&L's gas revenues for 1992 were affected by the recognition of a $4.9 million, before-tax refund to its natural gas customers resulting from an adjustment in the calculation of the purchased gas adjustment clause. Without the impact of this revenue adjustment, comparative gas margins would have declined for 1993 compared with 1992. The overall increases in gas revenues and purchased gas costs between years resulted primarily from increased volumes procured on behalf of transportation customers. This had the impact of decreasing margins as a percentage of total revenues. A change in the mix of gas sales from higher margin residential sales to lower margin sales also moved margins downward. Offsetting this decline, Wisconsin's strong economy enabled growth in the Commercial and Industrial classes, and there was also some overall increase in the demand for natural gas due to colder weather. Fees, Rents and Other Operating Revenues ("Other Revenues") and Other Operation Expense Other revenues increased between years as a result of RMT, Inc.'s ("RMT") and HPI's growth in their respective businesses and the result of acquisitions in the environmental and energy businesses. Other operation expense also increased as a result of the above factors. An additional increase resulted from higher WP&L employee benefit expense (See Notes to Consolidated Financial Statements, Note 8). These increases were offset somewhat by decreases in WP&L's conservation program expenditures and decreases in fees associated with the sale of WP&L's accounts receivable due to a decline in interest rates. Additionally, WP&L's cost management efforts have helped control annual inflationary pressures on general and administrative costs. Maintenance and Depreciation and Amortization Maintenance expense increased for 1993 compared with 1992, primarily due to service restoration expenses related to a severe storm in the summer of 1993. Depreciation and amortization expense increased, principally reflecting increased property additions and the commencement of deferred charge amortizations approved in WP&L's last two rate orders received in December 1992 and October 1993. The most significant amortizations include the amortization related to an acquisition adjustment which resulted from the purchase of transmission facilities and the amortization of costs incurred related to the remediation of former manufactured gas plant sites (See Notes to the Consolidated Financial Statements, Note 10). Allowance for Funds Used During Construction ("AFUDC") Total AFUDC increased in 1993 compared with 1992, reflecting the greater amounts of construction work in progress including the costs associated with WP&L's construction of two 86-megawatt combustion-turbine generators. Interest Expense Interest expense on debt increased between years, primarily due to increased capital expenditures related to HPI's investments in affordable housing. 1992 COMPARED WITH 1991 OVERVIEW Earnings per share of the company's common stock decreased 13 percent to $2.11 in 1992 compared with $2.43 in 1991. A combination of an electric rate decrease in March 1992 and significantly cooler summer weather led to lower electric revenues, gross margins and earnings at WP&L. WP&L's earnings were also affected by the recognition of a $4.9 million, before- tax refund to natural gas customers noted previously. HDC's contribution to earnings was slightly lower in 1992 compared with 1991, primarily due to the recognition in 1991 of a $2.8 million after-tax gain on the sale of a telecommunications investment. Exclusive of the sale, HDC's profitability increased in 1992, due to the success of its investments in affordable housing and the continued growth in the profitability of its environmental consulting business. Electric Operations WP&L's electric margin decreased during 1992 compared with 1991 due to decreased demand for electricity brought on by cooler summer weather. Residential customers, being the most weather sensitive, experienced the most significant decreases. However, improved economic conditions in 1992 kept the Industrial customer class growing steadily. Sales to commercial customers remained flat despite the negative weather impact due to increased customer growth in this sector and the improving economy. As a result of significantly lower weather-related peak demands, sales and revenues to other Class A utilities decreased. Electric production fuels expense decreased in response to reduced kWh sales, lower fuel costs and a greater reliance on purchased power. Purchased power expense increased in 1992 due to the greater availability of purchased power at competitive prices. Gas Operations After adjusting 1992 gas revenues for the customer refund noted previously, both gas revenues and gas margins increased during 1992 compared with 1991. Overall increases in gas revenues between years resulted primarily from the recovery of increased purchased gas costs through the purchased gas adjustment clause. Gas margins benefited from an increase in gas customers. The impacts of weather were comparable between years. Fees, Rents and Other Operating Revenues ("Other Revenues") and Other Operation Expense Other revenues increased between years as a result of RMT's and HPI's growth in their respective businesses. Other operation expense also increased as a result of the above factor. These increases were offset somewhat by reduced costs at WP&L. Contributing to the decrease in costs at WP&L was a decrease in WP&L's conservation program expenditures, a decrease in fees associated with the sale of WP&L's accounts receivable due to a decline in interest rates, and reduced employee benefit expenses. Additionally, WP&L's cost management efforts have helped control annual inflationary pressures on general and administrative costs. Maintenance and Depreciation and Amortization Expense Maintenance expense increased for 1992 compared with 1991, primarily due to an increased tree trimming program, increased costs associated with scheduled overhauls at generating units and major service restoration expenses related to three tornados which caused extensive damage to WP&L's service territory during the summer of 1992. Depreciation expense increased, principally reflecting increased property additions. Allowance for Funds Used During Construction ("AFUDC") and Other, net Total AFUDC increased in 1992 compared with 1991, reflecting the greater amounts of construction work in progress which includes the costs associated with WP&L's construction of two 86-megawatt combustion-turbine generators. Other, net decreased between years primarily due to a $2.8 million after-tax gain on the sale of certain nonutility investments that was recorded in 1991. Interest Expense Interest expense on debt increased between years, primarily due to the financing of increased capital expenditures related to HPI's investments in affordable housing and to increased debt outstanding at WP&L to fund construction activity. This increase was somewhat offset by WP&L's refinancing activities during 1992. To take advantage of recent low interest rates, WP&L issued $279 million principal amount of first mortgage bonds, of which $235 million was used to refinance the aggregate principal amount of existing series. The bonds, which had coupon payments ranging from 8 to 10 percent, were replaced with issues having coupons of 6.125 percent to 8.6 percent. Income Taxes Income taxes decreased between years, primarily due to lower taxable income and an increase in tax credits associated with affordable housing investments in 1992 compared with 1991. LIQUIDITY AND CAPITAL RESOURCES Rates and Regulatory Matters On September 30, 1993, WP&L received final decisions from the PSCW on its retail rate application filed in early 1993. The final order authorized an annual retail electric rate increase of $15.6 million, or 3.8 percent; a natural gas rate increase of $1.8 million, or 1.4 percent; and a nominal water rate increase. The new rates became effective October 1, 1993 and will remain effective until January 1, 1995. The regulatory return on common equity for WP&L was reduced from 12.4 percent to 11.6 percent. The allowed rates of return authorized by WP&L's regulators have decreased due to declines in debt capital costs and equity investor rate of return expectations. On August 6, 1993 the Federal Energy Regulatory Commission ("FERC") approved WP&L's request for a $2.1 million, or 2.9 percent increase in wholesale rates. The rates became effective October 1, 1993. Electric and Gas Sales Outlook To deal with competitive pressures arising from regulatory changes, WP&L is forecasting to hold retail rates flat through 1996. This objective arises from the competitive pressures forced by changes in regulation. The National Energy Policy Act contains a provision calling for "open transmission access". WP&L anticipates that retail wheeling will become a reality within a few years. In order to meet these new competitive challenges and maintain a low cost pricing advantage, WP&L's objective is to manage costs to maintain profitability while limiting any rate changes until 1997. These forecasts are subject to a number of assumptions, including the economy and weather. WP&L anticipates that its customer base will remain strong in the electric sectors and that favorable gas prices over alternative fuels prices should result in sales growth in gas sectors. Growth in customers' demand for electric service will require capacity additions. Capacity requirements will be met through increased generating capacity (two combustion-turbines in mid-1994), continuation of existing long-term contracts for purchase of capacity, increased efficiency at existing power plants from capital improvements and continued emphasis on cost effective demand-side management programs such as direct load control rate options including interruptible rates and conservation programs. Financing and Capital Structure The level of short-term borrowings fluctuates based on seasonal corporate needs, the timing of long-term financing and capital market conditions. The company's operating subsidiaries generally issue short-term debt to provide interim financing of construction and capital expenditures in excess of available internally generated funds. The subsidiaries periodically reduce their outstanding short-term debt through the issuance of long-term debt and through the company's additional investment in their common equity. To maintain flexibility in its capital structure and to take advantage of favorable short-term rates, the company, through WP&L, also uses proceeds from the sales of accounts receivable and unbilled revenues to finance a portion of its long-term cash needs. The company also anticipates that short-term debt funds will continue to be available at reasonable costs due to strong ratings by independent utility analysts and rating services. Commercial paper has been rated A-1+ by Standard & Poor's Corp. (S&P) and P-1 by Moody's Investors Service (Moody's). Bank lines of credit of $100 million at December 31, 1993 are available to support these borrowings. The company's capitalization at December 31, 1993, including the current maturities of long-term debt, variable rate demand bonds and short-term debt, consisted of 47.9 percent common equity, 4.9 percent preferred stock and 47.2 percent long-term debt. The common equity to total capitalization ratio at December 31, 1993 increased to 47.9 percent from 44.2 percent at December 31, 1992 due to the issuance of 1.65 million shares of Company common stock. The net proceeds from the public offering of $56.7 million were used to repay the short-term debt of its subsidiaries and for general corporate purposes, including construction. A retail rate order effective October 1, 1993, requires WP&L to maintain a utility common equity level of 50.31 percent of total utility capitalization during the test year August 1, 1993 to July 31, 1994. In addition, the PSCW ordered that it must approve the payment of dividends by WP&L to the company that are in excess of the level forecasted in the projected test year ($56.8 million), if such dividends would reduce WP&L's average common equity ratio below 50.31 percent. Capital Requirements The company's largest subsidiary, WP&L, is capital-intensive and requires large investments in long-lived assets. Therefore, the company's most significant capital requirements relate to WP&L construction expenditures. Estimated capital requirements of WP&L for the next five years are as follows: Included in the construction expenditure estimates, in addition to the recurring additions and improvements to the distribution and transmission systems, are the following: expenditures for managing and controlling electric line losses and for the electric delivery system which will save electric line losses and enhance WP&L's interconnection capability with other utilities; expenditures related to environmental compliance issues including the installation of additional emissions monitoring equipment and coal handling equipment; and expenditures associated with the construction of two 86-megawatt combustion-turbine generators expected to become operational in 1994 through 1996. In addition, the steam generator tubes at the Kewaunee Nuclear Power Plant ("Kewaunee") are susceptible to corrosion characteristics seen throughout the nuclear industry. Annual inspections are performed to identify degraded tubes. Degraded tubes are either repaired by sleeving or are removed with approximately 15 percent heat transfer margin, meaning that full power should be sustainable with the equivalent of 15 percent of the steam generator tubes plugged. Currently, the equivalent of 10 percent of the tubes in the steam generators are plugged. WP&L and the other joint owners continue to evaluate appropriate strategies, including replacement, as well as continued operation of the steam generators without replacement. WP&L and the joint owners intend to operate Kewaunee until at least 2013, the expiration of the present operating license. WP&L and the joint owners are also evaluating initiatives to improve the performance of Kewaunee. These initiatives include funding of the development of welded repair technology for steam generator tubes and numerous cost reduction measures such as the conversion from a 12-month to an 18-month fuel cycle. If the steam generators are not replaced, and excluding the possible affect of the aforementioned repair strategies, a gradual power reduction of approximately 1 percent per year may begin as soon as 1995. HDC has expanded its energy related products and services business and its environmental services through acquisitions during 1993. In addition to increasing its investment in affordable housing, HPI continues to market its affordable housing expertise by expanding its business to provide assistance to other corporate/public investors in their development, consultation and financing of affordable housing projects. Capital Resources One of the company's objectives is to finance construction expenditures through internally generated funds supplemented, when required, by outside financing. With this objective in place, the company has financed an average of 62 percent of its construction expenditures during the last five years from internal sources. However, during the next five years, the company expects this percentage to be reduced primarily due to the continuation of major construction expenditures and the maturity of $64 million of WP&L first mortgage bonds. External financing sources such as the issuance of long-term debt, common stock and short-term borrowings will be used by the company to finance the remaining construction expenditure requirements for this period. Current forecasts are that $71 million of additional equity and $60 million of long-term debt will be issued over the next three years. In 1993, the company increased its dividends by 3.4 percent and issued 451,233 new shares of common stock through its Dividend Reinvestment and Stock Purchase Plan, generating proceeds of $15.3 million. Also in 1993, a public offering of 1.65 million newly issued shares of the company's common stock raised proceeds of approximately $56.7 million. The proceeds were used by the company to refinance the short-term debt of its subsidiaries and for general corporate purposes including construction. Market value per share decreased 3 percent to $32.875 per share at December 31, 1993 compared with $33.875 per share at December 31, 1992. Return on equity for 1993 was 11.5 percent and has averaged 13.0 percent over the last five years. INFLATION Under current ratemaking methodologies prescribed by the various commissions that regulate WP&L, projected or forecasted operating costs, including the impacts of inflation, are incorporated into WP&L revenue requirements. Accordingly, the impacts of inflation on WP&L are currently mitigated. Inflationary impacts on the nonregulated businesses are not anticipated to be material to the company. FINANCIAL ACCOUNTING STANDARDS BOARD (the "FASB") ACCOUNTING STANDARDS ISSUED BUT NOT YET EFFECTIVE In November 1992, the FASB issued Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits" ("SFAS 112"). SFAS 112 requires adoption of the new accounting and disclosure rules effective January 1, 1994. The impact on earnings will not be material. OTHER EVENTS In November 1989, the PSCW concluded that WP&L did not properly administer a coal contract, resulting in an assessment to compensate ratepayers for excess fuel costs having been incurred. As a result, WP&L recorded a reserve in 1989 which had an after-tax affect of reducing 1989 net income by $4.9 million. The PSCW decision was found to represent unlawful retroactive ratemaking by both the Dane County Circuit Court and the Wisconsin Court of Appeals. The case was then appealed to the Wisconsin Supreme Court. Subsequent to December 31, 1993, the Wisconsin Supreme Court affirmed the decisions of the Dane County Circuit Court and Wisconsin Court of Appeals. Given the continued uncertainty related to the ultimate method of collection of the assessment from ratepayers to be approved by the PSCW, it is management's opinion that the financial impact of the Wisconsin Supreme Court's decision on the company cannot currently be determined and will require further evaluation. As a result, WP&L does not plan to adjust the reserve. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To WPL Holdings, Inc.: We have audited the accompanying consolidated balance sheets and statements of capitalization of WPL HOLDINGS, INC. (a Wisconsin corporation) and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income, common shareowners' investment 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 WPL Holdings, Inc. 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. Milwaukee, Wisconsin, ARTHUR ANDERSEN & CO. January 28, 1994. The accompanying notes are an integral part of the consolidated financial statements. The accompanying notes are an integral part of the consolidated financial statements. The accompanying notes are an integral part of the consolidated financial statements. The accompanying notes are an integral part of the consolidated financial statements. The accompanying notes are an integral part of the consolidated financial statements. WPL HOLDINGS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING AND REPORTING POLICIES: a. Business and Consolidation: WPL Holdings, Inc. (the "company" or "WPLH") is the parent holding company of Wisconsin Power and Light Company ("WP&L") and Heartland Development Corporation ("HDC"). The consolidated financial statements include the company and its consolidated subsidiaries, WP&L and HDC, along with their respective subsidiaries. All significant intercompany transactions have been eliminated in consolidation. Certain amounts from prior years have been reclassified to conform with the current year presentation. WP&L is a public utility predominantly engaged in the transmission and distribution of electric energy and the generation and bulk purchase of electric energy for sale. WP&L also transports, distributes and sells natural gas purchased from gas suppliers. Nearly all of WP&L's customers are located in south and central Wisconsin. WP&L's principal consolidated subsidiary is South Beloit Water, Gas and Electric Company. HDC and its principal subsidiaries are engaged in business development in three major areas: (1) environmental engineering and consulting through the Environmental Holding Company ("EHC") which is the parent company of RMT, Inc. ("RMT"), Jones and Neuse, Inc., Hydroscience, Inc. and Four Nines, Inc., (2) affordable housing and historic rehabilitation through Heartland Properties, Inc. ("HPI") and (3) energy related products and services which includes, in addition to Enserv, Inc., the recent acquisition of A&C Enercom, EcoGroup and Entec Consulting, Inc.. b. Regulation: WP&L's financial records are maintained in accordance with the uniform system of accounts prescribed by its regulators. The Public Service Commission of Wisconsin ("PSCW") and the Illinois Commerce Commission have jurisdiction over retail rates, which represent approximately 86 percent of electric revenues plus all gas revenues. The Federal Energy Regulatory Commission ("FERC") has jurisdiction over wholesale electric rates representing the balance of electric revenues. Statement of Financial Accounting Standards No. 71, "Accounting for the Effects of Certain Types of Regulation" provides that rate-regulated public utilities such as WP&L record certain costs and credits allowed in the ratemaking process in different periods than for the unregulated entities. These are deferred as regulatory assets or regulatory liabilities and are recognized in the Consolidated Statements of Income at the time they are reflected in rates. c. Utility Plant and Other Property and Equipment: Utility plant and other property and equipment are recorded at original cost and cost, respectively. Utility plant costs include financing costs which are capitalized through the PSCW-approved allowance for funds used during construction ("AFUDC"). The AFUDC capitalization rates approximate WP&L's cost of capital. These capitalized costs are recovered in rates as the cost of the utility plant is depreciated. Normal repairs and maintenance and minor items of utility plant and other property and equipment are expensed. Ordinary utility plant retirements, including removal costs less salvage value, are charged to accumulated depreciation upon removal from utility plant accounts, and no gain or loss is recognized. Upon retirement or sale of other property and equipment, the cost and related accumulated depreciation are removed from the accounts and any gain or loss is included in other income and deductions. d. Nuclear Fuel: Nuclear fuel is recorded at its original cost and is amortized to expense based upon the quantity of heat produced for the generation of electricity. This accumulated amortization assumes spent nuclear fuel will have no residual value. Estimated future disposal costs of such fuel are expensed based on kilowatthours ("Kwh") generated. e. Revenue: WP&L accrues utility revenues for services provided but not yet billed. f. Fuel and Purchased Gas: An automatic fuel adjustment clause for the FERC wholesale portion of WP&L's electric business operates to increase or decrease monthly rates based on changes in fuel costs. The PSCW retail electric rates provide a range from which actual fuel costs may vary in relation to costs forecasted and used in rates. If actual fuel costs fall outside this range, a hearing may be held to determine if a rate change is necessary, and a rate increase or decrease can result. WP&L's base gas cost recovery rates permit the recovery of or refund to all customers for any increases or decreases in the cost of gas purchased from WP&L's suppliers through a monthly purchased gas adjustment clause. g. Cash and Equivalents: The company considers all highly liquid debt instruments purchased with a maturity of three months or less to be cash equivalents. The carrying amount approximates fair value because of the short maturity of these items. h. Income Taxes: The company files a consolidated federal income tax return. Under the terms of an agreement between WPLH and its subsidiaries, WP&L and HDC calculate their respective federal tax provisions and make payments to WPLH as if they were separate taxable entities. Beginning in 1993, the company fully provides deferred income taxes in accordance with Statement of Financial Accounting Standards No.109, "Accounting for Income Taxes" ("SFAS 109"), to reflect tax effects of reporting book and tax items in different periods. NOTE 2. DEPRECIATION: The company uses the straight-line method of depreciation. For utility plant, straight-line depreciation is computed on the average balance of depreciable property at individual straight-line PSCW approved rates as follows: Electric Gas Water Common -------- --- ----- ------ 1993 3.6% 3.7% 2.5% 7.3% 1992 3.4 3.7 2.6 7.1 1991 3.4 3.7 2.6 6.9 Estimated useful lives related to other property and equipment are from three to 12 years for equipment and 31.5 to 40 years for buildings. NOTE 3. NUCLEAR OPERATIONS: Depreciation expense related to the Kewaunee Nuclear Power Plant includes a provision for the decommissioning of the plant which totaled $6.1 million, $3.9 million and $4.1 million in 1993, 1992 and 1991, respectively. Wisconsin utilities with ownership of nuclear generating plants are required by the PSCW to establish external trust funds to provide for plant decommissioning. The market value of the investments in the funds established by WP&L at December 31, 1993 and 1992, totaled $45.1 million and $42.8 million, respectively. WP&L's share of the decommissioning costs is estimated to be $149 million (in 1993 dollars, assuming the plant is operating through 2013) based on a 1992 study, using the immediate dismantlement method of decommissioning. Under the Nuclear Waste Policy Act of 1982, the U.S. Department of Energy ("DOE") is responsible for the ultimate storage and disposal of spent nuclear fuel removed from nuclear reactors. Interim storage space for spent nuclear fuel is currently provided at the Kewaunee Nuclear Power Plant. Currently there is on-site storage capacity for spent fuel through the year 1999. Nuclear fuel, net, at December 31 1993 and 1992, consists of (In Thousands of Dollars): 1993 1992 ---- ---- Original cost of nuclear fuel $147,325 $140,652 Less--Accumulated amortization 129,325 123,729 -------- -------- Nuclear fuel, net $ 18,000 $ 16,923 ======== ======== The Price Anderson Act provides for the payment of funds for public liability claims arising from a nuclear incident. Accordingly, in the event of a nuclear incident, WP&L, as a 41 percent owner of the Kewaunee Nuclear Power Plant, is subject to an overall assessment of approximately $32.5 million per incident for its ownership share of this reactor, not to exceed $4.1 million payable in any given year. Through its membership in Nuclear Electric Insurance Limited, WP&L has obtained property damage and decontamination insurance totaling $1.4 billion for loss from damage at the Kewaunee Nuclear Power Plant. In addition, WP&L maintains outage and replacement power insurance coverage totalling $99 million in the event an outage exceeds 21 weeks. NOTE 4. PROPERTY: a. Jointly Owned Utility Plants: WP&L participates with other Wisconsin utilities in the construction and operation of several jointly owned utility generating plants. The chart below represents WP&L's proportionate share of such plants as reflected in the Consolidated Balance Sheets at December 31, 1993 and 1992 (In Thousands of Dollars): Each of the respective joint owners finances its portion of construction costs. WP&L's share of operations and maintenance expenses is included in the Consolidated Statements of Income. b. Other Property and Equipment: As of December 31, 1993 and 1992, other property and equipment, net includes $100.9 million and $94.4 million, respectively, consisting primarily of rental property and equipment associated with HPI's affordable housing and historic rehabilitation project developments. c. Capital Expenditures: The company's capital expenditures for 1994 are estimated to total $166.7 million. Substantial commitments have been incurred for such expenditures. NOTE 5. NET ACCOUNTS RECEIVABLE: WP&L has a contract with a financial organization to sell, with limited recourse, certain accounts receivable. These receivables include customer receivables resulting from sales to other public utilities as well as from billings to the co-owners of the jointly owned electric generating plants that WP&L operates. The contract allows WP&L to sell up to $100 million of receivables at any time. Consideration paid to the financial organization under this contract includes, along with various other fees, a monthly discount charge on the outstanding balance of receivables sold that approximated a 4.14 percent annual rate during 1993. These costs are recovered in retail utility rates as an operating expense. All billing and collection functions remain the responsibility of WP&L. The contract expires August 19, 1995, unless extended by mutual agreement. As of December 31, 1993 and 1992, proceeds from the sale of accounts receivable totaled $74 million and $69 million, respectively. During 1993, WP&L sold an average of $75.9 million of accounts receivable per month, compared with $68.8 million in 1992. As a result of its diversified customer base and WP&L's sale of receivables, the company does not have any significant concentrations of credit risk in the December 31, 1993 net accounts receivable balance. NOTE 6. DEFERRED CHARGES AND OTHER: Certain costs are deferred and amortized in accordance with authorized or expected rate-making treatment. As of December 31, 1993 and 1992, deferred charges and other include regulatory created assets and other noncurrent items representing the following (In Thousands of Dollars): 1993 1992 ---- ---- Unamortized debt redemption expense $ 13,178 $15,384 Decontamination and decommissioning costs of Federal enrichment facilities 6,181 6,150 Prepaid pension costs 26,128 21,226 Conservation loans to WP&L customers (at cost which approximates market) 12,236 12,257 Goodwill 21,622 - Tax related (see Note 7) 28,608 - Emission allowance credits receivable 5,335 5,335 Other 48,058 27,684 ------- ------ $161,346 $88,036 ======== ======= NOTE 7. INCOME TAXES: The following table reconciles the statutory Federal income tax rate to the effective income tax rate: 1993 1992 1991 ---- ---- ---- Statutory Federal income tax rate 35.0% 34.0% 34.0% State income taxes, net of federal benefit 5.1 7.0 5.0 Investment tax credits restored (2.1) (2.7) (2.2) Amortization of excess deferred taxes (1.7) (1.8) (1.6) Affordable housing and historical tax credits (5.7) (7.5) (1.9) Other differences, net (3.2) (.6) (.4) ---- ---- ---- Effective income tax rate 27.4% 28.4% 32.9% ==== ==== ==== The breakdown of income tax expense as reflected in the Consolidated Statements of Income is as follows (In Thousands of Dollars): 1993 1992 1991 ---- ---- ---- Income taxes: Current Federal $20,725 $19,703 $26,775 Current state 6,500 5,343 5,904 Deferred 5,015 8,124 4,571 Investment tax credit restored (1,967) (2,125) (2,141) Affordable housing and historical tax credits (5,217) (7,788) (2,719) ------- ------- ------- $25,056 $23,257 $32,390 ======= ======= ======= Items which resulted in deferred income tax expense are as follows (In Thousands of Dollars): 1992 1991 ---- ---- Utility plant timing differences $4,104 $4,317 Qualified nuclear decommissioning trust contribution 709 709 Employee benefits 2,081 2,105 Other, net 1,230 (2,560) ------ ------ $8,124 $4,571 ====== ====== The temporary differences that resulted in accumulated deferred income tax assets and liabilities as of December 31, 1993 are as follows (In Thousands of Dollars): Deferred Tax (Assets) Liabilities ------------ Accelerated depreciation and other plant related $171,993 Excess deferred taxes 22,744 Unamortized investment tax credits (22,812) Allowance for equity funds used during construction 13,518 Regulatory liability 19,179 Other 8,222 -------- $212,844 ======== Changes in WP&L's deferred income taxes arising from the adoption of SFAS 109 represent amounts recoverable or refundable through future rates and have been recorded as net regulatory assets totalling approximately $29 million on the Consolidated Balance Sheets. These net regulatory assets are being recovered in rates over the estimated remaining useful lives of the assets to which they pertain. As part of HPI's investments in affordable housing, HPI is eligible to claim affordable housing and historic rehabilitation credits. These tax credits can be recognized to the extent the company has consolidated taxes payable against which the qualifying credits can be benefitted. NOTE 8. EMPLOYEE BENEFIT PLANS: a. Pension Plans: WP&L has noncontributory, defined benefit retirement plans covering substantially all employees. The benefits are based upon years of service and levels of compensation. WP&L's funding policy is to contribute at least the statutory minimum to a trust. The projected unit credit actuarial cost method was used to compute net pension costs and the accumulated and projected benefit obligations. The discount rate used in determining those benefit obligations was 7.25 percent for 1993, and 8 percent for 1992 and 1991. The long-term rate of return on assets used in determining those benefit obligations was 9.75 percent for 1993 and 10 percent for 1992 and 1991. The following table sets forth the funded status of the WP&L plans and amounts recognized in the company's Consolidated Balance Sheets at December 31, 1993 and 1992 (In Thousands of Dollars): 1993 1992 ---- ---- Accumulated benefit obligation-- Vested benefits $(135,303) $(119,883) Nonvested benefits (2,962) (869) --------- --------- $(138,265) $(120,752) ========= ========= Projected benefit obligation $(164,271) $(144,760) Plan assets at fair value, primarily common stocks and fixed income securities 183,881 164,771 --------- --------- Plan assets in excess of projected benefit obligation 19,610 20,011 Unrecognized net transition asset (21,823) (24,270) Unrecognized prior service cost 7,691 9,510 Unrecognized net loss 20,650 15,975 --------- --------- Prepaid pension costs, included in deferred charges and other $ 26,128 $ 21,226 ========= ========= The net pension (benefit) recognized in the Consolidated Statements of Income for 1993, 1992 and 1991 included the following components (In Thousands of Dollars): 1993 1992 1991 ---- ---- ---- Service cost $ 4,263 $ 3,912 $ 3,167 Interest cost on projected benefit obligation 11,614 10,615 9,469 Actual return on assets (24,759) (12,143) (30,035) Amortization and deferral 8,430 (5,317) 14,603 -------- -------- -------- Net pension (benefit) $ (452) $ (2,933) $ (2,796) ======== ======== ======== b. Postretirement Health-care and Life Insurance: Effective January 1, 1993, the company prospectively adopted Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" ("SFAS 106"). SFAS 106 establishes standards of financial accounting and reporting for the company's postretirement health-care and life insurance benefits. SFAS 106 requires the accrual of the expected cost of such benefits during the employees' years of service based on actuarial methodologies that closely parallel pension accounting requirements. WP&L has elected delayed recognition of the transition obligation and is amortizing the discounted present value of the transition obligation to expense over 20 years. For WP&L, the cost of providing postretirement benefits, including the transition obligation, is being recovered in retail rates and wholesale rates under current regulatory practices. For 1993, the annual net postretirement benefits costs recognized in the Consolidated Statements of Income consist of the following components (In Thousands of Dollars): Service cost $ 1,463 Interest cost on projected benefit obligation 3,151 Actual return on plan assets (696) Amortization of transition obligation 1,560 Amortization and deferral (27) ------- Net postretirement benefits cost $ 5,451 ======= The following table sets forth the plans' funded status (In Thousands of Dollars): ---- Accumulated postretirement benefit obligation-- Retirees $ (27,358) Fully eligible active plan participants (5,429) Other active plan participants (9,980) --------- Accumulated benefit obligation (42,767) Plan assets at fair value 7,073 --------- Accumulated benefit obligation in excess of plan assets $(35,694) Unrecognized transition obligation 29,638 Unrecognized loss 2,025 --------- Accrued postretirement benefits liability $ (4,031) ========= The postretirement benefits cost components for 1993 were calculated assuming health care cost trend rates ranging from 12.5 percent for 1993 and decreasing to 5 percent by the year 2002. The health care cost trend rate considers estimates of health care inflation, changes in utilization or delivery, technological advances, and changes in the health status of the plan participants. Increasing the health care cost trend rate by one percentage point in each year would increase the accumulated postretirement benefit obligation as of December 31, 1993 by $2.54 million and the aggregate of the service and interest cost components of the net periodic postretirement benefit cost for the year by $.4 million. The assumed discount rate used in determining the accumulated postretirement obligation was 7.25 percent. The long-term rate of return on assets was 9.50 percent. Plan assets are primarily invested in common stock,bonds and fixed income securities. The company's funding policy is to contribute the tax advantaged maximum to a trust. The costs for the postretirement health-care and life insurance benefits, based on an actuarial determination, were $1,335,000 and $1,078,000, respectively, for 1992 and 1991. c. Other Postemployment Benefits: In November 1992, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits" ("SFAS 112"). SFAS 112 establishes standards of financial accounting and reporting for the estimated cost of benefits provided by an employer to former or inactive employees after employment but before retirement. The effect of adopting SFAS 112, which must be adopted January 1, 1994, will not be material. NOTE 9. CAPITALIZATION: a. Common Shareowners' Investment: During 1993, 1992 and 1991, respectively, the company issued 451,233, 528,142 and 122,110 new shares of common stock through its Dividend Reinvestment and Stock Purchase Plan, generating proceeds of $15.3 million, $17.5 million and $3.3 million, respectively. On April 27, 1993, a public offering of 1.65 million newly issued shares of the company's common stock, priced at $35.50 per share, raised net proceeds of $56.7 million. The proceeds were used by the company to refinance short-term debt and for general corporate purposes including construction. In February 1989, the Board of Directors of the company declared a dividend distribution of one common stock purchase right ("right") on each outstanding share of the company's common stock. Each right would initially entitle shareowners to buy one-half of one share of the company's common stock at an exercise price of $60.00 per share, subject to adjustment. The rights are not currently exercisable, but would become exercisable if certain events occurred related to a person or group acquiring or attempting to acquire 20 percent or more of the outstanding shares of common stock. The rights expire on February 22, 1999, unless the rights are earlier redeemed or exchanged by the company. Authorized shares of common stock total 100,000,000 as of December 31, 1993, and can be categorized as follows: No. Of Shares ------------- Issued and outstanding 30,438,654 Reserved for issuance for Dividend Reinvestment and Stock Purchase Plan 891,874 Common Stock Rights Agreement 15,665,264 Unreserved 53,004,208 ----------- Total authorized 100,000,000 =========== A retail rate order effective October 1, 1993, requires WP&L to maintain a utility common equity level of 50.31 percent of total utility capitalization during the test year August 1, 1993 to July 31, 1994. In addition, the PSCW ordered that it must approve the payment of dividends by WP&L to the company that are in excess of the level forecasted in the projected test year ($56.8 million), if such dividends would reduce WP&L's average common equity ratio below 50.31 percent. b. Preferred Stock: On October 27, 1993, WP&L issued two new series of preferred stock through two separate public offerings. The 6.2% Series is non- redeemable for ten years and the 6.5% Series is non-redeemable for five years. The proceeds from the sale were used to retire 150,000 shares of 7.56% Series and 149,865 shares of 8.48% Series preferred stock. c. Long-term Debt: During 1992, WP&L issued $279 million of first mortgage bonds, of which $235 million was used to refinance the principal of existing series in order to take advantage of lower interest rates. The remaining proceeds were used for the payment of short-term debt and general corporate purposes. Substantially all of WP&L's utility plant is secured by its first mortgage bonds. Current maturities of long-term debt are as follows: $.7 million in 1994, $1.6 million in 1995, $3.3 million in 1996, $56.7 million in 1997 and $11.2 million in 1998. The fair value of the company's long-term debt, including variable rate demand bonds, is estimated at $518,251,000 and $475,909,000 as of December 31, 1993 and 1992, respectively, based on the quoted market prices for similar issues or on the current rates offered to the company for similar debt. NOTE 10. COMMITMENTS AND CONTINGENCIES: a. Coal Contract Commitments: To ensure an adequate supply of coal, WP&L has entered into certain long-term coal contracts. These contracts include a demand or take-or-pay clause under which payments are required if contracted quantities are not purchased. Purchase obligations on these coal and related rail contracts total approximately $263 million through December 31, 2004. WP&L's management believes it will meet minimum coal and rail purchase obligations under the contracts or recover in rates any demand or take-or-pay costs if minimum purchase obligations are not met. Minimum purchase obligations on these contracts over the next five years are estimated to be $67 million in 1994 and $27 million in 1995, 1996, 1997 and 1998, respectively. b. Purchased Power: Under firm purchase power contracts, WP&L is obligated to pay $11 million, $8 million, $5 million, $7 million and $14 million in 1994, 1995, 1996, 1997 and 1998, respectively. For 1994, this represents 2,515 megawatts of capacity. Purchase obligations on these purchase power contracts total approximately $169 million through December 31, 2007. c. Manufactured Gas Plant Sites: Historically, WP&L has owned 11 properties that have been associated with the production of manufactured gas. Currently, WP&L owns five of these sites, three are owned by municipalities, and the remaining three are owned by private companies. In 1989, WP&L initiated investigation of these manufactured gas plant sites. The Wisconsin Department of Natural Resources ("DNR") has been involved in reviewing preliminary investigation plans and has received reports regarding these investigations. Based on the results of WP&L's preliminary investigations, WP&L recorded an estimated liability and corresponding deferred charge of approximately $15 million as of December 31, 1991. In 1992, and into the beginning of 1993, WP&L continued its investigations and studies. WP&L confirmed that there was no contamination at two of the sites and received a close out letter from the DNR related to one of those sites and requested a close out letter for the other site. Additionally, the investigation of historical records at a third site indicated a minimal likelihood of any significant environmental impacts. In February 1993, WP&L completed more current cost estimates for the environmental remediation of the eight remaining sites. The results of this more current analysis indicated that during the next 35 years, WP&L will expend approximately $81 million for feasibility studies, data collection, soil remediation activities, groundwater research and groundwater remediation activities, including construction of slurry containment walls and the installation of groundwater pump and treatment facilities. This estimate was based on various assumptions, and is subject to continuous review and revision by management. Based on the cost estimate set forth above, which assumes a 4 percent average inflation over the 35 year period, WP&L will spend approximately $4.2 million, $1.5 million, $2.1 million, $4.4 million and $4.2 million in 1994 through 1998, respectively. The cost estimate also contemplates that primarily groundwater pump and treatment activities will take place after 1998 through and including 2027. During this time, WP&L estimates that it will incur average annual costs of $2.0 million to complete the planned groundwater remediation activities. With respect to rate recovery of these costs, the PSCW has approved a five year amortization of the unamortized balance of incurred environmental costs deferred to date. Based on the present regulatory record at the PSCW, management believes that future costs of remediating these manufactured gas plant sites will be recovered in rates. d. FERC Order No. 636: In 1992 the FERC issued Order No. 636 and 636-A which requires interstate pipelines to restructure their services. Under these orders, existing pipeline sales service would be "unbundled" such that gas supplies would be sold separately from interstate transportation services (pipelines serving WP&L implemented new services November 1, 1993). Pipelines will, however, seek to recover from their customers certain transition costs associated with restructuring. Any such recovery would be subject to prudence hearings at the FERC and state regulatory commissions. NOTE 11. SHORT-TERM DEBT AND LINES OF CREDIT: The company and its subsidiaries maintain bank lines of credit, most of which are at the bank prime rates, to obtain short-term borrowing flexibility, including pledging lines of credit as security for any commercial paper outstanding. Amounts available under these lines of credit totaled $100 million, $70 million and $52.5 million as of December 31, 1993, 1992 and 1991, respectively. Information regarding short-term debt and lines of credit is as follows (In Thousands of Dollars): NOTE 12. SEGMENT INFORMATION: The following table sets forth certain information relating to the company's consolidated operations (In Thousands of Dollars). NOTE 13. ACQUISITIONS: On August 31, 1993, the company issued 515,993 shares of company common stock in exchange for the outstanding common and preferred stock of Jones and Neuse, Inc. ("JN"), a 250-employee environmental consulting and engineering service firm based in Austin, Texas. This transaction was accounted for as a pooling of interests and all prior periods have been restated accordingly; such restatement was not material. The company intends to position JN as a service region of its own 550-employee environmental consulting and engineering company, RMT, a subsidiary of HDC. In February 1993, HDC acquired A&C Enercom Consultants, Inc. ("A&C"), a Georgia corporation, for cash and new shares of the company's common stock. A&C provides demand side management and energy related consulting services, primarily to public electric and gas utility companies. NOTE 14. CONSOLIDATED QUARTERLY FINANCIAL DATA (Unaudited): Seasonal factors significantly affect WP&L and, therefore, the data presented below should not be expected to be comparable between quarters nor necessarily indicative of the results to be expected for an annual period. The amounts below were not audited by independent public accountants, but reflect all adjustments necessary, in the opinion of the company, for a fair presentation of the data. Operating Operating Earnings Quarter Ended Revenues Income Net Income Per Share -------- --------- ---------- --------- (In Thousands except for Per Share Data) 1993: March 31 (*) $209,250 $36,490 $19,766 $.70 June 30 (*) 173,631 19,872 7,190 .24 September 30 173,869 29,358 13,258 .44 December 31 216,307 40,463 22,309 .73 1992 (*): March 31 $184,346 $36,223 $18,653 $.69 June 30 147,146 17,464 7,268 .26 September 30 156,516 25,624 12,290 .44 December 31 185,265 38,648 19,796 .71 (*) The financial information presented has been restated to reflect the pooling of JN (see Note 13). 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 Item 10 relating to directors and nominees for election as directors at the company's 1994 Annual Meeting of Shareowners is incorporated herein by reference to the information under the caption "Election of Directors" in the company's Proxy Statement (the "1994 Proxy Statement") filed with the Securities and Exchange Commission. The information required by Item 10 relating to executive officers is set forth in Part I of this Annual Report on Form 10-K. The information required by Item 10 relating to delinquent filers is incorporated herein by reference to the information under the caption "Compliance with Section 16(a) of the Securities Exchange Act of 1934" in the 1994 Proxy Statement. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The information required by Item 11 is incorporated herein by reference to the information under the caption "Compensation of Executive Officers" in the 1994 Proxy Statement. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information required by Item 12 is incorporated herein by reference to the information under the caption "Ownership of Voting Securities" in the 1994 Proxy Statement. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information required by Item 13 is incorporated herein by reference to the information under the caption "Election of Directors" in the 1994 Proxy Statement. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) (1) Consolidated Financial Statements Included in Part II of this report: Report of Independent Public Accountants on Schedules Consolidated Statements of Income for the Years Ended December 31, 1993, 1992 and 1991 Consolidated Balance Sheets, December 31, 1993 and 1992 Consolidated Statements of Cash Flows for the Years Ended December 31, 1993, 1992 and 1991 Consolidated Statements of Capitalization, December 31, 1993 and 1992 Consolidated Statements of Common Shareowners' Investment Notes to Consolidated Financial Statements (a) (2) Financial Statement Schedules For each of the years ended December 31, 1993, 1992 and 1991 Schedule II. Amounts Receivable from Related Parties Schedule III. Parent Company Financial Statements Schedule V. Property Plant and Equipment Schedule VI. Accumulated Provision for Depreciation and Accumulated Amortization of Nuclear Fuel Schedule VIII. Valuation and Qualifying Accounts and Reserves Schedule X. Supplementary Income Statement Information All other schedules are omitted because they are not applicable or not required, or because that required information is shown either in the consolidated financial statements or in the notes thereto. (a)(3) Exhibits Required by Securities and Exchange Commission Regulation S-K The following Exhibits are filed herewith or incorporated herein by reference. Documents indicated by an asterisk (*) are incorporated herein by reference. 3A* Restated Articles of Incorporation (Exhibit 4.1 to the company's Form S-3 Registration Statement No. 33-59972) 3B* By-Laws of as revised to January 1, 1993 4A* Indenture of Mortgage or Deed of Trust dated August 1, 1941, between WP&L and First Wisconsin Trust Company and George B. Luhman, as Trustees, filed as Exhibit 7(a) in File No. 2-6409, and the indentures supplemental thereto dated, respectively, January 1, 1948, September 1, 1948, June 1, 1950, April 1, 1951, April 1, 1952, September 1, 1953, October 1, 1954, March 1, 1959, May 1, 1962, August 1, 1968, June 1, 1969, October 1, 1970, July 1, 1971, April 1, 1974, December 1, 1975, May 1, 1976, May 15, 1978, August 1, 1980, January 15, 1981, August 1, 1984, January 15, 1986, June 1, 1986, August 1, 1988, December 1, 1990, September 1, 1991, October 1, 1991, March 1, 1992, May 1, 1992, June 1, 1992 and July 1, 1992 (Second Amended Exhibit 7(b) in File No. 2-7361; Amended Exhibit 7(c) in File No. 2-7628; Amended Exhibit 7.02 in File No. 2-8462; Amended Exhibit 7.02 in File No. 2-8882; Second Amendment Exhibit 4.03 in File No. 2-9526; Amended Exhibit 4.03 in File No. 2-10406; Amended Exhibit 2.02 in File No. 2-11130; Amended Exhibit 2.02 in File No. 2-14816; Amended Exhibit 2.02 in File No. 2-20372; Amended Exhibit 2.02 in File No. 2-29738; Amended Exhibit 2.02 in File No. 2-32947; Amended Exhibit 2.02 in File No. 2-38304; Amended Exhibit 2.02 in File No. 2-40802; Amended Exhibit 2.02 in File No. 2-50308; Exhibit 2.01(a) in File No. 2-57775; Amended Exhibit 2.02 in File No. 2-56036; Amended Exhibit 2.02 in File No. 2-61439; Exhibit 4.02 in File No. 2-70534; Amended Exhibit 4.03 File No. 2-70534; Exhibit 4.02 in File No. 33-2579; Amended Exhibit 4.03 in File No. 33-2579; Amended Exhibit 4.02 in File No. 33-4961; Exhibit 4B to WP&L's Form 10-K for the year ended December 31, 1988, Exhibit 4.1 to WP&L's Form 8-K dated December 10, 1990, Amended Exhibit 4.26 in File No. 33-45726, Amended Exhibit 4.27 in File No.33-45726, Exhibit 4.1 to WP&L's Form 8-K dated March 9, 1992, Exhibit 4.1 to WP&L's Form 8-K dated May 12, 1992, Exhibit 4.1 to WP&L's Form 8-K dated June 29, 1992 and Exhibit 4.1 to WP&L's Form 8-K dated July 20, 1992) 10A*# Executive Tenure Compensation Plan as revised November 10B*# Form of Supplemental Retirement Plan, as revised November 10C*# Forms of Deferred Compensation Plans, as amended June, 1990 (Exhibit 10C to the company's Form 10-K for the year ended December 31, 1990) 10C.1*# Officer's Deferred Compensation Plan II, as adopted September 1992 10C.2*# Officer's Deferred Compensation Plan III, as adopted January 1993 10F*# Pre-Retirement Survivor's Income Supplemental Plan, as revised November 1992 10H*# Management Incentive Plan 10I*# Deferred Compensation Plan for Directors, as adopted June 27, 1990 12 Computation of ratio of earnings to fixed charges and preferred dividend requirements after taxes 21 Subsidiaries of the company 23 Consent of Independent Public Accountants 99 1994 Proxy Statement for the Annual Meeting of Shareowners to be held May 18, 1994 Pursuant to Item 601(b)(4)(iii) of Regulation S-K, the company hereby agrees to furnish to the Securities and Exchange Commission, upon request, any instrument defining the rights of holders of unregistered long-term debt not filed as an exhibit to this Form 10-K. No such instrument authorizes securities in excess of 10 percent of the total assets of the company. # - A management contract or compensatory plan or arrangement. (b) Reports on Form 8-K. 1. WP&L filed a report on Form 8-K dated October 20, 1994, which reported, under "Item 5. Other Events", the agreement to sell: (i) 150,000 shares of its 6.2% Preferred Stock, with a stated value of $100, in a public offering through Goldman, Sachs & Co.; and (ii) 599,460 shares of its 6.5% Preferred Stock, with a stated value of $25 in a public offering through Robert W. Baird & Co. Incorporated. 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 23rd day of February 1994. WPL HOLDINGS, INC. By: /s/ Erroll B. Davis, Jr. Erroll B. Davis, 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 registrant and in the capacities indicated on the 23rd day of February 1994. /s/ Erroll B. Davis, Jr. President, Chief Executive Erroll B. Davis, Jr. Officer and Director (principal executive officer) /s/ Edward M. Gleason Vice President, Treasurer and Edward M. Gleason Corporate Secretary (principal financial officer) /s/ Daniel A. Doyle Controller and Treasurer - Daniel A. Doyle Wisconsin Power and Light Company (principal accounting officer) /s/ L. David Carley Director /s/ Milton E. Neshek Director L. David Carley Milton E. Neshek /s/ Rockne G. Flowers Director /s/ Henry C. Prange Director Rockne G. Flowers Henry C. Prange /s/ Donald R. Haldeman Director /s/ Henry F. Scheig Director Donald R. Haldeman Henry F. Scheig /s/ Katharine C. Lyall Director /s/ Carol T. Toussaint Director Katharine C. Lyall Carol T. Toussaint /s/ Arnold M. Nemirow Director Arnold M. Nemirow REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS ON SCHEDULES To WPL Holdings, Inc.: We have audited in accordance with generally accepted auditing standards, the consolidated financial statements included in the 1993 Form 10-K of WPL Holdings, Inc. and have issued our report thereon dated January 28, 1994. Our audit was made for the purpose of forming an opinion on those statements taken as a whole. Supplemental Schedules II, III, V, VI, VIII 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 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. Milwaukee, Wisconsin, ARTHUR ANDERSEN & CO. January 28, 1994. INDEX TO SCHEDULES WPL HOLDINGS, INC. INDEX TO FINANCIAL STATEMENT SCHEDULES FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 FINANCIAL STATEMENT SCHEDULES: II. Amounts Receivable from Related Parties III. Parent Company Financial Statements V. Property Plant and Equipment VI. Accumulated Provision for Depreciation and Accumulated Amortization of Nuclear Fuel VIII. Valuation and Qualifying Accounts and Reserves X. Supplementary Income Statement Information NOTE: All other schedules are omitted because they are not applicable or not required, or because that required information is shown either in the financial statements or in the notes thereto. The loan between HDC and Mr. Ahearn represents income taxes withheld in connection with shares vesting as a part of an employment agreement. The loan is to be in effect at market rates and is payable on July 1, 1994. The accompanying notes are an integral part of these statements. The accompanying notes are an integral part of this statement. The accompanying notes are an integral part of this statement. SCHEDULE III - CONDENSED PARENT COMPANY FINANCIAL STATEMENTS WPL HOLDINGS, INC. Supplemental Notes to Parent Company Only Financial Statements The following are supplemental notes to the WPL Holdings, Inc. (the "Company") Parent Company Financial Statements and should be read in conjunction with the Consolidated Financial Statements and Notes thereto included in the WPL Holdings, Inc. 1993 Annual Report, which are hereby incorporated herein by reference: Note A. The parent company files a consolidated Federal income tax return with its subsidiaries. Note B. Net amounts due to (due from) affiliates result from intercompany transactions including loans, federal income tax liabilities and an administrative allowance. Note C. Information regarding short-term debt is as follows: 1993 1992 (In Thousands) As of end of year: Notes payable outstanding.......... $32,958 $19,151 Interest rates on notes payable.... 3.58% 3.62% For the year ended: Maximum month-end amount of short-term debt.................. $36,000 $22,600 Average amount of short-term debt.. $25,827 $19,722 Average interest rate on short- term debt......................... 3.37% 3.93% Note D. During 1993, 1992 and 1991, Wisconsin Power and Light Company allocated and billed certain administrative and general expenses to using an allocation method approved by the Public Service Commission of Wisconsin. These expenses totalled $777,000, $867,000 and $886,000 during 1993, 1992 and 1991, respectively. SCHEDULE X WPL HOLDINGS, INC. AND SUBSIDIARIES SUPPLEMENTARY INCOME STATEMENT INFORMATION Year Ended December 31, 1993 1992 1991 (In Thousands) Real estate and personal property $18,523 $18,052 $16,292 Payroll............. 12,602 10,117 9,041 Other............... 1,253 1,092 1,201 ------- ------- ------- $32,378 $29,261 $26,534 ======= ======= ======= The amounts of maintenance and repairs, depreciation and taxes charged to other expense accounts are not significant. The amounts charged to the respective accounts for advertising aggregated less than one percent of total consolidated revenues, and no royalty expenses were incurred. WPL HOLDINGS, INC. AND SUBSIDIARIES Exhibit Index for the Year Ended December 31, 1993 Item Description 12 Computation of ratio of earnings to fixed charges and preferred dividend requirements after taxes 21 Subsidiaries of the Company 23 Consent of Independent Public Accountants 99 1994 Proxy Statement for the Annual Meeting of Shareowners to be held May 18, 1994 (To be filed with the Securities and Exchange Commission under Regulation 14A within 120 days after the end of the Company's fiscal year)

217028_1993.txt

217028_1993

1993

217028

ITEM 1. BUSINESS Description of the Business Rhone-Poulenc Rorer Inc., a Pennsylvania corporation, formerly known as Rorer Group Inc., (the "Company" or "RPR"), is the business formed in the 1990 combination of Rorer Group Inc. ("Rorer") and substantially all of the Human Pharmaceutical Business ("HPB") of Rhone-Poulenc S.A. ("RP"). RP, based in Paris, France, owns approximately 68 percent of the Company's common shares as of January 31, 1994 and controls the Company. The combination of Rorer and HPB increased Rorer's ability to compete effectively on a worldwide basis through the achievement of overall critical mass, increased investment in research and development, a substantial presence in Europe and the United States, and the opportunity to expand its operations in Japan. For HPB, the combination provided access for future products to the world's single largest pharmaceutical market--the United States--where HPB had no previous marketing or distribution network. For both entities, the combination afforded a substantial opportunity to achieve production, marketing and administrative synergies and better leverage the significant research and development activities of the combined Company. The Company is primarily engaged in the discovery, development, manufacture and marketing of a broad line of pharmaceutical products for human use. On the basis of sales, the Company is the leading pharmaceutical group in France, among the top three in Europe and among the largest in the world. The Company also has a growing presence in North America, in developing markets, and in Japan. The Company's products are manufactured in more than 30 countries and the Company has a commercial presence in all major markets of the world. The Company's pharmaceutical products are primarily comprised of prescription medicines, over-the-counter ("OTC") medicines and plasma derivatives. In addition, the Company manufactures and sells certain bulk pharmaceuticals and limited quantities of other chemicals. Pursuant to a strategy of focusing on pharmaceutical products, the Company sold its dietetic and nutritional products business (principally Dietetique et Sante in France and Dietisa in Spain) in 1991. In 1993, the Company acquired a 37% interest in Applied Immune Sciences, Inc. ("AIS"), a pioneer in cell therapy, and the right to purchase majority ownership interest around 60%. The Company also launched a long-term gene and cell therapy research and development collaboration with AIS and entered into agreements for current and future joint ventures for the marketing and distribution of cell therapy products and services. These agreements and other similar collaborations should strategically position the Company to play a major role in the development of commercial opportunities in both cell and gene therapies. Financial Information about Industry Segments and Foreign and Domestic Operations See note 14 to the consolidated financial statements, "Industry Segment and Operations by Geographic Area" appearing on page 41 of this report. Principal Products The Company's pharmaceutical products are primarily comprised of prescription medicines, OTC medicines and plasma derivatives. The Company's principal product focus can be categorized generally in the following major therapeutic areas: cardiovascular; infectious disease/oncology; bone metabolism/ rheumatology; central nervous system/analgesia; hypersensitivity; plasma derivatives; and gastroenterology. In addition, the Company manufactures and sells certain bulk chemicals, OTC products and pharmaceuticals in other therapeutic areas including dermatology. No single product contributed more than 6% of 1993 and 1992 sales, and the ten largest products as a group contributed 36% of the Company's 1993 sales (1992- 35%). The following principal therapeutic areas accounted for the indicated percentages of the Company's total net sales. - -------- * Certain reclassifications have been made from amounts shown in prior periods for therapeutic areas to conform to classifications now used by the Company. The Company's principal pharmaceutical products include the following: Maalox (R), a magnesium and aluminum hydroxide-based antacid for treatment of gastric hyperacidity; Orudis (R)/Profenid (R)/Oruvail (R) (ketoprofen), a non- steroid anti-inflammatory agent used in the treatment of rheumatoid arthritis; Calsynar (R)/Calcimar (R) (calcitonin) for the treatment of metabolic bone diseases such as post-menopausal osteoporosis; Albuminar (R), a protein replacement agent and plasma volume expander for loss of intra-vascular volume; Clexane (R)/Lovenox (R) (enoxaparin), a low molecular weight heparin used in the prevention and treatment of deep vein thrombosis after surgery; Azmacort (R), an inhaled corticosteroid for asthma; Monoclate-P (R), a pasteurized antihemophilic factor VIII:C product; Lozol (R) (indapamide), a diuretic used to treat hypertension; Doliprane (R) (paracetamol), an analgesic; Rovamycine (R) (spiramycine), a macrolide anti-infective; Sermion (R) (nicergoline), a cerebral vasodilator used in the treatment of memory disturbance due to aging and cognitive disorders; Imovane (R)/Amoban (R) (zopiclone), a non-benzodiazepine sleeping agent; Nasacort (R) (triamcinolone acetonide), an inhaled corticosteroid for allergic rhinitis; Flagyl (R) (metronidazole), an antiparasitic used in the treatment of trichomoniasis, amebiasis and anaerobic bacterial infections; Peflacine (R) (pefloxacine), an anti-infective quinolone product; DDAVP (R), primarily for treatment of nocturnal enuresis in children; Josacine (R) (josamycine), a macrolide antibiotic to treat upper respiratory infections; Sectral (R) (acebutolol), a beta-blocker used in the treatment of hypertension and angina; Slo-bid (TM)/Slo-Phyllin (R), a theophylline bronchodilator; Captea (R)/Captolane (R) (captopril), ACE inhibitors; Oroken (R) (cefixim), a third-generation cephalosporin anti-infective; Dilacor XR (R) (diltiazem), a calcium channel blocker used for treatment of hypertension; Selectol (R) (celiprolol), a highly cardioselective vasodilating beta-blocker used in the treatment of hypertension; Vasten (R) (pravastatin), a reductase inhibitor for treatment of hypercholesterolemia; Nitrong (R)/Nitrolingual (R) (nitroglycerin), used for the prevention and treatment of angina pectoris; and Frumil (R) (furosemide/amiloride HCl), a diuretic for hypertension. While the above products as well as others are important to the Company's strategy and focus in specific geographic markets, not all products are marketed by the Company in all three of the largest pharmaceutical markets of the world (Europe, United States and Japan). Customers, Marketing and Distribution The Company markets its products in more than 140 countries throughout the world. The Company's prescription products are sold primarily to drug wholesalers, retail pharmacies, hospitals and government authorities, while over-the-counter products are sold, in addition to the foregoing, to food chains and other retail outlets, particularly in the United States. The Company's products are sold to a large number of diverse customers. No one customer accounted for as much as 10 percent of the Company's consolidated net sales in 1993. Promotion of the Company's prescription products is directed primarily to physicians, hospitals and pharmacists through personal visits by professional sales representatives. In addition, this activity is supported by the Company's participation in scientific seminars, medical journal advertising and by direct distribution of samples and other printed material. Promotion of OTC products includes advertising directed at the end consumer through media such as television, radio or print. In France, where the Company enjoys the leading position, its prescription pharmaceutical marketing activities are presently conducted through three laboratories: Specia, Theraplix and Bellon. The Company's OTC business in France is carried on principally through its RP Labo subsidiary. Through the laboratories, the Company is party to certain arrangements in France with affiliates of Bristol-Myers Squibb, Bayer, and Astra to co-market such products as Vasten (R), a cholesterol-lowering agent; Captea (R), a combination ACE inhibitor and diuretic; Captolane (R), an ACE inhibitor; Nidrel (R), a calcium channel blocker and Zoltum (R), a proton pump inhibitor. In 1993, just over 34 percent of the Company's sales were in France. Also through its operations in France, the Company has entered into joint venture agreements for the development and possible future marketing throughout Western Europe of new compounds discovered by joint venture partners Dainippon and Chugai. The Company conducts its marketing efforts in the United States in four divisions: (1) Rhone-Poulenc Rorer Pharmaceuticals, the prescription pharmaceuticals division; (2) Rhone-Poulenc Rorer Consumer Pharmaceutical Products, which markets OTC products; (3) Armour Pharmaceutical Company, which markets plasma derivatives to hospitals; and (4) Dermik Laboratories, which markets prescription dermatological products principally to dermatologists. In 1993, just under 28 percent of the Company's sales were in the United States. The U.S. pharmaceutical industry is currently undergoing fundamental changes to the way health care is administered and provided. See "Governmental Regulation". These changes will necessitate that relationships with a smaller number of large customers (i.e., managed care organizations) be developed in addition to the traditional marketing focus on the individual physician. At the end of 1993, the Company reorganized on a regional basis its U.S. prescription pharmaceuticals division to better respond to this emerging managed care environment. An emerging markets unit will focus on nationally-organized managed care plans and will also be responsible for Arcola Laboratories, formed in mid-1993 to market generic versions of RPR products after patent or market exclusivity expiration in the United States. Operations in Other Europe (excluding France) contributed approximately 24 percent of 1993 consolidated sales. The Company's largest operations are in Germany, Italy and the United Kingdom. The Company conducts its prescription products operation in Germany under the names of Nattermann, Rorer and Rhone- Poulenc Pharmaceuticals. Plasma derivatives are marketed by Armour Pharmaceuticals. The OTC business in Germany is conducted through the Nattermann and Dr. Schieffer units. In 1991, the Company sold the Woelm trade name along with the Eschwege facility (and certain OTC products produced there) to an affiliate of Johnson & Johnson/Merck Consumer Pharmaceutical Co. In Italy, the Company conducts business through its Rhone-Poulenc Rorer S.p.A. subsidiary under the names Rhone-Poulenc and Rorer. In the United Kingdom, the Company markets branded prescription pharmaceuticals through its Rhone-Poulenc Rorer and May & Baker divisions. Plasma derivatives are marketed by Armour Pharmaceuticals. In addition, generic pharmaceuticals are marketed and distributed in the U.K. under the name of APS-Berk. In 1992, the RPR Family Health Division was created in the U.K. to develop OTC line extensions and new brand launches. In 1993, the Company strengthened and expanded its operations in Eastern Europe, building a sales force and entering into local production, warehousing and distribution arrangements. In the aggregate, geographic regions comprising the Rest of World area accounted for 14 percent of RPR's 1993 sales. The Company maintains a presence in Africa, Asia, Latin America, Canada, Australia and Japan. During 1991, the Company consolidated its activities in Japan, including its joint venture with Chugai, in Rhone-Poulenc Rorer Japan Inc. The Company's operations there are conducted primarily through this subsidiary; in addition, the Company has several licensing arrangements with Yamanouchi and other Japanese companies for the sale of RPR products in that market. Raw Materials and Manufacturing Substantial amounts of the active ingredients used in the Company's prescription and OTC medicines are manufactured at its bulk pharmaceutical and chemical facilities at Villeneuve la Garenne and Vitry-sur-Seine (near Paris, France), Dagenham (near London, England), Cologne (Germany), Lewes, Delaware (United States) and Marseilles (France). Other chemicals and botanicals are purchased from other companies. These materials are generally processed, compounded and packaged in facilities which the Company operates. See "Properties". The Company manufactures a substantial amount of the active ingredients contained in its pharmaceutical products and does not depend on other suppliers for these materials. Other raw materials and packaging supplies for the Company's pharmaceutical products generally are available in ample quantities under normal conditions. Such supplies were adequate in 1993, and no shortages are currently anticipated. During 1993, the Company produced virtually all of the magnesium and aluminum hydroxides used in its antacid products sold in the United States and a substantial portion of the magnesium and aluminum hydroxides used in products sold to the rest of the world. Armour's Plasma Alliance subsidiary, through the plasmapheresis process, collects all of the plasma used in the U.S. and substantially all of the plasma used worldwide at 21 collection centers throughout the southern and mid-western United States. Patents, Trademarks and Licenses Patents and Licenses. The Company has obtained patents in France, the United States, and other countries for the significant products discovered or developed through its research and development activities. Patent protection is available in the United States, France and most other developed countries for new active ingredients, as well as for pharmaceutical formulations or manufacturing processes. In some other countries, patent protection is available only for manufacturing processes. The Company also licenses patents and other know-how from third parties. Certain of the Company's licensed and owned products are covered by patents principally in the United States, France and/or other countries. These patents cover such principal products as Nasacort (R); Monoclate-P (R); Clexane (R)/Lovenox (R); Azmacort (R); Peflacine (R); Imovane (R) and Selectol (R). The Company's licensed or owned patents expire at various times through the next twenty years. The Company has been granted Supplementary Certificates of Protection to extend the patent terms of several of the Company's products in Europe. The U.S. Azmacort (R) patent expired in 1993. The U.S. Lozol (R) patent expired in 1988 and Lozol (R) U.S. FDA exclusivity expired in mid-1993. Product patent protection is no longer available in nearly all major markets for the active ingredients (such as ketoprofen, metronidazole, calcitonin, acebutolol and spiramycine) used in a number of the Company's leading products. However, the Company does not believe that the expiration of patent protection for the active ingredients used in these and other products has generally had a significant adverse effect on the Company because of the Company's ability thus far to develop and patent new processes, formulations and uses; to position many of its products in specific market niches; and because of the absence of a generic market in France. The Company believes that no single patent or license is material to the Company as a whole. The Company is routinely engaged in disputes over its patented products and processes, the more significant of which are discussed in "Legal Proceedings" herein. Trademarks. The Company also maintains numerous trademarks protected by registrations in the countries where its products are marketed. The Company's trademark for a pharmaceutical product generally assumes increasing importance when the patent for such product expires in a particular country. Except for trademarks relating to Maalox (R) products, no single trademark is considered material to the Company as a whole. There are currently no significant disputes concerning its trademarks. Competition Generally, the Company operates in an intensely competitive domestic and international environment, encountering competition in all of its geographical markets from large national and international competitors. Among the Company's chief competitors are Sandoz, Ciba-Geigy, Glaxo, Bayer, Merck, Upjohn, Roche, SmithKline Beecham and Schering-Plough. These and other competitors have substantial resources available for research, development and marketing activities. In general, a pharmaceutical product may be subject to competition from alternative therapies during the period of patent protection and thereafter it may also be open to competition from generic products. The launch by other companies of new products or processes with therapeutic advantages can result in product obsolescence and/or significant price erosion despite the existence of patent protection or recognized trademarks. Medical utility, product quality and marketing are other major competitive factors. Manufacturers of generic products typically do not invest as heavily in research and development and, consequently, are able to offer generic products at considerably lower prices than brand equivalents. A research-based pharmaceutical company may therefore seek to achieve a sufficient margin and sales volume during the period of patent protection to recover the original investment and to fund research for the future. There are, however, a number of factors that can enable products to remain profitable once all forms of patent protection (product, process, formulation and use) have ceased. These include a) creating for the prescriber or the consumer a strong brand identification supported by an active trademark registration and enforcement policy, b) offering a range of alternative formulations that generic manufacturers typically cannot produce, or c) complexity of manufacture of the active compound. Increasing governmental and other pressures in many countries in favor of the dispensing of generic products in substitution for brand-name products may increase competition for some of the Company's products which are no longer covered by patents. The Company believes that its competitive position in the medium- to long- term depends largely upon the ability of its research and development organization to discover and develop innovative products, as well as upon increasing productivity through improved manufacturing methods and marketing efforts. Research and Development The Company invests heavily in research and development, which management believes is critical to growth and competitiveness in the pharmaceutical industry. Research and development expenditures were $561 million in 1993, $521 million in 1992 and $445 million in 1991. Such expenditures represented 14%, 13% and 12% of net sales in 1993, 1992 and 1991, respectively. Following its combination with HPB, the Company concentrated research efforts at three research centers, in France, the United States, and the United Kingdom. See also "Properties." The Company has centralized and redirected its research in selected areas deemed by management to be of long-term market potential. Research and development programs are concentrated in several therapeutic areas: cardiovascular, cancer, infectious diseases/AIDS, respiratory, bone metabolism/rheumatology, and central nervous system. The Company has development projects in various stages which include, but are not limited to, the following: . Taxotere (R), an antitumor agent with potential therapeutic benefit against breast, lung and other forms of cancer; . Ebastine, an antihistaminic compound for treatment of seasonal or perennial allergic rhinitis; . an AIDS virus-derived immunotherapeutic agent designed to elicit an immune system response which might prevent or delay the onset of AIDS; . Menorest (R), an estrogen patch for female hormone replacement, as well as Combi-patch, an estrogen/progestin combination transdermal patch for the relief of menopausal symptoms; . Zagam (TM), a potential first-line therapy broad spectrum anti-infective compound (being developed in North America and co-developed in Europe through a joint venture with Dainippon); . Synercid (TM), an injectable streptogramin antibiotic for hospital- acquired infections; . Aprim (R) (aprikalim), a potassium channel opener for treatment of angina; . a potent and selective inhibitor of the enzyme phosphodiesterase type IV indicated in the inflammatory process in the lung; . new indications for the marketed anti-thrombotic drug, Lovenox (R), in the U.S.; and . a novel compound, Riluzole, for the treatment of Amyotrophic Lateral Sclerosis (ALS). There can be no assurance that these or other compounds in various stages of development will ultimately be approved for commercial sale. In 1993, the Company launched a long-term gene and cell therapy research and development collaboration with AIS. This arrangement and other similar collaborations should strategically position the Company to play a major role in the development of commercial opportunities in both cell and gene therapies. Governmental Regulation The introduction of new prescription pharmaceutical products is regulated in all countries where the Company does business. Regulatory requirements generally relate to the safety and efficacy of the product as well as to the manufacturing processes for and the packaging and labeling of such products. Clinical testing is required for pharmaceutical products. Completion of the lengthy application and testing process for required governmental approvals is costly and can significantly delay the introduction of new products in a given market. In the French prescription pharmaceutical market, direct price controls have maintained prices at a low level compared to other markets and have typically prevented the emergence of generic competition. The government is currently considering cost containment measures to respond to the nation's health care deficit, including physician prescribing guidelines to limit the volume of prescriptions written. A three-year policy agreement between pharmaceutical manufacturers and the French government signed in January 1994 will limit annual growth of prices for reimbursable pharmaceuticals to a level expected to be in line with the average inflation rate. In Germany, physician prescribing guidelines have been established and the selling prices of prescription products were reduced by 5% in 1993 and remain frozen through December 1994. A new reimbursement system was instituted in Italy in 1993 resulting in the removal of certain products from government reimbursement lists and price cuts of 2.5% to 4.5%. Effective October 1993, the U.K. Pharmaceutical Price Regulation Scheme enacted price reductions of up to 2.5% and limited the ability of companies at certain profitability levels to seek price increases. In Spain, decreases in pharmaceutical prices averaging 3% became effective in November 1993. In the European Community ("EC"), the Single Market formally came into being on January 1, 1993. The Maastricht Treaty creating the European Union was eventually ratified and came into effect in November 1993. The Single Market program was extended to five of the European Free Trade Association countries (Finland, Sweden, Norway, Austria and Iceland) through the creation of the European Economic Area effective January 1994. Directives relating to advertising, wholesale distribution, product classification and labelling/package inserts adopted during 1992 are now being implemented by the Member States. A regulation compensating the pharmaceutical industry for time lost during product development by providing extended patent protection for up to 15 years from the date of first marketing authorization in the EC also came into effect. The future systems package establishing the new European regulatory procedures and the European Medicines Evaluation Agency was adopted in mid-1993; operation of the new procedures will commence in January 1995. The Company's products sold in the United States are subject to the Food, Drug and Cosmetic Act, and accordingly are subject to investigation and pre- market approval of "new drugs" (as such term is defined in the Act), strict standards regarding their manufacture, safety and efficacy and detailed requirements with respect to labeling, promotion and, with respect to prescription drugs, advertising. All states have enacted generic substitution laws which permit, or in some instances require, the dispensing pharmacist to substitute a different manufacturer's version of a drug for the one prescribed. A variety of legislative proposals to expand public health care programs and/or impose pharmaceutical price or other restrictions in the U.S. have been discussed in recent years. During 1993, the Clinton Administration proposed the Health Security Act ("HSA") which would provide universal health coverage through standardized benefits for all U.S. citizens and would, by 1998, make sweeping structural and financial changes to the U.S. health care delivery system. Health care coverage would be provided primarily under managed-care arrangements available through regional or corporate health alliances determined at the state level. Elements of HSA and other proposals will be debated by legislators at various levels in the coming year. The precise form and effect of any final legislation cannot be predicted; however, most pharmaceutical manufacturers, including RPR, have reorganized to adapt to an emerging U.S. managed care environment which dictates that product offerings satisfy payor objectives aimed at lowering health care costs. U.S. Federal and state governments also continue to seek means to reduce costs of Medicare and Medicaid programs. Under the HSA, selected service cuts and spending caps on these programs would be imposed beginning in 1996. Medicare and Medicaid recipients would, in many instances, obtain coverage through regional alliances and be entitled to receive, among other things, outpatient prescription drug benefits. Drug manufacturers would be required to sign rebate agreements with the Department of Health and Human Services in order to participate in the Medicare and Medicaid prescription drug benefit. The exact form of these measures and whether additional restrictions on reimbursement for, or access to, certain drug products will be enacted is yet to be determined. Currently the Company operates under a Medicaid Rebate Agreement entered into with the U.S. Government under Section 4401 of the Omnibus Budget Reconciliation Act of 1990. Pursuant to the agreement, as of January 1, 1991, in order for federal reimbursement to be available for prescription drugs under state Medicaid plans, the Company must pay certain statutorily-prescribed rebates on Medicaid purchases. Effective in 1991, the law also denies federal Medicaid reimbursement for drug products of the original New Drug Application (NDA)-holder if a less expensive generic version of such drug is available from another manufacturer, unless the prescriber indicates on the prescription that the branded product is medically necessary. In addition to the agreement with the U.S. Federal Government, the Company has entered into similar rebate agreements with several state reimbursement programs. The Company does not believe that continued operation of these agreements will have a material adverse impact on the Company's financial condition in the foreseeable future. In most other developed markets governments exert controls over pharmaceutical prices either directly or by controlling admission to, or levels for, reimbursement by government health programs. The nature of such controls and their effect on the pharmaceutical industry varies greatly from country to country. It is not possible to predict the extent to which the Company or the pharmaceutical industry might be affected by the matters discussed above. Environmental Matters In 1993, the Company formed an Environmental Council to administer its worldwide environmental compliance policy. The Company believes that its operations comply in all material respects with applicable environmental laws and regulations including those of U.S. Federal, state and local authorities. The Company routinely makes, and expects that from time to time it will continue to make, capital expenditures for environmental compliance. It does not, however, anticipate that such future expenditures will materially affect its earnings or competitive position. Like many manufacturers, the Company has been advised of its potential responsibility relating to past waste disposal practices, including potential involvement at two sites on the U.S. National Priority List created by the Comprehensive Environmental Response Compensation and Liability Act (Superfund). The Company believes its share of liability for such matters, if any, to be negligible. Employees As of January 31, 1994, the Company and its subsidiaries had approximately 22,300 employees. In general, the Company considers its relations with employees worldwide to be satisfactory. Non-U.S. Operations Non-U.S. operations of the Company and its subsidiaries are subject in varying degrees to a number of risks inherent in conducting business outside of the United States. These include fluctuating currency exchange rates and the possibility of nationalization, expropriation or restrictive actions by local governments. The Company, in general, does not currently consider these factors to be deterrents to maintaining or expanding such operations. Executive Officers of the Company The identity of the Company's current executive officers and certain biographical information concerning such individuals are set forth below. No executive officer of the Company has any family relationship with any other. ITEM 2. ITEM 2. PROPERTIES A substantial portion of the Company's pharmaceutical production in most product categories is conducted in France, the United States, Germany, and the U.K. The Company has a total of 45 pharmaceutical plants throughout the world: in France (9), United States (5), elsewhere in Europe excluding France (9), Canada (1), Africa (7), Japan (2), other Asia (7) and Latin America (5). Included in the above are 6 plants dedicated solely or partially to the production of bulk pharmaceuticals and chemicals. These plants are located in France (3), the United Kingdom (1), the United States (1) and Germany (1). Research and development activities are conducted in facilities in Vitry-sur- Seine, France; in Collegeville, Pennsylvania, United States and Dagenham, United Kingdom. U.S.-based research operations were consolidated and relocated to the new research center/corporate office facility during 1992. The Company generally either owns its facilities or leases them under long- term leases. In December 1992, the Company sold its U.S. research center/corporate office facility to a third party for $258.0 million and leased it back on a triple net basis for an initial term of thirty years with options to renew for a longer period. The Company also leased the underlying land to the third party for sixty years and subleased it back with the facility. The Company believes that its properties are well maintained and generally adequate to meet its needs for the foreseeable future. Capital expenditures were $250 million in 1993 and $284 million in both 1992 and 1991. In 1992 and 1991, $63 million and $102 million, respectively, were for the U.S. research center/corporate office facility. ITEM 3. ITEM 3. LEGAL PROCEEDINGS Diethylstilbestrol ("DES") Litigation There are approximately two hundred legal actions pending against one or more subsidiaries of the Company and various groupings of more than one hundred pharmaceutical companies, in which it is generally alleged that "DES daughters" and/or their offspring were injured as a result of the development of various reproductive tract abnormalities in the "DES daughters" because of their in utero exposure to DES. Typically, William H. Rorer, Inc. ("WHR") and Kremers- Urban Company ("K-U"), two former operating subsidiaries of the Company, are named as defendants, along with numerous other former DES manufacturers, when the claimant is unable to identify the manufacturer of the DES to which she was exposed. While the aggregate monetary damages sought in all of these DES actions are substantial, the Company believes that both WHR and K-U have adequate defenses to DES claims. All pending cases are currently being defended by insurance carriers, sometimes under a reservation of rights. The Company is also responsible for the obligations of Nattermann & Cie GmbH ("Nattermann") with respect to DES-related legal actions brought against certain of its former U.S. subsidiaries. Under the terms of the 1990 Acquisition Agreement, Rhone- Poulenc S.A. is obligated to indemnify the Company for amounts expended on the Nattermann DES claims in excess of $2 million. The Company believes that the former Nattermann subsidiaries have adequate defenses to DES claims. AHF Litigation There are approximately one hundred sixty one pending lawsuits in the United States, twenty five in Canada and fifty three in Ireland against the Company's Armour Pharmaceutical Company ("Armour") subsidiary, and in some instances, the Company, in which individuals with hemophilia and infected with the Human Immunodeficiency Virus ("HIV"), or their representatives, claim that their infection with HIV and, in some cases, resulting illnesses, including Acquired Immune Deficiency Syndrome-related conditions or death therefrom, may have been caused by administration of anti-hemophilic factor ("AHF") concentrates processed by Armour in the early and mid-1980's; none of these cases involve Armour's currently distributed AHF concentrates. In most of these suits, Armour is one of a number of defendants, including other fractionators who supplied AHF during that period. To date, approximately sixty three claims have been resolved either by dismissal by the plaintiffs or the Court or through settlement. A majority of the currently pending lawsuits was filed in 1993, and management believes the number of lawsuits filed will continue to trend upward. It is not possible, however, to predict with certainty the number of additional lawsuits that may eventually be filed alleging HIV-related claims. Trials took place in three of the above lawsuits during 1993. In January 1993, a jury in Florida held that Armour was liable to the parents of a deceased HIV-infected hemophiliac for damages of approximately $2 million. Armour believes this verdict to be inconsistent with evidence specific to the case and, accordingly, it filed motions with the trial court seeking reversal or, alternatively, a new trial. The trial court has denied both motions. Armour has appealed this judgment to the United States Court of Appeals for the Eleventh Circuit. Regardless of the outcome of this case, and because the facts vary widely in such cases, the Company does not view this verdict as predictive of, or as precedent for, decisions in any other cases. Juries in other AHF cases have determined that Armour and the other plasma fractionators acted responsibly and were not negligent. In October 1993, Armour obtained a directed verdict dismissing it from a lawsuit pending in Louisiana State Court on the basis that the plaintiff had not presented evidence sufficient to maintain an action against Armour. Additionally, a jury verdict in favor of Armour and the other plasma fractionators was obtained in an action pending in the United States District Court for the Northern District of Illinois in November 1993. The jury concluded that the fractionators of Factor VIII concentrate in the early 1980's were not negligent in any of the ways charged and accordingly were not liable to the claimant. Plaintiff has filed a post-trial motion seeking a new trial. Although there are no other actions pending against Armour which are presently at trial, Armour reasonably expects that other cases will proceed to trial in the future. In July 1993, attorneys for certain plaintiffs filed a Petition with the Federal Multi-District Litigation Panel seeking the consolidation of all AHF litigation pending in U.S. Federal Courts for purposes of pre-trial discovery. This Petition was subsequently withdrawn. In October 1993, a new petition was filed, by attorneys for certain plaintiffs, with the Federal Multi-District Litigation Panel seeking consolidation to the U.S. District Court for the Northern District of Illinois. The Panel authorized consolidation in December 1993. In August 1993, a proposed class action lawsuit was filed in New Jersey State Court against several fractionators, including Armour, on behalf of HIV- infected hemophiliacs in New Jersey and their families (D.K., et al. v. Armour Pharmaceutical Company, et al., Sup. Ct., Middlesex County, NJ). In September 1993, a proposed national class action lawsuit was filed purportedly on behalf of up to ten thousand HIV-infected hemophiliacs and their families in the U.S. District Court for the Northern District of Illinois against Armour, RPR, other AHF fractionators and the National Hemophilia Foundation ("NHF") (Wadleigh, et al. v. Armour Pharmaceutical Company, et al.; United States District Court, Northern District, Illinois). Additionally, another proposed federal class action lawsuit was filed against Armour and other fractionators in October 1993 purportedly on behalf of all HIV-infected hemophiliacs residing in Idaho, Utah and Oregon and their families (Richard Roe and his mother, Jane Roe v. Armour Pharmaceutical Company, et al.; United States District Court, Idaho District). As the facts in each individual lawsuit vary widely, Armour does not believe that class action status is warranted. One U.S. federal court and one state court have denied previous petitions for class action certification. The Company intends to vigorously oppose the petitions requesting class action certification. In the U.S., Armour and other plasma fractionators have participated in discussions with representatives of the hemophilia community, including the NHF, concerning the issue of assistance for U.S. hemophiliacs infected with HIV. During 1993, the fractionators and representatives of the hemophilia community discussed several alternative proposals which included financial assistance and units of AHF concentrate which would be provided by the fractionators over periods spanning several years. Conditions of fractionator participation in such a plan included, among other things, participation by a substantial majority of HIV-infected hemophiliacs who would agree to forego legal proceedings against the fractionators. These discussions are not active at this time. While Armour will continue to vigorously defend its position in all cases and claims brought against it, the Company will evaluate alternative ways of resolving pending and threatened litigation. In Canada, representatives of the provincial governments have agreed to the participation of several fractionators, including Armour, in a recently announced Multi-Provincial Assistance Program for HIV-infected hemophiliacs. Under the provisions of this program, participants will release contributing parties, including Armour, from all legal claims related to infection with HIV. Armour's share of the fractionator's contribution to this Program was provided to the Canadian Provincial Governments in December 1993. The Company has contractual rights to certain insurance coverage provided by insurance carriers to Revlon, Inc., the party from which it purchased the Armour business in 1986 ("Revlon carriers"). The Company also believes it has certain insurance coverage from another principal insurance carrier ("principal carrier") and from an umbrella insurance carrier. In addition, the Company believes it has access to "excess" liability insurance coverage from other carriers, effective in 1986, for certain of these cases if certain self-insured retention levels from relevant insurable losses are exceeded. The Company has been involved in litigation with the principal and umbrella carriers as well as with certain of the Revlon carriers, relative to carrier defense and indemnity obligations associated with AHF litigation. A trial in the insurance coverage litigation, if necessary, would take place in United States District Court for the Eastern District of Pennsylvania sometime in 1994. In August 1993, the Court granted the Company's motion for partial summary judgment, deciding that the principal carrier is obligated to provide a defense to the Company for the AHF litigation. The Company and certain of the carriers have recently engaged in extensive discussions aimed principally at settling the extent and other conditions of coverage of those carriers. Based upon these discussions, the Company believes that, although not a certainty, a substantial level of coverage (including substantial coverage for legal defense expenditures) for the Company's estimated liability determined in accordance with Statement of Financial Accounting Standards No. 5 ("SFAS 5") is probable of occurrence. Shareholder Litigation In 1990, a former shareholder initiated a purported class action lawsuit against the Company, its Chairman, and two of its employees in the United States District Court for the Southern District of New York. This action was purportedly brought on behalf of all persons who sold the Company's common shares, convertible debentures and call options between August 8, 1989 and January 15, 1990. The plaintiff alleged, among other things, violations of federal securities laws arising from alleged false and misleading statements made prior to the public announcement of the 1990 transaction with Rhone- Poulenc S.A. and sought compensatory and punitive damages in an unspecified amount. The Court issued a decision permitting this action to proceed as a class action, although the scope of the class has not been defined. Three additional shareholder lawsuits were initiated in 1991, two purported class actions and one brought individually against the Company, its Chairman, and certain present and former employees. These lawsuits involve allegations and claims which are substantially similar to those made in the case described above. In the two additional purported class actions, the plaintiffs sought to represent all persons who sold the Company's common shares, the Company's convertible debentures, and call options between August 3, 1989 and January 15, 1990. The Court has refused to permit these actions to proceed as class actions and certain of the plaintiffs have chosen to proceed individually. The Company and the employee-defendants have asserted various defenses denying all liability. However, in order to avoid the expense and disruptive effects typically associated with defending these types of claims, the Company and the employee-defendants have agreed to settle these cases. The proposed settlement agreement was approved by the Court in December 1993. Antitrust Litigation The Company has been named as a defendant in six antitrust actions pending in state and federal courts in Northern California, eleven in Federal Court in the Southern District of New York, and single actions in the District of Minnesota, the District of South Carolina, the Southern District of Ohio, and the Southern District of Georgia. The suits allege that RPR, certain other pharmaceutical companies and wholesalers and a large mail order concern discriminated against independent community pharmacist plaintiffs with respect to the prices charged for pharmaceutical products and further conspired to maintain prices at artificially high levels to the detriment of these pharmacies. The federal actions purport to be class actions, as do three of the four state cases. Plaintiffs in these lawsuits seek injunctive relief and a monetary award for past damages alleged. While the cases are in their early stages, the Company believes that the claims are without merit and it intends to vigorously defend these lawsuits. Additionally, Petitions were filed with the Judicial Panel on Multi-District Litigation seeking to consolidate the federal actions in which the Company has been named with several other federal actions in which the Company has not been named for purposes of coordinating overlapping pre-trial proceedings, like discovery. The Panel heard oral argument on the Petitions in January 1994. Patent and Intellectual Property Litigation In 1987, Choay S.A. ("Choay") and Dropic, affiliates of Sanofi S.A. ("Sanofi"), filed suit against two subsidiaries of the Company alleging the Company's Lovenox (R) enoxaparin product infringes the French patent issued to Choay. In 1992, Choay filed patent infringement suits against the Company in the United States District Court for the Southern District of New York as well as in Italy, the United Kingdom and Germany. In April 1993, the Company reached an agreement with Sanofi which settles the above lawsuits. The Company was a plaintiff in three patent infringement lawsuits filed in United States District Courts involving the patent licensed exclusively to the Company by the Scripps Research Institute ("Scripps") covering the antihemophilic Factor VIII:C. Two suits are in the state of California where, procedurally, they have been consolidated, and one was in the state of Delaware. In January 1993, the Company settled its patent dispute with Miles Inc., defendant in one of the California cases. In December 1993, the Company settled its dispute with Miles' co-defendant, Genentech Inc. Settlement papers have been approved by the Court and the case has been dismissed. The Court in the remaining California case involving Chiron Corporation is considering pending summary judgment motions. If this case goes to trial, such trial is likely to be scheduled to commence within the next six to twelve months. In May 1993, the Company settled its patent dispute with Baxter Healthcare Corporation and Baxter International, Inc. ("Baxter"), defendant in the Delaware case. The court entered a consent judgment dismissing the case and acknowledging the validity of the Scripps patent and infringement by the Baxter plasma-derived and recombinant Factor VIII:C products. Pursuant to the settlement papers filed in the U.S. District Court in Delaware, Baxter paid the Company $105 million in June 1993 and agreed to pay ongoing royalties based on sales of its Factor VIII:C concentrates. The Company also granted Baxter a worldwide non-exclusive license covering its Factor VIII:C concentrates and entered into a supply agreement under which Baxter will provide the Company with recombinant Factor VIII:C. In February 1993, Tanabe Seiyaku Company ("Tanabe") of Japan and their U.S. licensee, Marion Merrell Dow Inc. ("MMD") initiated an action in the International Trade Commission ("ITC"), the administrative agency responsible for handling complaints of imports which allegedly infringe U.S. patent rights. The complaint names ten domestic and foreign respondents, including the Company, and alleges infringement of a Tanabe U.S. patent, claiming a process for preparing bulk diltiazem, the active ingredient in the Company's Dilacor XR (R) product. Tanabe and MMD are requesting relief in the form of an Exclusion Order and a Cease and Desist Order. The Company has raised several defenses, including lack of jurisdiction, patent invalidity, and non- infringement. The ITC has suspended the proceeding indefinitely in view of an ongoing reexamination proceeding involving the Tanabe U.S. process patent. The eventual outcomes of the above matters of pending litigation cannot be predicted with certainty. The defense of these matters and the defense of expected additional lawsuits related to these matters may require substantial legal defense expenditures. The Company follows SFAS 5 in determining whether to recognize losses and accrue liabilities relating to such matters. Accordingly, the Company recognizes a loss if available information indicates that a loss or range of losses is probable and reasonably estimable. The Company estimates such losses on the basis of current facts and circumstances, prior experience with similar matters, the number of claims and the anticipated cost of administering, defending and, in some cases, settling such claims. The Company has also recorded as an asset insurance recoveries which are determined to be probable of occurrence on the basis of the status of current discussions with its insurance carriers. If a contingent loss is not probable, but is reasonably possible, the Company discloses this contingency in the notes to its consolidated financial statements if it is material. Based on the information available, the Company does not believe that reasonably possible uninsured losses in excess of amounts recorded for the above matters of litigation would have a material adverse impact on the Company's financial position or results of operations. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. PART II ITEM 5. ITEM 5. MARKET PRICE OF AND DIVIDENDS ON COMMON EQUITY The price range at which the Company's common stock traded and the quarterly dividends paid per share during the last eight quarters are as follows: Rhone-Poulenc Rorer Inc. (RPR) common shares are listed and traded on the New York and Paris Stock Exchanges and are traded, unlisted, on the Philadelphia, Boston, Pacific and Midwest Stock Exchanges. On January 31, 1994, there were approximately 7,336 holders of record of Rhone-Poulenc Rorer Inc. common shares. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA RHONE-POULENC RORER INC. AND SUBSIDIARIES NINE-YEAR SELECTED FINANCIAL DATA (UNAUDITED) (DOLLARS AND SHARES IN MILLIONS EXCEPT PER SHARE DATA) - -------- Results include the accounts of the Human Pharmaceutical Business ("HPB") of Rhone-Poulenc S.A. from May 5, 1990. Results include pretax restructuring and other charges of $93.8 million in 1993, $73.6 million in 1991, $289.3 million in 1990, and $10.0 million in 1989. Results for 1993 also include $105.0 million proceeds from litigation settlement and pretax charges of $29.1 million related to an investment in AIS, including acquired research and development expense. Pretax gains on sales of product rights and non-strategic assets totaled $30.2 million in 1993, $23.1 million in 1992, $95.7 million in 1991, $78.8 million in 1990 and $30.9 million in 1989. Results for 1989 also include a $19.9 million pretax gain on contract termination fee. Effective January 1, 1992, the Company adopted SFAS 109, "Accounting for Income Taxes," and recorded a cumulative effect adjustment increasing 1992 income by $15.0 million ($.11 per share). Prior years reflect the application of SFAS 96, "Accounting For Income Taxes," effective January 1, 1987. The year 1985 has been restated to reflect operations discontinued on February 28, 1986. Employees and sales per employee for the year 1990 have been restated on a pro forma basis to include HPB as if it were part of the Company from January 1, 1990. All share and per share data have been adjusted to reflect a two-for-one common stock split effective June 7, 1991. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION Rhone-Poulenc Rorer Inc. ("RPR" or "the Company") is one of the largest research-based pharmaceutical companies in the world. RPR was formed in July 1990 by the combination of Rorer Group Inc. and substantially all of the human pharmaceutical business of Rhone-Poulenc S.A. ("RP"), based in Paris, France. RP owns approximately two-thirds of RPR's common stock and controls the Company. PHARMACEUTICAL INDUSTRY ENVIRONMENT As government and private payors seek means to reduce the rate of growth in health care expenditures in virtually all worldwide markets, the pharmaceutical industry continues to be affected by initiatives to limit both pharmaceutical prices and prescriptions written by physicians. As a result, annual prescription pharmaceutical revenue growth rates in major strategic markets have slowed from prior year levels. The degree to which pharmaceutical companies are individually affected will depend upon each company's product portfolio and its ability to manage in the environment specific to each country. In France, where the Company enjoys a leading position, the government is considering measures which include physician prescribing guidelines which would limit the volume of prescriptions written. A three-year policy agreement between pharmaceutical manufacturers and the French government signed in January 1994 will restrict annual growth of prices for reimbursable pharmaceuticals to an average inflation rate. Although these steps are not likely to affect RPR revenues significantly in the near term, future governmental actions cannot be determined. In the U.S., prior legislation requiring payment of rebates to state Medicaid programs reduced the Company's sales by $34 million in 1993, $21 million in 1992 and $12 million in 1991. During 1993, the Clinton Administration proposed the Health Security Act ("HSA"), which would provide universal health coverage through standardized benefits for all U.S. citizens and would, by 1998, make sweeping structural and financial changes to the U.S. health care delivery system. Elements of HSA and other proposals will be debated by legislators at various levels in the coming year. The precise form and effect of any final legislation cannot be predicted; however, most pharmaceutical manufacturers, including RPR, have reorganized to adapt to an emerging U.S. managed care environment which dictates that product offerings satisfy payor objectives aimed at lowering health care costs. In Germany, physician prescribing guidelines have been established and selling prices of prescription products remain frozen through December 1994. In Italy, new legislation affecting health care reimbursement lists was recently instituted, resulting in the removal of certain products from government reimbursement lists and price reductions of 2.5% to 4.5%. In October 1993, the U.K. Pharmaceutical Price Regulation Scheme enacted price reductions of up to 2.5% and will restrict certain more profitable companies from seeking pharmaceutical price increases in that country. In Japan, a biannual price reduction will take effect in April 1994, and in Spain, decreases in pharmaceutical prices averaging 3% took effect in November 1993. These measures, while indicative of a global trend toward more governmental control over health care expenditures, are neither new to the industry nor to RPR. In certain cases, the legislation may allow companies to negotiate other terms or conditions which can minimize the effect on revenues; however, these measures tend to restrict future revenue growth derived from existing products and, as a result, companies in the industry must look increasingly to achieve profitability objectives through more rapid commercialization of highly innovative therapies, integrated prescription, OTC and generic product strategies, aggressive cost reduction, strategic alliances with others and creative marketing solutions to meet the needs of payors. RESULTS OF OPERATIONS Principal Product Sales In the table and discussion which follows, percentage comparisons of year-to- year sales by therapeutic area and principal products are presented excluding the effects of exchange rate fluctuations. Certain reclassifications have been made from amounts shown in prior periods for therapeutic area totals to conform to classifications now used by the Company. * % change excludes currency translation effects. 1993 Compared with 1992 On net sales of $4,019 million in 1993, net income available to common shareholders was $409 million ($2.96 per share), 5% below $428 million reported in 1992 ($3.10 per share). Earnings per share benefitted by $.63 in 1993 from $105 million of proceeds from the settlement of litigation and $30 million of gains from sale of certain product rights and investments. In addition, 1993 results include an $11 million ($.08 per share) after-tax benefit from the extension in depreciation lives for certain production machinery and equipment effective January 1. Earnings in 1993 were reduced by $.59 per share due to $94 million of restructuring and other charges and $29 million of costs related to the Company's equity investment in Applied Immune Sciences, Inc. ("AIS"). Results for 1992 benefitted by $.12 per share from gains on the sale of assets and $.11 per share from adoption of Statement of Financial Accounting Standards No. 109 ("SFAS 109"), "Accounting for Income Taxes." The Company's 1993 reported net sales of $4,019 million were down 2% from 1992. The 2% decline consists of currency fluctuations (which reduced sales by 6%), divested products (-1%), price increases (less than +1%), and volume gains (+4%). No single product contributed more than 6% of worldwide sales in 1993, and the ten largest products contributed approximately 36%. Sales of the Company's key strategic products--to which particular marketing emphasis is directed and which, as a group, comprised 43% of 1993 sales--increased by 10%, approximately twice the 5% overall rate of sales growth, on a basis which excludes the effects of currency fluctuations and divested products. Sales in France, the Company's largest market, were $1,375 million in 1993 on an as-reported basis. Excluding the effects of fluctuating currency rates and product divestitures, sales increased 8% in 1993, driven primarily by demand for anti-infectives and analgesics following a strong influenza season. In the United States, prescription pharmaceuticals and over-the-counter products contributed to a 12% increase in sales, to $1,120 million, despite a fourth quarter decision to curtail year-end trade incentives on certain prescription pharmaceuticals. Sales in Other Europe of $978 million fell 8% due principally to the impact of restrictive government programs in Germany (where prescription product sales were down 26%) and Italy (down 31%). The sales decline in these countries was partially offset by higher branded product sales in Eastern and Southern Europe and generic products in Northern Europe. Sales in the Rest of World area increased 13% to $546 million, led principally by Japan. If the effects of restructuring charges and gains on asset sales are excluded from reported geographic area results in the years, income before income taxes as a percentage of sales ("IBT margin") increased in 1993 in the U.S., France and Rest of World but fell in Other Europe, triggered by market conditions in Italy and Germany. Sales of the Company's cardiovascular products in 1993 were led by Clexane (R)/Lovenox (R), a global low molecular weight heparin product, which performed well in France and was launched in the U.S. early in the year. The FDA exclusivity of Lozol (R), a diuretic sold principally in the U.S., expired in mid-1993. The Company introduced a half-strength presentation of Lozol (R) during the year as well as a generic indapamide product through its newly- established Arcola Labs unit in anticipation of further generic competition, the overall result of which is expected to be a decline in Lozol (R) sales. Dilacor XR (R), a once daily calcium channel blocker launched in the U.S. in mid-1992, attained steady prescription growth throughout 1993. Other cardiovascular products Frumil (R) (-19%), a leading diuretic facing generic competition in the U.K., and Biosinax (R) (-66%), a ganglioside sold in Italy, experienced sales declines as anticipated. Sales of infectious disease/oncology products were higher in 1993 on stronger first and fourth quarter demand for upper respiratory disease products in France. Sales of plasma derivatives by the Company's Armour Pharmaceutical Company ("Armour") were led by Albuminar (R) human serum albumin in Japan and Monoclate-P (R) (pasteurized antihemophiliac Factor VIII:C) in Other Europe markets. In the U.S., Monoclate-P (R) encountered competition from a recombinant form that entered the market in 1993; the Company launched its own recombinant version in the U.S. in late 1993 with a worldwide launch anticipated in 1994. Mononine (TM), launched in the U.S. in late 1992 for treatment of hemophilia B, also contributed to 1993 plasma derivatives sales growth. Hypersensitivity products were led by sales of the inhaled steroids Azmacort (R) and Nasacort (R) in North America. During the year, the Company entered into an agreement with U.K.-based Fisons to co-promote Azmacort (R) and Fisons' Tilade (R) in the U.S., further bolstering the Company's respiratory product position. Sales of Slo-bid (TM)/Slo-Phyllin (R), a theophylline bronchodilator sold primarily in the U.S., declined due to a shift in use to inhaled steroids, although brand market share was maintained. Sales of central nervous system/analgesia products were headed by the analgesic Doliprane (R), driven by a higher incidence of influenza in France, and Imovane (R)/Amoban (R), a non-benzodiazepine sleeping agent, which performed well in France and Japan. Sales of gastroenterology products benefitted from higher Maalox (R) antacid sales in the U.S., Canada and Japan which exceeded declines in Other Europe. Expansion of the U.S. antacid market contributed to higher factory sales in the U.S. although the brand's share of the highly competitive antacid market trailed 1992. In 1993, the Company launched Anti-Gas and Anti-Diarrheal line extensions of Maalox (R). Sales of Zoltum (R), a peptic ulcer medication co-marketed in France, more than doubled in 1993. A decline in sales of bone metabolism/rheumatology products included lower sales of calcitonin products for bone disorders and DDAVP (R) for nocturnal enuresis. Calcitonin products encountered competition and unfavorable legislation in Italy, their largest market and further sales declines are anticipated in 1994 under expected lower levels of government reimbursements. Calcitonins faced generic competition in the United States, where the Company's Arcola Labs unit also launched a generic version in the second half of 1993. Elsewhere, RPR recorded higher calcitonin sales in Spain and Japan in 1993. Sales of Orudis (R)/Profenid (R)/Oruvail (R), a ketoprofen anti-inflammatory, were marginally higher, led by sales in Japan. Sales in other therapeutic categories included sales of prescription skin care products marketed to dermatologists by Dermik Laboratories ("Dermik"), which increased 15%. Gross profit, as a percentage of sales, improved one percentage point in 1993 to 67% due to cost control and product mix-related improvements. Management will continue to emphasize productivity enhancements to achieve further gross profit margin improvements in the coming years. Selling, delivery and administrative expenses were 36.5% of sales compared to 36.7% sales in 1992. Higher expenses in support of selling and promotion of U.S. prescription pharmaceuticals and in Japan were more than offset by expense reductions in Europe, particularly Germany and Italy. Significant financial resources in support of selling and promotional activities will continue to be necessary for the Company to maintain its competitive position in all major markets. Research and development expenses increased 8% to $561 million, or 14% of sales, in 1993. The Company's research and development efforts continue to focus on innovative global products and technologies, particularly those with potential to prolong significantly and/or improve the quality of life worldwide. The Company's most important projects are Taxotere (R), for certain solid malignant tumors; Zagam (TM), a broad spectrum quinolone antibiotic; and an AIDS immunotherapeutic vaccine being developed in partnership with The Immune Response Corporation ("IRC"). Certain issues regarding the joint and individual responsibilities of RPR and IRC are currently in arbitration; such proceedings are not expected to impact the progress of the project. In addition, the Company's 1993 alliance with AIS represents an important entry into gene and cell therapy technology which, beyond the promise of AIS's immediate product line, is likely to affect how pharmaceutical research is conducted by the industry in the future. The Company's research and development efforts will also concentrate on bringing existing products to new markets, developing more effective dosage forms and drug delivery systems, and maximizing the benefits of new business alliances. At comparable exchange rates, research and development expenses are expected to approach $600 million in 1994. Restructuring and other charges of $94 million recorded in 1993 include the costs of restructuring marketing and manufacturing operations in the German and Italian prescription pharmaceutical businesses, the planned divestiture of a portion of a manufacturing facility in Monts, France, and increased provisions for certain litigation. In 1994, the Company expects to aggressively pursue other cost-reduction steps which offer attractive payback opportunities in the present environment. Such steps may give rise to a restructuring charge during the year; however, there are no specific plans at this time and it is not possible to estimate the costs or associated benefits of any such program which might be pursued. Excluding restructuring and other charges and litigation proceeds, operating income was approximately 16.5% of sales in 1993 and 1992. In 1993, the effects of expense controls in manufacturing and administration exceeded relatively higher research and development spending and lower selling price increases. In the current business environment, more aggressive product cost and administrative expense reduction policies will be major contributors to maintaining this profitability measure in the near term. Net interest expense declined by $44 million to $61 million in 1993 as a result of lower average net debt balances and worldwide interest rates. Approximately 92% of combined short- and long-term debt was at variable rates (principally in Europe) at December 31, 1993 and 1992. The remainder at December 31, 1993 is fixed either by its terms or by interest rate swap contracts expiring primarily in 1994. In 1994, net interest expense is anticipated to continue to decline due to lower average net debt. Other expense, net increased to $54 million from $12 million in 1992 due primarily to higher losses associated with equity-method investments, including $29 million of non-cash losses related to AIS including acquired research and development. The Company's effective income tax rate for 1993 was 28.7% compared with 27.2% for 1992 as a result of reduced tax benefits from Puerto Rico operations and reduced utilization of net operating losses outside the United States. In August 1993, the U.S. Omnibus Budget Reconciliation Act of 1993 (the "Act") was signed into law. The Act provides, among other things, a limitation on the Company's use of the Possessions Tax Credit beginning in December 1994, an increase in the U.S. corporate tax rate from 34% to 35% effective January 1, 1993, and a retroactive reinstatement of the Research and Experimentation Credit to July 1, 1992. These provisions gave rise to a retroactive rate adjustment for U.S. deferred taxes but had minimal impact overall on the Company's effective income tax rate in 1993. Although it is not expected to significantly change the Company's 1994 effective tax rate, the Act could increase the Company's effective rate by up to three percentage points in 1995 and thereafter as a result of the reduction in the Possessions Tax Credit benefit. However, the Company will seek to mitigate this effect through routine tax planning measures. In 1993, the Company issued $175 million of money market preferred stock in the U.S. with initial dividend rates fixed for two to five years and redeemed $75 million of Market Auction Preferred Shares ("MAPS"). At $12 million, dividends on preferred shares were higher than in 1992 due to the $100 million net increase in outstanding preferred shares, partially offset by the effect on auction rate dividends of lower U.S. short-term interest rates earlier in the year. 1992 Compared with 1991 On net sales of $4,096 million, net income available to common shareholders increased 31% to $428 million in 1992 ($3.10 per share). Sales growth, measured on a basis which excludes the effects of divested products, was just over 11%. Of such growth, price increases contributed just over two percentage points, currency fluctuations added three percentage points, and higher volume accounted for just under six percentage points. Sales of the Company's key strategic products increased by 17% in 1992, excluding currency fluctuation effects. Sales in 1992 were in the following geographic areas: France--$1,388 million (+5% over 1991, excluding the effects of fluctuating exchange rates and divested products); U.S.--$1,000 million (+17%); Other Europe--$1,218 million (+6%); and Rest of World--$490 million (+9%). IBT margin, excluding effects of restructuring charges and gains on asset sales, improved significantly on higher sales in the U.S. and, to a lesser degree, in France. IBT margin fell in Other Europe, triggered by market conditions in Italy and Eastern Europe, and in the Rest of World area due to higher operating costs in Japan and Mexico. Sales of cardiovascular products were led by growth of Clexane (R)/Lovenox (R) in France and other European markets. Dilacor XR (R), launched in the U.S. in June 1992, also advanced sales growth in the category. While France contributes most of the infectious disease/oncology sales, 1992 sales growth came principally from other markets in Asia, Africa and Northern Europe. A lower incidence of influenza in 1992 held sales of anti-infectives in France approximately level compared to 1991. Sales of bone metabolism/rheumatology products were led by calcitonin products and Orudis (R)/Profenid (R)/Oruvail (R). Higher sales of calcitonin in Japan and in Spain, following introduction of the intranasal spray, more than offset a 27% decline in Italy stemming from competitive pressures and legislative effects. Sales of Orudis (R)/Profenid (R)/Oruvail (R) benefitted from the introduction of new dosage forms to combat generic entries in some markets. Sales of central nervous system/analgesia products advanced on the performance of Doliprane (R) and Imovane (R)/Amoban (R). Sales growth of Imovane (R)/Amoban (R) was broad-based throughout France, Other Europe, Canada and Japan. Sales of hypersensitivity products were led by growth in the U.S. of Azmacort (R) and Nasacort (R). Following its second half 1991 launch, Nasacort (R) sales increased by threefold in 1992. Led by Monoclate-P (R) in Europe and Albuminar (R) in Japan and China, plasma derivative sales nearly doubled in markets outside the United States. Mononine (TM) was launched in the U.S. following FDA approval in August 1992. Sales of gastroenterology products, principally the Maalox (R) brand of antacid, declined during the year. Maalox (R) U.S. sales and market share trailed 1991 levels but were supported by launch of Maalox (R) HRF tablets and Maalox (R) caplets and new promotional initiatives in the second half of 1992. Elsewhere, Maalox (R) posted sales gains in Europe, Canada and in Japan, where Maalox (R) Plus entered the over-the-counter market. In France, Zoltum (R) contributed to 1992 sales growth following its late-1991 launch in a co- marketing arrangement. Sales performance of products in all other therapeutic categories was led by Dermik skin care products (+19%). Gross profit margin increased one percentage point from 65% of sales in 1991 to 66% in 1992, as selling price increases and productivity improvements exceeded the effects of unfavorable sales mix. Selling, delivery and administrative expenses were 36.7% of sales in 1992 compared to 36.8% in 1991. A lower ratio in the U.S. prescription pharmaceuticals business was offset by the effects of sales force expansions and higher marketing expenses in France, Germany and in Armour's U.S. operations. Administrative expenses in 1992 were limited to growth of 1% excluding currency effects. The Company's investment in research and development increased 17% from $445 million (11.6% of sales) in 1991 to $521 million (12.7% of sales) in 1992. In 1991, the Company recorded $74 million of restructuring charges for facility divestitures in Germany and the U.K., relocation of U.S. corporate offices and research facilities, and other costs. Lower average net debt and a greater concentration of lower cost dollar- denominated debt reduced net interest expense by $44 million in 1992. In 1992, the Company recorded gains of $23 million ($.12 per share) related principally to sales of product rights in the U.S. and France. In 1991, the Company sold its dietary products business in France and a product line in the U.S. and recorded a before-tax gain of $96 million. Other expense, net of $11 million in 1992 included foreign exchange gains of $8 million, most of which were realized on foreign currency forward contracts entered into and expiring during the fourth quarter. The Company's effective income tax rate for 1992 was 27.2% under SFAS 109, compared to 32.3% in 1991 under Statement of Financial Accounting Standards No. 96. The lower 1992 rate was the result of recognition of deferred tax benefits on certain non-U.S. net operating losses, an increase in the benefit from Puerto Rico operations and other adjustments. Dividends on Market Auction Preferred Shares, issued in December 1991, were $10 million in 1992. Inflation Although its effect has stabilized at historically low levels in most developed countries in recent years, price inflation continues to increase the Company's cost of goods and services. As a result, limited ability to raise selling prices in the current environment exposes companies in the industry to risk of profit erosion. The Company attempts to mitigate such adverse inflationary effects through quality initiatives to improve productivity and control costs. FINANCIAL CONDITION Cash Flows Net cash provided by operating activities was $721 million in 1993, $357 million in 1992, and $468 million in 1991. In 1993, operating cash flows include $105 million proceeds from the settlement of litigation. Operating cash flows were substantially higher in 1993 than in 1992 because of lower outlays for income taxes (lower by $114 million), working capital needs and restructuring activities. In addition, 1993 earnings included non-cash charges for rent and AIS research costs totaling $52 million. In 1992, operating cash flows were lower than in 1991 as higher cash requirements for taxes and working capital exceeded lower restructuring outlays. 1992 tax payments included settlement of an examination of the Company's 1986 consolidated U.S. tax return and substantial payments of 1991 taxes which had been deferred in several European subsidiaries following legal entity restructurings after the 1990 formation of RPR. Because certain 1993 operating cash flows will not recur, cash flows from operating activities are expected to be lower in 1994. Investing activities used cash of $346 million in 1993 and $88 million in 1991 and provided cash of $51 million in 1992. In 1993, the Company acquired a 37% interest in AIS for $117 million, while 1992 and 1991 investing cash flows benefitted from significantly higher proceeds from the sale of assets. Cash outlays for capital expenditures were $250 million in 1993, down from $284 million in years 1992 and 1991. Financing activities used cash of $375 million in 1993, $500 million in 1992 and $409 million in 1991. Net proceeds from issuances of preferred shares were $97 million in 1993 and $296 million in 1991, while net repayments of third party and RP borrowings were $265 million in 1993, $403 million in 1992, and $647 million in 1991. In 1993, the Company repurchased approximately two million of its common shares ($76 million) for a newly-established Employee Benefits Trust to fund employee benefits in the United States. Cash dividends paid to common shareholders were $138 million in 1993 ($1.00 per share), $94 million in 1992 ($.68 per share) and $61 million in 1991 ($.445 per share). In January 1994, the Board of Directors declared a first quarter cash dividend of $.28 per share, a 12% increase above the average 1993 quarterly dividend. Liquidity As a result of debt repayments, the Company's net debt (short- and long-term debt including notes payable to RP, less cash and cash equivalents, short-term investments and time deposits) to net debt plus equity ratio improved to .26 to 1 at December 31, 1993 from .38 to 1 at December 31, 1992. At December 31, 1993, the ratio of current assets to current liabilities was 1.37 to 1 compared to 1.63 to 1 a year ago. The change is principally due to a reduction of certain third party bank borrowings classified as long-term at December 31, 1992 and a higher level of temporary borrowings from RP classified as short-term at December 31, 1993 even though RPR has a continuing ability to refinance these borrowings on a long-term basis under committed bank lines. At December 31, 1993, the Company has committed lines of credit totaling $1.4 billion with no borrowings outstanding under these lines. Of this amount, $700 million relates to a long-term revolving credit facility unconditionally guaranteed by RP; the amount available under this facility reduces by $200 million per year until expiration of the facility in 1997. In a separate agreement with RP related to the issuance of MAPS, the Company must maintain as unused under this facility the smaller of $325 million or the principal amount of debt outstanding (excluding borrowings from, or guaranteed by, RP). The Company has an additional $250 million available under revolving credit agreements due in 1996. During 1993, the Company entered into several new multicurrency line of credit agreements with various banks totaling $495 million and maturing in one to five years. At December 31, 1993, the Company has the ability and intent to renew, or to refinance under these facilities, approximately $255 million of short- term third party borrowings for at least one year. Accordingly, this amount has been classified as long-term debt. Pursuant to a $500 million shelf registration filed in 1993, the Company issued $175 million of money market preferred stock and has the ability to issue an additional $325 million in debt or equity securities. In 1993, Moody's Investors Service ("Moody's") and Standard & Poor's ("S&P") lowered the Company's preferred stock credit ratings, attributing the change to the privatization of RP. As a result, the Company's preferred stock issues are now rated BBB by S&P and Baa1 by Moody's. The Company's senior unsecured debt ratings have been affirmed as BBB+ by S&P and A3 by Moody's. Other noncurrent assets increased at December 31, 1993 compared to 1992 due to early adoption of FASB Interpretation No. 39, "Offsetting of Amounts Related to Certain Contracts" ("FIN 39") with regard to probable insurance recoveries related to certain litigation liabilities, the equity investment in AIS and higher deferred tax assets. An increase in other noncurrent liabilities at December 31, 1993 included the impact of FIN 39 and pension accruals. Management believes that cash flows from operations, supplemented by financing expected to be available from external sources, will provide sufficient liquidity to meet its needs for the foreseeable future. Long-term liquidity is dependent upon the Company's competitive position, including its ability to discover, develop and market innovative new therapies. Insurance and Litigation The Company maintains significant levels of excess catastrophic general and products liability insurance obtained from independent third-party insurers. In light of the risks attendant to the Company's business activities, the limits and coverage terms of such insurance are believed reasonable in amount and scope and comparable to the insurance carried by others in the industry. The Company is involved in litigation incidental to its business including, but not limited to: (1) approximately 239 lawsuits pending in the United States, Canada and Ireland against RPR and its Armour subsidiary, in which it is claimed by individuals infected with the Human Immunodeficiency Virus ("HIV") that their infection with HIV and, in some cases, resulting illnesses, including Acquired Immune Deficiency Syndrome-related conditions or death therefrom, may have been caused by administration of antihemophilic factor ("AHF") concentrates processed by Armour in the early and mid-1980's. Armour has also been named as a defendant in three proposed class action lawsuits filed on behalf of HIV-infected hemophiliacs and their families. None of these cases involves Armour's currently distributed AHF concentrates; (2) legal actions pending against one or more subsidiaries of the Company and various groupings of more than one hundred pharmaceutical companies, in which it is generally alleged that certain individuals were injured as a result of the development of various reproductive tract abnormalities because of in utero exposure to diethylstilbestrol ("DES") (typically, two former operating subsidiaries of the Company are named as defendants, along with numerous other DES manufacturers, when the claimant is unable to identify the manufacturer); (3) antitrust actions alleging that the Company engaged in price discrimination practices to the detriment of certain independent community pharmacists; (4) an alleged infringement by the Company of a process patent for the manufacture of bulk diltiazem, an ingredient in the Company's product Dilacor XR (R); these proceedings have been indefinitely suspended; and (5) potential responsibility relating to past waste disposal practices, including potential involvement, for which the Company believes its share of liability, if any, to be negligible, at two sites on the U.S. National Priority List created by Superfund legislation. In addition, the Company agreed to settle shareholder litigation for an amount which is fully accrued at December 31, 1993. The eventual outcomes of the above matters of pending litigation cannot be predicted with certainty. The defense of these matters and the defense of expected additional lawsuits related to these matters may require substantial legal defense expenditures. The Company follows Statement of Financial Accounting Standards No. 5 in determining whether to recognize losses and accrue liabilities relating to such matters. Accordingly, the Company recognizes a loss if available information indicates that a loss or range of losses is probable and reasonably estimable. The Company estimates such losses on the basis of current facts and circumstances, prior experience with similar matters, the number of claims and the anticipated cost of administering, defending and, in some cases, settling such claims. The Company has also recorded as an asset certain insurance recoveries which are determined to be probable of occurrence on the basis of the status of current discussions with its insurance carriers. If a contingent loss is not probable, but is reasonably possible, the Company discloses this contingency in the notes to its consolidated financial statements if it is material. Based on the information available, the Company does not believe that reasonably possible uninsured losses in excess of amounts recorded for the above matters of litigation would have a material adverse impact on the Company's financial position or results of operations. Recently Issued Accounting Standards In November 1992, the Financial Accounting Standards Board issued Statement of Financial Accounting No. 112, "Employers' Accounting for Postemployment Benefits". RPR does not expect this new standard, which will be adopted in 1994, or various other recently issued accounting standards to materially affect financial position or results of operations. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA RHONE-POULENC RORER INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME (DOLLARS IN MILLIONS, EXCEPT PER SHARE DATA) See Notes to Consolidated Financial Statements. RHONE-POULENC RORER INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (DOLLARS IN MILLIONS) See Notes to Consolidated Financial Statements. RHONE-POULENC RORER INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (DOLLARS IN MILLIONS) See Notes to Consolidated Financial Statements. RHONE-POULENC RORER INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1. ACCOUNTING POLICIES Principles of Consolidation The consolidated financial statements include the accounts of Rhone-Poulenc Rorer Inc. and subsidiaries which are more than 50 percent owned. All subsidiaries are consolidated on the basis of twelve-month periods ending December 31. Certain prior year items have been reclassified to conform to current classifications. Investments in corporate joint ventures and other companies in which the Company has a 20 to 50 percent ownership are accounted for by the equity method. Cost investments, less than 20 percent owned, are carried at their original cost which approximated $34.7 million at December 31, 1993 (1992: $47.7 million). The carrying amount of cost investments for which it was practicable to estimate fair values was $21.2 million at December 31, 1993 (1992: $34.3 million), and the fair value of such investments, as determined by quoted market prices and pricing models, was $18.8 million (1992: $57.7 million). Equity and cost investments are included in other assets in the financial statements. Cash and Cash Equivalents and Time Deposits The Company considers cash on hand, cash in banks, certificates of deposit, time deposits and U.S. government and other short-term securities with maturities of three months or less when purchased as cash and cash equivalents. Investments with a maturity period of greater than three months but less than one year are classified as short-term investments. Certain mortgage-backed certificates, repurchase obligations and certificates of deposit with maturities of more than one year are classified as long-term time deposits. Due to the short maturity period of short-term investments and the variable rate nature of long-term time deposits, the carrying amount of these instruments approximates their fair values. Inventories Inventories are valued at the lower of cost or market, using the first-in, first-out (FIFO) or average cost methods. Property, Plant and Equipment Property, plant and equipment are recorded at cost. For financial accounting purposes, depreciation is computed principally on the straight-line method over the estimated useful lives of the assets. For income tax purposes, certain assets are depreciated using accelerated methods. Effective January 1, 1993, the Company extended the depreciation lives for certain production machinery and equipment. The change in estimate increased 1993 earnings by $11.1 million after taxes ($.08 per share). Goodwill and Intangible Assets Goodwill represents the excess of cost over the fair market value of net assets of businesses acquired. Goodwill is amortized on a straight-line basis over a period not to exceed forty years, and is reported net of accumulated amortization of $172.1 million in 1993 and $158.3 million in 1992. Intangibles, which principally represent the cost of acquiring patents and product lines, are amortized over their estimated useful lives and are reported net of accumulated amortization of $96.5 million in 1993 and $91.7 million in 1992. RHONE-POULENC RORER INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) Income Taxes The Company and substantially all of its United States subsidiaries file a consolidated federal income tax return. No provision has been made for United States income taxes or withholding taxes on the unremitted earnings of non-U.S. subsidiaries which are intended to be indefinitely reinvested. Effective January 1, 1992, the Company adopted Statement of Financial Accounting Standards No. 109 ("SFAS 109"), "Accounting for Income Taxes," and recorded a cumulative effect adjustment increasing 1992 net income by $15.0 million ($.11 per share). Foreign Currency Translation Financial information relating to the Company's subsidiaries located outside the United States is translated using the current rate method. Local currencies are considered the functional currencies except in countries with highly inflationary economies. Financial Instruments The Company enters into foreign exchange contracts to hedge exposures related to firm foreign currency commitments. Gains or losses from the contracts are recognized in the basis of the transaction being hedged. Gains and losses arising from foreign exchange contracts which are designated and effective as economic hedges of the Company's net foreign investments are recorded as translation adjustments. Cash flows from hedging contracts are classified in the same category as the cash flows from the items being hedged. At December 31, 1993, the Company was party to forward exchange and currency swap contracts to purchase $105.8 million equivalent in foreign currencies and to sell $373.7 million in foreign currencies during the first quarter of 1994. Such contracts totaled $111.9 million and $339.6 million, respectively, at December 31, 1992. The carrying values of the contracts approximated their fair values. The Company utilizes various instruments to hedge interest rate risk. The net receivable or payable under these arrangements is recognized as an adjustment to interest expense over the life of the contracts. At December 31, 1993, the Company was party to $332.5 million notional amount of swap contracts which fix interest rates over various periods, and $198.9 million notional amount of swap contracts which give rise to variable interest rate exposure over various periods. Such contracts totaled $340.8 million and $117.2 million, respectively, at December 31, 1992. The fair value of all such outstanding interest rate swap contracts, as determined through bank pricing models, was approximately equal to their December 31 carrying value. Concentrations of Credit Risk Financial instruments which potentially subject the Company to concentrations of credit risk consist principally of trade receivables, cash investments and time deposits, and foreign currency and interest rate swap contracts. Credit risk with respect to trade receivables is limited due to a large customer base in a wide geographic area. The Company places its cash investments and time deposits with credit worthy, high quality financial institutions and, by policy, limits the amount of credit exposure to any one institution. The Company does not anticipate nonperformance by the counterparties to its financial instruments. RHONE-POULENC RORER INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 2. RESTRUCTURING AND OTHER CHARGES, PROCEEDS FROM LITIGATION SETTLEMENT, AND GAIN ON SALE OF NON-STRATEGIC ASSETS In 1993, the Company recorded charges of $93.8 million for the costs of certain restructuring and manufacturing streamlining programs and increased provisions for certain litigation. The programs, principally in Europe, include restructuring of marketing and manufacturing operations in the Company's German and Italian prescription pharmaceutical businesses following governmental actions aimed at limiting prices and prescription volume. The programs also include a plan to divest a portion of a manufacturing facility in Monts, France by the end of 1995. In 1991, restructuring charges of $73.6 million were provided for facility divestitures in Germany and the U.K., relocation of U.S. corporate offices and research facilities, professional fees and other costs. At December 31, 1993 and 1992, amounts included in other current liabilities for restructuring were $37.9 million and $26.0 million, respectively. In 1993, the Company received $105.0 million cash proceeds from the settlement of a longstanding patent lawsuit with Baxter International concerning Factor VIII:C concentrates for the treatment of hemophilia. Gains from asset sales totaled $30.2 million in 1993 and included sales of product rights and certain investments. In 1992, the Company recorded gains of $23.1 million related principally to the sales of product rights in the U.S. and France. In 1991, the Company recorded $95.7 million of gains from the sales of non- strategic assets (principally a dietary products business in France and certain product rights in the U.S.). NOTE 3. EQUITY INVESTMENT IN APPLIED IMMUNE SCIENCES, INC. In 1993, the Company acquired for $117.3 million, including expenses, a 37% interest in Applied Immune Sciences, Inc. ("AIS") and a right to purchase majority ownership of approximately 60%. The companies also agreed to establish joint ventures related to cell therapy products and services. The Company recorded as other expense $29.1 million ($.14 per share) in 1993 for noncash equity losses associated with AIS, including acquired research and development of approximately 60% of the excess of the purchase price over the Company's share of the fair market value of the tangible net assets of AIS. The Company may be required by the terms of the acquisition agreement to purchase up to four million additional shares of AIS common stock at a cost of up to $100.0 million between 1995 and 1997 if AIS achieves certain development milestones and/or certain sales and earnings targets. NOTE 4. OTHER EXPENSE, NET RHONE-POULENC RORER INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 5. EARNINGS PER SHARE Earnings per common share were computed by dividing net income available to common shareholders by the weighted average number of shares of common stock outstanding. The weighted average number of shares used to compute primary earnings per common share were 138,168,739; 138,073,872 and 137,708,866 for the years 1993, 1992 and 1991, respectively. Common share equivalents in the form of stock options were excluded from the calculation as their dilutive effect was not material. NOTE 6. INVENTORIES NOTE 7. PROPERTY, PLANT AND EQUIPMENT, NET The Company incurred $75.5 million and $139.9 million in interest cost in 1993 and 1992, respectively, of which $4.3 million and $14.6 million, respectively, was capitalized as part of the cost of additions to property, plant and equipment. NOTE 8. DEBT Short-term debt consisted of the following: RHONE-POULENC RORER INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) Long-term debt, net of current portion, consisted of the following: The Company has classified $255.2 million of various short-term borrowings from banks as long-term debt in accordance with the Company's intention and ability to refinance such obligations on a long-term basis. The $255.2 million of notes payable classified as long-term consists of borrowings in various currencies and interest rates as follows: $96.3 million in U.S. dollars at 3.4%, $54.2 million in British pounds at 6.5%, $45.7 million in French francs at 6.6%, $42.8 million in Japanese yen at 3.6% and $16.2 million in German marks at 7.0%. At December 31, 1993, after the effect of interest rate swap contracts, approximately 92% of the Company's outstanding debt was at variable rates of interest. The aggregate maturities of all long-term debt, including related party debt, were: $22.0 million in 1994, $21.7 million in 1995, $36.5 million in 1996, $78.4 million in 1997, $194.9 million in 1998 and $100.7 million thereafter. At December 31, 1993, the Company had committed lines of credit totaling $1.4 billion with no borrowings outstanding under these lines. Of this amount, $700.0 million related to the Revolving Credit Facility Agreement dated April 30, 1990 ("the Facility"). The Facility is unconditionally guaranteed by Rhone- Poulenc S.A. ("RP") and expires in $100.0 million installments semi-annually through April 30, 1997. In connection with the 1991 issuance of Market Auction Preferred Shares, the Company agreed to maintain as unused a portion of the Facility of not less than the smaller of $325.0 million or total indebtedness (excluding amounts owed to or guaranteed by RP). Terms of the Facility contain certain covenants regarding the financial condition of RP, the most restrictive of which is the maintenance of minimum stockholders' equity and ratio of total indebtedness to net worth. The Company has an additional $250.0 million available under revolving credit agreements due in 1996. During 1993, the Company entered into several multicurrency credit line agreements with various banks totaling $495.0 million. These lines mature in one to five years. Borrowings under the above facilities can be made in various currencies, principally U.S. dollars, French francs, German marks and British pounds; interest rates vary with the respective currency's interbank offering rate. Amounts available under unused uncommitted lines of credit approximated $562.0 million at December 31, 1993. Pursuant to a $500.0 million shelf registration filed in 1993, the Company issued $175.0 million of money market preferred stock during the year and has the ability to issue an additional $325.0 million in debt or equity securities. RHONE-POULENC RORER INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 9. LEASE COMMITMENTS Rent expense was $49.4 million, $28.2 million and $27.0 million in 1993, 1992 and 1991, respectively. Future minimum lease commitments under all leases with initial or remaining noncancelable lease terms in excess of one year at December 31, 1993 are as follows: In December 1992, the Company sold its U.S. corporate offices and research facility to a third party for $258.0 million and leased it back for an initial term of thirty years with options to renew for a longer period. The Company also leased the underlying land to the third party for sixty years and subleased it back for thirty years with the facility. The Company pays taxes, insurance and maintenance costs associated with the facility. Average annual accounting rent is $22.5 million; under terms of the agreement, the first cash rental payment is in July 1994. NOTE 10. INCOME TAXES Effective January 1, 1992, the Company adopted SFAS 109, "Accounting for Income Taxes," which modifies the liability method prescribed by SFAS 96, particularly with respect to recognition of deferred tax benefits in certain circumstances. Upon adoption, the Company recorded a cumulative effect adjustment increasing 1992 net income by $15.0 million ($.11 per share). The components of income before income taxes are: RHONE-POULENC RORER INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) The provisions for income taxes are: Deferred income taxes are provided for temporary differences between book and tax bases of the Company's assets and liabilities. Temporary differences giving rise to a significant portion of the deferred tax assets and liabilities at December 31 are: The portion of the above net deferred tax asset classified as current was $60.3 million. At December 31, 1993, total deferred tax assets were $269.2 million and total deferred tax liabilities were $174.2 million before netting. As of January 1, 1993, similar temporary differences gave rise to total deferred tax assets of $185.6 million and total deferred tax liabilities of $128.9 million. The differences between the U.S. statutory income tax rate and the Company's effective income tax rate are: RHONE-POULENC RORER INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) The Company has subsidiaries in Puerto Rico and Ireland, where earnings are either exempt or substantially exempt from income taxes under local government incentive programs, the latest of which expires in the year 2010. The Company has non-U.S. net operating loss carryforwards of $37.4 million for tax return purposes which expire principally through the years 1994-1998. The U.S. tax returns for the years 1987-1989 are currently being examined by the IRS; the Company's French tax returns have been examined through the year 1990. Neither the IRS nor the French tax authorities have proposed any adjustments of a material nature. Unremitted earnings of non-U.S. subsidiaries which are intended to be indefinitely reinvested were $851.0 million at December 31, 1993. Withholding taxes payable if the entire amount of these earnings were remitted would be $54.2 million. U.S. income taxes payable if these earnings were remitted would be substantially offset by available foreign tax credits. NOTE 11. PENSIONS AND OTHER POSTRETIREMENT BENEFITS Pensions The Company has several defined benefit pension plans which cover a majority of its employees throughout the world. In the United States, the Company's funding policy is to contribute funds to a trust as necessary to provide for current service and for any unfunded projected benefit obligation over a reasonable period. To the extent that these requirements are fully covered by assets in the trust, a contribution may not be made in a particular year. Obligations under non-U.S. plans are systematically provided by depositing funds with trustees, under insurance policies or through book reserves. The funded status of the Company's plans at December 31 was as follows: RHONE-POULENC RORER INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) The accumulated benefit obligation of U.S. plans included in the above table was $148.8 million in 1993 and $122.5 million in 1992. U.S. plan assets were $128.5 million and $121.7 million at December 31, 1993 and 1992, respectively. Of the net accrued pension cost, $262.6 million and $241.4 million are included in other noncurrent liabilities in 1993 and 1992, respectively. The following items are the components of net periodic pension cost for the years ended December 31: Net periodic pension cost for U.S. plans included in the above amounts are $8.5 million, $8.2 million and $7.5 million for 1993, 1992 and 1991, respectively. The following weighted average assumptions, which are based on the economic environment of each applicable country, were used to determine the return on plan assets and benefit obligations: For U.S. plans, the discount rate was 7.5% in 1993 and 8.25% in 1992 and 1991. The expected return on plan assets of 9.5% remained constant from 1991 through 1993. The rate of future compensation increases was 5% in 1993 and 6% in 1992 and 1991. Savings Plans The Company sponsors defined contribution savings plans covering substantially all U.S. employees. Company contributions to the plans may not exceed the greater of 3% of employee compensation or three thousand dollars per employee. Amounts charged to expense were $6.2 million, $4.8 million and $3.8 million in 1993, 1992 and 1991, respectively. Postretirement Benefits Other Than Pensions Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other than Pensions" and is amortizing the $6.0 million accumulated postretirement benefit obligation over twenty years. The Company's non-U.S. affiliates generally contribute to government insurance programs during the employees' careers and do not sponsor additional postretirement programs. In the United States, the Company grants retirees access to its medical, prescription and life insurance programs for a premium targeted to equal the cost of such benefits. RHONE-POULENC RORER INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) Postemployment Benefits In November 1992, the Financial Accounting Standards Board issued Statement of Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits" ("SFAS 112"). SFAS 112, which will be adopted in the first quarter of 1994, requires recognition of the obligation to provide benefits to former or inactive employees after employment but before retirement. Adoption of the new standard will not materially affect the Company's financial position or results of operations. NOTE 12. STOCK PLANS Stock options and restricted shares have been granted to employees under plans approved by the shareholders in 1982 and 1985, as amended in 1988 ("Stock Plan"). The aggregate number of shares originally available for issuance or transfer to employees under these plans was 7,000,000. Option prices are equal to the fair market value of the shares on the date of grant. Options are exercisable during a period determined by the Company, but in no event later than ten years from the date granted. Shares issued under a restricted grant may not be sold or otherwise disposed of for a period designated by the Company. Restricted shares are returned to the Company if the grantee's employment terminates during the period of restriction. During the restriction period, the grantee is entitled to vote the shares and receive any dividends paid. The 1985 Stock Plan, as amended, permits the Company to grant stock appreciation rights in tandem with stock options. As of December 31, 1993, no such rights have been granted. The Equity Compensation Plan adopted in 1990 supplements the Stock Plan by providing for an additional 6,000,000 shares that may be issued to participants after all shares authorized pursuant to the terms of the Stock Plan have been utilized. The terms of the Equity Compensation Plan are substantially the same as those of the Stock Plan. Effective January 1, 1993, the Company substantially curtailed the granting of restricted shares to employees. In 1992 and 1991, respectively, 90,146 and 217,125 restricted shares were granted to employees under the Stock Plan. Due to employee terminations 12,312; 23,561 and 22,148 restricted shares were returned to the Company in 1993, 1992 and 1991, respectively. In connection with the 1990 transaction with RP, the Company granted to certain executives options to purchase a total of 1,090,008 shares at a price of $30.18 per share and 78,872 shares at a price of $49.25 per share. These options vest but are exercisable according to a schedule based upon the maturity of RP contingent value rights. In 1993, 375,347 options were exercised and 573,417 options were canceled. The remaining options expire in the year 2000. Stock option activity shown below reflects the two-for-one stock split effective June 7, 1991: RHONE-POULENC RORER INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) NOTE 13. SHAREHOLDERS' EQUITY In December 1991, the Company issued $300.0 million of Market Auction Preferred Shares ("MAPS") represented by four series, each consisting of 75,000 shares. Each series of MAPS is sold in units of 100 shares and is identical except as to dividend terms. Dividend rates, which are determined at separate auctions for each series, averaged 3.01% during 1993 (1992: 3.14%). Dividends are paid every 49 days, subject to certain exceptions. In 1993, the Company issued $175.0 million of money market preferred stock. A portion of the proceeds was used to redeem $75.0 million MAPS Series B. The money market preferred stock was issued in three series, consisting of 750 shares, 500 shares and 500 shares, respectively. The initial dividend period for all series commenced on August 1, 1993 at initial dividend rates of 4.7% per annum for a two-year period for Series 1; 5.125% per annum for a three-year period for Series 2; and 5.84% per annum for a five-year period for Series 3. After the initial dividend periods expire, dividends will be determined at separate auctions for each series. RHONE-POULENC RORER INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) The MAPS and money market preferred stock (collectively, "the Preferred Shares") rank prior to common shares of the Company as to dividends. Holders of Preferred Shares have no voting rights except in the event that preferred dividends are in arrears for at least 180 consecutive days. In such event, the authorized number of the Company's Board of Directors would be increased by two and the holders of record of the respective Preferred Shares may elect these additional directors. The Preferred Shares are not convertible into common stock or other shares of the Company and holders thereof have no preemptive rights. Upon the liquidation, dissolution, or winding up of the Company, or upon redemption of the Preferred Shares at the Company's option, holders would be entitled to a liquidation preference of $1,000 per share for MAPS or $100,000 per share for money market preferred stock, plus any accumulated and unpaid dividends thereon. In connection with the issuance of MAPS, the Company entered into a support agreement with RP pursuant to which both parties agreed that 1) RP will own a majority of the outstanding common stock of the Company entitled to elect directors; 2) RP will make a capital contribution to the Company if certain debt-to-capitalization or tangible net worth ratios do not meet specified levels or if the Company fails to pay a declared dividend on MAPS on a timely basis; and 3) RP, as guarantor of the Revolving Credit Facility Agreement dated April 30, 1990, will maintain such facility in full force, and the Company will maintain, as of any date, the unused portion of such facility in an amount equal to all principal, interest and premium amounts payable in the next twelve months with respect to short- and long-term debt other than amounts owed to RP or guaranteed by RP, subject to certain requirements and exceptions. In connection with the support agreement, the Company pays RP an annual fee which in 1993 approximated $.4 million ($.5 million in 1992). The support agreement does not constitute a guarantee by RP of any obligation of the Company, including MAPS, and is not enforceable by any holder of MAPS. The units of each series of MAPS must be redeemed in the event of breach of certain covenants in the support agreement. At December 31, 1993, there were 2,451,800 preferred shares without par value authorized and unissued (1992: 2,551,800). In March 1993, the Company's Board of Directors approved the repurchase from time to time of up to 5 million of its common shares on the open market. As of December 31, 1993, 1,873,300 shares had been acquired at a cost of $75.8 million and are being held in an Employee Benefits Trust to fund future employee benefits in the United States. At December 31, 1993, repurchase commitments existed for an additional 108,700 shares at a cost of $4.0 million. NOTE 14. INDUSTRY SEGMENT AND OPERATIONS BY GEOGRAPHIC AREA The Company's operations are conducted in one industry segment. Operations involve the production and sale of pharmaceuticals, primarily cardiovascular products, bone metabolism/rheumatology products, gastroenterology products, central nervous system/analgesia products, infectious disease/oncology products, hypersensitivity products, and plasma derivatives. In addition, the Company manufactures and markets a number of other products, including bulk pharmaceuticals and chemicals. Information about the Company's operations for the years 1993, 1992 and 1991 by geographic area is shown below. Inter-area affiliated sales are not significant. Corporate loss before income taxes includes corporate administrative expenses incurred in the U.S., worldwide net interest expense, and worldwide equity losses from unconsolidated affiliates. Corporate loss before income taxes also includes corporate administrative expenses incurred in France of $49.2 million in 1993, $54.3 million in 1992 and $40.2 million in 1991. RHONE-POULENC RORER INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED) Income before income taxes ("IBT") for the U.S. in 1993 includes income of $68.0 million from litigation settlement proceeds and gains on asset sales net of restructuring charges. France IBT includes $19.5 million of restructuring charges net of gains on asset sales in 1993 and $69.4 million of gains on asset sales in 1991. Other Europe IBT includes restructuring charges net of gains on asset sales totaling $30.2 million in 1993 and $50.2 million in 1991. NOTE 15. RELATED PARTY TRANSACTIONS The entities comprising the Company manage their cash separately. In the largest countries such as the U.S., France, the U.K. and Germany, the local entities have access to RP cash pooling arrangements whereby they can, at their own request, lend to or borrow from RP at market terms and conditions. Amounts receivable from RP and affiliates totaled $35.8 million and $55.0 million at December 31, 1993 and 1992, respectively. The 1993 balance includes $11.3 million of accounts receivable from sales of products and services to RP (1992: $10.8 million) and $24.6 million classified as other current assets (1992: $44.2 million). Accounts payable related to purchase of materials and services from RP and affiliates were $6.3 million at December 31, 1993 (1992: $6.5 million); accrued and other liabilities due to RP at December 31, 1993 were $12.9 million (1992: $11.9 million). In 1993, sales to RP and affiliates were $34.5 million; materials purchased from RP totaled $44.4 million. In 1992, these amounts were $37.2 million and $53.1 million, respectively. In 1993, RP also compensated the Company $1.7 million in cost of products sold related to the transfer of certain production activities. RHONE-POULENC RORER INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONCLUDED) At December 31, 1993, debt with RP and affiliates totaled $230.8 million (1992: $134.0 million). Related interest expense for 1993 was $24.9 million (1992: $46.4 million). During 1993, the Company paid $.6 million in debt guarantee fees to RP (1992: $1.0 million). RP charges the Company for expenses incurred on its behalf, including research, data processing, insurance, legal, tax, advertising, public relations and management fees. Such charges are reflected in the financial statements and amounted to approximately $20.2 million in 1993 (1992: $19.6 million). Management believes that the expenses so charged are representative of amounts that the Company would have incurred if it had been operated as an unaffiliated entity. NOTE 16. CONTINGENCIES The Company is involved in litigation incidental to its business including, but not limited to: (1) approximately 239 pending lawsuits in the United States, Canada and Ireland against the Company and its Armour Pharmaceutical Company subsidiary ("Armour"), in which it is claimed by individuals infected with the Human Immunodeficiency Virus ("HIV") that their infection with HIV and, in some cases, resulting illnesses, including Acquired Immune Deficiency Syndrome-related conditions or death therefrom, may have been caused by administration of antihemophilic factor ("AHF") concentrates processed by Armour in the early and mid-1980's. Armour has also been named as a defendant in three proposed class action lawsuits filed on behalf of HIV-infected hemophiliacs and their families. None of these cases involve Armour's currently distributed AHF concentrates; (2) legal actions pending against one or more subsidiaries of the Company and various groupings of more than one hundred pharmaceutical companies, in which it is generally alleged that certain individuals were injured as a result of the development of various reproductive tract abnormalities because of in utero exposure to diethylstilbestrol ("DES") (typically, two former operating subsidiaries of the Company are named as defendants, along with numerous other DES manufacturers, when the claimant is unable to identify the manufacturer); (3) antitrust actions alleging that the Company engaged in price discrimination practices to the detriment of certain independent community pharmacists; (4) an alleged infringement by the Company of a process patent for the manufacture of bulk diltiazem, an ingredient in the Company's product Dilacor XR (R); these proceedings have been indefinitely suspended; and (5) potential responsibility relating to past waste disposal practices, including potential involvement, for which the Company believes its share of liability, if any, to be negligible, at two sites on the U.S. National Priority List created by Superfund legislation. In addition, the Company agreed to settle shareholder litigation for an amount which is fully accrued at December 31, 1993. The eventual outcomes of the above matters of pending litigation can not be predicted with certainty. The defense of these matters and the defense of expected additional lawsuits related to these matters may require substantial legal defense expenditures. The Company follows Statement of Financial Accounting Standards No. 5 in determining whether to recognize losses and accrue liabilities relating to such matters. Accordingly, the Company recognizes a loss if available information indicates that a loss or range of losses is probable and reasonably estimable. The Company estimates such losses on the basis of current facts and circumstances, prior experience with similar matters, the number of claims and the anticipated cost of administering, defending and, in some cases, settling such claims. The Company has also recorded as an asset certain insurance recoveries which are determined to be probable of occurrence on the basis of the status of current discussions with its insurance carriers. If a contingent loss is not probable but is reasonably possible, the Company discloses this contingency in the notes to its consolidated financial statements if it is material. Based on the information available, the Company does not believe that reasonably possible uninsured losses in excess of amounts recorded for the above matters of litigation would have a material adverse impact on the Company's financial position or results of operations. As of December 31, 1993 the Company had unused standby letters of credit outstanding of $23.6 million. The letters of credit are issued primarily in the form of guarantees or performance bonds. RESPONSIBILITY FOR FINANCIAL STATEMENTS The management of Rhone-Poulenc Rorer Inc. is responsible for the information and representations contained in this report. Management believes that the financial statements have been prepared in conformity with generally accepted accounting principles and that the other information in this annual report is consistent with those statements. In preparing the financial statements, management is required to include amounts based on estimates and judgments which it believes are reasonable under the circumstances. In fulfilling its responsibilities for the integrity of the data presented and to safeguard the Company's assets, management employs a system of internal accounting controls designed to provide reasonable assurance, at appropriate cost, that the Company's assets are protected and that transactions are appropriately authorized, recorded and summarized. This system of control is supported by the selection of qualified personnel, by organizational assignments that provide appropriate delegation of authority and division of responsibilities, and by the dissemination of written policies and procedures. This control structure is further reinforced by a program of internal audits including a policy that requires responsive action by management. Coopers & Lybrand, the Company's independent accountants, performs audits in accordance with generally accepted auditing standards. The independent accountants conduct a review of internal accounting controls to the extent required by generally accepted auditing standards and perform such tests and procedures as they deem necessary to arrive at an opinion on the fairness of the financial statements presented herein. The Board of Directors, through the Audit Committee comprised solely of directors who are not employees of the Company, meets with management, the internal auditors and the independent accountants to ensure that each is properly discharging its respective responsibilities. Both the independent accountants and the internal auditors have free access to the Audit Committee, without management present, to discuss the results of their work, including internal accounting controls and the quality of financial reporting. The Audit Committee met three times in 1993. /s/ Robert E. Cawthorn Robert E. Cawthorn Chairman and Chief Executive Officer /s/ Patrick Langlois Patrick Langlois Senior Vice President and Chief Financial Officer /s/ Daniel J. Pedriani Daniel J. Pedriani Vice President and Corporate Controller REPORT OF INDEPENDENT ACCOUNTANTS To the Shareholders of Rhone-Poulenc Rorer Inc.: We have audited the accompanying consolidated balance sheets of Rhone-Poulenc Rorer Inc. and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income 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 Rhone-Poulenc Rorer 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 Note 10 to the consolidated financial statements, the Company changed its method of accounting for income taxes in 1992. /s/ COOPERS & LYBRAND Coopers & Lybrand Philadelphia, Pennsylvania January 26, 1994 RHONE-POULENC RORER INC. AND SUBSIDIARIES QUARTERLY DATA (UNAUDITED) (DOLLARS IN MILLIONS, EXCEPT PER SHARE DATA) - -------- Results for 1993 include pretax income of $105.0 million proceeds from litigation settlement in the second quarter. Results also includes $77.2 million and $16.6 million of restructuring and other charges recorded in the second and fourth quarters, respectively and a $27.0 million pretax charge for acquired research and development expense in the third quarter. Gains from sales of product rights and certain investments totaled $10.2 million, $2.5 million, $2.7 million and $14.8 million in each of the four quarters, respectively. Results for the first quarter of 1992 include a cumulative effect adjustment increasing earnings by $15.0 million as a result of adoption of Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes," effective January 1, 1992. Results also include $6.5 million and $16.6 million of gains on sales of non-strategic assets in the 1992 third and fourth quarter, respectively. Earnings per share amounts for each quarter are required to be computed independently and, therefore, the sum of the four quarters does not necessarily equal the amount computed for the total year. Rhone-Poulenc Rorer Inc. (RPR) common shares are listed and traded on the New York and Paris Stock Exchanges, and are traded, unlisted, on the Philadelphia, Boston, Pacific and Midwest Stock Exchanges. On January 31, 1994, there were 7,336 holders of record of RPR common shares. 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 relating to the directors of the Company entitled, "Election of Directors," in the Company's Proxy Statement dated March 21, 1994 is incorporated herein by reference. For information relating to the executive officers of the Company, refer to "Executive Officers of the Company" on pages 10 through 11 of this report. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION Information relating to executive compensation immediately before "Certain Relationships and Related Transactions," of the Company's Proxy Statement dated March 21, 1994, is incorporated herein by reference. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Information relating to security ownership of certain beneficial owners and management entitled, "Ownership of Shares" immediately before "Control of the Company," of the Company's Proxy Statement dated March 21, 1994, is incorporated herein by reference. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Information entitled, "Certain Relationships and Related Transactions" in the Company's Proxy Statement dated March 21, 1994, is 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: (b) No Current Reports on Form 8-K were filed during the fourth quarter. 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, THERETO DULY AUTHORIZED. Rhone-Poulenc Rorer Inc. March 8, 1994 By /s/ Robert E. Cawthorn ---------------------------------- ROBERT E. CAWTHORN 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 DATES INDICATED. NAME TITLE DATE /s/ Robert E. Cawthorn Chairman, Chief March 8, 1994 - ------------------------------------- Executive Officer ROBERT E. CAWTHORN and Director /s/ Patrick Langlois - ------------------------------------- Senior Vice March 8, 1994 PATRICK LANGLOIS President and Chief Financial Officer /s/ Daniel J. Pedriani - ------------------------------------- Vice President-- March 8, 1994 DANIEL J. PEDRIANI Corporate Controller (Chief Accounting Officer) Jean-Jacques Bertrand* Director March 8, 1994 - ------------------------------------- JEAN-JACQUES BERTRAND Jean-Marc Bruel* Director March 8, 1994 - ------------------------------------- JEAN-MARC BRUEL Michel de Rosen* Director President March 8, 1994 - ------------------------------------- and Chief Operating MICHEL DE ROSEN Officer Charles-Henri Filippi* Director March 8, 1994 - ------------------------------------- CHARLES-HENRI FILIPPI NAME TITLE DATE Claude Helene* Director March 8, 1994 - ------------------------------------- CLAUDE HELENE Michael H. Jordan* Director March 8, 1994 - ------------------------------------- MICHAEL H. JORDAN Manfred E. Karobath, MD* Director, Senior March 8, 1994 - ------------------------------------- Vice President, MANFRED E. KAROBATH, MD Research and Development Igor Landau* Director March 8, 1994 - ------------------------------------- IGOR LANDAU Peter J. Neff* Director March 8, 1994 - ------------------------------------- PETER J. NEFF James S. Riepe* Director March 8, 1994 - ------------------------------------- JAMES S. RIEPE Edward J. Stemmler, MD* Director March 8, 1994 - ------------------------------------- EDWARD J. STEMMLER, MD Jean-Pierre Tirouflet* Director March 8, 1994 - ------------------------------------- JEAN-PIERRE TIROUFLET * By his signature set forth below, John B. Bartlett, pursuant to duly authorized powers of attorney filed with the Securities and Exchange Commission, has signed this report on behalf of the persons whose signatures are printed above, in the capacities set forth opposite their respective names. /s/ John B. Bartlett General Counsel, March 8, 1994 - ------------------------------------- (Attorney-in-fact) JOHN B. BARTLETT REPORT OF INDEPENDENT ACCOUNTANTS To the Shareholders of Rhone-Poulenc Rorer Inc.: Our report on the consolidated financial statements of Rhone-Poulenc Rorer Inc. and subsidiaries is included on page 45 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 48 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 _____________________________________ COOPERS & LYBRAND Philadelphia, Pennsylvania January 26, 1994 SCHEDULE II RHONE-POULENC RORER INC. AND SUBSIDIARIES AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS, AND EMPLOYEES OTHER THAN RELATED PARTIES FOR THE YEARS 1993, 1992 AND 1991 (DOLLARS IN MILLIONS) SCHEDULE IV RHONE-POULENC RORER INC. AND SUBSIDIARIES INDEBTEDNESS TO RELATED PARTIES--NOT CURRENT FOR THE YEARS 1993, 1992 AND 1991 (DOLLARS IN MILLIONS) - -------- (1) The $29.6 million is denominated in British pounds at a variable interest rate of 6.0%. (2) Of the $28.9 million, approximately $18.5 million represents transfers to current. (3) Of the $34.0 million, $30.4 million is denominated in British pounds at a variable interest rate of 7.8%. (4) Of the $453.7 million, approximately $151.0 million represents transfers to current. (5) Of the $41.3 million, $37.4 million is denominated in British pounds at a variable interest rate of 12.2%. SCHEDULE V RHONE-POULENC RORER INC. AND SUBSIDIARIES PROPERTY, PLANT AND EQUIPMENT FOR THE YEARS 1993, 1992 AND 1991 (DOLLARS IN MILLIONS) - -------- (1) Additions reflect normal expenditures for expansion, replacement and modernization of the Company's facilities, and property, plant and equipment obtained through acquisition. (2) Includes reclassifications among property, plant and equipment accounts and the effect of foreign currency rate changes. (3) Includes approximately $63 million and $102 million in 1992 and 1991, respectively, related to new U.S. corporate offices, research center and site in Montgomery County, Pa. (4) Includes approximately $258 million related to the sale of the new U.S. corporate offices and research center. SCHEDULE VI RHONE-POULENC RORER INC. AND SUBSIDIARIES ACCUMULATED DEPRECIATION OF PROPERTY, PLANT AND EQUIPMENT FOR THE YEARS 1993, 1992 AND 1991 (DOLLARS IN MILLIONS) - -------- (1) Depreciation has been computed principally on the straight-line method for buildings and machinery and equipment at rates ranging from 2% to 20% and 5% to 50% per annum, respectively. (2) Includes reclassifications among property, plant and equipment accumulated depreciation accounts and the effect of foreign currency rate changes. SCHEDULE VII RHONE-POULENC RORER INC. AND SUBSIDIARIES GUARANTEES OF SECURITIES OF OTHER ISSUERS FOR THE YEARS 1993, 1992 AND 1991 (DOLLARS IN MILLIONS) - -------- (1) The Company's stock investment in Immune Response Corporation which is accounted for at cost totaled 8.9% at December 31, 1993 and 1992 and 9.6% at December 31, 1991. SCHEDULE VIII RHONE-POULENC RORER INC. AND SUBSIDIARIES VALUATION AND QUALIFYING ACCOUNTS FOR THE YEARS 1993, 1992 AND 1991 (DOLLARS IN MILLIONS) - -------- (1) Accounts charged off, net of recoveries and the effect of foreign currency rate changes. SCHEDULE IX RHONE-POULENC RORER INC. AND SUBSIDIARIES SHORT-TERM BORROWINGS FOR THE YEARS 1993, 1992 AND 1991 (DOLLARS IN MILLIONS) - -------- (1) At the end of any month. (2) Month-end average. (3) Calculated by relating appropriate interest expense to average aggregate borrowings. (4) Includes bank loans and short-term notes payable to Rhone-Poulenc S.A. SCHEDULE X RHONE-POULENC RORER INC. AND SUBSIDIARIES SUPPLEMENTARY INCOME STATEMENT INFORMATION FOR THE YEARS 1993, 1992 AND 1991 (DOLLARS IN MILLIONS) EXHIBIT INDEX (3)a. The By-laws of the Company are incorporated herein by reference to the Company's Annual Report on Form 10-K for the year ended December 31, 1990. b. The Amended and Restated Articles of Incorporation of the Company as of January 31, 1992. c. Articles of Amendment dated July 16, 1993 to The Amended and Restated Articles of Incorporation of the Company as of January 31, 1992. (4)a. $1,600,000,000 Revolving Credit Facility Agreement dated April 30, 1990 is incorporated herein by reference to the Company's Annual Report on Form 10-K for the year ended December 31, 1991. b. Deposit Agreement dated July 19, 1993 among Rhone-Poulenc Rorer Inc., Bankers Trust Company as Depositary, and the holders from time to time of the Depositary Receipts is incorporated herein by reference to the Company's Current Report on Form 8-K dated July 12, 1993. (10) Material Contracts. a. Form of Lease Agreement among the Company, Rhone-Poulenc Rorer Pharmaceuticals Inc. and the Owner Trustee is incorporated herein by reference to Exhibit 4.2.2 of the Company's Registration Statement No. 33-53378 on Form S-3, filed with the Securities and Exchange Commission on October 16, 1992. b. Armour Pharmaceutical Company Pension Program Amended and Restated effective January 1, 1989 is incorporated herein by reference to the Company's Annual Report on Form 10-K for the year ended December 31, 1991. c. Pension Plan of Rhone-Poulenc Rorer Inc. Amended and Restated effective January 1, 1989 is incorporated herein by reference to the Company's Annual Report on Form 10-K for the year ended December 31, 1991. d. Rhone-Poulenc Rorer Pharmaceuticals Inc. Fort Washington Hourly Employees' Pension Plan effective January 1, 1990 is incorporated herein by reference to the Company's Annual Report on Form 10-K for the year ended December 31, 1991. e. Rhone-Poulenc Rorer Employee Savings Plan as Amended and Restated effective January 1, 1992 is incorporated herein by reference to the Company's Annual Report on Form 10-K for the year ended December 31, 1991. f. Amendment 1992-1 to the Rhone-Poulenc Rorer Employee Savings Plan as Amended and Restated effective January 1, 1992 is incorporated herein by reference to the Company's Annual Report on Form 10-K for the year ended December 31, 1992. g. Amendment 1993-1 dated September 1, 1993 to the Rhone-Poulenc Rorer Employee Savings Plan as Amended and Restated effective January 1, 1992. h. The Rorer Group Inc. Stock Plan, adopted April 23, 1985, is incorporated herein by reference to the Registration Statement on Form S-8 (No. 33-2403) dated December 23, 1985. i. The Rhone-Poulenc Rorer Inc. Amended and Restated Stock Plan, adopted March 12, 1990, is incorporated herein by reference to the Company's Proxy Statement dated June 29, 1990, filed in connection with the July 31, 1990 Annual Meeting of Shareholders. j. The Rhone-Poulenc Rorer Inc. Equity Compensation Plan is incorporated herein by reference to the Company's Proxy Statement dated June 29, 1990, filed in connection with the July 31, 1990 Annual Meeting of Shareholders. k. The Rorer Group Inc. Incentive Stock Option Plan, adopted April 27, 1982, is incorporated herein by reference to the Company's Annual Report on Form 10-K for the year ended December 31, 1989. l. Amendment to the Rhone-Poulenc Rorer Inc. Incentive Stock Option Plan, effective March 11, 1990, is incorporated herein by reference to the Form 8, Amendment No. 1 to the Company's Annual Report on Form 10-K for the year ended December 31, 1989. m. The Rorer Group Inc. Non-Qualified Stock Option Plan, adopted April 24, 1973, is incorporated herein by reference to the Company's Annual Report on Form 10-K for the year ended December 31, 1989. n. The Rhone-Poulenc Rorer Inc. Annual Performance Incentive Plan is incorporated herein by reference to the Form 8, Amendment No. 1 to the Company's Annual Report on Form 10-K for the year ended December 31, 1989. o. The Rhone-Poulenc Rorer Inc. Retirement Plan for Outside Directors, adopted January 1, 1988, is incorporated herein by reference to the Form 8, Amendment No. 1 to the Company's Annual Report on Form 10-K for the year ended December 31, 1989. p. The Rhone-Poulenc Rorer Inc. Supplemental Executive Retirement Plan, adopted January 1, 1988, is incorporated herein by reference to the Form 8, Amendment No. 1 to the Company's Annual Report on Form 10-K for the year ended December 31, 1989. q. The Rhone-Poulenc Rorer Inc. Director Deferred Compensation Plan, effective March 1, 1987, is incorporated herein by reference to the Form 8, Amendment No. 1 to the Company's Annual Report on Form 10-K for the year ended December 31, 1987. r. Acquisition Agreement, dated as of March 12, 1990, between Rorer Group Inc. and Rhone-Poulenc S.A., is incorporated herein by reference to the Company's Current Report on Form 8-K dated March 12, 1990. s. Employment agreement with Robert E. Cawthorn, dated March 12, 1990, is incorporated herein by reference to the Company's Current Report on Form 8-K, dated March 12, 1990. t. Employment agreement with Manfred Karobath, dated January 27, 1992, is incorporated by reference to the Company's Annual Report on Form 10-K for the year ended December 31, 1992. u. The Indemnification Agreements between Rorer Group Inc. and Indemnified Representatives effective July 1, 1987, are incorporated herein by reference to the Company's Annual Report on Form 10-K for the year ended December 31, 1987. v. Supplemental Benefit and Deferred Compensation Trust Agreement, dated May 10, 1988, between Rorer Group Inc. and Philadelphia National Bank, as Trustee, is incorporated herein by reference to the Company's Annual Report on Form 10-K for the year ended December 31, 1989. (11) Statement re: Computation of Earnings per Share. (12) Statement re: Computation of Ratios. (21) Subsidiaries of the Registrant. (23) Consent of Independent Accountants. (24) Powers of Attorney.

63754_1993.txt

63754_1993

1993

63754

ITEM 1. BUSINESS The Registrant, a diversified specialty food company, is principally engaged in the manufacture of spices, seasonings, flavorings and other specialty food products and sells such products to the retail food market, the foodservice market and to industrial food processors throughout the world. The Registrant also, through subsidiary corporations, manufactures and markets plastic packaging products for the food, cosmetic and health care industries. The Registrant's Annual Report to Stockholders for 1993, which is enclosed as Exhibit 13, contains a description of the general development, during the last fiscal year, of the business of the Registrant, which was formed in 1915 under Maryland law as the successor to a business established in 1889. Pages 7 through 20 of that Report are incorporated by reference. The Registrant's net sales increased 5.8% in 1993 to $1,556,566 due to both sales price and volume changes. The Registrant operates in one business segment and has disclosed in Note 10 of the Notes to Consolidated Financial Statements on page 33 of its Annual Report to Stockholders for 1993, which Note is incorporated by reference, the financial information about the business segment required by this Item. SPECIALTY FOOD BUSINESS The Registrant's Annual Report to Stockholders for 1993 sets forth a description of the business conducted by the Registrant on pages 7 through 9. Those pages of the Registrant's Annual Report are incorporated by reference. PRINCIPAL PRODUCTS/MARKETING Spices, seasonings, flavorings, and other specialty food products are the Registrant's principal products. Spices, seasonings, flavorings, and other specialty food products accounted for approximately 90% of net sales on a consolidated basis during the three fiscal years ended November 30, 1993. No other product or class of similar products or services contributed as much as 10% to consolidated net sales during the last three fiscal years. The Registrant's efforts will continue to be directed primarily in the area of spices, seasonings, flavorings, and other specialty food products. The Registrant markets its consumer and foodservice products through its own sales organization, food brokers and distributors. In the industrial market, sales are made mostly through the Registrant's own sales force. PRODUCTS/INDUSTRY SEGMENTS The Registrant has not announced or made public information about a new product or industry segment that would require the investment of a material amount of the assets of the Registrant or that otherwise is material. RAW MATERIALS Many of the spices and herbs purchased by the Registrant are imported into the United States from the country of origin, although substantial quantities of particular materials, such as paprika, dehydrated vegetables, onion and garlic, and substantially all of the specialty food ingredients other than spices and herbs, originate in the United States. Some of the imported materials are purchased from dealers in the United States. The Registrant is a direct importer of certain raw materials, mainly black pepper, vanilla beans, cinnamon, herbs and seeds from the countries of origin. The principal purpose of such purchases is to satisfy the Registrant's own needs. The Registrant also sells imported raw materials to other food processors. The raw materials most important to the Registrant are onion, garlic and capsicums (paprika and chili peppers), which are produced in the United States, black pepper, most of which originates in India, Indonesia, Malaysia and Brazil, and vanilla beans, a large proportion of which the Registrant obtains from the Malagasy Republic and Indonesia. TRADEMARKS, LICENSES AND PATENTS The Registrant owns a number of registered trademarks, which in the aggregate may be material to the Registrant's business. However, the loss of any one of those trademarks, with the exception of the Registrant's McCormick and Schilling trademarks, would not have a material adverse impact on the Registrant's business. The McCormick and Schilling trademarks are extensively used by the Registrant in connection with the sale of a substantial number of the Registrant's products in the United States. The McCormick and Schilling trademarks are registered and used in various foreign countries as well. The terms of the trademark registrations are as prescribed by law and the registrations will be renewed for as long as the Registrant deems them to be useful. The Registrant has entered into a number of license agreements authorizing the use of its trademarks by persons in foreign countries. In the aggregate, the loss of those license agreements would not have a material adverse impact on the Registrant's business. The terms of the license agreements are generally 3 to 5 years or until such time as either party terminates the agreement. Those agreements with specific terms are renewable upon agreement of the parties. The Registrant owns various patents, but they are not viewed as material to the Registrant's business. SEASONAL NATURE OF BUSINESS Historically, the Registrant's sales and profits are lower in the first two quarters of the fiscal year and increase in the third and fourth quarters. WORKING CAPITAL In order to meet increased demand for its products during its fourth quarter, the Registrant usually builds its inventories during the second and third quarters. In common with other companies, the Registrant generally finances working capital items (inventory and receivables) through short-term borrowings, which include the use of lines of credit and the issuance of commercial paper. CUSTOMERS The Registrant has a large number of customers for its products. No single customer accounted for as much as 10% of consolidated net sales in 1993. In the same year, sales to the five largest customers represented approximately 20% of consolidated net sales. BACKLOG ORDERS The dollar amount of backlog orders of the Registrant's specialty food business is not material to an understanding of the Registrant's business, taken as a whole. GOVERNMENT CONTRACTS No material portion of the Registrant's business is subject to renegotiation of profits or termination of contracts or subcontracts at the election of the government. COMPETITION Although the Registrant is a leader in sales of certain spices and seasoning and flavoring products, and is the largest producer and distributor of dehydrated onions and garlic in the United States, its business is highly competitive. For further discussion, see pages 12 and 14 of the Registrant's Annual Report to Stockholders for 1993, which pages are incorporated by reference. RESEARCH AND QUALITY CONTROL The Registrant has emphasized quality and innovation in the development, production and packaging of its products. Many of the Registrant's products are prepared from confidential formulae developed by its research laboratories and product development departments. The long experience of the Registrant in its field contributes substantially to the quality of the products offered for sale. Quality specifications exist for the Registrant's products, and continuing quality control inspections and testing are performed. Total expenditures for these and other related activities during fiscal years 1993, 1992 and 1991 were approximately $38,226,000, $35,968,000 and $33,052,000, respectively. Of these amounts, expenditures for research and development amounted to $12,259,000 in 1993, $11,844,000 in 1992 and $11,438,000 in l991. The amount spent on customer-sponsored research activities is not material. ENVIRONMENTAL REGULATIONS Compliance with Federal, State and local provisions related to protection of the environment has had no material effect on the Registrant's business. No material capital expenditures for environmental control facilities are expected to be made during this fiscal year or the next. EMPLOYEES The Registrant had on average approximately 8,600 employees during fiscal year 1993. FOREIGN OPERATIONS International businesses have made significant contributions to the Registrant's growth and profits. In common with other companies with foreign operations, the Registrant is subject in varying degrees to certain risks typically associated with doing business abroad, such as local economic and market conditions, exchange and price controls, restrictions on investment, royalties and dividends and exchange rate fluctuations. Note 10 of the Notes to Consolidated Financial Statements on page 33 of the Registrant's Annual Report to Stockholders for 1993 contains the information required by subsection (d) of Item 101 of Regulation S-K, which Note is incorporated by reference. PACKAGING OPERATIONS The Registrant's Annual Report to Stockholders for 1993 sets forth a description of the Registrant's packaging group on page 9, which page is incorporated by reference. Setco, Inc. and Tubed Products, Inc., which comprise Registrant's packaging group, are wholly owned subsidiaries of the Registrant and are, respectively, manufacturers of plastic bottles and plastic squeeze tubes. Substantially all of the raw materials used in the packaging business originate in the United States. The market for plastic packaging is highly competitive. The Registrant is the largest single customer of the packaging group. All intracompany sales have been eliminated from the Registrant's consolidated financial statements. ITEM 2. ITEM 2. PROPERTIES The location and general character of the Registrant's principal plants and other materially important physical properties are as follows: (a) CONSUMER PRODUCTS A plant is located in Hunt Valley, Maryland on approximately 52 acres in the Hunt Valley Business Community. This plant contains approximately 540,000 square feet and is owned in fee. A plant of approximately 475,000 square feet located in Salinas, California is owned in fee and a plant of approximately 108,000 square feet located in Commerce, California is leased. These plants are used for processing, packaging and distributing spices and other food products. (b) INDUSTRIAL PRODUCTS (i) A plant complex is located in Gilroy, California consisting of connected and adjacent buildings owned in fee and providing approximately 894,000 square feet of space for milling, dehydrating, packaging, warehousing and distributing onion, garlic and capsicums. Adjacent to this plant complex is a 4.3 acre cogeneration facility which supplies steam to the dehydration business as well as electricity to Pacific Gas & Electric Company. The cogeneration facility was financed with an installment note secured by the property and equipment. This note is non-recourse to the Registrant. (ii) The Registrant has two principal plants devoted to industrial flavoring products in the United States. A plant of 102,000 square feet is located in Hunt Valley, Maryland and is owned in fee. A plant of 102,400 square feet is located in Dallas, Texas and is owned in fee. (c) SPICE MILLING Located adjacent to the consumer products plant in Hunt Valley is a spice milling and cleaning plant which is owned in fee by the Registrant and contains approximately 185,000 square feet. This plant services all food product groups of the Registrant. Much of the milling and grinding of raw materials for Registrant's seasoning products is done in this facility. (d) PACKAGING PRODUCTS The Registrant has four principal plants which are devoted to the production of plastic containers. The facilities are located in California, Massachusetts, New York and New Jersey, and range in size from 178,000 to 280,000 square feet. The plants in New York and New Jersey are leased and part of the Massachusetts facility was financed through an industrial revenue bond which is still outstanding. (e) INTERNATIONAL The Registrant has a plant in London, Ontario which is devoted to the processing, packaging an distribution of food products. This facility is approximately 145,000 square feet and is owned in fee. (f) RESEARCH AND DEVELOPMENT The Registrant has a facility in Hunt Valley, Maryland which houses the corporate research and development laboratories and the technical capabilities of the industrial division. The facility is approximately 200,000 square feet and is owned in fee. ITEM 3. ITEM 3. LEGAL PROCEEDINGS There are no material pending legal proceedings to which the Registrant or any of its subsidiaries is a party or to which any of their property is subject. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matter was submitted during the fourth quarter of Registrant's fiscal year 1993 to a vote of security holders. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The Registrant has disclosed at page 19 of its Annual Report to Stockholders for 1993, which page is incorporated by reference, the information relating to the market, market quotations, and dividends paid on Registrant's common stocks required by this Item. The approximate number of holders of common stock of the Registrant based on record ownership as of January 31, 1994 was as follows: Approximate Number Title of Class of Record Holders Common Stock, no par value 2,075 Common Stock Non-Voting, 10,892 no par value ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The Registrant has disclosed the information required by this Item in the Historical Financial Summary of its Annual Report to Stockholders for 1993 at page 20, which page is incorporated by reference. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The Registrant's Annual Report to Stockholders for 1993 at pages 11 through 19 contains a discussion and analysis of the Company's financial condition and results of operations for the three fiscal years ended November 30, 1993. Said pages are incorporated by reference. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The financial statements and supplementary data for McCormick & Company, Incorporated are included on pages 21 through 34 of the Annual Report to Stockholders for 1993, which pages are incorporated by reference. The report of independent auditors from Ernst & Young on such financial statements is included on page 35 of the Annual Report to Stockholders for 1993; supplemental schedules for 1991, 1992 and 1993 are included on pages 14 through 19 of this Report on Form 10-K. The unaudited quarterly data required by Item 302 of Regulation S-K is included in Note 11 of the Notes to Consolidated Financial Statements at page 34 of the Registrant's Annual Report to Stockholders for 1993, which Note is incorporated by reference. ITEM 9. Item 9. Changes in and None. Disagreements with Accountants on Accounting and Financial Disclosure. PART III Item 10. Item 11. Executive Registrant's Proxy Compensation. Statement dated February 16, 1994/Pages 9-17. Item 12. Item 12. Security Ownership Registrant's Proxy of Certain Statement dated Beneficial February 16, 1994/Pages Owners and 4-7. Management. Item 13. Item 13. Certain Registrant's Proxy Relationships Statement and Related Transactions. dated February 16, 1994/ Page 7. PART IV Item 14.

72207_1993.txt

72207_1993

1993

72207

ITEM 1. BUSINESS. GENERAL Noble Affiliates, Inc. is a Delaware corporation organized in 1969. The Registrant is principally engaged, through its subsidiaries, in the exploration for and production of oil and gas. In this report, unless otherwise indicated or the context otherwise requires, the "Company" or the "Registrant" refers to Noble Affiliates, Inc. and its subsidiaries. OIL AND GAS The Registrant's wholly owned subsidiary, Samedan Oil Corporation ("Samedan"), has been engaged in the exploration for and production of oil and gas since 1932. Samedan conducts its exploration and production operations throughout the major basins in the United States, including the Gulf of Mexico, and in foreign jurisdictions, primarily in Canada and Africa. For information regarding Samedan's oil and gas properties, see "Item 2 ITEM 2. PROPERTIES. OFFICES The principal executive office of the Company is located at 110 West Broadway, Ardmore, Oklahoma 73401. The principal executive office of Samedan is in Ardmore, Oklahoma, and Samedan also maintains division offices in Oklahoma City, Houston, Denver and Calgary, Canada. Samedan maintains three separate offices in Houston for its international, offshore and onshore oil and gas operations. Samedan maintains an office in Tunis, Tunisia, from which it operates its various concessions and producing property in Tunisia. The principal executive office of Noble Gas Marketing, Inc. is located in Houston. OIL AND GAS The estimated proved and proved developed oil and gas reserves of Samedan, as of December 31, 1993, 1992 and 1991 and the standardized measure of discounted future net cash flows attributable thereto at December 31, 1993, 1992 and 1991 are included in Note 9 of Notes to Consolidated Financial Statements appearing on pages 32 through 35 of the Registrant's 1993 annual report to shareholders, which Note is incorporated herein by reference ("Note 9"). Note 9 also includes Samedan's net production (including royalty and working interest production) of oil and natural gas for the three years ended December 31, 1993. Royalty production of both oil and gas (stated in oil barrel equivalents) is included in the "Crude Oil & Condensate" presentation in Note 9. Samedan has no oil or gas applicable to long-term supply or similar agreements with foreign governments or authorities in which Samedan acts as producer. Since January 1, 1993, no oil or gas reserve information has been filed with, or included in any report to, any federal authority or agency other than the Securities and Exchange Commission and the Energy Information Administration (the "EIA"). Samedan files Form 23, including reserve and other information, with the EIA. The following table sets forth for each of the last three years the average sales price (including transfers) per unit of oil produced and per unit of natural gas produced, and the average production (lifting) cost per unit of production. The number of productive oil and gas wells in which Samedan had interests and the developed acreage held as of December 31, 1993, were as follows: The undeveloped acreage (including both leases and concessions) that Samedan held as of December 31, 1993, is as follows: The following table sets forth for each of the last three years the number of net exploratory and development wells drilled by or on behalf of Samedan. An exploratory well is a well drilled to find and produce oil or gas in an unproved area, to find a new reservoir in a field previously found to be productive of oil or gas in another reservoir, or to extend a known reservoir. A development well, for purposes of the following table and as defined in the rules and regulations of the Securities and Exchange Commission, is a well drilled within the proved area of an oil or gas reservoir to the depth of a stratigraphic horizon known to be productive. The number of wells drilled refers to the number of wells completed at any time during the respective year, regardless of when drilling was initiated; and "completion" refers to the installation of permanent equipment for the production of oil or gas, or, in the case of a dry hole, to the reporting of abandonment to the appropriate agency. Samedan spent approximately $418.5 million in 1993 on the purchase of producing oil and gas properties. See Item 1. "Business -- Oil and Gas -- Acquisitions" hereof for a discussion of significant acquisitions in 1993. Approximately $6.2 million and $47.6 million, respectively, were spent on such purchases in 1992 and 1991. At March 16, 1994, Samedan was drilling 9 gross (3.1 net) exploratory wells, and 19 gross (8.1 net) development wells. These wells are located onshore in the United States in California, Colorado, Louisiana, New Mexico, Oklahoma, Texas and Wyoming and Canada in Alberta Province, and offshore Gulf of Mexico and California. These wells have objectives ranging from approximately 2,800 to 15,200 feet. The estimated drilling cost to Samedan of these wells is approximately $11,800,000 if all are dry and approximately $24,600,000 if all are completed as producing wells. ITEM 3. ITEM 3. LEGAL PROCEEDINGS. Samedan is an unsecured creditor of Columbia Gas Transmission Corporation ("Columbia") which filed for protection from creditors under Chapter 11 of the Federal Bankruptcy Code on July 31, 1991, in the United States Bankruptcy Court for the District of Delaware (the "Bankruptcy Court"). IN RE COLUMBIA GAS TRANSMISSION CORPORATION, Case No. 91-804 (Bankr. D. Del. 1991). Samedan and Columbia are parties to a gas sales contract, which terminates in 1998, covering a property in the Gulf of Mexico. Samedan's gas sales contract was rejected by Columbia in its bankruptcy proceeding. On March 16, 1992, Samedan filed a proof of claim with the Bankruptcy Court in the amount of approximately $117 million covering approximately $3.0 million for the contract price on prepetition gas purchases, approximately $2.0 million for the contract price due on prepetition take or pay obligations, and approximately $112 million for damages arising from the rejection of Samedan's gas sales contract. The full amount of Samedan's claim is classified as an unsecured non-priority claim. The Bankruptcy Court has established a claim procedure pursuant to which the claim of Samedan, and other creditors with claims arising from rejected gas sales contracts, shall be determined. Pursuant to such claims procedure, Charles P. Nomandin has been appointed as claims mediator in order to, among other things, estimate the claims of producers with claims arising from gas supply contracts. Samedan is participating in this claims resolution procedure and intends, if necessary, to advance and litigate the amount of its unsecured claim. A preliminary Plan of Reorganization for Columbia dated January 18, 1994 has been filed by Columbia, but the applicable schedules indicating the sums which individual producer claimants, such as Samedan, would receive under such Plan of Reorganization were not attached to that filing. Columbia has requested, and the Bankruptcy Court has agreed, that no action be taken by the Bankruptcy Court on that filing while settlement discussions take place between Columbia and the various creditor groups. Samedan is participating in such settlement discussions. It is unknown whether resolution of Samedan's claim will occur in 1994, or at what amount the claim may be ultimately resolved. There are no other material pending legal proceedings, other than ordinary routine litigation incidental to the business of the Registrant and its subsidiaries, to which the Registrant or any of its subsidiaries is a party or of which any of their property is the subject. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. Not applicable. EXECUTIVE OFFICERS OF THE REGISTRANT The following tabulation sets forth certain information, as of March 26, 1994, with respect to the executive officers of the Registrant. The terms of office for the officers of the Registrant continue until their successors are chosen and qualified. No officer or executive officer of the Registrant has an employment agreement with the Registrant or any of its subsidiaries. There are no family relationships between any of the Registrant's officers. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. The Registrant's common stock is listed and traded on the New York Stock Exchange under the symbol "NBL". The table captioned "Dividends and Stock Prices by Quarters" appearing on the inside back cover of the Registrant's 1993 annual report to shareholders contains certain information with respect to sales prices of the common stock and cash dividends declared by the Registrant on the common stock, and such table is incorporated herein by reference. At December 31, 1993, there were 2,100 shareholders of record of the Registrant. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA. Selected financial data of the Registrant is set forth on Page 21 of the Registrant'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. Management's discussion and analysis of financial condition and results of operations is set forth on pages 15 through 20 of the Registrant'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, appearing on pages 22 through 31, together with the report thereon of Arthur Andersen & Co. dated January 24, 1994 appearing on page 25, and the unaudited information, appearing on pages 32 through 35, of the Registrant's 1993 annual report to shareholders are incorporated herein by reference. With the exception of the aforementioned information and the information expressly incorporated into Items 2, 5, 6 and 7 hereof, the 1993 annual report to shareholders is not to be deemed to be filed as part of this report. The consolidated balance sheet of Natural Gas Clearinghouse (a Colorado partnership) and subsidiaries as of December 31, 1991, and the related consolidated statements of income, partners' equity and cash flows for the year then ended, appearing on pages through of the Registrant's Form 10-K for the year ended December 31, 1991 (the "1991 Form 10-K") together with the report thereon of Arthur Andersen & Co. dated February 21, 1992 appearing on page of the 1991 Form 10-K, 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 section entitled "Election of Directors" appearing on pages 3 and 4 of the Registrant's proxy statement for the 1994 annual meeting of shareholders sets forth certain information with respect to the directors of the Registrant and is incorporated herein by reference. Certain information with respect to the executive officers of the Registrant is set forth under the caption "Executive Officers of the Registrant" in Part I of this report. The section entitled "Certain Transactions" appearing on page 16 of the Registrant's proxy statement for the 1994 annual meeting of shareholders sets forth certain information with respect to compliance with Section 16(a) of the Exchange Act and is incorporated herein by reference. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION. The section entitled "Executive Compensation" appearing on pages 7 through 16 of the Registrant's proxy statement for the 1994 annual meeting of shareholders sets forth certain information with respect to the compensation of management of the Registrant, and, except for the report of the compensation and benefits committee of the Board of Directors (pages 7 through 10) and the information therein under "Performance Graph" (pages 15 and 16), is incorporated herein by reference. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. The sections entitled "Security Ownership of Certain Beneficial Owners" and "Security Ownership of Directors and Executive Officers" appearing on pages 2 and 5 of the Registrant's proxy statement for the 1994 annual meeting of shareholders set forth certain information with respect to the ownership of the Registrant's common stock, and are 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. All other schedules are omitted because they are not applicable or the required information is shown in the financial statements or notes thereto. Financial statements of two 50 percent or less owned entities accounted for by the equity method have been omitted because, in the aggregate, the proportionate share of their profit before income taxes and total assets are less than 20 percent of the respective consolidated amounts, and investments in such entities are less than 20 percent of consolidated total assets, of the Registrant. (3) Exhibits: The exhibits required to be filed by this Item 14 are set forth in the Index to Exhibits accompanying this report. (b) No report on Form 8-K was 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. NOBLE AFFILIATES, INC. Date: March 29, 1994 By: WILLIAM D. DICKSON ---------------------------------- William D. Dickson, Vice President-Finance 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. S-1 REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULES To Noble Affiliates, Inc.: We have audited in accordance with generally accepted auditing standards, the consolidated financial statements included in Noble Affiliates, Inc.'s annual report to shareholders incorporated by reference in this Form 10-K, and have issued our report thereon dated January 24, 1994. Our audit was 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 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. Oklahoma City, Oklahoma January 24, 1994 R-1 SCHEDULE V ---------- NOBLE AFFILIATES, INC. AND SUBSIDIARIES PROPERTY, PLANT AND EQUIPMENT (In thousands of dollars) V-1 SCHEDULE VI ----------- NOBLE AFFILIATES, INC. AND SUBSIDIARIES ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT (In thousands of dollars) VI-1 SCHEDULE IX ----------- NOBLE AFFILIATES, INC. AND SUBSIDIARIES SHORT-TERM BORROWINGS IX-1 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 Commission file number: December 31, 1993 0-7062 NOBLE AFFILIATES, INC. (Exact name of registrant as specified in its charter) Delaware 73-0785597 (State of incorporation) (I.R.S. employer identification number) 110 West Broadway Ardmore, Oklahoma 73401 (Address of principal (Zip Code) executive offices) INDEX TO EXHIBITS ----------------- E-1 E-2 E-3 E-4

722079_1993.txt

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1993

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ITEM 3. LEGAL PROCEEDINGS. Various legal proceedings are pending against Terra Industries and its subsidiaries. Management of Terra Industries considers that the aggregate liability, if any, resulting from these proceedings will not be material to Terra Industries. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. No items were submitted to a vote of security holders of Terra Industries during the fourth quarter of the 1993 fiscal year. EXECUTIVE OFFICERS OF TERRA INDUSTRIES The following paragraphs set forth the name, age and offices with Terra Industries of each present executive officer of Terra Industries, the period during which each executive officer has served as such and each executive officer's business experience during the past five years: There are no family relationships among the executive officers and directors of Terra Industries or arrangements or understandings between any executive officer and any other person pursuant to which any executive officer was selected as such. Officers of Terra Industries are elected annually to serve until their respective successors are elected and qualified. PART II ITEM 5. ITEM 5. MARKET FOR TERRA INDUSTRIES' COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. Information with respect to the market for Terra Industries' common equity and related stockholder matters contained in Terra Industries' 1993 Annual Report to Stockholders under the caption "Quarterly Financial and Stock Market Data (Unaudited)" is incorporated herein by reference. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA. Information with respect to selected financial data contained in Terra Industries' 1993 Annual Report to Stockholders under the caption "Financial Summary" is incorporated herein by reference. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. Information with respect to management's discussion and analysis of financial condition and results of operations contained in Terra Industries' 1993 Annual Report to Stockholders under the caption "Financial Review" is incorporated herein by reference. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. The consolidated financial statements, together with the report of independent accountants thereon, the information contained under the caption "Quarterly Financial and Stock Market Data (Unaudited)" contained in Terra Industries' 1993 Annual Report to Stockholders 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 OF TERRA INDUSTRIES. Information with respect to directors of Terra Industries under the caption "Election of Directors" in the Proxy Statement for the Annual Meeting of Stockholders of Terra Industries to be held on May 3, 1994, is incorporated herein by reference. Information with respect to executive officers who are not also directors of Terra Industries appears under the caption "Executive Officers of Terra Industries" in Part I hereof and is incorporated herein by reference. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION. Information with respect to executive compensation under the caption "EXECUTIVE COMPENSATION AND OTHER INFORMATION" in the Proxy Statement for the Annual Meeting of Stockholders of Terra Industries to be held on May 3, 1994, is incorporated herein by reference. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. Information with respect to security ownership of certain beneficial owners and management under the caption "Equity Security Ownership" in the Proxy Statement for the Annual Meeting of Stockholders of Terra Industries to be held on May 3, 1994, is incorporated herein by reference. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. Information with respect to certain relationships and related transactions under the caption "CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS" in the Proxy Statement for the Annual Meeting of Stockholders of Terra Industries to be held on May 3, 1994, is incorporated herein by reference. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K. (a) FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES 1. Consolidated Financial Statements of Terra Industries and its subsidiaries (incorporated herein by reference to Terra Industries' 1993 Annual Report to Stockholders). Consolidated Statements of Financial Position at 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 Changes in Stockholders' Equity for the years ended December 31, 1993, 1992 and 1991. Notes to the Consolidated Financial Statements. Independent Auditors' Report. Quarterly Production Data (Unaudited). Quarterly Financial and Stock Market Data (Unaudited). Stockholders and Dividends. Financial Summary. 2. Index to Financial Statement Schedules See Index to Financial Statement Schedules of Terra Industries and its subsidiaries at page S-1. 3. Other Financial Statements Individual financial statements of Terra Industries' subsidiaries are omitted because all such subsidiaries are included in the consolidated financial statements being filed. Individual financial statements of 50% or less owned persons accounted for on the equity method have been omitted because such 50% or less owned persons considered in the aggregate, as a single subsidiary, would not constitute a significant subsidiary. (b) EXECUTIVE COMPENSATION PLANS AND ARRANGEMENTS 1. Amended and Restated Deferred Compensation Agreement made as of May 1, 1991, by and between Terra Industries and R. F. Richards filed as Exhibit 10 to Terra Industries' Form 8-K dated September 30, 1991. 2. Resolution adopted by the Personnel Committee of the Board of Directors of Terra Industries with respect to supplemental retirement benefits for certain senior executive officers of Terra Industries, filed as Exhibit 10.4.2 to Terra Industries' Form 10-Q for the fiscal quarter ended March 31, 1991. 3. 1992 Executive Incentive Plan of Terra Industries filed as Exhibit 10.1.12 to Terra Industries' Form 10-K for the year ended December 31, 1991. 4. 1992 Stock Incentive Plan of Terra Industries filed as Exhibit 10.1.6 to Terra Industries' Form 10-K for the year ended December 31, 1992. 5. Form of Restricted Stock Agreement of Terra Industries under its 1992 Stock Incentive Plan filed as Exhibit 10.1.7 to Terra Industries' Form 10-K for the year ended December 31, 1992. 6. Form of Incentive Stock Option Agreement of Terra Industries under its 1992 Stock Incentive Plan filed as Exhibit 10.1.8 to Terra Industries' Form 10-K for the year ended December 31, 1992. 7. Form of Nonqualified Stock Incentive Agreement of Terra Industries under its 1992 Stock Incentive Plan filed as Exhibit 10.1.9 to Terra Industries' Form 10-K for the year ended December 31, 1992. 8. 1993 Incentive Award Program for Officers and Key Executives of Terra Industries filed as Exhibit 10.1.10 to Terra Industries' Form 10-K for the year ended December 31, 1992. 9. Excess Benefit Plan of Terra Industries as amended effective as of January 1, 1992, filed as Exhibit 10.1.13 to Terra Industries' Form 10-K for the year ended December 31, 1992. 10. Restricted Stock Agreement of Burton M. Joyce dated May 1, 1991, filed as Exhibit 10.1.14 to Terra Industries' Form 10-K for the year ended December 31, 1992. 11. Terra Industries Inc. Supplemental Deferred Compensation Plan effective as of December 20, 1993, filed as Exhibit 10.1.9 to Terra Industries' Form 10-K for the year ended December 31, 1993. 12. Retirement/Consulting Agreement, dated as of May 13, 1993 by and between Paul D. Foster and Terra International, filed as Exhibit 10.1.2 to Terra Industries' Form 10-K for the year ended December 31, 1993. 13. Consulting Agreement dated as of December 30, 1993, by and between Paul D. Foster and Terra International, filed as Exhibit 10.1.13 to Terra Industries' Form 10-K for the year ended December 31, 1993. 14. 1994 Incentive Award Program for Officers and Key Executives of Terra Industries filed as Exhibit 10.1.14 to Terra Industries' Form 10-K for the year ended December 31, 1993. (c) REPORTS ON FORM 8-K The following report on Form 8-K was filed during the fourth quarter of 1993: Form 8-K dated October 26, 1993, Item 5. (d) Exhibits 3.1.1 Articles of Restatement of Terra Industries filed with the State of Maryland on September 11, 1990, filed as Exhibit 3.1 to Terra Industries' Form 10-K for the year ended December 31, 1990, is incorporated herein by reference. [8 pages]. 3.1.2 Articles of Amendment of Terra Industries filed with the State of Maryland on May 6, 1992, filed as Exhibit 3.1.2 to Terra Industries' Form 10-K for the year ended December 31, 1992, is incorporated herein by reference. [2 pages]. 3.2 By-Laws of Terra Industries, as amended through August 7, 1991, filed as Exhibit 3 to Terra Industries' Form 8-K dated September 30, 1991, is incorporated herein by reference. [12 pages]. 4.1.1 Indenture dated as of May 31, 1987, from Terra Industries to Mellon Bank, N.A., as Trustee, including form of Debenture, filed as Exhibit 4 to Amendment No. 2 to the Registration Statement on Form S-3 (Registration No. 33-14171) filed by Terra Industries on June 11, 1987, is incorporated herein by reference. [105 pages]. 4.1.2 Revolving Credit Agreement dated as of November 24, 1992, among Terra International, Inc., CitiCorp USA, Inc., Mellon Bank, N.A., Continental Bank N.A., First Bank National Association, NationsBank of Texas, N.A. and Rabobank Nederland, filed as Exhibit 4.1.2 to Terra Industries' Form 10-K for the year ended December 31, 1992, is incorporated herein by reference. 4.1.3 First Amendment Agreement, dated as of March 26, 1993, by and between Terra International, Inc., the Lenders listed on the signature page thereto, and CitiCorp USA, Inc., as agent to Lenders. [17 pages]. 4.1.4 Second Amendment Agreement, dated as of December 30, 1993, by and between Terra International, Inc., the Lenders listed on the signature page thereto, and CitiCorp USA, Inc., as agent for the Lenders. [13 pages]. Other instruments defining the rights of holders of long-term debt of Terra Industries and its subsidiaries are not being filed because the total amount of securities authorized under any such instrument does not exceed 10 percent of the total assets of Terra Industries and its subsidiaries on a consolidated basis. Terra Industries agrees to furnish a copy of any instrument to the Securities and Exchange Commission upon request. 10.1.1 Amended and Restated Deferred Compensation Agreement made as of May 1, 1991, by and between Terra Industries and R. F. Richards filed as Exhibit 10 to Terra Industries' Form 8-K dated September 30, 1991, is incorporated herein by reference. [4 pages]. 10.1.2 Resolution adopted by the Personnel Committee of the Board of Directors of Terra Industries with respect to supplemental retirement benefits for certain senior executive officers of Terra Industries, filed as Exhibit 10.4.2 to Terra Industries' Form 10-Q for the fiscal quarter ended March 31, 1991, is incorporated herein by reference. [1 page] 10.1.3 1992 Executive Incentive Plan of Terra Industries filed as Exhibit 10.1.12 to Terra Industries' Form 10-K for the year ended December 31, 1991, is incorporated herein by reference. [3 pages]. 10.1.4 1992 Stock Incentive Plan of Terra Industries filed as Exhibit 10.1.6 to Terra Industries' Form 10-K for the year ended December 31, 1992, is incorporated herein by reference. [8 pages]. 10.1.5 Form of Restricted Stock Agreement of Terra Industries under its 1992 Stock Incentive Plan filed as Exhibit 10.1.7 to Terra Industries' Form 10-K for the year ended December 31, 1992, is incorporated. herein by reference. [4 pages]. 10.1.6 Form of Incentive Stock Option Agreement of Terra Industries under its 1992 Stock Incentive Plan, filed as Exhibit 10.1.8 to Terra Industries' Form 10-K for the year ended December 31, 1992, is incorporated herein by reference. [4 pages]. 10.1.7 Form of Nonqualified Stock Incentive Agreement of Terra Industries under its 1992 Stock Incentive Plan, filed as Exhibit 10.1.9 to Terra Industries' Form 10-K for the year ended December 31, 1992, is incorporated herein by reference. [4 pages]. 10.1.8 1993 Incentive Award Program for Officers and Key Executives of Terra Industries, filed as Exhibit 10.1.10 to Terra Industries' Form 10-K for the year ended December 31, 1992, is incorporated herein by reference. [3 pages]. 10.1.9 Terra Industries Inc. Supplemental Deferred Compensation Plan effective as of December 20, 1993. [19 pages.] 10.1.10 Excess Benefit Plan of Terra Industries as amended effective as of January 1, 1992, filed as Exhibit 10.1.13 to Terra Industries' Form 10-K for the year ended December 31, 1992, is incorporated herein by reference. [2 pages]. 10.1.11 Restricted Stock Agreement of Burton M. Joyce dated May 1, 1991, filed as Exhibit 10.1.14 to Terra Industries' Form 10-K for the year ended December 31, 1992, is incorporated herein by reference. [2 pages]. 10.1.12 Retirement/Consultant Agreement, dated as of May 13, 1993, by and between Paul D. Foster and Terra International. [4 pages]. 10.1.13 Consulting Agreement, dated as of December 30, 1993, by and between Paul D. Foster and Terra International. [2 pages]. 10.1.14 1994 Incentive Award Program for Officers and Key Executives of Terra Industries. [3 pages]. 10.2 Asset Sale and Purchase Agreement among Inspiration Consolidated Copper Company and Cyprus Miami Mining Corporation and Cyprus Christmas Mine Corporation dated as of June 30, 1989, filed as Exhibit 10.19 to Terra Industries' Form 10-Q for the quarter ended September 30, 1989, is incorporated herein by reference. [83 pages]. 10.3.1 Stock Purchase Agreement, dated as of June 14, 1991, among Minorco, Kirkdale Investments Limited, Terra Industries and Hudson Holdings Corporation, filed as Exhibit 2 to Terra Industries' Form 8-K dated June 14, 1991, is incorporated herein by reference. [55 pages]. 10.3.2 Amended and Restated Stock Purchase Agreement, dated as of July 31, 1991, among Minorco, Kirkdale Investments Limited, Terra Industries and Hudson Holdings Corporation, filed as Exhibit 1 to Terra Industries' Form 8-K dated July 31, 1991, is incorporated herein by reference. [62 pages]. 10.3.3 Option Agreement, dated as of June 14, 1991, among Kirkdale Investments Limited and Terra Industries, filed as Exhibit 3 to Terra Industries' Form 8-K dated June 14, 1991, is incorporated herein by reference. [16 pages]. 10.3.4 Amendment to Stock Option Agreement, dated July 31, 1991, among Minorco, Kirkdale Investments Limited and Terra Industries, filed as Exhibit 2 to Terra Industries' Form 8-K dated July 31, 1991, is incorporated herein by reference. [3 pages]. 10.4 Asset and Sale Purchase Agreement, dated as of April 8, 1993, by and between Terra International, Inc., Terra International (Canada) Inc. and ICI Canada Inc., filed as Exhibit A to Terra Industries' Form 8-K dated April 8, 1993, is incorporated herein by reference. [95 pages]. 10.5 Asset Purchase Agreement, dated as of December 30, 1993, by and between Terra International, Inc., The Upjohn Company and Asgrow Florida Company, filed as Exhibit A to Terra Industries' Form 8-K dated December 31, 1993, is incorporated herein by reference. [71 pages]. 10.6 Lease, dated as of April 8, 1993, between W. Patrick Moroney and Terra International (Canada) Inc. [42 pages]. 13 Financial Review and Consolidated Financial Statements as Contained in the Annual Report to Stockholders of Terra Industries for the fiscal year ended December 31, 1993. [32 pages]. 21 Subsidiaries of Terra Industries. [3 pages]. 24 Powers of Attorney [8 pages]. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, Terra Industries has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. TERRA INDUSTRIES INC. By: /s/ George H. Valentine ------------------------- George H. Valentine Vice President, General Counsel and Corporate Secretary Date: March 3, 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 Terra Industries and in the capacities and on the dates indicated: INDEX TO FINANCIAL STATEMENT SCHEDULES, REPORTS AND CONSENTS Financial statement schedules not included in this report have been omitted because they are not applicable or the required information is shown in the consolidated financial statements or the notes thereto. S-1 INDEPENDENT AUDITORS' REPORT ON FINANCIAL STATEMENT SCHEDULES TO THE BOARD OF DIRECTORS AND STOCKHOLDERS OF TERRA INDUSTRIES INC.: We have audited the consolidated financial statements of Terra Industries Inc. as of December 31, 1993 and 1992, and for each of the two years then ended, and have issued our report thereon dated February 1, 1994; such financial statements and report are included in the 1993 Annual Report to Stockholders of Terra Industries Inc. and are incorporated herein by reference. Our audits also included the Financial Statement Schedules of Terra Industries Inc. listed in Item 14(a) of this Form 10-K. These Financial Statement Schedules are the responsibility of the management of Terra Industries Inc. Our responsibility is to express an opinion 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. DELOITTE & TOUCHE Omaha, Nebraska February 1, 1994 INDEPENDENT AUDITORS' CONSENT We consent to the incorporation by reference in the Prospectuses constituting part of the Registration Statements on Form S-8 (Registration Nos. 33-46735, 33-46734, 33-30058 and 33-4939) and Registration Statements on Form S-3 (Registration Nos. 2-90808, 2-84876 and 2-84669) of Terra Industries Inc. of our report dated February 1, 1994, included in the 1993 Annual Report to Stockholders of Terra Industries Inc. which is incorporated by reference in this Form 10-K. We also consent to the incorporation by reference in such Prospectuses of our report on the Financial Statement Schedules, appearing above. DELOITTE & TOUCHE Omaha, Nebraska February 28, 1994 S-2 REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors and Stockholders of Terra Industries Inc. In our opinion, the consolidated financial statements listed in the index under Item 14(a)(1) and (2) on page 11 of the 1993 Annual Report on Form 10-K present fairly, in all material respects, the results of operations, cash flows and changes in stockholders' equity of Terra Industries Inc. and its subsidiaries for the year ended December 31, 1991, 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 audit. We conducted our audit 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 audit provides a reasonable basis for the opinion expressed above. We have not audited the consolidated financial statements of Terra Industries Inc. for any period subsequent to December 31,1991. PRICE WATERHOUSE February 13, 1992 New York, New York S-3 CONSENT OF INDEPENDENT ACCOUNTANTS We hereby consent to the incorporation by reference in the Prospectuses constituting part of the Registration Statements on Form S-3 (Registration Nos. 2-90808, 2-84876 and 2-84669) and Form S-8 (Registration Nos. 33-30058, 33-4939, 33-46734 and 33-46735) of Terra Industries Inc. of our report dated February 13, 1992 appearing on page S-3 of this Annual Report on Form 10-K. PRICE WATERHOUSE New York, New York March 1, 1994 S-4 SCHEDULE II TERRA INDUSTRIES INC. AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS, AND EMPLOYEES OTHER THAN RELATED PARTIES Years Ended December 31, 1993, 1992, and 1991 --------------------------------------------- (in thousands) (a) For 1992 the Corporation reclassified the accounts receivable of Alloy Research, Inc. to Net Assets of Discontinued Operations. (b) Represents amounts collected. S-5 TERRA INDUSTRIES INC. (Parent Company) SCHEDULE III - CONDENSED FINANCIAL INFORMATION OF REGISTRANT STATEMENTS OF FINANCIAL POSITION See accompanying Notes to the Condensed Financial Statements. S-6 TERRA INDUSTRIES INC. (Parent Company) SCHEDULE III - CONDENSED FINANCIAL INFORMATION OF REGISTRANT CONDENSED STATEMENTS OF OPERATIONS AND ACCUMULATED DEFICIT See accompanying Notes to the Condensed Financial Statements. S-7 TERRA INDUSTRIES INC. (Parent Company) SCHEDULE III - CONDENSED FINANCIAL INFORMATION OF REGISTRANT STATEMENTS OF CASH FLOWS See accompanying Notes to the Condensed Financial Statements. S-8 TERRA INDUSTRIES INC. (Parent Company) SCHEDULE III - CONDENSED FINANCIAL INFORMATION OF REGISTRANT NOTES TO THE CONDENSED FINANCIAL STATEMENTS 1. BASIS OF PRESENTATION The Condensed Financial Statements include the Registrant only and reflect the equity method of accounting for its wholly owned subsidiary, Terra International, Inc. (International). Equity in International's 1992 earnings includes the deduction of $5.7 million for the cumulative effect of accounting changes to recognize the prior service cost of providing post-retirement medical benefits to International's employee's. Equity in the financial results of the base metals, coal, leasing and other discontinued businesses have been included in discontinued operations. 2. LONG-TERM DEBT Long-term debt at December 31, 1993 and 1992 consists of 8.5% Convertible Subordinated Debentures (Debentures) of $72,057,000 that is due 2012. Sinking fund payments of $5,175,000 per year begin in 1998. The fair value, based upon redemption provisions, at December 31, 1993 is $74.4 million and at December 31, 1992 was $75.3 million. The Debentures are convertible into Common Shares any time prior to maturity, unless previously redeemed, at a conversion price of $8.083 per share. The Debentures are subject to redemption, upon not less than 20 days notice by mail, at any time, as a whole or in part, at the election of the Registrant. The redemption price, expressed as a percent of the principal amount of the Debentures to be redeemed, is 103.40% until May 31, 1994, 102.55% until May 31, 1995 and decreasing yearly thereafter to 100% at June 1, 1997. 3. COMMITMENTS AND CONTINGENCIES The Registrant is committed to a non-cancelable office lease expiring in 1998. Total minimum rental payments, are: 1994, $3.1 million; 1995, $3.1 million; 1996, $3.2 million; 1997, $3.3 million and 1998, $1.7 million. These amounts are not reduced by sublease rentals, which in 1993 were $2.0 million. The Registrant is contingently liable for retiree medical benefits of employees of coal mining operations sold on January 12, 1993. Under the purchase agreement, the purchaser agreed to indemnify the Registrant against its obligations under certain employee benefit plans. Due to the Coal Industry Retiree Health Benefit Act of 1992, certain retiree medical benefits of union coal miners have become statutorily mandated, and all companies owning 50 percent or more of any company liable for such benefits as of certain specified dates becomes liable for such benefits if the company directly liable is unable to pay them. As a result, if the purchaser becomes unable to pay its retiree medical obligations assumed pursuant to the sale, the Registrant may have to pay such amount. The Registrant has estimated that the present value of liabilities for which it retains contingent responsibility approximates $12 million at December 31, 1993. In the event the Registrant would be required to assume this liability, mineral reserves associated with the sold coal subsidiary would revert to the Registrant. The Registrant had letters of credit outstanding totaling $13.0 million at December 31, 1993 and $14.1 million at December 31, 1992, guaranteeing various insurance and financing activities. Short-term investments of $13.0 million at December 31, 1993 and 1992 are restricted to collateralize certain of the letters of credit. 4. INCOME TAXES The Registrant files a consolidated U.S. federal tax return. The principal operating subsidiaries provide for federal income taxes according to tax sharing agreements which allocate the benefits of operating losses and differences between financial reporting and income tax basis results to the Registrant. S-9 SCHEDULE V TERRA INDUSTRIES INC. PROPERTY, PLANT & EQUIPMENT Years Ended December 31, 1993, 1992, and 1991 ---------------------------------------------- (in thousands) (a) Discontinued operations include the Leasing and Construction Materials segments in 1992 and the Base Metals segment in 1991. (b) Amounts included in related to acquisitions during 1993 are $12,301. S-10 SCHEDULE VI TERRA INDUSTRIES INC. ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT Years Ended December 31, 1993, 1992, and 1991 (in thousands) (a) Discontinued operations included the Leasing and Construction Materials segments in 1992 and the Base Metals segment in 1991. S-11 SCHEDULE VIII TERRA INDUSTRIES INC. VALUATION AND QUALIFYING ACCOUNTS Years Ended December 31, 1993, 1992, and 1991 --------------------------------------------- (in thousands) (a) Write-offs, net of recoveries. S-12 SCHEDULE IX TERRA INDUSTRIES INC. SHORT-TERM BORROWINGS Years Ended December 31, 1993, 1992, and 1991 --------------------------------------------- (in thousands) (a) Based on number of days during the year. S-13 SCHEDULE X TERRA INDUSTRIES INC. SUPPLEMENTARY INCOME STATEMENT INFORMATION Years Ended December 31, 1993, 1992, and 1991 --------------------------------------------- (in thousands) (a) Less than one percent of total revenues. (b) Amounts have been restated to reflect discontinued operations. S-14 EXHIBIT INDEX 3.1.1 Articles of Restatement of Terra Industries filed with the State of Maryland on September 11, 1990, filed as Exhibit 3.1 to Terra Industries' Form 10-K for the year ended December 31, 1990, is incorporated herein by reference. [8 pages]. 3.1.2 Articles of Amendment of Terra Industries filed with the State of Maryland on May 6, 1992, filed as Exhibit 3.1.2 to Terra Industries' Form 10-K for the year ended December 31, 1992, is incorporated herein by reference. [2 pages]. 3.2 By-Laws of Terra Industries, as amended through August 7, 1991, filed as Exhibit 3 to Terra Industries' Form 8-K dated September 30, 1991, is incorporated herein by reference. [12 pages]. 4.1.1 Indenture dated as of May 31, 1987, from Terra Industries to Mellon Bank, N.A., as Trustee, including form of Debenture, filed as Exhibit 4 to Amendment No. 2 to the Registration Statement on Form S-3 (Registration No. 33-14171) filed by Terra Industries on June 11, 1987, is incorporated herein by reference. [105 pages]. 4.1.2 Revolving Credit Agreement dated as of November 24, 1992, among Terra International, Inc., CitiCorp USA, Inc., Mellon Bank, N.A., Continental Bank N.A., First Bank National Association, NationsBank of Texas, N.A. and Rabobank Nederland, filed as Exhibit 4.1.2 to Terra Industries' Form 10-K for the year ended December 31, 1992, is incorporated herein by reference. 4.1.3 First Amendment Agreement, dated as of March 26, 1993, by and between Terra International, Inc., the Lenders listed on the signature page thereto, and CitiCorp USA, Inc., as agent to Lenders. [17 pages]. 4.1.4 Second Amendment Agreement, dated as of December 30, 1993, by and between Terra International, Inc., the Lenders listed on the signature page thereto, and CitiCorp USA, Inc., as agent for the Lenders. [13 pages]. Other instruments defining the rights of holders of long-term debt of Terra Industries and its subsidiaries are not being filed because the total amount of securities authorized under any such instrument does not exceed 10 percent of the total assets of Terra Industries and its subsidiaries on a consolidated basis. Terra Industries agrees to furnish a copy of any instrument to the Securities and Exchange Commission upon request. 10.1.1 Amended and Restated Deferred Compensation Agreement made as of May 1, 1991, by and between Terra Industries and R. F. Richards filed as Exhibit 10 to Terra Industries' Form 8-K dated September 30, 1991, is incorporated herein by reference. [4 pages]. 10.1.2 Resolution adopted by the Personnel Committee of the Board of Directors of Terra Industries with respect to supplemental retirement benefits for certain senior executive officers of Terra Industries, filed as Exhibit 10.4.2 to Terra Industries' Form 10-Q for the fiscal quarter ended March 31, 1991, is incorporated herein by reference. [1 page] 10.1.3 1992 Executive Incentive Plan of Terra Industries filed as Exhibit 10.1.12 to Terra Industries' Form 10-K for the year ended December 31, 1991, is incorporated herein by reference. [3 pages]. 10.1.4 1992 Stock Incentive Plan of Terra Industries filed as Exhibit 10.1.6 to Terra Industries' Form 10-K for the year ended December 31, 1992, is incorporated herein by reference. [8 pages]. 10.1.5 Form of Restricted Stock Agreement of Terra Industries under its 1992 Stock Incentive Plan filed as Exhibit 10.1.7 to Terra Industries' Form 10-K for the year ended December 31, 1992, is incorporated. herein by reference. [4 pages]. 10.1.6 Form of Incentive Stock Option Agreement of Terra Industries under its 1992 Stock Incentive Plan, filed as Exhibit 10.1.8 to Terra Industries' Form 10-K for the year ended December 31, 1992, is incorporated herein by reference. [4 pages]. 10.1.7 Form of Nonqualified Stock Incentive Agreement of Terra Industries under its 1992 Stock Incentive Plan, filed as Exhibit 10.1.9 to Terra Industries' Form 10-K for the year ended December 31, 1992, is incorporated herein by reference. [4 pages]. 10.1.8 1993 Incentive Award Program for Officers and Key Executives of Terra Industries, filed as Exhibit 10.1.10 to Terra Industries' Form 10-K for the year ended December 31, 1992, is incorporated herein by reference. [3 pages]. 10.1.9 Terra Industries Inc. Supplemental Deferred Compensation Plan effective as of December 20, 1993. [19 pages.] 10.1.10 Excess Benefit Plan of Terra Industries as amended effective as of January 1, 1992, filed as Exhibit 10.1.13 to Terra Industries' Form 10-K for the year ended December 31, 1992, is incorporated herein by reference. [2 pages]. 10.1.11 Restricted Stock Agreement of Burton M. Joyce dated May 1, 1991, filed as Exhibit 10.1.14 to Terra Industries' Form 10-K for the year ended December 31, 1992, is incorporated herein by reference. [2 pages]. 10.1.12 Retirement/Consultant Agreement, dated as of May 13, 1993, by and between Paul D. Foster and Terra International. [4 pages]. 10.1.13 Consulting Agreement, dated as of December 30, 1993, by and between Paul D. Foster and Terra International. [2 pages]. 10.1.14 1994 Incentive Award Program for Officers and Key Executives of Terra Industries. [3 pages]. 10.2 Asset Sale and Purchase Agreement among Inspiration Consolidated Copper Company and Cyprus Miami Mining Corporation and Cyprus Christmas Mine Corporation dated as of June 30, 1989, filed as Exhibit 10.19 to Terra Industries' Form 10-Q for the quarter ended September 30, 1989, is incorporated herein by reference. [83 pages]. 10.3.1 Stock Purchase Agreement, dated as of June 14, 1991, among Minorco, Kirkdale Investments Limited, Terra Industries and Hudson Holdings Corporation, filed as Exhibit 2 to Terra Industries' Form 8-K dated June 14, 1991, is incorporated herein by reference. [55 pages]. 10.3.2 Amended and Restated Stock Purchase Agreement, dated as of July 31, 1991, among Minorco, Kirkdale Investments Limited, Terra Industries and Hudson Holdings Corporation, filed as Exhibit 1 to Terra Industries' Form 8-K dated July 31, 1991, is incorporated herein by reference. [62 pages]. 10.3.3 Option Agreement, dated as of June 14, 1991, among Kirkdale Investments Limited and Terra Industries, filed as Exhibit 3 to Terra Industries' Form 8-K dated June 14, 1991, is incorporated herein by reference. [16 pages]. 10.3.4 Amendment to Stock Option Agreement, dated July 31, 1991, among Minorco, Kirkdale Investments Limited and Terra Industries, filed as Exhibit 2 to Terra Industries' Form 8-K dated July 31, 1991, is incorporated herein by reference. [3 pages]. 10.4 Asset and Sale Purchase Agreement, dated as of April 8, 1993, by and between Terra International, Inc., Terra International (Canada) Inc. and ICI Canada Inc., filed as Exhibit A to Terra Industries' Form 8-K dated April 8, 1993, is incorporated herein by reference. [95 pages]. 10.5 Asset Purchase Agreement, dated as of December 30, 1993, by and between Terra International, Inc., The Upjohn Company and Asgrow Florida Company, filed as Exhibit A to Terra Industries' Form 8-K dated December 31, 1993, is incorporated herein by reference. [71 pages]. 10.6 Lease, dated as of April 8, 1993, between W. Patrick Moroney and Terra International (Canada) Inc. [42 pages]. 13 Financial Review and Consolidated Financial Statements as Contained in the Annual Report to Stockholders of Terra Industries for the fiscal year ended December 31, 1993. [32 pages]. 21 Subsidiaries of Terra Industries. [3 pages]. 24 Powers of Attorney [8 pages].

821189_1993.txt

821189_1993

1993

821189

ITEM 1. BUSINESS GENERAL Enron Oil & Gas Company (the 'Company'), a Delaware corporation, is engaged in the exploration for, and the development and production of, natural gas and crude oil primarily in major producing basins in the United States and, to a lesser extent, in Canada, Trinidad and selected other international areas. At December 31, 1993, the Company's estimated net proved natural gas reserves were 1,772 billion cubic feet ('Bcf') and estimated net proved crude oil, condensate and natural gas liquids reserves were 20.9 million barrels ('MMBbl'). (See 'Supplemental Information to Consolidated Financial Statements'). At such date, approximately 78% of the Company's reserves (on a natural gas equivalent basis) was located in the United States, 16% in Canada and 6% in Trinidad. As of December 31, 1993, the Company employed approximately 690 persons. The Company's core areas are the Big Piney area in Wyoming, South Texas primarily centered in the Lobo Trend area, the Matagorda Trend area located in federal waters offshore Texas and the Canyon Trend located in West Texas. The Company's other domestic natural gas and crude oil producing properties are located primarily in other areas of Texas, Utah, New Mexico, Oklahoma and California. The Company also has natural gas and crude oil producing properties located in western Canada, primarily in the provinces of Alberta, Saskatchewan and Manitoba, and in Trinidad. At December 31, 1993, 95% of the Company's proved domestic reserves (on a natural gas equivalent basis) was natural gas and 5% was crude oil, condensate and natural gas liquids. A substantial portion of the Company's natural gas reserves is in long-lived fields with well established production histories. The opportunity exists to increase production in many of these fields through infill drilling. Enron Corp. currently owns 80% of the outstanding common stock of the Company. (See 'Relationship Between the Company and Enron Corp.'). Unless the context otherwise requires, all references herein to the Company include Enron Oil & Gas Company, its predecessors and subsidiaries. Unless the context otherwise requires, all references herein to Enron Corp. include Enron Corp., its predecessors and affiliates, other than the Company and its subsidiaries. With respect to information on the Company's working interest in wells or acreage, 'net' oil and gas wells or acreage are determined by multiplying 'gross' oil and gas wells or acreage by the Company's working interest in the wells or acreage. Unless otherwise defined, all references to wells are gross. BUSINESS SEGMENTS The Company's operations are all natural gas and crude oil exploration and production related. Accordingly, such operations are classified as one business segment. EXPLORATION AND PRODUCTION The Company's six principal U.S. producing areas are the Big Piney area, South Texas area, Matagorda Trend area, Canyon Trend area, Pitchfork Ranch field and Vernal area. Properties in these areas comprised approximately 76% of the Company's domestic reserves (on a natural gas equivalent basis) and 83% of the Company's maximum domestic net natural gas deliverability as of December 31, 1993 and are substantially all operated by the Company. The Company also has operations in Canada and in Trinidad and is conducting exploration in selected other international areas. BIG PINEY AREA. The Company's largest reserve accumulation is located in the Big Piney area in Sublette and Lincoln counties in southwestern Wyoming. The Company is the holder of the largest productive acreage base in this area, with approximately 200,000 net acres under lease directly within field limits. A portion of the natural gas production from new wells drilled during 1991 and 1992 on the Company's leases in the Big Piney area is classified as tight formation natural gas. (See 'Other Matters - Tight Gas Sand Tax Credits (Section 29) and Severance Tax Exemption'). The Company operates approximately 461 natural gas wells in this area in which it owns a 91% average working interest. Production from the area net to the Company averaged 126 million cubic feet ('MMcf') per day of natural gas and 1.4 thousand barrels ('MBbl') per day of crude oil, condensate, and natural gas liquids in 1993. At December 31, 1993, maximum natural gas deliverability net to the Company was approximately 138 MMcf per day. The current principal producing intervals are the Frontier and Mesaverde formations. The Frontier formation, which occurs at 6,500-10,000 feet, contains approximately 66% of the Company's current Big Piney reserves. The Company drilled 48 wells in the Big Piney area in 1993 and anticipates an active drilling program will continue for several years. SOUTH TEXAS AREA. The Company's activities in South Texas are focused in the Wilcox, Expanded Wilcox, Frio and Lobo producing horizons. The primary area of activity is in the Lobo Trend which occurs primarily in Webb and Zapata counties. The Company operates approximately 625 wells in the South Texas area. Production is primarily from the Lobo sand of the Wilcox formation at depths ranging from 7,000 to 11,000 feet. The Company has approximately 260,000 acres under lease in this area and a majority of the natural gas production from new wells drilled during 1991 and 1992 on Company leases in the South Texas Lobo area is classified as tight formation natural gas. (See 'Other Matters - Tight Gas Sand Tax Credits (Section 29) and Severance Tax Exemption'). Natural gas sales net to the Company averaged 225 MMcf per day in 1993. At December 31, 1993, maximum natural gas deliverability net to the Company was approximately 250 MMcf per day. The Company drilled 104 wells in the South Texas area in 1993 and anticipates an active drilling program will continue for several years. MATAGORDA TREND AREA. The Company has an interest in several fields in the Matagorda Trend area, located 20 miles south of Port O'Connor, Texas in federal waters. The Company has a 78% working interest in Block 638 and a 92% working interest in Block 620. In Matagorda Blocks 555, 556, 700 and 713, the Company has an approximate 70%, 50%, 62% and 64% working interest, respectively. In addition, the Company has an approximate 82% and 50% working interest in Mustang Island Blocks 758 and 784, respectively. The Company operates all of the offshore tracts mentioned above. Natural gas sales from these areas net to the Company averaged 59 MMcf per day in 1993. At December 31, 1993, maximum natural gas deliverability net to the Company from these blocks was approximately 76 MMcf per day. The Company expects to maintain an active drilling program in the Gulf of Mexico during 1994. CANYON TREND AREA. The Company has added approximately 90,000 acres in this area during the last five years. Activities have been concentrated in Sutton, Crockett and Terrell Counties, Texas where the Company drilled 324 natural gas wells during the period 1991 through 1993. The Company operates approximately 500 natural gas wells in this area in which it owns a 95% average working interest. Production is from the Canyon sands and Strawn limestone at depths from 5,500 to 9,500 feet. At December 31, 1993, maximum natural gas deliverability net to the Company was approximately 70 MMcf per day. The Company expects to maintain an active drilling program in the Canyon Trend area during 1994. (See 'Other Matters - Tight Gas Sand Tax Credits (Section 29) and Severance Tax Exemption'). PITCHFORK RANCH FIELD. The Pitchfork Ranch field located in Lea County, New Mexico, produces primarily from the Bone Spring, Atoka and Morrow formations. In 1993, natural gas sales net to the Company averaged 44 MMcf per day. At December 31, 1993, maximum natural gas deliverability net to the Company was approximately 46 MMcf per day. During 1993, the Company significantly increased reserves and deliverability through drilling and workovers. The Company expects to maintain an active drilling program in this field during 1994. (See 'Other Matters - Tight Gas Sand Tax Credits (Section 29) and Severance Tax Exemption'). VERNAL AREA. In the Vernal area, located primarily in Uintah County, Utah, the Company operates approximately 187 producing wells and presently controls approximately 75,000 net acres. A majority of the natural gas production from new wells drilled during 1991 and 1992 on the Company's leases in the Vernal area is classified as tight formation natural gas. (See 'Other Matters - Tight Gas Sand Tax Credits (Section 29) and Severance Tax Exemption'). In 1993, natural gas sales from the Vernal area averaged 24 MMcf per day compared with approximately 29 MMcf per day maximum deliverability, both net to the Company. Production is from the Green River and Wasatch formations located at depths between 4,500-8,000 feet. The Company has an average working interest of approximately 60%. The Company drilled 14 wells in the Vernal area in 1993 and expects to maintain a comparable drilling program during 1994. CANADA. The Company is engaged in the exploration for and the development and production of natural gas and crude oil and the operation of natural gas processing plants in western Canada, principally in the provinces of Alberta, Saskatchewan, and Manitoba. The Company conducts operations from offices in Calgary. Effective December 31, 1992, the Company consummated the acquisition of a natural gas property located in the Sandhills field in Saskatchewan. The property was further developed in 1993 through the drilling of 150 wells resulting in deliverability net to the Company from the Sandhills property of approximately 36 MMcf per day at December 31, 1993. Maximum Canadian natural gas deliverability net to the Company at December 31, 1993 was approximately 76 MMcf per day, and the Company held approximately 324,000 net undeveloped acres in Canada. The Company expects to maintain an active drilling program in Canada during 1994. TRINIDAD. In November 1992, the Company was awarded a 95% working interest concession in the South East Coast Consortium Block offshore Trinidad, previously held by three government-owned energy companies. Three undeveloped fields containing crude oil and natural gas rich with condensate are scheduled for development over the next three to five years. Existing surplus processing and transportation capacity at the Pelican Field facilities owned and operated by Trinidadian companies is being used to process and transport the production. Natural gas is being sold into the local market under a take-or-pay agreement with the National Gas Company of Trinidad and Tobago. At December 31, 1993, maximum natural gas deliverability net to the Company was approximately 40 MMcf per day and the Company held approximately 74,000 net undeveloped acres in Trinidad. As a result of continued development activities, natural gas deliveries were averaging approximately 60 MMcf per day and condensate deliveries were averaging approximately 3.3 MBbl per day net to the Company as of mid-March 1994. The Company expects to maintain an active development drilling program in this area in 1994. OTHER INTERNATIONAL. The Company continues to pursue selected other conventional natural gas and crude oil opportunities outside North America. In 1993, two unsuccessful wells were drilled in Malaysia and one in the United Kingdom North Sea area. During 1994, the Company will pursue other exploitation opportunities in countries where indigenous natural gas reserves have been identified, particularly where synergies in natural gas transportation, processing and power cogeneration can be optimized with other Enron Corp. affiliated companies. The Company currently is actively involved in an effort to obtain joint venture concessions involving two oil fields (Panna and Mukta) and one natural gas field (Tapti) offshore India in the Bombay High area. Resolution is anticipated by mid-1994. In 1993, the Company continued expansion of its international opportunity portfolio in the coalbed methane recovery arena. In September 1992, the Company entered into an operating agreement under which it is serving as operator with another partner in a venture in the Lorraine Basin in France and under which it exercised, in March 1994, an option to acquire a 50% working interest in the concession. In addition, a 100% working interest concession has been obtained in the Galilee Basin in Queensland, Australia. Protocols have also been signed and joint venture agreements are in the government approval process in both Russia and Kazakhstan; joint feasibility studies are underway in China; and, several other high potential countries are under active investigation. MARKETING WELLHEAD MARKETING. The Company's wellhead natural gas production is currently being sold on the spot market and under long-term natural gas contracts at market responsive prices. In many instances, the long-term contract prices closely approximate the prices received for natural gas being sold on the spot market. Approximately one-half of the Company's wellhead natural gas production is currently being sold to pipeline and marketing subsidiaries of Enron Corp. Substantially all of the Company's wellhead crude oil and condensate is sold under short-term contracts at market responsive prices. OTHER MARKETING. Enron Oil & Gas Marketing, Inc. ('EOGM'), a wholly-owned subsidiary of the Company, is a marketing company engaging in various marketing activities. Both the Company and EOGM contract to provide, under long-term agreements, natural gas to various purchasers and then aggregate the necessary supplies for the sales with purchases from various sources including third-party producers, marketing companies, pipelines or from the Company's own production. In addition, EOGM has purchased and constructed several small gathering systems in order to facilitate its entry into the gathering business on a limited basis. EOGM anticipates providing gathering services when such activity will enhance its capability as an aggregator and marketer. Both EOGM and the Company utilize other short and long-term hedging mechanisms including sales and purchases in the futures market and price swap agreements. These marketing activities have provided an effective balance in managing the Company's exposure to commodity price risks in the energy market. In September 1992, the Company sold a volumetric production payment for $326.8 million to a limited partnership of which an Enron Corp. affiliated company is general partner with a 1% interest. Under the terms of the production payment agreements, the Company conveyed a real property interest of approximately 124 billion cubic feet equivalent ('Bcfe') (136 trillion British thermal units) of natural gas and other hydrocarbons in the Big Piney area of Wyoming. Effective October 1, 1993, the agreements were amended providing for the extension of the original term of the volumetric production payment through March 31, 1999 and including a revised schedule of daily quantities of hydrocarbons to be delivered which is approximately one-half of the original schedule. The revised schedule will total approximately 89.1 Bcfe (97.8 trillion British thermal units) versus approximately 87.9 Bcfe (96.4 trillion British thermal units) remaining to be delivered under the original agreement. Daily quantities of hydrocarbons no longer required to be delivered under the revised schedule during the period from October 1, 1993 through June 30, 1996 are available for sale by the Company. The Company retains responsibility for its working interest share of the cost of operations. The Company also entered into a separate agreement with the same limited partnership whereby it has agreed to exchange volumes owned by the Company in the Midcontinent area and the Texas Gulf Coast area for equivalent volumes produced and owned by the limited partnership in the Big Piney area. The costs incurred, if any, to effect redeliveries pursuant to such exchange are borne by the Company. The Company also has contracted to supply natural gas to a Texas City, Texas cogeneration facility which is owned by Cogenron Inc. Cogenron Inc. is 50% owned by Enron Corp. The primary contract provides for the sale of natural gas under a fixed schedule of prices substantially above current spot market prices. Current deliveries of approximately 45 MMcf of natural gas per day are being supplied primarily by purchases at market responsive prices under a long-term agreement with an Enron Corp. subsidiary. The Company has also entered into a price swap agreement with a third party that has the effect of converting the prices under this contract to a fixed schedule of prices. The resulting prices under this combination of purchase and price swap agreements are substantially below the fixed schedule of prices in the primary sales contract. The arrangements are designed, as to the volumes involved, to provide the Company a fixed margin of profit under its agreement with Cogenron Inc. However, the Company's commitment to deliver volumes of natural gas in excess of the current delivery levels at the schedule of predetermined prices discussed above could be disadvantageous to the Company during any time spot market prices exceed the applicable contract prices for natural gas. WELLHEAD VOLUMES AND PRICES, AND LEASE AND WELL EXPENSES The following table sets forth certain information regarding the Company's wellhead volumes of and average prices for natural gas per thousand cubic feet ('Mcf'), crude oil and condensate, and natural gas liquids per barrel ('Bbl'), and average lease and well expenses per thousand cubic feet equivalent ('Mcfe' - natural gas equivalents are determined using the ratio of 6.0 Mcf of natural gas to 1.0 barrel of crude oil and condensate or natural gas liquids) delivered during each of the three years in the period ended December 31, 1993: YEAR ENDED DECEMBER 31, 1993 1992 1991 VOLUMES (PER DAY) Natural Gas (MMcf) United States---------------- 648.6(1) 533.6(1) 465.8 Canada----------------------- 58.4 30.0 24.8 Trinidad--------------------- 2.3 - - Total---------------------- 709.3(1) 563.6(1) 490.6 Crude Oil and Condensate (MBbl) United States---------------- 6.6 6.3 5.9 Canada----------------------- 2.2 2.2 2.3 Trinidad--------------------- .1 - - Total---------------------- 8.9 8.5 8.2 Natural Gas Liquids (MBbl) United States---------------- .2 .3 .3 Canada----------------------- .4 .4 .3 Trinidad--------------------- - - - Total---------------------- .6 .7 .6 AVERAGE PRICES Natural Gas ($/Mcf) United States---------------- $ 1.97(2) $ 1.61(2) $ 1.38 Canada----------------------- 1.34 1.18 1.32 Trinidad--------------------- .89 - - Composite------------------ 1.92(2) 1.58(2) 1.37 Crude Oil and Condensate ($/Bbl) United States---------------- $ 16.96 $ 18.29 $ 19.24 Canada----------------------- 14.63 16.80 17.58 Trinidad--------------------- 14.36 - - Composite------------------ 16.37 17.90 18.78 Natural Gas Liquids ($/Bbl) United States---------------- $ 13.85 $ 11.56 $ 10.79 Canada----------------------- 9.46 10.05 12.48 Trinidad--------------------- - - - Composite------------------ 11.12 10.69 11.64 LEASE AND WELL EXPENSES ($/MCFE) United States---------------- $ .18 $ .20 $ .23 Canada----------------------- .48 .50 .57 Trinidad--------------------- 1.46 - - Composite------------------ .21 .22 .25 (1) Includes 81.0 MMcf per day in 1993 and 27.6 MMcf per day in 1992 delivered under the terms of a volumetric production payment agreement effective October 1, 1992, as amended. (2) Includes an average equivalent wellhead value of $1.57 per Mcf in 1993 and $1.70 per Mcf in 1992 for the volumes described in note (1), net of transportation costs. OTHER NATURAL GAS MARKETING VOLUMES AND PRICES The following table sets forth certain information regarding the Company's volumes of natural gas delivered under other marketing and volumetric production payment arrangements, and resulting average of sales prices and per unit amortization of deferred revenues along with associated costs during each of the three years in the period ended December 31, 1993. (See 'Marketing' for a discussion of other natural gas marketing arrangements and agreements). YEAR ENDED DECEMBER 31, 1993 1992 1991 Volumes (MMcf per day)--------------- 293.4(1) 254.9(1) 237.2 Average Gross Revenue ($/Mcf)-------- $ 2.57(2) $ 2.62(2) $ 2.63 Associated Costs ($/Mcf)(4)---------- 2.32(3) 1.99(3) 1.75 Margin ($/Mcf)----------------------- $ 0.25 $ 0.63 $ 0.88 (1) Includes 81.0 MMcf per day in 1993 and 27.6 MMcf per day in 1992 delivered under the terms of volumetric production payment and exchange agreements effective October 1, 1992, as amended. (2) Includes per unit deferred revenue amortization for the volumes detailed in note (1) at an equivalent of $2.50 per Mcf ($2.40 per million British thermal units) in 1993 and $2.51 per Mcf ($2.40 per million British thermal units) in 1992. (3) Includes an average value of $2.20 per Mcf in 1993 and $2.37 per Mcf in 1992, including average equivalent wellhead value, any applicable transportation costs and exchange differentials, for the volumes detailed in note (1). (4) Including transportation and exchange differentials. COMPETITION The Company actively competes for reserve acquisitions and exploration leases, licenses and concessions, frequently against companies with substantially larger financial and other resources. To the extent the Company's exploration budget is lower than that of certain of its competitors, the Company may be disadvantaged in effectively competing for certain reserves, leases, licenses and concessions. Competitive factors include price, contract terms, and quality of service, including pipeline connection times and distribution efficiencies. In addition, the Company faces competition from other producers and suppliers, including competition from Canadian natural gas. REGULATION DOMESTIC REGULATION OF NATURAL GAS AND CRUDE OIL PRODUCTION. Natural gas and crude oil production operations are subject to various types of regulation, including regulation in the United States by state and federal agencies. Domestic legislation affecting the oil and gas industry is under constant review for amendment or expansion. Also, numerous departments and agencies, both federal and state, are authorized by statute to issue and have issued rules and regulations which, among other things, require permits for the drilling of wells, regulate the spacing of wells, prevent the waste of natural gas and crude oil resources through proration, require drilling bonds and regulate environmental and safety matters. The regulatory burden on the oil and gas industry increases its cost of doing business and, consequently, affects its profitability. A substantial portion of the Company's oil and gas leases in the Big Piney area and in the Gulf of Mexico, as well as some in other areas, are granted by the federal government and administered by the Bureau of Land Management (the 'BLM') and the Minerals Management Service (the 'MMS') federal agencies. Operations conducted by the Company on federal oil and gas leases must comply with numerous statutory and regulatory restrictions. Certain operations must be conducted pursuant to appropriate permits issued by the BLM and the MMS. Sales of crude oil, condensate and natural gas liquids by the Company are made at unregulated market prices. The transportation and sale for resale of natural gas in interstate commerce are regulated pursuant to the Natural Gas Act of 1938 (the 'NGA') and the Natural Gas Policy Act of 1978 (the 'NGPA'). These statutes are administered by the Federal Energy Regulatory Commission (the 'FERC'). Effective January 1, 1993, the Natural Gas Wellhead Decontrol Act of 1989 deregulated natural gas prices for all 'first sales' of natural gas, which includes all sales by the Company of its own production. Consequently, sales of the Company's natural gas currently may be made at market prices, subject to applicable contract provisions. Regulation of natural gas importation is administered primarily by the Department of Energy's Office of Fossil Energy (the 'DOE/FE'), pursuant to the NGA. The NGA provides that any party seeking to import natural gas must first seek DOE/FE authorization, which authorization may be granted, modified or denied in accordance with the public interest. The Energy Policy Act of 1992 amended the NGA's public interest standard with respect to imports from and exports to certain countries, such as Canada, to deem imports from and exports to such countries to be in the public interest, and require such import/export applications to be granted without delay. In addition, the Energy Policy Act amended the NGPA to treat natural gas imported from Canada as 'first sales' of natural gas under Section 3 of the NGPA, thus allowing such imported natural gas to be sold for resale without certificate authorization from the FERC. Additionally, the National Energy Board of Canada has dramatically revised its natural gas export policies to permit large volumes of Canadian natural gas to compete with natural gas produced in the U.S. for the U.S. spot market. Additional natural gas pipeline capacity from Canada to the U.S. has been built and other such construction proposals are pending approval. While the impact on the Company of this change is uncertain, it is possible that it will increase competition in the markets in which the Company sells natural gas. For example, Canadian natural gas competes directly with natural gas produced from the Company's Big Piney area for customers located in the Pacific Northwest region of the United States. Since 1985, the FERC has endeavored to make natural gas transportation more accessible to gas buyers and sellers on an open and non-discriminatory basis. These efforts have significantly altered the marketing and pricing of natural gas. The FERC's latest action in this area is Order No. 636, issued in April 1992, which mandates a fundamental restructuring of interstate pipeline sales and transportation services. Order No. 636 requires interstate natural gas pipelines to 'unbundle' or segregate the sales, transportation, storage, and other components of their existing city-gate sales service, and to separately state the rates for each unbundled service. Under Order No. 636, unbundled pipeline sales can be made only in the production areas. Order No. 636 also requires interstate pipelines to assign capacity rights they have on upstream pipelines to such pipelines' former sales customers and provides for the recovery by interstate pipelines of costs associated with the transition from providing bundled sales services to providing unbundled transportation and storage services. The purpose of Order No. 636 is to further enhance competition in the natural gas industry by assuring the comparability of pipeline sales service and services offered by a pipelines' competitors. Various aspects of Order No. 636 were challenged, including alleged shifts of costs between pipeline customer groups and the continuing reliability of unbundled services. In two subsequent orders on rehearing of Order No. 636, namely Order Nos. 636-A and 636-B, the FERC modified the original order in response to these and other concerns. As of early February 1994, the FERC had issued final orders accepting most pipelines' Order No. 636 compliance filings. Numerous parties have filed petitions for court review of Order Nos. 636, 636-A and 636-B, as well as orders in individual pipeline restructuring proceedings. Upon such judicial review, these orders may be reversed in whole or in part. Order No. 636 does not directly regulate the Company's activities, but has had and will have an indirect effect because of its broad scope. With Order No. 636 only partially implemented and subject to court review, it is difficult to predict with precision its effects. In many instances, however, Order No. 636 has substantially reduced or brought to an end interstate pipelines' traditional role as wholesalers of natural gas in favor of providing only storage and transportation services. Order No. 636 has also created substantial uncertainty with respect to the marketing and transportation of natural gas. In spite of this uncertainty, Order No. 636 may enhance the Company's ability to market and transport its natural gas production. In December 1992, the FERC issued Order No. 547, governing the issuance of blanket marketer sales certificates to all natural gas sellers other than interstate pipelines. The order eliminates the need for natural gas producers and marketers to seek specific authorization under Section 7 of the NGA from the FERC to make sales of natural gas, such as imported natural gas and natural gas purchased from interstate pipelines. Instead, effective January 7, 1993, these natural gas sellers, by operation of the order, will be issued blanket certificates of public convenience and necessity allowing them to make jurisdictional natural gas sales for resale at negotiated rates without seeking specific FERC authorization. For marketers affiliated with interstate pipelines, Order No. 547 becomes effective for sales involving each affiliated pipeline as that pipeline complies with Order No. 636. The FERC intends Order No. 547, in tandem with Order No. 636, to foster a competitive market for natural gas by giving natural gas purchasers access to multiple supply sources at market-driven prices. The Company, as a natural gas producer, is covered by Order No. 547 and stands to benefit from the opportunity to market natural gas more freely under the blanket certificate as well as from the potential improvement in access to multiple natural gas purchasers. In December 1993, the FERC issued Order No. 497-E, which modified in some respects the standards of conduct, record keeping and reporting requirements and other measures that govern relationships between interstate pipelines and their marketing affiliates. Order No. 497-E narrowed the contemporaneous disclosure standard of conduct and the reporting requirements, while at the same time possibly expanding the class of pipeline and marketing affiliate employees to whom the standards of conduct apply. Order No. 497-E also extended until June 1994 the sunset date of the reporting requirements. The FERC simultaneously issued a notice of proposed rulemaking to revise these reporting requirements, which would establish new rules to go into effect before the June 1994 sunset date. Order No. 497 does not directly regulate the Company's activities, although a substantial portion of the Company's natural gas production is sold to or transported by interstate pipeline affiliates which are subject to the Order. The Company's activities may therefore be indirectly affected by these regulations. The Company owns, directly or indirectly, certain natural gas pipelines that it believes meet the traditional tests the FERC has used to establish a pipeline's status as a gatherer not subject to FERC jurisdiction under the NGA. State regulation of gathering facilities generally includes various safety, environmental, and in some circumstances, non-discriminatory take requirements, but does not generally entail rate regulation. Natural gas gathering may receive greater regulatory scrutiny at both the state and federal levels as the pipeline restructuring under Order No. 636 is implemented. For example, the State of Oklahoma recently enacted a prohibition against discriminatory gathering rates. In certain recent cases, the FERC has asserted ancillary NGA jurisdiction over gathering activities of interstate pipelines and their affiliates. In addition, the FERC recently convened a conference to consider issues relating to gathering services performed by interstate pipelines or their affiliates. The FERC intends to use information obtained to reevaluate the appropriateness of its traditional gathering criteria in light of Order No. 636 and to establish consistent policies for gathering rates and services for both interstate pipelines and their affiliates. It is not possible at this time to predict the outcome of this proceeding although it could ultimately affect access to and gathering rates for interstate gathering services. The Company's gathering operations could be adversely affected should they be subject in the future to the application of state or federal regulation of rates and services. The Company cannot predict the effect that any of the aforementioned orders or the challenges to such orders will ultimately have on the Company's operations. Additional proposals and proceedings that might affect the natural gas industry are pending before Congress, the FERC and the courts. The Company cannot predict when or whether any such proposals or proceedings may become effective. It should also be noted that the natural gas industry historically has been very heavily regulated; therefore, there is no assurance that the less regulated approach currently being pursued by the FERC will continue indefinitely. Thus, the Company cannot predict the ultimate outcome or durability of the unbundled regulatory regime mandated by Order No. 636. ENVIRONMENTAL REGULATION. Various federal, state and local laws and regulations covering the discharge of materials into the environment, or otherwise relating to the protection of the environment, may affect the Company's operations and costs as a result of their effect on natural gas and crude oil exploration, development and production operations. 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 exploration and development expenditure 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 compliance. The Company has been named as a potentially responsible party in one Comprehensive Environmental Response Compensation and Liability Act proceeding. However, management does not believe that any potential assessment resulting from such proceeding will have a materially adverse effect on the financial condition or results of operations of the Company. CANADIAN REGULATION. In Canada, the petroleum industry operates under Federal, provincial and municipal legislation and regulations governing land tenure, royalties, production rates, pricing, environmental protection, exports and other matters. The price of natural gas and crude oil in Canada has been deregulated and is now determined by market conditions and negotiations between buyers and sellers. Various matters relating to the transportation and export of natural gas continue to be subject to regulation by both provincial and Federal agencies; however, the North American Free Trade Agreement has reduced the risk of altering cross-border commercial transactions. Canadian governmental regulations may have a material effect on the economic parameters for engaging in oil and gas activities in Canada and may have a material effect on the advisability of investments in Canadian oil and gas drilling activities. The Company is monitoring political, regulatory and economic developments in Canada. RELATIONSHIP BETWEEN THE COMPANY AND ENRON CORP. OWNERSHIP OF COMMON STOCK. Enron Corp. owns 80% of the outstanding shares of common stock of the Company and, through its ability to elect all directors of the Company, has the ability to control all matters relating to the management of the Company, including any determination with respect to acquisition or disposition of Company assets, future issuance of common stock or other securities of the Company and any dividends payable on the common stock. Enron Corp. also has the ability to control the Company's exploration, development, acquisition and operating expenditure plans. If Enron Corp. should sell a substantial amount of the common stock of the Company that it owns, such action could adversely affect the prevailing market price for the common stock and could impair the Company's ability to raise capital through the sale of its equity securities. In addition, a sale by Enron Corp. of any common stock owned by Enron Corp. would cause Enron Corp.'s ownership interest in the Company to fall below 80% with the result that (i) the Company would cease to be included in the consolidated federal income tax return filed by Enron Corp. and (ii) the tax allocation agreement between the Company and Enron Corp. described below would terminate. The Company has granted certain registration rights to Enron Corp. with respect to the common stock owned by Enron Corp. (See 'Contractual Arrangements' below). There is no agreement between Enron Corp. and any other party, including the Company, that would prevent Enron Corp. from acquiring additional shares of common stock of the Company. CONTRACTUAL ARRANGEMENTS. The Company entered into a Services Agreement (the 'Services Agreement') with Enron Corp. effective January 1989, pursuant to which Enron Corp. provided various services, such as maintenance of certain employee benefit plans, provision of telecommunications and computer services, lease of office space and the provision of purchasing and operating services and certain other corporate staff and support services. Such services historically have been supplied to the Company by Enron Corp., and the Services Agreement provided for the further delivery of such services substantially identical in nature and quality to those services previously provided. The Company agreed to a fixed rate for the rental of office space and to reimburse Enron Corp. for all other direct costs incurred in rendering services to the Company under the contract and to pay Enron Corp. for allocated indirect costs incurred in rendering such services up to an annual maximum of $8 million, such cap to be increased for inflation and certain changes in the Company's allocation bases with the increase limited to a maximum of 10% per year. The Services Agreement was for an initial term of five years through December 1993. Effective January 1, 1994, the Company and Enron Corp. entered into a new services agreement (the 'New Services Agreement') pursuant to which Enron Corp. will, among other things, provide for the Company similar services substantially identical in nature and quality to those provided under terms of the previous agreement. The Company has agreed to pay and to reimburse Enron Corp. on bases essentially consistent with those included in the previous agreement, except that allocated indirect costs are subject to an annual maximum of $6.7 million for the year 1994 with any increase in such maximum for subsequent years not to exceed 7.5% per year. The New Services Agreement is for an initial term of five years through December 1998 and will continue thereafter until terminated by either party. The Company is included in the consolidated federal income tax return filed by Enron Corp. as the common parent for itself and its subsidiaries and affiliated companies, excluding any foreign subsidiaries. Consistent therewith and pursuant to a Tax Allocation Agreement (the 'Tax Agreement') between the Company, the Company's subsidiaries and Enron Corp., either Enron Corp. will pay to the Company and each subsidiary an amount equal to the tax benefit realized in the Enron Corp. consolidated federal income tax return resulting from the utilization of the Company's or the subsidiary's net operating losses and/or tax credits, or the Company and each subsidiary will pay to Enron Corp. an amount equal to the federal income tax computed on its separate taxable income less the tax benefits associated with any net operating losses and/or tax credits generated by the Company or the subsidiary which are utilized in the Enron Corp. consolidated return. Enron Corp. will pay the Company and each subsidiary for the tax benefits associated with their net operating losses and tax credits utilized in the Enron Corp. consolidated return, provided that a tax benefit was realized except as discussed in the following paragraph, even if such benefits could not have been used by the Company or the subsidiary on a separately filed tax return. In 1991, the Company and Enron Corp. modified the Tax Agreement to provide that, through 1992, the Company will realize the benefit of certain tight gas sand federal income tax credits available to the Company on a stand alone basis. The Company has also entered into an agreement with Enron Corp. providing for the Company to be paid for all realizable benefits associated with tight gas sand federal income tax credits concurrent with tax reporting and settlement for the periods in which they are generated. (See 'Other Matters Tight Gas Sand Tax Credits (Section 29) and Severance Tax Exemption'). The Tax Agreement applies to the Company and each of its subsidiaries for all years in which the Company or any of its subsidiaries are or were included in the Enron Corp. consolidated return. To the extent a state or other taxing jurisdiction requires or permits a consolidated, combined, or unitary tax return to be filed and such return includes the Company or any of its subsidiaries, the principles expressed with respect to consolidated federal income tax allocation shall apply. Pursuant to the terms of a Stock Restriction and Registration Agreement with Enron Corp., the Company has agreed that upon the request of Enron Corp. (or certain assignees), the Company will register under the Securities Act of 1933 and applicable state securities laws the sale of the Company common stock owned by Enron Corp. which Enron Corp. has requested to be registered. The Company's obligation is subject to certain limitations relating to a minimum amount of common stock required for registration, the timing of registration and other similar matters. The Company is obligated to pay all expenses incidental to such registration, excluding underwriters' discounts and commissions and certain legal fees and expenses. CONFLICTS OF INTEREST. The nature of the respective businesses of the Company and Enron Corp. and its affiliates is such as to potentially give rise to conflicts of interest between the two companies. Conflicts could arise, for example, with respect to transactions involving purchases, sales and transportation of natural gas and other business dealings between the Company and Enron Corp. and its affiliates, potential acquisitions of businesses or oil and gas properties, the issuance of additional shares of voting securities, the election of directors or the payment of dividends by the Company. Enron Corp. has advised the Company that it does not currently intend to engage in the exploration for and/or development and production of natural gas and crude oil except through its ownership of common stock of the Company. However, circumstances may arise that would cause Enron Corp. to engage in the exploration for and/or development and production of natural gas and crude oil in competition with the Company. For example, opportunities might arise which would require financial resources greater than those available to the Company or which are located in areas or countries in which the Company does not intend to operate. Also, Enron Corp. might acquire a competing oil and gas business as part of a larger acquisition. In addition, as part of Enron Corp.'s strategy of securing supplies of natural gas, Enron Corp. may from time to time acquire producing properties, and thereafter engage in exploration, development and production activities with respect to such properties. Such acquisition, exploration, development and production activities may directly or indirectly compete with the Company's business. Thus, there can be no assurances that Enron Corp. will not engage in the natural gas and crude oil exploration, development and production business in competition with the Company. The Company and Enron Corp. and its affiliates have in the past entered into significant intercompany transactions and agreements incident to their respective businesses, and the Company and Enron Corp. and its affiliates may be expected to enter into material transactions and agreements from time to time in the future. Such transactions and agreements have related to, among other things, the purchase and sale of natural gas, the financing of exploration and development efforts by the Company, and the provision of certain corporate services. (See 'Marketing' and the Consolidated Financial Statements and notes thereto). The Company believes that its existing transactions and agreements with Enron Corp. and its affiliates have been at least as favorable to the Company as could be obtained from third parties, and the Company intends that the terms of any future transactions and agreements between the Company and Enron Corp. and its affiliates will be at least as favorable to the Company as could be obtained from third parties. OTHER MATTERS ENERGY PRICES. Since the Company is primarily a natural gas company, it is more significantly impacted by changes in natural gas prices than in the prices for crude oil, condensate and natural gas liquids. During recent periods, natural gas has been priced significantly below parity with crude oil, condensate and natural gas liquids based on the energy equivalency of, and differences in transportation and processing costs associated with, the respective products. This imbalance in parity has been primarily driven by, among other things, a supply of domestic natural gas volumes in excess of demand requirements. The Company is unable to predict when this supply imbalance may resolve due to the significant impacts of factors such as general economic conditions, weather and other international energy supplies over which the Company has no control. However, during the latter part of 1993, certain shifts in the pricing structure for natural gas and crude oil and condensate suggest that the significance of the lack of parity between natural gas and crude oil and condensate pricing may be beginning to lessen. Natural gas prices have fluctuated, at times rather dramatically, during the last three years. These fluctuations have resulted in an overall increase in average wellhead natural gas prices realized by the Company of 15% from 1991 to 1992 and 22% from 1992 to 1993. Due to the many uncertainties associated with the world political environment, the availabilities of other world wide energy supplies and the relative competitive relationships of the various energy sources in the view of the consumers, the Company is unable to predict what changes may occur in natural gas prices in the future. Crude oil and condensate prices also have fluctuated, at times rather dramatically, during the last three years. These fluctuations have resulted in an overall decline in average wellhead crude and condensate prices realized by the Company of 5% from 1991 to 1992 and 9% from 1992 to 1993. Due to the many uncertainties associated with the world political environment, the availabilities of other world wide energy supplies and the relative competitive relationships of the various energy sources in the view of the consumers, the Company is unable to predict what changes may occur in crude oil and condensate prices in the future. TIGHT GAS SAND TAX CREDITS (SECTION 29) AND SEVERANCE TAX EXEMPTION. Federal tax law provides a tax credit for production of certain fuels produced from nonconventional sources (including natural gas produced from tight formations), subject to a number of limitations. Fuels qualifying for the credit must be produced from a well drilled or a facility placed in service before January 1, 1993, and must be sold before January 1, 2003. The credit, which is currently approximately $.52 per MMBtu of natural gas, is computed by reference to the price of crude oil, and is phased out as the price of crude oil exceeds $23.50 in 1980 dollars (adjusted for inflation) with complete phaseout if such price exceeds $29.50 in 1980 dollars (similarly adjusted). Under this formula, the commencement of phaseout would be triggered if the average price for crude oil rose above approximately $43 per barrel in current dollars. Significant benefits from the tax credit are accruing to the Company since a portion (and in some cases a substantial portion) of the Company's natural gas production from new wells drilled after November 5, 1990, and before January 1, 1993, on the Company's leases in several of the Company's significant producing areas qualify for this tax credit. Certain natural gas production from wells spudded or completed after May 24, 1989 and before September 1, 1996 in tight formations in Texas qualifies for a ten-year exemption, ending August 31, 2001, from Texas severance taxes, subject to certain limitations. OTHER. All of the Company's oil and gas activities are subject to the risks normally incident to the exploration for and development and production of natural gas and crude oil, including blowouts, cratering and fires, each of which could result in damage to life and property. Offshore operations are subject to usual marine perils, including hurricanes and other adverse weather conditions, and governmental regulations as well as interruption or termination by governmental authorities based on environmental and other considerations. In accordance with customary industry practices, insurance is maintained by the Company against some, but not all, of the risks. Losses and liabilities arising from such events could reduce revenues and increase costs to the Company to the extent not covered by insurance. The Company's overseas operations are subject to certain risks, including expropriation of assets, risks of increases in taxes and government royalties, renegotiation of contracts with foreign governments, political instability, payment delays, limits on allowable levels of production and current exchange and repatriation losses, as well as changes in laws and policies governing operations of overseas-based companies generally. CURRENT EXECUTIVE OFFICERS OF THE REGISTRANT The current executive officers of the Company and their names and ages are as follows: NAME AGE POSITION Forrest E. Hoglund----------------- 60 Chairman of the Board, President and Chief Executive Officer; Director Joe Michael McKinney--------------- 54 President-International Operations Mark G. Papa----------------------- 47 President-North American Operations George E. Uthlaut------------------ 60 Senior Vice President-Operations Walter C. Wilson------------------- 51 Senior Vice President and Chief Financial Officer Ben B. Boyd------------------------ 52 Vice President and Controller Dennis M. Ulak--------------------- 40 Vice President and General Counsel Forrest E. Hoglund joined the Company as Chairman of the Board, Chief Executive Officer and Director in September 1987. Since May 1990, he has also served as President of the Company. Mr. Hoglund was a director of USX Corporation from February 1986 until September 1987. He joined Texas Oil & Gas Corp. ('TXO') in 1977 as president, was named Chief Operating Officer in 1979, Chief Executive Officer in 1982, and served TXO in those capacities until September 1987. Mr. Hoglund is also a director of Texas Commerce Bancshares, Inc. Joe Michael McKinney has been President-International Operations since February 1994 with responsibilities for all exploration, drilling, production and engineering activities for the Company's international ventures outside North America. Mr. McKinney joined Enron Exploration Company, a wholly-owned subsidiary of the Company, in December 1991 as Senior Vice President of Operations and was elected President and Chief Operating Officer of Enron Exploration Company in April 1993, a capacity in which he continues to serve. Prior to joining the Company, Mr. McKinney held operations management positions with Union Texas Petroleum Company, The Superior Oil Company and Exxon Company, USA. Mark G. Papa has been President-North American Operations since February 1994. From May 1986 through January 1994, Mr. Papa served as Senior Vice President-Operations. Mr. Papa joined Belco Petroleum Corporation, a predecessor of the Company, in 1981 as Division Production Coordinator and served as Senior Vice President-Drilling and Production, BelNorth Petroleum Corporation from May 1984 until May 1986. George E. Uthlaut has been Senior Vice President-Operations of the Company since November 1987. Mr. Uthlaut was previously employed by Exxon Corporation (and affiliates) for 29 years in a number of managerial and technical positions. His last position was Headquarters Operations Manager, Production Department, Exxon Company, USA. Walter C. Wilson has been Senior Vice President and Chief Financial Officer since May 1991. Mr. Wilson joined the Company in November 1987 as Vice President and Controller and was named Senior Vice President-Finance in October 1988. Prior to joining the Company Mr. Wilson held financial management positions with Exxon Company, USA for 16 years and The Superior Oil Company for 4 years. Ben B. Boyd has been Vice President and Controller since March 1991. Mr. Boyd joined the Company in March 1989 as Director of Accounting and was named Controller in May 1990. Prior to joining the Company, Mr. Boyd held financial management positions with DeNovo Oil & Gas, Inc., Scurlock Oil Company and Coopers & Lybrand. Dennis M. Ulak has been Vice President and General Counsel since March 1992. Mr. Ulak joined the Company in March 1987 as Senior Counsel and was named Assistant General Counsel in August 1990. Prior to joining the Company, Mr. Ulak held various legal positions with Enron Corp. and Northern Natural Gas Company. ITEM 2. ITEM 2. PROPERTIES OIL AND GAS EXPLORATION AND PRODUCTION PROPERTIES AND RESERVES RESERVE INFORMATION. For estimates of the Company's net proved and proved developed reserves of natural gas and liquids, including crude oil, condensate and natural gas liquids, see 'Supplemental Information to Consolidated Financial Statements.' There are numerous uncertainties inherent in estimating quantities of proved reserves and in projecting future rates of production and timing of development expenditures, including many factors beyond the control of the producer. The reserve data set forth in Supplemental Information to Consolidated Financial Statements represent only estimates. Reserve engineering is a subjective process of estimating underground accumulations of natural gas and liquids, including crude oil, condensate and natural gas liquids, that cannot be measured in an exact manner. The accuracy of any reserve estimate is a function of the amount and quality of available data and of engineering and geological interpretation and judgment. As a result, estimates of different engineers normally 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 ultimately recovered. The meaningfulness of such estimates is highly dependent upon the accuracy of the assumptions upon which they were 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. Volumes generated from future activities of the Company are therefore highly dependent upon the level of success in acquiring or finding additional reserves and the costs incurred in doing so. The Company's estimates of reserves filed with other federal agencies agree with the information set forth in Supplemental Information to Consolidated Financial Statements. ACREAGE. The following table summarizes the Company's developed and undeveloped acreage at December 31, 1993. Excluded is acreage in which the Company's interest is limited to owned royalty, overriding royalty and other similar interests. PRODUCING WELL SUMMARY. The following table reflects the Company's ownership in gas wells in 316 fields and oil wells in 75 fields located in Texas, offshore Texas and Louisiana in the Gulf of Mexico, Oklahoma, New Mexico, Utah, Wyoming, California and various other states, Canada and Trinidad at December 31, 1993. Gross oil and gas wells include 229 with multiple completions. PRODUCTIVE WELLS GROSS NET Gas---------------------------------- 4,674 3,170 Oil---------------------------------- 884 527 Total---------------------------- 5,558 3,697 DRILLING AND ACQUISITION ACTIVITIES. During the years ended December 31, 1993, 1992 and 1991 the Company spent approximately $430.1, $395.7 and $254.8 million, respectively, for exploratory and development drilling and acquisition of leases and producing properties. The Company drilled, participated in the drilling of or acquired wells as set out in the table below for the periods indicated: All of the Company's drilling activities are conducted on a contract basis with independent drilling contractors. The Company owns no drilling equipment. ITEM 3. ITEM 3. LEGAL PROCEEDINGS The Company and its subsidiaries and related companies are named defendants in numerous lawsuits and named parties in numerous governmental proceedings arising in the ordinary course of business. While the outcome of lawsuits or other proceedings against the Company cannot be predicted with certainty, management does not expect these matters to have a material adverse effect on the financial condition or results of operations of the Company. TransAmerican Natural Gas Corporation ('TransAmerican') has filed a petition against the Company and Enron Corp. alleging breach of contract, tortious interference with contract, misappropriation of trade secrets and violation of state antitrust laws. The petition, as amended, seeks actual damages of $100 million plus exemplary damages of $300 million. The Company has answered the petition and is actively defending the matter; in addition, the Company has filed counterclaims against TransAmerican and a third-party claim against its sole shareholder, John R. Stanley, alleging fraud, negligent misrepresentation and breach of state antitrust laws. Trial, originally set for February 7, 1994, is now set for September 12, 1994. Although no assurances can be given, the Company believes that the claims made by TransAmerican are totally without merit, that the ultimate resolution of the matter will not have a materially adverse effect on its financial condition or results of operations, and that such ultimate resolution could result in a recovery to the Company. 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 SHAREHOLDER MATTERS The following table sets forth, for the periods indicated, the high and low sale prices per share for the common stock, as reported on the New York Stock Exchange Composite Tape, and the amount of cash dividends paid per share. PRICE RANGE CASH HIGH LOW DIVIDENDS First Quarter-------------------- 22.25 16.25 .05 Second Quarter------------------- 21.50 18.00 .05 Third Quarter-------------------- 24.63 17.63 .05 Fourth Quarter------------------- 25.13 19.25 .05 First Quarter-------------------- 21.88 16.63 .05 Second Quarter------------------- 27.25 20.50 .05 Third Quarter-------------------- 35.88 25.38 .05 Fourth Quarter------------------- 34.38 27.50 .05 First Quarter-------------------- 40.63 26.75 .06 Second Quarter------------------- 45.00 35.75 .06 Third Quarter-------------------- 53.63 39.75 .06 Fourth Quarter------------------- 54.00 34.13 .06 As of March 1, 1994, there were approximately 500 record holders of the Company's common stock, including individual participants in security position listings. There are an estimated 5,600 beneficial owners of the Company's common stock, including shares held in street name. Following the initial public offering and sale of its common stock in October 1989, the Company paid quarterly dividends of $0.05 per share beginning with an initial dividend paid in January 1990 with respect to the fourth quarter of 1989. Beginning in January 1993 with respect to the fourth quarter of 1992, the Company has paid quarterly dividends of $0.06 per share. The Company currently intends to continue to pay quarterly cash dividends on its outstanding shares of common stock. However, the determination of the amount of future cash dividends, if any, to be declared and paid will depend upon, among other things, the financial condition, funds from operations, level of exploration and development expenditure opportunities and future business prospects of the Company. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following review of operations for each of the three years in the period ended December 31, 1993 should be read in conjunction with the consolidated financial statements of the Company and notes thereto beginning with page. RESULTS OF OPERATIONS NET OPERATING REVENUES. Volume and price statistics for the specified years were as follows: YEAR ENDED DECEMBER 31, 1993 1992 1991 Wellhead Volumes Natural Gas (MMcf per day)------- 709.3(1) 563.6(1) 490.6 Crude Oil and Condensate (MBbl per day)----------------------- 8.9 8.5 8.2 Natural Gas Liquids (MBbl per day)--------------------------- 0.6 0.7 0.6 Wellhead Average Prices Natural Gas ($/Mcf)-------------- $ 1.92(2) $ 1.58(2) $ 1.37 Crude Oil and Condensate ($/Bbl)------------------------ 16.37 17.90 18.78 Natural Gas Liquids ($/Bbl)------ 11.12 10.69 11.64 Other Natural Gas Marketing Volumes (MMcf per day)----------- 293.4(1) 254.9(1) 237.2 Average Gross Revenue ($/Mcf)---- $ 2.57(3) $ 2.62(3) $ 2.63 Associated Costs ($/Mcf) (5)----- 2.32(4) 1.99(4) 1.75 Margin ($/Mcf)------------------- $ 0.25 $ 0.63 $ 0.88 (1) Includes 81.0 MMcf per day in 1993 and 27.6 MMcf per day in 1992 delivered under the terms of volumetric production payment and exchange agreements effective October 1, 1992, as amended. (2) Includes an average equivalent wellhead value of $1.57 per Mcf in 1993 and $1.70 per Mcf in 1992 for the volumes detailed in note (1), net of transportation costs. (3) Includes per unit deferred revenue amortization for the volumes detailed in note (1) at an equivalent of $2.50 per Mcf ($2.40 per million British thermal units) in 1993 and $2.51 per Mcf ($2.40 per million British thermal units) in 1992. (4) Includes an average value of $2.20 per Mcf in 1993 and $2.37 per Mcf in 1992, including average equivalent wellhead value, any applicable transportation costs and exchange differentials, for the volumes detailed in note (1). (5) Including transportation and exchange differentials. During 1993, net operating revenues increased to $568 million, up $115 million as compared to 1992. Average wellhead natural gas volumes increased approximately 26% compared to 1992 primarily reflecting the effects of exploration and development activities relating to tight gas sand formations. Wellhead natural gas delivered volumes were curtailed less during portions of 1993 than for the comparable periods in 1992 due to the significant increases realized in wellhead natural gas prices in 1993. Average wellhead natural gas prices were up approximately 22% in 1993 over those received in 1992, adding approximately $87 million to net operating revenues. Increases in wellhead natural gas volumes in 1993 added $83 million to net operating revenues compared to 1992. Average wellhead crude oil and condensate prices in 1993 were down 9% compared to 1992, reducing net operating revenues by $5 million. Increases in wellhead crude oil and condensate volumes in 1993 added approximately $2 million to net operating revenues compared to 1992. Other marketing activities associated with sales and purchases of natural gas, natural gas price swap transactions, other commodity price hedging of natural gas and crude oil and condensate prices utilizing futures market transactions, and margins relating to the volumetric production payment added $8 million to net operating revenues during 1993. This decrease of $54 million from 1992 primarily results from shrinking margins associated with sales under long-term fixed price contracts and amortization of volumetric production payment deferred revenue due to increases in market responsive natural gas prices associated with volumes supplying these dispositions and losses on natural gas commodity price hedging activities utilizing NYMEX commodity market transactions. The average associated costs of natural gas marketing, price swap and volumetric production payment transactions, including, where appropriate, average wellhead value, transportation costs and exchange differentials, increased $.33 per Mcf. Related other natural gas marketing volumes increased 15%. The net reduction in benefits from these other marketing activities, a substantial portion of which serve as hedges of commodity price risks for a portion of wellhead deliveries, are more than offset by an increase in revenues associated with market responsive price increases for wellhead deliveries, as noted above. The $18 million hedging loss in 1993 associated with forward sales of natural gas using the NYMEX futures market reflects the effects of transactions sold over a period of time that turned out to be a continually increasing natural gas pricing period. If the stronger market responsive pricing environment continues, the incremental benefits realized by the Company in prior years from these other marketing activities will continue to be reduced. However, in such circumstances the Company will continue to realize more significant benefits from the improved pricing related to wellhead deliveries. (See Note 2 to Consolidated Financial Statements). During 1992, net operating revenues increased to $453 million, up $65 million as compared to 1991. Average wellhead natural gas volumes increased approximately 15% compared to 1991 primarily reflecting the effects of exploration and development activities relating to tight gas sand formations. Although exploration and development efforts resulted in deliverability increases in certain core areas, the potential earnings and cash flow benefits were mitigated by voluntary curtailments during 1992. Wellhead natural gas delivered volumes were voluntarily curtailed by as much as 25% of deliverability during portions of the year due to lower than acceptable prices. Average wellhead natural gas prices were up approximately 15% and average wellhead crude oil and condensate prices were down 5% compared to 1991. The increase in average wellhead natural gas price received by the Company increased net operating revenues by approximately $38 million. The increase in wellhead natural gas volumes added approximately $43 million to net operating revenues. Increases in wellhead crude oil and condensate delivered volumes added $2 million to net operating revenues. A decrease in the average wellhead crude oil and condensate price decreased net operating revenues by $3 million. Other marketing activities associated with sales and purchases of natural gas, natural gas price swap transactions, natural gas and crude oil commodity price hedging utilizing futures market transactions and margins relating to the volumetric production payment added $63 million to net operating revenues during 1992, a decrease of $17 million from 1991. Other natural gas marketing volumes increased 7%. The average associated costs of supplying these commitments, including average equivalent wellhead value, transportation costs and exchange differentials, increased $.24 per Mcf. OPERATING EXPENSES. During 1993, total operating expenses of $465 million were $112 million higher than the $353 million incurred in 1992. Lease and well expenses increased approximately $10 million primarily due to expanded domestic and international operations. Exploration expenses increased approximately $4 million primarily due to increased exploration activities in North America. Dry hole expenses increased by almost $8 million and lease impairments were $5 million higher than in 1992. An unsuccessful domestic deep well added nearly $4 million to dry hole expenses and a related $3 million to lease impairments in 1993. Dry hole expenses also reflect the impact of increased drilling activity outside North America. Depreciation, depletion and amortization ('DD&A') expense increased $70 million to $250 million reflecting an increase in production volumes and an average DD&A rate increase from $.79 per Mcfe in 1992 to $.89 per Mcfe for 1993. The DD&A rate increase is primarily due, as expected, to factors associated with the tight gas sands drilling program which costs are being more than offset by benefits realized in the form of tight gas sand federal income tax credits and certain state severance tax exemptions. General and administrative expenses increased almost $9 million to $45 million primarily reflecting cost reductions included in 1992 related to changes associated with certain employee compensation plans and overall higher costs in 1993 due to an expansion of domestic and international operations. Taxes other than income increased $7 million primarily due to increased production volumes and revenues in 1993, partially offset by continuing benefits associated with certain state severance tax exemptions allowed on high cost natural gas sales and a $3 million reduction of state franchise taxes resulting from refunds of prior year payments received in 1993. Total per unit operating costs for lease and well expense, DD&A, general and administrative expense, interest expense, and taxes other than income increased $.03 per Mcfe, averaging $1.43 per Mcfe during 1993 compared to $1.40 per Mcfe for 1992. The total increase was associated with DD&A expense which was up $.10 per Mcfe as noted above being partially offset by a reduction of $.07 Mcfe in all other costs. During 1992, operating expenses increased $29 million to $353 million as compared to 1991. However, cost per Mcfe, including those associated with exploration expenditures, declined $.08 to $1.56 per Mcfe in 1992. Lease and well expenses remained essentially flat compared to 1991. However, lease and well expense per Mcfe declined $.03 per Mcfe to $.22 per Mcfe in 1992. Per unit operating cost reductions reflect the effects of a continuing focus on controlling operating costs in all areas of Company operations and benefits realized from the sale of properties which required higher maintenance costs along with increasing volumes which tend to reduce per unit impacts of costs that are more fixed in nature. Exploration expenses of $33 million increased $2 million over 1991 due to certain exploration activities in new international areas of interest. Dry hole expenses of $11 million decreased $4 million from 1991 due to decreased drilling activity in areas outside of North America partially mitigated by increased domestic drilling activities. Impairment of unproved oil and gas properties increased approximately $2 million to $15 million primarily reflecting certain costs associated with the decision to discontinue exploration activities in certain areas outside of North America, including Egypt, Indonesia and Syria in addition to reflecting the effects of accelerated relinquishments of certain domestic acreage holdings. DD&A expense increased $19 million to $180 million primarily reflecting increased production mitigated by a decline in the average DD&A rate from $.81 per Mcfe in 1991 to $.79 per Mcfe in 1992. The reduction in DD&A rates per Mcfe reflects the effects of a continuing focus on adding reserves with low finding costs along with the benefits of selling certain properties with higher than average cost bases. General and administrative expenses increased $1 million to $37 million primarily reflecting the effects of expanded operations. Taxes other than income increased $10 million to $28 million due to increased production volumes and revenues in 1992, increases in certain ad valorem and state franchise taxes and earnings benefits associated with the refund of certain state natural gas severance taxes in 1991 resulting from overpayments in prior years. This increase was mitigated by Texas severance tax exemptions for certain high cost gas production during 1992. OTHER INCOME. Other income for 1993 of $20 million reflects an increase of $17 million from the $3 million recorded for 1992. Other income for 1993 includes $13 million in gains on sales of oil and gas properties, an increase of $7 million over 1992, $4 million in interest income associated with the investment of funds temporarily surplus to the Company (See Note 3 to Consolidated Financial Statements) and $4 million associated with settlements related to the termination of certain long-term natural gas contracts. Other income in 1992 was $3 million compared to $12 million in 1991. Other income in 1992 included $6 million in gains on sales of oil and gas properties compared to $15 million in 1991. INTEREST EXPENSE. Net interest expense decreased $12 million, or 55%, to $10 million in 1993 as compared to 1992 reflecting the repayment of a substantial portion of the Company's long-term debt in 1992 with proceeds from the sale of common stock in August 1992 and the sale of a volumetric production payment in September 1992. The estimated fair value of outstanding interest rate swap agreements at December 31, 1993 was a negative $3.3 million based upon termination values obtained from third parties. (See Note 12 to Consolidated Financial Statements). Net interest expense decreased $7 million, or 24%, to $22 million in 1992 as compared to 1991, reflecting a restructuring of debt in early 1991 and lower interest rates. Using interest rate swap agreements with third parties effective in January 1992, the Company fixed short-term borrowing costs for the year for the equivalent of $225 million of its floating rate obligations. In addition, two of the interest rate swap agreements in notional amounts totalling $75 million were for a two-year period extending through 1993. Effective January 1, 1993, Enron Corp. assumed the Company's remaining obligations under these swap agreements. INCOME TAXES. Income tax benefit in 1993 includes a benefit of approximately $65 million associated with tight gas sand federal income tax credit utilization, an approximate $7 million predominantly one-time non-cash charge recorded in the third quarter of 1993 primarily to adjust the Company's accumulated deferred federal income tax liability for the increase in the corporate federal income tax rate from 34% to 35% and a $12 million benefit from the reduction of the Company's accumulated deferred federal income tax liability resulting from a year end reevaluation of deferred tax liability requirements. The Company adopted SFAS No. 109 effective January 1, 1993 and applied the provisions of the statement retroactively. As a result, the previously reported income tax benefit and net income for 1991 were restated with a reduction to both of $7 million. Net income for 1992 and 1993 was not affected by the restatement. The Company's consolidated balance sheets at December 31, 1992 and 1991 were also restated to reflect the increase to deferred income taxes payable of $7 million and the corresponding decrease to retained earnings of an equal amount. Income tax benefit in 1992 includes a benefit of approximately $43 million associated with tight gas sand federal income tax credit utilization and $2.8 million primarily related to investment tax credit, tight gas sand federal income tax credit and percentage depletion utilization based on actual returns as filed and settlements on audit of tax returns of predecessor companies for the years 1984 through 1985. Income tax benefit in 1991 includes a benefit of approximately $17 million associated with tight gas sand federal income tax credit utilization and $10.5 million related to utilization of net operating loss carryforwards, foreign tax credit and settlements on audit of tax returns of predecessor companies for tax years 1980 through 1983. CAPITAL RESOURCES AND LIQUIDITY CASH FLOW. The primary sources of cash for the Company during the three-year period ended December 31, 1993 included funds generated from operations, the sale of common stock, the sale of a volumetric production payment and proceeds from the sale of certain oil and gas properties. Primary cash outflows included funds used in operations, exploration and development expenditures, dividends, and the repayment of debt. Discretionary cash flow, a frequently used measure of performance for exploration and production companies, is generally derived by adjusting net income to eliminate the effects of depreciation, depletion and amortization, impairment of unproved oil and gas properties, deferred taxes, property sales net of tax, certain other miscellaneous non-cash amounts, except for amortization of deferred revenue, and exploration and dry hole expenses. In the case of the Company, the elimination of revenues associated with the amortization of deferred revenues created by the sale by the Company of a volumetric production payment is reflected in investing cash flows. The Company generated discretionary cash flow of approximately $487 million in 1993, $320 million in 1992 and $252 million in 1991. The 1993 amount includes $50 million associated with a federal income tax refund resulting from the settlement of an audit of federal income taxes paid in prior years. Net operating cash flows were approximately $480 million in 1993, $306 million in 1992 and $242 million in 1991. Increased 1993 net operating cash flows were primarily due to increased net operating revenues and a decrease in provision for current taxes resulting from both increased tight gas sand federal income tax credit utilization and proceeds from the receipt of a refund on settlement of an audit of federal income taxes paid in prior years. Increased 1992 net operating cash flows were primarily due to increased net operating revenues and an increase in current tax benefits as a result of tight gas sand federal income tax credit utilization. SALE OF CERTAIN PROPERTIES. In 1993, the Company received proceeds of $42 million from the sale of certain producing and non-producing oil and gas properties. Taxable gains resulting from these sales generated federal income taxes of $8 million, leaving net proceeds of $34 million. During 1992, the Company received proceeds of $33 million from the sale of certain producing and non-producing oil and gas properties. Taxable gains resulting from these sales generated federal income taxes of $8 million, leaving net proceeds of $25 million. In 1991, the Company received proceeds of $23 million from the sale of certain producing and non-producing oil and gas properties. Taxable gains resulting from these sales generated income taxes of $5 million, leaving net proceeds of $18 million. SALE OF COMMON STOCK. In August 1992, the Company completed the sale of 4.1 million shares of common stock resulting in aggregate net proceeds to the Company of approximately $112 million used primarily to repay long-term debt. Enron Corp. retained ownership of 80% of the Company. SALE OF VOLUMETRIC PRODUCTION PAYMENT. In September 1992, the Company sold a volumetric production payment for $326.8 million to a limited partnership. (See 'Business - Marketing - Other Marketing' and Note 4 to Consolidated Financial Statements). Under the terms of the production payment agreements, the Company conveyed a real property interest in approximately 124 bcfe (136 trillion British thermal units) of natural gas and other hydrocarbons in the Big Piney area of Wyoming to the purchaser. Effective October 1, 1993, the agreements were amended providing for the extension of the original term of the volumetric production payment through March 31, 1999 and including a revised schedule of daily quantities of hydrocarbons to be delivered which is approximately one-half of the original schedule. The revised schedule will total approximately 89.1 Bcfe (97.8 trillion British thermal units) versus approximately 87.9 Bcfe (96.4 trillion British thermal units) remaining to be delivered under the original agreement. Daily quantities of hydrocarbons no longer required to be delivered under the revised schedule during the period from October 1, 1993 through June 30, 1996 are available for sale by the Company. The Company retains responsibility for its working interest share of the cost of operations. A portion of the proceeds of the sale was used to repay a portion of the Company's long-term debt, with surplus funds advanced to Enron Corp. under a promissory note which facilitates the deposit of funds temporarily surplus to the Company. In accordance with generally accepted accounting principles, the Company accounted for the proceeds received in the transaction as deferred revenue which is being amortized into revenue and income as natural gas and other hydrocarbons are produced and delivered to the purchaser during the term, as revised, of the volumetric production payment thereby matching those revenues with the depreciation of asset values which remained on the balance sheet following the sale and the operating expenses incurred for which the Company retained responsibility. The Company expects the above transaction, as amended, to have minimal impact on future earnings. However, cash made available by the sale of the volumetric production payment has provided considerable financial flexibility for the pursuit of investment alternatives. EXPLORATION AND DEVELOPMENT EXPENDITURES. The table below sets out components of actual exploration and development expenditures for the years ended December 31, 1993, 1992 and 1991, along with those budgeted for the year 1994. ACTUAL BUDGETED EXPENDITURE CATEGORY 1993 1992 1991 1994 (IN MILLIONS) Capital Drilling and Facilities--------- $ 331.0 $ 259.9 $ 149.3 $ 360.0 Leasehold Acquisitions---------- 29.1 23.0 12.6 20.0 Producing Property Acquisitions-------------------- 9.2 65.2 42.4 4.0 Capitalized Interest and Other------------------------- 13.7 14.3 7.4 10.0 Total----------------------- 383.0 362.4 211.7 394.0 Exploration Expenses---------------- 55.3 44.0 46.1 56.0 Total------------------------------- $ 438.3 $ 406.4 $ 257.8 $ 450.0 Exploration and development expenditures in 1993 increased to $438 million, an 8% increase, as compared to the $406 million expended in 1992. The increase was attributable to increased domestic drilling activity with reduced emphasis on development drilling expenditures associated with tight gas sand formations. The Company also implemented its first development program outside of North America. During 1992 and 1993, the Company had a platform set, production facilities in place and natural gas flowing from the Kiskadee field offshore the southeast coast of Trinidad. Exploration and development expenditures increased $149 million, or 58%, in 1992 compared to 1991. The increase was primarily attributable to increased development drilling expenditures associated with tight gas sand activities and the acquisition in December 1992 of approximately $40 million of producing properties in Canada. (See 'Business - Exploration and Production' for additional information detailing the specific geographic locations of the Company's drilling programs and 'Outlook' below for a discussion related to 1994 exploration and development expenditure plans). FINANCING. The Company's long-term debt-to-total-capital ratio was 14% and 15% as of December 31, 1993 and 1992, respectively. The Company has entered into an agreement with Enron Corp. pursuant to which the Company may borrow funds from Enron Corp. at a representative market rate of interest on a revolving basis. During 1993, there were no funds borrowed by the Company under this agreement. Under a promissory note effective January 1, 1993 at a fixed interest rate of 7%, the Company advances funds temporarily surplus to the Company to Enron Corp. for investment purposes. Daily outstanding balances of funds advanced to Enron Corp. under the note averaged $60 million during 1993 with a balance of $97 million outstanding at December 31, 1993. There were no balances outstanding at December 31, 1993 under a commercial paper program initiated in 1990. The proceeds from the commercial paper program outstanding from time to time are used to fund current transactions. During 1993, total long-term debt increased $3 million to $153 million as a result of $33 million of new borrowings related to certain international drilling activities partially offset by $30 million classified as current maturities. (See Note 3 to the Consolidated Financial Statements). The estimated fair value of the Company's long-term debt, including current maturities of $30 million, at December 31, 1993 was $192 million based upon quoted market prices and, where such prices were not available, upon interest rates currently available to the Company at year end. (See Note 12 to the Consolidated Financial Statements). OUTLOOK. While the wellhead natural gas price environment was, on average, stronger during the year 1993, there continues to exist a good deal of uncertainty as to the direction of future natural gas price trends. However, recent experiences continue to suggest a possible converging of the overall supply/demand relationship reflecting, at least partially, the significantly reduced level of drilling activity during recent years. Management remains confident that continually increasing recognition of natural gas as a more environmentally friendly source of energy along with the availability of significant domestically sourced supplies will result in further increases in demand and a strengthening of the overall natural gas market over time. Being primarily a natural gas producer, the Company is more significantly impacted by changes in natural gas prices than by changes in crude oil and condensate prices. (See 'Business - Other Matters - Energy Prices'). Based on the portion of the Company's anticipated natural gas volumes for which prices have not, in effect, been hedged using the futures market and long-term marketing contracts, the Company's net income and cash flow sensitivity to changing natural gas prices is approximately $7 million for each $.10 per Mcf change in average wellhead natural gas prices. Using various commodity price hedging mechanisms, the Company has, in effect, locked in prices for an average of about two-thirds of its anticipated wellhead natural gas volumes for the year 1994. This level of hedging may change during the remainder of 1994 and will change in future years. Other factors representing positive impacts that are more certain continue to hold good potential for the Company in future periods. While the drilling qualification period for the tight gas sand federal income tax credit expired as of December 31, 1992, the Company has continued in 1993, and should continue in the future, to realize significant benefits associated with production from wells drilled during the qualifying period as it will be eligible for the federal income tax credit through the year 2002. However, all other factors remaining equal, the annual benefit, which was $65 million in 1993 and estimated to be approximately $40 million for 1994, is expected to continue to decline in future periods as production from the qualified wells declines. The drilling qualification period for a certain state severance tax exemption available on certain high cost natural gas revenues continues through the latter part of 1996. Consequently, new qualifying production will be added prospectively to that qualified at year end 1993. (See 'Business - Other Matters - Tight Gas Sand Tax Credit (Section 29) and Severance Tax Exemption'). Other natural gas marketing activities are also expected to continue to contribute meaningfully to financial results. However, the Company completed a fairly significant restructure of its other natural gas marketing portfolio during 1992 with the sale of a volumetric production payment of approximately 124 Bcfe (136 trillion British thermal units) for $326.8 million that was subsequently revised in 1993 (See 'Business - Marketing - Other Marketing' and Note 4 to Consolidated Financial Statements) and elimination of most delivery obligations under four long-term fixed price marketing contracts. The proceeds from the sale of the volumetric production payment added substantially to the financial flexibility of the Company supporting future development while the combined effect of all elements of the restructuring on net income has not been, and will not in the future be, significant. These factors are expected to contribute significantly to earnings, cash flow, and the ability of the Company to pursue the continuation of an active exploration, development and selective acquisition program. The Company will continue to focus development and certain exploration expenditures in its core and other major producing areas, and include limited but meaningful exploratory exposure in areas outside of North America. (See 'Business - Exploration and Production' for additional information detailing the specific geographic locations of the related drilling programs). Early-in-year activity will be managed within an annual expected expenditure level of approximately $450 million. This early-in-year planning will address the continuing uncertainty with regard to the future of the natural gas price environment and will be structured to maintain the flexibility necessary under the Company strategy of funding exploration, development and acquisition activities primarily from available internally generated cash flow. Expenditure plans for 1994 will continue to be focused toward certain areas that were not addressed as actively in the recent past due to the increased emphasis on tight gas sand drilling opportunities during 1991 and 1992 that were completed in early 1993. The Company will also be continuing expenditures in new areas outside of North America, primarily for additional development operations in Trinidad, possible new development operations in other countries, such as those currently being pursued in India, and the continued evaluation of coalbed methane recovery potential in France, Australia, China and certain other countries. The level of exploration and development expenditures may vary in 1994 and will vary in future periods depending on energy market conditions and other related economic factors. Based upon existing economic and market conditions, the Company believes net operating cash flow and available financing alternatives in 1994 will be sufficient to fund its net investing cash requirements for the year. However, the Company has significant flexibility with respect to its financing alternatives and adjustment of its exploration and development expenditure plans as circumstances warrant. There are no material continuing commitments associated with expenditure plans. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The information required hereunder is included in this report as set forth in the 'Index to Financial Statements' on page. 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 required by this Item regarding directors is set forth in the Proxy Statement under the caption entitled 'Election of Directors', and is incorporated herein by reference. See list of 'Current Executive Officers of the Registrant' in Part I located elsewhere herein. There are no family relationships among the officers listed, and there are no arrangements or understandings pursuant to which any of them were elected as officers. Officers are appointed or elected annually by the Board of Directors at its first meeting following the Annual Meeting of Shareholders, each to hold office until the corresponding meeting of the Board in the next year or until a successor shall have been elected, appointed or shall have qualified. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The information required by this Item is set forth in the Proxy Statement under the caption 'Compensation of Directors and Executive Officers', and is incorporated herein by reference. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information required by this Item is set forth in the Proxy Statement under the captions 'Election of Directors' and 'Compensation of Directors and Executive Officers', and is incorporated herein by reference. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information required by this Item is set forth in the Proxy Statement under the caption 'Compensation Committee Interlocks and Insider Participation', and is incorporated herein by reference. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (A)(1) AND (2) FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES See 'Index to Financial Statements' set forth on page. (A)(3) EXHIBITS See pages E-1 through E-3 for a listing of the exhibits. (B) REPORTS ON FORM 8-K No reports on Form 8-K were filed by the Company during the last quarter of 1993. ENRON OIL & GAS COMPANY PAGE Consolidated Financial Statements: Management's Responsibility for Financial Reporting---- Report of Independent Public Accountants--------------- Consolidated Statements of Income for Each of the Three Years in the Period Ended December 31, 1993---- Consolidated Balance Sheets -December 31, 1993 and 1992--------------------------------------------- Consolidated Statements of Shareholders' Equity for Each of the Three Years in the Period Ended December 31, 1993------------------------------ Consolidated Statements of Cash Flows for Each of the Three Years in the Period Ended December 31, 1993------------------------------------ Notes to Consolidated Financial Statements------------- Supplemental Information to Consolidated Financial Statements----------------------------------------------- Financial Statement Schedules: Schedule V -Property, Plant and Equipment----------- S-1 Schedule VI -Accumulated Depreciation, Depletion and Amortization of Property, Plant and Equipment---- S-2 Schedule VIII -Valuation and Qualifying Accounts and Reserves----------------------------------------- S-3 Schedule X -Supplemental Income Statement Information------------------------------------------- S-4 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. MANAGEMENT'S RESPONSIBILITY FOR FINANCIAL REPORTING The following consolidated financial statements of Enron Oil & Gas Company and its subsidiaries were prepared by management which is responsible for their integrity, objectivity and fair presentation. The statements have been prepared in conformity with generally accepted accounting principles and accordingly include some amounts that are based on the best estimates and judgements of management. Arthur Andersen & Co., independent public accountants, was engaged to audit the consolidated financial statements of Enron Oil & Gas Company and its subsidiaries and issue a report thereon. In the conduct of the audit, Arthur Andersen & Co. was given unrestricted access to all financial records and related data including minutes of all meetings of shareholders, the Board of Directors and committees of the Board. Management believes that all representations made to Arthur Andersen & Co. during the audit were valid and appropriate. Their audits of the years presented included developing an overall understanding of the Company's accounting systems, procedures and internal controls, and conducting tests and other auditing procedures sufficient to support their opinion on the financial statements. The report of Arthur Andersen & Co. appears on the following page. The system of internal controls of Enron Oil & Gas Company and its subsidiaries is designed to provide reasonable assurance as to the reliability of financial records as represented in published interim and annual financial statements and for the protection of assets. This system includes, but is not limited to, written policies and guidelines including a published code for the conduct of business affairs, the careful selection and training of qualified personnel, and a documented organizational structure outlining the separation of responsibilities among management representatives and staff groups, augmented by a strong program of internal audit. The adequacy of financial controls of Enron Oil & Gas Company and its subsidiaries and the accounting principles employed in financial reporting by the Company are under the general oversight of the Audit Committee of the Board of Directors. No member of this committee is an officer or employee of the Company. Both the independent public accountants and internal/contract auditors have direct access to the Audit Committee and meet with the committee from time to time to discuss accounting, auditing and financial reporting matters. Effective January 1, 1994, Arthur Andersen & Co. has been contracted to provide operational and internal control audit services previously handled by the internal audit staff of the Company. It should be recognized that there are inherent limitations to the effectiveness of any system of internal control, including the possibility of human error and circumvention or override. Accordingly, even an effective system can provide only reasonable assurance with respect to the preparation of reliable financial statements. Furthermore, the effectiveness of an internal control system can change with circumstances. It is management's opinion that, considering the criteria for effective internal control over financial reporting which consists of interrelated components including the control environment, risk-assessment process, control activities, information and communication systems, and monitoring, the Company maintained an effective system of internal control over the preparation of published interim and annual financial statements for all periods presented. BEN B. BOYD WALTER C. WILSON FORREST E. HOGLUND Vice President and Senior Vice President and Chairman of the Board, Controller Chief Financial Officer President and Chief Executive Officer Houston, Texas March 18, 1994 REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To Enron Oil & Gas Company: We have audited the accompanying consolidated balance sheets of Enron Oil & Gas Company (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 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 consolidated financial statements referred to above present fairly, in all material respects, the financial position of Enron Oil & Gas 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. 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 the index to financial statements 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. As explained in Note 7 to the consolidated financial statements, the Company adopted Statement of Financial Accounting Standards No. 109, 'Accounting for Income Taxes', effective January 1, 1993, and applied the provisions of the statement retroactively. ARTHUR ANDERSEN & CO. Houston, Texas February 18, 1994 (except with respect to the matters discussed in Note 3, as to which the date is March 11, 1994) ENRON OIL & GAS COMPANY CONSOLIDATED STATEMENTS OF INCOME (IN THOUSANDS EXCEPT PER SHARE AMOUNTS) YEAR ENDED DECEMBER 31, 1993 1992 1991 (RESTATED) NET OPERATING REVENUES Natural Gas Associated Companies----------- $ 279,921 $ 280,501 $ 275,362 Trade-------------------------- 225,241 108,487 46,241 Crude Oil, Condensate and Natural Gas Liquids Associated Companies----------- 38,953 38,775 41,237 Trade-------------------------- 16,881 20,152 21,599 Other----------------------------- 6,706 5,074 3,166 Total-------------------- 567,702 452,989 387,605 OPERATING EXPENSES Lease and Well-------------------- 59,344 49,406 49,922 Exploration----------------------- 36,921 33,278 31,470 Dry Hole-------------------------- 18,355 10,764 14,698 Impairment of Unproved Oil and Gas Properties---------------------- 20,467 15,136 12,791 Depreciation, Depletion and Amortization-------------------- 249,704 179,839 160,885 General and Administrative-------- 45,274 36,648 36,216 Taxes Other Than Income----------- 35,396 28,346 18,222 Total-------------------- 465,461 353,417 324,204 OPERATING INCOME--------------------- 102,241 99,572 63,401 OTHER INCOME------------------------- 19,953 2,561 11,768 INCOME BEFORE INTEREST EXPENSE AND TAXES------------------------------ 122,194 102,133 75,169 INTEREST EXPENSE Incurred Affiliate---------------------- - 1,747 9,503 Other-------------------------- 15,378 24,122 24,479 Capitalized----------------------- (5,457) (3,580) (4,482) Net Interest Expense----------- 9,921 22,289 29,500 INCOME BEFORE INCOME TAXES----------- 112,273 79,844 45,669 INCOME TAX BENEFIT------------------- (25,752) (17,736) (2,247) NET INCOME--------------------------- $ 138,025 $ 97,580 $ 47,916 EARNINGS PER SHARE OF COMMON STOCK------------------------------ $ 1.73 $ 1.26 $ .63 AVERAGE NUMBER OF COMMON SHARES------ 79,983 77,267 75,900 The accompanying notes are an integral part of these consolidated financial statements. ENRON OIL & GAS COMPANY CONSOLIDATED BALANCE SHEETS (IN THOUSANDS) AT DECEMBER 31, 1993 1992 (RESTATED) ASSETS CURRENT ASSETS Cash and Cash Equivalents--------- $ 103,129 $ 132,618 Accounts Receivable Associated Companies----------- 59,143 50,838 Trade-------------------------- 66,109 50,832 Inventories----------------------- 14,082 9,534 Other----------------------------- 6,962 3,190 Total----------------------- 249,425 247,012 OIL AND GAS PROPERTIES (Successful Efforts Method)---------------------- 2,772,220 2,475,371 Less: Accumulated Depreciation, Depletion and Amortization------ 1,226,175 1,007,360 Net Oil and Gas Properties---------------- 1,546,045 1,468,011 OTHER ASSETS------------------------- 15,692 15,989 TOTAL ASSETS------------------------- $ 1,811,162 $ 1,731,012 LIABILITIES AND SHAREHOLDERS' EQUITY CURRENT LIABILITIES Accounts Payable Associated Companies----------- $ 13,250 $ 1,889 Trade-------------------------- 143,542 128,695 Accrued Taxes Payable------------- 17,354 9,911 Dividends Payable----------------- 4,795 4,800 Current Maturities of Long-Term Debt---------------------------- 30,000 - Other----------------------------- 8,989 49,421 Total----------------------- 217,930 194,716 LONG-TERM DEBT----------------------- 153,000 150,000 OTHER LIABILITIES-------------------- 9,477 8,972 DEFERRED INCOME TAXES---------------- 270,154 248,943 DEFERRED REVENUE--------------------- 227,528 301,395 COMMITMENTS AND CONTINGENCIES (Note 8) SHAREHOLDERS' EQUITY Common Stock, No Par, 80,000,000 Shares Authorized and Issued---- 200,800 200,800 Additional Paid In Capital-------- 417,531 421,747 Cumulative Foreign Currency Translation Adjustment---------- (6,855) (1,726) Retained Earnings----------------- 324,995 206,165 Common Stock Held in Treasury, 80,000 shares------------------- (3,398) - Total Shareholders' Equity---------------------- 933,073 826,986 TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY----------------------------- $ 1,811,162 $ 1,731,012 The accompanying notes are an integral part of these consolidated financial statements. ENRON OIL & GAS COMPANY CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY (IN THOUSANDS EXCEPT PER SHARE AMOUNTS) ENRON OIL & GAS COMPANY CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS) YEAR ENDED DECEMBER 31, 1993 1992 1991 CASH FLOWS FROM OPERATING ACTIVITIES (RESTATED) Reconciliation of Net Income to Net Operating Cash Inflows: Net Income------------------------ $ 138,025 $ 97,580 $ 47,916 Items Not Requiring (Providing) Cash Depreciation, Depletion and Amortization----------------- 249,704 179,839 160,885 Impairment of Unproved Oil and Gas Properties--------------- 20,467 15,136 12,791 Deferred Income Taxes---------- 25,612 (17,917) (11,997) Other, Net--------------------- 1,768 5,713 5,073 Exploration Expenses-------------- 36,921 33,278 31,470 Dry Hole Expenses----------------- 18,355 10,764 14,698 Gains On Sales of Oil and Gas Properties---------------------- (13,318) (6,037) (14,983) Other, Net------------------------ 1,242 (6,147) 614 Changes in Components of Working Capital and Other Liabilities Accounts Receivable------------ (24,586) (12,732) (821) Inventories-------------------- (4,548) 3,687 (19) Accounts Payable--------------- 26,208 46,327 381 Accrued Taxes Payable---------- 7,443 247 1,011 Other Liabilities-------------- 772 (2,886) (1,006) Other, Net--------------------- (44,443) 33,784 3,839 Changes in Components of Working Capital Associated with Investing and Financing Activities---------------------- 40,042 (74,232) (7,976) NET OPERATING CASH INFLOWS----------- 479,664 306,404 241,876 INVESTING CASH FLOWS Additions to Oil and Gas Properties---------------------- (383,064) (362,403) (211,673) Exploration Expenses-------------- (36,921) (33,278) (31,470) Dry Hole Expenses----------------- (18,355) (10,764) (14,698) Proceeds from Sale of Properties---------------------- 41,815 33,412 22,827 Proceeds from Sale of Volumetric Production Payment-------------- - 326,775 - Amortization of Deferred Revenue------------------------- (73,867) (25,380) - Changes in Components of Working Capital Associated with Investing Activities------------ (37,256) 74,232 7,976 Other, Net------------------------ (4,905) (3,686) (3,020) NET INVESTING CASH OUTFLOWS---------- (512,553) (1,092) (230,058) FINANCING CASH FLOWS Long-Term Debt Affiliate---------------------- - (132,836) (145,082) Other-------------------------- 33,000 (139,556) 149,114 Common Stock Issued--------------- - 111,861 - Dividends Paid-------------------- (19,200) (15,385) (15,180) Treasury Stock Purchased---------- (16,698) (1,827) - Proceeds from Sales of Treasury Stock--------------------------- 9,084 1,250 - Other, Net------------------------ (2,786) - (466) NET FINANCING CASH INFLOWS (OUTFLOWS)------------------------- 3,400 (176,493) (11,614) INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS------------------------ (29,489) 128,819 204 CASH AND CASH EQUIVALENTS AT BEGINNING OF YEAR------------------ 132,618 3,799 3,595 CASH AND CASH EQUIVALENTS AT END OF YEAR------------------------------- $ 103,129 $ 132,618 $ 3,799 The accompanying notes are an integral part of these consolidated financial statements. ENRON OIL & GAS COMPANY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (DOLLARS IN THOUSANDS UNLESS OTHERWISE INDICATED) 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES PRINCIPLES OF CONSOLIDATION. The consolidated financial statements of Enron Oil & Gas Company (the 'Company'), 80% of the outstanding common stock of which is owned by Enron Corp., include the accounts of all domestic and foreign subsidiaries. All material intercompany accounts and transactions have been eliminated. Certain reclassifications have been made to consolidated financial statements for prior years to conform with the current presentation. CASH EQUIVALENTS. The Company records as cash equivalents all highly liquid short-term investments with maturities of three months or less. (See Note 3 'Long-Term Debt, Financing Arrangements with Enron Corp.') OIL AND GAS OPERATIONS. The Company accounts for its natural gas and crude oil exploration and production activities under the successful efforts method of accounting. Oil and gas lease acquisition costs are capitalized when incurred. Unproved properties with significant acquisition costs are assessed quarterly on a property-by-property basis and any impairment in value is recognized. Unproved properties with acquisition costs that are not individually significant are aggregated, and the portion of such costs estimated to be nonproductive, based on historical experience, is amortized over the average holding period. If the unproved properties are determined to be productive, the appropriate related costs are transferred to proved oil and gas properties. Lease rentals are expensed as incurred. Oil and gas exploration costs, other than the costs of drilling exploratory wells, are charged to expense as incurred. The costs of drilling exploratory wells are capitalized pending determination of whether they have discovered proved commercial reserves. If proved commercial reserves are not discovered, such drilling costs are expensed. The costs of all development wells and related equipment used in the production of crude oil and natural gas are capitalized. Depreciation, depletion and amortization of the cost of proved oil and gas properties is calculated using the unit-of-production method. Estimated future dismantlement, restoration and abandonment costs (classified as long-term liabilities), net of salvage values, are taken into account. Certain other assets are depreciated on a straight-line basis. Inventories, consisting primarily of tubular goods and well equipment held for use in the exploration for, and development and production of crude oil and natural gas reserves, are carried at cost with selected adjustments made from time to time to recognize changes in condition value. Natural gas revenues are recorded to recognize that during the course of normal production operations joint interest owners will, from time to time, take more or less than their ultimate share of natural gas volumes from jointly owned reservoirs. These volumetric imbalances are monitored over the life of the reservoir to achieve balancing, or minimize imbalances, by the time reserves are depleted. Final cash settlements are made, generally at the time a property is depleted, under one of a variety of arrangements generally accepted by the industry depending on the specific circumstances involved. The Company accrues revenues associated with undertakes and defers revenues associated with overtakes to recognize these potential ultimate imbalances. ACCOUNTING FOR FUTURES CONTRACTS. Futures transactions are entered into as hedges of commodity prices associated with the sales and purchases of natural gas and crude oil, in order to mitigate the risk of market price fluctuations. Changes in the market value of futures transactions entered into as hedges are deferred until the gain or loss is recognized on the hedged transactions. CAPITALIZED INTEREST COSTS. Certain interest costs have been capitalized as a part of the historical cost of unproved oil and gas properties. Interest costs capitalized during each of the three years in the period ended December 31, 1993 are set out in the Consolidated Statements of Income. INCOME TAXES. Taxable income of the Company, excluding that of any foreign subsidiaries, is included in the consolidated federal income tax return filed by Enron Corp. Pursuant to a tax allocation agreement between the Company, the Company's subsidiaries and Enron Corp., either Enron Corp. will pay to the Company and each subsidiary an amount equal to the tax benefit realized in the Enron Corp. consolidated federal income tax return resulting from the utilization of the Company's or the subsidiary's net operating losses and/or tax credits, or the Company and each subsidiary will pay to Enron Corp. an amount equal to the federal income tax computed on its separate taxable income less the tax benefits associated with any net operating losses and/or tax credits generated by the Company or the subsidiary which are utilized in the Enron Corp. consolidated return. Enron Corp. will pay the Company and each subsidiary for the tax benefits associated with their net operating losses and tax credits utilized in the Enron Corp. consolidated return, provided that a tax benefit was realized except as discussed in the following paragraph, even if such benefits could not have been used by the Company or the subsidiary on a separately filed tax return. In 1991, the Company and Enron Corp. modified the tax allocation agreement to provide that through 1992, the Company would realize the benefit of certain tight gas sand tax credits available to the Company on a stand alone basis. The Company has also entered into an agreement with Enron Corp. providing for the Company to be paid for all realizable benefits associated with tight gas sand tax credits concurrent with tax reporting and settlement for the periods in which they are generated. The tax allocation agreement applies to the Company and each of its subsidiaries for all years in which the Company or any of its subsidiaries are or were included in the Enron Corp. consolidated return. Taxes for any foreign subsidiaries of the Company are calculated on a separate return basis. The Company adopted the provisions of Statement of Financial Accounting Standards (SFAS) No. 109 -'Accounting for Income Taxes' effective January 1, 1993 and applied the provisions of the statement retroactively. The Company previously accounted for income taxes under the provisions of SFAS No. 96 which was superceded by SFAS No. 109. SFAS No. 109 retains the asset and liability approach for accounting for income taxes. Under this approach, deferred tax assets and liabilities are recognized based on anticipated future tax consequences attributable to differences between financial statement carrying amounts of assets and liabilities and their respective tax bases. FOREIGN CURRENCY TRANSLATION. For subsidiaries whose functional currency is deemed to be other than the U.S. dollar, asset and liability accounts are translated at year end rates of exchange and revenue and expenses are translated at average exchange rates prevailing during the year. Translation adjustments are included as a separate component of shareholders' equity. EARNINGS PER SHARE. Earnings per share is computed on the basis of the average number of common shares outstanding during the periods. 2. NATURAL GAS AND CRUDE OIL, CONDENSATE AND NATURAL GAS LIQUIDS NET OPERATING REVENUES Natural Gas Net Operating Revenues are comprised of the following: 1993 1992 1991 Wellhead Natural Gas Revenues Associated Companies(1)---------- $340,508(2) $223,249(2) $171,056 Trade---------------------------- 156,301 103,288 75,037 Total-------------------- $496,809 $326,537 $246,093 Other Natural Gas Marketing Activities Gross Revenues from: Associated Companies(3)------ $139,576 $186,600 $220,152 Trade------------------------ 135,606(4) 57,482(4) 7,215 Total-------------------- 275,182 244,082 227,367 Associated Costs from: Associated Companies(1)(5)-------------- 182,456(6) 133,170(6) 115,601 Trade------------------------ 66,273 52,283 36,011 Total-------------------- 248,729 185,453 151,612 Net---------------------- 26,453 58,629 75,755 NYMEX Commodity Price Hedging Gain (Loss)(7)----------------- (18,100) 3,822 (245) Total-------------------- $ 8,353 $ 62,451 $ 75,510 Crude Oil, Condensate and Natural Gas Liquids Net Operating Revenues are comprised of the following: 1993 1992 1991 Wellhead Crude Oil, Condensate and Natural Gas Liquids Revenues Associated Companies------------- $ 38,953 $ 38,474 $ 37,029 Trade---------------------------- 16,881 20,152 21,599 Total------------------------ $ 55,834 $ 58,626 $ 58,628 Other Crude Oil and Condensate Marketing Activities NYMEX Commodity Price Hedging Gain(7)------------------------ $ - $ 301 $ 4,208 (1) Wellhead Natural Gas Revenues in 1993, 1992 and 1991 include $129,504, $84,317 and $69,175, respectively, associated with deliveries by Enron Oil & Gas Company to Enron Oil & Gas Marketing, Inc., a wholly-owned subsidiary, reflected as a cost in Other Natural Gas Marketing Activities -Associated Costs. (2) Includes $46,358 and $20,667 in 1993 and 1992, respectively, associated with the equivalent wellhead value of volumes delivered under the terms of a volumetric production payment agreement effective October 1, 1992, as amended, net of transportation. (3) Includes the effect of a price swap agreement with an Enron Corp. affiliated company which in effect fixed the price of certain sales. (4) Includes $73,867 and $25,380 in 1993 and 1992, respectively, associated with the amortization of deferred revenues under the terms of volumetric production payment and exchange agreements effective October 1, 1992, as amended. (5) Includes the effect of a price swap agreement with a third party which in effect fixed the price of certain purchases. (6) Includes $65,042 and $23,977 in 1993 and 1992, respectively, for volumes delivered under volumetric production payment and exchange agreements effective October 1, 1992, as amended, including equivalent wellhead value, any applicable transportation costs and exchange differentials. (7) Represents gain or loss associated with commodity futures transactions primarily with Enron Corp. affiliated companies based on NYMEX prices in effect on dates of execution, less customary transaction fees. 3. LONG-TERM DEBT REVOLVING CREDIT AGREEMENT. In March 1994, the Company replaced an existing credit agreement with a Revolving Credit Agreement dated as of March 11, 1994, among the Company and the banks named therein (the 'Credit Agreement'). The Credit Agreement provides for aggregate borrowings of up to $100 million, with provisions for increases, at the option of the Company, up to $300 million. Advances under the Credit Agreement bear interest, at the option of the Company, based on a base rate, an adjusted CD rate or a Eurodollar rate. Each advance under the Credit Agreement matures on a date selected by the Company at the time of the advance, but in no event after January 15, 1998. FINANCING ARRANGEMENTS WITH ENRON CORP. The Company engages in various transactions with Enron Corp. that are characteristic of a consolidated group under common control. Activities of the Company not internally funded from operations have been and may be funded from time to time by advances from Enron Corp. The Company entered into an agreement with Enron Corp., effective October 12, 1989 (as amended effective September 29, 1992), under which the Company may borrow funds from Enron Corp. at a representative market rate of interest on a revolving basis. During 1993, there were no funds borrowed by the Company under this agreement. Any loan balance that may be outstanding from time to time is payable on demand but no later than September 29, 1995, the maturity date of this agreement. Any balances outstanding are classified as long-term based on the Company's intent and ability to refinance such amounts using available borrowing capacity. Interest expense recorded in 1992 and 1991 under the terms of this agreement totaled $.1 million and $.2 million, respectively. There was no interest expense relating to this agreement recorded in 1993. The Company also entered into an agreement with Enron Corp., effective October 12, 1989 (as amended effective September 29, 1992), which provides the Company the option of depositing any excess funds that may be available from time to time with Enron Corp. with interest at a representative market rate during the periods the funds were held by Enron Corp. Interest income recorded in 1992 and 1991 under the terms of this agreement totaled $1.4 million and $.3 million, respectively. Effective January 1, 1993, the Company executed a promissory note at a fixed interest rate of 7% with Enron Corp. providing for the investment of funds temporarily surplus to the Company from time to time with Enron Corp. Daily outstanding balances of funds advanced to Enron Corp. under this note averaged $60.3 million during 1993 with a balance of $96.6 million outstanding and included in Cash and Cash Equivalents at December 31, 1993. Interest income recorded in 1993 under the terms of this note totaled $4.4 million. OTHER LONG-TERM DEBT. Other long-term debt at December 31 consisted of the following: 1993 1992 Loans Payable-------------------- $ 50,000 $ 50,000 Senior Notes--------------------- 70,000 100,000 Promissory Note------------------ 33,000 - Total---------------- $ 153,000 $ 150,000 The Loans Payable are due in 1995 and bear interest at a variable rate based on the London Interbank Offered Rate which has, in effect, been converted to fixed interest rates ranging from 8.92% to 8.98% through maturity using interest rate swap agreements in equivalent dollar amounts. The Senior Notes bear interest at 9.1% with principal repayments of $30 million due in 1996 and $20 million due in 1997 and 1998. A principal repayment of $30 million is due in 1994 and is classified as current maturities of long-term debt at December 31, 1993. The Promissory Note is payable by one of the Company's subsidiaries to a bank, bears interest at 3 3/8% and represents interim financing under Section 936(d)(4) of the Internal Revenue Code of 1986, as amended, of a project involving the development of gas and oil fields. The note is due the earlier of April 30, 1994, as extended, or the closing date of the permanent financing and is collateralized with a letter of credit issued by a bank on behalf of the subsidiary and guaranteed by the Company. The note is classified as long-term based on the subsidiary's intent and ability to convert the balance of the note to permanent long-term financing. In March 1994, the subsidiary received two advances aggregating $31 million under a credit agreement dated as of March 8, 1994, between the subsidiary and a financial institution. The credit agreement provides for aggregate borrowings of up to $75 million. One of the advances is in the amount of $16 million, bears interest at a fixed rate of 4.52% and is due in 1998. The other advance is in the amount of $15 million, bears interest at a floating rate that resets quarterly equal to 84% of the LIBID Rate which is 1/8 of 1% less than the London Interbank Offered Rate and is due in 1998. Both advances are collaterized with a letter of credit issued by a bank on behalf of the subsidiary and guaranteed by the Company. The advances were used to partially repay the Promissory Note. There were no balances outstanding at December 31, 1993 and 1992 under a commercial paper program initiated in 1990. The proceeds from the commercial paper program outstanding from time to time are used to fund current transactions. Certain of the borrowings described above contain covenants requiring the maintenance of certain financial ratios and limitations on liens, debt issuance and dispositions of assets. In September 1991, the Company filed with the Securities and Exchange Commission a registration statement providing for the issuance and sale from time to time of up to $250 million of debt securities to the public. As of December 31, 1993, no debt securities had been issued under this registration statement. 4. DEFERRED REVENUE In September 1992, the Company sold a volumetric production payment for $326.8 million to a limited partnership of which an Enron Corp. affiliated company is general partner with a 1% interest. Under the terms of the production payment agreements, the Company conveyed a real property interest of approximately 124 billion cubic feet equivalent ('Bcfe') (136 trillion British thermal units) of natural gas and other hydrocarbons in the Big Piney area of Wyoming. The natural gas and other hydrocarbons were originally scheduled to be produced and delivered over a period of forty-five months which period commenced October 1, 1992. Effective October 1, 1993, the agreements were amended providing for the extension of the original term of the volumetric production payment through March 31, 1999 and including a revised schedule of daily quantities of hydrocarbons to be delivered which is approximately one-half of the original schedule. The revised schedule will total approximately 89.1 Bcfe (97.8 trillion British thermal units) versus approximately 87.9 Bcfe (96.4 trillion British thermal units) remaining to be delivered under the original agreement. Daily quantities of hydrocarbons no longer required to be delivered under the revised schedule during the period from October 1, 1993 through June 30, 1996 are available for sale by the Company. The Company retains responsibility for its working interest share of the cost of operations. The Company also entered into a separate agreement with the same limited partnership whereby it has agreed to exchange volumes owned by the Company in the Midcontinent area and the Texas Gulf Coast area for equivalent volumes produced and owned by the limited partnership in the Big Piney area. The costs incurred, if any, to effect redeliveries pursuant to such exchange are borne by the Company. A portion of the proceeds of the sale was used to repay a portion of the Company's long-term debt, with surplus funds advanced to Enron Corp. under a note agreement which facilitates the deposit of funds temporarily surplus to the Company. The Company accounted for the proceeds received in the transaction as deferred revenue which is being amortized into revenue and income as natural gas and other hydrocarbons are produced and delivered during the term, as revised, of the volumetric production payment. Annual remaining amortization of deferred revenue, based on revised scheduled deliveries under the volumetric production payment agreement, as amended, at December 31, 1993 was as follows: 1994--------------------------------- $ 43,344 1995--------------------------------- 43,344 1996--------------------------------- 43,463 1997--------------------------------- 43,344 1998--------------------------------- 43,344 1999--------------------------------- 10,689 Total------------------------ $ 227,528 5. SHAREHOLDERS' EQUITY In August 1992, the Company completed the offering and sale of 4.1 million shares of common stock. The shares were priced to the public at $28.50 per share. Net proceeds, after underwriting commissions and expenses, totaled approximately $112 million and were used primarily to repay long-term debt. In December 1992, the Board of Directors of the Company approved the reduction of the authorized common shares from 100 million to 80 million shares and cancelled the authorization for preferred shares. Such actions were approved by the shareholders in May 1993. Also in December 1992, the Board of Directors of the Company approved the purchase of up to 250,000 shares of common stock of the Company for, but not limited to, meeting obligations associated with stock option grants to qualified employees pursuant to the Enron Oil & Gas Company 1992 Stock Plan. (See Note 8 'Commitments and Contingencies -Enron Oil & Gas Company 1992 Stock Plan'). At December 31, 1993, 80,000 shares were held in treasury under this authorization. In February 1994, the Board of Directors authorized submission of a resolution to shareholders for approval at their annual meeting in May 1994 that would, contingent upon the Board of Directors of the Company declaring, on or before May 3, 1995, a stock split of either two-for-one or three-for-two, amend the Restated Certificate of Incorporation of the Company to increase the total number of authorized shares of the common stock of the Company from 80 million to 160 million shares in the event of a two-for-one stock split or to 120 million shares in the event of a three-for-two stock split. Such charter amendment, if adopted, will become effective when the appropriate Certificate of Amendment to the Company's Restated Certificate of Incorporation is filed with the Secretary of State of Delaware, which filing will only be authorized at such time as the Board of Directors takes the requisite action to approve either a two-for-one or a three-for-two stock split in either case effected as a dividend which action, if to be carried out under this resolution, must occur on or before May 3, 1995. 6. TRANSACTIONS WITH ENRON CORP. AND RELATED PARTIES NATURAL GAS AND CRUDE OIL, CONDENSATE AND NATURAL GAS LIQUIDS NET OPERATING REVENUES. Wellhead Natural Gas and Crude Oil, Condensate and Natural Gas Liquids Revenues and Other Natural Gas and Other Crude Oil and Condensate Marketing Activities include revenues from and associated costs paid to various subsidiaries and affiliates of Enron Corp. pursuant to contracts which, in the opinion of management, are no less favorable than could be obtained from third parties. Other Natural Gas and Other Crude Oil and Condensate Marketing Activities also include certain price swap and futures transactions with Enron Corp. affiliated companies which, in the opinion of management, are no less favorable than could be obtained from third parties. (See Note 2 'Natural Gas and Crude Oil, Condensate and Natural Gas Liquids Net Operating Revenues'). GENERAL AND ADMINISTRATIVE EXPENSES. The Company is charged by Enron Corp. for all direct costs associated with its operations. Such direct charges, excluding benefit plan charges (See Note 8 'Commitments and Contingencies -Employee Benefit Plans'), totaled $11.5 million, $4.9 million and $7.4 million for the years ended December 31, 1993, 1992 and 1991, respectively. Management believes that these charges are reasonable. Additionally, certain administrative costs not directly charged to any Enron Corp. operations or business segments are allocated to the entities of the consolidated group. Allocation percentages are generally determined utilizing weighted average factors derived from property gross book value, net operating revenues and payroll costs. Effective January 1, 1989, the Company entered into an agreement with Enron Corp., with an initial term of five years, providing for, among other things, an annual cap of $8.0 million to be applied to indirect allocated charges subject to adjustment for inflation and certain changes in the allocation bases of the Company. Approximately $7.9 million, $9.5 million, and $9.4 million were charged to the Company for indirect general and administrative expenses for the years ended December 31, 1993, 1992 and 1991, respectively. Management believes the indirect allocated charges for the numerous types of support services provided by the corporate staff are reasonable. Effective January 1, 1994, the Company and Enron Corp. entered into a new services agreement pursuant to which Enron Corp. will, among other things, provide for the Company similar services substantially identical in nature and quality to those provided under terms of the previous agreement. The Company has agreed to pay and to reimburse Enron Corp. on bases essentially consistent with those included in the previous agreement, except that allocated indirect costs are subject to an annual maximum of $6.7 million for the year 1994 with any increase in such maximum for subsequent years not to exceed 7.5% per year. The new services agreement is for an initial term of five years through December 1998 and will continue thereafter until terminated by either party. FINANCING. See Note 3 'Long-Term Debt' for a discussion of financing arrangements with Enron Corp. 7. INCOME TAXES As discussed in Note 1, effective January 1, 1993, the Company adopted SFAS No. 109 and applied the provisions of the statement retroactively. Under the provisions of SFAS No. 109, the effect of a change in a tax rate is recognized in income for the period that includes the date of enactment of such change. Consequently, the previously reported net income for 1991 was restated to $47.9 million ($.63 per share) from $54.9 million ($.72 per share), a reduction of $7.0 million primarily to recognize the enactment of a change in the computation of certain state franchise taxes, a portion of which is treated as an income tax under SFAS No. 109. Net income for 1992 and 1993 was not affected by the restatement. The Company's consolidated balance sheet at December 31, 1992 was also restated to reflect the increase to Deferred Income Taxes of $7.0 million and the corresponding decrease to Retained Earnings of an equal amount. In August 1993, the corporate federal income tax rate increased from 34% to 35% retroactive to January 1, 1993 resulting in an increase to the Company's 1993 deferred income tax provision of approximately $5.9 million with a corresponding increase to the Company's deferred income tax liability of an equal amount and a decrease of approximately $1.2 million to the Company's 1993 current income tax benefit. The principal components of the Company's net deferred income tax liability at December 31, 1993 and 1992 were as follows (in thousands): 1993 1992 (RESTATED) Deferred Income Tax Assets Non-Producing Leasehold Costs------ $ 5,234 $ 4,661 Seismic Costs Capitalized for Tax------------------------------ 5,643 6,505 Other------------------------------ 6,337 13,167 Total Deferred Income Tax Assets----------------------- 17,214 24,333 Deferred Income Tax Liabilities Oil & Gas Exploration and Development Costs Deducted for Tax Over Book Depreciation, Depletion and Amortization------- 276,422 253,009 Capitalized Interest--------------- 6,866 4,604 Other------------------------------ 4,080 15,663 Total Deferred Income Tax Liabilities------------------ 287,368 273,276 Net Deferred Income Tax Liability-------------------- $ 270,154 $ 248,943 The components of income (loss) before income taxes were as follows: [CAPTION] 1993 1992 1991 United States------------------------ $ 117,460 $ 74,226 $ 49,187 Foreign------------------------------ (5,187) 5,618 (3,518) Total------------------------ $ 112,273 $ 79,844 $ 45,669 Total income tax provision (benefit) was as follows: 1993 1992 1991 (RESTATED) Current: Federal-------------------------- $ (52,555) $ (292) $ 9,226 State---------------------------- 5 2 - Foreign-------------------------- 1,186 471 524 Total------------------------ (51,364) 181 9,750 Deferred: Federal-------------------------- 20,845 (21,729) (23,917) State---------------------------- 4,357 3,119 11,962 Foreign-------------------------- 410 693 (42) Total------------------------ 25,612 (17,917) (11,997) Income Tax Benefit----------------- $ (25,752) $ (17,736) $ (2,247) The differences between taxes computed at the U.S. federal statutory rate and the Company's effective rate were as follows: 1993 1992 1991 (RESTATED) Statutory Federal Income Tax--------- $ 39,296 $ 27,147 $ 15,528 State Income Tax, Net of Federal Benefit---------------------------- 2,835 2,059 877 Income Tax Related to Foreign Operations------------------------- 3,461 (1,649) 1,677 Tight Gas Sand Federal Income Tax Credits---------------------------- (65,172) (42,500) (16,926) Revision of Prior Years' Tax Estimates-------------------------- (12,060) (2,842) (10,461) SFAS No. 109 Restatement------------- - - 7,018 Federal Tax Rate Increase------------ 5,875 - - Other-------------------------------- 13 49 40 Income Tax Benefit--------------- $ (25,752) $ (17,736) $ (2,247) Current income tax receivable from (payable to) Enron Corp. at December 31, 1993, 1992 and 1991 amounted to $(6,892), $5,619 and $(4,522), respectively. The Company has an alternative minimum tax (AMT) credit carryforward of $2.7 million which can be used to offset regular income taxes payable in future years. The AMT credit carryforward has an indefinite carryforward period. The Company's foreign subsidiaries' undistributed earnings of approximately $45 million at December 31, 1993 are considered to be indefinitely invested outside the U.S. and, accordingly, no U.S. federal or state income taxes have been provided thereon. Upon distribution of those earnings in the form of dividends, the Company may be subject to both foreign withholding taxes and U.S. income taxes, net of allowable foreign tax credits. Determination of any potential amount of unrecognized deferred income tax liabilities is not practicable. In 1991, the Company recognized for financial reporting purposes the benefits attributable to the utilization of a previously unrecognized separate company net operating loss carryforward resulting in a tax benefit of approximately $7 million reflected in 1991 net income. 8. COMMITMENTS AND CONTINGENCIES EMPLOYEE BENEFIT PLANS. Employees of the Company are covered by various retirement, stock purchase and other benefit plans of Enron Corp. During each of the years ended December 31, 1993, 1992 and 1991, the Company was charged $4.5 million, $3.6 million and $3.6 million, respectively, for all such benefits, including pension expense totalling $.5 million, $.5 million and $.4 million, respectively, by Enron Corp. As of September 30, 1993, the most recent valuation date, the plan net assets of the Enron Corp. defined benefit plan in which the employees of the Company participate exceeded the actuarial present value of projected plan benefit obligations by approximately $25.3 million. The assumed discount rate, rate of return on plan assets and rate of increases in wages used in determining the actuarial present value of projected plan benefits were 7.0%, 10.5% and 4.0%, respectively. The Company also has in effect a pension and a savings plan related to its Canadian and Trinidadian subsidiaries. Activity related to these plans is not significant to the Company's operations. The Company provides certain medical, life insurance and dental benefits to eligible employees who retire under the Enron Corp. Retirement Plan and their eligible surviving spouses. Effective January 1, 1993, the Company adopted the provisions of SFAS No. 106 'Employers' Accounting for Postretirement Benefits Other Than Pensions'. The standard requires that employers providing postretirement benefits accrue those costs over the service lives of the employees expected to be eligible to receive such benefits. Such costs were previously recorded on a pay-as-you-go basis. The net periodic cost under SFAS No. 106 for 1993 was approximately $1.0 million, including service cost, interest cost and amortization of transition obligation in the amounts of $.1 million, $.5 million and $.4 million, respectively. The transition obligation existing at January 1, 1993 is being amortized over an average period of 19 years. The adoption of SFAS No. 106 did not have a material impact on the Company's results of operations. The accumulated postretirement benefit obligation ('APBO') existing at December 31, 1993 totaled $8.7 million, of which $7.2 million is applicable to current retirees and current employees eligible to retire. The measurement of the APBO assumes a 7% discount rate and a health care cost trend rate of 13% in 1993 decreasing to 5% by the year 2005 and beyond. A 1% increase in the health care cost trend rate would have the effect of increasing the APBO and the net periodic expense by approximately $.8 million and $.1 million, respectively. The Company does not currently intend to prefund its obligations under its postretirement welfare benefit plans. ENRON OIL & GAS COMPANY 1992 STOCK PLAN. In December 1991, the Board of Directors of the Company adopted the Enron Oil & Gas Company 1992 Stock Plan (the 'Stock Plan'). The Stock Plan was approved by the shareholders in May 1992. Under the Stock Plan, employees of the Company and its subsidiaries may be granted rights to purchase shares of common stock of the Company generally at a price not less than the market price of the stock at the date of grant. Options granted under the Stock Plan vest to the employee over a period of time based on the nature of the grants and as defined in the individual grant agreements. The following table sets forth Stock Plan transactions for the years ended December 31: NUMBER OF STOCK OPTIONS 1993 1992 Outstanding at January 1------------- 1,954,025 - Granted-------------------------- 460,300 2,024,025 Exercised------------------------ (335,925) (63,750) Forfeited------------------------ (16,000) (6,250) Outstanding at December 31 (Grant Prices of $18.50-$47.63 per Share)- 2,062,400 1,954,025 Available for Grant at December 31--- 537,925 982,225 At December 31, 1993, 1,249,975 of the Stock Plan options outstanding were vested. Of the remaining unvested Stock Plan options, approximately 377,550; 201,750; 157,375 and 75,750 vest in the years 1994, 1995, 1996 and 1997, respectively. During 1993 and 1992, the Company purchased 335,925 and 63,750 of its common shares, respectively, and simultaneously delivered such shares upon the exercise of stock options. The difference between the cost of the treasury shares and the exercise price of the options, net of federal income tax benefit of $2.8 million, is reflected as an adjustment to Additional Paid In Capital. In addition in October 1993, the Company commenced a stock repurchase program authorized by the Board of Directors to facilitate the availability of treasury shares of common stock for the settlement of employee stock option exercises pursuant to, but not limited to, the Enron Oil & Gas Company 1992 Stock Plan. At December 31, 1993, 80,000 shares were held in treasury under this authorization. (See Note 5 'Shareholders' Equity'). Pursuant to an amendment to and extension of an employment agreement with the Chairman of the Board, President and Chief Executive Officer of the Company (the 'Chairman'), as of January 1, 1992, the Chairman agreed to the cancellation of 1,000,000 previously issued stock appreciation right ('SAR') units. The Chairman was granted 1,110,000 stock options pursuant to the 1992 Stock Plan. These options have a grant price of $18.50 per share; 1,000,000 of the options follow the same vesting schedule as did the SAR unit grant, 100,000 options vest over four years and the remaining 10,000 options vested in one year since such options were granted in lieu of part of the Chairman's 1991 cash bonus. In addition, the Chairman was issued in May 1992, 463,320 shares of Enron Corp. common stock. Such number of shares reflects the effect of a two-for-one split of such stock on August 16, 1993. Of these shares, 370,656 shares are restricted until such shares vest on the earlier to occur of five years after their date of grant or when the Chairman commences receiving benefits from one or more of the qualified pension plans sponsored by Enron Corp. In February 1994, the Board of Directors of the Company adopted the Enron Oil & Gas Company 1994 Stock Plan (the '1994 Stock Plan'). Under the 1994 Stock Plan, employees of the Company and its subsidiaries may be granted rights to purchase shares of common stock of the Company generally at a price not less than the market price of the stock at the date of grant. Options granted under the 1994 Stock Plan vest to the employee over a period of time based on the nature of the grants and as defined in the individual grant agreements. The number of shares available for granting awards under the 1994 Stock Plan is 1,000,000 shares subject to certain adjustments. It is the intention of the Company that grants under the 1994 Stock Plan will be primarily to non-executive employees. LETTERS OF CREDIT. At December 31, 1993 and 1992, the Company had letters of credit outstanding totalling approximately $46.2 and $52.9 million, respectively. The letters of credit outstanding at December 31, 1993 include $33 million issued in connection with a promissory note between one of the Company's subsidiaries and a bank. The letters of credit outstanding at December 31, 1992 included $40 million issued in December 1992 in connection with the acquisition of producing properties in Canada, which acquisition was subsequently funded in early 1993. The related liability at December 31, 1992 for the acquisition was included in Other Current Liabilities. CONTINGENCIES. There are various suits and claims against the Company having arisen in the ordinary course of business. However, management does not believe these suits and claims will individually or in the aggregate have a material adverse effect on the Company's financial condition or results of operations. TransAmerican Natural Gas Corporation ('TransAmerican') has filed a petition against the Company and Enron Corp. alleging breach of contract, tortious interference with contract, misappropriation of trade secrets and violation of state antitrust laws. The petition, as amended, seeks actual damages of $100 million plus exemplary damages of $300 million. The Company has answered the petition and is actively defending the matter; in addition, the Company has filed counterclaims against TransAmerican and a third-party claim against its sole shareholder, John R. Stanley, alleging fraud, negligent misrepresentation and breach of state antitrust laws. Trial, originally set for February 7, 1994, is now set for September 12, 1994. Although no assurances can be given, the Company believes that the claims made by TransAmerican are totally without merit, that the ultimate resolution of the matter will not have a materially adverse effect on its financial condition or results of operations, and that such ultimate resolution could result in a recovery to the Company. The Company has been named as a potentially responsible party in certain Comprehensive Environmental Response Compensation and Liability Act proceedings. However, management does not believe that any potential assessments resulting from such proceedings will individually or in the aggregate have a materially adverse effect on the financial condition or results of operations of the Company. 9. CASH FLOW INFORMATION Gains on sales of certain oil and gas properties in the amount of $13.3 million, $6.0 million and $15.0 million are required to be removed from Net Income in connection with determining Net Operating Cash Inflows while the related proceeds are classified as investing cash flows for the years ended December 31, 1993, 1992 and 1991, respectively. However, current accounting guidelines will not permit the relevant federal income tax impact of these transactions to be reclassified to investing cash flows. The current federal income tax impact of these sales transactions was calculated by the Company to be $8.2 million, $8.2 million and $5.1 million for the years ended December 31, 1993, 1992 and 1991, respectively, which entered into the overall calculation of current federal income tax. The Company believes that this federal income tax impact should be considered in analyzing the elements of the cash flow statement. Cash paid for interest and paid (received) for income taxes was as follows for the years ended December 31: 1993 1992 1991 Interest (net of amount capitalized)----------------------- $ 10,517 $ 21,576 $ 30,967 Income taxes------------------------- (67,733) 7,365 6,618 10. BUSINESS SEGMENT INFORMATION The Company's operations are all natural gas and crude oil exploration and production related. Accordingly, such operations are classified as one business segment. Financial information by geographic area is presented below for the years ended December 31, or at December 31: 1993 1992 1991 Gross Operating Revenues United States-------------------- $ 640,205 $ 521,128 $ 436,856 Foreign-------------------------- 46,722 32,997 33,186 Total(1)--------------------- $ 686,927 $ 554,125 $ 470,042 Operating Income (Loss) United States-------------------- $ 112,686 $ 109,515 $ 77,333 Foreign-------------------------- (10,445) (9,943) (13,932) Total------------------------ $ 102,241 $ 99,572 $ 63,401 Identifiable Assets United States-------------------- $1,564,330 $1,568,093 $1,309,967 Foreign-------------------------- 246,832 162,919 145,641 Total------------------------ $1,811,162 $1,731,012 $1,455,608 (1) Not deducted are natural gas associated costs of $119,225, $101,136 and $82,437 in 1993, 1992 and 1991, respectively. 11. OTHER INCOME Other income consisted of the following for the years ended December 31: 1993 1992 1991 Gains on Sales of Oil and Gas Properties------------------------- $ 13,318 $ 6,037 $ 14,983 Litigation Reserve Accruals---------- (2,520) (2,194) (1,200) Interest Income---------------------- 5,789 1,555 424 Settlement of Natural Gas Contracts-------------------------- 4,248 - - Other, Net--------------------------- (882) (2,837) (2,439) Total------------------------ $ 19,953 $ 2,561 $ 11,768 12. CONCENTRATIONS OF CREDIT RISK AND ESTIMATED FAIR VALUE OF FINANCIAL INSTRUMENTS ACCOUNTS RECEIVABLE. Substantially all of the Company's accounts receivable at December 31, 1993 result from crude oil and natural gas sales and/or joint interest billings to affiliate and third party companies in the oil and gas industry. This concentration of customers and joint interest owners may impact the Company's overall credit risk, either positively or negatively, in that these entities may be similarly affected by changes in economic or other conditions. In determining whether or not to require collateral from a customer or joint interest owner, the Company analyzes the entity's net worth, cash flows, earnings, and credit ratings. Receivables are generally not collateralized. Historical credit losses incurred on receivables by the Company have been immaterial. LONG-TERM DEBT. At December 31, 1993, the Company had $153 million of long-term debt and $30 million of current maturities outstanding. (See Note 3 'Long-Term Debt'). The estimated fair value of such debt, including current maturities, at December 31, 1993 was approximately $192 million. The fair value of long-term debt is the value the Company would have to pay to retire the debt, including any premium or discount to the debtholder for the differential between the stated interest rate and the year-end market rate. The fair value of long-term debt is based upon quoted market prices and, where such quotes were not available, upon interest rates available to the Company at year-end. INTEREST RATE SWAP AGREEMENTS. In early 1992, the Company entered into $75 million in notional amount of interest rate swap agreements to hedge certain floating interest rate exposure in 1992 and 1993. This floating rate exposure arises from interest-bearing debt with interest payments subject to floating interest rates. (See Note 3 'Long-Term Debt'). Effective January 1, 1993, Enron Corp. assumed the Company's remaining obligations under these swap agreements. At December 31, 1993, the Company had outstanding interest rate swaps with notional principal amounts of $50 million which terminate April 1995. The estimated fair value of the outstanding swap agreements at December 31, 1993 was a negative $3.3 million. The fair value of interest rate swap agreements is based upon termination values obtained from third parties. FOREIGN CURRENCY CONTRACTS. The Company enters into foreign currency contracts from time to time to hedge specific currency exposure from commercial transactions. At December 31, 1993, there were no foreign currency contracts outstanding. PRICE RISK MANAGEMENT. During 1990 and 1991, the Company entered into certain price swap agreements to, in effect, hedge the market risk caused by fluctuations in the price of natural gas. The agreements call for the Company to make payments to (or receive payments from) the other party based upon the differential between a fixed and a variable price for natural gas as specified by the contract. The current swap agreements run for periods of up to ten years expiring in 2000 and have a notional contract amount of approximately $299 million at December 31, 1993. While notional contract amounts are used to express the magnitude of price and interest rate swap agreements, the amounts potentially subject to credit risk, in the event of nonperformance by the third parties, are substantially smaller. The Company does not anticipate nonperformance by the third parties. ENRON OIL & GAS COMPANY SUPPLEMENTAL INFORMATION TO CONSOLIDATED FINANCIAL STATEMENTS (IN THOUSANDS EXCEPT PER SHARE AMOUNTS UNLESS OTHERWISE INDICATED) (UNAUDITED EXCEPT FOR RESULTS OF OPERATIONS FOR OIL AND GAS PRODUCING ACTIVITIES) OIL AND GAS PRODUCING ACTIVITIES The following disclosures are made in accordance with SFAS No. 69 - 'Disclosures about Oil and Gas Producing Activities': OIL AND GAS RESERVES. Users of this information should be aware that the process of estimating quantities of 'proved' and 'proved developed' crude oil and natural gas reserves is very complex, requiring significant subjective decisions in the evaluation of all available geological, engineering and economic data for each reservoir. The data for a given reservoir may also change substantially over time as a result of numerous factors including, but not limited to, additional development activity, evolving production history, and continual reassessment of the viability of production under varying economic conditions. Consequently, material revisions to existing reserve estimates occur from time to time. Although every reasonable effort is made to ensure that reserve estimates reported represent the most accurate assessments possible, the significance of the subjective decisions required and variances in available data for various reservoirs make these estimates generally less precise than other estimates presented in connection with financial statement disclosures. Proved reserves represent estimated quantities of crude oil, condensate, natural gas and natural gas liquids that geological and engineering data demonstrate, with reasonable certainty, to be recoverable in future years from known reservoirs under economic and operating conditions existing at the time the estimates were made. Proved developed reserves are proved reserves expected to be recovered, through wells and equipment in place and under operating methods being utilized at the time the estimates were made. Canadian provincial royalties are determined based on a graduated percentage scale which varies with prices and production volumes. Canadian reserves, as presented on a net basis, assume prices and royalty rates in existence at the time the estimates were made, and the Company's estimate of future production volumes. Future fluctuations in prices, production rates, or changes in political or regulatory environments could cause the Company's share of future production from Canadian reserves to be materially different from that presented. Estimates of proved and proved developed reserves at December 31, 1993, 1992 and 1991 were based on studies performed by the Company's engineering staff for reserves in both the United States and Canada. Opinions by DeGolyer and MacNaughton, independent petroleum consultants, for the years ended December 31, 1993, 1992 and 1991 covering producing areas containing 65%, 69% and 73%, respectively, of proved reserves of the Company on a net-equivalent-cubic-feet-of-gas basis, indicate that the estimates of proved reserves prepared by the Company's engineering staff for the properties reviewed by DeGolyer and MacNaughton, when compared in total on a net-equivalent- cubic-feet-of-gas basis, do not differ materially from the estimates prepared by DeGolyer and MacNaughton. Such estimates by DeGolyer and MacNaughton in the aggregate varied by not more than 5% from those prepared by the Company's engineering staff. All reports by DeGolyer and MacNaughton were developed utilizing geological and engineering data provided by the Company. No major discovery or other favorable or adverse event subsequent to December 31, 1993 is believed to have caused a material change in the estimates of proved or proved developed reserves as of that date. The following table sets forth the Company's net proved and proved developed reserves at December 31 for each of the four years in the period ended December 31, 1993, and the changes in the net proved reserves for each of the three years in the period then ended as estimated by the Company's engineering staff. NET PROVED AND PROVED DEVELOPED RESERVE SUMMARY CAPITALIZED COSTS RELATING TO OIL AND GAS PRODUCING ACTIVITIES. The following table sets forth the capitalized costs relating to the Company's natural gas and crude oil producing activities at December 31, 1993 and 1992: 1993 1992 Proved properties-------------------- $ 2,675,419 $ 2,396,601 Unproved properties------------------ 96,801 78,770 Total---------------------------- 2,772,220 2,475,371 Accumulated depreciation, depletion and amortization------------------- (1,226,175) (1,007,360) Net capitalized costs---------------- $ 1,546,045 1,468,011 COSTS INCURRED IN OIL AND GAS PROPERTY ACQUISITION, EXPLORATION AND DEVELOPMENT ACTIVITIES. The acquisition, exploration and development costs disclosed in the following tables are in accordance with definitions in SFAS No. 19 - 'Financial Accounting and Reporting by Oil and Gas Producing Companies'. Acquisition costs include costs incurred to purchase, lease, or otherwise acquire property. Exploration costs include exploration expenses, additions to exploration wells in progress, and depreciation of support equipment used in exploration activities. Development costs include additions to production facilities and equipment, additions to development wells in progress and related facilities, and depreciation of support equipment and related facilities used in development activities. The following tables set forth costs incurred related to the Company's oil and gas activities for the years ended December 31: RESULTS OF OPERATIONS FOR OIL AND GAS PRODUCING ACTIVITIES(1). The following tables set forth results of operations for oil and gas producing activities for the years ended December 31: STANDARDIZED MEASURE OF DISCOUNTED FUTURE NET CASH FLOWS RELATING TO PROVED OIL AND GAS RESERVES. The following information has been developed utilizing procedures prescribed by SFAS No. 69 and based on crude oil and natural gas reserve and production volumes estimated by the engineering staff of the Company. It may be useful for certain comparison purposes, but should not be solely relied upon in evaluating the Company or its performance. Further, information contained in the following table should not be considered as representative of realistic assessments of future cash flows, nor should the Standardized Measure of Discounted Future Net Cash Flows be viewed as representative of the current value of the Company. The future cash flows presented below are based on sales prices, cost rates, and statutory income tax rates in existence as of the date of the projections. It is expected that material revisions to some estimates of crude oil and natural gas reserves may occur in the future, development and production of the reserves may occur in periods other than those assumed, and actual prices realized and costs incurred may vary significantly from those used. Management does not rely upon the following information in making investment and operating decisions. Such decisions are based upon a wide range of factors, including estimates of probable as well as proved reserves, and varying price and cost assumptions considered more representative of a range of possible economic conditions that may be anticipated. The following table sets forth the standardized measure of discounted future net cash flows from projected production of the Company's crude oil and natural gas reserves at December 31, for the years ended December 31: CHANGES IN STANDARDIZED MEASURE OF DISCOUNTED FUTURE NET CASH FLOWS. The following table sets forth the changes in the standardized measure of discounted future net cash flows at December 31, for each of the three years in the period ended December 31, 1993. SCHEDULE V S-1 SCHEDULE VI ENRON OIL & GAS COMPANY SCHEDULE VI -- ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (IN THOUSANDS) S-2 SCHEDULE VIII S-3 SCHEDULE X ENRON OIL & GAS COMPANY SCHEDULE X -- SUPPLEMENTAL INCOME STATEMENT INFORMATION FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (IN THOUSANDS) COLUMN A COLUMN B CHARGED TO EXPENSES ITEM 1993 1992 1991 Maintenance and repairs-------------- $ 8,198 $ 7,169 $ 7,107 Taxes, other than payroll and income taxes Property-------------------------- $ 12,525 $ 11,488 $ 6,401 Production/Severance-------------- 19,578 11,985 9,262 Franchise------------------------- 563 2,788 575 Other----------------------------- 107 32 124 Total-------------------------- $ 32,773 $ 26,293 $ 16,362 S-4 EXHIBITS Exhibits not incorporated herein by reference to a prior filing are designated by an asterisk (*) and are filed herewith; all exhibits not so designated are incorporated herein by reference to the Company's Form S-1 Registration Statement, Registration No. 33-30678, filed on August 24, 1989 ('Form S-1'), or as otherwise indicated. E-4 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. ENRON OIL & GAS COMPANY (REGISTRANT) By /s/ WALTER C. WILSON (WALTER C. WILSON) SENIOR VICE PRESIDENT AND CHIEF FINANCIAL OFFICER PURSUANT TO THE REQUIREMENTS OF THE SECURITIES EXCHANGE ACT OF 1934, THIS REPORT HAS BEEN SIGNED BY THE FOLLOWING PERSONS ON BEHALF OF REGISTRANT AND IN THE CAPACITIES WITH ENRON OIL & GAS COMPANY INDICATED AND ON THE 18TH DAY OF MARCH, 1994. SIGNATURE TITLE /s/ FORREST E. HOGLUND Chairman of the Board, President and (FORREST E. HOGLUND) Chief Executive Officer and Director (Principal Executive Officer) /s/ WALTER C. WILSON Senior Vice President and Chief (WALTER C. WILSON) Financial Officer (Principal Financial Officer) /s/ BEN B. BOYD Vice President and Controller (BEN B. BOYD) (Principal Accounting Officer) FRED C. ACKMAN * Director (FRED C. ACKMAN) RICHARD D. KINDER * Director (RICHARD D. KINDER) KENNETH L. LAY * Director (KENNETH L. LAY) EDWARD RANDALL, III * Director (EDWARD RANDALL, III) *By /s/ ANGUS H. DAVIS (ANGUS H. DAVIS) (ATTORNEY-IN-FACT FOR PERSONS INDICATED)